Equities

Odd moves have been taking place between different asset classes lately. Since early-July, the US dollar has been taking a beating and while commodities have been rising, high-beta emerging market and euro area stocks have been uncharacteristically and unsustainably trailing the SPX (not shown). Something is clearly off. Within the US market place, the interplay between the VIX and the SPX is also raising some eyebrows, as we highlighted again on Tuesday. Not only has the correlation between these two asset classes slingshot into positive territory, but also realized vol has collapsed compared with the recent jump in the VIX (see chart). According to empirical evidence, it pays to short the VIX when realized vol is above implied vol and buy the VIX when realized vol undershoots implied vol. Currently, we are in the latter phase and we reiterate our tactical view of buying some protection in the form of December VIX futures first recommended in late-July, refrain from chasing stocks higher in general, and in particular resist the temptation to stampede into tech stocks. Bottom Line: Keep your powder dry, a better entry point to redeploy capital will materialize late in the year, as the US Presidential election uncertainty recedes.

Chart 1 Today, we continue cautioning investors about how overstretched the equity market is and highlight a few key reasons not to chase it higher; especially technology stocks. The top five stocks in the SPX (AAPL, MSFT, AMZN, GOOGL & FB) have added $5.8tn to the S&P 500 market cap since 2015, whereas the bottom 495 stocks have added $5.1tn. Crudely put, as a contribution the SPX’s return the former account for 53%, whereas the bottom 495 stocks account for the remaining 47% of the advance over the same time frame. In percent return terms, these five tech titans’ market capitalization has more than quadrupled or risen by 350% over the past 5 ½ years from $1.67tn to $7.5tn. In marked contrast, the S&P 495 market cap has gone nowhere rising a mere 31% (increasing from 16.57tn to $21.7tn) during the same time frame (Chart 1, top panel). If investors have not been in these tech titans, then they have not really participated in the SPX’s run up. The measly return since 2015 in the Value Arithmetic index and negative return in the Value Line Geometric index gauging the mean and median US stock, respectively, corroborate our analysis (not shown).   Chart 2 Drilling deeper, the over concentration risks become even more apparent, even within the tech universe itself. Chart 2 shows that the S&P tech sector excluding AAPL & MSFT is just above the February highs, and nearly all the tech related return sits with the top five titans that are up almost 60% year-to-date (ytd). Worrisomely, the remaining S&P 426 stocks (which exclude all the tech names) are down 6% ytd. Once again, Chart 2 further reiterates the message that even the tech sector is a bifurcated market where only a handful of stocks have been generating all the alpha. Such extreme concentration, while not unprecedented, is a sign of an unhealthy overall market backdrop which makes it vulnerable to a significant shock.   Chart 3 Naturally, the overconcentration in the SPX is even more acute in the NASDAQ. While the top five SPX stocks comprise over a quarter of the index, the same five tech titans carry a 50% weight in the NASDAQ 100. True, the collapse in interest rates has boosted the NASDAQ forward P/E to the stratosphere, but the longer these high-flying stocks defy gravity the more painful the eventual snap will be (Chart 3, bottom panel). Already there are signs of trouble brewing beneath the surface. NASDAQ breadth is sinking, and this has proven a reliable leading indicator in the recent past, warning that a pullback is looming (Chart 3, top panel). The hypersensitive chip stocks are also suffering from exhaustion, unable to outperform the tech titan led NASDAQ (Chart 3, middle panel). Any hiccups in the tech space will negatively reverberate in the SPX: currently the S&P tech sector plus the FANG (FB, AMZN, NFLX & GOOGL) comprise 41% of the S&P 500.       Chart 4 Switching gears and drilling deeper into an S&P tech sub-group doesn’t brighten the short-term picture. The S&P technology hardware storage & peripherals (HS&P) index is in unchartered territory. The second panel of Chart 4 shows that the relative share price ratio is at the highest level as a percentage of its 200-day moving average since the late-1990s. Shown as a z-score, this technical indicator is stretched to the tune of almost four standard deviations above the historical mean (Chart 4, third panel). The last two times technical conditions were so overbought, it marked a multi-year peak in relative performance (Chart 4, top panel). Given that this sub-sector is home to AAPL, such extreme readings even on the index level confirm that the market is vulnerable to a snapback.                 Chart 5 Finally, going down to a stock level a couple of historical parallels are also in order. Specifically, Chart 5 compares the titans of the late 20th century with the current market leaders. The second and bottom panels of Chart 5 reveal that the market capitalization concentration of the top five stocks in the S&P 500 surpassed the late-1990s. However, there is an offsetting factor. In terms of valuation overshoot, the current 12-month forward P/E of these top five stocks near 45x is 3/4 that of late-1990s parabolic episode (Chart 5, top & third panels). Bottom Line: While we maintain a cyclical and structural (please see upcoming Weekly Report after Labor Day) bullish stance in the broad equity market, the shorter-term risk/reward trade-off is tilted to the downside, especially in the technology universe.

Highlights EM domestic fundamentals, global trade and commodities prices, as well as global financial market themes are the main drivers of EM financial assets and currencies. The positive effect of improving global growth and rising commodity prices on EM currencies (ex-China, Korea and Taiwan) has been offset by these countries’ inferior domestic fundamentals. The odds of a near-term US dollar rebound are rising. This will likely produce a setback in EM currencies, fixed-income markets and equities. However, such a setback will likely prove to be a buying opportunity. Increased central bank intervention in asset markets may diminish the importance of fundamentals in determining the asset prices. Feature Chart I-1Unusual Divergences EM risk assets have done well in absolute terms but have underperformed their DM counterparts.  This is unusual given the substantial weakness in the US dollar and the rally in commodities prices since April (Chart I-1). Until early this year, many commentators had argued that monetary policies of DM central banks were the principal drivers of EM financial markets. Given the zero interest rates and money printing that is prevalent in DM, the underperformance of EM equities and currencies is especially intriguing. Is this underperformance an aberration or is it fundamentally justified? What really drives EM performance? Back To Basics As we have argued over the years, EM risk assets and currencies are primarily driven by their domestic fundamentals, rather than by the actions and policies of the US Federal Reserve or the ECB. The critical determinant of EM stocks’ absolute as well as relative performance versus DM equities has been corporate profits. Chart I-2 illustrates that relative equity performance and relative EPS between EM and the US move in tandem, both in common and, critically, local currency terms. Similarly, the main reason why EM share prices in absolute terms have failed to deliver positive returns over the past 10 years is that their profits have been stagnant over the same period, even prior to the pandemic (Chart I-3). Interestingly, fluctuations in EM EPS resemble those of Korea’s exports. This reflects the importance of global growth in shaping EM profit trends. Chart I-2Corporate Profits Drive EM Absolute And Relative Performance Chart I-3EM EPS Has Been Flat For 10 Years   The key drivers of EM risk assets and currencies have been and remain: 1. EM domestic fundamentals that can be encapsulated by a potential risk-adjusted return on capital. The latter is impacted by both cyclical and structural growth trajectories, as well as by the quality and composition of growth. Risks to growth can be gauged based on factors such as (but not limited to): productivity, wages, inflation, fiscal and balance of payment positions, the global economic and financial environment, and the health of the banking system. In EM (ex-China, Korea and Taiwan), the fundamentals remain challenging: The business cycle recovery is slower in these economies than it is in China and advanced economies. Fiscal stimulus has not been as large as in many advanced countries, while the pandemic situation has been worse. Their banking systems were already fragile before the pandemic, and have lately been hit by defaults stemming from the unprecedented recession. These governments have less room than in DM and China, to stimulate fiscally and bail out debtors and banks. Banks in EM (ex-China, Korea and Taiwan) will continue struggling for some time, and their ability to finance a new expansion cycle will, for now, remain constrained (Chart I-4). A restructuring of non-performing loans and a recapitalization of banks will be required to kick-start a new credit cycle in many of these economies. 2. Global growth, especially relating to China’s business cycle and commodities. The recovery in China since April, along with rising commodities prices have been positive for EM (ex-China, Korea and Taiwan). Given the substantial stimulus injected into the Chinese economy, its recovery will continue well into next year (Chart I-5). As a result, higher commodities prices will benefit resource producing economies by supporting their balance of payments and enhancing income growth. Chart I-4EM ex-China: Limited Bank Support For Growth Chart I-5China's Stimulus Entails More Upside In Commodity Prices   3. Global financial market themes: a search for yield and leadership of new economy stocks. Global investment themes have an important bearing on EM financial markets. For example, in recent years, the increased market cap of new economy and semiconductor stocks – due to an exponential rise in their share prices – has amplified their importance for the aggregate EM equity index. The largest six mega cap stocks in the EM benchmark are new economy and semiconductor companies, and make up about 25% of the EM MSCI market cap. The six FAANGM stocks presently account for about 25% of the S&P 500. Hence, the concentration risk in EM is as high as it is in the US. Consequently, the trajectory of new economy and semiconductor stocks globally will be essential to the performance of the EM equity index. On August 20, we published an in-depth Special Report assessing near-term and structural outlooks for global semiconductor stocks. With new economy and semiconductor share prices going parabolic worldwide, we are witnessing a full-fledged mania, as we discussed in our July 16 report. The equal-weighted US FAANGM stock index has risen by 24-fold in nominal and 20-fold in real (inflation-adjusted) terms, since January 1, 2010 (Chart I-6). Chart I-6History Of Manias Of Past Decades In brief, with respect to magnitude and duration, the bull market in FAANGM is on par with the bubbles of previous decades (Chart I-6). Those bubbles culminated in bear markets, where prices fell by at least 50% after topping out. Chart I-7EM ex-TMT Stocks: Absolute And Relative Performance We do not know when the FAANGM rally will end. Timing a reversal in a powerful bull market is impossible. Also, we are not certain about the magnitude of such a potential drawdown. Nevertheless, our message is that the risk-reward tradeoff of chasing FAANGM at this stage is very unattractive. Excluding technology, media and telecommunication (TMT) – as most growth stocks are a part of TMT– EM equities remain in a bear market (Chart I-7, top panel). In relative terms, EM ex-TMT stocks have massively underperformed their global peers (Chart I-7, bottom panel).  Even with a larger weighting of mega-cap growth TMT stocks than the overall DM equity index, the aggregate EM equity index has underperformed the overall DM index. Bottom Line: EM domestic fundamentals, global trade and commodities prices, and global financial market themes are the main drivers of EM financial assets and currencies. What About The Dollar? The high correlation of the trade-weighted US dollar and EM equities is due to the following: (1) the greenback has been a countercyclical currency; and (2) the US dollar’s exchange rate against EM currencies reflects relative fundamentals in the US versus EM economies. When a global business cycle accelerates, the broad trade-weighted US dollar weakens. If this growth acceleration is led by China and other emerging economies, the greenback depreciates considerably versus EM currencies. The opposite is also true. In other words, the US dollar exchange rate’s strong negative correlation to EM equities is primarily due to the fact that the greenback’s exchange rates against EM currencies reflect both the global business cycle as well as EM growth and fundamentals. Chart I-8Divergence Between DM And EM Currencies In recent months, the greenback has: (1) depreciated due to the global economic recovery; (2) tumbled versus DM currencies due to the still raging pandemic and the socio-political instability in the US as well as the Fed’s commitment to staying behind the inflation curve in the years to come; and (3) not fallen much against EM (ex-China, Korea and Taiwan) currencies because their fundamentals have been poor, as discussed above. Bottom Line: Exchange rates in EM (ex-China, Korea and Taiwan) have failed to appreciate versus the dollar despite the latter’s plunge versus other DM currencies (Chart I-8). The positive effect of improving global growth and rising commodities prices on EM currencies (ex-China, Korea and Taiwan) has been offset by these countries’ inferior domestic fundamentals. Flows And Cash On The Sidelines Chart I-9Cash On The Sidelines Has Been Produced By The Fed's Debt Monetization What about capital flows? Aren’t they essential in driving EM financial markets? Of course, they are important. However, we view flows as resulting from and determined by fundamentals. Over the medium and long term, we assume that capital flows to regions where the return on capital is high or rising. Thus, we see ourselves as responsible for directing investors to those areas that we have identified as providing a high or rising return on capital (and cautioning investors when the opposite is true). The presumption is that beyond short-term volatility, investment flows will gravitate to countries/sectors/asset classes with high or rising returns on capital, just as they will abandon areas of low or falling returns on capital. In brief, fundamentals drive flows and flows determine asset price performance. Isn’t sizable cash on the sidelines a reason to be bullish? Yes, there is substantial cash on the sidelines. Along with zero short-term rates, this has been the potent force leading investors to purchase equities, credit and other risk assets since late March. Below we examine the case of the US, but this has also been true in many markets around the world. The top panel of Chart I-9 demonstrates that US institutional and retail money market funds – a measure of cash on the sidelines - presently stand at $4.2 trillion, having increased by $900 billion since March. Yet, the Fed and US commercial banks have increased their debt securities holdings by $2.9 trillion since March.   Furthermore, the Fed and US commercial banks hold $10.6 trillion of debt securities (Chart I-9, middle panel) – amounting to 18% of the aggregate equity and US dollar fixed-income market value (Chart I-9, bottom panel). These securities, held by the Fed and US commercial banks, are not available to non-bank investors. Chart I-10Investors' Cash Holdings Ratio Is Still Elevated Excluding debt securities owned by the Fed and commercial banks, we reckon that cash on the sidelines is equal to 8.4% of the value of equities and US dollar debt securities available to non-bank investors (Chart I-10). This is a relatively high cash ratio. Unprecedented purchases by the Fed and US commercial banks have not only removed a considerable chuck of debt securities from the market; they have also created money “out of thin air”. When central or commercial banks acquire a security from, or lend to, a non-bank entity, they are creating new money “out of thin air”. No one needs to save for the central bank and commercial banks to lend to or purchase a security from a non-bank. In short, savings versus spending decisions by economic agents (non-banks) do not affect the stock of money supply. We have deliberated on these topics at length in past reports. In sum, the Fed’s large purchases of debt securities amount to a de facto monetization of public and private debt. These operations have both reduced the amount of securities available to investors and boosted the latter’s cash balances. Hence, the Fed has boosted asset prices not only indirectly, by lowering short-term interest rates, but also directly, by printing new money and shrinking the amount of securities available to investors. We have in recent months argued that global risk assets are overpriced relative to fundamentals. However, investors have continued to deploy cash in asset markets, pushing prices higher. Given the zero money market interest rates and the still elevated cash balances, one can envision a scenario in which cash continues to be deployed in asset markets, pushing valuations to bubble levels across all risk assets. Pressure on investors to deploy their cash amid rising asset prices implies that only a major negative shock might be able to reverse this rally. There have been plenty of reasons to be cautious, including escalating US-China geopolitical tensions, the increasing odds of a contested US presidential election and, hence, elevated political uncertainty, the possibility of a US fiscal cliff, and a potential second wave of the pandemic. However, investors have so far shrugged off all of these and continue to allocate capital to risk assets. Bottom Line: Increased central bank intervention in asset markets may diminish the importance of fundamentals in determining the price of risk assets. This would also mean that the role of momentum investing and psychology may increase. Investment Strategy Currencies: The US dollar has become oversold and could stage a rebound in the near term. The euro has risen to its technical resistance (Chart I-11). The EM currency index (ex-China, Korea and Taiwan) has failed to break above its 200-day moving average (Chart I-12, top panel).  The emerging Asian trade-weighted currency index (ADXY) has rebounded to the upper boundary of its falling channel (Chart I-12, bottom panel). Chart I-11A Short-Term Resistance For Euro/USD Chart I-12EM Currencies Have Not Entered A Bull Market   Such technical profiles suggest that EM currencies have not yet entered a bull market despite the greenback’s considerable depreciation against DM currencies. This is a reflection of the poor fundamentals of EM (ex-China, Korea and Taiwan). In short, the odds of a US dollar rebound are rising. This could dent commodities prices and weigh on EM currencies. We continue recommending shorting a basket of EM currencies versus the euro, CHF and JPY. The downside in these DM currencies versus the greenback is limited. The euro could drop to 1.15, but not much below that level. Our basket of EM currencies to short includes: BRL, CLP, ZAR, TRY, PHP, KRW and IDR. Chart I-13EM Local Currency Bonds: Looking For A Better Entry Point Fixed-Income Markets: We have been neutral on EM local currency bonds and EM credit markets (USD bonds) since April 23 and June 4, respectively. The strategy is to wait for a correction in these markets before going long. The rebound in the US dollar and correction in commodities will provide a better entry point for these fixed-income markets (Chart I-13). Equities: On July 30, we recommended shifting the EM equity allocation within a global equity portfolio from underweight to neutral. In the near term, EM share prices will likely continue underperforming their DM counterparts. A bounce in the US dollar, rising geopolitical tensions between the US and China, as well as the continuation of a FAANGM-driven mania in US equities will result in EM equity underperformance versus DM. However, in the medium- to long-term, the balance of risks no longer justifies an underweight allocation. Arthur Budaghyan Chief Emerging Markets Strategist arthurb@bcaresearch.com Equities Recommendations Currencies, Credit And Fixed-Income Recommendations

Neutral - Downgrade Alert Bank stocks fail to catch a break. Following the recent Fed stress results and the resulting dividend cuts, banks have continued to trail both the broad equity market and their early cyclical peers: consumer discretionary stocks. Worryingly, on all three income generation fronts, dark clouds are gathering for banks, the nervous system of the US economy. While the initial knee jerk reaction of corporates was to tap their existing credit lines in order to fight the pandemic that caused an exponential rise in C&I loan growth, going forward a steep reversal is looming (middle & bottom panels). Bankers are tightening lending standards at the fastest pace in a decade despite ZIRP, weighing heavily on relative share prices (top panel). On the price of credit front, the Fed’s recent perching of the fed funds rate on the zero line for as far as the eye can see all but guarantees a tough pricing power environment for banks. The latest FDIC Quarterly Banking Profile revealed that the banking industry broke the 3 handle on net interest margins coming in at 2.81%, the lowest level since the history of the data dating back to 1984. Finally, with regard to credit quality, a double digit unemployment rate, along with commercial real estate ails will propel non-performing loans, which are extremely lagging by nature. While credit quality deterioration is late to show up, it wreaks immediate havoc on bank income statements as loan loss provisions. Aggressive provisioning will likely continue at least until the end of the year. Bottom Line: Stay neutral the S&P banks index, but it is now on downgrade alert.