Equities

Executive Summary Singapore stocks are at risk as an impending contraction in global trade will hurt this very open economy and its markets. The country’s foreign reserves are already shrinking as the balance of payments has slid into deficit. The Monetary Authority of Singapore’s (MAS) attempts to rein in inflation by pushing up the currency is also causing foreign reserves to contract, and local money supply to decelerate sharply. Inflationary pressures in Singapore are not entrenched and will soon subside. Wage growth is under control, and unit labor cost increases are subdued. Singapore’s export competitiveness remains robust; yet that does not preclude it from a period of shrinking exports over the next 6-12 months. Falling exports, shrinking foreign reserves, decelerating money supply and peaking inflation will dissuade MAS from pushing up the Singapore dollar much higher from current levels. Manufacturing Cycles Dictate The Performance Of Singapore Stocks Recommendation Inception Date RETURN Downgrade Singapore stocks from overweight to neutral May 10, 2021 2.3% Bottom Line: Equity investors should reduce their exposure to Singapore stocks in EM and Asian portfolios by downgrading their allocation from overweight to neutral. Absolute return investors should wait for a better entry point. Feature Chart 1Singapore Stocks' Outperformance Is Set To Take A Breather Like most global markets, Singapore stocks have sold off materially since early this year. Relative to EM and Asian counterparts, however, they have fared well – in line with our call back in May 2021 when we upgraded this bourse to overweight (Chart 1). The question is, given the changing macro backdrop − where a whiff of stagflation has permeated global investment landscapes – what should investors now do about this market? We believe that higher inflation in Singapore is a temporary phenomenon and will subside sooner rather than later. Contracting global trade, on the other hand, is a much more vital risk for this very open economy and its equity markets; and is a reason to downgrade this bourse. Indeed, Singapore stocks in absolute US dollar terms face more downside over the next several months. Relative to its EM and Asian counterparts also, this bourse’s outperformance is likely to take a breather.  Asian and EM equity portfolios would therefore do well to downgrade this market by a notch from overweight to neutral in EM and Asian equity baskets. Absolute return investors should stay on the sidelines for now. Unfavorable Settings Contracting global trade and tightening liquidity will weigh on Singapore stocks in the months ahead. Global trade volumes will fall as developed countries’ demand for goods (ex-auto) shrinks following the pandemic-era binge. Chinese growth will also likely be struggling to recover. What this means is that both global manufacturing and exports are heading towards a contraction. As a very open economy where goods exports make up 115% of GDP (and services exports another 55%), manufacturing and exports of goods drive income for the entire Singaporean economy and influence its stock market cycles. Chart 2 shows how ebbs and flows in manufacturing new orders dictate Singapore’s equity market performances. Chart 2Manufacturing Cycles Dictate The Performance Of Singapore Stocks The performances of financial and real estate stocks, which make up two-thirds of the MSCI Singapore index, are also highly dependent on business cycles − which in turn, are driven by swings in manufacturing and exports (Chart 3). One reason for that is, at 23% of GDP, manufacturing is the single largest sector in the economy. By comparison, finance and insurance make up 14% of the nation’s output, and real estate 3%. Any acceleration or deceleration in manufacturing activity therefore has a strong impact on the performance of tertiary sectors, including those of banking and real estate. In addition, MAS’ tightening is causing local money supply to decelerate (discussed in more detail later). Slower money growth is never bullish for stock prices (Chart 4). Chart 3Banks And Real Estate Stocks Also Move With Manufacturing And Exports Chart 4Decelerating Money Supply Is A Bad Omen For Share Prices   In sum, given the changing global macro backdrop of slowing manufacturing and trade, and elevated US inflation, Singapore stocks have not yet found a sustainable bottom in absolute terms. Relative to their EM counterparts, Singapore’s outperformance could also take a breather. During periods of weakening global trade and manufacturing, Singapore stocks usually do poorly relative to their EM peers. The top panel of Chart 5 shows US manufacturing PMI new orders as decelerating rapidly. Periods of falling and/or sub-50 PMI prints usually herald Singapore stocks’ underperformance relative to EM, with a few months lag. Singapore’s own new export orders are also about to slip into contraction territory. If history is any guide, this too entails a period of underperformance of this bourse versus EM going forward (Chart 5, bottom panel). Is Inflation Genuine In Singapore? The short answer is no; there is little genuine inflation in Singapore. The country is not witnessing any wage-price spiral either, unlike in the US. What we see there instead is just a one-off surge in inflation. Average monthly wages in Singapore have accelerated in the past year but are not out of line when compared to the past 20 years (Chart 6, top panel). Chart 5Weakening Manufacturing Orders Foreshadow Singapore Equities' Underperformance Chart 6Limited Wage Growth And Subdued Unit Labor Costs Will Rein In Inflationary Pressures   A controlled rise in wages has helped keep Singaporean firms’ unit labor costs (ULCs) in check. The middle panel of Chart 6 shows ULCs for the overall economy vis-à-vis the consumer price index. ULCs are much below pre-pandemic levels. This happens to be the case even in the service sector of the economy where productivity gains are much harder to achieve. In the goods producing sector, where productivity gains are relatively easier to achieve, ULCs have remained particularly low (Chart 6, bottom two panels). What this means is that firms are facing little wage-related cost pressures. They are, therefore, less likely to pass it on to customers via higher selling prices. That, in turn, will help cap inflationary pressures in the economy. Chart 7Sharply Slowing Money Growth Points To Peaking Inflation In fact, much of the recent rise in headline and core consumer inflation in Singapore has had to do with the explosive money growth seen during the pandemic. Both narrow (M1) and broad money (M3) growth rates in Singapore accelerated in 2020 to levels not seen since the Global Financial Crisis of 2008-09. Inflation usually follows money growth with several months lag, and this time was no different. That said, both measures of money have since decelerated markedly this year. This will rein in inflationary pressures going forward (Chart 7).  Looking forward, money supply itself will likely decelerate further in the months ahead. A critical reason for that is the manner in which the central bank (MAS) uses the currency to achieve its monetary policy objectives (i.e., to maintain price stability).   When inflation rises, MAS typically guides the trade-weighted Singapore dollar to appreciate, in an attempt to rein in inflation. In so doing, MAS buys local currency and sells foreign currency. This reduces local liquidity and money supply. Chart 8 shows that MAS is indeed guiding the Singapore dollar up: the trade weighted currency has risen by over 3% in the past six months tracking inflation. Not surprisingly, money growth in Singapore has decelerated meaningfully. In time, that will help pull inflation lower. There was an external factor too. In the past couple of years, the country had witnessed a massive improvement in its balance of payments (BoP). It skyrocketed from a minus 3% of GDP in 2019 to a plus 27% in 2021. To prevent the currency from surging, the central bank had resorted to a rapid accumulation of foreign reserves. As MAS pumped local currency into the system while purchasing foreign currencies, local money supply boomed (Chart 9). Chart 8In Order To Check Inflation, The MAS Has Pushed The Singapore Dollar Up... Chart 9...Causing Foreign Reserves To Drop, And Money Supply To Decelerate Materially Chart 10The Trade Surplus Will Narrow, Putting More Pressure On The Balance Of Payments But the tide has turned this year. The trade surplus has rolled over and will continue to shrink as global trade is set to weaken further this year as explained above. As such, Singapore’s current account surplus will also likely roll over. The capital account has already slipped back into massive deficits; so has the BoP (Chart 10). The upshot is that foreign reserves have begun to contract. This means MAS is now selling foreign reserves to buy back local currency. This is causing a deceleration in local money supply (Chart 9, above). In sum, the absence of meaningful wage pressures, a decelerating money supply, and a strengthening currency will help Singapore see its inflation ease sooner than in the US. Can Singapore Withstand A Stronger Currency? As discussed above, Singapore’s monetary policy entails tackling higher inflation by letting the Singapore dollar appreciate in nominal terms. But given the high inflation prints, an appreciating currency would mean that it gets even stronger in real terms (i.e., in inflation-adjusted terms). An expensive currency in real terms could erode competitiveness. So, the question is, can the Singapore economy withstand a stronger currency? The short answer is yes. Chart 11 shows that while the Singapore dollar has appreciated to new highs in nominal trade weighted terms, in real terms (ULC-based) it remains at around 15-year lows. As such, currency competitiveness should not be an issue anytime soon. Notably, real exchange rates calculated using ULCs are more representative of currency competitiveness than the use of consumer prices allows. The reason is that employee compensation is a major component of any company’s overall cost structure; and therefore, ULCs matter for a company much more directly than do consumer prices. The very low levels of the ULC-based real exchange rate indicates that the Singapore dollar is still very competitive. Indeed, Singapore’s export volumes have been on an upward trend relative to global exports (Chart 12). Chart 11The Singapore Dollar Remains A Highly Competitive Currency Chart 12Singapore Is Grabbing Export Market Share From The Rest Of The World Notably, Singapore continues to attract a very high amount of FDI. This will help raise productivity going forward, thereby keeping ULCs in check down the line. All that said, strong competitiveness (i.e., the ability to maintain global market share) does not preclude Singapore from experiencing a drop in its export revenues over the next 6-to-12 months. The reason is faltering goods demand in the US and Europe after a pandemic-era overconsumption. Falling exports, in turn, will lead to shrinking foreign reserves, decelerating money supply, and finally slowing growth and inflation. This will discourage MAS from pushing the Singapore dollar much higher from current levels. As Chart 11 showed, the Singaporean currency is already at an all-time high in trade-weighted terms. The rally in the trade-weighted Singapore dollar is therefore in late stages. Investment Recommendations Chart 13The Singapore Dollar's Outperformance Vesus Other Asian Currencies Is Late Singapore stocks, with a P/E ratio of 21.5, have become relatively expensive vis-à-vis their EM (13.1) and Asian (14.1) counterparts. In terms of the price-to-book value ratio however, they are not expensive. Considering all, we recommend that investors reduce their exposure to Singapore stocks in EM and Asian equity portfolios by downgrading their allocation from overweight to neutral. Our overweight stance since May 10, 2021, has yielded a gain of 2.3% so far. Absolute return investors should wait for a better entry point. The depreciation of the Singapore dollar vis-à-vis the US dollar likely has some more room given the impending deterioration in global trade. But the latter will also soon check the appreciation of the Singapore dollar versus other Asian currencies − as MAS will be dissuaded from guiding the currency up in view of peaking domestic inflation and shrinking trade (Chart 13). Rajeeb Pramanik Senior EM Strategist rajeeb.pramanik@bcaresearch.com

Executive Summary The Efficient Market Hypothesis (EMH) is flawed. This Holy Grail of financial economics assumes that investors are a homogenous bunch with identical investment horizons, when the reality is that investors have a wide spectrum of time horizons. The alternative but less well-known Fractal Market Hypothesis (FMH) recognizes that investors with different time horizons interpret the same facts and information differently. The key conclusion of the FMH is that when the different investment horizons are all active in the market, the price reflects all available information, meaning that the market is efficient, liquid, and stable. But when the different investment horizons start to converge and coalesce, the market becomes inefficient, illiquid, and vulnerable to a trend reversal. Using the FMH over the past six months, 5 structured recommendations were closed in profit: Short ILS/GBP, Short Coffee versus Cocoa, Short World Basic Resources versus Market, Long EUR/CHF, and Short Semiconductors versus Tech. Against this, 3 structured recommendations were closed in loss: Short Nickel versus Silver, Long Polish Bonds versus US Bonds, and Short World Semiconductors versus Biotech. Within the 10 open trades, 3 are in healthy profit, 4 are flat, and 3 are in loss. The Efficient Market Hypothesis Does Not Describe The Truth; The Fractal Market Hypothesis Does Bottom Line: As few investors are aware of the Fractal Market Hypothesis, it gives a competitive advantage to those that use it to identify potential trend reversals. Feature For nations and societies, disagreement and conflict are unhealthy. But for financial markets, the opposite is true – it is the lack of disagreement and conflict that is unhealthy. This is because the market needs disagreement to generate liquidity, the ability to trade quickly and in large volume without destabilizing the market price. If I want to buy a share, then somebody must sell me that share. It follows that I and the seller must disagree about the attractiveness of the share at the current price. Likewise, if I and like-minded individuals want to buy ten million shares, it follows that lots of market participants must disagree with us. If lots of market participants do not disagree with us, there will be insufficient liquidity to complete the transaction without a price change. And if too many people are engaged in groupthink, the price change could be extreme. Markets Become Inefficient When There Is Not Enough Disagreement How can there be major disagreement about the attractiveness of an investment when we all have access to the same facts and information? According to the Efficient Market Hypothesis (EMH) there cannot be, because asset prices always reflect all available information.1   Unfortunately, the Efficient Market Hypothesis is flawed. This Holy Grail of financial economics assumes that investors are a homogenous bunch with identical investment horizons, when the reality is that investors have a wide spectrum of time horizons – ranging from the milliseconds of momentum-driven high-frequency trading (HFT) to the decades of a value-driven pension fund. The market is efficient only when a wide spectrum of investment horizons is setting the price, signified by the market having a rich fractal structure. The alternative but less well-known Fractal Market Hypothesis (FMH) recognizes the reality of different time horizons. Crucially, the FMH acknowledges that investors with different time horizons interpret the same facts and information differently. In other words, they disagree (Box I-1). Box 1-1The Efficient Market Hypothesis Does Not Describe The Truth; The Fractal Market Hypothesis Does For example, the momentum-based high frequency trader might interpret a sharp one-day sell-off as a sell signal, but the value-based pension fund might interpret the same information as a buying opportunity. This disagreement will create liquidity without requiring a big price adjustment. Thereby it also fosters market stability. The key conclusion of the Fractal Market Hypothesis is that when the different investment horizons are all active in the market, the price does reflect all available information, meaning that the market is efficient, liquid, and stable. But when the different investment horizons start to converge and coalesce, the market becomes inefficient, illiquid, and vulnerable to a trend reversal. Buy and sell orders will no longer match without a price change, possibly extreme. Can we measure the loss of efficiency in a specific investment, and thereby anticipate a potential trend reversal? The answer is yes, by monitoring its fractal dimension, using the expression in the Appendix. Although many readers may find the concept of a fractal dimension intimidating, the idea is simple and intuitive. It just measures the complexity – or information content – in an object or structure. Thereby, when an investment’s fractal dimension reaches its lower limit, it warns that the information content of longer-term investors is missing from the price.  When the longer-term investors do ultimately re-enter the price setting process, the question is: will they endorse the recent trend because of some major change in the fundamentals – such as the start of the Russia/Ukraine war? Or will they reject it, as an unjustified deviation from a fundamental anchor. In most cases, it is the latter: a rejection and a trend reversal. As few investors are aware of the Fractal Market Hypothesis, it gives a competitive advantage to those that use it to identify potential trend reversals. Fractal Trading Update Using the Fractal Market Hypothesis over the past six months, 5 structured recommendations were closed in profit: Short ILS/GBP, Short Coffee versus Cocoa, Short World Basic Resources versus Market, Long EUR/CHF, and Short Semiconductors versus Tech. A fragile fractal structure warns of a crowded trade. One structured recommendation was closed flat: Short Personal Goods versus Consumer Services. Against this, 3 structured recommendations were closed in loss: Short Nickel versus Silver, Long Polish Bonds versus US Bonds, and Short World Semiconductors versus Biotech. Within the 10 open trades, 3 are in healthy profit, 4 are flat, and 3 are in loss. As for the unstructured recommendations, for which we do not define profit targets or expiry dates, we are pleased to report that out of 31 recommendations, only 2 failed to experience a countertrend reversal. Wins 1) November 18th: Short ILS/GBP Achieved its profit target of 4.2 percent. 2) November 25th: Short Coffee versus Cocoa (Chart I-1) Achieved almost half of its 30 percent profit target at expiry. Chart I-1Fractal Analysis Correctly Predicted A Reversal In Coffee Versus Cocoa 3) January 20th: Short World Semiconductors versus Tech (Chart I-2) Achieved its profit target of 6 percent. Chart I-2Fractal Analysis Correctly Predicted A Reversal In World Semiconductors Versus Technology 4) March 10th: Long EUR/CHF Achieved its profit target of 3.6 percent. 5)  April 14th: Short World Basic Resources versus Market (Chart I-3) Achieved its profit target of 11.5 percent. Chart I-3Fractal Analysis Correctly Predicted A Reversal In World Basic Resources Versus Market In addition, Short World Personal Goods versus Consumer Services which was opened on December 9th reached a high-water mark of 10.5 percent but expired flat. Losses 1) December 2nd: Short World Semiconductors versus Biotech Hit its stop loss of 9.5 percent. 2) January 13th: Long Poland versus US: 10-Year Government Bonds Reached a high-water mark of 3.7 percent, but then reversed to hit its stop loss of 8 percent. In the current geopolitical crisis, Poland has been a casualty due to its lengthy border with Ukraine. 3) February 3rd: Short Nickel versus Silver (Chart I-4) Hit its stop loss at 20 percent following an explosive short-squeeze rally in the Nickel price. Chart I-4Nickel's Short-Squeeze Rally Forced A Price Trend Prolongation Open Trades 1) January 27th: Long MSCI Korea versus All-Country World (Chart I-5) Open, in profit, having reached a high-water mark of 6 percent (versus an 8 percent target). Chart I-5Fractal Analysis Correctly Predicted A Rebound In Korea Versus All-Country World 2) February 24th: Long US Biotech versus US Tech Open, in profit, having reached a high-water mark of 10.5 (versus a 17.5 percent target). 3) March 3rd: Short World Banks versus Consumer Services Reached a high-water mark of 7.3 percent (versus a 12 percent target), but then reversed and is in loss. 4) March 24th: Long 5-Year T-bond Open, in modest loss. 5) April 7th: Short World Non-Life Insurance versus Homebuilders (Chart I-6) Open, in profit having reached a high-water mark of 12.4 percent (versus a 14 percent target). Chart I-6Fractal Analysis Correctly Predicted A Reversal In World Non-Life Insurance Versus Homebuilders 6) April 7th: Long JPY/CHF Reached a high-water mark of 3.4 percent versus a 4 percent target, but then reversed into modest loss. This suggests that the trade needed a narrower profit target. 7) April 28th: Short High Dividend ETF versus US 10-Year T-bond Open, in modest loss, having reached a high-water mark of 2.9 percent (versus a 6 percent target). 8) May 19th: Short FTSE 100 versus STOXX Europe 600 Open, and flat. 9) June 2nd: Long JPY/USD (Chart I-7) Open, and flat. Chart I-7The Sell-Off In JPY/USD Has Reached A Potential Turning Point 10) June 2nd: Short Australia Basic Resources versus World Market (Chart I-8) Open, and flat. Chart I-8The Australian Basic Resources Sector Is Vulnerable To Reversal   Our full watchlist of 29 investments that are at, or approaching turning points, is available on our website: cpt.bcaresearch.com Appendix: Calculating The Fractal Dimension Of A Financial Market Chart 1AUD/KRW Is Vulnerable To Reversal Chart 2Canada Versus Japan Is Reversing Chart 3Canada's TSX-60's Outperformance Might Be Over Chart 4US Healthcare Providers Vs. Software At Risk of Reversal Chart 5BRL/NZD At A Resistance Point Chart 6Homebuilders Versus Healthcare Services Has Turned Chart 7CNY/USD Has Reversed Chart 8CAD/SEK Is Vulnerable To Reversal Chart 9Financials Versus Industrials To Reverse Chart 10The Outperformance Of Resources Versus Biotech Has Started To Reverse Chart 11The Outperformance Of Resources Versus Healthcare Is Vulnerable To Reversal Chart 12FTSE100 Outperformance Vs. Euro Stoxx 50 Is Reversing Chart 13Netherlands Underperformance Vs. Switzerland Is Ending Chart 14The Sell-Off In The 30-Year T-Bond Is Approaching Fractal Fragility Chart 15The Sell-Off In The NASDAQ Is Approaching Fractal Fragility Chart 16Food And Beverage Outperformance Exhausted Chart 17The Strong Trend In The 18-Month-Out US Interest Rate Future Is Fragile Chart 18The Strong Trend In The 3 Year T-Bond Is Fragile Chart 19A Potential Switching Point From Tobacco Into Cannabis Chart 20Biotech Is A Major Buy Chart 21Norway's Outperformance Could End Chart 22Cotton Versus Platinum Is Reversing Chart 23Switzerland's Outperformance Vs. Germany Has Ended Chart 24The Rally In USD/EUR Has Ended Chart 25The Outperformance Of MSCI Hong Kong Versus China Is Vulnerable To Reversal Chart 26A Potential New Entry Point Into Petcare Chart 27Czech Outperformance Near Exhaustion Chart 28US REITS Are Oversold Versus Utilities Chart 29GBP/USD At A Turning Point Dhaval Joshi Chief Strategist dhaval@bcaresearch.com Hadi Elzein Research Associate hadi.elzein@bcaresearch.com Footnotes 1  Strictly speaking, the EMH assumes there is some disagreement, but that this disagreement is random and follows a standard Gaussian (bell-curve) distribution. Therefore, the EMH assumes that a share price just follows a random walk until new (unpredictable) fundamental information arrives. Fractal Trades 6-Month Recommendations Structural Recommendations Closed Fractal Trades Indicators To Watch - Bond Yields Chart II-1Indicators To Watch - Bond Yields - Euro Area Chart II-2Indicators To Watch - Bond Yields - Europe Ex Euro Area Chart II-3Indicators To Watch - Bond Yields - Asia Chart II-4Indicators To Watch - Bond Yields - Other Developed   Indicators To Watch - Interest Rate Expectations 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  

Executive Summary   Lower Rates Are A Tailwind For Growth Stocks We remain in the bearish camp. While the market bottom is getting closer, there are still hurdles to overcome such as elevated economic and earnings growth expectations, which need to come down to prevent new disappointments. Notably, the market focus has shifted away from inflation and has turned towards worries about growth as is evident in the falling 10-year Treasury yield. The environment of slowing growth and falling rates is a tailwind for growth stocks, warranting an upgrade of Growth to at least a benchmark weight. Technicals also signal that Growth is oversold relative to Value. The valuation differential has also moderated. However, we are wary of upgrading Growth to an outright overweight and downgrading Value to underweight as there is still plenty of economic uncertainty. We also posit that in the next several months the markets will be “fat and flat”, i.e., a bear market punctuated by rallies and pullbacks. In this environment, a balanced allocation between Growth and Value will reduce portfolio volatility and result in higher compound returns. Bottom Line: In a commentary to our chart pack report, we upgrade the Growth/Value style preference to benchmark allocation. Feature This week we provide you with a style chart pack. In this accompanying note, we will make a case for upgrading Growth and downgrading Value, bringing these style allocations to equal weight. We are booking a profit of 13% since we established the position in January 2022. We are getting closer to upgrading Growth to overweight. Performance May started as another tough month for equities, but, as they say, all’s well that ends well. After pulling back 10% since the beginning of May, and briefly touching bear market territory of -20%, the S&P 500 rebounded in the last 10 days of the month bringing the index to where it ended April. As a result, the S&P 500 was flat, and the NASDAQ was down 2.4% in May. As expected, the rally brought about a change in leadership (Chart I-1), with Consumer Discretionary and Technology leading the pack. Energy and Utilities are the only sectors that avoided rotation. Since May 20, Growth has outperformed Value by 3%. Chart I-1Recent Performance Bear Market Rally Or The Real Thing? Since the start of the May rally, investors have been debating whether it has legs. Bulls argue that we are in the early innings of a sustainable rebound in equities – after all, much of the bad news is already priced in, 45% of NYSE and 70% of NASDAQ have recently hit new 12-month lows, screaming oversold conditions, and making bottom fishing tempting  (Chart I-2). Bears consider this surge in performance a garden-variety bear market rally: Growth is slowing and none of the problems that have been haunting the markets over the past five months, such as inflation, war, China, and a hawkish Fed, have yet been resolved. Our views are closer to the bearish camp: We believe that, even if the market bottom is getting closer, there are still hurdles to overcome, such as elevated economic and earnings growth expectations, which need to come down to prevent new disappointments. As we discussed in the recent “What Is Next For Equities: They Will Be Fat And Flat” report, we believe that equities are likely to be range-bound over the next several months: A turn in inflation and a downshift in growth may ignite rallies on hopes of a gentler, data-driven Fed, and a shallower trajectory for the rate-hiking cycle  (Chart I-3). However, we argue that the Fed “put” is no longer in play and the Fed will stay focused on inflation, inadvertently puncturing any budding rallies. In addition to a hawkish Fed, investors will have to process what may become a sharp economic growth slowdown and an earnings recession in the US on the back of rising costs, a stronger dollar, and slowing global demand for US goods. Chart I-2Is Much Of The Bad News Already Priced In? Chart I-3Many Hope For A Shallower Hiking Cycle Growth Vs. Value: Shifting Positioning To Equal Weight When Growth Is Harder To Find, Growth Stocks Shine As we argued in the “Fat and Flat” report, there are multiple signs that economic growth is slowing, and that earnings growth will disappoint. Our Business Cycle Indicator, which is a compilation of soft and hard data across production, consumer, and credit dimensions, is also signaling a slowdown  (Chart I-4). Here we would like to emphasize our view: As of now, US economic growth is strong, and it is only its second derivative, i.e. a deceleration of growth, that is the root of our concerns. In a world where growth is becoming scarcer, companies that can deliver growth will shine. These are “growth” companies, i.e. large, stable companies with strong balance sheets that are able to generate positive cash flow and churn out strong earnings even under economic duress  (Chart I-5). Quality growth outperforms during slowdowns  (Chart I-6). This reasoning does not apply to speculative, barely profitable, growth companies which will fight for survival in a slow-growth world. Chart I-4We Are In A Slowdown Stage Of The Business Cycle Chart I-5Large Cap Growth Is Synonymous With Quality Chart I-6Growth Outperforms During Economic Slowdowns Of course, one might argue that economic growth has been slowing for about a year, initially by returning towards the pre-pandemic trend and, lately, as a result of monetary tightening. Yet, over the past six months, Growth has underperformed Value by nearly 11%. What is different now? First, inflation, and the monetary tightening that inevitably follows it, are the mortal enemies of growth stocks: Higher discount rates deflate the present value of future cash flows. Rising inflation and sharply rising Treasury yields are behind the recent sell-off in Growth stocks. However, recently, the market focus has shifted away from inflation, and seems to finally be turning towards worries about growth. As a result, the 10-year Treasury yield decreased from 3.12% to 2.75%, and its relentless climb may now be behind us  (Chart I-7). Lower rates are a tailwind for Growth stocks which rebounded at the first whiff of rate stabilization  (Chart I-8). Chart I-7Investors Concerns Have Shifted From Inflation To Growth Further, our research on macroeconomic regimes suggests that a turn in inflation heralds a change in market leadership from Value to Quality and Growth  (Chart I-9). Chart I-8Lower Rates Are A Tailwind For Growth Stocks Chart I-9Growth And Quality Will Lead Markets When Inflation Abates Growth Not Yet Cheap But Oversold This year’s sell-off is characterized by a multiple contraction. Growth is a poster child of this trend: Its forward multiple has decreased by 8 points, with the style currently trading at just under 20x forward earnings, which is the 61st percentile relative to its 10-year history (compare that to 28x and the 94th percentile back in January). As for Value, it also became cheaper, contracting from 16.8x in January to 14.9x (Table I-1). Table I-1Valuations And EPS Growth Expectations According to the BCA Valuations Indicator  (Chart I-10), the Growth/Value valuations spread has moderated but by itself, is not an impetus for a switch. However, looking at technicals, Growth is extremely oversold relative to Value and is at levels last seen in 2006. Why Neutral, Not Overweight? We hope we made a compelling case for shifting allocation from Value to Growth. Then why not go overweight, but just neutral? Mostly because many of the macroeconomic developments we have described are tentative and are just conjecture at this point – there is still plenty of uncertainty about inflation, rates, and the Fed monetary response. Second, while Growth stocks are supposed to grow faster than Value stocks, at the moment analysts expect them to grow at 8% and 11% respectively. We expect earnings growth expectations for Value stocks to be downgraded since they are dominated by cyclicals. However, until the new numbers are in for both styles, we need to be careful. Chart I-10Growth Is Getting Cheaper Relative To Value... It Also Appears Oversold Last, if we are right, and US equities are to test their bottom this summer in a “fat and flat” manner, there will be a frequent change in leadership, with Growth and Small outperforming during the rallies, and Value outperforming during pullbacks. Portfolios need exposure to both styles to achieve the highest compound returns as diversification reduces portfolio volatility. Once macroeconomic uncertainty dissipates, we will be able to pounce and shift Growth to overweight, and Value to underweight. For now, we are going to stay neutral out of an abundance of caution. Bottom Line Macroeconomic conditions are becoming more favorable for Growth as Treasury yields stabilize and economic growth slows, making the strong fundamentals and stable earnings of large-cap growth stocks more valuable. Growth is oversold relative to Value, and the relative performance differential of Growth vs. Value over the past six months has been staggering – it is time to book profits and prepare for the next chapter.   Irene Tunkel Chief Strategist, US Equity Strategy irene.tunkel@bcaresearch.com     S&P 500 Chart II-1Macroeconomic Backdrop Chart II-2Profitability Chart II-3Valuations And Technicals Chart II-4Uses Of Cash Cyclicals Vs Defensives Chart II-5Macroeconomic Backdrop Chart II-6Profitability Chart II-7Valuation And Technicals Chart II-8Uses Of Cash Growth Vs Value Chart II-9Macroeconomic Backdrop Chart II-10Profitability Chart II-11Valuations And Technicals Chart II-12Uses Of Cash Small Vs Large Chart II-13Macroeconomic Backdrop Chart II-14Profitability Chart II-15Valuations and Technicals Chart II-16Uses Of Cash Table A1Performance Table A2Valuations And Forward Earnings Growth   Footnotes Recommended Allocation Recommended Allocation: Addendum 

Listen to a short summary of this report.       Executive Summary Chinese Stocks Are Relatively Cheap The Chinese economy faces a trifecta of economic woes: 1) The threat of renewed Covid lockdowns; 2) Cooling export demand; 3) A floundering housing market. Trying to reflate the Chinese housing bubble would only damage the long-term prospects of China’s economy. A much better option would be to adopt measures that boost disposable income. Not only would this help offset the drag from slowing export growth and a negative housing wealth effect, but it would also take some of the sting out of China’s zero-Covid policy. With the Twentieth Party Congress slated for later this year, the political incentive to shower the economy with cash will only intensify. Chinese equities are trading at only 10-times forward earnings and about 1-times sales. A significant upward rating for equity valuations is likely if the government adopts broad-based income-support measures. Go long the iShares MSCI China ETF ($MCHI) as a tactical trade. Bottom Line: China faces a number of economic woes, but these are fully discounted by the market. What has not been discounted is a broad-based stimulus program focused on income-support measures.   Dear Client, I will be visiting clients in Saudi Arabia, Bahrain, and Abu Dhabi next week. No doubt, the outlook for oil prices will feature heavily in my discussions. I will brief you on any insights I learn in my report on June 17. In the meantime, I am pleased to announce that Matt Gertken, BCA’s Chief Geopolitical Strategist, will be the guest author of next week’s Global Investment Strategy report. Best regards, Peter Berezin Chief Global Strategist Triple Threat The Chinese economy faces a trifecta of economic woes: 1) The threat of renewed Covid lockdowns; 2) Cooling export demand; 3) A floundering housing market. Let us discuss each problem in turn.   Problem #1: China’s Zero-Covid Policy in the Age of Omicron Chart 1China’s Lockdown Index Remains Elevated China was able to successfully suppress the virus in the first two years of the pandemic. However, the emergence of the Omicron strain is challenging the government’s commitment to its zero-Covid policy. The BA.2 subvariant of Omicron is 50% more contagious than the original Omicron strain and about 4-times more contagious than the Delta strain. While 89% of China’s population has been fully vaccinated, the number drops off to 82% for those above the age of 60. And those who are vaccinated have been inoculated with vaccines that appear to be largely ineffective against Omicron. Keeping a virus as contagious as measles at bay in a population with little natural or artificial immunity is exceedingly difficult. While the authorities are starting to relax restrictions in Shanghai, China’s Effective Lockdown Index remains at elevated levels (Chart 1). A number of domestically designed mRNA vaccines are in phase 3 trials. However, it is not clear how effective they will be. Shanghai-based Fosun Pharma has inked a deal to distribute 100 million doses of Pfizer’s vaccine, but so far neither it nor Moderna’s vaccine have been approved for use. Our working assumption is that China will authorize the distribution of western-made mRNA vaccines later this year if its own offerings prove ineffectual. The Chinese government has already signed a deal to manufacture a generic version of Pfizer’s Paxlovid, which has been shown to cut the risk of hospitalization by 90% if taken within five days of the onset of symptoms. In the meantime, the authorities will continue to play whack-a-mole with Covid. Investors should expect more lockdowns during the remainder of the year.   Problem #2: Weaker Export Growth China’s export growth slowed sharply in April, with manufacturing production contracting at the fastest rate since data collection began. Activity appears to have rebounded somewhat in May, but the new export orders components of both the official and private-sector manufacturing PMIs still remain below 50 (Chart 2). Part of the export slowdown is attributable to lockdown restrictions. However, weaker external demand is also a culprit, as evidenced by the fact that Korean export growth — a bellwether for global trade — has decelerated (Chart 3).  Chart 2China’s Export Growth Has Rolled Over Chart 3Softer Export Growth Is Not A China-Specific Phenomenon Spending in developed economies is shifting from manufactured goods to services. Retail inventories in the US are now well above their pre-pandemic trend, suggesting that the demand for Chinese-made goods will remain subdued over the coming months (Chart 4). The surge in commodity prices is only adding to Chinese manufacturer woes. Input prices rose 10% faster than manufacturing output prices over the past 12 months. This is squeezing profit margins (Chart 5). Chart 4Well-Stocked Shelves In The US Bode Poorly For Chinese Export Demand Chart 5Surging Input Costs Are Weighing On The Profits Of Chinese Commodity Users A modest depreciation in the currency would help the Chinese export sector. However, after weakening from 6.37 in April to 6.79 in mid-May, USD/CNY has moved back to 6.66 on the back of the recent selloff in the US dollar. Chart 6The RMB Tends To Weaken When EUR/USD Is Rising We expect the dollar to weaken further over the next 12 months as the Fed tempers its hawkish rhetoric in response to falling inflation. Chart 6 shows that the trade-weighted RMB typically strengthens when EUR/USD is rising. Chester Ntonifor, BCA’s Chief Currency Strategist, expects EUR/USD to reach 1.16 by the end of the year.   Problem #3: Flagging Property Market Chinese housing sales, starts, and completions all contracted in April (Chart 7). New home prices dipped 0.2% on a month-over-month basis, and are up just 0.7% from a year earlier, the smallest gain since 2015. The percentage of households planning to buy a home is near record lows (Chart 8). Chart 7The Chinese Property Market Has Been Cooling Chart 8Intentions To Buy A House Have Declined China’s property developers are in dire straits. Corporate bonds for the sector are, on average, trading at 48 cents on the dollar (Chart 9). Goldman Sachs estimates that the default rate for property developers will reach 32% in 2022, up from their earlier estimate of 19%. The government is trying to prop up housing demand. The PBoC lowered the 5-year loan prime rate by 15 bps on May 20th, the largest such cut since 2019. The authorities have dropped the floor mortgage rate to a 14-year low of 4.25%. They have also taken steps to make it easier for property developers to issue domestic bonds. BCA’s China strategists believe these measures will foster a modest rebound in the property market in the second half of this year. However, they do not anticipate a robust recovery – of the sort experienced following the initial wave of the pandemic – due to the government’s continued adherence to the “three red lines” policy.1 China is building too many homes. While residential investment as a share GDP has been trending lower, it is still very high in relation to other countries. China’s working-age population is now shrinking, which suggests that housing demand will contract over the coming years (Chart 10). Chart 9Chinese Property Developer Bonds Are Trading At Distressed Levels Chart 10Shrinking Working-Age Population Implies Less Demand For Housing Chinese real estate prices are amongst the highest anywhere. The five biggest cities in the world with the lowest rental yields are all in China (Chart 11). The entire Chinese housing stock is worth nearly $100 trillion, making it the largest asset class in the world. As such, a decline in Chinese home prices would generate a sizable negative wealth effect. Chart 11Chinese Real Estate Is Expensive A Silver Bullet? Trying to reflate the Chinese housing bubble would only damage the long-term prospects of China’s economy. Luckily, one does not need to fill a leaky bucket through the same hole the water escaped. As long as there is enough demand throughout the economy, workers who lose their jobs in declining sectors will eventually find new jobs in other sectors. China needs to reorient its economy away from its historic reliance on investment and exports towards consumption. The easiest way to do that is to adopt measures that boost disposable income, which has slowed of late (Chart 12). Not only would this help offset the drag from slowing export growth and a negative housing wealth effect, but it would also take some of the sting out of China’s zero-Covid policy. The authorities have not talked much about pursuing large-scale income-support measures of the kind adopted by many developed economies during the pandemic. As a result, market participants have largely dismissed this possibility. Yet, with the Twentieth Party Congress slated for later this year, the political incentive to shower the economy with cash will only intensify. Chinese equities are trading at only 10-times forward earnings and about 1-times sales (Chart 13). A significant upward rating for equity valuations is likely if the government adopts broad-based income-support measures. As we saw in the US and elsewhere, stimulus cash has a habit of flowing into the stock market; and with real estate in the doldrums, equities may become the asset class of choice for many Chinese investors. With that in mind, we are going long the iShares MSCI China ETF ($MCHI) as a tactical trade. Chart 12Disposable Income Growth Has Been Trending Lower Chart 13Chinese Stocks Are Relatively Cheap At a global level, a floundering Chinese property market would have been a cause for grave concern in the past, as it would have represented a major deflationary shock. Times have changed, however. The problem now is too much inflation, rather than too little. To the extent that reduced Chinese investment injects more savings into the global economy and knocks down commodity prices, this would be welcomed by most investors. China’s economy may be heading for a “beautiful slowdown.” Peter Berezin Chief Global Strategist peterb@bcaresearch.com Follow me on LinkedIn Twitter   Footnotes   1      The People’s Bank of China and the housing ministry issued a deleveraging framework for property developers in August 2020, consisting of a 70% ceiling on liabilities-to-assets, a net debt-to-equity ratio capped at 100%, and a limit on short-term borrowing that cannot exceed cash reserves. Developers breaching these “red lines” run the risk of being cut off from access to new loans from banks, while those who respect them can only increase their interest-bearing borrowing by 15% at most. View Matrix Special Trade Recommendations Current MacroQuant Model Scores