Sectors

Internal equity dynamics are sending a powerful signal for the broad equity market. Not only are defensives outshining cyclicals and mega caps trouncing small and micro caps, but also transports are warning that the broad equity market is skating on thin ice (top panel). Importantly, drilling deeper into the highly cyclical trucking industry is instructive. Heavy-duty trucks new orders have plunged (middle panel). While this is likely a consequence of the U.S./China trade war that commenced in the spring of 2018, there are also elements of domestic demand ills that have pushed “class 8 trucks” orders to the lowest point since the late-2015/early-2016 manufacturing recession. In addition, the American Trucking Association’s trucking tonnage index has fallen recently and is contracting at an accelerating pace on a six-month rate of change basis (third panel). Bottom Line: We heed the signal from the highly sensitive transportation sector and remain cautious on the broad equity market.

Underweight A tactical trading opportunity has re-emerged in semi equipment stocks. This week we recommended trimming the S&P semi equipment index to underweight on a three-to-six month time horizon, but with a tight stop at the -7% relative return mark. Semi equipment stocks are capital intensive and require precision manufacturing, which makes their sales cycle a carbon copy of the broad manufacturing cycle. The middle panel of the chart shows this tight positive correlation with the ISM manufacturing index and sends a grim message for semi equipment manufacturers. With regard to industry operating metrics, the news is equally glum. Global semi cycles typically last four-to-five quarters and we only just passed the half way mark. Thus, there is more downside to industry sales momentum and we would lean against recent analyst relative revenue euphoria (bottom panel). Bottom Line: Downgrade the S&P semiconductor equipment index to underweight on a tactical – three-to-six month horizon – basis, but set a tight stop at the -7% relative return mark. For additional details please refer to this Monday’s Weekly Report. The ticker symbols for the stocks in this index are: BLBG – S5SEEQ – AMAT, LRCX, KLAC.

Highlights The onset of a down-oscillation in growth strongly suggests a rotation out of the growth-sensitive Industrials and Materials into the relatively defensive Healthcare sector. But if the sharpest move in bond yields has already happened, it also suggests that Banks might hold up versus other cyclical sectors. New recommendation 1: Overweight Banks versus Industrials. New recommendation 2: Overweight Eurostoxx50 versus Nikkei225. Remain overweight Eurostoxx50 versus Shanghai Composite and neutral versus the S&P500. Feature Chart of the WeekEuro Stoxx 50 Vs. Nikkei 225 = Global Banks In Euros Vs. Global Industrials In Yen Several decades ago, English football’s top division was a showcase for the top English and British footballers. But not anymore. This year, the top six footballers in the English Premier League hail from Argentina, the Netherlands, Belgium, Senegal, Portugal, plus a token Englishman. Nowadays, if you want to see English or British footballers you have to go to the lower divisions.1  The English Premier League provides a powerful analogy for the FTSE100. Many of the top companies in this blue-chip index have their origins and main businesses outside the U.K. The names say it all: Royal Dutch, Hong Kong and Shanghai Banking Corporation, British American Tobacco, and so on. Just like in football, if you want stock market exposure to the U.K, you now have to go to the lower divisions: the FTSE250 or the FTSE Small Cap. A view on an economy does not necessarily translate into the same view on its mainstream stock market. The leading companies in the FTSE100 are multinationals, whose sales and profits have a minimal exposure to the economic fortunes of the U.K. This leads to a result which causes investors a great deal of cognitive dissonance: a view on an economy does not necessarily translate into the same view on its mainstream stock market. Picking Stock Markets The Right Way Royal Dutch is neither a Dutch company nor a U.K. company, it is a global company. And the same is true for the vast majority of companies in the FTSE100 and all other major indexes such as the Eurostoxx50, Nikkei225, and S&P500. However, Royal Dutch is most definitely an oil and gas company which moves in lockstep with the global energy sector. Hence, by far the most important performance differentiator for any mainstream equity index is the sector fingerprint that distinguishes the equity index from its peers. Each major stock market has a distinguishing ‘long’ sector in which it contains up to a quarter of its total market capitalisation, as well as a distinguishing ‘short’ sector in which it has a significant under-representation. The combination of this long sector and short sector gives each equity index its distinguishing fingerprint (Table 1): FTSE100 = long energy, short technology. Eurostoxx50 = long banks, short technology. Nikkei225 = long industrials, short banks and energy. S&P500 = long technology, short materials. MSCI Emerging Markets = long technology, short healthcare. Another important factor is the currency. Royal Dutch receives its revenues and incurs its costs in multiple major currencies, such as euros and dollars. In other words, Royal Dutch’s global business is currency neutral. But the Royal Dutch stock price is quoted in London in pounds. Hence, if the pound strengthens, the company’s multi-currency profits will decline in pound terms, weighing on the stock price. Conversely, if the pound weakens, it will lift the Royal Dutch stock price. This means that the domestic economy can impact its stock market through the currency channel. Albeit it is a counterintuitive relationship: a strong economy via a strong currency hinders the stock market; a weak economy via a weak currency helps the stock market. Be Careful With Valuation Comparisons Chart of the Week to Chart I-7 should prove beyond doubt that the sector plus currency effect is all that you need to get right to allocate between these four major regions. The charts show all the permutations of relative performances taken from the S&P500, Eurostoxx50, Nikkei225 and FTSE100 over the last decade. Chart I-2FTSE 100 Vs. S&P 500 = Global Energy In Pounds Vs. Global Technology In Dollars Chart I-3FTSE 100 Vs. Nikkei 225 = Global Energy In Pounds Vs. Global Industrials In Yen Chart I-4FTSE 100 Vs. Euro Stoxx 50 = Global Energy In Pounds Vs. Global Banks In Euros Chart I-5Euro Stoxx 50 Vs. S&P 500 = Global Banks In Euros Vs. Global Technology In Dollars Chart I-6Euro Stoxx 600 Vs. MSCI Emerging Markets = Global Healthcare In Euros Vs. Global Technology In Dollars Chart I-7S&P500 Vs. Nikkei225 = Global Tech In Dollars Vs. Global Industrials ##br##In Yen One important implication of sectors and currencies driving stock market allocation is that the head-to-head comparison of stock market valuations is meaningless. Two sectors with vastly different structural growth prospects – say, energy and technology – must necessarily trade on vastly different valuations. So the sector with the lower valuation is not necessarily the better-valued sector. By extension, the stock market with the lower valuation because of its sector fingerprint is not necessarily the better-valued stock market. Likewise, if investors anticipate the pound to ultimately strengthen – because they see that the pound is structurally cheap today – they might downgrade Royal Dutch’s multi-currency profit growth expectations in pound terms and trade the stock at an apparent discount. But allowing for the anticipated decline in other currencies versus the pound there is no discount. It follows that any multinational listed in Europe will give a false impression of cheapness if investors see European currencies as structurally undervalued. Another implication is that simple ‘value’ indexes may not actually offer value. In reality, they comprise a collection of sectors on the lowest head-to-head valuations which, to repeat, does not necessarily make them better-valued. The sector plus currency effect is all that you need to allocate between equity markets. Some people suggest comparing a valuation with its own history, and assessing how many ‘standard deviations’ it is above or below its norm. Unfortunately, the concept of a standard deviation is meaningful only if the underlying series is ‘stationary’ – meaning, it has no step changes through time. But sector valuations are ‘non-stationary’: they do undergo major step changes when they enter a vastly different economic climate. For example, the structural outlook for bank profits undergoes a step change when a credit boom ends. Therefore, comparing a bank valuation after a credit boom with the valuation during the credit boom is like comparing an apple with an orange! The Current Message Last week, we pointed out that current activity indicators are losing momentum, or outright rolling over. The reason being that “both the interest rate impulse and short-term credit impulses are now on the cusp of down-oscillations, which will bear on economies and financial markets in the second half of the year.” This week’s profit warning from BASF supports this analysis. To be clear, this is not a binary issue about recession or no recession. This is just a common or garden down-oscillation in European (and global) growth which tends to happen every 18 months or so with remarkable regularity. Nevertheless, the down-oscillation has a major bearing on sector allocation (Chart I-8) and, therefore, a major bearing on regional equity allocation. Chart I-8Switch Out Of Growth-Sensitives Into Healthcare Based on the major equity index ‘sector fingerprints’ we need to rank the attractiveness of six major global sectors: Materials, Energy, Industrials, Banks, Healthcare, and Technology. In the first half of the year, Industrials outperformed while Banks underperformed. Why? Because Industrials were following the up-oscillation in growth whereas Banks were tracking the bond yield down, as the flattening (or inverting) yield curve ate into their margins. Now, the onset of a down-oscillation in growth strongly suggests a rotation out of the growth-sensitive Industrials and Materials into the relatively defensive Healthcare sector (Chart I-8). But if the sharpest move in bond yields has already happened, it also suggests that Banks might hold up versus other cyclical sectors (Chart I-9 and Chart I-10). Meanwhile, for Energy and Technology we do not hold a high-conviction view. Hence, our ranking of the sectors is as follows: Chart I-9Banks Have Tracked The Bond Yield ##br##Down... Chart I-10...But If The Sharpest Move In Yields Is Over, Banks Can Outperform Other Cyclicals Healthcare Banks Energy and Technology Industrials and Materials On the basis of this ranking, and the major equity index sector fingerprints we are making two new recommendations. Overweight Banks versus Industrials. Overweight Eurostoxx50 versus Nikkei225. For completeness, remain overweight Eurostoxx50 versus Shanghai Composite and neutral versus the S&P500. A New Look To Our Recommendations Finally, from this week onwards we are changing the way we show our investment recommendations. Trades will refer to an investment horizon of 3 months or less, and these will mostly fall within the Fractal Trading System. Cyclical Recommendations will refer to an investment horizon usually between 3 months and a year, and will be sub-divided into asset allocation, equities, and bonds, rates and currencies. Structural Recommendations will refer to an investment horizon longer than a year, and will also be sub-divided into asset allocation, equities, and bonds, rates and currencies. We are changing the way we show our investment recommendations. We have also taken the opportunity to close long-standing stale positions. We hope you find the new look more user-friendly. Next week we will be publishing a jointly written round table discussion in which we debate and explore the interesting view differences within BCA. Absent a major development in the markets, this will replace the normal weekly report. Fractal Trading System* This week we note that the strong rally in the Australian stock market has reached a 65-day fractal dimension which has signalled previous countertrend reversals especially in relative terms. Accordingly, this week’s recommended trade is short ASX 200 vs. FTSE100. The profit target is 2% with a symmetrical stop-loss. In other trades, we are pleased to report that short euro area industrials vs. market achieved its profit target and is now closed. This leaves five open positions. For any investment, excessive trend following and groupthink can reach a natural point of instability, at which point the established trend is highly likely to break down with or without an external catalyst. An early warning sign is the investment’s fractal dimension approaching its natural lower bound. Encouragingly, this trigger has consistently identified countertrend moves of various magnitudes across all asset classes. Chart I-11 The post-June 9, 2016 fractal trading model rules are: 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. Use the position size multiple to control risk. The position size will be smaller for more risky positions. * 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 Footnotes 1 The top six players are based on the six nominations for the 2019 PFA Footballer of the Year: Sergio Aguero (Argentina), Virgil Van Dijk (Netherlands), Eden Hazard (Belgium), Sadio Mane (Senegal), Bernardo Silva (Portugal), and Raheem Sterling (England). Virgil Van Dijk was the winner. Fractal Trading System Cyclical Recommendations Structural Recommendations Closed Fractal Trades 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  

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

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

Highlights The Chinese economy slowed in May following two months of improvement, but the June PMI data suggests that the pace of decline is moderating. Still, the economy remains highly vulnerable in a full-tariff scenario. This weekend’s agreement to continue trade talks was a weaker result compared with what emerged from the G20 meeting in Argentina, and did not represent any real progress toward a final trade agreement that includes a substantial tariff rollback. Our 6-12 month investment outlook remains unchanged: Chinese stocks face potentially acute near-term risks, but are likely to outperform global stocks over the coming year as mounting economic weakness forces policymakers to overcome their reluctance to act and to ultimately stimulate as needed. Feature The Caixin PMI decline in June appears to have been preceded by the official PMI in May. No change in the latter in June is thus somewhat encouraging. Tables 1 and 2 on pages 2 and 3 highlight key developments in China’s economy and its financial markets over the past month. On the growth front, May’s activity data shows that the economy slowed following two months of improvement, which underscores that the budding, credit-driven recovery in China’s investment relevant economic activity remains in its infancy and is vulnerable to a further deterioration in external demand. The Caixin manufacturing PMI fell back below the 50 mark in June, but this appears to have simply confirmed the prior decline in the official PMI. June’s official PMI was flat on the month, which in combination with only a modest further decline in new export orders, implies that the May slowdown in activity noted above did not repeat itself in June (at least not in terms of magnitude) Table 1China Macro Data Summary Table 2China Financial Market Performance Summary Within financial markets, Chinese stocks actively outperformed the global benchmark over the past month as the latter rallied. The rally was in response to assurances from the PBoC about the capacity to ease further if needed, and the steadily rising odds over the course of the month that a new tariff ceasefire would be reached at the G20 meeting in Osaka. While this expectation was indeed validated, our view is that the agreement to continue talks was a weaker result compared with what emerged from the G20 meeting in Argentina, and did not represent any real progress toward a final trade agreement that includes a substantial tariff rollback. As such, our 6-12 month investment outlook remains unchanged: Chinese stocks face potentially acute near-term risks, but are likely to outperform global stocks over the coming year as mounting economic weakness forces policymakers to overcome their reluctance to act and to ultimately stimulate as needed. In reference to Tables 1 and 2, we provide below several detailed observations concerning developments in China’s macro and financial market data: Chart 1A Sharp Decline In Electricity Production China’s economy slowed in May according to the Bloomberg Li Keqiang index, after having picked up for two months in a row. While both electricity production and rail cargo volume fell in May, the former fell sharply, almost into negative territory (Chart 1). This underscores that the budding, credit-driven recovery in China’s investment relevant economic activity remains in its infancy, and that economic activity is set to deteriorate meaningfully in a full-tariff scenario. Our LKI leading indicator rose modestly in May, with all six components showing an improvement. Still, the uptrend in the indicator is slight, and is being held back by the money supply components, particularly the growth in M2. Much stronger money & credit growth will be required if Chinese economic activity relapses and no deal to end U.S. import tariffs has occurred, but policymakers are likely to be reactive rather than proactive in this regard. The picture painted by China’s housing data continues to be a story of weak housing demand arrayed against seemingly strong housing construction and stable growth in house prices. However, we noted in a May 9 joint Special Report with our Emerging Market Strategy service that the strength observed in floor space started over the past year reflected a funding strategy by cash-strapped real estate developers.1 Launching new projects aggressively last year – i.e., more property starts – allowed real estate developers to pre-sell property units in order to raise cash in a tight credit environment. On the demand side, the annual change in the PBOC’s pledged supplementary lending injection has strongly predicted floor space sold over the past four years; it remains deeply in negative territory and our measure declined in May for the 8th month in a row. Given that housing construction cannot sustainably decouple from housing demand, we expect floor space started to slow meaningfully over the coming several months absent a major pickup in housing sales. Chart 2The Flat Official PMI In June Is Somewhat Encouraging The Caixin manufacturing PMI fell back below the 50 mark in June, but this appears to have simply confirmed the prior decline in the official PMI (Chart 2). The official PMI was flat in June with only a modest further decline in new export orders, which implies that the May slowdown in activity noted above did not repeat itself in June, at least not in terms of magnitude. Chinese stocks have rallied 8-9% over the past month in U.S. dollar terms, outpacing the EM and global equity benchmarks. The rally initially followed comments from Governor Yi Gang that the PBoC had “tremendous” room to ease monetary policy if needed, and was sustained by expectations later in the month of a second tariff truce emerging from the G20 meeting in Osaka. For China-exposed investors, the issue is not whether Chinese policymakers have the capacity to support China’s economy, but rather the willingness to ease materially. From our perspective, the renewal of trade talks with the U.S. does not represent material progress towards the ultimate removal of tariffs. But the existence of talks is likely to give Chinese authorities a reason (for now) to avoid aggressively stimulating the economy, meaning that our 6-12 month investment outlook remains unchanged. Chart 3The BAT Stocks Will Outperform China If Chinese Stocks Outperform Global The significant outperformance of the investable consumer discretionary has been the most meaningful equity sector development over the past month. We have noted in past reports that changes last December to the global industry classification standard (GICS) mean that trends in investable consumer discretionary are now largely driven by Alibaba’s stock price, and Chart 3 highlights that the BAT stocks (Baidu, Alibaba, and Tencent) have indeed risen relative to the overall investable index. We noted in last month’s macro & market review that investors appeared to be wrongly conflating the risks facing Huawei (U.S. supply chain reliance) with those facing the BATs (the outlook for Chinese consumer spending), and the outperformance of the latter over the past month, as expectations mounted of another tariff truce emerging from the G20, would appear to validate this view. This implies that the outlook for the relative performance of the BATs versus the Chinese equity benchmark is likely to be the same as that of Chinese stocks versus the global benchmark: near-term risk, but likely to outperform over a 6-12 month time horizon. Chinese interbank rates fell over the past month, in response to an injection of liquidity by the PBoC following the collapse and takeover of Baoshang bank. The event marked the first takeover of a commercial bank in China since 1998, and has been described by authorities as an isolated event that was caused, in part, by the illegal use of bank funds. Market participants have clearly been concerned that Baoshang is not an isolated event; China’s 3-month interbank repo rate rose nearly 60bps from early-April to mid-June, and the PBoC’s response was intended to help prevent a significant tightening in credit conditions for China’s smaller lenders. While bad debt concerns have clearly impacted the interbank market over the past several weeks, there has been little impact on China’s onshore corporate bond market (Chart 4). Spreads on bonds rated AA+ did rise meaningfully in June, but have since nearly returned to late-May levels. We continue to recommend an overweight stance towards Chinese onshore corporate bonds, on the basis that market participants are pricing in a much higher default rate than we expect over the coming 6-12 months. The risk to Hong Kong is not the stability of the peg, but the impact of higher interest rates on an extremely leveraged economy. Chart 4The Onshore Corporate Bond Market Is Not Concerned By The Baoshang Takeover Chart 5HKD Strength Reflects More Than Just Falling U.S. Rate Expectations The Hong Kong dollar has strengthened significantly over the past month, with USD-HKD having retreated to the midpoint of its band. This has occurred in part because of declining U.S. interest rate expectations, but also because of a sharp rise in 3-month HIBOR versus the base rate (Chart 5). The strengthening in HIBOR seems linked to the anti-extradition bill protests, implying that HKD has strengthened due to anti-capital flight measures by the HKMA. We see no major risk to the currency peg at the moment, but discussed the negative implications of higher interest rates in Hong Kong on the region’s property market and share prices in last week’s joint report with our Emerging Market Strategy service.2   Jonathan LaBerge, CFA, Vice President Special Reports jonathanl@bcaresearch.com   Footnotes   1      Please see Emerging Markets Strategy and China Investment Strategy Special Report, “China’s Property Market: Making Sense Of Divergences”, dated May 9, 2019, available at cis.bcaresearch.com. 2      Please see Emerging Markets Strategy and China Investment Strategy Special Report, “Hong Kong’s Currency Peg: Truths And Misconceptions”, dated June 27, 2019, available at cis.bcaresearch.com. Cyclical Investment Stance Equity Sector Recommendations

Overweight, High-Conviction We reiterate our high-conviction overweight call on the BCA Defense Index as three key demand drivers remain upbeat and will continue to underpin relative industry profitability. First, the global arms race is alive and well and any governments seeking to augment their defense capabilities have to solicit the U.S. defense manufacturers. U.S. defense spending is rising at a healthy clip representing the major source of revenue growth for the industry (top panel). Second, there is a space race going on with China and India working on manned missions to the moon, but recently President Trump signaled that he would like to beat both of these countries to the moon and in outer space. The defense industry also benefits when global space related demand is on the rise. Finally, cyber security remains a global threat and governments are serious about fighting it off decisively given the sensitivity of the data that cyber criminals are after. While defense stocks are not pure-play software outfits combating cyber criminals, recent industry tuck-in acquisitions include such software companies in order for defense contractors to offer one-stop shop solutions to governments. Bottom Line: The BCA Defense Index remains a secular overweight and a high-conviction overweight. Please see our most recent Weekly Report for more details. The ticker symbols for the stocks in the BCA Defense Index are: LLL, LMT, NOC, GD and RTN.