Developed Countries

Despite the strong rally in stocks since mid-March and a looming second wave of the pandemic, we continue to recommend that investors overweight equities on a 12-month horizon. Needless to say, this view has raised some eyebrows. With that in mind, this week we present a Q&A from the perspective of a skeptical reader who does not fully share our enthusiasm. Q: You said last week that a second wave of the pandemic is now your base case, yet you’re still sticking with your positive 12-month equity view. Why? A: A second wave of the pandemic, along with uncertainty about how the coming fiscal cliff in the US will be resolved, could unnerve investors temporarily. Nevertheless, we expect global equities to rise by about 10% from current levels over the next 12 months, handily outperforming bonds. While low interest rates and copious amounts of cash on the sidelines will provide a supportive backdrop for stocks, the main impetus for higher equity prices will be a recovery in economic activity and corporate profits. Q: It is hard to see the economy recovering very much if there is a second wave. A: It is important to get the arrow of causation right. Part of the reason we expect a second wave is because we think policymakers will continue to relax lockdown measures even if, as has already occurred in a number of US states, the infection rate rises. Granted, a second wave will moderate the pace at which containment measures can be dismantled. It will also prompt people to engage in more social distancing. Thus, a second wave would make the economic recovery slower than it otherwise would have been. However, it is doubtful that growth will grind to a halt. The appetite for continued lockdowns has clearly waned. For better or for worse, most western nations will follow the “Swedish model” of trying to limit the spread of the virus without imposing draconian restrictions on society. Chart 1CBO Projects The Unemployment Rate Will Fall Very Slowly Q: Even if the Swedish model works, and I doubt it will, we are still in a very deep economic hole. The unemployment rate in many countries is the highest since the Great Depression. The Congressional Budget Office does not foresee the US unemployment rate falling below 5% until 2028. A return to positive growth seems like a very low bar for success. We may need many years of above-trend growth just to get back to the pre-pandemic level of GDP! A: The Congressional Budget Office is too pessimistic in assuming that the recovery will be as sluggish as the one following the Great Recession (Chart 1). That recovery was weighed down by the need to repair household balance sheets after the bursting of a debt-fueled housing bubble. The current downturn was caused by external forces – an exogenous shock in econospeak. Historically, recoveries following exogenous shocks have tended to be more rapid than recoveries following recessions that were instigated by endogenous problems. Q: That may be so, but Wall Street is already penciling in a very rapid recovery. Last I checked, analysts expect S&P 500 earnings next year to be close to where they were last year. A: One has to be careful when comparing earnings estimates with economic growth projections. Chart 2 shows a breakdown of S&P 500 EPS estimates by sector. Appendix A also shows the evolution of these estimates over time. While analysts expect overall earnings per share (EPS) to return to last year’s levels in 2021, this is mainly because of the resilient profit outlook in the technology and health care sectors (the two biggest sectors in the S&P 500 by market cap). Outside those two sectors, EPS in 2021 is expected to be down 8.6% from 2019 levels, or 11.2% in real terms. Chart 2Breakdown Of S&P 500 EPS Estimates By Sector If one looks at the cyclically-sensitive industrials sector, earnings are projected to fall by 16% between 2019 and 2021. Energy sector earnings are projected to decline by 65%. Earnings in the consumer discretionary sector are expected to decline by 8%, despite the fact that Amazon accounts for nearly half of the sector by market cap.1 This suggests that analysts are expecting more of a U-shaped economic recovery than a V-shaped one. Chart 3The Present Value Of Earnings: A Scenario Analysis Q: Fair enough, but I am ultimately more interested in what the market is pricing in than what analysts are expecting. It seems to me that stock prices have rebounded much more rapidly than one would have anticipated based on the evolution in earnings estimates. A: That is true, but it is important to keep in mind that the fair value of the stock market does not solely depend on the expected path of earnings. It also depends on the discount rate we use to deflate those earnings. For the sake of argument, let us suppose that S&P 500 earnings only manage to reach $144 per share next year (10% below current consensus) and take five years to return to their pre-pandemic trend. All things equal, such a decline in earnings would reduce the present value of stocks by 4.2% relative to what it was at the start of the year (Chart 3). However, all things are not equal. The US 30-year Treasury yield, adjusted for inflation, has declined by 59 basis points this year. If we use this real yield as a proxy for the discount rate, the fair value of the S&P has actually increased by 8.7% since January 1st, despite the decline in earnings. Q: I think you’re doing a bit of a bait and switch here. You’re assuming that earnings estimates return to trend by the middle of the decade, but that long-term bond yields remain broadly unchanged over this period. If the economy and corporate earnings recover, won’t bond yields just go back to where they were last year, if not higher? A: Not necessarily. Conceptually, there is not a one-to-one mapping between interest rates and the full-employment level of aggregate demand.2 For example, consider a case where an adverse economic shock hits the economy, making households and businesses more reluctant to spend. If that were all there was to the story, the stock market would go down. But there is more to the story than that. Suppose the central bank cuts interest rates in response to this shock, which boosts demand by enough to return the economy to full employment. Now we have a new equilibrium where the level of demand – and by extension, the level of corporate profits – is the same as before but interest rates are lower. The fair value of the stock market has gone up! Q: Hold on. Central banks came into this recession with little fire power left. I agree that their actions have helped the stock market, but they have not been enough to rehabilitate the economy. A: Good point. That is where the role of fiscal policy comes in. One of the unsung benefits of lower interest rates is that they have incentivised governments to borrow more at a time when the economy needs all the fiscal support it can get. As Chart 4 shows, the fiscal response during this year’s downturn has been significantly larger than during the Great Recession. Thus, it is more correct to say that the combination of lower interest rates and fiscal easing have conceivably increased the fair value of the stock market. Chart 4Fiscal Stimulus Is Greater Today Than It Was During The Great Recession Q:  And yet despite all this fiscal and monetary support, GDP remains depressed. A: The point of the stimulus was not to raise output or employment. It was to keep households and businesses solvent during a time when their regular flow of income had dried up. Q: If households and businesses did not spend much of that money, where did it go? A: Much of it remains in the banking system. The US savings rate shot up to 33% in April. As Chart 5 illustrates, this was almost perfectly mirrored by the increase in bank deposits. Anyone who claims that savings have nothing to do with deposits should study this chart. Chart 5Lots Of Savings Slushing Around   Chart 6Stocks That Are Popular With Retail Investors Are Outperforming Q: And now, I suppose, these deposits are flowing into the stock market? A: Correct. That is one reason why stocks popular with retail investors have outperformed the S&P 500 by 30% since mid-March (Chart 6). Q: Have these retail flows really been important enough to matter? A: They have probably been more important than widely portrayed. Many of the online brokerages touting zero-commission trades make their money by selling order flow to hedge funds. Thus, the trading of individuals is magnified by the trading of institutional investors. More liquid markets tend to generate higher prices. There is also another subtle multiplier effect worth considering. You mentioned that money was “flowing into the stock market.” Technically speaking, “flow” is not the best word to use. For the most part, if I decide to buy some shares, someone else has to sell me their shares. On a net basis, there is no inflow of cash into the stock market. Rather, what happens is that my buy order lifts the price of the shares by enough to entice someone to sell their shares. Thus, if retail investors bid up the price of stocks to the point that institutions are forced to sell, those institutions are now left with excess cash that they have to deploy elsewhere in the stock market. As the value of investors’ stock portfolios rises, the percentage of their net worth held in cash falls. This game of hot potato only ends when the percentage of cash held by investors shrinks to a level that is consistent with their preferences. Importantly, this means that changes in the amount of cash on the sidelines can have a “multiplier” effect on stock prices. For example, if cash holdings go up by a dollar, and people want to hold ten times as much stock as cash, then stock market capitalization has to go up by ten dollars. Q: How far along are we in this game of hot potato? A: Despite the rally in stocks since mid-March, cash held in money market funds and savings deposits is still 10% higher as a share of market capitalization than at the start of the year. This suggests that the firepower to fuel further increases in the stock market has not been fully spent. Chart 7Equity Risk Premium Is Still Quite High Q: Wouldn’t you think that after a pandemic people would be more risk-averse and hence inclined to hold more cash? A: That would be a logical assumption, but it is not clear whether it is empirically true. There is some evidence from the psychological literature that people who survive life-threatening events tend to become less risk averse rather than more risk averse after the event has passed.3 A pandemic seems to qualify as a life-threatening event. In any case, when considering the equity risk premium, we should not only think about the riskiness of stocks; we should also think about the riskiness of bonds. Bond yields are near record lows. To the extent that yields cannot fall much from current levels, this makes bonds a less attractive hedge against downside economic news than they once were. So perhaps the equity risk premium, which is still quite high, should actually be lower than it currently is (Chart 7). Q: It seems that much of your optimism is based on the assumption that policy will stay stimulative. On the monetary side, that seems like a safe assumption. However, as you yourself mentioned at the outset, there is a risk that stocks will be upended by a premature tightening in fiscal policy. A: This is indeed a risk. In the US, the Paycheck Protection Program (PPP) will run out of funds over the coming month. The additional $600 per week in benefits that jobless workers are receiving will expire on July 31st, causing average unemployment payments to fall by about 60%. Direct payments to households have also ceased. Together, these three fiscal measures amount to about 5.5% of GDP. Furthermore, most states begin their fiscal year on July 1st. Despite receiving $275 billion in federal aid, they are still facing a roughly $250 billion (1.2% of GDP) financing shortfall in the coming fiscal year, which could force widespread layoffs. The good news is that both Republicans and Democrats want to avert this fiscal cliff. While negotiations over the next stimulus package could unnerve investors for a while, they will ultimately culminate in a deal. The Democrats want more spending, as does the White House. And if public opinion polls are to be believed, congressional Republicans will also cave in to voter demands for continued fiscal largess (Table 1). Table 1There Is Much Public Support For Fiscal Stimulus Q: It seems to me that the fiscal cliff is not the only political risk to worry about. Tensions with China are running high and there is domestic unrest in many cities around the world. Even if fiscal policy remains accommodative, President Trump will probably lose in November. This makes a repeal of his tax cuts more likely than not. A: It is true that betting markets now expect Joe Biden to become president (Chart 8). They also expect Democrats to regain control of the Senate. My personal view is that Trump has a better chance of being reelected than implied by betting markets. While the protests have hurt Trump’s favorability ratings in recent weeks, ongoing unrest could help him, given his claim of being the “law and order” president. It is worth recalling that after falling for more than 20 years, the nationwide homicide rate spiked by 23% between 2014 and 2016 following protests in cities such as St. Louis and Baltimore (Chart 9). This arguably helped Trump get elected, just like the Watts Riot in Los Angeles helped Ronald Reagan get elected as Governor of California in 1966. Chart 8Betting Markets Now Expect Joe Biden To Become President If Senator Biden were to prevail, then yes, Trump’s corporate tax cuts would be in jeopardy. A full repeal of the Trump tax cuts would reduce EPS of S&P 500 companies by about 12%. Chart 9Continued Unrest May Help Trump, As It Has In The Past However, it is possible that Democrats would choose to only partially reverse the corporate tax cuts, while also lifting taxes on higher-income households. One should also note that trade tensions with China would probably diminish under a Biden presidency, which would be a mitigating factor for equity investors. Chart 10Cyclical Sectors Should Outperform Defensives As Global Growth Recovers... And A Weaker Dollar Should Also Help Non-US Stocks Q: So to sum up, you are still bullish on stocks over a 12-month horizon, although you see some near-term risks stemming from the likelihood of a second wave of the pandemic and uncertainty about how and when the fiscal cliff problem in the US will be resolved. What are your favorite sectors, regions, and styles? A: Cyclical sectors should outperform defensives over the next 12 months as global growth recovers. Cyclicals are overrepresented outside the US, which should favor overseas markets. A weaker dollar should also help non-US stocks (Chart 10). The dollar generally trades as a countercyclical currency, implying that it will sell off as global growth recovers. Moreover, unlike last year, the greenback no longer enjoys the benefit of higher interest rates than those abroad. In terms of style, value should outperform growth. Growth stocks have done very well in a falling interest rate environment (Chart 11). However, interest rates cannot fall much further from current levels. Small caps should outperform large caps, both because small caps are more growth-sensitive and because they tend to be more popular among day traders. Google searches for “day trading” have spiked in the past few months (Chart 12). Chart 11Interest Rates Cannot Fall Much Lower From Current Levels, Which Will Allow Value To Outperform Growth Chart 12Day Trading Is Back In Vogue These Days Beyond the pure macro plays, the pandemic could lead to a number of unexpected changes that have yet to be fully discounted by markets. For example, we will likely see a surge in the demand for automobiles as people shun public transit. The pandemic could also accelerate the reshoring of manufacturing activity, particularly in the health care sector. Contract manufacturing companies with significant domestic operations will benefit. Additionally, more people will move to the suburbs to work from home and escape the virus and rising crime. This could boost the demand for new houses and lift suburban real estate prices. Since most suburbs are built on top of land previously zoned for agriculture, farmland prices could also rise. Appendix A Evolution Of S&P 500 EPS Estimates By Sector Peter Berezin Chief Global Strategist peterb@bcaresearch.com Footnotes 1  Amazon EPS is projected to rise by 54% between 2019 and 2021, from 11% of overall consumer discretionary earnings to 19%. 2 One can see this within the context of the IS-LM model that is taught to economics undergraduates. If the LM curve shifts outward while the IS curve shifts inward, one could end up with the situation where aggregate demand is the same as before, but the equilibrium interest rate is lower. 3  For example, Gennaro Bernile, Vineet Bhagwat, and P. Raghavendra Rau investigated the link between the intensity of early-life experiences on CEO’s attitudes towards risk. Their results suggest that CEOs who witnessed extreme levels of fatal natural disasters appear more cautious in approaching risk. In contrast, those that experience disasters without very negative consequences become desensitized to risk. For details, please see Gennaro Bernile, Vineet Bhagwat, and P. Raghavendra Rau, “What Doesn't Kill You Will Only Make You More Risk-Loving: Early-Life Disasters and CEO Behavior,“ The Journal of Finance, (72:1) February 2017.   Global Investment Strategy View Matrix Current MacroQuant Model Scores

The tape has been behaving oddly recently with up days in the SPX coinciding with green days in the VIX, and even down days in the SPX also corresponding to red days in the VIX. While it may be a temporary fluke, it has caught our attention as it did back in our February 18 Weekly Report when we first flagged it just one day prior to the SPX peak. The VIX is constructed to be nearly 100% inversely correlated with the SPX and once this relationship breaks down it typically spells trouble for the broad market. Importantly, as we highlight in the chart, since late-2017 every time such a breakdown occurred, the broad market subsequently suffered a setback. Keep in mind that a “VIX reading of 35 means that in 30 days the S&P 500 is expected to trade between 10.1% lower and 10.1% higher than its current level”.1 Bottom Line: The rare positive correlation between the SPX and vol warns that a short-term shakeout likely looms in the broad equity market.   Footnotes 1https://us.spindices.com/vix-intro/

While the SPX has now discounted a near fully functioning economy for the rest of the year and beyond (bottom panel), fixed income investors are not in total agreement. In fact, the missing ingredient in giving the green light for equities is a sell-off in the bond market, which financials/banks are currently sniffing out on the back of the reopening of the economy. Until fixed income investors get on the same page as equity investors, the SPX will remain on shaky ground (top panel). Bottom Line: While we remain constructive on the prospects of the broad equity market on the cyclical 9-12 months time horizon, resilience in the fixed income market and uncertainty regarding the Presidential Election outcome are key tail risks to our cyclically sanguine equity market view. Please refer to this Monday’s Weekly Report for additional details.  

Highlights When retail investors invest aggressively and central banks buy assets en masse, economic fundamentals take the back seat and momentum becomes king. Global risk assets are at a fork in the road: either they will relapse meaningfully as they have run well ahead of fundamentals or a budding mania will push global share prices to fresh new highs.   A budding mania is the basis behind our strategy of chasing momentum from this point on. Investors should adjust their strategy based on momentum in global stocks and the broad trade-weighted US dollar in the coming weeks. We are upgrading Chinese stocks from neutral to overweight and downgrading the Korean bourse from overweight to neutral within an EM equity portfolio. Feature Chart I-1Make It Or Break It Moment For US Dollar Global share prices have reached a point where they are no longer oversold. In turn, the trade-weighted US dollar has worked out its overbought conditions and is sitting on major defensive lines (Chart I-1). If the dollar relapses below its technical resistances, it will enter a bear market. Consistently, EM risk assets will enter a bull market. The trajectory of EM risk assets and currencies in the coming months will ultimately depend on what happens to the ongoing global FOMO (fear-of-missing-out) rally. We refer to it as a FOMO rally because both the DM and EM equity rallies have been taking place despite deteriorating corporate profit expectations, as we documented in our June 4 report. Why The FOMO Rally May Still Have Legs There are a number of reasons why this FOMO-driven rally could persist: Chart I-2Helicopter Money In The US First, the Federal Reserve is explicitly targeting higher asset prices, and to achieve this goal it is deploying its “nuclear” arsenal – printing money and monetizing public debt, lending to the private sector as well as buying corporate bonds. US broad money growth is at an all-time high (Chart I-2). Consequently, the risk of a full-blown equity bubble formation in the US cannot be ruled out. If this occurs, all EM risk assets will rally along with the S&P 500. US policymakers are throwing everything into the system to keep financial asset prices inflated. It seems that after any day that the S&P 500 sells off, the Fed or the US administration comes up with some sort of new measure to support the economy and asset prices. Historically, investors have placed a lot of weight on the Fed’s actions. Aggressive measures by the Fed have recently led investors to purchase stocks and corporate bonds, irrespective of the condition of the underlying economy. As a result, share prices worldwide have decoupled from corporate profit expectations (Chart I-3A and I-3B). If US policymakers succeed in lifting US share prices further, every investor will likely chase the rally and the US equity market will become a full-scale bubble. Chart I-3AGlobal Stocks Are Pricing In A Lot Of Good News Chart I-3BSurging EM Share Prices Amid Plunging Forward EPS Chart I-4Retail Investors Have Driven Up Trading Volumes At some point, the bubble will start cracking even if corporate earnings find their way back to a recovery path. When equities make up a large share of investors’ assets, any trigger could lead to marginal sellers outnumbering marginal buyers. As we discuss below, there are plenty of risks that could result in a trigger. Both retail and institutional investors are very averse to losses, and when the market begins to slide, investors will sell their shares simultaneously. The market will plunge. The Fed will be forced to buy stocks to avert the negative impact of falling share prices on the economy. In a nutshell, US equities and corporate bonds have become extremely dependent on the Fed. This might be good news in the short and medium term. Nevertheless, it is negative for the US in the long run. Second, when retail investors rush into the market and actively trade, fundamentals take the back seat. This is what has been occurring since March. Retail investors appear to be especially attracted to crushed or near-bankrupt US stocks as well as popular tech stocks. This is illustrated by the surge in turnover volumes on the Nasdaq as well as in Southwest Airline, Norwegian Cruise Lines and Chesapeake Energy stocks (Chart I-4). Yet the impact of their actions is not limited to these stocks. Stocks are fungible. When retail investors purchase shares of near-bankrupt companies at elevated prices (at higher than fundamentals warrant), institutional investors sell those stocks and move capital to other companies. In aggregate, the stock market index rises.  The ongoing retail investor mania is not solely a US phenomenon. It has become prevalent in many other countries. There are anecdotes that Japanese retail investors have been actively trading Jasdaq stocks, while Korean, Taiwanese and Filipino retail investors have been buying local shares en masse.1  The top panel of Chart I-5 illustrates that Korean individual investors have been accumulating stocks while foreigners have been selling out. In Taiwan, the share of individual investors in equity trading has been rising at the expense of domestic institutional investors (Chart I-5, bottom panel). Retail investors do not do much fundamental analysis, and it should not come as a surprise that share prices have decoupled from their fundamentals (profits) and have gained despite lingering massive risks. Retail investors appear to be especially attracted to crushed or near-bankrupt US stocks as well as popular tech stocks.  Third, the mania phase – the last and most speculative stage – in bubble formation typically lasts between nine and 18 months. This is based on the duration of the mania phase in the Nikkei (1989), the NASDAQ (1999-2000), oil (2008) and Chinese A shares (2014-‘15) (Chart I-6). The retail investor-driven equity mania began in March and is now three months old. If the duration of previous manias is any guide, the current rally could last another six months at least. Chart I-5Strong Retail Buying Is Also Evident In Korea And Taiwan Chart I-6How Long Mania Phase Lasted During Previous Bubbles? Chart I-7China A-Share Bubble: A Divergence Between Stocks And EPS The current equity mania resembles the one in China’s A-share market in 2014-‘15 in two aspects: (1) it is driven by retail investors and (2) it is occurring amid very underwhelming corporate profits. Chart I-7 demonstrates that Chinese A-share prices skyrocketed in H1 2015, despite a deteriorating corporate profit picture. It lasted for a while and ended with a bust without any policy tightening taking place. Finally, retail investors are not quick to give up when they lose money. Having acquired a taste for capital gains over the past few months, retail investors will likely become even more aggressive and will keep buying the dips. In such a scenario, institutional and professional investors may be forced to capitulate and chase risk assets higher. We are at a fork in the road: either retail investors will begin reducing their equity holdings soon, or institutional and professional investors will capitulate and start buying en masse. In the first scenario, stocks will tumble as retail investors rapidly head for the exits. The latter scenario on the other hand will push share prices considerably higher. This is the basis behind our strategy of chasing momentum from this point on. Bottom Line: All financial market manias eventually crash. However, if the market breaks out, the rally could endure for several months. Not chasing the rally will be very painful for portfolio managers. This is why even though we believe the current global equity rally has been a FOMO-driven mania, we recommend to play it if EM share prices break above, and the broad-trade weighted dollar relapses below, current levels. Plenty Of (Disregarded) Risks Chart I-8Number Of New Inflections Is Rising In Large EM Countries Even though global risk assets have been rallying, the global investment landscape remains poor, with plenty of risks. In particular: Geopolitical tensions are bound to rise between the US and China. Taiwan and its semiconductor sector are at the epicenter of the US-China technological and geopolitical standoffs. Timing any escalation is tricky, but Taiwanese stocks are not pricing in these risks. Further, odds are high that North Korea will test a strategic weapon, which will undermine the credibility of President Trump’s foreign policy. This is negative for the KOSPI and the Korean won. An escalation in US-China tensions encompassing technology, Hong Kong, Taiwan and the Koreas is negative for equity markets in China, South Korea and Taiwan alike. Together they account for about 60% of the EM MSCI equity benchmark market cap. Moreover, the China-India skirmish is a risk for Indian stocks. The number of new Covid-19 infections is rising in the majority of EM countries excluding China, Korea and Taiwan as demonstrated in Chart I-8. It will be hard to ameliorate consumer and business confidence and thereby boost spending in these countries amid a worsening trend in the global pandemic. Indeed, a second wave of the coronavirus now hitting Beijing is evidence that even the very efficient Chinese system is not able to prevent pockets of renewed infection outbreaks. This risk still looms large over many advanced and developing nations after the first wave subsides. The post-lockdown natural snapback in economic activity is creating a mirage of a V-shaped recovery. Like any mirage, it can last and drive markets for a while. However, it will eventually fade. When that happens, misalignments in financial markets will be ironed out rather abruptly. A snapback in economic activity around the world is natural following the unwinding of strict lockdowns. Nevertheless, the level of business activity remains very low. Going forward, persistent social distancing, the threat of a second wave and an initial substantial income drawdown will cap the speed of recovery in household and business spending around the world. In our February 20 report titled EM: Growing Risk Of A Breakdown, we contended that the most likely trajectory for Chinese growth is the one demonstrated in Chart I-9. It assumed the plunge in business activity would be succeeded by a rather sharp snap-back due to pent-up demand. However, this snapback would likely be followed by weaker growth in the following months. This is also our roadmap for the business cycles of many DM and EM economies. Even though on May 28 we upgraded our economic outlook for Chinese growth from negative to mildly positive, near-term risks for China-related plays remain. Consistent with the trajectory described above, the Chinese economy has been coming back to life, aided in large part by significant credit and fiscal stimulus (Chart I-10, top and middle panel). Traditional infrastructure investment has accelerated strongly (Chart I-10, bottom panel). Chart I-9Our Roadmap For China’s Business Cycle Chart I-10China: Money/Credit And Infrastructure Are Accelerating   Consequently, mainland demand for commodities has been very robust and raw materials prices have rallied. However, it remains to be seen if the recent strength in commodities purchases can be maintained going forward. A couple of our indicators and market price signals are also suggesting that caution is warranted in the near term with respect to China-related plays. First, our indicators for marginal propensity to spend among households and enterprises continue to deteriorate, even when May data points are included (Chart I-11). These indicators have been good pointers for consumer discretionary spending and business investment/demand for industrial metals, as illustrated in Chart I-11. Chart I-11Marginal Propensity To Spend Is Falling For Consumers And Enterprises Chart I-12Copper: Shanghai/London Premium And Prices   Second, the copper price premium in Shanghai over London has been a good coincident indicator for copper prices and has recently been flagging short-term risks to copper prices (Chart I-12). A rising Shanghai/London copper premium implies more robust demand in China, while a declining premium signals weaker copper demand in the mainland. Finally, share prices of property developers, industrials and materials in the onshore market have failed to advance much (Chart I-13). This fact does not corroborate that there is a strong recovery occurring in China’s broad capital spending outside infrastructure. Chart I-13Chinese Stocks Do Not Corroborate A Strong Recovery A similar message stems from the investable universe of Chinese stocks. We are using the sector indexes from the onshore market because they are less hyped by the global FOMO rally, and the number of companies included in these onshore sector indexes is larger than in the investable indexes. Bank share prices have done even worse (Chart I-13, bottom panel). Overall, near-term risks to China-plays remain and we are looking for a better entry point in the weeks and months ahead. The trend-setting US equity market is expensive, as we corroborated in our report on EM and US equity valuations a month ago. The forward P/E ratio stands at 22, using analysts’ 12-month forward EPS expectations that we believe are still optimistic. Global financial market correlations are presently high, and domestic conditions in EM ex-China, Korea and Taiwan are rather grim. If the S&P 500 relapses for whatever reason, there is little chance EM risk assets will avoid selling off. Bottom Line: Risks are abundant and fundamentals (profits, valuations, geopolitical risks, the ongoing pandemic) do not justify higher share prices. However, if a FOMO-driven rush into stocks persists, financial markets will continue ignoring fundamentals. Investment Strategy: Momentum Is Now King When retail investors invest aggressively and central banks buy assets en masse, it is not the time for fundamental analysis. Indeed, momentum becomes king. Investors should adjust their strategy based on momentum in global stocks and the broad trade-weighted US dollar in the coming weeks. Our composite momentum indicator for global share prices has risen to zero from extremely oversold levels (Chart I-14). Chart I-14Global Share Prices Are At A Critical Juncture If global and EM share prices break meaningfully above their 200-day moving averages and the US dollar breaks materially below its 200-day moving average (see Chart I-1 on page 1), our advice will be for investors to chase the rally. Even if DM and EM share prices break out, the odds are that EM stocks will continue underperforming DM ones. Hence, we continue to underweight EM in a global equity portfolio. The basis is that North Asian equity markets (China, Korea and Taiwan) are at risk of a heightened geopolitical confrontation between the US and China, as per our discussion above. Meanwhile, the remainder of EM is struggling with the pandemic. Hence, EM will continue to underperform, even if global share prices rise a lot. The current equity mania resembles the one in China’s A-share market in 2014-‘15 in two aspects: (1) it is driven by retail investors and (2) it is occurring amid very underwhelming corporate profits. That said, if global stocks and commodities prices break out and the greenback breaks down, we will close our remaining short positions in EM currencies and upgrade our stance on EM fixed-income markets from neutral to bullish. We have been receiving rates in Mexico, Colombia, Russia, India, China, Korea, Pakistan, Ukraine and Egypt, but have been reluctant to take on currency risk. Also, we upgraded our stance on EM credit markets to neutral on June 4. We will likely upgrade EM local currency bonds and EM credit markets further to “buy” if the above-mentioned breakouts transpire. Upgrade Chinese, Downgrade Korean Stocks Chart I-15DRAM And Korean Tech Stocks We are moving China from neutral to overweight and downgrading Korea from overweight to neutral relative to the EM equity benchmark. Regarding Korean equities, the risks are as follows: First, rising threats of North Korea testing a strategic weapon is negative for South Korea’s equities and currency. Second, DRAM prices and volumes are dropping. Chart I-15 shows that the DRAM revenue proxy is falling, a bad omen for Korean tech stocks that derive a lot of operating profits from DRAM sales.  Finally, the Korean bourse is heavy in old-economy stocks, which will experience a slow recovery in their profits from very low levels amid the enduring global trade downturn.  The reasons to upgrade Chinese investable stocks relative to the EM equity benchmark include: As we discussed above, the medium-term growth outlook for China is mildly positive due to the credit and fiscal stimulus Beijing has unleashed. The outlook for domestic demand is worse in many other developing economies. The credit and money bubble in China will inflate further and will pose a major challenge in the years ahead. That said, another round of major credit/money expansion will likely stabilize the system in the medium term. If the FOMO-driven mania continues, FAANG stocks will likely outperform, which will spread to similar stocks around the world. The Chinese investable index includes Alibaba, Tencent and other new economy stocks that will likely outperform the EM benchmark. If global markets correct and EM currencies drop, the Chinese RMB will appreciate relative to most EM exchange rates. This will help China’s equity performance relative to other EM bourses. Finally, if US-China tensions escalate and EM markets sell off, Chinese authorities will support share prices by deploying the national team and other government proxies to buy Chinese stocks. This will help the broad universe of Chinese stocks to outperform the EM benchmark. Chart I-16Long Chinese Investable / Short Korean Equities Bottom Line: We are upgrading Chinese stocks from neutral to overweight and downgrading the Korean bourse from overweight to neutral within an EM equity portfolio. Market-neutral investors should consider the following trade: long Chinese / short Korean equities (Chart I-16).   Arthur Budaghyan Chief Emerging Markets Strategist arthurb@bcaresearch.com   1     Please see the following articles: Coronavirus spawns new generation of Japanese stock pickers Stuck at Home, More Filipinos Try Luck at Stock Investing   Equities Recommendations Currencies, Credit And Fixed-Income Recommendations

Highlights We conservatively estimate lost output from shutdowns and social distancing will equal $10 trillion, and we expect the jobs market to be permanently scarred. Inflation, even at 2 percent, is a pipe dream, which leads to three investment conclusions on a 1-year horizon: Overweight US T-bonds and Spanish Bonos versus German Bunds and French OATs. Any high-quality bond yield that can decline will decline. Overweight CHF/USD. The tightening yield spread will structurally favour the CHF, while the haven status of the CHF should prevent it from underperforming in periods of market stress. Overweight defensive equities (technology and healthcare) versus cyclical equities (banks and energy). This implies underweight European equities versus other markets. Fractal trade: Short Germany versus the UK. The recent outperformance of German equities is technically extended. Feature Chart of the WeekCredit Impulses Are Large, But The Hole In Output Is Much Larger Big numbers befuddle us. Hardly a day passes without someone listing the unprecedented global stimulus unleashed to counter the coronavirus forced shutdowns – the trillions in government spending promises, tax relief, loan guarantees, money supply growth, and central bank asset-purchases. The most optimistic estimates quantify the total stimulus at $15 trillion. This includes $7 trillion of loan guarantees plus increases in central bank balance sheets which do not directly boost demand. So the direct stimulus is closer to $7 trillion.1 Yet the size of the stimulus is meaningless until we quantify the massive hole in economic output that needs to be filled. Assuming no further large-scale shutdowns, we conservatively estimate that the hole will amount to 12 percent of world output, or $10 trillion. A $10 Trillion Hole In Output Last week, the UK’s Office for National Statistics (ONS) helped us to estimate the hole in output, because unusually the ONS calculates UK GDP on a monthly basis. Between February and April, when the UK economy went from fully open to full shutdown, UK GDP collapsed by 25 percent. This despite the UK having an outsized number of jobs suitable for ‘working from home.’ For a more typical economy, we estimate that a full shutdown collapses output by 30 percent (Chart I-2). Chart I-2A Full Shutdown Collapses Output By 30 Percent The next question is: how long does the full shutdown last? Assuming it lasts for three months, output would suffer a hole amounting to 7.5 percent of annual GDP.2  But in practice, the economy will not fully re-open after three months. Social distancing will persist until people feel confident that the pandemic is under control. An effective vaccine against Covid-19 is unlikely to be available for a year. So, even without government policy to enforce social distancing, many people will choose to avoid crowds and congregations for fear of catching the virus. The size of the stimulus is meaningless until we quantify the massive hole in economic output. This means that the sectors that rely on crowds and congregations – leisure and hospitality and retail trade – will be operating at half-capacity, at best. Given that these sectors generate 9 percent of GDP, operating at half-capacity will create an additional hole amounting to 4.5 percent of output. More worryingly, these two sectors employ 21 percent of all workers, so operating at sub-par will leave the jobs market permanently scarred.3 Combining the 7.5 percent existing hole with the 4.5 percent future hole, the full hole in economic output will amount to around 12 percent of annual GDP. As global GDP is worth around $85 trillion, this equates to $10 trillion.  Crucially though, our estimate assumes that a second wave of the pandemic will not force a new cycle of shutdowns. If it does, the hole will become even bigger. Don’t Be Fooled By Money Supply Growth The recent growth in broad money supply seems a big number. Since the start of the year, the outstanding stock of bank loans has increased by around $0.7 trillion in the euro area, and by $1 trillion in both the US and China (Chart I-3 and Chart I-4). This has boosted the 6-month credit impulses in all three economies. Indeed, the US 6-month credit impulse recently hit its highest value of all time, and the combined 6-month impulse across all three blocs equals around $2 trillion (Chart of the Week). Chart I-3Don't Be Fooled By Money Supply Growth In The Euro Area And The US... Chart I-4...And In ##br##China This 6-month credit impulse quantifies the additional borrowing in the most recent six-month period compared to the previous period. Ordinarily, a $2 trillion impulse would create a huge boost to demand. After all, the private sector does not usually borrow just to hold the cash in a bank. Yet in the coronavirus crisis this is precisely what has happened. While the shutdowns lasted, firms drew on existing bank credit lines to build up emergency cash buffers. Therefore, much of the money growth will not generate new demand. While the shutdowns lasted, firms drew on existing bank credit lines to build up emergency cash buffers.  To the extent that this cash is sitting idly in a firm’s bank account, the monetary velocity will decline. Meaning there will be a much-reduced transmission from credit impulses to spending growth. Furthermore, when the economy re-opens, many firms will relinquish the precautionary credit lines. There is no point holding cash in the bank when there are few investment opportunities. Hence, credit impulses will fall back – as seems to be the case right now in the US. QE: The Great Misunderstanding To repeat, big numbers befuddle us. They must always be put into context. No truer is this than when it comes to central bank asset-purchases. The great misunderstanding is that the act of central banks buying assets, per se, drives up those asset prices. Central banks act as lenders of last resort to solvent but illiquid banks and sovereigns. If there is ample liquidity in these markets – as is the case now – then the primary function of central bank asset-purchases is to set the term-structure of interest rates. In turn, the term-structure of global interest rates establishes the prices of $500 trillion of global assets. The prices of these assets are inextricably inter-connected and inter-dependent4 (Chart I-5). Chart I-5The Prices Of $500 Trillion Of Assets Are Inextricably Inter-Connected The great misunderstanding is that the act of central banks buying assets, per se, drives up those asset prices. Yet central banks set no price target for their asset-purchases. They leave that to the market. Moreover, in the context of the $500 trillion of inter-dependent asset prices, the $10-15 trillion or so of central bank asset-purchases to date constitutes chicken feed (Chart I-6). Hence, the mechanism by which asset-purchases work is through the signal they give to the $500 trillion market on the likely course of interest rate policy. This sets the term-structure of interest rates, which in turn sets the required return on all the $500 trillion of assets (Chart I-7). Chart I-6$10-15 Trillion Of QE Is Chicken Feed... Chart I-7...Compared To $500 Trillion Of Assets Priced By The Term-Structure Of Interest Rates As the ECB’s former Chief Economist, Peter Praet, explains: “There is a signalling channel inherent in asset purchases, which reinforces the credibility of forward guidance on policy rates. This credibility of promises to follow a certain course for policy rates in the future is enhanced by the asset purchases, as these asset purchases are a concrete demonstration of our desire (to keep policy rates at the lower bound.)” The credible commitment to keep policy rates near the lower bound for an extended period depresses bond yields towards the lower bound too. But once bond yields have reached their lower bound the effectiveness of central bank asset-purchases becomes exhausted. Three Investment Conclusions The main purpose of this report was to put the $7 trillion of direct stimulus dollars unleashed into the economy into a proper context. With lost output estimated at $10 trillion and the jobs market permanently scarred, inflation – even at 2 percent – is a pipe dream. Moreover, a second wave of the pandemic and a new cycle of shutdowns would inject a further disinflationary impulse. This leads to three investment conclusions on a 1-year horizon: Any high-quality bond yield that can decline – because it is not already near the -1 percent lower bound to yields – will decline. An excellent relative value trade is to overweight US T-bonds and Spanish Bonos versus German Bunds and French OATs (Chart I-8). Long CHF/USD is a win-win. The tightening yield spread will structurally favour the CHF, while the haven status of the CHF should prevent it from underperforming in periods of market stress. Overweight defensive equities versus cyclical equities, with technology correctly defined as defensive, not cyclical. The performance of cyclicals (banks and energy) versus defensives (technology and healthcare) is now joined at the hip to the bond yield (Chart I-9). This implies underweight European equities versus other markets. Chart I-8Bond Yields That Can Decline Will Decline Chart I-9The Performance Of Cyclicals Versus Defensives Is Joined At The Hip To The Bond Yield Fractal Trading System* The recent outperformance of German equities is technically extended. Accordingly, this week’s recommended trade is to go short Germany versus the UK, expressed through the MSCI dollar indexes. Set the profit target and symmetrical stop-loss at 5 percent. In other trades, long euro area personal products versus healthcare achieved its 7 percent profit target at which it was closed. The rolling 1-year win ratio now stands at 65 percent. When the fractal dimension approaches the lower limit after an investment has been in an established trend it is a potential trigger for a liquidity-triggered trend reversal. Therefore, open a countertrend position. The profit target is a one-third reversal of the preceding 13-week move. Apply a symmetrical stop-loss. Close the position at the profit target or stop-loss. Otherwise close the position after 13 weeks. * For more details please see the European Investment Strategy Special Report “Fractals, Liquidity & A Trading Model,” dated  December 11, 2014, available at eis.bcaresearch.com. Footnotes 1 Source: Reuters estimate. 2 A 30 percent loss in output for a quarter of a year (3 months) amounts to a 30*0.25 = 7.5 percent loss in annual output. 3 Using the weights of leisure and hospitality and retail trade in the US economy as a proxy for the global weights. 4 The $500 trillion of assets comprises: real estate $300 trillion, public and private equity $100 trillion, corporate bonds and EM debt $50 trillion, and high-quality government bonds $50 trillion.   Dhaval Joshi Chief European Investment Strategist dhaval@bcaresearch.com Fractal Trading System   Cyclical Recommendations Structural Recommendations Closed Fractal Trades Trades Closed Trades Asset Performance Currency & Bond Equity Sector Country Equity Indicators Bond Yields Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Interest Rate Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations