Taiwan

Highlights The tech sector faces mounting domestic political and geopolitical risks. We fully expected stimulus hiccups but believe they will give way to large new fiscal support, given that COVID-19 is weighing on consumer confidence. Europe’s relative political stability is a good basis for the euro rally but any comeback in opinion polling by President Trump could give dollar bulls new life. DXY is approaching a critical threshold below which it would break down further. The US could take aggressive actions on Russia and Iran, but China and the Taiwan Strait remain the biggest geopolitical risk. Feature Near-term risks continue to mount against the equity rally, even as governments’ combined monetary and fiscal policies continue to support a cyclical economic rebound. Chart 1Tech Bubble Amid Tech War Tech Bubble Amid Tech War Tech Bubble Amid Tech War Testimony by the chief executives of Facebook, Apple, Amazon, and Alphabet to the US House of Representatives highlighted the major political risks facing the market leaders. There are three reasons not to dismiss these risks despite the theatrical nature of the hearings. First, the tech companies’ concentration of wealth would be conspicuous during any economic bust, but this bust has left pandemic-stricken consumers more reliant on their services. Second, acrimony is bipartisan – conservatives are enraged by the tendency of the tech companies to side with the Democratic Party in policing the range of acceptable political discourse, and they increasingly agree with liberals that the companies have excessive corporate power warranting anti-trust probes. Executive action is the immediate risk, but in the coming one-to-two years congressional majorities will also be mustered to tighten regulation. Third, technology is the root of the great power struggle between the US and China – a struggle that will not go away if Biden wins the election. Indeed Biden was part of the administration that launched the US’s “Pivot to Asia” and will have better success in galvanizing US diplomatic allies behind western alternatives to Chinese state-backed and military-linked tech companies. US tech companies struggle to outperform Chinese tech companies except during episodes of US tariffs, given the latter firms’ state-backed turn toward innovation and privileged capture of the Chinese domestic market (Chart 1). The US government cannot afford to break up these companies without weighing the strategic consequences for America’s international competitiveness. The attempt to coordinate a western pressure campaign against Huawei and other leading Chinese firms will continue over the long run as they are accused of stealing technology, circumventing UN sanctions, violating human rights, and compromising the national security of the democracies. China, for its part, will be forced to take counter-measures. US tech companies will be caught in the middle. Like the threat of executive regulation in the domestic sphere, the threat of state action in the international sphere is difficult to time. It could happen immediately, especially given that the US is having some success in galvanizing an alliance even under President Trump (see the UK decision to bar Huawei) and that President Trump’s falling election prospects remove the chief constraint on tough action against China (the administration will likely revoke Huawei’s general license on August 13 or closer to the election). Massive domestic economic stimulus empowers the US to impose a technological cordon and China to retaliate. Combining this headline risk to the tech sector with other indications that the equity rally is extended – the surge in gold prices, the fall in the 30-year/5-year Treasury slope – tells us that investors should be cautious about deploying fresh capital in the near term. Republicans Will Capitulate To New Stimulus Just as President Trump has ignored bad news on the coronavirus, financial markets have ignored bad news on the economy. Dismal Q2 GDP releases were fully expected – Germany shrank by 10.1% while the US shrank by 9.5% on a quarterly basis, 32.9% annualized. But the resurgence of the virus is threatening new government restrictions on economic activity. US initial unemployment claims have edged up over the past three weeks. US consumer confidence regarding future expectations plummeted from 106.1 in June to 91.5 in July, according to the Conference Board’s index. Chart 2Global Instability Will Follow Recession A Tech Bubble Amid A Tech War (GeoRisk Update) A Tech Bubble Amid A Tech War (GeoRisk Update) Setbacks in combating the virus will hurt consumers even assuming that governments lack the political will to enforce new lockdowns. The share of countries in recession has surged to levels not seen in 60 years (Chart 2). Financial markets can look past recessions, but the pandemic-driven recession will result in negative surprises and second-order effects that are unforeseen. Yes, fresh fiscal stimulus is coming, but this is more positive for the cyclical outlook than the tactical outlook. Stimulus “hiccups” could precipitate a near-term pullback – such a pullback may be necessary to force politicians to resolve disputes over the size and composition of new stimulus. This risk is immediate in the United States, where House Democrats, Senate Republicans, and the White House have hit an all-too-predictable impasse over the fifth round of stimulus. The bill under negotiation is likely to be President Trump’s last chance to score a legislative victory before the election and the last significant legislative economic relief until early 2021. The Senate Republicans have proposed a $1.1 trillion HEALS Act in response to the House Democrats’ $3.4 trillion HEROES Act, passed in mid-May. As we go to press, the federal unemployment insurance top-up of $600 per week is expiring, with a potential cost of 3% of GDP in fiscal tightening, as well as the moratorium on home evictions. Congress will have to rush through a stop-gap measure to extend these benefits if it cannot resolve the debate on the larger stimulus package. If Democrats and Republicans split the difference then we will get $2.5 trillion in stimulus, likely by August 10. Compromise on the larger package is easy in principle, as Table 1 shows. If the two sides split the difference between their proposals in a commonsense way, as shown in the fourth and fifth columns of Table 1, then the result will be a $2.5 trillion stimulus. This estimate fits with what we have published in the past and likely meets market expectations for the time being. Table 1Outline Of Fifth US COVID Stimulus Package (Estimate) A Tech Bubble Amid A Tech War (GeoRisk Update) A Tech Bubble Amid A Tech War (GeoRisk Update) Whether it is enough for the economy depends on how the virus develops and how governments respond once flu season picks up and combines with the coronavirus to pressure the health system this fall. A back-of-the-envelope estimate of the amount of spending necessary to keep the budget deficit from shrinking in the second half of the year comes much closer to the House Democrats’ $3.4 trillion bill (Table 2), which suggests that what appears to be a massive stimulus today could appear insufficient tomorrow. Nevertheless, $2.5 trillion is not exactly small. It would bring the US total to $5 trillion year-to-date, or 24% of GDP! Table 2Reducing The Budget Deficit On A Quarterly Basis Will Slow Economy A Tech Bubble Amid A Tech War (GeoRisk Update) A Tech Bubble Amid A Tech War (GeoRisk Update) While a compromise bill should come quickly, the Republican Party is more divided over this round of stimulus than earlier this year. Chart 3US Personal Income Looks Good Compared To 2008-09 US Personal Income Looks Good Compared To 2008-09 US Personal Income Looks Good Compared To 2008-09 First, there is some complacency due to the fact that the economy is recovering, not collapsing as was the case back in March. Our US bond strategist, Ryan Swift, has shown that US personal income is much better off, thus far, than it was in the months following the 2008 financial crisis, even though the initial pre-transfer hit to incomes is larger (Chart 3). Second, the Republican Party is reacting to growing unease within its ranks over the yawning budget deficit, now the largest since World War II (Chart 4). Chart 4If Republicans React To Deficit Concerns They Cook Their Own Goose If Republicans React To Deficit Concerns They Cook Their Own Goose If Republicans React To Deficit Concerns They Cook Their Own Goose Chart 5Consumer Confidence Sends Warning Signal To Republicans A Tech Bubble Amid A Tech War (GeoRisk Update) A Tech Bubble Amid A Tech War (GeoRisk Update) If Republicans are guided by complacency and fiscal hawks, they will cook their own goose. A failure to provide government support will cause a financial market selloff, will hurt consumer confidence, and will put the final nail in the coffin of their own chance of re-election as well as President Trump’s. Consumer confidence tracks fairly well with presidential approval rating and election outcomes. A further dip could disqualify Trump, whereas a last-minute boost due to stimulus and an economic surge could line him up for a comeback in the last lap (Chart 5). These constraints are obvious so we maintain our high conviction call that a bill will be passed, likely by August 10. But at these levels on the equity market, we simply have no confidence in the market gyrations leading up to or following the passage of the bill. Our conviction level is on the cyclical, 12-month horizon, in which case we expect US and global stimulus to operate and equities to rise. Bottom Line: Political and economic constraints will force Republicans to join Democrats and pass a new stimulus bill of about $2.5 trillion by around August 10. This is cyclically positive, but hiccups in getting it passed, negative surprises, and other risks tied to US politics discourage us from taking an overtly bullish stance over the next three months. Yes, US-China Tensions Are Still Relevant Chart 6Chinese Politburo"s Bark Worse Than Bite On Stimulus Chinese Politburo"s Bark Worse Than Bite On Stimulus Chinese Politburo"s Bark Worse Than Bite On Stimulus Financial markets have shrugged off US-China tensions this year for understandable reasons. The pandemic, recession, and stimulus have overweighed the ongoing US-China conflict. As we have argued, China is undertaking a sweeping fiscal and quasi-fiscal stimulus – despite lingering hawkish rhetoric – and the size is sufficient to assist in global economic recovery as well as domestic Chinese recovery. What the financial market overlooks is that China’s households and firms are still reluctant to spend (Chart 6). China’s Politburo's late July meetings on the economy are frequently important. Initial reports of this year’s meet-up reinforce the stimulus narrative. Hints of hawkishness here and there serve a political purpose in curbing market exuberance, both at home and in the US election context, but China will ultimately remain accommodative because it has already bumped up against its chief constraint of domestic stability. Note that this assessment also leaves space for market jitters in the near-term. The phase one trade deal remains intact as President Trump is counting on it to make the case for re-election while China is looking to avoid antagonizing a loose cannon president who still has a chance of re-election. As long as broad-based tariff rates do not rise, in keeping with Trump’s deal, financial markets can ignore the small fry. We maintain a 40% risk that Trump levels sweeping punitive measures; our base case is that he goes to the election arguing that he gets results through his deal-making while carrying a big stick. At the same time, our view that domestic stimulus removes the economic constraints on conflict, enabling the two countries to escalate tensions, has been vindicated in recent weeks. Chinese political risk continues on a general uptrend, based on market indicators. The market is also starting to price in the immense geopolitical risks embedded in Taiwan’s situation, which we have highlighted consistently since 2016. While North Korea remains on a diplomatic track, refraining from major military provocations, South Korean political risk is still elevated both for domestic and regional reasons (Chart 7). Chart 7China Political Risk Still Trending Upward China Political Risk Still Trending Upward China Political Risk Still Trending Upward The market is gradually pricing in a higher risk premium in the renminbi, Taiwanese dollar, and Korean won, and this pricing accords with our longstanding political assessment. The closure of the US and Chinese consulates in Houston and Chengdu is only the latest example of this escalating dynamic. While the US’s initial sanctions on China over Hong Kong were limited in economic impact, the longer term negative consequences continue to build. Hong Kong was the symbol of the Chinese Communist Party’s compatibility with western liberalism; the removal of Hong Kong’s autonomy strikes a permanent blow against this compatibility. China’s decision to go forward with the imposition of a national security law in Hong Kong – and now to bar pro-democratic candidates from the September 6 Legislative Council elections, which will probably be postponed anyway – has accelerated coalition-building among the western democracies. The UK is now clashing with China more openly, especially after blocking Huawei from its 5G system and welcoming Hong Kong political refugees. Australia and China have fought a miniature trade war of their own over China’s lack of transparency regarding COVID-19, and Canada is implicated in the Huawei affair. Even the EU has taken a more “realist” approach to China. Across the Taiwan Strait, political leaders are assisting fleeing Hong Kongers, crying out against Beijing’s expansion of control in its periphery, rallying support from informal allies in the US and West, and doubling down on their “Silicon Shield” (prowess in semiconductor production) as a source of protection. Intel Corporation’s decision to increase its dependency on TSMC for advanced microchips only heightens the centrality of this island and this company in the power struggle between the US and China. China cannot fulfill its global ambitions if the US succeeds in creating a technological cordon. Taiwan is the key to China’s breaking through that cordon. Therefore Taiwan is at heightened risk of economic or even military conflict. The base case is that Beijing will impose economic sanctions first, to undermine Taiwanese leadership. The uncertainty over the US’s willingness to defend Taiwan is still elevated, even if the US is gradually signaling a higher level of commitment. This uncertainty makes strategic miscalculations more likely than otherwise. But Taiwan’s extreme economic dependence on the mainland gives Beijing a lever to pursue its interests and at present that is the most important factor in keeping war risk contained. By the same token, Taiwanese economic and political diversification increases that risk. A “fourth Taiwan Strait crisis” that involves trade war and sanctions is our base case, but war cannot be ruled out, and any war would be a major war. Thus investors can safely ignore Tik-Tok, Hong Kong LegCo elections, and accusations of human rights violations in Xinjiang. But they cannot ignore concrete deterioration in the Taiwan Strait. Or, for that matter, the South and East China Seas, which are not about fishing and offshore drilling but about China’s strategic depth and positioning around Taiwan. Taiwan is at heightened risk of economic or military conflict. The latest developments have seen the CNY-USD exchange rate roll over after a period of appreciation associated with bilateral deal-keeping (Chart 8). Depreciation makes it more likely that President Trump will take punitive actions, but these will still be consistent with maintaining the phase one deal unless his re-election bid completely collapses, rendering him a lame duck and removing his constraints on more economically significant confrontation. We are perilously close to such an outcome, which is why Trump’s approval rating and head-to-head polling against Joe Biden must be monitored closely. If his budding rebound is dashed, then all bets are off with regard to China and Asian power politics. Chart 8A Warning Of Further US-China Escalation A Warning Of Further US-China Escalation A Warning Of Further US-China Escalation Bottom Line: China’s stimulus, like the US stimulus, is a reason for cyclical optimism regarding risk assets. The phase one trade deal with President Trump is less certain – there is a 40% chance it collapses as stimulus and/or Trump’s political woes remove constraints on conflict. Hong Kong is a red herring except with regard to coalition-building between the US and Europe; the Taiwan Strait is the real geopolitical risk. Maritime conflicts relate to Taiwan and are also market-relevant. Europe, Russia, And Oil Risks Europe has proved a geopolitical opportunity rather than a risk, as we have contended. The passage of joint debt issuance in keeping with the seven-year budget reinforces the point. The Dutch, facing an election early next year, held up the negotiations, but ultimately relented as expected. Emmanuel Macron, who convinced German Chancellor Angela Merkel to embrace this major compromise for European solidarity, is seeing his support bounce in opinion polls at home. He is being rewarded for taking a leadership position in favor of European integration as well as for overseeing a domestic economic rebound. His setback in local elections is overstated as a political risk given that the parties that benefited do not pose a risk to European integration, and will ally with him in 2022 against any populist or anti-establishment challenger. We still refrain from reinitiating our long EUR-USD trade, however, given the immediate risks from the US election cycle (Chart 9). We will reevaluate if Trump’s odds of victory fall further. A Biden victory is very favorable for the euro in our view. Chart 9EUR-USD Gets Boost From EU Solidarity EUR-USD Gets Boost From EU Solidarity EUR-USD Gets Boost From EU Solidarity We are bullish on pound sterling because even a delay or otherwise sub-optimal outcome to trade talks is mostly priced in at current levels (Charts 10A and 10B). Prime Minister Boris Johnson has the raw ability to walk away without a deal, in the context of strong domestic stimulus, but the long-term economic consequences could condemn him to a single term in office. Compromise is better and in both parties’ interests. Chart 10APound Sterling A Buy Over Long Run Pound Sterling A Buy Over Long Run Pound Sterling A Buy Over Long Run Chart 10BPound Sterling A Buy Over Long Run Pound Sterling A Buy Over Long Run Pound Sterling A Buy Over Long Run Two other risks are worth a mention in this month’s GeoRisk Update: Chart 11Russia: GeoRisk Indicator Russian Bonds May Face Sanctions Russia: GeoRisk Indicator Russian Bonds May Face Sanctions Russia: GeoRisk Indicator Russian Bonds May Face Sanctions Russia: In recent reports we have maintained that Russian geopolitical risk is understated by markets. Domestic unrest is rising, the Trump administration could impose penalties over Nordstream 2 or other issues to head off criticism on the campaign trail, and a Biden administration would be outright confrontational toward Putin’s regime. Moscow may intervene in the US elections or conduct larger cyber attacks. US sanctions could ultimately target trading of local currency Russian government bonds, which so far have been spared (Chart 11). Iran: The jury is still out on whether the recent series of mysterious explosions affecting critical infrastructure in Iran are evidence of a clandestine campaign of sabotage (Table 3). The nature of the incidents leaves some room for accident and coincidence.1 But the inclusion of military and nuclear sites in the list leads us to believe that some degree of “wag the dog” is going on. The prime suspect would be Israel and/or the United States during the window of opportunity afforded by the Trump administration, which looks to be closing over the next six months. Trump likely has a high tolerance for conflict with Iran ahead of the election. Even though Americans are war-weary, they will rally to the president’s defense if Iran is seen as the instigator, as opinion polls showed they did in September 2019 and January of this year. Iran is avoiding goading Trump so far but if it suffers too great of damage from sabotage then it may be forced to react. The dynamic is unstable and hence an oil price spike cannot be ruled out. Table 3Wag The Dog Scenario Playing Out In Iran A Tech Bubble Amid A Tech War (GeoRisk Update) A Tech Bubble Amid A Tech War (GeoRisk Update) Chart 12Oil Supply Risks Stem From Iran/Iraq, But COVID Threat To Demand Persists Oil Supply Risks Stem From Iran/Iraq, But COVID Threat To Demand Persists Oil Supply Risks Stem From Iran/Iraq, But COVID Threat To Demand Persists Oil markets have the capacity and the large inventories necessary to absorb supply disruptions caused by a single Iranian incident (Chart 12). Only a chain reaction or major conflict would add to upward pressure. This would also require global demand to stay firm. The threat from COVID-19 suggests that volatility is the only thing one can count on in the near-term. Over the long run we remain bullish crude oil due to the unfettered commitment by world governments to reflation. Bottom Line: The euro rally is fundamentally supported but faces exogenous risks in the short run. We would steer clear of Russian currency and local currency bonds over the US election campaign and aftermath, particularly if Trump’s polling upturn becomes a dead cat bounce. Iran is a “gray swan” geopolitical risk, hiding in plain sight, but its impact on oil markets will be limited unless a major war occurs. Investment Implications The US dollar is at a critical juncture. Our Foreign Exchange Strategist Chester Ntonifor argues that if the DXY index breaks beneath the 93-94 then the greenback has entered a structural bear market. The most recent close was 93.45 and it has hovered below 94 since Monday. Failure to pass US stimulus quickly could result in a dollar bounce along with other safe havens. Over the short run, investors should be prepared for this and other negative surprises relating to the US election and significant geopolitical risks, especially involving China, the tech war, and the Taiwan Strait. Over the long run, investors should position for more fiscal support to combine with ultra-easy monetary policy for as far as the eye can see. The Federal Reserve is not even “thinking about thinking about raising rates.” This combination ultimately entails rising commodity prices, a weakening dollar, and international equity outperformance relative to both US equities and government bonds.   Matt Gertken Vice President Geopolitical Strategy mattg@bcaresearch.com   Footnotes 1 See Raz Zimmt, "When it comes to Iran, not everything that goes boom in the night is sabotage," Atlantic Council, July 30, 2020. Section II: Appendix : GeoRisk Indicator China China: GeoRisk Indicator China: GeoRisk Indicator Russia Russia: GeoRisk Indicator Russia: GeoRisk Indicator UK UK: GeoRisk Indicator UK: GeoRisk Indicator Germany Germany: GeoRisk Indicator Germany: GeoRisk Indicator France France: GeoRisk Indicator France: GeoRisk Indicator Italy Italy: GeoRisk Indicator Italy: GeoRisk Indicator Canada Canada: GeoRisk Indicator Canada: GeoRisk Indicator Spain Spain: GeoRisk Indicator Spain: GeoRisk Indicator Taiwan Taiwan: GeoRisk Indicator Taiwan: GeoRisk Indicator Korea Korea: GeoRisk Indicator Korea: GeoRisk Indicator Turkey Turkey: GeoRisk Indicator Turkey: GeoRisk Indicator Brazil Brazil: GeoRisk Indicator Brazil: GeoRisk Indicator Section III: Geopolitical Calendar

Highlights The decade-long US equity market outperformance versus the rest of the world could be nearing its end. We are upgrading EM stocks from underweight to neutral within a global equity portfolio. We reiterate the change in our US dollar outlook from bullish to bearish. The concentration risk in EM (specifically in North Asia) mega-cap stocks, poor fundamentals in EM outside North Asia, and a potential flare-up in US-China tensions are the reasons why we are reluctant to be overweight EM stocks. Feature We recommended the short EM equities / long S&P 500 position in late 2010,1 and have reiterated this strategy consistently over the past decade. Since its inception, this trade has produced a 193% gain with extremely low volatility (Chart 1). We recommend taking profits on this position for the reasons elaborated in this report. Chart 1Book Profits On Our Short EM Stocks / Long S&P 500 Strategy Book Profits On Our Short EM Stocks / Long S&P 500 Strategy Book Profits On Our Short EM Stocks / Long S&P 500 Strategy Chart 2Equity Strategy Of the Decade: The Risk-Reward Is No Longer Attractive Equity Strategy Of the Decade: The Risk-Reward Is No Longer Attractive Equity Strategy Of the Decade: The Risk-Reward Is No Longer Attractive Consistently, we are upgrading EM stocks from underweight to neutral within a global equity portfolio. Our decade-long equity sector theme – introduced in our June 8, 2010 report2 – has been to underweight resources and overweight technology and healthcare (Chart 2). This sector strategy has been one of the reasons for underweighting EM and favoring the US market in a global equity portfolio over the past decade. Going forward, the risk-reward of this sector strategy is no longer attractive. Regarding EM absolute performance, we recommend that absolute-return investors remain on standby for a correction before going long the EM equity benchmark. The End Of US Equity Outperformance The decade-long US equity market outperformance versus the rest of the world could be nearing its end.It is widely known that this decade’s US equity outperformance was largely due to FAANGM stocks (Facebook, Amazon, Apple, Netflix, Google and Microsoft). The FAANGM rally meets many of the criteria for a bubble, as we elaborated in our July 16 report. Our FAANGM equity index – an equal-weighted average of the six stocks – has increased almost 20-fold in real (inflation-adjusted) terms since January 2010 (Chart 3). Chart 3Each Decade = One Mania Take Profits On The Short EM / Long S&P 500 Position Take Profits On The Short EM / Long S&P 500 Position Its rise is on par with the magnitude of the bull market in the Nasdaq 100 index through the 1990s, or of Walt Disney. through the 1960s, and it well exceeds other bubbles, as illustrated on Chart 3. All price indexes are shown in real (inflation-adjusted) terms. FAANGM stocks have greatly benefited from the recent “work from home” and other societal shifts and have been outperforming through the March financial carnage. It has made them unassailable in the eyes of investors. Yet, even great companies have a fair price, and considerable price overshoots will not be sustainable in the long term. We sense that a growing number of investors deem the US FAANGM and EM mega-cap stocks to be invincible. When some stocks are regarded as unbeatable, their top is not far. Therefore, it is highly unlikely that the FAANGM will outperform in the next selloff. Rather, the odds are that they will underperform because these stocks are extremely expensive, overbought, over-hyped and over-owned. The decade-long US equity market outperformance versus the rest of the world could be nearing its end. Apart from technology and FAANGM, US equities are facing a mediocre profit outlook. As long as the pandemic is not contained, America’s consumer and business confidence will remain lackluster, and, as a result, a recovery in their spending will be subdued. Chart 4US Stocks Are Not Cheap After Removing Market-Cap Bias US Stocks Are Not Cheap After Removing Market-Cap Bias US Stocks Are Not Cheap After Removing Market-Cap Bias Notably, the broad US equity market is also expensive. The equal-weighted US equity index is trading at a 12-month forward P/E ratio of 21 (Chart 4, top panel). The risks associated with domestic politics are rising in the US. Social, political and economic divisions have been magnified by both the pandemic and the economic downtrend. Social and political tensions will likely flare up around the November elections. Our colleagues from the Geopolitical team argue that a contested election is possible and could lead to a crisis of presidential legitimacy in the US. Finally, the US equity market cap has reached 58% of the global market cap, the highest on record. Gravity forces are likely to kick in sooner than later, capping US equity outperformance. Bottom Line: The tailwinds supporting the US equity outperformance are fading. We are booking gains on the short EM stocks / long S&P 500 strategy. Consistently, we are also closing the short EM banks / long US banks and short Chinese banks / long US banks positions. They have produced a 75% gain and an 11% loss, respectively. Downgrading The US Dollar Outlook = Upgrading The EM View We had been bullish on the US dollar and bearish on EM currencies since early 2011 (Chart 5, top panel), but on July 9 made a major change in our currency strategy: we switched our shorts in EM currencies away from the US dollar to against an equal-weighted basket of the euro, Swiss franc and the yen. Since then, the EM ex-China equal-weighted currency index has rebounded versus the US dollar, but has depreciated against the basket of the euro, CHF and JPY (Chart 5, bottom panel). Chart 5EM Currencies Have Bottomed Versus The US Dollar But Not Against Other Safe-Heavens EM Currencies Have Bottomed Versus The US Dollar But Not Against Other Safe-Heavens EM Currencies Have Bottomed Versus The US Dollar But Not Against Other Safe-Heavens While the US dollar could rebound in the short term, especially versus EM currencies, any rebound will likely prove to be short-lived. From now on, the strategy for the greenback should be selling into strength. Here is why: As US inflation rises in the coming years and the Fed refuses to raise interest rates, US real rates will drop further and, as a result, the US dollar will depreciate. A central bank that is behind the inflation curve is bearish for a nation’s currency. The main reason for turning negative on the US dollar structurally is the rising determination by the Federal Reserve to stay behind the inflation curve in the years to come. This strategy will instigate an inflation outbreak. Falling real interest rates have caused a plunge in the US dollar, as well as a surge in precious metal prices, in recent weeks. In fact, risk-on currencies have lately underperformed safe-haven currencies, such as the CHF and JPY (Chart 6). This market move confirms that the dollar’s recent plunge is due to fears of its debasement, not to robust growth in the world economy and in EM/China. As US inflation rises in the coming years and the Fed refuses to raise interest rates, US real rates will drop further and, as a result, the US dollar will depreciate.    Colossal debt monetization. The Fed is undertaking an immense monetization of public and private debt. The current situation, involving the Fed’s purchases of securities, is different from the one following the Lehman crisis. Back in 2008-2014, the Fed’s QE program did not produce an exponential rise in money supply. The US broad money supply (M2) was rising at a single-digit rate between 2009 and 2014 (Chart 7). Presently, US M2 growth has exploded to 24% from a year ago. Chart 6Risk-On Currencies Are Underperforming Safe-Heaven Ones Risk-On Currencies Are Underperforming Safe-Heaven Ones Risk-On Currencies Are Underperforming Safe-Heaven Ones Chart 7Helicopter' Money in the US Helicopter' Money in the US Helicopter' Money in the US The pace of US broad money growth is much higher than that of many advanced and developing economies. Chart 8 shows new money creation as a share of GDP across various economies. It demonstrates that Japan and the US are now experiencing the quickest rate of new money creation in the world.   In short, even though debt monetization is occurring in many advanced and EM economies, the US is doing it on an unprecedented scale. Chart 8Money Creation As % Of GDP In 2Q2020 Take Profits On The Short EM / Long S&P 500 Position Take Profits On The Short EM / Long S&P 500 Position “Helicopter” money will eventually lift inflation. The latest surge in the US money supply has only partially offset the collapse in its velocity. Consequently, America’s nominal GDP has plunged. This stems from the following identity: Nominal GDP = Price Level x Output Volume = Velocity of Money x Money Supply Solving the above equation for inflation, we get: Price Level = (Velocity of Money x Money Supply) / (Output Volume) Going forward, the velocity of US money will likely recover, for it is closely associated with consumers’ and businesses’ willingness to spend. At that point, rising velocity of money and greater money supply will work together to exert upward pressure on nominal GDP. Meantime, the pandemic will probably reduce potential output. The outcome of higher nominal spending and reduced potential productive capacity will be higher inflation. In sum, US inflation will rise well above 2% in the coming years. Yet, the Fed will stay put amid rising inflation. The upshot will be a structural downtrend in the US dollar. Whilst there are many arguments against rising inflation, we are leaning toward the view that US inflation will begin rising as of next year. We will elaborate on this inflation outlook in our future reports.     Rising political and social uncertainty in the US will weigh on the greenback. The failure by the US authorities to contain the spread of the pandemic will continue fueling political and social upheavals. This could culminate in a harshly contested presidential election and a reduction in the US dollar’s allure for foreign investors.    Portfolio inflows into the US will turn into outflows. The stellar performance of US equities attracted portfolio inflows into the US over the last 10 years. These capital inflows, in turn, boosted the greenback. But these dynamics are about to be reversed. Chart 9The US's Net International Investment Position Is At A Record Low The US's Net International Investment Position Is At A Record Low The US's Net International Investment Position Is At A Record Low The top panel of Chart 9 shows that the US’s net international investment position in equities is at its lowest point since 1986. This means that foreign ownership of US stocks exceeds US resident ownership of foreign equities by a record amount. This reflects the fact that investors have by a large margin favored the US versus other bourses. As American share prices outperformed their international peers, both domestic and foreign investors have poured more capital into US equities. As the US relative equity performance reverses, equity capital will flow out of the US, thus dragging down the US dollar. Chart 10 shows that the trade-weighted dollar tracks the relative performance of the S&P500 versus the global equity benchmark in local currency terms. Regarding debt securities, the US’s net international investment position has widened to  - US$8.5 trillion (Chart 9, bottom panel). Not all fixed-income investors hedge currency risk. As the dollar slides, there will be growing pressure on foreign fixed-income investors to hedge their dollar exposure or sell US and buy non-US debt securities. Chart 10A Top In The US$ = The End Of The US Equity Outperformance? A Top In The US$ = The End Of The US Equity Outperformance? A Top In The US$ = The End Of The US Equity Outperformance? Bottom Line: Immense public debt monetization leading to higher inflation down the road and the Fed falling behind the curve, will produce a lasting and considerable downtrend in the US dollar in the coming years. Why Not Overweight EM Stocks? There are a number of reasons why – for now – we are only upgrading EM equities to neutral, rather than to overweight within a global equity portfolio, and why we are still reluctant to recommend buying EM stocks for absolute-return investors:   Concentration risk in EM mega-cap stocks. As US FAANGM share prices come under selling pressure, contagion will spill over to EM mega-cap stocks. The latter have been responsible for a large share of gains in the EM equity index and, conversely, their pullback will considerably impact the EM benchmark’s performance. The top six companies combined account for about 24% of the MSCI EM equity market cap. To compare, US FAANGM (Facebook, Apple, Amazon, Netflix, Google and Microsoft) also account for 24% of the S&P 500 market cap. Hence, the concentration risk in EM equity space is as high as in the US. Geopolitical risk. A potential flare up in in geopolitical tensions will weigh on Chinese, South Korean and Taiwanese stocks. Given that they make up about 65% of the MSCI EM index equity market cap, the EM benchmark will suffer in absolute terms and be unlikely to outperform the global equity index. Faced with decreased approval in regard to his handling of the pandemic, and to a lesser extent, the economy and other social issues, President Trump could well resort to geopolitics to “rally Americans behind the flag.” He may, for example, ramp up tensions with China in an attempt to make geopolitics and China the focal points of the forthcoming presidential election. China will certainly retaliate. The South China Sea, Taiwan, technology transfers, treatment of multinational companies in both China and the US, as well as North Korea, could be focal points of a confrontation. This will weigh on business confidence in Asia and on capital spending. In our opinion, markets are vulnerable to such geopolitical risks. Poor domestic fundamentals in EM outside China, Korea and Taiwan. Fundamental backdrops remain inferior in many EM economies outside the North Asian ones. The number of new infections continues to rise in India, Indonesia, The Philippines, Brazil, Mexico, Colombia and Peru. Many EM economies will only slowly return to normalcy. In certain countries, banking systems were already in poor health, and things have gotten much worse after the crash in economic activity. As to the positives for EM, they are as follows: Rising Chinese demand will boost EM exports to China and help revive their growth. EM equity valuations are very appealing versus the S&P 500 (Chart 11). The bottom panel of Chart 11 shows that EM’s cyclically-adjusted P/E ratio relative to that in the US is over one standard deviation below its mean. Based on the 12-month forward P/E ratio for an equal-weighted index, EM stocks are cheaper than US ones (please refer to Chart 4 on page 4).  EM currencies are also cheap (Chart 12). While they might experience a short-term setback, as a global risk-off phase takes place, EM exchange rates have probably seen their lows versus the US dollar. Chart 11EM Stocks Offer Value Versus The S&P 500 EM Stocks Offer Value Versus The S&P 500 EM Stocks Offer Value Versus The S&P 500 Chart 12EM Currencies Are Cheap EM Currencies Are Cheap EM Currencies Are Cheap The US dollar’s weakness will mitigate risks for EM issuers of US dollar bonds and, thereby, induce more flows into EM sovereign and corporate credit markets. In short, EM local currency bonds will assuredly benefit from the US dollar’s slide. We have been neutral on both EM local currency bonds and EM sovereign and corporate credit, and are waiting for a correction before upgrading to overweight. In nutshell, little or no stress in EM fixed-income markets bodes well for EM share prices. Bottom Line: Risks to EM equity relative performance are presently balanced. A neutral allocation is warranted for now. EM relative equity performance versus DM is only slightly above its recent low (Chart 13, top panel). It is, therefore, a good juncture to move the EM equity allocation from underweight to neutral. In addition, both the EM equal-weighted and small-cap equity indexes are not yet signaling a broad-based and sustainable outperformance (Chart 13, middle and bottom panels). Chart 13EM Relative Equity Performance Is In A Bottom-Out Phase EM Relative Equity Performance Is In A Bottom-Out Phase EM Relative Equity Performance Is In A Bottom-Out Phase Some FAQs Question: Wouldn’t the US dollar rally if global stocks sell off? The greenback will likely attempt to rebound from current oversold levels when and as a global risk-off phase sets in. EM high-beta currencies could experience a non-trivial setback but will remain above their March lows. Yet, any rebound in the US dollar versus European currencies and the Japanese yen will be fleeting and moderate. On July 9, in anticipation of US dollar weakness, we booked profits on the short EM currencies/long US dollar strategy and recommended shorting several EM currencies versus an equal-weighted basket of the euro, CHF and JPY. This strategy remains intact for now. Our short list of EM currencies includes: BRL, CLP, ZAR, TRY, IDR, PHP and KRW. Odds are that EM stocks will likely be broadly flattish relative to those in DM amid the next sell off. Chart 14EM Stocks Have Been Low Beta EM Stocks Have Been Low Beta EM Stocks Have Been Low Beta Question: Aren’t EM stocks high-beta and won’t they underperform if, and as, global stocks sell off? The EM equity index has had a beta lower than one since 2013 (Chart 14). Odds are that EM stocks will likely be broadly flattish relative to those in DM amid the next sell off. Within the DM equity space, the US will likely underperform both Europe and Japan in common currency terms. Question: Which equity markets do you favor within the EM space? Our current overweights are China, Thailand, Russia, Peru, Pakistan and Mexico. Our underweights are Indonesia, India, Hong Kong, the Philippines, Turkey, South Africa, Chile and Brazil. Question: Which currencies and local currency bond markets do you recommend overweighting for dedicated EM managers? We recommended going long the Czech koruna versus the US dollar last week. Other currencies that we favor within the EM space are SGD, TWD, THB, MXN and RUB. As for local currency bonds or swap rates, our top picks are Mexico, Russia, Korea, India, China, Malaysia, Thailand, Peru, Ukraine and Pakistan. As always, the list of country recommendations for equities, fixed-income and currencies is available at the end of our reports (please refer to pages 14-15) or on the website.   Arthur Budaghyan Chief Emerging Markets Strategist arthurb@bcaresearch.com     Footnotes 1Please see Emerging Markets Strategy Weekly Reports "Inflation, Overheating And The Stampede Into Bonds," dated November 30, 2010, and "Emerging Markets In 2011: Not The Best Play In Town," dated December 14, 2010. 2Please see Emerging Markets Strategy Special Report "How To Play Emerging Market Growth In The Coming Decade," dated June 8, 2010   Equities Recommendations Currencies, Credit And Fixed-Income Recommendations

Highlights Incoming economic data suggests that China’s economy is in the process of bottoming, but also that the intensity of a recovery is likely to be more muted than it has been during past economic cycles. Recent Chinese equity market performance is consistent with a bottoming in the economy: cyclicals are outperforming defensives, and both the investable and domestic markets have broken above their respective 200-day moving averages versus global stocks. We continue to recommend that investors cyclically overweight Chinese domestic and investable stocks relative to the global benchmark. However, there is more potential upside for investable than domestic stocks, and the gains in both markets may be front loaded in the first half of the year. Feature Tables 1 and 2 on pages 2 and 3 highlight key developments in China’s economy and its financial markets over the past month. On the growth front, several indicators now suggest that China’s economy is in the process of bottoming, but these indicators also imply that the intensity of a recovery in economic activity is likely to be more muted than it has been during past economic cycles. We see this as consistent with the views presented in our December 11 Weekly Report,1 which laid out four key themes for China and its financial markets for 2020. Table 1China Macro Data Summary China Macro And Market Review China Macro And Market Review Table 2China Financial Market Performance Summary China Macro And Market Review China Macro And Market Review Within financial markets, recent developments are also consistent with the view that Chinese economic activity will modestly accelerate and that a Sino-American trade truce will last until the US presidential election in November 2020. Chinese stocks have rallied both in absolute terms and relative to global equities over the past month, and cyclical stocks are clearly outperforming defensives on an equally-weighted basis in both markets. The RMB has also appreciated modestly, with USD-CNY having now durably fallen back below the 7 mark. We continue to recommend that investors cyclically overweight Chinese domestic and investable stocks relative to the global benchmark, with the caveat that we expect more potential upside for investable than domestic stocks and the gains in both markets may be front loaded in the first half of the year. We expect modest further gains in the RMB over the coming few months, as we see the PBoC is unwilling to allow rapid appreciation. In reference to Tables 1 and 2, we provide several detailed observations below concerning developments in China’s macro and financial market data: Chart 1A Bottoming In China's Economic Growth Is Now Likely Underway A Bottoming In China's Economic Growth Is Now Likely Underway A Bottoming In China's Economic Growth Is Now Likely Underway On a smoothed basis, the Bloomberg Li Keqiang index (LKI) rose in November, driven largely by an improvement in electricity output (Chart 1). While our alternative LKI is weaker than Bloomberg’s measure, we see the improvement in the latter as a sign of a bottoming process for growth that is now underway (Bottom panel, Chart 1). Our leading indicator for the Li Keqiang index was essentially flat in November, with the large gap that has persisted between the degree of monetary accommodation and money & credit growth still present. There was a notable improvement in the Bloomberg Monetary Conditions Index (MCI) in November, but this can be attributed to a surge in headline inflation (which depressed real interest rates). This underscores that the ongoing uptrend in our LKI leading indicator is modest, and that an improvement in economic activity this year is thus unlikely to be sharp or intense. With the pace of pledged supplementary lending (PSL) injections and Tier 1 housing price appreciation as exceptions, all of the housing market data series that we track in Table 1 deteriorated in November. On a smoothed basis, residential housing sales rose at a slower pace and the previous surge in housing construction waned, in line with our expectation (Chart 2). House prices have continued to deviate from housing sales; deteriorating affordability and tight housing regulations have contributed to this divergence. Although funding from the PBoC’s PSL program improved in November, even further funding assistance is likely necessary in order to expect a strong uptrend in housing sales given the affordability and regulatory headwinds (Bottom panel, Chart 2). Both China’s Caixin and official manufacturing PMIs continue to signal positive signs for Chinese economic activity. While the Caixin PMI fell slightly in December, it stayed in expansionary territory for the fifth consecutive month. The official PMI also provided positive signs: the overall index remained above 50 for the second month, the production component rose further into expansionary territory, and the new export orders moved above the 50 mark. All told, China’s PMI data now clearly suggests that a bottoming in China’s economic growth is underway. Although the overall PMI data is sending a positive signal, Chart 3 highlights two series that are somewhat less positive. First, while the import component of the official PMI is rising, it is lagging other key sub-components and remains below 50. In addition, the PMI for small enterprises, which led the early phase of the 2016 recovery in the official PMI, has not meaningfully changed over the past few months. For now, these series suggest that a recovery in growth is likely to be muted compared with previous episodes over the past decade. Chart 2More Accommodative Funding Is Needed For Stronger Housing Sales More Accommodative Funding Is Needed For Stronger Housing Sales More Accommodative Funding Is Needed For Stronger Housing Sales Chart 3Weaker PMI Sub-Components Suggest A More Muted Recovery Weaker PMI Sub-Components Suggest A More Muted Recovery Weaker PMI Sub-Components Suggest A More Muted Recovery In USD terms, China’s equity markets (both investable and domestic) have rallied more than 8%-9% in absolute terms over the past month. In relative terms, both investable and A-share markets have also outperformed the global benchmark. It is notable that the relative performance trend of Chinese investable stocks has broken clearly above its 200-day moving average, which is the first time since the trade talks collapsed in May of last year (Chart 4A). The strong rally in China’s stock prices over the past month, particularly in the investable market, largely reflect the likely signing of a trade truce between the US and China. In our view, more accommodative monetary and fiscal support in 2020, as well as an ongoing truce, provide a sound basis to overweight China’s stocks within a global equity portfolio over both a tactical and cyclical horizon. However, we expect that China’s investable market has more upside potential than its domestic peer, given how much further the former fell in 2019.    From an equity sector perspective, the most notable development over the past month is that cyclical sectors have outperformed defensives in both the investable and domestic markets and have broken above their respective 200-day moving averages (Chart 4B). Among cyclical sectors, industrials, energy, consumer discretionary, especially materials and telecommunication services, have all contributed to cyclical outperformance over the past month. The outperformance of cyclical sectors is strongly consistent with continued outperformance of Chinese stocks versus the global average, and strengthens our conviction that investors should be overweight Chinese markets within a regional equity portfolio. China’s 3-month repo rate fell meaningfully over the past week, in response to a 50 bps cut in the reserve requirement ratio (RRR). The decline has merely returned the repo rate back to the level that prevailed on average in 2019, but it does underscore the PBoC’s desire to modestly ease liquidity on a net basis. We will be presenting a Special Report on China’s government bond market later this month, but for now, our view remains that easier monetary policy is unlikely to materially impact Chinese government bond yields this year, unless the PBoC decides to target sharply lower interbank repo rates (which is not our expectation). Chart 4AThe Meaningful Rally In China's Equity Markets Sends A Positive Signal The Meaningful Rally In China's Equity Markets Sends A Positive Signal The Meaningful Rally In China's Equity Markets Sends A Positive Signal Chart 4BThe Outperformance Of Cyclicals Over Defensives Is Consistent With An Economic Recovery The Outperformance Of Cyclicals Over Defensives Is Consistent With An Economic Recovery The Outperformance Of Cyclicals Over Defensives Is Consistent With An Economic Recovery China’s onshore corporate bond spread has risen slightly over the past month alongside falling corporate yields. Despite persistent concerns of rising defaults on China’s onshore corporate bonds, the overall default rate remains quite low compared with those in developed economies, and China’s corporate bond market will benefit from even a modest improvement in economic growth this year. As such, we expect a continued uptrend in China’s onshore corporate bond total return index, and would favor onshore corporate over duration-matched Chinese government bonds. Chart 5A Modest Further Downtrend In USD-CNY This Year Is Likely A Modest Further Downtrend In USD-CNY This Year Is Likely A Modest Further Downtrend In USD-CNY This Year Is Likely The RMB has gained more than 1.35% versus the U.S. dollar over the last month, which caused USD-CNY to durably break below 7 (Chart 5). The rise was clearly in response to news that the US and China will agree to a trade truce, and we expect a further modest downtrend in USD-CNY as China’s economy continues to improve. Investors should note that we are likely to close our long USD-CNH trade (currently registering a gain of 1%) following the signing of the Phase One deal on Jan 15, given that we opened the trade as a currency hedge for our overweight towards Chinese stocks (denominated in USD terms). As such, upon the signing of the deal, we would recommend that investors favor Chinese stocks versus the global benchmark in unhedged terms.   Qingyun Xu, CFA Senior Analyst qingyunx@bcaresearch.com Jing Sima China Strategist jings@bcaresearch.com Footnotes 1    Please see China Investment Strategy Weekly Report "2020 Key Views: Four Themes For China In The Coming Year," dated December 11, 2019, available at cis.bcaresearch.com Cyclical Investment Stance Equity Sector Recommendations

Dear Client, Over the past two weeks, I have been in Asia visiting BCA’s clients. Next week’s Report, on November 20 will be a recap of my observations from the road. This week we are sending you a Special Report on global semiconductor stock performance published by our Emerging Markets Strategy service, authored by my colleague Ellen JingYuan He.  This Special Report offers great insights on the development of 5G network industry, global demand beyond 5G smartphones, as well as investment implications derived from the research. I hope you find it interesting and insightful. Best regards, Jing Sima, China Strategist   Highlights Since early this year, global semiconductor stock prices have been front-running a demand recovery that has not yet begun. There is strong industry optimism surrounding a potential demand boost for semiconductors from the rollout of 5G networks and phones in 2020. Yet we expect actual 2020 Chinese 5G smartphone shipments to fall considerably short of what industry observers expect, especially in the first half of the year. Global semiconductor stocks are over-hyped. Even though momentum could push them higher in the short term, we believe there will be a better entry point in the coming months. Given that Korean semiconductor stocks have lagged, we are upgrading Korean tech stocks and the KOSPI to overweight within the EM equity benchmark. Feature Global semiconductor stock prices have been rallying strongly, increasingly diverging from global semiconductor sales since early January. The former have risen to new highs, while the latter have remained in deep contraction (Chart 1). Chart 1A Puzzle: Semiconductors Stock Prices Skyrocketed When Sales Remain In A Deep Contraction Global Semiconductor Market: Sales & Share Prices A Puzzle: Semiconductors Stock Prices Skyrocketed When Sales Remain In A Deep Contraction Global Semiconductor Market: Sales & Share Prices A Puzzle: Semiconductors Stock Prices Skyrocketed When Sales Remain In A Deep Contraction We are puzzled by such a dramatic divergence between share prices and the industry’s top line. After all, the ongoing contraction in worldwide semiconductor sales has been broad-based across both regions and the majority of top 10 semiconductor companies (Charts 2 and 3). Chart 2A Broad-Based Contraction Across All Regions… A Broad-Based Contraction Across All Regions... A Broad-Based Contraction Across All Regions... Chart 3…And Most Top Semiconductor Companies ...And Most Top Semiconductor Companies ...And Most Top Semiconductor Companies   In our June1 report, we argued that world semiconductor sales would continue to shrink through the remainder of 2019. This view has played out, but global semiconductor share prices have surged and outperformed the global equity benchmark.  Global semiconductor stock prices have been front-running a demand recovery that has not yet begun. It seems the market has been looking beyond the current weakness. It currently expects a potential demand boost for semiconductors from 5G phones in 2020 on the back of rising hopes of a US-China trade conflict resolution. Is such hype about 5G network and corresponding shipments justified? Our research leads us to contend that global semiconductor sales will likely post only low- to middle-single-digit growth in 2020, with most of the recovery back loaded in the second half of the year. Hype over 5G phones among industry participants and investors may continue pushing semiconductor share prices higher in the near term. However, the odds are that the reality of tepid semiconductor sales growth will likely set in early next year, and semiconductor stocks will correct considerably. In short, we do not recommend chasing the rally. There will be a better entry point in the months ahead. 5G-Smartphones: The Savior Of Semiconductor Demand? Chart 4Semiconductor Sales Are Still Contracting At A Double-Digit Rate Strong Global 5G-Smartphone Shipments In 2020? Strong Global 5G-Smartphone Shipments In 2020? The primary driver behind the rally in semiconductor share prices is strong optimism among major semiconductor producers and investors about a rapid ramp-up of global 5G-smartphone adoption. In addition, the market is also holding onto a good amount of hope for a US-China trade conflict resolution, which will also facilitate the pace of global 5G deployment. Mobile phones account for the largest share (29%) of global semiconductor revenue. The industry expects strong global 5G-smartphone shipments in 2020 to spur a meaningful recovery in semiconductor demand (Chart 4). Table 1 shows a list of estimates for 2020 global 5G-smartphone shipments by major semiconductor companies, industry analysts and investors, ranging from 120 million to 225 million units, with a mean of 180 million units. Table 1Market Forecasts Of In 2020 Global 5G-Smartphone Shipments Semiconductor Stocks: Is The 5G Hype Warranted? Semiconductor Stocks: Is The 5G Hype Warranted? In particular, Taiwan Semiconductor Manufacturing Company (TSMC), the world’s largest dedicated integrated circuit (IC) foundry, recently almost doubled its forecast for 5G smartphone penetration for 2020 to a mid-teen percentage from a single-digit percentage forecast made just six months ago. Given that global smartphone shipments currently stand at roughly 1.4 billion units per year, a 15% penetration rate would translate into 210 million units of 5G smartphone shipments in 2020. Meanwhile, Qualcomm, the world's largest maker of mobile application processors and baseband modems, last week predicted that 2020 global 5G smartphone shipments will range between 175 million units and 225 million units. We agree that 5G smartphone sales in 2020 will increase sharply from currently very low levels, but we also believe the penetration pace estimated by the industry is optimistic. The basis for our conclusion is as follows: Chart 5So Far, China 5G-Adoption Pace Has Been Much Slower Than Its 4G So Far, China 5G-Adoption Pace Has Been Much Slower Than Its 4G So Far, China 5G-Adoption Pace Has Been Much Slower Than Its 4G 5G-smartphone shipments in China will largely determine the pace of worldwide 5G-phone shipments. The country will be the world leader in the 5G smartphone market due to the government’s promotion of it and the advanced 5G technology held by China's largest telecom equipment producer, Huawei. China announced the debut of the 5G-era on June 6. Since then, total 5G-smartphone shipments have been only about 800,000 units through the end of September. In terms of the pace of penetration (5G-smartphone shipments as a share of total mobile phone shipments during the first three months of launch), the rate was a mere 0.3%. In comparison with the debut of the 4G-era in December 2013, shipments of 4G phones in China were significantly larger, and their adoption rate was much faster (Chart 5). During the first three months of the 4G launch, 4G phone shipments were 9.7 million units, reaching 10% of total smartphone shipments. Here are the most important reasons behind what will be a much slower penetration pace for 5G smartphones in China compared with the 4G rollout. We agree that 5G smartphone sales in 2020 will increase sharply from currently very low levels, but we also believe the penetration pace estimated by the industry is optimistic. Market saturation: The Chinese smartphone market has become much more saturated than it was six years ago when 4G was launched. Since then, there have been about 2.3 billion units of 4G smartphones sold, with 1.3 billion units sold in the past three years – nearly equaling the total Chinese population. This means the replacement need in China is low. High prices: 5G smartphones in China are currently much more expensive than 4G ones. 5G phone prices range from RMB 4000-7000 in China, while most of the 4G ones sell within the range of RMB 1000-3000. According to data from QuestMobile, a professional big data intelligence service provider in China's mobile internet market, in the first half of 2019, about 41% of smartphones were sold at RMB 1000-2000, about 30% at RMB 2000-3000, and only 10% at RMB 4000 and above. Functionality: At the moment, except for faster data download/upload speed, 5G smartphones do not offer much more functionality than 4G ones. Back in 2014, 4G phones had much more attractive features than 3G. For example, while 3G smartphones only allowed audio and picture transmission, those with 4G enabled video chatting and high-quality streaming video. In addition, for now, there are very few smartphone apps that can only be used for 5G phones. 5G Infrastructure: Presently, there is only very limited geographical coverage of 5G base stations. The number of 5G base stations is estimated to be 130 thousand units this year, only accounting for 1.6% of total base stations in China. In comparison, 65% of all Chinese base stations are 4G-enabled.  Meanwhile, to cover the same region, the number of 5G base stations needs to at least double that of 4G ones. It will take at a minimum two or three years to develop decent coverage of 5G base stations. Besides, the cost of building 5G-enabled infrastructure is much more expensive than the deployment of the 4G ones. There are two types of 5G networks: Non-standalone (NSA) and Standalone (SA). The 5G data transmission speed is significantly faster in SA mode than in NSA mode. However, the deployment cost of the SA network is much higher than the cost for NSA networks, as the latter can be built from existing 4G networks, but the former cannot. Critically, the Chinese government recently announced only SA-compatible 5G smartphones will be allowed to have access to the 5G network in China, starting January 1, 2020. This signals that the focus of future 5G network development will be centered around SA mode instead of this year’s NSA mode. Over 90% of China’s 5G network was NSA mode in 2019. Building a 5G SA network will take longer and cost more.  The market expects China to build as much as 1 million units of 5G base stations in 2020. Even if this goal is achieved, it only accounts for about 11% of total Chinese base stations. Chart 6Chinese Smartphone Sales: Still In Contraction Chinese Smartphone Sales: Still In Contraction Chinese Smartphone Sales: Still In Contraction Lack of variety of SA-compatible 5G-phone models. There are also limited options for SA-compatible 5G smartphones models. So far, even though Huawei, Xiaomi, Vivo, Oppo, ZTE and Samsung have all released 5G smartphones, only models from Huawei work under SA networks.2 All others only work under the NSA network. Hence, the variety of SA-compatible 5G phone models is very limited. This will likely delay sales of 5G phones in China. Many more models of SA-compatible 5G smartphones will likely be released only in the second half of next year, which may both drive down 5G smartphone prices and attract more buyers. Consumer spending slowdown: 4G smartphones can meet the needs of the majority of users, and most users have purchased a new phone within the past three years. With elevated economic uncertainty and slowing income growth, a larger proportion of people in China may decide to delay upgrading from 4G-phones to much more expensive 5G ones. This echoes a continuing decline in Chinese smartphone sales (Chart 6). Overall, from Chinese consumers’ perspective, a 5G phone in 2020 will be a nice-to-have, but not a must-have. Given all the aforementioned factors, our best guess for 2020 Chinese 5G smartphone shipments is 40-60 million units, with a larger proportion occurring in the second half of the year.  From Chinese consumers’ perspective, a 5G phone in 2020 will be a nice-to-have, but not a must-have. As China is much more aggressive in moving to 5G network adaptation than other large economies, we share industry experts’ forecasts that China will account for 50% of total global 5G shipments. Provided our estimate for China is about 50 million units, our global forecast for 5G phone shipments in 2020 comes to about 100 million units worldwide. This is substantially lower than industry and analyst average estimates of 180 million units (see Table 1 on page 4). Notably, rising 5G smartphone sales will cannibalize some 4G-phone demand. Consequently, aggregate demand for semiconductors will not grow, but the share of high-valued-added chips in the overall product mix will rise. Bottom Line: The penetration pace of 5G smartphones will be meaningfully slower than both the semiconductor producers and analysts expect. Most likely, a meaningful recovery in global aggregate smartphone sales will not occur over the next six months. We suspect the positive impact of 5G phone sales will be felt by global semiconductor producers largely in the second half of 2020. Semiconductor Demand Beyond 5G In terms of end usage, except smartphones, the top five end uses for semiconductors are personal computers (PCs) (12%), servers (11%), diverse consumer products (12%), automotive (10%), and industrial electronics (9%). Structural PC demand is down, but sales have been more or less flat in the past three years (Chart 7). Next year, commercial demand may accelerate as enterprises work through the remainder of their Windows 10 migration. However, household demand is still facing strong competition from tablets. Overall, we expect PC demand to remain stagnant. Global server shipments sank deeper into contraction in the second quarter of this year due to a slowdown in purchasing from cloud providers and hyperscale customers. They may stay in moderate contraction over the next six months as global economic uncertainty remain elevated, which may discourage enterprises’ investment plans (Chart 8). Chart 7Structural PC Demand Is Stagnant And Will Remain So In 2020 Global PCs Sales: Deeply Saturated Structural PC Demand: Remain Stagnant In 2020 Global PCs Sales: Deeply Saturated Structural PC Demand: Remain Stagnant In 2020 Chart 8Global Server Shipments: A Moderate Contraction In 2020 Global Server Shipment: Are In Contraction Global Server Shipments: Moderate Contraction In 2020 Global Server Shipment: Are In Contraction Global Server Shipments: Moderate Contraction In 2020 Chart 9Automotive-Related Semiconductor Demand: A Moderate Growth Ahead Automotive-Related Semiconductor Demand: A Moderate Growth Ahead Automotive-Related Semiconductor Demand: A Moderate Growth Ahead Chinese auto sales – about 30% of the world total – will likely stage a rate-of-change improvement, moving from deep to mild contraction or stagnation over the next six months.3 Increasing penetration of new energy vehicles and continuing 5G deployment may still result in moderate growth in auto-related semiconductor demand (Chart 9). Semiconductor demand from diverse consumer products slightly declined in the third quarter, with robust growth in tablets, eReaders and portable navigation devices, and contraction in all other subsectors including TV sets, gaming, printers and images, cameras and set-top boxes (Chart 10). This may remain in slight contraction or stagnation over the next three to six months. Automation and 5G deployment will likely continue to increase semiconductor sales in the industrial sector (Chart 11).  Chart 10Semiconductor Demand From Consumer Products: A Slight Contraction Or Stagnation Ahead Semiconductor Stocks: Is The 5G Hype Warranted? Semiconductor Stocks: Is The 5G Hype Warranted? Chart 11Industrial Semiconductor Demand: More Upside Ahead Industrial Semiconductor Demand: More Upside Ahead Industrial Semiconductor Demand: More Upside Ahead   Chart 12Memory Prices Still Signal Sluggish Semiconductor Demand Memory Prices Still Signal Sluggish Semiconductor Demand Memory Prices Still Signal Sluggish Semiconductor Demand Overall, demand recovery has not yet begun. The lack of price recovery in DRAM prices after 18 months of declines and still-low NAND prices are also signaling sluggish semiconductor demand (Chart 12). Bottom Line: Odds are that global semiconductor demand in sectors other than smartphones will show improvement in terms of rate of change, but will still likely be flat in 2020. TSMC Sales: A Harbinger Of Industry Recovery? TSMC, the world’s biggest semiconductor company, posted a revival in sales over four consecutive months from June to September. Do TSMC sales lead global semiconductor sales? The answer is not always. TSMC sales do not always correlate well with global semiconductor sales (Chart 13). For example, TSMC sales diverged from global semiconductor sales in 2017-‘18 and 2013-‘14. So what are the reasons for strong increase in TSMC sales? First, it reflects market share rotation in the global smartphone market in favor of smartphone producers that use TSMC-fabricated chips. Chart 13TSMC Sales Do Not Always Lead Global Semiconductor Sales TSMC Sales Do Not Always Lead Global Semiconductor Sales TSMC Sales Do Not Always Lead Global Semiconductor Sales Demand from the global smartphone sector contributes to almost half of TSMC’s total revenue. Apple and Huawei are TSMC’s two top customers. The most recent report from market research firm Canalys shows that while Apple’s smartphone shipments declined 7% year-on-year last quarter, Huawei’s shipments soared 29%.4 Combined, smartphone shipments from these two companies still jumped nearly 12% year-on-year in the third quarter of the year. This has increased their market share in the global smartphone market to 31% now from 28% a year ago. Second, rising TSMC sales also reflect market share rotation in the global server market, in particular rising shipments and growing market share of servers using AMD high-performing-computing (HPC) chips instead of Intel ones. AMD’s 7nm Epyc CPU, launched this August and manufactured by TSMC, has been taking share from Intel in the global server market. This has driven the increase in TSMC’s revenue from the HPC sector.  Third, the share of value-added products (high-end chips) in TSMC’s product mix has been rising rapidly. TSMC’s share of revenue from 7nm technology jumped from 21% to 27% in the third quarter, as most of Apple’s and Huawei’s chips and all of AMD’s Epyc CPUs are 7nm-based. Back in the third quarter of 2018, TSMC’s 7nm business only accounted for 11% of its total revenue. Chart 14Both TSMC Sales And Taiwanese PMI Could Continue To Improve While Global Semiconductor Sales Remain In Contraction Both TSMC Sales And Taiwanese PMI Could Continue To Improve While Global Semiconductor Sales Remain In Contraction Both TSMC Sales And Taiwanese PMI Could Continue To Improve While Global Semiconductor Sales Remain In Contraction Finally, although internet of things (IoT) and automotive chips only account for 9% and 4% of TSMC’s total share of revenue respectively, strong growth in both segments –33% year-on-year in IoT and 20% year-on-year in automotive – indeed shows exceptional demand in these two sectors in a weakening global economic environment. As IoT and automotive development will highly rely on global 5G infrastructure development, their impact will be meaningful once the global 5G network becomes well advanced and widely installed. To conclude, while a 40% boost in TSMC’s capital spending indeed paints a positive picture on global semiconductor demand over the longer term, rising TSMC sales do not mean an imminent and strong recovery in the global semiconductor sector is in the works. Huawei is the global 5G technology leader and the major supplier in both 5G-network equipment and 5G smartphones; the company will be a major revenue contributor to TSMC. As Huawei will likely place more orders to TSMC for chip fabrication, this will likely result in further improvement in TSMC’s sales (Chart 14). Bottom Line: Rising TSMC sales do not necessarily herald an imminent and robust cyclical recovery in the global semiconductor sector.  Investment Conclusions Global semiconductor stock prices have been front running a recovery that has not yet begun. In addition, there is still uncertainty about the technology aspect of US-China trade negotiations. The US will likely continue to have Huawei and other Chinese high-tech companies on its trade-ban list – its so-called Entity List. TSMC sales do not always correlate well with global semiconductor sales. Notably, global semiconductor sales and profits are still in deep contraction, while share prices are at all-time highs (Chart 15). As a result, semiconductor stocks’ multiples have spiked to their previous highs (Chart 16). Chart 15Semiconductor Companies Profits: Still In Deep Contraction Semiconductor Companies Profits: Still In Deep Contraction Semiconductor Companies Profits: Still In Deep Contraction Chart 16Elevated Semiconductor Stocks Multiples Elevated Semiconductor Stocks Multiples Elevated Semiconductor Stocks Multiples     While it is common for share prices to rally ahead of a business cycle/profit revival, we believe a true recovery will only emerge in spring 2020, and it will initially be much more subdued than industry watchers and investors expect. In the near term, strong momentum could still push semiconductor stock prices higher. However, the reality will then set in and there will be an air pocket before a more sustainable bull market emerges.   Our US Equity Investment Strategy earlier this week downgraded S&P semiconductor equipment companies to underweight and put the S&P Semiconductors Index on a downgrade alert.5 Their newly created top-down semiconductor profit growth model warns that an earnings recovery is not yet imminent (Chart 17). For EM-dedicated equity managers, we have been neutral on Asian semiconductor sectors. We continue to recommend a market-weight allocation to Taiwan’s overall market, while we are upgrading the Korean technology sector from a neutral allocation to overweight. Korean semiconductor stocks have rallied much less than their global peers. Hence, the risk of a major relapse is lower. Given that we have been overweight non-tech Korean stocks, upgrading tech stocks to overweight means we will be overweight the KOSPI within the EM equity benchmark (Chart 18). Chart 17Semiconductor Earnings Recovery: Not Imminent Semiconductor Earnings Recovery: Not Imminent Semiconductor Earnings Recovery: Not Imminent Chart 18Upgrade Korean Tech Stocks And Overweight KOSPI Within EM Upgrade Korean Tech Stocks And Overweight KOSPI Within EM Upgrade Korean Tech Stocks And Overweight KOSPI Within EM   Meanwhile, we remain long the Bloomberg Asia-Pacific Semiconductor Index and short the S&P 500 Semiconductor Index. This trade has produced a 7% gain since its initiation on June 13, 2019. The Bloomberg Asia-Pacific Semiconductor index has 12 stocks. Samsung and TSMC account for 38% and 37% of the index, respectively. The S&P 500 Semiconductor Index has 13 stocks. Intel, Broadcom, Texas Instruments and Qualcomm are the top five constituents, together accounting for nearly 77% of the index. Although the US and China may reach a temporary trade deal, the US will continue to restrict sales of tech products and high-end semiconductors to China. As a result, these US semiconductor companies, most of which are IC designing companies, will likely experience a more subdued than expected recovery in sales. Ellen JingYuan He Associate Vice President ellenj@bcaresearch.com Footnotes   1 Please see Emerging Markets Strategy Special Report "The Global Semiconductor Sector: Is A Cyclical Upturn Imminent?" dated June 13, 2019, available at ems.bcaresearch.com 2 https://www.guancha.cn/ChanJing/2019_09_21_518748.shtml http://www.cac.gov.cn/2019-10/23/c_1573361796389322.htm 3 Please see Emerging Markets Strategy Special Report "Chinese Auto Demand: Time For A  Recovery?" dated October 17, 2019, available at ems.bcaresearch.com 4 https://www.canalys.com/analysis/smartphone+analysis 5 Please see US Equity Strategy Special Report "Defying Gravity," dated November 4, 2019, available at uses.bcaresearch.com   Cyclical Investment Stance Equity Sector Recommendations

Highlights Since early this year, global semiconductor stock prices have been front-running a demand recovery that has not yet begun. There is strong industry optimism surrounding a potential demand boost for semiconductors from the rollout of 5G networks and phones in 2020. Yet we expect actual 2020 Chinese 5G smartphone shipments to fall considerably short of what industry observers expect, especially in the first half of the year. Global semiconductor stocks are over-hyped. Even though momentum could push them higher in the short term, we believe there will be a better entry point in the coming months. Given that Korean semiconductor stocks have lagged, we are upgrading Korean tech stocks and the KOSPI to overweight within the EM equity benchmark. Feature Global semiconductor stock prices have been rallying strongly, increasingly diverging from global semiconductor sales since early January. The former have risen to new highs, while the latter have remained in deep contraction (Chart 1). Chart 1A Puzzle: Semiconductors Stock Prices Skyrocketed When Sales Remain In A Deep Contraction Global Semiconductor Market: Sales & Share Prices A Puzzle: Semiconductors Stock Prices Skyrocketed When Sales Remain In A Deep Contraction Global Semiconductor Market: Sales & Share Prices A Puzzle: Semiconductors Stock Prices Skyrocketed When Sales Remain In A Deep Contraction We are puzzled by such a dramatic divergence between share prices and the industry’s top line. After all, the ongoing contraction in worldwide semiconductor sales has been broad-based across both regions and the majority of top 10 semiconductor companies (Charts 2 and 3). Chart 2A Broad-Based Contraction Across All Regions… A Broad-Based Contraction Across All Regions... A Broad-Based Contraction Across All Regions... Chart 3…And Most Top Semiconductor Companies ...And Most Top Semiconductor Companies ...And Most Top Semiconductor Companies   In our June1 report, we argued that world semiconductor sales would continue to shrink through the remainder of 2019. This view has played out, but global semiconductor share prices have surged and outperformed the global equity benchmark.  Global semiconductor stock prices have been front-running a demand recovery that has not yet begun. It seems the market has been looking beyond the current weakness. It currently expects a potential demand boost for semiconductors from 5G phones in 2020 on the back of rising hopes of a US-China trade conflict resolution. Is such hype about 5G network and corresponding shipments justified? Our research leads us to contend that global semiconductor sales will likely post only low- to middle-single-digit growth in 2020, with most of the recovery back loaded in the second half of the year. Hype over 5G phones among industry participants and investors may continue pushing semiconductor share prices higher in the near term. However, the odds are that the reality of tepid semiconductor sales growth will likely set in early next year, and semiconductor stocks will correct considerably. In short, we do not recommend chasing the rally. There will be a better entry point in the months ahead. 5G-Smartphones: The Savior Of Semiconductor Demand? Chart 4Semiconductor Sales Are Still Contracting At A Double-Digit Rate Strong Global 5G-Smartphone Shipments In 2020? Strong Global 5G-Smartphone Shipments In 2020? The primary driver behind the rally in semiconductor share prices is strong optimism among major semiconductor producers and investors about a rapid ramp-up of global 5G-smartphone adoption. In addition, the market is also holding onto a good amount of hope for a US-China trade conflict resolution, which will also facilitate the pace of global 5G deployment. Mobile phones account for the largest share (29%) of global semiconductor revenue. The industry expects strong global 5G-smartphone shipments in 2020 to spur a meaningful recovery in semiconductor demand (Chart 4). Table 1 shows a list of estimates for 2020 global 5G-smartphone shipments by major semiconductor companies, industry analysts and investors, ranging from 120 million to 225 million units, with a mean of 180 million units. Table 1Market Forecasts Of In 2020 Global 5G-Smartphone Shipments Semiconductor Stocks: Is The 5G Hype Warranted? Semiconductor Stocks: Is The 5G Hype Warranted? In particular, Taiwan Semiconductor Manufacturing Company (TSMC), the world’s largest dedicated integrated circuit (IC) foundry, recently almost doubled its forecast for 5G smartphone penetration for 2020 to a mid-teen percentage from a single-digit percentage forecast made just six months ago. Given that global smartphone shipments currently stand at roughly 1.4 billion units per year, a 15% penetration rate would translate into 210 million units of 5G smartphone shipments in 2020. Meanwhile, Qualcomm, the world's largest maker of mobile application processors and baseband modems, last week predicted that 2020 global 5G smartphone shipments will range between 175 million units and 225 million units. We agree that 5G smartphone sales in 2020 will increase sharply from currently very low levels, but we also believe the penetration pace estimated by the industry is optimistic. The basis for our conclusion is as follows: Chart 5So Far, China 5G-Adoption Pace Has Been Much Slower Than Its 4G So Far, China 5G-Adoption Pace Has Been Much Slower Than Its 4G So Far, China 5G-Adoption Pace Has Been Much Slower Than Its 4G 5G-smartphone shipments in China will largely determine the pace of worldwide 5G-phone shipments. The country will be the world leader in the 5G smartphone market due to the government’s promotion of it and the advanced 5G technology held by China's largest telecom equipment producer, Huawei. China announced the debut of the 5G-era on June 6. Since then, total 5G-smartphone shipments have been only about 800,000 units through the end of September. In terms of the pace of penetration (5G-smartphone shipments as a share of total mobile phone shipments during the first three months of launch), the rate was a mere 0.3%. In comparison with the debut of the 4G-era in December 2013, shipments of 4G phones in China were significantly larger, and their adoption rate was much faster (Chart 5). During the first three months of the 4G launch, 4G phone shipments were 9.7 million units, reaching 10% of total smartphone shipments. Here are the most important reasons behind what will be a much slower penetration pace for 5G smartphones in China compared with the 4G rollout. We agree that 5G smartphone sales in 2020 will increase sharply from currently very low levels, but we also believe the penetration pace estimated by the industry is optimistic. Market saturation: The Chinese smartphone market has become much more saturated than it was six years ago when 4G was launched. Since then, there have been about 2.3 billion units of 4G smartphones sold, with 1.3 billion units sold in the past three years – nearly equaling the total Chinese population. This means the replacement need in China is low. High prices: 5G smartphones in China are currently much more expensive than 4G ones. 5G phone prices range from RMB 4000-7000 in China, while most of the 4G ones sell within the range of RMB 1000-3000. According to data from QuestMobile, a professional big data intelligence service provider in China's mobile internet market, in the first half of 2019, about 41% of smartphones were sold at RMB 1000-2000, about 30% at RMB 2000-3000, and only 10% at RMB 4000 and above. Functionality: At the moment, except for faster data download/upload speed, 5G smartphones do not offer much more functionality than 4G ones. Back in 2014, 4G phones had much more attractive features than 3G. For example, while 3G smartphones only allowed audio and picture transmission, those with 4G enabled video chatting and high-quality streaming video. In addition, for now, there are very few smartphone apps that can only be used for 5G phones. 5G Infrastructure: Presently, there is only very limited geographical coverage of 5G base stations. The number of 5G base stations is estimated to be 130 thousand units this year, only accounting for 1.6% of total base stations in China. In comparison, 65% of all Chinese base stations are 4G-enabled.  Meanwhile, to cover the same region, the number of 5G base stations needs to at least double that of 4G ones. It will take at a minimum two or three years to develop decent coverage of 5G base stations. Besides, the cost of building 5G-enabled infrastructure is much more expensive than the deployment of the 4G ones. There are two types of 5G networks: Non-standalone (NSA) and Standalone (SA). The 5G data transmission speed is significantly faster in SA mode than in NSA mode. However, the deployment cost of the SA network is much higher than the cost for NSA networks, as the latter can be built from existing 4G networks, but the former cannot. Critically, the Chinese government recently announced only SA-compatible 5G smartphones will be allowed to have access to the 5G network in China, starting January 1, 2020. This signals that the focus of future 5G network development will be centered around SA mode instead of this year’s NSA mode. Over 90% of China’s 5G network was NSA mode in 2019. Building a 5G SA network will take longer and cost more.  The market expects China to build as much as 1 million units of 5G base stations in 2020. Even if this goal is achieved, it only accounts for about 11% of total Chinese base stations. Chart 6Chinese Smartphone Sales: Still In Contraction Chinese Smartphone Sales: Still In Contraction Chinese Smartphone Sales: Still In Contraction Lack of variety of SA-compatible 5G-phone models. There are also limited options for SA-compatible 5G smartphones models. So far, even though Huawei, Xiaomi, Vivo, Oppo, ZTE and Samsung have all released 5G smartphones, only models from Huawei work under SA networks.2 All others only work under the NSA network. Hence, the variety of SA-compatible 5G phone models is very limited. This will likely delay sales of 5G phones in China. Many more models of SA-compatible 5G smartphones will likely be released only in the second half of next year, which may both drive down 5G smartphone prices and attract more buyers. Consumer spending slowdown: 4G smartphones can meet the needs of the majority of users, and most users have purchased a new phone within the past three years. With elevated economic uncertainty and slowing income growth, a larger proportion of people in China may decide to delay upgrading from 4G-phones to much more expensive 5G ones. This echoes a continuing decline in Chinese smartphone sales (Chart 6). Overall, from Chinese consumers’ perspective, a 5G phone in 2020 will be a nice-to-have, but not a must-have. Given all the aforementioned factors, our best guess for 2020 Chinese 5G smartphone shipments is 40-60 million units, with a larger proportion occurring in the second half of the year.  From Chinese consumers’ perspective, a 5G phone in 2020 will be a nice-to-have, but not a must-have. As China is much more aggressive in moving to 5G network adaptation than other large economies, we share industry experts’ forecasts that China will account for 50% of total global 5G shipments. Provided our estimate for China is about 50 million units, our global forecast for 5G phone shipments in 2020 comes to about 100 million units worldwide. This is substantially lower than industry and analyst average estimates of 180 million units (see Table 1 on page 4). Notably, rising 5G smartphone sales will cannibalize some 4G-phone demand. Consequently, aggregate demand for semiconductors will not grow, but the share of high-valued-added chips in the overall product mix will rise. Bottom Line: The penetration pace of 5G smartphones will be meaningfully slower than both the semiconductor producers and analysts expect. Most likely, a meaningful recovery in global aggregate smartphone sales will not occur over the next six months. We suspect the positive impact of 5G phone sales will be felt by global semiconductor producers largely in the second half of 2020. Semiconductor Demand Beyond 5G In terms of end usage, except smartphones, the top five end uses for semiconductors are personal computers (PCs) (12%), servers (11%), diverse consumer products (12%), automotive (10%), and industrial electronics (9%). Structural PC demand is down, but sales have been more or less flat in the past three years (Chart 7). Next year, commercial demand may accelerate as enterprises work through the remainder of their Windows 10 migration. However, household demand is still facing strong competition from tablets. Overall, we expect PC demand to remain stagnant. Global server shipments sank deeper into contraction in the second quarter of this year due to a slowdown in purchasing from cloud providers and hyperscale customers. They may stay in moderate contraction over the next six months as global economic uncertainty remain elevated, which may discourage enterprises’ investment plans (Chart 8). Chart 7Structural PC Demand Is Stagnant And Will Remain So In 2020 Global PCs Sales: Deeply Saturated Structural PC Demand: Remain Stagnant In 2020 Global PCs Sales: Deeply Saturated Structural PC Demand: Remain Stagnant In 2020 Chart 8Global Server Shipments: A Moderate Contraction In 2020 Global Server Shipment: Are In Contraction Global Server Shipments: Moderate Contraction In 2020 Global Server Shipment: Are In Contraction Global Server Shipments: Moderate Contraction In 2020 Chart 9Automotive-Related Semiconductor Demand: A Moderate Growth Ahead Automotive-Related Semiconductor Demand: A Moderate Growth Ahead Automotive-Related Semiconductor Demand: A Moderate Growth Ahead Chinese auto sales – about 30% of the world total – will likely stage a rate-of-change improvement, moving from deep to mild contraction or stagnation over the next six months.3 Increasing penetration of new energy vehicles and continuing 5G deployment may still result in moderate growth in auto-related semiconductor demand (Chart 9). Semiconductor demand from diverse consumer products slightly declined in the third quarter, with robust growth in tablets, eReaders and portable navigation devices, and contraction in all other subsectors including TV sets, gaming, printers and images, cameras and set-top boxes (Chart 10). This may remain in slight contraction or stagnation over the next three to six months. Automation and 5G deployment will likely continue to increase semiconductor sales in the industrial sector (Chart 11).  Chart 10Semiconductor Demand From Consumer Products: A Slight Contraction Or Stagnation Ahead Semiconductor Stocks: Is The 5G Hype Warranted? Semiconductor Stocks: Is The 5G Hype Warranted? Chart 11Industrial Semiconductor Demand: More Upside Ahead Industrial Semiconductor Demand: More Upside Ahead Industrial Semiconductor Demand: More Upside Ahead   Chart 12Memory Prices Still Signal Sluggish Semiconductor Demand Memory Prices Still Signal Sluggish Semiconductor Demand Memory Prices Still Signal Sluggish Semiconductor Demand Overall, demand recovery has not yet begun. The lack of price recovery in DRAM prices after 18 months of declines and still-low NAND prices are also signaling sluggish semiconductor demand (Chart 12). Bottom Line: Odds are that global semiconductor demand in sectors other than smartphones will show improvement in terms of rate of change, but will still likely be flat in 2020. TSMC Sales: A Harbinger Of Industry Recovery? TSMC, the world’s biggest semiconductor company, posted a revival in sales over four consecutive months from June to September. Do TSMC sales lead global semiconductor sales? The answer is not always. TSMC sales do not always correlate well with global semiconductor sales (Chart 13). For example, TSMC sales diverged from global semiconductor sales in 2017-‘18 and 2013-‘14. So what are the reasons for strong increase in TSMC sales? First, it reflects market share rotation in the global smartphone market in favor of smartphone producers that use TSMC-fabricated chips. Chart 13TSMC Sales Do Not Always Lead Global Semiconductor Sales TSMC Sales Do Not Always Lead Global Semiconductor Sales TSMC Sales Do Not Always Lead Global Semiconductor Sales Demand from the global smartphone sector contributes to almost half of TSMC’s total revenue. Apple and Huawei are TSMC’s two top customers. The most recent report from market research firm Canalys shows that while Apple’s smartphone shipments declined 7% year-on-year last quarter, Huawei’s shipments soared 29%.4 Combined, smartphone shipments from these two companies still jumped nearly 12% year-on-year in the third quarter of the year. This has increased their market share in the global smartphone market to 31% now from 28% a year ago. Second, rising TSMC sales also reflect market share rotation in the global server market, in particular rising shipments and growing market share of servers using AMD high-performing-computing (HPC) chips instead of Intel ones. AMD’s 7nm Epyc CPU, launched this August and manufactured by TSMC, has been taking share from Intel in the global server market. This has driven the increase in TSMC’s revenue from the HPC sector.  Third, the share of value-added products (high-end chips) in TSMC’s product mix has been rising rapidly. TSMC’s share of revenue from 7nm technology jumped from 21% to 27% in the third quarter, as most of Apple’s and Huawei’s chips and all of AMD’s Epyc CPUs are 7nm-based. Back in the third quarter of 2018, TSMC’s 7nm business only accounted for 11% of its total revenue. Chart 14Both TSMC Sales And Taiwanese PMI Could Continue To Improve While Global Semiconductor Sales Remain In Contraction Both TSMC Sales And Taiwanese PMI Could Continue To Improve While Global Semiconductor Sales Remain In Contraction Both TSMC Sales And Taiwanese PMI Could Continue To Improve While Global Semiconductor Sales Remain In Contraction Finally, although internet of things (IoT) and automotive chips only account for 9% and 4% of TSMC’s total share of revenue respectively, strong growth in both segments –33% year-on-year in IoT and 20% year-on-year in automotive – indeed shows exceptional demand in these two sectors in a weakening global economic environment. As IoT and automotive development will highly rely on global 5G infrastructure development, their impact will be meaningful once the global 5G network becomes well advanced and widely installed. To conclude, while a 40% boost in TSMC’s capital spending indeed paints a positive picture on global semiconductor demand over the longer term, rising TSMC sales do not mean an imminent and strong recovery in the global semiconductor sector is in the works. Huawei is the global 5G technology leader and the major supplier in both 5G-network equipment and 5G smartphones; the company will be a major revenue contributor to TSMC. As Huawei will likely place more orders to TSMC for chip fabrication, this will likely result in further improvement in TSMC’s sales (Chart 14). Bottom Line: Rising TSMC sales do not necessarily herald an imminent and robust cyclical recovery in the global semiconductor sector.  Investment Conclusions Global semiconductor stock prices have been front running a recovery that has not yet begun. In addition, there is still uncertainty about the technology aspect of US-China trade negotiations. The US will likely continue to have Huawei and other Chinese high-tech companies on its trade-ban list – its so-called Entity List. TSMC sales do not always correlate well with global semiconductor sales. Notably, global semiconductor sales and profits are still in deep contraction, while share prices are at all-time highs (Chart 15). As a result, semiconductor stocks’ multiples have spiked to their previous highs (Chart 16). Chart 15Semiconductor Companies Profits: Still In Deep Contraction Semiconductor Companies Profits: Still In Deep Contraction Semiconductor Companies Profits: Still In Deep Contraction Chart 16Elevated Semiconductor Stocks Multiples Elevated Semiconductor Stocks Multiples Elevated Semiconductor Stocks Multiples     While it is common for share prices to rally ahead of a business cycle/profit revival, we believe a true recovery will only emerge in spring 2020, and it will initially be much more subdued than industry watchers and investors expect. In the near term, strong momentum could still push semiconductor stock prices higher. However, the reality will then set in and there will be an air pocket before a more sustainable bull market emerges.   Our US Equity Investment Strategy earlier this week downgraded S&P semiconductor equipment companies to underweight and put the S&P Semiconductors Index on a downgrade alert.5 Their newly created top-down semiconductor profit growth model warns that an earnings recovery is not yet imminent (Chart 17). For EM-dedicated equity managers, we have been neutral on Asian semiconductor sectors. We continue to recommend a market-weight allocation to Taiwan’s overall market, while we are upgrading the Korean technology sector from a neutral allocation to overweight. Korean semiconductor stocks have rallied much less than their global peers. Hence, the risk of a major relapse is lower. Given that we have been overweight non-tech Korean stocks, upgrading tech stocks to overweight means we will be overweight the KOSPI within the EM equity benchmark (Chart 18). Chart 17Semiconductor Earnings Recovery: Not Imminent Semiconductor Earnings Recovery: Not Imminent Semiconductor Earnings Recovery: Not Imminent Chart 18Upgrade Korean Tech Stocks And Overweight KOSPI Within EM Upgrade Korean Tech Stocks And Overweight KOSPI Within EM Upgrade Korean Tech Stocks And Overweight KOSPI Within EM   Meanwhile, we remain long the Bloomberg Asia-Pacific Semiconductor Index and short the S&P 500 Semiconductor Index. This trade has produced a 7% gain since its initiation on June 13, 2019. The Bloomberg Asia-Pacific Semiconductor index has 12 stocks. Samsung and TSMC account for 38% and 37% of the index, respectively. The S&P 500 Semiconductor Index has 13 stocks. Intel, Broadcom, Texas Instruments and Qualcomm are the top five constituents, together accounting for nearly 77% of the index. Although the US and China may reach a temporary trade deal, the US will continue to restrict sales of tech products and high-end semiconductors to China. As a result, these US semiconductor companies, most of which are IC designing companies, will likely experience a more subdued than expected recovery in sales. Ellen JingYuan He Associate Vice President ellenj@bcaresearch.com Footnotes   1 Please see Emerging Markets Strategy Special Report "The Global Semiconductor Sector: Is A Cyclical Upturn Imminent?" dated June 13, 2019, available at ems.bcaresearch.com 2 https://www.guancha.cn/ChanJing/2019_09_21_518748.shtml http://www.cac.gov.cn/2019-10/23/c_1573361796389322.htm 3 Please see Emerging Markets Strategy Special Report "Chinese Auto Demand: Time For A  Recovery?" dated October 17, 2019, available at ems.bcaresearch.com 4 https://www.canalys.com/analysis/smartphone+analysis 5 Please see US Equity Strategy Special Report "Defying Gravity," dated November 4, 2019, available at uses.bcaresearch.com

  Highlights While the Caixin PMI is pointing to improving economic conditions, other data series still reflect weak growth. China’s business cycle is likely to bottom in Q1 of next year, rather than in Q4. The failure of Chinese stocks to significantly outperform the global benchmark and the continued underperformance of cyclical stocks underscore the near-term risks to equities if this month’s trade & manufacturing data disappoint. We continue to recommend a neutral tactical stance (0-3 months) towards Chinese equities versus global stocks, but expect them to outperform on a cyclical (6-12 month) time horizon after economic growth firmly bottoms. Feature Tables 1 and 2 on pages 2 and 3 highlight key developments in China’s economy and its financial markets over the past month. On the growth front, the data remains mixed: the strength in the October Caixin PMI and the September pickup in electricity production are positive signs, but other important datapoints still point to weak conditions. We continue to expect that China’s business cycle is likely to bottom in Q1 of next year, rather than in Q4. We continue to expect that growth will bottom in Q1 of next year, rather than in Q4. Table 1China Macro Data Summary China Macro And Market Review China Macro And Market Review Table 2China Financial Market Performance Summary China Macro And Market Review China Macro And Market Review Within financial markets, Chinese stocks have rallied in absolute terms over the past month in response to greatly increased odds of a trade truce between China and the US, but have failed to outperform the global benchmark. This, in combination with the continued underperformance of cyclical stocks, suggests that hard evidence of an economic improvement in China will be required before Chinese stocks begin to rise in relative terms. The risk of near-term underperformance is still present, especially if October’s hard trade and manufacturing data disappoint. We continue to recommend a neutral tactical stance (0-3 months) towards Chinese equities versus global stocks, but expect them to outperform on a cyclical (6-12 month) time horizon after economic growth firmly bottoms. In reference to Tables 1 and 2, we provide below several detailed observations concerning developments in China’s macro and financial market data: Chart 1Not Yet A Clear Change In Trend Not Yet A Clear Change In Trend Not Yet A Clear Change In Trend The Bloomberg Li Keqiang index (LKI) ticked up in September, led by an improvement in electricity production. An improvement in the LKI in lockstep with a rising Caixin manufacturing PMI (discussed below) raises the odds that the Chinese economy may be bottoming earlier than we expect, but for now only modestly so. Chinese economic data is highly volatile, and Chart 1 shows that the improvement in the LKI is very muted when shown as a 3-month moving average. In addition, a slight improvement also occurred earlier this year, but proved to be a false signal. All told, for now we continue to expect that growth will bottom in Q1 of next year, rather than in Q4. Our leading indicator for the LKI was essentially flat in September on a smoothed basis, with sequential declines in M3 growth and the credit components of the indicator offsetting improvements in monetary conditions and M2. From a big picture perspective, the story of our LKI leading indicator remains unchanged: it continues to trend higher, at a much shallower pace than has been the case during previous easing cycles. The uptrend is the basis of our forecast that China’s growth will soon bottom, but the uncharacteristically shallow nature of the rise suggests that the eventual recovery will be modest. On a smoothed basis, Chinese residential floor space sold improved again in September, following a very significant rise in August. Over the past 12-18 months, we had emphasized that the double-digit pace of growth in China’s housing starts was unsustainable because it had entirely decoupled from the trend in sales (which have reliably led construction activity over the past decade). This gap disappeared over the summer due to a significant slowdown in starts, which is what we predicted would occur. However, the recent acceleration in floor space sold represents a legitimate fundamental improvement in the housing market, that for now is difficult to attribute to the recent drivers of housing demand (Chart 2).1 Still, investors should continue to watch China’s housing demand data closely over the coming few months, for further signs of a potential re-acceleration in housing construction. Investors need to see meaningful sequential improvements in China’s October trade and manufacturing data. The October improvement in China’s Caixin PMI was quite notable, as it appears to confirm the full one-point rise in the index that occurred in September and suggests that manufacturing in China’s private-sector is now durably expanding. Still, conflicting signals remain: the official PMI fell in October and remains below 50, and the significant September improvement in the Caixin PMI was not corroborated by an improvement in producer prices or nominal import growth (Chart 3). As PMIs are simply timely coincident indicators that do not generally have leading properties, investors will need to see meaningful sequential improvements in China’s October trade and manufacturing data in order to have confidence that the Caixin PMI improvement is not a false signal. Chart 2It Is Not Yet Apparent What Is Driving A Pickup In Housing Demand It Is Not Yet Apparent What Is Driving A Pickup In Housing Demand It Is Not Yet Apparent What Is Driving A Pickup In Housing Demand Chart 3If The Caixin PMI Is Not A False Signal, A Hard Data Improvement Must Occur Soon If The Caixin PMI Is Not A False Signal, A Hard Data Improvement Must Occur Soon If The Caixin PMI Is Not A False Signal, A Hard Data Improvement Must Occur Soon Chinese stocks have rallied 6-7% over the past month in absolute terms, but have modestly underperformed global equities. The rally in global stock prices has occurred largely in response to the mid-October announcement of a trade truce between China and the US. The failure of Chinese stocks to outperform during this period suggests hard evidence of an economic improvement in China will be required before Chinese stocks begin to outpace their global peers. At the regional equity level, the other notable development over the past month has been the continued outperformance of the MSCI Taiwan Index versus the global benchmark. Taiwan’s outperformance has been boosted by a rising TWD versus the dollar, but Taiwanese stocks have also outperformed in local currency terms. Taiwan province is highly exposed to global trade, and it is not surprising that equities have reacted positively to the prospect of a trade truce between the US and China. Further meaningful outperformance, however, will likely require a re-acceleration in Taiwanese exports, as export growth has merely halted its contraction (Chart 4). Within China’s investable equity market, cyclicals have underperformed defensives over the past month after having rallied significantly from late-August to mid-September (Chart 5). We noted in our October 30 Special Report that these cyclical sectors have historically been positively correlated with pro-cyclical macroeconomic and equity market variables,2 and their underperformance versus defensives is thus consistent with the failure of Chinese stocks in the aggregate to outperform global equities over the past month. In both cases, outperformance likely requires hard evidence of an upturn in China’s business cycle. Chart 4Export Growth Needs To Improve In Order To Expect Further Taiwanese Relative Outperformance Export Growth Needs To Improve In Order To Expect Further Taiwanese Relative Outperformance Export Growth Needs To Improve In Order To Expect Further Taiwanese Relative Outperformance Chart 5Cyclical Underperformance Underscores The Near-Term Risks To Chinese Vs. Global Stocks Cyclical Underperformance Underscores The Near-Term Risks To Chinese Vs. Global Stocks Cyclical Underperformance Underscores The Near-Term Risks To Chinese Vs. Global Stocks We do not take the rise in Chinese government bond yields as necessarily indicative of an imminent breakout in relative equity performance. Chart 6Chinese Relative Equity Performance Leads Bond Yields, Not The Other Way Around Chinese Relative Equity Performance Leads Bond Yields, Not The Other Way Around Chinese Relative Equity Performance Leads Bond Yields, Not The Other Way Around Chinese 10-year government bond yields have risen roughly 15bps over the past month, and are now 30bps off of their mid-August low. Many market participants view Chinese government bond yields as a leading growth barometer, but 10-year yields have actually lagged Chinese investable stock performance over the past two years (Chart 6). As such, we do not take the rise in yields as necessarily indicative of an imminent breakout in relative equity performance. Chinese onshore corporate bond spreads have declined over the past month as government bond yields have been rising, continuing a pattern of negative correlation between the two that has prevailed since early-2018. A negative correlation between yields and corporate bond spreads is a normal relationship, and it suggests that spreads may narrow over the coming year if the Chinese economy bottoms in Q1, as we expect. Spreads remain elevated despite the substantial easing in monetary conditions that occurred last year, due to persistent concerns about rising onshore defaults. While we acknowledge that defaults are indeed occurring, we have argued on several occasions that the pace of defaults would have to be much faster in order for current spreads to be justified.3 We continue to recommend a long RMB-denominated position in China’s onshore corporate bond market. The RMB has appreciated over the past month in response to news of a likely trade truce between the US and China, with most of the rise having occurred versus the US dollar. USD-CNY is likely to sustainably trade below the 7 mark in a trade truce scenario, but how much further downside is possible in the near-term absent a re-acceleration in Chinese economic activity remains an open question. With the Fed very likely on hold for the next year, stronger than expected economic growth in China would likely catalyze a persistent selloff in USD-CNY barring a re-emergence of the Sino-US trade war. This, however, is not our base-case view, meaning that we expect modest post-deal strength in the RMB.   Jonathan LaBerge, CFA Vice President Special Reports jonathanl@bcaresearch.com Jing Sima China Strategist JingS@bcaresearch.com   Footnotes 1. Please see China Investment Strategy Special Report, “China’s Property Market: Where Will It Go From Here?” dated September 13, 2018. 2. Please see China Investment Strategy Weekly Report, “A Guide To Chinese Investable Equity Sector Performance,” dated October 30, 2019. 3. Please see China Investment Strategy Weekly Reports, “A Shaky Ladder,” dated June 13, 2018, "Investing In The Middle Of A Trade War,” dated September 19, 2018 and "2019 Key Views: Four Themes For China In The Coming Year,” dated December 5, 2018. Cyclical Investment Stance Equity Sector Recommendations

Highlights Chinese economic growth slowed in June & July, but at a more moderate pace than had been the case earlier this year. The housing market is a notable exception, which appeared in June to slow in a broad-based fashion. The near-term (0-3 month) outlook is bearish for China-related assets, and investors should bet on further weakness in the RMB. However, investors should remain cyclically bullish (i.e., over a 6-12 month time horizon) in anticipation of an eventual reflationary response from Chinese policymakers that will boost domestic demand enough to offset the intensifying drag from weak external demand. Feature Tables 1 and 2 on pages 2 and 3 highlight key developments in China’s economy and its financial markets over the past month. On the growth front, coincident measures of economic activity suggest that China’s economy experienced “controlled weakness” in June and July: growth continued to slow, but at a more moderate pace than had been the case in late-2018 and early-2019. The housing market appeared to be the exception to this relative stability; all 10 of the core housing indicators that we track decelerated in June, suggesting that a moderation in housing-related activity was broad-based. This implies that a further slowdown in construction is likely over the coming months, barring a meaningful pickup in sales. Table 1China Macro Data Summary China Macro And Market Review China Macro And Market Review Table 2China Financial Market Performance Summary China Macro And Market Review China Macro And Market Review Within financial markets, all of the key developments have occurred over the past several trading days, in response to President Trump’s threat last week to further hike U.S. import tariffs at the beginning of September. Both investable and domestically-listed Chinese stocks have significantly underperformed the global benchmark, as have Hong Kong stocks in response to intensifying protests in the city. A sharp decline in the RMB and the U.S. designation of China as a currency manipulator have unnerved Chinese and global investors, and our bias is to expect even further weakness in the yuan. The near-term outlook remains bearish for China-related assets, as we see the selloff over the past week as the beginning of a financial market riot point that will force policymakers, both in China and the U.S., to address the economic weakness that a full-tariff scenario will entail. The near-term outlook remains bearish for China-related assets, as we see the selloff over the past week as the beginning of a financial market riot point that will force policymakers, both in China and the U.S., to address the economic weakness that a full-tariff scenario will entail. Still, investors should remain cyclically bullish in anticipation of an eventual reflationary response from Chinese policymakers that will boost domestic demand enough to offset the drag from weak external demand. Otherwise stated, we expect Chinese relative performance to trend lower in the near-term, but to be higher 12-months from today. Investors should also continue to hedge the inherent RMB exposure from a long US$ cyclical position in Chinese stocks with a long USD-CNH position. In reference to Tables 1 and 2, we provide below several detailed observations concerning developments in China’s macro and financial market data: Our leading indicator for the Li Keqiang Index is now in a clear uptrend, most recently led by a meaningful improvement in monetary conditions and credit growth. Chart 1Our Leading Indicator Is Now In A (Moderate-Strength) Uptrend Our Leading Indicator Is Now In A (Moderate-Strength) Uptrend Our Leading Indicator Is Now In A (Moderate-Strength) Uptrend Chart 2Money, And Still-Modest Credit Growth, Are Holding Back Our Leading Indicator Money, And Still-Modest Credit Growth, Are Holding Back Our Leading Indicator Money, And Still-Modest Credit Growth, Are Holding Back Our Leading Indicator The Li Keqiang index (LKI) rose moderately in June after a significant decline in May, but remains in a downtrend (Chart 1). The June increase was driven entirely by a pickup in electricity production (which had nearly contracted in May); bank loan growth and rail cargo volume both decelerated. The takeaway for investors is that while the Chinese economy did not slow meaningfully further in June, the pace of growth remained tepid, suggesting the economic activity remains vulnerable to a further increase in U.S. import tariffs. Our leading indicator for the LKI is now in a clear uptrend, most recently led by a meaningful improvement in monetary conditions and credit growth (Chart 2). However, the magnitude of the rise in the indicator is being held back by growth in the money supply, which has only slightly accelerated over the past few months, as well as a “half strength” recovery in credit. Our view is that Chinese policymakers are likely to wait for further economic weakness before allowing money & credit growth to significantly overshoot, which increases the odds of a continued market riot in the short-term. Chart 3Decelerating House Price Appreciation Is Coming Decelerating House Price Appreciation Is Coming Decelerating House Price Appreciation Is Coming All 10 of the housing indicators shown in Table 1 decelerated in June, suggesting that a moderation in housing-related activity was broad-based. Our BCA 70-city diffusion index for (YoY) house prices has an excellent track record at leading inflection points in overall price growth (Chart 3), and is currently suggesting that house price appreciation is at risk of falling back to mid-2018 levels (which would imply a 5-6 percentage point deceleration). Continued weakness in floor space sold continues to suggest that the ongoing pace of housing construction is unsustainable; we expect a further moderation in floor space started over the coming several months barring a meaningful pickup in sales. Both the Caixin and official manufacturing PMI for China rose in July, including the official new export orders component (which we have been closely following). However, the survey was taken prior to President Trump’s renewed tariff threat last week, and we expect the July gains to reverse in August barring a major de-escalation in the conflict. Both investable and domestically-listed Chinese stocks have significantly underperformed the global benchmark over the past week due to President Trump’s threat to impose tariffs on all remaining imports from China. We noted in our May 29 weekly report that a financial market riot point remained likely over the coming few months,1 and we explicitly recommend an underweight position in Chinese stocks for the remainder of 2019 in last week’s report.2 Still, investors should remain cyclically bullish in anticipation of an eventual reflationary response from Chinese policymakers that will boost domestic demand enough to offset the drag from weak external demand. Investors who are already positioned in favor of Chinese stocks should stay long, despite the likelihood of further near-term losses. ​​​​​​​Investors should remain cyclically bullish in anticipation of an eventual reflationary response from Chinese policymakers that will boost domestic demand enough to offset the drag from weak external demand. Chart 4Intensifying Protests Have Weighed On Hong Kong's Relative Equity Performance Intensifying Protests Have Weighed On Hong Kong's Relative Equity Performance Intensifying Protests Have Weighed On Hong Kong's Relative Equity Performance The MSCI Hong Kong index has also significantly underperformed the global benchmark since late-July, in response to intensifying protests in the city (Chart 4). The protests have been driven by underlying socio-economic factors as well as Beijing’s encroachment on traditional political liberties. However, Hong Kong has no real alternative to Beijing’s sovereignty, and the unrest should gradually die down as long as the imposition of martial law is avoided. Nonetheless, Hong Kong’s stock market is likely to remain under pressure in the interim; for now, we recommend that investors stay underweight versus China and Taiwan.​​​​​​​ The sector performance within China’s investable and domestically-listed equity markets over the past month has largely been along cyclical / defensive lines. In the investable market, consumer staples, health care, financials, information technology, communication services, and utilities have all outperformed, in contrast to energy, materials, industrials, consumer discretionary, and real estate stocks. The pattern has been similar in the domestic market, with two exceptions: modest staples underperformance, and material underperformance of comm services. Real estate stocks have been among the worst performers in both markets over the past month, possibly in response to the deteriorating housing market data that we highlighted above. China’s 3-month repo rate has fallen approximately 20 bps over the past month, and is now back close to its one-year low. We continue to believe that a cut to the benchmark lending rate is unlikely in the near-term, but could occur in Q4 if economic conditions in China weaken materially further.​​​​​​​ Chinese onshore corporate spreads increased modestly over the past month, but have not yet risen to a new high for the year. The uptrend in spreads that began in late-May does reflect renewed risks to the Chinese economy from a further increase in U.S. import tariffs, but annualizing the most recent pace of onshore corporate defaults suggests that onshore bond spreads are still much too high. Our long China onshore corporate bond trade continues to register gains in local currency terms (Chart 5), and we recommend that investors stick with a long/overweight currency-hedged stance. ​​​​​​​Our bias is to bet on further RMB weakness until policymakers aggressively ramp up their reflationary efforts. The yuan weakened sharply this week, with the U.S. dollar breaking above 7 versus both the onshore and offshore RMB (Chart 6). This is the weakest level for the currency since the global financial crisis, and the decline has clearly occurred in response to last week’s tariff threat. We noted in our May 15 report that a meaningful decline in the exchange rate would likely be required in order to stabilize the outlook for earnings & the economy,3 and we recommended at that time that investors should hedge the inherent RMB exposure from a long US$ cyclical position in Chinese stocks by opening a long USD-CNH trade. It is difficult to forecast how much further the RMB is likely to fall, but our bias is to bet on further weakness until policymakers aggressively ramp up their reflationary efforts. Stay tuned. Chart 5Despite Ongoing Default Concerns, Onshore Corporate Bonds Are Winners Despite Ongoing Default Concerns, Onshore Corporate Bonds Are Winners Despite Ongoing Default Concerns, Onshore Corporate Bonds Are Winners Chart 6Weakest RMB In A Decade, And Further Declines Are Likely Weakest RMB In A Decade, And Further Declines Are Likely Weakest RMB In A Decade, And Further Declines Are Likely   Jonathan LaBerge, CFA, Vice President Special Reports jonathanl@bcaresearch.com   Jing Sima China Strategist jings@bcaresearch.com 1      Please see China Investment Strategy Weekly Report, “Waiting For The Pain,” dated May 29, 2019. 2      Please see China Investment Strategy Weekly Report, “Threading A Stimulus Needle (Part 2): Will Proactive Fiscal Policy Lose Steam?” dated July 24, 2019. 3      Please see China Investment Strategy Weekly Report, “Simple Arithmetic,” dated May 15, 2019.   Cyclical Investment Stance Equity Sector Recommendations