Sectors

Feature GAA DM Equity Country Allocation Model Update The GAA DM Equity Country Allocation model is updated as of March 29, 2019. The quant model has not made changes in the direction of underweights and overweights compared to last month. However, the magnitude of the U.S underweight was reduced, so was that of the overweights in Spain and Germany, as shown in Table 1. Table 1Model Allocation Vs. Benchmark Weights As shown in Table 2 and Charts 1 - 3, the overall model underperformed the MSCI world benchmark by 44 bps in March, with a 45 bps of underperformance from the Level 2 model and a 20 bps of underperformance from Level 1. What has contributed to such an underperformance? As shown in Chart 4, directionally, 7 out of the 12 country allocations generated positive alpha, however, the negative value added from the overweights in Germany and Spain overwhelmed all the positives. This shows again that quant models with a “systematic” approach cannot fully capture “atypical” conditions in the market place. This is one of the reasons that we use (and also have suggested our clients to use) our quant models as a starting point in the decision-making process, but to use them together with human judgement. Table 2Performance (Total Returns In USD %) Chart 1GAA DM Model Vs. MSCI World   Chart 2GAA U.S. Vs. Non U.S. Model (Level 1)     Chart 3GAA Non U.S. Model (Level 2) Please see also the website http://gaa.bcaresearch.com/trades/allocation_performance. For more details on the models, please see Special Report, “Global Equity Allocation: Introducing The Developed Markets Country Allocation Model,” dated January 29, 2016, available at https://gaa.bcaresearch.com. Please note that the overall country and sector recommendations published in our Monthly Portfolio Update and Quarterly Portfolio Outlook use the results of these quantitative models as one input, but do not stick slavishly to them. We believe that models are a useful check, but structural changes and unquantifiable factors need to be considered too in making overall recommendations.   GAA Equity Sector Selection Model The GAA Equity Sector Model (Chart 5) is updated as of March 29, 2019. Chart 5Overall Model Performance Table 3Model’s Performance (March 1, 2019 - Current) Table 4Current Model Allocations   Following the changes implemented and the model relaunch last month, the model continues to maintain a slightly cyclical stance by overweighting Industrials and Materials. The relative tilts within cyclicals and defensives remains the same as the previous month. Global growth concerns still prevent the model from being outright bullish on cyclicals. The valuation component remains muted across all sectors. The model is still overweight Utilities due to positive inputs from its momentum and liquidity components. For more details on the model, please see the Special Report “Introducing the GAA Equity Sector Selection Model,” dated July 27, 2016, as well as the Sector Selection Model section in the Special Alert “GAA Quant Model Updates,” dated March 1, 2019 available at https://gaa.bcaresearch.com.   Xiaoli Tang, Associate Vice President xiaoliT@bcaresearch.com Amr Hanafy, Research Associate amrh@bcaresearch.com  

Highlights U.S. growth remains robust, despite some temporary softness in recent months. Ex U.S., growth continues to fall but, with China probably now ramping up monetary stimulus, should bottom in the second half. Central banks everywhere have turned more dovish, partly in an attempt to push up inflation expectations. The combination of resilient growth and easier monetary policy should be good for global equities. We remain overweight equities versus bonds. Bond yields have fallen sharply everywhere. However, with U.S. inflation still trending up, and central banks unlikely to turn any more dovish this year, yields are unlikely to fall much further in 2019. We recommend a slight underweight on duration. We remain overweight U.S. equities, but are on watch to upgrade the euro zone and Emerging Markets when we have stronger conviction about China’s stimulus. Given structural headwinds in both Europe and EM, this would probably be only a tactical upgrade. We have been tilting our equity sector recommendations in a more cyclical direction, last month raising Industrials and Energy to overweight. We also prefer credit over government bonds within the fixed-income category, though we warn that spreads will not fall much further given weak corporate fundamentals. Feature Recommended Allocation Overview Don’t Fight The Doves The performance of risk assets essentially comes down to a battle between growth and monetary policy/interest rates. Last September, despite the fact that global economic growth was clearly slowing, the Fed sounded hawkish; this triggered an 18% drop in global equities in Q4. But, since late last year, all major developed central banks have turned more dovish, culminating in March’s decision of the ECB to push back its guidance for its first rate hike, and the FOMC’s wiping out its two planned hikes for 2019. But, at the same time, U.S. economic growth is showing resilience, and we see the first “green shoots” of a cyclical pickup in growth outside the U.S. This is an environment in which risk assets should continue to perform well. Why did the Fed back off? The most likely explanation is that it wants to give itself more room to act come the next recession. Inflation expectations have become unanchored, with 10-year breakevens over the past decade steadily below a level that would be consistent with the Fed achieving its 2% core PCE inflation target in the long run. In the period since the Fed formally introduced this (supposedly “symmetrical”) target in 2012, it has exceeded it in only four months (Chart 1). Around recessions over the past 50 years, the Fed has on average cut rates by 655 basis points (Table 1). It sees little risk, therefore, in letting the economy “run a little hot” and allowing inflation to rise somewhat above 2%. This would reanchor expectations, and eventually get nominal short- and long-term rates higher before the next recession. Chart 1Market Doesn’t Believe The Fed’s Target Table 1Fed Won’t Be Able To Cut This Much Next Time   Chart 2Financial Conditions Now Much Easier Chart 3Housing Market Bottoming Out Meanwhile, U.S. growth seems to be stabilizing at a decent level after signs of weakness late last year caused by tighter financial conditions, a slowdown elsewhere in the world, and the six-week government shutdown. An easing of financial conditions since the beginning of the year should help to keep U.S. GDP growth above trend at around 2.0-2.5% this year (Chart 2). Most notably, interest-rate sensitive areas of the economy that were under pressure last year, especially housing, are showing signs of bottoming (Chart 3). Consumption also should be robust, given strong wage growth, consumer confidence close to historic record high levels, and amid no signs of a deterioration in the labor market (Chart 4). Chart 4No Signs Of Weaker Labor Market Chart 5Some 'Green Shoots' For Global Growth   A key question for us over the next few months will be when to shift allocations to more cyclical, higher-beta equity markets such as the euro area and Emerging Markets. These have underperformed year-to-date despite the strong risk-on market. China’s nascent reflationary stimulus will decide the timing and level of conviction of this shift. As we explain in detail on page 6, we think the jury is still out on whether China is injecting liquidity on anything like the same scale as it did in 2016. Even if it is, historically it has taken six to 12 months before the effect showed through via a rebound in global trade, commodity prices, and other China-related indicators. The first early signs of a bottoming are emerging: Chinese fixed-asset investment and the Caixin Manufacturing PMI beat expectations last month, the German ZEW Expectations indicator has started to recover, and the diffusion index of the Global Leading Economic Indicator (which often leads the LEI itself by a few months) has picked up (Chart 5). We are on watch to shift our allocation1 but, given the long-term structural headwinds against both Europe and EM, we need to be more convinced about the strength of Chinese stimulus before doing so. The seeds of recession are sown in expansions. Eventually, we see the newly dovish Fed falling behind the curve. The Fed Funds Rate is still below the range of estimates of the neutral rate – hard though this is to estimate in real time (Chart 6). If the economy remains as strong as we expect, sometime next year inflation could begin rising to uncomfortable levels (and asset bubbles start to be of concern), which would push the Fed back into hiking mode. Given that the market is pricing in Fed rate cuts, not hikes, and that the Fed can hardly sound any more dovish than it does now without moving to an outright easing path, it seems to us that long-term rates are very unlikely to fall from here (Chart 7). Chart 6Fed Still Below Neutral Chart 7Can The Fed Get Any More Dovish Than This? In this environment, therefore, we continue to expect global equities to outperform bonds over the next 12 months. However, a recession is possible in 2021 triggered by the Fed late next year needing to put its foot abruptly on the brake.   What Our Clients Are Asking Chart 8Ex-U.S. Equities Driven By China Stimulus When Is The Time To Switch Allocations To Europe And EM? It is slightly surprising that the 12% rally in global equities this year has been led by the low-beta U.S., up 13%, rather than Europe (up 9%) or emerging markets (up 9% - and much less if the strong Chinese market is excluded). Is it time to switch to these underperforming, more cyclical markets? Our answer is, not yet. Global growth ex-U.S. continues to weaken. It is likely to bottom sometime in the second half, as a result of Chinese growth stabilizing. However, the jury is still out on whether the increase in Chinese credit creation in January was a one-off, or major policy reversal. Even if it is the latter, a revival in global growth (and cyclical markets) has typically lagged Chinese stimulus by 6-12 months (Chart 8, panel 1). There are also significant structural headwinds for both the euro zone and Emerging Markets which make us reluctant to overweight them unless there are clear cyclical reasons to do so. Both have lagged global equities fairly consistently since the Global Financial Crisis, with only brief outperformance during periods of economic acceleration, such as in 2016 and 2012 (panel 2). The euro zone remains challenged by its banking system. Loan growth has been stagnant for years, and banks remain undercapitalized relative to their U.S. peers, and highly fragmented (panels 3 and 4). Emerging markets are hampered by their high level of foreign-currency debt (which makes them highly sensitive to U.S. financial conditions), dependence on China, and lack of structural reform. We could see ourselves shifting our recommendation from the U.S. to the euro area and EM, and becoming outright bearish on the U.S. dollar (a counter-cyclical currency), over the coming months if we find confirmation of a bottoming of global cyclical growth and become more confident in the size of China’s stimulus. But given the structural headwinds, and the steady underperformance of these markets, we need stronger evidence first.   Chart 9Oil, Positioning, And Housing Why Is The 10-Year Bond Yield So Depressed? Despite U.S. equities rallying back to within 4% of a record high, the U.S. Treasury bond yield has fallen further this year (Chart 9, panel 1). Moreover, the 3-month/10-year yield curve has briefly inverted. Besides the Fed’s recent more dovish turn, what has depressed bond yields? We would pin the cause on the following factors: Dampened inflation expectations: Over the past few years the 10-year yield has been closely correlated with the oil price via inflation expectations. A temporary supply shock in Q4 caused oil prices to decline sharply. But tighter supply this year should allow the oil price to recover further. This should cause a rise in inflation expectation (panel 2). Trade positioning: Late last year,  speculative short positions in government bonds were at their highest levels since 2015. However, the Q4 equity selloff pushed investors to cover their positions; these are now close to neutral (panel 3). Home Sales: Housing data has been weak over the past few quarters, with both existing and new home sales declining. But there are now signs of recovery: mortgage applications have started to pick up, which should in turn push home sales higher (panel 4). This should also allow for a rise in bond yields. Our key take-away from March’s FOMC meeting, when the tone turned decidedly dovish, is that the Fed is focusing on re-anchoring inflation expectations, which should push nominal yields higher. We think the market is very pessimistic by pricing in 42 and 56 bps of rate cuts over the next 12 and 24 months respectively. It would take a significant further weakening of economic data to make the Fed’s stance turn even more dovish and for nominal yields to fall even further.   How Will U.S. Corporate Bonds Perform In The Next Recession? Historically high levels of U.S. corporate debt, as well as declining credit quality in the investment-grade space, have started to worry investors (Chart 10). Specifically, investors are worried that, when the next default cycle comes, a large portion of investment-grade debt will be downgraded to junk, forcing fund managers who are constrained to hold certain credit qualities to sell. These worries seem to be justified. Investment-grade bonds of lower credit quality tend to experience large increases in migration to junk status during credit recessions (Chart 11). Given the current composition of the U.S. investment-grade corporate bond universe, a credit recession would imply a downgrade to junk status of 4.6% of the index if we assume similar behavior to previous recessions. Depending on the speed of the selloff, such a downgrade could also have grave consequence for liquidity. According to the Securities Industry and Financial Markets Association (SIFMA), average daily turnover in the U.S. corporate bond market was 0.34% in 2018. Thus, it is not hard to envision a situation where forced selling could surpass normal levels of liquidity. However, it is hard to tell what would be the effect of such a fire-sale on credit spreads, given that they tend to widen in recessions regardless. While this asset class could perform poorly in the next recession, we don’t expect that its weakness will translate to the real economy. Leveraged institutions such as banks hold just 18% of corporate credit. Furthermore, despite being at all-time highs, U.S. nonfinancial corporate debt to GDP is still at a much healthier level than in other countries (Chart 12). Chart 10Declining Quality In Investment Grade Chart 12U.S. Corporate Debt Levels Are Healthy Relative To The Rest Of The World   Chart 13A Value Rebound?   Is It Time To Favor Value Over Growth Again? Since it peaked in May 2007, the ratio of global value to growth has attempted to rebound several times amid a sustained downtrend (Chart 13). Due to the cyclical nature and the neutral relative valuation of the value/growth indexes, we have preferred to use sector positioning (cyclicals vs. defensives) to implement a value/growth style tilt in our global portfolio since March 20162 (Chart 13, panel 1). Lately, we have received many requests on the topic of the value-versus-growth-ratio. After reaching a historical low in August 2018, the  value/growth ratio slightly rebounded in Q4 2018 before reversing some of its gains so far this year. Additionally, the value/growth valuation gap as measured by both price-to-book and forward P/E has reached a historically low level (Chart 13, panel 4). As we have often noted, the sector composition of both the value and growth indexes changes over time.2 Chart 14 shows the current sector weights of S&P Pure Value and Pure Growth Indexes.3 It’s clear that now a bet on Pure Value versus Pure Growth is essentially a bet on Financials (which account for 35% of the Pure Value index) versus Tech and Healthcare (which together account for 38% of the Pure Growth index) - see also Chart 13, panel 2. Given the cyclical nature of the value/growth ratio and also the sector concentration, it’s not surprising that the value/growth play is also a play on euro area versus U.S. equities (Chart 13, panel 3). Currently, we are neutral on Financials and Tech, while overweight Healthcare in our global sector portfolio, and we are putting the euro area on an upgrade watch (see page 14). Therefore, maintaining a neutral stance between value and growth is in line with our sector and country views. However, a close watch for a possible upgrade of value is also warranted given the extreme valuation measures.   Global Economy Overview: U.S. growth has slowed recently, though it remains more robust than in the more cyclical economies in Europe and emerging markets. Central banks almost everywhere have recently turned dovish. However, China’s increased monetary stimulus should help global growth bottom out in H2. This could lead the Fed and central banks in other healthy economies to return to a rate-hiking path. U.S.: The U.S. economy has been weak in recent months. The Citigroup Economic Surprise Index (Chart 15, panel 1) has collapsed, and the Fed NowCasts point to only 1.3-1.7% QoQ annualized GDP growth in Q1 (compared to 2.2% in Q4). But the slowdown is mostly due to the six-week government shutdown (which probably took 1% off growth), some seasonal adjustment oddities (which leave Q1 as the weakest quarter almost every year), and tighter financial conditions in H2 2018 which have now largely reversed. The manufacturing and non-manufacturing ISMs in February were  still healthy at 54.2 and 59.7 respectively. Consumption (propelled by strong employment growth and accelerating wages) and capex remain strong (panel 3). BCA expects GDP growth in 2019 to be around 2.0-2.5%, still above trend. Euro Area: The European economy continues to slow, driven by weak exports to emerging markets, troubles in the banking sector, and political uncertainty. Q4 GDP growth was only 0.8% QoQ annualized, and the manufacturing PMI has fallen to 47.6 (with Germany as low as 44.7). But there are some early signs of an improvement. The ZEW Expectations index for Germany has bottomed (Chart 16, panel 1), fiscal policy should boost euro area growth this year by around 0.5 percentage points, and wage growth has begun to accelerate. The key remains Chinese stimulus, whose positive effects should help European exports recover sometime in H2. Chart 15U.S. Growth Slowing But Still Robust Chart 16Signs Of Bottoming In Global Ex-U.S.? Japan: Japan also remains highly dependent on a Chinese stimulus. Machine tool orders (the best indicator of capex demand from China) fell by 29% YoY in February. Despite stronger wage growth, now 1.2% YoY, inflation shows no signs of moving up towards the Bank of Japan’s target of 2%: ex energy and food CPI inflation is still only 0.4%. The biggest risk in 2019 is October’s planned consumption tax hike from 8% to 10%. Prime Minister Abe has said that he will cancel this only in the event of a shock on the scale of Lehman Brothers’ bankruptcy. The government has put in place measures to soften the impact (most notably a 5% rebate on purchases at small retailers after October 1 paid for electronically), but consumption is still likely to fall significantly. Emerging Markets: China seems to have ramped up its monetary stimulus, with total social financing in January and February combined up 12% over the same months last year. Recent data have shown signs of a stabilization of growth: the manufacturing PMI rebounded to 49.9 in February from 48.3, and fixed-asset investment beat expectations at 6.1% YoY in January and February combined. Nonetheless, the size of liquidity injection is likely to be smaller than in previous episodes such as 2016, since Premier Li Keqiang and the PBOC have warned of the risk of excessive speculation. Elsewhere, some emerging economies (notably Brazil and Mexico) have showed signs of recovery after last year’s deterioration, whereas others (such as South Africa, Indonesia, and Poland) continue to suffer. Interest rates: Central banks worldwide have generally turned more dovish in recent months, with the Fed and ECB both moving to signal no rate hikes this year. This has pushed down long-term rates globally, with 10-year bond yields falling below 0% again in Germany and Japan. However, with global growth likely to bottom over the next few months, rates may not stay at current depressed levels. U.S. inflation, in particular, continues to trend up, and the Fed’s target PCE inflation measure is likely to exceed 2% over coming months. We see the Fed turning more hawkish by year-end, and long rates globally more likely to rise than fall from current levels.   Global Equities Chart 17Watch Earnings Remain Cautiously Optimistic: We added risk in our January Portfolio Update4 by putting cash back to work in global equities, and then in the March Portfolio Update5 we reduced the underweight in EM equities and increased the tilt to cyclicals at the expense of defensives, to hedge against a continuing acceleration in Chinese credit growth. All these came after our risk reduction in July 2018.6 GAA’s portfolio approach has always been to take risks where they are most likely to be rewarded. BCA’s macro view is that global economic growth data is likely to be on the weak side in the coming months, but will pick up in the second half. This implies that equities are likely to rally again after a period of congestion within a trading range, supporting a cautiously optimistic portfolio allocation for the next 9-12 months. At the asset-class level, our positioning of overweight equities versus bonds while neutral on cash, reflects the “optimistic” side of our allocation. However, the rebound in global equities since the December sell-off has been driven completely by a valuation re-rating, while earnings growth has been revised down sharply. (Chart 17). As such, within global equities, our preference for low-beta countries (favoring DM versus EM, and favoring the U.S over the rest of DM) reflects the “cautious” aspect of our allocation. Our macro view hinges largely on what happens to China. There are signs that China may have abandoned its focus on deleveraging, yet it is too early to tell if it has switched back to a reflationary path. Therefore, our global equity sector overlay has a slight cyclical tilt by overweighting Industrials and Energy, which are among the main beneficiaries of Chinese reflationary policies or a positive resolution to U.S.-China trade negotiations. Chart 18Warming Up To The Euro Area Euro Area Equities: On Upgrade Watch We have favored U.S. equities relative to the euro area since July 2018.7 Since then, the U.S. has outperformed the euro area by 11% in USD terms and by 8% in local currency terms, with the difference being attributed to the weakness of the euro versus the U.S. dollar. Given BCA’s view on the global economy and the U.S. dollar, however, we are watching closely to switch our recommendation between the U.S. and euro area equities, for the following reasons: First, as shown in Chart 18, panel 1, the relative performance between the euro area and the U.S. is highly correlated with the EUR/USD exchange rate. BCA believes that the U.S. dollar is set for a period of weakness starting in the second half of the year,8 which bodes well for the outperformance of euro area equities. Second, relative earnings growth between the euro area and the U.S. is driven by the underlying strength of the economies, as represented by PMIs (panel 2). Both the relative earnings growth and relative PMI have stopped falling and have begun to bottom in favor of the euro area; Third, even though the euro area’s beta has been declining while that of the U.S. has increased, euro area beta is still higher than that in the U.S., making it more of a beneficiary of a global growth recovery; However, the relative valuation of euro area equities to their U.S. counterparts is now  neutral not at the extreme level which historically has been a good entry-point into eurozone  equities (panel 4).   Chart 19Becoming Less Defensive Global Sector Allocation: Gradually Becoming Less Defensive GAA’s sector portfolio took profits on its pro-cyclical positioning and went defensive in July 20189 and remained so until the March Monthly update10 when we upgraded Energy and Industrials to overweight from neutral, while downgrading Consumer Staples two notches to underweight from overweight (Chart 19). The upgrade of Industrials was mainly a hedge against further acceleration in China’s credit growth. But why did we upgrade Energy to overweight yet maintained an underweight in Materials? Long-term GAA clients know that, in terms of global sector allocation, we have structurally favored the oil-related Energy sector to the metals-related Materials sector since October 2016, because oil supply/demand is more global in nature while the supply/demand of metals, especially industrial metals, is closely linked to China (see also the Commodity section of this Quarterly on page 18). From a cyclical perspective, the relative performance of the two sectors has historically closely correlated with the relative prices of oil and metals, as shown in panel 2. This is not surprising because changes in forward earnings for the two sectors are also closely linked to change in the corresponding commodity prices (panels 3 and 4). BCA’s Commodity and Energy Strategy service has an overweight rating on oil and a neutral stance on metals, implying that the growth in the oil price will outpace that of metal prices, which suggests that the Energy sector will outperform the Materials sector (panel 2).   Government Bonds Maintain Slight Underweight On Duration. Global equities have recovered 16% since reaching the low of 2018 on December 24, yet the global bond yield has decreased by 21 bps over the same period. While the directional movement of bond yields is somewhat puzzling given such strong performance in equities (see page 7 for some explanations), it’s evident that the bond markets have been driven by the recent weakness in global growth (Chart 20, panel 3), and are pricing out any expectation of rate hikes over the coming year in major developed economies. Given the surprisingly dovish tone at the March FOMC meeting and BCA’s House View that global economic growth will rebound in the second half, bond yields are now highly exposed to any hawkish shift in central bank policies and any recovery in inflation expectations. As such, it’s still appropriate to maintain a slight underweight on duration over the next 9-12 months. Favor Linkers Vs. Nominal Bonds. Depressed inflation expectations have been one reason why global bond yields have decoupled from equities. However, the crude oil price, which closely correlates with inflation expectations, has stabilized. BCA’s Commodity & Energy Strategy service expects Brent crude to end 2019 at US$75 per barrel (Chart 21). This implies a significant rise in inflation expectations in the second half of the year, supporting our preference for inflation-linked bonds over nominal bonds. However, TIPS are no longer cheap. For those who have not already moved to overweight TIPS, we suggest “buying TIPS on dips”. Inflation-linked bonds (ILBs) in Australia and Japan are also still very attractive versus their respective nominal bonds. Overweighting ILBs in those two markets also fits well with our macro themes. Chart 20Rates: Likely More Upside Risk Chart 21Favor Inflation Linkers   Corporate Bonds Chart 22Tactical Upside Remains For Credit In February, we raised credit to overweight within a fixed-income portfolio while underweighting government bonds. So far, this has proven to be the right decision, as corporate bonds have generated excess returns of 90 basis points over duration-matched Treasuries. We based our positioning on the mounting evidence that global growth is turning up: credit impulses are starting to rebound in several major economies, monetary conditions have eased, and our diffusion index of global leading indicators has rebounded sharply, indicating that there remains tactical upside for global credit (Chart 22– panel 1 and 2). When will we close our tactical overweight? Our U.S. Bond Strategy Service has set a target for spreads of U.S. corporate bonds with different credit ratings. According to their targets, which denote the median spread typical of late-cycle environments, there is still some room for further spread compression in non-AAA credits (Chart 22 – panel 3 and 4). However, the upside is limited and, if spreads keep tightening, we will probably close our position by the end of Q2. On a cyclical horizon, the fundamentals of corporate health are still a headwind, with both the interest-coverage and liquidity ratio for U.S. investment-grade corporates standing near 10-year lows.11 Moreover, we expect these ratios to deteriorate further, as corporate profits will likely come under pressure due to increasing wage growth. Finally, we expect that the Fed will turn more hawkish by the end of 2019, turning monetary policy from a tailwind to a headwind. Thus, we recommend investors to remain overweight, but be ready to turn bearish in the back end of the year.   Commodities Chart 23Prefer Oil, Watch Metals Energy (Overweight): Stable demand, declining Venezuelan production due to U.S. sanctions, instability and possible outages in Libya, Iraq, and Nigeria, alongside the GCC’s commitment to cut output through year-end, should support oil prices and allow further upside (Chart 23, panels 1 & 2). While U.S. crude production is on the rise, bottlenecks in its export capabilities should limit market oversupply. Crude supply shocks should outweigh any slowdown in demand, specifically from emerging markets. BCA’s energy strategists expect Brent to average $75 and $80 throughout 2019 and 2020 respectively, and for the gap between WTI and Brent to narrow significantly. Industrial Metals (Neutral): China, the world’s largest consumer, still plays a big role in the direction of industrial metals. Year-to-date, metals prices have been supported partly by a more stable dollar. For now, we maintain a neutral stance until we see confirmation that Chinese stimulus will trigger further upside to metal prices perhaps in the second half. However, a lack of sustained Chinese demand, alongside weaker global growth over the next few months, would weigh down on metal prices (panel 3). Precious Metals (Neutral): Gold has reversed its downslide and rallied by over 10% from its Q4 2018 low. With the market pricing out any Fed rate hikes this year, rising inflation expectations, a weaker USD by year-end, and lower real rates should help gold outperform other commodities in this late-cycle phase. We recommend an allocation to gold as an inflation hedge, as well as a hedge against geopolitical risks (panel 4).     Currencies Chart 24The End Of The Dollar Bull Market U.S. Dollar: Our bullish stance on the dollar has proven to be correct, as the trade-weighted dollar has appreciated by 5% in the past 12-months thanks to the slowdown in global growth. However, the two reasons for the growth slowdown – Fed tightening and Chinese deleveraging – have started to ease. On March 20 the Fed revised its forward guidance to no rate hikes in 2019 and only one rate hike in 2020. Meanwhile, Chinese total social financing relative to GDP has bottomed, indicating that Chinese authorities have opted for a pause in their deleveraging campaign (Chart 24, panel 1). These developments will likely boost global growth and hurt the countercyclical greenback. Therefore, we recommend investors to slowly shift to a cyclical underweight on the dollar. Euro: Most of the factors that dragged the euro down last year are fading: political risk in Italy has eased, fiscal policy is moving from a headwind to a tailwind, and the relative LEI between the EU and the US has started to pick up (panel 2). Moreover, we see little scope for euro area monetary policy to turn any more dovish versus the U.S., since forward rate expectations currently stand near 2014 lows (panel 3). Thus, we expect the euro to be one of the best performing currencies this year. Yen: Easy monetary policy by global central banks will boost asset prices and reduce volatility, creating a risk-on environment that is typically negative for the yen (panel 4). Moreover, the IMF still projects Japan to have a negative fiscal drag of 0.7% this year, which will force the BoJ to prolong its yield curve control regime. As a result, we expect the yen to be one of the worst performing currencies this year.       Alternatives Intro: Investors’ allocation to alternatives is on the rise as we get closer to the end of the business cycle along with increasing realized volatility in traditional assets. In the alternatives assets space, we recommend thinking about allocations through three buckets: 1) return enhancers, means of outperforming traditional equity, fixed income, and mixed-asset strategies; 2) inflation hedges, means of preserving capital throughout periods of elevated inflation; and 3) volatility dampeners, means of reducing drawdowns and portfolio volatility during periods of market drawdowns. Return Enhancers: In our July and October 2018 Quarterly reports, we recommended investors trim back on PE allocations and reallocate towards hedge funds. Growing competition in the PE space has pushed up multiples. Given where the business cycle currently is, we favor macro hedge funds, as they tend to outperform in this sort of environment as well as in downturns and recessions (Chart 25, panel 1). Inflation Hedges: In our July 2018 Quarterly, we recommended investors pare back their real estate allocations, given the backdrop of a slowdown/sideways trend in the sector, and specifically within the retail segment. Given that the end of the current cycle is likely to be accompanied by elevated levels of inflation, we recommend clients to modestly allocate to commodity futures on the likelihood of a softer dollar and rising energy prices (panel 2). Volatility Dampeners: We continue to recommend both farmland and timberland since they have lower volatility than other traditional and alternative asset classes (panel 3). While timberland is more impacted by economic growth via the housing market, farmland has a near-zero correlation with economic growth. We do not favor structured products due to their unattractive valuations. Chart 25Prefer Hedge Funds Over Private Equity   Risks To Our View Our economic outlook is quite sanguine. What would undermine this scenario? Many investors have become nervous about the inversion of the U.S. yield curve. And we have shown in the past that an inversion of the 3-month/10-year yield curve has been a reliable indicator of recessions 12-18 months ahead.12 Its inversion in March, then, is a concern. But note that the indicator works only using a three-month moving average (Chart 26); the curve often inverted for a brief period without signaling recession. We expect long-term rates to rise from here, steepening the curve. But a prolongation of the current inversion would clearly be a worrying signal. The direction of China continues to play a key role in defining the macro picture. Our current allocation is based on the view that China is doing some monetary and fiscal stimulus but that, at the current pace, it will be much smaller than in 2016 (Chart 27). The weak response of money supply growth suggests, as Premier Li Keqiang has complained, that the liquidity is mostly going into speculation (note that A-shares have risen by 20% this year) rather than into the real economy. The March Total Social Financing data, released in mid-April, will give a better read of the degree of the reflation. If it is bigger than we expect, this would suggest a quicker shift into euro area and Emerging Market equities than we currently advocate. The U.S. dollar remains a key driver of asset allocation. The dollar is a counter-cyclical currency and, with global growth slowing, has continued to appreciate moderately this year (Chart 28). We see a weakening of the dollar later this year, when global growth picks up. But if this were to happen more quickly or dramatically than we expect – not impossible given the currency’s over-valuation and crowded long-dollar positions – EM stocks and commodity prices, given their strong inverse correlation with the dollar, could bounce sharply. Chart 26Yield Curve Inversion Chart 27How Much Is China Reflating? Chart 28Dollar Is Counter-Cyclical   Garry Evans, Chief Global Asset Allocation Strategist garry@bcaresearch.com Xiaoli Tang, Associate Vice President xiaolit@bcaresearch.com Juan Manuel Correa Ossa, Senior Analyst juanc@bcaresearch.com Amr Hanafy,  Research Associate amrh@bcaresearch.com   Footnotes 1      Please see the Equities Section of this Quarterly on page 14 for more details. 2      Please see Global Asset Allocation “GAA Quarterly,” dated March 31, 2016 available at gaa.bcaresearch.com 3       Please see https://us.spindices.com/documents/methodologies/methodology-sp-us-style.pdf 4       Please see Global Asset Allocation “Monthly - January 2019,” dated January 2, 2019 available at gaa.bcaresearch.com 5     Please see Global Asset Allocation “Monthly - March 2019,” dated March 1, 2019 available at gaa.bcaresearch.com 6       Please see Global Asset Allocation “Quarterly - July 2018,” dated July 2, 2018 available at gaa.bcaresearch.com 7       Please see Global Asset Allocation “Quarterly - July 2018,” dated July 2, 2018 available at gaa.bcaresearch.com 8       Please see Global Investment Strategy Weekly Report, “What’s Next For The Dollar?” dated March 15, 2019  available at gis. bcaresearch.com 9       Please see Global Asset Allocation “Quarterly - July 2018,” dated July 2, 2018 available at gaa.bcaresearch.com 10    Please see Global Asset Allocation “Monthly Portfolio Update,” dated March 1, 2019 available at gaa.bcaresearch.com 11    Based on BCA’s Global Fixed Income Strategy’s bottom-up health monitor. 12   Please see Global Asset Allocation Special Report, “Can Asset Allocators Rely On Yield Curves?” dated June 15, 2018 available at gaa.bcaresearch.com GAA Asset Allocation

Underweight When we last updated the S&P telecom services index, it had been enjoying a modicum of relative outperformance against the broad market. However, this rally has faltered as pricing power, an excellent predictor of relative performance (second panel), has collapsed back into deflation. The upcoming deployment of 5G networks (and resulting premium pricing) may provide a lift to sales, though we think the likely T-Mobile – Sprint tie-up and the evolution of another competitor with the ability to invest in parallel means any incremental sales gains will rapidly be competed away. The sell side shares our bearish view; though the rate of change of earnings underperformance has stabilized, analysts continue to expect the sector to undergrow the broad market (third panel). Contrarian investors may look at the severe derating the S&P telecom services index has faced as a bargain shopping opportunity (bottom panel). However, we caution the structural top line challenges, compounded by persistently low earnings growth, likely make this derating a value trap. Stay underweight. The ticker symbols for the stocks in this index are: BLBG: S5TELSX - T, VZ, CTL.

​​​​​​​   Overweight The S&P homebuilders index has been outperforming nicely so far this year on the back of renewed optimism in the domestic housing market. This is reflected in the V-shaped recovery from the end-of-year homebuilder blues in 2018 (second panel). Further, Lennar, the largest constituent firm of the S&P homebuilders index reported Q1 results this week that noted record orders through the first two months of the year. In their earnings release, Lennar highlighted a pullback in mortgage rates as the largest rationale behind resurgent demand; as the principal driver of house affordability (mortgage rates shown inverted, third panel), this is unsurprising. Still, housing starts data, also released this week, was tepid in the context of generationally low unemployment and firm household formation (bottom panel). We believe it is only a matter of time before housing starts catch up with increasing affordability-fueled demand and reiterate our overweight recommendation. We further express this view through a long S&P homebuilding/short S&P home improvement retail pair trade that we also reiterate.1 The ticker symbols for the stocks in this index are: BLBG: S5HOME - DHI, LEN, PHM.     1 Please see BCA U.S. Equity Strategy Report, “ Dissecting 2019 Earnings”, dated January 22, 2019, available at uses.bcaresearch.com  

Highlights For the Eurostoxx50 to outperform the S&P500, the big euro area banks have to outperform the big U.S. tech stocks. Tactically overweight Eurostoxx50 versus S&P500 as well as other pro-cyclical positions such as overweight EM versus DM… …but prepare to take profits in the summer months. In the medium term, the euro area versus U.S. long-bond yield spread has plenty of scope to compress from its current -180 bps… …and EUR/USD has the scope to head higher. Feature Without a shadow of a doubt, the chart that causes the greatest stir among our clients is the Chart of the Week. It shows that one of the biggest investment decisions, the choice between the euro area and U.S. equity markets, reduces to the choice between the three large euro area banks – Santander, BNP Paribas, and ING – and the three U.S. tech behemoths – Apple, Microsoft, and Google.  Chart of the WeekEurostoxx50 Vs. S&P500 Is Just 3 Banks Vs. 3 Tech Stocks! Clients are simultaneously amazed and unsettled by this manifestation of the Pareto Principle, which states that the vast majority of an effect is explained by a tiny minority of causes. Financials feature large in the Eurostoxx50 while tech giants dominate the S&P500. But the amazing thing is that almost all of the relative performance can be explained by just three stocks in each market. The vast majority of an effect is explained by a tiny minority of causes.  The chart creates a cognitive dissonance. What about the things that are supposed to matter for stock market selection: relative economic growth, profits growth, margins, valuations and geopolitics? The answer is that all of these are interesting areas of study, but they are mere details in the big picture. For the Eurostoxx50 to outperform the S&P500, the big euro area banks have to outperform the big U.S. tech stocks (Chart I-2). Period.  Chart 2For The Eurostoxx50 To Outperform The S&P500, Euro Area Banks Have To Outperform U.S. Tech Our view is that in the immediate future this is certainly possible, but that over the long haul it will prove to be a very tall order. When The Mean Is Meaningless The structural performances of vastly different equity sectors can diverge for a very long time. How long? Japanese banks have underperformed U.S. tech for thirty years and counting! In this situation, mean-reversion and ‘standard deviations’ from the mean become meaningless concepts (Chart I-3). Chart I-3Japanese Banks Have Underperformed U.S. Tech For Thirty Years And Counting! The statistical concept of a standard deviation is only meaningful if the underlying data is stationary, which is to say mean-reverting. If it isn’t, then it is impossible to say that a sector price or valuation is stretched either versus another sector, or versus its own history.  One problem is that sector performances and valuations undergo phase-shifts when they enter a different economic climate. The structural outlook for bank profits experiences a phase-shift when a debt super-cycle ends. Therefore, comparing a bank valuation after a debt super-cycle with the valuation during a debt super-cycle is as meaningless as comparing your height as an adult to your height when you were a child! Sector performances and valuations undergo phase-shifts when they enter a different economic climate. To which, a frequent riposte is: within the same sector, euro area companies appear cheaper than their counterparts elsewhere in the world. But again, this apparent value is deceptive because it is simply an adjustment for the so-called ‘currency translation effect’ and the anticipated long-term moves in exchange rates. If investors anticipate the euro ultimately to strengthen – because they see that it is trading well below purchasing power parity – then a multinational company listed on a euro area bourse will suffer a future headwind to its mixed-currency denominated profits when they are translated back to a stronger euro. To discount this anticipated headwind, the euro area multinational must trade cheaper compared with a peer in, say, the U.S. But the cheapness is a false impression. Pulling together these complexities of sector effects, phase-shifts in sector valuations and currency effects, making the big call between Europe and America on the basis of performance or valuation mean-reversion is dangerous. Instead, we come back to the basic question: should you tilt towards euro area financials or towards U.S. tech? Own Banks For The Short Term Only Japanese financial sector profits peaked in 1990 and stand at less than half that level today. Euro area financial sector profits peaked in 2007, and are tracking the Japanese experience with a 17-year lag. If euro area financial profits continue to follow in Japan’s footsteps, expect no sustained growth through the next 17 years (Chart I-4). Chart I-4Euro Area Financial Profits Are Following Japanese Footsteps In a post credit boom era, banks lose the lifeblood of their business: credit creation. This loss becomes a multi-decade headwind to financial sector profit growth and share price performance. Bank profits are dependent on two other drivers. One is operational leverage – the amount of equity held against the balance sheet. More stringent European regulation is making this a headwind too. Banks have to hold more equity capital against assets, diluting their profitability. The other driver is the net interest margin – the difference between rates received on loans and rates paid on deposits. In this regard, both fintech and the blockchain are likely to create a further headwind to bank profitability. Japan’s experience suggests that euro area financials will struggle to outperform structurally. Admittedly, U.S. tech may also face its own headwinds or phase-shift, most obviously antitrust lawsuits to counter its near-monopoly status. But even allowing for this, Japan’s experience suggests that euro area financials will struggle to outperform structurally. Rather, financials is a sector to play for outperformance phases lasting no more than a few quarters. Last autumn, we noted that short-term credit impulses in the major economies were flipping from a sharp down-oscillation into an up-oscillation phase (Chart I-5). On that basis, we recommended a tactical overweight to Eurostoxx50 versus S&P500 as well as other pro-cyclical positions such as overweight EM versus DM. Those pro-cyclical sector positions have broadly succeeded, but they are still appropriate given that up-oscillation phases very reliably last around nine months. Chart I-5Short-Term Credit Impulses Have Flipped To Up-Oscillations The caveat is: prepare to take profits in the summer months. The Fed Is Now At ‘Neutral’, But Where Is The ECB? Last week, the Federal Reserve confirmed that “the Federal funds rate (at 2.5 percent) is now in the broad range of estimates of neutral – the rate that tends neither to stimulate nor to restrain the economy.”  This begs the question: where is the ECB policy rate (now at 0 percent) relative to its neutral? Our very high conviction view is that the ECB policy rate is well below neutral. Financials is a sector to play for outperformance phases lasting no more than a few quarters. The twenty year life of the euro captures multiple manias and crises, some centred in Europe, some in the U.S. Through these twenty years, the euro area versus U.S. long bond yield spread has averaged -50 bps1 (Chart I-6). Over this same period, the euro area versus U.S. annual inflation differential has also averaged -50 bps (Chart I-7). Ergo, the real interest rate differential has averaged zero. Meaning, the ex-post neutral real interest rates in the euro area and the U.S. have been exactly the same. Chart I-6The Euro Area Vs. U.S. Yield Spread Has Averaged -50 Bps... Chart I-7...The Euro Area Vs. U.S. Inflation Spread Has Also Averaged -50 Bps With little difference in the neutral real rates over the past two decades, is there a valid reason to expect a difference in the future? An obvious response is the fragility of the euro area’s banking system will require the ECB to persist with its zero interest rate policy for years. In Germany and France, bank lending is healthy, and could easily weather modestly tighter monetary policy. In fact, the evidence suggests that this fear is exaggerated. In Germany and France, bank lending is healthy, and could easily weather modestly tighter monetary policy (Chart I-8). The problem has been localised in Italy, where bank lending relapsed once again in 2018. Chart I-8Bank Lending Is Healthy In Germany And France However, on closer examination this was a direct result of political tensions. Recently, Italian bank lending has been a very tight (inverse) function of the Italian bond yield. The BTP yield spiked last year when Rome escalated its budget spat with Brussels, and bank lending took a hard hit. But now that the Italian bond yield has retraced, lending should recover (Chart I-9). Chart I-9Italian Bank Lending Should Recover Now That The Bond Yield Has Come Down The central issue is can the U.S. policy rate – which is at neutral – and the ECB policy – which is below neutral – diverge much from here? Our high conviction answer is no. Therefore, in the medium term, the euro area versus U.S. long-bond yield spread has plenty of scope to compress from its current -180 bps, one way or the other (Chart I-10). Chart I-10Can Interest Rate Expectations Diverge Much From Here? It also implies that after remaining range-bound in the immediate future, EUR/USD has the scope to head higher. Dhaval Joshi, Chief European Investment Strategist dhaval@bcaresearch.com Fractal Trading System This week’s recommended trade is to go long SEK/NOK, as it is close to the limit of tight liquidity that has signaled many previous technical reversals in this currency cross. Set a profit target of 1.5 percent with a symmetrical stop-loss. In other trades, the on-going rally in government bonds caused the short position in 30-year T-bonds to hit its stop-loss. This leaves us with five open positions. Long SEK/NOK. 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 Footnotes 1 Calculated from the over 10-year government bond yield: euro area average, weighted by sovereign issue size, less U.S. Fractal Trading System Recommendations Asset Allocation Equity Regional and Country Allocation Equity Sector Allocation Bond and Interest Rate Allocation Currency and Other Allocation 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

Special Report

Highlights Taiwan’s semiconductor sector is facing both cyclical and structural headwinds. Semiconductor exports will continue to contract over the next six months or so, on retrenching global demand. In the long run, Taiwan is facing increasing competition from Korea in the high-end supply, and from mainland China in the medium- to low-end supply of the semiconductor market. The latest rebound in Taiwanese share prices is unsustainable, and they are about to relapse anew. Within an EM equity portfolio, we recommend staying neutral on Taiwanese stocks for now. Feature Taiwan’s exports and manufacturing are in full-blown recession. The equity market has rebounded after a major selloff last year. However, the overall manufacturing PMI and its export sub-component are extremely weak, and do not justify the latest share-price rebound (Chart I-1). Chart I-1Taiwanese Equities: Unsustainable Rally Are manufacturing activity and exports about to recover? Or will the stock market rally fade? Our answer is the latter. There are currently no signs suggesting a recovery in exports is imminent. Moreover, the engine of the economy – the semiconductor sector – is facing both cyclical and structural headwinds. We remain negative on Taiwanese stocks in absolute terms. Within an EM equity portfolio, we recommend a market-weight allocation to Taiwanese stocks for now. Importance Of Semiconductors Over the past 15 years, the semiconductor sector has become the cornerstone of the Taiwanese economy. The Taiwanese economy is highly dependent on its external sector, as exports contribute to nearly 70% of GDP. As such, Taiwan’s business cycle has often been closely associated with its export sector. This means the region’s growth outlook relies on both external demand (a cyclical factor) and the competitiveness of its export sector (more of a structural factor). Over the past 15 years, the semiconductor sector has become the cornerstone of the Taiwanese economy. It contributes to over one-third of the region’s total exports, up from 22% in 2009 (Chart I-2). Chart I-2Semiconductor: Cornerstone Of Taiwanese Economy Consistently, tech stocks also account for the lion’s share of the Taiwanese stock market, representing nearly 60% of the MSCI Taiwan Index and 47% of the Taiwanese Stock Exchange (TSE) index in market-value terms. There have been two key forces behind the significant growth of Taiwan’s semiconductor sector: booming global demand for smartphones/tablets and increasing competitiveness among domestic semiconductor companies. However, looking forward, the Taiwanese manufacturing sector and its semiconductor exports are facing a double-whammy: cyclical weakness in global demand and a relative decline in Taiwan’s export ability. In the context of a negative structural outlook, a cyclical downtrend engenders substantial deterioration in manufacturing, and by extension corporate profitability. Cyclical Downturn In Global Semiconductor Demand The outlook for the Taiwanese semiconductor industry remains poor. The global semiconductor industry has already been in a cyclical downtrend since early 2018. Global smartphone sales are shrinking. Both DRAM and NAND prices have been falling (Chart I-3). Chart I-3Falling Memory Chips Prices The freefall in Taiwan's new export orders seems to entail a further contraction in exports (Chart I-4). Chart I-4A Further Contraction In Exports Is Likely Importantly, exports of electronics parts lead Taiwanese tech EPS growth, and currently point to an impending contraction in corporate earnings (Chart I-5). Chart I-5An Impending Contraction In Corporate Earnings The outlook for the Taiwanese semiconductor industry remains poor. First, Taiwanese semiconductor producers are highly vulnerable to any further downside in global smartphone demand. There are two major pure-play wafer manufacturers in Taiwan: Taiwan Semiconductor Manufacturing Company (TSMC) and United Microelectronics (UMC). TSMC and UMC are the world’s largest and fourth-largest dedicated integrated circuit (IC) foundries, respectively. The smartphone sector has been the main revenue source for both companies, accounting for a 45% share for TSMC and 40% for UMC. Global smartphone demand is likely to decline further in 2019, as major markets such as mainland China and advanced economies have entered the saturation phase of mobile-phone demand. DRAMeXchange expects global smartphone production volume for 2019 to fall by 3.3% from last year following a 4% drop in 2018 (Chart I-6). Chart I-6Global Smartphone Demand Started A Downtrend Smartphone sales in mainland China remain in deep contraction after two consecutive years of declines (Chart I-7). Odds are that smartphone shipments will remain sluggish amid the ongoing economic slump in the mainland’s economy. Chart I-7Smartphone Sales In Mainland China Are In A Deep Contraction In addition, Taiwan’s TSMC is the sole chip supplier for Apple iPhones. A further decline in Apple smartphone shipments will reduce the company’s revenue and profits, damaging the region’s growth outlook. Mainland China now can produce top-notch quality smartphones at relatively cheaper selling prices. This will further crowd out higher-priced products from Apple, Samsung and others (Chart I-8). Chart I-8Apple Has Been Losing Market Share In Global Smartphone Market Second, the significant surge in bitcoin prices greatly boosted cryptocurrency mining activity in 2016-‘17 as miners quickly expanded their computing power. This boosted demand for graphic process unit (GPU) chips and in turn brought higher revenue for Taiwan chipmakers between June 2016 and early 2018. However, with the bust in bitcoin prices (Chart I-3 on page 3), demand from cryptocurrency mining has vanished and is unlikely to revive soon. Indeed, Taiwan chipmakers have suffered from last year’s plunge in cryptocurrency mining activity. According to TSMC, revenue from the cryptocurrency mining-related high-performance computing (HPC) sector contracted by double digits in 2018. Given that HPC demand is the second-biggest source of revenue for TSMC, with 32% share, TSMC revenue will be curtailed as HPC chip demand will continue to decline on weak bitcoin prices. Last, developments in new technologies, such as foldable smartphones, artificial intelligence, fifth-generation (5G) mobile networks and the so-called Internet of Things (IoTs) could only produce a modest pick-up in semiconductor demand. Most of these developments are still in their infancy and early stages. Hence, their growth will not be large enough to make a cyclical difference in global semiconductor demand. For example, the foldable smartphone that Huawei recently announced is indeed appealing. However, a lack of stability in panel supply and quite-high selling prices will limit sales. WitsView, a division of TrendForce, predicts that the market penetration rate of the foldable phone will be only 0.1% in 2019, and could rise to 1% in 2020 if more panel providers join the game, enabling a significant reduction in panel costs. Moreover, these categories together account for only ~23% of TSMC’s revenue; their modest growth will not be able to make up for the losses from the smartphone and HPC sectors within Taiwan’s economy. Besides, there has been a slowdown in demand from high-growth areas such as data center servers, as well as the automotive and industrial sectors. Putting it all together, odds are that global semiconductor demand will only materially recover in 2020. By that time, more-mature 5G technology and the increasing adoption of the 5G network and 5G-related products may be able to shift global semiconductor demand from the current downturn to a cyclical uptrend. Hence, the cyclical weakness in global semiconductor demand is likely to persist over the next six months. Consequently, Taiwan’s major types of semiconductor production will likely remain in contraction, and inventory levels will stay elevated (Chart I-9 and Chart I-10). Chart I-9Taiwan: Semiconductor Output Contraction Will Likely Continue Chart I-10Taiwan: Semiconductor Inventory Are Elevated Bottom Line: There are no signs of an imminent recovery in exports. A Potential Decline In Taiwan’s Semiconductor Competitiveness Taiwan wafer manufacturers are facing an increasing threat from their Korean and mainland China competitors. Leadership in advanced process technologies has been a key factor in Taiwan’s strong market position in the global semiconductor industry. With cutting-edge technologies, Taiwan has been the global wafer capacity leader since 2015. As of last year, it held about 22% of global installed wafer capacity (Chart I-11). However, Taiwan wafer manufacturers are facing an increasing threat from their Korean and mainland China competitors. Korean Chipmakers While Taiwan will remain highly competitive in 7 nanometer (nm) and 10 nm wafer production, it is facing fierce competition from Korea. Manufacturing technologies designated by smaller nanometer numbers tend to have faster speeds and be more power-efficient than technologies designated by larger numbers. TSMC was the first company in the world to mass-produce 7 nm node wafers. Its 7 nm deep ultraviolet lithography (DUV) node has been in mass production since April 2018, producing chips for AMD, Apple, HiSilicon, and Xilinx. Beginning at the end of this month, TSMC will be ready to begin mass production of 7nm wafers using extreme ultraviolet lithography (EUV). The switch from 7nm DUV to 7nm EUV allows for fewer defects and fewer steps required during the production process. The company also aims to boost volume production of its 5 nm nodes in early 2020 and has a target of 3 nm wafers for 2022. Last year, wafer revenue from 7nm and 10nm chips accounted for 9% and 11% of TSMC’s total revenue, respectively (Chart I-12). Samsung has been closely following TSMC in terms of technological innovation. It started mass production of EUV-based 7nm chips last October, with a plan of risk production1 of 5nm wafers in 2019 and a target of 4nm wafers in 2022. Meanwhile, IBM announced last December that it signed an agreement with Samsung to produce its next-generation processors with Samsung’s 7nm technology. As Samsung seeks to diversify its revenue source away from memory chips, which last year contributed to about 80% of its operating profit, the company has been determined to ramp up the development of its foundry business. It aims to replace TSMC as the world’s largest foundry producer by 2030. In the near term, Samsung aims to secure a 25% market share in the global pure-play foundry market by 2023, a rise from 19% currently. Last year, Samsung surpassed Taiwan’s UMC to become the world’s second-largest dedicated chipmaker. Moreover, Samsung’s capital spending has been and will continue to be much higher than TSMC. Over the course of 2017 and 2018, Samsung spent about $46.9 billion on semiconductor capital expenditures, more than double TSMC’s $21 billion. Hence, the competition between TSMC and Samsung in the high-end chip market will intensify in the coming years. Chipmakers In Mainland China The competition between TSMC and chipmakers from mainland China is also escalating. Chart I-12 shows that 80% of TSMC’s wafer revenue comes from bigger node wafers (bigger than 10 nm). Taiwan’s second-biggest chipmaker, UMC, only produces wafers equal to or bigger than 28 nm. Therefore, the chip market using less-advanced technology than 10 nm will be the main battlefield between Taiwanese and mainland China’s chipmakers. Before 2014, there were few wafer manufacturers in mainland China, and those that did exist were too weak to compete with giant market players like TSMC. In 2014, the Chinese central government made a move to foster development within the local IC industry. Since then, the authorities have poured significant amounts of capital into semiconductor foundries, as well as companies focused on memory production, chip design and related equipment and materials. Semiconductor Manufacturing International Corporation (SMIC) is the world’s fourth-largest dedicated wafer manufacturer, and is the largest in mainland China. While 28nm will likely remain a large part of its business, SMIC plans to go into production on its 14 nm technology in the first half of 2019. The company is also working on 10nm and 7nm nodes with the use of EUV. SMIC currently counts HiSilicon and Qualcomm as customers, manufacturing smartphone chips with medium-to-low technology. As mainland China aims to increase its self-sufficiency rate for ICs significantly over the next five to 10 years, the nation’s producers will significantly expand their wafer capacity. Mainland China is likely to reduce its semiconductor imports from Taiwan considerably in the coming years, especially wafer imports. According to IC Insights, nine 300mm wafer fabs2 are scheduled to open worldwide in 2019, with five of them in mainland China. Based on another set of data from SEMI, the number of 200mm wafer fabs in the world will increase from 194 in 2017 to 203 by 2022, with an additional 56 established fabs planning to expand their manufacturing capacity. Mainland China is expected to account for 44% of the growth. In comparison, Taiwan only accounts for about 10% of the growth. Mainland China currently accounts for over 30% of Taiwanese electronic parts exports (wafers, PCBs, mainboards and others). As mainland China continues to build new wafer manufacturing capacity and gradually improve its existing technology, it will switch its consumption from imports to domestic production. Consequently, mainland China is likely to reduce its semiconductor imports from Taiwan considerably in the coming years, especially wafer imports (Chart I-13). This is structurally bearish for Taiwanese semiconductor companies. Chart I-13Mainland China’s Semiconductor Imports From Taiwan Will Drop Bottom Line: Taiwan is facing increasing challenges from Korea in terms of defending its market share in the high-end wafer market. Meanwhile, Taiwan is also set to lose market share in the medium-to-low market to wafer producers from mainland China. What About The Rest Of The Economy? The rest of the economy is exhibiting mixed signals, with contracting major non-semiconductor export sectors but decent household consumption and property market. Table 1 shows Taiwan’s top 10 exported products, with the top three attributing to over half of total exports. Besides the semiconductor sector, exports of the other two major products – electrical machinery products and machinery – are beginning to contract (Chart I-14). Chart I-14Taiwan: Contracting Non-Semiconductor Exports However, the domestic economy seems to be running well at present. Production of construction materials in volume terms is growing rapidly, accompanied by a rebound in building permits granted (Chart I-15). While employment growth is decent, average wage growth has been quite strong (Chart I-16). With persistent contraction in exports and inflation very low, the central bank could cut rates in 2019. Chart I-15Decent Domestic Demand Chart I-16Strong Wage Growth Ongoing contraction in semiconductor exports will likely slow domestic demand with a time lag. In fact, the inverted 5-year/6-month yield curve is indeed signaling an economic slump in Taiwan (Chart I-17). Chart I-17Inverted Yield Curve Signals Continuing Economic Slump Ahead Investment Recommendations The latest rebound in Taiwanese stocks is unsustainable and share prices will relapse again. Within an EM equity portfolio, we recommend maintaining a market-weight allocation to Taiwan for now. We are reluctant to downgrade Taiwan to underweight because some other emerging markets and sectors within the EM universe have a poorer outlook. In addition, Taiwanese shares have already underperformed the EM benchmark since last September (Chart I-18). Chart I-18Taiwanese Stocks: Staying Neutral Within EM The Taiwanese currency is cheap (Chart I-19). The region has a massive current account surplus and foreigners do not hold any local bonds, which is very different from many other EM countries. Hence, Taiwan is less vulnerable to capital outflows than many current-account-deficit EM economies. The latter could be forced to raise rates, which will place pressure on their banks as well as on domestic demand. In contrast, Taiwan has the ability to cut rates. Chart I-19TWD Is Cheap Ellen JingYuan He, Associate Vice President Emerging Markets Strategy ellenj@bcaresearch.com     1 "Risk Production" means that a particular silicon wafer fabrication process has established a baseline in terms of process recipes, device models, and design kits, and has passed standard wafer level reliability tests. 2 A fab, sometimes called foundry, is a semiconductor fabrication plant where devices such as integrated circuits are manufactured. Equity Recommendations Fixed-Income, Credit And Currency Recommendations

Overweight (High-Conviction) Software stocks are on fire and leading profit indicators suggest that more gains are in store in the coming months. Sustained capital outlays on software are a key driver of industry profits (bottom panel). In an otherwise muted Q4 GDP release, rising non-residential fixed investment in general and surging investment in software in particular suggest that our bullish software capex thesis is alive and kicking (middle panel). The move to cloud computing and SaaS, the proliferation of AI, machine learning and augmented reality are not fads but enjoy a secular growth profile, and signal that capital outlays on software are also in a structural uptrend. Not only private sector software capex is near all-time highs as a share of total outlays, but also government investment in software is reaccelerating at the fastest pace since the tech bubble. When productivity gains are anemic, both the business and government sectors resort to software upgrades in order to boost productivity. Bottom Line: We reiterated our high-conviction overweight recommendation on the S&P software index on Monday. Please see our Weekly Report for more details. The ticker symbols for the stocks in this index are: BLBG: S5SOFT – MSFT, ORCL, ADBE, CRM, INTU, ADSK, RHT, CDNS, SNPS, ANSS, SYMC, CTXS, FTNT.