Equities

Highlights In the past week, it is becoming evident that the Chinese leadership is willing to abandon its financial de-risking agenda in exchange for a rapid economic recovery. Monetary conditions are already more accommodative than during the last easing cycle in 2015/2016. The recently announced policy initiatives on infrastructure, housing, and automobile sectors also resemble policy supports that led to a V-shaped economic recovery in 2016. As manufacturers in regions other than Hubei are returning to work and their production capacity continues to rise, the outbreak-induced economic shock may be smaller than investors currently fear. Hence, the odds are rising that the upcoming “insurance stimulus” may end up overshooting the short-term economic shock. As such, we maintain a constructive view on Chinese stocks over the next 6-12 months. Feature A surge in the number of COVID-19 infections outside of China (including South Korea, Japan, Iran, and Italy) risks delaying a global economic recovery, and has cast doubt on the outlook for the global economy beyond Q1 (Chart 1). Chart 1Pandemic Threats Expanding Globally Despite the sharp uptick in global investor concern, our constructive view on Chinese stocks remains unchanged for the next 6-12 months. Our view on Chinese risk assets is based on a simple arithmetic framework that we described last year when the trade war tensions between the US and China were escalating. In short, when gauging the net impact of an economic shock, investors should determine which of the following two scenarios is most likely: Scenario 1 (Bearish): Stimulus – Shock ≤ 0 Scenario 2 (Bullish): Stimulus – Shock > 0 While this framework is quite simplistic, the point is to underscore that economic shocks are almost always met with a policy response, and the goal is to determine whether this response is sufficient enough to offset the impact of the shock. If the Chinese leadership underestimates the severity of the shock and undershoots on the stimulus, this would be bearish for Chinese stocks (Scenario 1). In the current situation, however, even if the near-term economic outlook is deeply negative, investors should maintain a bullish cyclical (i.e. 6-12 month) outlook for China-related assets as long as the impact of China’s reflationary efforts more than offsets the negative shock to aggregate demand (Scenario 2). Major Stimulus Around The Corner? It is becoming evident that the Chinese policymakers, when dealing with an unprecedented public health crisis, are returning to aggressive fiscal and monetary easing. In fact, the odds are rising that the magnitude of the upcoming stimulus may resemble that of 2015/2016, and has an increasing possibility to overshoot in the next 6-12 months. In the past week, there has been a clear shift of policy focus from “financial de-risking” to “mitigating the economic damage from shocks at all costs”, as indicated by high-profile policy announcements. In an unprecedented large-scale teleconference on February 23,1 President Xi stated that China will not lower its economic growth target for this year, and that fiscal policy will be “more proactive” while monetary policy was upgraded from “prudent” to “flexible and moderate". Chart 2PBoC Looks Set For Massive Stimulus Xi also pledged to “introduce new policy measures in a timely manner”. China’s central bank, the PBoC, issued a statement signaling further cuts ahead in the bank reserve requirement ratio rate and interest rate.2 The PBoC has already aggressively eased monetary conditions in the past two weeks, and both the central bank policy and average lending rates are now lower than they were during the last massive easing cycle in 2015/2016 (Chart 2).  Other policy initiatives also suggest the Chinese authorities are stepping up coordinated efforts to boost the economy, beyond short-term and targeted financial support. The stimulative measures now span from infrastructure to housing and automobile sectors, the exact “three prongs” that supported a V-shaped economic recovery in 2016.3 This is in sharp contrast with last year, when Chinese policymakers largely resisted resorting to large-scale stimulus, despite immense pressure from the US-China trade war and tariff impositions.4 The ongoing COVID-19 epidemic seems to have forced China to return to its old economic playbook, as the Xi administration is clearly unwilling to tolerate economic hardships driven by an endogenous crisis. The ongoing epidemic seems to have forced China to return to its old economic playbook, as the Xi administration is clearly unwilling to tolerate economic hardships driven by an endogenous crisis. As we predicted in November last year,5 China was to frontload additional fiscal stimulus in Q1 this year to secure an economic recovery, which started to bud in Q4 last year. The increase in January’s credit numbers confirms our projection: local government bond issuance picked up significantly from last year while the contraction in shadow bank lending continued to ease, signaling a less restrictive policy bias on both the monetary and fiscal fronts (Chart 3).  Chart 3Stronger Fiscal Support Likely To Soon Follow The exact economic and monetary expansion growth targets will be officially set at the National People’s Congress meeting, which has been postponed from its usual schedule on March 5. Compared with the 6.1% real GDP growth achieved in 2019, we now think a growth target of 5.6% would be conservative for this year. According to an estimate by BCA’s Global Investment Strategy,6 China’s real GDP growth in Q1 could slow to 3.5% on a year-over-year basis. To achieve 5.6% growth, China would need at least 6.3% average real growth (year-over-year) for the next three quarters, 0.3 percentage points higher than in the second half of 2019. The growth in credit expansion, infrastructure spending and government expenditures will need to significantly outpace last year in the next 6-12 months. Bottom Line: The government appears to be willing to abandon its financial de-risking agenda to secure economic recovery. There is an increasing possibility that the stimulus may overshoot the economic shock this year. China’s Economic Engine Warms Up There are increasing signs that the scale of the upcoming stimulus may match that of the 2015/2016 cycle. The likely magnitude of the shock, on the other hand, might be smaller than investors fear as the evidence is mounting that production is returning to normality in China. Despite a lack of employees and raw materials, industrial activity in regions outside of Hubei is resuming. Chart 4…Small Companies Are Not Far Behind A survey of China’s 500 top manufacturers by China Enterprise Confederation7 indicated that most of the 342 respondents had resumed production as of February 20. They also reported that more than half of their employees had returned to work and the average capacity utilization rate had reached nearly 60% (Table 1). Furthermore, the China Association of Small and Medium Enterprises8 survey of 6,422 small businesses showed that as of February 14, more than half of the companies have resumed operations (Chart 4). By February 21, the daily coal consumption in China’s six largest power plants has reached 62% of the consumption from the same period last year (adjusted for Lunar Year calendar), 14 percentage points higher than February 10 - the first day officially scheduled for people to return to work.9 Table 1Large Manufacturers Have Reached More Than Half Of Their Production Capacity… The resurgence in the number of new infections has not slowed those regions down from reopening businesses, particularly along the manufacturing belt in China’s coastal regions (Chart 5). China’s leadership has repeatedly urged local governments to relax aggressive containment measures to allow production to resume. Unless the number of new cases in China picks up again, we expect business operations in regions outside of Hubei to continue re-opening in the coming weeks. Chart 580% Of China’s Coastal Regions Are Back To Work Most manufacturers in regions other than Hubei are returning to work and are running at about half of last year’s production capacity. Bottom Line: The aggressive containment measures seem to be effective inside China. Most manufacturers in regions other than Hubei are returning to work and are running at about half of last year’s production capacity. We expect the rate to improve. This will mitigate the impact of the virus outbreak on the Chinese economy.  “Scenario 2” Implies An Upturn In The Corporate Earnings Cycle The impact of the COVID-19 outbreak on China’s economy may be smaller than investors currently fear. The country is also in a better economic condition than in 2015/2016. If the Chinese leadership believes an “insurance stimulus” is warranted and allows credit growth in 2020 to reach near 28% of GDP, as in 2015-2016, then the stimulus will more than offset the outbreak-induced economic shock from Q1 and lead to a meaningful rise in this year’s corporate earnings (Chart 6): China’s households and corporates are actually more willing to spend now than in 2015-2016. We agree that China’s households and companies are both highly leveraged, and re-leveraging may further diminish their debt-servicing ability and willingness to invest or spend. Debt as a share of Chinese household disposable income has climbed by 33 percentage points compared with five years ago (Chart 7). The increase in debt load makes Chinese households particularly vulnerable to income reductions. But this supports our view that policymakers will make every reflationary effort to avoid massive layoffs. Additionally, the willingness to spend among Chinese households is not less than during the down cycle in 2015-2016 (Chart 7 bottom panel). Chart 6A 2015/2016-Style Stimulus Will Likely Triumph Over Short-Term Economic Shocks Chart 7Chinese Households Are More Indebted, But Are Also More Willing To Spend Than In 2015/2016 The debt-to-GDP ratio and debt-servicing cost-to-income ratio in China’s non-financial private sector have trended sideways in the past five years (Chart 8). The corporate cash flow situation is only slightly worse than in 2015 (Chart 9). The virus outbreak and drastic containment measures will temporarily weaken the corporates’ cash positions, but this negative situation can be partially offset by tax, fee and interest relief measures.10 Chart 8Chinese Corporates Are In Fact Not More Indebted Than In 2015/2016... Chart 9...And Their Cash Flow Situation Is Only Slightly Worse   Furthermore, China’s non-financial corporates’ marginal propensity to spend is actually higher than in 2015-2016 (Chart 10). This may be due to the more accommodative monetary backdrop than in 2015-2016. If Chinese authorities are to significantly step up their reflationary efforts, the easy monetary policy stance may be here to stay throughout 2020. Prior to the COVID-19 outbreak, the mild deflation in China’s PPI growth was already turning slightly positive on the heels of an improving economy. The historical relationship between China’s producer prices and industrial profits suggests that profit growth for both China’s onshore and offshore markets is highly linked to fluctuations in producer prices (Chart 11). An ultra-easy monetary policy, a weak RMB, and a more forceful boost to domestic demand will provide strong reflationary support to producer prices and industrial profits. Chart 10Chinese Corporates' Willingness To Spend Also Higher Than In 2015/2016 Chart 11A 2015/2016-Style Reflation Will Likely Lead To A Strong Rebound In Corporate Profits   Bottom Line: Despite a short-term economic shock, China’s economy is at a better starting point than in 2015-2016. If monetary and fiscal easing in 2020 reaches the same magnitude as five years ago, then the economy and corporate profits will likely begin to respond to the stimulus. Investment Conclusions The clear sign of policy shift to shoring up the economy suggests that, our Scenario 2 is the most likely outcome. The fiscal and monetary easing initiatives seem to resemble those of 2015/2016. The short-term outbreak-induced economic shock, on the other hand, looks to be smaller than the market anticipates. Manufacturers in China continue to resume production in regions outside of Hubei, a trend we believe will go on unless there is a significant threat that the virus will break out again in these Chinese regions. This supports our constructive view on China-related assets over a 6-12 month time horizon. The fiscal and monetary easing initiatives seem to resemble those of 2015/2016, and will likely overshoot the short-term economic shock. There is a risk to our constructive view, though, that the more forceful policy response from the Chinese leadership may imply a greater than anticipated short-term economic shock from the outbreak. This would challenge our bullish stance on Chinese stocks in the next three months. Substantially weaker economic data in Q1 would likely trigger a selloff in Chinese risk assets, both onshore and offshore. However, a severe short-term economic shock, followed by a burst of stimulus, would create strong investment opportunities. If the scale of Chinese policymakers’ reflationary measures ramps up significantly in the coming months, they will likely overshoot the short-term economic shock. Another reflationary cycle would certainly have a positive impact on global investors’ sentiment and Chinese financial assets. Stay tuned.   Jing Sima China Strategist jings@bcaresearch.com   Footnotes 1    http://english.www.gov.cn/news/topnews/202002/23/content_WS5e5286cdc6d0… 2   http://www.pbc.gov.cn/goutongjiaoliu/113456/113469/3975864/index.html 3   Please see China Investment Strategy Weekly Report "Threading A Stimulus Needle (Part 2): Will Proactive Fiscal Policy Lose Steam?," dated July 24, 2019, available at cis.bcaresearch.com 4   Please see China Investment Strategy Weekly Reports "Threading A Stimulus Needle (Part 1): A Reluctant PBoC," dated July 10, 2019, "Threading A Stimulus Needle (Part 2): Will Proactive Fiscal Policy Lose Steam?," dated July 24, 2019, "Don’t Bottom-Fish Chinese Assets (Yet)," dated August 14, 2019 and "Mild Deflation Means Timid Easing," dated October 9, 2019. available at cis.bcaresearch.com 5   Please see China Investment Strategy Weekly Report "Questions From The Road: Timing The Turn," dated November 20, 2019, available at cis.bcaresearch.com 6   Please see Global Investment Strategy Weekly Report "Markets Too Complacent About The Coronavirus," dated February 21, 2020, available at cis.bcaresearch.com 7   http://www.cec-ceda.org.cn/view_sy.php?id=42633 8   http://www.ce.cn/xwzx/gnsz/gdxw/202002/18/t20200218_34298844.shtml 9   http://www.21jingji.com/2020/2-21/wOMDEzNzhfMTUzNjAwOA.html 10  China has announced targeted measures to defer or lower taxes and administrative fees. It will also provide interest rate subsidies to affected businesses. Cyclical Investment Stance Equity Sector Recommendations

Special Report

Highlights Demand for construction machinery in China will contract by 10-15% over the next 12-18 months. Diminishing replacement demand, deteriorating property construction activity and only a moderate acceleration in infrastructure investment will weigh on construction machinery sales in China. We recommend avoiding or underweighting global construction machinery stocks. Feature China is the largest manufacturer and consumer of construction machinery in the world. The country accounts for about 30% of global construction machinery demand in unit terms. Construction machinery includes heavy-duty vehicles performing earthwork operations or other hefty construction tasks. In this report, our coverage of construction machinery refers to the seven most-used construction machines in the world – excavators, loaders, cranes, road rollers, bulldozers, ball-graders and spreaders. Between 2016 and 2019, machinery sales surged by  close to 170%. However, unlike during the 2009-2011 boom, sales were not  widespread across all types of machinery. Sales of these machines are often used by investors and strategists as a microcosm to detect the potency of an economy’s business cycle. An increase in machine sales is usually interpreted as a sign of an acceleration in real estate construction and/or infrastructure spending. Chart I-1Excavators In China: Robust Sales Vs. Diminishing Working Hours Are machinery sales a good measure of construction activity in both the real estate and infrastructure development? Not really. In this report we make the point that sales of construction machinery do not always reflect construction activity in the mainland. Specifically, Chart I-1 demonstrates that sales of excavators in China have differed from Komatsu’s Komtrax index for China. The latter is the average hours of operation per excavator. What explains this gap between resilient excavator sales and diminishing hours of excavator usage? This divergence has been due to the fact that robust excavator sales numbers have been supported by replacement demand as well as a changing product mix (a rising share of smaller and cheaper excavators bought by small entrepreneurs). China’s machinery imports have also been crowded out by a growing roster of domestically made models (import substitution). Boom-Bust Machinery Cycles Chart I-2Chinese Construction Machinery Demand Is Likely To Shrink Chinese sales1 of construction machinery (thereafter, machinery) skyrocketed between 2009 and 2011, when China drastically boosted its infrastructure spending and property construction surged. The 2009-2011 boom was followed by a bust: Between 2012 and 2015, total machinery sales dropped by nearly 70%, (Chart I-2). That bust was succeeded by another boom: between 2016 and 2019, machinery sales surged by close to 170%. However, unlike during the 2009-2011 boom, sales were not widespread across all types of machinery: only excavator and crane sales boomed (Chart I-3). The other five categories – loaders, road rollers, bulldozers, ball-graders and spreaders – experienced a relatively muted sales recovery; their 2019 unit sales were well below their respective 2011 highs (Chart I-4). Chart I-3The 2016-2019 Boom: Only Sales Excavators And Cranes Hit A New High...Going forward, we expect sales of construction machinery in China to experience a 10-15% downturn over the next 12-18 months (Chart I-2 on page 2). The basis for such a contraction is diminishing replacement demand, deteriorating property construction and only a moderate acceleration in infrastructure investment growth. Chart I-4...While Many Others Had A Relatively Muted Sales Recovery   Understanding Construction Machinery Demand China’s property construction and infrastructure development have been the main drivers behind construction machinery demand. Chart I-5 shows construction machinery sales in China are highly correlated with building floor space started. Meanwhile, Chart I-6 reveals that infrastructure investment distinctively led construction machinery sales between 2007 and 2013, but that relationship has broken down since 2014. Chart I-5Main Drivers For Construction Machinery Demand In China: Property Construction... Chart I-6...And Infrastructure Spending   Crucially, in the past three years, property and infrastructure development alone have not been enough to explain the surge in construction machinery sales. In particular, between 2018 and 2019, growth of both building floor areas started and infrastructure investment were weak, yet construction machinery sales still surged by an astonishing 50%. Crucially, in the past three years, property and infrastructure development alone have not been enough to explain the surge in construction machinery sales. Specific developments in the excavator market were behind this surge. Excavators are the largest component of China’s construction machinery market, with a 52% market share (Chart I-7). The decoupling of excavator sales from property construction and infrastructure investment has been due to non-macro forces such as: Replacement demand: Given the average lifespan of an excavator is about eight years, the excavators bought in 2009-2011 were likely replaced during 2017-2019. Meanwhile, strengthening environmental regulations on emissions of heavy construction machinery also accelerated the pace of replacement. According to the China Construction Machinery Association, replacement demand accounted for about 60% of all excavator sales last year. Price drop: The significant reduction in excavator prices, ranging from 15%-30% since the middle of 2018, spurred more purchases. Prices of excavators imported into China have also dropped about 30% in the past 18 months (Chart I-8). The fundamental reason behind excavator producers cutting prices was weak demand amid lingering excess capacity. Chart I-7The Breakdown Of China’s Construction Machinery Sales Chart I-8A Sizeable Drop In Prices Of Imported Excavators   Cranes are the only other construction machinery whose sales reached an all-time high last year. Similar to excavators, replacement demand has been the main factor behind sales. Excluding excavators and cranes, machinery sales have been lackluster, as illustrated in Chart I-4 on page 3. Bottom Line: Property construction and infrastructure development alone do not explain the strong growth in construction machinery sales between 2017 and 2019. Considerable replacement demand prompted by a sizable reduction in excavator prices also facilitated sales in China. A Downbeat Cyclical Demand Outlook Chart I-9Chinese Property Construction Is Very Weak We remain downbeat on Chinese construction machinery demand going forward. Chinese sales of construction machinery will likely contract 10-15% over the next 12-18 months (Chart I-2 on page 2). First, the Chinese property market remains vulnerable to the downside in 2020. A comprehensive measure of Chinese property construction activity – the “building construction” dataset2 – shows that “building construction” floor area started, under construction and completed are all either stagnant or in contraction (Chart I-9). Real estate is still facing considerable headwinds. The COVID-19 outbreak will reduce household income growth and hence weigh on home purchases in the months to come. In the meantime, structural impediments such as poor housing affordability, slowing rural-to-urban migration, demographic changes and the promotion of the housing rental market will also curtail housing demand. Further, the drop in sales will shrink developers’ cash flow, curbing their already feeble financial position to undertake new construction or complete already started projects. Second, the growth rate of China’s infrastructure investment will likely rebound only moderately from its current nominal 3% pace (Chart I-6 on page 4). Even though the central government is likely to implement more fiscal stimulus due to the current coronavirus outbreak, the infrastructure investment growth rate will still be well below the double digits it registered for most of the past decade. Local government special bond quotas are currently a moving target. No doubt, if economic conditions continue to deteriorate, the central government will continue to increase quotas. However, there are several critical points about the importance of special bond issuance that are worth emphasizing: Special bonds accounted for 14% of total infrastructure investment in 2019. Special bond issuance amounted to 7% of combined local government and government-managed funds expenditures last year. Aggregate infrastructure spending was equal to 30% of fixed asset investment excluding the value of land, and 18% of nominal GDP in 2019. It is roughly equal to property construction. Therefore, modest acceleration in infrastructure spending will likely be offset by shrinking property construction. On the whole, barring irrigation-style fiscal and credit stimulus – which has been repeatedly rejected by Beijing – infrastructure spending is unlikely to surge to the extent it did in 2009-‘10, 2013 and 2016-‘17. It is critical to realize that infrastructure spending during those episodes was funded not by Beijing-approved debt but via bank and shadow-banking credit that was beyond Beijing's control. Chart I-10Excavator Sales Are Likely To Fall Third, two specific factors below may result in a considerable reduction in excavator sales. Replacement demand will crater starting in 2020. Excavator sales in 2012 were 35% below their 2011 peak. Given the average eight-year replacement cycle, demand for excavators in 2020 and 2021 will be significantly below 2019 levels (Chart I-10). The price war in the excavator sector will continue, but it will fail to lift overall excavator demand. There are signposts that there is an oversupply of excavators in operation. Last year, excavator drivers (individual entrepreneurs) accounted for a large share of purchases, with the bulk of them opting for small-sized machines – the latter contributed about 70% of the total excavator sales growth. The surge in small service providers amid stagnant construction activity has intensified competition and hence depressed income among these individual owners. This will discourage new demand in the coming one to two years. A risk to this view is that replacement demand could be supported to some extent by increasingly stringent environmental rules. This year, the government will accelerate the scrapping process of off-road heavy vehicles below National III emission standards. Bottom Line: Chinese sales of construction machinery will likely experience a 10-15% downturn over the next 12-18 months, with the largest category – excavator sales – falling by 20% or more. Rising Competitiveness Of Chinese Machinery Producers China’s machinery producers have significantly enhanced their competitiveness. This has led to import substitution. For instance, sales of domestic-brand excavators accounted for 65% of total Chinese excavator sales, a considerable rise from 43% in 2014 and only 26% in 2009. Chinese sales of construction machinery will likely  experience a 10-15% downturn over  the next 12-18 months,  with the largest category  – excavator  sales – falling by  20% or  more. The increasing competitiveness of domestic producers has resulted in not only shrinking imports but also rising exports of construction machinery. As a result, Chinese construction machinery net exports have been on the rise (Chart I-11). In fact, excavators, loaders, cranes, and spreaders have all shown increasing net exports in both volume and value terms (Chart I-12). Chart I-11Chinese Construction Machinery: Flat Exports, Less Imports Chart I-12Increasing Net Exports Of Chinese Construction Machinery   We expect this trend to continue in the coming years. The ongoing Belt and Road Initiative (BRI) will facilitate construction machinery exports to BRI recipient countries. For example, on January 12, Chinese construction machinery manufacturer Zoomlion delivered its first batch of an order of 100 excavators to Ghana as part of a BRI agreement. Total BRI investment with Chinese financing will fall moderately in 2020, as the Chinese government will be applying greater scrutiny and tighter oversight over lending for BRI projects. However, we believe this moderate decline in BRI investment will not affect the country’s construction machinery exports by much. Chinese construction machinery companies are highly focused on technology improvements and 5G applications for their products. This will continue to increase the competitiveness of Chinese construction machinery producers. For example, last May, the 5G-based unmanned mining truck made its debut in China’s Bayan Obo mining region. Autonomous vehicles are more efficient and cheaper to maintain. The Bayan Obo mining area plans to purchase more unmanned mining trucks and transform existing traditional vehicles, with plans to make over 65% of its future fleet of mining cars autonomous. Technology improvements and 5G application will further enhance Chinese construction machinery producers’ productivity, making their products more competitive in the global marketplace. Bottom Line: China’s construction machinery net exports will continue to rise, implying a rising market share for mainland producers. This is a bad sign for foreign producers. Investment Implications Global construction machinery stock prices correlate closely with China’s domestic machinery sales (Chart I-13). This confirms the importance of the mainland, which accounts for 30% of global construction machinery demand. There are 30 stocks in the MSCI global construction machinery stock index, including Caterpillar, Komatsu, Paccar, Cummins and Volvo B.  China’s construction machinery  net exports  will continue to rise, implying a rising market share for  mainland producers. This is a bad sign for  foreign producers. Global machinery producers will likely suffer from both shrinking demand in China and a loss of market share to mainland producers. In fact, both Caterpillar and Komatsu excavator sales are already in contraction, even though mainland excavator sales did not contract in 2019 (Chart I-14). Chart I-13Global Construction Machinery Stocks: Closely Correlate With Chinese Demand Chart I-14Caterpillar And Komatsu Sales: Shrinking   However, a caveat is in order: both Caterpillar and Komatsu have manufacturing factories in China, ranking the third and seventh place in terms of domestic excavator sales, respectively. Hence, domestic producers also include some multinationals that have established operations on the mainland. A point on equity valuations is also in order: Chart I-15 demonstrates the cyclically adjusted P/E ratio for Caterpillar. This stock is not yet cheap. As its sales contract, the stock price will fall further. Chart I-15Cyclically-Adjusted P/E Ratio For Caterpillar: Not Cheap Chart I-16Global Machinery Stocks Are At Risk Overall, trailing EPS of both global construction machinery companies and mainland producers listed on the A-share market are beginning to contract (Chart I-16). This entails that their share prices are at risk.   On the whole, we recommend avoiding or underweighting global machinery stocks. Ellen JingYuan He Associate Vice President ellenj@bcaresearch.com     Footnotes 1 Please note that all the Chinese construction machinery sales data used in this report are compiled by China Construction Machinery Association. Based on the Association’s definition, its sales data Include exports and domestic sales of domestically produced machineries, but exclude imports. However, exports are small so this sales data can be used as a proxy of domestic demand. 2 This measure includes not only “commodity buildings” but also buildings built by non-real estate developers.

Highlights Portfolio Strategy Boeing’s 737 MAX grounding, China’s looming slowdown on the back of the coronavirus epidemic and weak industry operating metrics, all warrant a downgrade alert in the US aerospace index. Red hot demand for defense capital goods, defense industrial production that is firing on all cylinders, enticing industry operating metrics and pristine balance sheets, all suggest that it still pays to be long the pureplay defense index. Recent Changes There are no changes to our portfolio this week. Table 1 Feature Equities remained untethered last week, and floated skyward to fresh all-time highs. The second panel of Chart 1 shows that from a technical perspective the SPX has returned close to the early-2018 blow-off top level, when the deviation from its 200-day moving average reached a zenith. Similarly, drilling beneath the surface the percentage of S&P 500 groups trading above their 50-day and 200-day moving averages in absolute terms is also running high (third panel, Chart 1). Investor complacency reigns supreme. The coronavirus scare lasted a few days and despite AAPL’s recent warning, which is likely the tip of the iceberg and other companies are slated to issue Q1 profit warnings, investors are ignoring all the bad news and piling into equities in general and teflon-tech stocks in particular. Keep in mind that 12-month forward profit growth remains positively correlated with the 10-year US treasury yield. The former crested in early 2020, predating the coronavirus epidemic (bottom panel, Chart 1). The end result is a new multiple expansion phase with the S&P 500 forward P/E clearing the 19 handle. Chart 1Dizzying Heights Such complacency transcends the equity market and spills over to the junk bond market. The hunt for yield remains intact and the Barclays US total return high yield index is following up the path of the SPX. Momentum is also tracking closely the broad equity market (top & middle panels, Chart 2). Nevertheless, we remain cautious. Last week we highlighted that the “tenuous trio” cannot go up indefinitely and a simultaneous rise in all three asset classes (stock prices, bond prices and the US dollar) typically portends an equity market crack.1 The big risk is that a surging greenback will short-circuit EPS growth and our worst case EPS scenario of -1% profit growth in calendar 2020 as we highlighted in mid-January will materialize.2 Worrisomely, while the S&P 500 made fresh all-time highs last week, the DXY came close to breaking above par, the VIX stayed stubbornly glued near 15 and gold bullion eclipsed $1,600/oz (third & bottom panels, Chart 2). Something has got to give. Meanwhile, Chart 3 updates our Corporate Pricing Power Indicator (CPPI) that recently came out of the deflation zone. This tick up in the CPPI coupled with still softening wage inflation have pushed our S&P 500 profit margin proxy slightly higher but still below the zero line, signaling that the margin contraction phase will likely run its course this year (bottom panel, Chart 3). Chart 2Spiking Greenback And Bullion Signal Trouble Chart 3Modest Profit Margin Improvement Drilling beneath the surface, our CPPI remains soft and vulnerable to a deflationary shock if the coronavirus epidemic severely wounds the global economy. As a reminder, we calculate industry group pricing power from the relevant CPI, PPI, PCE and commodity growth rates for each of the 60 industry groups we track. Table 2 also highlights shorter term pricing power trends and each industry's spread to overall inflation. Table 2Industry Group Pricing Power A bit less than half of the industries we cover are lifting selling prices by more than 1%, and 35% are outright deflating. Worrisomely, 60% of the sectors we cover fail to raise prices at a faster clip than overall inflation. With regard to pricing power trends, roughly half of the industries we cover are either flat or in a downtrend (Table 2). Gold bullion remains on top of our table climbing at a 22%/annum rate despite the greenbacks recent rise, and only five additional commodity-related industries made it to the top thirty (Table 2). Most of the commodity complex is deflating courtesy of the appreciating US dollar, and the recent coronavirus epidemic will definitely sustain the downward pressure on commodity inflation as demand will likely suffer a major setback. Importantly, defensive sectors still occupy half of the top ten spots, similar to our last update in October 2019. On the flip side, four of the bottom eight industries are commodity related, a trend we expect to pick up steam in the coming quarters. This week we update our views on the two industrials sub-groups that are moving in opposite directions. Put The Aerospace Index On Downgrade Watch We are compelled to put the pureplay aerospace subgroup (currently rated neutral) on downgrade alert. A little over four years ago, we split the aerospace & defense coverage into pureplay aerospace and pureplay defense, as the profit drivers of these two industries started to steeply diverge. True, the yet to be completed UTX acquisition of RTN will re-complicate matters, but we will continue to cover these two groups independently. From a technical perspective, a head and shoulders pattern has likely formed, warning that the next leg down will be a rather painful one, especially if support at current levels gives way (top panel, Chart 4). Boeing (BA) dominates the pureplay aerospace subgroup and sustained delays to recertify the 737 MAX have weighed heavily on share prices. While the FAA and other country air safety regulators may give the green light for flights to resume for Boeing’s workhorse commercial jetliner, consumers may be reluctant to board this plane given all the negative publicity. This remains a big risk to BA and thus to the aerospace index. Chart 4Prior To Coronavirus Epidemic… On the macro front, prior to the coronavirus epidemic, the global PMI was on the path to recovery with a plethora of countries climbing above the boom/bust line (middle & bottom panels, Chart 4). In China specifically, Bloomberg’s story count of China slowdown has returned to the historical lower band of this time series, at a time when BCA’s Chinese credit & fiscal easing impulses were ticking higher (second & third panels, Chart 5). Tack on the ongoing Chinese monetary easing, and factors were falling into place for a robust recovery in demand for US aerospace products (bottom panel, Chart 5). Chart 6 shows why China is so important to this industry. Not only is future commercial aircraft demand growth centered round China, but also China at the recent peak accounted for 15% of total US aerospace exports. In fact, aerospace exports to China tripled since the GFC. Chart 5…Macro Data Were Firming Chart 6China Matters Most To Aerospace Unfortunately, the coronavirus epidemic changes all the China-related calculus and will further dampen demand for aerospace products, at least in the near-term. Granted, US aerospace sales are already nosediving and so are operating profits. Industry new orders are in a freefall of late courtesy of the 737 MAX grounding and halt in production (second & third panels, Chart 7). As a result, profit margins have collapsed probing the Great Recession lows (bottom panel, Chart 7). Similarly, aerospace shipments have taken it to the chin and inventories are sky high, whereas backlogs are contracting, albeit mildly (top, middle and fourth panels, Chart 8). Worrisomely, aerospace industrial production ground to a halt last month, with the resource utilization rate gaping down a whopping 560bps on a month-over-month basis (second & bottom panels, Chart 8). Boeing’s production ails will likely remain in place for the next three months, and sustain the downward pressure on output growth and capacity utilization. All of this suggests that profits are in for a rough ride. Chart 7737 MAX Ills… Chart 8…Weighing Heavily Executives’ knee-jerk reaction has been to tap credit lines in order to fend off this profit contraction phase, which has pushed the industry’s leverage to the stratosphere. In fact, the aerospace industry’s 3.5x net debt-to-EBITDA reading is the highest since the history of the data set, even higher than the aftermath of the 9/11 induced recession Chart 9). Finally, valuations have skyrocketed, rising to over three standard deviations above the past four decade mean. In marked contrast, relative technicals are washed out, probing two decade lows (Chart 10). Chart 9Rapid B/S Degradation Chart 10Overvalued, But Oversold In sum, Boeing’s 737 MAX grounding, China’s looming slowdown on the back of the coronavirus epidemic and weak industry operating metrics, all warrant a downgrade alert in the US aerospace index. Bottom Line: We are awaiting a bounce before downgrading the US aerospace index to a below benchmark allocation. It is now on our downgrade watch list. The ticker symbols for the stocks in the pureplay US aerospace index are: BA, UTX, TDG, TDY, TXT, HEI, SPR, HEI.A. Defense Rules Unlike their aerospace brethren, pureplay defense stocks are on fire on multiple fronts, and we reiterate our cyclical and secular (ten-year time horizon) overweight recommendations.3 Defense industrial production (IP) surpassed the end of the Cold War highs and is now in uncharted territory. On a year-over-year rate of change basis IP is running over 7% or fifteen percentage points higher than aerospace IP (Chart 11). This is a remarkable feat as overall IP is contracting and the US is still fighting off a manufacturing recession. Meanwhile, relative defense performance is in a V-shaped recovery, whereas relative aerospace performance is moving down along the right side of a lambda formation (top panel, Chart 11). As we mentioned above, M&A activity is also boosting takeover premia and the reduction of defense stock supply is bullish for stock prices (Chart 12). Chart 11Defense Is The Mirror Image Of Aerospace Chart 12Supportive M&A Upbeat defense outlays underpin relative share prices. Given that a global arms race is ongoing, demand for weapons will remain robust for the duration of this decade according to SIPRI’s estimates (Chart 13). Importantly, defense capital goods new orders are flirting with all-time highs, industry backlogs are not far behind and defense related exports are running red hot (Chart 14). Chart 13Insatiable… Chart 14…Demand… Besides the global rearmament, a global space race along with the real threat of cyberattacks – especially on governments – underscores that defense companies are well positioned to benefit from these two additional sources of revenues for years to come. This firm demand backdrop is reflected in near double digit sales growth outshining the broad market by a factor of 2:1. The last time defense sales were growing so briskly was during the Iraqi war in the early 2000s (Chart 15). However, one key difference between now and 2002 is margins. Back then profit margins were falling in the aftermath of the 9/11 induced recession. Fast forward to today and profit margins have doubled even eclipsing non-financial corporate sector margins (Chart 15). Given the industry’s high operating leverage, robust top line growth will flow straight to the bottom line and sustain the earnings-led relative share price outperformance phase. Keep in mind that not only are non-financial corporate sector profits contracting, but the sell-side community also expects defense EPS to continue to deflate in the coming twelve months (fourth & bottom panels, Chart 15). This represents a low bar for the defense industry to surpass. Defense stocks also have a fortress of a balance sheet: the net debt-to-EBITDA ratio runs below the broad market and the interest coverage ratio trounces the overall market. Tack on a soaring return-on-equity, and there is a long runway ahead for pureplay defense stocks (Chart 16). Chart 15…Underpins Operating Metrics Finally on the relative valuation front, while defense stocks trade at a massive premium to the broad market on a P/B basis, they are changing hands at a discount on both an EV/EBITDA and P/E basis. Defense stocks also command a higher dividend yield compared with the non-financial corporate sector (Chart 17). If our thesis continues to pan out, we deem that defense stocks will grow into their pricey P/B valuations, similar to what happened during the MAD doctrine era of the 1960s.4 Chart 16Fortress Of A B/S Chart 17Far From Overvalued On Most Ratios Netting it all out, red hot demand for defense capital goods, defense industrial production that is firing on all cylinders, enticing industry operating metrics and pristine balance sheets, all suggest that it still pays to be long the pureplay defense index. Bottom Line: Stay overweight the pureplay defense index both on a cyclical and secular time horizon. The ticker symbols for the stocks in this index are: LMT, RTN, NOC, GD, HII, AJRD, BWXT, CW, MRCY.   Anastasios Avgeriou US Equity Strategist anastasios@bcaresearch.com     Footnotes 1     Please see BCA US Equity Strategy Weekly Report, “Will The Fed Save The Day, Again?” dated February 18, 2020, available at uses.bcaresearch.com. 2     Please see BCA US Equity Strategy Weekly Report, “Three EPS Scenarios”, dated January 13, 2020, available atuses.bcaresearch.com. 3    Please see BCA US Equity Strategy Special Report, “Top US Sector Investment Ideas For The Next Decade” dated December 16, 2019, available at uses.bcaresearch.com. 4    Please see BCA US Equity Strategy Special Report, “Brothers In Arms” dated October 31, 2016, available at uses.bcaresearch.com. Current Recommendations Current Trades Strategic (10-Year) Trade Recommendations Size And Style Views June 3, 2019 Stay neutral cyclicals over defensives (downgrade alert)  January 22, 2018 Favor value over growth May 10, 2018 Favor large over small caps (Stop 10%) June 11, 2018 Long the BCA  Millennial basket  The ticker symbols are: (AAPL, AMZN, UBER, HD, LEN, MSFT, NFLX, SPOT, TSLA, V).

Overweight Investors tend to overreact to events such as virus epidemics, but we deem that such fears typically create trading opportunities, especially in the hardest-hit sectors. Similar to hotels (that we upgraded to neutral last week), airlines are part of the tourism-related industries that have suffered disproportionately. Were we not overweight the S&P airlines index, we would not hesitate to initiate such a position. True, consumer and business demand for air transportation services will come under pressure in the near-term, however, looking further out such demand destruction will likely prove transitory. The chart on the right highlights that the cyclical demand backdrop is robust for the US airline industry. Overall consumer outlays jumped recently, PCE services momentum is perking up, airfare PCE is outpacing overall consumer spending – an impressive feat – and consumer confidence is perched near cycle highs sustaining a wide gap with relative share prices. Bottom Line: Stay overweight the S&P airlines index. The ticker symbols for the stocks in this index are: BLBG S5AIRLX – LUV, DAL, UAL, AAL, ALK. For additional details please refer to this Monday’s Weekly Report.  

Highlights Global equities have benefited from the fact that the number of new coronavirus (COVID-19) cases continues to drift lower. Falling bond yields have also supported stocks. Nevertheless, risks remain. Even if the outbreak recedes, global growth is still set to fall to zero in the first quarter, before bouncing back over the remainder of the year. Thus, a near-term hit to corporate earnings now looks unavoidable. More worryingly, the possibility remains that the number of new cases will spike again as Chinese workers return to their jobs over the next few weeks. While we and others have compared the current outbreak to the SARS episode, a more relevant comparison could be the H1N1 (swine flu) outbreak of 2009-2010. Despite early efforts to contain it, 61 million Americans ended up catching the H1N1 virus, resulting in about 12,000 US deaths over a 12-month period. Globally, at least 150,000 people perished. It appears that the fatality rate from COVID-19 is significantly higher than for H1N1, though well below that of SARS and MERS. A full-blown pandemic with a fatality rate of 2% could lead to 20 million deaths worldwide. This would likely trigger a global downturn as deep as the Great Recession of 2008/09. The only consolation is that the recovery would be much more rapid than the one following the financial crisis. Although we are inclined to lean on the side of optimism, the truth is that neither we nor anyone else knows what the likelihood of such a pandemic scenario is. Thus, while we continue to maintain our positive 12-month view on global stocks, we recommend a more cautious near-term stance. Global Growth Set To Grind To A Halt In Q1 Based on the SARS example, we noted three weeks ago that risk assets were likely to bottom once the number of new coronavirus cases peaked. Sure enough, Chinese shares troughed on January 31st, just as the number of confirmed infections had begun to level off. The S&P 500 has been on a tear since then, hitting one record high after another (Chart 1). Falling bond yields have also supported stocks. Despite the decline in new infections, we think it is too early for investors to breathe a sigh of relief. For one thing, the economic data out of China remains abysmal. Real-time indicators of economic activity have been off-the-charts bad – much worse than what we saw during the SARS outbreak. While there has been some recovery in recent days, road congestion remains well below normal levels. In Shanghai, property sales are currently about four times lower than what is usual for this time of  year. Movie ticket sales have all but disappeared. Daily coal consumption, which tracks electricity consumption, has fallen by 70% (Chart 2). More than three-quarters of companies surveyed last week by the American Chamber of Commerce in Shanghai said that they cannot run a full production line due to a lack of staff. Chart 1Just As In The SARS Episode, Stocks Bottomed Around The Same Time The Number Of Infections Peaked   Chart 2Chinese Daily Activity Has Fallen Off A Cliff In our preliminary estimate of the impact of the virus on global growth, we penciled in zero growth for China on a quarter-over-quarter basis in Q1 of 2020, implying that the level of output in the first quarter would be the same as in the fourth quarter. Unfortunately, at this point, that looks far too optimistic. Chinese economic output will decline on a sequential basis. The only question is by how much. Despite the decline in new infections, we think it is too early for investors to breathe a sigh of relief. Chart 3 shows our updated baseline profile for global growth in Q1 and the remainder of this year. Assuming that production returns to normal over the coming weeks, it should be possible to limit the unannualized quarter-over-quarter decline in Chinese real GDP in Q1 to 1% (4% annualized). On a year-over-year basis (2020Q1 versus 2019Q1), this would drag Chinese growth down to 3.5%, the slowest pace in three decades. Relative to our earlier estimates, we expect larger spillover effects to the rest of the world, mainly stemming from the severe contraction in global tourism. Chart 3The Global Economy Will Come To A Standstill In Q1 The direct and indirect effects of the outbreak should be enough to push global growth down to zero on a quarter-over-quarter basis in Q1. Under our baseline scenario, growth will recover in the second quarter, leaving the level of global GDP down 0.5 percentage points for the year as a whole compared to what would have transpired if the virus had never emerged.   The Calm Before The Storm? Even after this downgrade to our assessment, we still see the risks to global growth from the COVID-19 outbreak as being tilted to the downside. This largely reflects our concern that contrary to our baseline scenario, the outbreak could reintensify over the next few weeks as more Chinese workers return to their jobs. As the dire situation on the Diamond Princess cruiseliner docked in the port of Yokohama illustrates, the COVID-19 virus remains highly contagious. Despite numerous efforts by medical authorities to keep those on board at a safe distance from one another, 621 of the 3,011 passengers and crew aboard the ship who have been tested have been infected with the virus. Worryingly, the virus also appears to be contagious even when carriers are not showing any symptoms. Just this week, the Japanese media reported on a case where the son of an infected doctor tested positive for the virus even though he had last seen his father three days before the doctor started displaying symptoms.  While the number of new infections has fallen in China, new clusters have appeared elsewhere. South Korea just reported 73 new cases in a little more than two days. Iran disclosed two deaths from the virus in Qom, a holy city just outside Tehran that receives 20 million visitors annually. This suggests that there are probably at least 100 infected people in the city. The World Health Organization has estimated RO, the average number of people someone with the COVID-19 virus will infect, to be between 1.4 and 2.5. A recent survey of 12 studies found a larger mean RO of 3.28.1  An RO above one would produce an exponential increase in the number of cases. Heavy-handed quarantine measures such as those imposed by China could probably drive RO below one. However, some governments may not be able to implement such measures, and even if they could, they might not be sustainable for months on end.  The H1N1 (Swine Flu) Template? All this raises the possibility that the COVID-19 outbreak could end up resembling the H1N1 (swine flu) pandemic of 2009-10. Despite initial hopes, early efforts to contain the H1N1 outbreak failed. The US Centers for Disease Control and Prevention calculated that 61 million Americans caught the virus over the course of the proceeding 12 months, resulting in over 12,000 deaths. Globally, an estimated 700 million-to-1.4 billion people contracted the virus. A paper published in the Lancet put the number of fatalities worldwide at 151,700-to-575,400.2 The reason one hears less about H1N1 than SARS is that the latter killed 5%-to-10% of those who contracted it, whereas the former killed 0.01%-to-0.08%. Based on very preliminary evidence, it appears that the fatality rate from COVID-19 is significantly higher than for H1N1, though well below that of SARS, and lower still than for MERS, a particularly nasty strain of the coronavirus that killed about one-third of those who contracted it. That said, COVID-19’s true fatality rate remains highly uncertain. In Hubei province, the fatality rate is running at 3.1%. Elsewhere in China, it stands at 0.9%. Outside China, the fatality rate appears to be 0.5%. Part of the gap between Hubei and elsewhere may be due to greater underreporting of mild and moderate cases in the stricken province. However, it is also likely that Hubei’s higher fatality rate reflects the tremendous pressures its medical system is currently under. If the COVID-19 outbreak were to morph into a pandemic, such pressures would only escalate since medical resources from less-afflicted areas could no longer be deployed to fight every local breakout. The Economic Impact Of A Pandemic: Deep But Brief Chart 4The Private-Sector Surplus In Developed Economies Is In Good Shape Assuming the COVID-19 virus infects a billion people with a fatality rate of 2%, this would translate into 20 million deaths worldwide. Such a pandemic would rattle the global economy, leading to a recession as deep as the one in 2008/09. Demand for most items other than necessities would collapse. Business and leisure travel would fizzle. The global supply chain would seize up. The only consolation is that the recession would likely be followed by a vigorous “V-shaped” recovery. Sluggish “U-shaped” recoveries tend to occur when there are many imbalances that need to be worked off. For example, the recovery in the US following the Great Recession was impeded by the need for households to pare back debt and for the excess supply of newly built homes to be run down. Today, the larger developed economies are in decent shape. The private-sector financial balance in advanced economies – the difference between what the private sector earns and spends – stands at a surplus of 3.4% of GDP. In 2007, the private-sector financial balance fell to 0.4%, hitting a deficit of 2% in the US. The private-sector balance also deteriorated sharply in the lead-up to the 2001 recession (Chart 4). Chinese debt levels have soared over the past decade. However, it is worth noting that China’s private-sector financial surplus reached 7.1% of GDP in 2019 – higher than in Japan or Germany (Chart 5). Rather than suffering from excess debt levels, China suffers from excess savings. It is these excess savings that have forced the authorities to push state-owned companies and local governments to engage in debt-financed investment spending in order to prop up aggregate demand and employment. It is also these savings that will allow the government to stimulate the economy to prevent an outright economic collapse. Chart 5The Private Sector Spends Less Than It Earns In Most Economies Life Goes On… For Most Chart 6'Til Death Do Us Part While it would take time, as horrific as a pandemic would be, most people would eventually adjust to living in a world where one’s longevity is less assured than it is today. That is the world in which humanity lived for centuries. It is also the world that prevailed during the Cold War. Keep in mind that in the US, an average 59 year-old man has a 1% chance of dying at some point within one year, and a 6% chance of dying over five years (Chart 6). Death is a part of life. As the virus circulates throughout the population, some people will perish. However, the vast majority will acquire immunity either by fighting off the disease or, if a vaccine becomes available later this year or in 2021, by being inoculated. All this will bring the pandemic to an end.  Investment Conclusions No one knows if the COVID-19 outbreak will recede or whether it will morph into a true pandemic. As macro strategists, all we can do is run through various scenarios and try to figure out the likely market impact. Chart 7Global Manufacturing Was On The Upswing Before The Outbreak Occurred If the number of new infections continues to decline, investors will likely look through the Q1 plunge in growth. Judging from the purchasing manager indices, global growth had already turned the corner in the weeks before the viral outbreak (Chart 7). With pent-up demand having accumulated in the intervening weeks, growth would bounce back in the second quarter. Under this benign scenario, equities still have upside, while bond yields will start rising again. As a countercyclical currency, the US dollar would also give up some of its recent gains. In a pandemic scenario, the recovery in growth will obviously be delayed. And when output does recover, it will be from significantly lower levels. Markets will end up going through their own version of Kubler-Ross' five stages of grief: denial, anger, bargaining, depression, and acceptance. Unfortunately, before we reach the acceptance stage, global equities could easily fall by 20% from current levels. On balance, while we continue to lean on the side of optimism by maintaining our positive 12-month view on global stocks, we recommend a more cautious near-term stance until there is greater clarity as to how the outbreak will evolve.   Peter Berezin Chief Global Strategist peterb@bcaresearch.com   Footnotes 1Ying Liu, Albert A Gayle, Annelies Wilder-Smith, and Joacim Rocklöv, “The reproductive number of COVID-19 is higher compared to SARS coronavirus,” Journal of Travel Medicine, February 2020. 2 Please see Sundar S. Shrestha, et al., “Estimating the Burden of 2009 Pandemic Influenza A (H1N1) in the United States (April 2009–April 2010),” Clinical Infectious Diseases (52:1), January 2011; Peter Doshi, “The 2009 Influenza Pandemic,” The Lancet Infectious Diseases (13:3), March 2013; and Heath Kelly, et al., “The Age-Specific Cumulative Incidence of Infection with Pandemic Influenza H1N1 2009 Was Similar in Various Countries Prior to Vaccination,” PLoS ONE 6(8), August 2011. Global Investment Strategy View Matrix MacroQuant Model And Current Subjective Scores Strategic Recommendations Closed Trades

Neutral It has been particularly difficult to distinguish a clear signal from noise lately with regard to the cyclicals versus defensives ratio. Relevant macro drivers, operating metrics and profit fundamentals, valuations and technicals all have been emitting conflicting messages. The recent coronavirus epidemic will likely make the waters murkier still. US Equity Strategy’s Global Trade Activity Indicator has turned south recently following in the footsteps of the Chinese manufacturing PMI data that ticked down and are slated to drop below the boom/bust line in the current month (top & bottom panels). The bond market also reflects a gloomy global economic backdrop with the global 10-year Treasury yield sinking like a stone. Such a lackluster bond market will likely weigh on relative share prices (middle panel). Bottom Line:  Remain on the sidelines on cyclicals versus defensives. For more details on the positive data on the cyclicals/defensives ratio please refer to this Monday’s Weekly Report.​​​​​​​

Highlights Analyses on Asian semis, Argentina and Russia are available on pages 7, 12 and 14, respectively. The most likely trajectory for Chinese growth will be as follows: the initial plunge in business activity will be succeeded by a rather sharp snap-back due to pent-up demand. However, that quick rebound will probably be followed by weaker growth. Financial markets will soon focus on growth beyond the temporary rebound. In our opinion, it will be weaker than markets are currently pricing. Thus, risks for EM risk assets and currencies are skewed to the downside. A major and lasting selloff in EM stocks will only occur if EM corporate bond yields rise. In this week’s report we discuss what it will take for EM corporate credit spreads to widen. Feature The downside risks to EM risk assets and currencies are growing. We continue to recommend underweighting EM equities, credit and currencies versus their DM counterparts. Today we are initiating a short position in EM stocks in absolute terms. Chart I-1 illustrates that the total return index (including carry) of EM ex-China currencies versus the US dollar has failed to break above its 2019 highs, and has rolled over decisively.  In contrast, the trade-weighted US dollar has exhibited a bullish technical configuration by rebounding from its 200-day moving average (Chart I-2). Odds are the dollar will make new highs. An upleg in the greenback will foreshadow a relapse in EM financial markets. Chart I-1EM Ex-China Currencies Have Been Struggling Despite Low US Rates Chart I-2The US Dollar Remains In A Bull Market   Growth Trajectory After The Dust Settles The evolution of the coronavirus remains highly uncertain and unpredictable. As with any pandemic or virus outbreak, its evolution will be complex with non-trivial odds of a second wave. Even under the assumption that the epidemic will be fully contained by the end of March, its economic impact on the Chinese and Asian economies will likely be greater than global financial markets are currently pricing. As investors come to the realization that this initial pick-up in economic activity after the virus outbreak will be followed by weaker growth, the odds of a selloff in equities and credit markets will rise. In our January 30 report titled Coronavirus Versus SARS: Mind The Economic Differences, we argued that using the framework from the SARS outbreak to analyze the current epidemic is inappropriate. First, only a small portion of the Chinese economy was shut down in 2003, and for a brief period of time. The current closures and limited operations are much more widespread and likely more prolonged. Table I-1China’s Importance Now And In 2003 Second, China accounts for a substantially larger share of the global economy today than it did in 2003 (Table I-1). Hence, the global business cycle is presently much more sensitive to demand and production in the mainland than it was during the SARS outbreak. Global financial markets have rebounded following the initial selloff in late January on expectations that the Chinese and global economies will experience a V-shaped recovery. In last week’s report, we discussed why the odds favor a tepid recovery for the Chinese business cycle and global trade. The main point of last week’s report was as follows: with the median company and household in China being overleveraged, any reduction in cash flow or income will undermine their ability to service their debt and will dent their confidence for some time. Hence, consumption, investment and hiring over the next several months will be negatively affected, even after the outbreak is contained. This in turn will diminish the multiplier effect of policy stimulus in China. Chart I-3Our Expectations Of China’s Business Cycle The most likely pattern for Chinese growth will likely resemble the trajectory demonstrated in Chart I-3. It assumes the plunge in business activity will be succeeded by a rather sharp snap-back due to pent-up demand. However, that snap-back will likely be followed by weaker growth, for reasons discussed in last week’s report. Equity and credit markets in Asia and worldwide have been sanguine because they have so far focused exclusively on expectations of a sharp rebound. As investors come to the realization that this initial pick-up in economic activity will be followed by weaker growth, the odds of a selloff in equities and credit markets will rise. Bottom Line: The most likely trajectory for Chinese and Asian growth will be as follows: the initial plunge in business activity will be succeeded by a rather sharp snap-back due to pent-up demand. However, that quick rebound will probably be followed by weaker growth. Financial markets are not pricing in this scenario. Thus, risks are skewed to the downside for EM risk assets and currencies. The Missing Ingredient For An Equity Selloff The missing ingredient for a selloff in EM equities is rising EM corporate bond yields. Chart I-4 illustrates that bear markets in EM stocks typically occur when EM US dollar corporate bond yields are rising. Hence, what matters for the direction of EM share prices is not risk-free rates/yields but EM corporate borrowing costs. Chart I-4The Destiny Of EM Equities Is DependEnt On EM Corporate Bond Yields EM (and US) corporate bond yields can rise under the following circumstances: (1) when US Treasury yields are ascending more than corporate credit spreads are tightening; (2) when credit spreads are widening more than Treasury yields are falling; or (3) when both government bond yields and corporate credit spreads are increasing simultaneously. Provided the backdrop of weaker growth is bullish for government bonds, presently corporate bond yields can only rise if credit spreads widen by more than the drop in Treasury yields. In short, the destiny of EM equities currently relies on corporate spreads. A major and lasting selloff in EM stocks will only occur if their respective corporate bond yields rise. From a historical perspective, EM and US corporate credit spreads are currently extremely tight (Chart I-5). A China-related growth scare could trigger a widening in EM corporate credit spreads. As this occurs, corporate bond yields will climb, causing share prices to plummet. EM corporate spreads have historically been correlated with EM exchange rates, the global/Chinese business cycle, and commodities prices (Chart I-6). The Chinese property market plays an especially pivotal role for the outlook of EM corporate spreads. Chart I-5EM And US Corporate Spread Remain Tame Chart I-6EM Corporate Spreads Inversely Correlate With EM Currencies And Commodities Prices   First, offshore bonds issued by mainland property developers account for a large share of the EM corporate bond index. Chart I-7China Property Market Will Continue Disappointing Second, swings in China’s property markets often drive the mainland’s business cycle and its demand for resources, chemicals and industrial machinery. In turn, Chinese imports of commodities affect both economic growth and exchange rates of EM ex-China. Finally, the latter two determine the direction of EM ex-China corporate spreads. China’s construction activity and property developers were struggling before the coronavirus outbreak (Chart I-7). Given their high debt burden, the ongoing plunge in new property sales and their cash flow will not only weigh on their debt sustainability but also force them to curtail construction activity. The latter will continue suppressing commodities prices. The sensitivity of EM corporate spreads to these variables have in recent years diminished because of the unrelenting search for yield by global investors. As QE policies by DM central banks have removed some $9 trillion of high-quality securities from circulation, the volume of securities available in the markets has shrunk. This has distorted historical correlations of EM corporate spreads with their fundamental drivers – namely, China’s construction activity, commodities prices, EM exchange rates and the global trade cycle. Nonetheless, EM corporate credit spreads’ sensitivity to these variables has diminished, but has not vanished outright. If EM currencies depreciate meaningfully, commodities prices plunge and China’s growth and the global trade cycle disappoint, odds are that EM corporate spreads will widen. Given that credit markets are already in overbought territory, any selloff could trigger a cascading effect, resulting in meaningful credit-spread widening. Bottom Line: A major and lasting selloff in EM stocks will only occur if their respective corporate bond yields rise. The timing is uncertain, but the odds of EM corporate credit spreads widening are mounting as Chinese growth underwhelms, commodities prices drop and EM currencies depreciate. If these trends persist, they will push EM shares prices over the cliff. As to today’s recommendation to short the EM stock index, we anticipate at least a 10% selloff in EM stocks in US-dollar terms. For currency investors, we are maintaining our shorts in a basket of EM currencies versus the dollar. This basket includes the BRL, CLP, COP, ZAR, KRW, IDR and PHP. Arthur Budaghyan Chief Emerging Markets Strategist arthurb@bcaresearch.com   Are Semiconductor Stocks Facing An Air Pocket? Global semiconductor share prices have continued to hit new highs, even though there has not been any recovery (positive growth) in global semiconductor sales or in their corporate earnings (EPS). The coronavirus outbreak and the resulting delay in 5G phone sales in China in the first half of 2020 will trigger a pullback in semiconductor equities. Global semiconductor sales bottomed on a rate-of-change basis in June, but their annual growth rate was still negative in December. In the meantime, global semi share prices have been rallying since January 2019. This divergence between stock prices and revenue of global semiconductor stocks is unprecedented (Chart II-1). Chart II-1Over-Hyped Global Semi Share Prices Odds are that global semi stocks in general, and Asian ones in particular, will experience a pullback in the coming weeks. The coronavirus outbreak will likely dampen expectations related to the speed of 5G adoption and penetration in China. Critically, China accounted for 35% of global semiconductor sales in 2019, versus 19% for the US and 10% for the whole of Europe. In brief, semiconductor demand from China is now greater than the US and European demand combined. Furthermore, the latest news that the US administration is considering changing its regulations to prevent shipments of semiconductor chips to China’s Huawei Technologies from global companies - including Taiwan's TSMC - could hurt chip stocks further. Since Huawei Technologies is the global leader in 5G networks and smartphones, the ban, if implemented, will instigate a sizable setback to 5G adoption in China and elsewhere. Table II-1Industry Forecasts Of The 2020 Global 5G- Smartphone Shipments Our updated estimate of global 5G smartphone shipments is between 160 million and 180 million units in 2020, which is below the median of industry expectations of 210 million units (Table II-1). The key reasons why the industry’s expectations are unreasonably high, in our opinion, are as follows: Chinese demand for new smartphones will likely stay weak (Chart II-2). The mainland smartphone market has become extremely saturated, with 1.3 billion units having been sold in just the past three years – nearly equaling the entire Chinese population. Chinese official data show that each Chinese household owned 2.5 phones on average in 2018, and that the average household size was about three persons (Chart II-3). This suggests that going forward nearly all potential phone demand in China is for replacement phones, and that there is no urgent need for households to buy new phones. Chart II-2Chinese Smartphone Demand: Further Decline In 2020 Chart II-3Chinese Households: No Urgent Need For A New Phone   The Chinese government’s boost to 5G infrastructure investment will likely increase annual installed 5G base stations from 130,000 units last year to about 600,000 to 800,000 this year. However, the total number of 5G base stations will still only account for about 7-9% of total base stations in China in 2020. Hence, geographical coverage will not be sufficiently wide enough to warrant a very high rate of 5G smartphone adoption and penetration. From Chinese consumers’ perspectives, a 5G phone in 2020 will be a ‘nice-to-have,’ but not a ‘must-have.’ Given increasing economic uncertainty and many concerns related to the use of 5G phones, mainland consumers may delay their purchases into 2021 when 5G phone networks will have more geographic coverage.  The number of 5G phone models on the market is expanding, but not that quickly. Consumers may take their time to wait for more models to hit the market before making a 5G phone purchase. For example, Apple will release four 5G phone models, but only in September 2020. Moreover, the price competition between 5G and 4G phones is getting increasingly intense. Smartphone producers have already started to cut prices of their 4G phones aggressively. For example, the price of Apple’s iPhone XS, released in September 2018, has already dropped by about 50% in China. Outside of China, 5G infrastructure development will be much slower. The majority of developed countries will likely give in to pressure from the US and limit their use of Huawei 5G equipment. This will delay infrastructure installation and adoption of 5G throughout the rest of the world because Huawei has the leading and cheapest 5G technology. In 2019, China accounted for about 70% of worldwide 5G smartphone shipments. We reckon that in 2020 Chinese 5G smartphone shipments will be between 120 million and 130 million units. Assuming this accounts for about 70-75% of the world shipment of 5G phones this year, we arrive at our estimate of global 5G smartphone shipments of between 160 million and 180 million units. We agree that 5G technology is revolutionary. Nevertheless, we still believe global semi share prices are presently overhyped by unreasonably optimistic 2020 projections. Overall, investors are pricing global semi stocks using the pace and trajectory of 4G smartphones adoption. However, in 2020 the number and speed of 5G phone penetration will continue lagging that of 4G ones when the latter were introduced in December 2013 (Chart II-4). We agree that 5G technology is revolutionary, and its adoption and penetration will surge in the coming years. Nevertheless, we still believe global semi share prices are presently overhyped by unreasonably optimistic 2020 projections (Chart II-5).  Chart II-4China 5G-Adoption Pace: Slower Than The Case With 4G Chart II-5Net Earnings Of Global Semi Sector: Too Optimistic?   Investment Implications Global semi stocks’ valuations are very elevated, as shown in Chart II-6 and Chart II-7. Besides, semi stocks are overbought, suggesting they could correct meaningfully if lofty growth expectations currently baked into their prices do not materialize in the first half of this year. Chart II-6Global Semi Stocks Valuations: Very Elevated Chart II-7Global Semi Stocks’ Valuations: Very Elevated   The coronavirus outbreak and the resulting delay in 5G phone sales in China in the first half of 2020, along with US pressure on global semi producers not to sell to Huawei, will likely trigger a pullback in semiconductor equities. We recommend patiently waiting for a better entry point for absolute return investors. Within the EM equity universe, we have not been underweight Asian semi stocks because of our negative outlook for the overall EM equity benchmark. The Argentine government will drag out foreign debt negotiations with the IMF and foreign private creditors to secure a more favorable settlement. We remain neutral on Taiwan and overweight Korea. The reason is that DRAM makers such as Samsung and Hynix have rallied much less than TSMC. Besides, geopolitical risks in relation to Taiwan in general and TSMC in particular are rising, warranting a more defensive stance on Taiwanese stocks relative to Korean equities. Ellen JingYuan He Associate Vice President ellenj@bcaresearch.com Argentina’s Eternal Tango With Foreign Creditors Chart III-1Downside Risks To Bond Prices Our view remains that debt negotiations will be drawn-out because the Argentine government is both unwilling and lacks the financial capacity to service public foreign debt. The administration’s recent attitude toward foreign creditors and the IMF have startled markets: sovereign Eurobond bond prices have tanked (Chart III-1). The reasons why the Fernandez administration will play tough ball with creditors and the IMF are as follows: The country’s foreign funding and the public sector debt situations are precarious. Hence, the lower the recovery rate they negotiate with creditors, the more funds will be available to expand social programs and secure domestic political support. Given Fernandez’s and Peronist’s voter base, the government is inclined to please the population at expense of foreign creditors. Moreover, Alberto Fernandez is facing increasing scrutiny from radical Peronists, who want to dissolve the debt altogether. Vice-president Fernandez de Kirchner stated that Argentina should not pay international agents until the economy escapes a recession. To further add to creditors’ frustration, the government has yet to announce a comprehensive economic plan to revive the economy and service outstanding debt. The public foreign currency debt burden is unsustainable – its level stands at $250 billion, about 4 times larger than exports. The country is still in a recession, and economic indicators do not show much improvement. Committing to fiscal austerity to service foreign debt would entail further economic suffering for Argentine businesses and households, something Fernandez rejected throughout his campaign. The authorities are singularly focused on reviving the economy: government expenditures have grown by over 50% annually under the current administration (Chart III-2). Crucially, Argentina has already achieved a large trade surplus and its current account balance is approaching zero (Chart III-3). Assuming exports stay flat, the economy can afford to maintain its current level of imports. This makes the authorities less willing to compromise and more inclined to adopt a tough stance in debt negotiations. Chart III-2Peronist Government Has Again Boosted Fiscal Spending Chart III-3Argentina: Current Account Is Almost Balanced   The risk of this negotiation strategy is that the nation will not be able to raise foreign funding for a while. Nevertheless, the country is currently de facto not receiving any external financing. Hence, this risk is less pressing. Moreover, the administration has already delayed all US$ bond payments until August. This allows them to extend negotiations with creditors over the next six months, thereby increasing uncertainty and further pushing down bond prices. A lower market price on Argentine bonds is beneficial for the government’s negotiation strategy as it implies lower expectations for foreign creditors. Thus, the Fernandez administration’s strategy will be to play hardball and draw-out negotiations as long as possible. We expect Argentina to reach a settlement with creditors no earlier than in the third quarter of this year and at recovery rates below current prices of the nation’s Eurobonds. Russian financial assets will be supported due to improving public sector governance, accelerating domestic demand growth and healthy macro fundamentals. Bottom Line: The government will drag out foreign debt negotiations with the IMF and foreign private creditors to secure a more favorable settlement. Continue to underweight Argentine financial assets over the next several months. Juan Egaña Research Associate juane@bcaresearch.com Russia: Harvesting The Benefits Of Macro Orthodoxy Russian financial markets have shown resilience in face of falling oil prices. This has been the upshot of the nation’s prudent macro policies in recent years. We have been positive on Russia and overweight Russian markets over the past two years and this stance remains intact. Going forward, Russian financial assets will be supported due to improving public sector governance, accelerating domestic demand growth and healthy macro fundamentals: Fiscal policy will be relaxed substantially – both infrastructure and social spending will rise. Specifically, the Kremlin is eager to ramp up the national projects program. This is bullish for domestic demand. Russia’s public finances are currently in a very healthy state. Public debt (14% of GDP) is minimal and foreign public debt (4% of GDP) is tiny. The overall fiscal balance is in large surplus (2.7% of GDP). The current account is also in surplus. Hence, a major boost in fiscal spending will not undermine Russia’s macro stability for some time. As a major sign of policy change, President Putin has sidelined or reduced the authority of policymakers who have been advocating tight fiscal policy. This policy change has been overdue as fiscal policy has been unreasonably tight for longer than required (Chart IV-1). Chart IV-1Russia: Government Spending Has Been Extremely Weak Importantly, the recent changes at the highest levels of government are also positive for governance and productivity. The new Prime Minister Mishustin has earned this appointment for his achievements as the head of the federal tax authority. He has restructured and reorganized the tax department in a way that has boosted its efficiency/productivity substantially and increased tax collection. By promoting him to the head of government, Putin has boosted Mishustin’s authority to reform the entire federal governance system. Given his record of accomplishment, odds are that the new prime minister will succeed in implementing some reforms and restructuring. Thereby, productivity growth that has been stagnant in Russia for a decade could revive modestly. Also, Putin was reluctant to boost infrastructure spending as he was afraid of money being misappropriated without a proper monitoring system. Putin now hopes Mishustin can introduce an efficient governance system of fiscal spending to assure infrastructure projects can be realized with reasonably minimal losses. As to monetary policy, real interest rates are still very high. The prime lending rate is 10%, the policy rate is 6% and nominal GDP growth is 3.3% (Chart IV-2). Weak growth (Chart IV-3) and low inflation will encourage the central bank to continue cutting interest rates. Chart IV-2Russia: Interest Rates Remain Excessively High Chart IV-3Russia's Growth Is Very Sluggish   Finally, the economy does not have any structural excesses and imbalances. The central bank has done a good job in cleansing the banking system and the latter is in healthy shape. Bottom Line: The ruble will be supported by improving productivity, cyclical growth acceleration and a healthy fiscal position. We continue recommending overweighting Russian stocks, local currency bonds and sovereign credit relative to their respective EM benchmarks. Last week, we also recommended a new trade: Short Turkish bank stocks / long Russian bank stocks. The main risk to the absolute performance of Russian markets is another plunge in oil prices and a broad selloff in EM. On November 14, 2019 we recommended absolute return investors to go long Russian local currency bonds and short oil. This strategy remains intact. Finally, we have been recommending the long ruble / short Colombian peso trade since May 31, 2018. This position has generated large gains and we are reiterating it. Arthur Budaghyan Chief Emerging Markets Strategist arthurb@bcaresearch.com Footnotes Equities Recommendations Currencies, Credit And Fixed-Income Recommendations