Equities

While the Fed remains committed to ZIRP for the remainder of the year, already FOMC members started talking about talking about tapering. The next logical step is for tapering to become reality as the year draws to a close or early in 2022. Peering above the 49th parallel, the BoC yesterday opted to taper bond purchases, albeit slightly, and may offer a glimpse of what may also take root in the US in the not too distant future. True, tapering is a good thing as the Central Bank’s (CB) confidence is high that the economy is on a solid footing and no longer needs additional CB support, however if history is an accurate guide, equity investors will have to digest the tapering news once it becomes reality. The chart shows G4 CB liquidity as a 26-week change in the asset side of the balance sheet, and given that some of this excess liquidity seeps over to the US equity market, its withdrawal will likely prove tumultuous. Bottom Line: Near-term caution is warranted on the prospects of the broad equity market that remains fully valued. Please see the next US equity sector Insight.

Highlights Surging Covid-19 cases to unprecedented levels have unsettled India’s equity and currency markets. Worryingly, the number of new cases in India might stay exceptionally high for a while due to several potential ongoing super-spreader events. Yet, the country’s medium- and longer-term outlooks remain positive. Asset allocators with less tolerance for volatility may tactically downgrade India to neutral in an EM equity portfolio. Long-term investors should continue overweighting the Indian bourse. Feature New COVID-19 cases in India have skyrocketed in the past few weeks – far surpassing previous peaks. The country now accounts for 40% of daily new cases globally (Charts 1 and 2). This has raised the possibility of fresh lockdowns and, as a result, Indian stocks and the currency have begun to sell off. Chart 1Daily COVID-19 Cases Have Lately Skyrocketed In India … Chart 2… Accounting For 40% Of Global Cases And 20% Of Deaths … We have been overweight India in an EM equity portfolio because of the country’s positive cyclical and structural outlook. Even though our views have not changed, we believe the parabolic surge in COVID-19 cases is likely to cause near-term volatility in Indian equity and currency markets. As such, we recommend that asset allocators who have less tolerance for volatility tactically downgrade Indian equities to neutral for the next couple of months. Below we elaborate the reasons for this near-term downgrade, as well as the reasons for our more upbeat view over the medium to long term. New Cases Might Stay High Chart 3… And Raising The Specter Of Another Stringent Lockdown Being a densely populated country with less than ideal living conditions, the attempts to control the spread of COVID-19 via social distancing measures is extremely difficult in India. Yet, the authorities tried to do exactly that last spring by imposing the most stringent lockdown measures anywhere in the world (Chart 3). The result was a complete collapse in economic activity: year-over-year industrial production fell by a half, and GDP contracted by 22% in the second quarter of 2020 from a year ago. Now facing an unprecedented surge in new cases, markets are apprehensive that even a partial lockdown will scuttle the nascent recovery in the economy. Worryingly, the number of new cases in India might stay exceptionally high for a while. The reason is that there are several potential super-spreader events going on. The country is undergoing state-level elections in five states where the candidates are canvassing in front of gatherings of tens of thousands of people. Currently, there is also a religious congregation taking place where up to three million pilgrims have assembled. Chart 4Should Morbidity And Mortality Rates Rise, A Harsh Lockdown May Become Inevitable The morbidity and mortality rates have not yet risen (Chart 4). This is a key metric and will likely determine the stringency of the authorities’ lockdown measures. Even though the Prime Minister has declared that stern lockdowns would be last-resort measures, the possibility cannot be excluded if hospitalization and mortality rates begin to rise. The following has also added to investor concerns: The fact that equity valuations are much higher now than they were last spring makes the market even more prone to a setback (Chart 5). Indian stocks have benefitted from a record amount of foreign portfolio inflows over the past 12 months – totaling $ 34 billion. The risk is therefore high that some of these flows might reverse in the near term if the threat of renewed lockdowns is realized. That will be a headwind for both stock market and the rupee (Chart 6). Finally, a rising US dollar, and a likely general underperformance of EM stocks over the next several months, will also encourage outflows from India. Chart 5Elevated Valuations Have Added To The Vulnerability Of Indian Stocks Chart 6A Reversal In Foreign Portfolio Inflows Will Cause Both Stocks And The Rupee To Fall Cyclical Outlook Remains Positive Beyond the near-term jitters, India’s cyclical outlook remains positive. The recovery has been solid as indicated by the following metrics: The number of E-way bills issued (a barometer of business activity) as part of the Goods & Services Tax (GST) collection mechanism keeps rising steadily. GST collection itself has also been strong – validating the same message (Chart 7). Manufacturing and Services PMIs printed over 55 in March – indicating robust expansion of activity. Order books of companies, as indicated by both RBI and Dun & Bradstreet surveys, look strong. These indicators herald an improvement in industrial production going forward (Chart 8). Chart 7Underlying Economic Recovery In India Has Been Robust So Far … Chart 8… Supported By Strong Order Books … In short, all of the above points to an ameliorating top lines (sales) for the corporates in the coming months, barring stringent lockdowns. Meanwhile, firms’ profits margins have also recovered meaningfully. An RBI survey of over 2600 companies shows that both gross and net profit margins had risen to above pre-pandemic levels by December 2020 (Chart 9). Given the wide margins, a recovery in sales levels will lead to accelerating profits in the quarters ahead. In a sign that profit re-acceleration is not far off, firms have begun to invest in new plants and machinery. Capital spending had already turned positive during the last quarter of 2020 versus the same period of 2019. Imports of capital goods have also begun to rise – corroborating new capex plans of the firms (Chart 10). Chart 9… And Healthy Profit Margins … Chart 10… Which Have Encouraged Firms To Resume Capital Spending New capital expenditure is undertaken only when firms are confident of strengthening demand. Besides, capex usually comes on the heels of rising profits. Higher capital goods imports and capital spending therefore indicate that the companies are optimistic of both sales and profits going forward. On its part, the central bank has ensured that the liquidity in the banking system remains abundant by engaging in plenty of open market operations. Bank credit growth, at 6.3%, is still low, but appears to have bottomed. Excluding the credit to large corporations – who have in recent years been replacing bank credit by local currency debt issuances – the credit growth rate is 9% (Chart 11). Odds are that beyond the near-term jitters due to rising COVID-19 cases, credit will accelerate in line with recovering economic activity. That will be bullish for bank stocks. Incidentally, banks make up the largest chunk of Indian equity index. Finally, Indian small caps continue to outperform their large cap counterparts (Chart 12). Smaller firms in India are much more vulnerable to a slowdown in growth and tighter credit conditions. The fact that they keep outperforming suggests that investors do not expect a major or lasting impact of the latest pandemic outbreak on the economy. Chart 11Bank Credit Will Rise As The Expansion Continues Chart 12Small Caps Outperformance Suggest Investors Are Sanguine About Growth And Credit Conditions Beyond the cyclical recovery, we are bullish on India’s longer-term outlook as well. The reason for that is India is one of the rare EM countries undertaking meaningful structural reforms. The country’s demographics are also highly favorable. We will elaborate on these and other structural issues in greater detail in our future reports. Investment Conclusions Indian stocks and the currency have entered a period of turbulence as surging COVID-19 cases prompt profit taking/selling. EM equity portfolios with low tolerance for volatility should therefore consider tactically downgrading this bourse to neutral for a couple of months. Absolute return investors (in US$ terms) should also brace for near-term volatility in Indian share prices. Over the medium-to-long term however, Indian stocks will likely outperform their EM peers as well as rally in absolute terms (Chart 13). Indian bank stocks are also suffering from the ongoing volatility. However, given Indian private banks’ higher efficiency and better balance sheets vis-à-vis banks elsewhere in the EM, long-term investors should continue to stick with our recommended trade of long Indian banks/ short EM banks (Chart 14). Chart 13Beyond The Near-Term Volatility, Indian Stocks Will Outperform Their EM Peers … Chart 14… So Will Indian Bank Stocks Vis-à-vis EM Banks Fixed income investors should continue receiving 10-year swap rates in India. With the abundant rainfall, food prices will decline. This will keep inflation under check. The rising COVID-19 cases and a potential lockdown are disinflationary in nature and will push down swap rates.   Rajeeb Pramanik Senior EM Strategist rajeeb.pramanik@bcaresearch.com

In lieu of next week’s strategy report, I will be presenting the first Counterpoint webcast titled ‘Mega-Themes, Coming Shocks, And Top Trades’. I hope you can join. Highlights Standard economic theory assumes that money is perfectly fungible. But in practice, money is not fungible, because people attach different emotions to their income and savings mental accounts. This is known as ‘mental accounting bias.’ Mental accounting bias means that we are more likely to use the massive stockpile of savings accumulated during the pandemic to pay down debt than to spend. Mental accounting bias also means that we are overpaying for high-yielding equities. Long-term investors should avoid banks, and they should avoid ‘value.’ Correctly calculated, the equity risk premium is now almost non-existent. US long-term bond yields have much more scope to move down than to move up. Fractal trade shortlist: equities versus bonds, PKR, and New Zealand equities. Feature Chart of the WeekConsumption Is Explained By Wages... Chart of the Week...Not By Stimulus Checks Many economists predict that, once economies fully reopen, the massive stockpile of household savings accumulated during the pandemic will unleash a tsunami of household spending. But economists are not the right people to make this prediction. The answer to whether households will, or will not, spend their stockpile of accumulated savings does not fall into the realm of Economics. It falls into the realm of Psychology. Whether We Spend Money Depends On Which ‘Mental Account’ It Occupies In A Major Anomaly In The Bond Market we pointed out that the propensity to spend out of income is high, but the propensity to spend out of wealth is low. Meaning that whether unspent income gets spent depends on whether households categorise it as additional income or additional wealth. This raised a follow-up question. How can the decision to spend money depend on whether someone categorises it as income or wealth? The answer comes from Psychology, and a phenomenon known as ‘mental accounting bias.’ Nobel Laureate psychologist Daniel Kahneman points out that we categorise our money into different accounts, which are sometimes physical, sometimes only mental – and that there is a clear hierarchy in our willingness to draw on these accounts for spending. There is a clear hierarchy in our willingness to spend from our ‘mental accounts’. At the top of the hierarchy comes our monthly wage check, followed by the money in our current (checking) account. These ‘income’ accounts we are willing to spend. Further down the hierarchy comes our savings account and our investment portfolio. These ‘savings’ or ‘wealth’ accounts we are unwilling to spend. Standard economic theory assumes that money is perfectly fungible, so that a pound in a current account is no different to a pound in a savings account. But in practice, money is not fungible, because people attach different emotions to their income and savings mental accounts. When we move money from our wages or our current account into our savings account, our willingness to spend it collapses. This explains why consumption closely tracks the wages that dominate our income mental account, but has no meaningful connection with stimulus checks which largely end up in our savings mental account (Chart of the Week and Chart I-2). Chart I-2Stimulus Checks Had No Meaningful Impact On Consumption Trends Yet while we are unwilling to spend our savings mental account, we are willing to pay down debt with it. Indeed, realising this emotional connection between our savings and our debt, many lenders offer mortgages which ‘offset’ a savings account against the mortgage debt. Pulling all of this together, the stockpile of household savings accumulated during the pandemic is unlikely to boost consumption trends. More likely, it will be used to reduce household debt. In which case, part of the recent rise in public debt will just end up paying down private debt, as happened in Japan during the 1990s (Chart I-3). Chart I-3In Japan, Public Debt Ended Up Paying Down Private Debt This spells trouble for bank asset growth. ‘Value’ Offers No Value Mental accounting bias also explains the dominant phenomenon in the financial markets of recent years – the so-called ‘search for yield’. At first glance, the search for yield makes sense, but on deeper thought the distinction between yield and capital appreciation is irrational. Just like income and wealth, the money that comes from an investment’s yield and the money that comes from its capital appreciation is perfectly fungible (assuming am equal tax treatment). Yet, in practice, many investors put yield and capital appreciation into separate mental accounts, categorising an investment’s yield as spending money, and its capital as saving money. Hence, those investors – say retirees – who want their assets to generate money for their spending mental account have an irrational bias towards investments that generate yield. Whereas those investors that want their assets to boost their saving mental account have a bias towards investments that generate capital growth. To reiterate, given that money is perfectly fungible, these mental accounts are irrational.  Under normal circumstances, these irrational biases are not a problem because there are enough investments available for both the spending and the saving mental accounts. But in recent years, the assets that would normally generate the safe income for the spending account – cash and government bonds – are no longer doing so. Hence, in the ensuing stampede for yield, income fixated investors have suffered a dangerous tunnel vision. By fixating on an equity’s yield rather than on its prospective total return, yield seeking investors are overpaying for high-yielding equities, and thereby sacrificing their long-term wealth. By fixating on an equity’s yield rather than on its prospective total return, investors are overpaying for high-yielding equities. Case in point. The 8 percent forward earnings yield on global financials appears to offer considerably more value than the 5 percent on healthcare and the 3.5 percent on technology. But what really matters is how that forward earnings yield translates into prospective total return. On this basis, the apparent value in financials turns out to be a mirage. Using the post financial crisis relationship between forward earnings yield and prospective return, high-yielding financials were, until very recently, priced to deliver a lower return than low-yielding technology. And financials are still priced to deliver a lower return than lower-yielding healthcare. To deliver the same long-term return as healthcare, the valuation of financials would have to decline by 20 percent (Chart I-4 - Chart I-6). Chart I-4Financials' 8 Percent Earnings Yield = A 2 Percent Prospective Return Chart I-5Healthcare's 5 Percent Earnings Yield = An 8 Percent Prospective Return Chart I-6Tech Is Expensive Therefore, mental accounting bias is a double whammy for banks. It spells trouble for bank asset growth, and it makes investors overpay for high-yielding equities. This creates the ultimate paradox of investment. The defining feature of ‘value’ is that it offers no value! Long-term investors should avoid banks, and they should avoid value. US Bond Yields Have More Scope To Move Down Than Up The foregoing analysis also carries important implications on the correct approach to value equities, and specifically the equity risk premium – meaning, the prospective excess return on equities versus high-quality bonds. The common incorrect approach is to take the forward earnings yield on equities and subtract the 10-year bond yield. Using a US forward earnings yield of 4.5 percent, this would suggest the equity risk premium is a comfortable 3 percent versus the nominal bond yield of 1.5 percent. Or a very comfortable 5.5 percent versus the real bond yield of -1 percent. The glaring error with this approach is that it is subtracting apples from oranges. The 10-year bond yield is the return you will receive from the bond over the next 10 years. But as you have just seen, the forward earnings yield is not the return you will receive from equities over the next 10 years. To subtract apples from apples we must first translate the forward earnings yield into a prospective 10-year total return. The current translation turns out to be a 2 percent nominal return (Chart I-7 - Chart I-8) or a 0 percent real return (Chart I-9 - Chart I-10). Comparing these with the nominal or real bond yields, we find that the equity risk premium is almost non-existent. Chart I-7Convert The Earnings Yield Into A Prospective Nominal Return... Chart I-8…To Find That The Equity Risk Premium Is Almost Non-Existent Chart I-9Convert The Earnings Yield Into A Prospective Real Return... Chart I-10...To Find That The Equity Risk Premium Is Almost Non-Existent The almost non-existent equity risk premium means that equities are richly valued, and that this rich valuation is contingent on bond yields not rising significantly. Moreover, it is not just equities that are richly valued. As we pointed out in The Road To Inflation Ends At Deflation the valuation of $300 trillion of global real estate is also highly contingent on bond yields not rising significantly. Equities are richly valued, and this rich valuation is contingent on bond yields not rising significantly. We conclude that, from current levels, US long-term bond yields have much more scope to move down than to move up. Candidates For Countertrend Reversal The strong rally in equities versus bonds since the pandemic low has reached a point of fractal fragility like that seen at the end of the 2013 bull run and the end of the early 2020 bear run (Chart I-11). As such, the current rally is due a breather. Chart I-11The Rally In Equities Versus Bonds Is Due A Breather In the Asia Pacific region, we note that the recent strong performance of the Pakistan rupee is susceptible to a countertrend sell-off (Chart I-12). Chart I-12Underweight The PKR Lastly, the ultra-defensive New Zealand stock market has massively underperformed over the past year. But fragility on both its 130-day and 65-day fractal structures suggests that it is ripe for a countertrend outperformance (Chart I-13). Chart I-13Overweight New Zealand Accordingly, this week’s recommendation is to overweight New Zealand versus the world, setting the profit target and symmetrical stop-loss at 4 percent.   Dhaval Joshi Chief Strategist dhaval@bcaresearch.com Fractal Trading System Fractal Trades 6-Month Recommendations Structural Recommendations Closed Fractal Trades Closed Trades Asset Performance Equity Market Performance   Indicators To Watch - Bond Yields Chart II-1Indicators To Watch - Bond Yields - ##br##Euro Area Chart II-2Indicators To Watch - Bond Yields - ##br##Europe Ex Euro Area Chart II-3Indicators To Watch - Bond Yields - ##br##Asia Chart II-4Indicators To Watch - Bond Yields - ##br##Other Developed   Indicators To Watch - Interest Rate Expectations Chart II-5Indicators To Watch - Interest Rate Expectations Chart II-6Indicators To Watch - Interest Rate Expectations Chart II-7Indicators To Watch - Interest Rate Expectations Chart II-8Indicators To Watch - Interest Rate Expectations    

US equity market euphoria got a jab in the arm yesterday and started to test the resolve of late-comers to the rally. While the self-reinforcing cycle of ultra loose financial conditions along with easy fiscal and monetary policies will continue to underpin markets on a cyclical time horizon, any let up in the near-term in any of these buoyant macro forces can have far reaching effects, especially given lofty valuations and rising complacency. Thus, we remain cautious in the short-term. Not only is this market in a desperate need of a breather given that it once again sits two standard deviations above the 20-month moving average (top panel) – a technical signal that allowed us to caution clients of extreme overbought conditions right before the September 2nd correction – but also a number of other factors are waving yellow flags. First, the US smart money flow index is revealing the fragility hidden beneath the SPX surface. The divergence between this index and the S&P 500 is reminiscent of the 2018 “Volmageddon” correction (third panel). Second, the total US equity call / put ratio is significantly diverging with equity prices, likely as a result of both smart money hedging their longs (second panel) and retail call buying frenzy going on a hiatus. Finally, our US Equity Internal Dynamics Indicator also ticked down of late cementing the argument that, for now, equities are fully priced as we posited in yesterday’s Strategy Report where we updated our SPX dividend discount model (bottom panel). Bottom Line: While we remain cyclically bullish, any mishaps on China’s and/or the Fed’s front will likely serve as a catalyst for a near-term correction.  

Weekly Performance Update For the week ending Thu Apr 15, 2021 The Market Monitor displays the trailing 1-quarter performance of strategies based around the BCA Score. For each region, we construct an equal-weighted, monthly rebalanced portfolio consisting of the top 3 stocks per sector and compare it with the regional benchmark. For each portfolio, we show the weekly performance of individual holdings in the Top Contributors/Detractors table. In addition, the Top Prospects table shows the holdings that currently have the highest BCA Score within the portfolio. For more details, click the region headers below to be redirected to the full historical backtest for the strategy. BCA US Portfolio Total Weekly Return BCA US Portfolio S&P500 TRI 0.74% 1.81% Top Contributors   DELL:US LPX:US DCP:US TTEC:US TRTN:US Weekly Return 21 bps 20 bps 16 bps 13 bps 13 bps Top Detractors   QFIN:US EXPI:US VIPS:US UHAL:US TX:US Weekly Return -49 bps -36 bps -12 bps -5 bps -4 bps Top Prospects   TX:US ESGR:US UHAL:US BRK.A:US VIPS:US BCA Score 99.68% 98.48% 93.23% 93.20% 92.08% BCA Canada Portfolio Total Weekly Return BCA Canada Portfolio S&P/TSX TRI -0.72% 0.49% Top Contributors   TOY:CA CSU:CA QBR.A:CA GIB.A:CA WIR.UN:CA Weekly Return 16 bps 12 bps 12 bps 7 bps 6 bps Top Detractors   APHA:CA CFP:CA LNF:CA WEED:CA ENGH:CA Weekly Return -45 bps -11 bps -10 bps -10 bps -9 bps Top Prospects   LNF:CA IFP:CA CFP:CA LNR:CA NWC:CA BCA Score 99.32% 96.68% 96.68% 93.39% 92.80% BCA UK Portfolio Total Weekly Return BCA UK Portfolio FTSE 100 TRI 0.76% 0.68% Top Contributors   NFC:GB SVST:GB OXIG:GB XPP:GB AGRO:GB Weekly Return 28 bps 25 bps 16 bps 15 bps 14 bps Top Detractors   AAF:GB TM17:GB GLO:GB AO.:GB SSE:GB Weekly Return -34 bps -12 bps -10 bps -9 bps -7 bps Top Prospects   SVST:GB FXPO:GB NLMK:GB BPCR:GB GYS:GB BCA Score 98.21% 98.16% 97.25% 96.79% 96.00% BCA Eurozone Portfolio Total Weekly Return BCA EMU Portfolio MSCI EMU TRI 0.61% 0.41% Top Contributors   CNV:FR SES:IT HDG:NL AOF:DE FLUX:BE Weekly Return 38 bps 19 bps 17 bps 16 bps 8 bps Top Detractors   TTALO:FI RIN:FR EDNR:IT TKA:AT VGP:BE Weekly Return -9 bps -8 bps -7 bps -7 bps -7 bps Top Prospects   PHH2:DE SOLV:BE SOL:IT CNV:FR BEKB:BE BCA Score 99.62% 98.82% 98.56% 97.48% 95.70% BCA Japan Portfolio Total Weekly Return BCA Japan Portfolio TOPIX TRI 0.05% 0.37% Top Contributors   8595:JP 8255:JP 5943:JP 6960:JP 7942:JP Weekly Return 27 bps 14 bps 8 bps 7 bps 5 bps Top Detractors   8850:JP 8795:JP 8173:JP 8198:JP 9413:JP Weekly Return -15 bps -11 bps -10 bps -10 bps -7 bps Top Prospects   9436:JP 1766:JP 8133:JP 7994:JP 4008:JP BCA Score 98.83% 98.68% 98.19% 98.10% 97.66% BCA Hong Kong Portfolio Total Weekly Return BCA Hong Kong Portfolio Hang Seng TRI -0.11% -0.74% Top Contributors   990:HK 1898:HK 1378:HK 1088:HK 373:HK Weekly Return 84 bps 15 bps 13 bps 9 bps 6 bps Top Detractors   856:HK 43:HK 579:HK 2798:HK 719:HK Weekly Return -22 bps -17 bps -17 bps -15 bps -11 bps Top Prospects   990:HK 2232:HK 1866:HK 3306:HK 811:HK BCA Score 99.79% 99.67% 98.68% 98.65% 98.32% BCA Australia Portfolio Total Weekly Return BCA Australia Portfolio S&P/ASX All Ord. TRI 0.64% 0.93% Top Contributors   PSQ:AU ADH:AU STX:AU MAQ:AU DDR:AU Weekly Return 23 bps 21 bps 18 bps 16 bps 15 bps Top Detractors   ZIM:AU PDN:AU CAJ:AU SIG:AU AGL:AU Weekly Return -25 bps -24 bps -13 bps -11 bps -10 bps Top Prospects   BSE:AU GRR:AU PIC:AU BLX:AU ZIM:AU BCA Score 99.77% 98.85% 98.02% 97.05% 96.86%