Equities

Highlights We are hesitant to call a top to the volatility spike just yet. The US dollar is experiencing a counter-trend bounce. We also see political and geopolitical risks flashing yellow. House Democrats are drafting a reconciliation bill that will remind financial markets of looming tax hikes. President Biden faces imminent tests on China/Taiwan and Iran. The tech sector has bounced amid the setback to the reflation trade. Over the long run the Biden administration’s reflationary agenda suggests tech will no longer outperform. Biden’s regulatory risk to the tech sector is not immediate but still a downside risk. No major piece of bipartisan legislation is forthcoming but the Department of Justice, FCC, and FTC can bring negative surprises. We are hitting pause on our S&P trades until Biden passes some early hurdles. Feature Volatility has room to run, judging by past post-crisis periods (Chart 1), and this time we are especially concerned with brewing geopolitical risks, namely the US-China tensions over the Taiwan Strait. This geopolitical risk comes on top of the short squeezes and battles that retail investors are having against hedge funds all over the market. China is reminding the world of its red line against Taiwanese independence while testing the newly seated Joe Biden administration over whether it will seek a technological blockade against the mainland. Economic and trade policy uncertainty have collapsed but they would surge in the event of a crisis incident (Chart 2). While war is not likely, it is possible, so we need to see the Biden administration defuse the situation and pass this first test before we are willing to take on more risk on a tactical three-to-six-month time frame. Chart 1Volatility Can Go Higher Still Chart 2Uncertainty Down But Beijing Testing Biden Chart 3Biden's Approval Starts At 55% President Biden’s average approval rating in his first two weeks in office is 55%, right where former President Trump’s disapproval rating would have suggested (Chart 3). This is a significant but not extravagant improvement in political capital for the White House. Our Political Capital Index shows Biden’s position as moderate-to-strong (Table 1). Table 1Biden’s Political Capital Moderate-To-Strong The implication is that he still has a chance of passing his $1.9 trillion American Rescue Plan as a bipartisan bill with 10 Republican senators, a feat that would likely lower the topline value to around $1.3 trillion (Republicans proposed $618 billion) and exclude an increase in the federal minimum wage to $15 per hour. There is also a strong swing of independents in favor of Democrats in the opinion polling, in the wake of the incident on Capitol Hill on January 6, despite the fact that Republican and Democratic party identification are both stuck at around 30% — meaning that the Biden administration does have something to gain by appearing bipartisan (Chart 4).1 Republicans might cooperate to staunch the bleeding of their own support. Even Republicans approve of stimulus amid the pandemic and they would later be able to oppose Biden’s more controversial proposals with better optics having demonstrated bipartisan intent at the outset. However, House Democrats are already proceeding with a budget resolution, the first step in the budget reconciliation process that enables them to bypass Republicans entirely and get almost everything they want (Diagram 1). Chart 4Will Independents Keep Breaking Toward Democrats? Diagram 1Timeline Of Impeachment, Budget Reconciliation, And Regular Legislation Biden’s political capital should strengthen over the next year as the vaccine rollout improves and the economy comes roaring back. Official economic projections suggest that growth will glide solidly above potential until 2026 and that the output gap will close by 2024 (Chart 5). These estimates will be disappointed in various ways, of course, but in the near-term the risk is to the upside as they do not include Biden’s proposed $1.9 trillion rescue plan or his remaining, post-COVID agenda afterwards, which could cost anywhere from $3.7-$6.4 trillion over a ten-year period.2 The economy will be at less risk of relapsing than of overheating. This is especially true given the Federal Reserve’s new average inflation targeting strategy, which will discourage rate hikes till next year at the very earliest (and, from a political point of view, we would think 2023). Looking at the chart, Biden’s economic backdrop is far more propitious than that of his former boss Barack Obama’s back in 2009. Biden’s political momentum is therefore sustainable when it comes to the two budget reconciliation bills he wants to pass this year and next year. Republican internal divisions will help him. These were highlighted this week by Republican National Committee Chair Ronna McDaniel’s criticism of former New York Mayor Rudy Giuliani’s claims of voter fraud after the election and Senate Minority Leader Mitch McConnell’s recent scathing criticism of controversial pro-Trump freshman House member Marjorie Taylor Greene of Georgia. Republicans are only beginning their internal struggle and it is not certain that it will be resolved in time for the 2022 midterm elections. This is another reason to think that Biden’s political capital will be sustained and that moderate Republicans might assist with some Democratic legislation. The risks to Biden’s momentum stem from foreign policy (China, Iran, Russia), rapidly emerging financial instability, his party’s attempts at social control, and any major (not minor) negative developments involving the still-running pandemic and vaccine rollout. Chart 5US Economic Outlook Over Biden’s Term Macro Reflation Says Stay Underweight Tech The tech sector experienced a manic phase last year when COVID-19 struck and lockdowns kept consumers at home with nothing to do but work, shop, and stare at their phones. The big five companies – Apple, Microsoft, Google, Amazon, and Facebook – together witnessed an extraordinary run up relative to the other 495 companies in the S&P index that has since peaked and dropped off (Chart 6). Chart 6Fade The Big Tech Bounce Over Long Run Tech stock market capitalization accounts for 34% of American economic output – an extreme sign of over-concentration at a time when the market is generally inflated, according to the Buffett Index of stock market cap relative to GDP (Chart 7). Tech outperformance rests on strong earnings growth – supercharged due to the COVID crisis – as well as the secular fall in bond yields as a result of the global backdrop of excessive savings, low inflation, and scarce growth. Tech stocks are especially sensitive to bond yields because markets are projecting their earnings far into the future, as our colleague Mathieu Savary explained back in August. Ultra-dovish monetary policy with zero interest rates for longer and longer time frames is a perennial gift to these companies (Chart 8). Chart 7Buffett Indicator Says Big Tech Too Big Chart 8Big Tech Maxing Out As Bond Yields Rise? The catch is when and if growth and inflation expectations pick up. Even during the Dotcom bubble in the 1990s, the tech sector could not withstand rising interest rates (Chart 9). Eventually higher inflation will translate into central bank hikes and rising real interest rates – which should be very bad for tech as future cash flows lose value. Rising rates increase the cost of capital, while cyclical industries perform better in high growth environments with rising commodity prices. A recovery of inflation is becoming a more visible risk to investors over the coming few years. Even though unemployment is still elevated, and the output gap negative, the sea change in fiscal policy is likely to close this gap quickly and put upward pressure on expectations and prices. It will still take time to close the gap but each new dose of government spending on top of what is needed to plug the gap in demand due to the pandemic-stricken service sector will accelerate the time frame in which the labor market will tighten and price pressure will return. Investors are increasingly wary of this inflation risk as it is the logical consequence of the new combination of extreme monetary and fiscal accommodation. Earnings in the tech sector relative to the rest of the market have also peaked – and did not exceed their previous high point in 2010 despite the uniquely favorable backdrop (Chart 10). The big five have nearly saturated a lot of markets which raises the possibility that if the policy backdrop darkens, then they will see earnings disappointments. The Biden administration’s plan to raise the corporate tax rate to 28% and impose a 15% minimum tax on company book income would come as a double whammy for tech earnings, as they are relatively more exposed to increases in effective tax rates than other sectors. Chart 9Big Tech Wants Deflation, Big Government Wants Reflation Chart 10Big Tech Earnings Outperformance Hit Ceiling Amid Pandemic Finally, there is the long building problem of regulatory risk, as Americans have clearly become more concerned about Big Tech’s power and influence over their daily lives and politics. Here we do not think the Biden administration poses an immediate threat of frontal legislative assault, but we do think the end game is greater regulation, including tougher enforcement from antitrust agencies. Combined with geopolitical risk from Europe and other countries also seeking to tax and regulate these companies, the recent global semiconductor shortage, and the potential for a Taiwanese tech blockade, the political risk is clearly to the downside. Bottom Line: The macro backdrop has darkened for the tech sector. With governments turning more reflationary via a sea change in fiscal policy on top of ultra-easy monetary policy, inflation expectations should recover and inflation-sensitive sectors like tech should underperform. This risk is clear despite the fact that inflation requires the labor market to heal first. Any political, geopolitical, or regulatory risks would only further undermine the case for tech sector outperformance. Tech, Polarization, And Disinflation A critical question for investors is the relationship between US political polarization, the tech sector, and the disinflationary macroeconomic context that has proven so beneficial for Big Tech’s stock market performance. If polarization leads to gridlock, austerity, and disinflation, then tech can continue to enjoy the policy environment. But if polarization subsides, or if it coexists with a reflationary backdrop – as is the case today – then tech faces a new risk. It is fair to hypothesize that the rise of Silicon Valley and especially of social media has something to do with the explosion in US polarization over the past three decades. A simple chart of the S&P 500 alongside our polarization proxy – which measures the difference in presidential approval based on party – suggests that polarization could have some connection with tech sector outperformance (Chart 11). This is not a coincidence but the causality may work differently than some assume. The first period of tech sector outperformance, which rested on the “peace dividend” period of hyper-globalization, strong growth, strong dollar, low inflation, and technical innovation, occurred during the explosion of US polarization in the wake of the Cold War, when the US’s common enemy fell and the country’s political parties turned to do battle with each other for global supremacy. The structural changes of Reaganomics and NAFTA coincided with the political battles of the Republican revolution of 1994 and Bill Clinton’s sex scandal and impeachment. This heady period came to a peak in 2000 when the dotcom bubble burst and the US suffered its first contested election since 1876. Essentially globalization led to a deflationary backdrop that favored tech but also triggered the political struggle within the US for the spoils of victory in the Cold War. Chart 11Big Tech Likes Polarization And Gridlock The second period of tech sector outperformance emerged from the Great Recession, still higher wealth inequality, and the slow-burn economic recovery of the 2010s. The disinflationary environment and dollar bull market proved beneficial to the tech companies. In this case globalization’s deflationary effects continued but were compounded with US household deleveraging, which was far more malicious for the American middle class. Crucially, polarization created gridlock in Congress from 2010, preventing the US from pursuing a robust fiscal policy in the wake of the crisis that might have led to a more rapid recovery. Instead an extended disinflationary environment fed into social unrest and populism. While public animus naturally turned against Wall Street and the Big Banks in the wake of the financial crisis, the Dodd-Frank financial reform helped to pacify the public’s anger (though not entirely – and financial regulation is gradually reemerging as a relevant political risk). As the financial crisis faded from memory, but the low-growth, disinflationary environment continued to take a toll on households, an angry electorate began to freely express itself in the digital realm. Tech companies were happy to ride this wave and outperformed other sectors. As the backlash continued mounting, tech companies failed to rein in the angry userbase they had cultivated, and now they are staring at massive regulatory and legal risks from policymakers. Both Barack Obama and Donald Trump used Twitter and social media as a tool to establish direct engagement with their political base, much as Franklin Delano Roosevelt had used the radio and the fireside chat. This rising political heft ultimately made the companies conspicuous as conservatives blamed them for supporting the Obama administration (and Clinton campaign) while liberals especially blamed them for getting Trump elected. The Trump saga in particular gave rise to the so-called “tech-lash,” or backlash, as the companies’ core base of young, urbanized, cosmopolitan, and international users called on the tech companies to stop the spread of Russian propaganda, or other propaganda they disagreed with, and undertake socially progressive causes. Meanwhile the older, conservative, and rural population doubted that Russian interference caused the 2016 election result and sensed that the tech companies’ content moderators might not be all that scrupulous regarding the difference between conservative views and Russian information warfare (Chart 12, top panel). In combination with the heated election year campaigning, the pandemic and the backlash against lockdown, tension in the virtual world came to a peak last year and spilled out into the real world. This all came to a head with Twitter and Facebook first censoring and then banning President Trump from their platforms amid his claims of voter fraud and the riot on Capitol Hill. Chart 12Big Tech Not The Chief Driver Of Polarization Two major policy changes have occurred that threaten to reverse this macro backdrop. First, as a result of the 2020 crisis the Democrats won control of the White House and Congress and can now pass their mammoth spending agenda, which goes beyond pandemic relief to expanding the role of government in American economy and society – including by reflating the economy and imposing higher taxes on corporations, both of which threaten to undermine the tech sector’s outperformance. Second, China’s secular slowdown, reduction of trade dependency, and divorce from the US economy have undermined hyper-globalization. The Biden administration is pursuing on-shoring and China restrictions albeit to a lesser extent than its predecessor. If technological advance and social media cause political polarization, then these policy shifts may not last long or have a durable macro effect. But technology and communication tools have advanced throughout history regardless of whether polarization in any given country was rising or falling. Older people are the most partisan in the US yet they are the least enthusiastic users of social media (Chart 12, bottom panel). Tech and social media have proliferated across the world and yet polarization has fallen in Germany, Australia, Sweden, and other economies even as it has risen in the United States and arguably the United Kingdom (Chart 13). If social media enabled populist outcomes like Trump and Brexit, then why did populism fall short in France, Spain, Italy, and Germany? Social media participation thrived on the rise of polarization through the 2000s and 2010s but it exacerbated the problem – and once polarization erupted in the form of an anti-establishment presidency, Russian interference, the Cambridge Analytica scandal, and real world riots and social unrest, the tech platforms found themselves in the crosshairs of both of the political factions and the various politicians trying to appease their anger. Silicon Valley and the FAANGs operate in a power struggle – not merely a politicized environment – that is here to stay and will direct their attention away from their primary business and toward paying for lobbyists in Washington, Brussels, and elsewhere. This in itself is a danger to their business models even if it were not the case that the macro and policy backdrop is less supportive. Bottom Line: The reflationary fiscal and policy backdrop will continue in the coming years, a macro headwind for tech outperformance, while political risks to the tech sector have grown substantially. Chart 13Polarization Falls In Many Countries Despite Social Media Congress In Check But Regulatory Risk Persists Democrats and Republicans have a different and opposed set of grievances against Big Tech, which is likely to prevent comprehensive legislation from developing anytime soon. But legislation is still possible, and in the meantime risks will come from emboldened regulators. Based on the House judiciary hearing in July 2020, Democrats are concerned with content moderation and market concentration. They want to fortify their recent gains in preventing social media companies from aiding what they regard as the spread of seditious and libelous material or propaganda that favors the anti-establishment Trumpist right wing. Judging by the Senate Republicans’ hearings in October and November 2020, Republicans are primarily concerned with content moderation– i.e. preventing conservatives from being de-platformed, and conservative views from being censored. Republicans are less concerned about market concentration, i.e. accusations of monopolistic and anti-competitive behavior.3 Now that the social media companies have more or less thrown in with the Democrats on content moderation, Democratic priorities are likely to shift to antitrust and anti-competitive behavior. But serious changes would require either abolishing the filibuster in the Senate (which is not happening for the time being due to last month’s bipartisan power-sharing arrangement) or winning over 10 Republicans. This will be difficult, especially when it comes to the Democratic belief that a generational shift in antitrust doctrine and practice is necessary. A frontal assault on the sector would require passing a law that resolves a number of jurisprudential issues so that the courts could be instructed to interpret antitrust issues with a greater focus on rooting out anti-competitive or collusive behavior (as opposed to lowering prices and preventing consumer harm). This is possible but Republican agreement would require major compromises that the Democrats are not inclined to make. A bipartisan bill is still possible because last year’s hearings revealed that there is common ground between the two parties. Both have agreed that anti-trust agencies should be strengthened and empowered to examine Big Tech; that data should be portable and platforms should be interoperable (rather than favoring their own services or imposing penalties for users who would switch services); that mergers and acquisitions should be examined with the presumption that consumers will be harmed, so that the merging parties must show that they cannot otherwise achieve the desired consumer benefits and that their actions will serve some public good; and that regulators need not trouble themselves excessively about the problem of accurately defining the market, which is always a sticking point for such fast evolving services.4 Moreover there is overlap between the populist sides of both parties, comparable to the bipartisan populist demands to give larger household rebates amid the COVID crisis. For example, Democrats want to revise Section 230 of the Communications Decency Act, which protects the tech companies from being held liable for the actions and comments of third parties on their platforms. The Democratic proposal is to break down the distinction between neutral tools and content creation, arguing that tech platforms can be “negligent” and that in order to benefit from the liability protections they should have to demonstrate that they have taken reasonable steps to prevent unlawful misuse of their platforms that cause harm to others. This idea of “reasonable moderation” would leave a very vague standard for judges that would lead to a complex operating environment across different jurisdictions, but it is attractive to Trumpists and right-wing populists who support greater ability to sue the platforms for alleged bias.5 Thus revising Section 230 could create a bridge between the two parties, albeit isolating the free-market contingent in either party. It would foist huge new liabilities not only on the tech giants but also on startups and market entrants with far fewer lawyers. The mechanism will be a decisive feature of any future legislative proposal, however. Republicans are staunchly opposed to creating an Internet oversight committee, similar to the Consumer Financial Protection Bureau, or anything that smacks of Big Brother and would risk too cozy of a relationship between the regulatory state and the immense capabilities of the tech companies. But they could be amenable to law that strengthens the antitrust agencies and alters the parameters of judicial scrutiny if they believed it would make consumer choice and innovation more likely. If popular opinion suggested great urgency on this issue then perhaps the parties’ differences could be resolved more quickly in the form of a major bill. But polls suggest the populace is also divided on tech regulation – in part because the pandemic left consumers largely thankful for the Internet services that they relied on so heavily while under lockdown. A bare majority of conservative Republicans and liberal Democrats now favor tech regulation, the average voter is lukewarm, and moderates of both parties show little enthusiasm (Chart 14). By contrast, at the height of Democratic anxiety over Trump’s election and Russian interference, a clear majority of Democrats and Democrat-leaning independents favored tougher regulation. Chart 14Public Split On Government Regulation Of Big Tech Companies In short, the public is split, the parties are split, and the various 2020 crises have temporarily subsided, so tech regulatory risk will emanate from regulatory authorities but not from major new legislation anytime soon. Regulatory agencies thus threaten to give tech stocks negative surprises – even if the process takes time. Biden will replace one commissioner on the Federal Trade Commission (FTC) immediately but may only be able to replace two Republican commissioners toward the end of his term, in September 2023 and 2024, meaning that the commission will be divided (Table 2). Any major crackdown on market concentration will have to proceed upon bipartisan grounds unless Democrats gain control of this commission sooner. Meanwhile Biden will be able to replace outgoing Republican Ajit Pai on the Federal Communications Commission (FCC) right away, giving a Democratic tilt to this body, which is capable of pursuing the administration’s goals on content regulation (Table 3). Here the Supreme Court may eventually weigh in to defend free speech and press rights, which Section 230 ultimately reinforces, but the tech companies will be in the firing line until then. Table 2Federal Trade Commission Balance Of Power Table 3Federal Communications Commission Balance Of Power Finally, Biden’s nominee for the US Assistant Attorney General for the antitrust division will be a critical post to watch for the Department of Justice’s involvement in tech regulation and antitrust, though this position requires Senate confirmation, which will rule out any populist candidate. If Biden picks a former Facebook lawyer as rumored then he clearly will not be prioritizing a tough antitrust stance.6 Bottom Line: With the Senate filibuster intact for the time being, Democrats need 10 Republican senators to join them to pass any significant legislation that would amount to a frontal assault on the tech sector. This is possible but not probable in the short run, as Congress prioritizes the fight against the pandemic, Republicans and Democrats remain divided and the public is lukewarm about regulation. Much more likely is a regulatory slow boil at the hands of the DOJ, FCC, FTC, and the states. Biden Maintains Obama Alliance With Silicon Valley Public opinion is wishy washy about Big Tech, as mentioned above. Compare attitudes toward Wall Street and the major pharmaceutical corporations. Opinion shifted against the banks drastically during the financial crisis and has since recovered to about 24% net approval, although there are also polls showing that consumers of all stripes believe the banking sector got off easy and could use more regulation (Chart 15). The health care industry also took a hit during the Great Recession, when laid off workers also lost their health insurance, and has also largely recovered due to its conduct during the pandemic. The exception is Big Pharma, which is widely blamed for excessive drug prices, got bashed under President Trump, and is about to get bashed by President Biden in the form of price caps and Medicare negotiations. By contrast with these sectors, the computer and Internet industry has seen a hit to its popular support since Trump’s election but never dipped into net negative territory and may be recovering due to its helpful role during the COVID lockdowns. When net popular approval turns negative then it will be a flashing red light for the tech sector that sweeping regulation is imminent. While some of the opinion polling is lagging, the crisis over the election is unlikely to produce this effect because the public views break down along partisan lines. Chart 15Big Tech More Popular Than Big Banks, Big Pharma Thus unlike the Trumpists, or the populists in the Democratic Party, the Biden administration is only inclined gradually to dial up the pressure on Big Tech. Biden would bite off more than any president could chew if he tackled tech aggressively along with other big corporations. His campaign platform and early executive orders show that he is already tackling Big Health Insurance and Big Oil, sectors that make up 7.5% and 1.4% of GDP respectively. There is at least some focus on re-regulating the financial industry as well (7.7% of value add), albeit with lower priority. To attempt a major overhaul of Big Tech (at least 5.3% of GDP) on top of all this would be impracticable even if Biden were inclined to listen to the anti-monopoly crusaders in his party. Information services are obviously important to the economies of solid blue states like California, New York, and Washington but they are increasingly important to critical swing states like Georgia and Pennsylvania – places where voters will be skeptical of Biden’s policies on energy and immigration. The information sector is growing fastest in blue states and in battlegrounds like Arizona. It employs more people in blue states and in battlegrounds like Georgia. And it is rapidly employing more people in the grand prize of Democratic designs, Texas, where an exodus of Californians fleeing poor governance and high costs holds out the possibility of creating a decisive Democratic ascendancy in the Electoral College. Silicon Valley and other tech clusters will maintain their unique strengths and network effects for a long time but the dispersion of the tech sector to cheaper heartland regions has electoral consequences that mainline Democrats will not want to suppress. Not only did the tech firms help Biden get elected through votes and media controls but also through campaign contributions. The financial and health care industries punished the Democrats for passing the Affordable Care Act (Obamacare) and Dodd-Frank reforms in 2009-12 (Chart 16). By contrast the tech heavily favors Democrats over Republicans (with donations at $170 million versus $20 million in the 2020 election). Biden’s priorities are two budget reconciliation bills that will partially reverse the Trump tax cuts in order to pay for the entrenchment and expansion of Obamacare and other aspects of his health care and child care agenda. He is also focused on infrastructure, particularly green infrastructure and renewables, to create jobs and galvanize the climate change coalition. Broad re-regulation is coming down the pike, but health, immigration, energy, and labor are higher priorities than tech. The tech sector faces greater scrutiny than before, first from the FCC and later from the DOJ and FTC, but the administration will have more room for maneuver later in its term. Bottom Line: The Obama administration forged an alliance with Silicon Valley that Biden will largely maintain. The purpose of regulatory pressure is to build leverage over the tech giants. Chart 16Big Tech A Big Donor To Democratic Party Investment Takeaways Not all of the dominoes are lined up to topple Big Tech in a massive display of federal monopoly busting. The public is lukewarm and the political elite are divided. Nevertheless the long-term trajectory points to greater government scrutiny – and the tech sector has no margin of safety for political risk as the macro backdrop has started to shift in a more inflationary direction. Our colleague Juan Correa Ossa has shown that antitrust action to curb corporate power has tended to occur at times in US history where stock market earnings are elevated or rising rapidly relative to average wages, when inflation is running hot, and yet the economy has entered a bust phase where politicians are looking for a scapegoat to deflect public anger (Table 4). Table 4Stock Performance In Selected Judicial Events While inflation is not an immediate problem (at least not yet), it was not a problem when the FTC and DOJ went after Microsoft starting in 1998. The distressed economy and tech bubble are good enough reason for investors to expect the government to increase antitrust pressure (Chart 17). If inflation recovers in the coming years around the time the Biden administration gains room to maneuver on this issue then it is doubly bad for the tech sector. Chart 17Anti-Trust Usually Follows Economic Bust In Microsoft’s case, the stock fell when the government first brought charges but rallied throughout the twists and turns of the courtroom – especially after 2002 when the case was settled, and ever since (Chart 18). Fortunately for the company the DOJ backed away from breakup and instead ordered it to open up its application programming to others. But even firms that are broken up usually create buying opportunities. Note that Microsoft cleared its image and has not become the subject of government or popular scrutiny again today. Today’s regulators are likely to place a greater burden of proof on tech companies attempting mergers and acquisitions. The alternative for startups is to hold an initial public offering – and IPOs have exploded amid the current context of low rates, easy money, investor exuberance, a chilling effect on M&A, and a lingering pandemic. The markets are frothy, buyer beware (Chart 19). Chart 18Microsoft's Anti-Trust Warning Chart 19Regulators Will Crack Down On M&A Strategically we remain favorable toward value stocks over growth stocks given the changing macro and policy backdrop outlined above (Chart 20). However, in the very near term we would not encourage investors to take on any additional risk. The latest bout of volatility is not necessarily over, political and geopolitical risks are now underrated after a period in which they subsided from peak levels, and exuberant markets are subject to very sharp corrections.   Matt Gertken Vice President Geopolitical Strategy mattg@bcaresearch.com Jesse Anak Kuri Associate Editor jesse.Kuri@bcaresearch.com Chart 20Take A Pause Amid Value Vs Growth Setback   Appendix Table A1Political Risk Matrix Table A2Biden’s Cabinet Position Appointments   Footnotes 1     Congressional Budget Office, “Overview of the Economic Outlook: 2021-2031,” February 2021, cbo.gov. 2     Committee for a Responsible Federal Budget, “The Cost of the Trump and Biden Campaign Plans” October 7, 2020, and “The Cost of the Trump and Biden COVID Response Plans,” October 29, 2020, October 7, 2020, crfb.org. 3    The huge gap between the two parties can be illustrated by the recent case of Parler, the microblog that sought to rival Twitter by maintaining laissez faire content moderation standards. When Parler came under fire for attracting conservatives in the wake of the Twitter ban against Trump, Apple and Amazon teamed up to block it from their app purchasing and cloud services, thus effectively banning the app for 99% of users. There is no doubt that any private platform can regulate content according to its own standards on its own sites. In the words of Section 230, this extends not only to “obscene” or “excessively violent” material but to anything “otherwise objectionable.” But once tech companies prevent the emergence of competitors and alternatives, and cooperate in doing so, they enter much more dangerous legal territory. And yet the response from the House Democrats on the oversight committee was to ask the FBI to investigate Parler for hosting far-right extremists. Conservatives are therefore up in arms. The courts have not yet weighed in but the case represents a larger risk to the tech firms than the usual challenges under Section 230. 4    Representative Ken Buck, “The Third Way,” House Judiciary Committee, Subcommittee on Antitrust, Commercial, and Administrative Law 5    See Will Duffield, “Circumventing Section 230: Product Liability Lawsuits Threaten Internet Speech,” Cato Institute, January 26, 2021, cato.org. 6    See Ryan Grim and David Dayen, “Merrick Garland Wants Former Facebook Lawyer To Top Antitrust Division,” The Intercept, January 28, 2021, theintercept.com. 

We are reopening our long “Back-To-Work”/short “COVID-19 Winners” pair trade that we first instituted in the September 8th, 2020 Strategy Report, and subsequently closed earlier this year for a gain of 21.5%, since inception as our risk management rolling stop was hit. Yesterday we highlighted that the recent market tumult is likely an equity-only event and the underlying cyclical drivers in the stock market remain intact. As equity vol settles down and the sudden fall in the 10-year Treasury yield reverses course (it remains one of the key risks to our economic reopening theme), there are high odds that the long “Back-To-Work”/short “COVID-19 Winners” share price ratio will resume its ascend. At the same time, the bullish theme for the economic reopening trade got another boost from the most recent ISM release that posted upbeat numbers especially on the prices paid subcomponent of the survey (bottom two panels). Thus, we are compelled to re-initiate this trade. With regard to the small cap bias that we recently monetized handsome gains for our portfolio – which is driven by similar macro catalysts – we are on the lookout to re-establish a small cap size bias, but at a better entry point (top two panels). Bottom Line: Reopen the long “Back-To-Work” / short “COVID-19 Winners” pair trade and put the small size bias on upgrade alert. The ticker symbols in the “Back-To-Work” and “COVID-19 Winners” baskets are: LUV, DAL, MAR, HLT, CVX, EOG, SBUX, MCD, CAT, HON, AXP, COF, NUE, GM; and TDOC, FCN, ZM, CTXS, JNJ, AMGN, REGN, CLX, RBGLY, WMT, COST, KR, NFLX, AMZN, respectively. ​​​​​​​

Highlights Chart 1China's PMIs Dropped In January January’s official PMI suggests that China’s economic recovery started the year on a weaker note. While both manufacturing and non-manufacturing PMIs remain in expansionary territory, the moderation was larger than in previous Januarys, which implies that more than seasonal factors were at play (Chart 1). The lockdowns in January due to a resurgence of COVID-19 cases in China are distorting business activities. Moreover, travel restrictions imposed for the upcoming Lunar New Year (LNY) will profoundly affect household consumption and the service sector in February and perhaps into March. Chinese stock prices, on the other hand, registered gains in January in both onshore and offshore markets. As noted in last week’s report, Chinese stocks face downside risks in the near term and we recommend that investors turn cautious. Economic and profit growth may disappoint in the first quarter, against a tightening policy backdrop. Feature Monetary Policy Normalization Remains On Track In the past three weeks, the PBoC drained short-term liquidity on a net basis from the interbank system. This action reversed market expectations in earlier January that the central bank would start to loosen monetary stance. Chart 2Chinas Monetary Policy Unlikely To Change Course When The Economy Strengthens The soft patch in China’s first-quarter economic recovery may prompt the PBoC to temporarily slow the pace of interest rate tightening, but it is unlikely that policymakers will reverse their policy normalization over the next 6 to 12 months (Chart 2). The authorities have been increasingly concerned about asset price inflation. In our view, near-term policy shifts will be tied to asset prices rather than consumer prices. The PBoC stated that its policymaking will be data dependent, but it may not succumb to a marginally slower recovery, particularly if the weakness proves to be transitory. Moreover, the unprecedented growth contraction from Q1 last year will boost economic data in the first three months of this year due to a low base effect. This year’s monetary policy could be reminiscent of 2019 when the PBoC frequently adjusted the short-term interbank rate (i.e. 1- to 7-days) while keeping the longer rate (3-month repo rate) mostly trendless throughout the year (Chart 3). In this scenario, China's 10-year government bond yield will not rise by as much as in 2017-2018 (Chart 4). Without a substantial improvement in profit growth, however, a slower rise in bond yields will be only marginally positive for Chinese stocks (Chart 4, bottom panel).  Chart 3Policy Normalization Remains On Track Chart 4Smaller Bond Yield Hikes Are Marginally Positive For Chinese Stocks   Corporations May Not Deliver Strong Profit Growth In 2021 Chart 5An Impressive Profit Recovery Supported The Stock Rally In 2H20 The newly released industrial profits data showed a sharp rebound in growth this past December, with the annual profit up by 4.1% over 2019. An impressive recovery in profit growth in the second half of last year helped to drive up Chinese stock prices (Chart 5). However, the magnitude of the rally in stock prices has been much more substantial than implied by the underlying profit growth. Industrial profits have barely recovered to their 2018 levels, while A shares have jumped by 40% in the past two years (Chart 5, bottom panel). Moreover, the strong recovery in profit growth may not be sustainable in 2021. While sales revenues may pick up even more this year, operating costs will likely increase, which would compress corporate profit margins (Chart 6). Lower operating costs from last year’s cheaper financing and growth-support policies, such as tax cuts and loan payment deferrals, helped to widen corporate profit margins. China’s social security contribution exemption and reduction policy reduced the cost burden of enterprises by 1.5 trillion yuan in 2020. Moreover, cheaper global commodity and oil prices in earlier 2020 also lowered China’s industrial input prices (Chart 7). Chart 6Increasing Operation Costs May Weigh On Industrial Profit Margins Chart 7Input Prices Have Risen Faster Than Output Prices Chart 8Product Inventories And Account Receivables Have Not Fully Recovered The normalization of policy rates and bond yields along with the rebound in commodity prices will weigh on industrial profit margins and profit growth this year. Furthermore, some cost-reduction benefits will be rolled back: policymakers have announced an end to the social security contribution waiver for corporations in 2021.  However, they will extend the reduction of unemployment insurance from the end of April 2021 to April 2022. It is still unclear whether China will grant the same scale of corporate tax relief this year as it did in 2020. We note that industrial inventory turnover has not recovered to its pre-pandemic level, finished product inventories remain high, and accounts receivable payments are taking longer to reach businesses compared with 2019. All these factors highlight a lack of vigor in the industrial sector’s recovery (Chart 8).  Travel Restrictions Will Dampen Q1 Economic Growth Chart 9A New Wave Of COVID-19 Cases In China New travel restrictions may cause some short-term distortion in China’s aggregate economy in the first quarter. China announced inter-provincial travel constraints for the LNY, effective between January 28 and March 8, due to a resurgence of COVID-19 cases in Beijing and the northern provinces (Chart 9). Local authorities urged migrant workers to stay in their work places and not return to their hometowns. According to the Ministry of Transport, it is estimated that around 50% of migrant workers will remain in place during the LNY. Manufacturing production (secondary industry) may increase slightly because workers will take fewer vacation days during the LNY. Nevertheless, the positive effect will be more than offset by large losses from consumption and tourism (tertiary industry). Reduced consumption from holiday travel, restaurant dining, offline shopping and services will overwhelm online retail sales of goods and services. All these factors will negatively impact Q1 GDP because tertiary industry accounts for around 55% of China’s GDP, a much larger slice than secondary industry1  (Chart 10).    January’s PMI shows that after narrowing in the past six months, the gap between production (supply) and new orders (demand) sub-indexes widened again in January (Chart 11). We expect the travel restrictions to exacerbate the goods oversupply in February and perhaps even into March. Chart 10New Travel Restrictions Will Have A Negative Impact On Q1 GDP Chart 11Goods Oversupply May Last Through Q1 Lingering Deflationary Pressures While headline CPI moved back into inflationary territory in December, mainly driven by food price increases, core CPI has fallen to its lowest level since late 2010 (Chart 12). Prices for some key consumer goods and services remain firmly in deflation and they may deteriorate further in Q1 due to a high price base during last year’s LNY. Chart 12Lingering Deflationary Pressures On Consumer Prices Chart 13PPI Will Likely Turn Positive In Q1 Due To Low Base Effect Chart 14A Stronger RMB Will Exacerbate Deflationary Pressures PPI deflation has eased and will probably turn positive in Q1 this year, supported by an expansionary business cycle and a low base (Chart 13). However, the risk of deflation may resurface in the second half of the year as stimulus effects subside. As such, China’s corporate profit growth will again face downward pressure, which would be exacerbated by a stronger RMB and rising real interest rate (Chart 14). Shipping Disruptions Should Be Transitory China’s export sector remains strong, benefiting from improving global demand and strength in China’s manufacturing supply chains. The drop in January’s PMI export new orders sub-index was mainly seasonal and could be due to the recent pandemic-related logistical disruptions and bottlenecks at ports (Chart 15).  The recent massive jump in freight costs reflects these one-off factors and bouts of inflation this year due to disruptions in logistics, which will likely prove to be transitory (Chart 16). Chart 15Exports Should Remain Robust Through 1H21 Chart 16A Jump In Freight Costs is Probably Transitory Real Estate Sector Under Stricter Scrutiny Housing demand and prices in top-tier cities picked up again in December despite rising mortgage rates and more restrictive bank lending to the real estate sector (Chart 17). In our view, the rebound in floor space started will be short-lived, and the gap between floor space started and completed will continue to converge (Chart 18). Real estate developers face stricter borrowing regulations and the rate of expansion of new projects will slow this year due to shrinking land transfers in 2020. Still, real estate developers will continue to finish their existing projects and promote new home sales. Therefore, on a net basis, we expect real estate investment and construction activities to remain stable in the first half of 2021.  Chart 17Housing Demand In First Tier Cities Climbed Again In December Chart 18A Rebound In Floor Space Started May Be Short lived Table 1China Macro Data Summary Table 2China Financial Market Performance Summary   Qingyun Xu, CFA Senior Analyst qingyunx@bcaresearch.com Jing Sima China Strategist jings@bcaresearch.com   Footnotes 1China’s secondary industry is mainly comprised of mining, manufacturing, the production and supply of electricity, gas and water, and construction. The tertiary industry refers to traffic, storage and mail businesses, information transfer, computer services and software, wholesale and retail trade, accommodation and food, finance, and other services. Cyclical Investment Stance Equity Sector Recommendations

We recommend investors monetize gains in the hedge we first recommended on December 7, 2020 in the form of VIX June futures, for a gain of 19% since inception, assuming conservatively that no leverage was used in executing this hedge. While the GME/Wallstreetbets saga has yet to fully play out, three reasons underpin our decision. First, this appears to be an equity only event as both USDJPY and USDCHF foreign exchange pairs went up last Wednesday and Friday. In a traditional “risk off” phase, the yen and the franc would spike versus the greenback not selloff. Second, during periods of active Fed QE the broad equity market has never fallen more than 10% from respective peaks. Using the Sunday night low for ES futures results in a 5.3% peak to trough fall for the broad market, well in the range of previous active Fed QE pullbacks. Finally, the spot VIX has jumped from 21 to a recent peak of 38, likely reflecting a lot of negative news. Spot VIX with a current (as we went to press) 33 handle implies that in the next 30 days the S&P 500 will either fall or rise by roughly 10% and vault to all-time highs or sink back to 3400. While the jury is still out on how this short squeeze phase will play out, a steeply inverted vol curve last week also signaled that the worst is likely behind us (see chart). Bottom Line: Crystalize 19% gains since inception in the VIX futures hedge, but stay vigilant.