Consumer Staples

Feature The purpose of this Special Report is to identify and provoke a healthy debate on the prevailing investment themes for the 2020s and to speculate on what the key US sector beneficiaries and likely losers may be. Every decade a dominant theme captures investors’ imaginations and morphs into a bubble. Massive speculation typically propels the relevant asset class into the stratosphere as investors extrapolate the good times far into the future and go on a buying frenzy. Chart 1 shows previous manic markets starting with the Nifty Fifty, gold bullion, the Nikkei 225, the NASDAQ 100, crude oil and most recently the FAANGs. Chart 1Manias: An Historical Roadmap Manias: An Historical Roadmap Manias: An Historical Roadmap What will be the dominant themes of the next decade? How should investors capitalize on some of these big trends? The purpose of this Special Report is to identify and provoke a healthy debate on the prevailing investment themes for the 2020s and to speculate on what the key US sector beneficiaries and likely losers may be. Theme #1: De-Globalization Picks Up Steam The first investment theme for the upcoming decade is the “apex of globalization” or “de-globalization”. We have written about this theme extensively at BCA Research and it is the mega-theme of our sister Geopolitical Strategy (GPS) service. Odds are high that countries will continue looking inward as the US adopts a more aggressive trade policy, China’s trend growth slows, and US-China strategic tensions intensify. The three pillars of globalization are the free movement of goods, capital, and people across national borders. We expect to see marginally less of each in the future. Chart 2 shows that we are at the conclusion of a period of tranquility. Pax Americana underpinned globalization as much as Pax Britannica before it. The US is in a relative decline after decades of geopolitical stability allowed countries like China to rise to “great power” status and rivals like Russia to recover from the chaos of the 1990s. Chart 2De-globalization Has Commenced De-globalization Has Commenced De-globalization Has Commenced De-globalization has become the consensus since the election of Donald Trump. But Trump is not the prophet of de-globalization; he is its acolyte. Globalization is ending because of structural factors, not cyclical ones. And its decline was pre-written into its “source code.” Three factors stand at the center of this assessment, outlined in our 2014 Special Report, “The Apex Of Globalization – All Downhill From Here”: multipolarity, populism and protectionism. Events have since confirmed this view. The three pillars of globalization are the free movement of goods, capital, and people across national borders. We expect to see marginally less of each in the future. Investment Implication #1: Profit Margin Peak The most profound and provocative investment implication from de-globalization is that SPX profit margins have peaked and will likely come under intense pressure, especially for US conglomerates that – on a relative basis to international peers – most enthusiastically embraced globalization. Reconstructed S&P 500 profits and sales data date back to the late-1920s. Historically, corporate profit margins and globalization (depicted as global trade as a percentage of GDP) have been positively correlated (Chart 3). Chart 3Profit Margin Trouble Profit Margin Trouble Profit Margin Trouble As countries are more outward looking, trade flourishes and openness to trade allows the free flow of capital to take advantage of profit-maximizing projects. Following the Great Recession and similar to the Great Depression, trade has suffered and trade barriers have risen. The Sino-American trade war has accelerated the inward movement of countries, including Korea and Japan, and has had negative knock-on effects on trade as evidenced by the now two-year old global growth deceleration. China’s response to President Trump’s election was to redouble its pursuit of economic self-sufficiency, which meant a crackdown on corporate debt and a fiscal boost to household consumption. Trump’s tariffs then damaged sentiment and trade between the two countries. Any deal reached prior to the 2020 US election will remain in doubt among global investors. The longer the trade war remains unresolved, the deeper the cracks will be in the foundations of the global trading system. Such a backdrop is negative for profit margins, as inward looking countries prevent capital from being allocated most efficiently. Moreover, the uprooting of supply chains due to the trade war hurts margins and the redeployment of equipment in different jurisdictions will do the same at a time when final demand is suffering a setback. In addition, rising profit margins are synonymous with wealth accruing to the top 1% of US families and vice versa. This relationship dates back to the late-1920s, as far back as our dataset goes. Using Piketty and Saez data, which exclude capital gains, it is clear that profit margin expansion exacerbates income inequality (top panel, Chart 4). Chart 4Heightened Risk Of Wealth Re-distribution Heightened Risk Of Wealth Re-distribution Heightened Risk Of Wealth Re-distribution Expanding margins lead to higher profits. Because families at the top of the income distribution are more often than not business owners, income disparities are the widest when margins are in overshoot territory. Eventually this income chasm comes to a head and generates political discontent. Populism has emerged on both the right and left wings of the US political spectrum – and since the rise of Trump, even Republicans complain about inequality and the excesses of “corporate welfare” and laissez-faire capitalism. Because inequality is extreme – relative to America’s developed peers – and political forces are mobilizing against it, the probability of wealth re-distribution is rising in the coming decades (middle panel, Chart 4). Labor’s share of national income has nowhere to go but higher in coming years and that is negative for profit margins, ceteris paribus (bottom panel, Chart 4). Drilling beneath the surface, the three secular US equity sector/factor implications of the apex of globalization paradigm shift are: prefer small caps over large caps prefer value over growth overweight the pure-play BCA Defense Index Investment Implication #2: Small Is Beautiful While a small cap bias is contrary to the cyclical US Equity Strategy view of preferring large caps to small caps, the issue is timing: the small cap preference is a secular view with a time horizon that spans the next decade. The small versus large cap share price ratio’s ebbs and flows persist over long cycles. Small caps outshined large caps uninterruptedly from 1999 to 2010. Since then large caps have had the upper hand (Chart 5). Were the apex of globalization theme to gain traction in the 2020s, small caps should reclaim the lead from large caps, especially in the wake of the next US recession. Similar to the death of the global banking model, companies with global footprints will suffer the most, especially compared with domestically focused outfits. One way to explore this theme is via domestic versus global sector preference. But a more investable way to position for this sea change, is to buy small caps (or microcaps) at the expense of large caps (or mega caps). Small caps are traditionally domestically geared compared with large caps that have significantly more foreign sales exposure. Chart 5It’s A Small World After All It’s A Small World After All It’s A Small World After All The closest ETF ticker symbols resembling this trade is long IWM:US/short SPY:US. Investment Implication #3: Buy Value At The Expense Of Growth Similar to the size bias, the style bias also moves in secular ways. Value outperformed growth from the dot com bust until the GFC. Since then growth has crushed value, even temporarily breaking below the year 2000 relative trough. This breakneck pace of appreciation for growth stocks is clearly unsustainable and offers long-term oriented investors a compelling entry point near two standard deviations below the historical mean (Chart 6). Chart 6Value Has The Upper Hand Versus Growth Value Has The Upper Hand Versus Growth Value Has The Upper Hand Versus Growth Financials populate value indexes, a similarity with small cap outfits. Traditionally, financials are a domestically focused sector with export exposure registering at half of the S&P’s average 40% level of internationally sourced revenues. On the flip side, tech stocks sit atop the growth table and they garner 60% of their revenue from abroad. This value over growth style preference will pay handsome dividends if the de-globalization theme becomes more main stream as countries become more hawkish on trade and the Sino-American war continues to erect barriers to trade that took decades to lift. The caveat? If President Trump strikes a short-term deal with China ahead of the 2020 election, the de-globalization theme will suffer a setback. But our geopolitical strategists expect a ceasefire at best, not a durable deal, and also expect the trade war to resume in some way, shape or form in 2021-22, regardless of the outcome of the US election. The closest ETF ticker symbols resembling this trade is long IVE:US/short IVW:US.  Investment Implication #4: Defense Fortress One final long-term playable investment idea from the apex of globalization is a structural bull market in defense stocks (Chart 7). Our October 2016 “Brothers In Arms” Special Report drew parallels with the late nineteenth century period of European rearmament, and the American and Soviet arms race of the 1960s. These movements were greatly beneficial to the aerospace and defense industry. Currently, the move by several countries to adopt more independent foreign policies, i.e. to move away from collaboration and cooperation toward isolationism and self-sufficiency, entails an accompanying arms race. Chart 7Stick With Pure-play Defense Stocks Stick With Pure-play Defense Stocks Stick With Pure-play Defense Stocks Table 1 Top US Sector Investment Ideas For The Next Decade Top US Sector Investment Ideas For The Next Decade China’s challenge to the regional political status quo motivates a boost to defense spending globally. In fact SIPRI data on global military spending by 2030 (Table 1) increases our conviction that this trade will succeed on a five-to-ten year horizon. Beyond the global arms race, two additional forces are at work underpinning pure-play defense contractors. A global space race with China, India and the US wanting to have manned missions to the moon, and the rise of global cybersecurity breaches. Defense companies are levered to both of these secular forces and should be prime sales and profit beneficiaries to rising space budgets and increasing cybersecurity combat budgets. The ticker symbols for the stocks in the pure-play BCA defense index are: LMT, RTN, NOC, GD, HII, AJRD, BWXT, CW, MRCY. Theme #2: Tech Sector Regulation, US Enacts Privacy Laws The second long-term geopolitical theme that we are exploring is the regulatory or “stroke of pen” risk that is rising on FAANG stocks – Facebook, Apple, Amazon, Netflix, and Google. These companies were this decade’s undisputed stock market winners. The US anti-trust regulatory framework was designed to curb broad anti-competitive actions of trusts. As Lina Khan discusses in her seminal article, these actions “include not only cost but also product quality, variety, and innovation.” However, through subsequent regulatory evolution, the Chicago School has focused the US anti-trust process on consumer welfare and prices. If President Reagan and the courts could change how anti-trust laws were administered in the 1980s, so too can future administrations and courts. Today the US Congress, on both sides of the aisle, is looking into regulatory tightening, while the judicial system will take longer to change its approach. Moreover, the impetus for tougher anti-trust policy is here. It comes from a long period of slow growth, income inequality, and economic volatility – such as in the 1870s-80s. This was certainly the case for Standard Oil in 1911, which became a nation-wide boogeyman despite most of its transgressions occurring in the farm belt states. Today, income inequality is a prominent political theme and source of consumer discontent. A narrative is emerging – which will be super-charged during the next recession – that growth has been unequally distributed between the old economy and the twenty-first century technology leaders. With regard to privacy, the news is equally grim for large tech outfits. The EU General Data Protection Regulation (GDPR), which came into force on May 2018, imposes compliance burdens on any company handling user data. In the US, California has signed its own version of the law – the Consumer Privacy Act – which will go into effect in January 2020. These laws give consumers the right to know what information companies are collecting about them and what companies that data is being shared with. They also allow consumers to ask technology companies to delete their data or not to sell it. While tech companies are likely to fight the new California law, and the US court system is a source of uncertainty, we believe the writing is on the wall. The EU is by some measures the largest consumer market on the planet. California is certainly the largest US market of the states. It is unlikely that the momentum behind consumer protection will change, especially with the EU and California taking the lead. The odds of a federal privacy law, following in the footsteps of the Consumer Privacy Act, are also rising. Investment Implication #5: Shun Interactive Media & Services Stocks These risks introduce a severe overhang for FAANG stocks. We are especially worried for the S&P interactive media & services index that includes GOOGL and FB. Tack on the threat of federal regulation and this represents another major headwind for profits and net profit margins that are extremely elevated for these near monopolies. Given that advertising revenue is crucial to the business model of social media companies (GOOGL and FB included), a significant uptick in privacy regulation will likely hurt their bottom line. With regard to profit margins, tech stocks in general command a profit margin twice as high as the SPX. Specifically, FB and GOOGL enjoy margins that are 500 basis points higher than the broad tech sector (Chart 8)! This is unsustainable and will likely serve as easy prey for policymakers. Our view does not necessarily call for breaking up these monopolies. The US will have to weigh the economic consequences of anti-trust policy in a context of multipolarity in which China’s national tech champions are emerging to compete with American companies for global market share. Nevertheless increased regulation is inevitable and some forced sales of crown jewel assets may take place. Moreover, the threat of a breakup will lurk in the background, creating uncertainty until key legislative and judicial battles have already been fought. That will take years. Finally, we doubt the tech sector will be left alone to “self-regulate” its incumbents and negotiate a price on consumers’ privacy. More likely, a new privacy law will loom overhead, serving as a negative catalyst for profit growth. Uncertainty will weigh on the S&P interactive media & services relative performance. Chart 8Regulation Will Squeeze Tech Margins Regulation Will Squeeze Tech Margins Regulation Will Squeeze Tech Margins The ticker symbols to short/underweight the S&P interactive media & services index are an equally weighted basket of GOOGL and FB (they command a 98% market cap weight in the index). Theme #3: SaaS, Artificial Intelligence, Augmented Reality And Autonomous Driving Are Not Fads The third big theme that will even outlive the upcoming decade is the proliferation of software as a service (SaaS). The move to cloud computing and SaaS, the wider adoption of artificial intelligence, machine learning, autonomous driving and augmented reality are not fads, but enjoy a secular growth profile. In the grander scheme of things today’s world is surrounded by software. Millions of lines of code go even into gasoline powered automobiles, let alone electric vehicles. Autonomous driving is synonymous with software, the Internet of Things (IoT) needs software, the space race depends on software, modern manufacturing and software are closely intertwined, phone calls for quite some time have been a software solution, and the list goes on and on. This tidal effect is hard to reverse and is already embedded in workflows across industries. Opportunities to penetrate health care and financial services more deeply remain unexplored and it is difficult to envision another competing industry unseating “king software”. These secular trends are not only productivity enhancing, but will also most likely prove recession-proof. When growth is scarce investors flock to any source of growth they can come by and we are foreseeing that when the next recession arrives, investors will likely seek shelter in pure play SaaS firms. Investment Implication #6: Software Is Eating The World Buying software stocks for the long haul seems like a bulletproof investment idea. But the recent stellar performance of software stocks that has moved valuations to overshoot territory. Our recommended strategy is to buy or add software stock exposure on any weakness with a 10-year investment time horizon. All of these secular trends have pushed capital outlays on software into a structural uptrend. Software related capex is not only garnering a larger slice of the tech spending budgets but also of the overall capex pie. If it were not for software capex, the contraction in non-residential investment in recent quarters would have been more severe (Chart 9). Private sector software capex is near all-time highs as a share of total outlays. Government investment in software is also reaccelerating at the fastest pace since the tech bubble. When productivity gains are anemic, both the business and government sectors resort to software upgrades in order to boost productivity. Cyber security is another more recent source of software related demand as governments around the globe are taking such risks extremely seriously (bottom panel, Chart 9). Given this upbeat demand backdrop and ongoing equity retirement, software stocks are primed to grow into their pricey valuations. Chart 9Software Is Eating The World Software Is Eating The World Software Is Eating The World Finally, this long-term trade will also serve as a hedge to the short/underweight position we recommend in the S&P interactive media & services index. The closest ETF ticker symbol resembling the S&P software index is IGV:US. Theme #4: Millennials Already Are The Largest Cohort And Will Dominate Spending The fourth long-term theme we anticipate will gain traction in the 2020s is the demographic rise of the Millennial generation. Much has been made of preparing for the arrival of the Millennial generation, accompanied by well-worn stereotypes of general "failure to launch" as they reach adulthood. However, "arrival" is a misnomer as this age cohort is already the largest and "failure" is simply untrue. According to the U.S. Census Bureau, Millennials are the US’s largest living generation. Millennials (or Echo Boomers) defined as people aged 18 to 37 (born 1982 to 2000), now number more than 80mn and represent more than one quarter of the US’s population. Baby Boomers (born 1946 to 1964) number about 75mn. Stealthily becoming the largest age group in the US over the last few years, Millennials per-year-birth-rate peaked at 4.3mn in 1990. Surprisingly, the pace matched that of the post-war Baby Boom peak-per-year-birth-rate in 1957 - the per-year average over the period was higher for the Baby Boomers (Chart 10). Chart 10Millennials Are The Largest Cohort Millennials Are The Largest Cohort Millennials Are The Largest Cohort This gap is now set to grow rapidly as the death rate of Baby Boomers accelerates. What is more, the largest one-year age cohort is only 25 years old, thus, Millennials will be the dominant generation for many years. It is unclear how these “kids” will impact the market as they become the most important consumers, borrowers and investors, but make no mistake: this is a seismic shift in economic power and it is here to stay. The Echo Boom is a big, generational demographic wave. A difficult and painful delay has not tempered its looming importance. Finally, this wave of echo-boomers is educated, relatively unburdened by debt (please see BOX in the June 11, 2018 Special Report on demystifying the student debt load as it pertains to Millennials), and as they inevitably “grow up”, form new households and have kids. They will borrow, spend, earn, but not necessarily save and invest to the same extent as the Boomers. And this will be an important long-term theme going forward. Near term we might already be seeing signs of their arrival and firms have begun to pivot accordingly. Investment Implication #7: Buy The BCA Millennials Equity Basket Millennials will boost consumption spending in a number of different ways. The relatively unburdened Millennial cohort will be entering prime home acquisition age soon and this should underpin the long-term prospects of the US housing market and derivative industries. Further, Millennials consume differently from their parents; social media, online shopping and smart phones are not the consumption categories of the Baby Boomers. With this in mind, we have created a basket of ten stocks that we think will be driven over the long term by the demographic rise of the Millennial. We note that these stocks are heavily weighted to the technology and consumer discretionary sectors, which is logical as Millennial consumption habits tend to be discretionary focused and technology-based. Beginning with consumer discretionary, we are highlighting AMZN, NFLX and SPOT as core holdings in our Millennials basket. AMZN’s heft dwarfs consumer discretionary indexes but it could fall in several categories; the acquisition of Whole Foods makes it a Millennials-focused consumer staples retailer and its cloud computing web services segment is a tech leader. NFLX and SPOT represent the means by which Millennials consume media, by streaming movies and music over the internet. The idea of owning physical media is rapidly becoming an anachronism. The home ownership themes noted in the report above lead us to add HD and LEN to the basket. Millennials are “doers” and are set to be the dominant DIYers in the next few years, making HD a logical choice. LEN, as the nation’s largest home builder, should benefit from the Millennials coming of age into home buyers. We are also adding TSLA to our basket as a lone clean tech-oriented equity. TSLA capitalizes on the increasing shift to clean energy of Millennials (the key reason why no traditional energy companies have a spot in our basket). The technology stocks in our Millennials basket are AAPL, UBER (which replaces FB as of today) and MSFT, together representing more than 9% of the total value of the S&P 500. AAPL’s inclusion in the list is predictable as the leading domestic purveyor of devices on which Millennials consume media content. FB is a predictable holding, with more than half of all Americans being monthly active users, dominated by the Millennial cohort. It has served our basket well since inception, but today we are compelled to remove it and replace it with UBER. UBER is a Millennial favorite and the epitome of the sharing economy. In reality UBER is a logistics company and while it is losing money it is eerily reminiscent of AMZN in its early days. Maybe UBER will dominate all means of transportation and its ease of use will propel it to a mega cap in the coming decade. Our inclusion of MSFT is based on its leadership in cloud computing, a rapidly growing industry. We expect the connectivity and mobile computing demands of Millennials will accelerate. The last stock we are adding to our basket is also the only financial services equity. Though avid consumers, Millennials have shown an aversion to cash, preferring card payment systems, including both debit and credit-based. Accordingly, we are adding the leader in both of these, V, to our Millennials basket (Chart 11). Chart 11Buy BCA’s Millennial Equity Basket Buy BCA’s Millennial Equity Basket Buy BCA’s Millennial Equity Basket Investors seeking long term exposure to stocks lifted by the supremacy of the Millennial generation should own our Millennial basket (AAPL, AMZN, UBER, HD, LEN, MSFT, NFLX, SPOT, TSLA, V). We would not hesitate to add other sharing economy stocks, including Airbnb, to this basket should they become investable in the near future. Theme #5: ESG Becomes Mainstream Investors are increasingly looking at allocating assets based on environmental, social, and governance (ESG) considerations, and this mini-theme has the potential to become a big trend in the 2020s. There are a number of factors that underpin ESG investing. First, Millennials are climate conscious and given that they already are the largest cohort in the US they will not only dominate spending, but also influence election results. Moreover, via social media Millennials can sway public opinion and participate in the ESG conversation. Second, ECB President Christine Lagarde recent speech to the Economic and Monetary Affairs Committee of the European Parliament is a must read.1 If the ECB were to explicitly focus on climate change policy as part of its monetary policy operations then this is a game changer. Green investment financing including “green bonds” could become mainstream. Keep in mind the as reported in the FT “the European Parliament has declared a climate emergency; the new European Commission (EC) has taken office on a promise of an imminent “green new deal”, and Commission president Ursula von der Leyen has vowed to accelerate emissions cuts.” Last Wednesday, the EC released “The European Green Deal” with a pretty aggressive time table. The EC president said “The green deal is Europe’s man on the moon moment” and presented 50 policies slated to get rolled by 2022 to meet revamped climate goals. The implication is that once ESG takes center stage at a number of these institutions it will be easier to become mainstream and propagate the world over. Third, large institutional investors are starting to adopt an ESG mindset, especially pension plans. These investors with trillions of dollars at their disposal can not only disfavor fossil fuel investment, but also undertake investments in “green projects” via private and public equity markets. Banks are also moving in the “greening of finance” direction and given that they are the pipelines of the global plumbing system, swift adoption will go a long way in taking ESG mainstream. Finally, the electric vehicle (EV) proliferation is another key driver on how the ESG theme will play out in the 2020s. As a reminder, in the US 50% of all energy consumption is gasoline related linked to automobiles. While battery technology still has limitations, EV is no longer a fad as the German and Japanese automakers are starting to make inroads on TSLA. These car manufacturers do not want to be left out, especially if this shift toward EV becomes mainstream in the 2020s. The Chinese are not far behind on the EV manufacturing front, however government policy can really become a game changer. If a number of countries and/or California mandate a large share of all new vehicles sold be EV, then the investment implications will be massive. Investment Implication #8: Avoid Fossil Fuels, Gambling, Alcohol And Tobacco… While there are a few ESG related ETFs, we would rather explore this theme’s investment implications of sectors to avoid in the coming decade. We are believers that ESG criteria will continue to gain in importance in institutional investment management decisions. Accordingly, we would tend to avoid ‘sin stocks’, including gambling, tobacco and alcohol; demand for their services is unlikely to decline but investment weightings should mean that share prices will underperform. Further, we think a clean energy shift will mean energy stocks will likely continue to be long-term underperformers (Chart 12). Chart 12Areas To Avoid As ESG Becomes Mainstream Areas To Avoid As ESG Becomes Mainstream Areas To Avoid As ESG Becomes Mainstream Final Thoughts On The US Dollar In this report, we tried to focus on the upcoming decade’s big themes that we deem will play out, and centered recommendations on US equities/sectors. We do not want to neglect some macroeconomic variables that tend to mean revert over time. Specifically, the US dollar, interest rates and most importantly US indebtedness, will also be key drivers of investment theses in the 2020s. Currently, debt is rising faster than nominal GDP growth with the government and non-financial business debt-to-GDP profiles on an unsustainable path (second panel, Chart 13). Granted, the saving grace has been generationally low interest rates as the debt service ratios have fallen (top panel, Chart 13). However, if the four decade bull market in Treasury bonds is over, or may end definitively with the next US recession sometime in the early 2020s, then rising interest rates are the only mechanism to concentrate CEOs’ and politicians’ minds. On the dollar front, Chart 14 highlights the ebbs and flows of the trade-weighted US dollar since it floated in the early-1970s. The DXY index has moved in six-to-ten year bull and bear markets. The most recent trough was during the depths of the Great Recession, while the (tentative?) peak was in late-2016. If history repeats, eventually the dollar will mean revert lower in the 2020s, especially given the fiscal profligacy of the current administration that may continue into 2024, assuming President Trump gets re-elected next November. Chart 13Unsustainable Debt Profiles Unsustainable Debt Profiles Unsustainable Debt Profiles Chart 14Greenback’s Historical Ebbs And Flows Greenback’s Historical Ebbs And Flows Greenback’s Historical Ebbs And Flows The US dollar remains the reserve currency of the world today, but that exorbitant privilege is clearly fraying on the edges as the balance-of-payments dynamics are heading in the wrong direction. Over the next five years, the US Congressional Budget Office (CBO) estimates that the US budget deficit will swell to 4.8% of GDP. Assuming the current account deficit widens a bit then stabilizes (usually happens when global growth improves), this will pin the twin deficits at 8% of GDP. This assumes no recession, which would have the potential to swell the deficit even further. The US saw its twin deficits swell to almost 13% of GDP following the financial crisis, but the difference then was that in the wake of the commodity boom the dollar was cheap (and commodity currencies overvalued). The subsequent shale revolution also greatly cushioned the US trade deficit. Shale productivity remains robust and US output will continue to rise, but the low-hanging fruit has already been plucked.   Another dollar-negative force is its expensiveness. By rising 35% since its trough, the USD has sapped the competitiveness of the US manufacturing sector, which is accentuating the American trade deficit outside of the commodity sector. If the ESG trend ends up hurting oil prices, the US current account will follow the widening deficit in manufactured products. Moreover, the US is lagging Europe on the green revolution. Either the US will have to import green technologies, or the US government will have to provide more subsidies to the private sector. Either way, both of these dynamics will hurt the US current account deficit further. Historically, the currency market is the main vehicle to correct such imbalances. Chart 15Twin Deficits Will Weigh On The US Dollar Twin Deficits Will Weigh On The US Dollar Twin Deficits Will Weigh On The US Dollar The apex of globalization will also hurt the greenback. In a world where all the markets are integrated, borrowers in EM nations often use the reserve currency to issue liabilities at a lower cost. This boosts the demand by EM central banks for US dollar reserves to protect domestic banking systems funded in USD. Moreover, some countries like China implement pegs (both official and unofficial) to the US dollar in order to maintain their competitiveness and export their production surpluses to the US. To do so they buy US assets. If the global economy becomes more fragmented and the Sino-US relationship continues to deteriorate structurally as we expect, then these sources of demand for the dollar will recede. Overlay the widening US current account deficit, and you have the perfect recipe for a depreciating trade-weighted US dollar. Finally, the US is likely to experience more inflation than the rest of the world following the next recession. The US economy has a smaller capital stock as a share of GDP than Europe or Japan, and American demographics are much more robust. This means that the neutral rate of interest is higher in the US than in other advanced economies. As a result, the Fed will have an easier time generating inflation by cutting real rates than both the ECB and the BoJ. Higher inflation will ultimately erode the purchasing power of the dollar and prove to be a structurally negative force for the USD.   Anastasios Avgeriou US Equity Strategist anastasios@bcaresearch.com Matt Gertken Geopolitical Strategist mattg@bcaresearch.com Marko Papic Chief Strategist, Clocktower Group marko@clocktowergroup.com Chester Ntonifor Foreign Exchange Strategist chestern@bcaresearch.com Mathieu Savary The Bank Credit Analyst mathieu@bcaresearch.com   References Please click on the links below to view reports: Peak Margins - October 7, 2019 The Polybius Solution - July 5, 2019 War! What Is It Good For? Global Defense Stocks! - October 31, 2018 The Dollar: Will The U.S. Invoke A "Nuclear" Option? - August 30, 2018 Is The Stock Rally Long In The FAANG? - August 1, 2018 Millennials Are Not Coming Of Age; They Are Already Here - June 11, 2018 Brothers In Arms - October 31, 2016 The End Of The Anglo-Saxon Economy?  - April 13, 2016 Apex of Globalization  - November 12, 2014 Footnotes 1           https://www.imf.org/en/News/Articles/2019/09/04/sp090419-Opening-Statement-by-Christine-Lagarde-to-ECON-Committee-of-European-Parliament

Highlights Building on a previous special report focused on the investable market, in this report we construct and present models designed to predict the odds of Chinese domestic equity sector outperformance. BCA Research's China Investment Strategy service will aim to use our newly developed sector outperformance probability models to better understand the drivers of performance at any given moment, and to make more active equity sector recommendations in the future. Episodes of domestic equity sector outperformance over the past decade appear to be more idiosyncratic (or sector specific) than has been the case for the investable market, suggesting that periods of “abnormal” relative sector performance may occur more frequently than in the investable universe. Among the predictors included in our model, our Li Keqiang leading indicator (based on monetary conditions, money, and credit growth) has been the most important. Our base case view argues in favor of domestic cyclicals over defensives over the coming year, but recent sector performance suggests that domestic consumer discretionary and tech should be favored within a cyclical equity portfolio over energy, materials, and industrials barring a surge in oil prices or a capitulation by Chinese policymakers in favor of “flood irrigation-style” stimulus. Over the long-term, we argue that investors have a good reason to favor domestic defensives over cyclicals until the latter demonstrates meaningfully better earnings performance. Feature We examined China’s investable equity sector performance in detail in our October 30 Special Report,1 with a particular emphasis on understanding the specific macroeconomic or equity market factors that have historically predicted relative sector performance. In today’s report, we extend our approach to China’s A-share market. Our research focused on constructing and presenting models that quantify a checklist-based approach to determining the odds of equity sector performance. The aim is to use these models to better understand the drivers of performance at any given moment, and to make more active equity sector recommendations in the future. These recommendations will not mechanically follow the models; rather, we plan to use them as a stand in for what typically would be expected given the macro and financial market environment, and as a basis to investigate “abnormal” relative performance. We find that episodes of domestic equity sector outperformance over the past decade appear to be more idiosyncratic (or sector specific) that has been the case for the investable market, suggesting that periods of “abnormal” relative sector performance may occur more frequently than in the investable universe. Among the macroeconomic and equity market factors that we found to be important predictors, our Li Keqiang leading indicator was the most significant. This confirms that China’s domestic market is more sensitive to monetary conditions, money, and credit growth than its investable peer. We also note the sharp difference in the relative performance of cyclicals versus defensives in the domestic market compared with the investable market, and what this means for investors over the coming 6-12 months. Finally, we argue that investors should maintain a structural bias towards defensive stocks in the domestic market until cyclicals demonstrate meaningfully better earnings performance, and point to an existing position in our trade book for investors interested in strategically allocating to the A-share market. Detailing Our Approach In our effort to better understand historical periods of domestic sector performance, we have chosen to model the probability of outperformance of each level 1 GICS sector (plus banks) based on a set of macro and equity market variables. Specifically, we use an analytical tool called a logistic regression, which forecasts the probability of a discrete event rather than forecasting the value of a dependent variable. We utilized this approach when building our earnings recession model for China (first presented in our January 16 Special Report).2 The “events” that we modeled are historical periods of individual Chinese investable sector outperformance from 2010 to 2018, relative to the MSCI China index (the “broad market”). We find that episodes of domestic equity sector outperformance over the past decade appear to be more idiosyncratic (or sector specific) than has been the case for the investable market. Chart I-1A and Chart I-1B illustrate these periods with shading in each panel. We then attempt to explain these episodes of outperformance with the following macro predictors: Chart I-1AThis Report Builds Models ##br##Aimed At... Chart 1A This Report Builds Models Aimed At… This Report Builds Models Aimed At… Chart I-1B...Predicting The Shaded Regions Of These Charts Chart IB …Predicting The Shaded Regions Of These Charts …Predicting The Shaded Regions Of These Charts Periods of accelerating economic activity, represented by our BCA's China Activity Index Periods of rising leading indicators of economic activity, represented by our BCA Li Keqiang (LKI) Leading Indicator Episodes of tight monetary policy, defined as periods where China’s 3-month interbank repo rate is rising Periods of accelerating inflation, measured both by headline and core inflation We also include several equity market variables: uptrends in relative sector earnings, periods of rising broad market stock prices, uptrends in broad market earnings, and episodes of extreme technical conditions and relative over/undervaluation for the sector in question. In the case of energy stocks, we also include oil prices as a predictor. Chart I-2A and Chart I-2B illustrate these periods as well as the macro & market variables that we have included as predictors. Chart I-2AWe Use These Macroeconomic And Equity Market Factors... Chart 2A We Use These Macroeconomic And Equity Market Factors… We Use These Macroeconomic And Equity Market Factors… Chart I-2B...To Predict Periods Of Equity Sector Outperformance Chart 2B …To Predict Periods Of Equity Sector Outperformance …To Predict Periods Of Equity Sector Outperformance Our approach also accounts for the existence of any leading or lagging relationships between the macro and market variables we have used as predictors and sector relative performance. In most cases the predictors lead relative sector performance, but in some cases it is the opposite. In the case of the latter, we have limited the lead of any variable in our models to three months in order to reduce the need to forecast. Finally, our approach also limits the extent to which we consider a leading relationship between our predictors and relative sector performance, in order to avoid picking up overlapping economic cycles. This issue, and the evidence supporting the existence of a 3½-year credit cycle in China, is detailed in Box I-1 of our October 30 Special Report (please see footnote 1). Key Drivers Of Sector Performance: Domestic Versus Investable Pages 11-22 present the results of each sector’s outperformance probability model, along with a list of factors that were found to be useful predictors and a summary of the results. The importance of the factors included in the models is shown in each of the tables at the top right of pages 11-22 by a score of 1-3 stars, (loosely representing key levels of statistical significance) as well as each factor’s optimal lead or lag. A minus sign shows that the predictor leads sector relative performance, whereas a plus sign shows that it lags. Following a review of our domestic equity sector outperformance models, differences in the results from those presented in our previous report can be organized into three distinct elements: 1) the breadth of macro & equity market factors in predicting sector performance, 2) the relative importance of our LKI leading indicator, and 3) the difference between domestic/investable cyclical versus defensive performance. The Breath Of Predictive Factors Chart I-3In The Domestic Market, The Breadth Of Predictive Factors Is Narrower Chart 3 In The Domestic Market, The Breadth Of Predictive Factors Is Narrower In The Domestic Market, The Breadth Of Predictive Factors Is Narrower Compared with the models for investible sector performance that we detailed in our previous report, our work modeling domestic equity sector performance highlights that the breadth of predictive factors is narrower, particularly among cyclical sectors (Chart I-3). Our model for domestic materials (shown on page 12) is one exception to this rule, but we found that our models for energy, industrial, and consumer discretionary relative performance were all focused on fewer predictors than is the case for the investable market. In addition, our domestic utilities model has considerably worse predictive power than our model for investable utilities. The case of industrials is particularly notable: our model for investable industrials highlighted the importance of tight monetary policy, rising core inflation, rising broad market stock prices & earnings, and overbought and oversold technical conditions in explaining past periods of industrial sector outperformance. By contrast, our domestic industrials model is quite simple: the sector has been more likely to outperform, with a lag, when our BCA China Activity Index and LKI leading indicator have been rising, and underperform following periods of extreme overvaluation. One of the core conclusions of our previous report was that investors should view the relative performance of investable industrials versus consumer staples as a reflationary barometer, given the strong sensitivity of both sectors to tight monetary policy. We explained this sensitivity by pointing to the substantial difference in corporate health between the two sectors: industrial firms are heavily debt-laden and thus experience deteriorating operating performance and an environment of rising interest rates. In comparison, food and beverage firms appear to have the strongest balance sheets among the sub-sectors that we have examined, suggesting that they would benefit less from easier monetary conditions than firms in other industries. Our leading indicator for Chinese economic activity has been considerably more important in predicting domestic equity sector outperformance than in the investable market. However, these dynamics appear to be completely absent in influencing performance in China’s domestic equity market. Not only has domestic industrial sector relative performance not been negatively linked to periods of tight monetary policy, but our model for consumer staples (shown on page 15) highlights that periods of staples performance have been driven by two simple factors: the relative trend in staples EPS  (positive sign), and the trend in broad market EPS (negative sign). The Relative Importance Of Monetary Conditions, Money, And Credit Growth Chart I-4 summarizes the significance of the factors in predicting sector performance in general, by summing up each predictor’s number of stars across all of the models. The chart shows that our LKI leading indicator is the most important signal of sector performance that emerged from our analysis, followed by rising core inflation, rising broad market stock prices, rising economic activity, and oversold technical conditions. The ranking of results shown in Chart I-4 is fairly similar to those that we listed for the investable market, with two exceptions. First, for the domestic market, periods of tight monetary policy were considerably less important than in the investable market as an important predictor of relative sector performance. Instead, our LKI leading indicator was by far the most important predictor, which underscores a point that we have made in previous reports: domestic stocks appear to be much more sensitive to the trend in monetary conditions, money, and credit growth than for the investable market. This increased sensitivity has helped explain the difference in performance this year between the investable and domestic market, underscoring that the former has more catch-up potential than the latter in a trade truce scenario. Chart I-4Monetary Conditions, Money, & Credit Growth Drive A-Share Performance Chart 4 Monetary Conditions, Money, & Credit Growth Drive A-Share Performance Monetary Conditions, Money, & Credit Growth Drive A-Share Performance Second, in the investable market, episodes of significant overvaluation had essentially no power to predict future episodes of equity market underperformance. But this factor was an important or very important contributor to our domestic industrials, health care, and tech models. This finding is consistent with our May 23 Special Report, which noted that value stocks have outperformed in China’s domestic equity market over the past five years and underperformed in the investable market (Chart I-5). Chart I-5Value Has Been A More Successful ##br##Factor In The Domestic Market Chart 5 Value Has Been A More Successful Factor In The Domestic Market Value Has Been A More Successful Factor In The Domestic Market   Major Differences In The Performance Of Cyclicals Versus Defensives The results of our models for domestic equity sector performance did not change the cyclical & defensive labels that we applied in our previous report. The signs of the predictors shown in the tables on pages 11-22 clearly highlight that the domestic energy, materials, industrials consumer discretionary, and information technology sectors are cyclical sectors, and that consumer staples, health care, financials, telecom services, utilities, and real estate are defensive. What is striking, however, is that there is a major difference in the relative performance of equally-weighted domestic cyclicals versus defensives compared with what has occurred in the investable market over the past decade. Chart I-6A and Chart I-6B illustrate the different relative performance trends, along with their corresponding trends in relative P/E and relative EPS. Whereas the relative performance of investable cyclicals versus defensives has had somewhat of a stable mean over the past decade, domestic cyclicals have badly underperformed since early-2011. The charts also make it clear that this underperformance has been driven by a downtrend in relative EPS, not due to trend differences in relative valuation. Chart I-6ACyclicals/Defensives Somewhat Mean-Reverting In The Investable Market... Chart 6A Cyclicals/Defensives Somewhat Mean-Reverting In The Investable Market… Cyclicals/Defensives Somewhat Mean-Reverting In The Investable Market… Chart I-6B...But Not So In The Domestic##br## Market Chart 6B …But Not So In The Domestic Market …But Not So In The Domestic Market Digging further, it appears that this discrepancy can be largely explained by the significant difference in performance between investable and domestic tech over the past decade (Chart I-7). Whereas the former has outperformed the overall investable index by roughly 4-5 times since 2010, the relative performance of the latter has only very modestly risen. In effect, Charts I-6 and I-7 highlight that Chinese cyclical sectors have been structurally impaired over the past decade and have only been “saved” in the investable market by massive outsized outperformance of the tech sector. The fact that investable tech sector performance itself has been largely driven by 2 extremely successful firms underscores how narrowly based the investible cyclical versus defensives performance trend has been. Chart I-7A Huge Gap In Tech Explains Domestic Cyclical Underperformance Chart 7 A Huge Gap In Tech Explains Domestic Cyclical Underperformance A Huge Gap In Tech Explains Domestic Cyclical Underperformance Investment Conclusions There are three conclusions that investors can draw from our analysis. First, our research shows that episodes of domestic equity sector outperformance over the past decade appear to be more idiosyncratic (or sector specific) that has been the case for the investable market. This does not mean that domestic sector performance is not significantly impacted by macro and top down equity market factors, but it suggests that periods of “abnormal” relative sector performance may occur more frequently than in the investable universe. As such, investors should be prepared to include episode-specific investigation of abnormal performance as a regular part of their domestic equity sector allocation decisions. Investors should favor domestic cyclicals over the coming year, with exposure focused on consumer discretionary and tech. Second, the fact that our LKI leading indicator is in an uptrend suggests that investors should favor domestic cyclicals over defensives over the coming year, with a caveat. We have noted in several previous reports that our indicator is in a shallow uptrend, and the slower pace of money and credit growth than during previous economic upswings suggests that the bar may be higher for some cyclical sectors to outperform. We would advise investors to watch closely over the coming 3-6 months for signs of a technical breakout in all cyclical sectors. But sector performance in Q1 of this year, when the overall A-share market rose sharply versus global stocks, suggests that domestic consumer discretionary and tech should be favored within a cyclical equity portfolio over energy, materials, and industrials barring a surge in oil prices or a capitulation by Chinese policymakers in favor of “flood irrigation-style” stimulus (Chart I-8). Within resources, we prefer the investable energy sector to its domestic peer, due to a sizeable valuation advantage. Chart I-8Favor Select Domestic Cyclical Sectors Over The Coming Year Chart 8 Favor Select Domestic Cyclical Sectors Over The Coming Year Favor Select Domestic Cyclical Sectors Over The Coming Year As a third and final point, abstracting from our bullish outlook for select cyclical sectors over the coming year, Charts 6 and 7 clearly argue for investors to maintain a structural bias towards defensive stocks in the domestic market until cyclicals demonstrate meaningfully better earnings performance. In the May 23 Special Report that we referred to above, we noted that an A-share portfolio formed of industry groups with above-median return on equity and below-median ex-post beta has significantly outperformed over the past decade. Table I-1 presents the current industry group weights of this portfolio, and shows that overweight exposure is concentrated in the health care, consumer staples, and real estate sectors (all of which are defensive), and a heavy underweight towards industrials. Table I-1Current High ROE / Low Beta Factor Industry Group Portfolio Weights* Table 1 Current High ROE / Low Beta Factor Industry Group Portfolio Weights* Current High ROE / Low Beta Factor Industry Group Portfolio Weights* For clients who are interested in strategically allocating to the A-share market, we maintain a long position in this portfolio relative to the MSCI China A Onshore index in our trade book, and plan to continue to update the performance of the trade on a weekly basis. Energy Chart II-1 Chart II-1 Energy Energy Table II-1 A Guide To Chinese Domestic Equity Sector Performance A Guide To Chinese Domestic Equity Sector Performance Similar to the investable energy sector, periods of domestic energy sector outperformance are strongly positively related to rising oil prices and rising headline inflation in China. We noted in our previous report that this is a behavioral relationship, rather than a fundamental one. Domestic energy stocks are negatively associated with rising broad market stock prices, unlike their investable peers. This largely reflects the fact that the relative performance of domestic energy stocks has been in a structural downtrend over the past decade. From 2010 to mid-2016, this decline was caused by a persistent underperformance in earnings. Since mid-2016, domestic energy sector EPS have been rising in relative terms, meaning that more recent underperformance has been due to multiple contractions. While not as relatively cheap as their investable peers, domestic energy stocks are heavily discounted versus the broad domestic market based on both the price/earnings ratio and the dividend yield. Consequently, it is possible that domestic energy stocks may at some point begin to outperform in a rising broad equity market environment. For now, our model argues for an underweight stance towards domestic energy due to the lack of a clear uptrend in oil prices. As a pure value play, investable energy stocks maintain a dividend yield of nearly 6.5%, and are thus more attractive than their domestic peers. Materials Chart II-2 Chart II-2 Materials Materials Table II-2 A Guide To Chinese Domestic Equity Sector Performance A Guide To Chinese Domestic Equity Sector Performance Our model for the domestic materials highlights that the sector’s performance has been related to strengthening economic activity and strongly related to a rising Li Keqiang leading indicator. Among the equity market variables that we tested, materials outperformance has been positively associated with rising relative EPS, rising broad market EPS, and prior oversold technical conditions. Similarly, the investable materials sector, these results show that domestic materials are a strong play on accelerating Chinese economic activity. The factors included in our domestic materials sector model are similar to those included in our investable material, except that relative material earnings have also been a significant predictor of sector relative performance. In addition, the macro & equity market predictors included in our domestic materials model have done a better job of leading material sector performance. The odds of domestic materials outperformance rose twice above the 50% mark this year according to our model, without any corresponding improvement in relative stock prices. The spikes in the model occurred largely because domestic materials became significantly oversold; technical conditions for the sector have only twice been weaker over the past decade. This underscores that investors should be watching domestic materials closely in Q1 of next year for signs of a relative rebound. Industrials Chart II-3 Chart II-3 Industrials Industrials Table II-3 A Guide To Chinese Domestic Equity Sector Performance A Guide To Chinese Domestic Equity Sector Performance The results of our model for domestic industrial sector outperformance are interesting, as they imply that the drivers of performance are different between the domestic and investable markets. In the investable index, we found that industrials were heavily sensitive to monetary policy, rising core inflation, relative sector earnings, and periods of rising broad market stock prices. Our domestic model is considerably simpler: industrials outperform, with a lag, when our activity index and Li Keqiang leading indicator are rising. Periods of strong overvaluation have also been significant in predicting future episodes of domestic industrial sector underperformance. It is not clear to us why the drivers of relative performance for domestic industrials have been different than in the investable equity index, But the good news is that the relative simplicity of the model makes the investment decision making process for domestic industrials considerably easier. Today, domestic industrials are significantly undervalued, and our Li Keqiang leading indicator is in a shallow uptrend. This suggests that domestic industrials are likely to begin outperforming at some point in early-2020 following a bottoming in Chinese economic activity, unless policymakers are quick to tighten once activity begins to improve (which would be contrary to our expectations). Consumer Discretionary Chart II-4 Chart II-4 Consumer Discretionary Consumer Discretionary Table II-4 A Guide To Chinese Domestic Equity Sector Performance A Guide To Chinese Domestic Equity Sector Performance Our domestic consumer discretionary model highlights that the sector’s relative performance is positively associated with a rising Li Keqiang leading indicator, rising core inflation, and rising broad market stock prices. Similar to its investable peers, domestic consumer discretionary stocks are cyclical, and positive relationship with core inflation may reflect improved pricing power for the sector. Unlike investable consumer discretionary, the domestic consumer discretionary has not been meaningfully impacted by the December 2018 changes to the global industry classification standard. Hence, our model does not exclude the internet & direct marketing retail sector as we did in our previous report on investable sectors. For now, our model suggests that the domestic consumer discretionary sector is likely to continue to underperform, given decelerating core inflation and the lack of a clear uptrend in the broad domestic equity index. However, as a cyclical sector, we will be watching closely for an upside breakout in domestic consumer discretionary performance in the first quarter as a signal to increase exposure to the sector. Consumer Staples Chart II-5 Chart II-5 Consumer Staples Consumer Staples Table II-5 A Guide To Chinese Domestic Equity Sector Performance A Guide To Chinese Domestic Equity Sector Performance Our domestic consumer staples model is significantly different than that shown in our previous report for investable staples. This reflects sizeable differences in investable/domestic staples relative performance over the past decade, particularly from mid-2015 to late-2017 (where domestic staples outperformed significantly and investable staples languished). Of the two predictors found to be significant in explaining historical periods of domestic staples performance, a negative relationship with the trend in broad market EPS has been the most important. This underscores that staples are defensive sector. The trend in staples relative earnings has closely followed in importance, showing that the tremendous outperformance in domestic consumer staples over the past several years has, at least in part, been driven by fundamentals. Still, domestic consumer staples are currently priced at 34x earnings per share, compared with 15x for the overall domestic market. While our model currently argues for continued staples outperformance, the risk of a valuation mean reversion next year, against the backdrop of an improving economy, is above average. Over the coming 6-12 months, investors should be closely monitoring domestic staples for signs of waning earnings momentum and/or a major technical breakdown as potential signals to reduce domestic staples exposure. Health Care Chart II-6 Chart II-6 Health Care Health Care Table II-6 A Guide To Chinese Domestic Equity Sector Performance A Guide To Chinese Domestic Equity Sector Performance Over the past decade, periods of domestic health care outperformance have been negatively associated with rising economic activity, rising core inflation, and rising broad market stock prices. Oversold technical conditions and periods of overvaluation have also helped predict future episodes of health care relative performance. These factors clearly point to the defensive nature of domestic health care, similar to health care stocks in the investable index. However, one clear difference between investable and domestic health care is that the former appears to have leading properties and the latter does not. We noted in our previous report that periods of investable health care underperformance appeared to lead, on average, our BCA Activity Index, periods of rising core inflation, and uptrends in the broad investable index. By contrast, domestic health care lags the Activity Index and core inflation by just over a year, and also lags the trend in broad market EPS. Our model points to further health care outperformance, but we would expect domestic health care stocks to underperform at some point next year following an improvement in economic activity and a resumed uptrend in broad domestic EPS. Financials Chart II-7 Chart II-7 Financials Financials Table II-7 A Guide To Chinese Domestic Equity Sector Performance A Guide To Chinese Domestic Equity Sector Performance Our outperformance probability model for domestic financials highlights that the sector is countercyclical: periods of outperformance have been negatively related to our LKI leading indicator, rising core inflation, and rising broad market stock prices. Similar to the case of the investable index and unlike the case globally, financials are clearly defensive. Investable financials have exhibited atypical performance this year according to the model presented in our previous report. By contrast, domestic financials have performed in line with what our model has suggested: our LKI leading indicator is in a shallow uptrend, and the relative performance of domestic financials has trended flat-to-down since late-2018. Barring a major shift by the PBoC towards a hawkish stance in the coming year (which we do not expect), our base case view for the Chinese economy implies that domestic financials are likely to continue to underperform. Banks Chart II-8 Chart II-8 Banks Banks Table II-8 A Guide To Chinese Domestic Equity Sector Performance A Guide To Chinese Domestic Equity Sector Performance Our model for domestic banks is similar to that of financials, with some important differences. In addition to being sensitive to our LKI leading indicator, domestic bank performance is negatively related to our Activity Index. Oversold technical conditions have also been quite important in predicting future episodes of domestic bank outperformance. The model is currently forecasting domestic bank underperformance, although it was late in predicting the selloff in bank stocks that began late last year. Similar to the case for domestic financials, our baseline view for the Chinese economy implies that domestic bank are likely to continue to underperform over the coming year. Information Technology Chart II-9 Information Technology Information Technology Table II-9 A Guide To Chinese Domestic Equity Sector Performance A Guide To Chinese Domestic Equity Sector Performance Our model for the domestic technology sector is different than that of investable tech, which reflects the vast difference in performance between the two sectors. While the relative performance of domestic tech has trended sideways over the past decade, investable tech stock prices have risen fourfold relative to the broad investable index. This difference is largely accounted for by the absence of the BAT stocks (Baidu, Alibaba, Tencent) from the domestic market. Similar to investable tech, domestic technology stocks are negatively related to tight monetary policy, and positively linked with a pro-cyclical economic variable (a rising LKI leading indicator). However, strangely, domestic tech has been strongly and negatively related to rising headline inflation, a finding with no clear fundamental basis. The model has been less successful in predicting domestic tech performance over the past year than in the past, which appears to be linked to the inclusion of headline inflation in the model. Rising headline inflation has been clearly associated with three major episodes of domestic tech underperformance since 2010, but over the past year domestic tech has outperformed as headline inflation accelerated. For now we would advise investors to focus on the other factors in the model: the lack of overvaluation, and our view that policy will remain easy on a measured basis, supports an overweight stance towards domestic tech over the coming year. Telecom Services Chart II-10 Telecom Services Telecom Services Table II-10 A Guide To Chinese Domestic Equity Sector Performance A Guide To Chinese Domestic Equity Sector Performance Our domestic telecom services relative performance model highlights that the sector is defensive like its investable peer, but the factors driving performance are somewhat different. The only similarity between the two models is that periods of outperformance are negatively related to rising broad market stocks prices for both investable and domestic telecom services, with domestic telecom stocks responding with a lag. Among the macro factors included in the model, periods of domestic telecom services outperformance are negatively and coincidently related to our LKI leading indicator, and positively related to tight monetary policy (with a slight lead). Oversold technical conditions have also proven to help predict future episodes of outperformance. The model failed to predict a brief period of outperformance in mid-2018, but has generally accurately predicted underperformance of domestic telecom stocks since early-2017. Barring a collapse in the US/China trade talks or considerably weaker near-term economic conditions than we expect, domestic telecom services will likely continue to underperform until the specter of tighter monetary policy emerges. This is unlikely to occur until the middle of 2020, at the earliest. Utilities Chart II-11 Utilities Utilities Table II-11 A Guide To Chinese Domestic Equity Sector Performance A Guide To Chinese Domestic Equity Sector Performance Overall, our domestic utilities model has considerably worse predictive power than our model for investable utilities. The model shows that the performance of domestic utilities is negatively related to rising core inflation (with a lag) and rising broad market EPS, but these relationships are not particularly strong. We noted in our June 19 Special Report that domestic utilities ranked highly on the impact that relative EPS had on predicting relative stock prices , yet relative sector earnings did not register as a significant predictor in our model. This apparent discrepancy is resolved by differences in the time horizon between these two approaches. The analysis that we presented in our June 19 Special Report examined the relationship between earnings and stock prices over the entire sample period (2011-2018), meaning that it examined the predictive power of earnings over the long-term. The models built in this report have focused strongly on explaining periods of outperformance over a 6-12 month time horizon, there have been enough deviations in the trend between the relative performance of utilities and relative utilities earnings that the relationship between the two was not sufficiently strong to show up in the model. In other words, the long-term link between utilities relative earnings and stock prices is strong, but the short-term link is fairly weak. Real Estate Chart II-12 Real Estate Real Estate Table II-12 A Guide To Chinese Domestic Equity Sector Performance A Guide To Chinese Domestic Equity Sector Performance Similar to investable real estate, our model shows that domestic real estate is a counter-cyclical sector in that it is negatively related to periods of rising economic activity, a rising LKI leading indicator, tight monetary policy, and rising core inflation. Overbought technical conditions have also aided in predicting future episodes of domestic real estate underperformance. Our model for domestic real estate stocks has performed quite well on average, but its predictive success since late-2017 has been mixed. This period of atypical underperformance has coincided with a considerably weaker rebound in residential floor space sold than has occurred in previous recoveries in the real estate market. This suggests that domestic real estate stocks are more susceptible to trends in housing sales than their investable peers (which appear to be mostly sensitive to rising house prices). We noted in our November 6 Weekly Report that floor space sold is picking up , but it still remains weak when compared with history. This, in combination with our view that the Chinese economy will improve over the coming year, suggests that investors should avoid domestic real estate exposure relative to the overall domestic equity market. Footnotes 1  Please see China Investment Strategy Special Report "A Guide To Chinese Investable Equity Sector Performance," dated October 30, 2019, available at cis.bcaresearch.com 2  Please see China Investment Strategy "Six Questions About Chinese Stocks," dated January 16, 2019, available at cis.bcaresearch.com 3  Please see China Investment Strategy Special Report "Chinese Equity Sector Earnings: Predictability, Cyclicality, And Relevance," dated June 19, 2019, available at cis.bcaresearch.com 4  Please see China Investment Strategy Weekly Report "China Macro And Market Review," dated November 6, 2019, available at uses.bcaresearch.com Cyclical Investment Stance Equity Sector Recommendations

Highlights In this report, we build and present models designed to predict the odds of Chinese investable equity sector outperformance, based on a set of macroeconomic and equity market factors. BCA Research's China Investment Strategy service will aim to use our newly developed sector outperformance probability models to help investors to better understand the drivers of performance at any given moment, and to make more active equity sector recommendations in the future. Among the top six factors explaining historical periods of sector performance, three were macroeconomic in orientation, and two were directly related to the broad Chinese equity market. We see this as strongly supportive of the potential returns to be earned from active top-down sector rotation within China’s investable market. Cyclical stocks are very depressed relative to defensives, and we would favor them versus defensives over the coming year if China strikes a trade deal with the US and the Chinese economy incrementally improves, as we expect. Feature In our June 19 Special Report, we reviewed the predictability and cyclicality of equity sector earnings in China's investable & domestic markets, and examined the relevance of earnings in predicting relative sector performance over the past decade. We noted that a few sectors scored highly in terms of earnings predictability and the relevance of those earnings in predicting relative performance. But we also highlighted that most of China's equity sectors, in both the investable and domestic markets, either demonstrated earnings trends that were difficult to predict based on the trend in overall market earnings or exhibited relative performance that was difficult to explain based on the relative earnings profile. Our models are designed to predict equity sector relative performance using a series of macroeconomic and equity market factors. In short, our June report underscored that China’s equity sectors warranted a closer examination, with a particular emphasis on understanding the specific macroeconomic or equity market factors that have historically predicted relative sector performance. Today’s report examines this question in depth, focused on China’s investable equity market. We hope to extend our research to the A-share market in the near future. Our approach focuses on constructing and presenting models that quantify a checklist-based approach to determining the odds of equity sector performance. The aim is to use these models to better understand the drivers of performance at any given moment, and to make more active equity sector recommendations in the future. These recommendations will not mechanically follow the models; rather, we plan to use them as a stand in for what typically would be expected given the macro and financial market environment, and as a basis to investigate “abnormal” relative performance. We conclude by highlighting the substantial underperformance of cyclical vs defensives sectors over the past two years, and argue that it is highly unlikely that cyclicals will underperform defensives over the coming 12 months if China strikes a trade deal with the US and the economy incrementally improves, as we expect. We also explain the importance of monitoring the relative performance of health care & utilities stocks over the coming few months, and present a unique sector-based barometer for gauging China’s reflationary stance. The latter two relative performance trends are likely to assist investors in positioning for the big call: the outperformance of Chinese investable stocks vs the global benchmark. Detailing Our Approach In our effort to better understand historical periods of sector outperformance, we have chosen to model the probability of outperformance of each level 1 GICS sector (plus banks) based on a set of macro and equity market variables. Specifically, we use an analytical tool called a logistic regression, which forecasts the probability of a discrete event rather than forecasting the value of a dependent variable. We utilized this approach when building our earnings recession model for China (first presented in our January 16 Special Report1), and investors will often see it (in its conceptually different but practically similar probit form) employed when analyzing the likelihood of an economic recession. The New York Fed’s US recession model is a notable example of the latter,2 which has received much attention by market participants over the past year following the inversion of the US yield curve. The “events” that we modeled are historical periods of individual Chinese investable sector outperformance from 2010 to 2018, relative to the MSCI China index (the “broad market”). Charts I-1A and I-1B illustrate these periods with shading in each panel. We then attempt to explain these episodes of outperformance with the following macro predictors: Chart I-1AThis Report Builds Models Aimed At... This Report Builds Models Aimed At... This Report Builds Models Aimed At... Chart I-1B...Predicting The Shaded Regions Of These Charts ...Predicting The Shaded Regions Of These Charts ...Predicting The Shaded Regions Of These Charts Periods of accelerating economic activity, represented by our BCA's China Activity Index Periods of rising leading indicators of economic activity, represented by our BCA Li Keqiang Leading Indicator Episodes of tight monetary policy, defined as periods where China’s 3-month interbank repo rate is rising Periods of accelerating inflation, measured both by headline and core inflation We also include several equity market variables: uptrends in relative sector earnings, periods of rising broad market stock prices, uptrends in broad market earnings, and episodes of extreme technical conditions and relative over/undervaluation for the sector in question. In the case of energy stocks, we also include oil prices as a predictor. Charts I-2A and I-2B illustrate these periods as well as the macro & market variables that we have included as predictors. Chart I-2AWe Use These Macroeconomic And Equity Market Factors... We Use These Macroeconomic And Equity Market Factors... We Use These Macroeconomic And Equity Market Factors... Chart I-2B...To Predict Periods Of Equity Sector Outperformance ...To Predict Periods Of Equity Sector Outperformance ...To Predict Periods Of Equity Sector Outperformance Our approach also accounts for the existence of any leading or lagging relationships between the macro and market variables we have used as predictors and sector relative performance. In most cases the predictors lead relative sector performance, but in some cases it is the opposite. In the case of the latter, we have limited the lead of any variable in our models to 3 months in order to reduce the need to forecast. The link between tight monetary policy and industrial sector performance is one exception to this rule that we detail below. Finally, our approach also limits the extent to which we consider a leading relationship between our predictors and relative sector performance, in order to avoid picking up overlapping economic cycles. This issue, and the evidence supporting the existence of a 3½-year credit cycle in China, are detailed in Box 1. Box 1 Accounting For China’s 3½-Year Credit Cycle Over the course of the analysis detailed in this report, judgments concerning how much of a lead or lag to allow when accounting for any leading or lagging relationships between sector relative performance and either macroeconomic & stock market predictors were necessary. In cases where sector relative performance led any of our predictors, we capped the lead at 3-months to reduce the need to forecast the predictors when using the models. As explained below, the 8-month lead between industrial sector relative performance and tight monetary policy was the only exception to this rule. We also did not include any leading relationship between relative sector stock performance and the trend in relative sector EPS, and allowed at most a co-incident relationship. Limits were also required in the cases where our predictors led relative sector performance. While more lead time is usually better from the perspective of investment strategy, Chart I-B1 presents strong evidence of a 3½ -year credit cycle in China. Chart I-B2 illustrates the problem with including significant lags between predictors and relative sector performance when economic cycles are short. The chart shows the lead/lag correlation profile of the stylized cycle shown in Chart I-B1, and highlights that lags greater than 12-14 months risk picking up the impact of the previous economic cycle. Given this, we have limited the extent to which our predictors can lead relative sector performance in our models, and in practice lead times are generally less than one year. Chart I-B1Over The Past Decade, China Has Experienced A 3½-Year Credit Cycle A Guide To Chinese Investable Equity Sector Performance A Guide To Chinese Investable Equity Sector Performance Chart I-B2With Short Cycles, Excessive Lags Risk Picking Up The Previous Cycle With Short Cycles, Excessive Lags Risk Picking Up The Previous Cycle With Short Cycles, Excessive Lags Risk Picking Up The Previous Cycle The Key Drivers Of Chinese Investable Equity Sectors Pages 12-23 present the results of each sector’s outperformance probability model, along with a list of factors that were found to be useful predictors and a summary of the results. The importance of the factors included in the models is shown in each of the tables at the top right of pages 12-23 by a score of 1-3 stars, (loosely representing key levels of statistical significance) as well as each factor’s optimal lead or lag. A minus sign shows that the predictor leads sector relative performance, whereas a plus sign shows that it lags. Rising core inflation in China is the most important signal of sector performance that emerged from our analysis. Chart I-3China’s Sectors Linked Strongly To Core Inflation, Monetary Policy, And Growth A Guide To Chinese Investable Equity Sector Performance A Guide To Chinese Investable Equity Sector Performance Chart I-3 summarizes the significance of the factors in predicting sector performance in general, by summing up each predictor’s number of stars across all of the models. The chart shows that rising core inflation in China is the most important signal of sector performance that emerged from our analysis, followed by tight monetary policy, rising economic activity, rising broad market stock prices, oversold technical conditions, and rising broad market earnings. Chart I-3 highlights two important points: If regarded through the lens of causality alone, the strong relationship between rising core inflation and sector performance is somewhat surprising: normally, pricing power is subordinate to revenue/sales/demand as the primary factor driving fundamental performance. However, given that inflation is a lagging economic variable, we suspect that the significance of inflation in our models actually reflects the middle phase of the economic cycle in which sectors tend to best exhibit meaningful out/underperformance. It is also a stronger predictor of periods of tight monetary policy in China than headline inflation.3 This is an encouraging result for investors, as it suggests good odds that future episodes of meaningful sector outperformance can be identified given a particular macro view. Among the top six factors explaining historical periods of sector performance, three were macroeconomic in orientation, and two were directly related to the broad Chinese equity market. While Chinese equity sector performance can sometimes be idiosyncratic, we see this as strongly supportive of the idea that investors can earn positive excess returns by actively shifting between China’s equity sectors using a top-down approach. Turning to the specific results of our sector models, we present the following big-picture findings of our research: Defining China’s Cyclical & Defensive Sectors From a top-down perspective, the most important element of sector rotation typically involves shifting from defensive to cyclical stocks when economic activity is set to improve (and vice versa). In China, it is clear from the results of our models that the investable energy, materials, industrials, consumer discretionary, and information technology sectors are cyclical sectors. The relative performance of these sectors exhibits a positive relationship to pro-cyclical macro variables, or broad market trends. Following last year’s GICS changes, we also include the media & entertainment industry group (within the new communication services sector) in this list. Correspondingly, investable consumer staples, health care, financials, telecom services, utilities, and real estate are defensive sectors in China. Chart I-4Cyclical Stocks Are Bombed Out Versus Defensives Cyclical Stocks Are Bombed Out Versus Defensives Cyclical Stocks Are Bombed Out Versus Defensives Chart I-4 illustrates how these sectors have performed over the past decade by grouping them into equally-weighted cyclical and defensive stock price indexes, as well as the relative performance of cyclicals versus defensives. The chart makes it clear that cyclical stock performance is essentially as weak as it has ever been relative to defensives over the past decade, with the exception of a brief period in 2013. Panel 2 highlights that all of the underperformance of cyclicals over the past two years has been due to de-rating, rather than due to underperforming earnings. The Atypical Case Of Financials & Real Estate The fact that financial and real estate stocks are defensive in China is somewhat curious. In the case of financials, the abnormality is straightforward: most global equity portfolio managers would consider financials to be cyclical, and our work suggests that this is not true for the investable market. Our explanation for this apparent discrepancy is also straightforward: while small and medium banks in China have obviously grown in prominence over the past decade, large state-owned or state-affiliated commercial banks are still dominant in the provision of credit to China's old economy. In most cases China’s large banks lend to state-owned enterprises with implicit government guarantees, meaning that the earnings risk for Chinese banks has typically been lower than for the investable market in the aggregate. It remains to be seen whether this will remain true in a world where Chinese policymakers are keen to slow the pace at which China’s macro leverage ratio rises and to render the existing stock of debt more sustainable for the non-financial sector. Indeed, over a multi-year time horizon, the risk are not trivial that banks will be forced to recapitalize as a result of forced changes to loan terms (eg: significant increases in the amortization period of existing loans) or the recognition of sizeable loan losses, which would clearly increase the cyclicality of the Chinese investable financial sector. Chart I-5A Seeming Contradiction: Real Estate Is High-Beta, But Defensive A Seeming Contradiction: Real Estate Is High-Beta, But Defensive A Seeming Contradiction: Real Estate Is High-Beta, But Defensive On the real estate front, the anomaly is not that real estate stocks respond defensively to macroeconomic and stock market variables, it is that real estate stock prices are considerably more volatile than this defensive characterization would suggest. Globally (and especially in the US), real estate stocks are often viewed as bond proxies and thus are typically low-beta, but Chart I-5 shows that this is not the case in China. In our view, this issue is reconciled by the fact that Chinese investable real estate stocks are also highly positively linked to Chinese house price appreciation, with relative performance typically leading a pickup in house prices by up to 1 year. This strongly leading relationship has meant that real estate stocks have often outperformed the broad market as economic activity is slowing, in anticipation that policy easing will lead to an eventual recovery in house prices. Chart I-6Still Following The Defensive Playbook This Year Still Following The Defensive Playbook This Year Still Following The Defensive Playbook This Year In effect, investable real estate stocks are a high-beta sector that have acted counter-cyclically due to the historical interplay between economic activity, monetary policy, and the housing market. Real estate performance this year has not deviated from this playbook (Chart I-6), and so for now we are content to include real estate stocks in our defensive index. But similar to the case of financials, we can conceive of scenarios in which ongoing Chinese financial sector reform may change this relationship in the future. The Unique Monetary Policy Sensitivity Of Industrials And Consumer Staples Pages 14 and 16 highlight that industrials and consumer staples stocks have typically been sensitive to periods of tight monetary policy. In the case of industrials the relationship is negative, whereas consumer staples relative performance has been positively linked to these periods. In both cases, relative performance has led periods of tight monetary policy, significantly so in the case of industrials (by an average of 8 months). While the relative performance of banks, tech, and real estate stocks have also been linked to periods of tight monetary policy, industrials and consumer staples are the only sectors that have tended to lead these periods. Chart I-7Diverging Corporate Health Explains Industrials/Staples Monetary Policy Sensitivity Diverging Corporate Health Explains Industrials/Staples Monetary Policy Sensitivity Diverging Corporate Health Explains Industrials/Staples Monetary Policy Sensitivity This is a revelatory finding, and in our view it is explained by divergences in corporate health and leverage for the two sectors. We reviewed Chinese corporate health in our August 28 Special Report,4 and noted that the food & beverage sub-industry was a clear (positive) outlier based on our corporate health monitors. In particular, Chart I-7 highlights that food & beverage corporate health is markedly better than that for machinery companies or for industrial firms in general, supporting the notion that high (low) leverage is impacting the relative performance of industrials (consumer staples). The Leading Nature Of Health Care & Utilities Health care and utilities exhibit similar key drivers of relative performance: in both cases, periods of rising economic activity, rising core inflation, and rising broad market stock prices are all negatively associated with performance. Health care and utilities relative performance also happens to lead all three of those predictors, by 1-3 months on average depending on the variable in question. Our modeling work highlights that these are the only sectors whose relative performance has led multiple factors, suggesting that health care & utilities stocks are particularly interesting market bellwethers to monitor. Core Inflation Matters More Than Headline, Except For Energy & Real Estate As highlighted in Chart I-3, rising core inflation has been a much more important signal about relative sector performance than headline inflation. Chart I-8In China, Food Prices (Not Energy) Account For Headline/Core Differences In China, Food Prices (Not Energy) Account For Headline/Core Differences In China, Food Prices (Not Energy) Account For Headline/Core Differences The two exceptions to this rule relate to the energy and real estate sectors, with the former positively linked to headline inflation and the latter negatively linked. In both cases, we suspect that the relationship is a behavioral rather than a fundamental one. For energy, while rising headline inflation in developed countries is usually associated with rising energy prices, this is not true in the case of China. Chart I-8 highlights that differences between headline and core inflation over the past decade have almost always been driven by rising food prices. This implies that some investors (incorrectly) view energy stocks as a hedge against increases in consumer prices, even if those increases are not driven by rising fuel costs. In the case of real estate, investor expectations of eroding real disposable income and its impact on the housing market are likely the best explanation for the negative link between real estate relative performance and rising headline inflation. Whereas rising core inflation likely reflects a durable improvement in economic momentum (and thus would be positively correlated with income growth), episodes of rising Chinese headline inflation often reflect supply shocks that investors may perceive to be detrimental to household spending power (and thus expected housing demand). Investment Conclusions Our work aimed at explaining historical periods of Chinese investable sector outperformance has three investment implications in the current environment. Cyclicals will probably outperform defensives over the coming year if China strikes a trade deal with the US and the Chinese economy incrementally improves, as we expect. First, within China’s investable market, Chart I-4 illustrated that cyclical stocks are very depressed relative to defensives. Given our view that Chinese investable stocks are likely to outperform their global peers over a 6-12 month time horizon, we would also favor cyclicals to defensives over that period. For investors who are not yet overweight cyclical stocks in China, we would advise waiting for concrete signs that growth has bottomed (which should emerge sometime in Q1) before putting on a long position as we remain tactically neutral towards Chinese versus global stocks. But the key point is that it is highly unlikely that cyclicals will underperform defensives over the coming year if China strikes a trade deal with the US and the Chinese economy incrementally improves, as we expect. Second, the fact that investable health care and utilities stocks have particularly leading properties suggests that they should be monitored closely over the coming few months. A technical breakdown in the relative performance of these sectors would be an important sign that market participants are anticipating a bottoming in China’s economy, which may give investors a green light to position for a bullish cyclical stance. For now, both of these sectors continue to outperform (Chart I-9), supporting our decision to remain tactically neutral towards Chinese stocks. Third, the heightened negative sensitivity of industrials and positive sensitivity of consumer staples to monetary policy suggests that the relative performance trend between the two sectors may serve as a reflationary barometer for China’s economy. Chart I-10 shows that industrials outperformed staples last year once the PBOC shifted into easing mode, and anticipated the recovery in the pace of credit growth. However, industrials soon began to underperform staples, which also seems to have anticipated the fact that the recovery in credit was set to be less powerful than what has occurred during previous cycles. The fact that the relative performance trend is off its recent low is notable, and may suggest that China’s existing reflationary stance will be sufficient to stabilize economic activity if a trade deal with the US is indeed finalized in the near future. Chart I-9Key Defensive Sectors Are Still Outperforming, Supporting Our Neutral Tactical Stance Key Defensive Sectors Are Still Outperforming, Supporting Our Neutral Tactical Stance Key Defensive Sectors Are Still Outperforming, Supporting Our Neutral Tactical Stance Chart I-10Industrials Vs. Staples Anticipated That Easing Would Only Be Measured Industrials Vs. Staples Anticipated That Easing Would Only Be Measured Industrials Vs. Staples Anticipated That Easing Would Only Be Measured As a final point, BCA Research's China Investment Strategy service will aim to use our newly developed sector outperformance probability models to make more active equity sector recommendations in the future. These recommendations will not mechanically follow the models; rather, we plan to use the models as a stand in for what typically would be expected given the macro and financial market environment, and as a basis to investigate “abnormal” relative performance. We hope you will find these models to be a helpful quantification of the risk versus return prospects of allocating among China’s investable sectors. As always, we welcome any feedback that you may have about our approach.   Energy Chart II-1 Energy Energy Table II-1 A Guide To Chinese Investable Equity Sector Performance A Guide To Chinese Investable Equity Sector Performance   Unsurprisingly, our energy sector model highlights that periods of energy outperformance are strongly linked to periods of rising crude oil prices. However, what is surprising is that periods of accelerating headline inflation in China are even more closely linked to periods of energy sector outperformance than episodes of rising oil prices, and that these periods of accelerating inflation are not generally caused by rising energy prices. The lack of a clear economic rationale for this relationship implies that some investors (incorrectly) view energy stocks as a hedge against increases in consumer prices, even if those increases are largely driven by rising food prices. The model also highlights that periods of strong undervaluation have historically been significant in predicting future energy sector outperformance, with a lag of roughly 8 months. The probability of energy sector outperformance has fallen sharply according to our model, but for now we continue to recommend a long absolute energy sector position on a 6-12 month time horizon. BCA’s Commodity & Energy Strategy service expects oil prices to trade at $70/barrel on average next year,5 Chinese headline inflation continues to rise, and we noted in our October 2 Weekly Report that energy stocks are heavily discounted.6 Barring a durable decline in oil prices below $55/barrel, investors should continue to favor China’s energy sector. Materials Chart II-2 Materials Materials Table II-2 A Guide To Chinese Investable Equity Sector Performance A Guide To Chinese Investable Equity Sector Performance Our model highlights that the materials sector is one of the clearest plays on accelerating industrial activity within the investable universe. Among the macro variables that we tested, periods of investable materials outperformance are strongly positively linked with periods when our BCA Activity Index and our leading indicator for the index have been rising. Periods of materials sector outperformance have also been positively correlated with prior periods of oversold technical conditions and rising broad market stock prices, underscoring that materials are a strongly pro-cyclical sector. We currently maintain no active relative sector trades, but our model suggests that investors should be underweight the investable materials sector relative to the broad investable index. Industrials Chart II-3 Industrials Industrials Table II-3 A Guide To Chinese Investable Equity Sector Performance A Guide To Chinese Investable Equity Sector Performance Periods of industrial sector outperformance have historically been positively correlated with relative industrial sector earnings, broad market stock prices, and prior oversold technical conditions. They have been negatively correlated with periods of tight monetary policy, rising core inflation, and prior overbought technical conditions. Since 2010, periods of industrial sector performance have led periods of tight monetary policy by 8 months, the longest lead of relative equity performance to any macro variable that we tested in our model (and the longest lead that we allowed). Industrial sector performance has also been strongly negatively linked with periods of rising core inflation. These findings, and the fact that our Activity Index and its leading indicator have not been highly successful at predicting periods of industrial sector outperformance, strongly suggest that industrials, while pro-cyclical, are primarily driven by expectations of easy monetary policy. We noted in an August 2018 Special Report that state-owned enterprises have become substantially leveraged over the past decade,7 and in a more recent report we highlighted that industries such as machinery have experienced a significant deterioration in corporate health over the past decade.8 This helps explain why industrial sector performance is so negatively impacted by tight policy. Our model suggests that the best time to be overweight industrial stocks is the early phase of an economic rebound, when Chinese stock prices are rising but market participants are not yet expecting tighter policy. These conditions may present themselves sometime in Q1, but probably not over the coming 0-3 months. Consumer Discretionary Ex-Internet & Direct Marketing Retail Chart II-4 Consumer Discretionary Ex-Internet & Direct Marketing Retail Consumer Discretionary Ex-Internet & Direct Marketing Retail Table II-4 A Guide To Chinese Investable Equity Sector Performance A Guide To Chinese Investable Equity Sector Performance Besides materials, China’s investable consumer discretionary sector has historically been the most positively associated with coincident and leading measures of industrial activity. Rising core inflation is also highly positively related to consumer discretionary outperformance, which may reflect improved pricing power for the sector. The strong link with industrial activity is in contrast to depictions of China’s consumer sector as being less correlated to money & credit trends than the overall economy, and is supportive of our view that industrial activity forms one of the three pillars of China’s business cycle.9 We ended the estimation period of our model as of December 2018, in order to avoid including the distortive effects of last year’s changes to the global industry classification standard (which resulted in Alibaba’s inclusion and overwhelming representation in the investable consumer discretionary sector). As such, the results of our model apply today to consumer discretionary stocks ex-internet & direct marketing retail. For now, the absence of an uptrend in our Activity Index and in core inflation is signaling underperformance of discretionary stocks outside of internet & direct marketing retail. Outperformance this year largely reflects a significant advance in consumer durable and apparel: by contrast, automobiles & components have underperformed the broad market by roughly 14% year-to-date. Consumer Staples Chart II-5 Consumer Staples Consumer Staples Table II-5 A Guide To Chinese Investable Equity Sector Performance A Guide To Chinese Investable Equity Sector Performance Historically, periods of consumer staples outperformance have been predicted by a falling Activity Index, periods of tight monetary policy, and over/undervalued conditions. The impact of monetary policy is particularly heavy in the model, suggesting that consumer staples are somewhat the mirror image of industrials in terms of the impact of leverage on relative equity performance. This too is supported by our August 28 Special Report,10 which noted that corporate health for the food & beverage sector was the strongest among the sectors we examined. However, the model failed to capture what has been very significant staples outperformance this year, highlighting the occasional limits of a rule-of-thumb approach to sector allocation. Investable consumer staples are reliably low-beta compared with the broad market, and we are not surprised that investors have strongly favored the sector this year amid enormous economic and policy uncertainty. An eventual improvement in economic activity, coupled with fairly rich valuation, should work against consumer staples stocks sometime in the first quarter of 2020. Investors who are positioned in favor of China-related assets should also be watching closely for any signs of a technical breakdown in the relative performance trend of investable staples. Health Care Chart II-6 Health Care Health Care Table II-6 A Guide To Chinese Investable Equity Sector Performance A Guide To Chinese Investable Equity Sector Performance Among the macro variables tested in our model, periods of health care outperformance are negatively related to coincident and leading measures of industrial activity and strongly negatively related to rising core inflation.  Health care outperformance is also strongly negatively related to periods of rising broad market stock prices, and positively related to prior oversold technical conditions. These results clearly signify that investable health care is a defensive sector, to be owned when the economy is slowing and when investable stocks in general are trending lower. Our model suggests that health care stocks are likely to continue to outperform, as they have been since the beginning of the year. A substantive US/China trade deal that meaningfully reduces economic uncertainty remains the key risk to health care outperformance over a 6- to 12-month time horizon. Financials Chart II-7 Financials Financials Table II-7 A Guide To Chinese Investable Equity Sector Performance A Guide To Chinese Investable Equity Sector Performance Our model highlights that periods of financial sector outperformance over the past decade have been negatively associated with periods of rising core inflation (a strong relationship), and with periods of rising index earnings. Oversold technical conditions have also helped explain future episodes of financial sector outperformance. The link between core inflation and the outperformance of financials appears to represent a behavioral rather than a fundamental relationship. When modeling periods of rising financial sector relative earnings, the trend in broad market EPS is more predictive than that of core inflation, highlighting that the latter’s explanatory power is due to investor behavior. The results of our model, and the fact that core inflation leads Chinese index earnings, suggests that financials are fundamentally counter-cyclical and that investors see rising Chinese core inflation as confirmation that an economic expansion is underway (and that broad market earnings are likely to rise). Our model is currently predicting financial sector outperformance, but investable financials have modestly underperformed since the beginning of the year. This appears to have been caused by the underperformance of financial sector earnings this year as overall index earnings growth has decelerated, contrary to what history would suggest. We suspect that the ongoing shadow banking crackdown is related to financial sector earnings underperformance, and we would advise against an overweight stance towards investable financials until signs of improving relative earnings emerge. Banks Chart II-8 Banks Banks Table II-8 A Guide To Chinese Investable Equity Sector Performance A Guide To Chinese Investable Equity Sector Performance Our model shows that periods of banking sector outperformance are more linked to macro variables than has been the case for the overall financial sector. Specifically, bank performance is negatively correlated with leading indicators of economic activity and rising core inflation, and especially negatively correlated with periods of tight monetary policy. Banks have also typically outperformed following periods of oversold technical conditions. Similar to financials, bank earnings are typically counter-cyclical, but relative bank earnings have not been good predictors of relative bank performance over the past decade. Still, the negative association of relative stock prices with leading economic indicators, rising core inflation and rising interest rates underscores that investors should normally be underweight banks if they expect overall Chinese stock prices to rise. Also similar to the overall financial sector, our model is currently predicting outperformance for bank stocks, but investable banks have underperformed year-to-date. The shadow banking crackdown is also likely impacting investable bank earnings, leading to a similar recommendation to avoid bank stocks until relative earnings look to be trending higher. “Tech+”   Chart II-9 Tech+' Tech+' Table II-9 A Guide To Chinese Investable Equity Sector Performance A Guide To Chinese Investable Equity Sector Performance Our technology model has worked well at predicting periods of tech sector outperformance over the past several years, particularly from 2015 – 2017. The model suggests that, in addition to being negatively related to prior overbought conditions, periods of technology sector outperformance are associated with improving growth conditions, easy monetary policy, and rising prices. In other words, tech stocks are a growth & liquidity play. Owing to last year’s changes to the GICS, the results of our model apply today to Chinese investable internet & direct marketing retail, the media & entertainment industry group (within the new communication services sector), and the now considerably smaller information technology sector (the sum of which could be considered the “tech+” sector). The model has been predicting tech sector outperformance since May (in response to easier monetary policy), which has occurred for the official information technology sector. However, the BAT (Baidu, Alibaba, and Tencent) stocks are only up fractionally in relative terms from their late-May low. Our expectation that China’s economy is likely to bottom in Q1 means that we may recommend upgrading “tech+” stocks relative to the investable benchmark in the coming months. Telecom Services Chart II-10 Telecom Services Telecom Services Table II-10 A Guide To Chinese Investable Equity Sector Performance A Guide To Chinese Investable Equity Sector Performance Our model for telecommunication services (now a level 2 industry group within the communication services sector) illustrates that telecom stocks have historically been counter-cyclical. Periods of telecom outperformance have been negatively associated with periods of rising core inflation, rising broad market stock prices, and rising broad market EPS. It is notable that telecom services stocks are driven more by cycles in overall stock prices than by cycles in economic activity. This suggests that investors tend to focus on the fact that telecom stocks are reliably low-beta compared with the overall investable market, causing out(under)performance of telecoms when the broad market is falling(rising). Similar to financials & banks, telecom stocks have not outperformed this year, in contrast to what our model would suggest. Earnings also appear to be the culprit, with the level of 12-month trailing earnings having fallen nearly 10% since the summer. China Mobile accounts for a sizeable portion of the telecom services index, and the company’s recent earnings weakness seems to be due to depreciation charges stemming from forced investment on 5G spending (mandated by the Chinese government). Our sense is that this will have only a temporary effect on telecom services EPS, meaning that investors should continue to expect the sector to behave in a counter-cyclical fashion over the coming year. Utilities Chart II-11 Utilities Utilities Table II-11 A Guide To Chinese Investable Equity Sector Performance A Guide To Chinese Investable Equity Sector Performance The early performance of our utilities model was mixed, as it generated several false sell signals during the 2011 – 2013 period despite recommending, on average, an overweight stance. However, over the past five years, the model has performed extremely well in terms of explaining periods of relative utilities performance. The model highlights that utilities are straightforwardly counter-cyclical. The relative performance of utilities stocks is positively related to its relative earnings trend, and negatively related to economic activity, rising core inflation, and broad market stock prices.  Consistent with a decline in the overall MSCI China index, the model has correctly predicted utilities outperformance this year. We expect utilities to underperform over a 6-12 month time horizon, but would advise against an aggressive underweight position until hard evidence of a bottom in Chinese economic activity emerges. Real Estate Chart II-12 Real Estate Real Estate Table II-12 A Guide To Chinese Investable Equity Sector Performance A Guide To Chinese Investable Equity Sector Performance Our model for the relative performance of investable real estate has been among the most successful of those detailed in this report, which is somewhat surprising given the macro factors that the model shows drive real estate performance. While periods of relative real estate performance are modestly (negatively) associated with periods of tight monetary policy, rising headline inflation is the most important macro predictor of real estate underperformance. Among market factors driving performance, real estate stocks reliably underperform when broad market EPS are trending higher, and they historically outperform for a time after becoming relatively undervalued. Real estate relative performance is also strongly linked to periods of rising house prices, but the former tends to significantly lead the latter. Given that core inflation has better predicted episodes of tight monetary policy than headline inflation, investor expectations of eroding real disposable income is likely the best explanation for the negative link between real estate relative performance and rising headline inflation. Whereas rising core inflation likely reflects a durable improvement in economic momentum (and thus would be positively correlated with income growth), episodes of rising Chinese headline inflation often reflect supply shocks that investors may perceive to be detrimental to household spending power (and thus expected housing demand). Beyond the negative link between higher inflation and interest rates on investable real estate performance, the strong negative association with broad market earnings underscores that investors treat real estate as a defensive sector. We thus expect real estate stocks to continue to outperform in the near term, but underperform over a 6-12 month time horizon.   Jonathan LaBerge, CFA Vice President jonathanl@bcaresearch.com   Footnotes 1. Please see China Investment Strategy, "Six Questions About Chinese Stocks," dated January 16, 2019. 2. Please see Federal Reserve Bank of New York, The Yield Curve as a Leading Indicator at https://www.newyorkfed.org/research/capital_markets/ycfaq.html 3. This is despite frequent concerns among investors that the PBOC is inclined to tighten in response to detrimental supply shocks. 4. Please see China Investment Strategy, "Messages From BCA’s China Industry Watch," dated August 28, 2019. 5. Please see Commodity & Energy Strategy, "Policy Uncertainty Lifts USD, Stifles Global Oil Demand Growth," dated October 17, 2019. 6. Please see China Investment Strategy, "China Macro & Market Review," dated October 2, 2019. 7. Please see China Investment Strategy, "Chinese Policymakers: Facing A Trade-Off Between Growth And Leveraging," dated August 29, 2018. 8. Please see China Investment Strategy, "Messages From BCA’s China Industry Watch," dated August 28, 2019. 9. Please see China Investment Strategy, "The Three Pillars Of China’s Economy," dated May 16, 2018. 10. Please see China Investment Strategy, "Messages From BCA’s China Industry Watch," dated August 28, 2019. Cyclical Investment Stance Equity Sector Recommendations

Overweight Last week Costco reported its fiscal fourth-quarter earnings, which came in beating expectations. These results are good news for our S&P hypermarkets overweight call as Costco accounts for nearly 50% of the index. We first recommended investors increase their exposure to this plain vanilla consumer defensive industry just under 3 months ago, and this position is already up 8% relative to the SPX since inception. Macroeconomic data remains soft across the board heralding more gains for the S&P hypermarkets index (second panel). Meanwhile, industry specific data is encouraging, with Big Box retail sales slated to firm further (third & bottom panels). Specifically, hypermarkets’ pricing power is set to increase as the relative consumer confidence by income (defined as the ratio of Americans who make less than $35,000/annum to those who make above $35,000/annum) has climbed to fresh cyclical highs (bottom panel). Bottom Line: Consumer staples stocks in general and hypermarkets in particular continue to shine. Stay overweight the S&P hypermarkets index. The ticker symbols for the stocks in this index are: BLBG: S5HYPC - WMT, COST. Believe The Hype Believe The Hype    

In late-summer 2010, we published a Special Report overviewing long-term U.S. equity sector relative performance during deflationary periods. Since then, inflation – core PCE deflator to be more specific – only briefly flirted with the Federal Reserve’s 2% target in mid-2018, while long-term inflation expectations never managed to re-anchor higher. Worrisomely, there are now budding signs that inflation will weaken in the coming quarters rather than rear its ugly head. Pundits – us included – are still waiting for inflationary pressures to finally pass-through. Worrisomely, there are now budding signs that inflation will weaken in the coming quarters rather than rear its ugly head (Chart 1). The late-2018 tightening in financial conditions will exert downward pressure on year-over-year CPI growth, albeit with a slight lag (top panel, Chart 1). More broadly, the ongoing deceleration in the U.S. economy, as evidenced by the sharp decline in the ISM manufacturing PMI (and most of its subcomponents), represents a serious headwind for inflation (second panel, Chart 1). Given weak global growth, the appreciating U.S. dollar – a countercyclical currency – will also weigh on inflation going forward (not shown). Further, we don’t view the recent perky inflation prints as sustainable. In fact, core goods CPI – which accounts for 25% of core CPI and has been the main driver lately – is expected to roll over and contract over the next 18 months (third panel, Chart 1). Chart 1Still Looking For Inflation? Still Looking For Inflation? Still Looking For Inflation? U.S. Equity Strategy’s corporate pricing power proxy has also sharply sunk corroborating that the path of least resistance is lower for core inflation (bottom panel, Chart 1). In other words, if Marty McFly could ride the DeLorean to travel back in time once more, he would certainly approve of deflation/disinflation being a major equity theme at BCA, and would even ask us to delve deeper into our prior analysis. That is precisely what we do in this Special Report. We acknowledge the current disinflationary trend and provide more details on the historical relative performance of the different equity sectors in such periods. We introduce a simple trading rule based on these deflationary episodes, which we define as two or more consecutive quarters of negative corporate sector price deflator growth (Chart 2). We treat single quarters of positive growth within broader deflationary trends as outliers, which translate into the occasional quarterly rebounds within the shaded areas. Chart 2Deflationary Periods Deflationary Periods Deflationary Periods The next pages provide some more color on the sectors historical relative performance. Notably, we add a brief overview of the annualized returns realized by heeding the signals from two consecutive quarters of negative corporate sector price deflator growth. Since 1960, there have been 27 such signals, with a median duration of 15 months and the shortest one being six months. As such, we feel comfortable using 6-, 12- and 24-month horizons to go long (short) the sectors we identified did well during deflationary (inflationary) periods, whenever signaled. Table 1 summarizes the results of this empirical exercise. Table 1 Sector Relative Performance And Deflation (From 1960 To Present) Sector Performance In A Deflationary World: Back To The Future? Sector Performance In A Deflationary World: Back To The Future? Our hypothesis during disinflationary periods is that defensives outshine cyclicals. The results for the GICS11 relative sector performance are consistent with our hypothesis. Specifically, following our deflationary signal, defensives are up 1.4% on a 6-month horizon, while cyclicals are down 2.5%. We also note an inflection point around the 12-month mark as cyclicals start to recover their losses moving from -2.5% to just -0.21%, while defensives are giving up their gains moving from 1.38% to 0.76%. This finding is consistent with the median deflation period duration of 15 months, as highlighted earlier. Similarly, if we look 24 months out, we observe that cyclicals are outperforming the market by 0.5% (largely driven by tech), and defensives are lagging the market by -1.2% (dragged by telecom and utilities) signaling that the market has recovered. Diagram 1Performance Time Line Sector Performance In A Deflationary World: Back To The Future? Sector Performance In A Deflationary World: Back To The Future? Importantly, we are currently in a deflationary environment as defined by our two-quarter signal that commenced mid-2018, and U.S. Equity Strategy has been actively reducing cyclical exposure over the past six months and highlighting that investors should be cautious on the prospects of the broad equity market. Turning back to Table 1, we also see some divergences in the GICS1 sector performance vs. some of our expectations. Utilities should outperform during disinflation periods, owing to two factors: (1) steady cash flow growth, (2) falling interest rates boost the allure of high yielding competing assets. Another notable outlier is the S&P consumer discretionary index. Specifically, the roughly 2% underperformance in the six months following our deflationary signal took us by surprise, as discretionary spending should at the margin get a boost from declining interest rates. To conclude, we also present a time line that summarizes results from Table 1 as well as the sector specific comments. Importantly, the time line is a road map that should be only used “as a rule of thumb” guide to navigate a deflationary environment. Keep in mind, that even though the median duration for a deflationary period is 15 months, it can still last anywhere from just under a year to over four years. As always, context is key. Finally, stay tuned for an update on our traditional U.S. equity sector profit margin outlook report that is due in the upcoming months. What follows are additional details of our analysis on a per sector basis, along with charts on sector specific pricing power and revenue turnover.     Jeremie Peloso, Research Analyst JeremieP@bcaresearch.com   Arseniy Urazov, Research Associate ArseniyU@bcaresearch.com   Consumer Staples (Overweight) Consumer Staples Consumer Staples The S&P consumer staples index performs well during deflationary periods. Likely explanatory variables are the safe haven status of this index along with an ongoing industry consolidation. Our sector pricing power proxy reveals that staples have not experienced a contraction in pricing power since 2003. While relative share prices are staging a recovery, they are still one standard deviation below the historical time trend. Further gains are likely given impressive returns on a 6-, 12-, and 24-month time horizon following our deflationary signal. We remain overweight the S&P consumer staples index. Consumer Staples Consumer Staples Energy (Overweight) Energy Energy Among the cyclical sectors, S&P energy is the second largest underperformer, declining 3.4% on average in relative terms in the six months following our deflationary signal. The underperformance is also evident in our PP proxy. Energy companies’ PP declines right as the economy enters deflation, which is consistent with our expectations, as oil plays a key role in virtually any inflation/deflation measure. One caveat at the current juncture is the recent oil price spike that may serve as a catalyst to unlock excellent value in bombed out energy equities. As a result of the drone attacks on Saudi Arabia’s production and refining facilities we expect geopolitical premia to get built into crude oil prices on a sustained basis. We are currently overweight the S&P energy index. Energy Energy Health Care (Overweight) Health Care Health Care During deflationary periods the S&P health care sector has outperformed the broad market, similar to its defensive sibling, the S&P consumer staples sector. On top of the safe haven nature of the health care industry, pricing power has never crossed below the zero line during the entire history of the data series. This remarkable feat also applies to the sector’s sales growth. We are currently overweight the S&P health care index. Health Care Health Care Industrials (Overweight) Industrials Industrials On the eve of deflation, industrials equities start wrestling with two opposing forces: cheapened raw materials versus slowing economic activity. In the end, economic softness wins the tug-of-war as this deep cyclical index underperforms the market on 6-, 12- and 24-month time horizon by -1.4%, -1.0% and -0.5%, respectively. The sector’s pricing power usually displays a sharp decline as we enter a deflationary zone weighing on industrials revenue prospects and thus relative performance. We are currently overweight the S&P industrials sector. Industrials Industrials Financials (Overweight) Financials Financials Being an early cyclical sector, it is not surprising that the S&P financials sector tends to underperform the broad market on 6-, 12- and 24-month horizon following our two-quarter deflation signal. The largest underperformance for financials comes late into the deflationary period. In fact, had we excluded utilities from our analysis, the S&P financials sector would have been the worst performing sector across the board on a 12- and 24-month time horizon. The heavyweight banks subgroup accounting for roughly 42% of the S&P financials market capitalization weight explains the underperformance. As a reminder banks underperform when the price of credit is falling owing to deflation/disinflation. Given that our fixed income strategists expect a selloff in the bond market, we remain overweight the S&P financials index. Financials Financials Technology (Neutral – Downgrade Alert) Technology Technology Back in 2010, we reiterated that tech equities were deflationary winners, a fact that has not changed since then. The frenetic pace of innovation in and of itself, has prepared the sector to cope with episodes of deflation. Within cyclicals, technology is by far the best performing sector in our Table 1, but the present-day geopolitical and trade tensions compel us to be neutral on the sector with a potential downgrade coming down the line via a software subgroup downgrade. Tech pricing power is resilient during deflationary episodes. However, tech sales growth, which appears to have peaked for the cycle, swings violently, warning of potential turbulence ahead if a down oscillation is looming. We are neutral the S&P technology sector, which is also on our downgrade watch list. Technology Technology Telecommunication Services (Neutral) Telecommunication Services Telecommunication Services Traditionally defensive telecom services stocks have been struggling recently, saddled with rising debt, fighting to remain relevant and avoid becoming a “dumb pipe”. The industry’s pricing power proxy also highlights the point as telecom companies never managed to regain their footing since the GFC. Another important point is that the index materially underperforms the market across all the time horizons we examined returning: -1.5%, -2.0% and -4.4%. Our hypothesis was that telecom carriers should outperform during deflationary periods owing to stable cash flow growth generation and a high dividend yield profile. But, empirical evidence shows the opposite. Likely, the four decades-long sustained underperformance of this now niche safe haven industry suggests that sector specific dynamics are at fault. We are currently neutral the S&P telecommunication services index. Telecommunication Services Telecommunication Services Materials (Underweight) Materials Materials Despite the massive demand from China and, more generally, from the EM complex for commodities over the past several years, the S&P materials sector never actually managed to break free from its structural downtrend. The sector is one of the major disinflationary losers as evident from the chart. Importantly, since the mid-70s, most of the periods when materials managed to outperform the broad market occurred outside the shaded areas and recessions. On average, materials sector pricing power also tends to decline sharply when global growth weakens, as is currently the case. And, with a slight delay, materials sector revenue growth will likely suffer a setback, warning that revenue growth has crested for the cycle. We reiterate our recent downgrade of the S&P materials sector to underweight. Materials Materials Consumer Discretionary (Underweight – Upgrade Alert) Consumer Discretionary Consumer Discretionary Contrary to our hypothesis, S&P consumer discretionary stocks underperform during disinflationary periods that weigh on interest rates. Likely decelerating economic activity trumps that fall in interest rates and consumers gravitate toward staple goods and services and away from discretionarfy purchases. Table 1 reveals that consumer discretionary stocks actually suffer the most early in a deflationary period (-2.0%), and then sharply recover 12 months out and turn marginally positive (0.1%). We are currently underweight the S&P consumer discretionary index, but have it on upgrade alert as a potential buying opportunity. Consumer Discretionary Consumer Discretionary Utilities (Underweight) Utilities Utilities As for the final sector of this Special Report, we had highlighted that the S&P utilities is a notable outlier in our analysis as it does not behave according to our expectations. Likely, some industry specific dynamics are at play as high-yielding safe haven utilities stocks severely underperform during deflationary periods. The sector returns -3.5%, -4.3%, and -4.5% versus the broad marekt on a 6-, 12, and 24-month time horizon, respectively. In theory, two factors should have pushed the relative share price higher: (1) steady cash flow growth and (2) falling interest rates, both of which boost the allure of high yielding competing assets. Neither one was sufficient to break away from the structural downtrend that has been haunting the sector over the years. We are currently underweight the S&P utilites index. Utilities Utilities   Footnotes 1    We are using GICS 2 Telecommunication Services index instead of the parent GICS 1 Communication Services index due to the lack of data as the index was only recently introduced.

Highlights It will be impossible for China to undertake even mild deleveraging and simultaneously accelerate household income growth. All deposits in the banking system have been created by banks “out of thin air” and have not been engendered by household savings. Contrary to widespread beliefs, mainland households are highly leveraged. Cyclically, high equity valuations, crowded investor positioning and the delayed cyclical recovery in the Chinese economy pose downside risks to consumer stocks. Structurally, real income growth per capita is contingent on productivity growth. The latter will slow in China but remain relatively elevated. Overall, investors should consider buying Chinese consumer plays on weakness. Feature Deliberations about China’s successful rebalancing often boils down to whether one believes that consumers will be able to offset the slowdown in investment and exports and keep overall real GDP growth close to current levels. The narrative typically presumes that Chinese households are not spending enough and can boost their spending counteracting the ongoing slowdowns in capital spending as well as in exports. This conjecture is fallible. Chart I-1The Myth Of Deficient Consumer Demand In China The Myth Of Deficient Consumer Demand In China The Myth Of Deficient Consumer Demand In China Consumer spending in China has in fact been booming over the past 20 years – it has been growing at a compounded annual growth rate (CAGR) of 10% in real terms since 1998 (Chart I-1, top panel). Hence, the imbalance in China has not been sluggish consumer spending. Rather, capital expenditure has been too strong for too long (Chart I-1, bottom panel). Healthy rebalancing entails a slowdown in investment spending – not an acceleration in household demand. Hence, the market relevant question is: Can the growth rate of household expenditure accelerate above 10% CAGR in real terms as capital spending and exports decelerate? Our hunch is that this is unlikely. As the authorities attempt to contain credit and investment excesses and trade war-induced relocation of manufacturers out of China gathers steam, the pertinent question is whether the slowdown in household expenditures in real terms will be mild (from the current 10% pace to 7.5-9% CAGR), medium (6-7.5%) or material (below 6%). In our opinion, the medium scenario has the highest odds of playing out. There are many positives about the vitality of Chinese consumers and we do not mean to downplay them. Nevertheless, many of these positives are well known, and the objective of our report is to reveal misconceptions about this segment.  Deleveraging And Consumers If and when deleveraging does transpire in China, the household income growth rate will decelerate, resulting in weaker spending growth. It will be impossible for the mainland economy to undertake even mild deleveraging and simultaneously accelerate household income growth. Chart I-2Capital Spending Is Much More Important Than Exports Capital Spending Is Much More Important Than Exports Capital Spending Is Much More Important Than Exports Our focus for this report is on a slowdown in credit and capital spending rather than exports. The basis is that the latter in general, and shipments to the U.S. in particular, have a much smaller impact than investment expenditures (Chart I-2). In turn, capital spending is mostly financed by credit. It is crucial to understand the significance of credit in driving national and household income growth in China since 2008. Currently, 2.5 yuan of new credit is needed to generate one yuan of GDP growth. This certifies that the mainland economy has become addicted to credit. As we have argued in depth in past reports, commercial banks do not intermediate savings into credit, but rather create new money/credit “out of thin air” when they lend to or buy securities from non-banks. This entails that output and income growth would have been much weaker had banks not provided credit equal to RMB 19 trillion over the past 12 months. For instance, a company affiliated with the provincial government has borrowed money from banks to build three bridges over the past 10 years, accumulating a lot of debt in the process. Ostensibly, operating these bridges does not generate enough cash flow to service its debt – a common occurrence in China. With the three bridges completed, the company would then apply for a new loan to build a fourth bridge. Should banks lend additional money to construct it? Notwithstanding this hypothetical company’s low creditworthiness, if banks provide additional financing, the credit bubble will become larger, and the issue of overcapacity will intensify. On the other hand, household income and spending growth will remain robust. If banks do not finance the construction of the fourth bridge, labor income growth in the province – employees of this company and its suppliers – will slump. Thus, if for whatever reason banks are unable or unwilling to extend as much in new credit as last year, output and income growth in this province will decelerate, all else equal. Given credit has been playing an enormous role in driving China’s economic growth over the past 10 years, it will be almost impossible to slow down credit without a downshift in household income growth. This example and analysis is not meant to suggest that bank credit origination is the sole growth driver in China. Theoretically, GDP can expand even with bank credit/money contracting. According to the quantity theory of money: Nominal GDP = Money Supply x Velocity of Money This means nominal GDP can grow even when the supply of money/credit is shrinking. For this to happen, the velocity of money should rise faster than the pace of decline in the supply of money/credit. From a practical perspective, this requires enterprises and consumers to increase the turnover (velocity) of their bank deposits and cash on hand (money supply). We have deliberated in past reports that the velocity of money and the savings rate are inversely related: A rising velocity of money entails a declining savings rate, and vice versa. Going back to our example of bridge construction, the relevant question is: Will companies and households in that province increase their spending (i.e., reduce their savings rate) if banks do not finance the construction of the fourth bridge? The realistic answer is not likely. If the fourth bridge does not receive financing, weaker income growth in that province – due to employment redundancies among construction companies and their suppliers – would lead to slower spending growth. Faced with slowing demand growth, other enterprises and households would likely turn cautious and increase their savings rates – i.e., reduce the velocity of money supply. In short, reduced credit origination will mostly likely generate slower household income growth and, consequently, spending. Chart I-3China: No Deleveraging So Far China: No Deleveraging So Far China: No Deleveraging So Far Broadly speaking, household income growth has not yet downshifted because deleveraging in China has not started. Chart I-3 illustrates that aggregate domestic credit – including public sector, enterprises and households – continues to grow above 10% and well above nominal GDP growth. In fact, credit growth has exceeded nominal GDP growth since 2008. This is local currency credit and does not include foreign currency debt, but the latter is small at 14.5% of GDP (or about US$ 2 trillion). To us, deleveraging implies credit growth that is no greater than nominal GDP growth – i.e., a flat or declining credit-to-GDP ratio for at least several years. If China is serious about deleveraging and curbing its money/credit bubble, the pace of credit expansion should decline to or below nominal GDP growth – which is presently 8%. If and when this occurs it will dampen household income and spending growth. Bottom Line: Chinese household income and spending will inevitably slow if money/credit growth slumps, given the Chinese economy’s excessive reliance on new credit origination over the past 10 years. Do Households Have A Savings Or Debt Glut? What about households’ enormous savings in China? Why wouldn’t households reduce their savings and boost spending? When referring to household savings, most allude to bank deposits. But in conventional economic theory – and according to the way household savings are statistically calculated at a national level – savings actually have no relation to bank deposits. Chart I-4No Empirical Evidence That Deposits = Savings No Empirical Evidence That Deposits = Savings No Empirical Evidence That Deposits = Savings Chart I-4 illustrates that in China, the annual change in household deposits is not equal to household savings (Chart I-4, top panel). Similarly, the annual rise in all deposits (based on central bank data) is vastly different from annual national savings (as defined by conventional macroeconomics and calculated by the National Bureau of Statistics) (Chart I-4, bottom panel). Bank deposits are a monetary concept that we will refer to as “money savings.” Deposits are created by banks “out of thin air,” as illustrated in our past reports.Meanwhile, the term “savings” in conventional macroeconomics denotes goods and services that are produced but not consumed, which is a real economic (not monetary) variable. Not surprisingly, there is no relationship between these “real savings” and “money savings,” as illustrated in Chart I-4. To illustrate that household “savings” (as defined by conventional macroeconomics) are not related to money supply/deposits, let us go back to the example of the company building bridges in China. When the company wire transfers a salary of RMB 1,000 to an employee, the amount of money supply in the banking system does not change. Suppose this employee decides to save 100% of her income this month. Will the supply of money increase or decrease? The answer is that it will not change: the deposit will remain at her bank account. Alternatively, if she decides to spend all RMB 1,000 (100% of her income), the supply of money also will not change – deposits will be transferred to other banks where her suppliers have their accounts.  If she cashes out her deposit and puts it under her mattress, the amount of bank deposits will decline, but cash in circulation will rise by the same amount. Provided money supply is equal to the sum of all bank deposits and cash in circulation, the amount of money supply will not change. The only way the supply of money will decline is if she pays down her loan to a bank. Conversely, the supply of money only rises when banks originate loans or buy assets from non-banks. In short, saving/not spending does not alter the amount of money supply. Rather, broad money supply is equal to the cumulative net money creation “out of thin air” primarily by commercial banks and less so by the central bank over the course of their history. This has nothing to do with household and national “savings.” The latter stand for goods and services produced but not consumed. We have discussed what “savings” mean in conventional economics in past reports. Chart I-5Chinese Households Are More Leveraged Than U.S. Ones Chinese Households Are More Leveraged Than U.S. Ones Chinese Households Are More Leveraged Than U.S. Ones Critically, Chinese households presently carry more debt as a share of their disposable income than American households (Chart I-5). This chart compares household debt to disposable income using official data from both China and the U.S. In the case of China, we add Peer-to-Peer (P2P) credit to consumer credit data published by the People’s Bank of China to calculate household debt. The argument by many commentators that consumers in China are not highly leveraged is grounded on the comparison of their debt to GDP. However, in all countries, household debt is assessed versus disposable income – not GDP. The income available to households to service their debt is their disposable income – not GDP. It is correct that Chinese households’ assets have surged in the past two decades as they have purchased significant amounts of real estate, and property prices have skyrocketed. A survey by China Economic Trend Institute holds that property accounts for 66% of household assets in China. To assess creditworthiness, investors should not rely on debtors’ asset values. If debtors are en masse forced to sell their assets to service debt, equity prices would tumble well beforehand. Rather, creditworthiness should be assessed based on recurring cash flow (income) available to debtors to service their debt. One should not be surprised as to why real estate prices are very high in China. Money and credit have been surging – have grown four-fold – over the past 10 years (Chart I-6) and are still expanding at close to a 10% pace. In particular, household debt is still growing at a whopping 15.5% annually (Chart I-7). If and as money/credit growth downshifts, property prices will deflate. Chart I-6Helicopter Money In China Helicopter Money In China Helicopter Money In China Chart I-7Household Credit Is Expanding Twice As Fast As Income Growth Household Credit Is Expanding Twice As Fast As Income Growth Household Credit Is Expanding Twice As Fast As Income Growth Importantly, housing affordability is low and households’ ability to service their mortgages is troubling. Chart I-8 exhibits the nationwide house price-to-income ratio for China and the U.S. In the Middle Kingdom, it is currently about 7.2, while in the U.S. the ratio has never been above 4. It only approached 4  at the peak of the housing bubble in 2006. Chart I-8House Prices Are Very Expensive In China House Prices Are Very Expensive In China House Prices Are Very Expensive In China Chart I-   In turn, Table I-1 illustrates mortgage interest-only payments as a share of household disposable income. The national average is 25.5%. These are very high ratios, suggesting an average new home buyer will have to allocate about a quarter of her or his household income just to pay the interest on a mortgage. These averages do not divulge enormous variations among households. High-income and rich households probably do not have much debt, and debt sustainability is not an issue for them. This also implies that there are many low-income households for whom the interest payments on mortgages absorb more than 25% of their disposable income.  Bottom Line: All deposits in the banking system have been created by banks “out of thin air” and have not been engendered by household savings. Contrary to widespread beliefs, mainland households have a lot of debt, and the latter is still expanding faster than nominal disposable income growth (Chart I-7 above). Positives And The Cyclical Outlook This section lists some positives for household incomes and spending, while also highlighting inherent risks: In the long run, per-capita real income growth in any country is equal to productivity growth. Productivity in China is still booming, justifying high real income growth. The question is whether such buoyant productivity growth can be sustained at a high level to justify robust real-income per-capita growth. Typically, easy money breeds complacency, misallocation of capital and ultimately lower productivity growth. Can China sustain productivity growth of 6% to assure a similar growth rate in real income per capita if the nation continues to experience easy money and a misallocation of capital? Forecasting productivity is not easy; only time will tell. Chart I-9Nominal Household Income, Wages And Salaries Nominal Household Income, Wages And Salaries Nominal Household Income, Wages And Salaries Per capita aggregate income as well as both wages and salaries are still expanding briskly – by about 8.5% in nominal terms from a year ago (Chart I-9). This is a formidable growth rate and entails vigorous spending power. The cyclical and long-term concern is whether the current rate of income growth is sustainable. So far there has been few redundancies, despite the fact that corporate revenue and profits have slumped. There is anecdotal evidence that the authorities are actively discouraging dismissals among both state-owned and private enterprises. If layoffs are avoided in this cycle, it will imply that the full pain of the slowdown is absorbed by shareholders. As a result, wages and salaries will rise as a share of GDP, causing a profit margin squeeze for companies. Will private shareholders be willing to invest in the future? Over the past year,  authorities have targeted the stimulus at consumers by cutting personal income taxes. However, this has not boosted consumption: First, the individual taxpayers’ base was very small; only one quarter of total employment (or 16% of the population) was paying personal income taxes before the most recent cut. Second, personal income tax savings have amounted to less than 2% of disposable income.   Finally, the savings from tax cuts are unevenly distributed across households. High-income families will probably get higher tax savings than lower-income ones, whereas the propensity to spend is higher for the latter than the former. Household deposit expansion has accelerated at the expense of enterprises (Chart I-10). This confirms that companies have not slowed the payments to employees (wage bill). Consequently, households have firepower which can be unleashed at any time.  However, there are presently no signs of a growing appetite to spend. Quite the contrary, our proxy for household marginal propensity to spend is falling (Chart I-11). Chart I-10Households Are Hoarding Money, Not Spending Households Are Hoarding Money, Not Spending Households Are Hoarding Money, Not Spending Chart I-11Household Marginal Propensity To Spend Is Still Falling Household Marginal Propensity To Spend Is Still Falling Household Marginal Propensity To Spend Is Still Falling Non-discretionary consumer spending has remained very robust. In contrast, discretionary spending has been extremely weak and shows no signs of recovery (Chart I-12). Finally, the impulses of non-government credit, broad money and household credit are weak (Chart I-13). Without these improving substantially and households’ marginal propensity to spend rising, it is difficult to expect a meaningful recovery in consumption. Chart I-12Discretionary Spending Is Sluggish Discretionary Spending Is Sluggish Discretionary Spending Is Sluggish Chart I-13Credit/Money Impulses Are Much Weaker Than In Previous Stimulus Credit/Money Impulses Are Much Weaker Than In Previous Stimulus Credit/Money Impulses Are Much Weaker Than In Previous Stimulus Bottom Line: A cyclical recovery in consumer spending hinges on another round of major credit and fiscal stimulus as well as improvement in households’ willingness to spend. Structurally, real income growth is contingent on China’s ability to sustain high productivity growth. Investment Implications If and as capital spending and exports growth slow further, the pace of expansion in consumer expenditure will also moderate. In such a scenario, overall economic growth in China will inevitably downshift. Structurally, Chinese consumer spending will slow from the torrid pace of 10% CAGR of the past 10 years to around 6-7.5% CAGR in real terms. This is a formidable growth rate, and warrants a bullish stance on the consumer sector. We identified Chinese consumers as a major investment theme for the current decade in our 2010 report titled How To Play EM This Decade? 1 In that report, we recommended selling commodities and sectors exposed to Chinese construction and instead favoring consumer plays, especially in the health care and tech sectors. This structural theme has played out well and has further to go. Chinese household spending on health care, education and other high-value services will rise as income per capita expands, albeit at a slower rate than before. Chart I-14 demonstrates that Chinese imports of medical and pharmaceutical products are surging, even though overall imports are currently contracting. Domestically, profit margins are expanding within the medical and pharmaceuticals industries but stagnating for the overall industrial sector (Chart I-15). Chart I-14Surging Demand For Medical Products/Goods Surging Demand For Medical Products/Goods Surging Demand For Medical Products/Goods Chart I-15Continue Favoring Companies In Health Care/Medical Space Continue Favoring Companies In Health Care/Medical Space Continue Favoring Companies In Health Care/Medical Space All that said, a bullish growth story does not always translate into strong equity returns. Charts I-16A and I-16B reveal that share prices of Chinese investible consumer sub-sectors have had mixed performance. With the exception of Alibaba and Tencent, a few of consumer equity sub-sectors have generated strong equity returns. Chart I-16AChinese Consumer Stocks: Mixed Performance Chinese Consumer Stocks: Mixed Performance Chinese Consumer Stocks: Mixed Performance Chart I-16BChinese Consumer Stocks: Mixed Performance Chinese Consumer Stocks: Mixed Performance Chinese Consumer Stocks: Mixed Performance Such poor equity performance given strong headline consumption growth has often been due to bottom-up problems such as profit margins squeeze, overexpansion, over-indebtedness, equity dilution, quality of management and other issues. Chart I- Apart from company specific risks, investors should also consider valuations. Buying good companies in great industries at very high equity multiples will probably produce meager returns. Table I-2 shows the trailing P/E ratio for various consumer sub-sectors. The majority of them trade at a trailing P/E ratio of above 20 and in some cases above 30. Besides, China’s consumer story has been well known for some time, and many portfolios are overweight China consumer plays. Consequently, investor positioning adds to near-term risks. Cyclically, high equity valuations, crowded investor positioning and the delayed cyclical recovery in the Chinese economy pose downside risks to consumer stocks as well. However, such a selloff will create conditions for selectively investing in reasonably valued high quality companies.   Arthur Budaghyan Chief Emerging Markets Strategist arthurb@bcaresearch.com Lin Xiang, Research Analyst linx@bcaresearch.com   Footnotes 1      Please see Emerging Markets Strategy Special Report, “How To Play Emerging Market Growth In The Coming Decade”, dated June 10, 2010, available at ems.bcaresearch.com Equities Recommendations Currencies, Credit And Fixed-Income Recommendations

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

Cleaned Up Cleaned Up Overweight Household products stocks are in a V-shaped recovery since the early-2018 market peak and these safe haven stocks have more upside in times of tumult (middle panel) despite their pricey valuations (bottom panel). Demand for staples remains robust despite the growth slowdown and the current message from the latest PCE report calls for additional relative share price gains (second panel). Not only domestic demand is upbeat, but industry exports are also on a roll, in spite of the U.S. dollar’s recent appreciation (fourth panel). This suggests that non-discretionary items remain in high demand in the rest of the developed world and the emerging markets despite the loss of consumer pricing power. Bottom Line: We reiterate our overweight stance on the S&P household products index. The ticker symbols for the stocks in this index are: PG, CL, CLX, KMB, CHD. ​​​​​​​