Shape Your ConvictionTM

US
Investment
Strategy

Weekly Report January 6, 2020

In this Issue
The Conventional Wisdom
02 A Stealth Earnings
Boom
• The consensus view seems to be We spent the last full week before the holi-
05 Multiples And The
Monetary Policy that equities have to cool off in days meeting with clients and prospects
Cycle 2020, even if the danger has passed: on the west coast. As they look ahead to
07 The Inflation Recession fears have dissipated as 2020, investors don’t see any major storm
Timetable the yield curve has returned to its clouds on the horizon, but they sense
08 Investment normal upward-sloping orientation and that stocks have run about as far as they
Implications US-China trade tensions have abated, can. We agree with the view that neither
but equity return expectations are a recession nor a bear market awaits, but
modest following last year’s bonanza. we expect equities will comfortably outdis-
tance bonds and cash. Forced to take a
• We agree that a bear market is
stand on whether the S&P 500 will beat or
unlikely, but expect a better year
fall short of the typical consensus expecta-
than the consensus, … : Bull markets
tion for mid-to-high-single-digit gains,1 we
tend to sprint to the finish line, and if
would happily bet the over.
the next recession won’t start before
the middle of 2021, 2020 should be As we detailed in our last two publications
another strong year for the S&P 500. in December, our optimistic take stems
from the deliberately reflationary policy
• … even if earnings growth is unin-
being pursued by the Fed and other major
spiring: Multiples almost always
central banks. Restoring inflation expecta-
Editorial Board expand when the Fed eases from an
tions to its desired range is job number one
Doug Peta already accommodative position, and
for the Fed, and its open commitment to
Chief US Investment they expand a lot provided the Fed isn’t
Strategist doing so ensures that risk assets will have
easing in response to a market bust or
Sara Porrello the monetary policy wind at their back for
financial crisis.
Senior Analyst an extended period. The European Central
Jennifer Lacombe • We expect that an inflation revival Bank and the Bank of Japan want to rekin-
Senior Analyst
will take the consensus by surprise, dle inflation as well, and can be counted
Caroline Miller upon to maintain easy policy settings.
Senior Vice President
but not this year: We think rising infla-
Mathieu Savary
tion will induce the Fed to bring the
Vice President curtain down on the expansion and the 1
The ten buy- and sell-side strategists surveyed in Bar-
Ryan Swift equity bull market, but not until 2021 at ron’s 2020 Outlook, published December 16th, called for
an average gain of 4%.
Vice President the earliest.

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 US Weekly Report January 6, 2020 02
Investment The Conventional Wisdom
Strategy

Earnings The rest of the world’s central banks will

CHART 1
growth has continue to take their cue from their more
been the A Great Decade for Earnings
influential peers, as no one wants the
primary driver
export headwind of a strong currency in a
of the 11-year- S&P 500

old equity low-growth environment. 400 400

bull market,
In our base-case scenario, easy monetary 300 300
not multiple
expansion. policy will encourage multiple expansion, CAGR = 14.6%
while a less threatening trade climate, 200 200

and a modest revival in Chinese aggregate

100 100
demand, will boost economic activity,
especially outside of the US. The modest CONSENSUS FORWARD S&P 500 EPS ESTIMATES*

global acceleration provoked by a pickup 250 250

in Chinese imports will support earnings

growth, so that both equity drivers, earn- 200 200

ings and multiples, will be moving in the CAGR = 9.6%

right direction. We anticipate that at least 150 150

half of the current bull market’s remaining

100 100
upside will come from multiple expansion,
however. Dismaying as it might be for inves-
S&P 500 FORWARD 4-QUARTER MULTIPLE*
tors with a value bent, our bull thesis is built
on the view that today’s fully-to-somewhat- 160 160
richly-valued stocks will become overvalued
before this market cycle is complete. 140 140
CAGR = 4.6%
120 120

A Stealth Earnings Boom 100 2020 100

2010 2012 2014 2016 2018

Skeptics of the efficacy of extraordinarily * SOURCE: REFINITIV IBES.
NOTE: MONTHLY DATA; ALL SERIES REBASED TO FEBRUARY 2009 = 100.
accommodative monetary policy have
decried the current bull market as “manip- 14.6% annualized appreciation in the S&P
ulated,” fed by monetary steroid injections 500 (Chart 1, top panel); multiple expan-
that have inflated asset prices at the cost sion has only contributed a third.
of undermining the real economy’s future
prospects. The data flatly contradict the Positioning for a valuation overshoot does
skeptics’ claims: since the end of February not inspire as much confidence as posi-
2009, consensus forward four-quarter S&P tioning for robust earnings growth. US
500 earnings expectations have grown at economic growth has been lackluster since
an annualized rate of 9.6% (Chart 1, middle the crisis (Chart 2, top panel), and it’s been
panel), while the forward multiple has downright anemic in Europe (Chart 2,
expanded at a 4.6% pace (Chart 1, bottom middle panel) and Japan (Chart 2, bottom
panel). Growth in forward earnings esti- panel). Few investors foresaw potent earn-
mates has accounted for two-thirds of the ings growth against that macro backdrop, as

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 US Weekly Report January 6, 2020 03
Investment The Conventional Wisdom
Strategy

The S&P 500 making further expansion seem improbable.

CHART 2
has thrived After adjusting for the secular decline in
despite a DM Growth Has Been Weak
effective corporate income tax rates, corpo-
decade US REAL GDP GROWTH rations’ growing share of national income,
of tepid 4.0 4.0

economic the expansion of the high-margin financial

3.5 3.5
growth, ... sector and the secular decline in debt service
3.0 3.0
costs,2 however, history suggested that profit
2.5 2.5 margins still had room to grow. It would be
2.0 2.0 2018 before they would peak, thanks in part
1.5 1.5 to the 40% cut in the top marginal corpo-
1.0 1.0
rate income tax rate, and the plunge in debt
service costs (Chart 4). Compensation is
EUROPE REAL GDP GROWTH corporations’ single largest expense, though,
3.0 3.0 and the inexorable decline in labor's share of
2.5 2.5 profits was the key driver (Chart 5). Since
2.0 2.0 China’s entry into the WTO, real wages have
1.5 1.5
failed to keep up with productivity gains
1.0 1.0
(Chart 6), dramatizing the shift of profit
.5 .5
share from labor to capital.
0 0
-.5 -.5
Profit margins contracted across the first
-1.0 -1.0
three quarters of 2019, with per-share
revenue growth topping per-share earnings
5 JAPAN REAL GDP GROWTH 5
growth by an average of three percent-
age points. We expect that real unit labor
4 4
costs will rise as the pendulum swings
3 3
back in labor’s direction in line with an
2 2
extremely tight job market and a slow-
1 1 down in outsourcing as globalization loses
0 0 momentum. Revived activity in the rest of
-1 -1 the world can offset some margin pressure
2020
from a rising wage bill, however, especially
2010 2011 2012 2013 2014 2015 2016 2017 2018 2019 if it helps push the dollar lower. And rising
NOTE: 4-QUARTER MOVING AVERAGE OF ANNUALIZED
QUARTER-ON-QUARTER GROWTH. DASHED LINE REPRESENTS
SERIES MEAN.
wages aren’t all bad for profits, as rising
household income leads to rising consump-
tion, and rising consumption boosts corpo-
aggregate corporate revenue growth ought
rate revenue growth. In our base-case
to converge with nominal GDP growth over
2020 scenario, S&P 500 earnings will grow
time. Only margin expansion could deliver
despite accelerating wage growth.
S&P 500 earnings growth above and beyond
a meager 4% revenue growth base.
2
Please see the October 2012 BCA Special Report, “Are US
As early as 2011, US corporate profit
Corporate Profit Margins Really All That High?” available
margins looked quite stretched (Chart 3), at www.bcaresearch.com.

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 US Weekly Report January 6, 2020 04
Investment The Conventional Wisdom
Strategy

... thanks to
CHART 3
margin gains
powered Never Say Die Margin Growth, Nourished On ...
by falling
interest 10.0 S&P 500 PROFIT MARGIN 10.0
rates, falling
tax rates
and capital 7.5 7.5
capturing a
greater share
of the pie
5.0 5.0
from labor.

2.5 2.5

2020

1995 2000 2005 2010 2015 2020

SOURCE: BLOOMBERG.

CHART 4 CHART 5
... Rock-Bottom Rates ... ... And Labor's Woes
BPs BPs % %
INVESTMENT GRADE US:
LABOR SHARE OF INCOME
450 450

400 400

350 350 64 64

300 300

250 250 62 62

BOTH PANELS:
BPs HIGH YIELD YIELD TO WORST* BPs

1000 1000 60 60

900 900

800 800
58 58
700 700

600 600
56 56
500 500
2020 2020

2010 2012 2014 2016 2018 2020 1950 1960 1970 1980 1990 2000 2010 2020
* SOURCE: BLOOMBERG BARCLAYS INDICES.

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 US Weekly Report January 6, 2020 05
Investment The Conventional Wisdom
Strategy

If margins
have finally CHART 6
peaked, Globalization Has Helped Corporate Profits
multiple 1.02 REAL WAGES* RELATIVE TO PRODUCTIVITY** 1.02
expansion
will have to
assume a
.98 .98
bigger role
in support-
ing the bull
market. .94 .94

.90 .90

2020

1970 1980 1990 2000 2010 2020

*HOURLY COMPENSATION DEFLATED BY IMPLICIT PRICE DEFLATOR, REBASED TO 1970 Q1 = 100
**OUTPUT-PER-ALL EMPLOYEE HOUR, REBASED TO 1970 Q1 = 100
NOTE: VERTICAL LINE DENOTES CHINA'S DECEMBER 2001 ENTRY INTO THE WORLD TRADE ORGANIZATION (WTO)

Multiples And The Monetary CHART 7

Policy Cycle Elevated But Not Worrisome
Although the S&P 500’s forward multiple S&P 500 FORWARD 4-QUARTER P/E MULTIPLE*
is already elevated (Chart 7), the historical 25 25

relationship between monetary policy and

equity multiples argues that re-rating is
more likely than de-rating going forward. We
divide the fed funds rate cycle (Chart 8) into 20 20

four phases based on the direction of the fed

funds rate (higher or lower) and the state
of monetary policy (easy or tight). We are
15 15
currently in Phase IV, when the Fed has most
recently eased policy while policy settings
were already accommodative.
10 10
Since consensus earnings estimates began
to be compiled in 1979, forward multiples
have shrunk when the Fed hikes rates and
2020
expanded when it cuts them (Table 1).
The empirical results align with intuition 1980 1990 2000 2010 2020
*SOURCE: REFINITIV IBES.
and arithmetic: investors should become NOTE: SOLID HORIZONTAL LINE REFLECTS SERIES MEAN, DASHED LINES
REFLECT +/- 1 STANDARD DEVIATION

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 US Weekly Report January 6, 2020 06
Investment The Conventional Wisdom
Strategy

It makes
CHART 8
perfect sense
that multiples
The Fed Funds Rate Cycle
expand when
the Fed cuts
rates, but it CYCLE PEAK

turns out that

they keep
expanding PHASE II PHASE III
(TIGHT, TIGHTENING) (TIGHT, EASING)
until a
rate hike is
imminent.
NEUTRAL

PHASE I PHASE IV
(EASY, TIGHTENING) (EASY, EASING)

CYCLE TROUGH 2020

stingier when the rate used to discount

TABLE 1
future earnings rises, and more generous A Consistent Inverse Relationship
when that rate falls. While we believe that
S&P ANNUALIZED FORWARD MULTIPLE GROWTH BY
the mid-cycle rate cuts are finished and CYCLE PHASE, SEPTEMBER 1979 - DECEMBER 2019

that the fed funds rate will fall no further CAGR

# OF
MONTHS
over the rest of this bull market, contin- PHASE I 0.1% 94
ued multiple expansion does not require PHASE II -6.3% 113
continued rate cuts. Phase IV usually ends PHASE III 8.9% 82

with an extended stretch when the Fed PHASE IV 5.9% 195

holds the funds rate at its trough level, but

HIKING (I & II) -3.5% 207
forward multiples do not peak until the EASING (III & IV) 6.4% 277
final stages of the phase. Making the intu-
ALL PHASES 2.1% 484
ition-and-arithmetic statement more exact,
investors become more generous when
rates fall, and remain that way until a rate
Away from the grinding de-rating following
hike is a sure bet.
the dot-com bust, and the slow re-rating
Away from the last two Phase IVs, when accompanying the tepid post-crisis recov-
the Fed cut rates in response to the duress ery, multiples have expanded at better than
issuing from the end of the dot-com mania a 17% annualized rate. Voluntary cuts like
and the financial crisis, re-rating gains last summer’s, made when policy is already
have been significantly larger. Table 2 easy, independent of the imperative to nurse
details the changes in multiples in each a post-crisis economy back to health, have
Phase IV episode over the last 40 years. been awfully good for investors.

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 US Weekly Report January 6, 2020 07
Investment The Conventional Wisdom
Strategy

Multiples
have really TABLE 2
surged when Voluntary Cuts Turbocharge Multiples
the Fed has S&P ANNUALIZED FORWARD MULTIPLE GROWTH DURING DURING PHASE IV
provided
STARTING ENDING # OF
discretionary MULTIPLE MULTIPLE
CAGR
MONTHS
accommoda- May - Jul '80 6.91 7.47 36.8% 3
tion outside Aug '82 - Feb '83 6.31 8.94 81.7% 7
of periods of Apr - Oct '86 11.94 12.26 4.6% 7
distress. Nov '87 - Feb '88 10.81 11.28 13.7% 4
Sep '91 - Dec '93 14.33 14.63 0.9% 28
Sep '98 - May '99 18.02 23.52 42.7% 9
Apr '01 - May '04 19.51 16.48 -5.2% 38
Mar '08 - Nov '15 13.10 16.57 3.1% 93
Jul - Dec '19 16.97 18.38 17.3% 6
ALL PHASES 5.9% 195
EX-TMT & CRISIS 17.6% 64

There have been only two instances when recent past exerts a powerful influence on
the starting multiple has been as high as it near-term expectations about the future.
was at the start of the latest run of rate cuts. Inflation is way down the list of investors’
As noted above, conditions in the spring of concerns because it has been dormant
2001, when the NASDAQ was a year into its ever since the crisis, just as it was in the
eventual two-and-a-half-year slide, and a mid-‘60s once memories of high postwar
recession had just begun, bear little resem- inflation had faded. It conversely remained
blance to conditions today. The fall of 1998, an acute fear for more than a decade after
when the Fed delivered a rapid-fire 75 basis the Volcker Fed turned the tide in the early
points of easing to protect the economy ‘80s (Chart 9).
from the potential ramifications of Long
The slow but meaningful rise in the
Term Capital Management’s failure, looks
trimmed mean PCE (Chart 10, top panel)
a lot more like last summer. It is not our
and CPI series3 (Chart 10, bottom panel)
base case that the latest round of insurance
should pull core PCE and core CPI higher
cuts will push forward multiples to dot-com
over time. In the near term, however, the
levels, but they do have scope to expand.
absence of upward momentum in several
leading inflation indicators will likely
The Inflation Timetable stretch “over time” beyond the first half of
the year, if not the whole year. As tight as
It remains our high-conviction view that the labor market is, unit labor costs have
inflation expectations will not return to the
Fed’s target levels quickly. Their path has
seemed to provide a nearly perfect real-life 3
Trimmed-mean inflation series operate like figure skating
judging in the Olympics – the top and bottom readings are
case study supporting the adaptive expec- thrown out, and the mean is calculated from the remaining
tations framework, which posits that the scores.

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 US Weekly Report January 6, 2020 08
Investment The Conventional Wisdom
Strategy

Trimmed-
CHART 9 CHART 10
mean
inflation
Recency Bias In Action Inflation's Not Dead, ...
Ann% Ann%
measures Chg CORE PCE DEFLATOR* Chg
US INFLATION EXPECTATION PROXY TRIMMED MEAN PCE**
suggest that
9 9
core inflation 2.5 2.5
will eventually
rise, ... 8 8
2.0 2.0

7 7 1.5 1.5

1.0 1.0
6 6

Ann% Ann%
Chg CORE CPI* Chg
5 5 TRIMMED MEAN CPI**

4 4 3 3

3 3 2 2

2 2
1 1
2020 2020

1950 1960 1970 1980 1990 2000 2010 2020 1995 2000 2005 2010 2015 2020
* EXCLUDING FOOD AND ENERGY.
** SOURCE: FEDERAL RESERVE BANK OF DALLAS.
***SOURCE: FEDERAL RESERVE BANK OF CLEVELAND.

not been able to break out of the range market slack. Upward wage pressure could
that’s contained them for the last five years then filter into consumer prices either via
(Chart 11, top panel); the New York Fed’s a cost-push or demand-pull framework, as
Underlying Inflation Gauge has pulled a corporations either seek to defend margins
disappearing act after a seemingly decisive from higher input costs or try to imple-
breakout in mid-2018 (Chart 11, middle ment opportunistic price hikes. Cost-push
panel); and the share of small businesses or demand-pull, many investors seem to
planning price increases has come off the be dismissing the potential for an infla-
late 2018 boil (Chart 11, bottom panel). tion revival, especially the ones we met in
northern California, where the deeply held
consensus view asserts that looming job
Investment Implications destruction from artificial intelligence makes
We spent the holidays reading up on the broad wage growth all but impossible.
history of strikes in the United States and Inflation is not an immediate concern, but
believe a shift in the balance of negotiating we expect it will ultimately spell the end of
power from management to labor may be the bull market and the expansion. Allocat-
stirring, as a two-part Special Report will ing a generous share of long-maturity Trea-
soon explore. Such a shift would render sury exposures to TIPS is an excellent way
wages much more sensitive to a lack of labor

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 US Weekly Report January 6, 2020 09
Investment The Conventional Wisdom
Strategy

... but more to protect a portfolio against its eventual

immedi- CHART 11
re-emergence. We advise investors to main-
ate leading ... But It's Still Hibernating
tain at least an equal weight allocation to Ann% Ann%
indicators of Chg Chg
equities to profit from our view that ongo- UNIT LABOR COSTS (Advanced 9 Months, RS)
inflation have
lost their ing multiple expansion will surprise to the
3
upward upside. Risk-friendly positioning remains 4

momentum. appropriate, as long as intensifying US-Iran

2
tensions or other geopolitical conflicts don’t
negate the positive impact of reflationary 2
0
monetary policy.
-2

1
Doug Peta, CFA -4

Chief US Investment Strategist

Ann% UNDERLYING INFLATION GAUGE** Ann%
dougp@bcaresearch.com Chg (Advanced 12 Months, RS) Chg

3
3

ALL PANELS:
TRIMMED MEAN 0
1 PCE DEFLATOR*

Ann% NFIB PLANNED PRICE INCREASES

Chg (Advanced 9 Months, RS) 40

3
30

2 20

10
1
2020

1995 2000 2005 2010 2015 2020

* SOURCE: FEDERAL RESERVE BANK OF DALLAS.
**FULL DATA MEASURE, SOURCE: FEDERAL RESERVE BANK OF
NEW YORK.

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US Weekly Report January 6, 2020 10
Investment The Conventional Wisdom
Strategy

Archive Of Previous Reports

Please click on the links below to view reports:

1. Paddling With The Current - December 16, 2019

2. 2020 Key Views: No Inflection Yet - December 9, 2019

3. Signal And Noise In M&A And Small-Caps - December 2, 2019

4. Stay The Course - November 25, 2019

5. Refreshing Our Rates View - November 18, 2019

6. Why Bother With Earnings? - November 11, 2019

7. How Bull Markets End - November 4, 2019

8. What The Biggest Banks See - October 28, 2019

9. Questions From The Road - October 21, 2019

10. The Manufacturing Slowdown's Impact On The US Economy - October 14, 2019

11. The Worry Loop - October 7, 2019

12. Euphoric Angst - September 30, 2019

13. Oil's Impact On The US Economy - September 23, 2019

14. Here Comes The Cavalry (Again) - September 16, 2019

15. Checking In On The GDP Equation -September 9, 2019

16. The Longer Run - September 2, 2019

17. Market Messages - August 26, 2019

18. When The Facts Change - August 12, 2019

19. What Can The Fed Really Do? - August 5, 2019

20. Agency Mortgage REITs Are Back In Season - July 30, 2019

21. How Will Equities Respond To Rate Cuts? - July 15, 2019

22. Fed Watching: An Executive Summary - July 1, 2019

23. Everybody Into The Pool! - June 24, 2019

24. The Fed, The Fed, The Fed (And China-US) - June 17, 2019

25. Context - June 10, 2019

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 US Weekly Report January 6, 2020 11
Investment The Conventional Wisdom
Strategy

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