Equities

Highlights The Taiwanese equity market has closely tracked the global benchmark over the past few years, meaning Taiwan is particularly an “alpha” rather than a “beta” play. This means that a bullish 6-12 month outlook for Taiwanese relative performance rests on the odds of a positive “Taiwan-specific” event. In our view, the forthcoming recovery in Chinese economic activity likely qualifies as an alpha catalyst for Taiwanese stocks over the coming 6-12 months, given the strong link between export-related indicators and Taiwanese relative performance. Investors should increase exposure relative to global equities (to overweight) over a 6-12 month time horizon in US$ terms. Evidence of Taiwanese central bank intervention implies that there is limited potential for TWD appreciation versus the U.S. dollar over the coming year. Our bet is that TWD-USD will remain broadly flat. Feature BCA’s China Investment Strategy team recommended that investors upgrade Chinese stocks to overweight (both investable and domestic) in an April 12 Special Alert,1 and last week’s report provided a detailed analysis and review of the Chinese economic and financial market outlook following our upgrade.2 This week’s report briefly updates the outlook for Taiwanese stocks, and argues that investors should increase exposure relative to global equities (to overweight) over a 6-12 month time horizon in US$ terms. However, we see somewhat less upside for Taiwanese stocks than for Chinese stocks, and recommend that investors reduce exposure to neutral once Taiwan registers a 6% relative return (versus the global benchmark) over the coming year. Relative To Global Stocks, Taiwan Is An Alpha (Not A Beta) Play It is a little known fact that Taiwan’s equity market has exhibited a remarkably different relative performance profile over the past decade than it did during the prior decade. On a rolling 10-year basis, Chart 1 shows that Taiwan consistently ranked poorly relative to other equity markets until the onset of the global financial crisis. But since 2008, and especially since 2013, Taiwan’s relative performance has improved meaningfully compared with other markets, recently scoring as highly as in the 90th percentile. Chart 2 highlights that this comparative improvement in relative performance has largely occurred because Taiwan has neither significantly outperformed or underperformed the global benchmark, in contrast to the U.S., emerging markets (EM), and developed markets (DM) ex-U.S. Chart 2 shows that regional equity performance since 2008 has been a simple story of massive U.S. outperformance alongside significant EM and DM ex-U.S. underperformance. Simply by keeping up with global stocks in the aggregate, Taiwan has managed to outperform most individual equity markets over the past decade. Chart 1Over The Past Decade, Taiwan Has Ranked Highly Compared With Other Equity Markets Chart 2Since 2013, Taiwan Has Tracked Global Stocks For investors, the consequence of Taiwan closely tracking the global benchmark over the past few years is that the Taiwanese equity market is particularly an “alpha” rather than a “beta” play, implying that a bullish 6-12 month outlook for Taiwanese relative performance rests on the odds of a positive “Taiwan-specific” event. Stronger Chinese Growth: A Likely “Alpha” Catalyst In our view, the forthcoming recovery in Chinese economic activity that we discussed in last week’s report likely qualifies as an alpha catalyst for Taiwanese stocks over the coming 6-12 months. Taiwanese relative performance has already reflects some of this likely improvement, but we believe that investors stand to gain somewhat further over the coming year. Investors should increase Taiwanese equity exposure relative to global stocks (to overweight) over a 6-12 month time horizon in US$ terms. Chart 3Exports To China, 12-Month Forward EPS, And Relative Stock Prices: All Likely To Improve Chart 4Buy Taiwanese Stocks, But Book Profits After A 6% Relative Return   Chart 3 presents the cyclical case for Taiwanese stocks in a nutshell. Panels 1 & 2 show that the new export orders component of the official Taiwanese manufacturing PMI rebounded massively in March, and that it has historically coincided with both Taiwanese exports to China and the relative Taiwanese Markit manufacturing PMI (versus the JPMorgan Global Manufacturing PMI). The latter, in turn, reliably leads the growth in absolute Taiwanese forward EPS, which have fallen sharply into negative territory over the past several months (Panel 3). Taiwanese relative US$ performance has typically correlated well with accelerating absolute Taiwanese forward earnings, underscoring that a period of relative gains loom. Given the likely uptrend in Taiwanese relative performance over the coming 6-12 months, we are opening a long MSCI Taiwan Index / short MSCI All Country World Index (US$) trade today, initiated at 0.725. Chart 4 highlights that a rally to 0.77 would mark both a 6% relative return from today’s levels and would almost constitute a return back to the post-2013 high in Taiwanese relative performance (90th percentile). As such, we would recommend that investors use this point as a stop-sell for our recommendation to favor Taiwanese stocks within a global equity portfolio. What’s Next For The Taiwanese Dollar? Over the coming 6-12 months, our bet is that TWD-USD will remain broadly flat. While it is difficult to conclusively prove, three observations point to recent intervention by the Taiwanese central bank, which is likely to limit major trends in the exchange rate: Over the coming 6-12 months, our bet is that TWD-USD will remain broadly flat. Chart 5The Taiwanese Dollar Has Not Been Responding To Interest Rate Differentials TWD-USD has trended flat since the middle of last year, after having fallen from its early-2018 highs. The earlier decline reflected the risk posed to the Taiwanese economy by the U.S.-Sino trade war, but was also consistent with an ever-widening interest rate differential between Taiwan and the U.S. (Chart 5). In the face of this gap and frequent positive and negative developments concerning the trade war, TWD’s extremely stable profile is quite suspicious. Chart 6 highlights that the ability of changes in the U.S. dollar to explain changes in TWD-USD has fallen sharply over the past several months, to a multi-year low. While the U.S. dollar has never been able to strongly explain changes in TWD-USD, a sudden weakening in the relationship is consistent with increased central bank intervention. In addition, panel 2 shows that the recent decline in the predictive power of the dollar has corresponded with a sharp pickup in the growth rate of official foreign exchange reserves. Chart 7 shows that TWD-CNY has been trading over the past two years at the high end of its post-2008 range. Taiwanese exports to China are meaningfully larger than those to the U.S., which highlights that there is an incentive for Taiwanese policymakers to limit further gains. To the extent that a strong link between TWD-USD and CNY-USD exists, our bias for a flat trend in the latter suggests that a strong trend in the former is unlikely. Chart 6Over The Past Year, TWD Has Largely Been Unresponsive To Dollar Moves Chart 7The Taiwanese Dollar Is Fairly Elevated Compared To CNY   As a final point, limited potential for TWD appreciation versus the U.S. dollar also implies that a full return to the March 2018 high for Taiwanese relative US$ performance is unlikely. This underscores the importance of our stop-sell recommendation, and reinforces that we are favoring Taiwanese stocks as a cyclical catch-up play, rather than as a high-conviction, long-term buy.   Jonathan LaBerge, CFA, Vice President Special Reports jonathanl@bcaresearch.com   Footnotes 1 Please see BCA Research’s China Investment Strategy Special Alert, “Upgrade Chinese Stocks To Overweight,” published April 12, 2019. Available at cis.bcaresearch.com. 2 Please see BCA Research’s China Investment Strategy Weekly Report, “In The Wake Of An Upgrade: An Investment Strategy Post-Mortem,” published April 17, 2019. Available at cis.bcaresearch.com. Cyclical Investment Stance Equity Sector Recommendations

Overweight A number of macro factors have fallen into place that have warmed us to the S&P movies & entertainment index. Consumer confidence remains glued to multi-decade highs and there are high odds that the big gulf that has opened up between confidence and relative share prices will narrow via a rise in the latter (top panel). Moreover, a vibrant labor market with payrolls expanding at a healthy clip (second panel), the unemployment rate and unemployment insurance claims at generational lows, all signal that consumers will keep their purse strings loose, especially given rising wages (third panel). More dollars spent on recreation is synonymous with a margin expansion in the S&P movies & entertainment index (bottom panel). This consumer spending backdrop is also conducive to a rise in relative profitability, the opposite of what the sell-side currently expects. Bottom Line: We lifted the S&P movies & entertainment index to overweight on Monday; please see our Weekly Report for more details. The ticker symbols for the stocks in this index are: BLBG: S5MOVI – DIS, NFLX, VIAb.

Highlights Portfolio Strategy Disney’s recent streaming pricing disclosure and a favorable macro backdrop for recreation PCE argue that more gains are in store for the S&P movies & entertainment index. The price of credit, credit quality and credit growth along with equity buybacks all suggest that bank profits will continue to overwhelm. Recent Changes Upgrade the S&P movies & entertainment index to overweight today. Table 1   Feature Equities continued to defy gravity last week as the earnings season warmed up and did not reveal any “skeletons in the closet”. Lower interest rates single-handedly explain the recent stock market exuberance (Treasury yield shown inverted, Chart 1). In more detail, the Fed’s complete pivot has suppressed the 10-year Treasury yield and last year’s forward multiple drubbing – to the tune of a 30% drawdown – has reversed. Chart 1Lower Yield = Higher Multiple Chart 2 shows that, year-to-date, the forward multiple has done all the heavy lifting in the SPX and then some, as EPS have actually subtracted from the broad market’s return. In theory, a lower discount rate should boost the multiple and vice versa. Nevertheless, there are good odds that the 10-year Treasury yield has troughed, and BCA’s fixed income strategists continue to expect a selloff in the bond market for the rest of the year. The implication is that equities are becoming fully priced and if profits fail to pick up the baton from the multiple expansion phase, the risk/reward tradeoff is to the downside on a tactical horizon. Meanwhile, there are a number of indicators we track that are still firing warning shots for the overall equity market. Margin debt has stalled and remains 13% below the all-time peak hit last year. Historically, this has been a coincident equity market indicator and a lack of confirmation is troublesome for the overall equity market (bottom panel, Chart 3). Chart 2SPX Return Explained Chart 3M&A Lull... M&A activity has taken a step back, with the total number of deals down 25% from the 2018 zenith (top panel, Chart 3). Similar to margin debt uptake, this is a coincident indicator and the latest weak reading is cause for concern, as it signals that animal spirits are low. With regard to frail sentiment, CEO confidence has taken a beating of late on all fronts. The most recent Business Roundtable and Conference Board CEO surveys reveal that chief executives are a worried bunch. Their views on the overall economic outlook, all industries (including services manufacturing, durable and non-durable), capital outlays, employment, and revenues all remain downbeat, and likely explain the recent M&A lull (Chart 4). On the profit front, last year’s once in a lifetime equity retirement will not repeat this year, warning that artificial EPS growth will weigh on overall profit growth in 2019. Beyond this grim reading on “soft data”, select financial market leading indicators are also not corroborating the euphoric equity market. J.P. Morgan’s EM FX index has petered out recently and both EM and Chinese investable stocks (in U.S. dollar terms) remain well below their early-2018 peaks. Similarly, China-levered U.S. semi equipment stocks are a far cry from their cyclical highs set last year and suggest that some caution is still warranted in the broad equity market (Chart 5). Chart 4...Drop In CEO Confidence... Chart 5...And Financial Indicators Still Flashing Red Finally, on the profit front, last year’s once in a lifetime equity retirement will not repeat this year, warning that artificial EPS growth will weigh on overall profit growth in 2019. In addition, Charts 6A & 6B show that buybacks are already concentrated in a few sectors. Our sense is that this concentration theme will continue this year and likely center around financials as banks will flex their equity retirement muscle.   This week we delve deeper into banks and upgrade a communication services subsector. “A Kind Of Magic” Factors have fallen into place to boost the recently rejigged S&P movies & entertainment index to an above benchmark allocation today. DIS and NFLX dominate this index now comprising roughly 97% of the market cap weight and VIAb is merely the third wheel. The dust has settled from the global media industry M&A frenzy of the past two years, but the push to the cloud via online streaming services suggests that it is only a temporary break. We would not rule out another round of inter- and intra-industry M&A, as content is king once again (Chart 7). Chart 7Rejigged Recent pricing news of Disney’s streaming service, expected later this year, sent reverberations across the media space as Disney priced it at such a low point in order to grab market share and likely pave the way for future price hikes. While streaming services have been mushrooming, there is space for a number of competitors, signaling that Netflix’s global streaming domination will not come crumbling down all of a sudden. While the index’s 12-month forward EPS took a hit with the NFLX addition in October, 2018 and the forward P/E jumped to the historical mean, this niche communication services subgroup is now clearly a growth index and will continue to command a premium valuation to the broad market (bottom panel, Chart 8). From a macro perspective there are also compelling reasons to warm up to the S&P movies & entertainment index. Consumer confidence remains glued to multi-decade highs and there are high odds that the big gulf that has opened up between confidence and relative share prices will narrow via a rise in the latter (top panel, Chart 8). Moreover, a vibrant labor market with payrolls expanding at a healthy clip (top panel, Chart 9), the unemployment rate and unemployment insurance claims at generational lows, all signal that consumers will keep their purse strings loose, especially given rising wages (third panel, Chart 9). Chart 8Positive Macro... Chart 9...Drivers... Tack on the confidence consumers have in residential real estate with house prices expanding both on a year-over-year and on a shorter-term basis (second panel, Chart 9), and the ingredients are in place for an increase in consumer recreation outlays. Disney’s streaming pricing disclosure, a favorable macro backdrop on recreation PCE and sell-side analyst extreme profit pessimism argue that more gains are in store for the S&P movies & entertainment index. Lift to overweight today. One final macro variable that is also on the side of the S&P movies & entertainment index is the ISM non-manufacturing index. Historically, real outlays on recreation activities has moved in lockstep with the ISM services survey and the current message is positive for PCE on recreation (bottom panel, Chart 9). More dollars spent on recreation is synonymous with a margin expansion in the S&P movies & entertainment index (third panel, Chart 8). This consumer spending backdrop is also conducive to a rise in relative profitability, the opposite of what the sell-side currently expects (middle panel, Chart 10). Chart 10...But Analysts Are Not Buying It Not only are industry EPS slated to trail the SPX by 300bps in the coming year, but also analysts have been vigorously downgrading their EPS estimates weighing on the sector’s net earnings revisions ratio (bottom panel, Chart 10). This is contrarily positive and we would lean against such analyst pessimism. Netting it all out, Disney’s streaming pricing disclosure, a favorable macro backdrop for recreation PCE and sell-side analyst extreme profit pessimism argue that more gains are in store for the S&P movies & entertainment index. Bottom Line: Lift the S&P movies & entertainment index to overweight today. The ticker symbols for the stocks in this index are: BLBG: S5MOVI – DIS, NFLX, VIAb. Bank Update: Primed For A Re-rating By the end of last week most banks reported profits that exceeded expectations and investors breathed a sigh of relief, despite the early-December yield curve inversion and the more recent broadening of the inversion from the 5/3 all the way out to the 10/fed funds rate slope. What partially explains the sector’s EPS resilience is net interest margins (NIMs) that just entered their fifth straight year of widening. While this may seem counterintuitive given the inverted/flattening yield curve, banks are repressing depositors by not passing on higher interest rates on deposits, thus guaranteeing extremely cheap funding. The bottom panel of Chart 11 shows that the 2-year Treasury yield/1-year CD rate slope is steep and it has historically moved in lockstep with bank NIMs. As a reminder, BCA’s bond strategists expect a selloff in the bond market and remain short duration, signaling that bank NIMs will not suffer a setback for the remainder of the year. Beyond the prospects for a further increase in the price of credit, another key source of bank EPS support is equity retirement. Citi explicitly mentioned it this earnings season, and the S&P financials sector buybacks, largely driven by banks, corroborate this anecdote (Chart 12). Chart 11Deciphering Bank Profit Resilience Chart 12New Buyback Kings In fact, there is a wide gap between this artificial EPS lift and relative share prices that will likely narrow in the coming months via a catch up phase in the latter, particularly if banks pass the Fed’s stringent stress test anew as we expect later this summer. On the credit quality front, bank NPLs remain anchored near cycle lows and tight labor markets suggest that a flare up in delinquencies is a low probability event in the coming year, especially given BCA’s view of no recession (bottom panel, Chart 13). Chargeoffs and souring loans are almost non-existent in all the categories that the Federal Reserve tracks, with the slight exception of credit card loans that are ticking higher, but from an extremely low base (we provide more details below in the risk section, second & third panels, Chart 13). Finally, loan growth has held up very well despite the stock market collapse in Q4/2018 and the massive tightening in financial conditions. While our overall loans & leases and C&I loan models are decelerating, they remain squarely in expansion mode and should continue to underpin bank profitability (second and bottom panel, Chart 14). Chart 13Pristine Credit Quality Chart 14Credit Growth Rests On A Solid Foundation  Consumer confidence remains sky-high and house prices are also rising at a healthy pace, signaling that mortgage (top panel, Chart 11) and consumer loan origination will remain upbeat (third panel, Chart 14). The price of credit, credit quality, credit growth along with buybacks all suggest that bank profits will continue to overwhelm. Stay overweight the S&P banks index. All of this positive news is already reflected in banks’ return on equity that vaulted higher recently signaling that a re-rating in still-extremely depressed valuations is looming in the coming quarters (Chart 15). Nevertheless, there are two risks to our sanguine S&P banks view that we are closely monitoring. First, our Economic Impulse Indicator remains near the zero line and, coupled with the still downbeat Citi Economic Surprise Index, warn that demand for loans may start softening at the margin (top panel, Chart 16). Chart 15Follow The ROE Chart 16Two Risks To Monitor Second, while the top 100 largest commercial banks are not showing a deterioration on the credit card delinquency front, the rest of the banks are waving a red flag as delinquencies are already at recessionary levels. This explains why the overall credit card delinquency rate is ticking higher (bottom panel, Chart 16). Netting it all out, the price of credit, credit quality, credit growth along with buybacks all suggest that bank profits will continue to overwhelm. Bottom Line: Stay overweight the S&P banks index. The ticker symbols for the stocks in this index are: BLBG: S5BANKX – JPM, BAC, WFC, C, USB, PNC, BBT, STI, MTB, FITB, FRC, KEY, CFG, RF, HBAN, SIVB, CMA, ZION, PBCT.   Anastasios Avgeriou, U.S. Equity Strategist anastasios@bcaresearch.com   Current Recommendations Current Trades Size And Style Views Favor value over growth Favor large over small caps

Special Report

Highlights Actively managed U.S. equity mutual funds have been hemorrhaging assets under management (AUM), with the lost AUM flowing directly to ETFs and index mutual funds. Chatter about the adverse consequences of too much passive investing is intensifying, and BCA clients are increasingly asking if a bubble is inflating in passive investing or ETFs more generally. We view passive investing as the surest cure for passive investing and do not worry that index tracking is undermining price discovery or distorting equity markets. Temporary distortions are manna from heaven for professional investors and we would like to have more of them. Active mutual fund management may not be all it’s cracked up to be, in any event. The Active Share metric, which measures the portion of a portfolio that differs from its benchmark, has been in steady decline for the last 30 years, indicating that active management practices have undergone a sea change. We have faith in ETFs’ underlying architecture and continue to recommend investing in them. They are an efficient, inexpensive and liquid way to gain market exposure and investors need not worry about getting stuck when the music stops. Feature Dear Client, The market impact of passive investing continues to be a hot topic among investors, sell-side researchers and the financial media. To contribute our view to the discussion, we are sending you a lightly edited update of a review of passive investing’s implications first published under our Global ETF Strategy banner in September 2017. We met with clients in China last week, and will be taking some time off this week, so we will not be publishing on April 29th. We will resume publication on Monday, May 6th. Best regards, Doug Peta   Over the last few years, we have received a thin but steady stream of questions from clients asking about a potential ETF bubble. We note that ETFs do not exhibit any of the characteristics delineated by economic historian Charles Kindleberger in Manias, Panics and Crashes. There is a difference between the increasingly widespread adoption of a useful innovation and a febrile spell of mass exuberance or suspension of disbelief. We have duly expressed the view in one-on-one communications with clients that ETFs shouldn’t inspire any particular worry. The related chatter about a passive investment bubble only seems to intensify, however, and we focus on it in this Special Report. We ultimately fail to see the justification for the most extreme warnings about the dangers of passive investing. Perhaps the emergence and bursting of two bubbles in rapid succession has sparked a mini-bubble in searching for bubbles among academics, investors and reporters. We do not think that the popularity of ETFs is distorting pricing mechanisms, though we would welcome a good distortion to break up the logjam of full-but-not-extreme valuations that portend tepid intermediate- and long-term balanced portfolio returns. The Active Management Exodus The causes and consequences may be a matter of debate, but the facts are clear: actively managed U.S. equity mutual funds have been losing ground to index mutual funds for two-and-a-half decades (Chart 1). Before ETFs began to boom ahead of the crisis, active equity mutual funds still managed to attract annual net inflows despite their share losses, but they have now suffered net outflows in every one of the last 12 years. Index ETF and index mutual fund inflows have amounted to nearly 90% of the active mutual funds’ outflows, with index ETFs drawing more than twice the AUM as their mutual fund counterparts (Chart 2). Chart 2Mirror Image Given the near symmetry of active mutual fund outflows and index fund inflows, it appears that an extended active-to-passive migration is well under way. The move is rational, and has helped investors at the expense of asset managers, as index funds cost considerably less than actively managed funds. (In 2017, the asset-weighted average expense ratio for actively managed and index equity mutual funds was 0.78% and 0.09%, respectively.) If mutual fund managers tend to be wealthier than their clients, the fee savings give the economy a modest boost by shifting wealth to households with a higher marginal propensity to consume. The Spoilsport Chorus What’s not to like about lower fees for the same, or better, returns?1 Plenty, as it turns out. The myriad objections to passive investing’s increasing sway boil down to three major arguments: passive investing undermines price discovery; passive investing undermines capital allocation; and passive investing is potentially anti-competitive. Price insensitivity carries the seeds of its own demise. An index-tracking investor is a price-insensitive investor, and a surfeit of passive investment could undermine equity markets’ price-discovery function. Index-trackers are free riders, living off of the active investors whose trading decisions set prices. Just as a parasite cannot live without a host, naive passive investors need price-setters to keep them safe. The passive investing naysayers’ heads are filled with images of lemmings rushing over the edge of a cliff after active investors are routed, but we are not so sure. It’s important to remember that the price an investor pays for a security2 is the major determinant of his/her long-run return, and a price-insensitive investor is all but certain to underperform a price-aware investor over time, perhaps by a material margin. Thus the cure for passive investment is passive investment; the fewer active investors participating in the markets, the greater the prospective returns accruing to active investment. Greater prospective returns will draw an increasing proportion of assets until active management is no longer likely to outperform. Then the pendulum will swing back to index investing – lather, rinse, repeat – but skilled security analysts will have a field day while their talents are underappreciated. Passive investing’s impact on markets’ capital allocation function is indirect at best. Only primary market transactions channel capital to, or from, ideas and enterprises. Secondary market transactions merely involve exchanges of capital between incumbents and new owners, and index tracking is a secondary-market function. The sell-siders that found passive investing wanting in comparison with central planning would seem to have been trying too hard to be provocative.3 The late John Bogle may have been a bit of a scold, but we’d take him over Karl Marx any day. The notion that high concentrations of ownership among passive holders could be anti-competitive strikes us as especially strained. An article published in The Atlantic a year and a half ago bore the provocative headline, “Are Index Funds Evil?” and sub-header, “A growing chorus of experts argue that they’re strangling the economy – and must be stopped.4” The article highlighted a working paper from a team of newly-minted PhDs that argued that high common ownership in the airline industry has been associated with decreased route competition and increased fares. If the same entities hold significant stakes in all of the companies in a particular industry, those entities may have an incentive to collude to restrain competition within the industry and thereby increase the size of the pie for the industry as a whole. This may be so at the airline-industry level, but as passive owners of the entire market, Vanguard, BlackRock and State Street own considerable stakes in every other industry as well, so increasing the profitability of a single portfolio segment at the expense of other portfolio segments would seem to be self-defeating, not to mention personally risky, given stiff antitrust penalties. What Makes A Bubble? Bubbles differ in their specifics, but they share several common empirical characteristics. Kindleberger homes in on the easy availability of credit and its role in enabling the euphoria that fuels temporarily self-reinforcing, albeit ultimately unsustainable, price gains. The gains generated by the headlong pursuit of short-term capital gains are the key to keeping the bubble going, but the upward price movement is halted in its tracks when credit availability slows, and prices plunge like Wile E. Coyote once it’s cut off. Neither ingredient has been a part of the ETF boom. Index ETFs are the opposite of a get-rich-quick scheme; they’re what investors buy when they decide to stop chasing after buried treasure. The easy and inexpensive availability of credit has surely contributed to elevated equity multiples (Chart 3) and narrow bond spreads (Chart 4). The instruments ETFs hold are somewhat pricey and will be vulnerable when the next recession comes, but they are not discounting euphoric expectations that cannot realistically be met. ETF sponsors do not rely on debt; launching an ETF is such a capital-light process that the field is full to bursting with several funds that amount to unfinished experiments. Without the burden of servicing debt, sponsors are free to throw their ideas up against a wall and see what sticks. Chart 3Equity Multiples Are Elevated... Chart 4... And Spreads Are Tight ETFs are not being bought on margin in any significant degree; they are not the apple of frenzied gain-chasers’ eyes. Aside from leveraged ETFs that provide a designated multiple of daily returns, pooled investment vehicles that amalgamate the performance of several securities are the antithesis of an ideal speculative instrument. Index ETFs allow an investor to obtain benchmark returns at low cost and with a minimum of fuss, and are a sane alternative to speculation. As Benjamin Graham put it, the dumb money ceases to be dumb when it acknowledges its limitations, and index investing is an explicit acknowledgement of one’s limitations. ETF Flows Are Not Coming Out Of Thin Air To the notion that “so much money is flowing into ETFs that it’s distorting prices across the board,” we say not necessarily. If the money to buy ETFs were materializing out of thin air (as it is in Tokyo and Zurich thanks to the efforts of the BoJ and the SNB), one could argue that ETF inflows are inflating multiples and narrowing spreads. But the money to purchase U.S.-listed ETFs comes almost entirely from sales of actively managed mutual funds. ETF purchases are a reallocation of existing investment capital, not new marginal investment with the potential to move markets. Just How Active Are The “Active” Outflows? Chart 5Indexing Hasn't Hijacked Equity Correlations On the subject of changes at the margin, if the capital to purchase index ETFs comes from mutual funds that are active in name only, they simply shift cash from one passive pocket to another, and don’t amount to any change at all. The professor-investors who created the Active Share metric to measure how much a portfolio deviates from its benchmark5 describe a mutual fund industry that has steadily migrated away from stock picking. By their reckoning, the share of mutual fund assets managed by closet indexers rose from 1% in 1980 to nearly 33% in 2009.6 Using the Active Share calculator at https://activeshare.info/, we find that one-third of AUM in actively-managed U.S. equity mutual funds with AUM of at least $1 billion are held by closet-indexing mutual funds (funds with Active Share of 60% or less). Our large-fund sample suggests that two-thirds of active fund AUM is truly active. The loss of even that amount of actively managed assets does not appear to have been enough to hijack internal market dynamics. If everyone became an index tracker, and all trades were trades of the entire market, correlations at the stock and sector level would go to 1. Despite ETFs’ growing muscle, and their capture of share from stock-picking funds, correlations have not consistently risen over the 2015-17 period that has witnessed a stampede from active to indexed equity funds (Chart 5). Investment Implications We do not believe that the steadily expanding investment in passive vehicles poses a threat to markets or investors. Passive vehicles offer investors the most cost-effective way to obtain market exposure and the actively managed funds they’re exchanging for index trackers have become increasingly less active as benchmark indexes have become more prominent. If the passive trend continues, and a rising share of capital is invested without regard for distinctions between companies, the ex-ante returns to active strategies will increase and investors will return to them in droves. In the meantime, if passive investing’s share reaches the tipping point, wherever it may be, fundamentally-focused investors will feast on excess returns. Active investors will clean up if passive investing ever crosses the tipping point. We do not worry that passive investing will weigh on the economy by hindering the efficient allocation of capital to the ideas with the most merit. Index tracking is confined to the secondary markets and will not consign the U.S. economy to a Soviet fate. We view the suggestion that index tracking may lead to collusion among operating companies as unfounded conjecture. Investors need not worry that ETFs are in a bubble, or that investing in passive strategies will be a drag on economic output.   Doug Peta, CFA Chief U.S. Investment Strategist dougp@bcaresearch.com   Footnotes 1 In a typical year, a majority of mutual funds underperform their benchmarks. 2 Price is defined as starting real yield for bonds, and cyclically-adjusted P/E for equities. 3 “The Silent Road to Serfdom: Why Passive Investing Is Worse Than Marxism,” August 23, 2016, Sanford C. Bernstein & Co., LLC. 4    Partnoy, Frank, “Are Index Funds Evil?” The Atlantic, September 2017. 5 Cremers, K.J. Martijn and Petajisto, Antti. “How Active Is Your Fund Manager? A New Measure That Predicts Performance,” Review of Financial Studies, September 2009. 6 Petajisto, Antti. “Active Share and Mutual Fund Performance,” Financial Analysts Journal, July/August 2013.

Highlights Chinese credit origination surpassed expectations in March. Credit growth is now clearly trending higher, and the latest data suggest that economic activity is rebounding. This bodes well for global growth. The conventional wisdom is that China’s releveraging efforts represent “short-term gain for long-term pain.” We disagree. For the most part, Chinese releveraging is inevitable, desirable, and sustainable. Credit growth is inevitable because rising debt is necessary for transforming the country’s copious savings into fixed-asset investment. It is desirable for ensuring that GDP growth stays close to trend. It is broadly sustainable because the interest rate at which the government and much of the private sector are able to borrow is well below the economy’s growth rate. In fact, under a plausible set of assumptions, faster credit growth in China could lead to a lower debt-to-GDP ratio. Stronger global growth later this year should weaken the U.S. dollar. We are closing our long DXY trade for a carry-adjusted gain of 16.4% and exiting our long USD/CNY trade for a loss of 3.1%. We are also taking profits on our short AUD/CAD, short EUR/CAD, and short EUR/RUB trades of 1.6%, 3.9%, and 8.6%, respectively, and initiating two new currency trades: short USD/RUB and long EUR/JPY. The combination of a weaker dollar and faster Chinese growth should benefit EM and European stocks. Gold hit our limit buy order of $1275/ounce and we are now long the yellow metal. Feature A Blockbuster Month For Chinese Credit Growth After turning cautious for about six months, we moved back to being bullish on global equities in late December. We also sold our put on the EEM ETF on January 3rd for a gain of 104% in anticipation of a wave of Chinese credit stimulus. Credit growth blew past expectations in January, but surprised on the downside in February. This made the March release particularly important. In the end, the March data did not disappoint those who were hoping for a solid reading. New CNY loans rose by RMB 1690 billion, above Bloomberg consensus estimates of RMB 1250 billion. Our adjusted aggregate financing measure, which excludes a number of items such as equity financing but includes local government bond issuance, rose by 12.3% year-over-year, up from 11.6% in February (Chart 1). China’s credit impulse leads the import component of its manufacturing PMI (Chart 2). The credit impulse bottomed in November 2018, which should feed into higher imports over the coming months. This week’s release of better-than-expected data on industrial production, retail sales, and housing activity all suggest that the rebound in Chinese growth is already afoot. Chart 1Chinese Credit Growth Is Rebounding... Chart 2...Which Should Bode Well For Global Exports To China   Short-Term Gain For Long-Term Pain? At times like these, the bears are always ready with their standby argument: Sure, China may be stimulating, but all that credit growth will just make the debt bubble even bigger. Once the bubble bursts, there will be hell to pay. Long-term investors should steer clear of any growth-sensitive assets. It is a seductive argument. But it is wrong. Chinese releveraging is: 1) inevitable; 2) desirable; and 3) sustainable. The fundamental macroeconomic problem that China faces is that it consumes too little of what it produces. 1. Chinese Debt Growth Is Inevitable The fundamental macroeconomic problem that China faces is that it consumes too little of what it produces. The result is a national savings rate of 45%, by far the highest of any major economy (Chart 3). Chart 3China Still Saving A Lot Chart 4From Exporting Savings To Investing Domestically And Building Up Debt   There was a time when China was able to export a large part of its excess production. Its current account surplus reached nearly 10% of GDP in 2007. As its economy has grown in relation to the rest of the world, running massive trade surpluses has become more difficult. This is especially true today, when the country is being targeted by the Trump administration and much of the international community for alleged unfair trade practices. As China’s ability to churn out large current account surpluses declined, the government moved to Plan B: propping up growth by recycling the country’s copious savings into fixed-asset investment. This process saw households park their savings in banks and other financial institutions which, in turn, lent the money out to companies and local governments in order to finance various investment projects. Not surprisingly, debt levels exploded higher (Chart 4). As China’s population ages and more workers leave the labor force, savings will decline. However, this is likely to be a slow process. In the meantime, further debt growth is inevitable. 2. Chinese Debt Growth Is Desirable In an ideal world, Chinese households would consume more of their incomes, leaving only enough savings to finance high-quality private and public investment projects. That is not the world we are living in. In a far-from-ideal world, we need to think about second-best solutions. Yes, a sizable share of Chinese investment spending goes towards projects of dubious value. Yet, the same could have been said about Japan’s fabled “bridges to nowhere.” One may regard the construction of a seldom-used bridge as a misallocation of capital. But what is the counterfactual? If the bridge had not been built, would the workers have found productive work? If not, then there also would have been a misallocation of capital – human capital – which is arguably a much more serious problem. In any case, keep in mind that the rate of return on private investment depends on the state of the economy. If an economy is suffering from chronic lack of demand, only the most worthwhile projects will be undertaken. As the economic outlook improves, the set of viable projects will expand. It is only when all excess private-sector savings have been depleted, and interest rates are rising, that public spending starts to crowd out private investment. 3. Chinese Debt Growth Is Sustainable Even if one accepts the proposition that China needs continued debt growth to maintain full employment, is it still possible that all this additional debt will push the economy into a full-blown debt crisis? Most self-professed “serious-minded” observers would say yes. But then again, many of these same observers were predicting that Japan was heading for a debt crisis when government debt reached 100% of GDP in the late 1990s. Today, Japan’s government debt-to-GDP ratio stands at about 240% of GDP, and yet interest rates remain at rock-bottom levels. China will avoid a debt crisis for the same reason Japan has been able to avoid one. Much of China’s debt stock is composed of state-owned enterprise, local government, and other forms of quasi-public sector debt. Credit policy in China is often indistinguishable from fiscal policy. Given the abundant supply of savings in the economy, most of this debt can be internally financed at fairly low interest rates. The standard equation for government debt dynamics says that the change in the debt-to-GDP ratio, D/Y, can be expressed as:1 G - T is the primary budget deficit, r  is the borrowing rate, and g is the growth rate of the economy (it is irrelevant whether r and g are defined in nominal or real terms, as long as they are both expressed the same way). China will avoid a debt crisis for the same reason Japan has been able to avoid one. The Chinese 10-year government bond yield is currently four percentage points below projected GDP growth over the next decade, which is one of the biggest gaps among the major economies (Chart 5). Arithmetically, this means that China can have as large a primary fiscal deficit as it wants. As long as r remains below g, the debt-to-GDP ratio will converge to a stable level. Chart 6 shows this point analytically. In fact, it is possible that a permanently larger budget deficit could lead to a decline in the equilibrium debt-to-GDP ratio. How could that be? The answer is revealed by the equation above. If the debt-to-GDP ratio is fairly high to begin with and an increase in the primary budget deficit leads to higher inflation (and hence, lower real rates and/or faster nominal GDP growth), this could more than fully counteract the increase in the deficit. Chart 7Stronger Growth Coincided With Accelerating Inflation And Lower Real Rates This is not just a theoretical curiosity. Historically, Chinese inflation has risen while real rates have fallen whenever GDP growth has accelerated (Chart 7). Given China’s high debt levels, even a modest amount of additional inflation could put significant downward pressure on the debt-to-GDP ratio.2  Of course, all this is predicated on the assumption that faster credit growth will not cause interest rates to rise above the growth rate of the economy. For the portion of China’s debt stock that is either directly or indirectly backstopped by the central government, this seems like a safe assumption. After all, if credit/fiscal stimulus is simply being undertaken in response to inadequate demand, there is no need for policymakers to hike rates. Things get trickier when we look at private debt. In the past, the government has encouraged state-owned banks to roll over souring loans for fear that a wave of defaults would undermine the economy and endanger social stability. More recently, however, policymakers have been backing away from this strategy due to the well-founded view that it encourages moral hazard. Faster growth in China in the second half of this year will lift Chinese imports. This will be welcome news for the rest of the world. We expect the authorities to continue taking steps to instill market discipline by allowing failing firms to, well, fail. Realistically, however, the transition to a full market-based economy will take quite a bit of time. In the interim, the government will keep cutting taxes and increasing on-budget spending in order to ensure that any decline in employment among failing firms is offset by employment growth elsewhere. In such an environment, neither a debt crisis nor a deep economic slowdown appear likely. Investment Conclusions Faster growth in China in the second half of this year will lift Chinese imports. This will be welcome news for the rest of the world. Chart 9Germany Welcomes The Upturn In Chinese Credit Growth While the U.S. will benefit from a revival in Chinese growth, Europe will gain even more (Chart 8). Germany, in particular, should see a pronounced acceleration in growth. China’s credit impulse leads Chinese automobile spending which, in turn, reliably leads euro area automobile exports, as well as overall exports (Chart 9). The recent rebound in the expectations component of the German ZEW index, as well as in the manufacturing output component of the April flash PMI, suggests that green shoots are starting to sprout (Chart 10). Italy should also benefit from the steep drop in bond yields since last October (Chart 11). Italian industrial production strongly surprised to the upside in February, suggesting that the euro area’s third biggest economy may have finally turned the corner. Chart 10Tentative Green Shoots Out Of Germany Chart 11Italy: The Drop In Bond Yields Should Boost The EconomyThe ECB will not hike rates this year even if growth shifts into higher gear, but the market will probably price in a bit more monetary tightening in 2020 and 2021. This should help lift the euro. We recommend that investors position themselves for this by going long EUR/JPY. Relatedly, we are closing our short EUR/CAD trade for a gain of 3.9%.   The U.S. dollar tends to be a countercyclical currency, meaning that it moves in the opposite direction of the global business cycle (Chart 12). This countercyclicality stems from the fact that the U.S. is more geared towards services than manufacturing compared with most other economies (Chart 13). As such, when global growth accelerates, capital tends to flow from the U.S. to the rest of the world, translating into more demand for foreign currency and less demand for dollars. Chart 12The Dollar Is A Countercyclical Currency Chart 13The U.S. Is A Low-Beta Play On Global Growth A “patient” Fed and the prospect of stronger global growth in the second half of this year are bearish for the dollar. As such, we are closing our long DXY trade for a carry-adjusted gain of 16.4% and exiting our long USD/CNY trade for a loss of 3.1%. We are also closing our short AUD/CAD trade for a gain of 1.6%. Faster Chinese growth will boost metal prices, which is bullish for the Aussie dollar. Lastly, we are switching our short EUR/RUB trade (which is currently up 8.6%) into a short USD/RUB trade. A weaker greenback and stronger global growth will be manna from heaven for international stocks, especially when priced in U.S. dollars. Investors should prepare to move European and EM equities to overweight within a global equity portfolio during the coming weeks. A “patient” Fed and the prospect of stronger global growth in the second half of this year are bearish for the dollar. We are less keen on upgrading Japanese equities. While Japanese exporters will benefit from stronger Chinese growth, the domestic economy will be weighed down by the upcoming hike in the sales tax, which is slated to take place in October. Moreover, the yen is likely to experience headwinds as global bond yields rise in relation to JGB yields. Investors contemplating buying Japanese stocks should hedge any currency risk. Finally, the price of gold fell to $1275/ounce earlier this week, triggering our buy order. With the Fed on pause, the U.S. economy starting to overheat, and the dollar likely to trend lower, bullion could shine over the coming months.   Peter Berezin, Chief Global Strategist Global Investment Strategy peterb@bcaresearch.com Footnotes 1      Please see Global Investment Strategy Weekly Report, “Is There Really Too Much Government Debt In The World?” dated February 22, 2019, for a fuller discussion of this debt sustainability equation. 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Highlights In China, “helicopter” money and the socialist put are positive for growth in the medium term but will prove harmful for the economy over the long run. In the socialist put scenario, a buy-and-hold strategy is inappropriate for Chinese stocks. The enormous amount of money supply in China is “the sword of Damocles” on the yuan’s exchange rate. A new equity trade: Short Chinese banks / long U.S. banks. Take profits on our short Chinese property developers / long U.S. homebuilders equity position. Feature Last week’s China credit and money data affirmed that Chinese banks have engaged in another round of massive credit and money injection into the economy. In the first quarter alone, aggregate credit rose by RMB 8.5 trillion (US$1.3 trillion). Aggregate credit growth accelerated to 11.6%, well above first-quarter nominal GDP growth of 8% (Chart I-1). This is in spite of numerous pledges by many of China’s top policymakers that they have no plans to resort to “floodgate irrigation” style stimulus, and that credit/money growth will be kept on par with nominal GDP growth. Our credit and fiscal spending impulse has spiked up, pointing to a potential improvement in economic data in the months ahead (Chart I-2). Chart I-1China: No Deleveraging At All What’s more, there is anecdotal evidence of a revival of housing demand in March, and that property developers have once again commenced bidding up land prices in certain parts of the country. Chart I-2China: Leading Economic Indicators   Regarding investment strategy, two weeks ago we put a stop-buy limit on the MSCI EM stock index at 1125. If this index breaks above this level we will turn tactically positive on EM risk assets. There is anecdotal evidence of a revival of housing demand in March, and that property developers have once again commenced bidding up land prices in certain parts of the country. Below are the pros and cons of upgrading the EM outlook at the current juncture. Pros The credit impulse in China leads both the mainland’s business cycle and the global manufacturing cycle by an average of nine months. Given its bottom was in December 2018, the trough in the mainland business and global industrial cycles should have been around August 2019 (Chart I-3). Chart I-3Global Manufacturing PMI Has Not Led Global Stocks Our assessment has been that the bottom in EM equities that occurred in late December 2018 was too early. Our basis has been that the Chinese and global manufacturing cycles were not likely to bottom before August 2019, according to their previous relationship with China’s credit and fiscal spending impulse. Consequently, we have been expecting China-related plays in financial markets to experience a setback before a more sustainable buying opportunity emerged. However, as China’s credit recovery is now gaining momentum and infrastructure spending financed by local government special bonds is accelerating, the window of downside risk for share prices is narrowing. There have been no recent major stimulus measures directed at China’s property market, but it appears banks have substantially boosted mortgage loan origination and their financing of property developers by loosening lending standards. Easy financing for both homebuyers and property developers makes a revival in real estate more likely. The property market and construction activity are critical to the mainland’s business cycle. If green shoots in the property market multiply, the odds of an overall growth recovery will rise substantially. Finally, if the EM equity index breaks above our stop-buy limit, it would clear an important technical resistance level, confirming the sustainability of this rally (Chart I-4). Cons EM corporate profit growth is contracting in U.S. dollar terms, and the pace of contraction will deepen into the end of this year. This assessment is based on the previous decline in China’s credit impulse. The latter suggests a bottom in EM EPS in December 2019 (Chart I-5). It is still unclear whether EM share prices can ignore this profit contraction and advance through the entire year without major bumps. Chart I-4EM Stocks Are Facing Technical Resistance Chart I-5EM Profits Will Continue Contracting   As of March, Chinese domestic smartphone sales (Chart I-6), as well as Korean, Japanese, Singaporean and Taiwanese exports to the mainland, are all still shrinking at double-digit rates from a year ago (Chart I-7). Chart I-6China: Consumer Spending In March Was Still Weak Chart I-7Exports To China Contracted At A Double-Digit Rate In March   Our indicators for marginal propensity to consume for Chinese households and companies remain in a downtrend as of March (Chart I-8). An upturn in these indicators is needed to validate that the fiscal and credit stimulus is accompanied by a greater multiplier effect. Chart I-8China: Marginal Propensity To Spend By Consumers And Enterprises Chart I-9Low Vol Precedes A ##br##Regime Shift Finally, financial markets’ aggregate volatility is extremely low (Chart I-9). This is especially true for the currency markets (Chart I-10, top panel). Typically, this is a sign of both complacency and a forthcoming major regime shift in financial markets. Chart I-10The Dollar Is Poised To Break Out Or Break Down We would be much more comfortable upgrading the EM outlook if the broad trade-weighted U.S. dollar broke down, corroborating the improvement in global/EM growth. So far, the greenback has been moving sideways along its 200-day moving average (Chart I-10, bottom panel). If the dollar breaks out, it would confirm the negative outlook for EM. Investors should closely watch foreign exchange markets and adjust their investment strategy accordingly. “Helicopter” Money Forever = A Socialist Put China’s forthcoming recovery is good news for financial markets. Nonetheless, the long-term outlook for the Chinese economy is deteriorating because the credit and money, as well as property bubbles, will keep expanding. First, China holds the world record with respect to corporate sector leverage (Chart I-11). Second, households in China are more leveraged than those in the U.S. (Chart I-12). Given that borrowing costs for households are higher in China than in the U.S., interest payments take up a larger share of Chinese households’ disposable income. Chart I-11Corporate Sector Leverage: China Holds The World Record Chart I-12Chinese Households Are More Leveraged Than Americans   Third, contrary to popular belief, banks do not channel savings/deposits into credit. They create deposits/money supply when they lend to or buy assets from non-banks. Money supply is the sum of deposits and cash in circulation. Financial markets’ aggregate volatility is extremely low. This is especially true for the currency markets. In a nutshell, credit and money excesses in China are not natural outcomes of the nation’s high savings rate but are the result of reckless credit origination by China’s commercial banks. We have elaborated on this point in a series of reports we have written on credit, money and savings.1 When commercial banks originate a loan, they create new money and new purchasing power “out of thin air.” Nobody needs to save for a bank to make a loan or buy assets. Consequently, new purchasing power for goods and services boosts demand in the real economy and inflates asset prices. Chinese banks have literally been dropping “helicopter” money over the past 10 years. Since January 2009 – the onset of the country’s massive credit binge – banks have created 165 trillion yuan ($25 trillion) of new broad money, based on our measure of M3 broad money. This is triple of the $8.3 trillion broad money supply created in the U.S., the euro area and Japan combined during the same period (Chart I-13, top panel). Chart I-13Helicopter Money In China China’s broad (M3) money supply now stands at 220 trillion yuan, equivalent to $32.5 trillion. What’s astonishing is that Chinese broad money is larger than the sum of broad money in both the U.S. and the euro area (i.e. all outstanding U.S. dollars and euros in the world combined) (Chart I-13, bottom panel). Yet China’s nominal GDP is only 38% of U.S. and euro area’s GDP combined. Credit and money excesses in China are not natural outcomes of the nation’s high savings rate but are the result of reckless credit origination by China’s commercial banks. In a market-based economy, the constraints on banks doing “helicopter” money are bank shareholders, regulators and central banks. Bank shareholders are the primary and largest losers from credit booms because they are highly exposed to non-performing loans. That is why they should be the first to cut credit flows to the economy when they sense non-payments on loans could rise. In China, neither bank shareholders nor bank regulators or the People’s Bank of China have prevented banks from expanding credit/money. Moreover, the authorities have not forced banks to acknowledge non-performing loans. This scenario – whereby banks expand credit without taking responsibility for collecting the loans – only occurs in a socialist system. This is the ultimate socialist put. China’s Potential Growth Roadmaps We have been arguing for several years that China is facing a historic choice between: (1) Moving toward a more market-based economic system that entails making creditors and borrowers take responsibility for their lending/borrowing and investment decisions. If lenders and borrowers are made explicitly accountable for their business/financial decisions, then credit flows will decelerate considerably, bankruptcies will mushroom and a period of deleveraging will be inevitable. However, the quality of capital allocation will improve, enhancing the country’s productivity and potential growth in the long run (Chart I-14). This is a scenario of medium-term pain, long-term gain. The recent ramp-up in credit growth does not suggest the authorities are willing to embrace this option. Chart I-15China: Structural Growth Tailwinds Have Dissipated (2) “Helicopter money” and a socialist put scenario entails lower potential GDP growth and rising inflation. If China continues opting to keep the socialist put in place, its potential growth rate – which is equivalent to the sum of growth rates in productivity and the labor force – will drop significantly. In the long run, this socialist put discourages innovation and breeds capital misallocation, reducing productivity growth. In fact, the industrialization ratio is 85% – not 60% as many contend(Chart I-15, top panel). Further, China’s labor force growth has stalled and will be mildly negative in the years to come (Chart I-15, bottom panel). Together, these circumstances point to a slower potential growth rate. Meanwhile, recurring stimulus via “helicopter” money will create mini-cycles around a falling potential growth rate (Chart I-16). Below we discuss the investment strategy this scenario entails. Implications Of The Socialist Put For The Currency… Slowing productivity and rampant money/purchasing power creation ultimately lead to rising inflation. Higher inflation and low interest rates - required to sustain an ever-rising debt burden - are a recipe for currency depreciation. Chinese households and businesses are eager to diversify their copious and mushrooming renminbi deposits into foreign currencies and assets. The PBoC’s foreign exchange reserves of $3 trillion are equal to only 10% of the amount of yuan deposits and cash in circulation. Foreign exchange reserves’ coverage of local currency money supply is much higher in many other EM countries, including Brazil and Russia (Chart I-17). Chart I-17China's FX Reserves Cover Less Local Currency Deposits Than Peers The enormous amount of money supply/deposits in China is “the sword of Damocles” on the yuan’s exchange rate in the long run. It is therefore inconceivable that China can fully open its capital account in the foreseeable future. On the contrary, capital account restrictions will be further tightened. Plus, the current account will become much more regulated so that there is no leakage of capital via trade transactions – such as over-invoicing of imports or under-invoicing of exports. The inability to repatriate capital when needed and structural RMB depreciation are the key risks to long-term investors in China’s onshore capital markets. …And Chinese Stocks In the socialist put scenario, a buy-and-hold strategy is inappropriate for Chinese stocks: Investors should attempt to play the resultant mini-cycles (Chart I-16). In reality, however, economic and especially financial market mini-cycles are not symmetric, and investors can make money only if they time them properly. In fact, this decade Chinese share prices – both in absolute terms and relative to global stocks – have experience wild swings (Chart I-18). Chart I-18Chinese Stocks Are Following Mini-Cycles Concerning the current outlook for Chinese investable stocks, our take is as follows: On absolute performance, we will turn positive on Chinese share prices if our stop-buy on EM equities is triggered, as per our discussion above. As for their relative performance within EM and global equity portfolios, simply because the stimulus originates in China does not warrant an overweight position in Chinese stocks. The primary losers from credit bubbles are banks and other financial companies. The basis is that they will carry the burden of potential rising non-performing loans unless the government bails them out by purchasing bad assets at par. The latter has not been the case so far this decade. Hence, an underweight position in Chinese banks/financials is currently warranted. Furthermore, the large debtors in the non-financial corporate sector should also be underweighted. When a company increases its debt but its new investments produce little net new cash flow, its equity value declines. It is difficult to find so many high-return investment projects, especially in a slowing economy. Therefore, another round of considerable capital misallocation is currently underway, and shareholders of the companies that are undertaking these investments will end up losing. In a socialist system, shareholders typically do not make money. They lose money. This is the rationale to underweight Chinese stocks within both EM and global equity portfolios. Yet, there is a caveat: This framework may not be pertinent to the two largest companies in the Chinese investable equity index Ali-Baba and Tencent - each of which accounts for 13% of the index. These two companies score well on the above issues but face different non-macro hazards including regulatory, business model and other risks. Weighing the pros and cons, we recommend maintaining a market weight allocation in Chinese equities within an EM equity portfolio. This is the view of BCA’s Emerging Markets Strategy team, which differs from the recommendations of other BCA services that are currently advocating an overweight position in Chinese stocks within a global equity portfolio. A New Trade: Short Chinese Bank / Long U.S. Bank Stocks Chinese banks’ equity value will erode as they once again expand their balance sheets aggressively, as per our discussion above. Chinese banks’ EPS have been and will continue to be diluted by the need to raise more capital. U.S. banks are better capitalized, and their asset quality is much better. Since the 2007-08 credit crisis, they have been much more prudent in expanding their balance sheets. U.S. bank stocks have underperformed the S&P 500 index since August 2018 because of falling U.S. interest rate expectations. The odds are high that U.S. bond yields are bottoming and will rise considerably – because the drag from China’s slowdown on the global economy is diminishing. This will help U.S. bank stocks. Although Chinese bank stocks optically appear undervalued, they are “cheap” for a reason. The fact that they have been “cheap” since 2011 and have failed to re-rate confirms that they suffer from chronic problems that have not been addressed yet (Chart I-19). Finally, their relative performance is facing a major resistance level, and will likely relapse (Chart I-20). Chart I-19Chinese Banks Are Cheap##br## For A Reason Chart I-20A New Trade: Short Chinese Banks / Long U.S. Banks   Take Profits On Short Chinese Property Developers / Long U.S. Homebuilders Position “Helicopter” money might be temporary positive for mainland property developers. In the meantime, share prices of U.S. homebuilders will be hurt due to rising U.S. bond yields. We are closing this position to protect profits. This recommendation has produced a 90% gain since its initiation on March 6, 2012. Arthur Budaghyan Chief Emerging Markets Strategist arthurb@bcaresearch.com Footnotes 1      Please see Emerging Markets Strategy Special Report "Misconceptions About China's Credit Excesses," dated October 26, 2016 and Emerging Markets Strategy Special Report "The True Meaning Of China's Great 'Savings' Wall," dated December 20, 2017, available at ems.bcaresearch.com Equity Recommendations Fixed-Income, Credit And Currency Recommendations