Sectors

Halloween Not Over Yet Halloween Not Over Yet The Omicron variant is a “known unknown” we fretted about even while the economic reopening was unfolding: Being prepared for multiple viral mutations is part of learning how to live with Covid.  The market did not take the news of a new variant in a stride. At this point, little is known about the strain, its virulence, immuno-evasion, and pathogenicity.  Uncertainty begets volatility: The VIX shot up more than 50% last Friday on the back of the virus scare. Investors have swiftly rotated from the "Reopening" basket back to the “Covid winners,” i.e., Growth and Technology stocks. Treasuries spiked as investors rushed to safety. However, market turbulence per se is of little concern for long-term investors. To gain clarity on Omicron’s effect on the markets, we will be watching the rate of hospitalizations in South Africa and the median age and vaccination status of people with severe infections. On a policy front, we will watch the response of the “zero-tolerance countries,” such as China, Israel, and Australia, and how widespread border closures and lockdowns are. And then, to add insult to injury, the Fed announced its plans for an accelerated pace of tapering. This news has clashed with investors’ fears of the variant and new lockdowns, and a hope for a compassionate and patient Fed. Equities have pulled back, indicating that the aggressive Fed response to inflation is not priced-in and that investors fear that tightening will choke off economic growth. Despite recent developments, our base case is still intact – growth returning to trend, supply chains normalizing, and inflation shifting lower. Omicron and a more aggressive Fed are unlikely to derail the economic recovery for the following reasons. First, global lockdowns are no longer palatable to the general public. Second, even if vaccine effectiveness is compromised, unlike in 2020, there are several drugs available, which significantly improve outcomes of even the most severe cases, regardless of the variant. Third, if virulency and severity are inversely correlated, we are hoping for a mild variant. Last, the Fed still has the flexibility to alter its response if Omicron presents a severe public health threat. Bottom Line: Covid introduced permanent uncertainty in the markets and has become “a known unknown.” For downside protection, we recommend a barbell approach to portfolio construction outlined in the September 13 "Barbell Portfolio: Safety First" Strategy Report. 

Dear Client, We are sending you our Strategy Outlook today where we outline our thoughts on the global economy and the direction of financial markets for 2022 and beyond. Next week, please join me for a webcast on Friday, December 10th at 10:00 AM EST (3:00 PM GMT, 4:00 PM CET, 11:00 PM HKT) to discuss the outlook. Also, we published a report this week transcribing our annual conversation with Mr. X, a long-standing BCA client. Please join my fellow BCA strategists and me on Tuesday, December 7th for a follow-up discussion hosted by my colleague, Jonathan LaBerge. Finally, you will receive a Special Report prepared by our Global Asset Allocation service on Monday, December 13th. Similarly to previous years, Garry Evans and his team have prepared a list of books and articles to read over the holiday period. This year they recommend reading materials on key themes of the moment, such as climate change, cryptocurrencies, supply-chain disruption, and gene technology. Included in this report are my team’s recommendations on what to read to understand the underlying causes of inflation. Best regards, Peter Berezin, Chief Global Strategist   Highlights Macroeconomic Outlook: Despite the risks posed by the Omicron variant, global growth should remain above trend in 2022. Inflation will temporarily dip next year as goods prices come off the boil. However, the structural trend for inflation is to the upside, especially in the US. Equities: Remain overweight stocks in 2022, favoring cyclicals, small caps, value stocks, and non-US equities. Look to turn more defensive in mid-2023 in advance of a stagflationary recession in 2024 or 2025. Fixed income: Maintain below-average interest rate duration exposure. The US 10-year Treasury yield will rise to 2%-to-2.25% by the end of 2022. Underweight the US, UK, Canada, and New Zealand in a global bond portfolio. Credit: Corporate debt will outperform high-quality government bonds next year. Favor HY over IG. Spreads will widen again in 2023. Currencies: As a momentum currency, the US dollar could strengthen some more over the next month or two. Over a 12-month horizon, however, the trade-weighted dollar will weaken. The Canadian dollar will be the best performing G10 currency next year. Commodities: Oil prices will rise, with Brent crude averaging $80/bbl in 2022. Metals prices will remain resilient thanks to tight supply and Chinese stimulus. We prefer gold over cryptos. I. Macroeconomic Outlook   Running out of Greek Letters Just as the world was looking forward to “life as normal”, a new variant of the virus has surfaced. While little is known about the Omicron variant, preliminary indications suggest that it is more transmissible than Delta. The emergence of the Omicron variant is coming in the midst of yet another Covid wave. The number of new cases has skyrocketed across parts of northern and central Europe, prompting governments to re-introduce stricter social distancing measures (Chart 1). New cases have also been trending higher in many parts of the US and Canada since the start of November. Chart 1 Despite the risks posed by Omicron, there are reasons for hope. BioNTech has said that its vaccine, jointly developed with Pfizer, will provide at least partial immunity against the new strain. At present, 55% of the world’s population has had at least one vaccine shot; 44% is fully vaccinated (Chart 2). China is close to launching its own mRNA vaccine next year, which it intends to administer as a booster shot. Chart 2 In a worst-case scenario, BioNTech has said that it could produce a new version of its vaccine within six weeks, with initial shipments beginning in about three months. New antiviral medications are also set to hit the market. Pfizer claims its newly developed pill cuts the risk of hospitalization by nearly 90% if taken within three days from the onset of symptoms. The drug-maker has announced its intention to produce enough of the medication to treat 50 million people in 2022. In addition, it is allowing generic versions to be manufactured in developing countries. The company has indicated that its antiviral pills will be effective in treating the new strain.   Global Growth: Slowing but from a High Level Assuming the vaccines and antiviral drugs are able to keep the new strain at bay, global growth should remain solidly above trend in 2022. Table 1 shows consensus GDP growth projections for the major economies. G7 growth is expected to tick up from 3.6% in 2021Q3 to 4.5% in 2021Q4. Growth is set to cool to 4.1% in 2022Q1, 3.6% in 2022Q2, 2.9% in 2022Q3, 2.3% in 2022Q4, and 2.1% in 2023Q1. Table 1Growth Is Slowing, But From Very High Levels Strategy Outlook - 2022 Key Views: The Beginning Of The End Strategy Outlook - 2022 Key Views: The Beginning Of The End Chart 3 According to the OECD, potential real GDP growth in the G7 is about 1.4% (Chart 3). Thus, while growth in developed economies will slow next year, it is unlikely to return to trend until the second half of 2023. Emerging markets face a more daunting outlook. The Chinese property market is weakening, and the recent collapse of the Turkish lira highlights the structural problems that some EMs face. Nevertheless, the combination of elevated commodity prices, forthcoming Chinese stimulus, and the resumption of the US dollar bear market starting next year should support EM growth. Relative to consensus, we think the risks to growth in both developed and emerging markets are tilted to the upside in 2022. Growth will likely start surprising to the downside in late 2023, however.   The United States: No Shortage of Demand US growth slowed to only 2.1% in the third quarter, reflecting the impact of the Delta variant wave and supply-chain bottlenecks. The semiconductor shortage hit the auto sector especially hard. The decline in vehicle spending alone shaved 2.2 percentage points off Q3 GDP growth. Chart 4Durable Goods Spending Is Still Above Pre-Pandemic Trend, While Services Spending Is Catching Up Durable Goods Spending Is Still Above Pre-Pandemic Trend, While Services Spending Is Catching Up Durable Goods Spending Is Still Above Pre-Pandemic Trend, While Services Spending Is Catching Up The fourth quarter is shaping up to be much stronger. The Bloomberg consensus estimate is for real GDP to expand by 4.9%. The Atlanta Fed’s GDPNow model is even more optimistic. It sees growth hitting 9.7%. The demand for goods will moderate in 2022. As of October, real goods spending was still 10% above its pre-pandemic trendline (Chart 4). In contrast, the demand for services will continue to rebound. While restaurant sales have recovered all their lost ground, spending on movie theaters, amusement parks, and live entertainment in October was still down 46% on a seasonally-adjusted basis compared to January 2020. Hotel spending was down 23%. Spending on public transport was down 25%. Spending on dental services was down 16% (Chart 5).   Chart 5 US households have accumulated $2.3 trillion in excess savings over the course of the pandemic. Some of this money will be spent over the course of 2022 (Chart 6). Increased borrowing should also help. After initially plunging during the pandemic, credit card balances are rising again (Chart 7). Banks are eager to make consumer loans (Chart 8). Chart 6Plenty Of Pent-Up Demand Plenty Of Pent-Up Demand Plenty Of Pent-Up Demand Chart 7Credit Card Spending Is Recovering Following The Pandemic Slump Credit Card Spending Is Recovering Following The Pandemic Slump Credit Card Spending Is Recovering Following The Pandemic Slump Household net worth has risen by over 100% of GDP since the start of the pandemic (Chart 9). In an earlier report, we estimated that the wealth effect alone could boost annual consumer spending by up to 4% of GDP. Chart 8Banks Are Easing Credit Standards For Consumer Loans Banks Are Easing Credit Standards For Consumer Loans Banks Are Easing Credit Standards For Consumer Loans Chart 9A Record Rise In Household Net Worth A Record Rise In Household Net Worth A Record Rise In Household Net Worth   Business investment will rebound in 2022, as firms seek to build out capacity, rebuild inventories, and automate more production in the face of growing labor shortages. After moving sideways for the better part of two decades, core capital goods orders have broken out to the upside. Surveys of capex intentions have improved sharply (Chart 10). Nonresidential investment was 6% below trend in Q3 – an even bigger gap than for consumer services spending – so there is plenty of scope for capex to increase. Residential investment should also remain strong in 2022 (Chart 11). The homeowner vacancy rate has dropped to a record low, as have inventories of new and existing homes for sale. Homebuilder sentiment rose to a 6-month high in November. Building permits are 7% above pre-pandemic levels. Chart 10Business Investment Should Be Strong In 2022 Business Investment Should Be Strong In 2022 Business Investment Should Be Strong In 2022 Chart 11Residential Construction Will Be Well Supported Residential Construction Will Be Well Supported Residential Construction Will Be Well Supported   US Monetary and Fiscal Policy: Baby Steps Towards Tightening Policy is unlikely to curb US aggregate demand by very much next year. While the Federal Reserve will expedite the tapering of asset purchases and begin raising rates next summer, the Fed is unlikely to raise rates significantly until inflation gets out of hand. As we discuss in the Feature section later in this report, the next leg in inflation will be to the downside, even if the long-term trend for inflation is to the upside. The respite from inflation next year will give the Fed some breathing space. A major tightening campaign is unlikely until mid-2023. Reflecting the Fed’s dovish posture, long-term real bond yields hit record low levels in November (Chart 12). Despite giving up some of its gains in recent days, Goldman’s US Financial Conditions Index stands near its easiest level in history (Chart 13). Chart 12US Real Bond Yields Hitting Record Lows US Real Bond Yields Hitting Record Lows US Real Bond Yields Hitting Record Lows Chart 13Easy Financial Conditions In The US Easy Financial Conditions In The US Easy Financial Conditions In The US US fiscal policy will get tighter next year, but not by very much. In November, President Biden signed a $1.2 trillion infrastructure bill into law, containing $550 billion in new spending. BCA’s geopolitical strategists expect Congress to pass a $1.5-to-$2 trillion social spending bill using the reconciliation process. The emergence of the Omicron strain will facilitate passage of the bill because it will allow the Democrats to add some “indispensable” pandemic relief to the package. All in all, the IMF foresees the US cyclically-adjusted primary budget deficit averaging 4.9% of GDP between 2022 and 2026, compared to 2.0% of GDP between 2014 and 2019 (Chart 14). Chart 14 It should also be noted that government spending on goods and services has been quite weak over the past two years (Chart 15). The budget deficit surged because transfer payments exploded. Unlike direct government spending, which is set to accelerate over the next few years, households saved a large share of transfer payments. Thus, the fiscal multiplier will increase next year, even as the budget deficit shrinks. Chart 15While Overall Consumption Has Recovered, Business Spending and Direct Government Expenditures Remain Below Trend While Overall Consumption Has Recovered, Business Spending and Direct Government Expenditures Remain Below Trend While Overall Consumption Has Recovered, Business Spending and Direct Government Expenditures Remain Below Trend Chart 16European Banks Have Cleaned Up Their Act European Banks Have Cleaned Up Their Act European Banks Have Cleaned Up Their Act Europe: Room to Grow The European economy faces near-term growth pressures. In addition to Covid-related lockdowns, high energy costs will take a bite out of growth. After having dipped in October, natural gas prices have jumped again due to delays in the opening of the Nord Stream 2 pipeline, strong Chinese gas demand, and rising risks of a colder winter due to La Niña. The majority of Germans are in favor of opening the pipeline, suggesting that it will ultimately be approved. This should help reduce gas prices. Meanwhile, the winter will pass and Chinese demand for gas should abate as domestic coal production increases. The combination of increased energy supplies, easing supply-chain bottlenecks, and hopefully some relief on the pandemic front, should all pave the way for better-than-expected growth across the euro area next year. After a decade of housecleaning, European banks are in much better shape (Chart 16). Capex intentions have risen (Chart 17). Consumer confidence is even stronger in the euro area than in the US (Chart 18). Chart 17 Chart 18Consumer Confidence Is At Pre-Pandemic Levels In The Euro Area, Unlike In The US Consumer Confidence Is At Pre-Pandemic Levels In The Euro Area, Unlike In The US Consumer Confidence Is At Pre-Pandemic Levels In The Euro Area, Unlike In The US Euro area fiscal policy should remain supportive. Infrastructure spending is set to increase as the Next Generation EU fund begins operations. Germany’s “Traffic Light” coalition will pursue a more expansionary fiscal stance. The IMF expects the euro area to run a cyclically-adjusted primary deficit of 1.2% of GDP between 2022 and 2026, compared to a surplus of 1.2% of GDP between 2014 and 2019. For its part, the ECB will maintain a highly accommodative monetary policy. While net asset purchases under the PEPP will end next March, the ECB is unlikely to raise rates until 2023 at the earliest. In contrast to the US, trimmed-mean inflation has barely risen in the euro area (Chart 19). Moreover, unlike their US counterparts, European firms are reporting few difficulties in finding qualified workers (Chart 20). In fact, euro area wage growth slowed to an all-time low of 1.35% in Q3 (Chart 21). Chart 19Trimmed-Mean Inflation: Higher In The US Than In The Euro Area And Japan Trimmed-Mean Inflation: Higher In The US Than In The Euro Area And Japan Trimmed-Mean Inflation: Higher In The US Than In The Euro Area And Japan Chart 20   Chart 21Wage Growth Remains Contained Across The Euro Area Wage Growth Remains Contained Across The Euro Area Wage Growth Remains Contained Across The Euro Area The UK finds itself somewhere between the US and the euro area. Trimmed-mean inflation is running above euro area levels, but below that of the US. UK labor market data remains very strong, as evidenced by robust employment gains, firm wage growth, and a record number of job vacancies. The PMIs stand at elevated levels, with the new orders component of November’s manufacturing PMI rising to the highest level since June. While worries about the impact of the Omicron variant will likely cause the Bank of England to postpone December’s rate hike, we expect the BoE to begin raising rates in February.   Japan: Short-Term Stimulus Boost A major Covid wave during the summer curbed Japanese growth. Consumer spending rebounded after the government removed the state of emergency on October 1 but could falter again if the Omicron variant spreads. The government has already told airlines to halt reservations for all incoming international flights for at least one month. On the positive side, the economy will benefit from new fiscal measures. Following the election on October 31, the new government led by Prime Minister Fumio Kishida announced a stimulus package worth 5.6% of GDP. As with most Japanese stimulus packages, the true magnitude of fiscal support will be much lower than the headline figure. Nevertheless, the combination of increased cash payments to households, support for small businesses, and subsidies for domestic travel should spur consumption in 2022. The capex recovery in Japan has lagged other major economies. This is partly due to the outsized role of the auto sector in Japan’s industrial base. Motor vehicle shipments fell 37% year-over-year in October, dragging down export growth with it. As automotive chip supplies increase, Japan’s manufacturing sector should gain some momentum. Despite the prospect of stronger growth next year, the Bank of Japan will stand pat. Core inflation remains close to zero, while long-term inflation expectations remain far below the BOJ’s 2% target. We do not expect the BOJ to raise rates until 2024 at the earliest.   China: Crosswinds The Chinese economy faces crosswinds going into 2022. On the one hand, the energy crisis should abate, helping to boost growth. China has reopened 170 coal mines and will probably begin re-importing Australian coal. Chinese coal prices have fallen drastically over the past 6 weeks (Chart 22). Coal accounts for about two-thirds of Chinese electricity generation. Chart 22Coal Prices Are Renormalizing In China Coal Prices Are Renormalizing In China Coal Prices Are Renormalizing In China Chart 23China's Property Market Has Weakened China's Property Market Has Weakened China's Property Market Has Weakened   The US may also trim tariffs on Chinese goods, as Treasury Secretary Yellen hinted this week. This will help Chinese manufacturers. On the other hand, the property market remains under stress. Housing starts, sales, and land purchases were down 34%, 21%, and 24%, respectively, in October relative to the same period last year. The proportion of households planning to buy a home has plummeted. Loan growth to real estate developers has decelerated to the lowest level on record (Chart 23). Nearly half of their offshore bonds are trading at less than 70 cents on the dollar. The authorities have taken steps to stabilize the property market. They have relaxed restrictions on mortgage lending and land sales, cut mortgage rates in some cities, and have allowed some developers to issue asset backed securities to repay outstanding debt. Most Chinese property is bought “off-plan”. The government does not want angry buyers to be deprived of their property. Thus, the existing stock of planned projects will be built. Chart 24 shows that this is a large number; in past years, developers have started more than twice as many projects as they have completed. The longer-term problem is that China builds too many homes. Like Japan in the early 1990s, China’s working-age population has peaked (Chart 25). According to the UN, it will decline by over 400 million by the end of the century. China simply does not need to construct as many new homes as it once did. Chart 24Chinese Construction: Halfway Done Chinese Construction: Halfway Done Chinese Construction: Halfway Done Chart 25Demographic Parallels Between China And Japan Demographic Parallels Between China And Japan Demographic Parallels Between China And Japan Chart 26 Japan was unable to fill the gap that a shrinking property sector left in aggregate demand in the early 1990s. As a result, the economy fell into a deflationary trap. China is likely to have more success. Unlike Japan, which waited too long to pursue large-scale fiscal stimulus, China will be more aggressive. The authorities will raise infrastructure spending next year with a focus on clean energy. They will also boost social spending. A frayed social safety net has forced Chinese households to save more than they would otherwise for precautionary reasons. This has weighed on consumption.  The fact that China is a middle-income country helps. In 1990, Japan’s output-per-worker was nearly 70% of US levels; China’s output-per-worker is still 20% of US levels (Chart 26). If Chinese incomes continue to grow at a reasonably brisk pace, this will make it easier to improve home affordability. It will also allow China to stabilize its debt-to-GDP ratio without a painful deleveraging campaign. II. Feature: The Long-Term Inflation Outlook   Two Steps Up, One Step Down We expect inflation in the US, and to a lesser degree abroad, to follow a “two steps up, one step down” trajectory of higher highs and higher lows. The US is currently near the top of those two steps. Inflation should dip over the next 6-to-9 months as the demand for goods moderates and supply-chain disruptions abate. Chart 27 shows that container shipping costs have started to come down. The number of ships anchored off the ports of Los Angeles and Long Beach is falling. US semiconductor firms are working overtime (Chart 28). Chip production in Japan and Korea is rising swiftly. DRAM chip prices have already started to decline. Chart 27Signs Of Easing Supply Issues On The Rough Seas Signs Of Easing Supply Issues On The Rough Seas Signs Of Easing Supply Issues On The Rough Seas Chart 28Semiconductor Manufacturers Are Stepping Up Their Game Semiconductor Manufacturers Are Stepping Up Their Game Semiconductor Manufacturers Are Stepping Up Their Game Reflecting the easing of supply-chain bottlenecks, both the “prices paid” and “supplier delivery” components of the manufacturing ISM declined in November.  The respite from inflation will not last long, however. The US labor market is heating up. So far, most of the wage growth has been at the bottom end of the income distribution (Chart 29). Wage growth will broaden out over the course of 2022, pushing up service price inflation in the process. Chart 29Wage Growth Has Picked Up, But Mainly At The Bottom Of The Income Distribution Wage Growth Has Picked Up, But Mainly At The Bottom Of The Income Distribution (I) Wage Growth Has Picked Up, But Mainly At The Bottom Of The Income Distribution (I) Chart 30Rent Inflation Has Increased Rent Inflation Has Increased Rent Inflation Has Increased Rent inflation will also rise, as the unemployment rate falls further. The Zillow rent index has spiked 14% (Chart 30). Rents account for 8% of the US CPI basket and 4% of the PCE basket.   Biased About Neutral? Investors are assuming that the Fed will step in to extinguish any inflationary fires before they get out of hand. The widely-followed 5-year/5-year forward TIPS breakeven inflation rate has fallen back below the Fed’s comfort zone (Chart 31). Chart 31Long-Term Inflation Expectations Are Not A Source Of Worry For The Fed Long-Term Inflation Expectations Are Not A Source Of Worry For The Fed (II) Long-Term Inflation Expectations Are Not A Source Of Worry For The Fed (II) Chart 32Both The Fed And Investors Have Lowered Their Estimate Of The Neutral Rate Both The Fed And Investors Have Lowered Their Estimate Of The Neutral Rate Both The Fed And Investors Have Lowered Their Estimate Of The Neutral Rate This may be wishful thinking. Back in 2012, when the Fed began publishing its “dots”, it thought the neutral rate of interest was 4.25%. Today, it considers it to be around 2.5% (Chart 32). Market participants broadly agree. Both investors and policymakers have bought into the secular stagnation thesis hook, line, and sinker. If the neutral rate turns out to be higher than widely believed, the Fed could find itself woefully behind the curve. Given the “long and variable” lags between changes in monetary policy and the resulting impact on the economy, inflation is liable to greatly overshoot the Fed’s target.   Structural Forces Turning More Inflationary Meanwhile, the forces that have underpinned low inflation over the past few decades are starting to fray: Globalization is in retreat: The ratio of global trade-to-manufacturing output has been flat for over a decade (Chart 33). Looking out, the ratio could decline as geopolitical tensions between China and the rest of the world continue to simmer, and more companies shift production back home in order to gain greater control over the supply chains of essential goods. Baby boomers are leaving the labor force en masse: As a group, baby boomers hold more than half of US household wealth (Chart 34). They will continue to run down their wealth once they retire. However, since they will no longer be working, they will no longer contribute to national output. Spending that is not matched by output tends to drive up inflation. Chart 33Globalization Plateaued Over a Decade Ago Globalization Plateaued Over a Decade Ago Globalization Plateaued Over a Decade Ago Chart 34 Social stability is in peril: The US homicide rate increased by 27% in 2020, the biggest one-year jump on record. All indications suggest that crime has continued to rise in 2021, coinciding with the ongoing decline in the incarceration rate (Chart 35). Amazingly, the murder rate and inflation are highly correlated (Chart 36). If the government cannot credibly commit to keeping people safe, how can it credibly commit to keeping inflation low? Without trust in government, inflation expectations could quickly become unmoored. Chart 35The Homicide Rate Has Tended To Rise When The Institutionalization Rate Has Declined The Homicide Rate Has Tended To Rise When The Institutionalization Rate Has Declined The Homicide Rate Has Tended To Rise When The Institutionalization Rate Has Declined Chart 36Bouts Of Inflation Tend To Coincide With Rising Crime Bouts Of Inflation Tend To Coincide With Rising Crime Bouts Of Inflation Tend To Coincide With Rising Crime The temptation to monetize debt will rise: Public-sector debt levels have soared to levels last seen during World War II. If bond yields rise as the Congressional Budget Office expects, debt-servicing costs will triple by the end of the decade (Chart 37). Faced with the prospect of having to divert funds from social programs to pay off bondholders, the government may apply political pressure on the Fed to keep rates low.​​​​​​ Chart 37   A Post-Pandemic Productivity Boom? Chart 38 Might faster productivity growth bail out the economy just like it did following the Second World War? Don’t bet on it. US labor productivity did increase sharply during the initial stages of the pandemic. However, that appears to have been largely driven by composition effects that saw many low-skilled, poorly-paid service workers lose their jobs. As these low-skilled workers have returned to the labor force, productivity growth has dropped. The absolute level of productivity declined by 5.0% at an annualized rate in the third quarter, leading to an 8.3% increase in labor costs. Productivity growth has been extremely weak outside the US (Chart 38). This gives weight to the view that the pandemic-induced changes in business practices have not contributed to higher productivity, at least so far. It is worth noting that a recent study of 10,000 skilled professionals at a major IT company revealed that work-from-home policies decreased productivity by 8%-to-19%, mainly because people ended up working longer. Increased investment spending should eventually boost productivity. However, the near-term impact of higher capex will be to boost aggregate demand, stoking inflation in the process. III. Financial Markets   A. Portfolio Strategy Above-Trend Global Growth Will Support Equities Our golden rule of investing is about as simple as they come: Don’t bet against stocks unless you think that there is a recession around the corner. As Chart 39 shows, recessions and equity bear markets almost always overlap. Chart 39 Chart 40Sentiment Towards Equities Is Already Bearish Sentiment Towards Equities Is Already Bearish Sentiment Towards Equities Is Already Bearish Equity corrections can occur outside of recessionary periods. In fact, we are experiencing such a correction right now. Yet, with the percentage of bearish investors reaching the highest level in over 12 months in this week’s AAII survey, chances are that the correction will not last much longer (Chart 40). A sustained decline in stock prices requires a sustained decline in corporate earnings; the latter normally only happens during economic downturns. Admittedly, it is impossible to know for sure if a recession is lurking around the corner. If the Omicron variant is able to completely evade the vaccines, growth will slow considerably over the coming months. Yet, even in that case, the global economy is unlikely to experience a sudden-stop of the sort that occurred last March. As noted at the outset of this report, pharma companies have the tools to tweak the vaccines, and most experts believe that the soon-to-be-released antivirals will be effective against the new strain. If economic growth remains above trend, earnings will rise (Chart 41). S&P 500 companies generated $53.82 per share in profits in Q3. The bottom-up consensus is for these companies to generate an average of $54.01 in quarterly profits between 2021Q4 and 2022Q3, implying almost no growth from 2021Q3 levels. This is a very low bar to clear. We expect global equities to produce high single-digit returns next year. Chart 41Analysts Increased Earnings Estimates This Year Analysts Increased Earnings Estimates This Year Analysts Increased Earnings Estimates This Year The Beginning of the End Our guess is that 2022 will be the last year of the secular equity bull market that began in 2009. In mid-2023 or so, the Fed will come around to the view that the neutral rate is higher than it once thought. Unfortunately, by then, it will be too late; a wage-price spiral will have already emerged. A nasty bear flattening of the yield curve will ensue: Long-term bond yields will rise but short-term rate expectations will increase even more. A recession will follow in 2024 or 2025. The most important real-time indicator we are focusing on to gauge when to turn more bearish on stocks is the 5y/5y forward TIPS breakeven rate. As noted earlier, it is still at the bottom end of the Fed’s comfort zone. If it were to rise above 3%, all hell could break loose, especially if this happened without a corresponding increase in crude oil prices. The Fed takes great pride in the success it has had in anchoring long-term expectations. Any evidence that expectations are becoming unmoored would cause the FOMC to panic.   B. Equity Sectors, Regions, And Styles Favor Value, Small Caps, and Non-US Markets in 2022 Until the Fed takes away the punch bowl, a modestly procyclical stance towards equity sectors, styles, and regional equity allocation is warranted. Chart 42The Relative Performance Of Value Stocks Has Closely Tracked Bond Yields This Year The Relative Performance Of Value Stocks Has Closely Tracked Bond Yields This Year The Relative Performance Of Value Stocks Has Closely Tracked Bond Yields This Year The relative performance of value versus growth stocks has broadly followed the trajectory of the 30-year Treasury yield this year (Chart 42). Rising yields should buoy value stocks, with banks being the biggest beneficiaries (Chart 43). In contrast, rising yields will weigh on tech stocks. Chart 43Rising Bond Yields Will Help Bank Shares But Hurt Tech Stocks Rising Bond Yields Will Help Bank Shares But Hurt Tech Stocks Rising Bond Yields Will Help Bank Shares But Hurt Tech Stocks   Chart 44The Winners And Losers Of Covid Waves The Winners And Losers Of Covid Waves The Winners And Losers Of Covid Waves If we receive some good news on the pandemic front, this should disproportionately help value. As Chart 44 illustrates, the relative performance of value versus growth stocks has tracked the number of new Covid cases globally. The correlation between new cases and the relative performance of IT and energy has been particularly strong. Rising capex spending will buoy industrial stocks. Industrials are overrepresented in value indices both in the US and abroad (Table 2). Along with financials, industrials are also overrepresented in small cap indices (Table 3). US small caps trade at 15-times forward earnings compared to 21-times for the S&P 500. Table 2Breaking Down Growth And Value By Sector Strategy Outlook - 2022 Key Views: The Beginning Of The End Strategy Outlook - 2022 Key Views: The Beginning Of The End Table 3Financials And Industrials Have A Larger Weight In US Small Caps Strategy Outlook - 2022 Key Views: The Beginning Of The End Strategy Outlook - 2022 Key Views: The Beginning Of The End Time to Look Abroad? Given our preference for cyclicals and value in 2022, it stands to reason that we should also favor non-US markets. Table 4 shows that non-US stock markets have more exposure to cyclical and value sectors. Table 4Cyclicals Are Overrepresented Outside The US Strategy Outlook - 2022 Key Views: The Beginning Of The End Strategy Outlook - 2022 Key Views: The Beginning Of The End Admittedly, favoring non-US stock markets has been a losing proposition for the past 12 years. US earnings have grown much faster than earnings abroad over this period (Chart 45). US stock returns have also benefited from rising relative valuations. Chart 45The US Has Been The Earnings Leader In Recent Years The US Has Been The Earnings Leader In Recent Years The US Has Been The Earnings Leader In Recent Years At this point, however, US stocks are trading at a significant premium to their overseas peers, whether measured by the P/E ratio, price-to-book, or price-to-sales (Chart 46). US profit margins are also more stretched than elsewhere (Chart 47).   Chart 46 Chart 47US Profit Margins Look Stretched US Profit Margins Look Stretched US Profit Margins Look Stretched Chart 48Non-US Stocks Tend To Do Best When The US Dollar Is Weakening Non-US Stocks Tend To Do Best When The US Dollar Is Weakening Non-US Stocks Tend To Do Best When The US Dollar Is Weakening The US dollar may be the ultimate arbiter of whether the US or international stock markets outperform in the 2022. Historically, there has been a close correlation between the trade-weighted dollar and the relative performance of US versus non-US equities (Chart 48). In general, non-US stocks do best when the dollar is weakening. The usual relationship between the dollar and the relative performance of US and non-US stocks broke down in 2020 when the dollar weakened but the tech-heavy US stock market nonetheless outperformed. However, if “reopening plays” gain the upper hand over “pandemic plays” in 2022, the historic relationship between the dollar and US/non-US returns will reassert itself. As we discuss later on, while near-term momentum favors the dollar, the greenback is likely to weaken over a 12-month horizon. This suggests that investors should look to increase exposure to non-US stocks in a month or two. Around that time, the energy shortage gripping Europe will begin to abate, China will be undertaking more stimulus, and investors will start to focus more on the prospect of higher US corporate taxes.    C. Fixed Income Maintain Below-Benchmark Duration The yield on a government bond equals the expected path of policy rates over the duration of the bond plus a term premium that compensates investors for locking in their savings at a fixed rate rather than rolling them over at the prevailing short-term rate. While expected policy rates have moved up in the US over the past 2 months, the market’s expectations of where policy rates will be in the second half of the decade have not changed much (Chart 49). Investors remain convinced of the secular stagnation thesis which postulates that the neutral rate of interest is very low. Chart 49 As for the term premium, it remains stuck in negative territory, much where it has been for the past 10 years (Chart 50). Chart 50Negative Term Premium Across The Board Negative Term Premium Across The Board Negative Term Premium Across The Board The Term Premium Will Increase The notion of a negative term premium may seem odd, as it implies that investors are willing to pay to take on duration risk. However, there is a good reason for why the term premium has been negative: The correlation between bond yields and stock prices has been positive (Chart 51). Chart 51Stocks And Bond Yields Have Not Always Been Positively Correlated Stocks And Bond Yields Have Not Always Been Positively Correlated Stocks And Bond Yields Have Not Always Been Positively Correlated When bond yields are positively correlated with stock prices, bonds are a hedge against bad economic news. If the economy falls into recession, equity prices will drop; the value of your home will go down; you may not get a bonus, or even worse, you may lose your job. But at least the value of your bond portfolio will go up! There is a catch, however: Bonds are a hedge against bad economic news only if that news is deflationary in nature. The 2001 and 2008-09 recessions all saw bond yields drop as the economy headed south. Both recessions were due to deflationary shocks: first the dotcom bust, and later, the bursting of the housing bubble. In contrast, bond yields rose in the lead up to the recession in the 1970s and early 80s. Bonds were not a good hedge against falling stock prices back then because it was surging inflation and rising bond yields that caused stocks to fall in the first place. This raises a worrying possibility that investors have largely overlooked: The term premium may increase as it becomes increasingly clear that the next recession will be caused not by inadequate demand but by Fed tightening in response to an overheated economy. A rising term premium would exacerbate the upward pressure on bond yields stemming from higher-than-expected inflation as well as upward revisions to estimates of the real neutral rate of interest. Again, we do not think that a “term premium explosion” is a significant risk for 2022. However, it is a major risk for 2023 and beyond. Investors should maintain a modestly below-benchmark duration stance for now but look to go maximally underweight duration towards the end of next year.   Global Bond Allocation BCA’s global fixed-income strategists recommend underweighting the US, Canada, the UK, and New Zealand in 2022. They suggest overweighting Japan, the euro area, and Australia. US Treasuries trade with a higher beta than most other government bond markets (Chart 52). Our bond strategists expect the US 10-year Treasury yield to hit 2%-to-2.25% by the end of next year. Chart 52High-And Low-Beta Bond Yields High-And Low-Beta Bond Yields High-And Low-Beta Bond Yields As discussed earlier, neither the ECB nor the BoJ are in a hurry to raise rates. Both euro area and Japanese bonds have outperformed the global benchmark when Treasury yields have risen (Chart 53). Chart 53 Chart 54UK Inflation Expectations Are Higher Than In Other Major Developed Economies UK Inflation Expectations Are Higher Than In Other Major Developed Economies UK Inflation Expectations Are Higher Than In Other Major Developed Economies While rate expectations in Australia have come down on the Omicron news, the markets are still pricing in four hikes next year. With wage growth still below the RBA’s target, our fixed-income strategists think the central bank will pursue a fairly dovish path next year. In contrast, they think New Zealand will continue its hiking cycle. Like Canada, the Reserve Bank of New Zealand has become increasingly concerned about soaring home prices and household indebtedness.  Inflation expectations are higher in the UK than elsewhere (Chart 54). With the BoE set to raise rates early next year, gilts will underperform the global benchmark.   Overweight High-Yield Corporate Bonds… For Now Chart 55High-Yield Spreads Are Pricing In A Default Rate Of Close To 4% High-Yield Spreads Are Pricing In A Default Rate Of Close To 4% High-Yield Spreads Are Pricing In A Default Rate Of Close To 4% The combination of above-trend economic growth and accommodative monetary policy will provide support for corporate bonds in 2022. For now, we prefer high yield over investment grade. According to our bond strategists, while high-yield spreads are quite tight, they are still pricing in a default rate of 3.8% (Chart 55). This is more than their fair value default estimate of 2.3%-to-2.8%. It is also above the year-to-date realized default rate of 1.7%.   As with equities, the bull market in corporate credit will end in 2023 as the Fed is forced to accelerate the pace of rate hikes in the face of an overheated economy and rising long-term inflation expectations.   D. Currencies and Commodities Dollar Strength Will Reverse in Early 2022 Since bottoming in May, the US dollar has been trending higher. The US dollar is a high momentum currency: When the greenback starts rising, it usually keeps rising (Chart 56). A simple trading rule that buys the dollar when it is trading above its various moving averages has delivered positive returns (Chart 57). This suggests that the greenback could very well strengthen further over the next month or two. Chart 56 Chart 57 Over a 12-month horizon, however, we think the trade-weighted dollar will weaken. Both speculators and asset managers are net long the dollar (Chart 58). Current positioning suggests we are nearing a dollar peak. Rising US rate expectations have helped the dollar this year. Chart 59 shows that both USD/EUR and USD/JPY have tracked the spread between the yield on the December 2022 Eurodollar and Euribor/Euroyen contracts, respectively. While the Fed will expedite the pace of tapering, the overall approach will still be one of “baby-steps” towards tightening next year. BCA’s bond strategists do not expect US rate expectations for end-2022 to rise from current levels. Chart 58Long Dollar Positions Are Getting Crowded Long Dollar Positions Are Getting Crowded Long Dollar Positions Are Getting Crowded Chart 59Interest Rates Have Played A Major Role On The Dollar's Performance This Year Interest Rates Have Played A Major Role On The Dollar's Performance This Year Interest Rates Have Played A Major Role On The Dollar's Performance This Year   The present level of real interest rate differentials is consistent with a much weaker dollar (Chart 60). Using CPI swaps as a proxy for expected inflation, 2-year real rates in the US are 42 basis points below other developed economies. This is similar to where real spreads were in 2013/14, when the trade-weighted dollar was 16% weaker than it is today. Chart 60AThe Dollar And Interest Rate Differentials (I) The Dollar And Interest Rate Differentials (I) The Dollar And Interest Rate Differentials (I) Chart 60BThe Dollar And Interest Rate Differentials (II) The Dollar And Interest Rate Differentials (II) The Dollar And Interest Rate Differentials (II) Meanwhile, growth outside the US will pick up next year as Europe’s energy crisis abates and China ramps up stimulus. If history is any guide, firmer growth abroad will put downward pressure on the dollar (Chart 61). Chart 61The Dollar Will Weaken As Global Growth Rotates From The US To The Rest Of The World The Dollar Will Weaken As Global Growth Rotates From The US To The Rest Of The World The Dollar Will Weaken As Global Growth Rotates From The US To The Rest Of The World Chart 62Dollar Headwinds Dollar Headwinds Dollar Headwinds Pricey Greenback The dollar’s lofty valuation has left it overvalued by nearly 20% on a Purchasing Power Parity (PPP) basis. The PPP exchange rate equalizes the price of a representative basket of goods and services between the US and other economies. Reflecting the dollar’s overvaluation, the US trade deficit has widened sharply. Excluding energy exports, the US trade deficit as a share of GDP is now the largest on record. Equity inflows have helped finance America’s burgeoning current account deficit (Chart 62). However, these inflows are starting to abate, and could drop further if global investors abandon their infatuation with US tech stocks.   Favor Commodity Currencies We favor commodity currencies for 2022, especially the Canadian dollar, which we expect to be the best performing G10 currency. Canadian real GDP growth will average nearly 5% in Q4 and the first half of next year. The Bank of Canada will start hiking rates next April. Oil prices should remain reasonably firm next year, helping the loonie and other petrocurrencies. Bob Ryan, BCA’s chief Commodity Strategist, expects the price of Brent crude to average $80/bbl in 2022 and 81$/bbl in 2023, which is well above the forwards (Chart 63). Years of underinvestment in crude oil production have led to tight supply conditions (Chart 64). Proven global oil reserves increased by only 6% between 2010 and 2020, having risen by 26% over the preceding decade. Chart 63 Chart 64   As with oil, there has been little investment in mining capacity in recent years. While a weaker property market in China will weigh on metals prices, this will be partly offset by Chinese fiscal stimulus. Looking further ahead, the outlook for metals remains bright. Whereas the proliferation of electric vehicles is bad news for oil demand over the long haul, it is good news for many metals. The typical electric vehicle requires about four times as much copper as a typical gasoline-powered vehicle. Huge amounts of copper will also be necessary to expand electrical grids.   The RMB Will Be Stable in 2022 It is striking that despite the appreciation in the trade-weighted dollar since June and escalating concerns about the health of the Chinese economy, the RMB has managed to strengthen by 0.3% against the US dollar. Chinese export growth will moderate in 2022 as global consumption shifts from goods to services. Rising global bond yields may also narrow the yield differential between China and the rest of the world. Nevertheless, we doubt the RMB will weaken very much. China wants the RMB to be a global reserve currency. A weak RMB would run counter to that goal. Rather than weakening the yuan, the Chinese authorities will use fiscal stimulus to support growth.   Gold Versus Cryptos? Gold prices tend to move closely with real bond yields (Chart 65). Since August 2020, however, the price of gold has slumped from a high of $2,067/oz to $1,768/oz, even though real yields remain near record lows. The divergence between real yields and gold prices may partly reflect growing demand for cryptocurrencies. Investors increasingly see cryptos as not just a disruptive economic force, but as the premier “anti-fiat” hedge. Whether that view pans out remains to be seen. So far, the vast majority of the demand for cryptocurrencies has stemmed from people hoping to get rich by buying cryptos. To the extent that people are using cryptos for online purchases, it is usually for illegal goods (Chart 66).  Chart 65Gold Prices Tend To Correlate Closely With Real Interest Rates Gold Prices Tend To Correlate Closely With Real Interest Rates Gold Prices Tend To Correlate Closely With Real Interest Rates Chart 66 Crypto proponents like to say that the supply of cryptos is finite. While this may be true for individual cryptocurrencies, it is not true for the sector as a whole. Over the past 8 years, the number of cryptocurrencies has swollen from 26 in 2013 to 7,877 (Chart 67). At least with gold, they are not adding any new elements to the periodic table. Chart 67 At any rate, the easy money in the crypto space has already been made. Bitcoin has doubled in price seven times since the start of 2016. If it were to double just one more time to $120,000, it would be worth $2.2 trillion, equal to the entire stock of US dollars in circulation. Investors looking to hedge long-term inflation risk should shift back into gold. Peter Berezin Chief Global Strategist pberezin@bcaresearch.com Global Investment Strategy View Matrix Image Special Trade Recommendations Image Current MacroQuant Model Scores Image

Highlights Financial markets in both mainstream EM and China are undergoing an adjustment that is not yet complete. EM equity and currency valuations are neutral. When valuations are neutral, the profit and liquidity cycles become the key drivers of share prices. Both these factors are currently headwinds to equity prices. Our investment strategy is to remain defensive going into the new year. Yet, the longer-term outlook is brighter. We see with high odds that the first half of the year will present an opportunity to turn positive on EM assets in absolute terms, and upgrade EM versus DM within global equity and fixed-income portfolios. Our checklist of fundamental factors that will cause us to turn bullish on EM and China include: (1) significant stimulus in China leading to a strong recovery in its credit impulse; (2) a rollover in Latin America’s core inflation that will open the door for monetary policy easing in these economies; and (3) the Fed abandoning its plans to hike rates, creating conditions for durable US dollar weakness. Feature Introduction: Beyond Omicron There is low visibility regarding the Omicron variant of the COVID-19 virus’s impact on societies and economies. We do not pretend to be experts in virology and on pandemics. So, in this 2022 outlook, we will focus on the macro fundamentals that go beyond Omicron. If the latter proves to be very disruptive for many economies, EM risk assets will sell off materially in the coming weeks. If Omicron proves to be a non-issue, macro fundamentals will prevail. In this case (and if our analysis is correct) EM risk assets will still fare poorly, at least in the early months of 2022. Chart 1The EM Selloff Has Been Occurring Since February 2021 The EM Selloff Has Been Occurring Since February 2021 The EM Selloff Has Been Occurring Since February 2021 Notably, the cross rate between the Swedish krona and Swiss franc correlates well with EM share prices and both had already been falling well before Omicron arrived (Chart 1). Overall, our investment strategy is to remain defensive going into the new year. Nevertheless, odds are significant that in H1 2022 there will be a buying opportunity in EM assets in absolute terms, and a better entry point to upgrade EM relative to DM within global equity and fixed-income portfolios. China’s Business Cycle And Macro Policy Will China ease policy substantially? It depends on how bad the economy, financial markets and business/consumer sentiment get. Beijing has already initiated piecemeal monetary and fiscal easing. However, if the growth slowdown is gradual and orderly, and financial markets do not panic, then policy easing will be measured. On the contrary, if growth tumbles sharply, business and consumer confidence deteriorate markedly and onshore share prices sell off hard, then policymakers will accelerate the stimulus. In a nutshell, substantial policy easing is not likely unless Chinese onshore stocks experience a meaningful deterioration. In the meantime, the Mainland economy will continue disappointing, and the path of least resistance for China-related plays is down: The annual change in excess reserves – that PBOC injects into the banking system – leads the credit impulse by six months (Chart 2, top panel). The former has stabilized but has not yet turned up. Hence, in the near term, the credit impulse will be stabilizing at very low levels but will not revive materially until spring 2022. This entails more growth disappointments in China’s old economy (Chart 2, bottom panel). In turn, the average of the manufacturing PMI’s new orders and backlog of orders series heralds more downside in EM non-TMT share prices (Chart 3). Chart 2China: An Economic Revival Is Not Imminent China: An Economic Revival Is Not Imminent China: An Economic Revival Is Not Imminent Chart 3EM Non-TMT Stocks Remain At Risk EM Non-TMT Stocks Remain At Risk EM Non-TMT Stocks Remain At Risk Property construction will not recover quickly. Marginal easing of real estate regulations and restrictions will not be sufficient to revive animal spirits among property developers and buyers. As we argued in a recent special report on the property market, real estate in China benefited from the biggest carry trade in the world over the past decade. With borrowing costs below the pace of house price appreciation, property developers in China have done what any business would do: they borrowed as much as they could and accumulated real estate assets in the forms of land, incomplete construction, and completed but unsold properties. Chart 4The Carry Trade In China's Real Estate The Carry Trade In China's Real Estate The Carry Trade In China's Real Estate The top panel of Chart 4 illustrates that developers have been starting many more projects than they have been completing. As a result, their unfinished construction has ballooned (Chart 4, bottom panel). Such a business model was profitable since developers’ borrowing costs were below the pace of real estate asset price appreciation. This dynamic will reverse going forward: real estate asset price appreciation will be below developers’ borrowing costs. Thus, property developers have every incentive to shed their assets as quickly as possible. This will discourage new land investment and new construction. In brief, odds are rising that the property market downtrend will be an extended one. In 2015, when property inventories swelled (Chart 4, bottom panel), it took outright monetization of residential properties by the PBOC through the PSL program1 to revive real estate demand and construction. Currently, anything short of aggressive monetization or a very large policy boost will be insufficient to reignite property market sentiment. Thus, the real estate market will continue to struggle. Chart 5 illustrates that real estate developer financing has dried up, heralding a significant contraction in floor space completion, i.e., construction activity. This will weigh on industrial commodities (Chart 5, bottom panel). Even if the government approves a larger special bond quota for local governments, traditional infrastructure spending is unlikely to accelerate meaningfully (Chart 6). The basis is that local governments will continue facing financing constraints from an ongoing slump in their land sales. The RMB 3.65 trillion special bond issuance quota in 2021 accounted for only 18% of local government on- and off-budget revenues. Meanwhile, land sales by local governments account for 40% of their on- and off-budget revenues. As the property market travails continue, local governments will not be able to materially increase traditional infrastructure spending.  Chart 5Less Funding = Less Completions = Less Commodity Demand Less Funding = Less Completions = Less Commodity Demand Less Funding = Less Completions = Less Commodity Demand Chart 6China: Traditional Infrastructure Has Been Weak China: Traditional Infrastructure Has Been Weak China: Traditional Infrastructure Has Been Weak In sum, the Chinese economy has developed formidable downward momentum that will not be easy to reverse. That said, authorities will likely begin injecting more stimulus in 2022 to secure a stable economy and financial markets in the second half of 2022, ahead of the important Party Congress. Bottom Line: The slowdown in the Chinese old economy will continue for now with negative ramifications for China-related financial markets. A buying opportunity for China plays leveraged to its old economy is likely sometime in 2022. Chinese Internet Stocks Chart 7Chinese Internet Stocks Are Not Cheap Chinese Internet Stocks Are Not Cheap Chinese Internet Stocks Are Not Cheap The outlook for Chinese TMT stocks remains uninspiring. We maintain that the regulatory changes affecting Chinese internet stocks are structural rather than cyclical in nature. There could be periods when the pace of regulatory clampdown eases, but these regulations will not be rolled back in any meaningful way. While Chinese platform companies’ equity valuations have already de-rated, these stocks are not cheap: their trailing and forward P/E ratios stand at 35 and 30, respectively (Chart 7). Their multiples will compress further for the following reasons: Their business models have to change because of regulatory requirements. Higher uncertainty about their future business models currently entails a higher equity risk premium. Authorities will cap these companies’ profitability like regulators do with monopolies and oligopolies, which heralds a lower return on equity. In addition, in line with the common prosperity policy, these companies will perform social duties – redistributing profits from shareholders to the society. All these will lower their profitability, warranting permanently lower multiples than those in the past 10 years. Beijing’s involvement in their management and the prioritization of national and geopolitical objectives over shareholder interests will lead foreign investors to dis-invest from these companies. Some large companies face non-trivial risks of delisting from the US. Last week, Beijing reportedly asked Didi to delist from the US due to concerns over its data security. For very different reasons, US and Chinese authorities do not want Chinese companies to be listed in the US. And when Chinese and US authorities do not want to see some of these stocks listed in the US, they will not be. Odds are rising that a few of them might be delisted in the coming years. In such a scenario, US institutional investors will offload their holdings of these companies. Chart 8China: Online Retail Sales Have Slowed Down China: Online Retail Sales Have Slowed Down China: Online Retail Sales Have Slowed Down In addition to the risk to multiples, these internet companies’ profits are also under threat. Chart 8 shows that online retail sales of goods and services have been lackluster compared to their torrid pace in the past 10 years. Bottom Line: The path of least resistance for Chinese internet/platform share prices remains down. Mainstream EM Economies In the majority of EM economies ex-China, Korea and Taiwan (herein referred to as mainstream EM), domestic demand will remain in the doldrums in H1 2022: Monetary policy has tightened in Latin America and Russia while real interest rates are elevated/restrictive in the ASEAN region. In countries where central banks have been hiking rates, domestic demand is bound to decelerate (Chart 9, top panel). In fact, domestic demand remains below pre-pandemic levels in many mainstream EMs (Chart 9, bottom panel). Rate hikes and/or high borrowing costs in real terms will continue to weigh on money and credit growth. The annual growth rates of broad money and bank loans have already reached record lows in both nominal and real terms (Chart 10). These are equity market-weighted aggregates for EM ex-China, Korea and Taiwan. Chart 9Mainstream EM: Domestic Demand Is At Risk Of A Relapse Mainstream EM: Domestic Demand Is At Risk Of A Relapse Mainstream EM: Domestic Demand Is At Risk Of A Relapse Chart 10Mainstream EM: Tepid Money And Credit Growth Mainstream EM: Tepid Money And Credit Growth Mainstream EM: Tepid Money And Credit Growth Chart 11Mainstream EM: No Fiscal Reprieve In 2022 Mainstream EM: No Fiscal Reprieve In 2022 Mainstream EM: No Fiscal Reprieve In 2022 For the same universe, the fiscal thrust in 2022 will be around -1% of GDP (Chart 11). Chart 12 illustrates the 2022 fiscal thrust – defined as the yearly change in the cyclically adjusted budget deficit – for individual countries. Only Turkey is projected to have a small positive fiscal thrust next year. Chart 12 The slowdown in China’s old economy will weigh on Asian economies and commodity producers elsewhere. Table 1 demonstrates that China is the top destination for Asian and commodity producing economies’ exports. Finally, political uncertainty and volatility will remain high in Latin America while geopolitical tensions will linger and escalate from time to time around Russia and Taiwan. We do not think political and geopolitical risks are fully reflected in these financial markets. This leaves these bourses vulnerable to these risks. Bottom Line: Economic growth in mainstream EM economies will disappoint, at least in H1 2022. What We Are Looking To Turn Bullish On EM Assets? Equities: A combination of the following will make us consider issuing a buy recommendation on EM equities: Significant stimulus in China leading to a strong recovery in its credit impulse (shown in Chart 2 above). A rollover in Latin America’s core inflation that will open the door for monetary policy easing in these economies. Regarding indicators, we would need to see all three of the following: EM M1 growth accelerates (Chart 13) Analysts’ net EPS expectations drop to their previous lows (Chart 14) Investor sentiment on EM equities declines to its previous lows (Chart 15). EM equity valuations are neutral in absolute terms. When valuations are neutral, share prices could rise or fall. In these cases, the profit cycle is the key driver of share prices. EM equity market cap-weighted narrow money (M1) growth suggests that EM EPS growth will decelerate well into 2022 (Chart 13 above). Such a profit slump is not yet priced in according to Chart 14. Chart 13An EM Profit Slump Is Imminent An EM Profit Slump Is Imminent An EM Profit Slump Is Imminent Chart 14Analysts Are Not Pricing In An EM Profit Slump Analysts Are Not Pricing In An EM Profit Slump Analysts Are Not Pricing In An EM Profit Slump Chart 15Investor Sentiment On EM Stocks Is Not Downbeat Investor Sentiment On EM Stocks Is Not Downbeat Investor Sentiment On EM Stocks Is Not Downbeat Chart 16Mainstream EM Currencies: Spot And Total Return Indexes Mainstream EM Currencies: Spot And Total Return Indexes Mainstream EM Currencies: Spot And Total Return Indexes Exchange Rates: The mainstream EM equity market cap-weighted currency spot rate versus the US dollar is not far from its 2020 spring lows. On a total return basis – when carry is taken into account – mainstream EM currencies are still above their March 2020 lows (Chart 16). Chart 17Mainstream EM: Real Effective Exchange Rates Mainstream EM: Real Effective Exchange Rates Mainstream EM: Real Effective Exchange Rates Critically, EM currencies are not particularly cheap (Chart 17). Given the lingering headwinds, they are likely to depreciate further. The mainstream EM aggregate real effective exchange rate will likely drop to one or two standard deviations below its mean before these currencies find a bottom (Chart 17). Barring a scenario in which the Omicron variant becomes a major drag on the US economy, the Federal Reserve will maintain its recent hawkish rhetoric due to rising core US inflation. This will support the US dollar and weigh on EM currencies. If Omicron produces a major selloff in financial markets, EM currencies will depreciate. In a nutshell, weak domestic demand and return on capital, political volatility, a slowdown in China and potentially lower commodity prices will all continue depressing EM currencies in the early months of 2022. In the following section about local rates, we list signposts that will make us turn positive on EM currencies Local Rates: EM local rates have gone up a great deal and they offer good value. However, as long as EM currencies do not find a floor, interest rates in high-yield local bond markets will not decline. Critically, US dollar returns on EM local currency bonds are primarily determined by exchange rates. Hence, a buying opportunity for international investors in EM high-yield local bonds will coincide with a bottom in their currencies. We recommend turning positive on mainstream EM currencies versus the US dollar if two out of these three conditions are met: The Fed abandons its intention to hike rates. Significant stimulus in China leading to a strong recovery in its credit impulse Mainstream EM’s aggregate real effective exchange rate drops more than one standard deviation below its mean (Chart 17). Chart 18EM Credit Spreads Are Driven By The EM Business Cycle And Currencies EM Credit Spreads Are Driven By The EM Business Cycle And Currencies EM Credit Spreads Are Driven By The EM Business Cycle And Currencies Credit Markets: As we discussed in a report published earlier this year titled A Primer on EM USD Bonds, the two key drivers of EM sovereign and corporate credit spreads are economic growth and the exchange rate (Chart 18). A positive turn on the EM/China business cycles and their currencies will make us immediately bullish on EM sovereign credit. As for high-yield Chinese USD property developers’ bonds, they are not a buy given their extremely high indebtedness and the dismal outlook for real estate. Investment Strategy Odds are that there will be a buying opportunity in EM equities, fixed income and currencies in 2022. The checklists we highlighted above outline what we will be monitoring to make us turn positive on EM equities, local rates, exchange rates and credit. Our current investment stance is as follows: There is likely to be more downside in EM equities in absolute terms. They will also continue underperforming their DM peers. We downgraded EM equities from neutral to underweight on March 25, 2021 and this strategy remains intact. Within the EM benchmark, our overweights are Korea, Singapore, China (favoring A shares over investable stocks), Vietnam, Russia, central Europe and Mexico. Our equity underweights are Brazil, Chile, Peru, Colombia, South Africa, Turkey and Indonesia. We recommend a neutral allocation to all other bourses in mainstream EM. A word on India, Korea and Mexico is warranted. We will publish a report on India next week. Concerning our overweight in the Korean bourse, lower DRAM prices and China’s slowdown have weighed on its performance in 2021 (Chart 19). However, weakness in semiconductor prices will prove to be short lived as the semiconductor industry is in a structural upswing. Besides, Korea and Mexico are two countries in the EM universe that will benefit from the US industrial boom – one of our major multi-year themes. Chart 20 shows that Korea’s relative equity performance versus the overall EM benchmark closely tracks global industrials relative share prices versus global non-TMT stocks. Chart 19A Soft Spot In The DRAM Industry A Soft Spot In The DRAM Industry A Soft Spot In The DRAM Industry Chart 20Overweight The KOSPI Within The EM Equity Space Overweight The KOSPI Within The EM Equity Space Overweight The KOSPI Within The EM Equity Space The path of least resistance for EM currencies versus the US dollar is presently down. We continue to recommend shorting the following basket of EM currencies versus the US dollar: BRL, CLP, COP, PEN, ZAR, KRW, THB and PHP. Last week, we recommended adding the Indonesian rupiah to this list and today we are booking profits on the short position in TRY. The currencies that we currently favor are CNY, INR, MYR, SGD, TWD, RUB, CZK and MXN. In local rates, we have been betting on the yield curve flattening in Mexico and Russia, have been recommending receiving 10-year swap rates in China and Malaysia as well as paying 10-year rates in the Czech Republic. In the EM credit space, we continue to recommend underweighting EM versus US corporate credit, quality adjusted. As with equities, we downgraded this allocation from neutral to underweight on March 25, 2021. Within the EM credit space, we favor sovereign versus corporate credit, quality adjusted. For EM sovereign credit and domestic bond portfolios, our recommended allocations across various countries are shown in the tables enclosed below. Finally, today we are closing our volatility trades: long EM equity volatility and EM currency volatility. Both positions were initiated on February 4, 2021 and have been profitable.   Arthur Budaghyan Chief Emerging Markets Strategist arthurb@bcaresearch.com     Footnotes 1Pledged Supplementary Lending was in effect in 2014-2018: The PBOC lent at very low interest rates to the three policy banks who in turn re-lent to local governments and regional property developers (mainly in tier-2 and smaller cities). These entities then bought slums from their owners, putting cash in their hands to purchase new and better properties. Equities Recommendations Currencies, Credit And Fixed-Income Recommendations

Image The latest CPI and PPI prints at 6.2% and 8.6% respectively, have surprised economists on the upside. Indeed, this level of inflation was unseen in the US for the last forty years. However, there are early signs that input costs inflation is abating, thanks to a resolution of the supply chain bottlenecks and an appreciating dollar.  A proxy for the global manufacturing input cost inflation comprises of the Baltic Dry Index, DRAM, coal, and natural gas prices, is showing signs of easing (see chart). The US dollar is putting downward pressure on the price of commodities and also acts as a natural cooler to the global economic activity, helping resolve supply-demand imbalances. Resolution of the supply chain disruptions and falling prices of inputs will offer support for the Industrials sector, which has been languishing on the back of shortages and rising PPI. This thesis supports our structural overweight of the US Industrials and the US Manufacturing Renaissance theme. The rising dollar will support more domestically oriented asset classes and sectors, such as Small Cap (overweight) and Consumer Services industry groups (overweight). Conversely, the strong dollar will become a headwind for the Technology sector which derives 58% of sales from abroad, and whose goods will become more expensive for the overseas buyers.  Resolution of the shipping delays may hinder the performance of the Transportation Industry (overweight) which was reaping huge rewards from an outsized demand for shipping.  Bottom Line: Inflation will likely head lower over the coming 3-6 months while the dollar is rising. We are monitoring the effects of these macroeconomic developments on the performance of different segments of US equities. ​​​​​​​  

Dear Client, We will be working on our 2022 Outlook for China, which will be published on December 8. Next week we will be sending you BCA Research’s Annual Outlook, featuring long-time BCA client Mr. X, who visits towards the end of each year to discuss the economic and financial market outlook for the year ahead. Best regards, Jing Sima China Strategist Feature In meetings with our North American clients this past week, we expressed the view that China’s economic growth is on a downward trend and easing measures have been gradual and modest in scope. Most clients agreed that China’s economy faces tremendous headwinds, however, some investors were more optimistic about the outlook for Chinese stocks in the next 6 to 12 months. Valuations in both China’s onshore and offshore equity markets have dropped to multi-year lows and macro policies have started to ease. Cheaply valued Chinese stocks should have more upside in the wake of policy support. Policy tone recently pivoted to a more growth supporting bias, but the existing easing measures will not offset the deceleration in both credit growth and domestic demand. China’s economic activity may worsen before it stabilizes in mid-2022. Moreover, China’s financial markets do not seem to have priced in the economic weakness. Therefore, in the next one to two quarters, risks to Chinese stocks are tilted toward the downside. Chart 1Chinese Stocks Will Truly Bottom When The Economy Troughs Chinese Stocks Will Truly Bottom When The Economy Troughs Chinese Stocks Will Truly Bottom When The Economy Troughs Below are some of the main questions from our meetings and our answers. Q: Policies have started to be more pro-growth. Why do you still underweight Chinese stocks? A: There are two reasons that we maintain a cautious view on Chinese stocks for at least the next six months, in both absolute terms and relative to global equities. First, we do not think that the magnitude of existing easing measures is sufficient to offset the economy’s downward momentum. Secondly, China’s business cycle lags credit growth by about six to nine months. The timing of a turnaround in the economy and stock prices may be later than investors have priced in. In short, we need to see more reflationary measures and a rebound in credit growth to have a legitimate macro fundamental basis to overweight Chinese stocks (Chart 1). Credit growth on a year-on-year basis stopped falling in October. The underlying data in credit creation, however, points to a weakening in demand for corporate loans (Chart 2). Loans to the housing sector are well below a year ago (Chart 3). Chart 2Weakening Loan Demand Weakening Loan Demand Weakening Loan Demand Chart 3Bank Loans To The Housing Sector Have Not Turned Around Bank Loans To The Housing Sector Have Not Turned Around Bank Loans To The Housing Sector Have Not Turned Around Chart 4It Will Take Time For Policy Easing To Restore Confidence In The Corporate Sector It Will Take Time For Policy Easing To Restore Confidence In The Corporate Sector It Will Take Time For Policy Easing To Restore Confidence In The Corporate Sector Despite an acceleration in local government bond issuance in October and RMB300 billion in additional bank loans to support small and medium enterprises, growth in medium- to long-term corporate loans peaked (Chart 4). In previous cycles, a rollover in corporate demand for longer-term bank lending on average lasted more than nine months, suggesting that any policy adjustments will take a while to restore confidence in the corporate sector. Without a decisive pickup in credit growth, corporate earnings growth will be at risk of deteriorating. Moreover, policy tightening since earlier this year is still working its way through the economy and major economic indicators in China continue to decline (Chart 5). We think that China’s economy is set to decelerate even more in the next several months, suggesting that earnings uncertainty will likely rise. This, combined with reactive policymakers, already slowing earnings momentum, and a downward adjustment in 12-month forward earnings, suggests that investors have not yet reached the maximum bearishness for Chinese stock prices (Chart 6). Chart 5No Signs Of Improvement In The Economy No Signs Of Improvement In The Economy No Signs Of Improvement In The Economy Chart 6The Earnings Adjustement Process Is Only Beginning The Earnings Adjustement Process Is Only Beginning The Earnings Adjustement Process Is Only Beginning   Q: What is the impact of China’s property market slowdown on the economy? Will recent policy easing stop deterioration in the real estate sector? A: Policy has been recalibrated by relaxing restrictions on mortgage lending and rules for land sales.1 However, the negative financing loop among developers, households and local governments may take longer to improve. Meanwhile, the market may underestimate the downside risks in housing-related activity in the next 6 to 12 months. Chart 7Households' Home Buying Intentions Have Plummeted Households' Home Buying Intentions Have Plummeted Households' Home Buying Intentions Have Plummeted Our view is based on the following: Home sales will likely remain in contraction in the next two quarters. Aggressive crackdowns on property market speculation in the past 12 months have fundamentally shifted consumers’ expectations for future home prices. The impending pilot property tax reform2 (details yet to be disclosed) will only encourage the wait-and-see sentiment of potential buyers. Home sales contracted by 24% in October from a year ago. In previous cycles, contractions in home sales normally lasted for more than 12 months. Moreover, the proportion of households planning to buy a house dropped to only 7.7% in Q3 2021 from 11.6% in Q4 2020 (Chart 7). Real estate developers have slashed new projects and land purchases to preserve liquidity for debt servicing (Chart 8, first and second panels). Policymakers may succeed in prompting banks to resume lending to developers in order to alleviate the escalating risk of widespread defaults. However, so far the marginal easing has failed to reverse the downward trend in bank credit to developers along with home sales (Chart 8, third and bottom panels). Funding constraints for real estate developers will probably be sustained for another six months, despite the recent easing measures. Construction activity, housing starts, and real estate investment will likely remain in doldrum at least through 1H22 (Chart 9). Chart 8Housing Activities Are Still Falling Housing Activities Are Still Falling Housing Activities Are Still Falling Chart 9Less Funding = Less Investment And Completions Less Funding = Less Investment And Completions Less Funding = Less Investment And Completions The marked reduction in land sales will impede local governments’ revenues and weigh on infrastructure investment (Chart 10). Real estate and infrastructure financing contributed 50% of the increase in total Chart 10Local Government Revenues Largely Depend On The Housing Sector Local Government Revenues Largely Depend On The Housing Sector Local Government Revenues Largely Depend On The Housing Sector social financing in 2020. Given that local governments face funding constraints from a slump in land sale incomes, policies on leverage from local government financing vehicles (LGFVs) will have to meaningfully loosen up to allow a rise in bank lending to support infrastructure investment. As discussed in previous reports, an acceleration in local government special-purpose bond issuance can only partially offset weak credit growth. Furthermore, shadow banking activity, which comprises LGFV borrowing and is highly correlated with China’s infrastructure investment growth, remains in contraction and indicates that growth in infrastructure investment is unlikely to rebound strongly (Chart 11). The sharp weakening of real estate construction activities will drag down the demand for building materials, machinery, home appliances and automobiles. Real estate accounts for about 60% of Chinese households’ wealth, thus any substantial drop in home prices will further weaken households’ propensity to consume (Chart 12). Chart 11More Easing Needed For A Meaningful Pickup In Infrastructure Investment More Easing Needed For A Meaningful Pickup In Infrastructure Investment More Easing Needed For A Meaningful Pickup In Infrastructure Investment Chart 12Falling Demand For Commodities And Consumer Goods Falling Demand For Commodities And Consumer Goods Falling Demand For Commodities And Consumer Goods Chart 13AOn The Surface Housing Inventories Are Lower Than Six Years Ago... On The Surface Housing Inventories Are Lower Than Six Years Ago... On The Surface Housing Inventories Are Lower Than Six Years Ago... There are nontrivial risks that the real estate slowdown will evolve into a downturn similar to that of 2014-15. Although the existing housing inventory is more modest than the start of the 2014/15 property downturn, developers have accumulated more debt and unfinished projects in this cycle than in the past (Charts 13A & 13B). Policymakers will have to relax property sector policies much more forcefully to prevent the downturn from intensifying. In the interim, we will likely witness more deterioration in the sector. Chart 13B...But Developers Have Built Up Massive Leverages And Hidden Inventories In The Past Three Years ...But Developers Have Built Up Massive Leverages And Hidden Inventories In the Past Three Years ...But Developers Have Built Up Massive Leverages And Hidden Inventories In the Past Three Years   Q: If the property market accounts for such a big portion of local governments’ revenues, why hasn’t the waning housing market forced policymakers to loosen restrictions? A: We think regulators have been slow to backtrack property market reforms because this year China’s fiscal deficit has narrowed from last year due to lower government spending and improved income from corporate taxes. In previous property market downturns, such as 2011/12, 2015/16 and 2019, property policy restrictions were lightened following major declines in government revenues (Chart 14). However, in 2021 China’s fiscal balance sheet has been stronger than in previous cycles; central and local governments have collected much more taxes, particularly corporate taxes, than in 2020 (Chart 15). Meanwhile, government expenditures so far this year have been lower, resulting in a large improvement in the country’s fiscal deficit (Chart 16). Chart 14Falling Gov Revenues Forced Policymakers To Backtrack Reforms In The Past... Falling Gov Revenues Forced Policymakers To Backtrack Reforms In The Past... Falling Gov Revenues Forced Policymakers To Backtrack Reforms In The Past... Chart 15...But This Year Gov Tax Revenues Have Been Strong ...But This Year Gov Tax Revenues Have Been Strong ...But This Year Gov Tax Revenues Have Been Strong Chart 16Fiscal Deficit Improved This Year Despite Falling evenues From Land Sales Fiscal Deficit Improved This Year Despite Falling evenues From Land Sales Fiscal Deficit Improved This Year Despite Falling evenues From Land Sales As discussed above, slightly loosened restrictions on land purchases by some regional governments will not restore developers’ confidence and boost the demand for land. The sharp increase in government's corporate tax collection will also start to ebb as economic growth slows and corporate profits decline. As such, even if government expenditures remain the same next year, the fiscal deficit will grow because revenues will be under substantial downward pressure. We expect that Chinese policymakers will have to take more actions to stabilize fiscal conditions. Forecasting exactly when this will occur is difficult, but a benign government balance sheet in much of this year is delaying policymakers’ response to the flagging housing market. Meantime, both policymakers and investors may be complacent about the state of the economy until the full scale of the property sector spillover risk becomes clear.   Q: Rates are low and industrial profit growth has been strong this year. Why has capex been so sluggish? A: Investment growth in the manufacturing sector has been lackluster because their profit margins have been squeezed by rising input costs. On the other hand, investment in the mining industry has been constrained by policy restrictions. An acceleration in China’s de-carbonization efforts this year has likely constrained investment in the mining sector. Even though industrial profit growth has been concentrated among the upstream industries such as mining which profits grew by a stunning 100% this year, investment in the sector was mostly flat from a year ago (Chart 17). During the first half of the year, mid- to downstream firms were caught between rising input prices and a weak recovery in domestic consumption. Manufacturing investment grew faster than the mining sector, but manufacturing profit growth only increased by about 30% year to date (Chart 18). However, we think manufacturing investment growth may improve slightly into 2022 as the sector continues to gain pricing power. Chart 17Mining Sector's Profit Growth Way Outpaced Investment Mining Sector's Profit Growth Way Outpaced Investment Mining Sector's Profit Growth Way Outpaced Investment Chart 18Manufacturing Sector Profit Growth Has Been Much More Muted Than Upstream Industries Manufacturing Sector Profit Growth Has Been Much More Muted Than Upstream Industries Manufacturing Sector Profit Growth Has Been Much More Muted Than Upstream Industries   Q: The RMB has been strong against the dollar, despite China’s maturing business cycle. What is your outlook for the RMB next year? A: The RMB exchange rate has been boosted by China’s record current account surplus, wide interest rate differentials and speculation that tension between the US and China will abate. However, all three favorable conditions supporting the RMB are in danger of reversing next year. Chart 19The RMB Has Been Appreciating Despite A Strong USD The RMB Has Been Appreciating Despite A Strong USD The RMB Has Been Appreciating Despite A Strong USD Chart 20The RMB's Appreciation Deviates From Economic Fundamentals The RMB's Appreciation Deviates From Economic Fundamentals The RMB's Appreciation Deviates From Economic Fundamentals Despite broad-based dollar strength, the CNY/USD has appreciated by 4.5% year to date (Chart 19). The RMB’s appreciation deviates from China’s economic fundamentals (Chart 20).       Strong global demand for goods has boosted Chinese exports while travel restrictions curbed foreign exchange outflows by domestic households (Chart 21). China-US real interest rate differentials have been in favor of the CNY versus USD, bringing net foreign inflows to China’s onshore bond market (Chart 22). Additionally, the recent meeting between President Joe Biden and President Xi Jinping has prompted speculation that the US will lessen tariffs on Chinese imports. Chart 21Large Current Account Surplus Large Current Account Surplus Large Current Account Surplus Chart 22Favorable Interest Rate Differentials And Strong Fund Inflows Favorable Interest Rate Differentials And Strong Fund Inflows Favorable Interest Rate Differentials And Strong Fund Inflows Chart 23China's Extremely Robust Export Growth Unlikely To Sustain In 2022 China's Extremely Robust Export Growth Unlikely To Sustain In 2022 China's Extremely Robust Export Growth Unlikely To Sustain In 2022 Chart 24A Strong RMB Does Not Bode Well For Chinese Exporters' Profits A Strong RMB Does Not Bode Well For Chinese Exporters' Profits A Strong RMB Does Not Bode Well For Chinese Exporters' Profits These factors will likely turn against the CNY next year. First, export growth will moderate as the composition of US consumption rotates from goods to services (Chart 23). Secondly, it would not be in the PBoC’s best interests to let the RMB strengthen too rapidly because an appreciating currency would be a deflationary force on China’s export and manufacturing sectors (Chart 24). While we expect policymakers to maintain their preference for a gradual approach to stimulus, we assign a high probability to a reserve requirement ratio (RRR) cut in early 2022. In this environment, Chinese bond yields will decline, which would narrow the China-US interest rate differential. Finally, while there may be some changes to US tariffs on China, it is doubtful that there would be a broad-based removal of tariffs. Chart 25The CNY/USD Will Likely Fall And Converge To Chinese Stocks' (Under)performance The CNY/USD Will Likely Fall And Converge To Chinese Stocks' (Under)performance The CNY/USD Will Likely Fall And Converge To Chinese Stocks' (Under)performance The CNY’s outperformance stands out as it marks a break from its correlation with China’s relative equity performance vis-à-vis the US (Chart 25). The signal from the currency suggests that either global equity investors are overly pessimistic about economic and regulatory risks in China, or overly optimistic about the value of China’s currency. The latter option is more likely at the moment, and the CNY/USD exchange rate is at the risk of converging to the underperformance of Chinese investable stocks next year.   Jing Sima China Strategist jings@bcaresearch.com Footnotes 1  China Cities Ease Land Bidding Rules as Property Stress Spreads - Bloomberg 2  China’s Pilot Property Tax Reforms Benefit Markets Despite Short-Term Pain, Analysts Say - Caixin Global Market/Sector Recommendations Cyclical Investment Stance

Highlights Last month we published a report on the US corporate margins, titled “Marginally Worse.” In the report, we concluded that margins are likely to contract next year, hobbled by a slowdown in top-line growth, falling productivity, a decline in corporate pricing power, and soaring costs of labor and materials. Q3-2021 – another stellar earnings season: Companies achieved superior earnings growth and expanded margins. However, many companies guided down for Q4-2021 and 2022 citing mounting challenges, such as higher costs of labor, shipping, and raw materials. As such, deciphering which sectors are best positioned to maintain profitability is of paramount importance. Framework for Sector Margin Scorecard: We introduce a framework to rank the S&P 500 sector based on the expected resilience of their margins. It is based on four factors that provide a uniform basis for comparison across all sectors, despite their inherent differences in cost structure, effects of input costs, and ability to manage prices. The four factors driving changes in operating margins are: Sell-side operating margins forecasts as a concise summary of bottom-up company trends Pent-up demand for the sector’s products proxied by the difference between annualized sales growth in 2020 and 2021 and long-term annualized sales growth Pricing power or ability to pass on costs to customers Degree of operating leverage or ability to spread costs when sales volume increases Sectors with most resilient margins: According to this scorecard, Financials, Healthcare, Energy, and Utilities are in the best position to preserve operating margins (Table 1). Table 1Sector Margins Scorecard Sector Margins Scorecard Sector Margins Scorecard Energy Sector - Upgrade to Overweight The medium-term supply/demand backdrop is highly supportive of the current crude oil prices, with a Brent price target of $81 and upside price risk due to inadequate capex. Margins are still below the pre-pandemic peak and the street expects them to increase by 7.74 percentage points over the next 12 months. High operating leverage converts growing demand from the global economic recovery into profitability. Financials – Overweight: O/W Banks, EW Insurance While sell-side analysts anticipate Financials margins will decline, we believe that margins may surprise on the upside: The sector has high operating leverage, is somewhat insulated from supply chain disruptions, sees green shoots in loan growth, and its pricing power is improving. Further, the BCA house view expects the 10-year Treasury yield will rise to 2.0% - 2.25% by the end of 2022, supporting net interest margins. Healthcare - Overweight: O/W Medical Equipment and Services, EW Pharma In July we published a report on the Healthcare sector, titled “Checking The Pulse: Deep Dive Into The Health Care Sector” and upgraded it to Overweight. The Healthcare sector is one of the most resilient sectors profitability-wise as, being defensive in nature, its sales are unaffected by changes in economic demand. The street expects margins to expand by over 2% over the next 12 months. Further, there is still significant pent-up demand for the health care services, and specifically for the elective procedures – the most lucrative segment of the Healthcare Sector. Pricing power has recently picked up.    Feature Last month we published a report on US corporate profit margins, titled “Marginally Worse.” In that report, we took a close look at corporate margins by analyzing their key drivers. We have concluded that margins are likely to contract next year, driven by a slowdown in top-line growth, falling productivity, and a decline in corporate pricing power. The sales side of the margin equation will fail to offset upward cost pressures imposed by the tight labor market, soaring input prices and transportation costs, rising depreciation expense, and a potential increase in tax rates. We also developed a simple model that encapsulates all the moving parts (Chart 1). Our forecast, based on the model, reiterates that the path of least resistance for US corporate margins is lower. Chart 1 In this report, we will take a close look at the S&P 500 sectors to gauge their ability to grow earnings and preserve margins. We aim to rank them by their ability to maintain profitability. Q3-2021 Earnings Season: Stellar Results Operating sector margins are a focal point for investors in the current environment of soaring shipping costs, PPI readings unseen for the last forty years, and a wage-price spiral that may lead to prolonged periods of elevated inflation. While rising costs have been a concern for a while now, the Q3-2021 earnings season has surprised on the upside, with 81% of companies exceeding analyst earnings expectations. Earnings increased by 42% year-over-year and sales 17%. The two-year annualized growth rate (CAGR) for S&P 500 earnings is 14.6% and 5.7% for sales. The pandemic trough has been all but forgotten, and earnings are back to their trend (Chart 2). Chart 2 Chart 3 All sectors, except for Industrials and Consumer Discretionary, have earnings and sales that exceed pre-pandemic levels (Chart 3). Energy, Materials, and Tech enjoyed annualized eps growth over the past two years in excess of 20%. And of course, because of such robust earnings growth, most sectors have reached 2010 -2021 peak margins (Chart 4). And these are unprecedented high peaks: Most sectors’ margins are more than two standard deviations away from their five-year averages. From a statistical standpoint, Z-scores in this “zip code” indicate that the probability of even higher margins is minuscule (Chart 5). Chart 4 ​​​​​​​ Chart 5 How were companies able to achieve such stellar earnings growth and peak margins despite all the cost and supply chain disruption headwinds? The answer is strong sales growth, efficiency in managing suppliers, ability to pass on costs to customers by raising prices, and finally, high operating leverage. Here is what happened in the words of the companies: Home Depot: “Professional home improvement contractors have had huge backlogs of work to do, and impatient customers have in many cases been willing to pay up in order to get the goods needed despite supply chain problems.” Microsoft: "We do have good understanding of lead times required to meet the capacity and signals that we’re seeing. I think we do a good job managing that. It’s not to say we’re not impacted. Multiple suppliers are important to be able to manage through that, and I feel the team has done a very good job.” Union Pacific Corporation: "The Union Pacific team successfully navigated global supply chain disruptions, a major bridge outage, and additional weather events to produce strong quarterly revenue growth and financial results." Honeywell: "Our disciplined approach to productivity and pricing helped deliver a strong third quarter despite an uncertain global environment marked by supply chain constraints, increasing raw material inflation, and labor market challenges.” Coca-Cola: Our results through the first nine months of 2021," CEO Frank Harrison said, "reflect a strong balance of volume growth, price realization, and prudent expense management." However, there are also multiple cracks in the foundation, with companies such as Target and Amazon guiding lower both for Q4-2021 and 2022 citing higher costs of labor, shipping, and raw materials. As such, deciphering which sectors can maintain profitability is of paramount importance. Building A Sector Margin Scorecard So which sectors have the best ability to preserve or even expand margins over the next year? Forecasting profitability by sector is tricky, as every sector is different, and has disparate drivers of sales and costs, making cross-sectional comparisons challenging. However, we have an advantage – we are not aiming to predict a point estimate for each sector margin a year from now, but rather rank all sectors from best to worst in terms of their ability to maintain profitability. To do so, we have created a scorecard based on four factors that provide a uniform basis for comparison across all sectors, despite their inherent differences in cost structure, effects of input costs, and ability to manage prices. These factors also implicitly incorporate a potential mean reversion, i.e., high readings are unlikely to move even higher. Four factors capturing future changes in the profit margins are: Sell-side forecasts of operating margins over the next 12 months as a concise summary of bottom-up company trends Pent-up demand for the sector’s products proxied by the difference between 2019-2021 sales CAGR and long-term annualized sales growth Pricing power or ability to pass on costs to customers Degree of operating leverage or ability to spread costs when sales volume increases Factor 1: Expected Change In Operating Margins Over The Next 12 Months Top-down sector margin expectations for the next 12 months are an aggregation of the bottom-up company forecasts. Since the stock market is a market of stocks, this is an important summary of companies' trends which we incorporate into our ranking framework. In line with our view, sell-side analysts expect S&P 500 margins to contract by 1.2% over the next 12 months. Margin contraction is expected across the board with two notable exceptions: Energy and Healthcare. In the scorecard, we rank sectors based on the expected magnitude of the margin change, such that sectors with the least compression, or outright growth, are scoring better (Chart 6). Chart 6 Factor 2: Pent-up Demand For The Sector’s Products Most sectors have enjoyed a fantastic sales and earnings recovery this year (Chart 7), with sales exceeding pre-pandemic levels thanks to strong consumer demand. Chart 7 However, to gauge the level of pent-up demand for each sector, we compare 2020-2021 CAGR of sales growth with a long-term sales growth rate. We call this factor “sales growth differential.” Our thinking is that if recent sales growth is below a pre-pandemic normal, there is still demand left on the table. For example, the Consumer Discretionary sector is not yet back to the pre-pandemic “normal” pace of growth. Therefore, there is still strong demand for its products and services. This aligns well with what we were observing for months now. Fears of Covid-19 have resulted in a shift of spending from services to goods. As a result, demand for goods has overshot pre-pandemic levels, while demand for services is below its pre-pandemic trend and is enjoying a rebound (Chart 8). Chart 8There Is Still Pent-up Demand For Services There Is Still Pent-up Demand For Services There Is Still Pent-up Demand For Services In the scorecard, we assign a higher score to the sectors like Industrials and Consumer Discretionary expecting a more significant pickup in sales growth, and a lower score to the sectors with sales growth that exceeds the historical average on the concern that mean reversion may be in store: A strong bounce back in sales has already materialized, and demand has been pulled forward. Factor 3: Pricing Power Pricing Power is a proprietary BCA indicator based on the PPI and CPI indices for the 60 different industries. Industries are rolled up into sector indices and the market index.1 Sectors with higher pricing power can pass on their costs to their customers. However, at some point, they may no longer be able to raise prices as that will dampen demand for their products. As a result, after a series of price increases, companies’ pricing power wanes. Today, pricing power of companies in most sectors is already two-to-three standard deviations above the five-year average, suggesting that the probability of further gains is extremely low, i.e., one percent or less (Chart 9). The only exceptions are the Healthcare and Financial sectors whose pricing power has barely budged. Chart 9 What sectors do we prefer? Ones with a very high pricing power that is about to roll over or the ones whose pricing power is handicapped by outside political pressures and competitive headwinds? Since we believe that markets are driven by the second derivative, waning pricing power may have a detrimental effect on sector performance, while low and stable pricing power is already priced into expectations. To reflect this thinking, we penalize sectors whose pricing power is high relative to five years of history, expecting mean reversion. Factor 4: Degree Of Operating Leverage The degree of operating leverage (DOL), which gauges the company’s ability to spread its costs over sales, is largely determined by the cost of each marginal unit sold. This is a metric that assesses the cost structure of the sector in terms of fixed costs vs. variable costs. Sectors with higher fixed costs have higher operating leverage: It costs next to nothing to produce a marginal unit of sales, which leads to higher profitability as volume grows. We calculate DOL as the following: DOL= % Change in Operating Income/ % Change in Sales Percentage of change in operating income and sales is a five-year change to smooth out volatility and assess the longer-term relationship. Further, to obtain a comprehensive picture of the longer-term DOL, we calculate a median reading for each sector from 2010 to 2021. Median ignores extreme values and is better at capturing the “normal”. We also exclude negative and zero readings from our calculations to gauge DOL only when the companies are profitable (Chart 10). Chart 10 Bringing It All Together: Operating Margins Sector Scorecard We have ranked all 11 sectors along the four dimensions described above. As a result, we expect Financials, Healthcare, Energy, and Utilities to be in the best position to preserve operating margins (Table 1). Table 1Sector Margins Scorecard Sector Margins Scorecard Sector Margins Scorecard Energy Sector - Upgrade To An Overweight Energy profit margins are linked to underlying commodity prices. BCA Commodity and Energy strategists’ view is that the medium-term supply/demand backdrop is highly supportive of the current energy pricing dynamics and that the oil price is expected to stay high, at around its current level, for the next two years. They also note that upside price risk is increasing going forward, due to inadequate capex. Current operating margins remain well below the previous cyclical peak (Chart 11) and are expected to increase by 7.74 percentage points over the next 12 months. Although the price of oil has risen above the breakeven levels, energy companies are reluctant to invest in capex due to pressure from shareholder activists and newly found financial discipline. As a result, prices are likely to remain high until “high prices cure high prices”. In the meantime, energy producers are returning cash to shareholders – a unique bonus in the current world starved for yield. Chart 11The Street Expects the Energy Sector Margins To Expand. We concur... The Street Expects the Energy Sector Margins To Expand. We concur... The Street Expects the Energy Sector Margins To Expand. We concur... Oil demand is expected to stay robust on the back of the global economic recovery, especially with an increase in consumption by airlines that are resuming international travel. Case in point: ExxonMobil (XOM) “anticipates demand improvement in its downstream segment with a continued economic recovery.” Upgrade Energy from an Equal Weight to an Overweight Financials – Overweight: O/W Banks, EW Insurance 2021 was a blockbuster year for banks on the back of the booming M&A and IPO activity. However, to achieve sustainable profitability, they need to jumpstart the loan growth process. There are early signs that lending is likely to pick up next year (Chart 12). According to JPM: "The customers who typically contribute to credit card loan growth are starting to spend the savings built up from the pandemic at a faster clip, suggesting they could be getting closer to taking on debt again" Regional banks already see the green shoots. According to Key Bank:"We are pleased with the trajectory of our loan growth." Chart 12Early Signs Of Lending Picking Up Early Signs Of Lending Picking Up Early Signs Of Lending Picking Up  ​​​​​​​Insurance companies are faring worse than Banks. Higher costs of labor and materials result in higher replacement costs, and higher customer payouts. However, insurers succeed in incorporating these higher expenses into pricing. While sell-side analysts anticipate margins will decline, (Chart 13) we believe that they may surprise on the upside: High operating leverage, improving pricing power (Chart 14) and growing demand for loans will contribute to strong profitability. Further, BCA expects the 10-year Treasury yield will rise to 2.0% - 2.25% by the end of 2022, supporting wider net interest margins. Chart 13While The Street Has Doubts About The Financial Sector Margins, We Are Constructive... While The Street Has Doubts About The Financial Sector Margins, We Are Constructive... While The Street Has Doubts About The Financial Sector Margins, We Are Constructive... Chart 14Pricing Power Is Improving Pricing Power Is Improving Pricing Power Is Improving Healthcare - Overweight: O/W Medical Equipment and Services, EW Pharma In July we published a report on the Healthcare sector, titled “Checking The Pulse: Deep Dive Into The Health Care Sector.” In this report, we upgraded the Healthcare sector to an overweight. Today, we reiterate the call. First, in a slowdown stage of the business cycle, Healthcare tends to outperform. Second, the Healthcare sector is one of the most resilient sectors profitability-wise as, being defensive by nature, its sales are unaffected by changes in economic demand. The street expects margins to expand by over 2% over the next 12 months (Chart 15). Further, there is still significant pent-up demand for health care services, and specifically for elective procedures – the most lucrative segment of the Healthcare market. Pricing power has recently picked up (Chart 16). Companies concur that life is getting better: According to JNJ:” many of the hospitals and other providers have to pay more for their input, and that's going to be reflected in the economics as we go forward. And of course, all that is reflected in how we price going forward”. Chart 15The Healthcare Margins Are Posed To Widen The Healthcare Margins Are Posed To Widen The Healthcare Margins Are Posed To Widen Chart 16After A Prolonged Decline, Healthcare Pricing Power Is Finally On The Rise After A Prolonged Decline, Healthcare Pricing Power Is Finally On The Rise After A Prolonged Decline, Healthcare Pricing Power Is Finally On The Rise Consumer Staples - Underweight Our sector margins scorecard has identified Consumer Staples as a sector most susceptible to a margin squeeze. Sell-side expects margins to contract by 2% (Chart 17). This is a sector that has low operating leverage which indicates that the marginal cost of producing each additional unit is high, and is particularly vulnerable to rising input costs. At the same time pricing power of the sector is likely to wane: companies were able to raise prices throughout 2021, and now pricing power is over four standard deviations above the five-year average (Chart 18). Raising prices in the environment when fiscal stimulus is in the rearview mirror, against a backdrop of negative real wage growth, will be challenging. Walmart surely knows its customers: It decided to “absorb higher costs and keep prices low for customers all across the business.” Operating Margins of Consumer Staples are likely to contract in 2022. Chart 17Consumer Staples Margins Are Expected To Plunge Consumer Staples Margins Are Expected To Plunge Consumer Staples Margins Are Expected To Plunge Chart 18Pricing Power Is Not Sustainable Pricing Power Is Not Sustainable Pricing Power Is Not Sustainable Investment Implications Our analysis indicates that companies in most sectors have reached their peak margins in Q3-2021. Looking ahead, there will be distinct profitability tracks, with some sectors expanding margins while others will experience margin compression. Sectors that have higher operating leverage, pent-up demand left over from the pandemic slowdown, and whose pricing power may still increase will fare best. Our scorecard screened all the 11 sectors based on these conditions, and Financials, Energy, Healthcare, and Utilities have the best shot at maintaining and even expanding their margins. We have been overweight Financials and Healthcare in our portfolios for a while now, and the expectation of resilient profitability only reinforces our conviction. We are upgrading Energy from neutral to an overweight on the back of the expected margin expansion and high oil price target. We are still underweight Utilities which we consider as a bond proxy, unlikely to outperform in a rising rates environment. Bottom Line In this report, we introduce a framework to rank the S&P 500 sectors based on the expected resilience of their margins. Factors we consider are operating leverage, pricing power, pent-up demand, and sell-side margin expectations. As a result of the analysis, we believe that Financials, Energy, Healthcare, and Utilities are posed for strong profitability in 2022.   Irene Tunkel Chief Strategist, US Equity Strategy irene.tunkel@bcaresearch.com Appendix: Chart 19 CHART 19 CHART 19 Chart 20 CHART 20 CHART 20 Chart 21 CHART 21 CHART 21 Chart 22 CHART 22 CHART 22 Chart 23 CHART 23 CHART 23 Chart 24 CHART 24 CHART 24 Chart 25 CHART 25 CHART 25 Chart 26 CHART 26 CHART 26 Chart 27 CHART 27 CHART 27 Chart 28 CHART 28 CHART 28 Chart 29 CHART 29 CHART 29 Chart 30 CHART 30 CHART 30 Footnotes 1     Pricing power is calculated by finding the difference between how much the industry has been able to increase prices and the change in the cost of the raw materials due to inflation.  For example, for airlines, pricing power would be measured as the difference in the airfare CPI and jet fuel inflation. The exact calculation is industry specific.  Industries are rolled up into sector indices and the market index.   Recommended Allocation

Dear Client, There will be no report next week as we will be working on our Quarterly Strategy Outlook, which will be published the following week. In the meantime, please keep an eye out for BCA Research’s Annual Outlook, featuring long-time BCA client Mr. X, who visits towards the end of each year to discuss the economic and financial market outlook for the year ahead. Best regards, Peter Berezin Chief Global Strategist Highlights Inflation in the US, and to a lesser extent, in other major economies, will follow a “two steps up, one step down” trajectory of higher highs and higher lows.  While inflation will fall in the first half of next year as goods prices stabilize, an overheated labor market will cause inflation to re-accelerate into 2023. The Fed will be slow to respond to high inflation, implying that monetary policy will remain accommodative next year. This should help propel stocks to new highs. Chinese stimulus will offset much of the drag from a weaker domestic property market. The dollar is a high momentum currency, so we wouldn’t bet against the greenback in the near term. Nevertheless, with “long dollar” now a consensus trade, we would position for a weaker dollar over a 12-month horizon. A depreciating dollar next year should help non-US equities, especially beleaguered emerging market stocks. The dollar will strengthen anew in 2023, as the Fed is forced to turn more hawkish, and global equities begin to buckle. From Ice To Fire In past reports, we have contended that inflation in the US, and to a lesser extent, in other major economies, would follow a “two steps up, one step down” trajectory of higher highs and higher lows.  We are currently near the top of those two steps. The pandemic ushered in a major re-allocation of spending from services to goods (Chart 1). US inflation should dip over the next 6-to-9 months as the demand for goods decelerates and supply-chain disruptions abate. Chart 1The Pandemic Caused A Major Shift In Spending From Services To Goods The Pandemic Caused A Major Shift In Spending From Services To Goods The Pandemic Caused A Major Shift In Spending From Services To Goods CHart 2Those With Low Paid Jobs Are Enjoying Stronger Wage Gains Those With Low Paid Jobs Are Enjoying Stronger Wage Gains Those With Low Paid Jobs Are Enjoying Stronger Wage Gains The respite from inflation will not last long, however. The labor market is heating up. So far, most of the wage growth has been at the bottom end of the income distribution (Chart 2). Wage growth will broaden over the course of 2022, setting the scene for a price-wage spiral in 2023. We doubt that either fiscal or monetary policy will tighten fast enough to prevent such a spiral from emerging. As a result, US inflation will surprise meaningfully on the upside. Our view has no shortage of detractors. In this week’s report, we address the main counterarguments in a Q&A format:   Q: What makes you think that service spending will rebound fast enough to offset the drag from weaker goods consumption? Chart 3Inventory Restocking Could Be A Source Of Growth Next Year Inventory Restocking Could Be A Source Of Growth Next Year Inventory Restocking Could Be A Source Of Growth Next Year A: There is still a lot of pent-up demand for goods. Try calling any auto dealership. You will hear the same thing: “We have nothing in stock now, but if you put in an order today, you might get a vehicle in 3-to-6 months.” Thus, durable goods sales are unlikely to weaken quickly. And with inventories near record low levels, firms will need to produce more than they sell (Chart 3). Inventory restocking will support GDP growth. As for services, real spending in the US grew by 7.9% in the third quarter, an impressive feat considering that this coincided with the Delta-variant wave. Service growth will stay strong in the fourth quarter. The ISM non-manufacturing index jumped to a record high of 66.7 in October, up from 61.9 in September. The Atlanta Fed’s GDPNow model is tracking real PCE growth of 9.2% in Q4. Goldman’s Current Activity Indicator has hooked up (Chart 4). Chart 4 Q: Aren’t you worried that spending on services might stall next year? A: Not really. Chart 5 shows the percentage change in real spending for various types of services from January 2020 to September 2021, the last month of available data. Chart 5 Chart 6 The greatest decline in spending occurred in those sectors that were most directly affected by the pandemic. Notably, spending on movie theaters, amusement parks, and live entertainment in September was still down 46% on a seasonally-adjusted basis compared to last January. Hotel spending was down 22%. Spending on public transport was down 26%. Only spending on restaurants was back to normal. The number of Covid cases has once again started to trend higher in the US, so that path to normalization will take time (Chart 6). Nevertheless, with vaccination rates still edging up and new antiviral drugs set to hit the market, it is reasonable to assume that many of the hardest-hit service categories will recover next year.   Q: What about medical services? Some have speculated that the shift to telemedicine will require much lower spending down the road. A: It is true that spending on outpatient services in September was $43 billon below pre-pandemic levels. However, over two-fifths of that shortfall was in dental services, which are not amenable to telemedicine. Spending on dental services was down 16% from its January 2020 levels, compared to 6% for physician services. A more plausible theory is that many people are still worried about venturing to the doctor’s or dentist’s office. In addition, a lot of elective procedures were canceled or postponed due to the pandemic. Clearing that backlog will lift medical spending next year. Chart 7The Flow Of Savings Has Fallen Back To Pre-Pandemic Levels But The Stock Of Accumulated Savings Remains High The Flow Of Savings Has Fallen Back To Pre-Pandemic Levels But The Stock Of Accumulated Savings Remains High The Flow Of Savings Has Fallen Back To Pre-Pandemic Levels But The Stock Of Accumulated Savings Remains High In any case, the cost of a telemedicine appointment is typically no different from an in-person one. And, to the extent that telemedicine does become more widespread, this could encourage more people to seek medical assistance. Lastly, even if spending on certain services does not fully recover after the pandemic, this will probably simply result in a permanent increase in spending on goods. The only way that overall consumer spending will falter is if the savings rate rises, which seems unlikely to us. Q: Why do you say that? The savings rate has been very high throughout the pandemic. A: The savings rate did spike during the pandemic, but that was mainly because fewer services were available, and because households were getting transfer payments from the government. Now that these payments have ended, the savings rate has dropped to 7.5%, roughly where it was prior to the pandemic. There is good reason to think the savings rate will keep falling next year. Households are sitting on $2.3 trillion in excess savings, most of which reside in bank deposits (Chart 7). As they run down those savings, consumption will rise in relation to income. The household deleveraging cycle is over. After initially plunging during the pandemic, credit card balances are rising (Chart 8). Banks are eager to make consumer loans (Chart 9). Household net worth has risen by over 100% of GDP since the start of the pandemic (Chart 10). As we discussed three weeks ago, the wealth effect alone could boost annual consumer spending by up to 4% of GDP. Chart 8APost-GFC Deleveraging Has Ended And People Are Swiping Credit Cards Again Following The Pandemic Scare Post-GFC Deleveraging Has Ended And People Are Swiping Credit Cards Again Following The Pandemic Scare Post-GFC Deleveraging Has Ended And People Are Swiping Credit Cards Again Following The Pandemic Scare Chart 8BPost-GFC Deleveraging Has Ended And People Are Swiping Credit Cards Again Following The Pandemic Scare Post-GFC Deleveraging Has Ended And People Are Swiping Credit Cards Again Following The Pandemic Scare Post-GFC Deleveraging Has Ended And People Are Swiping Credit Cards Again Following The Pandemic Scare   Chart 9Banks Are Easing Credit Standards For Consumer Loans Banks Are Easing Credit Standards For Consumer Loans Banks Are Easing Credit Standards For Consumer Loans Chart 10A Record Rise In Household Net Worth A Record Rise In Household Net Worth A Record Rise In Household Net Worth   Q: Household wealth could fall as the Fed starts tapering and eventually raising rates. Wouldn’t that cool the economy? A: The taper is a fait accompli, and markets are already pricing in rate hikes starting in the second half of next year. If the Fed were to signal its intention to raise rates more quickly than what has been priced in, then home prices and stocks could certainly weaken. We do not think the Fed will pivot in a more hawkish direction before the end of next year, however. The Fed’s estimate of the neutral rate is only 2.5%, a big step down from its estimate of 4.25% in 2012. The market’s view is broadly in line with the Fed’s (Chart 11).  Despite the upward move in realized inflation, long-term inflation expectations remain in check – expected inflation 5-to-10 years out in the University of Michigan survey has increased from 2.3% in late 2019 to 2.9%, bringing it back to where it was between 2010 and 2015. The 5-year/ 5-year forward TIPS breakeven inflation rate is near the bottom end of the Fed’s comfort zone (Chart 12). Chart 11The Fed And Investors Still Believe In Secular Stagnation The Fed And Investors Still Believe In Secular Stagnation The Fed And Investors Still Believe In Secular Stagnation Chart 12Long-Term Inflation Expectations Are Not Yet A Concern For The Fed Long-Term Inflation Expectations Are Not Yet A Concern For The Fed Long-Term Inflation Expectations Are Not Yet A Concern For The Fed   Q: What about fiscal policy? Isn’t it set to tighten sharply next year? A: The US budget deficit will decline next year. However, this will happen against the backdrop of strong private demand growth. Moreover, budget deficits are likely to remain elevated in the post-pandemic period. This week, President Biden signed a $1.2 trillion infrastructure bill into law, containing $550 billion in new spending. BCA’s geopolitical strategists expect Congress to pass a $1.5-to-$2 trillion social spending bill using the reconciliation process. All in all, the IMF foresees the US cyclically-adjusted primary budget deficit averaging 4.9% of GDP between 2022 and 2026, compared to 2.0% of GDP between 2014 and 2019 (Chart 13). Chart 13 Chart 14While Overall Consumption Has Recovered, Business Spending and Direct Government Expenditures Remain Below Trend While Overall Consumption Has Recovered, Business Spending and Direct Government Expenditures Remain Below Trend While Overall Consumption Has Recovered, Business Spending and Direct Government Expenditures Remain Below Trend   It should also be noted that government spending on goods and services has been quite weak over the past two years (Chart 14). The budget deficit surged because transfer payments exploded. Unlike direct government spending, which is set to accelerate over the next few years, households saved a large share of transfer payments. Thus, the fiscal multiplier will increase next year, even as the budget deficit shrinks.   Q: We have focused a lot on demand, but what about supply? There are over 4 million fewer Americans employed today than before the pandemic and yet the job openings rate is near a record high. Chart 15Despite A Notable Decline, There Are Still A Lot Of People Avoiding Work Because Of Worries About Contracting Or Transmitting Covid Despite A Notable Decline, There Are Still A Lot Of People Avoiding Work Because Of Worries About Contracting Or Transmitting Covid Despite A Notable Decline, There Are Still A Lot Of People Avoiding Work Because Of Worries About Contracting Or Transmitting Covid A: Some people who left the workforce will regain employment. According to the Census Bureau’s Household Pulse Survey, there are still 2.5 million people not working because they are afraid of catching or transmitting the virus (Chart 15). That said, some workers may remain sidelined for a while longer. The very same survey also revealed that about 8 million of the 100 million workers currently subject to vaccine mandates say that “they will definitely not get the vaccine.” In addition, about 3.6 million workers have retired since the start of the pandemic, about 1.2 million more than one would have expected based on pre-existing demographic trends. Most of these retirees will not work again. Lifestyle choices may keep others from seeking employment. Female labor participation has declined much more during the pandemic and than it did during the Great Recession (Chart 16). While many mothers will re-enter the labor force now that schools have reopened, some may simply choose to stay at home. Chart 16 The bottom line is that the pandemic has reduced labor supply at a time when labor demand remains very strong. This is likely to exacerbate the labor shortage.   Q: Any chance that higher productivity will offset some of the damage to the supply side of the economy from decreased labor participation? A: US labor productivity did increase sharply during the initial stages of the pandemic. However, that appears to have been largely driven by composition effects in which low-skilled, poorly-paid service workers lost their jobs. As these low-skilled workers have returned to the labor force, productivity growth has dropped. The absolute level of productivity declined by 5.0% at an annualized rate in the third quarter, leading to an 8.3% increase in labor costs. It is telling that productivity growth has been extremely weak outside the US (Chart 17). This gives weight to the view that the pandemic-induced changes in business practices have not contributed to higher productivity, at least so far. It is also noteworthy that a recent study of 10,000 skilled professionals at a major IT company revealed that work-from-home policies decreased productivity by 8%-to-19%, mainly because people ended up working longer. Increased investment spending should eventually boost productivity. Core capital goods orders, which lead corporate capex, are up 18% since the start of the pandemic (Chart 18). However, the near-term impact of increased investment spending will be to boost aggregate demand, stoking inflation in the process. Chart 17 Chart 18US Capex Should Pick Up US Capex Should Pick Up US Capex Should Pick Up   Q: We have spoken a lot about the US, but the world’s second biggest economy, China, is facing a massive deflationary shock from the implosion of its real estate market. Could that deflationary impulse potentially cancel out the inflationary impulse from an overheated US economy? A: You are quite correct that inflation has risen the most in the US. While inflation has picked up in Europe, this mainly reflects base effects (Chart 19). Inflation in China has fallen since the start of the pandemic despite booming exports. There are striking demographic parallels between China today and Japan in the early 1990s. The bursting of Japan’s property bubble corresponded with a peak in the country’s working-age population (Chart 20). China’s working-age population has also peaked and is set to decline by more than 40% over the remainder of the century. Chart 19The US Stands Out As The Inflation Leader The US Stands Out As The Inflation Leader The US Stands Out As The Inflation Leader Chart 20Demographic Parallels Between China And Japan Demographic Parallels Between China And Japan Demographic Parallels Between China And Japan That said, there are important differences between the two nations. In 1990, Japan was a rich economy; output-per-hour was nearly 70% of US levels. China is still a middle-income economy; output-per-hour is only 20% of US levels (Chart 21). China has the ability to outgrow some of its problems in a way that Japan did not. In addition, Chinese policymakers have learned from some of Japan’s mistakes. They have been trying to curb the economy’s dependence on property development; real estate development investment has fallen from 12% of GDP in 2014 to less than 10% of GDP (Chart 22). China is still building too many new homes, but unlike Japan in the 1990s, the government is likely to pursue stimulus measures to compensate for a shrinking property sector. This should keep the economy from entering a deflationary slump. Chart 21 Chart 22Real Estate Investment Has Peaked In China Real Estate Investment Has Peaked In China Real Estate Investment Has Peaked In China   Q: Let’s bring this back to markets. What is the main investment takeaway from your view? A: The main takeaway is that investors should remain bullish on stocks and other risk assets for the next 12 months but be prepared to turn more cautious in 2023. The neutral rate of interest in the US is higher than generally assumed. This means that monetary policy is currently more accommodative than widely believed, which is good for stocks. Unfortunately, it also means that a policy error is likely: The Fed will keep rates too low for too long, causing the economy to overheat. Chart 23Bank Stocks Tend To Outperform When Yields Rise Bank Stocks Tend To Outperform When Yields Rise Bank Stocks Tend To Outperform When Yields Rise This overheating will not be evident over the next six months. As we noted at the outset of this report, the US economy is currently at the top of the proverbial two steps in our projected “two steps up, one step down” trajectory for inflation. The cresting in durable goods inflation will provide a temporary respite from inflationary worries, even as the underlying long-term driver of higher inflation – an increasingly tight labor market – gains traction. Strong consumer demand and persistent labor shortages will incentivize companies to invest in new capacity and automate production. This will benefit industrial stocks and select tech names. Rising bond yields will also boost bank shares (Chart 23). A country’s current account balance is simply the difference between what it saves and what it invests. With savings on the downswing and investment on the upswing, the US will find it increasingly difficult to finance its burgeoning trade deficit. The US dollar is a high momentum currency, so we wouldn’t necessarily bet against the greenback in the near term (Chart 24). Nevertheless, with “long dollar” now a consensus trade, we would position for a weaker dollar over a 12-month horizon (Chart 25). Chart 24 Chart 25Long Dollar Is A Crowded Trade Long Dollar Is A Crowded Trade Long Dollar Is A Crowded Trade   Chart 26A Depreciating Dollar Next Year Should Help Non-US Equities A Depreciating Dollar Next Year Should Help Non-US Equities A Depreciating Dollar Next Year Should Help Non-US Equities A depreciating dollar next year should help non-US equities, especially beleaguered emerging markets (Chart 26). The dollar will strengthen anew in 2023, as the Fed is forced to turn more hawkish, and global equities begin to buckle.   Peter Berezin Chief Global Strategist pberezin@bcaresearch.com Global Investment Strategy View Matrix Image Special Trade Recommendations Image Current MacroQuant Model Scores Image

Over the past few weeks, we have received numerous questions on the interplay between the S&P 500 earnings and the forward P/E multiple. The clients are asking how much earnings need to grow for the S&P 500 forward multiple to come down from the hefty 21.5x towards a historical average of 18x.  To answer this question, we have created a matrix that summarizes permutations of changes in the index price and earnings growth and their effects on the resulting forward multiple. If we assume that the price of the S&P 500 does not budge, and investors get a 0% return over the next 12 months, earnings will have to grow by about 30% over the next 12 months for the multiple to come down to 18x – hardly a realistic scenario. If the S&P 500 returns 5%, then 30% earnings growth will result in the 19.6x multiple.  The sell-side analysts currently expect a 10% earnings growth over the next twelve months: With no change in the price of the index, the resulting multiple will be 21.5x. If the S&P 500 returns 5%, the multiple will move to 23.2x. Bottom Line: Strong earnings growth does not justify elevated valuations, and re-rating is hardly in the cards. Image  

Highlights Why have Value stocks underperformed so much during the past decade? The rise in intangible assets is likely the most important reason since traditional valuation metrics are no longer an accurate measure of intrinsic value. Value stocks today have a larger negative tilt to Quality than they did in the past. This has hurt Value due to Quality's outperformance. Value's underperformance is not just the result of the relative performance of a few sectors or industries, although this has played a role. Falling interest rates have not been the main driver of Value’s underperformance as they can only account for a small portion of returns. “Migration”, or mean-reversion in and out of value buckets, has declined since the Great Financial Crisis, possibly because of an increase in monopoly power. But even this cannot fully account for the underperformance since 2012. We propose that investors who wish to invest in Value screen for Quality. They should also express their Value tilts in sectors with few intangibles, such as Energy or Materials. More sophisticated stock pickers can adjust earnings and book values for intangibles. Asset allocators who invest only in indices should stay away from a structural allocation to Value. Feature Chart 1No Premium From Value Stocks Over The Last Four Decades No Premium From Value Stocks Over The Last Four Decades No Premium From Value Stocks Over The Last Four Decades Betting on cheap stocks has been a cornerstone of equity investing for decades. The rationale is simple: Stocks which are undervalued, according to some measure of intrinsic value, will eventually converge up to their fair value, on average, while stocks that are overvalued will converge down, on average. Historically, this bet on mean-reversion has proven successful – low price-to-book stocks have outperformed high price-to-book stocks by more than 3% per annum since 1927. However, the recent decades have put Value investing to the test. The Value factor, as defined by Fama and French, has not provided a structural premium in the US large cap space since the late 1970s (Chart 1, panel 1). Commercial Value indices haven’t been any more successful: Value aggregates by MSCI, Russell, and S&P have either underperformed or performed in line with the market benchmark over the same time frame (Chart 1, panel 2). The current situation presents a difficult dilemma. On the one hand, buying Value could be a tremendous opportunity. By several measures, Value stocks are the most undervalued they have been since the end of the tech bubble, right before they went on a historic run (Chart 2). Academic work has argued that these deep value spreads tend to be positively correlated with long-term outperformance of Value stocks.1 In a world of sky-high valuations and with equities and bonds projected to deliver very low returns over the next decade, a cheap return stream would be a fantastic addition to most portfolios. Chart 2Value Stocks Are Really Cheap Value Stocks Are Really Cheap Value Stocks Are Really Cheap Chart 3   And yet, Value has become so popular, that many investors are now worried that the Value premium may no longer exist. This worry is not without merit. Several studies have shown that factors lose a sizable portion of their premium once they appear in academic literature2  (Chart 3). Other issues, such as the inability of valuation metrics to properly account for intrinsic value in the modern economy, have also led some investors to seriously question whether buying Value indices will deliver excess returns in the future. So what is the right answer? Why has Value underperformed so much? Is the beaten down Value factor a generational buying opportunity? Or will it continue its decline going forward? In this report we try to answer these questions. Using a company-level dataset from our BCA Research Equity Analyzer (EA), as well as drawing on the latest academic research, we assess the evidence behind Five Theories On Value’s Underperformance. Once we determine which explanations have merit and which do not, we conclude by providing some guidelines on how investors should consider the Value factor going forward in our Investment Implications section. A word of caution: We have constructed our sample of companies to roughly resemble the sample used by MSCI World. Thus, the conclusions from our analysis based on the EA dataset should be relevant to Value indices in general. However, be advised that the methodology that EA uses is different from other commercial Value indices. Specifically, the EA methodology is more aggressive in its positioning and uses a wider array of metrics. For clarity, Table 1 shows the metrics used by EA compared to other Value indices. If you wish to know more on how the methodology works, please refer to the Appendix. Table 1Value Factor Methodologies Mythbusting The Value Factor Mythbusting The Value Factor Also, please note that our report will not deal with the cyclical outlook for Value. While it is entirely possible that a period of cyclical growth could help Value stocks outperform, the question we are trying to answer is whether buying cheap versus expensive stocks still provides a structural premium over the long term. While the Global Asset Allocation service does not use the Value versus Growth framework for equity allocation, our colleagues from our Global Investment Strategy service have written extensively on why they believe investors should pivot to Value on a cyclical basis.3 Five Theories On Value’s Underperformance Chart 4More To The Underperformance Of Value Than Sector Tilts More To The Underperformance Of Value Than Sector Tilts More To The Underperformance Of Value Than Sector Tilts Theory #1: The underperformance of Value indices is purely a result of their sector composition Some investors suggest that Value stocks’ large underweight of mega-cap tech, as well as their overweight in Financials and Energy, have been responsible for Value’s woes over the past decade. However, our research suggests that this theory is not entirely correct. A Value index with the same sector and industry weightings as the Developed Markets (DM) benchmark has still underperformed by more than 15% since 2010 (Chart 4, panel 1). Sector and industry composition have been responsible for about a third of the underperformance of the DM Value index. What about excluding the FAANGM stocks? Again, the story is similar. Even when omitting these stocks from our investment universe, Value stocks have still underperformed by almost the same amount as a regular Value composite (Chart 4, panel 2). Finally, we can also look at the performance of cheap versus expensive stocks within each industry. Chart 5A shows that cheap stocks have underperformed expensive stocks in 18 and 17 out the 24 GICS Level 2 industries in DM and in the US, respectively, since 2012 (roughly corresponding to the peak in relative performance in the EA Value index). Even on an equally-weighted basis, which eliminates the effects of large companies, cheap stocks have underperformed expensive stocks in both the average and median industry (Chart 5B). Chart 5 Chart 5 Verdict: Myth. The underperformance of cheap versus expensive stocks has been broad. While sector and industry dynamics have certainly been an important factor, Value's underperformance is not just the result of a few companies, sectors, or industries. Chart 6Value Likes Rising Yields... Value Likes Rising Yields... Value Likes Rising Yields... Theory #2: The decline in interest rates is to blame for the underperformance of Value Another reason used to explain the underperformance of Value is the secular decline in interest rates. The reasoning goes as follows: Cash flows from growth stocks are set to be received further into the future, while cash flows from Value stocks are closer to the present. Using a Discounted Cash Flow model, one can show that all else being equal, a decline in the discount rate should result in a relatively higher increase in the present value for Growth stocks versus Value stocks. There is some evidence in support of this theory. While prior to 2010, Value and interest rates had an inconsistent relationship, the beta of cheap stocks to the monthly change in the 10-year US Treasury yield has increased markedly over the past 10 years (Chart 6, panel 1). On the other hand, the beta of expensive stocks to yields has become increasingly more negative. A similar situation occurs when we use the yield curve. Cheap stocks tend to exhibit higher excess returns whenever it steepens, while expensive stocks do so when it flattens (Chart 6, panel 2). Importantly, these relationships are not purely a result of Value’s exposure to banks. Value stocks excluding financials also show a strong positive relationship to both the 10-year yield and yield curve slope versus their growth counterparts (Chart 7). But while this relationship is statistically significant, it fails to be economically significant. Our analysis shows that the betas to either interest rates or the slope of the yield curve only explain a small fraction of the performance of cheap or expensive stocks (Chart 8). This result is in line with the research from Maloney and Moskowitz, which showed that the vast majority of the decline in Value in recent years could not be explained by interest rates.4 Chart 7...Even When Excluding Financials... ...Even When Excluding Financials... ...Even When Excluding Financials... Chart 8...But Yields Don't Explain Much ...But Yields Don't Explain Much ...But Yields Don't Explain Much   Verdict: Myth. Cheap stocks have an increasingly positive beta to both the 10-year yield and the slope of the yield curve, whereas expensive stocks have an increasingly negative beta. However, while these betas are statistically significant, they can only account for a small portion of Value's underperformance. Theory #3: A decline in market mean-reversion is responsible for the underperformance of Value In a seminal paper, Fama and French describe the process of migration.5 Migration is when stocks move across different value buckets: For example, when stocks in the cheap bucket migrate to the neutral and expensive buckets, and when stocks in the expensive bucket migrate to the neutral or cheap buckets. Historically, this process of mean-reversion has provided a significant share of the Value premium. However, migration has declined significantly over the past decade (Chart 9, panel 1). The amount of market cap migrating each month as a percentage of total market cap has declined from over 12% before the GFC to less than 8% currently. Importantly, this decline in migration has been broad-based. Neither cheap, neutral, nor expensive stocks are moving to other valuation cohorts at the same rates that prevailed in the past (Chart 9, panel 2). The market has become much more ossified: Value stocks remain Value stocks, Neutral stocks remain Neutral stocks, and Growth stocks remain Growth stocks.5 Chart 9What Happens In Value Now Stays In Value What Happens In Value Now Stays In Value What Happens In Value Now Stays In Value Chart 10Market Concentration Could Be The Reason Why Migration Has Declined Market Concentration Could Be The Reason Why Migration Has Declined Market Concentration Could Be The Reason Why Migration Has Declined Why has migration declined? One theory is that industries have increasingly become more monopolistic, which means that it has become harder for new entrants to gain market share (Chart 10). Meanwhile market leaders are able to grow at an above-average pace thanks to their large network effects.6 What has been the role of this decreased migration in the performance of Value? A paper written by Arnott, Harvey, Kalesnik, and Linainmaa showed that while the returns attributable to migration have decreased over the past 15 years, this change is still not strong enough to explain the deep underperformance in Value.7 Our own research assigns it a relatively larger weight, with migration accounting for a little less than half of the underperformance of Value since 20128 (Table 2). Table 2Return Attribution Of Cheap And Expensive Stocks Mythbusting The Value Factor Mythbusting The Value Factor Verdict: Somewhat True. Migration has declined since the GFC, possibly because of an increase in monopoly power. While this decline has certainly played a role in the underperformance of Value, it explains, at most, less than half of the drawdown since 2012. Theory #4: Value has underperformed because it is increasingly a play on junk stocks Chart 11 It is a well-known empirical fact that cheap stocks tend to have lower Quality than expensive stocks. Conceptually this makes sense: Companies with higher profitability, more stability, and less leverage should trade at a valuation premium, whereas low income, high-debt companies should trade at a discount. However, this gap in Quality between cheap and expensive stocks is not always the same. Consider the composition of cheap and expensive stocks in 2000 – the eve of the tech bubble crash. About a third of expensive stocks were also junk (low quality), whereas 36% were quality stocks (Chart 11). Today, this composition is much different: Only about a fifth of the market capitalization of expensive stocks is junk, whereas quality stocks now make up 44% of the overall expensive cohort. On the other hand, the Quality of cheap stocks has deteriorated: Cheap junk stocks are now 37% of the cheap cohort versus 29% in 2000. Importantly, the difference in Quality between cheap and expensive stocks tends to be a good predictor for value returns (Chart 12). A big gap in the Quality factor often implies lower returns of cheap versus expensive stocks, whereas a small gap implies higher returns. These results are in line with similar research which has shown that Quality, or Quality proxies like profitability, can be used to enhance the Value factor.9 Chart 12Value Does Well When The Quality Gap Is Small Value Does Well When The Quality Gap Is Small Value Does Well When The Quality Gap Is Small Why is this the case? As we have discussed in the past, Quality has been one of the best performing factors over the past 30 years - likely driven by powerful behavioral biases as well as by the incentives in the money management industry.10 As a result, taking an overly negative position on this factor over a long enough period eventually eats away at the Value premium. Verdict: True. Value stocks today have a larger negative tilt to Quality than they did in the past. This negative tilt has hurt Value as excess returns of cheap stocks tend to be dependent on their Quality gap to expensive stocks. Theory #5: Value has underperformed because traditional valuation metrics are no longer a reliable indicator of intrinsic value How exactly to measure whether a company is cheap or expensive has been a matter of debate since the very beginnings of Value investing. Benjamin Graham famously cautioned against using book value as a measure of intrinsic value, preferring a more holistic approach. Today most index providers use a combination of traditional valuation metrics like price-to-book and price-to-earnings to build Value indices. It is fair to ask if these measures are still relevant for today’s companies. Intangible investment has become a much larger part of the economy, having surpassed tangible investment in the US in the late 1990s (Chart 13). However, both US GAAP and IFRS are very restrictive on the capitalization of R&D activities, which are known to originate valuable intangible assets.11 Other types of intangible capital such as unique production processes or customer lists are normally also expensed within SG&A expenses and are never capitalized unless there is an acquisition. This means that both the book value and earnings of intangible-heavy companies could be inadequate estimates of their true intrinsic value. Chart 13 Is there any evidence that this is the case? Using our EA dataset, we confirm that expensive companies generally have higher R&D expenditures as a percent of sales than cheap companies (Chart 14). Importantly, we see that the performance of Value within low R&D stocks is much better than the performance within high R&D stocks (Chart 15). This is line with the work of Dugar and Pozharny, who found that the value relevance for both earnings and book values has declined for high intangible companies, while it has stayed stable for low-intangible companies.12 This suggests that traditional valuation measures are losing their relevance as intangible-heavy companies become a larger part of the economy.13 Chart 14Growth Stocks Spend More On Intangibles Growth Stocks Spend More On Intangibles Growth Stocks Spend More On Intangibles Chart 15Are Traditional Metrics Underestimating Intrinsic Value In High-Intangible Companies? Are Traditional Metrics Underestimating Intrinsic Value In High-Intangible Companies? Are Traditional Metrics Underestimating Intrinsic Value In High-Intangible Companies? The effect of intangibles on traditional valuation metrics can also give us a clue as to why Value has performed well in some industries but not in others. Using a measure of intangible intensity derived by Dugar and Pozharny14 – which includes identifiable intangible assets, intellectual capital (as proxied by R&D spending), and organizational capital (as proxied by SG&A spending) – we can see that Value has done relatively better in industries with lower intangible intensity while it has performed relatively worse in industries with higher intangible intensity (Chart 16). Chart 16 Verdict: True. Value performs better when considering only companies with low R&D expenses or industries with low-intangible intensity. This suggests that the rise in intangible assets might be responsible for the underperformance of cheap stocks, as traditional valuation metrics may no longer be an accurate measure of intrinsic value in intangible-heavy companies or industries. Investment Implications Chart 17Investors Can Invest In Value Within Low-Intangible Sectors Investors Can Invest In Value Within Low-Intangible Sectors Investors Can Invest In Value Within Low-Intangible Sectors What does our analysis mean for investors? Aside from the most well-known practices to improve the performance of Value – for example, using a wide array of valuation metrics, exploiting value in small stocks, or using equal-weighted indices to avoid the effect of sector weightings or large companies15 – we would recommend investors first screen cheap stocks for quality to avoid Value traps. Investors should also account for the failure of traditional metrics to measure intangible assets. This can be done in two ways: The first is to take Value tilts only on intangible-light sectors such as Energy and Materials – for example, allocating only to the cheapest oil and materials stocks. For the last decade, the cheapest Energy and Materials companies have outperformed their respective sectors, even while overall Value has cratered (Chart 17). Alternatively, more sophisticated stock pickers can adjust valuation ratios to account for intangibles. There is some promise to this approach. Arnott, Harvey, Kalesnik, and Linainmaa showed that even a crude adjustment to the HML (High-Minus-Low) index consistently outperforms the regular value factor16 (Chart 18). What about asset allocators who invest only in broad indices? We would recommend that they stay away from structural allocations to commercial Value indices altogether. While it is true that sector rotations or interest-rate movements could benefit value on a short-term basis, in the long term, the negative Quality tilt of Value stocks should be a drag on returns. Additionally, it remains a big risk that indices based on traditional measures are underestimating intangible value. This underestimation will only get worse as the economy becomes more digitalized. Investors who wish to take advantage of trends like higher inflation or rising interest rates should just bet on cyclical sectors. So far this has been the right approach. Just this year, even though interest rates have increased by more than 60 basis points, and both Financials and Energy have outperformed IT by 13% and 30% respectively, Value stocks have underperformed Growth stocks (Chart 19). Chart 18Adjusting For Intangibles Improves Value Adjusting For Intangibles Improves Value Adjusting For Intangibles Improves Value Chart 19Rates Rose, Financials And Energy Outperformed IT, And Yet Value Underperformed Growth Rates Rose, Financials And Energy Outperformed IT, And Yet Value Underperformed Growth Rates Rose, Financials And Energy Outperformed IT, And Yet Value Underperformed Growth Appendix A Note On Methodology The Equity Analyzer service is a stock picking tool that applies a top-down approach to bottom-up stock picking. The crux of the platform is the BCA Score, which is a weighted composite of 30 cross sectionally percentile ranked factors. Within this report we focus on the value (price-to-earnings, price-to-book, price-to-cash, price-to-cash flow and price-to-sales) and quality (accruals, profitability, asset growth, and return on equity) factors used in the BCA Score model. Each of the factors are cross sectionally-percentile ranked, within the specified universe, where a score of 100% is best ranked stock according to that particular score. From here, we create the value and quality scores used in this report by equal-weighting and combining the scores from each value and quality factors. It is important to note that a high score does not mean the underlying value is high, but that it exhibits a better characteristic for forecasting future excess returns. For example, the stock with the highest value score would be considered the cheapest. The scores are re-calculated each period and applied on a one-period forward basis when calculating returns. To keep the analysis comparable the MSCI Data and relevant to our clients, we limit the universe of stocks to only those with a market capitalization greater than 1 billion USD. Also, unless otherwise specified, the scores are market-cap weighted when aggregated and all returns are in US dollars.   Juan Correa-Ossa, CFA Editor/Strategist juanc@bcaresearch.com Lucas Laskey Senior Quantitative Analyst lucasl@bcaresearch.com Footnotes 1  Please see Clifford Asness, John M. Liew, Lasse Heje Pedersen, and Ashwin K Thapar, “Deep Value,” The Journal of Portfolio Management, 47-64 (11-40), 2021.2   2  Please see Andrew Y. Chen and Mihail Velikov, “Zeroing in on the Expected Returns of Anomalies,” Finance and Economic Discussion Series 2020-039, Board of Governors of the Federal Reserve. 3 Please see Global Investment Strategy Report, “Pivot To Value,” dated September 18, 2020. 4 Please see Thomas Maloney and Tobias J. Moskowitz, “Value and Interest Rates: Are Rates to Blame for Value’s Torments?” The Journal of Portfolio Management, 47-6 (65-87), 2021. 5 Please see Eugene Fama and Kenneth French, “Migration,” Financial Analyst Journal, 63-3 (48-58), 2007. 6 Please see Robert D. Arnott, Campbell R. Harvey, Vitali Kalesnik and Juhani T. Linainmaa, “Reports of Value’s death May Be Greatly Exaggerated,” Financial Analyst Journal, 77-1 (44-67), 2021. 7  Please see Robert D. Arnott, Campbell R. Harvey, Vitali Kalesnik and Juhani T. Linainmaa (2021). 8  Much like us, Lev and Srivastava assign a relatively bigger role to the decline in migration. For more details, please see Baruch Lev and Anup Srivastava, “Explaining the Recent Failure of Value Investing,” NYU Stern School of Business (2019). 9  Please see Clifford Asness, Andrea Frazzini, Ronen Israel and Tobias Moskowitz, “Fact, Fiction, and Value Investing,” The Journal of Portfolio Management, 42-1 (34-52), 2015. 10 Please see Global Asset Allocation Special Report, “Junk Disposal: The Quality Factor In Equity Markets,” dated September 8, 2020. 11 US GAAP requires both Research and Development costs to be expensed. IFRS prohibits capitalization of Research cost but allows it for Development costs provided that some conditions are met. For a further discussion on the accounting treatment of intangibles, please see Amitabh Dugar and Jacob Pozharny, “Equity Investing in the Age of Intangibles,” Financial Analyst Journal, 77-2 (21-42), 2021. 12 Please see Amitabh Dugar and Jacob Pozharny (2021). 13This also follows from research from Lev and Srivastava which showed that while capitalizing intangibles did not improve the value factor in the 1970s, it increased returns substantially after the 1990s. For more details, please see Baruch Lev and Anup Srivastava (2019). 14This measure excludes Banks, Diversified Financials, and Insurance. For more details, please see Amitabh Dugar and Jacob Pozharny (2021). 15Please see Clifford Asness, Andrea Frazzini, Ronen Israel and Tobias Moskowitz (2015). 16Please see Robert D. Arnott, Campbell R. Harvey, Vitali Kalesnik and Juhani T. Linainmaa (2021).