Equities

Highlights Analysis on South Africa is published below. The “EM” label does not guarantee a secular bull market. None of the individual EM bourses has outperformed DM on a consistent basis over the past 40 years. EM share performance in both absolute terms and relative to DM has exhibited long-term cycles of around seven to 10 years. Getting these cycles right is instrumental to successful investing in EM. EM investing is predominantly about exchange rates. From a long-term (structural) perspective, EM equities are only modestly cheap in absolute terms but are very cheap versus the U.S. Feature We often receive questions from asset allocators about the long-term outlook for EM equities and currencies. The general perception among longer-term allocators is that while EMs may underperform over the short term, they always outperform developed markets (DM) in the long run. Consistently, the overwhelming majority of investors’ long-term return forecasts ascribe the highest potential return to EM equities and bonds among various regions and asset classes. This week we focus on the historical long-term performance of EMs. Contrary to popular sentiment, our findings show that EM stocks and currencies have not outperformed their U.S./DM peers in the past 40 years – as long as EMs have existed as an asset class. Hence, there is no guarantee that EM share prices and currencies will always outperform their DM counterparts on a secular basis going forward. Notably, EM share performance in both absolute terms and relative to DM has exhibited long-term cycles of around seven to 10 years. Getting these cycles right is instrumental to successful investing in EM. At the moment, the odds are that the current bout of EM equity and currency underperformance is not yet over, and more downside is likely before a major upturn emerges. The “EM” Label Does Not Guarantee A Secular Bull Market EM share prices have been in a wide trading range since 2010 (Chart I-1), despite the 10-year bull market in the S&P 500. Chart I-1Lost Decade For EM Stocks Remarkably, there is no single EM bourse that has been in a bull market during this decade (Chart I-2 and Chart I-3). This proves that this has indeed been a “lost” decade for EM. Chart I-2Individual EM Bourses: A Very Long-Term Perspective Chart I-3Individual EM Bourses: A Very Long-Term Perspective Historically, secular bull markets have been followed by bear markets not only in the boom-bust economies of Latin America, EMEA and Southeast Asia but also in former Asian tiger economies including Korea, Taiwan and Singapore (Chart I-4). This is despite the fact that per-capita real income has been growing rather rapidly in these Asian economies. Chart I-4Former Asian Tigers: Long-Term Equity Performance Remarkably, China and Vietnam have been exhibiting similar dynamics over the past 20 years – rapid per-capita real income growth and poor equity market returns (Chart I-5). Chart I-5China And Vietnam: Stock Prices And GDP Per Capita The message from all of these charts is as follows: Periods of industrialization and urbanization – even if successful – do not always entail structural bull markets. The U.S. fits this pattern as well. During the period between 1870 and 1900, the U.S. was experiencing industrialization and urbanization along with many productivity enhancements such as the steam engine, electricity and infrastructure construction. Even though America’s prosperity and real income per-capita levels surged during this period, corporate earnings per share and stock prices were rather flat (Chart I-6). Chart I-6The U.S. In The Late 1800s: Stocks, Profits And GDP Hence, rising per-capita real income and prosperity do not translate into higher share prices on a consistent basis. This is not to say that no country can ever deliver healthy stock market gains in the long run. Some certainly will, and it is our job to identify and expose these to clients. The point is that the “emerging market” status does not guarantee a structural bull market. Asset Allocation: Play Cycles Chart 7 illustrates that EM relative equity performance versus DM in general and the U.S. in particular has gone through several major swings over the past 40 years. Remarkably, none of the individual EM bourses has outperformed DM on a consistent basis over this time frame (Chart I-8A and I-8B). Chart I-7EM Versus DM: Relative Total Equity Returns Chart I-8ANo Single EM Bourse Has Outperformed DM In Past 40 Years Chart I-8BNo Single EM Bourse Has Outperformed DM In Past 40 Years Failure to outperform DM stocks is not only inherent for bourses in twin-deficit and inflation-prone regions/countries such as Latin America, Russia, Turkey, South Africa and South East Asia (including India), but it has also been true for share prices in rapidly growing countries such as China and Vietnam (Chart I-9). Chart I-9Chinese And Vietnamese Stocks Have Not Outperformed DM Remarkably, equity markets in the former Asian tigers – Korea, Taiwan and Singapore – have also failed to outperform their DM peers in the past 40 years (Chart I-10). This is in spite of the fact that real income per-capita growth in these Asian nations has by far outpaced that in both the U.S. and DM (Chart I-11). Chart I-10Former Asian Tigers Have Not Outperformed DM Equities... Chart I-11…Despite Economic Outperformance Evidently, the assumption that EM stocks will outperform DM equities on the back of higher potential growth rates is not validated by historical data. First, higher potential growth does not always ensure robust realized GDP growth. Second, even if real GDP-per-capita growth rises considerably, this does not always guarantee superior equity market returns. Some of the reasons for this include productivity benefits being transferred to employees rather than to shareholders, chronic equity dilution, and a misallocation of capital that boosts economic growth at the expense of shareholders. Bottom Line: EM relative stock performance versus DM has been fluctuating in well-defined long-term cycles. In our view, EM relative equity performance has not yet reached the bottom in this downtrend. We downgraded EM stocks in April 2010 and have been recommending a short EM equities / long S&P 500 strategy since December 2010 (please refer to Chart I-7 on page 5). EM Investing Is Primarily About Exchange Rates Exchange rates hold the key to getting EM equity cycles right for international investors. As demonstrated in Chart I-12, historically the bulk of EM equity return erosion has been due to currency depreciation. Chart I-12EM Investing Is All About Exchange Rates Exchange rates of structurally weak EM economies depreciate chronically. Common reasons include lack of productivity growth, high inflation, current account deficits, uncontrolled fiscal expansion, and reliance on volatile foreign portfolio flows. Periods of currency depreciation also occur in emerging Asian economies that have low inflation and typically run current account surpluses. Chart I-13 shows spot rates for Korea, Taiwan and Singapore versus the SDR which is a weighted average of USD, the euro, JPY, GBP, and CNY.1 Chart I-13Former Asian Tiger Currencies: Wide Fluctuations None of these Asian-tiger currencies has consistently appreciated versus the SDR. As in the case of share prices, there have been multi-year exchange rate swings. Further, U.S. dollar total returns on EM local bonds are also primarily driven by their currencies (Chart I-14). Consequently, the cycles in EM local currency bonds match EM exchange rate cycles. Chart I-14Total Return On Local Currency Bonds EM credit spread fluctuations are also by and large contingent on their exchange rates. Credit spreads on EM sovereign and corporate U.S. dollar bonds gauge debt servicing risk. The latter is highly influenced by exchange rates. Currency depreciation (appreciation) increases (decreases) debt servicing costs thereby affecting credit spreads. Bottom Line: Exchange rate fluctuations are driven by macro crosscurrents, making macro an indispensable know-how for EM investing. We maintain that EM currencies are susceptible to renewed weakness against the U.S. dollar as China’s growth continues to weaken, weighing on EM growth and thereby their respective exchange rates (Chart I-15). In turn, the U.S. dollar is a countercyclical currency and does well when global growth decelerates. Chart I-15EM Currencies Are Pro-Cyclical Valuations: The Starting Point Matters… In recent years, a long-term bullish case for EM equities and currencies has often been made on the grounds of cheap valuations. Chart I-16 illustrates the equity market-cap weighted real effective exchange rate for EM ex-China, Korea and Taiwan – a measure that is pertinent for both EM equity and fixed-income investors.2 It reveals that EM currency valuations are only slightly below their historical mean. Chart I-16EM Ex-China, Korea, Taiwan Currencies Are Modestly Cheap As to the CNY, KRW and TWD, their valuations are not at an extreme, and the CNY holds the key. The main long-term risk to the RMB is capital outflows from Chinese households and companies as discussed in February 14 report. For long-term investors, the pertinent equity valuation yardstick is the cyclically adjusted P/E (CAPE) ratio. The idea behind the CAPE model is to remove cyclicality of corporate profits when computing the P/E ratio – i.e., to look beyond a business cycle. Hence, the CAPE ratio is a structural valuation model – i.e., it works in the long term. Only investors with a time horizon greater than three years should use this valuation measure in their investment decisions. Our CAPE model gauges equity valuations under the assumption of per-share earnings converging to their trend line. The latter is derived by a regression of the cyclically adjusted EPS in real U.S. dollar terms on time. The EM CAPE ratio presently stands at 0.5 standard deviations below its historical mean (Chart I-17). This means EM stocks are modestly cheap from a long-term perspective. Meanwhile, the U.S.’s CAPE ratio is very elevated (Chart I-18). Chart I-17EM Equities Are Modestly Cheap From AA1 Structural Perspective Chart I-18U.S. Stocks Are Expensive From AA1 Structural Perspective On a relative basis, EMs are very attractive relative to U.S. stocks (Chart I-19). This entails that the probability of EM stocks outperforming U.S. equities is very high from a secular perspective – longer than three years. Chart I-19EM Equities Are Cheap Versus U.S. From AA1 Structural Perspective Nevertheless, a caveat is in order. Our CAPE model assumes that EPS in real U.S. dollar terms will rise at the same pace as it has historically. The slope of the time trend – the historical compound annual growth rate (CARG) of EPS in inflation-adjusted U.S. dollar terms – is 2.8% for EM and 2% for the U.S. Please note that we determined the earnings time trend (trend line) using historical ranges – 1983 to present for EM, and 1935 to present for the U.S. Hence, these CAPE models assume that EM EPS will grow 0.8 percentage points (2.8% minus 2%) faster than U.S. corporate EPS in inflation-adjusted U.S. dollar terms, as they have done historically. Under this assumption, EM stocks are considerably cheaper than the U.S. market. That said, in the medium term, corporate earnings are the key driver of EM share prices, and contracting profits pose a risk to EM performance, as discussed in our February 21 report. Bottom Line: From a long-term perspective, EM equities and currencies are only modestly cheap in absolute terms. Based on our CAPE ratio model, EM stocks are very cheap versus the U.S. However, the CAPE ratio is a structural valuation measure, and only investors with a time horizon of longer than three years should put considerable emphasis on it. …But Beware Of A Potential Value Trap If for whatever reason there is a change in the slope of the EM EPS long-term trend – i.e., per-share earnings fail to expand in the coming years at their historical rate, as discussed above, our CAPE model would be invalidated. In such a case, EM share prices are unlikely to enter a secular bull market in absolute terms and outperform their U.S. counterparts structurally. The key to sustaining the current upward slope in the long-term trajectory of EPS in real U.S. dollar terms is for EM/Chinese companies to undertake corporate restructuring and increase efficiency. Critically, recurring Chinese credit and fiscal stimulus as well as cheap and abundant money from international investors have not fostered corporate restructuring in China, nor in other EM countries. The basis is that easy and cheap financing and economic growth propped-up by periodic Chinese stimulus has made companies complacent, undermining their productivity and efficiency. The ultimate outcome will be weak corporate profitability over the long run. Another long-term risk to corporate earnings in China and some other EMs is the expanding role of the state in the economy. In these circumstances, China/EM corporate profitability will also suffer over the long run. The basis is that in any country the private sector is better than the government in generating strong corporate earnings. Bottom Line: Without structural reforms and corporate restructuring in EM/China, EM stocks are unlikely to outperform their DM peers on a secular basis. Investment Conclusions The medium-term EM outlook remains poor for the reasons we elaborated on in last week’s report titled, EM: A Sustainable Rally or A False Start? Further, investor sentiment on EM is very bullish, and positioning in EM equities and currencies is elevated (Chart I-20). We continue to recommend underweighting EM stocks, credit markets and currencies versus their DM counterparts and the U.S. in particular. Chart I-20Investors Are Very Bullish On EM From a long-term perspective, EM equity and currency valuations are modestly cheap. However, a durable long-term expansion in EM economies is contingent on a sustainable bottom in Chinese growth. The latter hinges on deleveraging and corporate restructuring in China, neither of which have occurred to a meaningful extent. For EM equity portfolios, we presently recommend overweighting Mexico, Brazil, Chile, central Europe, Russia, Thailand and Korean non-tech stocks. Our current (not structural) underweights are South Africa, Indonesia, India, the Philippines, Hong Kong and Peru. Within the EM equity space, two weeks ago we booked triple-digit profits on our strategic long positions in EM tech versus both the overall EM index and EM materials stocks, respectively. These positions were initiated in 2010. The basis for these strategic recommendations was our broader theme for the decade of being long what Chinese consumers buy, and short plays on Chinese construction, which we initiated on June 8, 2010. This week we are closing our long central European banks / short euro area banks equity position. We recommended it on April 6, 2016, and it has produced a 14% gain since then. Arthur Budaghyan Chief Emerging Markets Strategist arthurb@bcaresearch.com South Africa: Debt Deflation Or Currency Depreciation? South Africa’s public debt dynamics are on an unsustainable track. Two prerequisites for public debt sustainability are (1) for interest rates to be below nominal GDP growth or (2) continuous robust primary fiscal surpluses. Hence, a government can stabilize its debt-to-GDP ratio by either having nominal GDP above its borrowing costs, or by running persistent and sizable primary fiscal surpluses. Neither of these two stipulations are presently satisfied in South Africa. The gap between government local currency bond yields and nominal GDP growth is at its widest in over the past 10 years (Chart II-1). Meanwhile, the primary fiscal deficit is 0.75% of GDP (Chart II-2). Chart II-1South Africa: An Unsustainable Gap Chart II-2South Africa Has Not Had A Primary Fiscal Surplus In A Decade Faced with very low real potential GDP growth stemming from the economy’s poor structural backdrop, the authorities in South Africa ultimately have two choices to stabilize the public debt-to-GDP ratio: Tighten fiscal policy substantially, trying to achieve persistent large primary budget surpluses; or Inflate their way out of debt, which would require a large currency depreciation to boost nominal GDP growth above borrowing costs. With this in mind, we performed a simulation on public debt, assuming fiscal tightening but no substantial currency depreciation (Table II-1). The first scenario uses the 2019 consolidated budget government assumptions and projections for nominal GDP, government revenues and expenditures, i.e., it is the government's scenario. In this scenario, the public debt-to-GDP ratio rises only to 58% by the end of the 2021-‘22 fiscal year. However, government forecasts always end up being optimistic. We believe this scenario is implausible due to its overestimation of nominal GDP, and hence government revenue growth. As the government tightens fiscal policy, nominal GDP growth and ultimately government revenue will disappoint substantially. For the second scenario, we used government projections for fiscal spending in the coming years, but our own estimates for nominal GDP and government revenue growth. Notably, excluding interest payments and fiscal support for ailing state-owned enterprises like Eskom, nominal growth of government expenditures in the current year is at 7.5%, and estimated to be 6.8% the next two fiscal years. That is why we project nominal GDP and government revenue growth to be very weak. The basis of our assumption is as follows: Barring considerable currency depreciation, as the authorities undertake substantial fiscal tightening in the next three years, nominal GDP and consequently government revenue growth will plunge. Importantly, government revenues exhibit a non-linear relationship with nominal GDP – government revenues fluctuate much more than nominal GDP (Chart II-3). Chart II-3Government Revenues Are 'High-Beta' On Nominal GDP Growth As government revenue growth underwhelms, the primary deficit will widen and the public debt-to-GDP ratio will escalate, reaching 70% of GDP by the end of the 2021-‘22 fiscal year, according to our projections (Table II-1). Overall, without considerably lower interest rates and material currency depreciation, the government’s financial position will enter a debt deflation spiral. Fiscal tightening will hurt nominal growth damaging fiscal revenues. As a result, the fiscal deficit will widen – not narrow – and the debt-to-GDP ratio will rise. Therefore, the only feasible option for South Africa to stabilize public debt is to reduce interest rates dramatically and depreciate the currency. This will engender higher inflation and nominal growth, thereby boosting government revenues and capping the public debt burden. At 10%, the share of foreign currency debt as part of South Africa’s public debt is low. Hence, currency depreciation will do less damage to public debt dynamics than keeping interest rates at high levels. On the whole, the rand is a very structurally weak currency, and is bound to depreciate due to deteriorating public debt dynamics. Chart II-4 plots the real effective exchange rate of the rand based on CPI and PPI. It is evident that its valuation is not yet depressed. Chart II-4The Rand Is Modestly Cheap Meanwhile, cyclical headwinds also warrant currency depreciation (Chart II-5). Chart II-5Widening Trade Deficit Warrants Currency Depreciation Market Recommendations Continue shorting the ZAR versus the U.S. dollar and the MXN. Consistent with the negative outlook for the exchange rate, investors should underweight South African local currency government bonds and sovereign credit within respective EM portfolios. Finally, we recommend EM equity portfolios remain underweight South African equities. Andrija Vesic, Research Analyst andrijav@bcaresearch.com Arthur Budaghyan Chief Emerging Markets Strategist arthurb@bcaresearch.com   Footnotes 1       Special Drawing Rights. The value of the SDR is based on a basket of five currencies: the U.S. dollar, the euro, the Chinese renminbi, the Japanese yen, and the British pound sterling. 2      We exclude these three currencies since their bourses have very large equity market cap in the EM stock index and, hence, would make any aggregate currency measure unrepresentative for the rest of EM.   Equity Recommendations Fixed-Income, Credit And Currency Recommendations

Highlights February’s credit release earlier this week confirmed that credit growth is not yet on a “blowout” trajectory. If maintained, the recent pace of credit expansion implies a moderate credit cycle, not a large acceleration like what occurred in 2015/2016. We agree that a trade deal between China and the U.S. is likely to occur, but a sustained, cyclical (i.e. 6-12 month) rise in Chinese relative equity performance requires stability in the outlook for earnings, which have not yet reflected the ongoing economic slowdown. A confirmed meeting date between Presidents Trump & Xi coupled with more evidence that a moderate credit expansion is underway would likely lead us to upgrade our cyclical stance towards Chinese investable stocks (to overweight). Feature Tables 1 and 2 on pages 2 and 3 highlight key developments in China’s economy and its financial markets over the past month. On the growth front, data releases later this week will provide a crucial read on the pace of the slowdown in coincident economic activity. The ongoing weakness in trade and producer prices suggests that activity has continued to decelerate as the previously beneficial trade frontrunning effect washes out of the data. While we agree that January’s gargantuan credit number means that growth will bottom at some point this year, the February data released earlier this week highlights that credit growth is not yet on a “blowout” trajectory. If maintained, the recent pace of credit expansion implies a moderate credit cycle, not a large acceleration like what occurred in 2015/2016. Table 1China Macro Data Summary Table 2China Financial Market Performance Summary From an investment strategy perspective, we recommended in our February 27 Weekly Report that investors place Chinese investable stocks on upgrade watch, but that an immediate shift to a cyclical overweight was not yet warranted. The recent outperformance of investable stocks vs. the global benchmark largely reflects global investor expectations of a trade deal between China and the U.S. in the very near future, which we agree is likely to occur. But we have underscored that a sustained, cyclical (i.e. 6-12 month) rise in Chinese relative equity performance requires stability in the outlook for earnings, which have not yet reflected the slowdown that is underway. Barring a substantial trade-deal-driven rise in the RMB (which would dampen profits further and raise the bar for credit), a confirmed meeting date between Presidents Trump & Xi coupled with further evidence that a moderate credit expansion is underway would likely lead us to upgrade our cyclical stance towards Chinese investable stocks (to overweight). In reference to Tables 1 and 2, we provide several detailed observations concerning developments in China’s macro and financial market data below: The January and February data for several measures of coincident activity, including both measures of the Li Keqiang index (LKI) that we track, are set to be updated tomorrow. However, a number of data series that have been released over the past two months point to a continued deceleration: growth in rail cargo volume ticked down in January, producer prices are on the cusp of deflation, and nominal import and export growth decelerated again in February (measured either in US$ or RMB terms). The four components of our LKI leading indicator available for February have all sequentially declined, including the growth in adjusted TSF and adjusted TSF as a share of GDP. Credit had surged in January, but ticked down in February. Chart 1 illustrates the likely path of adjusted TSF as a share of GDP if the average pace of credit growth over the past three months is sustained. The chart implies that credit will have durably bottomed, but that the pace of advance will be weaker than that experienced in past cycles. Chart 1The Recent Pace Of Growth Implies A Moderate Credit Cycle​​​​​​​ January and February data for residential floor space started and sold will also be updated tomorrow, and it will be important to see whether the gap that has emerged between construction and sales has persisted. Floor space sold has reliably led starts since 2010, and we recently highlighted that the PBOC pledged supplementary lending program has led sales since 2015. The pace of PSL decelerated further in February, suggesting that the outlook for sales (which are already in negative YoY territory) is deteriorating. Based on the leading relationships that we have identified, residential construction volume is unsustainably strong. The seemingly inconsistent messages between the NBS and Caixin manufacturing PMIs in February (down and up, respectively) may in fact reflect the PBOC’s focus on easing financial conditions for small businesses. While the NBS PMI includes a much broader sample of firms than the Caixin PMI, the latter focuses heavily on private sector SMEs. Given this, February’s data may suggest that the export outlook is improving, but we would caution against the conclusion that the overall manufacturing sector has bottomed until both PMIs are clearly rising. Over the past month, the most notable development in China’s equity market has been the near-vertical outperformance of A-shares versus the global benchmark. A catch-up period for A-shares was arguably warranted given the sustained rally in investable stocks since early-November, but Chart 2 highlights that the speed of the recent rise has pushed relative A-share performance quickly into overbought territory. At a minimum, a period of consolidation over the coming few weeks is likely. Chart 2Too Far, Too Fast​​​​​​​ The relative performance of EM stocks ex-China is one of the equity components of our BCA Market-Based China Growth Indicator, which has recovered over the past few months. However, Chart 3 highlights that the performance of EM ex-China reliably led Chinese investable stocks since the beginning of last year, and are now raising a red flag. A near-term relapse in investable equity performance would be consistent with our view that earnings face further downside risk over the coming few months. ​​​​​​​Chart 3EM Ex-China Is Flashing A Warning Sign For Chinese Investable Stocks Within the investable equity market, our low-volatility sector portfolio remains in an uptrend versus the broad market, although the composition of this portfolio has shifted significantly over the past few weeks. Financials, industrials, and energy stocks now account for 86% of our long MSCI China Low-Beta Sectors / short MSCI China trade, which is likely surprising to many investors given their traditionally cyclical characteristics. Chart 4 highlights that the relative performance of our low-beta trade has exhibited a reliably counter-cyclical message; this, in combination with the fact that it remains above its 200-day moving average, signals that it is still premature to shift to a cyclical overweight stance favoring Chinese stocks. Chart 4No Green Light Yet From Low-Vol Stocks Value stocks have been responsible for more of the rally in China’s investable market versus the global average than their growth peers (Chart 5). This underscores that at least part of the rise in investable performance has been due to a relative valuation trade, rather than strong conviction that the Chinese economy will strengthen materially over the coming year. Chart 5The Rally Has Been Led By Cheap Stocks Table 2 highlights that the 3-month interbank repo rate is down materially from its 12-month high, a decline that is now passing through into lower bank lending rates. According to the PBOC, the weighted average lending rate declined 30 basis points in Q4, after having been essentially unchanged in Q3. The decline validates our model for predicting the rate, which had been calling for a non-trivial decline. Despite the continual expression of concern in the financial press about rising onshore corporate bond defaults, spreads on SOE corporate bonds have been steady over the past 6 months. Spreads remain elevated when compared with late-2016 levels, but the recent trend in spreads does not suggest that domestic financial conditions are getting tighter. Chart 6 shows that the recent rise in CNY-USD is consistent with a tariff-based framework that we had presented for the exchange rate several times last year. While the rate was on its way to breaking through the psychologically important level of 7 for USD-CNY, trade talks with the U.S. have helped the rate rise to a point that is consistent with the current tariff regime. CNY-USD has already overshot to the upside based on interest rate differentials, but Chart 6 implies that further gains may occur if tariff rollbacks are part of an eventual deal with the U.S. Chart 6CNY-USD May Rise Materially Further If Tariffs Are Rolled Back Jonathan LaBerge, CFA, Vice President Special Reports jonathanl@bcaresearch.com Cyclical Investment Stance Equity Sector Recommendations

Neutral In this week’s Special Report, we moved to a neutral recommendation on the BCA aerospace index. The report highlights the two pillars supporting the aerospace index and its relative performance: global trade sentiment and execution-driven profit performance. With respect to the first, relief in trade wars represents a powerful catalyst. Nevertheless, that same trade sentiment pendulum swings both ways and we believe elevated trade tensions will increase volatility and decrease predictability, particularly considering the global nature of aerospace firms (second panel). Still, aerospace sales and earnings growth look assured for a reasonable forecast horizon, considering the upbeat commercial aerospace demand over the past five years as well as the current robust order environment. However, aerospace firms have been blowing out their balance sheets to retire debt and currently enjoy near-record valuations (third & bottom panels). Bottom Line: On balance, we think it no longer pays to be underweight the BCA aerospace index and we moved to a benchmark allocation. Please see Monday’s Special Report for more details.   ​​​​​​​

Special Report

Feature It no longer pays to be underweight the BCA aerospace index considering the long profit growth runway and potential trade easing catalysts. Accordingly, we are moving to a benchmark allocation in this sector. There are two pillars supporting the BCA aerospace index and its relative performance: global trade sentiment and execution-driven profit performance. Despite a tangible easing in trade tensions between the U.S. and China, the global trade environment remains uncertain in the near term as economic weakness has permeated beyond U.S. shores and new trade issues seem likely to pop up (including potential tariffs on EU- or Japan-produced autos) to replace those being resolved. Aerospace profits are soaring to new heights and have been underpinning an aerospace bull market in 2019; a robust order environment suggests this may continue. However, a debt-fueled change in corporate capitalization and stratospheric valuations should keep investor expectations grounded. The Canary In The Coal Mine  The ebb and flow of the trade dispute with China has been reflected partially in the relative performance of industrials1 in general (top panel, Chart 1), aerospace in particular (middle panel, Chart 1) and Boeing specifically (bottom panel, Chart 1). This is due in large part to Boeing taking on the mantle of a global trade bellwether and also dominating our index. Chart 1Aerospace Is Leading The Way Considering the global nature of the firm, this role seems appropriate. Chart 2 shows the company’s order backlog by region; the domestic market represents only 25% of the next several years of production while all of the DM represents only 40%. The bulk of Boeing’s production backlog, and hence future revenues, are derived from the EM. Boeing is also particularly unique in that it has virtually no currency exposure as its products are invariably priced in U.S. dollars, as is the case with the bulk of U.S. aerospace firms. Examining relative performance with global leading indicators provides some insight. The global manufacturing PMI shares an exceptionally tight directional relationship with aerospace’s relative performance (second panel, Chart 3). Though the current message is negative, BCA’s Global Leading Economic Indicator (GLEI) diffusion index has already started to recover (bottom panel, Chart 3), signaling that global growth is likely putting in a bottom and aerospace outperformance may resume anew. Chart 3Global Indicators Lead Relative Performance Nevertheless, from a sentiment perspective, aerospace investors are focused squarely on weakness in the Chinese economy. On this front, we think there are three reasons to be modestly hopeful. First, negativity has been prominent in the media narrative (second panel, Chart 4) but this seems now fully priced in to the market. Second, China’s efforts to reflate the economy and the resulting rising odds of a soft landing is a boon to U.S. aerospace stocks (third panel, Chart 4). Lastly, as we have highlighted repeatedly in previous research, resolution of the trade spat between the U.S. and China would provide a significant catalyst for U.S. equities with particular emphasis on the trade-geared aerospace stocks. Chart 4Aerospace Is An EM Bellwether Net, though we remain optimistic for global trade, aerospace’s role as the wind vane for how trade winds are blowing should add both a greater degree of volatility and unpredictability to the index. Earnings Are Increasing Thrust In Aerospace  Despite the above section, the reason why aerospace stocks went vertical at the end of January of this year was not easing trade relations. Rather, it was Boeing’s release of blowout earnings which was followed by earnings beats across the sector. Industry sales have pushed into double-digit growth territory (second panel, Chart 5) while margins are reaching into the stratosphere, hitting record levels (third panel, Chart 5). Chart 5Aerospace Margins At Record Highs We think the reason why earnings are so elevated has much to do with the age of the order book. In Chart 6, we show Boeing’s order backlog and the years of production in backlog. Following a meltdown in 2008, Boeing’s backlog consistently represented between six and eight years of production. The implication is that the portion of the backlog currently being delivered was booked in the 2012 to 2014 period (circled in Chart 6) which happened to be the best order growth period in Boeing’s history and, in the context of this exceptionally powerful demand, likely built in particularly wide margins. This is compounded to the upside by being that much further along the production curve, particularly for some airliner programs that were troubled at the time, notably the 787 program. Nevertheless, it stands to reason that the bookings added to backlog in the difficult period during and immediately post the GFC and the resulting weak margin performance of 2016-2017 has largely been worked through. Investors should now focus on the current margin profile as being the new status quo and current bookings as an indication of future earnings growth. Can Orders Sustain This Trajectory?  New orders in aerospace are driven, as with all capex decisions, by growth and margin considerations. With respect to the latter, the obvious driver is jet fuel prices which are usually the largest cost line item in an airline’s P&L. In 2010, jet fuel prices spiked and stayed elevated for the next five years (jet fuel prices shown advanced by nine months, top panel, Chart 7). Global airlines responded by splurging on new orders to replace older, less efficient aircraft with more modern and highly efficient types. Chart 7Fare Growth & Input Costs Drive Orders Though jet fuel prices are off the heights that spurred the extraordinary order growth in the early part of this decade, they are also above the lows of the energy price crash in 2015. If BCA’s bullish oil view comes to fruition, order flow should continue to be well supported by the refleeting theme. At the same time as fuel prices were spiking in 2010, DM consumer confidence was climbing out from beneath the recession (G7 consumer confidence shown advanced by one year, bottom panel Chart 7), giving airlines the demand push to add capacity to global fleets. The rapid increase in aerospace orders has been revealing itself in global airline capacity growth, which has been increasing by mid-single digits for the past six years (top panel, Chart 8). Interestingly, global load factors (the ratio of revenue-paying passengers to available seats, the airline industry measure of capacity utilization) have been rising despite this increase in capacity, implying global demand has been outstripping supply growth. This data is echoed in the core domestic market where the load factor has plateaued at a record high level, approximating the global average (bottom panel, Chart 9), while capacity has grown mostly uninterrupted since the GFC. Chart 9Few Barriers To Domestic Capacity Expansion In sum, we expect upbeat aerospace orders on the back of firming passenger demand driving capacity growth combined with the pursuit of ever more efficient aircraft to drive profits. However, given the long lead times, order growth should be used only as a guide; profit growth has driven relative performance (bottom panel, Chart 10) to a much greater degree than order growth (middle panel, Chart 10). Chart 10Earnings Drive Performance Over Orders Changing Financial Structure And Costly Equities Notwithstanding the rapid increase in sales and, hence, production in the aerospace sector, capex has been in decline for the last couple of years (second panel, Chart 11). However, industry debt levels have been rapidly increasing (third panel, Chart 11), begging the question: where has the industry been deploying capital? Chart 11Debts Levels Are Rising... The answer is in share buybacks. Our share count proxy (middle panel, Chart 12) shows that industry share counts have been roughly halved over the past decade, which partially underlies the outperformance of sector equities. In late-2018, Boeing announced a new $20 billion stock buyback plan, representing roughly 10% of its market capitalization, implying share buybacks in the aerospace sector are not fading anytime soon. Chart 12...As Share Counts Are Shrinking At the same time, profit growth has not kept pace with the ramp up in leverage and leverage ratios have worsened to their highest point since the aviation crises of the early-2000’s (bottom panel, Chart 12). While still reasonable relative to the broad market, net debt / EBITDA has reached a level where further deterioration would likely add an incremental risk premium to aerospace stocks, denting valuations. With that in mind, valuations bear close examination. The exceptionally robust stock price run over the past two years and ballooning balance sheets has resulted in sector enterprise values skyrocketing (second panel, Chart 13). Relative to sector EBITDA, equities in the aerospace sector are as expensive as they have ever been (bottom panel, Chart 13). Chart 13Sky-High Valuations... This message is echoed by our valuation and technical indicators (Chart 14) which indicate that aerospace stocks are at least one standard deviation overvalued and overbought, respectively. Chart 14...Across Multiple Measures A Word On Defense Few of the stocks in our aerospace index are pure-play commercial aerospace investments. Rather, most of the companies rely, to a certain extent, on defense revenues either as a primary supplier of defense goods or as a part of defense production supply chains. Boeing, for example, averaged more than 20% of its revenues in the last three fiscal years from its defense segment. United Technologies, the next largest constituent firm, will likely generate an even greater proportion of its revenues from defense once its spinoff of its commercial & industrial businesses are complete, though at 14% of sales last year, defense is clearly a significant driver. Late last year we reiterated our secular overweight in the BCA defense index2 and we take this opportunity to do it again. We believe defense remains on a structural growth trajectory, driven by rising competition between the world's great nations, the decline of globalization and the resumption of a global arms race. Domestic defense spending has been rocketing higher since the Trump administration took the reins (second and third panels, Chart 15). Further, the non-partisan Congressional Budget Office projects this rapid buildup in defense spending to continue apace for the foreseeable future (bottom panel, Chart 15). With little political will to pare this growth from either side of the aisle, we see no reason to expect these estimates to falter. As such, our positive view on defense equities stands in support of our more sanguine view of their aerospace peers. Chart 15Defense Spending Is Accelerating A Long Runway For Aerospace But Risks Are Elevated Overall, aerospace sales and earnings growth look assured for a reasonable forecast horizon, considering the upbeat commercial aerospace demand over the past five years as well as the current robust order environment. Add to this the powerful catalyst that relief in trade wars represent, at least from a sentiment perspective, and aerospace equities are on a solid footing. Nevertheless, that same trade sentiment pendulum swings both ways and we believe elevated trade tensions will increase volatility and decrease predictability. Further, aerospace firms have been blowing out their balance sheets to retire debt and currently enjoy record valuations. Net, we think it no longer pays to be underweight the BCA aerospace index and we are moving to a benchmark allocation. The ticker symbols for the stocks in the BCA aerospace index are: BA, UTX, HON, TXT.   Chris Bowes, Associate Editor chrisb@bcaresearch.com Footnotes 1 Please see BCA U.S. Equity Strategy Weekly Report, “Reflationary Or Recessionary?,” dated February 25, 2018, available at uses.bcaresearch.com. 2 Please see BCA U.S. Equity Strategy Weekly Report, “Icarus Moment?,” dated October 22, 2018, available at uses.bcaresearch.com.

Highlights All the U.S. data look broadly similar to us, …: The data series are decelerating, one by one, but they generally remain at a fairly high level relative to history. … and we have begun sounding like a broken record in our morning meetings, … : “There’s no doubt that [insert data series name here] is slowing, but it’s still nowhere close to heralding a recession. As a matter of fact, it remains at a level consistent with above-trend growth. That’s what we should expect given the pattern of fiscal thrust across last year and this year, combined with still-accommodative monetary policy.” … so we’re revisiting our checklists to see if we should change our bearish rates and bullish equities views: We periodically review our checklists, which we rolled out in the fall, to assess whether or not our positioning rationale still applies. Our recommendations may still be the same, but at least we put them to the test: The business cycle, the inflation outlook, the Fed’s reaction function, the corporate profit outlook, and valuations have not changed enough to dictate changing our views. We continually seek out evidence that we’re getting it wrong, but we haven’t found any in the current data. Feature We have become a bit self-conscious about offering our take on the latest U.S. economic data releases at BCA’s daily morning meetings. It’s one thing to be out of step with the prevailing view, or to offer a novel theory that fails to achieve much traction in the room. (Strategists who don’t get shot down by their peers every once in a while aren’t pushing the conventional wisdom enough.) It’s quite another to keep recycling the same narrative, and we’re at something of a loss for a way to maintain our colleagues’ interest. Beep. You’ve reached the voicemail box of the U.S. Investment Strategy team. We believe today’s (insert series name here) release indicates that while the U.S. economy is decelerating, it continues to be on a path to grow at, if not above, trend in 2019. This is consistent with the 60-basis-point decline in fiscal thrust from 2018 to 2019. That decline is large enough to ensure deceleration in 2019, but the 40 bps that’s still going to be deployed this year is also sufficient to ensure that the economy will be able to grow above its 2% trend rate, provided the rest of the world does not fall apart. Thank you for your call, and please do not hesitate to call again if we can be of any further assistance. Beep. We created our bond upgrade and equity downgrade checklists last fall to help guard against sticking with our views beyond their sell-by date. Both checklists have a negative bias, in that they’re meant to help reveal the points at which the underpinnings of our views no longer apply. The bond checklist is broadly geared to identifying either, one, the presence of slack in the economy that might call for easier policy, or, two, a convergence of the fixed-income markets’ views with ours that would limit the potential payoff from maintaining below-benchmark duration positioning.1 Our equity downgrade checklist looks out for signs of an approaching recession, pressure on corporate earnings, inflation pressures that might inspire the Fed to remove accommodation in a hurry, or signs of euphoria that can’t be sustained.2 Reviewing the data series that comprise the checklists did not lead us to change our views. The exercise does help us adhere to a process, however, and we think they help keep us from falling into an analytical rut. We will revisit them with increasing frequency as the cycles we’re trying to track approach their inflection points, while keeping an eye out for any new indicators that might broaden their insights. Is A Bearish Rates View Still Appropriate? The first section of our bond checklist (Table 1) focuses on market perceptions of the Fed. Following our U.S. Bond Strategy service’s golden rule, if the Fed hikes more than it is expected to hike, long-duration positions will underperform. If it hikes less than expected, long-duration positions will outperform. As implied by the overnight index swap (OIS) curves, the money market now expects that the fed funds rate has peaked at 2.5%, and that a rate cut will likely bring it down to 2.25% by the end of 2020 (Chart 1). Table 1Bond Upgrade Checklist Chart 1Markets Are Pricing In A Rate Cut We beg to differ. With little to no slack remaining in the economy as a whole (the output gap is closed), and unemployment well below its natural level and poised to fall further, we think inflation pressures are percolating below the surface. Once they begin to reveal themselves, we expect the Fed will have no choice but to resume its tightening campaign. Our estimate of the equilibrium rate (3% now, rising to about 3⅜% by year-end) appears to be well above the financial markets’ estimate, and we therefore believe the Fed has plenty of room to hike without capsizing the economy. An inverted yield curve has historically been a reliable sign that the Fed has gone too far in its efforts to prevent overheating, and we are watching it now for hints that the fed funds rate may be done rising. Though the curve flattened considerably as the 10-year Treasury yield plunged in the fourth quarter (Chart 2), we think it’s very unlikely to invert while the Fed is on hold. An on-hold Fed implies that the 3-month bill rate will remain in the mid-to-high 2.40s and that the 10-year Treasury yield would have to dip below 2.5% for the curve to invert. Such an outcome would be completely incompatible with below-target inflation and above-trend economic growth. Chart 2The Yield Curve Has Flattened, But Inversion Is A Stretch Inflation is not yet an issue on most investors’ radar screens because it has been conspicuously missing in action around the developed world for the last ten years. In the U.S., headline measures rolled over upon oil’s slide, masking the fact that the core measures are hovering around 2% and remain in uptrends (Chart 3). Inflation break-evens have plunged, and are well below the 2.3-2.5% level that is consistent with the Fed’s 2% inflation target, but their decline was nearly entirely a function of the decline in oil prices (Chart 4). Our Commodity & Energy Strategy service is calling for higher crude prices across the rest of this year, so even though we’ve checked the break-evens box, we expect we’ll be unchecking it as the break-evens reverse in step with oil. Chart 3Headline Inflation's Decline ... Chart 4... Is An Oil Story The labor market remains quite tight. Although the unemployment rate ticked up in December and January, it came down again in February and remains below the estimated natural rate of unemployment where upward wage pressures typically begin to take hold (Chart 5, top panel). Unemployment ticked higher in December and January, despite robust job gains, because the share of working-age Americans participating in the labor force rose. The exodus of the baby boomers from the work force will make it very difficult for the participation rate to keep rising, however (Chart 5, middle panel), and the elevated level of workers quitting their jobs (Chart 5, bottom panel) indicates that employers are poaching workers from one another, driving wages higher. Chart 5The Labor Market Is Tight And Getting Tighter Instability is a double-edged sword as it relates to monetary policy. The Fed is likely to return to hiking rates if it believes it can cut off rising instability before it goes too far. If instability is far enough advanced that it threatens the economy, however, the Fed may well ease policy to try to counteract it. For now, it appears to us that the key cyclical segments of the economy are on track to keep warming up, but are nowhere near overheating (Chart 6). We are not overly concerned about the frisky lending climate that Governor Brainard called out in September, but ongoing anecdotal reports of bond-market froth will presumably keep the Fed alert to the need to dial back accommodation. Acutely bad conditions elsewhere in the global economy would make the Fed consider rate cuts, but if the rest of the world perks up by mid-year, in line with BCA’s base case, the Fed will feel less urgency to indemnify the U.S. against foreign distress. Chart 6Cyclical Segments Are Warming Up Should We Still Be Constructive On Equities? Every box in our equity downgrade checklist remains unchecked, starting with our silent recession alarms (Table 2). The yield curve has not inverted, and as we noted in the review of our rates checklist, we do not believe it will while the Fed remains on hold. Growth has come off the boil, but the LEI is not close to contracting on a year-over-year basis (Chart 7). The fed funds rate remains below our estimate of equilibrium, as we expect it will for the rest of the year, and the three-month moving average of the unemployment rate has not risen by a third of a percentage point from its current cyclical bottom. Table 2Equity Downgrade Checklist Chart 7The LEI May Be Decelerating, But It's Still A Ways From Contracting Labor market tightness will eventually manifest itself in higher wages, which will squeeze corporate profit margins, but until real wage gains begin to outstrip productivity growth (i.e., until labor starts capturing a bigger piece of the pie), corporate earnings will not be at risk (Chart 8). The dollar has spent the last several months going sideways, and BBB corporate yields are now below their level when we rolled out the equity checklist in mid-October (Chart 9). The savings rate has backed up to near the top of its six-year range, and we would check the box if it were to break out of it (Chart 10). There have been no blowups in EM or anywhere in the rest of the world that cast a shadow over U.S. corporate earnings. Chart 8Wage Growth Doesn't Cut Into Profits Until It Outstrips Productivity And Inflation Chart 9Round Trip Chart 10The Savings Rate Has Risen, But Not Enough To Check The Box As noted in our bond checklist comments, above, core inflation measures have dipped below 2% but remain in an uptrend. Both headline CPI and the inflation break-evens relapsed with oil prices, but we expect that a crude recovery will help restore inflation expectations. Bull markets tend to end amid a general feeling of euphoria, and we therefore continue to keep an eye out for signs of over-exuberance. Valuations are elevated but hardly extreme, and we don’t see anecdotal indications of widespread silliness, or suspension of disbelief. Investment Implications From our perspective, overheating in the U.S. remains a very real possibility. Since that is a distinctly minority view, the potential reward for underweighting Treasuries and holding all bond exposures below benchmark duration is alluring. We reiterate our recommendations that investors underweight Treasuries and maintain below-benchmark-duration across their fixed-income portfolios. We expect we will continue to do so until the U.S. economy weakens, or the Treasury curve begins to price in some of our bearish rates view. We reiterate our cyclical recommendation to overweight equities despite the tactical caution we expressed last week.3 We simply expect that the S&P 500 will have to consolidate some of its rapid year-to-date gains before moving on to an eventual new cycle high at 3,000 or above. Stocks don’t go straight up, even if they did for nearly all of January and February, and it is reasonable to expect elevated volatility in the latter stages of a bull market. We thought that the 2,800 level might provide some technical resistance, offering tactically oriented sellers an attractive point to reduce equity exposures, while tactically oriented buyers were likely to find better entry points going forward.   Doug Peta, CFA Chief U.S. Investment Strategist dougp@bcaresearch.com   Footnotes 1 Please see the U.S. Investment Strategy Weekly Report, “What Would It Take To Change Our Bearish Rates View?,” published September 17, 2018. Available at usis.bcaresearch.com. 2 Please see the U.S. Investment Strategy Weekly Report, “Introducing Our Equity Downgrade Checklist,” published October 15, 2018. Available at usis.bcaresearch.com. 3 Please see the U.S. Investment Strategy Weekly Report, “How Much Do U.S. Equities Have Left?,” published March 4, 2019. Available at usis.bcaresearch.com.

Prefer Large Caps To Small Caps (High-Conviction) Small caps have been underperforming their large cap brethren this month as the latter internationally-exposed group has been benefitting disproportionally from news of a potential trade deal ending the U.S. - China dispute. While this transitory benefit of an easing in trade tensions was expected, we think the focus should remain sharply on the diverging fundamentals of the groups. Large cap operating margins are at levels not far from record highs while small cap profits have fallen off a cliff (second panel). Though small cap margins have recovered somewhat in the last year, investors could be forgiven for expecting more, considering their profligacy in expanding their balance sheets, particularly when compared to the relative discipline shown by large caps (third panel). At the same time, small caps trade at a 30% premium to large caps on a cyclically-adjusted P/E basis, making them particularly prone to a fall should investors decide that equity risk premiums do not reflect the much-worsened leverage ratios. Bottom Line: We reiterate our high-conviction call favoring large over small caps.

Overweight Within our broad-based U.S. equity sector and subsector coverage, we continue to recommend a modest gold-related hedge via being overweight the global gold mining index (given that the S&P gold index only comprises a single stock) versus the MSCI All-Country World Index, expressed through the long GDX:US/short ACWI:US exchange traded funds. Globally there is a slowdown that has infected a number of economies and BCA’s calculated Global ZEW economic sentiment index has lit a fire under gold mining stocks (Global ZEW shown inverted, second panel). The longer the global soft-patch lasts, the longer Central Banks will remain on the sidelines or even ease monetary policy in order to rekindle growth. Moreover, the global policy uncertainty index is perking up given the ongoing U.S./China trade tussle (top panel), recent news of a no deal between the U.S. and North Korea and looming Brexit deadline. All of this underpins global gold stocks. Tack on the recent fear that gripped markets, and skyrocketing equity risk premia, and the ingredients are in place for additional gains in the relative share price ratio (bottom panel). Bottom Line: Stay overweight the global gold miners index (long GDX:US/short ACWI:US); please see Monday’s Weekly Report for more details.