Valuations

Special Report

Highlights Below-Benchmark Portfolio Duration: Bond investors should keep portfolio duration low in 2022. While the market’s pricing of the expected Fed liftoff date and initial pace of rate hikes is reasonable, terminal fed funds rate expectations are far too low. Own Treasury Curve Steepeners: The 2/10 Treasury slope will flatten by less than what is currently discounted in the forward curve in 2022. Investors should position for this by going long the 2-year note versus a duration-matched barbell consisting of cash and the 10-year note. Sell Short-Maturity TIPS: Investors should maintain a neutral allocation to long-maturity TIPS versus nominal Treasuries and an underweight allocation to short-maturity TIPS versus nominal Treasuries. We also recommend an outright short position in 2-year TIPS, as short-maturity real yields have a lot of upside in 2022. Overweight Corporate Bonds Versus Treasuries … For Now: We are overweight corporate bonds versus duration-matched Treasuries, for now, but expect to turn more defensive in the first half of 2022 once the yield curve sustainably moves into a flatter regime. Relative valuations suggest that investors should favor high-yield corporates over investment grade. Overweight Emerging Market Bonds Versus US Corporates: EM bonds offer an attractive spread advantage versus US corporates, and a weakening US dollar will help boost returns in 2022. A Maximum Overweight Allocation To Municipal Bonds: Municipal bonds offer exceptional value, especially at the long-end of the curve, and state & local government balance sheets are in excellent shape. Underweight Agency MBS: Agency Mortgage-Backed Securities don’t adequately compensate investors for the likely pace of refi activity in 2021. An up-in-coupon stance is also advisable to take advantage of rising bond yields. Feature BCA published its 2022 Outlook on December 1st. That report lays out the main macroeconomic themes that our strategists see driving markets next year. This Special Report explains how investors can profit from those themes in US fixed income markets. Specifically, we offer seven key US fixed income views for 2022. This report is limited to the seven key investment views, and only discusses Fed policy in the context of how it influences those views. Next week we will publish a more comprehensive “Fed In 2022” report that will delve into our outlook for the Fed next year. Outlook Summary First, a summary of the main economic views presented in BCA’s 2022 Outlook.1   On Economic Growth: The COVID-19 pandemic will recede in importance in 2022 allowing US economic growth to remain above trend. Sizeable household savings and wealth will support consumer spending, the composition of which will shift away from goods and towards services. Corporate capital expenditures also look set to surge. On Inflation: A transition in consumer spending from goods to services and an increase in labor supply will cause US inflation to fall in 2022, though it will remain above the Fed’s target. On Fed Policy: The first Fed rate hike will occur between June and December 2022, depending on the paths of inflation and inflation expectations during the next few months. Fed tightening will continue into 2023. On China and Emerging Markets: Further policy easing in H1 2022 will lead to a reacceleration in Chinese economic activity in the back half of the year. The BCA house view is negative on EM equities for now but will turn more bullish when clearer signs of Chinese policy easing emerge. Risks To The Outlook: The greatest risk to the outlook is that the spread of the Omicron variant leads to the re-imposition of public health measures that will weigh on economic activity. The effect of the Omicron variant remains uncertain, but increasingly widespread vaccination and the advent of anti-viral treatments should help mitigate any negative economic impacts. Key View #1: Below-Benchmark Portfolio Duration Bond investors should keep portfolio duration low in 2022, favoring the 2-year maturity over the 10-year. While the market’s pricing of the expected Fed liftoff date and initial pace of rate hikes is reasonable, terminal fed funds rate expectations are far too low. Our recommendation to keep portfolio duration low in 2022 stems directly from our assessment of Federal Reserve policy. Without going into too much detail – we will do that in next week’s “Fed In 2022” report – the Fed appears to have adopted a more hawkish reaction function during the past month. The Fed’s official forward guidance says that it will not lift rates until the labor market reaches “maximum employment”. However, Fed Chair Jay Powell weakened that commitment in recent Senate testimony. Powell said that persistently high inflation threatens the economic recovery and implied that to reach its maximum employment goal the Fed may need to act pre-emptively to tame inflation. To us, this means that the Fed’s “maximum employment” condition for lifting rates is no longer binding. The Fed will accelerate the pace of tapering when it meets this week and will start lifting rates between June and December of next year, depending on the interim trends in inflation and inflation expectations. After liftoff, Fed rate hikes will proceed at a predictable pace of 75-100 bps per year until economic growth slows significantly. We expect the fed funds rate to reach at least 2% before that occurs, consistent with survey estimates of the long-run neutral fed funds rate. Let’s compare our estimate of the future fed funds rate path with what is currently priced in the bond market (Chart 1). Chart 1The Market's Rate Expectations Liftoff The overnight index swap (OIS) curve is priced for Fed liftoff in May 2022. This is a tad early compared to our projections, but not by much. Pace After liftoff, the OIS curve is priced for the fed funds rate to rise 79 bps during the subsequent 12 months. Again, this is roughly consistent with our own expectations that the Fed will deliver three or four 25 basis point rate hikes per year. Terminal Rate It is the market’s pricing of the endpoint of the next tightening cycle – the terminal fed funds rate – that disagrees significantly with our forecast. The OIS curve is priced for the funds rate to reach 1.5% in 2024 and then stabilize. This is too low. It is too low compared to the last tightening cycle when the fed funds rate reached 2.45% in 2019. It is also too low compared to survey estimates from market participants and primary dealers. The median respondent to the New York Fed’s Survey of Market Participants estimates that the long-run neutral fed funds rate is 2%. The median response to the same question from the Survey of Primary Dealers is 2.25% and the median FOMC participant pegs the long-run neutral rate at 2.5%. Meanwhile, the 5-year/5-year forward Treasury yield – a rough proxy for the long-run neutral interest rate that’s priced in the Treasury market – sits at only 1.73%. Historically, the 5-year/5-year forward yield converges with survey estimates of the long-run neutral rate as the Fed moves toward tightening (Chart 2). This means the 5-year/5-year forward Treasury yield has at least 27-52 bps of upside in 2022. Chart 25y5y Has Room To Rise Treasury Yield Forecasts Chart 3Treasury Yield Forecasts Chart 3 shows the 2-year, 5-year and 10-year Treasury yields along with the expected paths that are discounted in the forward curve for the next 12 months. The shaded regions in each panel represent our fair value estimates of where those yields will trade if the market moves to price-in our expected future path for the fed funds rate. The upper bound of the fair value range represents the most hawkish fed funds rate scenario that we think is feasible. It assumes that Fed liftoff occurs in June, that rate hikes proceed at a pace of 100 bps per year and that the fed funds rate levels-off at a terminal rate of 2.08% (8 bps above the lower-end of a 2%-2.25% target range). The lower bound of the fair value range represents the most dovish fed funds rate scenario that we think is feasible. It assumes that Fed liftoff occurs in December 2022, that rate hikes proceed at a pace of 75 bps per year and that the fed funds rate levels-of at a terminal rate of 2.08%. Chart 3 shows that the 10-year Treasury yield is well below even the lower-end of our fair value range. The 5-year Treasury yield is a bit too low compared to our target range and the 2-year yield is consistent with our fair value range, though at the very upper-end. The investment conclusions are obvious. Bond investors should keep portfolio duration low in 2022. They should avoid the 10-year maturity and allocate most funds to shorter maturities like the 2-year. It should be noted that we used a conservative 2.08% terminal rate estimate in the scenarios presented in Chart 3. This is at the low-end of most survey estimates. What’s more, the BCA Outlook makes a strong case that those survey estimates will be revised higher once it becomes apparent that interest rates will have to rise to well above 2% to contain inflation. We agree that survey estimates of the long-run fed funds rate are probably too low, but we don’t expect them to be revised higher in 2022. Upward terminal rate revisions are probably a story for 2023 or 2024, sometime after the Fed has delivered a few rate hikes and it becomes apparent that more will be needed to slow an overheating economy. Appendix A at the end of this report translates different fed funds rate scenarios into 12-month expected returns for every Treasury maturity. We show scenarios where the liftoff date varies between June 2022 and December 2022, where the pace of rate hikes varies between 75 bps and 100 bps per year and where the terminal fed funds rate varies between 2.08% and 2.58%. The 10-year Treasury note is projected to deliver negative returns in every scenario we tested. Meanwhile, the 2-year Treasury note is projected to deliver a small positive return in every single scenario. These results support our conclusion from Chart 3. Investors should maintain below-benchmark portfolio duration and favor short maturities over long maturities. Risks To The View The first risk to our bearish view on US Treasuries is a resurgence of the pandemic. The 10-year Treasury yield continues to track the “pandemic trade” in the stock market. That is, the 10-year yield rises when a basket of equities that benefit from economic re-opening outperforms a basket of equities that benefit from lockdowns, and vice-versa (Chart 4). So far, the news about the virulence of the Omicron COVID variant has been encouraging, and our base case scenario assumes a further easing of pandemic concerns over the course of 2022. The second risk to our view is that the Fed moves too aggressively toward rate hikes causing an abrupt tightening of financial conditions that weighs on economic growth and sends long-dated bond yields lower. The shaded region in Chart 5 shows that this exact dynamic played out in 2018. Fed rate hikes started to pressure the dollar higher and weigh on equities. This led to tighter financial conditions and slower economic growth. The impact of tighter financial conditions was not immediately evident in the bond market, but slower growth eventually caused the Fed to back away from rate hikes leading to a late-2018 peak in the 10-year yield. Chart 410yr Tracks The "Pandemic Trade" Chart 5Watch Financial Conditions In 2022 Compared to the 2018 scenario, we see less risk of Fed over-tightening in 2022 mainly because the fed funds rate is starting out at a much lower level. However, it will be important to track financial conditions as the Fed moves toward liftoff. Undue tightening would cause us to reverse our positioning. Key View #2: Own Treasury Curve Steepeners The 2/10 Treasury slope will flatten by less than what is currently discounted in the forward curve in 2022. Investors should position for this by going long the 2-year note versus a duration-matched barbell consisting of cash and the 10-year note. We also recommend buying the 20-year bond versus a duration-matched barbell consisting of the 10-year note and 30-year bond as an attractive duration-neutral carry trade. The scenarios presented in the prior section show that the 2-year Treasury yield is priced within the bounds of our estimated fair value range while the 10-year Treasury yield looks too low. Logically, it makes sense to position for a steepening of the 2/10 Treasury curve to profit from this divergence. Chart 6 illustrates the implications of the prior section’s fair value estimates for different Treasury slopes. Our fair value range projects that the 2/10 Treasury slope will be between 38 bps and 89 bps in 12 months, above the 37 bps that is currently priced into the forward curve. The forward curve is also priced for too much flattening in the 2/5 Treasury slope, while the 5/10 slope is consistent with the lower end of our fair value range.   The conclusion is that investors should implement 2/10 Treasury curve steepeners in 2022 on the expectation that the 2/10 slope will flatten by less than what is currently discounted in the forward curve. A comparison of the 5-year/5-year forward Treasury yield with a target range based on survey estimates of the long-run neutral fed funds rate also supports the case for 2/10 steepeners. Historically, an increase in the 5-year/5-year forward yield towards its target range corresponds with a steepening of the 2/10 slope (Chart 7). Bear-flattening moves in the 2/10 slope only occur when the 5-year/5-year forward is within its target band, as was the case in 2017/18. Given that the 5-year/5-year forward yield is currently well below its survey-derived target range, there is room for some 2/10 steepening as yields rise. Chart 6Treasury Slope Forecasts Chart 7A Rising 5y5y Will Steepen The Curve One way to position for a steeper 2/10 curve is to go long the 5-year Treasury note versus a duration-matched barbell consisting of the 2-year and 10-year notes. Presently, this trade looks very attractive. The 2/5/10 butterfly spread shows a significant yield advantage in the 5-year bullet over the 2/10 barbell, both in absolute terms and relative to our fair value model (Chart 8). While we view this as a good trade, we don’t think it’s the best way to position for 2/10 steepening. We prefer a position long the 2-year note versus a duration-matched barbell consisting of cash and the 10-year note. This trade gives you long exposure at the 2-year maturity instead of the 5-year maturity which will boost returns if the 2/5 slope steepens, as we anticipate it will (Chart 6, panel 2). Chart 8Curve Steepeners Are Cheap In addition to our recommended 2/10 steepener, we advise clients to favor the 20-year bond versus a duration-matched barbell consisting of the 10-year note and 30-year bond. While we’d expect some flattening of the 10/30 slope in 2022, this trade should still perform well because of its huge carry advantage. The tables in Appendix A show that the 20-year bond earns a massive 12-month carry (income plus rolldown return) of 3.05% compared to 1.85% for the 10-year note and 1.80% for the 30-year bond. Key View #3: Sell Short-Maturity TIPS Chart 9TIPS Breakevens Investors should maintain a neutral allocation to long-maturity TIPS versus nominal Treasuries and an underweight allocation to short-maturity TIPS versus nominal Treasuries. Other attractive positions include: an outright short position in 2-year TIPS, an inflation curve steepener (short 2yr TIPS/long 2yr nominal/long 10yr TIPS/short 10yr nominal), and a TIPS curve flattener (short 2yr TIPS/long 10yr TIPS). As noted at the beginning of this report, we see inflation trending down in 2022. Inflation will remain high enough for the Fed to feel comfortable lifting rates, but it won’t match the elevated readings that are currently discounted in TIPS. Interestingly, long-maturity TIPS breakeven inflation rates are roughly consistent with the Fed’s 2.3%-2.5% target range (Chart 9). The 5-year/5-year forward TIPS breakeven inflation rate is a bit too low, at 2.13%, and the 10-year TIPS breakeven inflation rate is currently 2.47%. With long-dated TIPS breakevens so close to the Fed’s target, we recommend a neutral allocation to long-maturity TIPS versus long-maturity nominal Treasuries heading into 2022. In our view, the mispricing in TIPS lies at the front-end of the curve. The 2-year TIPS breakeven inflation rate has risen to 3.23%, well above the Fed’s 2.3%-2.5% target range. This year’s surge in short-maturity TIPS breakevens has also resulted in a deeply inverted inflation slope (Chart 9, bottom panel). Table 1Regression of Monthly Changes In CPI Swap Rate Versus Monthly Changes In 12-Month Headline CPI Inflation (2010 - Present) Short-maturity inflation expectations are highly sensitive to changes in CPI inflation, much more so than long-maturity expectations. In fact, monthly changes in the 2-year CPI swap rate are more than twice as sensitive to headline inflation than are monthly changes in the 10-year CPI swap rate (Table 1). This means that the cost of short-maturity inflation compensation will decline as inflation moderates in 2022. We recommend an underweight allocation to short-maturity TIPS versus short-maturity nominal Treasuries. We also think an outright short position in 2-year TIPS will be highly profitable in 2022. If we assume that the 2-year TIPS breakeven inflation rate falls to the middle of the Fed’s target range during the next 12 months, and additionally that the 2-year nominal Treasury yield converges with our fair value estimate using the scenario of a September Fed liftoff, 100 bps per year hike pace and 2.08% terminal rate, then we calculate that the 2-year TIPS yield will rise from its current -2.56% to -0.98% during the next 12 months (Chart 10). Chart 10A Lot Of Upside In Short-Maturity Real Yields Short 2-Year TIPS Chart 10 also shows that the anticipated rise in the 2-year TIPS yield greatly outpaces the modest expected increase in the 10-year TIPS yield. This means that a position in 2/10 TIPS curve flatteners will turn a profit in 2022 (Chart 10, bottom panel). Key View #4: Overweight Corporate Bonds Versus Treasuries … For Now We are overweight corporate bonds versus duration-matched Treasuries, for now, but expect to turn more defensive in the first half of 2022 once the yield curve sustainably moves into a flatter regime. Relative valuations suggest that investors should favor high-yield corporates over investment grade. A key pillar of our corporate bond investment process is to split the economic cycle into three phases based on the slope of the yield curve (Chart 11). Phase 1 of the cycle is defined as the period from the end of the last recession until the 3-year/10-year Treasury slope breaks below 50 bps. Phase 2 of the cycle spans the period when the slope is between 0 bps and 50 bps. Phase 3 lasts from when the yield curve inverts until the start of the next recession. Chart 11The Three Phases Of The Economic Cycle Our historical analysis shows that excess corporate bond returns versus duration-matched Treasuries tend to be strongest in Phase 1. They are usually positive, but much lower, in Phase 2 and are often negative in Phase 3 (Table 2). Table 2Corporate Bond Returns Across The Three Phases Of The Cycle We have been firmly in Phase 1 since April 2020 and, as we would expect, excess corporate bond returns have been strong. However, we will not remain in Phase 1 much longer. The 3-year/10-year Treasury slope is currently 50 bps, right on the precipice between Phase 1 and Phase 2. We recommend an overweight allocation to corporate bonds versus Treasuries for now, but we will adopt a more defensive posture toward corporates once we transition into Phase 2. We expect this will happen sometime in the first half of 2022. Why Are We Not In Phase 2 Already? Chart 12Curve Flattening Is Overdone The 3-year/10-year Treasury slope is hovering right around 50 bps. However, as is noted earlier in this report, we think that recent yield curve flattening is overdone and expect it to reverse somewhat in the coming months. Chart 12 shows the 3-year/10-year slope along with an expected fair value range. This range is based on a 100 bps Fed rate hike pace, a 2.08% terminal rate and varying the liftoff date between June 2022 and December 2022. This fair value range only breaks below 50 bps between March and September of next year. Given our yield curve view, we are positioned for one last period of strong corporate bond outperformance during the next few months. But we will turn more defensive once we judge that we have sustainably transitioned into a Phase 2 environment. Why Turn More Defensive In Phase 2? Chart 13IG Corporate Valuations It’s correct to point out that excess corporate bond returns are still generally positive in Phase 2 environments, so ideally, we would remain overweight corporate bonds versus Treasuries throughout Phase 2. This makes sense theoretically, but strategically we think it will be wise to adopt a different approach this cycle. The main reason to err on the side of caution is that corporate bond valuations are extremely stretched. The 12-month breakeven spread for the investment grade corporate bond index is at its 6th percentile since 1995. This means that the investment grade corporate bond index has only been more expensive than today 6% of the time since 1995 (Chart 13). Tight spreads mean that expected returns will be modest, even in a favorable cyclical environment. In other words, we are not sacrificing much expected return by reducing exposure early in the cycle. Given that we can’t predict the start of the next Phase 3 period with exact precision, we think it makes sense to be more defensive this cycle. We will sacrifice some modest expected returns to ensure that we are well positioned for the next period of significant spread widening. Our corporate bond strategy is supported by an empirical study of historical returns. Table 3A shows average 12-month excess returns for the investment grade corporate bond index after certain combinations of the 3/10 Treasury slope and average index option-adjusted spread (OAS) are observed. Table 3B shows 90% confidence intervals for the averages presented in Table 3A. The tables show that a strategy of remaining overweight corporate bonds versus Treasuries after the yield curve transitions into Phase 2 only works when the corporate index OAS is above 100 bps. A transition into Phase 2 portends negative excess corporate bond returns when the OAS is below 100 bps, as it is today. Favor High-Yield Over Investment Grade Chart 14HY Corporate Valuations While investment grade corporate bonds look extremely expensive compared to history, high-yield corporate bonds look somewhat expensive, but much less so. The average High-Yield index OAS is 1 bp below its pre-COVID low, but investors still get a nice spread pickup for moving out of the Baa-rated credit tier and into the Ba-rated tier (Chart 14). Our prior research has shown that high-yield corporates tend to outperform duration-matched Treasuries when the excess index spread after accounting for default losses is above 100 bps.2 If we assume a minimum required excess spread of 100 bps and a 40% recovery rate on defaulted debt, we can calculate that the junk index is priced for a default rate of 3.4% during the next 12 months (Chart 14, bottom panel). All available evidence suggests that the default rate will come in below 3.4% during the next 12 months, leading to positive excess returns for high-yield corporate bonds. The default rate came in at 1.8% for the 12-month period ending in November and it has been dropping like a stone, consistent with the reading from our Default Rate Model (Chart 15). We also recently wrote about the exceptionally good health of corporate balance sheets.3 We expect the default rate will be in the mid-2% range in 2022, below what is priced into the junk index. Chart 15Corporate Defaults Will Stay Low In 2022 Junk’s valuation advantage leads us to recommend that investors maintain a preference for high-yield corporates over investment grade. We will turn more defensive on both investment grade and high-yield corporates once we transition into a Phase 2 environment, but we may still retain our preference for high-yield over investment grade at that time, as long as junk stays relatively cheap. Key View #5: Overweight Emerging Market Bonds Versus US Corporates Investment grade USD-denominated Emerging Market bonds (both sovereigns and corporates) will outperform US corporate bonds with the same credit rating and duration in 2022. EM bonds offer an attractive spread advantage versus US corporates, and 2022 returns will be boosted by a weakening US dollar. We see an opportunity in Emerging Market (EM) bonds for US investors in 2022. Note that we are only referring to investment grade EM bonds denominated in US dollars. We consider both investment grade USD-denominated EM sovereign bonds and investment grade USD-denominated EM corporate & quasi-sovereign bonds. EM Sovereigns Chart 16EM Sovereigns EM sovereigns have modestly outperformed Treasuries so far this year (see Appendix B for a complete breakdown of year-to-date performance for different corporate bond sectors), and yet the sector remains attractively valued in the sense that the average index OAS has still not recovered its pre-COVID low (Chart 16). A look at recent performance trends shows that EM sovereigns outperformed credit rating and duration-matched US corporates in H2 2020 when the sector benefited from a huge yield advantage and a rapidly depreciating US dollar.4 This year, EM sovereigns lagged US corporates as the dollar strengthened. Looking ahead to 2022, we think that the recent bout of dollar strength is close to its end as the bond market has already moved to price-in an extremely hawkish Fed outlook at the front-end of the curve. A flat or depreciating dollar will benefit EM bonds in 2022, as will the yield advantage in EM sovereigns versus credit rating and duration-matched US corporates (Chart 16, panel 4). This yield advantage will only look more attractive as the Treasury curve flattens and the outlook for US corporate spreads deteriorates. At the country level, we see the best EM sovereign opportunities in Mexico, Russia, Chile, UAE, Qatar and Saudi Arabia. The bonds of all these countries outperformed credit rating and duration-matched US corporate bonds during the past 12 months, and they continue to offer a sizeable spread advantage (Chart 17). EM Corporates & Quasi-Sovereigns The investment grade USD-denominated EM Corporate & Quasi-Sovereign index shows a similar relative return pattern to the EM Sovereign index, though overall performance has been better (Chart 18). We see that the index outperformed credit rating and duration-matched US corporates dramatically in H2 2020 when the dollar was under pressure. Relative returns have been more stable this year as the dollar has strengthened. Chart 18EM Corporates & Quasi-Sovereigns EM corporates & quasi-sovereigns should continue to outperform credit rating and duration-matched US corporates in 2022. A weaker dollar will certainly help, but the main driver of outperformance will be the very attractive yield advantage (Chart 18, panel 4). Key View #6: A Maximum Overweight Allocation To Municipal Bonds Municipal bonds offer exceptional value, especially at the long-end of the curve, and state & local government balance sheets are in excellent shape. US bond investors should favor tax-exempt municipal bonds relative to both Treasuries and equivalently-rated corporate bonds. Long-maturity tax-exempt municipal bonds continue to be one the most attractively priced assets in the US fixed income space. As we discussed in a recent report, one big reason for the attractive valuation is that municipal bonds tend to pay premium coupon rates.5 This significantly reduces the duration risk in long-dated munis. The first two columns of Table 4 show the yield ratios and breakeven tax rates between different municipal bond sectors and duration-matched Treasury securities. We see that the breakeven tax rate – the tax rate that equalizes after-tax yields between the two sectors – is a mere 11% for 12-17 year general obligation munis. The breakeven tax rate between 12-17 year revenue munis and duration-matched Treasuries is only 3%, and the longest-maturity munis actually offer a before-tax yield advantage versus Treasuries! Table 4Muni/Treasury And Muni/Credit Yield Ratios Table 4 shows that munis also offer excellent value compared to corporate bonds with the same credit rating and duration, especially at the long-end of the curve. Breakeven tax rates between munis and corporate credit range from 3% to 21% for maturities longer than 12 years. What’s even more impressive about municipal bonds is that their attractive valuations are buttressed by extremely high credit quality. State & local government balance sheets have received a huge boost from federal stimulus during the past two years, and this has sent net state & local government savings (revenues minus expenditures) surging into positive territory (Chart 19). But it’s not just federal stimulus that has aided state & local governments. Even if we exclude transfer payments altogether, we find that the difference between tax receipts and consumption expenditures is rising sharply relative to interest expense (Chart 19, panel 2). Ratings agencies have noticed the improvement in state & local government budgets and ratings upgrades have far outpaced downgrades during the past year (Chart 19, bottom panel). Chart 19State & Local Balance Sheets In Good Shape Key View #7: Underweight Agency MBS Chart 20Poor MBS Performance Will Continue Agency Mortgage-Backed Securities don’t adequately compensate investors for the likely pace of refi activity in 2021. An up-in-coupon stance is also advisable to take advantage of rising bond yields. We noted in a recent report that Agency Mortgage-Backed Securities have performed poorly in 2021.6 The main reason for the poor performance is that the compensation for prepayment risk embedded in MBS spreads (aka option cost) started the year at a very low level, but mortgage refinancing activity has been much higher than expected (Chart 20). The conventional 30-year MBS option cost has been rising, but it is still only back to where it was in 2019 (Chart 20, panel 2). This is not sufficiently attractive for us to advocate buying MBS. While rising bond yields will be a tailwind for refi activity in 2022, we still expect the pace of refinancings to be relatively strong because the rapid run-up in home prices has made it extremely enticing for households to tap the equity in their homes through cash-out refis. Within a recommended underweight allocation to MBS, we recommend that investors favor higher coupon securities over lower coupon ones. Higher-coupon MBS carry less duration than lower-coupon MBS and also wider OAS and greater convexity. This means that high-coupon MBS will outperform low-coupon MBS if bond yields rise in 2022, as we expect they will. Appendix A: Treasury Return Forecasts   Appendix B: US Bond Sector Year-To-Date Performance Ryan Swift US Bond Strategist rswift@bcaresearch.com Footnotes 1 Please see The Bank Credit Analyst, “Outlook 2022: Peak Inflation – Or Just Getting Started?”, dated December 1, 2021. 2 Please see US Bond Strategy Weekly Report, “No Holding Back”, dated June 16, 2020. 3 Please see US Bond Strategy Weekly Report, “The Fed’s Inflation Problem”, dated November 23, 2021. 4 A weaker dollar tends to benefit USD-denominated EM bonds because it makes it easier for foreign issuers to service their dollar denominated debts. 5 Please see US Bond Strategy Weekly Report, “The Best & Worst Spots On The Yield Curve”, dated October 26, 2021. 6 Please see US Bond Strategy Weekly Report, “The Omicron Impact”, dated November 30, 2021. Recommended Portfolio Specification Other Recommendations Treasury Index Returns Spread Product Returns

Special Report

Highlights Why have Value stocks underperformed so much during the past decade? The rise in intangible assets is likely the most important reason since traditional valuation metrics are no longer an accurate measure of intrinsic value. Value stocks today have a larger negative tilt to Quality than they did in the past. This has hurt Value due to Quality's outperformance. Value's underperformance is not just the result of the relative performance of a few sectors or industries, although this has played a role. Falling interest rates have not been the main driver of Value’s underperformance as they can only account for a small portion of returns. “Migration”, or mean-reversion in and out of value buckets, has declined since the Great Financial Crisis, possibly because of an increase in monopoly power. But even this cannot fully account for the underperformance since 2012. We propose that investors who wish to invest in Value screen for Quality. They should also express their Value tilts in sectors with few intangibles, such as Energy or Materials. More sophisticated stock pickers can adjust earnings and book values for intangibles. Asset allocators who invest only in indices should stay away from a structural allocation to Value. Feature Chart 1No Premium From Value Stocks Over The Last Four Decades Betting on cheap stocks has been a cornerstone of equity investing for decades. The rationale is simple: Stocks which are undervalued, according to some measure of intrinsic value, will eventually converge up to their fair value, on average, while stocks that are overvalued will converge down, on average. Historically, this bet on mean-reversion has proven successful – low price-to-book stocks have outperformed high price-to-book stocks by more than 3% per annum since 1927. However, the recent decades have put Value investing to the test. The Value factor, as defined by Fama and French, has not provided a structural premium in the US large cap space since the late 1970s (Chart 1, panel 1). Commercial Value indices haven’t been any more successful: Value aggregates by MSCI, Russell, and S&P have either underperformed or performed in line with the market benchmark over the same time frame (Chart 1, panel 2). The current situation presents a difficult dilemma. On the one hand, buying Value could be a tremendous opportunity. By several measures, Value stocks are the most undervalued they have been since the end of the tech bubble, right before they went on a historic run (Chart 2). Academic work has argued that these deep value spreads tend to be positively correlated with long-term outperformance of Value stocks.1 In a world of sky-high valuations and with equities and bonds projected to deliver very low returns over the next decade, a cheap return stream would be a fantastic addition to most portfolios. Chart 2Value Stocks Are Really Cheap   And yet, Value has become so popular, that many investors are now worried that the Value premium may no longer exist. This worry is not without merit. Several studies have shown that factors lose a sizable portion of their premium once they appear in academic literature2  (Chart 3). Other issues, such as the inability of valuation metrics to properly account for intrinsic value in the modern economy, have also led some investors to seriously question whether buying Value indices will deliver excess returns in the future. So what is the right answer? Why has Value underperformed so much? Is the beaten down Value factor a generational buying opportunity? Or will it continue its decline going forward? In this report we try to answer these questions. Using a company-level dataset from our BCA Research Equity Analyzer (EA), as well as drawing on the latest academic research, we assess the evidence behind Five Theories On Value’s Underperformance. Once we determine which explanations have merit and which do not, we conclude by providing some guidelines on how investors should consider the Value factor going forward in our Investment Implications section. A word of caution: We have constructed our sample of companies to roughly resemble the sample used by MSCI World. Thus, the conclusions from our analysis based on the EA dataset should be relevant to Value indices in general. However, be advised that the methodology that EA uses is different from other commercial Value indices. Specifically, the EA methodology is more aggressive in its positioning and uses a wider array of metrics. For clarity, Table 1 shows the metrics used by EA compared to other Value indices. If you wish to know more on how the methodology works, please refer to the Appendix. Table 1Value Factor Methodologies Also, please note that our report will not deal with the cyclical outlook for Value. While it is entirely possible that a period of cyclical growth could help Value stocks outperform, the question we are trying to answer is whether buying cheap versus expensive stocks still provides a structural premium over the long term. While the Global Asset Allocation service does not use the Value versus Growth framework for equity allocation, our colleagues from our Global Investment Strategy service have written extensively on why they believe investors should pivot to Value on a cyclical basis.3 Five Theories On Value’s Underperformance Chart 4More To The Underperformance Of Value Than Sector Tilts Theory #1: The underperformance of Value indices is purely a result of their sector composition Some investors suggest that Value stocks’ large underweight of mega-cap tech, as well as their overweight in Financials and Energy, have been responsible for Value’s woes over the past decade. However, our research suggests that this theory is not entirely correct. A Value index with the same sector and industry weightings as the Developed Markets (DM) benchmark has still underperformed by more than 15% since 2010 (Chart 4, panel 1). Sector and industry composition have been responsible for about a third of the underperformance of the DM Value index. What about excluding the FAANGM stocks? Again, the story is similar. Even when omitting these stocks from our investment universe, Value stocks have still underperformed by almost the same amount as a regular Value composite (Chart 4, panel 2). Finally, we can also look at the performance of cheap versus expensive stocks within each industry. Chart 5A shows that cheap stocks have underperformed expensive stocks in 18 and 17 out the 24 GICS Level 2 industries in DM and in the US, respectively, since 2012 (roughly corresponding to the peak in relative performance in the EA Value index). Even on an equally-weighted basis, which eliminates the effects of large companies, cheap stocks have underperformed expensive stocks in both the average and median industry (Chart 5B). Verdict: Myth. The underperformance of cheap versus expensive stocks has been broad. While sector and industry dynamics have certainly been an important factor, Value's underperformance is not just the result of a few companies, sectors, or industries. Chart 6Value Likes Rising Yields... Theory #2: The decline in interest rates is to blame for the underperformance of Value Another reason used to explain the underperformance of Value is the secular decline in interest rates. The reasoning goes as follows: Cash flows from growth stocks are set to be received further into the future, while cash flows from Value stocks are closer to the present. Using a Discounted Cash Flow model, one can show that all else being equal, a decline in the discount rate should result in a relatively higher increase in the present value for Growth stocks versus Value stocks. There is some evidence in support of this theory. While prior to 2010, Value and interest rates had an inconsistent relationship, the beta of cheap stocks to the monthly change in the 10-year US Treasury yield has increased markedly over the past 10 years (Chart 6, panel 1). On the other hand, the beta of expensive stocks to yields has become increasingly more negative. A similar situation occurs when we use the yield curve. Cheap stocks tend to exhibit higher excess returns whenever it steepens, while expensive stocks do so when it flattens (Chart 6, panel 2). Importantly, these relationships are not purely a result of Value’s exposure to banks. Value stocks excluding financials also show a strong positive relationship to both the 10-year yield and yield curve slope versus their growth counterparts (Chart 7). But while this relationship is statistically significant, it fails to be economically significant. Our analysis shows that the betas to either interest rates or the slope of the yield curve only explain a small fraction of the performance of cheap or expensive stocks (Chart 8). This result is in line with the research from Maloney and Moskowitz, which showed that the vast majority of the decline in Value in recent years could not be explained by interest rates.4 Chart 7...Even When Excluding Financials... Chart 8...But Yields Don't Explain Much   Verdict: Myth. Cheap stocks have an increasingly positive beta to both the 10-year yield and the slope of the yield curve, whereas expensive stocks have an increasingly negative beta. However, while these betas are statistically significant, they can only account for a small portion of Value's underperformance. Theory #3: A decline in market mean-reversion is responsible for the underperformance of Value In a seminal paper, Fama and French describe the process of migration.5 Migration is when stocks move across different value buckets: For example, when stocks in the cheap bucket migrate to the neutral and expensive buckets, and when stocks in the expensive bucket migrate to the neutral or cheap buckets. Historically, this process of mean-reversion has provided a significant share of the Value premium. However, migration has declined significantly over the past decade (Chart 9, panel 1). The amount of market cap migrating each month as a percentage of total market cap has declined from over 12% before the GFC to less than 8% currently. Importantly, this decline in migration has been broad-based. Neither cheap, neutral, nor expensive stocks are moving to other valuation cohorts at the same rates that prevailed in the past (Chart 9, panel 2). The market has become much more ossified: Value stocks remain Value stocks, Neutral stocks remain Neutral stocks, and Growth stocks remain Growth stocks.5 Chart 9What Happens In Value Now Stays In Value Chart 10Market Concentration Could Be The Reason Why Migration Has Declined Why has migration declined? One theory is that industries have increasingly become more monopolistic, which means that it has become harder for new entrants to gain market share (Chart 10). Meanwhile market leaders are able to grow at an above-average pace thanks to their large network effects.6 What has been the role of this decreased migration in the performance of Value? A paper written by Arnott, Harvey, Kalesnik, and Linainmaa showed that while the returns attributable to migration have decreased over the past 15 years, this change is still not strong enough to explain the deep underperformance in Value.7 Our own research assigns it a relatively larger weight, with migration accounting for a little less than half of the underperformance of Value since 20128 (Table 2). Table 2Return Attribution Of Cheap And Expensive Stocks Verdict: Somewhat True. Migration has declined since the GFC, possibly because of an increase in monopoly power. While this decline has certainly played a role in the underperformance of Value, it explains, at most, less than half of the drawdown since 2012. Theory #4: Value has underperformed because it is increasingly a play on junk stocks It is a well-known empirical fact that cheap stocks tend to have lower Quality than expensive stocks. Conceptually this makes sense: Companies with higher profitability, more stability, and less leverage should trade at a valuation premium, whereas low income, high-debt companies should trade at a discount. However, this gap in Quality between cheap and expensive stocks is not always the same. Consider the composition of cheap and expensive stocks in 2000 – the eve of the tech bubble crash. About a third of expensive stocks were also junk (low quality), whereas 36% were quality stocks (Chart 11). Today, this composition is much different: Only about a fifth of the market capitalization of expensive stocks is junk, whereas quality stocks now make up 44% of the overall expensive cohort. On the other hand, the Quality of cheap stocks has deteriorated: Cheap junk stocks are now 37% of the cheap cohort versus 29% in 2000. Importantly, the difference in Quality between cheap and expensive stocks tends to be a good predictor for value returns (Chart 12). A big gap in the Quality factor often implies lower returns of cheap versus expensive stocks, whereas a small gap implies higher returns. These results are in line with similar research which has shown that Quality, or Quality proxies like profitability, can be used to enhance the Value factor.9 Chart 12Value Does Well When The Quality Gap Is Small Why is this the case? As we have discussed in the past, Quality has been one of the best performing factors over the past 30 years - likely driven by powerful behavioral biases as well as by the incentives in the money management industry.10 As a result, taking an overly negative position on this factor over a long enough period eventually eats away at the Value premium. Verdict: True. Value stocks today have a larger negative tilt to Quality than they did in the past. This negative tilt has hurt Value as excess returns of cheap stocks tend to be dependent on their Quality gap to expensive stocks. Theory #5: Value has underperformed because traditional valuation metrics are no longer a reliable indicator of intrinsic value How exactly to measure whether a company is cheap or expensive has been a matter of debate since the very beginnings of Value investing. Benjamin Graham famously cautioned against using book value as a measure of intrinsic value, preferring a more holistic approach. Today most index providers use a combination of traditional valuation metrics like price-to-book and price-to-earnings to build Value indices. It is fair to ask if these measures are still relevant for today’s companies. Intangible investment has become a much larger part of the economy, having surpassed tangible investment in the US in the late 1990s (Chart 13). However, both US GAAP and IFRS are very restrictive on the capitalization of R&D activities, which are known to originate valuable intangible assets.11 Other types of intangible capital such as unique production processes or customer lists are normally also expensed within SG&A expenses and are never capitalized unless there is an acquisition. This means that both the book value and earnings of intangible-heavy companies could be inadequate estimates of their true intrinsic value. Is there any evidence that this is the case? Using our EA dataset, we confirm that expensive companies generally have higher R&D expenditures as a percent of sales than cheap companies (Chart 14). Importantly, we see that the performance of Value within low R&D stocks is much better than the performance within high R&D stocks (Chart 15). This is line with the work of Dugar and Pozharny, who found that the value relevance for both earnings and book values has declined for high intangible companies, while it has stayed stable for low-intangible companies.12 This suggests that traditional valuation measures are losing their relevance as intangible-heavy companies become a larger part of the economy.13 Chart 14Growth Stocks Spend More On Intangibles Chart 15Are Traditional Metrics Underestimating Intrinsic Value In High-Intangible Companies? The effect of intangibles on traditional valuation metrics can also give us a clue as to why Value has performed well in some industries but not in others. Using a measure of intangible intensity derived by Dugar and Pozharny14 – which includes identifiable intangible assets, intellectual capital (as proxied by R&D spending), and organizational capital (as proxied by SG&A spending) – we can see that Value has done relatively better in industries with lower intangible intensity while it has performed relatively worse in industries with higher intangible intensity (Chart 16). Verdict: True. Value performs better when considering only companies with low R&D expenses or industries with low-intangible intensity. This suggests that the rise in intangible assets might be responsible for the underperformance of cheap stocks, as traditional valuation metrics may no longer be an accurate measure of intrinsic value in intangible-heavy companies or industries. Investment Implications Chart 17Investors Can Invest In Value Within Low-Intangible Sectors What does our analysis mean for investors? Aside from the most well-known practices to improve the performance of Value – for example, using a wide array of valuation metrics, exploiting value in small stocks, or using equal-weighted indices to avoid the effect of sector weightings or large companies15 – we would recommend investors first screen cheap stocks for quality to avoid Value traps. Investors should also account for the failure of traditional metrics to measure intangible assets. This can be done in two ways: The first is to take Value tilts only on intangible-light sectors such as Energy and Materials – for example, allocating only to the cheapest oil and materials stocks. For the last decade, the cheapest Energy and Materials companies have outperformed their respective sectors, even while overall Value has cratered (Chart 17). Alternatively, more sophisticated stock pickers can adjust valuation ratios to account for intangibles. There is some promise to this approach. Arnott, Harvey, Kalesnik, and Linainmaa showed that even a crude adjustment to the HML (High-Minus-Low) index consistently outperforms the regular value factor16 (Chart 18). What about asset allocators who invest only in broad indices? We would recommend that they stay away from structural allocations to commercial Value indices altogether. While it is true that sector rotations or interest-rate movements could benefit value on a short-term basis, in the long term, the negative Quality tilt of Value stocks should be a drag on returns. Additionally, it remains a big risk that indices based on traditional measures are underestimating intangible value. This underestimation will only get worse as the economy becomes more digitalized. Investors who wish to take advantage of trends like higher inflation or rising interest rates should just bet on cyclical sectors. So far this has been the right approach. Just this year, even though interest rates have increased by more than 60 basis points, and both Financials and Energy have outperformed IT by 13% and 30% respectively, Value stocks have underperformed Growth stocks (Chart 19). Chart 18Adjusting For Intangibles Improves Value Chart 19Rates Rose, Financials And Energy Outperformed IT, And Yet Value Underperformed Growth Appendix A Note On Methodology The Equity Analyzer service is a stock picking tool that applies a top-down approach to bottom-up stock picking. The crux of the platform is the BCA Score, which is a weighted composite of 30 cross sectionally percentile ranked factors. Within this report we focus on the value (price-to-earnings, price-to-book, price-to-cash, price-to-cash flow and price-to-sales) and quality (accruals, profitability, asset growth, and return on equity) factors used in the BCA Score model. Each of the factors are cross sectionally-percentile ranked, within the specified universe, where a score of 100% is best ranked stock according to that particular score. From here, we create the value and quality scores used in this report by equal-weighting and combining the scores from each value and quality factors. It is important to note that a high score does not mean the underlying value is high, but that it exhibits a better characteristic for forecasting future excess returns. For example, the stock with the highest value score would be considered the cheapest. The scores are re-calculated each period and applied on a one-period forward basis when calculating returns. To keep the analysis comparable the MSCI Data and relevant to our clients, we limit the universe of stocks to only those with a market capitalization greater than 1 billion USD. Also, unless otherwise specified, the scores are market-cap weighted when aggregated and all returns are in US dollars.   Juan Correa-Ossa, CFA Editor/Strategist juanc@bcaresearch.com Lucas Laskey Senior Quantitative Analyst lucasl@bcaresearch.com Footnotes 1  Please see Clifford Asness, John M. Liew, Lasse Heje Pedersen, and Ashwin K Thapar, “Deep Value,” The Journal of Portfolio Management, 47-64 (11-40), 2021.2   2  Please see Andrew Y. Chen and Mihail Velikov, “Zeroing in on the Expected Returns of Anomalies,” Finance and Economic Discussion Series 2020-039, Board of Governors of the Federal Reserve. 3 Please see Global Investment Strategy Report, “Pivot To Value,” dated September 18, 2020. 4 Please see Thomas Maloney and Tobias J. Moskowitz, “Value and Interest Rates: Are Rates to Blame for Value’s Torments?” The Journal of Portfolio Management, 47-6 (65-87), 2021. 5 Please see Eugene Fama and Kenneth French, “Migration,” Financial Analyst Journal, 63-3 (48-58), 2007. 6 Please see Robert D. Arnott, Campbell R. Harvey, Vitali Kalesnik and Juhani T. Linainmaa, “Reports of Value’s death May Be Greatly Exaggerated,” Financial Analyst Journal, 77-1 (44-67), 2021. 7  Please see Robert D. Arnott, Campbell R. Harvey, Vitali Kalesnik and Juhani T. Linainmaa (2021). 8  Much like us, Lev and Srivastava assign a relatively bigger role to the decline in migration. For more details, please see Baruch Lev and Anup Srivastava, “Explaining the Recent Failure of Value Investing,” NYU Stern School of Business (2019). 9  Please see Clifford Asness, Andrea Frazzini, Ronen Israel and Tobias Moskowitz, “Fact, Fiction, and Value Investing,” The Journal of Portfolio Management, 42-1 (34-52), 2015. 10 Please see Global Asset Allocation Special Report, “Junk Disposal: The Quality Factor In Equity Markets,” dated September 8, 2020. 11 US GAAP requires both Research and Development costs to be expensed. IFRS prohibits capitalization of Research cost but allows it for Development costs provided that some conditions are met. For a further discussion on the accounting treatment of intangibles, please see Amitabh Dugar and Jacob Pozharny, “Equity Investing in the Age of Intangibles,” Financial Analyst Journal, 77-2 (21-42), 2021. 12 Please see Amitabh Dugar and Jacob Pozharny (2021). 13This also follows from research from Lev and Srivastava which showed that while capitalizing intangibles did not improve the value factor in the 1970s, it increased returns substantially after the 1990s. For more details, please see Baruch Lev and Anup Srivastava (2019). 14This measure excludes Banks, Diversified Financials, and Insurance. For more details, please see Amitabh Dugar and Jacob Pozharny (2021). 15Please see Clifford Asness, Andrea Frazzini, Ronen Israel and Tobias Moskowitz (2015). 16Please see Robert D. Arnott, Campbell R. Harvey, Vitali Kalesnik and Juhani T. Linainmaa (2021).  

Bank Credit Analyst

Having worked as an economist for close to 50 years, the current strange and uncertain environment seems a good time to look back and consider some of the lessons I have learned. An additional reason for writing this rather personal report is that, after 34 exciting and interesting years, I will retire from BCA at the end of this month. Over the ages, there has been an insatiable demand for predictions – seeking those who are believed to have a window into the future, whether it be the Oracle of Delphi or the proverbial guru on the mountaintop. Surely, someone somewhere must know what is going to happen? Unfortunately, my almost half century in the forecasting business has highlighted that the future is essentially unknowable, and I have not come across anyone with a consistently good track record. Fortunately, all is not lost because forecasting errors can be minimized by following some basic rules and practices. Dealing With Shocks Chart 1My First Forecasting Shock My career as an economist began in January 1973 when I joined the Forecasting Division within the Corporate Planning Department of British Petroleum in London. At the time, this seemed a strange move to friends who had entered the booming financial sector. The oil industry was regarded as incredibly dull with the crude price averaging $2.50 a barrel during the previous five years and no expectations of a major change in the foreseeable future (Chart 1). Of course, industry experts did not foresee the October 1973 war in the Middle East and OPEC’s resulting embargo of oil deliveries to the US. The crude price spiked above $15 a barrel in early 1974 and remained in double digits even after the embargo ended. This was my first lesson in the power of unforeseen shocks to destroy the basis of current forecasts and force a complete rethink of the outlook. A problem in dealing with major shocks is that some are transitory (e.g. natural disasters such as Japan’s devastating Fukushima earthquake) and some reflect a structural shift in the outlook. The oil shock was clearly in the latter category. OPEC suddenly became aware of its power to influence the market and from that time on, it took a more aggressive role in setting prices. At BP, long-run planning could not assume a return to pre-1974 prices and that was a game changer. In practice, most shocks are transitory, even if it is not evident at the time. And I believe that is true of the Covid-19 pandemic. Even if the virus cannot be eradicated, treatments will improve and we will learn to live with it, just as we live with the common cold and seasonal flu. There may be a lasting impact on some areas such as increased working from home, but I am skeptical that there will be any major change to the underlying drivers of economic growth. At most, it may encourage some trends that are already underway. However, the extreme policy response to the crisis will have some important effects and I will return to that later. Catching Structural Shifts Many economists spend much of their time making detailed economic forecasts for the coming one and two years. That may have great value in helping firms plan production schedules but is of limited value in helping investors time the market. As I have noted in previous reports, economists have done a poor job of forecasting recessions, which is the most important thing to get right from a planning point of view. Table 1 shows the recession forecasting record of the Federal Reserve, an institution that has tremendous economic brainpower and resources at its disposal. The Fed staff failed to predict any of the recessions in the past 50 years and other official and private sector forecasters were no better. Table 1Fed Economic Forecasts vs. Outcomes BCA has wisely eschewed short-term economic forecasts. You would never read in a BCA publication a statement such as “we have revised next year’s GDP growth from 3.2% to 2.7%”. That does not mean we don’t care about the short-run economic outlook: we believe it is necessary to have a view about whether the consensus on economic trends is likely to be disappointed - either on the upside or downside. However, it is more important to focus on catching the long-term structural shifts in economic trends. Looking back over the past 50 years, the most important economic development for investors to get right was the rising inflation of the 1970s and its subsequent multi-decade decline. Any investors smart enough to be on the right side of the long-run inflation cycle would have avoided stocks and bonds and embraced commodities in the 1970s and done the reverse thereafter. While BCA’s track record was not perfect, it generally was on the right side of these trends. Another long-run trend that investors needed to identify was the surge in global trade and interdependence, beginning in the 1990s as former-communist countries and China embraced more market-friendly policies. This not only reinforced global disinflation but also shifted economic power from labor to capital, driving profit margins to record levels. Chart 2The Retreat From Globalization Turning to the current environment, another structural shift is underway. Several years ago, we noted that the tide was turning against globalization. This showed up in a decline in cross-border capital flows, political and popular antipathy to large-scale immigration, and a flattening in the ratio of global trade to production (Chart 2). Recent developments have exacerbated these trends. Notably, the Covid-related disruptions to supply chains has forced a rethink about the wisdom of relying so heavily on foreign production facilities. The shift away from globalization is likely to persist for some time. This will support the case for a structural increase in inflation, a development underpinned by other forces. For example, the pendulum is swinging away from capital back to labor, central banks are setting themselves up to stay too easy for too long and crushing public sector debt burdens will make policymakers more willing to tolerate inflation overshoots. A structural increase in inflation (albeit nowhere near 1970’s levels) means that investors should expect a further decline in profit margins, higher interest rates and gains in inflation hedges. This will be a gradual shift with price pressures likely to moderate in the coming year as supply chain disruptions ease. Ignore Monetary Policy At Your Peril The level of interest rates is the single most important driver of asset prices which means that investors must pay close attention to central bank policy. During my career I have had a lot of contact with central bankers, not least because I was fortunate enough to attend the Federal Reserve’s Jackson Hole symposium for 18 years. Central bankers tend to be treated with great professional reverence. Every statement is examined for nuances about their views and there seems to be an implicit assumption that superior access to information and market intelligence gives them an edge when it comes to understanding economic trends and developments. Sadly, this is not the case. My many discussions with senior policymakers have made it abundantly clear that regarding the big questions about the outlook, they are no better placed than the rest of us. For example, like forecasters in general, they are struggling to know whether the recent rise in inflation is temporary, when supply chain disruptions will end and what will happen to resource prices. This is rather disconcerting as it would be desirable if those twiddling the policy dials were more informed than us outside observers. Chart 3Low Rates Underpin the Bull Market Regardless of whether policymakers fully understand the long-run implications of their policies, the actions of central bankers have major market effects. One might reasonably have thought that the adverse economic impact of the pandemic would seriously damage the stock market, but the hit was short-lived with the MSCI All-Country Index currently 27% above its end-2019 level and close to its all-time high. This can be attributed to the fact that short-term interest rates in the major developed economies have been kept close to zero for more than a year (Chart 3). In 1852, the eminent financial journalist Walter Bagehot famously quipped that “John Bull can stand many things, but he can’t stand 2%”. In other words, a world of low interest rates is anathema to investors, forcing them to take greater risks in order to secure higher returns. What was true then remains true today. Low rates have driven investors into stocks as an explicit objective of central bank policy. Chart 4Inflation Undershoots For Two Decades In the 1960s and 1970s, central bankers erred by keeping policy too easy for too long. Their formative years as policymakers were in the earlier decades when deflation was seen as a much bigger threat than inflation. This dulled their perception about the inflation risks of their policies. In contrast, the policymakers in charge during the 1980s to 2000s were fiercely anti-inflationary as they had experienced the inflationary consequences of their predecessors. Now the pendulum has swung back again because inflation has underperformed central bank expectations for the past 20 years, a period that also saw some severe deflationary shocks (Chart 4). In other words, the scene is setting up again for policy errors on the side of too much monetary stimulus and higher inflation. The high inflation of the 1970s was grim for financial assets with both equities and bonds delivering negative real returns. Bond investors underestimated the persistence and level of inflation which means they accepted ex-ante negative real yields. On the equity side, higher inflation did tremendous damage to corporate finances because of rising costs and the failure of companies to set aside enough for depreciation. Inflation accounting did not exist in those days and corporate restructuring had yet to occur. There is now much more awareness of inflation risks and accounting is better. Thus, inflation will be much less damaging to equities than before. However, we have returned to negative bond yields, largely as a result of policy-imposed financial repression rather than investor complacency. In other words, a new inflation cycle likely will be more damaging to bonds than stocks. What About Debt? On joining BCA, I had to learn about “The Debt Supercycle”, a term the company developed in the 1970s to describe the role of policy in feeding a seemingly never-ending cycle of increased leverage, resulting financial vulnerability and ever-desperate measures by policymakers to keep things afloat. This was well highlighted by the Fed’s response to the bursting of the tech bubble in the early 2000s when it kept interest rates at historically low rates even as the economy recovered. This helped create the conditions for the subsequent debt-driven housing bubble which led to an even greater policy response when that blew up in 2007-08. The essential message from BCA’s Debt Supercycle thesis is that investors should never underestimate the lengths to which policymakers will go to keep the economic/financial ship afloat. The Debt Supercycle primarily referred to the trend in private sector indebtedness in the US, although it applied to other countries. For example, in 2012, ECB President Mario Draghi noted that he was prepared “to do whatever it takes to preserve the euro”. Chart 5A Shift in the Debt Supercycle To all intents, the financial crisis of 2007-09 effectively ended the private sector Debt Supercyle in the US. Despite keeping interest rates at extremely low levels, the Fed has been unable to trigger a new upturn to household sector leverage (Chart 5). Corporate debt burdens have risen, but largely for financial engineering purposes (equity buybacks and M&A) rather than capital spending. With the private sector no longer willing or able to go on another debt-fueled spending spree, the public sector has had to take its place. The past decade has witnessed an unprecedented peacetime increase in government deficits and debt. Inevitably, the surge in government debt has fueled bearish predictions of looming financial disaster. However, the same lessons apply regarding private sector excesses: the authorities will go to extreme lengths to prevent financial and economic chaos. The solution to excessive government debt is not to pursue even greater fiscal stimulus. Instead, the solution will be a mix of financial repression, higher inflation and eventually renewed fiscal discipline. That will not rule out periodic crises to force necessary policy actions, but investors should not assume that current high levels of government debt will inevitably lead to financial Armageddon. I apologize if that sounds complacent and I know that our long-standing client Mr. X would take a very different view. Who Is Mr. X? I have been asked countless times over the years whether Mr. X is a real person and, if so, who he is. I have always refused to answer this question, just as Coca Cola Inc. would never reveal the recipe for its drink. After all, it’s interesting to have a little mystery in an otherwise strait-laced business. What I can say is that our end-year conversations with Mr. X have proved invaluable in clarifying our thinking as we prepare our Annual Outlook report. It highlights the need to avoid groupthink and take account of a wide range of views. Mr. X is an interesting character in that he views the world through an Austrian School perspective. This means he favors free market solutions over aggressive policy interventions and has a healthy distrust of both politicians and central bankers. He does not like debt and fears inflation. All this has given him a bearish bias toward risk assets over the past few decades and it has been a perpetual struggle for us to convince him to adopt a more pro-growth investment strategy. That said, he was correctly more bearish than us in late 2007 and while we were not optimistic at that time, we should have paid more attention to his views. We recently held our annual discussion with Mr. X, along with his daughter Ms. X who joined his family office a couple of years ago. She does not share his Austrian School perspective and is much more inclined to take risks, given her hedge fund background. You will discover their latest thinking in our new Outlook report, due to be published next month. Timing The Markets The Bank Credit Analyst began publication in 1949 and it was years ahead of its time in understanding the role of money and credit in driving the economy and asset markets. Its founder, Hamilton Bolton, developed a series of monetary indicators that enabled him to make very prescient market calls and that is what put the company on the map. The focused monetary approach worked very well until the end of the 1970s because banks were the dominant financial intermediary, creating a relatively stable and predictable relationship between trends in money and the financial markets. It all changed with financial deregulation and innovation, beginning in the 1980s. BCA’s monetary indicators no longer worked so well, and we had to adopt a more comprehensive approach. Timing the markets is as much art as science but I would make the following observations: The stance of monetary policy remains the most important factor to consider, despite the less stable relationship between money flows and markets. Current negative real interest rates at a time when the economy is expanding are a powerful incentive to favor risk assets. Valuation is poor indicator of near-run trends. As Keynes famously noted “the stock market can stay irrational longer than you can remain solvent”. I learned that painful lesson in the late 1990s when I advocated caution in the Bank Credit Analyst yet the markets marched ever higher, until they finally broke in early 2000. Not a happy time! Yet, there is a well-established correlation between starting valuations and long-run returns so they cannot be completely ignored (Chart 6). Chart 6Valuation Matters for Long-Run Returns Chart 7Technicals Still Positive For Stocks Technical indicators can provide useful information around major turning points, although they are prone to false signals. Investor sentiment typically is at a bullish extreme at market tops and vice versa at bottoms. Also, I remember reading a large tome that reviewed every technical indicator known to man and it concluded that the most reliable one was the humble moving average crossover. Following a simple rule such as acting when the index crosses its 200-day average will keep you out of the market for the bulk of a bear phase and in for the bulk of a bull run. Of course, by definition, it will be a bit late and there will be many whipsaws. Currently, the stock market is above its rising 200-day average and investor sentiment is far from a bullish extreme (Chart 7). Don’t base your market expectations on consensus forecasts for the economy. The economy is a lagging not leading indicator of the markets. However, if your economic view is very different from the consensus, then that should impact your strategy. The bottom line is that there is no magic solution to consistently successful market timing. This explains why 86% of US active equity managers underperformed the benchmark index over the past 10 years, according to S&P Dow Jones data.1 At BCA, we follow a disciplined comprehensive approach that has served us well over the years, but inevitably we also suffer the occasional wobble. Concluding Thoughts Within BCA I have developed a reputation of being the resident bear and that does not bother me at all. It suits my Scottish temperament (probably weather-related), and anyway, I think it is more fun to be bearish. The language of the dark side is very rich and descriptive and it is not a surprise that bad news sells more newspapers than good news. To be bullish when there always are many problems around just makes one sound complacent and out-of-touch. Of course, it is important to get the markets right and I would never take a bearish view just to be different. In practice, I have generally been positive on risk assets, but that has not stopped me from pointing out the downside risks along the way. Perhaps, I have spent too much time talking to Mr. X! I have had much to be thankful for during my career. It has been a great privilege to interact with so many very smart and interesting people and a constantly changing economic and financial environment has kept me fully engaged. Whenever I was foolish enough to think I had things figured out, events taught me otherwise. I may be leaving BCA but will continue to follow economic and market developments with keen interest.   Martin H. Barnes, Senior Vice President Chief Economist mbarnes@bcaresearch.com mhbarnes15@gmail.com   Footnotes 1Detailed data on the performance of active managers are available at https://www.spglobal.com/spdji/en/research-insights/spiva/

Highlights Cross-Atlantic Policy Divergence: A steadily tightening US labor market means that the Fed remains on track to formally announce tapering next month. Meanwhile, the ECB is signaling that they are in no hurry to do the same given scant evidence that surging energy prices are seeping into broader European inflation. This leads us to make the following changes to our tactical trade portfolio – taking profits on the 10-year French inflation breakeven spread widener; while switching out of the long December 2023 Euribor futures trade into a 10-year US Treasury-German Bund spread widening trade. Surging Antipodean Inflation: Australia and New Zealand are both seeing higher realized inflation, but market-based inflation expectations are falling in the former and rising in the latter. This leads us to make the following changes to our tactical trades: taking profits on the Australia-US 10-year spread widener; entering a new 10-year Australia inflation breakeven spread widener; and closing the underwater 2-year/5-year New Zealand curve flattening trade. Feature This week, we present a review of the shorter-term recommendations currently in our list of Tactical Overlay trades. These are positions that are intended to complement our strategic Model Bond Portfolio, with shorter holding periods – our goal is no longer than six months - and sometimes in smaller markets that are outside our usual core bond market coverage. As can be seen in the table on page 17, we typically organize these ideas by the type of trade (i.e. yield curve flatteners or cross-country spread wideners). Yet for the purposes of this review, we see two interesting themes that better organize the current trades and help guide our decision to keep them or enter new ones. Playing A Hawkish Fed Versus A Dovish ECB Federal Reserve officials have spent the past few months signaling that a tapering of bond purchases was increasingly likely to begin before year-end given the steadily improving US labor market. The September payrolls report released last Friday, even with the headline employment growth number below expectations for the second consecutive month, does not change that trajectory. Chart of the WeekCyclical UST Curve Flattening Pressures The US unemployment rate fell to 4.8% in September, continuing the uninterrupted decline from the April 2020 peak of 14.8% (Chart of the Week). The pace of that decline has accelerated in recent months, although the Delta variant surge in the US has created distortions in both the numerator and denominator of the unemployment rate. Now that the US Delta wave has crested and case numbers are falling, growth in both employment and the labor force should start to accelerate in the next few payrolls reports. This will result in a faster pace of US job growth, albeit with a slower decline in the unemployment rate, likely starting as soon as the October jobs report. The US Treasury curve has already been reshaping in preparation for a less accommodative Fed, with flattening seen beyond the 5-year point (middle panel). We have positioned for a more hawkish Fed, and a flatter Treasury curve, in our Tactical Overlay via a butterfly trade. Specifically, we are short a 5-year Treasury bullet versus a long position in a 2-year/10-year barbell, all using on-the-run cash Treasuries. That trade was initiated on June 22, 2021 and has so far generated a small profit of +0.27%. Our butterfly spread valuation model for that 2/5/10 Treasury butterfly shows that the 5-year bullet has not yet reached an undervalued extreme versus the 2/10 barbell (Chart 2). We are keeping this trade in our Tactical Overlay, as the current 2/5/10 butterfly spread of 23bps is still 6bps below the +1 standard deviation level implied by our model. Chart 2Stay In Our 2/5/10 UST Butterfly Trade Moving across the Atlantic, our trades have been the mirror image of our Fed recommendations, positioning for a continued dovish, reflationary ECB policy bias. We have expressed that via two trades: long 10-year French inflation breakevens and long December 2021 Euribor futures. We continue to see no reason for the ECB to follow the Fed’s path towards imminent tapering and signaling future rate hikes. Growth momentum has cooled in the euro area, with both the Markit composite PMI and the ZEW growth expectations index having peaked in June (Chart 3). At the same time, inflation expectations have picked up. The 5-year/5-year forward CPI swap rate has risen to 1.8%, still below the ECB’s 2% inflation target but well above the 2020 low of 0.7% (middle panel). Markets are focusing on the higher inflation and not the slowing growth, with the EUR overnight index swap (OIS) curve now pricing in 12bps of rate hikes in 2022 (bottom panel). We see that as a highly improbable outcome. There is little evidence that the latest pickup in euro area realized inflation is broadening out beyond surging energy price inflation and supply-constrained goods inflation (Chart 4). Euro area headline CPI inflation hit a 13-year high of 3.0% in August, with the “flash” estimate for September showing a further acceleration to 3.4%. Yet core inflation only reached 1.6% in August - a month when the trimmed mean euro area CPI inflation rate calculated by our colleagues at BCA Research European Investment Strategy was a scant 0.2%. Chart 3ECB Will Not React To This Cyclical Bout Of Inflation Chart 4Euro Area Inflation Upturn Is Not Broad-Based While the September flash estimate of core inflation did perk up to 1.9%, the trimmed mean measure shows that the rise in euro area inflation to date has not been broad based. Like the Fed, ECB officials have indicated that they view this pick-up in inflation as “transitory”, fueled by soaring energy costs and base effect comparisons to low inflation in 2020. Signs that higher inflation was feeding into “second round” effects like rising wage growth might change the ECB’s thinking. From that perspective, the recent increase in labor strike activity in Germany is a potentially worrisome sign, but the starting point is one of low wage growth – the latest available data on euro area wage costs showed a -0.1% decline during Q2/2021. Chart 5Close Our Long Dec/23 Euribor Futures Trade We have been trying to fade ECB rate hike expectations via our long December 2023 Euribor futures trade. That position, initiated on May 18, 2021 has generated a small loss of -0.11% (Chart 5). We still expect the ECB to keep rates on hold in 2022, and most likely 2023, so there is the potential for that trade to recover that underperformance. However, that position has now reached the six-month holding period “re-evaluation” limit that we have imposed on our Tactical Overlay trades. Thus, we are closing that trade this week. In its place, we are initiating a new tactical trade to position for not only persistent ECB dovishness but a more hawkish Fed – a US Treasury-German Bund spread widening trade using 10-year bond futures. The specific details of the trade (futures contracts, duration-neutral weightings on each leg of the trade) can be found in the table on page 17. This new UST-Bund trade is attractive for three reasons: Our valuation model for the Treasury-Bund spread - which uses relative policy interest rates, relative unemployment, relative inflation and the relative size of the Fed and ECB balance sheets as inputs – shows that the spread is currently undervalued by more than one full standard deviation, and fair value is rising (Chart 6). The technical backdrop for the Treasury-Bund spread has turned more favorable for wideners, with the spread having fallen back to its 200-day moving average and the 26-week change in the spread now down to levels that preceded past turning points in the spread (Chart 7). Chart 6Enter A New 10yr UST-Bund Spread Widening Trade Relative data surprises are pointing to relatively higher US yields and a wider Treasury-Bund spread, with the Citigroup Data Surprise Index for the US now rising and the euro area equivalent measure falling (Chart 8). Chart 7UST-Bund Technical Backdrop Positioned For Widening Chart 8Relative Data Surprises Favor Wider UST-Bund Spread While we are entering a new trade to play for a relatively dovish ECB, we are also choosing to take the substantial profit in our tactical trade in French inflation breakevens. Specifically, we are closing our 10-year French inflation breakeven spread widening position – long a 10-year cash OATi bond, short 10-year French bond futures – with a solid gain of +6.3%. Chart 9Take Profits On Our Long 10yr French Breakevens Trade We have held this trade for nine months, a bit longer than our typical tactical trade holding period. We did so because French 10-year breakevens continued to look cheap on our valuation model. Now, the breakeven spread has risen to fair value (Chart 9), prompting us to take our gains and move on. Diverging Inflation Expectations In Australia & New Zealand Playing Fed/ECB policy divergence was the first main theme of this Tactical Overlay trade review. The second broad theme is also a divergence, between inflation expectations in New Zealand (which are rising) and Australia (which are falling). This trend leads us to close two existing trades and enter a new position. Chart 10An Inflation-Induced Bear Steepening Of Yield Curves In New Zealand, we are closing out our 2-year/5-year government bond yield curve flattener trade, initiated on July 21, for a loss of -0.32%. While we were correct in our expectation of ramped-up hawkishness from the Reserve Bank of New Zealand (RBNZ), we were caught offside by persistently sticky inflation which has become a headache for global central bankers. With supply squeezes and high commodity prices not going away anytime soon, sovereign curves have bear-steepened across developed markets, driven by rising long-dated inflation expectations (Chart 10). This global steepening pressure also hit the New Zealand curve, to the detriment of our domestic RBNZ-focused flattener trade. There was also a technical component to the steepening in the New Zealand 2-year/5-year curve (Chart 11). With the 2-year/5-year curve having dipped far below its 200-day moving average and the 26-week rate of change at stretched levels, the flattener was already “overbought” when we entered the trade. Despite a steady stream of hawkish messaging from the RBNZ, leading to an actual rate hike last week, technicals did win out in the short term as the 2-year/5-year spread steepened back up towards the 200-day moving average. Chart 11The NZ 2s/5s Curve Has Also Steepened Due To Technical Factors On the positive side, our decision to implement this trade as a duration-neutral “butterfly”, selling a 2-year bond, and using the proceeds to buy a weighted combination of a 5-year bond and a 3-month treasury bill with an equivalent duration to the 2-year bond, worked as intended with the butterfly underperforming as the underlying 2-year/5-year curve steepened. Looking forward, technicals are still some distance from turning favorable and will remain a headwind for the flattener trade. Implied forward rates are also not in our favor, with markets already pricing in some flattening, making this a negative carry trade. Over a cyclical horizon – i.e. beyond our normal six-month holding period for tactical trades - we still expect the shorter-end of the New Zealand to flatten. The experience of past hiking cycles shows that the 2-year/5-year curve tends to continue flattening during policy tightening, usually leveling out at 0bps before re-steepening (Chart 12). Considering that we have already been in this trade for three months, however, we do not believe our initial curve flattening bias will play out successfully over the remainder of our six-month tactical horizon. While we are closing out our flattener trade, we will investigate ways to better express our bearish cyclical view on New Zealand sovereign debt in a future report. Turning to Australia, we are closing out our long Australia/short US spread trade, implemented using 10-year bond futures, taking a healthy profit of +2.1%. We have held this trade for longer than our typical six-month holding period (the trade was initiated on January 26, 2021) because our Australia-US 10-year spread valuation model has continued to flash that the spread was too wide to its fair value (Chart 13). The model has been signaling that the spread should be negative, yet Australian yields have been unable to trade below US yields for any sustained length of time in 2021. Furthermore, the model-implied fair value is now starting to bottom out, suggesting a diminishing tailwind from the relative fundamental drivers of the spread embedded in our model. Chart 12The NZ 2s/5s Curve Will Flatten Over A Cyclical Horizon Chart 13Take Profits On Our 10-Yr Australia-US Spread Narrowing Trade Chart 14Inputs Into Our Australia-US Spread Model The inputs into our 10-year spread model are relative policy interest rates, core inflation, unemployment and the size of central bank balance sheets (to incorporate QE effects) for Australia and the US. Of these variables, the biggest drivers of the decline in the fair value since the start of the COVID pandemic in 2020 have been relative inflation and the relative size of the Fed and Reserve Bank of Australia (RBA) balance sheets as a percentage of GDP (Chart 14). Both of those trends are related. Persistently underwhelming Australian inflation – despite accelerating inflation in the US and other developed economies over the past year – has forced the RBA into a pace of asset purchases relative to GDP that exceeded even what the Fed has done since the pandemic started (bottom panel). However, Australian inflation finally began catching up to the rising trends seen elsewhere in the spring of this year, with headline CPI inflation jumping from 1.1% to 3.8% on a year-over-year basis during Q2. Australian bond yields have traded more in line with US yields since that mid-year pop in inflation, preventing the Australia-US spread from narrowing below zero and converging to our model-implied fair value. This is despite a severe COVID wave that forced much of Australia into the kind of severe lockdowns that the nation avoided during the worst of the global pandemic in 2020. With Australian inflation now moving higher and converging towards US levels, economic restrictions starting to be lifted thanks to a rapid vaccination campaign, and the RBA having already done some tapering of its asset purchases before the Fed, the fundamental rationale for holding our Australia-US trade is no longer valid, leading us to take profits. The convergence to fair value in our spread model is now more likely to come from fair value rising rather than the actual spread falling. The pickup in Australian inflation also leads us to enter a new trade Down Under. This week, we are initiating a new trade, going long 10-year Australia inflation breakevens, implemented by going long a 10-year cash inflation-linked bond and selling 10-year bond futures. The details of the new trade are shown in the table on page 17. Despite the uptick in realized Australian inflation, breakevens have actually been declining over the past several months, falling from a peak of 247bps on May 13 to the current 208bps. That move has accelerated more recently due to a rise in Australian real yields that has coincided with markets pricing in more future RBA rate hikes. Our 24-month Australia discounter, which measures the total amount of tightening over the next two years discounted in the AUD OIS curve, now shows that 104bps of rate hikes are expected by the fourth quarter of 2023 (Chart 15, bottom panel). This has occurred despite Australian wage growth remaining well below the 3-4% range that the RBA believes is consistent with underlying Australian inflation returning sustainably to the RBA’s 2-3% target band (top two panels). Chart 15Market Expectations For The RBA Are Too Hawkish Chart 16Go Long 10-Yr Australian Inflation Breakevens Australian real bond yields have begun to move higher in response to this more hawkish market policy expectation that seems overdone, helping push breakeven inflation even lower more recently. This has helped unwind some of the overvaluation of 10-year inflation breakevens from earlier in 2021. Our fundamental model for the 10-year Australian breakeven showed that the spread was over two standard deviations above fair value to start 2020 (Chart 16). The decline in the spread since that has largely eliminated that overvaluation, providing a better entry point for a new breakeven spread widening trade. With survey-based measures of inflation expectations rising even as breakevens fall back to fair value (bottom panel), we see a strong case for adding a new Australian inflation trade to our Tactical Overlay.   Robert Robis, CFA Chief Fixed Income Strategist rrobis@bcaresearch.com Shakti Sharma Senior Analyst ShaktiS@bcaresearch.com Recommendations The GFIS Recommended Portfolio Vs. The Custom Benchmark Index Duration Regional Allocation Spread Product Tactical Trades Yields & Returns Global Bond Yields Historical Returns

Highlights Equity valuations are extremely stretched versus bonds, so there is little wiggle room for bonds to sell off before pulling down large tracts of the stock market. We estimate that bond yields can rise by no more than 30 bps, before the Fed is forced to talk them back down again. Starting from an earnings yield that is extreme versus its history, we should prudently assume that the prospective long-term real return from equities will be far below the current earnings yield of 4.6 percent, and closer to zero, even if not actually negative. In capitalist economies, gluts may or may not lead to shortages; but shortages always lead to gluts. In other words, the current inflation is sowing the seeds of its own destruction. Hence, we reiterate our structural recommendation to overweight US T-bonds versus US TIPS. Fractal analysis: Cotton, and Polish equities. Feature Chart of the WeekTech Stocks Have Been Tracking The 30-Year T-Bond Price One-For-One Equity valuations are extremely stretched versus bonds. The upshot is that there is little wiggle room for bonds to sell off before pulling down large tracts of the stock market. This is not just an abstract hypothesis – it is an empirical fact, as recent market action is making painfully clear. Since February, the global tech sector has tracked the 30-year T-bond price almost one-for-one. The near perfect fit proves that the tech (and broader growth stock) rally has been entirely premised on the bond market rally. Hence, on the three occasions that bonds have sold off sharply – including in the last couple of weeks – tech stocks have sold off sharply too (Chart of the Week). Put simply, the performance of the tech sector is being driven by the change in its valuation, and the change in its valuation is being driven by the change in the bond yield (Chart I-2). Chart I-2Tech Stock Valuations Are Being Driven By The Bond Yield Of course, stock prices are also premised on earnings. So, given enough time, rising earnings can make valuations less stretched, adding more wiggle room for bonds to sell off. The trouble is that a change in earnings happens much more gradually than can a change in valuation – a 10 percent rise in earnings can take a year, whereas a 10 percent fall in valuation can happen in a week. Bond Yields Remain The Dominant Driver Of The Stock Market For the next few months at least, the movement in bond yields will remain the dominant driver of the most stretched parts of the stock market and, by extension, the overall market itself. This is especially true for the growth-heavy S&P 500 which, since March, has been tracking the 30-year T-bond price one-for-one (Chart I-3). Chart I-3The S&P 500 Has Also Been Tracking The 30-Year T-Bond Price One-For-One The key question for investors is, what is the upper limit to bond yields before stock market damage causes the Federal Reserve to talk them down again? To answer this question, our working assumption is that a 15 percent drawdown in growth stocks would damage the growth-heavy S&P 500 enough – and thereby worsen ‘financial conditions’ enough – for the Fed to change its tone. Based on this year’s very tight relationship between tech stocks and the 30-year T-bond yield, a 15 percent drawdown would occur if the 30-year T-bond yield increased to 2.4 percent from 2.1 percent today (Chart I-4). Chart I-4The Fed's 'Pain Point' Is Only 30 Basis Points Away This confirms our view that the resistance level to long-duration bond yields is around 30 bps above current levels, equivalent to around 1.8 percent on the 10-year T-bond yield. More About The ‘Negative Equity Risk Premium’ Our recent report The Equity Risk Premium Turns Negative For The First Time Since 2002 caused quite a stir. So, let’s elaborate and clarify the arguments we made about the equity risk premium (ERP) – the estimated excess return that stocks will deliver over bonds over a long investment horizon, such as 10 years. Many investors estimate the ERP by taking the stock market’s earnings yield – currently 4.6 percent in the US1 – and subtracting the real 10-year bond yield – currently -0.9 percent on US Treasury Inflation Protected Securities (TIPS). At first glance, this presents a very generous ERP of 5.5 percent. So, equities are attractively valued versus bonds, right? Wrong. The glaring error is that the earnings yield estimates the stock market’s prospective return only if the earnings yield starts and ends at the same level. If it does not, then the prospective return could be very different to the earnings yield. For example, imagine that the stock market was trading at a bubble price-to-earnings multiple of 100, meaning an earnings yield of 1 percent. Clearly, from such a bubble valuation, nobody would expect the market to return 1 percent. Instead, as the bubble burst, and valuations normalised, the prospective return would be deeply negative. It follows that when, as now, the earnings yield is extreme versus its history, we must build in some prudent normalisation to estimate the prospective return. The question is, how? One approach is to use history to inform us of the likely normalisation. Chart I-5 does this using the ‘best-fit’ relationship between the earnings yield at each point through 1990-2011 and subsequent 10-year real return from each starting point. Using the best-fit for this specific episode, the current earnings yield of 4.6 percent implies a prospective 10-year real return not of 4.6 percent, but of -1.1 percent. Chart I-5Based On History, The Current Earnings Yield Implies A Prospective 10-Year Real Return Much Less Than 4.6 Percent Yet this best-fit approach meets a common reproach – that the best-fit for this specific episode is massively distorted by the dot com bubble peak and the global financial crisis (GFC) trough occurring (by coincidence) almost 10 years apart. We can counter this reproach in two ways. First, the best-fit relationship is much better than the raw earnings yield even for undistorted 10-year periods such as 1995-2005 or 2011-2021. Better still, we can change the prospective return from 10 years to 7 years and thereby remove the dot com bubble peak to GFC trough distortion. Chart I-6 shows that this 7-year best-fit relationship also works much better than the raw earnings yield. Chart I-6Based On History, The Current Earnings Yield Implies A Prospective 7-Year Real Return Much Less Than 4.6 Percent Admittedly, the best-fit comes from just one episode in history, and there is no certainty that the 10-year and 7-year relationships that applied during that one episode should apply through 2021-31 and 2021-28 respectively. Nevertheless, starting from an earnings yield that is extreme versus its history, as is the case now, we should prudently assume that the prospective long-term real return from equities will be far below 4.6 percent, and closer to zero, even if not actually negative. Will The ‘Real’ Real Yield Please Stand Up Measuring the ERP also requires an estimate of the prospective real return on bonds. This part should be easy because the yield on the US 10-year TIPS – currently -0.9 percent – is the guaranteed 10-year real return of buying and holding that investment. It is derived by taking the yield on the 10-year T-bond – currently 1.5 percent – and subtracting the market’s expected rate of inflation over the next 10 years – currently 2.4 percent. But the equivalent real return on the much larger conventional bond market could be quite different. In this case, it will be the 10-year T-bond yield minus the actual rate of inflation over the next 10 years. To the extent that the actual rate of inflation turns out less than the expected rate of 2.4 percent, the real return on the T-bond will turn out higher than that on the TIPS. In fact, this has consistently turned out to be the case. The market has consistently overestimated the inflation rate over the subsequent 10 years, meaning that the real return on T-bonds has been around 1 percent higher than that on TIPS (Chart I-7). Chart I-7Will The 'Real' Real Yield Please Stand Up Yet given the current surge in inflation, and no end in sight for supply chain disruptions and bottlenecks, is it plausible that the next ten years’ rate of inflation will be lower than 2.4 percent? The answer is yes. Because, as my colleague Peter Berezin points out: in capitalist economies, gluts may or may not lead to shortages; but shortages always lead to gluts. And gluts always cause prices to collapse. In other words, the current inflation is sowing the seeds of its own destruction. Hence, we reiterate our structural recommendation to overweight US T-bonds versus US TIPS. The Cotton Is Stretched, And So Are Polish Equities Talking of shortages, cotton now adds to the list of commodities in which supply bottlenecks have raised prices to extremes. Cotton prices have reached a 10-year high due to weather conditions in the US (the world’s biggest cotton producer) combined with shipping disruptions. However, with cotton now exhibiting extreme fragility on its combined 130/260-day fractal structure, there is a high likelihood of a price reversal in the coming months when the shortage turns into a glut (Chart I-8). Chart I-8The Cotton Is Stretched Meanwhile, the bank-heavy Polish equity market has surged on the back of the spectacular outperformance of its banks sector. This strong uptrend has now reached the point of fragility on its 130-day fractal structure that has indicated several previous reversals (Chart I-9). Chart I-9Poland's Outperformance Is Stretched Accordingly, this week’s recommended trade is to underweight the Warsaw General Index versus the Eurostoxx 600, setting a profit target and symmetrical stop-loss at 6 percent.   Dhaval Joshi Chief Strategist dhaval@bcaresearch.com   Footnotes 1 Based on the 12-month forward earnings yield. Fractal Trading System Fractal Trades 6-Month Recommendations Structural And Thematic Recommendations Closed Fractal Trades     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 ##br##- Interest Rate Expectations Chart II-7Indicators To Watch ##br##- Interest Rate Expectations   Chart II-6Indicators To Watch ##br##- Interest Rate Expectations Chart II-8Indicators To Watch ##br##- Interest Rate Expectations      

Highlights European small-cap equities have structurally outperformed large-cap stocks. This outperformance echoes the desirable sectoral biases of small-cap stocks. It also reflects the inability of European large-cap stocks to expand their markups, unlike US large caps. The pro-cyclicality of European small-cap stocks and the limited correlation of their relative performance to the Chinese credit cycle make them an attractive play in European portfolios. The current risk-off phase in global markets suggests it is still too early to buy European small-cap stocks, but an opportunity to overweight them will emerge in the coming weeks. Feature Markets last week were volatile and corrected sharply. This fit with the view expressed in our previous strategy report, which argued that the near-term outlook for European equities was still clouded by the confluence of the coming Fed tightening and a Chinese economic slowdown.  Chart 1Ebbing COVID Allows For Central Bank Repricing The market seems especially concerned by the deterioration in liquidity conditions. The Delta wave is ebbing around the world (Chart 1) and inflation is proving to be stickier than policymakers had originally anticipated. As a result, investors appear to be pricing in the potential implications of central banks moving from being behind the curve to ahead of the curve. Moreover, surging natural gas prices in Europe, empty gas stations in the UK, labor shortages around the world, and steep automobile production cuts by major players like Toyota and GM raise the specter of stagflation. In this context, bond yields are rising and stocks are agitated. The dollar’s rally further tightens global financial conditions and adds to the systemic stress, which intensifies the very unsettling environment for investors. Consequently, seasonal October weakness remains on the table. Chart 2Tactical Vulnerabilities Remain We continue to see this selling phase as temporary. Sentiment will be consistent with a trough in risk assets soon (Chart 2). Additionally, Chinese authorities will reflate the economy much more aggressively than they have so far, even if it probably takes more market pain first. In this context, we focus on what to buy to take advantage of the eventual rebound in cyclical plays. This week, we look at European small-cap stocks that have handsomely outperformed their larger counterparts over the past ten years. In Europe, Small Is Beautiful Chart 3Small Caps Lead In Europe The underperformance of European stocks relative to the US over the past 13 years is well known by investors. Less known is that, since 2012, European small-cap stocks have performed roughly in line with their US counterparts. In other words, European small-cap stocks have massively outperformed Euro Area equity benchmarks (Chart 3). Two forces explain the ability of European small caps to beat their larger competitors by 85% since the Great Financial Crisis. The sectoral composition of European small-cap indexes helped them outperform their larger competitors. Using MSCI benchmarks, the small-cap index largest overweight are industrials and real estate, compared to financials, healthcare, and consumer staples for large caps (Table 1). Industrials have been one of the best performing sectors in the cyclicals and value categories, while financials have greatly suffered. Meanwhile, real estate equities enjoy falling yields, while financials hate them. This dichotomy explains why European small caps outperformed as European yields collapse (Chart 4). It is also why, unlike in the US, the relative performance of European small-cap equities exhibits little correlation with the slope of the yield curve. Table 1Small Caps Overweighs The Right Sectors Chart 4European Small Caps Like Lower Bund Yields The poor performance of the European large-cap stocks is the second element explaining the outperformance of European small caps. The European large-cap stocks lie at the heart of Europe’s underperformance relative to the US, not the smaller firms. According to researchers De Loecker, Eeckhout, and Unger, US firms have grown their markups massively since the 1980s (Chart 5).1 These expanding markups reflect a growing market power, which is the result of rising market concentration among the dominant players in nearly all the industries.2 In fact, Grullon, Larkin & Michaely show that industries with a greater level of concentration also display higher levels of RoA (Chart 6).3 The problem for European large firms is that they have not experienced the same increase in industry concentration as US businesses. Research by the OECD demonstrates that industry concentration rose significantly more in the US than in Europe over the past 20 years (Chart 7). This is particularly true in the service sector (Chart 7, middle panel) and the less digital-intensive industries (Chart 7, bottom panel).4 Chart 5Higher US Markups Chart 6As Concentration Increases, So Do RoAs Chart 7Europe Did Not Witness The Same Increase In Concentration Without this increase in market power, European large caps could not experience a meaningful pick up in their RoEs relative to those of small-cap stocks. They have therefore been fully victim to their sector composition and massively underperform smaller firms as well as US large businesses. Bottom Line: The structural outperformance of European small caps relative to large-cap stocks reflects the former’s large overweight in industrials and real estate stocks compared to the latter’s overrepresentation of financials, healthcare, and consumer staples names. Additionally, the inability of large-cap European names to increase industrial concentration has prevented them from mimicking the extraordinary growth in markups and RoE witnessed in the US. As a result, European small-cap names could massively beat their larger counterparts. Can The Outperformance Continue? The structural outperformance of small caps will become challenged if Europe experiences a structural increase in yields, which will hurt real estate stocks while helping financials. This sectoral effect will result in a structural outperformance of European stocks. On a cyclical horizon, however, the outlook continues to favor small-cap over large-cap equities in Europe and the Eurozone. Chart 8The Relative Performance Of European Small Caps is Procyclical As in the US, the relative performance of European small-cap stocks is pro-cyclical. As Chart 8 shows, small-cap stocks generate the largest excess returns at the beginning of business cycle upswings. They continue to outperform, as long as the business cycle points up. Only once a slowdown begins do small- cap names underperform. Similarly, the relative performance of small-cap equities correlates closely with the Euro Area Manufacturing PMI (Chart 9). It also displays a negative correlation with high-yield spreads (Chart 9, middle panel). Additionally, small-cap stocks track the evolution of inflation swaps (Chart 9, bottom panel). This behavior of small caps means that they remain an attractive bet over the next 18 to 24 months. The European economy is likely to continue to grow robustly over the coming two years and thus stay in the quadrant where small caps outperform. Moreover, the ECB’s policy will generate very accommodative monetary conditions for an extended period. Hence, European high-yield bonds will continue to outperform safe havens and the labor market will tighten further, which will help CPI swap climb up. Despite this procyclicality, the relative performance of small-cap stocks displays only a loose correlation with the European cyclical/defensive split (Chart 10). Moreover, small caps do not correlate closely with commodity prices (Chart 10 middle panel). These two observations reflect the limited relationship between the relative performance of small-cap equities and the Chinese credit impulse (Chart 10, bottom panel). The small caps’ lack of sensitivity to the Chinese economy is the consequence of their lower international bent compared to that of large-cap firms. Chart 9More Signs Of Procyclicality Chart 10Low Correlation To China Plays This low correlation with Chinese economic variables is likely to prove another asset for small-cap equities. As we have witnessed with the Evergrande saga or the rotating crackdowns from one industry to the next, China will remain a source of uncertainty for the global economy and global capital markets for the foreseeable future. Thus, a low-correlation relative performance is an attractive attribute. Chart 11Not Particularly Cheap European small-cap stocks are not without blemish. Unlike in the US, they trade at a premium to large-cap stocks on many valuation metrics. For example, their price-to-forward earnings, price-to-trailing earnings, price-to-cash flow ratios and dividend yields stands at 21 vs 16, 35 vs 35, 18 vs 10 and 1.2% vs 2%, respectively. True, small-cap indexes carry a large proportion of companies with negative earnings. Adjusting for this characteristic, the forward P/E ratio falls to 15.12, which is just under the similarly adjusted forward P/E ratio of the Eurozone benchmark. Our Composite Small Cap Relative Valuation Indicator, which amalgamates this information, is directly in the neutral zone (Chart 11). The neutral relative valuation of small-cap stocks is a handicap because they sport operating metrics that are worse than their larger cousins. Their RoE are a meagre 6.3% vs 7.7%. Moreover, forward earnings have rebounded sharply already and long-term growth expectations are lofty (Chart 12). This leaves the euro as the ultimate arbiter of the path of European small caps. As Chart 13 illustrates, the trade-weighted euro closely tracks the relative performance of the Euro Area small-cap benchmark. This reflects the more domestic nature of small caps, but also, their procyclicality, which mimics that of the euro. Chart 12Some Good News In The Price Chart 13A Play On The Euro Chart 14A Weaker Yuan Could Lift The Dollar The euro continues to face near-term hurdles, which creates a problem for small-cap stocks. The dollar is catching a bid as the Fed moves closer to its tapering and eventual rate hike. Moreover, interest rate differentials between China and the US are narrowing, which will weigh on the yuan (Chart 14). A weaker CNY often causes EM currencies to depreciate and puts downward pressure on the euro. Furthermore, if the global equity correction perdures a few more weeks, the dollar will benefit from additional risk-off flows, which will also hurt the euro. Beyond these near-term risks, BCA’s foreign exchange strategists continue to hold a positive cyclical outlook on the dollar. The greenback’s defining characteristic is its counter-cyclicality. Thus, BCA’s expectation that the period of risks to global growth is temporary also means that the dollar’s rally has a finite life. As we argued last week, Chinese policymakers are unlikely to let the economic deterioration fester for too long, as it would risk uncontrolled deleveraging pressures. Moreover, global capex and inventory trends also point toward a growth re-acceleration in the first half of 2022.  In this environment, the euro—which still behaves as the anti-dollar—will be able to regain its footing. Therefore, we will not chase EUR/USD below the 1.15 - 1.12 zone.  Chart 15History Rhymes The near-term risks to the euro and small-cap stocks create a buying opportunity for investors with a 12- to 18-month investment horizon. A short period of small-cap underperformance will allow small-cap equities to digest completely the period of outperformance that took place between March 2020 and June 2021 (Chart 15). It will also follow the pattern of the past ten years, wherein periods of outperformance last 18 to 24 months and are followed by a short decline before resuming anew.  Bottom line: Small-cap stocks are an attractive vehicle to bet on pro-cyclical assets in Europe. They have benefited from a structural outperformance as a result of their attractive sectoral profile. Moreover, their relative performance strengthens when the global business cycle is in expansion, yet it is a rare cyclical asset with a limited correlation to Chinese credit trends. European small-cap stocks are tightly correlated with the trade-weighted euro. In the near term, this could cause a period of underperformance to develop; however, this is a buying opportunity for investors with a 12- to 18-month investment horizon. Mathieu Savary, Chief European Strategist Mathieu@bcaresearch.com   Footnotes 1J. De Loecker, J. Eeckhout, G. Unger, “The Rise Of Market Power And The Macroeconomic Implications,” Mimeo 2018. 2Please see The Bank Credit Analyst Section II "The Productivity Puzzle: Competition Is The Missing Ingredient," dated June 27, 2019, available at bcaresearch.com 3G. Grullon, Y. Larkin and R. Michaely, “Are Us Industries Becoming More Concentrated?,” April 2017. 4Bajgar, M., et al. (2019), “Industry Concentration in Europe and North America,” OECD Productivity Working Papers, No. 18, OECD Publishing, Paris, https://doi.org/10.1787/2ff98246-en. Tactical Recommendations Cyclical Recommendations Structural Recommendations Closed Trades Currency Performance Fixed Income Performance Equity Performance

Bank Credit Analyst

HighlightsSince 2008, US equity outperformance versus global ex-US stocks has not been driven by stronger top-line growth. Instead, it has been caused by a narrowly-based increase in profit margins, the accretive impact of share buybacks on the EPS of US growth stocks, and an outsized expansion in equity multiples. To a lesser extent, the dollar has also boosted common currency relative performance.There are significant secular risks to these sources of US equity outperformance over the past 14 years. Elevated tech sector profit margins are likely to lead to increased competition and higher odds of regulatory action, leveraging has reduced the ability of US companies to continue to accrete EPS through changes to capital structure, relative multiples are not justified by relative ROE, and the US dollar is expensive and is likely to fall over a multi-year horizon.In absolute terms, we forecast that US stocks will earn annualized nominal total returns of between 1.8 - 4.7% over the coming decade, assuming 4-5% annual revenue growth, flat profit margins, a constant 2% dividend yield, and a constant equity risk premium. Long-maturity bond yields are below their equilibrium levels and are likely to rise in real terms over time, which will weigh on elevated equity multiples.Over the coming 6-12 months, our view that US 10-Year Treasury yields are likely to rise argues for an underweight stance toward growth versus value stocks. In turn, this implies that US stocks will underperform global stocks, especially versus developed markets ex-US.The risks that we have highlighted to the sources of US outperformance suggest that US stocks may be flat versus their global peers over the long-term, arguing for a neutral strategic allocation. It also suggests that investors should be prepared to accept more volatility in order to reduce the gap between expected and desired returns, and should look towards riskier investments and asset classes (such as real estate and alternative investments) as potential portfolio return enhancements.Feature Chart II-1The US Has Massively Outperformed Other Equity Markets Since The Global Financial Crisis The US equity market has vastly outperformed its peers since the 2008/2009 global financial crisis. Chart II-1 highlights that an investment in US stocks at the end of 2007 is now worth over 4 times the invested amount, versus approximately 1.6 times for global ex-US stocks (when measured in US dollar terms). The chart also shows that USD-denominated total returns have been roughly the same for developed markets ex-US as they have been for emerging markets, highlighting the exceptional nature of US equities.In this report we provide a deep examination of the sources of US equity performance, their likely sustainability, and what this implies for long-term investor return expectations. US stocks have not outperformed because of stronger top-line (i.e. revenue) growth, and instead have benefitted from a narrowly-based increase in profit margins, active changes to capital structure that have benefitted stockholders, an outsized expansion in equity multiples relative to global stocks, and a structural appreciation in the US dollar.We conclude that there are significant risks to all of these sources of outperformance, and that a neutral strategic allocation to US equities is now likely warranted. We also highlight that, while a strategic overweight stance is still warranted toward stocks versus bonds, investors should no longer count on US stocks to deliver returns that are in line with or above commonly-cited absolute return expectations. This argues for a greater tolerance of volatility, and the pursuit of riskier investments and asset classes (such as real estate and alternative investments) as potential portfolio return enhancements.A Deep Examination Of US Outperformance Since 2008Breaking down historical total return performance is the first step in judging whether US equities are likely to outperform their global ex-US peers on a structural basis. Below we deconstruct US and global total return performance over the past 14 years into six different components, and analyze the impact of some of these components on a sector-by-sector basis. The six components presented are:Total revenue growth for each equity market, in local currency termsThe change in profit marginsThe impact of changes in capital structure and index compositionThe change in the trailing P/E ratioThe income return from dividendsThe impact of changes in foreign exchangeThe sum of the first three factors explains the total growth in earnings per share over the period, and the addition of the fourth factor explains each market’s local currency price return. Income returns are added to explain total return over the period, with the sixth factor then explaining common currency total return performance. The FX effect for US stocks is zero by construction, given that we measure common currency performance in US$ terms. Chart II-2Strong US Returns Have Not Been Due To Strong Top Line Growth Chart II-2 presents the annualized absolute impact of these factors for the MSCI US index since 2008. The chart highlights that U.S. stock prices have earned roughly 11% per year in total return terms over the past 14 years, with significant contributions from revenue growth, multiple expansion, margins, and the return from dividends.Interestingly, however, Chart II-3 highlights that US equities have not significantly outperformed on the basis of the first factor, total local currency revenue growth, at least relative to overall global ex-US stocks (see Box II-1 for more details). DM ex-US stocks have experienced very weak revenue growth since 2008, but this has been compensated for by outsized EM revenue growth. It is also notable that US revenue growth has actually underperformed US GDP growth over the period, dispelling the notion that US equity outperformance has been due to strong top-line effects.Chart II-3The US Has Outperformed Due To Margins, Capital Structure, Multiples, And The Dollar Box II-1Proxying The Impact Of Changes In Shares OutstandingWe proxy the impact of changes in shares outstanding (and thus the impact of equity dilution / accretion) by dividing each index’s market capitalization by its stock price. This measure is not a perfect proxy, as changes in index composition (such as the addition/deletion of index constituents) will change the index’s market capitalization but not its stock price. We also calculate total revenue for each market by multiplying local currency sales per share by the market cap / stock price ratio, meaning that the total revenue growth figures shown in Chart II-3 should best be viewed as estimates that in some cases reflect index composition effects.However, Chart II-B1 highlights that adjusting the market cap / stock price ratio for the number of firms in the index does not meaningfully change our overall conclusions. This approach would imply a larger dilution effect for DM ex-US than suggested in Chart II-3, and a smaller effect for emerging markets (due to a significant rise in the number of EM index constituents since 2008). In addition, global ex-US revenue growth is modestly lower than US revenue growth when using this approach. But this gap would account for a fraction of US equity outperformance over the period, underscoring that the US has massively outperformed global ex-US stocks due to margin, capital structure, and multiple expansion effects. Chart II-B1The US Has Not Meaningfully Outperformed Due To Revenue Growth, No Matter How You Slice It Chart II-3 also highlights that global ex-US stocks have modestly outperformed the US in terms of the fifth factor, the income return from dividends. This has almost offset the negative FX return (the sixth factor) from a net rise in the US dollar over the period.What is clear from the chart is that the second, third, and fourth factors explain almost all of the difference in total return between US and global ex-US stocks since 2008. The US experienced a significant increase in profit margins versus a modest contraction for global ex-US, a modest fillip from changes in capital structure and index composition versus a substantial drag for ex-US stocks, and a sizable rise in equity multiples that has outpaced what has occurred around the globe in response to structurally lower interest rates. Chart II-4US Margin Outperformance Has Been Narrowly-Based The significant rise in aggregate US profit margins over the past 14 years has often been attributed to the strong competitiveness of US companies, but Chart II-4 highlights that the aggregate change mostly reflects a narrow sector composition effect. The chart shows the change in US and global ex-US profit margins by level 1 GICS sector since 2008, and underscores that overall profit margins outside of the US have fallen mostly due to lower oil prices. Conversely, in the US, profit margins have substantially risen in only three out of ten sectors: health care, information technology, and communication services.Chart II-5 highlights that global ex-US equity multiples have risen in a majority of sectors since 2008, but not by the same magnitude as what has occurred in the US. De-rating in the resource sector partially explains the gap, but stronger US multiple expansion in the heavily-weighted consumer discretionary, information technology, and communication services sectors appears to explain most of the gap in multiple expansion.Chart II-5Multiples Have Risen Globally, But More So For Broadly-Defined US Tech Stocks Finally, Charts II-6 & II-7 highlights that there has been a strong growth versus value dimension to the impact of changes in capital structure and index composition on regional equity performance. The charts show that equity dilution and other changes to index composition have caused a similar drag on the returns from value stocks in the US and outside the US. However, the charts also highlight that the more important effect has been the accretive impact of share buybacks on the EPS of US growth stocks, which has not been matched by growth stocks outside of the US. As noted in Box II-1, part of this gap may be explained by an increase in the number of companies included in the MSCI Emerging Markets index, but Chart II-8 highlights that the global ex-US ratio of market capitalization to stock price has still risen significantly over the past 14 years, in contrast to that of the US even after controlling for the number of index components. Chart II-6There Has Been A Strong Style Dimension…  Chart II-7…To The Impact Of Changes In Capital Structure And Index Composition  Chart II-8The Accretive Impact Of US Growth Stock Buybacks Has Not Been Matched Globally The bottom line for investors is that there have been multiple factors contributing to US equity outperformance since 2008, but aggregate top-line growth has not been one of them. Broadly-defined technology companies (including media & entertainment and internet retail firms) have been responsible for nearly all of the relative rise in profit margins and most of the relative expansion in multiples over the past 14 years, and US growth stocks have benefitted from the accretive impact of share buybacks to a larger degree than what has occurred globally.The Relative Secular Return Outlook For US StocksWe present below several structural risks to the continued outperformance of US equities for the factors that have been most responsible for this performance over the past 14 years. In some cases, these risks speak to the potential for US outperformance to end, not necessarily that the US will underperform. But even the cessation of US outperformance along one or more of these factors would be significant, as it would imply a potential inflection point in the most consequential trend in regional equity performance since the 2008/2009 global financial crisis.Profit MarginsChart II-9 presents the 12-month trailing combined profit margin for the US consumer discretionary, information technology, and communication services sector versus that of the remaining sectors. The chart underscores the points made by Chart II-4 in time series form, namely that the net increase in overall US profit margins since 2008 has been narrowly based. Chart II-9The US Profit Margin Expansion Has Been Driven By Broadly-Defined Tech Stocks Over a 6-12 month time horizon, the clear risk to US profit margins is an end to the COVID-19 pandemic. The profitability of broadly-defined tech stocks has surged during the pandemic, in response to a significant shift toward online goods purchases and elevated spending on tech equipment. A durable end to the pandemic is likely to reverse some of these spending patterns, which will likely weigh on margins for broadly-defined tech stocks. Chart II-10The Regulatory Risks Facing Big Tech Are Real Over the longer term, the risk is that extremely elevated profit margins are likely to increase the odds of regulatory action from Washington and invite competition. On the former point, our US Political Strategy service has highlighted that a bipartisan consensus in public opinion holds that Big Tech needs tougher regulation (Chart II-10), and this consensus grew substantially over the controversial 2020 political cycle.1 This regulatory pressure is currently best described as a “slow boil,” as not all surveys show strong majorities in favor of regulation, and Republicans and Democrats disagree on the aims of regulation.But the bottom line is that Big Tech is likely to remain in the hot seat after the various controversies of the pandemic and 2016-2020 elections, just as big banks faced tougher regulation in the wake of the subprime mortgage crisis. This underscores that a “slow boil” may turn into a faster one at some point over the secular horizon, which would very likely weigh on profit margins. Elevated tech sector profit margins makes regulatory action more likely because policymakers will perceive a stronger ability for these firms to weather a “regulatory shock.”On the latter point about competition, it is true that broadly-defined tech stocks follow a “platform” business model that will be difficult to supplant. These companies benefit from powerful network effects that have taken years to accrue, suggesting that they will not be rapidly replaced by competitors.Still, the experience of Microsoft in the years following its meteoric rise in the second half of the 1990s provides a cautionary tale for broadly-defined tech stocks today. In the late-1990s, it was difficult for investors to envision how Microsoft’s near-total product dominance of the PC ecosystem could ever be displaced, but it eventually lost market share due to the rise of mobile devices and their competing operating systems.In addition, Microsoft’s fundamental performance suffered even before the rise of the modern-day smartphone & mobile device market. Chart II-11 highlights the annualized components of Microsoft’s price return from 1999-2007 versus the late-1990s period, which underscores that changes in margins, changes in multiples, and stock price returns may be persistently negative in a scenario in which revenue growth slows (even if revenue growth itself remains positive).Chart II-11Microsoft Offers A Cautionary Tale For Dominant Business Models Some of the reversal of Microsoft’s fortunes during this period were self-inflicted, and the firm also suffered from an economy-wide slowdown in tech equipment spending as a result of the 2001 recession that persisted into the early years of the subsequent recovery. But the key point for investors is that company and sector dominance may wane, and the fact that broadly-defined tech sector profit margins are extremely elevated raises the risk that further increases may not materialize.Capital Structure And Index CompositionAs noted above, the beneficial impact from changes in capital structure and index composition for US equities has occurred due to the accretive impact of share buybacks on the EPS of US growth stocks, which has not been matched by growth stocks outside of the US.In our view, this accretive impact has occurred for two reasons. First, US growth stocks have taken advantage of historically low interest rates and leverage to shift their capital structure to be more debt-focused over the past 14 years. Second, this shift has been aided by the fact that US growth stocks have experienced stronger cash flows than their global peers, which have been used to service higher debt payments.However, Charts II-12 and II-13 suggest that this process may be in its late innings. Chart II-12 highlights that the US nonfinancial corporate sector debt service ratio (DSR) did indeed fall below that of the euro area following the global financial crisis, but that this reversed in 2016. At the onset of the pandemic, the US nonfinancial corporate sector DSR was rising sharply, and was approaching its early-2000 highs. During the pandemic, the corporate sector DSR has continued to rise in both regions, but this almost exclusively reflects a (temporary) decline in operating income, not a surge in corporate sector debt or a rise in interest rates.Not all of the pre-pandemic rise in the US corporate sector DSR was concentrated in broadly-defined tech stocks, but some of it likely was. The key point for investors is that the US nonfinancial corporate sector had a lower capacity to leverage itself relative to companies in the euro area at the onset of the pandemic, which implies a less accretive impact on relative earnings per share in the future. Chart II-13 reinforces this point by highlighting that the uptrend in relative cash flow for US growth stocks, versus global ex-US, appears to have ended in 2015. The uptrend has continued in per share terms, but this appears to be flattered by the impact of buybacks itself. Chart II-12Can The US Continue To Accrete EPS Through Stock Buybacks?  Chart II-13US Growth Companies Are No Longer Generating More Cash Than Their Global Peers  Admittedly, we see no basis to conclude that the persistent earnings dilution that has occurred in emerging markets over the past 14 years will end, or even slow, over the secular horizon. This underscores that emerging markets will need to generate stronger revenue growth to prevent the dilution effect from acting as a continued drag on EM vs. US equity performance, and it is an open question as to whether this will occur. Thus, for now, we have more conviction in the view that capital structure and index composition changes may contribute less to US equity outperformance versus developed markets ex-US over the coming several years.Equity MultiplesThere are three arguments against the idea that US equity multiples will continue to expand relative to those of global ex-US stocks. First, Chart II-14 highlights a point that we have made in previous Bank Credit Analyst reports, which is that aggressive multiple expansion in the US has now rendered US stocks to be the most dependent on low long-maturity bond yields than at any point since the global financial crisis. Chart II-14US Stocks Are The Most Dependent On Low Bond Yields In Over A Decade Over the coming 6- to 12-months, we strongly doubt that US 10-year Treasury yields will rise outside of the range that would be consistent with the US equity risk premium from 2002 to 2007 (discussed in further detail in the next section). But the chart also shows that this range is now clearly below trend nominal GDP growth, suggesting that higher interest rates on a structural basis may cause outright multiple contraction for US stocks. This is particularly true for growth stocks, which have been responsible for a significant portion of US equity outperformance, given their comparatively long earnings duration. Chart II-15US Multiples Are Not Justified By Higher Return On Equity Second, it has been often argued by some investors that a premium is warranted for US stocks given their comparatively high return on equity, but Chart II-15 highlights that this is not the case. The chart shows the relative price-to-book ratio for the US versus global and developed markets ex-US compared with regression-based predicted values based on relative return on equity. The chart clearly highlights that the US price-to-book ratio is meaningfully higher than it should be relative to global stocks, especially when compared to other developed markets. Versus DM ex-US, the only comparable period that saw a relative P/B – relative ROE deviation of this magnitude occurred in the late-1980s, when US stocks were meaningfully less expensive than relative ROE would have suggested. This relationship completely normalized in the years that followed, which would imply a substantial relative multiple contraction for US stocks over the coming several years were the gap shown in Chart II-15 to close.Third, Chart II-16 presents the share of US stock market capitalization accounted for by the largest 10% of stocks by size. The chart highlights that the concentration of US market capitalization has risen to an extreme level that has only been reached in two other cases over the past century. Historically, prior stock market concentration has been associated with future increases in the equity risk premium, underscoring that broadly-defined US tech sector concentration bodes poorly for future returns. Chart II-16The US Stock Market Is Now Extremely Concentrated The Foreign Exchange EffectAs a final point, Chart II-17 illustrates the degree to which US relative performance has meaningfully benefitted from a rise in the US dollar since 2008. The chart highlights that an equity market-weighted dollar index has risen 20% from its late-2007 level, which has boosted US common currency relative performance.The US dollar was arguably modestly undervalued just prior to the 2008/2009 global financial crisis, but Chart II-18 highlights that it is now meaningfully overvalued versus other major currencies. Over a multi-year horizon, this argues against further relative common currency gains for US stocks from the foreign exchange effect. Chart II-17The US Dollar Has Helped US Common Currency Performance...  Chart II-18…And Is Now Expensive  The Absolute Secular Return Outlook For US StocksOver a secular horizon, the most common method for forecasting equity returns is to predict whether earnings are likely to grow faster or slower than nominal potential GDP growth, and whether equity multiples are likely to rise or fall.For the reasons described above, we have no plausible basis on which to forecast that US profit margins are inclined to rise further over time given how extended they have become. This suggests that a reasonable long-term earnings forecast should be closely linked to one’s forecast for revenue growth. Chart II-19S&P 500 Revenue Is Low Relative To US GDP, And May Rise Over The Next Decade Chart II-19 presents S&P 500 revenue as a percent of nominal GDP, and underscores a fact that we noted above: revenue growth for US equities has underperformed US GDP since the global financial crisis. This undoubtedly has been linked to the fallout from the crisis and other exogenous shocks like the massive decline in energy prices in 2014/2015, which are unlikely to be repeated. Over the next ten years, the US Congressional Budget Office is forecasting nominal potential growth of roughly 4%; allowing for a potential rise in US equity revenue to GDP suggests that investors should expect earnings growth on the order of 4-5% per year over the coming decade, if extremely elevated profit margins are sustained. Chart II-20Multiples Seem To Predict Future Returns Well… Unfortunately for equity investors, there are slim odds that US equity multiples will continue to rise or even stay at their current level. Equity valuation has been shown to have nearly zero ability to predict stock returns over a 6-12 month time horizon or even over the following 3-5 years, but 10-year regressions relating current valuations on future 10-year compound returns tend to be highly predictive (Chart II-20). Utilizing this approach, today’s 12-month forward P/E ratio would imply a 10-year future total return of just 2.9% (Chart II-21). That, in turn, would imply a annual drag of 3-4% from multiple contraction over the coming decade, given our 4-5% earnings growth forecast and a historically average dividend yield of roughly 2%.One problem with the method shown in Charts II-20 and II-21 is the fact that the relationship between today’s P/E ratio and 10-year future returns captures more than the impact of potentially mean-reverting multiples. It also includes any correlation between the starting point of valuation and subsequent earnings growth, which is likely to be spurious. This effect turns out to be important: we can see in Chart II-21 that the strong fit of the relationship is influenced by the fact that the global financial crisis occurred roughly 10-years after the equity market bubble of the late-1990s. Chart II-21...But That Depends Heavily On The Tech Bubble / GFC Relationship Astute investors may infer a legitimate causal link between these two events, via too-easy monetary policy. But from the perspective of forecasting, predicting future returns based on prevailing equity multiples confusingly mixes together three effects: the relative timing of business cycles, the impact of changes in interest rates, and the potential mean-reverting nature of the equity risk premium.In order to disentangle these effects for the purposes of forecasting, we present a long-history estimate of the US equity risk premium based on Robert Shiller’s Irrational Exuberance dataset (Chart II-22). We define the equity risk premium as earnings per share (as reported) as a percent of the S&P 500, minus the real long-maturity interest rate. We calculate the real rate by subtracting the BCA adaptive inflation expectations model – essentially an exponentially smoothed version of actual inflation – from the nominal long-term bond yield. Chart II-22The US ERP Seems Normal Based On A Very Long Term History... The chart highlights that this estimate of the ERP is currently exactly in line with its median value since 1872. Chart II-23 presents essentially the same conclusion, based on data since 1979, using the forward operating P/E ratio for the S&P 500 and the same definition for real bond yields.This implies that, if interest rates were at equilibrium levels, investors would have a reasonable basis to conclude that equity multiples would be unchanged over a secular investment horizon. However, as we have highlighted several times in previous reports, long-maturity government bond yields are likely well below equilibrium levels. Chart II-24 highlights that long-maturity US government bond yields have not been this low relative to trend growth since the late-1970s. Chart II-23...And Based On The Forward Earnings Yield Over The Past Four Decades  Chart II-24Interest Rates Are Well Below Equilibrium, And Are Likely To Rise Over Time  We presented in an April report why a gap between interest rates and trend rates of growth was indeed justified for a few years following the global financial crisis, but that a decline in the equilibrium real rate of interest (“r-star”) only appeared to be permanent due to persistent, non-monetary policy shocks to aggregate demand that occurred over the course of the last economic cycle.2In a scenario where the US output gap turns positive, inflation rises modestly above target, and where permanent damage to the labor market from the pandemic is relatively limited over the coming 6-18 months, it seems reasonable to conclude that the narrative of secular stagnation may ultimately be challenged and that investor expectations for the neutral rate may converge toward trend rates of economic growth. This would weigh on equity multiples, and thus lower equity total returns from the 6-7% implied by our earnings forecast and income return assumption. Chart II-25US Stocks Are Likely To Earn Annual Total Returns Between 1.8-4.7% Over The Next Decade Were real long-maturity bond yields to rise by 100-200bps over the coming decade, this would imply annualized total returns of between 1.8 - 4.7% from US stocks, assuming 4-5% annual revenue growth, flat profit margins, a constant 2% dividend yield, and a constant ERP (Chart II-25). While this would beat the returns offered by bonds, implying that investors should still be structurally overweight equities versus fixed-income assets, it would also fall meaningfully short of the average pension fund return objective (Chart II-26), as well as the absolute return goals of many investors. Chart II-26Future Returns From US Stocks Will Greatly Disappoint Investors Investment Conclusions Chart II-27Over The Coming Year, Favor Value And Global Ex-US Stocks Over the coming 6-12 months, our view that 10-year US Treasury yields are likely to rise supports an overweight stance toward value versus growth stocks. Chart II-27 highlights that the underperformance of growth argues for an underweight stance toward US stocks within a global equity portfolio, especially versus developed markets ex-US.Over a longer-term horizon, there are two key investment implications from our research. First, the risks that we have highlighted to the sources of US outperformance over the past 14 years suggests that investors should not bank on a continuation of this trend over the next decade. We have not made the case in this report for the outperformance of global ex-US stocks, merely that the continued outperformance of US stocks now rests on an unreliable foundation. This may suggest that US relative performance will be flat over the structural horizon, arguing for a neutral strategic allocation. But even the cessation of US outperformance would be a significant development, as it would end the most consequential trend in regional equity performance in the post-GFC era.Second, investors should expect meaningfully lower absolute returns from US stocks over the next decade than what they have earned since 2008/2009, barring a continued rise in the already stretched profit margins of broadly-defined tech stocks. A structurally overweight stance is still warranted toward equities versus fixed-income, but even a 100% equity allocation is unlikely to meet investor return expectations in the high single-digits. As a consequence, global investors should be prepared to accept more volatility in order to reduce the gap between expected and desired returns, and should look towards riskier investments and asset classes (such as real estate and alternative investments) as potential portfolio return enhancements.Jonathan LaBerge, CFAVice PresidentThe Bank Credit AnalystFootnotes1  Please see US Political Strategy "Forget Biden's Budget," dated June 2, 2021, available at usps.bcaresearch.com2  Please see The Bank Credit Analyst “R-star, And The Structural Risk To Stocks,” dated March 31, 2021, available at bca.bcaresearch.com

Bank Credit Analyst

Highlights The global fight against the Delta variant of COVID-19 continued to show progress in the month of September, but not without cost. Growth in services activity slowed meaningfully, which has likely delayed the return to potential output in the US until March of next year (at the earliest). However, even with this revised timeline, maximum employment remains a very possible outcome by next summer, barring a further extension of the pandemic in advanced economies. In this regard, the Fed’s likely decision at its next meeting to taper the rate of its asset purchases makes sense and is consistent with a first rate hike in the second half of 2022. The rise in long-maturity bond yields following this month’s Fed meeting is consistent with the view that 10-year Treasurys are overvalued and that yields will trend higher over the coming year. Fixed-income investors should stay short duration. The degree to which global shipping costs are being driven by the forces of supply versus demand will affect the Fed's criteria for liftoff next year, via changes in goods prices as well as consumer expectations for inflation. In our view, a detailed examination of shipping prices over the past 18 months points to a future pace of inflation that is not dangerously above-target, but does meet the Fed’s liftoff criteria. A mix-shift in consumer spending, away from goods and toward services, is not a threat to economic activity or S&P 500 earnings – so long as the decline in the former is not outsized relative to the rise in the latter. It will, however, disproportionately impact China, and could be the trigger for meaningful further easing by Chinese policymakers. In the interim, a catalyst for EM stocks may remain elusive. We continue to recommend an overweight stance toward value versus growth stocks and global ex-US versus the US, particularly in favor of developed markets ex-US. Investors should remain cyclically overweight stocks versus bonds, although it is possible that both assets will post negative returns for a short period at some point over the coming 12 months in response to higher long-maturity bond yields. Still, we expect both stock prices and the stock-to-bond ratio to be higher a year from today. Feature The global fight against the Delta variant of COVID-19 continued to show progress in the month of September. Chart I-1 highlights that an estimate of the reproduction rate of the disease in developed economies has fallen below one, and the weekly change in hospitalizations in both the US and UK – the two countries at the epicenter of the Delta wave that have not reintroduced widespread COVID-19 control measures – have fallen back into negative territory. In addition, we estimate that approximately 6% of the world’s population received vaccines against COVID-19 in September, with now 45% of the globe having received a first dose and 33% now fully vaccinated. Pfizer’s announcement last week that it has found a “favorable safety profile and robust neutralizing antibody responses” from its vaccine trial in children five to eleven years of age suggests that the FDA may grant emergency use authorization within weeks, which would likely raise the vaccination rate in the US (and ultimately other advanced economies) by at least 5 percentage points in fairly short order. This would also further reduce the impact of school/classroom closures on the labor market, via both an increased participation rate and increased hiring in the education sector. This fight, however, has not been without cost. US jobs growth slowed significantly in August, manufacturing and services PMIs continued to slow in September, and, as Chart I-2 highlights, the normalization in transportation use that was well underway in the first half of the year has clearly inflected in both the US and UK in response to the spread of Delta. Consensus market expectations for Q3 growth have been cut in the US, and to a lesser extent in the euro area, and the Fed reduced its forecast for 2021 real GDP growth from 7% to 5.9% following the September FOMC meeting. Chart I-1The Delta Wave Continues To Abate... Chart I-2...But At A Cost To Economic Activity   The Path Toward Eventually Tighter Monetary Policy It has been surprising to some investors that the Fed has moved forward with their plans to taper the rate of its asset purchases against this backdrop of slowing near-term growth – an event that now seems likely to occur at its next meeting barring a disastrous September payroll report. In our view, this is not especially surprising, given that the Fed has expressed a desire for net purchases to reach zero before they raise interest rates for the first time. Chair Powell noted during last week’s press conference that FOMC participants felt a “gradual tapering process that concludes around the middle of next year is likely to be appropriate”, underscoring that the Fed wants the flexibility to raise interest rates in the second half of next year. The timing of the first Fed rate hike is entirely subject to the evolution of the economic data over the next year, and is not, in any way, calendar-based. But we presented in last month's Special Report why the Fed’s maximum employment criteria may be met as early as next summer,1 and the Fed’s projections for the pace of tapering are consistent with our analysis. Chart I-3Maximum Employment Remains A Very Possible Outcome By Next Summer The Fed’s most recent Summary of Economic Projections (“SEP”) also seemingly confirmed Fed Vice Chair Richard Clarida’s view that a 3.8% unemployment rate is consistent with maximum employment, barring any issues with the “breadth and inclusivity” of the labor market recovery. We noted in last month’s report that these issues are unlikely in a scenario where jobs growth is sufficiently high to bring down the unemployment rate below 4%. Chart I-3 highlights that both the Fed’s forecast and Bloomberg consensus expectations imply a closed output gap by March, even after factoring in the near-term impact of the Delta variant. Consequently, maximum employment remains a very possible outcome by next summer, barring a further extension of the pandemic in advanced economies. Long-maturity bond yields rose following the Fed meeting, which is also not especially surprising given how low yields have fallen relative to the fair value implied by the Fed’s SEP forecasts even assuming a December 2022 initial rate hike. Chart I-4 highlights that the fair value of the 10-year Treasury yield today is roughly 2% using this approach, rising to 2.15% by next summer. Ironically, the September SEP update modestly lowered the fair value shown in Chart I-4 relative to what would otherwise have been the case, as it implied that the Fed is expecting to raise interest rates at a pace of approximately three hikes per year – rather than the four that prevailed prior to the pandemic. Investors should also note that the fair value for the 10-year yield is nontrivially lower based on market participant and primary dealer estimates of the terminal Fed funds rate (also shown in Chart I-4), although they still imply that long-maturity yields should trend higher over the coming year. Global Trade, Inflation, And The Fed A return to maximum employment will likely signal the onset of monetary policy tightening, as long as the Fed's inflation criteria for liftoff have been met. For now, inflation is signaling a green light for hikes next year, even after excluding the prices of COVID-impacted services and cars (Chart I-5). In fact, more recently, CPI ex-direct COVID effects has been pointing in the “non-transitory” direction, which continues to prompt questions from investors about whether the Fed will be forced to hike earlier than it currently expects for reasons other than a return to maximum employment. Chart I-4US Long-Maturity Bond Yields Are Set To Move Higher Over The Coming Year Chart I-5For Now, Inflation Is Signaling A Green Light For Hikes Next Year   At least some portion of the current pace of increase in consumer goods prices is tied to surging import costs, which have run well in-excess of what would be predicted by the relationship with the US dollar (Chart I-6). This, in turn, is being driven by an explosion in shipping costs that has occurred since the onset of the pandemic, which is being driven both by demand and supply-side factors (Chart I-7). Chart I-6US CPI Is Being Affected By Surging Import Prices... Chart I-7...Which Are Being Driven By An Explosion In Shipping Costs   The degree to which global shipping costs are being driven by the forces of supply versus demand will affect the Fed's criteria for liftoff next year, via changes in goods prices as well as consumer expectations for inflation. To the extent that demand side factors are mostly responsible, investors should have higher confidence that the recent surge in consumer prices is transitory, because a shift away from above-trend goods spending and toward below-trend services spending is likely over the coming year. If supply-side factors are mostly responsible, then it is conceivable that the global supply chain impact on consumer goods prices will persist for longer than would otherwise be the case, potentially raising the odds of a larger or more sustained rise in inflation expectations. In our view, a detailed examination of shipping prices over the past 18 months points to a mix of both demand and supply effects, even since the beginning of 2021. However, as we highlight below, several facts point toward the view that supply-side factors will be the dominant driver over the coming year, and that they are more likely to exert a disinflationary/deflationary rather than inflationary effect: Chart I-8 breaks down the cumulative change in the overall Freightos Baltic Index by route since December 2019. The chart makes it clear that shipping costs from China/East Asia to the West Coast of the US have risen far more than any other route, underscoring that US demand for goods has been an important part of the rise in shipping costs. Chart I-8US Demand For Goods Is An Important Part Of The Shipping Cost Story Chart I-9US Goods Spending Has Clearly Been Boosted By US Fiscal Policy Chart I-9 shows the level of real US personal consumption expenditures on goods relative to its pre-pandemic trendline, underscoring both that goods spending is currently well-above trend, and that there have been two distinct phases of rising goods spending: from May to October 2020 following the passage of the CARES act, and from January to March 2021 following the December 2020 extension of UI benefits and in anticipation of the passage of the American Rescue Plan. Since March, US real goods spending has trended lower, a pattern that we expect will continue over the coming year. Chart I-10 highlights that while the global supply chain struggled heavily last year in response to surging demand and the lagging effects of labor shortages and factory shutdowns during the earliest phase of the pandemic, there were some signs of supply-side normalization in the first half of 2021. The chart highlights that the number of ships at anchor at the Los Angeles and Long Beach ports declined meaningfully from February to June, and global shipping schedule reliability tentatively improved in March. The chart also shows that shipping costs from China/East Asia to the West Coast of the US continued to rise in Q2 seemingly as a lagged response to the Jan-Mar rise in goods spending, but they were still low at the end of June compared to today’s levels. Chart I-10Supply-Side Factors Seem To Have Driven A Majority Of This Year's Increase In Shipping Costs In Q3, circumstances drastically changed. Shipping costs between China/East Asia to the West Coast of the US rapidly doubled, and the number of ships at anchor at the LA/LB ports exploded well past its peak in early February. This rise in China/US shipping costs since late-June has accounted for nearly 60% of the cumulative rise since the pandemic began, and cannot be attributed to increased demand. Instead, the increase in prices and the surge in port congestion in Q3 appears to have been caused by the one-month closure of the Port of Yantian that began in late-May, in response to an outbreak of COVID-19 in Guangdong province. Yantian is the fourth largest port in the world and exports a sizeable majority of global electronics given its close proximity to Shenzhen, underscoring the impact that its closure likely had on an already bottlenecked logistical system. There are two key points emanating from our analysis of global shipping costs. First, demand has been an important effect driving costs higher, but it does not appear to have driven most of the increase in shipping costs this year. Still, over the coming year, goods demand in advanced economies is likely to wane as consumer spending shifts from goods to services spending, which will help ease clogged global trade channels and lower shipping costs. Second, the (brief) evidence of supply-side normalization in the first half of 2021, when consumer demand was actually strengthening, suggests that the supply-side of the global trade system will turn disinflationary over the coming year if further COVID-related labor market shocks can be avoided. What does this mean for the Fed and the prospect of monetary policy tightening next year? In our view, the combination of a positive output gap, stable but normalized inflation expectations, and disinflation (or outright deflation) in COVID-related goods and services (including import prices) is likely to lead to a pace of inflation that meets the Fed’s liftoff criteria. Chart I-11 highlights that important longer-term inflation expectations measures have recently been well-behaved, despite a surge in actual inflation and shorter-term expectations for inflation. Aided by disinflation/deflation in certain high-profile COVID-related goods and services prices, this argues against meaningful upside risks to inflation. However, the current level of long-term expectations and the fact that the output gap is set to turn positive in the first half of next year argues against the notion that inflation will fall below target outside of COVID-related effects. As such, we continue to expect that the Fed will raise interest rates next year, potentially as early as next summer, driven by the progress towards maximum employment. Spending Shifts And The Equity Market We noted above, and in previous reports, that consumer spending in advanced economies is likely to continue to shift away from goods and toward services over the coming year. This raises the question of whether a contraction in goods spending will weigh disproportionately on the economy and equity earnings, given the close historical correlation between manufacturing activity and the business cycle. Chart I-12 illustrates this risk: in a hypothetical scenario in which real goods spending were to return to the trendline shown in Chart I-9 by March of next year, it would contract on the order of 10% on a year-over-year basis, on par with what occurred last year and vastly in excess of what even normally occurs during a recession. Chart I-11Longer-Term Inflation Expectations Remain Well-Behaved Chart I-12A Contraction In Goods Spending Is Likely Over The Coming Year   Chart I-12 is a hypothetical scenario and not a forecast, as there is some evidence that consumers are currently deferring durable goods purchases on the expectation that prices will become more favorable. In addition, a positive output gap next year implies that goods spending may settle above its pre-pandemic trendline. Nevertheless, the prospect of a potentially significant slowdown in goods spending has unnerved some investors, even given the prospect of improved services spending. Chart I-13highlights that this fear is understandable given how the US economy normally behaves. The top panel of the chart shows the year-over-year contribution to real GDP growth from real goods and services spending, and the bottom panel shows these contributions in absolute terms to better illustrate their relative magnitudes. The chart makes it clear that goods spending is normally a more forceful driver of economic activity than is the case for services spending, which ostensibly supports concerns that a significant slowdown in the former may be destabilizing for overall activity. Chart I-13Normally, Goods Spending Predominantly Drives Activity. Not This Cycle. However, Chart I-13 also highlights that the magnitude of the recent contribution to growth from services spending has been absolutely unprecedented in the post-WWII economic environment. This is not surprising given the nature of the COVID-19 pandemic, but it is important because it underscores that investors should not rely excessively on typical rules of thumb about how modern economies tend to function over the course of the business cycle. In terms of the impact on overall economic activity, investors should focus on the net impact of goods plus services spending. It is certainly possible that the former will slow at a pace that is not fully compensated by the latter, but our sense is that this is not likely to occur barring a further extension of the pandemic in advanced economies. Chart I-14Over The Past 5 Years, S&P 500 Sales Have Been More Correlated With Services Than Goods Spending Chart I-14 presents a similar conclusion for the US equity market. The chart highlights the historical five-year correlation between the quarterly growth of nominal spending and S&P 500 sales per share. The chart shows that S&P 500 revenue was more sensitive to goods versus services spending prior to the 1990s, when the US was more manufacturing-oriented and goods were more likely to be produced domestically than is the case today. Another gap in the correlation emerged following the global financial crisis when the US household sector underwent several years of deleveraging. But over the past five years, Chart I-14 highlights that S&P 500 revenue growth has actually been more strongly correlated with US services spending than goods spending. Some of this increased correlation might reflect technology-related services spending which could suffer in a post-pandemic environment, but the bottom line from Chart I-14 is that there is not much empirical support for the view that US equity fundamentals will be disproportionately impacted by a slowdown in goods spending, so long as services spending rises in lockstep. China: Exacerbating An Underlying Trend Chart I-15China Will Be Disproportionately Affected By Slowing DM Goods Spending China, on the other hand, will be disproportionately affected by slower goods spending in advanced economies, because its exports have disproportionately benefited from the surge in spending on goods over the past year. Chart I-15 highlights that Chinese export volume growth has exploded this year, and that current export growth is running at a pace of 10% in volume terms – significantly higher than has been the case on average over the past decade. Several problems in China have been in the headlines over the past few months: a regulatory crackdown by Chinese authorities on new economy companies, the situation with Evergrande and, more recently, power shortages that have forced factories in several key manufacturing hubs to curtail production as a result of China’s ban on coal imports from Australia (Chart I-16). However, the key point for investors is that these are not truly new risks to China’s growth outlook; rather, they are developments that have the potential to magnify the impact of an already established trend: the ongoing slowdown in China’s economy that has clearly been caused by a decline in its credit impulse (Chart I-17). In turn, China’s decelerating credit impulse has been caused by tighter regulatory and monetary policy. Chart I-16Power Outages: The Latest Negative Headline From China Chart I-17China Is Slowing Because Policymakers Have Tightened   BCA’s China Investment Strategy service has provided a detailed analysis of the ongoing Evergrande saga.2 In short, our view is that the government will likely restructure Evergrande’s debt to prevent the company’s crisis from evolving into a systemic financial risk. As such, Beijing may rescue the stakeholders of Evergrande, but likely not its shareholders. However, in terms of stimulating the broader economy, it is still not clear that Chinese policymakers are willing to engage in more than gradual or piecemeal stimulus, given a higher pain threshold for a slower economy and a lower appetite for leverage. This may change once Chinese export growth slows in response to a shift in DM spending from goods to services, as policymakers will no longer be able to rely on the external sector for support. This potentially offsetting nature of eventual Chinese stimulus and global goods spending underscores both the importance of a normalization in DM services spending as an impulse for global growth, as well as the fact that a catalyst for EM stocks may remain elusive over the tactical horizon. Investment Conclusions In Section 2 of this month’s report, we explain why the performance of US stocks may be flat versus their global peers over a structural time horizon. We also highlighted that US stocks are likely to earn low annualized total returns over the coming 10 years (between 1.8 - 4.7%), which would fall well short of the absolute return goals of many investors. Chart I-18Losses From Both Stocks And Bonds Are Rare, But Are Linked To Higher Rates Over the coming 6-12 month time horizon, we continue to recommend an overweight stance towards value vs. growth stocks and global ex-US vs. US, particularly in favor of developed markets ex-US. The relative performance of value vs. growth stocks is likely to benefit from the transition to a post-pandemic state and a rise in long-maturity bond yields, as monetary policy shifts towards the point of tightening. Regional equity trends have been closely correlated with style over the past two years, and the underperformance of growth strongly implies US equity underperformance. From an asset allocation perspective, investors should remain overweight stocks versus bonds over the coming year, although it is possible that both assets will post negative returns for a short period at some point over the coming 12 months. Chart I-18 highlights that outside of the context of recessions, months with negative returns from both stocks and long-maturity bonds are quite rare, but they tend to be associated with periods of monetary policy tightening (or in anticipation of such periods). Fundamentally, we do not see a rise in bond yields to any of the levels shown in Chart I-4 as being threatening to economic growth or necessarily implying lower equity market multiples. But the speed of adjustment in bond yields could unnerve equity investors, and there are open questions as to how far the equity risk premium can fall before T.I.N.A. – “There Is No Alternative” – becomes a less persuasive argument. As such, we would not rule out a brief correction in stocks at some point over the coming several months, but we expect both stock prices and the stock-to-bond ratio to be higher a year from today. Jonathan LaBerge, CFA Vice President The Bank Credit Analyst September 30, 2021 Next Report: October 28, 2021 II. The “Invincible” US Equity Market: The Longer-Term Outlook For US Stocks In Relative And Absolute Terms Since 2008, US equity outperformance versus global ex-US stocks has not been driven by stronger top-line growth. Instead, it has been caused by a narrowly-based increase in profit margins, the accretive impact of share buybacks on the EPS of US growth stocks, and an outsized expansion in equity multiples. To a lesser extent, the dollar has also boosted common currency relative performance. There are significant secular risks to these sources of US equity outperformance over the past 14 years. Elevated tech sector profit margins are likely to lead to increased competition and higher odds of regulatory action, leveraging has reduced the ability of US companies to continue to accrete EPS through changes to capital structure, relative multiples are not justified by relative ROE, and the US dollar is expensive and is likely to fall over a multi-year horizon. In absolute terms, we forecast that US stocks will earn annualized nominal total returns of between 1.8 - 4.7% over the coming decade, assuming 4-5% annual revenue growth, flat profit margins, a constant 2% dividend yield, and a constant equity risk premium. Long-maturity bond yields are below their equilibrium levels and are likely to rise in real terms over time, which will weigh on elevated equity multiples. Over the coming 6-12 months, our view that US 10-Year Treasury yields are likely to rise argues for an underweight stance toward growth versus value stocks. In turn, this implies that US stocks will underperform global stocks, especially versus developed markets ex-US. The risks that we have highlighted to the sources of US outperformance suggest that US stocks may be flat versus their global peers over the long-term, arguing for a neutral strategic allocation. It also suggests that investors should be prepared to accept more volatility in order to reduce the gap between expected and desired returns, and should look towards riskier investments and asset classes (such as real estate and alternative investments) as potential portfolio return enhancements. Chart II-1The US Has Massively Outperformed Other Equity Markets Since The Global Financial Crisis The US equity market has vastly outperformed its peers since the 2008/2009 global financial crisis. Chart II-1 highlights that an investment in US stocks at the end of 2007 is now worth over 4 times the invested amount, versus approximately 1.6 times for global ex-US stocks (when measured in US dollar terms). The chart also shows that USD-denominated total returns have been roughly the same for developed markets ex-US as they have been for emerging markets, highlighting the exceptional nature of US equities. In this report we provide a deep examination of the sources of US equity performance, their likely sustainability, and what this implies for long-term investor return expectations. US stocks have not outperformed because of stronger top-line (i.e. revenue) growth, and instead have benefitted from a narrowly-based increase in profit margins, active changes to capital structure that have benefitted stockholders, an outsized expansion in equity multiples relative to global stocks, and a structural appreciation in the US dollar. We conclude that there are significant risks to all of these sources of outperformance, and that a neutral strategic allocation to US equities is now likely warranted. We also highlight that, while a strategic overweight stance is still warranted toward stocks versus bonds, investors should no longer count on US stocks to deliver returns that are in line with or above commonly-cited absolute return expectations. This argues for a greater tolerance of volatility, and the pursuit of riskier investments and asset classes (such as real estate and alternative investments) as potential portfolio return enhancements. A Deep Examination Of US Outperformance Since 2008 Breaking down historical total return performance is the first step in judging whether US equities are likely to outperform their global ex-US peers on a structural basis. Below we deconstruct US and global total return performance over the past 14 years into six different components, and analyze the impact of some of these components on a sector-by-sector basis. The six components presented are: Total revenue growth for each equity market, in local currency terms The change in profit margins The impact of changes in capital structure and index composition The change in the trailing P/E ratio The income return from dividends The impact of changes in foreign exchange The sum of the first three factors explains the total growth in earnings per share over the period, and the addition of the fourth factor explains each market’s local currency price return. Income returns are added to explain total return over the period, with the sixth factor then explaining common currency total return performance. The FX effect for US stocks is zero by construction, given that we measure common currency performance in US$ terms. Chart II-2Strong US Returns Have Not Been Due To Strong Top Line Growth Chart II-2 presents the annualized absolute impact of these factors for the MSCI US index since 2008. The chart highlights that U.S. stock prices have earned roughly 11% per year in total return terms over the past 14 years, with significant contributions from revenue growth, multiple expansion, margins, and the return from dividends. Interestingly, however, Chart II-3 highlights that US equities have not significantly outperformed on the basis of the first factor, total local currency revenue growth, at least relative to overall global ex-US stocks (see Box II-1 for more details). DM ex-US stocks have experienced very weak revenue growth since 2008, but this has been compensated for by outsized EM revenue growth. It is also notable that US revenue growth has actually underperformed US GDP growth over the period, dispelling the notion that US equity outperformance has been due to strong top-line effects. Chart II-3The US Has Outperformed Due To Margins, Capital Structure, Multiples, And The Dollar Box II-1 Proxying The Impact Of Changes In Shares Outstanding We proxy the impact of changes in shares outstanding (and thus the impact of equity dilution / accretion) by dividing each index’s market capitalization by its stock price. This measure is not a perfect proxy, as changes in index composition (such as the addition/deletion of index constituents) will change the index’s market capitalization but not its stock price. We also calculate total revenue for each market by multiplying local currency sales per share by the market cap / stock price ratio, meaning that the total revenue growth figures shown in Chart II-3 should best be viewed as estimates that in some cases reflect index composition effects. However, Chart II-B1 highlights that adjusting the market cap / stock price ratio for the number of firms in the index does not meaningfully change our overall conclusions. This approach would imply a larger dilution effect for DM ex-US than suggested in Chart II-3, and a smaller effect for emerging markets (due to a significant rise in the number of EM index constituents since 2008). In addition, global ex-US revenue growth is modestly lower than US revenue growth when using this approach. But this gap would account for a fraction of US equity outperformance over the period, underscoring that the US has massively outperformed global ex-US stocks due to margin, capital structure, and multiple expansion effects. Chart II-B1The US Has Not Meaningfully Outperformed Due To Revenue Growth, No Matter How You Slice It Chart II-3 also highlights that global ex-US stocks have modestly outperformed the US in terms of the fifth factor, the income return from dividends. This has almost offset the negative FX return (the sixth factor) from a net rise in the US dollar over the period. What is clear from the chart is that the second, third, and fourth factors explain almost all of the difference in total return between US and global ex-US stocks since 2008. The US experienced a significant increase in profit margins versus a modest contraction for global ex-US, a modest fillip from changes in capital structure and index composition versus a substantial drag for ex-US stocks, and a sizable rise in equity multiples that has outpaced what has occurred around the globe in response to structurally lower interest rates. Chart II-4US Margin Outperformance Has Been Narrowly-Based The significant rise in aggregate US profit margins over the past 14 years has often been attributed to the strong competitiveness of US companies, but Chart II-4 highlights that the aggregate change mostly reflects a narrow sector composition effect. The chart shows the change in US and global ex-US profit margins by level 1 GICS sector since 2008, and underscores that overall profit margins outside of the US have fallen mostly due to lower oil prices. Conversely, in the US, profit margins have substantially risen in only three out of ten sectors: health care, information technology, and communication services. Chart II-5 highlights that global ex-US equity multiples have risen in a majority of sectors since 2008, but not by the same magnitude as what has occurred in the US. De-rating in the resource sector partially explains the gap, but stronger US multiple expansion in the heavily-weighted consumer discretionary, information technology, and communication services sectors appears to explain most of the gap in multiple expansion. Chart II-5Multiples Have Risen Globally, But More So For Broadly-Defined US Tech Stocks Finally, Charts II-6 & II-7 highlights that there has been a strong growth versus value dimension to the impact of changes in capital structure and index composition on regional equity performance. The charts show that equity dilution and other changes to index composition have caused a similar drag on the returns from value stocks in the US and outside the US. However, the charts also highlight that the more important effect has been the accretive impact of share buybacks on the EPS of US growth stocks, which has not been matched by growth stocks outside of the US. As noted in Box II-1, part of this gap may be explained by an increase in the number of companies included in the MSCI Emerging Markets index, but Chart II-8 highlights that the global ex-US ratio of market capitalization to stock price has still risen significantly over the past 14 years, in contrast to that of the US even after controlling for the number of index components. Chart II-6There Has Been A Strong Style Dimension… Chart II-7…To The Impact Of Changes In Capital Structure And Index Composition Chart II-8The Accretive Impact Of US Growth Stock Buybacks Has Not Been Matched Globally The bottom line for investors is that there have been multiple factors contributing to US equity outperformance since 2008, but aggregate top-line growth has not been one of them. Broadly-defined technology companies (including media & entertainment and internet retail firms) have been responsible for nearly all of the relative rise in profit margins and most of the relative expansion in multiples over the past 14 years, and US growth stocks have benefitted from the accretive impact of share buybacks to a larger degree than what has occurred globally. The Relative Secular Return Outlook For US Stocks We present below several structural risks to the continued outperformance of US equities for the factors that have been most responsible for this performance over the past 14 years. In some cases, these risks speak to the potential for US outperformance to end, not necessarily that the US will underperform. But even the cessation of US outperformance along one or more of these factors would be significant, as it would imply a potential inflection point in the most consequential trend in regional equity performance since the 2008/2009 global financial crisis. Profit Margins Chart II-9 presents the 12-month trailing combined profit margin for the US consumer discretionary, information technology, and communication services sector versus that of the remaining sectors. The chart underscores the points made by Chart II-4 in time series form, namely that the net increase in overall US profit margins since 2008 has been narrowly based. Chart II-9The US Profit Margin Expansion Has Been Driven By Broadly-Defined Tech Stocks Over a 6-12 month time horizon, the clear risk to US profit margins is an end to the COVID-19 pandemic. The profitability of broadly-defined tech stocks has surged during the pandemic, in response to a significant shift toward online goods purchases and elevated spending on tech equipment. A durable end to the pandemic is likely to reverse some of these spending patterns, which will likely weigh on margins for broadly-defined tech stocks. Chart II-10The Regulatory Risks Facing Big Tech Are Real Over the longer term, the risk is that extremely elevated profit margins are likely to increase the odds of regulatory action from Washington and invite competition. On the former point, our US Political Strategy service has highlighted that a bipartisan consensus in public opinion holds that Big Tech needs tougher regulation (Chart II-10), and this consensus grew substantially over the controversial 2020 political cycle.3 This regulatory pressure is currently best described as a “slow boil,” as not all surveys show strong majorities in favor of regulation, and Republicans and Democrats disagree on the aims of regulation. But the bottom line is that Big Tech is likely to remain in the hot seat after the various controversies of the pandemic and 2016-2020 elections, just as big banks faced tougher regulation in the wake of the subprime mortgage crisis. This underscores that a “slow boil” may turn into a faster one at some point over the secular horizon, which would very likely weigh on profit margins. Elevated tech sector profit margins makes regulatory action more likely because policymakers will perceive a stronger ability for these firms to weather a “regulatory shock.” On the latter point about competition, it is true that broadly-defined tech stocks follow a “platform” business model that will be difficult to supplant. These companies benefit from powerful network effects that have taken years to accrue, suggesting that they will not be rapidly replaced by competitors. Still, the experience of Microsoft in the years following its meteoric rise in the second half of the 1990s provides a cautionary tale for broadly-defined tech stocks today. In the late-1990s, it was difficult for investors to envision how Microsoft’s near-total product dominance of the PC ecosystem could ever be displaced, but it eventually lost market share due to the rise of mobile devices and their competing operating systems. In addition, Microsoft’s fundamental performance suffered even before the rise of the modern-day smartphone & mobile device market. Chart II-11 highlights the annualized components of Microsoft’s price return from 1999-2007 versus the late-1990s period, which underscores that changes in margins, changes in multiples, and stock price returns may be persistently negative in a scenario in which revenue growth slows (even if revenue growth itself remains positive). Chart II-11Microsoft Offers A Cautionary Tale For Dominant Business Models Some of the reversal of Microsoft’s fortunes during this period were self-inflicted, and the firm also suffered from an economy-wide slowdown in tech equipment spending as a result of the 2001 recession that persisted into the early years of the subsequent recovery. But the key point for investors is that company and sector dominance may wane, and the fact that broadly-defined tech sector profit margins are extremely elevated raises the risk that further increases may not materialize. Capital Structure And Index Composition As noted above, the beneficial impact from changes in capital structure and index composition for US equities has occurred due to the accretive impact of share buybacks on the EPS of US growth stocks, which has not been matched by growth stocks outside of the US. In our view, this accretive impact has occurred for two reasons. First, US growth stocks have taken advantage of historically low interest rates and leverage to shift their capital structure to be more debt-focused over the past 14 years. Second, this shift has been aided by the fact that US growth stocks have experienced stronger cash flows than their global peers, which have been used to service higher debt payments. However, Charts II-12 and II-13 suggest that this process may be in its late innings. Chart II-12 highlights that the US nonfinancial corporate sector debt service ratio (DSR) did indeed fall below that of the euro area following the global financial crisis, but that this reversed in 2016. At the onset of the pandemic, the US nonfinancial corporate sector DSR was rising sharply, and was approaching its early-2000 highs. During the pandemic, the corporate sector DSR has continued to rise in both regions, but this almost exclusively reflects a (temporary) decline in operating income, not a surge in corporate sector debt or a rise in interest rates. Not all of the pre-pandemic rise in the US corporate sector DSR was concentrated in broadly-defined tech stocks, but some of it likely was. The key point for investors is that the US nonfinancial corporate sector had a lower capacity to leverage itself relative to companies in the euro area at the onset of the pandemic, which implies a less accretive impact on relative earnings per share in the future. Chart II-13 reinforces this point by highlighting that the uptrend in relative cash flow for US growth stocks, versus global ex-US, appears to have ended in 2015. The uptrend has continued in per share terms, but this appears to be flattered by the impact of buybacks itself. Chart II-12Can The US Continue To Accrete EPS Through Stock Buybacks? Chart II-13US Growth Companies Are No Longer Generating More Cash Than Their Global Peers   Admittedly, we see no basis to conclude that the persistent earnings dilution that has occurred in emerging markets over the past 14 years will end, or even slow, over the secular horizon. This underscores that emerging markets will need to generate stronger revenue growth to prevent the dilution effect from acting as a continued drag on EM vs. US equity performance, and it is an open question as to whether this will occur. Thus, for now, we have more conviction in the view that capital structure and index composition changes may contribute less to US equity outperformance versus developed markets ex-US over the coming several years. Equity Multiples There are three arguments against the idea that US equity multiples will continue to expand relative to those of global ex-US stocks. First, Chart II-14 highlights a point that we have made in previous Bank Credit Analyst reports, which is that aggressive multiple expansion in the US has now rendered US stocks to be the most dependent on low long-maturity bond yields than at any point since the global financial crisis. Chart II-14US Stocks Are The Most Dependent On Low Bond Yields In Over A Decade Over the coming 6- to 12-months, we strongly doubt that US 10-year Treasury yields will rise outside of the range that would be consistent with the US equity risk premium from 2002 to 2007 (discussed in further detail in the next section). But the chart also shows that this range is now clearly below trend nominal GDP growth, suggesting that higher interest rates on a structural basis may cause outright multiple contraction for US stocks. This is particularly true for growth stocks, which have been responsible for a significant portion of US equity outperformance, given their comparatively long earnings duration. Chart II-15US Multiples Are Not Justified By Higher Return On Equity Second, it has been often argued by some investors that a premium is warranted for US stocks given their comparatively high return on equity, but Chart II-15 highlights that this is not the case. The chart shows the relative price-to-book ratio for the US versus global and developed markets ex-US compared with regression-based predicted values based on relative return on equity. The chart clearly highlights that the US price-to-book ratio is meaningfully higher than it should be relative to global stocks, especially when compared to other developed markets. Versus DM ex-US, the only comparable period that saw a relative P/B – relative ROE deviation of this magnitude occurred in the late-1980s, when US stocks were meaningfully less expensive than relative ROE would have suggested. This relationship completely normalized in the years that followed, which would imply a substantial relative multiple contraction for US stocks over the coming several years were the gap shown in Chart II-15 to close. Third, Chart II-16 presents the share of US stock market capitalization accounted for by the largest 10% of stocks by size. The chart highlights that the concentration of US market capitalization has risen to an extreme level that has only been reached in two other cases over the past century. Historically, prior stock market concentration has been associated with future increases in the equity risk premium, underscoring that broadly-defined US tech sector concentration bodes poorly for future returns. Chart II-16The US Stock Market Is Now Extremely Concentrated The Foreign Exchange Effect As a final point, Chart II-17 illustrates the degree to which US relative performance has meaningfully benefitted from a rise in the US dollar since 2008. The chart highlights that an equity market-weighted dollar index has risen 20% from its late-2007 level, which has boosted US common currency relative performance. The US dollar was arguably modestly undervalued just prior to the 2008/2009 global financial crisis, but Chart II-18 highlights that it is now meaningfully overvalued versus other major currencies. Over a multi-year horizon, this argues against further relative common currency gains for US stocks from the foreign exchange effect. Chart II-17The US Dollar Has Helped US Common Currency Performance... Chart II-18…And Is Now Expensive   The Absolute Secular Return Outlook For US Stocks Over a secular horizon, the most common method for forecasting equity returns is to predict whether earnings are likely to grow faster or slower than nominal potential GDP growth, and whether equity multiples are likely to rise or fall. For the reasons described above, we have no plausible basis on which to forecast that US profit margins are inclined to rise further over time given how extended they have become. This suggests that a reasonable long-term earnings forecast should be closely linked to one’s forecast for revenue growth. Chart II-19S&P 500 Revenue Is Low Relative To US GDP, And May Rise Over The Next Decade Chart II-19 presents S&P 500 revenue as a percent of nominal GDP, and underscores a fact that we noted above: revenue growth for US equities has underperformed US GDP since the global financial crisis. This undoubtedly has been linked to the fallout from the crisis and other exogenous shocks like the massive decline in energy prices in 2014/2015, which are unlikely to be repeated. Over the next ten years, the US Congressional Budget Office is forecasting nominal potential growth of roughly 4%; allowing for a potential rise in US equity revenue to GDP suggests that investors should expect earnings growth on the order of 4-5% per year over the coming decade, if extremely elevated profit margins are sustained. Chart II-20Multiples Seem To Predict Future Returns Well… Unfortunately for equity investors, there are slim odds that US equity multiples will continue to rise or even stay at their current level. Equity valuation has been shown to have nearly zero ability to predict stock returns over a 6-12 month time horizon or even over the following 3-5 years, but 10-year regressions relating current valuations on future 10-year compound returns tend to be highly predictive (Chart II-20). Utilizing this approach, today’s 12-month forward P/E ratio would imply a 10-year future total return of just 2.9% (Chart II-21). That, in turn, would imply a annual drag of 3-4% from multiple contraction over the coming decade, given our 4-5% earnings growth forecast and a historically average dividend yield of roughly 2%. One problem with the method shown in Charts II-20 and II-21 is the fact that the relationship between today’s P/E ratio and 10-year future returns captures more than the impact of potentially mean-reverting multiples. It also includes any correlation between the starting point of valuation and subsequent earnings growth, which is likely to be spurious. This effect turns out to be important: we can see in Chart II-21 that the strong fit of the relationship is influenced by the fact that the global financial crisis occurred roughly 10-years after the equity market bubble of the late-1990s. Chart II-21...But That Depends Heavily On The Tech Bubble / GFC Relationship Astute investors may infer a legitimate causal link between these two events, via too-easy monetary policy. But from the perspective of forecasting, predicting future returns based on prevailing equity multiples confusingly mixes together three effects: the relative timing of business cycles, the impact of changes in interest rates, and the potential mean-reverting nature of the equity risk premium. In order to disentangle these effects for the purposes of forecasting, we present a long-history estimate of the US equity risk premium based on Robert Shiller’s Irrational Exuberance dataset (Chart II-22). We define the equity risk premium as earnings per share (as reported) as a percent of the S&P 500, minus the real long-maturity interest rate. We calculate the real rate by subtracting the BCA adaptive inflation expectations model – essentially an exponentially smoothed version of actual inflation – from the nominal long-term bond yield. Chart II-22The US ERP Seems Normal Based On A Very Long Term History... The chart highlights that this estimate of the ERP is currently exactly in line with its median value since 1872. Chart II-23 presents essentially the same conclusion, based on data since 1979, using the forward operating P/E ratio for the S&P 500 and the same definition for real bond yields. This implies that, if interest rates were at equilibrium levels, investors would have a reasonable basis to conclude that equity multiples would be unchanged over a secular investment horizon. However, as we have highlighted several times in previous reports, long-maturity government bond yields are likely well below equilibrium levels. Chart II-24 highlights that long-maturity US government bond yields have not been this low relative to trend growth since the late-1970s. Chart II-23...And Based On The Forward Earnings Yield Over The Past Four Decades Chart II-24Interest Rates Are Well Below Equilibrium, And Are Likely To Rise Over Time   We presented in an April report why a gap between interest rates and trend rates of growth was indeed justified for a few years following the global financial crisis, but that a decline in the equilibrium real rate of interest (“r-star”) only appeared to be permanent due to persistent, non-monetary policy shocks to aggregate demand that occurred over the course of the last economic cycle.4 In a scenario where the US output gap turns positive, inflation rises modestly above target, and where permanent damage to the labor market from the pandemic is relatively limited over the coming 6-18 months, it seems reasonable to conclude that the narrative of secular stagnation may ultimately be challenged and that investor expectations for the neutral rate may converge toward trend rates of economic growth. This would weigh on equity multiples, and thus lower equity total returns from the 6-7% implied by our earnings forecast and income return assumption. Chart II-25US Stocks Are Likely To Earn Annual Total Returns Between 1.8-4.7% Over The Next Decade Were real long-maturity bond yields to rise by 100-200bps over the coming decade, this would imply annualized total returns of between 1.8 - 4.7% from US stocks, assuming 4-5% annual revenue growth, flat profit margins, a constant 2% dividend yield, and a constant ERP (Chart II-25). While this would beat the returns offered by bonds, implying that investors should still be structurally overweight equities versus fixed-income assets, it would also fall meaningfully short of the average pension fund return objective (Chart II-26), as well as the absolute return goals of many investors. Chart II-26Future Returns From US Stocks Will Greatly Disappoint Investors Investment Conclusions Chart II-27Over The Coming Year, Favor Value And Global Ex-US Stocks Over the coming 6-12 months, our view that 10-year US Treasury yields are likely to rise supports an overweight stance toward value versus growth stocks. Chart II-27 highlights that the underperformance of growth argues for an underweight stance toward US stocks within a global equity portfolio, especially versus developed markets ex-US. Over a longer-term horizon, there are two key investment implications from our research. First, the risks that we have highlighted to the sources of US outperformance over the past 14 years suggests that investors should not bank on a continuation of this trend over the next decade. We have not made the case in this report for the outperformance of global ex-US stocks, merely that the continued outperformance of US stocks now rests on an unreliable foundation. This may suggest that US relative performance will be flat over the structural horizon, arguing for a neutral strategic allocation. But even the cessation of US outperformance would be a significant development, as it would end the most consequential trend in regional equity performance in the post-GFC era. Second, investors should expect meaningfully lower absolute returns from US stocks over the next decade than what they have earned since 2008/2009, barring a continued rise in the already stretched profit margins of broadly-defined tech stocks. A structurally overweight stance is still warranted toward equities versus fixed-income, but even a 100% equity allocation is unlikely to meet investor return expectations in the high single-digits. As a consequence, global investors should be prepared to accept more volatility in order to reduce the gap between expected and desired returns, and should look towards riskier investments and asset classes (such as real estate and alternative investments) as potential portfolio return enhancements. Jonathan LaBerge, CFA Vice President The Bank Credit Analyst III. Indicators And Reference Charts BCA’s equity indicators highlight that the “easy” money from expectations of an eventual end to the pandemic have already been made. Our technical, valuation, and sentiment indicators remain very extended, highlighting that investors should expect positive but modest returns from stocks over the coming 6-12 months. Our monetary indicator has retreated below the boom/bust line, although this mostly reflects the use of producer prices to deflate money growth. In nominal terms, the supply of money continues to grow. Still, the retreat in the indicator highlights that the monetary policy stance is likely to shift in a tighter direction over the coming year. Forward equity earnings are pricing in a substantial further rise in earnings per share, and there is no meaningful sign of waning forward earnings momentum as net revisions and positive earnings surprises remain near record highs. Bottom-up analyst earning expectations are now almost certainly too high, but stocks are likely to be supported by robust revenue growth over the coming year. Within a global equity portfolio, global ex-US equities have underperformed alongside cyclical sectors, banks, and value stocks more generally. On a 12-month time horizon, we would recommend that investors position for the underperformance of financial assets that are negatively correlated with long-maturity government bond yields. The US 10-Year Treasury yield has broken above its 200-day moving average, beginning its recovery after falling sharply since mid-March. After a decline initially caused by waning growth momentum and the impact of the Delta variant of SARS-COV-2, long-maturity bond yields appear to be responding to the interest rate guidance that the Fed has been providing. 10-Year Treasury Yields remain below the fair value implied by a late-2022 rate hike scenario, underscoring that 10-Year Yields are set to trend higher over the coming year. The extreme rise in some commodity prices over the past several months has eased. Lumber prices have almost fully normalized, whereas the pace of advance in industrial metals prices has eased. Global shipping costs have exploded due to supply-side constraints, but are likely to ease over the coming year if further COVID-related labor market shocks can be avoided. US and global LEIs remain very elevated but have started to roll over. Our global LEI diffusion index has declined very significantly, but this likely reflects the outsized impact of a few emerging market countries (whose vaccination progress is still lagging). Still-strong leading and coincident indicators underscore that the global demand for goods is robust, and that output is below pre-pandemic levels in most economies because of very weak services spending. The latter will recover significantly at some point over the coming year, as social distancing and other pandemic control measures disappear. EQUITIES: Chart III-1US Equity Indicators Chart III-2Willingness To Pay For Risk Chart III-3US Equity Sentiment Indicators   Chart III-4US Stock Market Breadth Chart III-5US Stock Market Valuation Chart III-6US Earnings Chart III-7Global Stock Market And Earnings: Relative Performance Chart III-8Global Stock Market And Earnings: Relative Performance   FIXED INCOME: Chart III-9US Treasurys And Valuations Chart III-10Yield Curve Slopes Chart III-11Selected US Bond Yields Chart III-1210-Year Treasury Yield ComponentsChart III-13US Corporate Bonds And Health Monitor Chart III-14Global Bonds: Developed Markets Chart III-15Global Bonds: Emerging Markets   CURRENCIES: Chart III-16US Dollar And PPP Chart III-17US Dollar And Indicator Chart III-18US Dollar Fundamentals Chart III-19Japanese Yen Technicals Chart III-20Euro Technicals Chart III-21Euro/Yen Technicals Chart III-22Euro/Pound Technicals   COMMODITIES: Chart III-23Broad Commodity Indicators Chart III-24Commodity Prices Chart III-25Commodity Prices Chart III-26Commodity Sentiment Chart III-27Speculative Positioning   ECONOMY: Chart III-28US And Global Macro Backdrop Chart III-29US Macro Snapshot Chart III-30US Growth Outlook Chart III-31US Cyclical Spending Chart III-32US Labor Market Chart III-33US Consumption Chart III-34US Housing Chart III-35US Debt And Deleveraging   Chart III-36US Financial Conditions Chart III-37Global Economic Snapshot: Europe Chart III-38Global Economic Snapshot: China   Jonathan LaBerge, CFA Vice President The Bank Credit Analyst Footnotes 1  Please see The Bank Credit Analyst "The Return To Maximum Employment: It May Be Faster Than You Think," dated August 26, 2021, available at bca.bcaresearch.com 2  Please see China Investment Strategy "A Quick Take On Embattled Evergrande," dated September 21, 2021, and China Investment Strategy "The Evergrande Saga Continues," dated September 29, 2021, available at cis.bcaresearch.com 3 Please see US Political Strategy "Forget Biden's Budget," dated June 2, 2021, available at usps.bcaresearch.com 4     Please see The Bank Credit Analyst “R-star, And The Structural Risk To Stocks,” dated March 31, 2021, available at bca.bcaresearch.com