Sectors

Highlights Analysis on the Chinese property market is available below. In the Philippines, domestic demand is set to accelerate at the hands of the government’s fiscal boost. The current account deficit will widen and the peso and local bonds will likely sell-off. This warrants an underweight stance in this interest rate-sensitive bourse. A new trade: Pay 2-year swap rates. The outlook for China’s property market and construction activity is downbeat. Financial market plays leveraged to mainland construction activity remain at risk. The Philippines: The Cycle Is Turning The relative performance of Philippine equities against the EM benchmark is moving inversely to the direction of relative (Philippines minus EM) local bond yields (Chart I-1). When local Philippine bond yields drop versus those of other EMs, this bourse outperforms, and vice versa. Likewise, Philippine share prices in absolute terms exhibit a negative relationship with local bond yields (Chart I-2). The rationale behind this high sensitivity in share prices to local interest rates is the large presence of banks and property stocks in the Philippines' bourse. Banks account for 20% and real estate stocks another 21% of the local stock exchange. These sectors benefit in a falling interest rate environment and suffer during periods of rising rates. Chart I-1Philippines Vs. EM: Relative Stock Prices And Bond Yields Philippines Vs. EM: Relative Stock Prices And Bond Yields Philippines Vs. EM: Relative Stock Prices And Bond Yields Chart I-2Philippine Stocks Are Inversely Correlated To Domestic Bond Yields Philippine Stocks Are Inversely Correlated To Domestic Bond Yields Philippine Stocks Are Inversely Correlated To Domestic Bond Yields Our underweight position in Philippine equities has not played out because the economy has slowed much more than we had expected, which has also coincided with collapsing US Treasury bond yields. Consequently, Philippine local bond yields have plummeted, supporting the stock market’s absolute and relative performance. Chart I-3Philippine Growth Slowed Due To A Slump In Government Spending Philippine Growth Slowed Due To A Slump In Government Spending Philippine Growth Slowed Due To A Slump In Government Spending Chart I-4Negative Fiscal & Credit Impulse Stabilized The Current Account Deficit Negative Fiscal & Credit Impulse Stabilized The Current Account Deficit Negative Fiscal & Credit Impulse Stabilized The Current Account Deficit The growth rate of the Philippines has decelerated markedly due to sharp slowdowns in both government spending and bank loan growth (Chart I-3). In fact, the combined bank loan and fiscal spending impulse has plunged, leading to a major slowdown in domestic demand, which in turn has stabilized the current account (Chart I-4). The latter effect has supported the currency and allowed the central bank to cut rates. A budget deadlock on a number of items delayed the approval of the 2019 budget, causing government spending to plunge in the first half of 2019. In short, it was unintended fiscal tightening that has wrong-footed our view on the direction of the macro cycle, and consequently Philippine financial markets. Government spending has been instrumental in driving fixed capital formation since President Rodrigo Duterte came to power in May 2016. Philippine local bond yields have plummeted, supporting the stock market’s absolute and relative performance. Going forward, the macro cycle is set to reverse: Chart I-5Philippines: Signs Of A Growth Rebound Philippines: Signs Of A Growth Rebound Philippines: Signs Of A Growth Rebound Government expenditure will rise substantially – infrastructure spending in particular – lifting imports. The 2019 budget was approved back in April, and the House of Representatives has given the green light to extend the shelf-life of the current 2019 budget. Moreover, the fiscal 2020 budget, now approved by Duterte, entails 12% nominal growth in government expenditures in general and 14% growth in capital/infrastructure spending in particular. Duterte will oversee 100 flagship infrastructure projects estimated to cost 4.3 trillion Philippine pesos, or 24% of GDP. More than half of these projects are either ongoing or will commence construction in the next six to eight months. The larger infrastructure expenditure will encourage bank lending. Overall, domestic demand will revive considerably, causing the current account deficit to widen. Importantly, the expected fiscal boost will come on top of already strong consumer spending. The marginal propensity to spend among households and companies is already improving, confirming domestic growth acceleration (Chart I-5, top panel). In particular, both vehicle and machinery sales are recovering (Chart I-5, middle panel). Narrow and broad money impulses have bottomed (Chart I-5, bottom panel). Stronger imports amid still-depressed exports due to sluggish global demand will lead to a widening of the current account deficit. We expect the peso to resume its depreciation. Renewed currency weakness and a domestic demand revival will put a floor under inflation. The central bank is headed by Governor Benjamin Diokno, the former Budget Secretary and an associate of populist President Duterte. The odds are that the central bank will not hike interest rates in the face of a rising current account deficit and modestly rising inflation. This will reinforce currency depreciation. Finally, domestic bond yields are set to rise. A widening fiscal deficit has historically coincided with higher domestic bond yields (Chart I-6). Odds are it will not be different this time. Besides, Philippine banks have been relentlessly purchasing government bonds because credit demand from companies has been sluggish (Chart I-7). As private credit demand begins to recover and banks accelerate their loan origination, they will become net sellers – or will at least ease their pace of government bond purchases – pushing yields higher. Chart I-6Rising Fiscal Deficit Is Bad News For Bonds Rising Fiscal Deficit Is Bad News For Bonds Rising Fiscal Deficit Is Bad News For Bonds Chart I-7Philippine Commercial Banks Have Been Purchasing Government Bonds En Masse Philippine Commercial Banks Have Been Purchasing Government Bonds En Masse Philippine Commercial Banks Have Been Purchasing Government Bonds En Masse Bottom Line: Unintended fiscal tightening has slowed domestic demand, narrowed the current account deficit, supported the currency and induced a drop in local bond yields. This has allowed the Philippines’ interest rate-sensitive bourse to outperform the overall EM equity index. Going forward, the macro cycle is set to reverse. This cycle is about to reverse due to strong fiscal expansion: Domestic demand and imports will grow briskly, and the current account deficit will widen considerably. Widening twin deficits will lead to material currency depreciation and higher domestic bond yields. Investment Recommendations Continue shorting the Philippine peso versus the US dollar. 2-year swap rates are 48 basis points below the policy rate (Chart I-8). The market will price out rate cuts as the business cycle recovers and the currency depreciates. We recommend a new trade: pay 2-year swap rates. Dedicated EM fixed-income investors should underweight the Philippines in their EM domestic currency bonds and sovereign credit portfolios. Chart I-8The Market Is Expecting Rate Cuts The Market Is Expecting Rate Cuts The Market Is Expecting Rate Cuts Chart I-9Philippine Equity Market Is Not Cheap Philippine Equity Market Is Not Cheap Philippine Equity Market Is Not Cheap     Does an upcoming growth revival warrant an overweight stance in Philippine stocks within an EM equity portfolio? As shown in Charts I-1 and I-2, this equity market is more sensitive to interest rates than growth. The growth deceleration did not prevent this stock market from outperforming its EM peers. Hence, higher local bond yields amid renewed currency depreciation will likely lead to a period of underperformance. Finally, Philippine stocks are not cheap in absolute terms or relative to the EM benchmark (Chart I-9). Hence, they will not respond well to rising interest rates. Chart I-10Philippine Property Stocks Will Suffer As Interest Rates Rise Philippine Property Stocks Will Suffer As Interest Rates Rise Philippine Property Stocks Will Suffer As Interest Rates Rise Within this bourse, underweight/short property stocks. These stocks are the most vulnerable to rising bond yields (Chart I-10). The key risks to our strategy are lower global bond yields and continuous flows of foreign capital into EM assets in general, and local bonds in particular.   Ayman Kawtharani Editor/Strategist ayman@bcaresearch.com Arthur Budaghyan Chief Emerging Markets Strategist arthurb@bcaresearch.com   China: Making Sense Of The Property Market Real estate activity in general, and property construction volumes in particular, are critical to our thesis of an ongoing growth slowdown in China. The basis is that construction volumes on the mainland have a considerable impact on industrial activity both within and outside China. On the structural front, housing demand is facing major headwinds: Genuine pent-up demand for housing has diminished. Most Chinese households already own at least one property. Based on a recent survey conducted by The Economic Daily,1 nearly 97% of households surveyed own at least one residential property. Last year’s China Household Finance Survey (CHFS), conducted by Southwestern University of Finance and Economics of China, showed about 68% of new homes sold in China’s urban areas in the first quarter of 2018 were purchased for the purpose of investment. In addition, the living area per capita in China’s urban areas has risen to 40 square meters as of the end of last year – larger than in South Korea and Japan. Other structural impediments include low affordability, slowing rural-to-urban migration, demographic changes and the promotion of the housing rental market. The government has been repeatedly stressing that China will not use the property market as a short-term economic growth-booster this time. The authorities will also continue to prevent speculative housing demand. Between late 2015 and 2017, the People's Bank of China undertook outright monetization of excess housing inventories via the Pledged Supplementary Lending (PSL) program. So far, even though the Chinese economy has already slowed considerably, the government has not injected much stimulus into the property market. On the contrary, the government has drastically reduced the number of slum-reconstruction units as well as its PSL injection this year. This year, the government has also started a new long-term project of renovating residential buildings built in 2000 or earlier. The projects involved include adding parking lots, elevators, fiber cable installments, electricity/gas line improvements, and so on. This renovation program will likely delay property purchases from those owners who were considering purchasing new properties instead of living in the older residential buildings. Chart II-1Property Sales In China: A Sustainable Recovery? Property Sales In China: A Sustainable Recovery? Property Sales In China: A Sustainable Recovery? From a cyclical perspective (6-12 months), falling home prices and relatively tight financing for property developers will likely prevent a recovery in construction activity: First, Chart II-1 shows there has recently been a pickup in residential property sales. Our research reveals that this has been the result of aggressive promotion strategies – price reductions – implemented by many real estate developers. Among the promotions being offered by many developers are “buy one property, get the second one at half price,” “buy a house and get a car for free,” or “buy a house and get free furniture and decorations.” Local governments have been “discouraging” outright property price declines. Yet, it seems they have allowed implicit price reductions to take place. In cases where outright price cuts cannot be avoided, the authorities try to limit them. Earlier this month, the government of Maanshan, a third-tier city in the Anhui province, released a rule instructing property developers not to lower prices by more than 10%. The outlook for China’s property market and construction activity is downbeat. As a result, official statistics on new housing prices do not truly reflect price pressures in the marketplace. Official statistics show new housing prices are rising at 9% since last year. Nevertheless, many 1st- and 2nd- tier cities are showing price declines in their secondhand residential property markets (Chart II-2).  Chart II-2China: Secondary Market Property Prices Are Weak China: Secondary Market Property Prices Are Weak China: Secondary Market Property Prices Are Weak Chart II-3Chinese Property Developers: Massive Pre-Sold Homes, But Lack Of Funding To Complete Construction Chinese Property Developers: Massive Pre-Sold Homes, But Lack Of Funding To Complete Construction Chinese Property Developers: Massive Pre-Sold Homes, But Lack Of Funding To Complete Construction   All in all, it seems that falling home prices have begun to spread from 1st tier cities to some 2nd- and 3rd-tier cities. The number of cities reporting declines in residential home prices is on the rise.   Second, in theory, falling property prices should discourage new starts and new construction. Falling prices signal that supply is exceeding demand, with producers typically responding by curtailing output. This holds true for any industry. However, the intricacies of property developers in China may be different. Chart II-4Building Construction Data Is A Broader Measure Than Commodity Buildings Building Construction Data Is A Broader Measure Than Commodity Buildings Building Construction Data Is A Broader Measure Than Commodity Buildings Specifically, property developers have been pre-selling aggressively since 2017 while slowing their completion process due to lack of financing (Chart II-3). Such financial constraints arose due to their rapid expansion in the past 10 years. Having already incurred enormous amounts of leverage, they have resorted to pre-sales as another source of funding. Property developers are currently under pressure to deliver those units that were pre sold about two years ago. Will they be able to secure new funding and ramp up construction? Or will they default or delay delivery of houses? It may well be different for each developer. The ones with strong balance sheets and access to financing will build and deliver. The weakest ones will default, while the average ones will likely delay delivery. Hence, it is difficult to gauge construction trends in the next six months in the residential property market. Even so, it is unlikely to be very strong given the industry is highly fragmented, and many small and medium and even some large developers are financially weak. Finally, there is a large gap between the two construction activity datasets – both published by the National Bureau of Statistics. These datasets are referred to as “commodity buildings” and “building construction” (Chart II-4). “Commodity buildings” – i.e., those developed by real estate developers (the equivalent of homebuilders in the US), are only a subset of “building construction.” The “building construction” dataset is more comprehensive. It includes not only “commodity buildings” but also buildings built by non-real estate developers. For example, companies, universities, and various organizations that can construct both residential and non-residential buildings for their own use. Both datasets include residential and non-residential buildings. From a cyclical perspective (6-12 months), falling home prices and relatively tight financing for property developers will likely prevent a recovery in construction activity. Chart II-5 illustrates that “building construction” floor area started, under construction and completed are all shrinking. They are much weaker than floor area started, under construction and completed of “commodity buildings.” Chart II-5Building Construction Is In Recession Building Construction Is In Recession Building Construction Is In Recession Chart II-6Falling Construction-Related Commodities Prices Reflect The Weakness In China Construction Activity Falling Construction-Related Commodities Prices Reflect The Weakness In China Construction Activity Falling Construction-Related Commodities Prices Reflect The Weakness In China Construction Activity The take-away from these datasets is as follows: Construction activity in China goes beyond property developers and “commodity buildings” statistics do not always paint the complete picture. Companies and organizations have dramatically curtailed their construction activity. Combined with tight financing conditions for real estate developers, this heralds a downbeat outlook for construction activity. Bottom Line: While short-term fluctuations in construction activity are impossible to gauge in China, the cyclical outlook remains negative. The current round of stimulus has avoided the property market, and real estate bubble excesses have not yet been wrung out. This is why we remain negative on China’s construction outlook and continue to recommend underweighting property developers relative to both the A-share and investable equity indexes. Falling steel, iron ore and industrial commodities prices confirm that construction activity in China remains weak (Chart II-6).   Ellen JingYuan He Associate Vice President ellenj@bcaresearch.com     Footnotes 1    The Economic Daily, administratively managed by the Ministry of Communication, is one of the most influential and authoritative newspapers in China. It is an official outlet for the government to publicize its economic policies. Equities Recommendations Currencies, Credit And Fixed-Income Recommendations

  Real estate activity in general, and property construction volumes in particular, are critical to our thesis of an ongoing growth slowdown in China. The basis is that construction volumes on the mainland have a considerable impact on industrial activity both within and outside China. On the structural front, housing demand is facing major headwinds: Genuine pent-up demand for housing has diminished. Most Chinese households already own at least one property. Based on a recent survey conducted by The Economic Daily,1 nearly 97% of households surveyed own at least one residential property. Last year’s China Household Finance Survey (CHFS), conducted by Southwestern University of Finance and Economics of China, showed about 68% of new homes sold in China’s urban areas in the first quarter of 2018 were purchased for the purpose of investment. In addition, the living area per capita in China’s urban areas has risen to 40 square meters as of the end of last year – larger than in South Korea and Japan. Other structural impediments include low affordability, slowing rural-to-urban migration, demographic changes and the promotion of the housing rental market. The government has been repeatedly stressing that China will not use the property market as a short-term economic growth-booster this time. The authorities will also continue to prevent speculative housing demand. Between late 2015 and 2017, the People's Bank of China undertook outright monetization of excess housing inventories via the Pledged Supplementary Lending (PSL) program. So far, even though the Chinese economy has already slowed considerably, the government has not injected much stimulus into the property market. On the contrary, the government has drastically reduced the number of slum-reconstruction units as well as its PSL injection this year. This year, the government has also started a new long-term project of renovating residential buildings built in 2000 or earlier. The projects involved include adding parking lots, elevators, fiber cable installments, electricity/gas line improvements, and so on. This renovation program will likely delay property purchases from those owners who were considering purchasing new properties instead of living in the older residential buildings. Chart II-1Property Sales In China: A Sustainable Recovery? Property Sales In China: A Sustainable Recovery? Property Sales In China: A Sustainable Recovery? From a cyclical perspective (6-12 months), falling home prices and relatively tight financing for property developers will likely prevent a recovery in construction activity: First, Chart II-1 shows there has recently been a pickup in residential property sales. Our research reveals that this has been the result of aggressive promotion strategies – price reductions – implemented by many real estate developers. Among the promotions being offered by many developers are “buy one property, get the second one at half price,” “buy a house and get a car for free,” or “buy a house and get free furniture and decorations.” Local governments have been “discouraging” outright property price declines. Yet, it seems they have allowed implicit price reductions to take place. In cases where outright price cuts cannot be avoided, the authorities try to limit them. Earlier this month, the government of Maanshan, a third-tier city in the Anhui province, released a rule instructing property developers not to lower prices by more than 10%. The outlook for China’s property market and construction activity is downbeat. As a result, official statistics on new housing prices do not truly reflect price pressures in the marketplace. Official statistics show new housing prices are rising at 9% since last year. Nevertheless, many 1st- and 2nd- tier cities are showing price declines in their secondhand residential property markets (Chart II-2).  Chart II-2China: Secondary Market Property Prices Are Weak China: Secondary Market Property Prices Are Weak China: Secondary Market Property Prices Are Weak Chart II-3Chinese Property Developers: Massive Pre-Sold Homes, But Lack Of Funding To Complete Construction Chinese Property Developers: Massive Pre-Sold Homes, But Lack Of Funding To Complete Construction Chinese Property Developers: Massive Pre-Sold Homes, But Lack Of Funding To Complete Construction   All in all, it seems that falling home prices have begun to spread from 1st tier cities to some 2nd- and 3rd-tier cities. The number of cities reporting declines in residential home prices is on the rise.   Second, in theory, falling property prices should discourage new starts and new construction. Falling prices signal that supply is exceeding demand, with producers typically responding by curtailing output. This holds true for any industry. However, the intricacies of property developers in China may be different. Chart II-4Building Construction Data Is A Broader Measure Than Commodity Buildings Building Construction Data Is A Broader Measure Than Commodity Buildings Building Construction Data Is A Broader Measure Than Commodity Buildings Specifically, property developers have been pre-selling aggressively since 2017 while slowing their completion process due to lack of financing (Chart II-3). Such financial constraints arose due to their rapid expansion in the past 10 years. Having already incurred enormous amounts of leverage, they have resorted to pre-sales as another source of funding. Property developers are currently under pressure to deliver those units that were pre sold about two years ago. Will they be able to secure new funding and ramp up construction? Or will they default or delay delivery of houses? It may well be different for each developer. The ones with strong balance sheets and access to financing will build and deliver. The weakest ones will default, while the average ones will likely delay delivery. Hence, it is difficult to gauge construction trends in the next six months in the residential property market. Even so, it is unlikely to be very strong given the industry is highly fragmented, and many small and medium and even some large developers are financially weak. Finally, there is a large gap between the two construction activity datasets – both published by the National Bureau of Statistics. These datasets are referred to as “commodity buildings” and “building construction” (Chart II-4). “Commodity buildings” – i.e., those developed by real estate developers (the equivalent of homebuilders in the US), are only a subset of “building construction.” The “building construction” dataset is more comprehensive. It includes not only “commodity buildings” but also buildings built by non-real estate developers. For example, companies, universities, and various organizations that can construct both residential and non-residential buildings for their own use. Both datasets include residential and non-residential buildings. From a cyclical perspective (6-12 months), falling home prices and relatively tight financing for property developers will likely prevent a recovery in construction activity. Chart II-5 illustrates that “building construction” floor area started, under construction and completed are all shrinking. They are much weaker than floor area started, under construction and completed of “commodity buildings.” Chart II-5Building Construction Is In Recession Building Construction Is In Recession Building Construction Is In Recession Chart II-6Falling Construction-Related Commodities Prices Reflect The Weakness In China Construction Activity Falling Construction-Related Commodities Prices Reflect The Weakness In China Construction Activity Falling Construction-Related Commodities Prices Reflect The Weakness In China Construction Activity The take-away from these datasets is as follows: Construction activity in China goes beyond property developers and “commodity buildings” statistics do not always paint the complete picture. Companies and organizations have dramatically curtailed their construction activity. Combined with tight financing conditions for real estate developers, this heralds a downbeat outlook for construction activity. Bottom Line: While short-term fluctuations in construction activity are impossible to gauge in China, the cyclical outlook remains negative. The current round of stimulus has avoided the property market, and real estate bubble excesses have not yet been wrung out. This is why we remain negative on China’s construction outlook and continue to recommend underweighting property developers relative to both the A-share and investable equity indexes. Falling steel, iron ore and industrial commodities prices confirm that construction activity in China remains weak (Chart II-6).   Ellen JingYuan He Associate Vice President ellenj@bcaresearch.com     Footnotes 1    The Economic Daily, administratively managed by the Ministry of Communication, is one of the most influential and authoritative newspapers in China. It is an official outlet for the government to publicize its economic policies.

Disconnected Disconnected Underweight Bellwether CSCO’s latest guidance was weak and confirmed that the capex-laden S&P communications equipment tech sub-index is in for a rough ride. Worryingly, CSCO’s key enterprise segment has no pulse. Historically, this data series has been positively correlated with telecom carrier capital outlays and the current message is grim (second panel). Tack on the ongoing manufacturing recession with CEOs canceling/postponing capital spending plans and the outlook dims further for the revenue prospects of communications equipment vendors (third & bottom panels). Adding insult to injury, the US/China trade war is further complicating the picture as the ongoing tariffs have exacerbated the global growth slowdown, and global capex plans have come under intense scrutiny. Bottom Line: Continue to avoid the S&P communications equipment index. The ticker symbols for the stocks in this index are: BLBG – S5COMM – CSCO, JNPR, MSI, ANET, FFIV. Please refer to this Monday’s Weekly Report for more details.

Feature We spent the past two weeks visiting and exchanging views with our clients in Asia. We presented our view that the ongoing stimulus measures are beginning to bear fruit in terms of stabilizing China’s economic activity, and that we expect the economic slowdown to bottom early next year. In addition, Chinese policymakers are signaling their willingness to accelerate stimulus on both monetary and fiscal fronts, which should mitigate the downside risks and help the economy regain traction in 2020. Interestingly, our view sparked divergent responses: clients outside of China were more upbeat about the state of the Chinese economy than clients from mainland China.  While few investors we spoke to showed concerns over an imminent “hard landing” in China’s economy or systemic risk from China’s financial system, our mainland Chinese clients remain skeptical that the ongoing stimulus will be sufficient to revive the economy. They were also worried that financial regulations may be too restrictive to generate the amount of money growth needed for the economy. Another interesting observation was that while being pessimistic about the economy, our mainland Chinese investors share our assessment that Chinese domestic stocks still have some upside in the coming year. On the other hand, global investors, who are more sanguine about China’s economic recovery, prefer to wait on the sidelines before favoring Chinese investable stocks (Chart 1). Chart 1AA Tale Of Two Markets: Onshore Outperforms Global Markets... A Tale Of Two Markets: Onshore Outperforms Global Markets A Tale Of Two Markets: Onshore Outperforms Global Markets Chart 1B...While Offshore Underperforms ...While Offshore Underperforms ...While Offshore Underperforms Below we present some of the top questions that were posed by investors during our trip, along with our answers. We recap the conclusions of our view, and draw out the investment implications of the differences between the sentiments towards China’s equity markets, in the last question of the report. Q: Recent economic data suggests a weakening Chinese economy. Why do you think the economy will reach a bottom in 2020? Historically, China’s credit formation has consistently led economic activity by about three quarters (Chart 2).  Even though credit growth this year has not been as strong as in previous expansionary cycles, a turning point in the credit impulse occurred at the start of 2019. This suggests that economic activity should turn around within the next two quarters. Chart 2Expecting A Turn In Q1 2020 Expecting A Turn In Q1 2020 Expecting A Turn In Q1 2020 Chart 3Emerging Green Shoots Emerging Green Shoots Emerging Green Shoots   Furthermore, despite weakening headline economic data, some underlying components indicate promising improvements (Chart 3): Growth in infrastructure investment has ticked up modestly in the past couple months, and is set to improve further. The State Council mandated local governments to allocate the proceeds from special-purpose bond sales to infrastructure projects by the end of October. This, combined with a frontloading of next year’s local government bonds, should lend support to infrastructure spending in the coming months. After fluctuating in and out of contraction for a year, growth in auto manufacturing production picked up in August and remained positive through October. This improvement is due to less contraction in auto sales and a faster reduction in auto inventories. Moreover, electricity output surged in October, which also indicates that growth may be gaining momentum. Chart 4Trade Should Improve Into 2020 Trade Should Improve Into 2020 Trade Should Improve Into 2020 Lastly, global financial conditions have eased significantly and credit growth has picked up worldwide, which should help support global demand. Even though Sino-US trade negotiations are ongoing, our baseline view is that a “Phase One” trade deal will be inked in the next couple months. Eased trade tensions and even some rollbacks in the existing tariffs on Chinese export goods, coupled with improved global demand, should provide some tailwinds to China’s external sector (Chart 4). Q: What is your outlook on China’s economic policy for 2020? The Chinese economic growth model remains reliant on credit formation and capital investment. Therefore, the sustainability of an economic recovery depends on whether Chinese policymakers are willing to keep the stimulus wheel turning. Chart 5A Sign Of A Policy Shift A Sign Of A Policy Shift A Sign Of A Policy Shift For investors favoring China-related assets, the good news is that there has been an increasing urgency in policymakers’ tone to support economic growth since September. Capex growth from state-owned enterprises (SOEs) has increasingly outpaced the private sector, which is significant:  A sustained rotation in the pace of SOE vis-à-vis private sector capex marked a turning point in the 2015-2016 cycle, when Chinese policymakers’ imperative to supporting growth outweighed their desire to continue with structural reforms (Chart 5).  We do not expect a 2016-style drastic rise in SOE capex growth next year, because the current economic slowdown is not as severe or prolonged as in 2015. Nonetheless, the rotation in capex growth is an important signal that Chinese policymakers may be more willing to stimulate the economy by again allowing the state sector to upstage the private sector. In the meantime, we expect that some pro-growth “policy adjustments” will be deployed in 2020: Chart 6Infrastructure Investment Likely To Rise Infrastructure Investment Likely To Rise Infrastructure Investment Likely To Rise Monetary policy will incrementally ease, with one to two 10-15bps loan prime rate (LPR) cuts in the next 3-6 months. At the same time, China’s central bank (PBoC) will keep bank liquidity ample and commercial banks’ funding costs relatively low, by continuing frequent liquidity injections to stabilize the interbank rate. A further cut in the reserve requirement ratio (RRR) is also highly likely. Keeping banks well capitalized will partially mitigate the pressure commercial banks face from falling profit margins and rising credit defaults. Accommodative monetary conditions will also support more stimulus on the fiscal front. We expect that the National People’s Congress in March 2020 will approve higher quotas on the issuing of local government bonds. Chinese state-owned commercial banks will continue to be the main buyers for local government bonds.  A portion of 2020 local government special-purpose bond issuance will be frontloaded to the remainder of 2019 and into the first months of next year. Relaxed capital requirements will likely boost local governments’ infrastructure project funding and expenditures. Our model suggests infrastructure spending should pick up from the current 3.3% year-on-year, to close to 7.5% in the second and third quarters next year (Chart 6). There are subtle signs that the government is starting to relax restrictions on the real estate sector. Land sales by local governments have increased since mid-2019, and the trend will continue into 2020 (Chart 7).  Income from land sales accounts for 70% of local government revenues, thus allowing more land sales should help fund a larger local government spending budget next year. Declining government subsidies to shantytown renovation (namely the Pledged Supplementary Lending, or PSL) have recently abated and will likely continue to improve (Chart 8). Chart 7Some Improvement To Come In The Real Estate Sector Some Improvement To Come In The Real Estate Sector Some Improvement To Come In The Real Estate Sector Chart 8Government Subsidies Will Continue Government Subsidies Will Continue Government Subsidies Will Continue   December’s Central Economic Work Conference (CEWC) will set policy priorities for the following year. We think Chinese policymakers will make economic growth a top priority for 2020. Credit growth swelled in the first quarter of 2019 following the December 2018 CEWC, and we expect a surge in early 2020 as well.Due to the unusually high credit growth in January this year and the seasonal factor next year (Chinese New Year will fall in January 2020), the surge in credit growth, on a year-over-year basis, will more likely be muted until towards the end of the first quarter and into the second quarter. Investors should overweight Chinese investable stocks in the next 6-12 months, but need to watch for more positive signs to upgrade tactical stance. Beyond the second quarter, however, the outlook gets cloudier as tension from the US election heats up and President Trump may change his trade negotiation strategies with China.1 This may have implications on China’s domestic policies. But for now, our baseline view is that Chinese policymakers will incrementally accelerate the pace of economic stimulus throughout next year. Q:  Monetary policy has been accommodative for more than a year, but capex this year has fallen below market expectations compared with past cycles. How will further stimulus help to revive investment and economic growth next year? In short, our answer is this: interest rate cuts alone will not be enough to boost economic growth in China. Capex, and growth more generally, will only revive through synchronized policy support from the Chinese authorities. In a previous report2 we discussed that the lack of response to monetary easing has been due to a less effective monetary policy transmission mechanism, a reactive and reluctant central bank, and a debt-loaded corporate sector. More importantly, the “half-measured” stimulus has been preferred by Chinese authorities in this cycle, as they prioritized financial de-risking over growth and have significantly tightened financial regulations since 2016. Given the expected policy pivot to a more pro-growth stance in the coming year, the following underlines our conviction that capex should pick up in 2020.  Modern Money Theory (MMT), with Chinese characteristics:3 local governments will ramp up debt again, and this quasi-fiscal stimulus will be a key support to the economy in 2020. During the 2015-2016 cycle, aggressive interest cuts did not result in a significant uptick in credit growth. Bank lending was not the core driver for economic recovery in 2016. The economy only bottomed following an unprecedented issuance of local government bonds after mid-2015 (Chart 9).  Chinese authorities will keep a “back door” open: even though overall tight financial regulations will remain intact, we expect the PBoC to allow a more moderate contraction in shadow banking (Chart 10). This will provide smaller banks and enterprises access to tap into bank credit. Importantly, this means the government will acquiesce to local governments in providing extra funding through shadow banking. We already see local government financing vehicles (LGFV) making a comeback in recent months. Chart 9A Chinese Version Of MMT A Chinese Version Of MMT A Chinese Version Of MMT Chart 10The "Back Door" May Open Wider The "Back Door" May Open Wider The "Back Door" May Open Wider     Small- and medium-sized enterprises (SMEs) will benefit from lowered financing costs through the new LPR system. As we pointed out in our previous report,4 the new LPR regime is not intended as much to expand bank credit as to help struggling SMEs survive economic hardships. This, along with tax cuts, should provide SMEs some relief from capital constraints. Q. CPI has been rising sharply and is above the government’s inflation target of 3%. Will inflation prevent the PBoC from maintaining an easy monetary policy? Chart 11PBoC Likely To Capitulate To Producer Deflation PBoC Likely To Capitulate To Producer Deflation PBoC Likely To Capitulate To Producer Deflation No. We think deflationary pressure in the industrial sector (measured by producer prices) poses a bigger threat to the economy, and that PBoC is more likely to loosen monetary policy than to tighten (Chart 11). Chart 12 shows that the recent surge in headline consumer prices has almost been entirely driven by soaring pork prices. There is compelling evidence from historical data that, unless core consumer price inflation also rises, climbing food prices alone will have a limited impact on PBoC policy (Chart 13). We think this approach is justified, as the necessity of “core feedthrough” is also what most central banks in the developed world look for when confronted with a detrimental supply shock. Chart 12Rising Pork Prices Have Driven Up Headline Inflation... Rising Pork Prices Have Driven Up Headline Inflation... Rising Pork Prices Have Driven Up Headline Inflation... Chart 13...But Won't Be Driving Up Interest Rates ...But Won't Be Driving Up Interest Rates ...But Won't Be Driving Up Interest Rates Chart 14A Wild Year For The RMB A Wild Year For The RMB A Wild Year For The RMB Core CPI has been trending downwards since February 2018, and there is no evidence to suggest that food prices will drive up core CPI inflation (Chart 13, bottom panel).  This, in combination with deflating producer prices, means that the probability of tighter monetary policy over the coming 6-9 months is extremely low. In fact, we expect, with high conviction, that the PBOC will guide the LPR lower in the coming months. Q: What is your view on the RMB for 2020? The RMB depreciated by 5% against the US dollar from its peak in February this year, mostly driven by market expectations of US tariffs imposed on Chinese export goods. Interest rate differentials, short-term capital flows, and economic fundamentals all have played much smaller roles in the RMB’s value changes (Chart 14). The depreciation in the CNY/USD this year has pushed the RMB close to two sigma below its long-term trend (Chart 15). As we expect a “Phase One” trade deal to be signed and trade tensions abating at least in the near term, the RMB will face upward pressure through the first half of 2020. The appreciation will also be supported by, although to a lesser extent, China’s improved domestic economy, rising demand for RMB-denominated assets, and a weakening US dollar (Chart 16). According to our model, the USD/CNY exchange rate can return to a 6.8-7.0 range, if a significant portion of the existing tariffs is rolled back (Chart 17).  This range seems to be within the “fair value” of the RMB, justifiable by the current China-US interest rate differential (Chart 14, bottom panel). Chart 15Has The RMB Gone Too Far? Has The RMB Gone Too Far? Has The RMB Gone Too Far? Chart 16Demand For RMB Assets On The Rise, Despite The Trade War Demand For RMB Assets On The Rise, Despite The Trade War Demand For RMB Assets On The Rise, Despite The Trade War However, it would not be in the PBoC’s best interests to let the RMB appreciate too rapidly, because an appreciating Chinese currency would act as a deflationary force on China’s export and manufacturing sectors.  The large differential in the China-US interest rates would allow PBoC to cut interest and/or RRR rates, to ease upward pressure on the RMB.   Chart 17Tariff Rollbacks Will Push Up RMB Tariff Rollbacks Will Push Up RMB Tariff Rollbacks Will Push Up RMB   Q: How should equity investors position themselves towards China over the coming year? We are bullish on Chinese investable stocks in the next 6 to 12 months, based on our view that the Chinese economy will bottom in the first quarter next year, policy will be incrementally more supportive, and a “Phase One” trade deal will be signed soon. In the very near term, however, we think downside risks to Chinese equities are not trivial. We remain a neutral tactical stance, but will continue to watch for the following signs before upgrading our tactical call from neutral to overweight.5 Chart 18A (top panel) shows that cyclical stocks remain very depressed relative to defensives, underscoring investors’ lack of confidence in the Chinese economy and trade negotiations. A breakout in cyclicals versus defensives would signify a major improvement in investor sentiment towards Chinese economic growth. An uptick in the relative performance of industrials and consumer staples (Chart 18A, bottom panel). The negative sensitivity of industrials and positive sensitivity of consumer staples to monetary policy suggests that the relative performance between the two sectors may be a reflationary barometer for China’s economy. The relative performance trend remains off its recent low, which suggests that China’s existing policy stance has not yet turned more reflationary. A technical breakdown in the relative performance of healthcare and utility stocks (Chart 18B) would also be a bullish sign. Investable health care and utilities stocks have historically led China’s economic activity, core inflation and stock prices by 1-3 months. A technical breakdown in the relative performance of these sectors would signify that market participants anticipate a bottom in China’s economy. As we mentioned at the outset, we observed an interesting divergence in sentiment among our domestic versus global investors. This divergence is reflected in both the onshore and offshore stock markets; year to date, onshore A shares have outperformed global benchmarks by 5.6% (Chart 1, on page 1 of the report). Chart 18AWaiting For A Telltale Sign... Waiting For A Telltale Sign... Waiting For A Telltale Sign... Chart 18B...Before A Tactical Upgrade ...Before A Tactical Upgrade ...Before A Tactical Upgrade However, all of the outperformance in A shares occurred before end April, when the trade talks broke down and domestic credit expansion significantly slowed from the first quarter. Since May, the relative performance of A shares in US dollar terms has been mostly flat, reflecting the fact the markets were not expecting a significant stimulus forthcoming.  Chinese investable stocks, on the other hand, have been trading heavily on the day-to-day news surrounding the trade negotiations and have significantly underperformed both domestic A shares and global benchmarks. Therefore, our base case view of a trade truce coupled with an improved Chinese economy and more supportive policy near year, warrant a cyclical overweight stance favoring Chinese investable stocks over their domestic peers. Earnings from both onshore and offshore markets will benefit from a modest improvement in economic activity, but we think the investable market will benefit more from the trade truce and more upside growth potential. Stay tuned.   Jing Sima China Strategist jings@bcaresearch.com Footnotes 1Please see Geopolitical Strategy Special Report, "Is China Afraid Of The Big Bad Warren?" dated October 25, 2019, available at gps.bcaresearch.com 2Please see China Investment Strategy Weekly Report, " Threading A Stimulus Needle (Part 1): A Reluctant PBoC," dated July 10 2019, available at cis.bcaresearch.com 3We call it a “MMT” because China’s state-owned commercial banks own approximately 80% of local government bonds. The commercial banks are essentially backed by China’s central bank, which has a fiat currency system and can make independent monetary policy decisions. 4Please see China Investment Strategy Weekly Report, "Mild Deflation Means Timid Easing," dated October 9, 2019, available at cis.bcaresearch.com 5Please see China Investment Strategy Special Report, "A Guide To Chinese Investable Equity Sector Performance," dated October 30, 2019, available at cis.bcaresearch.com Cyclical Investment Stance Equity Sector Recommendations

REIT's Demand Ails REIT's Demand Ails Underweight Similar to utilities, REITs have come to the forefront lately as they have populated the top return sector ranks. Importantly, today several key factors signal that investors should shed public market real estate exposure. Namely, weakening supply/demand dynamics, pricing pressures, macro headwinds and still pricey valuations (primarily rock bottom cap rates) are all firing warning shots. On the demand front, not only our proprietary real estate demand indicator has sunk recently, but also the latest Fed Senior Loan Officer survey revealed that demand for CRE loans remains feeble (third & bottom panels). Simultaneously, fewer bankers are willing to extend CRE credit according to the same quarterly Fed survey (second panel). This tightening backdrop coupled with decelerating credit growth, will continue to weigh on CRE prices and S&P REITs.  Bottom Line: We reiterate our underweight rating in the S&P real estate sector. For more details, please refer to the most recent Weekly Report. The ticker symbols for the stocks in this index are: BLBG – S5RLST – AMT, PLD, CCI, SPG, EQIX, WELL, PSA, EQR, AVB, SBAC, O, DLR, WY, VTR, ESS, BXP, CBRE, ARE, PEAK, MAA, UDR, EXR, DRE, HST, REG, VNO, IRM, FRT, KIM, AIV, SLG, MAC. ​​​​​​​

Dear Client, Instead of our regular weekly report next Monday, this Friday November 22, you will receive our flagship publication “The Bank Credit Analyst” with our annual investment outlook. Our regular publication service will resume on December 2  with our high-conviction calls for 2020. Kind regards, Anastasios Avgeriou Highlights Portfolio Strategy Weakening supply/demand dynamics, pricing pressures, macro headwinds and pricey valuations are all warning that REITs are headed south. Global capex blues and the ongoing manufacturing recession, the resilient US dollar and weak operating metrics all confirm that an underweight stance is still warranted in the S&P communications equipment index. Recent Changes There are no changes to our portfolio this week. Table 1 Gasping For Air Gasping For Air Feature The S&P 500 made fresh all-time highs again last week, as investors focused on hopes of a US/China trade deal and continued to ignore negative data/news at their own peril. Domestically, unemployment insurance claims jumped to the highest level since June, and none of the major market and industry groups showed a gain in output on a month-over-month basis in October according to the latest Fed industrial production release. Internationally, Korean exports remain in the doldrums, Chinese data releases were weak across the board, and the mighty US dollar is making multi-decade highs versus a slew of EM currencies. Chart 1Disquieting Gap Disquieting Gap Disquieting Gap All of this begs the question is global growth going to recover and aid the equity market grow into its lofty valuation? Our indicators suggest that a definitive earnings trough is now pushed out to Q2/2020. Thus, equity market caution is still warranted.   Given all the recent equity market euphoria, we feel more and more like “the lone calf standing on the desolate, dangerous, wolf-patrolled prairie of contrary opinion” as – arguably the greatest trader of all time – Jesse Livermore mused roughly a century ago. Share buybacks have been a key pillar underpinning stocks since the GFC averaging roughly $500bn/annum since 2010. But, last year equity retirement jumped to nearly $1tn/annum. That is clearly unsustainable, warning that there is a disconnect between the S&P 500 and already steeply decelerating share buybacks. Our equity retirement estimate for next year is a return to the 10-year average, signaling that the market may hit a significant air pocket (top panel, Chart 1). Another perplexing recent phenomenon has been the lack of buying on margin that typically confirms SPX breakouts. While this episode may be similar to the 2015/16 episode, if margin debt does not recover soon it will exert downward pull on the broad market (bottom panel, Chart 1). Turning over to earnings, revenues, margins and the forward multiple is instructive. Turning over to earnings, revenues, margins and the forward multiple is instructive. Chart 2 highlights the S&P 500 earnings growth surprise factor. In more detail, this IBES/Refinitiv data show how accurate the sell side analysts’ 12-month forward EPS forecasts have been over time: a reading above zero implies the analyst community was too timid, while a fall below zero signals analysts were too optimistic. Chart 2Unhinged From The EPS Accuracy Signal Unhinged From The EPS Accuracy Signal Unhinged From The EPS Accuracy Signal Equity market momentum moves with the ebb and flow of this factor and given the still downbeat message both from our SPX profit model (please refer to our recent webcast slides) and our simple liquidity indicator (please see Chart 4 from last week’s publication), we doubt 10% profit growth is even plausible for 2020. On the margin front, all four key profit margin drivers are on the brink of turning from tailwinds to headwinds as we recently highlighted in our “Peak Margins?” Special Report. Revenue growth is also at risk of a standstill. Domestic producer prices are deflating, and the ISM prices paid index has been clobbered. German, Japanese, Korean and Chinese wholesale prices are contracting and the OECD’s composite PPI measure is also sinking, suggesting that final demand is anemic at best. Under such a dire global pricing backdrop, it will be challenging for SPX sales to sustain their positive momentum, especially if the greenback remains well bid (Chart 3). Chart 3Top Line Growth Troubles Top Line Growth Troubles Top Line Growth Troubles Forward multiples have slingshot higher despite a near 40bps increase in the 10-year yield since Labor Day. When the discount rate rises the multiple should come in and vice versa. Thus, we would lean against the recent spike in the S&P 500 forward P/E (10-year yield shown inverted, Chart 4). This week we are updating our negative views on a niche high-yielding sector and a tech subgroup. Finally, while sifting through market internals, we recently stumbled upon the GICS2 S&P consumer services index. Digging deeper into services was revealing. This relative share price ratio has gapped down of late. One of the reasons is that the services component of the personal consumption expenditure (PCE) data is decelerating (PCE services shown advanced, middle panel, Chart 5). The ISM non-manufacturing survey is also an excellent leading indicator of the S&P consumer services index, and warns that things will likely get worse before they get better (bottom panel, Chart 5).       Chart 4Lofty Valuations Lofty Valuations Lofty Valuations Chart 5Market Internals Signal: Sit This One Out Market Internals Signal: Sit This One Out Market Internals Signal: Sit This One Out This week we are updating our negative views on a niche high-yielding sector and a tech subgroup. Getting Real With Real Estate We would refrain from chasing high yielding real estate stocks higher, and would rather avoid them altogether at the current juncture. Similar to utilities, REITs have come to the forefront lately as they have populated the top return sector ranks. However, real estate stocks, which have split out of the financials sector, are a niche GICS1 sector with a mere 3% market capitalization weight in the SPX, and have not driven the S&P 500 to all-time highs. Instead, tech stocks have, owing to their 23% market capitalization weight, as we have shown in recent research.1 Importantly, several key factors continue to signal that investors should shed public market real estate exposure. Namely, weakening supply/demand dynamics, pricing pressures, macro headwinds and still pricey valuations (primarily rock bottom cap rates) are all firing warning shots. The commercial real estate (CRE) sector is a bubble candidate that exemplifies this cycle’s excesses. As we have highlighted in the past, CRE prices sit at roughly two standard deviations above both the historical time trend and the previous cycle’s peak (not shown).2 Worryingly, CRE demand is waning. Not only our proprietary real estate demand indicator has sunk recently, but also the latest Fed Senior Loan Officer survey revealed that demand for CRE loans remains feeble (third & bottom panels, Chart 6). Simultaneously, fewer bankers are willing to extend CRE credit according to the same quarterly Fed survey (Chart 7). This tightening backdrop is weighing on CRE credit growth and CRE prices (second panel, Chart 6). In fact, absent credit growth providing the necessary fuel to sustain the CRE price inflation frenzy, there are rising odds that investors pull the plug on REITs (top panel, Chart 7). Chart 6Demand Ails Demand Ails Demand Ails Chart 7Time To... Time To... Time To... Already, occupancy rates have crested and there are increasing anecdotes of credit quality deterioration. As a result, CRE rents are also failing to keep up with inflation which eats into relative cash flow growth prospects (Chart 8). The supply side build up tilts this delicate balance further into deficit. Non-residential construction shows no signs of abating, with multi-family housing starts still running at an historically high rate of roughly 400K/annum (Chart 9). Such relentless overbuilding sows the seeds of the eventual felling in CRE prices and rents, which should also dent the S&P real estate sector. Chart 8...Lighten Up On Real Estate ...Lighten Up On Real Estate ...Lighten Up On Real Estate Chart 9Supply Build Up Is Deflationary Supply Build Up Is Deflationary Supply Build Up Is Deflationary Meanwhile, interest rate related headwinds will also weigh on this high-yielding sector in coming quarters, especially if the selloff in the bond market gains steam as BCA’s fixed income strategists continue to expect. While in the 2000s REITs were positively correlated with the 10-year Treasury yield, since 2010 this relationship has flipped and is now a tight inverse correlation (Chart 10). Chart 10Rising Yields = Sell REITs Rising Yields = Sell REITs Rising Yields = Sell REITs Finally, our proprietary Valuation Indicator (VI) has enjoyed an impressive run since the 2017 trough and despite the recent relative selloff remains in overvalued territory. Our Technical Indicator (TI) hit a wall of late near one standard deviation above the historical mean and has only partially unwound the overbought reading since the early 2018 bottom. If our thesis pans out, we expect heightened selling pressure to weigh further on our VI and TI (Chart 11). Chart 11Still Too Pricey Still Too Pricey Still Too Pricey Bottom Line: We reiterate our underweight rating in the S&P real estate sector. The ticker symbols for the stocks in this index are: BLBG – S5RLST – AMT, PLD, CCI, SPG, EQIX, WELL, PSA, EQR, AVB, SBAC, O, DLR, WY, VTR, ESS, BXP, CBRE, ARE, PEAK, MAA, UDR, EXR, DRE, HST, REG, VNO, IRM, FRT, KIM, AIV, SLG, MAC . Lost Signal The communications equipment rally stalled early in the summer and has since morphed into a bear market. We are sticking with our underweight recommendation, especially given a darkening profit outlook for this niche tech sub-group. Bellwether CSCO’s latest guidance was weak and confirmed that this capex-laden tech sub-index is in for a rough ride. Worryingly, CSCO’s key enterprise segment has no pulse. Historically, this data series has been positively correlated with telecom carrier capital outlays and the current message is grim (second panel, Chart 12). Tack on the ongoing manufacturing recession with CEOs canceling/postponing capital spending plans and the outlook dims further for the revenue prospects of communications equipment vendors (third & bottom panels, Chart 12). Chart 12Heed The CSCO Warning Heed The CSCO Warning Heed The CSCO Warning Adding insult to injury, the US/China trade war is further complicating the picture. The ongoing tariffs have exacerbated the global growth slowdown and global capex plans have come under intense scrutiny. The IFO’s World Economic Outlook capex intentions survey has plunged, warning that global exports of telecom gear have ample downside (Chart 13). Chart 13Global Capex Blues Global Capex Blues Global Capex Blues Chart 14US Dollar The Deflator US Dollar The Deflator US Dollar The Deflator The greenback’s resilience is also sapping business purchasing power, especially in the emerging markets, denting final-demand. Therefore, the US dollar’s appreciation robs communications equipment manufacturers’ pricing power, makes their goods more expensive in the global market place, and as a consequence forces market share losses on them (Chart 14). The greenback’s resilience is also sapping business purchasing power, especially in the emerging markets, denting final-demand. The implication of weakening pricing power is that profits will likely underwhelm. Currently, the sell-side is penciling in roughly 10% EPS growth for the S&P communications equipment index over and above the SPX in the next twelve months. This is a tall order and we would lean against such extreme analyst optimism (bottom panel, Chart 15). Operating metrics are quickly losing steam, another harbinger of profit ails for this tech sub-group. In more detail, our productivity proxy has taken a steep turn for the worse and industry executives have also put investment projects on hold (middle panel, Chart 15). Moreover, the communication equipment new orders-to-inventories ratio is contracting and industry resource utilization is probing multi-year lows, according to the Fed’s latest industrial production release. Under such a backdrop, relative top line growth is on track to level off and likely flirt with the contraction zone (Chart 16). Chart 15Operating Metric... Operating Metric... Operating Metric... Chart 16...Dysphoria ...Dysphoria ...Dysphoria Netting it all out, global capex blues, the resilient US dollar and weak operating metrics all confirm that an underweight stance is still warranted in the S&P communications equipment index.    Bottom Line: Continue to avoid the S&P communications equipment index. The ticker symbols for the stocks in this index are: BLBG – S5COMM – CSCO, JNPR, MSI, ANET, FFIV. Anastasios Avgeriou US Equity Strategist anastasios@bcaresearch.com Footnotes 1 Please see BCA US Equity Strategy Insight Report, “Deciphering Sector Returns” dated August 30, 2019, available at uses.bcaresearch.com. 2 Please see BCA US Equity Strategy Special Report, “10 Most FAQs From The Road” dated April 8, 2019, available at uses.bcaresearch.com. Current Recommendations Current Trades Size And Style Views Stay neutral cyclicals over defensives (downgrade alert) Favor value over growth Favor large over small caps (Stop 10%)

Dear Client, I will be visiting clients in Paris, Amsterdam, and London next week. In lieu of our regular report, we will be sending you a Special Report from Matt Gertken, BCA’s Chief Geopolitical Strategist. Matt argues that US politics and the 2020 election represent the greatest source of geopolitical risk over the coming year, and possibly beyond. Best regards, Peter Berezin Highlights Having underperformed for more than ten years, non-US stocks are set to gain the upper hand over their US peers. A reacceleration in global growth, a weaker US dollar, and favorable valuations should all support non-US stocks next year. Meanwhile, one of the greater drivers of US equity outperformance – the stellar returns of tech stocks – is likely to dissipate. Investors should remain overweight global equities relative to bonds, but start increasing allocations to non-US stocks at the expense of US stocks. US Stocks: From Leaders To Laggards? US equities have handily outperformed their global peers since 2008. About half of that outperformance was due to faster sales-per-share growth in the US, a third was due to faster growth in US margins, and the rest was due to relative P/E expansion in favor of the US (Chart 1). Looking ahead, non-US stocks are set to gain the upper hand over their US peers thanks to an improving global growth backdrop, a weaker US dollar, and an increasingly irresistible valuation tailwind. Chart 1Faster Sales Growth, Rising Margins, And Relative PE Expansion Helped Drive US Outperformance Over The Past Decade A Window Of Opportunity For International Stocks A Window Of Opportunity For International Stocks Improving Global Growth Outlook Global growth should benefit next year from the dovish pivot by most central banks. The share of central banks cutting/raising rates leads global growth by about 6-to-9 months (Chart 2). Chart 2Lower Rates Should Help Spur Growth Lower Rates Should Help Spur Growth Lower Rates Should Help Spur Growth Chart 3The Effects Of Easing Monetary Policy Should Soon Trickle Down To The Economy The Effects Of Easing Monetary Policy Should Soon Trickle Down To The Economy The Effects Of Easing Monetary Policy Should Soon Trickle Down To The Economy The global manufacturing downturn is also coming to end as inventories continue to be run down. The auto sector, which has been at the forefront of the manufacturing slowdown, is finally showing signs of life. US banks stopped tightening lending standards for auto loans in the third quarter. They are also reporting stronger demand for vehicle financing (Chart 3). In Europe, the new orders-to-inventory ratio of the Markit Europe Automobile PMI has moved back to parity for the first time since the autumn of 2018. In China, vehicle production and sales are rebounding on a rate-of-change basis (Chart 4). Both automobile ownership and vehicle sales in China are still a fraction of what they are in most other economies (Chart 5). Chart 4Chinese Auto Sector Is Bottoming Out Chinese Auto Sector Is Bottoming Out Chinese Auto Sector Is Bottoming Out Chart 5China: Structural Outlook For Autos Is Bright China: Structural Outlook For Autos Is Bright China: Structural Outlook For Autos Is Bright The trade war is a clear and present danger to our bullish outlook on global growth. The good news is that President Trump has a strong incentive to make a deal. A resurgence in the trade war would hurt the economy, which is Trump’s best selling point (Chart 6). As a self-described master negotiator, Trump has to produce a “tremendous” deal for the American people. Had he negotiated an agreement a year or two ago, he would currently be on the hook for showing that it resulted in a smaller trade deficit with China. But with the presidential election only a year away, he can semi-credibly claim that the trade balance will improve only after he is re-elected. Assuming a “Phase 1” agreement is concluded, global business sentiment should improve. Chart 6Trump Gets Reasonably High Marks On His Handling Of The Economy, But Not Much Else A Window Of Opportunity For International Stocks A Window Of Opportunity For International Stocks A détente in the trade war is unlikely to cause China to restart its deleveraging campaign. Credit growth is currently only a few points above trend nominal GDP growth, implying that the ratio of credit-to-GDP is barely increasing (Chart 7). The combined Chinese credit and fiscal impulse is still rising; it reliably leads global growth by about nine months (Chart 8). Chart 7China: The Deleveraging Campaign Has Been Put On The Backburner China: The Deleveraging Campaign Has Been Put On The Backburner China: The Deleveraging Campaign Has Been Put On The Backburner Chart 8Chinese Stimulus Should Boost Global Growth Chinese Stimulus Should Boost Global Growth Chinese Stimulus Should Boost Global Growth Faster Global Growth Should Disproportionately Benefit Non-US stocks The sector composition of international stocks is more skewed towards cyclicals than defensives compared to US stocks (Table 1). As a result, non-US stocks generally outperform their US peers when global growth accelerates (Chart 9). Table 1Cyclicals Are More Heavily Weighted Outside The US Stock Market A Window Of Opportunity For International Stocks A Window Of Opportunity For International Stocks We would include financials in our definition of cyclical sectors. As global growth improves, long-term bond yields will increase at the margin (Chart 10). Since central banks are in no hurry to raise rates, yield curves will steepen. This will boost bank net interest margins, flattering profits and share prices (Chart 11). Chart 9Non-US Equities Usually Outperform When Global Growth Improves Non-US Equities Usually Outperform When Global Growth Improves Non-US Equities Usually Outperform When Global Growth Improves Chart 10Stronger Economic Growth Will Put Upward Pressure On Government Bond Yields Stronger Economic Growth Will Put Upward Pressure On Government Bond Yields Stronger Economic Growth Will Put Upward Pressure On Government Bond Yields   The US Dollar Should Weaken Compared to most other economies, the United States has a large service sector and a small manufacturing base. This makes the US a “low beta” play on global growth. As a result, capital tends to flow from the US to the rest of the world when global growth picks up, putting downward pressure on the US dollar in the process (Chart 12). Chart 11Steeper Yield Curves Will Benefit Financials Steeper Yield Curves Will Benefit Financials Steeper Yield Curves Will Benefit Financials Chart 12The Dollar Is A Countercyclical Currency The Dollar Is A Countercyclical Currency The Dollar Is A Countercyclical Currency   Interest-rate differentials have been moving against the dollar for most of this year (Chart 13). This makes the greenback more vulnerable to a correction. Chart 13The Dollar Has Been Diverging From Rate Differentials This Year The Dollar Has Been Diverging From Rate Differentials This Year The Dollar Has Been Diverging From Rate Differentials This Year Chart 14Long Dollar Is A Crowded Trade Long Dollar Is A Crowded Trade Long Dollar Is A Crowded Trade Bullish sentiment towards the dollar also remains somewhat stretched. Net long speculative positions are near the top of their historic range (Chart 14). Our tactical MacroQuant model, which has an excellent track record of predicting short-to-medium term moves in the dollar, has dropped its bullish bias towards the currency (Chart 15).   Chart 15MacroQuant Has Soured On The US Dollar A Window Of Opportunity For International Stocks A Window Of Opportunity For International Stocks A weaker dollar will help boost commodity prices, which is usually good news for cyclical stocks (Chart 16). A softer dollar will also raise the USD value of overseas shares, thus making international stocks more attractive in common-currency terms. Valuations Favor Non-US Stocks There is an old investment adage which says that valuations are useless as a short-term timing tool. That is only partially true. While valuations by themselves offer little guidance as to where the stock market is going in the short run, combined with a catalyst, valuations can make a big difference. When stocks are cheap, a bullish catalyst can cause prices to surge; whereas when stocks are expensive, a bearish catalyst can cause them to plunge. Looking ahead, non-US stocks are set to gain the upper hand over their US peers thanks to an improving global growth backdrop, a weaker US dollar, and an increasingly irresistible valuation tailwind. Non-US stocks are currently trading at 13.8-times forward earnings. This represents a significant discount to US stocks, which trade at a forward PE ratio of 17.7. The valuation discount is even greater if one looks at other measures such as the cyclically-adjusted PE, price-to-book, price-to-sales, and the dividend yield (Chart 17). Chart 16A Weaker Dollar Tends To Support Commodity Prices A Weaker Dollar Tends To Support Commodity Prices A Weaker Dollar Tends To Support Commodity Prices Chart 17US Stocks Are More Expensive... US Stocks Are More Expensive... US Stocks Are More Expensive...   Differences in sector weights account for about a quarter of the valuation gap between the US and the rest of the world (Chart 18). The rest of the gap is due to cheaper valuations within sectors. Financials, utilities, and consumer discretionary stocks, in particular, are quite a bit more expensive in the US than elsewhere (Chart 19). Chart 18…Even When Adjusting For Sector Weights A Window Of Opportunity For International Stocks A Window Of Opportunity For International Stocks Chart 19AEquity Sector Valuations: US Versus The Rest Of The World (I) Equity Sector Valuations: US Versus The Rest Of The World (I) Equity Sector Valuations: US Versus The Rest Of The World (I) Chart 19BEquity Sector Valuations: US Versus The Rest Of The World (II) Equity Sector Valuations: US Versus The Rest Of The World (II) Equity Sector Valuations: US Versus The Rest Of The World (II)   The valuation gap between the US and the rest of the world is even starker if we compare earnings yields with bond yields. Since bond yields are lower outside the US, the implied equity risk premium is markedly higher for non-US stocks (Chart 20). An examination of the relative performance of US vs non-US companies over the past 50 years reveals two major tops, and one potential top. Some commentators have argued that the loftier valuations enjoyed by US stocks are warranted due to their superior growth prospects. While there may be some truth to that, it is worth noting that the IMF projects GDP growth (based on MSCI country weights) will be faster outside the US over the next five years (Chart 21). Chart 20Equity Risk Premia Remain Quite High Equity Risk Premia Remain Quite High Equity Risk Premia Remain Quite High Chart 21Growth Prospects Brighter Outside The US Growth Prospects Brighter Outside The US Growth Prospects Brighter Outside The US   One should also keep in mind that relatively fast US earnings growth is a fairly recent phenomenon. Between 1970 and 2008, European EPS actually grew slightly faster than US EPS (Chart 22). Earnings in emerging markets also increased more rapidly than in the US during the two decades leading up to the Global Financial Crisis. Chart 22US Earnings Have Not Always Outperformed US Earnings Have Not Always Outperformed US Earnings Have Not Always Outperformed The Role Of US Tech The large weight of the tech sector in the US stock market explains much of the superior performance of US stocks over the past decade. As Chart 23 illustrates, EPS in the I.T. sector has grown a lot more quickly than in other sectors. Chart 23US Earnings: Who Has Been Doing The Heaving Lifting? A Window Of Opportunity For International Stocks A Window Of Opportunity For International Stocks Chart 24S&P 500: Much Of The Increase In Margins Has Occurred In The I.T. Sector S&P 500: Much Of The Increase In Margins Has Occurred In The I.T. Sector S&P 500: Much Of The Increase In Margins Has Occurred In The I.T. Sector Looking out, there are four reasons why US tech stocks may be due for a breather. First, tech valuations have gotten stretched relative to the broader market. Second, tech margins have risen to unprecedented high levels. We estimate that about half of the increase in S&P 500 profit margins since 2007 has been due to I.T. (Chart 24). Even that understates the role of tech in the expansion of profit margins because Standard & Poor’s no longer classifies some large-cap behemoths such as Google and Facebook as I.T. companies. Third, tech companies may face increased regulatory scrutiny in the years ahead stemming from alleged privacy violations, perceived monopolistic behavior, and worries about the censorship of online speech. This could weigh on sales and earnings growth. Fourth, the growth in private equity funds is likely to limit the number of tech companies that go public at a very early stage. Stock market investors were very lucky that companies such as Microsoft, Cisco, Nvidia, Qualcomm, Oracle, Amazon, and Netflix issued shares to the public at a young stage in their development (Table 2). All seven had market caps below $1 billion when they went public. Such hidden gems are becoming less common: The number of publicly listed companies in the US has fallen by more than half over the past two decades (Chart 25). The median age of tech companies at the time of IPO has risen from around 7 in the 1990s to 12 years today (Chart 26). Table 2Big Gains From Once Small Companies A Window Of Opportunity For International Stocks A Window Of Opportunity For International Stocks Chart 25The Number Of Publicly Listed Companies Fell The Number Of Publicly Listed Companies Fell The Number Of Publicly Listed Companies Fell   Chart 26Tech Companies Entering The Public Arena Are Now More Mature A Window Of Opportunity For International Stocks A Window Of Opportunity For International Stocks Had Uber gone public as a small, upstart company not long after it was founded in 2009, it probably would have also made public shareholders a lot of money. Instead, it ended up going public this year with a market cap of $75 billion, only to see it shrink to as low as $40 billion in the ensuing six months. We won’t even mention what would have happened if WeWork had gone public. Investment Conclusions An examination of the relative performance of US vs non-US companies over the past 50 years reveals two major tops, and one potential top: The first during the “Nifty 50” era of the late 1960s, the second during the 1990s dotcom boom, and the third during the recent FAANG craze (Chart 27). It is too early to say whether FAANG stocks have peaked, but it is worth noting that the group has underperformed the S&P 500 since May (Chart 28). Chart 27Putting The Recent FAANG Craze Into Context Putting The Recent FAANG Craze Into Context Putting The Recent FAANG Craze Into Context Chart 28FAANG Stocks And The Market FAANG Stocks And The Market FAANG Stocks And The Market Chart 29Has The Underperformance Of Value Run Its Course? Has The Underperformance Of Value Run Its Course? Has The Underperformance Of Value Run Its Course?   Regardless of whether the secular outperformance of US equities is ending, the cyclical backdrop that we foresee over the next 12-to-18 months – characterized by faster global growth, a weakening dollar, and higher commodity prices – is likely to favor non-US stocks. As such, investors should remain overweight global equities relative to bonds, but start increasing allocations to non-US stocks at the expense of US stocks. Consistent with this, we are initiating a new recommendation to go long the MSCI ACWI ex USA index versus the MSCI USA index in dollar terms. Looking across the various stock markets outside the US, we are particularly fond of Europe. Net profit margins among companies in the STOXX Europe 600 index are about three percentage points below the S&P 500. This gives European companies greater scope to boost earnings. European banks are especially attractive, sporting a forward PE of 8.3, a price-to-book ratio of 0.6, and a dividend yield of 6.1%. Lastly, on the question of style investing, we would note that the relative performance of the MSCI value and growth indices closely tracks the performance of global financials versus I.T. (Chart 29). Given our preference for the former over the latter, we suspect that value will outperform growth next year.   Peter Berezin Chief Global Strategist peterb@bcaresearch.com   Footnotes   Strategy & Market Trends MacroQuant Model And Current Subjective Scores A Window Of Opportunity For International Stocks A Window Of Opportunity For International Stocks Tactical Trades Strategic Recommendations Closed Trades

Out Of Power Warning Out Of Power Warning Underweight Utilities stocks have been all the rave this year, but given their small weighting in the SPX they only explain a very small part of the broad market’s run (in contrast, the heavyweight tech sector explains most of the S&P 500’s rise as we highlighted in recent research). We reiterate our underweight stance in this small defensive sector that has run way ahead of soft profit fundamentals. Worrisomely, utilities trade with a 20 forward P/E handle and command a 20% premium to the broad market, but their forecast EPS growth rate at 5% trails the SPX by 350bps (not shown). The sector’s operating metrics reveal that investors piling into utilities is unwarranted. Natural gas prices are contracting at the steepest pace of the past four years (middle panel) and signal that the path of least resistance is lower for relative share price momentum. Meanwhile, electricity capacity utilization is in a multi decade downtrend, warning that the relative profitability will remain under pressure in the coming quarters (bottom panel). Bottom Line: Shy away from the expensive S&P utilities sector. Please refer to this Monday’s Weekly Report for additional details. The ticker symbols for the stocks in this index are: BLBG – S5UTIL– PPL, PNW, ATO, PEG, FE, EIX, AEE, SO, SRE, AEP, XEL, DTE, EVRG, WEC, AES, CMS, LNT, ED, NRG, D, AWK, DUK, ETR, EXC, NEE, CNP, NI, ES.