Technology
Tech titans (AAPL, MSFT, AMZN, GOOGL & FB) peaked last September at roughly 26% market cap weight in the SPX, and have since fallen 300bps despite four of the five stocks recently hitting new all-time highs (AAPL is the last man standing). This portfolio rebalancing that we first recommended in early September away from tech stocks and into other deep cyclicals remains intact, and while recently the tech titans have stabilized, more pain likely looms. The chart shows that the S&P 5 have been perfectly inversely correlated with the 10-year US Treasury (UST) yield. Keep in mind that bonds typically lead stocks: last early-August the 10-year UST yield troughed near 50bps and a month later the tech titans peaked (top panel). The implication is that when the selloff in the bond market resumes it will serve as a catalyst for a catch down phase in the tech titans. Bottom Line: We remain cyclically neutral the S&P tech sector, underweight the S&P communications services sector and continue to recommend investors rebalance away from the tech titans and into the still undervalued S&P industrials and S&P energy sectors. Also, from a structural perspective, we reiterate our long SPY/short QQQ trade. Chart 1
Highlights Rising CO2 emissions on the back of stronger global energy growth this year will keep energy markets focused on expanding ESG risks in the buildout of renewable generation via metals mining (Chart of the Week). EM energy demand is expected to grow 3.4% this year vs. 2019 levels and will account for ~ 70% of global energy demand growth. Demand in DM economies will fall 3% this year vs 2019 levels. Overall, global demand is expected to recover all the ground lost to the COVID-19 pandemic, according to the IEA. Rising energy demand will be met by higher fossil-fuel use, with coal demand increasing by more than total renewables generation this year and accounting for more than half of global energy demand growth. Demand for renewable power will increase by 8,300 TWh (8%) this year, the largest y/y increase recorded by the IEA. As renewables generation is built out, demand for bulks (iron ore and steel) and base metals will increase.1 Building that new energy supply will contribute to rising CO2, particularly in the renewables' supply chains. Feature Energy demand will recover much of the ground lost to the COVID-19 pandemic last year, according to the IEA.2 Most of this is down to successful rollouts of vaccination programs in systemically important economies – e.g., China, the US and the UK – and the massive fiscal and monetary stimulus deployed to carry the global economy through the pandemic. The risk of further lockdowns and uncontrolled spread of variants of the virus remains high, but, at present, progress continues to be made and wider vaccine distribution can be expected. The IEA expects a global recovery in energy demand of 4.6% this year, which will put total demand at ~ 0.5% above 2019 levels. The global rebound will be led by EM economies, where demand is expected to grow 3.4% this year vs. 2019 levels and will account for ~ 70% of global energy demand growth. Energy demand in DM economies will fall 3% this year vs 2019 levels. Overall, global demand is expected to recover all the ground lost to the COVID-19 pandemic, according to the IEA. Chart of the WeekGlobal CO2 Emissions Will Rebound Post-COVID-19 Coal demand will lead the rebound in fossil-fuel use, which is expected to account for more than total renewables demand globally this year, covering more than half of global energy demand growth. This will push CO2 emissions up by 5% this year. Asia coal demand – led by China's and India's world-leading coal-plant buildout over the past 20 years – will account for 80% of world demand (Chart 2). Chart 2China, India Lead Coal-Fired Generation Buildout Demand for renewable power will post its biggest year-on-year gain on record, increasing by 8,300 TWh (8%) this year. This increase comes at the back of roughly a decade of an increasing share of electricity from renewables globally (Chart 3). As renewables generation is built out, demand for bulks (iron ore and steel) and base metals will increase.3 Building that new energy supply will contribute to rising CO2, particularly in the renewables' supply chains. Chart 3Share of Electricity From Renewables Has Been Increasing ESG Risks Increase With Renewables Buildout Governments have pledged to invest vast sums of money into the green energy transition, to reduce fossil fuels consumption and deforestation, thus curbing temperature increases. In addition, banks have pledged trillions will be made available to support the buildout of renewable technologies over the coming years. The World Bank, under the most ambitious scenarios considered (IEA ETP B2DS and IRENA REmap), projects that renewables, will make up approximately 90% of the installed electricity generation capacity up to 2050. This analysis excludes oil, biomass and tidal energy. (Chart 4). Building these renewable energy sources will be extremely mineral intensive (Chart 5). Chart 4Renewables Potential Is Huge … While we have highlighted issues such as a lack of mining capex and decreasing ore grades in past research – both of which can be addressed by higher metals and minerals prices – the environmental, social and governance (ESG) risks posed by mining are equally important factors for investors, policymakers and mining companies to consider.4 The mining industry generally uses three principal sources of energy for its operations – diesel fuel (mostly in moving mined ore down the supply chain for processing), grid electricity and explosives. Of these three, diesel and electricity consumption contributes substantially to mining’s GHG emissions. In the mining stage, land clearing, drilling, blasting, crushing and hauling require a considerable amount of energy, and hence emit the highest amounts of greenhouse gases (GHGs). Chart 5… As Are Its Mineral Requirements The Environmental Impact Of Mining Under the scenarios depicted in Chart 5, copper suppliers could be called on to produce approximately 21mm MT of the red metal annually between now and 2050, which is equivalent to a 7% annual increase of supplies vs. the 2017 reference year shown in the chart. Mining sufficient amounts of copper, a metal which is critical to the renewable energy buildout, both in terms of quantity and versatility, will test miners' and governments' ability to extract sufficient amounts of ore for further processing without massively damaging the environment or indigenous populations' habitats (Chart 6). Chart 6Copper Spans All Renewables Technologies A recent risk analysis of 308 undeveloped copper orebodies found that for 180 of the orebodies – roughly equivalent to 570mm MT of copper – ore-grade risk was characterized as moderate-to-high risk.5 High risk implies a lower concentration of metal in the ore deposits. Mining in ore bodies with lower copper grades will be more energy intensive, and thus will emit more greenhouse gases. Table 1 is a risk matrix of the 40 mines that have the most amount of copper tonnage in this analysis: 27 of these mines displayed in the matrix have a medium-to-high grade risk. Table 1Mining Risk Matrix Another analysis established a negative relationship between the ore-grade quality and energy consumption across mines for different metals and minerals.6 This paper found that, as ore grade depletes, the energy needed to extract it and send it along the supply chain for further processing is exponentially higher (Chart 7). Lastly, a recent examination found that in 2018, primary metals and mining accounted for approximately 10% of the total greenhouse gases. Using a case study of Chile, the world’s largest producer of the red metal, the researchers found that fuel consumption increased by 130% and electricity consumption per unit of mined copper increased by 32% from 2001 to 2017. This increase was primarily due to decreasing ore grades.7 As ore grades continue to fall, these exponential relationships likely will persist or become more significant. Chart 7Energy Use Rises As Ore Quality Falls Bottom Line: While technology can improve extraction, it cannot reduce the minimum energy required for the mining process. This increased energy use will contribute to the total amount of CO2 and other GHGs emitted in the process of extracting the ores required to realize a low-carbon future. Trade-Off Between CO2 Emissions And Economic Development A recent Reuters analysis highlights the gap between EM and DM from the perspective of their renewable energy transition priorities.8 Of the 17 UN Sustainable Development Goals (SDGs), “Taking action to combat climate change” takes precedence over the rest for DM economies. This is largely because they have already dealt with other energy and income intensive SDGs such as improvements in healthcare and poverty reduction. The large scale of unmet energy demand in developing countries poses a huge challenge to controlling CO2 emissions. The populations of these countries are growing fast and are projected to continue increasing over the next three decades. Rising populations, make the issue of a "green-energy transition" extremely dynamic – i.e., not only do EM economies need to replace existing fossil fuels, but they also need to add enough extra zero-emission fuel sources to meet the growth in energy demand. Bottom Line: Coupled with the increased amount of energy required to mine the same amount of metal (due to lower ore grades), rising energy demand resulting from a burgeoning population in EM economies - which use fossil fuels to meet their primary needs - will require more metals to be mined for the renewable energy transition. This will further increase the amount of carbon dioxide and other greenhouse gas emissions from mine activity, and increase the risk to indigenous populations living close-by to the sources of this new metals supply. ESG risks will increase as a result, presenting greater challenges to attracting funding to these efforts. Ashwin Shyam Research Associate Commodity & Energy Strategy ashwin.shyam@bcaresearch.com Robert P. Ryan Chief Commodity & Energy Strategist rryan@bcaresearch.com Commodities Round-Up Energy: Bullish OPEC 2.0 was expected to stick with its decision to return ~ 2mm b/d of supply to the market at its ministerial meeting Wednesday. Markets remain wary of demand slowing as COVID-19-induced lockdowns persist and case counts increase globally. The production being returned to market includes 1mm b/d of voluntary cuts by Saudi Arabia, which could, if needs be, keep barrels off the market if demand weakens. Base Metals: Bullish Front-month COMEX copper is holding above $4.50/lb, after breaching its 11-year high earlier this week. The proximate cause of the initial lift above that level was news of a strike by Chilean port workers on Monday protesting restrictions on early pension-fund drawdowns, according to mining.com. After a slight breather, prices returned to trading north of $4.50/lb by mid-week. Last week, we raised our Dec21 COMEX copper price forecast to $5.00/lb from $4.50/lb. Separately, high-grade iron ore (65% Fe) hit record highs, while the benchmark grade (62% Fe) traded above $190/MT earlier in the week on the back of lower-than-expected production by major suppliers and USD weakness. Steel futures on the Shanghai Futures Exchange hit another record as well, as strong demand and threats of mandated reductions in Chinese steel output to reduce pollution loom (Chart 8). Precious Metals: Bullish Rising COVID cases, especially in India, Brazil and Japan are increasing gold’s safe-haven appeal (Chart 9). The US CFTC, in its Commitment of Traders (COT) report for the week ending April 20, stated that speculators raised their COMEX gold bullish positions. At the end of the two-day FOMC meeting, the Fed decided against lifting interest rates and withdrawing support for the US economy. However, officials sounded more optimistic about the economy than they did in March. The decision did not give any sign interest rates would be lifted, or asset purchases would be tapered against the backdrop of a steadily improving economy. Net, this could increase demand for gold, as inflationary pressures rise. As of Tuesday’s close, COMEX gold was trading at $1778/oz. Ags/Softs: Neutral Corn and bean futures settled down by mid-week after a sharp rally earlier. After rising to a new eight-year high just below $7/bushel due to cold weather in the US, and fears a lower harvest in Brazil will reduce global grain supplies, corn settled down to ~ $6.85/bu at mid-week trading. Beans traded above $15.50/bu earlier in the week, their highest since June 2014, and settled down to ~ $15.36/bu by mid-week. Attention remains focused on global supplies. The uptrend in grains and beans remains intact. Chart 8 Chart 9 Footnotes 1 Please see Renewables, China's FYP Underpin Metals Demand, published 26 November 2020, for further discussion. It is available at ces.bcaresearch.com. 2 Please see Global Energy Review 2021, the IEA's Flagship report for April 2021. 3 Please see Renewables, China's FYP Underpin Metals Demand, published 26 November 2020, for further discussion. It is available at ces.bcaresearch.com. 4 We discussed these capex issues in last week's research, Copper Headed Higher On Surge In Steel Prices, which is available at ces.bcaresearch.com. 5 Please see Valenta et al.’s ‘Re-thinking complex orebodies: Consequences for the future world supply of copper’ published in 2019 for this analysis. 6 Please see Calvo et. al.’s ‘Decreasing Ore Grades in Global Metallic Mining: A Theoretical Issue or a Global Reality?’ published in 2016 for this analysis. 7 Please see Azadi et. al.’s ‘Transparency on greenhouse gas emissions from mining to enable climate change mitigation’ published in 2020 for this analysis. 8 Please see John Kemp's Column: CO2 emission limits and economic development published 19 April 2021 by reuters.com. Investment Views and Themes Strategic Recommendations Tactical Trades Commodity Prices and Plays Reference Table Trades Closed in 2021 Summary of Closed Trades
Highlights Biden will host a global summit for Earth Day on April 22-23, giving public attention to his climate change policy push. Investors should count on Biden’s green infrastructure package becoming the bulk of his climate push, given uncertainty over the 2022 midterm elections. However, over the long run, American public opinion is shifting in favor of renewables and the US will seek to maintain its technological edge via participating in the green tech race. Go long our “Biden Fiscal Advantage Basket” versus the Nasdaq 100. Feature The Biden administration’s $2.3 trillion American Jobs Plan is often referred to as a “green infrastructure” package and in this report we take a look at what makes it green – and what are the investment implications. Biden will virtually host a global climate summit on April 22-23, Earth Day, which the Chinese President Xi Jinping is expected to attend, thus providing momentum to the green investment theme. The stock market anticipated Biden’s electoral victory last year and renewable energy stocks rallied exorbitantly, with ultra-easy monetary and fiscal policy as a fundamental support. The market’s reaction to Biden’s official outline of his plan last month suggests that investors are energized about Biden’s infrastructure package but already suffering from some green fatigue (Chart 1). However, this bill’s passage will initiate the US’s official entrance into the global green energy race and from that point of view renewable plays should recover. Once the American Jobs Plan passes, likely sometime this fall, Biden’s climate agenda will be virtually finished, from an investment perspective. Investors have little visibility beyond 2022 as the president’s party rarely hangs onto the House of Representatives in his first midterm election. However, over the long run, American public opinion is shifting in favor of renewable energy. And Biden also has regulatory tools to push the Democratic Party’s climate agenda from 2022-24 regardless. Chart 1Biden's AJP Already Priced Chart 2Biden’s First Budget: Boom In Non-Defense Discretionary Spending Biden’s first presidential budget, released on April 13, also highlights the US’s attempt to boost climate policy (the Environmental Protection Agency’s funding would go up by 21%). More broadly it highlights the US’s ongoing sea change in fiscal policy. Discretionary spending turned around under President Trump’s populism and will continue under Biden’s populism. The difference lies in social spending versus defense. Biden proposes a 15.2% increase in non-defense discretionary spending, with education, commerce, health, and environment while the departments of defense and justice see much smaller increases (Chart 2). But we doubt that even defense spending will be curtailed given the US’s global strategic challenges. The president’s budget proposals are drops in the bucket compared to the trillions in his economic stimulus packages. Biden’s American Family Plan will be outlined in detail later this month but it only has a 50/50 chance of passing by the 2022 midterm election. This leaves us with the American Jobs Plan as the real macro policy factor to watch. And in the case of green energy, in particular, the Democrats may not have another opportunity to pass major legislation for many years. The US’s Strategic Basis For Green Energy The American Jobs Plan is billed as a $2.3 trillion green infrastructure package but in reality the package should be broken into traditional infrastructure ($784 billion for roads and bridges), social welfare ($647 billion for elderly care, education, etc), green initiatives ($370 billion for electrical grid and retrofits, etc), tech initiatives ($280 billion for broadband, semiconductors, research and development), and small business support, in order of dollar value (Chart 3). The implication is that climate policy is important but not the top priority. Still, $370 billion is the biggest green package the US has ever launched. It consists of $150 billion for “hard” green infrastructure, such as new electricity grid and $220 billion for “soft” green infrastructure, such as tax credits for buying EVs (Chart 4). Chart 3Biden’s AJP: Green Initiatives Total $370 Billion Chart 4Biden’s AJP: Green Initiatives Mostly Rebates/Incentive The US has moved slowly on green energy policy – relative to Europe or China – because it does not face the same strategic necessity. China faces domestic social unrest if it does not reduce pollution, it faces American strategic containment if it does not reduce its dependency on the Middle East (35% of total oil consumption), and it faces the middle-income trap if it does not increase innovation and productivity. Europe is similarly dependent on a geopolitical enemy for its energy supply – Russia provides 35% of its oil consumption and 38% of its natural gas – and it must also increase productivity. Europe and China are net energy importers who have a great strategic interest in making energy supply a matter of manufacturing prowess rather than divine natural resource endowment (Chart 5). The US is late to the green energy game in part because it does not share the same degree of strategic necessity. Like the EU, the US took care of its most pressing pollution problems decades ago. But unlike the EU, the US is a net energy exporter thanks to the fracking revolution. However, the US is not truly energy independent – an Iranian closure of the Strait of Hormuz would cause global oil prices to spike and trigger a recession. And the US also has a powerful strategic interest in maintaining its global leadership and its edge in technology, innovation, and productivity (Chart 6). The US cannot afford to miss out on the green tech race even if starting from a more secure natural resource base. Chart 5US Green Focus Less Motivated By Energy Security Than China, EU US public opinion is also following European opinion regarding climate change and environmental protection. True, voters are more urgently concerned about the economy, jobs, and health care over the environment – as we showed in our Special Report on health care earlier this year. But the administration has decided not to rehash the health care battles of the Obama administration – having seen Republicans fail to repeal Obamacare – and instead to open up a new policy domain with climate change. Even if the environment is low priority for most voters, they do not oppose green projects in principle – in fact, they favor renewable energy over fossil fuels when it comes to the US’s energy future (Chart 7). And voters strongly favor infrastructure, which means they are more susceptible to green energy projects when presented as part of a broader infrastructure buildout – as opposed to a transformative “Green New Deal” designed to revolutionize every aspect of US life. Chart 6US Green Focus Motivated By Global Innovation/Tech Race Chart 7US Public Supports Renewable Energy The US shift to green energy is well underway, with renewables ready to surpass coal in the national energy mix (Chart 8). The natural gas boom of the past decade has worked wonders in reducing coal dependency and hence overall carbon emissions (Chart 9). Chart 8Shift To Renewables Well Underway Chart 9US Carbon Emissions To Fall Further Bottom Line: The US does not have the same energy security problems as China and the EU, which is one reason the US trails these competitors in green energy production and policy. But the US has a powerful interest in maintaining its technological edge and productivity growth. So policymakers will continue to push the green agenda even as the public follows Europe in becoming more favorable toward it over the long run. US Climate Policy Will Advance In Fits And Starts The fact that the US lacks the same strategic urgency as Europe and China suggests that the green energy push in the US will progress in fits and starts rather than in a straight line. Popular opinion cited above is supportive enough to allow a political party to push a green agenda if it has control of both the White House and Congress. The Biden administration has moderate-to-strong political capital based on our Political Capital Index (Appendix). But this could change with the next election, which would introduce a ruffle in the current narrative in which Biden saves planet earth. One factor that helps Biden is that his presidency is entirely about economic stimulus and recovery, which enables him to minimize the regulatory and punitive side of his party’s energy agenda. While the American Jobs Plan includes corporate tax hikes, his climate policy in itself is all about spending rather than taxation. There is no carbon pricing scheme anywhere to be seen. And Biden’s Transportation Secretary, Pete Buttigieg (“Mayor Pete,” a center-left politician from Indiana), immediately reversed his recent suggestion that the government levy a gasoline tax or vehicle mileage tax. Biden cannot get any revolutionary green measures passed through the Senate, given that moderate Democrats like Senators Joe Manchin of West Virginia and John Tester of Montana hail from coal-heavy states. The Democrats must also pay heed to the swing states for future elections. Biden only narrowly won his home state of Pennsylvania, after pledging to phase out oil and natural gas in the last presidential debate. True, Biden’s American Jobs Plan will remove subsidies for the oil and gas sector – but these subsidies are not very large. Notably, subsidies for renewables already overwhelm those for traditional infrastructure, even under the Trump administration (Chart 10). Chart 10Subsidy Reform Will Promote Renewables Chart 11Green Policy At Risk In 2022 Midterm These points underscore the fact that US climate policy is uncertain over the medium term, when the pandemic fades and the Democrats attempt more ambitious climate proposals. The Republican Party supports the traditional energy sector and is skeptical about climate change. The GOP could easily make a net gain of five seats in the 2022 midterm elections and take back control of the House of Representatives. They would not be able to repeal Biden’s laws or regulations, given his veto and likely Democratic majority in the Senate, but they would be able to pare back green funding. Republicans are not uniform on the issue of climate but more than half of Trump supporters in 2020 considered climate change unimportant. Young party members, moderates, and women were more split on the issue, with 60% of moderate Republicans viewing climate change as somewhat or very important (Chart 11). The takeaway is that Republicans would obstruct but not repeal future climate policy. Climate policy would be limited to Biden’s regulations until at least 2024. Hence investors can expect US climate policy to plow forward in the short run but to encounter resistance in the medium run. This is also likely to be the case as various other crises will emerge and soak up government attention and resources (most likely geopolitical conflicts). Chart 12Green Policy More Likely Over Long Term Over the long run climate policy will have more reliable support. Younger Republicans support federal environmental policy more than their elders, are increasingly favorable toward government regulation to that end, and prefer renewables to fossil fuels (Chart 12). The millennials and younger generations will make up more than half of the electorate by around 2028. Even then the government’s focus on climate will wax and wane given the other pressing matters of the day. Investment Takeaways A tsunami of money has been created, a lot of it is finding its way into the stock market, and a lot of it is finding its way into green and sustainable energy companies – companies that now have a privileged position in terms of both government support and conspicuous consumption. Combine this with a tidal wave of institutional funds pouring into anything and everything labeled ESG (environmental, social, and governance) – and the stigma attached to climate skepticism and denialism – and investors should fully expect irrational exuberance and stock bubbles. Consider the US’s premier EV maker, Tesla. The vertical run-up in Tesla stock has occurred alongside the run-up in US money supply. Tesla’s price trend conforms with the profile of a range of stock market bubbles of the past (Chart 13), as shown by our US Equity Strategy. Chart 13ALow Rates And Vast Money Growth... Chart 13B...Will Fuel Green Bubble That being said, renewables stocks surged throughout 2020 on the back of stimulus and Biden’s likely election – and have since fallen back. They have underperformed cyclical and defensive sectors alike this year to date (Chart 14). As highlighted above, the Democrats’ climate ambitions could yet be pared back in the Senate. However, given the argument in this report, there is sufficient political capital for the climate provisions of the American Jobs Plan to pass. Renewable plays should recover, at least on a tactical, “buy the rumor, sell the news” basis. To play Biden’s American Jobs Plan, our US Equity Strategist Anastasios Avgeriou constructed a “Biden Fiscal Advantage Basket” comprising eight ETFs and one stock, all equal weighted (Chart 15, top panel). Instead of buying specific stocks, Anastasios opted for ETFs so as to diversify away company-specific risk. Chart 14Renewables Corrected But Will Recover Chart 15Introducing The Biden Fiscal Advantage Basket The goal was to filter for ETFs that hold mostly US companies and that offered the highest possible liquidity. From a portfolio construction perspective, he aimed to match the different spending segments of Biden’s White House proposal with an ETF. The ticker symbols included in the basket are: PAVE, PHO, QCLN, TAN, WOOD, SOXX, HAIL, GRID and SU. We choose SU as there is no pure play Canadian oil sands ETF trading in USD. Granted there is some replication of stocks included in these ETFs. In certain ETFs there is also a sizable international stock exposure, including EM and Chinese stocks. One final caveat is that these ETFs have a high concentration of technology stocks. Our sense is that this basket should outperform the S&P500 on a cyclical and structural basis albeit not tactically (Chart 15, middle panel). However, given the high-tech exposure, our preferred way to express this trade is via a long/short pair trade versus the QQQ high-tech ETF, which tracks the largest 100 companies on the Nasdaq stock exchange (Chart 15, bottom panel). Table 1 shows a number of related ETFs that did not make the cut but that readers may find intriguing and that deserve further research. Later this month we will publish a joint special report with our US Equity Strategy service, updating our views on Biden’s proposals and elaborating on this equity basket. Table 1Infrastructure and Renewables Related ETFs More broadly, US equities are still enjoying a positive cyclical backdrop, whereas the passage of the American Jobs Plan later this year has a 50% chance of marking peak stimulus (the American Families Plan may not pass). Tactically, however, we are more cautious. There are also several pronounced foreign policy stress tests facing the Biden administration imminently, including serious Russia/Ukraine, Israel/Iran, and China/Taiwan saber-rattling that we fully expect to engender volatility and safe-haven flows. At least one FOMC member, Saint Louis Fed President Jim Bullard, is now openly thinking about thinking about the Fed’s tapering asset purchases – that is, once the US vaccination rate reaches 75%. Our US Investment Strategy recently showed that this rate of vaccination could be reached as early as September. Matt Gertken Vice President Geopolitical Strategy mattg@bcaresearch.com Jesse Anak Kuri Associate Editor jesse.Kuri@bcaresearch.com Anastasios Avgeriou US Equity Strategist anastasios@bcaresearch.com Appendix Table A1Political Risk Matrix Table A2Political Capital Index Table A3APolitical Capital: White House And Congress Table A3BPolitical Capital: Household And Business Sentiment Table A3CPolitical Capital: The Economy And Markets Table A4Biden’s Cabinet Position Appointments
Overweight Our long-held view that digitalization of the economy is still in the early innings remains intact, and hence we reiterate our cyclical (and structural) preference for software companies. The recent pullback in the relative share price ratio also offers a compelling entry point for investors to further augment their overweight stance. Importantly, generationally low interest rates along with ample software companies’ free cash flow has emboldened the industry to embark on a new M&A frenzy that effectively reduces the supply of stocks available to investors and pushes prices higher (top panel). Already, the average M&A premium paid is probing new highs since the GFC at the same time as the actual count of deals is going through the roof. Both of these dynamics bode well for the future earnings power of software stocks. As a reminder, we are currently employing a barbell portfolio strategy within the GICS1 technology sector by preferring defensive software- and services-related stocks over more aggressive hardware and equipment equities. Bottom Line: Stay overweight the S&P software index. The ticker symbols for the stocks in this index are: BLBG: S5SOFT – MSFT, ADBE, CRM, ORCL, INTU, NOW, ADSK, ANSS, SNPS, CDNS, FTNT, PAYC, CTXS, NLOK, TYL.
Initiating a long S&P semis/short S&P technology hardware storage & peripherals (THS&P) pair trade is the ultimate reflationary play given its tight positive correlation with the 10-year US Treasury yield (top panel). Not only does the bond market spell more upside for this relative share price ratio, but the trade also captures a significant early supply chain advantage of chip stocks over their hardware brethren. Switching from macro to industry level data, and the news on the operating front is equally enticing. Chip capital outlays trounce THS&P stocks’ investments by a wide margin, which should further boost relative revenue prospects (bottom panel). In fact, chip sales already have the upper hand compared with tech hardware storage and peripherals revenues and a relative reacceleration phase looms as the chip industry’s bottlenecks get resolved in the back half of the year (not shown). Tack on recent news of President Biden’s preliminary infrastructure plans that include a $50bn sum for semiconductors in order to bolster US based manufacturing and research and development and the demand profile for chip stocks brightens further. Bottom Line: We initiated a long S&P semis/short S&P THS&P pair trade in a recent Special Report. The ticker symbols for the stocks in the S&P semiconductors and S&P THS&P indexes are BLBG: S5SECO – INTC, TXN, ADI, AMD, MXIM, XLNX, MCHP, NVDA, AVGO, QCOM, MU, SWKS, QRVO, NXPI, MPWR, and BLBG: S5CMPE – AAPL, HPQ, HPE, WDC, NTAP, STX, respectively.
The BCA Research Global Asset Allocation (GAA) Forum will take place online on May 18th. We have put together a great lineup of speakers to discuss issues of importance to CIOs and asset allocators. These include the latest thinking on portfolio construction, factor investing, alternatives, and ESG. Our keynote speaker will be Keith Ambachtsheer, founder of KPA Advisory and author of many books on investment management including "The Future of Pension Management: Integrating Design, Governance and Investing" (2016). His presentation will be followed by a panel discussion of top CIOs including Maxime Aucoin of CDPQ, James Davis of OPTrust, and Catherine Ulozas of the Drexel University Endowment. The event is complimentary for all GAA subscribers, who can see a full agenda and register here. Others can sign up here. We hope you can join us on May 18th for what should be a stimulating and informative day of ideas and discussion. Highlights Recommended Allocation Global growth will rebound later this year, fueled by an end of lockdowns and generous fiscal stimulus. Despite that, central banks will not move towards tightening until 2023 at the earliest. This remains a very positive environment for risk assets like equities, though the upside is inevitably limited given stretched valuations. We continue to recommend a risk-on position, with overweights in equities and higher-risk corporate bonds. It is unlikely that long-term rates will rise much further over the coming months. But there is a risk that they could, and so we become more wary on interest-sensitive assets. Accordingly, we cut our overweight on the IT sector to neutral, and go overweight Financials. We continue to prefer cyclical sectors, and stay overweight Industrials and Energy. Chinese growth is slowing and so we cut our recommendation on Chinese equities to underweight. Some Emerging Markets will suffer from tighter US financial conditions, so we would be selective in our positions in both EM equity and debt. We stay firmly underweight government bonds, and recommend an underweight on duration, and favor linkers. Within alternatives, we raise Private Equity to overweight. The return to normality will give PE funds a wider range of opportunities, and allow them to pick up distressed assets at attractive valuations. Overview What Higher Rates Mean For Asset Allocation The past few months have seen a sharp rise in long-term interest rates everywhere (Chart 1). These have reflected better growth prospects, but also a greater appreciation of the risk of inflation over the next few years (Chart 2). Our main message in this Quarterly Portfolio Outlook is that we do not expect long-term rates to rise much further over the coming months, but that there is a risk that they could. This would be unlikely to undermine the positive case for risk assets overall, but it would affect asset allocation towards interest-rate sensitive assets such as growth stocks and Emerging Markets, and could have an impact on the US dollar. Chart 1Rates Are Rising Everywhere Chart 2...Because Of Both Growth And Inflation Expectations We accordingly keep our recommendation for an overweight on equities and riskier corporate credit on the 12-month investment horizon, but are tweaking some of our other allocation recommendations. The macro environment for the rest of the year continues to look favorable. Pent-up consumer demand will be released once lockdowns end. In the US, this should be mid-July by when, at the current rate, the US will have vaccinated enough people to achieve herd immunity (Chart 3). Excess household savings in the major developed economies have reached almost $3 trillion (Chart 4). At least a part of that will be spent when consumers can go out for entertainment and travel again. Chart 3US On Track To Hit Herd Immunity By July Chart 4Global Excess Savings Total Trillion Fiscal stimulus remains generous, especially in the US after the passing of the $1.9 trillion package in March (with another $2 trillion dedicated towards infrastructure spending likely to be approved within the next six months). The OECD estimates that the recent US stimulus alone will boost US GDP growth by almost 3 percentage points in the first full year and have a significant knock-on effect on other economies (Chart 5). Central banks, too, remain wary of the uneven and fragile nature of the recovery and so will not move towards tightening in the next 12 months. The Fed is not signalling a rate hike before 2024 – and it is likely to be the first major central bank to raise rates. In this environment, it is not surprising that long-term rates have risen. We showed in March’s Monthly Portfolio Update that, since 1990, equities have almost always performed strongly when rates are rising. This is likely to continue unless there is either (1) an inflation scare, or (2) the Fed turns more hawkish than the market believes is appropriate. Inflation could spike temporarily over the coming months, which might spook markets (see What Our Clients Are Asking on page 9 for more discussion of this). But sustained inflation is improbable until the labor market recovers to a level where significant wage increases come through (Chart 6). This is unlikely before 2023 at the earliest. Chart 5US Fiscal Stimulus Will Help Everyone Chart 6Labor Market Still Well Away From Full Employment BCA Research’s fixed-income strategists do not see the US 10-year Treasury yield rising much above 1.8% this year.1 Inflation expectations should settle down around the current level (shown in Chart 2, panel 2) which is consistent with the Fed achieving its 2% PCE inflation target on average over the cycle. Treasury yields are largely driven by whether the Fed turns out to be more or less hawkish than the market expects (Chart 7). The market is already pricing in the first Fed rate hike in Q3 2022 (Chart 8). We think it unlikely that the market will start to price in an earlier hike than that. Chart 7The Fed Unlikely To Hike Ahead Of What Market Expects... Chart 8...Since This Is As Early As Q3 2022 How much would a further rise in rates hurt the economy and stock market? Rates are still well below a level that would trigger problems. First, long-term rates are considerably below trend nominal GDP growth, which is around 3.5% (Chart 9). Second, short-term real rates are well below r* – hard though that is to measure at the moment given the volatility of the economy in the past 12 months (Chart 10). Finally, one of the best indicators of economic pressure is a decline in cyclical sectors (consumer spending on durables, corporate capex, and residential investment) as a percentage of GDP (Chart 11). This is because these are the most interest-rate sensitive parts of the economy. But, at the moment, consumers are so cashed up they do not need to borrow to spend. The same is true of corporates, which raised huge amounts of cash last year. The only potential problem is real estate, buoyed last year by low rates which are now reversing (Chart 12). But mortgage rates are still very low and this is not a big enough sector to derail the broader economy. Chart 9Long-Term Rates Well Below Damaging Levels... Chart 10...Such As The R-Star Chart 11Interest-Rate Sensitive Sectors Are Robust... Chart 12...With The Possible Exception Of Housing Chart 13Debt Levels Are High In Emerging Markets... Chart 14...Which Makes Them Vulnerable To Tightening Financial Conditions This sanguine view may not apply to Emerging Markets, however. Given the amount of foreign-currency debt they have built up in the past decade (Chart 13), they are very sensitive to US financial conditions, particularly a rise in rates and an appreciation of the US dollar (Chart 14). Accordingly, we have become more cautious on the outlook for both EM equity and debt over the next 6-12 months. Garry Evans, Senior Vice President Chief Global Asset Allocation Strategist garry@bcaresearch.com What Our Clients Are Asking What will happen to inflation? How can we tell if it is trending up? Chart 15Watch The Trimmed Mean Inflation Measure How much inflation rises will be a key driver of asset performance over the next 12-18 months. Too much inflation will push up long-term rates and undermine the case for risk assets. But the picture is likely to be complicated. US inflation will rise sharply in year-on-year terms in March and April because of the base effect (comparison with the worst period of the pandemic in 2020), pricier gasoline, rising import prices due to the weaker dollar, and supply-chain bottlenecks that are pushing up manufacturing costs. Core PCE inflation could get close to 2.5% year-on-year (Chart 15, panel 1). In the second half, too, an end to lockdowns could push up service-sector inflation – which has unsurprisingly been weak in the past nine months – as consumers rush out to restaurants and on vacation (panel 3). The Fed has signalled that it will view these as temporary effects. But they may spook the market for a while. Next year, however, it would be surprising to see strong underlying inflation unless employment makes a miraculous recovery. Payrolls would have to increase by 420,000 a month to get back to “maximum employment” by end-2022.2 Absent that, wage growth is likely to stay muted. Conventional inflation gauges may not be very useful at indicating underlying inflation pressures, in a world where consumers switch their spending depending on what is currently allowed under pandemic regulations. The Dallas Fed’s Trimmed Mean Inflation indicator (which excludes the 31% of the 178 items in the consumer basket with the highest price rises each month, and the 24% with the lowest) may be the best true measure. Research shows that historically it has been closer to trend headline PCE inflation in the long run than the core inflation measure, and predicts future inflation better (panel 4). Currently it is at 1.6% year-on-year and trending down. Investors should focus on this measure to see whether rising inflation is becoming a risk. How can investors best protect against rising inflation? In May 2019 we released a report describing how to best to hedge against inflation.3 In that report, we analyzed every period of rising inflation dating back to the 1970s. Our conclusions were the following: The level of inflation will determine how rising inflation affects assets. When inflation goes from 1% to 2%, the macro environment is entirely different from when it goes from 5% to 6%. Thus, inflation hedging should not be thought of as a static exercise but a dynamic one (Table 1). Table 1Winners During Different Inflationary Regimes As long as the annual inflation rate is below about 3%, equities tend to be the best performing asset during high inflation periods, surpassing even commodities. This is because monetary policy tends to stay accommodative and cost pressures remain benign for most companies. However, as inflation passes this threshold, things start to change. Central banks start to become restrictive as they seek to curb inflation. This rise in policy rates starts to choke off the bull market. Meanwhile cost pressures become more significant and, as a result, equities begin to suffer. It is at this time when commodities – particularly oil and industrial metals – and US TIPS become a much better asset to hold. Finally, if the central bank fails to quash inflation, inflation expectations become unanchored, creating a toxic cocktail of rising prices and poor growth. During such periods, the best strategy is to hold the most defensive securities in each asset class, such as Health Care or Utilities within the equity market, or gold within commodities. Can the shift to renewables drive a new commodities supercycle? Chart 16The Shift To Renewables Is Likely To Be A Tailwind For Metal Prices... The rise in commodity prices in H2 2020 has made investors ask whether we are on the verge of a new commodities “supercycle” (Chart 16). Our Commodity & Energy strategists argue that the fundamental drivers of each commodities segment differ. Here we focus on industrial metals – particularly those pertaining to renewable energy and transport electrification. Prices of metals used in electric vehicles (EVs) have risen by an average 53% since July 2020, reflecting strong demand that is outstripping supply (Chart 16). In the short-term, metals markets are likely to be in deficit, especially as demand recovers after the pandemic. Modelling longer-term demand is tricky since it relies on assumptions for the emergence of new technologies, metals’ efficiency, recycling rates, and the share of renewables. A study by the Institute for Sustainable Futures showed that, in the most positive scenarios, demand for some metals will exceed available resources and reserves (Table 2).4 The most pessimistic scenarios – which, for example, assume no major electrification of the transport system – show demand at approximately half of available resources. It is likely that demand will lay somewhere between those scenarios. Table 2...As Future Demand Exceeds Supply Supply is concentrated in a handful of countries: For example, the DR Congo is responsible for more than 65% of cobalt production and 50% of the world’s reserves;5 Australia supplies almost 50% of the world’s lithium and has 22% of its reserves.6 Production bottlenecks could therefore put significant upside pressures on prices. Factoring in supply/demand dynamics, as well as an assessment of future technological advancements, we conclude that industrial metals might be posed for a bull market over the upcoming years. How can we add alpha in the bond bear market? Chart 17Government Bond Yield Sensitivities To USTs For a portfolio benchmarked to the global Treasury index, one way to add alpha is through country allocation. BCA’s Fixed Income Strategy recommends overweighting low yield-beta countries (Germany, France, and Japan) and underweighting high yield-beta countries (Canada, Australia, and the UK).7 The yield beta is defined as the sensitivity of a country’s yield change to changes in the US 10-year Treasury yield, as shown in Chart 17. BCA’s view is that the Fed will be the first major central bank to lift interest rate, therefore investors' underweights should be concentrated in the US Treasury index. It’s worth noting, however, that yield beta is influenced by many factors, and can change over time. When applying this approach, it’s important to pay attention to key factors in each country, especially those that are critical to central bank policy decisions (Table 3). Table 3A Watch List For Bond Investors Global Economy Chart 18US Growth Already Looks Strong... Overview: Growth continues to recover from the pandemic, although the pace varies. Manufacturing has rebounded strongly, as consumers spend their fiscal handouts on computer and household equipment, but services remain very weak, especially in Europe and Japan. Successful vaccination programs and the end of lockdowns in many countries should lead to strong growth in H2, as consumers spend their accumulated savings and companies increase capex to meet this demand. Perhaps the biggest risk to growth is premature tightening in China, but the authorities there are very aware of this risk and so it is unlikely to drag much on global growth. US: Although the big upside surprises to economic growth are over (Chart 18, panel 1), the US continues to expand more strongly than other major economies, due to its relatively limited lockdowns and large fiscal stimulus (which last year and this combined reached 25% of GDP, with another $2 trillion package in the works). Fed NowCasts suggest that Q1 GDP will come in at around 5-6% quarter-on-quarter annualized, with the OECD’s full-year GDP growth forecast as high as 6.5%. Nonetheless, there is still some way to go: Consumer expenditure and capex remain weak by historical standards, and new jobless claims in March still averaged 727,000 a week. Euro Area: More stringent pandemic regulations and slow vaccine rollout mean that the European service sector has been slow to recover. The services PMI in March was still only 48.4, though manufacturing has rebounded strongly to 64.2 (Chart 19, panel 1). Fiscal stimulus is also much smaller than in the US, with the EUR750 billion approved in December to be spent mostly on infrastructure over a period of years. Growth should rebound in H2 if lockdowns end and the vaccination program accelerates. But the OECD forecasts full-year GDP growth of only 3.9%. Chart 19...But Chinese Growth Has Probably Peaked Japan has seen the weakest rebound among the major economies, slightly puzzlingly so given its heavy weight in manufacturing and large exposure to the Chinese economy. Industrial production still shrank 3% year-on-year in February (Chart 19, panel 2), exports were down 4.5% YoY in February, and the manufacturing PMI is barely above 50. The main culprit remains domestic consumption, with confidence very weak and wages still declining, leading to a 2.4% YoY decline in retail sales in January. The OECD full-year GDP growth forecast is just 2.4%. Emerging Markets: The Chinese authorities have been moderately tightening policy for six months and this is starting to impact growth. Both the manufacturing and services PMIs have peaked, though they remain above 50 (panel 3). The policy tightening is likely to be only moderate and so growth this year should not slow drastically. Nonetheless, there remains the risk of a policy mistake. Elsewhere, many EM central banks are struggling with the dilemma of whether to cut rates to boost growth, or raise rates to defend a weakening currency. Real policy rates range from over 2% in Indonesia to below -2% in Brazil and the Philippines. This will add to volatility in the EM universe. Interest Rates: Policy rates in developed economies will not rise any time soon. The Fed is signalling no rise until 2024 (although the futures are now pricing in the first hike in Q3 2022). Other major central banks are likely to wait even longer. A crucial question is whether long-term rates will rise further, after the jump in the US 10-year Treasury yield to a high of 1.73%, from 0.92% at the start of the year. We see only limited upside in yields over the next nine months, as underlying inflation pressures should remain weak and central banks will remain highly reluctant to bring forward the pace of monetary policy normalization. Global Equities Chart 20Has The Equity Market Priced In All The Earnings Growth? The global equities index eked out a 4% gain in Q1 2021, completely driven by a rebound in the profit outlook, since the forward PE multiple slightly contracted by 4%. Forward EPS has now recovered to the pre-pandemic level, while both the index level and PE multiple are 52% and 43% higher than at the end of March 2020 (Chart 20). While BCA’s global earnings model points to nearly 20% earnings growth over the next 12 months and analysts are still revising up earnings forecasts, the key question in our mind is whether the equity market has priced in all the earnings growth. Equity valuations are still not cheap by historical standards despite the small contraction in PEs in Q1. In addition, the VIX index has come down to 19.6, right at its historical average since January 1990, and profit margins in both EM and DM have come under pressure. As an asset class, however, stocks are still attractively valued compared to bonds (panel 5). Given our long-held approach of taking risk where risk will most likely be rewarded, we remain overweight equities versus bonds at the asset-class level, but we are taking some risk off the table in our country and sector allocations by downgrading China to underweight (from overweight) and upgrading the UK to overweight (from neutral), and by taking profits in our Tech overweight and upgrading Financials to overweight (see next two pages). To sum up, we are overweight the US and UK, underweight Japan, the euro area, and China, while neutral on Canada, Australia, and non-China EM. Sector-wise, we are overweight Industrials, Financials, Energy, and Health Care; underweight Consumer Staples, Utilities, and Real Estate; and neutral on Tech, Consumer Discretionary, Communication Services, and Materials. Country Allocation: Downgrade China To Underweight From Overweight Chart 21China Is Risking Overtightening We started to separate the overall EM into China and Other EM in the January Monthly Portfolio Update this year. We initiated China with an Overweight and “Other EM” with a Neutral weighting in the global equity portfolio. The key rationale was that Chinese growth would remain strong in H1 2021 due to its earlier stimulus, while some EM countries would benefit from Chinese growth but others were still suffering from structural issues. In Q1, China underperformed the global benchmark by 4.5%, while the other EM markets underperformed slightly. China’s National People’s Congress (NPC) indicated that Chinese policymakers will gradually pull back policy support this year. BCA’s China Investment Strategists think that fiscal thrust will be neutral in 2021 while credit expansion will be at a lower rate compared to 2020. The Chinese economy should remain strong in H1 but will slow to a benign and managed growth rate afterwards. Therefore, the risk of policy overtightening is not trivial and could threaten China’s economic growth and corporate profit outlook. The outperformance of Chinese stocks since the end of 2019 has been largely driven by multiple expansion (Chart 21, panel 1), but the slowdown in the credit impulse implies that the recent underperformance of Chinese equities has not run its course because multiple contraction will likely have to catch up and will therefore put more downward pressure on price (panels 2 and 3). We remain neutral on the non-China EM countries, implying an underweight for the overall EM universe. We use the proceeds to fund an upgrade of the UK to Overweight from Neutral because the UK index is comprised largely of globally exposed companies and because we have upgraded GBP to overweight (see page 21). Sector Allocation: Upgrade Financials To Overweight By Downgrading Tech To Neutral Chart 22Financials And Tech: Trading Places One year ago, we upgraded Tech to overweight and downgraded Financials to neutral given our views on the impact of the pandemic and interest rates.8 This position has netted out an alpha of 1123 basis points in one year. BCA Research’s House View now calls for somewhat higher global interest rates and steeper yield curves (especially in the US) over the next 9-12 months. Accordingly, we are downgrading Tech to neutral and upgrading Financials to overweight. Financials have outperformed the broad market by about 20% since September 2020 after global yields bottomed in July 2020. We do not expect yields to rise significantly from the current level, nor do we expect Tech earnings growth to slow significantly (Chart 22, panel 5). So why do we make such shift between Financials and Tech? There are three key reasons: First, the Tech sector is a long-duration asset with high sensitivity to changes in the discount rate. In contrast, Financials’ earnings benefit from steepening yield curves. If history is any guide, we should see more aggressive analyst earnings revisions going forward in favor of Financials (Chart 22, panel 3). Second, the performance of Financials relative to Tech has been on a long-term structural downtrend since the Global Financial Crisis. A countertrend rebound to the neutral zone from the currently very oversold level would imply further upside (Chart 22, panel 1). Last, Financials are trading at an extremely large discount to the Tech sector (Chart 22, panel 2). In an environment where overall equity valuations are stretched by historical standards, it is prudent to rotate into an extremely cheap sector from an extremely expensive sector. Government Bonds Chart 23Policy Mix Is Bond-Bearish Maintain Below-Benchmark Duration. Global bond yields have climbed sharply in Q1, supported by strong economic growth, mostly smooth rollout of vaccination and the Biden Administration’s very stimulative fiscal package of USD1.9 trillion. The US stimulus package changes the trajectory of the 2021 US fiscal impulse from a $0.8 trillion contraction to a $0.3 trillion expansion, according to estimates from the US Committee for a Responsible Federal Budget. Going forward, the path of least resistance for global yields is still up, though the upside will be limited given the resolve of central banks to maintain accommodative monetary policies (Chart 23). Chart 24Stay Long TIPS Still Favor Linkers Vs. Nominal Bonds. Our overweight position in inflation-linked bonds relative to nominal bonds has panned out well so far this year, as has our positioning for a flattening inflation-protection curve. Even though inflation expectations have run up quickly, the 5 year-5 year forward inflation breakeven rate is still below 2.3-2.5%, the range that is consistent with core PCE reaching the Fed’s 2% target in a sustainable fashion (Chart 24). The US TIPS 5/10-year curve is inverted already, but our fixed income strategists are still reluctant to exit the curve-flattening position for two key reasons: 1) The Fed has indicated that it will tolerate core PCE overshooting the 2% target because it will try to hit the target from above rather than from below; and 2) the short end of the inflation expectation curve is more sensitive to actual inflation than the long end. There are signs (core producer prices, prices paid in the ISM manufacturing survey, and NFIB reported prices are all rising) that core PCE will reach 2% in the next 12 months. Corporate Bonds Chart 25High-Yield Offers Best Value In Fixed Income Since the beginning of the year, investment-grade bonds have outperformed duration-matched Treasurys by 62 basis points, while high-yield bonds have outperformed duration-marched Treasurys by 232 basis points. In the current reflationary environment, we believe that the best strategy within fixed-income portfolios is to overweight low-duration assets and maximize credit exposure where the spread makes a large portion of the yield. Thus, we remain overweight high-yield bonds. We believe that high yield offers much better value than higher quality credits. Currently spreads for high-yield bonds are in the middle of their historical distribution – a stark contrast from their investment-grade counterparts, which are trading at very expensive levels (Chart 25, panel 1). Moreover, the reopening of the economy should help the more cyclical sectors of the bond market, where the lower credit qualities are concentrated. But could a rise in yields start hurting sub-investment-grade companies and increase their borrowing costs? We do not think this is likely for now. Most of the bonds in the US high-yield index mature in more than three years, which means that high-risk corporates will not have to finance themselves with higher rates yet (Chart 25, panel 2). On the other hand, we remain underweight investment-grade credit. Not only are these bonds expensive, but they offer very little upside in any scenario. On the one hand, these bonds should underperform further if raise continue to rise – a result of their high duration. On the other hand, if a severe recession were to hit, spreads would most likely widen, which will also result in underperformance. Commodities Chart 26Limited Upside For Oil From Here Energy (Overweight): Despite the recent mid-March selloff, which was most likely triggered by profit taking, oil prices are still up 25% since the beginning of the year. This happened on the back of the restoration of some economic activity, the OPEC 2.0 coalition maintaining production discipline and therefore keeping supply in check, and the recovery in crude demand drawing down inventory. However, earlier forecasts of the 2021 oil demand recovery were a bit too optimistic amid continuing pandemic uncertainty. There is now, therefore, only limited upside for the oil price, at least this year. Our Commodity & Energy strategists expect the Brent crude price to average $65/bbl this year (Chart 26, panels 1 & 2). Industrial Metals (Neutral): We have previously highlighted that Chinese restocking activity in 2020 was a big factor behind the rally in industrial metals prices. As this eases, and Chinese growth slows, commodity prices might correct somewhat in the short term. However, fundamental changes in demand for alternative energy makes us ask whether we are now entering a new commodities “supercycle” for certain metals (for more analysis of this, see What Our Clients Are Asking on page 11). If history is any guide, however, the commodities bear market may have a little longer to run. Historically, commodity bear cycles lasted 17 years on average and we are only 10 years into this one (panel 3). On balance, therefore, we remain neutral on industrial metals for now. Precious Metals (Neutral): After peaking last August, the gold price has continued to tumble, down almost 19% since and 11% since the beginning of the year. We have been wary of the metal’s lofty valuation – the real price of gold remains near a historical high. The recent rise in real rates put more downside pressure on gold. However, the pullback in prices should provide investors who see gold as a long-term inflation hedge and do not buy the metal with a view to strong absolute performance over the next 12 months, with an attractive entry point. We maintain a slight overweight position to hedge against inflation and unexpected tail risks (panel 4). Currencies US Dollar Chart 27Vaccinations will help USD and GBP in 2021 While we still believe that the dollar is in a major bear market, the current environment could see a significant dollar countertrend. Thanks to its gargantuan fiscal stimulus as well as its relatively fast vaccination campaign, the US is likely to grow faster than the rest of the world during 2021 (Chart 27, panel 1). This dynamic should put further upward pressure on US real rates relative to the rest of the world, helping the dollar in the process. To hedge this risk, we are upgrading the US dollar from underweight to neutral in our currency portfolio. Euro The euro should experience a temporary pullback. Economic activity in Europe, particularly in the service sector is lagging the US – a consequence of Europe’s slow vaccination campaign. This sluggishness in economic activity will translate into a worse real rate differential vis-a-vis the US, dragging the euro lower in the process. Thus, we are downgrading the euro from overweight to neutral. British Pound One currency that might perform well in this environment is the British pound. Consumer spending in the UK was particularly hard hit during the pandemic, since such a high share of it is geared towards social activities like restaurants and hotels (Chart 27, panel 2). However, thanks to Britain’s successful vaccination campaign, UK consumption is likely to experience a sharp snapback. As growth expectations improve, real rates should grind higher vis-à-vis the rest of the world, pushing the pound higher. Moreover, valuations for this currency are attractive: The pound currently trades at a 10% discount to purchasing power parity fair value. As a result, we are upgrading the GBP from neutral to overweight. Alternatives Chart 28Turning More Positive On Private Equity Return Enhancers: In last October’s Quarterly Outlook, we advised investors to prepare for new opportunities in Private Equity (PE) as fund managers look to deploy record high dry power. A gradual return to normality is likely to provide PE funds with a wider range of opportunities, while still allowing them to pick up distressed assets at attractive valuations. This is illustrated by the annualized quarterly returns of PE funds in Q2 and Q3 2020, which reached 43% and 56% respectively. PE funds raised in recession and early-cycle years tend to have a higher median net IRR than those raised in the latter stages of bull markets. This suggests that returns from the 2020 and 2021 vintages should be strong. In recent years, capital flows have increasingly gone to the longer established and larger funds, which tend to have better access to the most attractive deals and therefore record the strongest returns. This trend is likely to continue. Given the time it takes to shift allocations in private assets, we increase our recommended allocation in PE to overweight. Inflation Hedges: It is not clear that inflation will come roaring back in the next couple of years. But what is certain is that market participants are concerned about this risk, which should give a boost to inflation-hedge assets. Given this backdrop, we continue to favor commodity futures (Chart 28, panel 2). In other circumstances, real estate would also have been a beneficiary in this environment. But the slowdown in commercial real estate, as many corporate tenants review whether they need expensive city-center space, makes us remain cautious on real estate. Volatility Dampeners: We continue to favor farmland and timberland over structured products, particularly mortgage-backed securities (MBS). Farmland offers attractive yields and should continue to provide the best portfolio protection in the event of any market distress (Chart 28, panel 3). Risks To Our View The main risks to our central view are to the downside. Because global equities have risen by 55% over the past 12 months, and with the forward PE of the MSCI ACWI index at 19.5x (Chart 29), the room for price appreciation over the next 12 months is inevitably limited. There are several things that could undermine the economic recovery and equity bull market. The COVID-19 pandemic remains the greatest unknown. The vaccination rollout has been very uneven (Chart 30). New strains, especially the one first identified in Brazil, are highly contagious and people who previously had COVID-19 do not seem to have immunity against them. Behavior once COVID cases decline is also hard to predict. Will people be happy again to fly, attend events in large stadiums, and socialize in crowded bars, or will many remain wary for years? This would undermine the case for a strong rebound in consumption. Chart 29Is Perfection Priced In? Chart 30Vaccination Has Been Spotty Vaccination Has Been Spotty Chart 31China Slowing Again? As often, a slowdown in China is a risk. The authorities there have signalled a pullback in stimulus, and the credit impulse has begun to slow (Chart 31). Our China strategists think the authorities will be careful not to tighten too drastically (with the fiscal thrust expected to be neutral this year), and that growth will slow only to a benign and moderate rate in the second half.9 But there is a lot of room for policy error. Finally, inflation. As we argue elsewhere in this Quarterly, it will inevitably pick up for technical reasons in March and April, and then again in late 2021 as renewed consumer demand for services (especially travel and entertainment) pushes up prices. The Fed has emphasized that these phenomena are temporary and that underlying inflation will not emerge until the economy returns to full employment. But the market might get spooked for a while when inflation jumps, pushing up long-term interest rates and triggering an equity market correction. Footnotes 1 Please see US Bond Strategy Report, “The Fed Looks Backward While Markets Look Forward,” dated March 23, 2021. 2 Please see US Bond Strategy Report, “The Fed Looks Backward While Markets Look Forward,” dated March 23, 2021, 3 Please see Global Asset Allocation Special Report, “Investors’ Guide To Inflation Hedging: How To Invest When Inflation Rises,” dated May 22, 2019. 4 Dominish, E., Florin, N. and Teske, S., 2019, Responsible Minerals Sourcing for Renewable Energy. Report prepared for Earthworks by the Institute for Sustainable Futures, University of Technology Sydney. The optimistic scenario is referred to as “total metals demand” scenario, which assumed current materials intensity and market share continues into the future without recycling or efficiency improvements. This study is based on 2018 production levels and therefore expansion of future production may vary results. 5US Geological Survey, Mineral Commodity Summaries 2021. 6 Chile is estimated to have the largest reserve of lithium. 7 Please see Global Fixed Income Strategy Report, “Harder, Better, Faster, Stronger,” dated March 16, 2021. 8 Please see Global Asset Allocation, “Quarterly Portfolio Outlook: Playing The Optionality,” dated April 1, 2020. 9 Please see China Investment Strategy Report, “National People’s Congress Sets Tone For 2021 Growth,” dated March 17, 2021. GAA Asset Allocation
Highlights Biden has enough political capital to pass at least one more major piece of legislation. The next major bill will increase the budget deficit further, adding additional stimulus, though it will consist of structural reforms over a ten-year time frame and with a drag created by tax hikes. Our annual key views are on track: polarization has subsided but remains at peak levels from a historical point of view; structural reform is underway, although any chance of bipartisanship is slipping; the Republicans remain deeply divided despite some signs of regrouping. Investors should remain cyclically bullish although the sharp rise in bond yields, the bounce in the US dollar, China’s growth deceleration, and geopolitical risks all warrant tactical caution in the near term. Feature The first quarter of the year brought a few political surprises – from the Capitol Hill riot to Trump’s second impeachment – but the only significant surprise for the American investor was the Democratic victory in the Georgia Senate runoffs. This victory changed the policy setting, producing a Democratic majority in the US Senate and enabling the Biden administration to project three budget reconciliation bills (for FY2021, 2022, 2023) that require zero Republican votes. The first of these bills was signed into law promptly as expected. The $1.9 trillion American Rescue Plan Act consists of short-term cash handouts and social spending that will supercharge an economic recovery that is rapidly accelerating due to the rollout of vaccines for COVID-19 (Chart 1). Chart 1American Rescue Plan Boosts GDP The second major piece of legislation, likely the budget reconciliation bill for FY2022, will consist of net increases to the budget deficit, thus further stimulating the economy, albeit along with structural reform, i.e. social safety net and tax hikes, and a 10-year time horizon. In the second quarter investors will learn the parameters of the bill through Biden’s address to a joint session of Congress, an idealistic presidential budget proposal, a more realistic House and Senate budget resolution, and an extended negotiation. Yet Biden’s second bill will probably not be signed into law until the third or even fourth quarter. Big Government Is Back The American Rescue Plan Act cements a new era of “Big Government” that should be ascribed not to any particular party but to underlying populist pressures in the United States. President Trump’s big-spending ways and pandemic relief packages had already produced a major step up in the government contribution to economic output, as shown in Chart 2, and this will go higher once Biden’s 8.7% of GDP bill is added to the mix. This increase in the government role is likely to last beyond the pandemic given that President Trump had already taught the Republicans that fiscal austerity does not win votes. Republicans will still be the party of “limited government” but that is a relative concept and they will not be able to win elections on a platform of slashing spending, at least not until stagflation returns. In the meantime they are out of power and tax-and-spend liberals rule the roost. Chart 2Era Of Big Government Is Back Our updated budget projections show that the decline of stimulus spending will be gradual in the coming years if Biden delivers his second reconciliation bill for FY2022 (Chart 3). Major changes from previous versions have to do with changes to the Congressional Budget Office’s baseline outlook. Our new Democratic Low Spending scenario assumes a $2 trillion dollar green/infrastructure package, a $1 trillion health care reform, and a roughly $2 trillion increase in tax revenue. The Democrats will raise taxes – at least partially repealing Trump’s Tax Cut and Jobs Act and raising a few other taxes. We expect the market to be negatively surprised by the magnitude of tax hikes, at least initially, though the upside risk to the equity market is that tax hikes will be watered down by moderate Democrats in the Senate. We would not bet on a positive tax surprise because even moderate Democrats are in favor of taxing corporations and the wealthy, the taxes can be phased in over a 10-year period, and the economy is on a cyclical upswing combined with mammoth new spending programs. Chart 3US Budget Deficit Booms Under Biden Our presumption that Biden will sign his second major bill into law this fall (even as late as December) rests on the vulnerability of his administration and party. Traditional Democrats, embodied by Biden, Democratic leaders in Congress, and Biden’s technocratic cabinet (Appendix), face a historic accumulation of political pressure from their populist left-wing and from Trump’s populist Republican Party. If they cannot deliver on major “bread and butter” promises to the American people, while including just enough progressive elements to keep the far left at bay, they risk extinction in coming election cycles. This pressure is real and will enable at least one more major legislative achievement. Bottom Line: Government spending has taken a big step up and Biden’s second major legislative initiative will ensure that the step up is permanent rather than a temporary response to a crisis. The macro impact is inflationary on the margin. Biden’s Second Reconciliation Bill Is the Biden administration over-stimulating the economy and setting the US up for overheating? It looks like it, though the size of tax hikes is as yet unknown. Going forward the stock market will be extremely attentive to two risks that cut in different directions: excessive stimulus and excessive tax hikes. The American Rescue Plan alone is more than twice as large as the estimated output gap. The output gap is widely expected to be closed by the end of the year (Chart 4). Even a $1 trillion infrastructure package – much lower than the currently rumored $3 trillion – would be excessive in this context. Chart 4Output Gap Is Virtually Closed The infrastructure package that is being planned – which would include a range of measures in addition to roads and bridges, such as green energy projects, supply chain on-shoring, and digital infrastructure – would take place over a ten-year period and will be coupled with a drag from new taxes. A modern-age infrastructure plan would boost productivity and hence potential GDP growth, which could offset some of the inflationary impact. Speculatively, the simplest path for achieving Biden’s objectives would be to put his health care reform (with other welfare proposals) in the FY2022 reconciliation bill along with tax reform. Tax changes are the purpose of the reconciliation process. Unlike infrastructure, health provisions are virtually guaranteed to pass the arcane rules of reconciliation. This is not a minor concern: the Senate parliamentarian ruled out a federal minimum wage hike in the American Rescue Plan because it was not directly germane to government revenues and expenditures and could do the same to infrastructure. Bear in mind that the Obama administration passed a key component of the Affordable Care Act (Obamacare) via reconciliation, setting a precedent that health care is germane. More broadly the Democratic Party has prioritized health care since 1992, now has a chance to clinch it, and has repeatedly benefited at the ballot box on the health agenda. Infrastructure, unlike health and tax reform, could conceivably pass in a regular bill, or piecemeal in annual spending bills, in which Biden would wheel and deal to try to get 60 votes (50 Democrats, 10 Republicans). However, the latest rumors as we go to press suggest the Democrats will prioritize infrastructure and link it to tax reform. Republicans will not vote for tax hikes so reconciliation would still be required in this case. Reconciliation is trickier with infrastructure spending than with health care, though not impossible. What is clear is that Biden’s agenda is too large to fit into one bill, that tax hikes are being planned, and that reconciliation is necessary for tax hikes. Based on our scenarios in Table 1, every realistic scenario involves an increase to the budget deficit, ranging from around $500 billion to $5.4 trillion over the 10-year period. Therefore the economy will receive additional stimulus on top of the unprecedented peacetime stimulus it has already received. Table 1Scenarios For Biden’s Second Reconciliation Bill Two other gleanings from Q1 bear mentioning: Biden’s policies on trade and immigration. On trade, Biden is coopting Trump’s hawkish China policy while trying to improve trade relations with allies and partners. The trade deficit is set to expand along with economic recovery and stimulus, resulting in larger twin deficits (Chart 5). This trend should weigh on the US dollar – but the dollar has strengthened so far this year. Given the US’s inherent strengths – rule of law, innovation, faster relative growth – and the structural rise in global geopolitical tensions, covered regularly by our twin Geopolitical Strategy, we are loathe to bet against a rising dollar. However, investors should note that the BCA House View expects the dollar to relapse and the dollar bear market to continue. On immigration, Biden faces his greatest domestic policy challenge. By easing border and immigration enforcement amid a hyper-charged economic recovery, he has invited a large flow of immigrants and refugees (Chart 6). He is thus forced to take urgent border actions to staunch the flow. If he does what is necessary to maintain order then he will widen the rift with the far left. Meanwhile Republicans are finding an issue over which they can start to reunite. Chart 5US Twin Deficits Balloon Chart 6Immigration A Looming Problem For Biden Bottom Line: The air of crisis is dissipating rapidly and proposed tax hikes will motivate opposition but Biden still has enough political capital to get at least one more budget reconciliation bill passed. The bill will focus on health/welfare (easier to pass but more inflationary) or infrastructure (harder but better for productivity). Either way the net deficit impact will be negative and the dual risk of higher taxes and economic overheating will create hurdles for the stock market rally. Updating Our Three Key Views For 2021 How do the events of Q1 impact our three key views for 2021? At the start of the year we forecast (1) that the US’s political polarization would subside but remain at historically peak levels; (2) that the US would launch major structural reforms, in some cases on a bipartisan basis; (3) that Republican disunity would enable this contradictory environment of polarization yet occasional bipartisanship. Based on the first quarter’s events, we would draw the following conclusions for the second quarter and beyond: 1. Peak Polarization: Polarization has indeed subsided (Chart 7). The country is still vulnerable to major polarizing events, including domestic extremists of whatever stripe, though any major terrorist attack would likely strengthen support for the sitting government. A fall in polarization is just one positive factor in Biden’s overall political capital, which we measure through our US Political Capital Index (Table 2). We consider Biden’s political capital moderate-to-strong because consumer confidence and the economy will likely improve. However, passing legislation will gradually get harder. The Obama administration had considerably greater strength in the Senate than the Biden administration, though, as mentioned, reconciliation guarantees Biden one or two more major pieces of legislation (Chart 8). Democrats can still overturn the filibuster, which requires a 60-vote majority on regular legislation, as we have long highlighted. But for now they seem to accept a watering-down of the filibuster (a “talking filibuster”) that will still give the minority Republicans the ability to halt controversial legislation. Chart 7Polarization Slips But Remains Elevated Table 2Biden’s Political Capital Is Moderate To Strong Chart 8Major Legislation Can Pass Early In Presidential Term 2. Bipartisan Structural Reform: The fact that not a single Republican senator voted for the American Rescue Plan Act, despite the lingering pandemic and air of crisis, suggests that bipartisanship is extremely limited, e.g. limited to the seven Republican senators who voted to convict Trump (Table 3). However, bipartisanship is still possible on an infrastructure package if the Democrats do not link it with tax hikes. Table 3Centrist Senators – And Republicans Who Voted To Convict Trump Beneath the surface there is bipartisanship when it comes to trade, supply chains, and countering China. Tariffs bottomed under the Obama administration and Biden started off with another round of “Buy America” provisions and a tentative decision to maintain Trump’s tariffs on China (Chart 9). Measures to boost US supply chain resilience in technology, health, and defense could be rolled up into an infrastructure package to help garner 10 Republican votes. Republicans have prepared for possible compromise by clearing the way for the use of “earmarks,” or constituency-based legislative incentives, otherwise known as pork-barrel spending. Chart 9Tarriff Levels Bottomed Under Obama The market currently expects an infrastructure bill to pass, as indicated by the outperformance of infrastructure-related stocks, industrials, and materials relative to the market. Our BCA Infrastructure basket is outperforming (Chart 10). The market does not currently expect the Democrats to focus on health care policy, which creates the likelihood of a negative surprise for this sector (Chart 11). Chart 10Market Says Infrastructure Will Pass (One Way Or Another) The managed health care sub-sector (the insurance companies) staged a surprise rally over the past month that should reverse as Biden’s legislative proposals become known. However, Big Pharma and biotech continue to sell off as expected. Again, the simplest FY2022 reconciliation bill would consist of Biden’s health reform plus tax reform. The market is having some doubts about Democrats’ climate change agenda, which will be stuffed into the infrastructure package, given that the US renewable energy index has rolled over relative to global renewables. US cyclicals are also outperforming renewables (Chart 12). If Democrats do not use reconciliation, they may not get many green projects passed. If they do use reconciliation, their health and welfare reforms will have to wait until a FY2023 reconciliation bill that may not get passed. Chart 11More Pain Coming For Health Insurers, Big Pharma Chart 12Market Skeptical About Biden Climate Agenda Passage 3. Republicans In The Wilderness: Although Republicans have begun to regroup faster than many expected, the divisions within the party have not been healed and will continue to flare up in disputes that threaten to wreck the party. Trump and the populist wing are preparing to put up primary election challengers to establishment Republican senators and representatives who voted against Trump or otherwise who vote against his “America First” agenda. Yet it is possible that 10 Republicans will find it impossible to vote against Biden’s infrastructure package if it is well-designed regarding supply chains and China and not linked with tax hikes. Trump could split the party via his personal following (which may be enhanced by a new social media outlet) and his ability to divide the party’s votes if he forms a “Patriot Party.” We recently showed, via the “Prisoner’s Dilemma” in game theory, that the Republicans must choose a Trumpist agenda of fiscal largesse, trade protectionism, and border security if they are to succeed. Yet Trump may or may not choose to run for president again or form a third party. The result is that Trump is more likely than not to be the Republican candidate in 2024 but there are huge risks to the party’s coherence as the party establishment tries to convince Trump to bow out and support a successor (Diagram 1). The point is that Trump remains a loose cannon and is capable of dividing the party single-handedly. Since investors cannot predict Trump’s behavior they should not expect the Republicans to unite in the near term. Diagram 1Game Theory Says Republicans Will Court Trump Bottom Line: Our three key views for 2021 are broadly on track – polarization is subsiding but still near peak levels, structural reform is underway (though bipartisanship is clearly at risk), and the Republicans remain divided and ineffectual. The Democrats’ handling of their infrastructure package will determine if bipartisanship can reinforce structural reform but the FY2022 reconciliation process enables them to achieve some reform regardless. Investment Takeaways The Federal Reserve expects GDP to grow by 6.5% in 2021 as a whole (up from the 4.2% estimate in December) and the unemployment rate to fall to 4.5% by the end of the year (down from 5% previously). Treasury Secretary Janet Yellen is expected to predict full employment by 2022. Households are likely to spend at least a third of the $699 billion in dole money they receive (stimulus checks and topped-up unemployment benefits), according to surveys highlighted by our Global Investment Strategy. This summer will have a party on every block, whether authorized or not. While details are scant about the exact makeup of the Biden administration’s next major legislation, what is clear is that it will have a net negative impact on the budget balance. Democrats will raise taxes but not so much as to jeopardize the economic recovery and their election prospects in 2022-24. This ultra-easy fiscal policy coincides with an ultra-easy monetary policy in which the Fed has insisted it will not raise rates through 2023. The market expects four rate hikes by that time, which would put the Fed funds rate at about 1.1%. The Fed will eventually have to adjust its path for the Fed funds rate and start thinking about thinking about tapering asset purchases. But the main thing to remember is that the Fed has committed to generating an inflation overshoot. In this context, US investors should be cyclically bullish albeit tactically guarded given the sharp rise in bond yields and rising dollar. A pro-cyclical orientation would favor small caps over large caps, cyclicals over defensives, and value over growth stocks. All of these positions have recently met with some resistance and could face a healthy near-term correction. Cyclical stocks are historically very elevated relative to defensives (Chart 13). But over a 12-month period the recovery and stimulus will reinforce the bullish view, as rising bond yields will not stop equities from rising if the Fed stands pat. Chart 13Cyclicals Look Toppy Versus Defensives The chief risks to the pro-cyclical orientation stem from any breakout in the US dollar, the rollover in China’s growth momentum, and the Biden administration’s tax hikes and foreign policy challenges. These risks are all immediate and serious, especially given high stock market valuations. China’s policy tightening will not be fully felt in the economy until the second half of the year and Biden’s specific foreign policy challenges can result in negative geopolitical shocks at any time this year or over the next four years. The point is to buy on the dips unless surprise events fundamentally alter the reflationary cyclical backdrop. With regard to equity sectors, our US Political Risk Matrix highlights the chief policy risks to our US Equity Strategy’s views. Generally speaking Biden poses upside risks to industrials and consumer discretionary sectors and downside risks to energy, health care, tech, and communications (Table 4). After a quarter’s worth of information on markets and policy, these views are mostly confirmed: stay cyclically bullish on industrials and financials, bearish on tech and health care. Table 4US Political Risk Matrix In the case of energy we continue to be neutral-to-bullish over a 12-month time horizon as long as demand is recovering, global inventories are drawing down, and the immediate geopolitical scene is conducive to tit-for-tat attacks in the Middle East, as is the case in the first half of the year. But Biden’s regulatory risks and disruptive climate change agenda can bring negative surprises for US oil producers and Biden’s foreign policy would ultimately be positive for Middle East oil supply. In the case of communications services we are neutral-to-bearish. The Biden administration is allied with Big Tech but it is tightening regulation and anti-trust enforcement gradually to gain greater control over the sector.1 The Treasury selloff is set to continue. Yields are starting to reach pre-COVID levels and have a way to go until they challenge 2018 levels. From peak to trough in the Bloomberg Barclays Treasury Index, the current selloff is not as bad as in the past four recoveries, as our US Bond Strategy has shown. As the economic rebound shows up in hard data over the course of this year, the Fed’s revised expectations will confirm the bond selloff in the financial market. We would thus favor high-yield corporate bonds. We remain overweight TIPS and municipal bonds relative to duration-matched nominal bonds. In recent years presidential approval has correlated remarkably well with the stock-to-bond ratio about two months later (Chart 14). The implication is that higher presidential approval is consistent with receding uncertainty and greater consumer optimism about the economy, which is reflected in rising bond yields and share prices. Neither Biden’s approval rating nor the stock-to-bond ratio is likely to go much higher without a consolidation phase, however, as implied by the chart. Chart 14Stock-To-Bond Ratio Needs A Breather In Q2 Matt Gertken Vice President Geopolitical Strategy mattg@bcaresearch.com Appendix Table A1APolitical Capital: White House And Congress Table A1BPolitical Capital: Household And Business Sentiment Table A1CPolitical Capital: The Economy And Markets Table A2Biden’s Cabinet Position Appointments Footnotes 1 Biden is expected to nominate anti-trust scholar Lina Khan for FTC commissioner.
While the Fed’s dots dovishly surprised, the FOMC’s output and inflation projections were on the hawkish side. Adding the committee’s core PCE price inflation estimate for 2021 to their real GDP forecast results in a roughly 9% nominal GDP estimate, assuming the PCE and GDP deflators approximate one another. The last time the US economy hit such a high mark on a q/q annualized basis (ex-2020) was in late-2003 (Chart 1). Back then the Bush tax cuts were signed into law in late May 2003 turbocharging the economy. Chart 2 shows that the fed funds rate was pegged at 1% and the bond market was in selloff mode, with both the 10-year US Treasury yields surging violently and inflation breakevens galloping higher. While the S&P eventually shrugged off the bond market’s new equilibrium yield, drilling beneath the surface is revealing. Chart 1 Chart 2 As a reminder, back then the Fed was actually sowing the seeds of the housing bubble by keeping rates at 1%, which resulted in an economy running on steroids. Deep cyclical sectors outperformed the SPX and defensives significantly lagged the broad market especially as the economic data caught on fire in 2004 (see Appendix Charts A1, A2, A3, ). Financials were range bound and relative tech performance slumped in 2004 (for inclusion purposes Charts A4-A9 in the Appendix also show GICS2 sector relative performance). Bottom Line: Using the 2003/4 parallel as a guidepost we remain comfortable with our current positioning of preferring industrials and energy to consumer staples and communication services. Appendix Chart A1 Chart A2 Chart A3 Chart A4 Chart A5 Chart A6 Chart A7 Chart A8 Chart A9