Consumer Discretionary

Special Report

Highlights It will be impossible for China to undertake even mild deleveraging and simultaneously accelerate household income growth. All deposits in the banking system have been created by banks “out of thin air” and have not been engendered by household savings. Contrary to widespread beliefs, mainland households are highly leveraged. Cyclically, high equity valuations, crowded investor positioning and the delayed cyclical recovery in the Chinese economy pose downside risks to consumer stocks. Structurally, real income growth per capita is contingent on productivity growth. The latter will slow in China but remain relatively elevated. Overall, investors should consider buying Chinese consumer plays on weakness. Feature Deliberations about China’s successful rebalancing often boils down to whether one believes that consumers will be able to offset the slowdown in investment and exports and keep overall real GDP growth close to current levels. The narrative typically presumes that Chinese households are not spending enough and can boost their spending counteracting the ongoing slowdowns in capital spending as well as in exports. This conjecture is fallible. Chart I-1The Myth Of Deficient Consumer Demand In China Consumer spending in China has in fact been booming over the past 20 years – it has been growing at a compounded annual growth rate (CAGR) of 10% in real terms since 1998 (Chart I-1, top panel). Hence, the imbalance in China has not been sluggish consumer spending. Rather, capital expenditure has been too strong for too long (Chart I-1, bottom panel). Healthy rebalancing entails a slowdown in investment spending – not an acceleration in household demand. Hence, the market relevant question is: Can the growth rate of household expenditure accelerate above 10% CAGR in real terms as capital spending and exports decelerate? Our hunch is that this is unlikely. As the authorities attempt to contain credit and investment excesses and trade war-induced relocation of manufacturers out of China gathers steam, the pertinent question is whether the slowdown in household expenditures in real terms will be mild (from the current 10% pace to 7.5-9% CAGR), medium (6-7.5%) or material (below 6%). In our opinion, the medium scenario has the highest odds of playing out. There are many positives about the vitality of Chinese consumers and we do not mean to downplay them. Nevertheless, many of these positives are well known, and the objective of our report is to reveal misconceptions about this segment.  Deleveraging And Consumers If and when deleveraging does transpire in China, the household income growth rate will decelerate, resulting in weaker spending growth. It will be impossible for the mainland economy to undertake even mild deleveraging and simultaneously accelerate household income growth. Chart I-2Capital Spending Is Much More Important Than Exports Our focus for this report is on a slowdown in credit and capital spending rather than exports. The basis is that the latter in general, and shipments to the U.S. in particular, have a much smaller impact than investment expenditures (Chart I-2). In turn, capital spending is mostly financed by credit. It is crucial to understand the significance of credit in driving national and household income growth in China since 2008. Currently, 2.5 yuan of new credit is needed to generate one yuan of GDP growth. This certifies that the mainland economy has become addicted to credit. As we have argued in depth in past reports, commercial banks do not intermediate savings into credit, but rather create new money/credit “out of thin air” when they lend to or buy securities from non-banks. This entails that output and income growth would have been much weaker had banks not provided credit equal to RMB 19 trillion over the past 12 months. For instance, a company affiliated with the provincial government has borrowed money from banks to build three bridges over the past 10 years, accumulating a lot of debt in the process. Ostensibly, operating these bridges does not generate enough cash flow to service its debt – a common occurrence in China. With the three bridges completed, the company would then apply for a new loan to build a fourth bridge. Should banks lend additional money to construct it? Notwithstanding this hypothetical company’s low creditworthiness, if banks provide additional financing, the credit bubble will become larger, and the issue of overcapacity will intensify. On the other hand, household income and spending growth will remain robust. If banks do not finance the construction of the fourth bridge, labor income growth in the province – employees of this company and its suppliers – will slump. Thus, if for whatever reason banks are unable or unwilling to extend as much in new credit as last year, output and income growth in this province will decelerate, all else equal. Given credit has been playing an enormous role in driving China’s economic growth over the past 10 years, it will be almost impossible to slow down credit without a downshift in household income growth. This example and analysis is not meant to suggest that bank credit origination is the sole growth driver in China. Theoretically, GDP can expand even with bank credit/money contracting. According to the quantity theory of money: Nominal GDP = Money Supply x Velocity of Money This means nominal GDP can grow even when the supply of money/credit is shrinking. For this to happen, the velocity of money should rise faster than the pace of decline in the supply of money/credit. From a practical perspective, this requires enterprises and consumers to increase the turnover (velocity) of their bank deposits and cash on hand (money supply). We have deliberated in past reports that the velocity of money and the savings rate are inversely related: A rising velocity of money entails a declining savings rate, and vice versa. Going back to our example of bridge construction, the relevant question is: Will companies and households in that province increase their spending (i.e., reduce their savings rate) if banks do not finance the construction of the fourth bridge? The realistic answer is not likely. If the fourth bridge does not receive financing, weaker income growth in that province – due to employment redundancies among construction companies and their suppliers – would lead to slower spending growth. Faced with slowing demand growth, other enterprises and households would likely turn cautious and increase their savings rates – i.e., reduce the velocity of money supply. In short, reduced credit origination will mostly likely generate slower household income growth and, consequently, spending. Chart I-3China: No Deleveraging So Far Broadly speaking, household income growth has not yet downshifted because deleveraging in China has not started. Chart I-3 illustrates that aggregate domestic credit – including public sector, enterprises and households – continues to grow above 10% and well above nominal GDP growth. In fact, credit growth has exceeded nominal GDP growth since 2008. This is local currency credit and does not include foreign currency debt, but the latter is small at 14.5% of GDP (or about US$ 2 trillion). To us, deleveraging implies credit growth that is no greater than nominal GDP growth – i.e., a flat or declining credit-to-GDP ratio for at least several years. If China is serious about deleveraging and curbing its money/credit bubble, the pace of credit expansion should decline to or below nominal GDP growth – which is presently 8%. If and when this occurs it will dampen household income and spending growth. Bottom Line: Chinese household income and spending will inevitably slow if money/credit growth slumps, given the Chinese economy’s excessive reliance on new credit origination over the past 10 years. Do Households Have A Savings Or Debt Glut? What about households’ enormous savings in China? Why wouldn’t households reduce their savings and boost spending? When referring to household savings, most allude to bank deposits. But in conventional economic theory – and according to the way household savings are statistically calculated at a national level – savings actually have no relation to bank deposits. Chart I-4No Empirical Evidence That Deposits = Savings Chart I-4 illustrates that in China, the annual change in household deposits is not equal to household savings (Chart I-4, top panel). Similarly, the annual rise in all deposits (based on central bank data) is vastly different from annual national savings (as defined by conventional macroeconomics and calculated by the National Bureau of Statistics) (Chart I-4, bottom panel). Bank deposits are a monetary concept that we will refer to as “money savings.” Deposits are created by banks “out of thin air,” as illustrated in our past reports.Meanwhile, the term “savings” in conventional macroeconomics denotes goods and services that are produced but not consumed, which is a real economic (not monetary) variable. Not surprisingly, there is no relationship between these “real savings” and “money savings,” as illustrated in Chart I-4. To illustrate that household “savings” (as defined by conventional macroeconomics) are not related to money supply/deposits, let us go back to the example of the company building bridges in China. When the company wire transfers a salary of RMB 1,000 to an employee, the amount of money supply in the banking system does not change. Suppose this employee decides to save 100% of her income this month. Will the supply of money increase or decrease? The answer is that it will not change: the deposit will remain at her bank account. Alternatively, if she decides to spend all RMB 1,000 (100% of her income), the supply of money also will not change – deposits will be transferred to other banks where her suppliers have their accounts.  If she cashes out her deposit and puts it under her mattress, the amount of bank deposits will decline, but cash in circulation will rise by the same amount. Provided money supply is equal to the sum of all bank deposits and cash in circulation, the amount of money supply will not change. The only way the supply of money will decline is if she pays down her loan to a bank. Conversely, the supply of money only rises when banks originate loans or buy assets from non-banks. In short, saving/not spending does not alter the amount of money supply. Rather, broad money supply is equal to the cumulative net money creation “out of thin air” primarily by commercial banks and less so by the central bank over the course of their history. This has nothing to do with household and national “savings.” The latter stand for goods and services produced but not consumed. We have discussed what “savings” mean in conventional economics in past reports. Chart I-5Chinese Households Are More Leveraged Than U.S. Ones Critically, Chinese households presently carry more debt as a share of their disposable income than American households (Chart I-5). This chart compares household debt to disposable income using official data from both China and the U.S. In the case of China, we add Peer-to-Peer (P2P) credit to consumer credit data published by the People’s Bank of China to calculate household debt. The argument by many commentators that consumers in China are not highly leveraged is grounded on the comparison of their debt to GDP. However, in all countries, household debt is assessed versus disposable income – not GDP. The income available to households to service their debt is their disposable income – not GDP. It is correct that Chinese households’ assets have surged in the past two decades as they have purchased significant amounts of real estate, and property prices have skyrocketed. A survey by China Economic Trend Institute holds that property accounts for 66% of household assets in China. To assess creditworthiness, investors should not rely on debtors’ asset values. If debtors are en masse forced to sell their assets to service debt, equity prices would tumble well beforehand. Rather, creditworthiness should be assessed based on recurring cash flow (income) available to debtors to service their debt. One should not be surprised as to why real estate prices are very high in China. Money and credit have been surging – have grown four-fold – over the past 10 years (Chart I-6) and are still expanding at close to a 10% pace. In particular, household debt is still growing at a whopping 15.5% annually (Chart I-7). If and as money/credit growth downshifts, property prices will deflate. Chart I-6Helicopter Money In China Chart I-7Household Credit Is Expanding Twice As Fast As Income Growth Importantly, housing affordability is low and households’ ability to service their mortgages is troubling. Chart I-8 exhibits the nationwide house price-to-income ratio for China and the U.S. In the Middle Kingdom, it is currently about 7.2, while in the U.S. the ratio has never been above 4. It only approached 4  at the peak of the housing bubble in 2006. Chart I-8House Prices Are Very Expensive In China   In turn, Table I-1 illustrates mortgage interest-only payments as a share of household disposable income. The national average is 25.5%. These are very high ratios, suggesting an average new home buyer will have to allocate about a quarter of her or his household income just to pay the interest on a mortgage. These averages do not divulge enormous variations among households. High-income and rich households probably do not have much debt, and debt sustainability is not an issue for them. This also implies that there are many low-income households for whom the interest payments on mortgages absorb more than 25% of their disposable income.  Bottom Line: All deposits in the banking system have been created by banks “out of thin air” and have not been engendered by household savings. Contrary to widespread beliefs, mainland households have a lot of debt, and the latter is still expanding faster than nominal disposable income growth (Chart I-7 above). Positives And The Cyclical Outlook This section lists some positives for household incomes and spending, while also highlighting inherent risks: In the long run, per-capita real income growth in any country is equal to productivity growth. Productivity in China is still booming, justifying high real income growth. The question is whether such buoyant productivity growth can be sustained at a high level to justify robust real-income per-capita growth. Typically, easy money breeds complacency, misallocation of capital and ultimately lower productivity growth. Can China sustain productivity growth of 6% to assure a similar growth rate in real income per capita if the nation continues to experience easy money and a misallocation of capital? Forecasting productivity is not easy; only time will tell. Chart I-9Nominal Household Income, Wages And Salaries Per capita aggregate income as well as both wages and salaries are still expanding briskly – by about 8.5% in nominal terms from a year ago (Chart I-9). This is a formidable growth rate and entails vigorous spending power. The cyclical and long-term concern is whether the current rate of income growth is sustainable. So far there has been few redundancies, despite the fact that corporate revenue and profits have slumped. There is anecdotal evidence that the authorities are actively discouraging dismissals among both state-owned and private enterprises. If layoffs are avoided in this cycle, it will imply that the full pain of the slowdown is absorbed by shareholders. As a result, wages and salaries will rise as a share of GDP, causing a profit margin squeeze for companies. Will private shareholders be willing to invest in the future? Over the past year,  authorities have targeted the stimulus at consumers by cutting personal income taxes. However, this has not boosted consumption: First, the individual taxpayers’ base was very small; only one quarter of total employment (or 16% of the population) was paying personal income taxes before the most recent cut. Second, personal income tax savings have amounted to less than 2% of disposable income.   Finally, the savings from tax cuts are unevenly distributed across households. High-income families will probably get higher tax savings than lower-income ones, whereas the propensity to spend is higher for the latter than the former. Household deposit expansion has accelerated at the expense of enterprises (Chart I-10). This confirms that companies have not slowed the payments to employees (wage bill). Consequently, households have firepower which can be unleashed at any time.  However, there are presently no signs of a growing appetite to spend. Quite the contrary, our proxy for household marginal propensity to spend is falling (Chart I-11). Chart I-10Households Are Hoarding Money, Not Spending Chart I-11Household Marginal Propensity To Spend Is Still Falling Non-discretionary consumer spending has remained very robust. In contrast, discretionary spending has been extremely weak and shows no signs of recovery (Chart I-12). Finally, the impulses of non-government credit, broad money and household credit are weak (Chart I-13). Without these improving substantially and households’ marginal propensity to spend rising, it is difficult to expect a meaningful recovery in consumption. Chart I-12Discretionary Spending Is Sluggish Chart I-13Credit/Money Impulses Are Much Weaker Than In Previous Stimulus Bottom Line: A cyclical recovery in consumer spending hinges on another round of major credit and fiscal stimulus as well as improvement in households’ willingness to spend. Structurally, real income growth is contingent on China’s ability to sustain high productivity growth. Investment Implications If and as capital spending and exports growth slow further, the pace of expansion in consumer expenditure will also moderate. In such a scenario, overall economic growth in China will inevitably downshift. Structurally, Chinese consumer spending will slow from the torrid pace of 10% CAGR of the past 10 years to around 6-7.5% CAGR in real terms. This is a formidable growth rate, and warrants a bullish stance on the consumer sector. We identified Chinese consumers as a major investment theme for the current decade in our 2010 report titled How To Play EM This Decade? 1 In that report, we recommended selling commodities and sectors exposed to Chinese construction and instead favoring consumer plays, especially in the health care and tech sectors. This structural theme has played out well and has further to go. Chinese household spending on health care, education and other high-value services will rise as income per capita expands, albeit at a slower rate than before. Chart I-14 demonstrates that Chinese imports of medical and pharmaceutical products are surging, even though overall imports are currently contracting. Domestically, profit margins are expanding within the medical and pharmaceuticals industries but stagnating for the overall industrial sector (Chart I-15). Chart I-14Surging Demand For Medical Products/Goods Chart I-15Continue Favoring Companies In Health Care/Medical Space All that said, a bullish growth story does not always translate into strong equity returns. Charts I-16A and I-16B reveal that share prices of Chinese investible consumer sub-sectors have had mixed performance. With the exception of Alibaba and Tencent, a few of consumer equity sub-sectors have generated strong equity returns. Chart I-16AChinese Consumer Stocks: Mixed Performance Chart I-16BChinese Consumer Stocks: Mixed Performance Such poor equity performance given strong headline consumption growth has often been due to bottom-up problems such as profit margins squeeze, overexpansion, over-indebtedness, equity dilution, quality of management and other issues. Apart from company specific risks, investors should also consider valuations. Buying good companies in great industries at very high equity multiples will probably produce meager returns. Table I-2 shows the trailing P/E ratio for various consumer sub-sectors. The majority of them trade at a trailing P/E ratio of above 20 and in some cases above 30. Besides, China’s consumer story has been well known for some time, and many portfolios are overweight China consumer plays. Consequently, investor positioning adds to near-term risks. Cyclically, high equity valuations, crowded investor positioning and the delayed cyclical recovery in the Chinese economy pose downside risks to consumer stocks as well. However, such a selloff will create conditions for selectively investing in reasonably valued high quality companies.   Arthur Budaghyan Chief Emerging Markets Strategist arthurb@bcaresearch.com Lin Xiang, Research Analyst linx@bcaresearch.com   Footnotes 1      Please see Emerging Markets Strategy Special Report, “How To Play Emerging Market Growth In The Coming Decade”, dated June 10, 2010, available at ems.bcaresearch.com Equities Recommendations Currencies, Credit And Fixed-Income Recommendations

Highlights Portfolio Strategy The sustained global growth slowdown, widening junk spreads, along with the risk of a U.S. recession becoming a self-fulfilling prophecy suggest that caution is still warranted in the broad equity market on a 3-12 month time horizon. Weakening consumer sentiment, softening hotel industry operating metrics that point to a margin squeeze, anemic relative outlays on lodging and a decelerating ISM non-manufacturing index, all signal that more pain lies ahead for the S&P hotels, resorts & cruise lines index.   Waning industry operating metrics, a bearish signal from our EPS growth model along with the mighty U.S. dollar warns against bottom fishing in the S&P electrical components & equipment (EC&E) index.  Recent Changes There are no changes to the portfolio this week. Table 1 Feature The S&P 500 traded in an uncharacteristically tight range last week before falling apart on Friday on the back of a re-escalation in the U.S./China trade war. Worries of recession also resurfaced. Not only did the MARKIT flash manufacturing PMI break below the 50 expansion/contraction line, but it also pulled down the MARKIT flash services PMI survey that barely held above the boom/bust line. Adding insult to injury, the 10/2 yield curve slope inverted anew last week further fanning these recession fears. Worrisomely, consumer sentiment took a hit recently according to the University of Michigan survey (top panel, Chart 1). Importantly, what caught our attention was the following commentary: “The main takeaway for consumers from the first cut in interest rates in a decade was to increase apprehensions about a possible recession. Consumers concluded, following the Fed’s lead, that they may need to reduce spending in anticipation of a potential recession.” While the consumer is the last and most significant pillar standing for the U.S. economy, reflexivity may spoil the party and a recession may become a self-fulfilling prophecy. This is the message the bond market is sending and it is warning that the path of least resistance is a lot lower for stocks (bottom panel, Chart 1). Chart 1“The First Cut Is The Deepest” Economists are also downgrading their U.S. real GDP growth estimates and that forecast now stands at 2.3% for the current year according to Bloomberg. While the recession alarm bells are not sounding off, these downward revisions bode ill for stocks (Chart 2)  Chart 2Watch Out Down Below Moving to another part of the fixed income market, stress is slowly building in the high yield market especially given the recent tick up in bankruptcies and the blind sides that cove-lite loans now pose to bond investors. As a reminder, the U.S. high yield option adjusted spread (OAS) troughed last September and continues to emit a distress signal for the broad equity market (junk OAS shown inverted, top panel, Chart 3). Chart 3Mind The Gaps With regard to global growth, it is still missing in action, and given that Dr. Copper is on the verge of a breakdown, a global growth recovery is a Q1/2020 story at the earliest. This week we update a consumer discretion­ary subindex and also highlight an industrials sector subgroup. Chart 4SPX: The Next Shoe To Drop? Chart 5Risk To View Other financial market variables concur that global growth is elusive. J.P. Morgan’s EM FX index has broken down and EM equities are also hanging from a thread. The EM high yield OAS has broken out signaling that the risk off phase has yet to fully run its course (EM junk OAS shown inverted, bottom panel, Chart 4). Finally, there is a short-term risk to our cautious equity market view. Indiscriminate buying in U.S. Treasurys has now pushed the 10-year yield down almost 180bps from last November’s peak deeply in overvalued territory. While such a move is not unprecedented, buying may be exhausted and in need of at least a short-term breather (Chart 5).     Netting it all out, the sustained global growth slowdown, widening junk spreads, along with the risk of a U.S. recession becoming a self-fulfilling prophecy suggest that caution is still warranted in the broad equity market on a 3-12 month time horizon. As a reminder, this is U.S. Equity Strategy’s view, which contrasts BCA’s sanguine equity market house view. This week we update a consumer discretionary subindex and also highlight an industrials sector subgroup. Empty Spaces When the consumer is worried about a possible recession as the latest survey revealed, the knee jerk reaction is to tighten the purse strings and marginally retrench. The latest University of Michigan consumer sentiment survey made for grim reading and such souring in confidence will continue to weigh on lodging equities (Chart 6). As a result, we remain underweight the niche S&P hotels, resorts & cruise lines consumer discretionary subgroup. When the consumer is worried about a possible recession as the latest survey revealed, the knee jerk reaction is to tighten the purse strings and marginally retrench. Chart 6Stay Checked Out Of Hotels   Already discretionary retail sales have taken the back seat and non-discretionary retail sales are in the driver’s seat. In fact, the top panel of Chart 7 shows that the relative retail sales backdrop has plunged to levels last seen during the GFC, warning that relative share prices have ample room to fall. Drilling deeper in the consumption data is instructive. Lodging outlays are decelerating and are also trailing overall PCE. The implication is that relative profits will likely underwhelm sustaining the 18-month long de-rating phase (middle & bottom panels, Chart 7). On the operating front the news is equally dour. While selling prices are expanding, the relentless construction binge will lead to a mean reversion sooner rather than later (bottom panel, Chart 8).   Chart 7De-rating Phase To Gain Steam Chart 8Margin Squeeze Looming   Tack on the ongoing assault from the new sharing economy unicorns like Airbnb, and industry pricing power will remain in check in coming quarters. Similarly, the ISM non-manufacturing price subcomponent is warning that a deflation scare is looming in the lodging industry (second panel, Chart 8). Not only are selling prices under attack, but also labor-related input costs are on fire. The sector’s wage inflation is climbing at a 3.9%/annum pace or roughly 120bps higher that the overall employment cost index (third panel, Chart 8). Taken together, there are high odds that a profit margin squeeze will weigh on profits and on relative share prices (top panel, Chart 8). Importantly, the overall ISM services survey best encapsulates the bearish backdrop of the S&P hotels, resorts & cruise lines index. Historically, relative share prices have been moving in tandem with the ISM non-manufacturing survey and the current message is that selling pressures on relative share prices will persist in the coming months (Chart 9). Chart 9Heed The Message From The ISM Services Survey In sum, weakening consumer sentiment, softening hotel industry operating metrics that point to a margin squeeze, anemic relative outlays on lodging and a decelerating ISM non-manufacturing index signal that more pain lies ahead for the S&P hotels, resorts & cruise lines index. Bottom Line: Continue to avoid the S&P hotels, resorts & cruise lines index. The ticker symbols for the stocks in this index are: BLBG: S5HOTL – MAR, HLT, RCL, CCL, NCLH. Short Circuited The S&P EC&E index broke down recently (top panel, Chart 10) and we reiterate our underweight recommendation in this industrials sector subgroup. While it is tempting to bottom fish here especially given oversold technical and bombed out valuations (bottom panel, Chart 11), a number of the indicators we track suggest that more losses are around the corner. Chart 10Sell The Weakness Chart 11Good Reasons For Valuation Discount   First the trade-weighted dollar has broken out to fresh cyclical highs despite the collapse in the 10-year yield. Historically, relative share prices and the greenback are tightly inversely correlated and the current weak global growth message the U.S. dollar is emitting is bearish for the S&P EC&E index (U.S. dollar shown inverted, middle panel, Chart 10). This global growth soft patch is not only negative for new orders owing to deficient foreign demand, but the appreciating currency also makes EC&E exports less competitive in the global market place (U.S. dollar shown inverted, bottom panel, Chart 10). Second, while industry new orders have been resilient, the massive inventory buildup dwarfs new order growth and warns that a deflationary liquidation phase is looming (middle panel, Chart 11). In fact, the recent drubbing in the ISM manufacturing prices paid subcomponent portends a deflationary industry phase (third panel, Chart 12). Adding it all up, waning industry operating metrics, a bearish signal from our EPS growth model along with the mighty U.S. dollar warns against bottom fishing in the S&P EC&E index. Other operating metrics are also warning that EC&E profits will underwhelm. Industry weekly hours worked have plunged and sell-side analysts have been aggressively cutting EPS estimates (bottom panel, Chart 13). On the productivity front, executives have not adjusted labor cost structures to lower running rates yet (second panel, Chart 13) and, thus, our EC&E productivity gauge (industrials production versus employment) is contracting which bodes ill for industry earnings (third panel, Chart 13). Chart 12Weak Profit Backdrop Chart 13Deteriorating Operating Metrics   Finally, our S&P EC&E EPS growth model does an excellent job in encapsulating all these moving parts and is signaling that the path of least resistance is lower for EPS growth in the coming months (bottom panel, Chart 12). Adding it all up, waning industry operating metrics, a bearish signal from our EPS growth model along with the mighty U.S. dollar warns against bottom fishing in the S&P EC&E index. Bottom Line: Stay underweight the S&P EC&E index. BLBG: S5ELCO – AME, EMR, ETN, ROK.     Anastasios Avgeriou, U.S. Equity Strategist anastasios@bcaresearch.com   Current Recommendations Current Trades Size And Style Views Favor value over growth Favor large over small caps

Highlights Markets expressed disappointment over last week’s FOMC meeting, … : Equities sold off, Treasury yields slid, and the curve flattened. … but we didn’t think there was all that much to get excited about, … : Data dependence remains the Fed’s mantra, and it was never likely that the FOMC would signal that policy through September has been pre-programmed. … though the specter of escalating trade tensions was a bummer: We have followed our repeated exogenous-shock caveat with an acknowledgement of the gravity of trade barriers. Our geopolitical strategists don’t expect a resolution any time soon, though, and White House tweets are here to stay. Marginally easier monetary policy is not likely to have all that much of an effect on the economy: A reduction in the fed funds rate from 2.5% to 2% isn’t likely to turbo-charge housing or corporate investment, but we do expect that the major central banks’ easing bias will support risk assets. Feature The FOMC delivered the result we expected at the conclusion of its meeting last week: a 25-basis-point cut and a dovish adjustment to its balance sheet runoff plans. Markets acted as if they’d been blindsided. Apparently it really isn’t what you say, it’s how you say it. Or maybe, as our colleague Martin Barnes has long contended, press conferences and all the other assorted communications strategies do more harm than good. We have nearly reached the point of Fed fatigue ourselves, but there’s no ignoring the elephant in the room. The Fed is squarely in the center of every investor’s mind and may well remain there for the rest of what was shaping up as a slow-news month before the latest tariff move. American and Chinese negotiators have called it quits until September; lawmakers have left the building in London and Brussels; the ECB’s Governing Council will be idle until mid-September; and the winnowing of the Democratic field is so far off that even Bill de Blasio remains a presidential candidate. We devote this week’s report to an examination of increased accommodation’s implications for financial markets and the U.S. economy. What did the FOMC do on Wednesday? Chart 1An Adjustment, Not A New Direction The FOMC cut the fed funds rate by 25 basis points, to a range of 2-2.25%, and terminated its modest balance sheet reduction effort two months ahead of time. It studiously kept its options open with regard to future policy rate adjustments, with Chair Powell describing the cut as a “mid-cycle adjustment,” rather than a transition to full-on policy easing. The mid-cycle reference kiboshed hopes that the cut was meant to bring the curtain down on the tightening cycle that began at the end of 2015 (Chart 1). The hawkish surprise concerning the future direction of the fed funds rate overwhelmed the modestly dovish news that the Fed is immediately ending small-scale quantitative tightening. How did markets take the developments? Not so well, especially over the two hours of Wednesday afternoon trading following the decision. The S&P 500 sold off by close to 2% during the press conference, the dollar surged against the euro, and the yield curve flattened as long-dated Treasuries surged while the 2-year note sold off sharply. Equities recovered their losses in Thursday morning’s trading, though bonds and the dollar held much of their gains, before the latest salvo in the U.S.-China dispute sent investors in all markets scurrying for cover. Overall, financial markets were disappointed that they didn’t get a clearer signal that additional accommodation is on the way. Did markets overreact? In retrospect, it looks like they’d gotten their hopes up too high. The Fed wants to avoid surprises by keeping markets apprised of future developments, but it’s hard to envision it deliberately boxing itself in. It wants to preserve the flexibility to act as it sees fit, so data dependence remains the order of the day, just as it has for the last several years. We continue to take the Fed at its word that policy is not on a pre-set course. Markets seemed to be looking for a little more solicitousness from the Fed. Central bankers will presumably always attempt to guard their discretion, but the monetary policy path is far from clear, given elevated economic uncertainty. Between the stop-and-start trade hostilities with China and the Whack-a-Mole emergence of tariff threats against long-standing allies and trade partners, global manufacturing is reeling and corporate managers have every reason to hold back on capex. The differences of opinion within BCA reflect the lack of an obvious economic direction. Dissention within the Fed – Boston’s Rosengren and Kansas City’s George voted against last week’s cut, while Minneapolis’ Kashkari surely wanted it to be larger – shows that the way forward is not so clear-cut. So is it a good thing or a bad thing that the Fed cut rates? We view easier policy as a market positive over the one-year timeframe that drives most investors. There will come a point of diminishing returns, when risk assets no longer respond to incremental accommodation, but we don’t think we’re there yet. Equity multiples have room to expand before they become silly and the ECB is apparently preparing a new round of asset purchases. Given that it’s exhausted the supply of Eurozone sovereigns, it will have to proceed to evicting incumbent holders from their positions somewhat further out the risk curve, prodding them to venture out still further to redeploy the proceeds, putting downward pressure on spreads globally. How will a lower fed funds rate impact the economy? How much time do you have? The textbook answer is that a lower fed funds rate directly reduces the cost of financing big-ticket consumer purchases and corporate initiatives while indirectly nudging households and corporate managers to make them by boosting their confidence. Unconventional measures like asset purchases (QE) push investors further out the risk curve, lifting the prices of risky assets, lowering lending spreads and increasing asset holders’ wealth. They also promote a broader sense of well-being (the CNBC screen is framed in green, print headlines are cheerful, and jobs are increasingly easier to find), fueling confidence that helps reinforce the direct effects of easier policy. As Chair Powell put it in January, “Our policy works through changing financial conditions[,] … it’s … the essence of what we do.” The logic behind the textbook answer is undeniably sound, and it’s displayed in the simple six-channel model in Figure 1. People respond to incentives, and when the cost of consumption and investment falls, they are likely to save less and consume and invest more (Interest Rates/Substitution Effect). Increasing numbers of observers are becoming restless, however, as events on the ground don’t seem to jibe with the theory. Ten years of a negative real fed funds rate has failed to generate much oomph, and markets sputtered on cue once it tiptoed into positive territory (Chart 2), coinciding with the current global economic softness. Chart 2Real Rates Are Still Low Relative To History Martin Barnes, our resident grumpy economist, scoffs at how little extraordinary accommodation has been able to achieve. (Don’t get him started on the communication strategies.) Even after adjusting for how a half-century of Scotland and Montreal weather has colored his perspective, he has a point. “Do you really want to buy equities and riskier bonds in an economy that needs this much help just to grow at 2%?” he might ask. For the time being, yes, we still do. Although the channels promoting economic activity are not functioning as reliably as they have in the past, the channels boosting asset prices – Portfolio Balance, Confidence/Risk Taking, and Interest Rates/Substitution – are still A-Okay (Figure 1). The initial reaction to the FOMC meeting suggests that it will be very hard for the Fed to surprise dovishly in a relative sense, blocking the Currency channel for the time being. The Credit channel is still hindered by post-crisis regulations from Basel to Capitol Hill, at least in terms of the official banking system. Trade tensions have roiled net exports via retaliatory tariffs and suppressed global aggregate demand.1 Shouldn’t housing be at the forefront of any pickup in activity? Chart 3Lower Rates Haven't Helped Much Yet Housing is the classic proxy for tracing the effects of easier policy on the domestic economy, since nearly all of its end consumers finance their purchases, and its domestic concentration insulates it from trade effects. It has failed to respond much to the monetary policy shifts that have brought 30-year fixed mortgage rates down nearly 100 basis points year to date (Chart 3). Fed skeptics suggest that the muted response is evidence of the declining efficacy of easy policy, though we have been inclined to read the data as an indication that homebuilders aren’t building enough starter and move-up homes to bring homeownership within reach of first-time homebuyers and median-income households. Housing should exhibit a high sensitivity to changes in monetary policy, but an abundance of other debt burdens and a lack of affordable supply may be holding it back.   One should have expected that the housing pickup would be muted, and slower to take hold in this expansion, given the severity of the recession and its mortgage-lending roots. Adjusted for inflation, private residential investment, which has declined slightly for four straight quarters, is just over two-thirds of its 2005 peak (Chart 4, middle panel). In the past, residential investment has been more sensitive to the level of the fed funds rate than its direction. Since 1961, the Fed has hiked rates in as many quarters as it has cut them, and the difference in annualized growth has been relatively modest: 2.8% when the Fed has been cutting rates, and 1.6% when it’s been raising them. Chart 4Residential Investment Responds To The Monetary Policy Backdrop... Per our equilibrium fed funds rate framework, we deem monetary policy to be accommodative when the fed funds rate is below our estimate of equilibrium, and restrictive when the funds rate exceeds it (Chart 4, top panel). Despite the fact that the Fed has hiked as often as it has cut since 1961, we estimate that policy has been easy for two-thirds of the time, and the difference in residential investment growth in the two policy states has been dramatic: 6.8% when policy is easy and -6.6% when policy is tight (Chart 4, bottom panel). With the Fed keeping policy easy for longer, housing will have the wind at its back, though it isn’t much more than a breeze at the moment. The same goes for construction employment, which has grown more rapidly under accommodative monetary policy (2.1% versus 0.7% when policy is tight), but has merely treaded water over the last 11 years of easy policy (Chart 5). Chart 5... And So Does Construction Employment The bottom line is that the jury is still out on housing activity. Low mortgage rates will help renters buy homes (and fill them with furniture and appliances), and put more cash in the pockets of homeowners who refinance their existing loans, but the market remains soft. Though it can’t be captured by the aggregate data, it does seem possible that median-income households may be burdened by too much student loan, automobile and/or credit card debt to save the required down payment.2 Disparities between households may well be holding the economy back, but they have a silver lining if they encourage the Fed to pursue accommodative policies for longer than it otherwise would. Will rate cuts give the economy a tangible lift? We don’t know for sure, but no one else does, either. We are convinced that easier monetary conditions will help the economy at the margin. Ten years into the expansion, though, it is not clear if the economy has pent-up demand that easier conditions will help release. Externally, worsening trade tensions could exacerbate the global manufacturing slowdown, further squeezing global aggregate demand, and exporting recession pressures to the U.S. Our mandate is not to forecast the economy in itself, though. We and our clients are investors, not government officials or public-policy professors, and we focus on the economy only to the extent that it impacts financial markets. In the near term, incremental accommodation should boost risk asset prices, provided that trade tensions don’t ratchet up enough to undermine investor, consumer and business confidence. Animal spirits matter, and if they shift decisively from greed and toward fear, they can become a self-fulfilling prophecy that sweeps monetary policy efforts before them. Ex-a significantly negative exogenous event, we remain constructive on the U.S. economy, and continue to look for a global revival outside of the U.S. Investment Implications The incremental information received this week – an FOMC meeting that mostly went off as we expected, a modest escalation in U.S. pressure on China in line with our geopolitical strategists’ warnings that a final deal is not at hand, mixed global manufacturing PMIs, a surge in U.S. consumer confidence, a straight-down-the-middle employment situation report, and an upward inflection in S&P 500 earnings growth that has 2Q EPS now tracking to a 2.7% year-over-year gain – did not change our perspective. We see U.S. economic growth decelerating from its 2018 pace, but remaining above trend, and an absence of imbalances that would make the economy more vulnerable. We have made our peace with recurring flare-ups of hostilities between the U.S. and China, and trade tensions will only change our investment outlook if they worsen materially. The Fed is not magic, but it is doing the best it can to keep the expansion going for the purpose of spreading its gains as broadly as possible, and the easing bias among major central banks is gathering force. On balance, the new information received last week didn’t do anything to change our overall take. We remain constructive, and think investment portfolios should as well. We recognize that the climate is uncertain, and that we should accordingly dial back our conviction. Part of the reason the agency mortgage REITs appeal to us at this juncture is that they offer the opportunity to reduce equity beta and enhance a balanced portfolio’s capacity to absorb shocks. We watched the flattening in the yield curve with dismay, but we continue to expect that incremental monetary accommodation will promote a steeper curve. Easier monetary conditions promote growth, boosting the real component of interest rates, and can stoke inflation pressures when an economy is operating at or above capacity, as the U.S. has been for over a year. We remain vigilant, but our base-case constructive take is unchanged.   Doug Peta, CFA Chief U.S. Investment Strategist dougp@bcaresearch.com Footnotes 1 As we were preparing to go to press on Thursday, the U.S. announced the imposition of new tariff levies on the subset of Chinese imports that hadn’t yet been subjected to tariffs. The move supported our geopolitical strategists’ view that the trade war is unlikely to be settled soon. 2 Andriotis, AnnaMaria; Brown, Ken; and Shifflett, Shane, “Families Go Deep in Debt to Stay in the Middle Class,” Wall Street Journal, August 1, 2019.

Highlights Portfolio Strategy Despite the Fed’s supra natural powers, the deep rooted global growth slowdown will likely win the tug of war versus flush liquidity, especially if the trade war spat stays unresolved and the U.S. dollar remains well bid, both of which undermine U.S. corporate sector profitability. Recent Changes There are no changes to the portfolio this week. Table 1 Feature Equities hit all-time highs last week, eagerly anticipating this Wednesday’s Fed decision to commence an easing interest rate cycle and save the day. The looming global liquidity injection is the sole reason that stocks are holding near their all-time highs. While markets are treating the Fed as a deity, empirical evidence suggests that risks are actually lurking beneath the surface. Over the past two decades the correlation between stocks and the fed funds rate has been tight and positive. Given the bond market’s view of four fed cuts in the coming year, equity gains are likely running on fumes (Chart 1). Chart 1Mind The Positive Correlation As we highlighted recently, we remain perplexed that stocks are diverging from earnings.1 Anticipating a flush global liquidity backdrop (i.e. global central banks increasing their reflationary efforts) likely explains this dynamic as the former should ultimately rekindle economic growth, which in turn should boost profit growth. However, the disinflationary fallout from the ongoing manufacturing recession and the petering out in the global credit impulse signal that the liquidity pipes remain clogged. We recently read and re-read the Bank For International Settlements (BIS) Hyun Song Shin’s “What is behind the recent slowdown” speech where he eloquently argues that the global trade deceleration predates last spring’s U.S./China trade dispute.2 Shin has a compelling argument blaming the growth deceleration on the drop in manufactured goods global value chains (GVC) and he depicts this as global trade trailing global GDP (top panel, Chart 2). Interestingly, despite the V-shaped recovery following the Great Recession, global trade never really regained its footing, failing to surpass the 2007 peak. Shin then links this slowdown in global supply chains to financial conditions and the role that banking plays in global trade financing. The middle panel of Chart 2 shows that the GVC move with the ebbs and flows of global banks. In other words, healthy banks tend to boost global trade and vice versa. Finally, given that most trade financing is conducted in U.S. dollars, the greenback’s recent appreciation also explains trade blues. Simply put, decreased availability of U.S. dollar denominated bank credit as a result of a rising greenback is another culprit (U.S. dollar shown inverted, bottom panel, Chart 2). Ergo, there is no miracle cure for the sputtering world economy, especially given the recent re-escalation in global trade tensions and the stubbornly high U.S. dollar, and the gap between buoyant share prices and poor profit performance is likely to narrow via a fall in the former. Two weeks ago we highlighted that foreign sourced profits for U.S. multinationals are under attack as BCA’s global ex-U.S. ZEW survey ticked down anew (top panel, Chart 3). Tack on the global race to ZIRP (and in some cases further into NIRP) and it is crystal clear that the profit recession has yet to run its course. Chart 2Grim Trade Backdrop... Chart 3...Will Continue To Weigh On Foreign Sourced Profits   Meanwhile, China is likely exporting its deflation to the rest of the world and until its business sector regains pricing power, U.S. profits will continue to suffer (bottom panel, Chart 3). Turning over to U.S. shores and domestic corporate pricing power, the news is equally grim. Our pricing power proxy is outright contracting and warns that revenue growth is also under duress for U.S. corporates. Similarly, the ISM manufacturing prices paid subcomponent fell below the 50 boom/bust line and steeply contracting raw industrials commodities are signaling that 6%/annum top line growth for the SPX is unsustainable (Chart 4). On a cyclical 3-12 month time horizon we remain cautious on the broad equity market. Chart 4Sales Pressures... Chart 5...Are Building Rapidly Melting inflation expectations and the NY Fed’s softening Underlying Inflation Gauge (UIG) best encapsulate this softening revenue backdrop and warn that any further letdown in inflation risks sinking S&P 500 sales growth below the zero line (Chart 5).   Netting it all out, despite the Fed’s supra natural powers, the deep rooted global growth slowdown will likely win the tug of war versus flush liquidity, especially if the trade war spat stays unresolved and the U.S. dollar remains well bid, both of which undermine U.S. corporate sector profitability. On a cyclical 3-12 month time horizon we remain cautious on the broad equity market. This is U.S. Equity Strategy’s view, which stands in contrast to the more sanguine equity BCA House View. What follows is a recap of recent (mostly) defensive moves in the health care, consumer staples, materials, tech, consumer discretionary and communication services sectors.   Anastasios Avgeriou, U.S. Equity Strategist anastasios@bcaresearch.com   S&P Health Care (Overweight) Upgraded from Neutral S&P Health Care Equipment (Overweight) Upgraded from Neutral Fear-based sell-off created a buying opportunity in the U.S. health care equipment index as fundamentals remain upbeat. Rising U.S. medical equipment exports are a tailwind for this health care subgroup as 60% of its revenues are generated outside the United States (second panel). The EM demographic shift (not shown) represents yet another boost to the sector as U.S. companies are the technology leaders and often the only source for equipping hospitals/clinics around the globe. Our move to upgrade the S&P health care equipment index also pushed the entire health care sector from neutral to overweight (bottom panel). S&P Health Care S&P Managed Health Care (Overweight) Upgraded from Neutral The Bernie Sanders “Medicare For All” bill reintroduction created a buying opportunity in the S&P managed health care index and we were swift to act on it in mid-April. Contained industry cost factors including wages staying at the 2% mark help preserve industry margins (bottom panel). Melting medical cost inflation signals that HMO profit margins will likely expand (third panel). Overall healthy labor market conditions with unemployment insurance claims probing 60-year lows should underpin managed health care enrollment (top & second panels). S&P Managed Health Care   S&P Hypermarkets (Overweight) Upgraded from Neutral S&P Soft Drinks (Neutral) Upgraded from Underweight A deteriorating macro landscape reflected in the steep fall in U.S. economic data surprises, the drubbing of the 10-year U.S. Treasury yield and melting inflation make a compelling case for an overweight stance in the S&P Hypermarkets index (top & second panels). Similarly, safe haven soft drinks stocks shine when economic conditions are deteriorating (third panel). This defensive pure-play consumer goods sub-sector is also enjoying a rebound in operating metrics, and thus it no longer pays to stay bearish. We lifted exposure to neutral last week, locking in gains of 5.5% since inception. S&P Hypermarkets   S&P Materials (Neutral) Downgraded from Overweight S&P Chemicals (Underweight) Downgraded from Neutral Global macro headwinds continue to weigh on this deep cyclical sub-index as the risks of a full-blown trade war will likely take a bite out of final demand (third panel). Chemical producers garner 60% of their revenues from abroad and falling U.S. chemical exports are troublesome for this index (top & second panels). Given that chemicals have a 74% market cap weight in the S&P materials index, our move to underweight on the sub-index level also pushed the entire S&P materials index to neutral from overweight. S&P Materials   S&P Technology (Neutral) Downgrade Alert S&P Software (Overweight) Lifted trailing stops As a part of our portfolio de-risking measures, we put a 27% profit-taking stop loss on our overweight S&P software index call on June 10. Once triggered, a downgrade to neutral in the S&P software index would also push our S&P tech sector weight to a below benchmark allocation. Meanwhile, our EPS model for the overall tech sector is on the verge of contraction on the back of sinking capex and a firming U.S. dollar (middle panel). The San Francisco Fed’s Tech Pulse Index is also closing in on the expansion/contraction line warning that tech stocks are in for a rough ride (bottom panel). S&P Technology   S&P Technology Hardware, Storage & Peripherals (Neutral) Downgraded from Overweight As nearly 60% of the revenues for the S&P technology hardware, storage & peripherals (THS&P) index are sourced from abroad, deflating EM currencies sap foreign consumer purchasing power and weigh on the industry’s exports (third panel). Global export volumes have sunk into contractionary territory, to a level last seen during the Great Recession (not shown) and underscore that industry exports will remain under pressure. The IFO World Economic Survey confirms this challenging export backdrop as it is still pointing toward sustained global export ails (second panel). As a result, all of this has shaken our confidence in an overweight stance in the S&P THS&P and we were compelled to move to the sidelines in early June for a modest relative loss since inception. S&P Technology Hardware, Storage & Peripherals S&P Consumer Discretionary (Underweight) Upgrade Alert S&P Home Improvement Retail (Neutral) Upgraded from underweight In the July 8 Weekly Report, we put the S&P consumer discretionary sector on an upgrade alert as this early-cyclical sector benefits the most from lower interest rates (bottom panel). The way we will execute this upgrade will be by triggering the upgrade alert on the S&P internet retail index. Melting interest rates and rebounding lumber prices are a boon for home improvement retailers (HIR, second & third panels). Tack on profit-augmenting industry productivity gains and it no longer pays to be bearish HIR. S&P Consumer Discretionary S&P Homebuilders (Neutral) Downgraded from overweight Long S&P Homebuilders / Short S&P Home Improvement Retail Booked Profits Lumber represents an input cost to homebuilders (we booked profits of 10% in our overweight recommendation on May 22 and downgraded to neutral) whereas it is an important selling item in Big Box building & supply retailers that make a set margin on it (third panel). On June 18, as part of our de-risking strategy, we locked in 10% gains in the long S&P homebuilders/short S&P home improvement retail trade that hit our stop loss and we moved to the sidelines. S&P Homebuilders S&P Telecommunication Services (Neutral) Upgraded from Underweight The recent escalation of the trade spat has pushed July’s Markit’s flash U.S. manufacturing PMI reading to 50 - the lowest level since the history of the data. Historically, relative S&P telecom services share price momentum has moved inversely with the manufacturing PMI and the current message is to expect a sustained rebound in the former (bottom panel). Rock bottom profit expectations and firming industry operating metrics signal that most of the grim news is priced in bombed out telecom services valuations (middle panel), and it no longer pays to be underweight. In late-May, we lifted exposure to neutral for 6% relative gains since inception. S&P Telecommunication Services S&P Movies & Entertainment (Overweight) Upgraded from Neutral Structural shifts in the streaming services industry marked a start of a pricing war with incumbents and new entrants fighting for market share, as evidenced by DIS’s pricing of their upcoming Disney+ service. Consumer confidence remains glued to multi-decade highs and there are high odds that the big gulf that has opened up between confidence and relative S&P movies & entertainment share prices will narrow via a rise in the latter (top panel). Moreover, more dollars spent on recreation is synonymous with a margin expansion in the S&P movies & entertainment index (bottom panel). This consumer spending backdrop is also conducive to a rise in relative profitability, the opposite of what the sell-side currently expects. S&P Movies & Entertainment   Arseniy Urazov, Research Associate ArseniyU@bcaresearch.com Footnotes 1      Please see BCA U.S. Equity Strategy Weekly Report, “Beware Profit Recession” dated July 8, 2019, available at uses.bcaresearch.com. 2      https://www.bis.org/speeches/sp190514.pdf   Current Recommendations Current Trades Size And Style Views Favor value over growth Favor large over small caps

Neutral This week we upgraded the S&P home improvement retail (HIR) index to a benchmark allocation and removed it from our high-conviction underweight list for a small relative loss. Similar to the parent Consumer Discretionary GICS1 sector, HIR stocks are inversely correlated with interest rates (fed funds rate discounter shown inverted, middle panel), given the close residential real estate market links they enjoy. Now that the bond market forecasts that the Fed will cut rates four times by next July, home improvement retailers should be cheering this news. Moreover, home improvement retailers have been flexing their pricing power muscles recently and this represents another boost to their top line growth prospects (bottom panel). Bottom Line: Lift the S&P HIR index to neutral and remove from the high-conviction underweight list. For additional details, on why it no longer pays to be underweight the S&P HIR index, please see this Monday’s Weekly Report. The ticker symbols for the stocks in this index are: BLBG – S5HOMI – HD, LOW.

Highlights Portfolio Strategy Rising lumber prices, melting interest rates and profit-augmenting industry productivity gains all signal that it no longer pays to be bearish the S&P home improvement retail (HIR) index. Poor revenue growth prospects, the ongoing global manufacturing contraction and downbeat financial variables all indicate that high-beta semi equipment stocks have ample downside. Recent Changes Downgrade the S&P semi equipment index to underweight on a tactical three-to-six month time horizon, today. Upgrade the S&P home improvement retail index to neutral and remove from the high-conviction underweight list, today. Put the S&P consumer discretionary sector on upgrade alert and remove from the high-conviction underweight list, today. Table 1 Feature July 10 marks the two year anniversary of our seminal “SPX 3,000?” report.1 We were very early both compared with the sell and buy side (to our knowledge the great Byron Wien is the only other strategist that had such a target) and as a reminder, at the time, the S&P 500 was trading near 2,400. A number of BCA peers and BCA clients alike confronted our über bullishness with disbelief, but our 3,000 target – based on our dividend discount model, an EPS and multiple sensitivity analysis and an equilibrium equity risk premium analysis – proved a prescient call. Throughout this period (we had actually been bullish since Brexit, when our profit growth models hooked up) we maintained our cyclical bullishness and never wavered (top panel, Chart 1). Now that SPX futures hit our 2019 target, we want to remain ahead of the curve, as Stan Druckenmiller once mused: “…you have to visualize the situation 18 months from now, and whatever that is, that's where the price will be, not where it is today”. Chart 1Rally Running On Fumes In early June we shaved our 2021 EPS to $140 and our end-2020 SPX target fell to a range of 1,890-2,310. We posited that the easy gains in equities were behind us and we are not willing to play 100-200 points to the upside for a potential 1,000 point drawdown, owing to a souring macro backdrop (five key reasons underpin our cautious broad equity market stance that we outline in our recent webcast). On the eve of earnings season, investors have been obsessing with the “Fed put”, but neglecting the looming profit recession (bottom panel, Chart 1). Moreover, while markets cheered the trade truce following the recent G20 meeting, odds are high that manufacturing will remain in the doldrums as the tariff rate on $200bn of Chinese imports went up from 10% to 25% on May 10, and no tariff rollback was agreed. As a result, highly-cyclical global trade and manufacturing will likely continue to weigh on the economy for the remainder of the year. A simple liquidity indicator points to profit growth trouble into early-2020, which stands in marked contract with sell-side analysts who anticipate 10% EPS growth. Chart 2 shows the gulf gap between industrial production and broad money growth. Since 1960, this liquidity indicator has been an excellent leading indicator of SPX profit momentum and the current message is to expect a sustained deceleration in the latter. Chart 2Earnings… BCA U.S. Equity Strategy’s four-factor macro S&P 500 profit growth model corroborates this signal and warns that a profit contraction is nearing (Chart 3). Chart 3…Trouble… Following up from last week, Goldman Sachs’ U.S. Current Activity Indicator is also flashing red for SPX profit growth. Similarly, our corporate pricing power gauge is sinking steadily and underscores that a profit recession is a high probability outcome (Chart 4). Meanwhile, a longtime friend that I call “the smartest man in California” brought a slight variation of Chart 5 to my attention recently and highlighted that: “Historically, periods of falling manufacturing PMI result in larger negative earnings growth surprises as market forecasters rarely anticipate the breadth and depth of slowdowns. Profit growth trends are set to weaken further in the coming six months. Without profit growth, equity markets lack the necessary ‘oxygen’ for a durable high-quality rally, and until there is an upturn in growth momentum, rallies should be faded.” Chart 4…Proliferating   Chart 5Expect Downward… Even net EPS revisions have taken a turn for the worse and are probing recent lows (Chart 6). Drilling beneath the surface is revealing. Trade-exposed sectors bear the brunt of the EPS downgrades. Tech (60% foreign sales exposure), materials, industrials, and energy are deeply in negative territory (Chart 7). On the flip side, defensive sectors are offsetting some of the cyclical sectors' weakness with health care, real estate, utilities and consumer staples hovering close to zero (Chart 8). Chart 6…Profit Surprises Chart 7Net Earnings Revisions… Chart 8…Sectorial Breakdown With regard to the contribution to profit growth for calendar 2019, the divergences have widened significantly since our last update in early-April, with the financials sector solely holding the broad market’s profit fate in its hands. In more detail, Chart 9 shows that financials are responsible for 79% of the overall anticipated profit growth, up from 45% in early-April, whereas technology, energy and materials each have a negative profit growth contribution north of 30%. Table 2 puts all these figures in perspective, and also updates the sector market capitalization and profit weights. Table 2S&P 500 Earnings Analysis In sum, the SPX profit growth backdrop remains anemic and absent a pickup in growth momentum the risk/reward tradeoff is skewed to the down side. On a cyclical 3-12 month time horizon we remain cautious on the broad equity market. This is U.S. Equity Strategy’s view, which stands in contrast to the more sanguine equity BCA House View. This week we are making a subsurface change in an early-cyclical subgroup, and trimming a highly cyclical tech subindex. Put Consumer Discretionary Stocks On Upgrade Alert, And… Consumer discretionary stocks have marked time over the past year. But, now that the Fed is ready to ease monetary policy it will no longer pay to be bearish (Chart 10). This early-cyclical sector benefits the most from lower interest rates, and vice versa. Thus, we are putting this sector on our upgrade watch list and removing it from our high-conviction underweight list. We anticipate to execute this upgrade in coming weeks via boosting the S&P internet retail index to overweight. This subgroup is already on upgrade alert. Before triggering these upgrades, however, today we recommend a subsurface consumer discretionary move. Chart 10Lower Interest Rate Beneficiary …Lift The Home Improvement Retailers To Neutral We are compelled to upgrade the S&P HIR index to a benchmark allocation and remove it from our high-conviction underweight list for a small relative loss. Similar to the parent GICS1 sector, HIR stocks are inversely correlated with interest rates (fed funds rate discounter shown inverted, middle panel, Chart 11), given the close residential real estate market links they enjoy (top panel, Chart 12). Now that the bond market forecasts that the Fed will cut rates four times by next July, home improvement retailers should be cheering this news. Chart 11Two Profit Boosters Chart 12Resilient Pricing Power Jumping lumber prices should be a boon to HIR same-store sales. Recent steep production curtailments in lumber yards have been a tonic to prices that have rebounded $100/tbf in a little over a month. Keep in mind, that building materials & construction supplies stores make a set margin on lumber sales and thus higher selling prices translate straight into higher profits; the opposite is also true (bottom panel, Chart 11). Home improvement retailers have been flexing their pricing power muscles recently and this represents another boost to their top line growth prospects (middle panel, Chart 12). While the recent tariff rate increase related input cost inflation has yet to hit the industry’s bottom line, it remains to be seen if HIR margins will take a hit or retailers will pass it on through further price hikes. Importantly, industry labor restraint is a welcome offset and has been a profit booster as measured by our expanding productivity gauge (bottom panel, Chart 12). Our HIR model captures all these positive forces and has likely put in a durable trough recently, signaling that a brightening backdrop looms for the S&P HIR index (Chart 13). Chart 13Model Says It No Longer Pays To Be Bearish But prior to getting carried away up the bullish lane, these Big Box retailers have to contend with some key headwinds, and prevent us from boosting exposure to an above benchmark allocation. Residential fixed investment has been contracting for five consecutive quarters and remains a far cry from the 2006 peak as a share of output (Chart 14). Similarly, existing home sales, a key HIR demand driver, have softened recently at a time when home inventories have jumped (inventories shown inverted, top panel, Chart 15).  Chart 14But, Some Headwinds… Chart 15…Persist As a result, remodeling activity has taken a backseat, at the margin, weighing on industry same-store sales growth (bottom panel, Chart 15). Home owners have avoided dipping into their currently rebuilt home equity to undertake renovation projects. Until the reflationary wave of lower mortgage rates rekindles single family home sales and thus remodeling activity, only a neutral weighting is warranted in the S&P HIR index. All of this has led to a sustained deterioration in HIR operating metrics with the sales-to-inventories ratio contracting at an accelerating pace. The implication is that before long, home improvement retailers may have to resort to margin-denting price concessions to clear the inventory overhang (middle panel, Chart 15). Netting it all out, rising lumber prices, melting interest rates and profit-augmenting industry productivity gains all signal that it no longer pays to be bearish the S&P HIR index.   Bottom Line: Lift the S&P HIR index to neutral and remove from the high-conviction underweight list for a relative loss of 5.9% since inception. The ticker symbols for the stocks in this index are: BLBG – S5HOMI – HD, LOW. Downgrade Semi Equipment To Underweight     While the post G-20 trade related entente should have boosted semi equipment stocks that garner a large slice of their revenues in China, relative share prices are below Friday’s June 28 close. A tactical trading opportunity has re-emerged, and today we recommend trimming the S&P semi equipment index to underweight on a three-to-six month time horizon, but with a tight stop at the -7% relative return mark.  But before proceeding with our analysis, a brief recap of the recent history of our moves in this hyper-cyclical tech sub-index is in order. In late-November 2017 we recommended a high-conviction underweight position in the S&P semi equipment index at the height of the bitcoin fever.2 In mid-December 2018 we swung for the fences and upgraded this niche semi index to overweight as the street had finally capitulated and became extremely bearish on semi equipment stocks.3 Finally in early-March 2019 we booked handsome profits in this trade and moved to the sidelines (vertical lines denote recommendation changes, Chart 16).4 Semi equipment stocks are capital intensive, require precision manufacturing and their sales cycle is a carbon copy of the broad manufacturing cycle. The middle panel of Chart 17 shows this tight positive correlation with the ISM manufacturing index and sends a grim message for semi equipment manufacturers. Chart 16Time To Fade Semi Equipment Stocks Chart 17Chip Equipment Equities Follow The Manufacturing Cycle Global trade and manufacturing continue to contract and, specifically, the EM manufacturing PMI is below the 50 boom/bust line (second panel, Chart 18). Tack on elevated policy uncertainty, and the implication is that investors should sell semi equipment stock strength (top panel, Chart 18). Growth-sensitive financial variables also signal a challenging backdrop for relative share prices. Not only are emerging market stocks trailing their global peers year-to-date, but EM Asian currencies are also exerting downward pull on the relative share price ratio (third & bottom panels, Chart 18). Finally, with regard to industry operating metrics, the news is equally glum. Global semi cycles typically last four-to-five quarters and we only just passed the half way mark. Thus, there is more downside to industry sales momentum and we would lean against recent analyst relative revenue euphoria (middle panel, Chart 19). Asian DRAM prices are deflating, and this semi equipment industry pricing power proxy emits a similarly weak signal for top line growth (bottom panel, Chart 19). Chart 18Financial Variables Say Sell Chart 19Lean Against Recovering Top Line Growth Estimates Summing it all up, poor revenue growth prospects, the ongoing global manufacturing contraction and downbeat financial variables all indicate that semi equipment stocks have ample downside. Bottom Line: Downgrade the S&P semiconductor equipment index to underweight on a tactical basis (three-to-six month horizon), but set a tight stop at the -7% relative return mark. The ticker symbols for the stocks in this index are: BLBG – S5SEEQ– AMAT, LRCX, KLAC.   Anastasios Avgeriou, U.S. Equity Strategist anastasios@bcaresearch.com   Footnotes: 1      Please see BCA U.S. Equity Strategy Report, “SPX 3,000?” dated July 10, 2017, available at uses.bcaresearch.com. 2      Please see BCA U.S. Equity Strategy Weekly Report, “2018 High-Conviction Calls” dated November 27, 2017, available at uses.bcaresearch.com. 3      Please see BCA U.S. Equity Strategy Weekly Report, “Signal Vs. Noise” dated December 17, 2018, available at uses.bcaresearch.com. 4      Please see BCA U.S. Equity Strategy Weekly Report, “The Good, The Bad And The Ugly” dated March 4, 2019, available at uses.bcaresearch.com. Current Recommendations Current Trades Size And Style Views Favor value over growth Favor large over small caps

Special Report

Highlights The report reviews our framework for predicting broad market earnings in China based on the experience of the past decade, and documents the relationship between sector earnings and broad market earnings for both the investable and domestic market. We also review the cyclicality of earnings in each sector, and highlight the sectors where relative earnings have been successful at predicting relative performance. Energy and consumer discretionary in both markets, along with real estate and financials in the domestic market, have historically been the best candidates for a classic top-down fundamental “sector rotation” strategy. Compared with these sectors, investable telecom stocks have exhibited a weaker link between sector and index earnings, but this has occurred because of relatively steady, low volatility earnings growth. As such, telecom stocks are reliably defensive, but only in the investable market. We conclude by noting the extreme nature of long-term de/re-rating trends that have occurred for several of China’s equity sectors, and argue that the strength of the relationship between earnings and stock prices for these sectors is set to rise over a secular time horizon. Over the coming few years, investors should focus nearly exclusively on the earnings outlook for high flying and beaten down sectors, as further multiple expansion/contraction is unlikely to drive future returns (without an earnings catalyst). Feature Last week’s joint report with our Geopolitical Strategy service provided investors with an update on the trade war in the lead up to the G20 meeting in Osaka.1 While a new tariff ceasefire may emerge from the meeting, the report underscored why the odds are skewed against a positive outcome over the coming 18 months. Our bet is that investors are unlikely to assume that a deal will occur merely in response to a new timetable for talks, implying that any near-term boost to stock prices will be minimal until negotiators provide market participants with evidence (rather than hope) that a deal is achievable. This means that a financial market riot point remains likely over the coming few months, and that a cyclically bullish stance towards Chinese stocks rests on the likelihood of a major policy response in China to counter the likely shock to its export sector. During times of high policy uncertainty, we often take the opportunity to review and update our framework for key asset drivers. In today’s report we review our framework for predicting broad market earnings in China based on the experience of the past decade, and then document the relationship between sector earnings and broad market earnings for both the investable and domestic market. We review the cyclicality of earnings in each sector, and highlight the sectors where relative earnings have been successful at predicting relative performance. We conclude with a summary of what our results would imply over the tactical and cyclical investment horizons given our view of China’s likely growth trajectory, and highlight why several sectors may see a stronger relationship between their earnings and stock prices over the secular horizon. The report illustrates our key conclusions in the body of the text, but reference charts for each sector/industry group in both the investable and domestic market are provided as a convenience on pages 12 - 23. Predicting Chinese Equity Index Earnings Our framework for predicting index EPS is straightforward but reliable. Chart 1Stronger Economic Activity = Stronger Investable Earnings Chart 1 presents the first element of our framework for predicting Chinese investable earnings per share (EPS) growth. The chart illustrates the strong leading relationship between our BCA China Activity Indicator and the year-over-year growth rate of investable EPS, which underscores that the fundamental performance of Chinese equities is still predominantly driven by China’s “old economy”. The leading nature of our activity index partly reflects the fact that earnings per share are measured on a trailing basis; the key point for investors is that indicators such as our Activity Index have been more successful at capturing the coincident trend in China’s economy than, for example, real GDP growth has over the past several years. Chart 2illustrates that the earnings cycle for the investable and domestic equity markets is the same, with the magnitude of a given cycle accounting for the difference between the two markets. This means that investors exposed to the Chinese equity market should be focused heavily on predicting the coincident trend in the economy, as doing so will lead investors to the same conclusion about the trend in H- and A-share EPS growth. Chart 2Same Earnings Cycle In The Investable And Domestic Markets Chart 3Our Leading Indicator Reliably Predicts Economic Activity In turn, Chart 3 presents our framework for predicting Chinese economic activity, which we originally laid out in our November 30, 2017 Special Report.2 The chart shows that our leading activity indicator has reliably predicted inflection points in actual activity over the past several years, including the slowdown of the past two years (the leading indicator peaked in Q1 2017). As detailed in the report, our indicator is based on monetary conditions and money & credit growth. Panel 2 of Chart 3 shows that monetary conditions are very easy and credit growth is picking up, though it needs to continue to improve alongside a forceful pickup in money growth in order for the economy to strengthen. The key takeaway for investors is that the overall earnings cycle in China is strongly linked to “old economy” economic activity, which in turn appears to reliably predicted by our indicator. This provides us with a stable platform from which we can examine (and ultimately predict) equity sector EPS. Sector Earnings: Predictability And Cyclicality Given the strong link between Chinese economic activity and equity market EPS that we noted above, the question for equity-oriented investors is then to identify the relationship between sector and overall index EPS. In other words, to what degree are sector EPS in China linked to the overall earnings trend (versus being driven by idiosyncratic factors), and is this relationship pro- or counter-cyclical in nature? Charts 4 and 5 present the answers to these questions, based on the 2011 – 2018 period.3 The charts present the highest R-squared value resulting from a regression of detrended sector EPS versus broad market EPS for both the investable and domestic markets, after accounting for any leading/lagging relationships. The color/shading of each bar denotes whether the beta of the relationship for each sector or industry group is above or below 1. The charts present a mix of surprising and unsurprising results. Among the latter in the investable market, the cyclicality of typically high-beta sectors such as energy, materials, industrials, consumer discretionary, and technology would be readily accepted by most investors, as would the defensive characteristics of financials, telecom services, health care, utilities, and consumer staples. Investable consumer staples, health care, and utilities EPS are driven by either bottom-up/industry-specific factors or macro factors that are not fully captured by the trend in China’s business cycle. However, there were several less-intuitive results that emerged from our analysis, related to both the investable and domestic markets: Within the investable market, the low predictability of health care, utilities, and consumer staples EPS is somewhat difficult to explain. A weak relationship would easily be explained if EPS growth for these sectors were somewhat constant in the face of fluctuations in overall index EPS, but Chart 6 shows that the volatility in EPS growth for these sectors are not bottom-ranked (see also pages 16, 17 and 22). In fact, utilities EPS growth vol has been relatively high, and it is higher for health care and consumer staples than it is for financials and banks, whose EPS growth are highly linked to the overall earnings cycle. This result suggests that the determinants of earnings for these sectors are driven by either bottom-up/industry-specific factors or macro factors that are not fully captured by the trend in China’s business cycle. The low predictability of consumer staples and utilities EPS observed in the investable market is also evident in the domestic market, suggesting that this finding is not the result of quirky data. We noted earlier that overall index earnings are highly correlated with our BCA China Activity Index, and we have noted in past reports that China’s business cycle continues to be subject to its “old” growth model centered on investment and exports rather than the services and consumer sectors.4 This may explain the relatively idiosyncratic EPS profile for consumer staples, although it still fails to explain the low predictability and relatively high volatility of utilities earnings. Telecom services and technology earnings also have a very low correlation with overall earnings in the domestic market, which is similar to the investable market but more extreme. On the tech front, this is explained by the fact that Alibaba and Tencent, China’s tech giants, are not listed in the domestic market, underscoring that investable tech and domestic tech should be considered by investors to be distinctly separate sectors. In the investable market the low predictability and defensive characteristic of telecom services EPS can be explained by stable, low-volatility growth, but this is not true in the domestic market. In fact, over the past several years the volatility of domestic telecom EPS growth has been among the highest of any of China’s domestic equity sectors, and it has been cyclical rather than defensive in nature. These findings are difficult to explain from a top-down perspective. Finally, while Charts 4 and 5 show a difference in the cyclicality of real estate earnings between the investable and domestic markets, the difference is not substantial: the beta of the former is 1.03 versus 0.94 for the latter. The truly surprising result from real estate stocks is that their EPS growth is not considerably high-beta, given the boom & bust nature of Chinese property prices and the enormous amount of activity that has occurred in Chinese real estate over the past decade. Given that beta is determined relative to the overall index, this is emblematic (and an important reminder) of the underlying cyclicality of China’s economy and its financial markets relative to its global counterparts. Sector Earnings: Relevance For Stock Prices Following our review of the predictability and cyclicality of Chinese sector EPS, Charts 7 and 8 illustrate the relationship between relative EPS and relative stock price performance for these sectors. The charts highlight several notable points: In both the investable and domestic markets, the relative performance of energy and consumer discretionary stocks have been highly explained by the trend in relative EPS. Both of these sectors have also shown reasonably high EPS predictability (based on overall index EPS), suggesting that these two sectors have historically been the best candidates for a classic top-down fundamental “sector rotation” strategy. The relative re-rating of consumer staples and de-rating of banks reflects the existence of a long consumer economy / short industrial economy trade. Chart 9Multiples Have Been More Important In Driving The Returns Of These Sectors Within the investable market, relative EPS has not been successful at predicting relative stock price performance for financials/banks, health care, consumer staples, and industrials. This means that multiple expansion/contraction has been a relatively more important factor in driving returns, which can clearly be seen in Chart 9. The chart shows that investable banks, health care, and industrials have been meaningfully de-rated over the past several years, whereas the relative P/E ratio for consumer staples stocks has risen (albeit in a choppy fashion). Domestic consumer staples have also benefited from re-rating, although it has occurred entirely within the past three years and has merely made up for the substantial de-rating that took place in 2012 (Chart 9, panel 2). Taken together, the relative re-rating of consumer staples and de-rating of banks and industrials reflects, at least in part, the existence of a long consumer economy / short industrial economy trade. The relative EPS trend of utilities in both markets and that of telecom services stocks in the investable market have done a decent-to-good job of predicting relative stock price performance. We noted earlier that investable telecom services earnings appear to have a weak relationship with overall index earnings because of their low variability, meaning that they have also been a good top-down rotation candidate on the defensive side of the spectrum. The high responsiveness of the relative equity performance of Chinese utilities to relative EPS raises the importance of predicting the latter, which is likely to be a topic of future reports for BCA’s China Investment Strategy service. Finally, Chart 7 shows that the most important sector trend in the investable market over the past several years, the outperformance of information technology, has been strongly explained by the trend in relative EPS. This is good news for investors, as it suggests that relative tech returns can be reasonably predicted by accurate earnings analysis. From a top-down perspective, we noted earlier that the relationship between tech and overall index EPS has not been extremely high, which raises the bar for investors to understand the idiosyncratic drivers of earnings for the BAT (Baidu, Alibaba, and Tencent) stocks. Chinese consumer spending remains the most important macro factor for these stocks, but our understanding of this relationship is not complete and is an area of ongoing research at BCA. Investment Conclusions Chart 10 summarizes the results of Charts 4-5 and 7-8, by grouping investable and domestic equity sectors into four quadrants based on top-down EPS predictability (x-axis) and the impact of the trend in relative EPS on relative stock price performance (y-axis): Over a multi-year time horizon, the relationship between relative earnings and relative stock prices is likely to rise for several sectors. As we noted above, energy and consumer discretionary in both markets along with real estate and financials in the domestic market have had the strongest relationship across both dimensions (top-right quadrant). The EPS relationship is cyclical in both markets in the case of energy and consumer discretionary, whereas it is modestly cyclical for domestic real estate and defensive for domestic financials. Sectors in the top-left quadrant have shown a strong link between earnings and stock price performance, but a weaker link between sector and index earnings. This is the case for telecom services because of relatively steady, low volatility earnings growth, meaning that telecom stocks are reliably defensive. Fluctuations in the growth of index EPS do not explain the majority of changes in investable tech EPS, but it is an important driver in a cyclical relationship. Sectors in the bottom-right quadrant have a predominantly strong and defensive relationship with index earnings growth (with the exception of domestic industrials), but have experienced significant changes in multiples over the past several years that have materially impacted their relative stock price performance. We showed in Chart 9 that banks have been meaningfully de-rated over the past several years; this process appears to have halted at the end of 2017, suggesting that the relationship between relative earnings and relative stock prices may be stronger going forward. Chart 11Investable Real Estate And Materials Stocks Trade At A Huge Discount Finally, sectors in the bottom left quadrant have had relatively idiosyncratic earnings trends, and relative EPS have not explained a majority of the trend in relative performance. We would draw a distinction between investable industrials, real estate, and materials and the rest of the sectors shown, as they are on the cusp of being in the top-right or bottom-right quadrants, and all three appear to have suffered from meaningful de-rating. Investable real estate and materials now trade at over a 40% discount to the overall index (Chart 11), raising a serious question as to whether relative P/Es can continue to compress and explain the majority of relative equity performance. However, investable consumer staples and health care, along with domestic technology and telecom services stocks, do appear to be legitimately idiosyncratic, suggesting that an equity beta approach (regressing sector returns against index returns) is the best top-down method available to investors when allocating to these sectors. For investable staples and health care their equity return betas are clearly defensive, whereas domestic tech and telecom services stocks are market neutral. What does this all mean for investors? Our findings above lead us to some specific conclusions over the tactical (0-3 months), cyclical (6-12 months), and secular (multi-year) horizons: Over the cyclical horizon, we expect Chinese co-incident economic activity to pick up and for overall index EPS to improve, suggesting that global investors have a fundamental basis to be overweight investable energy, consumer discretionary, materials, media & entertainment (within the new communication services sector) and industrial stocks, at the expense of telecom services and financials.5 Investable health care, consumer staples, and utilities stocks are also likely to underperform, although this view is based on a statistical/empirical relationship rather than a fundamental one. In the domestic market, our findings support substituting real estate for technology in comparison to the investable sectors we listed above, but we are concerned that policymakers may crack down more heavily on the property sector if they allow overall credit growth to rise meaningfully as part of a stimulative response. For now, we would not recommend aggressive bets in favor of the domestic real estate sector. Chart 12Flagging Earnings Growth Heightens Tactical Risks To Chinese Stocks Over the tactical horizon, however, we would advise either the opposite stance, or a benchmark sector allocation. In addition to our view that a financial market riot point remains likely over the coming few months to force policymakers to address the economic weakness that an escalated tariff scenario would entail, broad-market Chinese EPS growth continues to decelerate (Chart 12). We see this continued slowdown as a lagged response to past economic weakness, which we expect will be reversed over the coming year due to stronger money & credit growth. However, sectors with pro-cyclical earnings growth may fare poorly in the near term until investors gain confidence that the (inevitable) policy response will stabilize the earnings outlook. Over the secular horizon, the most important conclusion is that there have been several long-term sectoral de/re-rating trends within China’s equity market. In the investable market, health care, consumer staples, and consumer discretionary (of which Alibaba is heavily represented) trade at 100-200% of a premium relative to the broad equity market on a trailing earnings basis, whereas financials, materials, and real estate stocks trade at a 40-60% discount. These divergences also exist in the domestic market, although the range is somewhat less extreme. A simple contrarian instinct might be to strategically overweight/underweight expensive/cheap sectors, but to us the simpler conclusion is that the extreme nature of these trends means that the strength of the relationship between EPS and stock prices for these sectors is set to rise. Over the coming few years, investors should focus nearly exclusively on the earnings outlook for high flying and beaten down sectors, a question that is very likely to be the topic of additional China Investment Strategy reports this year. Stay tuned!   Jonathan LaBerge, CFA, Vice President Special Reports jonathanl@bcaresearch.com     Reference Charts Energy Chart 13 Chart 14 Materials Chart 15 Chart 16   Industrials Chart 17 Chart 18   Consumer Discretionary Chart 19 Chart 20   Consumer Staples Chart 21 Chart 22   Health Care Chart 23 Chart 24   Financials Chart 25 Chart 26   Banking Chart 27 Chart 28   Information Technology Chart 29 Chart 30   Telecom Services Chart 31 Chart 32   Utilities Chart 33 Chart 34   Real Estate Chart 35 Chart 36   Footnotes 1      Please see Geopolitical Strategy and China Investment Strategy Special Report, “Another Phony G20? And A Word On Hong Kong”, dated June 14, 2019, available at cis.bcaresearch.com. 2      Please see China Investment Strategy Special Report, “The Data Lab: Testing The Predictability Of China’s Business Cycle”, dated November 30, 2017, available at cis.bcaresearch.com. 3      S&P Dow Jones and MSCI Inc. implemented major structural changes to the Global Industry Classification Standard (GICS) in Q4 2018 that substantially altered the sector composition of the MSCI China Investable index. The weight of the information technology sector in the investable index dropped dramatically after the GICS changes occurred. Investors should note that we used Q3 2018 as the end date of our analysis in order to remove any impact from the GICS sector change; the reference charts shown on pages 12 – 23 provide all data since 2011. 4     Please see China Investment Strategy Weekly Report, “The Three Pillars Of China’s Economy”, dated May 16, 2018, available at cis.bcaresearch.com. 5      Due to the changes to the GICS classification structure noted in footnote 3, the tech sector relationships that we highlighted above now apply to the consumer discretionary sector (level 1) and media & entertainment industry-group (level 2, within the new level 1 communication services sector. Cyclical Investment Stance Equity Sector Recommendations

Since early March, when we first turned tactically cautious on the prospects of the broad equity market, we started applying risk metrics to our portfolio in order to protect profits. In recent weeks as our cautiousness morphed from a tactical into a cyclical time horizon, we have both added more stops and also tightened existing trailing stops to our portfolio. As a result, our long S&P homebuilding/short S&P home improvement retail market- and sector-neutral trade got stopped out last week at the 10% return mark since the January 22nd, 2019 inception. Bottom Line: We have been increasingly using risk management metrics to protect gains in our U.S. equity portfolio and we are obeying the trailing stop on the long S&P homebuilders/short S&P home improvement retailers pair trade for a gain of 10% since inception. 

Underweight High-Conviction The latest GDP release as it pertains to housing made for grim reading: residential fixed investment has subtracted from real GDP growth for five consecutive quarters, which is unprecedented outside of a recession (top panel). Residential investment is also on the verge of contracting in absolute terms (second panel) and will likely weigh on home improvement retailers (HIR). The direct link to HIR comes via existing home sales: when a home changes ownership usually some renovation activity takes place. Finally, lumber prices continue to crumble and given that HIR make a set margin on lumber sales, HIR profits will likely underwhelm (bottom panel). Bottom Line: We reiterate our high-conviction underweight status in the S&P HIR index. The ticker symbols for the stocks in this index are: BLBG: S5HOMI – HD, LOW. Home Improvement Retailers: Timber Alert