Equities

Highlights The coronavirus scare is the catalyst for the recent correction, not the cause. The true cause is that the stock market had reached a point of groupthink-triggered instability and therefore needed the slightest catalyst to correct. Bond yields will stay depressed for (at least) the first half of 2020. Long-term investors should use corrections to overweight equities versus bonds, provided bond yields stay near or below current levels. The pound and UK-exposed investments will come under near-term pressure as UK/EU trade deal tensions ratchet up. But ultimately, UK-exposed investments will enjoy a major leg up later this year if both the UK and EU blink. Feature Chart of the WeekThe Next Up-Leg In The Pound And UK-Exposed Investments Will Occur Later In 2020 Corrections, Catalysts, And Coronavirus Markets have suffered a correction, begging the question: what caused it? The question is a good one, because identifying the cause can help to inform our response. Yet the danger is that the knee-jerk narrative pinpoints the catalyst rather than the true cause. In which case our response will be wrong too. For example, consider the following two narratives: Tree foliage collapses because of 40 mph winds. Tree foliage collapses because it is autumn. The first narrative is exciting, satisfying, and headline grabbing, but it only pinpoints the catalyst for the foliage collapse: the puff of wind. The second explanation is dull and less newsworthy, but it pinpoints the true cause: in autumn, tree foliage is unstable. Likewise, the coronavirus scare is the catalyst for the recent correction. The true cause is that the stock market had reached a point of groupthink-triggered instability and therefore needed the slightest catalyst to correct. The catalyst could have come from anywhere at any time. If it hadn’t been the coronavirus scare, it would have been the next worry… or the one after that. On January 9 in Markets Are Fractally Fragile we warned that usually cautious value investors had become momentum traders – undermining market liquidity and stability. When this happens, there is a two in three chance of a tactical reversal (Chart I-2). Chart I-2When Markets Are Fractally Fragile, There Is A 2 In 3 Chance Of A Tactical Reversal We also warned that the bond yield 6-month impulse – the change in the change – had recently become a severe 100 bps headwind to growth. At this severity of headwind, there is a nine in ten chance that bond yields have reached a near-term peak (Chart I-3). Chart I-3When The Bond Yield 6-Month Impulse Becomes A Severe Headwind, There Is A 9 In 10 Chance Of A Near-Term Peak In Yields In combination, we warned that equities would underperform bonds by about 4 percent on a tactical horizon. Now that this anticipated correction has happened, what next? Long-term investors should use corrections to overweight equities versus bonds.  First, irrespective of coronavirus – or any other catalyst – the recent severe headwind to growth from the bond yield impulse suggests that bond yields will stay depressed for (at least) the first half of 2020. Second, the good news is that the ultra-low bond yields justify and underpin the valuation of equities. Hence, at the current level of bond yields, long-term investors should use corrections to overweight equities versus bonds. Brexit Is “Done”. Or Is It? Rumour has it that Boris Johnson will banish the word Brexit from the UK government lexicon after January 31, because Brexit is now “done”. Good luck with that. When Britain wakes up bleary-eyed on Saturday February 1, what will have changed? Not a lot. The UK will have lost its voice and votes in the EU decision making institutions. Yet in practical terms nothing will have changed, because the UK and EU will enter an 11-month ‘standstill’ transition period in which existing arrangements will continue: the free movement of people, financial contributions, and full access to the single market without tariffs or customs checks. The Conservative government made a manifesto pledge not to extend the 11-month transition, so the more important question is: what will change when the standstill period ends on December 31? The answer depends on what sort of trade deal the UK and EU can negotiate in the limited space of 11 months. Or indeed whether they can negotiate a trade deal at all. Therein lies the problem. A free trade deal with the EU will require a mutual commitment to a ‘level playing field’. If the UK wants to diverge on food standards, environmental protection, labour rights, and state aid – as the Brexit purists yearn – then there is zero chance that the EU will agree to a free trade deal.  This leaves two options, neither of which is appealing. The first is for the UK to end the 11-month standstill period without a trade deal. Technically, this would not be ‘no deal’ because the withdrawal agreement would still bind both sides on citizens’ rights, financial contributions, and arrangements for Northern Ireland. A free trade deal with the EU will require a mutual commitment to a ‘level playing field’.  However, for UK companies, the option of ending the standstill period without a trade deal would constitute a painful dislocation from the single market involving tariffs and customs checks. It would also hurt the EU economies most exposed to the UK, notably Ireland and the Netherlands. Moreover, a full customs and tariff border in the Irish Sea would endanger the very existence of a ‘United’ Kingdom which included Northern Ireland.   The second option is for the UK to accept a trade deal on EU terms, recognising that the EU is the larger and more economically powerful party in the negotiation. The EU will offer the UK a tariff-free and quota-free trade deal conditional on strict level playing field conditions where the UK chooses to diverge from EU standards, combined with a mechanism to adjudicate on any level playing field disputes. Though economically better than no trade deal at all, the Brexit purists would claim it isn’t Brexit. Meanwhile, even without tariffs and quotas, UK companies whose just-in-time supply chains depended on the EU would still suffer disruption, as the level playing field was policed at every border crossing. So this option would satisfy nobody in the UK. The bigger practical problem is a lack of time to leave the EU regulatory orbit smoothly. Nobody believes that eleven months is enough time to implement a system in Northern Ireland that prevent a hard border in the Irish Sea; or indeed to implement a new UK immigration system if free movement were to end at the end of 2020. So what’s the resolution? The answer is the same as it has always been for Brexit – a gradual ratcheting up of tension ahead of a hard deadline to focus minds and force progress. Followed by a ‘fudged resolution’ at the eleventh hour in which both sides blink – because neither side is prepared to go over the cliff-edge. Recall that to get the withdrawal agreement over the line, the UK blinked by allowing Northern Ireland to be treated differently; but the EU also blinked by allowing the withdrawal agreement to be reopened. And once this happened, the pound and UK-exposed investments enjoyed a major leg up (Chart I-1 and Chart I-4-Chart I-7). Chart I-4The FTSE 250 Is A UK-Exposed ##br##Investment Chart I-5The FTSE 100 Is Not A UK-Exposed Investment Chart I-6UK General Retail Is A UK-Exposed Investment Chart I-7UK Clothing And Accessories Is Not A ##br##UK-Exposed Investment In the next fudged resolution, the UK could blink by retaining full regulatory alignment with the EU in most areas for a little while longer, and where it doesn’t the EU could blink by becoming flexible in its interpretation of ‘level playing field’. Obviously, nobody would call this an extension to the transition, but the UK would, in most practical terms, still be in the single market on January 1 2021. UK-exposed investments will enjoy their next major leg up later this year In this playbook, the pound and UK-exposed investments will come under near-term pressure, as UK/EU trade deal tensions ratchet up. But ultimately, UK-exposed investments will enjoy their next major leg up later this year if both the UK and the EU blink (Chart I-8). Chart I-8The Pound Still Has A Brexit Discount Fractal Trading System* There are no new trades this week. The rolling 1-year win ratio now stands at 62 percent. Chart I-9EUR/GBP When the fractal dimension approaches the lower limit after an investment has been in an established trend it is a potential trigger for a liquidity-triggered trend reversal. Therefore, open a countertrend position. The profit target is a one-third reversal of the preceding 13-week move. Apply a symmetrical stop-loss. Close the position at the profit target or stop-loss. Otherwise close the position after 13 weeks. * For more details please see the European Investment Strategy Special Report “Fractals, Liquidity & A Trading Model,” dated   December 11, 2014, available at eis.bcaresearch.com.   Dhaval Joshi Chief European Investment Strategist dhaval@bcaresearch.com Fractal Trading System   Cyclical Recommendations Structural Recommendations Trades Closed Trades Asset Performance Currency & Bond Equity Sector Country Equity Indicators Bond Yields Chart II-1Indicators To Watch - Bond Yields Chart II-2Indicators To Watch - Bond Yields Chart II-3Indicators To Watch - Bond Yields Chart II-4Indicators To Watch - Bond Yields   Interest Rate Chart II-5Indicators To Watch - Interest Rate Expectations Chart II-6Indicators To Watch - Interest Rate Expectations Chart II-7Indicators To Watch - Interest Rate Expectations Chart II-8Indicators To Watch - Interest Rate Expectations  

Special Report

Highlights Historically, the stocks with the lowest volatility have outperformed the stocks with the highest volatility, a trend that defies some of the most fundamental theories in finance. The low-volatility factor has outperformed the market in absolute return terms, with a substantial reduction in downside risk, in every major equity market. Compensation structure, benchmarking, analyst bias, and the preference for lottery-like stocks are all plausible explanations for why the low-volatility anomaly persists. Shifting some exposure from bonds to minimum-volatility equities might be an attractive way to keep returns high while remaining hedged against downside risk in a world of low interest rates. Feature Chart 1The Low-Volatility Anomaly Conventional wisdom suggests that achieving the right mix between risk and return requires a tradeoff: Take on too little risk, and returns will be subpar, but take on too much, and a large loss becomes likely. However, the empirical evidence shows that no such tradeoff exists in the equity market: Historically, the return of stocks with the lowest volatility has been better than the return of stocks with the highest volatility (Chart 1, top panel). Even when using a measure of systematic risk such as beta, there appears to be very little relationship between risk and return – a result that emphatically contradicts what is predicted by the CAPM (Chart 1, bottom panel). The success of low risk stocks – a well-documented phenomenon known as the low-volatility anomaly1  – challenges some of the most fundamental premises of finance and economics. After all, how could taking on less risk result in better returns? In this report, we dive into this anomaly, with the intent of answering the following questions: What kind of portfolios can exploit this anomaly? What are the risk/return characteristics to this factor and what sectors is it exposed to? Why does this factor work? How can investors use the low-volatility factor in their asset allocation process? To answer these questions we explore the historical performance of the MSCI minimum-volatility index. Additionally, we explore the academic research surrounding the low-volatility anomaly. Finally, we look into how low-volatility equities have performed as a hedge for a global equity portfolio when compared to government bonds. Low Volatility Vs. Minimum Volatility There are two types of portfolios that are generally used to exploit the low-volatility anomaly: Low-volatility portfolios are built first by sorting the stock universe according to the stocks' trailing standard deviation, and then by buying the stocks with the lowest standard deviation. Usually the index buys the bottom quintile of stocks ranked by volatility. Minimum-volatility portfolios are built through an optimization procedure, by which funds are allocated to the stock mix that would have minimized the historical volatility of a portfolio (subject to certain constraints). Chart 2No Dramatic Difference Between Low Vol And Min Vol The main advantage of minimum-volatility portfolios over low-volatility portfolios is that they do not consider only low-volatility stocks but also stocks with low covariance between each other. However, the construction of these portfolios also requires estimating large covariance matrices, which are prone to a significant degree of noise, and thus often have to be adjusted by statistical methods.2 That being said, there is little performance difference between these two methodologies in practice, though minimum-volatility portfolios do tend to be much more constrained than low-volatility portfolios (Chart 2). In this report we will focus on the more popular MSCI minimum-volatility portfolios, given that their historical data is more readily available.   Risk-Return Characteristics Of Minimum Volatility At the global level, minimum volatility has outperformed not only the market since 1990, but also the most popular equity factors, with the exception of momentum (Chart 3, top panel). The outperformance relative to the benchmark has proved to be robust, as minimum volatility has beaten the returns for the benchmark in the biggest developed markets as well as emerging markets for almost two decades (Chart 3, bottom panel). The most attractive feature of minimum volatility is the significant reduction in risk it provides. Since 1988, the annualized volatility of minimum volatility has been 10%, a considerable improvement vis-à-vis the market and relative to other popular equity factors (Chart 4, top panel). Meanwhile, even though return skew of minimum volatility has been more negative than the benchmark, minimum volatility achieved a substantial reduction in tail risk with a 10% conditional VaR of only 5% (Chart 4, middle and bottom panel). Chart 3Min Vol Outperformance Is Broad-Based Chart 4Min Vol Provides A Substantial Reduction In Risk In addition to its risk reduction, minimum volatility also has a countercyclical relative return profile, outperforming during bear markets, and underperforming slightly during bull markets (Chart 5, top panel). This return profile occurs partly due to the sector skew of this factor, which overweights defensive sectors such as Utilities and Consumer Staples relative to the global benchmark3 (Chart 5, middle panel). At the global level, this defensive tilt exposes minimum volatility to significant duration risk, given that the stocks in this index tend to have bond-like properties (Chart 5, bottom panel). The negative relationship between interest rates and the low-volatility factor has been well documented by the academic literature: Some studies estimate that up to 80% of the outperformance of low-volatility equities can be explained by exposure to duration risk.4 Chart 5Global Min Vol Is Sensitive To Interest Rates Chart 6Min Vol Is Expensive     On average, minimum volatility also tends to overweight stocks with a higher dividend yield than the market (Chart 6, panel 1). This yield difference accounts for roughly a quarter of the return difference between minimum volatility and the benchmark since 1990. However, high dividend yield and minimum volatility are not synonymous: Over the past decade, minimum volatility has selected stocks that are more expensive than the benchmark, a stark difference from high dividend yield portfolios, which exclusively select very cheap stocks (Chart 6, panel 2). The current high overvaluation of minimum volatility relative to the market could spell bad news for this factor in the near future: While valuation and returns do not have a straightforward relationship, extreme levels of valuation relative to the benchmark have historically resulted in subsequent underperformance of this factor relative to the market (Chart 6, panels 3 and 4). Why Does The Low-Volatility Factor Work? Analyst Forecasts It has been shown empirically that equity analysts tend to have an optimistic bias, due to the need of the analyst to maintain good relationships with the companies they cover. Moreover, investors do not adjust for this bias, meaning that the stocks of companies that receive an overly optimistic forecast tend to rise initially when the forecast is released, but then mean-revert once the forecast does not materialize. Chart 7Analyst Bias Is Larger In High-Vol Stocks It seems that this dynamic might be more pervasive in high-volatility stocks. In their paper “When Sell-Side Analysts Meet High-Volatility Stocks: An Alternative Explanation for the Low-Volatility Puzzle,” Hsu et al. show that analysts’ positive bias is larger for more volatile stocks, even when adjusting for confounding variables like size, sector and country5 (Chart 7).  It is easy to see why this might be the case: An extremely optimistic bias on a low variance stock would look unrealistic to most investors. Thus, analysts are more prone to express a large positive bias on high variance stocks, where bias is harder to detect. Ultimately, this bias causes these stocks to become chronically overvalued. Salary Structure of Managers Chart 8Institutions Favor High Vol The payoff structure of fund managers has also been suggested as a possible cause of the low-volatility anomaly.6 The structure of compensation for fund managers often resembles an option: A bonus is granted if the portfolio returns are higher than a certain threshold. In such a structure, the compensation of portfolio managers resembles a call option: The probability of a payoff increases with volatility, creating an incentive to invest in high-volatility stocks.  However, this preference for high-volatility stocks will overbid them, causing them to underperform. There is some evidence that this is in fact the case. Once the effect of size is neutralized, stocks with high institutional ownership tend to be more volatile than stocks with low institutional ownership (Chart 8). Moreover, a study on the exposure of hedge funds to popular risk factors from 2000 to 2016, showed that hedge funds have a large short exposure to the anomaly, indicating that they favor high-volatility over low-volatility stocks.7   Lottery Stocks Chart 9The Low-Volatility Anomaly Is Most Prevalent In Lottery-Like Stocks Not all high-volatility stocks are chronic underperformers. In the paper “The Low Volatility Anomaly and the Preference for Gambling,” Hsu et al. identify that the low-volatility anomaly is largest in stocks with strong lottery-like characteristics (the authors define lottery-like as the stocks that had the highest maximum daily return the previous month)8 (Chart 9). Meanwhile, other high-volatility stocks are much more likely to have higher or equal returns than their low-volatility counterparts. Why is this the case? Investors tend to have a preference for “home-run” stocks, which have a large probability of a small loss, but a small probability of a large gain – a well-documented behavioral bias known as the long-shot bias.9 This bias might cause investors to overbid for lottery-like stocks, causing them to underperform as a cohort. This phenomenon might be related to the incentives in the money management industry. Flows to equity funds tend to be very skewed to the very best performing funds. This means that fund managers have a high incentive to invest in stocks that have the potential of an extremely high payoff. Benchmarking Chart 10Benchmarking Could Be To Blame For The Low-Vol Anomaly While the low-volatility anomaly has been found in other asset classes,10 it is interesting to note that the anomaly occurs only within asset classes and not across asset classes. Indeed, the traditional risk-return relationship is conserved when looking at a multi-asset universe (Chart 10, top panel). One possible solution to this puzzle might be the effect of benchmarking. Within an asset class, benchmarked managers are not only measured according to their return relative to their benchmark but also to their tracking risk (volatility of return difference). Under this structure, investors do not have a large incentive to exploit the alpha from low-volatility or low-beta stocks, since such a strategy would result in a relatively high tracking error.11 This high tracking error will make the excess return of low-volatility stocks relatively less attractive for benchmarked managers, even if these stocks are clearly superior in terms of raw risk-adjusted returns (Chart 10, bottom panel). How Can Minimum Volatility Be Used In Asset Allocation? Chart 11Sensitivity Of Min Vol To Interest Rates Has Increased In The Last Decade The interest rate sensitivity of low-volatility stocks has been a topic of significant interest for academic researchers. A study that attempted to measure this sensitivity found that equities in the lowest volatility decile have an interest-rate exposure equivalent to a 66% equity/34% bond portfolio.12 Moreover, this sensitivity has increased in recent years: Factor analysis shows that while the beta of the excess returns of minimum volatility to the equity market has remained constant, the beta to the bond market has increased significantly over the last decade13 (Chart 11, top panel). Interestingly this process seems to have accelerated as bond yields fell below dividend yields – a result which might arise because the market starts perceiving bonds, and low-volatility equities as close substitutes when they provide a similar cash flow (Chart 11, bottom panel). At first glance, this relatively high duration risk appears to be a red flag, particularly if you share our view that interest rates have reached a multi-year bottom. After all, an environment where interest rates rise would imply that minimum volatility would underperform global equities on a structural basis.  However, the sensitivity of minimum volatility to interest rates can be used to the advantage of an asset allocator. Specifically, in a world of low bond yields, it could be attractive for an investor to shift some of the exposure he or she has from bonds to minimum-volatility equities. Why would an investor do this? As we discussed in our October 2019 report, low bond yields will cause bonds to generate returns that are much lower than their historical averages. This means that using government bonds as a hedge for an equity portfolio is likely to result in a severe drag on performance.14 On the other hand, while minimum-volatility equities do not have the same hedging potency as bonds, their returns are much higher, which suggests that at the right allocation they could prove to be a better hedge. In a world of low bond yields, it could be attractive for an investor to shift some of the exposure he or she has from bonds to minimum-volatility equities. How has such a strategy worked historically? Chart 12 shows how allocating incremental amounts of global minimum-volatility equities to an equity portfolio compares to adding incremental amounts of global government bonds. Overall, allocating an additional 3% of minimum-volatility equities to a portfolio had the same effect as adding 1% of government bonds in terms of downside protection and volatility reduction, but with a much higher return. This effect was robust throughout the sample period. Consider a portfolio with 30% government bonds, 30% minimum volatility and 40% global equities. With the exception of the 1990-1994 period, this portfolio had roughly the same 10% conditional VaR in all sub periods as a portfolio with 40% government bonds and 60% equities, but a significantly higher return (Chart 13). Moreover, the volatility of the portfolio that includes minimum volatility has also been lower than the 60/40 portfolio since 2000. Chart 12Min Vol Provides Protection With A Relatively High Return Chart 13Min-Vol Protection Has Been Robust Bottom Line The low-volatility anomaly contradicts what is perhaps the most fundamental pillar in finance: The tradeoff between risk and return. As such, this anomaly might be the most puzzling inefficiency in markets. But will it persist? The evidence suggests that the anomaly is caused by strong institutional incentives, which are likely to continue. Thus, investors should strongly consider investing in low-volatility stocks in the future. However, the following points should be taken into account: Investors who are evaluated according to their information ratio should avoid low/minimum-volatility stocks, given that their large volatility difference with the benchmark will result in a relatively high tracking error. Relatively high valuations and an uptrend in interest rates may hurt the performance of low/minimum-volatility stocks relative to the broad equity market in the near future. However, the interest-rate exposure of low/minimum-volatility stocks might prove attractive to multi-asset investors. Specifically, investing in minimum-volatility equities and reducing bond exposure might be a way to boost returns while remaining hedged.   Juan Correa Ossa, CFA Senior Analyst juanc@bcaresearch.com   Footnotes 1  The discovery of the low-volatility anomaly predates the discovery of both the size and value anomalies. For more details, please see Michael C. Jensen, Fischer Black, and Myron S. Scholes, “The Capital Asset Pricing Model: Some Empirical Tests,” Studies in the Theory Of Capital Markets, Praeger Publishers Inc., 1972. 2 For more details on the construction of minimum-volatility portfolios, please see Tzee-man Chow, Jason C. Hsu,Li-Lan Kuo, and Feifei Li, “A Study of Low Volatility Portfolio Construction Methods,” The Journal of Portfolio Management, Vol. 40, No. 4, 2014. 3 However, research has shown that the low-volatility anomaly still holds within sectors, suggesting that its outperformance is not only a result of sector bias. For more details, please see Raul Leote de Carvalho, Majdouline Zakaria, Lu Xiao, and Pierre Moulin, “Low Risk Anomaly Everywhere - Evidence from Equity Sectors,” (November 19, 2014). 4 Please see Joost Driessen, Ivo Kuiper, Korhan Nazliben, and Robbert Beilo, “Does Interest Rate Exposure Explain the Low-Volatility Anomaly?” Journal of Banking and Finance, Vol. 103, 2019. 5 Please see Jason C. Hsu, Hideaki Kudoh and Toru Yamada, “When Sell-Side Analysts Meet High-Volatility Stocks: An Alternative Explanation for the Low-Volatility Puzzle,”  Journal Of Investment Management (JOIM), Second Quarter 2013. 6 Please see Nardin L. Baker and Robert A. Haugen, “Low Risk Stocks Outperform within All Observable Markets of the World,” (April 27, 2012). 7 Please see David Blitz, “Are Hedge Funds on the Other Side of the Low-Volatility Trade?”  The Journal of Alternatives Investments, Vol. 21, No. 1, Summer 2018. 8 Please see Jason C. Hsu and Vivek Viswanathan, “The Low Volatility Anomaly and the Preference for Gambling,” Risk-Based and Factor Investing, pages 291-303; (2015). 9 There is some debate as to whether the long-shot bias is truly irrational in financial markets, where payoffs and probabilities are not known with precision. 10 Researchers have found that the low-volatility anomaly exists in the government and corporate bond market. For more details please see, Raul Leote de Carvalho, Patrick Dugnolle, Lu Xiao, and Pierre Moulin, “Low-Risk Anomalies in Global Fixed Income: Evidence from Major Broad Markets,” The Journal of Fixed Income, vol. 23, No. 4, Spring 2014. 11 Please see Malcolm Baker, and Brendan Bradley, and Jeffrey Wurgler, “Benchmarks as Limits to Arbitrage: Understanding the Low-Volatility Anomaly,” Financial Analysts Journal, Vol. 67, No. 1, 2011. 12 Please see Joost Driessen, Ivo Kuiper, and Korhan Nazliben, and Robbert Beilo, “Does Interest Rate Exposure Explain the Low-Volatility Anomaly?” Journal of Banking and Finance, Vol. 103, 2019. 13 We calculate sensitivity for US stocks instead of global stocks due to the effects of currency returns. 14 Please see Global Asset Allocation Strategy Report “Safe Haven Review: A Guide To Portfolio Protection In The 2020s,” dated October 29 2019, available at gaa.bcaresearch.com.

Highlights Portfolio Strategy There are high odds that China’s real GDP deceleration will continue for the next decade, casting a shadow over the profit prospects of the S&P 1500 metals & mining index. A structural below benchmark allocation is warranted. Rising total mutual fund assets under management, improved trading revenue prospects, rising investor confidence along with a revival in IPO and M&A activity, all signal that it still pays to be overweight the S&P capital markets index. Recent Changes There are no changes in our portfolio this week. Table 1 Feature “When the music stops, in terms of liquidity, things will be complicated. But as long as the music is playing, you’ve got to get up and dance. We’re still dancing.” - Charles Owen "Chuck" Prince III (ex-CEO of Citigroup) The SPX remains near all time highs and the invincible tech sector continues to lead the pack. Two weeks ago we showed that the market capitalization concentration of the top five stocks in the S&P 500 surpassed the late-1990s parallel (Chart 1), and Table 2 shows that late in the cycle a handful of stocks explain a sizable part of the broad market’s return.1 However, in terms of valuation overshoot the current forward P/E of these top five stocks is roughly half the late-1990s parabolic episode (Chart 2). Chart 1Vertigo Warning Chart 2Unlike The Late-1990s While the overall market does not fully resemble the excesses of the dot.com bubble era, at least not yet, there are elements that are eerily reminiscent of the late-1990s. Table 2Contribution To Late Cycle Rallies In The SPX Chart 3Correlation Breakdown Contrary to popular belief, during manias historical correlations break down and the forward multiple becomes positively correlated with the discount rate. So in the late 1990s, the fed funds rate and the 10-year yield jumped 200bps in a short time span and the SPX forward P/E soared 40% from roughly 18x to 25x (Chart 3) before collapsing to 14x soon thereafter. Simultaneously, the US dollar was roaring as real interest rates were 4%, but the NASDAQ 100 outperformed the emerging markets, another break in historical correlations. As Chuck Prince mused in 2007, there is a narrative in the equity market today that, “as long as the music is playing, you’ve got to get up and dance”. While the overall market does not fully resemble the excesses of the dot.com bubble era, at least not yet, there are elements that are eerily reminiscent of the late-1990s. We filtered for large cap stocks that are at all-time highs and have increased in value at a minimum 10x since 2010. Among the stocks that met these criteria, five really stand out, Apple, Tesla, Lam Research, Amd & Salesforce, and comprise our “ATLAS” index; the mania in these stocks will likely end in tears (Chart 4). Even their forward P/E ratio has gone exponential, hitting a 60 handle last year similar to top five SPX stocks in the late-1990s. Chart 4ATLAS: Holding The World On His Shoulders Currently, SPX profits are barely growing and the sole reason equities are higher is the massive injection of liquidity via the drubbing in interest rates and the restart of QE. From peak-to-trough the 10-year yield fell 175bps in nine months, and the Fed commenced expanding its balance sheet by $60bn/month since last September; yet profits have barely budged. Ultimately, profits have to show up and the news on this front remains grim. The current non-inflationary trend-growth backdrop is a “goldilocks” scenario especially for tech stocks that thrive during disinflationary periods. While stocks can go higher defying weak EPS fundamentals as they have yet to reach a fully euphoric state according to our Complacency-Anxiety Indicator (Chart 5), a sell-off in the bond market will likely cause some consternation in equities in general and tech stocks in particular similar to early- and late-2018. Chart 5Not Max Complacent Yet Other catalysts that can suddenly cause “the music to stop” are either the recent coronavirus becoming an epidemic or a geopolitical event that would result in a risk off backdrop. Ultimately, profits have to show up and the news on this front remains grim. Our mid-January “Three EPS Scenarios” analysis still suggests that the SPX is 9% overvalued.2 This week we are updating our capital markets view and adding a sixth long-term theme and a related investment implication to our mid-December 2019, Special Report titled, “Top US Sector Investment Ideas For The Next Decade”.3 Sixth Big Theme For The Decade And Investment Implications China’s ascendancy on the world scene was a mega driver of equity markets in the 2000s following its inclusion in the WTO. The commodity super-cycle captured investors’ imaginations and China’s insatiable appetite for commodities caused a massive bubble in the commodity complex in general and commodity-related equities in particular. Nevertheless, the Great Recession posed a severe threat to China and the authorities injected an extraordinary amount of stimulus into the economy (15% of GDP over two years). This succeeded in doubling real GDP growth, but only temporarily. The unintended consequence was an enormous debt binge fueled by cheap money. Moreover, this debt burden along with falling labor force growth and productivity forced the government to re-think its policies as they caused a steady down drift in real output growth. The sixth big theme for the 2020s is a sustained deceleration of Chinese real GDP growth to a range of 4% to 2% (Chart 6). Not only is the debt overhang weighing on real output growth, but Chinese leaders are adamant about transitioning the economy to developed market status, which is synonymous with higher consumption expenditures at the expense of gross fixed capital formation. Chart 6From Boom… Chart 7…To Bust In other words, China remains committed to weaning its economy off of investment and reconfiguring it toward consumption (Chart 7). This is a strategic plan but it is possible that the Chinese economy can achieve this transition in due time. While this will not happen overnight, the implication is steadily lower real GDP growth as is common among large, mature, developed market economies. China will remain one of the top commodity consumers in the world, as urbanization is ongoing, but the intensity of commodity consumption will continue to decelerate (Chart 8). At the margin, this change in consumption behavior will have knock on effects on the broad basic resources sector in general and the S&P 1500 metals & mining index in particular. Were this Chinese backdrop to pan out in the coming decade as we expect, it would sustain the relative underperformance of metals & mining equities as Chart 6 & 7 depict. Chart 8Commodity Consumption Deceleration Will… Chart 9…Continue To Weigh On Metals & Mining Profits Importantly, these commodity producers will have to adjust their still bloated cost structures to lower run rates which is de facto negative both for relative sales and profit growth (Chart 9). Tack on the large negative footprint mining extraction has on the environment, and if ESG investing (our fifth big theme for the decade4) also takes off, investors should avoid the S&P 1500 metals & mining index on a secular basis. Bottom Line: There are high odds that China’s real GDP deceleration will continue for the next decade, casting a shadow over the profit prospects of the S&P 1500 metals & mining index. A structural below benchmark allocation is warranted. The ticker symbols for the stocks in this index are: BLBG S15METL – NEM, FCX, NUE, RS, RGLD, STLD, CMC, ATI, CRS, CLF, CMP, X, KALU, WOR, MTRN, HCC, AKS, SXC, HAYN, CENX, TMST, ZEUS. Capital Markets Update Capital markets stocks have come out of hibernation recently and are on the cusp of breaking out – in a bullish fashion – of their 18-month trading range. A number of the indicators we track signal that an earnings-led outperformance period is in the cards for this financials sub-group and we reiterate our overweight stance. Sloshing liquidity has pushed investors out the risk spectrum and high yield bond option adjusted spreads are flirting with multi-year lows. Such a tame junk bond market backdrop coupled with easy financial conditions are conducive to rising M&A activity (Chart 10). Importantly, the Fed’s Senior Loan Officer Survey paints an improving profit backdrop for investment banks. Not only are bankers willing extenders of credit, but demand for credit for the majority of loan categories that the Fed tracks is squarely in positive territory (top panel, Chart 11). Chart 10Subsiding Risks Are A Boon To Capital Markets Chart 11Positive Profit Catalysts This is likely a consequence of last year’s drubbing in the price of credit. M&A activity usually goes hand in hand with loan growth, underscoring that business combinations are on track to accelerate (third panel, Chart 10). This will revive a lucrative business line for capital markets firms. Total mutual fund assets are expanding at a brisk rate and hitting fresh all-time highs, signaling an uptick in risk appetite (third panel, Chart 11). Rising investor confidence will facilitate both new and secondary share issuance, an important source of fee generation for capital markets firms. Moreover, equity trading volumes have sprang back to life in recent weeks underscoring that the recent impressive Q4 earnings results will likely continue into Q1/2020 (bottom panel, Chart 10). Meanwhile, the three Fed rate cuts last year should work through the economy and at least stem further losses in the ISM manufacturing survey. The US/China trade détente will also lead to a stabilization in global growth. In fact, the V-shaped recovery in the global ZEW survey suggests that capital markets profits will likely outpace the broad market this year (second & bottom panels, Chart 11). Finally, the recent surge in the stock-to-bond ratio reflects a massive psychological shift, from last year’s recessionary fears to growing investor confidence that tail risks are abating (Chart 12). Still depressed valuations neither reflect the firming capital markets profit outlook nor the rising industry ROE (bottom panel, Chart 12). Adding it all up, accelerating total mutual fund assets under management, improved trading revenue prospects, rising investor confidence and a revival in IPO and M&A activity, all signal that it still pays to be overweight the S&P capital markets index.  Bottom Line: Stay overweight the S&P capital markets index. The ticker symbols for the stocks in this index are: BLBG S5CAPM – GS, CME, SPGI, MS, BLK, SCHW, ICE, MCO, BK, TROW, STT, MSCI, NTRS, AMP, MKTX, CBOE, NDAQ, RJF, ETFC, BEN, IVZ. Chart 12Valuation Re-Rating Looms     Anastasios Avgeriou US Equity Strategist anastasios@bcaresearch.com     1     Please see BCA US Equity Strategy Weekly Report, “Three EPS Scenarios” dated January 13, 2020, available at uses.bcaresearch.com. 2     Ibid. 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     Ibid.   Current Recommendations Current Trades Size And Style Views Stay neutral cyclicals over defensives (downgrade alert) Favor value over growth Favor large over small caps (Stop 10%)

Highlights Global growth is poised to accelerate this year, although the spread of the coronavirus could dampen spending in the very short term. History suggests that the likelihood of a recession rises when unemployment falls to very low levels. Three channels have been proposed to explain why that is: 1) Low unemployment can prompt households and businesses to overextend themselves, making the economy more fragile; 2) Faster wage growth stemming from a tight labor market can compress profit margins, leading to less capital spending and hiring; 3) Shrinking spare capacity can fuel inflation, forcing central banks to raise rates. The first channel is highly relevant for some smaller, developed economies where housing bubbles have formed and household debt has reached very high levels. However, it is not an immediate concern in the US, Japan, and most of the euro area. We would downplay the importance of the second channel, as faster wage growth is also likely to raise aggregate demand and incentivize firms to increase capital spending on labor-saving technologies. The third channel poses the greatest long-term risk, but is unlikely to be market-relevant this year. Investors should remain bullish on global equities over the next 12-to-18 months. A more prudent stance will be warranted starting in the second half of 2021. Global Equities: Sticking With Bullish Global equities are vulnerable to a short-term correction after having gained 16% since their August lows. Nevertheless, we continue to maintain a positive outlook on stocks for the next 12 months due to our expectation that global growth will gather steam over the course of the year. The latest data on global manufacturing activity has generally been supportive of our constructive thesis. The New York Fed Manufacturing PMI beat expectations, while the Philly Fed PMI jumped nearly 15 points to the highest level in eight months. The business outlook (six months ahead) component of the Philly Fed index rose to its best level since May 2018. European manufacturing should also improve this year. Growth expectations for Germany in the ZEW index surged in January, rising to the highest level since July 2015 (Chart 1). The Sentix and IFO indices have also moved higher. Encouragingly, euro area car registrations rose by 22% year-over-year in December. In the UK, business confidence in the CBI survey of manufacturers surged from -44 in Q3 of 2019 to +23 in Q4, the largest increase in the 62-year history of the survey. Fiscal stimulus and diminished risk of a disorderly Brexit should also bolster growth this year. Chart 1Some Green Shoots Emerging In The Euro Area Chart 2EM Asia Is Rebounding The manufacturing and trade data in Asia have been improving. Following last week’s better Chinese trade data, Korean exports recovered on a rate-of-change basis for a fourth month in a row. Japanese exports to China increased for the first time since last February. In Taiwan, industrial production increased by more than expected in December, as did export orders. Our EM Asia Economic Diffusion Index has risen to the highest level since October 2018 (Chart 2). Coronavirus: Nothing To Sneeze At? The outbreak of the coronavirus represents a potential short-term threat to the budding global economic recovery. Conceptually, outbreaks can affect the economy in two ways. One, they can reduce demand by curtailing spending on travel, entertainment, restaurants, or anything that requires close proximity to others. Two, they can reduce supply by causing people to avoid going to work. In practice, the first effect usually dominates the second. As a result, such outbreaks tend to have a deflationary impact. The Brookings Institution estimates that the 2003 SARS epidemic shaved about one percentage point from Chinese growth that year.1 The fact that this outbreak is happening during the Chinese New Year celebrations, when over 400 million people will be on the move, has the potential to exacerbate the transmission of the virus, and in the process, amplify the economic damage. That said, while it is from the same class of zoonotic viruses, early indications suggest that this particular strain is less lethal than SARS. In addition, the Chinese authorities have moved faster to address the risks than they did during the SARS outbreak. The government has effectively quarantined Wuhan, a city of 11 million people, where the virus appears to have originated. They have also sequenced the virus and shared the information with the global medical community. This has allowed the US Centers for Disease Control (CDC) to develop a test for the virus, which is likely to become available over the coming weeks. The Dark Side Of Low Unemployment Provided the coronavirus outbreak is contained, stronger global growth should continue to soak up lingering labor market slack. This raises the question of whether, at some point, declining unemployment could become counterproductive. The outbreak of the coronavirus represents a potential short-term threat to the budding global economic recovery. The unemployment rate in the OECD currently stands at 5.1%, below the low of 5.5% set in 2007 (Chart 3). In the US, the unemployment rate has dropped to a 50-year low. Chart 3Unemployment Rates Are Below Their Pre-Crisis Lows In Most Economies No one would deny that the decline in unemployment since the financial crisis has been a welcome development. However, it does carry one major risk: Historically, the likelihood of a recession has risen when unemployment has fallen to very low levels (Chart 4). Chart 4Recessions Become More Likely When The Labor Market Begins To Overheat Three channels have been proposed to explain this positive correlation: 1) Low unemployment can prompt households and businesses to overextend themselves, making the economy more fragile; 2) Faster wage growth stemming from a tight labor market can compress profit margins, leading to less capital spending and hiring; 3) Shrinking spare capacity can fuel inflation.  This can force central banks to raise rates, choking off growth. Let’s examine each in turn. Unemployment And Irrational Exuberance Chart 5Growing Housing Imbalances In Some Economies A strong economy promotes risk-taking. While some risk-taking is essential for capitalism, an excessive amount can lead to the buildup of imbalances, thereby setting the stage for an eventual downturn. In Australia, New Zealand, Canada, and the Scandinavian economies, the combination of low interest rates and strong economic growth has stoked debt-fueled housing bubbles (Chart 5, panel 3). As we discussed last week, higher interest rates in those economies could sow the seeds for economic distress.2 In most other countries, financial imbalances are not severe enough to trigger recessions. Chart 6 shows that the private-sector financial balance – the difference between what the private sector earns and spends – still stands at a healthy surplus of 3.4% of GDP in advanced economies. In 2007, the private-sector financial balance fell to 0.4% in advanced economies, reaching a deficit of 2% in the US. The private-sector balance also deteriorated sharply in the lead-up to the 2001 recession (Chart 7). Chart 6The Private Sector Spends Less Than It Earns In Most Economies Chart 7The Private-Sector Surplus Is Larger Than It Was Before The End Of Previous Expansions   In the US, the personal savings rate has risen to nearly 8%, much higher than one would expect based on the level of household net worth (Chart 8). Despite growing at around 2.5% in 2018/19, real personal consumption has increased at a slower pace than predicted by the level of consumer confidence. This suggests that households have maintained a fairly prudent disposition. Consistent with this, the ratio of household debt-to-disposable income has declined by 32 percentage points since 2008. Chart 8Households Are Saving More Than One Would Expect Granted, some credit categories have seen large increases (Chart 9). Student debt has risen to 9% of disposable income. Auto loans have moved back to their pre-recession highs. We would not worry too much about the former, as the vast majority of student debt is guaranteed by the government. Auto loans are more of a concern. However, it is important to keep in mind that the auto loan market is less than one-sixth as large as the mortgage market. Moreover, after loosening lending standards for vehicle loans between 2011 and 2016, banks have since tightened them. This adjustment appears to be largely complete. Lending standards did not tighten any further in the latest Senior Loan Officer Survey, while demand for auto loans rose at the fastest pace in two years. The share of auto loans falling into delinquency has been trending lower, which suggests that delinquency rates are peaking (Chart 10). Chart 9US Household Debt Levels Have Fallen, Despite Increases in Student And Auto Loans Chart 10Auto Loans: Monitoring Trends In Credit Standards And Delinquency Rates Lastly, we would point out that despite all the hoopla over the state of the auto market, auto loan asset-backed securities have performed well (Chart 11). While default rates have risen, lenders have generally set interest rates high enough to absorb incoming losses. Chart 11Securitized Auto Loans Have Performed Well Will Falling Profit Margins Derail The Expansion? Profit margins usually peak a few years before the onset of a recessions (Chart 12, top panel). This has led some to speculate that falling margins could usher in a recession by curbing companies’ willingness to hire workers and invest in new capacity. Chart 12A Peak In Profit Margins: An Ominous Sign? While it is an interesting theory, it does not stand up to closer scrutiny. Surveys of business sentiment clearly show that capital spending intentions are positively correlated with plans to raise wages (Chart 13, left panel). Far from cutting capital expenditures in response to rising wages, firms are more likely to boost capex if they are also planning to increase labor compensation.  Chart 13AFaster Wage Growth, Increased Hiring, And More Capex Go Hand In Hand (I) Chart 13BFaster Wage Growth, Increased Hiring, And More Capex Go Hand In Hand (II) One reason for this is that rising wages make automation more attractive. By definition, automation requires more capital spending. However, that is not the entire story because firms also tend to hire more workers during periods when wage growth is rising (Chart 13, right panel). This implies that a third factor – strong economic growth – is responsible for both accelerating wages and rising hiring intentions. The fact that real business sales are strongly correlated with both employment growth and nonresidential investment is evidence for this claim (Chart 12, bottom panel). Falling Margins: A Symptom Of A Problem The discussion above suggests that faster wage growth is unlikely to dissuade firms from either hiring more workers or boosting capital spending. Indeed, the opposite is probably true: Since workers normally spend more of every dollar of income than firms do, an increase in the share of national income flowing to workers will lift aggregate demand. So why do profit margins usually peak before recessions? The answer is that declining labor market slack tends to push up unit labor costs, forcing central banks to hike interest rates in an effort to stave off rising inflation. Thus, falling margins are just a symptom of an underlying problem: economic overheating. Don’t blame lower margins for recessions. Blame central banks. Inflation Is Not A Threat... Yet For now, unit labor cost inflation remains reasonably well contained in the major economies (Chart 14). However, there is little evidence to suggest that the historic relationship between labor market slack and wage growth has broken down (Chart 15). Barring a major surge in productivity growth, inflation is likely to accelerate eventually as companies try to pass on higher labor costs to their customers. Chart 14AUnit Labor Costs Are Well Behaved For Now (I) Chart 14BUnit Labor Costs Are Well Behaved For Now (II)       Chart 15Correlation Between Labor Market Slack And Wage Growth Remains Intact We do not know exactly when such a price-wage spiral will emerge. Inflation is a notoriously lagging indicator (Chart 16). Our best guess is that inflation could become a serious risk for investors in late 2021 or 2022. Thus, investors should remain overweight global equities for the next 12-to-18 months, but be prepared to turn more cautious in the second half of 2021.  Chart 16Inflation Is A Lagging Indicator   Peter Berezin Chief Global Strategist peterb@bcaresearch.com   Footnotes 1   Jong-Wha Lee and Warwick J. McKibbin, “Globalization and Disease: The Case of SARS,” Brookings Institution, dated February 2004. 2  Please see Global Investment Strategy Weekly Report, “Bond Yields: How High Is Too High?” dated January 17, 2020.   Global Investment Strategy View Matrix MacroQuant Model And Current Subjective Scores Strategic Recommendations Closed Trades

Highlights An analysis on India is available on page 12. There is extreme complacency in global financial markets. With currency markets’ implied volatility at a record low, we recommend going long EM currency volatility. The latter will rise in the next six month regardless the direction of global risk assets. For now, we remain long the EM MSCI equity index with a stop point at 1050. In India, nominal income growth has fallen below lending rates. The latter have not declined despite monetary easing. The authorities will force banks to reduce their lending rates, which will hurt bank stocks. Feature “…we have probably seen the end of the boom-bust cycle.” Bob Prince, Co-CIO of Bridgewater World Economic Forum, Davos January 22, 2020 Low Volatility = Complacency Chart I-1Go Long Currency Volatility The comment above by co-CIO of the largest hedge fund declaring the end of boom-bust cycle is consistent with lingering complacency in global financial markets. Any time an influential person made a similar declaration in the past, it marked a major turning point in financial markets. Remarkably, implied volatility for the US dollar has plummeted to a record low, as it has for EM currencies and a wide range of equity markets. Chart I-1 illustrates the implied volatility for EM currencies and the US dollar. Such low levels of implied currency market volatility historically preceded major moves in currency markets and often led to a material selloff in broad EM financial markets. It does not mean that the world economy will crash but financial markets volatility in general and currency market volatility in particular are bound to rise considerably in the months ahead. The risk-reward profile of going long EM currency or US dollar volatility appears very attractive. Today we recommend investors to go long EM currency volatility. The latter will rise regardless the direction of global risk assets. Concerning overall strategy, EM financial markets are entering a testing period. How broader EM risk assets and currencies perform in the coming weeks will signal how durable and long-lasting the current EM rally will be. Given global risk assets are overbought, a correction or consolidation phase is overdue. If EM equities, currencies and credit markets outperform, or at least do not underperform their DM peers in the course of this indigestion phase, it will beckon more upside for EM risk assets in 2020. If during budding market turbulence EM risk assets and currencies underperform their DM peers, it will signal their vulnerability in 2020.Implied volatility for the US dollar has plummeted to a record low, as it has for EM currencies. Implied volatility for the US dollar has plummeted to a record low, as it has for EM currencies. For now, we remain long the EM MSCI equity index with a stop point at 1050. We will upgrade our EM equity and credit market allocations versus DM if the EM universe generally exhibits relative resilience in the coming weeks, and more of our indicators confirm China’s growth recovery. Hints Of Recovery… December economic data out of China were strong, and it seems that the credit and fiscal stimulus are finally beginning to lift growth: Chinese imports and nominal industrial output – among the most reliable measures of the Chinese business cycle – posted very robust growth numbers in December (Chart I-2). DRAM and NAND semiconductor prices are climbing, and China’s container freight index is also in revival mode (Chart I-3). These high-frequency (daily and weekly) data confirm improving business activity in both the global semiconductor sector and in overall world trade. Chart I-2China's December Economic Data Were Strong Chart I-3Asia's Trade Is Recovering   There are tentative signs of amelioration in our proxies for marginal propensity to spend by households and enterprises in China (Chart I-4). A more decisive improvement in these indicators is needed to reinforce the positive outlook for China’s growth. …But Doubts Still Linger Despite the recent improvement in Chinese economic data and the rebound in China-related plays, there are a number of financial market indicators that are not yet confirming a sustainable business cycle recovery in China and global trade. In particular: First, apart from semiconductor stocks, global cyclical equity sectors and sub-sectors – industrials, materials, and freight and logistics – have begun, once again, underperforming defensive sectors (Chart I-5). Outperformance by these cyclical sectors against defensives is essential in confirming that global and Chinese capital spending – which were the primary sources of the most recent slowdown – are picking up again. Chart I-4China: Tentative Improvement In Household And Corporate Marginal Propensity To Spend Chart I-5Global Equities: Cyclicals Are Again Underperforming Defensives   Notably, the relative performance of EM share prices to the global equity benchmark historically tracks the relative performance of global materials versus the global overall stock index.1 However, the two have recently diverged (Chart I-6). In short, global materials are not corroborating sustainability in the recent EM outperformance. If EM equities, currencies and credit markets outperform, or at least do not underperform their DM peers in the course of this indigestion phase, it will beckon more upside for EM risk assets in 2020. Second, the rebound in Chinese and EM shares prices is not corroborated by Chinese onshore government bond yields, which are dipping to new cyclical lows (Chart I-7). In other words, interest rate expectations in China are falling – i.e., they are not confirming a robust recovery. Chart I-6Unsustainable Decoupling Chart I-7A Message From The Chinese Fixed-Income Market   Third, EM ex-China currencies have not yet broken out versus the US dollar (Chart I-8). Consistently, the broad trade-weighted US dollar has not yet broken down. Chart I-9 illustrates that the greenback’s advance-decline line has not yet fallen below its 200-day moving average, a condition that has historically been required to confirm the dollar’s cyclical bear market. Chart I-8EM Currencies: No Breakout Yet Chart I-9The US Dollar Is At A Critical Juncture   We view these exchange rate patterns as a litmus test to validate turning points in the global business cycle. Finally, the technical profiles of the KOSPI, EM small cap stocks and copper prices are inconclusive (Chart I-10). These markets have rebounded but seem to be confronting a critical technical test. If they decisively break above these technical levels, it will be a sign that the EM bull market will be lasting and durable. Otherwise, caution is still warranted. Bottom Line: There is a good amount of complacency among global investors at a time when there are several market signals that are still challenging the view of enduring revival in China/EM growth. Corporate Profits Will Be The Arbiter Ultimately, economic growth and corporate profits will determine the direction of not only share prices but also EM sovereign and corporate credit spreads as well as their currencies. So far, the EM equity rebound of the past 12 months has been solely due to multiples expansion amid a deepening EM profit recession: Earnings per share in US dollar terms has been contracting by 10% from a year ago, and the rate of change has so far not turned around (Chart I-11). Chart I-10The KOSPI And Copper Are Facing A Resilience Test Chart I-11EM Equities: A Profitless Rally?   Going forward, however, EM corporate profits growth is set to improve. Our indicator for semiconductor companies’ revenues is heralding a revival in semi sector profits (Chart I-12, top panel). The rate-of-change improvement in commodities prices is also foreshadowing potential amelioration in corporate earnings growth among energy producers and materials (Chart I-12, middle and bottom panels). Chart I-12EPS Growth In EM Technology, Energy And Materials We are negative on EM bank profits due to their need to recognize and provision for non-performing loans as well as the authorities’ mounting pressures on them to reduce lending rates. The latter will shrink banks’ elevated net interest rate margins. The profit profile of other EM equity sectors is illustrated in Chart I-13A and I-13B. Chart I-13AEM EPS Growth By Sectors Chart I-13BEM EPS Growth By Sectors   Provided technology, materials and energy stocks account for 33% of the MSCI EM aggregate equity index’s earnings (banks account for another 28% of total profits), it is safe to assume that the growth rate of EM EPS will move from -10% currently to zero or mildly positive territory by mid-2020. Nevertheless, beyond the next several months, our leading indicators on the EM profit outlook are not positive. China’s narrow money growth leads EM EPS by 12 months, and currently suggests the EPS recovery will be both muted and short-lived (Chart I-14). The technical profiles of the KOSPI, EM small cap stocks and copper prices are inconclusive. Further, China’s broad money impulse points to a peak in the credit impulse in the first half of the year (Chart I-15). Given that EM share prices bottomed a year ago, simultaneously with China’s credit impulse, odds are that EM equities could slump with a rollover in the latter. Chart I-14EM EPS: Marginal Improvement Ahead But No Robust Recovery Chart I-15China: A Signpost Of A Potential Top In The Credit Impulse   Chart I-16DM Central Banks' Assets And EM Stocks And Currencies: No Stable Correlation What if the current liquidity-driven rally continues? In our report last week titled A Primer On Liquidity, we elaborated at great length about the different liquidity measures and how they influence financial asset prices. Empirically, changes in DM central banks’ balance sheets have had no stable correlation with either EM share prices or EM local currency bonds, as demonstrated in Chart I-16. There have been periods over the past 10 years when EM risk assets and currencies have performed poorly, despite an accelerating pace of QE programs worldwide (Chart I-16). The true and critical driver for EM equity and currency performance has been EM’s own domestic fundamentals and China’s business cycle (please refer to Chart I-11 on page 7). To be sure, we are not suggesting that DM central bank policies have not affected global and EM financial markets at all. They have done so in spades. By purchasing and withdrawing about $9 trillion in high-quality securities from the marketplace, the monetary authorities have shrunk the stock of available financial assets. Consequently, even though QE programs have expanded broad money supply only modestly,2 the upshot has been that more money has been chasing fewer financial assets. Also, low interest rates reduce the opportunity cost of owning risk assets. These two phenomena have led investors to bid up prices of various securities, including EM ones. Nevertheless, despite the ongoing and indiscriminate global search for yield, EM share prices in US dollar terms and EM ex-China currencies (including carry, i.e. on a total-return basis) are still below their 2010 levels. Such poor performance of EM risk assets has been a corollary of just how bad EM fundamentals have been. Bottom Line: EM corporate profits will improve on a rate-of-change basis in the coming months. However, forward-looking indicators do not yet point to a robust recovery in EM corporate profits as occurred in 2017. Investment Conclusions We are maintaining our long EM equities position with a stop point at 1050 for the MSCI EM stock index (7% below the current level). If EM share prices, credit markets and currencies outperform their DM peers during a correction/consolidation phase, we will upgrade EM allocations to overweight in global equity and credit portfolios. At the moment, EM is confronting a resilience test. Within the EM equity universe, our overweights are Russia, Korea, Thailand, Mexico, UAE, Pakistan and central Europe. Our recommended equity underweights include Indonesia, the Philippines, Hong Kong domestic stocks, South Africa, Turkey and Colombia. In sovereign credit and local bond markets, our overweights are Mexico, Russia, Thailand, Malaysia, Pakistan and Ukraine. In turn, South Africa, Turkey, Philippines and Indonesia warrant an underweight stance. Today we are upgrading Indian bonds from neutral to overweight (see page 17).  In the currency space, we continue holding a short position versus the US dollar in the following basket of currencies: BRL, ZAR, CLP, COP, IDR, PHP and KRW. As always, the full list of our positions is presented at the end of report (please refer to pages 18-19 and on our website).   Arthur Budaghyan Chief Emerging Markets Strategist arthurb@bcaresearch.com India: Beware Of Private Banks And Consumer Perils Indian private banks and consumer staple stocks have been holding up the Indian equity market at a time when the rest of the bourse has been sluggish. Both sectors, however, are extremely expensive and thus tremendously sensitive to minor profit disappointments. Remarkably, private banks now trade at a price-to-earnings (P/E) ratio of 31 and price-to-book value (PBV) ratio of 4. Indian consumer staple stocks, on the other hand, trade at a P/E ratio of 41 (Chart II-1 and Chart II-2). Chart II-1Indian Private Bank Stocks Are Expensive Chart II-2Indian Consumer Staple Stocks Are Very Pricey   Chart II-3A Credit Boom Among Indian Private Banks Given that private banks have been specializing in both mortgages and non-mortgage consumer lending, the call on both private bank and consumer staple stocks is contingent on consumer financial health. The loan book of private banks has expanded tremendously: since 2010 it has grown at a compounded annual growth rate (CAGR) of 20% and 14% in nominal and real (inflation-adjusted) terms, respectively (Chart II-3).3 In turn, the share of household loans is reasonably large at around 52% of private banks total loan book.  Unfortunately, India’s consumer sector appears to be fragile at the moment. Employment and wage growth have downshifted – the Manpower employment index is at a 14-year low (Chart II-4). Consequently, household disposable income growth has decelerated to 9% in nominal terms (Chart II-5). Critically, households’ ability to service debt has deteriorated as nominal disposable household income growth has fallen slightly below borrowing costs, i.e., bank lending rates (Chart II-5). This development is precarious not only because it makes it more difficult for consumers to service their debt – causing NPLs to rise – but it also dampens consumer credit demand. Consequently, private banks’ considerable exposure to consumers could reverse the fortunes of the former as consumers face increasing difficulties servicing their debt. Moreover, with borrowing costs above nominal income growth, banks in India could face adverse selection problem. The latter is a phenomenon when loan demand primarily comes from riskier borrowers who are in desperate need for funding. In such a case, non-performing loans are bound to mushroom. Chart II-4India's Labor Market Is In Doldrums Chart II-5India: Household Nominal Income And Lending Rate Overall, household spending is in the doldrums. Two- and three-wheeler and passenger car unit sales have all been contracting. In the meantime, consumer demand for non-durable goods has also weakened, as reflected by stalling non-durable consumer goods production. Residential property demand has plummeted. According to the Reserve Bank of India’s December Financial Stability Report – quoting data from PropTiger DataLabs – housing sales units contracted by 20% in September from a year ago. In turn, growth in house prices has been anemic (Chart II-6). Prices are now growing below core inflation, i.e. property prices are deflating in real terms. Households’ ability to service debt has deteriorated as nominal disposable household income growth has fallen slightly below borrowing costs. Going forward, odds are that employment and wage growth will remain weak in India. The basis is the corporate sector is also struggling and still reluctant to invest and hire. Chart II-7 illustrates that the number of investment projects has collapsed, while capital goods production and capital goods imports are both shrinking (Chart II-7). Chart II-6India: Housing Market Is Feeble Chart II-7India: Companies Are Not Investing   Overall, the entire Indian economy is suffering from high borrowing costs in real (adjusted for inflation) terms (Chart II-8, top panel). Chart II-8Lending Rates Have Not Declined Despite Monetary Easing Importantly, the monetary policy transmission mechanism has not been working effectively in India. Even though the central bank has cut its policy rate by 135 basis points in 2019, prime borrowing did not budge (Chart II-8, middle panel). Consequently, loan growth has decelerated sharply (Chart II-8, bottom panel). On the whole, for the economy to recover, it requires considerably lower borrowing costs or a substantial fiscal boost. Indian central and state fiscal aggregate budget deficit is already wide at 6% of GDP. With public debt-to-GDP ratio at 68%, there is some but not enormous room for boosting government expenditures drastically. This makes reducing commercial bank lending rates the most feasible mechanism to jump-start the economy. Consequently, the authorities will become more aggressive in forcing commercial banks to cut their lending rates. This seems to be taking place as in September 2019 the RBI asked Indian commercial banks to link lending rates on certain types of loans more closely to the central bank’s policy rate to ensure more effective monetary policy transmission. Yet doing so will squeeze down commercial banks’ net interest rate margins – which have widened – and will hit banks’ profits. Alternatively, if lending rates do not fall, non-performing loans (NPLs) will increase because only risky borrowers will be willing to borrow while existing debtors will struggle to service their debt at current elevated interest rates. This will also depress bank profits. These two negative scenarios are probably reflected in low valuations of public bank share prices, but they are not yet priced in among private banks stocks. Given the latter’s exuberant valuations, only a small drop in net interest rate margins or a small rise in NPLs, will be enough to drag their share prices lower. Investment Conclusions Chart II-9India Vs. EM Relative Equity Performance Is Often About Oil Travails of the Indian economy will persist for now. Much more policy support is required to turn the business cycle around. EM equity investors should keep a neutral allocation to Indian stocks within an EM equity portfolio. Indian share prices often outperform their EM peers when oil prices drop and lag when crude prices rally (Chart II-9). Given our negative view on oil prices,4 we are reluctant to downgrade this bourse to underweight. Private banks are susceptible to a drawdown as either their net interest rate margins will drop or they will face rising non-performing loans. Consumer staples stocks are expensive and, hence, are vulnerable to marginal profit disappointments. We are upgrading our allocation to Indian domestic bonds from neutral to overweight within an EM local bond portfolio. Consistently, we are closing our yield curve steepening trade in India. This position has produced a 30 basis points gain since July 2016. Low inflation, weak real growth, a struggling credit system and ineffective transmission of monetary easing argue for even lower interest rates in India. The surge in food prices should be viewed as a relative price shock, not inflation. Higher food prices will curb the spending power of consumers and weaken their expenditures on non-food items. In addition, core inflation remains very low. Ayman Kawtharani Editor/Strategist ayman@bcaresearch.com Footnotes 1  Please click on the link to access EM: Perception versus Reality report. 2  Commercial banks’ reserves at central banks do not constitute and are not a part of narrow or broad money supply. 3  The calculation is based on the annual reports of four large Indian private banks: HDFC Bank, ICICI Bank, Kotak Mahindra Bank, and Axis Bank. 4   This is the Emerging Markets Strategy team’s view and it differs for BCA’s house view on oil. Equities Recommendations Currencies, Credit And Fixed-Income Recommendations

Highlights The bank credit 6-month impulse is likely to drop sharply in Europe, drop modestly in the US, but remain positive in China. Hence, the momentum of first-half economic data is likely to be worse in Europe than in China – albeit the Wuhan coronavirus scare is an unknown risk to this view. Initiate long CNY/GBP on a 6-month horizon. Underweight banks and the cyclical-heavy Eurostoxx 50 versus other markets, again on a 6-month horizon. There will be a better time to enter these positions later in the year when 6-month impulses are improving. Long-term investors seeking value in Europe should focus on the main currencies and not on the main equity indexes. Fractal trade: long EUR/GBP. Europe And China Play A Role-Reversal In recent dispatches we have highlighted that the euro area bond yield 6-month impulse stands near +100 bps, posing the strongest headwind to growth for three years. To make matters worse, the impulse has flipped from a strong -100 bps tailwind last summer into the current strong headwind, equating to a marked deterioration in the weather. But in China, it is the opposite story. Last summer, the China bond yield 6-month impulse constituted a strong +80 bps headwind; today the headwind has disappeared. Indeed, it has morphed into a tailwind, albeit a very mild tailwind at just -10 bps. In this sense, Europe and China are now playing a role-reversal. The momentum of first-half economic data is likely to be worse in Europe than in China – albeit with the caveat that the Wuhan coronavirus scare is an unknown risk to this view (Chart of the Week). Chart of the WeekBond Yields In Europe And China Play A Role-Reversal For the sake of completeness, we should address the world’s other large economy, the United States. Just as in the euro area, the US bond yield 6-month impulse has flipped from a strong -100 bps tailwind last summer into a current headwind. But the headwind, at +50 bps, is not as strong as it is in the euro area (Chart I-2). Chart I-2Headwind Impulses In The Euro Area And The US, But Not In China The Four Impulse Framework For Short-Term Growth The bond yield 6-month impulse is the first component of our proprietary ‘four impulse framework’ for short-term growth. The bond yield 6-month impulse is important because it usually leads the framework’s second component, the bank credit 6-month impulse, by a few months. This relationship makes perfect sense as, at the margin, it is the price of credit that drives credit demand. Indeed, to the extent that monetary policy drives growth, this is the main mechanism by which it operates, albeit with a slight delay. The bond yield impulse usually leads the credit impulse. On this compelling theoretical and empirical evidence, the bank credit impulse is now likely to drop sharply in the euro area (Chart I-3), drop modestly in the US (Chart I-4), but remain positive in China (Chart I-5). Chart I-3The Credit 6-Month Impulse Is Likely To Drop Sharply In The Euro Area... Chart I-4...Drop Modestly In ##br##The US...   Chart I-5...But Remain Positive In China But we must also consider the other two impulses in our four impulse framework. In the case of the euro area, the third important impulse is the oil price 6-month impulse. This is because the euro area relies on oil imports whose volumes tend to be price inelastic. Hence, when the oil price falls it subtracts from imports, thereby adding to net exports and growth – and vice-versa when the oil price rises. In the middle of 2019, the oil price impulse constituted a very strong headwind which helps to explain the midyear sharp slowdown in Germany. Subsequently, the headwind eased, even reversing into a modest tailwind which facilitated a recovery. But the tailwind is now fading (Chart I-6).  Chart I-6A Fading Tailwind From The Oil Price 6-Month Impulse The fourth and final component of our four impulse framework is geopolitical risk. This is not an impulse in the strict mathematical sense, but it is the same broad idea applied to the flow of geopolitical tail-events, both negative and positive. Europe’s positive events came several months ago: first in early-August when Italy ousted the firebrand Matteo Salvini from government; then in early-October when the UK parliament legislated against a no-deal Halloween Brexit. The tailwind from these positive events has now likely faded. For China, a positive geopolitical event and potential mild tailwind has come more recently, with the signing of the phase one trade deal with the US. Against this, the Wuhan coronavirus scare is a new risk – though based on the latest information it is unlikely to impact a 6-month view. The tailwind from the oil price impulse is now fading. On the four impulse framework, the momentum of first-half economic data is likely to favour China over Europe. We have found that the best way of playing this is through the exchange rate (Chart I-7), though given recent moves our preferred expression is versus the pound rather than the euro. Hence, on a 6-month horizon, initiate long CNY/GBP. Chart I-7Play Relative Impulses Through Currencies More generally, can the mild tailwind in China counter the headwinds in the West? No. Despite the improvement in China, the aggregate global bond yield impulse still constitutes a +50 bps headwind, which is almost certain to weigh down the global credit impulse through the early months of 2020 (Chart I-8). Chart I-8The Global Credit 6-Month Impulse Will Weaken In Early 2020 Therefore, as discussed last week in Strong Headwind Warrants Caution In H1, we recommend an underweight stance to banks and to the cyclical-heavy Eurostoxx 50 versus other markets, again on a 6-month horizon. This is not to say that these positions cannot do better on a 12-month view, as per the BCA house view. But if so, any outperformance will be back-end loaded, and there will be a better time to enter these positions later in the year when 6-month impulses are improving. Where Is The Value In Europe? One of the most common questions we get is: are European equities cheaper than US equities? Usually, this question comes from our US clients who are aware that their own stock market is expensive and wish that Europe might be less so. Unfortunately, the wishful thinking won’t make it come true! Major stock market indexes comprise multinational companies with global footprints. For these multinationals, there is no such thing as a ‘European’ company or a ‘US’ company. They are simply global companies that could list their shares on any major stock market. Now ask yourself this: is it really plausible that such a multinational would be cheaper if its primary listing was in Frankfurt as opposed to New York? Of course not. The valuation depends on the industry and company specifics, but it is highly unlikely to depend on whether the company is listed in Frankfurt or New York. It is not European equities that are cheap, it is European currencies that are cheap. But then why do companies with dual listings in Europe and outside Europe trade at a valuation discount in their European listing? For example, Carnival Cruises trades around 8 percent dearer in New York than in London (Chart I-9); and BHP Billiton trades around 15 percent dearer in Sydney than in London (Chart I-10). The answer is that the London listing is quoted in pounds, the New York listing is quoted in US dollars, the Sydney listing is quoted in Australian dollars, but Carnival’s and BHP’s sales and profits are denominated in a mix of international currencies. Chart I-9Carnival Cruises Trades Dearer In New York Than In London Chart I-10BHP Trades Dearer In Sydney ##br##Than In London Hence, Carnival and BHP are trading dearer in New York and Sydney because the market is expecting their mixed currency earnings to appreciate more in US dollar and Australian dollar terms respectively than in pound terms. Put another way, the market is expecting the pound to appreciate structurally versus the major non-European currencies. Therein lies the important message. It is not European equities that are cheap, it is European currencies that are cheap. For those of you still in doubt, just visit the ECB website. The central bank’s own currency valuation indicator admits that the trade-weighted euro is 10 percent undervalued (Chart I-11). Chart I-11The ECB Admits That The Euro Is 10 Percent Undervalued Hence, investors seeking value in Europe should not focus on the main equity indexes. Instead, they should focus on the main currencies. That said, valuation based investing only works if you have a long enough time horizon, meaning at least two years. For shorter horizons, economic momentum and technical factors dominate. In this regard, the pound’s strong rally faces resistance once post-Brexit trade deal negotiations begin in earnest after January 31. As a tactical trade, go long EUR/GBP (see next section). Fractal Trading System* The Brexit deal unleashed a strong rally in the pound, but this is vulnerable to a countertrend setback once the trade deal negotiations begin in earnest. Accordingly, this week's recommendation is long EUR/GBP. Set a profit target at 2 percent with a symmetrical stop-loss. In other trades, long tin achieved its 5 percent profit target at which it was closed. The rolling 1-year win ratio stands at 62 percent. Chart I-12EUR/GBP When the fractal dimension approaches the lower limit after an investment has been in an established trend it is a potential trigger for a liquidity-triggered trend reversal. Therefore, open a countertrend position. The profit target is a one-third reversal of the preceding 13-week move. Apply a symmetrical stop-loss. Close the position at the profit target or stop-loss. Otherwise close the position after 13 weeks. * For more details please see the European Investment Strategy Special Report “Fractals, Liquidity & A Trading Model,” dated   December 11, 2014, available at eis.bcaresearch.com.   Dhaval Joshi Chief European Investment Strategist dhaval@bcaresearch.com Fractal Trading System   Cyclical Recommendations Structural Recommendations Trades Closed Trades Asset Performance Currency & Bond Equity Sector Country Equity Indicators Bond Yields Chart II-1Indicators To Watch - Bond Yields Chart II-2Indicators To Watch - Bond Yields Chart II-3Indicators To Watch - Bond Yields Chart II-4Indicators To Watch - Bond Yields   Interest Rate Chart II-5Indicators To Watch - Interest Rate Expectations Chart II-6Indicators To Watch - Interest Rate Expectations Chart II-7Indicators To Watch - Interest Rate Expectations Chart II-8Indicators To Watch - Interest Rate Expectations  

Highlights The recently signed Phase One deal is positive for China and global equity markets as it brings a temporary truce to the trade war. However, China is unlikely to change its current policy trajectory to create additional domestic demand to consume $200 billion in new imports from the US. China is likely to meet the commitment only half way in the next two years, and meet the 2020 import target from the US by a redistribution of its purchases overseas. The RMB will modestly appreciate in the next three to six months. On the monetary policy front, there is no sign of further monetary easing from the PBoC. We continue to recommend an overweight stance towards Chinese stocks in the next six months, relative to the global benchmark. Feature Economic data released last week, including Q4 GDP growth, December industrial production, fixed-asset investment and trade data, all suggest that the Chinese economy bottomed before the end of 2019. The Phase One trade deal between China and the US marks a significant de-escalation in a two-year trade war. The RMB appreciated by 1.4% against the greenback since the beginning of the year, pushing USD-CNY firmly below the key psychological 7 mark. The performance of equities in China’s onshore and offshore markets confirms that the economy has bottomed. Since December 11, 2019, Chinese cyclical sectors have outperformed defensives and both the investable and domestic markets have broken above their respective 200-day moving averages versus global stocks (Chart 1A and 1B). Chart 1ABoth Onshore And Offshore Equities Signal A Bottoming In China's Economy Chart 1BCyclicals Have Significantly Outperformed Defensives Lately We continue to recommend a cyclical long stance on Chinese stocks. We expect pro-growth policy support to accelerate in the first quarter, economic recovery to further solidify, and the Phase One trade deal to reduce economic and financial market volatility until the November 2020 US presidential election. All of these factors should support an outperformance in Chinese stocks relative to their global peers. Some Inconvenient Truth To The Truce China’s commitment to purchase an additional $200 billion in goods from the US was more than market participants anticipated. We do not think China will honor this commitment to its full extent. Moreover, we also do not think this will change China’s domestic economic policy trajectory for 2020. Details in Chapter 6 of the Phase One trade agreement titled “Expanding Trade”1 include: In the next 2 years, China is committed to purchase an additional $200 billion worth of goods and services from the US, from the 2017 baseline. The additional $200 billion amount is split over the next two years: China will need to add no less than $77 billion of imports from the US in 2020, and $123 billion in 2021. This amounts to a 41% increase in 2020 and a 66% increase in 2021, from the 2017 baseline of $186 billion (Chart 2). The text from Chapter 6 of the Phase One deal also specifies that, between January 2020 and December 2021, China will add a total of $77.7 billion in purchases of manufactured goods (including aircraft components), $32 billion in agricultural products, $52.4 billion in energy and $37.9 billion in services from the US (Chart 3). Chart 2Phase One Trade Deal Sets An Ambitious Import Target For The Next Two Years Chart 3Chinese Imports Of Agro And Energy Goods From The US Likely To See The Biggest Increase In 2020 From 2019   China’s annual import growth from the US in 2017 was the highest one in the past ten years.  If we assume that China will simply add $200 billion of new imports in the next two years from the US to this high starting point, it will need to boost domestic demand to accommodate at least a 4-6% increase in total imports in the next two years from 2019.2 In contrast, growth in China’s total imports in 2019 contracted by 3% from 2018, and averaged at only 2% in the last five years. In other words, in 2020 and 2021, even if China does not increase imports from other countries, just the commitment from purchases of US goods alone would require a sizable boost in China’s domestic demand. However, the assumption above is overly simplified and optimistic. Even though Chinese leadership may have shifted their policy priority from financial deleveraging to supporting economic growth this year, we do not think they will fully abandon the battle against systemic risks in the financial sector. Therefore, China is unlikely to significantly deviate from its current policy trajectory and stimulate aggressively to create additional domestic demand to consume the agreed $200 billion in new imports from the US. It is equally unlikely that China will absorb the $200 billion additional imports from the US, at the expense of its domestic production. A more plausible approach, which is our base case scenario, is that China will meet a large portion of the 2020 import target before November, to show good faith. After the US presidential election, China will face the challenge of either a re-escalation from the Phase Two trade talk with a re-elected President Trump, or a new US president with his/her own political agenda. In either case, at this point China is unlikely to have the intention to meet the import target for 2021. Chart 4China Likely To Shift Agro And Energy Import Suppliers To The US In 2020, to absorb a $77 billion additional imports from the US, China will likely shift some of its imports, such as agriculture and energy products, from other countries to suppliers in the US. China currently imports $150 billion of agriculture goods and $298 billion of energy related products on an annual basis, so the pie is large enough to absorb some of increased import commitments by shifting the sources of imports (Chart 4). The same logic goes for the manufactured goods category in the trade agreement, which includes cars, airplanes, steel, industrial machinery, and so on.3 China is likely to choose to shift its import suppliers of these goods to the US, while increasing its own share of intermediate goods supplies to the US manufacturers. Almost all of the eight subcategories under the manufactured goods category in the Phase One trade agreement are deeply integrated in the global supply chain. For example, foreign value-added share accounts for 23% of the total output value of the US automobile industry.4 In other words, if a “Made in America” car is worth $20,000, $4,600 is produced by foreign suppliers of intermediate goods. Since China has been the leading source of this foreign value-added in the US automobile industry, a sizeable slice of these additional imports will likely benefit Chinese manufacturers. In this scenario, we expect an increase in bilateral trade between China and the US in 2020, at the expense of other players in the global supply chain. Lastly, while this is not our base case scenario, it is possible the Phase One trade agreement was set up for failure, if China is simply hoping to delay the imposition of additional tariffs as part of a gamble that President Trump will not be re-elected. In this scenario, China might not make any meaningful additional purchases from the US even in 2020 (while claiming that they will be made closer to the election), implying that bilateral trade between China and the US will only revert to its historical average this year, at best. Bottom Line: Chinese policymakers are unlikely willing to alter their existing policy trajectory when accommodating more imports of US goods. China will, at best, reshuffle its supply chain to absorb a portion of the commitment before November 2020. The RMB And Monetary Policy: A Refocus On The Economic Fundamentals As tensions from the US-China trade war abate, investors are starting to refocus on economic fundamentals. The RMB has appreciated by 1.4% against the USD since the beginning of this year (Chart 5). The recent appreciation in the currency is a reversal to its fair value, which reflects an ongoing economic recovery (Chart 6). In the next three to six months, the improvement in China’s economic fundamentals and market sentiment should support a continuation in the RMB’s reversal to its structural trend. Chart 5USD/CNY Has Durably Fallen Below 7 Chart 6The Recent Appreciation In RMB Is A Reversal To Its Fair Value   But Chinese leadership’s cautious approach to boosting domestic demand will also cap the upside potential in the RMB appreciation. We think Chinese policymakers will maintain their tight grip this year on local government spending and bank lending, and will continue to fine-tune policies based on economic conditions. This will limit the magnitude in both the stimulus and economic recovery. Baring a major re-escalation in the trade war, the RMB should oscillate within a relatively narrow band through the third quarter of this year. For that reason, the PBoC is unlikely to intervene in the RMB exchange rate by significantly altering its monetary stance (Chart 7). The 3-month interbank lending rate, China’s de facto policy rate, remains low compared with the 2015-16 easing cycle. There is no sign that the PBoC will allow the rate to fall much more. The recent bank reserve requirement ratio (RRR) rate cut provides additional liquidity to the interbank system, but on a net basis liquidity does not seem excessive (Chart 8). Chart 7PBoC Unlikely To Alter Monetary Policy To Intervene RMB Exchange Rate This Year Chart 8No Sign Of Meaningful Monetary Easing From PBoC   Historically, the 3-month interbank lending rate only falls significantly and durably when the PBoC places consecutive RRR rate cuts (in both 2015 and mid-2018) and/or keeps net fund injections positive through the open market for a prolonged period (such as in the 2015/16 easing cycle). Chart 8 suggests the current monetary environment does not indicate that such an extremely easy stance is in place, as PBoC net fund injections through the open market remain negative. Furthermore, neither the 3-month interbank lending rate nor the 10-year government bond yield has fallen below its most recent lows in the third quarter of last year. Bottom Line: While the current environment supports a stronger RMB, the upside potential in RMB appreciation is capped by a modest scale of economic recovery. There is no sign that the PBoC is easing its monetary stance by lowering the policy rate. Investment Conclusions We have been cyclically overweight Chinese stocks on the basis of a bottoming in the economy in the first quarter of 2020, and the likelihood of an eventual trade deal. These two factors were confirmed in the past two weeks. Last week’s small selloffs in both onshore and offshore Chinese equity markets were likely technical corrections and pre-Chinese New Year profit taking, rather than a fundamental shift in investors’ sentiment towards Chinese stocks (Chart 9). We expect Chinese stocks to resume an upward trajectory after the Chinese New Year. Chart 9Small Corrections Following A 14% Gain Since Dec 2019 Chart 10Offshore Stocks Still Showing More Upside Potential Than Onshore China’s economic conditions and corporate earnings should continue to improve, with investable stocks showing more upside potential than their domestic counterparts (Chart 10). As growth supporting measures continue to work their way through the economy and solidify an economic recovery, China’s leadership may pull back the scale of the stimulus in the second half of the year. Therefore, the relative outperformance in both markets may be front loaded and subsequently subside in the second half of 2020. Jing Sima China Strategist jings@bcaresearch.com   Footnotes 1    https://assets.bwbx.io/documents/users/iqjWHBFdfxIU/rVaHxDBUtdew/v0  2   China’s total imports of goods and services in 2019 was $2604 billion, including $168 billion imports from the US. If China was to fully meet the $200 billion target of additional imports from the US, assuming no change to imports from other countries in 2020 from 2019, China’s total imports would jump to $2699 billion in 2020 and $2745 billion in 2021. 3   The eight subcategories of Manufacturing Goods listed in the Annex 6.1 of the Phase One Trade agreement include: Industrial Machinery, Electrical Equipment and Machinery, Pharmaceutical Products, Aircraft, Vehicles, Optical and Medical Instruments, Iron and Steel, Other Manufactured Goods including solar-grade polysilicon and other organic and inorganic chemicals, hardwood lumber, integrated circuits (manufactured in US), and chemical products. 4   WIOD Data, 2016 release and OECD Input-Output Tables (IOTs), 2015 release. Cyclical Investment Stance Equity Sector Recommendations