Equities

Special Report

Feature The SPX suffered its third 5.3-7.3% pullback since early April last week, which we deem a healthy development as markets cannot go up in a straight line. While there is a chance this latest pullback may morph into a correction, our sense is that equities will remain range bound in the near-term consolidating the vast gains made since the March 23 lows. Now that earnings season is practically over and macro data will remain backward looking, a large void signals that technicals will dominate trading. On that front, this looming lateral move will likely confine the SPX between the critical 50-day and 200-day moving averages – a roughly 10% range between 2,712 and 3,000 – until a catalyst breaks the stalemate (top panel, Chart 1A). With regard to the cyclical outlook, ultra-accommodative fiscal and monetary policies remain the dominant macro themes, and underpin our sanguine equity market view for the next year. Chart 1AConsolidating Gains Dollar The Reflator Importantly, King Dollar is a key macro variable that we are closely monitoring and as we highlighted last week, the Fed is indirectly aiming at jawboning the greenback.1 US dollar based liquidity is one of the most important determinants/drivers of global growth. The longer US dollar liquidity gets replenished, the more upward pressure it will put on SPX momentum and SPX EPS (Chart 1B). Sloshing US dollar based liquidity will serve as a much needed catalyst for a global growth recovery. Chart 1BHeed The Message From US Dollar Liquidity: Chart Of The Year Candidate The Yield Curve, Interests Rates And Profits Meanwhile, the yield curve, in fact a number of different yield curve slopes, troughed prior to the SPX in March, preserving its leading properties both near equity market tops and bottoms (middle & bottom panels, Chart 1A). The Fed orchestrated the steepening of the yield curve – which is typical during recessions – with the two preemptive cuts in March. Crucially, the yield curve is signaling that in the back half of the year SPX profits will also trough. True, a profit shortfall is upon us in Q2, and the steeper the fall, the higher the chance of a V-shaped recovery, owing to base effects (yield curve shown advanced, Chart 2). Chart 2Steep Yield Curve Slope Will Reflate Profits Encouragingly, the Fed reiterated last week that it will remain ultra-accommodative. While it will refrain from delving into NIRP, QE5 can expand anew and sustain the perching of the 2-year and even the 5-year and 7-year Treasury yields near zero. In fact, the shadow fed funds rate is already below zero as we highlighted last week.2 This monetary backdrop coupled with rising fiscal deficits as far as the eye can see – which will put upward pressure on long-term Treasury yields – will ensure a steep yield curve, and thus engineer a profit recovery (Chart 2). With regard to the interplay of interest rates and profit growth, the two are tightly inversely correlated (Chart 3). Empirical evidence suggests that since the mid-1980s profit growth is the mirror image of the year-over-year change in 7-year Treasury yields, albeit with a significant lag. Chart 3Interest Rate Pummeling Is A Boon For EPS What EPS Growth Is Discounted? Currently, if the relationship between profits and yields were to hold, then SPX EPS growth would stage a sizable come back in 2021. Chart 4 depicts the sell side’s quarterly EPS forecasts all the way to end 2021. Indeed, following a steep contraction, a brisk V-shaped profit recovery is looming in 2021 as we first argued three weeks ago that “historical precedents show an explosive year-over-year growth increase in EPS from recessionary troughs”.3 In more detail, Chart 5 breaks down 12-month forward EPS growth per sector. Tech comes out on top and by a wide margin with a near double-digit profit growth rate in absolute terms. This gulf is even more pronounced relative to the contracting SPX EPS growth rate. In fact, tech relative profit growth just reached the highest level since 2004 and explains the broad market’s tech dependence. As a reminder, tech market cap is back to the 2018 peak despite the fact the GOOGL and FB have now moved to the newly formed S&P communication services index. If one were to add the pair and AMZN back to the tech sector’s weight, it would comprise over 36% of the SPX, higher even than the dotcom bubble era (Chart 6)! Chart 4V-Shaped Profit Recovery Chart 5Tech… Chart 6…Reigns Supreme Tech Titans Digression A brief digression is in order as it pertains to the tech titans. We have been inundated with requests recently on the subject of valuations and the concentration of returns in the top five SPX stocks. We first commented on this in January, and reiterate today that the current tech sector’s supposed overvaluation is nowhere near the dotcom excesses .4 Back then, the top five SPX stocks commanded a forward P/E over 60, but today’s valuation pales in comparison with the late-1990s, as the equivalent P/E is roughly half that multiple (please refer to Chart 2 of the January 27, 2020 Weekly Report). Why? Because at the turn of the millennium, tech stocks had very little earnings to show for, but now the tech sector has the largest profit weight among its GICS1 peers. Thus, tech stocks trade at a modest 9% premium to the broad market whereas in 1999 they were changing hands at more than twice the SPX multiple (Chart 7). Chart 8 attempts to shed more light on the subject. The top panel shows the overall SPX market cap and also excluding the top five stocks. Then we subtract the top five stocks’ forward P/E from the broad market and show where the S&P 500 ex-top five stocks P/E trades (second panel, Chart 8). Since the FB IPO, these stocks have indeed increased their influence on the broad market’s valuation (third panel, Chart 8). Chart 7What Relative Overvaluation? Chart 8Top Five Are Pricey, But For Good Reason Sectorial Profit Growth Breakdown Circling back to the breakdown of 12-month forward EPS growth per sector, traditional defensive sectors (utilities, staples and health care) all enjoy positive 12-month forward profit growth in absolute terms, and so do communication services that just kissed off the zero line. All other sectors are contracting at differing degrees (Chart 5). On a longer-term basis, as expected no GICS1 sector is slated to contract, but their five-year growth rates are widely dispersed. Consumer discretionary, real estate, materials and tech occupy the top ranks with double digit growth rates, while utilities, consumer staples, energy, industrials and financials are in mid-single digits and at the bottom of the pit. Communication services and health care hover in the middle, on a par with the broad market (Chart 9). Chart 9Long-Term Growth Has Reset Lower Higher Profits Are Synonymous With Higher Returns Intuitively, the higher the forward profit growth rate, the higher each sector’s trailing return. Chart 10 depicts this positive correlation on the GICS1 sectors and corroborates that the laggard energy sector has the lowest year-to-date return, whereas tech stocks lead the pack. Importantly, SPX sector profit weights are extremely important. Chart 11 ranks the GICS1 sectors 12-month forward profit weights. Tech, health care and financials comprise roughly 60% of total S&P 500 earnings for the coming year. Whereas the drubbing in the energy sector (83% projected EPS contraction) has drifted into oblivion within the SPX context and has a mere 0.5% profit weight (Chart 11). Chart 10Higher Growth = Higher Returns Chart 11Top three Comprise 60% Of Profit Weight Bottom Line: While the top three sectors inherently carry the bulk of the risk on the SPX earnings front courtesy of the high concentration, our sense is that both tech (neutral) and health care (overweight) will deliver according to the messages from our macro EPS growth models (Chart 12). Financials (overweight) profits are a question mark, and therefore pose the greatest risk to our still constructive 9-12 month broad equity market view.     Anastasios Avgeriou US Equity Strategist anastasios@bcaresearch.com Chart 12EPS Growth Models Emit Positive Signals   Footnotes 1     Please see BCA US Equity Strategy Weekly Report, “The Bottomless Punchbowl” dated May 11, 2020, available at uses.bcaresearch.com. 2     Ibid. 3    Please see BCA US Equity Strategy Weekly Report, “Gauging Fair Value” dated April 27, 2020, available at uses.bcaresearch.com.          4    Please see BCA US Equity Strategy Weekly Reports, “Three EPS Scenarios” dated January 13, 2020 and “When The Music Stops...” dated January 27, 2020, available at uses.bcaresearch.com.  

The SPX 12-month forward P/E climbed to a new near two-decade high recently, as it almost kissed off the 21 handle (bottom panel). While investors begin to worry about lofty valuations, keep in mind that calendar 2020 profits are far from trend EPS. Peering across the valley to calendar 2021 and 2022 profits reveals that there is still more room for valuations to expand. Our sense is that the SPX some time next year can reclaim our trend EPS estimate near $162, and thus bring down the forward multiple to a more reasonable level (middle panel).  The Fed’s ultra-dovish stance is a key driver behind the multiple expansion phase of late. Tack on the recent dip in fed funds futures below the zero lower bound, and factors have fallen into place for a sustained valuation overshoot phase. Bottom Line: We remain constructive on the prospects of the broad equity market on a cyclical 9-12 month time horizon. ​​​​​​​

Dear Client, In lieu of our regular report next week, we will be sending you a Special Report on China from Matt Gertken, BCA Research’s Chief Geopolitical Strategist. Matt will discuss whether China’s President Xi Jinping is losing his political mandate. Best regards, Peter Berezin, Chief Global Strategist Highlights The pandemic is likely to have a more severe impact on Main Street than Wall Street, which helps explain why stocks have rallied off their lows even as bond yields have remained depressed. Equity investors are hoping that central banks will keep rates lower for longer, while fiscal easing will revive demand. The end result could be lower bond yields within the context of a full employment economy – a win-win for stocks.  In the near term, these hopes could be dashed, given bleak economic data, falling earnings estimates, and rising worries about a second wave of the pandemic. Longer term, an elevated equity risk premium and the likelihood that the pandemic will not have a significantly negative effect on the supply side of the economy argue for overweighting stocks over bonds. Negative real rates will continue to support gold prices. A weaker dollar later this year will also help. Divergent Signals Chart 1Conflicting Signals Global equities have rallied 24% off their March lows. The S&P 500 is down only 12% year-to-date and is trading close to where it was last August. In contrast, bond yields have barely risen since March. The US 10-year note currently yields 0.63%, down from 1.92% at the start of the year. The yield on the 30-year bond stands at a mere 1.3%. While crude oil and industrial metal prices have generally tracked bond yields, gold prices have rallied alongside equities (Chart 1). It would be easy to throw up one’s hands and exclaim that markets are behaving schizophrenically. Yet, we think it is possible to reconcile these seemingly divergent price patterns in a way that sheds light on where the major asset classes are likely to go in the months ahead. Two important points should be kept in mind: Bonds and industrial commodities tend to reflect the outlook for the real economy (i.e., Main Street) whereas stocks reflect the outlook for corporate earnings (i.e., Wall Street). The two often move together but can occasionally diverge in important ways. Stock prices and bond yields will tend to move in tandem when deflationary pressures are intensifying; however, the two often move in opposite directions when monetary policy is becoming more accommodative. The former prevailed in early March whereas the latter has been the dominant force since central banks have opened up the monetary spigots. The Real Economy Is Suffering The current economic downturn will go down as the deepest since the Great Depression. The IMF expects global GDP to contract by 3% this year, compared with a flat reading in 2009. GDP in advanced economies is projected to fall by 6%, twice as bad as in 2009 (Chart 2). Chart 2Severe Damage To The Global Economy This Year Unemployment rates are also likely to reach the highest levels since the 1930s. The US unemployment rate spiked to 14.7% in April. Even that understates the true increase in joblessness. The labor force has shrunk by 8 million workers since February. If everyone who had left the labor force had been considered unemployed, the unemployment rate would have jumped to nearly 19% (Chart 3). Unemployment among less-skilled workers rose more than among the skilled. Joblessness also increased more among women than men (Chart 4). Chart 3Increase In Joblessness Is Understated Chart 4Unemployment Has Risen More For Less Skilled Workers And Women The one silver lining is that unlike in past recessions, temporary layoffs have accounted for the vast majority of job losses (Chart 5). This suggests that the links between firms and workers have yet to be severed. As businesses reopen, the hope is that most of these workers will be able to return to their jobs, fueling a rebound in spending. Chart 5Temporary Layoffs Account For Most Of The Recent Increase In Unemployment Risks Of A Second Wave Will that hope be realized? As we discussed last week, the virus that causes COVID-19 is highly contagious – probably twice as contagious as the one that caused the Spanish flu.1 While some social distancing measures will persist even if governments relax lockdown orders, the risk is high that we will see a second wave of infections. Even if a second wave ensues, we do not expect stocks to take out their March lows. In many places, the second wave could come on top of a first wave that has barely abated. This is precisely what happened during the Spanish flu pandemic (Chart 6). Stock prices and credit spreads have closely tracked the number of Google queries about the coronavirus (Chart 7). If the number of new infections begins to trend higher, concern about the pandemic will deepen. This makes us somewhat wary about the near-term direction of risk assets. Chart 6The Lesson From The Spanish Flu: The Second Wave Could Be Worse Than The First Chart 7Joined At The Hip   March Was The Bottom In Equities Nevertheless, even if a second wave ensues, we do not expect stocks to take out their March lows. This is partly because the cone of uncertainty around the virus has narrowed. We now know that the fatality rate from the virus is around 1%-to-1.5%, which makes COVID-19 ten times more deadly than the common flu, but still less lethal than SARS or MERS, let alone some avian flu strains which have mortality rates upwards of 50%. A few treatments for the virus are on the horizon. Gilead’s remdesivir appears to be effective in treating COVID-19. Blood plasma injections also look promising. A vaccine developed by researchers at the University of Oxford has been shown to be safe on humans and effective against COVID-19 on rhesus monkeys. Production of the vaccine has already begun, and if it works well on humans, the Oxford scientists expect it to be widely available by September.2 The Stock Market Is Not The Economy Then there is the issue of Main Street versus Wall Street. US equities account for over half of global stock market capitalization. Tech and health care are the two largest sectors in the S&P 500. The former has benefited from the shift towards digital commerce in the wake of the pandemic, while the latter is a highly defensive sector that has gained from the flurry of interest in new treatments for the disease (Chart 8). Chart 8AUS Equity Sectors: Winners And Losers From The Pandemic (I) Chart 8BUS Equity Sectors: Winners And Losers From The Pandemic (II) Even within individual sectors, the impact on Wall Street has been more muted than on Main Street. For example, spending on consumer discretionary goods and services has plummeted across the real economy over the past few months. Yet, this has not hurt equity investors as much as one might have expected. Amazon accounts for 55% of the retail sector’s market capitalization. Home Depot is in second place by market cap. Home Depot’s stock is trading near an all-time high, buoyed by increased spending on home improvement projects by people stuck at home. McDonald's, which is benefiting from the shift to take-out ordering, is the largest stock in the consumer services sector (followed by Starbucks). Contrary to the claim that the stock market is blissfully ignorant of the mounting economic damage, those sectors that one would expect to suffer from a pandemic-induced downturn have, in fact, suffered. Airline stocks, which account for less than 2% of the industrials sector, have plunged. The same is true for cruise ship stocks. Bank stocks have also been beaten down, reflecting fears of heightened loan losses. Likewise, lower oil prices have undercut the stocks of energy exploration and production companies (Chart 9). At the regional level, non-US stocks, with their heavy weighting in deep cyclicals and financials, have underperformed their US peers. Small caps have also lagged their large cap brethren, while value stocks have trailed growth stocks (Chart 10). Chart 9Sectors Expected To Suffer From A Pandemic-Induced Downturn Have, In Fact, Suffered Chart 10Non-US Stocks, Small Caps, And Value Stocks Have Underperformed Tech stocks are overrepresented in growth indices, which helps explain why growth has outperformed value. Tech companies also tend to carry little debt while sporting large cash holdings. Companies with strong balance sheets have greatly outperformed companies with weak ones since the start of the year (Chart 11). Chart 11Firms With Strong Balance Sheets Have Excelled Relative To Weak Ones Chart 12Real Rates Have Come Down This Year In addition, growth companies have disproportionately benefited from the dramatic decline in real interest rates (Chart 12). A drop in the discount rate raises the present value of a stream of cash flows more the further out in time those cash flows are expected to be realized.   What Low Bond Yields Are Telling Us Doesn’t the decline in real long-term interest rates signal that future economic growth will be considerably weaker? If so, doesn’t this nullify the benefit to growth companies in particular, and the stock market in general, from a lower discount rate? Not necessarily! While lockdowns have led to a temporary drop in aggregate supply, they have not severely undermined the long-term productive capacity of the economy. Unlike during a war, no factories have been destroyed. And while heightened unemployment could lead to some atrophying of skills, the human capital base has remained largely intact. Chart 13 shows that output-per-worker eventually returned to its long-term trend following the Great Depression. Chart 13No Clear Evidence That The Great Depression Lowered Long-Term Trend Growth What the pandemic has done is made some forms of capital obsolete. We probably will not need as many cruise ships or airplanes as we once thought. But these items are not a huge part of the capital stock. And while some brick and mortar stores will disappear, this was part of a long-term shift toward a digital economy – a shift that has been raising productivity levels, rather than lowering them. Demand Is The Bigger Issue So why have long-term real interest rates fallen so much? The answer has more to do with demand than supply. Investors are betting that the pandemic will force central banks to keep interest rates at ultra-low levels for a very long period of time. All things equal, such an extended period of low rates might be necessary if the pandemic causes households to increase precautionary savings and prompts businesses to cut back on investment spending for an extended period of time. All things are not equal, however. As discussed in greater detail in Box 1, if real interest rates fall by enough, aggregate demand could still return to levels consistent with full employment since lower interest rates would discourage savings while encouraging capital expenditures. What if interest rates cannot fall by enough because of the zero-lower bound? In that case, fiscal policy would have to pick up the slack. Either taxes would need to be cut so that the private sector becomes more eager to spend, or the government would need to undertake more spending directly on goods and services. When interest rates are close to zero, worries about debt sustainability diminish since debt can be rolled over at little cost. In the end, the economy could end up in a new post-pandemic equilibrium where real interest rates are lower and fiscal deficits are larger. Applying Theory To Practice Framed in this light, we can make sense of what has happened over the past few months. The drop in long-term bond yields in February and early March was driven by falling inflationary expectations and rising financial stress. Yields then briefly jumped in mid-March as panicky investors dumped bonds in a mad scramble to raise cash. Not surprisingly, stocks suffered during this period. The Federal Reserve reacted to this turmoil by cutting rates to zero. It also initiated large-scale asset purchases, which injected much needed cash into the markets. In addition, the Fed dusted off the alphabet soup of programs created during the financial crisis, while launching a few new ones in an effort to increase the availability of credit and reduce funding costs. Other central banks also eased aggressively. As Chart 14 illustrates with a set of simple examples, even a modest decline in long-term interest rates has the power to significantly raise the present value of future cash flows. To compliment the easing in monetary policy, governments loosened fiscal policy (Chart 15). The point of the stimulus was not to raise GDP. After all, governments wanted most non-essential workers to remain at home. What fiscal easing did do was allow many struggling households and businesses to meet their financial obligations, while hopefully having enough income left over to generate some pent-up demand for when businesses did reopen their doors. Chart 14What Happens To Earnings During A Recessionary Shock? Chart 15Will It Be Enough? Ultimately, equity investors are hoping for an outcome where fiscal policy is eased by enough to eventually restore full employment while interest rates stay low well beyond that point in order to induce the private sector to keep spending: A win-win combination for stocks. Chart 16Gold Prices Move In The Opposite Direction To Real Rates The discussion above can also explain the divergent moves in commodity prices. Most industrial metals are consumed not long after they are produced. This makes industrial metal prices highly sensitive to the state of the global business cycle. In contrast, almost all of the gold that has ever been unearthed is still around. This makes gold an anticipatory asset whose price reflects expectations about future demand. Since owning gold does not generate any income, the opportunity cost of holding gold is simply the interest rate (Chart 16). When real interest rates rise, as they did briefly in early March when deflationary fears intensified, gold prices tend to fall. When real interest rates decline, as they did after central banks slashed rates and restarted large-scale QE programs, gold prices tend to rise. Investment Conclusions The current environment bears a passing resemblance to the one that prevailed in late 2008. Following the stock market crash in the wake of Lehman’s bankruptcy, the S&P 500 rallied by 24% between November 20, 2008 and January 6, 2009 to reach a level of 935. Had you bought stocks on that day in January, you still would have made good money over a 12-month horizon. However, you would have lost money over a 3-month horizon since the S&P 500 ultimately dropped to as low as 667 on March 6. During that painful first quarter of 2009, the economic surprise index remained firmly below zero, while earnings estimates continued to drift lower, just like today (Chart 17). As noted above, we do not expect stocks to take out their March 2020 lows, but a temporary sell-off would not surprise us, especially against a backdrop where a second wave of the pandemic looks increasingly likely. Chart 17Is Today A Replay Of Late 2008/Early 2009? Chart 18Favor Equities Over Bonds Over A 12-Month Horizon Despite our near-term concerns, we continue to think that stocks will outperform bonds over a 12-month horizon. The equity risk premium remains elevated, particularly outside the US (Chart 18). While non-US stocks do not have as much exposure to tech and health care, they do benefit from very cheap valuations. European banks are trading at washed out levels (Chart 19). The cyclically-adjusted PE ratio for EM stocks is near record lows (Chart 20). Investors should consider increasing exposure to non-US equities if global growth begins to reaccelerate this summer. Chart 19European Banks Are Trading At Washed Out Levels Chart 20EM Stocks Are Very Cheap Given our view that central banks want real rates to stay low and will refrain from tightening monetary policy even if inflation eventually begins to rise, investors should maintain above-average exposure to gold. A weaker US dollar later this year will also help bullion. Box 1The Role Of Monetary And Fiscal Policy Following Savings Shocks Peter Berezin Chief Global Strategist peterb@bcaresearch.com Footnotes 1  Please see Global Investment Strategy Weekly Report, “Risks To The U,” dated May 7, 2020. 2  Charlie D’Agata, “Oxford scientists say a vaccine may be widely available by September,” cbsnews (April 30, 2020). Global Investment Strategy View Matrix Current MacroQuant Model Scores

Neutral As reopening of the economy will, at the margin, bring back diners (take out mostly) to restaurants, the two heavyweights that comprise 80% of the market cap of the S&P restaurants group are anything but discretionary. In our view, MCD is defensive and SBUX has become a staple. Thus, as the economy slowly reopens and store traffic picks up, these bellwether stocks will lead this index higher. With regard to macro data, most of the restaurant-relevant releases are looking in the rear view mirror. In other words, the trouncing in restaurant retail sales and employment, food-away-from-home PCE and even the collapse in the Restaurant Performance Index were “known knowns”. Therefore, all of this grim news is already reflected in the 30% drubbing in relative performance from peak-to-trough (see chart). Bottom Line: Lift the S&P restaurants index to neutral from previously underweight, and please see this Monday’s report for additional details.  

Special Report

Highlights Even though EM equities appear cheap, the key near-term threats to them are their poor fundamentals and a renewed sell off in the S&P 500. Given the immense uncertainty, the current equity risk premium (ERP) should be at the upper end of its historical range. Hence, the discount rate – the sum of the risk-free rate and the ERP – should be reasonably high. This makes US equity valuations rather expensive. The key risk to our defensive strategy is that the rally in global growth stocks evolves into a full-fledged mania. Feature Every investor is aware that global corporate profits have collapsed due to nationwide lockdowns and profits will eventually recover as the lockdowns are gradually eased. This thesis, though, is not helpful for equity investors. To price equities properly, investors need to know how low corporate profits will fall and how fast and strong the eventual recovery will be.  Currently, visibility on the magnitude and speed of the decline in profits and the subsequent recovery is factually nil. In fact, very few companies are providing any guidance. There is enormous uncertainty surrounding the pace at which economies will be reopened, the possibility of secondary infection outbreaks and the discovery of a remedy or a vaccine for this virus. Besides, it is hard to forecast how fast animal spirits will revive among consumers and businesses worldwide. Thus, it is impossible to reliably forecast the magnitude and pace of both the decline in corporate profits and the subsequent recovery. What framework should investors use to value stocks when facing extremely low visibility? The CAPE Ratio Presently, the best method for valuing stocks is the Cyclically-Adjusted P/E (CAPE) ratio. This is a structural valuation measure that looks beyond the profit cycle, i.e., removes the cyclicality of earnings per share (EPS) from P/E ratio calculations. When the profit outlook is as muddy as it is today and the possible range of outcomes is very wide, it is safe to assume that in the next 12-18 months corporate profits will revert to their historical trend, i.e., drop below and then recover to their structural trend. This is a better conjecture than any attempt to forecast the magnitude and speed of both the profit plunge and subsequent recovery. Hence, the appropriate question for investors at this time is: what is the forward P/E multiple on equities assuming that EPS will plummet and then recover to their historical trend over the next 12 to 18 months? The CAPE model provides the answer to this question. Presently, the best method for valuing stocks is the Cyclically-Adjusted P/E (CAPE) ratio. Chart I-1 illustrates our EM CAPE model, showing EM equities as cheap as they were at previous major bear market bottoms. The EM CAPE is presently 12.5 assuming EM EPS plunge further in the coming months but recover to their long-run trend in 12-18 months from now (Chart I-1, bottom panel). Our measure for US CAPE presently stands in high 20s, well above its historical average of 18 (Chart I-2). Chart I-1EM Equity Valuations Are Low Chart I-2US Equity Valuations Are Expensive   Box I-1 on page 3 elaborates how our CAPE model is built and how it differs from Shiller’s CAPE ratio. Even though EM equities are very cheap, the key near-term threats to them are two-fold: (1) EM fundamentals remain downbeat, which is creating a near-term risk to share prices; and (2) a renewed sell off in the S&P 500 would drag EM stocks lower, despite cheap EM equity valuations. In the next section, we explore US equity valuations in a bit more detail. BOX I-1 Our CAPE Versus The Shiller CAPE: Differences In Methodologies Due to the lack of historical data for EM, we were unable to use Robert Shiller's methodology for constructing the CAPE ratio for developing markets. The Shiller method uses a 10-year moving average of EPS to calculate the cyclically adjusted EPS. However, in the case of EM aggregate EPS, data only goes back to 1986. If we were to calculate a 10-year moving average for EM EPS, we would lose 10 years of data, and the valuation indicator would only start in 1996. This is too short a time-frame for a structural valuation indicator. Chart I-3Comparing Two CAPE Methodologies Instead, we used the following methodology to construct the CAPE ratio for EM: We deflated EM EPS and EM equity prices (both in US dollar terms) by US consumer price inflation to get EM EPS and EM share prices in real (inflation-adjusted) US dollar terms. Then we ran a regression of EM EPS in real US dollar terms against a time trend. The resulting trend line represents the cyclically adjusted or structural EPS in real US dollar terms (Chart I-1, bottom panel on page 1). Finally, we divided EM stock prices in real US dollar terms by the cyclically-adjusted real US dollar EM EPS trend line. The outcome is the EM CAPE ratio (Chart I-1, top panel on page 1). To be sure that our methodology produced a reasonable outcome, we computed a CAPE ratio using our methodology for the US stock market and compared it with the Shiller CAPE ratio. Chart I-3 illustrates that our methodology generated a CAPE ratio that is similar to Shiller’s CAPE ratio. We are therefore confident that the results generated by our CAPE methodology are robust and sensible. Low Visibility = High Equity Risk Premium Chart I-4CAPE Ratio Negatively Correlates With Corporate Bond Yields It is a well-known fact that US equity multiples are very high. However, a common narrative in the investment community often justifies currently high US equity multiples by very low interest rates. One consideration that is missing in this argument is the equity risk premium. The P/E ratio is negatively correlated to the discount rate.1 The discount rate is the sum of the risk-free rate and the equity risk premium (ERP). Chart I-4 demonstrates that US CAPE ratio has been inversely correlated with corporate bond (BAA) yields. The latter includes both risk-free government bond yields and corporate credit spreads. Presently, one should use an ERP that is materially higher than its historical mean. Investors are currently facing record high uncertainty related to the business cycle as well as the structural trends in economic, political and geopolitical spheres. In short, enormous lingering uncertainty warrants using an ERP that is at the upper range of its historical trend. Critically, ERP is not a static variable. Yet, many equity valuation models assume that the ERP is constant and, therefore, compare equity multiples with risk-free rates. Such models are wrong-headed because a change in the ERP can in itself cause large fluctuations in share prices. Chart I-5Estimated US Equity Risk Premium Going forward, visibility on both the evolution of the virus containment measures and the global business cycle will eventually improve and, thereby, decrease ERPs that investors require. This will produce a lower discount rate heralding higher equity multiples. As of today, however, the tremendous uncertainty about the outlook still warrants a higher ERP. Chart I-5 illustrates that the US ERP based on our CAPE model is presently 270 basis points. It is elevated but still below historic peaks recorded in 2008 and 2011. Provided we face extremely limited visibility about the global outlook, we contend that the US ERP will likely rise in the short run. The latter will depress US equity valuations and prices. Bottom Line: Given the immense ambiguities investors are facing in regard to the business cycle and to economic, political and geopolitical trends, the ERP should be at the upper end of its historical range. Hence, the discount factor – the sum of the risk-free rate and the ERP – should be reasonably high. We conclude that US equity valuations are rather expensive despite the very low risk-free rate. Falling US stocks will drag EM share prices lower.  EM Versus The S&P 500: Three Conditions For A Reversal Chart I-6Relative CAPE Ratio: EM Versus US The relative EM versus US CAPE ratio is shown on Chart I-6. According to it, EM equities relative to their US counterparts are as cheap as they were at their previous major bottom in 2001. Nevertheless, valuation is not a good timing tool. For EM to start outperforming the S&P 500, three conditions are required: 1. China’s economy should embark on a cyclical recovery that is greater than the natural snapback in activity that it has been experiencing in the wake of the end of its lockdown. So far, the mainland economy is still in a snapback phase rather than in an expansion mode. 2. Global equity sector leadership should rotate from growth to value stocks, such as resource-related and banks. This has not occurred yet. The EM equity index is more sensitive to the performance of financials than the S&P 500 is. Table I-1 and I-2 represents individual EM and US sector weights in terms of both market cap and total corporate earnings in their respective equity benchmark. Financials account for 36.6% of EM total earnings and 20.9% of EM market cap. The same ratios for US financials in America’s broad equity index are 22.2% for earnings and 10.5% for the market cap. Table I-1EM Equity Sector Earnings And Market Cap Weights Table I-2US Equity Sector Earnings And Market Cap Weights   Further, EM equity prices remain highly correlated to global materials stocks (Chart I-7). As we discussed in our October 10, 2019 report, the rationale is as follows: both industrial metal prices and EM equities are driven primarily by China. Enormous lingering uncertainty warrants using an ERP that is at the upper range of its historical trend. 3. The US dollar should enter an extended bear market. The greenback has been resilient despite the Federal Reserve’s outright debt monetization and the general risk-on mood in global equity and credit markets. Further, the EM ex-China currency index has failed to rebound despite the noteworthy rally in the S&P 500 since late March (Chart I-8). Chart I-7EM Stocks Correlate With Global Materials Chart I-8EM Currencies Have Failed To Rally   For the greenback to depreciate, US dollars should be recycled overseas via augmented US imports or capital outflows from the US. It seems that none of this is currently taking place. The dollar is probably experiencing the last leg of its structural bull market that commenced in 2011. In financial markets, the final phase of a structural trend can last longer and run further than many investors expect. Odds are that the greenback will overshoot before topping out. Chart I-9 presents the real effective exchange rate for the US dollar, the euro and the Japanese yen, based on unit labor costs. This is our favored currency valuation measure. It reveals that the greenback is already expensive, but that its valuation can become even more expensive and reach two standard deviations above fair value before the US dollar peaks. In turn, according to the same measure, valuations of commodity currencies like NZD, AUD and CAD have downshifted considerably (Chart I-10). Nevertheless, they are not yet very cheap. Therefore, further undershoots cannot be ruled out. Chart I-9G3 Currency Valuations Chart I-10Commodity Currencies Valuations   Bottom Line: The conditions for EM stocks to begin outperforming the S&P 500 have not yet been satisfied. EM outperformance is not imminent. The Key Risk The key risk to our strategy of not chasing the recent equity rebound is as follows: The rally in expensive global growth stocks could evolve into a full-fledged mania. The latter would then lift the broader equity index, including value stocks. The average retail investor in any corner of the world can now make the case for an exponential rise in growth stocks: major central banks are printing money, risk-free interest rates are at zero, businesses in “new economy” are relatively immune to COVID shutdowns and, moreover, they represent the future. All conditions for a bubble formation are present: a concept that captures the average person’s imagination, good fundamentals and solid past performance, as well as liquidity overflow.  Growth companies that are leading this rally are very expensive and over-owned while the laggards – the value stocks – have a ruinous profit outlook. The only problem with this thesis is that these stocks have already rallied massively over the past decade and are consequently expensive and over-owned (Chart I-11). Chart I-11Each Decade Had A Mania Can they still go higher, dragging up overall equity indexes? They can, as the human imagination has no limits. If retail investors continue piling up on stocks – and there is some evidence they have been doing so – share prices will rise despite the expensive valuation of growth companies and the disastrous profit outlook for value stocks. Like any bubble, this mania, if it occurs, will eventually culminate with a crash. Investment Conclusions Chart I-12Growth And Value Stocks EM equities have become cheap and oversold, which is why we closed our short position in EM stocks on March 19. Nevertheless, we have not yet recommended buying or overweighting EM stocks. The near-term outlook remains risky and EM valuations could remain depressed for a while given that investors currently face zero visibility. Consistently, the risk-reward of global and EM equities is yet not attractive. The basis is as follows: Growth companies that are leading this rally are very expensive and over-owned while the laggards – the value stocks – have a ruinous profit outlook (Chart I-12).  For now, we continue recommending underweighting EM versus DM equities. Arthur Budaghyan Chief Emerging Markets Strategist arthurb@bcaresearch.com   Footnote 1   The P/E ratio inversely correlates to the discount rate: P/E ratio = (Payout rate x (1 + Growth rate)) / (Discount rate – Growth rate)

The Fed’s unorthodox monetary policy will likely continue to underpin equity prices in the coming 9-12 months. Specifically, according to Leo Krippner’s shadow short rates (SSR) estimate, the shadow fed funds rate is now negative, which is tailwind for the SPX (SSR shown inverted, top panel). Falling interest rates are a boon to equities via a rising price-to-earnings multiple (SSR shown inverted, bottom panel). Also, while the Fed would never admit to it, it is trying to devalue the US dollar and reflate the global economy, which will indirectly boost S&P 500 revenues. As a reminder, 40% of SPX sales are internationally sourced and thus a falling greenback is a welcoming sign for S&P 500 turnover (middle panel). Bottom Line: We remain constructive on the prospects of the broad equity market on a cyclical time horizon. Please refer to this Monday’s Weekly Report for more details.