Technology

Highlights The global fight against the Delta variant of COVID-19 continued to show progress in the month of September, but not without cost. Growth in services activity slowed meaningfully, which has likely delayed the return to potential output in the US until March of next year (at the earliest). However, even with this revised timeline, maximum employment remains a very possible outcome by next summer, barring a further extension of the pandemic in advanced economies. In this regard, the Fed’s likely decision at its next meeting to taper the rate of its asset purchases makes sense and is consistent with a first rate hike in the second half of 2022. The rise in long-maturity bond yields following this month’s Fed meeting is consistent with the view that 10-year Treasurys are overvalued and that yields will trend higher over the coming year. Fixed-income investors should stay short duration. The degree to which global shipping costs are being driven by the forces of supply versus demand will affect the Fed's criteria for liftoff next year, via changes in goods prices as well as consumer expectations for inflation. In our view, a detailed examination of shipping prices over the past 18 months points to a future pace of inflation that is not dangerously above-target, but does meet the Fed’s liftoff criteria. A mix-shift in consumer spending, away from goods and toward services, is not a threat to economic activity or S&P 500 earnings – so long as the decline in the former is not outsized relative to the rise in the latter. It will, however, disproportionately impact China, and could be the trigger for meaningful further easing by Chinese policymakers. In the interim, a catalyst for EM stocks may remain elusive. We continue to recommend an overweight stance toward value versus growth stocks and global ex-US versus the US, particularly in favor of developed markets ex-US. Investors should remain cyclically overweight stocks versus bonds, although it is possible that both assets will post negative returns for a short period at some point over the coming 12 months in response to higher long-maturity bond yields. Still, we expect both stock prices and the stock-to-bond ratio to be higher a year from today. Feature The global fight against the Delta variant of COVID-19 continued to show progress in the month of September. Chart I-1 highlights that an estimate of the reproduction rate of the disease in developed economies has fallen below one, and the weekly change in hospitalizations in both the US and UK – the two countries at the epicenter of the Delta wave that have not reintroduced widespread COVID-19 control measures – have fallen back into negative territory. In addition, we estimate that approximately 6% of the world’s population received vaccines against COVID-19 in September, with now 45% of the globe having received a first dose and 33% now fully vaccinated. Pfizer’s announcement last week that it has found a “favorable safety profile and robust neutralizing antibody responses” from its vaccine trial in children five to eleven years of age suggests that the FDA may grant emergency use authorization within weeks, which would likely raise the vaccination rate in the US (and ultimately other advanced economies) by at least 5 percentage points in fairly short order. This would also further reduce the impact of school/classroom closures on the labor market, via both an increased participation rate and increased hiring in the education sector. This fight, however, has not been without cost. US jobs growth slowed significantly in August, manufacturing and services PMIs continued to slow in September, and, as Chart I-2 highlights, the normalization in transportation use that was well underway in the first half of the year has clearly inflected in both the US and UK in response to the spread of Delta. Consensus market expectations for Q3 growth have been cut in the US, and to a lesser extent in the euro area, and the Fed reduced its forecast for 2021 real GDP growth from 7% to 5.9% following the September FOMC meeting. Chart I-1The Delta Wave Continues To Abate... Chart I-2...But At A Cost To Economic Activity   The Path Toward Eventually Tighter Monetary Policy It has been surprising to some investors that the Fed has moved forward with their plans to taper the rate of its asset purchases against this backdrop of slowing near-term growth – an event that now seems likely to occur at its next meeting barring a disastrous September payroll report. In our view, this is not especially surprising, given that the Fed has expressed a desire for net purchases to reach zero before they raise interest rates for the first time. Chair Powell noted during last week’s press conference that FOMC participants felt a “gradual tapering process that concludes around the middle of next year is likely to be appropriate”, underscoring that the Fed wants the flexibility to raise interest rates in the second half of next year. The timing of the first Fed rate hike is entirely subject to the evolution of the economic data over the next year, and is not, in any way, calendar-based. But we presented in last month's Special Report why the Fed’s maximum employment criteria may be met as early as next summer,1 and the Fed’s projections for the pace of tapering are consistent with our analysis. Chart I-3Maximum Employment Remains A Very Possible Outcome By Next Summer The Fed’s most recent Summary of Economic Projections (“SEP”) also seemingly confirmed Fed Vice Chair Richard Clarida’s view that a 3.8% unemployment rate is consistent with maximum employment, barring any issues with the “breadth and inclusivity” of the labor market recovery. We noted in last month’s report that these issues are unlikely in a scenario where jobs growth is sufficiently high to bring down the unemployment rate below 4%. Chart I-3 highlights that both the Fed’s forecast and Bloomberg consensus expectations imply a closed output gap by March, even after factoring in the near-term impact of the Delta variant. Consequently, maximum employment remains a very possible outcome by next summer, barring a further extension of the pandemic in advanced economies. Long-maturity bond yields rose following the Fed meeting, which is also not especially surprising given how low yields have fallen relative to the fair value implied by the Fed’s SEP forecasts even assuming a December 2022 initial rate hike. Chart I-4 highlights that the fair value of the 10-year Treasury yield today is roughly 2% using this approach, rising to 2.15% by next summer. Ironically, the September SEP update modestly lowered the fair value shown in Chart I-4 relative to what would otherwise have been the case, as it implied that the Fed is expecting to raise interest rates at a pace of approximately three hikes per year – rather than the four that prevailed prior to the pandemic. Investors should also note that the fair value for the 10-year yield is nontrivially lower based on market participant and primary dealer estimates of the terminal Fed funds rate (also shown in Chart I-4), although they still imply that long-maturity yields should trend higher over the coming year. Global Trade, Inflation, And The Fed A return to maximum employment will likely signal the onset of monetary policy tightening, as long as the Fed's inflation criteria for liftoff have been met. For now, inflation is signaling a green light for hikes next year, even after excluding the prices of COVID-impacted services and cars (Chart I-5). In fact, more recently, CPI ex-direct COVID effects has been pointing in the “non-transitory” direction, which continues to prompt questions from investors about whether the Fed will be forced to hike earlier than it currently expects for reasons other than a return to maximum employment. Chart I-4US Long-Maturity Bond Yields Are Set To Move Higher Over The Coming Year Chart I-5For Now, Inflation Is Signaling A Green Light For Hikes Next Year   At least some portion of the current pace of increase in consumer goods prices is tied to surging import costs, which have run well in-excess of what would be predicted by the relationship with the US dollar (Chart I-6). This, in turn, is being driven by an explosion in shipping costs that has occurred since the onset of the pandemic, which is being driven both by demand and supply-side factors (Chart I-7). Chart I-6US CPI Is Being Affected By Surging Import Prices... Chart I-7...Which Are Being Driven By An Explosion In Shipping Costs   The degree to which global shipping costs are being driven by the forces of supply versus demand will affect the Fed's criteria for liftoff next year, via changes in goods prices as well as consumer expectations for inflation. To the extent that demand side factors are mostly responsible, investors should have higher confidence that the recent surge in consumer prices is transitory, because a shift away from above-trend goods spending and toward below-trend services spending is likely over the coming year. If supply-side factors are mostly responsible, then it is conceivable that the global supply chain impact on consumer goods prices will persist for longer than would otherwise be the case, potentially raising the odds of a larger or more sustained rise in inflation expectations. In our view, a detailed examination of shipping prices over the past 18 months points to a mix of both demand and supply effects, even since the beginning of 2021. However, as we highlight below, several facts point toward the view that supply-side factors will be the dominant driver over the coming year, and that they are more likely to exert a disinflationary/deflationary rather than inflationary effect: Chart I-8 breaks down the cumulative change in the overall Freightos Baltic Index by route since December 2019. The chart makes it clear that shipping costs from China/East Asia to the West Coast of the US have risen far more than any other route, underscoring that US demand for goods has been an important part of the rise in shipping costs. Chart I-8US Demand For Goods Is An Important Part Of The Shipping Cost Story Chart I-9US Goods Spending Has Clearly Been Boosted By US Fiscal Policy Chart I-9 shows the level of real US personal consumption expenditures on goods relative to its pre-pandemic trendline, underscoring both that goods spending is currently well-above trend, and that there have been two distinct phases of rising goods spending: from May to October 2020 following the passage of the CARES act, and from January to March 2021 following the December 2020 extension of UI benefits and in anticipation of the passage of the American Rescue Plan. Since March, US real goods spending has trended lower, a pattern that we expect will continue over the coming year. Chart I-10 highlights that while the global supply chain struggled heavily last year in response to surging demand and the lagging effects of labor shortages and factory shutdowns during the earliest phase of the pandemic, there were some signs of supply-side normalization in the first half of 2021. The chart highlights that the number of ships at anchor at the Los Angeles and Long Beach ports declined meaningfully from February to June, and global shipping schedule reliability tentatively improved in March. The chart also shows that shipping costs from China/East Asia to the West Coast of the US continued to rise in Q2 seemingly as a lagged response to the Jan-Mar rise in goods spending, but they were still low at the end of June compared to today’s levels. Chart I-10Supply-Side Factors Seem To Have Driven A Majority Of This Year's Increase In Shipping Costs In Q3, circumstances drastically changed. Shipping costs between China/East Asia to the West Coast of the US rapidly doubled, and the number of ships at anchor at the LA/LB ports exploded well past its peak in early February. This rise in China/US shipping costs since late-June has accounted for nearly 60% of the cumulative rise since the pandemic began, and cannot be attributed to increased demand. Instead, the increase in prices and the surge in port congestion in Q3 appears to have been caused by the one-month closure of the Port of Yantian that began in late-May, in response to an outbreak of COVID-19 in Guangdong province. Yantian is the fourth largest port in the world and exports a sizeable majority of global electronics given its close proximity to Shenzhen, underscoring the impact that its closure likely had on an already bottlenecked logistical system. There are two key points emanating from our analysis of global shipping costs. First, demand has been an important effect driving costs higher, but it does not appear to have driven most of the increase in shipping costs this year. Still, over the coming year, goods demand in advanced economies is likely to wane as consumer spending shifts from goods to services spending, which will help ease clogged global trade channels and lower shipping costs. Second, the (brief) evidence of supply-side normalization in the first half of 2021, when consumer demand was actually strengthening, suggests that the supply-side of the global trade system will turn disinflationary over the coming year if further COVID-related labor market shocks can be avoided. What does this mean for the Fed and the prospect of monetary policy tightening next year? In our view, the combination of a positive output gap, stable but normalized inflation expectations, and disinflation (or outright deflation) in COVID-related goods and services (including import prices) is likely to lead to a pace of inflation that meets the Fed’s liftoff criteria. Chart I-11 highlights that important longer-term inflation expectations measures have recently been well-behaved, despite a surge in actual inflation and shorter-term expectations for inflation. Aided by disinflation/deflation in certain high-profile COVID-related goods and services prices, this argues against meaningful upside risks to inflation. However, the current level of long-term expectations and the fact that the output gap is set to turn positive in the first half of next year argues against the notion that inflation will fall below target outside of COVID-related effects. As such, we continue to expect that the Fed will raise interest rates next year, potentially as early as next summer, driven by the progress towards maximum employment. Spending Shifts And The Equity Market We noted above, and in previous reports, that consumer spending in advanced economies is likely to continue to shift away from goods and toward services over the coming year. This raises the question of whether a contraction in goods spending will weigh disproportionately on the economy and equity earnings, given the close historical correlation between manufacturing activity and the business cycle. Chart I-12 illustrates this risk: in a hypothetical scenario in which real goods spending were to return to the trendline shown in Chart I-9 by March of next year, it would contract on the order of 10% on a year-over-year basis, on par with what occurred last year and vastly in excess of what even normally occurs during a recession. Chart I-11Longer-Term Inflation Expectations Remain Well-Behaved Chart I-12A Contraction In Goods Spending Is Likely Over The Coming Year   Chart I-12 is a hypothetical scenario and not a forecast, as there is some evidence that consumers are currently deferring durable goods purchases on the expectation that prices will become more favorable. In addition, a positive output gap next year implies that goods spending may settle above its pre-pandemic trendline. Nevertheless, the prospect of a potentially significant slowdown in goods spending has unnerved some investors, even given the prospect of improved services spending. Chart I-13highlights that this fear is understandable given how the US economy normally behaves. The top panel of the chart shows the year-over-year contribution to real GDP growth from real goods and services spending, and the bottom panel shows these contributions in absolute terms to better illustrate their relative magnitudes. The chart makes it clear that goods spending is normally a more forceful driver of economic activity than is the case for services spending, which ostensibly supports concerns that a significant slowdown in the former may be destabilizing for overall activity. Chart I-13Normally, Goods Spending Predominantly Drives Activity. Not This Cycle. However, Chart I-13 also highlights that the magnitude of the recent contribution to growth from services spending has been absolutely unprecedented in the post-WWII economic environment. This is not surprising given the nature of the COVID-19 pandemic, but it is important because it underscores that investors should not rely excessively on typical rules of thumb about how modern economies tend to function over the course of the business cycle. In terms of the impact on overall economic activity, investors should focus on the net impact of goods plus services spending. It is certainly possible that the former will slow at a pace that is not fully compensated by the latter, but our sense is that this is not likely to occur barring a further extension of the pandemic in advanced economies. Chart I-14Over The Past 5 Years, S&P 500 Sales Have Been More Correlated With Services Than Goods Spending Chart I-14 presents a similar conclusion for the US equity market. The chart highlights the historical five-year correlation between the quarterly growth of nominal spending and S&P 500 sales per share. The chart shows that S&P 500 revenue was more sensitive to goods versus services spending prior to the 1990s, when the US was more manufacturing-oriented and goods were more likely to be produced domestically than is the case today. Another gap in the correlation emerged following the global financial crisis when the US household sector underwent several years of deleveraging. But over the past five years, Chart I-14 highlights that S&P 500 revenue growth has actually been more strongly correlated with US services spending than goods spending. Some of this increased correlation might reflect technology-related services spending which could suffer in a post-pandemic environment, but the bottom line from Chart I-14 is that there is not much empirical support for the view that US equity fundamentals will be disproportionately impacted by a slowdown in goods spending, so long as services spending rises in lockstep. China: Exacerbating An Underlying Trend Chart I-15China Will Be Disproportionately Affected By Slowing DM Goods Spending China, on the other hand, will be disproportionately affected by slower goods spending in advanced economies, because its exports have disproportionately benefited from the surge in spending on goods over the past year. Chart I-15 highlights that Chinese export volume growth has exploded this year, and that current export growth is running at a pace of 10% in volume terms – significantly higher than has been the case on average over the past decade. Several problems in China have been in the headlines over the past few months: a regulatory crackdown by Chinese authorities on new economy companies, the situation with Evergrande and, more recently, power shortages that have forced factories in several key manufacturing hubs to curtail production as a result of China’s ban on coal imports from Australia (Chart I-16). However, the key point for investors is that these are not truly new risks to China’s growth outlook; rather, they are developments that have the potential to magnify the impact of an already established trend: the ongoing slowdown in China’s economy that has clearly been caused by a decline in its credit impulse (Chart I-17). In turn, China’s decelerating credit impulse has been caused by tighter regulatory and monetary policy. Chart I-16Power Outages: The Latest Negative Headline From China Chart I-17China Is Slowing Because Policymakers Have Tightened   BCA’s China Investment Strategy service has provided a detailed analysis of the ongoing Evergrande saga.2 In short, our view is that the government will likely restructure Evergrande’s debt to prevent the company’s crisis from evolving into a systemic financial risk. As such, Beijing may rescue the stakeholders of Evergrande, but likely not its shareholders. However, in terms of stimulating the broader economy, it is still not clear that Chinese policymakers are willing to engage in more than gradual or piecemeal stimulus, given a higher pain threshold for a slower economy and a lower appetite for leverage. This may change once Chinese export growth slows in response to a shift in DM spending from goods to services, as policymakers will no longer be able to rely on the external sector for support. This potentially offsetting nature of eventual Chinese stimulus and global goods spending underscores both the importance of a normalization in DM services spending as an impulse for global growth, as well as the fact that a catalyst for EM stocks may remain elusive over the tactical horizon. Investment Conclusions In Section 2 of this month’s report, we explain why the performance of US stocks may be flat versus their global peers over a structural time horizon. We also highlighted that US stocks are likely to earn low annualized total returns over the coming 10 years (between 1.8 - 4.7%), which would fall well short of the absolute return goals of many investors. Chart I-18Losses From Both Stocks And Bonds Are Rare, But Are Linked To Higher Rates Over the coming 6-12 month time horizon, we continue to recommend an overweight stance towards value vs. growth stocks and global ex-US vs. US, particularly in favor of developed markets ex-US. The relative performance of value vs. growth stocks is likely to benefit from the transition to a post-pandemic state and a rise in long-maturity bond yields, as monetary policy shifts towards the point of tightening. Regional equity trends have been closely correlated with style over the past two years, and the underperformance of growth strongly implies US equity underperformance. From an asset allocation perspective, investors should remain overweight stocks versus bonds over the coming year, although it is possible that both assets will post negative returns for a short period at some point over the coming 12 months. Chart I-18 highlights that outside of the context of recessions, months with negative returns from both stocks and long-maturity bonds are quite rare, but they tend to be associated with periods of monetary policy tightening (or in anticipation of such periods). Fundamentally, we do not see a rise in bond yields to any of the levels shown in Chart I-4 as being threatening to economic growth or necessarily implying lower equity market multiples. But the speed of adjustment in bond yields could unnerve equity investors, and there are open questions as to how far the equity risk premium can fall before T.I.N.A. – “There Is No Alternative” – becomes a less persuasive argument. As such, we would not rule out a brief correction in stocks at some point over the coming several months, but we expect both stock prices and the stock-to-bond ratio to be higher a year from today. Jonathan LaBerge, CFA Vice President The Bank Credit Analyst September 30, 2021 Next Report: October 28, 2021 II. The “Invincible” US Equity Market: The Longer-Term Outlook For US Stocks In Relative And Absolute Terms Since 2008, US equity outperformance versus global ex-US stocks has not been driven by stronger top-line growth. Instead, it has been caused by a narrowly-based increase in profit margins, the accretive impact of share buybacks on the EPS of US growth stocks, and an outsized expansion in equity multiples. To a lesser extent, the dollar has also boosted common currency relative performance. There are significant secular risks to these sources of US equity outperformance over the past 14 years. Elevated tech sector profit margins are likely to lead to increased competition and higher odds of regulatory action, leveraging has reduced the ability of US companies to continue to accrete EPS through changes to capital structure, relative multiples are not justified by relative ROE, and the US dollar is expensive and is likely to fall over a multi-year horizon. In absolute terms, we forecast that US stocks will earn annualized nominal total returns of between 1.8 - 4.7% over the coming decade, assuming 4-5% annual revenue growth, flat profit margins, a constant 2% dividend yield, and a constant equity risk premium. Long-maturity bond yields are below their equilibrium levels and are likely to rise in real terms over time, which will weigh on elevated equity multiples. Over the coming 6-12 months, our view that US 10-Year Treasury yields are likely to rise argues for an underweight stance toward growth versus value stocks. In turn, this implies that US stocks will underperform global stocks, especially versus developed markets ex-US. The risks that we have highlighted to the sources of US outperformance suggest that US stocks may be flat versus their global peers over the long-term, arguing for a neutral strategic allocation. It also suggests that investors should be prepared to accept more volatility in order to reduce the gap between expected and desired returns, and should look towards riskier investments and asset classes (such as real estate and alternative investments) as potential portfolio return enhancements. Chart II-1The US Has Massively Outperformed Other Equity Markets Since The Global Financial Crisis The US equity market has vastly outperformed its peers since the 2008/2009 global financial crisis. Chart II-1 highlights that an investment in US stocks at the end of 2007 is now worth over 4 times the invested amount, versus approximately 1.6 times for global ex-US stocks (when measured in US dollar terms). The chart also shows that USD-denominated total returns have been roughly the same for developed markets ex-US as they have been for emerging markets, highlighting the exceptional nature of US equities. In this report we provide a deep examination of the sources of US equity performance, their likely sustainability, and what this implies for long-term investor return expectations. US stocks have not outperformed because of stronger top-line (i.e. revenue) growth, and instead have benefitted from a narrowly-based increase in profit margins, active changes to capital structure that have benefitted stockholders, an outsized expansion in equity multiples relative to global stocks, and a structural appreciation in the US dollar. We conclude that there are significant risks to all of these sources of outperformance, and that a neutral strategic allocation to US equities is now likely warranted. We also highlight that, while a strategic overweight stance is still warranted toward stocks versus bonds, investors should no longer count on US stocks to deliver returns that are in line with or above commonly-cited absolute return expectations. This argues for a greater tolerance of volatility, and the pursuit of riskier investments and asset classes (such as real estate and alternative investments) as potential portfolio return enhancements. A Deep Examination Of US Outperformance Since 2008 Breaking down historical total return performance is the first step in judging whether US equities are likely to outperform their global ex-US peers on a structural basis. Below we deconstruct US and global total return performance over the past 14 years into six different components, and analyze the impact of some of these components on a sector-by-sector basis. The six components presented are: Total revenue growth for each equity market, in local currency terms The change in profit margins The impact of changes in capital structure and index composition The change in the trailing P/E ratio The income return from dividends The impact of changes in foreign exchange The sum of the first three factors explains the total growth in earnings per share over the period, and the addition of the fourth factor explains each market’s local currency price return. Income returns are added to explain total return over the period, with the sixth factor then explaining common currency total return performance. The FX effect for US stocks is zero by construction, given that we measure common currency performance in US$ terms. Chart II-2Strong US Returns Have Not Been Due To Strong Top Line Growth Chart II-2 presents the annualized absolute impact of these factors for the MSCI US index since 2008. The chart highlights that U.S. stock prices have earned roughly 11% per year in total return terms over the past 14 years, with significant contributions from revenue growth, multiple expansion, margins, and the return from dividends. Interestingly, however, Chart II-3 highlights that US equities have not significantly outperformed on the basis of the first factor, total local currency revenue growth, at least relative to overall global ex-US stocks (see Box II-1 for more details). DM ex-US stocks have experienced very weak revenue growth since 2008, but this has been compensated for by outsized EM revenue growth. It is also notable that US revenue growth has actually underperformed US GDP growth over the period, dispelling the notion that US equity outperformance has been due to strong top-line effects. Chart II-3The US Has Outperformed Due To Margins, Capital Structure, Multiples, And The Dollar Box II-1 Proxying The Impact Of Changes In Shares Outstanding We proxy the impact of changes in shares outstanding (and thus the impact of equity dilution / accretion) by dividing each index’s market capitalization by its stock price. This measure is not a perfect proxy, as changes in index composition (such as the addition/deletion of index constituents) will change the index’s market capitalization but not its stock price. We also calculate total revenue for each market by multiplying local currency sales per share by the market cap / stock price ratio, meaning that the total revenue growth figures shown in Chart II-3 should best be viewed as estimates that in some cases reflect index composition effects. However, Chart II-B1 highlights that adjusting the market cap / stock price ratio for the number of firms in the index does not meaningfully change our overall conclusions. This approach would imply a larger dilution effect for DM ex-US than suggested in Chart II-3, and a smaller effect for emerging markets (due to a significant rise in the number of EM index constituents since 2008). In addition, global ex-US revenue growth is modestly lower than US revenue growth when using this approach. But this gap would account for a fraction of US equity outperformance over the period, underscoring that the US has massively outperformed global ex-US stocks due to margin, capital structure, and multiple expansion effects. Chart II-B1The US Has Not Meaningfully Outperformed Due To Revenue Growth, No Matter How You Slice It Chart II-3 also highlights that global ex-US stocks have modestly outperformed the US in terms of the fifth factor, the income return from dividends. This has almost offset the negative FX return (the sixth factor) from a net rise in the US dollar over the period. What is clear from the chart is that the second, third, and fourth factors explain almost all of the difference in total return between US and global ex-US stocks since 2008. The US experienced a significant increase in profit margins versus a modest contraction for global ex-US, a modest fillip from changes in capital structure and index composition versus a substantial drag for ex-US stocks, and a sizable rise in equity multiples that has outpaced what has occurred around the globe in response to structurally lower interest rates. Chart II-4US Margin Outperformance Has Been Narrowly-Based The significant rise in aggregate US profit margins over the past 14 years has often been attributed to the strong competitiveness of US companies, but Chart II-4 highlights that the aggregate change mostly reflects a narrow sector composition effect. The chart shows the change in US and global ex-US profit margins by level 1 GICS sector since 2008, and underscores that overall profit margins outside of the US have fallen mostly due to lower oil prices. Conversely, in the US, profit margins have substantially risen in only three out of ten sectors: health care, information technology, and communication services. Chart II-5 highlights that global ex-US equity multiples have risen in a majority of sectors since 2008, but not by the same magnitude as what has occurred in the US. De-rating in the resource sector partially explains the gap, but stronger US multiple expansion in the heavily-weighted consumer discretionary, information technology, and communication services sectors appears to explain most of the gap in multiple expansion. Chart II-5Multiples Have Risen Globally, But More So For Broadly-Defined US Tech Stocks Finally, Charts II-6 & II-7 highlights that there has been a strong growth versus value dimension to the impact of changes in capital structure and index composition on regional equity performance. The charts show that equity dilution and other changes to index composition have caused a similar drag on the returns from value stocks in the US and outside the US. However, the charts also highlight that the more important effect has been the accretive impact of share buybacks on the EPS of US growth stocks, which has not been matched by growth stocks outside of the US. As noted in Box II-1, part of this gap may be explained by an increase in the number of companies included in the MSCI Emerging Markets index, but Chart II-8 highlights that the global ex-US ratio of market capitalization to stock price has still risen significantly over the past 14 years, in contrast to that of the US even after controlling for the number of index components. Chart II-6There Has Been A Strong Style Dimension… Chart II-7…To The Impact Of Changes In Capital Structure And Index Composition Chart II-8The Accretive Impact Of US Growth Stock Buybacks Has Not Been Matched Globally The bottom line for investors is that there have been multiple factors contributing to US equity outperformance since 2008, but aggregate top-line growth has not been one of them. Broadly-defined technology companies (including media & entertainment and internet retail firms) have been responsible for nearly all of the relative rise in profit margins and most of the relative expansion in multiples over the past 14 years, and US growth stocks have benefitted from the accretive impact of share buybacks to a larger degree than what has occurred globally. The Relative Secular Return Outlook For US Stocks We present below several structural risks to the continued outperformance of US equities for the factors that have been most responsible for this performance over the past 14 years. In some cases, these risks speak to the potential for US outperformance to end, not necessarily that the US will underperform. But even the cessation of US outperformance along one or more of these factors would be significant, as it would imply a potential inflection point in the most consequential trend in regional equity performance since the 2008/2009 global financial crisis. Profit Margins Chart II-9 presents the 12-month trailing combined profit margin for the US consumer discretionary, information technology, and communication services sector versus that of the remaining sectors. The chart underscores the points made by Chart II-4 in time series form, namely that the net increase in overall US profit margins since 2008 has been narrowly based. Chart II-9The US Profit Margin Expansion Has Been Driven By Broadly-Defined Tech Stocks Over a 6-12 month time horizon, the clear risk to US profit margins is an end to the COVID-19 pandemic. The profitability of broadly-defined tech stocks has surged during the pandemic, in response to a significant shift toward online goods purchases and elevated spending on tech equipment. A durable end to the pandemic is likely to reverse some of these spending patterns, which will likely weigh on margins for broadly-defined tech stocks. Chart II-10The Regulatory Risks Facing Big Tech Are Real Over the longer term, the risk is that extremely elevated profit margins are likely to increase the odds of regulatory action from Washington and invite competition. On the former point, our US Political Strategy service has highlighted that a bipartisan consensus in public opinion holds that Big Tech needs tougher regulation (Chart II-10), and this consensus grew substantially over the controversial 2020 political cycle.3 This regulatory pressure is currently best described as a “slow boil,” as not all surveys show strong majorities in favor of regulation, and Republicans and Democrats disagree on the aims of regulation. But the bottom line is that Big Tech is likely to remain in the hot seat after the various controversies of the pandemic and 2016-2020 elections, just as big banks faced tougher regulation in the wake of the subprime mortgage crisis. This underscores that a “slow boil” may turn into a faster one at some point over the secular horizon, which would very likely weigh on profit margins. Elevated tech sector profit margins makes regulatory action more likely because policymakers will perceive a stronger ability for these firms to weather a “regulatory shock.” On the latter point about competition, it is true that broadly-defined tech stocks follow a “platform” business model that will be difficult to supplant. These companies benefit from powerful network effects that have taken years to accrue, suggesting that they will not be rapidly replaced by competitors. Still, the experience of Microsoft in the years following its meteoric rise in the second half of the 1990s provides a cautionary tale for broadly-defined tech stocks today. In the late-1990s, it was difficult for investors to envision how Microsoft’s near-total product dominance of the PC ecosystem could ever be displaced, but it eventually lost market share due to the rise of mobile devices and their competing operating systems. In addition, Microsoft’s fundamental performance suffered even before the rise of the modern-day smartphone & mobile device market. Chart II-11 highlights the annualized components of Microsoft’s price return from 1999-2007 versus the late-1990s period, which underscores that changes in margins, changes in multiples, and stock price returns may be persistently negative in a scenario in which revenue growth slows (even if revenue growth itself remains positive). Chart II-11Microsoft Offers A Cautionary Tale For Dominant Business Models Some of the reversal of Microsoft’s fortunes during this period were self-inflicted, and the firm also suffered from an economy-wide slowdown in tech equipment spending as a result of the 2001 recession that persisted into the early years of the subsequent recovery. But the key point for investors is that company and sector dominance may wane, and the fact that broadly-defined tech sector profit margins are extremely elevated raises the risk that further increases may not materialize. Capital Structure And Index Composition As noted above, the beneficial impact from changes in capital structure and index composition for US equities has occurred due to the accretive impact of share buybacks on the EPS of US growth stocks, which has not been matched by growth stocks outside of the US. In our view, this accretive impact has occurred for two reasons. First, US growth stocks have taken advantage of historically low interest rates and leverage to shift their capital structure to be more debt-focused over the past 14 years. Second, this shift has been aided by the fact that US growth stocks have experienced stronger cash flows than their global peers, which have been used to service higher debt payments. However, Charts II-12 and II-13 suggest that this process may be in its late innings. Chart II-12 highlights that the US nonfinancial corporate sector debt service ratio (DSR) did indeed fall below that of the euro area following the global financial crisis, but that this reversed in 2016. At the onset of the pandemic, the US nonfinancial corporate sector DSR was rising sharply, and was approaching its early-2000 highs. During the pandemic, the corporate sector DSR has continued to rise in both regions, but this almost exclusively reflects a (temporary) decline in operating income, not a surge in corporate sector debt or a rise in interest rates. Not all of the pre-pandemic rise in the US corporate sector DSR was concentrated in broadly-defined tech stocks, but some of it likely was. The key point for investors is that the US nonfinancial corporate sector had a lower capacity to leverage itself relative to companies in the euro area at the onset of the pandemic, which implies a less accretive impact on relative earnings per share in the future. Chart II-13 reinforces this point by highlighting that the uptrend in relative cash flow for US growth stocks, versus global ex-US, appears to have ended in 2015. The uptrend has continued in per share terms, but this appears to be flattered by the impact of buybacks itself. Chart II-12Can The US Continue To Accrete EPS Through Stock Buybacks? Chart II-13US Growth Companies Are No Longer Generating More Cash Than Their Global Peers   Admittedly, we see no basis to conclude that the persistent earnings dilution that has occurred in emerging markets over the past 14 years will end, or even slow, over the secular horizon. This underscores that emerging markets will need to generate stronger revenue growth to prevent the dilution effect from acting as a continued drag on EM vs. US equity performance, and it is an open question as to whether this will occur. Thus, for now, we have more conviction in the view that capital structure and index composition changes may contribute less to US equity outperformance versus developed markets ex-US over the coming several years. Equity Multiples There are three arguments against the idea that US equity multiples will continue to expand relative to those of global ex-US stocks. First, Chart II-14 highlights a point that we have made in previous Bank Credit Analyst reports, which is that aggressive multiple expansion in the US has now rendered US stocks to be the most dependent on low long-maturity bond yields than at any point since the global financial crisis. Chart II-14US Stocks Are The Most Dependent On Low Bond Yields In Over A Decade Over the coming 6- to 12-months, we strongly doubt that US 10-year Treasury yields will rise outside of the range that would be consistent with the US equity risk premium from 2002 to 2007 (discussed in further detail in the next section). But the chart also shows that this range is now clearly below trend nominal GDP growth, suggesting that higher interest rates on a structural basis may cause outright multiple contraction for US stocks. This is particularly true for growth stocks, which have been responsible for a significant portion of US equity outperformance, given their comparatively long earnings duration. Chart II-15US Multiples Are Not Justified By Higher Return On Equity Second, it has been often argued by some investors that a premium is warranted for US stocks given their comparatively high return on equity, but Chart II-15 highlights that this is not the case. The chart shows the relative price-to-book ratio for the US versus global and developed markets ex-US compared with regression-based predicted values based on relative return on equity. The chart clearly highlights that the US price-to-book ratio is meaningfully higher than it should be relative to global stocks, especially when compared to other developed markets. Versus DM ex-US, the only comparable period that saw a relative P/B – relative ROE deviation of this magnitude occurred in the late-1980s, when US stocks were meaningfully less expensive than relative ROE would have suggested. This relationship completely normalized in the years that followed, which would imply a substantial relative multiple contraction for US stocks over the coming several years were the gap shown in Chart II-15 to close. Third, Chart II-16 presents the share of US stock market capitalization accounted for by the largest 10% of stocks by size. The chart highlights that the concentration of US market capitalization has risen to an extreme level that has only been reached in two other cases over the past century. Historically, prior stock market concentration has been associated with future increases in the equity risk premium, underscoring that broadly-defined US tech sector concentration bodes poorly for future returns. Chart II-16The US Stock Market Is Now Extremely Concentrated The Foreign Exchange Effect As a final point, Chart II-17 illustrates the degree to which US relative performance has meaningfully benefitted from a rise in the US dollar since 2008. The chart highlights that an equity market-weighted dollar index has risen 20% from its late-2007 level, which has boosted US common currency relative performance. The US dollar was arguably modestly undervalued just prior to the 2008/2009 global financial crisis, but Chart II-18 highlights that it is now meaningfully overvalued versus other major currencies. Over a multi-year horizon, this argues against further relative common currency gains for US stocks from the foreign exchange effect. Chart II-17The US Dollar Has Helped US Common Currency Performance... Chart II-18…And Is Now Expensive   The Absolute Secular Return Outlook For US Stocks Over a secular horizon, the most common method for forecasting equity returns is to predict whether earnings are likely to grow faster or slower than nominal potential GDP growth, and whether equity multiples are likely to rise or fall. For the reasons described above, we have no plausible basis on which to forecast that US profit margins are inclined to rise further over time given how extended they have become. This suggests that a reasonable long-term earnings forecast should be closely linked to one’s forecast for revenue growth. Chart II-19S&P 500 Revenue Is Low Relative To US GDP, And May Rise Over The Next Decade Chart II-19 presents S&P 500 revenue as a percent of nominal GDP, and underscores a fact that we noted above: revenue growth for US equities has underperformed US GDP since the global financial crisis. This undoubtedly has been linked to the fallout from the crisis and other exogenous shocks like the massive decline in energy prices in 2014/2015, which are unlikely to be repeated. Over the next ten years, the US Congressional Budget Office is forecasting nominal potential growth of roughly 4%; allowing for a potential rise in US equity revenue to GDP suggests that investors should expect earnings growth on the order of 4-5% per year over the coming decade, if extremely elevated profit margins are sustained. Chart II-20Multiples Seem To Predict Future Returns Well… Unfortunately for equity investors, there are slim odds that US equity multiples will continue to rise or even stay at their current level. Equity valuation has been shown to have nearly zero ability to predict stock returns over a 6-12 month time horizon or even over the following 3-5 years, but 10-year regressions relating current valuations on future 10-year compound returns tend to be highly predictive (Chart II-20). Utilizing this approach, today’s 12-month forward P/E ratio would imply a 10-year future total return of just 2.9% (Chart II-21). That, in turn, would imply a annual drag of 3-4% from multiple contraction over the coming decade, given our 4-5% earnings growth forecast and a historically average dividend yield of roughly 2%. One problem with the method shown in Charts II-20 and II-21 is the fact that the relationship between today’s P/E ratio and 10-year future returns captures more than the impact of potentially mean-reverting multiples. It also includes any correlation between the starting point of valuation and subsequent earnings growth, which is likely to be spurious. This effect turns out to be important: we can see in Chart II-21 that the strong fit of the relationship is influenced by the fact that the global financial crisis occurred roughly 10-years after the equity market bubble of the late-1990s. Chart II-21...But That Depends Heavily On The Tech Bubble / GFC Relationship Astute investors may infer a legitimate causal link between these two events, via too-easy monetary policy. But from the perspective of forecasting, predicting future returns based on prevailing equity multiples confusingly mixes together three effects: the relative timing of business cycles, the impact of changes in interest rates, and the potential mean-reverting nature of the equity risk premium. In order to disentangle these effects for the purposes of forecasting, we present a long-history estimate of the US equity risk premium based on Robert Shiller’s Irrational Exuberance dataset (Chart II-22). We define the equity risk premium as earnings per share (as reported) as a percent of the S&P 500, minus the real long-maturity interest rate. We calculate the real rate by subtracting the BCA adaptive inflation expectations model – essentially an exponentially smoothed version of actual inflation – from the nominal long-term bond yield. Chart II-22The US ERP Seems Normal Based On A Very Long Term History... The chart highlights that this estimate of the ERP is currently exactly in line with its median value since 1872. Chart II-23 presents essentially the same conclusion, based on data since 1979, using the forward operating P/E ratio for the S&P 500 and the same definition for real bond yields. This implies that, if interest rates were at equilibrium levels, investors would have a reasonable basis to conclude that equity multiples would be unchanged over a secular investment horizon. However, as we have highlighted several times in previous reports, long-maturity government bond yields are likely well below equilibrium levels. Chart II-24 highlights that long-maturity US government bond yields have not been this low relative to trend growth since the late-1970s. Chart II-23...And Based On The Forward Earnings Yield Over The Past Four Decades Chart II-24Interest Rates Are Well Below Equilibrium, And Are Likely To Rise Over Time   We presented in an April report why a gap between interest rates and trend rates of growth was indeed justified for a few years following the global financial crisis, but that a decline in the equilibrium real rate of interest (“r-star”) only appeared to be permanent due to persistent, non-monetary policy shocks to aggregate demand that occurred over the course of the last economic cycle.4 In a scenario where the US output gap turns positive, inflation rises modestly above target, and where permanent damage to the labor market from the pandemic is relatively limited over the coming 6-18 months, it seems reasonable to conclude that the narrative of secular stagnation may ultimately be challenged and that investor expectations for the neutral rate may converge toward trend rates of economic growth. This would weigh on equity multiples, and thus lower equity total returns from the 6-7% implied by our earnings forecast and income return assumption. Chart II-25US Stocks Are Likely To Earn Annual Total Returns Between 1.8-4.7% Over The Next Decade Were real long-maturity bond yields to rise by 100-200bps over the coming decade, this would imply annualized total returns of between 1.8 - 4.7% from US stocks, assuming 4-5% annual revenue growth, flat profit margins, a constant 2% dividend yield, and a constant ERP (Chart II-25). While this would beat the returns offered by bonds, implying that investors should still be structurally overweight equities versus fixed-income assets, it would also fall meaningfully short of the average pension fund return objective (Chart II-26), as well as the absolute return goals of many investors. Chart II-26Future Returns From US Stocks Will Greatly Disappoint Investors Investment Conclusions Chart II-27Over The Coming Year, Favor Value And Global Ex-US Stocks Over the coming 6-12 months, our view that 10-year US Treasury yields are likely to rise supports an overweight stance toward value versus growth stocks. Chart II-27 highlights that the underperformance of growth argues for an underweight stance toward US stocks within a global equity portfolio, especially versus developed markets ex-US. Over a longer-term horizon, there are two key investment implications from our research. First, the risks that we have highlighted to the sources of US outperformance over the past 14 years suggests that investors should not bank on a continuation of this trend over the next decade. We have not made the case in this report for the outperformance of global ex-US stocks, merely that the continued outperformance of US stocks now rests on an unreliable foundation. This may suggest that US relative performance will be flat over the structural horizon, arguing for a neutral strategic allocation. But even the cessation of US outperformance would be a significant development, as it would end the most consequential trend in regional equity performance in the post-GFC era. Second, investors should expect meaningfully lower absolute returns from US stocks over the next decade than what they have earned since 2008/2009, barring a continued rise in the already stretched profit margins of broadly-defined tech stocks. A structurally overweight stance is still warranted toward equities versus fixed-income, but even a 100% equity allocation is unlikely to meet investor return expectations in the high single-digits. As a consequence, global investors should be prepared to accept more volatility in order to reduce the gap between expected and desired returns, and should look towards riskier investments and asset classes (such as real estate and alternative investments) as potential portfolio return enhancements. Jonathan LaBerge, CFA Vice President The Bank Credit Analyst III. Indicators And Reference Charts BCA’s equity indicators highlight that the “easy” money from expectations of an eventual end to the pandemic have already been made. Our technical, valuation, and sentiment indicators remain very extended, highlighting that investors should expect positive but modest returns from stocks over the coming 6-12 months. Our monetary indicator has retreated below the boom/bust line, although this mostly reflects the use of producer prices to deflate money growth. In nominal terms, the supply of money continues to grow. Still, the retreat in the indicator highlights that the monetary policy stance is likely to shift in a tighter direction over the coming year. Forward equity earnings are pricing in a substantial further rise in earnings per share, and there is no meaningful sign of waning forward earnings momentum as net revisions and positive earnings surprises remain near record highs. Bottom-up analyst earning expectations are now almost certainly too high, but stocks are likely to be supported by robust revenue growth over the coming year. Within a global equity portfolio, global ex-US equities have underperformed alongside cyclical sectors, banks, and value stocks more generally. On a 12-month time horizon, we would recommend that investors position for the underperformance of financial assets that are negatively correlated with long-maturity government bond yields. The US 10-Year Treasury yield has broken above its 200-day moving average, beginning its recovery after falling sharply since mid-March. After a decline initially caused by waning growth momentum and the impact of the Delta variant of SARS-COV-2, long-maturity bond yields appear to be responding to the interest rate guidance that the Fed has been providing. 10-Year Treasury Yields remain below the fair value implied by a late-2022 rate hike scenario, underscoring that 10-Year Yields are set to trend higher over the coming year. The extreme rise in some commodity prices over the past several months has eased. Lumber prices have almost fully normalized, whereas the pace of advance in industrial metals prices has eased. Global shipping costs have exploded due to supply-side constraints, but are likely to ease over the coming year if further COVID-related labor market shocks can be avoided. US and global LEIs remain very elevated but have started to roll over. Our global LEI diffusion index has declined very significantly, but this likely reflects the outsized impact of a few emerging market countries (whose vaccination progress is still lagging). Still-strong leading and coincident indicators underscore that the global demand for goods is robust, and that output is below pre-pandemic levels in most economies because of very weak services spending. The latter will recover significantly at some point over the coming year, as social distancing and other pandemic control measures disappear. EQUITIES: Chart III-1US Equity Indicators Chart III-2Willingness To Pay For Risk Chart III-3US Equity Sentiment Indicators   Chart III-4US Stock Market Breadth Chart III-5US Stock Market Valuation Chart III-6US Earnings Chart III-7Global Stock Market And Earnings: Relative Performance Chart III-8Global Stock Market And Earnings: Relative Performance   FIXED INCOME: Chart III-9US Treasurys And Valuations Chart III-10Yield Curve Slopes Chart III-11Selected US Bond Yields Chart III-1210-Year Treasury Yield ComponentsChart III-13US Corporate Bonds And Health Monitor Chart III-14Global Bonds: Developed Markets Chart III-15Global Bonds: Emerging Markets   CURRENCIES: Chart III-16US Dollar And PPP Chart III-17US Dollar And Indicator Chart III-18US Dollar Fundamentals Chart III-19Japanese Yen Technicals Chart III-20Euro Technicals Chart III-21Euro/Yen Technicals Chart III-22Euro/Pound Technicals   COMMODITIES: Chart III-23Broad Commodity Indicators Chart III-24Commodity Prices Chart III-25Commodity Prices Chart III-26Commodity Sentiment Chart III-27Speculative Positioning   ECONOMY: Chart III-28US And Global Macro Backdrop Chart III-29US Macro Snapshot Chart III-30US Growth Outlook Chart III-31US Cyclical Spending Chart III-32US Labor Market Chart III-33US Consumption Chart III-34US Housing Chart III-35US Debt And Deleveraging   Chart III-36US Financial Conditions Chart III-37Global Economic Snapshot: Europe Chart III-38Global Economic Snapshot: China   Jonathan LaBerge, CFA Vice President The Bank Credit Analyst Footnotes 1  Please see The Bank Credit Analyst "The Return To Maximum Employment: It May Be Faster Than You Think," dated August 26, 2021, available at bca.bcaresearch.com 2  Please see China Investment Strategy "A Quick Take On Embattled Evergrande," dated September 21, 2021, and China Investment Strategy "The Evergrande Saga Continues," dated September 29, 2021, available at cis.bcaresearch.com 3 Please see US Political Strategy "Forget Biden's Budget," dated June 2, 2021, available at usps.bcaresearch.com 4     Please see The Bank Credit Analyst “R-star, And The Structural Risk To Stocks,” dated March 31, 2021, available at bca.bcaresearch.com

August PPI reading came in at 8.3%. Naturally, many investors are wondering whether the companies will be able to pass their soaring input costs to the customers. An in-depth analysis of margins and pricing power requires a significant research effort. However, below are some examples illustrating our thinking process on the topic. We also included pricing power sector charts in the Appendix.   Companies’ ability to hike prices is a function of the elasticity of demand, which is heterogeneous across industries and products. It also depends on product differentiation and competition in the industry. For some categories, such as consumer durables, pricing power has declined as prices reached the upper limit of affordability (Chart 1). As a result, durables goods manufacturers’ pricing power has peaked, and this sector is at a higher risk of margin squeeze. Margins of the Health Care sector have been under pressure for years (Chart 2). This can be tied back to Pharma being under perennial pressure from both politicians aiming to lower prescription drug prices, and from competition from the generics. Meanwhile, the Consumer Discretionary sector is in better shape thanks to pent-up demand for services and discretionary goods – consumers are in good financial health and are able to tolerate marginal prices increases. We expect discretionary and services industries to be able to maintain their margins. Bottom Line: The ability to exert pricing power and pass on costs to customers is highly industry-specific and can not be generalized. CHART 1 CHART 2 Appendix  

Today we take a close look at the historical GICS1 level performance following the taper event in 2013.  Chart 1 provides an overview of a price action of the 10-year US Treasury yield, the US dollar, and gold to provide context, while Charts 2 - 4 summarize performance of the S&P sectors.   Chart 1 Chart 2 Chart 3 Chart 4 The Fed’s decision to modestly reduce the pace of its asset purchases in December of 2013 was a risk-off event which triggered a decline in Treasury yields and put upward pressure on the dollar. S&P 500 sectors followed the script from a risk-off “playbook” with Technology outperforming on the back of falling Treasury rates, while Financials underperformed.  A spike in USD also led to underperformance of the Energy sector. The Consumer Discretionary sector was a notable outlier underperforming the S&P 500 by 6%.  However, empirical analysis is hardly helpful in this case as in 2013 Amazon constituted 7.05% of the sector weight compared to 40% today. Finally, the performance of the defensive sectors was mixed as while tapering was perceived by the market as a clear risk-off event, it was also a sign that the economy is strong, and the Fed is comfortable with withdrawing the liquidity crutch. Bottom Line: Investors should not worry about the Fed and tapering as in the US its effect was short-lived and many more years of the bull market have ensued after it.    

Please note that next Friday September 24 at 10am EDT, we will host a webcast featuring a debate between my colleague Peter Berezin and me. The topic of debate is whether investors should overweight EM in a global portfolio. Please join us by registering via this link.   Highlights Chinese internet companies’ ROE will drop, warranting lower equity valuations. However, their ROE and equity multiples will not fall to the levels of listed state-owned enterprises (SOEs). Evergrande’s partial default on its liabilities will likely reinforce credit tightening that has been underway in China over the past 12 months. EM ex-TMT stocks also remain vulnerable. Continue underweighting EM in global equity and credit portfolios. Feature This is the September issue of Charts That Matter. We begin by addressing the issues concerning Chinese internet companies that have been subject to intense debate among investors. We then present key charts on overall EM and various asset classes along with brief commentary. Are Chinese Internet Stocks Investable? There is an ongoing debate in the investment community as to whether Chinese equities in general and Chinese TMT stocks in particular will remain investable. Our short answer is: they will remain investable but mind their valuations. In our opinion, “investable” means that they will from time to time offer medium- and long-term investment opportunities. Our hunch is that they may do so in the future. Nevertheless, we do not think that Chinese TMT stocks presently offer a good buying opportunity. In fact, their share prices have material downside from current levels. In our recent report and webcast, we identified the primary risks to Chinese platform companies: Higher uncertainty about their business model = a higher equity risk premium. Government regulating their profitability like those of mono- and oligopolies = low multiples. These companies performing their social duties in the form of redistributing profits from shareholders to Chinese peoples. Beijing’s involvement in their management and in the prioritization of national and geopolitical objectives over shareholder interests. Risks of delisting from US stock exchanges. Although these companies will remain investable, investors should bear these risks in mind and give careful consideration to what multiples they pay for such stocks. Going forward, Chinese platform companies’ return on equity will be considerably lower than they have been or what their current multiplies imply. A lower return on equity warrants a lower equity multiple. Chart 1Chinese Growth Stocks Are Not Cheap On the whole, the current valuations of Chinese internet stocks are still high. Chart 1 shows trailing and 12-month forward P/E ratios for Chinese MSCI Growth Investable Index at 34 and 31, respectively. A downshifting return on equity and high uncertainty around these businesses herald lower equity valuations to come. Besides, in the case of several companies, there are also political underpinnings of this regulatory crackdown. In the case of Alibaba, a mainland government official has recently noted that Alibaba’s chairman, Jack Ma, has been acquiring media companies across the country, and now owns nearly 30 provincial-level media companies, as well as the South China Morning Post in Hong Kong. Beijing will not tolerate the control of or influence over domestic media from anyone outside the inner leadership circle. In this context, it is probable that Alibaba’s businesses will remain subject to severe regulatory pressures. How much lower should these companies’ multiples drop to become attractive? Meaningfully lower, but not to the level of multiples of listed state-owned enterprises (SOEs). Here are two reasons why these platform companies will not trade at multiples of SOEs in China: First, many existing SOEs operate in cyclical industries – commodities, industrials, autos, and banks – that structurally have low equity multiples. By contrast, platform companies operate in non-cyclical sectors that structurally have lower business cycle volatility and, therefore, should trade at higher equity multiples than cyclical industries. Second, many SOEs often had losses because they operated in non-oligopolistic industries. Faced with intense competition they had to cut prices to support volumes and employment. By contrast, platform companies’ profitability will be suppressed and capped by new government policies, but they will remain profitable because they operate in oligopolistic industries. In short, platform companies’ ROEs will be higher than those of traditional/”old-economy” SOEs. All in all, our bias is that platform companies’ valuation multiples will contract further but will not be as low as Chinese, Russian, or Brazilian SOEs have been. Bottom Line: Investors should be mindful of further de-rating in Chinese TMT/platform company stocks. These stocks are not yet out of woods. On Property Market Clampdown And Evergrande's Default Evergrande will likely default on some of its liabilities but there will be a bailout or roll-over of its other debt.  Is the partial default by Evergrande, a very large Chinese property developer, a sign of a bottom in Chinese offshore equity and bond markets or will it produce a full-blown credit crisis in China? This is a valid question because both outcomes are possible: a partial bankruptcy can be a culmination of all existing negatives and can trigger policy stimulus that will produce an economic recovery and a major rally (an example of this is the LTCM crisis in the US in 1998); or  a partial bankruptcy can lead to a credit crunch escalation becoming a systemic event. An example of this is Lehman Brothers’ bankruptcy in 2008. We will assign the highest probability to a third scenario: the well-telegraphed Evergrande default might not create a systemic crisis or crash. However, it will likely reinforce chronic credit tightening that has been underway in China over the past 12 months. This is negative for China and EM risk assets. Predicting the trajectory and speed of market adjustments – a crisis (wholesale selloff) versus a regular bear market interrupted by short-term rebounds – is impossible. That said, investors should stay put for now. On another note, during our webcast last week, a client asked whether restrictions on property developers’ leverage will hinder their ability and willingness to build. In turn, limited property supply will likely push up property prices, which is contrary to Beijing’s goals of curbing property price inflation. So, why are authorities pursuing this clampdown on property developers? Chart 2Property Starts And Prices Are Positively Correlated This is a very good question, and we have the following observations. In our view, authorities are clamping down on property developers’ leverage because historically there was a strong positive correlation between property starts and house prices (Chart 2). The basis for this positive correlation is that when property developers start more projects, they raise expectations via aggressive marketing of higher prices in future. As a result, people become more inclined to buy houses. In fact, more supply has not precluded property prices from surging and vice versa, as shown in Chart 2. Provided housing valuations (the house price-to-income ratios) are exceptionally high in China and high-income households have been buying multiple apartments, we can argue that (speculative) expectations for higher prices in the future have often been an important driver of demand. So, authorities are probably hoping to break this speculative cycle where higher prices breed higher prices. Aggressive marketing on the part of property developers – creating an atmosphere of euphoria around new property launches – has been an essential driver for surging house price expectations. Hence, authorities’ reasoning is that curbing property developers’ relentless debt financed expansion activity is essential for both (1) to restrain excessive house prices inflation (a social stability goal) and (2) to reduce risks of a future credit crisis (a financial stability goal). Finally, with many households/investors who own multiple properties (that are vacant rather than rented out), authorities hope that diminished expectations for future house price appreciation will bring some of these vacant properties to the market. If this occurs, the supply of residential properties for sale and rent will not drop dramatically despite lower starts by property developers. It is also critical to assess the implications of the ongoing carnage in Chinese offshore corporate bonds, where the epicenter of the selloff is property companies. The fact that property developers are experiencing a credit crunch and will be forced to deleverage has implications for China’s business cycle and other EM economies. Chart 3 illustrates that the periods of rising emerging Asian USD corporate bond yields (shown inverted on the chart) coincide with lower emerging Asian ex-TMT share prices. The link is as follows: the ongoing credit stress and deleveraging by mainland property developers means less construction and diminished demand for raw materials and industrial goods as well as possibly household white goods. There are thus negative implications not only for emerging Asian non-TMT stocks but also for overall EM. Bottom Line: Property construction in China will continue contracting (Chart 4). This will weigh on raw materials and industrial goods demand in China and beyond it. Chart 3Rising Emerging Asian Corporate Bond Yields Point To Lower Asian ex-TMT Stocks Chart 4Chinese Housing: Sales And Starts Are Contracting   Arthur Budaghyan Chief Emerging Markets Strategist arthurb@bcaresearch.com     Have EM Stocks Bottomed? Investor sentiment on EM equities has plunged close to its previous lows. However, this is a necessary but not sufficient condition to issue a buy recommendation. Critically, EM narrow money growth points to EPS deceleration in the next nine months. Yet, analysts’ net EPS revisions remain elevated and have not yet dropped to negative levels. Our bias is that EM net EPS revisions will be downgraded in the coming months. From a technical perspective, the EM equity index has failed to break above its 200-day moving average. This is a negative technical signal.  Chart 5 Chart 6 Chart 7 Chart 8 EM Underperformance Is Broad-Based Not only have EM TMT stocks massively underperformed their global peers, but also EM ex-TMT stocks have been underperforming their global counterparts. Besides, the EM equal-weighted stock index has failed to break above its previous highs. Failure to break above a resistance line is often a bad omen. Finally, EM ex-TMT share prices correlate with the average of AUD, NZD and CAD, and the latter remains in a corrective phase.  Chart 9 Chart 10 Chart 11 Red Flags For EM Periods of rising EM USD corporate bond yields coincide with lower EM share prices. EM corporate USD bond yields are rising (shown inverted below) and we expect more upside. Either US Treasury bond yields will rise and EM corporate spreads will stay broadly constant, or EM credit spreads will widen and US Treasury yields will stay range-bound. Either of these scenarios will produce higher EM corporate bond yields and, thereby, herald lower EM equity prices. Further, a breakdown in platinum prices is also raising a red flag for EM risk assets.  Chart 12 Chart 13 Have Chinese And Asian Stocks Hit An Air Pocket? Relative performance of emerging Asian equities versus the global stock index has broken below its previous lows. Technically, this entails a protracted period of underperformance. Neither emerging Asian ex-TMT nor Chinese investable ex-TMT share prices have been able to break above their major resistance lines. Failure to break above a resistance line is often a bad omen. Meantime, Chinese onshore stocks and corporate bonds have not sold off enough so that authorities panic and stimulate aggressively.  Chart 14 Chart 15 Chart 16 Chart 17 The US Dollar As A Litmus Test EM risk assets negatively correlate with the US dollar. The broad trade-weighted US dollar is holding above its 200-day moving average. Plus, investor sentiment on the greenback remains negative. Finally, the US dollar moves inversely with relative performance of global cyclical sectors versus global defensives (the dollar is shown inverted on chart below). The ongoing slowdown in China is bullish for the US dollar because the US economy is the least vulnerable to China’s economy. Overall, we expect the US dollar to continue firming in the coming months. Chart 18 Chart 19 Chart 20 Global Mining Stocks, Commodity Currencies And Commodity Prices The share prices of BHP and Rio Tinto have fallen dramatically in absolute terms. This reflects the plunge in iron ore prices and might also be a harbinger of a broader selloff in industrial metals. Further, the average of AUD, NZD and CAD also signals a correction in the broad commodities price index.  Chart 21 Chart 22 Chart 23 Is This Decoupling Sustainable? Industrial metals prices were historically correlated with the Chinese business cycle but have decoupled since early this year. Several commodity prices – like coal, steel and aluminum – have shot up due to production shutdowns as a part of the Chinese government’s decarbonization policies. However, it will be extraordinary if commodity prices continue advancing amid a protracted slowdown in China’s old economy.   Chart 24 Chart 25 Chinese Commodity Imports Have Contracted Reflecting a demand slowdown and the government’s willingness to dampen commodity price inflation, China has been shrinking its imports of several commodities. It has also released some of its strategic reserves for oil and certain industrial metals. High commodity prices are hurting profit margins of manufacturing and industrial companies leading them to lower output. Beijing is determined to curb and bring down key commodity prices to lessen the negative impact on overall growth and employment.  Chart 26 Chart 27 Chinese Stimulus: How Fast And How Large? In recent months, China has been injecting more liquidity into the banking system. Rising commercial banks’ excess reserves at the PBOC point to a bottom in the credit impulse in Q4 of this year. However, the credit impulse leads the business cycle by about nine months. This implies that the economy will not revive before Q2 next year at best. In fact, the aggregate building floor area started and the installation of electricity transmission lines are already contracting and will continue shrinking till Q2 next year.   Chart 28 Chart 29 Chart 30 Chart 31 An Inflation Dichotomy Between China And The US In China, consumer price inflation remains largely contained. However, in the US core consumer price inflation measures are still rising and are above 2%. An optimal exchange rate adjustment to redistribute inflation pressures from the US into China will require a stronger US dollar and a weaker RMB.  Chart 32 Chart 33 Inflation And Monetary Tightening In EM ex-China Core measures of inflation have been rising in many Eastern European and Latin American economies. Their central banks will hike interest rates further. This will hurt their domestic demand at a time when the recovery in these economies has been underwhelming. Monetary and fiscal tightening will offset benefits from reopening as their vaccination rates ameliorate.  Chart 34 Chart 35 Chart 36 Chart 37 What Drives EM Credit Markets? We downgraded our allocation to EM credit, currencies and equities from neutral to underweight on March 25, 2021. This strategy remains intact. The outlook for the key drivers of EM credit – EM/China business cycles and EM exchange rates – remains downbeat. In fact, EM credit markets – both investment grade and high-yield – have been underperforming their US counterparts and this trend will persist.  Chart 38 Chart 39 Chart 40 Chart 41 Our Relative Equity Value Strategies We have been recommending investors go long Chinese A shares / short Chinese investable stocks since March 4, 2021 and this strategy has been extremely profitable. The same is true for the short Chinese property developers / long overall index and short Chinese investable value stocks versus global value stocks strategies. Finally, our recommendation to be long global industrials / short global materials has so far been flat but we expect it to play out for the reasons elaborated in the linked report.  Chart 42 Chart 43 Chart 44 Chart 45 Retail Equity Mania In Korea And Taiwan The retail mania continues in the Korean and Taiwanese stock markets. Retail investors are the main buyers while foreign investors and domestic institutional investors have been scaling back their exposure. Surging margin loans and equity trading volumes in Korea confirm ongoing equity euphoria. We continue overweighting Korean stocks and are neutral on Taiwanese stocks within an EM equity portfolio. The difference in our strategy is due to the potential geopolitical risks that Taiwan is facing. Chart 46 Chart 47 Chart 48 Chart 49 The Semi Cycle And Risks To The Absolute Performance Of Korean And Taiwanese Stocks DRAM and NAND prices have rolled over. This is a near-term risk to the absolute performance of Korean tech stocks. However, if global industrial stocks outperform, as we expect, Korean share prices will outperform the EM equity benchmark because the KOSPI is a good proxy play on global industrials within the EM universe. Although global semiconductor shortages remain widespread, the 6-month outlook for Taiwanese technology companies has rolled over too.  Chart 50 Chart 51 Chart 52 Chart 53 Footnotes Equities Recommendations Currencies, Credit And Fixed-Income Recommendations

Highlights The US government issued its first-ever water-shortage declaration for the Colorado River basin in August, due to historically low water levels at the major reservoirs fed by the river (Chart of the Week). The drought producing the water shortage was connected to climate change by US officials.1 Globally, climate-change remediation efforts – e.g., carbon taxes – likely will create exogenous shocks similar to the oil-price shock of the 1970s. Remedial efforts will compete with redressing chronic underfunding of infrastructure. The US water supply infrastructure, for example, faces an investment shortfall of ~ $3.3 trillion over the next 20 years to replace aging plants and equipment, based on an analysis by the American Society of Civil Engineers (ASCE).  This will translate to a $6,000 per-capita cost by 2039 if the current funding gap persists. Fluctuating weather and the increasing prevalence of droughts and floods will increase volatility in markets such as agriculture which rely on stable climate and precipitation patterns.We are getting long the FIW ETF at tonight's close. The ETF tracks the performance of equities in the ISE Clean Edge Water Index, which covers firms providing potable water and wastewater treatment technologies and services. This is a strategic recommendation. Feature A decades-long drought in the US Southwest linked by US officials to climate change will result in further water rationing in the region. The drought has reduced total Colorado River system water-storage levels to 40% of capacity – vs. 49% at the same time last year. It has drawn attention to the impact of climate change on daily life, and the acute need for remediation efforts. The US Southwest is a desert. Droughts and low water availability are facts of life in the region. The current drought began in 2012, and is forcing federal, state, and local governments to take unprecedented conservation measures. The first-ever water-shortage declaration by the US Bureau of Reclamation sets in motion remedial measures that will reduce water availability in the Lower Colorado basin starting in October (Map 1). Chart 1Drought Hits Colorado River Especially Hard Map 1Colorado River Basin The two largest reservoirs in the US – Lake Powell and Lake Meade, part of the massive engineering projects along the Colorado – began in the 1930s and now supply water to 40mm people in the US Southwest. Half of those people get their water from Lake Powell. Emergency rationing began in August, primarily affecting Arizona, but will be extended to the region later in the year. Lake Powell is used to hold run-off from the upper basin of the Colorado River from Colorado, New Mexico, Utah and Wyoming. Water from Powell is sent south to supply the lower-basin states of California, Arizona, and Nevada. Reduced snowpack due to weather shifts caused by climate change has reduced water levels in Powell, while falling soil-moisture levels and higher evaporation rates, contribute to the acceleration of droughts and their persistence down-river. Chart 2Southwests Exceptionally Hard Drought Steadily increasing demand for water from agriculture, energy production and human activity brought on by population growth and holiday-makers have made the current drought exceptional (Chart 2). Most of the Southwest has been "abnormally dry or even drier" during 2002-05 and from 2012-20, according to the US EPA. According to data from the National Oceanic and Atmospheric Administration, most of the US Southwest was also warmer than the 1981 – 2010 average temperature during July (Map 2). The Colorado River Compact of 1922 governing the water-sharing rights of the river expires in 2026. Negotiations on the new treaties already have begun, as the seven states in the Colorado basin sort out their rights alongside huge agricultural  interest, native American tribes, Mexico, and fast-growing urban centers like Las Vegas. Map 2Most Of The US Southwest Is Warmer Than Average Global Water Emergency States around the globe are dealing with water crises as a result of climate change. "From Yemen to India, and parts of Central America to the African Sahel, about a quarter of the world's people face extreme water shortages that are fueling conflict, social unrest and migration," according to the World Economic Forum. Droughts, and more generally, changing weather patterns will make agricultural markets more volatile. Food production shortages due to unpredictable weather are compounding lingering pandemic related supply chain disruptions, leading to higher food prices (Chart 3). This could also fuel social unrest and political uncertainty. Floods in China’s Henan province - a key agriculture and pork region - inundated farms. Drought and extreme heat in North America are destroying crops in parts of Canada and the US. While flooding in July damaged Europe’s crops, the continent’s main medium-term risk, will be water scarcity.2  Droughts and extreme weather in Brazil have deep implications for agricultural markets, given the variety and quantity of products it exports. Water scarcity and an unusual succession of polar air masses caused coffee prices to rise earlier this year (Chart 4). The country is suffering from what national government agencies consider the worst drought in nearly a century. According to data from the NASA Earth Observatory, many of the agricultural states in Brazil saw more water evaporate from the ground and plants’ leaves than during normal conditions (Map 3). Chart 3The Pandemic and Changing Weather Patterns Will Keep Food Prices High Chart 4Unpredictable Weather Will Increase Volatility In Markets For Agricultural Commodities Map 3Brazil Is Suffering From Its Worst Drought In Nearly A Century Agriculture itself could be part of a longer-term and irreversible problem – i.e. desertification. Irrigation required for modern day farming drains aquifers and leads to soil erosion. According to the EU, nearly a quarter of Spain’s aquifers are exploited, with agricultural states, such as Andalusia consuming 80% of the state’s total water. Irrigation intensive farming, the possibility of higher global temperatures and the increased prevalence of droughts and forest fires are conducive to soil infertility and subsequent desertification. This is a global phenomenon, with the crisis graver still in north Africa, Mozambique and Palestinian regions. Changing weather patterns could also impact the production of non-agricultural goods and services. One such instance is semiconductors, which are used in machines and devices spanning cars to mobile phones. Taiwan, home to the Taiwan Semiconductor Manufacturing Company – the world’s largest contract chipmaker - suffered from a severe drought earlier this year (Chart 5). While the drought did not seriously disrupt chipmaking, in an already tight market, the event did bring the issue of the impact of water shortages on semiconductor manufacturing to the fore. According to Sustainalytics, a typical chipmaking plant uses 2 to 4 million gallons of water per day to clean semiconductors. While wet weather has returned to Taiwan, relying on rainfall and typhoons to satisfy the chipmaking sector’s water needs going forward could lead to volatility in these markets. Chart 5Taiwan Faced Its Worst Drought In History Earlier This Year Climate Change As A Macro Factor The scale of remediating existing environmental damage to the planet and the cost of investing in the technology required to sustain development and growth will be daunting. Unfortunately, there is not a great deal of research looking into how much of a cost households, firms and governments will incur on these fronts. Estimates of the actual price of CO2 – the policy variable most governments and policymakers focus on – range from as little as $1.30/ton to as much as $13/ton, according to the Peterson Institute for International Economics.3 PIIE's Jean Pisani-Ferry estimates the true cost is around $10/ton presently, after accounting for a lack of full reporting on costs and subsidies that reduce carbon costs. The cost of carbon likely will have to increase by an order of magnitude – to $130/ton or more over the next decade – to incentivize the necessary investment in technology required to deal with climate change and to sufficiently induce, via prices, behavioral adaptations by consumers at all levels. The PIIE notes, "… the accelerated pace of climate change and the magnitude of the effort involved in decarbonizing the economy, while at the same time investing in adaptation, the transition to net zero is likely to involve, over a 30-year period, major shifts in growth patterns." These are early days for assessing the costs and global macro effects of decarbonization. However, PIIE notes, these costs can be expected to "include a significant negative supply shock, an investment surge sizable enough to affect the global equilibrium interest rate, large adverse consumer welfare effects, distributional shifts, and substantial pressure on public finances." Much of the investment required to address climate change will be concentrated on commodity markets. Underlying structural issues, such as lack of investment in expanding supplies of metals and hydrocarbons required during the transition to net-zero CO2 emissions, will impart an upward bias to base metals, oil and natural gas prices over the next decade. We remain bullish industrial commodities broadly, as a result. Investment Implications Massive investment in infrastructure will be needed to address emerging water crises around the world. The American Society of Civil Engineers (ASCE) projects an investment shortfall of ~ $3.3 trillion over the next 20 years to replace aging water infrastructure in the US alone. This will translate to a $6,000 per-capita cost by 2039 if the current funding gap persists.4 At tonight's close we will be getting long the FIW ETF, which is focused on US-based firms providing potable water and wastewater treatment services. This ETF provides direct investment exposure to water remediation efforts and needed infrastructure modernization in the US. We also remain long commodity index exposure – the S&P GSCI and the COMT ETF – as a way to retain exposure to the higher commodity-price volatility that climate change will create in grain and food markets. This volatility will keep the balance of price risks to the upside.   Robert P. Ryan Chief Commodity & Energy Strategist rryan@bcaresearch.com Ashwin Shyam Research Associate Commodity & Energy Strategy ashwin.shyam@bcaresearch.com   Commodities Round-Up Energy: Bullish Hurricane Ida shut in ~ 96% of total US Gulf of Mexico (GoM) oil production. Colonial Pipeline, a major refined product artery for the US South and East coast closed a few of its lines due to the hurricane but has restarted operations since then. Since the share of US crude oil from this region has fallen, WTI and RBOB gasoline prices have only marginally increased, despite virtually zero crude oil production from the GoM (Chart 6). Prices are, however, likely to remain volatile, as energy producers in the region check for damage to infrastructure. Power outages and a pause in refining activity in the region will also feed price volatility over the coming weeks. Despite raising the 2022 demand forecast and pressure from the US, OPEC 2.0 stuck to its 400k b/d per month production hike in its meeting on Wednesday.     Base Metals: Bullish A bill to increase the amount of royalties payable by copper miners in Chile was passed in the senate mining committee on Tuesday. As per the bill, taxes will be commensurate with the value of the red metal. If the bill is passed in its current format, it will disincentivize further private mining investments in the nation, warned Diego Hernandez, President of the National Society of Mining (SONAMI). Amid a prolonged drought in Chile during July, the government has outlined a plan for miners to cut water consumption from natural sources by 2050. Increased union bargaining power - due to higher copper prices -, a bill that will increase mining royalties, and environmental regulation, are putting pressure on miners in the world’s largest copper producing nation.   Precious Metals: Bullish Jay Powell’s dovish remarks at the Jackson Hole Symposium were bullish for gold prices. The chairman of the US Central Bank stated the possibility of tapering asset purchases before the end of 2021 but did not provide a timeline. Powell reiterated the absence of a mechanical relationship between tapering and an interest rate hike. Raising interest rates is contingent on factors, such as the prevalence of COVID, inflation and employment levels in the US. The fact that the US economy is not close to reaching the maximum employment level, according to Powell, could keep interest rates lower for longer, supporting gold prices (Chart 7). Ags/Softs: Neutral The USDA crop Progress Report for the week ending August 29th reported 60% of the corn crop was good to excellent quality, marginally down by 2% vs comparable dates in 2020. Soybean crop quality on the other hand was down 11% from a year ago and was recorded at  56%. Chart 6 Chart 7     Footnotes 1     Please see Reclamation announces 2022 operating conditions for Lake Powell and Lake Mead; Historic Drought Impacting Entire Colorado River Basin. Released by the US Bureau of Reclamation on August 16, 2021. 2     Please refer to Water stress is the main medium-term climate risk for Europe’s biggest economies, S&P Global, published on August 13, 2021. 3    Please see 21-20 Climate Policy is Macroeconomic Policy, and the Implications Will Be Significant by Jean Pisani-Ferry, which was published in August 2021.  4    Please see The Economic Benefits of Investing in Water Infrastructure, published by the ASCE and The Value of Water Campaign on August 26, 2020.   Investment Views and Themes Recommendations Strategic Recommendations Commodity Prices and Plays Reference Table Trades Closed in 2021 Summary of Closed Trades

FAANGs, have become the new age “staples” and provide downside protection during equity market drawdowns which are usually accompanied by falling rates and spikes in volatility.  FAANGS are expensive, and falling rates justify their valuation premium.  Further, the tech titans are defensive because of their sheer size and liquidity, predictable cash flows, and sound balance sheets. In short, these stocks are no longer just Growth, but rather High Quality Growth.  The chart on the right illustrates relative performance of FAANGs with respect to the S&P 500 excluding FAANGs across different time frames. The message is consistent across time, with FAANGs outperforming the SPX ex-FAANGs during VIX spikes. While the outperformance magnitude varies, it seems to average 0.2% per day. Recent market developments also confirm this analysis with FAANGs outperforming the SPX ex-FAANGs by 11%+ from May 10 local trough, which also coincides with the date when the recent mini-bull market in bonds began. Bottom Line: FAANGs offer a safe harbor during SPX drawdowns.

Overweight Today we are upgrading the Semiconductor industry group to an overweight. Semis received a lot of bad press this year as chip shortages became a major production bottleneck for a range of industries from autos to gaming computers. Semiconductor manufacturers have reduced their capacity during the pandemic and were struggling to ramp up production to meet pent up demand. This industry is highly cyclical and is a high beta play on the global recovery. The chart on the right illustrates that historically, US Semi earnings have been joined at the hip with the global sales and inventory cycles. Global inventories are at all time lows, and a new restocking cycle is in its infancy. A shortage of chips translates into higher prices and strong earnings growth, which is likely to continue far into the future. Street consensus expects 18% EPS growth over the next 12 months. Further, semis stocks have been in a consolidation mode for the first half of 2021 and have accumulated enough dry powder for a new leg higher. This industry group is trading with a 7% discount to the S&P 500 forward earnings multiple (19.8x vs 21.3x) Importantly, as our BCA colleague, Arthur Budaghyan, observed, semiconductor chip manufacturing is becoming a strategic asset, especially in a standoff between China and the US, and the country that controls the production of semis controls the production of most tech goods. This view highlight structural importance of this investment theme. Bottom Line: We are upgrading the S&P Semiconductors & Semiconductor equipment index to overweight from neutral allocation.

Highlights Earnings season was impressive, with 87% of companies beating analyst earnings expectations. Analysts’ targets were too low because a whopping 38% of companies provided negative forward guidance for the Q2-2021 results. The markets expect 12-17% earnings growth over the next 12 months. Growth is past its peak and is returning to trend. Earnings growth will pick up the baton from multiple expansion and will propel US equity markets further. Yet, returns will be lower than in the past due to high valuation “speed limit.” US equity market is expensive, and earnings growth with a 10% handle will not deliver a significant re-rating, while growth rates above 20% are unlikely. We still like the consumer theme: Earnings results were strong, and more growth is expected ahead, especially in the consumer services space. Overweight Health Care: Pent up demand for elective procedures will propel earnings growth higher. Overweight Industrials to benefit from the US manufacturing Renaissance long term, and from a rebound in earnings growth in response to the inventory restocking cycle and infrastructure spending short term. Stay underweight Materials: China slowing will take a toll on the earnings growth of industrial metals miners and on the Materials sector as a whole. Overweight Growth vs Value for now. Watch for a persistent rise in rates and steeping of the yield curve – once that happens, rotate into Value and Small Caps, which thrive in such a macroeconomic environment. Feature The Q2-2021 earnings season is coming to an end, and it is time to take stock of the companies’ results and validate our equity views on styles, sectors, and investment themes into the balance of the year. Review Of The Q2-2021 Earnings Season The S&P 500 Key Earnings Results Stats S&P 500 quarterly earnings grew 93% YoY, and sales increased by 23.5% YoY compared to the same quarter a year ago (Table 1). Q2-2021 earnings stand 29% above the Q2-2019 level, which translates into 14% annualized growth. CAGR for sales for the same period is 4.6%. 87% of the companies have beaten both sales and earnings expectations. Earnings surprise is 16%, while sales surprise is 4.6%. As our colleagues from US Investment Strategy (USIS) have observed, beats are unprecedented: Their magnitude is more than two standard deviations above the historical average (Chart 1). Table 1S&P 500 Q2-2021 Earnings And Sales Results Chart 1Earnings Surprises Are Unprecedented Decoding The S&P 500 Earnings Season Results While we are impressed with the earnings results delivered by the US companies, our reaction to these superb growth numbers and beats is tepid, like the market’s reaction. The average reaction to an EPS beat this earnings season was about 0.9%. Misses were penalized harshly with stocks falling 1.1%. S&P 500 is up only 2% since the beginning of the reporting season. There are a few reasons for this lukewarm reception: Analyst targets were too low: Ubiquitous beats of earnings and sales expectations indicate that the analyst targets were too low despite upgrades throughout the earnings season (downgrades are more typical). The bar was set too low because a whopping 38% of the companies provided negative forward guidance for the Q2-2021 results. Growth was lumpy: Much of the robust growth can be explained by what we can call two sides of the same coin, one being a low base for the comparisons – after all, in the summer of 2020, the economy was close to a standstill – and the other is a pent-up demand for goods and services. In other words, all the growth postponed in 2020 was delivered at once over this past couple of quarters. With that, a 14% annualized growth rate for the S&P 500 earnings since 2019, which smooths results over time, is strong but not exceptional. Corporate guidance was cautious: Many companies have warned investors that their high growth rates are unsustainable (31% of companies guided lower for Q3-2021). Since the markets are forward-looking, reported earnings growth is seen in the rearview mirror and is priced in, and it is future growth that matters. Earnings growth has returned to trend: Earnings have fully recovered from the pandemic dip. The street bottom-up EPS growth projections (according to Refinitiv) for the rest of 2021, 2022, and 2023 are based on that assumption (Chart 2). The corollary to the point above is that earnings growth has peaked (Chart 3, RHS): Earnings will grow forward along the trend line at about 6-8% annually, which is the historical average. Chart 2Earnings Growth Is Returning To Trend What To Expect Over The Next Four Quarters? According to the data compiled by Refinitiv, analysts expect Q3-2021 earnings to be 5% (QoQ) below their Q2-2021 level, staying flat for the next couple of quarters and exceeding the current level only in Q2-2022 (Chart 3, LHS). Aggregating quarterly growth rates into next 12 months growth rate, analysts expect 12.6% YoY growth over the next 12 months. Chart 3Growth Has Peaked And Quarterly Earnings Are Expected To Be Almost Flat We believe that these growth expectations are too low, as they are based on the expectation that over the next four quarters EPS will stay practically flat. Therefore, most of the 12.6% YoY growth can be attributed to a base effect. It is likely that YoY growth will be higher: Some sector earnings are still at a pre-pandemic level, while others should grow simply because the economy is expanding. IBES expects EPS NTM to grow at 17% over the next 12 months, which is slightly more realistic in our opinion (Chart 4). The difference with Refinitiv is in the calculation methodology. Our working assumption is that next year’s growth will be within the 12-17% YoY range. From Multiple Expansion To Earnings Growth! Return decomposition demonstrates that in 2020, the S&P 500 return was 26%, with 43% contributed by the multiple expansion, and 19% detracted by the earnings contraction: Over the past year, returns have been borrowed from the future, but this year is payback time. The source of the equity returns is shifting from multiple expansion to earnings growth. This means that 12%-17% expected EPS growth (and possibly more if we get a positive earnings surprise) in the upcoming four quarters will propel the markets higher (Chart 5). Chart 4IBES Expect Next 12 Months Growth To Be 17% Chart 5Earnings Growth Replaces Multiple Expansion As A Driver Of Returns Will the S&P 500 Grow Into Its Big Valuations Shoes? Not So Fast At present, the S&P 500 is trading at 21.3x forward earnings (PE NTM), which is steep compared to a historical average of 18x. PE NTM multiples will compress if earnings growth exceeds index price appreciation. While we do expect multiple expansion to pass the baton to earnings growth over the next 12 months, we are curious to know by how much earnings would have to grow for PE to come down to 18x. To get an answer, we created a scenario analysis matrix, varying price and earnings growth simultaneously. The most likely scenario is for the earnings to grow at 3-5% each quarter over the next 12 months (13-16% annualized) and, assuming that the S&P 500 price does not move, it will trade at 20.5-21x forward earnings multiples. For PE to come down to 18x, earnings would have to grow by more than 10% every quarter, or 30% over the next 12 months, which is way above the growth rates expected by the market. Therefore, we are unlikely to see significant multiple compression without a market correction (Table 2). US equities are expensive, no excuses. Table 2Earnings Have To Grow in Double-Digits For PE NTM To Come Down To 18x Zooming In On The US Equity Market Segments Table 3Style Indices Q2-21 Sales And Earnings GrowthValue Outgrew Growth: Earnings of Value grew 31% faster than earnings of Growth (Table 3). However, looking under the hood, annualized EPS growth of Growth was 16% p.a. since 2019, while EPS of Value contracted by 2% p.a. This means that for many Value companies, the earnings surge is a function of the base effect; earnings have not yet reached their pre-pandemic levels (Chart 6) and have room to run further. Chart 6Small Delivered Spectacular 2019-2021 Growth Small Crushes Earnings: Small Caps' quarterly results have been nothing short of astonishing: EPS in Q2-21 is 10 times higher than during the same quarter a year ago. This growth surge can’t be attributed just to the base effect, as earnings are double what they were two years ago. The S&P 600 has an annualized earnings growth rate over the past two years of 42%, and sales growth of 6.2%. Sectors Sector results are characterized by a powerful rebound of the cyclical sectors: Industrials, Consumer Discretionary, Energy, Materials, and Financials have delivered triple-digit earnings growth, and double-digit sales growth (Table 4). Table 4S&P 500 Sectors' Q2-21 Sales And Earnings Growth However, looking at 2019-2021 CAGR, we observe that the Industrials sector earnings are still 10% below the 2019 level, and the Consumer Discretionary sector has only grown 2% annualized, much slower than the market. The case is the same for Energy. Financials and Materials growth was very strong: The former benefited from the M&A and IPO boom, while the latter has grown thanks to stimulative Chinese policy, which has been tightened lately (Chart 7). Chart 7Cyclical Sectors Did Not Grow Much Since 2019 Despite Recent Profit Rebound Profitability Is Unlikely to Return To A Previous Peak Many companies have tightened their belts during the pandemic to preserve capital in the face of uncertainty. Margins have compressed, but less than expected in such a dire situation. Currently, the majority of sectors has margins close to their historical averages (Chart 8). While most sectors, with exception of Financials and Technology, are below peak margins, it is unlikely that they will be able to return to their former highs. Sales will soar thanks to stimulative fiscal and monetary policies, strong demand by consumers, and inflation. Yet the bottom line may be impeded by the increases in labor and input costs and tighter fiscal policy, which have not yet been priced in by the market. Market Expectations For The Next 12 Months According to IBES, earnings growth will be propelled by the cyclicals, such as Industrials, Consumer Discretionary and Energy (though less so as it is a small sector). These expectations are well aligned with our investment thesis (Chart 9). Chart 8Most Sectors' Margins Are Back To Normal, But Peak Margins Are Elusive Chart 9Cyclical Sectors Are Expected To Grow The Most Over The Next 12 Months Investment Themes Consumers Are Flush With Cash One of our key investment themes is that the US consumer still has plenty of money to spend: Excess savings in the US currently stand at $2.5 trillion, and disposable incomes have been padded by the pandemic helicopter cash drops. While spending on goods had exceeded its historical trend and has recently turned, spending on services is still below pre-pandemic levels (Chart 10). During Q2-2021, Consumer Services earnings grew by 154%, exceeding analyst targets by 27%, though the level of earnings is only 5% above the Q2-2019 level (Chart 11). This suggests that the theme has worked, but also that it has the potential to run further only if not derailed by the fear of COVID-19 variants. However, the approach to investing in this sector needs to be granular, with overweights allocated to service industries such as hotels, restaurants, and leisure (S&P leisure products, S&P hotels, S&P restaurants). Chart 10Real Spending On Services Is At Pre-Pandemic Levels: Room For Further Rebound Chart 11The Consumer Discretionary Sector Growth Will Stay Robust We recommend staying away from Internet Retail (downgrade is pending) and the other sectors that have outsized exposure to consumer goods. Amazon earnings were a case in point: The company disappointed analysts with weaker revenue growth as well as provided a more cautious outlook as it finds it difficult to surpass its stellar pandemic numbers. Brick and mortar retail is likely to fare better, as going out to shop now falls into the “experiences” basket. China Slowdown: Underweight The Materials Sector Chinese growth is slowing, which has an adverse effect on demand for industrial metals (Chart 12). As a result, we have underweighted the Materials sector, along with the Metals and Mining industry. This call was on the money: While Materials more than doubled earnings over the past year, its earnings surprise at 6.40% is the smallest of all the sectors. The Materials sector has underperformed S&P 500 by 8% since the beginning of June. Chart 12Materials Sector Earnings Growth Is Slowing Post-COVID-19 Normalization: Overweight The Health Care Sector We upgraded this sector to an overweight three weeks ago. We intended to add a defensive sector in our portfolio to make it more robust in the face of an imminent market pullback, likely volatility on the back of elevated valuations and the upcoming debt ceiling kerfuffle. This quarter, Health Care posted mixed results despite being among the key beneficiaries of the pandemic. There are several factors at play. One is that some US vaccine manufacturers pledged to produce vaccines at no profit (J&J). Another reason is that the pandemic forced hospitals to halt their non-emergency operations that serve as an important end-demand market for the S&P Health Care sector. Weak Q2-2021 earnings suggest untapped demand for medical services and elective procedures. Just now, hospitals started reopening, and we expect a spike in the number of hospital visits, with positive spillover effects for medical equipment manufacturers and pharmaceutical companies. We are sticking to our overweight unless Delta and Lambda take over the hospital beds. US Manufacturing Renaissance The Industrials delivered triple-digit growth, but the sector’s earnings are still below pre-pandemic levels. There was an earnings growth dichotomy at play. Manufacturing companies that derive a high percentage of earnings from abroad have been affected by a slowdown of Chinese demand and by inflationary pressures. CAT’s recent 20% drawdown in relative terms encapsulates these headwinds. Domestic and services-oriented stocks like railroads reported exceptionally strong demand. Looking ahead, we are constructive on the sector. There is still significant pent-up demand for industrial goods and services, inventories are historically low (Chart 13) and need to be replenished, Federal infrastructure spending is a near certainty, and onshoring of US manufacturing is a new structural theme. Analysts concur: Expected EPS growth for the sector over the next 12 months is 46%. Chart 13Inventories Are At All Time Low Chart 14Value-Growth Earnings Growth Differential Is Closing Rate Stabilization: Overweight Technology and Growth vs Value Technology is one of our core overweights in the portfolio and the sector fared well last quarter. One of the drivers behind the strong quarter is an accelerating shift to remote work as companies re-evaluate the need for offices, especially given the possibility of new virus variants. A similar upbeat message came from the semiconductor industry: A shortage of chips that touches all corners of manufacturing from cars to computers, translates into strong earnings growth, which is likely to continue far into the future. As our BCA colleague, Arthur Budaghyan observed, semiconductor chip manufacturing is becoming a strategic asset, especially in a standoff between China and the US, and the country that controls the production of semis controls the production of most tech goods. We have been overweight Growth vs Value in our portfolios since the beginning of June. Since then, Growth has outperformed Value by about 6%. While Value was growing faster than Growth in Q2-21, the earnings growth expectation between Growth and Value is closing. After a strong run, Growth is expensive again, trading at 28x forward earnings compared to 16x for Value. We expect the yield curve to steepen and yields to rise this fall once workers return to work and the unemployment rate falls further. In other words, we are edging closer to downgrading Growth to neutral; we are just waiting to get more visibility on the Delta variant scare. Upgrade Small vs Large When Rates Rise Again Back in June, we wrote a deep-dive report on Small / Large cap allocation and concluded that an equal-weighted allocation was warranted. This call has not worked so far as Small has underperformed Large by about 5%. Our reasons for not overweighting Small vs Large were manifold: Slowing growth, flattening yield curve, mean reversion of high-yield spreads and, most importantly, a significant downgrade of earnings expectations (Chart 15). Chart 15Small Cap Downgrades Likely Ran Their Course However, we are warming up to Small: Reported earnings and sales growth was impressive. Furthermore, we expect the yield curve to steepen (helping banks in the S&P 600) as people go back to work in September, and rates to go up to as high as 1.8% by the end of the year. When the timing is right, we will swap overweight in the Growth stocks to an overweight in Small. Investment Implications The earnings season was impressive, but growth is returning to trend and is past its peak. The markets expect 12-17% earnings growth over the next 12 months. Earnings growth will pick up the baton from multiple expansion and will propel US equity markets further. Yet returns will be lower than in the past due to a high valuation “speed limit.” The US equity market is expensive, and earnings growth with a 10% handle will not deliver a significant re-rating, while growth rates above 20% are unlikely. We still like the consumer theme: Earnings results were strong, and more growth is expected ahead, especially in the consumer services space. Overweight Health Care: Pent-up demand for elective procedures will propel earnings growth higher. Overweight Industrials which will benefit from the US manufacturing Renaissance over the long term, and from a rebound in earnings growth in response to the inventory restocking cycle and infrastructure spending over the short term. Stay underweight Materials: China slowing will take a toll on the earnings growth of industrial metals miners and on the Materials sector as a whole. Overweight Growth vs Value for now. Watch for a persistent rise in rates and steeping of the yield curve – once that happens, rotate into Value and Small Caps, which thrive in such a macroeconomic environment. Bottom Line The earnings season produced peak growth, and the next phase of the cycle is earnings growth returning to trend. This normalization will be a tailwind for the equity markets and will replace multiple expansion as a driver of equity returns. We are sticking to our overweights in Industrials, Health Care and Consumer Discretionary, and our underweight in Materials. We are reconsidering our overweight in Growth and neutral positioning in Small Caps. Once rates turn up decisively, a rotation into Small and Value is warranted.   Irene Tunkel Chief Strategist, US Equity Strategy irene.tunkel@bcaresearch.com   Recommended Allocation

Highlights Since 2008, the 10-year T-bond yield has struggled to exceed the earnings yield on technology stocks minus a constant of 2.5 percent. Based on the current technology earnings yield of 3.8 percent, and the 10-year T-bond yield at 1.3 percent, stock markets are on the edge of rationality. But at the limit, the elastic can briefly stretch by around 0.5 percent before it eventually snaps back. Hence, the 10-year T-bond yield could make a brief trip to 1.8 percent before reversing. The labour market participation rate for African Americans dropped sharply in July to 2.3 percent below its pre-pandemic benchmark level. The weakest performing demographic group could set the employment condition for the Fed’s lift-off, making it later than the market is pricing. The next shock will drive down the T-bond yield to its ultimate low, and the stock market’s valuation to its ultimate high. Fractal analysis: NOK/GBP, Hong Kong versus the world, and Netherlands versus New Zealand. Feature Chart of the WeekSince 2008, The 10-Year T-Bond Yield Has Struggled to Exceed the Earnings Yield On Tech (Minus A Constant Of 2.5 Percent) Since 2008, a remarkable financial relationship has held true. The 10-year T-bond yield has struggled to exceed the earnings yield on technology stocks minus a constant of 2.5 percent. The 10-year T-bond yield has struggled to exceed the earnings yield on technology stocks minus a constant of 2.5 percent. T-bond yield ≤ technology forward earnings yield – 2.5% (Chart I-1). The upshot is that whenever, as now, the yields on tech and other high-flying growth stocks have become depressed – which is to say highly valued – the upper limit to the bond yield has been established not by the economy, but by the financial markets. On the occasions that the bond yield has attempted to breach its stock market-set upper limit, it has unleashed a self-correcting sequence of events. It has pulled up the tech sector earnings yield, which is to say pulled down the tech sector’s valuation and price. Then, to contain and reverse this sharp sell-off, the bond yield has quickly unwound its short-lived spike. Stock Markets Are On The Edge Of Rationality Earlier this year in The Rational Bubble Is Turning Irrational we highlighted that the T-bond yield was at its stock market-set upper limit. And in the subsequent six months, the markets have behaved exactly as predicted. First, tech stocks declined sharply through February-March. Then, bond yields declined sharply through May-July, allowing tech stocks to claw back their declines and then reach new highs. Indeed, since mid-February, the T-bond yield and tech stocks have moved as a near-perfect mirror image (Chart I-2). Chart I-2The T-Bond Yield And Tech Stocks Have Moved As A Near-Perfect Mirror Image In the long run, a depressed earnings yield relative to the bond yield – which is to say a high valuation – can normalise as earnings go up. But in the short term, the adjustment must come from either the equity price declining or the bond yield declining. Or some combination of the two. With the tech earnings yield now at 3.8 percent – and assuming the post-GFC 2.5 percent minimum gap still holds true – it would set the upper limit of the 10-year T-bond yield at 1.3 percent, close to where it is trading today. Still, at the limit, the elastic can briefly stretch before it eventually snaps back. Over the last thirteen years, the maximum stretch has been around 0.5 percent. This means that, based on the current earnings yield of the tech sector, the 10-year T-bond yield could make a brief trip to 1.8 percent before reversing. For equity investors, a higher T-bond yield would support the value versus growth trade. But given that it would be a brief trip, the opportunity would not be cyclical (12-month) but merely tactical (3-month), as has been the case over the past ten years. Since 2012, cyclical opportunities to overweight value versus growth have been virtually non-existent, but there have been several good tactical opportunities (Chart I-3 and Chart I-4). Chart I-3Cyclical Opportunities To Overweight Value Versus Growth Have Been Virtually Non-Existent... Chart I-4...But There Have Been Several Good Tactical Opportunities We await a fractal signal that T-bonds are overbought to initiate this tactical trade. Stay tuned. The Truth About The Jobs Recovery At first glance, last week’s US employment report appeared strong. The unemployment rate continued its plunge from 14.8 percent in April 2020 to 5.4 percent in July 2021, constituting the fastest jobs recovery of all time. But the first glance doesn’t tell the true story.   Unlike in previous recessions, the number of workers put on furlough or ‘temporary layoff’ surged and then plunged as the pandemic let rip and then was brought under control. Hence, to get the true story of the jobs recovery, we must strip out the furloughed workers and focus on the unemployment rate based on those ‘not on temporary layoff’ (Chart I-5). Chart I-5To Get The True Story Of The Jobs Recovery, Focus On Those 'Not On Temporary Layoff' Based on this truer measure of labour market slack, the pace of the current recovery in jobs looks remarkably like the recoveries that followed previous downturns in 1974/75, the early 1980s, the early 1990s, dot com bust, and the GFC. The true story is that the US is little more than a third of the way on the journey to full employment (Chart I-6). Chart I-6The Pace Of The Current Jobs Recovery Looks Remarkably Like Previous Recoveries This is significant, because unlike in previous recoveries, the Federal Reserve is now explicitly targeting full employment before it lifts the policy interest rate. Furthermore, the employment recovery must be broad and inclusive of minority demographic groups, which adds further conditionality for the Fed. While the market is focussing on the aggregate employment market, it is the weakest performing demographic group that could set the condition for the Fed’s lift-off. On this note, the labour market participation rate for African Americans dropped sharply in July to 2.3 percent below its pre-pandemic benchmark level (Chart I-7). This raises an interesting point. While the market is focussing on the aggregate employment market, it is the weakest performing demographic group that could set the condition for lift-off, if the Fed stays true to its promise of inclusivity. Which would push back lift-off to later than the market is pricing. Chart I-7The Labour Market Participation Rate For African Americans Dropped Sharply In July Shocks Do Not Have A Cycle According to the recovery in jobs then, we are still ‘early cycle.’ Some people argue that early cycle implies that a recession is a distant prospect, that stocks only underperform in a recession, and therefore that the bull market in stocks has further to run. The investment conclusion is right, but the reasoning is wrong, on two counts. First, nobody can predict the precise timing of recessions or shocks. Second, recessions or shocks do not have a ‘cycle.’ Shocks can come in quickfire succession such as the back-to-back GFC in 2008 and the euro debt crisis which started in 2010, or the back-to-back votes for Brexit and Trump in 2016 (Chart I-8). Chart I-8Shocks Do Not Have A Cycle Yet, while we cannot predict the precise timing of shocks, The Shock Theory Of Bond Yields tells us that we can predict their statistical distribution very accurately. The upshot is that in any 5-year period, the probability of (at least) one shock is an extremely high 81 percent, and in any 10-year period, it is a near-certain 96 percent.  Given the tight feedback from bond yields to stocks and then back to bond yields, we can say with high conviction that the next shock will drive down the T-bond yield to its ultimate low. This will happen directly from a deflationary shock, or indirectly from an initially inflationary shock that drives up bond yields through the upper limit set by stock valuations. The resulting sharp correction in stocks will then cause bond yields to reverse to the ultimate low. The next shock will drive down the T-bond yield to its ultimate low, and the stock market’s valuation to its ultimate high. In turn, the ultimate low in the T-bond yield will mark the ultimate high in the stock market’s valuation, and the end of the structural bull market in stocks. Until then, long-term investors should own stocks. Fractal Analysis Update This week’s fractal analysis highlights three recent price moves that are at risk of reversal because of fragile fractal structures. First, the recent sell-off in NOK/GBP has become fragile on its 65-day fractal structure implying a likelihood of a countertrend move based on similar recent signals (Chart I-9). Chart I-9NOK/GBP Is Oversold Second, the sell-off following China’s aggressive crackdown on its technology and private education sectors has created fragility in Hong Kong’s relative performance on its composite 65-day/130-day fractal dimension. Assuming the worst of the policy crackdown is over, this would imply a countertrend reversal based on similar signals over the past decade. The recommended trade is long Hong Kong versus developed world (MSCI indexes), setting the profit target and symmetrical stop-loss at 4 percent (Chart I-10). Chart I-10Hong Kong Versus The World Is Oversold Finally, the massive outperformance of tech-heavy Netherlands versus healthcare and utility-heavy New Zealand has reached the limit of fragility on its 260-day fractal structure that signalled major turning points in 2011, 2015, 2016, and 2018 (Chart I-11). Hence the recommended trade is short Netherlands versus New Zealand, setting the profit target and symmetrical stop-loss at 13 percent. Chart I-11Netherlands Versus New Zealand Is Overbought   Dhaval Joshi Chief Strategist dhaval@bcaresearch.com Fractal Trading System Fractal Trades 6-Month Recommendations Structural Recommendations Closed Fractal Trades Closed Trades Asset Performance Equity Market Performance   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 - 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