GavekalResearch

Strategy Monthly

Two Equity Rotations

For A Post-Covid World
December 2020
 Strategy Monthly – December 2020
Two Equity Rotations For A Post-Covid World 3
Will Denyer
The impending rollout of vaccines in the United States is spurring two big equity
rotations. With investors looking ahead to a post-Covid world, a rotation has begun
from stocks that thrived in the pandemic to those that merely clung on. Second,
the expectation that a robust economic recovery will push interest rates up
has caused beaten-down value stocks to recover some mojo. Investors should play
these rotations at a granular, sub-sector level. They should also look outside of
the US market, which is weighted toward growth stocks that may lag in a
post-pandemic world.
Where We Stand 19
A round-up of research highlights from the last month
Indicators 24
Data Dashboard: Betting on recovery

GavekalResearch 2
 Two Equity Rotations For A Post-Covid World

Will Denyer
wdenyer@gavekal.com

GavekalResearch 3
 Vaccine news has sparked two equity rotations

Covid winners Covid losers Growth Value

Drivers: Drivers:
1) Current Covid situation 1) Interest rate outlook
2) Vaccine prospects
3) Post-Covid fallout (a new normal?)

The announcement of successful vaccine trials by Pfizer
and Moderna forced investors to reset their portfolio
positioning for the shift to a post-Covid environment (see
Turning The Page On 2020?). The pandemic may be very
bad in the US and other northern hemisphere countries,
but there is at least a clear road map for ending
restrictions in the spring.
The vaccine news has kicked off two equity rotations:
1) From stocks that thrived in the pandemic (Covid
winners) to those battered by its strictures (Covid
losers)
2) From growth to value plays
There is some overlap between (i) and (ii) but their
performance-drivers are fundamentally different (see Two
Equity Rotations In The Making).

GavekalResearch 4
 The first equity rotation: Covid winners to Covid losers
We select Covid “winners” and “losers” according to their
performance from the pre-crisis peak on Feb 19 until just
before Pfizer’s Nov 9 vaccine announcement, which
spurred the “post-Covid” equity market rotation.
High-performing sectors like online retail, air freight and
logistics and tech hardware tended to serve people stuck
at home. Life sciences got an obvious boost, while metals
were spurred by massive central bank money printing.
GavekalResearch
Losers included airlines, which saw travel collapse; energy
providers, which saw demand plunge; banks, which
suffered a sharp fall in yields; and utilities, which faced less
demand and the imposition of forbearance schemes.
It pays to get granular. Surprisingly, hotels, restaurants
and leisure stocks gained—e.g. Starbucks and McDonald’s,
which did well with take-out. The winners-and-losers table
overleaf digs into these sub-industries.
5
 Stock pickers should dig into sub-industries to find good Covid losers
Covid-winners
(20%+ outperformance)
Copper
Air freight & logistics
Internet & direct marketing retail
Gold
Agricultural & farm machinery
Tech hardware & storage
Computer & electronics retail
Home furnishing retail
Life sciences tools & services
General merchandise stores
Household appliances
Application software
Div. real estate activities
GavekalResearch
Covid-losers Stock pickers should focus
(20%+ underperformance) on “Covid losers” that have
Oil & gas drilling Coal & cons fuels Reinsurance been badly beaten up
Department stores Office REITs Broadcasting
since February.
These include hotels,
Mortgage REITs Hotels, resorts & cruises Education services
cruise lines and leisure
Oil & gas equipment &
Leisure facilities Life & health insurance
providers. Other
services
predictably hard-hit sub-
Oil & gas E&P Diversified banks Marine industries include energy,
brick-and-mortar retail,
Hotel & resort REITs Aerospace & defense Consumer finance
finance, travel and
Oil & gas refining & marketing Commercial printing Regional banks education services. Even
mortgage REITS faced
Airlines Diversified REITs Gas utilities margin calls during the
Retail REITs Health care REITs Thrifts & mortgage finance
financial panic, and have
been slow to recover.
Integrated oil & gas Residential REITs Real estate services
Yet before jumping in,
Security & alarm services Multi-line insurance Heavy electrical equip boots and all, investors
should assess how three
Apparel, accessories & luxury
Textiles Advertising
goods
key Covid-related drivers
will impact this winners-to-
Oil & gas storage &
transportation
Drug retail Alternative carriers losers rotation.
6
 Covid winners/losers driver #1: State of the pandemic

The US is suffering a “third wave” of Covid-19 infections,
with daily cases and hospitalizations topping their April
and July peaks. The situation may worsen due to people
travelling and having family gatherings during last week’s
Thanksgiving holiday. Improved treatments have boosted
the disease’s recovery rate, but the sheer size of this wave
means that total deaths may soon also make new highs.
This Covid wave is leading to fresh restrictions on travel
and big gatherings across the US that will hit growth in
4Q20 (see The Brake On US Growth). But don’t expect a
major decline. Most recent economic data continues to
point to growth. Despite the outbreak, manufacturing
and service sector PMIs rose in November.

GavekalResearch 7
 Covid winners/losers driver #2: Vaccine prospects are key
November’s positive vaccine news has become the key
market driver, for two reasons:
1) Investors knew that a winter Covid wave was likely
and will not be surprised by a post-Thanksgiving
holiday bump in the infection rate.
2) Equity prices discount years of future earnings, so a
few months of disruption can be handled if an end-
date to the crisis is in sight.
GavekalResearch
The US government is already testing its vaccine
distribution network and there are rising hopes that the
population can be rapidly inoculated. To that end, the
government plans to start delivering vaccines to high-risk
individuals this month and have 70-80% of the population
vaccinated by summer.
Since Pfizer’s Nov 9 announcement, Covid-loser stocks
have rallied, while Covid winners have lagged.
8
 Covid winners/losers driver #3: Old normal, or new normal?
• Activities that got suppressed by the pandemic will recover but may never
return to their pre-Covid levels.
• Business travel for example, will rise after the pandemic yet probably settle
at a lower level, as many firms have learned to transact remotely. On the
flipside, teleconferencing may fall, but not to pre-Covid levels.
• A similar dynamic is likely in retail, as consumers return to brick-and-mortar
stores and do less shopping online. Yet, the overall effect will be for less
footfall in malls and more spending with online retailers.
• As the equity rotation from Covid winners to losers matures, the challenge
will be to assess, for each industry, how much goes back to the old normal.

GavekalResearch 9
 The second equity rotation: from growth to value
There is overlap between
stocks in the Covid
winners-to-losers rotation,
and those in the growth-
to-value rotation.
Bank and energy stocks
tend to be, at the same
time, both Covid losers and
value stocks. Internet
stocks are often Covid
winners and also growth
stocks.
Such overlap explains why
this chart is similar to those
on slide-7 showing Covid
winners and losers.
These two rotations could
stay correlated and render
nit-picking distinctions
meaningless. Yet they have
fundamentally different
drivers, so this link could
easily break down.

GavekalResearch 10
 The growth-to-value rotation is an interest rate play
For both growth and value
stocks, the unifying driver
is interest rates.
Growth stocks are
expensive compared to
current earnings but are
expected to have strong
profit growth far into the
future. This makes them
long-duration assets as
they are sensitive to
changes in long-term
interest rates.
In contrast, value stocks
are cheap compared to
current earnings. This
means they do not rely on
earnings in the distant
future. As a result, they are
less sensitive to changes in
long-term rates and can be
thought of as short-
duration equities.

GavekalResearch 11
 Yields will rise but not enough to sink the equity market

Real US yields were at zero even before Covid. Once the Such a scenario points to a 100bp rise in 10-year treasury
pandemic hit, they went deeply negative and nominal yields. Even without the Federal Reserve lifting short rates
yields fell even more. This reminds of the flight into super-from zero, this could happen. It would only bring the yield
safe assets during the eurozone’s 2012 crisis. curve back to the middle of its range (see Either Steeper,
Europe’s financial conditions “normalized” only after Mario Or Much Steeper). Such a move need not upend equity
Draghi promised to do “whatever it takes” to save the euro. markets as during the 2013 “taper tantrum” US yields rose
A successful vaccine rollout could have a similar effect and 100bp—back then, value outperformed growth plays but
push US yields back up toward their pre-Covid levels. the market did not correct (see slide 11).

GavekalResearch 12
 Inflation remains sub-par, so the Fed should stay dovish

If a successful vaccine rollout is the key force spurring a With the targeted PCE price index still running well below
rise in yields, other factors—notably weak pricing 2% YoY, the Fed is accumulating “misses” to the downside,
pressure—may act as a countervailing force. which it must compensate for by letting inflation run
Given that inflation remains sub-par, the Fed is likely to above its target. Hence, fear not March’s likely inflation
remain in dovish mode for a while longer. In addition, the spike due to base effects. The Fed will stay dovish.
central bank’s new policy framework (adopted in August) Inflation expectations (from surveys and market prices)
commits it to targeting an “average” inflation rate of 2%, so are also still below normal—not what the Fed would call
it can let the economy run “hot” before tightening. “well anchored”.

GavekalResearch 13
 A behind-the-scenes cash dump may also retard the yield rise
The US Treasury amassed a
huge cash pile, as it issued
T-bills in bulk to pre-fund
anticipated payments. This
effectively sterilized a
chunk of new Fed money.
The cash is being used to
settle loans given by banks
to small firms that are now
being switched to
government grants. Banks
may put this cash into
treasuries, weighing on
yields (see A Behind The
Scenes Cash Boost).
Emergency Treasury and
Fed programs are also set
to lapse at the end of the
year. That could free up
cash, marginally reducing
new treasury bond issues.
This too may reduce the
upward pressure on yields.

GavekalResearch 14
 A 100bp rise in yields need not stop US equities in their tracks
One reason the US equity market took the 2013 “taper
tantrum” in its stride is that bond yields remained very low
when compared to both the corporate return on invested
capital and equity earnings yields.
Today, the “Wicksellian spread” between the return on
capital and its cost is also very positive, especially after
returns rebounded in 3Q20. This is positive for profits as
companies can cheaply refinance, or borrow more.
GavekalResearch
The difference with 2013 is in equity valuations. The
spread between earnings yields (a real measure) and real
yields on treasuries remains positive, which favors equities
over bonds. However, that spread is less than 100bp,
which is far less than in 2013. On balance, US equities still
look a decent bet as relative valuations are not stretched
like in 2000. However, investors should hold more cash
than in 2013 (see Not Cheap, But Not Expensive Either).
15
 There are better options internationally than US equities
US equities may be fairly
valued versus bonds, but
they are expensive
compared to other world
equity markets.
Markets that are both
cheap relative to the US
and quoted in a cheap
currency include the
eurozone, Japan, UK and
Canada. Australia has
already moved out of the
bargain bin (see Time To
Look Beyond The US).
Another reason to look
beyond the US is that a still
richly-valued US dollar has
downside potential as a
Biden administration is
more likely to cut tariffs
than hike them.

GavekalResearch 16
 The US is also fairly light on Covid losers and value plays

Different horses suit different courses. The US market is
heavy on growth stocks and light on value plays. That
situation worked in its favor when yields were falling, and
earnings could be discounted at ever lower rates. But if
bond yields start creeping higher, other markets with a
more distinct value composition may outperform.
The tech-heavy US market is also relatively light on Covid-
loser stocks like banks, energy firms and airlines. This
beaten-up grouping makes up about 9% of the US market
compared to around 12% for the world as a whole. There
are better ways to play the coiled-spring response than in
the US market.

GavekalResearch 17
 Conclusion
• These two equity rotations in the US are likely just getting started.
• So long as the vaccine roll-out is successful, investors should expect "Covid
losers" to outperform, while "Covid winners" lose momentum.
• Treasury yields are likely to rebound on an improving US growth outlook,
which will spur a further rotation from growth to value stocks.
• But easy monetary policy and ample liquidity flows should retard the rise
in yields, and so reduce the risk of a broad US equity market correction.
• It pays to play these rotations at a granular level (by industry, sub-industry
or company). But cruder proxies also suffice.
• A simple way to add exposure to both value plays and Covid losers would
be to underweight the US equity market and overweight non-US markets.

GavekalResearch 18
 Where We Stand
Research highlights from the past month

GavekalResearch 19
 Where We Stand
Global investment
• Pfizer’s vaccine news could mean investors stop worrying about Covid-19, triggering a sharp reversal in a range of
prices and raising a host of questions. (Louis Gave, Turning The Page On 2020?)
• With investors focused on the pandemic and US election, something happened that may have bigger long-term
consequences for geopolitics: Intel lost its edge over TSMC. (Louis Gave, The New Geostrategic Pressure Point)
• The market reaction to the US election was what you would expect when a centrist and conventional politician
replaces an extreme and erratic populist. (Anatole Kaletsky, Pricing The Post-Election World)
• The aftermath of the US election points to deep distrust between America’s two great political tribes that could yet
spell trouble for investors. (Charles Gave, Markets And The Split Between American Trees And American Boats)
• US equities will start to underperform Asian currencies, and US equity holdings should be changed from a market-
capitalization basis to an equally-weighted one. (Charles Gave, Are The Markets Trying To Tell Us Something?)
• The US dollar faces headwinds and US stocks look expensive compared with equity markets elsewhere. Favor
unhedged positions in selected non-US equity markets. (Will Denyer, Time To Look Beyond The US)
• The renminbi’s strengthening has important implications for everything from global bond yields, through energy
prices, to the relative performance of US growth and value stocks. (Louis Gave, The Importance Of The Renminbi)
• There are 365 Chinese companies listed in the US. Given US-China tensions, this situation won’t last, especially as
such firms can tap Hong Kong. (Louis Gave & Thomas Gatley, The Fate Of Chinese Listings In The US)
The United States
• As the pandemic intensifies, the chance of a fourth quarter GDP contraction is rising. Investors can take solace from
inflation being benign (Tan Kai Xian, A Boost From US Restocking; Will Denyer, US Inflation Is Still Benign).

GavekalResearch 20
 Where We Stand
• With vaccines on the way and hopes for an early end to the pandemic rising, the US yield curve has two likely
trajectories, and they both point in the same direction. (Tan Kai Xian, Either Steeper, Or Much Steeper)
• Since Pfizer announced its successful vaccine trials, managers have been forced to reassess their US portfolio
positioning. That process has likely only just got going (Will Denyer, Two Equity Rotations In The Making).
• US equities, and growth stocks especially, got buoyed in early November by predictions of a Joe Biden presidency
and split Congress. (Will Denyer & Yanmei Xie, US Election Points To A Bullish Result)
• Before the US election, US investors feared a drawn-out result, whose legitimacy would be questioned by one of the
candidates. So why did financial markets cheer the result? (Louis Gave, The Post-Election Rally)
Europe
• A third of stocks in Europe’s key benchmark are down by more than -20% this year. Hence, the re-rating of cyclicals
and Covid-stricken firms will keep going. (Cedric Gemehl & Nick Andrews, After Consolidation, A Further Rerating)
• After Joe Biden’s win in the US election, the UK may be forced to accept a trade deal that leaves it as an effective
satellite of the European Union. (Nick Andrews, Biden And Brexit)
• A veto by Hungary and Poland of the EU’s €750bn recovery fund is more than the spat described by Nick and Cedric,
says Charles. It points to fundamental issues of sovereignty and legitimacy. (Nick Andrews & Cedric Gemehl, Limits
To EU Solidarity; Charles Gave, Dear Cedric And Nick, Allow Me To Disagree...)
• Anti-Covid lockdowns being imposed by European governments make as much sense as building a second, smaller,
Maginot line would have done back in 1943. (Louis Gave, Let’s Build A Second Maginot Line!)
• The relative shift in the gradient of the US dollar and euro yield curves points to Europe’s currency strengthening
against the dollar. (Nick Andrews, Yield Curves, The Euro And The Dollar)

GavekalResearch 21
 Where We Stand
China
• The suspension of Ant Group’s IPO by regulators showed that the state is stronger than financial innovation.
(Andrew Batson, Ant Stomped; Andrew Batson, Dan Wang and Ernan Cui, The Internet Is No Longer Exempt)
• China’s economy continues to perform well as do its companies, which posted strong results in 3Q20. (Thomas
Gatley, A Surge In Earnings; Dragonomics team, Full Speed Ahead)
• The pandemic has upended consumers’ habits. (Ernan Cui, How Covid-19 Changed Chinese Consumers)
• Policymakers seem relaxed about the flood of foreign money coming into Chinese sovereign bonds. Yet, a missed
debt payment by a local state-owned enterprise is a bad omen for credit investors. (Wei He, The Second Wave Of
Bond Inflows; Xiaoxi Zhang & Wei He, Cracks Appear In Local Support For Bonds)
• In almost no area of the US-China relationship can President-elect Biden fully reverse the Trump administration’s
combative approach. (Arthur Kroeber, Fine-Tuning The US-China Rivalry)
• US rules barring investment in 31 firms allegedly linked to China’s military may not survive court challenges. Yet
Huawei’s bad situation has convinced policymakers that China must cut its reliance on US technology. (Dan Wang
& Thomas Gatley, Another Trump Attack On Chinese Stocks; Dan Wang, The Race To Decouple, This Time Is
Different For Industrial Policy; Huawei's Slow Strangulation)
• China’s property sector led the rebound from Covid-19 lockdown, but how long can the new boom last? (Rosealea
Yao, Housing & Construction Review 2020)
• In the last three weeks, investors in Chinese assets have suffered a series of shocks. Yet the country may soon enjoy
a "triple merit" scenario of a strengthening currency, falling real interest rates and rising asset prices. (Louis Gave,
Three Strikes And Still In; China’s Departure From Past Standard Operating Procedures)

GavekalResearch 22
 Where We Stand
Rest of the world
• New Zealand led the way in making central banks independent of their governments. It is out front again, with a
proposal to have its central bank set policy with an eye on property prices. (Louis Gave, A Bridge Too Far?)
• In clinching a key Asian trade deal, Beijing has put itself at the center of the region’s trade and investment
networks, ousting the US as the leading power. (Tom Miller, After RCEP: A Tough Ask For Pivot 2.0)
• As global uncertainty has started to recede following the US election result and on the promise of Covid vaccines,
so the skies have begun to clear for Asian currencies. (Vincent Tsui, The Upside For Asian Currencies)
• After a big downturn, Indian demand has picked up and growth should resume in 4Q20. Still, the economic
scarring from this year’s contraction will take a long time to heal. (Tom Miller, The Scars Beneath India’s Cheer)
• As President-Elect Joe Biden prepares to bring Iran in from the cold, it was no coincidence that the first-ever visit to
Saudi Arabia by an Israeli prime minister took place. (Tom Holland, The Realignments Begin)

GavekalResearch 23
 Indicators
Betting on recovery

Continuously updated charts of all our main indicators

are available on the Gavekal Indicators Dashboard page on our website

GavekalResearch 24
 Restocking, fiscal and monetary stimulus lead to rising recovery

The Covid pandemic and resulting restrictions on activity Looking slightly ahead, inventories are very low across
still weigh on everyday life in many places around the most of the developed world, and this probably means an
world. European countries have been particularly eager to economic boost will occur once restocking starts to
impose restrictions this fall. happen in earnest.
Yet despite these headwinds, economic activity has Meanwhile, the fiscal and monetary impulse remains very
generally held up better than expected. Indeed, our much in effect across the OECD, which is also likely to add
models and indicators show a slight pick-up in the pace of impetus to growth.
the recovery.

GavekalResearch 25
 A spectacular month for stocks, where rotation was the buzzword

After a challenging October, equities came roaring back in
November. Indeed, the MSCI World index recorded a
stunning 11.8% MoM rise, which represents the single
biggest monthly leap since January 1975.
Leading the charge was Europe, where the local stock
market jumped more than 20%.
A significant partial cause of this renewed appetite for risk
was news that several different Covid-19 vaccines have
showed themselves to be effective in late-stage testing.
This precipitated a big rotation in markets, where previous
“Covid losers” such as energy, industrials and financials
have started to outperform significantly.

GavekalResearch 26
Inflation –So far, pandemic deflation is still in place, but for how long?

GavekalResearch 27
Currencies – Long Asian forex plays, which will follow the renminbi higher

GavekalResearch 28
 www.gavekal.com

Gavekal Ltd Head Office Gavekal Dragonomics

Suite 3101 Central Plaza China Office
18 Harbour Road Room 2110, Tower A
Wanchai, Hong Kong Pacific Century Place, 2A Gongti Beilu
Beijing 100027, China
Tel: +852 2869 8363
Fax: +852 2869 8131 Tel: +86 10 8454 9987
Fax: +86 10 8454 9984

For inquiries contact

sales@gavekal.com