Style: Growth / Value
Highlights The economic performance of Sweden, which did not have a lockdown, has been almost as bad as Denmark, which did have a lockdown. This proves that the current recession is not ‘man-made’, it is ‘pandemic-made’. While the pandemic remains in play, investors should maintain a defensive bias to their portfolios: favouring US T-bonds in bond portfolios, and technology and healthcare in equity portfolios. The technology sector has become defensive, largely because it has flipped from hardware dominance to software dominance. A new recommendation is to overweight technology-heavy Netherlands. Fractal trade: short AUD/CHF. Feature Chart I-IASweden: Avoiding A Lockdown Did Not Prevent A Slump In Consumption... Chart I-1B...But Led To Many More ##br##Infections Sweden and Denmark are neighbours. They speak near-identical languages and share a broadly similar culture and demographic. Yet the two countries have followed completely different strategies to halt the coronavirus pandemic. Sweden chose not to impose a lockdown. Instead, it opted for a ‘trust based’ approach, relying on its citizens to act sensibly and appropriately. Whereas Denmark imposed one of Europe’s earliest and most draconian lockdowns. The contrasting approaches of Sweden and neighbouring Denmark provide us with the closest thing to a controlled experiment on pandemic strategies. The Recession Is Not ‘Man-Made’, It Is ‘Pandemic-Made’ The surprising thing is that the economic performance of Sweden, which did not have a lockdown, has been almost as bad as Denmark, which did. This year, the unemployment rates in both economies have surged by 2 percentage points (albeit the latest data is for May in Sweden and April in Denmark). Furthermore, high-frequency measures of consumption show that Sweden suffered almost as severe a contraction as Denmark (Chart of the Week and Chart I-2). Chart I-2Unemployment Has Surged In Both No-Lockdown Sweden And Lockdown Denmark This surprising result challenges the popular view that this global recession is man-made. This view argues that without the government-imposed lockdowns, the global economy would not have entered a tailspin. But if this view is right, then why did consumption crash in Sweden? The simple answer is that in a pandemic, most people will change their behaviour to avoid catching the virus. The cautious behaviour is voluntary, irrespective of whether there is no lockdown, as in Sweden, or there is a lockdown, as in Denmark. People will shun public transport, shopping, and other crowded places, and even think twice about letting their children go to school. In a pandemic, the majority of people will change their behaviour even without a lockdown. But if the cautious behaviour is voluntary, then why impose a lockdown? The answer is that without a lockdown, the majority will behave sensibly to avoid catching the virus, but a minority will take a ‘devil may care’ attitude. In the pandemic, this is critical because less than 10 percent of infected people are responsible for creating 90 percent of all coronavirus infections. If this tiny minority of so-called ‘super-spreaders’ is left unchecked, then the pandemic will let rip. All of which brings us back to Sweden versus Denmark. As a result of not imposing a mandatory lockdown to rein in its super-spreaders, Sweden now has one of the world’s worst coronavirus infection and mortality rates, four times higher than Denmark (Chart I-3, Chart I-4, Chart I-5). Chart I-3No-Lockdown Sweden Has Suffered Many More Deaths Than Lockdown Denmark Chart I-4Avoiding A Lockdown Meant More Infections… Chart I-5…And More ##br##Deaths Put simply, containing the pandemic depends on reining in a minority of super-spreaders. Which explains why no-lockdown Sweden suffered a much worse outbreak of the disease than lockdown Denmark. In contrast, the economy depends on the behaviour of the majority. In a pandemic the majority will voluntarily exercise caution. Which explains why no-lockdown Sweden and lockdown Denmark suffered similar contractions in consumption. Looking ahead, will the widespread adoption of face masks and plexiglass screens change the public’s cautious behaviour? To a certain extent, yes – it will permit essential activities and let people take calculated risks. That said, if you are forced to wear a mask on public transport and in the shops, and you have to spread out in restaurants while being served by a masked waiter, then – rightly or wrongly – you are getting a strong signal: the danger is still out there. Meaning that many people will continue to shun discretionary activities and spending. The upshot is that while the pandemic remains in play, investors should maintain a defensive bias to their portfolios. Explaining Why Technology Is Now Defensive A defensive bias to your portfolio now requires an exposure to technology – because in 2020 the tech sector is behaving like a classic defensive. Its relative performance is correlating positively with the bond price, like other classic defensive sectors such as healthcare (Chart I-6 and Chart I-7). Chart I-6In 2020, Tech Is Behaving Like A Defensive... Chart I-7...Like Healthcare The behaviour of the technology sector in the current recession contrasts with its performance in the global financial crisis of 2008. Back then, it behaved like a classic cyclical – its relative performance correlated negatively with the bond price (Chart I-8). Begging the question: why has the tech sector’s behaviour flipped from cyclical to defensive? Chart I-8In 2008, Tech Behaved Like A Cyclical The main reason is that the tech sector’s composition has flipped from hardware dominance to software dominance. In 2008, the sector market cap had a 65:35 tilt to technology hardware. But today, it is the mirror-image: a 65:35 tilt to computer and software services (Chart I-9). Chart I-9Tech Is More Defensive Now Because It Is Dominated By Software Computer and software services have many defensive characteristics suited to the current environment: For many companies, enterprise software is now business critical. It is a must-have rather than a like-to-have. Computer and software services use a subscription-based revenue model, minimising the dependency on discretionary spending. Computer and software services are helping firms to cut costs through automation and back-office efficiencies as well as facilitating the boom in ‘working from home’. The sector is cash rich. Despite these defensive characteristics, there remains a lingering worry: is the tech sector overvalued? The Rally In Growth Defensives Is Not A Mania Some people fear that the recent run-up in stock markets does not make sense, other than as a ‘Robin Hood’ day-trader fuelled mania. After all, the pandemic is still very much in play, and so are other geopolitical risks, so how can some stock prices be near all-time highs? Yet the recent run-up in growth defensives such as tech and healthcare does make sense. Their valuations have moved in near-perfect lockstep with the bond yield, implying that the rally is based on fundamentals (Chart I-10). Chart I-10Tech And Healthcare Valuations Are Tracking The Bond Yield Simply put, if the 10-year T-bond is going to deliver a pitiful 0.7 percent a year over the next decade, then the prospective return from growth defensives must also compress. It would be absurd to expect these stocks to be priced for high single digit returns. Since late 2018, the decline in growth defensives’ forward earnings yield has broadly tracked the 250bps decline in the 10-year T-bond yield. Given that the forward earnings yield correlates well with the 10-year prospective return, the depressed bond yield is depressing the prospective return from growth defensives – as it should. Tech and healthcare valuations have moved in near-perfect lockstep with the bond yield. But with the pandemic and geopolitical risks menacing in the background, shouldn’t the gap between the prospective return on stocks and bonds – the equity risk premium – be larger? This is open to debate. When bond yields approach the lower bound, the appeal of owning bonds also diminishes because bond prices have limited upside. Nevertheless, the gap between the tech and healthcare forward earnings yield and the bond yield has gone up this year and is much larger than in 2018 (Chart I-11). This suggests that valuations are taking some account of the pandemic and other risks. Moreover, in a longer-term perspective the current gap between the tech and healthcare forward earnings yield and the bond yield, at +4 percent, hardly indicates a mania. In the true mania of 2000, the gap stood at -4 percent! (Chart I-12) Chart I-11The Equity Risk Premium Has Risen In 2020 Chart I-12Tech And Health Care Valuations Are Not In A Mania In summary, until the pandemic is conquered, investors should maintain a defensive bias to their portfolios. Bond investors should overweight US T-bonds versus core European bonds. Equity investors should overweight the growth defensives, technology and healthcare, which implies overweighting the technology-heavy US versus Europe. A new recommendation is to overweight technology-heavy Netherlands. Stay overweight healthcare-heavy Switzerland, and bank-light France and Germany (albeit expect a technical 5 percent underperformance of Germany versus the UK in the coming weeks). And stay underweight bank-heavy Austria. Fractal Trading System* The AUD is technically overbought and vulnerable to a tactical reversal. Accordingly, this week’s recommended trade is short AUD/CHF, with a profit target and symmetrical stop-loss set at 4.2 percent. The rolling 1-year win ratio now stands at 63 percent. Chart I-13AUD/CHF When the fractal dimension approaches the lower limit after an investment has been in an established trend it is a potential trigger for a liquidity-triggered trend reversal. Therefore, open a countertrend position. The profit target is a one-third reversal of the preceding 13-week move. Apply a symmetrical stop-loss. Close the position at the profit target or stop-loss. Otherwise close the position after 13 weeks. * For more details please see the European Investment Strategy Special Report “Fractals, Liquidity & A Trading Model,” dated December 11, 2014, available at eis.bcaresearch.com. Dhaval Joshi Chief European Investment Strategist dhaval@bcaresearch.com Fractal Trading System Cyclical Recommendations Structural Recommendations Closed Fractal Trades Trades Closed Trades Asset Performance Currency & Bond Equity Sector Country Equity Indicators Bond Yields Chart II-1Indicators To Watch - Bond Yields Chart II-2Indicators To Watch - Bond Yields Chart II-3Indicators To Watch - Bond Yields Chart II-4Indicators To Watch - Bond Yields Interest Rate Chart II-5Indicators To Watch - Interest Rate Expectations Chart II-6Indicators To Watch - Interest Rate Expectations Chart II-7Indicators To Watch - Interest Rate Expectations Chart II-8Indicators To Watch - Interest Rate Expectations
Despite the strong rally in stocks since mid-March and a looming second wave of the pandemic, we continue to recommend that investors overweight equities on a 12-month horizon. Needless to say, this view has raised some eyebrows. With that in mind, this week we present a Q&A from the perspective of a skeptical reader who does not fully share our enthusiasm. Q: You said last week that a second wave of the pandemic is now your base case, yet you’re still sticking with your positive 12-month equity view. Why? A: A second wave of the pandemic, along with uncertainty about how the coming fiscal cliff in the US will be resolved, could unnerve investors temporarily. Nevertheless, we expect global equities to rise by about 10% from current levels over the next 12 months, handily outperforming bonds. While low interest rates and copious amounts of cash on the sidelines will provide a supportive backdrop for stocks, the main impetus for higher equity prices will be a recovery in economic activity and corporate profits. Q: It is hard to see the economy recovering very much if there is a second wave. A: It is important to get the arrow of causation right. Part of the reason we expect a second wave is because we think policymakers will continue to relax lockdown measures even if, as has already occurred in a number of US states, the infection rate rises. Granted, a second wave will moderate the pace at which containment measures can be dismantled. It will also prompt people to engage in more social distancing. Thus, a second wave would make the economic recovery slower than it otherwise would have been. However, it is doubtful that growth will grind to a halt. The appetite for continued lockdowns has clearly waned. For better or for worse, most western nations will follow the “Swedish model” of trying to limit the spread of the virus without imposing draconian restrictions on society. Chart 1CBO Projects The Unemployment Rate Will Fall Very Slowly Q: Even if the Swedish model works, and I doubt it will, we are still in a very deep economic hole. The unemployment rate in many countries is the highest since the Great Depression. The Congressional Budget Office does not foresee the US unemployment rate falling below 5% until 2028. A return to positive growth seems like a very low bar for success. We may need many years of above-trend growth just to get back to the pre-pandemic level of GDP! A: The Congressional Budget Office is too pessimistic in assuming that the recovery will be as sluggish as the one following the Great Recession (Chart 1). That recovery was weighed down by the need to repair household balance sheets after the bursting of a debt-fueled housing bubble. The current downturn was caused by external forces – an exogenous shock in econospeak. Historically, recoveries following exogenous shocks have tended to be more rapid than recoveries following recessions that were instigated by endogenous problems. Q: That may be so, but Wall Street is already penciling in a very rapid recovery. Last I checked, analysts expect S&P 500 earnings next year to be close to where they were last year. A: One has to be careful when comparing earnings estimates with economic growth projections. Chart 2 shows a breakdown of S&P 500 EPS estimates by sector. Appendix A also shows the evolution of these estimates over time. While analysts expect overall earnings per share (EPS) to return to last year’s levels in 2021, this is mainly because of the resilient profit outlook in the technology and health care sectors (the two biggest sectors in the S&P 500 by market cap). Outside those two sectors, EPS in 2021 is expected to be down 8.6% from 2019 levels, or 11.2% in real terms. Chart 2Breakdown Of S&P 500 EPS Estimates By Sector If one looks at the cyclically-sensitive industrials sector, earnings are projected to fall by 16% between 2019 and 2021. Energy sector earnings are projected to decline by 65%. Earnings in the consumer discretionary sector are expected to decline by 8%, despite the fact that Amazon accounts for nearly half of the sector by market cap.1 This suggests that analysts are expecting more of a U-shaped economic recovery than a V-shaped one. Chart 3The Present Value Of Earnings: A Scenario Analysis Q: Fair enough, but I am ultimately more interested in what the market is pricing in than what analysts are expecting. It seems to me that stock prices have rebounded much more rapidly than one would have anticipated based on the evolution in earnings estimates. A: That is true, but it is important to keep in mind that the fair value of the stock market does not solely depend on the expected path of earnings. It also depends on the discount rate we use to deflate those earnings. For the sake of argument, let us suppose that S&P 500 earnings only manage to reach $144 per share next year (10% below current consensus) and take five years to return to their pre-pandemic trend. All things equal, such a decline in earnings would reduce the present value of stocks by 4.2% relative to what it was at the start of the year (Chart 3). However, all things are not equal. The US 30-year Treasury yield, adjusted for inflation, has declined by 59 basis points this year. If we use this real yield as a proxy for the discount rate, the fair value of the S&P has actually increased by 8.7% since January 1st, despite the decline in earnings. Q: I think you’re doing a bit of a bait and switch here. You’re assuming that earnings estimates return to trend by the middle of the decade, but that long-term bond yields remain broadly unchanged over this period. If the economy and corporate earnings recover, won’t bond yields just go back to where they were last year, if not higher? A: Not necessarily. Conceptually, there is not a one-to-one mapping between interest rates and the full-employment level of aggregate demand.2 For example, consider a case where an adverse economic shock hits the economy, making households and businesses more reluctant to spend. If that were all there was to the story, the stock market would go down. But there is more to the story than that. Suppose the central bank cuts interest rates in response to this shock, which boosts demand by enough to return the economy to full employment. Now we have a new equilibrium where the level of demand – and by extension, the level of corporate profits – is the same as before but interest rates are lower. The fair value of the stock market has gone up! Q: Hold on. Central banks came into this recession with little fire power left. I agree that their actions have helped the stock market, but they have not been enough to rehabilitate the economy. A: Good point. That is where the role of fiscal policy comes in. One of the unsung benefits of lower interest rates is that they have incentivised governments to borrow more at a time when the economy needs all the fiscal support it can get. As Chart 4 shows, the fiscal response during this year’s downturn has been significantly larger than during the Great Recession. Thus, it is more correct to say that the combination of lower interest rates and fiscal easing have conceivably increased the fair value of the stock market. Chart 4Fiscal Stimulus Is Greater Today Than It Was During The Great Recession Q: And yet despite all this fiscal and monetary support, GDP remains depressed. A: The point of the stimulus was not to raise output or employment. It was to keep households and businesses solvent during a time when their regular flow of income had dried up. Q: If households and businesses did not spend much of that money, where did it go? A: Much of it remains in the banking system. The US savings rate shot up to 33% in April. As Chart 5 illustrates, this was almost perfectly mirrored by the increase in bank deposits. Anyone who claims that savings have nothing to do with deposits should study this chart. Chart 5Lots Of Savings Slushing Around Chart 6Stocks That Are Popular With Retail Investors Are Outperforming Q: And now, I suppose, these deposits are flowing into the stock market? A: Correct. That is one reason why stocks popular with retail investors have outperformed the S&P 500 by 30% since mid-March (Chart 6). Q: Have these retail flows really been important enough to matter? A: They have probably been more important than widely portrayed. Many of the online brokerages touting zero-commission trades make their money by selling order flow to hedge funds. Thus, the trading of individuals is magnified by the trading of institutional investors. More liquid markets tend to generate higher prices. There is also another subtle multiplier effect worth considering. You mentioned that money was “flowing into the stock market.” Technically speaking, “flow” is not the best word to use. For the most part, if I decide to buy some shares, someone else has to sell me their shares. On a net basis, there is no inflow of cash into the stock market. Rather, what happens is that my buy order lifts the price of the shares by enough to entice someone to sell their shares. Thus, if retail investors bid up the price of stocks to the point that institutions are forced to sell, those institutions are now left with excess cash that they have to deploy elsewhere in the stock market. As the value of investors’ stock portfolios rises, the percentage of their net worth held in cash falls. This game of hot potato only ends when the percentage of cash held by investors shrinks to a level that is consistent with their preferences. Importantly, this means that changes in the amount of cash on the sidelines can have a “multiplier” effect on stock prices. For example, if cash holdings go up by a dollar, and people want to hold ten times as much stock as cash, then stock market capitalization has to go up by ten dollars. Q: How far along are we in this game of hot potato? A: Despite the rally in stocks since mid-March, cash held in money market funds and savings deposits is still 10% higher as a share of market capitalization than at the start of the year. This suggests that the firepower to fuel further increases in the stock market has not been fully spent. Chart 7Equity Risk Premium Is Still Quite High Q: Wouldn’t you think that after a pandemic people would be more risk-averse and hence inclined to hold more cash? A: That would be a logical assumption, but it is not clear whether it is empirically true. There is some evidence from the psychological literature that people who survive life-threatening events tend to become less risk averse rather than more risk averse after the event has passed.3 A pandemic seems to qualify as a life-threatening event. In any case, when considering the equity risk premium, we should not only think about the riskiness of stocks; we should also think about the riskiness of bonds. Bond yields are near record lows. To the extent that yields cannot fall much from current levels, this makes bonds a less attractive hedge against downside economic news than they once were. So perhaps the equity risk premium, which is still quite high, should actually be lower than it currently is (Chart 7). Q: It seems that much of your optimism is based on the assumption that policy will stay stimulative. On the monetary side, that seems like a safe assumption. However, as you yourself mentioned at the outset, there is a risk that stocks will be upended by a premature tightening in fiscal policy. A: This is indeed a risk. In the US, the Paycheck Protection Program (PPP) will run out of funds over the coming month. The additional $600 per week in benefits that jobless workers are receiving will expire on July 31st, causing average unemployment payments to fall by about 60%. Direct payments to households have also ceased. Together, these three fiscal measures amount to about 5.5% of GDP. Furthermore, most states begin their fiscal year on July 1st. Despite receiving $275 billion in federal aid, they are still facing a roughly $250 billion (1.2% of GDP) financing shortfall in the coming fiscal year, which could force widespread layoffs. The good news is that both Republicans and Democrats want to avert this fiscal cliff. While negotiations over the next stimulus package could unnerve investors for a while, they will ultimately culminate in a deal. The Democrats want more spending, as does the White House. And if public opinion polls are to be believed, congressional Republicans will also cave in to voter demands for continued fiscal largess (Table 1). Table 1There Is Much Public Support For Fiscal Stimulus Q: It seems to me that the fiscal cliff is not the only political risk to worry about. Tensions with China are running high and there is domestic unrest in many cities around the world. Even if fiscal policy remains accommodative, President Trump will probably lose in November. This makes a repeal of his tax cuts more likely than not. A: It is true that betting markets now expect Joe Biden to become president (Chart 8). They also expect Democrats to regain control of the Senate. My personal view is that Trump has a better chance of being reelected than implied by betting markets. While the protests have hurt Trump’s favorability ratings in recent weeks, ongoing unrest could help him, given his claim of being the “law and order” president. It is worth recalling that after falling for more than 20 years, the nationwide homicide rate spiked by 23% between 2014 and 2016 following protests in cities such as St. Louis and Baltimore (Chart 9). This arguably helped Trump get elected, just like the Watts Riot in Los Angeles helped Ronald Reagan get elected as Governor of California in 1966. Chart 8Betting Markets Now Expect Joe Biden To Become President If Senator Biden were to prevail, then yes, Trump’s corporate tax cuts would be in jeopardy. A full repeal of the Trump tax cuts would reduce EPS of S&P 500 companies by about 12%. Chart 9Continued Unrest May Help Trump, As It Has In The Past However, it is possible that Democrats would choose to only partially reverse the corporate tax cuts, while also lifting taxes on higher-income households. One should also note that trade tensions with China would probably diminish under a Biden presidency, which would be a mitigating factor for equity investors. Chart 10Cyclical Sectors Should Outperform Defensives As Global Growth Recovers... And A Weaker Dollar Should Also Help Non-US Stocks Q: So to sum up, you are still bullish on stocks over a 12-month horizon, although you see some near-term risks stemming from the likelihood of a second wave of the pandemic and uncertainty about how and when the fiscal cliff problem in the US will be resolved. What are your favorite sectors, regions, and styles? A: Cyclical sectors should outperform defensives over the next 12 months as global growth recovers. Cyclicals are overrepresented outside the US, which should favor overseas markets. A weaker dollar should also help non-US stocks (Chart 10). The dollar generally trades as a countercyclical currency, implying that it will sell off as global growth recovers. Moreover, unlike last year, the greenback no longer enjoys the benefit of higher interest rates than those abroad. In terms of style, value should outperform growth. Growth stocks have done very well in a falling interest rate environment (Chart 11). However, interest rates cannot fall much further from current levels. Small caps should outperform large caps, both because small caps are more growth-sensitive and because they tend to be more popular among day traders. Google searches for “day trading” have spiked in the past few months (Chart 12). Chart 11Interest Rates Cannot Fall Much Lower From Current Levels, Which Will Allow Value To Outperform Growth Chart 12Day Trading Is Back In Vogue These Days Beyond the pure macro plays, the pandemic could lead to a number of unexpected changes that have yet to be fully discounted by markets. For example, we will likely see a surge in the demand for automobiles as people shun public transit. The pandemic could also accelerate the reshoring of manufacturing activity, particularly in the health care sector. Contract manufacturing companies with significant domestic operations will benefit. Additionally, more people will move to the suburbs to work from home and escape the virus and rising crime. This could boost the demand for new houses and lift suburban real estate prices. Since most suburbs are built on top of land previously zoned for agriculture, farmland prices could also rise. Appendix A Evolution Of S&P 500 EPS Estimates By Sector Peter Berezin Chief Global Strategist peterb@bcaresearch.com Footnotes 1 Amazon EPS is projected to rise by 54% between 2019 and 2021, from 11% of overall consumer discretionary earnings to 19%. 2 One can see this within the context of the IS-LM model that is taught to economics undergraduates. If the LM curve shifts outward while the IS curve shifts inward, one could end up with the situation where aggregate demand is the same as before, but the equilibrium interest rate is lower. 3 For example, Gennaro Bernile, Vineet Bhagwat, and P. Raghavendra Rau investigated the link between the intensity of early-life experiences on CEO’s attitudes towards risk. Their results suggest that CEOs who witnessed extreme levels of fatal natural disasters appear more cautious in approaching risk. In contrast, those that experience disasters without very negative consequences become desensitized to risk. For details, please see Gennaro Bernile, Vineet Bhagwat, and P. Raghavendra Rau, “What Doesn't Kill You Will Only Make You More Risk-Loving: Early-Life Disasters and CEO Behavior,“ The Journal of Finance, (72:1) February 2017. Global Investment Strategy View Matrix Current MacroQuant Model Scores
In a webcast this Friday I will be joined by our Chief US Equity Strategist, Anastasios Avgeriou to debate ‘Sectors To Own, And Sectors To Avoid In The Post-Covid World’. Today’s report preludes five of the points that we will debate. Please join us for the full discussion and conclusions on Friday, June 12, at 8:00 AM EDT (1:00 PM BST, 2:00 PM CEST, 8.00 PM HKT). Highlights Technology is behaving like a Defensive. Defensive versus Cyclical = Growth versus Value. Growth stocks are not a bubble if bond yields stay ultra-low. The post-Covid world will reinforce existing sector mega-trends. Sectors are driving regional and country relative performance. Fractal trade: Long ZAR/CLP. Chart of the WeekSector Defensiveness/Cyclicality = Positive/Negative Sensitivity To The Bond Price 1. Technology Is Behaving Like A Defensive How do we judge an equity sector’s sensitivity to the post-Covid economy, so that we can define it as cyclical or defensive? One approach is to compare the sector’s relative performance with the bond price. According to this approach, the more negatively sensitive to the bond price, the more cyclical is the sector. And the more positively sensitive to the bond price, the more defensive is the sector (Chart I-1). On this basis the most cyclical sectors in the post-Covid economy are, unsurprisingly: energy, banks, and materials. Healthcare is unsurprisingly defensive. Meanwhile, the industrials sector sits closest to neutral between cyclical and defensive, showing the least sensitivity to the bond price. The tech sector’s vulnerability to economic cyclicality appears to have greatly reduced. The big surprise is technology, whose high positive sensitivity to the bond price during the 2020 crisis qualifies it as even more defensive than healthcare. This contrasts sharply with its behaviour during the 2008 crisis. Back then, tech’s relative performance was negatively correlated with the bond price, defining it as classically cyclical. But over the past year, tech’s relative performance has been positively correlated with the bond price, defining it as classically defensive (Chart I-2 and Chart I-3). Chart I-2In 2008, Tech Behaved Like ##br##A Cyclical... Chart I-3...But In 2020, Tech Is Behaving Like A Defensive This is not to say that the big tech companies cannot suffer shocks. They can. For example, from new superior technologies, or from anti-oligopoly legislation. However, the tech sector’s vulnerability to economic cyclicality appears to have greatly reduced over the past decade. 2. Defensive Versus Cyclical = Growth Versus Value If we reclassify the tech sector as defensive in the 2020s economy, then the post mid-March rebound in stocks was first led by defensives. Cyclicals took over leadership of the rally only in May. Moreover, with the reclassification of tech as defensive, the two dominant defensive sectors become tech and healthcare. But tech and healthcare are also the dominant ‘growth’ sectors. The upshot is that growth versus value has now become precisely the same decision as defensive versus cyclical (Chart I-4). Chart I-4Defensive Versus Cyclical = Growth Versus Value 3. Growth Stocks Are Not A Bubble If Bond Yields Stay Ultra-Low Some people fear that growth stocks have become dangerously overvalued. There is even mention of the B-word. Let’s address these fears. Yes, valuations have become richer. For example, the forward earnings yield for healthcare is down to 5 percent; and for big tech it is down to just over 4 percent. This valuation starting point has proved to be an excellent guide to prospective 10-year returns, and now implies an expected annualised return from big tech in the mid-single digits. Yet this modest positive return is well above the extremes of the negative 10-year returns implied and delivered from the dot com bubble (Chart I-5). Chart I-5Big Tech Is Priced To Deliver A Positive Return, Unlike In 2000 Moreover, we must judge the implied returns from growth stocks against those available from competing long-duration assets – specifically, against the benchmark of high-quality government bond yields. If bond yields are ultra-low, then they must depress the implied returns on growth stocks too. Meaning higher absolute valuations (Chart I-6 and Chart I-7). Chart I-6Tech's Forward Earnings Yield Is Above The Bond Yield, Unlike In 2000 Chart I-7Healthcare's Forward Earnings Yield Is Above The Bond Yield, Unlike In 2000 In the real bubble of 2000, big tech was priced to return 12 percent (per annum) less than the 10-year T-bond. Whereas today, the implied return from big tech – though low in absolute terms – is above the ultra-low yield on the 10-year T-bond. If bond yields are ultra-low, then they must depress the implied returns on growth stocks too. The upshot is that high absolute valuations of growth stocks are contingent on bond yields remaining at ultra-low levels. And that the biggest threat to growth stock valuations would be a sustained rise in bond yields. 4. The Post-Covid World Will Reinforce Existing Sector Mega-Trends If a sector maintains a structural uptrend in sales and profits, then a big drop in the share price provides an excellent buying opportunity for long-term investors. This is because the lower share price stretches the elastic between the price and the up-trending profits, resulting in an eventual catch-up. However, if sales and profits are in terminal decline, then the sell-off is not a buying opportunity other than on a tactical basis. This is because the elastic will lose its tension as profits drift down towards the lower price. In fact, despite the sell-off, if the profit downtrend continues, the price may be forced ultimately to catch-down. This leads to a somewhat counterintuitive conclusion. After a big drop in the stock market, long-term investors should not buy everything that has dropped. And they should not buy the stocks and sectors that have dropped the most if their profits are in major downtrends. In this regard, the post-Covid world is likely to reinforce the existing mega-trends. The profits of oil and gas, and of European banks will remain in major structural downtrends (Chart I-8 and Chart I-9). Conversely, the profits of healthcare, and of European personal products will remain in major structural uptrends (Chart I-10 and Chart I-11). Chart I-8Oil And Gas Profits In A Major ##br##Downtrend Chart I-9Bank Profits In A Major ##br##Downtrend Chart I-10Healthcare Profits In A Major Uptrend Chart I-11Personal Products Profits In A Major Uptrend 5. Sectors Are Driving Regional And Country Relative Performance Finally, sector winners and losers determine regional and country equity market winners and losers. Nowadays, a stock market’s relative performance is predominantly a play on its distinguishing overweight and underweight ‘sector fingerprint’. This is because major stock markets are dominated by multinational corporations which are plays on their global sectors, rather than the region or country in which they have a stock market listing. It follows that when tech and healthcare outperform, the tech-heavy and healthcare-heavy US stock market must outperform, while healthcare-lite emerging markets (EM) must underperform. It also follows that the tech-heavy Netherlands and healthcare-heavy Denmark stock markets must outperform. Sector mega-trends will shape the mega-trends in regional and country relative performance. Equally, when energy and banks underperform, the energy-heavy Norway and bank-heavy Spain stock markets must underperform. (Chart I-12 and Chart I-13). These are just a few examples. Every stock market is defined by a sector fingerprint which drives its relative performance. Chart I-12Sector Relative Performance Drives... Chart I-13...Regional And Country Relative Performance If sector mega-trends continue, they will also shape the mega-trends in regional and country relative performance – favouring those stock markets that are heavy in growth stocks and light in old-fashioned cyclicals. Please join the webcast to hear the full debate and conclusions. Fractal Trading System* This week’s recommended trade is to go long the South African rand versus the Chilean peso. Set the profit target and symmetrical stop-loss at 5 percent. In other trades, long Spanish 10-year bonds versus New Zealand 10-year bonds achieved its 3.5 percent profit target at which it was closed. And long Australia versus New Zealand equities is approaching its 12 percent profit target. The rolling 1-year win ratio now stands at 63 percent. Chart I-14ZAR/CLP When the fractal dimension approaches the lower limit after an investment has been in an established trend it is a potential trigger for a liquidity-triggered trend reversal. Therefore, open a countertrend position. The profit target is a one-third reversal of the preceding 13-week move. Apply a symmetrical stop-loss. Close the position at the profit target or stop-loss. Otherwise close the position after 13 weeks. * For more details please see the European Investment Strategy Special Report “Fractals, Liquidity & A Trading Model,” dated December 11, 2014, available at eis.bcaresearch.com. Dhaval Joshi Chief European Investment Strategist dhaval@bcaresearch.com Fractal Trading System Cyclical Recommendations Structural Recommendations Closed Fractal Trades Trades Closed Trades Asset Performance Currency & Bond Equity Sector Country Equity Indicators Bond Yields Chart II-1Indicators To Watch - Bond Yields Chart II-2Indicators To Watch - Bond Yields Chart II-3Indicators To Watch - Bond Yields Chart II-4Indicators To Watch - Bond Yields Interest Rate Chart II-5Indicators To Watch - Interest Rate Expectations Chart II-6Indicators To Watch - Interest Rate Expectations Chart II-7Indicators To Watch - Interest Rate Expectations Chart II-8Indicators To Watch - Interest Rate Expectations
Highlights The good stock market = ‘growth defensives’ like technology that benefit from lower bond yields. The bad stock market = ‘value cyclicals’ like banks that suffer from lower bond yields. Structurally favour growth defensives given that ultra-low bond yields are here to stay. Adjust the sovereign bond portfolio to: Long 30-year US T-bonds and Spanish Bonos. Short 30-year German Bunds and French OATs. Fractal trade: Long 10-year Spanish Bonos, short 10-year New Zealand bonds. Feature It has become increasingly meaningless to talk about ‘the stock market’ as one entity. The stock market has split into two distinct markets: a ‘good stock market’ and a ‘bad stock market’. To be clear, the split started before the coronavirus crisis, but the crisis has hastened the break-up (Chart of the Week). Chart of the WeekThe Good Stock Market, And The Bad Stock Market What distinguishes the good stock market from the bad stock market? The answer is the relationship with the bond yield. For the good market, the dominant message from lower bond yields is a valuation boom and higher prices (Chart I-2); but for the bad market, the dominant message from lower bond yields is a profits recession and lower prices. Chart I-2Tech Stocks Rally On Lower Bond Yields The Good Stock Market, And The Bad Stock Market For the good stock market, the valuation uplift that comes from lower bond yields far outweighs the coronavirus induced slump to sales and profits. Conversely, for the bad stock market, the coronavirus induced slump to sales and profits far outweighs any valuation uplift from lower bond yields. For the ‘good stock market’, the valuation uplift from lower bond yields outweighs the coronavirus induced slump to sales and profits. The valuation uplift from lower bond yields is greatest for growth stocks. This is because the further into the future that cashflows are, the greater the increase in their ‘net present values’ Moreover, this valuation uplift becomes exponential at ultra-low bond yields. As bond prices start to have less upside than downside, they become riskier. Hence, both components of the required return on growth stocks – the bond yield and the equity risk premium – shrink together, justifying the exponentially higher net present value (Chart I-3). Chart I-3Tech Valuations Rise Exponentially On Lower Bond Yields Meanwhile, the coronavirus induced slump to sales and profits is greatest for cyclical stocks. For many cyclicals – such as airlines, hotels, and restaurants – the hit to sales, profits, and employment will be long-lasting, as consumer and business behaviour adapts to the post Covid-19 world. Hence: The good stock market = ‘growth defensives’ whose epitome is technology. The bad stock market = ‘value cyclicals’ whose epitome is banks (Chart I-4). Chart I-4Banks Sell Off On Lower Bond Yields Banks suffer a double whammy. Not only does the lower bond yield signify a structurally poor outlook for credit creation which constitutes bank ‘sales’, but the flattening yield curve also signifies a shrinking net interest (profit) margin. Euro area banks suffer an additional complication. They are exposed to the sovereign yield spread on ‘periphery’ bonds such as Italian BTPs over German bunds. A widening of such spreads signals heightening tensions within the euro area, which hurts the solvencies of periphery banks with large holdings of periphery bonds (Chart I-5). Chart I-5Euro Area Banks Also Sell Off On Wider Sovereign Yield Spreads It follows that euro area banks need two conditions to rally. High quality bond yields must rise, and peripheral euro area yield spreads must fall. Given that such a star alignment is likely to be the exception rather than the norm, euro area banks should be bought for the occasional countertrend rally when technical signals justify it. Right now, the required signal is for high-quality bonds to become technically overbought, presaging a tactical bout of bond underperformance and bank outperformance. However, our most-trusted technical indicator is not yet giving the required signal. Stay tuned (Chart I-6). Chart I-6Bonds Are Not Yet Technically Overbought In the meantime, we prefer to play the euro area’s increasing solidarity – specifically, to underwrite a €500bn coronavirus recovery plan – through relative value positions in sovereign bonds. In our recent webcast Why Leaving The Euro Would be MAD, But Mad Things Happen we pointed out that in the euro era, labour market competitiveness in Spain has improved by more than in France. Making it hard to justify the near 100bps yield premium on 30-year Spanish Bonos versus French OATs (Chart I-7). Chart I-7The Yield Premium On Spanish Bonos Is Hard To Justify Since inception a year ago, our long 30-year US T-bonds and Italian BTPs versus 30-year German Bunds and Spanish Bonos is up by 15 percent. It is time to adjust this bond portfolio. Go long 30-year US T-bonds and Spanish Bonos versus 30-year German Bunds and French OATs. And take profit on long 10-year Italian BTPs versus 10-year Spanish Bonos. Are Ultra-Low Bond Yields Sustainable? At first glance, the divergence of the stock market into a booming good part and a languishing bad part might tempt investors to play long-term ‘mean reversion’: specifically, to sell growth defensives like technology and buy value cyclicals like banks. But be careful. The concept of mean reversion is only meaningful if the underlying trend is sideways – or in technical terms ‘stationary’. Statistics 101 warns us that if the underlying trend is not stationary, the concept of mean reversion – and indeed the much-abused concept of ‘standard deviation’ – is meaningless. If inflation persists below 2%, bond yields will remain ultra-low. Given that all investment is now just one big correlated trade to the bond yield, this raises a crucial question: is the bond yield stationary? Put another way, are bonds in an almighty bubble? Are bond yields unsustainably low, and at risk of a violent spike upwards? The answer depends on a further question: is sub-2 percent inflation unsustainably low? (Chart I-8) If inflation persists below central banks’ totemic 2 percent inflation target, then central banks will have no choice but to push and hold the monetary easing ‘pedal to the metal’. Therefore, bond yields will keep trending lower until, one by one, they reach the lower bound at around -1 percent. Chart I-8Is Sub-2 Percent Inflation Unsustainably Low? To us, the answer to this question is crystal clear. Not only is sub-2 percent inflation sustainable, it is the norm. Genuine price stability is not an arbitrary 2 percent inflation target that central banks can pluck out of the air. Rather, it is a steady state of broadly flat-lining prices that economies can remain in for centuries, so long as governments do not debase the broad money supply. Between 1675 and 1914 – when Great Britain was mostly on the gold standard – the price level barely budged, meaning inflation averaged near-zero for hundreds of years (Chart I-9). Chart I-9Inflation Averaged Near-Zero For Hundreds Of Years Today we have fiat money rather than the gold standard. However, the rapidly growing cryptocurrency asset-class is an embryonic 21st century gold standard ‘waiting in the wings.’ The mere fact that an alternative, and potentially superior, monetary system is waiting in the wings is a strong incentive for competent governments to preserve the value of fiat money. Which is to say, an incentive not to destroy the genuine price stability that advanced economies have now re-entered after a brief lapse in the 20th century. Ultra-Low Bond Yields Are Here To Stay, Structurally Favouring Growth Defensives It is in the gift of governments to destroy price stability should they desire. Witness Argentina, Venezuela or Zimbabwe. Yet these examples and the example of the 1970s teach us that when price stability is destroyed, inflation appears non-linearly, which is to say unpredictably and uncontrollably. This is because it suddenly becomes rational for governments to create money as fast as possible, and for consumers and firms to spend it as fast as possible. As the product of money supply and its velocity equals nominal demand, inflation skyrockets (Chart I-10). Chart I-10When Price Stability Is Destroyed, Inflation Appears Non-Linearly An early warning sign that governments are on the road to Venezuela is that central banks lose their independence. Or, at the very least, their inflation-targeting remits become diluted. Neither of these seem conceivable right now. Sub-2 percent inflation was the norm for hundreds of years. Never say never – but in the advanced economies the destruction of price stability is a tail-risk rather than a central threat. The upshot is that ultra-low bond yields are here to stay. Long-term investors should structurally own the good stock market – growth defensives – and structurally avoid the bad stock market – value cyclicals. That said, from time to time, there will be tactical countertrend opportunities to go long value cyclicals like banks. Stay tuned for those tactical opportunities. This leaves one final question: when all investment has just become one big correlated trade to the bond yield, how can investors take on uncorrelated positions to diversify? The answer is to take long-short positions within growth defensives, and within value cyclicals. For example, within growth defensives right now, stay tactically long personal products versus healthcare. Fractal Trading System* As discussed, Spanish Bonos offer good relative value. They are also technically oversold relative to other developed market sovereign bonds. Accordingly, this week’s recommended trade is long Spanish 10-year Bonos, short New Zealand 10-year bonds. Set the profit target and symmetrical stop-loss at 3.5 percent. In other trades, long PLN/EUR quickly achieved its 2 percent profit target at which it was closed. The rolling 1-year win ratio now stands at 62 percent. Chart I-11 When the fractal dimension approaches the lower limit after an investment has been in an established trend it is a potential trigger for a liquidity-triggered trend reversal. Therefore, open a countertrend position. The profit target is a one-third reversal of the preceding 13-week move. Apply a symmetrical stop-loss. Close the position at the profit target or stop-loss. Otherwise close the position after 13 weeks. * For more details please see the European Investment Strategy Special Report “Fractals, Liquidity & A Trading Model,” dated December 11, 2014, available at eis.bcaresearch.com. Dhaval Joshi Chief European Investment Strategist dhaval@bcaresearch.com Fractal Trading System Cyclical Recommendations Structural Recommendations Closed Fractal Trades Trades Closed Trades Asset Performance Currency & Bond Equity Sector Country Equity Indicators Bond Yields Chart II-1Indicators To Watch - Bond Yields Chart II-2Indicators To Watch - Bond Yields Chart II-3Indicators To Watch - Bond Yields Chart II-4Indicators To Watch - Bond Yields Interest Rate Chart II-5Indicators To Watch - Interest Rate Expectations Chart II-6Indicators To Watch - Interest Rate Expectations Chart II-7Indicators To Watch - Interest Rate Expectations Chart II-8Indicators To Watch - Interest Rate Expectations
Analysis on Chile is available below. Highlights Major equity leadership rotations normally occur around bear markets or corrections. Hence, a major broad selloff will likely be a precondition for EM, commodities, global cyclicals and value stocks to commence outperforming. The odds that EM equities will underperform the S&P 500 or DM share prices in an equity drawdown are 65-70%. A weaker dollar is essential to EM outperformance. We remain bullish on the dollar and are underweight/short EM. Feature The current decade has been characterized by the substantial outperformance of growth versus value stocks, the S&P 500 versus emerging and other international markets. BCA held its annual conference in New York last week. One of the key topics that investors wanted to get a handle on was the potential for a leadership rotation in global equity markets. The current decade has been characterized by the substantial outperformance of growth versus value stocks, the S&P 500 versus emerging and other international markets, FAANG share prices versus commodities and “old economy” stocks. Is this trend about to reverse? Opinions among our conference speakers certainly differed. Some still showed a penchant for growth stocks and U.S. equities, while others recommended global value and EM stocks. Our Themes For The Decade Our key long-term themes – laid out in our June 8, 2010 Special Report titled How To Play Emerging Market Growth In The Coming Decade1 – have shaped our investment strategy over the past decade have been: Commodities and materials and energy equity sectors as well as machinery stocks will be in a bear market because Chinese capital spending has peaked. Hence, investors should avoid EMs that are very sensitive to resource prices. Favoring EM/Chinese consumer plays, namely technology as well as healthcare stocks in general and healthcare equipment stocks in particular, is the way to play China/EM growth this decade. Given tech and healthcare account for a smaller weighting in EM stock indexes than in DM ones, we have been recommending that investors underweight EM against DM stocks. Needless to say, these themes have panned out extremely well, with EM, resources, commodities-related and machinery equity sectors underperforming massively (Chart I-1), and tech, consumer and healthcare stocks outperforming (Chart I-2). These themes have guided our strategy over the past nine years, leading us to be underweight EM equities in favor of the S&P 500, which is heavily dominated by tech, consumer and healthcare companies. Chart I-1China Capex Plays Have Underperformed This Decade Chart I-2Our Favorites For This Decade Have Outperformed Any investment trend has a beginning and an end. It is essential not to overstay in winning strategies. Critically, Chart I-3 shows that the magnitude of the rise in FAANG stocks over the past 10 years is comparable to bubbles of previous decades. This chart compares asset prices in real (inflation-adjusted) U.S. dollar terms. Chart I-3FAANG And Previous Bubbles In Perspective Only history will tell whether FAANGs are currently in a bubble or not. Presently, we do not have a high conviction view on this matter. However, even if they are not in a bubble, they are extremely overbought and expensive. Their failure to break above their 2018 highs is a negative technical signal. Altogether, this warrants a cautious stance on the absolute performance of FAANGs. Bottom Line: Regardless of the direction of FAANG stocks, odds are that EM share prices will relapse in absolute terms before a sustainable bottom emerges. For a detailed discussion on this, please refer to pages 6-9. In such a scenario, it is hard to envision FAANG stocks rallying. They may continue outperforming on a relative basis, but they will still deflate in absolute terms. Equity Rotations Occur Around Bear Markets The relative performance of global growth versus value stocks often experiences trend reversals during or after selloffs. With respect to equity leadership rotation, it is crucial to note that equity leadership rotations typically occur during or after bear markets and/or corrections in global share prices. Chart I-4 illustrates EM relative stock prices versus DM along with the global equity index. Over the past 25 years, there have been several major leadership changes between EM and DM – and all of them coincided with, or were preceded by, either a bear market or a correction in global share prices. Similarly, the relative performance of global growth versus value stocks often experiences trend reversals during or after selloffs (Chart I-5). Chart I-4EM Versus DM: Equity Rotations Chart I-5Global Growth Versus Value: Leadership Rotations Finally, structural trend changes in the relative performance of the global tech sector, energy stocks and materials have also occurred during or after drawdowns in global share prices (Chart I-6). Chart I-6Global Technology, Energy And Materials: Leadership Rotations Bottom Line: Major equity leadership rotations normally occur around bear markets or corrections. Hence, a major selloff is likely before EM, commodities, global cyclicals and value stocks begin to outperform. We will contemplate changing our relative equity strategy if a major broad selloff transpires. In such an equity drawdown, there is a 30-35% chance that EM may outperform the S&P 500, as it did during the carnage in global stocks in the fourth quarter of last year. In short, the probability that EM share prices underperform the S&P 500 and DM is 65-70%. A weaker dollar is essential for EM outperformance. BCA’s Emerging Markets Strategy service remains bullish on the dollar and is underweight/short EM. A Breakdown In EM And Global Cyclicals? With China’s manufacturing PMI once again on the rise, it is critical to challenge our view on the Chinese business cycle as well as global manufacturing and trade. In our opinion, the latest rise in the mainland manufacturing PMI is an aberration rather than a new trend: Chinese share prices over the years have been coincident with or leading mainland manufacturing PMI. Stocks are currently pointing to a relapse in the latter (Chart I-7). The message from Chinese share prices is that the latest improvement in the nation’s manufacturing PMI should be faded. Chart I-7Chinese Share Prices And Manufacturing PMI The global manufacturing recession is still spreading. The global manufacturing recession is still spreading. This has yet to be discounted in global cyclical equity sectors. The latter have been moving sideways over the past year and a half, despite the contraction in global manufacturing activity (Chart I-8). Equity investors’ patience may be wearing thin as the expected global manufacturing recovery has so far failed to materialize. Chart I-8Global Cyclical Stocks And Manufacturing PMI Chart I-9EM EPS And Korean Exports: Moving In Tandem Korean exports in September contracted at a rate close to 10% year-on-year (Chart I-9, top panel). Interestingly, the level of EM corporate earnings per share (EPS) in U.S. dollar terms exhibits a similar pattern with Korean exports (Chart I-9, bottom panel). Both are at the same level they were in 2010. Hence, over this decade EM EPS and Korean exports in U.S. dollar terms have not expanded at all. U.S. high-beta stocks in aggregate as well as share prices of high-beta industrials and technology stocks are close to breaking below their technical support lines (Chart I-10). They could be canaries in a coal mine for the S&P 500. Chart I-10U.S. High-Beta Stocks Are Breaking Down Chart I-11A Bearish Signal For EM And Commodities Despite a very weak U.S. manufacturing PMI, the dollar remains well bid. This signifies that the global manufacturing recession emanates from the rest of the world – not the U.S. In fact, the U.S. manufacturing sector has been the last domino to fall. Persistent strength in the greenback is a symptom of weakening global growth. Our Risk-On / Safe-Haven Currency ratio2 – which is agnostic to dollar trends – is plunging, corroborating the downbeat outlook for global growth in general and commodities prices in particular (Chart I-11). Finally, overall EM and Asian high-yield corporate credit spreads are widening versus investment grade ones. This is a sign of rising risk aversion. EM credit markets and local currency bonds have so far been reasonably resilient, despite the selloff in EM share prices and currencies (Chart I-12). The basis for such decoupling has been the indiscriminate search for yield rather than improving EM growth dynamics. Chart I-12EM Credit Markets Will Recouple To Downside With Stocks And Currencies Deteriorating growth will eventually cause a widening of EM credit spreads. Besides, persistent EM currency depreciation will likely lead to outflows from EM high-yield local bond markets. Bottom Line: EM equities, credit markets and high-yielding local currency bonds are at risk of a major selloff. Our list of country allocations across various EM asset classes as well as our trades can always be found at the end of our reports, please refer to pages 14-15. We continue to recommend shorting the following basket of EM currencies versus the dollar: ZAR, CLP, COP, IDR, MYR, PHP and KRW. Arthur Budaghyan Chief Emerging Markets Strategist arthurb@bcaresearch.com Chile: Still Favor Bonds Over Stocks; Bet On Lower Inflation We have been betting on sluggish growth, lower interest rates and a weakening currency in Chile. These positions have panned out well as the economy has slowed considerably, local bond yields have plunged and the currency depreciated significantly (Chart II-1, top and middle panels). However, our overweight position in Chilean equities within a dedicated EM stock portfolio has performed poorly (Chart II-1, bottom panel). Is it time to reconsider our position? Chart II-1Our Strategy For Chile Having re-examined the cyclical dynamics of this economy and putting it in the context of the global backdrop, we reiterate our investment recommendations. We also see a new investment opportunity within the Chilean fixed-income markets – investors should consider betting on lower inflation expectations, i.e., going long domestic bonds and shorting inflation-linked bonds. We believe the bond market’s medium-to long-term inflation expectations are overstated and will drop in the coming months. The Chilean economy will likely weaken further and inflation is set to drop considerably beyond the near term. Even though the central bank has already cut rates by 100 basis points, it will take both more easing and time before the credit impulse turns positive and lifts domestic demand. The credit impulse for businesses points to a relapse in capital spending (Chart II-2). The adopted fiscal stimulus has been negligible at 0.21% of GDP for 2019 and 2020. While government spending growth is bottoming, overall fiscal expenditures account for 20% of GDP. In brief, they are too small to make a major difference for the economy. Chart II-2Chile: Falling Credit Impulse = Weak Capex With non-mining exports contracting and commodities prices plunging, the export sectors will continue to depress growth. Corporate profits are shrinking and this will dent capital spending and hiring. Critically, rising unit labor costs are depressing corporate profit margins (Chart II-3). The latter have spiked because the output slowdown has not yet been matched by layoffs or lower wage growth. In turn, forthcoming layoffs amid the already rising unemployment rate will certainly lead to considerable wage disinflation (Chart II-4). Chile has seen massive inflows of immigrants from Venezuela in recent years, which will prove to be a major disinflationary force for this economy in the medium-term. Finally, goods price inflation – which has stemmed from currency depreciation – could prevent consumer inflation from falling in the near term. Yet, this phenomena will not be sustainable beyond the near term. Chart II-3Shrinking Profits Will Lead Businesses To Reduce Unit Labor Costs Chart II-4Wage Growth Is Unsustainably High On the whole, the fixed-income market will look through currency depreciation-induced goods inflation and begin pricing in much lower inflation expectations. We recommend betting that 3-year inflation expectations will decline from 2.5% to 1.5% in the next 12 months (Chart II-5). We have been receiving 3-year swap rates since May 31st, 2018 and this position remains intact. The peso will continue to depreciate as copper prices fall further. Notably, the real effective exchange rate based on unit labor costs – computed by the OECD – suggests that the peso is still expensive (Chart II-6). The last datapoint is as of September 2019. This is probably due to depreciation in other Latin American currencies. Chart II-5Chile: Inflation Expectations To Plunge Chart II-6The CLP Is Not Cheap Finally, we are reluctant to downgrade the Chilean bourse within an EM equity portfolio. Policy easing and large underperformance as well as the positive structural outlook should produce a period of outperformance by this stock market amid the selloff in the overall EM equity universe. Local asset allocators should continue favoring bonds versus stocks. Bottom Line: As a new trade for fixed-income investors: We recommend going long 3-year domestic bonds and shorting 3-year inflation-linked bonds. Juan Egaña, Research Associate juane@bcaresearch.com Arthur Budaghyan Chief Emerging Markets Strategist arthurb@bcaresearch.com Footnotes 1 Please see Emerging Markets Strategy Special Report, “How To Play Emerging Market Growth In The Coming Decade”, dated June 8, 2010, available at ems.bcaresearch.com 2 Average of CAD, AUD, NZD, BRL, CLP & ZAR total return indices relative to average of JPY & CHF total returns (including carry). Equities Recommendations Currencies, Credit And Fixed-Income Recommendations