Sectors

Overweight - High Conviction Synchronized global capex growth, a derivative of BCA's synchronized global growth thesis, will be a dominant theme next year, benefiting cyclicals over defensives. The S&P software index is a clear capex upcycle beneficiary and we recommend an upgrade to a high-conviction overweight stance today. If software commands a larger slice of the overall capital spending pie as we expect, then industry profits should enjoy a healthy rebound (second panel). Recovering bank loan growth signals that businesses are beginning to loosen their purse strings anew (third panel). CEO confidence is pushing decade highs, pointing to a pickup in software investments and rekindling software M&A activity, with the number of industry deals jumping in recent months. Our newly introduced S&P software EPS model encapsulates this sanguine industry backdrop and heralds a bright profit outlook (bottom panel). Overall, we recommend moving to an overweight position; see yesterday's Weekly Report for more details. The ticker symbols for the stocks in this index are: BLBG: S5SOFT-MSFT, ORCL, ADBE, CRM, ATVI, INTU, EA, ADSK, RHT, SYMC, SNPS, ANSS, CDNS, CTXS, CA. 2018 Key Views: High-Conviction Calls - Software 2018 Key Views: High-Conviction Calls - Software

Highlights Portfolio Strategy Synchronized global capex growth, a derivative of BCA's synchronized global growth thesis, will be a dominant theme next year, benefiting cyclicals over defensives. Three high-conviction calls are levered to this theme. Higher interest rates on the back of a pickup in inflation expectations is another BCA theme that should materialize in 2018. Three calls focus on a selloff in the bond markets for the coming year. Two special situations round up our high-conviction calls for 2018. Recent Changes S&P Software index - Boost to overweight. S&P Homebuilding index - Downgrade to underweight. Table 1 High-Conviction Calls High-Conviction Calls Feature Equities continued to grind higher last week, largely ignoring tax bill passage jitters. The S&P 500 is on track to register an eighth consecutive month of positive monthly returns, an impressive feat. Firm global economic data suggests that the synchronized global growth theme is gaining traction and remains investors' focal point. While the 10/2 yield curve flattening is a bit unnerving, another curve to watch is the spread between 2-year yields and the Fed funds rate, or what BCA often refers to as the "Fed Spread". This spread has widened 50bps since early September closely tracking the Citi economic surprise index (Chart 1A), and signals that the U.S. economy remains on a solid footing. We would be most worried that a recession was imminent were both slopes concurrently flattening and approaching inversion (third panel, Chart 1A). Chart 1AThe 'Fed Spread'Is Right The 'Fed Spread'Is Right The 'Fed Spread'Is Right Chart 1BHigher Interest Rates Theme Higher Interest Rates Theme Higher Interest Rates Theme Moreover, credit growth has turned the corner, and the three, six and twelve month credit impulses are all simultaneously rising at a time when total loans outstanding have hit an all-time high. Importantly, credit breadth is also broad-based. Our six month impulse diffusion index shows that six out of the eight credit categories that the Fed tracks have a positive second derivative (Chart 1A). All of this suggests that, cyclically, the path of least resistance is higher for equities, especially given BCA's view of a recession hitting only in 2019. In this context, we are revealing our high-conviction calls for the next year. Most of our calls leverage two BCA themes: synchronized global capex growth (a derivative of our flagship publication's "The Bank Credit Analyst" synchronized global growth theme articulated in last week's outlook)1 and a higher interest rate theme ("The Bank Credit Analyst" expects yields to be under upward pressure in most major markets during 2018)2. Over the past few months we have been articulating the ongoing synchronized global capital spending macro theme3 that, despite still flying under the radar, will likely dominate in 2018. Table 2 on page 4 shows that both DM and EM countries are simultaneously expanding gross fixed capital formation. As a result, we reiterate our recent cyclical over defensive portfolio bent,4 and tie three high-conviction overweight calls to this theme. Table 2Synchronized Global Capex Growth High-Conviction Calls High-Conviction Calls Similarly in recent reports we have been highlighting BCA's U.S. Bond Strategy view of a higher 10-year yield on the back of rising inflation expectations for 2018. If BCA's constructive crude oil view pans out then inflation and rates may get an added boost (Chart 1B). Three high-conviction calls are levered to this theme. Finally, we have a couple of special situations, and this year we characterize two out of these eight calls as speculative. Anastasios Avgeriou, Vice President U.S. Equity Strategy anastasios@bcaresearch.com 1 Please see BCA The Bank Credit Analyst Monthly Report, "OUTLOOK 2018 Policy And The Markets: On A Collision Course," dated November 20, 2017, available at bca.bcaresearch.com. 2 Ibid. 3 Please see BCA U.S. Equity Strategy Weekly Report, "Invincible" dated November 6, 2017, available at uses.bcaresearch.com. 4 Please see BCA U.S. Equity Strategy Special Report, "Top 5 Reasons To Favor Cyclicals Over Defensives" dated October 16, 2017, available at uses.bcaresearch.com. 5 Please see BCA U.S. Bond Strategy Weekly Report, "Living With The Carry Trade" dated October 17, 2017, available at usbs.bcaresearch.com. Construction Machinery & Heavy Trucks (Overweight, Capex Theme) The capex upcycle will likely fuel the next machinery stock outperformance upleg. Not only are expectations for overall capital outlays as good as they get (Chart 2), but there are also tentative signs that even the previously moribund mining and oil & gas complexes will be capex upcycle participants. While we are not calling for a return to the previous cycle's peak, even a modest renormalization of capital spending plans (i.e. maintenance capex alone would suffice) in these two key machinery client segments would rekindle industry sales growth. A quick channel check also waves the green flag. Both machinery shipments and new orders are outpacing inventory accumulation (Chart 2). Moreover, backlogs are rebuilding at the quickest pace of the past five years (not shown). This suggests that client demand visibility is returning. This machinery end-demand improvement is a global phenomenon. In fact, the fourth panel of Chart 2 shows that global machinery new orders are climbing faster than domestic new order growth. Tack on the reaccelerating global credit impulse courtesy of the latest Bank for International Settlements Quarterly Review and the ingredients are in place for a global machinery export boom. Finally, our machinery EPS model is firing on all cylinders, underscoring that the earnings-led recovery has more running room (Chart 2). The ticker symbols for the stocks in this index are: BLBG: S5CSTF - CAT, CMI, PCAR. Chart 2S&P Construction Machinery & Heavy Trucks S&P Construction Machinery & Heavy Trucks S&P Construction Machinery & Heavy Trucks Energy (Overweight, Capex Theme) The slingshot recovery in basic resources investment - albeit from a very low base - suggests that there is more room for relative gains in the S&P energy index in the coming months (second panel, Chart 3). The U.S. dollar remains down significantly for the year and, irrespective of future moves, it should continue to goose energy sector profits owing to the positive impact on the underlying commodity. Importantly, energy producers are a levered play on oil prices and the latter have jumped roughly $14/bbl to $58/bbl or ~32% since July 10th, but energy stocks are up only 8% in absolute terms. Given BCA's still sanguine crude oil market view, we expect a significant catch up phase in energy equity prices into 2018. On the supply front, Cushing and OECD oil stocks are now contracting. As oil inventories get whittled down, OPEC stays disciplined and oil demand grinds higher, oil prices will remain well bid. The implication is that the relative share price advance is still in the early innings. Relative valuations have ticked up in the neutral zone according to our composite relative Valuation Indicator, but on a number of metrics value remains extremely compelling in the energy space. Finally, our EPS model heralds additional growth in the coming quarters on the back of solid industry pricing power and sustained global oil producer discipline. The ticker symbols for the stocks in this index are: BLBG: S5ENRS - XLE:US. Chart 3S&P Energy S&P Energy S&P Energy Software (Overweight, Capex Theme) The S&P software index is a clear capex upcycle beneficiary (Chart 4) and we recommend an upgrade to a high-conviction overweight stance today. If software commands a larger slice of the overall capital spending pie as we expect, then industry profits should enjoy a healthy rebound (second panel, Chart 4). Small business sector plans to expand have returned to a level last seen prior to the Great Recession, underscoring that software related outlays will likely follow them higher. Recovering bank loan growth is also corroborating this upbeat spending message: capital outlays on software are poised to accelerate based on rebounding bank loans. The latter signals that businesses are beginning to loosen their purse strings anew (Chart 4). Reviving animal spirits suggest that demand for software upgrades will stay elevated. CEO confidence is pushing decade highs. Such ebullience is positive for a pickup in software investments. It has also rekindled software M&A activity, with the number of industry deals jumping in recent months. Meanwhile, the structural pull from the proliferation of cloud computing and software-as-a-service has served as a catalyst to raise the profile of this more defensive and mature tech sub-sector. Finally, our newly introduced S&P software EPS model encapsulates this sanguine industry backdrop and heralds a bright profit outlook. The ticker symbols for the stocks in this index are: BLBG: S5SOFT-MSFT, ORCL, ADBE, CRM, ATVI, INTU, EA, ADSK, RHT, SYMC, SNPS, ANSS, CDNS, CTXS, CA. Chart 4S&P Software S&P Software S&P Software Banks (Overweight, Higher Interest Rates Theme) The S&P banks index is a core overweight portfolio holding and there are high odds of significant relative gains in the coming quarters. All three key drivers of bank profits, namely price of credit, loan growth and credit quality, are simultaneously moving in the right direction. On the price front, the market expects the 10-year yield to hit 2.47% in November 2018 from roughly 2.32% currently. BCA expects the 10-year yield will rise more quickly than is discounted in the forward curve. Our U.S. bond strategists think core inflation will soon resume its modest cyclical uptrend (Chart 5). A parallel recovery in the cost of inflation protection will impart 50-60 basis points of upside to the 10-year Treasury yield by the time core inflation reaches the Fed's 2% target.5 C&I and consumer loans, two large credit categories, are both forecast to reaccelerate in the coming months. The ISM has been on fire lately and consumer confidence has been following closely behind. Our credit growth model captures these positive forces and is sending an unambiguously positive message for loan reacceleration in the coming months (Chart 5). Finally, credit quality remains pristine despite some pockets of weakness in, subprime especially, auto loans. At this stage of the cycle, near or at full employment, NPLs will remain muted. The ticker symbols for the stocks in this index are: BLBG: S5BANKX - WFC, JPM, BAC, C, USB, PNC, BBT, STI, MTB, FITB, CFG, RF, KEY, HBAN, CMA, ZION, PBCT.  Chart 5S&P Banks S&P Banks S&P Banks Utilities (Underweight, Higher Interest Rates Theme) Increasing global economic growth expectations bode ill for defensive utilities stocks (global manufacturing PMI diffusion index shown inverted, top panel, Chart 6). Synchronized global economic and capex growth (second panel, Chart 6) and coordinated tightening in monetary policy spells trouble for bonds. Our U.S. Bond strategists expect a bond selloff to gain steam in 2018. Given that utilities essentially trade as a proxy for bonds, this macro backdrop leaves them vulnerable to a significant underperformance phase. Importantly, the stock-to-bond (S/B) ratio and utilities sector relative performance also has a tight inverse correlation. The implication is that downside risks remain acute. Without the support of continued declines in bond yields, or of indiscriminate capital flight from all riskier assets, utilities advances depend on improving fundamentals. The news on the domestic operating front is grim. Contracting natural gas prices, the marginal price setter for the industry, suggest that recent utilities pricing power gains are running on empty. Add on waning productivity, with labor additions handily outpacing electricity production, and the ingredients for a margin squeeze are in place. Finally, industry utilization rates are probing multi-decade lows and overcapacity is negative for pricing power. Turbine and generator inventories have been hitting all-time highs. This is a deflationary backdrop. The ticker symbols for the stocks in this index are: BLBG: S5UTIL - XLU:US. Chart 6S&P Utilities S&P Utilities S&P Utilities Pharmaceuticals (Underweight, Special Situation) Weak pricing power fundamentals, a soft spending backdrop, a depreciating U.S. dollar and deteriorating industry operating metrics will sustain downward pressure on pharma stocks in the coming year. Both in absolute terms and relative to overall PPI, pharma selling prices are steadily losing steam (Chart 7). In the context of a bloated industry workforce, the profit margin outlook darkens significantly. If the Trump administration also manages to clamp down on the secular growth of pharma selling price inflation, then industry margins will remain under chronic pressure. Moreover, our dual synchronized global economic and capex growth themes bode ill for defensive pharma stocks. Nondiscretionary health care outlays jump in times of duress and underwhelm during expansions. Currently, the soaring ISM manufacturing index is signaling that pharma profits will remain under pressure in the coming months as the most cyclical parts of the economy flex their muscles (the ISM survey is shown inverted, second panel, Chart 7). A depreciating currency is also synonymous with pharma profit sickness (bottom panel, Chart 7). While pharma exports should at least provide some top line growth relief during depreciating U.S. dollar phases, they are contracting at an accelerating pace (middle panel, Chart 7), warning that global pharma demand is ill. Finally, even on the operating metric front, the outlook is dark. Pharma industrial production is nil and our productivity proxy remains muted, warning that profits will likely underwhelm. The ticker symbols for the stocks in this index are: BLBG: S5PHAR - JNJ, PFE, MRK, BMY, AGN, LLY, ZTS, MYL, PRGO. Chart 7S&P Pharma S&P Pharma S&P Pharma Homebuilding (Speculative Underweight, Higher Interest Rates Theme) Year-to-date, the niche homebuilding index is the best performing sub-index within consumer discretionary stocks surpassing even the internet retail subgroup that AMZN is part of, and has bested the broad market by 50 percentage points. Such exuberance is unwarranted and we deem that stocks prices have run way ahead of earnings fundamentals. Worrisomely the trifecta of higher interest rates, high lumber prices and likely tax reform blues are substantial headwinds to the index's profit potential. The second panel of Chart 8 shows that if BCA's interest rate view materializes in 2018, then 30-year fixed mortgage rates will rise in tandem with the 10-year yield (assuming the spread stays intact) and cause, at the margin, some consternation to homeownership. Near all-time highs in lumber prices are also a cause for concern (bottom panel, Chart 8). Lumber is an input cost to new homes built and eats into homebuilder margins if they decide not to pass it on to the consumer. If they do add it as a surcharge to new home selling prices, then existing homes become a "cheaper" alternative, hurting new home demand. Finally, the GOP tax plan may change mortgage interest and property tax deductions, affecting largely new home owners and becoming a net negative to the homebuilding index. The ticker symbols for the stocks in this index are: BLBG: S5HOME-DHI, LEN, PHM, LEN / B. Chart 8S&P Homebuilding S&P Homebuilding S&P Homebuilding Semiconductor Equipment (Speculative Underweight, Special Situation) Semiconductor stocks in general and semi equipment in particular have gone parabolic. The latter have bested the market by 60 percentage points year-to-date, and over a two-year period the outperformance jumps to roughly 180 percentage points (top panel, Chart 9). Something has got to give, and we are putting the S&P semi equipment index on our speculative high-conviction underweight list. A global M&A frenzy and the bitcoin/ICO mania (bottom panel, Chart 9) have pushed chip equipment stocks to the stratosphere. In absolute terms this index is near the tech bubble peak, and relative share prices are following close behind (top panel, Chart 9). Worrisomely five year EPS growth forecasts recently surpassed the 25% mark, an all-time high. Both the tech sector's (in 2000) and the biotech index's (2001 and 2014) long term growth estimates hit a wall near such breakneck pace (second panel, Chart 9). This indefinite profit euphoria is unwarranted and we would lean against it. On the operating front, DRAM prices (a pricing power proxy) have tentatively peaked and so have semi sales (an industry end-demand proxy), warning that extrapolating the recent semi equipment V-shaped profit recovery far into the future is fraught with danger (third & fourth panels, Chart 9). The ticker symbols for the stocks in this index are: BLBG: S5SEEQ-AMAT, LRCX, KLC. Chart 9S&P Semis S&P Semis S&P Semis Current Recommendations Current Trades High-Conviction Calls High-Conviction Calls High-Conviction Calls High-Conviction Calls High-Conviction Calls High-Conviction Calls Size And Style Views Favor small over large caps and stay neutral growth over value.

Dear Client, Today we are sending you a two-part Special Report prepared by my colleague Billy Zicheng Huang of our Emerging Markets Equity Sector Strategy team, entitled “A Sector Guide To A-shares”. Part I of the report was published in September, and emphasized the key takeaways from MSCI’s decision to include A-shares in the MSCI EM index beginning in June 2018. More importantly, it provided a comprehensive analysis of the financials, industrials, consumer discretionary, and consumer staples sectors. Part II of the report was published at the end of October, and provided an analysis of the remaining sectors not included in Part I. The reports underscore that while the top-down impact of MSCI’s decision is limited, it is significant in terms of expanding potential alpha from security selection. I trust that you will find this report to be useful. Best regards, Jonathan LaBerge, CFA, Vice President Special Reports Part I of the Special Report discussed the market impact of MSCI's decision to include A-shares in the MSCI Emerging Markets Index, followed by a comprehensive analysis of the four most investment-relevant sectors with corresponding company calls in each sector. In the second part of the Special Report, the EMES team will analyze the remaining sectors, and provide investment recommendations. We will publish an Investment Case by the end of this year, highlighting our best sector picks from Part I and Part II of the Special Reports to construct an A-share portfolio. A Recap In the first part of our A-shares special report, the EMES team discussed the key takeaways from A-shares' inclusion in the MSCI EM index and concluded that, despite a limited near-term impact on the market from a passive investment standpoint, the MSCI's decision will provide an expansion of the investable universe for active EM investors, and more opportunities to allocate assets and generate alpha.1 Moreover, we looked at the four sectors most relevant for investors - financials, industrials, consumer discretionary, and consumer staples - analyzing valuations, profitability, leverage, and the growth outlook. In this special report, we will continue our journey through the remaining sectors: energy, healthcare, IT, materials, real estate, and utilities. Please note that only one company, Dr.Peng Telecom & Media (CH 600804), will be added to telecoms, and will not result in material changes to the sector. Thus we omitted analysis of this sector. Energy Seven companies from the energy sector will be included into the MSCI EM index, including six from the oil & gas industry. The equally weighted basket of the seven A-share energy companies has underperformed the MSCI EM index year to date by 26.2%, and by 19.8% over a one-year period (Table 1). With the Chinese government's mandate to cut excess capacity, capex growth in the energy sector will continue to be weak, which will weigh on the growth outlook for the sector. Image In terms of valuation, stripping out two dual-listed names that are already in the MSCI EM Index (Sinopec and PetroChina - please see Appendix I for the full list), Lu'an Environmental and Xishan Coal & Electric Power are trading at significantly cheaper valuations than their peers. On the other end of the spectrum, Guanghui Energy and Wintime Energy's P/Es have expensive valuations. Looking at profitability, low P/E names tend to have high ROEs, while Guanghui Energy suffers from the weakest ROE (Charts 1A & 1B). From a profitability-versus-valuation perspective, Lu'an Environmental offers a superior risk-reward profile, while Guanghui Energy has the least favorable risk-reward profile (Chart 1C). Image Image Image Wintime and Lu'an reported the strongest operating margins, while Offshore Oil Engineering has the weakest margin among peers (Chart 1D). On leverage, Offshore Oil Engineering has the lowest debt-to-equity (D/E) ratio, mainly because its core business is energy equipment and service rather than oil & gas exploration. All energy producers are highly leveraged, with Wintime and Guanghui topping the list. On free cash flow yield, Lu'an leads the table, while both Guanghui and Wintime have negative yields which, together with high leverage, is a negative combination (Charts 1E, 1F, 1G). Image Image Image Image The A-share Energy companies have a dividend yield of less than 2%, with Offshore Oil Engineering enjoying the highest yield among peers, while Xishan Coal & Electric Power has the lowest yield (Chart 1H). Screening the earnings forecasts, all companies' EPS are expected to growth by more than 10%, led by Offshore Oil Engineering and Guanghui Energy (Chart 1I). Image Image Taking all the factors into consideration, we suggest investors should be cautious on the energy sector, and should be especially cautious about betting on the likelihood of Guanghui Energy's turnaround. The company registered surprising positive bottom-line growth in 1H17, but this was mainly due to a low base in 2016. The commencement of its new liquefied natural gas (LNG) terminal in Jiangsu Province will not help much to lift sales volumes or margins, given little LNG price recovery and growing competition from well-positioned larger players such as Kunlun and CNOOC. Healthcare There are 13 companies in the A-share healthcare sector. Stocks in the sector have a heavy tilt towards pharmaceutical producers. The equally weighted basket has underperformed the MSCI EM index year to date by 1.8%, and outperformed by 0.9% over a one-year period (Table 2). On an absolute return basis performance was resilient across various time horizons. The EMES team has been bullish on healthcare sector on a long-term investment horizon, with overweight calls on Fosun Pharma (2196 HK) from among the current MSCI EM constituents.2 We prefer companies with innovative drug R&D pipelines, which will more likely take advantage of the new China FDA rule encouraging biopharmaceutical innovation. Image Shanghai Pharma and Fosun Pharma are excluded from our analysis, as their H-listed shares are already in the MSCI EM index. Examining valuations, on a trailing P/E basis we favor Sanjiu Medical and Dong-E-E-Jiao. By contrast, Hengrui Medicine and Guizhou Bailing look expensive (Chart 2A). Looking at the profitability side, Salubris Pharma and Dong-E-E-Jiao have the strongest ROE, while Tongrentang and Baiyunshan Pharma lie on the other end of the spectrum (Chart 2B). In summary, Salubris Pharma and Dong-E-E-Jiao will likely outperform, based on a valuation-versus-profitability comparison (Chart 2C). Image Image Image Furthermore, Salubris Pharma and Dong-E-E-Jiao also lead by operating margin, with relatively safe leverage levels at the same time (Chart 2D). On the other hand, Jointown suffers from the highest debt level, the only one with debt-to-equity surpassing 100%. In terms of free cash flow, Sanjiu Medical and Salubris have the most attractive FCF yield, while Jointown and Tasly, both companies with the highest debt levels, also display a worryingly negative FCF yield (Charts 2E, 2F, 2G). Salubris and Baiyun Shan dominate the dividend yield rank (Chart 2H). Image Image Image Image Concerning the earnings outlook, Huadong Medicine and Kangmei are expected to see fast bottom-line growth in 2018, driven by robust antibiotic and cardiovascular sales respectively, while Tongrentang and Baiyunshan are likely to fall behind the industry average (Chart 2I). Image Image In summary, we prefer Salubris Pharma among the A-share healthcare basket, supported by its stronger fundamentals and the bullish outlook on innovative drug R&D and sales in China, in which Salubris Pharma is specialized. IT 14 names from the IT sector will be added to the MSCI EM index. The equally weighted basket has outperformed the MSCI EM index year to date by 22.3%, and outperformed by 23.3% over a one-year period (Table 3), with most stocks performing strongly across various investment horizons. We believe the A-share IT basket provides investors with attractive opportunities in the investable universe given that it is less expensive than its H-share counterpart. The inclusion will also dilute the weight of IT sector ADRs, such as Alibaba and Sina Weibo, in the index. Please note that Protruly Vision Tech has been suspended from trading due to legal issues, with no further detail released by the court. Stripping out ZTE because of its H-share listing already in the MSCI EM index, there are 12 names left. Image Regarding valuations, most companies are trading at a below-50 trailing P/E, with the exceptions of Hundsun Tech and iFlytek, both of which are above 150x, while Aisino and BOE are relatively undervalued compared to other names in the sector. It is worth mentioning that Hundsun is 100% owned by Zhejiang Finance Credit Network Technology, a company 99% owned by Alibaba. From a profitability perspective, Hikvision Digital and Dahua Tech have the highest ROE, while Hundsun Tech and Tsinghua Unisplendour lie at the other end of the spectrum (Charts 3A & 3B). Taking these two factors into consideration, we highlight Hikvision Digital and Dahua Tech as the most attractive based on their risk-reward profile (Chart 3C). Image Image Image When looking at the income statement, Sanan Optoelectronics displays robust operating margins, with 2345 Network following suit. By contrast, Hundsun Tech and Tsinghua Unisplendour report the most disappointing margins (Chart 3D). On the positive side, Hundsun Tech has virtually zero debt on the balance sheet, while Dongxu Optoelectronic is more than 80% leveraged. Meanwhile, only four companies register positive FCF yields. Taking both metrics into account, Aisino can most easily service its debt with free cash flow (Charts 3E, 3F, 3G). By dividend yield, Aisino and Hikvision rank top (Chart 3H). Image Image Image Image With respect to forward EPS growth, iFlytek and Hundsun Tech are expected to see the fastest bottom-line expansion, while Aisino's and BOE Tech's bottom lines will increase at the slowest pace (Chart 3I). Image Image Based on our criteria, we like video surveillance manufacturers Hikvision and Dahua Tech for their robust fundamentals and reasonable valuations. In particular, Hikvision is likely to have the largest market cap among A-share tech companies newly included in the MSCI indexes. Materials Currently only seven Chinese companies from the materials sector are included into the MSCI EM Index. After the inclusion, some 26 more companies will be added, substantially expanding the investable universe. Two subsectors will most likely draw investors' attention due to the significant exposure increase: metals & mining, and chemicals. The equally weighted basket has underperformed the MSCI EM index year to date by 2%, but outperformed by 4.6% over a one-year period (Table 4). We exclude five names, which are already in the current MSCI EM index: Sinopec Shanghai Petrochem, Anhui Conch Cement, Aluminum Corp of China, Jiangxi Copper, and Zijin Mining. Among the other companies, we have been underweight Maanshan Iron & Steel (H-share listing) and Aluminum Corp of China (H-share listing) in our China Materials trade, and overweight Tianqi Lithium in the lithium supply chain trade. Image Maanshan Iron & Steel and Angang Steel have attractive valuations, with trailing P/Es below 15. On the other end of this scale, China Northern Rare Earth and Baotou Steel appear very expensive (Chart 4A). On profitability, Wanhua Chemical and Tianqi Lithium top the ROE rank, while Jinduicheng Molybdenum and Baotou Steel sit at the bottom (Chart 4B). Screening the risk-reward profile, it is noticeable that chemicals normally demonstrate a better ROE vs. P/E metric than companies from the metals & mining industry. Specifically, Wanhua Chemical and Tianqi Lithium are the most attractive, while Jindiucheng Molybdenum is the least attractive (Chart 4C). Image Image Image In terms of operations, Tianqi Lithium reported the strongest operating margin, followed by Junzheng, while Hainan Rubber and Jinduicheng Molybdenum are the only companies that registered negative operating margins (Chart 4D). Looking at the balance sheet, Jinduicheng Molybdenum has the healthiest leverage, while Hesteel shows the most worrisome leverage. Moreover, it has the lowest FCF yield. In terms of FCF yield versus leverage, Kingenta offers the best tradeoff, while Hesteel is the least attractive (Charts 4E, 4F, 4G). Furthermore, dividend yield favors Longsheng and disfavors Northern Rare Earth (Chart 4H). Image Image Image Image In terms of projected EPS growth, Jinduicheng Molybdenum and Shandong Gold Mining have the strongest outlook for next year, while Maanshan Iron & Steel and Angang Steel are likely to report profit declines (Chart 4I). Image Image In summary, apart from Maanshan Iron & Steel, Hainan Rubber is a good candidate for the underweight basket due to its relatively expensive valuation, negative margin and FCF yield. Moreover, its focus on the rubber business diversifies the portfolio risk from metal & mining-concentrated underweight exposure. China Molybdenum, with its above-average risk-reward profile, moderately strong operations and financial position, as well as robust growth outlook, is a good candidate for the overweight basket of our lithium supply trade to replace Ganfeng Lithium. The company has a strong market presence in Congo, where over 60% of cobalt is mined. Real Estate Some 14 developers will be added to the existing MSCI EM index. Among the top 10 Chinese developers, measured by contracted sales and floor space sold, existing MSCI EM constituents account for six, while the A-share list will add two (Poly Real Estate and China Fortune Land). In the environment of property market tightening in China, primary land supply has remained stagnant. The government is unlikely to ease the supply restrictions in the near-term, especially in the residential land space. In this vein, we believe large market players will be better-positioned in this market, due to their bargaining power. Also, developers with heavy exposure to commercial property will be less affected by policy uncertainty than their residential counterparts. Looking at historical performance, the equally weighted basket has underperformed the MSCI EM index year to date by 20.5%, and by 17.1% over a one-year period (Table 5). Image Xinhu Zhongbao and Financial Street are trading at the cheapest valuations, while Zhejiang China Commodities and China Fortune Land seem to be slightly overpriced compared to peers. The ROE for Xinhu Zhongbao is remarkable, while Zhangjiang High-tech Park is the only company with ROE under 10% (Charts 5A, 5B). Taking both dimensions into account, Xinhu Zhongbao and Gemdale display an attractive risk-reward profile (Chart 5C). Image Image Image Looking at operational metrics, Zhejiang China Commodities and Financial Street enjoy the highest margin, while Xinhu Zhongbao and Tahoe lie on the other end of the spectrum (Chart 5D). Due to the nature of business, leverage is high across the sector. In particular, Oceanwide and Tahoe have a high debt-to-equity ratio, while Zhejiang China Commodities and Gemdale have a more prudent capital structure. Furthermore, FCF yields vary a lot across companies, with Financial Street and Xinhu Zhongbao on the positive end, and Tahoe and Oceanwide on the negative. Financial Street also beats other developers in terms of cash generation for debt payment (Charts 5E, 5F, 5G). Image Image Image Image Gemdale and Risesun have the highest dividend yield, while Tahoe and Zhejiang China Commodities have the lowest (Chart 5H). Image Regarding the full-year 2018 expectations, Financial Street and Zhejiang China Commodities have a robust growth outlook with respect to funds from operations (FFO) and EPS respectively, while Gemdale is likely to see sluggish growth on both metrics (Charts 5I & 5J). In summary, we believe Financial Street Holding is likely to outperform in the real estate sector, given its appealing risk-reward profile, decent dividend yield, superior cash flow yield and operating margin, reasonable debt ratio, and robust FFO growth. Its large-scale and commercial property exposure is expected to be more immune to policy tightening in China. Image Image Utilities Some 12 utility companies will be added to the existing MSCI EM index, most of which are in power generation and renewables. EMES published in July an investment case on China utilities, underlining our preference toward companies with a focus on the environment and clean power, in line with the Chinese government's emphasis in the 13th five-year plan.3 In the A-share basket, we highlight Yangtze Power, the hydro power large cap, National Nuclear, as its name suggests the state-owned nuclear power operator, and Beijing Capital, the water utility provider. The equally weighted basket has underperformed the MSCI EM index year to date by 19.2%, and by 14.2% over a one-year period (Table 6). Image Huaneng Power is excluded from our analysis, as its H-share is already in the MSCI EM Index. Screening valuations, the trailing P/E factor favors Shenery and Chuantou Energy. By contrast, Huadian Power and Beijing Capital look expensive (Chart 6A). On profitability, Yangtze Power and Chuantou Energy have the strongest ROE, while Huadian Power and Shenzhen Energy fall far behind the average (Chart 6B). Based on valuation versus profitability, Chuantou Energy, Yangtze Power, and SDIC Power will likely outperform (Chart 6C). Image Image Image Yangtze Power and SDIC Power have remarkably high operating margins, while Shenery and Beijing Capital are at the other end of the spectrum (Chart 6D). Concerning leverage, most large-scale players such as Datang International Power and National Nuclear Power are highly leveraged. By contrast, low leveraged players, such as Hubei Energy and Shenergy, tend to have small market caps of around US$ 5 bn. In terms of FCF yield, we highlight Yangtze Power and Chuantou Energy, while we are cautious on Shenzhen Energy and National Nuclear Power due to their deeply negative yields. In summary, we like Chuantou Energy, Yangzte Power, Zheneng Electric, and Shenergy with respect to FCF yield versus leverage, which also coincides with dividend yield rank (Charts 6E, 6F, 6G, 6H). Image Image Image Image Finally, Huadian Power and Datang are expected to show the fastest bottom-line growth next year, while Yangtze Power and Chuantou Energy are likely to see limited earnings expansion (Chart 6I). Image Image Therefore, within utilities sector, we expect Yangtze Power to outperform in the long term, supported by its appealing risk-reward profile, margin expansion, and debt service ability. We also like the fact that the company's dominant strength of hydropower is the Yangtze River Delta. Billy Zicheng Huang, Research Analyst billyh@bcaresearch.com 1 Please see EM Equity Sector Strategy Special Report "A Sector Guide To A-shares - Part I ", dated September 19, 2017, available at emes.bcaresearch.com 2 Please see EM Equity Sector Strategy Investment case "China Healthcare, Getting Healthier", dated August 9, 2016, available at emes.bcaresearch.com 3 Please see EM Equity Sector Strategy Investment case "Budding Green Equities In China", dated July 11, 2017, available at emes.bcaresearch.com Appendix - I Image Appendix - II Overweight Company Profile Image Image Image Image Underweight Company Profile Image Image

Dear Client, Today we are sending you a two-part Special Report prepared by my colleague Billy Zicheng Huang of our Emerging Markets Equity Sector Strategy team, entitled “A Sector Guide To A-shares”. Part I of the report was published in September, and emphasized the key takeaways from MSCI’s decision to include A-shares in the MSCI EM index beginning in June 2018. More importantly, it provided a comprehensive analysis of the financials, industrials, consumer discretionary, and consumer staples sectors. Part II of the report was published at the end of October, and provided an analysis of the remaining sectors not included in Part I. The reports underscore that while the top-down impact of MSCI’s decision is limited, it is significant in terms of expanding potential alpha from security selection. I trust that you will find this report to be useful. Best regards, Jonathan LaBerge, CFA, Vice President Special Reports The EMES team will be publishing a series of Special Reports in the coming weeks, analyzing sector dynamics and company highlights of Chinese A shares that MSCI has decided to include in the MSCI EM index from next June. In the first part of our report, we emphasize the key takeaways from A-shares' inclusion, followed by a comprehensive analysis of the four sectors that investors will probably most focus on. The second part of our report to be released in the coming weeks will analyze the remaining sectors. MSCI's decision to include Chinese A shares will likely have only a limited near-term impact on the market from a passive investment perspective. A 5% inclusion factor will not cause significant changes to the current sector weightings of the MSCI EM index or the MSCI China index. The symbolic effect - that global investors are becoming more confident in the Chinese market's efficiency and transparency - is likely to have a larger impact. From an active investment perspective, however, an expansion of the investable universe will give investors with EM mandates more opportunities to allocate assets and generate alpha. Impact Is Limited On A Macro Perspective... On June 20, MSCI announced its decision to include Chinese A shares in the MSCI EM index and the MSCI ACWI index on a gradual basis starting from June 2018.1 The inclusion process will be finalized in two steps following the May semi-annual index review and August quarterly review in 2018, at a 5% inclusion factor. Full inclusion of the remaining A-share universe is expected to take place gradually over five to 10 years. After three previous proposals of an A-shares inclusion having been rejected by investors surveyed by MSCI, the successful start of the inclusion process signifies that the A-share market is gaining broad support from institutional investors. This follows the Chinese government's and regulators' focus on improving market accessibility via stock connect programs (Hong Kong-Shanghai connect, and Hong Kong-Shenzhen connect) as well as improving market liquidity via loosening requirements for index-linked financial instruments. Further steps regarding capital movement and better reporting standards are expected to be implemented in due course. influence of the inclusion is minimal from a broad market perspective. As is planned, 222 A-share companies will be added to the MSCI EM index, accounting for a pro-forma weight of only 0.73% of the MSCI EM index, or 2.5% of the MSCI China index (Charts 1A and 1B). A shares will boost China's weight in the MSCI EM by approximately only 1%, given the 5% inclusion factor. Sector-wise, it will not substantially move the current weights of each sector either. Company wise, all selected stocks are large caps, with 43 being "A" and "H" dual-listed companies already included in the current MSCI EM index, mostly concentrated in the financials, industrials and materials sectors (see Appendix I). This means the inclusions are unlikely to make any meaningful contribution to index performance in the upcoming year. Similarly, capital inflows from passive fund trackers are expected to be negligible, only marginally adding to the trading income of the Hong Kong Exchange through the northbound stock connect program. refore, we believe the impact from an investor perspective is more symbolic, confirming a positive outlook on market transparency and corporate governance. Image Image ...But Significant In Stock Selection Despite immaterial near-term market impact, the 222 A-share large-cap stocks will expand the investable universe, providing active investors with plenty of opportunities to extract alpha. In particular, compared to the current weights of the 11 sectors, industrials, financials, consumer staples, materials, healthcare, utilities, and real estate would see weight expansion, while IT, telecom, energy, and consumer discretionary would see weight contraction (Table 1). Image Newly added stocks mainly come from the financial and industrial sectors, with the name count by far outpacing other sectors. Given an overall larger market cap, these two sectors will experience the most substantial incremental weight boost under the full inclusion scenario. However, this does not mean sectors with fewer companies to be added are negligible. Instead, liquidity in these sectors is expected to improve significantly, with specific stocks drawing strong interest from investors. Since the launch of BCA's EMES service, we have made several calls on A-share stocks as out-of-benchmark plays, including Yutong Bus (600066 CH) and Tianqi Lithium (002466 CH) from our best-performing trade, overweight the lithium supply chain. In this vein, in this Special Report we will identify and analyze four sectors that we believe are most investment-relevant. A second Special Report examining the remaining sectors will follow in the coming weeks. Financials Some 50 companies from the financials sector will be included in the MSCI EM index, with a strong tilt toward brokerage firms (27). The rest will be split between banks (19) and insurers (4). Banks The equally weighted basket of 19 A-share banks has underperformed the MSCI EM index year to date by 13.4%, and underperformed by 11.6% over a one-year period (Table 2). In absolute return terms, however, performance has been resilient across various time horizons. It is worth mentioning that the "big five banks" are all listed in both mainland China and Hong Kong. Therefore, investors will focus more on joint-stock banks and regional banks in the A-share universe, which makes analysis on shadow banking activities within the earnings profile crucial. Image In terms of valuation, stripping out dual-listed banks that already exist in the MSCI EM index, Huaxia Bank and CITIC Bank are trading below their book values, displaying relatively cheap valuations. Looking at profitability, three regional banks top the earnings profile: Bank of Guiyang, Bank of Ningbo, and Bank of Nanjing, while the two "cheapest" banks, Huaxia and CITIC, display the lowest ROE (Charts 2A & 2B). From a profitability versus valuation perspective, companies such as Huaxia Bank, Industrial Bank, Bank of Beijing and Pudong Development Bank offer a superior risk-reward profile (Chart 3). Image Image Image Bank of Guiyang and Ping An Bank report the highest net interest margins, but pay a relatively low dividend yield. On the other hand, Industrial Bank and Bank of Beijing have the lowest net interest margins, but relatively high dividend yields (Charts 4A & 4B). Image Image In terms of asset quality, Bank of Nanjing and Bank of Ningbo report the lowest NPL ratios, both under 1%, while Pudong Development Bank and Ping An Bank are at the top of the table. Meanwhile, Bank of Nanjing and Bank of Guiyang show the most robust loan growth, while Bank of Shanghai and Huaxia Bank suffer from the most sluggish loan growth (Charts 5A & 5B). Therefore, on a two-dimensional measure, we prefer Bank of Nanjing, and Bank of Guiyang (Chart 6). Image Image Image Screening the earnings forecast, Bank of Guiyang and Bank of Ningbo are expected to see the fastest growth in two years, while CITIC Bank and Ping An Bank will see the slowest growth (Chart 7). Image Diversified Financials The equally-weighted basket of 27 diversified financial companies has underperformed the MSCI EM index year to date by 26.5%, and by 27.8% over a one-year period (Table 3). Currently there are only nine diversified financial companies in the MSCI EM, with seven securities companies and two state-owned asset management companies specializing in distressed asset management. As mentioned, the inclusion of A shares will not improve brokerage fees dramatically in the near term, but this milestone event could trigger a positive outlook on market sentiment, especially for the broad A-share market, where the dominant players are retail investors. This could explain the subsector's resilient performance over the past three months. Therefore, it is reasonable to be bullish on diversified financials, with the largest securities names expecting a revenue boost in the longer term. Some pure A-share names include Shenwan Hongyuan, Guosen, and Avic Capital. Image Similar to banks, after stripping out dual-listed names already included in MSCI EM (CITIC, Everbright, GF, Haitong, and Huatai), Northeast Securities and Guotai Junan Securities have the cheapest valuations, while Anxin Trust seems to be the overpriced compared to its peers. Accordingly, its ROE is remarkable (Charts 8A & 8B). Taking both dimensions into account, Guotai Junan Securities and Northeast Securities display attractive risk-reward profile (Chart 9). Image Image Image Looking at the top line, performances diverge across various securities companies. Pacific and Guoyuan generate the highest net interest margin, while Orient and Northeast suffer from serious top-line contraction (Chart 10A). Meanwhile, Guoyuan and Anxin score the highest dividend yield, exceeding 2%, while Sinolink pays less than a 0.5% dividend yield (Chart 10B). Image Image Looking at the earnings forecast, Western Securities, AVIC Capital and Sealand Securities are expected to see the strongest bottom-line growth in 2018, while local securities companies Shanxi and Huaan rank at the bottom of the spectrum (Chart 11). Image Insurance The following four insurers are already constituents of the MSCI EM index: China Life, China Pacific, New China Life and Ping An. The equally weighted basket has outperformed the MSCI EM index year to date by 12.4%, and outperformed by 21.2% over a one-year period (Table 4). We will not analyze the subsector in much detail, given none of them are pure A-share companies. As such, market impact from the inclusion will not be material. EMES has been overweight Ping An's H shares since August 9, 2016.2 Image Industrials There are 44 companies in the industrials sector, the second-largest name count after financials. This sector is also expected to make the greatest impact on sector weights, assuming full A-shares inclusion. Stocks in the sector are split between airlines, national defense, machinery, construction and transportation. The equally weighted basket has underperformed the MSCI EM index year to date by 20.5%, and by 22.8% over a one-year period (Table 5). We believe increasing construction activity boosted by the 'One Belt, One Road' initiative will drive sales growth of construction equipment, while disputes in the South China Sea, India, Tibet and Xinjiang autonomous districts will continue to boost the defense industry. Image Air China, Southern Airline, China Communications Construction, China Railway Construction, China Railway Group, China State Construction Engineering, CRRC, Weichai Power, and COSCO are excluded from our analysis, as their H-listed shares are already in the MSCI EM index. Looking at valuations, the trailing P/E varies significantly across companies. Defense stocks in general are more expensive compared to other industries. By contrast, Daqin Railway stands on the lowest end of the P/E ranking, while electrical equipment companies normally display lower valuations (Chart 12A). Looking at the profitability side, Yutong Bus, one of our overweight calls, leads the ROE ranking, while Zoomlion lies on the lowest end by registering a net loss (Chart 12B). In summary, Yutong Bus, Chint Electrics, Gold Mantis and Beijing Orient Landscape will likely outperform, based on a valuation versus profitability profile comparison (Chart 13). Image Image Image Furthermore, the EV/EBITDA forecast for 2017 coincides with our overweight call on national defense stocks. It is worth noting that Eastern Airline would likely see unsatisfactory growth in terms of firm value (Chart 14A). Shanghai International Airport, Tus-sound Environment and Beijing Landscape rank as the top three measured by operating margin, while XCMG Construction Machine displays a negative margin, despite excavator sales in China surging year over year (Chart 14B). In terms of dividend and free cash flow, Yutong Bus and Zoomlion score highest on dividend yield, and Sany Heavy Industry, Daqin Railway, and XCMG secure highest free cash flow yield. On the other hand, Sany and other (check) defense stocks generate the least in dividend yields, and more than half of the companies post negative free cash flow yield (Charts 14C & 14D). Investors should be cautious on airline companies with negative free cash flow, such as Eastern Airline and Hainan Airline. Image Image Image Image Looking at leverage, Shanghai International Airport and AECC Aero-engine Control have the lowest debt-to-equity ratio, while Power Construction and China Eastern Airline are highly leveraged (Chart 14E). Image Last but not least, looking at expected growth profile, XCMG is forecast to see the highest bottom-line growth, driven by growing demand for excavators, while China Eastern Airline and Zoomlion are expected to suffer from negative growth (Chart 15). Image Consumer Discretionary Some 26 names from the consumer discretionary sector will be added to the MSCI EM index. Stripping out Fuyao Glass, BYD, Guangzhou Auto, and Haier, which are already included in the index, there are still six automakers and auto components manufacturers to be included. This should provide investors with enough investable stocks for an auto industry play. Furthermore, six A-share media companies will be added to the index over a one-year period (Table 6). Sector performance has been overall disappointing, with some exceptions being CITIC Guoan Information, Chinese Universe Publishing, Wanxiang Qianchao and China International Travel. Image Regarding valuations, CITIC Guoan Information, Suning Commerce and Alpha Group are the most expensive, with trailing P/Es surging above 50, while two automakers (SAIC and Huayu) along with a travel agency (Shenzhen Overseas Chinese Town) are relatively undervalued in the sector. From a profitability perspective, Robam Appliances and Midea Group generate solid ROE, while CITIC Guoan Information and Sunning Commerce dominate the other end of the spectrum (Charts 16A & 16B). Taking these two factors into consideration, we highlight Robam Appliances, Midea Group, and Xinhua Media as the most attractive (Chart 17) based on a risk/reward profile. Investors should be cautious on Suning Commerce, not only from a fundamental perspective but also because its acquisition of Inter Milan is unlikely to generate synergy amid the Chinese government's tightening of rules on overseas M&A in the entertainment and leisure industries. Image Image Image Looking at the income statement, Shenzhen Overseas Chinese Town displays robust operating performance, matching its high valuation. Robam Appliances and China South Publishing follow suit. By contrast, Suning Commerce suffers from negative margins (Chart 18A). When comparing free cash flow, Midea Group and China South Publishing register the highest yield, while Shenzhen Overseas Chinese Town, Gran Automotive Service, and CITIC Guoan Information have negative yields (Chart 18B). Meanwhile, autos and auto components manufacturers enjoy the highest dividend yields, such as SAIC Motor, Huayu Automotive System, Weifu High-Tech, and Grand Automotive Service (Chart 18C). Image Image Image With respect to leverage, the media industry normally displays the lowest D/E ratio, seen in firms such as China Film, Xinhua Media and China South Publishing. On the other hand, auto and auto component manufacturers as well as large retailers are highly leveraged (Chart 18D). Image Based on our criteria, Guoan Information and Robam Appliances are expected to see the fastest bottom-line growth, while Xinhua Media, Wanxiang Qiaochao, and Xinjiekou Dept.'s bottom lines would remain stagnant (Chart 19). Image Consumer Staples Currently only nine Chinese consumer staples constituents are included in the MSCI EM Index. After the inclusion, 14 more companies will be added, substantially expanding the investable universe. Two subsectors will most likely draw investors' attention: food producers such as Yili and Henan Shuanghui, as well as beverage producers, especially premium liquor producers such as Moutai, Wuliangye Yibin and Yanghe Brewery. The equally weighted basket has underperformed the MSCI EM index year to date by 19.6%, and by 11% over a one-year period (Table 7). The sector has not deviated much from the EM benchmark across the selected time horizon. In particular, premium liquor manufacturers have been the main contributor to overall sector performance. Their sales are expected to experience a seasonal peak in September and October during the Chinese mid-autumn festival and National Day. Both Wuliangye Yibin and Moutai announced robust top-line and bottom-line growth in their second-quarter financial results, largely beating market expectations. Image Stripping out the one dual-listed name already in the MSCI EM index (Tsingtao Brewery), Changyu Pioneer, New Hope Liuhe, and Shuanghui display attractive valuations, with trailing P/Es under 20. On the other end of the metrics, Yonghui Superstores, and Luzhou Laojiao are the most expensive (Chart 20A). Examining profitability measures, Shuanghui and Moutai top the ROE rank, while Bailian Group and Yonghui Superstores sit at the bottom of the rank (Chart 20B). Looking at risk/reward profile, it is noticeable that Shuanghui, Yili and Yanghe Brewery are well positioned (Chart 21). Image Image Image In terms of operations, premium liquor makers reported overall strong operating margins, led by Moutai and Yanghe Brewery, while Bailian Group and New Hope Liuhe stand at the other end of the spectrum (Chart 22A). Looking at the capex-to-sales ratio, Wuliangye and Shuanghui score the best measures, driven by strong sales with less capex. While Changyu Pioneer demonstrates a much higher ratio compared to all peers (Chart 22B), this can be partially explained by its high capex requirement, as it is the only wine maker in the sector. Nonetheless, we believe its top line is expected to be under downward pressure as the wine market in China becomes increasingly competitive, and as premium products from France, Australia, and the U.S. gain easier market access through not only traditional in-store sales but also authorized e-commerce platforms like JD.com. Similarly, free cash flow measure also indicates that Changyu Pioneer is the only liquor player that suffers from negative yield (Chart 22C). Image Image Image In terms of financial position, with the exception of COFCO Tunhe Sugar, all companies in the sector display reasonable levels of leverage (Chart 22D). Image Looking at top-line growth, sales forecasts in FY2017 are more in favor of Moutai, Dabeinong Technology, and Luzhou Laojiao, but less in favor of Bailian Group, Shuanghui, and Changyu Pioneer (Chart 23A). Moreover, when looking at bottom-line growth two years out, Luzhou Laojiao and Yonghui Superstores score the highest rankings, while Changyu Pioneer and Shuanghui are at the other end of the spectrum (Chart 23B). Image Image In summary, among food producers, we are inclined to overweight Shuanghui. Among beverage producers, we like Yanghe Brewery, and Wuliangye, but are avoiding Changyu Pioneer. What's Next? We will highlight the following sectors in part 2 of our Special Report: Materials, energy, IT, telecoms, healthcare, and real estate. Billy Zicheng Huang, Research Analyst billyh@bcaresearch.com Appendix - I Image Appendix - II Overweight Company Profile Image Image Image Image Underweight Company Profile Image Image 1 For the full MSCI press release, please visit: https://www.msci.com/eqb/pressreleases/archive/2017_Market_Classification_Announcement_Press_Release_FINAL.pdf 2 Please see EM Equity Sector Strategy - Investment case "China Healthcare, Getting Healthier", dated August 9, 2016, available at emes.bcaresearch.com

Overweight After a very healthy start to the year, the S&P containers & packaging index has fallen back to where it started. Worries over hydrocarbon input prices, driven by hurricane-related supply constraints, combined with overcapacity concerns in containerboard have been the key culprits. While these cost fears are legitimate, we think investor focus should remain squarely on the demand side of the equation. Container & packaging earnings have been dramatically outpacing the broad market, driven by surging food production (second panel). Increasing consumer outlays on food and beverage (the drivers of packaging demand) have been closely associated with valuation rerating phases for the industry; a significant increase in the former over the past year has not been met with a catch up yet in the latter (bottom panel). We think investors will be rewarded for patience; stay overweight. The ticker symbols for the stocks in this index are: BLBG: S5CONP - IP, WRK, BLL, PKG, SEE, AVY. Container & Packaging Valuation Has Not Caught Up To Demand Container & Packaging Valuation Has Not Caught Up To Demand

Highlights The path of least resistance for steel, coal and iron ore prices is down over the next 12-24 months. China's "de-capacity" reforms in steel and coal will continue into 2018 and 2019, but the scale and pace of "de-capacity" will diminish. The Mainland's steel and coal output will likely rise going forward as new capacity using more efficient and ecologically friendly technologies come on stream. Both the steel and coal industries in China are becoming more efficient and more competitive, with low-quality output falling and high-quality supply rising. Feature Reducing capacity (also called "de-capacity") in the oversupplied commodities markets (e.g., steel, coal, cement, and aluminum) has been a key priority within China's structural supply side reforms over the past two years. The reforms were announced by President Xi Jinping in November 2015 and have focused primarily on steel and coal, and to a lesser extent on the aluminum and cement sectors. China's "de-capacity" reforms have been aiming to reduce inefficient productive capacity and low-quality output of the above mentioned commodities, as well as boost medium-to-high-quality production. The main focus of this report is to dissect China's supply side "de-capacity" reforms, and to assess their impact on steel, coal and iron ore prices. The de-capacity reforms were announced in late 2015 and, coincidentally, all major industrial commodities prices made a synchronized bottom in late 2015/early 2016 (Chart I-1). Chart I-1ASynchronized Bottom & Rally: ##br##Due To Chinese 'De-Capacity' Reforms? Synchronized Bottom & Rally: Due To Chinese 'De-Capacity' Reforms? Synchronized Bottom & Rally: Due To Chinese 'De-Capacity' Reforms? Chart I-1BSynchronized Bottom & Rally: ##br##Due To Chinese 'De-Capacity' Reforms? Synchronized Bottom & Rally: Due To Chinese 'De-Capacity' Reforms? Synchronized Bottom & Rally: Due To Chinese 'De-Capacity' Reforms? China is the largest producer and consumer of various raw materials, ranging from steel and coal to base metals. Hence, two interesting questions arise: was it the "de-capacity" reforms or other factors that caused the various raw materials to bottom in early 2016 and rally thereafter? How will China's ongoing "de-capacity" reforms affect steel, coal, and iron ore prices going into 2018 and 2019? Progress Of "De-Capacity" Reforms Three main approaches have been used by policymakers with respect to de-capacity reforms: The government sets up capacity reduction targets and then implements concrete plans to achieve these targets. The government conducts inspections to ensure the reforms are being implemented or for environmental protection purposes. The government aims to eliminate outdated capacity by setting up electricity price rules (higher electricity prices for producers with inefficient technologies) as well as ordering banks to curtail lending to those producers. In terms of timelines, the Chinese supply side "de-capacity" reforms so far have been rolled out in three phases: Phase I: Initiation and preparation phase (2015 Q4 - 2016 H1): The first phase involved policy makers drawing related policies and capacity reduction targets in the steel and coal industries. Local governments and related SOEs began implementing the so-called "de-capacity" reforms. During this period, only 30% of the 2016 capacity reduction targets for both steel and coal markets were achieved. Phase II: The accelerating implementation phase (2016 H2): The second phase included a ramp-up of "de-capacity" reforms, with over 70% of 2016 steel and coal capacity reduction targets being implemented. Meanwhile, steel production disruptions increased due to more stringent environmental rules, more frequent inspections, and government-ordered closures of low-quality steel (called "Ditiaogang" in Chinese) production in Jiangsu and Shandong provinces. Phase III: The reform-deepening phase (2017): The third phase, implemented in the first half of this year, was a clamping down on overcapacity to eliminate all illegal sub-standard steel (Ditiaogang) production and capacity by the end of June 2017. To date, the Chinese authorities have succeeded in their "de-capacity" reforms in steel and coal: both the steel and coal industries in China have become more efficient, more competitive, and have much less obsolete excess capacity: The government's plan was to reduce capacity by 100-150 million metric tons in steel and 1 billion metric tons in coal within "three to five years." This equated to a 9-13% and 18% reduction of existing 2015 Chinese capacity in steel and coal, respectively. In addition, this is equivalent to 7-9% for steel and 10% for coal of 2015's global output (Table I-1). As of August 2017, within less than two years since the beginning of the supply side reforms, 77% of the steel "de-capacity" target (or 10% of 2015 capacity) and 52% of the coal "de-capacity" target (or 7% of 2015 capacity) have been achieved (Table I-1). Table I-1Chinese Supply-Side Reform - Capacity Reduction Target And Actual Achievement China's 'De-Capacity' Reforms: Where Steel & Coal Prices Are Headed China's 'De-Capacity' Reforms: Where Steel & Coal Prices Are Headed With declining capacity and rising production, the capacity utilization rates (CUR) of the steel and coal industries have increased meaningfully. The National Bureau of Statistics (NBS) reported that as of the third quarter of 2017, the CUR for the steel industry has risen to 76.7% (the highest since 2013, and an increase of 4.4 percentage points from a year ago). As for the coal sector, the CUR reached 69% (the highest since 2015, and an increase of 10.6 percentage points from a year ago). With outdated and illegal production capacity exiting the marketplace, the number of companies and the number of employees have declined significantly in both the steel and coal industries (Chart I-2 and Chart I-3). Since the start of the "de-capacity" reforms, the central government has allocated 100 billion yuan (0.1% of GDP and 3.6% of central government spending) to a special fund for the relocation of employees in the coal and steel industries. Chart I-2Consolidation In Chinese Steel ##br##And Coal Sectors: Fewer Companies... Consolidation In Chinese Steel And Coal Sectors: Fewer Companies... Consolidation In Chinese Steel And Coal Sectors: Fewer Companies... Chart I-3...And Fewer Employees ...And Fewer Employees ...And Fewer Employees Higher prices for steel and coal have greatly boosted producers' profitability. From January 2016 to September 2017, the number of loss-making enterprises as a share of all enterprises has dropped from 25% to 17% in the steel industry and from 34% to 21% in the coal sector. Improving financial conditions have enhanced steel and coal companies' ability to invest in industrial upgrades (i.e., more investment in advanced technologies and new equipment). Bottom Line: Chinese "de-capacity" reforms have been successfully implemented, which has improved economic efficiency in the steel and coal industries by reducing high-cost and low-quality supply, and by increasing lower-cost and high-quality output. Understanding The Cycle In this section, we try to connect the dots between the progress of China's supply side reforms, and steel and coal prices. Chart I-4A and Chart I-4B show the fascinating dynamics among policy actions, production and prices. Chart I-4APolicy Actions And Market Dynamics: Coal Sector Policy Actions And Market Dynamics: Steel Sector Policy Actions And Market Dynamics: Steel Sector Chart I-4BPolicy Actions And Market Dynamics: Steel Sector Policy Actions And Market Dynamics: Coal Sector Policy Actions And Market Dynamics: Coal Sector Here are our major findings: (A) Except for coal, Chinese "de-capacity" reforms were not the major trigger for the price bottom in major industrial commodities in early 2016. As the period from November 2015 to June 2016 was only the initiation stage of the reforms, not much steel capacity reduction - only 1.2% of total existing 2015 capacity - occurred in the first half year of 2016. Moreover, most of the reduced capacity was outdated capacity and probably had been offline for years. Therefore, the policy driven capacity cut in the first half of 2016 was unlikely the reason for the rally in steel prices. The reasons behind the bottom in raw materials prices in general and steel in particular during the first half of 2016 were the following: 1. Production cuts in both 2015 and the first half of 2016 was market-driven. In other words, it was not government reforms but natural market forces (the dramatic drop in raw materials prices in 2015) that caused company closures and declines in various raw materials output in both 2015 and the first half of 2016 (Chart I-4A). The price recovery in the first half of 2016 was not sufficient to make most producers profitable. 2. Remarkably, the authorities injected considerable amounts of credit and fiscal stimulus in late 2015 and early 2016. As a result, demand recovery was another major trigger for the synchronized bottom in early 2016. The rise in the aggregate credit and fiscal spending impulse led to a revival in property construction, automobile production and infrastructure investment in the first half of 2016 (Chart I-5). 3. Financial/speculative demand for commodities was also a driving force behind the early 2016 price recovery. Chart I-6 illustrates that Mainland trading volumes in various commodities futures surged in the first half of 2016, and specifically in coal in the third quarter of 2016, coinciding with their respective price spikes. Chart I-5Strong Demand Recovery In 2016 Strong Demand Recovery In 2016 Strong Demand Recovery In 2016 Chart I-6Speculative Buying In Early 2016 Speculative Buying In Early 2016 Speculative Buying In Early 2016 All of these factors contributed to the synchronized price bottom in early 2016 and the consequent price rally in the first half of 2016, in which Chinese "de-capacity" reforms only played a minor role, especially in the steel market. (B) Chinese "de-capacity" reforms were the determining factor for the coal price spike in 2016 and steel price appreciation in 2017. Coal in 2016: "De-capacity" reforms were behind the surge in coal and coke prices throughout 2016. In February 2016, the National Development and Reform Commission (NDRC) stipulated that domestic coal mines could operate no more than 276 working days in one year, down from 330 working days in the past. This was equivalent to the immediate removal of 16% of existing operating capacity off the market. Before this decision, Chinese coal production had already declined 2.5% in 2014 and 3.3% in 2015 (Chart I-4B on page 6). On top of this decision, the government enforced a 250 million metric ton capacity cut target in the coal industry in 2016. Furthermore, actual coal capacity reduction in 2016 was 116% of that year's target (Table I-1). The end result was a 10% decline in Chinese coal production during the period of January and September of 2016 from the same period of 2015, triggering an exponential rise in both thermal coal and coking coal prices (Chart I-1 on page 2). Coking coal is mainly used for coke production, and coke is employed as a fuel in smelting iron ore in a blast furnace to produce steel. Therefore, a shortage of coking coal combined with a revival in steel production made coke the best-performing commodity last year, with its price skyrocketing by 300%. Chart I-7Diverging Prices In 2017 DIVERGING PRICES IN 2017 DIVERGING PRICES IN 2017 Towards the end of last year, the authorities realized that "de-capacity" in the coal market was too aggressive, and began loosening up coal production restrictions in September 2016. Last November the NDRC further eased policy by allowing companies to operate 330 days a year again (Chart I-4B on page 6). In response to these adjustments, thermal coal, coking coal and coke prices all peaked in December 2016/early 2017 (Chart I-1 on page 2). This reveals how Chinese supply side reforms can be a determining factor for global commodities prices. Steel prices in 2017: Steel prices have exhibited a steady rally throughout 2017, even though prices for coal, coke and iron ore all declined. There has been considerable price divergence this year between steel, on one hand, and coal, coke and iron ore, on the other. Prices for thermal coal, coking coal, coke and iron ore all peaked in late 2016/early 2017, while prices for steel continued to rise and reached a six-year high in September, expanding profit margins for steel producers (Chart I-7). The resilience of steel prices this year was because the Mainland had dismantled all "Ditiaogang" capacity by the end of June 2017, resulting in an accelerated drop in steel products production (Chart I-4A on page 6). "Ditiaogang" is low-quality steel made by melting scrap metal in cheap and easy-to-install induction furnaces. These steel products are of poor quality, and also lead to environmental degradation. "Ditiaogang" is often converted into products like rebar and wire rods. As steel produced this way is illegal, it is not recorded in official crude steel production data. However, after it is converted into steel products, official steel products production data do include it. Both falling steel products production and surging scrap steel exports entail that the "Ditiaogang" capacity elimination policy has been very effective (Chart I-8). Chart I-8The Removal Of 'Ditiaogang' Has ##br##Been Successfully Implemented The Removal Of 'Ditiaogang' Has Been Successfully Implemented The Removal Of 'Ditiaogang' Has Been Successfully Implemented As reported by the government, about 120 million metric tons per year of "Ditiaogang" capacity has been eliminated, more than double this year's steel "de-capacity" target of 50 million metric tons. A considerable portion of the 120 million metric ton "Ditiaogang" capacity was still in operation early this year when "Ditiaogang" producers enjoyed higher profit margins than large steel producers. This rapid change created a sudden squeeze on steel products supply, which consequently boosted their prices. Bottom Line: China's "de-capacity" reforms have played a major role in driving the rallies in steel prices in 2017 and in the coal markets in 2016. In short, China's supply-side reforms have been effective in shaping prices and boosting efficiency in Mainland industries by eliminating weak/inefficient producers or forcing their industrial upgrade. However, the government efforts at times have also produced large price swings, as in the case of both coal and coke. The Outlook For 2018 And 2019 Given past success and the nation's leadership adherence to reforms, China will firmly proceed with its "de-capacity" reform strategy over the next two years. However, steel and coal prices are likely to decline going forward. The most aggressive phase of "de-capacity" reforms is now behind us. The pace of capacity reduction for both steel and coal will decrease over the next two years as more than half of the 2016-2020 target has already been achieved for both sectors. Both steel and coal producers currently enjoy near-decade high profit margins, and their profits have swelled (Chart I-9A and Chart I-9B). Not surprisingly, steel and coal producers have already sped up their investment in advanced technologies to augment their capacity - by introducing ecologically friendly equipment that can produce medium- to high-end quality products. Chart I-9AStrong Profits For Steel And Coal Producers Rising Profit Margins For Steel And Coal Producers Rising Profit Margins For Steel And Coal Producers Chart I-9BRising Profit Margins For Steel And Coal Producers Strong Profits For Steel And Coal Producers Strong Profits For Steel And Coal Producers Importantly, the capacity swap policy introduced by the authorities has been allowing steel and coal producers to add new capacity to replace obsolete capacity at a ratio of 1:1-1.25 (the range depends on region). In short, having eliminated the inefficient/outdated capacity, producers are now allowed to add as much capacity as they had before, but using efficient technologies. This will weigh on steel and coal prices as output gains and production costs will likely be lower with new technologies. In addition, Chinese steel producers are accelerating the expansion of advanced electric furnace (EF) capacity. At 6%, current Chinese EF steel output as a share of total steel production is much lower than the same ratio for the major world steel producers and the world average (Chart I-10). The Chinese government's target is to raise the share of EF crude steel production as a share of total production to 15% by 2020. It usually takes at least 1-2 years to build a new EF plant. Hence, newly installed EF capacity will likely come into operation in 2018-'19. On the whole, this points to lower prices for crude steel and steel products. The EF steel-making process only requires scrap steel and electricity to produce crude steel. It does not need either iron ore or coke. This is negative for iron ore and coke prices. With the abundance of used cars and used home appliances in China, the domestic availability of scrap steel has significantly improved over the past few decades. In addition, electricity prices for industrial use have declined by about 5% since March 2015. Therefore, easing resource constraints (availability of scrap steel) and lower electricity costs will facilitate EF steel capacity expansion in China. Some words about the policy-driven steel production cut during the winter season. More than two dozen cities in northern China drew up detailed action plans during September and October to fight the notorious winter smog. China has set a target to reduce the level of Particulate Matter (PM) 2.5 pollution by at least 15% in cities around the Beijing-Tianjin-Hebei region between October 2017 and March 2018. The new rules will require seasonal suspensions or production cuts of steel, aluminum and cement (with the most focus on steel) during the winter heating season from November 15 to March 15. Therefore, over the next four months, downside in steel and coal prices may be limited due to support from these output cuts. This also entails less short-term demand for coke and iron ore, prices for these commodities may remain under downward pressure. Nonetheless, Chinese crude steel output is set to continue rising over the next two years, which in turn will eventually reverse the recent decline in steel products production and assure expansion in steel products production in 2018-'19 (Chart I-11). Chart I-10Chinese Electric Furnace Crude ##br##Steel Production Will Go Up China's 'De-Capacity' Reforms: Where Steel & Coal Prices Are Headed China's 'De-Capacity' Reforms: Where Steel & Coal Prices Are Headed Chart I-11Steel Products Output Will Soon Catch Up Steel Products Output Will Soon Catch Up Steel Products Output Will Soon Catch Up For coal, production will accelerate in 2018. The NDRC expects coal production capacity to rise by a net 200 million metric tons this year as increases at more "advanced" mines exceed shutdowns of outmoded facilities. This will be a 50 million metric ton gain over this year's 150 million metric ton obsolete capacity reduction target. In addition, China's coal utilization rate as of the third quarter of 2017 was still below 70%, implying substantial additional capacity remains, potentially boosting coal output, so long as the government does not alter the 330 working-day rule. Importantly, on the demand side, China is aiming to reduce coal usage for electricity generation while promoting renewable energy like hydro, nuclear, wind and solar. This constitutes a structural headwind to coal prices. This is especially significant, given than China accounts for half of global coal consumption. The supply side reforms of the past two years (shutting down inferior capacity) along with the adoption of new, more efficient technologies, has already strengthened the competitiveness of Chinese steel and coal producers. This entails that China will soon resume net exports of steel products, and that its net imports of coal will drop (Chart I-12). This is bad news for international steel and coal producers, who in the past two years have benefited from higher steel and coal prices on the back of a revival in Chinese demand, and curtailed supply. Last but not least, our broad money impulse as well as the aggregate credit and fiscal spending impulse shows that economic growth in general and demand for industrial metals in particular are set to decelerate considerably in the next nine to 12 months or so (Chart I-13). Chart I-12China May Increase Its Net Steel Exports ##br##And Decrease Its Net Coal Imports China May Increase Its Net Steel Exports And Decrease Its Net Coal Imports China May Increase Its Net Steel Exports And Decrease Its Net Coal Imports Chart I-13Demand Is Set To Decelerate bca.ems_sr_2017_11_22_s1_c13 bca.ems_sr_2017_11_22_s1_c13 Chinese steel and coal markets will determine the direction of coke and iron ore prices, both of which will likely be headed lower as well. Coke: Rising coking coal output as a result of coal production ramping up will increase coke supply sizably. As an increasing share of steel output will come from non-coke-reliant EF capacity, coke demand growth will be constrained. Iron ore: Recovering domestic iron ore production could cap China's imports of iron ore (Chart I-14). First, a marginal rise in profit margins for Chinese iron ore domestic producers and a declining number of loss-generating companies heralds modest upside for iron ore output in China (Chart I-15). Chart I-14Chinese Iron Ore Output Will Rise Chinese Iron Ore Output Will Rise Chinese Iron Ore Output Will Rise Chart I-15Chinese Iron Ore Producers: ##br##Marginal Rise In Profit Margins Chinese Iron Ore Producers: Marginal Rise In Profit Margins Chinese Iron Ore Producers: Marginal Rise In Profit Margins Second, more vertical integration - a rising number of Chinese steel producers that have bought iron ore mines - will result in higher domestic iron ore output. Steel companies' current fat profit margins could prompt them to boost iron ore output from the mines that they have integrated into their production chain. Although profits from iron ore production specifically are likely to be limited. This will be the case especially if the government encourages them to do so. Last year, Chinese iron ore imports accounted for 87% of national total consumption - an all-time high. The authorities dislike such great dependence on resource imports, and the government will likely introduce policies such as reducing taxes for domestic iron ore producers or other efforts to boost domestic production. Bottom Line: China's "de-capacity" reforms in steel and coal will continue into 2018 and 2019, but the scale and pace of "de-capacity" will diminish. The Mainland's steel and coal output will likely rise going forward as new capacity using more efficient and ecologically friendly technologies come on stream. The path of least resistance for steel, coal and iron ore prices is down over the next 12-24 months. Ellen JingYuan He, Editor/Strategist EllenJ@bcaresearch.com Equity Recommendations Fixed-Income, Credit And Currency Recommendations

Last week, Wal-Mart (WMT) surprised the market with exceptionally strong results, notably the 50% surge in online sales which followed a similar number the quarter before. The soaring internet sales are the culmination of a strategy to build up the infrastructure to compete online with Amazon, a strategy that finally appears to be yielding the promised results. However, a war for online market share, while terrific for the consumer, should have a predictably negative impact on margins. In fact, these have been trending down since 2010 (second panel). Still, the market rewarded WMT for the Q3 earnings report and both the stock and the index it dominates gapped higher. The S&P hypermarkets index is now trading at a 20% premium to the overall market (bottom panel), implying most or all of the good news has been priced into the stocks. We prefer to sit on the sidelines until margins can stage a recovery (which may take considerable time); stay neutral. The ticker symbols for the stocks in this index are: BLBG: S5HYPC - WMT, COST. Gearing Up For A Fight Gearing Up For A Fight

The shares of movie & entertainment firms have been under pressure in the last several weeks, despite what has generally been a positive Q3 earnings print, driven down by speculation the AT&T/Time Warner merger may be blocked by the Department of Justice. Rumors that Disney was interested in acquiring most of Fox were not enough to lift spirits in the beleaguered index. The more important driver is the secular decline in consumer spending on media, which seems likely to continue to weigh on the industry's top line. High operating leverage, which has been a boom to EPS growth in the past, is now swinging the other way, explaining the drop in earnings growth (second panel). The industry has rerated to the downside in 2017, implying that the weak profit outlook is mostly priced in to the index (bottom panel). As such, we continue to recommend a benchmark allocation in the S&P movies & entertainment index. The ticker symbols for the stocks in this index are: BLBG: S5MOVI - DIS, TWX, FOXA, FOX, VIAB. Merger Woes Weigh On Movies Merger Woes Weigh On Movies

Highlights Broad Chinese equity market performance since last month's Party Congress is consistent with our view that the pace of reforms over the coming year will not cause a meaningful deceleration in China's industrial sector. Stay overweight Chinese stocks. After accounting for idiosyncrasy, divergent sector performance is largely consistent with the stated intentions of Chinese policymakers. Our new China Reform Monitor, which is based on sector performance, should help investors identify whether the pace of reforms is moving too rapidly to be consistent with a benign growth outlook. We are adding two new reform-themed trades this week, and closing one existing position (with a healthy profit). Feature BCA's China Investment Strategy service has presented a relatively benign view of the economic impact of stepped up reform efforts in China over the coming 6-12 months. As we noted in last week's report, while a "status quo" scenario of no significant reforms is highly unlikely over the coming year, the pace of reforms will be structured at a level of intensity that will be sufficient to avoid an outsized deceleration in China's industrial sector. We also highlighted that monitoring reform progress would be an important theme to revisit, and in this week's report we review the response of investors to the Party Congress, both at the broad market and sector level, to judge whether it is consistent with our outlook and positioning. We also introduce two new reform-themed trades, and recommend booking profits on an existing position. Broad Market Performance Post-Congress Before gauging the market's view of the likely impact of refocused reform efforts on the Chinese economy over the coming year, it is worth revisiting what kind of market performance would be consistent with our view. To recap the view of our Geopolitical Strategy service,1 President Xi's reform agenda is likely to intensify over the next 12 months, suggesting that Chinese policymakers will make meaningful efforts to: Pare back heavy-polluting industry Hasten the transition of China's economy to "consumer-led" growth2 Deleverage the financial sector Continue to crack down on corruption and graft From the perspective of BCA's China Investment Strategy service, a rapid and intense pace of these reforms would likely be a net negative for Chinese equities, as well as for emerging markets (EM) and other plays on China's industrial sector. For example, in terms of the impact on Chinese stock prices, we highlighted in last week's report that MSCI China ex-tech earnings have been closely correlated with the Li Keqiang index, which would likely decline non-trivially in the face of a very pressing reform push. In addition, the potential for a policy mistake would presumably raise the risk premium on Chinese equities, which would reverse at least some of their meaningful re-rating vs the global benchmark since late-2015. As such, to be consistent with our view, broad market performance (relative to emerging market or global stocks) should have been largely unaffected in the immediate aftermath of the Party Congress, but somewhat divergent at the sector level, given the likely creation of at least some industry "winners" and "losers" from renewed reforms. For the overall market, Chart 1 shows that this is exactly what has occurred over the past month. The chart presents the relative performance of Chinese equities versus the emerging market (EM) and global benchmarks, both in US$ terms and rebased to 100 on the day of President Xi's speech at the Party Congress. The initial reaction to the speech was modestly negative, with Chinese stocks falling a little over 2% in relative terms versus their global peers. But this loss disappeared less than three weeks following the speech, underscoring that market participants agree with our assessment that a rebooted reform effort will not threaten the economy as a whole. Investors should stay overweight Chinese stocks relative to their benchmark. Chart 1No Sign That Stepped Up Reforms Will Be A Net Negative For Chinese Economic Growth No Sign That Stepped Up Reforms Will Be A Net Negative For Chinese Economic Growth No Sign That Stepped Up Reforms Will Be A Net Negative For Chinese Economic Growth The Sector Implications Of Renewed Reforms Chart 2 shows that the sector effects of President Xi's speech have indeed been more divergent, which is also in line with our perspective of view-consistent performance. The chart shows that the past month's performance of the 11 level 1 GICS sectors relative to the broad market can be grouped into three distinct categories: Chart 2China's Reforms Will Create Some Winners##br## And Losers China's Reforms Will Create Some Winners And Losers China's Reforms Will Create Some Winners And Losers Clear outperformers, which include health care, energy, information technology, and consumer staples, Neutral to modest underperformers, which include utilities, telecom services, and financials, and Clear underperformers, which include industrials, real estate, consumer discretionary, and materials Several of these results are not surprising, as they clearly resonate with the stated intensions of Chinese policymakers. In particular, the outperformance of health care, technology, and consumer staples stocks and the underperformance of capital-goods intensive industrials straightforwardly reflects the goal of re-orienting "old China" towards a new, consumer-focused economy. While energy stocks are viewed as a traditionally cyclically-sensitive carbon-intensive sector, oil prices have risen over the past month and China's share of global energy consumption is much smaller than that of base metals. However, the relative return profiles of a few sectors mentioned above are at least somewhat counterintuitive. On this front, several observations are noteworthy: At first blush, the significant underperformance of Chinese consumer discretionary stocks is counterintuitive if policymakers are aiming to reduce the country's reliance on investment and increase the share of private consumption. However, as Table 1 shows, Chinese consumer discretionary stocks have likely sold off due to the automobile & components industry group, which is potentially at risk of being negatively impacted by the environmental mandate of President Xi's proposed reforms. The table shows that the automobiles & components industry group accounts for a full 1/3rd of Chinese consumer discretionary market capitalization, which is non-trivially larger than in the case of the global benchmark. Table 1 also highlights that China's retailing industry group is as large as that of automobiles & components, which in theory should have provided an offset to the latter's weakness. However, in market capitalization terms, retailers in the MSCI China index are dominated by two large players, one of which is active in providing corporate travel management services. The continuation and expansion of China's anti-corruption campaign was a key message from the Party Congress, and it would appear that investors are concerned about the potential for anti-graft efforts to negatively impact the demand for goods & services that could be potentially linked to corruption or largesse. The underperformance of the materials sector is seemingly reform-consistent, although here too the details of China's investible indexes matter. Table 2 presents a sub-industry breakdown of the MSCI China materials index, as well as an indication whether rebooted reform efforts are a clear negative for the sub-industry. The table highlights that the likely impact of a renewed reform push is mixed: construction materials firms and copper producers (at least in terms of output) are like to suffer, but there are no obvious negative implications for aluminum,3 gold, and paper products producers. The impact on commodity chemicals producers is ambiguous, given that packaging for consumer goods is a significant end market for the petrochemical industry. Table 1Autos Make Up A Significant Share Of ##br##China's Consumer Discretionary Sector Messages From The Market, Post-Party Congress Messages From The Market, Post-Party Congress Table 2Impact Of Renewed Reforms ##br##On The Materials Sector Is Mixed Messages From The Market, Post-Party Congress Messages From The Market, Post-Party Congress Finally, there appears to be at least somewhat of a discrepancy between the benign performance of Chinese financials and the underperformance of the real estate sector. Attempts to curb "excessive" financial risks and debt could certainly hurt the real estate sector, but this would also negatively impact banks via a slowdown in credit growth. For now, the significant valuation gap between Chinese financials and real estate appears to be the only explanation for this divergent performance post Party Congress, but we will continue to watch these sectors for signs of a wider market implication. Sector idiosyncrasies aside, the broad conclusion from China's equity market performance over the past month is that investors acknowledge that there are likely to be winners and losers from a rebooted reform mandate, but that overall economic growth in China is not likely to significantly decelerate. This is consistent with our view that the pace of reform efforts over the coming year will not be so intense as to trigger a meaningful decline in the growth rate of China's industrial sector. But the potential for an aggressive pace of reforms is a clear risk to our view that the ongoing slowdown in China's economy is likely to be benign and controlled. Chart 3 introduces our China Reform Monitor as one way to monitor this risk, which is calculated as an equally-weighted average of the four "winner" sectors highlighted above relative to an equally-weighted average of the remaining seven sectors. Significant underperformance of "loser" sectors could become a headwind for broad MSCI China outperformance (especially ex-tech), and we will be watching closely for signs that our monitor is rising largely due to outright declines in the denominator. Chart 3Our China Reform Monitor Will Help Us Track The Impact Of A Renewed Reform Push Our China Reform Monitor Will Help Us Track The Impact Of A Renewed Reform Push Our China Reform Monitor Will Help Us Track The Impact Of A Renewed Reform Push Two New Reform-Themed Trade Ideas, And One Trade Closure We have new two trade ideas for investors given the performance of Chinese equities in the wake of the Party Congress: Long investable consumer staples / short investable consumer discretionary Long investable environmental, social and governance (ESG) leaders / short investable benchmark The basis for the first trade stems from our earlier discussion of the current limitations of China's investable consumer discretionary index as a clear-cut play on retail-oriented consumer spending. In addition, while consumer staples stocks are reliably low-beta, they have recently been rising vs consumer discretionary in relative terms despite a rise in the broad investable market (Chart 4). The odds favor a continuation of this trend if a renewed reform push continues to appear likely (i.e., we are banking that this trade will be driven by alpha rather than beta). Chart 4Staples Are A Better Consumer Play Staples Are A Better Consumer Play Staples Are A Better Consumer Play Chart 5ESG Leaders Should Fare Quite Well In A Reform Environment ESG Leaders Should Fare Quite Well In A Reform Environment ESG Leaders Should Fare Quite Well In A Reform Environment The basis for the second trade is to overweight stocks that are best positioned to deliver "sustainable" growth. Our proxy for this trade is the MSCI ESG Leaders index, which favors firms with the highest MSCI ESG ratings in each sector (using a proprietary ranking scheme). The index maintains similar sector weights as the investable benchmark, which limits the beta risk of the trade. Chart 5 highlights that MSCI's ESG Leaders index has outperformed the broad market by almost 7% per year since 2010, with current valuation levels that are broadly similar to the benchmark. To us, this trade represents an attractive risk-reward profile even if the pace of China's reforms are not aggressive over the coming year. Chart 6Close Our China / DM Materials Trade Close Our China / DM Materials Trade Close Our China / DM Materials Trade Finally, we recommend closing our long MSCI China investable materials sector / short developed markets materials trade. A scenario where China continues to shrink the domestic production capacity of metals without significantly curtailing its overall import volume may be modestly positive for global base metals prices, but it would appear that DM materials producers would benefit more from this outcome than Chinese producers (owing to the impact of production constraints on the volume of product sold). While the Chinese material sector remains grossly undervalued versus its DM peer, the bottom line is that the outlook for this trade is cloudier than before at a time when it is correcting sharply from previously overbought conditions (Chart 6). We suggest that investors close the trade for now, booking a healthy profit of 11%. Jonathan LaBerge, CFA, Vice President Special Reports jonathanl@bcaresearch.com 1 Please see BCA Special Report, "China: Party Congress Ends ... So What?" dated November 2, 2016, available at bca.bcaresearch.com. 2 Investors should note that BCA's China Investment Strategy service has long been skeptical of calls to shift China's economy to a consumption-driven growth model, because it significantly raises the odds that the country will not be able to escape the middle-income trap. For example, please see Please see China Investment Strategy Special Report, "On A Higher Note", dated October 5, 2017, available at cis.bcaresearch.com 3 In our view, the use of aluminum in transportation is consistent with an environmental protection mandate, given that its light-weight properties allow for reduced energy consumption. For example, in the U.S. in 2014/2015, Ford Motor Company switched the production of the F150 from a steel to an aluminum frame, resulting in a significant improvement in fuel economy. Cyclical Investment Stance Equity Sector Recommendations

Highlights The current mini-upswing in the global mini-cycle started in May and is likely to end around January. On a 6-month horizon, lean against the rally in industrial metals. Equity investors should underweight Basic Resources, and especially Industrial Metals and Mining. The contrasting economic fortunes of Spain and Italy may switch. The peak bank credit impulse for Spain is almost certainly behind it, while for Italy it likely lies ahead. On this hope, we will dip our toes into a small pair-trade: long Italian BTPs versus French OATs. Feature Key to the medium-term behaviour of markets is the existence of what we call 'mini-cycles' in global activity. The evolution of these perpetual mini-cycles explains much of what has happened, what is happening, and what will happen, to financial markets both in Europe and more broadly. Chart of the WeekExpect A Trend-Reversal In The Metals Market Expect A Trend-Reversal In The Metals Market Expect A Trend-Reversal In The Metals Market Mini-cycles are not a hypothesis. They are an indisputable empirical fact. Just look at the global bond yield (Chart I-2), metal price inflation (Chart I-3), global inflation (Chart I-4), and the bank credit impulse (Chart I-5 and Chart I-6). The regular mini-cycles shout out at you! Furthermore, given that these clearly observed mini-cycles show the same half-cycle length of about 8 months, Investment Reductionism strongly suggests that there is a common over-arching driver. Chart I-2The Global Bond Yield Exhibits Mini-Cycles The Global Bond Yield Exhibits Mini-Cycles The Global Bond Yield Exhibits Mini-Cycles Chart I-3Metal Price Inflation Exhibits Mini-Cycles Metal Price Inflation Exhibits Mini-Cycles Metal Price Inflation Exhibits Mini-Cycles Chart I-4Inflation Exhibits Mini-Cycles Inflation Exhibits Mini-Cycles Inflation Exhibits Mini-Cycles Chart I-5The Global Credit Impulse Exhibits Mini-Cycles The Global Credit Impulse Exhibits Mini-Cycles The Global Credit Impulse Exhibits Mini-Cycles Chart I-6Individual Credit Impulses Exhibit Mini-Cycles Individual Credit Impulses Exhibit Mini-Cycles Individual Credit Impulses Exhibit Mini-Cycles Explaining Mini-Cycles Previously,1 we explained that the distinct mini-cycles are interconnected parts of the same never-ending feedback loop. A lower bond yield accelerates bank credit flows... which boosts economic growth... which pushes up commodity inflation and overall inflation... causing the bond market to raise the bond yield, at which point the cycle reverses. And then the alternate cycles repeat ad perpetuam (see Box I-1). Box I-1The Mathematics Of Mini-Cycles How To Profit From Mini-Cycles How To Profit From Mini-Cycles One common question we get is: why focus on bank credit analysis and not on bond-intermediated credit analysis too? The simple answer is that bank credit expands the broad money supply whereas bond-intermediated credit usually does not. When a bank issues a new loan, fractional reserve banking allows it to create money 'out of thin air'. In contrast, when a company or government issues a new bond, no new money is created, unless the primary issue is financed by the central bank - which is generally forbidden. Usually, when a bond is issued, existing money just moves from one account - that of the bond buyer - to another account - that of the bond issuer. This means that bond-intermediated credit cannot increase demand by creating new money, but only by increasing the velocity of existing money. Whereas bank credit can increase demand by increasing both the amount of money and its velocity. Therefore, changes in bank credit are the much bigger driver of the mini-cycle in economic activity. If a bank issues 100 euros of credit today, then we know that this new money will be spent in the coming days and weeks - because nobody borrows money just to sit on it. If, in the previous period, the bank had issued 90 euros which was spent, it means that economic activity in the coming period will grow by 10 euros. But if the bank had previously issued 110 euros, it means that economic activity in the coming period will contract by 10 euros. In this way, the cycles in credit and activity are interconnected. Mini-upswings in the credit impulse mini-cycle tend to signal mini-upswings in commodity inflation (Chart I-7), overall inflation and bond yields. So if we can identify turning points in the credit impulse then we can correctly position the cyclical stance of our investment strategy. Chart I-7The Same Mini-Cycle: The Global Credit Impulse And Metal Price Inflation The Same Mini-Cycle: The Global Credit Impulse And Metal Price Inflation The Same Mini-Cycle: The Global Credit Impulse And Metal Price Inflation The problem is that the bank credit data is slow to come out. For example, although we are in the middle of November, the last bank credit data for the euro area refers to September. This means that if the mini-cycle is turning now, we might not find out until January. Nevertheless, we can still use the mini-cycle framework. We know that the current mini-upswing started in May and that mini-upswings have an average length of 8 months. Hence, we can infer that the mini-upswing is likely to end around January. That said, upswing lengths do have some degree of variation: the current upswing might be longer or shorter than the average. How to avoid being too early or too late? Combining Mini-Cycles With Fractal Analysis To optimise our proprietary mini-cycle framework, we propose combining it with our proprietary fractal analysis framework. As regular readers know, fractal analysis measures whether herding in a specific investment has become excessive, signalling the end of its price trend. The combined mini-cycle and fractal framework works best if we use a 130-day herding indicator (fractal dimension), as it broadly aligns with the mini half-cycle length. Excessive herding signals that an investment's trend is approaching exhaustion because the liquidity that has fuelled the trend is about to evaporate. Liquidity is plentiful when the market is split between different herds - say, short-term momentum traders and long-term value investors. This is because the herds disagree with each other. If the price fluctuates up, the momentum trader wants to buy while the value investor wants to sell; and vice-versa. So the herds trade with each other with plentiful liquidity. But liquidity starts to evaporate when too many value investors join the momentum herd. Instead of dispassionately investing on the basis of value, value investors get sucked into chasing a price trend, and their buy orders add fuel to the trend. The tipping point comes when all the value investors have joined the momentum herd. If a value investor then suddenly reverts to type and puts in a sell order, he will find that there are no buyers left. Liquidity has evaporated, and finding new liquidity might require a substantial reversal in the price to attract a buy order from an ultra-long-term deep value investor. Earlier this year, our combined frameworks signalled that the aggressive rise in bond yields was likely to reverse (Chart I-8). Therefore, on February 2 we correctly advised: "Lean against the rise in bond yields and bank equities." Chart I-8Excessive Herding In Bonds Always Signals A Trend Reversal Excessive Herding In Bonds Always Signals A Trend Reversal Excessive Herding In Bonds Always Signals A Trend Reversal Today, we see the same dynamic in parts of the commodity rally - and specifically the move in the LME Index (Chart of the Week). Hence, on a 6-month horizon, lean against the rally in industrial metals. Equity investors should underweight Basic Resources, and especially Industrial Metals and Mining. Could Italy Be A Good Surprise? Returning to the concept of the bank credit cycle, the evolution of longer-term impulses also explains the contrasting recent fortunes of Spain and Italy. In 2013, Spain recapitalized its banking system and ring-fenced bad assets within a 'bad bank'. In effect, it finally did what other economies - most notably the U.S., U.K. and Ireland - had done several years earlier in response to their own housing-related banking crises. As Spanish banks' aggressive deleveraging ended, the bank credit impulse rebounded very sharply and has remained positive for several years. This undoubtedly explains why Spanish real GDP has grown by 13% since mid-2013 (Chart I-9). In contrast, Italy's banking system remained dysfunctional - which meant that its own credit impulse stayed much more muted and barely positive over the past four years (Chart I-10). But now, the Italian banking system is slowly recuperating. Italian banks' equity capital is rising, their solvency is improving, and the share of non-performing loans has fallen sharply this year. Chart I-9Spain's Peak Credit Impulse##br## Is Probably Behind It Spain"s Peak Credit Impulse Is Probably Behind It Spain"s Peak Credit Impulse Is Probably Behind It Chart I-10Italy's Peak Credit Impulse##br## Is Likely Ahead Of It Italy"s Peak Credit Impulse Is Likely Ahead Of It Italy"s Peak Credit Impulse Is Likely Ahead Of It So the contrasting economic fortunes of Spain and Italy may switch. The peak bank credit impulse for Spain is almost certainly behind it, while for Italy it likely lies ahead. On this hope, we will dip our toes into a small pair-trade: long Italian BTPs versus French OATs. Dhaval Joshi, Senior Vice President Chief European Investment Strategist dhaval@bcaresearch.com 1 Please see the European Investment Strategy Weekly Report 'Credit Slumps While Animal Spirits Soar. Why?' March 30, 2017 available at eis.bcaresearch.com Fractal Trading Model* There are no new trades this week, leaving us with six open positions. For any investment, excessive trend following and groupthink can reach a natural point of instability, at which point the established trend is highly likely to break down with or without an external catalyst. An early warning sign is the investment's fractal dimension approaching its natural lower bound. Encouragingly, this trigger has consistently identified countertrend moves of various magnitudes across all asset classes. Chart I-11 Short Nikkei225/Long Eurostoxx50 Short Nikkei225/Long Eurostoxx50 The post-June 9, 2016 fractal trading model rules are: When the fractal dimension approaches the lower limit after an investment has been in an established trend it is a potential trigger for a liquidity-triggered trend reversal. Therefore, open a countertrend position. The profit target is a one-third reversal of the preceding 13-week move. Apply a symmetrical stop-loss. Close the position at the profit target or stop-loss. Otherwise close the position after 13 weeks. Use the position size multiple to control risk. The position size will be smaller for more risky positions. * For more details please see the European Investment Strategy Special Report "Fractals, Liquidity & A Trading Model," dated December 11, 2014, available at eis.bcaresearch.com Fractal Trading Model Recommendations Equities Bond & Interest Rates Currency & Other Positions Closed Fractal Trades Trades Closed Trades Asset Performance Currency & Bond Equity Sector Country Equity Indicators Bond Yields Chart II-1Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Chart II-2Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Chart II-3Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Chart II-4Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Interest Rate Chart II-5Indicators To Watch -##br## Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Chart II-6Indicators To Watch - ##br##Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Chart II-7Indicators To Watch -##br## Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Chart II-8Indicators To Watch -##br## Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations