Equities

Highlights Please note that country sections on Mexico and Colombia published below. The policy stimulus in China could produce a growth revival in the second half of 2019, but there are no signs of an imminent bottom in China’s growth over the next several months. The lack of policy support for real estate is the key difference between the current stimulus program and previous ones. Crucially, the property market holds the key to consumer and business sentiment and hence, their willingness to spend. Continue to overweight Mexico within EM currency, fixed-income and equity portfolios. Colombia warrants a neutral weighting. A new trade: bet on yield curve flattening. Feature China has been undertaking both fiscal and monetary stimulus since last summer. A key question among investors is: At what point will the cumulative effects of these efforts become sufficient to revive the mainland’s business cycle and produce a rally in China-related plays akin to 2016-’17? This report helps investors dissect China’s stimulus, and reviews the indicators that will likely help identify the turning point in the mainland’s business cycle, as well as in China-exposed financial markets. Chart I-1 conveys the main message: Our credit and fiscal spending impulse is still falling, indicating that the slump in the Chinese industrial sector will persist for now with negative ramifications for EM corporate profits and other segments of the global economy that are leveraged to China. Looking forward, odds are reasonably high that the credit and fiscal spending impulse will bottom sometime in the first half of 2019. Yet, a bottom in China-plays in global financial markets is likely be several months away from now and potential downside could still be substantial. Monetary Stimulus On the monetary policy front, there has been multifaceted easing: Several cuts to banks’ reserve requirement ratios (RRRs) have been implemented; Lower interest rates for SME borrowers and a reduction in funding costs for the banks that originate these loans; The use of preferential liquidity provisions to encourage banks to purchase bonds issued by private companies. Monetary easing in of itself is not a sufficient condition to produce an economic revival. There are two variables standing between easing liquidity/lower borrowing costs, on the one hand, and the performance of the economy on the other: The first one is the money multiplier, which is calculated as a ratio of broad money supply (or banks assets) to excess reserves. It measures the willingness of banks to expand their balance sheets at a given level of excess reserves, assuming there is loan demand. Chart I-2 shows that China’s money multiplier has risen substantially since 2008 but has recently rolled over. A further drop in the money multiplier could offset the positive effect of monetary easing. Chart I-2China: Money Multiplier Is Falling In other words, the central bank is injecting more liquidity into the banking system and interbank rates are falling, but commercial banks may be unwilling or unable to originate more loans due to financial regulations, lack of loan demand or for other reasons. Notably, the growth rate of bank assets (including policy banks) remains lackluster, while non-bank (shadow) credit is decelerating (Chart I-3). Chart I-3China: Bank Credit And Non-Bank Credit The second variable is the willingness of companies and households to spend. This is captured by our proxies for marginal propensity to spend by companies and consumers. Chart I-4 denotes that both propensity measures are dropping, signifying a diminishing willingness to spend among these two sectors. Chart I-4China: Diminishing Propensity To Spend By Consumers And Companies If economic sentiment among businesses and households remains downbeat – which has been the case in China over the past six to nine months – their reduced expenditures could offset any positive impulse from increased credit origination. Economists think of nominal GDP (aggregate spending) as money supply times the velocity of money (Nominal GDP = Money Supply x Velocity of Money). New lending activity among banks increases money supply, while economic agents’ spending raises the velocity of money. If the velocity of money drops more than the rise in money supply, aggregate expenditure (nominal GDP growth) will decline. Chart I-5 illustrates that the velocity of money rose in 2017, supporting robust growth during this period, despite very lackluster money growth. The opposite phenomenon – a decline in the velocity of money offsetting faster money expansion – could be a risk to the positive view on Chinese growth in 2019. Chart I-5Velocity Of Money: Will It Resume Its Decline? Bottom Line: There is so far no clear evidence that the credit cycle has bottomed. Besides, a bottom in the credit impulse is not in and of itself sufficient to herald an economic recovery. Fiscal Stimulus Unlike in previous easing episodes, policymakers this time around have prioritized fiscal over monetary stimulus because of the already high leverage. In the past six months or so, the government has announced the following fiscal measures: A reduction in the personal income tax rate; Subtraction of certain household expenses from taxable personal income; A reduction in taxes and fees paid by small businesses; A potential VAT cut. These measures will certainly have a positive impact on small businesses and consumer spending. This is why we do not foresee a deepening slump in consumer spending. Nevertheless, the tax reductions and other policies benefiting small businesses and households are unlikely to boost industrial output and construction in China. The latter two are crucial for global investors because many countries are leveraged to China’s industrial and construction activity. For the industrial part of the economy, the most pertinent stimulus measure announced so far has been the issuance of local government special bonds. These bonds are used for infrastructure/public welfare projects. Chart I-6A shows the growth rates of aggregate fiscal spending and its components, which are expenditures by central and local governments as well as by government managed funds (GMFs). GMF spending – a form of quasi-government (off-balance sheet) spending – has surged in recent years and now accounts for 8.5% of GDP, which is more than twice larger than central government spending (Chart I-6B). Chart I-6AChina: Fiscal Spending Annual Growth... Chart I-6B…And As % Of Nominal GDP Although the 2019 budget has not yet been released – it will be announced in March during the National People's Congress – there have been some announcements that we can use to gauge the potential fiscal spending impulse in 2019. On the positive side, Beijing has recently authorized local governments to begin issuing bonds in early 2019 before the overall budget is released in March. Local governments are sanctioned to issue RMB 810 trillion of special bonds, which is 60% of their 2018 quotas. This contrasts with the previous years' practice, when local governments only started to issue bonds in April after obtaining directives from Beijing. The earlier-than-usual quota authorization will allow local governments to issue bonds from the beginning of the year. There is no timeline as to when these bonds will be issued, but it is safe to assume that their issuance will occur in the first half of 2019. This, in turn, should boost infrastructure investments throughout 2019. On the negative side, government managed funds (GMFs) derive 85% of their revenues from land sales. Land sales are tumbling due to previous credit tightening and scarce access to financing among property developers. Chart I-7 demonstrates that land sales lag the credit cycle by nine months. As developers are no longer acquiring land, GMF revenues and spending are set to shrink over the next 12 months. This will, to a certain degree, offset the augmented special bonds issuance. Chart I-7China: Credit Leads Land Sales And Quasi-Fiscal Spending We performed a simulation on what would be the aggregate fiscal impulse in 2019 using the following assumptions: Central and local government spending growth rates are held constant at 2018 levels. Local government special bond issuance is RMB 1.62 trillion. This is twice the recently authorized quota. Hence, our simulation assumes a 20% increase in local government special bond issuance in 2019 over 2018, respectively. GMF land revenues drop by 25% – a comparable drop in land sales occurred in 2015. Table I-1 reveals that using these assumptions, the fiscal spending impulse in 2019 will be 0.1% of GDP down from 4% in 2018 (Chart I-8, bottom panel).   Chart I-8China: Credit And Fiscal Spending Impulse The next step is to combine this with our credit impulse forecast. We assume the 2019 year-end growth rate of credit to companies and households will be 9% in our pessimistic scenario, 10% in our baseline scenario and 11% in our optimistic scenario, compared with the December 2018 recorded rate of 10%. This entails no deleveraging at all. Under these assumptions, our forecasts for aggregate credit and fiscal impulses are 0.2% of GDP (pessimistic), 2.3% (baseline) and 4.4% (optimistic) (Table I-1). Presently, the credit and fiscal impulse is close to zero (Chart I-8). Bottom Line: China’s credit and fiscal spending impulse will bottom in the first half of 2019 (Chart I-8). However, this does not mean that EM/China plays have already bottomed and investors should chase the latest rebound in China-plays worldwide. We discuss the historical correlation between the credit and fiscal impulse and China-related financial markets below. What Is Different From Previous Stimulus Programs? The lack of stimulus targeting the real estate sector is the key difference between the current stimulus programs and those implemented in the past 10 years. The central government has so far abstained from stimulating the property market due to already existing speculative excesses there. This is very different from the policy easing that took place in 2008-‘09, 2012 and 2015-’16, when the authorities boosted property markets along with other sectors of the economy. Chart I-9 reveals that the 2015-‘17 residential property market revival and following boom was facilitated by the Pledged Supplementary Lending (PSL) program conducted by the People’s Bank of China (PBoC) – which was de-facto the outright monetarization of real estate by the central bank.1 The authorities have so far been reluctant to use this PSL program again, and the odds are that housing sales and new construction will continue to decline (Chart I-10). Chart I-9Residential Property Market Is Deteriorating Chart I-10China: Construction Volumes Are Shrinking Importantly, the property market holds the key to consumer and business sentiment and, hence, their willingness to spend. The latter is crucial to the growth outlook. Overall, a deepening slump in real estate demand and prices could dent consumer and small business confidence as well as their spending. Meanwhile, shrinking construction volumes will dampen industrial sectors (Chart I-10). Investment Implications: A Replay Of 2016-‘17? How does the credit and fiscal impulse relate to financial markets globally that are leveraged to the Chinese economy? The top two panels of Chart I-11 show our money impulse as well as credit and fiscal spending impulse (CFI), while the bottom two panels contain EM share prices and industrial metals prices. There are a few observations to be made: Chart I-11China: Money And Credit/Fiscal Impulses, EM Stocks And Metals Prices First, the CFI has not yet bottomed – i.e., it has not confirmed the upturn in the money impulse. Second, as illustrated in this Chart, the bottoms in the money impulse as well as the CFI in July 2015 preceded the bottom in EM and commodities by six months, and their peaks led the top in financial markets - in January 2018 - by about 15 months. Besides, in 2012-‘13, the rise in both the money impulse and CFI did not do much to help EM stocks or industrial commodities prices. Third, the credit and fiscal impulse leads the global manufacturing PMI by several months as illustrated in Chart I-1 on page 1, as well as mainland’s capital goods imports (Chart I-12). Chart I-12China's Impact On Industrial Goods And Commodities On the whole, investors should consider buying China-related plays only after both the money impulse and the CFI bottom together which has not yet occurred. Besides, even if these indicators rise in tandem, the bottom in China-related financial market plays could be a few months later because these impulses have historically led markets. This is why we believe a final down leg in EM and China-related plays still lies ahead. Typically, the last/capitulation phase in bear markets is considerable and being early can be very painful. Bottom Line: We continue to recommend underweighting/playing EM and China-related risk assets on the short side. Arthur Budaghyan, Senior Vice President Emerging Markets Strategy arthurb@bcaresearch.com Lin Xiang, Research Analyst linx@bcaresearch.com Mexico: Reiterating Our Overweight Stance Mexican financial markets have rebounded, outperforming their EM counterparts since mid-December. This outperformance has further upside because the AMLO administration is proving to be less populist and more pragmatic, especially relative to investors’ expectations. We are reiterating our recommendations to overweight Mexican markets, especially the currency, local fixed-income and sovereign credit, within respective EM portfolios due to the following considerations: The 2019 budget is a prime example of sensible rather than populist policies by the AMLO administration. The budget targets a primary surplus of 1% of GDP versus 0.8% of GDP in 2018 (Chart II-1). Notably, the 2019 budget envisages an absolute decline in nominal expenditures in 29 out of 56 categories. Chart II-1Fiscal Tightening In 2019 Such a restrained budget follows the conservative fiscal policy of the previous administration. In brief, the nation’s fiscal policy and public debt profile remain sound. Public spending will be increased mostly in the areas that are critical to boosting productivity. These include infrastructure spending, vocational training, promoting “financial deepening” and competition, eliminating graft and improving security. These efforts are critical to boosting business confidence, investment and ultimately productivity. On the revenue side, the budget has become much less reliant on oil revenues than before. The share of oil revenues in total government revenues historically hovered around 30%, but in 2018 it declined to 18%. The 2019 budget assumes an average oil price of $55 per barrel, a conservative projection. Investors have also been somewhat alarmed by the 16% hike in minimum wages, but this should be put into historical context. Chart II-2 illustrates that the minimum wage in real terms (deflated by consumer price inflation) dropped by 70% since its peak in 1976, before rising in the recent years. Chart II-2Historical Perspective On Minimum Wage Importantly, Mexico’s competitiveness problem does not stem from high wages but from a lack of productivity gains. Productivity has been stagnant, and wages in real terms have not risen in many years. Hence, the true test for the nation is to raise productivity, not curb wages. Remarkably, the Mexican peso is very cheap, as measured by the real effective exchange rate based on unit labor costs (Chart II-3). Hence, the minimum wage hike can be viewed as payback after decades of dramatic declines in the minimum wage in real terms. Chart II-3The Mexican Peso Is Cheap The central bank has overdone it with hiking interest rates: interest rates are currently among the highest of the mainstream EM economies, both in nominal and real terms (Chart II-4). Hence, local rates offer great value relative to other EMs (Chart II-4, bottom panel). Chart II-4High Real And Nominal Interest Rates Tight fiscal and monetary policies will curb domestic demand and promote disinflation. Money and credit growth remain very sluggish (Chart II-5). This is negative for consumer and business spending, but positive for investors in local currency bonds. Chart II-5Monetary Growth Is Weak The basis is that a retrenchment in domestic demand and thereby imports will help stabilize the trade balance amid low oil prices. Hence, this is on the margin a positive for the peso as well as for local currency bonds relative to their EM counterparts. Finally, Mexico will benefit from its ties to the U.S. economy, unlike many other EMs that are more exposed to China. Investment Recommendation We continue to recommend overweighting the peso and local currency bonds within an EM fixed-income portfolio. Currency traders should maintain our long MXN / short ZAR trade (Chart II-6, top two panels). Chart II-6Remain Overweight Mexican Currency And Fixed-Income Credit market investors should continue to overweight Mexican sovereign credit within an EM credit portfolio (Chart II-6, bottom panel). Finally, we are also reiterating our long Mexico position within an EM equity portfolio. While domestic demand growth and corporate profits will continue to disappoint, the declining risk premium on Mexican assets due to a re-assessment among investors of AMLO’s policies warrants a mild overweight in large caps and a sizable overweight in small caps relative to their EM peers. Colombia: Headed Into Another Downtrend The Colombian economy is set to undergo another phase of growth retrenchment: The government is planning to reduce the overall fiscal deficit from 4.5% to 2.4% of GDP by the end of 2019 (Chart III-1). Oil-related revenues make up under 10% of total government revenues, and they are shrinking as both oil production and prices have plunged. Chart III-1Fiscal Policy Will Tighten In 2019 As a result, the government should undertake major fiscal cutbacks and hike taxes to achieve the overall budget deficit target of 2.4%. Such substantial fiscal tightening will hurt domestic demand. Regarding the exchange rate, the central bank is pursuing a “hands-off” approach, which is likely to continue. Therefore, the currency is set to depreciate due to the large current account deficit and lack of sufficient foreign funding. Notably, the current account deficit excluding oil is -7% of GDP (Chart III-2, top panel), and the plunge in oil prices and weak domestic demand will cause FDI inflows to drop meaningfully (Chart III-2, bottom panel). Together, this points to further currency depreciation. Chart III-2BoP Dynamics Are Deteriorating Meanwhile, the central bank is not in a position to ease policy to offset the impact of fiscal tightening, as a weaker exchange rate historically leads to higher inflation (Chart III-3, top panel). In fact, given core inflation is at the upper end of the central bank’s target range (Chart III-3, bottom panel), a considerable currency depreciation could lead to rate hikes. Raising rates amid weakening growth is a recipe for considerable yield curve flattening. Chart III-3Weaker Currency = Higher Inflation Lending rates remain well above nominal GDP growth, and the banking system is still restructuring following years of a credit boom. Credit growth will remain weak, reinforcing weakness in domestic demand stemming from substantial fiscal tightening. Finally, consumer and business confidence seem to be faltering due to the negative attention surrounding Colombian President Iván Duque Márquez’s policies. The negative terms-of-trade shocks and the imminent fiscal tightening will reinforce worsening sentiment among economic agents. Profound cyclical headwinds to growth indicate that the economy is set to return to a growth recession – a very low but slightly positive growth rate. With respect to investment strategy, we recommend the following: First, we are downgrading this bourse from overweight to neutral within an EM equity portfolio. While overweighting Latin American stocks as a whole within an EM equity portfolio, we believe that Brazilian, Chilean and Mexican share prices offer a better risk-reward profile than Colombian ones (Chart III-4). Chart III-4Colombia Is Unlikely To Outperform LATAM Second, as to sovereign credit investors, we are reiterating an overweight stance because fiscal tightening and monetary policy orthodoxy as well as low government debt levels will help Colombian sovereign credit to outperform. Third, two opposing cross-currents will shape the domestic bond market. On the one hand, weak growth is positive for bonds. On the other hand, currency depreciation is negative. Net-net, investors in local currency government bonds should be slightly overweight or neutral this market within an EM local bond portfolio. For fixed-income investors, we recommend a new trade: position for yield curve flattening (Chart III-5). This is a bet on a considerable growth slowdown amid looming fiscal austerity. Chart III-5Colombia: Bet On Yield Curve Flattening Andrija Vesic, Research Analyst andrijav@bcaresearch.com Footnotes 1      Please see Emerging Markets Strategy Special Report "China Real Estate: A Never-Bursting Bubble?" dated April 6, 2018, available on ems.bcaresearch.com   Equity Recommendations Fixed-Income, Credit And Currency Recommendations

Both autos and automotive components stocks have been underperforming, the former since 2013 and the latter quite dramatically since the beginning of 2018 (top panel). This in spite of light vehicle sales stuck at persistently elevated levels that have driven auto components new orders to all-time highs (second panel). However, with light vehicle sales seemingly unable to breach the levels of the past three years, the chorus that the peak of the automotive cycle has passed is impossible to ignore. We think the reason for the stalling of the automotive growth engine is the lack of available credit. For the better part of the past two years, lenders have been tightening standards for auto loans (third panel). With both financing rates and loan delinquencies on the rise (bottom panel), both the demand for and supply of credit for auto lending seems likely to worsen. Accordingly, we are squarely in the bearish camp for light vehicle sales, hence light vehicle production, hence auto component manufacturers. Stay underweight. The ticker symbols for the stocks in the S&P auto components index are: BLBG: S5AUTC - APTV, BWA, GT.    

Highlights Buy the pound as soon as the U.K. parliament coalesces a majority around an action plan to counter a no-deal Brexit. For equity investors the best play is a FTSE Small Company Index ETF and/or U.K. REITS. Beaten-down banks, industrials and materials can continue their recent countertrend outperformances. This necessarily means that the cyclical-heavy Eurostoxx50 can continue its recent countertrend outperformance versus the S&P500. Go overweight industrials versus utilities as a tactical trade. Feature Chart of the WeekWere It Not For Brexit, U.K. Interest Rates Would be 1 Percent Higher Please join me for a webcast today at 10.00 AM EST (3.00 PM GMT, 4.00 PM CET, 11.00 PM HKT) when I will be elaborating on some of the ideas in this report as well as other major investment themes. For those of you who cannot participate live, the webcast will also be available as a playback. Were it not for the psychodrama called Brexit, the pound would be trading at $1.50 rather than at $1.28. We can say this with utmost confidence because ‘cable’ is very closely tracking the difference in 2-year interest rates in the U.K. versus the U.S. Absent the Brexit shenanigans, U.K. interest rates would be around 1 percent closer to those in the U.S., implying that pound/dollar would be around 15 percent higher ( Chart I-2 and Chart I-3 ). Chart I-2Absent The Brexit Discount On U.K. Interest Rates... Chart I-3...The Pound Would Be At $1.50 Explaining Brexit’s Impact On U.K. Interest Rates And The Pound The difference in U.K. versus U.S. interest rates usually tracks the difference in their inflation rates, in effect equalizing real interest rates in the two economies. But the Brexit referendum in 2016 forced the Bank of England into an ‘emergency monetary policy’ mode, whereby interest rates were left depressed relative to the inflation fundamentals, and U.K. real interest rates collapsed. Applying the BoE’s pre-Brexit reaction function to the current inflation dynamics, U.K. interest rates – and therefore the pound – would be in a completely different ballpark. After all, U.K. and U.S. core inflation rates and unemployment rates are virtually identical ( Chart of the Week  ). It follows that the pound’s trajectory will be higher in any negotiated Brexit – or indeed ‘no Brexit’ – which avoids a complete and overnight no-deal divorce. The simple reason is that a transition period lasting several years that continues to give the U.K. access to the EU single market will allow the BoE to revert to its pre-Brexit monetary policy reaction function. But any workable alternative to a no-deal Brexit must satisfy two conditions: the way forward must be acceptable to the EU27; and it must command a majority in the U.K. parliament. From the perspective of investors, what this way forward turns out to be – Common Market 2.0, permanent customs union, second referendum, or general election – does not really matter. What matters is that a parliamentary majority exists for a course of action that avoids no-deal. The investment strategy is to buy the pound as soon as the U.K. parliament coalesces a majority around an action plan to counter a no-deal Brexit . In this event, do not buy the FTSE100. Whenever the pound strengthens, the weaker translation of the FTSE100 companies’ dollar-denominated earnings tends to weigh down this large-cap index. A better play is the FTSE250 mid-cap index ( Chart I-4 ), but for equity investors t he best play is a FTSE Small Company Index ETF and/or U.K. REITS ( Chart I-5 ). Chart I-4A Negotiated Brexit Would Favour The FTSE250... Chart I-5...And U.K. Small Companies Europeans Are Celebrating Lower Oil Europeans will be celebrating the near halving of the crude oil price from its $86 high just three months ago. The simple reason is that Europeans are net importers of energy, and the amount of energy they consume tends to be price inelastic. After all, Europeans have to do the school run and stay warm in winter, irrespective of the oil price. Hence, when energy prices soar as they did for most of 2018, it squeezes European real spending. Conversely, when energy prices plunge as they have more recently, it boosts real spending ( Chart I-6 ). A second transmission mechanism is via credit creation: higher inflation, through its implication for tighter monetary policy, lifts bond yields and depresses credit impulses; lower inflation does the opposite, it depresses bond yields and lifts credit impulses. The upshot is that higher oil weighed on European growth in 2018 while lower oil should boost growth in early 2019. Chart I-6Inflation Is Likely To Plunge, Boosting Real Incomes Compelling proof comes from the oscillations in the euro area economy. For several years, these growth oscillations have perfectly and inversely tracked oscillations in the oil price ( Chart I-7 ). The economic implication is that the recent collapse in energy prices should engineer some sort of growth rebound in the euro area. The investment implication is that such a growth rebound will support the classically cyclical equity sectors – banks, industrials and materials – because of their very high operational leverage to economic growth. Chart I-7Euro Area Growth Oscillations Inversely Track Oil Price Oscillations Profit is a small number created from the difference between two large numbers: sales minus the cost of generating those sales. But the dominant cost – the wage bill – tends to be quite sticky. Hence, if a company’s sales are highly sensitive to the economy, the power of operational leverage means that a small change in GDP can have a dramatically large proportional impact on profit. This is a simple principle, but it turns out to be an excellent explanation for the Eurostoxx50 earnings per share (eps) cycle. Because the index is dominated by the classically economic-sensitive sectors, Eurostoxx50 eps growth has a very high operational leverage to changes in euro area GDP growth, potentially as high as 50 times over short periods such as six months ( Chart I-8 ). In contrast the less cyclical S&P500 has an operational leverage to economic growth of less than 10 ( Chart I-9 ). Chart I-8Eurostoxx50 Profits Growth Is Highly Geared To Economic Growth Chart I-9S&P500 Profits Growth Is Less Geared To Economic Growth On the expectation that euro area growth will rebound modestly in early 2019, the beaten-down banks, industrials and materials can continue their recent countertrend outperformances. And this necessarily means that the cyclical-heavy Eurostoxx50 can continue its recent countertrend outperformance versus the S&P500. Explaining The ‘Unexplainable’ Moves In Markets During the recent Christmas holiday period, financial markets experienced sharp moves with no explainable catalyst. Such reversals leave many strategists and analysts scratching their heads in bewilderment, wondering: what was the catalyst for that reversal? The answer is there was no fundamental catalyst; the market reversed because liquidity dried up . But to explain why liquidity dried up and markets ‘unexplainably’ reversed, we first need to understand what creates market liquidity in the first place. Market liquidity is the ability to convert cash into an investment quickly and in volume without affecting its price. But for an investor to convert a large amount of cash into an investment without affecting its price, another investor must be willing to do the exact opposite – convert a large amount of the investment into cash at the given price. Therefore, market liquidity comes from a disagreement about the attractiveness of an investment at that given price. Investors disagree about the attractiveness of an investment at a given price because investors with different time horizons interpret the same facts and information very differently. Hence, a market remains stable when it possesses investors with many different time horizons. The reason is that when a day-trader experiences a ‘six-sigma’ price move, an investor with a longer investment horizon, for example 65 days, will step in and stabilize the market. The longer-term investor will do so because, within his investment horizon, the day-trader’s six-sigma price move is not unusual. As long as another investor has a longer trading horizon than the investor experiencing an extreme event, the market will stabilize itself. Therefore, the market’s liquidity and stability are maximized when its participants possess a variation of investment horizons, say, both the 1 day horizon and the 65 day horizon. The corollary is that the market’s liquidity and stability disappear when its participants no longer possesses this healthy variation in horizons. In technical terms, this occurs when the market’s 65-day fractal dimension collapses to its lower bound. Without a shadow of a doubt, this is what happened to the S&P500 on Christmas Eve and triggered a 5 percent market rebound on Boxing Day ( Chart I-10 ). And this is now what is happening to the relative performance of industrials versus utilities, which is also in the process of a similar liquidity-triggered rebound ( Chart I-11 ). Chart I-10A Liquidity Shortage Triggered A Sharp Rebound In The S&P500   Chart I-11Expect A Liquidity-Triggered Rebound In Industrials Versus Utilities   Fractal Trading System* This week we note that the strong rally in the Indian rupee versus the Pakistan rupee has reached a point where an imminent liquidity shortage could trigger a countertrend move. Go short the Indian rupee versus the Pakistan rupee with a profit target of 3 percent, and a symmetrical stop-loss. For any investment, excessive trend following and groupthink can reach a natural point of instability, at which point the established trend is highly likely to break down with or without an external catalyst. An early warning sign is the investment’s fractal dimension approaching its natural lower bound. Encouragingly, this trigger has consistently identified countertrend moves of various magnitudes across all asset classes. Chart I-12 The post-June 9, 2016 fractal trading model rules are: When the fractal dimension approaches the lower limit after an investment has been in an established trend it is a potential trigger for a liquidity-triggered trend reversal. Therefore, open a countertrend position. The profit target is a one-third reversal of the preceding 13-week move. Apply a symmetrical stop-loss. Close the position at the profit target or stop-loss. Otherwise close the position after 13 weeks. Use the position size multiple to control risk. The position size will be smaller for more risky positions. * For more details please see the European Investment Strategy Special Report “Fractals, Liquidity & A Trading Model,” dated December 11, 2014, available at eis.bcaresearch.com   Dhaval Joshi , Senior Vice President Chief European Investment Strategist dhaval@bcaresearch.com Fractal Trading System Recommendations Asset Allocation Equity Regional and Country Allocation Equity Sector Allocation Bond and Interest Rate Allocation Currency and Other Allocation Closed Fractal Trades Trades Closed Trades Asset Performance Currency & Bond Equity Sector Country Equity Indicators Bond Yields Chart II-1Indicators To Watch - Bond Yields Chart II-2Indicators To Watch - Bond Yields Chart II-3Indicators To Watch - Bond Yields Chart II-4Indicators To Watch - Bond Yields Interest Rate Chart II-5Indicators To Watch - Interest Rate Expectations Chart II-6Indicators To Watch - Interest Rate Expectations Chart II-7Indicators To Watch - Interest Rate Expectations Chart II-8Indicators To Watch - Interest Rate Expectations  

In a recent Insight Report ,1 we highlighted the collapse in valuations that were making us grow more constructive on the S&P internet retail index. In fact, sky high valuations were what kept us on the sidelines in the first place in our early-2018 initiation of coverage on the sector.2 That trend has continued into 2019 (second and third panels) and we are compelled to add an upgrade alert to the sector. The timing of such a move may be surprising as for a brief time last week, Amazon (representing roughly 85% of the index) overtook Microsoft as the most valuable public company in the world. However, that title was largely due to Apple’s fall, rather than an Amazon rally; importantly, Amazon’s stock is off roughly 20% from when it breached the $1 trillion market cap mark in September, 2018. However, as we have noted in the past, the dominance of one stock in this index introduces a greater degree of specific risk and hence volatility in our valuation measures, which we view as less reliable than usual. Accordingly, we would wait until valuations deliver a more convincing narrative before catalyzing our upgrade alert. The ticker symbols for the stocks this index are: BLBG: S5INRE - AMZN, BKNG, EBAY, EXPE.         1 Please see BCA U.S. Equity Strategy Weekly Report, “The Amazonification Of Internet Retail,” dated October 17, 2018, available at uses.bcaresearch.com. 2 Please see BCA U.S. Equity Strategy Special Report, “ Internet Retail: Dialed Up” dated February 26, 2018, available at uses.bcaresearch.com.

Special Report

Highlights Our market-based China growth indicator has risen meaningfully since mid-December, but mostly due to the equity components. For now, we regard this as a mixed signal, rather than a green light for Chinese stocks. Our research suggests that the odds of a serious earnings contraction for Chinese investable stocks over the coming year are high. Stocks are only likely to bottom near the end of the earnings adjustment process, if the 2014-2015 episode is a guide. Despite reasonable relative valuation, the long-term downtrend in sales-to-GDP suggests that Chinese stocks may be a “value trap” even over a multi-year time horizon. Feature Over the past several months BCA’s China Investment Strategy service has focused heavily on the cyclical condition of China’s economy, and whether any “green shoots” are evident from the key indicators that we track. We noted in last week’s report that our leading indicator for China’s old economy continues to point to slower growth over the coming months,1 a conclusion that is generally supported by the December trade, money, and credit data. In today's special report we address six questions concerning the outlook for Chinese stocks in light of passive outperformance versus the global benchmark over the past 3 months. We highlighted in last week’s report that investors should not view recent outperformance as a positive cyclical sign for Chinese stocks, and our answers to the questions below will hopefully provide readers with a fuller understanding of our neutral stance over a 6- to 12-month time horizon. The bottom line of our analysis is that a cyclical (6-12 month) overweight stance toward Chinese investable stocks versus the global benchmark remains uncompelling until the earnings contraction that is likely to occur this year is well underway. Chinese stocks offer reasonable-to-good valuation relative to global stocks, but may be cheap for a reason even over a multi-year time horizon. We remain tactically overweight Chinese investable stocks in recognition of the fact that investors may bid up the market in the lead-up to a possible trade deal with the U.S., but a legitimate improvement in domestic fundamentals is likely needed before we recommend investors upgrade their medium-term equity allocation to China. Q: Are the market signals from China-related assets bullish or bearish for Chinese stocks? A: Our market-based China growth indicator has risen meaningfully since mid-December, but mostly due to the equity components. For now, we regard this as a mixed signal, rather than a green light for Chinese stocks. Chart 1 presents our market-based China growth indicator, its four asset class subcomponents, and the range between the strongest and weakest components. Table 1 shows the change in the indicator and its 17 individual components since December 10, when the indicator clearly broke out. Chart 1Largely Driven By EM Equity Relative Performance Both the chart and the table make it clear that the recent rise in the indicator is not uniform. While it is true that most of the individual components have improved over the past month, the equity components and two currency measures (the inverse of the dollar and Asian currencies), especially CNY-USD have accounted for most of the gains. Table 1(Anomalous) Equity Relative Performance Has Driven The Recent Improvement In Our MBCGI As we noted in last week’s report, the Q4 outperformance of Chinese / emerging market stocks has been passive in nature, meaning that they have outperformed simply because developed market equities have collapsed. This, in combination with the fact that the strongest currency components have been linked to declining interest rate expectations in the U.S., tell us that the aggregate indicator has largely risen due to a 1) generalized selloff in global risk assets, 2) perceptions of easier Fed policy, and 3) a modest improvement in sentiment concerning the U.S.-China trade war. While it would not normally be the case that a global equity selloff would cause the equity component of our indicator to rise, December was atypical because many China-related assets had already declined in advance of the selloff. Are the latter two factors noted above reason enough move to an overweight stance towards Chinese stocks over the coming 6- to 12-months? In our view, the answer is “not yet”. While easier U.S. monetary policy is certainly welcome (particularly given our view that a recession is unlikely), it is not yet clear that either of the negative factors waiting on Chinese stocks in absolute terms will be resolved over the coming year. The first factor is the trade war with the U.S. We agree that the odds of some sort of a deal that avoids further tariff imposition have risen significantly over the past two months, more than we anticipated in the lead-up to the G20 meeting in Argentina. However, given the deep, structural nature of the dispute between the U.S. and China, we think it is dangerous to pre-emptively act on an agreement that may not come or may take much longer to be reached than investors currently hope. This risk is in addition to what is likely to be a deceleration in export growth over the coming few months regardless of the outcome of negotiations, as the export front-running effect that has boosted trade volume over the past several months wanes. But as we address in the next question, the second negative factor impacting Chinese stocks is the upcoming impact of a slowing domestic economy on Chinese earnings, an effect that is not likely to be impacted by the changes in the global economy implied by financial markets since mid-December. Q: What is the outlook for Chinese earnings growth over the coming year? A: Our research suggests that the odds of a serious earnings contraction over the coming year are high. Chart 2 presents an update to a model for Chinese ex-tech (or “old economy”) earnings growth that is part of our analytical toolkit.2 The model paints a rosy outlook for earnings growth, suggesting that it is set to decelerate over the coming year but will continue to grow at a double-digit rate. Chart 2The Li Keqiang Index Suggests Ex-Tech Earnings Growth Will Stay Positive... However, one problem with the approach used in Chart 2 is the fact that we have used the Li Keqiang index (LKI) as the independent variable in the model. Historically the LKI has reliably led ex-tech earnings growth, but we have highlighted several times over the past few months that the index is currently being supported by trade front-running activity that is very likely to wane, a view that is strongly consistent with the very negative December trade data that was released earlier this week. Chart 3 presents a different approach, namely the prediction of the odds of a serious investable equity earnings contraction over the coming 12-months (defined as earnings growth falling below -5%). The statistical approach taken in Chart 3 (logistic regression) is similar to that often employed by researchers attempting to predict the odds of a recession, and the chart shows that the model successfully warned of the two major earnings contractions over the past decade. Crucially, the odds of a major contraction did not rise about the 50% mark in 2012, when investable earnings growth decelerated significantly and fell briefly into negative territory. Chart 3...But Other Measures Imply High Odds Of An Outright Contraction The current message from the model is clear: the odds of a significant earnings contraction over the coming 12-months are as high as 70%, implying that the deceleration in 12-onth trailing earnings growth shown in panel 2 of Chart 3 is likely to continue. Q: If earnings are set to contract, when will investors anticipate a recovery? A: Near the end of the earnings adjustment process (for investable stocks), if the 2014-2015 episode is any guide. Chart 4 presents some perspective on the issue of when investors are likely to anticipate an eventual bottom in earnings if a contraction does indeed occur. The chart shows the level of 12-month forward earnings for investable and domestic stocks, and circles at what point stocks in each market bottomed during the massive selloff in the Chinese equity market from 2014-2015. Chart 4The Forward Earnings Adjustment Process Has Yet To Begin The chart shows that the domestic market bottomed roughly halfway through the earnings adjustment process, whereas the investable market bottomed almost at the end of the process. The chart also shows that this adjustment process has barely begun, which (in combination with Chart 3) currently argues against a cyclically overweight stance towards global stocks. Q: In the developed world (particularly the U.S.), elevated profit margins are viewed as a potential risk to earnings over the coming few years. Is profit margin mean-reversion a risk in China? A: Based on the absolute level of profit margins, no. Relative to the history of poor profitability for Chinese stocks, yes. Chart 5 shows the 12-month trailing profit margins for global and investable Chinese stocks. It shows how global margins have now moved past their previous cycle highs, a circumstance that is even more extreme in the case of the U.S. Chart 5Chinese Profit Margins Are Very Low, But Very Elevated Relative To Their History Investable Chinese margins are very low, which at first blush implies less risk of a mean-reversion assuming a common mean. However, panel 2 shows that Chinese investable margins are as high relative to their own history as they are for global stocks, and they have followed a similar pattern over the past few years. This suggests that the central tendency for Chinese margins is indeed significantly lower than it is for the global benchmark, and that the risk of mean reversion is similarly elevated in the face of a major economic shock. How is it possible that Chinese investable ROE has been similar or even higher than that of the global benchmark, but that profit margins are substantially lower? The answer, with very high likelihood, is leverage. Panel 1 of Chart 6 shows ROE for both markets, whereas panel 2 shows ROE divided by the profit margins shown in Chart 5. Using the DuPont approach to decomposing ROE, ROE divided by profit margins is equal to sales over equity, or the product of the asset turnover (sales/assets) and leverage (assets/equity) ratios. Panel 2 shows that product of turnover and leverage is more than twice that of global stocks, implying that Chinese companies are either extremely efficient in the use of their assets to generate sales, or they are very highly levered compared with global stocks. Chart 6High Chinese ROE The Result Of High Leverage The latter is overwhelmingly more likely. We presented evidence in our August 29 Special Report suggesting that Chinese state-owned enterprises (SOEs) now have a negative net return on borrowed funds,3 a situation that has been caused by persistent leveraging since 2010. Not only does this explain the low profitability of Chinese stocks, it also magnifies the risk of significant mean reversion beyond a 6-12 month time horizon if Chinese policymakers panic and aggressively stimulate credit to stabilize a slowing economy. Q: Are Chinese stocks relatively cheap? A: The domestic equity market, yes. The investable market, somewhat. We presented Charts 7 and 8 in our final report of 2018,4 which showed the following: The forward P/E ratio for both domestic and investable Chinese stocks has improved substantially over the past several months. In relative terms, Chinese stocks are not as cheap as they have ever been but, depending on the measure employed, usually haven’t been cheaper (at least over the past decade). The A-share market particularly stands out, with all four relative valuation measures near, at, or above their 2014 levels. Chart 7Chinese Stocks Have Become Cheaper In Absolute Terms…   Chart 8…And Relative To Global Stocks Since we published our December report, global stocks sold off severely, which has somewhat diminished the relative cheapness of investable Chinese stocks. But the bottom line for investors is that Chinese stocks are not expensive in absolute terms, relative to global stocks, or compared with the history of relative valuation. Q: Given reasonable-to-good valuation, are Chinese stocks a good long-term buy? A: Not necessarily. It is distinctly possible that Chinese investable stocks are an example of a “value trap”. When discussing equity valuations in our last report of the year, we also mused about whether Chinese stocks are a great long-term buy. We noted that valuation is normally a powerful predictor of 10-year future performance, but that deviations from this relationship can exist. Chart 9 shows a vivid example of such a deviation, by presenting the profile of investable and domestic equities versus U.S. and global stocks, all rebased to the start of the U.S. recession in December 2007. The chart shows that for every $100 invested in equities at the end of 2007, local currency prices have fallen to $52 for domestic stocks and $86 for investable stocks. This is in sharp contrast to $128 for global equities, and a whopping $176 for the S&P 500. Chart 9A (Largely) Lost Decade For Chinese Stocks Excessive Chinese stock market valuation at the end of the last economic cycle has certainly contributed to the divergence shown in Chart 9. But Chart 10 shows another, less discussed factor: Chinese fundamental performance has not kept up with GDP growth, in contrast to developed markets. The chart shows the indexed ratio of sales per share to nominal GDP growth for the U.S. and China, and highlights that the latter has not only trended downward over time but has collapsed over the past four years. Chart 10Are Chinese Stocks Really A Play On Higher Chinese Growth? At root, the secularly bullish narrative surrounding Chinese stocks is based on the fact that China’s rate of economic growth is considerably higher than that of the developed world. But if the fundamental performance of China’s listed equities cannot keep pace with the economy, are they such a compelling buy simply because they are not expensive? An alternative view is that Chinese stocks are cheap for a reason, i.e. that they are a value trap. In combination with the sizeable risks facing the Chinese economy from extremely elevated levels of corporate debt, the best answer that we can give investors looking out over a multi-year horizon is that Chinese stocks are a great long-term buy for those who do not share our structural concerns. On a risk-adjusted basis, we do not yet find the value proposition to be compelling, meaning that our recommended multi-year allocation to Chinese stocks is neutral. Jonathan LaBerge, CFA, Vice President Special Reports jonathanl@bcaresearch.com   Footnotes 1 Please see China Investment Strategy Weekly Report “Monitoring The (Weak) Pulse Of The Data”, dated January 9, 2019, available at cis.bcaresearch.com. 2 Owing to the recent changes to the global industrial classification system (GICS), the chart shows Chinese earnings growth excluding the information technology and communication services sectors. 3 Please see China Investment Strategy Special Report “Chinese Policymakers: Facing A Trade-Off Between Growth And Leveraging”, dated August 29, 2018, available at cis.bcaresearch.com. 4 Please see China Investment Strategy Weekly Report “Legacies of 2018”, dated December 19, 2018, available at cis.bcaresearch.com. Cyclical Investment Stance Equity Sector Recommendations

Overweight While steel stocks should have benefitted enormously from the U.S./China trade war and steel import tariffs, China macro dictates the fate of the S&P 1500 steel index. China’s waning fiscal and credit impulses have weighed heavily on U.S. steel stocks. Nevertheless, the recovering Li Keqiang index is sending a positive signal (second panel) and recent news of a mini fiscal package centered on high speed rail infrastructure spending is a step in the right direction (bottom panel). The U.S. dollar is another important macro variable driving U.S. steel stocks performance. The greenback’s steep appreciation since April 2018 has dealt a dual blow to domestic steel producers: not only is the underlying commodity quoted globally in U.S. dollars, but also FX translation losses have dented sector profitability. A pause in the Fed’s hiking cycle could catalyze a reversal of these headwinds. Bottom Line: In Monday’s Weekly Report, we lifted the S&P 1500 steel index from underweight to overweight and locked in gains of 2.3%. This move shifts the S&P materials sector into the overweight column; please see our Weekly Report for more details. The ticker symbols for the stocks in the S&P 1500 steel index are: BLBG: S15STEL – NUE, STLD, RS, X, ATI, CMC, CRS, WOR, AKS, SXC, TMST, HAYN and ZEUS.