Industrials

Special Report

Highlights China’s infrastructure investment growth rate could rebound moderately from its current nominal 3% pace, but will remain well below the double-digit rate it has registered for most of the past decade.  A lack of funding for local governments and their financing vehicles will somewhat cap the upside in infrastructure fixed-asset investment (FAI) in the next six to nine months. Special bond issuance will be insufficient to ensuring a major recovery in infrastructure spending. Investors should tread cautiously on infrastructure plays in financial markets. Feature Chart I-1Chinese Infrastructure Investment: Double-Digit Growth Again? Nominal infrastructure investment growth in China has slowed from over 15% in 2017 to 3% currently (Chart I-1). This is the weakest growth rate since 2005 excluding the late 2011-early 2012 period. Over the past decade, each time the Chinese economy experienced a considerable slowdown, infrastructure construction was ramped up to revive growth. Infrastructure spending growth skyrocketed in 2009 and was also boosted in 2012. In 2015-2016, it was not allowed to decelerate with the issuance of nearly RMB 2 trillion of special infrastructure bonds. This time the government has also reacted. Since mid-2018, the Chinese authorities have dramatically raised local governments’ special bonds balance limits, prompted local governments to front-load their issuance this year, and also encouraged the private sector to participate in public-private partnership (PPP) infrastructure projects. Will Chinese infrastructure FAI growth accelerate over the next six to nine months from its current nominal 3% pace to double digits? The short answer is no. We believe Chinese infrastructure investment growth could rebound moderately in the next six to nine months, but will still remain below the double-digit growth seen in the past and well below the 18% average growth of the past 15 years. For purposes of this report, the composition of “infrastructure” includes three categories – (1) Transport, Storage and Postal Service, (2) Water Conservancy, Environment & Utility Management, and (3) Electricity, Gas & Water Production and Supply. Chart I-2 presents the breakdown of the nominal infrastructure FAI by category. Funding Constraint Preceding both the 2011-2012 and 2018 infrastructure investment slumps, the Chinese central government increased its scrutiny on local government debt and tightened funding conditions for infrastructure projects. As a result, all three categories of infrastructure spending experienced a sharp deceleration (Chart I-3). Overall, financing and qualitative limitations that Beijing imposes on local government infrastructure spending hold the key to the outlook. We believe Chinese infrastructure investment growth could rebound moderately in the next six to nine months, but will still remain below the double-digit growth seen in the past and well below the 18% average growth of the past 15 years. Looking forward, without a considerable recovery in available financing, there will be no meaningful rebound in Chinese infrastructure investment and construction activity. For now, we are not very optimistic on financing. Chart I-4 shows the breakdown of the major funding sources of Chinese infrastructure investment. All of them are likely to face considerable funding constraints over the next six to nine months. Chart I-3Chinese Infrastructure Investment Growth Has Decelerated Across The Board   1. Self-Raised Funds Self-raised funds contribute nearly 60% of overall infrastructure funding. They include net local government special bond issuance, PPP financing and government-managed funds’ (GMFs) revenues excluding proceeds from special bond issuance. A. Local government special bond issuance, which is exclusively used to fund infrastructure projects, has been the major source of financing for local governments in the past 12 months. The authorities significantly boosted net local government bond issuance to RMB 1.2 trillion in the first six months of this year from only RMB 361 billion in the same period in 2018. However, the amount of special bond issuance in the second half of this year will unlikely be significant enough to boost infrastructure FAI greatly. First, the central government has not only set a limit on the aggregate local government special bond balance, but it also set limits for each of the 31 provinces/provincial-level cities.1 In the past three years, nearly all provinces did not use up their special bond issuance quotas. This resulted in an outstanding aggregate amount of special bonds of only about 85% of the limit.2 In both 2017 and 2018, local governments were left with RMB 1.1 trillion special bond issuance quota unused for that year. Second, based on the limit on outstanding amount special bonds set by the central government for the end of 2019, local governments could issue another RMB 0.8-1 trillion of special bonds in the second half of this year. In comparison, in 2018, the issuance was heavily concentrated in the second half of the year with RMB 1.6 trillion. Our estimate shows there will be only RMB 400-600 billion increase in net total special bond issuance in 2019 versus 2018.3 This will translate into a merely 2-3% growth in Chinese infrastructure investment. Third, net local government special bond issuance made up only 15% of overall infrastructure FAI over the past 12 months. Hence, there is still a huge financing gap to be filled (Chart I-5). B. Public-private partnerships (PPP) are unlikely to meet the financing shortage either. PPPs have become an important financing model for Chinese local governments to fund infrastructure investments since 2014. Nevertheless, to control rising local government debt risks, the central government has tightened regulations on PPP projects since early last year. A series of tightened rules have resulted in a sharp deceleration in both PPP investment and overall infrastructure investment growth. Consequently, PPPs contributions to total infrastructure FAI have plunged from over 30% in 2017 to 10% currently (Chart I-6). Chart I-5Special Bond Issuance Accounted For Only 15% Of Infrastructure FAI Chart I-6Public-Private Partnerships: Too Small To Meet The Financing Shortage   So far, the rules on PPP projects on local governments remain tight. In March, the central government tightened its rule on local government participation in PPP projects. The new rule states that, if a local government has already spent more than 5% of its overall general expenditures on PPP projects excluding sewage and waste disposal PPP projects, it will not be allowed to invest in any new PPP projects. Before March, the threshold was over 10%. In early July, the National Development and Reform Commission (NDRC) demanded all PPP projects undertake a thorough feasibility study. The NDRC emphasized that PPP projects that do not follow standard procedures will not be allowed. Chart I-7Government-Managed Funds: Headwinds From Falling Land Sales C. Government-managed funds (GMF) excluding special bond issuance accounts, which contribute about 15% of overall infrastructure financing, are also facing constraints. According to the country’s Budget Law, the GMF budget refers to the budget for revenues and expenditures of the funds raised for specific developmental objectives. In brief, GMFs constitute de-facto off-balance-sheet government revenues and spending. Land sales by local governments are one major revenue source for GMFs. Contracting property floor space sold is likely to depress real estate developers’ land purchases, further reducing local governments’ revenues from selling land (Chart I-7). This will curb local governments’ ability to finance their infrastructure projects through GMFs. 2. Domestic Loans Domestic loans contribute to about 15% of overall infrastructure financing. Infrastructure projects are generally long term in nature. Presently, the impulse of non-household medium- and long-term (MLT) lending has stabilized but has not yet improved (Chart I-8). While not all of MLT loans are used for infrastructure, sluggish MLT lending reflects commercial banks’ reluctance to finance infrastructure projects. We believe a decelerating economy, mounting local government debt, and often-low returns on infrastructure projects will continue to constrain loan funding of infrastructure projects from both banks and the private sector. 3. General Government Budget The general government budget (which includes central and local governments) accounts for about 15% of overall infrastructure financing. The general budget is also facing headwinds from declining revenue due to recent tax cuts and lower corporate profit growth (Chart I-9). Chart I-8Sluggish Medium/Long-Term Bank Lending Chart I-9Government General Budget: Large Deficit   Bottom Line: Funding constraints will likely linger, making any recovery in Chinese infrastructure investment growth moderate over the next six to nine months. Local government special bonds will not be a game-changer. Their net issuance accounted for only 15% of overall infrastructure FAI over the past 12 months. While local governments could issue another RMB 0.8-1 trillion of special bonds in the second half of 2019, it would be well below the RMB 1.4 trillion of special bond issuance that was rolled out in the second half of 2018. FAI In Transportation: In Nominal Terms… The transportation sector accounts for about 31% of total Chinese infrastructure investment. It includes railway, highway, urban public transit, air and water transport. Table I-1 shows the 13th five-year (2016-2020) transportation investment plan released by the government in February 2017,4 which excludes urban public transit. The authorities planned to invest RMB 15 trillion in the transportation sector over the five-year period between 2016 and 2020, with highways accounting for over half of the investment, followed by railways (23%), air transportation (4.3%) and water transportation (3.3%). The table also shows our calculation of the realized investment amount in these four sub-sectors for the period of January 2016 to June 2019. Local government special bonds will not be a game-changer. Their net issuance accounted for only 15% of overall infrastructure FAI over the past 12 months. Table I-1 suggests the remaining FAI for the transportation sector for the July 2019 to December 2020 period will be considerably smaller than the FAI amount over the past 18 months. This entails a major drag on infrastructure investment at least over the next 18 months. It is important to emphasize that this is conditional on the central planners in Beijing sticking to their five-year plan for infrastructure FAI. As of now, there has been no announcement of revisions to these five-year FAI targets. Bottom Line: China has already completed the overwhelming majority of its planned transportation FAI for 2016-2020. Consequently, without revisions to the targets and budgets by central planners in Beijing, transportation investment will likely contract year-on-year over the next 18 months. …And Real Terms Table I-2 summarizes the 2020 targets for major Chinese infrastructure development (urban rail transit, railway, highway and airport) in real terms. Chart I-10Transportation 2020 Targets: Not Far Away In real terms, the annual growth of transportation infrastructure will likely be 4.2% in both 2019 and 2020. We illustrated in the previous section that the five-year budget plan had been front-loaded, leaving a very small budget for transportation investment over the next 18 months. This may suggest that without considerably exceeding the budget, transportation infrastructure will fail to achieve the 4.2% annual growth in real terms both this year and next. In brief, more funding should be dispatched/allowed by the central planners in Beijing for infrastructure FAI not to shrink. Second, urban rail transit, high-speed railways, highways and airports will reach their respective 2020 targets, while non-high-speed railway construction will likely be a little bit off its 2020 target. Third, based on the 2020 targets, urban rail transit will enjoy very fast growth over the next one and a half years. Fourth, the growth of high-speed railways and highways will be very low, at around 1-2% in real terms (Chart I-10). Finally, while the number of airports will increase at a faster pace, their contribution to overall infrastructure investment will remain insignificant as they only account for about 1.4% of overall infrastructure investment. Bottom Line: In real terms, transport infrastructure growth will likely be only about 4% over the next six to nine months. Future Infrastructure Investment Focus Urban rail transit, environmental management and public utility management will likely be the major driving forces for Chinese infrastructure investment over the next 18 months. Urban rail transit line length will likely register fast growth of around 10% over the next six to nine months. As the central government enforces increasingly stringent rules on environmental protection, investment in environmental management will likely experience continued growth acceleration (Chart I-11). China has already completed the overwhelming majority of its planned transportation FAI for 2016-2020. Consequently, without revisions to the targets and budgets by central planners in Beijing, transportation investment will likely contract year-on-year over the next 18 months. Meanwhile, as the country’s urbanization continues and more townships and city suburbs become urbanized,5 public utility management investment will also grow moderately. Public utility management investment, contributing a massive 45% of overall infrastructure investment, includes sewer systems, sewer treatment facilities, waste treatment and disposal, streetlights, city roads construction, parks, bridges and tunnels in the city. Investment Implications Investors should not hold their breath expecting a major upswing in infrastructure FAI and a major rally in related financial markets. Chinese steel demand is sensitive to construction of railways and urban rail transit lines (Chart I-12, top panel). In turn, mainland cement demand is dependent on highway construction (Chart I-12, bottom panel). Chart I-11Environment Management: Will Continue Booming Chart I-12Chinese Infrastructure Spending Will Moderately Boost Steel & Cement Demand...   Chart I-13...And Steel & Cement Prices At The Margin The infrastructure sector accounts for about 10-15% of total Chinese steel use, and about 30-40% of Chinese cement consumption. Nevertheless, given that we believe Chinese infrastructure spending will only have a moderate recovery, the positive effect on steel and cement prices will be muted as well (Chart I-13). The same holds true for spending on industrial machinery, equipment, chemicals and various materials. Notably, risks to this baseline scenario of a muted recovery are to the downside because of the lack of funding. Barring a substantial increase in the special bond issuance quota this year or a major credit binge, infrastructure FAI growth could in fact stall. Ellen JingYuan He, Associate Vice President ellenj@bcaresearch.com   Footnotes 1  Please note that the central government only set the special bond balance limit (not the quota) for local governments. The often-cited “quota” in the news is derived by calculating the difference between the current limit and the previous year’s limit. The “quota” used in this report is the difference between the current special bond balance limit and the actual special bond balance of the previous year end. 2  At the end of 2018, Chinese special bond balance was RMB 7.4 trillion, only 85.8% of the special bond balance limit of RMB 8.6 trillion. This ratio was 84.6% in 2017 and 85.5% in 2016. On average, the ratio was 85.3% in the past three years. 3  Given that the central government is aiming to somewhat stimulate infrastructure spending by increasing special bond issuance, we assume special bond balance at the end of 2019 to reach 88%-90% of the limit (RMB 10.8 trillion) that it has set for 2019. This will be higher than the 85% average of the past three years. In turn, this means that the special bond balance at the end of this year will likely be RMB 9.5-9.7 trillion. Since the balance at the end of last year was RMB 7.4 trillion, this results that net special bond issuance will be around RMB 2.1-2.3 trillion in 2019. Given the net special bond issuance last year was RMB 1.7 trillion, it follows that there will only be a RMB 400-600 billion increase in total special bond issuance in 2019 versus 2018. 4  Please see www.gov.cn/xinwen/2017-02/28/content_5171576.htm, published February 28, 2017, by the Chinese central government website. 5  Please see Emerging Markets Strategy/China Investment Strategy Special Report “Industrialization-Driven Urbanization In China Is Losing Steam,” dated January 2, 2019, available on ems.bcaresearch.com

Overweight-Downgrade Alert Airline stocks bounced off a critical support level on the back of encouraging profit results (top panel). Lower kerosene prices especially for the non-hedged carriers are flowing straight to the bottom line and a busy travel season signals additional gains in the coming months (jet fuel shown inverted, second panel). Not only domestic, but also international airfares are rebounding smartly and signal more revenue growth for airline stocks despite the grounding of the 737 MAX jet likely into 2020 (third panel). Sell side analysts have taken notice and the industry’s net EPS revisions ratio is on a slingshot recovery. While we continue to avoid rails (see the recent Insight) and remain neutral on airfreight & logistics, airlines are a positive exception within transports.   Bottom Line: Stick with an above benchmark allocation in the S&P airlines index, but stay tuned. The ticker symbols for the stocks in this index are: BLBG: S5AIRL - DAL, LUV, UAL, AAL and ALK.

Underweight Our underweight S&P railroads call has moved into the black as CSX rattled the industry and chopped 2019 revenue growth from positive 1-2% to negative 2%. While UNP’s numbers were better than expected and partially offset CSX’s weakness, transport data does not lie and warns that a sizable slowdown is already underway in rail freight (second panel). In fact, our rail shipments diffusion indicator is sinking like a stone to levels last hit at the depths of the GFC (third panel). Such broad-based weakness in nearly every rail carload category is worrisome and warns that overly optimistic relative profit expectations (not shown) will suffer a setback. Softening demand for rail freight services will likely remain under intense downward pressure as there is little progress made on the U.S./China trade spat front. As a result, industry pricing power will continue to wane and ignite a de-rating phase in rail valuations (bottom panel). Bottom Line: Stay underweight the S&P railroads index. The ticker symbols for the stocks in this index are: BLBG: S5RAIL - UNP, CSX, NSC, KSU.

Internal equity dynamics are sending a powerful signal for the broad equity market. Not only are defensives outshining cyclicals and mega caps trouncing small and micro caps, but also transports are warning that the broad equity market is skating on thin ice (top panel). Importantly, drilling deeper into the highly cyclical trucking industry is instructive. Heavy-duty trucks new orders have plunged (middle panel). While this is likely a consequence of the U.S./China trade war that commenced in the spring of 2018, there are also elements of domestic demand ills that have pushed “class 8 trucks” orders to the lowest point since the late-2015/early-2016 manufacturing recession. In addition, the American Trucking Association’s trucking tonnage index has fallen recently and is contracting at an accelerating pace on a six-month rate of change basis (third panel). Bottom Line: We heed the signal from the highly sensitive transportation sector and remain cautious on the broad equity market.

Highlights The onset of a down-oscillation in growth strongly suggests a rotation out of the growth-sensitive Industrials and Materials into the relatively defensive Healthcare sector. But if the sharpest move in bond yields has already happened, it also suggests that Banks might hold up versus other cyclical sectors. New recommendation 1: Overweight Banks versus Industrials. New recommendation 2: Overweight Eurostoxx50 versus Nikkei225. Remain overweight Eurostoxx50 versus Shanghai Composite and neutral versus the S&P500. Feature Chart of the WeekEuro Stoxx 50 Vs. Nikkei 225 = Global Banks In Euros Vs. Global Industrials In Yen Several decades ago, English football’s top division was a showcase for the top English and British footballers. But not anymore. This year, the top six footballers in the English Premier League hail from Argentina, the Netherlands, Belgium, Senegal, Portugal, plus a token Englishman. Nowadays, if you want to see English or British footballers you have to go to the lower divisions.1  The English Premier League provides a powerful analogy for the FTSE100. Many of the top companies in this blue-chip index have their origins and main businesses outside the U.K. The names say it all: Royal Dutch, Hong Kong and Shanghai Banking Corporation, British American Tobacco, and so on. Just like in football, if you want stock market exposure to the U.K, you now have to go to the lower divisions: the FTSE250 or the FTSE Small Cap. A view on an economy does not necessarily translate into the same view on its mainstream stock market. The leading companies in the FTSE100 are multinationals, whose sales and profits have a minimal exposure to the economic fortunes of the U.K. This leads to a result which causes investors a great deal of cognitive dissonance: a view on an economy does not necessarily translate into the same view on its mainstream stock market. Picking Stock Markets The Right Way Royal Dutch is neither a Dutch company nor a U.K. company, it is a global company. And the same is true for the vast majority of companies in the FTSE100 and all other major indexes such as the Eurostoxx50, Nikkei225, and S&P500. However, Royal Dutch is most definitely an oil and gas company which moves in lockstep with the global energy sector. Hence, by far the most important performance differentiator for any mainstream equity index is the sector fingerprint that distinguishes the equity index from its peers. Each major stock market has a distinguishing ‘long’ sector in which it contains up to a quarter of its total market capitalisation, as well as a distinguishing ‘short’ sector in which it has a significant under-representation. The combination of this long sector and short sector gives each equity index its distinguishing fingerprint (Table 1): FTSE100 = long energy, short technology. Eurostoxx50 = long banks, short technology. Nikkei225 = long industrials, short banks and energy. S&P500 = long technology, short materials. MSCI Emerging Markets = long technology, short healthcare. Another important factor is the currency. Royal Dutch receives its revenues and incurs its costs in multiple major currencies, such as euros and dollars. In other words, Royal Dutch’s global business is currency neutral. But the Royal Dutch stock price is quoted in London in pounds. Hence, if the pound strengthens, the company’s multi-currency profits will decline in pound terms, weighing on the stock price. Conversely, if the pound weakens, it will lift the Royal Dutch stock price. This means that the domestic economy can impact its stock market through the currency channel. Albeit it is a counterintuitive relationship: a strong economy via a strong currency hinders the stock market; a weak economy via a weak currency helps the stock market. Be Careful With Valuation Comparisons Chart of the Week to Chart I-7 should prove beyond doubt that the sector plus currency effect is all that you need to get right to allocate between these four major regions. The charts show all the permutations of relative performances taken from the S&P500, Eurostoxx50, Nikkei225 and FTSE100 over the last decade. Chart I-2FTSE 100 Vs. S&P 500 = Global Energy In Pounds Vs. Global Technology In Dollars Chart I-3FTSE 100 Vs. Nikkei 225 = Global Energy In Pounds Vs. Global Industrials In Yen Chart I-4FTSE 100 Vs. Euro Stoxx 50 = Global Energy In Pounds Vs. Global Banks In Euros Chart I-5Euro Stoxx 50 Vs. S&P 500 = Global Banks In Euros Vs. Global Technology In Dollars Chart I-6Euro Stoxx 600 Vs. MSCI Emerging Markets = Global Healthcare In Euros Vs. Global Technology In Dollars Chart I-7S&P500 Vs. Nikkei225 = Global Tech In Dollars Vs. Global Industrials ##br##In Yen One important implication of sectors and currencies driving stock market allocation is that the head-to-head comparison of stock market valuations is meaningless. Two sectors with vastly different structural growth prospects – say, energy and technology – must necessarily trade on vastly different valuations. So the sector with the lower valuation is not necessarily the better-valued sector. By extension, the stock market with the lower valuation because of its sector fingerprint is not necessarily the better-valued stock market. Likewise, if investors anticipate the pound to ultimately strengthen – because they see that the pound is structurally cheap today – they might downgrade Royal Dutch’s multi-currency profit growth expectations in pound terms and trade the stock at an apparent discount. But allowing for the anticipated decline in other currencies versus the pound there is no discount. It follows that any multinational listed in Europe will give a false impression of cheapness if investors see European currencies as structurally undervalued. Another implication is that simple ‘value’ indexes may not actually offer value. In reality, they comprise a collection of sectors on the lowest head-to-head valuations which, to repeat, does not necessarily make them better-valued. The sector plus currency effect is all that you need to allocate between equity markets. Some people suggest comparing a valuation with its own history, and assessing how many ‘standard deviations’ it is above or below its norm. Unfortunately, the concept of a standard deviation is meaningful only if the underlying series is ‘stationary’ – meaning, it has no step changes through time. But sector valuations are ‘non-stationary’: they do undergo major step changes when they enter a vastly different economic climate. For example, the structural outlook for bank profits undergoes a step change when a credit boom ends. Therefore, comparing a bank valuation after a credit boom with the valuation during the credit boom is like comparing an apple with an orange! The Current Message Last week, we pointed out that current activity indicators are losing momentum, or outright rolling over. The reason being that “both the interest rate impulse and short-term credit impulses are now on the cusp of down-oscillations, which will bear on economies and financial markets in the second half of the year.” This week’s profit warning from BASF supports this analysis. To be clear, this is not a binary issue about recession or no recession. This is just a common or garden down-oscillation in European (and global) growth which tends to happen every 18 months or so with remarkable regularity. Nevertheless, the down-oscillation has a major bearing on sector allocation (Chart I-8) and, therefore, a major bearing on regional equity allocation. Chart I-8Switch Out Of Growth-Sensitives Into Healthcare Based on the major equity index ‘sector fingerprints’ we need to rank the attractiveness of six major global sectors: Materials, Energy, Industrials, Banks, Healthcare, and Technology. In the first half of the year, Industrials outperformed while Banks underperformed. Why? Because Industrials were following the up-oscillation in growth whereas Banks were tracking the bond yield down, as the flattening (or inverting) yield curve ate into their margins. Now, the onset of a down-oscillation in growth strongly suggests a rotation out of the growth-sensitive Industrials and Materials into the relatively defensive Healthcare sector (Chart I-8). But if the sharpest move in bond yields has already happened, it also suggests that Banks might hold up versus other cyclical sectors (Chart I-9 and Chart I-10). Meanwhile, for Energy and Technology we do not hold a high-conviction view. Hence, our ranking of the sectors is as follows: Chart I-9Banks Have Tracked The Bond Yield ##br##Down... Chart I-10...But If The Sharpest Move In Yields Is Over, Banks Can Outperform Other Cyclicals Healthcare Banks Energy and Technology Industrials and Materials On the basis of this ranking, and the major equity index sector fingerprints we are making two new recommendations. Overweight Banks versus Industrials. Overweight Eurostoxx50 versus Nikkei225. For completeness, remain overweight Eurostoxx50 versus Shanghai Composite and neutral versus the S&P500. A New Look To Our Recommendations Finally, from this week onwards we are changing the way we show our investment recommendations. Trades will refer to an investment horizon of 3 months or less, and these will mostly fall within the Fractal Trading System. Cyclical Recommendations will refer to an investment horizon usually between 3 months and a year, and will be sub-divided into asset allocation, equities, and bonds, rates and currencies. Structural Recommendations will refer to an investment horizon longer than a year, and will also be sub-divided into asset allocation, equities, and bonds, rates and currencies. We are changing the way we show our investment recommendations. We have also taken the opportunity to close long-standing stale positions. We hope you find the new look more user-friendly. Next week we will be publishing a jointly written round table discussion in which we debate and explore the interesting view differences within BCA. Absent a major development in the markets, this will replace the normal weekly report. Fractal Trading System* This week we note that the strong rally in the Australian stock market has reached a 65-day fractal dimension which has signalled previous countertrend reversals especially in relative terms. Accordingly, this week’s recommended trade is short ASX 200 vs. FTSE100. The profit target is 2% with a symmetrical stop-loss. In other trades, we are pleased to report that short euro area industrials vs. market achieved its profit target and is now closed. This leaves five open positions. For any investment, excessive trend following and groupthink can reach a natural point of instability, at which point the established trend is highly likely to break down with or without an external catalyst. An early warning sign is the investment’s fractal dimension approaching its natural lower bound. Encouragingly, this trigger has consistently identified countertrend moves of various magnitudes across all asset classes. Chart I-11 The post-June 9, 2016 fractal trading model rules are: When the fractal dimension approaches the lower limit after an investment has been in an established trend it is a potential trigger for a liquidity-triggered trend reversal. Therefore, open a countertrend position. The profit target is a one-third reversal of the preceding 13-week move. Apply a symmetrical stop-loss. Close the position at the profit target or stop-loss. Otherwise close the position after 13 weeks. Use the position size multiple to control risk. The position size will be smaller for more risky positions. * For more details please see the European Investment Strategy Special Report “Fractals, Liquidity & A Trading Model,” dated December 11, 2014, available at eis.bcaresearch.com. Dhaval Joshi, Chief European Investment Strategist dhaval@bcaresearch.com Footnotes 1 The top six players are based on the six nominations for the 2019 PFA Footballer of the Year: Sergio Aguero (Argentina), Virgil Van Dijk (Netherlands), Eden Hazard (Belgium), Sadio Mane (Senegal), Bernardo Silva (Portugal), and Raheem Sterling (England). Virgil Van Dijk was the winner. Fractal Trading System Cyclical Recommendations Structural Recommendations Closed Fractal Trades Trades Closed Trades Asset Performance Currency & Bond Equity Sector Country Equity Indicators Bond Yields Chart II-1Indicators To Watch - Bond Yields Chart II-2Indicators To Watch - Bond Yields Chart II-3Indicators To Watch - Bond Yields Chart II-4Indicators To Watch - Bond Yields   Interest Rate Chart II-5Indicators To Watch - Interest Rate Expectations Chart II-6Indicators To Watch - Interest Rate Expectations Chart II-7Indicators To Watch - Interest Rate Expectations Chart II-8Indicators To Watch - Interest Rate Expectations  

Overweight, High-Conviction We reiterate our high-conviction overweight call on the BCA Defense Index as three key demand drivers remain upbeat and will continue to underpin relative industry profitability. First, the global arms race is alive and well and any governments seeking to augment their defense capabilities have to solicit the U.S. defense manufacturers. U.S. defense spending is rising at a healthy clip representing the major source of revenue growth for the industry (top panel). Second, there is a space race going on with China and India working on manned missions to the moon, but recently President Trump signaled that he would like to beat both of these countries to the moon and in outer space. The defense industry also benefits when global space related demand is on the rise. Finally, cyber security remains a global threat and governments are serious about fighting it off decisively given the sensitivity of the data that cyber criminals are after. While defense stocks are not pure-play software outfits combating cyber criminals, recent industry tuck-in acquisitions include such software companies in order for defense contractors to offer one-stop shop solutions to governments. Bottom Line: The BCA Defense Index remains a secular overweight and a high-conviction overweight. Please see our most recent Weekly Report for more details. The ticker symbols for the stocks in the BCA Defense Index are: LLL, LMT, NOC, GD and RTN.      

Highlights Portfolio Strategy Business sector selling price inflation is sinking like a stone following the bond market’s melting inflation expectations, at a time when wage inflation continues to expand smartly. There are good odds that profit margins have already peaked for the cycle, and we reiterate our cyclically cautious overall equity market view. The souring global macro backdrop, rising policy uncertainty, melting real yields and a stampede into bonds all signal that it still pays to hold global gold miners as a portfolio hedge. Three key defense manufacturers’ demand drivers – global rearmament, a space race and cyber security – remain upbeat and will continue to underpin relative industry profitability. Recent Changes There are no changes to the portfolio this week. Table 1 Feature The SPX fell from all-time highs last week on the eve of the G20 Trump-Xi meeting, the outcome of which will dominate trading this week. The “three hopes” rally, as we have coined it predicated upon a U.S./China trade deal, Chinese massive reflation and a fresh Fed easing cycle, is at risk of disappointment as all the good news is likely already priced into stocks. Stocks may suffer a buy the rumor sell the news setback as they did back in early-December right after the Argentina G20 meeting. Following up from last week’s charts 3-6 that generated higher-than-usual responses from clients, we were encouraged to broaden out these eighteen indicators and try to include some positive ones as it appeared that we may be cherry picking the data.1 Put differently, there must be some economic data series that would offset the grim U.S. macro backdrop we painted and likely aid the Fed in its looming easing cycle. This week we update our corporate pricing power table, highlight a safe haven materials subgroup, and an industrials bulletproof subindex. With regard to the 2018 stock market related fiscal easing boost, neither corporate tax rates would drop further in 2019 nor would buybacks hit the $1tn mark this year. Already, the Standard & Poor’s reported preliminary data that showed buybacks contracted sequentially by 7.7% in Q1/2019 (top panel, Chart 1).2 Retail sales and personal consumption expenditures (PCE) are indeed expanding, however retail sales have decelerated lately (top & second panels, Chart 2). In contrast, consumer sentiment and consumer confidence are contracting on a year-over-year (yoy) basis and the U.S. leading economic indicator is steeply decelerating near 2%/annum from almost 7% at the beginning of the year (middle, fourth & bottom panels, Chart 2). Chart 1Buybacks Are Decelerating Chart 2Retail Sales And PCE Are Expanding   The mortgage application purchase index is gaining momentum courtesy of the 125bps drop in interest rates over the past eight months. But, equity market internals suggest that some of these applications may not convert into home sales: relative homebuilders share price momentum is contracting (Chart 3). As a reminder we recently monetized relative gains of 10% in the S&P homebuilding index, since inception.3  Sticking with housing, new median single family home prices remain 10% below their 2017 zenith, and the Case-Shiller 20-city index growth rate hit the zero line recently on a month-over-month basis. New home sales are in contraction territory (Chart 4). Chart 3Are Cracks Forming… Chart 4…In The Housing Market?   On the labor front, while the unemployment rate and unemployment insurance claims are both at generationally low levels, it will be extremely difficult for either of these labor market series to fall significantly from current levels. In contrast, there are rising odds that the deteriorating credit quality backdrop will soon infect the labor market (top & second panels, Chart 5). Already, “jobs are hard to get” confirming that the unemployment rate cannot fall much further from current levels (middle panel, Chart 5). Not only is credit quality deteriorating at the margin, but also loan growth is decelerating with our credit impulse diffusion indicator falling below the boom/bust line (fourth & bottom panels, Chart 5). U.S. manufacturing, the most cyclical part of the U.S. economy, is under intense pressure. The U.S./China trade tussle is the culprit. Industrial production and capacity utilization petered out last year in September and November, respectively (top & second panels, Chart 6). Chart 5Could The Labor Market Sour Next? Chart 6Manufacturing Has No…   Chart 7…Pulse Durable goods orders are not showing any signs of a turnaround with overall orders flirting with the zero line and core orders contracting (third panel, Chart 6). Total business sales-to-inventories are stuck in the contraction zone (bottom panel, Chart 6). Manufacturing survey data series are all in a synchronous meltdown. Seven regional Fed manufacturing surveys are all sinking (Chart 7). Such broad-based weakness bodes ill for the upcoming ISM manufacturing survey print (we went to print on Friday after the market close, and as a reminder we observed Canada Day yesterday).   The ISM manufacturing new orders-to-inventories ratio sits right at one, warning that more profit trouble looms for the SPX (bottom panel, Chart 1). Keep in mind that typically the ISM manufacturing survey pulls down the ISM services one, as the former represents the most cyclical parts of the U.S. economy. Both are currently contracting on a yoy basis (Chart 8). Adding it all up, the negative economic data clearly dominate and only a handful of data series remain standing. The final tally on these indicators is fifteen negative and five positive (Chart 9). We are still awaiting a turn in the majority of the data to confirm the economy is on a solid footing. Chart 8ISM Services Survey Is Contracting Chart 10Heed The Message From The GS Current Activity Indicator Goldman Sachs’ Current Activity Indicator (GSCAI, a first principal component of 37 weekly and monthly data series) does an excellent job in capturing all these forces. Currently, the GSCAI is steeply decelerating, warning that SPX profit growth will surprise to the downside in coming quarters (top panel, Chart 10).  Thus, we reiterate that a cyclically (3-12 month horizon) cautious equity market stance is still warranted. This is U.S. Equity Strategy’s view, which stands in contrast to the sanguine equity BCA House View. This week we update our corporate pricing power table, highlight a safe haven materials subgroup, and an industrials bulletproof subindex. Corporate Pricing Power Update U.S. Equity Strategy’s corporate sector pricing power proxy has sunk further since our last update three months ago, and is now deflating 1.1%/annum. Chart 11 shows that the last time the business sector was mired in deflation was during the 2015/16 manufacturing recession. Chart 11Profit Margin Trouble To Persist However, the big difference between now and 2015/16 is that wages are currently expanding at a healthy clip, warning that the corporate sector margin squeeze will not abate any time soon. Granted, unit labor costs are indeed contracting on the back of a surge in productivity, and may thus provide a partial offset. SPX margins have been contracting for two consecutive quarters and sell-side analysts forecast that they will contract for another two. Our margin proxy corroborates this grim sell-side profit margin expectation, and similar to the 2015/2016 episode is firing a margin squeeze warning shot (bottom panel, Chart 11). Digging beneath the surface, our corporate pricing power proxy is revealing. As a reminder, we calculate industry group pricing power from the relevant CPI, PPI, PCE and commodity growth rates for each of the 60 industry groups we track. Table 2 also highlights shorter term pricing power trends and each industry's spread to overall inflation. Two thirds of the industries we cover are lifting selling prices, but only a quarter are raising prices at a faster clip than overall inflation. On a selling price inflation trend basis, 81% of the industries we cover are either flat or in a downtrend (Table 2). Table 2Industry Group Pricing Power There is only one commodity-related industry in the top ten, a sea change from our late-March update when the commodity complex dominated the top ranks occupying six spots (Table 2). Interestingly, industrials have a healthy showing in the top sixteen spots with five entries. On the flip side, energy-related industries continue to populate the bottom of the ranks as WTI crude oil is still deflating from the October 2018 peak. In sum, business sector selling price inflation is sinking like a stone following the bond market’s melting inflation expectations, at a time when wage inflation continues to expand smartly. There are good odds that profit margins have already peaked for the cycle, and we reiterate our cyclically cautious overall equity market view. In sum, business sector selling price inflation is sinking like a stone following the bond market’s melting inflation expectations, at a time when wage inflation continues to expand smartly. There are good odds that profit margins have already peaked for the cycle, and we reiterate our cyclically cautious overall equity market view. Glittering Gold On March 4th, 2019 we reiterated our view that it still made sense to hold an above benchmark allocation to gold equities as a portfolio hedge.4 While our overweight position is in the red since inception, it has recouped 15% versus the broad market since our early-March update, and more gains are in store in the coming months. When global growth is in retreat investors bid up the price of the safe-haven shiny metal which in turn pulls global gold miners higher. The opposite is also true. Chart 12 shows this inverse relationship gold mining equities have with global growth. In more detail, relative share prices move inversely with the global manufacturing PMI (PMI shown inverted, Chart 12). Chart 12Gold Miners Benefit From… Currently, economists, tracked by Bloomberg, have been aggressively decreasing their estimates for 2019 global real GDP growth, down 50bps year-to-date to 3.3% (bottom panel, Chart 13). Similarly, the global ZEW economic sentiment survey has collapsed to levels last hit during the great recession (top panel, Chart 14). Chart 13…Global Growth… Chart 14…Slowdown   Tack on the sustained increase in global policy uncertainty with trade wars, Iranian sanctions, Brexit and Italian politics to name a few, and global gold miners are in the pole position (top panel, Chart 13). As a result, global equity risk premia have come out of hibernation and signal that the gold mining rally has more legs (middle panel, Chart 14). This souring global macro backdrop has dealt a blow to global real yields that are melting. Given that gold equities sport a low dividend yield, they are primary beneficiaries of this disinflationary global economic backdrop (real yield shown inverted, middle panel, Chart 13). Chart 15Negative Yielding Bonds Boost Global Gold Miners Meanwhile, investors have been piling into global bonds and currently negative yielding bonds have surpassed the $13tn mark. Such a stampede into negative yielding bonds has been a boon to global gold mining stocks (Chart 15). This investor risk aversion is also evident in the total return stock-to-bond (S/B) ratio: bonds have been outperforming equities since late-September 2018. Since the early 1990s, relative share prices have been moving in the opposite direction of the S/B ratio, and the current message is to expect more gains in the former (S/B ratio shown inverted, Chart 16). Chart 16When Bonds Outperform Stocks, Buy Gold Miners Chart 17A Tad Overbought, But Still Cheap Meanwhile, the Fed is about to embark on an easing cycle courtesy of a softening economic backdrop and any insurance interest rate cuts will likely put a further dent in the dollar. The upshot is that gold is priced in U.S. dollars similar to the broad commodity complex and tends to rise in price when the greenback depreciates and vice versa. A lower trade-weighted dollar will also boost relative share prices (U.S. dollar shown inverted, bottom panel, Chart 14). Finally, while relative share prices are slightly overbought, relative valuations remain in the neutral zone (Chart 17). In sum, the souring global macro backdrop, rising policy uncertainty, melting real yields and a stampede into bonds all signal that it still pays to hold global gold miners as a portfolio hedge. Bottom Line: We remain overweight the global gold mining index. The ticker symbol for the global gold mining exchange traded fund is: GDX: US. Defense Delivers Recent M&A news in the aerospace & defense sector with UTX bidding for RTN was initially cheered by investors, but President Trump signaled that such a deal would decrease competition in the sector and U.S. regulators would block it. Irrespective of the outcome of this deal, we remain overweight the pure-play BCA Defense Index on a structural basis and also reiterate its high-conviction overweight status. Three key pillars will sustain the upbeat sales and profit backdrop for defense stocks. In sum, the souring global macro backdrop, rising policy uncertainty, melting real yields and a stampede into bonds all signal that it still pays to hold global gold miners as a portfolio hedge. First, the global arms race is alive and well and any governments seeking to augment their defense capabilities have to solicit the U.S. defense manufacturers. U.S. defense spending is rising at a healthy clip representing the major source of revenue growth for the industry (Chart 18). Defense capital goods orders have taken off and backlogs are at the highest level since 2012. The industry’s shipments-to-inventories ratio is also probing decade highs and weapons exports are near all-time highs (Chart 19). Chart 18Defense Spending Remains Upbeat Chart 19Healthy Operating Metrics   Second, there is a space race going on with China and India working on manned missions to the moon, but recently President Trump signaled that he would like to beat both of these countries to the moon and in outer space. The defense industry also benefits when global space related demand is on the rise. Finally, cyber security remains a global threat and governments are serious about fighting it off decisively given the sensitivity of the data that cyber criminals are after. While defense stocks are not pure-play software outfits combating cyber criminals, recent industry tuck in acquisitions include such software companies in order for defense contractors to offer one-stop shop solutions to governments. Netting it all up, three key defense manufacturers’ demand drivers – global rearmament, a space race and cyber security – remain upbeat and will continue to underpin relative industry profitability. With regard to the financial health of the sector, balance sheets are pristine with net debt-to-EBITDA registering below the broad non-financial equity market and below 2x. Interest coverage is sky high at over 10x, again trumping the broad market. On the return on equity (ROE) front, defense stocks have the upper hand trading at an all-time high ROE of 39% or more than twice the broad market ROE (Chart 20). Looking at the valuation backdrop, relative valuations have corrected recently and defense equities no longer command a premium versus the overall market on both an EV/EBITDA and P/E basis (second & bottom panels, Chart 21). Chart 20Excellent Financial Standing Chart 21Valuations Have Corrected   Netting it all up, three key defense manufacturers’ demand drivers – global rearmament, a space race and cyber security – remain upbeat and will continue to underpin relative industry profitability. Bottom Line: The BCA Defense Index remains a secular overweight and a high-conviction overweight. The ticker symbols for the stocks in the BCA Defense Index are: LLL, LMT, NOC, GD and RTN. Anastasios Avgeriou, U.S. Equity Strategist anastasios@bcaresearch.com          Footnotes 1      Please see BCA U.S. Equity Strategy Weekly Report, “Cracks Forming” dated June 24, 2019, available at uses.bcaresearch.com. 2      https://us.spindices.com/documents/index-news-and-announcements/2019062… 3      Please see BCA U.S. Equity Strategy Insight Report, “Locking In Homebuilder Gains” dated May 22, 2019, available at uses.bcaresearch.com. 4      Please see BCA U.S. Equity Strategy Report, “The Good, The Bad And The Ugly,” dated March 4, 2019, available at uses.bcaresearch.com. Current Recommendations Current Trades Size And Style Views Favor value over growth Favor large over small caps