Developed Countries
Highlights The consensus view seems to be that equities have to cool off in 2020, even if the danger has passed: Recession fears have dissipated as the yield curve has returned to its normal upward-sloping orientation and US-China trade tensions have abated, but equity return expectations are modest following last year’s bonanza. We agree that a bear market is unlikely, but expect a better year than the consensus, … : Bull markets tend to sprint to the finish line, and if the next recession won’t start before the middle of 2021, 2020 should be another strong year for the S&P 500. … even if earnings growth is uninspiring: Multiples almost always expand when the Fed eases from an already accommodative position, and they expand a lot provided the Fed isn’t easing in response to a market bust or financial crisis. We expect that an inflation revival will take the consensus by surprise, but not this year: We think rising inflation will induce the Fed to bring the curtain down on the expansion and the equity bull market, but not until 2021 at the earliest. Feature We spent the last full week before the holidays meeting with clients and prospects on the west coast. As they look ahead to 2020, investors don’t see any major storm clouds on the horizon, but they sense that stocks have run about as far as they can. We agree with the view that neither a recession nor a bear market awaits, but we expect equities will comfortably outdistance bonds and cash. Forced to take a stand on whether the S&P 500 will beat or fall short of the typical consensus expectation for mid-to-high-single-digit gains,1 we would happily bet the over. As we detailed in our last two publications in December, our optimistic take stems from the deliberately reflationary policy being pursued by the Fed and other major central banks. Restoring inflation expectations to its desired range is job number one for the Fed, and its open commitment to doing so ensures that risk assets will have the monetary policy wind at their back for an extended period. The European Central Bank and the Bank of Japan want to rekindle inflation as well, and can be counted upon to maintain easy policy settings. The rest of the world’s central banks will continue to take their cue from their more influential peers, as no one wants the export headwind of a strong currency in a low-growth environment. Earnings growth has been the primary driver of the 11-year-old equity bull market, not multiple expansion. In our base-case scenario, easy monetary policy will encourage multiple expansion, while a less threatening trade climate, and a modest revival in Chinese aggregate demand, will boost economic activity, especially outside of the US. The modest global acceleration provoked by a pickup in Chinese imports will support earnings growth, so that both equity drivers, earnings and multiples, will be moving in the right direction. We anticipate that at least half of the current bull market’s remaining upside will come from multiple expansion, however. Dismaying as it might be for investors with a value bent, our bull thesis is built on the view that today’s fully-to-somewhat-richly-valued stocks will become overvalued before this market cycle is complete. A Stealth Earnings Boom Skeptics of the efficacy of extraordinarily accommodative monetary policy have decried the current bull market as “manipulated,” fed by monetary steroid injections that have inflated asset prices at the cost of undermining the real economy’s future prospects. The data flatly contradict the skeptics’ claims: since the end of February 2009, consensus forward four-quarter S&P 500 earnings expectations have grown at an annualized rate of 9.6% (Chart 1, middle panel), while the forward multiple has expanded at a 4.6% pace (Chart 1, bottom panel). Growth in forward earnings estimates has accounted for two-thirds of the 14.6% annualized appreciation in the S&P 500 (Chart 1, top panel); multiple expansion has only contributed a third. Chart 1A Great Decade For Earnings Chart 2DM Growth Has Been Weak Positioning for a valuation overshoot does not inspire as much confidence as positioning for robust earnings growth. US economic growth has been lackluster since the crisis (Chart 2, top panel), and it’s been downright anemic in Europe (Chart 2, middle panel) and Japan (Chart 2, bottom panel). Few investors foresaw potent earnings growth against that macro backdrop, as aggregate corporate revenue growth ought to converge with nominal GDP growth over time. Only margin expansion could deliver S&P 500 earnings growth above and beyond a meager 4% revenue growth base. As early as 2011, US corporate profit margins looked quite stretched (Chart 3), making further expansion seem improbable. After adjusting for the secular decline in effective corporate income tax rates, corporations’ growing share of national income, the expansion of the high-margin financial sector and the secular decline in debt service costs,2 however, history suggested that profit margins still had room to grow. It would be 2018 before they would peak, thanks in part to the 40% cut in the top marginal corporate income tax rate, and the plunge in debt service costs (Chart 4). Compensation is corporations’ single largest expense, though, and the inexorable decline in labor's share of profits was the key driver (Chart 5). Since China’s entry into the WTO, real wages have failed to keep up with productivity gains (Chart 6), dramatizing the shift of profit share from labor to capital. Chart 3Never Say Die Margin Growth, Nourished On... Chart 4... Rock-Bottom Rates ... Chart 5... And Labor's Woes Chart 6Globalization Has Helped Corporate Profits Profit margins contracted across the first three quarters of 2019, with per-share revenue growth topping per-share earnings growth by an average of three percentage points. We expect that real unit labor costs will rise as the pendulum swings back in labor’s direction in line with an extremely tight job market and a slowdown in outsourcing as globalization loses momentum. Revived activity in the rest of the world can offset some margin pressure from a rising wage bill, however, especially if it helps push the dollar lower. And rising wages aren’t all bad for profits, as rising household income leads to rising consumption, and rising consumption boosts corporate revenue growth. In our base-case 2020 scenario, S&P 500 earnings will grow despite accelerating wage growth. Multiples And The Monetary Policy Cycle Although the S&P 500’s forward multiple is already elevated (Chart 7), the historical relationship between monetary policy and equity multiples argues that re-rating is more likely than de-rating going forward. We divide the fed funds rate cycle (Chart 8) into four phases based on the direction of the fed funds rate (higher or lower) and the state of monetary policy (easy or tight). We are currently in Phase IV, when the Fed has most recently eased policy while policy settings were already accommodative. If margins have finally peaked, multiple expansion will have to assume a bigger role in supporting the bull market. Chart 7Elevated But Not Worrisome Chart 8The Fed Funds Rate Cycle Since consensus earnings estimates began to be compiled in 1979, forward multiples have shrunk when the Fed hikes rates and expanded when it cuts them (Table 1). The empirical results align with intuition and arithmetic: investors should become stingier when the rate used to discount future earnings rises, and more generous when that rate falls. While we believe that the mid-cycle rate cuts are finished and that the fed funds rate will fall no further over the rest of this bull market, continued multiple expansion does not require continued rate cuts. Phase IV usually ends with an extended stretch when the Fed holds the funds rate at its trough level, but forward multiples do not peak until the final stages of the phase. Making the intuition-and-arithmetic statement more exact, investors become more generous when rates fall, and remain that way until a rate hike is a sure bet. Table 1A Consistent Inverse Relationship Away from the last two Phase IVs, when the Fed cut rates in response to the duress issuing from the end of the dot-com mania and the financial crisis, re-rating gains have been significantly larger. Table 2 details the changes in multiples in each Phase IV episode over the last 40 years. Away from the grinding de-rating following the dot-com bust, and the slow re-rating accompanying the tepid post-crisis recovery, multiples have expanded at better than a 17% annualized rate. Voluntary cuts like last summer’s, made when policy is already easy, independent of the imperative to nurse a post-crisis economy back to health, have been awfully good for investors. Table 2Voluntary Cuts Turbocharge Multiples There have been only two instances when the starting multiple has been as high as it was at the start of the latest run of rate cuts. As noted above, conditions in the spring of 2001, when the NASDAQ was a year into its eventual two-and-a-half-year slide, and a recession had just begun, bear little resemblance to conditions today. The fall of 1998, when the Fed delivered a rapid-fire 75 basis points of easing to protect the economy from the potential ramifications of Long Term Capital Management’s failure, looks a lot more like last summer. It is not our base case that the latest round of insurance cuts will push forward multiples to dot-com levels, but they do have scope to expand. The Inflation Timetable It remains our high-conviction view that inflation expectations will not return to the Fed’s target levels quickly. Their path has seemed to provide a nearly perfect real-life case study supporting the adaptive expectations framework, which posits that the recent past exerts a powerful influence on near-term expectations about the future. Inflation is way down the list of investors’ concerns because it has been dormant ever since the crisis, just as it was in the mid-‘60s once memories of high postwar inflation had faded. It conversely remained an acute fear for more than a decade after the Volcker Fed turned the tide in the early ‘80s (Chart 9). Multiples have really surged when the Fed has provided discretionary accommodation outside of periods of distress. The slow but meaningful rise in the trimmed mean PCE (Chart 10, top panel) and CPI series3 (Chart 10, bottom panel) should pull core PCE and core CPI higher over time. In the near term, however, the absence of upward momentum in several leading inflation indicators will likely stretch “over time” beyond the first half of the year, if not the whole year. As tight as the labor market is, unit labor costs have not been able to break out of the range that’s contained them for the last five years (Chart 11, top panel); the New York Fed’s Underlying Inflation Gauge has pulled a disappearing act after a seemingly decisive breakout in mid-2018 (Chart 11, middle panel); and the share of small businesses planning price increases has come off the late 2018 boil (Chart 11, bottom panel). Chart 9Recency Bias In Action Chart 10Inflation's Not Dead, ... Chart 11... But It's Still Hibernating Investment Implications We spent the holidays reading up on the history of strikes in the United States and believe a shift in the balance of negotiating power from management to labor may be stirring, as a two-part Special Report will soon explore. Such a shift would render wages much more sensitive to a lack of labor market slack. Upward wage pressure could then filter into consumer prices either via a cost-push or demand-pull framework, as corporations either seek to defend margins from higher input costs or try to implement opportunistic price hikes. Cost-push or demand-pull, many investors seem to be dismissing the potential for an inflation revival, especially the ones we met in northern California, where the deeply held consensus view asserts that looming job destruction from artificial intelligence makes broad wage growth all but impossible. Inflation is not an immediate concern, but we expect it will ultimately spell the end of the bull market and the expansion. Allocating a generous share of long-maturity Treasury exposures to TIPS is an excellent way to protect a portfolio against its eventual re-emergence. We advise investors to maintain at least an equal weight allocation to equities to profit from our view that ongoing multiple expansion will surprise to the upside. Risk-friendly positioning remains appropriate, as long as intensifying US-Iran tensions or other geopolitical conflicts don’t negate the positive impact of reflationary monetary policy. Doug Peta, CFA Chief US Investment Strategist dougp@bcaresearch.com Footnotes 1 The ten buy- and sell-side strategists surveyed in Barron’s 2020 Outlook, published December 16th, called for an average gain of 4%. 2 Please see the October 2012 BCA Special Report, “Are US Corporate Profit Margins Really All That High?” available at www.bcaresearch.com. 3 Trimmed-mean inflation series operate like figure skating judging in the Olympics – the top and bottom readings are thrown out, and the mean is calculated from the remaining scores.
Feature One of BCA Research’s key geopolitical views since May 2019, outlined recently in our 2020 Outlook, is rapidly materializing: a dramatic escalation in the US-Iran conflict. On January 3 the United States successfully conducted a drone strike against a convoy carrying two high-level targets near the Baghdad International Airport. These were Iranian General Qassim Soleimani and his key Iraqi associate, Abu Mahdi al-Muhandes. The former, Soleimani, was Iran’s most influential military and intelligence leader, and one of its most powerful leaders overall. He was the head of the formidable Quds Force, the overseas arm of the Iranian Revolutionary Guard Corps (IRGC), the staunchest military wing of the regime at home and abroad. The latter target, al-Muhandes, was the head of Iraq’s Kataib Hezbollah militia and the broader coalition of pro-Iran Shiite militias in Iraq known as the Popular Mobilization Forces (PMF). This coalition was partly responsible for defeating the Islamic State in Iraq and Syria. Since then it has sought to consolidate Iranian influence in Iraq, pushing back against Iraqi Sunnis and Shia nationalists, and their allies in the US and Persian Gulf. Chart 1Bull Market In US-Iran Tensions The US assassinations follow a significant increase in Iranian and Iran-backed militant attacks against US allies in the Middle East this year. These stem from a breakdown in the US-Iran diplomatic detente that was enshrined in the 2015 nuclear agreement. President Donald Trump revoked this agreement in 2018 and in May 2019 imposed crippling sanctions on Iran’s oil exports and economy — initiating a “bull market” in US-Iran strategic tensions (Chart 1). Recent events show a clear path of strategic escalation — even in the wake of a summer of “fire and fury” and the extraordinary Iran-backed attack on Saudi Arabia’s Abqaiq oil refinery in September. Widespread popular unrest has dissolved the Iraqi government, creating intense competition between Iraqi nationalists, led by Moqtada al-Sadr, and Iran’s proxies, led by al-Muhandes and the PMF. This unrest marked a significant challenge to Iran’s sphere of influence and necessitated an Iranian backlash. For instance, al-Sadr’s enemies attacked his headquarters with a drone in early December. Meanwhile Kataib Hezbollah launched a spate of rocket strikes against US and Iraqi bases that culminated in the death of an American contractor near Kirkuk on December 28 — crossing an American red line. The US retaliated with damaging air strikes against Kataib Hezbollah in Iraq and Syria on December 29, prompting a PMF blockade of the US Embassy in Baghdad on December 31. While this was a limited blockade, the US has now retaliated by assassinating Soleimani and al-Muhandes, taking the conflict to a new level. There is every reason to expect tensions to escalate further in the new year. First, the Iranian regime is under severe economic stress due to the US sanctions and broader global slowdown (Charts 2A&B). Domestic protests have erupted in recent years, while the regime struggles with economic isolation, a restless youth population, and a looming succession when Supreme Leader Ali Khamenei eventually steps down. This is an existential struggle for the regime, while President Trump may only be in office for 12 months. Public opinion polls show that the Iranian populace blames the government for economic mismanagement, and yet that the renewed conflict with the US under the Trump administration is shifting the blame to US sanctions (Chart 3). Hence the regime will continue to distract the populace by resisting Trump’s pressure tactics. Chart 2ARegime Survival ... Chart 2B... An Existential Challenge Chart 3US Conflict Distracts From Domestic Woes This tendency will be reinforced by the death of Soleimani, which heightens the regime’s vulnerability while rallying domestic support due to Soleimani’s popularity as a leader (Chart 4). The regime is looking to its survival over the long run. It would be a remarkable shift in policy for Tehran to enter negotiations with Trump, since it would then risk vindicating his “maximum pressure” doctrine, possibly helping him secure a second term in office. Chart 4Hard-Line Soleimani Was Popular (Reformist President Rouhani Is Not) Meanwhile President Trump’s circumstances are apparently urging him to double down on his aggressive foreign policy against Iran. First, while he will not be removed from office by a Republican Senate, his impeachment trial threatens to mar his re-election chances. This is a prime motivation to pursue foreign policy objectives to distract the public and seek policy wins. Chart 5Falling Oil Import Dependency Emboldens US Second, the Trump administration may feel emboldened by the rise of US shale oil production and decline in US oil import dependency (Chart 5). Simulations we published in our December 6 Strategic Outlook show that Iran would have to sustain an oil supply cutoff as large as the Abqaiq attack for four months in order to drive gasoline prices high enough to harm the US economy as a whole. This buffer may have convinced Trump he has plenty of room for maneuver in confronting Iran. Third, Trump undoubtedly feels the need to maintain the credibility of his threats against Iran, North Korea, and other nations given his impeachment, widely known electoral and economic vulnerability, and his recent capitulation to China in the trade war. The clear threat by Iran to create a humiliating US embassy crisis in Baghdad likely struck a nerve in the White House, reviving memories of Saigon under Gerald Ford, Tehran under Jimmy Carter, and Benghazi under Barack Obama. By taking the offensive, President Trump has reinforced the red line against the death of American citizens or attacks on US assets. Nevertheless he now runs the risk of driving Iran into further escalation rather than negotiation. Iran is not yet likely to court a full-scale American attack by shutting down the Strait of Hormuz. It is more likely to retaliate via regional proxy attacks, including cutting off oil production, pipelines, and shipping — at a time of its choosing. If Trump’s pressure tactics succeed, it will advance its nuclear program rather than staging large-scale attacks. Investment Conclusions Iraqi instability will worsen as a result of the past month’s events, bringing 3.5 million barrels of daily oil production under a higher probability of disruption than when we first flagged this risk. Supply disruptions there or elsewhere in the region would hasten the drawdown in global inventories and backwardation of prices occurring due to the revival in global demand on China stimulus and OPEC 2.0 production cuts. Continued oil volatility, as in 2018-19, should be expected, but the risk for now lies to the upside as Middle East tensions could cause an overshoot. We remain long Brent crude and overweight energy sector equities. Second, the US election — and hence US domestic and foreign policy over the next five years — could hang in the balance if the Iran conflict escalates to broader and more open hostilities as we expect. President Trump is favored for re-election. Yet we have contended since 2018 that the revocation of the Iran nuclear deal was a grave geopolitical decision that could jeopardize Trump’s economy and hence re-election — and that remains the case. Chart 6Trump 'Maximum Pressure' A Gamble In 2020 Trump was elected in part because he is viewed as strong on terrorism, and the confrontation with Iran and its proxies will reinforce that reputation in the short run. Iranian attacks will also boost Trump’s approval rating, other things being equal. However, much can change by November. Jimmy Carter’s election troubles with Iran point to a serious risk to Trump, as the initial surge in patriotic support could turn sour over time if unemployment rises as a result of any oil shocks (Chart 6). Even George Bush Jr saw a dramatic fall in approval, from a much higher base than Trump, despite foreign policy conditions that were more transparently favorable to him in 2004 than any conflict with Iran will be to Trump in 2020. Trump has campaigned against Middle Eastern wars to a war-weary public, so the rally around the flag effect will not necessarily play to his favor in the final count. It is too soon to speculate about these matters — our view remains unchanged — but the Iran conflict is now much more likely to be a major factor in the US election and Iran is certainly capable of frustrating US presidents. This reinforces our base case that Trump is only slightly favored to win. Moreover his foreign policy conflicts — in Asia as well as the Middle East — ensure that global policy uncertainty and geopolitical risk will remain elevated despite dropping off from the highs reached last year amid the trade war. We remain long pure play global defense stocks on a cyclical and secular basis. We see gold as the appropriate hedge given our expectation that the trade ceasefire and China stimulus will reinforce a global growth recovery despite Middle Eastern turmoil. Higher oil prices push up inflation expectations and limit any benefit to government bonds. Matt Gertken Vice President Geopolitical Strategist mattg@bcaresearch.com
GAA DM Equity Country Allocation Model Update The GAA DM Equity Country Allocation model is updated as of December 31, 2019. The model made two significant changes to its allocations this month. First, the allocation to the US is now neutral from underweight previously; second, Australia becomes the second largest overweight (from underweight previously), largely due to an improvement in liquidity conditions. Japan, the UK and France remain the three large underweight countries, as shown in Table 1. Table 1Model Allocation Vs. Benchmark Weights As shown in Table 2 and Charts 1, 2 and 3, the overall model outperformed the MSCI World benchmark in December by 7 bps, driven by the outperformance from the Level 2 model (17 bps), especially the overweight of Spain and underweight of Japan. The Level 1 model also generated one basis point of outperformance from the slight underweight in the US. Since going live, the overall model has outperformed by 64 bps, with 270 bps of outperformance by the Level 2 model, offset by 58 bps of underperformance from Level 1. Table 2Performance (Total Returns In USD %) Chart 1GAA DM Model Vs. MSCI World Chart 2GAA US Vs. Non US Model (Level 1) Chart 3GAA Non US Model (Level 2) For more on historical performance, please refer to our website http://gaa.bcaresearch.com/trades/allocation_performance. For more details on the models, please see Special Report, “Global Equity Allocation: Introducing The Developed Markets Country Allocation Model,” dated January 29, 2016, available at https://gaa.bcaresearch.com. Please note that the overall country and sector recommendations published in our Monthly Portfolio Update and Quarterly Portfolio Outlook use the results of these quantitative models as one input, but do not stick slavishly to them. We believe that models are a useful check, but structural changes and unquantifiable factors need to be considered as well when making overall recommendations. GAA Equity Sector Selection Model The GAA Equity Sector Model (Chart 4) is updated as of December 31, 2019. The model’s relative tilts between cyclicals and defensives have changed compared to last month. The global growth proxies used in our model have turned bullish, based on rising metal prices and EM currencies appreciating relative to the US dollar. This in turn led the model to reverse its defensive overweight it had instated last month on Consumer Staples and favor more cyclical sectors. The valuation component remains muted across all sectors except Energy. The accommodative stance likely to be implemented by global central banks will continue to lead the model to favor a mixed bag of cyclical and defensive sectors. The model is now overweight five sectors in total, four cyclical versus one defensive sectors. These are Consumer Discretionary, Information Technology, Financials, Materials, and Health Care. Chart 4Overall Model Performance Table 3Overall Model Performance For more details on the model, please see the Special Report “Introducing the GAA Equity Sector Selection Model”, dated July 27, 2016, as well as the Sector Selection Model section in the Special Alert “GAA Quant Model Updates”, dated March 1, 2019 available at https://gaa.bcaresearch.com. Table 4Current Model Allocations Xiaoli Tang Associate Vice President xiaoliT@bcaresearch.com Amr Hanafy Research Associate amrh@bcaresearch.com
Feature Recommended Allocation Since BCA published its 2020 Outlook,1 and the December GAA Monthly Portfolio Update,2 nothing has happened to make us fundamentally change our views. We see the global manufacturing cycle rebounding over the coming quarters, but major central banks remaining dovish. This combination of accelerating growth and easy monetary policy should be positive for risk assets. We accordingly continue to recommend an overweight on equities versus bonds, prefer the more cyclical euro zone and EM equity markets over the US, and selectively like credit (particularly the riskier end of the US junk bond universe). In the 2020 Outlook, we laid out a series of milestones that would indicate how our scenario is playing out: whether we need to reconsider it, or whether we should be adding further to risk (Table 1). Here is how those milestones are progressing. Table 1Milestones For The 2020 Outlook Chinese growth. Total Social Financing picked up in November (CNY1.75 trillion versus CNY619 billion the previous month) and the most recent hard data (notably retail sales and industrial production) showed improvement. But the momentum of credit creation and activity generally remain weak (Chart 1). We expect that Chinese growth will begin to accelerate in early 2020, due to the lagged effect of monetary stimulus in the first half of last year, and easier fiscal policy. Moreover, December’s annual Central Economic Work Conference pointed to greater government emphasis on growth stability.3 The clampdown on shadow banking also seems to be easing (Chart 2). However, we need to see further signs of Chinese growth accelerating before, for example, we become more bullish on Emerging Markets and commodities. Chart 1Chinese Credit And Activity Remain Weak Chart 2Clampdown On Shadow Banking Easing? Trade war. The last-minute agreement to cancel the December 15 rise in US tariffs on Chinese imports represents the “ceasefire” we expected, rather than “phase one” of a more profound agreement. It is still unclear whether previous tariffs will be rolled back (Chart 3). China’s supposed promise to increase imports of US agricultural products from $10 billion a year to $40 billion-$50 billion seems unrealistic. Progress on more fundamental topics such as China’s subsidies for state-owned companies seems far off. For now, President Trump has done enough to minimize the negative impact on the US economy in an election year. But there remains a possibility that trade war reemerges as a risk during 2020. Chart 3How Far The Rollback? Progress against these milestones suggests that our current asset allocation recommendation structure – moderately risk-on, but with hedges against downside risk – is appropriate for now. Global growth. Data confirming the rebound in the manufacturing cycle remain mixed. Economic surprises have generally been positive in the euro zone, but have slipped in the US and Japan, and remain soft in the Emerging Markets (Chart 4). In Germany, the manufacturing PMI slipped back to 43.7 in December, but the Ifo and ZEW surveys both rebounded (Chart 5). There is, however, still little sign that the weakness in manufacturing is spilling over into consumption and services. In Germany, unemployment remains at a record low and wages are strong. In the US, wage growth continues to trend up, and there is no indication in the weekly initial claims data that companies are starting to lay off workers at more than the seasonally normal pace (Chart 6). Market indicators of the cycle are also showing some positive signs. Among commodities, the price of copper – the most cyclical metal – has begun to rise. Chinese cyclical stocks are outperforming defensives. But the US dollar has not yet showed any significant depreciation (Chart 7). Chart 4Economic Surprises Mixed Chart 5Germany Showing Signs Of Bottoming Chart 6No Problems In The Labor Market Chart 7Some Positive Signs From The Markets US politics. President Trump’s approval rating has picked up slightly – we warned that its slipping might cause him to get aggressive on trade or foreign policy (Chart 8). Markets might worry at the possibility of “President Warren” given her focus on increased regulation of industries such as finance, energy, and technology. But she has fallen a little in the polls. Even in liberal California (where the primary will be unusually early next year – March 3), she is only level with Biden and Sanders in opinion polls. Our geopolitical strategists see US politics as one of the key geopolitical risks this year,4 but the risk seems subdued for now. Chart 8Trump’s Approval Rating Stable To Rising Fed tightening. Expansions usually end when inflation rises, either causing the Fed to raise rates to choke it off, or with the Fed ignoring the inflation and allowing debt and asset bubbles to form. Any signs, therefore, that inflation, or inflation expectations, are rising would signal that we are truly in the “end game”. For now, there are no such signs. US inflation is likely to soften over the next six months, as a result of the economic slowdown and strong dollar. And TIPS breakevens imply the market believes the Fed will miss its inflation target by an average of 80-90 BPs a year over the next decade (Chart 9). The Fed is likely to sound very dovish over the coming year. The review of its monetary policy framework, probably to be announced in July, may result in some sort of “catch-up” policy: under this, if inflation undershoots the Fed’s target, the target automatically rises the following year.5 Its efforts to support the repo market, including short-term Treasury securities purchases of $60 billion a month, will increase the Fed’s balance-sheet, and represent a “mini-QE” (Chart 10). The Fed is likely to be reluctant to turn more hawkish ahead of the presidential election. These dovish moves – and continued accommodative policies from the ECB and Bank of Japan – mean that monetary policy will be supportive for risk assets throughout 2020. Chart 9Inflation Remains Subdued These milestones suggest, therefore, that our current asset allocation recommendation structure – moderately risk-on, but with hedges (long cash and gold) against downside risk – is appropriate for now. Chart 10A "Mini-QE"? Equities: We shifted last month to an underweight on US equities, with an overweight on the euro zone, and neutral on Emerging Markets. The US tends to underperform during upswings in the global manufacturing cycle (Chart 11). Europe looks attractive because of its heavy weighting in sectors we like such as Financials, Autos and Capital Goods. Europe’s returns will also be boosted by the appreciation in the euro and pound that we expect (our equity recommendations assume no currency hedging). For EM, we would turn more positive if we saw a clear pickup in Chinese credit and economic growth. Chart 11US Underperforms When Growth Picks Up Chart 12Fed Won't Cut As The Market Expects Fixed Income: Our positive view on global growth implies that long-term rates will rise. We see the US Treasury 10-year yield reaching 2.5% by mid-2020. The market still expects the Fed to cut rates once over the next 12 months. If it stays on hold, as we expect, that slight hawkish surprise would be compatible with a moderate rise in rates (Chart 12). Core euro zone rates might rise by a little less, perhaps by 30-40 BPs, and Japanese government bond yields by 10-15 BPs. We, therefore, continue to recommend a small underweight on duration and an overweight on TIPS which look particularly cheaply valued. Within credit, our preferences are for European investment grade (not as expensive as in the US, and with the ECB buying corporate debt again) and the lower end of the US junk-bond universe (since CCC-rated bonds missed out on 2019’s rally). In a rebounding global economy, the US dollar should depreciate, particularly since it looks somewhat over-valued, and with speculative positions long the dollar. Currencies: In a rebounding global economy, the US dollar should depreciate, particularly since it looks somewhat over-valued (Chart 13), and with speculative positions long the dollar (Chart 14). But its performance is likely to vary depending on the currency pair. Our FX strategists expect the dollar to weaken to 1.18 against the euro and 1.40 against the pound over the next 12 months, and even more against currencies such as the NOK, SEK, and AUD.6 But the dollar is likely to strengthen against the yen (an even more counter-cyclical currency) and against currencies in EM, where central banks will continue to cut rates and inject liquidity aggressively to support their economies. Chart 13Dollar Looks Expensive... Chart 14...And Speculators Are Long Commodities: Supply in the oil market remains tight, with OPEC deepening its production cuts to 1.7 million barrels/day. The crude oil price was held down in 2019 by weakening demand, which should recover along with the cycle in 2020 (Chart 15). Our energy strategists expect Brent to average $67 a barrel in 2020 (compared to $66 now), with WTI $4 lower. Metal prices could rise in 2020 as Chinese growth recovers and the US dollar depreciates – the two most important factors that drive them (Chart 16). Given the uncertainty over both, we remain neutral for now, but would turn more positive (including on commodity-related assets, such as Australian or EM equities) if we see clear signs of their moving in the right direction. We see gold as a good downside hedge in a world of ultra-low interest rates, especially since central banks may allow inflation to overshoot over the coming years. Chart 15Supply/Demand Balance Points To Higher Oil Price Chart 16Metals Are Driven By The Dollar And China Garry Evans, Senior Vice President Chief Global Asset Allocation Strategist garry@bcaresearch.com Footnotes 1 Please see "Outlook 2020: Heading Into The End Game," dated 22 November 2019, available at bca.bcaresearch.com. 2 Please see "GAA Monthly Portfolio Update: How To Position For The End Game," dated 2 December 2019, available at gaa.bcaresearch.com. 3 Please see China Investment Strategy Weekly Report, "A Year-End Tactical Upgrade," dated 18 December 2019, available at cis.bcaresearch.com 4 Please see Geopolitical Strategy "Strategic Outlook: 2020 Key Views: The Anarchic Society," dated 6 December 2019, available at gps.bcaresearch.com 5 For example, if the Fed's inflation target is 2% but inflation is only 1.7% one year, the target would automatically rise to 2.3% the following year. 6 Please see Foreign Exchange Strategy, "2020 Key Views: Top Trade Ideas," dated December 13, 2019, available at fes.bcaresearch.com GAA Asset Allocation
Underweight We would refrain from chasing high yielding real estate stocks higher, and instead we are including them in our high-conviction underweight call list for 2020. The commercial real estate (CRE) sector is a bubble candidate that exemplifies this cycle’s excesses. CRE prices sit at roughly two standard deviations above both the historical time trend and the previous cycle’s peak (not shown). Worryingly, CRE demand is waning. Not only our proprietary real estate demand indicator has sunk recently, but also the latest Fed Senior Loan Officer survey revealed that demand for CRE loans remains feeble. Simultaneously, fewer bankers are willing to extend CRE credit according to the same quarterly Fed survey. Occupancy rates have crested and there are increasing anecdotes of credit quality deterioration. As a result, CRE rents are also failing to keep up with inflation which eats into relative cash flow growth prospects. The supply side build up tilts this delicate balance further into deficit. Non-residential construction shows no signs of abating, with multi-family housing starts still running at an historically high rate of roughly 400K/annum. Finally, interest rate related headwinds will also weigh on this high-yielding sector in coming quarters, especially if the sell-off in the bond market gains steam as BCA expects. The ticker symbols for the stocks in this index are: BLBG – S5RLST – AMT, PLD, CCI, SPG, EQIX, WELL, PSA, EQR, AVB, SBAC, O, DLR, WY, VTR, ESS, BXP, CBRE, ARE, PEAK, MAA, UDR, EXR, DRE, HST, REG, VNO, IRM, FRT, KIM, AIV, SLG, MAC.
Dear Client, In addition to this short weekly report, you will also receive a Special Report on investment themes over the next decade, penned by our colleagues in the US Equity Strategy and Geopolitical Strategy services. The implications for the dollar could be profound, and I hope you will find it insightful. This will be our final publication for the year. We will resume publication on January 10, 2020. Thank you for your readership and wishing you a prosperous New Year. Best regards, Chester Ntonifor Highlights We expect the USD/CAD to fall to 1.20 in the coming months. However, we recommend favoring both the aussie and the euro over the loonie. Stand aside on sterling for now. Feature We expect CAD/USD to gravitate higher in the next few months. In a somewhat hawkish shift, the Bank of Canada kept rates on hold at its last policy meeting. It may however later view this move as a policy mistake, not because the economy was under pressure, but because other central banks have been mostly cutting rates this year (Chart I-1). Upward pressure on the CAD will tighten domestic financial conditions. This will ensure that while CAD/USD may touch 0.80-0.82 cents in the next few months (Chart I-2), it will likely underperform its procyclical peers. Chart I-1Peak ##br##Divergence? Chart I-2Interest Rate Differentials Could Push USD/CAD To 1.20 More recently, Canadian data is beginning to take a surprising turn to the downside. The November jobs report was the worst since the financial crisis. This was the second consecutive monthly drop, with losses spread across both part-time and full-time (Chart I-3). Most importantly, the unemployment rate in Canada has tended to stage powerful V-shaped recoveries, and the rise in November suggests caution (bottom panel). Manufacturing and resources in Quebec, Alberta and British Columbia bore the brunt of the employment declines. Chart I-3Worst Job Report Since 2007 Chart I-4Uneven Housing Recovery Housing remains a pillar of household wealth in Canada, and the recovery in prices remains uneven (Chart I-4). The risk is that this continues to restrain spending in Canada, which has remained weak despite robust wage growth. Nationwide house price growth has slowed to a standstill. A study by the Reserve Bank of New Zealand shows that on average, the elasticity of consumption growth to house price changes is asymmetric to the downside.1 Negative housing shocks tend to hurt consumption by more than the boost received from positive shocks. This makes sense since at very elevated debt levels, leveraged gains are used to pay down debt aggressively, whereas leveraged losses hit bottom lines directly. Housing remains a pillar of household wealth in Canada, and the recovery in prices remains uneven. The increase in the budget deficit next year is mainly due to the increase in pension liabilities (low rates led to lower returns), rather than significant new spending (Chart I-5).2 This means the scope for the BoC to raise rates could be much less compared to other central banks, should the global economy pick up steam next year. Fiscal spending looks much more forthcoming in Europe, Japan and the US (Chart I-6). Chart I-5Projected Federal Budgetary Balance The latest inflation print shows that domestic prices in Canada remain well anchored at the midpoint of the BoC’s target band. However, there are downside risks from the lagged effect of softening producer prices (Chart I-7). Chart I-6Higher Budget Deficits Outside Canada Chart I-7Risk To Canadian Inflation More importantly, terms of trade in Canada have been slowing, especially when compared to its commodity peers (Chart I-8). Rising energy prices, as we expect, will be a tailwind, but the Western Canadian Select discount and persistent infrastructure problems are headwinds. Fiscal spending looks much more forthcoming in Europe, Japan and the US. We favor the aussie over the loonie since the downturn in the Australian housing market appears much further advanced compared to Canada. Historically, policy divergences between the RBA and the BoC have followed the relative growth profiles of their biggest export markets, and the message so far is that the RBA is well ahead of the curve in its dovish bias (Chart I-9). Our expectation is that the recent green shoots in Chinese growth are a prelude to another mini-up cycle, in line with the view of our colleague Jing Sima from BCA’s China Investment Strategy service Chart I-8CAD, AUD, NZD And Terms Of Trade Chart I-9Buy AUD/CAD This week, we are also recommending investors buy EUR/CAD. First, valuations and balance-of-payment dynamics favor the euro versus the Canadian dollar. Second, we estimate there is more scope for long-term interest rate expectations to rise in the euro area than in Canada. This is just a matter of mathematics, since European rates have already fallen to rock-bottom levels. Meanwhile, economic surprises are inflecting higher in the Eurozone relative to Canada (Chart I-10). Chart I-10Buy EUR/CAD EUR/CAD is sitting at the bottom of the upward trending channel that has existed since 2012. On a technical basis, the downside has been eliminated for now. Meanwhile, initial upside resistance rests at the triple top, a nudge above 1.6 (Chart I-11). Chart I-11EUR/CAD Technicals: Limited Downside Housekeeping We were stopped out of our long GBP/JPY trade for a profit of 9.6%. On a tactical basis, we are standing aside for now as volatility could rise, especially amid thin holiday trading. Meanwhile, on a technical basis, EUR/GBP is also due for mean reversion (Chart I-12). That said, our eventual target for GBP/USD is 1.40 for clients willing to stomach the volatility. Chart I-12Tactical Upside For EUR/GBP Chester Ntonifor Foreign Exchange Strategist chestern@bcaresearch.com Footnotes 1 Mairead de Roiste, Apostolos Fasianos, Robert Kirkby, and Fang Yao, “Household Leverage and Asymmetric Housing Wealth Effects - Evidence from New Zealand,” Reserve Bank of New Zealand, Discussion Paper Series, (April 2019). 2 Jordan Press, “Morneau’s fiscal update shows Canada’s deficit increased by billions for next 2 years,” Global News, The Canadian Press, December 16, 2019. Currencies U.S. Dollar Chart II-1USD Technicals 1 Chart II-2USD Technicals 2 Recent data in the US have been mixed: Markit flash manufacturing PMI marginally fell to 52.5, while services PMI increased to 52.2 in December. The New York Empire State Manufacturing index increased to 3.5 from 2.9 in December, while the Philly Fed Manufacturing index fell sharply to 0.3 from 10.4. On the housing market front, NAHB housing market index increased to 76 from 71 in December. Both building permits and housing starts increased by 1.5 million and 1.4 million month-on-month, respectively in November. The DXY index increased by 0.3% this week following the recent plunge. Various dollar indicators continue to point to the downside, including interest rate differentials, the bond-to-gold ratio, portfolio inflows, and rebounding global growth. We went short the DXY index last week. Stay with it. Report Links: Updating Our Balance Of Payments Monitor - November 29, 2019 Place A Limit Sell On DXY At 100 - November 15, 2019 Signposts For A Reversal In The Dollar Bull Market - November 1, 2019 The Euro Chart II-3EUR Technicals 1 Chart II-4EUR Technicals 2 Recent data in the euro area have been mostly positive: Markit manufacturing PMI fell to 45.9 from 46.9 in December, while services PMI increased to 52.4. The trade surplus increased to €24.5 billion from €18.7 billion in October. Headline and core inflation were both unchanged at 1% and 1.3% year-on-year, respectively in November. EUR/USD fell by 0.2% this week. The weaker-than-expected manufacturing PMI releases on Monday were not adequate to alter our positive view on global growth. Both German and Korean exports have been stabilizing, which signals that global trade is on a recovery path. We expect the euro to outperform in the near term and we suggest to play the euro strength via the Canadian dollar. Report Links: Updating Our Balance Of Payments Monitor - November 29, 2019 On Money Velocity, EUR/USD And Silver - October 11, 2019 A Few Trade Ideas - Sept. 27, 2019 The Yen Chart II-5JPY Technicals 1 Chart II-6JPY Technicals 2 Recent data in Japan have been negative: Manufacturing PMI fell marginally to 48.8 from 48.9 in December. The trade deficit widened to ¥82.1 billion in November. Exports and imports both plunged by 7.9% and 15.7% year-on-year, respectively. USD/JPY increased by 0.2% this week. On Wednesday, the BoJ held its interest rate unchanged. With the key short-term cash rate at -0.1%, and asset purchases already tapering, the BoJ has little room to act. On the fiscal front however, the recently announced stimulus package brightens the Japanese economy’s outlook. We continue to recommend the Japanese yen as a safe-haven hedge. Report Links: Updating Our Balance Of Payments Monitor - November 29, 2019 Signposts For A Reversal In The Dollar Bull Market - November 1, 2019 A Few Trade Ideas - Sept. 27, 2019 British Pound Chart II-7GBP Technicals 1 Chart II-8GBP Technicals 2 Recent data in the UK have been mixed: Both Markit manufacturing and services PMIs fell to 47.4 and 49 in December. The ILO unemployment rate was unchanged at 3.8%. Average earnings continued to grow by 3.2% year-on-year in October, however this slowed from 3.7% the previous month. Both headline and core inflation were unchanged at 1.5% and 1.7% year-on-year respectively, in November. Retail sales grew by 1% year-on-year in November. The British pound fell by 2.5% against the US dollar this week, erasing the gains from positive election news last week. Meanwhile, the BoE kept interest rates unchanged at 0.75% as widely expected, with two dissenting members that favored a cut. The pound is likely to stay volatile until January 31st, but the ultimate resting spot for GBP/USD is around 1.40. We will stand aside for now, ahead of thin holiday trading. Report Links: Updating Our Balance Of Payments Monitor - November 29, 2019 A Few Trade Ideas - Sept. 27, 2019 United Kingdon: Cyclical Slowdown Or Structural Malaise? - Sept. 20, 2019 Australian Dollar Chart II-9AUD Technicals 1 Chart I-10AUD Technicals 2 Recent data in Australia have been positive: Both manufacturing and services PMIs fell to 49.5 and 49.4, respectively in December, but the decline was not specific to Australia. 40K new jobs were created in November, including 36K new part-time jobs and 4K new full-time jobs. The unemployment rate fell further to 5.2% in November. The Australian dollar fell by 0.4% against the US dollar this week. In its latest meeting minutes, the RBA stated that “the depreciation (in the Australian dollar) reflected the reduction in the interest differential between Australia and the major advanced economies, and had occurred despite an increase in the terms of trade over this period.” The fact that Australian balance of payments is improving tremendously suggests that the exchange rate is on the cheaper end. Report Links: Updating Our Balance Of Payments Monitor - November 29, 2019 A Contrarian View On The Australian Dollar - May 24, 2019 Beware Of Diminishing Marginal Returns - April 19, 2019 New Zealand Dollar Chart II-11NZD Technicals 1 Chart II-12NZD Technicals 2 Recent data in New Zealand have been positive: The Westpac consumer index increased to 109.9 from 103.1 in Q4. ANZ business confidence increased to -13.2 from -26.4 in December. ANZ activity outlook also increased by 17.2% month-on-month in December. The current account deficit widened to NZ$6.4 billion from NZ$1.1 billion in Q3. The trade deficit narrowed to NZ$753 million from NZ$1,039 million in November. Exports rose 7.6% year-on-year, and imports also increased by 2% year-on-year. GDP growth accelerated by 0.7% quarter-on-quarter in Q3, compared with only 0.1% the previous quarter. NZD/USD fell by 0.4% this week. Both hard data and soft data in New Zealand are starting to look up, which is consistent with our positive view on global growth. The New Zealand dollar is likely to outperform along with the economic expansion in 2020. Report Links: Updating Our Balance Of Payments Monitor - November 29, 2019 Place A Limit Sell On DXY At 100 - November 15, 2019 USD/CNY And Market Turbulence - August 9, 201 Canadian Dollar Chart II-13CAD Technicals 1 Chart II-14CAD Technicals 2 Recent data in Canada have been mixed: Manufacturing sales fell by 0.7% month-on-month in October. Core inflation was unchanged at 1.9% year-on-year in November. Headline inflation, however, soared to 2.2% from 1.9% in November, mostly attributable to higher gasoline prices. ADP recorded an increase of 31K jobs in November, lower than the expectations of 67K. The Canadian dollar rose by 0.4% against the US dollar this week, post the inflation print. While we believe that the loonie will outperform the USD, it is likely to underperform its petrocurrency peers and other high-beta currencies. Please refer to our front section this week for a more in-depth analysis on the loonie. Report Links: Updating Our Balance Of Payments Monitor - November 29, 2019 Making Money With Petrocurrencies - November 8, 2019 Signposts For A Reversal In The Dollar Bull Market - November 1, 2019 Swiss Franc Chart II-15CHF Technicals 1 Chart II-16CHF Technicals 2 Recent data in Switzerland have been negative: The trade surplus narrowed slightly to CHF 2.2 billion in November 2019, the smallest trade surplus since August. The Swiss franc appreciated by 0.4% against the US dollar this week. In the Q4'19 Quarterly Bulletin released this week, the SNB stated that “the franc remains highly valued, and that negative interest rates and the willingness to intervene counteract the attractiveness of Swiss franc investments and thus ease upward pressure on the currency.” Moreover, the SNB lowered its inflation projection compared with the previous forecast in September. Our bias is that EUR/CHF will appreciate in the coming months, as the SNB stems appreciation in its currency. Report Links: Updating Our Balance Of Payments Monitor - November 29, 2019 Notes On The SNB - October 4, 2019 What To Do About The Swiss Franc? - May 17, 2019 Norwegian Krone Chart II-17NOK Technicals 1 Chart II-18NOK Technicals 2 Recent data in Norway have been positive: The trade surplus came in at NOK 18.8 billion in November. This is an improvement compared with a surplus of only NOK 5.9 billion the previous month and a deficit of 1.4 billion in September. The Norwegian krone appreciated by 0.6% this week, supported by rising energy prices. WTI crude oil prices are up 16% since the bottom in October this year. The Norges Bank kept its interest rate on hold at 1.5% this week. The still attractive interest rate differential and positive oil outlook both suggest that the krone will be one of the best performing currencies going into next year. Report Links: Updating Our Balance Of Payments Monitor - November 29, 2019 Making Money With Petrocurrencies - November 8, 2019 A Few Trade Ideas - Sept. 27, 2019 Swedish Krona Chart II-19SEK Technicals 1 Chart II-20SEK Technicals 2 Recent data in Sweden have been positive: The consumer confidence index increased to 94.1 from 92 in December. USD/SEK fell by 0.7% this week. On Thursday, the Riksbank raised its interest rate by 25 bps to 0%, abandoning negative interest rates after almost 5 years. The bank also said in a statement that “the conditions are good for inflation to remain close to the target going forward.” Interest rate differentials are moving in favor of the SEK. Moreover, we believe that the previous weakness in the Swedish krona had been mostly led by soft data, while hard data remain resilient. We continue to recommend long SEK as our high-conviction trade for next year. Report Links: Updating Our Balance Of Payments Monitor - November 29, 2019 Where To Next For The US Dollar? - June 7, 2019 Balance Of Payments Across The G10 - February 15, 2019 Trades & Forecasts Forecast Summary Core Portfolio Tactical Trades Limit Orders Closed Trades
Despite the slowdown in global growth, a stronger dollar, and the trade war, US real final demand is on track to grow by 2.5% this year. This is above the pace of potential GDP growth of 1.7%-to-2%. The Fed’s 75 basis points of rate cuts have moved…
Feature The purpose of this Special Report is to identify and provoke a healthy debate on the prevailing investment themes for the 2020s and to speculate on what the key US sector beneficiaries and likely losers may be. Every decade a dominant theme captures investors’ imaginations and morphs into a bubble. Massive speculation typically propels the relevant asset class into the stratosphere as investors extrapolate the good times far into the future and go on a buying frenzy. Chart 1 shows previous manic markets starting with the Nifty Fifty, gold bullion, the Nikkei 225, the NASDAQ 100, crude oil and most recently the FAANGs. Chart 1Manias: An Historical Roadmap What will be the dominant themes of the next decade? How should investors capitalize on some of these big trends? The purpose of this Special Report is to identify and provoke a healthy debate on the prevailing investment themes for the 2020s and to speculate on what the key US sector beneficiaries and likely losers may be. Theme #1: De-Globalization Picks Up Steam The first investment theme for the upcoming decade is the “apex of globalization” or “de-globalization”. We have written about this theme extensively at BCA Research and it is the mega-theme of our sister Geopolitical Strategy (GPS) service. Odds are high that countries will continue looking inward as the US adopts a more aggressive trade policy, China’s trend growth slows, and US-China strategic tensions intensify. The three pillars of globalization are the free movement of goods, capital, and people across national borders. We expect to see marginally less of each in the future. Chart 2 shows that we are at the conclusion of a period of tranquility. Pax Americana underpinned globalization as much as Pax Britannica before it. The US is in a relative decline after decades of geopolitical stability allowed countries like China to rise to “great power” status and rivals like Russia to recover from the chaos of the 1990s. Chart 2De-globalization Has Commenced De-globalization has become the consensus since the election of Donald Trump. But Trump is not the prophet of de-globalization; he is its acolyte. Globalization is ending because of structural factors, not cyclical ones. And its decline was pre-written into its “source code.” Three factors stand at the center of this assessment, outlined in our 2014 Special Report, “The Apex Of Globalization – All Downhill From Here”: multipolarity, populism and protectionism. Events have since confirmed this view. The three pillars of globalization are the free movement of goods, capital, and people across national borders. We expect to see marginally less of each in the future. Investment Implication #1: Profit Margin Peak The most profound and provocative investment implication from de-globalization is that SPX profit margins have peaked and will likely come under intense pressure, especially for US conglomerates that – on a relative basis to international peers – most enthusiastically embraced globalization. Reconstructed S&P 500 profits and sales data date back to the late-1920s. Historically, corporate profit margins and globalization (depicted as global trade as a percentage of GDP) have been positively correlated (Chart 3). Chart 3Profit Margin Trouble As countries are more outward looking, trade flourishes and openness to trade allows the free flow of capital to take advantage of profit-maximizing projects. Following the Great Recession and similar to the Great Depression, trade has suffered and trade barriers have risen. The Sino-American trade war has accelerated the inward movement of countries, including Korea and Japan, and has had negative knock-on effects on trade as evidenced by the now two-year old global growth deceleration. China’s response to President Trump’s election was to redouble its pursuit of economic self-sufficiency, which meant a crackdown on corporate debt and a fiscal boost to household consumption. Trump’s tariffs then damaged sentiment and trade between the two countries. Any deal reached prior to the 2020 US election will remain in doubt among global investors. The longer the trade war remains unresolved, the deeper the cracks will be in the foundations of the global trading system. Such a backdrop is negative for profit margins, as inward looking countries prevent capital from being allocated most efficiently. Moreover, the uprooting of supply chains due to the trade war hurts margins and the redeployment of equipment in different jurisdictions will do the same at a time when final demand is suffering a setback. In addition, rising profit margins are synonymous with wealth accruing to the top 1% of US families and vice versa. This relationship dates back to the late-1920s, as far back as our dataset goes. Using Piketty and Saez data, which exclude capital gains, it is clear that profit margin expansion exacerbates income inequality (top panel, Chart 4). Chart 4Heightened Risk Of Wealth Re-distribution Expanding margins lead to higher profits. Because families at the top of the income distribution are more often than not business owners, income disparities are the widest when margins are in overshoot territory. Eventually this income chasm comes to a head and generates political discontent. Populism has emerged on both the right and left wings of the US political spectrum – and since the rise of Trump, even Republicans complain about inequality and the excesses of “corporate welfare” and laissez-faire capitalism. Because inequality is extreme – relative to America’s developed peers – and political forces are mobilizing against it, the probability of wealth re-distribution is rising in the coming decades (middle panel, Chart 4). Labor’s share of national income has nowhere to go but higher in coming years and that is negative for profit margins, ceteris paribus (bottom panel, Chart 4). Drilling beneath the surface, the three secular US equity sector/factor implications of the apex of globalization paradigm shift are: prefer small caps over large caps prefer value over growth overweight the pure-play BCA Defense Index Investment Implication #2: Small Is Beautiful While a small cap bias is contrary to the cyclical US Equity Strategy view of preferring large caps to small caps, the issue is timing: the small cap preference is a secular view with a time horizon that spans the next decade. The small versus large cap share price ratio’s ebbs and flows persist over long cycles. Small caps outshined large caps uninterruptedly from 1999 to 2010. Since then large caps have had the upper hand (Chart 5). Were the apex of globalization theme to gain traction in the 2020s, small caps should reclaim the lead from large caps, especially in the wake of the next US recession. Similar to the death of the global banking model, companies with global footprints will suffer the most, especially compared with domestically focused outfits. One way to explore this theme is via domestic versus global sector preference. But a more investable way to position for this sea change, is to buy small caps (or microcaps) at the expense of large caps (or mega caps). Small caps are traditionally domestically geared compared with large caps that have significantly more foreign sales exposure. Chart 5It’s A Small World After All The closest ETF ticker symbols resembling this trade is long IWM:US/short SPY:US. Investment Implication #3: Buy Value At The Expense Of Growth Similar to the size bias, the style bias also moves in secular ways. Value outperformed growth from the dot com bust until the GFC. Since then growth has crushed value, even temporarily breaking below the year 2000 relative trough. This breakneck pace of appreciation for growth stocks is clearly unsustainable and offers long-term oriented investors a compelling entry point near two standard deviations below the historical mean (Chart 6). Chart 6Value Has The Upper Hand Versus Growth Financials populate value indexes, a similarity with small cap outfits. Traditionally, financials are a domestically focused sector with export exposure registering at half of the S&P’s average 40% level of internationally sourced revenues. On the flip side, tech stocks sit atop the growth table and they garner 60% of their revenue from abroad. This value over growth style preference will pay handsome dividends if the de-globalization theme becomes more main stream as countries become more hawkish on trade and the Sino-American war continues to erect barriers to trade that took decades to lift. The caveat? If President Trump strikes a short-term deal with China ahead of the 2020 election, the de-globalization theme will suffer a setback. But our geopolitical strategists expect a ceasefire at best, not a durable deal, and also expect the trade war to resume in some way, shape or form in 2021-22, regardless of the outcome of the US election. The closest ETF ticker symbols resembling this trade is long IVE:US/short IVW:US. Investment Implication #4: Defense Fortress One final long-term playable investment idea from the apex of globalization is a structural bull market in defense stocks (Chart 7). Our October 2016 “Brothers In Arms” Special Report drew parallels with the late nineteenth century period of European rearmament, and the American and Soviet arms race of the 1960s. These movements were greatly beneficial to the aerospace and defense industry. Currently, the move by several countries to adopt more independent foreign policies, i.e. to move away from collaboration and cooperation toward isolationism and self-sufficiency, entails an accompanying arms race. Chart 7Stick With Pure-play Defense Stocks Table 1 China’s challenge to the regional political status quo motivates a boost to defense spending globally. In fact SIPRI data on global military spending by 2030 (Table 1) increases our conviction that this trade will succeed on a five-to-ten year horizon. Beyond the global arms race, two additional forces are at work underpinning pure-play defense contractors. A global space race with China, India and the US wanting to have manned missions to the moon, and the rise of global cybersecurity breaches. Defense companies are levered to both of these secular forces and should be prime sales and profit beneficiaries to rising space budgets and increasing cybersecurity combat budgets. The ticker symbols for the stocks in the pure-play BCA defense index are: LMT, RTN, NOC, GD, HII, AJRD, BWXT, CW, MRCY. Theme #2: Tech Sector Regulation, US Enacts Privacy Laws The second long-term geopolitical theme that we are exploring is the regulatory or “stroke of pen” risk that is rising on FAANG stocks – Facebook, Apple, Amazon, Netflix, and Google. These companies were this decade’s undisputed stock market winners. The US anti-trust regulatory framework was designed to curb broad anti-competitive actions of trusts. As Lina Khan discusses in her seminal article, these actions “include not only cost but also product quality, variety, and innovation.” However, through subsequent regulatory evolution, the Chicago School has focused the US anti-trust process on consumer welfare and prices. If President Reagan and the courts could change how anti-trust laws were administered in the 1980s, so too can future administrations and courts. Today the US Congress, on both sides of the aisle, is looking into regulatory tightening, while the judicial system will take longer to change its approach. Moreover, the impetus for tougher anti-trust policy is here. It comes from a long period of slow growth, income inequality, and economic volatility – such as in the 1870s-80s. This was certainly the case for Standard Oil in 1911, which became a nation-wide boogeyman despite most of its transgressions occurring in the farm belt states. Today, income inequality is a prominent political theme and source of consumer discontent. A narrative is emerging – which will be super-charged during the next recession – that growth has been unequally distributed between the old economy and the twenty-first century technology leaders. With regard to privacy, the news is equally grim for large tech outfits. The EU General Data Protection Regulation (GDPR), which came into force on May 2018, imposes compliance burdens on any company handling user data. In the US, California has signed its own version of the law – the Consumer Privacy Act – which will go into effect in January 2020. These laws give consumers the right to know what information companies are collecting about them and what companies that data is being shared with. They also allow consumers to ask technology companies to delete their data or not to sell it. While tech companies are likely to fight the new California law, and the US court system is a source of uncertainty, we believe the writing is on the wall. The EU is by some measures the largest consumer market on the planet. California is certainly the largest US market of the states. It is unlikely that the momentum behind consumer protection will change, especially with the EU and California taking the lead. The odds of a federal privacy law, following in the footsteps of the Consumer Privacy Act, are also rising. Investment Implication #5: Shun Interactive Media & Services Stocks These risks introduce a severe overhang for FAANG stocks. We are especially worried for the S&P interactive media & services index that includes GOOGL and FB. Tack on the threat of federal regulation and this represents another major headwind for profits and net profit margins that are extremely elevated for these near monopolies. Given that advertising revenue is crucial to the business model of social media companies (GOOGL and FB included), a significant uptick in privacy regulation will likely hurt their bottom line. With regard to profit margins, tech stocks in general command a profit margin twice as high as the SPX. Specifically, FB and GOOGL enjoy margins that are 500 basis points higher than the broad tech sector (Chart 8)! This is unsustainable and will likely serve as easy prey for policymakers. Our view does not necessarily call for breaking up these monopolies. The US will have to weigh the economic consequences of anti-trust policy in a context of multipolarity in which China’s national tech champions are emerging to compete with American companies for global market share. Nevertheless increased regulation is inevitable and some forced sales of crown jewel assets may take place. Moreover, the threat of a breakup will lurk in the background, creating uncertainty until key legislative and judicial battles have already been fought. That will take years. Finally, we doubt the tech sector will be left alone to “self-regulate” its incumbents and negotiate a price on consumers’ privacy. More likely, a new privacy law will loom overhead, serving as a negative catalyst for profit growth. Uncertainty will weigh on the S&P interactive media & services relative performance. Chart 8Regulation Will Squeeze Tech Margins The ticker symbols to short/underweight the S&P interactive media & services index are an equally weighted basket of GOOGL and FB (they command a 98% market cap weight in the index). Theme #3: SaaS, Artificial Intelligence, Augmented Reality And Autonomous Driving Are Not Fads The third big theme that will even outlive the upcoming decade is the proliferation of software as a service (SaaS). The move to cloud computing and SaaS, the wider adoption of artificial intelligence, machine learning, autonomous driving and augmented reality are not fads, but enjoy a secular growth profile. In the grander scheme of things today’s world is surrounded by software. Millions of lines of code go even into gasoline powered automobiles, let alone electric vehicles. Autonomous driving is synonymous with software, the Internet of Things (IoT) needs software, the space race depends on software, modern manufacturing and software are closely intertwined, phone calls for quite some time have been a software solution, and the list goes on and on. This tidal effect is hard to reverse and is already embedded in workflows across industries. Opportunities to penetrate health care and financial services more deeply remain unexplored and it is difficult to envision another competing industry unseating “king software”. These secular trends are not only productivity enhancing, but will also most likely prove recession-proof. When growth is scarce investors flock to any source of growth they can come by and we are foreseeing that when the next recession arrives, investors will likely seek shelter in pure play SaaS firms. Investment Implication #6: Software Is Eating The World Buying software stocks for the long haul seems like a bulletproof investment idea. But the recent stellar performance of software stocks that has moved valuations to overshoot territory. Our recommended strategy is to buy or add software stock exposure on any weakness with a 10-year investment time horizon. All of these secular trends have pushed capital outlays on software into a structural uptrend. Software related capex is not only garnering a larger slice of the tech spending budgets but also of the overall capex pie. If it were not for software capex, the contraction in non-residential investment in recent quarters would have been more severe (Chart 9). Private sector software capex is near all-time highs as a share of total outlays. Government investment in software is also reaccelerating at the fastest pace since the tech bubble. When productivity gains are anemic, both the business and government sectors resort to software upgrades in order to boost productivity. Cyber security is another more recent source of software related demand as governments around the globe are taking such risks extremely seriously (bottom panel, Chart 9). Given this upbeat demand backdrop and ongoing equity retirement, software stocks are primed to grow into their pricey valuations. Chart 9Software Is Eating The World Finally, this long-term trade will also serve as a hedge to the short/underweight position we recommend in the S&P interactive media & services index. The closest ETF ticker symbol resembling the S&P software index is IGV:US. Theme #4: Millennials Already Are The Largest Cohort And Will Dominate Spending The fourth long-term theme we anticipate will gain traction in the 2020s is the demographic rise of the Millennial generation. Much has been made of preparing for the arrival of the Millennial generation, accompanied by well-worn stereotypes of general "failure to launch" as they reach adulthood. However, "arrival" is a misnomer as this age cohort is already the largest and "failure" is simply untrue. According to the U.S. Census Bureau, Millennials are the US’s largest living generation. Millennials (or Echo Boomers) defined as people aged 18 to 37 (born 1982 to 2000), now number more than 80mn and represent more than one quarter of the US’s population. Baby Boomers (born 1946 to 1964) number about 75mn. Stealthily becoming the largest age group in the US over the last few years, Millennials per-year-birth-rate peaked at 4.3mn in 1990. Surprisingly, the pace matched that of the post-war Baby Boom peak-per-year-birth-rate in 1957 - the per-year average over the period was higher for the Baby Boomers (Chart 10). Chart 10Millennials Are The Largest Cohort This gap is now set to grow rapidly as the death rate of Baby Boomers accelerates. What is more, the largest one-year age cohort is only 25 years old, thus, Millennials will be the dominant generation for many years. It is unclear how these “kids” will impact the market as they become the most important consumers, borrowers and investors, but make no mistake: this is a seismic shift in economic power and it is here to stay. The Echo Boom is a big, generational demographic wave. A difficult and painful delay has not tempered its looming importance. Finally, this wave of echo-boomers is educated, relatively unburdened by debt (please see BOX in the June 11, 2018 Special Report on demystifying the student debt load as it pertains to Millennials), and as they inevitably “grow up”, form new households and have kids. They will borrow, spend, earn, but not necessarily save and invest to the same extent as the Boomers. And this will be an important long-term theme going forward. Near term we might already be seeing signs of their arrival and firms have begun to pivot accordingly. Investment Implication #7: Buy The BCA Millennials Equity Basket Millennials will boost consumption spending in a number of different ways. The relatively unburdened Millennial cohort will be entering prime home acquisition age soon and this should underpin the long-term prospects of the US housing market and derivative industries. Further, Millennials consume differently from their parents; social media, online shopping and smart phones are not the consumption categories of the Baby Boomers. With this in mind, we have created a basket of ten stocks that we think will be driven over the long term by the demographic rise of the Millennial. We note that these stocks are heavily weighted to the technology and consumer discretionary sectors, which is logical as Millennial consumption habits tend to be discretionary focused and technology-based. Beginning with consumer discretionary, we are highlighting AMZN, NFLX and SPOT as core holdings in our Millennials basket. AMZN’s heft dwarfs consumer discretionary indexes but it could fall in several categories; the acquisition of Whole Foods makes it a Millennials-focused consumer staples retailer and its cloud computing web services segment is a tech leader. NFLX and SPOT represent the means by which Millennials consume media, by streaming movies and music over the internet. The idea of owning physical media is rapidly becoming an anachronism. The home ownership themes noted in the report above lead us to add HD and LEN to the basket. Millennials are “doers” and are set to be the dominant DIYers in the next few years, making HD a logical choice. LEN, as the nation’s largest home builder, should benefit from the Millennials coming of age into home buyers. We are also adding TSLA to our basket as a lone clean tech-oriented equity. TSLA capitalizes on the increasing shift to clean energy of Millennials (the key reason why no traditional energy companies have a spot in our basket). The technology stocks in our Millennials basket are AAPL, UBER (which replaces FB as of today) and MSFT, together representing more than 9% of the total value of the S&P 500. AAPL’s inclusion in the list is predictable as the leading domestic purveyor of devices on which Millennials consume media content. FB is a predictable holding, with more than half of all Americans being monthly active users, dominated by the Millennial cohort. It has served our basket well since inception, but today we are compelled to remove it and replace it with UBER. UBER is a Millennial favorite and the epitome of the sharing economy. In reality UBER is a logistics company and while it is losing money it is eerily reminiscent of AMZN in its early days. Maybe UBER will dominate all means of transportation and its ease of use will propel it to a mega cap in the coming decade. Our inclusion of MSFT is based on its leadership in cloud computing, a rapidly growing industry. We expect the connectivity and mobile computing demands of Millennials will accelerate. The last stock we are adding to our basket is also the only financial services equity. Though avid consumers, Millennials have shown an aversion to cash, preferring card payment systems, including both debit and credit-based. Accordingly, we are adding the leader in both of these, V, to our Millennials basket (Chart 11). Chart 11Buy BCA’s Millennial Equity Basket Investors seeking long term exposure to stocks lifted by the supremacy of the Millennial generation should own our Millennial basket (AAPL, AMZN, UBER, HD, LEN, MSFT, NFLX, SPOT, TSLA, V). We would not hesitate to add other sharing economy stocks, including Airbnb, to this basket should they become investable in the near future. Theme #5: ESG Becomes Mainstream Investors are increasingly looking at allocating assets based on environmental, social, and governance (ESG) considerations, and this mini-theme has the potential to become a big trend in the 2020s. There are a number of factors that underpin ESG investing. First, Millennials are climate conscious and given that they already are the largest cohort in the US they will not only dominate spending, but also influence election results. Moreover, via social media Millennials can sway public opinion and participate in the ESG conversation. Second, ECB President Christine Lagarde recent speech to the Economic and Monetary Affairs Committee of the European Parliament is a must read.1 If the ECB were to explicitly focus on climate change policy as part of its monetary policy operations then this is a game changer. Green investment financing including “green bonds” could become mainstream. Keep in mind the as reported in the FT “the European Parliament has declared a climate emergency; the new European Commission (EC) has taken office on a promise of an imminent “green new deal”, and Commission president Ursula von der Leyen has vowed to accelerate emissions cuts.” Last Wednesday, the EC released “The European Green Deal” with a pretty aggressive time table. The EC president said “The green deal is Europe’s man on the moon moment” and presented 50 policies slated to get rolled by 2022 to meet revamped climate goals. The implication is that once ESG takes center stage at a number of these institutions it will be easier to become mainstream and propagate the world over. Third, large institutional investors are starting to adopt an ESG mindset, especially pension plans. These investors with trillions of dollars at their disposal can not only disfavor fossil fuel investment, but also undertake investments in “green projects” via private and public equity markets. Banks are also moving in the “greening of finance” direction and given that they are the pipelines of the global plumbing system, swift adoption will go a long way in taking ESG mainstream. Finally, the electric vehicle (EV) proliferation is another key driver on how the ESG theme will play out in the 2020s. As a reminder, in the US 50% of all energy consumption is gasoline related linked to automobiles. While battery technology still has limitations, EV is no longer a fad as the German and Japanese automakers are starting to make inroads on TSLA. These car manufacturers do not want to be left out, especially if this shift toward EV becomes mainstream in the 2020s. The Chinese are not far behind on the EV manufacturing front, however government policy can really become a game changer. If a number of countries and/or California mandate a large share of all new vehicles sold be EV, then the investment implications will be massive. Investment Implication #8: Avoid Fossil Fuels, Gambling, Alcohol And Tobacco… While there are a few ESG related ETFs, we would rather explore this theme’s investment implications of sectors to avoid in the coming decade. We are believers that ESG criteria will continue to gain in importance in institutional investment management decisions. Accordingly, we would tend to avoid ‘sin stocks’, including gambling, tobacco and alcohol; demand for their services is unlikely to decline but investment weightings should mean that share prices will underperform. Further, we think a clean energy shift will mean energy stocks will likely continue to be long-term underperformers (Chart 12). Chart 12Areas To Avoid As ESG Becomes Mainstream Final Thoughts On The US Dollar In this report, we tried to focus on the upcoming decade’s big themes that we deem will play out, and centered recommendations on US equities/sectors. We do not want to neglect some macroeconomic variables that tend to mean revert over time. Specifically, the US dollar, interest rates and most importantly US indebtedness, will also be key drivers of investment theses in the 2020s. Currently, debt is rising faster than nominal GDP growth with the government and non-financial business debt-to-GDP profiles on an unsustainable path (second panel, Chart 13). Granted, the saving grace has been generationally low interest rates as the debt service ratios have fallen (top panel, Chart 13). However, if the four decade bull market in Treasury bonds is over, or may end definitively with the next US recession sometime in the early 2020s, then rising interest rates are the only mechanism to concentrate CEOs’ and politicians’ minds. On the dollar front, Chart 14 highlights the ebbs and flows of the trade-weighted US dollar since it floated in the early-1970s. The DXY index has moved in six-to-ten year bull and bear markets. The most recent trough was during the depths of the Great Recession, while the (tentative?) peak was in late-2016. If history repeats, eventually the dollar will mean revert lower in the 2020s, especially given the fiscal profligacy of the current administration that may continue into 2024, assuming President Trump gets re-elected next November. Chart 13Unsustainable Debt Profiles Chart 14Greenback’s Historical Ebbs And Flows The US dollar remains the reserve currency of the world today, but that exorbitant privilege is clearly fraying on the edges as the balance-of-payments dynamics are heading in the wrong direction. Over the next five years, the US Congressional Budget Office (CBO) estimates that the US budget deficit will swell to 4.8% of GDP. Assuming the current account deficit widens a bit then stabilizes (usually happens when global growth improves), this will pin the twin deficits at 8% of GDP. This assumes no recession, which would have the potential to swell the deficit even further. The US saw its twin deficits swell to almost 13% of GDP following the financial crisis, but the difference then was that in the wake of the commodity boom the dollar was cheap (and commodity currencies overvalued). The subsequent shale revolution also greatly cushioned the US trade deficit. Shale productivity remains robust and US output will continue to rise, but the low-hanging fruit has already been plucked. Another dollar-negative force is its expensiveness. By rising 35% since its trough, the USD has sapped the competitiveness of the US manufacturing sector, which is accentuating the American trade deficit outside of the commodity sector (Chart 14). If the ESG trend ends up hurting oil prices, the US current account will follow the widening deficit in manufactured products. Moreover, the US is lagging Europe on the green revolution. Either the US will have to import green technologies, or the US government will have to provide more subsidies to the private sector. Either way, both of these dynamics will hurt the US current account deficit further. Historically, the currency market is the main vehicle to correct such imbalances. Chart 15Twin Deficits Will Weigh On The US Dollar The apex of globalization will also hurt the greenback. In a world where all the markets are integrated, borrowers in EM nations often use the reserve currency to issue liabilities at a lower cost. This boosts the demand by EM central banks for US dollar reserves to protect domestic banking systems funded in USD. Moreover, some countries like China implement pegs (both official and unofficial) to the US dollar in order to maintain their competitiveness and export their production surpluses to the US. To do so they buy US assets. If the global economy becomes more fragmented and the Sino-US relationship continues to deteriorate structurally as we expect, then these sources of demand for the dollar will recede. Overlay the widening US current account deficit, and you have the perfect recipe for a depreciating trade-weighted US dollar. Finally, the US is likely to experience more inflation than the rest of the world following the next recession. The US economy has a smaller capital stock as a share of GDP than Europe or Japan, and American demographics are much more robust. This means that the neutral rate of interest is higher in the US than in other advanced economies. As a result, the Fed will have an easier time generating inflation by cutting real rates than both the ECB and the BoJ. Higher inflation will ultimately erode the purchasing power of the dollar and prove to be a structurally negative force for the USD. Anastasios Avgeriou US Equity Strategist anastasios@bcaresearch.com Matt Gertken Geopolitical Strategist mattg@bcaresearch.com Marko Papic Chief Strategist, Clocktower Group marko@clocktowergroup.com Chester Ntonifor Foreign Exchange Strategist chestern@bcaresearch.com Mathieu Savary The Bank Credit Analyst mathieu@bcaresearch.com References Please click on the links below to view reports: Peak Margins - October 7, 2019 The Polybius Solution - July 5, 2019 War! What Is It Good For? Global Defense Stocks! - October 31, 2018 The Dollar: Will The U.S. Invoke A "Nuclear" Option? - August 30, 2018 Is The Stock Rally Long In The FAANG? - August 1, 2018 Millennials Are Not Coming Of Age; They Are Already Here - June 11, 2018 Brothers In Arms - October 31, 2016 The End Of The Anglo-Saxon Economy? - April 13, 2016 Apex of Globalization - November 12, 2014 Footnotes 1 https://www.imf.org/en/News/Articles/2019/09/04/sp090419-Opening-Statement-by-Christine-Lagarde-to-ECON-Committee-of-European-Parliament