Market Capitalization: Large / Small
Highlights The US business cycle is shifting into a slowdown stage: US economic and earnings growth will remain robust but decelerate from their peak. Treasury rates have stabilized, and inflation fears, if not dissipated, have become priced in. The consumer is flash with cash, and pent-up demand has not yet faded. Demand for services exceeds demand for goods. Valuations are rich, and short-term consolidation is likely. Considering this market backdrop, we recommend a barbell positioning for equity portfolios – a combination of Growth and Cyclicals: Shift allocation towards stable growth sectors, such as Technology, which are getting a shot in the arm from rates stabilization and the growth slowdown. Take a granular approach to selection of cyclical sectors and industries, with preference for the ones most exposed to consumer pent-up demand for goods and services and to a revival of global trade flows. Differentiate between Value and Cyclicals: Cyclicals are more “growthy” than run-of-the-mill Value sectors. Feature In our report of June 7, 2021, we outlined our investment framework. In this report we apply our investment principles to analyze the state of the equity markets today and derive investment recommendations. Business Cycle Is Shifting Into A Slowdown Stage The pandemic is barely over, but the markets have already galloped through both the recovery and expansion stages of the business cycle on the back of economic reopening, fiscal and monetary stimulus, and pent-up demand (Table 1). Table 1Stages Of The Business Cycle We posit that the business cycle is at the crest of the expansion stage and is shifting into a moderate slowdown. While growth is to remain robust, it has most likely peaked and is starting to decelerate: The ISM Composite reading is elevated but has slipped from a high of 64.2 in March to 62.6 in June (Chart 1). According to Bloomberg consensus estimates, GDP growth is to slow from 6.4% in 2021 to 4% in 2022. The earnings cycle is also peaking. In Q1-2021 US equities delivered 53% YoY earnings growth. Going forward, expectations are for 21% (Chart 2). Chart 1ISM Composite Has Peaked Chart 2EPS Growth Has Also Peaked While earnings growth is expected to remain robust, a change in pace often manifests itself in a change of market leadership from Value to Growth. Prices Set To Rise But At A Slower Pace Since the beginning of this year, investors’ eyes have been fixed on rising inflation readings. The crux of the debate was centered on whether high inflation is here to stay or is a transitory phenomenon. While we don’t have a definitive answer yet, there is a sufficient body of evidence to suggest that inflation is likely to decelerate. First, the 5-year inflation breakeven has stabilized indicating that the market expects consumer price increases to moderate (Chart 3). Second, the recent spike in the inflation reading has been exacerbated by the base effect of comparison with the darkest days of the pandemic in March-May 2020. Inflation troughed in June of 2020, which will anchor this coming summer’s inflation numbers to a higher base. (Chart 4). Chart 3Inflation Breakeven Stabilized Chart 4Base Effects Of The Spring 2020 Are To Roll Off Third, inflation is likely to dissipate to more normal levels later in the year thanks to millions rejoining the labor force upon expiration of supplemental employment insurance benefits in the fall, and the supply chain gradually becoming unclogged. Last, the bubble in commodities prices has burst with prices of lumber, corn and steel coming down from their highs by more than 30%, keeping a lid on PPI, and subsequently on the price of finished goods (Chart 5 & Chart 6) . Chart 5Bubble In Commodities Burst Chart 6PPI To Follow Commodity Prices Rates Are Stabilizing After rising by nearly 1% from 0.5% to 1.5% in the course of just four months from November 2020 to February 2021, the 10-year Treasury yield has been range bound between 1.5% and 1.7% despite fireworks in the US economic data ranging from CPI readings to unemployment beats (Chart 7). The fact that the bond market is refusing to budge no matter how positive a macro release number we get, confirms our view that a post Covid-19 economic revival and accelerated growth have been priced in. Case in point: The Citi Economic Surprise Index (CESI) turned down from its February highs and is approaching zero. Chart 7Rates Are Range Bound Since March Given the tight positive correlation (44%) between CESI and UST10Y, and inflation moderating, it is unlikely that the bond market will enter another aggressive sell-off phase (Chart 8). It is possible that rates will continue to grind higher over the summer, but the rate of ascent, which is more important for growth-oriented assets than the level (excluding extreme readings), is likely to be slow. Chart 8Positive Economic Data Is Priced In Consumers Are Flash With Cash After a series of helicopter cash drops, most consumers came out of the recession in a better financial shape than they entered it. According estimates by Peter G Peterson Foundation, only 22% and 19% of second and third round of stimulus checks have been spent (in addition, some of the money was used to pay off debt). Personal savings have increased by roughly $1.5 trillion from January 2020 trough, and disposable income has increased by 6% (Chart 9). With plentiful jobs and quit rates off the map, we expect consumer confidence to remain high and support spending. The investment implication is that we favor parts of the equity market most exposed to American consumer. Chart 9Consumers Are Flash With Cash Services Are In Higher Demand Than Goods After months of consumer behavior altered by fears of the pandemic, economic reopening has brought about strong demand for services. Indeed, the latest Non-manufacturing ISM PMI reading was 64 compared to 61 for Manufacturing, which has clearly peaked. As a result, we favor service sectors, both in the consumer and industrial space (Chart 10). Chart 10Demand For Services Outstrips Demand For Goods Global Trade Flows Are Soaring The global push for vaccinations and pent-up demand have jump-started trade flows around the globe. Despite shipping bottlenecks and container shortages, global trade is thriving, strengthening demand for industrial goods and transportation services (Chart 11). Chart 11Global Trade Soars Valuations Are Elevated The US equity market had a fantastic run over the past year, delivering 93% return from March 2020 trough, and is now trading at 30x trailing PE. Forward-looking PE is also elevated at 23x. About 40% of S&P 500 industry groups are trading in the top 10% of their historical valuations. In a way, markets have borrowed returns from the future (Chart 12). With valuations close to an all-time high, equity markets do not have much safety margin and are vulnerable to a correction which may be triggered by hawkish rhetoric from the Fed, or upside inflation or employment surprises. Having said that, we are bullish on equity markets on a three to six months horizon. Chart 12US Equities Are Expensive Lastly, high valuation is not necessarily an impediment to a continued bull market but more of a speed limit: Returns of US equities are to be modest going forward. To keep portfolio return volatility down and enhance compounding effects, we recommend carrying a healthy allocation to such defensive sectors as Health Care. We would stay away from bond proxies like Utilities and Telecom. Investment Implications To sum it all up: Economic and earnings growth is to remain robust but come down from the peak, inflation is to decelerate but stay high, rates are to remain stable, consumer spending is to stay robust, demand for services is to exceed demand for goods and global trade flows are soaring. What do these economic developments mean for portfolio positioning? What styles and sectors will fare best in the current economic environment? Growth does well when rates and inflation are stabilizing thanks to the long duration nature of its earnings stream, and shines in a slowdown when growth becomes scarcer. Cyclicals thrive in an environment of falling inflation, but a mature cycle is not an ideal backdrop for their outperformance. In terms of sector selection, we favor Cyclicals with exposure to consumers, playing growth through the “new economy”, i.e. Software and Services, and Internet Retailing. We will fund the new positions by taking profits from recent winners, Financials and Materials. The following is a brief rationale for these allocations. Value/Growth Rotation Between November 5, 2020 and May 7, 2021, long-duration Growth equities underperformed Value equities by 16%, beaten down by rising rates and accelerating economic growth. However, recently the case for Growth has strengthened. With rates stabilizing and inflation decelerating, there are already early signs that Growth stocks are staging a comeback, outperforming Value by 2.5% since May 10. Chart 13 shows that, in an enviroment of slowing inflation, Growth tends to outperform Value (Chart 14). Chart 13Growth Underperforms Value Since October 2020 Chart 14Growth Has Outperformed When Inflation Decelerates Further, peak economic and earnings growth, as well as the business cycle moving into a slowdown stage, bode well for Growth sectors (Chart 15). Chart 15Growth Shines In A Slowdown Stage Chart 16Growth Is Less Frothy Now Further, zooming into fundamentals and valuations, we observe that Growth stocks remain expensive, trading at a forward multiple of 27x, which is a 53% premium to Value, but some of the froth has come off as the style is now trading 3 points lower than back in December 2020 (Chart 16). Comparing Growth and Value earnings expectations, Value stocks are expected to grow about 10% faster than Growth stocks (Chart 17). The crux of the current Growth/Value dilemma is that, while optically Value is more attractive: cheaper than Growth and offering higher earnings growth, it is also much more sensitive to a slowdown in economic growth and rates stabilization (even if rates remain high). Thus, if we are right and rates and inflation have indeed steadied, and growth is slowing. Growth will outperform Value despite the latter’s superior fundamentals. The explanation lies in a sector composition of the two styles. Value’s top allocation is Financials, for which stabilizing rates and a flattening yield curve are detrimental. Growth’s top allocation is Information Technology (40% of the index), which thrives in an environment of lower growth and stable rates (Chart 18). All in all, we recommend topping up Growth sectors in a portfolio to be better positioned for an imminent change in regime. Chart 17Value Is Expected To Have Higher Earnings Growth Chart 18Growth Is Exposed To Tech, Value To Financials Cyclicals Vs Defensives Similarly to Value, Cyclicals have outperformed Defensives by about 10.7% since November. However, in March this rally ran out of steam, and relative returns remain range bound Chart 19. Further, performance of Cyclicals is sensitive to the stages of the business cycle. Normally, in a slowdown stage, Cyclicals lag. Chart 20 shows performance of Cyclicals during the slowdown stage of the business cycles. Chart 19Cyclicals Have Not Outperformed Defensives Since March Chart 20Slowdown Regime Doesn’t Favor Cyclicals However, this cycle may turn out somewhat different due to supply-chain disruptions and pent-up demand. Many of the conditions supporting Cyclicals are still in place: The potential infrastructure package, improving global trade and easy financial conditions. Earnings expectations relative to Defensives remain robust, and valuations have recently compressed from a 97% premium in February 2021, to 17% in May (Chart 21). Hence, we are not yet ready to give up on Cyclical stocks but will be granular in our allocations, favoring industry groups most exposed to services, global trade, infrastructure, and the US consumer. Chart 21Cyclicals Have Rerated Rel To Defensives Are Cyclicals The Same As Value? The reader may observe that we favor Cyclicals over Value and wonder if they are not one and the same. While recently Value and Cyclicals have been nearly 90% correlated (Chart 22), this relationship changes over time. Cyclicals have higher exposure than Value to stable growth sectors like Technology, and Consumer Discretionary (Chart 23). We prefer Cyclicals to Value because Technology is a quintessential growth sector favored by the current macroeconomic backdrop, and the Consumer Discretionary sector is exposed to increases in discretionary income and consumer demand for services. Choosing between Value and Cyclicals, we pick Cyclicals (Chart 23). Chart 22Relationship Between Value And Cyclicals Changes Over Time Chart 23Cyclicals Have More Exposure To Stable Growth Than Value Investment Recommendations Overweight Growth-Oriented And Cyclical Sectors Growth-oriented industries groups and industries benefiting from rate stabilization, such as Software and IT Services, Semiconductors, and Internet Retail. Valuations are expensive but are justified by strong expected long-term earnings growth. Cyclical industries exposed to consumer demand for services and experiences, such as Hotels, Restaurants, Entertainment, and Airlines. Discretionary goods industry groups such as Autos & Components, and Consumer Durables. Industrial service-oriented industry groups, such as Transportation and Professional Services Global trade and infrastructure exposed industries such as Transportation, Construction and Engineering, and Building Materials. Equal Weight Defensive Sectors Health care valuations and returns have been subdued due to disruptions wrecked by the pandemic. However, in addition to trading at 16x forward earnings, the sector expects solid earnings growth (10% over the next 12 months) and is likely to benefit from post-Covid-19 normalization in health care and diminished policy risks. To be more specific, policy risk for Big Pharma is higher as it is a bipartisan target, while managed health care got a big positive policy surprise when Biden wisely decided earlier this year not to re-fight the health care battles of the Obama administration. Underweight Sectors Negatively Affected By Rate And Inflation Stabilization (Off High Levels) Rate stabilization and yield-curve flattening is detrimental to rate-sensitive sectors such as Banks and Insurance. Inflation deceleration will be detrimental to industry groups with high pricing power and high exposure to raw materials. Since commodities prices have rolled over, the Metals and Mining industry group may take a pause. We will also avoid bond-proxy sectors like Utilities and Consumer Staples: Rates have stabilized but a bull market in bonds is highly unlikely Bottom Line Peak growth, inflation and rates stabilization herald a new lease of life for Growth stocks. Strong consumption and pent-up demand for goods and services as well as a revival of global trade support further outperformance of Cyclicals. Irene Tunkel Chief Strategist, US Equity Strategy irene.tunkel@bcaresearch.com Recommended Allocation
Highlights President Biden has called for the US intelligence community to investigate the origins of COVID-19 and one of Biden’s top diplomats has stated the obvious: the era of “engagement” with China is over. This clinches our long-held view that any Democratic president would be a hawk like President Trump. The US-China conflict – and global geopolitical risk – will revive and undermine global risk appetite. China faces a confluence of geopolitical and macroeconomic challenges, suggesting that its equity underperformance will continue. Domestic Chinese investors should stay long government bonds. Foreign investors should sell into the bond rally to reduce exposure to any future sanctions. The impending agreement of a global minimum corporate tax rate has limited concrete implications that are not already known but it symbolizes the return of Big Government in the western world. Our updated GeoRisk Indicators are available in the Appendix, as well as our monthly geopolitical calendar. Feature In our quarterly webcast, “Geopolitics And Bull Markets,” we argued that geopolitical themes matter to investors when they have a demonstrable relationship with the macroeconomic backdrop. When geopolitics and macro are synchronized, a simple yet powerful investment thesis can be discerned. The US war on terror, Russia’s resurgence, the EU debt crisis, and Brexit each provided cases in which a geopolitically informed macro view was both accessible and actionable at an early stage. Investors generally did well if they sold the relevant country’s currency and disfavored its equities on a relative basis. Chart 1China's Decade Of Troubles Of course, the market takeaway is not always so clear. When geopolitics and macroeconomics are desynchronized, the trick is to determine which framework will prevail over the financial markets and for how long. Sometimes the market moves to its own rhythm. The goal is not to trade on geopolitics but rather to invest with geopolitics. One of our key views for this year – headwinds for China – is an example of synchronization. Two weeks ago we discussed China’s macroeconomic challenge. In this report we discuss China’s foreign policy challenge: geopolitical pressure from the US and its allies. In particular we address President Biden’s call for a deeper intelligence dive into the origins of COVID-19. The takeaway is negative for China’s currency and risk assets. The Great Recession dealt a painful blow to the Chinese version of the East Asian economic miracle. By 2015, China’s financial turmoil and currency devaluation should have convinced even bullish investors to keep their distance from Chinese stocks and the renminbi. If investors stuck with this bearish view despite the post-2016 rally, on fear of trade war, they were rewarded in 2018-19. Only with China’s containment of COVID-19 and large economic stimulus in 2020 has CNY-USD threatened to break out (Chart 1). We expect the renminbi to weaken anew, especially once the Fed begins to taper asset purchases. Our cyclical view is still bullish but US-China relations are unstable so we remain tactically defensive. Forget Biden’s China Review, He’s A Hawk Chinese financial markets face a host of challenges this year, despite the positive factors for China’s manufacturing sector amid the global recovery. At home these challenges consist of a structural economic slowdown, a withdrawal of policy stimulus, bearish sentiment among households, and an ongoing government crackdown on systemic risk. Abroad the Democratic Party’s return to power in Washington means that the US will bring more allies to bear in its attempt to curb China’s rise. This combination of factors presents a headwind for Chinese equities and a tailwind for government bonds (Chart 2). This is true at least until the government should hit its pain threshold and re-stimulate. Chart 2Global Investors Still Wary New stimulus may not occur in 2022. The Communist Party’s leadership rotation merely requires economic stability, not rapid growth. While the central government has a record of stimulating when its pain threshold is hit, even under the economically hawkish President Xi Jinping, a financial market riot is usually part of this threshold. This implies near-term downside, particularly for global commodities and metals, which are also facing a Chinese regulatory backlash to deter speculation. In this context, President Biden’s call for a deeper US intelligence investigation into the origin of COVID-19 is an important confirming signal of the US’s hawkish turn toward China. Biden gave 90 days for the intelligence community to report back to him. We will not enter into the debate about COVID-19’s origins. From a geopolitical point of view it is a moot point. The facts of the virus origin may never be established. According to Biden’s statement, at least one US intelligence agency believes the “lab leak theory” is the most likely source of the virus (while two other agencies decided in favor of animal-to-human transmission). Meanwhile Chinese government spokespeople continue to push the theory that the virus originated at the US’s Fort Detrick in Maryland or at a US-affiliated global research center. What is certain is that the first major outbreak of a highly contagious disease occurred in Wuhan. Both sides are demanding greater transparency and will reject each other’s claims based on a lack of transparency. If the US intelligence report concludes that COVID originated from the Wuhan Institute of Virology, the Chinese government and media will reject the report. If the report exonerates the Wuhan laboratory, at least half of the US public will disbelieve it and it will not deter Biden from drawing a hard line on more macro-relevant policy disputes with China. The US’s hawkish bipartisan consensus on China took shape before COVID. Biden’s decision to order the fresh report introduces skepticism regarding the World Health Organization’s narrative, which was until now the mainstream media’s narrative. Previously this skepticism was ghettoized in US public discourse: indeed, until Biden’s announcement on May 26, the social media company Facebook suppressed claims that the virus came from a lab accident or human failure. Thus Biden’s action will ensure that a large swathe of the American public will always tend to support this theory regardless of the next report’s findings. At the same time Biden discontinued a State Department effort to prove the lab leak theory, which shows that it is not a foregone conclusion what his administration will decide. The good news is that even if the report concluded in favor of the lab leak, the Biden administration would remain highly unlikely to demand that China pay “reparations,” like the Trump administration demanded in 2020. This demand, if actualized, would be explosive. The bad news is that a future nationalist administration could conceivably use the investigation as a basis to demand reparations. Nationalism is a force to be reckoned with in both countries and the dispute over COVID’s origin will exacerbate it. Traditionally the presidents of both countries would tamp down nationalism or attempt to keep it harnessed. But in the post-Xi, post-Trump era it is harder to control. The death toll of COVID-19 will be a permanent source of popular grievance around the world and a wedge between the US and China (Chart 3). China’s international image suffered dramatically in 2020. So far in 2021 China has not regained any diplomatic ground. Chart 3Death Toll Of COVID-19 The US is repairing its image via a return to multilateralism while the Europeans have put their Comprehensive Agreement on Investment with China on hold due to a spat over sanctions arising from western accusations of genocide (a subject on which China pointedly answered that it did not need to be lectured by Europeans). Notably Biden’s Department of State also endorsed its predecessor’s accusation of genocide in Xinjiang. Any authoritative US intelligence review that solidifies doubts about the WHO’s initial investigation – even if it should not affirm the lab leak theory – would give Biden more ammunition in global opinion to form a democratic alliance to pressure China (for example, in Europe). An important factor that enables the US to remain hawkish on China is fiscal stimulus. While stimulus helps bring about economic recovery, it also lowers the bar to political confrontation (Chart 4). Countries with supercharged domestic demand do not have as much to fear from punitive trade measures. The Biden administration has not taken new punitive measures against China but it is clearly not worried about Chinese retaliation. Chart 4Large Fiscal Stimulus Lowers The Bar To Geopolitical Conflict China’s stimulus is underrated in this chart (which excludes non-fiscal measures) but it is still true that China’s policy has been somewhat restrained and it will need to stimulate its economy again in response to any new punitive measures or any global loss of confidence. At least China is limited in its ability to tighten policy due to the threat of US pressure and western trade protectionism. Simultaneous with Biden’s announcement on COVID-19, his administration’s coordinator for Indo-Pacific affairs, Kurt Campbell, proclaimed in a speech that the era of “engagement” with China is officially over and the new paradigm is one of “competition.” By now Campbell is stating the obvious. But this tone is a change both from his tone while serving in President Obama’s Department of State and from his article in Foreign Affairs last year (when he was basically auditioning for his current role in the Biden administration).1 Campbell even said in his latest remarks that the Trump administration was right about the “direction” of China policy (though not the “execution”), which is candid. Campbell was speaking at Stanford University but his comments were obviously aimed for broader consumption. Investors no longer need to wait for the outcome of the Biden administration’s comprehensive review of policy toward China. The answer is known: the Biden administration’s hawkishness is confirmed. The Department of Defense report on China policy, due in June, is very unlikely to strike a more dovish posture than the president’s health policy. Now investors must worry about how rapidly tensions will escalate and put a drag on global sentiment. Bottom Line: US-China relations are unstable and pose an immediate threat to global risk appetite. The fundamental geopolitical assessment of US-China relations has been confirmed yet again. The US is seeking to constrain China’s rise because China is the only country capable of rivaling the US for supremacy in Asia and the world. Meanwhile China is rejecting liberalization in favor of economic self-sufficiency and maintaining an offensive foreign policy as it is wary of US containment and interference. Presidents Biden and Xi Jinping are still capable of stabilizing relations in the medium term but they are unlikely to substantially de-escalate tensions. And at the moment tensions are escalating. China’s Reaction: The Example Of Australia How will China respond to Biden’s new inquiry into COVID’s origins? Obviously Beijing will react negatively but we would not expect anything concrete to occur until the result of the inquiry is released in 90 days. China will be more constrained in its response to the US than it has been with Australia, which called for an international inquiry early last year, as the US is a superior power. Australia was the first to ban Chinese telecom company Huawei from its 5G network (back in 2018) and it was the first to call for a COVID probe. Relations between China and Australia have deteriorated steadily since then, but macro trends have clearly driven the Aussie dollar. The AUD-JPY exchange rate is a good measure for global risk appetite and it is wavering in recent weeks (Chart 5). Chart 5Australian Dollar Follows Macro Trends, Rallies Amid China Trade Spat Tensions have also escalated due to China’s dependency on Australian commodity exports at a time of spiking commodity prices. This is a recurring theme going back to the Stern Hu affair. The COVID spat led China to impose a series of sanctions against Australian beef, barley, wine, and coal. But because China cannot replace Australian resources (at least, not in the short term), its punitive measures are limited. It faces rising producer prices as a result of its trade restrictions (Chart 6). This dependency is a bigger problem for China today than it was in previous cycles so China will try to diversify. Chart 6Constraints On China's Tarrifs On Australia By contrast, China is not likely to impose sanctions on the US in response to Biden’s investigation, unless Biden attacks first. China’s imports from the US are booming and its currency is appreciating sharply. Despite Beijing’s efforts to keep the Phase One trade deal from collapsing, Biden is maintaining Trump’s tariffs and the US-China trade divorce is proceeding (Chart 7). Bilateral tariff rates are still 16-17 percentage points higher than they were in 2018, with US tariffs on China at 19% (versus 3% on the rest of the world) while Chinese tariffs on the US stand at 21% (versus 6% on the rest of the world). The Biden administration timed this week’s hawkish statements to coincide with the first meeting of US trade negotiators with China, which was a more civil affair. Both countries acknowledged that the relationship is important and trade needs to be continued. However, US Trade Representative Katherine Tai’s comments were not overly optimistic (she told Reuters that the relationship is “very, very challenging”). She has also been explicit about maintaining policy continuity with the Trump administration. We highly doubt that China’s share of US imports will ever surpass its pre-Trump peaks. The Biden administration has also refrained so far from loosening export controls on high-tech trade with China. This has caused a bull market in Taiwan while causing problems for Chinese semiconductor stocks’ relative performance (Chart 8). If Biden’s policy review does not lead to any relaxation of export controls on commercial items then it will mark a further escalation in tensions. Chart 7US Tarrifs Reduce China In Trade Deficit Bottom Line: Until Presidents Biden and Xi stabilize relations at the top, the trade negotiations over implementing the Phase One trade deal – and any new Phase Two talks – cannot bring major positive surprises for financial markets. Chart 8US Export Controls Amid Chip Shortage Congress Is More Hawkish Than Biden Biden’s ability to reduce frictions with China, should he seek to, will also be limited by Congress and public opinion. With the US deeply politically divided, and polarization at historically high levels, China has emerged as one of the few areas of agreement. The hawkish consensus is symbolized by new legislation such as the Strategic Competition Act, which is making its way through the Senate rapidly. Congress is also trying to boost US competitiveness through bills such as the Endless Frontier Act. These bills would subject China to scrutiny and potential punitive measures over a broad range of issues but most of all they would ignite US industrial policy , STEM education, and R&D, and diversify the US’s supply chains. We would highlight three key points with regard to the global impact of this legislation: Global supply chains are shifting regardless: This trend is fairly well established in tech, defense, and pharmaceuticals. It will continue unless we see a major policy reversal from China to try to court western powers and reduce frictions. The EU and India are less enthusiastic than the US and Australia about removing China from supply chains but they are not opposed. The EU Commission has recommended new defensive economic measures that cover supply chains in batteries, cloud services, hydrogen energy, pharmaceuticals, materials, and semiconductors. As mentioned, the EU is also hesitating to ratify the Comprehensive Agreement on Investment with China. Hence the EU is moving in the US’s direction independently of proposed US laws. After all, China’s rise up the tech value chain (and its decision to stop cutting back the size of its manufacturing sector) ultimately threatens the EU’s comparative advantage. The EU is also aligned with the US on democratic values and network security. India has taken a harder stance on China than usual, which marks an important break with the past. India’s decision to exclude Huawei from its 5G network is not final but it is likely to be at least partially implemented. A working group of democracies is forming regardless. The Strategic Competition Act calls for the creation of a working group of democracies but the truth is that this is already happening through more effective forums like the G7 and bilateral summits. Just as the implementation of the act would will ultimately depend on President Biden, so the willingness of other countries to adopt the recommendations of the working group would depend on their own executives. Allies have leeway as Biden will not use punitive measures against them: Any policy change from the EU, UK, India, and Australia will be independent of the US Congress passing the Strategic Competition Act. These countries will be self-directed. The US would have to devote diplomatic energy to maintaining a sustained effort by these states to counter China in the face of economic costs. This will be limited by the fact that the Biden administration will be very reluctant to impose punitive measures on allies to insist on their cooperation. The allies will set the pace of pressure on China rather than the United States. This gives the EU an important position, particularly Germany. And yet the trends in Germany suggest that the government will be more hawkish on China after the federal elections in September. Bottom Line: The Biden administration is unlikely to use punitive measures against allies so new US laws are less important than overall US diplomacy with each of the allies. Some allies will be less compliant with US policies given their need for trade with China. But so far there appears to be a common position taking shape even with the EU that is prejudicial to China’s involvement in key sectors of emerging technologies. If China does not respond by reducing its foreign policy assertiveness, then China’s economic growth will suffer. That drag would have to be offset by new supply chain construction in Southeast Asia and other countries. Investment Takeaways The foregoing highlights the international risks facing China even at a time when its trend growth is slowing (Chart 9) and its ongoing struggle with domestic financial imbalances is intensifying. China’s debt-service costs have risen sharply and Beijing is putting pressure on corporations and local governments to straighten out their finances (Chart 10), resulting in a wave of defaults. This backdrop is worrisome for investors until policymakers reassure them that government support will continue. Chart 9China's Growth Potential Slowing Chart 10China's Leaders Struggle With Debt China’s domestic stability is a key indicator of whether geopolitical risks could spiral out of control. In particular we think aggressive action in the Taiwan Strait is likely to be delayed as long as the Chinese economy and regime are stable. China has rattled sabers over the strait this year in a warning to the United States not to cross its red line (Chart 11). It is not yet clear how Biden’s policy continuity with the Trump administration will affect cross-strait stability. We see no basis yet for changing our view that there is a 60% chance of a market-negative geopolitical incident in 2021-22 and a 5% chance of full-scale war in the short run. Chart 11China PLA Flights Over Taiwan Strait Putting all of the above together, we see substantial support for two key market-relevant geopolitical risks: Chinese domestic politics (including policy tightening) and persistent US-China tensions (including but not limited to the Taiwan Strait). We remain tactically defensive, a stance supported by several recent turns in global markets: The global stock-to-bond ratio has rolled over. China is a negative factor for global risk appetite (Chart 12). Global cyclical equities are no longer outperforming defensives. There is a stark divergence between Chinese cyclicals and global cyclicals stemming from the painful transition in China’s bloated industrial economy (Chart 13). Global large caps are catching a bid relative to small caps (Chart 14). Chart 12Global Stock-To-Bond Ratio Rolled Over Chart 13Global Cyclicals-To-Defensives Pause Chart 14Global Large Caps Catch A Bid Versus Small Caps Cyclically the global economic recovery should continue as the pandemic wanes. China will eventually relax policy to prevent too abrupt of a slowdown. Therefore our strategic portfolio reflects our high-conviction view that the current global economic expansion will continue even as it faces hurdles from the secular rise in geopolitical risk, especially US-China cold war. Measurable geopolitical risk and policy uncertainty are likely to rebound sooner rather than later, with a negative impact on high-beta risk assets. Matt Gertken Vice President Geopolitical Strategy mattg@bcaresearch.com Coda: Global Minimum Tax Symbolizes Return Of Big Government On Thursday, the US Treasury Department released a proposal to set the global minimum corporate tax rate at 15%. The plan is to stop what Treasury Secretary Janet Yellen has referred to as a global “race to the bottom” and create the basis for a rehabilitation of government budgets damaged by pandemic-era stimulus. Although the newly proposed 15% rate is significantly below President Biden’s bid to raise the US Global Intangible Low-Taxed Income (GILTI) rate to 21% from 10.5%, it is the same rate as his proposed minimum tax on corporate book income. Biden is also raising the headline corporate tax rate from 21% to around 25% (or at highest 28%). Negotiators at the OECD were initially discussing a 12.5% global minimum rate. The finance ministers of both France and Germany – where the corporate income tax rates are 32.0% and 29.9%, respectively – both responded positively to the announcement. However, Ireland, which uses low corporate taxes as an economic development strategy, is obviously more comfortable with a minimum closer to its own 12.5% rate. Discussions are likely to occur when G7 finance ministers meet on June 4-5. Countries are hoping to establish a broad outline for the proposal by the G20 meeting in early July. It is highly likely that the OECD will come to an agreement. However, it is not a truly “global” minimum as there will still be tax havens. Compliance and enforcement will vary across countries. A close look at the domestic political capital of the relevant countries shows that while many countries have the raw parliamentary majorities necessary to raise taxes, most countries have substantial conservative contingents capable of preventing stiff corporate tax hikes (Table 1, in the Appendix). Our Geopolitical strategists highlight that the Biden administration’s compromise on the minimum rate reflects its pragmatism as well as emphasis on multilateralism. Any global deal will be non-binding but the two most important low-tax players are already committed to raising corporate rates well above this level: Biden’s plan is noted above, while the UK’s budget for March includes a jump in the business rate to 25% in April 2023 from the current 19%. Ireland and Hungary are the only outliers but they may eventually be forced to yield to such a large coalition of bigger economies (Chart 15). Chart 15Global Minimum Corporate Tax Impact Is Symbolic Rather Than Concrete Thus a nominal minimum corporate tax rate is likely to be forged but it will not be truly global and it will not change the corporate rate for most countries. The reality of what companies pay will also depend on loopholes, tax havens, and the effective tax rate. Bottom Line: On a structural horizon, the global minimum corporate tax is significant for showing a paradigm shift in global macro policy: western governments are starting to raise taxes and revenue after decades of cutting taxes. The experiment with limited government has ended and Big Government is making a comeback. On a cyclical horizon, the US concession on global minimum tax is that the Biden administration aims to be pragmatic and “get things done.” Biden is also working with Republicans to pass bills covering some bipartisan aspects of his domestic agenda, such as trade, manufacturing, and China. The takeaway from a global point of view is that Biden may prove to be a compromiser rather than an ideologue, unlike his predecessors. Matt Gertken Vice President Geopolitical Strategy mattg@bcaresearch.com Roukaya Ibrahim Vice President Daily Insights RoukayaI@bcaresearch.com Footnotes 1 Kurt M. Campbell and Jake Sullivan, "Competition Without Catastrophe," Foreign Affairs, September/October 2019, foreignaffairs.com. Section II: Appendix Table 1OECD: Which Countries Are Willing And Able To Raise Corporate Tax Rates? GeoRisk Indicator China Russia UK Germany France Italy Canada Spain Taiwan – Province Of China Korea Turkey Brazil Australia Section III: Geopolitical Calendar
Highlights Important leading indicators of Eurozone activity point to record growth in the coming quarters. Progress on the vaccination front, global pent-up demand, and easing fiscal policy will fuel the Euro Area recovery. Consensus growth expectations for the Eurozone do not reflect this upbeat outlook; hence, European economic surprises will remain firm. Robust economic surprises will help European stocks, especially small-cap ones. They will also allow for a stronger EUR/USD and rising German 10-year yields. The UK economy is strong, and the BoE will be among the first central banks to tighten policy meaningfully. However, investors understand the UK’s strength well. While the cyclical outlook for the pound is bright against both the USD and the EUR, the GBP is vulnerable to some near-term profit taking. Downgrade UK small-cap stocks to neutral on a tactical basis. Feature The case for the Eurozone’s recovery is only growing stronger. However, consensus growth forecasts for the Euro Area remain modest. Faced with this dichotomy, the European economy has ample room to generate positive surprises in the coming months. This process will support European financial assets, small-cap stocks in particular. This contrasts with UK assets, where investors have already embedded generous growth assumptions in response to the country’s rapid pace of vaccination. A tactical downgrade of UK small-cap equities is appropriate. Surprise! Two indicators from outside the Eurozone point to an elevated likelihood that the European economy will generate some exceptionally strong growth numbers over the coming 12 months. First, the Swiss KOF Economic Barometer hit an all-time high in April. The KOF series is an excellent leading indicator of Switzerland’s economic activity, and it currently forecasts record GDP growth and PMIs for that country (Chart 1). This message of strength for Switzerland bodes well for the Eurozone. While the Swiss market is defensive, owing to its heavy exposure to healthcare and consumer staple stocks, the Swiss economy is pro-cyclical. Exports represent 60% of GDP, and exports to the Eurozone account for 40% of this total. Moreover, the growth-sensitive machinery, consumer goods, and chemicals categories account for almost 50% of shipments. Based on these observations, the KOF Economic Barometer forecasting ability unsurprisingly extends beyond Swiss economic variables; it also anticipates positive growth for the Global Manufacturing PMI, the Euro Area Manufacturing PMI, and the Eurozone’s forward earnings (Chart 2). Chart 1Climbing Swiss Peaks Chart 2A Good Sign For The Eurozone Second, an aggregation of Swedish economic data confirms the KOF indicator’s message and also calls for record economic activity in Europe. Our Swedish Economic Diffusion Index, which incorporates 14 data series from the Nordic country, points toward a further acceleration in the Euro Area PMIs relative to the US (Chart 3). It is also consistent with a pick-up in the performance of European equities relative to the US. These important indicators of the European economy reflect a variety of forces at play that increasingly point toward stronger growth. Among them, the improvement in the pace of vaccination is crucial to lifting the mood across the continent. As the top panel of Chart 4 illustrates, the number of daily vaccine doses administered across major Euro Area economies is accelerating sharply. While it took three months to inoculate 20% of the population, it only took one month to raise the vaccinated population to nearly 40% (Chart 4, bottom panel). Chart 3Sweden Leads The Eurozone Chart 4Accelerating Vaccinations Euro Area fiscal policy is also moving in a more growth-friendly direction. The Italian Budget announced on April 26 will add EUR248 billion in spending over the next six years. For the moment, Germany has abandoned its debt brake, and, as we wrote three weeks ago, the September election is likely to reify this outcome and further ease fiscal policy in Europe’s biggest economy. Spain is the second largest recipient of the NGEU funds, and it is expected to increase fiscal spending by EUR167 billion over the coming six years. In addition, France has yet to give clear hints about its plan, but next year’s elections are likely to result in further stimulus measures as well. Thus, fiscal easing in Europe will only increase from this point on (Chart 5). Chart 5The Expanding European Stimulus Accumulated pent-up demand remains another potent fuel for growth in the Euro Area. Unlike in the US, spending on durable goods in the Eurozone has not overtaken its pre-pandemic levels (Chart 6). Furthermore, global inventory-to-sales ratio are low, which hints at a coming inventory restocking cycle. These two trends will benefit Euro Area economic activity. The service sector recovery has more to go. Despite some recent improvements, the Eurozone’s Service PMI remains depressed compared to that of the US (Chart 7, top panel). However, the acceleration in the European vaccination campaign and the continued injection of fiscal support at the same time as the lockdowns ebb should result in a significant catch up in service activity in the Euro Area. Thus, the double-dip recession is on the verge of ending and giving way to a robust GDP expansion (Chart 7, bottom panel). Chart 6Ample European Pent-up Demand Chart 7The Service Sector Recovery Is Paramount Even though the recovery in GDP growth will lead to strong positive economic surprises for the Euro Area, consensus growth expectations for the region remain conservative. According to Bloomberg, Eurozone annual GDP growth is expected to reach 12.6% in Q2 because of an extremely strong base effect. However, growth will decelerate suddenly and hit 2.3% in Q3 and 4.3% in Q4. Growth is anticipated to be 4.1% in 2022. These are low thresholds to beat, and thus, economic surprises will remain positive. Chart 8Decomposing The Surprises The source of positive economic surprises is likely to be broad-based. If the service sector recaptures some of its previous shine, the Surveys and Business Cycle component and the Labor Market component of the Bloomberg surprises index will improve and remain positive for many months (Chart 8). Moreover, the absorption of pent-up demand will allow the Retail and Wholesale as well the Personal/Household components to remain robust or firm up further. Finally, the strength of the global manufacturing sector and the elevated potential for a global inventory restocking will allow the Industrial component to firm up anew. Bottom Line: The European economy is in a good place to validate the upbeat message from the KOF Economic Barometer or the Swedish Economic Diffusion Index. Since expectations for European economic activity are still limited for the second half of 2021, this strong growth performance will result in positive economic surprises. Investment Implications The heightened odds that Europe will generate significant positive economic surprises for the coming quarters means that investors’ perspective of the Euro Area will gradually improve. While this process will ultimately curtail the ability of Europe to beat expectations, it will also lift Eurozone assets. If our forecast is correct that European economic surprises will largely be positive over the coming 6 to 12 months, then European equities are more likely to generate generous returns than otherwise. Table 1 highlights that positive changes in the Economic Surprise Index (ESI) on a 3-month, 6-month, and 12-month horizon coincide with returns of the Euro Area MSCI equity benchmarks that have positive batting averages of 72%, 70%, and 73%, respectively. Moreover, the average and median returns are significantly higher than when the ESI deteriorates. Table 1Forecasting Strong Surprises Means Forecasting Strong Equity Returns The signal from the ESI is weaker if we do not make forecasts about its direction. The batting averages of subsequent 3-month and 6-month equity returns following an improving ESI are 63% and 69%, respectively, and the median subsequent returns are higher than if today’s ESI is deteriorating, but not to the same extent as when we make a forecast of the ESI. 12-month returns for the Eurozone MSCI index have a 58% chance of being positive, if the ESI increases over a 12-month window, which is lower than the 63% batting average if the ESI worsens. Moreover, average and median 12-month expected returns are somewhat higher if the ESI has been deteriorating rather than improving over the past 12-month period. European small cap equities will be prime beneficiaries of the coming growth outperformance. From an economic perspective, this makes sense because small-cap stocks are geared more toward domestic growth than large-cap equities, which are dominated by multinationals. Table 2 shows that 3-month, 6-month, and 12-month periods of improvement in the surprise index precede an outperformance of small-cap relative to large-cap stocks over similar windows of time. Thus, the current positive level of the European ESI and its ability to rise further should favor small-cap European equities. Table 2Favor Small-Cap Stocks Table 3A Bullish Backdrop For EUR/USD The same exercise shows that the outlook also favors the euro. European economic surprises should continue to outpace the US, because Eurozone growth will catch up to the US, but investors already have much loftier expectations for US activity than for the Euro Area. Table 3 illustrates that periods when the Eurozone’s ESI is greater than that of the US, EUR/USD generates a positive 3-month return 65% of the time, with a median gain of 1.3%. When the US ESI is higher, the EUR/USD depreciates 55% of the time, with a median loss of -0.5%. Chart 9Rising German Yields? Finally, the potential for stronger European ESI is negative for Bunds. Speeches by various members of the European Central Bank Governing Council indicate that the ECB will tolerate higher yields, if they reflect stronger economic activity. As the European vaccination campaign advances and the fiscal stimulus increases, the need to maintain depressed Bunds yields recedes. Hence, a continuation of positive ESI readings is now more likely to boost these yields. Additionally, the gap between the European ESI and the US one will remain positive, thus, a period of rising German yields relative to the US is more likely (Chart 9). Bottom Line: The ability of the European economy to continue to surprise positively should generate attractive equity returns on the continent. Moreover, this economic backdrop is consistent with an outperformance of small-cap equities, as well as an appreciating EUR/USD. Under these circumstances, Bunds yields should experience more upside. Country Focus: The UK’s Outlook Is Brightening, Unsurprisingly Last week, the Bank of England left the total size of its asset purchase program in place at GBP875 billion, even if the weekly pace of purchases was slowed to GBP3.4 billion from GBP4.4 billion. The BoE also raised its 2021 growth forecast to 7.5%, from 5% in February. The BoE is joining the Bank of Canada as one of the first central banks to taper its asset purchase program. It will also be one of the first central banks to increase interest rates, after the Norges Bank, but ahead of the Fed. In a way, the UK shares many similarities with our recent positive depiction of the Swedish economy. Chart 10Support For Household Net Worth The rapid pace of vaccination in the UK allows for a vigorous economic recovery. In all likelihood, the UK economy will have contracted in Q1 2021 because of the severe lockdowns that prevailed then; however, these lockdowns are being eased and economic fundamentals point up. Our Global Fixed Income and Foreign Exchange strategists recently demonstrated that house prices are increasing on the back of rising mortgage approvals and falling household debt-servicing obligations (Chart 10). The robust readings of the RICS House Prices survey only confirm the positive outlook for housing prices. Expanding house prices will elevate consumption. An appreciating housing stock boosts the wealth of households and leads to higher UK consumer confidence. Moreover, business confidence is improving; the rise in capex intentions not only indicates that investments will increase, but is also a precursor to climbing job vacancies (Chart 11). Brighter labor market prospects often result in rising consumption, especially if wages firm up, as we argued seven weeks ago. The current bout of economic strength points to some upside in UK inflation as well. The elevated PMI readings and the rapid increase in construction activity are reliable forecasters of higher CPI prints (Chart 12). However, this not a uniquely British phenomenon, and it remains to be seen how durable this rising inflation will be. Chart 11UK Consumption Will Rise More Chart 12Accelerating UK Inflation Despite this positive economic outlook, investors should adopt a more cautious tactical stance toward UK markets. The problem for British assets is that investors have understood UK’s vaccination strength so well that they embed much optimism in the price of financial instruments levered to domestic economic activity. In contrast to the Eurozone, Bloomberg consensus forecast anticipate Q2 year-on-year GDP growth of 20.7%, 6.1% for Q3 and 6.5% for Q4. Cable is particularly ripe for some near-term profit taking. Our Intermediate-Term Technical Indicator and the 52-week rate of change of GBP/USD, as well as net speculative positions and sentiment, all point to a correction in that pair (Chart 13). Moreover, the 13-week momentum measure for EUR/GBP shows that the rapid decline in this cross is also overdone. As a result, BCA’s Foreign Exchange strategists closed their short EUR/GBP position to book some gains. It is also time to downgrade British mid- and small-cap stocks from our current overweight stance, at least on a tactical basis. Compared to large-cap UK stocks, small-cap names have moved in a parabolic fashion, and the ratio’s elevated 52-week rate-of-change measure warns of a pullback, especially in light of the deterioration in near-term momentum (Chart 14). The message from technical indicators is particularly concerning, because the forward earnings of small-cap stocks are plunging relative to large cap ones (Chart 15). Additionally, valuation multiples on UK small-cap stocks have vastly outpaced those of their larger counterparts, despite a rapid decline in relative RoE (Chart 16). Chart 13Cable Is Ripe For Some Near-Term Profit Taking Chart 14UK Small-Cap Stocks Are Technically Vulnerable Chart 15Deteriorating Profit Performance Chart 16Quite The Valuation Premium Ultimately, these cautious views are of a short-term nature. BCA’s Foreign Exchange strategists remain upbeat on the pound on a 12- to 24-month basis. Cable continues to trade at a deep discount to our purchasing-power parity estimate, which adjusts for the composition of price indexes in the UK and the US (Chart 17). Moreover, real short rate differentials still favor GBP/USD. The pound also trades at a discount to the euro based on long-term valuation metrics. Most importantly, real interest rates differentials at both the short- and long-end of the curve, as well as the outlook for the evolution of monetary policy in the UK relative to the Euro Area, indicate a significantly lower EUR/GBP (Chart 18). Chart 17Despite Nera-term risks, Cable's Cyclical Underpinning Is Strong Chart 18Lower EUR/GBP Ahead For small-cap equities, the cyclical picture is more complex. On the one hand, their domestic exposure and a higher pound over the coming 12 to 24 months should help them, unlike the large-cap UK stocks, which derive most of their income from abroad and are negatively affected by a higher GBP. On the other hand, UK small-cap stocks have become so expensive that we need to see how an appreciating pound will boost their earnings relative to large-cap stocks before adjusting our neutral stance. Bottom Line: The strong UK economy will allow the BoE to be one of the first major DM central banks to tighten policy. This will support a further appreciation of the pound against both the dollar and the euro over the coming 12 to 24 months. Nonetheless, the GBP has been overbought on a tactical basis and is vulnerable to a near-term pullback. Similarly, compared to large-cap equities, we are downgrading small-cap UK stocks from overweight to neutral on a tactical basis. Mathieu Savary, Chief European Investment Strategist Mathieu@bcaresearch.com Jeremie Peloso, Associate Editor JeremieP@bcaresearch.com Cyclical Recommendations Structural Recommendations Trades Currency Performance Fixed Income Performance Government Bonds Corporate Bonds Equity Performance Major Stock Indices Geographic Performance Sector Performance Closed Trades
Small cap stocks have significantly outperformed large cap stocks since November, after having substantially underperformed in the early stages of the pandemic. As such, investors have looked at small cap stocks’ recently stellar relative performance as…
Upgrade Alert Small cap indexes regained their footing late last year and recovered two years of losses relative to the SPX in a mere quarter. During that uprising in mid-January we monetized sizable gains both on a cyclical and tactical (high-conviction) time horizon, and subsequently added the small cap bias back to our upgrade watch list. Following a drubbing in absolute and relative valuations, small caps have regained their luster and are now trading at a near 15% premium on a 10-year Cyclically Adjusted P/E (CAPE) basis. Given BCA’s view that the sell-off in the bond market has staying power, we are monitoring this ratio closely for a better entry point. Bottom Line: Small cap stock indexes remain on our upgrade alert list, awaiting a more compelling level to re-establish a small cap size portfolio bias.
We are reopening our long “Back-To-Work”/short “COVID-19 Winners” pair trade that we first instituted in the September 8th, 2020 Strategy Report, and subsequently closed earlier this year for a gain of 21.5%, since inception as our risk management rolling stop was hit. Yesterday we highlighted that the recent market tumult is likely an equity-only event and the underlying cyclical drivers in the stock market remain intact. As equity vol settles down and the sudden fall in the 10-year Treasury yield reverses course (it remains one of the key risks to our economic reopening theme), there are high odds that the long “Back-To-Work”/short “COVID-19 Winners” share price ratio will resume its ascend. At the same time, the bullish theme for the economic reopening trade got another boost from the most recent ISM release that posted upbeat numbers especially on the prices paid subcomponent of the survey (bottom two panels). Thus, we are compelled to re-initiate this trade. With regard to the small cap bias that we recently monetized handsome gains for our portfolio – which is driven by similar macro catalysts – we are on the lookout to re-establish a small cap size bias, but at a better entry point (top two panels). Bottom Line: Reopen the long “Back-To-Work” / short “COVID-19 Winners” pair trade and put the small size bias on upgrade alert. The ticker symbols in the “Back-To-Work” and “COVID-19 Winners” baskets are: LUV, DAL, MAR, HLT, CVX, EOG, SBUX, MCD, CAT, HON, AXP, COF, NUE, GM; and TDOC, FCN, ZM, CTXS, JNJ, AMGN, REGN, CLX, RBGLY, WMT, COST, KR, NFLX, AMZN, respectively.
Overconcentration of returns in a handful of stocks has been an overarching theme in a number of our 2020 publications. For instance, we separated the SPX in the S&P 5 vs. the S&P 495 in late-July, and showed how a handful of tech titan stocks dominated S&P 500 returns, especially since 2015. Roughly a month later these tech stocks peaked, and the normalization process began (top panel). It is remarkable that the S&P 5 are down in absolute terms since their September 2 crest, whereas the S&P 495 are up over 15%. The recent surge in the 10-year Treasury yield exacerbated the nosedive in relative share prices as it deals a blow to the bubbly valuation of the longest duration sector in the SPX: the tech sector. Crudely put, the steeper the selloff in the bond market the greater the fall in relative market capitalization (10-year Treasury yield shown inverted, middle & bottom panels). Bottom Line: Stick with a barbell tech sub-group positioning, preferring software and services to hardware and equipment, but stay tuned.
Consistent with the previous Insight’s cautionary tone, we recommend investors book gains of 16% on the small size bias that we have been exploring since the October 26, 2020 inception (top panel) and 6% since the high-conviction calls report on December 7, 2020. Small caps have gone parabolic since late October and the small/large 13-week rate of change annualized momentum is at the highest print since the dotcom bubble era breaching 100%/annum recently (second panel), and second largest ever in the history of our data set (not shown). The top 10 constituents of small cap indexes are now populated by highly speculative names (see here and here) and in the Russell 2000 specifically the weights of some of the top 10 constituents have jumped to more than 10 fold from the 0.05% median weight to over 0.5% weight. In other words, elements of frothiness are also evident in small cap indexes. At least a pause for breath is likely in the next three months and we opt to move to the sidelines and downgrade the size bias back down to neutral. Finally, we are also shifting the 10% stop in our long “Back-To Work”/short “COVID-19 Winners” pair trade baskets to a 5% rolling stop in order to protect gains of over 25% since the September 8, 2020 inception (bottom panel). Bottom Line: The easy money has been made in the small/large ratio, lock in gains and step aside. Today we also switch our trailing 10% stop to a rolling 5% stop in the long “Back-To Work”/short “COVID-19 Winners” pair trade baskets. Stay tuned.
Overweight Vaccine efficacy announcements have paved the way for a sustainable great rotation trade into small caps and out of large caps. One of the key small size bias drivers is the delta in sector composition between the small and large cap indexes. The relative gap in deep cyclicals alone is 13% as we highlighted in recent research. Relative share prices remain far apart from the budding recovery in the commodity complex including Dr. Copper’s flirtations with seven-year highs. Thus, the small caps catch up phase has a long ways to go (top & fourth panels). The financials sector gulf is also significant, with small caps’ exposure relative to their large cap brethren clocking in at over 700bps. Already, the yield curve is steepening and there are high odds of a selloff in the bond market as the economy continues to reopen (third panel). In addition, easy fiscal policy is a tonic to the small/large share price ratio. As a flood of money enters the economy with a slight lag, small caps will continue to make up ground lost during the early stages of the pandemic (fiscal balance shown inverted, second panel). Bottom Line: A small size bias is a high-conviction call for 2021.