Market Capitalization: Large / Small

Dear client, Next Monday December 14, 2020 we will be hosting our last webcasts for the year “From Alpha To Omega With Anastasios”, one at 10am EST for our US, European and Middle Eastern clients and one at 8pm EST for our Asia Pacific, Australia and New Zealand clients; our final weekly publication for 2020 will be on Monday December 21, 2020 where we will highlight our top charts of the past year. Kind Regards, Anastasios Highlights Portfolio Strategy Our high-conviction overweight calls comprise four “Back-To Work” beneficiaries, and a hedge. In marked contrast, all of our high-conviction underweights are focused on “COVID-19 Winners” that should lose some of their luster next year. Recent Changes Upgrade the S&P real estate sector to overweight, today. Feature Favorable Macro Backdrop Easy monetary and loose fiscal policies will remain intact and sustain flush liquidity conditions next year. As a result, the global economy will continue to gain traction. Importantly, early-August marked a critical economic inflection point. Gold prices peaked and 10-year real and nominal yields troughed (yields shown inverted, top & middle panels, Chart 1). The bullion and bond markets corroborated the economic recovery that equities and the ISM manufacturing surveys sniffed out in late-spring. This is important for cementing the bull market in equities which is predicated on a durable economic recovery. In other words, the rise in real yields serves as a green light for further stock gains as it signals that the economy is on the recovery path. The bottom panel of Chart 1 also highlights that non-US equity markets started sporting accelerating profit growth expectations in August. Eurozone and other ex-US bourses zoomed past the US EPS growth trajectory as the latter reached a plateau. Chart 1Inflection Point This gives us confidence that 2021 will be a bumper year for SPX profits and help carry the market higher near our 4,000 target. As a reminder, on November 9 in a Special Report, we lifted our EPS estimate to $168 for calendar 2021 and introduced an end-2021 SPX target of 4,000 (Chart 2). Chart 2Earnings Will Do The Heavy Lifting In 2021 Two Risks To Monitor Nevertheless, the bond market represents a risk to our sanguine equity market view. Simply put, if the 10-year US Treasury yield stalls, then it will also stop the rotation trade in its tracks. The budding improvement in the Chinese and EM economic cycles will likely be sustainable next year, consistent with the Chinese four-year cycles of the past twenty years (Chart 3). Each up-cycle has typically been driven by credit expansion and capital spending, on the back of fiscal and monetary easing. These conditions are in place once again. Chart 3Follow The Chinese Four-year Cycle We recently showed that China’s fiscal easing will likely continue to grease the wheels of global trade into mid-2021 and thus debase the greenback (Chart 4), but will likely run out of steam in the back half of next year. Thus, China’s reflation going on hiatus is another key risk we will monitor in 2021 that could serve as a growth scare catalyst and reset stocks. Chart 4Laggard Deep Cyclicals Have The Upper Hand Year In Review 2020 is a year to forget as far as the coronavirus human toll is concerned; the economic and EPS recessions, while short lived, were deep. The COVID-19-inflicted wounds, especially to services industries the world over, were deep and there will be severe scarring. Early in the year, equities felt the COVID-19 tremor and collapsed 35% from the February 19 highs, but extremely aggressive monetary and fiscal policy responses filled the void and were the dominant themes in the ensuing recovery that saw the SPX vault to all-time highs. Our portfolio was resilient and was able to absorb the COVID-19 shock as we were bulletproofing it in the back half of 2019 and early-2020 for a recession owing largely to the yield curve inversion. Importantly, we were not dogmatic and on March 16 we turned cyclically bullish. This eventually culminated into the March 23 Strategy Report where we penned 20 reasons to start buying stocks and coincided with the trough in the SPX. This cyclical shift in our view from bearish-to-bullish aided our portfolio performance as we started adding cyclical exposure and trimming defensive exposure in order to benefit from the immense monetary and fiscal policy responses. Early on, we deemed these macro forces were forceful enough to really turn things around and we remained bullish on a cyclical time horizon. All in all, our trades produced alpha to the tune of 425bps. While our pair trades were sub-par (as is custom we are closing the remaining today), our high-conviction trades and cyclical portfolio moves recorded solid gains (please see the final tally below). Ray Of Light Encouragingly, there is light at the end of the tunnel, as a number of vaccines will become available late this year and/or early in 2021. This is great news for the economy and for stocks. We have positioned the portfolio to benefit from the reopening of the economy and the vaccine will act as an accelerant as our flagship publication posited last week while documenting BCA’s upbeat Outlook for 2021. Our portfolio enjoys a cyclical-over-defensive bent, has a small cap bias and we remain committed to the “Back-To-Work” basket versus the “COVID-19 Winners” basket (Chart 5). In the short-term, equities have discounted a lot of good news, which is likely to steal from next year’s returns. However, as populations get inoculated and large parts of the global economy reopen, a virtuous cycle of increasing consumer and business confidence would boost investment and GDP and prove a boon for corporate profits. Already the rally is broadening out with the value line arithmetic and geometric indexes outshining the SPX (Chart 6). An active ETF (RVRS:US) that has a reverse weighting to US large caps is also besting the S&P 500 and signals that more gains are in store in the New Year, especially for the still beaten down deep cyclical laggards. Chart 5Stick With The Reopening Trade Chart 6Rally Is Broadening Out, And That’s Healthy More Overweights Than Underweights As is custom every year, this Strategy Report introduces our high-conviction calls for 2021. This year we have four overweights, a bonus volatility trade on the long side, three underweights, and a bonus structural trade that we add to our trades of the decade first introduced in mid-December 2019. Our overweights comprise three “Back-To-Work” beneficiaries, a great rotation trade and a hedge. All of our underweights are focused on “COVID-19 Winners” that should lose some of their luster next year. Finally, this year we take a page out of Byron Wien’s annual “10 surprises” list and offer our clients three “also rans”, which got close but ultimately failed to make our high-conviction list.   Anastasios Avgeriou US Equity Strategist anastasios@bcaresearch.com   Overweight Hotels (Back-To-Work Theme) The recent positive vaccine news is a key reason we are warming up to this consumer discretionary sub group. While neither lodging nor cruise line vacationing will return to their previous peaks any time soon, both industries will survive and thus should no longer be priced for bankruptcy. One key industry demand determinant is confidence. Consumer sentiment has staged a W-shaped recovery. It is still flimsy, but the vaccine efficacy news should catapult confidence higher in the coming quarters. The implication is that the wide gulf between consumer confidence and relative share prices will narrow via a catch up phase in the latter (top panel, Chart 7). Moreover, the ISM non-manufacturing survey is on a sling shot recovery following the bombed out spring readings. This rebound also suggests that the path of least resistance is higher for lodging stocks (second panel, Chart 7). Our hotel demand indicator does an excellent job in encapsulating all these different forces and forecasts an enticing lodging services demand backdrop into 2021 (third panel, Chart 7). Already, consumer outlays on hotels are staging a comeback, albeit from an extremely depressed level. The upshot is that an earnings-led bounce is in the cards (fourth panel, Chart 7). Finally, washed out technicals and extremely alluring valuations provide an attractive reward/risk tradeoff at the current juncture (bottom panel, Chart 7). Bottom Line: The S&P hotels, resorts & cruise lines index is a high-conviction overweight. The ticker symbols for the stocks in this index are: BLBG: S5HOTL – MAR, HLT, CCL, RCL, NCLH. Chart 7Buy Hotels Overweight Real Estate (Back-To-Work Theme) Boost the S&P real estate sector all the way to overweight today, in order to benefit from the looming full reopening of the economy on the back of the vaccine’s arrival. We have been bearish this niche S&P sector and delivered alpha to our portfolio both via the cyclical and high-conviction underweights this year. Nevertheless, we do not want to overstay our welcome and the time is ripe for a bullish commercial real estate (CRE) stance. The bearish story is well known, but some bullish undertones are widely neglected. The rebound in relative share prices is substantially trailing the 2009 episode, when REITs outshined the SPX by 65% one year following the March 2009 trough. Currently, on a similar SPX advance from the March 2020 lows, REITs are lagging the S&P 500 by 22% (top panel, Chart 8). As large parts of CRE have been at the epicenter of the pandemic, any return to even semi-normalcy in 2021 should see these beaten down stocks sling shot passed the SPX. When the fiscal package finally passes, it will likely serve as a fresh reflationary bridge to support the economy. The proverbial “kicking the can down the road” will thus lift some uncertainty hanging over CRE landlords receiving rents and also via banks not foreclosing distressed properties which would have further depressed CRE prices. CRE prices will likely recover in the New Year as vulture funds and opportunistic investors are already bargain hunting. Tack on the likely refinancing lifeline bankers will extend to CRE debt originators (middle & bottom panels, Chart 8) and such a backdrop will loosen the noose around distressed property landlords. Bottom Line: Boost the S&P real estate sector to an above benchmark allocation and add it to the high-conviction overweight call list.   Chart 8Upgrade Real Estate To Overweight Overweight Industrials (Back-To-Work Theme) Add the S&P industrials sector to the high-conviction overweight list. Emerging markets (EM) and China represent the key source for the sector’s buoyancy. The EM manufacturing PMI clocking in at 53.9 hit an all-time high (top panel, Chart 9). China’s PMIs are also on a similar trajectory, and the Chinese Citi economic surprise index has swung a whopping 277 points from -239 to +38 over the past nine months (second panel, Chart 9). The upshot is that US industrials stocks should outperform when China and the EM are vibrant. Peering over to the currency market, the debasing of the US dollar should also underpin industrials stocks via the export relief valve. A depreciating greenback also lifts the commodity complex and hence industrials equities that are levered to the extraction of commodities and other derivative activities (middle panel, Chart 9). Capex intentions are firming and CEO confidence is upbeat for the coming six months. The ISM manufacturing new orders-to-inventories ratio is corroborating the budding recovery in the soft data. Green shoots are also evident in hard data releases. Durable goods orders are on the verge of expanding anew (fourth panel, Chart 9). Sell-side analysts have never been more pessimistic with regard to the sector’s long-term EPS growth rate that is penciled in to trail the broad market by almost 800bps (bottom panel, Chart 9)! This bearishness is contrarily positive as a little bit of good news can go a long way. Bottom Line: The S&P industrials sector is a high-conviction overweight.  Chart 9Overweight Industrials Overweight Small Caps At The Expense Of Large Caps (Rotation Trade) Recent 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, Chart 10). 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, Chart 10). 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, Chart 10). Not only is fiscal stimulus providing a lifeline to debt-burdened small caps, but also the Fed’s opening up of the monetary spigots has pushed fixed income investors out the risk spectrum. Thus, the proverbial “kicking the can down the road” is boosting the allure of small cap stocks (junk spread shown inverted, bottom panel, Chart 10). Bottom Line: A small size bias is a high-conviction call for 2021. Chart 10Prefer Small Caps To Large Caps Long VIX June 2021 Expiry Futures (Hedge Trade) We want to hedge our overweight exposures with a long VIX futures position for the June 16, 2021 expiry. We are spending $25.3 to go long and are comfortable paying up for insurance when the SPX is at all-time highs and there is a risk of some growth disappointment in the next six months. Chart 11 draws a parallel with the March 2009 SPX lows and plots the VIX in 2009 and 2010. While the path of least resistance is lower for volatility, sporadic surges are typical in the year following recessions. The S&P 500 also troughed in March 2020 and if history is an accurate guide, the path to SPX 4,000 will be rocky next year. As a reminder, the S&P 500 suffered a 16% correction in May 2010 and the VIX spiked higher. Positioning remains lopsided with both VIX put/call ratios (volume and open interest) at historically high levels, underscoring investor complacency. Net speculative futures positions as a percent of open interest are also probing multi-year lows, corroborating the complacent options data. Finally, the equity volatility curve has flipped from a 10% backwardation to a steep contango in the past month with the 3rd month now trading at a 25% premium to spot VIX; such a complacent level typically warns of a looming spike in the VIX. Bottom Line: Go long the VIX June 2021 futures as a small hedge to overweight equity positions. Chart 11Go Long VIX Futures As A Hedge Underweight Homebuilders (COVID-19 Winner Theme) We deem that most, if not all, of the good news (low mortgage rates, low inventories, high demand, work-from-home reality, all-time highs on the overall NAHB housing sentiment survey) is already priced in galloping homebuilders stock prices and exuberant expectations. While being contrarian is fraught with danger, because more often than not the herd is right, there is a key macro driver that gives us confidence to be bearish homebuilders: interest rates. If our economic reopening thesis proves accurate next year, then the COVID-19 winners – homebuilders included – will take the back seat. Historically, interest rates and relative share prices have been inversely correlated and a steep selloff in the bond market is bad news for homebuilding stocks (top panel, Chart 12). On the operating housing front, some cracks are forming. New home sales, while brisk in absolute terms, are losing out to existing housing sales and homebuilders have resorted to price concessions in order to drive volumes (second & third panels, Chart 12). Profit margins are at the highest level since the subprime crisis and are vulnerable to a squeeze, not only from lower selling prices, but also from rising input costs. Framing lumber comprises roughly 15% of a new home’s commodity related costs and lumber prices have been expanding all year long (bottom panel, Chart 12). Bottom Line: Put the S&P homebuilding index to the high-conviction underweight call list. The ticker symbols for the stocks in this index are: BLBG: S5HOME – LEN, PHM, DHI, NVR. Chart 12Avoid Homebuilders Underweight Pharma (COVID-19 Winner Theme) The S&P pharmaceutical index is a high-conviction underweight for 2021. On the macro front, the Fed’s ZIRP bodes ill for defensive pharma equities. The Fed was uncharacteristically quick this recession to drop rates to the lower zero bound to reflate the economy. As a result, safe haven equities, Big Pharma included, typically trail the broad market as the economy gets out of the ER and into the recovery room (second panel, Chart 13). Importantly, relative pharmaceutical profits are highly counter cyclical: they rise at the onset of recession and collapse as the economy heals. Currently, as the world economy has transitioned to a V-shaped recovery, the reopening of the economy into the New Year will continue to knock the wind out of relative pharma profitability. Similarly, an appreciating greenback has historically been synonymous with pharma outperformance and vice versa (third panel, Chart 13). Keep in mind, Big Pharma make the lion’s share of their profits domestically, further cementing the positive correlation with the US dollar. This local profit sourcing represents one of the main reasons why politicians on both sides of the aisle are after domestic pharma profits. Pharma prices are on the cusp of contracting. Importantly, President Trump’s late-July executive order “to allow importation of certain prescription drugs from Canada” among other provisions is a direct blow to the profit prospects of Big Pharma (bottom panel, Chart 13). Bottom Line: We are cognizant that the COVID-19 vaccine will lift Big Pharma, but only temporarily, as cyclical forces will more than offset the positive vaccine news. The S&P pharmaceuticals index is a high-conviction underweight. The ticker symbols for the stocks in this index are: BLBG – S5PHARX: JNJ, PFE, MRK, LLY, BMY, ZTS, CTLT, MYL, PRGO. Chart 13Sell Pharma Underweight Consumer Staples (COVID-19 Winner Theme) Countercyclical consumer staples stocks served their purpose and supported our portfolio in the front half of 2020. Now that vaccines are coming, we are adding the S&P consumer staples sector to the high-conviction underweight call list. The current macro backdrop underscores that the path of least resistance is lower for relative share prices. Not only is the ISM manufacturing survey on fire, but also, consumer confidence is forming a trough (ISM manufacturing shown inverted, second panel, Chart 14). One of the factors that will drive relative earnings lower is the weaker US dollar. As a reminder, the S&P consumer staples sector derives approximately 32% of its sales from abroad, which is 10 percentage points lower than the S&P 500. As a consequence, on a relative basis, staples stocks benefit much less than the rest of the market from a falling currency (third panel, Chart 14). Our relative macro earnings model does an excellent job in encapsulating all these moving parts and paints a dark profit picture for this GICS1 sector in the New Year (fourth panel, Chart 14). Bottom Line: The S&P consumer staples sector is a high-conviction underweight.   Chart 14Underweight Consumer Staples Short NASDAQ 100 / Long S&P 500 (Secular 10-year Call) We first wrote about the extreme market cap concentration in January when we were cautioning investors of an SPX drawdown and drew parallels with the dotcom era. Back in late-1999/early-2000 the top 5 stocks comprised 18% of the S&P 500. In July we delved deeper and split the S&P 500 in the S&P 5 versus the S&P 495 to highlight the extraordinary narrow returns since 2015. Such extreme concentration in a handful of tech titan stocks is clearly unsustainable. The bullish case for tech is well documented and understood; the COVID-19 pandemic acted as an accelerant to the technological adoption of the new remote working realities. However, $2tn valuations (AAPL, MSFT & AMZN) make little sense to us, especially if there is little earnings follow through and most of the returns are explained by multiple expansion. In all likelihood, the easy money has been made. Going back to the early 1970s is instructive in order to put the tech juggernaut into proper perspective. Every decade or so there have been clearly defined booms and busts in US tech stocks (Chart 15). Schumpeter’s “creative destruction” forces are undoubtedly at play. What is interesting is that not only have tech stocks likely stalled near the dotcom era peak, but also they have been outperforming since the end of the GFC (i.e. roughly a decade); they are due for at least a breather. If history rhymes, we have entered a new bust cycle and the tech sector’s underperformance will play out over the coming decade. Bottom Line: We are compelled to add to our structural trades and recommend investors underweight the tech sector on a ten-year time horizon via the short QQQ / long SPY exchange traded funds which offer the most liquidity. Chart 15Short QQQ / Long SPX For The Next Decade Also Rans Within consumer discretionary, automobiles & auto parts & components piqued our interest from the long side. These stocks would greatly benefit from a reopening economy as a semblance of normality returns sometime next year. Nevertheless, two key factors kept us at bay. First, similar to homebuilders, this index has gone vertical since the March lows, besting the SPX by a factor of 2:1 (top panel, Chart 16). We maintain exposure via our “Back-To-Work” basket with GM, but even this auto manufacturer is up 50% since the September 8, 2020 inception. Finally, TSLA is about to enter the SPX at a stratospheric valuation that would dominate the automobile sub group. This is eerily reminiscent of YHOO’s SPX inclusion in late-1999 that led the dotcom bubble peak by four months. The parallel is making us nervous, therefore we are staying patiently on the sidelines. On the underweight side we wanted to include the niche S&P semi equipment index, but opted not to as the Bitcoin mania has really pushed these stocks to the stratosphere (middle panel, Chart 16). In addition, this chip sub-group has one of the highest export exposures in the SPX with a large slice of foreign revenue originating in China. Hence, news of a Biden presidency also served as a catalyst to propel them higher (i.e. at the margin, a less hawkish president on the Sino/American trade war). We really struggled with global gold miners (GDX:US). Our initial thinking was to downgrade them to underweight (from currently neutral), which is consistent with global growth reaccelerating and interest rates rising. However, we missed the boat when it set sail in early August (bottom panel, Chart 16). Now, the gold bearish trade is gaining momentum and has become a consensus trade as big macro investors (Tudor and Druckenmiller among others) are shifting toward Bitcoin and have been vociferous about their positioning. Thus, we preferred to remain on the sidelines with a benchmark allocation. Chart 16Three “Also Rans” Footnotes   Current Recommendations Current Trades Strategic (10-Year) Trade Recommendations Size And Style Views October 26, 2020 Favor small over large caps July 27, 2020 Overweight cyclicals over defensives June 11, 2018 Long the BCA Millennial basket  The ticker symbols are: (AAPL, AMZN, UBER, HD, LEN, MSFT, NFLX, SPOT, TSLA, V). January 22, 2018 Favor value over growth  

The vaccine announcement this week accelerated the unwinding of the long tech short everything else pandemic trade. While such a rotation is augmenting our portfolio via an explicit long “Back To Work”/short “COVID-19 Winners” trade, as we highlighted in yesterday’s Daily US Sector Insight, our small cap size bias is another prime beneficiary. Specifically, small caps outshined large caps by nearly 4% this week. One of the key drivers behind such a quick move 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. The implication is that as manufacturing rebounds, so will the relative performance of small caps (top panel). Moreover, 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, bottom panel). Bottom Line: We reiterate our recent small cap bias.

This week we instituted a new size view preferring small caps to large caps as the sector composition of the former is better positioned to benefit from reviving economic growth. Table 1 shows that industrials comprise the largest market cap weight in small cap indexes, and coupled with the materials and energy laggards, the deep cyclical (ex-tech) weight adds up to 26% or twice the SPX weight. With regard to defensives, small caps have lower exposure compared with the SPX to the tune of 700bps (ex-telecom services). Taken together, the relative cyclicals (ex-tech)/defensives (ex-telecom) gap is 20 percentage points. Moreover, rising yields will act as a headwind to the technology universe that large caps have a disproportionately high exposure to (or 14% delta with small caps). Bottom Line: We initiated a long small caps/short large caps trade with a 9-12 month time horizon via the long IWM:US/short SPY:US exchange trade funds. For more information, please refer to this Monday’s Weekly Report. Table 1

Your feedback is important to us. Please take our client survey today. Highlights Portfolio Strategy Today we recommend investors shift to a small versus large cap size bias on the back of rising inflation expectations, a steepening yield curve, a recovering commodity complex, a semblance of normality as the economy fully reopens in 2021, a looming fiscal stimulus package, and deeply oversold conditions. Recent Changes Prefer highly-cyclical small caps at the expense of more defensive large caps. Table 1 Feature The SPX was rudderless last week as another week of intense fiscal policy drama dominated headline news both in Washington, D.C. and on Wall Street, overshadowing Q3 earnings season. Markets remain hostage to the stimulus tug-of-war and the renewed uncertainty has cast a shadow on the short-term prospects of durable gains in the broad equity market. We continue to recommend investors stay patient and opt to put fresh cash to work after the election-related uncertainty lifts. Odds remain high that the SPX glides lower into November before it resumes its cyclical bull market. Recently, we read Marko Papic’s (Chief Strategist at Clocktower Group) seminal book Geopolitical Alpha and we participated in a vibrant webcast hosted by our sister Geopolitical Strategy service last Wednesday celebrating Marko’s milestone. Marko’s book is a page turner and lived up to our high expectations: he concisely delivered content full of bold out-of-consensus predictions. Pages 92/93 reveal Marko’s most important forecast in our view: “The transition from the Washington to Buenos Aires Consensus will dominate markets over the next decade. This transition is more relevant than the US-China geopolitical rivalry, risks to European integration, and technological change. All assets will be influenced by the deluge of fiscal and monetary policy”. In recent research, we have been writing about the transition to the fiscally irresponsible Buenos Aires Consensus, and COVID-19 has not only made the US government profligate, but also insensitive to rising debt loads (Chart 1). Chart 1Buenos Aires Consensus  However, borrowing from Marko’s framework and applying a material constraint in the form of interest rates is instructive. We turned cyclically bullish on the SPX in mid-March and on March 23 we published the QE shaded chart that we are updating today; from the three asset classes we showcase only the 10-year US Treasury yield has yet to rise to a level consistent with some semblance of economic normality (Chart 2). The Fed has likely slayed all the Bond Vigilantes, but the Fed itself is the mega Vigilante, at the moment in a multi-year hibernation. Pundits use the 1994 example for the massive selloff in the bond market (the one that produced Democratic political adviser James Carville’s great quote: “I used to think that if there was reincarnation, I wanted to come back as the president or the pope or as a .400 baseball hitter. But now I would like to come back as the bond market. You can intimidate everybody.”). However, they neglect to mention that the Fed doubled the fed funds rate (FFR) from 3% to 6% in a short time span, first igniting and then turbocharging the selloff in the bond market (Chart 3). Chart 2QE Is Always Bullish Chart 3Lessons From History This cycle, the Fed is acting as an enabler of the transition to the Buenos Aires Consensus. Thus the interplay between the Fed and the bond market will be critical to monitor in coming quarters and years. More specifically, understanding the Fed’s reaction function to a potential doubling in the 10-year US Treasury yield and jump in the FFR change expectations is essential. The most recent and relevant example was during the GFC, when the Fed held the FFR near zero from December 2008 until December 2015. In this seven-year period, the interplay between the FFR change expectations and the 10-year US Treasury yield reveals that the sensitivity of interest rates to FFR change expectations stood near 2-to-1; i.e. a 50bps increase in the FFR change expectations would push the 10-year yield 100bps higher and vice versa (Chart 4). Chart 4Rates Sensitivity At The Zero-Bound Back Then... The most important divergence occurred in May 2013, with the now infamous Bernanke taper tantrum speech, following which the bond market sold off violently, but the FFR change expectations stayed relatively calm near the zero line (Chart 4). Year-to-date, the 10-year US Treasury yield’s sensitivity to FFR change expectations has ranged between 1-to-1 and 2-to-1 (Chart 5). Looking ahead post the election, the odds are rising of a mammoth fiscal package, especially if there is a “Blue Sweep” but also potentially in a renewed Trump administration. Under such a backdrop the 10-year US Treasury yield would spike and so will FFR hike expectations. Tack on the real possibility of a vaccine landing some time in 2021 and the economy will likely roar, creating a feedback loop further underpinning long bond yields. The only regulatory mechanism for fiscal prudence comes from the bond market. Put differently, only rising interest rates on an expanding debt pile can concentrate politicians’ minds (Chart 6). Therefore, the Fed’s reaction function will be critical in how they deal with the looming increase in interest rates and FFR hike expectations. Chart 5...And Today Chart 6Interest Rates Are The Only Constraint               In that scenario, will the Fed try to talk the bond market down, utilize some form of yield curve control (YCC), or do nothing? With the YCC option similar to the 1940s as the most likely outcome as we posited in late summer, we expect that inflation will make a comeback and that would aid the Fed as it will accomplish its recent mission to finally generate inflation. It will also aid the government by inflating its way out of a debt trap by reversing the current dire debt-to-GDP arithmetic (please refer to our June 1 Inflation Special Report for more details on US equity sector implications). From an equity market’s perspective, the Fed’s reaction function poses a short-term risk: an unchecked selloff in the bond market will trigger a more pronounced tech sector underperformance period and unlock excellent value in beaten down financials (Chart 7). This week we continue to add more cyclicality to our portfolio and recommend a small versus large cap size bias on the back of rising odds of a “Blue Trifecta” and a massive stimulus package, and in accordance with our reopening of the economy theme we have been recently exploring. Chart 7Rotation Looming   It’s A Small World After All We recommend investors implement a small size bias either via the Russell 2000 IWM:US exchange traded fund versus the SPY or via the S&P small cap IJR:US exchange traded fund at the expense of the SPY. These two small cap ETFs offer the most liquidity and each have roughly $40bn AUM. On March 20 in the middle of the pandemic and then on April 28 we monetized handsome gains for our portfolio by closing out our high- conviction and cyclical large cap bias, respectively. In hindsight, we should have flipped and implemented a small cap bias as up until early June, small caps were outshining large caps. Since then, they have retraced almost half the gains and now present an exploitable opportunity (top panel, Chart 8). The bearish small cap story is by now well ingrained. Small caps are plagued by a heavy debt load, have no or little trailing earnings to show for let alone nearly 1 in 3 small caps have no forward EPS and profit margins have collapsed near the zero line (Chart 8). While debt saddled small caps are a tough pill to swallow, the untold story is warranting some attention. First, according to a recent FT article, there is so much sloshing liquidity around that asset managers cannot raise private debt funds fast enough.1 Not only is the fiscal stimulus providing a lifeline to debt burdened small caps, but also the Fed’s opening up of the monetary spigots has pushed fixed income investors out the risk spectrum. Thus, the proverbial “kicking the can down the road” is boosting the allure of small cap stocks (junk spread shown inverted, top panel, Chart 9). Chart 8All The Bad News Is Priced In Chart 9Catch Up Phase… Second, the sector composition of small versus large caps represents a high-octane version of the SPX cyclicals/defensives portfolio bent that we have been exploring since late-July/early August. Table 2 shows that industrials comprise the largest market cap weight in small cap indexes. Tack on the materials and energy laggards and the deep cyclical (ex-tech) weight increases to 26% or twice the SPX weight. With regard to defensives the small caps have lower exposure compared with the SPX to the tune of 700bps (ex-telecom services). Taken together, the relative cyclicals (ex-tech)/defensives (ex-telecom) gap is 20 percentage points, confirming the small cap universe’s higher beta status. As a result we expect a narrowing of the gap as laggard small caps play catch up (bottom panel, Chart 9). Meanwhile, inflation expectations have recovered smartly from the depths of the COVID-19 accelerated recession and have formed an unmistakable V-shape (top panel, Chart 10). However, the small/large share price ratio has yet to follow suit. In fact, the Commodity Research Bureau’s overall index is also on fire signaling that commodity inflation is making a comeback. Relative share prices remain far apart from the budding recovery in the commodity complex including Dr. Copper’s flirting around with two-year highs (not shown). Table 2S&P 600/S&P 500 Sector Comparison Table If our thesis that the economic recovery will accelerate in the New Year as a vaccine will make possible a full reopening of the economy, then the upshot is that relative share prices will converge higher to rising commodity prices (bottom panel, Chart 10). Chart 10…Looms Large Another way to depict the deep cyclicality of the small cap index is to compare it with the emerging markets (EMs). The small/large ratio is back to where it was at the turn of the century, giving back 15-20 years of outperformance depending on which small cap index one uses (Russell 2000 or S&P 600). Similarly, EMs performance versus the SPX has returned to a depressed level last seen in the aftermath of the dotcom bust and is a carbon copy of the small/large ratio (middle panel, Chart 11). The implication is that small caps go as EMs go and an EM recovery bodes well for a small cap outperformance phase. Circling back to Table 2, the financials sector delta 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 up the reopening path and a vaccine is nearing (bottom panel, Chart 11). Similarly, the VIX has collapsed from north of 80 to below 30 recently confirming that the intense ‘risk off’ phase is over. Nevertheless, there is ample room for the VIX to fall further as it remains stubbornly at an historically elevated print 10 points above the mean. Importantly, the VIX has remained above 20 for over 160 trading days. Were it not for the GFC this would be a record streak (VIX shown inverted, top panel, Chart 11). Finally, the two year drubbing of small caps has worked off some of the overvaluation and our relative Valuation Indicator has returned back to the neutral zone. Importantly, small caps are so unloved and under-owned that our relative Technical Indicator is probing multi-decade lows. Historically, such a depressed relative positioning level has been contrarily positive and served as a launch-pad to significantly higher relative share prices on a cyclical time horizon (Chart 12). Chart 11High Beta ‘Risk On’ Beneficiary Chart 12What’s Not To Like? Adding it all up, a small versus large cap outperformance period looms on the back of rising inflation expectations, a steepening yield curve, a recovering commodity complex, a semblance of normality as the economy fully reopens in 2021, a looming fiscal stimulus package, and deeply oversold conditions. Bottom Line: Initiate a long small caps/short large caps trade today with a 9-12 month time horizon via the long IWM:US/short SPY:US exchange trade funds.     Anastasios Avgeriou US Equity Strategist anastasios@bcaresearch.com   Footnotes 1     https://www.ft.com/content/b7e29f0d-d906-421c-9a0a-910099e6eed9 Current Recommendations Current Trades Strategic (10-Year) Trade Recommendations Size And Style Views October 26, 2020 Favor small over large caps July 27, 2020 Overweight cyclicals over defensives June 11, 2018 Long the BCA Millennial basket  The ticker symbols are: (AAPL, AMZN, UBER, HD, LEN, MSFT, NFLX, SPOT, TSLA, V). January 22, 2018 Favor value over growth

Rotation out of the tech titans is a high probability scenario given that the easy money has already been made as AAPL, MSFT and AMZN each commanded an almost $2tn market capitalization near the peak on September 2. Thus, booking some of these tech gains and redeploying capital in other unloved deep cyclical sectors would go a long way, especially if our thesis that the economic recovery will gain steam into 2021 pans out. Using a concrete rebalancing example to illustrate such a rotation is instructive.1 The tech titans’ (top 5 stocks) market cap weight in the SPX is 22%. Were an investor to take 10% of this weight or 220bps and redeploy it to the materials sector, which commands a 2.7% market cap weight in the SPX, would effectively double the exposure on this deep cyclical sector. The same would apply to the energy sector that comprises a mere 2.2% of the SPX, while industrials with an 8.4% market cap weight would get a sizable 26% lift. Bottom Line: As the economy opens up, it pays to rotate out of fully priced tech titans and into the beaten down deep cyclicals.    Footnotes 1 Our example assumes benchmark allocation in all sectors for illustrative purposes.

Special Report

Highlights Along with momentum, quality has been the best performing factor over the past 30 years. It has also been less volatile and has exhibited milder drawdowns than other factors. There are multiple traits that are considered as signs of quality. However, profitability explains the lion’s share of the quality premium, though accounting quality and payout dilution also play a role. The reason why quality stocks outperform remains a mystery, though the preference for lottery stocks as well as the failure to account for the persistence of quality are plausible explanations. Both small caps and value stocks have negative tilts to quality. Adjusting for this tilt by buying small-cap quality indices or value indices with quality filters, can help investors exploit these factors more effectively. Feature “Investment must always consider the price as well as the quality of the security” – Benjamin Graham & David Dodd, Security Analysis, Principles and Technique, 1934 Legendary investor Benjamin Graham is one of the most significant figures in the history of finance. His two books, The Intelligent Investor and Security Analysis, stand as foundational pillars in the field of fundamental analysis. Moreover, as the mentor of the most famous investor ever, Warren Buffet, he has influenced a generation of investors into caring deeply about not overpaying for stocks. Thanks to these feats, Graham has come to be known as the “father of value investing”. And yet this moniker, though well-deserved, ignores a substantial portion of his legacy. Graham was not solely concerned with valuations.1 In fact, out of the seven criteria that he used to pick securities, only two of them focused on valuation measures. The rest, focused on metrics like profitability, leverage, and stability. These attributes encompass what is broadly known today as quality. But what exactly is quality? While certain traits have historically been associated with this factor, quality was not seen until more recently as something that you could easily define. Instead, a more holistic approach to quality was preferred.2 It wasn’t until the work of Robert Novy-Marx in the early 2010s, and US investment firm AQR thereafter, that the possibility of measuring quality, as well as systematically exploiting it, became prominent within the factor literature. Since then, quality has become a more popular strategy, with various commercial providers offering quality indices in recent years. However, much remains unknown about this newly discovered factor. Thus, in this report we take a deep dive into quality with the intent of providing some clarity on the following three issues: Definition of quality: What metrics are used to determine if a stock is a “quality” stock? Which of the many quality traits have the best track record? Characteristics of quality: What has been the historical performance of quality? What is its sector exposure? Why does it work? Implementation of quality: How can the quality factor be used in conjunction with other factors to increase returns? In order to answer these questions, we explore the historical performance of the MSCI Quality indices – though we also touch on quality indices by other providers. Moreover, we survey the academic literature around quality, and we propose a couple of ways by which investors can use this factor to exploit the value and small-cap premia more effectively. Definition Of Quality There is no universal agreement on how to measure quality, though there are some general traits that are agreed upon by the academic literature. An often used definition of quality is the “Quality Minus Junk” (QMJ) factor by AQR. In their research, Assness et al. use three traits, each of which is measured by five to six different metrics3 (Table 1). All the metrics are standardized and then averaged to arrive at a single quality measure. This quality measure is then used to build a quality portfolio. Table 1Metrics Used In AQR's Quality Minus Junk Factor (QMJ) However, not all quality indices take so many measures into account. In fact, most commercial providers limit themselves to three or four variables to construct their quality indices. As an example, MSCI determines quality using three criteria: Return on equity, earnings variability, and leverage. All three variables are then winsorized,4 standardized, and then averaged to create a quality score. This quality score determines the weight of each stock within the index. Table 2 expands on the methodology of the quality benchmarks offered by various index providers. Table 2Quality Metrics For Popular Index Providers The lack of a homogenous definition for quality makes performance evaluation of quality problematic. After all, the outperformance of quality could simply be a function of data mining by optimizing for a group of variables that produce excess returns in a backtest. This approach can lead to a large outperformance in-sample, but which might not necessarily replicate when applied in a real-world portfolio.5 To address this issue, some academics have tried to pinpoint which among the many quality traits truly add value in order to build a simpler and more parsimonious factor. In “What is Quality?”, Hsu et al. found that profitability is the most important quality characteristic, having a large and significant multifactor alpha6 (Table 3). Accounting quality and payout dilution have also been relatively reliable sources of excess returns. On the other hand, there is little evidence that most metrics for capital structure, profitability growth, or earnings stability, provide a premium that is not captured by other factors. Table 3Drivers Of The Quality Premium Given the preponderance that profitability has in the overall performance of the quality factor, some academics have suggested that the quality factor should be reduced to profitability.7 However, not everybody agrees with this approach. In fact, other researchers have advocated for including more metrics such as ESG or corporate governance, in an effort to bring back the more holistic approach that Graham practiced.8 Overall, much disagreement about how to measure quality remains, and the subject is still an open debate. Characteristics Of Quality Historical Performance, Composition And Valuation Over the past 30 years, the MSCI Quality Index has, along with momentum, been the best performing factor in the equity markets (Chart 1, top panel). During this time frame, quality stocks have outperformed minimum volatility stocks by 2.6% per year, the global benchmark by 3.5% per year, and value stocks by 4% per year. The performance of quality has also been relatively robust, though the factor has performed better in some countries than others (Chart 1, bottom panel). Quality has performed best in European countries and Canada, while its outperformance has been more muted in Australia and Japan. Historically, quality has been the second most defensive factor after minimum volatility (Chart 2, panels 1 and 2). Moreover, it has exhibited lower volatility, and smaller drawdowns than the overall market. The defensive tilt of quality seems to arise because of the “flight to quality” phenomenon, where investors flock to higher quality assets during periods of markets stress. Interestingly, quality tends to outperform in equity markets and bond markets at the same time (Chart 2, bottom panel). This suggests that quality might be a common risk factor that is captured across asset classes. Chart 1Quality Has Outperformed Most Other Factors Chart 2Quality Is A Defensive Factor Chart 3Quality Overweights Expensive Sectors What about composition? Within the global index, the quality factor currently has a large country bias to defensive markets like the US and Switzerland. This is mostly the result of its overweight to Information Technology, Consumer Staples and Health Care, and a large underweight position in Financials (Chart 3, top panel). This sector positioning also results in quality having high valuations relative to the overall market (Chart 3, bottom panel). It must be noted that valuations for quality stocks have risen significantly over the past few years. It is hard to know how this valuation compares to the past for the MSCI indices, given that valuation measures for MSCI Quality are only available starting in 2013. However, research by AQR has shown that relatively high prices for quality tend to result in lower returns.9 Thus, high valuations could pose a risk for quality going forward. Explanations For The Quality Anomaly Using a dividend-discount framework, one can show that, in theory, high-quality companies should trade at higher price-to-book values than low quality ones (for more details please see Appendix 1). Asness et at have shown that this is the case empirically – high-quality stocks trade at a valuation premium to low-quality stocks (Chart 4, top panel). Chart 4Analysts Are Most Optimistic On Low Quality Stocks However, the mystery of quality lies in the fact that this premium does not appear to be as large as it should be. In other words, while analyst and market participants correctly assign higher multiples to high-quality stocks, this multiple is not large enough, and results in high-quality stocks being undervalued. Ultimately, this leads to the outperformance of high-quality stocks versus low-quality ones (Chart 4, bottom panel). Why do market participants overvalue low quality/junk stocks and undervalue high quality stocks? One reason could be a preference for lottery-like stocks. As we discussed in our January report on the low- volatility anomaly, investors tend to prefer “home-run” stocks – a result of behavioral biases as well as the incentives in the money management industry.10 Thus, distressed companies with low levels of profitability and large levels of debt, may attract some investors betting on a turnaround in the hope of a large windfall if the company survives.11 On the flip side, investors might perceive that high-quality companies – which are usually stable, profitable, and more expensive – cannot produce the same type of extreme payoff, and may even be prone to mean reversion, given that their success is evident and well known.  But this last assumption is a mistake. Quality is a highly persistent characteristic, which means that a high-quality stock today is very likely to remain a high-quality stock in the future (Table 4). It is easy to see why this is the case. A company with very high levels of profitability has likely achieved this by building a moat around its business through a strong brand, proprietary technology, or network effects. It is possible that failure to take this into account results in an undervaluation of high-quality stocks.  Table 4Quality Is Persistent BOX 1 The Behavior Of Quality In Equity And Credit Markets Chart 5Quality Delivers A Different Premium In Different Asset Classes While there is a very tight correlation between the performance of quality in credit and equity markets, the structural premium obtained from this factor in each market is very different. Over a long period, investors are rewarded for investing in high-quality equities, while the opposite occurs when investing in high-quality credit issues (Chart 5). Why would the same risk factor provide a positive premium in one market but provide a negative one in another? The exact reason remains unclear, but the behavioral explanations for the quality factor might provide a clue. As opposed to equity markets, returns in credit markets – even if very high – are naturally capped. As an example: An investor who buys a low-quality issue with a 20% yield-to-maturity, knows that in the absence of a default, the most he or she can earn from holding the issue to maturity is 20%. The fact that the maximum return is well established beforehand might prevent investors from displaying behavioral biases. Specifically, a well-defined upside might cause investors to think more rationally and mechanically about an investment. In contrast, securities where the upside is high but not well-defined might make it more likely for investors to see a very risky investment as a lottery, since extraordinary returns are technically within the realm of possibility. Whatever the reason is, the different premium that this factor offers in these two asset classes presents a potentially attractive opportunity for asset allocators. We will explore how investors could take advantage of this discrepancy in future reports on factor allocation.   Implementation Of Quality Using Quality And Size Chart 6The Small-Cap Premium Is Higher When Adjusted For Quality Historically, small-cap stocks have delivered excess returns over large cap-stocks – a well-documented phenomenon known as the size premium. However, this premium has been very unstable and extremely seasonal, occurring mostly in the month of January, and providing no excess returns in all other months. Moreover, some research has suggested that the size premium cannot be harvested easily in practice, since most of the premium is concentrated in the very smallest stocks (microcaps), which are highly illiquid.12 The issues surrounding the size premium have prompted some academics to question its existence. However, recent research on the interaction of quality and size has brought back interest to this topic. In the paper “Size Matters, If You Control Your Junk”, Assness et al show that many of the problems with the size premium are caused by the bias that small caps have to low quality. Once this low-quality bias is accounted for, the size premium becomes much larger and stable – a result that also holds when controlling for a quality proxy like profitability (Chart 6). Notably, the concentration of returns in January and in microcaps also disappears when the bias is removed.13 This bias to low quality is a significant problem in most popular small-cap indices. The profitability of indices like the S&P 600 has historically been lower than its large-cap counterparts (Chart 7,  top panel). Moreover, a similar story holds for leverage: While the much maligned increase in corporate debt is evident in small-cap indices, it is virtually nonexistent when looking at large-cap indices like the S&P 500, where leverage measures stand barely above 30- year lows (Chart 7, bottom panel). How can this bias be removed? Stock-level filters for quality might be difficult to implement for many investors. Instead, an easier solution is to exploit the size premium through a small-cap quality index. S&P currently offers the S&P 600 Quality Index, which selects the 120 highest-quality stocks out of the S&P 600. Importantly, since this quality adjustment removes some of the low-quality bias from the S&P 600, the S&P 600 Quality index is able to maintain performance on the upside, while also limiting the sharp periods of underperformance that usually affect small caps during bear markets (Chart 8). Chart 7Small-Cap Stocks Have A Lot Of Junk Chart 8Small-Cap Quality Is A Better Way To Exploit The Size Anomaly   Using Quality And Value The intersection between value and quality – a pair of factors that have a negative correlation – has been a topic of interest since quality was first discovered.14 They stand as perfect complements of each other: The value factor tries to find cheap stocks, regardless of their quality, while the quality factor tries to find quality stocks regardless of their price. Together they make for a powerful combination: Quality stocks at affordable prices. Some research has suggested that this combination of value and quality lies behind the success of Graham’s greatest student. According to the seminal paper titled “Buffet’s Alpha”, the biggest factor exposures of the Berkshire Hathaway portfolio from 1980 to 2011, outside of overall market risk, were quality and value15 (Chart 9). Exposure to these factors, along with low beta, as well as the ability of Berkshire Hathaway to obtain cheap leverage thanks to its insurance business, explained most of the excess returns that Warren Buffet was able to achieve. Chart 9Buffett's Motto: High Quality, Cheap, And Low Risk Commercial providers have started to offer indices which combine value and quality. As an example, MSCI offers the Prime Value indices, where stocks are first screened for quality and then ranked according to a value score. This methodology has outperformed its normal value counterparts in both the euro area and the US (Chart 10). Chart 10Quality Adjustments By MSCI Improve Value In The Euro Area Chart 11Stronger Quality Filters Are Needed In The US To Enhance Value   Interestingly, despite value’s recent doldrums, the quality adjustment done in the Prime Value index has helped value perform relatively well in the euro area for the past couple years. However, the same cannot be said in the US where performance of Value and Prime Value has been almost identical since 2003. This suggest a couple of options: It could be that, even when adjusting for quality, value behaves fundamentally differently in different countries. Alternatively, it could also mean that the US market is more efficient at pricing quality, which would imply that a simple quality filter would not do much, since quality at an attractive valuation would be harder to find. We suspect the reason might be the latter. In this case a stronger quality filter might be needed to substantially enhance the performance of value. The newly released Russell 1000 QARP (Quality At A Reasonable Price) Index follows this methodology. It applies a double quality filter and then compounds it by a value score. This index has substantially enhanced performance relatively to the Russell 1000 Value index (Chart 11). Moreover, it has also been able to fare better relative to the broad market and has avoided the large underperformance that value has undergone since 2018. Bottom Line Quality has been one of the most successful factors over the past three decades. But will this performance continue? While the exact reason behind the quality anomaly remains unclear, the evidence suggests that institutional incentives and behavioral biases, which are likely to persist in the future, might be responsible for the outperformance of quality in the market. Thus, investors should consider adding quality stocks to their portfolios. Moreover, quality can also be used to enhance the performance of other popular factors in the following ways: Correcting for the low-quality bias of small caps, makes the small-cap premium larger and much more stable over the long term. A practical way to correct for this low-quality bias is to buy small-cap quality portfolios such as the S&P 600 Quality Index. Value stocks also tend to have low quality. Investors can improve the performance of the value factor by using quality filters to find quality stocks that are also cheap. The quality filters in the MSCI Prime Value Index has significantly improved the performance of value in the euro area. Meanwhile, the Russell 1000 QARP index, which selects for value stocks using a stronger quality filter than MSCI, has kept pace with the overall market even amidst value’s collapse.   Juan Correa Ossa, CFA  Associate Editor juanc@bcaresearch.com Appendix 1 Footnotes 1  Robert Novy-Marx, “Quality Investing,” Working Paper, 1-28 (2014) 2  In Graham’s own words: “An indefinite and approximate measure of the intrinsic value may be sufficient. To use a homely simile, it is quite possible to decide by inspection that a woman is old enough to vote without knowing her age or that a man is heavier than he should be without knowing his exact weight.” 3  Asness, C.S., Frazzini, A. & Pedersen, L.H. “Quality minus junk,” Rev Account Stud 24, 34–112 (2019). 4 Winsorization is a way to remove the effects of outliers in the data. In this case all the values above the 95th percentile are set to the 95th percentile value and all the values below the 5th percentile are set to the 5th percentile value. 5 Robert Novy-Marx, “Backtesting Strategies Based on Multiple Signals,” NBER Working Paper No. w21329 (2015). 6 Jason Hsu, Vitali Kalesnik, Engin Kose, “What Is Quality?” Financial Analysts Journal, 75:2, 44-61 (2019). 7 Amanda White, “Quality is Explained by Profitability,” Top1000funds.com, (2015). 8 Dan Hanson and Rohan Dhanuka, “The ‘Science’ and ‘Art’ of High Quality Investing,” Journal of Applied Corporate Finance, 27:2 (2015). 9 C.S. Asness, A. Frazzini, and L.H. Pedersen, “Quality minus junk,” Rev Account Stud 24, 34–112 (2019). 10 Please see Global Asset Allocation Special Report, “Less Risk And More Reward? The Low-Volatility Factor In Equity Markets”, dated January 29, 2020. 11 This theory on the quality anomaly might explain the different performance of quality in credit and equity markets. For more details, please see Box 1. 12 Please see Global Asset Allocation Special Report, “Small Cap Outperformance: Fact Or Myth?” dated April 7, 2020. 13 Cliff S. Asness, Andrea Frazzini, Ronen Israel, and Lasse Heje Pedersen, “Size Matters, If You Control Your Junk,” CEPR Discussion Paper, No. DP12684 (2018). 14 Robert Novy - Marx, “The Other Side of Value: The Gross Profitability Premium,” Journal of Financial Economics, 108(1) , 1 - 28, (2013) and “The Quality Dimension of Value Investing,” University of Rochester, Working Paper (2014). 15 Andrea Frazzini, David Kabiller, and Lasse Heje Pedersen,  "Buffett’s Alpha," Financial Analysts Journal, 74-4, 35-55 (2018).    

Bank Credit Analyst

Highlights A weak dollar and low bond yields have pushed up the S&P 500 more than anticipated. Cyclical forces favor loftier stock prices in 12 months. Froth creates short-term vulnerabilities that higher yields could catalyze. The lack of yield curve control along with an improving economic outlook and a decline in deflationary risks indicate that Treasury yields will move toward 1% in the coming months. Long-term investors should begin to add small-cap stocks to their core US holdings. Feature The S&P 500 recent all-time high flies in the face of a long list of tactical indicators that flag an elevated risk of correction. The strength of the US equity market is a testament to the power of policy stimulus, the perceived invincibility of tech titans and the hopes that the powerful economic recovery will continue. Although equities will climb in the coming year, a move up in yields should transfer the leadership from tech and growth stocks to value and traditional cyclicals. While these shifts usually do not spell the end of bull runs, often they generate periods of elevated volatility, especially when the displaced leaders account for 40% of market capitalization. Small-cap stocks look increasingly attractive. A Post Mortem We have been cyclically bullish since late March,1 but on June 25th we warned that the S&P 500 would churn between 2800 and 3200 for the rest of the summer.2 This view did not materialize for several reasons. We underestimated the impact of a weak dollar, which has given a second life to the equity bull market. When expressed in euros, the S&P 500 has been flat since June 5 (Chart I-1). Relative to gold, the S&P 500 is down by 9% since June 8, which further highlights how equities have been supported by a weak US currency and a plentiful money supply. Meanwhile, the S&P 500 has outperformed the EURO STOXX 50 by 7.8% since June 5; however, when we factor in the effect of the strong euro, US equities have steadily underperformed the Eurozone benchmark since early May (Chart I-1, bottom panel). Low bond yields have also buttressed US equities. Near-zero interest rates have allowed the valuation of growth stocks to hit extraordinary levels. The NASDAQ trades at 32-times 2020 earnings and 27-times 2021 EPS. The S&P tech is valued at 29-times 2020 EPS and 25-times next year’s profits. In the most extreme cases, the five tech stocks that have accounted for 31.7% of market gains since March 23 (Apple, Amazon, Microsoft, Alphabet and Facebook) trade on average at 40-times 2020 EPS and 32-times 2021 earnings. Low bond yields have also buttressed US equities. Importantly, COVID-19 has had a positive influence on these same tech stocks. According to our European Investment Strategy colleagues, while spending on restaurant, entertainment and retail collapsed during the pandemic, outlays surged on Amazon, Apple products, Netflix subscriptions, etc.3 At the apex of the crisis, online retail sales expanded by 26.3% annually in the US, while bricks-and-mortar sales contracted by an unprecedented -17.7%. Meanwhile, global shipments of personal computers and servers are expanding by 11.2% and 21.5% annually, respectively (Chart I-2, top panel). Therefore, the largest sector of the S&P 500 is outperforming relative to the rest of the market (Chat I-2, bottom panel). As long as investors continue to expect COVID-19 to affect consumer behavior, they will pay a premium for tech stocks that benefit from the pandemic. Chart I-1The Weak Dollar Is Fueling The Recent Rally Chart I-2Earnings Have Supported Tech Stocks   Can Stocks Remain Unscathed? The outlook for stocks is positive, but near-term risks have not dissipated because short-term market conditions remain frothy. Watch for higher bond yields as the force to concretize the tactical risks. The following cyclical forces continue to act as crucial tailwinds for equities: The equity risk premium (ERP) remains low. Computations of ERP must factor in the expected expansion of earnings. To incorporate this alteration, we assume that long-term cash flows will grow in line with potential nominal GDP growth. However, we must also consider the absence of stability of the ERP’s mean. After this adjustment, the ERP is still consistent with significant additional gains for the S&P 500 (Chart I-3). Monetary policy is extraordinarily accommodative. Even when we account for the S&P 500’s elevated multiples, the exceptional jump in the BCA Monetary Indicator is large enough to push up equity prices (Chart I-4). Moreover, the strength of US housing activity indicators confirms that the Federal Reserve has pulled the right levers to boost domestic economic activity. For example, the NAHB Housing Market Index has reached a 22-year record, building permits in July grew at their fastest monthly rate in 30 years, and the Mortgage Applications Index for purchases rocketed to a 11-year high in August. Chart I-3A Low ERP Underpins Equities... Chart I-4...So Does Monetary Policy   The US economy continues to heal. For stocks to climb further on a cyclical basis, the market will need more than five tech giants leading the charge. Hence, earnings expectations for the rest of the market must also mount. Practically, the economy must recover its output loss and the pandemic must ebb. For now, the four-week moving average of initial unemployment claims is drifting lower, and the ISM New Orders-to-Inventories spread is consistent with a faster and more solid business cycle upswing. The ERP is still consistent with significant additional gains for the S&P 500. The global industrial sector outlook is brightening. Manufacturing and trade disproportionately contribute to fluctuations in global economic activity, therefore, they exert an outsized influence on the earnings of non-tech multinationals. The strength in Singapore’s electronics shipments indicates that our Global Industrial Activity Nowcast will accelerate (Chart I-5, top panel). Moreover, the rapid expansion in China’s credit flows points to a marked increase in Chinese imports, which will help industrial and commodity exporters around the world (Chart I-5, bottom panel). Core producer prices have bottomed. Core producer prices are a direct input in the corporate sector’s pricing power. A trough in this inflation gauge leads to stronger EPS and widening profit margins for the S&P 500 (Chart I-6). Chart I-5The Global Industrial Cycle Is Turning The Corner Chart I-6Easing Deflationary Pressures Will Help Profits   Investors should still wait to allocate new funds to the stock market. The stock market’s near-term outlook remains marked by short-term froth that dampens our cyclical optimism, especially because the market advance has been concentrated in a small group of equities. Chart I-7Tactical Froth The Exposure Index of the National Association of Active Investment Managers has hit 100.1 (Chart I-7). Such a lofty reading indicates that the price of stocks already incorporates optimistic expectations. From a contrarian perspective, this development boosts the probability that swing traders will face disappointments in the near future and will sell their equity holdings. Similarly, the put/call ratio is near a 10-year low, which confirms that traders have bought a lot of upside exposure to stocks without much protection against a pullback. This level of confidence is often a precursor to a significant correction. Finally, our Tactical Strength Indicator is 1.7-sigma above its mean. Historically, when this risk gauge has hit a reading above 1.3, there is a good probability that the S&P 500 will correct or move sideways (Chart I-8). A catalyst must emerge for those aforementioned vulnerabilities to morph into a correction. If Treasury yields move closer to 1%, then stocks will experience a significant pullback of 10% or more as the market rotates away from the leadership of growth stocks. This risk would be especially salient if real yields move up. As Chart I-9 illustrates, falling TIPS yields have been a pillar of the powerful rally of growth stocks. Moreover, low real yields are arithmetically necessary to justify the current level of market multiples exhibited by the S&P 500 (Chart I-9, bottom panel). Chart I-8The S&P 500 Is Vulnerable To A Correction Chart I-9Falling Real Yields Have Helped Growth Stocks   Growth and high-P/E ratio stocks are heavily represented in the tech and healthcare sectors, which together account for 42% of the S&P 500. This means that higher yields will likely temporarily drag down the entire market. Ultimately, leadership changes are painful events, but they rarely mark the end of bull markets. Can Yields Move Up? Chart I-10Positive Signs For Inflation It is time to tweak our bond market view because yields should soon move higher. For the past five months, we have written that yields offer minimal downside and that their asymmetric risk profile made government bonds an unappealing investment. We underweighted this asset class relative to stocks and recommended investors bet on higher inflation breakeven rates. However, forces are aligning to expect real rates to rise and thus, nominal yields should move up. The sequencing of the market’s response to QE increasingly favors lower bond prices. Our US Equity Strategy team recently highlighted that in 2009 stocks were the first asset to reflect the implementation of QE1 by the Fed.4 A weaker dollar followed. Bond yields started to perk up only after the USD deteriorated by enough, after stock prices had climbed by enough and after corporate spreads had narrowed by enough to ease financial conditions to stimulate the economy. So far, 2020 echoes the 2009 pattern and our Financial Conditions Index is more stimulatory than it was prior to the COVID-19 outbreak (see Chart III-36 in Section III). Chart I-11Commodities Point To Higher Yields... Inflation momentum confirms the risks to bonds. The apex of the deflationary shock has already passed. In July, core CPI excluding shelter rose by 0.84% month-on-month, which was the highest reading since 1981 when the Fed was combating the most violent inflation outbreak in generations. The upturn in core producer prices also warns that the annual inflation rate of core CPI should accelerate meaningfully by early 2021 (Chart I-10). The dollar’s weakness is another inflationary force. Import prices from China have already bottomed, which points to an escalation in goods inflation in the coming months. Firming commodity prices constitute another risk for yields. Our Commodities Advance/Decline line has recently broken out. This technical development is consistent with higher commodity prices and higher bond yields (Chart I-11). Rallying natural resources are inflationary, but they also indicate that the global economy is strengthening, which should put upward pressure on real interest rates. Strength in the housing sector also confirms that government bond yields have upside. As we highlighted above, a robust housing market is an important validation that monetary policy is very accommodative. By definition, the objective of loose policy is to boost future economic activity and eradicate deflationary pressures. The surge in lumber indicates bond prices are showing downside risk (Chart I-12). Additionally, the upswing in mortgage issuance is occurring as the Treasury and corporations boost their borrowings, which will generate more demand to use savings generated in the economy. The price of those savings will be higher real interest rates. Chart I-12...Especially Lumber The ebbing of COVID-19 also suggests that economic activity has scope to accelerate. Moreover, the House of Representatives reconvened to address the problems plaguing the US Postal Service ahead of the November elections. This early return to work gives Washington another opportunity to negotiate the stimulus bill that it failed to pass earlier this month. We still expect such a bill to ultimately become law because both Democrats and Republicans have too much to lose in November if the economy relapses in response of political paralysis. Declining infections and increased government support will bolster aggregate demand and put upward pressure on rates. The stock market’s near-term outlook remains marked by short-term froth that dampens our cyclical optimism. Market dynamics are also very negative for bonds. Our Valuation Index highlights that Treasurys are incredibly expensive (Chart I-13, top panel). Moreover, our Composite Technical Indicator remains overbought, though it has lost momentum. In this context, the lack of appetite for yield curve control or more QE demonstrated by the Federal Open Market Committee creates a genuine danger for bonds. Without these policies, bond yields will have trouble resisting the upward push created by our rising US Pipeline Inflation Pressures Index, our rebounding Nominal Cyclical Spending proxy (which is an average of the ISM Manufacturing headline index and Prices Paid component), and the uptick in the amount of liquidity sitting on commercial banks’ balance sheets (Chart I-14). Chart I-13Treasurys Are Expensive And Losing Momentum Chart I-14Building Cyclical Risks For Bonds   Thus, equities are at risk on a tactical basis because we anticipate that 10-year Treasury yields may climb towards 1%, including a rise in TIPS yields. The US election creates an additional near-term hurdle for stocks. As we wrote last month, President Trump will likely become more belligerent toward the US’s trading partners in the coming months. Moreover, Vice-President Joe Biden, who has a comfortable lead in the polls including in key swing states such as Florida, Michigan, Pennsylvania, and Wisconsin wants to cancel half of the 2017 tax cuts.5  Small Over Big Long-term investors should expect stocks to beat bonds on a 5- to 10-year horizon, but equities will generate paltry real returns compared with the past 40 years. Elevated valuations for US equities are consistent with long-term annualized real rates of return of only 0.5% (Chart I-15). Moreover, the long-term outlook for profit margins is poor. As we wrote three months ago, mounting populism will result in redistributive policies that will lift the share of wages relative to GDP.6 Moreover, the shift of the US population to the left on economic matters will push up corporate tax rates. Increased labor costs and corporate taxes are negative for profit margins. If profit margins normalize, then equities will probably underperform the uninspiring expected returns implied by current market multiples. The surge in lumber indicates bond prices are showing downside risk. Investors can still generate generous returns through geographical and sectoral selection. We have highlighted how value stocks, industrials and materials, and EM and European equities will likely beat US equities.7 This month we will explore how US small-cap equities are also well placed to best the dismal projected real returns offered by their large-cap counterparts. Our BCA Relative Technical Indicator shows that small-cap stocks are 1.8-sigma oversold when compared with the S&P 500, which indicates a capitulation among investors toward these equities. The bifurcation is even greater if we compare small-cap equities with the S&P 100’s mega-caps that have driven up the US market in recent years. Incorporating these influences, our Cyclical Capitalization Indicator has moved in favor of small-cap stocks, which suggests that small-cap stocks will be rerated if the yield curve can steepen further (Chart I-16). Equities are at risk on a tactical basis because we anticipate that 10-year Treasury yields may climb towards 1%. Chart I-15Valuations And Profit Margins Threaten Long-Term Stock Returns Chart I-16Indicators Favor Small Cap Stocks Chart I-17A Debt Turnaround Would Help Small Cap Stocks Debt dynamics could also increasingly beneficial to small-cap equities. In the past few years, the heavy debt-to-EBITDA of smaller firms created a major headwind for small-cap investors. The indebtedness of small-cap stocks often decreases relative to large-caps when an economic recovery begins. This shift in leverage portends an increase in small-caps’ relative future returns (Chart I-17). Our negative bias toward the dollar and our positive view on commodities also benefit small-cap stocks. Since the early 1990s, increasing real commodity prices and a falling Dollar Index have coexisted with a robust performance of small-cap firms (Chart I-18). The negative US balance-of-payment dynamics, coupled with escalating inflation risks, will continue to weigh on the dollar, especially as various large EM nations try to diversify their reserves and payment systems away from the dollar.8 Meanwhile, a declining dollar, expanding global growth, monetary debasement, populism, inflation and a lack of investment in supply, all will accentuate the appeal of natural resources. The sectoral bias of small-cap indices will capitalize on these trends. Chart I-18Small Is Beautiful Chart I-19Small Cap Stocks Like Higher Yields   Finally, cyclical timing is also moving in favor of small-cap firms. Since 2014, the Russell 2000 has outperformed the S&P 500 when real yields moved higher (Chart I-19). Small-cap firms display a more marked pro-cyclicality than large firms. Additionally, the S&P 500 growth bias implies that the US large-cap benchmark underperforms the small cap indices when real yields increase.   Mathieu Savary Vice President The Bank Credit Analyst August 27, 2020 Next Report: September 24, 2020   II. Global Semiconductor Stocks: A Hiatus Is Overdue In A Structural Bull Market The strength in global semiconductor sales in recent months has been due to one-off factors stemming from pandemic-related lockdowns. As the one-off demand surge subsides, global semiconductor sales will decline modestly toward the end of this year. In the near term, global semiconductor stock prices are vulnerable due to overbought conditions, excessive valuations and demand disappointment. The global semiconductor industry is at the epicenter of the US-China confrontation, and more US restrictions on chips sales to China are probable. This is another risk for this sector's share prices.   Nevertheless, the structural outlook for global semiconductor demand is constructive. Its CAGR may rise from 3% during 2014-2019 to 5% during 2020-2024.  Investor euphoria has taken hold of semiconductor stocks. Global semiconductor stock prices have skyrocketed by 68% from March lows and 96% from December 2018 lows. Meanwhile, global semiconductor sales during March-June rose only by 5% from a year ago. As a result, the ratio of market cap for global semiconductor stocks relative to global semiconductor sales has reached its highest level since at least the inception of data in 2003 (Chart II-1). Chart II-1Global Semi Sector: Market Cap-To-Sales Ratio Has Surged With semi equity multiples very elevated, their share prices have become even more sensitive to global semiconductor demand growth. Hence, the focus of this report is to try to gauge the strength of global semiconductor demand, both in the near term and structurally. The strength in global semiconductor sales in recent months has been due to one-off factors stemming from the lockdowns. Near-term semiconductor stock prices could disappoint due to weak chip demand from the smartphone sector and diminishing purchases of personal computers (PCs) and servers. However, structurally, we are positive on global semiconductor demand, which is underpinned by the continuing rollout of 5G networks and phones, a wider adoption of data centers, and further technological advancements in artificial intelligence (AI), cloud computing, edge computing and smaller nodes for chip manufacturing (Box II-1). Box II-1 Key Technologies Underpinning Potential Global Semiconductor Demand AI refers to the simulation of human intelligence in machines, for example, computers that play chess and self-driving cars. The goals of AI include learning, reasoning and perception. Cloud computing is the delivery of computing services – including servers, storage, databases, networking, software, analytics and intelligence – over the Internet (“the cloud”) to offer faster innovation, flexible resources and economies of scale. Edge computing is a form of distributed computing, which brings computation and data storage closer to where it is needed, to improve response times and save bandwidth. Technology node refers to the width of line that can be processed with a minimum width in the semiconductor manufacturing industry, such as technology nodes of 10 nanometers (nm), 7nm, 5nm and 3nm. The smaller the nodes are, the more advanced they are. Near-Term Headwinds Semiconductor demand worldwide grew by 6% year-on-year in the first half of this year. There has been a remarkable divergence between world semiconductor sales and the global business cycle (Chart II-2). The divergence between semiconductor sales and economic activity was most striking in the US and China. Semiconductor sales in China rose by 5% year-on-year in Q12020, and in the US they grew by 29% year-on-year in Q22020, despite a contraction in their aggregate demand during the same period. By contrast, Q2 annual growth of semiconductors sales was -2.2% for Japan, -17% for Europe and 1.8% for Asia ex. China and Japan (Chart II-3). Chart II-2World Semi Sales Diverged From The Global Business Cycle Chart II-3Strong Semi Sales In The US And China, But Not Elsewhere   The reasons why the US and China posted a surge in semiconductor demand while Europe and Japan experienced a contraction in domestic semiconductor sales are as follows: Most data center investment is occurring in the US and China. Chart II-4 shows that 40% of global hyperscale data centers are operating in the US, much larger than any other countries/regions. China, in turn, ranked second, with a global share of 8%. Chart II-4The US Has The Most Global Hyperscale Data Centers Demand contraction in Europe and Japan is due to semiconductor demand in these regions mainly originating from the automobile sector, where production was severely hit by the global pandemic. About 37% of European semiconductor sales were from last year’s automotive market. We believe the divergence between global economic activity and semiconductor sales, as demonstrated by Chart II-2 on page 3, has been due to one-off factors, as the global pandemic lockdowns have spurred semiconductor demand. Such a one-off demand boost will likely dissipate in the coming months. Traditional PCs and tablets: There has been a surge in demand for traditional PCs9 and tablets in the past six months. This was due to the significant increase in online activities, such as working from home, education, e-commerce, gaming and entertainment. Data from the International Data Corporation (IDC) has revealed that shipments of traditional PCs and tablets in volume terms had a strong year-on-year growth of 11.2% and 18.6%, respectively, in the period of April-June (Chart II-5). Looking forward, even renewed lockdowns will not lead to a similar rush to buy these products. Many households are already equipped to work from home and for other online activities. With many countries gradually opening their economies, such demand will diminish. The traditional PC and tablet sectors together account for about 13% of global chip demand (Chart II-6). Chart II-5Personal Computers Sales Have Surged Amid Lockdowns Server demand: Another major semiconductor demand contribution in Q2020 was from the server sector, which spiked by 21% year-on-year (Chart II-7). The surge in online activities triggered a strong demand for cloud services and remote work applications, both of which require computer servers to run on. Chart II-6The Breakdown Of Global Semiconductor Sales By Type Of Usage However, demand from the server sector is also set to diminish in 2H2020 and Q1 2021. Provided the inventories at major data center operators, including Microsoft, Google and Amazon, remain at high levels,10 global cloud service providers will likely reduce their orders of servers next quarter.11  Enterprises will also likely cut their investment in computer servers in 2H2020, as many of them had already increased their purchases of servers to prepare employees and business processes for remote working. We expect global server demand growth to soften in 2H2020. The Digitimes Research forecasted a 5.6% quarter-on-quarter contraction in 3Q2020 and a further cut in global sever shipment in the 4Q2020.10 The global server sector accounts for about 10% of global chip demand and, together with PCs and tablets, they make for 23% (please refer to Chart II-6 on page 5). Further, the smartphone sector – accounting for 27% of global semiconductor demand – will continue struggling in H2 this year. Chart II-7Server Sales Have Surged Amid Lockdowns Chart II-8Global Smartphone Shipments Will Likely Remain Weak In 2020H2   The global total smartphone demand has been hit severely, as households delayed their new smartphone purchases. According to Canalys’ data, global smartphone shipments dropped by 13% and 14% year-on-year in Q1 and Q2, respectively. We expect smartphone shipments to continue contracting over the next three-to-six months (Chart II-8). We believe global consumers will remain cautious in their spending on discretionary goods, such as smartphones, due to lowered incomes and increased job uncertainty. The IDC also forecasted that global smartphone shipments would not grow until 1Q2021.12 The Chinese smartphone sales showed a considerable weakness in July, with a 35% year-on-year contraction, which is much deeper than the 20% decline in H1 this year. 5G smartphone shipments also slowed last month, with a 21% drop from the previous month. The global semiconductor industry is at the epicenter of the US-China confrontation. Bottom Line: The strength in global semiconductor sales in recent months has been due to one-off factors stemming from the lockdowns. As this one-off demand subsides, global semiconductor sales will decline modestly toward the end of this year. Given the overbought conditions and the elevated equity valuations, global semiconductor stocks are currently vulnerable to near-term disappointments in semiconductor demand. At The Epicenter Of The US-China Rivalry Semiconductors are at the epicenter of the US-China confrontation. Ultimately, the US-China contention is about future technological dominance. That is access to technology and the capability to develop new technologies. China currently accounts for about 35% of the global semiconductor demand. US restrictions on semi producers worldwide to supply semiconductors to Chinese buyers constitute a major risk to semiconductor stock prices. On August 17, the US announced fresh sanctions that restrict all US and foreign semiconductor companies from selling chips developed or produced using US software or technology to Huawei, without first obtaining a license. In May, the US had already limited companies, such as the Taiwan Semiconductor Manufacturing Company (TSMC), from making and supplying Huawei with its self-designed chips. In addition, the US recently threatened bans on Chinese-owned apps TikTok and WeChat, and signaled that it could soon restrict Alibaba’s operations in the US. Chart II-9Global Semi Companies' Sales To China Are Substantial The global semiconductor sector is highly vulnerable to further escalation in the tension between these two superpowers. Major global semiconductor companies’ sales are heavily exposed to China, and their revenue from China ranges from 16% to 50% of total (Chart II-9). We have been puzzled why global semi share prices have been rallying in spite of US limitations on semiconductor shipments to Huawei and its affiliated entities. One explanation could be that the Chinese companies that are not affiliated with Huawei are able to import semiconductors and then supply them to Huawei. If this is true, the US will have no other choice but to limit all semiconductor sales to China. This will be devastating for global semi producers given their large exposure to China. In anticipation of US punitive policies limiting its access to semiconductors, China had boosted its semiconductor imports over the past 12 months (Chart II-10, top panel). Chinese imports of integrated circuits rose by 12% year-on-year in 1H2020, which is much higher than the 5% year-on-year increase in Chinese semiconductor demand during the same period (Chart II-10, bottom panel). This gap suggests the country had restocked its semiconductor inventories. China has particularly restocked its imports of non-memory chips with imports of processor & controller and other non-memory chips in H1, surging by 30% and 20%, respectively, in US dollar terms (Chart II-11). For memory chips, the contraction in Chinese imports was mainly due to a decline in global memory chip prices. Chart II-10China Had Likely Restocked Its Semi Inventories Chart II-11Strong Chinese Imports In Non-Memory Chips   Bottom Line: The global semiconductor industry is at the epicenter of the US-China confrontation, and more restrictions on sales to China are probable. In turn, the restocked semiconductor inventory in China raises the odds of weakening mainland semiconductor import demand in H2 of this year. Structural Tailwinds Table II-1Global Semiconductor Demand CAGR Forecast Over 2020-2024 By Device We are optimistic on structural global semiconductor demand. Its nominal CAGR may rise from 3% during 2014-2019 to 5% during 2020-2024 in US dollar terms. Table II-1 shows our demand growth forecasts for global chips in the main consuming sectors over the next five years. The major contributing sectors during 2020-2024 will be 5G smartphones, servers, industrials, electronics and automotive manufacturing. The underlying driving forces are the continuing rollout of 5G networks and phones, the development of data centers, and further technological advancements in AI, cloud computing and edge computing. Currently, the world is still in the early stages of 5G network development. AI, cloud computing and edge computing are constantly evolving. With increasing adoption of 5G smartphones, computer servers and IoT devices, global semiconductor demand is in a structural uptrend (Box II-2). Box II-2 Key Components For The Virtual World In Development Data centers and cloud computing allow data to be stored and applications to be running off-premises and to be accessed remotely through the internet. Edge computing allows data from Internet of things (IoT) devices to be analyzed at the edge of the network before being sent to a data center or cloud. IoT devices contain sensors and mini-computer processors that act on the data collected by the sensors via machine learning. The IoT is a growing system of billions of devices — or things — worldwide that connect to the internet and to each other through wireless networks. AI technology empowers cloud computing, edge computing and IoT devices. 5G is at the heart of the IoT industry transformation, making a world of everything connected possible. Chart II-125G Phone Shipments In China Will Continue To Rise 5G Smartphone Currently, China is the world’s largest 5G-smartphone consumer and the leading 5G-adopter in the world. According to Digitimes Research, global 5G smartphone shipments will reach over 250 million units in 2020, with 170 million (68%) in China and only 80 million units in the world ex. China. Looking forward, 5G smartphone shipments are set to accelerate worldwide over the coming years. The 5G phone shipments in China will continue to rise. The 5G phone sales penetration rate in China is likely to rise from 60% in July to 95% by the end of 2022. In such a case, we estimate that the monthly Chinese 5G phone shipments will increase from the current 16 million units to about 25-30 million units in 2022 (Chart II-12). In the rest of the world, the 5G smartphone adoption pace will also likely speed up over the next five years. The 5G phone selling prices in the world outside China will drop, as more models are introduced and become more affordable. 5G smartphone prices have already fallen in China and will inevitably fall elsewhere. Chinese 5G smartphone producers will ship their low-priced 5G phones overseas, putting pressure on other producers to lower their prices. The 5G infrastructure development is accelerating in China and will accelerate in the rest of the world. Both China and South Korea have been very aggressive in their respective 5G network development. As of the end of June, China's top three carriers: China Mobile, China Unicom, and China Telecom – which together serve more than 1.6 billion mobile users in the country – had installed 400,000 5G base stations against an annual target of 500,000. In comparison, as of April 2020, American carriers had only put up about 10,000 5G base stations.13  As the US is competing with China on the 5G front, the country will likely boost its investment in 5G network development aggressively over the next five years in order to catch up to, or even exceed, China. Importantly, the 5G smartphone has more silicon content than 4G smartphones. More silicon content means higher semiconductor value. Rising 5G smartphone sales and higher silicon content together will more than offset the loss in semiconductor sales due to falling global 4G smartphone shipments. Overall, global semiconductor stock prices have diverged from their sales and profits. Based on our analysis, we expect a CAGR growth of 4% in semiconductor demand from the global smartphone sector over the next five years, slightly lower than the 5% in previous five years (Table II-1 on page 10). This also takes into consideration that the 5G network will be more difficult and more expensive to develop than the 4G network. Servers Global server shipment growth will be highly dependent on both the pace and the scale of data center development (Box II-3). Data centers account for over 60% of global server demand.  Box II-3 Data Centers There are four main types of data centers – enterprise data centers, managed services data centers, colocation data centers, and cloud data centers. Data centers can have a wide range of number of servers. Corporate data centers tend to have either 200 (small companies), or 1000 servers (large companies). In comparison, a hyperscale data center usually has a minimum of 5,000 servers linked with an ultra-high speed, high fiber count network. Outsourcing and a move towards the cloud are driving the growth of the hyperscale data center. Instead of companies investing in physical hardware, they can rent server space from a cloud provider to both save their data and reduce costs. Amazon, Microsoft, Google, Apple and Alibaba are all top global cloud service providers. The more hyperscales to be built up, the higher the demand for servers. In 2019, about 13% of the total number of data centers in China were of the hyperscale and large-scale varieties. The plan of new infrastructure development announced earlier this year by Beijing was aiming to increase the number of hyperscale and large-scale data centers in China. Among current data centers either under construction or to be developed in the near future, 36% of them are hyperscale and large-scale data centers.   The future growth of data centers is promising. The global trend of data localization14 due to the concerns of data privacy and national security will also bolster a boom of data centers over the next five years. A growing number of countries are adopting data localization requirements, such as China, Russia, Indonesia, Nigeria, Vietnam and some EU countries. While the Chinese data center market is expected to expand by a CAGR of about 28% over 2020-2022,15 a report recently released by Technavio forecasted the global data center industry’s CAGR at over 17% during 2019-2023.  We forecast that the global semiconductor demand from servers will grow at a CAGR of 12% over 2020-2024. IoTs Technological advancements in AI, cloud computing and edge computing, in combination with 5G network development, will facilitate the IoTs adoption. According to the GSMA,16 46 operators in 24 markets had launched commercially available 5G networks by 30 January 2020. It forecasted that global IoT connections will be increased from 12 billion mobile devices in 2019 to 25 billion in 2025 with a CAGR at 13%.17   IoTs chips include the Artificial Intelligence of Things (AIoT) – a powerful convergence of AI and the IoT. IoTs is an interconnected network of physical devices. Every device in the IoT is capable of collecting and transferring data through the network. Looking forward, global demand of AI chips and IoT chips will have significant potential to grow with creation of “smarter manufacturing”, “smarter buildings”, “smarter cities”, etc. AI applications can be used in manufacturing processes to render them smarter and more automated. Productivity will be enhanced as machines achieve significantly improved uptime while also reducing labor costs. There are plenty of upsides in industrial semiconductor demand (Chart II-13). We expect the CAGR of industrial electronics to increase from 3.4% during 2014-2019 to 8% during 2020-2024. AI applications can create smart buildings by increasing connectivity across enterprise assets, enabling home network infrastructure (e.g., routers and extenders) and employing home-security devices (e.g., cameras, alarms and locks). AI applications can be used to create smart cities. A smart city is an urban area that uses different types of IoT electronic sensors to collect data. Insights gained from that data are used to manage assets, resources and services efficiently; in return, that data is used improve operations across the city. China has already developed about 750 trial sites of smart cities with different degrees of smartness in the past decade. As AI and 5G technology advances, the existing smart cities’ “smartness” will be upgraded and new trial smart cities will be implemented. Based on IDC data, China’s investment in smart cities will rise at a CAGR of 13.5% over 2020-2023 (Chart II-14). Globally, the U.S., Japan, European countries and other nations are also actively developing smart cities. According to a new study conducted by Grand View Research, the global smart cities market size is expected to grow at a CAGR of 24.7% from 2020 to 2027.18  Chart II-13Plenty Of Upside In Industrial Semi Demand Chart II-14China’s Investment In Smart Cities Will Continue To Grow   Automotive We expect the global automotive chip market to grow at a CAGR of 9% during 2020-2024, as in 2014-2019. The increase in consumption of semiconductors by the auto industry will continue to be driven by the market evolution toward autonomous, connected, electric and shared mobility. Most new vehicles now include some level of advanced driver assist systems (ADAS), such as adaptive cruise control, automatic brakes, blind spot monitoring, and parallel parking. The whole industry is progressing toward fully autonomous vehicles in the coming years. Increasing adoption of automotive chips and recovering car sales will revive automotive chip sales. In addition, rising penetration of new energy vehicles (NEVs) is beneficial to semiconductor sales, as NEVs contain higher semiconductor content than conventional vehicles. Conventional vehicles contain an average of a $330 value of semiconductor content while hybrid electric vehicles can contain up to $1,000 and $3,500 worth of semiconductors.19 Regarding other sectors, we are also positive on structural demand of storage and consumer electronics. AI applications generate vast volumes of data — about 80 exabytes per year, which is expected to increase by about tenfold to 845 exabytes by 2025.20 In addition, developers are now using more data in AI and deep learning (DL) training, which also increases storage requirements. With massive potential demand for storage, we estimate a CAGR of 7% over 2020-2024 (Table II-1 on page 10). A recent report from ABI Research predicts that the COVID-19 pandemic will increase global sales of wearables (such as a Fitbit or Apple Watch) by 29% to 30 million shipments of the devices this year. With contribution from wearables, we expect global semiconductor demand from the consumer sector to grow at a CAGR of 3% over 2020-2024, the same rate as in the previous five years. Bottom Line: Continuing rollout of 5G networks and phones, development of data centers, and further technological advancements in AI and cloud computing will provide tailwinds to structural global semiconductor demand, accelerating its CAGR growth from 3% during 2014-2019 to 5% during 2020-2024. Valuations And Investment Conclusions Most global semiconductor stocks are currently over-hyped. Critically, both DRAM and NAND prices have been deflating since January, reflecting weak demand for memory chips. Yet, share prices of memory producers have rallied (Chart II-15). Overall, global semiconductor stock prices have diverged from their sales and profits (Chart II-16). Chart II-15Falling Memory Prices Pose Risk To Memory Stocks Chart II-16Global Semiconductor Stocks Have Deviated From Profits   Consequently, the multiples of semiconductor stocks have spiked to multi-year highs (Chart II-17).  Even after adjusting for negative US real bond yields, valuations of semiconductor stocks are not cheap. Chart II-18 illustrates the equity risk premium for global semiconductor stocks is at the lower end of its range of the past 10 years. The ERP is calculated as forward earnings yield minus 10-year US TIPS yields. Chart II-17Global Semi Stocks: Elevated Valuations Chart II-18Equity Risk Premium For Global Semi Stocks Is Historically Low   It is impossible to time a correction or know what the trigger would be (US-China tensions have been our best guess). Nevertheless, we do not recommend chasing semiconductor stocks higher due to their overstretched technicals and valuations on the one hand and potential weakening demand in H2 on the other. In addition, the ratio of global semi equipment stock prices relative to the semi equity index correlates with absolute share prices of global semi companies. This is because equipment producers are higher-beta as they outperform during growth accelerations and underperform during growth slumps. The basis is that semi manufacturers have to purchase equipment if there is actual strong demand coming up and vice versa. The recent underperformance by global semi equipment stocks relative to the semi equity index might be an early sign of a potential reversal in semi share prices in absolute terms (Chart II-19). Chart II-19A Signal Of A Potential Reversal In Semi Share Prices Meanwhile, we believe the subsector- memory chip stocks - will outperform the overall semiconductor index amidst the potential correction, because they have lagged and are less over-extended. Finally, we remain neutral on Taiwanese and Korean bourses within the EM equity space for now. Escalation in US-China confrontation, as well as their exposure to semiconductors, put these bourses at near-term risk. That said, we are reluctant to underweight these markets because fundamentals in EM outside North Asia remain challenging.   Ellen JingYuan He Associate Vice President Emerging Markets Strategy III. Indicators And Reference Charts We continue to favor stocks at the expense of bonds, but equities are increasingly vulnerable because short-term sentiment and positioning measures are growing increasingly stretched. Three forces can prompt a correction. First, a rebound in yields toward 1% would cause turbulence for the S&P 500, because the index is dominated by growth stocks that are highly sensitive to fluctuations in the risk-free rate. Second, a dollar bounce would hurt the S&P 500 because a depreciating USD has fueled the US stock market rally since June. Finally, the US presidential election is drawing nearer; hence, the risk of potentially damaging political headlines is growing.  Despite these short-term risks, the main pillar supporting the rally remains intact: global monetary conditions are highly accommodative and the chance of inflation moving high enough to spook central bankers is minimal in the near future. Additionally, the fiscal spigots are open and governments around the world will ultimately continue to support their economies. Hence, any correction in the S&P 500 is unlikely to move beyond 15% or a level of 2900. Our cyclical indicators confirm the positive backdrop for stocks. While our Valuation Indicator has reached overvalued territory, our Monetary Indicator remains extremely accommodative. Moreover, our Technical Indicator is now flashing a clear buy signal. Putting all those forces together, our Intermediate-Term Indicator continues to support equities. Finally, our Revealed Preference Indicator strongly argues in favor of staying invested in equities. That being said, our Speculation Indicator has surged back up, thus the volatility of the rally should increase. Bonds remain extremely unappealing. Our Bond Valuation Index shows Treasurys as prohibitively expensive and our Composite Technical Indicator continues to lose momentum. So far, government bond yields have managed to remain stable at very low levels even if they have not declined further. Nonetheless, bonds have underperformed equities, which is a trend that will remain in place for many more quarters. Moreover, the pick-up in commodity prices and in various gauges of the business cycle suggests that bond yields should soon move higher, especially because the Fed is far from enthused at the concept of yield curve control. Our Cyclical Bond Indicator has turned higher and will soon flash an outright sell signal. The dollar continues to weaken after its recent breakdown. For now, the USD’s weakness has been concentrated among DM currencies. For the dollar to weaken further, EM currencies must begin to rally more markedly than they have until now, especially in Latin America. The firmness of the CNY is a good sign for the EM complex, but another clear up-leg in global growth must emerge before EM currencies can fully blossom. As a result, we are likely to have entered a temporary period of consolidation for the US dollar. The extremely oversold nature of our Dollar Composite Technical Indicator supports the idea that the dollar needs to digest its recent losses before its poor fundamentals force it lower once again. Finally, commodities have been a prime beneficiary of the weakness in the dollar and the combination of stable yields and improving economic activity. Our Composite Technical Indicator is now well into overbought territory which makes natural resource prices vulnerable to a pullback. A move up in yields as well as a short-term rebound in the dollar will likely catalyze any underlying technical risks to commodities. Gold will be particularly vulnerable to any such pullback, especially if higher real yields are the cause of the correction in natural resource prices. Despite these short-term worries, the outlook for commodities remains bright. As a result, we would use any correction to add exposure to the commodity complex. EQUITIES: Chart III-1US Equity Indicators Chart III-2Willingness To Pay For Risk Chart III-3US Equity Sentiment Indicators   Chart III-4Revealed Preference Indicator Chart III-5US Stock Market Valuation Chart III-6US Earnings Chart III-7Global Stock Market And Earnings: Relative Performance Chart III-8Global Stock Market And Earnings: Relative Performance   FIXED INCOME: Chart III-9US Treasurys And Valuations Chart III-10Yield Curve Slopes Chart III-11Selected US Bond Yields Chart III-1210-Year Treasury Yield ComponentsChart III-13US Corporate Bonds And Health Monitor Chart III-14Global Bonds: Developed Markets Chart III-15Global Bonds: Emerging Markets   CURRENCIES: Chart III-16US Dollar And PPP Chart III-17US Dollar And Indicator Chart III-18US Dollar Fundamentals Chart III-19Japanese Yen Technicals Chart III-20Euro Technicals Chart III-21Euro/Yen Technicals Chart III-22Euro/Pound Technicals   COMMODITIES: Chart III-23Broad Commodity Indicators Chart III-24Commodity Prices Chart III-25Commodity Prices Chart III-26Commodity Sentiment Chart III-27Speculative Positioning   ECONOMY: Chart III-28US And Global Macro Backdrop Chart III-29US Macro Snapshot Chart III-30US Growth Outlook Chart III-31US Cyclical Spending Chart III-32US Labor Market Chart III-33US Consumption Chart III-34US Housing Chart III-35US Debt And Deleveraging   Chart III-36US Financial Conditions Chart III-37Global Economic Snapshot: Europe Chart III-38Global Economic Snapshot: China   Mathieu Savary Vice President The Bank Credit Analyst Footnotes 1 Please see The Bank Credit Analyst "April 2020," dated March 26, 2020, available at bca.bcaresearch.com 2 Please see The Bank Credit Analyst "July 2020," dated June 25, 2020, available at bca.bcaresearch.com 3 Please see European Investment Strategy "An Economy Without Mouths Or Noses Will Lose 10 Percent Of Jobs," dated July 30, 2020, available at eis.bcaresearch.com 4 Please see US Equity Strategy "Inversely Correlated," dated August 25, 2020, available at uses.bcaresearch.com 5 Please see The Bank Credit Analyst "August 2020," dated July 30, 2020, available at bca.bcaresearch.com 6 Please see The Bank Credit Analyst "June 2020," dated May 28, 2020, available at bca.bcaresearch.com 7 Please see The Bank Credit Analyst "August 2020," dated July 30, 2020, available at bca.bcaresearch.com 8 Diversifying away from the dollar does not mean that the USD will lose its reserve status. However, a return to the share of FX reserves that prevailed in the first half of the 1990s will hurt the dollar, especially because the US net international investment position has fallen from -4.6% of GDP in 1992 to -57% today. 9 Traditional PCs are comprised of desktops, notebooks, and workstations. 10 Global server shipments to contract 5.6% sequentially in 3Q2020, says Digitimes Research 11 Global server shipments forecast to increase by 5% this year: TrendForce 12 IDC Expects Worldwide Smartphone Shipments to Plummet 11.9% in 2020 Fueled by Ongoing COVID-19 Challenges 13 America does not want China to dominate 5G mobile networks 14 “Data localization” can be defined as the act of storing data on a device that is physically located within the country where the data was created. Data localization requirements are governmental obligations that explicitly mandate local storage of personal information or strongly encourage local storage through data protection laws that erect stringent legal compliance obligations on cross-border data transfers. 15 The big data center industry ushered in another outbreak 16 The GSMA represents the interests of mobile operators worldwide, uniting more than 750 operators with almost 400 companies in the broader mobile ecosystem, including handset and device makers, software companies, equipment providers and internet companies, as well as organizations in adjacent industry sectors. 17 GSMA: 5G Moves from Hype to Reality – but 4G Still King 18 Smart Cities Market Size Worth $463.9 billion By 2027 19 The Automotive Semiconductor Market – Key Determinants of U.S. Firm Competitiveness 20 AI is data Pac-Man. Winning requires a flashy new storage strategy.

Dear Client, In lieu of our regular report next week, we will be sending you a Special Report from my colleague Garry Evans, Chief Global Asset Allocation Strategist. Garry will be discussing the social and industrial changes that will remain in place even after the COVID-19 pandemic is over, and how investors should tilt their portfolios to take advantage of them. I hope you find his report insightful. Best regards, Peter Berezin, Chief Global Strategist Highlights The number of coronavirus cases in the US appears to have peaked. Negotiations to avert a fiscal cliff continue in Washington. While we expect a deal to be reached, markets could tread nervously until this happens. The US dollar will weaken further over the next 12 months. Narrowing interest rate differentials, a revival in global growth, deteriorating momentum, and pricey valuations all bode poorly for the greenback. Global equities in general, and non-US stocks in particular, tend to fare well in a weak dollar environment. Small cap and value stocks usually outperform when the dollar weakens. Bank shares should start to do better as yield curves steepen and faster economic growth reduces concerns over non-performing loans. US Virus Wave Cresting, But Fiscal Risks Intensifying Chart 1US: Number Of New Cases Seems To Be Peaking Last week, we argued that the two biggest near-term threats to stocks and other risky assets were the rising number of coronavirus cases in parts of the US and the looming fiscal cliff.1 Since then, the news on the virus has been broadly positive, while developments on the fiscal front have been mixed. Chart 1 shows that the number of new cases seems to have peaked in the US. In Texas, Florida, California, and Arizona, the share of doctor visits linked to suspected Covid infections is trending lower. This metric leads diagnoses by about one-to-two weeks (Chart 2).   Chart 2Doctor Visits, Which Lead Diagnoses, Are Trending Lower Over half the US population lives in states that have either suspended or reversed reopening plans (Chart 3). Assuming the number of infections keeps falling and fiscal policy is not unduly tightened, household spending and employment growth – which appear to have stalled out in the second half of July – should begin to pick up. Chart 3Not So Fast Unfortunately, the assumption that fiscal policy will remain stimulative looks somewhat shaky. Expanded unemployment benefits for 30 million Americans, consisting mainly of an additional $600 per week for unemployed workers, are set to expire at the end of July. Congressional Republicans have suggested trimming benefits to $200 per week. However, even that would represent a fiscal tightening of nearly 3% of GDP. A Question Of Incentives The Republican position is understandable, given that two-thirds of unemployed workers are currently receiving more in unemployment benefits than they earned while working. Thus, some scaling back of benefits is not only inevitable, but desirable. The question is one of timing. While job openings have risen from their lows, they are still 23% below where they were at the start of the year. According to the NFIB survey, the share of small businesses reporting difficulty in finding qualified workers has also fallen from year-ago levels. When the binding constraint on employment is a shortage of jobs rather than a shortage of workers, higher unemployment benefits will likely boost hiring. This is because increased benefits will increase spending on goods and services across the economy, thus augmenting the demand for labor. Debt, Gold, And The Dollar Chart 4Gold Prices Have Risen On The Back Of Falling Real Yields Does the inevitable increase in government debt due to ongoing fiscal stimulus portend disaster down the road? According to many commentators, the recent drop in the dollar and the surge in gold prices is surely telling us that it does. While it is a compelling story, it is mainly false. The yield on the 30-year Treasury bond currently stands at 1.20%, down from 1.5% in mid-June and 2.33% at the start of the year. Bondholders may be many things, but masochistic is not one of them. If they really thought a fiscal crisis was around the corner, yields would be a lot higher. So why is the dollar falling and gold rallying? The answer is inflation expectations have risen off very low levels, which has pushed down real yields. Gold prices are almost perfectly correlated with real interest rates (Chart 4). The Real Reason The Dollar Has Fallen Going into this year, US real yields had a lot more room to decline than rates abroad. For example, at the start of 2019, US real 2-year yields were 221 bps above comparable euro area yields. Today, US real rates are 35 bps lower – a swing of 256 bps. Yield differentials have narrowed against other economies as well, which has pushed down the value of the dollar (Chart 5). In addition, relative growth dynamics have hurt the greenback. The US economy tends to be less cyclical than most of its trading partners. While the US benefits from faster global growth, the rest of the world benefits even more. This causes capital to flow from the US to other countries, leading to a weaker dollar (Chart 6). Chart 5The Greenback Has Been Losing Interest Rate Support Chart 6The Dollar Usually Weakens When Global Growth Accelerates   Chart 7The Dollar And Cycles BCA Research’s Foreign Exchange Strategist, Chester Ntonifor, has stressed that the dollar typically fares worst in the initial stages of business cycle recoveries (Chart 7). That is the stage we are in today. Indeed, the gap in growth between the US and the rest of the world is likely to be larger than usual over the next few quarters because the pandemic has hit the US harder than most other developed economies. Momentum is also working against the dollar. Being a contrarian is usually a smart investment strategy. That is not the case when it comes to trading the dollar. With the dollar, you want to follow the herd.  This is because the dollar is a high momentum currency (Chart 8). A simple trading rule that buys the dollar when it is trading above its 50-day or 200-day moving average, and sells the dollar when it is trading below its respective moving averages, has historically made a lot of money. Likewise, the dollar performs best prospectively when sentiment is bullish and improving (Chart 9). Currently, the dollar is trading below its various moving averages. Sentiment is also poor and deteriorating (Chart 10).   Chart 8USD Is A High Momentum Currency Chart 9Trading The Dollar: The Trend Is Your Friend Chart 10The Dollar Has Started Breaking Down   Chart 11The Dollar Is Still Fairly Expensive If the dollar were cheap, all the factors discussed above could be overlooked. But the dollar is not cheap. It is still pricey based on purchasing power parity measures which compare the common-currency cost of identical consumption bundles from one country to the next (Chart 11). A Weaker Dollar is Bullish For Stocks, Especially Non-US Stocks Global equities in general, and non-US stocks in particular, tend to perform well when the dollar is weakening (Chart 12). Chart 12A Weaker Dollar Should Help Global Equities   Chart 13Cyclicals Tend To Outperform Defensives In A Falling Dollar Environment Cyclical sectors such as industrials, energy, and materials normally outperform defensives in a weak dollar environment (Chart 13). Relative profit growth in these sectors tends to rise when the dollar depreciates (Chart 14). To the extent that cyclicals are overrepresented in stock market indices outside the US, this gives non-US equities a leg up. Chart 14Relative Profit Growth In Cyclical Sectors Tend To Rise When The USD Depreciates EM Is The Big Winner From Dollar Weakness A weaker dollar is particularly beneficial to emerging markets. Commodity prices usually rise when the dollar drops (Chart 15). Rising resource prices are good news for many emerging markets. EM debt dynamics also tend to improve when the dollar weakens. EM external debt has grown in recent years (Chart 16). About 80% of EM foreign currency denominated debt is in dollars. A falling dollar reduces the local-currency value of US dollar-denominated liabilities, thus strengthening the balance sheets of many EM companies and governments. Emerging markets with large current account deficits and significant dollar liabilities such as Brazil, Indonesia, Turkey, and Mexico will outperform EMs that generally run current account surpluses and have little in the way of foreign-currency debt. Chart 15Commodity Prices Usually Rise When The Dollar Falls Chart 16EM External Debt Has Grown In Recent Years The Federal Reserve today is trying to engineer an easing in US financial conditions. A weaker dollar is facilitating that goal. Historically, EM stocks have been almost perfectly inversely correlated with US financial conditions (Chart 17). Chart 17EM Equities Benefit From Easier US Financial Conditions What About DM? The impact of a weaker dollar on the stock markets of developed economies is more nuanced. Consider the euro area, for example. On the one hand, a stronger euro hurts the euro area economy, which can ultimately push down domestic profits. A stronger EUR/USD also reduces the profits of European companies with operations in the US when those profits are converted back into euros. That can also hurt European stocks. On the other hand, the overall reflationary effect of a weaker dollar on global growth tends to push up profits. In practice, the latter effect usually dominates the former. Thus, euro area stocks, just like stocks in most other markets, generally outperform the US when the dollar is weakening (Chart 18). Chart 18ANon-US Stock Markets Do Well Vis-À-Vis The US When The Dollar Is Weakening Chart 18BNon-US Stock Markets Do Well Vis-À-Vis The US When The Dollar Is Weakening Small Caps And Value Stocks Tend To Outperform When The Dollar Weakens Even though companies in the small cap Russell 2000 index generate less of their sales from abroad than those in the S&P 500, small caps still tend to outperform large caps in weak dollar environments (Chart 19). This is partly because smaller companies are more cyclical in nature. It is also because the US dollar performs best in a risk-off setting when investors are pouring money into the safe-haven Treasury markets. In contrast, small caps excel in a risk-on environment. Value stocks tend to outperform growth stocks in a weaker dollar environment (Chart 20). Like small caps, cyclical equity sectors are overrepresented in value indices. Financials also tend to punch above their weight in value indices. Chart 19Small Caps Tend To Outperform Large Caps During Weak Dollar Environments... Chart 20...The Same Goes For Value Stocks Small caps and value stocks outperformed between 2000 and 2008, a time when the US dollar was generally weakening. That period saw both a commodity boom and a wave of debt-fueled housing booms. The former lifted commodity prices, while the latter buoyed financials. Commodity prices should rise over the next 12 months thanks to a rebound in global growth and copious Chinese stimulus. Chart 21 shows that the Chinese credit impulse is on track to reach the highest levels since the Global Financial Crisis, while the fiscal deficit will probably hit a record 8% of GDP. The Outlook For Financial Stocks Gauging the outlook for financials is trickier. Credit growth has slowed sharply since the Global Financial Crisis, which has weighed on bank profits. The structural decline in bond yields has also been toxic for bank shares (Chart 22). Lower bond yields tend to translate into flatter yield curves, which can depress net interest margins. Chart 21China Has Opened The Spigots Chart 22The Structural Decline In Bond Yields Has Been Negative For Bank And Value Stocks A falling dollar has historically been associated with higher bond yields (Chart 23). As global growth recovers over the next 12 months, bond yields will edge higher. That said, central bank bond purchases, coupled with aggressive forward guidance, will keep bond yields from rising as much as they normally would. And even if nominal yields do rise, inflation expectations will rise even more, implying that real yields will fall further. Falling real yields tend to benefit growth stocks more than they benefit value stocks. Chart 23Bond Yields Tend To Rise When The Dollar Weakens Still, even a modest steepening of the yield curve will be good for bank earnings. A recovery in economic activity should also dampen concerns about a spike in bad loans. Credit spreads normally fall when economic growth is improving and the dollar is weakening (Chart 24). Banks have significantly increased provisions since the start of the year, which has depressed reported earnings. If some of those provisions are reversed, profits will jump. Chart 24Credit Spreads Tend To Fall When Growth Is Improving And The Dollar Is Weakening Chart 25Bank And Value Stocks Are Quite Cheap Moreover, bank stocks in particular, and value stocks in general, are extremely cheap by historic standards (Chart 25). Thus, while the case for favoring value over growth is not as clear-cut as it could be, it is strong enough that long term-oriented investors should consider moving capital from high-flying tech stocks to unloved value stocks.   Peter Berezin Chief Global Strategist peterb@bcaresearch.com Footnotes 1  Please see Global Investment Strategy Weekly Report, “Will Bond Yields Ever Go Up?” dated July 24, 2020. 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