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The Fed’s minutes earlier this week served as a catalyst for a mini pullback in equities, as the US dollar caught a bid. Unemployment insurance claims above the million mark added insult to injury and the odds are rising that this mini-risk off phase morphs into a steeper drawdown. Sentiment as measured by the CBOE’s put/call ratios (both the composite and the equity one) are extremely stretched and a snapback is likely looming. Historically, the equity put/call ratio and the SPX 12-month forward P/E are near perfectly inversely correlated. Both data series hover near previous extremes and warn that investor complacency reigns supreme (put/call ratio shown inverted, bottom panel). The implication is that given that equities are fully valued, any minor hiccups – especially on the (geo)political front – can cause a disproportionate fall in equities. Bottom Line: We would refrain from chasing stocks higher here, and choose to deploy fresh capital late in the year at a better entry point, as the US Presidential election uncertainty recedes.

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Highlights The strength in global semiconductor sales in recent months has been due to one-off factors stemming from pandemic-related lockdowns. As the one-off demand surge subsides, global semiconductor sales will decline modestly toward the end of this year. In the near term, global semiconductor stock prices are vulnerable due to overbought conditions, excessive valuations and demand disappointment. The global semiconductor industry is at the epicenter of the US-China confrontation, and more US restrictions on chips sales to China are probable. This is another risk for this sector's share prices.   Nevertheless, the structural outlook for global semiconductor demand is constructive. Its CAGR may rise from 3% during 2014-2019 to 5% during 2020-2024. Feature Investor euphoria has taken hold of semiconductor stocks. Global semiconductor stock prices have skyrocketed by 68% from March lows and 96% from December 2018 lows. Meanwhile, global semiconductor sales during March-June rose only by 5% from a year ago. As a result, the ratio of market cap for global semiconductor stocks relative to global semiconductor sales has reached its highest level since at least the inception of data in 2003 (Chart 1). Chart 1Global Semiconductor Sector: Market Cap-To-Sales Ratio Has Surged With semi equity multiples very elevated, their share prices have become even more sensitive to global semiconductor demand growth. Hence, the focus of this report is to try to gauge the strength of global semiconductor demand, both in the near term and structurally. Near-term semiconductor stock prices could disappoint due to weak chip demand from the smartphone sector and diminishing purchases of personal computers (PCs) and servers. However, structurally, we are positive on global semiconductor demand, which is underpinned by the continuing rollout of 5G networks and phones, a wider adoption of data centers, and further technological advancements in artificial intelligence (AI), cloud computing, edge computing and smaller nodes for chip manufacturing (Box 1).   Box 1 Key Technologies Underpinning Potential Global Semiconductor Demand AI refers to the simulation of human intelligence in machines, for example, computers that play chess and self-driving cars. The goals of AI include learning, reasoning and perception. Cloud computing is the delivery of computing services – including servers, storage, databases, networking, software, analytics and intelligence – over the Internet (“the cloud”) to offer faster innovation, flexible resources and economies of scale. Edge computing is a form of distributed computing, which brings computation and data storage closer to where it is needed, to improve response times and save bandwidth. Technology node refers to the width of line that can be processed with a minimum width in the semiconductor manufacturing industry, such as technology nodes of 10 nanometers (nm), 7nm, 5nm and 3nm. The smaller the nodes are, the more advanced they are.   Near-Term Headwinds Chart 2World Semiconductor Sales Diverged From The Global Business Cycle Semiconductor demand worldwide grew by 6% year-on-year in the first half of this year. There has been a remarkable divergence between world  semiconductor sales and the global business cycle (Chart 2). The divergence between semiconductor sales and economic activity was most striking in the US and China. Semiconductor sales in China rose by 5% year-on-year in Q12020, and in the US they grew by 29% year-on-year in Q22020, despite a contraction in their aggregate demand during the same period. By contrast, Q2 annual growth of semiconductors sales was -2.2% for Japan, -17% for Europe and 1.8% for Asia ex. China and Japan (Chart 3). The reasons why the US and China posted a surge in semiconductor demand while Europe and Japan experienced a contraction in domestic semiconductor sales are as follows: Most data center investment is occurring in the US and China. Chart 4 shows that 40% of global hyperscale data centers are operating in the US, much larger than any other countries/regions. China, in turn, ranked second, with a global share of 8%. Chart 3Strong Semiconductor Sales In The US And China, But Not Elsewhere Chart 4The US Has The Most Global Hyperscale Data Centers Demand contraction in Europe and Japan is due to semiconductor demand in these regions mainly originating from the automobile sector, where production was severely hit by the global pandemic. About 37% of European semiconductor sales were from last year’s automotive market. We believe the divergence between global economic activity and semiconductor sales, as demonstrated by Chart 2 on page 3, has been due to one-off factors, as the global pandemic lockdowns have spurred semiconductor demand. Such a one-off demand boost will likely dissipate in the coming months. Traditional PCs and tablets: There has been a surge in demand for traditional PCs1 and tablets in the past six months. This was due to the significant increase in online activities, such as working from home, education, e-commerce, gaming and entertainment. Data from the International Data Corporation (IDC) has revealed that shipments of traditional PCs and tablets in volume terms had a strong year-on-year growth of 11.2% and 18.6%, respectively, in the period of April-June (Chart 5). Looking forward, even renewed lockdowns will not lead to a similar rush to buy these products. Many households are already equipped to work from home and for other online activities. With many countries gradually opening their economies, such demand will diminish. The traditional PC and tablet sectors together account for about 13% of global chip demand (Chart 6). Chart 5Personal Computers Sales Have Surged Amid Lockdowns Chart 6The Breakdown Of Global Semiconductor Sales By Type Of Usage Chart 7Server Sales Have Surged Amid Lockdowns Server demand: Another major semiconductor demand contribution in Q2020 was from the server sector, which spiked by 21% year-on-year (Chart 7). The surge in online activities triggered a strong demand for cloud services and remote work applications, both of which require computer servers to run on. However, demand from the server sector is also set to diminish in 2H2020 and Q1 2021. Provided the inventories at major data center operators, including Microsoft, Google and Amazon, remain at high levels,2 global cloud service providers will likely reduce their orders of servers next quarter.3  Enterprises will also likely cut their investment in computer servers in 2H2020, as many of them had already increased their purchases of servers to prepare employees and business processes for remote working. We expect global server demand growth to soften in 2H2020. The Digitimes Research forecasted a 5.6% quarter-on-quarter contraction in 3Q2020 and a further cut in global sever shipment in the 4Q2020.2 The global server sector accounts for about 10% of global chip demand and, together with PCs and tablets, they make for 23% (please refer to Chart 6 on page 5). Further, the smartphone sector – accounting for 27% of global semiconductor demand – will continue struggling in H2 this year. The global total smartphone demand has been hit severely, as households delayed their new smartphone purchases. According to Canalys’ data, global smartphone shipments dropped by 13% and 14% year-on-year in Q1 and Q2, respectively. The strength in global semiconductor sales in recent months has been due to one-off factors stemming from the lockdowns. Chart 8Global Smartphone Shipments Will Likely Remain Weak In 2020H2 We expect smartphone shipments to continue contracting over the next three-to-six months (Chart 8). We believe global consumers will remain cautious in their spending on discretionary goods, such as smartphones, due to lowered incomes and increased job uncertainty. The IDC also forecasted that global smartphone shipments would not grow until 1Q2021.4 The Chinese smartphone sales showed a considerable weakness in July, with a 35% year-on-year contraction, which is much deeper than the 20% decline in H1 this year. 5G smartphone shipments also slowed last month, with a 21% drop from the previous month. Bottom Line: The strength in global semiconductor sales in recent months has been due to one-off factors stemming from the lockdowns. As this one-off demand subsides, global semiconductor sales will decline modestly toward the end of this year. Given the overbought conditions and the elevated equity valuations, global semiconductor stocks are currently vulnerable to near-term disappointments in semiconductor demand. At The Epicenter Of The US-China Rivalry Semiconductors are at the epicenter of the US-China confrontation. Ultimately, the US-China contention is about future technological dominance. That is access to technology and the capability to develop new technologies. The global semiconductor industry is at the epicenter of the US-China confrontation. China currently accounts for about 35% of the global semiconductor demand. US restrictions on semi producers worldwide to supply semiconductors to Chinese buyers constitute a major risk to semiconductor stock prices. On August 17, the US announced fresh sanctions that restrict all US and foreign semiconductor companies from selling chips developed or produced using US software or technology to Huawei, without first obtaining a license. In May, the US had already limited companies, such as the Taiwan Semiconductor Manufacturing Company (TSMC), from making and supplying Huawei with its self-designed chips.   In addition, the US recently threatened bans on Chinese-owned apps TikTok and WeChat, and signaled that it could soon restrict Alibaba’s operations in the US. Chart 9Global Semi Companies' Sales To China Are Substantial The global semiconductor sector is highly vulnerable to further escalation in the tension between these two superpowers. Major global semiconductor companies’ sales are heavily exposed to China, and their revenue from China ranges from 16% to 50% of total (Chart 9). We have been puzzled why global semi share prices have been rallying in spite of US limitations on semiconductor shipments to Huawei and its affiliated entities. One explanation could be that the Chinese companies that are not affiliated with Huawei are able to import semiconductors and then supply them to Huawei. If this is true, the US will have no other choice but to limit all semiconductor sales to China. This will be devastating for global semi producers given their large exposure to China. In anticipation of US punitive policies limiting its access to semiconductors, China had boosted its semiconductor imports over the past 12 months (Chart 10, top panel). Chinese imports of integrated circuits rose by 12% year-on-year in 1H2020, which is much higher than the 5% year-on-year increase in Chinese semiconductor demand during the same period (Chart 10, bottom panel). This gap suggests the country had restocked its semiconductor inventories. China has particularly restocked its imports of non-memory chips with imports of processor & controller and other non-memory chips in H1, surging by 30% and 20%, respectively, in US dollar terms (Chart 11). For memory chips, the contraction in Chinese imports was mainly due to a decline in global memory chip prices. Chart 10China Had Likely Restocked Its Semi Inventories Chart 11Strong Chinese Imports In Non-Memory Chips Bottom Line: The global semiconductor industry is at the epicenter of the US-China confrontation, and more restrictions on sales to China are probable. In turn, the restocked semiconductor inventory in China raises the odds of weakening mainland semiconductor import demand in H2 of this year. Structural Tailwinds Table 1Global Semiconductor Demand CAGR Forecast Over 2020-2024 By Device We are optimistic on structural global semiconductor demand. Its nominal CAGR may rise from 3% during 2014-2019 to 5% during 2020-2024 in US dollar terms. Table 1 shows our demand growth forecasts for global chips in the main consuming sectors over the next five years. The major contributing sectors during 2020-2024 will be 5G smartphones, servers, industrials, electronics and automotive manufacturing. The underlying driving forces are the continuing rollout of 5G networks and phones, the development of data centers, and further technological advancements in AI, cloud computing and edge computing. Currently, the world is still in the early stages of 5G network development. AI, cloud computing and edge computing are constantly evolving. With increasing adoption of 5G smartphones, computer servers and IoT devices, global semiconductor demand is in a structural uptrend (Box 2). Box 2 Key Components For The Virtual World In Development Data centers and cloud computing allow data to be stored and applications to be running off-premises and to be accessed remotely through the internet. Edge computing allows data from Internet of things (IoT) devices to be analyzed at the edge of the network before being sent to a data center or cloud.  IoT devices contain sensors and mini-computer processors that act on the data collected by the sensors via machine learning. The IoT is a growing system of billions of devices — or things — worldwide that connect to the internet and to each other through wireless networks.  AI technology empowers cloud computing, edge computing and IoT devices.  5G is at the heart of the IoT industry transformation, making a world of everything connected possible.    5G Smartphone Currently, China is the world’s largest 5G-smartphone consumer and the leading 5G-adopter in the world. According to Digitimes Research, global 5G smartphone shipments will reach over 250 million units in 2020, with 170 million (68%) in China and only 80 million units in the world ex. China. Looking forward, 5G smartphone shipments are set to accelerate worldwide over the coming years. Chart 125G Phone Shipments In China Will Continue To Rise The 5G phone shipments in China will continue to rise. The 5G phone sales penetration rate in China is likely to rise from 60% in July to 95% by the end of 2022. In such a case, we estimate that the monthly Chinese 5G phone shipments will increase from the current 16 million units to about 25-30 million units in 2022 (Chart 12). In the rest of the world, the 5G smartphone adoption pace will also likely speed up over the next five years. The 5G phone selling prices in the world outside China will drop, as more models are introduced and become more affordable. 5G smartphone prices have already fallen in China and will inevitably fall elsewhere. Chinese 5G smartphone producers will ship their low-priced 5G phones overseas, putting pressure on other producers to lower their prices.   The 5G infrastructure development is accelerating in China and will accelerate in the rest of the world. Both China and South Korea have been very aggressive in their respective 5G network development. As of the end of June, China's top three carriers: China Mobile, China Unicom, and China Telecom – which together serve more than 1.6 billion mobile users in the country – had installed 400,000 5G base stations against an annual target of 500,000. In comparison, as of April 2020, American carriers had only put up about 10,000 5G base stations.5  As the US is competing with China on the 5G front, the country will likely boost its investment in 5G network development aggressively over the next five years in order to catch up to, or even exceed, China. Importantly, the 5G smartphone has more silicon content than 4G smartphones. More silicon content means higher semiconductor value. Rising 5G smartphone sales and higher silicon content together will more than offset the loss in semiconductor sales due to falling global 4G smartphone shipments. Based on our analysis, we expect a CAGR growth of 4% in semiconductor demand from the global smartphone sector over the next five years, slightly lower than the 5% in previous five years (Table 1 on page 10). This also takes into consideration that the 5G network will be more difficult and more expensive to develop than the 4G network. Servers Global server shipment growth will be highly dependent on both the pace and the scale of data center development (Box 3). Data centers account for over 60% of global server demand.  The future growth of data centers is promising. The global trend of data localization6 due to the concerns of data privacy and national security will also bolster a boom of data centers over the next five years. A growing number of countries are adopting data localization requirements, such as China, Russia, Indonesia, Nigeria, Vietnam and some EU countries. While the Chinese data center market is expected to expand by a CAGR of about 28% over 2020-2022,7 a report recently released by Technavio forecasted the global data center industry’s CAGR at over 17% during 2019-2023.  We forecast that the global semiconductor demand from servers will grow at a CAGR of 12% over 2020-2024.   Box 3 Data Centers There are four main types of data centers – enterprise data centers, managed services data centers, colocation data centers, and cloud data centers. Data centers can have a wide range of number of servers. Corporate data centers tend to have either 200 (small companies), or 1000 servers (large companies). In comparison, a hyperscale data center usually has a minimum of 5,000 servers linked with an ultra-high speed, high fiber count network. Outsourcing and a move towards the cloud are driving the growth of the hyperscale data center. Instead of companies investing in physical hardware, they can rent server space from a cloud provider to both save their data and reduce costs. Amazon, Microsoft, Google, Apple and Alibaba are all top global cloud service providers. The more hyperscales to be built up, the higher the demand for servers. In 2019, about 13% of the total number of data centers in China were of the hyperscale and large-scale varieties. The plan of new infrastructure development announced earlier this year by Beijing was aiming to increase the number of hyperscale and large-scale data centers in China. Among current data centers either under construction or to be developed in the near future, 36% of them are hyperscale and large-scale data centers.   IoTs Technological advancements in AI, cloud computing and edge computing, in combination with 5G network development, will facilitate the IoTs adoption. According to the GSMA,8 46 operators in 24 markets had launched commercially available 5G networks by 30 January 2020. It forecasted that global IoT connections will be increased from 12 billion mobile devices in 2019 to 25 billion in 2025 with a CAGR at 13%.9   IoTs chips include the Artificial Intelligence of Things (AIoT) – a powerful convergence of AI and the IoT. IoTs is an interconnected network of physical devices. Every device in the IoT is capable of collecting and transferring data through the network. Looking forward, global demand of AI chips and IoT chips will have significant potential to grow with creation of “smarter manufacturing”, “smarter buildings”, “smarter cities”, etc. AI applications can be used in manufacturing processes to render them smarter and more automated. Productivity will be enhanced as machines achieve significantly improved uptime while also reducing labor costs. There are plenty of upsides in industrial semiconductor demand (Chart 13). We expect the CAGR of industrial electronics to increase from 3.4% during 2014-2019 to 8% during 2020-2024. AI applications can create smart buildings by increasing connectivity across enterprise assets, enabling home network infrastructure (e.g., routers and extenders) and employing home-security devices (e.g., cameras, alarms and locks). AI applications can be used to create smart cities. A smart city is an urban area that uses different types of IoT electronic sensors to collect data. Insights gained from that data are used to manage assets, resources and services efficiently; in return, that data is used improve operations across the city. China has already developed about 750 trial sites of smart cities with different degrees of smartness in the past decade. As AI and 5G technology advances, the existing smart cities’ “smartness” will be upgraded and new trial smart cities will be implemented. Based on IDC data, China’s investment in smart cities will rise at a CAGR of 13.5% over 2020-2023 (Chart 14). Globally, the U.S., Japan, European countries and other nations are also actively developing smart cities. According to a new study conducted by Grand View Research, the global smart cities market size is expected to grow at a CAGR of 24.7% from 2020 to 2027.10  Chart 13Plenty Of Upside In Industrial Semiconductor Demand Chart 14China’s Investment In Smart Cities Will Continue To Grow   Automotive We expect the global automotive chip market to grow at a CAGR of 9% during 2020-2024, as in 2014-2019. The increase in consumption of semiconductors by the auto industry will continue to be driven by the market evolution toward autonomous, connected, electric and shared mobility. Most new vehicles now include some level of advanced driver assist systems (ADAS), such as adaptive cruise control, automatic brakes, blind spot monitoring, and parallel parking. The whole industry is progressing toward fully autonomous vehicles in the coming years. Increasing adoption of automotive chips and recovering car sales will revive automotive chip sales. In addition, rising penetration of new energy vehicles (NEVs) is beneficial to semiconductor sales, as NEVs contain higher semiconductor content than conventional vehicles. Conventional vehicles contain an average of a $330 value of semiconductor content while hybrid electric vehicles can contain up to $1,000 and $3,500 worth of semiconductors.11 Regarding other sectors, we are also positive on structural demand of storage and consumer electronics. AI applications generate vast volumes of data—about 80 exabytes per year, which is expected to increase by about tenfold to 845 exabytes by 2025.12 In addition, developers are now using more data in AI and deep learning (DL) training, which also increases storage requirements. With massive potential demand for storage, we estimate a CAGR of 7% over 2020-2024 (Table 1 on page 10). A recent report from ABI Research predicts that the COVID-19 pandemic will increase global sales of wearables (such as a Fitbit or Apple Watch) by 29% to 30 million shipments of the devices this year. With contribution from wearables, we expect global semiconductor demand from the consumer sector to grow at a CAGR of 3% over 2020-2024, the same rate as in the previous five years. Bottom Line: Continuing rollout of 5G networks and phones, development of data centers, and further technological advancements in AI and cloud computing will provide tailwinds to structural global semiconductor demand, accelerating its CAGR growth from 3% during 2014-2019 to 5% during 2020-2024. Valuations And Investment Conclusions Most global semiconductor stocks are currently over-hyped. Critically, both DRAM and NAND prices have been deflating since January, reflecting weak demand for memory chips. Yet, share prices of memory producers have rallied (Chart 15). Overall, global semiconductor stock prices have diverged from their sales and profits. Overall, global semiconductor stock prices have diverged from their sales and profits (Chart 16). Chart 15Falling Memory Prices Pose Risk To Memory Stocks Chart 16Global Semiconductor Stocks Have Deviated From Profits Consequently, the multiples of semiconductor stocks have spiked to multi-year highs (Chart 17).  Even after adjusting for negative US real bond yields, valuations of semiconductor stocks are not cheap. Chart 18 illustrates the equity risk premium for global semiconductor stocks is at the lower end of its range of the past 10 years. The ERP is calculated as forward earnings yield minus 10-year US TIPS yields. It is impossible to time a correction or know what the trigger would be (US-China tensions have been our best guess). Nevertheless, we do not recommend chasing semiconductor stocks higher due to their overstretched technicals and valuations on the one hand and potential weakening demand in H2 on the other. Chart 17Global Semiconductor Stocks: Elevated Valuations Chart 18Equity Risk Premium For Global Semi Stocks Is Historically Low In addition, the ratio of global semi equipment stock prices relative to the semi equity index correlates with absolute share prices of global semi companies. This is because equipment producers are higher-beta as they outperform during growth accelerations and underperform during growth slumps. The basis is that semi manufacturers have to purchase equipment if there is actual strong demand coming up and vice versa. The recent underperformance by global semi equipment stocks relative to the semi equity index might be an early sign of a potential reversal in semi share prices in absolute terms (Chart 19). Chart 19A Signal Of A Potential Reversal In Semi Share Prices Meanwhile, we believe the subsector- memory chip stocks - will outperform the overall semiconductor index amidst the potential correction, because they have lagged and are less over-extended. Finally, we remain neutral on Taiwanese and Korean bourses within the EM equity space for now. Escalation in US-China confrontation, as well as their exposure to semiconductors, put these bourses at near-term risk. That said, we are reluctant to underweight these markets because fundamentals in EM outside North Asia remain challenging.   Ellen JingYuan He Associate Vice President ellenj@bcaresearch.com   Footnotes 1Traditional PCs are comprised of desktops, notebooks, and workstations. 2Global server shipments to contract 5.6% sequentially in 3Q2020, says Digitimes Research 3Global server shipments forecast to increase by 5% this year: TrendForce 4IDC Expects Worldwide Smartphone Shipments to Plummet 11.9% in 2020 Fueled by Ongoing COVID-19 Challenges 5America does not want China to dominate 5G mobile networks 6“Data localization” can be defined as the act of storing data on a device that is physically located within the country where the data was created. Data localization requirements are governmental obligations that explicitly mandate local storage of personal information or strongly encourage local storage through data protection laws that erect stringent legal compliance obligations on cross-border data transfers. 7The big data center industry ushered in another outbreak 8The GSMA represents the interests of mobile operators worldwide, uniting more than 750 operators with almost 400 companies in the broader mobile ecosystem, including handset and device makers, software companies, equipment providers and internet companies, as well as organizations in adjacent industry sectors. 9GSMA: 5G Moves from Hype to Reality – but 4G Still King 10Smart Cities Market Size Worth $463.9 billion By 2027 11The Automotive Semiconductor Market – Key Determinants of U.S. Firm Competitiveness 12AI is data Pac-Man. Winning requires a flashy new storage strategy.

Our recent bump of the S&P materials sector to overweight on July 27th pushed our cyclicals vs defensives positioning to the overweight column. Since then, this bent has netted our portfolio roughly 6% of returns. Similar to any rate of change series that is mean reverting by construction, the cyclicals/defensives ratio is the ultimate mean reverting pairing of S&P 500 sectors.  Importantly, taking a cue from the ISM’s new orders-to-inventories (NOI) ratio, another consistent mean reverting macro pair, is in order. The chart shows that cyclicals/defensives relative share prices move in lockstep with the NOI ratio, and the current message is to expect a definitive breakout in the former. This is especially true as the economy is reopening and the “work from home” stock darlings pass the baton to the “back to business as usual” laggard stocks. Bottom Line: We reiterate our recent cyclicals versus defensives preference. For additional details please refer to our August 3, Special Report “Top 10 Reasons To Start Nibbling On Cyclicals At The Expense Of Defensives”.     

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Feature Feature ChartThe Sales Of Makeup And Perfumes Collapsed, But The Sales Of Hair Care And Skin Care Grew The pandemic era is diminishing our close quarters intimacy with people, which raises a fascinating question. In a world of social and physical distancing, widespread use of face coverings, and virtual meetings on Zoom or Skype, is it still important to look good? Is it important to smell good? And perhaps the most fascinating question of all: is it important to feel good? The so-called ‘lipstick effect’ is a putative counter-cyclical phenomenon during recessions in which the demand for small treats and pick-me-ups increases while other spending is shrinking. One theory is that it is based on the basic human desire to feel good, even during hard times. When budgets are squeezed, people simply cut out large extravagances and substitute them with small luxuries, epitomised by lipstick. The lipstick effect was first recorded during the Great Depression. Between 1930 and 1933, unemployment in Germany surged to six million. But thanks to the booming demand for its cosmetics, the German firm Beiersdorf could boast that it did not have to lay off a single worker. Across the Atlantic, the same was true. When US economic output shrank by a third, cosmetics were one of the few products whose sales grew. The lipstick effect was also observed during the Great Recession. Between September 2008 and January 2009 when US consumer spending shrank, the sales of cosmetics bucked the downtrend, and grew (Chart I-2).  Chart I-2Cosmetics Sales Grew In The 2008 Recession... The Lipstick Effect Is Working In An Evolved Form Fast forward to 2020, and the pandemic-induced economic slump is the one recession in which we would expect not to observe the lipstick effect. After all, if you are in lockdown, or must maintain physical distancing with other people, or must wear a face covering when near other people, what is the point of wearing makeup or perfume? The sales of cosmetics and fragrances collapsed in the 2020 recession… Just as we would expect, between February and April this year, the US sales of cosmetics and fragrances collapsed by 18 percent, exactly in line with the plunge in US consumer spending. On the face of it, the lipstick effect does not work under a facemask (Chart I-3). Chart I-3...But Shrank In The 2020 Recession Yet on closer examination, the lipstick effect is working, albeit in an evolved form. While the sales of makeup and perfumes have collapsed in 2020, the sales of skincare and haircare products are growing (Chart I-1). As the pandemic took hold and forced hair and beauty salons to shutter, people replaced salon visits with at-home care routines. And interestingly, even in the Great Recession of 2008-09, the US sales of haircare and non-cosmetic personal products outperformed the sales of cosmetics (Chart I-4-Chart I-7). Chart I-4Hair Care And Skin Care Sales Grew In The 2008 Recession... Chart I-5...And Grew In The 2020 ##br##Recession Chart I-6Total Personal Products Sales Grew In The 2008 Recession... Chart I-7...And Have Held Up Well In The 2020 Recession In fact, 60 percent of the total beauty market comprises skincare and haircare products compared with 30 percent for makeup and perfumes (Chart I-8). It turns out that the cosmetics and personal products firms that have a diversified exposure to all segments of the beauty market are the ones that outperform in hard times as well as good. And it turns out that these companies are European. Chart I-8Skin Care And Hair Care Dominates The Beauty Market The European Cosmetics Sector Is Outperforming In hard times, the European cosmetics sector, led by L’Oréal, has consistently outperformed the US cosmetics sector, led by Estee Lauder, and the Japanese cosmetics sector, led by Shiseido. In hard times, the European cosmetics sector, led by L’Oréal, has consistently outperformed. Specifically, the 12-month forward earnings for the European cosmetics sector barely declined in the 2008-09 recession and have barely declined in the 2020 recession. In contrast, the forward earnings for the US and Japanese cosmetics sectors collapsed both then and now (Chart I-9). Chart I-9The European Cosmetics Sector Has Been Recession-Proof Furthermore, the latest quarterly reports show that while operating profits for L’Oréal are down by around 20 percent from a year ago, the operating profits for Estee Lauder and Shiseido have slumped by more than 80 percent.1 As a result, the L’Oréal share price took a much smaller hit than those of Estee Lauder and Shiseido in both the 2008 and the 2020 stock market crashes (Chart I-10 and Chart I-11). Chart I-10L’Oréal Took A Smaller Hit Than Estee Lauder And Shiseido In 2008… Chart I-11…And In ##br##2020 An important reason for L’Oréal’s consistent outperformance is its diversified product range. L’Oréal acknowledges that for both its consumer products and luxury divisions “the health crisis triggered a sharp deceleration in the makeup market”. But the hit to makeup was counterbalanced by continued strong growth in skin care thanks, for example, to the launch of serums in its Revitalift range. Additionally, its hair care products grew thanks to Fructis Hair Food plus very strong performance in the “highly dynamic home-use hair colour market”.  Estee Lauder confirms that “Covid-19 and its various impacts have influenced consumer preferences due to the closures of offices, retail stores and other businesses and the significant decline in social gatherings”. While the demand for makeup and fragrance has slumped, the demand for skin care and hair care products has been more resilient. The trouble is that hair care accounts for less than 4 percent of Estee Lauder’s total sales. Meanwhile, the collapse in makeup sales has forced goodwill asset impairments to several of its makeup brands causing the 80 percent collapse in its overall profits. Likewise, Shiseido blames the 83 percent slump in its operating profits largely on “a product mix deterioration” which outweighed prompt cost-saving measures in response to the rapid deterioration of the market environment. Another vulnerability is that Shiseido’s sales are highly concentrated in Asia. By comparison, L’Oréal benefits from geographical diversification, with sales almost equally split between Europe, the Americas, and Asia (Table I-1). Table I-1L’Oréal Benefits From Geographical Diversification The European Personal Products Sector Is Also Outperforming Turning to the general personal products sector, the leading companies are Unilever and Beiersdorf in Europe, Procter & Gamble, Colgate-Palmolive, and Kimberly Clark in the US, and Kao in Japan. In the personal products sector too, Europe has consistently outperformed the US and Japan. In the personal products sector too, Europe has consistently outperformed the US and Japan. Indeed, while the European sector’s profits have steadily grown through the past decade, the US sector’s profits have been going nowhere since the mid-2010s (Chart 1-12). Chart I-12The European Personal Products Sector’s Profits Have Grown Through The Past Decade   One reason for the European personal products sector’s reliable growth is that both Unilever and Beiersdorf are highly exposed to the beauty sector – in fact, Unilever has an even larger market share than Estee Lauder (Chart I-13). And as we have just seen, a diversified exposure to all segments of the beauty sector – makeup, fragrances, skin care, and hair care – should produce resilient growth in all economic backdrops. Pre-pandemic, and potentially once the pandemic is over, makeup and fragrances were/will be the growth drivers. Whereas during the pandemic, skin care and hair care are the drivers. Chart I-13Unilever Is A Big Player In Beauty A final point is that despite the superior and safer growth prospects of the European cosmetics and personal products companies, they are not generally more richly valued than their peers in the US and Japan (Table I-2 and Table I-3). Table I-2The European Cosmetics Sector Is Not More Expensive Table I-3The European Personal Products Sector Is Not More Expensive To sum up, for the pandemic era and beyond, the European cosmetics and personal products sector is well set for diversified growth via product mix, price points, and regional exposures. And it is relatively well valued versus its peers elsewhere in the world. As such, the sector – dominated by L’Oréal, Unilever, and Beiersdorf – should remain a core holding in an investment portfolio.   Dhaval Joshi Chief European Investment Strategist dhaval@bcaresearch.com   Mohamed El Shennawy Research Associate mohamede@bcaresearch.com Footnotes 1 The most recent quarterly report for Estee Lauder is due on August 20. But at the time of writing the latest quarterly report was to the end of June 2020 for L’Oréal and to the end of March 2020 for Estee Lauder and Shiseido.

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Highlights The underperformance of value versus growth has been a reason behind the dollar bull market rather than a consequence of it. The rationale is that the catalyst for any sector to outperform is return on capital rather than the cost of capital. The outperformance of health care and technology has been on the back of rising profits, rather than just investor exuberance and/or low bond yields. Cyclical currencies with a high concentration of value sectors have tracked the relative performance of their representative bourses. A reversal will require value sectors to start outperforming on a sustainable basis. It is encouraging that leadership changes in equity markets occur more often than not. Historically, these tend to take place every decade. Bombed-out valuations suggest some deep-value sectors have become sufficiently cheap to compensate for a pessimistic profit scenario. An outperformance of value versus growth will favor cyclical currencies. We are long a basket of petrocurrencies, the SEK, and GBP. We are also short USD/JPY as portfolio insurance (and as a play on the cyclical Japanese market). Feature The usual market narrative is that for non-US stocks to outperform, the dollar has to decline. This also applies to value stocks that have a higher weighting outside the US, compared to growth stocks. At the center of this premise is that the dollar is a reserve currency. As a result, three reasons emblem the view. First, a fall in the dollar eases financing costs for non-US corporations borrowing in dollars. Second, commodities tend to do well when the dollar declines, benefiting emerging market and commodity-producing countries. And finally, a lower dollar boosts the common-currency returns for US-based investors, leading to more capital deployment in offshore markets. On the surface, this makes sense. But digging deeper into the thesis, it appears that a lower US dollar is a necessary but not sufficient condition for non-US (or value) stocks to outperform. The reason is that profit growth (the ultimate driver of stock prices) is more contingent on productivity gains rather than translation effects. As such, the value-versus-growth debate is important, not only for the sectors involved, but for currency strategy as well. A Two-Decade Postmortem Chart 1 plots the MSCI global value index versus its growth counterpart, superimposed against the US dollar. Two trends become apparent: The relative performance of value versus growth typically bottoms or peaks ahead of turns in the US dollar. The relationship between the value/growth ratio and the US dollar is not always in sync. There was a period of decoupling after the financial crisis, and, more recently, in 2015-2016. This was also the case in the ‘80s and around the Asian crisis in the late ‘90s. Flows tend to gravitate to capital markets with the highest expected returns, and this is certainly the case when value or growth style tilts are concerned. This is important for currency strategy, since sector composition can drive a country’s equity returns. Meanwhile, both equity and currency relative performances tend to be in sync (Chart 2A and Chart 2B). Chart 1Value/Growth Turns Before The Dollar Chart 2ACurrencies Follow Relative Equity Performance Chart 2BCurrencies Follow Relative Equity Performance According to the MSCI classification, information technology and health care are the biggest components of the growth index – a whopping 49%. This is in stark contrast to financials and industrials, which make up 33% of the value index. Not surprisingly, currencies with a heavy value weighting in their domestic bourses (Table 1) have suffered indiscriminately compared to their growth counterparts, over the last decade. Table 1Sector Weights Across G10 Take the US and Switzerland, which have the highest equity concentration in traditional growth sectors, at over 60%. Both the US dollar and Swiss franc have held up remarkably well in trade-weighted terms since the onset of the dollar bull market (Chart 3). Likewise, it would have been a miracle for petrocurrencies (CAD, NOK and AUD) to hold up amid the recent underperformance in energy and financials. This suggests that at minimum, the underperformance of value versus growth has been a reason for the dollar bull market rather than a consequence of it. Chart 3Style Tilt Drives Currency Performance Chicken And Egg Problem? What about the narrative that a decline in the dollar greases the engine of non-US stocks? Yes, but not entirely. It is certainly the case that most global trade and financing is conducted in US dollars, and so a fall in the US dollar (commensurate with lower interest rates) leads to easier global financial conditions. As Chart 4 clearly illustrates, corporate spreads abroad have been tightly correlated to dollar volatility. A lower dollar also eases repayment costs for non-US borrowers. A lower dollar also boosts resource prices through the numeraire effect (Chart 5). Meanwhile, rising commodity prices flatter industries tied to the resource value chain such as industrials, materials, and energy. Second-round economic effects also buffet other cyclical industries such as retail and hospitality, which help boost the domestic equity index. That said, the rally in commodities, value stocks, and emerging market share prices in 2016-2017 occurred despite a dollar that was flat-to-higher – so the causality versus effect link is not always trivial. Part of the reason is that, over the past few years, both emerging market and other non-US corporates have diversified their sources of debt funding. Euro- and yen-denominated debt have been surging (Chart 6), which has kept their cost of capital low, even as the dollar has risen. Chart 4The Dollar And Funding Stresses Chart 5Tied To The Hip Chart 6Lots Of Non-US Debt It is also important to note that in commodity bull markets, prices tend to rise in all currencies, including domestically (Chart 7). This is crucial for sector outperformance since the translation effect for profits will otherwise be negative, given local-currency fixed and variable costs. This suggests that demand is the driving force behind bull markets in commodity prices and cyclical stocks, rather than a lower greenback. Chart 7Commodity Bull Markets In Different Currencies Chart 8China And Commodities This demand has come in the form of Chinese stimulus. Chart 8 shows a close correlation between excess liquidity in China (a measure of the centripetal force from Chinese credit) and resource share valuations. Ergo, a key barometer for value to outperform growth is that Chinese demand picks up, plugging the hole in exactly the sectors that have borne the brunt of deleveraging in recent years A look at corporate balance sheets and income statements corroborates this view. Growth has outperformed value on the back of a re-rating, but also on profitability. Chart 9A and Chart 9B rank G10 equity bourses on the basis of return on equity and their corresponding price-to-book ratios. Not surprisingly, the winners of the last decade have had the biggest returns on equity, as was the case for the winners during the prior decade. Chart 9AMarkets Bid Up High Returns To Capital Chart 9BMarkets Bid Up High Returns To Capital As such, the catalyst for any sector to outperform is return on capital rather than the cost of capital. Structural Shift? There is some evidence that the underperformance of value versus growth could be structural. For one, being a value manager seems to be following the fate of telephone switchboard operators in the early 1900s. Perhaps the advent of computer trading systems has systematically eroded the value premium. As such it is becoming more and more difficult, even for the most skillful value managers, to beat their own index. An inability for value sectors to outperform will be a key risk to a dollar-bearish view. Work done on our in-house Equity Trading Strategy platform corroborates this view. Since about 2014, a long/short strategy based on the best value stocks relative to the worst in terms of a swath of fundamental valuation metrics has been flat compared to a more blended strategy (Chart 10). According to our quantitative specialists, the best value can be found in European countries such as Sweden, Denmark, the Netherlands, and Germany (Chart 11). Surprisingly, their proprietary value model rate Switzerland and New Zealand quite highly, despite a clear defensive bias in these equity markets. Unsurprisingly, some of the countries that have had the weakest currencies in the last decade such as Sweden and the Eurozone members have highly favored value sectors. Chart 10A Dearth Of Value Managers Chart 11Lots Of Value Outside The US Going forward, a few things could change. One of the primary reasons why growth has outperformed value has been the drop in bond yields, which has increased the appeal of companies with low payout ratios and much more backdated cash flows (Chart 12). But as countries from Japan to Australia implement yield-curve controls at the zero bound, the capitalized dividend from low yields is bound to be exhausted. Meanwhile, any rise in yields will favor deep-value sectors like banks (due to rising net interest margins) and commodities (due to inflation protection). Chart 12A Lower Discount Favors Long-Duration Assets Second, falling global trade and the proliferation of Environmental, Social and Governance (ESG) investing has hammered traditional industries such as energy and autos. Part of this trend is structural, but there is also a cyclical component. For the auto industry in particular, auto sales are strongly (inversely) correlated to the unemployment rate, and as more economies reopen, car sales should pick up. Meanwhile, traditional auto and energy companies are stepping up their electric vehicle and alternative energy strategies, meaning the first-mover advantage for the avant-gardes like Tesla and Nikola could be eroded. Finally, valuation tends to be a key catalyst near recessions. Given that over the years, one of the more consistent drivers of long-term equity returns has been the valuation starting point, this favors non-US stocks (Chart 13A, Chart 13B, Chart 13C, Chart 13D). Not surprisingly, the currencies that are the most undervalued in our models1 also have cheap equity markets. Even if one focuses solely on growth sectors such as technology and health care, non-US companies are still more attractive, according to our Equity Trading Strategy platform (Chart 14). This suggests some measure of convergence is due. Chart 13AProspective Returns Higher Outside The US Chart 13BProspective Returns Higher Outside The US Chart 13CProspective Returns Higher Outside The US Chart 13DProspective Returns Higher Outside The US Chart 14Attractive Growth Stocks Outside The US It is encouraging that leadership changes in equity markets occur more often than not. Historically, these tend to occur every decade. Bombed-out valuations suggest some deep-value sectors have become sufficiently cheap to compensate for a pessimistic profit scenario. Portfolio Construction An outperformance of value versus growth will favor cyclical currencies. The catalyst will have to be improving return on capital from value sectors, but the valuation starting point is already quite compelling. Meanwhile, even traditional growth sectors are still cheaper outside the US. We are already selectively long a basket of petrocurrencies, the SEK, and GBP. We are also short USD/JPY as portfolio insurance (and as a play on the cyclical Japanese market). Should value stocks gain more widespread appeal, we will add the Eurozone and emerging market currencies to this basket. Elsewhere, a tactical trading opportunity has also opened up to go short the NZD/CAD cross. Little known is that the New Zealand stock market is the most defensive in the world (previously referenced in Table 1). This has helped keep the New Zealand dollar higher than would have otherwise been the case. Should value start to outperform growth, this will favor the CAD/NZD cross (Chart 15). Chart 15CAD/NZD And Relative Stocks While we commend Prime Minister Jacinda Ardern’s efforts to limit the spread of COVID-19 in New Zealand, the economy will soon start to bump against supply-side constraints. More specifically, COVID-19 has accentuated the immigration cliff in New Zealand, an important hit to the labor dividend for the economy (Chart 16). As such, the neutral rate of interest is bound to head lower. Chart 16A Top For NZD/CAD? This is in stark contrast to Canada, where the current government was pro-immigration even before widespread lockdowns. Meanwhile, in the commodity space, our bias is that energy will fare better than agriculture, boosting relative Canadian terms of trade. Go short NZD/CAD for a trade.   Chester Ntonifor Foreign Exchange Strategist chestern@bcaresearch.com     Footnotes 1 Please see Foreign Exchange Strategy Weekly Report , "Updating Our Intermediate-Term Models", dated July 3, 2020.