Global

The odds of a cyclical upturn in global semiconductors over the next three-to-six months are low as global demand remains feeble and is contracting 15%/annum (top panel). Drilling deeper into global demand reveals that the slowdown is structural, affecting a number of geographical areas (bottom five panels). Chip company revenues have so far contracted by 24% since the October 2018 peak, which is disproportionally more than the decline in share prices. The global semiconductor equity index is only 14% below its March 2018 high. It appears as though the market is expecting a quick recovery in semi sales. However, as we highlighted in our most recent Special Report authored by Ellen JingYuan He, Associate Vice President of Emerging Markets Strategy, there are structural problems in each of the key segments that drive global semiconductor sales, warning that the odds of an upturn are low. Please see the next Insight where we discuss the major demand driver that accounts for 29% of the world’s total semiconductor sales. ​​​​​​​

Special Report

Highlights The odds of a cyclical upturn in the global semiconductor sector over the next three to six months are low. Global semiconductor demand will continue to decline due to contracting demand for smartphones, automobiles, personal computers (PCs), and servers. Global semiconductor stocks are still facing considerable downside in absolute terms. We recommend going long Asian semiconductor stocks versus the U.S. S&P 500 semiconductor index. Dedicated EM equity portfolios should stay neutral on the Taiwanese bourse and Korean technology sector relative to the overall EM benchmark. Feature Chart 1 shows share prices of the global semiconductor sector and global semiconductor sales in the past two decades. Chart 1Global Semiconductor Market: Sales & Share Prices Was last December’s trough in global semiconductor equity prices the ultimate bottom in this cycle? The odds are in favor of a continued contraction in global semiconductor sales and further downside in semiconductor share prices over the next three to six months. Cycle-On-Cycle Analysis Semiconductor sales experienced five recessions over the past 20 years. Table 1 illustrates the peak-to-bottom percentage decline in nominal global semiconductor sales and the magnitude of the drop in global semiconductor share prices in U.S. dollar terms during these five cyclical downturns in this industry. It also indicates the duration of each downturn and the number of months that semiconductor stocks led the bottom in global semiconductor sales. Table 1Key Statistics Of Five Cyclical Downturns In Global Semiconductor Market The current shrinkage of semiconductor sales is worse than the 2011-12 and 2015 downturns. Yet, it is still smaller than the magnitude during the 2008 Great Financial Crisis and the 2001 tech bubble bust. The revenue of semiconductor companies has so far contracted by 24%, which is disproportionally more than the decline in share prices of these companies. The global semiconductor equity index is only 14% below its March 2018 high. It appears as though the market is expecting a quick recovery in semiconductor sales. As per Table 1, in the downturns of 2008, 2011 and 2015, global semiconductor stocks all bottomed before the bottom of global semiconductor sales. Only in the 2001 episode, stock prices bottomed eight months after the bottom in sales. In the current cyclical downturn, global semiconductor sales have so far had only four months of growth contraction,1 far less than the 13-16 months experienced in all the past four cycles. All in all, we would lean against the market’s expectation of an imminent recovery in the semiconductor cycle. The demand downturn will last another three to six months and share prices are facing major headwinds. Global Semiconductor Demand Semiconductor sales are in contraction across countries and regions (Chart 2). In April – before President Trump’s tweet on imposing new import tariff on China, global semiconductor sales growth sank to a negative 15% year-on-year. The short-term (three-to-six month) outlook for global semiconductor demand remains dismal. Chart 3 shows global semiconductor revenue breakdown in terms of end usage. Mobile phones account for the largest share (29%) of the market, followed by PCs (12%), miscellaneous consumer products (12%), and servers (11%). All of these major demand sources are under downward pressure: Smartphone Sales Global smartphone sales are shrinking (Chart 4). According to the International Data Corporation (IDC), global smartphone shipments declined 6.6% year-on-year in volume terms in the first quarter of this year, worse than last year’s 4.4% drop. Chart 2Semiconductor Sales Are In Contraction Across Countries  In the current cyclical downturn, global semiconductor sales have so far had only four months of growth contraction, far less than the 13-16 months experienced in all the past four cycles. Chart 4Global Smartphone Sales: Contracting We expect smartphone shipments to continue contracting in the second half of this year. Major markets such as mainland China and advanced economies have entered the saturation phase of mobile-phone demand. For example, U.S. shipments were down 15% year-on-year in the first quarter due to near-full market penetration. In China, smartphone sales have shown signs of stabilization (Chart 5). However, this is probably temporary and has been driven by the boom in Huawei smartphone sales in China since early this year. The incredible 50% year-on-year growth of Huawei smartphone sales in the first quarter is not sustainable. While global sales of Huawei smartphones increased by 20 million units, total global smartphone sales of all brands fell by 22 million units (Chart 6). The U.S. punitive actions towards China and Huawei have also instigated nationalism in China. This has triggered a Chinese buying-spree of the Huawei smartphone. Chart 5Chinese Smartphone Sales: Temporary Stabilization Yet, this has probably reduced the number of potential Chinese smartphones buyers in the near future. After all, many buyers likely made the purchase earlier than otherwise planned in the absence of a trade war. Although Samsung, Huawei, OnePlus, Xiaomi, Motorola, LG, and ZTE have either released or will release their 5G phones this year, the sales growth from 5G phones will not be able to offset the loss in 2G, 3G and 4G phone sales, at least not in 2019. The IDC estimated that 5G phones would only account for about 0.5% of the market share this year. 5G will likely only begin affecting overall semiconductor demand next year, when they account for a larger share of smartphone sales.   Huawei is the market leader in 5G technology. The U.S. boycott of Huawei will likely continue. This will only slow the pace of 5G phone adoption and the development of 5G networks worldwide. On balance, global smartphone demand may only recover next year. Server Demand Global server shipments also experienced a 5% contraction in volume terms in the first quarter of this year, according to IDC (Chart 7). The outlook for the rest of 2019 does not look promising. Global server demand will likely remain in contraction in the second half of this year. Many hyperscale data centers have already purchased considerable amounts of servers in advance of the trade war to avoid tariffs.2 Meanwhile, the escalation in the U.S.-China confrontation has increased economic uncertainties. This may delay potential datacenter investments. Decelerating 5G network development worldwide due to the U.S. ban on Huawei will also tend to discourage new datacenter and cloud services projects. This is because the 5G technology enables datacenter and cloud services to experience a huge improvement in terms of data transfer speeds, latency, connectivity, capacity, reliability and mobility. Chart 7Global Server Shipment: Are In Contraction Personal Computers (PC) PCs sales are also in contraction (Chart 8). PC demand has entered into the deep-maturation phase while facing strong competition from tablets and laptops. Auto Sales Global auto sales also sank by 5% in April from a year ago, registering the worst contraction since 2009 (Chart 9). Chart 8Global PCs Sales: Deeply Saturated Chart 9Global Auto Sales Are In Contraction As Well Regarding auto demand, the Chinese government may continue to implement more supportive policies to stimulate car sales in China. However, we believe the recovery will be delayed. The government has already implemented a number of policies to lift domestic car sales since late January, including providing subsidies to encourage new energy vehicle sales, to promote auto sales in rural areas, and to increase auto replacement. The central government recently loosened auto sales restrictions in the first tier cities of Guangzhou and Shenzhen that have restrictive auto sales policies. However, all of these policies have failed to lift Chinese domestic car sales out of deep contraction. The key reason has been a diminishing willingness to spend among Chinese consumers, as suggested by falling households’ marginal propensity to consume (Chart 10). Bottom Line: Global semiconductor demand growth will likely remain weak and will fail to recover in the second half of this year. The basis is that its major upstream markets (smartphone, servers, PCs and automobiles) are all facing cyclically declining demand. Chart 10Chinese Consumers: Diminishing Willingness To Consume Inventories And Prices Chart 11 shows the semiconductor supply chain illustrating the process of manufacturing semiconductors starting with silicon wafers and up to final electronic products. Box 1 explains the role of key segments and players along the supply chain. Box 1 A Brief Explanation Of The Key Segments/Players Of The Supply Chain Both integrated device manufacturers (IDM) and foundries are at the center of the supply chain, responsible for chip manufacturing. In terms of semiconductor sales revenue, Samsung, Intel and SK Hynix are the world’s top three IDM companies and TSMC, Global Foundries and United Microelectronics Corp (UMC) are the world’s top three foundries. While IDMs cover most of the process from IC design, chip fabrication, assembly, testing and packaging, IDM companies still have to purchase raw materials and equipment for the chip-making process. Foundry companies receive orders from IC designing companies like Qualcomm, Nvidia, and Huawei HiSilicon, then purchase needed raw materials and equipment to proceed in the chip-manufacturing process. Both IDMs and foundries can either outsource the tasks of semiconductor assembly and testing or perform them on their own. The final semiconductor products will be used in electronics products, such as smartphones, computers, home appliances, automobiles, etc. Global semiconductor demand growth will likely remain weak and will fail to recover in the second half of this year. The basis is that its major upstream markets (smartphone, servers, PCs and automobiles) are all facing cyclically declining demand. In a typical business cycle, a cyclical downturn begins with a slump in demand for final electronic products (upstream demand). This leads to falling semiconductor sales. As a result, inventory buildup will occur across most of the segments along the semiconductor supply chain. Chipmakers: Producers’ semiconductor inventory in both Taiwan and Korea have reached either a record high or a near-record high (Chart 12). The installed wafer capacities at these two countries are the world’s largest, together accounting for 43% of total global wafer capacity. In addition, the inventory of some major electronic parts and components have also increased considerably in Taiwan (Chart 13). This also implies weaker demand for semiconductor raw materials. Chart 12Chipmakers: A Rapid Buildup In Inventory Chart 13Rising Inventory Of Some Major Electronic Parts And Components Raw material suppliers: Silicon wafer is the indispensable raw material required in the chip manufacturing process. Japanese companies account for over half of global silicon wafer supply.Chart 14 shows that silicon wafer inventory in Japan has had a significant buildup in volume terms since late last year. Importantly, it is not declining yet. Chart 14Silicon Wafer Inventory: A Significant Buildup As Well Outsourced semiconductor assembly and test (OSAT) providers: Both Singapore and Thailand are OSAT providers while they also manufacture, assemble and export electronic products. Both countries are closer to the downstream side of the semiconductor supply chain. Semiconductor inventory at these two countries has also jumped to a record high (Chart 15).   Chart 15Singapore and Thailand: Record High Semiconductor inventory   Importantly, a marginal improvement in demand will tend to support spot prices. For example, in the memory chip market, falling prices denote weak demand relative to excess supply. When prices of DRAM and NAND start to form a bottom or decisively move up, this may indicate the arrival of a cyclical upturn. So far, both DRAM and NAND prices are continuing to fall (Chart 16). In addition, the prices of silicon wafer – the most important raw material used in the chip-making process – have declined in the first half of this year.3  Chart 16Still Falling Memory Chip Prices Chart 17Deflating DRAM Prices Suggest Downside Risks To Korean Tech StocksIn short, prices are the most important variable to monitor. Chart 17 exhibits the high correlation between DRAM prices and the Korean technology sector stock prices. Falling DRAM prices suggest downside risks to technology stocks in Korea. Samsung accounts for about 65% of Korea’s tech index and 27% of the overall Korean equity index. Memory chips accounted for 68% of Samsung’s operating profits in the first quarter of this year.   Bottom Line: There has been involuntary inventory accumulation along the entire supply chain of semiconductors. This and ongoing price deflation among various types of semiconductors foreshadow a downbeat near-term outlook. The Interpretation Of Some Positive Developments There have been some positive developments in the past several months. Taiwanese PMI new orders diffusion index in the electronics sector jumped out of deep contraction to reach zero, and Chinese semiconductor imports halted their decline in both volume and value terms (Chart 18). The improvement in the aforementioned data was probably mainly due to large semiconductor purchases by China to hedge the rising risk of U.S. blocking China’s technological development (Chart 19). Chart 18Some Positive Development Chart 19China: More Semiconductors Purchases Before The Tariff And U.S. Huawei Ban? Besides, Huawei smartphone sales have been booming, which we deliberated on page 5, could have been responsible for the improvement in these data. This one-off surge will likely dwindle going forward. Investment Conclusions We remain negative on Asian semiconductor share prices in absolute terms. A continued contraction in global semiconductor sales will further squeeze their profits. In relative terms, we are neutral on the Asian semiconductor sector: we continue recommending market-weight allocation to Taiwan’s overall market and the Korean technology sector within the EM equity benchmark. As a new trade, we recommend going long Asian semiconductor stocks and short the S&P 500 semiconductor index over the next three to six months (Chart 20). The Bloomberg Asia Pacific semiconductor index has nine stocks. Samsung and TSMC account for 42% and 38% of the index, respectively. There has been involuntary inventory accumulation along the entire supply chain of semiconductors. This and ongoing price deflation among various types of semiconductors foreshadow the downbeat near-term outlook. Samsung will likely benefit from the U.S. ban on Huawei in the smartphone sector outside of China. In addition, Samsung will win some market share from Apple as the latter does not have a 5G phone to release this year. These positive factors may partially offset the negative impact from falling memory prices and demand on Samsung. The S&P 500 semiconductor index has 13 stocks. Intel, Broadcom, Texas Instruments and Qualcomm are the top five constituents, together accounting for nearly 70% of the index. Most of these companies are IC designing companies, which will likely suffer as Chinese demand for their products shrink due to the U.S. administration's ban on Huawei. This position will also benefit from U.S. dollar appreciation. A firm dollar will hurt profits of U.S. semiconductor stocks. In turn, currency depreciation in Korea and Taiwan will on the margin benefit Asian semiconductor stocks. Chart 20Recommend Long Asia Pacific Semiconductor Stock Vs. S&P 500 Semiconductor Index Chart 21The 2015 Experience Chart 21 shows that global foundry companies outperformed global IC designing companies during the final phase of the 2015 cyclical downturn. Odds are that these dynamics will play out in this downturn as well. Finally, the relative performance of Asian semiconductor stocks versus U.S. ones is oversold and might stage some sort of mean reversion (Chart 20). Ellen JingYuan He, Associate Vice President ellenj@bcaresearch.com Footnotes 1      Please note that here the calculation for “the number of months of the growth contraction” is different from the one for the “peak-to-bottom duration” in Table 1. “The number of months of the growth contraction” equals the number of months when semiconductor sales year-on-year growth is negative. 2      https://marketrealist.com/2019/05/nvidias-data-center-revenue-inference-rendering-and-edge/ 3      http://www.sohu.com/a/300386061_132567, http://news.moore.ren/industry/104958.htm

Highlights We spent nearly all of last week engaged in dialogue with clients: Over the course of a dozen face-to-face meetings, and multiple follow-up questions, we learned that crowding out is a real phenomenon. The Fed and trade tensions were essentially all that people wanted to discuss. We’re expecting a 25-basis-point rate cut in July, but our investment recommendations have not changed: We remain bullish on risk assets and bearish on Treasuries, and we continue to recommend that investors maintain below-benchmark duration positioning. Feature It turns out that you really can’t fight the Fed. Not when meeting with investors right now, anyway, as its impending moves dominated our discussions with several U.S.-based clients last week. We expect monetary policy will be Topic A on our meetings schedule this week and next, especially if the plot thickens after the FOMC releases its updated Summary of Economic Projections (“the dots”) and markets mull over Wednesday’s post-meeting statement and press conference. This report covers our recent exchanges with investors on the points that came up most often. Chart 1Healing, If Not Yet Fully Healed Q: How likely is it that the Fed will cut rates? We think a rate cut at the FOMC meeting beginning tomorrow is unlikely. Fed officials only revealed that they were seriously contemplating the idea recently, and it would feel rather sudden if they followed through so soon, especially when the Mexican tariff cloud has lifted, economic data have been reasonably firm and financial conditions are still easing (Chart 1). We pay particularly close attention when Fed speakers all start singing from the same sheet, though, and the prepared-to-adjust-the-target-range-as-necessary refrain is signaling a rate cut. Our base case is that changes in the post-meeting statement and the updated dots will point in the direction of a cut at the next FOMC conclave at the end of July. Q: Why has the Fed changed its tune so much since mid-December? We view the Fed’s evolution from a tightening bias to an easing bias as having unfolded in three distinct stages. The first stage occurred in early January, following the sharp fourth-quarter selloff in equities and corporate bonds. The decline in stock prices amounted to a meaningful decline in household wealth, the sudden widening in bond spreads heralded higher debt-service costs for corporations and consumers, and the surge in mortgage rates caused several would-be homebuyers to lose their nerve (Chart 2). With the accumulated tightening in financial conditions equating to at least one, if not two, 25-basis-point hikes in the fed funds rate, additional hikes would have amounted to piling on, and the Fed opted to move to the sidelines for perhaps a six-month stay. Financial conditions are still tighter than they were before the fourth-quarter selloff, but they’ve eased quite a bit. Chart 2The Rate Backup Spooked Homebuyers, But They'll Be Back The Fed signaled an even lengthier pause in March, bemoaning the risk of too-low inflation expectations, at a time when global growth was already slumping (Chart 3). It seemed to us that it began to worry about the prospect of entering the next recession with inflation expectations below 2%, from which it would not be able to lower the real fed funds rate below -2%. Inflation expectations of 2.5%, on the other hand, would support a real fed funds rate of -2.5%, providing the Fed with additional firepower to restart the economy. The post-meeting dots removed two full rate hikes from the median voter’s terminal-rate projection, and appeared to stretch the Fed’s pause from six months to twelve. Chart 3As Global Trade Goes, So Goes Global Growth Global trade facilitates global growth. Impediments to trade can cast a long shadow over the global economy, and the escalation of trade tensions provided the catalyst for the Fed’s latest dovish turn. Against a backdrop of uninspiring global growth, taking out some monetary policy insurance to protect against increasing trade frictions may well be a prudent course of action, especially in a low-inflation environment. At the moment, we assign slightly better than a 50% probability that the FOMC will cut the target rate at its July 30-31 meeting, but much could change between now and then. Q: What will happen if the Fed cuts rates? If the Fed cuts the fed funds rate in response to a rapidly weakening economy, risk assets will fare poorly. If the economy’s doing fine, and the rate cut is simply an insurance policy, the additional accommodation would give the economy an incremental boost, extending the longevity of the expansion. A longer runway for the business cycle, in turn, would mean longer (and bigger) bull markets in equities and spread product. In our base-case scenario in which the economy’s doing fine, a rate cut (or cuts) would be tantamount to spiking the punchbowl, and would therefore extend the sell-by date on our overweight equities and spread product recommendations. We don’t think the U.S. economy needs easier monetary policy, but there’s nothing in the current low-inflation environment that would prevent the Fed from cutting the fed funds rate as insurance against a downturn. Q: But what will happen if the Fed falls short of the rate-cut expectations that are already being discounted by the markets? As implied by the overnight index swap (OIS) curves, the money markets are pricing in 75 basis points (“bps”) of rate cuts in 2019, and another 25 in 2020 (Chart 4). Those expectations are awfully aggressive, and they are flatly incompatible with our constructive view. If the economy proves to be more resilient than expected, spread product will outperform Treasuries, especially given how much the latter have surged on the pickup in risk aversion. In line with our U.S. Bond Strategy service’s Golden Rule of Bond Investing,1 we expect that long-maturity Treasuries will underperform the overall Treasury index if actual rate cuts fall short of expected rate cuts over the next twelve months. We expect that the yield curve will first shift higher as the market discounts a better economic future (real rates rise) and then steepen as investors begin to discount the inflation implications of unneeded incremental monetary accommodation. Chart 4The Money Market Seems To Foresee A Recession Chart 5Stocks Do Better When Real Rates Are Rising If the economy surprises to the upside, the resulting boost to earnings should help equity investors overcome any disappointment resulting from a rate-cut shortfall. In terms of equity analysts’ spreadsheets, we expect that the boost to the earnings numerator would be large enough to overcome the drag from a larger interest rate denominator. Empirically, U.S. equities perform better over periods when real rates are rising than they do when real rates are falling (Chart 5). Q: What do you see for the rest of the world? We see improvement for the rest of the world. After 2017’s globally synchronized upturn, the first since the crisis, 2018 was marked by a sharp divergence in momentum. The U.S., fueled by fiscal stimulus, powered ahead, while China slowed, hobbled by monetary tightening. We think it is telling that the rest of the world followed China, the world’s second largest standalone economy, rather than the U.S., the comparatively closed number one (Chart 6). Chart 6Divergent Paths Our China Investment Strategy and Geopolitical Strategy teams have repeatedly made the case that investors have underestimated the lagged impact of tight monetary policy and slowing domestic credit growth on the Chinese economy over the past two years. While the existing tariffs on imports to the U.S. are a drag on Chinese growth, policymakers’ efforts to redirect credit creation from the shadow banking system to the regulated banking system has had a larger impact on economic activity. Now that the regulatory impediment has been removed, total social financing growth has picked up, and our China team expects it to rise meaningfully over the coming year in order to overcome the combination of still-muted economic momentum and a larger shock to the export sector (Chart 7). The key takeaway is that ongoing policy efforts will allow Chinese growth to stabilize and there is scope for policy to induce re-acceleration over the coming six to twelve months. The bullish scenario holds that Chinese growth will rebound as policymakers make use of that capacity. Chart 7Add Leverage In Case Of Tariffs Chinese imports are the key channel by which China impacts growth in the rest of the world. Increased Chinese aggregate demand will feed increased demand for materials and goods imports. China’s imports are Europe’s, Japan’s, emerging Asia’s, and the resource economies’ exports. If China bottoms and turns higher, we anticipate that its trading partners will as well with a lag of a few months. We side with the bulls and expect that it will, and we expect that the China-driven revival in the global economy, ex-U.S., will help spark a modest self-reinforcing acceleration cycle. As this virtuous circle begins to turn, the growth divergence between the U.S. (where the fiscal thrust from the stimulus package is nearly spent) and the rest of the world will narrow. We expect the dollar will peak once markets catch on to the shift, and that U.S. equities will shift from leader to laggard, in common-currency terms. Narrowing equity outperformance should help push the dollar lower at the margin, which in turn should help blunt Treasuries’ appeal to foreign investors, steering investment capital away from the U.S. Dollar softness, at the margin, should help contribute to S&P 500 earnings gains, reinforcing our bullish equity take in absolute terms. An exogenous shock could trip up the U.S. economy, but it’s hard to find clear-cut signs of internal weakness. Q: What data are you watching to tell you that your view may not come to pass? Much of our sanguine take turns on the idea that monetary policy settings have not yet turned restrictive. We cannot know in real time where the line of demarcation between reflationary and restrictive monetary policy lies, however, so we are on the lookout for data that might disprove our assessment that the fed funds rate is still comfortably in reflationary territory. Housing is the segment of the economy that is most sensitive to interest rates, and we would be concerned if it took a turn for the worse. For now, though, we’re encouraged by the homebuilder sentiment survey, which has retraced nearly all of its fourth-quarter losses (Chart 8), and suggests that the modest recovery in housing starts and new home sales will continue. Chart 8Homebuilders Are Feeling Pretty Chipper Chart 9What Recession? The inverted yield curve has gotten everyone’s attention, but one month of inversion is not enough to declare that a recession is on the way. It also appears that the inversion may have been inspired by investor risk aversion more than a sense that recession is nigh. Our Global Fixed Income Strategy service looked at the average position of several key data series at the onset of the last five recessions and found that conditions look a lot better than they did when those recessions were developing (Chart 9).2 The Leading Economic Index’s (LEI) recession forecasting record matches the yield curve’s. When it contracts on a year-over-year basis, recessions have reliably followed (Chart 10). The LEI is still expanding, but it has been steadily decelerating, and we are keeping a close eye on it. If it contracted while the yield curve was inverted, we would probably have to throw in the towel on our view that policy is still easy, and a recession is therefore still a ways off. Chart 10The LEI Is Not Yet Sounding The Recession Alarm   Doug Peta, CFA Chief U.S. Investment Strategist dougp@bcaresearch.com   Footnotes 1 Please see the U.S. Bond Strategy Special Report titled, “The Golden Rule Of Bond Investing,” published July 24, 2018, available at usbs.bcaresearch.com. 2 Please see the Global Fixed Income Strategy Weekly Report titled, “The Risk Aversion Curve Inversion,” published June 4, 2019, available at gfis.bcaresearch.com.

Special Report

Highlights The odds of a cyclical upturn in the global semiconductor sector over the next three to six months are low. Global semiconductor demand will continue to decline due to contracting demand for smartphones, automobiles, personal computers (PCs), and servers. Global semiconductor stocks are still facing considerable downside in absolute terms. We recommend going long Asian semiconductor stocks versus the U.S. S&P 500 semiconductor index. Dedicated EM equity portfolios should stay neutral on the Taiwanese bourse and Korean technology sector relative to the overall EM benchmark. Feature Chart 1 shows share prices of the global semiconductor sector and global semiconductor sales in the past two decades. Chart 1Global Semiconductor Market: Sales & Share Prices Was last December’s trough in global semiconductor equity prices the ultimate bottom in this cycle? The odds are in favor of a continued contraction in global semiconductor sales and further downside in semiconductor share prices over the next three to six months. Cycle-On-Cycle Analysis Semiconductor sales experienced five recessions over the past 20 years. Table 1 illustrates the peak-to-bottom percentage decline in nominal global semiconductor sales and the magnitude of the drop in global semiconductor share prices in U.S. dollar terms during these five cyclical downturns in this industry. It also indicates the duration of each downturn and the number of months that semiconductor stocks led the bottom in global semiconductor sales. Table 1Key Statistics Of Five Cyclical Downturns In Global Semiconductor Market The current shrinkage of semiconductor sales is worse than the 2011-12 and 2015 downturns. Yet, it is still smaller than the magnitude during the 2008 Great Financial Crisis and the 2001 tech bubble bust. The revenue of semiconductor companies has so far contracted by 24%, which is disproportionally more than the decline in share prices of these companies. The global semiconductor equity index is only 14% below its March 2018 high. It appears as though the market is expecting a quick recovery in semiconductor sales. As per Table 1, in the downturns of 2008, 2011 and 2015, global semiconductor stocks all bottomed before the bottom of global semiconductor sales. Only in the 2001 episode, stock prices bottomed eight months after the bottom in sales. In the current cyclical downturn, global semiconductor sales have so far had only four months of growth contraction,1 far less than the 13-16 months experienced in all the past four cycles. All in all, we would lean against the market’s expectation of an imminent recovery in the semiconductor cycle. The demand downturn will last another three to six months and share prices are facing major headwinds. Global Semiconductor Demand Semiconductor sales are in contraction across countries and regions (Chart 2). In April – before President Trump’s tweet on imposing new import tariff on China, global semiconductor sales growth sank to a negative 15% year-on-year. The short-term (three-to-six month) outlook for global semiconductor demand remains dismal. Chart 3 shows global semiconductor revenue breakdown in terms of end usage. Mobile phones account for the largest share (29%) of the market, followed by PCs (12%), miscellaneous consumer products (12%), and servers (11%). All of these major demand sources are under downward pressure: Smartphone Sales Global smartphone sales are shrinking (Chart 4). According to the International Data Corporation (IDC), global smartphone shipments declined 6.6% year-on-year in volume terms in the first quarter of this year, worse than last year’s 4.4% drop. Chart 2Semiconductor Sales Are In Contraction Across Countries  In the current cyclical downturn, global semiconductor sales have so far had only four months of growth contraction, far less than the 13-16 months experienced in all the past four cycles. Chart 4Global Smartphone Sales: Contracting We expect smartphone shipments to continue contracting in the second half of this year. Major markets such as mainland China and advanced economies have entered the saturation phase of mobile-phone demand. For example, U.S. shipments were down 15% year-on-year in the first quarter due to near-full market penetration. In China, smartphone sales have shown signs of stabilization (Chart 5). However, this is probably temporary and has been driven by the boom in Huawei smartphone sales in China since early this year. The incredible 50% year-on-year growth of Huawei smartphone sales in the first quarter is not sustainable. While global sales of Huawei smartphones increased by 20 million units, total global smartphone sales of all brands fell by 22 million units (Chart 6). The U.S. punitive actions towards China and Huawei have also instigated nationalism in China. This has triggered a Chinese buying-spree of the Huawei smartphone. Chart 5Chinese Smartphone Sales: Temporary Stabilization Yet, this has probably reduced the number of potential Chinese smartphones buyers in the near future. After all, many buyers likely made the purchase earlier than otherwise planned in the absence of a trade war. Although Samsung, Huawei, OnePlus, Xiaomi, Motorola, LG, and ZTE have either released or will release their 5G phones this year, the sales growth from 5G phones will not be able to offset the loss in 2G, 3G and 4G phone sales, at least not in 2019. The IDC estimated that 5G phones would only account for about 0.5% of the market share this year. 5G will likely only begin affecting overall semiconductor demand next year, when they account for a larger share of smartphone sales.   Huawei is the market leader in 5G technology. The U.S. boycott of Huawei will likely continue. This will only slow the pace of 5G phone adoption and the development of 5G networks worldwide. On balance, global smartphone demand may only recover next year. Server Demand Global server shipments also experienced a 5% contraction in volume terms in the first quarter of this year, according to IDC (Chart 7). The outlook for the rest of 2019 does not look promising. Global server demand will likely remain in contraction in the second half of this year. Many hyperscale data centers have already purchased considerable amounts of severs in advance of the trade war to avoid tariffs.2 Meanwhile, the escalation in the U.S.-China confrontation has increased economic uncertainties. This may delay potential datacenter investments. Decelerating 5G network development worldwide due to the U.S. ban on Huawei will also tend to discourage new datacenter and cloud services projects. This is because the 5G technology enables datacenter and cloud services to experience a huge improvement in terms of data transfer speeds, latency, connectivity, capacity, reliability and mobility. Chart 7Global Server Shipment: Are In Contraction Personal Computers (PC) PCs sales are also in contraction (Chart 8). PC demand has entered into the deep-maturation phase while facing strong competition from tablets and laptops. Auto Sales Global auto sales also sank by 5% in April from a year ago, registering the worst contraction since 2009 (Chart 9). Chart 8Global PCs Sales: Deeply Saturated Chart 9Global Auto Sales Are In Contraction As Well Regarding auto demand, the Chinese government may continue to implement more supportive policies to stimulate car sales in China. However, we believe the recovery will be delayed. The government has already implemented a number of policies to lift domestic car sales since late January, including providing subsidies to encourage new energy vehicle sales, to promote auto sales in rural areas, and to increase auto replacement. The central government recently loosened auto sales restrictions in the first tier cities of Guangzhou and Shenzhen that have restrictive auto sales policies. However, all of these policies have failed to lift Chinese domestic car sales out of deep contraction. The key reason has been a diminishing willingness to spend among Chinese consumers, as suggested by falling households’ marginal propensity to consume (Chart 10). Bottom Line: Global semiconductor demand growth will likely remain weak and will fail to recover in the second half of this year. The basis is that its major upstream markets (smartphone, servers, PCs and automobiles) are all facing cyclically declining demand. Chart 10Chinese Consumers: Diminishing Willingness To Consume Inventories And Prices Chart 11 shows the semiconductor supply chain illustrating the process of manufacturing semiconductors starting with silicon wafers and up to final electronic products. Box 1 explains the role of key segments and players along the supply chain. Box 1 A Brief Explanation Of The Key Segments/Players Of The Supply Chain Both integrated device manufacturers (IDM) and foundries are at the center of the supply chain, responsible for chip manufacturing. In terms of semiconductor sales revenue, Samsung, Intel and SK Hynix are the world’s top three IDM companies and TSMC, Global Foundries and United Microelectronics Corp (UMC) are the world’s top three foundries. While IDMs cover most of the process from IC design, chip fabrication, assembly, testing and packaging, IDM companies still have to purchase raw materials and equipment for the chip-making process. Foundry companies receive orders from IC designing companies like Qualcomm, Nvidia, and Huawei HiSilicon, then purchase needed raw materials and equipment to proceed in the chip-manufacturing process. Both IDMs and foundries can either outsource the tasks of semiconductor assembly and testing or perform them on their own. The final semiconductor products will be used in electronics products, such as smartphones, computers, home appliances, automobiles, etc. Global semiconductor demand growth will likely remain weak and will fail to recover in the second half of this year. The basis is that its major upstream markets (smartphone, servers, PCs and automobiles) are all facing cyclically declining demand. In a typical business cycle, a cyclical downturn begins with a slump in demand for final electronic products (upstream demand). This leads to falling semiconductor sales. As a result, inventory buildup will occur across most of the segments along the semiconductor supply chain. Chipmakers: Producers’ semiconductor inventory in both Taiwan and Korea have reached either a record high or a near-record high (Chart 12). The installed wafer capacities at these two countries are the world’s largest, together accounting for 43% of total global wafer capacity. In addition, the inventory of some major electronic parts and components have also increased considerably in Taiwan (Chart 13). This also implies weaker demand for semiconductor raw materials. Chart 12Chipmakers: A Rapid Buildup In Inventory Chart 13Rising Inventory Of Some Major Electronic Parts And Components Raw material suppliers: Silicon wafer is the indispensable raw material required in the chip manufacturing process. Japanese companies account for over half of global silicon wafer supply.Chart 14 shows that silicon wafer inventory in Japan has had a significant buildup in volume terms since late last year. Importantly, it is not declining yet. Chart 14Silicon Wafer Inventory: A Significant Buildup As Well Outsourced semiconductor assembly and test (OSAT) providers: Both Singapore and Thailand are OSAT providers while they also manufacture, assemble and export electronic products. Both countries are closer to the downstream side of the semiconductor supply chain. Semiconductor inventory at these two countries has also jumped to a record high (Chart 15).   Chart 15Singapore and Thailand: Record High Semiconductor inventory   Importantly, a marginal improvement in demand will tend to support spot prices. For example, in the memory chip market, falling prices denote weak demand relative to excess supply. When prices of DRAM and NAND start to form a bottom or decisively move up, this may indicate the arrival of a cyclical upturn. So far, both DRAM and NAND prices are continuing to fall (Chart 16). In addition, the prices of silicon wafer – the most important raw material used in the chip-making process – have declined in the first half of this year.3  Chart 16Still Falling Memory Chip Prices Chart 17Deflating DRAM Prices Suggest Downside Risks To Korean Tech StocksIn short, prices are the most important variable to monitor. Chart 17 exhibits the high correlation between DRAM prices and the Korean technology sector stock prices. Falling DRAM prices suggest downside risks to technology stocks in Korea. Samsung accounts for about 65% of Korea’s tech index and 27% of the overall Korean equity index. Memory chips accounted for 68% of Samsung’s operating profits in the first quarter of this year.   Bottom Line: There has been involuntary inventory accumulation along the entire supply chain of semiconductors. This and ongoing price deflation among various types of semiconductors foreshadow a downbeat near-term outlook. The Interpretation Of Some Positive Developments There have been some positive developments in the past several months. Taiwanese PMI new orders diffusion index in the electronics sector jumped out of deep contraction to reach zero, and Chinese semiconductor imports halted their decline in both volume and value terms (Chart 18). The improvement in the aforementioned data was probably mainly due to large semiconductor purchases by China to hedge the rising risk of U.S. blocking China’s technological development (Chart 19). Chart 18Some Positive Development Chart 19China: More Semiconductors Purchases Before The Tariff And U.S. Huawei Ban? Besides, Huawei smartphone sales have been booming, which we deliberated on page 5, could have been responsible for the improvement in these data. This one-off surge will likely dwindle going forward. Investment Conclusions We remain negative on Asian semiconductor share prices in absolute terms. A continued contraction in global semiconductor sales will further squeeze their profits. In relative terms, we are neutral on the Asian semiconductor sector: we continue recommending market-weight allocation to Taiwan’s overall market and the Korean technology sector within the EM equity benchmark. As a new trade, we recommend going long Asian semiconductor stocks and short the S&P 500 semiconductor index over the next three to six months (Chart 20). The Bloomberg Asia Pacific semiconductor index has nine stocks. Samsung and TSMC account for 42% and 38% of the index, respectively. There has been involuntary inventory accumulation along the entire supply chain of semiconductors. This and ongoing price deflation among various types of semiconductors foreshadow the downbeat near-term outlook. Samsung will likely benefit from the U.S. ban on Huawei in the smartphone sector outside of China. In addition, Samsung will win some market share from Apple as the latter does not have a 5G phone to release this year. These positive factors may partially offset the negative impact from falling memory prices and demand on Samsung. The S&P 500 semiconductor index has 13 stocks. Intel, Broadcom, Texas Instruments and Qualcomm are the top five constituents, together accounting for nearly 70% of the index. Most of these companies are IC designing companies, which will likely suffer as Chinese demand for their products shrink due to the U.S. administration's ban on Huawei. This position will also benefit from U.S. dollar appreciation. A firm dollar will hurt profits of U.S. semiconductor stocks. In turn, currency depreciation in Korea and Taiwan will on the margin benefit Asian semiconductor stocks. Chart 20Recommend Long Asia Pacific Semiconductor Stock Vs. S&P 500 Semiconductor Index Chart 21The 2015 Experience Chart 21 shows that global foundry companies outperformed global IC designing companies during the final phase of the 2015 cyclical downturn. Odds are that these dynamics will play out in this downturn as well. Finally, the relative performance of Asian semiconductor stocks versus U.S. ones is oversold and might stage some sort of mean reversion (Chart 20). Ellen JingYuan He, Associate Vice President ellenj@bcaresearch.com Footnotes 1      Please note that here the calculation for “the number of months of the growth contraction” is different from the one for the “peak-to-bottom duration” in Table 1. “The number of months of the growth contraction” equals the number of months when semiconductor sales year-on-year growth is negative. 2      https://marketrealist.com/2019/05/nvidias-data-center-revenue-inference-rendering-and-edge/ 3      http://www.sohu.com/a/300386061_132567, http://news.moore.ren/industry/104958.htm   Equity Recommendations Fixed-Income, Credit And Currency Recommendations

Highlights The European barometer that best gauges global growth is euro area growth excluding inventory adjustments. Euro area growth excluding inventory adjustments is now running at a blistering 4.2 percent nominal pace – close to its 10-year upper bound – and is unlikely to accelerate much further. All the evidence shows that we are at the tail-end of a global growth up-oscillation. Irrespective of the evolution of the trade war, our high conviction view is that our global growth barometer will show weaker readings in the second half of the year. We present the correct investment strategy for this environment within the report. Feature Chart of the WeekGrowth Isn’t Going To Get Much Better Europe is an excellent barometer of the world economy. Not only is Europe a big chunk of the global economy in its own right, Europe also has a very open economy with a huge external sector. Gross exports amount to almost a half of GDP in the euro area, compared to little more than a tenth in the United States (Chart I-2). But here’s the key point: the European barometer that best gauges global growth is not euro area growth per se; it is euro area growth excluding inventory adjustments (Chart of the Week and Chart I-3). Chart I-2Europe Has A Very Open Economy Chart I-3Euro Area Growth Ex Inventory Adjustments Has Rebounded Sharply If euro area firms were building inventories, it would clearly boost economic output; and vice versa. However, this inventory building would not represent genuine end demand from abroad. It follows that we must strip out inventory adjustments to yield a truer gauge of external demand.1 The Reading From Our European Barometer What does euro area growth excluding inventory adjustments show? The long-term analysis confirms that global activity suffered its sharpest setbacks this millennium in 2002, 2008, 2012, and again briefly last year. But in the first quarter of this year, euro area real growth excluding inventory adjustments bounced back to a very robust 2.5 percent clip or, in nominal terms, a blistering 4.2 percent clip.2 Indeed, in nominal terms, our barometer was close to its strongest reading since 2010! These impressive numbers leave us with not a shred of doubt: after a sharp setback, global growth commenced a strong rebound at the end of last year. Global growth commenced a strong rebound at the end of last year. For those still in doubt, further compelling evidence comes from the very clear recent outperformance of the economically sensitive global sectors: industrials and financials. Through the past decade, the relative performance of these global cyclicals has closely tracked our European barometer – albeit a brief decoupling did occur in 2012 after Draghi’s “whatever it takes” speech gave all financial assets a big shot in the arm (Chart I-4). Chart I-4Global Cyclicals Are Tracking Our Growth Barometer One problem is that our barometer gives a reading just once a quarter and these readings come out after a long delay. From the mid-point of the quarter to which the GDP data refers to their release date around one month after the quarter end, there is a two and a half month delay. Begging the question, is there a more frequent and timely current activity indicator (CAI) for the euro area? The answer is yes. We have found that the ZEW economic sentiment indicator (not to be confused with the current situation indicator) does the job well in real-time (Chart I-5 and Chart I-6). Chart I-5The ZEW Economic Sentiment Indicator... Chart I-6...Is A Good Current Activity Indicator   How Should Investors Use Our Barometer? However, investors face an even more fundamental problem. The equity market is itself a real-time current activity indicator. To be more precise, the best current activity is not the equity market taken as a whole – because the aggregate equity market can move as a result of drivers other than current economic activity, most notably central bank policy. Rather, as we have just shown, the very best current activity indicator is the performance of economically sensitive sectors – such as industrials and financials – relative to the total market (Chart I-7 and Chart I-8). Chart I-7The Best Current Activity Indicator... Chart I-8...Is The Relative Performance Of Global Cyclicals This means that even if we could measure GDP growth excluding inventory adjustments in real time, it would not help investors. After all, it would be ludicrous to expect one current activity indicator consistently to lead another current activity indicator! What we really need is a future activity indicator (FAI). If we could reliably predict where our barometer’s reading would be three or six months from now we could also reliably allocate our investments ‘ahead of the move’. Still, sometimes the current reading does inform us about the future. If a barometer already reads ‘very dry’ then we know that the weather is not going to get any better in the next few months! To be clear, euro area nominal growth excluding inventories, running at a blistering 4.2 percent pace, is near a 10-year high not just on a quarter-on-quarter basis but also on a six month on six month basis. The chances that it moves significantly higher are close to nil.   We are at the tail-end of a global growth up-oscillation. We should also look at the short-term impulses that drive growth. Crucially, these emanate from the short-term changes – and not the levels – of bond yields, the oil price (inverted), and bank credit flows. These impulses are now losing momentum (Chart I-9). Chart I-9Short-Term Impulses Are Losing Momentum The Correct Investment Strategy   To sum up, all the evidence shows that we are at the tail-end of a global growth up-oscillation. Irrespective of the evolution of the trade war, our high conviction view is that our global growth barometer – euro area growth excluding inventory adjustments – is highly unlikely to accelerate much further from its blistering 4.2 percent nominal clip. Much more likely, it will show weaker readings in the second half of the year. The yen is still an excellent defensive currency. Nevertheless, in the near term, asset allocation is a tough call. This is because, very unusually, all asset classes have performed well in unison, making it hard to rotate into one that offers value (Chart I-10). Hence, from a tactical perspective, we are shorting a 30:60:10 portfolio of equities, long-dated bonds, and crude oil. So far, the position is slightly down but we recommend holding it until it either achieves a 3 percent profit or it hits a 3 percent stop-loss. Chart I-10All Asset-Classes Have Performed Well In Unison For equities versus bonds, our long DAX versus the 30-year bund is now broadly flat since inception in January. But we will hold it for a while longer until we see clearer signs that global growth has flipped into a down-oscillation.   Within bonds, our underweight German 10-year bunds versus U.S 10-year T-bonds is still appropriate given the closer proximity of the bund yield, at -0.2 percent, to the mathematical lower bound. Moreover, this relative position has been working well recently.  Within equities, overweight European equities versus China and the U.S. has also been working well. However, we will be looking for opportunities to switch to underweight Europe versus the less economically sensitive U.S. equity market within the next couple of months. Finally, our stance to the euro – long versus the dollar, short versus the yen – has also been working well. The stance remains appropriate as the yen is still an excellent defensive currency, with the big additional advantage of possessing minimal political risk. Fractal Trading System* Given the synchronized rally of all asset classes this year, the financial services sector has strongly outperformed the market. But according to its 130-day fractal dimension, this strong outperformance is approaching technical exhaustion. Accordingly, this week’s trade recommendation is to short the financial services sector versus the market. The profit target is 2 percent with a symmetrical stop-loss. (One way of executing this is to short the IYG ETF versus the MSCI All Country World Index). In other trades, we are pleased to report that short NZX 50 versus FTSE100 achieved its 2 percent profit target and is now closed, leaving three open positions. For any investment, excessive trend following and groupthink can reach a natural point of instability, at which point the established trend is highly likely to break down with or without an external catalyst. An early warning sign is the investment’s fractal dimension approaching its natural lower bound. Encouragingly, this trigger has consistently identified countertrend moves of various magnitudes across all asset classes. Chart I-11 The post-June 9, 2016 fractal trading model rules are: 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. Use the position size multiple to control risk. The position size will be smaller for more risky positions.   * 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 Footnotes 1 To be precise, it is the change in the change in inventories that contributes to GDP growth. For example, if the change in inventories added 0.5 percent to GDP this quarter, but 1 percent last quarter, then it will have subtracted 0.5% from growth this quarter. 2 Quarter-on-quarter growth at annualised rates. Fractal Trading System Recommendations Asset Allocation Equity Regional and Country Allocation Equity Sector Allocation Bond and Interest Rate Allocation Currency and Other Allocation 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-8Indicators To Watch - Interest Rate Expectations  

Special Report

Feature Through the past five years, the global long bond yield has tried to surpass 2.5 percent on three occasions – once in 2015, twice in 2018. But it has failed (Feature Chart). The global long bond yield’s five-year struggle to break through 2.5 percent convinces us that the so-called ‘neutral’ rate of interest is now extremely low, indeed zero in real terms. This is a very high conviction view though, to be clear, not every BCA strategist may necessarily concur. Feature ChartSince 2015, The Global Long Bond Yield Has Struggled To Surpass 2.5 Percent The neutral rate of interest is the interest rate at which monetary policy is neither accommodative nor restrictive, the interest rate consistent with the economy maintaining full employment while keeping inflation constant. That much is generally accepted. Here’s where we differ from the conventional thinking: what is setting the neutral rate now is not the economy’s direct sensitivity to the interest rate via rate sensitive sectors such as mortgage lending or home construction: rather, it is the economy’s indirect sensitivity to the interest rate via its impact on equities and other so-called ‘risky’ assets. This Special Report challenges the conventional wisdom on the neutral rate on three specific points: The neutral rate is based on the bond yield, not on the policy interest rate. The neutral rate is global, not European or region specific. The neutral rate is nominal, not real. The Neutral Rate Is Based On The Bond Yield, Not On The Policy Interest Rate The $400 trillion combined value of equities, corporate bonds, real estate and other risky assets dwarfs the $80 trillion global economy by five to one. These risky assets are long-duration assets, because their cash flows extend into the distant future. Hence, the market calibrates the expected return available on these risky assets from the supposedly less risky return available from long-duration bonds – the bond yield – plus a ‘risk premium’. Now comes the part of the story that is not well understood, even by central bankers, because it derives from recent advances outside their field of expertise. Years of research in behavioural finance conclude that the measure that best encapsulates our perception of an investment’s risk is not its volatility but its negative asymmetry: the potential largest loss as a multiple of the potential largest gain (Chart I-2). The $400 trillion combined value of equities, corporate bonds, real estate and other risky assets dwarfs the $80 trillion global economy by five to one. Crucially, when the bond yield gets low, the proximity of its lower bound dramatically reduces the potential for price gains while leaving open the potential for large losses. This sudden onset of negative asymmetry means that bonds are no longer less risky than equities or other risky assets (Chart I-3). So risky assets no longer need to deliver a higher expected return than bonds (Chart I-4). Chart I-5Equities Offer Diversification Benefits Too! Some people counter that bonds offer investors a diversification benefit and, because of this, investors still need a higher return from equities. This argument is wrong. Just as bonds can protect equity investors, equities can protect bond investors during vicious sell-offs in the bond market – such as after Trump’s shock victory in 2016 (Chart I-5). So we could equally argue that equities require the lower return. In fact, at a low bond yield, with the same negative asymmetry and diversification properties, both equities and bonds must offer the same prospective return.   The upshot is that once the bond yield gets low and stays low, equity (and other risky asset) returns collapse to the feeble return offered by bonds with no additional ‘risk premium’ giving the valuation of $400 trillion of assets an exponential uplift (Chart I-6). The unfortunate corollary is that if the bond yield was no longer low, the valuation of $400 trillion of assets would suffer an exponential decline. And the consequent deterioration in financial conditions would send a chill wind through the global economy. Theoretically and empirically, the hyper-sensitivity of equity valuations to bond yields is greatest when the 10-year bond yield is in the 2-3 percent range. But which 10-year bond yield?1  Chart I-6Equities Are Now Priced To Generate A Feeble Long-Term Return The Neutral Rate Is Global, Not European Or Region Specific The question: ‘will European equities go up or down?’ is essentially the same as ‘will U.S. equities go up or down?’ or ‘will Chinese equities go up or down?’ albeit the size of the moves can be quite different. The same applies to mainstream bond markets; in directional terms, bonds move together. Chart I-7The Global 10-Year Yield Is The Average Of The Euro Area, U.S., And China Given this tight directional integration of global capital markets – and to some extent economies too – asset allocators make the asset class choice between equities and bonds their primary decision, and the regional allocation the subsidiary decision. It follows that the point of hyper-sensitivity of equity valuations, be it in Europe or any other region, is when the global 10-year bond yield is in the 2-3 percent range. What is the global 10-year bond yield? Previously, we defined it in terms of the German bund, U.S. T-bond, and JGB. But we now have an even better definition: it is the simple average of the 10-year yields in the world’s three major economies; the euro area, U.S., and China (Chart I-7).2  Given this yield’s five year struggle to surpass 2.5 percent, we can say that the ‘neutral’ rate, at which tighter financial conditions do not threaten any major economy, might be somewhere below this recent empirical limit, at around 2 percent. The Neutral Rate Is Nominal, Not Real Investors always think about the negative asymmetry of returns in nominal terms. This is because the losses they fear tend to be too short and too sharp for the real return to be meaningfully different from the nominal return.3 It follows that the aforementioned hyper-sensitivity of equity valuations is when the nominal bond yield is in the 2-3 percent range, resulting in a neutral nominal rate which might be 2 percent (Chart I-8). But if inflation is also running fairly close to 2 percent, as it is in the major economies, the upshot is that the neutral real rate of interest is zero.  What Does All Of This Mean? To sum up, a decade of ultra-loose monetary policy has fostered an addiction to – or at least a dependency on – low bond yields (Chart I-9). But the dependency is not of the rate sensitive sectors in the economy per se, rather it is of the rich valuation of risky assets whose worth dwarfs the global economy by five to one (Chart I-10). Gradually, this dependency should diminish as economic and profit growth improves valuations, but this will take time. Chart I-9A Decade Of Ultra-Loose Monetary Policy... Chart I-10...Has Made The Rich Valuation Of Risky Assets Dependent On Low Bond Yields In the meantime, the integration of global capital markets means that the valuation cue for European – and all regional – stock markets now comes from the global 10-year bond yield. Given its recent decline to slightly below neutral, stock markets are unlikely to free fall. A decade of ultra-loose monetary policy has fostered an addiction to – or at least a dependency on – low bond yields. That said, the aggregate market is likely to be in a sideways structural pattern, as it has been for the past eighteen months, and the big opportunities will continue to come from sector rotation: in the second half of the year switch out of economically sensitives such as industrials, and into defensives such as healthcare. A final point is that any decline in the global bond yield to below neutral will come disproportionately from higher yielding bond markets. This will underpin the lower yielding major currencies such as the euro. But our first choice for the second half of the year remains the Japanese yen. Fractal Trading System* This week, we see an excellent opportunity to short Russia’s recent strong outperformance versus Japan. The recommended trade is short MOEX versus Nikkei225 with a profit target of 5 percent and symmetrical stop-loss. In other trades, short WTI crude versus LMEX achieved its profit target. Against this, short the French OAT reached its stop-loss. This leaves three open positions. For any investment, excessive trend following and groupthink can reach a natural point of instability, at which point the established trend is highly likely to break down with or without an external catalyst. An early warning sign is the investment’s fractal dimension approaching its natural lower bound. Encouragingly, this trigger has consistently identified countertrend moves of various magnitudes across all asset classes. Chart I-11 The post-June 9, 2016 fractal trading model rules are: 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. Use the position size multiple to control risk. The position size will be smaller for more risky positions. * 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 Footnotes 1 Consider what happens to valuations when bond yields decline from 4% to 2%. At a 4% bond yield, equities possess significantly more negative asymmetry than 10-year bonds. So investors will demand a comparatively higher return from equities, let’s say 8% a year. Whereas, at a 2% bond yield, equities and 10-year bonds possess the same negative asymmetry. So investors will demand the same return from equities as they can get from bonds, 2% a year. At the lower bond yield, the bond must deliver 2% a year less for ten years compared to previously, meaning its price must rise by 22%. But equities must deliver 6% a year less for ten years, so the equity market must surge by 80%. 2 We define the global 10-year bond yield as the simple average of the three 10-year bond yields in the euro area, U.S., and China, where the 10-year bond yield in the euro area is the issue-weighted average of the euro area’s individual 10-year bond yields. 3 For example, if bonds had a countertrend correction of 10% in a month when the economy was suffering severe deflation of 10% (per annum), it would still equate to a 9% loss in real terms! Fractal Trading System Recommendations Asset Allocation Equity Regional and Country Allocation Equity Sector Allocation Bond and Interest Rate Allocation Currency and Other Allocation 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 - ##br##Interest Rate Expectations Chart II-6Indicators To Watch -##br## Interest Rate Expectations Chart II-7Indicators To Watch -##br## Interest Rate Expectations Chart II-8Indicators To Watch - ##br##Interest Rate Expectations