Sectors

Neutral - Downgrade Alert The National Restaurant Association's Restaurant Performance Index (RPI), a measure of the industry's outlook, has spent most of the past decade above 100, indicating industry expansion (second panel). However, this has not translated into restaurant stock outperformance (top panel). On a rate of change basis (right side, second panel), the direction of the RPI offers better insight in the relative share price ratio movements. This metric has recently rolled over, sending a negative message. Restaurants have been continuously losing share of the consumer's wallet for the past two years, while food input costs have held mostly constant (third panel), suggesting industry margins are tightening. At the same time, construction spending has been steadily heading upward (bottom panel) at a time when employment costs (the largest industry input cost) have also been rising. This implication of lower returns on a higher capital base does not bode well for still reasonably expensive valuations. Bottom Line: We are adding a downgrade alert to our neutral recommendation on the S&P restaurants index. The ticker symbols for the stocks in this index are: BLBG: S5REST - MCD, SBUX, YUM, DRI, CMG.

Special Report

Feature The prospect of a 5S-Lega government in Italy is unnerving some analysts and commentators. Italy's sovereign debt-to-GDP ratio is already one of the highest in the world. A seemingly endless economic stagnation is constraining GDP, and now the populists are proposing policies that would increase the deficit, lifting sovereign debt even higher. Feature ChartFiscal Thrust Has Driven Italy's ##br##Growth In Recent Years The suggested cures to Italy's high sovereign debt-to-GDP ratio divide into two opposing camps. One camp - Italy's populists - wants to boost GDP, the ratio's denominator. The other camp - Brussels - wants to rein in sovereign debt, the ratio's numerator. Who's right? It is not a simple choice. Growth and debt are not independent variables. It is impossible to boost growth quickly without a positive credit impulse from some part of the economy. Equally, reducing government borrowing can have a devastating impact on growth (Chart I-2). Therefore, to resolve the conflict between Italy's populists and Brussels, we need to understand the specific relationship in Italy between government debt, GDP, and their interaction: the fiscal multiplier. Chart I-2The Fiscal Multiplier Is High ##br##When The Private Sector Or Banks Are Financially Unhealthy Italy Is Right, Brussels Is Wrong Imagine that government debt starts at 130 and GDP starts at 100. Imagine also that each unit of government borrowing to spend lifts GDP by one unit, meaning the fiscal multiplier equals one. Under these assumptions, three units of fiscal thrust would lift debt to 133 and lift GDP to 103, reducing the debt-to-GDP ratio to 129%. Conversely, three units of fiscal drag would reduce debt to 127 and reduce GDP to 97, paradoxically increasing the debt-to-GDP ratio to 131% and making the austerity strategy entirely counterproductive. Critics will snap back that these two assumptions appear inconsistent. When sovereign indebtedness is already high, at say 130% of GDP, it seems implausible that the fiscal multiplier could also be high: the government has already done its useful borrowing to spend and, at the margin, additional borrowing is likely to be 'fiscally irresponsible'. This criticism would be valid if the government was the only part of the economy that could borrow. But it isn't. Whether the fiscal multiplier is high or low also depends on what is happening in the private sector (Chart I-3). Chart I-3The Fiscal Multiplier Is Low ##br##When The Private Sector And Banks Are Financially Healthy Fiscal multipliers become very high when there is a breakdown in the ability of households and firms to borrow and/or a breakdown in the ability of banks to lend. After such a breakdown, credit flows to the private sector remain depressed however low (or negative) interest rates go. Specifically, this happens after a severe economic trauma when large numbers of households and firms are simultaneously repairing their badly damaged balance sheets and/or when banks are insolvent. If the one and only engine of demand - government spending - then cuts out, the economy can enter a prolonged stagnation. Under such conditions, thrift reinforces thrift: one unit of fiscal drag can trigger an additional private sector spending cut, magnifying the impact of the original cut. In other words, the fiscal multiplier can exceed one and reach a level as high as two according to several academic and empirical studies.1 During and immediately after the global financial crisis, fiscal multipliers surged. Through 2009-12, fiscal thrust had a very strong explanatory power for GDP growth; across 14 major economies, the regression slope of 1.5 confirms a high average fiscal multiplier. In other words, each unit of fiscal thrust boosted GDP by 1.5 units; and each unit of fiscal drag depressed GDP by 1.5 units.2 Another way to see this is to observe that in the global financial crisis the economies that had the largest fiscal thrusts tended to experience the least severe recessions. The annual fiscal thrust in the U.S., U.K. and France equalled 2% of GDP; in Spain it equalled 3%.3 By contrast, Germany and Italy had negligible fiscal thrusts, and they suffered the worst recessions. But by 2012, households and firms around the world were willing to borrow again, and banks were sufficiently recapitalised to lend. Hence, fiscal multipliers slumped: fiscal thrust no longer had any explanatory power for GDP growth (Charts I-4 - I-7). Chart I-4Post 2012: No Connection Between##br## Fiscal Thrust And Growth In The U.S. Chart I-5Post 2012: No Connection Between##br## Fiscal Thrust And Growth In The U.K. Chart I-6Post 2012: No Connection Between ##br##Fiscal Thrust And Growth In The Germany Chart I-7Post 2012: No Connection Between##br## Fiscal Thrust And Growth In The France There was one glaring exception to this trend: alas, poor Italy. Trapped in the EU's inflexible and misguided fiscal compact, and without an outright crisis, the Italian government could not recapitalise the dysfunctional banks. Although the solvency of the banks has improved in the past year, the evidence strongly suggests that fiscal thrust remains the main driver of the Italian economy (Feature Chart). On this evidence, the best economic policy for Italy right now is not to adhere slavishly to the misguided one-size-fits-all EU fiscal compact. The best policy is to use fiscal thrust intelligently to boost growth. We conclude that, on this specific point, Italy's populists are right and Brussels is wrong. Italy Needs Growth Italian BTPs offer a yield premium over German bunds as a compensation for two possible risks. One risk is a haircut or, more euphemistically, a 'restructuring'. But the likelihood of such a restructuring is very low. Putting aside the damage it would do to Italy's international standing, the simpler explanation is that it would kill the Italian banking system. As a rule of thumb, a bank's investors start to get nervous about its solvency when equity capital no longer covers its net non-performing loans (NPLs). In this regard, the largest Italian banks now have €165 billion of equity capital against €130 billion of NPLs, implying excess capital of €35 billion. The banks also hold around €350 billion of Italian government bonds (Chart I-8). Chart I-8Italian Banks Own 350 Billion Euro Of Italian Government Bonds So a mere 10% haircut on these BTPs could cripple the banking system and send the economy into a new tailspin. Meaning, it is in nobody's interest to restructure Italian bonds. The more likely risk to BTP holders - albeit still small - is redenomination out of the euro and into a reinstated lira. In which case the yield premium on BTPs ought to equal: (The likely loss on being paid in liras rather than deutschmarks) multiplied by (the annual probability of Italy leaving the euro) The first of these terms captures Italy's competitiveness shortfall versus Germany, which will change quite gradually. The second term captures a political risk, as leaving the euro would require a mandate from the Italian people. This means that the second term is very sensitive (inversely) to the popularity of the euro in Italy. It follows that a policy that kick starts growth and improves living standards - thereby boosting the popularity of the euro amongst the Italian people - is also a good policy for Italian bonds, banks, sustainable growth in Italy, and therefore for the euro itself. Bear in mind that Italy's structural deficit, at just 1%, is nowhere near the double-digit percentage levels that reliably signal the onset of a sovereign debt trap (Table I-1). Table I-1Italy's Structural Deficit Has Almost Disappeared Given Italy's high fiscal multiplier, we conclude once again that Italy's populists are right and Brussels is wrong. Some Investment Considerations Italian assets rallied strongly at the start of the year and certainly did not discount an election outcome in which the unlikely bedfellows 5S and La Lega formed a government. Therefore, from a technical perspective, the rally was extended and ripe for a pullback. A further consideration for Italy's MIB is that it is over-weighted to banks, so a sustained outperformance from the stock market requires a sustained outperformance from global banks, which we do not expect to start imminently. So in the near term, we prefer France's CAC to Italy's MIB. We have also opened a tactical pair-trade: long Poland's Warsaw General Index, short Italy's MIB. However, later this year, we expect both our credit impulse (cyclical) indicator and fractal dimension (technical) indicator to signal a better entry point into banks, into the Italian equity market and for BTP yield spread compression. Italy's structural deficit, at 1%, is amongst the lowest in the world, so Italy has plenty of 'fiscal space'. Moreover, fiscal stimulus can deliver bang for its buck because Italy appears to have a high fiscal multiplier. This differentiates Italy from other major economies, and makes the EU's one-size-fits-all fiscal compact entirely counterproductive for the euro area's third largest economy. This means that policies that push back against Brussels on this specific point might finally permit Italy to escape its decade-long growth trap. And therefore, somewhat paradoxically, they will enable the yield premium on 10-year Italian BTPs versus 10-year French OATs ultimately to compress. Dhaval Joshi, Senior Vice President Chief European Investment Strategist dhaval@bcaresearch.com 1 For example, please see: When Is The Government Spending Multiplier Large? Christiano, Eichenbaum and Rebelo, Northwestern University. 2 Even removing the outlier data point that is Greece, the best-fit line has a slope of 1.1. And the r-squared explanatory power remains significant at 0.5. 3 Through 2008-9.

Highlights China's industrial sector will continue decelerating, while consumer spending is so far booming. The world economy in general and EM in particular are exposed much more to China's industrial sector than to its consumer spending. The U.S. dollar will continue strengthening, regardless of the trend in U.S. bond yields. The reason is slowing global trade. The dollar rally and weakening global demand will ultimately lead to lower commodities prices. Stay put on / underweight EM financial markets. Turkey will need to hike interest rates more before a buying opportunity in its financial markets emerges. Feature The two key elements affecting the performance of EM financial markets are the U.S. dollar and commodities prices. The combination of a weak U.S. dollar and higher commodities prices is typically bullish for EM. The opposite also holds true: A strong dollar and lower commodities prices are bearish for EM. But what about the recent dynamics - the rally in the greenback and strong commodities prices? This combination is unlikely to be sustained. Historically, the divergence between the dollar's exchange rate and commodities prices has never lasted long (Chart I-1). The fundamental linkage between the U.S. dollar and commodities prices is global growth: improving global growth is positive for resource prices, and the U.S. currency has historically been negatively correlated with global trade - the trade-weighted dollar is shown inverted in this chart (Chart I-2). Chart I-1Commodities And The Dollar Chart I-2Global Growth And The Dollar Hence, if global growth stays strong, the U.S. dollar will pare its recent gains and commodities prices will stay well-bid. Conversely, if global trade decelerates commodities prices will inevitably have to change direction. We expect the dollar to stay well-bid because the current phase of dollar rally will at some point be followed by a second phase where the greenback's strength is driven by a slowdown in global trade. In this phase, commodities prices and U.S. bond yields will drop alongside a strengthening U.S. dollar. Weaker growth in China and in other EMs is the key reason we expect global trade volumes to slow. Is China Slowing? Making sense of growth conditions in China is never easy, but it is particularly confusing these days. We maintain that there is growing evidence that China's industrial segment is slowing and will continue doing so, yet consumer spending is still booming. The basis for the industrial slowdown is a deceleration in both money and credit growth, which has been taking place over the past 18 months or so. With respect to households, the borrowing binge continues. The unrelenting 20%+ annual growth in household credit continues to fuel the property bubble. In turn, a rising wealth effect from real estate as well as decent income growth are the underpinnings behind the booming consumer sector. The main and relevant point for investors from the perspective of China's impact on broader EM is as follows: the drop in the credit and fiscal impulse is heralding a deceleration in capital expenditures/construction. That, in turn, will lead to fewer imports of commodities and materials. Imports are the main transmission mechanism from China's economy to the rest of the world. Mainland imports in RMB terms have indeed decelerated meaningfully, yet import values in U.S. dollar terms have not (Chart I-3). So, what explains the recent gap between imports in yuan and dollar terms? The RMB's rally versus the U.S. dollar in the past 15 months has been responsible for this gap between import values. As one would expect, the spending power of mainland industrial companies has moderated because less credit and fiscal expenditures are being injected into the system (Chart I-4). Yet because the RMB now buys 10% more U.S. dollars than it did a year ago, mainland buyers' purchasing power of foreign goods that are priced in dollars has improved. As a result, the pace of growth of the value of U.S. dollar imports has remained buoyant. Chart I-3Chinese Imports In RMB & USD Terms Chart I-4Weaker Purchasing Power ##br##In China Will Hurt Imports If the RMB's exchange rate versus the dollar remains flat over the next 12 months, the growth rates of both imports in RMB and dollar terms will converge. In this case, a further slowdown in import spending in RMB terms will translate into considerable deceleration in mainland imports in U.S. dollar terms. In brief, the exchange rate is important because the U.S. dollar's depreciation versus the RMB since January 2017 has prevented the spillover from a slowdown in China's imports in local currency terms to the rest of the world in general and EM in particular. Chart I-5Goods And Services Imports: China And U.S. If and as the dollar continues to rally versus the majority of currencies, China could allow its currency to slip versus the greenback to assure a flat trade-weighted exchange rate and preserve its competitiveness. In such a scenario, China's purchasing power of goods and services from the rest of world will be impaired - which in turn means this economy will be remitting fewer dollars to the rest of the world. This will reduce the flow of U.S. dollars from China to EMs, adversely impacting the latter's financial markets and economies. Chart I-5 illustrates that China's imports of goods and services amount to $2.3 trillion compared with U.S. imports of goods and services of $3.1 trillion. Therefore, in terms of importance in global imports, China is not too far behind America. This holds true with respect to remitting dollars to the rest of the world. Provided that China imports more from EM - both from Asian manufacturing economies and commodities producers - than the U.S. does, then less mainland imports will entail fewer dollars flowing to EM. In short, the continued slowdown in China's purchasing power in U.S. dollar terms will negatively affect the rest of EM. This rests on our baseline view that mainland credit growth will continue slowing and the RMB will weaken against the dollar, albeit modestly for now. Mirroring the divergence between industrial sectors and consumers in the Middle Kingdom, there has been an equally clear divergence within imports: Imports of industrial supplies excluding machinery have slumped, while imports of household goods have continued to flourish. Chart I-6 demonstrates that imports have decelerated for base metals, chemicals, wood, mineral products and rubber. Even oil and petroleum products imports have slowed (Chart I-7). Yet imports of consumer goods are roaring (Chart I-8). Chart I-6China: Industrial Imports Are Slowing Chart I-7Chinese Fuel Imports Are Slowing Chart I-8Chinese Consumer Goods Imports Are Robust Which one is more important for EM: the industrial sector or consumer spending? Many developing economies in Latin America, Africa, the Middle East as well as countries such as Russia, Indonesia and Malaysia are very dependent on their commodities exports. These economies do not benefit much from booming Chinese consumers. For them, the critical variable is the mainland's industrial sector and its absorption of minerals and resources. In terms of size, Table I-1 illustrates that non-food commodities, industrial goods, machinery, equipment and transportation make up overwhelming majority of China's total imports. Meanwhile, consumer goods imports, excluding autos, comprise 15% of total imports. Hence, their impact on the rest of the world is small. Table I-1Structure Of Chinese Imports Further, most of consumer goods that households in China consume are produced locally rather than imported. That is why the world economy at large and EM in particular are more exposed to the mainland's industrial sector than its consumer one. Aside from imports, there are several other variables that validate our thesis of an ongoing slowdown in China's industrial sector. In particular: Total floor space sold (residential plus non-residential) has rolled over, heralding weakness in floor space started and, eventually, construction activity (Chart I-9). Growth rates of total freight traffic, diesel consumption, electricity and plate glass output have slumped (Chart I-10). Chart I-9Slowdown In Chinese Real Estate Chart I-10China: Industrial Economy Is Weakening Nominal manufacturing production is decelerating in response to a weaker broad money impulse (Chart I-11). The Komatsu Komtrax index - which measures average hours of machine use per unit of construction equipment (excluding mining equipment) - has begun contracting (Chart I-12). Chart I-11China: Downside Risks In Manufacturing Chart I-12China: Sign Of Construction Slump Even though China's spending on tech products has been vibrant, the global semiconductor cycle - a harbinger of overall tech industry growth - is clearly downshifting as evidenced by declining semiconductor prices (Chart I-13). Finally, narrow money (M1) growth has historically correlated with Chinese H-share prices, and is currently pointing to considerable downside risk for Chinese equity prices (Chart I-14). Chart I-13Semiconductor Prices Are Falling Chart I-14Chinese Share Prices Are At Risk Bottom Line: China's industrial sector has been decelerating, a trend that will persist. Meanwhile, consumer spending is so far booming. The former is more important to the rest of the world in general and EM in particular than the latter. EM Selloff: Two Phases While it is impossible to forecast the timing and character of market dynamics and mini-cycles with precision, our assessment is that two phases of an EM selloff are likely. Phase 1: A relapse in EM financial markets occurs on the back of rising U.S. bond yields, a strong dollar, amid resilient commodities prices. This phase is currently underway. Phase 2: U.S. bond yields peter out and drift lower, yet the U.S. dollar continues to firm up, commodities prices relapse and the EM selloff progresses. This stage has not yet commenced. The driving force behind these dynamics would be slower global demand growth emanating from China and spreading to other developing countries. In between Phases 1 and 2, it is possible that EM will stage a temporary rebound. Yet the duration and magnitude of such a rebound are impossible to gauge. Because of its transient nature, barring precise timing, the rebound will be very difficult to play profitably. It is not impossible to envision that the escalating turmoil in EM financial markets could at some point lead the Federal Reserve to sound less hawkish. That could mark a top in U.S. bond yields. In such a scenario, will a peak in U.S. bond yields mark a bottom in EM currencies? It may do so temporarily, but the sustainability of a rally in EM currencies and risk assets would be contingent on global growth in general and commodities prices in particular. Chart I-15An Unsustainable Rebound ##br##In EM Stocks In 2014 As a matter of fact, a similar two-phase selloff with a rebound in between occurred in 2013-'15. Chart I-15 illustrates that EM currencies and stocks staged a short-lived rebound after U.S. bond yields peaked in late 2013. Yet this rally proved transient. The underlying impetus behind the resumption in the EM downtrend back in 2014-'15 was weakening growth in China, falling commodities prices and poor domestic fundamentals. Similar to the 2013-'15 episode, any rebound in EM risk assets resulting from lower U.S. bond yields will likely be fleeting if commodities prices drop, the dollar continues to firm up and global growth disappoints. To sum up, a potential rollover in U.S. bond yields in the coming months will not automatically entail an ultimate bottom in EM risk assets. Trends in global growth - particularly in China - and commodities prices will be critical to the outlook for EM. As per our themes and discussion above, we maintain that China's industrial growth and construction will surprise on the downside. Consequently, China's commodities imports will moderate, which will weigh on commodities prices. In the interim, weak global trade dynamics stemming from EM/China will benefit the dollar, which is a countercyclical currency. Bottom Line: The U.S. dollar will continue strengthening regardless of the trend in U.S. bond yields because of slowing global trade. The dollar rally and weakening global demand will ultimately lead to lower commodities prices. EM financial markets will remain under selling pressure as long as global growth continues slowing. EM Foreign Funding Vulnerability Ranking Which countries are most exposed to lower foreign funding? Chart I-16 presents ranking of EM countries based on foreign funding requirements. The latter is calculated as the current account balance plus foreign debt that is due in the coming months. Chart I-16Vulnerability Ranking: Dependence On Foreign Funding Turkey, Malaysia, Peru and Chile have the heaviest foreign funding requirements in the next six months. Mostly, these stem from foreign debt obligations by their banks and companies. Even though most companies and banks with foreign debt will not default, their credit spreads will likely widen. The basis for this is depreciating currencies will make their foreign debt liabilities more expensive to service. Besides, as these debtors allocate more resources to service foreign debt, their spending will be negatively impacted and their domestic economies will weaken. Investment Conclusions Chart I-17Downside Risks In EM Share prices The dollar's strength will be lasting. Stay short a basket of select currencies such as the BRL, TRY, ZAR, CLP, IDR, KRW and MYR versus the U.S. dollar. For portfolios that need to overweight some EM currencies relative to the rest, our favorites are MXN, RUB, PLN, CZK, TWD, THB and SGD. CNY will for now modestly weaken versus the dollar but outperform many other EM peers. The biggest risk to the U.S. dollar in our opinion is the Trump administration's preference for a weaker greenback. Therefore, "open-mouth" operations by the U.S. administration to weaken the dollar are possible, and the dollar could experience temporary setbacks. Yet the path of least resistance for the dollar remains up, for now. There is considerable downside in EM share prices. Stay put and underweight EM versus DM in general and the S&P 500 in particular. Chart I-17 illustrates that rising EM sovereign bond yields and U.S. corporate bond yields (both shown inverted on the chart) herald a further selloff in EM stocks. Our equity overweights are Taiwan, Korea, Thailand, India, central Europe, Chile and Mexico, and our underweights are Brazil, Turkey, South Africa, Peru, Malaysia and Indonesia. For fixed-income investors, defensive positioning is warranted. As EM currencies continue to depreciate, sovereign and corporate credit spreads will widen further. Credit portfolios should continue underweighting EM sovereign and corporate credit relative U.S./DM corporate credit. Foreign holdings of EM local currency bonds remain massive. EM currency depreciation versus DM currencies will erode returns for foreign investors and could spur some bond selling, exerting upward pressure on local yields as well.1 Arthur Budaghyan, Senior Vice President Emerging Markets Strategy arthurb@bcaresearch.com Turkey: Is The Worst Over? After having dropped 30% in U.S. dollar terms since their peak in late January, Turkish equity prices are beginning to look depressed, begging the question whether a buying opportunity is in the cards. Our assessment is as follows: the nation's financial markets are not yet at the point to warrant an upgrade (Chart II-1). Judgment on Turkish markets is contingent on three questions: Has the lira become cheap? Are real interest rates sufficiently high to depress domestic demand and reduce inflationary pressures? Are equity valuations cheap enough to warrant buying despite the poor cyclical profit outlook? First, the lira needs to get cheaper. Our favorite measure of currency valuation is the real effective exchange rate based on unit labor costs. This takes into account both wages and productivity. Hence, it gauges competitiveness much better than the measures of real effective exchange rate based on consumer and producer prices. Using this measure, as of May 23 the lira is one standard deviations below its historical mean (Chart II-2). For it to reach one-and-half or two standard deviations below its fair value, it would roughly take another 10%-20% depreciation, versus an equal-weighted basket of the dollar and euro. Chart II-1Turkish Financial Markets ##br##Have More Downside Chart II-2The Turkish Lira Is Not That Cheap Second, in regard to monetary policy, our view is that it would take an increase of around 200-250bps in the policy rate in addition to yesterday's hike of 300bps to stabilize financial markets. Core inflation will likely rise to at least 14-15% from the current level of 12% in response to the ongoing currency depreciation. With the effective policy rate (the late liquidity window rate) now at 16.5%, another 200-250 basis points hike would push the nominal rates to 18.5-19% and real policy rate to 3.5-4%, a minimum level that is likely required to depress excessive domestic demand growth. Finally, equity valuations are reasonably appealing but not cheap enough to put a floor under share prices given the outlook for contracting corporate and bank profits. Chart II-3 demonstrates that the cyclically-adjusted P/E (CAPE) ratio for Turkish stocks is now about 6, compared with the historical average of 8. Although this bourse is already one standard deviation cheap, the outlook for profit recession likely warrants even lower valuation to justify buying. Chart II-3Turkish Equities Could Get Cheaper An approximate 20% drop in share prices in local currency terms will bring the CAPE to 4.8, one-and-half standard deviation below the fair value. On the whole, an additional 15% depreciation in the lira versus an equal-weighted basket of the dollar and euro, in combination with 200-250 basis points hike in the policy rate, and a 20% drop in share prices in local currency terms will likely create a buying opportunity in Turkish financial markets. That said, it is doubtful whether there is the political will - to tolerate another 15% drop in the currency from current levels or more tightening in monetary conditions in the very near run ahead of the upcoming June parliamentary elections. Given the authorities' tolerance for higher borrowing costs is low, investors should not rule out the potential for capital controls to be imposed. In fact, to protect assets against possible capital control, we would recommend investors who are short to consider booking profits if the exchange rate surpasses 5 USDTRY in a rapid manner. Our open directional trades at the moment remain: Short Turkish bank stocks Short TRY / long USD Non-dedicated long-only investors should for now stay clear of Turkish financial markets. As to dedicated EM equity and fixed income portfolios (both credit and local currency bonds), we continue recommending underweight positions in Turkey. Stephan Gabillard, Senior Analyst stephang@bcaresearch.com 1 We discussed EM currencies and bonds in details in May 10, 2018; the link is available on page 19. Equity Recommendations Fixed-Income, Credit And Currency Recommendations

Telecom services stocks rallied Tuesday, following positive news coming out of VZ's sellside analyst presentation. The mood was generous enough that our high-conviction underweight recommendation was stopped out at a 10% relative return.1 We are accordingly compelled to remove the S&P telecom services index from our high-conviction list for an impressive relative gain of 10% in the three months since we initiated the trade.2 Still, our bearish thesis remains unchanged: A combination of still-contracting pricing power weighing on earnings (second panel) and higher Treasury yields (which are negatively correlated with high-dividend yielding telecom services stocks, top panel) should keep relative performance suppressed. Valuations have fallen significantly (the reason we added the stop in the first place, bottom panel) but we think the industry is in a de-rating phase, implying the new valuation paradigm has a degree of permanence. Bottom Line: Stay underweight the telecom services index but remove it from the high-conviction list. The ticker symbols for the stocks in this index are: BLBG: S5TELS - T, VZ, CTL. 1 Please see BCA U.S. Equity Strategy Insight Report, "Merger Mania Keeps The Telco Bears Happy," dated May 11, 2018, available at uses.bcaresearch.com. 2 Please see BCA U.S. Equity Strategy Weekly Report, "Manic-Depressive?" dated February 12, 2018, available at uses.bcaresearch.com.

Special Report

Feature Chart I-1Recent Defaults Have Focused Attention ##br##On Corporate Health The recent spike in defaults on bonds and loans in China, including missed debt repayments by local government financing vehicles (LGFV) and some listed companies, has unsettled investors over the past few weeks.1 The yield spread between 5-year government bonds and 5-year corporate bonds AA minus in China's domestic bond market, has recently hit their widest level in nearly two years (Chart I-1). As a result, some investors are concerned about the possibility of widespread defaults as the Chinese government's deleveraging campaign continues to roll out, and sweeping new rules on shadow banking take effect. Given the report focus on corporate health, this week we are updating our China Industry Watch thematic chartpack to present a visual presentation of the changing situation in China's corporate sector, and its relevance to the broader stock market performance. Overall, the Chinese corporate sector has continued to deleverage and its financial situation has improved modestly. Our Corporate Health Monitor (CHM),2 which is an equally weighted average of net income margin, return on capital, EBIT-to-debt ratio, debt-to-asset ratio and interest coverage ratio, shows that the health of most sectors are improving. Specifically, for steel, construction materials, automobile, food& beverage and tech, our CHMs are in healthy territory. For oil & gas, coal, non-ferrous metals and machinery, CHMs are still below zero but are recovering. In terms of profit growth, it has remained robust for most of the sectors shown in the report. In particular, profit growth has accelerated substantially in the coal and steel sectors, as higher selling prices helped offset the impact of production constraints on revenue and aggressive cost cutting increased gross margins. Firms in the energy sector have also enjoyed higher profit growth as oil prices rebounded. In terms of the leverage picture, the liabilities-to-assets ratio has continued to decline broadly across sectors (Chart I-2). However, in regards of debt sustainability, the interest-to-sales ratio has increased substantially in coal, steel, and non-ferrous sectors, due to dramatic decline in sales resulting from production constraints. The interest coverage ratio in these sector is less problematic because of improving gross margins. For the tech sector, however, there has been a spike in the interest-to-sales ratio and a sharp decline in interest coverage. Looking beyond the fairly broad-based improvement in our overall non-financial CHM, we doubt that a broad-based default wave will occur in response to the crackdown on shadow banking. First, by our estimation, the recent defaults cited above account for only 0.09% of outstanding corporate bonds. Second, the latest PBOC monetary report changed the tone from emphasizing "deleveraging" to "stabilizing leverage and restructuring", which shows that regulators are as concerned about the stability of the economy as they are about reducing excessive debts. One problem that is worth monitoring is the negative trend in overall industrial enterprises sales, which had a negative growth rate in Q1 relative to the same quarter last year. Part of this negative growth rate is likely due to base effects, given that Q1 2017 itself was abnormally strong. Nevertheless, comparing first three month of the sales this year to that of previous years, it is clear that 2018's value did not reflect an uptrend in the data (Chart I-3). This weak top line performance is somewhat worrisome and we will continue to watch for signs of a further slowdown. Chart I-2A Continued Decline In Debt-To-Assets Chart I-3Tepid Topline Growth Is Worrisome Lin Xiang, Research Analyst linx@bcaresearch.com Jonathan LaBerge, CFA, Vice President Special Reports jonathanl@bcaresearch.com BCA China Industry Watch includes four categories of financial ratios to monitor a sector's leverage, profitability, growth and efficiency, respectively. Some of these ratios, as shown in Table 1, are slightly tweaked from conventional definitions due to data availability. The financial data in our exercise are from the official statistics on overall industrial firms, of which the listed companies are a subset, but most financial ratios based on the two sets of data are very similar, especially for the heavy industries that dominate the Chinese stock markets - both onshore and offshore. The financial ratios on leverage, growth and profitability are almost identical for some sectors, while some other sectors that are not well represented in the stock market, such as technology, healthcare and consumer sectors, show notable divergences. As the Chinese equity universe continues to expand, we expect that the two sets of data will increasingly converge. Table 1The China Industry Watch 1 More than 10 companies, several of them listed, from a variety of industries have defaulted on 17 bonds worth more than 16.5 billion yuan (US$2.6 billion), according to figures from Choice. 2 Please see China Investment Strategy Special Report, “Introducing The BCA China Industry Watch,” dated February 10, 2016, available at cis.bcaresearch.com. Appendix: China Industry Watch All Firms Chart II-1Non-Financial Firms: Stock Price & Valuation Indicators Chart II-2Non-Financial Firms: Relative Performance Of Valuation Indicators Chart II-3Non-Financial Firms: Leverage Indicators Chart II-4Non-Financial Firms: Growth Indicators Chart II-5Non-Financial Firms: Profitability Indicators Chart II-6Non-Financial Firms: Efficiency Indicators Oil & Gas Sector Chart II-7Oil&Gas Sector: Stock Price & Valuation Indicators Chart II-8Oil&Gas Sector: Relative Performance Of Valuation Indicators Chart II-9Oil&Gas Sector: Leverage Indicators Chart II-10Oil&Gas Sector: Growth Indicators Chart II-11Oil&Gas Sector: Profitability Indicators Chart II-12Oil&Gas Sector: Efficiency Indicators Coal Sector Chart II-13Coal Sector: Stock Price & Valuation Indicators Chart II-14Coal Sector: Relative Performance Of Valuation Indicators Chart II-15Coal Sector: Leverage Indicators Chart II-16Coal Sector: Growth Indicators Chart II-17Coal Sector: Profitability Indicators Chart II-18Coal Sector: Efficiency Indicators Steel Sector Chart II-19Steel Sector: Stock Price & Valuation Indicators Chart II-20Steel Sector: Relative Performance Of Valuation Indicators Chart II-21Steel Sector: Leverage Indicators Chart II-22Steel Sector: Growth Indicators Chart II-23Steel Sector: Profitability Indicators Chart II-24Steel Sector: Efficiency Indicators Non Ferrous Metals Sector Chart II-25Non Ferrous Metals Sector: Stock Price & Valuation Indicators Chart II-26Non Ferrous Metals Sector: Relative Performance Of Valuation Indicators Chart II-27Non Ferrous Metals Sector: Leverage Indicators Chart II-28Non Ferrous Metals Sector: Growth Indicators Chart II-29Non Ferrous Metals Sector: Profitability Indicators Chart II-30Non Ferrous Metals Sector: Efficiency Indicators Construction Material Sector Chart II-31Construction Material Sector: Stock Price & Valuation Indicators Chart II-32Construction Material Sector: Relative Performance Of Valuation Indicators Chart II-33Construction Material Sector: Leverage Indicators Chart II-34Construction Material Sector: Growth Indicators Chart II-35Construction Material Sector: Profitability Indicators Chart II-36Construction Material Sector: Efficiency Indicators Machinery Sector Chart III-37Machinery Sector: Stock Price & Valuation Indicators Chart III-38Machinery Sector: Relative Performance Of Valuation Indicators Chart III-39Machinery Sector: Leverage Indicators Chart III-40Machinery Sector: Growth Indicators Chart III-41Machinery Sector: Profitability Indicators Chart III-42Machinery Sector: Efficiency Indicators Automobile Sector Chart III-43Automobile Sector: Stock Price & Valuation Indicators Chart III-44Automobile Sector: Relative Performance Of Valuation Indicators Chart III-45Automobile Sector: Leverage Indicators Chart III-46Automobile Sector: Growth Indicators Chart III-47Automobile Sector: Profitability Indicators Chart III-48Automobile Sector: Efficiency Indicators Food & Beverage Sector Chart III-49Food&Beverage Sector: Stock Price & Valuation Indicators Chart III-50Food&Beverage Sector: Relative Performance Of Valuation Indicators Chart III-51Food&Beverage Sector: Leverage Indicators Chart III-52Food&Beverage Sector: Growth Indicators Chart III-53Food&Beverage Sector: Profitability Indicators Chart III-54Food&Beverage Sector: Efficiency Indicators Information Technology Sector Chart III-55Information Technology Sector: Stock Price & Valuation Indicators Chart III-56Information Technology Sector: Relative Performance Of Valuation Indicators Chart III-57Information Technology Sector: Leverage Indicators Chart III-58Information Technology Sector: Growth Indicators Chart III-59Information Technology Sector: Profitability Indicators Chart III-60Information Technology Sector: Efficiency Indicators Utilities Sector Chart III-61Utilities Sector: Stock Price & Valuation Indicators Chart III-62Utilities Sector: Relative Performance Of Valuation Indicators Chart III-63Utilities Sector: Leverage Indicators Chart III-64Utilities Sector: Growth Indicators Chart III-65Utilities Sector: Profitability Indicators Chart III-66Utilities Sector: Efficiency Indicators Cyclical Investment Stance Equity Sector Recommendations

Special Report

As with all bull markets, the question on investors' minds has never been if it would end but when it will end as the former is a certainty and the latter is the source of alpha. We have previously noted that by almost all measures, this is the longest bull market in history1 and, with its age starting to show, it is time to focus on late-cycle dynamics. Our preferred leading indicator for declines in U.S. equity markets has been the ISM manufacturing composite index. The ISM has, despite a few false positives, led both recessions and S&P 500 troughs with remarkable accuracy (Chart 1). Chart 1Our Preferred Leading Indicator When gains in the S&P 500 are broken into their respective components, it becomes apparent that the ISM is a strong predictor of both sentiment, as measured by changes in the valuation multiple (Chart 2), as well as profit prospects, as measured by earnings growth (Chart 3). Chart 2ISM Leads Valuation... Chart 3...And Earnings Still, valuations and earnings eventually, and invariably, converge, usually explosively so in a recession. Accordingly, measuring the ISM's lead time should provide some insight into the duration of the economic expansion as well as appropriate sector allocation. In our last Weekly Report,2 we examined how in the late/later stages of economic expansion, banks, representing a prototypical early-cyclical sector, underperformed the broad market. In this report, we are broadening the analysis to all of the GICS1 sectors of the S&P 500. Timing Is Everything We begin our analysis by examining the duration of leads between the cyclical peak of the ISM and the end of economic expansion (i.e. the start of recession as defined by the NBER) going back to the 1960s with our results summarized in Table 1. These results are somewhat unhelpful as the durations range from as short as 8 months at the beginning of the 1980s to more than 3 years, as in the period preceding the Great Recession. With the hypothesis in mind that the market would have sniffed out a recession before economic activity actually began to contract, we split the duration into two periods: the time between the peak of the ISM and the peak of the S&P 500 and the time between the peak of the S&P 500 and the beginning of the recession (Table 2). While the duration inconsistency between iterations argues against using this data to forecast the longevity of an equity bull market, a closer examination of the periods yields a key insight: The duration of the blow off phase of the bull market is on average more than three times longer than the fall before the recession. Table 1ISM Peak To Recession Table 2Late Cycle Can Be Split in Two Phases Still, the purpose of this report is not to estimate the length of time between the most recent ISM peak (March, 2018) and recession; as shown above, such an exercise would be meaningless as history has never rhymed in this regard. Rather, this Special Report should offer a portfolio allocation roadmap if, as we believe, the ISM has peaked but the S&P 500 has yet to see its cyclical highs.3 Riding The Wave Chart 4S&P 500 Cycle-On-Cycle Returns Chart 4 shows a cycle-on-cycle analysis of S&P 500 returns in the periods between the peak of the ISM and the beginning of the recession, across the seven iterations since the 1960's. This chart requires some explanation; because the time frames between ISM peak and recession vary so substantially per iteration, we have segmented each period into eight parts. Each part can represent a time frame as short as one or as long as eight months; what matters is the direction of the market, not the time frame. We have overlaid this cycle-on-cycle chart with the S&P 500, indexed to 0 at the most recent ISM peak in March of this year. It is worth qualifying that the S&P 500 peaked before the ISM in two of the seven iterations we have examined and, by overlaying the year-to-date S&P 500 over this curve, we are explicitly stating that we expect the S&P 500 peak in the current cycle to follow the peak in the ISM, as happened in five iterations, including the most recent three (please refer to our recent publication where we lifted our SPX peak target to 32004). Despite the machinations in creating Chart 4, the pattern is remarkably consistent; the S&P 500 falls modestly after the ISM peaks but then delivers one last hurrah, before the end of the cycle. Once again, however, the trick to securing the excess returns earned in the fat times is timing, as the fall after the S&P 500 peak is precipitous. Further, given the much shorter time frame on the back end of the curve, haste is of the essence. Sector Winners & Losers As shown in Table 3, the average return of the S&P 500 from the peak of the ISM to the beginning of the recession is a fairly modest 6.7% (non-compounded). That return appears even more modest in the context of an average 25 month duration. When the returns are split into the periods before and after the peak of the S&P 500, the 25% gain before the peak and the 12% decline after (Tables 4 and 5) are more significant and underscore the role of timing for capital preservation in the late cycle. Table 3Health Care Outperforms In The Late Cycle Table 4High Beta Stocks Outperform Early... Table 5...Defensive Stocks Beat Late The top performers in the first phase of the late cycle equity market surge are some of the highest beta sectors, including energy and technology. Also, unsurprisingly, these sectors have performed poorly in the latter phase we examined when the market slides toward recession. Still, we would highlight the S&P energy index as a portfolio overweight in the late cycle. Energy has historically been the top performer from the peak of the ISM to the peak of the S&P 500 and, while it is a sub-par performer in the latter stages, it continues to outperform the falling broad market. Further, energy registered relative performance gains in every iteration we examined and was the only sector to consistently repeat its performance, positive or negative. The current iteration of the late cycle should probably see stellar returns in this sector as crude oil prices have only recently broken out, a pattern that has repeated following other ISM peaks (Chart 5); BCA's Commodity & Energy Strategy expects this trend to continue in 2018. As such, the nascent turnaround in sector performance (Chart 6) should have long legs; we reiterate our high-conviction overweight in this deep cyclical sector. Chart 5Oil And ISM Move In Sync... Chart 6...And So Do Energy Equities Another interesting insight from this research is the strong performance of the S&P health care sector in both phases we examined (Chart 7). This is largely due to the high-beta biotech sub-sector outperforming early (Chart 8) with the more defensive managed health care and pharma sub-indexes sustaining the outperformance following the SPX peak (Chart 9). Chart 7Health Care Is A Resilient Late Cycle Performer Chart 8Biotech Leads Early In light of this research and given recent pricing power developments, we are adding an upgrade alert to the pharma and biotech groups and thus to the broad S&P health care index. The ticker symbols for the stocks in these indexes are: BLBG: S5BIOT - ABBV, AMGN, GILD,CELG, BIIB, VRTX, ALXN, REGN, INCY and BLBG: S5PHAR - JNJ, PFE, MRK, BMY, LLY, AGN, ZTS, MYL, NKTR, PRGO. Chart 9...While Pharma Outperforms Late Stay Cyclical (For Now) The current backdrop of a Fed that seems likely to be permissive of an inflation overshoot (or at least not too hawkish), combined with a strong domestic fiscal thrust in the form of tax cuts and a potential infrastructure bill, supports our thesis that, despite being past the peak of the ISM, the S&P 500 has not yet seen its best days. Accordingly, the upshot of our analysis is that it pays to maintain a cyclical portfolio bent to capture the most lucrative phase of the bull market. This is reflected in our overall portfolio allocation; we note that the top and bottom performers in this analysis (S&P energy and S&P telecom services, Table 3) are overweight and underweight, respectively, on our high conviction list. Still, our upgrade alerts in the health care sector should stand as a caution to readers that we are prepared to reduce beta in our portfolio allocation should our other leading indicators flash yellow. For now, however, we continue to believe the odds of recession are close to nil on a 9-12 month horizon and, accordingly, remain positive on the broad market's prospects with a cyclical portfolio allocation over defensive. Chris Bowes, Associate Editor chrisb@bcaresearch.com 1 Please see BCA U.S. Equity Strategy Weekly Report, "Sector Winners & Losers When Fiscal Easing Offsets Monetary Tightening," dated April 16, 2018, available at uses.bcaresearch.com. 2 Please see BCA U.S. Equity Strategy Weekly Report, "Resilient," dated May 14, 2018, available at uses.bcaresearch.com. 3 Please see BCA U.S. Equity Strategy Weekly Report, "Lifting SPX Target," dated April 30, 2018, available at uses.bcaresearch.com. 4 Ibid.

Underweight While we continue to recommend a core portfolio overweight in the S&P financials index, the S&P insurance sub-index remains our sole underweight. Unlike its financials brethren, the insurance industry is defensive rather than cyclical and thrives when the economy is slowing. Currently, the U.S. and global economies are expanding above trend and, under such a backdrop, investors have historically avoided insurance equities. The top panel of our chart drives this point home. Over the past four decades the greenback and relative share prices have been positively correlated. The U.S. dollar peaked in December 2016 and since then it has been goosing global output, and simultaneously weighing on insurance stocks. Similarly, a rising 10-year Treasury yield reflecting improving economic growth also anchors insurance stocks (10-year Treasury yield shown inverted, second panel). While higher interest rates are positive for investment portfolio income, they also imply mark-to-market losses on bond portfolios. Higher interest rates also incent insurers to underwrite at a faster pace with more lenient standards, which is often a precursor to increased competition and diminishing pricing power, eventually sapping profits. Bottom Line: We reiterate our underweight stance in the S&P insurance index. The ticker symbols for the stocks in this index are: BLBG: S5INSU - AIG, CB, MET, MMC, PRU, TRV, AFL, AON, ALL, PGR, WLTW, HIG, PFG, L, CINF, LNC, XL, AJG, UNM, TMK, AIZ, RE, BHF.

Underweight - Upgrade Alert Homebuilders took another beating this week, and it seems as if they cannot catch a break. While the latest NAHB sentiment survey reflected homebuilder optimism, survey participants acknowledged that spiking building material costs are now hurting profitability (lumber prices shown inverted, middle panel). Tack on the recent jump in the 10-year Treasury yield that also pushed the 30-year fixed mortgage rate significantly higher and first time home buyers are, at the margin, getting priced out of the new home market (interest rates shown inverted, top panel). When we recently put the S&P homebuilding index on upgrade alert, we thought most of the bad news was already priced into deflated prices and valuations. However, persistent input cost inflation pressures coupled with additional interest rate increases suggest that patience is warranted before crystalizing relative gains to the tune of 25% since our late-November inception. Worrisomely, long-term EPS euphoria pushing 30%, or twice the rate of the SPX, has hit a level that typically marks relative share price tops, not troughs (bottom panel). We would lean against such exuberance and wait for another breakdown in relative share prices before acting on our upgrade alert. Bottom Line: Shy away from homebuilders for now, but stay tuned. The ticker symbols for the stocks in this index are: BLBG: S5HOME - DHI, LEN, PHM.

Highlights An examination of the three pillars of China's economy provides an unambiguous signal that a slowdown is underway. This would normally warrant, at most, a neutral allocation to Chinese stocks, but several factors argue against cutting exposure for now. Stay overweight, but with a short leash. Recent changes in the BCA China Investable Sector Alpha Portfolio's recommended allocation have validated two of our recent investment recommendations. In addition, the model is providing a curiously bullish signal about the relative performance of Chinese vs global stocks that heightens our reluctance to reduce Chinese equity exposure. Our China Reform Monitor signals that investors do not view the current pace of structural reforms as being overly burdensome for the economy. In addition, while Chinese policymakers have made some significant gains in improving China's air quality over the past 18 months, these changes have mostly occurred from a near-hazardous starting point (suggesting that more progress will be needed). As such, we recommend that investors stick with our long ESG leaders / short investable benchmark trade over the coming year. Feature Global investor sentiment improved modestly on Monday, in response to statements from President Trump indicating a possible détente between the U.S. and China on the issue of trade. In particular, Mr. Trump signaled a willingness to assist ZTE, a Chinese telecommunications equipment maker, whose operations would have been enormously impacted by the U.S. Commerce Department's decision last month to ban American companies from selling to the firm. In the view of our Geopolitical Strategy Service, announcements like these should be viewed as marginally positive developments within the context of a serious downtrend in U.S./China relations. Investors appear to be eager to respond to positive news about waning U.S. protectionism, but the reality is that several important decisions related to the U.S.' section 301 probe have yet to be announced.1 As we noted in last week's Special Report,2 this underscores that the near-term risks to China from the external sector are clearly to the downside. Abstracting from the day-to-day assessment of the trade picture, we have emphasized that other core elements of the China outlook have deteriorated. As we present below, an aggregate view of the three pillars of China's economy continues to argue for a (contained) slowdown, with protectionism acting as a downside risk to an already sober economic outlook. Extremely cheap valuation and the high-beta nature of Chinese ex-tech stocks continue to justify an overweight stance versus global equities, but we recommend that investors keep Chinese stocks on downgrade watch for the remainder of Q2 as the risks to the Chinese economy warrant an ongoing assessment of what is currently a finely balanced equity allocation decision. Assessing The Three Pillars Chart 1 presents our stylized framework for analyzing China's economy. It highlights that China's business cycle is largely driven by three "pillars": industrial activity, the housing market, and trade. While the services sector, the Chinese consumer, and/or the technology sector are of interesting secular relevance, generally-speaking China's business cycle continues to be subject to its "old" growth model centered on investment and exports. Chart 1The Three Pillars Of China's Business Cycle Industrial Activity: We took an empirical approach to predicting China's industrial sector activity in our November 30 Special Report,3 and tested the ability of 40 different macro data series to lead the Li Keqiang index (LKI). While the LKI is closely followed and somewhat cliché, we have focused on it because of its strong correlation with ex-tech earnings and import growth. The results of our November report pointed to the success of monetary condition indexes, money supply, and credit measures to reliably predict the LKI since China's real GDP growth peaked in 2010. We constructed our BCA Li Keqiang Leading Indicator based on these measures, and we have frequently highlighted over the past few months that the indicator is pointing to a continued deceleration in China's industrial activity (Chart 2). Housing: We noted in our November report that housing market data also correlates with the LKI, albeit less well than the components of our Leading Indicator. One important observation about China's housing market that we highlighted in our February 8 Weekly Report is that residential floor space sold appears to have reliably led floor space started (a proxy for real residential investment) since 2010 (Chart 3). Over the past 6-8 months, however, floor space started appears to have diverged from the trend in floor space sold, which may have been caused by a non-trivial reduction in housing inventories over the past few years.4 Nonetheless, we also noted that the level of inventories remains quite elevated, suggesting that the uptrend in floor space started is unlikely to continue without a renewed uptrend in sales volume. In our view, this conclusion implies that the housing outlook over the coming 6-12 months is neutral, at best. Chart 2China's Industrial Sector ##br##Will Continue To Slow Chart 3Resi Sales Volume Does Not Point To ##br##A Sustained Pickup In Construction Trade: The third pillar of China's economy is the external sector, which remains important even though net exports have fallen quite significantly in terms of contribution to China's growth. We noted in our April 18 Weekly Report that there is a strongly positive relationship between the annual change in contribution to growth from China's net exports and subsequent gross capital formation, highlighting that external demand provides an important multiplier effect for Chinese activity. For now, nominal export growth (in CNY terms) remains at the high end of its 5-year range, reflecting the strength of the global economy. But three significant risks remain to the export outlook: 1) the clear and present danger of U.S. import tariffs, 2) the possibility that Chinese policymakers may accelerate their reform efforts to take advantage of the "window of opportunity" provided by robust global demand,4 and 3) the very substantial rise in the export-weighted RMB (Chart 4), which is fast approaching its 2015 high. As a final point on trade, Chart 5 highlights that the recent divergence between the LKI and nominal import growth is resolved when examining the latter in CNY terms. The chart suggests that while export growth has been buoyed by a strong global economy, China's contribution to the global growth impulse is diminishing. The very tight link demonstrated in Chart 5 also suggests that industrial activity is the most important pillar to watch among the three noted above, which means that Chart 2 argues for a negative export outlook for China's major trading partners. Chart 4A Non-Trivial Deterioration ##br##In Competitiveness Chart 5The Rise In CNYUSD Is Flattering ##br##Imports Measured In Dollars Our assessment of the three pillars of China's economy points to a conclusion that we have highlighted frequently in our recent reports: China's industrial sector is slowing, and there are downside risks to the export outlook. The character of the slowdown does not suggest that a major shock to the global economy is likely to emanate from China over the coming 6-12 months, but the outlook is more consistent with a reduction than an expansion in China's contribution to global growth. Under normal circumstances, at best this would warrant a neutral asset allocation outlook to China-related financial assets. Chart 6The Uptrend In Relative Chinese ##br##Ex-Tech Performance Is Intact However, we have also argued that the relatively attractive valuation and the technical profile of Chinese equities suggests that investors should have a high threshold for reducing their exposure to China within a global equity portfolio. Chart 6 highlights that Chinese ex-tech share prices continue to demonstrate resilient performance versus their global peers, despite the ongoing slowdown in China's economy. In addition, as we will note below, our BCA China Investable Sector Alpha Portfolio is providing a curiously bullish signal about the relative performance of Chinese stocks, which heightens our reluctance to cut exposure. Bottom Line: An examination of the three pillars of China's economy provides an unambiguous signal that a slowdown is underway. This would normally warrant, at most, a neutral allocation to Chinese stocks, but several factors argue against cutting exposure for now. Stay overweight, but with a short leash. Reading The Tea Leaves From Our Sector Alpha Portfolio We introduced our BCA China Investable Sector Alpha Portfolio in a January Special Report, in part to demonstrate that the concept of alpha persistence (i.e. alpha that is persistently positive or negative) has material implications for portfolio returns. In particular, we noted that the portfolio's strategy of allocating to China's investable equity sectors based on the significance of alpha has resulted in over 200bps of long-term outperformance versus the investable benchmark, without taking on any additional risk (Table 1). Table 1An Alpha-Based Sector Model Has Historically Outperformed China's Investable Stock Market Table 2 presents the portfolio's current allocation, relative to the current benchmark weights for each sector as well as the portfolio's sectoral allocation when we published our January report. Two observations are noteworthy: The model recommends an overweight allocation to resources; consumer staples; health care; utilities; and real estate, at the expense of industrials; consumer discretionary; financials; technology; and telecom services. These positions are largely in-line with the model's recommendations in January, except for a non-trivial increase in exposure to energy and financials, and a significant reduction in technology and consumer discretionary. The portfolio's reduced exposure to technology and consumer discretionary stocks validate two recent investment recommendations from BCA's China Investment Strategy team: we recommended a long consumer staples / short consumer discretionary trade on November 16,5 and we recommend that investors retain cyclical exposure to investable Chinese stocks while neutralizing exposure to the tech sector on February 15.6 Table 2Our Sector Alpha Portfolio Has Validated Two Of Our Recent Recommendations Chart 7 highlights another interesting insight from the model, by presenting the beta of the portfolio relative to the investable benchmark alongside the benchmark's performance versus global stocks. First, the chart underscores the limited systemic risk of the portfolio, as the portfolio's beta rarely deviates materially from 1. But more importantly, it appears that the portfolio's beta versus the investable benchmark is somewhat correlated with (and leads) China's performance versus global stocks: Chart 7A Curiously Bullish Signal From ##br##Our Sector Alpha Portfolio Prior to the global financial crisis, the portfolio's beta was above 1 and rising, until early-2007 (preceding the peak in relative performance by about a year). Following the crisis, the portfolio beta steadily declined until late-2014/early-2015, interrupted only by a brief rise back above 1 from 2009-2010. Chinese stock prices steadily underperformed global equities during this period. The portfolio beta rose back to 1 in mid-2015, and stayed flat until early last year. Chinese stocks technically underperformed global stocks during this period, but by a much more modest amount than what occurred on average from 2009 to 2014. In this case, the rise in the portfolio beta in 2015 appeared to correctly signal that a sharply underweight stance towards Chinese stocks was no longer warranted. Finally, the portfolio beta surged rapidly higher last year, in line with a material rise in the relative performance of Chinese stocks. It has fallen modestly since January, but remains at one of the highest levels seen over the past 15 years. Drawing pro-cyclical inferences from the beta characteristics of risk-adjusted performers is a novel approach for BCA's China Investment Strategy service, and for now we regard the results of Chart 7 as a curious signal that warrants further examination. Still, this bullish sign is consistent with the general resilience of Chinese stocks that we have observed over the past several months, which continues to argue in favor of a high threshold to cut exposure to China within a global equity portfolio. Bottom Line: Recent changes in the BCA China Investable Sector Alpha Portfolio's recommended allocation have validated two of our recent investment recommendations. In addition, the model is providing a curiously bullish signal about the relative performance of Chinese vs global stocks that heightens our reluctance to reduce Chinese equity exposure. An Update On The "Reform Trade" We noted in the aftermath of last November's Communist Party Congress that China was likely to step up its reform efforts in 2018, and make meaningful efforts to: Pare back heavy-polluting industry Hasten the transition of China's economy to "consumer-led" growth7 Halt leveraging in the corporate/financial sector Eliminate corruption and graft As a result of this outlook, we highlighted that the pace of renewed structural reforms would be a key theme to watch this year, in order to ensure that the pursuit of these policies would not unintentionally cause a repeat of the significant slowdown in the economy that occurred in 2014/2015. We presented our framework for monitoring this risk in our November 16 Weekly Report, which was to track an index that we called the BCA China Reform Monitor. The monitor is calculated as an equally-weighted average of four "winner" sectors that outperformed the investable benchmark in the month following the Party Congress relative to an equally-weighted average of the remaining seven sectors. We argued that significant underperformance of "loser" sectors could be a sign that reform intensity has become too burdensome for the economy (and thus a material headwind ex-tech equity performance), and highlighted that we would be watching for signs that our monitor was rising largely due to outright declines in the denominator. Using this framework, Chart 8 suggests that structural reform efforts are ongoing but that investors do not view the current pace of these reforms as overly burdensome for the economy. In particular, panel 2 highlights that recent movements in our Reform Monitor have been driven by fairly steady outperformance of the "winner" sectors, with "loser" sectors simply trending sideways. While it is possible that Chinese policymakers will intensify their efforts to reform the economy over the coming 6-12 months,4 for now our China Reform Monitor continues to support an overweight stance towards Chinese ex-tech stocks vs their global peers. However, given the message of our Reform Monitor, it is somewhat surprising that another of our reform-themed trades has fared so poorly over the past three months. Chart 9 presents the performance of our long investable environmental, social and governance (ESG) leaders / short investable benchmark trade, which was up approximately 4% since inception in late-January but is now down 1.4%. The basis of this trade was to overweight stocks that are best positioned to deliver "sustainable" growth, which we argued would fare well in a reform environment. Does the underperformance of this trade suggest that the reform theme is unlikely to be investment-relevant over the coming year? Chart 8Structural Reforms Not Viewed As ##br##Economically Restrictive By Investors Chart 9ESG Leaders Should Fare Quite ##br##Well In A Reform Environment In our view, the answer is no. First, while the MSCI ESG leaders index maintains roughly similar sector weights as the investable benchmark (which limits the beta risk of the trade), Table 3 highlights that differences do exist. These modest differences in sector allocation do appear to be impacting performance (Chart 10), in particular the underweight allocation to energy stocks (which are outperforming) and the overweight allocation to technology (which has sold off since mid-March). Table 3Sector Allocation Has Impacted The Recent Performance Of China's ESG Leaders Chart 10Sector Allocation Impacting Recent ##br##Performance Of ESG Leaders Second, while China made significant gains last year in improving air quality in several major population centers (such as Beijing and Shanghai), these improvements have mostly occurred from a near-hazardous starting point and have simply rendered China's air to be less unhealthy. Even in Beijing, Chart 11 highlights that PM2.5 readings have started to increase again, from a level that only briefly reached "good" quality. In addition, Chart 12 highlights that some of the improvement in air quality last year occurred, at least in part, because China shifted polluting activity from one province to another. This implies that Chinese policymakers will continue to wrestle with improving the country's air quality for some time to come, which in our view continues to favor ESG leaders over the coming year and beyond. Chart 11Some Significant Recent Gains In Air ##br##Quality, But Part Of An Ongoing Battle Chart 12Air Quality Gains In Some Provinces, At The Expense Of Others Bottom Line: Our China Reform Monitor signals that investors do not view the current pace of structural reforms as being overly burdensome for the economy. In addition, while Chinese policymakers have made some significant gains in improving China's air quality over the past 18 months, these changes have mostly occurred from a near-hazardous starting point (suggesting that more progress will be needed). As such, we recommend that investors stick with our long ESG leaders / short investable benchmark trade over the coming year. Jonathan LaBerge, CFA, Vice President Special Reports jonathanl@bcaresearch.com 1 Please see Geopolitical Strategy Weekly Report "Inside The Beltway," dated May 2, 2018, available on gps.bcaresearch.com 2 Please see Geopolitical Strategy and China Investment Strategy Special Report "China's "Red Line" In The Trade Talks," dated May 9, 2018, available on cis.bcaresearch.com 3 Please see China Investment Strategy Special Report "The Data Lab: Testing The Predictability Of China's Business Cycle," dated November 30, 2017, available on cis.bcaresearch.com 4 Please see China Investment Strategy Weekly Report "China: A Low-Conviction Overweight," dated May 2, 2018, available on cis.bcaresearch.com 5 Please see China Investment Strategy Weekly Report "Messages From The Market, Post-Party Congress," dated November 16, 2017, available on cis.bcaresearch.com 6 Please see China Investment Strategy Weekly Report "After The Selloff: A View From China," dated February 15, 2018, available on cis.bcaresearch.com 7 Investors should note that BCA's China Investment Strategy service has long been skeptical of calls to shift China's economy to a consumption-driven growth model, because it significantly raises the odds that the country will not be able to escape the middle income trap. For example, please see Please see China Investment Strategy Special Report, "On A Higher Note", dated October 5, 2017, available at cis.bcaresearch.com Cyclical Investment Stance Equity Sector Recommendations

Overweight Despite a blockbuster earnings season, banks have come under pressure recently. Worrisomely, they have not followed the 10-year Treasury yield higher and that is cause for concern, particularly since they have re-established a correlation with the yield curve. This positive correlation shift from interest rates to the yield curve slope is important as it will likely squeeze banks' net interest margins, a key profit driver (second panel). The third and bottom panels show that there is increasing empirical evidence that banks have already started making this transition away from the 10-year UST yield and toward the 10/2 yield curve, and we are thus compelled to book profits and remove this early cyclical index from the high-conviction overweight call list. The S&P banks index is now also on downgrade alert. Bottom Line: Stay overweight banks for now, but lock in gains of 6% and remove the S&P banks index from the high-conviction overweight call list, as our confidence is not as high as in late-November. Further, we are putting this key financials sub index on downgrade alert reflecting the negative implication from our later stages of the business cycle analysis (please see our Weekly Report for our analysis of the business cycle). The ticker symbols for the stocks in this index are: BLBG: S5BANKX - WFC, JPM, BAC, C, USB, PNC, BBT, STI, MTB, FITB, CFG, RF, KEY, HBAN, CMA, ZION, PBCT, SIVB.