Sectors

Short Circuited Short Circuited Underweight BCA U.S. Equity Strategy’s electrical components & equipment (EC&E) three-factor earnings model did an excellent job in anticipating the recent breakdown in the S&P EC&E index (top & bottom panels). First, the trade-weighted dollar has broken out to fresh cyclical highs. Historically, relative share prices and the greenback are tightly inversely correlated and the current weak global growth message that the U.S. dollar is emitting is bearish for the S&P EC&E index (U.S. dollar shown inverted, second panel). This global growth soft patch is not only negative for new orders owing to deficient foreign demand, but the appreciating currency also makes EC&E exports less competitive in the global market place (U.S. dollar shown inverted, third panel). For details on the other two driver’s behind our bearish S&P EC&E index stance, please refer to our most recent Weekly Report. Bottom Line: We reiterate our underweight recommendation for the S&P EC&E index. The ticker symbols for the stocks in the index are: BLBG: S5ELCO – AME, EMR, ETN, ROK.   ​​​​​​​

Highlights Portfolio Strategy The sustained global growth slowdown, widening junk spreads, along with the risk of a U.S. recession becoming a self-fulfilling prophecy suggest that caution is still warranted in the broad equity market on a 3-12 month time horizon. Weakening consumer sentiment, softening hotel industry operating metrics that point to a margin squeeze, anemic relative outlays on lodging and a decelerating ISM non-manufacturing index, all signal that more pain lies ahead for the S&P hotels, resorts & cruise lines index.   Waning industry operating metrics, a bearish signal from our EPS growth model along with the mighty U.S. dollar warns against bottom fishing in the S&P electrical components & equipment (EC&E) index.  Recent Changes There are no changes to the portfolio this week. Table 1 Elusive Growth Elusive Growth Feature The S&P 500 traded in an uncharacteristically tight range last week before falling apart on Friday on the back of a re-escalation in the U.S./China trade war. Worries of recession also resurfaced. Not only did the MARKIT flash manufacturing PMI break below the 50 expansion/contraction line, but it also pulled down the MARKIT flash services PMI survey that barely held above the boom/bust line. Adding insult to injury, the 10/2 yield curve slope inverted anew last week further fanning these recession fears. Worrisomely, consumer sentiment took a hit recently according to the University of Michigan survey (top panel, Chart 1). Importantly, what caught our attention was the following commentary: “The main takeaway for consumers from the first cut in interest rates in a decade was to increase apprehensions about a possible recession. Consumers concluded, following the Fed’s lead, that they may need to reduce spending in anticipation of a potential recession.” While the consumer is the last and most significant pillar standing for the U.S. economy, reflexivity may spoil the party and a recession may become a self-fulfilling prophecy. This is the message the bond market is sending and it is warning that the path of least resistance is a lot lower for stocks (bottom panel, Chart 1). Chart 1“The First Cut Is The Deepest” “The First Cut Is The Deepest” “The First Cut Is The Deepest” Economists are also downgrading their U.S. real GDP growth estimates and that forecast now stands at 2.3% for the current year according to Bloomberg. While the recession alarm bells are not sounding off, these downward revisions bode ill for stocks (Chart 2)  Chart 2Watch Out Down Below Watch Out Down Below Watch Out Down Below Moving to another part of the fixed income market, stress is slowly building in the high yield market especially given the recent tick up in bankruptcies and the blind sides that cove-lite loans now pose to bond investors. As a reminder, the U.S. high yield option adjusted spread (OAS) troughed last September and continues to emit a distress signal for the broad equity market (junk OAS shown inverted, top panel, Chart 3). Chart 3Mind The Gaps Mind The Gaps Mind The Gaps With regard to global growth, it is still missing in action, and given that Dr. Copper is on the verge of a breakdown, a global growth recovery is a Q1/2020 story at the earliest. This week we update a consumer discretion­ary subindex and also highlight an industrials sector subgroup. Chart 4SPX: The Next Shoe To Drop? SPX: The Next Shoe To Drop? SPX: The Next Shoe To Drop? Chart 5Risk To View Risk To View Risk To View Other financial market variables concur that global growth is elusive. J.P. Morgan’s EM FX index has broken down and EM equities are also hanging from a thread. The EM high yield OAS has broken out signaling that the risk off phase has yet to fully run its course (EM junk OAS shown inverted, bottom panel, Chart 4). Finally, there is a short-term risk to our cautious equity market view. Indiscriminate buying in U.S. Treasurys has now pushed the 10-year yield down almost 180bps from last November’s peak deeply in overvalued territory. While such a move is not unprecedented, buying may be exhausted and in need of at least a short-term breather (Chart 5).     Netting it all out, the sustained global growth slowdown, widening junk spreads, along with the risk of a U.S. recession becoming a self-fulfilling prophecy suggest that caution is still warranted in the broad equity market on a 3-12 month time horizon. As a reminder, this is U.S. Equity Strategy’s view, which contrasts BCA’s sanguine equity market house view. This week we update a consumer discretionary subindex and also highlight an industrials sector subgroup. Empty Spaces When the consumer is worried about a possible recession as the latest survey revealed, the knee jerk reaction is to tighten the purse strings and marginally retrench. The latest University of Michigan consumer sentiment survey made for grim reading and such souring in confidence will continue to weigh on lodging equities (Chart 6). As a result, we remain underweight the niche S&P hotels, resorts & cruise lines consumer discretionary subgroup. When the consumer is worried about a possible recession as the latest survey revealed, the knee jerk reaction is to tighten the purse strings and marginally retrench. Chart 6Stay Checked Out Of Hotels Stay Checked Out Of Hotels Stay Checked Out Of Hotels   Already discretionary retail sales have taken the back seat and non-discretionary retail sales are in the driver’s seat. In fact, the top panel of Chart 7 shows that the relative retail sales backdrop has plunged to levels last seen during the GFC, warning that relative share prices have ample room to fall. Drilling deeper in the consumption data is instructive. Lodging outlays are decelerating and are also trailing overall PCE. The implication is that relative profits will likely underwhelm sustaining the 18-month long de-rating phase (middle & bottom panels, Chart 7). On the operating front the news is equally dour. While selling prices are expanding, the relentless construction binge will lead to a mean reversion sooner rather than later (bottom panel, Chart 8).   Chart 7De-rating Phase To Gain Steam De-rating Phase To Gain Steam De-rating Phase To Gain Steam Chart 8Margin Squeeze Looming Margin Squeeze Looming Margin Squeeze Looming   Tack on the ongoing assault from the new sharing economy unicorns like Airbnb, and industry pricing power will remain in check in coming quarters. Similarly, the ISM non-manufacturing price subcomponent is warning that a deflation scare is looming in the lodging industry (second panel, Chart 8). Not only are selling prices under attack, but also labor-related input costs are on fire. The sector’s wage inflation is climbing at a 3.9%/annum pace or roughly 120bps higher that the overall employment cost index (third panel, Chart 8). Taken together, there are high odds that a profit margin squeeze will weigh on profits and on relative share prices (top panel, Chart 8). Importantly, the overall ISM services survey best encapsulates the bearish backdrop of the S&P hotels, resorts & cruise lines index. Historically, relative share prices have been moving in tandem with the ISM non-manufacturing survey and the current message is that selling pressures on relative share prices will persist in the coming months (Chart 9). Chart 9Heed The Message From The ISM Services Survey Heed The Message From The ISM Services Survey Heed The Message From The ISM Services Survey In sum, weakening consumer sentiment, softening hotel industry operating metrics that point to a margin squeeze, anemic relative outlays on lodging and a decelerating ISM non-manufacturing index signal that more pain lies ahead for the S&P hotels, resorts & cruise lines index. Bottom Line: Continue to avoid the S&P hotels, resorts & cruise lines index. The ticker symbols for the stocks in this index are: BLBG: S5HOTL – MAR, HLT, RCL, CCL, NCLH. Short Circuited The S&P EC&E index broke down recently (top panel, Chart 10) and we reiterate our underweight recommendation in this industrials sector subgroup. While it is tempting to bottom fish here especially given oversold technical and bombed out valuations (bottom panel, Chart 11), a number of the indicators we track suggest that more losses are around the corner. Chart 10Sell The Weakness Sell The Weakness Sell The Weakness Chart 11Good Reasons For Valuation Discount Good Reasons For Valuation Discount Good Reasons For Valuation Discount   First the trade-weighted dollar has broken out to fresh cyclical highs despite the collapse in the 10-year yield. Historically, relative share prices and the greenback are tightly inversely correlated and the current weak global growth message the U.S. dollar is emitting is bearish for the S&P EC&E index (U.S. dollar shown inverted, middle panel, Chart 10). This global growth soft patch is not only negative for new orders owing to deficient foreign demand, but the appreciating currency also makes EC&E exports less competitive in the global market place (U.S. dollar shown inverted, bottom panel, Chart 10). Second, while industry new orders have been resilient, the massive inventory buildup dwarfs new order growth and warns that a deflationary liquidation phase is looming (middle panel, Chart 11). In fact, the recent drubbing in the ISM manufacturing prices paid subcomponent portends a deflationary industry phase (third panel, Chart 12). Adding it all up, waning industry operating metrics, a bearish signal from our EPS growth model along with the mighty U.S. dollar warns against bottom fishing in the S&P EC&E index. Other operating metrics are also warning that EC&E profits will underwhelm. Industry weekly hours worked have plunged and sell-side analysts have been aggressively cutting EPS estimates (bottom panel, Chart 13). On the productivity front, executives have not adjusted labor cost structures to lower running rates yet (second panel, Chart 13) and, thus, our EC&E productivity gauge (industrials production versus employment) is contracting which bodes ill for industry earnings (third panel, Chart 13). Chart 12Weak Profit Backdrop Weak Profit Backdrop Weak Profit Backdrop Chart 13Deteriorating Operating Metrics Deteriorating Operating Metrics Deteriorating Operating Metrics   Finally, our S&P EC&E EPS growth model does an excellent job in encapsulating all these moving parts and is signaling that the path of least resistance is lower for EPS growth in the coming months (bottom panel, Chart 12). Adding it all up, waning industry operating metrics, a bearish signal from our EPS growth model along with the mighty U.S. dollar warns against bottom fishing in the S&P EC&E index. Bottom Line: Stay underweight the S&P EC&E index. BLBG: S5ELCO – AME, EMR, ETN, ROK.     Anastasios Avgeriou, U.S. Equity Strategist anastasios@bcaresearch.com   Current Recommendations Current Trades Size And Style Views Favor value over growth Favor large over small caps

Highlights Sovereign bond yields have cratered over the last few months, … : Over the last three months, 10-year yields in the U.S., France, Germany, Switzerland and Australia have fallen by 71, 64, 53, 54, and 67 basis points, respectively. … and the Treasury curve has experienced a significant bull flattening, … : Month-to-date total returns for the Barclays Bloomberg Long, Intermediate and 1-3-Year Treasury Indexes are 9.2%, 1.6% and 1.1%, respectively. … indicating that the bond market thinks more rate cuts are in store: The textbook interpretation of an inverted curve is that monetary policy is too tight and needs to be loosened, but technical factors have amplified the flattening pressure. Is the bond market reacting to weakening growth prospects, or uber-dovish central banks?: The answer has implications well beyond the fixed-income universe. It could mean the difference between an economic slowdown and a market melt-up. Feature BCA researchers convened last week for our monthly View Meeting, much of which was given over to the global decline in sovereign bond yields. Does their plunge owe more to weakening growth prospects or central banks’ synchronized dovish pivot? There have surely been elements of both; after all, central banks wouldn’t be so dovish if they weren’t concerned about the growth outlook. It is clear to our fixed-income strategists that the yield move has overshot the data, however, and they mainly attribute the overshoot to monetary policy. No central bank wants a stronger currency while confronting a demand deficiency aggravated by trade tensions and a global manufacturing slowdown. The New York Times Business section put the prevailing policy winds into living color in a nearly full-page, four-column graphic spotlighting the 32 central banks that have cut their policy rate so far this year.1 The pell-mell rush to cut rates is emblematic of a global scramble for competitiveness. No central bank wants its economy to be caught without a buffer while other economies are busily reinforcing theirs. The Message From The Bond Market Trade tensions are a legitimate threat to global economic growth already challenged by a downswing in the global manufacturing cycle. A recession is a possibility, but it is hardly a foregone conclusion. We agree with our fixed-income colleagues that the yield selloff has overrun the economic fundamentals. Last week’s preliminary European manufacturing PMIs suggested that manufacturing may finally be stabilizing, and there is still no evidence that the manufacturing downturn has infected the services sector (Chart 1). A recession is hardly a foregone conclusion. 10-year Treasury yields have been falling sharply since their 3.25% peak in early November, and the current leg down is the third in a series of sharp declines (Chart 2, top panel). Global sovereign yields have followed the same pattern (Chart 2, bottom panel), but the latest plunge is as much a reflection of ubiquitous easing biases as it is of new concerns about economic weakness. That may sound like a minor point, of interest only to macro specialists, but it has import for all investors. If the yield decline isn’t signaling new softness, then easier financial conditions will be free to act as a tailwind for risk assets. Chart 1Services Are Holding Up ... Services Are Holding Up ... Services Are Holding Up ... Chart 2A Brief Inversion ... But Yields Are Freefalling A Brief Inversion ... But Yields Are Freefalling A Brief Inversion ... But Yields Are Freefalling Neither investment-grade (Chart 3, top panel) nor high-yield corporate bond spreads evince any particular concern about the economy (Chart 3, bottom panel). Although they’ve ticked up, they remain near the bottom of their post-crisis range, and are nowhere near the levels they reached in 2011-12, during the federal budget showdown/U.S. downgrade and the flare-up of the Eurozone crisis, or in 2015-16, during the last manufacturing recession. With banks still easing lending standards for corporate and industrial borrowers (Chart 4), spreads won’t undergo a systematic widening. Borrowers do not default as long as there is a lender willing to roll over their maturing obligations, so tighter credit standards are a precondition for spread-widening cycles. Chart 3No Sign Of Stress Among Corporate Borrowers ... No Sign Of Stress Among Corporate Borrowers ... No Sign Of Stress Among Corporate Borrowers ... Chart 4... And Banks Aren't Applying Any Pressure ... And Banks Aren't Applying Any Pressure ... And Banks Aren't Applying Any Pressure The Message From The Housing Market Chart 5Lower Rates Have Yet To Impact Housing ... Lower Rates Have Yet To Impact Housing ... Lower Rates Have Yet To Impact Housing ... We have been disappointed by residential investment’s muted response to the significant year-to-date decline in mortgage rates (Chart 5, bottom panel). The trajectory of starts and permits (Chart 5, top panel) hasn’t changed, new and existing home sales haven’t perked up (Chart 5, second panel), and mortgage purchase applications (Chart 5, third panel) appear not to have heard the news that rates are much lower. We thought that the swift fall in mortgage rates would promote more residential investment than it has to date. There is a difference, however, between disappointing growth and a full-on contraction. With affordability remaining high relative to history (Chart 6), and apartment rents exceeding monthly mortgage payments in several locales (Chart 7), housing demand should remain well supported. There are no excesses in the housing market in terms of inventory or oncoming supply that would make housing a source of economic or financial instability. Inventory relative to the number of households is bumping around its all-time lows (Chart 8), and cumulative household formations have easily outstripped housing starts since the crisis broke (Chart 9). Structural factors like a lack of supply geared to first-time and first-move-up buyers, and the ravenous appetite of pools of capital purchasing single-family homes for rent, are squeezing out some would-be buyers, but housing is not about to induce a recession. There are plenty of things for investors to be concerned about, but the housing market isn’t one of them. Chart 6... Though They Have Placed Homeownership In Easier Reach ... Though They Have Placed Homeownership In Easier Reach ... Though They Have Placed Homeownership In Easier Reach Chart 7 Chart 8... Inventories Are At Record Lows, ... ... Inventories Are At Record Lows, ... ... Inventories Are At Record Lows, ... Chart 9 The View From Broad And Wall We concede that stocks are not behaving as if all is well. Big daily swings are not a feature of healthy markets, and eight of this month’s sixteen sessions have registered moves of at least 1%. The second quarter’s 3% year-over-year earnings growth is three percentage points better than the consensus expected when earnings season kicked off, however, and despite the single-day moves, the S&P 500 has spent all but the first day of the month in a well-defined range between 2,825 and 2,945 (Chart 10). The market may be jumpy from one day to the next, but investors have not been concerned enough to engage in sustained selling. Chart 10 The equity market’s verdict on housing is more optimistic than ours. Inspired by earnings reports, the S&P 1500 Homebuilders Index have broken out to a new 52-week high (Chart 11). Retailers were the stars of last week’s earnings releases, with Lowe’s, Nordstrom and Target posting double-digit percentage gains after reporting numbers that failed to live up to investors’ worst fears. Equities are validating the view that the U.S. consumer is alive and kicking. Chart 11Homebuilder Stocks Have Broken Out Homebuilder Stocks Have Broken Out Homebuilder Stocks Have Broken Out The GDP Outlook Chart 12Capex Intentions: Elevated But Slipping Capex Intentions: Elevated But Slipping Capex Intentions: Elevated But Slipping If consumers are well positioned, the U.S. economy should be, too. Consumption accounts for two-thirds of the U.S. economy, with investment and government spending equally dividing the other third. Federal expenditures amount to about 40% of government spending, and between this year’s fiscal thrust and next year’s hotly contested presidential election, D.C. can be counted upon to do its part for the economy. At the state and local level, healthy household income should support state sales and income tax receipts, while still-rising home prices will provide the property taxes to keep municipal coffers full. That leaves fixed asset investment as the economy’s Achilles heel. We are confident, as noted above, that residential investment will not decline enough to pose a problem for the economy, but corporate investment is in the crosshairs of the uncertainty surrounding the multiple trade squabbles. The NFIB survey and the regional Fed surveys indicate that capital expenditure plans are rolling over, even if they remain at a fairly high level (Chart 12). Our base case remains that investment will not fall enough to offset robust consumption and trend-level government spending, but a marked worsening in trade tensions could erode business confidence enough to drag the economy below stall speed. Busted Thesis In our mutual-fund days, we followed one rule without exception. If our thesis for owning a stock was disproved, we got rid of the stock without a backward glance. We no longer manage money, but our clients do, and we try to set a good example, especially in the inevitable instances when things go wrong. We are closing out our agency mREIT recommendation on the ground that we got the rates call underpinning it very wrong. Things went wrong with our agency mortgage REIT recommendation right from the get-go. In retrospect, we should have waited until the FOMC meeting dust settled before putting on a curve-dependent position. We are closing it out now, though, because we recommended the group in anticipation of a steeper yield curve. Given that we think it will take some time for investors to become convinced that a recession is not imminent, and given that mechanical factors may push yields even lower, we do not expect sustained curve steepening for several months. Although we only held it for four weeks, the recommendation left a mark. Through Thursday’s close, our defined subset of agency mREITs lost 11%, while the S&P 500 is down 3.1% and the Barclays High Yield Index is flat. We’re taking our medicine and moving on, but we will take another look at the group when the curve eventually does begin to steepen. Investment Implications Even if recession fears are overblown, as we and a majority of our colleagues believe, it will likely take some time for investors to overcome their concerns. That leads us to believe that equities may be unable to make new highs in the near term, and that Treasury yields have more downside risk than upside risk in the next few months, as rising convexity2 compels investors following asset-liability management strategies to seek out long-maturity bonds. The yield point may sound complex and esoteric, but our Global Fixed Income Strategy team increasingly believes it’s a key to understanding the negative-yield phenomenon and is researching the issue for an upcoming Special Report. Monetary accommodation is not a silver bullet. If the economy has already flipped from expansion to contraction, modest rate cuts parceled out at a deliberate pace will be insufficient to turn things around, and equities and spread product will suffer. If the expansion remains intact, however, rate cuts will help shore up the economy at the margin and quite possibly fuel a new phase of the bull markets in risk assets. Our money is on the latter, and we expect that this bull cycle has one more burst in it that will allow it to sprint to the finish line like the majority of its predecessors. Doug Peta, CFA Chief U.S. Investment Strategist dougp@bcaresearch.com   Footnotes 1 Smialek, Jeanna and Russell, Karl, “Rates Are Falling Again. That May Be Dangerous.” New York Times, August 17, 2019, p. B1. 2 Duration measures a bond’s sensitivity to changes in interest rates. Convexity measures duration’s sensitivity to changes in interest rates, which increases as rates fall. Investors like life insurers and pension funds, who match the duration of their investment portfolios with the duration of their liabilities, are forced to increase the duration of their bond holdings at an increasing rate as interest rates fall.

Fade The Insurance Rebound Fade The Insurance Rebound Underweight While insurers have enjoyed a knee jerk rally recently, relative share prices remain in a downtrend, and we recommend fading this run-up. House and auto sales have been in contraction for nearly a year, which bodes ill for insurance profits that have already been struggling to keep pace with the broad market (second panel). This is largely reflected in insurance pricing power, which has barely climbed out from outright deflation (third panel). Bottom Line: Decelerating house and auto sales will continue to weigh on insurers’ pricing power prospects. Stay underweight the S&P insurance index. The ticker symbols for the stocks in this index are: BLBG: S5INSU – CB, MMC, MET, PGR, AON, PRU, AIG, AFL, TRV, ALL, WLTW, HIG, AJG, PFG, CINF, L, LNC, RE, AIZ, GL, UNM. ​​​​​​​

In this Monday’s Special Report we dissected S&P sectors’ relative performance following Powell’s recent interest rate cut characterization as a “mid-cycle adjustment.” Our view remains that a recession likely looms in the coming 18 months, but should we be proven wrong, this Special Report can serve as a road map of what to expect next. The key findings are summarized below: The rate-sensitive sectors – S&P utilities, telecoms, consumer discretionary and financials – underperform early before they outperform once the Fed has started to ease with the exception of the S&P utilities, which initially delivers low but positive returns and continue to underperform up to two years after the beginning of the “mid-cycle adjustments.” Similarly, we find that most of the deep cyclicals underperform in the run-up to the first rate cut and usually outperform subsequently. The S&P energy is an exception as it outperformed heading into the cutting cycle and then underperformed 6 and 12 months following the first rate cut. Please see this Monday’s Special Report for more details. Chart

Dear Clients, This week we have an abbreviated Weekly Report followed by a Special Report penned by my colleagues Jeremie Peloso and Arseniy Urazov on the Fed’s “mid-cycle adjustment” and sector performance. I hope you will find this report insightful. Best regards, Anastasios Avgeriou, U.S. Equity Strategist Highlights Portfolio Strategy The 10/2 yield curve inversion, the outright collapse in long term bond yields, prospects for heightened volatility and renewed trade uncertainty that is weighing on SPX EPS, all signal that investors should avoid buying the dips and instead be fading the rallies. Recent Changes There are no changes to the portfolio this week. Table 1 Point Break Point Break Feature Chart 1Repricing To Lower EPS Backdrop Has Started Repricing To Lower EPS Backdrop Has Started Repricing To Lower EPS Backdrop Has Started The SPX took it to the chin last week, but managed to recover some of the losses by Friday’s close. It appears as though equity investors are slowly becoming thick skinned to President Trump’s tweets and instead starting to focus on softening earnings fundamentals. Last week we showed that SPX EPS are at stall speed, having a tough time surpassing the $165/share mark, eerily reminiscent of the 2014-16 episode when they hit a wall near $118/share.1 Importantly, sell-side analysts are trimming Q3/2019, Q4/2019 and calendar 2020 EPS estimates and investors need to be patient and wait out this shake out period that will be full of bearish undertones (Chart 1). U.S. Equity Strategy’s view remains cautious on a 3-12 month horizon on the prospects of the broad equity market, which stands in contrast to BCA’s sanguine cyclical equity market house view.   Another similarity with the 2015/2016 manufacturing recession episode is the Chinese renminbi devaluation on August 11, 2015 and subsequent parabolic move in the VIX above 50 on August 24, 2015. There are high odds that the SPX will succumb to the renminbi’s recent devaluation (Chart 2) and volatility will surge further in coming months as the trade war outcome is highly uncertain. Indeed, a number of internal equity market indicators suggest that the volatility spike has yet to run its course (Chart 3). Chart 2The Yuan To Watch The Yuan To Watch The Yuan To Watch Chart 3Vol Is Primed To Spike Vol Is Primed To Spike Vol Is Primed To Spike Beyond the heightened volatility, the brief 10/2 yield curve slope inversion last week was unnerving and a reason to remain cyclically cautious on the overall equity market outlook (Chart 4). As a reminder, the yield curve inversion signals additional Fed interest rate cuts and, historically, that has been a bearish backdrop for stocks as we highlighted in recent research (please see Chart 1 from the July 29th Weekly Report). In addition, the collapse in long term interest rates is cause for concern as it suggests that growth will be scarce in coming quarters. While stocks have been benefiting from lower interest rates via higher valuation multiples as theory would suggest, our sense is that a tipping point likely occurred last week. The implication is that stocks will likely heed the bearish message bonds are sending and converge to the steeply declining 10-year nominal and real yields (Chart 5).   Chart 4Another Bad Omen Another Bad Omen Another Bad Omen Chart 5Time To Get Back Together Time To Get Back Together Time To Get Back Together   Adding it up, the 10/2 yield curve inversion, the outright collapse in long term bond yields, prospects for heightened volatility and renewed trade uncertainty that is weighing on SPX EPS, all signal that investors should avoid buying the dips and instead be fading the rallies.   Anastasios Avgeriou, U.S. Equity Strategist anastasios@bcaresearch.com   Footnotes 1      Please see BCA U.S. Equity Strategy Insight Report, “Trump Backpedals, Again” dated August 14, 2019, available at uses.bcaresearch.com.

Feature Chart 1A Feeling Of Deja Vu? A Feeling Of Deja Vu? A Feeling Of Deja Vu? Chair Powell described the recent rate cut as a “mid-cycle adjustment,” rather than a transition to full-on policy easing. This mid-cycle reference was most likely intended to leave the door open for (i) additional “insurance cuts”, likely as soon as September,1 and (ii) the tightening cycle that began at the end of 2015 to eventually resume. Needless to say the market – and President Trump –did not appreciate the hawkish tone of the latter. Importantly, it shows that the current cycle is very similar to the one in the mid-90s (Chart 1). Back then, following the post-Mexican peso devaluation (Tequila Crisis) in December 1994, the bond market started pricing three Fed cuts while the stock market was rebounding in Q1/1995 from the previous quarter’s drawdown (Chart 1, panel 2). Further, the Fed rate cuts in the mid-90s came in response to persistently low and weakening U.S. inflation (Chart 1, panel 3) amidst slowing growth in the rest of the world (Chart 1, panel 4). Bear with us, there is more to it. Former President Clinton was up for reelection the year following the first rate cut in July 1995, at a time that would later be painted as one of “irrational exuberance” in financial markets by then-Chairman Alan Greenspan. In other words, the Fed acted to sustain that economic expansion, respond to the deflationary pressures and mitigate international developments. Sound familiar?  Table 1Run-Up To The First Rate Cut: Now Vs. 1995 Sector Performance And Fed “Mid-Cycle Adjustments”: For Better Or For Worse Sector Performance And Fed “Mid-Cycle Adjustments”: For Better Or For Worse As a result, we decided to follow-up on the Special Report published in May when we examined which sectors performed best during Fed loosening cycles leading to recessions.2 In this issue, we delve a little deeper and – in light of all the similarities mentioned above – only look at the sectors’ relative performance following “mid-cycle adjustments” in the post-war era or, broadly speaking, the six loosening cycles that did not morph into a recession. We first isolate the 1995 episode, as the similarities in the stock market’s behavior between now and then are uncanny (Table 1). The S&P returned 18.6% and 17.3% in the six months leading to the 1995 and 2019 initial rate cuts, respectively. In relative terms, seven of the 10 sectors actually performed in a similar fashion over these two periods.3 Further, we broaden out our analysis by including six such non-recessionary loosening episodes, as highlighted in Chart 2. We omit the short-lived tightening in monetary policy both in 1976 and 1986 and instead look at the broader loosening trend. Chart 2Post-War Era Mid-Cycle Adjustments Post-War Era Mid-Cycle Adjustments Post-War Era Mid-Cycle Adjustments Table 2 displays the results of our analysis of the sectors’ relative average performance during “mid-cycle adjustments.” Table 2Sector Relative Performance And Non-Recessionary Fed Rate Cuts Sector Performance And Fed “Mid-Cycle Adjustments”: For Better Or For Worse Sector Performance And Fed “Mid-Cycle Adjustments”: For Better Or For Worse The average performance of the broad market registers negative returns ahead of the first rate cut followed by strong 6-, 12- and 24-month positive returns given the more supportive monetary backdrop and the absence of a dreaded recession. What follows in Charts A, B, C and D, is the sectors’ relative performance in the four different timeframes. Image Image Image Image The rate-sensitive sectors – S&P utilities, telecoms, consumer discretionary and financials – underperform early before they outperform once the Fed has started to ease with the exception of the S&P utilities which initially delivers low but positive returns and continue to underperform up to two years after the beginning of the “mid-cycle adjustments.” Chart 3Defying Gravity Defying Gravity Defying Gravity Similarly, we find that most of the deep cyclicals underperform in the run-up to the first rate cut and usually outperform subsequently. The S&P energy is an exception as it outperformed heading into the cutting cycle and then underperformed 6 to 12 months after the first rate cut. Admittedly, we cannot yet rule out the possibility Jay Powell and the Fed might very well be wrong and that the July cut will turn out to be more than just a “mid-cycle adjustment.”  After all, various slopes of the yield curve have already inverted (Chart 2, bottom panel) and the probability that the U.S. might enter into a recession 12 months from now reached 31.5% at the end of July, according to the New York Fed probit model based on the 3-month/10-year Treasury slope (Chart 3). Besides, that was before the yield curve underwent a roughly parallel shift lower of about 30 bps in a few days earlier this month, following the FOMC meeting and news about the escalation in Sino-U.S. trade tensions. Chart 3 shows our probit forecast taking into account the recent further yield curve inversion. What we know is that the current loosening episode is likely to run at least for the rest of the year. Market participants still expect at least three additional rate cuts from the Fed over the next 12 months (Chart 1, panel 2) and, as a reminder, the “mid-cycle adjustments” in the past all provided more than one interest rate cut. While we use this Special Report as a roadmap to sector performance before and after a “mid-cycle adjustment,” our view remains that a recession looms in the coming 18 months and, as such, we continue to decrease cyclical sector exposure and to add defensive exposure.4 (For purposes of completeness, we included reference charts in Appendix A showing individual sector relative performance since 1960 with the non-recessionary Fed rate cut episodes highlighted.) Finally, for those interested in how the yield curve reacts to such “mid-cycle adjustments,” our U.S. Bond Strategists5 performed a similar exercise and found that the 10-year Treasury yield has a tendency to rise following non-recessionary rate cuts and decline following rate cuts that led to a U.S. recession. They also document an interesting yield curve pattern: the curve tends to steepen quite sharply in the aftermath of a non-recessionary rate cut, before starting to flatten after a few months. Appendix A  Chart 4A U.S. S&P Consumer Staples U.S. S&P Consumer Staples Chart 4B U.S. S&P Health Care U.S. S&P Health Care Chart 4C U.S. S&P Utilities U.S. S&P Utilities Chart 4D U.S. S&P Telecom. Services U.S. S&P Telecom. Services Chart 4E U.S. S&P Energy U.S. S&P Energy Chart 4F U.S. S&P Technology U.S. S&P Technology Chart 4G U.S. S&P Industrials U.S. S&P Industrials Chart 4H U.S. S&P Materials U.S. S&P Materials Chart 4I U.S. S&P Consumer Discreationary U.S. S&P Consumer Discreationary Chart 4J U.S. S&P Financials U.S. S&P Financials   Jeremie Peloso, Research Analyst JeremieP@bcaresearch.com Arseniy Urazov, Research Associate ArseniyU@bcaresearch.com Footnotes 1 As we go to press, the probability of a 25 bps rate cut for the September FOMC meeting is 74.2% and of 25.8% for a 50 bps rate cut, based on CME FedWatch Tool. 2 Please see U.S. Equity Strategy Special Report, “Sector Performance And Fed Loosening Cycles: A Historical Roadmap”, dated May 6, 2019, available at uses.bcaresearch.com 3 Please see U.S. Equity Strategy Weekly Report, “A Recession Thought Experiment”, dated June 10, 2019, available at uses.bcaresearch.com 4 Please see U.S. Equity Strategy Weekly Report, “The Fed Apotheosis”, dated July 29, 2019, available at uses.bcaresearch.com 5 Please see U.S. Bond Strategy Weekly Report, “Track Records”, dated June 18, 2019, available at usbs.bcaresearch.com

Somewhere To Hide Somewhere To Hide Overweight Yesterday, Walmart delivered an upbeat profit report that propelled the S&P hypermarkets index to fresh multi-year relative performance highs. More gains are in store in coming months as this safe haven index has a lot going for it. Global growth remains anemic at best and as we posited in late spring there are high odds that the global growth reacceleration will be pushed out to at least Q1/2020. This bearish economic backdrop provides a shelter for investors to hide in hypermarket equities when the going gets tough (global manufacturing PMI shown inverted, middle panel). Domestic conditions are also wavering as evidenced by the drubbing in the 10-year real yield. The plunge in this economic growth metric is disconcerting, but a fillip to hypermarket equities (real yield shown inverted, top panel). Finally, oil prices are deflating and will continue to do so into the fall. Tack on the appreciating greenback that is keeping import prices in check despite the trade war and our Hypermarkets Pressure Gauge is signaling that relative forward earnings have more upside (bottom panel). Bottom Line: We reiterate our recent upgrade to overweight in the S&P hypermarkets index. The ticker symbols for the stocks in this index are: BLBG: S5HYPC - WMT, COST.

Chart II-1Is Deflation In Steel And Coal Back? Is Deflation In Steel And Coal Back? Is Deflation In Steel And Coal Back? Unlike 2015 when steel, iron ore and coal prices collapsed, in the current downturn they have so far held up reasonably well. They have begun falling only recently (Chart II-1). Even though we do not anticipate a 2015-type Armageddon in steel, iron ore and coal prices, they will deflate further due to supply outpacing demand in China. For both steel and coal, the pace of “de-capacity” reforms in China has diminished considerably, with declining shutdowns of inefficient capacity and rising advanced capacity, as we argued in a couple of reports last year.  This has led to a faster growth in supply, while demand has been dwindling with weak economic growth. Lower steel, iron ore and coal prices will harm Chinese and global producers along with their respective countries.1 Steel And Iron Ore First, both crude steel and steel products output will likely grow at a pace of 5-7% (Chart II-2). As the 2016-2020 steel de-capacity target (150 million tons capacity reduction) was already achieved by the end of 2018, the scale of further shutdowns will be limited. In addition, collapsing graphite electrode prices reflect an increased supply of this material. This along with more availability of scrap steel will facilitate the continuing expansion of cleaner technology (electric furnace (EF)) steel capacity and their output in China. The newly added EF steel capacity is planned at about 21 million tons in 2019 (representing 1.8% of official aggregate steel production capacity), slightly lower than the 25 million tons in 2018. Second, we expect steel products demand to grow at 3-5%, slightly weaker than output. Construction accounts for about 55% of Chinese final steel demand, with about 35% stemming from the property market and 20% from infrastructure. The automotive sector contributes about 10% of final Chinese steel demand. All of these end markets are weak and do not yet show signs of revival (Chart II-3). Chart II-2Steel Production In China Steel Production In China Steel Production In China Chart II-3No Recovery In Chinese Demand No Recovery In Chinese Demand No Recovery In Chinese Demand   Concerning iron ore price, we expect more downside than in steel. Supply disruptions among Brazilian and Australian producers were the main cause for the significant rally in iron ore prices this year. Evidence is that these producers have already resumed their output recovery. Current iron ore prices are still well above marginal production costs of major global iron ore producers. Besides, ongoing large currency depreciation in commodity producing countries will push down their marginal production costs in U.S. dollars terms. This will encourage further supply.  As China has increased its use of scrap steel in its crude steel production, the country’s iron ore demand has not grown much. In fact, imports of this raw material have contracted (Chart II-4) As scrap steel prices are currently very low relative to the price of imported iron ore (Chart II-5), steel producers in China will continue to use scrap steel instead of iron ore. Chart II-4China's Imports Of Iron Ore Have Been Shrinking China's Imports Of Iron Ore Have Been Shrinking China's Imports Of Iron Ore Have Been Shrinking Chart II-5Scrap Steel Is A Cheap Substitute For Iron Ore Scrap Steel Is A Cheap Substitute For Iron Ore Scrap Steel Is A Cheap Substitute For Iron Ore   Coal Chart II-6Coal Output Is Rising, But Beijing's Goal To Reduce Its Usage Coal Output Is Rising, But Beijing's Goal To Reduce Its Usage Coal Output Is Rising, But Beijing's Goal To Reduce Its Usage Chinese coal prices will also be under downward pressure. First, coal output growth will likely slow but will still stand at 2-4% down from a current 6% level (Chart II-6, top panel). The government has set a production goal of 3900 million tons for 2020. Given last year’s output of 3680 million tons, this implies only a 2.9% annual growth rate this year and the next. Second, the demand for both thermal coal and coking coal will likely weaken. They account for 80% and 20% of total coal demand, respectively. About 60% of Chinese coal is used to generate thermal power. As the country continues to promote the use of clean energy, thermal power output growth will likely slow further. Increasing the nation’s reliance on clean energy is an imperative strategic objective for Beijing. Given that thermal coal still accounts for a whopping 70% of electricity production, China will maintain its effort on reducing coal in its energy mix (Chart II-6, bottom panel). In the same vein, the government will continue to replace coal with natural gas in home heating. Finally, Chinese coal import volumes are likely to decline as the nation is increasingly relying on its domestic sources. In particular, the strategic Menghua railway construction will be completed in October. It will be used to transport the commodity from large producers in the north to the coal-deficit provinces in the south. This will reduce the nation’s coal imports, as the transportation cost of shipping domestic coal to the southern power plants will become more competitive than imported coal. Macro And Investment Implications First, companies and economies producing these commodities will face deflationary pressures. These include - but are not limited to - Indonesia, Australia, Brazil and South Africa, as well as steel producers around the world. Second, the RMB depreciation will allow China to gain further market share in the global steel market. In fact, China’s share of global steel output has been rising (Chart II-7, top panel). The bottom panel of Chart II-7 shows that steel production in the world excluding China have actually come to a grinding halt at a time when mainland producers have enjoyed high output growth. Global steel stocks have broken down and global mining equities are heading into a breakdown (Chart II-8). Chart II-7China Has Been Gaining A Share In Global Steel Market China Has Been Gaining A Share In Global Steel Market China Has Been Gaining A Share In Global Steel Market Chart II-8Breakdown In Steel And Mining Stocks Breakdown In Steel And Mining Stocks Breakdown In Steel And Mining Stocks   Finally, we remain bearish on commodities and other global growth sensitive currencies. In particular, we continue shorting the following basket of EM currencies against the U.S. dollar: ZAR, CLP, COP, IDR, MYR and KRW. Ellen JingYuan He, Associate Vice President ellenj@bcaresearch.com Footnotes 1      This is BCA’s Emerging Markets Strategy view and is different from BCA’s house view.

Highlights The current global trade downtrend has primarily been due to a contraction in Chinese imports. The latter reflects weakness in China's domestic demand in general and capital spending in particular. The current global manufacturing and trade downturns will prove to be drawn out. Several important markets have already experienced technical breakdowns, and a few others are at risk of doing so. EM domestic bonds and EM credit markets could be the last shoe to drop in this EM selloff. Steel, iron ore and coal prices, will all deflate further due to supply outpacing demand in China. Feature In our report last week, we argued that the odds of a liquidation phase in EM are growing. This week’s report continues exploring this theme, offering additional rationale and evidence of a pending breakdown in EM. Trade Tariffs: The Wrong Focus? The media and many investors seem to be solely focused on the impact of U.S. tariffs against imports from China. Yet these tariffs have not been the primary cause of the ongoing global manufacturing and trade recessions. It appears that the headlines and many investors are looking at individual trees and ignoring the forest. Chart I-1Chinese Imports Are Worse Than Exports Chinese Imports Are Worse Than Exports Chinese Imports Are Worse Than Exports Global trade contraction and China’s growth slump are not solely due to the trade tariffs imposed by the U.S. but rather stem from weakening domestic demand in China. Chart I-1 illustrates that Chinese aggregate exports are faring much better than imports. If the imposed tariffs were the main culprit behind both weakness in Chinese growth and global trade, mainland exports would have registered a far-greater hit by now than imports. However, they have not yet done so. This entails that U.S. tariffs have so far not had a substantial impact on Chinese and global manufacturing. The key point we would like to emphasize is that the current global trade downtrend has primarily been due to a contraction in Chinese imports. In turn, the accelerating decline in mainland imports is a reflection of relapsing domestic demand in China. The latter has been instigated by lethargic money/credit impulses owing to the government’s 2017-2018 deleveraging campaign and its reluctance to undertake an economy-wide irrigation type stimulus. What’s more, the recent RMB depreciation will likely intensify the Chinese import contraction already underway, as the same amount of yuan will buy less goods priced in U.S. dollars than before (Chart I-2). Given the majority of goods and commodities procured by mainland companies are priced in dollars, suppliers will receive fewer dollars, and their revenue derived from sales to and in China will continue to shrink (Chart I-3). Chart I-2RMB Depreciation Will Depress China's Purchases From Rest Of The World RMB Depreciation Will Depress China's Purchases From Rest Of The World RMB Depreciation Will Depress China's Purchases From Rest Of The World Chart I-3China Is In A Recession From Perspective Of Its Suppliers China Is In A Recession From Perspective Of Its Suppliers China Is In A Recession From Perspective Of Its Suppliers   We do not deny that the trade war has prompted a deterioration in sentiment among Chinese businesses and consumers as well as multinational companies, which in turn has dented both their spending and global trade. We do not see these issues reversing anytime soon. If the imposed tariffs were the main culprit behind both weakness in Chinese growth and global trade, mainland exports would have registered a far-greater hit by now than imports. Chart I-4EM EPS Are Contracting EM EPS Are Contracting EM EPS Are Contracting Even though U.S. President Donald Trump is flip-flopping on tariffs and their implementation, barring a major deal between the U.S. and China, business sentiment worldwide will not improve on a dime. In brief, delaying some import tariffs from September to December is unlikely to promote an imminent global trade recovery. The confrontation between the U.S. and China is profoundly not about trade: it is a geopolitical confrontation for global hegemony that will last years if not decades. Businesses in China and CEOs of multinational companies realize this, and they will not change their investment plans on Trump’s latest tweet delaying some tariffs. For now, we do not detect signs of an impending growth turnaround in China’s domestic demand and global trade. Therefore, China-related risk assets, commodities and global cyclicals are at risk of breaking down. Economic Rationale The global trade and manufacturing recession will linger for a while longer, and a recovery is not in the offing: The business cycle in EM/China continues to downshift. Consistently, corporate earnings are already or soon will be contracting in EM, China and the rest of emerging Asia (Chart I-4). EM corporate EPS contraction is broad-based (Chart I-5A and I-5B). The recent declines in oil and base metals prices entail earnings shrinkage for energy and materials companies (Chart I-5B, bottom two panels). Chart I-5AEM EPS Contraction Is Broad Based EM EPS Contraction Is Broad Based EM EPS Contraction Is Broad Based Chart I-5BEM EPS Contraction Is Broad Based EM EPS Contraction Is Broad Based EM EPS Contraction Is Broad Based   China’s monetary and fiscal stimulus has not yet been sufficient to revive capital spending in general and construction activity in particular (Chart I-6). Chinese household spending is also exhibiting little signs of recovery (Chart I-7). Chart I-6China: Building Construction Is Dwindling China: Building Construction Is Dwindling China: Building Construction Is Dwindling Chart I-7China: Consumer Spending Has Not Yet Recovered China: Consumer Spending Has Not Yet Recovered China: Consumer Spending Has Not Yet Recovered   Domestic demand continues to deteriorate, not only in China but also in other emerging economies, as we documented in our July 25 report. In EM ex-China, imports of capital goods and auto sales are contracting (Chart I-8). High-frequency freight data point to ongoing weakness in shipments in both the U.S. and China (Chart I-9). Chart I-8EM Ex-China: Domestic Demand Is Depressed EM Ex-China: Domestic Demand Is Depressed EM Ex-China: Domestic Demand Is Depressed Bottom Line: The current global manufacturing and trade downturns will prove to be drawn out, and investors should be wary of betting on an impending recovery. This is BCA’s Emerging Markets Strategy view and is different from BCA’s house view which is anticipating an imminent global business cycle recovery. Chart I-9Global Freight Does Not Signal Recovery Global Freight Does Not Signal Recovery Global Freight Does Not Signal Recovery   Breakdown Watch Financial market segments sensitive to the global business cycle have been splintering at the edges. These cracks appear to be proliferating to the center and will render considerable damage to aggregate equity indexes. EM corporate EPS contraction is broad-based. We explained our rationale behind using long-term moving averages to identify significant breakouts and breakdowns in last week’s report. We also highlighted the numerous breakdowns that have already transpired. Today, we supplement the list: EM equity relative performance versus DM has fallen below its previous lows (Chart I-10, top panel). Crucially, emerging Asian stocks’ relative performance versus DM has clearly breached its 2015-2016 lows (Chart I-10, bottom panel). The KOSPI and Chinese H-share indexes have broken below their three-year moving averages (Chart I-11, top two panels). Chart I-10EM Equities Relative Performance Has Broken Down EM Equities Relative Performance Has Broken Down EM Equities Relative Performance Has Broken Down Chinese bank stocks in particular have been responsible for dragging China’s H-share index lower (Chart I-11, bottom panel). In addition, Chinese small-cap stocks dropped below their December low, as have copper prices and our Risk-On versus Safe-Haven currency ratio1 (Chart I-12). Finally, German chemical and industrial share prices such as BASF, Siemens and ThyssenKrupp have decisively broken down (Chart I-13). Chart I-11Breakdowns In Korea And China... Breakdowns In Korea And China... Breakdowns In Korea And China...   Chart I-12...In Commodities Space As Well bca.ems_wr_2019_08_15_s1_c12 bca.ems_wr_2019_08_15_s1_c12 Chart I-13German Manufacturing Stocks Are In Free Fall German Manufacturing Stocks Are In Free Fall German Manufacturing Stocks Are In Free Fall   This implies that Germany’s manufacturing slowdown is not limited to the auto sector but rather is pervasive. Besides, these companies are greatly exposed to China/EM demand, and their share prices simply reflect the ongoing slump in China/EM capital spending. There are several other market signals that are at a critical technical juncture, and their move lower will confirm our downbeat view on global growth and cyclical markets. In particular: The global stocks-to-U.S. Treasurys ratio has dropped to a critical technical line (Chart I-14, top panel). Failure to hold this defense line would signal considerable downside in global cyclical assets. Similarly, the Chinese stock-to-bond ratio – calculated using total returns of both the MSCI China All-Share index and domestic government bonds – has plunged. The path of least resistance for this ratio might be to the downside (Chart I-14, bottom panel). Given China is the epicenter of the global slowdown, this ratio is of vital importance. The lack of recovery in this ratio signifies lingering downside growth risks. Finally, global cyclical sectors’ relative performance versus defensive ones is sitting on its three-year moving average (Chart I-15). A move lower will qualify as a major breakdown and confirm the absence of a global manufacturing and trade recovery. Chart I-14Global Stocks-To-Bonds Ratio: Sitting On Edge Global Stocks-To-Bonds Ratio: Sitting On Edge Global Stocks-To-Bonds Ratio: Sitting On Edge Chart I-15Global Cyclicals Versus Defensives: At A Critical Juncture Global Cyclicals Versus Defensives: At A Critical Juncture Global Cyclicals Versus Defensives: At A Critical Juncture   Bottom Line: Several important markets have already experienced technical breakdowns, and a few others are at risk of doing so. All in all, these provide us with confidence in maintaining our downbeat stance on EM risk assets and currencies. EM Bonds: The Last Shoe To Drop? Although EM share prices are back to their December lows, EM local currency and U.S. dollar bonds have done well this year, benefiting from the indiscriminate global bond market rally. However, there are limits to how far and for how long the performance of EM domestic and U.S. dollar bonds can diverge from EM stocks, currencies and commodities prices (Chart I-16). EM domestic bond yields have plunged close to the 2013 lows they touched prior to the Federal Reserve’s ‘Taper Tantrum’ selloff (Chart I-17, top panel). That said, on a total return basis in common currency terms, the GBI EM domestic bond index has not outperformed U.S. Treasurys, as shown in the bottom panel of Chart I-17. Chart I-16Which Way These Gaps Will Close? Which Way These Gaps Will Close? Which Way These Gaps Will Close? Chart I-17EM Domestic Bonds: Poor Risk-Reward Profile EM Domestic Bonds: Poor Risk-Reward Profile EM Domestic Bonds: Poor Risk-Reward Profile   Looking forward, EM exchange rates remain critical to the returns of this asset class. With the GBI EM local currency bond index’s yield spread over five-year U.S. Treasurys at about 400 basis points, EM currencies have very little room to depreciate before foreign investors begin experiencing losses. We believe that further RMB depreciation, commodities prices deflation and EM exports contraction all bode ill for EM exchange rates. Consequently, we expect EM local bonds to underperform U.S. Treasurys of similar duration over the next several months. German chemical and industrial share prices such as BASF, Siemens and ThyssenKrupp have decisively broken down. Finally, the euro has begun rapid appreciation versus EM currencies. This will erode EM local bonds’ returns to European investors and trigger a period of outflows. Within this asset class, our overweights are Mexico, Russia, Central Europe, Chile, Korea and Thailand, while we continue to recommend underweight positions in the Philippines, Indonesia, Turkey, South Africa, Brazil, Argentina and Peru within an EM local currency bond portfolio. As to EM credit space (hard currency bonds), these markets are overbought, and investors positioning is heavy. EM currency depreciation and lower commodities prices typically herald widening spreads. Argentina has a large weight in the EM credit indexes, and the crash in Argentine markets could be a trigger for outflows from this asset class. Technically speaking, there are already several negative signposts. The excess returns on EM sovereign and corporate bonds seem to have rolled over, having failed to surpass their early 2018 highs (Chart I-18). Besides, EM sovereign CDS spreads are breaking out (Chart I-19, top panel). Chart I-18EM Credit Markets Is Toppy EM Credit Markets Is Toppy EM Credit Markets Is Toppy Chart I-19EM Credit Space Is Entering Selloff EM Credit Space Is Entering Selloff EM Credit Space Is Entering Selloff   Finally, there are noticeable cracks in the emerging Asian corporate credit market. The price index of China’s high-yield property bonds – that account for a very large portion not only of the Chinese but also the emerging Asian corporate bond universes – has petered out at an important technical resistance level (Chart I-19, bottom panel). Further, the relative total return of emerging Asia’s investment-grade corporate bonds against their high-yield peers is correlated with Asia corporate spreads, and presently points to wider spreads (Chart I-20). The rationale is that periods when safer parts of the credit universe outperform the riskier ones are usually associated with widening credit spreads. China’s property market remains vulnerable as the central authorities in Beijing have not provided much housing-related stimulus in the current downtrend. Furthermore, companies in this space are overleveraged, generate poor cash flow and have limited access to credit. The euro has begun rapid appreciation versus EM currencies. This will erode EM local bonds’ returns to European investors and trigger a period of outflows. Overall, Chinese property developers will affect the EM credit space in two ways. First, their credit spreads will likely continue to shoot up, generating investor anxiety and outflows from this asset class. Second, reduced investment by debt-laden and cash-strapped property developers will inflict pain on industrial and materials companies in Asia and beyond. We discuss the outlook for steel, iron ore and coal, which are very exposed to Chinese construction, in the section below. Bottom Line: For asset allocators, we recommend underweighting EM sovereign and corporate credit versus U.S. investment grade, a strategy we have been advocating since August 16, 2017 (Chart I-21). For dedicated portfolios, the list of our overweights and underweights, as always, is presented at the end of the report (page 21). Chart I-20Emerging Asian Corporate Spreads Will Widen Emerging Asian Corporate Spreads Will Widen Emerging Asian Corporate Spreads Will Widen Chart I-21Favor U.S. Investment Grade Versus EM Overall Credit Favor U.S. Investment Grade Versus EM Overall Credit Favor U.S. Investment Grade Versus EM Overall Credit   As for EM domestic bonds, we continue to recommend betting on yield declines in select countries without taking on currency risk. These include Korea, Chile, Mexico and Russia. We will warm up to this asset class in general when we alter our negative EM currency view. Arthur Budaghyan Chief Emerging Markets Strategist arthurb@bcaresearch.com Chinese Steel, Iron Ore And Coal Markets: Renewed Deflation Chart II-1Is Deflation In Steel And Coal Back? Is Deflation In Steel And Coal Back? Is Deflation In Steel And Coal Back? Unlike 2015 when steel, iron ore and coal prices collapsed, in the current downturn they have so far held up reasonably well. They have begun falling only recently (Chart II-1). Even though we do not anticipate a 2015-type Armageddon in steel, iron ore and coal prices, they will deflate further due to supply outpacing demand in China. For both steel and coal, the pace of “de-capacity” reforms in China has diminished considerably, with declining shutdowns of inefficient capacity and rising advanced capacity, as we argued in a couple of reports last year.  This has led to a faster growth in supply, while demand has been dwindling with weak economic growth. Lower steel, iron ore and coal prices will harm Chinese and global producers along with their respective countries.2 Steel And Iron Ore First, both crude steel and steel products output will likely grow at a pace of 5-7% (Chart II-2). As the 2016-2020 steel de-capacity target (150 million tons capacity reduction) was already achieved by the end of 2018, the scale of further shutdowns will be limited. In addition, collapsing graphite electrode prices reflect an increased supply of this material. This along with more availability of scrap steel will facilitate the continuing expansion of cleaner technology (electric furnace (EF)) steel capacity and their output in China. The newly added EF steel capacity is planned at about 21 million tons in 2019 (representing 1.8% of official aggregate steel production capacity), slightly lower than the 25 million tons in 2018. Second, we expect steel products demand to grow at 3-5%, slightly weaker than output. Construction accounts for about 55% of Chinese final steel demand, with about 35% stemming from the property market and 20% from infrastructure. The automotive sector contributes about 10% of final Chinese steel demand. All of these end markets are weak and do not yet show signs of revival (Chart II-3). Chart II-2Steel Production In China Steel Production In China Steel Production In China Chart II-3No Recovery In Chinese Demand No Recovery In Chinese Demand No Recovery In Chinese Demand   Concerning iron ore price, we expect more downside than in steel. Supply disruptions among Brazilian and Australian producers were the main cause for the significant rally in iron ore prices this year. Evidence is that these producers have already resumed their output recovery. Current iron ore prices are still well above marginal production costs of major global iron ore producers. Besides, ongoing large currency depreciation in commodity producing countries will push down their marginal production costs in U.S. dollars terms. This will encourage further supply.  As China has increased its use of scrap steel in its crude steel production, the country’s iron ore demand has not grown much. In fact, imports of this raw material have contracted (Chart II-4) As scrap steel prices are currently very low relative to the price of imported iron ore (Chart II-5), steel producers in China will continue to use scrap steel instead of iron ore. Chart II-4China's Imports Of Iron Ore Have Been Shrinking China's Imports Of Iron Ore Have Been Shrinking China's Imports Of Iron Ore Have Been Shrinking Chart II-5Scrap Steel Is A Cheap Substitute For Iron Ore Scrap Steel Is A Cheap Substitute For Iron Ore Scrap Steel Is A Cheap Substitute For Iron Ore   Coal Chart II-6Coal Output Is Rising, But Beijing's Goal To Reduce Its Usage Coal Output Is Rising, But Beijing's Goal To Reduce Its Usage Coal Output Is Rising, But Beijing's Goal To Reduce Its Usage Chinese coal prices will also be under downward pressure. First, coal output growth will likely slow but will still stand at 2-4% down from a current 6% level (Chart II-6, top panel). The government has set a production goal of 3900 million tons for 2020. Given last year’s output of 3680 million tons, this implies only a 2.9% annual growth rate this year and the next. Second, the demand for both thermal coal and coking coal will likely weaken. They account for 80% and 20% of total coal demand, respectively. About 60% of Chinese coal is used to generate thermal power. As the country continues to promote the use of clean energy, thermal power output growth will likely slow further. Increasing the nation’s reliance on clean energy is an imperative strategic objective for Beijing. Given that thermal coal still accounts for a whopping 70% of electricity production, China will maintain its effort on reducing coal in its energy mix (Chart II-6, bottom panel). In the same vein, the government will continue to replace coal with natural gas in home heating. Finally, Chinese coal import volumes are likely to decline as the nation is increasingly relying on its domestic sources. In particular, the strategic Menghua railway construction will be completed in October. It will be used to transport the commodity from large producers in the north to the coal-deficit provinces in the south. This will reduce the nation’s coal imports, as the transportation cost of shipping domestic coal to the southern power plants will become more competitive than imported coal. Macro And Investment Implications First, companies and economies producing these commodities will face deflationary pressures. These include - but are not limited to - Indonesia, Australia, Brazil and South Africa, as well as steel producers around the world. Second, the RMB depreciation will allow China to gain further market share in the global steel market. In fact, China’s share of global steel output has been rising (Chart II-7, top panel). The bottom panel of Chart II-7 shows that steel production in the world excluding China have actually come to a grinding halt at a time when mainland producers have enjoyed high output growth. Global steel stocks have broken down and global mining equities are heading into a breakdown (Chart II-8). Chart II-7China Has Been Gaining A Share In Global Steel Market China Has Been Gaining A Share In Global Steel Market China Has Been Gaining A Share In Global Steel Market Chart II-8Breakdown In Steel And Mining Stocks Breakdown In Steel And Mining Stocks Breakdown In Steel And Mining Stocks   Finally, we remain bearish on commodities and other global growth sensitive currencies. In particular, we continue shorting the following basket of EM currencies against the U.S. dollar: ZAR, CLP, COP, IDR, MYR and KRW. Ellen JingYuan He, Associate Vice President ellenj@bcaresearch.com   Footnotes 1          Average of CAD, AUD, NZD, BRL, CLP & ZAR total return (including carry) indices relative to average of JPY & CHF total returns. 2      This is BCA’s Emerging Markets Strategy view and is different from BCA’s house view. Equities Recommendations Currencies, Fixed-Income And Credit Recommendations