Sectors

Highlights The long term direction for the pound is higher... ...but as the EU withdrawal bill passes through the U.K. parliament, expect a very hairy ride. The stock markets in Norway, Sweden and Denmark are driven by energy, industrials, and biotech respectively. Upgrade Sweden to neutral and downgrade Denmark to underweight. Think of semiconductors as twenty-first century commodities. Overweight the semiconductor sector versus broader technology indexes. Chart of the WeekBritish Public Opinion On Brexit Is Shifting Feature The Brexit drama is playing out exactly as scripted (Chart I-2). Chart I-2The Pound Is Following The Brexit Drama In July, we wrote: "The U.K. government's much hyped 'Chequers' proposal for Brexit risks getting a cold shower... the EU27 will almost instantaneously reject the proposed division between goods and services as 'cherry-picking' from its indivisible four freedoms - goods, services, capital, and people... the rejection will be based not just on the EU's founding principles, but also on the practical realities of a modern economy - specifically, the distinction between goods and services has become increasingly blurred." 1 Hence, the Chequers proposal to avoid a hard border between Northern Ireland and the Irish Republic is just wishful thinking: "The Irish border trilemma will remain unsolved, leaving a 'backstop' option of Northern Ireland remaining in the EU single market - an outcome that will be politically unpalatable." 2 What happens next? Understanding Brexit In a sense, Brexit is very simple. The EU27 sees only three options for the long-term political and economic relationship between the U.K. and the EU. Remain in the EU (no Brexit). Plug into an off-the-shelf setup, either the European Economic Area (EEA), European Free Trade Association (EFTA), or a permanent customs union, which already establish the EU relationship with Norway, Iceland, Liechtenstein, and Switzerland (soft Brexit). Become a 'third country' to the EU like, for example, Canada (hard Brexit). The first option, to stay in the EU, is politically impossible unless a new U.K. referendum overturned the original referendum's vote to leave. The second option, to join the EEA, EFTA, or permanent customs union is very difficult for Theresa May - because it is strongly opposed by many of the Conservative government's ministers and members of parliament who regard the option as 'Brino' (Brexit in name only). However, in a significant recent development, the opposition leader Jeremy Corbyn has committed the Labour party to a Brexit that keeps the U.K. in a permanent customs union.3 The third option, to become a 'third country', would very likely require some sort of border in Ireland. As already discussed, the only way to avoid a border would be a perfect alignment between the U.K and EU on tariffs and regulations for goods and services. But then, there would be little point in becoming a third country. Here's the crucial issue. The EU27 does not know which option the U.K. will eventually take, yet it must provide an 'all-weather' safeguard for the Good Friday peace agreement, requiring no border between Northern Ireland and the Irish Republic. Therefore, the EU27 will need the withdrawal agreement to commit: either the whole of the U.K. to a potentially permanent customs union with the EU; or Northern Ireland to a potentially permanent customs separation from the rest of the U.K. - in effect, breaking up the U.K by creating a border between Britain and Northern Ireland. Clearly, the hard Brexiters and/or Northern Ireland unionist MPs will vote down a withdrawal bill which contains either of these commitments, thereby wiping out Theresa May's slender majority. The intriguing question is: might Labour MPs - or enough of them - vote for a potentially permanent customs union to get the soft Brexit they want? Labour would be torn between the national interest and the party interest, as it would be missing a golden opportunity to topple the Conservative government. If the withdrawal bill musters a majority, it would remove the prospect of a 'no deal' Brexit and the pound would rally - because it would liberate the Bank of England to hike interest rates more aggressively (Chart I-3 and Chart I-4). If the bill failed, the government and specifically Theresa May would be badly wounded. She might call a general election there and then. Chart I-3Absent Brexit, U.K. Interest Rates Would Be Higher Chart I-4Absent Brexit, U.K. Interest Rates Would Be Higher If May limped on, parliament would nevertheless have the final say on whether to proceed with a no deal Brexit. And the parliamentary arithmetic indicates that a clear majority of MPs would vote against proceeding over the cliff-edge. At this point with the government paralysed, the only way to unlock the paralysis would be to go back to the people. Either in a general election or in a new referendum, the key issue for the public would be a choice between one of the three aforementioned options for the U.K./EU long-term relationship - because by then, it would be clear that those are the only options on offer. Based on a clear recent shift in British public opinion, the preference is more likely to be for a soft (or no) Brexit than to become a third country (Chart of the Week). Bottom Line: The long term direction for the pound is higher but, as the withdrawal bill passes through parliament, expect a very hairy ride. Understanding Scandinavian Stock Markets The Scandinavian countries - Norway, Sweden, and Denmark - have many things in common: their languages, cultures, and lifestyles, to name just a few. However, when it comes to their stock markets, the three countries could not be more different. Looking at the three bourses, each has a defining dominant sector (or sectors) whose market weighting swamps all others. In Norway, oil and gas accounts for over 40 percent of the market; in Sweden, industrials accounts for 30 percent of the market and financials accounts for another 30 percent; and in Denmark, healthcare accounts for 50 percent of the market (Table I-1). Table I-1The Scandinavian Stock Markets Could Not Be More Different! In a sense, the dominant equity market sectors in Norway and Sweden just reflect their economies. Norway has a large energy sector; Sweden specializes in advanced industrial equipment and machinery and it also has very high level of private sector indebtedness, explaining the outsized weighting in banks. However, Denmark's equity market - dominated as it is by Novo Nordisk, which is essentially a biotech company - has little connection with Denmark's economy. The important point is that the four dominant sectors - oil and gas, industrials, financials, and biotech - each outperform or underperform as global (or at least pan-regional) sectors. If oil and gas outperforms, it outperforms everywhere and not just locally. It follows that the relative performance of the four dominant equity sectors drives the relative stock market performances of Norway, Sweden, and Denmark. Norway versus Sweden = Energy versus Industrials (Chart I-5) Chart I-5Norway Vs. Sweden = Energy Vs. Industrials Norway versus Denmark = Energy versus Biotech (Chart I-6) Chart I-6Norway Vs. Denmark = Energy Vs. Biotech Sweden versus Denmark = Industrials and Financials versus Biotech (Chart I-7) Chart I-7Sweden Vs. Denmark = Industrials And Financials Vs. Biotech Last week, we upgraded some of the more classical cyclical sectors to a relative overweight. Our argument was that if an inflationary impulse is dominating, beaten-down cyclicals have more upside than the more richly-valued equity sectors; and if a disinflationary impulse from higher bond yields is dominating, its main casualty will be the more richly-valued equity sectors. On this basis, our ranking of the four sectors is: Industrials, Financials, Energy, Biotech. Which means the ranking of the Scandinavian stock markets is: Sweden, Norway, Denmark. Bottom Line: From a pan-European perspective, upgrade Sweden to neutral and downgrade Denmark to underweight. Understanding Semiconductors The best way to understand semiconductors is to think of them as twenty-first century commodities. In the twentieth century, many everyday goods and products contained a classical commodity such as copper. Today, the ubiquity of electronic gadgets, devices, and screens contains a twenty-first century equivalent: the microchip. Hence, semiconductors are to the tech world what classical commodities are to the non-tech world. They exhibit exactly the same cycle of relative performance. If, as we expect, beaten-down industrial commodities outperform, it follows that the beaten-down semiconductor sector will outperform broader technology indexes (Chart I-8). Chart I-8Semiconductors Follow The Commodity Cycle Bottom Line: Overweight the semiconductor sector versus technology. Dhaval Joshi, Senior Vice President Chief European Investment Strategist dhaval@bcaresearch.com 1 For example, the sale of a car is no longer the sale of just a good. As car companies often structure the financing of the car purchase, a car purchase can be a hybrid of a good - the car itself, and a service - the financing package. Therefore, a single market for cars requires a single market for both goods and services. 2 The Irish border trilemma comprises: 1. the U.K./EU land border between Northern Ireland and the Irish Republic; 2. the Good Friday peace agreement requiring the absence of any physical border within Ireland; 3.the Northern Ireland unionists' refusal to countenance a U.K./EU border at the Irish Sea, which would entail a customs border between Northern Ireland and the rest of the U.K. 3 At the Labour Party's just-held 2018 conference, Jeremy Corbyn made a commitment to joining a permanent U.K./EU customs union. Fractal Trading Model* This week's recommended trade comes from Down Under. The 25% outperformance of Australian telecoms (driven by Telstra) versus insurers (driven by IAG and AMP) over the past 3 months appears technically extended, with a 65-day fractal dimension at a level that has regularly indicated the start of a countertrend move. Therefore, the recommended trade is short Australian telecoms versus insurers, setting a profit target of 7% and a symmetrical stop-loss. In other trades, long CRB Industrial commodities versus MSCI World Index achieved its profit target very quickly, leaving four open trades. 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-9 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 Fractal Trading Model Recommendations Equities Bond & Interest Rates Currency & Other Positions Closed Fractal Trades Trades Closed Trades Asset Performance Currency & Bond Equity Sector Country Equity Indicators Bond Yields Chart I-1Indicators To Watch - Bond Yields Chart I-2Indicators To Watch - Bond Yields Chart I-3Indicators To Watch - Bond Yields Chart I-4Indicators To Watch - Bond Yields Interest Rate Chart I-5Indicators To Watch - Interest Rate Expectations Chart I-6Indicators To Watch - Interest Rate Expectations Chart I-7Indicators To Watch - Interest Rate Expectations Chart I-8Indicators To Watch - Interest Rate Expectations

  Neutral In our recent initiation of coverage on the newly minted Communication Services sector, we examined the impact of a variety of technology and consumer discretionary stocks being pulled together to form a new GICS1 sector.1 One sector that saw some important changes was the S&P internet retail index, a sub-sector of consumer discretionary, with Netflix and TripAdvisor moving out and eBay moving in. Our thesis of continued elevated profit growth being offset by sky-high valuations is unchanged by these moves, though there are two important developments. First, the moves are not equal from a market cap perspective and the stocks moving out are much larger than the one moving in. The upshot is that Amazon goes from 75% of the index to 85% now, meaning that little else matters than that sole equity to an even greater extent. Thus, the second development is Amazon’s 12% share price pullback this month which has made the sky-high index valuation look less-so (second and third panels). Our take is that the decreased diversification has added specific risk that should naturally increase the index’s volatility and, accordingly, our valuation and technical indicators are less reliable. As such, we are maintaining our benchmark allocation recommendation, though we are growing more constructive as the valuation declines. The ticker symbols for the stocks this index are: BLBG: S5INRE - AMZN, BKNG, EBAY, EXPE.   1 Please see BCA U.S. Equity Strategy Special Report, “New Lines Of Communication” dated October 1, 2018, available at uses.bcaresearch.com.  

Special Report

Highlights The pace of "de-capacity" reforms in China will continue to diminish, with declining shutdowns of inefficient capacity and rising advanced capacity over the next 12-15 months. Coal prices may have less downside than steel prices due to more resilient domestic demand, and lower production growth for the former than the latter. Meanwhile, iron ore prices may have limited downside and could outperform steel prices due to increasing shutdowns of domestic iron ore mines. Go long September 2019 thermal coal and iron ore futures versus September 2019 steel rebar futures. Chinese coal producers' shares may outperform Chinese steel producers' shares. Feature This April, our Special Report titled, "Revisiting China's 'De-Capacity' Reforms," painted a negative picture for steel and coal prices over 2018 and 2019 on diminishing pace of "de-capacity" reforms and rising steel and coal output.1 So far, our call has not yet played out. Both steel and coal prices have been firm over the past five months (Chart 1A). Meanwhile, iron ore and coking coal have also rebounded (Chart 1B). Chart 1ASteel And Coal Prices: More Upside Ahead? Chart 1BIron Ore And Coking Coal Prices: Following Steel And Coal Prices? In this report, we return to the analysis we laid out back in April, with the goal of identifying whether or not the rally in steel and coal prices will continue. Another major question to answer is why share prices of coal and steel companies have continued to plunge, even though coal and steel prices have held up well. In brief, our research findings still suggest that steel and coal prices are likely to fall over the next 12-15 months on a diminishing pace of de-capacity (less shutdowns of old capacity) and rising advanced capacity. We also reckon that coal prices may have less downside than steel prices over the next 12-15 months due to more resilient domestic demand and smaller production growth compared to steel; we conclude by outlining a long/short trade opportunity tied to this view. Understanding The Recent Price Rally The recent strength in both steel and coal prices has been due to a tighter supply-demand balance than we expected: Steel Falling steel product output and still-solid steel demand growth have pushed up steel prices this year. While crude steel production has had strong growth so far this year (9% year-on-year and 50 million tons in volume), total output of steel product has actually declined by 20 million tons (2.7%) year-on-year during the same period (Chart 2). Steel products, including rebars, wire rods, sheets and other items, are made from crude steel and consumed in end consumption. Tianjin province - a city very close to Beijing - accounted for more than 100% of the reduction of steel product output, as 40% of the province's operating capacity was shut down due to the city's "de-capacity" policy and increasingly stringent environmental regulations. In addition, Chinese steel products production had already experienced huge cut last year by nearly 100 million due to the government's "Ditiaogang" de-capacity policy.2 As a result, strong crude steel output growth this year has not been able to lift steel product production from contraction, creating a shortage in Chinese steel product supply. To put it in perspective, total steel products production for the first eight months of this year is at a five-year low. Chart 2Falling Steel Product Output Amid Strong Crude Steel Production Growth Chart 3Steel Demand Has Been Robust As Well Meanwhile, massive pledged supplementary lending (PSL) injections - the People's Bank of China's direct lending to the real estate market - had extended property sales and starts beyond what appeared to be a sustainable trajectory, thereby lifting steel demand to some extent3 (Chart 3). Hence, weaker-than-expected steel products supply combined with slightly better demand than we anticipated have tightened the Chinese domestic steel market further, and underpinned high steel prices. Coal Similarly, the rebound in coal prices has also been due to declining output and strong demand growth. Chinese coal output turned out to be much weaker than we expected due to extremely stringent and frequent environmental and safety inspections on coal output (Chart 4). Back in mid-2017, in order to curb pollution, China demanded that coal mines plant trees, boost efficiency, cut down noise and seal off facilities from the outside world as part of a new "green mining" plan. This year's inspection have been even more stringent. Operations among coal mines, coal-washing plants and coal storage facilities were halted immediately if inspection teams found they failed to meet the related standards. As a result, Chinese coal production contracted 1% for the first eight months of this year. Chart 4Weaker-Than-Expected Coal Output Chart 5Resilient Thermal Coal Demand On the demand side, electricity generation from thermal power has remained quite robust at 7% (Chart 5). Again, coal prices have rebounded as the domestic coal supply-demand balance has tightened. Will Steel And Coal Prices Continue To Rise? The short answer is no. Many of the drivers underpinning the recent rally in steel and coal prices are set to fade over the next 12-15 months: Steel Steel prices will likely weaken in 2019 on rising steel product output and faltering steel demand growth. First, production of both crude steel and steel products will rise considerably next year, as the steel sector's de-capacity target is almost reached and new advanced capacity will come on stream faster to replace old or inefficient capacity that has already exited the market. Table 1 showed the 82% of this year's steel de-capacity target was already achieved by the end of July, leaving not much in the way of additional de-capacity cuts needed through the remainder of 2018. If this year's de-capacity cut target of 30 million tons is fulfilled over the next two months, there will be no need for any more capacity cuts in 2019, as the high end of the 2016-2020 de-capacity target (150 million tons) will be fully met this year. Table 1Supply-Side Reform - Capacity Reduction Target And Actual Achievement Record-high profit margins that Chinese steel producers are currently enjoying will also help boost steel production (Chart 6). This was the main driver behind this year's strong growth in crude steel output, despite more stringent environmental policies and ongoing de-capacity efforts. In addition, falling graphite electrode prices and increasing graphite electrode production will facilitate the expansion of cleaner electric furnace (EF) steel capacity and production in China (Chart 7). Chart 6Steel Producers' Profit Margin: At A Record High Chart 7Rising Graphite Electrode Supply Will Facilitate EF Steel Output EF technology uses scrap steel as raw materials, graphite electrodes and electricity to produce crude steel. The availability of graphite electrode has been one major bottleneck for the development of EF capacity. As of late 2017, there were about 524,000 tons of new graphite electrode capacity under construction, most of which will be completed within the next two years. This will nearly double the current capacity of 590,000 tons. As this capacity gradually enters into the market, graphite electrode prices will drop further, encouraging more EF steel projects. In 2017, newly added EF steel capacity was about 30 million tons, and EF steel production increased by about 24 million tons (47% year-on-year). With rising graphite electrode supply, EF capacity this year is expected to add 40 million tons, resulting in about a 25-30 million ton increase in EF steel output. In 2019, based on the government's goal of 15% of total steel production being EF steel by 2020, we expect another 25-30 million tons new EF capacity to come online. This alone would translate into 3-4% rise in steel product production in 2019. Second, while steel supply is rising, the demand outlook seems more pessimistic. Our September 13 Special Report titled, "China's Property Market: Where Will It Go From Here?" concluded that the Chinese property market is facing increasing downside risks. Diminishing PSL direct financing from the central bank and shrinking funding sources for Chinese real estate developers point to a considerable slowdown in property starts and construction, which will eventually lead to faltering demand for steel. Chinese auto output growth is weak, with the three-month moving average growth registering a 6% contraction this September. The government has boosted infrastructure projects. This will support steel demand to some extent, but it is unlikely to offset demand weakness from the down-trending property market. The property market is the biggest steel-consuming sector, accounting for 38% of total Chinese steel consumption - much higher than the 23% share from the infrastructure sector. Bottom Line: Steel prices may stay high over the next two or three months due to low inventories and heating-season production controls within the steel industry. Nonetheless, steel prices are vulnerable to the downside over the next 12-15 months on rising steel product output and faltering steel demand growth. Coal Coal prices will likely decline over the next 12-15 months, but the price downside may be less than that of steel. First, on the supply side, coal output will rise only moderately (i.e., 2-3%) in 2019. There are three drivers pushing up Chinese coal output. The government in May asked domestic coal producers to ramp up coal output, as current coal market supply has been tight this year. Particularly, the National Development and Reform Commission (NDRC) demanded that the top three coal produce provinces (Shanxi, Shaanxi, and Inner Mongolia) increase their aggregated coal output by at least 300,000 tons per day as soon as possible. However, the June-July environmental inspections within the major producing province of Mongolia resulted in a 14 million ton year-on-year drop in the province's coal output. If the 300,000 ton per day increase is realized in 2019, it will be equivalent to nearly 100 million tons of new coal supply next year, which is about 2.8% growth from 2017's output of 3.52 billion tons. Based on government data, 660 million tons of capacity is currently under construction, which includes new technologically advanced capacity that has already been built and ready to use but has not yet received government approval. If 30% of the under-construction capacity comes to market in 2019 and runs at a capacity utilization rate of 70%, it will translate into about 140 million tons of new coal supply next year, which is about 4% growth from last year. Due to too-strict production policies during the winter heating season, there was a coal supply crisis last winter. This year, the government is likely to implement a less stringent production policy for coal. In this case, coal producers will likely produce more to take advantage of seven-year-high profit margins (Chart 8). Chart 8Coal Producers' Profit Margin: At A Multi-Year High However, at the same time there are also two drivers dragging down coal output. Table 1 above shows that at the end of July, only 53% of this year's coal de-capacity target and 65% of the government's 2016-2020 coal capacity reduction target had been achieved. This implies that Chinese coal producers still need to cut 70 million tons of old coal capacity through the remainder of 2018 and another 210 million tons of inefficient capacity in the coming two years (2019 and 2020) - possibly 105 million tons of cuts in each year. Similar to steel, coal de-capacity reforms are also diminishing (e.g. a 150-million ton reduction target in 2018 versus a 105 million-ton reduction target in 2019). However, different from steel, the remaining de-capacity target for coal is still quite significant. With continuing the implementation of its de-capacity plan, excluding the three major producing provinces, the remaining provinces that in general have smaller-scale coal mines may face further cuts in their coal production. For the first eight months of this year, 13 out of the 22 non-top-three coal-producing provinces registered a contraction in coal output. Environmental policies will likely remain strict, given the country seems determined to improve its air quality. More frequent inspection and/or stricter policies will further curb coal production. On balance, we still expect overall coal output to increase moderately (i.e., 2-3%) next year. Second, on the demand side, coal demand growth will weaken only slightly due to robust thermal coal consumption for thermal power generation (Chart 5 above). We expect Chinese electricity consumption to grow at 5-6% next year - a touch lower than this year - on strong demand from both the residential and service sectors. Most of the growth will likely be supplied by thermal power, as some 72% of total electricity generation is currently thermal power. In addition, the government has limited hydropower and nuclear power projects coming onstream next year. In the meantime, coal consumption for heating will likely be replaced by natural gas or electricity, and coking coal demand may fall due to EF steel expansion and more use of scrap steel in blast furnaces. Bottom Line: Coal prices are likely to head south on rising supply and weakening demand growth next year. In addition, we expect coal prices to fall less than steel prices over the next 12-15 months on a tighter supply-demand balance for the former than the latter. What About The Iron Ore Market? The outlook for iron ore prices is becoming less downbeat. Iron ore prices may have limited downside and could outperform steel prices over the next 12-15 months - due to increasing shutdowns of mainland iron ore mines. Government data show that Chinese domestic iron ore output contracted 40% year-on-year in the first eight months of this year (Chart 9). About 60% of the decline was from Hebei - the province that has probably imposed the strictest environmental policies among all the provinces targeting ferrous- and coal- related industries - due to its proximity to the capital, Beijing. Chart 9Significant Drop In Domestic Iron Ore Output Profit margins for iron ore miners has tanked to a 15-year low due to rising production costs on environmental protections. The number of loss-making enterprises as a share of the total number of iron ore companies has reached a record high (Chart 10). Although EF steel capacity additions will contribute to most of the growth in crude steel output next year, non-EF crude steel capacity, which uses iron ore as its main input, will also increase to some extent. This will also lift iron ore demand, which will lead to further declines in port inventories and rising imports (Chart 11). Chart 10Iron Ore Producers' Profit Margin: At A 15-Year Low Chart 11Chinese Iron Ore Imports Are Likely To Go Up Bottom Line: We are less bearish on iron ore prices and expect them to outperform steel prices. Chinese iron ore imports will likely grow again. Investment Implications Three main investment implications can be drawn from our analysis. Price ratios of thermal coal/steel rebar and iron ore/steel rebar have fallen to record low levels (Chart 12). As we expect thermal coal and iron ore prices to outperform steel, we recommend going long September 2019 thermal coal futures/short September 2019 steel rebar futures and going long September 2019 iron ore futures/short September 2019 steel rebar futures on Chinese exchanges in RMB. Chinese coal imports including both thermal coal and coking coal could remain strong, which would at a margin be positive news for Chinese major coal importers Australia, Indonesia, Russia and Mongolia. In the meantime, Chinese iron ore imports are likely to rebound in 2019 as well. This will be positive news for producers in Australia, Brazil and South Africa. Chart 12Both Thermal Coal And Iron Ore Will Likely Outperform Steel Chart 13Coal Producers' Shares May Outperform Steel Producers' Stocks Despite stubbornly high coal and steel prices, Chinese share prices of coal producers and steel producers have still plunged (Chart 13, top and middle panel). From a top-down standpoint, it is hard to explain such poor share price performance among Chinese steel and coal companies when their profits have been booming. Our hunch is that these companies have been forced by the government to shoulder the debt of their peer companies that were shut down. This is an example of how the government can force shareholders of profitable companies to bear losses from restructuring by merging zombie companies into profitable ones. Based on our analysis, Chinese steel producers' share prices are still at risk of falling steel prices, while coal-producing companies may benefit from rising production and limited downside in coal prices. Hence, Chinese coal producers' shares may continue to outperform steel producers' shares with the price ratio of the former versus the latter just rebounding from three-year lows (Chart 13, bottom panel). Ellen JingYuan He, Associate Vice President Emerging Markets Strategy EllenJ@bcaresearch.com 1 Pease see Emerging Markets Strategy Special Reports "China's 'De-Capacity' Reforms: Where Steel & Coal Prices Are Headed", dated November 22, 2017, and "Revisiting China's De-Capacity Reforms", dated April 26, 2018, available at ems.bcaresearch.com. 2 Ditiaogang" is low-quality steel made by melting scrap metal in cheap and easy-to-install induction furnaces. These steel products are of poor quality and also lead to environmental degradation. As "Ditiaogang" is illegal in China, it is not recorded in official crude steel production data. However, after it is converted into steel products, official steel products production data do include it. Consequently, last year's significant removal of "Ditiaogang" and statistical issues have caused the big divergence between crude steel production expansion and steel products output contraction since then. 3 Pease see China Investment Strategy Special Report "China's Property Market: Where Will It Go From Here?", dated September 13, 2018, available at cis.bcaresearch.com. Cyclical Investment Stance Equity Sector Recommendations

Consumer staples stocks have been staging a recovery late in the year, buoyed by an exceptionally strong consumer. However, the S&P packaged foods sub-index has not participated in the rebound, held back by trade and currency headwinds in this export market-exposed sector. Still, we remain constructive on the index as those headwinds could evaporate as suddenly as they came, leaving a very solid domestic demand backdrop to lift the stocks into outperformance territory. Indeed, the environment looks exceptionally healthy; food retailers have been riding a five-year rising tide of sales (second panel). Further, consumers have been boosting their food consumption, which has historically been a good leading indicator of top line growth (third panel). In the context of a strong dollar providing a meaningful offset to packaging and raw food commodity prices, margin expansion looks particularly potent. Despite the bright outlook, the S&P packaged foods index remains deeply discounted, trading well below its eight-year average earnings multiple as well as the market multiple (bottom panel). We think investors should pick this one out of the bargain bin; stay overweight. The ticker symbols for the stocks in this index are: BLBG: S5PACK - MDLZ, KHC, GIS, TSN, K, MKC, HSY, CAG, SJM, HRL, CPB.

Underweight - Upgrade Alert The S&P airlines index has been buffeted by headwinds arising from the increasing cost of jet fuel; as the top panel of our chart shows, the price of jet fuel is the single largest driver of airline relative stock performance. In an environment where nearly all airlines bear the volatility of fuel costs without hedging offsets and where such costs represent roughly a quarter of the total, this correlation is logical. Airlines have been responding to rising jet fuel prices by cancelling planned capacity expansions and clamping down on controllable costs, as evidenced by Delta's strong Q3 earnings report this week. Still, the sell side has been reducing profit forecasts in parallel with falling stock prices. The upshot is that valuations have moved sideways to lower (bottom panel). As a reminder, we added an upgrade alert to the S&P airlines index this summer as these depressed valuations reflect much of the bad news. We reiterate that we would not hesitate to crystallize relative profits north of 27% since our underweight inception if fuel prices reverse direction. Bottom Line: Stay underweight the S&P airlines index for now and maintain an upgrade alert. The ticker symbols for the stocks in this index are: BLBG: S5AIRL - DAL, LUV, AAL, UAL, ALK.

Overweight - Downgrade Alert Between Friday of this week and Monday of next, roughly 75% of the S&P banks index, representing the nation's largest lenders, will be reporting their Q3 earnings results. Our loan growth and earnings models continue to point significantly higher, particularly the former which is near a 30-year high, a result of a booming economy and record low unemployment. The question becomes whether or not the market cares; the S&P banks index delivered earnings outperformances in both Q1 and Q2 of this year and still underperformed the broad market. Further, the spread between relative performance and yields is widening and even a steepening in the yield curve has not been enough to stimulate a banks rally. We put the S&P banks index on downgrade alert in mid-May when we locked in gains vs. the SPX of 6% and removed it from the high-conviction overweight list, and warned that were banks not to participate in the next bond market selloff we would pull the trigger and downgrade to neutral. Our patience is wearing thin as we await the market's reaction to what should be another solid earnings quarter. Bottom Line: Stay overweight banks, but stay tuned.

Highlights Asset allocation: Go long industrial commodities versus equities on a 6-month horizon. If an inflationary impulse is dominating, beaten-down industrial commodities have more upside than richly valued equities; and if a disinflationary impulse is dominating, its main casualty will be equities. Currencies: Take profits on long EUR/CNY. Maintain a broadly neutral stance to EUR, with short EUR/JPY counterbalancing long EUR/USD. Equity sectors: overweight basic materials versus the market. And within the basic materials sector, overweight basic resources versus chemicals. Chart of the WeekChina's 6-Month Credit Impulse Provides A Perfect Explanation For Commodity Inflation Feature Equity markets are entering the crossfire between two opposing forces: an inflationary impulse coming from the global economy; and a disinflationary impulse as higher bond yields threaten to deflate the very rich valuations of equities and other risk-assets. As this battle plays out in the coming months a good strategy is to go long commodities versus equities. The logic is simple: if the inflationary impulse from the economy is dominating, then beaten-down industrial commodities have more upside than richly valued equities; and if the disinflationary impulse from higher bond yields is dominating, then commodities have less downside than equities, because commodities have a much weaker valuation link with bond yields. Therefore, going long industrial commodities versus equities on a 6-month horizon should be a good strategy however the battle between inflationary and disinflationary impulses plays out. Inflationary Impulse Battles Disinflationary Impulse Chart I-2 shows the credit impulse oscillations in the euro area, U.S., and China since the start of the millennium, all expressed in dollars to allow a comparison between the three major economies. It is a fascinating chart because the change in the dominant oscillation - the one with the highest amplitude - perfectly illustrates the shift in global economic power and influence from Europe and the U.S. to China. Chart I-2The Shift In Economic Power From Europe And The U.S. To China Through 2000-08 the impulses in the euro area and the U.S. dominated. But during the global financial crisis that all changed: the credit stimulus from China dwarfed the responses from the western economies. Then through 2009-12 the impulse oscillations from the three major economies were briefly the same size, before China took on the undisputed mantle of dominant impulse, which it has held consistently since 2013. The world's three major economies are now all in 'up' oscillations according to their credit impulses. This means the global economy will experience an inflationary impulse for the next couple of quarters or so. However, battling the inflationary impulse is a disinflationary impulse. As the inflationary impulse pushes up bond yields, it threatens to deflate the very rich valuations of equities (and other risk-assets). Crucially, this disinflationary force is particularly vicious when bond yields are rising from ultra-low levels. We have described this dynamic exhaustively in previous reports, so we will not go into the detail here. But in a nutshell, both parts of an equity's required return - the risk-free component and the risk premium - go up together when bond yields are rising from ultra-low levels. Meaning that rising yields deflate equity valuations exponentially (Chart I-3).1 Chart I-3At Low Bond Yields The Valuation Of Equities Changes Exponentially But Which Inflationary Impulse? At our recent investment conference in Toronto, the three speakers on the China panel gave three different conclusions on China: aggressively bullish, moderately bullish, and bearish! The aggressive bull pointed out that the 3-month credit impulse has gone vertical (Chart I-4); the moderate bull pointed out that the 6-month credit impulse appears to be turning up (Chart I-5); while the bearish argument was that the level of the 12-month credit and fiscal impulse remains depressed. Chart I-4The 3-Month Impulse Is Up Sharply... Chart I-5But The 6-Month Impulse Is Just Turning So which narrative should we use? The answer is the one that provides the best explanatory power for the cycles that we actually observe in the economic and financial market data. As we described in our Special Report The Cobweb Theory And Market Cycles, the theory and evidence powerfully identifies the 6-month credit impulse as the one with the best explanatory power for the oscillations that we actually observe in the economy and markets - because the 6-month period aligns most closely with the lag between credit demand and credit supply.2 In any case, as we use the 6-month impulse to powerful effect in Europe, consistency demands that we must use the 6-month impulses in U.S. and China too. For the sceptics, the Chart of the Week should finally obliterate any lingering doubts. China's 6-month impulse gives a spookily perfect explanation for the industrial commodity inflation cycle. The important takeaway right now is that if the 6-month impulse is turning up, so will industrial commodity inflation. What Does All Of This Mean For Investors? This brings us to our central message. As we have just seen, an up-oscillation in 6-month impulses, especially in China, will lift industrial commodity inflation. But it will likely have a much smaller influence on developed market equities which, in these circumstances, will be under the strong constraining spell of higher bond yields. On this basis the asset allocation recommendation is to go long industrial commodities versus equities on a 6-month horizon (Chart I-6). Chart I-6Go Long Commodities Vs. Equities Interestingly, technical analysis also supports this recommendation over the next three months or so. Our tried and tested measure of excessive trending and groupthink suggests that the recent underperformance of industrial commodities relative to developed market equities is extreme and at a point which indicates a countertrend move, or at least a trend exhaustion (Chart I-7). Chart I-7The Underperformance Of Industrial Commodities Is Technically Stretched For currencies, the foregoing analysis and charts means it is time to take profits in our long position in the euro versus the Chinese yuan. This leaves us with a broadly neutral exposure to the euro, with a short position versus the yen counterbalancing a long position versus the dollar. As for European equities, many years ago they were a pure play on events in Europe. Today, this might still be true for European 'tail-events' such as the euro sovereign debt crisis, or a potential 'no deal' Brexit. However, for the most part, European equity markets are tightly integrated with global equity markets - at least in direction if not level. Given that industrial commodity inflation takes its cue from the 6-month credit impulse - especially in China - it is hardly surprising that the European basic materials sector follows exactly the same cycle, both in absolute terms (Chart I-8) and relative to the broader equity market (Chart I-9). Therefore the equity sector recommendation is to overweight basic materials versus the market. Chart I-8China's 6-Month Credit Impulse Drives Europe's Basic Material Equities In Absolute Terms... Chart I-9...And In Relative Terms Interestingly, there is also a play within the basic materials sector. The basic resources sector which represents the miners and extractors of raw materials should fare better than the chemicals sector which uses these raw materials as an input (Chart I-10). Hence, overweight basic resources versus chemicals. Chart I-10Overweight Basic Resources Vs. Chemicals Readers may argue that most of the foregoing charts illustrate the same cycle. But that's precisely the point! Never forget that financial markets follow the Pareto principle: the most important 20 percent of analysis explains 80 percent of the moves across all asset classes across all geographies across all times. The key to successful investing is to find the most important 20 percent of analysis. Dhaval Joshi, Senior Vice President Chief European Investment Strategist dhaval@bcaresearch.com 1 Please see the European Investment Strategy Weekly Reports 'Trapped: Have Equities Trapped Bonds?' September 13, 2018 and 'The Rule Of 4 For Equities And Bonds' August 2, 2018 available at eis.bcaresearch.com 2 Please see the European Investment Strategy Special Report 'The Cobweb Theory And Market Cycles' January 11, 2018 available at eis.bcaresearch.com Fractal Trading Model* It was a busy week for our trades. Long basic resources versus chemicals achieved its profit target, but short U.S. telecom versus U.S. autos hit its stop-loss. Meanwhile, short trade-weighted dollar reached the end of its 65 day holding period broadly flat. All three trades are now closed. In line with the main body of the report, this week's trade recommendation is to go long industrial commodities (represented by the CRB industrials index) versus equities (represented by the MSCI World Index in USD). The profit target is 2% 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 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 Fractal Trading Model Recommendations Equities Bond & Interest Rates Currency & Other Positions 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 Utilities stocks are the ultimate loser from a backup in interest rates as they serve as premier fixed income proxies in the equity space and we are compelled to trim exposure to below benchmark. The niche S&P utilities sector yields 3.5% and when the competing risk free asset is near 3.2% and rising, investors prefer to shed, at the margin, riskier high-yielding equities and park the proceeds in U.S. Treasurys (top and second panels). Apart from the tight inverse correlation utilities have with interest rates, they are also a defensive sector that outperforms the broad market when the economy is in retreat. Currently a plethora of recent economic releases are signaling that the U.S. economy is overheating. The bottom panel of our chart illustrates the safe haven status of utility stocks (ISM survey shown inverted). Despite the above, spiking natural gas prices and a supportive electricity demand backdrop from a roaring economy present risks to our view; rising interest rates and a vibrant U.S. economy should nevertheless overwhelm. Bottom Line: We downgraded the S&P utilities sector to underweight yesterday; please see yesterday's Weekly Report for more details.