Technology

Dear Client, I will be visiting clients in Paris, Amsterdam, and London next week. In lieu of our regular report, we will be sending you a Special Report from Matt Gertken, BCA’s Chief Geopolitical Strategist. Matt argues that US politics and the 2020 election represent the greatest source of geopolitical risk over the coming year, and possibly beyond. Best regards, Peter Berezin Highlights Having underperformed for more than ten years, non-US stocks are set to gain the upper hand over their US peers. A reacceleration in global growth, a weaker US dollar, and favorable valuations should all support non-US stocks next year. Meanwhile, one of the greater drivers of US equity outperformance – the stellar returns of tech stocks – is likely to dissipate. Investors should remain overweight global equities relative to bonds, but start increasing allocations to non-US stocks at the expense of US stocks. US Stocks: From Leaders To Laggards? US equities have handily outperformed their global peers since 2008. About half of that outperformance was due to faster sales-per-share growth in the US, a third was due to faster growth in US margins, and the rest was due to relative P/E expansion in favor of the US (Chart 1). Looking ahead, non-US stocks are set to gain the upper hand over their US peers thanks to an improving global growth backdrop, a weaker US dollar, and an increasingly irresistible valuation tailwind. Chart 1Faster Sales Growth, Rising Margins, And Relative PE Expansion Helped Drive US Outperformance Over The Past Decade Improving Global Growth Outlook Global growth should benefit next year from the dovish pivot by most central banks. The share of central banks cutting/raising rates leads global growth by about 6-to-9 months (Chart 2). Chart 2Lower Rates Should Help Spur Growth Chart 3The Effects Of Easing Monetary Policy Should Soon Trickle Down To The Economy The global manufacturing downturn is also coming to end as inventories continue to be run down. The auto sector, which has been at the forefront of the manufacturing slowdown, is finally showing signs of life. US banks stopped tightening lending standards for auto loans in the third quarter. They are also reporting stronger demand for vehicle financing (Chart 3). In Europe, the new orders-to-inventory ratio of the Markit Europe Automobile PMI has moved back to parity for the first time since the autumn of 2018. In China, vehicle production and sales are rebounding on a rate-of-change basis (Chart 4). Both automobile ownership and vehicle sales in China are still a fraction of what they are in most other economies (Chart 5). Chart 4Chinese Auto Sector Is Bottoming Out Chart 5China: Structural Outlook For Autos Is Bright The trade war is a clear and present danger to our bullish outlook on global growth. The good news is that President Trump has a strong incentive to make a deal. A resurgence in the trade war would hurt the economy, which is Trump’s best selling point (Chart 6). As a self-described master negotiator, Trump has to produce a “tremendous” deal for the American people. Had he negotiated an agreement a year or two ago, he would currently be on the hook for showing that it resulted in a smaller trade deficit with China. But with the presidential election only a year away, he can semi-credibly claim that the trade balance will improve only after he is re-elected. Assuming a “Phase 1” agreement is concluded, global business sentiment should improve. Chart 6Trump Gets Reasonably High Marks On His Handling Of The Economy, But Not Much Else A détente in the trade war is unlikely to cause China to restart its deleveraging campaign. Credit growth is currently only a few points above trend nominal GDP growth, implying that the ratio of credit-to-GDP is barely increasing (Chart 7). The combined Chinese credit and fiscal impulse is still rising; it reliably leads global growth by about nine months (Chart 8). Chart 7China: The Deleveraging Campaign Has Been Put On The Backburner Chart 8Chinese Stimulus Should Boost Global Growth Faster Global Growth Should Disproportionately Benefit Non-US stocks The sector composition of international stocks is more skewed towards cyclicals than defensives compared to US stocks (Table 1). As a result, non-US stocks generally outperform their US peers when global growth accelerates (Chart 9). Table 1Cyclicals Are More Heavily Weighted Outside The US Stock Market We would include financials in our definition of cyclical sectors. As global growth improves, long-term bond yields will increase at the margin (Chart 10). Since central banks are in no hurry to raise rates, yield curves will steepen. This will boost bank net interest margins, flattering profits and share prices (Chart 11). Chart 9Non-US Equities Usually Outperform When Global Growth Improves Chart 10Stronger Economic Growth Will Put Upward Pressure On Government Bond Yields   The US Dollar Should Weaken Compared to most other economies, the United States has a large service sector and a small manufacturing base. This makes the US a “low beta” play on global growth. As a result, capital tends to flow from the US to the rest of the world when global growth picks up, putting downward pressure on the US dollar in the process (Chart 12). Chart 11Steeper Yield Curves Will Benefit Financials Chart 12The Dollar Is A Countercyclical Currency   Interest-rate differentials have been moving against the dollar for most of this year (Chart 13). This makes the greenback more vulnerable to a correction. Chart 13The Dollar Has Been Diverging From Rate Differentials This Year Chart 14Long Dollar Is A Crowded Trade Bullish sentiment towards the dollar also remains somewhat stretched. Net long speculative positions are near the top of their historic range (Chart 14). Our tactical MacroQuant model, which has an excellent track record of predicting short-to-medium term moves in the dollar, has dropped its bullish bias towards the currency (Chart 15).   Chart 15MacroQuant Has Soured On The US Dollar A weaker dollar will help boost commodity prices, which is usually good news for cyclical stocks (Chart 16). A softer dollar will also raise the USD value of overseas shares, thus making international stocks more attractive in common-currency terms. Valuations Favor Non-US Stocks There is an old investment adage which says that valuations are useless as a short-term timing tool. That is only partially true. While valuations by themselves offer little guidance as to where the stock market is going in the short run, combined with a catalyst, valuations can make a big difference. When stocks are cheap, a bullish catalyst can cause prices to surge; whereas when stocks are expensive, a bearish catalyst can cause them to plunge. Looking ahead, non-US stocks are set to gain the upper hand over their US peers thanks to an improving global growth backdrop, a weaker US dollar, and an increasingly irresistible valuation tailwind. Non-US stocks are currently trading at 13.8-times forward earnings. This represents a significant discount to US stocks, which trade at a forward PE ratio of 17.7. The valuation discount is even greater if one looks at other measures such as the cyclically-adjusted PE, price-to-book, price-to-sales, and the dividend yield (Chart 17). Chart 16A Weaker Dollar Tends To Support Commodity Prices Chart 17US Stocks Are More Expensive...   Differences in sector weights account for about a quarter of the valuation gap between the US and the rest of the world (Chart 18). The rest of the gap is due to cheaper valuations within sectors. Financials, utilities, and consumer discretionary stocks, in particular, are quite a bit more expensive in the US than elsewhere (Chart 19). Chart 18…Even When Adjusting For Sector Weights Chart 19AEquity Sector Valuations: US Versus The Rest Of The World (I) Chart 19BEquity Sector Valuations: US Versus The Rest Of The World (II)   The valuation gap between the US and the rest of the world is even starker if we compare earnings yields with bond yields. Since bond yields are lower outside the US, the implied equity risk premium is markedly higher for non-US stocks (Chart 20). An examination of the relative performance of US vs non-US companies over the past 50 years reveals two major tops, and one potential top. Some commentators have argued that the loftier valuations enjoyed by US stocks are warranted due to their superior growth prospects. While there may be some truth to that, it is worth noting that the IMF projects GDP growth (based on MSCI country weights) will be faster outside the US over the next five years (Chart 21). Chart 20Equity Risk Premia Remain Quite High Chart 21Growth Prospects Brighter Outside The US   One should also keep in mind that relatively fast US earnings growth is a fairly recent phenomenon. Between 1970 and 2008, European EPS actually grew slightly faster than US EPS (Chart 22). Earnings in emerging markets also increased more rapidly than in the US during the two decades leading up to the Global Financial Crisis. Chart 22US Earnings Have Not Always Outperformed The Role Of US Tech The large weight of the tech sector in the US stock market explains much of the superior performance of US stocks over the past decade. As Chart 23 illustrates, EPS in the I.T. sector has grown a lot more quickly than in other sectors. Chart 23US Earnings: Who Has Been Doing The Heaving Lifting? Chart 24S&P 500: Much Of The Increase In Margins Has Occurred In The I.T. Sector Looking out, there are four reasons why US tech stocks may be due for a breather. First, tech valuations have gotten stretched relative to the broader market. Second, tech margins have risen to unprecedented high levels. We estimate that about half of the increase in S&P 500 profit margins since 2007 has been due to I.T. (Chart 24). Even that understates the role of tech in the expansion of profit margins because Standard & Poor’s no longer classifies some large-cap behemoths such as Google and Facebook as I.T. companies. Third, tech companies may face increased regulatory scrutiny in the years ahead stemming from alleged privacy violations, perceived monopolistic behavior, and worries about the censorship of online speech. This could weigh on sales and earnings growth. Fourth, the growth in private equity funds is likely to limit the number of tech companies that go public at a very early stage. Stock market investors were very lucky that companies such as Microsoft, Cisco, Nvidia, Qualcomm, Oracle, Amazon, and Netflix issued shares to the public at a young stage in their development (Table 2). All seven had market caps below $1 billion when they went public. Such hidden gems are becoming less common: The number of publicly listed companies in the US has fallen by more than half over the past two decades (Chart 25). The median age of tech companies at the time of IPO has risen from around 7 in the 1990s to 12 years today (Chart 26). Table 2Big Gains From Once Small Companies Chart 25The Number Of Publicly Listed Companies Fell   Chart 26Tech Companies Entering The Public Arena Are Now More Mature Had Uber gone public as a small, upstart company not long after it was founded in 2009, it probably would have also made public shareholders a lot of money. Instead, it ended up going public this year with a market cap of $75 billion, only to see it shrink to as low as $40 billion in the ensuing six months. We won’t even mention what would have happened if WeWork had gone public. Investment Conclusions An examination of the relative performance of US vs non-US companies over the past 50 years reveals two major tops, and one potential top: The first during the “Nifty 50” era of the late 1960s, the second during the 1990s dotcom boom, and the third during the recent FAANG craze (Chart 27). It is too early to say whether FAANG stocks have peaked, but it is worth noting that the group has underperformed the S&P 500 since May (Chart 28). Chart 27Putting The Recent FAANG Craze Into Context Chart 28FAANG Stocks And The Market Chart 29Has The Underperformance Of Value Run Its Course?   Regardless of whether the secular outperformance of US equities is ending, the cyclical backdrop that we foresee over the next 12-to-18 months – characterized by faster global growth, a weakening dollar, and higher commodity prices – is likely to favor non-US stocks. As such, investors should remain overweight global equities relative to bonds, but start increasing allocations to non-US stocks at the expense of US stocks. Consistent with this, we are initiating a new recommendation to go long the MSCI ACWI ex USA index versus the MSCI USA index in dollar terms. Looking across the various stock markets outside the US, we are particularly fond of Europe. Net profit margins among companies in the STOXX Europe 600 index are about three percentage points below the S&P 500. This gives European companies greater scope to boost earnings. European banks are especially attractive, sporting a forward PE of 8.3, a price-to-book ratio of 0.6, and a dividend yield of 6.1%. Lastly, on the question of style investing, we would note that the relative performance of the MSCI value and growth indices closely tracks the performance of global financials versus I.T. (Chart 29). Given our preference for the former over the latter, we suspect that value will outperform growth next year.   Peter Berezin Chief Global Strategist peterb@bcaresearch.com   Footnotes   Strategy & Market Trends MacroQuant Model And Current Subjective Scores Tactical Trades Strategic Recommendations Closed Trades

Special Report

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

Special Report

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

Underweight The S&P semi equipment index has made the headlines reaching fresh cycle-highs. While bulls would buy this breakout, we are sticking our heads out and recommend selling the strength and warn that the S&P semi equipment cycle-high looks like a mania (please refer to Chart 8 from this Monday’s Weekly Report). Deflating DRAM prices, which also serve as our industry’s pricing power proxy, highlight that demand remains deficient both for semis and semi equipment. Historically, the sector’s relative profit expectations and pricing power have moved in lockstep and the current message is to fade sell-side analysts’ buoyancy (bottom panel). Moreover, the plunge in overall tech capex growth (especially excluding software) further dims an already bleak semi equipment profit outlook. Bottom Line: This week we downgraded the S&P semi equipment index to underweight, but given the industry’s volatility we also set a 10% stop loss. The ticker symbols for the stocks in this index are: BLBG – S5SEEQ – AMAT, LRCX, KLAC. For additional details, please refer to this Monday’s Weekly Report.    

Highlights Portfolio Strategy Lack of profit growth, deficient industry demand, perky valuations and extremely overbought conditions all suggest that the time is ripe for an underweight stance in the S&P semi equipment index. The chip down cycle is far from over, leading global semi sales indicators remain downbeat and our semi profit growth model is waving a yellow flag, compelling us to put the S&P semiconductors index on downgrade alert. Recent Changes Downgrade the S&P semiconductor equipment index to underweight, today. Table 1 Feature The S&P 500 made fresh all-time highs last week, despite the ongoing profit contraction and a well telegraphed hawkish Fed interest rate cut. The “hope rally” continues and the longer it lasts defying sagging profit fundamentals, the larger the snapback will be in the ensuing months. We remain cautious awaiting a turn in our proprietary four-factor macro SPX earnings growth model and in the meantime our strategy is to sell this strength and raise dry powder. Worrisomely, Chart 1 shows that analysts have thrown in the towel and are downgrading SPX long-term profit growth expectations at a faster pace than in the aftermath of the dotcom bubble. Historically, the S&P 500 and its five-year forward EPS growth estimates are joined at the hip, and the current message is bearish for the broad equity market.  Chart 1Will Sinking Profit Growth Expectations Pull Stocks Lower? Importantly, on the valuation front, in May of 2018 we first showed the SPX P/E/G ratio and at the time we accurately argued that “on this valuation measure the SPX appears cheap”.1 How times have changed since then. Following that trough, the P/E/G ratio has nearly doubled and is now sitting right at 1.5 or one standard deviation above the historical mean (we divide the 12-month forward price-to-earnings ratio by the long-term EPS growth rate using I/B/E/S data, second panel, Chart 2). We are clearly in overshoot territory and this valuation metric represents another yellow flag. Chart 2SPX P/E/G Ratio Is In Overshoot Territory Moving on to the bond market, what caught our attention was a recent WSJ article detailing how investors are no longer paying up to own the lowest quality paper and while overall junk spreads were coming in, at the bottom of the pit investors were shunning CCC rated junk bonds.2 What is interesting is that this lowest quality corner of the junk market has some excellent forward looking properties and tends to lead not only the overall junk market, but also equities. Chart 3 shows the CCC rated option adjusted spread (OAS) versus the overall high yield OAS on a year-over-year change basis on inverted scale. This measure of bond market stress is moving in the opposite direction of S&P 500 momentum and we expect stocks to converge lower to this junk bond market stress indicator (JBMSI). Chart 3Bond Market Not Buying Stock Market Euphoria This week we are downgrading a niche tech subgroup that has gone parabolic and updating another early-cyclical tech subindex. The overall corporate bond ratings migration data (defined as downgrades minus upgrades as a percent of total) corroborates the JBMSI message and warns that the steep divergence with stocks is unsustainable (corporate bond ratings migration data shown inverted, middle panel, Chart 4). Chart 4Unsustainable Divergences Similarly, the S&P 500’s net earnings revision ratio is also negative and before long it will exert downward pull on SPX momentum (bottom panel, Chart 4). Under such a backdrop, we continue to recommend investors avoid chasing the broad equity market higher and instead build up their cash coffers, at least until we get a definitive signal that the path of least resistance is higher for profits. This week we are downgrading a niche tech subgroup that has gone parabolic and updating another early-cyclical tech subindex. Sell The Semi Equipment Exuberance Tech stocks have been on a tear with the sector besting the SPX by over 40% since 2015. While such a breakneck pace is unsustainable, what is missing from this outperformance is relative forward earnings participation. In fact, tech profit expectations stalled versus the overall market in late-2018 and have not been able to keep up with relative share prices. In other words, the forward multiple has skyrocketed and is now trading at a 15% premium to the SPX, at a time when relative margins are sinking like a stone (Chart 5). Importantly, given that stock performance should follow profit performance we are perplexed by this dynamic with investors religiously bidding up the sector’s forward multiple. Tack on the recent news of a plunge in overall tech capex growth – especially excluding software – and the tech sector’s bleak profit outlook dims further (Chart 6). Worryingly, within the tech sector the semiconductor equipment space is even more puzzling. Chart 7 shows that relative forward profits are trailing relative share prices as investors have extrapolated the recent positive trade news far into the future. As a reminder this index has a 90% foreign sales exposure with roughly 30% of sales originating from China. As a result, the S&P semiconductor equipment forward P/E is just below the broad market, nearly doubling on a year-over-year basis (middle panel, Chart 7). Chart 5Mind The Gap   Chart 6Even Tech Investment Is Cracking The last time we tried to lean against semi equipment exuberance on the back of deteriorating profit fundamentals was on July 8 when we downgraded this index to underweight. But, we were offside and thankfully our risk management metric (stop loss at -7%) limited our downside a mere ten days later. Chart 7Sell Semi Equipment Stocks Since then, relative share prices have skyrocketed by 40% and we now have more confidence to re-enter our position. Today we recommend a downgrade in the S&P semi equipment index to a below benchmark allocation. This is a speculative/tactical downgrade and thus we also set a trailing stop loss near the -10% relative return mark. While bulls would buy this breakout, we are sticking our heads out and recommend selling the strength and warn that the S&P semi equipment all-time highs look more like a mania, eerily similar to the dotcom bubble era (Chart 8). Chart 8Chip Equipment Mania The contracting ISM manufacturing survey signals that relative share price momentum running at a 60%/annum clip is unwarranted and bound to return to earth (second panel, Chart 9). The same holds true for relative forward profit and revenue growth expectations, especially given the ongoing contraction in global semi sales (third & bottom panels, Chart 9). This deficient demand for semis and therefore semi equipment manufacturers is also apparent in deflating DRAM prices, our industry pricing power proxy. Historically, relative profit expectations and pricing power have moved in lockstep and the current message is to fade sell-side analysts’ buoyancy. Net earnings revisions have slingshot from extreme pessimism to extreme optimism during the past quarter and are vulnerable to disappointment (Chart 10). Chart 9To The Moon… Chart 10…And Back? Not only is the relative share price momentum running at the fastest clip in 19 years, but our proprietary Technical Indicator is also signaling that it is a good time to shun away from these hyper-cyclical tech stocks. The last three times our TI spiked to over one standard deviation above the historical mean, relative share prices corrected on average by 36% in the ensuing 12-18 months (Chart 11). While we are confident to downgrade this index to underweight, there is a risk to our bearish view. Were the U.S. dollar to depreciate definitively from current levels, then it would reflate the global economy and put this position offside. In fact, there are some green shoots in the emerging markets that are appearing, but in order for them to blossom further and not get nipped in the bud the trade-weighted U.S. dollar has to fall (Chart 12). Chart 11Time To Be Contrarian In sum, lack of profit growth, deficient industry demand, perky valuations and extremely overbought conditions all suggest that the time is ripe for an underweight stance in the S&P chip equipment index. Chart 12Risk To View: U.S. Dollar The Global Reflator Bottom Line: Downgrade the S&P semi equipment index to underweight, today with a stop loss at the -10% relative return mark. The ticker symbols for the stocks in this index are: BLBG – S5SEEQ – AMAT, LRCX, KLAC. Is Semi Euphoria Warranted? Similar to the broad tech space and the S&P semiconductor equipment subgroup, semi producers are also showing signs of excess. Chart 13 shows that relative forward EPS are in a clear and steep downtrend with no end in sight, whereas relative share prices are near post GFC highs, pushing the semi forward P/E on a par with the SPX. While the relative margin squeeze in chip stocks has been a whopping 5%, semi forward margins are still projected to outpace overall market by an impressive 15% (bottom panel, Chart 13). Trailing semiconductor earnings are contracting and our newly created top-down chip profit growth model is sputtering, warning that more earnings pain lies ahead (semi pricing power, global exports and the greenback comprise our proprietary S&P semiconductors earnings model, Chart 14). While chip earnings season has been a mixed bag with INTC on the bullish side and TXN on the bearish camp, TXN’s CFO commentary really grabbed our attention musing that: “When there are tensions in trade and obstacles to trade, what do businesses do? They become more cautious. And they pull back. And we are at the very end of a long supply chain. And when the ones at the very front pull back, it becomes a traffic jam” (emphasis ours). Chart 13Falling Profits Should Exert Downward Pull On Stocks Chart 14BCA Chip Profit Growth Model Is Bearish Our global semi sales-to-inventories ratio is still contracting also warning that the path of least resistance is lower for chip profits (Chart 15). In other words, the inventory liquidation phase has just began and steep price concessions to rebalance the markets will continue to weigh on the sector’s profit prospects. With regard to chip final-demand, while 5G euphoria has gripped the sector, our proprietary global auto sales proxy and global capex indicator (using the IFO’s World Economic Survey dataset) underscore that the global chip down cycle is far from over (Chart 16). Chart 15Semi Down Cycle … Chart 16… Is Far… Netting it all out, the chip down cycle is ongoing and leading global semi sales indicators remain downbeat. Other macro variables confirm that semi end-demand remains feeble. The global manufacturing PMI is waning and our diffusion index is probing multi-year lows. Our in-house calculated Global ZEW survey is also heralding additional global semi sales weakness in the coming months as it is hovering near levels last hit during the Great Recession (middle panel, Chart 17). Chinese electronics imports remain in contractionary territory (bottom panel, Chart 17) and U.S. new orders for computers & electronic products are on the verge of contraction (not shown). Despite this souring backdrop, investors have given the semi industry the benefit of the doubt and are anticipating a swift final-demand recovery. Our indicators suggest otherwise, and we expect relative share prices to converge lower to still contracting relative profit and revenue estimates (Chart 18). Chart 17…From Over… Chart 18…But Investors Are Mesmerized Netting it all out, the chip down cycle is ongoing and leading global semi sales indicators remain downbeat. Moreover, our semi profit growth model is waving a yellow flag, compelling us to put the S&P semiconductors index on downgrade alert. Bottom Line: Stay on the sidelines in the S&P semiconductors index for now, remove the upgrade alert and put it on downgrade watch. Stay tuned. The ticker symbols for the stocks in this index are: BLBG – S5SECO – INTC, TXN, ADI, AMD, MXIM, XLNX, MCHP, NVDA, AVGO, QCOM, MU, SWKS, QRVO.   Anastasios Avgeriou U.S. Equity Strategist anastasios@bcaresearch.com     Footnotes 1.              Please see BCA U.S. Equity Strategy Report, “Resilient” dated May 14, 2018, available at uses.bcaresearch.com. 2.             https://www.wsj.com/articles/wave-of-financial-stress-hits-low-rated-companies-11571736606 Current Recommendations Current Trades Size And Style Views Stay neutral cyclicals over defensives (downgrade alert) Favor value over growth Favor large over small caps (Stop 10%)

Special Report

Highlights In this report, we build and present models designed to predict the odds of Chinese investable equity sector outperformance, based on a set of macroeconomic and equity market factors. BCA Research's China Investment Strategy service will aim to use our newly developed sector outperformance probability models to help investors to better understand the drivers of performance at any given moment, and to make more active equity sector recommendations in the future. Among the top six factors explaining historical periods of sector performance, three were macroeconomic in orientation, and two were directly related to the broad Chinese equity market. We see this as strongly supportive of the potential returns to be earned from active top-down sector rotation within China’s investable market. Cyclical stocks are very depressed relative to defensives, and we would favor them versus defensives over the coming year if China strikes a trade deal with the US and the Chinese economy incrementally improves, as we expect. Feature In our June 19 Special Report, we reviewed the predictability and cyclicality of equity sector earnings in China's investable & domestic markets, and examined the relevance of earnings in predicting relative sector performance over the past decade. We noted that a few sectors scored highly in terms of earnings predictability and the relevance of those earnings in predicting relative performance. But we also highlighted that most of China's equity sectors, in both the investable and domestic markets, either demonstrated earnings trends that were difficult to predict based on the trend in overall market earnings or exhibited relative performance that was difficult to explain based on the relative earnings profile. Our models are designed to predict equity sector relative performance using a series of macroeconomic and equity market factors. In short, our June report underscored that China’s equity sectors warranted a closer examination, with a particular emphasis on understanding the specific macroeconomic or equity market factors that have historically predicted relative sector performance. Today’s report examines this question in depth, focused on China’s investable equity market. We hope to extend our research to the A-share market in the near future. Our approach focuses on constructing and presenting models that quantify a checklist-based approach to determining the odds of equity sector performance. The aim is to use these models to better understand the drivers of performance at any given moment, and to make more active equity sector recommendations in the future. These recommendations will not mechanically follow the models; rather, we plan to use them as a stand in for what typically would be expected given the macro and financial market environment, and as a basis to investigate “abnormal” relative performance. We conclude by highlighting the substantial underperformance of cyclical vs defensives sectors over the past two years, and argue that it is highly unlikely that cyclicals will underperform defensives over the coming 12 months if China strikes a trade deal with the US and the economy incrementally improves, as we expect. We also explain the importance of monitoring the relative performance of health care & utilities stocks over the coming few months, and present a unique sector-based barometer for gauging China’s reflationary stance. The latter two relative performance trends are likely to assist investors in positioning for the big call: the outperformance of Chinese investable stocks vs the global benchmark. Detailing Our Approach In our effort to better understand historical periods of sector outperformance, we have chosen to model the probability of outperformance of each level 1 GICS sector (plus banks) based on a set of macro and equity market variables. Specifically, we use an analytical tool called a logistic regression, which forecasts the probability of a discrete event rather than forecasting the value of a dependent variable. We utilized this approach when building our earnings recession model for China (first presented in our January 16 Special Report1), and investors will often see it (in its conceptually different but practically similar probit form) employed when analyzing the likelihood of an economic recession. The New York Fed’s US recession model is a notable example of the latter,2 which has received much attention by market participants over the past year following the inversion of the US yield curve. The “events” that we modeled are historical periods of individual Chinese investable sector outperformance from 2010 to 2018, relative to the MSCI China index (the “broad market”). Charts I-1A and I-1B illustrate these periods with shading in each panel. We then attempt to explain these episodes of outperformance with the following macro predictors: Chart I-1AThis Report Builds Models Aimed At... Chart I-1B...Predicting The Shaded Regions Of These Charts Periods of accelerating economic activity, represented by our BCA's China Activity Index Periods of rising leading indicators of economic activity, represented by our BCA Li Keqiang Leading Indicator Episodes of tight monetary policy, defined as periods where China’s 3-month interbank repo rate is rising Periods of accelerating inflation, measured both by headline and core inflation We also include several equity market variables: uptrends in relative sector earnings, periods of rising broad market stock prices, uptrends in broad market earnings, and episodes of extreme technical conditions and relative over/undervaluation for the sector in question. In the case of energy stocks, we also include oil prices as a predictor. Charts I-2A and I-2B illustrate these periods as well as the macro & market variables that we have included as predictors. Chart I-2AWe Use These Macroeconomic And Equity Market Factors... Chart I-2B...To Predict Periods Of Equity Sector Outperformance Our approach also accounts for the existence of any leading or lagging relationships between the macro and market variables we have used as predictors and sector relative performance. In most cases the predictors lead relative sector performance, but in some cases it is the opposite. In the case of the latter, we have limited the lead of any variable in our models to 3 months in order to reduce the need to forecast. The link between tight monetary policy and industrial sector performance is one exception to this rule that we detail below. Finally, our approach also limits the extent to which we consider a leading relationship between our predictors and relative sector performance, in order to avoid picking up overlapping economic cycles. This issue, and the evidence supporting the existence of a 3½-year credit cycle in China, are detailed in Box 1. Box 1 Accounting For China’s 3½-Year Credit Cycle Over the course of the analysis detailed in this report, judgments concerning how much of a lead or lag to allow when accounting for any leading or lagging relationships between sector relative performance and either macroeconomic & stock market predictors were necessary. In cases where sector relative performance led any of our predictors, we capped the lead at 3-months to reduce the need to forecast the predictors when using the models. As explained below, the 8-month lead between industrial sector relative performance and tight monetary policy was the only exception to this rule. We also did not include any leading relationship between relative sector stock performance and the trend in relative sector EPS, and allowed at most a co-incident relationship. Limits were also required in the cases where our predictors led relative sector performance. While more lead time is usually better from the perspective of investment strategy, Chart I-B1 presents strong evidence of a 3½ -year credit cycle in China. Chart I-B2 illustrates the problem with including significant lags between predictors and relative sector performance when economic cycles are short. The chart shows the lead/lag correlation profile of the stylized cycle shown in Chart I-B1, and highlights that lags greater than 12-14 months risk picking up the impact of the previous economic cycle. Given this, we have limited the extent to which our predictors can lead relative sector performance in our models, and in practice lead times are generally less than one year. Chart I-B1Over The Past Decade, China Has Experienced A 3½-Year Credit Cycle Chart I-B2With Short Cycles, Excessive Lags Risk Picking Up The Previous Cycle The Key Drivers Of Chinese Investable Equity Sectors Pages 12-23 present the results of each sector’s outperformance probability model, along with a list of factors that were found to be useful predictors and a summary of the results. The importance of the factors included in the models is shown in each of the tables at the top right of pages 12-23 by a score of 1-3 stars, (loosely representing key levels of statistical significance) as well as each factor’s optimal lead or lag. A minus sign shows that the predictor leads sector relative performance, whereas a plus sign shows that it lags. Rising core inflation in China is the most important signal of sector performance that emerged from our analysis. Chart I-3China’s Sectors Linked Strongly To Core Inflation, Monetary Policy, And Growth Chart I-3 summarizes the significance of the factors in predicting sector performance in general, by summing up each predictor’s number of stars across all of the models. The chart shows that rising core inflation in China is the most important signal of sector performance that emerged from our analysis, followed by tight monetary policy, rising economic activity, rising broad market stock prices, oversold technical conditions, and rising broad market earnings. Chart I-3 highlights two important points: If regarded through the lens of causality alone, the strong relationship between rising core inflation and sector performance is somewhat surprising: normally, pricing power is subordinate to revenue/sales/demand as the primary factor driving fundamental performance. However, given that inflation is a lagging economic variable, we suspect that the significance of inflation in our models actually reflects the middle phase of the economic cycle in which sectors tend to best exhibit meaningful out/underperformance. It is also a stronger predictor of periods of tight monetary policy in China than headline inflation.3 This is an encouraging result for investors, as it suggests good odds that future episodes of meaningful sector outperformance can be identified given a particular macro view. Among the top six factors explaining historical periods of sector performance, three were macroeconomic in orientation, and two were directly related to the broad Chinese equity market. While Chinese equity sector performance can sometimes be idiosyncratic, we see this as strongly supportive of the idea that investors can earn positive excess returns by actively shifting between China’s equity sectors using a top-down approach. Turning to the specific results of our sector models, we present the following big-picture findings of our research: Defining China’s Cyclical & Defensive Sectors From a top-down perspective, the most important element of sector rotation typically involves shifting from defensive to cyclical stocks when economic activity is set to improve (and vice versa). In China, it is clear from the results of our models that the investable energy, materials, industrials, consumer discretionary, and information technology sectors are cyclical sectors. The relative performance of these sectors exhibits a positive relationship to pro-cyclical macro variables, or broad market trends. Following last year’s GICS changes, we also include the media & entertainment industry group (within the new communication services sector) in this list. Correspondingly, investable consumer staples, health care, financials, telecom services, utilities, and real estate are defensive sectors in China. Chart I-4Cyclical Stocks Are Bombed Out Versus Defensives Chart I-4 illustrates how these sectors have performed over the past decade by grouping them into equally-weighted cyclical and defensive stock price indexes, as well as the relative performance of cyclicals versus defensives. The chart makes it clear that cyclical stock performance is essentially as weak as it has ever been relative to defensives over the past decade, with the exception of a brief period in 2013. Panel 2 highlights that all of the underperformance of cyclicals over the past two years has been due to de-rating, rather than due to underperforming earnings. The Atypical Case Of Financials & Real Estate The fact that financial and real estate stocks are defensive in China is somewhat curious. In the case of financials, the abnormality is straightforward: most global equity portfolio managers would consider financials to be cyclical, and our work suggests that this is not true for the investable market. Our explanation for this apparent discrepancy is also straightforward: while small and medium banks in China have obviously grown in prominence over the past decade, large state-owned or state-affiliated commercial banks are still dominant in the provision of credit to China's old economy. In most cases China’s large banks lend to state-owned enterprises with implicit government guarantees, meaning that the earnings risk for Chinese banks has typically been lower than for the investable market in the aggregate. It remains to be seen whether this will remain true in a world where Chinese policymakers are keen to slow the pace at which China’s macro leverage ratio rises and to render the existing stock of debt more sustainable for the non-financial sector. Indeed, over a multi-year time horizon, the risk are not trivial that banks will be forced to recapitalize as a result of forced changes to loan terms (eg: significant increases in the amortization period of existing loans) or the recognition of sizeable loan losses, which would clearly increase the cyclicality of the Chinese investable financial sector. Chart I-5A Seeming Contradiction: Real Estate Is High-Beta, But Defensive On the real estate front, the anomaly is not that real estate stocks respond defensively to macroeconomic and stock market variables, it is that real estate stock prices are considerably more volatile than this defensive characterization would suggest. Globally (and especially in the US), real estate stocks are often viewed as bond proxies and thus are typically low-beta, but Chart I-5 shows that this is not the case in China. In our view, this issue is reconciled by the fact that Chinese investable real estate stocks are also highly positively linked to Chinese house price appreciation, with relative performance typically leading a pickup in house prices by up to 1 year. This strongly leading relationship has meant that real estate stocks have often outperformed the broad market as economic activity is slowing, in anticipation that policy easing will lead to an eventual recovery in house prices. Chart I-6Still Following The Defensive Playbook This Year In effect, investable real estate stocks are a high-beta sector that have acted counter-cyclically due to the historical interplay between economic activity, monetary policy, and the housing market. Real estate performance this year has not deviated from this playbook (Chart I-6), and so for now we are content to include real estate stocks in our defensive index. But similar to the case of financials, we can conceive of scenarios in which ongoing Chinese financial sector reform may change this relationship in the future. The Unique Monetary Policy Sensitivity Of Industrials And Consumer Staples Pages 14 and 16 highlight that industrials and consumer staples stocks have typically been sensitive to periods of tight monetary policy. In the case of industrials the relationship is negative, whereas consumer staples relative performance has been positively linked to these periods. In both cases, relative performance has led periods of tight monetary policy, significantly so in the case of industrials (by an average of 8 months). While the relative performance of banks, tech, and real estate stocks have also been linked to periods of tight monetary policy, industrials and consumer staples are the only sectors that have tended to lead these periods. Chart I-7Diverging Corporate Health Explains Industrials/Staples Monetary Policy Sensitivity This is a revelatory finding, and in our view it is explained by divergences in corporate health and leverage for the two sectors. We reviewed Chinese corporate health in our August 28 Special Report,4 and noted that the food & beverage sub-industry was a clear (positive) outlier based on our corporate health monitors. In particular, Chart I-7 highlights that food & beverage corporate health is markedly better than that for machinery companies or for industrial firms in general, supporting the notion that high (low) leverage is impacting the relative performance of industrials (consumer staples). The Leading Nature Of Health Care & Utilities Health care and utilities exhibit similar key drivers of relative performance: in both cases, periods of rising economic activity, rising core inflation, and rising broad market stock prices are all negatively associated with performance. Health care and utilities relative performance also happens to lead all three of those predictors, by 1-3 months on average depending on the variable in question. Our modeling work highlights that these are the only sectors whose relative performance has led multiple factors, suggesting that health care & utilities stocks are particularly interesting market bellwethers to monitor. Core Inflation Matters More Than Headline, Except For Energy & Real Estate As highlighted in Chart I-3, rising core inflation has been a much more important signal about relative sector performance than headline inflation. Chart I-8In China, Food Prices (Not Energy) Account For Headline/Core Differences The two exceptions to this rule relate to the energy and real estate sectors, with the former positively linked to headline inflation and the latter negatively linked. In both cases, we suspect that the relationship is a behavioral rather than a fundamental one. For energy, while rising headline inflation in developed countries is usually associated with rising energy prices, this is not true in the case of China. Chart I-8 highlights that differences between headline and core inflation over the past decade have almost always been driven by rising food prices. This implies that some investors (incorrectly) view energy stocks as a hedge against increases in consumer prices, even if those increases are not driven by rising fuel costs. In the case of real estate, investor expectations of eroding real disposable income and its impact on the housing market are likely the best explanation for the negative link between real estate relative performance and rising headline inflation. Whereas rising core inflation likely reflects a durable improvement in economic momentum (and thus would be positively correlated with income growth), episodes of rising Chinese headline inflation often reflect supply shocks that investors may perceive to be detrimental to household spending power (and thus expected housing demand). Investment Conclusions Our work aimed at explaining historical periods of Chinese investable sector outperformance has three investment implications in the current environment. Cyclicals will probably outperform defensives over the coming year if China strikes a trade deal with the US and the Chinese economy incrementally improves, as we expect. First, within China’s investable market, Chart I-4 illustrated that cyclical stocks are very depressed relative to defensives. Given our view that Chinese investable stocks are likely to outperform their global peers over a 6-12 month time horizon, we would also favor cyclicals to defensives over that period. For investors who are not yet overweight cyclical stocks in China, we would advise waiting for concrete signs that growth has bottomed (which should emerge sometime in Q1) before putting on a long position as we remain tactically neutral towards Chinese versus global stocks. But the key point is that it is highly unlikely that cyclicals will underperform defensives over the coming year if China strikes a trade deal with the US and the Chinese economy incrementally improves, as we expect. Second, the fact that investable health care and utilities stocks have particularly leading properties suggests that they should be monitored closely over the coming few months. A technical breakdown in the relative performance of these sectors would be an important sign that market participants are anticipating a bottoming in China’s economy, which may give investors a green light to position for a bullish cyclical stance. For now, both of these sectors continue to outperform (Chart I-9), supporting our decision to remain tactically neutral towards Chinese stocks. Third, the heightened negative sensitivity of industrials and positive sensitivity of consumer staples to monetary policy suggests that the relative performance trend between the two sectors may serve as a reflationary barometer for China’s economy. Chart I-10 shows that industrials outperformed staples last year once the PBOC shifted into easing mode, and anticipated the recovery in the pace of credit growth. However, industrials soon began to underperform staples, which also seems to have anticipated the fact that the recovery in credit was set to be less powerful than what has occurred during previous cycles. The fact that the relative performance trend is off its recent low is notable, and may suggest that China’s existing reflationary stance will be sufficient to stabilize economic activity if a trade deal with the US is indeed finalized in the near future. Chart I-9Key Defensive Sectors Are Still Outperforming, Supporting Our Neutral Tactical Stance Chart I-10Industrials Vs. Staples Anticipated That Easing Would Only Be Measured As a final point, BCA Research's China Investment Strategy service will aim to use our newly developed sector outperformance probability models to make more active equity sector recommendations in the future. These recommendations will not mechanically follow the models; rather, we plan to use the models as a stand in for what typically would be expected given the macro and financial market environment, and as a basis to investigate “abnormal” relative performance. We hope you will find these models to be a helpful quantification of the risk versus return prospects of allocating among China’s investable sectors. As always, we welcome any feedback that you may have about our approach.   Energy Chart II-1 Table II-1   Unsurprisingly, our energy sector model highlights that periods of energy outperformance are strongly linked to periods of rising crude oil prices. However, what is surprising is that periods of accelerating headline inflation in China are even more closely linked to periods of energy sector outperformance than episodes of rising oil prices, and that these periods of accelerating inflation are not generally caused by rising energy prices. The lack of a clear economic rationale for this relationship implies that some investors (incorrectly) view energy stocks as a hedge against increases in consumer prices, even if those increases are largely driven by rising food prices. The model also highlights that periods of strong undervaluation have historically been significant in predicting future energy sector outperformance, with a lag of roughly 8 months. The probability of energy sector outperformance has fallen sharply according to our model, but for now we continue to recommend a long absolute energy sector position on a 6-12 month time horizon. BCA’s Commodity & Energy Strategy service expects oil prices to trade at $70/barrel on average next year,5 Chinese headline inflation continues to rise, and we noted in our October 2 Weekly Report that energy stocks are heavily discounted.6 Barring a durable decline in oil prices below $55/barrel, investors should continue to favor China’s energy sector. Materials Chart II-2 Table II-2 Our model highlights that the materials sector is one of the clearest plays on accelerating industrial activity within the investable universe. Among the macro variables that we tested, periods of investable materials outperformance are strongly positively linked with periods when our BCA Activity Index and our leading indicator for the index have been rising. Periods of materials sector outperformance have also been positively correlated with prior periods of oversold technical conditions and rising broad market stock prices, underscoring that materials are a strongly pro-cyclical sector. We currently maintain no active relative sector trades, but our model suggests that investors should be underweight the investable materials sector relative to the broad investable index. Industrials Chart II-3 Table II-3 Periods of industrial sector outperformance have historically been positively correlated with relative industrial sector earnings, broad market stock prices, and prior oversold technical conditions. They have been negatively correlated with periods of tight monetary policy, rising core inflation, and prior overbought technical conditions. Since 2010, periods of industrial sector performance have led periods of tight monetary policy by 8 months, the longest lead of relative equity performance to any macro variable that we tested in our model (and the longest lead that we allowed). Industrial sector performance has also been strongly negatively linked with periods of rising core inflation. These findings, and the fact that our Activity Index and its leading indicator have not been highly successful at predicting periods of industrial sector outperformance, strongly suggest that industrials, while pro-cyclical, are primarily driven by expectations of easy monetary policy. We noted in an August 2018 Special Report that state-owned enterprises have become substantially leveraged over the past decade,7 and in a more recent report we highlighted that industries such as machinery have experienced a significant deterioration in corporate health over the past decade.8 This helps explain why industrial sector performance is so negatively impacted by tight policy. Our model suggests that the best time to be overweight industrial stocks is the early phase of an economic rebound, when Chinese stock prices are rising but market participants are not yet expecting tighter policy. These conditions may present themselves sometime in Q1, but probably not over the coming 0-3 months. Consumer Discretionary Ex-Internet & Direct Marketing Retail Chart II-4 Table II-4 Besides materials, China’s investable consumer discretionary sector has historically been the most positively associated with coincident and leading measures of industrial activity. Rising core inflation is also highly positively related to consumer discretionary outperformance, which may reflect improved pricing power for the sector. The strong link with industrial activity is in contrast to depictions of China’s consumer sector as being less correlated to money & credit trends than the overall economy, and is supportive of our view that industrial activity forms one of the three pillars of China’s business cycle.9 We ended the estimation period of our model as of December 2018, in order to avoid including the distortive effects of last year’s changes to the global industry classification standard (which resulted in Alibaba’s inclusion and overwhelming representation in the investable consumer discretionary sector). As such, the results of our model apply today to consumer discretionary stocks ex-internet & direct marketing retail. For now, the absence of an uptrend in our Activity Index and in core inflation is signaling underperformance of discretionary stocks outside of internet & direct marketing retail. Outperformance this year largely reflects a significant advance in consumer durable and apparel: by contrast, automobiles & components have underperformed the broad market by roughly 14% year-to-date. Consumer Staples Chart II-5 Table II-5 Historically, periods of consumer staples outperformance have been predicted by a falling Activity Index, periods of tight monetary policy, and over/undervalued conditions. The impact of monetary policy is particularly heavy in the model, suggesting that consumer staples are somewhat the mirror image of industrials in terms of the impact of leverage on relative equity performance. This too is supported by our August 28 Special Report,10 which noted that corporate health for the food & beverage sector was the strongest among the sectors we examined. However, the model failed to capture what has been very significant staples outperformance this year, highlighting the occasional limits of a rule-of-thumb approach to sector allocation. Investable consumer staples are reliably low-beta compared with the broad market, and we are not surprised that investors have strongly favored the sector this year amid enormous economic and policy uncertainty. An eventual improvement in economic activity, coupled with fairly rich valuation, should work against consumer staples stocks sometime in the first quarter of 2020. Investors who are positioned in favor of China-related assets should also be watching closely for any signs of a technical breakdown in the relative performance trend of investable staples. Health Care Chart II-6 Table II-6 Among the macro variables tested in our model, periods of health care outperformance are negatively related to coincident and leading measures of industrial activity and strongly negatively related to rising core inflation.  Health care outperformance is also strongly negatively related to periods of rising broad market stock prices, and positively related to prior oversold technical conditions. These results clearly signify that investable health care is a defensive sector, to be owned when the economy is slowing and when investable stocks in general are trending lower. Our model suggests that health care stocks are likely to continue to outperform, as they have been since the beginning of the year. A substantive US/China trade deal that meaningfully reduces economic uncertainty remains the key risk to health care outperformance over a 6- to 12-month time horizon. Financials Chart II-7 Table II-7 Our model highlights that periods of financial sector outperformance over the past decade have been negatively associated with periods of rising core inflation (a strong relationship), and with periods of rising index earnings. Oversold technical conditions have also helped explain future episodes of financial sector outperformance. The link between core inflation and the outperformance of financials appears to represent a behavioral rather than a fundamental relationship. When modeling periods of rising financial sector relative earnings, the trend in broad market EPS is more predictive than that of core inflation, highlighting that the latter’s explanatory power is due to investor behavior. The results of our model, and the fact that core inflation leads Chinese index earnings, suggests that financials are fundamentally counter-cyclical and that investors see rising Chinese core inflation as confirmation that an economic expansion is underway (and that broad market earnings are likely to rise). Our model is currently predicting financial sector outperformance, but investable financials have modestly underperformed since the beginning of the year. This appears to have been caused by the underperformance of financial sector earnings this year as overall index earnings growth has decelerated, contrary to what history would suggest. We suspect that the ongoing shadow banking crackdown is related to financial sector earnings underperformance, and we would advise against an overweight stance towards investable financials until signs of improving relative earnings emerge. Banks Chart II-8 Table II-8 Our model shows that periods of banking sector outperformance are more linked to macro variables than has been the case for the overall financial sector. Specifically, bank performance is negatively correlated with leading indicators of economic activity and rising core inflation, and especially negatively correlated with periods of tight monetary policy. Banks have also typically outperformed following periods of oversold technical conditions. Similar to financials, bank earnings are typically counter-cyclical, but relative bank earnings have not been good predictors of relative bank performance over the past decade. Still, the negative association of relative stock prices with leading economic indicators, rising core inflation and rising interest rates underscores that investors should normally be underweight banks if they expect overall Chinese stock prices to rise. Also similar to the overall financial sector, our model is currently predicting outperformance for bank stocks, but investable banks have underperformed year-to-date. The shadow banking crackdown is also likely impacting investable bank earnings, leading to a similar recommendation to avoid bank stocks until relative earnings look to be trending higher. “Tech+”   Chart II-9 Table II-9 Our technology model has worked well at predicting periods of tech sector outperformance over the past several years, particularly from 2015 – 2017. The model suggests that, in addition to being negatively related to prior overbought conditions, periods of technology sector outperformance are associated with improving growth conditions, easy monetary policy, and rising prices. In other words, tech stocks are a growth & liquidity play. Owing to last year’s changes to the GICS, the results of our model apply today to Chinese investable internet & direct marketing retail, the media & entertainment industry group (within the new communication services sector), and the now considerably smaller information technology sector (the sum of which could be considered the “tech+” sector). The model has been predicting tech sector outperformance since May (in response to easier monetary policy), which has occurred for the official information technology sector. However, the BAT (Baidu, Alibaba, and Tencent) stocks are only up fractionally in relative terms from their late-May low. Our expectation that China’s economy is likely to bottom in Q1 means that we may recommend upgrading “tech+” stocks relative to the investable benchmark in the coming months. Telecom Services Chart II-10 Table II-10 Our model for telecommunication services (now a level 2 industry group within the communication services sector) illustrates that telecom stocks have historically been counter-cyclical. Periods of telecom outperformance have been negatively associated with periods of rising core inflation, rising broad market stock prices, and rising broad market EPS. It is notable that telecom services stocks are driven more by cycles in overall stock prices than by cycles in economic activity. This suggests that investors tend to focus on the fact that telecom stocks are reliably low-beta compared with the overall investable market, causing out(under)performance of telecoms when the broad market is falling(rising). Similar to financials & banks, telecom stocks have not outperformed this year, in contrast to what our model would suggest. Earnings also appear to be the culprit, with the level of 12-month trailing earnings having fallen nearly 10% since the summer. China Mobile accounts for a sizeable portion of the telecom services index, and the company’s recent earnings weakness seems to be due to depreciation charges stemming from forced investment on 5G spending (mandated by the Chinese government). Our sense is that this will have only a temporary effect on telecom services EPS, meaning that investors should continue to expect the sector to behave in a counter-cyclical fashion over the coming year. Utilities Chart II-11 Table II-11 The early performance of our utilities model was mixed, as it generated several false sell signals during the 2011 – 2013 period despite recommending, on average, an overweight stance. However, over the past five years, the model has performed extremely well in terms of explaining periods of relative utilities performance. The model highlights that utilities are straightforwardly counter-cyclical. The relative performance of utilities stocks is positively related to its relative earnings trend, and negatively related to economic activity, rising core inflation, and broad market stock prices.  Consistent with a decline in the overall MSCI China index, the model has correctly predicted utilities outperformance this year. We expect utilities to underperform over a 6-12 month time horizon, but would advise against an aggressive underweight position until hard evidence of a bottom in Chinese economic activity emerges. Real Estate Chart II-12 Table II-12 Our model for the relative performance of investable real estate has been among the most successful of those detailed in this report, which is somewhat surprising given the macro factors that the model shows drive real estate performance. While periods of relative real estate performance are modestly (negatively) associated with periods of tight monetary policy, rising headline inflation is the most important macro predictor of real estate underperformance. Among market factors driving performance, real estate stocks reliably underperform when broad market EPS are trending higher, and they historically outperform for a time after becoming relatively undervalued. Real estate relative performance is also strongly linked to periods of rising house prices, but the former tends to significantly lead the latter. Given that core inflation has better predicted episodes of tight monetary policy than headline inflation, investor expectations of eroding real disposable income is likely the best explanation for the negative link between real estate relative performance and rising headline inflation. Whereas rising core inflation likely reflects a durable improvement in economic momentum (and thus would be positively correlated with income growth), episodes of rising Chinese headline inflation often reflect supply shocks that investors may perceive to be detrimental to household spending power (and thus expected housing demand). Beyond the negative link between higher inflation and interest rates on investable real estate performance, the strong negative association with broad market earnings underscores that investors treat real estate as a defensive sector. We thus expect real estate stocks to continue to outperform in the near term, but underperform over a 6-12 month time horizon.   Jonathan LaBerge, CFA Vice President jonathanl@bcaresearch.com   Footnotes 1. Please see China Investment Strategy, "Six Questions About Chinese Stocks," dated January 16, 2019. 2. Please see Federal Reserve Bank of New York, The Yield Curve as a Leading Indicator at https://www.newyorkfed.org/research/capital_markets/ycfaq.html 3. This is despite frequent concerns among investors that the PBOC is inclined to tighten in response to detrimental supply shocks. 4. Please see China Investment Strategy, "Messages From BCA’s China Industry Watch," dated August 28, 2019. 5. Please see Commodity & Energy Strategy, "Policy Uncertainty Lifts USD, Stifles Global Oil Demand Growth," dated October 17, 2019. 6. Please see China Investment Strategy, "China Macro & Market Review," dated October 2, 2019. 7. Please see China Investment Strategy, "Chinese Policymakers: Facing A Trade-Off Between Growth And Leveraging," dated August 29, 2018. 8. Please see China Investment Strategy, "Messages From BCA’s China Industry Watch," dated August 28, 2019. 9. Please see China Investment Strategy, "The Three Pillars Of China’s Economy," dated May 16, 2018. 10. Please see China Investment Strategy, "Messages From BCA’s China Industry Watch," dated August 28, 2019. Cyclical Investment Stance Equity Sector Recommendations