Equities

Special Report

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

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

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

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

Highlights Analysis on Indonesia is available below. EM financial markets have diverged from the global growth indicators they have historically correlated with. This raises doubts about the sustainability of this rally. In China, broad bank credit has not accelerated at all, while non-bank credit growth rose sharply in January. The lack of recovery in broad bank credit growth is corroborated by lingering sluggishness in broad money growth. This refutes widespread perception in the global investment community that Chinese banks have re-opened the credit spigots again. Feature The headline news has all been positive for emerging markets over the past two months: The Federal Reserve is going on hold, China is stimulating its economy, the U.S. and China are nearing a trade agreement and risk-on market dynamics are permeating worldwide. Nevertheless, EM stocks have failed to outperform the global equity benchmark (Chart I-1, top panel). Notably, EM relative equity performance rolled over in late December when global share prices bottomed. Chart I-1EM Stocks Have Underperformed DM Ones Since Late December In absolute terms, EM equities have been attempting to break above their 200-day moving average, but have so far failed to do so decisively (Chart I-1, bottom panel). When a market struggles to break out or outperform amid favorable news flows and buoyant investor sentiment, the odds are that it is facing formidable headwinds under the surface, and is at risk of relapsing. We sense EM currently fits this profile. Needless to say, investor consensus is very bullish on EM, and dominated by the above-mentioned narrative, specifically the Fed turning dovish and China stimulating, which is reminiscent of 2016 when EM staged a cyclical rally. Consequently, investors have rushed to pile into EM stocks and fixed-income. Chart I-2 illustrates that asset managers’ net holdings of EM ETF (EEM) futures have doubled since October 2018. Chart I-2Investor Consensus Is Very Bullish On EM As of mid-February, EMs were by far the most overweight region within global equity portfolios, according to the most recent Bank of America/Merrill Lynch survey. The survey states that net 37% of global equity investors - who participated in the survey - were overweight EM. One of our clients that we met with on the road last week summed it up like this: “Investors have ‘recency bias’.” In other words, investors believe that 2019 will resemble 2016, and in turn have no appetite to bet against Chinese stimulus. We are in accord with this interpretation of investor behavior and the EM/China rally. Yet there are some noteworthy differences between today and 2016. First, in 2016, there was massive stimulus for China’s property market. At the time, the People’s Bank of China (PBoC) monetized the unsold housing stock in Tier-3 and -4 cities via its Pledged Supplementary Lending facility. At present, there is no stimulus for real estate. Second, by early 2016 EM profits had already contracted substantially. EM profits have yet to shrink in the current downtrend. Our thesis is that EM profits will contract this year for reasons we elaborated on in depth in our previous report, Mind The Time Gap. China’s credit and fiscal impulse leads EM/Chinese profits by about 12 months, and the recent improvement in this indicator, if sustained, suggests that a trough in EM/Chinese corporate earnings will only be reached in late 2019 (Chart I-3). Therefore, as EM profits shrink, investors will likely sell EM risk assets. Chart I-3EM Corporate Earnings Are Beginning To Contract Altogether, these differences with 2016 make us reluctant to chase the current EM rally, and we continue to expect a meaningful reversal in EM risk assets in the months ahead. Monitoring Global Growth We maintain that EM is much more leveraged to global trade and China’s growth than to Fed policy. For a detailed discussion on this matter, please refer to EM: A Replay of 2016 or 2001? report from February 7, 2019. Therefore, the Fed’s dovish turn is not a sufficient reason to buy EM risk assets. To buy EM cyclically, we would need to change our outlook on global trade and Chinese imports. China influences the rest of the world via its imports. A closer look at the indicators that correlate with EM risk assets and commodities do not justify the recent EM rebound. In particular: The import sub-component of China’s NBS manufacturing PMI strongly correlates with EM share prices, excess returns in EM sovereign credit, and industrial metals prices and suggest that investors should fade this rebound (Chart I-4). Chart I-4EM Stocks, EM Credit Markets, As Well As Commodities Prices Are Driven By Chinese Imports The Caixin manufacturing PMI for China was up in February, but the NBS manufacturing PMI fell. In turn, manufacturing PMI indexes in Korea, Taiwan, Japan and Singapore are all plunging, with several of them dropping well below the 50 boom-bust mark (Chart I-5). Chart I-5Asian Manufacturing Is Contracting Korean, Taiwanese, Japanese and Singaporean shipments to China were shrinking in January, while their exports to the U.S. were resilient (Chart I-6). This confirms that global trade has been weak due to China, and that there are no signs of its reversal. Chart I-6Asian Exports To China And U.S. Moreover, Korea released its February export data, and its aggregate outbound shipments are contracting (Chart I-7). Chart I-7Korean Exports: Deepening Contraction Further, China’s container freight index – the price to ship containers – has rolled over again after picking-up late last year due to front-loading of shipments to the U.S. which were induced by the U.S. import tariffs. This signals ongoing weakness in global demand, and does not justify the latest rebound in EM financial markets in general and currencies in particular (Chart I-8). Chart I-8Global Trade Is A Risk To EM Currencies Finally, even in the U.S. where manufacturing has been the most resilient globally, the odds point to notable weakness in this sector. Specifically, the continuous underperformance of U.S. high-beta industrial stocks to U.S. overall industrials beckons a further slowdown in American manufacturing (Chart I-9). Chart I-9U.S. Manufacturing Is In A Soft Spot Bottom Line: Although financial markets are forward-looking, the recent rally has been too fast and has already gone too far. This has created conditions for a material setback as global/China growth will continue to disappoint in the months ahead.  China: Credit Versus Money Growth We have been receiving questions from clients as to whether investors should heed to the message from China’s money or credit data, given they are presently sending contradictory messages (Chart I-10). Chart I-10China: Narrow, Broad Money, And Aggregate Credit Even though narrow money (M1) has historically been an excellent indicator for China/EM business cycles, the most recent (January) print – M1 annual growth rate registered a record low – was distorted due to technical/seasonal factors, and should be ignored. Specifically, deposits by enterprises plunged in January and household deposits surged as companies paid out bonuses to employees in late January ahead of the Chinese New Year that began on February 5 (Chart I-11). Provided enterprise demand deposits are in M1 but household demand deposits are a part of M2, M1 was artificially depressed in January. It will rebound in February. Chart I-11China: Technical Reasons For M1 Plunge In January Broad money provides a more comprehensive picture of money creation in China. As such, it is more relevant to compare broad money with aggregate credit. To compute aggregate credit, we add outstanding central and local government bonds to Total Social Financing (TSF). Chart I-12 illustrates the latest improvement in aggregate credit is not confirmed by either the PBoC’s broad money measure, M2, or our measure, M3 (M3 = M2 plus other deposits plus banks’ other liabilities excluding bonds). We created this M3 measure of broad money supply because in our opinion, M2 has been underestimating the extent of money creation in China in recent years due to financial engineering. Chart I-12The Recent Uptick In Aggregate Credit Is Not Confirmed By Broad Money As discussed in Box I-1 on pages 12-13, lending or purchasing of securities by banks simultaneously creates money. Therefore, bank broad credit acceleration should be mirrored in a broad money upturn. Does the lack of revival in broad money mean the latest uptick in aggregate credit data has been driven by non-bank credit? Our analysis suggests yes – non-bank credit is responsible for the strong rise in the aggregate credit numbers in January. We deconstructed aggregate credit into broad bank credit and non-bank credit (Diagram I-1). Chart I-13 illustrates that broad bank credit has not accelerated at all, while non-bank credit growth rose in January. Chart I-13China: Recent Credit Acceleration Is Due To Non-Bank Credit The lack of recovery in broad bank credit growth is corroborated by lingering sluggishness in broad money (both M2 and M3) growth (Chart I-14). Chart I-14Broad Bank Credit Is Consistent With Broad Money (As It Should Be) Consequently, this refutes the widespread perception in the global investment community that Chinese banks have re-opened the credit spigots. Chart I-15demonstrates the annual growth rate of each component of broad bank credit. While mainland banks’ loan growth to enterprises has accelerated, their lending to non-bank financial institutions has continued to shrink.  Chart I-15Broad Bank Credit And Its Components In sum, broad bank credit and broad money have not revived, and their impulses are rolling over, having failed to break above zero (Chart I-14, bottom panel). Bottom Line: The improvement in aggregate credit growth in January was due to credit provided/bonds purchased by non-banks rather than by banks. This does not tell us whether the credit growth acceleration is sustainable. For a more detailed discussion on the differences between money and credit, please refer to Box I-1 on page 12-13. Investors prefer simple narratives, and have readily embraced the story that China has opened up the credit faucets. Broad bank credit data and broad money supply data do not corroborate this thesis. It may change in the months ahead, but our point is that for the moment there is not yet a simple narrative about China’s credit cycle. Investment Implications Even though China’s aggregate credit impulse ticked up in January, the 2011-‘12 and 2015-‘16 episodes signify that its bottoming can last many months. Critically, EM financial markets have historically lagged turning points in the aggregate credit impulse. These time lags have been anywhere between three to 18 months over the past 10 years. Furthermore, in 2012 there was only a minor rebound in EM share prices – not a cyclical rally – in response to the significant rise in China’s aggregate credit impulse (Chart I-16, top panel). Chart I-16Beware Of The Time Lag Hence, even if January marked the bottom in the aggregate credit impulse – which is plausible in our opinion – EM risk assets will remain at risk based on historical time lags between the aggregate credit impulse and China-related financial markets.1 BOX 1 Why And When Money Supply Differs From Credit The following elaborates on the key differences between broad money supply and aggregate credit.  1. Why and when do broad money and credit diverge?  When commercial banks provide loans to or buy bonds (or any other asset) from non-banks, they simultaneously create new money supply/deposits. Broad money supply is the sum of all deposits in the banking system, which is why we use the terms money and deposits interchangeably. When non-bank financial institutions – in China's case financial trust and investment corporations, financial leasing companies, auto-financing companies and loan companies – as well as enterprises and households make loans or buy bonds, they do not create money. Hence, money supply/deposits is mostly equal to net cumulative broad bank credit creation. The difference between aggregate credit and money supply is due to lending activities of non-bank entities (see Diagram I-1 on page 9). Lending, purchasing of bonds, or any other forms of financing by non-bank entities does not change money supply. Thus, aggregate credit is more relevant than money supply to forecast business cycle fluctuations. Apart from the fact that banks still play a very large role in aggregate financing in China, there are a few other reasons why one should not ignore broad money and rely solely on aggregate credit: Banks can extend credit, but might choose not to classify it as loans on their balance sheet for regulatory reasons. Chinese banks did this in the past by booking loans as non-standard credit assets. In any case, when a bank lends to a non-bank it creates new deposits/money, and it is hard to conceal deposits/liabilities. In these cases, broad money supply gives a better signal about the true extent of credit growth than statistics on loans. If under regulatory pressures banks reclassify their non-standard credit assets as loans, the amount of loans will expand, even though no new lending occurs. Yet, money supply/deposits will not change. In this case, loan numbers will give a false signal and money supply will be a better indicator for new credit origination by banks and, thereby, for economic activity. The true measure of Chinese bank loans and credit data were probably disguised over the past several years because banks and non-bank financial institutions were involved in financial engineering. However, in the past two years, the regulatory clampdown forced Chinese commercial banks to unwind some of these structures and properly reclassify items on their balance sheets. Both the masking of credit assets and the ensuing reclassification could have distorted loan and credit data. This is why we use broad money supply as a litmus test to gauge banks’ broad credit origination. Given TSF includes bank loans but does not include banks’ non-standard credit assets, we believe TSF understates the amount of credit in the economy. As a result, we have not been able to calculate an accurate aggregate level of non-bank credit. Only since mid-2017, when under the regulatory clampdown, banks have stopped classifying loans as non-standard credit assets, can the annual growth rate of TSF serve as a meaningful statistic. Hence, we estimate the annual growth rate of non-bank credit only starting in 2018 (please refer to Chart I-13 on page 9). 2. Does the central bank (PBoC) create money by injecting liquidity into the system? Barring lending to or buying assets from non-banks – which does not typically occur outside of quantitative easing (QE) programs – central banks do not create broad money or deposits. Central banks create banking system reserves, which are not part of the broad money supply in any country. Money supply/deposits, the ultimate purchasing power for economic agents, is created solely by commercial banks “out of thin air,” as we have discussed and illustrated in our series of reports on money, credit and savings. 3. Why do we use impulses (second derivatives of money/credit) rather than growth rates? Our goal is to forecast a change in economic activity/capital spending/imports/enterprise revenues – i.e., a change in flow variables. Money and credit are stock variables. Therefore, a change (the first derivative) in outstanding money and credit produces flow variables. The latter measures new credit and money origination in a given period. These are comparable with flow variables like spending, income and profits. To gauge changes in flow variables, i.e., the growth rate of spending, one needs to calculate a change in new money and credit origination – i.e., change in their net flow. In brief, to do an apples-to-apples comparison, one needs to use the second derivative (a change in change) in money and credit – i.e., changes in their flows – to predict changes in flow variables such as GDP/capital spending/imports/enterprise revenues.   Arthur Budaghyan, Senior Vice President Emerging Markets Strategy arthurb@bcaresearch.com Lin Xiang, Research Analyst linx@bcaresearch.com   Indonesia: It Is Not All About The Fed Indonesian stocks have outperformed their emerging market peers significantly in the past few months as the Federal Reserve has turned dovish and U.S. rate expectations have declined. Although U.S. bond yields do strongly and inversely correlate with Indonesian stocks’ relative performance versus the EM equity benchmark (Chart II-1, top panel), we believe there are other factors – such as Chinese growth and commodities prices – that are also important to this market (Chart II-1, bottom panel). Chart II-1Indonesian Stocks: The Fed Versus Commodities In the next several months, slowing Chinese growth, lower commodities prices, and a renewed sell-off in EM markets will take a toll on Indonesian financial markets. Indonesian exports are contracting which will intensify as commodities prices fall and China’s purchases of coal and base metals drop (Chart II-2, top panel). Chart II-2Indonesia: Exports Are Shrinking Indonesia’s current account deficit is already large and will continue widening as the export contraction deepens (Chart II-2, bottom panel). Remarkably, the nation’s commercial banks have been encouraged to keep the credit taps open as the central bank – Bank Indonesia (BI) – has been injecting enormous amounts of liquidity (excess reserves) into the banking system (Chart II-3, top panel). Given these liquidity injections, bank credit and domestic demand growth have remained more resilient than would otherwise have been the case. Chart II-3The Central Bank Is Injecting Liquidity Yet, by injecting such enormous amounts of excess reserves into the system, the central bank has more than negated its previous liquidity tightening, resulting from the sales of its foreign exchange reserves in order to defend the rupiah (Chart II-3, bottom panel). The implications of such policy are that these excess reserves could encourage speculation against the rupiah, especially amid weakening global growth and falling commodities prices. Provided foreigners own large portions of Indonesian stocks and local-currency government bonds, a depreciation in the rupiah will produce a renewed selloff in the nation’s financial markets. A final point on Indonesian commercial banks: their net interest margins have been narrowing sharply (Chart II-4, top panel). Chart II-4Commercial Banks' Profits Will Weaken Moreover, as global growth slows, non-performing loans (NPLs) on the balance sheets of Indonesian banks will rise. In turn, provisioning for bad loans will also increase, and bank earnings will decline (Chart II-4, bottom panel). These dynamics will be bearish for Indonesian commercial banks, which account for 44% of the overall MSCI Indonesia index. Bottom Line: Continue avoiding/underweighting Indonesian stocks and fixed-income markets. We continue shorting the IDR versus the U.S. dollar. Ayman Kawtharani, Associate Editor ayman@bcaresearch.com Footnotes 1      Please note that this represents the Emerging Markets Strategy team’s view and is different from BCA’s house view on global risk assets and global growth. The key point of contention is the outlook for China’s growth.   Equity Recommendations Fixed-Income, Credit And Currency Recommendations

Dear Client, I am travelling this week so this report is a joint effort juxtaposing two contrasting observations about France. The ‘opulence’ part highlights France as the world’s dominant producer of luxury goods, and makes the case that some of the French luxury goods companies should form a core part of a long-term investment portfolio. The ‘rebellion’ part borrows from a recent Special Report on French politics penned by my colleague Jeremie Peloso. It analyses the recent yellow vest protests in France, and assesses whether they are a cause for concern. Best regards, Dhaval Joshi, Chief European Investment Strategist Feature Opulence Made In France Global luxury goods sales amount to a quarter of a trillion dollars, and Europe dominates in the production of these luxury goods. Measured by the number of companies, the leading luxury goods country is Italy. But on the more important metric of share of total global sales, the undisputed world leader is France. In fact, just four French companies produce a quarter of the world’s luxury goods sales. The four are: LVMH, Kering, L’Oreal, and Hermes1 (Chart of the Week, Chart I-2, and Table I-1). France’s luxury goods sector is an excellent diversifier for investors. This is because, compared to other goods and services, luxuries follow very different laws of economics: The demand for luxuries has a positive elasticity to price. Put more simply, the desirability of a luxury increases as its price goes up. This is opposite to the demand for non-luxuries which has a negative elasticity to price: for non-luxury items, the demand declines as the price goes up. By definition, you cannot compete with a luxury item by undercutting its price. Given that a luxury implies fine-craftsmanship rather than mass production, the sector is highly resilient to the existential threats confronting other European industries that emanate from out-sourcing to lower cost economies and from automation. Luxury demand is also relatively insensitive to exchange rate movements. The barrier to entry into the luxuries sector is extremely high. It takes years, or even decades, for a luxury item to acquire its premium status based on consistent high quality in materials and craftsmanship. This high barrier to entry makes it much harder for other economies to challenge the European and French dominance in providing these luxury products. Despite these attractive characteristics the sector does still require a source of structural demand. Our premise, expounded in our Special Report “Buying European Clothes: An Investment Megatrend”, is that the feminisation of consumer spending, particularly in Europe, is providing a strong structural tailwind to the demand for ‘soft’ luxury goods. A recent industry study by Deloitte corroborates this thesis, pointing out that the strongest growth in the luxury sector is to be found in cosmetics, fragrances, bags and accessories. On this premise, the four leading French companies are big beneficiaries.2,3   Are market valuations already aware of, and fully discounting, the thesis of feminisation of consumer spending? We think not, as most investors are surprised by the thesis and unaware of the on-going dynamics behind it. On this basis, three of the four French luxury companies, trading on forward PE multiples in the 20s or below, still appear reasonably valued for their growth prospects (Table I-2). The exception is Hermes which, on a multiple of 40, does seem richly priced. The bottom line is that the three other leading French luxury goods companies – LVMH, Kering, and L’Oreal – do deserve to be a core part of a long-term investment portfolio. Rebellion Made In France The yellow vest protest movement is not a coherent force led by a clear leadership. What started on the social media as a protest against the fuel tax in rural areas has evolved into a movement against President Macron. This transition occurred in part because a large segment of the population believes that Macron’s reforms have mainly benefited the wealthy. 77 percent of respondents in a recent poll view him as the “president of the rich.” The modification of the ‘wealth tax’ – which mostly shifts the focus toward real estate assets instead of financial assets – was highly criticized for favouring the wealthiest households. It resonated strongly with the perception that past governments helped the wealthiest households to accumulate more wealth on the back of the middle class. But it is not clear how intense or durable this popular sentiment will be, given that this type of inequality is not extreme in France and has not been rising (Chart I-3). Chart I-3What Income Inequality? Public support for the protests has hovered consistently around 70 percent since they started in November 2018 (Chart I-4). However, there are now more respondents who think that the protests should stop as that they should continue (Chart I-5). As a sign of things to come, a demonstration against the yellow vests and in support of Macron and his government – held by the “red scarves” – managed to gather more people on the streets of Paris than the regionally based yellow vests have done in the capital city.4 Who are the yellow vests? They are mostly rural, mostly hold a high school degree (or less), and overwhelmingly support anti-establishment political leaders Marine Le Pen (right-wing leader of the National Rally) or Jean-Luc Mélenchon (left-wing leader of La France Insoumise). This suggests that the movement has failed to cross the ideological aisle and win converts from the centre (Diagram I-1). How many French people are actually protesting? Although there was a slight pickup in protests at the beginning of January, the numbers countrywide are not high. In fact, they are far from what they were back in November and therefore would have to get much larger for markets to become concerned anew (Chart I-6). If we are to compare these protests to those in 1995 or 2010, the numbers pale in comparison (Table I-3). For instance, the protest of December 1995 brought a million people onto the streets while the demonstrations against the Woerth pension reform in 2010 lasted for seven months and gathered close to nine million protesters across eight different events (Chart I-7). We would compare the yellow vest protests to the 15-month long Spanish Indignados in 2011, which gathered between six and eight million protesters overall, and the U.S. Occupy Wall Street protests that same year. The two movements were similarly disorganized and combined disparate and often contradictory demands. In both cases, the governments largely ignored the protesters. Thus the yellow vests should not have a major impact on Macron’s reform agenda. As expected, Macron has not mentioned changing course on his most business-friendly reforms, which we see as a signal to investors that, despite the recent chaos, the plan remains the same. There is no strategic reason why Macron would reverse course. His popularity is already in the doldrums. His only chance at another term is to plough ahead and campaign in 2022 on his accomplishments. Nevertheless, to ensure that he does not plough into a rock, Macron will adjust course to calm the protesters. For example, the recent increase in the minimum wage that the government announced in response to the demonstrations was not supposed to be implemented until later in the presidential term. In a similar vein, pension reforms will likely be postponed given the ongoing protests. Macron hoped to introduce a universal, unified pension system by the middle of 2019 to replace an overly complex and fragmented system in which 42 different types of pension coexist, each one having its own rules of calculation. Though protests (both yellow vest and otherwise) have been unimpressive by historical standards, it might be too risky for the government to push the pension reform so close to these events. Such adjustments to the reform agenda should help reduce the protest movement’s fervour or otherwise its support. The bottom line is that the yellow vest protests were to be expected – they are the natural consequence of Emmanuel Macron’s push to reform the French economy and state. However, when compared to previous efforts to derail government reforms, the numbers simply do not stack up. Their disunited and broad objectives are likely to limit the effectiveness of the movement going forward.5   Dhaval Joshi,  Chief European Investment Strategist dhaval@bcaresearch.com Jeremie Peloso, Research Analyst jeremiep@bcaresearch.com Footnotes 1 In the case of L’Oreal this refers to the L’Oreal Luxe division. 2  Please see the European Investment Strategy “Buying European Clothes: An Investment Megatrend”, dated December 6, 2018 available at eis.bcaresearch.com. 3 Deloitte: Global Powers of Luxury Goods 2018, Shaping the future of the luxury industry 4 According to the government, 10,500 “red scarves” marched in Paris on January 27, 2018. 5 For the full report, please see the Geopolitical Strategy Special Report “France: La March A Suivre?”, dated February 27, 2019, available at gps.bcaresearch.com.  

Neutral We have successfully ridden down the S&P 1500 components index on a structural basis over the past four years. But now, factors are falling into place for an end to this multi-year bloodbath. On Monday, we lifted exposure to neutral from underweight, locking in relative gains of 36% since inception. In the U.S., light vehicle sales have been stable over the past five years and the latest Conference Board consumer confidence release showed that consumers’ plans to purchase a car remain upbeat, and could serve as a catalyst to unlock excellent relative value (middle panel). With regard to President Trump’s hawkish tariff rhetoric and the ongoing U.S./China trade tussle, automobile components makers have taken a big hit. But, there are high odds of an end to the U.S./China trade dispute. Tack on a softening greenback courtesy of a more dovish Fed. U.S. auto components producers will likely grab a larger slice of the global auto parts revenue pie (top panel). Still a number of risks keep us from turning outright bullish on this consumer discretionary subsector, including auto loan delinquencies which are increasing rapidly, approaching last cycle’s peak (bottom panel). Bottom Line: The easy money has already been made by shying away from auto component manufacturers and we lifted the S&P 1500 auto components index to neutral; please see Monday’s Weekly Report for more details. The ticker symbols for the stocks in this index are: BLBG: S15AUTC – APTV, BWA, GNTX, GT, DAN, VC, FOXF, DORM, LCII, DJPH, AXL, ADNT, CTB, THRM, GTX, SMP, CPS, MPAA, SUP.

Highlights Portfolio Strategy While equities will likely be higher in the coming 9-12 months, we would refrain from committing fresh capital to the market at this juncture. A better entry point lies ahead. Tactically, this market needs a breather to digest the V-shaped formation since last December’s G20 meeting before it resumes its bull run. Firming leading indicators of global auto sales, upbeat auto components industry operating metrics, a softening U.S. dollar, the looming truce in the U.S./China trade spat and depressed relative technicals and valuations all suggest that it no longer pays to be bearish the S&P 1500 auto components index. Augment positions to neutral. The global economic soft patch that is exerting downward pressure on real interest rates, a soft U.S. dollar and rising global policy uncertainty, all signal that it still makes sense to hold a global gold mining equity portfolio hedge. Recent Changes Lift the S&P 1500 auto components index to neutral and cement gains of 36% today. From a portfolio management perspective, downgrade the S&P semi equipment index to neutral for a gain of 16% since the December 17, 2018 inception. Table 1 Feature The S&P 500 hit a trouble spot last week, despite positive news on the U.S./China trade tussle. Clearly, there is an element of “buy the rumor sell the news” in the market as equities have come a long way this year, reversing all of last December’s steep losses. But, the SPX now faces stiff resistance at the most important 2,800 level as we highlighted in recent research.1 Chart 1 shows “The Good”. From a sentiment/technical perspective, fresh all-time highs in the S&P 500 advance/decline line portend ongoing gains in this broad-based equity market advance. The junk bond market sends an equally encouraging signal: The Barclays total return high yield corporate bond index has vaulted to new highs, which bodes well for the SPX (middle panel, Chart 1). Finally, all three of the S&P risk parity total return indexes2 have slingshot into uncharted territory and suggest that the S&P 500 is headed there next. Chart 1The Good… Nevertheless, there are some cracks appearing in the U.S. economy. News of an abysmal retail sales report was quickly discredited by pundits, with some blaming poor data collection due to the government shutdown. Chart 2 shows “The Bad”. Worrisomely, contracting intermodal rail carloads and a nosedive in the “First Data merchant services dollar spend” at retailers likely corroborate the Commerce Department’s weak retail sales data. Moreover, the recent plunge in the Goldman Sachs MAP (Macro-data Assessment Platform) Surprise Index, which is now probing a three year low, suggests that the U.S. economy is in a soft-patch. Chart 2…The Bad… Charts 3 & 4 show “The Ugly”. Our Economic Impulse Indicator (EII) first introduced last October,3 has taken a turn for the worse. Six economic indicators encapsulating the U.S. economy comprise the EII, and there is clear deterioration in economic activity on a second derivative basis. The recent contraction in the overall business (manufacturing, wholesale and retail) sales-to-inventories (SI) ratio also warns of profit trouble in the coming quarters (Chart 4). Keep in mind that this data series only goes to November 2018 and once it gets updated to include December later this week, the SI ratio will likely fall deeper into the contraction zone. Chart 3…And The… Chart 4…Ugly So should investors take some chips off the table given this macro backdrop? Prior to answering the question, as a reminder, BCA’s view remains that the business cycle is alive and well and there is no recession on a cyclical time horizon. Therefore, equities should be higher in the coming 9-12 months. Our end-2019 SPX target remains at 3,000 based on $181 EPS for calendar year 2020 assuming a 16.5 multiple.4 Nevertheless from a shorter-term perspective, we would refrain from committing fresh capital to this market, as we believe a better entry point lies ahead. Tactically, this market now needs a breather to digest the V-shaped formation since last December’s G20 meeting, before it resumes its bull run. In addition, we would book gains on any alpha generating tactical trades; today we crystalize 16% gains in the S&P semi equipment tactical overweight position since the December 17, 2018 inception and downgrade to neutral. This week, we book handsome profits on a long-held underweight in a consumer discretionary subindex that Trump’s hawkish tariff rhetoric and actions have badly wounded. We also update a materials subsector that benefits from the ongoing global reflationary impulse. Auto Components: Aiming For Pole Position? We have successfully ridden down the S&P 1500 components index on a structural basis over the past four years. But now, factors are falling into place for an end to this multi-year bloodbath. We are lifting exposure to neutral from underweight, locking in relative gains of 36% since inception. Global auto sales are the main driver of auto components profits, thus identifying where we stand in the global auto sales cycle is key. Bellwether German automakers have been caught in an emissions-related downdraft with “Dieselgate” weighing heavily on this sector when new emissions-test procedures were implemented last quarter. The top panel of Chart 5 shows that the worst is likely behind this drubbing in German automobile production as new orders have recently gone vertical. Backlogs are also sky-high and suggest that a definitive turn looms in German motor vehicle output. The upshot is that global auto sales may come out of their recent funk. Chart 5Global Auto Sales Are About To Turn The Japanese car industry, the other global heavyweight, also suffered a minor setback last year, but leading indicators of Japanese auto production are also ticking higher. Japanese industrial robot shipments are at fresh cyclical highs and signal that global auto sales will hook up (bottom panel, Chart 5). In the U.S., light vehicle sales have been stable over the past five years, but auto industrial production growth has been roaring, rising 40 percentage points from the manufacturing recession trough (second panel, Chart 6). Chart 6Improving… All of this paints a brightening backdrop for U.S. auto components manufacturers. Indeed, auto components new orders are at all-time highs (middle panel, Chart 7), at a time when inventories remain tame. In fact the new orders-to-inventories ratio sits squarely above one and continues to firm, with unfilled orders also at all-time highs (Chart 8). As a result, selling prices are accelerating at a healthy clip (third panel, Chart 6). The upshot is that industry profits will likely overwhelm. Chart 7…Operating… Chart 8...Auto Component Metrics On the domestic demand front, the latest Conference Board consumer confidence release showed that consumers’ plans to purchase a car remain upbeat, and could serve as a catalyst to unlock excellent relative value (bottom panel, Chart 7). With regard to President Trump’s hawkish tariff rhetoric and the ongoing U.S./China trade tussle, automobile components makers have taken a big hit. But, there are high odds of an end to the U.S./China trade dispute. Tack on a softening greenback courtesy of a more dovish Fed. U.S. auto components producers will likely grab a larger slice of the global auto parts revenue pie (top panel, Chart 7). Despite these tailwinds, investors have relentlessly avoided auto component stocks. Technicals remain washed out and industry valuations are a small fraction of the broad market and below the historical mean as per the relative price-to-sales ratio (Chart 9). Chart 9Cheap And Oversold… Nevertheless, we refrain from turning outright bullish on this consumer discretionary subsector given the following risks: First, auto loan delinquencies are increasing rapidly, approaching last cycle’s peak. Second, car financing interest rates are still rising, which, at the margin, dents demand for new car sales. Third, auto credit growth is decelerating and demand for auto loans is also anemic according to the Fed’s latest Senior Loan Officer survey (Chart 10). This stands in marked contrast to the aforementioned Conference Board’s survey of consumers’ plans to buy a car. Finally, were President Trump to proceed with auto tariffs on European car manufacturers once he strikes a deal with China, U.S. auto parts producers will suffer a setback. Chart 10…But There Are Some Risks Netting it all out, the easy money has already been made by shying away from auto component manufacturers. Firming leading indicators of global auto sales, upbeat auto components industry operating metrics, a softening U.S. dollar, the looming truce in the U.S./China trade spat and depressed relative technicals and valuations all suggest that it no longer pays to be bearish the S&P 1500 auto components index. Bottom Line: Lift the S&P 1500 auto components index to neutral and crystalize gains of 36% today. The ticker symbols for the stocks in this index are: BLBG: S15AUTC – APTV, BWA, GNTX, GT, DAN, VC, FOXF, DORM, LCII, DJPH, AXL, ADNT, CTB, THRM, GTX, SMP, CPS, MPAA, SUP. A Modest Gold Portfolio Hedge Still Makes Sense Within our broad-based U.S. equity sector and subsector coverage, we continue to recommend a modest gold-related hedge via being overweight the global gold mining index (given that the S&P gold index only comprises a single stock) versus the MSCI All-Country World Index, expressed through the long GDX:US/short ACWI:US exchange traded funds. There is compelling evidence that gold bullion is a reliable reflationary gauge. The shiny metal troughed in mid-August, leading even the JP Morgan EM FX index. Since then, it has been in an uninterrupted run rising over $180/oz. or 15% and sniffing out a reflationary impulse. Not only is there a tight inverse correlation with the trade-weighted U.S. dollar, but over the past three years the Chinese renminbi also moves in close lockstep with gold (Chart 11). Now that Chinese policymakers have opened the credit spigots (January credit data revealed the largest ever month-over-month loan increase in the history of the data, please refer to the second panel of Chart 2 in last week’s publication)5 reflating their economy, there are high odds that gold can break out of its past five year trading range in a bullish fashion. Chart 11Gold Is Sniffing Out A Reflationary Impulse Commodity sentiment and positioning data suggest that gold’s run up will prove durable and continue to underpin the relative share price ratio (second & third panels, Chart 12). Chart 12Bullish Bullion Positioning Underpins Global Gold Miners Importantly, the precious metals industry has not stood still. It has embarked on a massive consolidation phase and the recent spike in M&A activity in global gold miners signals that there is more upside for relative share prices (top panel, Chart 12). But the good news does not stop there. Globally there is a slowdown that has infected a number of economies and BCA’s calculated Global ZEW economic sentiment index has lit a fire under gold mining stocks (Global ZEW shown inverted, second panel, Chart 13). The longer the global soft-patch lasts the longer Central Banks will remain on the sidelines or even ease monetary policy in order to rekindle growth. This macro backdrop represents fertile ground for gold and gold related equities (bottom panel, Chart 14). Chart 13Rising Uncertainty, Global Growth Softpatch And… Chart 14…Falling Real Rates Are Excellent Gold Mining Supports Keep in mind that gold bullion yields zero and the gold mining equities’ dividend yield trails the broad market by 100bps; thus, there is an opportunity cost to holding gold and gold related equities, especially now that even U.S. cash yields 2.5%. This explains the inverse correlation with real interest rates and the recent 30bps fall in the U.S. 10-year TIPS yield reinforces gold bullion and the relative share price ratio (TIPS yield shown inverted, middle panel, Chart 14). Moreover, the global policy uncertainty index is perking up given the ongoing U.S./China trade tussle (top panel, Chart 13), recent news of a no deal between the U.S. and North Korea and looming Brexit deadline. All of this underpins global gold stocks (top panel, Chart 13). Tack on the recent fear that gripped markets, and skyrocketing equity risk premia, and the ingredients are in place for additional gains in the relative share price ratio (third panel, Chart 13). While some semblance of normality has returned to global bourses year-to-date, fixed income investors do not share the euphoria their equity peers are emitting. Such a dichotomy favors global gold mining stocks. Finally, with regard to relative valuations and technicals, global gold equities remain in undervalued territory, but have recently recovered smartly from deeply oversold conditions (Chart 15). Chart 15Valuations Ready To Shine In sum, gold bullion is sniffing out a reflationary impulse that is bullish for global gold mining equities. The global economic soft patch that is exerting downward pressure on real interest rates, a soft U.S. dollar and rising global policy uncertainty, all signal that it still makes sense to hold a global gold mining equity portfolio hedge. Bottom Line: Stay overweight the global gold miners index (long GDX:US/short ACWI:US), and remove the downgrade alert.   Anastasios Avgeriou, U.S. Equity Strategist anastasios@bcaresearch.com   Footnotes 1      Please see BCA U.S. Equity Strategy Weekly Report, “Trader’s Paradise” dated January 28, 2019,available at uses.bcaresearch.com. 2      https://us.spindices.com/documents/methodologies/methodology-sp-risk-parity-indices.pdf?force_download=true 3      Please see BCA U.S. Equity Strategy Report, “Icarus Moment” dated October 22, 2018, available at uses.bcaresearch.com. 4      Please see BCA U.S. Equity Strategy Report, “Catharsis” dated January 14, 2019, available at uses.bcaresearch.com. 5      Please see BCA U.S. Equity Strategy Report, “Reflationary Or Recessionary” dated February 25, 2019, available at uses.bcaresearch.com. Current Recommendations Current Trades Size And Style Views Favor value over growth Favor large over small caps