Sectors
Highlights Portfolio Strategy The strong U.S. dollar is tightening global liquidity conditions, putting the post-election jump in stock prices at risk unless growth imminently accelerates. The spike in large cap industrial stocks represents a massive knee-jerk overreaction and we are adding the sector on our high conviction underweight list. Take profits in the S&P air freight & logistics group and cut to neutral, and downgrade the S&P electrical components & equipment group to underweight. Recent Changes S&P Air Freight & Logistics - Take profits of 6% and reduce to neutral. S&P Electrical Components & Equipment - Trim to underweight from neutral. S&P Industrials Sector - Add to our high-conviction underweight list. Table 1 Feature Equities are still in a post-election honeymoon phase. The savage reaction in the bond market has not yet backlashed onto the broad stock market. Instead it has sparked a rapid and powerful rotation in intra-sector capital flows. The danger is that an unwinding of the momentum trade in the bond market is being misinterpreted as a pro-growth, pro-cyclical investment shift. Investors appear to be equating a potential increase in economic growth with better profitability. However, basing equity strategy on unknown future policies is fraught with risk, as is equating GDP with corporate profits. Trump's signature policies, protectionism and fiscal spending, are inflationary and U.S. dollar bullish, and the timing of implementation and ultimate size of spending programs, remain anyone's guess. In a closed economy driven more by consumption than investment, a strong currency can be supportive via increased purchasing power and a dampening in corporate sector input costs. But what's good for the economy should not be automatically extrapolated through to profits. Net earnings revisions fall when the currency is strong (Chart 1). Capital has won out handily vs. labor since the Great Recession, which allowed profits to boom even though economic growth was below-potential. This is changing. Labor costs are now on the upswing, and productivity has deteriorated. If the economy strengthens, it may only serve to boost wage inflation. If labor expenses accelerate, it becomes even more critical for corporate sector sales to regain traction in order to offset the squeeze on profit margins. However, just under half of S&P 500 sales come from abroad. A strong U.S. dollar means the U.S. will be importing deflationary pressures, undermining pricing power. U.S. dollar appreciation also saps growth in developing countries. Emerging market capital spending is already contracting (Chart 2), and as shown last week, financial strains are flaring back up. Ergo, U.S. companies will be less competitive, and selling into weaker demand growth abroad. Chart 1A Strong Dollar Will Sink Profits... Chart 2... And Hit Global Growth Chart 3 shows that S&P 500 sales typically contract during major dollar bull markets. A recovery has only occurred once currency depreciation occurs. The equity market reaction has been mixed during these periods, as a strong dollar has capped growth and pushed down Treasury yields, supporting a valuation expansion. We do not recommend positioning for a bullish equity outlook, given already overvalued conditions and the rise in government bond yields. It is notable that the inflation component of yields has done the heavy lifting, rather than an upgrading in economic expectations (Chart 4). In other words, there is a sequencing issue, a strong currency saps profits now, while stimulus may only arrive much later. U.S. dollar-based global financial liquidity is now contracting as a consequence of U.S. dollar strength (Chart 4). If excess liquidity and low rates were the argument for supporting high valuations previously, tighter liquidity and rising rates can't also justify current multiples, especially if global growth is soft. As discussed in our November 3, 2014 Special Report, currency strength favors a mostly non-cyclical, domestically-oriented portfolio structure. One of our favored themes over the past few months has been to tilt portfolios in favor of domestic vs. globally-oriented industries. With the U.S. dollar breaking above its trading range, a catalyst now exists to spur an imminent recovery in the domestic vs. global share price ratio. The latter had become extremely oversold as the U.S. dollar consolidated and the Chinese economy began to stabilize, but economic fundamentals are shifting decisively back in favor of the U.S. The U.S. PMI is already making small strides vs. the Chinese and euro area PMI (Chart 5, second panel), heralding a rebound in the cyclical share price momentum. Chart 3No Sales Recovery Ahead Chart 4Tighter Liquidity, Rising Inflation Chart 5Domestic Will Beat Global World export growth remains anemic, and world export prices continue to deflate, albeit at a lesser rate. Sagging Asian currencies warn that trade is at risk, over and above protectionist rhetoric and/or policies. When compared with the reacceleration in U.S. retail sales, the outlook for domestic-sourced profits is even brighter. We reiterate our theme of tilting to domestic vs. globally-oriented industries. The bottom line is that the outlook for the broad averages has soured as a consequence of a strong dollar, rising yields and the prospect for tighter Fed policy. These dynamics augur well for domestic vs. global bias, small vs. large caps and defensive vs. cyclical sector strategy. This week we are taking some cyclicality out of our portfolio following the wild market gyrations in the past two weeks. Taking Advantage Of The Industrials Sector Overreaction... Industrials have vaulted higher, in relative terms, on the back of hopes for rampant fiscal stimulus and infrastructure spending as far as the eye can see, ignoring any negatives that may arise from protectionist policies and tighter monetary conditions. While defense contractors may see an increase in activity (we continue to recommend an overweight in the BCA defense index), in aggregate, the surge in the large cap industrials sector is an opportunity to retool exposure from a position of strength. Large cap industrials companies garner approximately 45% of their revenue from outside the U.S. The industrials sector has the second worst track record among all sectors during U.S. dollar bull phases, trailing only the materials sector. Regression analysis shows that industrial sectors sales would contract by 4.5% for every 10% in the trade-weighted dollar (Chart 6). Without revenue growth, it is hard for industrial companies to generate good profitability, given high operating leverage. The U.S. dollar surge is a direct threat to any benefit from an increase in domestic infrastructure spending. Commodity prices key off the U.S. dollar. Emerging markets (EM) are also sensitive to the currency. A strong U.S. dollar undermines income in commodity producing countries, creates financial strains related to EM foreign currency denominated debt and reins in domestic liquidity in countries that need to intervene to stop their currencies falling too far lest capital flight and inflation occur. As noted last week, emerging market currencies are already rolling over, and CDX spreads have begun to widen (Chart 7). EM equity markets are underperforming the global benchmark, reinforcing the lack of a regional growth impulse (Chart 7). It is rare for the industrial sector to deviate from relative EM equity performance. There has been no evidence of EM deleveraging, and the back up in global bond yields represents a financial stress. If U.S. industrials stocks are a high-beta play on EM, then contrarians should beware recent sector action. Chart 6Top-Line Trouble Ahead Chart 7Sell The Spike Importantly, capital spending is in retreat. Business investment is a function of confidence and expected return on investment. The gap between the return on and cost of capital is narrowing fast (Chart 8). Free cash flow is paltry, especially in resource sectors, major industrial sector end markets. It is hard to envision a major capital spending turnaround if the U.S. dollar keeps climbing and the cost of capital backs up further. Policy ambiguity will act as a weight for at least the next few quarters. During this period, the negative profit impact of the contraction in private and public sector construction activity will ultimately re-exert a major influence on sector risk premia. It will take at least several quarters before any hoped for fiscal spending will benefit industrial companies. Industrials sector pricing power has shifted from a deep negative to neutral. However, that appears to represent an unwinding of the rate of change shock more than a resumption of conditions conducive to companies lifting selling prices. Chart 9 shows that capital goods import price are still deflating. As the Chinese currency devalues, putting downward pressure on its regional counterparts, deflationary pressures will re-intensify for U.S. industrial firms (Chart 9). Chart 8Fiscal Stimulus Is Needed... Right Now! Chart 9The Dollar Will Do Damage ...By Selling Electrical Components & Equipment ... In terms of specifics, were we not underweight machinery shares already, we would institute a high conviction underweight today. In addition, the S&P electrical equipment and components (ECE) index looks equally vulnerable. While less exposed to commodity prices than machinery stocks, ECE shares have benefited alongside the overall sector from the post-election buying frenzy. Hefty short positions likely played a large role in powering the spike (Chart 10), and we are uncomfortable with paying a premium valuation for a dubious earnings outlook, particularly given the sector's brutal long-term track record during U.S. dollar bull markets (Chart 11, top panel, the currency is shown inverted). From a cyclical perspective, it is premature to position for a reversal in the relative earnings bear market. New orders for electric equipment are sensitive to EM currency movements. The current message is that new orders are likely to languish (Chart 11). Relief is not imminent from domestic sources. Chart 11 shows that real investment spending on electrical equipment is contracting at a steep rate. That is consistent with the trend in overall construction spending, which represents a long-term headwind. It is no surprise that industry productivity growth is contracting (Chart 11), reinforcing that the path of least resistance for profits is lower. It would take a major resurgence in top-line growth to restore productivity to positive levels. The ECE industry is one of the few 'smokestack' parts of the economy to have added capacity in recent years. That is confirmed by persistent growth in ECE wage inflation (Chart 12). Without a pickup in demand, this backdrop is conducive to ongoing deflation (Chart 12, bottom panel). Sell into strength. Chart 10Short Covering Will Not Last... Chart 11... As Fundamentals Erode Chart 12Cost Structures Are Too High ...And Taking Profits In Air Freight Stocks ... Elsewhere, we are taking profits on our overweight S&P air freight & logistics index. While we only recently went overweight in early-September, a much shorter time horizon than our desired cyclical calls, we are concerned that the index has front run an improvement in global trade that may be slow to materialize. Our upgrade was predicated on a tightening in inventories relative to GDP, which boosts the need for just-in-time air freight services, as well as a pickup in emerging markets activity. However, our confidence in the latter has been shaken. Air freight stocks are a reflation play, and a surging U.S. dollar is a threat to global liquidity (Chart 13). Global revenue ton miles have already crested after a muted rebound (Chart 14, second panel). Chart 13A Reflation Play Chart 14Take Profits Moreover, protectionist/anti-globalization sentiment may heat up, representing a risk to a recovery in global trade. The IFO export expectations index continues to sink, a warning for relative forward earnings estimates (Chart 14). The contraction in transport and warehousing hours worked confirms that transport activity is not yet on the mend (Chart 14). Relative performance has a history of violent oscillations, and the price ratio has soared to the top end of its multiyear range. Thus, even though the structural increase in online sales bodes well for long-term growth, and value remains appealing, we are booking profits and reducing positions in this globally-exposed group back to neutral in order to de-risk in our portfolio. Bottom Line: Take profits of 6% in the S&P air freight & logistics index and reduce to neutral. Downgrade the S&P electrical equipment index to underweight and add the overall industrial sector to our high conviction underweight list. The ticker symbols for the stocks in these indexes are: BLBG: S5AIRF - UPS, FDX, CHRW, EXPD, and BLBG: S5ELCO - AME AYI EMR ETN ROK. Current Recommendations Current Trades Size And Style Views Favor small over large caps and growth over value.
Highlights The U.S. accounts for 18% of Chinese exports, while China accounts for only 8% of American overseas sales, which puts China at a disadvantage in a full-blown trade war. However, China has become an increasingly important export destination of American companies in recent years, while the significance of the U.S. in China's total trade peaked in the late 1990s. The case of China U.S. steel trade dispute suggests that unless the U.S. imposes punitive tariffs on imports from all countries, picking on China will only shift American demand to other more expensive alternatives, while the benefits to American domestic producers will be questionable, let alone American consumers. A more inward-looking U.S. administration certainly bodes poorly for international trade and globalization. However, the role of China should not be underestimated. Potential protectionist threats from the U.S. will likely generate a mutual desire among China and other economies to work more closely. Feature Global financial markets have gradually been coming to terms with the concept of President Donald Trump. Interestingly, U.S. equity market participants appear to be cheering on a potentially sizable fiscal spending package under the new administration, which has boosted industrial sector stocks over the past week. Markets in Asia, particularly Chinese H shares, however, have been less upbeat and have focused more on a possible protectionism backlash emanating from the U.S. under the new leadership. Tough talk on China has featured in every U.S. presidential campaign going back to Nixon reaching out to China in the early 1970s - from Jimmy Carter's strong condemnation of Nixon-Kissinger's "immoral" secret diplomacy of "ass kissing" the Chinese, to Bill Clinton's harsh warnings to the "butchers of Beijing", to repeated pledges by Obama in the 2008 campaign to label China as a "currency manipulator" - all of which signaled an immediate confrontation. Once in office, however, all candidates significantly softened their rhetoric, as government policies require much more realistic and thoughtful discussion, negotiation and compromise. Furthermore, given the huge importance of trade for both economies, a full-fledged trade war between the U.S. and China would risk the growth recession and enormous financial volatility around the globe, a lose-lose outcome hardly conceivable to anyone, no matter how much chest-thumping and aggrandizing is involved. To be sure, the threat of protectionism should not be downplayed. It appears clear that president-elect Trump will be less accommodative to free trade than his predecessors, which is confirmed by his choice of Mr. Dan Dimicco, a former CEO of an American steelmaker and an outspoken critic of U.S. trade policy, particularly with China, to head his trade transition team. However, it is unpredictable at the moment what specific measures he would take to be able to assess potential consequences. It is therefore more useful to take a step back and look at the big picture of trade relations between the two countries. China-U.S. Bilateral Trade Chinese sales to the U.S. far outnumber its purchases, leading to an ever-growing trade surplus in China's favor (Chart 1). In fact, the U.S. accounts for over half of China's total trade surplus - a key piece of evidence supporting some American politicians' accusation of China's purported currency manipulation and unfair trade practices. The U.S. accounts for 18% of Chinese exports, while China accounts for only 8% of American overseas sales, which puts China at a disadvantage in a full-blown trade war. Underneath, however, China has become an increasingly important export destination of American companies in recent years, while the significance of the U.S. as part of China's total trade peaked in the late 1990s (Chart 2). The share of U.S.-bound Chinese exports has remained roughly unchanged since the global financial crisis, and down significantly from pre-crisis levels. Chinese sales to the U.S. in recent years have been largely in line with overall export growth. On the contrary, American shipments to China have increased sharply as a share of total exports. Over the past five years, China has accounted for almost 20% of the net increase in U.S. exports, far outpacing any other American trade partner. Chart 1U.S.-China##br## Bilateral Trade Chart 2China Depends More ##br##On The U.S. Than Vice Versa Conventional wisdom holds that protectionist policies will be of more benefit to those countries running deficits in bilateral trade. However, a trade war with China would also remove the biggest source of marginal demand for American goods, which would be met with strong domestic resistance. Anti-Dumping And China's Trade Performance China is no stranger to anti-dumping measures in global trade. The country accounts for 30% of all anti-dumping actions initiated by World Trade Organization (WTO) members in recent years, even though Chinese products account for only about 14% of total global goods exports. China has not been regarded as a "market economy" by major developed countries, making it an easier target for punitive tariffs and other barriers under WTO rules. A case in point is steel products, which remain center stage in the ongoing trade dispute between China and the U.S. President George W. Bush in 2002 imposed tariffs of up to 30% on a broad range of Chinese steel products, while the Obama administration further upped the ante with various product-specific punitive measures during his tenor. These measures have dramatically changed steel trade for both countries: From the U.S. side, total American steel imports have remained largely range-bound in the past 20 years, but Chinese steel products have had a dramatic rollercoaster ride (Chart 3). Punitive tariffs led to a collapse of Chinese steel in the U.S. market, accounting for a mere 3% of total U.S. steel imports, down from a peak of almost 20% in 2008. However, the losses to Chinese steelmakers have simply been filled by other exporting countries. For example, U.S. steel imports from Brazil have roared back to historical high levels as Chinese products plummeted (Chart 3, bottom panel). On the Chinese side, Chinese steel products suffered huge market share losses in the U.S., but the country's total steel exports have continued to make new record highs, as it has dramatically expanded sales to other markets, particularly developing countries (Chart 4). The U.S. currently accounts for about 1% of total Chinese steel exports, down from about 10% at the peak, while Vietnam has rapidly replaced the U.S. as a key market for Chinese steelmakers to expand overseas sales. Chart 3China In U.S. Steel Imports Chart 4U.S. In Chinese Steel Exports Moreover, the punitive measures imposed by the U.S. have pushed Chinese steelmakers into higher value-added products. The top panel of Chart 5 shows the average price of American steel imports from China was roughly comparable to U.S. steel purchases from other developing countries in the late 1990s, while Germany and Japanese steelmakers traditionally occupied the higher-priced segments. The situation has shifted quickly in the past two decades: The unit price of Chinese steel sales in the U.S. has risen rapidly relatively to their peers, increasingly challenging producers in more advanced countries. Other emerging countries have filled the space left by China and remained at the lower end of the spectrum. Similarly, on the Chinese side, the average price of Chinese steel exports to the U.S. has increased sharply in recent years relative to other major markets, particularly developing countries (Chart 5, bottom panel). Currently, the average price of China's steel products exported to the U.S. is far higher than to other countries - almost triple that to other emerging countries. This confirms that Chinese steelmakers have been moving up the value-added ladder in the U.S. market, but have been "dumping" cheaper products to other developing countries. The important point here is that the punitive tariffs have indeed significantly reduced Chinese sales to the U.S., but other steel-producing countries have simply "stolen" China's lunch. By the same token, unless the U.S. imposes punitive tariffs on imports from all countries, picking on China will only shift American demand to other more expensive alternatives, while the benefits to American domestic producers will be questionable, let alone American consumers. Moreover, President Trump may still target Chinese steel products as a highly symbolic gesture to show his toughened stance on China and to keep his campaign trail promises of reviving rust-belt states - the relevance of which, however, has diminished dramatically, as steel products now account for only a tiny fraction of total trade between these two countries (Chart 6). Chart 5Chinese Steelmakers##br## Are Moving Up The Value Chain Chart 6Steel Is No Longer ##br##Relevant For China-U.S. Trade U.S. And China In Global Trade A more inward-looking U.S. administration certainly bodes poorly for international trade and globalization. However, the role of China should not be underestimated. For tradable goods, it is well known that China has long surpassed the U.S. as the world top exporter. For imports of goods, the U.S. is still bigger, but the gap has narrowed dramatically (Chart 7). China has already become a bigger market than the U.S. for a growing list of countries, particularly commodities producers and China's Asian neighbors. What is much less known is that Chinese imports of services just this year also surpassed that of the U.S., marking an important milestone in China's global reach and influence (Chart 8). Moreover, China's exports of services are much smaller, leaving a deficit almost as large as U.S. service surpluses with the rest of the world. Chart 7U.S. And China##br## In Global Trade Of Goods Chart 8China Surpassed##br##The U.S. In Service Imports In a world starving for growth, China remains a bright spot. Potential protectionist threats from the U.S. will likely generate a mutual desire among China and other economies to work more closely. China will inevitably continue to explore bilateral and multilateral free-trade agreements (FTA) with its main trade partners. China currently has 19 FTAs under construction, among which 14 agreements have been signed and implemented. Together, FTAs cover an increasingly bigger share of Chinese exports, higher than Chinese sales to the U.S. (Chart 9). Chart 9China Sells More To FTA##br## Countries Than To The U.S. Meanwhile, China will likely take a more active role in negotiating the "Regional Comprehensive Economic Partnership (RCEP)" - an ambitious multilateral agreement on trade and investments that covers almost half of the world population and output. On the other hand, the outlook of the Trans-Pacific Partnership (TPP) under President Trump has become more uncertain, which may also push other emerging countries to participate in China-initiated trade deals. If President Trump indeed turns more inward, the center of global trade will further shift toward China. A Word On The RMB And Industrial Stocks The RMB has continued to drift lower against the greenback in recent days, which still reflects the dollar's broad strength rather than RMB weakness. In fact, the trade-weighted RMB has strengthened notably (Chart 10). Conspiracy theories abound that China may engineer a flash-crash of the RMB before President Trump takes office to "preempt" any protectionist pressures. This scenario certainly cannot be ruled out, but it is highly unlikely in our view, as it may further intensify trade tensions between the two countries, making Trump's trade policy on China even less predictable. In short, we maintain the view that the near-term RMB outlook is entirely dictated by the movement of the dollar, and that the Chinese authorities should be able to maintain exchange rate stability, as discussed in recent reports.1 Turning to the stock market, Chinese industrial stocks have not joined the sharp post-Trump rally of their U.S. counterparts, likely a reflection of investors' conviction that protectionism in the U.S. may benefit domestic firms at the expense of foreign entities, particularly Chinese firms. (Chart 11). However, similar to almost all other major sectors, the profitability of Chinese industrial names is almost identical to their American peers, but they are trading at hefty discounts based on conventional valuation indicators, reflecting a much larger risk premium in Chinese stocks. For now, we remain on the sidelines with respect to Chinese stocks due to developing global uncertainty, as discussed in detail last week.2 Beyond near-term tactical consideration, we expect Chinese shares to resume their uptrend both in absolute terms and against EM and global benchmarks. Chart 10The RMB Remains Stable##br## In Trade-Weighted Terms Chart 11Industrial Stocks:##br## Spot The Differences Yan Wang, Senior Vice President China Investment Strategy yanw@bcaresearch.com 1 Please see China Investment Strategy Weekly Report, "The RMB's Near-Term Dilemma And Long-Term Ambition", dated October 20, 2016, and "Greater China Currencies: An Overview", dated November 3, 2016, available at cis.bcaresearch.com 2 Please see China Investment Strategy Weekly Report, "Chinese Stocks: Between Domestic Improvement And External Uncertainty", dated November 10, 2016, available at cis.bcaresearch.com Cyclical Investment Stance Equity Sector Recommendations
Highlights The 50bps spike in the JPM global government bond yield since August constitutes one of the most aggressive tightenings since the Great Recession. Higher bond yields weaken credit growth, and weaker credit growth almost always depresses subsequent GDP growth. Maintain at most a neutral weighting to equities. Lean against the aggressive sell-offs in Healthcare, Consumer Goods, Telecoms and government bonds. Lean against the aggressive rally in Financials. Feature November 9 is an important date in the annals of history. November 9, 1989 was the day that the Berlin Wall came down. Chart of the WeekGlobalization Has Been Good For Profits, Bad For Wages Through 1961-89, the Berlin Wall divided a city. More significantly, it symbolized a divided world. So when the wall came down on November 9, 1989, it marked a new era of globalization. Goods, services, capital and people started to move around the world much more freely, resulting in greater efficiencies and lower costs. In developed economies, profits surged. Using the United States as an example, in the 27 years since the Berlin Wall came down, stock market real earnings per share have gone up 200% (Chart I-2). Chart I-2The Backdrop For Populism But globalization has exacted a heavy price: the pressure on wages means that in the 27 years since the Berlin Wall came down, U.S. median household real income has gone up just 10%. By comparison, in the 28 years that the Berlin Wall stood, the median household real income went up 60% (Chart of the Week). November 9 is also the date that Donald Trump won the presidency of the United States. So exactly 27 years after one symbolic wall fell, is another one about to go up? Will Mr. Trump's promised wall with Mexico symbolize a new era of anti-globalization, and a reversal of the economic and financial trends since the Berlin Wall came down? Flaws In The Trump Plan Economists are almost unanimous that protectionism, trade barriers and tariffs - in other words, "building walls" - depresses long-term global growth. It is conceivable that protectionism could help some parts of the U.S. economy, though other parts might lose out as trading partners retaliated. It is inconceivable that protectionism would be good for the world economy as a whole. Chart I-3One Of The Most Aggressive Tightenings ##br##Since The Great Recession But what about Trump's noise about fiscal stimulus, and specifically infrastructure spending - why would anybody not get excited about that? The two word answer is: crowding out. If a dollar that is borrowed and spent by the government (or even forecast to be borrowed and spent by the government) pushes up the bond yield (Chart I-3), it makes it more expensive for the private sector to borrow and spend. If, as a result, the private sector scales back its borrowing by a dollar, the dollar of government spending would have no impact on GDP. This is because the dollar of government spending has crowded out a dollar of private sector spending. The fiscal multiplier would be zero. But doesn't the euro area debt crisis provide compelling evidence of the power of fiscal thrust and a very high fiscal multiplier? No, not exactly. The fiscal multiplier was high through the debt crisis because euro area austerity - a fiscal tightening - very unusually coincided with sharply rising bond yields - which killed private sector borrowing. In other words, fiscal tightening and private sector tightening were reinforcing each other. Through 2009-12, when the euro area debt crisis escalated, the relationship between fiscal tightening and growth in GDP per capita in 13 sampled economies had a near-perfect explanatory power (r-squared of 0.9); and its slope of 1.5 indicated an extremely high average fiscal multiplier (Chart I-4). But through 2012-15, after Mario Draghi "did whatever it takes" the unusual combination of fiscal tightening and higher bond yields no longer existed, and both the explanatory power of the relationship and fiscal multiplier collapsed (Chart I-5). Chart I-4A Very Strong Connection Between Fiscal Policy And Growth Through 2009-12... Chart I-5...But No Connection Between Fiscal Policy And Growth Through 2012-15 The lesson is that the efficacy of fiscal stimulus and infrastructure spending crucially depends on its impact on the bond yield - and thereby on private sector borrowing. Now note that the 6-month increase in the U.S. (and global) 10-year bond yield constitutes one of the sharpest tightenings since the Great Recession. Higher borrowing costs depress credit growth as captured in the 6-month credit impulse (Chart I-6). A weaker 6-month credit impulse then almost always depresses subsequent 6-month GDP growth (Chart I-7). Chart I-6Higher Borrowing Costs Depress##br## Credit Growth... Chart I-7...And Weaker Credit Growth Depresses ##br##Subsequent GDP Growth So yes, fiscal stimulus and infrastructure spending could be effective as long as the bond yield is anchored, as it is in Japan. But if the bond yield goes up sharply, the consequent drag from the private sector will partly or entirely negate any putative boost from the government. Explaining Market Shocks And Electoral Shocks In his seminal book Thinking, Fast And Slow psychologist and Nobel Laureate Daniel Kahneman1 proposed that the human brain has evolved two separate and independent systems for decision making: a fast, rapid-response, associative way of thinking which he calls "System 1" and a slow, analytical, measured way of thinking which he calls "System 2". The two ways of thinking, fast and slow, have evolved to protect us from two types of threat to our survival: immediate, and long-term. Thousands of years ago, the immediate threat to survival might have been a sudden noise in the bushes suggesting that a predator was stalking. Today, for a bond investor, the immediate threat might be a sudden noise about aggressive U.S. fiscal stimulus, suggesting that the end of deflationary pressures is nigh. Faced with this immediate but uncertain threat, using the slow and measured thinking of System 2 could be fatal. So we obey the fast-thinking, associative, emotional System 1 and run for cover - or sell bonds. Thousands of years ago, a long-term threat might have been a war of attrition against an enemy tribe. Today, for the bond investor, the long-term threat might be the end of the debt super cycle, suggesting that deflationary pressures will persist. Faced with this long war of attrition, an over-reliance on the impulsive decisions of System 1 could also be fatal. We must use the measured analysis and strategies of slow-thinking System 2. Kahneman's System 1 and 2 is also an excellent framework to help explain how the simple messages of the Brexiteers and Donald Trump led to stunning success at the ballot box. Faced with job destruction and stagnant real wages, many people intuitively believe that less globalization, less competition and less immigration must mean more jobs and a better standard of living. Associative and emotional System 1 immediately identifies with simple messages such as "take back control" or "build a wall". The success of the Brexiteers and Donald Trump was to acknowledge the deep malaise that many people are feeling and offer simple and intuitive cures. To be absolutely clear, this is neither an endorsement nor a criticism of the Brexiteers or Donald Trump, but simply an explanation of why their message hit home. Still, as we have argued, the more analytical and measured System 2 will find that the simple and intuitive cures that the Brexiteers and Donald Trump offer are not the panaceas that they might first seem. The Immediate Investment Decision Short-term traders generally use the rapid-response, associative, emotional System 1 for their decision making. Long-term investors generally use the slow, analytical, measured System 2. But after a shock, disoriented long-term investors may also switch from System 2 to System 1 and just follow the herd. Eventually though, System 2 switches back on, and the excessive herding and trend-following reverses. At the moment, several sector trends are at or near such a point of reversal according to our excessive groupthink indicator (Chart I-8, Chart I-9, Chart I-10, Chart I-11, Chart I-12). Chart I-8Healthcare Reversals After Excessive Trend-Following Chart I-9Consumer Goods Reversals After Excessive Trend-Following Chart I-10Telecoms Reversals After Excessive Trend-Following Chart I-11Financials Reversals After Excessive Trend-Following Chart I-12Government Bond Reversals After Excessive Trend-Following Specifically, on a 3-month trading view, we would lean against the aggressive sell-offs in Healthcare, Consumer Goods, Telecoms and government bonds; and we would lean against the aggressive rally in Financials. More generally, what does the Trump victory mean for European equities? In today's highly-connected financial markets, mainstream investments in Europe overwhelmingly depend on global developments, and not on parochial issues. The dominant components of the Eurostoxx600, FTSE100, DAX30, CAC40, AEX, SMI, and other major indices, are multinationals with a truly global footprint. So the answer rests on two subsidiary questions: What does the Trump victory mean for global monetary conditions? What does the Trump victory mean for global growth? As already mentioned, global monetary conditions have tightened significantly in recent months, and in accelerated fashion after the Trump victory. The 50bps tightening in the JPM global government bond yield since August constitutes one of the sharpest 3-month spikes since the Great Recession. But as in previous cases, the spike may be self-limiting given its squeeze on credit sensitive sectors and emerging markets. Since August, the dividend yield on equities is little changed - meaning that equities have become more expensive relative to bonds. But this is hard to justify as short-term growth prospects have, if anything, worsened. To repeat the powerful messages from Chart 6 and Chart 7, higher bond yields weaken credit growth; and weaker credit growth almost always depresses subsequent GDP growth. Putting all this together, asset allocators should maintain at most a neutral weighting to equities. Dhaval Joshi, Senior Vice President European Investment Strategy dhaval@bcaresearch.com 1 Daniel Kahneman won the Nobel Prize in economics in 2002 for his work on decision making. Fractal Trading Model* There are no new trades this week. After the big recent moves in markets, four open positions were closed at their trading-rule limits, two at profit targets, two at stop-losses. For any investment, excessive trend following and groupthink can reach a natural point of instability, at which point the established trend is highly likely to break down with or without an external catalyst. An early warning sign is the investment's fractal dimension approaching its natural lower bound. Encouragingly, this trigger has consistently identified countertrend moves of various magnitudes across all asset classes. Chart 1-13 * 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 The post-June 9, 2016 fractal trading model rules are: 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. Use the position size multiple to control risk. The position size will be smaller for more risky positions. Fractal Trading Model Recommendations Equities Bond & Interest Rates Currency & Other Positions Closed Fractal Trades Trades Closed Trades Asset Performance Currency & Bond Equity Sector Country Equity Indicators Bond Yields Chart II-1Indicators To Watch - Bond Yields Chart II-2Indicators To Watch - Bond Yields Chart II-3Indicators To Watch - Bond Yields Chart II-4Indicators To Watch - Bond Yields Interest Rate Chart II-5Indicators To Watch##br## - Interest Rate Expectations Chart II-6Indicators To Watch##br## - Interest Rate Expectations Chart II-7Indicators To Watch##br## - Interest Rate Expectations Chart II-8Indicators To Watch##br## - Interest Rate Expectations
Feature Today’s Insight is a Special Report written by BCA’s Senior Technology Strategist, Brian Piccioni. Brian discusses the reasons for ongoing M&A in the semiconductor industry, and the investment implications. We trust you will find this report insightful and informative. Semiconductor Consolidation Makes Sense But Changes Little We have written extensively about our stance against financial engineering through M&A in the high tech sector.1 However, we view the semiconductor space as somewhat of an anomaly. Unlike most tech goods, a large portion of semiconductor products generate revenues for many years, even decades, after they are first released. Although most of the development costs of these devices are depreciated in the first few years after introduction, price deflation continues. This means that for most such devices, margins do not rise to a very high level. In addition, incremental costs may be associated with "die shrinks" (making smaller devices with the same function), and changes in IC packaging, as the cost of the package can be more than the semiconductor itself. In addition to the inherent benefits of buying a company that makes a product line with long duration revenues, most semiconductors are sold through the same channels and have similar, if not identical, customers. This can allow for the rationalization of sales and marketing efforts. On the surface it might appear there is an opportunity for economies of scale in manufacturing, but these can prove elusive. It is often not worth the effort to consolidate manufacturing for an acquired company due to large differences in manufacturing processes. This is especially true since it would require an investment in R&D for a catalog of mostly dated products. These products would have to be "re-qualified" by customers, as there is no guarantee parts produced in a different factory will function the same as the old one. While most high tech M&A destroys shareholder value, that is less likely to be the case when two mature semiconductor companies combine (Chart 1). However, industry consolidation is not likely to lead to pricing power or unusual profitability post consolidation because: Semiconductor buyers are reluctant to adopt a product made by only one vendor; There is a powerful push for the adoption of technologies based upon Open Standards in order to avoid semiconductor vendors having too much power over customers; and For the most part, with the exception of leading edge process technology used in CPU and commodity memory devices, semiconductor expertise is well understood and widely available, as are the tools for the development of new devices. Total Intangible Asset Writedowns And Restructuring Charges As A Percent ##br##Of Assets By S&P 500 Tech Sub-Sector, 2000 - 2016 Semiconductor Buyers Are Reluctant To Adopt A Product Made By Only One Vendor Large device manufacturers always had an aversion to single sourced semiconductors but exceptions were made when there was a critical need or simply no other choice. For example, if you are going to design a PC you are either going to use a single-sourced device from Intel or AMD. Things changed after the "Dot Com" bubble when equipment manufacturers found themselves unable to ship finished products because a single-source vendor had declared bankruptcy and the parts were no longer being made. Even when a single source part is specified, an effort is made to ensure there are substitutes available. This hedges against the possibility the part may no longer be available and also reduces vendor pricing power. Powerful Push For The Adoption Of Technologies Based Upon Open Standards Open standards are standards where form, fit, and function, are both defined and easily referenced. The standard itself is typically inexpensive to license and any related Intellectual Property is available for license on "fair and equitable" terms, meaning that the price is reasonable and the same for all licensees. Open standards have a long history in the semiconductor industry. The market for certain devices such as memory chips would likely have never developed if every vendor had a different way of doing things. Nevertheless, companies such as Intel were able to establish a proprietary standard CPU architecture and profited handsomely as a result. Similarly, purported abuses by companies such as Rambus and Qualcomm have resulted in all players being leery of patent suits. It is now very difficult to get manufacturers to accept a new standard unless it is open. Difficult To Benefit From Competitive Advantage, Even For Largest Players The components sold by most small semiconductor companies do not require cutting edge process technology or expertise. The largest companies such as Intel, Samsung, and TSMC may have an advantage due to their process R&D, but competition among themselves limits returns. In addition, there are very few "must have" products nowadays, and consumers and businesses can typically decide to simply not purchase a new PC, video game, etc., if prices get out of hand. Industry Consolidation Will Not Fuel Growth As we have frequently noted, semiconductor industry growth has slowed to GDP plus or minus a few points (Chart 2). The industry operates within the context of chronic high price deflation, meaning many more units have to be sold each year just to keep revenues flat. Some end markets allowed for the sale of higher value-add components with increased functionality, offsetting some of the deflation. However, the era of hyper growth in PCs, networking gear and smartphones is in the past. This places downward pressure on pricing through the value chain. Chart 2Semiconductor Industry Growth Has Slowed, ##br##Now Near GDP Growth Rate Loosely speaking the industry can be separated into commodity semiconductors and proprietary ones. Commodity devices are exact functional equivalents to devices sold by multiple vendors. Examples might be discrete devices such as transistors and diodes, memory chips, logic devices, and so on. The competition in commodity semiconductors is so extreme that for some products package costs can be similar to the cost of the semiconductor itself and saving a small amount of plastic or using slightly thinner leads influences profit margins. The product life of many commodity products extends to decades. The market for proprietary semiconductors is somewhat more complicated than for commodity devices. Intel is the prototypical example of a company that makes mostly proprietary devices, though Qualcomm, Xilinx, and others exist. Some companies such as Texas Instruments are a sort of hybrid, offering both commodity and proprietary products. It would be a mistake to assume that proprietary vendors have no competition, because substitutes are typically available. A smartphone vendor can select a high end ARM-based microprocessor from Qualcomm, make its own, or buy from any number of licensees selling similar devices, depending on the market segment and price range it is targeting. This has the effect of limiting the price of a proprietary device and the associated margins. As with any M&A transaction the opportunity arises to take associated restructuring charges, write-downs, and all manner of "one-time" items which can make "non-GAAP" earnings look better than before. Similarly, management may decide to cut costs by reducing R&D and other expenses to improve near-term performance at the expense of long term results. Company managers typically highlight "synergies" and "complimentary businesses" when selling their latest M&A transactions. Nevertheless, it is rare that the combination of two semiconductor companies actually amounts to something greater than what the two were apart. Instead, what tends to result is a mix of products and activities with varying degrees of margins and growth potential. Like any overly diversified portfolio, the combined companies are more likely to grow at the same rate as the industry than to become high-tech powerhouses. In summary there is no reason to believe that organic revenue growth will arise as a consequence of any particular semiconductor M&A transaction and it is far more likely that revenue growth and margins will trend towards the mean for the industry, setting aside the impact of "non-GAAP" adjustments. Why Is There A Buyer's Panic? As we have shown, in most cases industry consolidation will not provide much in the way of operational leverage to the consolidator's results. Similarly there is little reason to believe that companies which remain independent will be affected positively or negatively from the trend.2 This raises the question of why these transactions are occurring at such a frenetic pace. Most likely the answer has more to do with capital market trends than objective business decisions. Investors have elected to reward high tech companies for financial engineering on an equal footing with organic growth (i.e. innovation), and the capital is very cheap nowadays (Chart 3). As we have addressed previously, increasingly imaginative "non-GAAP" financial presentation means that overpaying for an acquired product line is better for the bottom line than developing it in house, so managers are focusing more on financial engineering than actual engineering. Cheap capital and less-than-rational capital markets mean that companies become acquirers or targets. As companies get larger, the targets need to be large enough to "move the needle" with respect to financial impact. This goes all the way down the food chain as mid-cap companies buy small-cap companies and large cap-companies buy mid-cap companies. There are a finite number of target firms for any given company and this creates a sort of "buyer's panic" which stimulates the buyers to move quickly before the target is acquired by a rival (Chart 4). As acquirers get bigger they become the targets of larger acquirers, as they are now large enough to provide the illusion of growth. Chart 3Capital For Financial Engineering Is Cheap Chart 4'Buyer's Panic' In Semiconductor Industry Non-S&P 500 Semiconductor Companies Are Also Targets Unless the cost of capital rises significantly or investors suddenly get concerned about actual operating results rather than "non-GAAP" performance, consolidation will continue until there is a relatively modest number of large semiconductor companies. As we explained above, this does not mean these companies will have superior margins or revenue growth. Indeed we believe the end of the consolidation period will have negative impact for semiconductor industry valuations because: Opportunities for financial engineering of revenue growth and managing "non-GAAP" earnings will be limited; Balance sheets will typically be highly leveraged; and Valuation premiums associated with M&A activity will disappear. Until the consolidation phase runs its course investors should be able to profit by assembling a portfolio of smaller names since these are more likely to be acquired. This is a major reason we have most of the smaller members of the S&P 500 Semiconductor sub-index rated Overweight. Table 1Summary Of Potential Semiconductor Targets We have identified 14 additional small semiconductor firms that are not included in the S&P 500 as likely targets (Table 1). This list is not exhaustive but represents companies which are both likely to be acquired and large and liquid enough to be investible. We selected the most attractive companies based on the Price-Earnings-to-Growth (PEG) ratio, which attempts to adjust valuation for growth prospects. These companies, which have a PEG ratio close to or below 1, are bolded in Table 1 above. We are adding these 10 companies to our Overweight list, and will track these recommendations as an equally-weighted index (Chart 5). Chart 5Small Semiconductor Companies Should ##br##Outperform Due To M&A However, due to the "buyer's panic" described above, companies that appear expensive or exhibit deteriorating financial performance are also potential acquisition targets. As such, it is important to note that our recommendations in this sub-sector are not driven by company fundamentals. Alternatively, investors might consider playing consolidation through the iShares PHLX Semiconductor ETF (SOXX). The structure of this ETF limits the weight of each constituent to approximately 8%, effectively overweighing smaller firms. Brian Piccioni, Vice President Technology Sector Strategy brianp@bcaresearch.com Paul Kantorovich, Research Analyst paulk@bcaresearch.com 1 Please see Technology Sector Strategy Weekly Report, "Tech Company Red Flags Part 2: Intangible Assets And Restructuring Charges," dated July 12, 2016, available at tech.bcaresearch.com 2 That would not be the case if, for example, Hynix and Samsung, two major DRAM manufacturers, were to merge which would be problematic for the #3 player Micron. However, we doubt regulators would permit such a merger.
Financials have celebrated the modest upshift in the interest rate structure and hopes for a reversal of the regulatory framework that has been a structural noose on profitability, and risk premiums. These factors, along with our domestic vs. global bias, pushed us to move up to a neutral sector weighting. As part of this shift, we moved to an overweight stance in the asset management and custody bank (AMCB) group. Even modestly higher interest rates would reduce a major profit impediment. Fees on funds held in trust have been decimated by ZIRP, underscoring that the latest uptick in short-term Treasury yields is a plus. Relative performance had already diverged negatively from the stock-to-bond ratio, the equity risk premium and global economic sentiment. This gap could close if the rate outlook has firmed. There is still structural downward pressure on fees as low cost ETFs gain market share, but that is being partially offset by renewed growth in total mutual fund assets. If flows into bonds shift into higher margin equity products, this will provide another offset to the structural downward pressure on fees. In sum, despite our concerns about overall financial sector productivity growth, we lifted sector weightings to neutral and the sub-component S&P AMCB index to overweight. The ticker symbols for the stocks in this index are: BLBG: S5AMGT - BK, BLK, STT, AMP, TROW, NTRS, BEN, IVZ, AMG, LM.
Highlights Portfolio Strategy Retail food stocks are deep into the buy zone. Deflating food costs augur well for profit margins in the coming quarters. Lift the financial sector to neutral, via the asset manager and investment bank indexes. Recent Changes S&P Financials Sector - Raise to neutral, recording a loss of 8%. S&P Asset Manager & Custody Bank Index - Raise to overweight from underweight, locking in a profit of 5%. S&P Investment Bank & Brokerage Index - Raise to neutral, recording a loss of 3%. Table 1Sector Performance Returns (%) Equity markets celebrated the surprise Republican U.S. election victory. Investors believe the regime shift will entail fiscal stimulus and a lifting in regulatory constraints that stir animal spirits and lift the economy out of its growth funk. The reality is that it is premature to make long-term assumptions. Meanwhile, the underlying fragility of the U.S. economic expansion will be tested in the coming quarters. Indeed, it is easy to envision a hit to business confidence, causing delays in decision making and investment, especially given Trump's anti-trade rhetoric and penchant for profligacy. Policy uncertainty and confidence have been reliable leading indicators for valuations, and slippage would put upward pressure on the Equity Risk Premium (Chart 1). It will be critical to monitor aggregate financial conditions. The Goldman Sachs Financial Conditions index has tentatively edged up (Chart 1), and if corporate bond spreads, long-term yields and the U.S. dollar move much higher, upside risks will intensify. The low level of overall potential growth has made the economy increasingly sensitive to swings in financial conditions and deflationary impulses from abroad. Both the high yield and investment-grade corporate bond index are languishing, perhaps picking up on the deflationary signal from U.S. dollar strength and growth drag from higher Treasury yields (Chart 2, bottom panel). It is notable that emerging markets currencies have pulled back. These exchange rates are typically pro-cyclical. Sustained currency weakness typically leads to domestic corporate bond spread widening (Chart 2, CDX spreads shown inverted). In the past five years, it has paid to bet on defensive over cyclical sectors when EM currencies weaken and CDX spreads are this tight, i.e. contrarians should take note. At a minimum, it may be a signal that global growth is less robust than the rise in global bond yields implies. As a result, forecasts for double-digit profit growth in the next twelve months look very aggressive, even if our economic outlook proves too cautious. The tentative trough in third quarter S&P 500 profits has not yet been validated by other indicators. For example, tracking tax revenue provides a good real-time gauge on corporate sector cash flows. Federal income tax receipts have dropped into negative territory. Corporate income taxes are contracting. Previous major and sustainable overall profit recoveries have been either led by, or coincident with, corporate income tax growth (Chart 3). This argues against extrapolating positive third quarter earnings growth in the S&P 500. Chart 1Watch Confidence And Financial Conditions Chart 2Don't Get Caught Up In The Hype Chart 3Taxes And Profits Rather than get overly excited about the potential for a new fiscal spending impulse, it may be more appropriate to view the latter as truncating downside economic risks, given that the corporate sector remains a key headwind to stronger growth, even excluding its balance sheet stress. Consequently, we still expect undervalued defensives to retake a leadership role from overvalued cyclical sectors and we also retain a domestic vs. global bias. If the U.S. dollar breaks above its recent trading range, the odds of the broad market making further liquidity fueled gains will diminish significantly. Importantly, the last few days of market moves have been massively exaggerated, as industrials and materials have rallied as if fiscal stimulus is about to hit next month. Even when implemented, it is not a panacea for sector earnings. Drug and biotech stocks have soared as if pricing pressures will evaporate, when in reality price pressures emerged prior to any political interference. Tech stocks have been crushed because of fears they will be forced to move production back to the U.S. All of these knee-jerk reactions should be treated with caution, with the exception of financials, where a step function reduction in the risk premium may be underway. There Is A New Sheriff In Town: Lift Financials To Neutral Financials have celebrated the modest upshift in the interest rate structure and hopes for a reversal of the regulatory framework that has been a structural noose on profitability, and risk premiums. These factors, along with our domestic vs. global bias, argue against maintaining a below benchmark weighting on a tactical basis. As discussed last week, our view on banks remains cautious, however, asset managers and investment banks have lower odds of falling back toward recent lows even after election euphoria inevitably fades. The largest earnings drags from the past year have eased. M&A activity has troughed. New and secondary stock offerings have hooked back up and margin debt is back to new highs, suggesting that investor risk appetites have stopped shrinking (Chart 4). Thus, capital formation is unlikely to dry up, even if upside is limited given poor corporate sector balance sheet health and an upward creep in the cost of capital. In terms of asset managers and custody banks (AMCB), even modestly higher interest rates would reduce a major profit impediment. Fees on funds held in trust have been decimated by ZIRP, underscoring that the latest uptick in short-term Treasury yields is a plus. Relative performance had already diverged negatively from the stock-to-bond ratio, the equity risk premium and global economic sentiment (Chart 5). This gap could close with a prospective thawing in relations between lawmakers and the industry. There is still structural downward pressure on fees as low cost ETFs gain market share, but that is being partially offset by the renewed growth in total mutual fund assets (Chart 4, bottom panel). Bear in mind that both groups tend to do well when the stocks outperform bonds, as seems likely in the near run given creeping protectionism. In sum, despite our concerns about overall financial sector productivity growth, mainly owing to rising bank cost structures, and the risks of a renewed deflationary impulse from U.S. dollar strength, we are lifting sector weightings to neutral. This will put us onside with the objective message from our Cyclical Macro Indicator, the buy signal from our Technical Indicator (Chart 6) and our broader theme of favoring domestic vs. global industries. Chart 4Earnings Drivers Have Stabilized Chart 5Recovery Candidate Chart 6Following Our Indicators Bottom Line: The Republican victory has provided a fillip to the financials sector, and underweight positions putting underweight positions offside. We are lifting allocations to neutral, via the S&P AMCB and S&P investment banks & brokerage indexes. AMCB moves to overweight, and the latter to neutral, with an eye to downgrading again once euphoria fades and investor focus returns to economic durability. Food Retailers: Too Cheap To Overlook Food retailers offer attractive value, defensive and domestic equity exposure with the potential for upside profit surprises. This group will benefit if U.S. wage inflation persists. The latter would boost consumer purchasing power and could lead to tighter financial conditions, either through U.S. dollar strength and/or a tighter Fed. The defensive appeal of retail food equities would shine through under that scenario. The starting point for grocery stocks is extremely appealing. The price ratio is extraordinarily oversold. It fell farther below its 200-day moving average than at any time since 2002, before recently bouncing (Chart 7). Valuations are cheap, return on equity is solid and share prices have diverged negatively from a number of macro indicators. For instance, relative performance has been tightly linked with the U.S. dollar, but the former plunged even as the currency firmed (Chart 8, top panel). A strong exchange rate will keep a lid on imported food costs, boost the allure of domestically-oriented industries while lifting consumer spending power. Chart 7Extraordinarily Oversold Chart 8Top-Line Improvement Ahead Outlays on food products have climbed as a share of total spending in the past six months, reversing a long-term downtrend (Chart 8). If consumer confidence stays firm as a consequence of rising wage growth and a positive wealth effect, then it is conceivable that store traffic and total grocery spending will accelerate. The surge in capital spending in recent years reflects store upgrades and a refreshed shopping experience, which could also translate into faster sales growth. Now that capital spending growth is cooling, it will reduce a profit margin drag. Profitability should also benefit from cost deflation. The food manufacturing PPI is contracting, reflecting shrinking raw food prices (Chart 9, top panel, shown inverted). It is normal for food stocks to outperform when raw food prices fall. Importantly, capacity utilization rates in the packaged food industry are very low (Chart 9), which augurs well for ongoing pricing pressure among suppliers. Tack on deflation in industry wage inflation, and it is no wonder profit margins have been able to grind back toward previous highs without a strong sales impulse. If sales rebound, as seems likely given evidence of market share gains away from hypermarkets (Chart 10, bottom panel), then grocery stores should continue to demonstrate decent pricing power gains (Chart 10, middle panel). Chart 9Cost Deflation Chart 10Gaining Market Share Adding it up, the ingredients for a powerful rally in the S&P retail food store index exist, with good downside protection should the economy disappoint on the back of tighter financial conditions. Bottom Line: We recommend an overweight position in the S&P retail food store index (BLBG: S5FDRE - KR, WFM). Current Recommendations Current Trades Size And Style Views Favor small over large caps and growth over value.
Highlights We remain positive on Chinese stocks both from structural and cyclical point of view, especially on H shares. In the near term, stay on the sidelines due to developing global uncertainty. The Q3 earnings scorecard of listed companies confirms an upturn in the Chinese profit cycle. Earnings momentum will likely be carried forward to at least early next year. The Chinese economy has improved notably, especially in the industrial sector. We expect the economy will likely continue to surprise to the upside. Feature Tuesday's U.S. election surprise sent strong shockwaves to global risk assets, including Chinese stocks. We tactically downgraded our "bullishness" rating on Chinese H shares in early October,1 partly due to brewing global uncertainty, but were still caught off guard by the election result. World financial markets have yet to fully grasp the implication and consequences of a President Trump. Yesterday, we sent clients a Special Report titled "U.S. Election: Outcomes & Investment Implications" prepared by Marko Papic, our Chief Geopolitical Strategist, providing our initial assessment on these important issues. As far as China is concerned, the biggest threat is the harsh anti-China trade policies that dominantly featured Mr. Trump's election campaign. A full-blown protectionist backlash is undoubtedly bearish for China and the rest of the world; this is a disturbing uncertainty that has to be carefully monitored and assessed going forward. However, it is also worth noting that anti-China rhetoric has been regularly featured in all U.S. presidential election campaigns by candidates from both parties as soon as the diplomatic tie between these two countries was established in 1979, but the economic integration has continued to deepen. For now, we do not advocate any kneejerk adjustment to investment strategy, as it is utterly unpredictable how much of Mr. Trump's campaign rhetoric will become real policy. An easier bet over the near term is that the Chinese authorities will likely maintain policy support to boost domestic demand in the wake of rising external uncertainty. Strategically, China will likely press forward its ongoing long-term initiatives to expand its global influence, such as the "One Belt One Road" (OBOR) project and Asian Infrastructure Development Bank. Meanwhile, China will continue to explore bilateral and multi-lateral free trade deals with its major trade partners to foster a more predictable global trade environment. We will follow up on these issues in our future research. While Chinese stocks have suffered badly from global contagion this week, Chinese domestic factors have, ironically, continued to turn more positive of late, with an improving cyclical economic profile, a largely accommodative policy stance and a strong recovery in profits. In the near term we are staying on the sidelines, as the uncertainty unleashed by the U.S. presidential elections continues to play out. Nonetheless, barring a major protectionist backlash, we remain positive on Chinese H shares both from a structural and cyclical perspective, and expect this asset class to outperform both global and EM peers. A Strong Earnings Recovery From an investor's stand point, the most important development is the sharp recovery in earnings reported by Chinese domestically listed A-share companies in the third quarter. Specifically: A share-listed companies' average earnings increased by 22% in the third quarter from Q3 2015, or by 3% for the first three quarters compared with a year ago (Table 1). Excluding financials and petroleum firms, earnings jumped by almost 50% in Q3, according to our calculations, or 21% year-to-date. While the sharp earnings recovery in Q3 is partially attributable to last year's low base, our model suggests that earnings momentum will likely be carried forward to at least early next year (Chart 1). Table 1Earnings Scorecard The earnings recovery reflects both top-line growth and margin expansion. Improving producer prices have eased deflationary pressure in the economy, particularly for the corporate sector. Total sales of A share-listed firms have benefited from the pickup in nominal GDP growth, and profit margins have also continued to widen in the last quarter, both of which are conducive for earnings growth (Chart 2). Cash flow positions have also continued to improve, especially in select sectors. Overall cash and cash equivalents held by Chinese non-bank firms as a share of assets currently stand at elevated levels, underscoring an overall cautious stance on business expansion and liquid balance sheets (Chart 3).2 Specifically, real estate developers' operating cash flow continues to increase sharply, boosted by strong sales, but capital expenditures have been muted, leading to a significant hoarding of cash. This will likely reduce financial stress among developers, even if housing policies begin to be tightened. Chart 1Strong Earnings Grow... Chart 2... Due To Rising Sales And Improving Margin Chart 3Developers' Improving Cash Flow And Balance Sheet In short, the Q3 earnings scorecard confirms our long-held view of an upturn in the Chinese profit cycle.3 We expect bottom-up analysts will continue to upgrade earnings expectations, which will provide a positive cyclical backdrop for Chinese stocks (Chart 4). The Economy Will Remain Resilient China's recent macro numbers have largely come in stronger than expected, albeit modestly. Overall, the economy has maintained positive momentum, especially in the industrial sector. The Keqiang Index - a combination of bank loan growth, railway freight activity and electricity consumption - has strengthened sharply, underscoring significant improvement in industrial activity (Chart 5). Looking forward, we expect the economy will likely continue to surprise to the upside. Chart 4Net Earnings Revision Will Continue To Improve Chart 5Keqiang Index Versus GDP Growth Business managers have largely been cautious, and have been focused on inventory destocking instead of business expansion. Industrial production has so far been muted, despite improvement in some leading indicators (Chart 6). Meanwhile, slowing capital spending among private enterprises has been one of the key reasons for slower growth in recent years; this should turn around as profitability improves (Chart 7). At minimum, downward pressure on private sector investment should diminish going forward. This, together with government-sponsored infrastructure construction, should underpin overall capital spending. Chart 6Industrial Production Has Been Muted Chart 7Profit Recovery Helps Capex On the policy front, monetary conditions continue to be accommodative. The trade-weighted exchange rate has remained low, and real interest rates have continued to drift lower through nominal declines and rising producer prices. Furthermore, inflation is unlikely to become a meaningful policy constraint anytime soon. Headline CPI picked up slightly last month, driven by food prices (Chart 8). However, this was largely due to the base effect. Agricultural wholesale prices have been mostly flat in recent years, and there is no case for generalized food inflation. The risk of any near term policy tightening has further diminished in the wake of the global uncertainty. Meanwhile, previous stimulative policies should continue to allow the economy to build forward momentum. The housing tightening policies imposed last month have begun to have a negative impact on home sales, which introduces a new risk factor for the economy, as discussed in a previous report. Anecdotal evidence suggests that property transactions in some major cities have dropped notably, even though home sales nationwide appear to remain buoyant (Chart 9).4 In addition, new housing construction has rolled over in the past few months, as developers have also focused on destocking inventories despite rising sales. However, inventories were already headed lower, which will eventually support new construction. Already, developers' land purchases have turned positive in recent months. In short, the impact of tightened housing policies should continue to be closely monitored. For now, our base case remains that housing construction will likely remain sluggish, but will not go through another major downturn. This view is further reinforced by the strong earnings and cash positions of real estate developers in the last quarter. Chart 8No Case For Food Inflation Chart 9Housing: Another Major Downturn Is Unlikely Chinese Stocks And Global Risk Aversion As far as Chinese stocks are concerned, we are positive both from structural and cyclical point of view, especially on H shares. Structurally, this asset class has been deeply depressed in recent years with an unduly high risk premium, which will eventually be renormalized through multiples expansion. Cyclically, the economy's budding forward momentum, strong profit recovery and accommodative policy stance are all supportive for stock prices. At a minimum, Chinese H shares should continue to outperform their global and EM peers. Tactically, however, we remain cautious as knee-jerk reactions in the stock market following the U.S. election surprise will continue to dominate the broader market trends. Furthermore, even as the impact of the election shock begins to fade, investors' focus may shift back over to a possible December rate hike by the Federal Reserve and another up leg in the U.S. dollar - both of which are negative for global liquidity and risk assets. Chart 10 shows that our proxy of global dollar liquidity has deteriorated significantly of late, which historically has often been accompanied by an increase in volatility in stocks. This time around, however, the market appears to have so far been rather sanguine, and is vulnerable to negative surprises. This is especially true, as global bellwether U.S. stocks are not cheap. In addition, Chinese stocks are overbought in the near term, and a period of consolidation or even correction is overdue (Chart 11). Our technical models for both A shares and H shares remain elevated even after the recent correction, which heralded further near-term difficulties. A favorable cyclical profile and large valuation buffer, particularly for H shares, should limit the downside for Chinese stocks, but the risk-return tradeoff in the near term is not particularly attractive, and warrants a more cautious stance. Chart 10Dollar Liquidity And Equity Volatility Chart 11Chinese Stocks Remain Near Term Overbought The bottom line is that we downgraded our "bullish rating" on Chinese H shares last month, and for now remain on the sidelines. Beyond near-term volatility we reiterate our positive conviction for this asset class, and expect Chinese H shares to continue to advance both in absolute terms and against the EM and global benchmarks. Yan Wang, Senior Vice President China Investment Strategy yanw@bcaresearch.com 1 Please see China Investment Strategy Weekly Report, "Housing Tightening: Now And 2010" , dated October 13, 2016, available at cis.bcaresearch.com 2 Please see China Investment Strategy Special Report, "Rethinking Chinese Leverage", dated October 27, 2016, available at cis.bcaresearch.com 3 Please see China Investment Strategy Weekly Reports, "2016: A Choppy Bottoming" , dated January 6, 2016 and "China: Four Important Charts" , dated April 13, 2016 and "Chinese Growth, Profits And Stock Prices", dated July 20, 2016, available at cis.bcaresearch.com 4 Please see China Investment Strategy Weekly Report, "Housing Tightening: Now And 2010" , dated October 13, 2016, available at cis.bcaresearch.com Cyclical Investment Stance Equity Sector Recommendations
Highlights Most narratives surrounding G7 bond yields, the U.S. dollar, Chinese credit/fiscal impulses, and the RMB exchange rate - which justified the EM rally from February's lows - have been overturned. To be consistent, this warrants a relapse in EM risk assets. In China, recent property market and marginal credit policy tightening will weigh on growth. Feature The more recent strength in Chinese and emerging markets' (EM) manufacturing PMI indexes as well as the bounce in industrial metals prices have gone against our negative view on EM/China growth and related markets. While it is hard to predict market patterns over the next several weeks, we maintain that the EM rally is on borrowed time, and that the risk-reward profile for EM risk assets (stocks, credit markets and currencies) remains very unfavorable. Tracking Correlations And Indicators The overwhelming majority of indicators and variables that supported the rally in EM since February have reversed in recent months. Specifically: China's credit and fiscal spending impulses have rolled over (Charts I-1 and Chart I-2, on page 1). This will likely lead to a rollover in mainland industrial activity early next year (Chart 1, top panel). Similarly, this bodes ill for much-followed Chinese ex-factory producer prices - i.e., producer price deflation will probably recommence early next year (Chart I-1, bottom panel). Chart I-1China: Industrial Sectors To Retreat? Chart I-2China: Credit And Fiscal Impulses In a nutshell, the strong credit and fiscal impulses of late 2015 and early 2016 explain the stabilization and mild improvement in the Chinese economy during the past few months. However, these same impulses project renewed weakness/rollover in the economy in early 2017. If financial markets are forward looking, they should begin pricing-in deteriorating growth momentum sooner than later - especially as Chinese policymakers are announcing marginal tightening policies (see below for more details). One of the narratives that triggered the EM and global equity rally in February was speculation that there was a "Shanghai accord" between global central banks. According to this narrative, the People's Bank of China (PBoC) promised not to devalue the RMB in exchange for the Federal Reserve not hiking rates. Since then, the RMB has continued to depreciate, both versus the greenback and the CFETS1 basket. Yet EM and global stocks have completely disregarded the RMB depreciation (Chart I-3). We do not have good explanation as to why. Indeed, the RMB has weakened meaningfully, despite the PBoC's massive currency defense: the latter's foreign exchange reserves have shrunk further since then (Chart I-4), as capital flight has exceeded the enormous current account surplus by a large margin. Chart I-3Investors Are ##br##Complacent About RMB Chart I-4China: Foreign Exchange ##br##Reserves Still Shrinking Chart I-5PBoC Liquidity Injections ##br##Have Been Enormous The PBoC's selling of U.S. dollars to prop up the yuan has drained domestic currency liquidity and one would expect interbank rates to rise. However, the PBoC has been re-injecting RMBs into the system to keep interest rates low (Chart I-5). Such RMB liquidity proliferation makes further declines in the currency's value all the more likely. We expect the RMB to continue depreciating. Yet global financial markets have become extremely complacent about the potential for additional RMB depreciation. After having been bullish on U.S./G7 bonds for the past several years, in our July 13 Weekly Report,2 we highlighted that U.S./G7 bond yields would rise and closed our strategic short EM equities/long 30-year U.S. Treasurys position. Even though U.S./G7 bond yields have risen since July, EM equities have not declined. Given that falling G7 bond yields were used as justification for the EM rally, the opposite should also hold true. We expect U.S. bond yields to rise further. Our EM Corporate Health Monitor - constructed using bottom-up financial variables of companies with outstanding U.S. dollar corporate bonds - points to a reversal in the EM corporate credit market rally (Chart I-6). Furthermore, EM sovereign and corporate credit spreads have tightened considerably and are now very overbought and expensive. As we argued in our Special Report titled EM Corporate Health Is Flashing Red3 that introduced the EM Corporate Financial Health (CFH) Monitor, EM corporate credit spreads are as expensive as they were before they began widening in 2013 and 2014 (Chart I-7). Chart I-6EM Corporate Bond Rally To Reverse? Chart I-7EM Corporate Spreads Are Too Tight Finally, the U.S. dollar sold off early this year, but it has held firm in recent months. Nevertheless, EM risk assets have not retreated, despite the greenback's strength (Chart I-8). Few would argue that sharp U.S. dollar appreciation is negative for EM risk assets, but there is a debate among investors and analysts about whether EM risk assets can rally amidst a gradual appreciation in the U.S. dollar. Turning to the empirical evidence, Chart I-9 reveals that in the past 30 years any U.S. dollar appreciation - whether gradual or not - even versus DM currencies has coincided with weakness in EM share prices. Chart I-8EM Investors Have ##br##Ignored U.S. Dollar Strength Chart I-9EM Equities And ##br##U.S. Dollar: A 30 Year History Bottom Line: The majority of narratives that justified the EM rally from February's lows have been overturned. To be consistent, this warrants a relapse in EM risk assets. China's Credit And Property Tightening In recent weeks, there have been numerous policy tightening efforts in China. In particular: At the annual World Bank/IMF meetings in Washington last month, PBoC Governor Zhou Xiaochuan stated that once markets stabilized there would no longer be additional large increases in bank credit. His exact words were: "With the gradual recovery of the global economy, China will control its credit growth".4 As U.S. and European PMIs have firmed up and U.S. employment and wage growth is robust, Chinese policymakers will be emboldened to moderate unsustainable credit growth and not to repeat the massive fiscal push of early this year. In a bid to curb excessive bank credit growth and discourage "window dressing" accounting, the PBoC announced on October 255 that going forward it will include off-balance-sheet wealth management products (WMPs) in the calculation of banks' quarterly Marco Prudential Assessment ratios, starting from the third quarter. The clampdown on WMP accounting will reduce banks' capital adequacy ratios (CARs). One key reason that banks had aggressively boosted the size of their off-balance-sheet WMP assets was that they were not required to have capital charges against them, helping banks extend more credit while complying with CARs. In short, Chinese banks' CARs are inflated. This policy measure along with provisioning and writing-off non-performing loans, if reinforced, could meaningfully reduce the CARs of all Chinese banks, especially small- and medium-sized ones, as well as force them to reduce the pace of credit expansion. Given that the majority of medium and small banks have been more aggressive than the country's five biggest banks in expanding credit in recent years, this may have a damping effect on credit growth in 2017. In fact, the 110 medium and small banks retain 60% of on- and off-balance-sheet credit claims on companies, while the five largest banks hold 40% (Table I-1). Hence, credit trends in small and medium banks are at least as important as those among large banks. Table I-1China: Five Largest Banks Hold Only 40% Of Credit Assets Finally, a number of cities have announced various tightening measures on property markets of late, including the re-launch of house purchasing restrictions and increases in minimum down payments. Similar restrictions on home purchases served as an efficient tool for curbing property purchases in 2013-14, and there is no reason why it will be different this time around. This is especially true given the market is more expensive than it was back in 2013. In addition, the government has curbed financing for property developers. The biggest economic risk remains construction activity. Even though housing sales and prices have skyrocketed by 20-40% in the past 12 months (Chart I-10, top and middle panels), residential floor space started has been very timid - it has in fact failed to recover (Chart I-10, bottom panel). As residential property sales contract again due to new purchasing restrictions, property developers will certainly curtail new investment, and housing construction activity will shrink anew. The same is true for commercial properties (Chart I-11). Chart I-10China's Residential Market: ##br##Demand, Prices And Starts Chart I-11China's Non-Residential ##br##Market: Demand And Starts An interesting question is why property starts have been so weak, as indicated in the bottom panels of Chart I-10 and Chart I-11 - particularly when both floor space sold (units) and property prices have surged exponentially in the past 12 months. Our view is that there is a large hidden inventory overhang in the Chinese property market. For example, government data on residential floor space started, completed and under construction attest that there is still a large gap between floor space started versus completed (Chart I-12). From these data/charts and the enormous leverage carried by property developers, we infer the latter have been accumulating / carrying on their balance sheets vast amounts of inventory in excess of what market-based sources suggest, and what is widely followed by analysts. It is very hard to make sense of the Chinese property inventory data, but we suspect these market-based data sources may track only inventories that have been completed and released to the market - and do not account for inventories classified as "under construction". For residential housing, according to government data the "under construction floor space" is 5 billion square meters (Chart I-13, top panel), which is equal to 3.5-4 years of sales at the fervent pace of the past 12 months (Chart I-13, bottom panel). Another way to assess this is as follows: Assuming an average construction cycle of three years, there will be supply of new housing in amounts of 16.7 units in each of the next three years. This compares with sales of 13.3 million units in the past 12 months that occurred amid a buying frenzy and booming mortgage lending. Faced with a potential drop in sales due to the recent purchasing restrictions, elevated inventories, enormous leverage (Chart I-14), and tighter financing, property developers will most likely curtail new starts. In turn, a reduction in property starts means less construction activity next year, and weak demand for commodities. Consistent with the rollover in the fiscal spending impulse, infrastructure spending will likely also lose its potency in early 2017. Chart I-12China's Residential ##br##Market: Hidden Inventories Chart I-13Chinese Real Estate: Massive ##br##Volumes Under Construction Chart I-14Leverage Of Chinese ##br##Listed Property Developers Bottom Line: Recent property market and marginal credit policy tightening will weigh on construction activity and depress Chinese demand for commodities and industrial goods next year. Confirmation Bias, Or Bias Based On Fundamentals? Why did we not follow the indicators discussed above from February through June, when the EM rally emerged and these indicators bottomed? Do we have a confirmation bias? We did not recommend playing the EM rebound early this year because we did not believe the rally would last this long or go this far. If we had had conviction about the duration and magnitude of the rally, we would have changed our strategy - tactically upgrading EM risk assets despite our negative structural and cyclical views. Simply put, we were wrong on strategy. In our April 13, 2016 Weekly Report,6 we argued that based on China's injection of massive amounts of fiscal and credit stimulus, growth would marginally improve in the months ahead. Yet, we stopped short of recommending chasing the EM rally given the menace of numerous cyclical and structural negatives surrounding the EM/China growth outlook. As to the reasons why we put more emphasis on some indicators and less on others at various times, we have the following points: We are biased in so far as our assessment and analysis of EM/China is based on fundamentals. In this sense, we are biased towards centering our investment strategy on fundamentals. Specifically, given our view/analysis that EM/China have credit bubbles/excesses, rapidly falling or weak productivity growth and record-low return on capital (Chart I-15), we cannot help but to have a fundamentally bearish bias on EM. This, in turn, means that we view any rally in EM risk assets or uptick in EM/China economic indicators with suspicion and likely as unsustainable. The opposite also holds true. All in all, if we are wrong on our fundamental view and analysis, we will be wrong on financial markets. When investors expect a bear market, they are better off selling rallies and not buying dips. When an asset class is in a multiyear bull market, it pays off to buy dips rather not sell rallies. Unless one can time market swings well, it is hard to make money on the long sides of bear markets. Similarly, it is difficult to profit from short positions in bull markets. In brief, countertrend moves are about timing. Timing does not depend on fundamentals. It is often a coin toss. Typically we do not recommend clients invest based on a coin toss. For example, it is impossible to rationalize why the EM rally did not begin following the August 2015 selloff, but instead started in February 2016. In late August 2015, with carnage in EM risk assets pervasive, it was clear that Chinese policymakers would stimulate and in fact the massive fiscal stimulus was initiated in August/September 2015 not in 2016. Similarly, China's manufacturing PMI bottomed in September 2015, not in 2016 (Chart I-16). Chart I-15EM Non-Financial Return ##br##On Equity Is At All Time Low Chart I-16China's Manufacturing PMI ##br##Bottomed In October 2015 In September 2015, EM and global equities rebounded, but chasing momentum at that time did not pay off as risk assets cratered in the following months. This is all to say that timing markets is often a random walk. We do attempt to time market moves that go along with our fundamental bias, but prefer not to time market moves that go against the primary trend. We assume any countertrend move is typically short-lived and unsustainable. That said, we also realize these moves can be very painful for investors if they last long enough, like this EM rally. Finally, we often get questions on fund flows. We do not make investment recommendations based on fund flows - even though we recognize they are very important in driving markets. The reason is that there is no comprehensive data on global fund flows that one can analyze and make reasonably educated bets. The often-cited EPRF dataset only tracks inflows and outflows of mutual funds and ETFs. It does not account for flows and positioning of various asset managers, sovereign funds, pension funds, insurance companies, hedge funds and private wealth managers, among many others. What's more, the EPRF dataset only covers the funds located in advanced countries and offshore jurisdictions, but not emerging countries where investment pools have become large and important. In brief, the available investment flow and portfolio positioning data are not comprehensive at all, and they cannot be relied upon too much to make investment recommendations. In this vein, a question arises: Why can't flows into EM sustain the current rally for a while even though it is not based on fundamentals? In this context, let's consider the case of the rally in euro area share prices when markets sensed the arrival of the European Central Bank's quantitative easing efforts at the beginning of 2015. There was a fervent rush to buy/overweight euro area stocks heading into the QE announcement by the ECB. European bourses surged. Nevertheless, euro area equity prices have been sliding and massively underperforming the global equity benchmark since March 2015 (Chart I-17). The reason the ECB's QE has not helped euro area stocks is because their fundamentals were bad - profits have been shrinking despite the ECB's QE. We suspect EM stocks and currencies will have a similar destiny: EM profits will disappoint considerably, and the current rally will prove unsustainable. Notably, net EPS revisions have so far failed to move into the positive territory (Chart I-18). Chart I-17Euro Area Stocks And EPS: ##br##Why The QE Rally Proved To Be Bogus Chart I-18EM Stocks And EPS: ##br##Earning Revisions Are Still Contracting Arthur Budaghyan, Senior Vice President Emerging Markets Strategy & Frontier Markets Strategy arthurb@bcaresearch.com 1 China Foreign Exchange Trading System. 2 Please refer to the Emerging Markets Strategy Weekly Report, titled "Risks To Our Negative EM View," dated July 13, 2016; a link is available on page 15. 3 Please refer to the Emerging Markets Strategy Special Report, titled "EM Corporate Health Is Flashing Red," dated September 14, 2016; a link is available on page 15. 4 Please see http://www.pbc.gov.cn/goutongjiaoliu/113456/113469/3155686/index.html 5 Please see http://www.pbc.gov.cn/goutongjiaoliu/113456/113469/3183204/index.html 6 Please refer to the Emerging Markets Strategy Weekly Report titled, "Revisiting China's Fiscal And Credit Impulses," dated April 13, 2016; a link is available on page 15. Equity Recommendations Fixed-Income, Credit And Currency Recommendations
Regardless of who wins the U.S. election, the gaping mismatch between fundamentals and broad market valuations remains intact, but will be in jeopardy of re-converging should the Fed signal an intention to tighten monetary conditions through next year. As previously outlined, our view is that the economy, particularly the corporate sector, will struggle further if financial conditions become more restrictive and/or election uncertainty persists. The non-financial corporate sector's return on equity has already fallen to its lowest level in more than 60 years. Yet the median price/sales and price/earnings ratios are flirting with all-time highs. That divergence is not sustainable, given the direct link between ROE, profit growth and valuations. Central bank benevolence has underwritten this gap, and any ebbing in financial liquidity is a potential catalyst for it to close.