Sectors

BCA Research is proud to announce a new feature to help clients get the most out of our research: an Executive Summary cover page on each of the BCA Research Reports. We created these summaries to help you quickly capture the main points of each report through an at-a-glance read of key insights, chart of the day, investment recommendations and a bottom line. For a deeper analysis, you may refer to the full BCA Research Report. Dear Clients, On behalf of the China Investment Strategy team, I would like to wish you a very happy, healthy, and prosperous Chinese New Year of the Tiger! Gong Xi Fa Chai, Best regards, Jing Sima China Strategist Executive Summary Chinese Investable Value Stocks Earnings Growth Will Likely Stabilize By Mid-2022 Chinese Investable Value Stocks Earnings Growth Will Likely Stabilize By Mid-2022 Chinese Investable Value Stocks Earnings Growth Will Likely Stabilize By Mid-2022 Chinese investable stocks passively outperformed their global counterparts in the first month of the year. However, we do not think January’s outperformance in the aggregate MSCI China Index will be sustained beyond the next six months. On a cyclical basis, when global stocks recover, growth stocks will likely underperform value stocks. The tech-heavy MSCI China Index is therefore less attractive to investors than other EM and developed market (DM) equities that are more value centric. Chinese investable ex-tech stocks are cheaply valued versus their global peers. Even if the earnings recovery in 2H22 are modest, Chinese investable value stocks are still attractive on a risk-reward basis. For investors that look to increase exposure to China on a cyclical basis, we recommend long Chinese investable value stocks while minimizing exposure to the tech sector. CYCLICAL RECOMMENDATIONS (6 - 18 MONTHS) INITIATION DATE RETURN SINCE INCEPTION (%) COMMENT EQUITIES Long MSCI China Value Index /Short MSCI China Growth Index 02-02-22     Bottom Line: We expect the tech sector’s passive outperformance in January to be short lived. Value stocks in Chinese investable equities, on the other hand, offer a better risk-reward profile relative to their TMT peers and for investors with a 6- to 12-month investment horizon. Feature Chart 1Chinese Investable Stocks Passively Outperformed In January This Year Chinese Investable Stocks Passively Outperformed In January This Year Chinese Investable Stocks Passively Outperformed In January This Year Chinese investable stocks dropped by 5% in January from December last year, giving up a 3% gain in the first three weeks (Chart 1). Still, the MSCI China Index outperformed global stocks by 2%. Some media reports stated that global investors have been drawn to Chinese offshore equities for their relatively cheap valuations and China’s easier monetary policy compared with other major economies . In our January 19 report we recommended investors tactically (0 to 6 months) upgrade the MSCI China Index to overweight within a global equity portfolio, based on the notion that the MSCI China Index would passively outperform since it would fall less than global equities. We maintain this view but do not expect the outperformance in aggregate Chinese investable stocks to endure on a cyclical basis. Our judgment is that while both China’s investable TMT (technology, media, and telecommunications) and ex-TMT stocks have been deeply discounted versus global stocks, beyond the next six months the investable TMT stocks will likely be a drag on the aggregate MSCI China Index. Thus, for investors looking for trades to increase their cyclical exposure to Chinese stocks, we recommend minimize their exposure to the tech sector. Meanwhile, we continue to favor onshore stocks versus their offshore counterparts, despite cheaper relative valuations in offshore stocks. We will discuss our view of the onshore market in next week’s report. A Valuation Catch-Up A valuation catch-up, as opposed to an improvement in China’s economic fundamentals, appears to be driving the passive outperformance in Chinese investable stocks. Our assessment is based on the following observations: Chart 2Chinese Stocks Normally Fall In Risk-Off Environment Chinese Stocks Normally Fall In Risk-Off Environment Chinese Stocks Normally Fall In Risk-Off Environment The beta of Chinese investable stocks has been steadily increasing over the past few years, versus both EM and global stocks. The high beta and pro-risk nature of Chinese investable stocks suggest their prices should fall in a risk-off market. Generally investors would not favor Chinese stocks during global market selloffs. Chart 2 shows that both EM and global stock benchmarks have fallen below their 200-day moving averages. Therefore, investors have been buying Chinese stocks against a risk-off market backdrop because Chinese stocks offer better risk-reward profile either due to their favorable valuations or higher earnings growth. It is simplistic to assume that investors favor Chinese investable stocks because of the country’s easier monetary policy versus the rest of the world. Chinese A-share stocks, which valuations are neutral, have been selling off more than the offshore stocks (Chart 3). Chinese onshore tech company stocks also suffered large losses in January, similar to their US peers (Chart 3, middle and bottom panels). Therefore, the divergence in the relative performance between the Chinese onshore and offshore markets suggests that discounted valuations in offshore Chinese stocks rather than economic fundamentals have driven the relative gains in the investable bourse. The mirror image in regional equity performance this year compared with last year also suggests that factors other than monetary policy explain equity dynamics (Chart 4). While the tech-heavy US bourse was the worst performer among major indices, markets that generated the greatest returns in 2021 have suffered the biggest losses so far in 2022. This phenomenon suggests that investors may be locking in last year’s gains, which is accentuating the underperformance of 2021’s winners and the outperformance of last year’s losers. Chart 42022 Is A Mirror Image Of 2021 Chinese Investable Stocks In A Global Equity Selloff Chinese Investable Stocks In A Global Equity Selloff Chart 3Chinese Onshore Stocks Followed The Global Market Downtrend Chinese Onshore Stocks Followed The Global Market Downtrend Chinese Onshore Stocks Followed The Global Market Downtrend   Bottom Line: Chinese investable stocks ended January with a much smaller loss than their global peers. The relative outperformance in the MSCI China Index has been mainly driven by its cheaper valuations relative to its global peers. Complacency Risk And Chinese Investable Stocks We see the recent global stock market selloff as a sharp reduction in complacency in the market, particularly in the high-flying tech sector (Chart 5). The correction in global tech stock prices will likely continue for a few months while the market digests a sudden rise in bond yields. As such, the prices in Chinese offshore tech companies will also fall in absolute terms but can still passively outperform their global counterparts, given their deeply discounted relative valuations. Nonetheless, several factors make us cautious about the exposure of China's outsized tech sector beyond the next six months. Hence, our overweight stance on Chinese investable stocks (in relative terms) is limited to the short term (i.e. in the next 0 to 6 months). The growth rates of the 12-month trailing and forward earnings for global tech stocks are both above the 85th percentiles (Chart 6). This indicates that a substantial amount of profit growth has already been priced into global tech stocks, raising the risk of earnings disappointment in the next 6 to 12 months. By contrast, China's TMT-stock 12-month trailing and forward earnings have fallen to below the 25th percentiles (Chart 6, bottom panel). This suggests that the global exuberance in tech earnings is less priced in among Chinese TMT stocks. Chart 5A Sharp Complacency Reduction In The Tech Sector A Sharp Complacency Reduction In The Tech Sector A Sharp Complacency Reduction In The Tech Sector Chart 6Global Tech Earnings Growth Remains Significantly Stretched Global Tech Earnings Growth Remains Significantly Stretched Global Tech Earnings Growth Remains Significantly Stretched However, as noted in our previous reports, Chinese growth/tech companies’ price discount relative to their earnings reflects structural risks that investors are pricing in. These structural headwinds may not intensify in the near term but are not going away either. The regulatory backdrop has not improved enough to justify a sustained faster multiple expansion in China’s internet giants. Beijing continues to rein in its internet behemoths and tighten regulations related to data. It is not yet clear what impact some of the new regulations announced last year will have on the tech sector’s business models. At the very least, antitrust regulations will chip away at the competitive advantage of these tech titans. Furthermore, China's investable TMT sector appears to be a domestic consumer play and thus, likely to weaken in the coming 6 to 12 months given the poor outlook for consumption (Chart 7). Even though China has stepped up its policy support for the aggregate economy, its stringent measures to counter the domestic COVID situation will significantly weigh on its service sector and consumption. The downbeat prospect on China's housing market will also curb consumption growth based on the expectations for employment and income dynamics (Chart 8). Chart 7Outlook For Chinese Internet Sales Remains Downbeat Outlook For Chinese Internet Sales Remains Downbeat Outlook For Chinese Internet Sales Remains Downbeat Chart 8Housing Market Slump A Significant Drag On Household Consumption Housing Market Slump A Significant Drag On Household Consumption Housing Market Slump A Significant Drag On Household Consumption Chart 9Rising Rates Are A Tailwind For Value Stocks Rising Rates Are A Tailwind For Value Stocks Rising Rates Are A Tailwind For Value Stocks Lastly, we expect the pace of increases in bond yields to slow and global equities to trend higher beyond the next couple months. In this case, we are not convinced that Chinese investable stocks will continue to outperform their global peers. The reason for our skepticism is that in a climate of rising interest rates, growth stocks tend to underperform value ones (Chart 9). Given that China's TMT sector’s weight (43%) is considerably higher than the global benchmark (30%), Chinese investable stocks will underperform once valuations in China’s TMT stocks catch up to be in line with those of the global tech sector. Bottom Line: From a valuation perspective, Chinese investable stocks currently look reasonable. In the next a few months when global tech stocks continue to sell off, Chinese offshore tech companies and stocks in general will likely passively outperform their global peers. However, from a risk-reward standpoint and beyond the next six months, the MSCI China Index is at a disadvantage due to a high concentration of stocks in the tech sector. Investment Conclusions On a cyclical basis, Chinese investable stocks will not be immune from global market selloffs due to the offshore market’s high volatility and positive correlation with global stocks. In addition, the MSCI China Index will likely underperform global equities in an up market because of a higher-than-average stake in tech stocks. As such, in a global portfolio we continue to favor onshore stocks over the investable bourse, despite cheaper relative valuations in offshore market equities. Next week’s report will discuss our views on the onshore market. Meanwhile, given the risks facing stocks in China’s tech sector, we propose a new trade recommendation for investors with a cyclical time horizon: long MSCI China Value Index /Short MSCI China Growth Index. The trade will increase cyclical exposure to Chinese offshore stocks, while minimizing stake in the offshore tech sector. The MSCI's China growth index is almost entirely made up of TMT equities, meaning that a relative value play will effectively mimic an ex-TMT position. Extremely cheap valuations in Chinese ex-TMT equities versus global stocks indicate that investors have already priced in a degree of weakness in China's economy (Chart 10). We remain alert to the possibility of a more pronounced near-term slowdown in the business cycle, but we expect China’s economy to regain its footing and stabilize by mid-2022. Our model shows that earnings will decelerate sharply in 1H22 (Chart 11). However, even if the upcoming stimulus and earnings recovery in 2H22 are modest, Chinese value stocks are still attractive on a risk-reward basis given the sizeable valuation discount levied on China relative to global stocks. Chart 10Chinese Investable Value Stocks Are Trading At A Huge Discount Versus Global Chinese Investable Value Stocks Are Trading At A Huge Discount Versus Global Chinese Investable Value Stocks Are Trading At A Huge Discount Versus Global Chart 11Chinese Investable Value Stocks Earnings Growth Will Likely Stabilize By Mid-2022 Chinese Investable Value Stocks Earnings Growth Will Likely Stabilize By Mid-2022 Chinese Investable Value Stocks Earnings Growth Will Likely Stabilize By Mid-2022   Jing Sima China Strategist jings@bcaresearch.com Strategic Themes Cyclical Recommendations Tactical Recommendations

BCA Research is proud to announce a new feature to help clients get the most out of our research: an Executive Summary cover page on each of the BCA Research Reports. We created these summaries to help you quickly capture the main points of each report through an at-a-glance read of key insights, chart of the day, investment recommendations and a bottom line. For a deeper analysis, you may refer to the full BCA Research Report. Executive Summary The Software and Services Industry is undergoing a fundamental transformation in its business model catalyzed by a momentous migration of software applications to the cloud and broad-based digitization of the economy. This shift is accompanied by displacement of the traditional on-prem license and support model with a more lucrative cloud-based subscription model.  While on-prem software sales are contracting, cloud revenue is growing in double digits. As a result, the industry enjoys spectacular margins and earnings growth. Its earnings have also proven to be resilient across the business cycle because software and IT services increase companies’ productivity in good times and bad. Rising rates are a headwind, but a temporary one. Margins Will Continue To Expand Margins Are To Continue Expanding Margins Are To Continue Expanding Bottom Line: The Software and Services industry group is an all-weather industry with resilient earnings and strong growth throughout the business cycle. It is also in the epicenter of technological innovation: Migration to the cloud and digital transformation enhance the industry’s growth and profitability.  We continue recommending both a tactical and a structural overweight. Feature Performance Technology stocks found themselves in the eye of this month’s market rout. After falling 19% from its peak, the NASDAQ is now firmly in correction territory. The Technology sector is down 11%, while the Software and Services industry group is down 10% (Chart 1). In the “Are We There Yet?” report published last week, we posited that it is not yet the right time to bottom fish: While the Technology sector appears oversold, macroeconomic headwinds from the imminent monetary tightening and a slowdown in demand for technology goods and services may prolong the pain. The interplay of valuations and fundamentals for the sector is not yet favorable. While we are underweight the Technology sector, thanks to our underweight positions in Semiconductors and Hardware and Equipment, we remain overweight Software and Services (S&S). In this report, we will conduct a “deep dive” into S&S and reevaluate our positioning (Table 1). Although S&S is down more than 10% from the peak,  it has outperformed the S&P 500 by 88% since 2011 (Chart 2). The million-dollar question we will try to answer is whether this outperformance continues over the tactical and structural time horizons. Chart 1Software And Services Outperformed Other Tech Industries Software And Services: On The Seventh Cloud Software And Services: On The Seventh Cloud Chart 2S&S Outperformed The S&P 500 By 88% Over The Past 10 Years S&S Outperformed The S&P 500 By 88% Over The Past 10 Years S&S Outperformed The S&P 500 By 88% Over The Past 10 Years Table 1Performance Software And Services: On The Seventh Cloud Software And Services: On The Seventh Cloud Sneak Preview: We maintain our overweight of the Software and Services sector thanks to positive market trends, the all-weather nature of the industry, and resilient earnings. Industry Group Composition The Software And Services Industry Group Is Top Heavy The S&P 500 Software and Services industry group is the largest in the Technology sector and is 48% of the sector market cap. The industry group is split between Software, which is about two-thirds of its market cap, and IT Services, which is one-third (Chart 3). Just like other technology industries, it is dominated by one of the FAANGs+M, Microsoft in this case, which makes up 42% of the industry group index weight. The top 10 constituents out of 36 comprise 80% of the industry’s weight (Table 2). During the current pullback, the S&S industry group has fallen by more than 10%, cushioned by the performance of its larger players. But this masks the pain of the smaller and less profitable constituents, which have fallen by more than 30% (Chart 4). Chart 3Software Dwarfs IT Services Software And Services: On The Seventh Cloud Software And Services: On The Seventh Cloud Chart 4Some Smaller Constituents Have Fallen More Than 15% YTD Software And Services: On The Seventh Cloud Software And Services: On The Seventh Cloud Table 2S&S Industry Is Dominated By A Handful Of Successful Companies Software And Services: On The Seventh Cloud Software And Services: On The Seventh Cloud However, market dominance runs much deeper than just market capitalization: Microsoft, Adobe, Salesforce, and Oracle account for 87% of the Software Industry revenue, while Visa, Mastercard, Accenture, and PayPal generate 42% of the IT Services industry revenue. Larger industry players are also more profitable thanks to the high operating leverage the industry enjoys. Clearly, just a few companies drive sales and earnings growth, valuations, and performance. On the bright side, these are some of the most successful US technology companies, and their size is their competitive moat. We believe that the industry group is in “good hands.” Key Trends Cloud Migration Following the success of offshoring the US manufacturing base to China that allowed corporations to reduce labor costs, companies are now experimenting with outsourcing other key infrastructure elements. This time, however, the migration is happening to digital cloud platforms. Instead of investing in pricey servers and other hardware assets, corporations have the choice of going with Software-as-a-Service (SaaS), Platform-as-a-Service (PaaS), or Infrastructure-as-a-Service (IaaS) solutions offered by the tech titans. Not only are cloud solutions more cost-effective, but they also offer the convenience and flexibility to scale corporate hardware infrastructure by simply purchasing more or less computational power. COVID-19 lockdowns and the migration of the white-collar workforce towards remote work have motivated companies to transition their technology and operations to the cloud, and have acted as a catalyst for “digital offshoring.” Digital Transformation Digital transformation is in many ways similar to cloud migration. Essentially, it represents broader software penetration into the US economy. Whether it is a manufacturing production or customer relationship management process, wider adoption of software allows for a more efficient business solution via automation and process optimization. Airbnb and Uber are the poster children of digital transformation. While some industries have already undergone digital transformation, there are notable areas which lag behind. For instance, banks’ failure to modernize their digital infrastructure to speed up transactions and to increase overall user convenience has arguably led to the development of the crypto space as an alternative to the slow-evolving traditional financial institutions. The broader implication is that there are still major sectors in the economy that are yet to ramp up automation and increase efficiencies via digital transformation, meaning that there is a healthy demand pipeline for the tech companies. Types Of Software And Services Companies Software: Migration To The Cloud Is A Key Driver Of Growth In the past, classifying software companies was a relatively straightforward exercise: They were divided into system software vs. application software. System software included such categories as operating systems for PCs, and other hardware and database software. Application software covered Enterprise Resource Planning (ERP), Customer Relationship Management (CRM), Communications and Collaborations, etc. However, over time, the industry landscape has changed, first by the mergers that blurred the distinction across these lines, and lately, thanks to ubiquitous migration to the cloud model and digitization of the economy. Therefore, it is most practical to classify software companies by their type of business model, i.e., legacy license and support model, or cloud-based, or hybrid.  Pure cloud-first: These companies derive 100% of their sales from the cloud model – Salesforce.com (CRM), ServiceNow (Now), and Twilio (TWLO) are among the biggest winners. Cloud/license hybrid: These are companies that derive 50%+ of their sales from the cloud, such as Microsoft (MSFT), Atlassian (TEAM), Autodesk (ADSK), and Adobe (ADBE). Legacy license and support model (aka On-Premises): Constellation Software (CSU), Citrix Systems (CTSX) – these companies are likely to struggle to grow organically. Types Of Cloud Application Services The cloud-based business model in turn can be classified under three different types of service: Software-as-a-Service (SaaS), Infrastructure-as-a-Service (IaaS), or Platform-as-a-Service (PaaS). Software-as-a-Service: Customers configure and access a web-based application operated by a SaaS provider over the internet. Salesforce.com, Workday (DAY), ServiceNow, and Oracle are some of the most established players. Infrastructure-as-a-Service: This service gives customers access to virtual storage and servers over the internet, enabling them to develop and run any application just as if it were running in their own data center. Amazon’s AWS, Microsoft’s Azure, and IBM are the key competitors in this space. Platform-as-a-Service: This service occupies a middle ground between SaaS and IaaS, i.e. between a full-fledged app that can be used “out-of-the-box” and a “raw server and storage” instance, making the customer responsible for installing and configuring its own “full stack.” PaaS offerings tend to be less standardized. Salesforce.com, Microsoft, and Oracle are the leaders. IDC projects the continued strength of this segment and expects it to grow at an annualized rate of 29.7% over the next five years. The following table from Microsoft presents a perfect explanation of the different software service models (Table 3). Table 3Differences In Cloud Computing Service Models Software And Services: On The Seventh Cloud Software And Services: On The Seventh Cloud License And Support Vs. Cloud Subscription Model Growth Rates Broad-based migration to the cloud is shifting the industry’s revenue composition, with accelerating bifurcation between cloud and on-prem models: Cloud subscription revenue is replacing the traditional license and support model. As a result, legacy on-prem revenue has recently been contracting, and once the last of the legacy enterprise applications are retired, it will be fully replaced by cloud revenue. According to estimates by CFRA,1  the software industry grew by 4% in 2021, with a 22% year-on-year increase in cloud subscription revenue, which now constitutes 37% of total industry revenue, and a 3% decline in traditional software revenue. The surge in cloud growth is likely to continue, thanks to the accelerating pace of digital transformation. This trend is also promulgated by some of the largest players, such as Microsoft, whose cloud subscription revenue now constitutes more than half of the overall revenue and is an engine of growth in the software space. Strong cloud revenue growth is not just a function of recruiting new users but is also supported by the proliferation of new cloud apps and upgrades to the existing ones.  Importantly, the cloud subscription model is also more profitable than the license model, whose EBITDA margins rarely exceed 40%. Cloud-based services take longer to become profitable but have much higher operating leverage: Once profitable, cloud and hybrid companies often have operating margins around 50-60%.  Software is one of the most resilient technology industries, performing equally well in a growing economy and during downturns: Subscription pricing is sticky, and switching costs are high. As a result, companies, which derive a large share of their revenue from the cloud, have stable and predictable sales. Once clients are onboarded, cloud providers may also be able to exercise their pricing power. IT Services IT services is a smaller segment of the Software and Services industry group and is a hodge-podge of different companies that provide a wide range of services from IT consulting to FinTech. The following is a brief description of the key categories: IT Consulting: The S&P 500 IT Consulting companies are Accenture, Gartner, and Cognizant.  Companies offer Professional advice in IT, management, HR, logistics, and many others. Since the pandemic, these companies’ key focus is on assisting their clients with digital transformation and improving companies’ operations. This industry is one of the key beneficiaries of accelerated migration to the cloud and has enjoyed exponential growth over the past decade. Its revenue stream is highly resilient, as even during economic downturns, clients are seeking advice on the best ways to navigate an uncertain market environment. Outsourcing: Companies such as ADP and Paychex provide HR and business services solutions for mid-sized and small companies. Their services cover payroll, benefits, retirement, and insurance services.   This industry has been growing its sales and profits at a healthy clip over the past few years. Now it is focused on modernizing itself by moving its own operations to the cloud and deploying Artificial Intelligence to improve operations. These companies are also undergoing digital transformation and are moving towards the SaaS model. Financial Transaction Services: This is a FinTech industry that includes card and payment processors, such as Visa, Mastercard, and PayPal, and each of these players operates their own proprietary payment networks.  Digital payments and the wide acceptance of e-commerce drive this space. Lately, these companies have been at the forefront of the adoption of digital currencies as viable payment options. Payment companies are among the earliest adopters of the cloud, and their business model is best described as Transaction-processing-as-a-service. These are highly profitable companies that consistently generate an operating margin above 60%. Key Industry Drivers Software Enhances Productivity And Improves Profitability Broadly speaking, the Software and Services industry group is considered a defensive holding owing to the resiliency of its earnings (Chart 5). Software enhances productivity: During economic downturns, it helps reduce costs, and during expansions, it helps overcome capacity constraints and labor shortages. While pandemic labor shortages and lockdowns produced a spike in productivity, more recently it has been falling, which has warranted a year-over-year increase in software investment (Chart 6). Chart 5S&S Earnings Are Resilient Across The Business Cycle S&S Earnings Are Resilient Across The Business Cycle S&S Earnings Are Resilient Across The Business Cycle Chart 6Investing In Software Improves Productivity Investing In Software Improves Productivity Investing In Software Improves Productivity Further, both labor shortages and rising wages are prompting companies to redesign their operations to contain costs and preserve margins. To do so, many are accelerating investments in Capex and automation, much of which is achieved through investment in software and IT services, replacing both labor and capital.  According to CFRA, “software is no longer used to manage a means of production, but rather IS means of production .” Software-related Capex is not only garnering a larger slice of tech spending budgets but also of the overall Capex pie (Chart 7). Chart 7Share Of Software In Overall Capex Has Been Rising Steadily Share Of Software In Overall Capex Has Been Rising Steadily Share Of Software In Overall Capex Has Been Rising Steadily Macroeconomic Backdrop Imminent Rate Hikes Tighter monetary policy and runaway inflation are at the fore of investors’ minds and, arguably, a cause of the current market rout.  Software stocks have outperformed the other long-duration technology stocks. To gauge the reaction of S&S to the upcoming rate hike, we have repeated an exercise we conducted for the Technology sector last week – historical performance of the industry six months before and after the first rate hike (Chart 8).   Clearly, industry returns fall two to three months before the first rate hike, but eventually recover once a new monetary regime is priced in. The year-to-date correction of the software stocks is textbook behavior. Chart 8S&S Underperforms Before The First Rate Hike Software And Services: On The Seventh Cloud Software And Services: On The Seventh Cloud Software And Services Is A Global Industry – Beware Of A Strong Dollar The Technology sector is one of the most global sectors in the S&P 500 and derives 40% of sales from abroad; similarly, Software and Services has a broad international footprint. As US rates trend higher, and the interest rate differential favors the US vs. other countries, the USD is likely to appreciate further. With a stronger dollar, products of US software firms are more expensive to foreigners, which may have a dampening effect on demand. The US firms’ profitability has also been hit by an unfavorable translation from foreign currency back to the USD. Historically, the path of the dollar and the returns of S&S were inversely correlated (Chart 9). Chart 9Historically, Stronger Dollar Has Been A Headwind For The Industry Historically, Stronger Dollar Has Been A Headwind For The Industry Historically, Stronger Dollar Has Been A Headwind For The Industry The redeeming grace is that, as we mentioned before, software subscription revenue is sticky, and switching costs for customers are high. As such, we expect the adverse effect on demand to be minor. Fundamentals Sales Growth According to Grandview Research , the business software and services market is expected to grow at a compound annualized rate of 11.3% from 2021 to 2028. This strong growth is underpinned by the robust pace of enterprise application cloud migration and digital transformation, which see no end in sight. The street expects the Software and Services industry to grow on par with the Technology sector at just under 20% over the next 12 months, and growth is slowing off high levels.  The pandemic has shifted forward some of the spending on software, as companies rushed to adjust to remote work.  However, the industry continues to grow at a healthy clip (Chart 10). Chart 10Sales Growth Is Slowing Sales Growth Is Slowing Sales Growth Is Slowing Labor Costs Are Contained For Now The S&S companies first and foremost rely on the talent and ingenuity of their workforce to deliver cutting-edge technological solutions. Wages are one of the largest expenses in the industry. Recent increases in salaries accompanied by labor shortages and “the great resignation” are bound to cut into the margins of these companies. So far, software and services companies have been able to counter the trend (Chart 11) by deploying creative solutions, offering their employees a wide range of perks, and throwing their net wide in search of talent by offering remote work.   Chart 11Industry Labor Costs Have Been Contained Industry Labor Costs Have Been Contained Industry Labor Costs Have Been Contained Resilient Earnings Growth For the reasons discussed above, S&S earnings growth is remarkably resilient and stable throughout the business cycle (Chart 12). Currently, earnings expectations of S&S over the next 12 months exceed growth expectations for both the Technology sector and the S&P 500. Over the next 12 months, S&S earnings are expected to grow at 14% compared to 8.6% for the S&P 500 (Table 4). Chart 12S&S EPS Growth Bests The Tech Sector And The S&P 500 S&S EPS Growth Bests The Tech Sector And The S&P 500 S&S EPS Growth Bests The Tech Sector And The S&P 500 Table 4Earnings Growth Vs. Valuations Software And Services: On The Seventh Cloud Software And Services: On The Seventh Cloud Despite the slowdown in sales growth and the pick-up in labor costs, EBITDA margins have exceeded the previous peak, and are projected to trend higher towards 40% over the course of the year (Chart 13). Expecting a growth slowdown, analysts have been revising earnings expectations down for S&S companies, but by now the downgrading process has run its course, and the bar is set low (Chart 14). Chart 13Margins Will Continue To Expand Margins Will Continue To Expand Margins Will Continue To Expand Chart 14Downgrades Are Bottoming Downgrades Are Bottoming Downgrades Are Bottoming   Valuations Since the S&S industry group’s earnings are expected to grow faster than the earnings of the Tech sector and the S&P 500, it is not surprising that it trades with a 44% premium to the S&P 500 on a forward earnings basis – a steep mark-up. The current correction has taken some froth off the industry’s valuations , with multiples contracting by 3.9 points. Even after the correction, the sector appears overvalued (Chart 15). Adjusting for expected 12-month EPS growth, S&S appears more attractively valued and trades with a discount both to tech and the broad market (Table 4). It is also important to note that the industry group is home to a plethora of quite a few smaller companies, which tend to be more expensive and more volatile: Chart 16 plots companies’ forward earnings multiples against their weight in the industry group.   Chart 15Valuations Are Still Dear... Valuations Are Still Dear... Valuations Are Still Dear... Chart 16Significant Valuation Dispersion Among The Constituents Software And Services: On The Seventh Cloud Software And Services: On The Seventh Cloud Technicals Recently, the BCA Technical Indicator has moved into the oversold territory, indicating investor capitulation. This means that this bar is cleared, and from a technical standpoint alone, Software and Services is a buy (Chart 17). Chart 17... But Technicals Indicate That S&S Is Oversold ... But Technicals Indicate That S&S Is Oversold ... But Technicals Indicate That S&S Is Oversold Investment Implications We are both tactically and structurally bullish on the Software and Services industry group. Tactically Bullish The Software and Services industry group is an all-weather industry with an unprecedented combination of both earnings resiliency and strong growth throughout the business cycle. It is also undergoing a fundamental transformation in its business model catalyzed by a ubiquitous shift in software applications to the cloud, accompanied by displacement of the traditional on-prem license and support model with a more lucrative subscription model. The industry is expected to grow earnings in double digits and expand margins, unhindered by rising labor costs. Rising rates are certainly a headwind, but hopefully a temporary one. Froth has come off valuations, and a new monetary regime is gradually getting priced in. According to the technical indicator, the sector is oversold. On balance, we have a positive outlook on the industry group (Table 5) and maintain our overweight position. Table 5Software And Services Scorecard Software And Services: On The Seventh Cloud Software And Services: On The Seventh Cloud Structurally Bullish Our long-held belief is that the broader push to the cloud, augmented reality, AI, cybersecurity, and autonomous driving, which are all software dependent, are not fads but are here to stay. Software and Services are at the epicenter of technological innovation and are home to some of the best American companies.   Irene Tunkel Chief Strategist, US Equity Strategy irene.tunkel@bcaresearch.com     Footnotes 1     CFRA, Industry Surveys, Software, July 2021 Recommended Allocation

The BCA house view is that the US Treasury rates will move higher this year. Monetary tightening has been one of our core investment themes, and a reason for overweighing banks back in September 2021, which outperformed the S&P 500 by 7% since we initiated this position. Today, we double down on our bearish outlook for US bonds and upgrade another rate-sensitive industry group – insurance. While insurance only marginally bested the S&P 500 in 2021, it is now up 9% year-to-date in relative terms. Upgrading Insurance Upgrading Insurance Most insurers have struggled over the past decade, as persistently low rates have had an adverse effect on their earnings, capital, reserves, and liquidity. These companies’ priority is asset/liability matching, i.e., investment income needs to match contractual obligations. Higher rates make it easier for the insurers to reach their target rates of returns without wading into riskier asset classes. Also, rising rates are a tailwind for the industry: They enjoy a positive roll return by reinvesting premiums at higher yields (top panel). In addition to rising rates, there are several other factors that support the strong performance of the industry over the next few months. Life Insurance: There is an increased demand for traditional life insurance as, for many, pandemic underlined a need for protection; millennials are coming of age; and lastly, life and health insurance are perks offered by employers to workers in a tight labor market. Premiums are expected to grow at 4% in 2022, a minor slowdown from 5.8% 2021 estimated growth.1 Vaccinations and new COVID treatments have reduced mortality from the virus, potentially boosting profitability. With the rising number of baby boomers, demand for retirement products is increasing. However, challenging conditions of the public capital markets may create headwinds for the asset management side of the life insurers business. P&C Insurance:  Insured loss from COVID is beginning to stabilize, although there are some outstanding litigations on coverage terms under business interruption coverage. Ongoing economic recovery drives an increase in demand for commercial lines coverage. The insurance pricing environment remains “hard”, with the demand that is relatively inelastic and economically defensive. CFRA forecasts written premium growth of 6% to 9% in 2021 and 7% to 10% in 2022.2 Cyber insurance will get traction as a result of the frequency and severity of high-profile cyber attacks. Written premiums are expected to grow by 22% in 20223 with an average rate increase of 18%. In terms of fundamentals, the street sales growth estimates are set at 3% vs 7% for the SPX. Relative earnings growth expectations are also low (-5%) and are nearly on par with the GFC levels, setting up insurers for positive earnings surprises (middle panel). Valuations are undemanding, with the relative P/B ratio at a multi-decade low (bottom panel). Bottom Line: Today, we double down on our bearish outlook for the US bonds and upgrade the S&P insurance index to overweight. Ticker symbols in the S&P insurance index are: CB, MMC, AON, MET, PGR, AIG, PRU, TRV, AFL, ALL, AJG, L, WTW, HIG, PFG, BRO, CINF, WRB, RE, GL, LNC, AIZ. Footnotes 1    CFRA Industry Surveys, Life and Health Insurance, December 2021. 2    CFRA Industry Surveys, Property and Casualty Insurance, July 2021. 3    Ibid.

Feature Is the worst over for US and EM equities? Clearly, the risk-reward of stocks has somewhat improved, given they are no longer overbought and some bad news has already been priced in. However, conditions for a durable bottom and a sustainable and lasting rally do not yet exist. In the case of the S&P 500, our capitulation indicator has not yet reached the lows that marked the major bottoms of the past 12 years (Chart 1). Chart 1US Stocks Have Not Reached Their Selling Climax Yet US Stocks Have Not Reached Their Selling Climax Yet US Stocks Have Not Reached Their Selling Climax Yet Chart 2Components Of US Equity Capitulation Indicator Components Of US Equity Capitulation Indicator Components Of US Equity Capitulation Indicator None of its four components – the advance/decline line, momentum, breadth and investor sentiment – are back to their lows of 2010, 2011, 2015-16 and 2018 (Chart 2). In the past three cases, the S&P 500 corrected by 17-20%. A correction of this magnitude is our base case for the S&P 500 at the moment. The S&P drawdown has so far been half of this. US inflation and the Fed’s policy remain the key headwinds to US share prices. Core consumer price inflation is substantially above the Fed’s preferred range (2-2.25%) and wage growth is accelerating. As a result, the Fed will lose credibility if it does not sound ready to hike interest rates materially. The US equity market is vulnerable to such a not-dovish stance from the Fed because it is still very expensive. Inflation has also become a political problem. One reason Biden’s popularity has been sliding in the polls is the rapid pace of consumer price increases. Heading into the mid-term elections in the fall, the White House and the Democrats will not oppose the Fed raising interest rates to fight inflation. Overall, BCA’s Emerging Markets Strategy team believes markets/investors are underestimating inflation risks in the US. Core inflation will not drop below 3% unless the economy slows down and employment/wages slump. High and rising trimmed-mean and median CPI measures suggest inflation is broad-based. Normalization in supply-side factors will not be enough to lower core inflation below 3%. Importantly, the median and trimmed-mean core inflation measures strip out goods and services that post abnormal fluctuations. Their elevated readings corroborate that inflation is genuine and broad-based. Hence, pressure on the Fed to tighten will remain substantial. This is bad news for a still overvalued US stock market. Chart 3EM EPS Is Set To Dissapoint EM EPS Is Set To Dissapoint EM EPS Is Set To Dissapoint Concerning EM equities and currencies, economic growth in EM will disappoint. Chart 3 suggests that EM corporate profits are set to deteriorate materially in the coming six months or so. Besides, investor sentiment on EM equities is not downbeat – it is neutral (Chart 28 below). From a contrarian perspective, there is not yet a case to buy EM stocks in absolute terms. China’s business cycle recovery is still several months away. In other EM countries, monetary policy has tightened substantially, real interest rates remain high, or the banking system is too unhealthy to support growth. Finally, fiscal policy will be slightly tight this year in the majority of EM. As domestic demand in China and in mainstream EMs disappoint and the Fed does not do a dovish pivot soon, EM currencies will resume their depreciation versus the US dollar. Chart 4 shows that China’s credit and fiscal impulse leads EM currency cycles and is presently pointing to more EM currency depreciation. Charts 32 and 33 (below) are pointing to further greenback strength. Finally, EM growth disappointments and a strong greenback will pressure EM fixed income markets. EM high-yield (HY) credit – both sovereign and corporate – has been selling off, but investment-grade (IG) credit has been holding up (Chart 5). This is a sign that investors have been reluctant to offload EM IG credit and points to lingering positive sentiment on EM and lack of capitulation. Sluggish EM growth and an appreciating US dollar are headwinds for EM credit markets. Chart 4EM Currencies Remain At Risk EM Currencies Remain At Risk EM Currencies Remain At Risk Chart 5EM Credit Markets: The Selloff Will Broaden EM Credit Markets: The Selloff Will Broaden EM Credit Markets: The Selloff Will Broaden Bottom Line: We continue to recommend a defensive strategy for absolute return investors. For global equity portfolios, we recommend underweighting EM and the US, and overweighting Europe and Japan. The path of least resistance for the US dollar is up for now. The charts on the following pages are the most important ones for investors today. Arthur Budaghyan Chief Emerging Markets Strategist arthurb@bcaresearch.com US Stocks Have Not Reached Their Selling Climax Yet Even though only 17% of the NASDAQ’s stocks are above their 200-day moving average, the same measure for the NYSE index is 38%, well above its previous lows. Besides, the NYSE’s advance/decline line has broken down, signifying a broadening equity rout. Finally, the US median stock has broken below its 200-day moving average after going sideways for 9-12 months. When such a profile occurs, the sell-off lasts more than a couple of weeks. Chart 6 US Stocks Have Not Reached Their Selling Climax Yet US Stocks Have Not Reached Their Selling Climax Yet Chart 7 US Stocks Have Not Reached Their Selling Climax Yet US Stocks Have Not Reached Their Selling Climax Yet Chart 8 US Stocks Have Not Reached Their Selling Climax Yet US Stocks Have Not Reached Their Selling Climax Yet Chart 9 US Stocks Have Not Reached Their Selling Climax Yet US Stocks Have Not Reached Their Selling Climax Yet Non-US Stocks Are Not Oversold Yet Neither global ex-US nor EM stocks are very oversold. Global ex-US and European share prices in SDR terms have been moving sideways for about 9-12 months prior to breaking down recently. Such a breakdown means a weakness in share prices that will likely last for a while. Chart 10 Non-US Stocks Are Not Oversold Yet Non-US Stocks Are Not Oversold Yet Chart 11 Non-US Stocks Are Not Oversold Yet Non-US Stocks Are Not Oversold Yet Chart 12 Non-US Stocks Are Not Oversold Yet Non-US Stocks Are Not Oversold Yet Chart 13 Non-US Stocks Are Not Oversold Yet Non-US Stocks Are Not Oversold Yet Growth Stocks Have Broken Down Various indexes of growth/TMT stocks have broken below their moving averages that have served as a support since spring 2020. This along with the fact that US interest rates will likely rise suggests that the bull market in growth stocks is either over or in for a prolonged hibernation. Chart 14 Growth Stocks Have Broken Down Growth Stocks Have Broken Down Chart 15 Growth Stocks Have Broken Down Growth Stocks Have Broken Down Chart 16 Growth Stocks Have Broken Down Growth Stocks Have Broken Down Chart 17 Growth Stocks Have Broken Down Growth Stocks Have Broken Down Is FAANGM A Bubble? In the past 12 years, US FAANGM stocks rose as much as the previous bubbles. When those bubbles peaked, their prices did not move sideways but rather collapsed. We do not assert that US FAANGM stocks will drop by more than 35% (we simply do not know). The point we would like to emphasize is that the bull market is over for now. At best, US growth stocks will likely be in a trading range in the coming 12-24 months.  Chart 18 Is FAANGM A Bubble? Is FAANGM A Bubble? Chart 19 Is FAANGM A Bubble? Is FAANGM A Bubble? US Share Prices And Corporate Margins: Defying Gravity? From a very long-term perspective, the US equity market is rather overextended. Share prices in real terms are almost two standard deviations above their time trend. Similarly, corporate profits in real terms are also very elevated, not least in their reflection of record-high profit margins. The key questions for US equity investors are: (1) how persistent/sticky core inflation will be; and (2) how low corporate profit margins will drop. Wages are the key to both inflation and corporate margins. We believe wage growth will accelerate materially. That will be bad for the outlook of inflation and corporate profit margins, although it will be good news for corporate top lines. Chart 20 US Share Prices And Corporate Margins: Defying Gravity? US Share Prices And Corporate Margins: Defying Gravity? Chart 21 US Share Prices And Corporate Margins: Defying Gravity? US Share Prices And Corporate Margins: Defying Gravity? The Levels of EM Share Prices And Corporate Profits Have Been Flat For 12 years Contrary to the US, EM share prices are not overextended – they have been flat in absolute terms for the past 12 years. The reason for such dismal performance has been stagnant corporate profits. The latter have been flat-to-down in real terms for the past 12-14 years. A breakout in EM share prices in absolute terms will require their EPS entering a secular uptrend. While this is not impossible this decade, it is not imminent. Chart 22 The Levels Of EM Share Prices And Corporate Profits Have Been Flat For 12 Years The Levels Of EM Share Prices And Corporate Profits Have Been Flat For 12 Years Chart 23 The Levels Of EM Share Prices And Corporate Profits Have Been Flat For 12 Years The Levels Of EM Share Prices And Corporate Profits Have Been Flat For 12 Years Long-Term Equity Valuations (Cyclically-Adjusted P/E Ratio) Based on a cyclically-adjusted P/E (CAPE) ratio, EM stocks are close to their fair value. In contrast, based on the same measure, US equities are very overvalued. As a result, the relative CAPE ratio of EM versus the US is at a record low. Hence, on a multi-year horizon, odds are that EM share prices will outperform their US peers. In a nutshell, EM ex-China, Korea, Taiwan currencies are also close to their fair value. We will be looking to upgrade EM in the coming months. Chart 24 Long-Term Equity Valuations (Cyclically-Adjusted P/E Ratio) Long-Term Equity Valuations (Cyclically-Adjusted P/E Ratio) Chart 25 Long-Term Equity Valuations (Cyclically-Adjusted P/E Ratio) Long-Term Equity Valuations (Cyclically-Adjusted P/E Ratio) Chart 26 Long-Term Equity Valuations (Cyclically-Adjusted P/E Ratio) Long-Term Equity Valuations (Cyclically-Adjusted P/E Ratio) Chart 27 Long-Term Equity Valuations (Cyclically-Adjusted P/E Ratio) Long-Term Equity Valuations (Cyclically-Adjusted P/E Ratio) Investors Are Not Bearish On EM And Europe One missing factor to upgrade EM (non-US markets in general) is investor sentiment. Sentiment is neutral on EM stocks and is fairly upbeat on Europe. In brief, a capitulation has also not yet occurred in non-US markets. On the whole, the current EM sell-off will likely linger until sentiment becomes downbeat. Chart 28 Investors Are Not Bearish On EM And Europe Investors Are Not Bearish On EM And Europe Chart 29 Investors Are Not Bearish On EM And Europe Investors Are Not Bearish On EM And Europe Directional Indicators For EM Stocks Points To More Downside The cross rate between SEK (a pro-cyclical currency) and CHF (a defensive one) moves in tandem with EM share prices. The same holds for the NZD versus the USD. The rationale is as follows: all of these currencies correlate with the global business cycle and global risk-on/off trends. Presently, the SEK/CHF cross and the NZD point to lower EM share prices. Chart 30 Directional Indicators For EM Stocks Points To More Downside Directional Indicators For EM Stocks Points To More Downside Chart 31 Directional Indicators For EM Stocks Points To More Downside Directional Indicators For EM Stocks Points To More Downside The US Dollar Is To Rally Further The Fed’s willingness (for now) to hike rates is positive for the greenback. The trend in relative TIPS yields between the US and Germany heralds further USD strength against the euro. Also, the cross rate between SEK (a pro-cyclical currency) and CHF (a defensive one) entails more upside in the broad trade-weighted US dollar. Chart 32 The US Dollar Is To Rally Further The US Dollar Is To Rally Further Chart 33 The US Dollar Is To Rally Further The US Dollar Is To Rally Further Worrisome Market Profiles Several markets such as EM non-TMT share prices, Korean tech stocks, the Chinese onshore CSI300 stock index and silver prices have all failed to break above their 200-day moving averages and are now relapsing. Such a profile is often consistent with new cyclical lows in these markets. Chart 34 Worrisome Market Profiles Worrisome Market Profiles Chart 35 Worrisome Market Profiles Worrisome Market Profiles Chart 36 Worrisome Market Profiles Worrisome Market Profiles Chart 37 Worrisome Market Profiles Worrisome Market Profiles China’s Liquidity And Credit Cycles Even though China has heightened the pace of monetary easing, it will take several months before its credit impulse rebounds. On average, it takes about six months for reductions in the required reserve ratio (liquidity injections) to produce a meaningful recovery in the credit impulse. So far, the excess reserve ratio has stabilized but not improved. This means the credit impulse will continue stabilizing in the coming months, but a major rise is unlikely in the near term. In turn, the credit cycle leads share prices by several months. All in all, a risk window for China-related plays remains open in the coming months. Chart 38 China's Liquidity And Credit Cycles China's Liquidity And Credit Cycles Chart 39 China's Liquidity And Credit Cycles China's Liquidity And Credit Cycles   Footnotes

Highlights In the short term, the US stock market price will track the 30-year T-bond price, with every 10 bps move in the yield moving the stock market and bond price by 2.5 percent. We think that the bond market will not allow the stock market to suffer a peak-to-trough decline of more than 15-20 percent. Given that the drawdown is already 10 percent, it equates to no more than 20-40 bps of upside for the 30-year T-bond yield, to a level of 2.3-2.5 percent. Hence, we are quite close to an entry-point for both stocks and long-duration bonds. In the next few years, the structural bull market will continue, ending only at the ultimate low in the 30-year bond yield. But on a 5-year horizon, the blockchain will be the undoing of the US stock market – by undermining the vast profits that the US tech behemoths make from owning, controlling, and manipulating our data and the digital content that we create. In that sense, the blockchain will ultimately reveal – and pop – a ‘super bubble’. Fractal trading watchlist: We add Korea and CAD/SEK, and update bitcoin, biotech, and nickel versus silver. Feature Chart of the WeekIf The Market Is Not Far From Its Fundamentals, Can This Really Be A 'Super Bubble'? If The Market Is Not Far From Its Fundamentals, Can This Really Be A 'Super Bubble'? If The Market Is Not Far From Its Fundamentals, Can This Really Be A 'Super Bubble'? Why has the stock market started 2022 on such a poor footing? Chart I-2 and Chart I-3 identify the main culprit. Through the past year, the tech-heavy Nasdaq index has been tracking the 30-year T-bond price on a one-for-one basis, while the broader S&P 500 shows a connection that is almost as good. Chart I-2The Nasdaq Has Been Tracking The 30-Year T-Bond Price One-For-One... The Nasdaq Has Been Tracking The 30-Year T-Bond Price One-For-One... The Nasdaq Has Been Tracking The 30-Year T-Bond Price One-For-One... Chart I-3…The S&P 500 Has Also Been Tracking The 30-Year T-Bond Price ...The S&P 500 Has Also Been Tracking The 30-Year T-Bond Price ...The S&P 500 Has Also Been Tracking The 30-Year T-Bond Price Therefore, as the 30-year T-bond price has taken a tumble, so have growth-heavy stock markets. Put simply, the ‘bond component’ of these stock markets has been dominating recent performance, overwhelming the ‘profits component’ which tends to move more glacially. It follows that the short-term direction of the stock market has been set – and will continue to be set – by the direction of the 30-year T-bond price. Stocks And Bonds Are Nearing A ‘Pinch Point’ The next few paragraphs are necessarily technical, but worth absorbing – as they are fundamental to understanding the stock market’s recent sell-off, as well as its future evolution. The duration of any investment quantifies how far into the future its cashflows lie, by averaging those cashflows into one theoretical future ‘lump sum’. For a bond, the duration also equals the percentage change in the bond price for every 1 percent change in its yield.1 Crucially, the duration of the US stock market is the same as that of the 30-year T-bond, at around 25 years. Therefore, if all else were equal, the US stock market price should track the 30-year T-bond price, with every 10 bps move in the yield moving the stock market and bond prices by 2.5 percent. In the long run of course, all else is not equal. The 30-year T-bond generates a fixed income stream, whereas the stock market generates income that tracks profits. Allowing for this difference, the US stock market should track: (The 30-year T-bond price) multiplied by (profits expected in the year ahead) multiplied by (a constant) In which the constant expresses the theoretical lump-sum payment 25 years ahead as a multiple of the profits in the year ahead – and thereby quantifies the expected structural growth in profits. We can ignore this constant if the structural growth in profits does not change. Nevertheless, remember this constant, as we will come back to it later when we discuss a putative ‘super bubble’. The ‘bond component’ of the stock market has been dominating recent performance. This model for the stock market seems simplistic. Yet it provides an excellent explanation for the market’s evolution through the past 40 years (Chart I-4), as well as through the past year in which, to repeat, the bond component has been the dominant driver. Chart I-4The US Stock Market = The 30-Year T-Bond Price Multiplied By Profits The US Stock Market = The 30-Year T-Bond Price Multiplied By Profits The US Stock Market = The 30-Year T-Bond Price Multiplied By Profits In the short term then, given the 25 year duration of the US stock market, every 10 bps rise in the 30-year T-bond yield will drag down the stock market by 2.5 percent. We can also deduce that the sell-off will be self-limiting and self-correcting, because at some ‘pinch point’ the bond market will assess that the deflationary impulse from financial instability will snuff out the recent inflationary impulse in the economy. Where is that pinch point? Our sense is that the bond market will not allow the stock market to suffer a peak-to-trough decline of more than 15-20 percent. Given that the drawdown is already 10 percent, it equates to no more than 20-40 bps of upside for the 30-year T-bond yield, to a level of 2.3-2.5 percent. Hence, we are quite close to an entry-point for both stocks and long-duration bonds. The Case Against A ‘Super Bubble’ (And The Case For) As is typical, the recent market setback has unleashed narratives of an almighty bubble starting to pop. Stealing the headlines is value investor Jeremy Grantham of GMO, who claims that “today in the US we are in the fourth super bubble of the last hundred years.” Is there any merit to Mr. Grantham’s claim? An investment is in a bubble if its price has completely broken free from its fundamentals. For example, in the dot com boom, the stock market did become a super bubble. But as we have just shown, the US stock market today is not that far removed from its fundamental components of the 30-year T-bond price multiplied by profits. At first glance then, Mr. Grantham appears to be wrong (Chart of the Week). Still, if the underlying components – the 30-year T-bond and/or profits – were in a bubble, then the stock market would also be in a bubble. In this regard, isn’t the deeply negative real yield on long-dated bonds a sure sign of a bubble? The answer is, not necessarily. As we explained last week in Time To Get Real About Real Interest Rates, the deeply negative real yield on Treasury Inflation Protected Securities (TIPS) is premised on an expected rate of inflation that we should take with a huge dose of salt. Putting in a more realistic forward inflation rate, the real yield on long-dated bonds is positive, albeit just. What about profits – are they in a bubble? The US (and world) profit margin stands at an all-time high, around 20 percent greater than its post-GFC average (Chart I-5). But a 20 percent excess is not quite what we mean by a bubble. Chart I-5Profit Margins Are At An All-Time High Profit Margins Are At An All-Time High Profit Margins Are At An All-Time High There is one final way that Mr. Grantham could be right, and for this we must come back to the previously mentioned constant which quantifies the expected long-term growth in profits. If this expected structural growth were to collapse, then the stock market would also collapse. This is precisely what happened to the non-US stock market after the dot com bust, when the expected structural growth – and therefore the structural valuation – phase-shifted sharply lower (Chart I-6 and Chart I-7). As a result, the non-US stock market also phase-shifted sharply lower from the previous relationship with its fundamentals (Chart I-8). Could the same ultimately happen to the US stock market? Chart I-6The Structural Growth And Valuation Of Non-US Stocks Phase-Shifted Down... The Structural Growth And Valuation Of Non-US Stocks Phase-Shifted Down... The Structural Growth And Valuation Of Non-US Stocks Phase-Shifted Down... Chart I-7...Could The Same Happen To ##br##US Stocks? ...Could The Same Happen To US Stocks? ...Could The Same Happen To US Stocks? Chart I-8Non-US Stocks Phase-Shifted Lower From Their Previous Relationship With Fundamentals Non-US Stocks Phase-Shifted Lower From Their Previous Relationship With Fundamentals Non-US Stocks Phase-Shifted Lower From Their Previous Relationship With Fundamentals The answer is yes – and the main risk comes from the blockchain and its threat to the pseudo-monopoly status that the US tech behemoths have in owning, controlling, manipulating, and monetising our data and the digital content that we create. If the blockchain returned that ownership and control back to us, it would devastate the profits of Facebook, Google, and the other behemoths that dominate the US stock market. If the expected structural growth were to collapse, then the stock market would also collapse. That said, the blockchain is a long-term risk to the stock market, likely to manifest itself on a 5-year horizon. Before we get there, in the next deflationary shock, the 30-year T-bond yield has the scope to decline by at least 150 bps, equating to a 40 percent increase in the ‘bond component’ of the US stock market. To conclude, the structural bull market will end only at the ultimate low in the 30-year bond yield. And then, the blockchain will reveal – and pop – a ‘super bubble’. Fractal Trading Watchlist This week we add Korea and CAD/SEK, and update bitcoin, biotech, and nickel versus silver. Of note, the near 30 percent underperformance of Korea through the past year has reached the point of fractal fragility that has signalled previous major reversals in 2015, 2017 and 2019 (Chart I-9). Accordingly, this week’s recommended trade is to go long Korea versus the world (MSCI indexes), setting the profit target and symmetrical stop-loss at 8 percent.  Chart I-9Korea Is Approaching A Turning Point Versus The World Korea Is Approaching A Turning Point Versus The World Korea Is Approaching A Turning Point Versus The World Korea Approaching A Turning Point Versus EM Korea Approaching A Turning Point Versus EM Korea Approaching A Turning Point Versus EM CAD/SEK Could Reverse CAD/SEK Could Reverse CAD/SEK Could Reverse Bitcoin Near A First Support Level Biotech Approaching A Major Buy Biotech Approaching A Major Buy Biotech Approaching A Major Buy Biotech Approaching A Major Buy Biotech Approaching A Major Buy Nickel Approaching A Sell Versus Silver Nickel Approaching A Sell Versus Silver Nickel Approaching A Sell Versus Silver Dhaval Joshi Chief Strategist dhaval@bcaresearch.com Footnotes 1 Defined fully, the duration of an investment is the weighted average of the times of its cashflows, in which the weights are the present values of the cashflows. Fractal Trading System Fractal Trades The Case Against A ‘Super Bubble’ (And The Case For) The Case Against A ‘Super Bubble’ (And The Case For) The Case Against A ‘Super Bubble’ (And The Case For) The Case Against A ‘Super Bubble’ (And The Case For) 6-Month Recommendations Structural Recommendations Closed Fractal Trades Indicators To Watch - Bond Yields Chart II-1Indicators To Watch - Bond Yields - ##br##Euro Area Indicators To Watch - Bond Yields - Euro Area Indicators To Watch - Bond Yields - Euro Area Chart II-2Indicators To Watch - Bond Yields - ##br##Europe Ex Euro Area Indicators To Watch - Bond Yields - Europe Ex Euro Area Indicators To Watch - Bond Yields - Europe Ex Euro Area Chart II-3Indicators To Watch - Bond Yields - ##br##Asia Indicators To Watch - Bond Yields - Asia Indicators To Watch - Bond Yields - Asia Chart II-4Indicators To Watch - Bond Yields - ##br##Other Developed Indicators To Watch - Bond Yields - Other Developed Indicators To Watch - Bond Yields - Other Developed   Indicators To Watch - Interest Rate Expectations Chart II-5Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Chart II-6Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Chart II-7Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Chart II-8Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations  

Highlights The Biden administration faces significant risks from outside the US economy – our third “key view” for 2022. The Ukraine conflict brings one external risk to the forefront. These external risks would exacerbate the global supply squeeze, potentially pushing up commodity prices until they start to kill demand. Investors should prepare for oil price overshoots.  Exogenous risks – such as foreign policy crises – rarely help the president’s party in the midterm election. Any crisis that adds to short-term inflation will hurt the ruling party. Tactically we continue to prefer defensive equities. Close our tactical long industrials / short consumer discretionary trade for a gain of 11.6%. Close long energy stocks for a 15.6% gain and convert to long energy small caps versus large caps. Buy the dip in cyber security stocks. Feature Stock market volatility is back, thanks in no small part to external risks such as Europe’s energy shortage and Russia’s conflict with the West over Ukraine. In our forecast for 2022, we highlighted the Biden administration’s external risks as our third key view. The rapidly deteriorating geopolitical situation was one of several reasons behind this view and it has now clearly moved to the forefront. In this report we highlight the consequences for domestic-oriented US investors. Biden’s immediate external risks, if they materialize, will increase the likelihood that Democrats will lose control of Congress, causing US fiscal policy to freeze and driving policy uncertainty and the dollar upward. For detailed coverage of the Ukraine conflict and its global geopolitical, macro, and market implications please refer to our Geopolitical Strategy reports. Why Is Biden Vulnerable To External Risks The Biden administration and the Democratic Party face serious external risks in 2022. The Omicron variant and global supply constraints are a major factor. Also the US’s domestic political divisions invite challenges from abroad. President Biden is politically weak ahead of midterm elections on November 8. His net approval rating is under water at -10 percentage points. Republicans are now leading the generic congressional ballot with 45.5% support against Democrats’ 41.8%. On a deeper level, Democrats are beset by a socialist fringe on their left wing, making it difficult to pass legislation, and an enthusiastic nationalist opposition movement with a viable challenger for the presidency in 2024 (former President Trump). At best they will pass one more major bill this year before Congress gets gridlocked. Foreign rivals have an advantage in this context. America’s chief rivals face limited political constraints at home (no midterm elections) but they can make low-cost, high-impact threats against the Biden administration through their leverage over the global supply chain and hence voters’ pocketbooks. External Risks Are Inflationary (At Least At First) External risks begin with inflation. The US’s large imbalance of investment over savings is evident in a current account deficit of 3.3% and deteriorating terms of trade. American demand is exceedingly strong due to accumulated household savings, a new capex cycle, and lingering effects of monetary and fiscal stimulus. Yet global supply is impeded. Import prices are rising at a 5.7% rate, the fastest since the BLS started the series in 2010, while imports from China are rising at a 4.7% clip. China’s “zero Covid” policy implies that supply disruptions will keep up the inflationary pressure this year (Chart 1, first panel). The US is also importing inflation from rising commodity prices. West Texas Intermediate crude oil prices have risen to $83 per barrel and average gasoline prices stand at $3.3. With global supply-demand balances tight, WTI prices should average $77 per barrel this year and $78 next year, according to our Commodity & Energy Strategy. In this context, unplanned supply disruptions are likely and will put more pressure on the supply side. Any conflicts with oil producers such as Russia and Iran will backfire in the form of higher prices at the pump (Chart 1, second panel). Yet geopolitical competitors (Russia, Iran, China) have unfinished business with the US stemming from the Trump administration. It is also possible that Biden could negotiate diplomatic solutions, reducing the risk of an oil price spike, but that is not the current trajectory. Chart 1Biden's External Risks Are Inflationary For Now Biden's External Risks Are Inflationary For Now Biden's External Risks Are Inflationary For Now Interest rate hikes from the Federal Reserve will not easily control inflation derived from external sources and supply constraints. They will take time to dampen domestic demand. Yet voters usually solidify their opinions by mid-summer. Inflation may not have come down much by that time. Biden and the Democratic Party are at the mercy of the global supply chain. In this context Russia deliberately forced its way to the top of the US and global agenda by demanding that the West renounce any attempt to threaten its national security via Ukraine or the former Soviet Union. Energy Shock From Russia? The Ukraine crisis threatens an increase in global energy prices. Russia provides 8% of Europe’s commodity imports, 18% of its energy imports, and 16% of its natural gas imports (Chart 2). Russia is already withholding energy supplies from Europe, helping push natural gas prices up by 122% since last August. If war ignites, Russia could reduce energy flows to Ukraine and hence to the rest of Europe. Europe would not be willing to impose as harsh of sanctions as the US because its energy supply depends on it. The US can increase exports to Europe but it cannot replace Russia without depriving its other allies and partners, including India, Japan, and South Korea (Chart 3). The squeeze will cause prices to rise at first but if it is not addressed by higher output from the US and OPEC 2.0, then demand will be destroyed. Note that in 1979, 2008, and 2014, Russian military invasions coincided with a peak in global oil prices. Chart 2Geopolitical Risks Cause Resource Squeeze Biden’s External Risks Biden’s External Risks Chart 3Can US Replace Russia For Europe? Not Really. Biden’s External Risks Biden’s External Risks If other supply problems emerged simultaneously, the slowdown could be especially disruptive. If US-Iran negotiations fail, then another energy supply risk will emerge immediately this spring. The implication is not only a rise in oil prices but also a resilient dollar, which is also the implication of the Fed’s looming rate hikes. Defensive plays would tend to beat cyclical plays, at least in the short run until the crisis abates. But it is important to look at previous examples of Russian aggression to test this hypothesis. US Market Response To Russian Belligerence When Russia invaded Georgia in August 2008, the attack had limited impact on global financial markets, which were focused on the subprime mortgage crisis unfolding on Wall Street. Naturally stocks underperformed bonds, cyclicals underperformed defensives, and value went sideways against growth. Small caps rallied at first versus large caps but then hit a turning point from outperformance to underperformance (Chart 4). Note that the invasion began while President Putin watched the summer Olympics live in Beijing. So one cannot rule out a limited military action against Ukraine in the near term just because Putin is also headed to Beijing for this winter’s Olympics. When Russia invaded Ukraine in February 2014, seizing the Crimean peninsula in the Black Sea, the attack had a greater impact on global financial markets than with Georgia, although Ukraine’s relevance to the global economy was (and is) still limited. Chart 4Market Reaction To Russia Invasion Of Georgia, 2008 Market Reaction To Russia Invasion Of Georgia, 2008 Market Reaction To Russia Invasion Of Georgia, 2008 Chart 5Market Reaction To Russia Invasion Of Ukraine, 2014 Market Reaction To Russia Invasion Of Ukraine, 2014 Market Reaction To Russia Invasion Of Ukraine, 2014 Bonds outperformed stocks, cyclicals were flat-to-up against defensives (energy clearly outperformed defensives), and small caps stumbled but then beat out large caps (Chart 5). Energy stocks theoretically stood to benefit but crashed later that year due to supply glut and China policy tightening. In 2022 the situation is different from these previous Russian invasions in that the world is already in the thrall of an energy supply squeeze brought on by various factors. China’s economy is growing slowly but authorities are easing policy. A comparison of the winter of 2021-22 with that of 2013-14, when Russia invaded Crimea, suggests that energy stocks have already far outpaced growth and defensives (Chart 6). Energy small caps, however, could rally substantially against large cap peers. Tactically US investors should maintain a risk-averse positioning until the Russians make a military decision and the West announces its retaliatory measures. This analysis suggests that cyclicals and small caps face volatility but can ultimately grind higher after the onset of any new war in Ukraine. The magnitude of the war will obviously matter, which is why we maintain a defensive tactical positioning. The next question centers on the medium-term policy impact of Biden’s external risks. Chart 6Market Context: 2022 Versus 2014 Market Context: 2022 Versus 2014 Market Context: 2022 Versus 2014 Implications For US Midterms And Policy It is possible that Biden’s external risks will play a role in the 2022 midterms. It depends on which risks materialize. Most likely a Russian re-invasion of Ukraine would have a negative effect on the Democrats, especially if it adds to voters’ inflation woes. Major foreign policy successes or failures have a substantial impact on a president’s re-election chances but midterms are less obvious. Midterms almost always go against the president’s party because the previous election’s losers turn out in droves while winners sit home in complacency or disillusionment. The midterm electorate tends to be older, whiter, and more educated than the presidential electorate. Chart 7 shows only midterm elections in which external risks – such as foreign policy – played a major role. In the House, the only time the president’s party gained seats was in 2002, though it only lost four seats in 1962. In the Senate, the president’s party gained seats in 1962, 2002, and 2018 and only lost 2 seats in 1954. From these points we can draw the following conclusions: Chart 7US Midterm Elections: Ruling Party Performance Amid Foreign Policy Crises Biden’s External Risks Biden’s External Risks Foreign policy crises do not generally help the president’s party. While major crises like 9/11 helped the Republicans, and the 1962 Cuban Missile Crisis minimized Democrats’ losses, nevertheless the 1942 midterm occurred after Pearl Harbor and the Democrats lost seats. Minor crises like the 1958 “Lebanon Crisis” also do not help. Russia’s invasion of Ukraine in 2014 falls under this category and did not help President Obama’s Democrats. A major threat to the homeland can help the president’s party on the margin. This is the significance of 1962 and 2002. The ruling party either minimized losses or made absolute gains in the House, while gaining seats in the Senate. (The 2018 midterm is the other case in which the president’s party gained Senate seats, amid President Trump’s trade war with China, but Republicans suffered heavily in the House.) Wartime escalation and entanglement hurt the president’s party. President Johnson’s Democrats suffered deep losses in 1966, as did President George W. Bush’s Republicans in 2006. Obama’s troop surge in Afghanistan was not the main issue but did not help his party in 2010. Ceasefires and peace treaties do not help the president’s party, even when the end of the war is seen as a victory. World War I was drawing to a close in 1918 but Democrats suffered for having gotten the US involved. Democrats also lost in 1946, despite US triumph in WWII. The Korean war ended on a far more ambivalent note and Republicans suffered at the ballot box. Vietnam was drawing to an ignominious close in 1974, which also occurred in the aftermath of the Arab oil embargo, recession, and Watergate scandal, so no surprise Republicans lost seats. If there is a foreign policy crisis this year, the “best case” for Biden’s Democrats – in crass political terms – would be one that engenders a patriotic rally, like happened with the Cuban Missile Crisis or 9/11. If Democrats only lose four seats in 2022, like Kennedy in 1962, they will have a one-seat majority in the House. However, this best-case scenario is unlikely. As noted, 1962 and 2002 consisted of direct threats to the US homeland. All other crises either hurt or did not help the president’s party. In 2014, while voters had other things on their minds that year, Russia’s invasion of Crimea reinforced criticisms of Obama’s foreign policy already centered on Libya, Syria, and Iran. Obama responded with sanctions and aid to Ukraine, as Biden threatens to do today. Democrats lost 13 seats in the House and 9 seats in the Senate. A similar negative impact should be expected if Russia re-invades in 2022. Biden is already vulnerable: his approval rating collapsed after his messy withdrawal from Afghanistan (reinforcing the fourth bullet about ending wars above). A new foreign policy crisis could cement the narrative of foreign policy incompetence. It matters a great deal whether an exogenous crisis automatically hurts the voter’s pocketbook. If it does, then any initial rally around the flag will fade over time, leaving the negative material impact behind and angering voters. In 1974, President Ford’s approval rating shot up above 50% as he took over from Nixon, yet his party still suffered from the inflationary economic backdrop and dour foreign policy backdrop. In 1978, President Carter’s approval rating also recovered to nearly 50% in time for the vote but it was not enough to overcome inflationary malaise – and Iranian oil strikes began in September (Chart 8). If we subtract the Misery Index (unemployment plus inflation) from the president’s approval rating, we see that Kennedy had a 70% approval during the Cuban Missile Crisis, and Bush had a 62% approval in 2002. But Johnson and Carter were sinking toward 35% during their first midterms, which is where Biden stands today (Chart 9). Chart 8Different Reactions For Different Crises Biden’s External Risks Biden’s External Risks Chart 9Best And Worst Case Scenarios Of Foreign Policy Crisis For Democrats Biden’s External Risks Biden’s External Risks Thus Biden’s external risks, depending on which ones materialize, suggest that the Democratic Party will face another headwind in November. Democrats are very likely to lose the House and somewhat likely to lose the Senate. Gridlock is already setting in – as will be apparent with the potential government shutdown over the February 18 deadline to pass spending bills. But the midterm will formalize it. Policy uncertainty will continue to creep up and weigh on investor risk appetite this year. In other words, even if cyclicals rally through a Ukraine conflict, they may not outperform defensives later this year. Investment Takeaways Cyclically we are booking an 15.6% gain on our long energy trade and will convert it to a long US energy small caps relative to large caps trade. The external risks highlighted in this report would push up oil prices at least initially (Chart 10). However, volatility will pick up from here. OPEC 2.0 will want to keep Brent crude prices from settling above the $90 per barrel that starts to crimp demand, as our Commodity & Energy Strategy argues. Higher prices will also encourage new production, including from the US shale patch (Chart 11). Note that energy stocks, like other cyclicals, tend to underperform during midterm election years as policy uncertainty affects markets. Chart 10Book Gains On Tactical Long Energy Equities Trade Book Gains On Tactical Long Energy Equities Trade Book Gains On Tactical Long Energy Equities Trade Chart 11US Oil Producers Will Step Up US Oil Producers Will Step Up US Oil Producers Will Step Up  Tactically we recommend closing our long industrials / short consumer discretionary for a gain of 11.6%. Normally, consumer discretionary stocks are the best performing sector during midterm election years while industrials are the worst. But because of China’s policy easing, we took a tactical bet that the opposite would occur at the start of the year. However, external risks should now cause this situation to reverse by pushing up the dollar, penalizing industrials, without hurting the American consumer too much (Chart 12). Industrial equities are pricing in strong capex intentions but geopolitical conflicts would weigh on those intentions, while new orders and core durable goods orders could suffer a bit (Chart 13). The midterms will come into focus later this year and weigh on industrials as well. Chart 12Close Long Industrials Trade For Now Close Long Industrials Trade For Now Close Long Industrials Trade For Now Chart 13Industrials Still Attractive On Cyclical Basis Industrials Still Attractive On Cyclical Basis Industrials Still Attractive On Cyclical Basis Cyclically stick with cyber security stocks. They have sold off along with the tech sector as interest rates rise. But long cyber security is a secular investment thesis based on digitization of the economy, rising cyber crime, and geopolitical risk. Tensions with Russia, proxied by the fall in the ruble and rise in aerospace/defense stocks, point to the fact that investors recognize international tensions will remain high (Chart 14). Cyber space will remain an area of conflict even if physical conflict does not materialize. Growth stocks should also revive later as midterm policy uncertainty picks up. Chart 14Cyber Security Is A Secular Trade ... Buy The Dip Cyber Security Is A Secular Trade ... Buy The Dip Cyber Security Is A Secular Trade ... Buy The Dip Chart 15Overweight Health Care Amid Political Risk Overweight Health Care Amid Political Risk Overweight Health Care Amid Political Risk Tactically stick with overweight health care on rising uncertainty and expectations that the dollar will pick up (Chart 15). Defensives, especially health, should also outperform as the year goes on and midterms approach. Pricing power is returning to the sector but the Biden administration only has a little legislative ammunition left and its regulatory focus lies elsewhere for now.     Matt Gertken Vice President US Political Strategist mattg@bcaresearch.com   Strategic View Open Tactical Positions (0-6 Months) Open Cyclical Recommendations (6-18 Months) Table A2Political Risk Matrix Biden’s External Risks Biden’s External Risks Table A3US Political Capital Index Biden’s External Risks Biden’s External Risks Image Image Table A4APolitical Capital: White House And Congress Biden’s External Risks Biden’s External Risks Table A4BPolitical Capital: Household And Business Sentiment Biden’s External Risks Biden’s External Risks Table A4CPolitical Capital: The Economy And Markets Biden’s External Risks Biden’s External Risks

Feature Chart 1Weak Economic Fundamentals Undermine Stock Performance Intensified Monetary Policy Easing, Unresponsive Underlying Demand Intensified Monetary Policy Easing, Unresponsive Underlying Demand Monetary policy easing has intensified in the past two months. The PBoC reduced one-year loan prime rate (LPR) by 10 bps and five-year by 5 bps following last week’s 10bps cut in policy rates1 and December’s 50 bps drop in the reserve requirement rate (RRR). Nonetheless, the onshore financial market’s response to the monetary policy actions has been muted. China’s A-share market price index fell by 3% in the past month. Credit growth has bottomed, but there is no sign of a strong rebound despite recent rate decreases (Chart 1, top panel). The impaired monetary policy transmission mechanism will likely delay China’s economic recovery, which normally lags the credit cycle by six to nine months. Moreover, the marginal propensity to spend among both corporates and households continues to decline, highlighting a lack of confidence among real economy participants, and will in turn dampen the positive effects of policy stimulus (Chart 2).  The poor performance of Chinese onshore stocks (in absolute terms) is due to a muted improvement in credit growth and deteriorating economic fundamentals (Chart 1, bottom panel). Our model shows that China’s corporate profits are set to contract in next six months, implying that the risk-reward profile of Chinese stocks in absolute terms is not yet attractive (Chart 3). Therefore, investors should maintain an underweight allocation to Chinese equities for the time being. Chart 2Lack Of Confidence Dampens Corporate Earnings Outlook Lack Of Confidence Dampens Corporate Earnings Outlook Lack Of Confidence Dampens Corporate Earnings Outlook Chart 3China's Corporate Profits Set To Contract In Next Six Months China's Corporate Profits Set To Contract In Next Six Months China's Corporate Profits Set To Contract In Next Six Months   Qingyun Xu, CFA Associate Editor qingyunx@bcaresearch.com Improving Liquidity, Weakening Credit Demand The modest uptick in December’s total social financing (TSF) growth largely reflects a significant increase in government bond issuance, while bank loan growth continued on a downward trend (Chart 4). Corporate loan demand remained sluggish, which dragged down aggregate bank credit growth (Chart 5). Downbeat business confidence suggests that corporate demand for credit will take longer to turn around, and therefore will reduce the effectiveness of current easing measures. Chart 4Monetary Easing Since Q3 Has Failed To Boost Credit Growth So Far Monetary Easing Since Q3 Has Failed To Boost Credit Growth So Far Monetary Easing Since Q3 Has Failed To Boost Credit Growth So Far Chart 5Corporate Demand For Loans Weaker Than Suggested By Headline Data Corporate Demand For Loans Weaker Than Suggested By Headline Data Corporate Demand For Loans Weaker Than Suggested By Headline Data Meanwhile, corporate bill financing has risen rapidly in recent months and now accounts for almost 40% of new bank loans, the highest level since 2010 (Chart 5, bottom panel). The high share of short-term lending to the corporate sector highlights the underlying weakness in both loan supply and demand.  Banks are risk averse and reluctant to approve longer-term credit to the corporate sector, while corporates are unwilling to take on more debt.  As a result, banks have had to issue short-term bills in order to meet their lending quota. Proactive Fiscal Policy Will Have A Limited Impact On Infrastructure Investments Chart 6Local Government SPBs Will Be Frontloaded In 2022 Intensified Monetary Policy Easing, Unresponsive Underlying Demand Intensified Monetary Policy Easing, Unresponsive Underlying Demand Fiscal policy will likely be frontloaded in Q1 this year, but the impact of a proactive fiscal policy on boosting infrastructural investment may be limited. According to a statement by the Ministry of Finance last December, around RMB1.46 trillion in the quota for local government special purpose bonds (SPBs) has been frontloaded for 2022. If we assume that all of the SPBs will be issued in Q1, the amount will be higher than SPBs issued during the same period in 2019, 2020 and 2021 (Chart 6). We expect a total SPBs quota of RMB 3.5 trillion for 2022, roughly the same as 2021.  This implies a zero fiscal impulse on SPBs in 2022 compared with 2021. However, there were an estimated 1.2 trillion in SPB proceeds in 2021 that local governments failed to invest and this amount could be deployed in 2022. If we add last year’s SPB carryover to this year’s quota, there may be a 30% increase in the available funds to invest in infrastructure projects in 2022. Chart 7Higher LG Bond Issuance Does Not Mean Substantial Boost In Infrastructure Spending Higher LG Bond Issuance Does Not Mean Substantial Boost In Infrastructure Spending Higher LG Bond Issuance Does Not Mean Substantial Boost In Infrastructure Spending However, a 30% jump in SPB proceeds does not suggest an equal boost in infrastructure spending this year (Chart 7). As noted in previous reports, SPBs issued by local governments only account for around 15% of total funding for infrastructure spending. Bank loans, which remain in the doldrums, are a much more significant driver in supporting the sector’s investment.  Secondly, infrastructure spending has structurally downshifted since 2017 due to a sweeping financial deleveraging campaign to rein in shadow banking activity by local government financing vehicles (LGFVs). Shadow banking activity, which is highly correlated with infrastructure investment growth, is stuck in a deep contraction with no signs of an imminent turnaround (Chart 7, bottom panel). Thirdly, land sales play a prominent role in local government financing, accounting for more than 40% of local government aggregate revenues2 compared with about 15% from SPBs (Chart 8). Local government fiscal spending power will be constrained due to a significant and ongoing slowdown in land sales and regulatory pressures on LGFVs (Chart 8, bottom panel).    Therefore, we expect that infrastructure spending will only moderately rebound in 2022. At best, it will return to its pre-pandemic rate of around 4% (year-over-year) in 2022 (Chart 9, top panel). Notably, onshore infrastructure stocks have priced in the recent favorable news about proactive fiscal policy support in 2022 (Chart 9, bottom panel). Given that infrastructure investment will likely only improve modestly this year, on a cyclical basis the sector’s stock performance upside will be capped and renewed weakness is likely. Chart 8Government Funds Face Headwinds From Falling Land Sales Government Funds Face Headwinds From Falling Land Sales Government Funds Face Headwinds From Falling Land Sales Chart 9Infrastructure Investment Will Likely Recover To Its Pre-Pandemic Growth Rate Infrastructure Investment Will Likely Recover To Its Pre-Pandemic Growth Rate Infrastructure Investment Will Likely Recover To Its Pre-Pandemic Growth Rate More Policy Fine-Tuning Is Underway, But Housing Policy Reversal Remains Doubtful Last week’s 5bp reduction in the 5-year LPR, which serves as a benchmark for mortgage loans, was positive for the housing market. However, the cut is insufficient to revive the demand for housing. Moreover, the asymmetrical rate reductions - a 10bps drop in the 1-year LPR versus a 5bps reduction in the 5-year - signals that the authorities are reluctant to decisively reverse housing policies. Sentiment in the housing sector remains downbeat. A survey conducted by the PBoC shows that the willingness to buy a home has plunged to the lowest level since 2017 (Chart 10). Medium- to long-term household loan growth, which is highly correlated with home sales, decelerated further in December (Chart 10, bottom panel). Given that home prices continue to decline, buyers may be expecting more price discounts and refrain from making purchases despite slightly cheaper mortgage rates. Although there was a modest pickup in medium- to long-term consumer loan growth in November, it was mainly driven by pent-up mortgage applications delayed by the banks in Q3. Moreover, advance payments for real estate developers remained in contraction through end-2021. The prolonged weakness in the demand for mortgages and homes highlights our view that it will take more than a minor mortgage rate cut to revive sentiment (Chart 11). Chart 10Sentiment In Housing Market Has Plummeted To A Multi-Year Low Sentiment In Housing Market Has Plummeted To A Multi-Year Low Sentiment In Housing Market Has Plummeted To A Multi-Year Low Chart 11Funding Among Real Estate Developers Has Not Improved Funding Among Real Estate Developers Has Not Improved Funding Among Real Estate Developers Has Not Improved Without a decisive improvement in home sales, real estate developers will continue to face funding constraints, which will weigh on new investment and housing projects (Chart 12). We expect the contraction in real estate investment and housing starts to be sustained through at least 1H22 (Chart 13). Chart 12Policymakers Will Have To Allow Significant Re-leveraging To Revive Housing Demand Policymakers Will Have To Allow Significant Re-leveraging To Revive Housing Demand Policymakers Will Have To Allow Significant Re-leveraging To Revive Housing Demand Chart 13Real Estate Investment And Housing Starts Will Remain In Contraction Through 1H22 Real Estate Investment And Housing Starts Will Remain In Contraction Through 1H22 Real Estate Investment And Housing Starts Will Remain In Contraction Through 1H22 Chinese Export Growth Will Converge To Long-Term Growth Chart 14Vigorous Exports Provided Crucial Support To China's Economy In 2021 Vigorous Exports Provided Crucial Support To China's Economy In 2021 Vigorous Exports Provided Crucial Support To China's Economy In 2021 China’s exports grew vigorously in 2021, providing critical support to the economy.  Net exports contributed 1.7 percentage points to the 8.1% rate of real GDP growth in 2021, the highest growth contribution since 2006. China’s share of global exports expanded to more than 15%, about 2 percentage points higher than the pre-pandemic average from 2015 to 2019 (Chart 14). The export sector probably will not repeat last year’s strong performance. The widening divergence of exports in value and in volume suggests that the solid aggregate value of exports has been mainly buttressed by soaring export prices since July 2021 (Chart 15). The price effect will likely gradually abate in 2022 due to easing global supply chain constraints, softer global economic growth and a high base factor from 2021. Indeed, export prices from China and other industrialized countries may have already peaked (Chart 16). Chart 15Robust Exports Growth Since 2H21 Driven By Soaring Export Prices Robust Exports Growth Since 2H21 Driven By Soaring Export Prices Robust Exports Growth Since 2H21 Driven By Soaring Export Prices Chart 16Export Prices May Have Peaked Export Prices May Have Peaked Export Prices May Have Peaked Services spending worldwide will likely normalize and lead global demand growth in 2022. Meanwhile, goods spending will moderate, implying weaker demand for China’s manufactured goods (Chart 17). Furthermore, China’s strong exports to emerging markets (EM) since Q2 2021 reflected supply shortages due to production interruptions in the EMs (Chart 18). We expect supply chain disruptions in these economies to ease in 2H22 when Omicron-induced infections subside and antiviral treatments become available worldwide. As such, China’s exports to those regions may gradually return to pre-pandemic levels. Chart 17US Household Consumption Will Likely Rotate From Goods To Services In 2022 US Household Consumption Will Likely Rotate From Goods To Services In 2022 US Household Consumption Will Likely Rotate From Goods To Services In 2022 Chart 18Rising Exports To EMs In 2021 May Not Continue Into 2022 Rising Exports To EMs In 2021 May Not Continue Into 2022 Rising Exports To EMs In 2021 May Not Continue Into 2022 China’s manufacturing utilization capacity reached a historical high in 2021, supported by hardy external demand for goods. However, profit margins in the manufacturing sector have been squeezed due to surging input costs (Chart 19). Manufacturing investment growth has been falling, reflecting the reluctance by manufacturers to expand their business operations amid narrowing profit margins (Chart 20). The profit outlook for the manufacturing sector will be at risk of deterioration when the growth in both export volumes and prices moderate in 2022.  Chart 19Manufacturing Sector's Profit Margins Have Been Squeezed Manufacturing Sector's Profit Margins Have Been Squeezed Manufacturing Sector's Profit Margins Have Been Squeezed Chart 20Manufacturing Investment Growth And Output Volume Both Rolled Over Manufacturing Investment Growth And Output Volume Both Rolled Over Manufacturing Investment Growth And Output Volume Both Rolled Over Rising Import Prices Mask The Weakness In Chinese Domestic Demand Chinese import growth in value remained resilient through December, but has increasingly been driven by rising import prices. Import growth in volume, which is a truer picture of China’s domestic demand, decelerated at a faster rate in 2H21 (Chart 21). Credit impulse, which normally leads import growth by around six months, only ticked up slightly. The minor improvement in the rate of Chinese credit expansion will provide limited support to the country’s imports in 1H 2022 (Chart 22).  Chart 21Rising Import Prices Masked The Weakness In China's Domestic Demand Rising Import Prices Masked The Weakness In China's Domestic Demand Rising Import Prices Masked The Weakness In China's Domestic Demand   Chart 22Modest Rebound In Credit Impulse Will Provide Limited Support To Chinese Imports Modest Rebound In Credit Impulse Will Provide Limited Support To Chinese Imports Modest Rebound In Credit Impulse Will Provide Limited Support To Chinese Imports Chart 23Chinese Imports Of Key Commodities Rebounded Aimed Easing In Production Constraints Chinese Imports Of Key Commodities Rebounded Aimed Easing In Production Constraints Chinese Imports Of Key Commodities Rebounded Aimed Easing In Production Constraints The volume of Chinese-imported key commodities, such as iron ore and steel, rebounded in the past three months, but its growth remains in contraction on a year-on-year basis (Chart 23). The improvement in Chinese commodity imports, in our view, reflects an easing in production constraints rather than escalating demand. Recently released economic data, ranging from manufacturing PMI, industrial production, fixed-asset investment and construction activity, all point to an imbalanced supply-demand picture in China’s economy (discussed in the next section).    Sluggish Quarterly Economic Growth At End Of 2021 China’s economy expanded by 8.1% in 2021 or at a 5.1% average annual rate in the past two years.  However, quarterly GDP growth on a year-over-year basis slowed further to 4% in Q4 from 4.9% in the previous quarter. On a sequential basis, seasonally adjusted GDP growth in Q4 was 1.6 percentage points above that of Q3, but slightly below its historical mean (Chart 24). Chart 24Subdued GDP Growth In Q4 Subdued GDP Growth In Q4 Subdued GDP Growth In Q4 Chart 25Investment And Consumption Have Been Poor Economic Links Investment And Consumption Have Been Poor Economic Links Investment And Consumption Have Been Poor Economic Links Chart 26Softness In Investment And Consumption More Than Offset Robust Exports Softness In Investment And Consumption More Than Offset Robust Exports Softness In Investment And Consumption More Than Offset Robust Exports Although industrial production accelerated somewhat in December, it reflects a catch-up phase following a period of constrained output amid last fall’s energy crisis (Chart 25). On the other hand, lackluster domestic demand and a further slowdown in the housing market significantly dragged down China’s economic expansion in Q4. Both fixed-asset investment and consumption decelerated significantly in 2021 Q4, more than offsetting an improvement in net exports (Chart 26, top panel). Notably, year-over-year growth rates in construction and real estate components of real GDP fell below zero in Q4 (Chart 26, bottom panel). In light of the subdued credit growth through end-2021, China’s economic activity will not regain its footing until mid-2022.  Slow Recovery In Household Consumption Likely Through 1H22 The household consumption recovery was sluggish in 2021 and it will face strong headwinds at least through 1H22. China’s consumption recovery has been hindered by a worsening labor market situation, depressed household sentiment and renewed threats from flareups in domestic COVID-19 cases. China’s labor market situation shows a mixed picture. The urban unemployment rate has dropped to pre-pandemic levels and stabilized at 5.1% in December. It remains well within the government’s 2021 unemployment target of “around 5.5%”. However, urban new job creations plunged sharply and the number of migrant workers returning to the cities remains far below the pre-pandemic trend (Chart 27). China’s imbalanced economic recovery in the past two years led to a substantially slower pace of job creation in labor-intensive service sectors (Chart 28). Moreover, wages have been cut and the unemployment rate among younger workers have climbed rapidly in sectors suffering from last year’s regulatory crackdowns in real estate, education and internet platforms. Even though policies have recently eased at margin, it will take time for labor market dynamics (a lagging indicator) to improve. Chart 27Labor Market Situation Is Worsening Labor Market Situation Is Worsening Labor Market Situation Is Worsening Chart 28Imbalanced Economic Recovery Led To A Mixed Picture In The Labor Market Imbalanced Economic Recovery Led To A Mixed Picture In The Labor Market Imbalanced Economic Recovery Led To A Mixed Picture In The Labor Market Chinese household expenditures have lagged disposable incomes since the outbreak of the pandemic (Chart 29). The propensity to consume has declined since 2018 and the downward trend has been exacerbated by the pandemic since early 2020 along with a soaring preference to save (Chart 30). Chart 29Chinese Household Expenditures Have Lagged Disposable Income Growth Chinese Household Expenditures Have Lagged Disposable Income Growth Chinese Household Expenditures Have Lagged Disposable Income Growth Chart 30Poor Sentiment On Future Income Contributes To Consumers' Unwillingness To Spend Poor Sentiment On Future Income Contributes To Consumers' Unwillingness To Spend Poor Sentiment On Future Income Contributes To Consumers' Unwillingness To Spend Household consumption also faces renewed threats from increases in domestic COVID-19 cases. Since Q3 last year, more frequent city-wide lockdowns and inter-regional travel bans have had profound negative effects on the country’s service sector and retail sales (Chart 31 & 32). Omicron has also spread to China, triggering new waves of stringent countermeasures. China will not abandon its zero-tolerance policy towards COVID anytime soon, thus we expect the stop-and-go economic reopening to continue to weigh on the country’s service sector activity and consumption at least through 1H22. Chart 32Service Sector Activities Struggle To Return To Pre-Pandemic Trends Service Sector Activities Struggle To Return To Pre-Pandemic Trends Service Sector Activities Struggle To Return To Pre-Pandemic Trends Chart 31China's Stringent COVID Countermeasures Will Curb Service Sector Recovery In 2022 China's Stringent COVID Countermeasures Will Curb Service Sector Recovery In 2022 China's Stringent COVID Countermeasures Will Curb Service Sector Recovery In 2022   Table 1China Macro Data Summary Intensified Monetary Policy Easing, Unresponsive Underlying Demand Intensified Monetary Policy Easing, Unresponsive Underlying Demand Table 2China Financial Market Performance Summary Intensified Monetary Policy Easing, Unresponsive Underlying Demand Intensified Monetary Policy Easing, Unresponsive Underlying Demand   Footnotes 1     The 7-day reverse repo and the 1-year Medium-term Lending Facility (MLF) rates. 2     Including local government budgetary and managed funds revenues.   Strategic View Cyclical Recommendations Tactical Recommendations

Highlights 2022 has had a rough start for equity investors: the S&P 500 is now down 8% from its peak, and NASDAQ is officially in correction territory.  The question on everyone’s mind is how long this correction will last, and whether it is the right time to start buying beaten-up Tech stocks. Looking “under the hood” of the NASDAQ, we observe that with the technology space being top-heavy and dominated by the likes of Microsoft and Apple, index returns mask the heavy losses of some of the smaller, and less profitable, constituents, with many down 40-50% from their peaks.  Analysis of the market breadth shows that three-quarters of NASDAQ names are trading below their one-week highs, which, according to our analysis, indicates that Tech is (almost) ripe for a bounce back. Chart 0 However, the sector is currently under duress from rising rates and imminent monetary tightening.  Historically, Tech’s worst performance was two to three months prior to the first rate hike – the current pullback is a “textbook” behavior.  It will take another couple of months after the rate hike for a sustainable rebound. In addition to headwinds from rising rates, there is also an ongoing slowdown in demand for tech products and services, which translates into a deceleration of earnings and sales growth. On the valuations front, Technology is trading with a significant premium to the market, while its expected earnings growth is on par with that of the S&P 500. We recommend investors to be patient: While Tech appears oversold, and recent volatility is a function of market panic, the stars have not yet aligned for the sector.  We are tactically bearish but structurally bullish. Feature 2022 has had a rough start for equity investors: Since the beginning of January, the S&P 500 has pulled back 8%.  Market consensus is that this violent rotation is a repricing of risk, triggered by the Fed’s new hawkish stance aimed at taming the runaway inflation that has surged to a nearly 40-year high. The market expects the first rate hike as soon as March, followed by three more into the year-end. It is also grappling with the timing and degree of quantitative tightening (QT), which will follow on the heels of tapering. Energy and Financials are the only sectors in the green so far this year, with Real Estate, Healthcare, and Tech being hit the hardest (Chart 1). Internet Retail is down almost 20% from its local peak in mid-2021 and Interactive Media, home of Facebook, is down 11%. NASDAQ is officially in correction territory (Chart 2). Rising rates have hit growth and interest-rate-sensitive areas of the market the hardest. Chart 1 Chart 2 While these negative returns indicate a sharp pullback, they don’t do justice to how painful this correction has been, as much of it was happening under the radar. The S&P 500 and many of its tech-related sectors and industries are top-heavy, being home to FAANG+M, which has proven to be more immune to rising rates.  It is the smaller growth companies that have fallen much more than the top-line number indicates, with many down 40-50% from their peaks. However, now with more than 58% of stocks in the NASDAQ trading below their 30-week moving average, the natural question is: “Are we there yet?” or how much longer will this sell-off last? There are early signs of bottom-fishing among the stocks and industries hit hardest. Yet most days, both the S&P 500 and the NASDAQ start in the green, only to finish splattering to a new low (Chart 3). Chart 3Mega-cap Tech Has Fallen But Less Than Small-cap Brethren Mega-cap Tech Has Fallen But Less Than Small-cap Brethren Mega-cap Tech Has Fallen But Less Than Small-cap Brethren In this report, we will aim to gauge when the sell-off in tech names will have run its course by focusing on the S&P 500 Technology sector.    Also in today’s publication, we will reverse our usual course of analysis: We will start from the technicals as they are most helpful for timing entry points, and we will follow with macro and fundamentals.   Tech Sector Is Top Heavy The S&P 500 Technology sector is top-heavy, with each industry group dominated by one of the tech giants, such as Microsoft in Software and Services, Apple in Hardware and Equipment, and Nvidia in Semiconductors. We call this trio “MAN.” The MAN accounts for 50% of the S&P 500 Technology sector market capitalization (Chart 4). As a result, both sector performance and valuation are heavily affected by index composition.  Chart 4 To unpack what is going on within the Tech sector, we plotted the dispersion of last month’s performance within the sector through a market cap bucket, with the first bucket containing the MANs. The last couple of buckets, 10 and 11, contain some of the smallest stocks in the index. Unsurprisingly, the largest stocks in the sector have not fallen that much. The correction has most affected stocks in buckets 7 through 11, with a market cap of between $8 to $33 billion, and these are the names that may be most tempting for “bottom-fishing.” Technicals It Is A Blood Bath Out There A useful indicator of market breadth, allowing us a look under the hood”, is the percentage of stocks making new lows – which currently stands at nearly 75% (Chart 5). This is a high reading which has happened only 11% of the months since 2000.  However, once this metric rises above 85%, it indicates that the market is oversold.  When that happens, the Tech sector outperforms the S&P 500 by around 7% over the next six months, and returns are positive every month (Chart 6).  Based on this indicator, the NASDAQ in general, and Tech in particular, are close to the oversold conditions and are ready for a bounce.  Chart 5Pullback In Tech Stocks Is Broad-based Pullback In Tech Stocks Is Broad-based Pullback In Tech Stocks Is Broad-based Chart 6 However, the BCA Technical Indicator for the sector (Chart 7) is still in neutral territory. It is driven primarily by momentum components: It gauges the trend in equities and determines if the market is at an extreme in terms of momentum or investor psychology.  This indicator is highly affected by the performance of the largest index constituents. All in all, we conclude that from a technical standpoint, the Tech sector is getting closer to a rebound. Chart 7The Technical Indicator Is In The Neutral Territory The Technical Indicator Is In The Neutral Territory The Technical Indicator Is In The Neutral Territory Macroeconomic Backdrop New Rate Hiking Cycle Will Take Time Getting Used To Ok, Tech is oversold. Yet there is still the not-so-small matter of a new, tighter monetary regime. How does Tech fare in the environment of rising rates? Clearly, not so good so far. However, the question is, how long will it take for the higher rates to be priced in, and for Tech to rebound. To answer this question, we have run another empirical study, anchoring the performance of the Tech sector to the beginning of each hiking cycle since 1996 (Charts 8 and 9).   Chart 8 Chart 9 According to our analysis, Tech’s worst performance is two to three months prior to the first rate hike – the current pullback in Tech is a perfect illustration. While we may expect a rebound rally “when the second shoe drops” and the Fed announces the first hike, it appears that a sustainable rally may still be a couple of months away. Based on this analysis, we conclude that it will pay off to be patient and wait until the summer. It Is The Economy, Stupid! Apart from the headwind from rising rates, there is also an ongoing slowdown in demand for Tech Business Investment (Chart 10). Moreover, the Tech New Orders Index peaked at a high level at the end of 2021 and has recently turned (Chart 11). So has Private Tech Investment (Chart 12).  This indicates that demand is waning following the surge that accompanied the most recent push to digital transformation—which was accelerated by the onset of the pandemic.   Chart 10Slowdown In Tech Business Investment Slowdown In Tech Business Investment Slowdown In Tech Business Investment Chart 11Tech New Orders Have Peaked Tech New Orders Have Peaked Tech New Orders Have Peaked Chart 12Private Tech Investment Is Also Slowing Private Tech Investment Is Also Slowing Private Tech Investment Is Also Slowing The macroeconomic backdrop is unfavorable for the Tech Sector Fundamentals Sales And Earnings Growth Are Slowing While the Tech sector enjoyed a fantastic sales recovery in 2021, with sales growth exceeding pre-pandemic levels, this year may be different. Waning demand for tech products and services translates into a sales growth slowdown (Chart 13).   Chart 13The Tech Sector Sales Growth Is Slowing... The Tech Sector Sales Growth Is Slowing... The Tech Sector Sales Growth Is Slowing... Chart 14... So Is Earnings Growth ... So Is Earnings Growth ... So Is Earnings Growth With sales growth slowing, earnings growth is bound to follow (Chart 14), which is no different from the broad market. Technology sector earnings growth for the next 12 months is converging with that of the S&P 500: 10% vs. 9% respectively (Chart 15). Margins are expected to compress in 2022, albeit from the high levels (Chart 16). Chart 15Tech And The S&P 500 Expected Earnings Growth Has Converged Tech And The S&P 500 Expected Earnings Growth Has Converged Tech And The S&P 500 Expected Earnings Growth Has Converged Chart 16Margins Are Expected To Compress Margins Are Expected To Compress Margins Are Expected To Compress Of course, the Q4-2021 earnings results could bring a respite.  So far blended the year-on-year earnings growth rate is 15.8%: However, only 5 companies out of 71 have reported, beating expectations by 4.6%.  Will these results save the day? Possibly – expectations are a low bar to clear.  Time will tell.  But to prop up the sector, results from the MAN have got to be stellar. Valuations: Better But Not Good Enough While Tech earnings are expected to grow in line with the S&P 500, the sector is trading with a 28% premium to the market at 27x vs. 21x forward PE (Table 1). Relative PE NTM currently stands at 1.7 standard deviations above the five-year average. Although this may seem high, the froth has come off as, only two months ago, Tech was trading at 2.4 standard deviations. This is a significant change, but the sector is not yet cheap enough for bargain hunting. Adjusting for the growth rate differential between Tech and the S&P 500, we divide PE NTM over EPS Growth NTM, to arrive at PEG: Even so, Tech is still more expensive trading at 2.7 for a percentage of future growth, compared to 2.3 for the S&P 500. However, Tech is a growth sector, and perhaps by looking at only one-year-ahead earnings growth, we are being myopic. Let’s take a look at longer-term growth expectations. Curiously, over the next five years, Tech earnings are expected to grow at about an 18% annualized rate, while the S&P 500 is expected to grow at 21% (Chart 17). As a result, the PE/Long-Term Earnings Growth Rate for Tech is 1.5 vs. 1.0 for the S&P 500. Table 1Tech Valuation Premium Is Still Too High Are We There Yet? Are We There Yet? Chart 17Long-term Earnings Growth Does Not Justify Valuation Premium Either Long-term Earnings Growth Does Not Justify Valuation Premium Either Long-term Earnings Growth Does Not Justify Valuation Premium Either Of course, we need to keep in mind that since this sector is so top-heavy, the forward PE of the MAN affects overall sector valuations. As you can see in the table below (Table 2), MAN is trading with a premium to the sector. However, within the sector, companies with sky-high valuations are easier to find among smaller constituents (Chart 18). Valuations are elevated, while fundamentals are deteriorating  Table 2The Largest Tech Companies Are Trading With A Premium To The Sector Are We There Yet? Are We There Yet? Chart 18 Investment Implications While it is tempting to add to Technology on the back of this pullback, we recommend caution. Tech is oversold and recent volatility is a function of market panic, yet the stars have not yet aligned for the sector. Historically, Tech has delivered negative returns several months prior to rate hikes and underperformed the broad market. Economic normalization also brings a slowdown in demand for tech goods and services, which translates into less exciting sales and earnings growth, and margin compression. Although some froth has come off, valuations for the sector remain elevated, and the premium over the S&P 500 is not justified. The scorecard summarizes each of these points, and it is clear that, on balance, the sector has quite a few challenges ahead (Table 3). Table 3Technology Sector Scorecard Are We There Yet? Are We There Yet? On a more optimistic note, this sell-off has been fast and furious, and the worst is most likely behind. We are underweight the Technology sector. Within the sector, we are underweight Semiconductors, and Hardware and Equipment. We are still overweight Software and Services for portfolio diversification purposes. The Software sector will be one of our next “deep dives.” Stay tuned. Are we there yet?  No, we still have a few months to go. Structural Positioning While we reiterate our tactical underweighting of the Tech sector, we are bullish on it over the longer investment horizon. This sector is at the heart of US technological innovation, such as cloud computing, artificial intelligence, cybersecurity, chip design that powers EV and AV, and many others.  The sector is home to some of the best American companies, which have powered US equities throughout the past decade, and will continue to do so for decades ahead. Bottom Line Despite a sell-off of NASDAQ and the Technology sector, we are not yet recommending increasing cyclical allocation to Tech: While technicals appear attractive, tighter monetary policy, the slowdown in demand for tech goods and services, pressures on profitability, and elevated valuations remain headwinds. We reiterate our underweight to the Technology sector on a tactical basis.  We are structurally bullish.    Irene Tunkel Chief Strategist, US Equity Strategy irene.tunkel@bcaresearch.com   Recommended Allocation

Image US defense stocks have been on a tear of late (outperforming SPX by 10% since late November), benefiting from both macro and geopolitical trends.   From a macro standpoint, the Defense industry has been neglected by investors for a while, and now trades at 15.4x forward earnings, with a 27% discount to S&P 500.  As a “value” industry, it is likely to outperform in the environment of rising rates. On a geopolitical front, there is a secular rise in geopolitical risks due to a great power rivalry, hypo-globalization, and rising nationalism across the globe. The recent rise in commodity prices also means that countries will get back to active competition over resources and territory, in the Middle East, the South China Sea, the Mediterranean, Central Asia.  As such, the US refocusing on great power competition means Democrats and Republicans both support larger defense budgets, and Biden’s Congress already confirmed this with a large 2021 defense spending bill ($780bn, an increase of 5% from the peak during Trump’s presidency). China is increasing defense spending for the same reason, attempting to carve out a sphere of influence in East Asia, secure supply chains, and deter America in the event of a conflict in China’s neighborhood such as over Taiwan. There is also a rise in defense spending among other emerging powers, such as India, which is coming into its own as a geopolitical force and expanding its military to meet the China challenge as well as the ongoing Pakistan threat. The US allied states, that were formerly dovish, such as Germany and Japan, are also ramping up their defense spending.  Bottom Line: Changing world order will inevitably bring a military buildup between major powers benefiting US defense stocks on a secular basis. The US defense industry is represented by the following companies: LMT, NOC, GD, LHX, AXON, HII. ​​​​​​​  

Highlights The bond market assumes that when recent inflation has been high, it will be higher than average for the next ten years. Yet the reality is the exact opposite. High inflation is followed by lower than average inflation. This means that the ex-post real yield delivered by 10-year T-bonds will turn out to be much higher than the negative ex-ante real yield that 10-year Treasury Inflation Protected Securities (TIPS) are now offering. Long-term investors should overweight 10-year T-bonds versus 10-year TIPS. Underweight (or outright short) US TIPS. Underweight commodities, and especially underweight those commodities that have not yet corrected. Fractal trading watchlist: the US dollar, alternative energy, biotech, nickel versus silver, and an update on semiconductors. Feature Chart of the WeekThe Real Yield Turns Out To Be Higher Than Expected The Real Yield Turns Out To Be Higher Than Expected The Real Yield Turns Out To Be Higher Than Expected Real interest rates are negative. Or are they? Given that real interest rates form the foundation of most asset prices, getting this question right is of paramount importance. Over the short term, yes, real interest rates are negative. Policy interest rates in the major developed economies are unlikely to rise quickly from their current near-zero levels. So, they will remain below the rate of inflation. But what about over the longer term, say ten years – are long-term real interest rates truly negative? The Real Bond Yield Is The Mirror Image Of Backward-Looking Inflation The negative US real 10-year bond yield of -0.7 percent comprises the nominal yield of 1.8 percent minus an expected inflation rate of 2.5 percent. This means that the negativity of the real bond yield hinges on the expectation for inflation over the next ten years. Therein lies the big problem. Many people believe that the bond market’s expected 10-year inflation rate is an independent and forward-looking assessment of how inflation will evolve. Yet nothing could be further from the truth. The bond market’s expected inflation is just the result of an algorithm that uses historic inflation. And at that, an extremely short period of historic inflation, just six months.1  The bond market’s expected inflation is just the result of an algorithm that uses historic inflation. Specifically, in the pandemic era, the bond market has derived its expected 10-year inflation rate from the historic six month (annualized) inflation rate, which it assumes will gradually converge to a long-term rate of just below 2 percent during the first four years, then stay there for the remaining six years2 (Figure I-1). We recommend that readers replicate this simple calculation for themselves to shatter any illusion that there is anything forward-looking about the bond market’s inflation expectation! (Chart I-2). Chart I- Chart I-2Expected 10-Year Inflation Is Just Based On The Last 6 Months Of Inflation! Expected 10-Year Inflation Is Just Based On The Last 6 Months Of Inflation! Expected 10-Year Inflation Is Just Based On The Last 6 Months Of Inflation! The upshot is that when the backward-looking six month inflation rate is low, like it was in the depths of the global financial crisis in late 2008 or the pandemic recession in early 2020, the market assumes that the forward-looking ten year inflation rate will be low. And when the backward-looking six-month inflation rate is high, like now or in early-2008, the bond market assumes that the forward-looking ten year inflation rate will be high. In other words, the bond market extrapolates the last six months of inflation into the next ten years. This observation leads to an immediate investment conclusion. The US six-month inflation rate has already peaked. As it cools, it will also cool the expected 10-year inflation rate, thereby putting upward pressure on the mirror image Treasury Inflation Protected Securities (TIPS) real yield. It follows that investors should underweight (or outright short) US 10-year TIPS (Chart I-3). Chart I-3As Inflation Cools, TIPS Will Underperform As Inflation Cools, TIPS Will Underperform As Inflation Cools, TIPS Will Underperform The Real Bond Yield Is Based On A False Expectation There is a more fundamental issue at stake. The market assumes that when recent inflation has been low, it will be lower than average for the next ten years. And when recent inflation has been high, it will be higher than average for the next ten years. Yet the reality is the exact opposite. Low inflation is followed by higher than average inflation, and high inflation is followed by lower than average inflation. The price level is lower than the 2012 expectation of where it would stand in 2022! Another way of putting this is that the market assumes that any breakout of the consumer price index (CPI) will be amplified over the following ten years (Chart I-4). Yet the reality is that any breakout of the price level tends to trend-revert over the following ten years. This means that after the CPI’s decline in late 2008, the market massively underestimated where the price level would be ten years later. But earlier in 2008, when the CPI had surged, the market massively overestimated where the price level would be ten years later. Chart I-4The Market Exaggerates Any Deviations In The CPI Into The Distant Future The Market Exaggerates Any Deviations In The CPI Into The Distant Future The Market Exaggerates Any Deviations In The CPI Into The Distant Future Today in 2022, the price level seems to be uncomfortably high. But the remarkable thing is that it is still lower than the 2012 expectation of where it would stand in 2022! (Chart I-5). Chart I-5The Market Overestimates Where The Price Level Will Stand 10 Years Ahead The Market Overestimates Where The Price Level Will Stand 10 Years Ahead The Market Overestimates Where The Price Level Will Stand 10 Years Ahead The crucial point is that after surges in the price level, realised 10-year inflation turns out to be at least 1 percent lower than the bond market’s expectation (Chart I-6). This means that the ex-post real yield delivered by 10-year T-bonds turns out to be at least 1 percent higher than the ex-ante real yield that 10-year TIPS offered at the start of the ten year period (Chart of the Week). Chart I-6Actual Inflation Turns Out To Be Lower Than Expected Actual Inflation Turns Out To Be Lower Than Expected Actual Inflation Turns Out To Be Lower Than Expected It follows that after the current surge in the price level, the (actual) real yield that will be delivered by 10-year T-bonds over the next ten years will not be the -0.7 percent indicated by the TIPS 10-year real yield. Instead, if history is any guide, it will be at least +0.3 percent. Therefore, in answer to our original question, the real long-term interest rate is almost certainly not negative. Of course, the obvious comeback is that ‘this time is different’. But we really wouldn’t bet the farm on it. Many people thought this time is different during the price level surge in early 2008 as well as the lows in late 2008 and early 2020. But those times were not different. And our bet is that this time isn’t any different either. This means that the real yield on T-bonds will turn out to be much higher than that on TIPS. Long-term investors should overweight T-bonds versus TIPS. Commodities Are Vulnerable A final important observation relates to commodities. Commodity prices have been tightly tracking the 6-month inflation rate, but which way does the causality run in this tight relationship? At first glance, it might seem that the causality runs from commodity prices to the inflation rate. Yet on further consideration, this cannot be right. It is not the commodity price level that drives the overall inflation rate, it is the commodity inflation rate that drives the overall inflation rate. And in the past year, overall inflation has decoupled (upwards) from commodity inflation (Chart I-7 and Chart I-8). Chart I-7Inflation Is Tracking ##br##Commodity Prices... Inflation Is Tracking Commodity Prices... Inflation Is Tracking Commodity Prices... Chart I-8...But Inflation Should Be Tracking Commodity Inflation ...But Inflation Should Be Tracking Commodity Inflation ...But Inflation Should Be Tracking Commodity Inflation Therefore, the causality in the tight relationship between the 6-month inflation rate and commodity prices must run from backward-looking inflation to commodity prices. And the likely explanation is that investors are bidding up commodity prices as a hedge against the backward-looking inflation which they are incorrectly extrapolating into the future. Low inflation is followed by higher than average inflation, and high inflation is followed by lower than average inflation. It follows that as 6-month inflation cools, so will commodity prices. The investment conclusion is to underweight commodities, and especially to underweight those commodities that have not yet corrected. Fractal Trading Watchlist This week’s observations relate to the US dollar, alternative energy, biotech, nickel versus silver, and an update on semiconductors. The US dollar reached a point of fragility in early December, from which it experienced a classic short-term countertrend sell-off. As such, the countertrend sell-off is mostly done. Alternative energy versus old energy is approaching a major buying point. Biotech versus the market is very close to a major buying point. Nickel versus silver is very close to a major selling point. Semiconductors versus technology was on our sell watchlist last week, and has now hit its point of maximum fragility (Chart I-9). Therefore, the recommended trade is to short semiconductors versus broad technology, setting a profit target and symmetrical stop-loss at 6 percent. Chart 9Semiconductors Are Due A Reversal Semiconductors Are Due A Reversal Semiconductors Are Due A Reversal Fractal Trading Watchlist Fractal Trading Watchlist Fractal Trading Watchlist Fractal Trading Watchlist Fractal Trading Watchlist Fractal Trading Watchlist Fractal Trading Watchlist Fractal Trading Watchlist Fractal Trading Watchlist Dhaval Joshi Chief Strategist dhaval@bcaresearch.com Footnotes 1 The expected 10-year inflation rate = (deviation of 6-month annualized inflation from 1.6)*0.2 + 1.6. 2 Inflation is based on the PCE deflator. 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