Equities

Highlights Equity valuations are extremely stretched versus bonds, so there is little wiggle room for bonds to sell off before pulling down large tracts of the stock market. We estimate that bond yields can rise by no more than 30 bps, before the Fed is forced to talk them back down again. Starting from an earnings yield that is extreme versus its history, we should prudently assume that the prospective long-term real return from equities will be far below the current earnings yield of 4.6 percent, and closer to zero, even if not actually negative. In capitalist economies, gluts may or may not lead to shortages; but shortages always lead to gluts. In other words, the current inflation is sowing the seeds of its own destruction. Hence, we reiterate our structural recommendation to overweight US T-bonds versus US TIPS. Fractal analysis: Cotton, and Polish equities. Feature Chart of the WeekTech Stocks Have Been Tracking The 30-Year T-Bond Price One-For-One Equity valuations are extremely stretched versus bonds. The upshot is that there is little wiggle room for bonds to sell off before pulling down large tracts of the stock market. This is not just an abstract hypothesis – it is an empirical fact, as recent market action is making painfully clear. Since February, the global tech sector has tracked the 30-year T-bond price almost one-for-one. The near perfect fit proves that the tech (and broader growth stock) rally has been entirely premised on the bond market rally. Hence, on the three occasions that bonds have sold off sharply – including in the last couple of weeks – tech stocks have sold off sharply too (Chart of the Week). Put simply, the performance of the tech sector is being driven by the change in its valuation, and the change in its valuation is being driven by the change in the bond yield (Chart I-2). Chart I-2Tech Stock Valuations Are Being Driven By The Bond Yield Of course, stock prices are also premised on earnings. So, given enough time, rising earnings can make valuations less stretched, adding more wiggle room for bonds to sell off. The trouble is that a change in earnings happens much more gradually than can a change in valuation – a 10 percent rise in earnings can take a year, whereas a 10 percent fall in valuation can happen in a week. Bond Yields Remain The Dominant Driver Of The Stock Market For the next few months at least, the movement in bond yields will remain the dominant driver of the most stretched parts of the stock market and, by extension, the overall market itself. This is especially true for the growth-heavy S&P 500 which, since March, has been tracking the 30-year T-bond price one-for-one (Chart I-3). Chart I-3The S&P 500 Has Also Been Tracking The 30-Year T-Bond Price One-For-One The key question for investors is, what is the upper limit to bond yields before stock market damage causes the Federal Reserve to talk them down again? To answer this question, our working assumption is that a 15 percent drawdown in growth stocks would damage the growth-heavy S&P 500 enough – and thereby worsen ‘financial conditions’ enough – for the Fed to change its tone. Based on this year’s very tight relationship between tech stocks and the 30-year T-bond yield, a 15 percent drawdown would occur if the 30-year T-bond yield increased to 2.4 percent from 2.1 percent today (Chart I-4). Chart I-4The Fed's 'Pain Point' Is Only 30 Basis Points Away This confirms our view that the resistance level to long-duration bond yields is around 30 bps above current levels, equivalent to around 1.8 percent on the 10-year T-bond yield. More About The ‘Negative Equity Risk Premium’ Our recent report The Equity Risk Premium Turns Negative For The First Time Since 2002 caused quite a stir. So, let’s elaborate and clarify the arguments we made about the equity risk premium (ERP) – the estimated excess return that stocks will deliver over bonds over a long investment horizon, such as 10 years. Many investors estimate the ERP by taking the stock market’s earnings yield – currently 4.6 percent in the US1 – and subtracting the real 10-year bond yield – currently -0.9 percent on US Treasury Inflation Protected Securities (TIPS). At first glance, this presents a very generous ERP of 5.5 percent. So, equities are attractively valued versus bonds, right? Wrong. The glaring error is that the earnings yield estimates the stock market’s prospective return only if the earnings yield starts and ends at the same level. If it does not, then the prospective return could be very different to the earnings yield. For example, imagine that the stock market was trading at a bubble price-to-earnings multiple of 100, meaning an earnings yield of 1 percent. Clearly, from such a bubble valuation, nobody would expect the market to return 1 percent. Instead, as the bubble burst, and valuations normalised, the prospective return would be deeply negative. It follows that when, as now, the earnings yield is extreme versus its history, we must build in some prudent normalisation to estimate the prospective return. The question is, how? One approach is to use history to inform us of the likely normalisation. Chart I-5 does this using the ‘best-fit’ relationship between the earnings yield at each point through 1990-2011 and subsequent 10-year real return from each starting point. Using the best-fit for this specific episode, the current earnings yield of 4.6 percent implies a prospective 10-year real return not of 4.6 percent, but of -1.1 percent. Chart I-5Based On History, The Current Earnings Yield Implies A Prospective 10-Year Real Return Much Less Than 4.6 Percent Yet this best-fit approach meets a common reproach – that the best-fit for this specific episode is massively distorted by the dot com bubble peak and the global financial crisis (GFC) trough occurring (by coincidence) almost 10 years apart. We can counter this reproach in two ways. First, the best-fit relationship is much better than the raw earnings yield even for undistorted 10-year periods such as 1995-2005 or 2011-2021. Better still, we can change the prospective return from 10 years to 7 years and thereby remove the dot com bubble peak to GFC trough distortion. Chart I-6 shows that this 7-year best-fit relationship also works much better than the raw earnings yield. Chart I-6Based On History, The Current Earnings Yield Implies A Prospective 7-Year Real Return Much Less Than 4.6 Percent Admittedly, the best-fit comes from just one episode in history, and there is no certainty that the 10-year and 7-year relationships that applied during that one episode should apply through 2021-31 and 2021-28 respectively. Nevertheless, starting from an earnings yield that is extreme versus its history, as is the case now, we should prudently assume that the prospective long-term real return from equities will be far below 4.6 percent, and closer to zero, even if not actually negative. Will The ‘Real’ Real Yield Please Stand Up Measuring the ERP also requires an estimate of the prospective real return on bonds. This part should be easy because the yield on the US 10-year TIPS – currently -0.9 percent – is the guaranteed 10-year real return of buying and holding that investment. It is derived by taking the yield on the 10-year T-bond – currently 1.5 percent – and subtracting the market’s expected rate of inflation over the next 10 years – currently 2.4 percent. But the equivalent real return on the much larger conventional bond market could be quite different. In this case, it will be the 10-year T-bond yield minus the actual rate of inflation over the next 10 years. To the extent that the actual rate of inflation turns out less than the expected rate of 2.4 percent, the real return on the T-bond will turn out higher than that on the TIPS. In fact, this has consistently turned out to be the case. The market has consistently overestimated the inflation rate over the subsequent 10 years, meaning that the real return on T-bonds has been around 1 percent higher than that on TIPS (Chart I-7). Chart I-7Will The 'Real' Real Yield Please Stand Up Yet given the current surge in inflation, and no end in sight for supply chain disruptions and bottlenecks, is it plausible that the next ten years’ rate of inflation will be lower than 2.4 percent? The answer is yes. Because, as my colleague Peter Berezin points out: in capitalist economies, gluts may or may not lead to shortages; but shortages always lead to gluts. And gluts always cause prices to collapse. In other words, the current inflation is sowing the seeds of its own destruction. Hence, we reiterate our structural recommendation to overweight US T-bonds versus US TIPS. The Cotton Is Stretched, And So Are Polish Equities Talking of shortages, cotton now adds to the list of commodities in which supply bottlenecks have raised prices to extremes. Cotton prices have reached a 10-year high due to weather conditions in the US (the world’s biggest cotton producer) combined with shipping disruptions. However, with cotton now exhibiting extreme fragility on its combined 130/260-day fractal structure, there is a high likelihood of a price reversal in the coming months when the shortage turns into a glut (Chart I-8). Chart I-8The Cotton Is Stretched Meanwhile, the bank-heavy Polish equity market has surged on the back of the spectacular outperformance of its banks sector. This strong uptrend has now reached the point of fragility on its 130-day fractal structure that has indicated several previous reversals (Chart I-9). Chart I-9Poland's Outperformance Is Stretched Accordingly, this week’s recommended trade is to underweight the Warsaw General Index versus the Eurostoxx 600, setting a profit target and symmetrical stop-loss at 6 percent.   Dhaval Joshi Chief Strategist dhaval@bcaresearch.com   Footnotes 1 Based on the 12-month forward earnings yield. Fractal Trading System Fractal Trades 6-Month Recommendations Structural And Thematic Recommendations Closed Fractal Trades     Indicators To Watch - Bond Yields Chart II-1Indicators To Watch - Bond Yields ##br##- Euro Area Chart II-2Indicators To Watch - Bond Yields ##br##- Europe Ex Euro Area   Chart II-3Indicators To Watch - Bond Yields ##br##- Asia Chart II-4Indicators To Watch - Bond Yields ##br##- Other Developed   Indicators To Watch - Interest Rate Expectations Chart II-5Indicators To Watch ##br##- Interest Rate Expectations Chart II-7Indicators To Watch ##br##- Interest Rate Expectations   Chart II-6Indicators To Watch ##br##- Interest Rate Expectations Chart II-8Indicators To Watch ##br##- Interest Rate Expectations      

Special Report

Highlights Electricity shortages in China are largely due to excessive power demand rather than a matter of shrinking electricity production. Chinese electricity consumption has been supercharged by the export sector’s booming demand for electricity. Excessive overseas (mainly US) demand for goods has been the main culprit behind China’s robust electricity demand. Divergence in the mainland economy between booming exports on the one hand and weakening property construction and infrastructure spending on the other hand will reduce the likelihood that policymakers will rush to stimulate. Odds are that Chinese and EM share prices will continue selling off and underperforming DM equities. Feature Contrary to popular perceptions, China’s electricity crisis is not due to drastic supply shortages but rather caused by excessive demand. This has implications for macro policy. Given that electricity shortages stem from strong demand, policymakers will be less aggressive in providing blanket stimulus over the near term. The basis is that unleashing more stimulus to boost the industrial sector – at a time when there are already scarcities of electricity and other inputs – will intensify the shortages and aggravate the situation. Robust Electricity Demand Electricity demand has been outstripping growing electricity output. Hence, shortages are largely due to excessive electricity demand. Charts 1 and 2 demonstrate that both electricity consumption and output have been expanding but demand growth has outpacing supply. Notably, electricity demand has surged above its trend by more than electricity production.  Chart 1Chinese Electricity Production Is Above Its Trend Chart 2Chinese Electricity Consumption Is Well Above Its Trend The mainland’s electricity demand has been strong due to surging manufacturing consumption of electricity. The top panel of Chart 3illustrates that electricity consumption in manufacturing has become overextended. On the other hand, residential demand for electricity has been expanding gradually and has not been excessive (Chart 3, bottom panel). The manufacturing sector has been supercharged by booming exports. Chart 4 reveals that China’s industrial output and exports have expanded briskly – their levels have surged well above their 10-year trend. Chart 3Electricity Demand Growth Is Driven By Manufacturing Not Residential Consumption Chart 4Manufacturing And Exports Have Been Very Strong Chart 5US Goods Demand: Classic Overheating DM countries’ stimulus has been responsible for this export boom. Specifically, US demand for goods has been running well above its pre-pandemic trend (Chart 5). Bottom Line: Both electricity consumption and production have been rising but demand has outstripped supply, resulting in shortages. On Supply Constraints Not only has total electricity output been rising but electricity produced by thermal coal has also been expanding, albeit gradually (Chart 6). China still generates 71% of its electricity using thermal coal. While electricity output growth from this source has slowed down recently, it has still not contracted (Chart 7). Chart 6China: Sources Of Electricity Production Chart 7Electricity Output Has Slowed But Not Contracted   Similarly, coal supply has been rising slowly, i.e., it has not shrunk (Chart 8). Coal supply has been capped due to the following reasons: Coal production has decelerated due to decarbonization policies adopted by Beijing. Authorities have also constrained coal mining by strictly enforcing safety protocols in mines following accidents early this year. Moreover, coal imports have been constrained by Beijing's ban on coal from Australia. Beijing’s “dual control” policy – which imposes targets on energy intensity and the level of energy consumption on provinces – has also led several local governments to reduce electricity production in recent weeks to ensure that annual targets are met. Finally, in recent years electricity prices have been flat-to-down while coal prices have surged (Chart 9). Thus, coal-based power generators have recently been incurring losses and some of them have been reluctant to produce more electricity. Chart 8China's Coal Supply Has Been Timid   Chart 9Coal Power Plants Are Operating With Losses   Authorities have begun tackling these problems. Coal supply will likely rise moderately as will electricity output from thermal coal. Reportedly, some Australian coal has in recent days been offloaded in China, and authorities have eased restriction on coal production and encouraged banks to lend to coal producers and electricity generators. Bottom Line: There has been a slowdown – not a contraction – in electricity produced by thermal coal. Authorities have started addressing these bottlenecks and odds are that electricity output will catch up with electricity demand before year-end, i.e., the power shortages will likely gradually ebb. Implications For Chinese Macro Policy Given that electricity demand has been outstripping supply, clients might wonder about the pace of China’s economic growth. This has ramifications as to whether or not authorities will stimulate aggressively. On the one hand, the manufacturing and especially export-oriented segments have been expanding briskly. As shown in Chart 4 above, manufacturing output in general and exports in particular have been overheating. Further, the labor market has been tightening, as is illustrated in Chart 10. On the other hand, as we have been writing, construction and infrastructure spending have been weakening (Chart 11). Chart 10China: Urban Labor Market Is Tight Chart 11Construction And Infrastructure Have Slowed Granted property developers, local governments and LGFVs are facing debt limits and financing constraints, it is safe to assume that they will cut back on their capital spending. China’s construction and infrastructure spending accounts for a large share of industrial metals demand. This is a basis for our argument that industrial metal prices remain at risk of declining. Unlike the current power crunch, industrial metal shortages are not caused by excessive demand but rather are due to shrinking production. Chart 12 shows that China’s steel output has contracted. Hence, the surge in steel prices has been due to production cutbacks. Local governments are probably shutting down metals production in response to decarbonization policies and to divert power to export-oriented companies. The fact that the price of steel’s key ingredient – iron ore – has collapsed is consistent with reduced demand for it (Chart 13). This is in contrast with the current strong demand for coal. Chart 12Lower Steel Production = Higher Steel Prices Chart 13Weak Iron Ore Demand = Lower Prices Overall, the bifurcation in the economy characterized by booming exports versus weakening property construction and infrastructure spending reduces the likelihood that policymakers will rush to stimulate. Rather, they will provide targeted support to negatively affected segments of the economy in the form of easier credit access, easing industry regulation and easier decarbonization targets. Bottom Line: Policymakers in Beijing will not rush to provide a blanket stimulus for now. Rather, they will use this period of booming exports to undertake deleveraging in the real estate sector as well as local governments and their affiliated companies. Investment Implications: Barring any large stimulus, construction and infrastructure spending will continue to disappoint, which is bad for industrial metals. This outlook in combination with the ongoing regulatory clampdown on internet companies heralds lower prices for Chinese investable stocks. Chart 14Stay Long A Shares / Short Chinese Investable Stocks Given that Chinese investable stocks include few export companies, booming exports will not be sufficient to propel China’s MSCI Investable equity index higher. Among the Chinese indexes, we reiterate our long A shares / short China MSCI Investable index strategy, a recommendation made in early March (Chart 14). Reshuffling The EM Portfolio BCA’s Emerging Markets Strategy team is recommending the following changes in country allocation within EM equity and fixed-income portfolios. Equities: We are downgrading Indian stocks from overweight to neutral. The reasons for this portfolio shift are presented in the country report we are publishing today. In its place, dedicated EM equity managers should upgrade Russian and Central European equity markets like Poland, Czech Republic and Hungary from neutral to overweight. The rationale is that high oil prices favor Russian equity outperformance. Barring a major crash in oil prices, we are comfortable maintaining an overweight allocation to Russia in an EM portfolio. ​​​​​​​In turn, rising bond yields in core Europe are positive for bank stocks that have a large weight in Central European bourses.   Fixed Income: We are upgrading Russian local currency bonds from neutral to overweight within an EM domestic bond portfolio. A hawkish central bank is positive for the long end of the Russian yield curve. 10-year yields also offer great value. Further, high energy prices (even if they drop from current very elevated levels but remain above $60 per a barrel) will help the ruble to outperform its EM peers. We maintain a yield curve trade of receiving 10-year/paying 1-year swap rates in Russia. Finally, we continue overweighting Russian sovereign and corporate credit within an EM credit portfolio.   Arthur Budaghyan Chief Emerging Markets Strategist arthurb@bcaresearch.com Equities Recommendations Currencies, Credit And Fixed-Income Recommendations

With inflation readings elevated for longer than expected and global growth data rolling over, fears of stagflation are tightening their grip over the markets. Together, inflation and a not fully recovered labor market, have pushed the US misery index above the one standard deviation mark (Chart 1). We conducted an empirical analysis to examine how different sectors and styles fared during periods of stagflation. To do so, we defined stagflation as periods with inflation is above 3% and industrial production is contracting on a YoY basis. We have only 24 months in this regime since 1989, which constitutes 6.3% of all observations. Admittedly, our sample is small. We then calculate the median relative returns of each S&P 500 sector across the regime. Chart 1 Here is what we found: Out of the three S&P “long duration” growth sectors (Technology, Communication Services, and Consumer Discretionary), two are in the red as inflationary headwinds are overpowering scarcity of growth in the economy. Meanwhile, the traditional inflationary beneficiaries, such as Financials, Materials, and Energy outperformed the S&P 500. Historically, the Health Care sector was also a good deflation hedge due to its inelastic demand profile. However, more recently pricing power of the sector has been declining due to a perfect storm of regulatory changes and patent cliffs. The Consumer Staples index is another defensive sector that outperformed during stagflation as consumers prioritize everyday necessities over other spending (Chart 2). Chart 2 Bottom Line: If stagflation fears materialize, Financials, Consumer Staples, Energy, and Materials are the key sectors that have the best chance to withstand the headwinds.

Foreword Today we are publishing a charts-only report focused on the S&P 500, and GICS 1 sectors.  Many of the charts are self-explanatory; to some, we have added a short commentary. The charts cover macro, valuations, fundamentals, technicals, and the uses of cash. Our goal is to equip you with all the data you need to make investment decisions along these sector dimensions. We also include performance, valuations and earnings growth expectation tables for all styles, sectors, industry groups, and industries (GICS 1, 2 and 3). We hope you will find this publication useful. We alternate between Styles and Sector chart pack updates on a bi-monthly basis. Changes In Positioning Downgrade Growth to an equal weight and upgrade Value to an equal weight.  Upgrade Small to an overweight and downgrade Large to an underweight. Downgrade Technology to equal weight by reducing overweight in Software and Services.  We remain overweight Semiconductors and Equipment. We are on board with the ongoing market rotation: We were waiting for a decisive shift in rates and a dissipation of the Covid-19 scare as a signal to initiate this repositioning (Chart 1). Chart 1Performance Of S&P 500 Sectors And Styles Overarching Investment Themes: Rotation Has Begun! Taper Tantrum 2.0: With tapering imminent and monetary tightening around the corner, both real yields and nominal yields are up sharply over the past couple of weeks (Chart 2A).  Chart 2ARates Are Up Sharply Chart 2BProbability Of Two Rate Hikes In 2022 Has Been Climbing Market expects two rate hikes by the end of 2022: Although Chairman Powell has explicitly separated the decision to taper from the timing of the first rate hike, which he conditioned on full employment and which is “a long way off,” the market is still spooked by the timing and the speed of rate hikes. Currently, the probability of two rate hikes in 2022 stands at around 40%, rising sharply over the past two weeks (Chart 2B). The BCA house view is that the Fed will start hiking in December of 2022. Market rotation is on: Rising yields and a recent decline in Delta variant infections have triggered a fast and furious style and sector rotation. Higher rates put pressure on rate-sensitive sectors and styles, such as Growth, Technology, Communication Services, and Real Estate. While the “taper tantrum” pullback affects the entire US equity market, areas most geared to rising rates, such as Cyclicals, Financials, and Small Caps fare the best (Chart 3). An easing of the Delta scare has led to the “reopening” trade outperforming the ”work-from-home” trade.   Chart 3Rotation Away From Rate-sensitive Sectors And Styles Macro Economic slowdown is finally priced in: At long last, deteriorating economic data is fully digested by investors. The Citigroup Economic Surprise index is still in negative territory (Chart 4A) but has turned decisively. The markets move on the second derivative and a “less bad” economic surprise is a major positive for the markets. Chart 4ADeterioration Of Economic Data Is Finally Priced In Chart 4BSupply Bottleneck Are Not Easing Supply-chain disruptions are not abating: Shipping costs continue their ascent. The average delay of cargo ships traveling between the Far East and North America is 12 days – compare that to 1 day in January 2020.1 The ISM PMI Supplier Performance index increased from 69.5 in August to 73.4 indicating that supply bottlenecks are not easing (Chart 4B). There are also significant backlogs of goods (Chart 5A), and plenty of new orders. It will take time for supply chains to normalize, with most industry participants expecting the situation to improve only in 2022. Chart 5AManufacturers Are Overwhelmed Chart 5BA Whiff Of Stagflation? Labor shortages: Companies are still struggling to fill job openings. According to the US Census Survey, “pandemic layoff” or “caring for children” were the top reasons for not working. The number of people not working because of Covid-19 infections or fear of Covid spiked at the end of August.2  This explains the August jobs report. The ugly “S” word: With the ubiquitous shortage of input materials and labor, along with transportation delays, suppliers are simply unable to meet demand for goods, pushing prices higher.  Stagflation may be rearing its ugly head: The Dallas Fed manufacturing index is showing a divergence, with prices moving higher while business activity is shifting lower. This is not the case with the ISM PMI index components, but investors need to be vigilant (Chart 5B). Americans are in a worse mood: Consumer confidence survey readings continue on a downward path. The combination of higher prices for everyday goods, the loss of purchasing power, the discontinuation of supplementary unemployment benefits, and paychecks not adjusted for inflation weigh on consumer sentiment. On the positive side, jobs are still plentiful.  Valuation And Profitability Despite recent turbulence and rotations across sectors and styles, consensus is still expecting 15% YoY earnings growth over the next 12 months. However, QoQ growth rates look very different as we remove the base effect: Growth is expected to dip this coming quarter (Q3, 2021), and stay modest for most of 2022. This is a low bar that should be easy for companies to clear, although supply disruptions may dent corporate earnings. In the meantime, valuations remain elevated at 20.7 forward earnings (Chart 6). Chart 6Earnings Growth Expectations Are Modest Sentiment There are still inflows into US equities, but they are easing. This can be explained by FOMO (fear of missing out), and lots of cash sitting on the sidelines that many retail investors aim to park in US equities.  (Chart 7A). However, this is changing as rising rates render the TINA (“there is no alternative”) trade much less attractive. Chart 7AInflows Into US Equities Are Easing Chart 7BCapex Is On The Rise Uses Of Cash Capex: Capital goods orders are soaring, pointing to robust capex.  The latest S&P estimates suggest that capex will rise 13% this year.3 This points to economic normalization, and attests to corporate confidence in economic growth. It is also a likely byproduct of shortages that plague the US supply chain – companies are expanding their capacity. (Chart 7B). Investment Implications Low for longer is over: The Fed has committed to tapering within the next 2-3 months.  Unless this intention is derailed by another Covid scare or a significant deterioration in economic growth, we are now convinced that rates will move up to hit the BCA house view of 1.7%-1.9% by year-end. S&P 500:  There is plenty of rotation under the hood; yet we expect US equities to hold their own into the balance of the year as, for now, monetary and fiscal policy remain easy, and earnings growth is likely to surprise on the upside. Severe and prolonged supply disruptions are a key risk to this view, as they chip away from economic growth, and cut into companies sales growth and profitability. Growth vs. Value: With rates rising into year-end, interest-rate sensitive stocks, such as Growth and the Technology sector, are under pressure.  Since we opened overweight Growth and underweight Value position on June 14, Growth has outperformed S&P 500 by 4.1%, and Value underperformed by 4.5%.  We do not want to overstay our welcome, and are neutralizing both sides of the trade, bringing positioning to an equal weight.  Technology has beaten the S&P 500 by 2.2%, and we are shifting to an equal weight positioning by reducing overweight of the Software Industry Group. We remain overweight Semiconductors and Equipment. We are closing our overweight to Growth and underweight to Value allocation. We reduce overweight to Technology. Chart 7C Cyclicals vs. Defensives:  The onset of the Delta variant is dissipating, and we expect consumer cyclicals to rebound as more people are willing to travel and eat out. We also believe that the parts of the Industrials sector most exposed to restocking of inventories, infrastructure, and construction will perform strongly. Small vs. Large: We are upgrading Small from neutral to an overweight, and downgrade Large to an underweight. Small is highly geared to rising rates. It is also cheaper than Large, and most of the earnings downgrades are already in the price. We are now constructive on this asset class.   Irene Tunkel Chief Strategist, US Equity Strategy irene.tunkel@bcaresearch.com   S&P 500 Chart 8Macroeconomic Backdrop Chart 9Profitability Chart 10Valuations And Technicals Chart 11Uses Of Cash Communication Services Chart 12Macroeconomic Backdrop Chart 13Profitability Chart 14Valuations And Technicals Chart 15Uses Of Cash Consumer Discretionary Chart 16Macroeconomic Backdrop Chart 17Profitability Chart 18Valuations And Technicals Chart 19Uses Of Cash Consumer Staples Chart 20Macroeconomic Backdrop Chart 21Profitability Chart 22Valuations And Technicals Chart 23Uses Of Cash Energy Chart 24Macroeconomic Backdrop Chart 25Profitability Chart 26Valuations And Technicals Chart 27Uses Of Cash Financials Chart 28Macroeconomic Backdrop Chart 29Profitability Chart 30Valuations And Technicals Chart 31Uses Of Cash Health Care Chart 32Macroeconomic Backdrop Chart 33Profitability Chart 34Valuations And Technicals Chart 35Uses Of Cash Industrials Chart 36Macroeconomic Backdrop Chart 37Profitability Chart 38Valuations And Technicals Chart 39Uses Of Cash Information Technology Chart 40Macroeconomic Backdrop Chart 41Profitability Chart 42Valuations And Technicals Chart 43Uses Of Cash Materials Chart 44Macroeconomic Backdrop Chart 45Profitability Chart 46Valuations And Technicals Chart 47Uses Of Cash Real Estate Chart 48Macroeconomic Backdrop Chart 49Profitability Chart 50Valuations And Technicals Chart 51Uses Of Cash Utilities Chart 52Macroeconomic Backdrop Chart 53Profitability Chart 54Valuations And Technicals Chart 55Uses Of Cash       Footnotes 1     Source: eeSea 2     US Census Household Pulse Survey, Employment Table 3. 3    S&P Global Market Intelligence, S&P Global Ratings; Universe is Global Capex 2000   Recommended Allocation

Highlights European small-cap equities have structurally outperformed large-cap stocks. This outperformance echoes the desirable sectoral biases of small-cap stocks. It also reflects the inability of European large-cap stocks to expand their markups, unlike US large caps. The pro-cyclicality of European small-cap stocks and the limited correlation of their relative performance to the Chinese credit cycle make them an attractive play in European portfolios. The current risk-off phase in global markets suggests it is still too early to buy European small-cap stocks, but an opportunity to overweight them will emerge in the coming weeks. Feature Markets last week were volatile and corrected sharply. This fit with the view expressed in our previous strategy report, which argued that the near-term outlook for European equities was still clouded by the confluence of the coming Fed tightening and a Chinese economic slowdown.  Chart 1Ebbing COVID Allows For Central Bank Repricing The market seems especially concerned by the deterioration in liquidity conditions. The Delta wave is ebbing around the world (Chart 1) and inflation is proving to be stickier than policymakers had originally anticipated. As a result, investors appear to be pricing in the potential implications of central banks moving from being behind the curve to ahead of the curve. Moreover, surging natural gas prices in Europe, empty gas stations in the UK, labor shortages around the world, and steep automobile production cuts by major players like Toyota and GM raise the specter of stagflation. In this context, bond yields are rising and stocks are agitated. The dollar’s rally further tightens global financial conditions and adds to the systemic stress, which intensifies the very unsettling environment for investors. Consequently, seasonal October weakness remains on the table. Chart 2Tactical Vulnerabilities Remain We continue to see this selling phase as temporary. Sentiment will be consistent with a trough in risk assets soon (Chart 2). Additionally, Chinese authorities will reflate the economy much more aggressively than they have so far, even if it probably takes more market pain first. In this context, we focus on what to buy to take advantage of the eventual rebound in cyclical plays. This week, we look at European small-cap stocks that have handsomely outperformed their larger counterparts over the past ten years. In Europe, Small Is Beautiful Chart 3Small Caps Lead In Europe The underperformance of European stocks relative to the US over the past 13 years is well known by investors. Less known is that, since 2012, European small-cap stocks have performed roughly in line with their US counterparts. In other words, European small-cap stocks have massively outperformed Euro Area equity benchmarks (Chart 3). Two forces explain the ability of European small caps to beat their larger competitors by 85% since the Great Financial Crisis. The sectoral composition of European small-cap indexes helped them outperform their larger competitors. Using MSCI benchmarks, the small-cap index largest overweight are industrials and real estate, compared to financials, healthcare, and consumer staples for large caps (Table 1). Industrials have been one of the best performing sectors in the cyclicals and value categories, while financials have greatly suffered. Meanwhile, real estate equities enjoy falling yields, while financials hate them. This dichotomy explains why European small caps outperformed as European yields collapse (Chart 4). It is also why, unlike in the US, the relative performance of European small-cap equities exhibits little correlation with the slope of the yield curve. Table 1Small Caps Overweighs The Right Sectors Chart 4European Small Caps Like Lower Bund Yields The poor performance of the European large-cap stocks is the second element explaining the outperformance of European small caps. The European large-cap stocks lie at the heart of Europe’s underperformance relative to the US, not the smaller firms. According to researchers De Loecker, Eeckhout, and Unger, US firms have grown their markups massively since the 1980s (Chart 5).1 These expanding markups reflect a growing market power, which is the result of rising market concentration among the dominant players in nearly all the industries.2 In fact, Grullon, Larkin & Michaely show that industries with a greater level of concentration also display higher levels of RoA (Chart 6).3 The problem for European large firms is that they have not experienced the same increase in industry concentration as US businesses. Research by the OECD demonstrates that industry concentration rose significantly more in the US than in Europe over the past 20 years (Chart 7). This is particularly true in the service sector (Chart 7, middle panel) and the less digital-intensive industries (Chart 7, bottom panel).4 Chart 5Higher US Markups Chart 6As Concentration Increases, So Do RoAs Chart 7Europe Did Not Witness The Same Increase In Concentration Without this increase in market power, European large caps could not experience a meaningful pick up in their RoEs relative to those of small-cap stocks. They have therefore been fully victim to their sector composition and massively underperform smaller firms as well as US large businesses. Bottom Line: The structural outperformance of European small caps relative to large-cap stocks reflects the former’s large overweight in industrials and real estate stocks compared to the latter’s overrepresentation of financials, healthcare, and consumer staples names. Additionally, the inability of large-cap European names to increase industrial concentration has prevented them from mimicking the extraordinary growth in markups and RoE witnessed in the US. As a result, European small-cap names could massively beat their larger counterparts. Can The Outperformance Continue? The structural outperformance of small caps will become challenged if Europe experiences a structural increase in yields, which will hurt real estate stocks while helping financials. This sectoral effect will result in a structural outperformance of European stocks. On a cyclical horizon, however, the outlook continues to favor small-cap over large-cap equities in Europe and the Eurozone. Chart 8The Relative Performance Of European Small Caps is Procyclical As in the US, the relative performance of European small-cap stocks is pro-cyclical. As Chart 8 shows, small-cap stocks generate the largest excess returns at the beginning of business cycle upswings. They continue to outperform, as long as the business cycle points up. Only once a slowdown begins do small- cap names underperform. Similarly, the relative performance of small-cap equities correlates closely with the Euro Area Manufacturing PMI (Chart 9). It also displays a negative correlation with high-yield spreads (Chart 9, middle panel). Additionally, small-cap stocks track the evolution of inflation swaps (Chart 9, bottom panel). This behavior of small caps means that they remain an attractive bet over the next 18 to 24 months. The European economy is likely to continue to grow robustly over the coming two years and thus stay in the quadrant where small caps outperform. Moreover, the ECB’s policy will generate very accommodative monetary conditions for an extended period. Hence, European high-yield bonds will continue to outperform safe havens and the labor market will tighten further, which will help CPI swap climb up. Despite this procyclicality, the relative performance of small-cap stocks displays only a loose correlation with the European cyclical/defensive split (Chart 10). Moreover, small caps do not correlate closely with commodity prices (Chart 10 middle panel). These two observations reflect the limited relationship between the relative performance of small-cap equities and the Chinese credit impulse (Chart 10, bottom panel). The small caps’ lack of sensitivity to the Chinese economy is the consequence of their lower international bent compared to that of large-cap firms. Chart 9More Signs Of Procyclicality Chart 10Low Correlation To China Plays This low correlation with Chinese economic variables is likely to prove another asset for small-cap equities. As we have witnessed with the Evergrande saga or the rotating crackdowns from one industry to the next, China will remain a source of uncertainty for the global economy and global capital markets for the foreseeable future. Thus, a low-correlation relative performance is an attractive attribute. Chart 11Not Particularly Cheap European small-cap stocks are not without blemish. Unlike in the US, they trade at a premium to large-cap stocks on many valuation metrics. For example, their price-to-forward earnings, price-to-trailing earnings, price-to-cash flow ratios and dividend yields stands at 21 vs 16, 35 vs 35, 18 vs 10 and 1.2% vs 2%, respectively. True, small-cap indexes carry a large proportion of companies with negative earnings. Adjusting for this characteristic, the forward P/E ratio falls to 15.12, which is just under the similarly adjusted forward P/E ratio of the Eurozone benchmark. Our Composite Small Cap Relative Valuation Indicator, which amalgamates this information, is directly in the neutral zone (Chart 11). The neutral relative valuation of small-cap stocks is a handicap because they sport operating metrics that are worse than their larger cousins. Their RoE are a meagre 6.3% vs 7.7%. Moreover, forward earnings have rebounded sharply already and long-term growth expectations are lofty (Chart 12). This leaves the euro as the ultimate arbiter of the path of European small caps. As Chart 13 illustrates, the trade-weighted euro closely tracks the relative performance of the Euro Area small-cap benchmark. This reflects the more domestic nature of small caps, but also, their procyclicality, which mimics that of the euro. Chart 12Some Good News In The Price Chart 13A Play On The Euro Chart 14A Weaker Yuan Could Lift The Dollar The euro continues to face near-term hurdles, which creates a problem for small-cap stocks. The dollar is catching a bid as the Fed moves closer to its tapering and eventual rate hike. Moreover, interest rate differentials between China and the US are narrowing, which will weigh on the yuan (Chart 14). A weaker CNY often causes EM currencies to depreciate and puts downward pressure on the euro. Furthermore, if the global equity correction perdures a few more weeks, the dollar will benefit from additional risk-off flows, which will also hurt the euro. Beyond these near-term risks, BCA’s foreign exchange strategists continue to hold a positive cyclical outlook on the dollar. The greenback’s defining characteristic is its counter-cyclicality. Thus, BCA’s expectation that the period of risks to global growth is temporary also means that the dollar’s rally has a finite life. As we argued last week, Chinese policymakers are unlikely to let the economic deterioration fester for too long, as it would risk uncontrolled deleveraging pressures. Moreover, global capex and inventory trends also point toward a growth re-acceleration in the first half of 2022.  In this environment, the euro—which still behaves as the anti-dollar—will be able to regain its footing. Therefore, we will not chase EUR/USD below the 1.15 - 1.12 zone.  Chart 15History Rhymes The near-term risks to the euro and small-cap stocks create a buying opportunity for investors with a 12- to 18-month investment horizon. A short period of small-cap underperformance will allow small-cap equities to digest completely the period of outperformance that took place between March 2020 and June 2021 (Chart 15). It will also follow the pattern of the past ten years, wherein periods of outperformance last 18 to 24 months and are followed by a short decline before resuming anew.  Bottom line: Small-cap stocks are an attractive vehicle to bet on pro-cyclical assets in Europe. They have benefited from a structural outperformance as a result of their attractive sectoral profile. Moreover, their relative performance strengthens when the global business cycle is in expansion, yet it is a rare cyclical asset with a limited correlation to Chinese credit trends. European small-cap stocks are tightly correlated with the trade-weighted euro. In the near term, this could cause a period of underperformance to develop; however, this is a buying opportunity for investors with a 12- to 18-month investment horizon. Mathieu Savary, Chief European Strategist Mathieu@bcaresearch.com   Footnotes 1J. De Loecker, J. Eeckhout, G. Unger, “The Rise Of Market Power And The Macroeconomic Implications,” Mimeo 2018. 2Please see The Bank Credit Analyst Section II "The Productivity Puzzle: Competition Is The Missing Ingredient," dated June 27, 2019, available at bcaresearch.com 3G. Grullon, Y. Larkin and R. Michaely, “Are Us Industries Becoming More Concentrated?,” April 2017. 4Bajgar, M., et al. (2019), “Industry Concentration in Europe and North America,” OECD Productivity Working Papers, No. 18, OECD Publishing, Paris, https://doi.org/10.1787/2ff98246-en. 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