Sectors

Underweight While Johnson & Johnson’s (JNJ) recent earnings release was in line with expectations, one phrase caught our attention: “Our robust growth can be attributed to volume, not price” - JNJ CEO Alex Gorsky. We agree with Alex Gorsky that industry pricing dynamics are disappointing to say the least, and will remain a headwind for the foreseeable future (third panel). Meanwhile, on the volume front industry level data reveals that retail sales have “caught the flu” and are infecting relative share prices (second panel). Adding insult to injury, the capex cycle has clearly turned for the worse underscoring that the path of least resistance remains to the downside for Big Pharma. Bottom Line: We remain underweight the S&P pharmaceuticals index. The ticker symbols for the stocks in this index are: BLBG: S5PHAR – JNJ, PFE, MRK, LLY, BMY, ZTS, AGN, MYL, PRGO.  

Highlights An analysis on India is available on page 12. There is extreme complacency in global financial markets. With currency markets’ implied volatility at a record low, we recommend going long EM currency volatility. The latter will rise in the next six month regardless the direction of global risk assets. For now, we remain long the EM MSCI equity index with a stop point at 1050. In India, nominal income growth has fallen below lending rates. The latter have not declined despite monetary easing. The authorities will force banks to reduce their lending rates, which will hurt bank stocks. Feature “…we have probably seen the end of the boom-bust cycle.” Bob Prince, Co-CIO of Bridgewater World Economic Forum, Davos January 22, 2020 Low Volatility = Complacency Chart I-1Go Long Currency Volatility The comment above by co-CIO of the largest hedge fund declaring the end of boom-bust cycle is consistent with lingering complacency in global financial markets. Any time an influential person made a similar declaration in the past, it marked a major turning point in financial markets. Remarkably, implied volatility for the US dollar has plummeted to a record low, as it has for EM currencies and a wide range of equity markets. Chart I-1 illustrates the implied volatility for EM currencies and the US dollar. Such low levels of implied currency market volatility historically preceded major moves in currency markets and often led to a material selloff in broad EM financial markets. It does not mean that the world economy will crash but financial markets volatility in general and currency market volatility in particular are bound to rise considerably in the months ahead. The risk-reward profile of going long EM currency or US dollar volatility appears very attractive. Today we recommend investors to go long EM currency volatility. The latter will rise regardless the direction of global risk assets. Concerning overall strategy, EM financial markets are entering a testing period. How broader EM risk assets and currencies perform in the coming weeks will signal how durable and long-lasting the current EM rally will be. Given global risk assets are overbought, a correction or consolidation phase is overdue. If EM equities, currencies and credit markets outperform, or at least do not underperform their DM peers in the course of this indigestion phase, it will beckon more upside for EM risk assets in 2020. If during budding market turbulence EM risk assets and currencies underperform their DM peers, it will signal their vulnerability in 2020.Implied volatility for the US dollar has plummeted to a record low, as it has for EM currencies. Implied volatility for the US dollar has plummeted to a record low, as it has for EM currencies. For now, we remain long the EM MSCI equity index with a stop point at 1050. We will upgrade our EM equity and credit market allocations versus DM if the EM universe generally exhibits relative resilience in the coming weeks, and more of our indicators confirm China’s growth recovery. Hints Of Recovery… December economic data out of China were strong, and it seems that the credit and fiscal stimulus are finally beginning to lift growth: Chinese imports and nominal industrial output – among the most reliable measures of the Chinese business cycle – posted very robust growth numbers in December (Chart I-2). DRAM and NAND semiconductor prices are climbing, and China’s container freight index is also in revival mode (Chart I-3). These high-frequency (daily and weekly) data confirm improving business activity in both the global semiconductor sector and in overall world trade. Chart I-2China's December Economic Data Were Strong Chart I-3Asia's Trade Is Recovering   There are tentative signs of amelioration in our proxies for marginal propensity to spend by households and enterprises in China (Chart I-4). A more decisive improvement in these indicators is needed to reinforce the positive outlook for China’s growth. …But Doubts Still Linger Despite the recent improvement in Chinese economic data and the rebound in China-related plays, there are a number of financial market indicators that are not yet confirming a sustainable business cycle recovery in China and global trade. In particular: First, apart from semiconductor stocks, global cyclical equity sectors and sub-sectors – industrials, materials, and freight and logistics – have begun, once again, underperforming defensive sectors (Chart I-5). Outperformance by these cyclical sectors against defensives is essential in confirming that global and Chinese capital spending – which were the primary sources of the most recent slowdown – are picking up again. Chart I-4China: Tentative Improvement In Household And Corporate Marginal Propensity To Spend Chart I-5Global Equities: Cyclicals Are Again Underperforming Defensives   Notably, the relative performance of EM share prices to the global equity benchmark historically tracks the relative performance of global materials versus the global overall stock index.1 However, the two have recently diverged (Chart I-6). In short, global materials are not corroborating sustainability in the recent EM outperformance. If EM equities, currencies and credit markets outperform, or at least do not underperform their DM peers in the course of this indigestion phase, it will beckon more upside for EM risk assets in 2020. Second, the rebound in Chinese and EM shares prices is not corroborated by Chinese onshore government bond yields, which are dipping to new cyclical lows (Chart I-7). In other words, interest rate expectations in China are falling – i.e., they are not confirming a robust recovery. Chart I-6Unsustainable Decoupling Chart I-7A Message From The Chinese Fixed-Income Market   Third, EM ex-China currencies have not yet broken out versus the US dollar (Chart I-8). Consistently, the broad trade-weighted US dollar has not yet broken down. Chart I-9 illustrates that the greenback’s advance-decline line has not yet fallen below its 200-day moving average, a condition that has historically been required to confirm the dollar’s cyclical bear market. Chart I-8EM Currencies: No Breakout Yet Chart I-9The US Dollar Is At A Critical Juncture   We view these exchange rate patterns as a litmus test to validate turning points in the global business cycle. Finally, the technical profiles of the KOSPI, EM small cap stocks and copper prices are inconclusive (Chart I-10). These markets have rebounded but seem to be confronting a critical technical test. If they decisively break above these technical levels, it will be a sign that the EM bull market will be lasting and durable. Otherwise, caution is still warranted. Bottom Line: There is a good amount of complacency among global investors at a time when there are several market signals that are still challenging the view of enduring revival in China/EM growth. Corporate Profits Will Be The Arbiter Ultimately, economic growth and corporate profits will determine the direction of not only share prices but also EM sovereign and corporate credit spreads as well as their currencies. So far, the EM equity rebound of the past 12 months has been solely due to multiples expansion amid a deepening EM profit recession: Earnings per share in US dollar terms has been contracting by 10% from a year ago, and the rate of change has so far not turned around (Chart I-11). Chart I-10The KOSPI And Copper Are Facing A Resilience Test Chart I-11EM Equities: A Profitless Rally?   Going forward, however, EM corporate profits growth is set to improve. Our indicator for semiconductor companies’ revenues is heralding a revival in semi sector profits (Chart I-12, top panel). The rate-of-change improvement in commodities prices is also foreshadowing potential amelioration in corporate earnings growth among energy producers and materials (Chart I-12, middle and bottom panels). Chart I-12EPS Growth In EM Technology, Energy And Materials We are negative on EM bank profits due to their need to recognize and provision for non-performing loans as well as the authorities’ mounting pressures on them to reduce lending rates. The latter will shrink banks’ elevated net interest rate margins. The profit profile of other EM equity sectors is illustrated in Chart I-13A and I-13B. Chart I-13AEM EPS Growth By Sectors Chart I-13BEM EPS Growth By Sectors   Provided technology, materials and energy stocks account for 33% of the MSCI EM aggregate equity index’s earnings (banks account for another 28% of total profits), it is safe to assume that the growth rate of EM EPS will move from -10% currently to zero or mildly positive territory by mid-2020. Nevertheless, beyond the next several months, our leading indicators on the EM profit outlook are not positive. China’s narrow money growth leads EM EPS by 12 months, and currently suggests the EPS recovery will be both muted and short-lived (Chart I-14). The technical profiles of the KOSPI, EM small cap stocks and copper prices are inconclusive. Further, China’s broad money impulse points to a peak in the credit impulse in the first half of the year (Chart I-15). Given that EM share prices bottomed a year ago, simultaneously with China’s credit impulse, odds are that EM equities could slump with a rollover in the latter. Chart I-14EM EPS: Marginal Improvement Ahead But No Robust Recovery Chart I-15China: A Signpost Of A Potential Top In The Credit Impulse   Chart I-16DM Central Banks' Assets And EM Stocks And Currencies: No Stable Correlation What if the current liquidity-driven rally continues? In our report last week titled A Primer On Liquidity, we elaborated at great length about the different liquidity measures and how they influence financial asset prices. Empirically, changes in DM central banks’ balance sheets have had no stable correlation with either EM share prices or EM local currency bonds, as demonstrated in Chart I-16. There have been periods over the past 10 years when EM risk assets and currencies have performed poorly, despite an accelerating pace of QE programs worldwide (Chart I-16). The true and critical driver for EM equity and currency performance has been EM’s own domestic fundamentals and China’s business cycle (please refer to Chart I-11 on page 7). To be sure, we are not suggesting that DM central bank policies have not affected global and EM financial markets at all. They have done so in spades. By purchasing and withdrawing about $9 trillion in high-quality securities from the marketplace, the monetary authorities have shrunk the stock of available financial assets. Consequently, even though QE programs have expanded broad money supply only modestly,2 the upshot has been that more money has been chasing fewer financial assets. Also, low interest rates reduce the opportunity cost of owning risk assets. These two phenomena have led investors to bid up prices of various securities, including EM ones. Nevertheless, despite the ongoing and indiscriminate global search for yield, EM share prices in US dollar terms and EM ex-China currencies (including carry, i.e. on a total-return basis) are still below their 2010 levels. Such poor performance of EM risk assets has been a corollary of just how bad EM fundamentals have been. Bottom Line: EM corporate profits will improve on a rate-of-change basis in the coming months. However, forward-looking indicators do not yet point to a robust recovery in EM corporate profits as occurred in 2017. Investment Conclusions We are maintaining our long EM equities position with a stop point at 1050 for the MSCI EM stock index (7% below the current level). If EM share prices, credit markets and currencies outperform their DM peers during a correction/consolidation phase, we will upgrade EM allocations to overweight in global equity and credit portfolios. At the moment, EM is confronting a resilience test. Within the EM equity universe, our overweights are Russia, Korea, Thailand, Mexico, UAE, Pakistan and central Europe. Our recommended equity underweights include Indonesia, the Philippines, Hong Kong domestic stocks, South Africa, Turkey and Colombia. In sovereign credit and local bond markets, our overweights are Mexico, Russia, Thailand, Malaysia, Pakistan and Ukraine. In turn, South Africa, Turkey, Philippines and Indonesia warrant an underweight stance. Today we are upgrading Indian bonds from neutral to overweight (see page 17).  In the currency space, we continue holding a short position versus the US dollar in the following basket of currencies: BRL, ZAR, CLP, COP, IDR, PHP and KRW. As always, the full list of our positions is presented at the end of report (please refer to pages 18-19 and on our website).   Arthur Budaghyan Chief Emerging Markets Strategist arthurb@bcaresearch.com India: Beware Of Private Banks And Consumer Perils Indian private banks and consumer staple stocks have been holding up the Indian equity market at a time when the rest of the bourse has been sluggish. Both sectors, however, are extremely expensive and thus tremendously sensitive to minor profit disappointments. Remarkably, private banks now trade at a price-to-earnings (P/E) ratio of 31 and price-to-book value (PBV) ratio of 4. Indian consumer staple stocks, on the other hand, trade at a P/E ratio of 41 (Chart II-1 and Chart II-2). Chart II-1Indian Private Bank Stocks Are Expensive Chart II-2Indian Consumer Staple Stocks Are Very Pricey   Chart II-3A Credit Boom Among Indian Private Banks Given that private banks have been specializing in both mortgages and non-mortgage consumer lending, the call on both private bank and consumer staple stocks is contingent on consumer financial health. The loan book of private banks has expanded tremendously: since 2010 it has grown at a compounded annual growth rate (CAGR) of 20% and 14% in nominal and real (inflation-adjusted) terms, respectively (Chart II-3).3 In turn, the share of household loans is reasonably large at around 52% of private banks total loan book.  Unfortunately, India’s consumer sector appears to be fragile at the moment. Employment and wage growth have downshifted – the Manpower employment index is at a 14-year low (Chart II-4). Consequently, household disposable income growth has decelerated to 9% in nominal terms (Chart II-5). Critically, households’ ability to service debt has deteriorated as nominal disposable household income growth has fallen slightly below borrowing costs, i.e., bank lending rates (Chart II-5). This development is precarious not only because it makes it more difficult for consumers to service their debt – causing NPLs to rise – but it also dampens consumer credit demand. Consequently, private banks’ considerable exposure to consumers could reverse the fortunes of the former as consumers face increasing difficulties servicing their debt. Moreover, with borrowing costs above nominal income growth, banks in India could face adverse selection problem. The latter is a phenomenon when loan demand primarily comes from riskier borrowers who are in desperate need for funding. In such a case, non-performing loans are bound to mushroom. Chart II-4India's Labor Market Is In Doldrums Chart II-5India: Household Nominal Income And Lending Rate Overall, household spending is in the doldrums. Two- and three-wheeler and passenger car unit sales have all been contracting. In the meantime, consumer demand for non-durable goods has also weakened, as reflected by stalling non-durable consumer goods production. Residential property demand has plummeted. According to the Reserve Bank of India’s December Financial Stability Report – quoting data from PropTiger DataLabs – housing sales units contracted by 20% in September from a year ago. In turn, growth in house prices has been anemic (Chart II-6). Prices are now growing below core inflation, i.e. property prices are deflating in real terms. Households’ ability to service debt has deteriorated as nominal disposable household income growth has fallen slightly below borrowing costs. Going forward, odds are that employment and wage growth will remain weak in India. The basis is the corporate sector is also struggling and still reluctant to invest and hire. Chart II-7 illustrates that the number of investment projects has collapsed, while capital goods production and capital goods imports are both shrinking (Chart II-7). Chart II-6India: Housing Market Is Feeble Chart II-7India: Companies Are Not Investing   Overall, the entire Indian economy is suffering from high borrowing costs in real (adjusted for inflation) terms (Chart II-8, top panel). Chart II-8Lending Rates Have Not Declined Despite Monetary Easing Importantly, the monetary policy transmission mechanism has not been working effectively in India. Even though the central bank has cut its policy rate by 135 basis points in 2019, prime borrowing did not budge (Chart II-8, middle panel). Consequently, loan growth has decelerated sharply (Chart II-8, bottom panel). On the whole, for the economy to recover, it requires considerably lower borrowing costs or a substantial fiscal boost. Indian central and state fiscal aggregate budget deficit is already wide at 6% of GDP. With public debt-to-GDP ratio at 68%, there is some but not enormous room for boosting government expenditures drastically. This makes reducing commercial bank lending rates the most feasible mechanism to jump-start the economy. Consequently, the authorities will become more aggressive in forcing commercial banks to cut their lending rates. This seems to be taking place as in September 2019 the RBI asked Indian commercial banks to link lending rates on certain types of loans more closely to the central bank’s policy rate to ensure more effective monetary policy transmission. Yet doing so will squeeze down commercial banks’ net interest rate margins – which have widened – and will hit banks’ profits. Alternatively, if lending rates do not fall, non-performing loans (NPLs) will increase because only risky borrowers will be willing to borrow while existing debtors will struggle to service their debt at current elevated interest rates. This will also depress bank profits. These two negative scenarios are probably reflected in low valuations of public bank share prices, but they are not yet priced in among private banks stocks. Given the latter’s exuberant valuations, only a small drop in net interest rate margins or a small rise in NPLs, will be enough to drag their share prices lower. Investment Conclusions Chart II-9India Vs. EM Relative Equity Performance Is Often About Oil Travails of the Indian economy will persist for now. Much more policy support is required to turn the business cycle around. EM equity investors should keep a neutral allocation to Indian stocks within an EM equity portfolio. Indian share prices often outperform their EM peers when oil prices drop and lag when crude prices rally (Chart II-9). Given our negative view on oil prices,4 we are reluctant to downgrade this bourse to underweight. Private banks are susceptible to a drawdown as either their net interest rate margins will drop or they will face rising non-performing loans. Consumer staples stocks are expensive and, hence, are vulnerable to marginal profit disappointments. We are upgrading our allocation to Indian domestic bonds from neutral to overweight within an EM local bond portfolio. Consistently, we are closing our yield curve steepening trade in India. This position has produced a 30 basis points gain since July 2016. Low inflation, weak real growth, a struggling credit system and ineffective transmission of monetary easing argue for even lower interest rates in India. The surge in food prices should be viewed as a relative price shock, not inflation. Higher food prices will curb the spending power of consumers and weaken their expenditures on non-food items. In addition, core inflation remains very low. Ayman Kawtharani Editor/Strategist ayman@bcaresearch.com Footnotes 1  Please click on the link to access EM: Perception versus Reality report. 2  Commercial banks’ reserves at central banks do not constitute and are not a part of narrow or broad money supply. 3  The calculation is based on the annual reports of four large Indian private banks: HDFC Bank, ICICI Bank, Kotak Mahindra Bank, and Axis Bank. 4   This is the Emerging Markets Strategy team’s view and it differs for BCA’s house view on oil. Equities Recommendations Currencies, Credit And Fixed-Income Recommendations

Overweight In our most recent Special Report we outline why we believe the S&P industrials index is set to outperform the market. Among other reasons, industrials forward earnings breadth – defined as the net number of sub-sectors with higher forward earnings revisions – has bounced off extreme lows signaling that the sell-off in relative share prices is reaching exhaustion. Historically, similar sharp bounces have marked previous price reversals (second panel). With regard to fundamentals, expanding profit margins since mid-2018 also reflect positive sector dynamics, despite the industry having borne the brunt of the US/China trade war. In fact, CEOs managed to compensate for the falling selling prices at the expense of labor (third & bottom panels). Bottom Line: Remain overweight the S&P industrials index. For more details please refer to the most recent Special Report.

Special Report

Highlights Macro winds are slowly changing, compelling investors to take a second look at highly cyclical sectors such as industrials. In this Special Report we highlight that the S&P industrials index is trading at a nearly 10% discount to the market on a forward P/E basis, meanwhile a list of welcoming omens has appeared on the horizon which will serve as a foundation for the relative share price outperformance. Increasing odds of a modest rebound in the US manufacturing PMI Stabilization in EM in general and Chinese economy in particular BCA’s House View of a weaker dollar Healthy industry operating metrics Table 1 Feature While US manufacturing remains in recession, investors have already positioned for a V-shaped recovery according to the spectacular run-up in the S&P 500. However, drilling beneath the surface is revealing. Instead of hypersensitive industrials equities sniffing out a recovery in the manufacturing sector, the SPX’s advance has been solely driven by tech mega caps, and thus leaving in the dust all their deep cyclical peers. Why? Because the industrials complex has borne the brunt of the trade war (Chart 1). However, our expectation remains for a natural healing of the economy sometime in the first half of the year, and a rotation out of tech equities into capital goods stocks. Industrials equities will be among the first beneficiaries of this improving macro backdrop. Specifically, four key themes underpin our bullish stance on the S&P industrials index: Increasing odds of a modest rebound in the US manufacturing PMI Stabilization in EM in general and Chinese economy in particular BCA’s House View of a weaker dollar Healthy industry operating metrics Chart 1Trade War Echoes The ISM Will Soon Turn The Corner ISM’s manufacturing PMI survey is still below the 50 boom/bust line, but much of the macro pessimism is likely already reflected in the data, as it is set to bottom by the end of Q1 2020 and rebound into Q2 2020. To be clear, we are not expecting a jump into the high 50s, but rather look for a more balanced recovery into the low 50s. Nevertheless, it is a 5-point rise from the current recessionary level, and the S&P industrials index will cheer a relief in macro data. Charts 2 & 3 clearly depict that the ISM manufacturing PMI is set to improve in the coming months. First, our demand/supply proxy for the overall US economy (comprising of retail and industrial production data) is signaling that industrial production will likely bottom by mid-2020, despite Boeing’s ails (Chart 2, bottom panel). Industrial production is also known to lag PMI by roughly three months, which translates into PMI bottoming in Q1 2020, if history at least rhymes. Moreover, the bond market is also sending a similar message (Chart 2, third panel). As a reminder, BCA’s House View calls for a sell-off in the bond market to a range of 2.25-2.5% for this year. Chart 2Long Term And … Chart 3… Short Term Drivers Are Positive Both coincident and short-term leading economic variables also emit a positive signal. Lumber prices have recovered sharply over the past year (Chart 3, second panel), and given their close correlation with the ISM manufacturing PMI, the move underscores that the bottoming process in the latter has already begun. Moreover, survey internals have made a modest turn on a three-month moving average basis, suggesting that the path of least resistance is to the upside (Chart 3, bottom panel). On the political front, our sister Geopolitical Strategy service has been right on Trump having to retreat and to agree on a “ceasefire” deal as the 2020 elections are looming. Following the October and December tariff “postponement/cancelation” coupled with lower chances of any tariff hikes at all until the 2020 election will likely provide a further boost to the “soft” survey data. As a reminder, the increase in trade policy uncertainty over 2018-2019 has been a large contributor to data deterioration (Chart 1). EM And Chinese Green Shoots A rising share of international sales for the S&P industrials index originates from the EM, as those countries are responsible for a large percent of world total commodity consumption and construction activity. The EM manufacturing PMI has done a good job at tracing the S&P industrials relative share price performance, and the current divergence between the two can serve as yet another catalyst for a rally (Chart 4, top panel). Most importantly, China is also enjoying green shoots. BCA’s Chinese credit & fiscal impulse has been grinding higher over the past year foreshadowing a further rebound in EM data, and consequently benefiting US industrials. Finally, Chinese infrastructure spending that managed to climb out of negative territory will, at the margin, further boost industrials end-demand (Chart 4, middle & bottom panels). Chart 4International Arena Improving The Dollar Is Petering Out Switching gears to the greenback, more good news is in store for the S&P industrials index. Forty-four percent of sales are international for the S&P industrials sector, making it sensitive to FX fluctuations. BCA’s House View for 2020 calls for a weaker USD and should it be proven correct, industrials P&Ls will enjoy positive currency translation tailwinds. Chart 5 shows a newly created dollar model first published by our sister The Bank Credit Analyst service, heralding a softer greenback in the coming months. The real trade-weighted US dollar has been a key driver for the S&P industrials’ sales ever since 1975 as they remained in positive territory even during the recent manufacturing recession. A turn in the US dollar will reignite sales growth and underpin the relative share price ratio (Chart 6, bottom panel). Chart 5The Softening US Dollar … In addition, a depreciating US dollar has been synonymous with a relative multiple expansion phase, and a definitive fall in the dollar will likely serve as a catalyst to unlock excellent value in bombed out relative valuations (Chart 6, third panel). Looking at sales from a different angle, our industrials sector exports proxy has a tight inverse correlation with the USD, and is likely to hook higher given that the US dollar is flat on a year-over-year basis (Chart 6, second panel). Chart 6… Holds The Key … Chart 7… And So Do Our EPS Models Finally, our relative earnings growth model does an excellent job at encapsulating all the profit drivers and is signaling that an earnings-led outperformance period looms (Chart 7). Enticing Operating Metrics Drilling down and away from macro and toward industry-level data is instructive. First, industrials forward earnings breadth – defined as the net number of sub-sectors with higher forward earnings revisions – has bounced off extreme lows signaling that the sell-off in relative share prices is reaching exhaustion. Historically, similar sharp bounces have marked previous price reversals (Chart 8, second panel). Chart 8Selling Climax? Chart 9More Welcoming News Expanding profit margins since mid-2018 also reflect positive sector dynamics as the industry managed to shrug off falling selling prices at the expense of labor (Chart 8, third & fourth panels). Importantly, the CRB raw industrials index is tracing a bottom and a depreciating US dollar will assist in orchestrating a recovery in industrials PPI (Chart 9). With regard to balance sheet health, interest coverage and net debt-to-EBITDA ratios are not sounding alarm bells as they are comparable to the broad market. Industrials are also steadily pumping out healthy free cash flow numbers, which should be a welcoming sign for investors (Chart 10). Despite all these tailwinds, sell-side analysts are still overly pessimistic on relative long-term profit prospects (Chart 11, fourth panel). Chart 10Good B/S All Around Chart 11No Red Flags Neither BCA composite Valuations nor Technical Indicators caution against overweighting the S&P industrials index (Chart 11, second and third panels). In fact, on a forward P/E basis, the sector is trading at a nearly 10% discount to the broad market making it an historically “cheap” addition to one’s portfolio (Chart 11, bottom panel). Risks To Monitor There are a few key risks to our view. First, we treat the current de-escalation in the trade war as temporary. Should Trump get reelected in 2020 for another term, all of the pre-election constraints will be lifted, likely allowing him to get back to his tariff hawkishness. Second, the US economy has already suffered too much damage making it vulnerable to an external shock. Were a black swan to materialize, the dollar would skyrocket putting our industrials view offside. Finally, should the Chinese government miscalculate the amount of stimulus required to reignite their economy, US industrials will again be among the first ones to suffer the consequences via the final-demand link. Put simply, any combination of these risks would slay animal spirits and postpone capex-led US industrials sector recovery. Bottom Line: Increasing chances of a rebound in the ISM manufacturing PMI coupled with green shoots in the EM, expectations for a weaker US dollar and sound industry level data, argue for an above benchmark allocation in the S&P industrials index. Please stay tuned for an upcoming Special Report on how to position within the industrials complex.     Arseniy Urazov Research Associate ArseniyU@bcaresearch.com  

Overweight The S&P software index has gone parabolic. SPX returns are extremely concentrated as we showed on Monday’s Weekly Report, with the S&P software & services GICS2 sector being responsible for 18% of the broad market’s gains since late-2018 (see bar chart below). We are participating in this rally via sustaining an overweight stance in the S&P software index – a positon that is currently up nearly 40% since inception in relative terms. However, we are compelled to raise our trailing stop to 32% (from 27% previously) as this concentrated nature of returns is making us uneasy. Should it get triggered, it will have a domino effect on our portfolio. The move to a benchmark S&P software index allocation will push the broad S&P technology sector to underweight, and consequently tilt the portfolio to a modest defensive over cyclical bent. Bottom Line: Remain overweight the S&P software index, but tighten the trailing stop to the 32% relative return mark. The ticker symbols for the stocks in this index are: BLBG – S5SOFT: MSFT, ADBE, CRM, ORCL, INTU, NOW, ADSK, ANSS, SNPS, CDNS, NLOK, FTNT, CTXS.

Neutral Our recent gold miners overweight has pushed the broad materials sector from underweight to neutral. Simultaneously, macro data also suggests that it no longer pays to be bearish materials stocks. Our materials sector profit growth model has troughed and signals that a turnaround in EPS growth is underway and should gain steam this year (second panel). Keep in mind that this niche deep cyclical sector has borne the brunt of the Sino/American trade war and the recent de-escalation can serve as a catalyst for an earnings-led recovery. Moreover, this industry is not at a standstill. Contrary to the overall economy, materials executives are investing in new projects as financial market reported materials sector capex clearly shows (third panel). These investments should bear fruit in coming quarters and translate into higher top line growth, something that is not at all discounted in bombed out relative sales growth expectations (bottom panel). Bottom Line: Book relative gains of 5% since inception and lift the S&P materials sector to a benchmark allocation. Please refer to this Monday’s Weekly Report for more details. ​​​​​​​