Equities

Special Report

Dear Client, I hosted a Webcast on Thursday, April 4th, during which I discussed the major investment themes and views I see playing out for the rest of the year and beyond. A replay can be accessed from this link. Best regards, Peter Berezin, Chief Global Strategist Highlights The exodus of baby boomers from the labor market is likely to lower income growth, which will reduce sales growth among publicly-listed companies over the coming years. After-tax profit margins may also come under pressure, while both the risk-free interest rate and the equity risk premium could rise. While it is difficult to estimate the magnitude of these effects, our best guess is that aging will have a moderately negative, though far from catastrophic, effect on equity prices. Even if the headwinds to equities from population aging turn out to be minimal, long-term investors are still likely to earn subpar returns given that valuations are fairly stretched today. In such an environment, a nimble investment approach, which focuses on the state of the business cycle among other things, will be necessary for generating alpha. Investors should maintain a cyclically bullish stance towards global equities for the time being, but begin paring back exposure late next year in advance of a recession in 2021. Feature Will Grandpa Sink The Stock Market? About 55% of U.S. stock market wealth is held by the baby boom generation – those born between 1946 and 1964 (Chart 1). As baby boomers increasingly exit the labor force and draw down their accumulated savings, there is a growing concern that equity prices will come under pressure.  Financial pundit Robert Kiyosaki published a book more than a decade ago arguing, in his usual hyperbolic style, that retiring boomers would trigger “the biggest stock market crash in history.”1 Conveniently, he even gave a date for the crash: 2016, the year when the first baby boomers would celebrate their 70th birthdays. Kiyosaki’s prophesized crash never happened. But does he still have a point? Will aging populations torpedo stocks? A Framework For Thinking About The Value Of The Stock Market Conceptually, the value of the stock market should equal the present value of the cash flows which shareholders can expect to receive. As Appendix 1 explains, this means that today’s dividend yield should equal the difference between the rate that investors use to discount those cash flows and the expected growth rate of cash flows. The discount rate is the sum of the risk-free rate and an equity risk premium. Cash flow growth tends to track earnings growth. The latter can be broken down into sales growth and margin growth. Thus, one can express the dividend yield ( D/P )  as the sum of four variables: The formula shows that an increase in either sales growth or profit margins will reduce the dividend yield (thus implying an increase in equity prices), while an increase in either the risk-free rate (rf) or the equity risk premium (rp) will raise the dividend yield. As we discuss below, demographic trends are likely to shift all four variables in the direction of lower equity prices. As baby boomers increasingly exit the labor force and draw down their accumulated savings, there is a growing concern that equity prices will come under pressure. 1. Aging And Sales Growth At the economy-wide level, business sales closely track GDP growth (Chart 2). GDP growth, in turn, is simply the sum of employment growth and productivity growth. Chart 2Business Sales Closely Track GDP Growth As baby boomers continue to age, more and more of them will leave the labor force. This will result in slower labor force growth. While this development will weigh on GDP growth, it is important to recognize that most of the decline in labor force growth in developed economies has already occurred (Chart 3). Chart 3ADM Labor Force Growth: Most Of The Decline Has Already Taken Place (I) Chart 3BDM Labor Force Growth: Most Of The Decline Has Already Taken Place (II) The annual growth rate of the labor force in the G7 peaked at 1.7% in 1980, but has averaged only 0.3% over the past decade. The UN estimates that the number of people in G7 economies between the ages of 15 and 64 – a crude proxy for the potential size of the labor force – will contract by 0.1% per year over the next twenty years, a modest step down from positive growth of 0.1% over the past decade. Productivity growth has been quite weak in developed economies since the mid-2000s (Chart 4). Whether this trend persists remains to be seen. On the positive side, robotics, AI, and genetic engineering could all boost productivity growth. On the negative side, cognitive test scores in developed economies have peaked and are now trending lower. Consistent with this observation, Heckman and LaFontaine have shown that properly measured, the U.S. high school graduation rate has been falling since the early 1970s.2 This makes baby boomers arguably the best educated generation in history. An open question concerns the extent to which slower economy-wide GDP growth filters down to sales growth among listed companies. While it is highly likely that S&P 500 sales growth will decline in an environment of weaker growth, the impact of falling GDP growth on sales may be blunted by at least three factors. First, developed economy firms will still be able to benefit from rising sales to emerging markets, even if they are suffering from sluggish sales growth at home. Second, domestic consumption will decelerate more slowly than income growth as older workers deplete their savings. Third, lower productivity growth will coincide with less “creative destruction,” which will benefit incumbent firms. In fact, this is already happening. Chart 5 shows that net firm formation has fallen dramatically since the 1970s. Chart 4In Developed Markets, Productivity Growth Has Been Falling For Over A Decade Chart 5A Sharp Drop In New Firm Formation   2. Aging And Profit Margins Population aging can affect profit margins in two ways: First, it can shift spending across sectors. For example, if age-related spending migrates from sectors with high margins to those with low margins, aggregate profit margins will decline. Second, aging can affect margins within sectors. Looking across sectors, health care spending is likely to rise in response to population aging. According to the Congressional Budget Office, health care expenditures are set to increase from 5.2% of GDP to 9.2% of GDP by 2048 (Chart 6). There once was a time when health care margins were double the S&P 500 average (Chart 7). During the past two decades, however, health care margins have fallen, and are now slightly below the S&P average. Chart 7AS&P 500 Margins By Sector (I) Chart 7BS&P 500 Margins By Sector (II) Looking out, it is likely that health care margins will continue to contract, as cash-strapped governments look for ways to cut health care costs. Presidential hopefuls Bernie Sanders, Elizabeth Warren, and Kamala Harris have all championed “Medicare for all.” If implemented, such a policy prescription would decimate health care sector profits by reducing demand for private insurance while giving the federal government more bargaining power to negotiate lower drug prices. Most of the decline in labor force growth in developed economies has already occurred. The only silver lining, pardon the pun, for margins is that older people tend to display greater brand loyalty (Chart 8). Whether this is because of experience, habit, or nostalgia is not clear, but older consumers switch products less often, preferring to stick with “what they know.”3 Perhaps reflecting a general tendency for self-reported happiness to increase in old age, elderly consumers also tend to express greater satisfaction with their purchases. Nevertheless, on balance, we expect aging to make a slightly negative contribution to profit margins. 3. Aging And The Risk-Free Rate Proponents of the secular stagnation thesis posit that demographic trends have led to a decline in the neutral rate of interest. As Chart 9 shows, aging could depress the neutral rate if an older population causes the aggregate investment schedule to shift inwards or the aggregate savings schedule to shift outwards. Chart 9Two Ways For Real Rates To Fall According to the standard “accelerator” model, the optimal level of investment spending is determined by the growth rate of aggregate demand.4 To the extent that slower population growth discourages firms from expanding capacity, this will lead to a lower neutral rate of interest. That said, as noted above, most of the decline in labor force growth in developed economies has already occurred. This implies that investment spending may not fall much further from current levels. What about savings? At the outset, aging will increase savings as more people move into their prime saving years (ages 30-to-50). Declining fertility rates will also tend to reduce spending on children, while allowing more women to join the labor force. Aging could morph from a force that has dragged down the neutral rate of interest to one that will start slowly pushing it back up. Over time, however, aging is likely to reduce the savings rate, as more workers retire, leaving fewer workers in the labor force. Once health care spending is included, consumption actually increases in old age, especially in the last few years of life (Chart 10). Globally, the ratio of workers-to-consumers increased from the early 1970s to the middle of this decade, but has now begun to decline (Chart 11). This suggests that aging could morph from a force that has dragged down the neutral rate of interest to one that will start slowly pushing it back up. Chart 10Savings Over The Life Cycle Chart 11The Worker-To-Consumer Ratio Has Peaked Globally   Instead of running larger deficits to finance pension and health care spending, governments could raise taxes. This would reduce private consumption, thus generating additional savings for the economy. While such a step could prevent the risk-free interest rate from rising, some of the tax burden would likely end up falling on the owners of capital in the form of higher taxes on dividends, capital gains, and business profits. This would lead to lower after-tax profit margins and slower sales growth. The end result would still be the same: weaker equity prices. 4. Aging And The Equity Risk Premium When people discuss the impact that aging baby boomers will have on the stock market, they are usually – whether they realize it or not – talking about the equity risk premium. By definition, for every seller of stock there must be a buyer of stock. If baby boomers start selling shares to finance their retirement spending, someone will need to buy their shares, provided the price is low enough. The question is by how much do share prices need to fall to clear the market? In theory, households should accumulate assets over their working years and then deplete their savings in retirement. In practice, uncertainty about the timing of death, the desire to pass on wealth to future generations, and the need to maintain enough assets to finance unforeseen health care expenses all tend to induce households to run down wealth at only a modest pace during retirement. A study by John Ameriks and Stephen Zeldes using a random sample of 16,000 accounts from a major retirement fund found no evidence that households gradually decrease equity allocations as they age.5 Looking out, it is possible that baby boomers will run down their equity holdings more quickly than prior generations. For instance, the decline in family size over the past fifty years and evolving societal norms may end up causing boomers to bequeath smaller estates than in the past. The increasing popularity of annuities may also reduce the likelihood of unintended bequests. In addition, the proliferation of target-date funds may produce a more rapid shift out of equities than would occur if investors had to consciously decide to reduce exposure to the stock market. Nevertheless, we suspect that any additional selling by baby boomers will only put modest downward pressure on equity prices. This is because the wealthiest 10% of U.S. households hold 84% of all stock market wealth, while the bottom 50% hold less than 1% (Chart 12). Households in the top one percent of the wealth distribution hold close to half of all stocks. These ultra-wealthy households tend to consume a fairly small share of their assets during retirement. As a result, most of their assets end up being bequeathed to family members and/or charities when they pass away. Chart 12The Wealthiest 10% In The U.S. Own The Bulk Of Equities Chart 13Foreign Ownership Of U.S. Stocks Has Grown Foreign purchases of U.S. stocks should also blunt the impact of any selling by retiring baby boomers. Foreigners now hold 27% of U.S. stock market wealth, up from 5% in the mid-1970s (Chart 13). If foreign demand for U.S. equities increases in line with global ex-U.S. real GDP, this will add about $250 billion in demand for U.S. stocks (in constant dollars) over the next twenty years. This is five times greater than the roughly $50 billion in annual net selling that would occur if all investors followed the popular rule of thumb which instructs them to take their age and subtract it from 100 in order to determine how much of their financial wealth to allocate to equities. Investment Implications The discussion above suggests that aging is likely to have a moderately negative, though far from catastrophic, effect on equity prices by: 1) reducing sales growth among listed companies; 2) putting downward pressure on after-tax profit margins; 3) increasing the risk-free rate of interest; and 4) raising the equity risk premium. It is difficult to be precise about how large these effects will turn out to be. Three factors cloud any potential calculation. First, as the equation presented at the outset of this report illustrates, small shifts in any one variable can lead to big changes in the fair value of the stock market. To see this point, let us take the current S&P 500 dividend yield of 2.0% and add 1.5% to account for net share buybacks (gross buybacks less share issuance). This gives a “cash flow to shareholders” yield of 3.5%. Now consider a one percentage-point increase in the equity risk premium. An increase in the equity risk premium of this magnitude would require the cash flow yield to rise to 4.5%. This, in turn, would necessitate that equity prices fall by 22%. That’s a lot. The second factor that makes it difficult to be precise about the extent to which demographic changes will affect stock prices is that there are likely to be interaction effects among the variables in the equation above. For instance, rising labor shortages stemming from the withdrawal of baby boomers from the labor market could put downward pressure on profit margins. The resulting increase in labor’s share of income would likely boost aggregate demand, thereby contributing to a higher neutral rate of interest. Chart 14Japan’s Population Bust Was Largely Foreseen At this point, one of two things could happen. On the one hand, if central banks failed to raise rates, this would cause the economy to overheat, leading to higher inflation. Higher inflation could push up the equity risk premium, as was the case in the 1970s. On the other hand, if central banks did raise interest rates, this could cause debt burdens to become unsustainable. That could also push up the equity risk premium. The third factor that makes it challenging to estimate the impact of demographics on stocks is that it is difficult to know the proper baseline for computing the effects of aging on stock market valuations. To the extent that the variables in the equation are all forward-looking, they should incorporate the market’s views on how the retirement of baby boomers will affect the relevant drivers of equity returns. This implies that shifts in equity valuations must stem from forecast revisions rather than from anticipated trends. Thus, as an example, any change to the “sales growth” term should be properly viewed as expressing not how future sales growth will differ from past sales growth, but by how much future sales growth will differ from what investors are currently projecting. It is tempting to assume that the market has already priced in the impact of population aging.  After all, the fact that baby boomers are exiting the labor force is not exactly breaking news. Yet, in the past, markets have proven to be surprisingly oblivious to easy-to-predict demographic developments. For example, Japanese investors were keen to buy stocks and real estate in the late 1980s, despite the fact that published projections at the time showed that the country’s working-age population would decline at an accelerating pace over the subsequent decade (Chart 14). Academic work supports the view that investors tend to understate the importance of demographic forces. Stefano Della Vigna and Joshua Pollet have shown that a trading strategy that exploits predictable age-related changes in spending on such items as toys, bicycles, beer, and life insurance would have earned an annualized risk-adjusted return of approximately six percent.6 Chart 15Poor Long-Term Returns In Store For U.S. Stocks The fact that equity valuations today are stretched in the U.S., and no better than middling in the rest of the world, should add to investor concerns. Chart 15 shows that the ratio of household equity holdings-to-total financial assets has been an extremely reliable predictor of 10-year equity returns in the post-war era. Today, this indicator is pointing to low single-digit returns for U.S. stocks over the next decade. This suggests that even if the headwinds to equities from population aging turn out to be minimal, long-term investors will still earn subpar returns from stocks relative to recent history. In such an environment, a nimble investment approach, which focuses on the state of the business cycle among other things, will be necessary for generating alpha. As discussed in our recently published Strategy Outlook, investors should maintain a cyclically bullish stance towards stocks for the time being, but begin paring back exposure late next year in advance of a recession in 2021.7   Peter Berezin, Chief Global Strategist Global Investment Strategy peterb@bcaresearch.com   Footnotes 1      Robert T. Kiyosaki, and Sharon L. Lechter, “Rich Dad's Prophecy: Why the Biggest Stock Market Crash in History Is Still Coming...And How You Can Prepare Yourself and Profit from It!” Time Warner, 2003. 2      James Heckman and Paul LaFontaine, "The American High School Graduation Rate: Trends and Levels," The Review of Economics and Statistics 92:2, (May 2010): 244–262. 3      Please see Rajesh Iyer, Timothy H. Reisenwitz, and Jacqueline K. Eastman, “The Impact Of Cognitive Age On Seniors’ Lifestyles,” Marketing Management Journal, 18:2, (Fall 2008); and Komal Gyani Karani, and Katherine A. Fraccastoro, “Resistance To Brand Switching: The Elderly Consumer,“ Journal of Business & Economics Research, 8:12, (December 2010). 4      In most economic models, the capital-to-output ratio is assumed to converge towards a stable level over time. By definition, the capital stock in Year t is determined by the capital stock in Year t-1 plus whatever net investment (gross investment minus depreciation) takes place in Year t. In general, the optimal net investment-to-GDP ratio will equal the product of the capital-to-output ratio and the growth rate of GDP. For example, suppose that the capital-to-output ratio is three (meaning that the capital stock is three times as large as GDP). If output does not change from one year to the next, no additional net investment would be necessary to maintain a stable capital-to-output ratio. However, if output is growing at 2%, net investment of 3X2%=6% of GDP would be required. 5      John Ameriks and Stephen P. Zeldes, “How Do Household Portfolio Shares Vary with Age?” Working Paper, 2004. 6      Stefano Della Vigna, and Joshua M. Pollet, “Demographics and Industry Returns,” American Economic Review, 97:5 (2007). 7      Please see Global Investment Strategy, “Second Quarter 2019 Strategy Outlook: From Dead Zone To End Zone,” dated March 29, 2019.   Strategy & Market Trends MacroQuant Model And Current Subjective Scores Tactical Trades Strategic Recommendations Closed Trades

  Underweight The relative resilience of consumer discretionary stocks has been puzzling over the past two years. Typically, rising interest rates prelude a period of underperformance in these highly rate sensitive stocks (fed funds rate shown inverted, bottom panel) but the divergence has grown exceptionally wide. Regardless, we believe our negative thesis is sound. Consumer confidence is near record highs (though it has started to decline), which appears to be driving the relative share price gains but consumer credit has not followed suit (second panel), implying consumers are not backing up their positivity with their wallets. The sell-side too appears to discount soaring consumer confidence as earnings estimates have not kept pace with share prices, driving sector valuations to a 25% premium to the broad market and well above sustainable average levels (third panel). However, this is partially explained by Amazon, which carries roughly 30% weight in the S&P consumer discretionary index but only 12.5% of operating profit, and its exceptional outperformance since the beginning of 2018. Nonetheless, we expect retail sales to follow the opposite path of interest rates, as it always has in past cycles, and a derating to occur. Bottom Line: We reiterate our below-benchmark allocation rating on the S&P consumer discretionary index as valuations have grown excessive and BCA’s view remains that interest rates are near their trough.

Highlights Foreign investors have been rushing into Indian equities in anticipation of a Modi win. While Modi’s chances are reasonable, he may not win an outright majority. Keep tactically underweighting Indian stocks for now. The structural outlook for Vietnam is strong and improving. A bottom in Vietnamese equities is in the making. Investors should overweight Vietnamese stocks within an EM equity portfolio. Feature Indian Equities: A Window Of Risk Remains Foreign investors have been rushing into Indian equities in anticipation of a win by current Prime Minister Narendra Modi in the upcoming general elections. As a result, Indian stocks have been outperforming the EM benchmark. Nevertheless, a window of risk for the Indian bourse remains. While Modi’s chances of winning the elections are reasonable, he and his party – the Bharatiya Janata Party, or BJP – may not win an outright majority in the lower house, as occurred in May 2014. While Modi’s chances of winning the elections are reasonable, he and his party – the Bharatiya Janata Party, or BJP – may not win an outright majority in the lower house, as occurred in May 2014. The basis for Modi not being able to win an outright majority is that rural area incomes have weakened substantially due to falling food prices (Chart I-1). Corroborating this distress in rural areas, stock prices of rural-exposed companies have massively underperformed urban-exposed ones (Chart I-2). Chart I-1India's Food Prices Have Been Falling Despite Low Rainfall Chart I-2Rural-Exposed Stocks Have Massively Underperformed Urban Stocks   Even though both monetary and fiscal policies are easing, these macro policies always work with a time lag and will not improve domestic growth before the elections. A BJP-led minority-government will force Modi to increasingly rely on his allies in the National Democratic Alliance (NDA) coalition. The prime minister will then be forced to frequently offer concessions, watering down his reform agenda. The BJP’s allies in the NDA coalition are not necessarily as market-friendly. This is why we believe such an outcome would upset Indian financial markets after its most recent outperformance. Meanwhile, rural demand weakness has spilled over into the broader Indian economy. Passenger car sales, as well as sales of two- and three-wheelers are on the verge of contraction, and growth in tractor sales is falling sharply (Chart I-3). Chart I-3Indian Cyclical Growth Is Decelerating Chart I-4Indian EPS Growth Will Likely Contract Moreover, the bottom panel of Chart I-3 illustrates that the production of intermediate goods is contracting and manufacturing production is decelerating. Worryingly, the domestic growth slowdown has stalled EPS growth for the overall market, and net profit margins are falling (Chart I-4). The large-cap equity index has so far disregarded poor earnings performance, which magnifies the risk to Indian stocks if the BJP fails to win a majority government. Notably, small-cap stocks have failed to advance much and have not corroborated the rally in large-caps (Chart I-5). India’s stock market breadth is also poor, which is a bad omen for the sustainability of the current rally (Chart I-6). Chart I-5India Small Cap Stock Are Not Confirming The Rally Chart I-6India's Stock Market Breadth Is Poor   Finally, rising oil prices will negatively impact India’s trade balance dynamics (Chart I-7, top panel). The stock market’s relative performance has diverged from the recent rise in oil prices – an unsustainable trend (Chart I-7, bottom panel).           Investment Recommendations Chart I-7Higher Oil Prices Are Not Discounted By Indian Equities The Indian economy will remain weak over the next several months, which places Modi’s majority re-election bid at risk. Beyond the elections, fiscal and monetary easing will kick in and boost cyclical growth in the second half of the year. Food prices are also beginning to pick up due to below average rainfall (Chart I-1, page 1). The latter will revive rural income and by extension spending. We recommend tactically underweighting Indian stocks for now. A better entry point to upgrade will likely emerge in the next few months as euphoria surrounding the upcoming elections comes to an end and a growth slowdown is finally priced in. For fixed-income investors, we recommend continuing to bet on yield-curve steepening. A dovish central bank will cut interest rates and keep them low. This, along with fiscal easing, will revive growth later this year. A growth recovery and rising food inflation will lift the long end of the yield curve.   Ayman Kawtharani, Associate Editor ayman@bcaresearch.com   Vietnam: Structural Tailwinds Getting Stronger; Buy On A Dip Our negative call on Vietnamese stocks since last May has turned out well.1 The significant deceleration in export growth alongside the selloff in broader emerging markets has generated a double-digit drop in Vietnamese stock prices over the past 12 months (Chart II-1, top panel). Chart II-1Vietnamese Equities: An Upturn Is Ahead Looking forward, a new upturn in Vietnamese equities is in the making. The structural outlook for Vietnam is strong and improving. Investors should overweight Vietnamese stocks within an EM equity portfolio (Chart II-1, bottom panel). Shifting Supply Chain For some time, companies in China have been moving their supply chain to Vietnam due to its cheap labor, inexpensive land and supportive policies. The geopolitical confrontation between the U.S. and China that began last year has served to accelerate this process. The U.S. and China may soon reach a trade deal. This will give Chinese manufacturers and multinational companies more time to prepare for their relocation, but it will not stop the ongoing supply chain shift. Both multinationals and Chinese producers would prefer to have alternative supply chains that are not exposed to a potential re-escalation in geopolitical tensions between the U.S. and China in the years to come.2 Chart II-2 shows that Chinese companies have nearly tripled their foreign direct investment in Vietnam over the past nine months. The surge in relocations from the mainland has boosted land prices and wages in Vietnam significantly. For example, the rental price of industrial land at Giang Dien industrial park on a long-term lease of up to 50 years has risen as much as 50% to US$90 per square meter last October from US$60-70 a year ago. The relocations have occurred not only for low-value-added companies such as textile and footwear makers, but also for high-value-add companies like electronics assembly producers. According to the Chairman of Shenzhen-Vietnam Industrial Park, most of the companies that established factories in the park last year have been focused on light processing such as electronic assembly. Chart II-2Accelerating Supply Chain Shift Chart II-3Strong U.S. Imports From Vietnam Chart II-3 shows that U.S. imports from Vietnam have been much stronger than those from China and the rest of the world. This may be the result of both the accelerated supply chain shift last year and the structural competitiveness of Vietnamese goods. Vietnam continues to take market share from China in global markets such as footwear, garments and electronics (Chart II-4). Both multinationals and Chinese producers would prefer to have alternative supply chains that are not exposed to a potential re-escalation in geopolitical tensions between the U.S. and China in the years to come. In fact, rising FDIs have already led to a growth rebound in imports among foreign invested enterprises (FIE), heralding an export growth acceleration in the months ahead (Chart II-5). FIEs import most of the input materials they need to manufacture their goods, which are then exported overseas. This is why this segment’s imports lead export growth. Chart II-4Vietnam: Taking More Market Share From China Chart II-5Rising FIE Imports Herald Export Growth Acceleration   Escaping A Global Slowdown In Smartphone Demand The biggest contributor to Vietnam’s current account and trade surplus has been the smartphone sector (Chart II-6). However, the ongoing downturn in global smartphone shipments may not affect Vietnam due to the latter’s gains in the global smartphone production and assembly market share: Vietnam mobile phone output (mostly Samsung smartphones) fell only slightly (1.2%) last year when Samsung smartphone shipments contracted by 8% (Chart II-7). This reflected Vietnam’s strong competitiveness relative to the other five countries where Samsung smartphones are manufactured: China, India, Brazil, Indonesia and South Korea. Over half of Samsung smartphones were produced in Vietnam last year. Chart II-6Phone Sector: The Biggest Driver Of Vietnamese Trade Surplus Chart II-7Vietnam May Withstand Well In A Global Smartphone Demand Slowdown Last December, Samsung closed its Chinese Tianjin plant. Without any additional production reductions in other plants, total Samsung capacity will be cut by about 7%. This further lowers the odds of a considerable production cut in Vietnam in the case of a further drop in global smartphone demand. Other Encouraging Signs Many other positive signs have emerged that point to a cyclical upturn ahead for Vietnam: Chart II-8Strong Domestic Demand Retail sales growth has been accelerating, and automobile sales have reached new highs, suggesting strong domestic demand (Chart II-8). Despite declining visitor arrivals, the country’s tourism revenue still grew at a robust 10% pace last year. In 2019, the country is expecting a 15% year-on-year growth in visitor arrivals. The Comprehensive and Progressive Agreement for Trans-Pacific Partnership (CPTPP), which came into force for Vietnam in January, and the EU-Vietnam Free Trade Agreement (EVFTA), which will take effect later this year, will be highly beneficial to the Vietnamese economy. Both headline and core inflation are low. The country’s foreign reserves also jumped by 14% over the past 12 months to a record high of US$63.5 billion, equivalent to 26% of GDP. Investment Recommendations We recommend buying Vietnamese equities on dips. Dedicated equity investors should overweight Vietnam in an EM equity portfolio: The Vietnamese property market is booming on surging income growth and low interest rates. The real estate sector accounts for 45% of the MSCI Vietnam Index and 28% of the VN All-Share Index. According to CBRE Vietnam, there was a sharp rise in overseas investors in Vietnamese real estate in 2018, particularly from China. The real estate services firm reported that Chinese customers accounted for 44% of total transactions in the first nine months of 2018. In 2017, there was a 21% year-on-year increase in Chinese buyers. Buoyant household income growth is positive for consumer staples stocks, which accounts for 34% of the MSCI Vietnam Index and 8% of the VN All-Shares Index. Buoyant household income growth is positive for consumer staples stocks, which accounts for 34% of the MSCI Vietnam Index and 8% of the VN All-Shares Index. Vietnamese corporate earnings will outpace broader EM EPS, warranting equity market outperformance (Chart II-9). Vietnam's inclusion into some influential EM equity indices would significantly boost interest from foreign investors (Chart II-10). Chart II-9Vietnamese Corporate Earnings Growth: Better Than EM Chart II-10Rising Interest From Foreign Investors   Technically, it seems the correction in Vietnamese stocks is late, and that the equity market will resume its upturn sooner rather than later.   Ellen JingYuan He, Associate Vice President Emerging Markets Strategy ellenj@bcaresearch.com Footnotes 1 Please see Frontier Markets Strategy Special Report titled “Vietnamese Equities: Take A Step Back For Now, ” dated May 15, 2018. Available at fms.bcaresearch.com. 2 Please see Geopolitical Strategy and China Investment Strategy Special Report titled “China-U.S. Trade: A Structural Deal?” dated March 6, 2019. Available at gps.bcaresearch.com. Equity Recommendations Fixed-Income, Credit And Currency Recommendations

In Monday’s Special Report, we answered clients’ most frequently asked questions from our recent marketing trip to the old continent. Front of mind for most of our clients was the recent broadening out of the U.S. yield curve inversion to the 10/fed funds rate and especially the implications of the inversion for sector positioning and the duration of the business cycle. From an equity strategy point of view, we are focused on the SPX’s performance following the yield curve inversion and, within that framework, the appropriate sectoral positioning therein. In mid-December last year we showed the results of our research and made a simple observation that the 10/2 yield curve inversion (which, importantly, has not yet occurred) almost always takes place prior to the S&P peak.1 In Monday’s Special Report, we broadened this analysis to show the S&P 500’s return and the sector returns from the time the 10/2 yield curve slope inverts until the S&P peaks, and we summarize the results in the table below. While every cycle is different, clearly it pays to have energy exposure more often than not. In contrast, high-yielding defensive sectors like utilities and telecom services fare poorly in these late-cycle iterations. Please see our Special Report for answers to other client questions.   1      Please see BCA U.S. Equity Strategy Weekly Report, “ Signal Vs. Noise,” dated December 17, 2018, available at uses.bcaresearch.com.

Special Report

Feature This week, instead of our regular Weekly Report, we will answer clients’ most frequently asked questions (FAQs) from our recent marketing trip to the old continent. Table 1 lists these questions and below we will attempt to weave a cohesive piece and answer all of these interesting questions. Clients inquiring about “how is everyone else positioned” or the related “what is the general investor sentiment like” is by far the most FAQ we always get from the road and we purposefully omit it from Table 1. Table 1Most FAQs From The Road During our last three developed markets (DM) trips, while we cannot comment on the positioning question, with regard to general investor sentiment, Australia and New Zealand are off the charts bullish. On the opposite end of the spectrum, Europe is extremely bearish, especially continental Europe. The U.S. is somewhere in the middle. Chart 1Fed’s Pivot On Display With that out of the way, the recent broadening out of the U.S. yield curve inversion to the 10/fed funds rate took center stage in our client interactions, especially the implications of the inversion for sector positioning and the duration of the business cycle. To set the record straight, a yield curve inversion does not forecast recession. Instead, it explicitly signals that the market expects the Fed’s next move to be an interest rate cut (top panel, Chart 1). In that context, the yield curve has never had a false-positive reading. Even in May 1998, it accurately forecast that the Fed would decrease the fed funds rate as it actually did in the fallout of the LTCM meltdown later that year (bottom panel, Chart 1). As equity investors, what consumes us is the SPX’s performance following the yield curve inversion. On that front, mid-December last year we showed the results of our research and made a simple observation that the yield curve inversion almost always takes place prior to the S&P peak (Table 2, Charts 2 & 3). Table 2Yield Curve Inversions And S&P 500 Peaks Chart 3…And Then The SPX Peaks In addition, today we show the S&P 500’s return and the sector returns from the time the 10/2 yield curve slope inverts until the S&P peaks, and we summarize the results in Table 3. Table 3Sector Returns From Y/C Inversion To SPX Peak While every cycle is different, clearly it pays to have energy exposure more often than not. In contrast, high-yielding defensive sectors like utilities and telecom services fare poorly in these late-cycle iterations. Meanwhile, Table 4 highlights sector performance from the SPX peak until the U.S. recession hits. We first showed these results on May 22, 2018, and we are on track to publish a Special Report on May 5 on how to position portfolios at the onset of a Fed easing cycle, so stay tuned. Table 4Defensive Stocks Beat Late Investors remain infatuated with the recession signal that the yield curve inversion emits. Moreover, recent news of an onslaught of Unicorn IPOs that would bring stock supply to the equity market, near the $100bn mark on an annualized basis according to some estimates, have also brought forward recession fears, as smart money is cashing in on their investments. Chart 4 shows that $100bn per annum in IPOs has coincided with the SPX peak in the previous two cycles. Our long-held view remains that either a mega M&A deal in the tech or biotech space or Uber’s IPO at a stratospheric valuation could serve as the anecdote that confirms the current cycle’s peak. On the yield curve front specifically, the top panel of Chart 5 shows that the most important yield curve, the 10/2, has not yet inverted. Moreover, the 30/10 and the 30/5 slopes are steepening. True, we are late cycle, but we need all the slopes to invert to get a confirmation that the recession is a foregone conclusion. Chart 4Mind The Excess Supply Chart 510/2 Y/C Has Yet To Invert The Fed’s tightening cycle has not only inverted most parts of the yield curve starting early last December, but has inflicted some damage on profit margins. Following up from our recent profit margin work highlighting nil corporate pricing power at a time when wage costs are perking up, BCA’s Monetary Indicator signals more SPX margin pain in the coming months (Chart 6). In fact, sell-side estimates call for another three consecutive quarters of a year-over-year contraction in profit margins. Chart 6Margin Trouble In more detail, the earnings deceleration that commenced in Q4 2018 and is gaining steam is disconcerting. As a reminder, Q4 included the lower corporate tax rate and the Q/Q deceleration is not solely due to the tech sector profit warnings. Eight out of the 11 GICS1 sectors sharply decelerated, two modestly accelerated and only industrials steeply accelerated to a cyclical EPS peak growth rate (Table 5). This EPS breadth deterioration is eerily reminiscent of early-2015 (Chart 7) and is disquieting. Short-term caution is also warranted given the increase in investor complacency. The one sided positioning in the VIX futures market is worrisome. As a reminder, net speculative positions are now at a lower low than the February 2018 level when the VIX snapped to over 50 and caused a massive tremor in the equity market (net speculative positions shown inverted, Chart 8). Table 5Historical/Current/Future Earnings Growth Rates Chart 7Bad Breadth Chart 8Too Complacent But, before getting overly bearish there are some growth green shoots that suggest that Q2-to-Q3 will likely mark the trough in EPS/EBITDA growth and margins (Chart 9). Beyond these positive leading profit indicators, a resolution to the U.S./China trade tussle and China’s trifecta of policy easing measures will also aid in turning profit growth around and really power up U.S. cyclicals’ EPS growth rates. Following up from the January Fed meeting, on February 4 we penned a report titled “Don’t Fight The PBoC” and it is now clear with the recent manufacturing PMI release that China’s easing on all three fronts – credit (Chart 10), monetary (Chart 11) and fiscal (Chart 12) – is starting to pay some dividends. In that light, the U.S. cyclicals vs. U.S. defensives recent outperformance has more room to run. Chart 9Growth Green Shoots Chart 10Chineasing… Chart 11...On All… Chart 12…Fronts   Deep cyclicals have another major advantage this cycle compared with defensives. While at this stage of the business cycle one would expect capital intensive businesses to become debt saddled, cyclicals are still de-levering from the depths of the late-2015/early-2016 manufacturing recession, i.e. paying down debt and increasing cash flow. Defensives, however, are doing the exact opposite with relative cash flow growth problems and piling on debt. Thus, on a relative basis Chart 13 shows that the indebtedness profile clearly favors deep cyclicals vs. defensives. From a bigger picture perspective, while the U.S. has not really purged any debt and it has just shifted it around from the financial and household sectors to the non-financial business and government sectors (Chart 14), the near all-time high in non-financial business sector credit as a share of GDP is disconcerting (top panel, Chart 14). Clearly the excesses are in this segment of U.S. debt and it is unsurprising that debt saddled stocks have been underperforming equities with pristine balance sheets since the 2016 presidential elections (top panel, Chart 15). Such outperformance has staying power, especially given that we are late in the cycle and the Fed has raised interest rates to the point where parts of the yield curve are inverted and a default cycle looms large (bottom panel, Chart 15). Chart 13Cyclicals Have The Upper Hand Chart 14U.S. Debt Profile Breakdown One sub-sector that epitomizes the current cycle’s excesses is commercial real estate (CRE). CRE prices have overshot the historical time trend by almost two standard deviations and it has already been three and a half years since they surpassed the previous all-time high (Chart 16). The recent pullback in the 10-year Treasury yield has pushed cap rates even lower and the bubble in CRE is further inflated. Looking back at the late-1980s pricking of that CRE bubble is instructive and when this cycle ends a big deflationary impulse will likely deal a blow to the CRE market.       Chart 15Hide In Pristine Balance Sheets Chart 16CRE Excesses Are A Yellow Flag Speaking of bubbles, the biggest bubble we currently see is not in equities, but in bonds. Table 6 shows that red is taking over and is reminiscent of mid-year 2016 when the 10-year U.S. Treasury yield troughed a hair above 1.3%. Globally, negative yielding debt is near all-time highs (Chart 17) and the excesses are even larger in the EM sovereign space and in select DM corporates. Mexico raising century debt in U.S. dollars, in cable and in euros is perplexing, as Mexico was at the epicenter of the 1982 LatAm crisis and again in 1994 with the Tequila crisis. Argentina also raising century debt recently in hard currency speaks to the magnitude of the current bond bubble. On the corporate side, Sanofi and LVMH placing negative yielding debt is beyond our understanding, or Total issuing a perpetual bond with a 1.75% coupon. Table 6Red Takes Over   Chart 17Bonds Are In A Bubble All of this is likely linked to the unintended consequences of global QE where fixed income investors are pushed out the risk spectrum and are forced into buying riskier credit. When this bond bubble gets pricked it will end in tears as it always does and the catalyst will likely be the next U.S. recession that will cause a global recession. While our cyclical 9-to-12 month equity market view is constructive and we believe the U.S. will avoid recession, our structural 1-to-3 year view is negative. Nevertheless, we constantly challenge our thesis and the biggest pushback to the negative structural view is the following: What if the Fed can engineer a soft landing in the U.S. as it did twice in the mid-1990s, and the business cycle runs hot for another 5 years (Chart 18)? What if the starting point of low interest rates with the real fed funds rates still close to zero is very stimulative for the U.S. economy as no recession has ever started with a fed funds rate perched near zero (Chart 19)? Finally, what if the late-2015/early-2016 manufacturing recession was actually an economic recession despite the fact that the NBER did not designate it as such and the business cycle got reignited, especially with President Trump’s election that lifted animal spirits? As a reminder, while S&P profits have contracted outside of an economic recession twice before, SPX sales had never achieved that feat, until late-2015/early-2016 (Chart 20). In other words, the revenue recession we had was unprecedented and felt like an economic recession. Chart 18The Fed Has Engineered A Soft Landing Chart 19Stimulative Real Rates Chart 20There Is Always A First Time If that were the case and the cycle were to extend into the 2020s, then the risk is that SPX EPS vault to $200 and valuations overshoot, i.e. the forward P/E multiple spikes to a 20 handle and the SPX catapults to 4,000. In that case, we would leave 1,000 points on the table and our SPX 3,000 view would be way offside. While this is a risk to our negative structural view, there are two sectors we really like for the long-term as we deem them secular growth plays and should do exceptionally well on a 10-year horizon: software and defense stocks. Three key drivers underpin our bullish view on software: galloping higher private and public sector software outlays, a structurally enticing software demand backdrop and ongoing industry M&A (Chart 21). Most importantly, the move to cloud computing and SaaS, the proliferation of AI, machine learning and augmented reality are not fads but enjoy a secular growth profile, and signal that capital outlays on software are in a structural uptrend. With regard to defense stocks, the three key pillars we highlighted in our “Brothers In Arms” Special Report on October 31, 2016 remain intact: the global rearmament is still gaining steam, a space race with manned missions to the moon now includes the U.S., China and India, and cybersecurity is a real threat for governments around the world (Chart 22). On all three fronts, defense stocks stand to benefit as they have beefed up their offerings to provide governments with a one-stop shop solution covering most of these needs. Chart 21Buy The Software Breakout Chart 22Defense Stocks Remain A Long-term Buy     Anastasios Avgeriou, U.S. Equity Strategist anastasios@bcaresearch.com

Overweight Caterpillar and, by virtue of its relative dominance, the S&P construction machinery & heavy truck (CMHT) index were at the front of the news cycle this week as an analyst downgraded CAT based on a belief that global growth had collapsed. The market largely ignored the report and both CAT and the S&P CMHT index have continued their outperformance since the late-October trough, when we reiterated our overweight recommendation in our Daily Sector Insight report titled “A Buying Opportunity In Construction Machinery”. The signals from the indicators we track imply that the “global growth collapse” is both late and overstated. The CRB raw industrials index, which moves in lockstep with the S&P CMHT index’s relative performance, unsurprisingly showed weakness at the end of 2018 but has since recovered (second panel). Further, the global credit impulse, an excellent leading indicator of relative profitability, has ticked up into positive territory after sending a weakening signal in 2018 and implies a resumption of profit outperformance (third panel). The combination of positive relative sales growth and still-tepid share price action has taken the relative valuation to levels not seen since the 2015-16 manufacturing recession (bottom panel), which marks an exceptionally affordable entry point, particularly for investors seeking to gain exposure to a China/U.S. trade tussle resolution. We continue to think such buying opportunities are rare and reiterate our overweight recommendation. The ticker symbols for the stocks in this index are: BLBG: S5CSTF - CAT, CMI, PCAR.

Highlights Maintain a pro-cyclical stance for the time being – overweight equities versus bonds, long commodities, overweight industrial equities, and underweight healthcare equities. But be warned, absent a continued decline in the bond yield and/or oil price, short-term positive impulses on the economy will fade and even turn negative later in the year. Hence in the summer months, look for opportunities to take profits in these pro-cyclical positions. U.K. economy plays can outperform once a cross-party parliamentary majority is found for a course of action that leads to an orderly Brexit (or no Brexit). Feature At the end of last year, we made a bold prediction: economies and financial markets would follow the opposite path in 2019 compared to 2018. Specifically we pointed out that “through most of 2018, global growth was decelerating while inflation was accelerating. Now this configuration is flipping: global growth is rebounding while inflation is set to collapse… 2019 will present investors a mirror-image pattern to 2018” (Chart of the Week). Chart of the WeekWhy 2019 Is The Opposite Of 2018 Four months on, we are delighted to report that the mirror-image pattern is unfolding exactly as predicted. This year, stock markets are up sharply; bond markets have rallied; metal prices have made double-digit gains, growth-sensitive industrial shares are outperforming; while defensive healthcare shares are underperforming. All of these are the precise opposite of what happened in early 2018 (Chart 1-2 - Chart I-6). Chart I-2Equities: 2019 Is The Opposite Of 2018 Chart I-3Bonds: 2019 Is The Opposite Of 2018   Chart I-4Commodities: 2019 Is The Opposite Of 2018 Chart I-5Cyclicals: 2019 Is The Opposite Of 2018   Chart I-6Defensives: 2019 Is The Opposite Of 2018 Why 2019 Is The Opposite Of 2018 The basis for our bold prediction was twofold. We noted that China’s 6-month credit impulse “had gone vertical” (Chart I-7). Indeed, the rebound from the trough amounted to $500 billion (and still counting), equivalent to a near 1 percent shot in the arm for global GDP. Chart I-7China's 6-Month Credit Impulse Has Gone Vertical We also argued back then that “a racing certainty for early 2019 is that headline inflation will collapse. This is because the plunge in the crude oil price is about to feed through into headline consumer price indexes. Inevitably, it will seep through into core inflation too, via the impact on energy dependent prices such as transport costs.” “Coming at a time that central banks have professed a much greater reliance on incoming data, we can deduce that central banks will find it hard to tighten policy in the face of weaker headline and core inflation prints. Crucially though, the ECB and BoJ were not planning on tightening policy anyway, so the plunge in reported inflation will be much more impactful on the Federal Reserve.” Lo and behold. China’s PMI has rebounded sharply, and the Fed has stopped hiking rates. Still, central banks’ enhanced ‘data-dependency’ carries perils. The high-profile hard data – such as CPI inflation and GDP growth prints – on which monetary policy ‘depends’ is a record of what happened in the past, sometimes the distant past. This year’s market moves are the precise opposite of what happened in early 2018. Hence, enhanced data-dependency means that central banks are now ‘driving by looking through the rear-view mirror’ rather than looking at the current terrain. In turn, monetary policy expectations are driving bond and equity market valuations. By contrast, equity market growth expectations are based on the here and now; they move in synch with economic activity in real-time, leading even the survey-based PMIs. This also solves the puzzle as to why bonds and equities can sometimes give conflicting messages. Last year, the configuration of accelerating inflation with decelerating global growth hit equities and with a lose-lose: heavy pressure on both valuations and growth expectations. Furthermore, when interest rates rise from low levels they undermine the support for elevated risk-asset valuations in a viciously non-linear way. Chart I-8In 2018, Higher Bond Yields Pressured Equity Valuations At low interest rates, bond prices develop the same unattractive negative asymmetry as equities. Therefore, an extended period of ultra-low interest rates removes the need for an equity risk premium, and justifies sharply higher valuations for equities and other risk-assets. But in early 2018, as hawkish central banks pushed up 10-year global bond yield towards 2 percent, this process reversed viciously: bond prices lost their negative asymmetry, re-requiring an equity risk premium and sharply lower valuations for risk-assets at a time that growth expectations were also sliding (Chart I-8).1 By contrast, the early 2019 configuration of dovish central banks and accelerating short-term credit impulses has provided equities a ‘mirror-image’ win-win: a boost to both valuations and to growth expectations.  What Happens Next In 2019? Chart I-9Headline Inflation Will Soon Tick Up Understand that the all-important impulses to an economy do not come from the level of the bond yield, oil price, net exports, inventories, and so on. The impulse always comes from the change in these metrics. And as the metrics cannot decline (or rise) incessantly, impulses always fade and then reverse. The oil price has rebounded 30 percent from its recent lows. Necessarily, this means that headline inflation prints will soon stabilise or even tick up (Chart I-9). Furthermore, central banks’ abrupt pivot to dovish has already happened. It would be hard to repeat or continue such a move. As central banks react to the inevitably backward-looking hard data prints, our expectation is that bond yields will stabilise or even tick up. Will equity markets also react positively to the better economic data prints? Not necessarily. To repeat, equity markets’ growth expectations move in synch with economic activity in real-time, leading even the survey-based PMIs. Equity markets never wait for the backward-looking data prints. China plays are tracking its short-term credit impulse which has gone vertical (Chart I-10). Hence, in 2019 to date, U.K. mining stocks are already up 25 percent; the Shenzhen Composite is already up 40 percent! Chart I-10China Plays Have Already Surged Still, the current win-win configuration can continue for a little while longer, given that a typical upswing in short-term credit impulses lasts around eight months. But be warned, absent a continued decline in the bond yield and/or oil price, short-term impulses will fade and even turn negative later in the year. The early 2019 configuration of dovish central banks and accelerating short-term credit impulses has provided equities a win-win. Hence, maintain a pro-cyclical stance for the time being – overweight equities versus bonds, long commodities, overweight industrial equities, and underweight healthcare equities. But our strong advice is: in the summer months, look for opportunities to take profits in all of these positions. When Will Brexit’s Groundhog Day End? We really would prefer not to talk about Brexit. It is not just that every day is Groundhog Day, every day is a shambolic Groundhog Day. Still, on a positive note this means that our investment strategy for Brexit has also remained a constant (Chart I-11). Chart I-11For Investors, Brexit Simplifies To A Binary Outcome It is not sufficient for the U.K. parliament to express what it is against (a no-deal Brexit); parliament must express what course of action it is for, leading to an orderly Brexit, or no Brexit, and that this course of action must also be acceptable to the EU27. At that point, irrespective of the exact course of action – a customs union, Common Market 2.0, or a confirmatory referendum in which ‘remain’ is an option – buy the pound, the FTSE250, and U.K. homebuilder shares. Theresa May’s overture to engage in a national unity strategy with the Labour Party is a step in the right direction. In this regard, Theresa May’s overture to engage in a national unity strategy with the Labour Party is a step in the right direction, because it finally puts national interest above party interest. To be clear, Brexit has been trapped in Groundhog Day because there is insufficient support among Conservative and DUP MPs for a relationship with the EU27 that would: Protect the cross-border supply chains which are vital to so many U.K. businesses. Avoid a hard customs border on the island of Ireland or between Ireland and Britain. Deliver on the narrow 52:48 vote to leave the EU, which was driven by a desire to control migration and the supremacy of the European Court of Justice; rather than a desire to strike independent trade deals, which is irrelevant for a majority of voters. The ray of light is that there is potentially a broader cross-party parliamentary majority for a course of action that would meet the above three conditions. Once it is found, U.K. economy plays can look forward to the “sunlit uplands”. Fractal Trading System* In line with the main body of this report, we continue to see evidence that the recent rally in bonds is technically extended. Accordingly, this week’s recommended trade is to short the 10-year OAT. The profit target is 1.3 percent with a symmetrical stop-loss. In other trades, short INR/PKR hit its 3 percent stop-loss and is now closed, leaving five open positions. For any investment, excessive trend following and groupthink can reach a natural point of instability, at which point the established trend is highly likely to break down with or without an external catalyst. An early warning sign is the investment’s fractal dimension approaching its natural lower bound. Encouragingly, this trigger has consistently identified countertrend moves of various magnitudes across all asset classes. Chart I-12 The post-June 9, 2016 fractal trading model rules are: When the fractal dimension approaches the lower limit after an investment has been in an established trend it is a potential trigger for a liquidity-triggered trend reversal. Therefore, open a countertrend position. The profit target is a one-third reversal of the preceding 13-week move. Apply a symmetrical stop-loss. Close the position at the profit target or stop-loss. Otherwise close the position after 13 weeks. Use the position size multiple to control risk. The position size will be smaller for more risky positions.   *  For more details please see the European Investment Strategy Special Report “Fractals, Liquidity & A Trading Model,” dated December 11, 2014, available at eis.bcaresearch.com Dhaval Joshi, Chief European Investment Strategist dhaval@bcaresearch.com Footnotes 1 Please see the European Investment Strategy Weekly Report “Risk: The Great Misunderstanding Of Finance”, October 25, 2018 available at eis.bcaresearch.com  Fractal Trading System Recommendations Asset Allocation Equity Regional and Country Allocation Equity Sector Allocation Bond and Interest Rate Allocation Currency and Other Allocation Closed Fractal Trades Trades Closed Trades Asset Performance Currency & Bond Equity Sector Country Equity Indicators Bond Yields Chart II-1Indicators To Watch - Bond Yields Chart II-2Indicators To Watch - Bond Yields   Chart II-3Indicators To Watch - Bond Yields Chart II-4Indicators To Watch - Bond Yields   Interest Rate Chart II-5Indicators To Watch - Interest Rate Expectations Chart II-6Indicators To Watch - Interest Rate Expectations Chart II-7Indicators To Watch - Interest Rate Expectations Chart II-8Indicators To Watch - Interest Rate Expectations  

Highlights Odds are that the recent improvement in Chinese manufacturing PMIs could be due to inventory re-stocking rather than a decisive turnaround in final demand. “Hard” data have not shown meaningful improvements in China’s final demand. Weighing the pros and cons, we are instituting a stop-buy on our EM strategy: We will turn tactically positive on EM risk assets if the MSCI EM equity index breaks above 1125, which is 4% above its current level. Keep Malaysia on an upgrade watch list. Downgrade Brazil to underweight. Feature The strong Chinese PMI prints released this week have challenged our negative view on EM assets and China plays. This week we take a deeper look at the underlying reasons behind the recent improvement in China’s PMI data. In addition, we elaborate on what it would take for us to alter our current strategy on EM risk assets. A Manufacturing Upturn The upturn in China’s manufacturing PMIs in March has been validated by improvement in Taiwanese PMI’s export orders (Chart I-1, top panel). The latter’s amelioration has been broad-based across all sectors: electronics and optical, electrical machinery and equipment, basic materials, and chemical/biological/medical (Chart I-1, bottom panel). China accounts for 30% of Taiwanese exports, making Taiwan’s manufacturing sector heavily exposed to China’s business cycle. Does this improvement in manufacturing PMIs reflect a final demand revival in China? Looking For Final Demand Revival China’s domestic and overseas orders remain weak, as exhibited in Chart I-2. These indicators give us the primary trajectory of the Chinese business cycle, while the PMI indexes exhibit considerable short-term volatility. Chart I-1One-Month Surge In China's And Taiwan's PMIs Chart I-2Noise And Business Cycle Trajectory   The domestic demand and overseas orders reflect quarterly data from 5,000 enterprises. The latest datapoints are from Q1 2019 and were released on March 22. To be sure, we are not suggesting an absence of bright spots, but at the moment “hard” data do not corroborate broad-based improvement in final demand. Consumer spending: There has been no improvement in households’ propensity to spend. Our proxy for households’ marginal propensity to spend has not turned up (Chart I-3). Consistently, China’s smartphone sales and passenger car sales are contracting at double-digit rates, while the growth rate in online sales of services has not improved (Chart I-4, top three panels). Chart I-3Chinese Consumers' Propensity To Spend Chart I-4China: No Improvement In "Hard" Data   The bottom panel of Chart I-4 demonstrates the retail sales of consumer goods during the Chinese New Year compared with the previous year’s spring festival. It is evident that as of mid-February, when this year’s spring festival took place, there was no improvement in Chinese consumer demand. Business spending / investment: Our proxy for enterprises’ propensity to spend continues to decline (Chart I-5). Companies’ propensity to spend has historically led the cyclical trajectory in industrial metals prices. Crucially, this has not corroborated the rebound in base metals prices over the past three months. Besides, China’s imports of capital goods, its total imports from Korea and its machinery and machine tool imports from Japan are all still contracting at a double-digit rate (Chart I-6). Chart I-5China: Enterprises' Propensity To Spend And Metals Chart I-6Contracting At A Double Digit Rate   China’s fixed asset investment in infrastructure has picked up of late and will continue to improve. However, this may not be sufficient to revive the mainland’s economy. China’s growth decelerated in 2014-2015 and industrial commodities prices dwindled, despite robust growth in infrastructure investment at the time (Chart I-7). The culprit was the decline in property construction in 2014-2015. As to the property market, the People’s Bank of China’s (PBoC) Pledged Supplementary Lending (PSL) financing points to further weakness in property demand in the coming months (Chart I-8). Chart I-7China's Infrastructure Investment And Base Metals Prices Chart I-8China: The Outlook For Residential Property Demand   Moreover, property starts have been surging, yet their completions have been tumbling. This suggests a ballooning amount of work-in-progress on real estate developers’ balance sheets. To be sure, we are not suggesting an absence of bright spots, but at the moment “hard” data do not corroborate broad-based improvement in final demand. It may well be that property developers do not have financing to complete work or that they are reluctant to bring new units to the market amid tame demand. Whatever the case, the mediocre pace of construction activity is negative for suppliers to the construction industry. Government spending: Aggregate government spending in China – including central and local government as well as government-managed funds (GMF) – has been very robust in the past year (Chart I-9). Hence, government spending has not been the reason behind the economic slowdown. Chart I-9China's Aggregate Fiscal Spending For 2019, overall government spending is projected to expand by 11% in nominal terms from a year ago, down from 17% in 2018. The key fiscal risk is shrinking land sales, which account for 86% of GMF revenues. The latter have substantially increased in size and now makeup 27% of aggregate fiscal spending. Local and central government expenditures account for 62% and 11% of aggregate fiscal spending, respectively. If land revenues undershoot, GMF and local governments will not be able to meet their expenditure targets without Beijing altering the former’s borrowing quotas. In brief, fiscal policy may be involuntarily tightened due to a shortfall in land sales revenues before the central government permits local governments to borrow more. Exports: Chinese shipments to the U.S. will recover as China and the U.S. finalize their trade deal. The media is extremely focused on the trade negotiations, and markets have been trading off the headlines. Nevertheless, it is essential to realize that China’s exports to the U.S. make up only 3.6% of the country’s total GDP (Chart I-10). This contrasts with capital spending that accounts for 42% of the mainland’s GDP.  Consequently, we believe the credit cycle that drives construction and capital spending is more important to China’s growth than its shipments to the U.S. Global ex-China Demand: The areas of global final demand that weighed on global growth last year remain depressed. Global semiconductors and auto sales have been shrinking at a rapid pace and have so far not experienced a reversal (Chart I-11). Chart I-10China Is Not Reliant On Exports To The U.S. Chart I-11Global "Hard" Data Are Still Bad   Bottom Line: There is a lack of pertinent “hard” business cycle data in China that have improved. What Does It All Mean Having reviewed final demand conditions in China, it is reasonable to argue that the improvement in the Chinese and Taiwanese manufacturing PMIs could be due to inventory re-stocking. Unfortunately, in China, there is limited reliable data that quantifies inventory levels well in various industries. Having reviewed final demand conditions in China, it is reasonable to argue that the improvement in the Chinese and Taiwanese manufacturing PMIs could be due to inventory re-stocking. The consensus view in the investment community is that China’s credit stimulus has boosted the economy since the beginning of this year. Business conditions have certainly improved. The rally in Chinese stocks has in turn mirrored this improvement. Yet it is not clear that this revival in the business cycle is due to the credit stimulus. Chart I-12 plots the credit impulse, including local government general and special bonds issuance, with the three typical business cycle variables: manufacturing PMI and nominal manufacturing production growth. Chart I-12China: Credit Impulse Leads "Hard" Data As can be seen from the chart, the manufacturing PMI is very volatile. In the short term, there is little correlation between it and the credit impulse (Chart I-12, top panel). Meanwhile, the credit impulse leads nominal manufacturing output growth by nine months (Chart I-12, bottom panel). Based on the past time lag relationships, the mainland’s business cycle should not have bottomed until the third quarter of this year. Hence, the bottom in the manufacturing PMIs in January does not fit the historical pattern of the relationship between the credit impulse and the mainland’s business cycle. Bottom Line: Presently, it is hard to make a definite conclusion on the reasons behind the pick-up in Chinese manufacturing. That said, business cycles do not always evolve in a common-sense manner that can be both rationalized and forecast by indicators. Therefore, it is essential for investors, to have confirmation signals from financial markets on the direction of the business cycle. Financial Markets As A Litmus Test We continuously monitor numerous financial markets that are sensitive to both the global and Chinese business cycles. These financial market-based indicators are often coincident with EM asset prices. Hence, they can be used to confirm or refute EM market direction. Our Risk-On-to-Safe-Haven (ROSH) currency ratio has recently softened, flashing a warning signal for EM share prices (Chart I-13). Chart I-13Currency Markets Are Flashing Amber For EM Stocks The ROSH ratio is the relative total return (including carry) of six commodities currencies (AUD, NZD, CAD, CLP, BRL and ZAR) versus two safe-haven currencies: the yen and Swiss franc. Hence, this currency ratio is agnostic to U.S. dollar trends, making its signals especially valuable. Our Reflation Confirming Indicator has retreated, also signaling a pullback in the EM equity index (Chart I-14). This indicator is composed of an equal-weighted average of industrial metals prices (a play on Chinese growth), platinum prices (a play on global reflation) and U.S. lumber prices (a proxy play on U.S. growth). Chart I-14Commodities Markets Are Flashing Amber For EM Stocks Within EM credit markets, corporate investment-grade spreads have begun narrowing versus high-yield spreads (Chart I-15). This typically coincides with lower EM share prices. Finally, EM share prices have been underperforming DM since late December. Relative performance of EM ex-China stocks against the global equity index has been even more underwhelming. In short, these markets are at a critical juncture. A decisive breakout will entail a lasting rally, while a failure to break out will signal imminent downside risk. Bottom Line: These financial market signals are not consistent with a durable China-led recovery in the global business cycle. Investment Strategy A number of financial markets are currently at a critical juncture. These markets will either break out or break down, with subsequently significant moves. The broad U.S. trade-weighted dollar has been flattish in the past nine months despite falling interest rate expectations in the U.S. and the risk-on market environment. We read this as a sign of underlying strength. The trade-weighted dollar is presently sitting on its 200-day moving average (Chart I-16). Consistent with a flattish trend in the greenback, the U.S. dollar volatility has dropped to very low levels. Exchange rates usually do not trade sideways much longer than that. Hence, the dollar is about to break out or break down and any move will be lasting and large. Chart I-15A Message From EM Corporate Credit Market Chart I-16The U.S. Dollar Is About To Make A Big Move   The Korean won has been forming a tapering wedge pattern from both short-term and long-term perspectives (Chart I-17, top and middle panels). Its volatility has also plunged to a record low (Chart I-17, bottom panel). Chart I-17The Korean Won Is At Crossroads Chart I-18A Stop-Buy On EM Stocks Finally, emerging Asian equities’ relative performance to global stocks is facing an important technical resistance as are copper and oil prices. In short, these markets are at a critical juncture. A decisive breakout will entail a lasting rally, while a failure to break out will signal imminent downside risk. Consistently, China’s “soft” data that has improved markedly yet there is no “hard” data confirmation. Moreover, there is some evidence to suggest that the pickup in the soft data may simply reflect inventory building.   Weighing the pros and cons, we are instituting a stop-buy on our EM strategy: We will turn tactically positive on EM risk assets if the MSCI EM equity index in U.S. dollar terms breaks above 1125, which is 4% above its current level (Chart I-18). Arthur Budaghyan Chief Emerging Markets Strategist arthurb@bcaresearch.com Malaysia: Keep On Upgrade Watch List Malaysian equities have been underperforming their EM counterparts since 2013 and are now resting around their 2017 lows (Chart II-1). The odds are high that this market’s underperformance is late. Chart II-1Malaysian Stocks Relative to EM Investors should keep Malaysian equities on an upgrade watch list. We upgraded the Malaysian bourse from underweight to neutral in December 2018. In a Special Report published at that time, we argued that the structural outlook for Malaysia had improved, yet the cyclical downturn would persist. The latter did not warrant moving the bourse to overweight. This view is still at play. Economic Slowdown Is Advanced The Malaysian economy has been digesting credit and property market excesses. Property sector: Property sales have declined by 37% since 2010, and prices for some property segments are beginning to deflate (Chart II-2). Similarly, housing construction approvals have slumped severely since 2012. Consumers: Passenger vehicle sales have been falling since 2012 along with households' declining marginal propensity to consume, and retail trade has been very weak (Chart II-3). Chart II-2Property Sector Is Depressed Chart II-3Consumer Sector Is Weak   An ongoing purge of excesses by companies entails lower wage growth and weaker employment, resulting in subdued household income growth. The latter could extend the consumer slump. Business sector: Capital spending growth in real terms has decelerated and may contract. Both profit margins and return-on-equity (ROE) for non-financial publicly listed companies have slumped and are currently resting below their 2008 levels (Chart II-4). This warrants cost-cutting and reduced corporate spending/capital expenditures for now. Chart II-4Corporate Restructuring On The Way? Reduced employment and weak wage growth are negative dynamics for households but positive for companies’ profit margins. Commercial Banks: Malaysian banks remain unhealthy. At 1.5%, their NPLs remain low relative to the credit boom that occurred over the past decade. Moreover, Malaysian banks have been lowering their provisions levels to boost profits. This is an unsustainable strategy. Provided economic growth will remain weak, both NPLs and provisions will rise, hurting banks’ profits and share prices. Banks hold a very large market-cap weighting in this bourse, and the negative outlook for banks’ profits deters us from upgrading this equity market. Purging Excesses: Implications For The Exchange Rate Purging of economic excesses is painful in the short- and medium-term, as it instills deflation. A currency often depreciates during this phase to mitigate the deflationary forces in the economy. However, purging excesses, deleveraging and corporate restructuring are ultimately structurally bullish for a currency. First, corporate restructuring and improved capital allocation lift productivity growth in the long run. The Malaysian economy has been digesting credit and property market excesses. Second, low inflation or outright deflation allow the currency to depreciate in real terms. The Malaysian ringgit is already cheap based on the real effective exchange rate (Chart II-5). Finally, amid deflation and in the absence of widespread bailout of debtors funded by bank loans or excessive government borrowing, cash becomes “king”. Hence, deleveraging is ultimately currency positive. In contrast, pervasive bailouts funded by money creation – i.e., mushrooming money growth – usually undermine residents’ and foreigners’ willingness to hold the currency. A capital flight ensues and the currency plunges. Malaysia in 2015 was the latter case, with the ringgit plummeting as residents converted their ringgits to U.S. dollars (Chart II-6, top panel). Chart II-5The Ringgit Is Cheap Chart II-6Malaysia: 2015 Vs. Now   Presently, the opposite dynamics are at play. The central bank is reducing commercial banks’ excess reserves, domestic private credit growth is weak and residents are not fleeing the ringgit (Chart II-6). In addition, the structural reorientation of the economy from commodities to semiconductors/technology is beginning to bear fruit. As a result, overall trade balance has significantly improved, despite weak commodities prices. This is also positive for the currency. Finally, a more stable (i.e., modestly weaker) exchange rate amid both a global and domestic downturn will allow Malaysia’s central bank to reduce interest rates and smooth the growth slump. This is in contrast to 2015 when capital outflows and the plunging currency did not allow the central bank to reduce borrowing costs. Investment Conclusions We recommend keeping Malaysian stocks on an upgrade watch list for now. We recommend upgrading Malaysian sovereign credit and local currency government bonds from underweight to neutral relative to their respective EM benchmarks A relatively stable ringgit will benefit Malaysia’s local and U.S. dollar bonds. Furthermore, foreign ownership of local bonds has fallen meaningfully, diminishing the risk of future outflows. Ayman Kawtharani, Associate Editor ayman@bcaresearch.com Arthur Budaghyan Chief Emerging Markets Strategist arthurb@bcaresearch.com Downgrading Brazil: The Honeymoon Is Over In our October 9 report, we upgraded Brazil following the outcome of the first round of presidential elections. We, like the market, gave a benefit of the doubt to the new president. However, the honeymoon is over for President Bolsonaro. The markets are becoming increasingly pessimistic because of the lack of progress on the social security reforms front. It is no secret that Brazil needs bold pension reform to make its public debt sustainable. As things stand now, the public debt dynamic in Brazil is precarious. Two prerequisites for public debt sustainability are (1) for interest rates to be below nominal GDP growth or (2) continuous robust primary fiscal surpluses. Hence, a government can stabilize its debt-to-GDP ratio by either having nominal GDP above its borrowing costs, or by running persistent and sizable primary fiscal surpluses. Neither of these two stipulations are presently satisfied in Brazil. The gap between government local currency bond yields and nominal GDP growth is still very wide (Chart III-1). Meanwhile, the primary fiscal deficit is 1.5% of GDP (Chart III-2). Chart III-1Brazil: An Unsustainable Gap Chart III-2Brazil: Public Debt Dynamics Are Precarious     In the early 2000s, the government stabilized its public debt dynamics by running persistent primary surpluses of about 4% of GDP (Chart III-2, top panel). Will Brazil achieve primary fiscal surpluses in the coming years assuming some form of the pension reform is adopted? It is doubtful. According to the government’s own forecasts, the submitted draft of social security reforms, including the one for the army, will save only BRL190 billion in next four years or 0.7% of GDP per year. The current primary deficit is 1.5% of GDP (Chart III-2). Unless nominal GDP growth and government revenue growth shoot up, the primary deficit will not be eliminated or the primary surplus will be very small. Overall, it seems unlikely that the government’s proposed pension reforms will be sufficient to turn around Brazil’s public debt dynamics in the next several years - barring very strong economic growth that will fill in government coffers. Bottom Line: We are downgrading Brazil from overweight to underweight within EM equity, local currency bonds and sovereign credit benchmarks. Andrija Vesic, Research Analyst andrijav@bcaresearch.com Footnotes Equity Recommendations Fixed-Income, Credit And Currency Recommendations