Asia

Global semiconductor share prices have continued to hit new highs, even though there has not been any recovery (positive growth) in global semiconductor sales or in their corporate earnings (EPS). Global semiconductor sales bottomed on a rate-of-change basis in June, but their annual growth rate was still negative in December. In the meantime, global semi share prices have been rallying since January 2019. This divergence between stock prices and revenue of global semiconductor stocks is unprecedented (Chart II-1). Chart II-1Global Semiconductor Market: Sales & Share Prices Over-Hyped Global Semi Share Prices Odds are that global semi stocks in general, and Asian ones in particular, will experience a pullback in the coming weeks. The coronavirus outbreak will likely dampen expectations related to the speed of 5G adoption and penetration in China. Critically, China accounted for 35% of global semiconductor sales in 2019, versus 19% for the US and 10% for the whole of Europe. In brief, semiconductor demand from China is now greater than the US and European demand combined. Furthermore, the latest news that the US administration is considering changing its regulations to prevent shipments of semiconductor chips to China’s Huawei Technologies from global companies - including Taiwan's TSMC - could hurt chip stocks further. Since Huawei Technologies is the global leader in 5G networks and smartphones, the ban, if implemented, will instigate a sizable setback to 5G adoption in China and elsewhere. Our updated estimate of global 5G smartphone shipments is between 160 million and 180 million units in 2020, which is below the median of industry expectations of 210 million units (Table II-1). The key reasons why the industry’s expectations are unreasonably high, in our opinion, are as follows: Chinese demand for new smartphones will likely stay weak (Chart II-2). The mainland smartphone market has become extremely saturated, with 1.3 billion units having been sold in just the past three years – nearly equaling the entire Chinese population. Table II-1Industry Forecasts Of The 2020 Global 5G- Smartphone Shipments Chart II-2Chinese Smartphone Demand: Further Decline In 2020     Chinese official data show that each Chinese household owned 2.5 phones on average in 2018, and that the average household size was about three persons (Chart II-3). This suggests that going forward nearly all potential phone demand in China is for replacement phones, and that there is no urgent need for households to buy new phones. Chart II-3Chinese Households: No Urgent Need For A New Phone The Chinese government’s boost to 5G infrastructure investment will likely increase annual installed 5G base stations from 130,000 units last year to about 600,000 to 800,000 this year. However, the total number of 5G base stations will still only account for about 7-9% of total base stations in China in 2020. Hence, geographical coverage will not be sufficiently wide enough to warrant a very high rate of 5G smartphone adoption and penetration. From Chinese consumers’ perspectives, a 5G phone in 2020 will be a ‘nice-to-have,’ but not a ‘must-have.’ Given increasing economic uncertainty and many concerns related to the use of 5G phones, mainland consumers may delay their purchases into 2021 when 5G phone networks will have more geographic coverage.  The number of 5G phone models on the market is expanding, but not that quickly. Consumers may take their time to wait for more models to hit the market before making a 5G phone purchase. For example, Apple will release four 5G phone models, but only in September 2020. Moreover, the price competition between 5G and 4G phones is getting increasingly intense. Smartphone producers have already started to cut prices of their 4G phones aggressively. For example, the price of Apple’s iPhone XS, released in September 2018, has already dropped by about 50% in China. Outside of China, 5G infrastructure development will be much slower. The majority of developed countries will likely give in to pressure from the US and limit their use of Huawei 5G equipment. This will delay infrastructure installation and adoption of 5G throughout the rest of the world because Huawei has the leading and cheapest 5G technology. In 2019, China accounted for about 70% of worldwide 5G smartphone shipments. We reckon that in 2020 Chinese 5G smartphone shipments will be between 120 million and 130 million units. Assuming this accounts for about 70-75% of the world shipment of 5G phones this year, we arrive at our estimate of global 5G smartphone shipments of between 160 million and 180 million units. Overall, investors are pricing global semi stocks using the pace and trajectory of 4G smartphones adoption. However, in 2020 the number and speed of 5G phone penetration will continue lagging that of 4G ones when the latter were introduced in December 2013 (Chart II-4). We agree that 5G technology is revolutionary, and its adoption and penetration will surge in the coming years. Nevertheless, we still believe global semi share prices are presently overhyped by unreasonably optimistic 2020 projections (Chart II-5).  Chart II-4China 5G-Adoption Pace: Slower Than The Case With 4G Chart II-5Net Earnings Of Global Semi Sector: Too Optimistic?   Investment Implications Global semi stocks’ valuations are very elevated, as shown in Chart II-6 and Chart II-7. Besides, semi stocks are overbought, suggesting they could correct meaningfully if lofty growth expectations currently baked into their prices do not materialize in the first half of this year. Chart II-6Global Semi Stocks Valuations: Very Elevated Chart II-7Global Semi Stocks’ Valuations: Very Elevated   The coronavirus outbreak and the resulting delay in 5G phone sales in China in the first half of 2020, along with US pressure on global semi producers not to sell to Huawei, will likely trigger a pullback in semiconductor equities. We recommend patiently waiting for a better entry point for absolute return investors. Within the EM equity universe, we have not been underweight Asian semi stocks because of our negative outlook for the overall EM equity benchmark. We remain neutral on Taiwan and overweight Korea. The reason is that DRAM makers such as Samsung and Hynix have rallied much less than TSMC. Besides, geopolitical risks in relation to Taiwan in general and TSMC in particular are rising, warranting a more defensive stance on Taiwanese stocks relative to Korean equities. Ellen JingYuan He Associate Vice President ellenj@bcaresearch.com

Global semiconductor share prices have continued to hit new highs, even though there has not been any recovery (positive growth) in global semiconductor sales or in their corporate earnings (EPS). Global semiconductor sales bottomed on a rate-of-change basis in June, but their annual growth rate was still negative in December. In the meantime, global semi share prices have been rallying since January 2019. This divergence between stock prices and revenue of global semiconductor stocks is unprecedented (Chart II-1). Odds are that global semi stocks in general, and Asian ones in particular, will experience a pullback in the coming weeks. The coronavirus outbreak will likely dampen expectations related to the speed of 5G adoption and penetration in China. Critically, China accounted for 35% of global semiconductor sales in 2019, versus 19% for the US and 10% for the whole of Europe. In brief, semiconductor demand from China is now greater than the US and European demand combined. Furthermore, the latest news that the US administration is considering changing its regulations to prevent shipments of semiconductor chips to China’s Huawei Technologies from global companies - including Taiwan's TSMC - could hurt chip stocks further. Since Huawei Technologies is the global leader in 5G networks and smartphones, the ban, if implemented, will instigate a sizable setback to 5G adoption in China and elsewhere. Our updated estimate of global 5G smartphone shipments is between 160 million and 180 million units in 2020, which is below the median of industry expectations of 210 million units (Table II-1). The key reasons why the industry’s expectations are unreasonably high, in our opinion, are as follows: Chinese demand for new smartphones will likely stay weak (Chart II-2). The mainland smartphone market has become extremely saturated, with 1.3 billion units having been sold in just the past three years – nearly equaling the entire Chinese population.     Chinese official data show that each Chinese household owned 2.5 phones on average in 2018, and that the average household size was about three persons (Chart II-3). This suggests that going forward nearly all potential phone demand in China is for replacement phones, and that there is no urgent need for households to buy new phones. The Chinese government’s boost to 5G infrastructure investment will likely increase annual installed 5G base stations from 130,000 units last year to about 600,000 to 800,000 this year. However, the total number of 5G base stations will still only account for about 7-9% of total base stations in China in 2020. Hence, geographical coverage will not be sufficiently wide enough to warrant a very high rate of 5G smartphone adoption and penetration. From Chinese consumers’ perspectives, a 5G phone in 2020 will be a ‘nice-to-have,’ but not a ‘must-have.’ Given increasing economic uncertainty and many concerns related to the use of 5G phones, mainland consumers may delay their purchases into 2021 when 5G phone networks will have more geographic coverage.  The number of 5G phone models on the market is expanding, but not that quickly. Consumers may take their time to wait for more models to hit the market before making a 5G phone purchase. For example, Apple will release four 5G phone models, but only in September 2020. Moreover, the price competition between 5G and 4G phones is getting increasingly intense. Smartphone producers have already started to cut prices of their 4G phones aggressively. For example, the price of Apple’s iPhone XS, released in September 2018, has already dropped by about 50% in China. Outside of China, 5G infrastructure development will be much slower. The majority of developed countries will likely give in to pressure from the US and limit their use of Huawei 5G equipment. This will delay infrastructure installation and adoption of 5G throughout the rest of the world because Huawei has the leading and cheapest 5G technology. In 2019, China accounted for about 70% of worldwide 5G smartphone shipments. We reckon that in 2020 Chinese 5G smartphone shipments will be between 120 million and 130 million units. Assuming this accounts for about 70-75% of the world shipment of 5G phones this year, we arrive at our estimate of global 5G smartphone shipments of between 160 million and 180 million units. Overall, investors are pricing global semi stocks using the pace and trajectory of 4G smartphones adoption. However, in 2020 the number and speed of 5G phone penetration will continue lagging that of 4G ones when the latter were introduced in December 2013 (Chart II-4). We agree that 5G technology is revolutionary, and its adoption and penetration will surge in the coming years. Nevertheless, we still believe global semi share prices are presently overhyped by unreasonably optimistic 2020 projections (Chart II-5).  Investment Implications Global semi stocks’ valuations are very elevated, as shown in Chart II-6 and Chart II-7. Besides, semi stocks are overbought, suggesting they could correct meaningfully if lofty growth expectations currently baked into their prices do not materialize in the first half of this year.   The coronavirus outbreak and the resulting delay in 5G phone sales in China in the first half of 2020, along with US pressure on global semi producers not to sell to Huawei, will likely trigger a pullback in semiconductor equities. We recommend patiently waiting for a better entry point for absolute return investors. Within the EM equity universe, we have not been underweight Asian semi stocks because of our negative outlook for the overall EM equity benchmark. We remain neutral on Taiwan and overweight Korea. The reason is that DRAM makers such as Samsung and Hynix have rallied much less than TSMC. Besides, geopolitical risks in relation to Taiwan in general and TSMC in particular are rising, warranting a more defensive stance on Taiwanese stocks relative to Korean equities. Ellen JingYuan He Associate Vice President ellenj@bcaresearch.com

Highlights Chinese policymakers will deliver more growth-supporting measures in the coming months, but Chinese government bond yields have already priced in a much weaker economic slowdown and a more aggressive policy response. While we think monetary policy may get even looser in the very near term, there is limited potential for the short-end of the Chinese government bond yield curve to remain at such low levels. The PBoC’s recent liquidity injections are mostly a preventive measure to avoid an acute cash crunch in the real economy, and the historical path following the 2003 SARS outbreak suggests the additional monetary easing action is unlikely to be sustained over the coming 6-12 months. As such, Chinese government bond yields will rebound in expectation of better economic conditions and more restrictive monetary conditions. On a cyclical basis, we continue to overweight Chinese equities over government bonds. Feature Chinese bond yields have declined sharply over the past two weeks, as investors weighed both the economic consequences of the Covid-19 outbreak and the likelihood of more accommodative monetary policy. Following the extended Chinese New Year holiday, China’s central bank (PBoC) has carried out five cash injections, pumping nearly 3 trillion yuan into the interbank market (Chart 1). It also lowered the de jure policy rate - the 7-day reverse repo rate - by 10bps to cut the cost of funding for commercial banks. The 3-month SHIBOR (which trades very closely to the 3-month repo rate), which we have long viewed as China’s de facto short-term policy rate, quickly reversed its January rise and fell back to its July-2018 low (Chart 2). Chart 1Large And Frequent Liquidity Injections Since The Onset Of The Virus Outbreak Chart 2Monetary Conditions Turned Much Easier In Just Three Weeks The PBoC’s aggressive easing measures of late have sparked market speculation that China is entering another major monetary and credit easing cycle, and that a government bond rally is well underway with even lower yields to come. Chart 3Extremely Tight Relationship Between Interbank Lending Rate And Government Bond Yields In our January 29 Special Report1 on China’s government bond market, we discussed how there has been a strong relationship in the past decade between unexpected changes in the 3-month SHIBOR and the long-end of China’s government bond yields. In order for the current rally in government securities to be sustained, investors need to believe that the PBoC’s easing measures are here to stay and that there will be additional policy rate cuts in the months to come (Chart 3). There are indications that Chinese policymakers are looking to deliver more growth-supporting measures over the coming months. However, it is likely that the current bond rally will be a near-term event rather than a cyclical (6-12 months) trend. Therefore, on a cyclical time horizon, we continue to recommend overweighting Chinese stocks versus Chinese government bonds and would advise against an aggressively long duration stance. Has The Covid-19 Epidemic Peaked? The fact that the number of new suspected cases is also in decline sends a signal that the outbreak outside Hubei may have largely been contained.  Chart 4Financial Market Shakes Off Some Of The "Fear Element" From The Outbreak Investors appear to concur with our view that the Covid-19 outbreak has largely become a Hubei-specific crisis.2 Chinese stocks in the onshore and offshore markets have recovered more than half of the losses from their bottom on February 3, when the number of new cases outside of the Hubei epicenter reached a tentative peak. The 12-month change in the yields of Chinese 3 and 10-year government bonds also inched up since then (Chart 4). While the Chinese government’s rollout of supportive measures, including liquidity injections and policy rate cuts since early February might have helped improve market sentiment, the fact the epidemic outside Hubei province seems to be contained also helps explain the bottom in equity prices and bond yields. In addition, the number of new suspected cases outside Hubei province has trended down since February 9 (Chart 5). The diagnosis methodology was recently revised to include suspects with clinical symptoms, regardless of whether they had a history of contact with infected cases from Wuhan. This new methodology has lowered the bar for registering newly suspected cases. While the situation surrounding the Covid-19 outbreak is still fluid, the fact that the number of new suspected cases is also in decline sends a signal that the outbreak outside Hubei may have largely been contained. Bottom Line: Outside of the epicenter, the Covid-19 outbreak may have peaked. This means the fear element driving down Chinese government bond yields may soon end. Chart 5The Situation Continues To Get Better Outside Of The Epicenter Current Bond Rally Unlikely A Cyclical Play Bond yields now appear to have largely priced in a delayed economic recovery and more aggressive policy response. We think the current rally in Chinese government bonds will thus only be a short-term event rather than a cyclical (6-12 month) play. The rally in China’s government bond market since mid-2018 was largely driven by market expectations of a significant slowdown in the Chinese economy, and a much easier monetary policy in responding to a slowing Chinese domestic demand and a protracted Sino-US trade war. Bond market is pricing in a 2015-2016-style economic slowdown and a policy response that is more aggressive than four years ago. Cyclically, we think both of these factors are absent from the current situation, and a normalization back to the pre-outbreak monetary stance may come earlier than the market expects. In the last two weeks, Chinese government bond markets have discounted a sharp slowdown in economic activity; 10-year Chinese government bond yields are back below 3.0% for the first time since 2016 and the 3-month SHIBOR is now 25bps lower than the bottom in 2015-2016 (Chart 6). This suggests the market is pricing in a 2015-2016-style economic slowdown and a policy response that is more aggressive than four years ago. The nature of the current situation, as we pointed out in our previous reports,3 represents a temporary delay rather than a derailing of an economic recovery in China.  The Covid-19 outbreak and the unprecedented containment measures paused the Chinese economy in the first quarter, just as it was coming off of a two-year soft patch. But domestic demand was not nearly as weak as in 2015-2016 before the outbreak (Chart 7). Chart 6Bond Market Is Pricing In A 2015-2016-Style Economic Slowdown Chart 7A Chinese Economic Recovery Was Budding Pre-Outbreak Chart 8The PBoC Is Generally A Reactive Central Bank, But A Proactive Central Bank In Reversing Crisis Easing If the virus is contained outside of the epicenter in the next couple of weeks and the hit to China’s overall economy is limited to Q1, then the PBoC will likely normalize policy back to its pre-outbreak stance. While the PBoC is generally a reactive central bank and has historically lagged a pickup in economic activity, it was proactive in normalizing its monetary policy following short-term shocks. Chart 8 shows the historical path of 3-month SHIBOR in the year following a bottom in economic activity in 2009, 2012, and 2015.  In all three economic slowdowns, there has not been a significant rise in interbank rates in the first nine months of an economic recovery. Following the SARS outbreak, however, the PBoC reversed its easy stance and significantly tightened liquidity conditions in the banking system only four months after the peak of the SARS outbreak. While we do not expect the PBoC to shift into a tightening mode this year, a shift back to the pre-outbreak policy trajectory sometime in Q2 is highly likely, provided the Covid-19 outbreak is contained outside of Hubei province.  In turn, Chinese government bond yields will rebound in expectation of better economic conditions and more restrictive monetary conditions. PBoC is also unlikely to open a liquidity floodgate. Despite large liquidity injections in the past two weeks, we are not convinced that the PBoC intends to fully open the liquidity tap in the interbank market.  So far, most of the financial support measures have been a combination of targeted low-cost funding to non-financial corporations and fiscal subsidies to local governments and businesses. This differs from 2015-2016 when the PBoC aggressively cut interbank rates and the 1-year benchmark lending rate, and kept excessive liquidity in the interbank system for a prolonged period (Chart 9). As Chart 9 (bottom panel) shows, PBoC’s net fund injections have been extremely volatile since Covid-19 erupted in January. This suggests that while the PBoC has added large doses of liquidity into the interbank market, demand for financial support in the banking system has mostly matched or even outstripped supply. In other words, the PBoC is not flooding the interbank system with cash, rather it is preventing an outbreak-induced illiquidity issue from turning into a widespread insolvency problem.  The PBoC is trying to prevent an outbreak-induced illiquidity issue from turning into a widespread insolvency problem.  Chart 9Monetary Policy Not Turning Back To A 2015-2016-Style "Floodgate Irrigation" Chart 10Private Sector Highly Leveraged... This approach is warranted. Small businesses have been disproportionally hit by the outbreak and are reporting a severe shortage of cash. China’s private sector is particularly vulnerable to cash flow restrictions because many businesses are highly leveraged (Chart 10).  A joint survey of 995 small and mid-size companies by Tsinghua and Peking universities showed that more than 60% of respondents said they can survive for only one to two months with their current savings (Chart 11).   Chart 11…Making Small Businesses Especially Vulnerable To Cash-Flow Constraints Additionally, there is a risk that the PBoC is underestimating the demand for cash in the banking system, particularly from small- and medium-sized banks. This underestimation could lead to a rise in the interbank lending rate. This occurred in 2017 when the crackdown of shadow bank lending caused a funding squeeze for China’s small and mid-sized banks, which led to a material rise in interbank lending rates and government bond yields (shown in Chart 6). It is also the reason that we primarily track the 3-month SHIBOR over the 7-day rate, as the former tends to capture the effects of these funding squeezes whereas the latter does not. The demand for cash in the interbank market in the current quarter will be higher than in the same period last year. The government has announced an additional debt quota of 848 billion yuan, on top of the previously authorized quota of 1 trillion yuan worth of local government bonds that would be frontloaded in Q1. This is a 32% increase from a total of 1400 billion yuan of bonds that local government frontloaded in Q1 2019. This implies the demand for cash in the interbank market will remain high as commercial banks account for about 80% of local government bond purchases.4 A temporary spike in corporate bond defaults leading to a jump in the interbank rate could also push up government bond yields. Additionally, the delayed resumption of work, the loss of production and the cash crunch facing small companies raise the risk of a surge in overdue bank loans and defaults. This could also escalate the demand for cash from smaller banks, because large commercial banks may be unwilling to lend to riskier borrowers in the interbank market. The 3-month SHIBOR has inched up since the takeover of Baoshang Bank in May 2019. Chart 12Average Lending Rates Lag Short-Term Bond Yields We expect the PBoC to lower the loan prime rate (LPR), following the 10bps cut in the medium lending facility rate (MLF) on February 17. As we pointed out in our January 29 Special Report, this easing by the PBoC will reduce corporate lending rates, but not necessarily interbank rates. Chart 12 shows that the change in average lending rates lags the change in Chinese government bond yields. Therefore, the upcoming cuts in the LPR are a result of lowered interbank rates and bond yields, not a cause for changes in government bond yields going forward. Bottom Line: Monetary policy will remain relatively loose this year, but we think the PBoC’s recent aggressive easing will be a temporary event. Any additional easing by the PBoC this year will likely be through providing short-term cash relief and temporarily lowered funding costs to non-financial corporations. There are also near-term risks that interbank rates may be pushed up due to a liquidity crunch.  Hence, yields at the short-end will likely be volatile in the near term whereas yields at the long-end are unlikely to stay at their current low levels. Investment Conclusions While we think monetary policy may get even looser in the very near term, there is limited potential for the short-end of the Chinese government bond yield curve to remain at such low levels. Barring a lasting economic slowdown from the Covid-19 outbreak, the long-end of the curve has the potential to move moderately higher in the second half of the year, as China’s economy recovers from the outbreak-induced shock. Bond yields at the short-end will likely be volatile in the near term whereas yields at the long-end are unlikely to stay at their current low levels. Given this, we continue to expect Chinese domestic and investable equities to outperform government bonds in the next 6-12 months, and we would advise Chinese fixed-income investors against an aggressively long duration stance. Onshore corporate bonds, while risking a higher default rate in the near term, shares a similar outlook on a cyclical basis: onshore spreads are pricing in (massively) higher default losses than we believe are warranted. This means that onshore corporate bonds will still outperform duration-matched government bonds without any changes in yield, underpinning another year of Chinese corporate bond market outperformance versus government bonds.   Jing Sima China Strategist jings@bcaresearch.com   Footnotes 1    Please see China Investment Strategy Special Report "How To Analyze And Position Towards Chinese Government Bonds," dated January 29, 2020, available at cis.bcaresearch.com 2   Please see China Investment Strategy Weekly Report "The Evolving Crisis," dated February 13, 2020, available at cis.bcaresearch.com 3   Please see China Investment Strategy Weekly Report "Recovery, Temporarily Interrupted," dated February 5, 2020, available at cis.bcaresearch.com 4   ChinaBond, as of 2019 Cyclical Investment Stance Equity Sector Recommendations

Highlights Why did S&P 500 profit margins fall in 2019?: Compensation gains, trade tensions and spotty growth were the most likely culprits, though the absence of standardized disclosure hinders full attribution. Was it a one-off, or the beginning of a trend?: We believe that profit margins have likely peaked, though we expect that they will contract only modestly this year. The outcome of the election could have a significant margin impact going forward. The coronavirus outbreak may be worsening around Wuhan, but it does not appear to be metastasizing elsewhere: Our China strategists foresee an extended lockdown of Hubei province, but expect that the rest of the Chinese economy will be able to overcome it. They are cautiously optimistic about the prospects for containment. Sustainability What a difference a year makes. Last President’s Day, the S&P 500 was more than 5% below its September 2018 peak (18% below its current level), amidst widespread fears that the Fed may have tightened into a recession. The month-long government shutdown was an embarrassing own goal, and trade tensions loomed as a threat to corporate earnings and global growth. It would take another two months before the S&P 500 fully recovered, only to have the yield curve invert soon thereafter. The coronavirus epidemic (COVID-19) has the curve flirting with inversion again, but stocks have shrugged off the growth risks. They continue to scale the wall of worry as self-appointed bubble spotters’ blood pressure soars, leaving them sputtering like Judge Smails or the bank official overseeing Charles Foster Kane’s trust. While we acknowledge that COVID-19 and Bernie Sanders’ post-Iowa-and-New Hampshire position at the head of the Democratic pack could yet become problematic for markets and the economy, our take aligns much more closely with Fed Chair Powell’s House testimony last week. “There’s nothing about this expansion that is unstable or unsustainable.” COVID-19 Update Chart 1What Happens In Hubei Our China Investment Strategy colleagues were encouraged by the latest Chinese data on the outbreak. Although they foresee that Wuhan, and quite possibly all of Hubei province, will be shut down through the end of March, they do not think the action will thwart China’s nascent growth recovery. In their estimation, domestic companies will be able to reroute their supply chains with minimal disruption. If the equity market avoids a virus-related plunge, as they expect, the economy may dodge the deleterious impact on confidence that might otherwise emerge. Our sanguine China outlook encountered some resistance from clients, who have been surprised at how swiftly markets seemed to put the outbreak aside, and skeptical of official reports that seemed a little too good to be true. We suggested that they employ a trust-but-verify approach similar to ours. We are taking official data as given, while using other countries’ data as a reasonableness check. We are monitoring the magnitude of PRC policy efforts to mitigate the virus’ drag and remaining vigilant for any signs of global supply chain disruptions. Bottom Line: Our China strategists were heartened by official reports indicating that the coronavirus has been mostly contained in Hubei province (Chart 1), but are actively seeking out other evidence for corroboration before concluding that the worst is over. Making Sense Of Declining Profit Margins As we showed last week, S&P 500 profit margins narrowed across 2019, with 2% EPS growth lagging 5% growth in per-share revenue. Margins do not remain fixed over time, but the contraction represented a notable shift after several years of steady margin expansion. Even when EPS declined on a year-over-year basis for four straight quarters across 2015 and 2016, margins mainly held their own as revenues, which contracted year-over-year for six consecutive quarters, had it worse (Chart 2). Chart 2Fun While It Lasted We primarily attribute last year’s decline to gains in labor’s share of income. Although average hourly earnings growth decelerated from 2018 to 2019, real unit labor cost growth flipped from negative to positive. Tariffs also likely detracted from income, as domestic businesses were surely not able to pass through all of their increased cost of goods sold to their customers against a backdrop of persistently low inflation and limited pricing power. Decelerating US and global growth was also a drag (Chart 3). Chart 3Growth Decelerated Everywhere In 2019 Have Profit Margins Peaked? Excepting meaningful structural changes, profit margins are a mean-reverting series. Following steady margin expansion over three business cycle expansions spanning nearly three decades, mean reversion is an unappealing prospect for equity investors (Chart 4). Unless corporate tax rates are raised, though, the mean going forward will be higher than the mean established when federal taxation was more onerous. Additionally, an in-depth Bank Credit Analyst study argued that profit margins have not grown as much as it would appear to the naked eye,1 but they are elevated, and their future direction will influence prospective equity returns. Chart 4Margins Have Thrived In The Last Three Expansions A definitive analysis of S&P 500 margins would compile detailed revenue and expense data for each constituent in the index, but compiling the bottom-up data would repeatedly bump up against inconsistent disclosure conventions across companies and industries. For now, we will have to content ourselves with what we can glean from top-down analysis. Margins shrank in 2019 because of rising real unit labor costs, increased tariffs and global growth deceleration. Employee compensation is far and away the single biggest expense item for businesses as a whole. Changes in compensation are therefore the most consistently critical driver of changes in margins. Other key factors include: overall economic growth, growth relative to capacity, globalization, competitive intensity, and growth of the capital stock. GDP Growth Over time, growth in a company’s revenues should converge with the weighted average of economic growth in the countries in which it operates. The sensitivity of any given company’s net income to changes in sales revenue depends on its operating leverage, but any company with at least some fixed costs will see its margins expand as sales rise. We expect that US GDP growth will moderate going forward, given that hoped-for increases in economic capacity do not appear to have offset the growth overhang from the stimulus package’s increased deficits.2 For the current year, however, we expect that an acceleration in non-US growth may largely offset moderating US growth for the aggregate S&P 500. (Chart 5) Chart 5Sales Growth Feeds Operating Leverage The Output Gap The degree of excess capacity in the economy is most easily proxied by the output gap, the difference between the economy’s actual output and its long-run potential output, which is a function of productivity and labor force growth. Pricing power is directly related to the output gap; it’s weak when the gap is negative, and robust when the gap is positive. Excess capacity is the enemy of profits, and margins benefit when it is worked off, even if positive output gaps can’t persist indefinitely (Chart 6). With the economy continuing to grow at close to its estimated trend rate, the output gap isn’t likely to have an impact this year. Globalization allows US companies to tap lower-cost inputs in the developing world. Chart 6Excess Capacity Erodes Pricing Power Globalization Globalization has been a major force promoting margin expansion over the last 20 to 30 years, granting US-domiciled businesses access to the developing world’s lower-cost inputs. Outsourcing saves money and global supply chains have significantly reduced product costs. Tariffs and other trade barriers are an obstacle to outsourcing, and it is our in-house geopolitical strategists’ view that the US will continue to backtrack from globalization no matter which party captures the White House in November. Changes in the sum of exports and imports as a share of GDP provide a simple proxy for changes in the intensity of globalization (Chart 7). Chart 7More Open Borders = Higher Margins Competitiveness Margins are directly related to the intensity of globalization, but they are inversely related to the intensity of competition, which is itself inversely related to the degree of industry concentration. The laissez-faire approach to anti-trust enforcement which has generally prevailed since the Reagan administration has promoted concentration. Businesses gain pricing power as their industries move along the spectrum from perfect competition toward monopoly, just as they gain increasing power to set wages as individual labor markets move toward monopsony. Pressure for federal action to reverse the four-decade trend toward concentration will rise if the Democrats win the White House, especially as our Geopolitical Strategy service holds that the party that takes the presidency will also take the Senate. Productivity Changes in margins are directly related to the pace of productivity gains. Workers are able to do more in a given period of time when they’re endowed with more and/or better tools, and investment provides those tools. Increases in the size of the capital stock lead to productivity gains. The NFIB survey suggests that small businesses are poised to increase capital expenditures, and the capex intentions components of the regional Fed manufacturing surveys have begun pointing in that direction as well, but investment has consistently disappointed since the crisis (Chart 8), and productivity growth has been tepid for an extended period of time as a result. Chart 8Investment Pays Off In Higher Margins Unit Labor Costs Rising labor costs by themselves do not necessarily mean that margins will contract. If output increases more than rising wages, margins will expand. We therefore watch unit labor costs, which measure output-adjusted changes in compensation. Growth in real unit labor costs is our preferred measure for their additional insight into profitability, given that changes in the overall price level are a solid proxy for changes in sales prices. When real unit labor costs are falling, corporate margins are likely expanding as revenue gains can be expected to outpace employees’ compensation per unit of output. Given the especially tight labor market, we expect real unit labor costs to continue to rise, chipping away at profit margins (Chart 9). Chart 9Persistently Negative Real Unit Labor Costs Have Boosted Margins Taxes, Interest Rates And The Dollar The biggest driver of after-tax margins in recent years has been the 40% reduction in the top marginal federal corporate income tax rate from 35% to 21% beginning in 2018. We expect no material corporate tax changes if the president wins re-election, while we would expect that an incoming Democratic administration, fortified by House and Senate majorities, would prioritize increasing corporate tax revenues. We expect a modest rise in interest rates over the year, which is unlikely to materially impact firms’ interest expense. We expect that the dollar will weaken in 2020, as incremental growth in the rest of the world exceeds incremental growth in the US, providing the S&P 500 with a modest margin tailwind. Bottom Line: On balance, we expect that the S&P 500 will face modest margin headwinds in 2020. If the Democrats assume control of the White House and both houses of Congress next January, downward pressure on margins could intensify. Investment Implications Falling margins against a backdrop of tepid revenue growth suggest that 2020 S&P 500 earnings growth will be nothing to write home about. Stocks will have to get an assist from multiple expansion if they are to continue producing double-digit annual returns. We do not think multiple expansion is much of a stretch – it would be consistent with the latter stages of previous bull markets – but equities do not need to generate double-digit returns to top the prospective returns on offer from Treasuries, credit-sensitive fixed income or cash. As long as the margin compression unfolds slowly, equities will merit at least an equal-weight allocation in balanced portfolios as will spread product in dedicated fixed income portfolios. Corporate profit margins would quickly feel the burn in a Sanders administration. We expect that profit margins will compress slowly, as it remains our base case (albeit with limited conviction) that the president will win re-election. Under a Democratic regime, however, corporate tax rates would likely rise, anti-trust enforcement would likely unwind some of the buildup in industry concentration, and organized labor would gain a more sympathetic ear in Washington. If Bernie Sanders were to win the presidency instead of one of the Democratic moderates, margin compression would likely unfold much more rapidly (and multiples would be at immediate risk, to boot). The upcoming election is thus approaching something of a binary outcome for equities. We still see monetary policy as the swing factor for the ongoing expansion, and financial market returns, and we therefore remain constructive on the economy and risk assets. The election could upend that framework, however, passing the baton from the Fed to elected officials. We will be tracking the primary and general election ups and downs closely.   Doug Peta, CFA Chief US Investment Strategist dougp@bcaresearch.com Footnotes 1 Please see the October 2012 Bank Credit Analyst Special Report, "Are US Corporate Profit Margins Really All That High?" available at www.bcaresearch.com. 2 The economic case for the stimulus package rested on the expectation that it would promote investment in the capital stock that would not otherwise occur (via immediate expensing of investments and repatriation of capital held overseas) and facilitate labor force participation. A capex burst that followed its passage quickly fizzled, and we are of the opinion that the minor provisions intended to expand labor force participation have had little effect.