Developed Countries

Highlights Portfolio Strategy The budding recovery in Chinese infrastructure outlays and easing in monetary conditions, a pause in the U.S. dollar’s rally on the back of a more dovish Fed and improving domestic steel final-demand dynamics along with compelling valuations and technicals, all suggest it no longer pays to be bearish the S&P 1500 steel index. Boost to overweight. A marginally improving China monetary backdrop, a de-escalation in the U.S./China trade tussle, recovering EM market internals and a brightening profit backdrop, all signal that a re-rating phase looms in the S&P materials sector. Upgrade to a modest overweight. Recent Changes Boost the niche S&P 1500 Steel Index to overweight today. This move also lifts the S&P Materials Index to a modest overweight. Table 1 Feature The S&P 500 convulsed following the December 19th Fed meeting and suffered a cathartic 450 point peak-to-trough fall last month. The Fed likely made a policy error, and Fed Chair Powell’s resolve is getting tested as has happened with every Chair since Volcker (Chart 1).1 Chart 1Powell's Resolve Getting Tested The top panel of Chart 2 shows that the 2018 peak in the SPX occurred one week prior to the September Fed meeting. That meeting, when the Fed raised rates for the third time that year, was the straw that broke the camel's back. Indeed, the bond market has been signaling that the U.S. economy has reached the neutral rate last year, as the 10-year UST yield stalled near the 3.10% mark on several occasions (middle panel, Chart 2). Chart 2Fed Policy Mistake Our recent research also suggests that the Fed’s tightening cycle (from trough-to-peak) is now above the historical median and at least a pause is warranted.2 To put last year’s discount rate increases into further perspective, bottom panel of Chart 2 shows that a 100bps increase in the fed funds rate caused a roughly 30% collapse in the forward P/E. Not only is this multiple compression overdone, but prices also corrected 19% from peak-to-trough, likely paving the way for a smart recovery. Our running assumption remains that the U.S. economy will avoid recession this year and EPS will continue to expand. True, the yield curve inversions have widened beyond the 5/3 and 5/2 slopes to the 7/1, and we heed the bond market’s message (Chart 3). However, as we highlighted last month, yield curve inversions occur before stock market peaks. Keep in mind that the most important yield curve slope, the 10/2, has not yet inverted. The upshot is that the SPX has yet to peter out for the cycle.3 Chart 3Yield Curve Inversion Is Spreading With regard to our end-2019 SPX target we are revising our base case scenario to 3,000 (from 3,150 previously),4 based on a 2020 EPS revision to $181 (from $191 previously),5 but we are sustaining the multiple at 16.5 times (Table 2). Assuming 2018 EPS end near $162, this represents a 6% EPS CAGR, in line with the still mid-single digit expansion signal from our EPS growth model (Chart 4). Table 2SPX EPS & Multiple SensitivityChart 4EPS Growth Model Still Expects Mid-Single Digit Expansion Adding it up, stocks hit rock bottom late-last year and a pause in the Fed tightening cycle, at least for the first half of the year, will likely serve as a welcome catalyst; any positive news on the trade tussle front with China will also act as a tonic for stocks, especially beaten down deep cyclicals. This week we are upgrading a U.S./China trade war GICS1 sector victim to a modest overweight position, via boosting a niche deep cyclical sub-index to an above benchmark allocation. Made Of Steel We are booking gains of 2.3% in the niche S&P 1500 steel index and boosting it from underweight all the way to an overweight stance. Beyond the contrary buy signal that bombed out technicals and depressed valuations are sending (Chart 5), there are high odds that relative profit outperformance is in the early innings. Chart 5Steel Is A Steal While U.S. steel stocks should have benefitted enormously from the U.S./China trade war and steel import tariffs, China macro dictates the fate of the S&P 1500 steel index. China’s waning fiscal and credit impulses have weighed heavily on U.S. steel stocks (top panel, Chart 6). Chinese authorities have been trying to engineer a soft landing, but the Chinese manufacturing PMI has now dipped below the boom/bust line (middle panel, Chart 6). Chart 6Mixed China Signals... Nevertheless, the recovering Li KEQIANG index is sending a positive signal (bottom panel, Chart 6). In addition, recent news of a mini fiscal package centered on high speed rail infrastructure spending is a step in the right direction. Historically, Chinese infrastructure outlays and relative share prices have been joined at the hip (middle panel, Chart 7). Chart 7...But Monetary And Fiscal Taps Are Opening On the monetary front, the easing in the banks’ reserve-requirement-ratio (RRR), albeit with a delayed effect, should also aid infrastructure spending uptake (RRR shown inverted, bottom panel, Chart 7). Similarly, the steepening in the Chinese yield curve underscores that easing financial conditions are conducive to a pickup in capital outlays (top panel, Chart 7). The U.S. dollar is another important macro variable driving U.S. steel stocks performance. The greenback’s steep appreciation since April 2018 has dealt a dual blow to domestic steel producers: not only is the underlying commodity quoted globally in U.S. dollars, but also FX translation losses have dented sector profitability. Despite the grim U.S. dollar news, there is light at the end of the tunnel. Were the Fed to pause its hiking cycle, at least in the front half of the year, the greenback’s advance may go on hiatus. Importantly, J.P. Morgan’s EM FX index is staging a comeback and steel prices are holding their own (top and bottom panels, Chart 8). Chart 8Bright Profit Drivers On the domestic front, news is also encouraging. Ever since President Trump came into power, blast furnaces have been running around the clock. Industry resource utilization rates are in a V-shaped recovery since 2016 and only recently returned to levels last seen prior to the Great Recession (middle panel, Chart 8). Steel new order growth is running at a healthy clip and is even surpassing inventory accumulation. This bright demand backdrop is a boon for steelmaking earnings (Chart 9). Chart 9Domestic Operating Backdrop... With regard to the domestic demand front, while automobile sales have been flirting with the zero growth line for the better part of the past three years, non-residential construction has been a primary beneficiary from the easing in fiscal policy (bottom panel, Chart 10). Fiscal thrust will continue to goose the U.S. economy in 2019, according to the IMF’s October 2018 World Economic Outlook update, and a new infrastructure spending bill, however modest, will, at the margin, buoy steel profits. Finally, according to the Fed’s latest Senior Loan Officer Survey, bankers are far from constricting the flow of credit toward the key end-demand segments, autos and commercial real estate. Chart 10...And Domestic Demand Will Buoy Steel Profits In sum, compelling valuations and technicals, the budding recovery in Chinese infrastructure outlays and easing in monetary conditions, a pause in the U.S. dollar’s rally on the back of a more dovish Fed and improving domestic steel final-demand dynamics, all suggest that it no longer pays to be bearish the S&P 1500 steel index. Bottom Line: Lift the S&P 1500 steel index from underweight to overweight and lock in gains of 2.3%. The ticker symbols for the stocks in the S&P 1500 steel index are: BLBG: S15STEL – NUE, STLD, RS, X, ATI, CMC, CRS, WOR, AKS, SXC, TMST, HAYN and ZEUS. Time To Dip Into Materials Raising the S&P 1500 steel index to an above benchmark allocation shifts the S&P materials sector into the overweight column. China macro dominates the direction of U.S. materials stocks. On the monetary front, the easing cycle continues unabated and the near 150bps year-over-year drop in the 10-year Chinese Treasury yield will soon start to bear fruit (yield change shown inverted and advanced, bottom panel, Chart 11). Chart 11Buy Materials As China's Monetary Spigots Are Loosening The renminbi also moves in lockstep with relative share prices. The apparent de-escalation in the U.S./China trade tensions has boosted the CNYUSD and is signaling that a playable reflation trade is in the offing in the S&P materials sector (top panel, Chart 11). Beyond the budding recovery in some key Chinese data (bottom panel, Chart 12), the troughing in emerging markets (EM) currencies versus the greenback also suggests that U.S. materials stocks have put in a bottom (top panel, Chart 12). Chart 12Shifting EM Internals Are A Boon For Materials The EM stock outperformance compared with the global benchmark (second panel, Chart 12) along with EM market internals corroborate the EM FX message. In more detail, EM Latin American equities have been significantly outperforming EM Asian bourses. This real time proxy of commodity producers versus consumers has been an excellent indicator of relative share prices and the current message is to expect more relative gains in the S&P materials sector (third panel, Chart 12). On the earnings front, while last year’s trade dispute related collapse in relative share prices is signaling profit trouble in the coming months, our EPS growth model (comprising the U.S. dollar, interest rates and commodity prices) has ticked up. Similar to the 2012 and 2016 lows, there are good odds that our model is picking up a soft landing in profits (second panel, Chart 13). Chart 13Profit Growth Model Has Troughed S&P materials sub-sector EPS breadth has slingshot higher compared with the overall market and relative long-term EPS growth forecasts are trying to bottom near the 2016 nadir (third & bottom panels, Chart 13). With regard to the sector’s financial health, materials’ indebtedness profile remains in recovery mode, still in the aftermath of the late-2015/early-2016 manufacturing recession with net debt-to-EBITDA in a free fall and a steeply accelerating interest coverage ratio. Capital outlays are also expanding smartly and are now on an even keel with sales growth (Chart 14). Given this improvement in corporate health, there are low odds of debt-related materials sector deflation. Chart 14Clean Bill Of Corporate Health Taking the pulse of investor sentiment toward this niche deep cyclical sector reveals that technical conditions are as oversold as can be; in fact our Technical Indicator sits at one standard deviation below the historical mean, a level that has preceded previous recovery rallies (Chart 15). Chart 15Contrary Buy Alert: Under-owned... Finally, according to our Valuation Indicator, relative valuations have crumbled to the lowest level since the GFC, and even relative EV/EBITDA has also corrected to the historical mean (Chart 16). Chart 16...And Unloved Netting it out, a marginally improving China monetary backdrop along with a de-escalation in the U.S./China trade tussle, recovering EM market internals and a brightening profit backdrop, all signal that a re-rating phase looms in the S&P materials sector. Bottom Line: Lift the S&P materials sector to a modest overweight position.   Anastasios Avgeriou, Vice President U.S. Equity Strategy anastasios@bcaresearch.com Footnotes 1      Please see BCA U.S. Equity Strategy Weekly Report, “Will The Market Test Powell?” dated November 13, 2017, available at uses.bcaresearch.com. 2      Please see BCA U.S. Equity Strategy Weekly Report, “Manic Market” dated November 19, 2018, available at uses.bcaresearch.com. 3      Please see BCA U.S. Equity Strategy Weekly Report, “Signal Vs. Noise” dated December 17, 2018, available at uses.bcaresearch.com. 4      Please see BCA U.S. Equity Strategy Weekly Report, “Lifting SPX Target” dated April 30, 2018, available at uses.bcaresearch.com. 5      Ibid. Current Recommendations Current Trades Size And Style Views Favor value over growth Favor large over small caps

Highlights Survey data are easing, but that should not come as a surprise: The economy should decelerate as fiscal thrust is dialed back. Just a little patience (yeah-eah): A chorus of Fed speakers have taken to the podiums to reassure the public that the FOMC is taking its concerns seriously. The labor force participation rate popped in December, but investors shouldn’t count on it to produce a Goldilocks dual-mandate outcome: The demographic obstacle to continued part-rate gains is formidable. It is too early to de-risk portfolios: We remain constructive on risk assets and the economy. Feature Walking past flat-screen TVs during the workday has become considerably more pleasant. CNBC has switched out its red-drenched Market Sell-Off backdrop for a bright-green backdrop framing cheerful messages like, “Stocks are on track to rise for the third day in four.” In the ten sessions following Christmas Eve, the S&P 500 gained a stout 10%. Even a sharply negative preannouncement from Apple, and the prospect that 8% of Amazon’s outstanding shares could eventually hit the market, failed to halt the upward march. Only the disappointing December ISM Manufacturing survey has managed to bother the equity market over the course of the snapback rally, but the disappointment was quickly forgotten upon the next morning’s release of the gangbusters December employment report. The down-2.5%-one-day-up-3.5%-the-next action highlighted the fragility of the investor psyche. Markets are deeply uncertain about the economy, and how the Fed’s rate-hiking campaign will impact it. This week, we consider the evidence from the ISM and NFIB surveys, the recent wave of comments from Jay Powell and the regional Fed presidents, and the labor market to reassess our outlook for financial markets and the economy. Survey Says Over the first two weeks of January, the ISM surveys, the NFIB small business survey and the Job Openings and Labor Turnover Survey (JOLTS) all indicated slowing in their subject areas. An investor could point to them as evidence that the expansion is on its last legs, but we interpreted them as mixed, and do not see them as an argument for de-risking portfolios. Recall that the economy grew so far above trend in 2018 because of a generous helping of fiscal stimulus; as the stimulus is throttled back, the economy will decelerate. Markets had already factored the survey results into their expectations and took them in stride (Chart 1). Chart 1Soft Data Are Not A Surprise The magnitude of the weakness in the manufacturing ISM survey did come as a surprise. Beneath the headline (Chart 2, top panel), the employment reading slipped (Chart 2, second panel) and prices paid plunged (Chart 2, third panel), suggesting that the economy may not be so robust after all, but at least stagflation is not yet a concern. New orders, the component with the best leading properties, fell a whopping eleven points to get uncomfortably close to the boom/bust line (Chart 2, bottom panel). Chart 2Manufacturing May Be Wobbling, ... Manufacturing accounts for a modest share of U.S. employment and output, and we don’t dwell too much on it per se, but it may provide a window into global conditions. Trade tensions’ impact on global growth has been our foremost worry this year, and it is possible that the weakening manufacturing ISM points to weakness in the global economy. The U.S. is fairly inured from global weakness relative to other economies, but there is no such thing as decoupling. Weakness in the rest of the world will eventually make itself felt in the U.S., and we are watching the trade climate and global conditions carefully. The services ISM also declined more than expected, but a reading in the 57-58 range is strong, and points to an economy growing above trend. Employment (Chart 3, second panel) and new orders (Chart 3, bottom panel) both remain at or above a standard deviation above the mean. It is often true that markets care more about incremental changes than levels, but it is not an always-and-everywhere rule. In the context of an economy operating well above capacity, some slowing is both inevitable and desirable. We will watch the services ISM for signs of continued slowing, but we do not yet see any cause for concern. Chart 3... But Services Are Still Strong Small-business optimism continues to support a constructive take on the economy, despite the modest pullback in the NFIB survey and some of its key components. The headline index has come off of the all-time highs it set in 2018, but remains at very high levels relative to history (Chart 4, top panel). Job openings hit an all-time high in December (Chart 4, second panel), underscoring the message from the persistently strong payrolls data, and the share of small businesses deeming it a good time to expand (Chart 4, third panel) and that plan to expand headcount over the next three months (Chart 4, bottom panel) are well above one-standard-deviation levels. Surveys are soft data, but both the headline optimism index and the good-time-to-expand component have begun to slide well in advance of the last three recessions, suggesting they’re useful leading indicators. Chart 4Small-Businesses Are Still Bulled Up As strong as the employment picture has been, it is only a coincident indicator. The dot-com recession took employers (Chart 5, top panel) and job-hopping employees (Chart 5, bottom panel) by surprise, but there is nothing in the rate of job openings or quits in the JOLTS (Job Openings and Labor Turnover Survey) data that should inspire concern about the state of the economy. The series are off their highs, but there’s nothing to worry about at their still-elevated levels. Chart 5Softer, But Hardly Soft Bottom Line: Survey data have weakened as fiscal stimulus has waned, just as investors should have expected. We are keeping a close eye on the new orders component of the ISM Manufacturing survey, but nothing in the services ISM, NFIB or JOLTS surveys merits too much concern. FOMC Members Speak (And Speak, And Speak) The New Year brought an avalanche of comments from FOMC members. Chairman Powell, Vice Chairman Clarida, and seven regional presidents gave speeches, made appearances, or sat for interviews in the first two weeks of January, and New York Fed president Williams gave a long interview to CNBC two days after the December meeting. Away from uber-dove Bullard (St. Louis), who warned in a Wall Street Journal interview that further rate hikes could tip the economy into a recession, the various officials stressed the Fed’s open-mindedness. (Bullard, who is an FOMC voter this year, has repeatedly urged caution about hiking too much.) The overall thrust of the remarks has been to accentuate the FOMC’s commitment to go where the data lead. Echoing the language in the December minutes, several speakers noted that the Fed can be “patient,” given that inflation shows no signs of breaking out. The impact has been to soothe markets, which seem to be acutely concerned that rate hikes might go too far. (Though the speakers did little to ease concerns about balance-sheet reduction, or “quantitative tightening,” the Treasury, corporate-bond, and equity markets retraced much of their risk-off moves anyway.) Jay Powell set the tone for the overall message in a public appearance on January 4th, when he said the Fed “was listening sensitively to the message the markets are sending.” He underlined the data-dependency theme in an appearance last week, in which he said that, “we can be patient and flexible and wait and see what does evolve, and I think for the meantime, we’re waiting and watching. You should anticipate that we’re going to be patient and watching, and waiting and seeing.” His FOMC colleagues took care to drive home the same talking points, noting that data dependency includes following sentiment surveys, talking with business contacts, and watching markets. The speakers and the minutes also highlighted the discrepancy between robust 2018 growth of at least 3% and the much gloomier outlook implied by financial markets’ dreadful fourth quarter. None of the sensitive listeners disregarded the markets’ concerns, though Boston president Rosengren suggested that the markets may have gotten carried away. “My own view is that the economic outlook is actually brighter than the outlook one might infer from recent financial market movements.” Although we think the Fed will hike several more times before reaching this cycle’s terminal fed funds rate, the uniformity of the FOMC member comments leads us to expect that it will take a break, perhaps until June. Bottom Line: Our terminal fed funds rate estimate remains considerably higher than the money market’s, but we expect the Fed will pause for a few meetings. A pause may soothe markets and unwind the tightening of financial conditions that occurred in the fourth quarter, clearing the way for the Fed to resume its tightening campaign. Labor-Market Goldilocks The December employment report pointed the way to an outcome that could satisfy financial markets and FOMC doves like Minneapolis president Kashkari. Despite the outsize expansion in nonfarm payrolls, the unemployment rate rose by two ticks because of a surge in labor force participation. Last week, Kashkari attributed his ongoing aversion to rate hikes to the possibility that there’s more slack in the labor market than the committee may realize. “There might be a lot more people out there that we just don’t know [about] that are uncounted. Let’s go figure that out, and if we see inflationary pressures building, we can always hike rates then.” If the participation rate rises at a pace that allows new labor supply to offset continuing demand for workers, expanding payrolls don’t have to exert any generalized upward pressure on wages. Absent upward wage pressure, inflation could easily remain well-behaved. One month doesn’t make a trend, but December’s 63.1% reading brought the part rate back to the top of the range that has been in place for five years (Chart 6). A breakout could point the way to a Goldilocks outcome of inflation-free employment gains, but demographics suggest that there’s a limit to how much the part rate can advance. Chart 6Back To The Top Of The Range The demographic drag on participation is largely a function of the baby boomers’ extended departure from the work force. AARP estimates that at least 10,000 of them turn 65 every day, and will continue to do so into the 2030s. Boomer employment was in its heyday in the late ‘90s, when potential participation exceeded 67% (Chart 7, top panel), and all of the baby boomers were in their prime working years.1 Now that they are exiting the labor force in a lengthy procession, labor force participation is swimming upstream, and it may not be able to do much more than hold the level it’s maintained since 2014. Chart 7How Much More Slack? The shrinking supply of discouraged workers (workers who would start a job tomorrow if they were offered one, but are no longer actively looking for work and are therefore not counted as unemployed), suggests that much of the slack in the labor market has already been consumed (Chart 7, bottom panel). The disability rolls could be a source of Kashkari’s “uncounted” potential workers, however. The share of idled workers receiving disability benefits rose after the crisis (Chart 8), accounting for some of the widening gap between the part rate and the demographically-adjusted part rate. It is possible that some people who weren’t truly disabled will be motivated to come back to work, and their return to the work force may account for some of the pickup in participation, but our best guess is that they represent no more than a marginal source of labor supply. Chart 8Disability Claimants Won't Save The Day Bottom Line: The available evidence suggests that the labor market is quite tight. We expect that upward wage pressures will become increasingly apparent across 2019. Investment Implications An increasingly conciliatory Fed offers additional support for our equity overweight. A Fed pause might relieve some upward pressure on interest rates, but we expect that relief will only be temporary. As financial markets heal, easier financial conditions will clear the way for the Fed to resume its rate-hiking campaign. The sharp decline in Treasury yields at longer maturities only increases our conviction in underweighting Treasuries and maintaining below-benchmark duration positioning in all bond portfolios. As we noted last week, we think the high-yield bond market overreacted last quarter. Against a benign default outlook for 2019, 200 basis points of spread-widening seems extreme. A spread-product upgrade would fit with our equity upgrade, but we will wait until our U.S. Bond Strategy colleagues complete their review of their own recommendation before we consider changing our call. Doug Peta, Senior Vice President U.S. Investment Strategy dougp@bcaresearch.com   Footnotes 1 Workers between the ages of 25 and 54, inclusive, are considered to be in their prime working years. The boomers were born between 1946 and 1964, and they were all in their prime working years from 1989 (when the youngest cohort turned 25) to 2000 (when the oldest cohort turned 54). 2018 was the last year that any of the boomers were between 25 and 54.

  Underweight (High-Conviction) The flattening of both fixed residential investment and existing home sales (bottom panel) have given us cause for concern with respect to home improvement retailers (HIR). While we remain bullish on the domestic housing market, HIR have seen huge valuation gains over the past four years (top panel), which the softer data fail to justify. In the context of lumber prices that have fallen from their parabolic highs (third panel), at least a slowing of top line growth seems inevitable. Our earnings model captures these factors as well as higher mortgage rates, all of which have driven our HIR earnings model into outright deflation (bottom panel). Even if this proves to be overly pessimistic, it should at least drive higher equity risk premiums in the sector, taking some wind out of the inflated valuation. Bottom Line: Valuations in HIR are not supported by softening demand data, revenue headwinds and rising interest rates. We reiterate our high-conviction underweight recommendation. The ticker symbols for the stocks in this index are: BLBG: S5HOMI - HD, LOW.    

Highlights EM equity and credit outperformance versus the U.S. in the past three months was an aberration in the cyclical and structural downtrend. Hence, the recent outperformance of EM assets provides a good entry point for investors to short EM/China assets against their U.S. counterparts. In our opinion, this strategy will work in the coming months regardless of whether global risk assets rebound or sell off – i.e., they are not dependent on market direction. Feature The fourth quarter of 2018 was marked by a precipitous plunge in global equities, led by the U.S. In the meantime, EM stocks have outperformed the global equity benchmark in the past three months. Will EM and U.S. stocks trade places again, or will EM continue to outperform U.S. and DM equities? By the end of December, global share prices had become extremely oversold, and investor sentiment was downbeat. A trifecta of confidence-boosting developments – the rapprochement between the U.S. and China in trade negotiations, the announcement of more policy stimulus in China and reassurances from Federal Reserve Chairman Jerome Powell that monetary policy tightening is not predetermined – have since led to a rebound in global stocks. A key question for asset allocators heading into 2019 is: Will EM continue to outperform the global equity index in this rebound? We do not think so. The odds are considerable that EM will resume its underperformance versus DM in general and the U.S. in particular. The fundamental rationale for staying bearish on EM is that global trade and manufacturing remain on a downward trajectory. Chart I-1 illustrates that EM risk assets sell off when global trade is slowing, especially when the weakness stems from China. Chart I-1EM Selloff Has Been Due To Slowdown In China Chinese policymakers are easing both fiscal and monetary policies, but the impact of their efforts on the economy is yet to be seen. Declining interest rates in China do not constitute a sufficient condition to buy EM risk assets. Importantly, EM stocks often drop when Chinese interest rates are falling, as that reflects a deteriorating growth outlook (Chart I-2). Chart I-2Lower Interest Rates In China Is Not A Reason To Buy EM In short, monetary and fiscal stimulus in China are not yet sufficient to revive the mainland’s business cycle. The latter is critical to the performance of EM risk assets. We will explore China’s fiscal and credit stimulus efforts in much more detail in the coming weeks. Finally, EM equity valuations are no better than those in the U.S. In particular, our EM/U.S. relative stock valuation indicator based on a 20% trimmed mean is currently neutral (Chart I-3). This valuation measure strips out the top and bottom 10% for EM as well as U.S. sub-sectors and computes an equally weighted average of the other 80%. Hence, it eliminates the outliers that for structural or industry specific reasons trade at much lower or higher multiples. Consequently, contrary to the common narrative in the investment industry, EM equities are not cheap versus U.S. ones. Chart I-3EM Equities Are Not Cheaper Than U.S. Ones Given our high conviction on the view that U.S. will outperform EM over the coming several months, we are reiterating a few of our long-standing strategic recommendations/pair trades: Short EM stocks / long the S&P 500; Short EM banks / long U.S. banks; Short EM high-yield corporate credit / long U.S. high-yield corporate credit; Short Chinese property developers / long U.S. homebuilders. In all four cases, the recent outperformance of EM assets provides a good entry point for investors who do not yet have these positions. In our opinion, these recommendations will work in the coming months regardless of whether global risk assets rebound or sell off – i.e., they are not dependent on market direction. No Turnaround In Global Trade/Manufacturing Global cyclical equity sectors have plunged significantly and their prices may be recovering/stabilizing due to oversold conditions. Yet there are few signs of improvement in global trade and manufacturing, and no indication of a significant turnaround in financial markets that are most sensitive to global trade and Chinese growth. Our Risk-On-to-Safe-Haven (RSH) currency ratio1 has relapsed again following a failed rebound attempt (Chart I-4, top panel). Interestingly, this ratio seems to be forming a head-and-shoulders pattern, suggesting the next big move could be to the downside. As we have shown in past reports, EM share prices correlate strongly with this indicator, and a major downleg in this indicator would be consistent with a major drop in EM stocks. Chart I-4No Buy Signal For EM From The Global Currency Markets Furthermore, the annual rate of change on this currency ratio leads the EM manufacturing PMI, and it presently foreshadows more downside in the latter (Chart I-4, bottom panel). Korean and Taiwanese exports contracted slightly in December from a year ago. As frontloading from U.S. import tariffs wanes, their exports will shrink further. Chips prices are falling, signaling that the slump of the global tech hardware sector is not yet over (Chart I-5). Chart I-5Chip Prices Are Still Plunging Continued deterioration in global trade and manufacturing is bad news for emerging Asia. The technical profile of Asian stock markets is also poor, raising the odds of a meltdown as cyclical economic conditions in the region deteriorate further. The region’s relative equity performance versus global and Latin American indexes is relapsing, having failed to break above long-term moving averages (Chart I-6). Chart I-6Underweight Emerging Asian Stocks Versus Both World And Latin America Odds are that emerging Asian stocks will drop in absolute terms, underperforming both the EM and global equity benchmarks. This will drag the EM index down further. We continue to recommend the following strategy: long Latin American stocks / short emerging Asian equities. The U.S. manufacturing leading indicator – the ISM manufacturing new orders-to-inventory ratio – remains in a downtrend (Chart I-7). Chart I-7The U.S. Selloff Has Been Partially Due To Manufacturing Slowdown The average of new and backlog orders from the Chinese manufacturing PMI survey has plunged to its previous lows (Chart I-8, top panel). The domestic orders component of the People’s Bank of China’s latest 5000 industrial enterprise survey is also in a free fall (Chart I-8, bottom panel). Chart I-8China: No Sign Of Bottom In Industrial Sectors Meanwhile, the impact of Chinese domestic demand on the rest of the world occurs via mainland imports. The leading indicator for imports – the manufacturing PMI import sub-component – has plunged to 46, well below the 50 boom-bust line (see Chart I-1, bottom panel on page 1). Within the investable Chinese equity universe, cyclical sectors exposed to capital spending are making new lows in absolute terms (Chart I-9, top and middle panels). At the same time property stocks are relapsing again (Chart I-9, bottom panel). Chart I-9China: Not Much Rebound In Cyclical Equity Sectors While the authorities are once again boosting infrastructure spending by allowing local governments to issue more special bonds, the mainland’s real estate market has ground to a halt. The latter will likely offset the former. Finally, the MSCI China All Shares index – which incorporates all Chinese stocks trading inside and outside the country – has not rebounded much, despite being oversold (Chart I-10, top panel). Chart I-10China All Share Index: Poor Performance Continues Notably, this index’s relative performance versus both DM and EM equity indexes has failed to break above its 200-day moving average, despite the announced policy stimulus (Chart I-10, middle and bottom panels). These are negative technical signposts that bode ill for the outlook for Chinese share prices. Bottom Line: Odds are high that the global trade/manufacturing or related equity sectors/segments will continue struggling in the months ahead. What About The U.S. Dollar? The trade-weighted U.S. dollar has been going sideways for several months. While lower U.S. interest rate expectations have weighed on the greenback, the global manufacturing slowdown and risk-off sentiment in financial markets have put a floor under its value. The dollar is a countercyclical currency, and it does well when global growth is weakening, and vice versa (Chart I-11). Chart I-11The U.S. Dollar Is A Counter-Cyclical Currency It is impossible to know how long this standstill phase in the currency markets will last. What we do know is that when it breaks one way or another, the move will be violent and large. We believe risks to the U.S. currency are to the upside. First, U.S. consumer spending growth remains robust, and the labor market is very tight. Unless the rest of the world plunges into a major growth slump, pulling the U.S. down with it, U.S. interest rate expectations should recover, lifting the dollar. Second, a further downshift in U.S. interest rate expectations will likely occur only if the global economic slowdown is so severe that it leads the market to price in Fed rate cuts. In this scenario, the greenback will rally violently as well. The basis is that the dollar tends to appreciate during global slumps and sell off amid global growth recoveries, as illustrated in Chart I-11. Third, the only scenario where the dollar could plunge is where global trade recovers briskly, driven by growth outside the U.S. in general and in China/EM in particular. This is the least-likely scenario at the current juncture, in our opinion. The trend in the dollar is critical to the relative performance between EM and U.S. stocks. Chart I-12 demonstrates that periods of EM equity underperformance versus the U.S. typically coincide with an appreciation in the trade-weighted greenback, and vice versa. Chart I-12When EM Stocks Outperform The Global Benchmark, U.S. Underperforms And Dollar Weakens And Vice Versa Bottom Line: The next big move in the U.S. dollar will likely be up, not down. Investment Considerations Global equity prices are already reflecting a lot of bad news; they are oversold, and investor sentiment on global growth has become downbeat (Chart I-13). This could create a window for global equities to rebound on a tactical basis. Chart I-13U.S./Global Stocks Are Oversold The majority of our colleagues at BCA believe global equities are primed for a cyclical rally. We within BCA’s EM team agree with the equity rebound narrative but on a tactical basis and believe that any rebound will be led by U.S. stocks – and that EM will lag. We are not convinced that global equities are in a cyclical bull market yet. The main difference between BCA’s house view and the EM team’s outlook is the risks related to China’s economy and their impact on global cyclical equity sectors. The U.S. is relatively unexposed to Chinese growth, EM economies, commodities producers, Japan and Germany. Therefore, U.S. stocks will outperform and the dollar will do well if Chinese growth continues disappointing. Ongoing trade talks between China and the U.S. may bring about some positive results, and the Fed may continue to sound more dovish. However, we contend that the main culprit behind the global equity selloff in 2018 was neither the trade war nor the Fed, but the slowdown in global trade/manufacturing (please refer to Chart 1 and 7 on pages 1 and 6, respectively). On this front, we do not foresee an imminent reversal, as argued above. The latest underperformance of the U.S. has created a good entry point for our relative strategies/trades to be short EM / long U.S. We reiterate the following strategies/trades (Chart I-14): Chart I-14Reiterating Four EM Vs. U.S. Strategies/Trades Short EM stocks / long the S&P 500; Short EM banks / long U.S. banks; Short EM HY corporate credit / long U.S. HY corporate credit; Short Chinese property developers / long U.S. homebuilders. Within the EM equity space, we continue to recommend underweighting emerging Asia while overweighting Latin America, Russia and Central Europe. In particular, we are reiterating our long Latin America / short Emerging Asian equities trade initiated on October 11, 2018 (please refer to Chart I-6 on page 5). The complete list of our country equity allocations is presented on page 12. Finally, the path of least resistance for the dollar is up. We continue to recommend shorting a basket of the following EM currencies against the dollar: ZAR, IDR, MYR, KRW, COP and CLP. Arthur Budaghyan, Senior Vice President Emerging Markets Strategy arthurb@bcaresearch.com Footnotes 1      Average of CAD, AUD, NZD, BRL, CLP & ZAR total return indices relative to average of JPY & CHF total returns (including carry). Equity Recommendations Fixed-Income, Credit And Currency Recommendations