Sectors

Feature The GAA DM Equity Country Allocation model is updated as of February 28, 2019. The quant model increased allocations to Spain, Italy, Sweden and Germany at the expense of the U.S., the Netherlands and Switzerland. As such, now the model underweights the U.S., Japan, the U.K, France, Canada (downgraded from overweight) and Australia, while overweighting Germany, Spain, Italy, Switzerland and Sweden (upgraded from underweight), as shown in Table 1. Table 1Model Allocation Vs. Benchmark Weights As shown in Table 2 and Charts 1, 2 and 3, the overall model outperformed the MSCI World benchmark by 18 bps in February, with a 54 bps of outperformance from the Level 2 model offset by a 9 bps of underperformance from Level 1. Since going live, the overall model has outperformed by 148 bps, with Level 2 outperforming by 267 bps and Level 1 outperforming by 29 bps. Table 2Performance (Total Returns In USD %) Chart 1GAA DM Model Vs. MSCI World Chart 2GAA U.S. Vs. Non U.S. Model (Level 1) Chart 3GAA Non U.S. Model (Level 2)​​​​​​​ Please see also the website http://gaa.bcaresearch.com/trades/allocation_performance. For more details on the models, please see Special Report, “Global Equity Allocation: Introducing The Developed Markets Country Allocation Model,” dated January 29, 2016, available at https://gaa.bcaresearch.com. Please note that the overall country and sector recommendations published in our Monthly Portfolio Update and Quarterly Portfolio Outlook use the results of these quantitative models as one input, but do not stick slavishly to them. We believe that models are a useful check, but structural changes and unquantifiable factors need to be considered too in making overall recommendations.   GAA Equity Sector Selection Model We are happy to reintroduce the GAA Equity Sector Selection model after we suspended it as of October 2018 following the GICS adjustments to global sector composition. As noted in our September 2018 Special Alert and October 2018 Quarterly, the most notable changes occurred in the new Communication Services sector (previously known as Telecommunication Services) and the Information Technology sector, whereas the Consumer Discretionary sector had various yet insubstantial movements in and out of the sector. Having received historical performance of the revised data, we have retested and adjusted various inputs in the model to match the cyclicality of the revised sectors. We were able to backtest the model to only June 2008 as this was the starting point of the revised data. Given the nature of firms that are now included in the global Communication Services sector, we revised our classification of this sector from a defensive to a cyclical. Hence, it will be positively impacted by the model’s growth component. Furthermore, we have introduced Real Estate as its own sector (following its removal from Financials in August 2016). Additionally, we have neutralized the impact of the liquidity component on the Real Estate sector; in other terms, we found no evidence that the Fed cycle affects this sector in any of its four phases. We also revised the valuations component by shortening the confirming signal of our technical indicator from a 12-month to a 6-month moving average. To properly assess the model’s adjusted performance, we have reset the “since going live date” to begin in March 2019. However, the historical backtested performance of the model will still be shown in Chart 4. Additionally, we show the old model’s performance vs. its benchmark (Table 3). Chart 4Overall Model Performance Given the above, and following our Monthly Update that was released yesterday, the model corroborates our slightly cyclical stance by overweighting Industrials and Materials (Table 4). Additionally, the model’s biggest underweight shift from last month was on Consumer Staples as the momentum indicator significantly deteriorated. The model is overweight Utilities due to positive inputs from its momentum and liquidity components. Table 3Old Model’s Performance Table 4Current Model Allocations​​​​​​​ For more details on the model, please see the Special Report “Introducing The GAA Equity Sector Selection Model,” dated July 27, 2016, available at https://gaa.bcaresearch.com.   Xiaoli Tang, Associate Vice President xiaoliT@bcaresearch.com   Amr Hanafy, Research Associate amrh@bcaresearch.com  

Neutral There are high odds that the chip cycle will soon take a turn for the better. Global chip sales have been decelerating for 17 months and are now on the cusp of contraction (middle panel). Over the past two decades, steep contractions have been associated with recession. Given that BCA’s view does not call for recession this year, it is highly unlikely for global semi sales to suffer a major setback. While we do not rule out a brief and shallow dip below zero similar to the 2011/12 and 2015/16 parallels, leading indicators of global semi sales suggest that a trough is near. Namely, BCA’s Global Leading Economic Indicator (GLEI) diffusion index is in a V-shaped recovery signaling that global growth is close to a nadir (middle panel). Similarly the U.S. dollar is decelerating which is a boon to global growth and conducive to higher global chip sales (trade-weighted U.S. dollar shown inverted, bottom panel). Bottom Line: In Monday’s Weekly Report, we lifted the S&P semiconductors index to neutral and added it to our upgrade watch list; we are looking for an opportunity to boost to overweight on a pullback, stay tuned. Finally, from a risk management perspective we increased our trailing stop to 15% in our tactical overweight in the S&P semi equipment index, in order to protect gains. The ticker symbols for the stocks in the S&P semiconductors index are: BLBG: S5SECO – INTC, AVGO, TXN, NVDA, QCOM, MU, ADI, XLNX, AMD, MCHP, MXIM, SWKS, QRVO.  

Highlights The global shipping-fuels market will tighten as UN-mandated fuel standards kick in next year. This will keep ship fuels, known as bunkers, and other distillate prices – e.g., diesel and jet fuel – elevated relative to other refined products like gasoline. In turn, this will boost demand for lighter, sweeter crudes – particularly Brent and similar grades – that allow refiners to raise distillate yields, as they scramble to meet higher demand for low-sulfur ship-fuel next year. After pipeline expansions in the Permian Basin come on line later this year, WTI exports should provide the marginal light-sweet barrel refiners will need to raise distillate output next year. Light-sweet exports from the U.S. will find a ready home in the Atlantic Basin and Asia, as demand for shipping fuels – along with other distillates– rises. Still, the ramp in WTI exports from the U.S. will be hampered by a lack of deep-water ports that can accommodate very large crude carriers (VLCCs) used to ship crude oil globally. As a result, we expect the light-sweet crude market ex-U.S. to tighten. Given this expectation, we are extending our long July 2019 Brent vs. short July 2020 Brent recommendation – up 240.2% since inception January 3 – to long 2H19 Brent vs. short 2H20 Brent. Highlights Energy: Overweight. In line with our expectation, OPEC is showing no sign of agreeing to raise production less than two months after initiating output cuts to drain inventories. Separately, Muhammadu Buhari was re-elected for a second four-year term as Nigeria’s president. The main opposition party rejected the results, following record-low voter turnout, after elections were unexpectedly delayed by one week, according to the BBC. Base Metals/Bulks: Neutral. The prompt March copper contract on the CME’s COMEX is attempting to fill a gap just above $2.95/lb, which opened in July 2018 as U.S. – China trade tensions rose. Positive signals from Sino – U.S. trade talks are supporting prices. Precious Metals: Neutral. Palladium traded to a record high of $1,536.50/oz Monday, pushing it more than $200/oz over gold. Platinum prices also rallied, as South African miners were notified by labor unions of intended strikes next week. Russia’s leading producer, Norilsk Nickel, which accounts for 40% of global palladium production, expects an 800k-ounce physical deficit in 2019, according to Reuters. Ags/Softs: Underweight. U.S. President Donald Trump said he would delay increasing U.S. tariffs on Chinese imports. Trump also said he expects to meet China’s President Xi Jinping to conclude the trade deal they’ve been negotiating if both sides continue to make progress. Feature Maritime shipping represents ~ 80% of international trade, and is responsible for roughly 90% of the total sulfur emissions from the transportation sector. In 2008, the UN’s International Maritime Organization (IMO) adopted a new regulation to reduce the cap for sulfur content of ships’ fuel oil – known as bunker fuel – to 3.5% from 4.5% in 2012, and to 0.5% from 3.5% in 2020 (Chart 1).1 Chart of the WeekReducing Marine Sulfur Pollution Requires Higher-Priced Low-Sulfur Fuels Around 50% of the cost of shipping is fuel costs. This amounts to more than 4mm b/d of bunker fuel (~ 3.5mm b/d of High-Sulfur Fuel Oil, or HSFO, and ~ 0.8mm b/d of marine gasoil, known as MGO). Hence, the IMO 2020 regs threaten demand of ~ 3.5mm b/d of HSFO. As the January 1, 2020, IMO deadline approaches, uncertainty surrounding the new regs remains elevated. On the demand side, shippers have the option to install abatement technology (i.e., scrubbers); burn IMO 2020-compliant fuels like MGO; use liquefied natural gas (LNG) as a fuel on ships; or do nothing, i.e., not comply with the regulation. Refiners on the supply side have to adjust via a combination of increasing MGO and Low-Sulfur Fuel Oil (LSFO) production; modifying their crude slates, which will favor lighter, sweeter crudes like Brent and WTI; building additional refining capacity; or running their units harder – i.e., increase refinery utilization rates – to produce more fuel. Demand for bunkers is the only part of the HSFO market that is growing. IMO 2020 removes the all-important shipping consumer of residual fuel oil, which will have a major impact on simple refineries, and will force a dramatic reconfiguration of the shipping and refining industries. To date, shippers and refiners have been slow to implement required changes as market participants have an incentive to move last.2 We agree with a recent McKinsey analysis, which notes the simplest solution for shippers is to switch to MGO.3 We also could see an uptick in demand for LSFO with sulfur content below the 0.5% limit for blending purposes. This would push demand for the lower-sulfur fuels and prices up. It also would pressure HSFO prices lower over the short term, to the point where this fuel can compete in the utility sector as a fuel, or in the refining sector as a charging stock for complex refiners. The IEA expects MGO consumption to rise from 0.8mm b/d to 1.7mm b/d in 2020.4 Complex Refiners, Light-Sweet Crude Producers Benefit Moving to LSFO and MGO shifts the burden of IMO 2020 to the refining market. According to the IEA, around 80% of the sulfur content in crude is removed from the final product. Once IMO 2020 is implemented, this will rise to 90%. In the lead-up to the IMO 2020 deadline, refiners are adjusting their crude slates to minimize residual fuel and maximize distillate output. As a result, demand for light-sweet crudes like Brent and WTI – the crude being produced in ever-rising quantities in the U.S. shales – will increase. At the same time, heavier crudes exported by Venezuela and GCC states will see demand fall, which means the spread between these crudes will favor the lighter, sweeter barrel, all else equal.5 Simple refineries incapable of cracking the complex heavy-sour crudes favored by U.S. Gulf Coast refiners will either have to upgrade, close, or use low-sulfur crude as a charging-stock input. According to McKinsey, the switch to marine gasoil will lead to an increase of 1.5mm b/d of distillate demand. This represents ~ 2.2 to 2.7mm b/d of increased demand for light-sweet oil. The IEA estimates diesel prices could rise by 20 – 30%, as a result.6 This increased demand for low-sulfur bunkers – MGO in particular –will keep prices for distillates generally well supported over the next year or so at the expense of HSFO. S&P Global Platts reported this week the first physical trade for U.S. Gulf Coast 0.5% MGO was done in its official trading window at $67.70/bbl, a $3.75/bbl premium to HSFO.7 IMO 2020 will keep distillates the star performers for refiners. Distillate crack spreads – most visible in the ultra-low-sulfur diesel (ULSD) cracks employing the CME’s NY Harbor ULSD futures vs. WTI and Brent – recently were trading $16/bbl over gasoline cracks using the Exchange’s RBOB futures (Charts 2A and 2B). We expect these cracks to remain wide, to incentivize more distillate-production capacity. Chart 2ABrent Diesel And Gasoline Cracks Likely Trade > $14/bbl Wide Chart 2BBrent Diesel Cracks Will Remain Elevated Following IMO 2020 Prices for other distillates also will be supported by IMO 2020 – e.g., jet fuel – over the coming year, given the high correlation of products within this cut of the barrel. These distillate prices also are highly correlated with Brent and WTI prices, as can be seen in Chart 3, and in Tables 1 and 2. These high correlations likely will persist as IMO 2020 is implemented, and hedgers seek out liquid markets in which to shed their price risk.8 Chart 3Global Distillate Prices Will Be Supported by IMO 2020Table 1Distillate Fuels’ Correlations Remain High Around The WorldTable 2Percent Changes In Distillates Also Are Highly Correlated Baker & O’Brien, an energy consultancy based in Dallas, Texas, expects a number of factors – ranging from non-compliance with IMO 2020; increased use of scrubbers to capture sulfur-oxide emissions; blending to make IMO 2020-compliant marine fuel; upgrades by refiners and changes in their crude slates – will lead to lower prices once the market adjusts to the new regs.9 We do not disagree, but the timing on this likely hinges on how quickly U.S. light-sweet crude oil exports ramp up. Investment Implications WTI exports – actually LTO exports from U.S. shales – will provide the marginal light-sweet barrel refiners will need to raise distillate output next year. As a result, LTO exports from the U.S. will find a ready home in the Atlantic Basin and Asia, as demand for low-sulfur shipping fuels increases. However, this will not happen overnight. At present WTI exports from the U.S. are hampered by a lack of deep-water ports that can accommodate the VLCCs used to ship crude oil. The 2mm b/d of expanded pipeline capacity out of the Permian by the end of this year will move the U.S. crude-oil bottleneck from the Permian to the U.S. Gulf.10 So, as refiners prepare this year for the IMO 2020 regs effective January 1, 2020, the light-sweet crude market ex-U.S. – particularly Brent– will tighten. This already is visible in the backwardation we were expecting at the beginning of this year, when we recommended getting long July 2019 Brent vs. short July 2020 Brent, which is up 240.2% since inception on January 3. Given our expectation for a tighter light-sweet crude market ex-U.S., we are liquidating our existing Brent 2019 long position vs. a short position in July 2020 at tonight’s close, and replacing it with a long 2H19 Brent vs. a short 2H20 Brent position.11 Bottom Line: The implementation of IMO 2020 will tighten marine fuels markets globally, as refiners increase their demand for light-sweet crude oil and shippers most likely increase their demand for MGO and lower-sulfur fuels generally.     Robert P. Ryan, Senior Vice President Commodity & Energy Strategy rryan@bcaresearch.com Hugo Bélanger, Senior Analyst Commodity & Energy Strategy HugoB@bcaresearch.com   Footnotes 1      The regulation is part of Annex VI to the International Convention for the Prevention of Pollution from Ships (MARPOL). Following the adoption of the regulation in 2008, a provision was kept in order to review the compliant fuel availability and possibly push the implementation to 2025. In October 2016, the IMO’s Marine Environment Protection Committee confirmed the final implementation date (January 1, 2020) following a positive assessment of the availability for shippers of compliant fuels. Any amendment to MARPOL needs to be circulated for a minimum of six months, and can only be implemented 16 months after adoption, therefore, no legal amendment to the current January 2020 date are possible. Please see https://www.iea.org/etp/tracking2017/internationalshipping/ 2      The slow response by refiners can be explained by: (1) the fact that a switch to LSFO or MGO prior to the actual deadline would lead to a financial loss due to the current high price of LSFO and MGO vs. HSFO; (2) abatement technology requires large upfront investments (i.e. capital cost of new processing units, storage tanks, loss of revenue from laying ships in dry dock while they are retrofitted, and a permanent loss of deck space and loading capacity to the new equipment); and (3) the unpredictability of fuel prices and the endogenous relationship between other shippers and the behavior of prices. In other words, trying to get out in front of the official implementation of IMO 2020 leads to unnecessary financial burdens and to competitive disadvantage. Please see Halff, Antoine, Lara Younes, Tim Boersma (2019), “The Likely Implications of the new IMO standards on the shipping industry.”  Energy Policy, 126: 277 - 286. 3      Please see “IMO 2020 and the outlook for marine fuels,” published by McKinsey & Company, September 2018.  S&P Global Platts reaches a similar conclusion in a report entitled “Turning tides, the future of fuel oil after IMO 2020,” which was released this month.  Platts notes, “The IMO’s lower sulphur cap is set to take away the bulk of marine fuel oil demand from the start of next year.  Most ship owners and operators will switch to burning new low-sulfur bunker blends, translating into an almost overnight shift of 3 million b/d of demand.” 4      The IEA expects 30% of the current HSFO bunker demand will switch to marine gasoil (MGO), 30% of the HSFO bunker demand will switch to the new ultra low 0.5% sulphur fuel (ULSFO), and 40% of HSFO bunker demand will remain.)  In the IEA’s modeling, this could push prices up by as much as 30%.  Please see “Oil 2018: Analysis and forecasts to 2023” published by the IEA. It is available at iea.org 5      Please see “IMO 2020 and the Brent – Dubai Spread,” published by The Oxford Institute For Energy Studies in September 2018.  Of course, reducing the export of heavy-sour crudes, as has been done by the Gulf Arab members of OPEC will keep the Brent – Dubai spread tighter than pure economics would dictate. 6      Please see sources in footnotes 3 and 4. 7      This trade was done in the Platts Market on Close assessment.  Please see “USGC Marine Fuel 0.5% has first physical trade in Platts MOC process,” published by S&P Global Platts February 26, 2019. 8      These are short-term correlations, which use daily data from 2017 to now. We present correlations in levels and in percent-changes, given these are cointegrated variables. Please see section 3.3 of “Correlation, regression, and cointegration of nonstationary economic time series,” by Soren Johansen, published November 6, 2007, by the Center for Research in Econometric Analysis of Time Series at the University of Aarhus. 9      Please see “The Thunder Rolls – IMO 2020 And The Need For Increased Global Oil Refinery Runs (Part 3)” published by Baker & O’Brien, December 11, 2018. 10     An additional 1mm b/d of new takeaway is scheduled for 1H21, following a final investment decision from an Exxon-led group that will move Permian Basin LTO to the U.S. Gulf.  This came one day after Exxon FID’d a 250k b/d buildout of its Beaumont refinery in Houston, which will increase capacity by more than 65%, Natural Gas Intelligence reported January 30. 11     Please see EIA’s This Week in Petroleum report titled “Upcoming changes in marine fuel sulfur limits will affect crude oil and petroleum product markets,” published January 16, 2019. Investment Views and Themes Recommendations Strategic Recommendations Tactical Trades Commodity Prices and Plays Reference Table   Trades Closed in Summary of Closed Trades

Overweight We recently upgraded the S&P materials index to overweight via boosting the steel index to an above benchmark allocation and subsequently we also put on a market-neutral trade: long materials / short utilities; we reiterate all three recent moves. The top panel of the chart shows that Chinese stocks are capturing the reflationary policy trifecta (credit, monetary and fiscal) that the Chinese authorities are instituting and deep cyclical materials stocks will likely be the primary beneficiaries of such efforts. Importantly, Chinese construction materials industrial production (IP) is expanding at an accelerating pace (bottom panel), and is the mirror image of still decelerating overall Chinese IP growth prints. Recovering Chinese demand for construction materials on the back of increasing infrastructure spending underpins the recent firming commodity price backdrop and suggests that S&P materials profits are on a solid footing. Bottom Line: Stay overweight the S&P materials index.

Special Report

Highlights Korean stocks are facing downside risks over the next several months. Exports will continue to contract on falling semiconductor prices and retrenching global demand. Growth deceleration and low inflation will lead the central bank to cut rates in 2019. Within an EM equity portfolio, we are downgrading Korean tech stocks from overweight to neutral but remain overweight the non-tech sector. We are booking gains on our strategic long positions in EM tech versus both the broader EM equity benchmark and materials. The KRW/USD exchange rate is at a critical technical juncture. Investors should wait to buy on a breakout and/or sell on a breakdown of the tapering wedge pattern. Feature   Decelerating and lately contracting South Korean exports have been a major drag on the economy and stock market (Chart I-1). The country is heavily reliant on manufacturing, with exports of goods contributing to nearly half of real GDP. Chart I-1Korean Stocks: Unsustainable Rebound? Although exports are currently shrinking, Korean domestic stock prices still rebounded. The rebound has mostly been driven by the information technology (tech) sector (Chart I-2). Is this recent rally justified by underlying fundamentals? Will share prices continue to rise in 2019? Our inclination is ‘no’ to both questions. There are still dark clouds on the horizon for both Korea’s business cycle and stock market. We are downgrading Korean tech stocks to neutral from overweight within a dedicated EM equity portfolio. However, we are maintaining our overweight in non-tech stocks relative to the EM equity benchmark. Lingering Risks In The Semiconductor Industry Korea’s dependence on the semiconductor sector has risen considerably in the past several years: Semiconductor exports have risen from under 10% to slightly above 20% of total goods exports (Chart I-3). As such, the outlook for semiconductor exports is a critical factor for future economic growth. Chart I-3Korea: Increasing Reliance On The Semiconductor Sector Table 1 lists the top 10 major exported goods from Korea, together contributing about 72% of total exports. Semiconductors are by far the largest component. Last year, overseas sales of semiconductors alone contributed to some 90% of growth in Korean exports, and about one-third of the country’s nominal GDP growth. Notably, Korea produces the largest quantity of DRAM and NAND memory chips in the world. Last year, Korean semiconductor companies accounted for about 70% of global DRAM and 50% of NAND flash global sales revenue. In 2019 Korean semiconductor exports will likely contract due to further deflation in DRAM and NAND memory prices (Chart I-4). Chart I-4Memory Prices Are Plunging The 2016-2017 surge in DRAM and NAND flash prices was due to supply shortages relative to demand. Last year, NAND prices plunged and DRAM prices began to fall as their supply-demand balances shifted to oversupply. This year, the glut will worsen. Demand Global demand for DRAM and NAND memory is slowing. Memory demand from the global smartphone sector – one important end-user market for DRAM and NAND memory chips – is contracting. According to the International Data Corporation (IDC), the global mobile phone sector is the biggest end-market for both DRAM and NAND memory chips, with nearly 40% market share in each. As major markets like China and advanced economies have entered the saturation phase of mobile-phone demand, global smartphone shipments are likely to decline further in 2019 (Chart I-5, top panel). Chart I-5Global Memory Demand Is Slowing DRAMeXchange1 expects global smartphone production volume for 2019 to fall by 3.3% from last year. In addition, the significant surge in bitcoin prices greatly boosted cryptocurrency mining activity in 2016-‘17 as miners quickly expanded their computing power. This contributed to strong DRAM demand and in turn higher semiconductor prices between June 2016 and May 2018. With the bust of bitcoin prices, this demand has vanished, which will further weigh on prices (Chart I-5, bottom panel). Supply High semiconductor prices in 2016-2017 boosted global production capacity expansion of DRAM and NAND memory chips. Based on data compiled by the IDC, global DRAM and NAND flash capacity expanded by 5.7% and 4.3% respectively in 2018 from a year earlier. As most of the global new capacity was added in the second half of 2018, the output of DRAM and NAND in 2019 will be higher than last year. Moreover, DRAM capacity will grow an additional 4% this year. Because of rising supply and slowing demand, both DRAM and NAND markets are in excess supply and have high inventories. DRAMeXchange forecasts that average DRAM prices will drop by at least another 20% in 2019, while NAND flash prices will fall another 10% from current levels. DRAM and NAND flash memory are the largest components of Korean tech producers. Yet they also sell many other tech products such as analog integrated circuits, LCD drivers, discrete circuits, sensors, actuators, and so on. Apart from the negative impact of declining global DRAM and NAND flash prices, the country’s semiconductor exports will also suffer from slowing demand in China in 2019. China, the biggest importer of Korean semiconductor products, has already shown waning demand. Its imports of electronic integrated circuits and micro-assemblies have contracted over the past two months in both value and volume terms (Chart I-6, top and middle panels). This mirrors a similar contraction in Korean semiconductor exports over the same period (Chart I-6, bottom panel). Chart I-6Weakening Chinese Semiconductor Demand Bottom Line: Korean semiconductor producers will likely face a contraction in their sales in 2019 due to weakening demand and deflating semiconductor prices. Diminishing Competitive Advantage Korea has been losing its competitive edge in key sectors like automobiles and smartphones. Even though the country remains highly competitive in the global semiconductor industry, it is beginning to show early signs of losing competitiveness there too. Improving competitiveness among other producers as well as a slowing pace of technological improvement and rising production costs are major reasons underlying Korea’s diminishing global competitiveness. Automobiles Korean auto manufacturers have lost market share in the global auto market. In China, the world’s biggest auto market, Korean brands’ market share has declined significantly in the past four years, losing out to both Japanese and German brands (Chart I-7, top three panels). Chart I-7Korea: Losing Market Shares In China's Auto Market Korean car companies have established auto manufacturing plants in China over the past decade. As a result, all Korean cars sold in China are produced within China, and automobile exports to China from Korea have fallen to zero (Chart I-7, bottom panel). Due to Korean auto manufacturers’ diminishing competitive advantage, Korean automobile production and exports peaked in 2012 in terms of volumes, and have been on a downtrend over the past seven years (Chart I-8, top panel). Chart I-8Further Decline In Korean Auto Output And Exports Is Possible While demand for Korean cars in the EU remains resilient, sales volumes in the U.S., China and the rest of world have been on a downward trajectory (Chart I-8, bottom three panels). Smartphones In the global smartphone market, Korea’s major smartphone-producing company – Samsung – has been in fierce competition with Chinese brands, and it seems to be losing the battle. Chart I-9 shows that while Samsung’s smartphone sales declined 8% year-on-year last year, smartphone sales from major Chinese smartphone producers (Huawei, Xiaomi, Oppo and Vivo) continued to grow at a pace of 20%. Chart I-9Korea: Losing Market Shares In Global Smartphone Market From 2012 to 2018, China’s share of global smartphone shipments rose from 6% to 39%. By comparison, Samsung’s share declined from 30% to 21% over the same period. Semiconductors Korean semiconductor companies – notably Samsung and SK Hynix – will likely remain the biggest producers in the memory market, given their advanced technology. However, there are still signs that Korean semiconductor companies will face increasing challenges in protecting their market share. Based on IDC data, Korean semiconductor companies’ share of global DRAM capacity will inch lower to 65% in 2019 from 65.4% in 2017, while their share of NAND capacity will decline to 53.8% from 57.5% during the same period. Meanwhile, China is focusing on boosting its self-sufficiency in terms of semiconductor production. At the moment there is still a three- to four-year technological gap between China and Korea in DRAM and NAND mass production, though the gap is likely to narrow. In the meantime, the U.S. will continue to create obstacles to prevent the rise of the Chinese semiconductor sector. However, these factors will only delay – not avert – the sector’s development and growth. We believe China will remain firmly committed to develop its semiconductor sector, particularly memory products, irrespective of the cost of investment necessary to do so. Similar to what has transpired in both automobile and smartphone production (Chart I-10), China will slowly increase its penetration in the semiconductor market with increasing capacity and a narrower technology gap over the next five to 10 years. After all, the world’s biggest semiconductor demand is in China. Chart I-10China: A Rising Star In Global Auto And Smartphone Market Significant increase in labor costs = falling export competitiveness for all sectors Korean President Moon Jae-in’s flagship economic policy, “income-led growth,” has resulted in dramatic increases in minimum wages since he took office in 2017, further damaging Korea’s competitiveness. The nation’s minimum wage was hiked by 7.3% in 2017, 16.4% in 2018 and will rise by another 11% to 8,350 KRW or $7.40 an hour, in 2019. As the president remains committed to meeting his campaign pledge of lifting the minimum wage to 10,000 KRW an hour, or about $8.90, this would require a further 20% increase in the next year or two. In addition, the government has also limited the maximum workweek to 52 hours since last July for businesses with more than 300 workers. Last month, the Cabinet further approved a revision bill whereby workers are eligible to receive an additional eight hours of wages every weekend for 40 hours of work that week. The new wage regulations have become a substantial burden on employers in all industries. The impact is more severe on small- and medium-sized enterprises (SMEs). According a recent survey, about 30% of SMEs have been unable to pay workers due to the state-set minimum wage. It is also affecting large manufacturers. According to a joint statement released in late December by the Korea Automobile Manufacturers Association and the Korea Auto Industries Cooperative Association, local automakers’ annual labor cost burdens will increase by at least 700 billion won (US$630 million) a year. As for auto parts manufacturers, a skyrocketing financial burden due to the new policy may threaten their survival. In addition, despite the KORUS FTA agreement reached between Korea and the U.S. last September, Korean auto manufacturers still fear they will be subject to new tariffs in 2019. On February 17, the U.S. Commerce Department submitted a report about imposing tariffs on imported automobiles and auto parts to U.S. President Donald Trump, who will make a decision by May 18. Our Geopolitical Strategy Service (GPS) team believes the odds of U.S. administration imposing auto tariffs on imported cars from Korea are small as this will be against the KORUS FTA agreement.2 Our GPS team also believes Japan is less likely to suffer a tariff than the EU, and even if Japan suffers a tariff along with the EU, Japan will negotiate a waiver more quickly than the EU. In both cases, Korea is likely to sell more cars in the U.S., but it will continue to face strong competition from Japan. Bottom Line: In addition to weakening global demand, a deterioration in Korea’s competitive advantage, due in large part to improving competitiveness among other producers and rising domestic wages, will negatively affect Korean exports. What About Domestic Demand? Record fiscal spending in 2019 will boost public sector consumption considerably, offsetting weakening consumption in the private sector. As the new wage policy will likely result in more layoffs and additional shuttering of businesses, domestic retail sales growth will remain under pressure (Chart I-11). Hence, an unintended consequence of the government’s higher income policy will be weaker aggregate income and consumer spending growth. Chart I-11KOREA The New Wage Policy May Trigger More Layoffs And Weaken Retail Sales Manufacturing and service sector jobs, including wholesale and retail trade and hotels and restaurants, account for 17% and 23% of total employment, respectively. Of all sectors, these two lost the most employees in January from a year ago. Meanwhile, due to the government’s deregulation of loans in 2014, Korean household debt has increased at a much faster pace than nominal income growth (Chart 12, top panel). As a result, Korea’s household debt has rapidly risen to 86% of its GDP as of the end of the third quarter of last year, from 72% four years ago – (Chart I-12, bottom panel). Elevated household debt at a time of rising layoffs will increase consumer anxiety and weigh on household spending. Chart I-12High Household Debt Will Weigh On Spending In order to combat an economic downturn, the government last month approved a record 467 trillion won ($418 billion, 26.5% of the country’s 2018 GDP) budget for 2019, up 9.5% from last year. The last time the budget increased by such a big scale was in 2009, when spending rose 10.7% in the wake of the global financial crisis. In addition, the government will front-load spending – with 61% of the budget to be spent in the first half of 2019. Household spending and government expenditures account for 48% and 15% of real GDP, respectively, while exports equal about 50% of real GDP. Hence, the increase in fiscal spending will not entirely offset the contraction in exports and slowdown in consumer spending. This entails a considerable slowdown in economic growth in 2019. Bet On Monetary Easing With growth disappointing and both headline and core inflation well below 2% (Chart I-13), the central bank will cut rates in 2019. Chart I-13Bet On A Rate Cut So far, economic growth has decelerated in the past 10 months, and recent data shows no signs of recovery. The country’s manufacturing sector is in contraction, with manufacturing PMI holding below the 50 boom-bust line in January (Chart I-14). Meanwhile, South Korea's unemployment rate rose to a nine-year high in January, with most of the job losses in the manufacturing and construction sectors. Chart I-14Manufacturing Sector: Still In Contraction Saramin, a South Korean job search portal, surveyed 906 firms in South Korea last month, 77% of which expressed unwillingness to hire new employees due to higher labor costs and negative business sentiment. Retail sales volume growth recently tumbled to 2-3%, pointing to faltering domestic demand (Chart I-11 above, bottom panel). The fixed-income market is not pricing in a rate cut in 2019. Therefore, investors should consider betting on lower interest rates. Shrinking exports and rate cuts will likely undermine the Korean won. Bottom Line: Economic deceleration and low inflation will lead the central bank to cut interest rates in 2019. Investment Implications The following are our investment recommendations: Downgrade the Korean tech sector from overweight to neutral within the EM space. We are reluctant to downgrade to underweight because many other emerging markets and sectors within the EM universe have poorer structural fundamentals than Korean tech. The tech sector accounts for 38% of the MSCI Korea Index, and 27% of the KOSPI in terms of market value. The stock with the largest weight in the MSCI Korea equity index is Samsung Electronics, with a share of 25%, followed by SK Hynix, with a ~5% share. Both are very sensitive to semiconductor prices. Specifically, semiconductor sales accounted for 31% of Samsung’s revenue, but contributed 77% of Samsung’s operating profit last year (Table I-2). Falling prices reduce producers’ profits by more than falling volumes.3 Hence, profits of semiconductor producers in Korea and globally will shrink in 2019. This will lead to a substantial selloff in Korean tech stocks (Chart I-15). Chart I-15Falling Memory Prices Will Trigger A Sell-Off In Korean Tech Stocks Meanwhile, China accounts for 33% of Samsung’s revenue, making it the largest market (Chart I-16). The ongoing economic slump in China’s domestic demand implies weaker demand for Korean shipments to China, which account for 28% of its exports and 14% of its GDP. ​​​​​​​ We are booking gains on our strategic long position in the Korean tech sector versus the EM benchmark index first instituted on January 27, 2010. This trade resulted in a 136% gain (Chart I-17, top panel). Chart I-16Taking Profits On Our Overweight Tech Positions Consistently, we are also taking profits on our long EM tech / short EM materials stocks trade, a strategic recommendation initiated on February 23, 2010 that has yielded a 186% gain (Chart I-17, second panel). The basis for this strategic position was our broader theme for the decade of being long what Chinese consumers buy and short plays on Chinese construction, which we initiated on June 8, 2010.4 Stay overweight non-tech equities within the EM space. The fiscal stimulus will have a considerable positive impact on the economy. Besides, Korean non-tech stocks have been weak relative to the EM equity benchmark, and in a renewed EM selloff they could act as a low-beta play (Chart I-17, bottom panel). We initiated our long Korean non-tech sector versus the EM benchmark index on May 31, 2018, which has so far been flat. The KRW/USD exchange rate is at a critical technical juncture. Investors should wait and buy on a breakout or sell on a breakdown of the tapering wedge pattern. The KRW/USD has been in a tight trading range over the past eight months (Chart I-18) and is approaching a major breaking point – i.e., any move will be significant, which we expect will largely depend on the movement of the RMB/USD. Chart I-18Tapering Wedge Patterns The natural path for the RMB would have been depreciation versus the U.S. dollar. However, China may opt for a flat exchange rate versus the U.S. dollar given its promises to the U.S. within the framework of forthcoming trade agreements. We have been shorting the KRW versus an equally weighted basket of USD and yen since February 14, 2018. We continue to hold this trade for the time being. Investors should augment their positions if the KRW/USD breaks down or close this trade and go long the won if the KRW/USD breaks out of its tapering wedge pattern. With respect to fixed income, we continue to receive Korean 10-year swap rates as we expect interest rates to fall meaningfully. Local investors should overweight bonds versus stocks.   Ellen JingYuan He, Associate Vice President Emerging Markets Strategy ellenj@bcaresearch.com     Footnotes 1 DRAMeXchange, the memory and storage division of a technology research firm TrendForce, has been conducting research on DRAM and NAND Flash since its creation in 2000. 2 Please see the Geopolitical Strategy Weekly Report, "Trump's Demands On China", published April 4, 2018. Available at gps.bcaresearch.com. 3 Please see the Emerging Markets Strategy Weekly Report “Corporate Profits: Recession Is Bad, Deflation Is Worse”, dated January 28, 2016, available at www.bcaresearch.com 4 Please see the Emerging Markets Strategy Special Report “How To Play Emerging Market Growth In The Coming Decade”, dated June 8, 2010, available at www.bcaresearch.com. Equity Recommendations Fixed-Income, Credit And Currency Recommendations

Highlights A no-deal Brexit which did not cause pain pour encourager les autres would be the much graver existential threat for the EU. A U.K. parliamentary vote to extend Article 50 by a few months would not be a game changer in itself, because it just delays the day of judgement. The real denouement will only happen when a workable route to a benign Brexit option commands a majority in the U.K. parliament. This is the point at which U.K. exposed risk-assets would outperform sustainably. Investors should then buy: the pound, the FTSE250, FTSE Small Cap, and U.K. homebuilders. Feature Chart of the WeekU.K. Homebuilders Is The Best Equity Sector To Play Brexit The Article 50 process that governs Brexit is fast approaching its two-year time limit, and the question naturally arises as to what will happen when the clock strikes midnight on March 29.1  To answer this question, it is worth stepping back to ask something even more fundamental: what was the purpose of the two-year time limit in the first place? The EU Must Protect The Integrity Of The Union The two-year time limit in Article 50 was designed to disadvantage the exiting country relative to the EU, and this disadvantage has now become abundantly clear. After the two years have run down, a no-deal or ‘cliff edge’ exit would be bad for the EU27, but it would be far worse for the U.K. This balance of power has put the EU27 very much in the driving seat of the Brexit process, and there is no reason to presume that the EU27 will do anything other than prioritise and protect its own interests. For the EU27, the priority right now is to protect the unity and integrity of the Union in the face of a growing existential threat from populists and nationalists. Unfortunately, much of this has been overlooked in the Brexiteer rhetoric, with arguments like "they need to sell us their BMWs and Prosecco". Clearly, frictionless and barrier-less trade is in the economic interests of both parties, but the economic reality is that less than a tenth of EU27 exports go to the U.K. while something approaching half of U.K. exports go to the EU27 (Chart I-2 and Chart I-3). Chart I-2Less Than A Tenth Of EU27 Exports Go To The U.K. ... Chart I-3...While Almost Half Of U.K. Exports Go To the EU27 Brexit is essentially a huge economic gamble in the name of an overarching political aim to ‘take back control’ (Chart I-4). Remember that the case for Brexit largely hinged on the desire to regain political sovereignty: specifically, controlling migration and ending the supremacy of the European Court of Justice. That’s fine, we have no qualms about that. But if the case for Brexit was largely political, it’s a bit rich to presume that the EU27 will not also prioritise its own overarching political aims – even if these political aims come at the cost of a short-term setback to the European economy. Chart I-4U.K. House Prices Have Stagnated Since The Brexit Negotiations Started Brexit Is The Litmus Test For Optimality Of The EU A catastrophic no-deal Brexit would undoubtedly hurt the EU27, and be particularly painful for the member states most exposed to U.K. trade, notably Ireland and the Netherlands. But here’s the paradox: a no-deal Brexit which did not cause pain pour encourager les autres would be the much graver existential threat for the EU. If membership of the EU and its institutions is supposedly an optimal economic and political structure for European states, then Brexit is the litmus test for the sub-optimality of exiting, and especially the heavy cost of exiting abruptly. If, after the two-year notice of Article 50, the U.K. abruptly left the EU with negligible disruption and then quickly thrived outside the EU, it would galvanize the European nationalists and populists to emulate a newly confident and resurgent U.K.’s quick and painless divorce. As this could be the death knell of the European project, the paradox is highlighted in our mischievous title: why a catastrophic no-deal might be good… for the EU. Brexit can take three ultimate shapes: The U.K. revokes its intention to withdraw the EU and remains a full member of the Union. A long transition to a new and negotiated trading relationship between the U.K. and the EU27. A sharp cliff-edge in which the U.K. abruptly becomes a third country to the EU27. The U.K. population now clearly favours option 1 – remain – over the two alternatives (Chart I-5). Meanwhile, the U.K. parliament has expressed its opposition, albeit not yet legally binding opposition, to option 3 – the no-deal Brexit. As for the EU27, the best outcome is for the U.K. to revoke its intention to withdraw and thrive within the club; the next best outcome is a long transition to Brexit, during which and after which the U.K. economy underperforms its European peers to illustrate the sub-optimality of exiting. But if Brexit is a cliff-edge, it has to be demonstrably painful. Hence, the EU27 will want to put off the day it has to confront this paradox if there is any chance of avoiding it. Article 50 does allow for this delay. The specific wording of paragraph 3 states: The Treaties shall cease to apply to the State in question from the date of entry into force of the withdrawal agreement or, failing that, two years after the notification referred to in paragraph 2, unless the European Council, in agreement with the Member State concerned, unanimously decides to extend this period. But a close reading suggests that if there is still a real possibility of finalising a withdrawal agreement, or if withdrawal is an outcome that the State no longer desires, then this would not represent ‘failing’. Meaning that the period of negotiation of a withdrawal agreement could be extended beyond March 29, or indeed Article 50 could be entirely revoked. A Short Delay Is Not A Game Changer, But A Second Referendum Would Be Looking at the desired outcomes of the U.K. population, the U.K. parliament, and the EU27, Brexit should rationally end up as benign options 1 or 2. The trouble is that rational outcomes can be thwarted if there is no mechanism to implement them. Although the U.K. parliament has expressed its desire to avoid a no-deal, it has not yet coalesced a majority around how exactly to avoid the cliff-edge outcome. A parliamentary vote to extend Article 50 by a few months would not be a game changer in itself because it just delays the day of judgement, though a longer extension would be more significant. But if the extension facilitated a second referendum or a general election, then that would be a game changer – as there would be the potential for the U.K. population to overturn the decision to leave.    It follows that the real denouement will only happen when a workable route to either of the benign Brexit options 1 or 2 above commands a majority in the U.K. parliament. From the perspective of investors, what this way forward turns out to be – permanent customs union, Common Market 2.0, second referendum, or general election – does not really matter. What matters is that a parliamentary majority exists for a positive course of action that eliminates no-deal rather than just delays it. This would be the point at which the BoE is finally liberated from its emergency policy (Chart I-6 and Chart I-7), pushing up U.K. gilt yields relative to other government bond yields (Chart I-8), and allowing a sustained rally in the pound (Chart I-9). Chart I-6Brexit Has Subdued The BoE... Chart I-7...Despite A Tight U.K. Labour Market Chart I-8Were It Not For Brexit, U.K. Interest Rates Would Be 1 Percent Higher... Chart I-9…And The Pound Would Be At $1.50 In this event, U.K. exposed risk-assets would also outperform. Note that the FTSE100 is not one of these investments. Whenever the pound strengthens, the weaker translation of the FTSE100 companies’ dollar-denominated earnings tends to weigh down this large-cap index (Chart I-10). Instead, investors should focus on: the FTSE250 (Chart I-11) and the FTSE Small Cap, but the best play is the U.K. homebuilders (Chart of the Week). Chart I-10When The Pound Rallies, The FTSE100 Underperforms... Chart I-11...So Prefer The FTSE250 Fractal Trading System* We are pleased to report that long Italy’s MIB versus Eurostoxx600 reached the end of its 3-month holding period very comfortably in profit which is now crystallised. This week, we note that the sharp underperformance of aluminium versus tin is at the limit of tight liquidity which has previously signalled a trend-reversal. Hence, the recommended trade is long aluminium versus tin. Set a profit target of 6.5 percent with a symmetrical stop-loss. 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-12 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, Senior Vice President Chief European Investment Strategist dhaval@bcaresearch.com Footnote 1 Midnight British Summer Time Fractal Trading System Recommendations Asset Allocation Equity Regional and Country Allocation Equity Sector Allocation Bond and Interest Rate Allocation Currency and Other Allocation 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

Underweight (High-Conviction) Home Depot, the S&P home improvement retail (HIR) index heavyweight, reported earnings yesterday that missed expectations as same store sales fell well short of estimates. The company also added guidance that this key figure would moderate in the coming year from 2018 levels. While a slower rate of top line growth this quarter was fairly predictable, given the Q4 collapse in lumber prices (recall that HIR earns a markup on lumber), the outlook does not bode well. This tough operating environment is captured by our model that, even with a modest recovery in lumber prices, still points to a significant decline in the S&P HIR index (third panel). Still, the HIR index trades at a premium to the broad index despite the headwinds facing the sector (bottom panel). A premium valuation seems misplaced and we accordingly reiterate our high-conviction underweight recommendation on the sector. We further point investors to our market neutral trade going long homebuilders/short HIR.1 The ticker symbols for the stocks in this index is BLBG: S5HOMI – HD and LOW.   1       Please see BCA U.S. Equity Strategy Report, “Dissecting 2019 Earnings,” dated January 22, 2019, available at uses.bcaresearch.com.

Overweight General Electric took the S&P industrial conglomerates index higher yesterday on news it had agreed to sell its BioPharma business to Danaher, the former home of GE’s relatively new CEO. The deal, which will raise more than $21 billion for the firm, was celebrated by investors who delivered one of the best share price moves for the company in a decade. Importantly, GE promised to use the proceeds of the transaction to pay down the debt load that has weighed on the stock since the GFC. Further, the deal will see Danaher assuming the pension obligations of the group, another source of shareholder angst. We share investor sentiment with respect to deleveraging; more is better for this highly indebted sector and yesterday’s news is another step in the right direction (third panel). Tack on the catalyst that relief in the trade war with China adds (please see our previous Insight Report) and the recent rally in the still reasonably valued S&P industrial conglomerates index (bottom panel) looks very sustainable; stay overweight. The ticker symbols for the stocks in this index are: BLBG: S5INDCX - GE, MMM, HON, ROP.