Economy

Highlights So What? The U.S.-China tariff ceasefire is a net positive, but a final deal is by no means assured. Why? In the near term there may be a play on global risk assets, but beyond that we remain cautious. Global divergence remains the key theme, and China now has less reason to stimulate. What to watch for a final deal: Trump’s approval rating, China’s structural concessions, and geopolitical tensions. We recommend booking gains on our long DM / short EM trades. Go long EM oil producers on OPEC 2.0 cuts. Feature U.S. President Donald Trump and Chinese President Xi Jinping have agreed to a trade truce at the G20 summit in Buenos Aires. The deal includes: Tariff Ceasefire: A 90-day ceasefire – until March 1 – on hiking the second-round tariffs from 10% to 25% on $200bn of Chinese imports. Substantive Talks: The talks will center on structural changes to the Chinese economy, including forced tech transfer, IP theft, hacking, and non-tariff barriers. Vice-Premier Liu He, Xi Jinping’s key economics and trade advisor, may visit Washington in mid-December. Imports: China has agreed to import more goods to lower the U.S. trade deficit, including agricultural and capital goods. This harkens back to the failed May 20 “beef and Boeings” deal. As with the previous deal, there are no deadlines or quantities promised. Not included in the two-and-a-half-hour dinner between Trump and Xi was a substantive discussion on geopolitical tensions. While Chinese statements following the summit did reaffirm Chinese commitment to the U.S.-North Korean diplomacy, there was no broader agreement on tensions, particularly in the South China Sea. The U.S. has recently demanded that China demilitarize the area. Should investors “play” the summit? Tactically, there is an opportunity to play global risk assets in the near term. Cyclically and structurally, however, both economic fundamentals and the underlying trajectory of U.S.-China relations call for caution over the course of 2019. Will The Truce Hold? There are five reasons to doubt the sustainability of the truce: Trade imbalance: It is highly unlikely that the trade imbalance between China and the U.S. can be substantively altered over the course of 90 days. The U.S. economy is in “rude health,” the USD is strong, unemployment is low and pushing up wages, and the output gap is closed. These are the macroeconomic conditions normally associated with an elevated trade imbalance (Chart 1). Chart 1Trade Deficit To Rise Despite Tariffs Domestic politics: The just-concluded midterm election saw no opposition to President Trump on trade. The Democratic Party candidates campaigned against the president on a range of issues throughout the election season, but not on the issue of his aggressive China policy. Polling from the summer also shows that a majority of American voters consider trade with China unfair, unlike trade with other countries (Chart 2). As such, President Trump will have to produce a convincing deal in order to ensure that his base, and many Democrats, support the deal. Chart 2Americans Are Focused On China As Unfair Structural tensions: U.S. Trade Representative Robert Lighthizer issued a hawkish report ahead of the G20 summit concluding that China has not substantively changed any of the trade practices that initiated U.S. tariffs.1 The report was an update to the original investigation that launched the Section 301 tariffs against China. Lighthizer’s report therefore provides a road-map for what the U.S. will want to see over the course of 90 days. High-tech transfers: The Department of Commerce announced on November 19 a “Review of Controls for Certain Emerging Technologies.” This review will conclude on December 19 when the public comment period ends. In the report, the federal government lists biotech, AI, genetic computation, microprocessors, data analytics, quantum computing, logistics, 3D printing, robotics, hypersonic propulsion, advanced materials, and advanced surveillance as technologies with potential “dual-use” that may be critical to U.S. national security and thus might merit consideration for export control.2 As such, the U.S. may decide to impose export controls on technologies that China deems critical to accomplishing its “Made in China 2025” goals within the period of the 90 day talks. If those export controls were to include critical items – such as semiconductors, which are critical to China’s export-oriented manufacturing (Chart 3) – negotiations may become more complicated. Geopolitics: The trade truce did not contain any substantive resolution to ongoing strategic tensions between the U.S. and China. These tensions precede President Trump: we have detailed them in these pages since 2012.3 As such, the U.S. defense and intelligence community will have to be on board with any trade deal and that may suggest that Beijing will be asked to make geopolitical concessions over the course of the next 90 days. Chart 3China Accounts For 60% Of Global Semiconductor Demand Despite the above, the trade truce is a meaningful and substantive move away from an open trade war. Yes, the U.S. will retain tariffs on $250bn Chinese imports, with China maintaining tariffs on $66bn of U.S. imports (Chart 4). No, the U.S. did not rule out a third round of tariffs covering the remaining $267 billion of Chinese imports, if things go awry. Nevertheless, the 90-day truce implies that the U.S. will not ratchet up the tensions for now. Chart 4U.S.-China Trade Hit By Tariffs The truce also allows China to make substantive changes to its domestic economic policies that may satisfy some of the structural concerns cited in the above U.S. Trade Representative report. The soundest basis for a durable deal lies in China recommitting to structural reforms: this would both be positive for China’s productivity and would assuage some of Washington’s underlying anxieties about China’s state-backed industrial policies. Significantly, China’s Ministry of Foreign Affairs now says that it will “gradually resolve the legitimate concerns of the U.S. in the process of advancing a new round of reform and opening up in China.” When would this new round of reform occur? The upcoming Central Economic Work Conference, and the 40th anniversary of Deng Xiaoping’s reforms, should be watched closely for new initiatives. Also, the new March 1 tariff deadline lines up with the calendar for China’s National People’s Congress (NPC). The NPC meets every year and is the occasion when any major new domestic reforms would need to be laid out. Thus, any Chinese compromises on structural issues could be rolled out as part of a more general reform agenda in March. This is important because the U.S. administration is determined to focus on implementation and not to let China delay resolution of differences through endless rounds of dialogue. As such, investors should watch the following issues over the course of the next three months in order to gauge the likelihood of a substantive deal that not only rules out new tariffs but also rolls back the existing ones: Polls: President Trump is focused on his 2020 reelection. As such, he will want to see political gains from the easing of pressure on China, both in the general populace and amongst his GOP base (Chart 5). A slump in the polls, or a threatening turn in the Mueller investigation, may justify a shift in the narrative come March-April and thus end the truce. Chart 5Trump’s Approval Will Affect Trade Talks Big ticket announcements: China is going to have to make big-ticket item purchases. A huge order of Boeing airplanes, a massive ramp-up in the purchase of agricultural products, a raft of direct investments in manufacturing in the heartland … these are the type of announcements that President Trump could use to sell a substantive deal to his base. Structural changes to the Chinese economy: China will have to prove that it is addressing the concerns outlined in the U.S. Trade Representative report. We suspect that Lighthizer issued the report ahead of the G20 summit so as to set the benchmark for what the U.S. wants to see from Beijing. It is a high benchmark as it includes: An end to cyber theft, hacking, and corporate espionage; Substantive, rather than merely “incremental,” improvements to U.S. market access, including increased ownership of ventures; Serious changes to state-subsidized industrial programs that utilize stolen technology, particularly the so-called “Strategic Emerging Industries” program and “Made in China 2025”; An end to China’s state-backed investment campaign in Silicon Valley. No new U.S. embargoes: The public comment period for the newly proposed U.S. export controls ends on December 19. That suggests that high-tech restrictions could emerge over the course of the first quarter of 2019. These could exacerbate tensions. No new geopolitical tensions: Geopolitical tensions, such as over human rights in Xinjiang or the militarization of the South China Sea, would obviously make a deal less likely.  Bottom Line: The trade truce could lead to a substantive trade deal between China and the U.S. However, many impediments remain. Investors have to answer three key questions: is the deal politically useful for President Trump ahead of the 2020 election? Does the deal resolve the concerns laid out in the U.S. Trade Representative’s Section 301 report? And will geopolitical and national security tensions ease? Since 2012, we have had a structurally bearish view of the Sino-American relationship. This view is based on long-term structural factors that we do not think can be resolved over the course of 90 days. That said, every structural view can have cyclical deviations. The question we now turn to is how to play such a cyclical deviation in terms of the markets. What Does The Truce Mean For The Markets? In our view, the trade war has been of secondary importance to global markets. Far more relevant to the BCA House View that DM assets will outperform EM has been our conclusion that U.S. and Chinese economies would experience policy divergence. The U.S. economy has been buoyed by pro-cyclical stimulus, whereas Chinese policymakers have created a macro-prudential framework that has impaired the country’s credit channel. This divergence has led to the outperformance of the U.S. economy over the rest of the world, leading to a substantive USD rally (Chart 6). Chart 6U.S. Outperformance Should Be Bullish USD While this view has worked out well in 2018, it appears to be fraying as the year comes to the end: Chart 7U.S. Growth Weakening? Fed dovishness: Our recent travels to Asia, the Middle East, Europe, and the Midwest have revealed unease among investors regarding the health of the U.S. economy. Some recent data, such as the woeful core durable goods orders (Chart 7) and weak housing, have prompted calls for a more dovish Fed. On cue, Fed Chair Jay Powell delivered what was perceived as a dovish speech. BCA’s Chief Global Strategist, Peter Berezin, makes a strong case for why investors should fade the enthusiasm.4 Specifically, Peter thinks that investors are focusing too much on the unknown – the neutral rate – and not enough on the known – the budding inflationary pressures (Chart 8). Nonetheless, in the near-term, the narrative of a “Fed pause” may overwhelm the data. Chart 8Does The Fed Like It Hot? Chart 9Fiscal Policy Becomes More Proactive Chinese stimulus: Evidence of a broad-based, irrigation-style, credit stimulus is scant in China’s data. Nonetheless, many investors we have met on the road are latching on to higher local government bond issuance (Chart 9) and a positive M2 credit impulse (Chart 10). Moreover, Q1 almost always brings a boost in new lending in China. Our colleague Dhaval Joshi, BCA’s Chief European Strategist, has recently pointed out that the global credit impulse has hooked up, suggesting that EM underperformance is over (Chart 11).5 We do not think that China can turn the corner on a slumping economy without a substantive increase in its total social financing, which remains subdued both in growth terms and as a second derivative (Chart 12). However, we concede that the narrative may have shifted sufficiently in the near term to warrant some tactical caution on our cyclical House View. ​​​​​​​Chart 10China's M2 Turned Positive Chart 11An Up-Oscillation In Global Credit Growth Technically Favours EM Trade truce: Trade concerns have had a clear impact on the outperformance of U.S. equities relative to the rest of the world (Chart 13). As such, a trade truce may alter the narrative sufficiently in the near term to change the direction. In this report, we cite why we are cautious regarding the truce leading to a substantive deal. However, we are biased by our structural perspective that Sino-American tensions are unavoidable. The vast majority of our clients and global investors does not share this view. In fact, the trade war has caught the investment community by surprise. As such, we would argue that investors are biased towards a “win-win” scenario. Therefore, investors may not be cautious, but may in fact project a much higher probability of a final deal into their market decisions. Chart 12China's Total Credit Is Weak Chart 13U.S. Is Winning The Trade War Over the course of 2019, we do not think the global risk asset bullishness is sustainable. In fact, a reprieve rally now is going to make global growth resynchronization less likely and continued policy divergence more likely. Why? First, Chinese policymakers will have less of a reason to deploy an irrigation-style credit stimulus if fears of an accelerated trade war abate. Second, the Fed will have less of a reason to back off from its hiking trajectory if both the DXY rally and equity market volatility ease. That said, we are going to close our long DM / short EM trades for the time being. This includes: Our long DM equities / short EM equities, for a gain of 15.70%; Our long U.S. Dollar (DXY) index for a gain of 0.56%; Our long USD / Short EM currency basket for a loss of 0.76%; Our long JPY/GBP call, for a gain of 0.32%. Our hedge of being long China play index ought to outperform on a tactical horizon, so we are leaving it open despite its paltry return so far of 0.32%. Also, we are keeping our long Chinese equities ex. Tech / short EM equities trade, as Chinese assets should rally on the back of the truce. Note that, as outlined above, China’s tech sector is not out of the woods yet. Our decision to close these recommendations is to preserve profits, not change our investment stance. On a cyclical horizon, we remain skeptical that global risk assets will outperform DM, and U.S. assets in particular, over the course of 2019. In the end, we do not believe that a mere narrative shift will be sustainable, especially given the robustness of the U.S. labor market (Chart 14) and the tepidness of Chinese stimulus (Chart 15). Chart 14A Tight Labor Market Chart 15Compare Any Stimulus To Previous Efforts Finally, a word on oil prices. The G20 was crucial for the oil call, as well as the trade war, given that Saudi Arabia and Russia suggested that their OPEC 2.0 union would produce supply cuts at the upcoming Vienna meeting on December 6. This proves that fundamentals were more important than the narrative that Saudi leadership “owed” a favor to President Trump. In particular, the Saudis have fiscal constraints given their budget breakeven oil price is around $80-$85 per barrel. As such, we are reinitiating our long EM energy producers (ex-Russia) / short broad EM (ex-China) equity call. We are excluding Russia from the “long” due to lingering geopolitical concerns – sanctions and Ukraine – and China from the “short,” as we are now tactically bullish on China.   Marko Papic, Senior Vice President Chief Geopolitical Strategist marko@bcaresearch.com Matt Gertken, Vice President Geopolitical Strategy mattg@bcaresearch.com   Footnotes 1      Please see Office of the United States Trade Representative, “Update Concerning China’s Acts, Policies, And Practices Related To Technology Transfer, Intellectual Property, And Innovation,” dated November 20, 2018, available at www.ustr.gov. 2      Please see The Federal Register, “Review of Controls for Certain Emerging Technologies,” dated November 19, 2018, available at www.federalregister.gov. 3      Please see Geopolitical Strategy Special Report, “Power And Politics In East Asia: Cold War 2.0?,” dated September 25, 2012, Global Investment Strategy Special Report, “Searing Sun: Japan-China Conflict Heating Up,” dated January 25, 2013, “Sino-American Conflict: More Likely Than You Think, Part II,” dated November 6, 2015, and “The South China Sea: Smooth Sailing?,” dated March 28, 2017, available at gps.bcaresearch.com. 4      Please see Global Investment Strategy Weekly Report, “Shades Of 2015,” dated November 30, 2018, available at gis.bcaresearch.com. 5      Please see European Investment Strategy Weekly Report, “DM Versus EM, And Two European Psychodramas,” dated November 22, 2018, available at eis.bcaresearch.com. 

Highlights Portfolio Strategy Higher interest rates, with the Federal Reserve tightening monetary policy three more times in the next seven months, will be the dominant theme next year. All four of our high-conviction underweight calls are levered to this theme. The later stages of the U.S. capex upcycle underpin three of our high-conviction overweight calls for 2019. Recent Changes Downgrade the S&P Home Improvement Retail index to underweight today. Trim the S&P Interactive Media & Services index to a below benchmark allocation today.  Table 1 Feature Fed policy will dominate markets next year as the dual tightening backdrop – rising fed funds rate and accelerated downsizing of the Fed balance sheet – remains intact. Two weeks ago we raised the question: is the Fed tightening monetary policy too far too fast?1 In more detail, we put the latest monetary tightening cycle in historical perspective and examined trough-to-peak moves in the fed funds rate since the 1950s (Chart 1). Chart 1Too Far Too Fast? A good friend I call “the smartest man in California” correctly pointed out that 500bps of tightening today is not the same as in the 1970s or 1980s. Chart 2 adjusts for that by including the average nominal GDP growth rate during these tightening episodes and adds more color to each era. As a reminder, the latest cycle that commenced in December 2015 is already 25bps above the median, if one uses the Wu-Xia shadow fed funds rate to capture the full quantitative easing effect, and above-average nominal output growth. Chart 2Trough-To-Peak Tightening Cycle Already Above Historical Median Trying to answer the question, we are concerned that as the Fed remains committed to tighten monetary policy three more times by mid-2019, a yield curve inversion looms, especially if the U.S. economy suffers a soft patch in the first half of next year (please refer to our Economic Impulse Indicator analysis in the October 22ndand November 19th Weekly Reports). This would signal at least a pause, if not reversal, in Fed policy. With that in mind, this week we are revealing our high-conviction calls for 2019. Four of our calls are a play on this tightening monetary backdrop that is one of BCA’s themes for next year.2 The later stages of the U.S. capex upcycle underpin three of our high-conviction calls. Table 22018 High-Conviction Calls Recap However, before we highlight our 2019 high-conviction calls in detail, Table 2 tallies our calls from last year. We had a stellar performance in our 2018 high-conviction calls with an average excess return of 11.6% versus the S&P 500. As the year turns the corner, closing out the remaining calls brings down the average relative return to 7.5%, still a very impressive number, with a total of ten hits and only two misses for the year.    Anastasios Avgeriou, Vice President U.S. Equity Strategy anastasios@bcaresearch.com     Software (Overweight, Capex Theme) Software stocks are our first hold out from last year’s high-conviction overweight list, levered to the capex upcycle theme. Chart 3 shows that relative capital outlays and the share price ratio are joined at the hip. Software upgrades offer the simplest, quickest and most effective capital deployment, especially when productivity gains ground to a halt. Importantly, leading indicators of overall capex remain upbeat and should continue to underpin software profits. Beyond capex, M&A has been fueling software stock prices. It did not take long for the large CA acquisition to get surpassed by RHT and more recently SYMC was also rumored to be in play (Chart 3). Inter-industry M&A activity is reaching fever pitch and this frenzy is bidding up premia to stratospheric levels. The push to the cloud, SaaS and even AI has boosted the appeal of software stocks and brought them to the forefront of potential takeout candidates. These are secular trends and will likely continue to gain steam irrespective of the different stages in the business cycle. As a result, software stocks should remain core tech holdings in equity portfolios. The recovery in the software price deflator (Chart 3), a proxy for industry pricing power, corroborates the upbeat demand backdrop. With regard to financial statements, software stocks have pristine balance sheets with more cash on hand than debt, which sustains the net debt-to-EBITDA ratio in negative territory. Interest coverage is great at 10x and free cash flow generation is expanding smartly. The ticker symbols for the stocks in this index are: BLBG: S5SOFT - MSFT, ORCL, ADBE, CRM, INTU, RHT, ADSK, SNPS, CTXS, ANSS, CDNS, FTNT and SYMC. Chart 3Software   Air Freight & Logistics (Overweight, Capex Theme) Air freight & logistics stocks are the second hold out from our high-conviction overweight list, although we added it to list only in late-March. This transportation sub-index laggered is a capex and trade de-escalation play for the first half of 2019. Importantly, energy costs comprise a large chunk of freight services input costs and the recent drubbing in oil markets will boost margins especially on the eve of the busiest season for courier delivery services (top panel, Chart 4). On that front, there are high odds that this holiday sales season will be another record setting one, as wage inflation is underpinning discretionary incomes. Keep in mind that the accelerating domestic manufacturing shipments-to-inventories ratio confirms that demand for hauling services is upbeat. The implication is that rising demand for freight services will buoy industry profits and lift valuations out of their recent funk (Chart 4). Firming industry operating metrics also tell a positive story and suggest that relative share prices will soon take off. Air freight pricing power has been healthy, in expansionary territory and above overall inflation measures. While the U.S./China trade tussle and the appreciating greenback are clear risks to our sanguine S&P air freight & logistics transportation subindex, most of the grim news is already reflected in depressed relative forward profit estimates, bombed out valuations and washed out technicals (Chart 4). The ticker symbols for the stocks in this index are: BLBG: S5AIRF - FDX, UPS, EXPD and CHRW. Chart 4Air Freight & Logistics   Defense (Overweight, Capex Theme) We have been overweight the pure-play BCA defense index since late-2015 and there are high odds that this juggernaut that really commenced with the George Walker Bush presidency remains in a secular growth trajectory. Our strategy is to add exposure on any meaningful pullbacks and keep this index as a structural overweight within the GICS1 S&P industrials index. The recent drawdown offers such an opportunity and we are adding this index to the 2019 high-conviction overweight list. The rise of global "multipolarity" - or competition between the world's great nations - and the decline of globalization, along with a global arms race and increased risk of cyber-attacks, have been documented in our "Brothers In Arms" Special Report. These trends all signal that global defense related spending will remain upbeat in the coming decade.3 In the U.S. in particular, where military spending in absolute terms is greater than the rest of the world put together, defense spending and investment have bottomed and will continue to accelerate (Chart 5). In fact, the CBO continues to project that defense outlays will jump further next year. While such a breakneck pace is clearly unsustainable, President Trump is serious about upgrading and updating the U.S. military in order to keep China's geopolitical and military ascendancy in check (as well as to deal with Russia and Iran).4 The upshot is that defense outlays will continue to expand into the 2020s. Such a buoyant demand backdrop is music to the ears of defense contractor CEOs, and represents a boost to defense equity revenue growth prospects. This capital goods sub-industry has extremely high fixed costs and thus any increase in top line growth flows straight to the bottom line. Put differently, defense contractors enjoy high operating leverage. No wonder M&A activity is robust: at least four large deals have been announced in the past year that are underpinning takeout premia. A closer look at operating metrics corroborates that defense goods manufacturers are firing on all cylinders. New orders recently jumped to fresh all-time highs and the industry's shipments-to-inventories ratio is rising, on track to surpass the 2008 peak. Unfilled orders are also running at a high rate, signaling that factories will keep on humming at least for the next few quarters. Importantly, the industry is not standing still and is making significant investments. U.S. defense capex as reported in the financial statements of constituent firms is growing at roughly 20%/annum or twice as fast as overall capex (Chart 5 on page 7). While interest coverage has been modestly deteriorating, it is twice as high as the overall market (Chart 5 on page 7). Impressively, defense ROE is running near 30%, again roughly double the rate of the broad market. The ticker symbols for the stocks in the BCA defense index are: LMT, LLL, NOC, GD and RTN. Chart 5Defense   Consumer Discretionary (Underweight, Higher Fed Funds Rate Theme) We recommend investors avoid the consumer discretionary sector that suffers when interest rates rise. Chart 6 depicts this inverse correlation consumer discretionary equities have with interest rates, especially the fed funds rate. Most discretionary equites are levered off of floating rates and thus any increase in the fed funds rates gets reflected immediately in banks' prime lending rate. Also, most consumer debt is floating rate debt and thus tighter monetary conditions, at the margin, dampen consumer debt uptake and, as a knock-on effect, weigh on discretionary consumer outlays. Recently we highlighted that, now that the Fed has been raising rates and allowing bonds to roll off its balance sheet, volatility is making a comeback. Unsurprisingly, the consumer discretionary share price ratio is inversely correlated with the VIX index, signaling that more pain lies ahead for this early cyclical index (VIX shown inverted, Chart 6). Sentiment and technical indicators also point to more downside ahead for this interest-rate sensitive index. Our sector advance/decline line is waning and EPS breadth has plunged. Worrisomely, sell-side analysts are penciling in an extremely optimistic 5-year outlook with EPS growth 23.4%/annum or 1.4 times higher than the overall market. Clearly this is not realistic as it assumes a tripling of EPS in the coming 5 years. Relative EPS estimates have already given way as AMZN commands very little EPS weight, despite its massive market cap weight (30% of the S&P consumer discretionary sector), and suggests that relative share prices will converge lower (Chart 6 on page 9). As a result, the 12-month forward P/E ratio is trading at a 24% premium to the broad market and significantly above the historical mean. Technicals are almost as extended as relative valuations and cyclical momentum has likely peaked, warning that a downdraft in relative share prices looms (Chart 6 on page 9). Chart 6Consumer Discretionary   Home Improvement Retail (Underweight, Higher Fed Funds Rate Theme) While the probablity of a housing recession remains low, we are concerned that too much euphoria is already priced in the S&P home improvement retail (HIR) index, and there are high odds that next year HIR will suffer the same fate as homebuilders did this year (Chart 7). Thus, we are downgrading the S&P HIR index to underweight and adding it to the high-conviction underweight list for 2019. Fixed residential investment (FRI) as a percentage of GDP is up 50% from trough to the recent peak, whereas relative HIR performance is up 170% in the same time frame. Our worry is that optimistic sell side analysts' relative profit forecasts will be hard to attain, let alone surpass as FRI is steadily sinking (Chart 7). Worrisomely, our HIR model has plunged on the back of the wholesale liquidation in lumber prices and rising interest rates (Chart 7). Lumber deflation will prove a profit headwind as building supply Big Box retailers make a set margin on wood products. Select industry operating metrics suggest that the easy profits are behind HIR. Not only is our productivity growth proxy (sales per employee) on the verge of deflating, but also an inventory surge has sunk the HIR sales-to-inventories ratio into the contraction zone. Finally, there is rising supply of new and existing homes for sale already on the market, and that puts off remodeling activity at least until this supply glut clears (months' supply shown inverted, Chart 7). The ticker symbols for the stocks in this index are: BLBG: S5HOMI - HD, LOW. Chart 7Home Improvement Retail   Short Small Caps/Long Large Caps (Higher Fed Funds Rate Theme) The days in the sun are over for small cap stocks and we are compelled to put the size bias favoring large caps in our high-conviction calls list for 2019. Small caps are severely debt saddled. Sustained small cap balance sheet degradation is worrying, with S&P 600 net debt-to-EBITDA close to 4 compared with less than 2 for the SPX (Chart 8). Such gearing is fraught with danger as the default rate has nowhere to go but higher. Small and medium enterprises (SMEs) have a higher dependency on bank credit as opposed to the bond market access that mega caps enjoy. Most bank credit is floating rate debt and so are lines of credit, and as the Fed remains firm on tightening monetary policy, interest expense costs are skyrocketing for SMEs. In a relative sense this will weigh on net profits. Moreover, small caps are a lot more sensitive to interest rates, and the selloff in the 10-year Treasury note heralds more pain in 2019 (Chart 8). Small caps are high(er) beta stocks and when volatility spikes they underperform large caps. When the Fed ballooned its balance sheet and dropped the fed funds rate to zero it suppressed volatility. Now that the Fed has been decreasing the size of its balance sheet and raising interest rates, this is working in reverse and volatility is making a comeback as we have been highlighting in our research, and will continue to weigh on small caps (VIX shown inverted, middle panel, Chart 8). Another way to showcase small caps' riskier status is the close correlation they have with the relative EM equity share price ratio. When EMs outperform the SPX, small caps follow suit and vice versa. Importantly a wide gap has opened recently and we suspect that it will narrow via small caps following the EM higher beta stocks lower (SPX vs. EM ratio shown inverted, fourth panel, Chart 8 on page 12). Chart 8Small Vs. Large   Interactive Media & Services (Underweight, Higher Fed Funds Rate Theme) In our initiation of coverage on the S&P interactive media & services index,5 we highlighted three key risks that offset the revenue & profit growth vigor of this group, comprised almost entirely of Alphabet (Google) and Facebook. These were a renewed regulatory focus, rapid unpredictable changes in tastes & technology and an appreciating U.S. dollar. It is the first of these that has risen most dramatically since that report. Tack on the inverse correlation these growth stocks have with interest rates (top panel, Chart 9) and that is causing us to lower our recommendation to underweight and include this index in the high-conviction underweight list for 2019. Increasing regulatory efforts on technology will be a key theme next year, one we explored this past summer.6 Our conclusion was that both antitrust (particularly in the case of Alphabet) and privacy regulation (particularly in the case of Facebook) added significant risk to these near monopolies; calls for legislating both have dramatically amplified. Tim Cook, Apple’s CEO, recently commented that more regulation for Facebook and Alphabet was inevitable; we agree. While the form such regulation might take remains open to debate (for example, the U.S. could adopt an EU-style General Data Protection Regulation (GDPR)), we fear the associated headline risk (not to mention likely profit headwinds) will impair stock prices in the S&P interactive media & services index. This communication services sub-index is particularly prone to such a risk when it already trades at close to a 40% valuation premium to the broad market (middle panel, Chart 9 on page 14). Adding insult to injury is the PEG ratio that is trading at a 60% premium to the broad market (bottom panel, Chart 9 on page 14). In the face of the Fed’s sustained tightening cycle these extreme growth stocks are vulnerable to massive gravitational pull. The ticker symbols in the stocks in this index are: S5INMS – GOOGL, GOOG, FB, TWTR and TRIP. Chart 9Interactive Media & Services Footnotes 1      Please see BCA U.S. Equity Strategy Report, "Manic Market," dated November 19, 2018, available at uses.bcaresearch.com. 2      Please see BCA The Bank Credit Analyst Report, "OUTLOOK 2019: Late-Cycle Turbulence", dated November 26, 2018, available at bca.bcaresearch.com. 3      Please see BCA U.S. Equity Strategy Special Report, "Brothers In Arms," dated October 31, 2016, available at uses.bcaresearch.com. 4      Please see BCA Geopolitical Strategy Special Report, "A Global Show Of Force?" dated October 10, 2018, available at gps.bcaresearch.com. 5      Please see BCA U.S. Equity Strategy Special Report, "New Lines Of Communication," dated October 1, 2018, available at uses.bcaresearch.com. 6      Please see BCA U.S. Equity Strategy Special Report, "Is The Stock Rally Long In The FAANG?", dated August 1, 2018, available at uses.bcaresearch.com.   Current Recommendations Current Trades Size And Style Views Favor value over growth Favor large over small caps

Special Report

Highlights Our Special Report on housing betrayed little concern, … : We noted the softness in housing, and its drag on U.S. growth, in our November 19 Special Report, but we concluded that it was not sending a more worrisome message about the U.S. economic outlook. ... which didn’t mesh with several of our clients’ assessments, … : Our conclusion was apparently out of step with a fair proportion of investors. The clients who contacted us are not convinced that the softness so far isn’t just the tip of the iceberg. … so we’ve been discussing it a lot, … : Some BCA strategists are also more uneasy about housing and what it may be saying about the fate of the expansion. The topic continues to be bandied about in our daily meetings, and it probably hasn’t been exhausted yet. … and we’re sharing the conversations with everyone now: Publicly airing our one-on-one discussions gives all clients a chance to listen in and also gives us a chance to expand upon our views. Though we stand by our original conclusion, engaging in dialogue has enhanced our understanding of the issues. Feature The stock market still feels a little shaky, but the S&P 500 bounced smartly off of 2,640 once again, the abbreviated day-after-Thanksgiving session aside. Our Global Investment Strategy colleagues’ MacroQuant model sees more near-term downside, but neither of our teams believes that the bull market is over. The economy is strong; monetary policy remains accommodative; and fiscal stimulus will continue to support growth in 2019, albeit to a lesser degree. We do not see the good times ending for risk assets or the expansion until the Fed intervenes to bring the curtain down. We will discuss our outlook for the coming year, and the way we expect the key cycles will evolve, next week. For now, we turn to the wave of client questions that followed our Special Report on housing two weeks ago. The general view seems to be that we are not taking the potential implications of disappointing housing data seriously enough. The highlights of our follow-up discussions appear below, but we continue to believe that the housing slowdown does not portend larger immediate problems. Q: What about the effect of the new $10,000 cap on the deductibility of state and local taxes in high-tax states? The $10,000 cap on state and local tax (SALT) deductions will hurt housing demand at the margin, as will lower limits on mortgage interest deductibility. People respond to incentives, and several households may choose to rent instead of buy now that homeownership subsidies have been dialed back. The 1986 Tax Reform Act provides a ready antecedent. The mortal wound it dealt real estate tax shelters set the stage for the commercial real estate downturn of the late ‘80s and early ‘90s, and it also contributed to the nearly decade-long stagnation in nominal home prices (Chart 1) that was quite nasty in inflation-adjusted terms (Chart 2). Chart 1The Last Tax-Code Revamp Squeezed Home Values...   Chart 2...Especially On An Inflation-Adjusted Basis The regional disparities in home sales do not suggest that the tax changes have been a primary driver of the softness. Households in states with high income-tax burdens are most likely to go from itemizing their deductions (the mechanism for claiming housing subsidies) to taking the standard deduction. If the SALT rule change were squeezing home sales, one would expect that the states with the highest income-tax rates would be experiencing the biggest declines. We tested that proposition by comparing population-weighted tax rates with the share of home sales in each region. Although the South has the lowest top marginal income tax rate by a mile (Table 1), it has lost nearly two percentage points, or 4%, of its national market share since this year’s peak in home sales (Table 2). The high-tax Northeast, on the other hand, picked up nearly one percentage point, or 9%, of market share. The onerously-taxed West has lost the same proportional share as the South, but its homes are also the least affordable – a family earning the median income barely qualifies for a standard mortgage to buy the median-priced house in that region (Chart 3, bottom panel). Table 1Regional Income Tax Rates   Table 2Regional Share Of National Home Sales   Chart 3Only The West Is A Stretch Bottom Line: Income tax changes reducing homeowner subsidies will surely dampen marginal demand for homes, but they have not yet had an observable effect on the regional data. Q: The decline in activity has been modest so far, but what if it’s the start of something bigger? How do you know it’s not 2006? Housing is an important part of the economy, and residential investment could become a problem if it weakens further. We did not mean to imply that investors can ignore what’s going on in the industry. Residential activity puts a lot of people to work, directly and indirectly, and drives big-ticket consumption of home improvements, appliances and home furnishings. Its status as a rate-sensitive pillar helps provide insight into the effect of monetary policy, a particular flash point right now. From the narrow perspective of whether or not housing is likely to tip the economy into a recession, however, the arithmetic is clear. According to the IMF’s latest projections, fiscal stimulus will add 40 basis points to real GDP in 2019. Merely offsetting the effect of next year’s fiscal thrust would require residential investment, which accounts for 3.3% of GDP, to contract by 12% on an annualized basis. Residential construction would have to grind to a halt to wipe out projected growth of 2.5%. Even following October’s new home sales dud, the housing market is nowhere near oversupplied (Chart 4). The supply/demand balance is night-and-day different from what it was ahead of the crisis. Back then, there was also a decade of excessive mortgage issuance that needed to be unwound. Housing remains an important component of the economy, but it has shrunk to the point that it is not in a position to overwhelm the preponderance of positive macro data. Chart 4Supply Is Tight Bottom Line: We are watching housing, as BCA always has, but the market’s aggregate undersupply gives us confidence that residential activity is not about to fall off of a cliff. Q: The value of the housing stock is so large that it wouldn’t take a bust to have major economic implications. Consumption would immediately be at risk, and the economy with it. It is true that homes account for a sizable portion of household net worth, but the widely-repeated notion that homes are the biggest asset on the aggregate household balance sheet is misleading. When considered in terms of homeowner equity (home value net of mortgage obligations), homes currently account for about 14% of aggregate household net worth. Pension entitlements and equity and mutual fund holdings each account for about a quarter of net worth, and cash and equity in non-corporate businesses each account for about an eighth (Chart 5). Homeowner equity’s share of household net worth has rebounded nicely from its crisis lows, but it is a full third below its 1980s and 2006 peaks. Chart 5Home Values Matter, But They're Far From The Whole Story The point is that a generalized decline in home prices might affect consumption less than investors fear. The wealth effect is real, but fluctuations in home values are not evident to homeowners in real time. While we estimate that consumption falls five cents for every dollar decline in home values, the two series do not always march in lockstep, as in the ‘90s and the initial post-crisis years, when consumption grew even as home prices shrank (Chart 6, bottom panel). With the market in a state of undersupply, we don’t see a reason to expect that home prices are at much risk. Chart 6Consumption And Home Price Appreciation Are Linked Bottom Line: Absent overbuilding, foolhardy lending, or a harmful structural change on the order of the imposition of the passive activity rules, there is no clear catalyst for severe home-price declines. The economy should be able to handle a modest home-price correction without too much ado. Q: Not so fast. The crisis demonstrated that there’s a direct link between housing and credit conditions. It doesn’t take a perma-bear to see how a decline in home prices could cause the banking system to seize up. Our BCA colleagues are quite familiar with our view that homes are the collateral for the U.S. banking system. That view is a broad generalization, but the crisis bore it out. Banks are vastly better capitalized than they were in 2007, however, and it is difficult to see a path to major declines in home prices. Busts follow booms because they’re a necessary cure for unsustainable excesses, but nothing extreme has occurred this time on either the supply or the price fronts. Although we are hardly card-carrying Austrians, we have a lot of sympathy for the view that ZIRP, NIRP and QE programs subjected financial markets to distortions. They abetted a search for yield that allowed questionable credits to attract capital and promoted a widespread relaxation of debt covenants. They additionally seem to have lit a fire under property values in jurisdictions where home prices have become detached from standard value metrics. In the main, however, those jurisdictions are not in the U.S. (Chart 7). Chart 7U.S. Housing Isn't The Problem In talking through the bank exposure issue with a client, we arrived at a simple rule: property markets that haven’t already received their comeuppance are the property markets that threaten wealth, confidence and banking systems. The U.S. got its comeuppance in the crisis: property values plunged, loans went bad en masse, banks and specialty lenders failed, the survivors were chastened, and new regulations were put in place to protect the bankers from themselves and the economy from banks. As the Fed continues on its slow march to remove monetary accommodation, it is entirely reasonable for a macro-minded investor to be on the lookout for wobbly property markets. S/he would be best served by studying the rest of the dollar bloc: Canada, Australia and New Zealand are all vulnerable; the United States is not. Q: The Kansas City market is bifurcated by price. Supply is constrained at lower price points, although the formerly red-hot move-up segment has slowed considerably since mortgage rates spiked. High-end homes are being discounted sharply, and the baby boomers’ 4,000-6,000-square-foot suburban behemoths, untouched since the ‘80s, cost as much as brand-new high-end construction once you factor in the work they’d need to make them appeal to today’s buyers. Meanwhile, the limited supply of homes for first-time buyers has multi-family apartments popping up on every block. A market based on location, location, location is inherently heterogeneous, but a lot of what is happening in Kansas City appears to be playing out nationally. The rapid rise in mortgage rates has dented demand across the board. We’ve been hearing rumblings about easy multi-family credit for a while, most memorably from a Texas client who told us in 2014 that a blueprint was all it took for an apartment developer to get a bank loan. There is no investment idea so good that it can’t be destroyed by too much capital, and it’s entirely possible that some developers, commercial real estate lenders, commercial mortgage-backed securities holders and apartment REITs could be vulnerable if entry-level supply surges. There is no sign right now that it will, however. According to the Harvard Joint Center for Housing Studies, “virtually all” of the nation’s metropolitan areas “had more homes for sale in the top third of the market by price than in the bottom third.” A limited supply of available land and rising construction costs push developers to migrate to higher price points. The trend toward more expensive homes has been in place across the entire 30-year history of the Harvard center’s annual survey: the share of smaller homes (1,800 square feet or less) has slid from 50 percent in 1988 to 36 percent in 2000 and 22 percent in 2017.1 The fate of the boomers’ homes touches on what may be the most compelling long-term issue: to whom will the baby boomers pass the baton? Will the millennials accumulate enough wealth to be able to take it? Will they want to, after living through the formative experience of the financial crisis? Will suburban and exurban homes go vacant as preferences shift to the density and walkability of town and city centers? Are wide swaths of the existing housing stock destined for obsolescence? We are not inclined to think so. Even if homeownership is suppressed by a lessened desire to own, or delays in starting a career in the wake of the crisis, millennials and their families will still need a roof over their heads. We expect that purchase and rental prices will correct for changes in location and decorating preferences; homebuyers will put up with dark cabinets, loud tile patterns and wall-to-wall shag carpeting if the price is right. Lower prices might be what’s needed to help solve a potentially thorny problem raised by a client in the antipodes: the transfer of wealth across generations. He sees barriers to homeownership for the middle class as a social and political powder keg. A transfer of wealth from older generations to younger generations, accomplished by property markdowns instead of punitive income and property taxes, could be far less disruptive for markets and may even help to ease inequality strains. Furthermore, buyers who get a deal on a property have more money available for other consumption, while those who pay up retain less dry powder to help keep the economy humming. Investment Implications Investors are well served to be alert for excesses that cannot be sustained, and it is a near certainty that a 10-year expansion nourished on extreme monetary accommodation would have bred more than a few. From our perspective, however, all of the worst ones exist beyond the borders of the United States. Virtually all of the post-crisis increase in private-sector leverage has been contained in the emerging markets. The wild residential party has been raging in the developed world’s other former British colonies: Canada, Australia and New Zealand face inevitably sharp declines in construction activity and home prices. We are neither congenital Pollyannas nor market cheerleaders. We are bent on sniffing out market and economic inflection points as adroitly as possible, but we’re convinced that investors who are looking for them in U.S. housing are barking up the wrong tree. The Fed is moving steadily toward inducing an inflection point, but it is not yet upon us, and when it arrives, the attendant distress is not going to be centered on the United States, which already underwent its trial by fire ten years ago. We remain vigilant, but we are constructive on the U.S. economy and risk assets, especially in relation to the rest of the world.   Doug Peta, Senior Vice President U.S. Investment Strategy dougp@bcaresearch.com   Footnotes 1The State of the Nation’s Housing 2018, Joint Center for Housing Studies of Harvard University, p.6.