Equities

Special Report

Highlights Italy looks like it will form a national unity coalition under Super Mario Draghi – though it is not yet a done deal. A snap election is still our base case, whether in 2021 or 2022, but the ECB will do “whatever it takes,” as will Draghi if he becomes Italy’s prime minister. Even if the right-wing populist parties win power in a snap election, their goal is to expand fiscal spending, not exit the Euro Area. And they would rule in a world where even Germany and Brussels concede the need for soft budgets. Go long BTPs versus German bunds, and Italian stocks versus Spanish stocks, on a tactical 3-6 month horizon. The structural outlook for Italy is still bearish until Italy can secure its recovery and launch structural reforms. Feature In 2016-17 we wrote two special reports on Italy under the heading of “Europe’s Divine Comedy.” In “Inferno” we focused on Italy’s structural flaws and in “Purgatorio” we explained why Italy would stay in the European Union. We have long awaited the chance to write the third installment, which must be called “Paradiso” in honor of Dante Alighieri. But the tragedy of the pandemic makes this title sadly inappropriate. The new government that is tentatively taking shape is not the solution to the country’s long-term problems either. Former European Central Bank President Mario Draghi is an excellent policymaker and would ensure that Italy does not add political chaos to its pandemic woes this year. A unity government under Draghi – which is not yet a done deal as we go to press – would be a tactical and even cyclical positive for Italian equity and bond prices but not a structural positive. The paradise of national revival will have to wait for a later date. In the meantime Italy’s performance will be dictated by its surroundings. The Black Death Italy suffered worse than the rest of Europe from COVID-19, judging both by deaths and the economic slump (Chart 1). It was the first western country to suffer a major outbreak. Outgoing Prime Minister Giuseppe Conte was the first western leader to impose a Chinese-style lockdown – which came as a shock for democratic populations unfamiliar with such draconian measures. Few will forget the terrifying moment in March when the military was deployed in Bergamo to help dispose of the bodies.1 Chart 1Italy's National Crisis Chart 2Italy’s Unemployment Problem – Especially In The South The crisis struck at an awkward time in Italian politics as well. Like the US and UK, Italy saw a surge of populism in the 2010s. Hostility toward the political elite arose largely in reaction to hyper-globalization, the adoption of the euro, and deep structural flaws that have engendered a sluggish and unequal economy: Poor demographics: Italy’s population peaked in 2017 and is expected to fall from 61 million to 31 million by the year 2100. Its fertility rate is 1.3, the lowest in the OECD except South Korea. It has the third smallest youth share of population (13%) and stands second only to Japan in elderly share of population (23%).2 North-South division: Southern Italy, the Mezzogiorno, is poorer, less educated, less efficient, and less well governed than northern Italy. Unemployment is 7 percentage points higher in the south than in Italy on average (Chart 2). In our “Inferno” report we concluded that regional divisions discourage exiting the Eurozone and EU, since southern Italy benefits from EU transfers and northern Italy would refuse to subsidize southern Italy without EU support (Chart 3).   Chart 3EU Budget Allocations Favor Italy Low productivity: Italy’s real output per hour has lagged that of its European peers as the country has struggled to adjust to globalization, digitization, aging, and emerging technologies (Chart 4). Chart 4Italy's Lagging Productivity High debt: Italy’s debt-to-GDP ratio is expected to rise from to 134.8% to 152.6% by the year 2025, putting it on a higher-debt trajectory than even the worst case projections prior to the pandemic (Chart 5). Normally Italy runs a current account surplus and primary budget surplus, although the pandemic has pushed the country down the road of budget deficits (Chart 6). The debt problem is manageable as long as inflation is low and the ECB purchases Italian government bonds – which it will do in the interest of financial stability. But it sucks away growth and investment over time, a problem that will revive whenever the EU Commission tries to return to semi-normal fiscal policy restraints. Chart 5Italy’s Debt Pile Chart 6Italy’s Budget Surplus Destroyed By COVID-19 Italy’s predicament can be illustrated simply by comparing the growth of GDP per capita over the past decade to that of Spain, which is a structurally comparable Mediterranean European economy and yet has generated a lot more wealth for its people after having slashed government spending and reformed the labor market and pension system in the wake of the debt crisis (Chart 7). Chart 7Spain Reformed, Italy Didn't Structural reforms undertaken by the technocratic Mario Monti government in the wake of the sovereign debt crisis proved insufficient. Subsequent reform efforts went up in a puff of smoke when Matteo Renzi’s pro-reform constitutional referendum failed in 2016. Italy’s government is congenitally gridlocked because the lower and upper houses of the legislature have equal powers, like in the US, but its parliamentary governments can be easily toppled by either house. The 2016 constitutional reforms would have given the central government historic new powers to force through painful yet necessary structural changes – but centrist voters of different stripes hesitated to grant these new powers since they looked likely to go to populist parties on the brink of victory in the looming 2017 elections. The populists – the right-wing League in the north and the left-wing Five Star Movement in the south – did indeed come to power in 2017 but Italian’s political establishment subsequently restrained them from pursuing either serious euroskepticism or massive fiscal spending. Pro-establishment President Sergio Mattarella rejected any cabinet members who would attack the monetary union. Subsequent battles with Brussels and Germany prevented Italy from passing a blowout stimulus that challenged EU fiscal orthodoxy and threatened to precipitate a solvency crisis in the banking system. In 2019 the ambitious League broke with the Five Star Movement, which collaborated with the center-left Democratic Party to form a new coalition. But the resulting compromise government, its populism diluted, only managed one structural reform – to reduce the size of parliament – plus a moderate increase in government spending. The populist parties ended up being right about the need for more proactive fiscal policy, as Germany conceded in late 2019 and as COVID-19 lockdowns made absolutely necessary in early 2020. French President Emmanuel Macron and German Chancellor Angela Merkel agreed to launch a €750 billion EU Recovery Fund that enabled jointly issued debt for EU members, solidifying a proactive fiscal turn in the bloc. Italy now has €209 billion coming its way. This is a boon for the recovery, though it is also the origin of the politicking that brought down the ruling coalition last month. With central banks monumentally dovish, European and American fiscal engines firing on all cylinders, and China’s 2020 stimulus still coursing through the world’s veins, the macro backdrop is positive for Italy. But with Italy’s economy still shackled by fundamental flaws, it will not be a lead actor or an endogenous growth story. Bottom Line: Italy missed the chance in the 2010s to undertake structural reforms that could lift productivity and potential growth. Now it is struggling to maintain political order in the wake of a devastating pandemic and recession. The vaccine and global recovery will lift Italian assets but the future remains extremely uncertain, given the eventual need to climb down from extreme stimulus and impose painful structural reforms. Paradiso? Or Paradiso Perduto? The latest political turmoil arose over the EU Recovery Fund and how Italy will spend the €209 billion allotted to it, as well as the €38.6 billion allotted to the country under the EU’s structural budget for 2021-28. Ostensibly Matteo Renzi pulled his Italia Viva party out of the ruling coalition because he feared that former Prime Minister Conte, together with his economy and industry ministers, would spend the funds on short-term vote-winning handouts rather than long-term structural fixes in health, education, and culture. But Renzi was not appeased when Conte offered to spend more on health and education as requested. Renzi’s party fares poorly in opinion polls and the recent electoral reforms were not favorable to it, so he can hardly have wanted a new election. He wanted Italy to tap €36 billion from the European Stability Mechanism in addition to taking EU recovery funds, since this would come with strings attached in the form of structural reform. He apparently wanted to precipitate a new pro-establishment coalition. President Mattarella’s appointment of Mario Draghi to lead a national unity coalition is the solution. But as we go to press it is not certain that Draghi will be able to command a majority in parliament. Chart 8Salvini's League Lost Steam But Populist Right Still Powerful Matteo Salvini and the League are the pivotal players now. Salvini and his party suffered loss of popular support in 2019 as a result of his ambitious attempt to break from the government, force new elections, and rule on its own. The party especially suffered from the pandemic, which hit its base of voters in Lombardy hard and sent voters in support of the central government as well as the political establishment (Chart 8). Salvini must now decide whether to try to rebuild his status by joining Draghi in the national interest, to show he can be a team player, albeit at risk of being seen as an institutional politician. If so, he would cede the right-wing anti-establishment space to his partner Giorgia Meloni, who leads the Brothers of Italy, which has eaten up all the support Salvini has lost since the European parliament election of 2019. What is clear is that his current strategy is not working, and he played ball with the big boys during the 2017-19 period, so we would not rule him out of a Draghi government. If Draghi does not win over Salvini and the League, he would need to win the support of the Five Star Movement to form a coalition. The party’s leaders initially said they would not join Draghi, who epitomizes the establishment of which they are sworn enemies. Yet Five Star has not lost any popular support for working with the conventional Democratic Party, in stark contrast with the League, which stayed ideologically pure but lost supporters. Some Five Star members, including Foreign Minister Luigi Di Maio, former leader of the party, want to work with Draghi and stay in government. Hence the party could still join Draghi, or it could break apart with some members defecting. It would require 33% of Five Star members in the Chamber of Deputies and 28% of Five Star members in the Senate to join Draghi to give him a majority, assuming the League and Brothers of Italy refuse to cooperate (Table 1). Interestingly, if the League is absent from the vote, and all parties other than the Brothers and Five Star join Draghi, then he could also form a government. This would give cover to the League under the pretense of COVID vigilance, without being seen as actively preventing a government formation. Table 1'Whatever It Takes' To Build A National Unity Coalition Under Super Mario Draghi We have favored an early election and this could still occur. If there is an election it will happen before June because an election cannot happen within the last six months of the current president’s term, as per Article 88 of the Constitution. If Italy avoids a snap election till June, political stability is ensured at least till January. The pandemic was the justification for avoiding a snap election but the pandemic did not prevent the regional elections or constitutional referendum in September. The referendum was a hurdle that needed to be cleared before the next election, so now the way is open. All of the parties are greedily eying the presidency, with President Mattarella’s seven-year term set to expire next January. Mattarella has emerged as a staunch defender of the establishment and a check on anti-establishment parties. If the populists gain a plurality prior to January, then they can try to get a more sympathetic or neutral policymaker in that position. By contrast, the pro-establishment parties are hoping that a Draghi coalition can last long enough to ensure that one of their own holds that post. Since the latter need either the League or Five Star to govern, they would have to compromise on the next president – which is a very big concession. In distributing EU recovery funds, there is little doubt that a unity government under Draghi would be a credible way of proceeding. Draghi has joined other central bankers, like the Fed’s Janet Yellen, in voicing strong support for fiscal policy to get the developed democracies out of their current low-growth morass. He would have the authority and expertise to direct spending to productivity-enhancing projects at home while working with Brussels to allow Italy the greatest possible flexibility. Italy’s portion of EU recovery funds is shown in Chart 9, with the black bar indicating the part consisting of loans. The sector breakdown of total EU recovery fund is shown in Table 2. Chart 9Italy’s Fiscal Stimulus To Receive EU Top-Up Table 2Composition Of EU Recovery Fund By Economic Sector Yet a Draghi government is not a permanent solution to Italy’s political crisis or its economic malaise. Currently the political parties are squabbling over how to distribute a windfall of special funds – Italy is benefiting from a more pragmatic EU policy as it emerges from a crisis. But in future the parties will be fighting over what to do when the funds are spent. Even if the EU continues to be generous the stimulus will decelerate, while structural reforms will have to be attempted yet again. A technocratic Draghi government would be well positioned to institute the reforms that Italy needs but the economic medicine could sow the seeds for another voter backlash – in which case the anti-establishment right would be in prime position. This would set up a giant clash with Germany and Brussels. Italy, The EU, And Global Power Politics Geopolitically, Italy matters because it is a test of whether the European Union will continue consolidating power within its sphere of influence. If Draghi can form a unity government, oversee economic recovery and long-delayed structural reforms, and survive to reap the benefits at the voting booth, it would mark a historic victory for the EU as it lurches from crisis to crisis in pursuit of deeper integration and ever closer union. The Italian question would effectively be resolved and the EU would have the capacity to handle other challenges elsewhere. Europe’s geopolitical coherence is critical for global geopolitics as well. Europe is the prime beneficiary of US-China competition – at least until such time as it is forced to choose sides. Since Europe is a great power, it can remain neutral for a long time, using America as a stick against Chinese technology theft while expanding market share in China as it diversifies away from the United States (Chart 10). Chancellor Merkel has already signaled to Biden that she is not eager to join any “bloc” against China. Biden will have to devote a massive diplomatic effort to convince the Europeans, who are not as concerned about China’s military and strategic threat, that it is necessary to form a grand alliance toward containing China’s rise. Chart 10EU Balances Between US And China The EU’s efforts to carve out a sphere of influence have momentum. The German and EU approach to fiscal policy has become more dovish and proactive, a concession to the southern European economies that will improve their support for the European project. Across the Atlantic the EU states see President Trump’s rise and fall as a story of America’s declining influence, which improves the EU’s authority over its own populace, and yet has not resulted in an American-imposed trade war that would undermine the recovery. To the east, EU states see Russian authoritarianism and its discontents, which reinforce the public’s commitment to democratic values and the single market. To the north, they see the negative example of Brexit, which continues to plague the UK, with Scotland pushing for independence again. To the south, Europeans have become less concerned about illegal immigration, having watched the inflow of migrants from Turkey, the Middle East, and North Africa fall sharply – at least until the next major regime failure in these regions causes a new wave of refugees (Chart 11). These events have encouraged various countries to fall in line behind the consensus of European solidarity and geopolitical independence. A technocratic government in Italy would reinforce these trends but a populist government would not be able to avoid or override them. Chart 11Europe Less Concerned About Refugees (For Now) Chart 12Italian Euroskeptics Constrained By Public Opinion The Italian populist parties are still in the ascent but they do not seek to exit the EU or monetary union (Chart 12). We fully expect Italy to see snap elections in 2022 if not 2023, given the fragility of any new coalition to emerge today. If the right-wing League and Brothers should win control of government, and clash with Germany and Brussels, they would still operate within an environment circumscribed by these geopolitical limitations. Otherwise greater solidarity gives the EU greater room for maneuver among the US, China, and Russia. Investment Takeaways In the short run, the Draghi government is bullish for Italian assets. If Draghi fails and snap elections are called, the downside to European equities and the euro is limited, since any risk of an Italian exit from the EU dissipated back in 2016-18. Past turmoil resulted in higher Italian bond yields and wider spreads between BTPs and German bunds because markets had to price in the risk that the Euro Area would break up. We have long highlighted that this risk was overstated and markets are well aware of that by now. The market’s muted reaction to this latest kerfuffle proves the point (Chart 13). Chart 13Markets Unimpressed By Italian Political Turmoil On overweight stance toward Italian government bonds has been one of the highest conviction calls of our fixed income strategist, Rob Robis, over the past year. He expects that Italian bond yields (and spreads over German debt) will converge to Spanish levels, thus restoring a relationship last seen sustainably in 2016. He also notes that the ECB is willing to use quantitative easing to support Italy when its politics inject a risk premium into government bonds and spreads widen. The central bank is also providing additional support to Italy via cheap bank funding (TLTROs) that helps limit Italian risk premia at a time when underlying credit growth is exceedingly weak. During the height of the COVID lockdowns last year, the ECB increased its buying of Italian bonds higher than levels implied by its Capital Key weighting scheme, which officially governs bond purchases. Once Italian yields fell back to pre-pandemic levels, the ECB slowed the pace of purchases to levels at or below the Capital Key weights. As long as the pandemic lingers, the ECB will have the ability and pretext to ensure that Italian spreads do not rise too high (Chart 14). Chart 14Overweight Italian Government Bonds True, investors may be more reluctant to drive Italian yields and spreads to new lows as long as there is a risk of elections this year or next that could bring anti-establishment leaders to power and trigger an increase in Italian political risk premia. But this trap between politics and QE still justifies an overweight stance within global bond portfolios, as Italian yields will remain too attractive for investors to ignore given the puny levels of alternative sovereign bond yields available elsewhere in the Euro Area. Go tactically long Italian BTPs relative to German bunds. Italian stocks have seen a long and dreary downtrend versus global stocks, whether relative to developed or emerging markets, including or excluding the US and China. However, they are trading at a heavy discount in terms of price-to-book and price-to-sales metrics and a Draghi government to direct stimulus funding is doubly good news. Italian stocks have rebounded against Spanish equities since 2017 – as have Italian banks versus Spanish banks. Italian non-performing loans declined from a peak of €178 billion in 2015 to €63 billion in 2020. The banks raised enough equity capital to cover these NPLs. Since banks form a significant part of the Italian bourse, an improvement in bank balance sheets would be positive for the overall market. A Draghi government would reinvigorate this tendency, especially if it credibly commits to structural reforms that elevate potential growth. Spain’s structural reforms are priced in and it is next in line for a post-COVID political shakeup (Chart 15). Go tactically long Italian stocks relative to Spanish. While a Draghi coalition is marginally positive for the euro there are several factors motivating the dollar’s counter-trend bounce in the near term (Chart 16). US and Eurozone growth are diverging, with the EU struggling to roll out its COVID vaccine while the US prepares to pile a new $1.5-$1.9 trillion fiscal stimulus on top of the unspent $900 billion stimulus passed at the end of last year. Chart 15Italian Stocks Have Upside Versus Spanish Chart 16Wait For Geopolitical Risk To Clear Before Shorting USD-EUR Over the long run, a Draghi government provides limited upside with regard to Italian assets. The new coalition serves to avoid an election, not enable structural reform. An unstable ruling coalition will lose support over time in what will be a difficult post-pandemic environment. An early election and anti-establishment victory are not unlikely, if not in 2021 then in 2022 when Italy faces a falling stimulus impulse and the need for painful reforms. For now the truly bullish development is Germany’s dovish shift on fiscal policy rather than any temporary sign of Italian political functionality. Dysfunction can return to Italy fairly quickly but an accommodative Germany is hard to be gotten. Hence Italy’s biggest political risks will come if populist parties win full control of government in the next election while Germany and Brussels seek to normalize fiscal policy and impose some semblance of restraint in the wake of the crisis. It is also possible that a new economic shock or wave of immigration could bring Italy’s populists not only to take power but to rediscover their original euroskepticism. Thus any preference for Italian assets should be seen as a cyclical play on global growth and European solidarity and reflation – not a structural play on Italy’s endogenous strengths. Last week we shifted to the sidelines of the stock rally due to our concern that political and geopolitical risks have fallen too much off the radar. The Biden administration faces tests over China/Taiwan and Iran/Israel. Biden’s tax hikes will come into view soon. Chinese policy tightening is also a concern, even for those of us who do not expect overtightening. These factors pose downside risk to bubbly global stock markets in the near term.   Matt Gertken Vice President Geopolitical Strategy mattg@bcaresearch.com   Footnotes 1 Angela Giuffrida and Lorenzo Tondo, "‘A generation has died’: Italian province struggles to bury its coronavirus dead," The Guardian, March 19, 2020, theguardian.com. 2 See Stein Emil Vollset et al, "Fertility, mortality, migration, and population scenarios for 195 countries and territories from 2017 to 2100: a forecasting analysis for the Global Burden of Disease Study," The Lancet, July 14, 2020, thelancet.com.

Highlights There is too much euphoria and complacency in global markets. The main distinction between the current and previous episodes of speculative equity market excesses is that classic end-of-business cycle conditions – such as economic overheating and policy tightening – are now absent. Yet, it does not mean that the bull market will continue uninterrupted. This rally might be short circuited by gravitational forces as happened with the S&P 500 in 1987 and Chinese onshore stocks in 2015. Investors should consider going long EM equity or EM currency volatility to hedge their exposure. Feature There is growing evidence that the global equity rally has turned into a frenzy. Signs of investor euphoria include: The number of traded call options in the US equity market has surged to an all-time high (Chart 1). The number of put options has spiked only in the past couple of weeks and remains well below the number of call options. Chart 1A Call Buying Frenzy Is A Symptom Of Investor Exuberance Critically, there is currently too much complacency: the US put-call ratio is as low as it was in 2000 (Chart 2). The volume of stocks traded on and off all US stock exchanges has exploded since late October, reaching an all-time high (Chart 3). Chart 2A Sign Of Equity Market Complacency Chart 3US Equity Trading Volumes Are At All-Time Highs Chart 4Retail Investors Haven Been A Powerful Force In Korea And Taiwan Equity fervor is prevalent not only among American individual investors but also in many parts of the world. For instance, the breathtaking rallies in the KOSPI and Taiwanese stocks has been primarily driven by local retail investors, as shown in Chart 4. The surge in Taiwanese share prices is stunning because it completely ignores the escalating geopolitical tensions over Taiwan. BCA Research’s Chief Geopolitical Strategist, Matt Gertken, recently argued that while China is unlikely to invade Taiwan immediately, a military stand-off cannot be ruled out. China and the US have yet to arrive at a mutual understanding regarding China’s access to computer chips made in Taiwan. Overall, since the lockdowns in March last year, individual investors have rushed into equities in many countries such as the US, Korea, Taiwan, Japan, India and Brazil, to name a few. Finally, US institutional investors are fully invested, as shown in Chart 5. Besides, Chart 6 reveals that US-domiciled EM equity mutual funds’ liquidity ratio (cash as a percentage of assets) is very low. Chart 5US Institutional Investors Are Long Stocks Chart 6US-Domiciled EM Mutual Funds' Cash Is Low   There have been doubts within the global investment community about the potential for small individual investors to move the needle in the overall market. We believe that their impact has been substantial: First, there is plenty of anecdotal evidence to suggest that individual traders have been involved in options trading since the pandemic erupted. By purchasing call options, retail investors exert substantial upward pressure on share prices: dealers – who sell/write call options – typically hedge their risks by acquiring and holding the underlying stock for the duration of respective options. In short, by putting even small amounts of money at work to purchase call options, individual traders meaningfully affect share prices. Second, price formation in financial markets is influenced by the marginal investor. Everything else being equal, the entry of a new buyer into the marketplace leads to higher prices. Further, retail investors’ impact on financial markets has not been limited solely to stocks they purchase. Rather, there has been a ripple effect on the broader market. For instance, there is evidence that individual investors flocked to the market in March and April and bought en masse shares of companies most negatively affected by the pandemic, such as cruise operations, hotels, airlines and energy producers. As individual investors provided substantial bids for these stocks, institutional investors were able to offload these stocks and buy others. For instance, in Q2 last year Warren Buffett offloaded his airline stocks and allocated that capital to natural gas storage and pipelines, banks, pharma and auto stocks. If retail investors had not provided support to stocks of companies hit hard by the lockdowns and social distancing, Warren Buffett and other professional investors would not have had the opportunity to exit their positions in these stocks at acceptable prices and acquire other securities. This is the mechanism whereby the impact of new market entrants extends beyond the specific equities they purchase. Chart 7A Mini Call Option Mania Among Retail Investors Finally, Charts 1 and 3 above clearly illustrate the surge in both the number of call options and trading volumes since last March. Among call options, transactions with a small number of options have ballooned (Chart 7). This reflects individual investors activity. Consistently, the number of brokerage accounts for retail investors has mushroomed in the US and elsewhere. Bottom Line: It is obvious that the ongoing equity market euphoria is considerable. Individual investors have been playing a vital role in fostering it. The GameStop stock saga, among others, reinforces this point. When And How Will It End? This bull market shares some similarities with previous market cycles, but it also has its distinct features. Similarities: Retail investors typically rush into financial markets toward the end of a bull market. The current US equity market rally began in 2009. After the S&P 500 showed its resilience by rebounding quickly and making new highs following the selloffs in 2015, 2018 and 2019, retail investors were reassured to jump on the bull market train when the 2020 crash occurred.  In short, it took about 11 years of a US equity bull run for individual investors to feel comfortable enough to play the stock market. This is a characteristic of a late cycle/mature bull market. Speculative instruments and schemes are designed and launched. The IPO boom in SPACs1 will probably go down in history as a key feature of the speculative excesses in this cycle. Valuations overshoot during stock market euphoria but investors find reasons to justify lofty equity multiples. FAANGM stocks and other parts of the US equity market are expensive, but investors are using extremely low US bond yields – artificially suppressed by the Federal Reserve – to justify the current multiples. In such a case, the bond market will likely hold equities hostage. As bond yields rise going forward, equity valuations will be threatened. In fact, we believe rising bond yields, not the outlook for economic growth, to be the primary risk to US share prices akin to the late 1960s (Chart 8). Differences: Typically, retail investors feel comfortable investing in the stock market when the economy is strong. In this cycle, they jumped on the stock market train when the economy crashed due to the pandemic. This is a departure from previous cycles. Massive stimulus and ongoing vaccination deployment suggest the economic outlook for the US and many emerging economies is positive. In particular, EM corporate profits are set to recover (Chart 9). Chart 8The US In The 1960s: Share Prices And Treasury Yields Chart 9EM EPS Is To Recover   Hence, it is hard to be bearish on stocks based on the cyclical outlook for growth, assuming vaccination campaigns will allow many major economies to fully reopen in H2 2021. Yet, a lot of this good news seem to be already priced in. Retail investors arrive to the stock market party usually in the late stage of a business cycle – when unemployment is low, inflation is rising, and policymakers are tightening policies. That combination proves lethal for the equity market and a major top in share prices ensues. Presently, due to the pandemic-induced lockdowns, we have the opposite occurring in the US and in many EM economies. Unemployment is high, inflation remains contained, and policymakers are committed to providing unlimited stimulus. In short, the main distinction between the current and previous episodes of speculative equity market excesses is that classic end-of-business cycle conditions – such as economic overheating and policy tightening – are now absent. History doesn't repeat itself, but it does rhyme. Does it mean that the bull market will continue uninterrupted? Not necessarily. This rally might be short circuited for reasons that may differ from those that terminated previous stock market frenzies. First, speculative bubbles could burst without policy tightening. An example of this is China’s equity bubble in 2015, which crashed without policy tightening due to gravitational forces reasserting themselves. Another example is the 1987 US stock market crash that occurred without an economic or fundamental financial cause. Chart 10 illustrates the cyclical trajectories of US GDP and the Fed funds rate did not change materially before and after the equity market crash. In short, the 1987 equity crash was a case when excessive speculation/overbought conditions rather than policy tightening or a recession caused an abrupt equity sell-off. Second, in the EM equity universe, leadership has been extremely narrow. Only a handful of companies have outperformed the aggregate benchmark, propelling the index to 2007 highs. These include a few Chinese new economy stocks, and Korean and Taiwanese technology stocks (Chart 11). Outside North Asian markets (China, Korea and Taiwan), every single EM bourse has underperformed both the EM and global equity benchmarks in the past year. Chart 10The 1987 S&P 500 Crash Was Not Caused By The Fed Or The Economy Chart 11Euphoria In Asian TMT Stocks Chart 12Global ex-TMT Stocks Have Not Broken Out Yet If these global and EM TMT stocks relapse, they will inflict major damage on the EM and global indexes. The EM index has become extremely concentrated with the top five stocks accounting for 24% of the MSCI EM equity index’s market cap. Interestingly, global ex-TMT stocks have not yet broken out to new highs (Chart 12). Finally, US overall equity and global TMT valuations are vulnerable to rising US bond yields. The latter could rise without the Fed hinting at policy tightening if fixed-income investors decide that the Fed is behind the inflation curve. This could trigger a major selloff even if policymakers do not tighten policy. Investment Conclusions Chart 13Go Long EM Equity And Currency Volatility We are in a euphoria phase where fundamentals are less pertinent. The market can either rally a lot or sell off hard regardless of the profit outlook. Navigating through such markets is challenging. Going long EM equity or EM currency volatility offers a good risk-reward profile (Chart 13). Volatility will likely rise in the coming months in both scenarios: either risk assets continue rallying or they sell off. For global equity and credit portfolios, we continue recommending a neutral allocation to EM. The long-term US dollar outlook is negative, but it is oversold and odds of a near-term rebound are still high. Our currency strategy remains to short a basket of EM currencies versus an equal-weighted average of the euro, CHF and JPY. This basket of EM currencies includes the BRL, CLP, ZAR, KRW and TRY. We continue receiving 10-year swap rates in Mexico, Colombia, Russia, China, India, Indonesia and Korea. Arthur Budaghyan Chief Emerging Markets Strategist arthurb@bcaresearch.com   Footnotes 1 Special Purpose Acquisition Companies (SPAC), also known as “blank check companies”, are organizations with no commercial operations that raise capital through an IPO, which is then deployed to purchase an existing company. This process is done to bypass the lengthy process of launching a traditional IPO for a young company.   Equities Recommendations Currencies, Credit And Fixed-Income Recommendations

The S&P 500 is clawing back its losses after it hiccupped last week correcting approximately 5% from peak-to-trough as the dust from the GME/WSB saga is settling down. As we showed in this Monday’s Strategy Report, there is a natural monetary tightening occurring via the financial markets that is likely to test the Fed’s resolve. Namely, whenever all three assets, the US dollar, the 10-year US Treasury, and crude oil rise together, the SPX suffers a pullback (see chart). Year-to-date, two out of these three variables are firing warning shots, and given rising odds of a US dollar reversal, the tightening trio is signaling at least some equity market indigestion. Bottom Line: The simultaneous rise in the US dollar, the 10-year US Treasury yield, and crude oil all signal that equity investors should stay vigilant.

In lieu of the next strategy report, I will be presenting the quarterly webcast titled ‘Five Contrarian Predictions For 2021-22’ on Thursday February 11 at 10.00AM EST (3.00PM GMT, 4.00PM CET, 11.00PM HKT). I hope you can join. Highlights Many of the ‘short squeezed’ investments that day traders have bid up are at, or approaching, collapsed short-term fractal structures. As such, patient long-term investors should take the other side. The biggest risk to the stock market remains the vulnerability of valuations to even a modest rise in bond yields. The happy corollary is that the structural bull market in equities will only end when the 10-year T-bond yield reaches zero. Until then, stay structurally overweight equities. Structurally overweight value-heavy European equities versus value-heavy emerging markets (EM) equities. Do not structurally overweight value-heavy European equities versus growth-heavy US equities. This is a ‘widow maker’ trade. Fractal trade: short AUD/JPY. Feature Chart of the WeekShort-Squeezed Investments Now Have Collapsed Fractal Structures (Gamestop) There is no divine law that decrees the ‘correct’ time-horizon for any investment. Depending on your objectives and skills, a correct investment horizon could be anything spanning a few milliseconds to a hundred years. Once you absorb this fundamental point, it leads to a profound conclusion:  The ‘correct’ price for any investment depends on your investment horizon. The Most Important Investment Question Is, Who Is Setting The Price? A long-term investor and a day trader will go through completely different thought processes to determine a stock’s ‘correct’ price. The long-term investor, intending to buy and hold the stock for ten years, will receive 40 quarterly dividend payments plus the stock price as it stands in 2031. Hence, the correct price is the discounted value of those expected cashflows. But for the day trader, intending to buy today to sell tomorrow, only one cashflow matters – tomorrow’s price. Hence, the correct price is simply the expected price at which he can sell tomorrow. The longer-term cashflows are irrelevant, unless they set the selling price tomorrow. Yet this is unlikely, because as Benjamin Graham put it:   In the long run the market is a weighing machine, but in the short run it is a voting machine. Therefore, a long-term investor and a day trader are completely different animals, whose price-setting behaviour must be seen through different lenses. This matters because the price is always set by the last marginal transaction. The important question then is, who is setting the price? All of which brings us to the battle raging between a cabal of day traders and a group of hedge funds. The day trader is buying today because he expects that the hedge fund, desperate to cover its short positions, must buy at an even higher price tomorrow. The day trader’s behaviour is rational, so long as it is within the law, and so long as the hedge fund short-covering is the marginal price taker. Eventually though, the desperate hedge fund will not take the price, because there are no more short positions left to cover. At this point, if the day trader wants to exit his position, the marginal buyer will be a longer-term investor who will only buy at a much lower fundamentally-determined price. The day trader will have won the battle, but lost the war. The crucial takeaway is that we should always monitor which time-horizon of investors is setting the marginal price of an investment. We can do this by continually measuring the fractal structure of the investment’s price. We should always monitor which time-horizon of investors is setting the marginal price of an investment. When the fractal structure of an investment has collapsed, it means that the time-horizon of investors setting the price has compressed to a near-term limit. Thereby it signals that the price-setting baton will return to long-term investors who will reset the price to valuation anchors, such as discounted long-term cashflows. The implication is that the preceding trend, fuelled by short-term price setters, is likely to reverse. Today, we observe that many of the investments that day traders have recently bid up are at, or approaching, collapsed short-term fractal structures. As such, patient long-term investors should take the other side (Chart of the Week, Chart I-2 and Chart I-3). Chart I-2Short-Squeezed Investments Now Have Collapsed Fractal Structures (AMC Entertainment) Chart I-3Short-Squeezed Investments Now Have Collapsed Fractal Structures (Blackberry) The Major Misunderstanding About Real Bond Yields A common question we get is, should we compare the prospective returns on equities and bonds in nominal terms or in real terms? In an apples-for-apples comparison it shouldn’t really matter. The problem is that while we know the prospective nominal return from bonds (it is just the bond yield), it is extremely difficult to know the prospective real return from bonds. As the markets are lousy at predicting inflation, the ex-ante real bond yield is a lousy predictor of the ex-post real bond yield. A trustworthy ex-ante real bond yield requires a trustworthy prediction of inflation. But both the inflation forwards market and the breakeven inflation rate implied in inflation protected bonds are lousy at predicting inflation.1 As the markets are lousy at predicting inflation, the ex-ante real bond yield is a lousy predictor of the ex-post real bond yield (Chart I-4 and Chart I-5). Chart I-4The Markets Are Lousy At Predicting Inflation In Europe... Chart I-5...And In The ##br##US A second point is that the required excess return on equities versus bonds is a nominal concept. This is because the bond yield’s lower limit is set in nominal terms, at say -1 percent. Proximity to this nominal yield limit makes bonds very risky because there is no longer any upside to price, only downside. As the riskiness of equities and bonds converges, the required nominal return on equities collapses towards the ultra-low nominal bond yield. There are two important takeaways. First, we should always compare the valuation of equities and their prospective nominal return with the nominal bond yield. Second, the valuation of equities is exponentially sensitive to an ultra-low nominal bond yield (Chart I-6). Chart I-6The Relationship Between The Bond Yield And Stock Market Valuation Is Exponential We conclude that the biggest risk to the stock market remains the vulnerability of valuations to even a modest rise in bond yields. Yet the happy corollary is that the structural bull market in equities will only end when bond yields can go no lower. In practice, this means when the 10-year T-bond yield reaches zero. Until then, long-term investors should stay in the stock market. The Major Misunderstanding About Valuation Another common question we get is, is it always meaningful to compare an investment’s valuation versus its own history? The answer is no. The comparison with a historical average is meaningful only if the valuation is mathematically stationary, which is to say it has not undergone a ‘phase-shift’. If the valuation has undergone a phase-shift, then the comparison with its own history is meaningless.  As an analogy, nobody would compare their bodyweight with its lifetime average, because we understand that our bodyweight undergoes a phase-shift from childhood to adulthood. If we did compare our bodyweight with its lifetime average, it would give the false signal that we were permanently overweight! Likewise, to avoid getting a false signal from a valuation, we should always ask, has it undergone a phase-shift? If a valuation has undergone a phase-shift, then a comparison with its own history is meaningless. Unfortunately, the structural prospects for financials, oil and gas, and basic resources – sectors that dominate ‘value’ indexes and stock markets – did suffer a major downward phase-shift at the start of the 2000s (Chart I-7). It follows that we cannot compare the valuations of ‘value heavy’ indexes with their long-term history, and draw any meaningful conclusions. Chart I-7Value' Sector Profits Are In A Major Structural Downturn Proving this point, the relationship between value-heavy European valuations and subsequent 10-year return is much worse for periods ending after the global financial crisis compared with periods ending before it. Whereas the relationship between growth-heavy US valuations and subsequent return has barely changed, because the structural prospects for growth sectors have not suffered downward phase-shifts (Chart I-8 and Chart I-9). Chart I-8The Relationship Between Valuation And Future Return Has Changed In Europe... Chart I-9...But Not So Much ##br##In The US Given the ongoing trends in value versus growth profits, it is much safer to overweight value-heavy European equities versus value-heavy emerging markets (EM) equities. Do not structurally overweight value-heavy European equities versus growth-heavy US equities. This is a ‘widow maker’ trade. Fractal Trading System* The rally in AUD/JPY is at a potential a near-term top based on its collapsed 65-day fractal structure. Accordingly, this week’s recommended trade is short AUD/JPY, setting the profit target and symmetrical stop-loss at 2.8 percent. Chart I-10AUD/JPY In other trades, short European basic resources versus the market achieved its 4 percent profit target and is now closed. The rolling 12-month win ratio now stands at 57 percent. 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 Footnotes 1 Europe and the US have deep and liquid markets in 5-year 5-year inflation swaps (or forwards), which price the expected 5-year inflation rate 5 years ahead. The current swap measures the annual inflation rate expected through 2026-31. The UK and the US also have deep and liquid markets in inflation-protected government bonds: UK index-linked gilts, and US Treasury Inflation Protected Securities (TIPS). The yield offered on such a security is real, which means in excess of inflation. The yield offered on a similar-maturity conventional bond is nominal. This means that the difference between the two yields equates to the market’s expectation for inflation over the maturity, known as the ‘breakeven inflation rate.’ 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