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  Underweight (High-Conviction) The flattening of both fixed residential investment and existing home sales (bottom panel) have given us cause for concern with respect to home improvement retailers (HIR). While we remain bullish on the domestic housing market, HIR have seen huge valuation gains over the past four years (top panel), which the softer data fail to justify. In the context of lumber prices that have fallen from their parabolic highs (third panel), at least a slowing of top line growth seems inevitable. Our earnings model captures these factors as well as higher mortgage rates, all of which have driven our HIR earnings model into outright deflation (bottom panel). Even if this proves to be overly pessimistic, it should at least drive higher equity risk premiums in the sector, taking some wind out of the inflated valuation. Bottom Line: Valuations in HIR are not supported by softening demand data, revenue headwinds and rising interest rates. We reiterate our high-conviction underweight recommendation. The ticker symbols for the stocks in this index are: BLBG: S5HOMI - HD, LOW.    

Highlights EM equity and credit outperformance versus the U.S. in the past three months was an aberration in the cyclical and structural downtrend. Hence, the recent outperformance of EM assets provides a good entry point for investors to short EM/China assets against their U.S. counterparts. In our opinion, this strategy will work in the coming months regardless of whether global risk assets rebound or sell off – i.e., they are not dependent on market direction. Feature The fourth quarter of 2018 was marked by a precipitous plunge in global equities, led by the U.S. In the meantime, EM stocks have outperformed the global equity benchmark in the past three months. Will EM and U.S. stocks trade places again, or will EM continue to outperform U.S. and DM equities? By the end of December, global share prices had become extremely oversold, and investor sentiment was downbeat. A trifecta of confidence-boosting developments – the rapprochement between the U.S. and China in trade negotiations, the announcement of more policy stimulus in China and reassurances from Federal Reserve Chairman Jerome Powell that monetary policy tightening is not predetermined – have since led to a rebound in global stocks. A key question for asset allocators heading into 2019 is: Will EM continue to outperform the global equity index in this rebound? We do not think so. The odds are considerable that EM will resume its underperformance versus DM in general and the U.S. in particular. The fundamental rationale for staying bearish on EM is that global trade and manufacturing remain on a downward trajectory. Chart I-1 illustrates that EM risk assets sell off when global trade is slowing, especially when the weakness stems from China. Chart I-1EM Selloff Has Been Due To Slowdown In China Chinese policymakers are easing both fiscal and monetary policies, but the impact of their efforts on the economy is yet to be seen. Declining interest rates in China do not constitute a sufficient condition to buy EM risk assets. Importantly, EM stocks often drop when Chinese interest rates are falling, as that reflects a deteriorating growth outlook (Chart I-2). Chart I-2Lower Interest Rates In China Is Not A Reason To Buy EM In short, monetary and fiscal stimulus in China are not yet sufficient to revive the mainland’s business cycle. The latter is critical to the performance of EM risk assets. We will explore China’s fiscal and credit stimulus efforts in much more detail in the coming weeks. Finally, EM equity valuations are no better than those in the U.S. In particular, our EM/U.S. relative stock valuation indicator based on a 20% trimmed mean is currently neutral (Chart I-3). This valuation measure strips out the top and bottom 10% for EM as well as U.S. sub-sectors and computes an equally weighted average of the other 80%. Hence, it eliminates the outliers that for structural or industry specific reasons trade at much lower or higher multiples. Consequently, contrary to the common narrative in the investment industry, EM equities are not cheap versus U.S. ones. Chart I-3EM Equities Are Not Cheaper Than U.S. Ones Given our high conviction on the view that U.S. will outperform EM over the coming several months, we are reiterating a few of our long-standing strategic recommendations/pair trades: Short EM stocks / long the S&P 500; Short EM banks / long U.S. banks; Short EM high-yield corporate credit / long U.S. high-yield corporate credit; Short Chinese property developers / long U.S. homebuilders. In all four cases, the recent outperformance of EM assets provides a good entry point for investors who do not yet have these positions. In our opinion, these recommendations will work in the coming months regardless of whether global risk assets rebound or sell off – i.e., they are not dependent on market direction. No Turnaround In Global Trade/Manufacturing Global cyclical equity sectors have plunged significantly and their prices may be recovering/stabilizing due to oversold conditions. Yet there are few signs of improvement in global trade and manufacturing, and no indication of a significant turnaround in financial markets that are most sensitive to global trade and Chinese growth. Our Risk-On-to-Safe-Haven (RSH) currency ratio1 has relapsed again following a failed rebound attempt (Chart I-4, top panel). Interestingly, this ratio seems to be forming a head-and-shoulders pattern, suggesting the next big move could be to the downside. As we have shown in past reports, EM share prices correlate strongly with this indicator, and a major downleg in this indicator would be consistent with a major drop in EM stocks. Chart I-4No Buy Signal For EM From The Global Currency Markets Furthermore, the annual rate of change on this currency ratio leads the EM manufacturing PMI, and it presently foreshadows more downside in the latter (Chart I-4, bottom panel). Korean and Taiwanese exports contracted slightly in December from a year ago. As frontloading from U.S. import tariffs wanes, their exports will shrink further. Chips prices are falling, signaling that the slump of the global tech hardware sector is not yet over (Chart I-5). Chart I-5Chip Prices Are Still Plunging Continued deterioration in global trade and manufacturing is bad news for emerging Asia. The technical profile of Asian stock markets is also poor, raising the odds of a meltdown as cyclical economic conditions in the region deteriorate further. The region’s relative equity performance versus global and Latin American indexes is relapsing, having failed to break above long-term moving averages (Chart I-6). Chart I-6Underweight Emerging Asian Stocks Versus Both World And Latin America Odds are that emerging Asian stocks will drop in absolute terms, underperforming both the EM and global equity benchmarks. This will drag the EM index down further. We continue to recommend the following strategy: long Latin American stocks / short emerging Asian equities. The U.S. manufacturing leading indicator – the ISM manufacturing new orders-to-inventory ratio – remains in a downtrend (Chart I-7). Chart I-7The U.S. Selloff Has Been Partially Due To Manufacturing Slowdown The average of new and backlog orders from the Chinese manufacturing PMI survey has plunged to its previous lows (Chart I-8, top panel). The domestic orders component of the People’s Bank of China’s latest 5000 industrial enterprise survey is also in a free fall (Chart I-8, bottom panel). Chart I-8China: No Sign Of Bottom In Industrial Sectors Meanwhile, the impact of Chinese domestic demand on the rest of the world occurs via mainland imports. The leading indicator for imports – the manufacturing PMI import sub-component – has plunged to 46, well below the 50 boom-bust line (see Chart I-1, bottom panel on page 1). Within the investable Chinese equity universe, cyclical sectors exposed to capital spending are making new lows in absolute terms (Chart I-9, top and middle panels). At the same time property stocks are relapsing again (Chart I-9, bottom panel). Chart I-9China: Not Much Rebound In Cyclical Equity Sectors While the authorities are once again boosting infrastructure spending by allowing local governments to issue more special bonds, the mainland’s real estate market has ground to a halt. The latter will likely offset the former. Finally, the MSCI China All Shares index – which incorporates all Chinese stocks trading inside and outside the country – has not rebounded much, despite being oversold (Chart I-10, top panel). Chart I-10China All Share Index: Poor Performance Continues Notably, this index’s relative performance versus both DM and EM equity indexes has failed to break above its 200-day moving average, despite the announced policy stimulus (Chart I-10, middle and bottom panels). These are negative technical signposts that bode ill for the outlook for Chinese share prices. Bottom Line: Odds are high that the global trade/manufacturing or related equity sectors/segments will continue struggling in the months ahead. What About The U.S. Dollar? The trade-weighted U.S. dollar has been going sideways for several months. While lower U.S. interest rate expectations have weighed on the greenback, the global manufacturing slowdown and risk-off sentiment in financial markets have put a floor under its value. The dollar is a countercyclical currency, and it does well when global growth is weakening, and vice versa (Chart I-11). Chart I-11The U.S. Dollar Is A Counter-Cyclical Currency It is impossible to know how long this standstill phase in the currency markets will last. What we do know is that when it breaks one way or another, the move will be violent and large. We believe risks to the U.S. currency are to the upside. First, U.S. consumer spending growth remains robust, and the labor market is very tight. Unless the rest of the world plunges into a major growth slump, pulling the U.S. down with it, U.S. interest rate expectations should recover, lifting the dollar. Second, a further downshift in U.S. interest rate expectations will likely occur only if the global economic slowdown is so severe that it leads the market to price in Fed rate cuts. In this scenario, the greenback will rally violently as well. The basis is that the dollar tends to appreciate during global slumps and sell off amid global growth recoveries, as illustrated in Chart I-11. Third, the only scenario where the dollar could plunge is where global trade recovers briskly, driven by growth outside the U.S. in general and in China/EM in particular. This is the least-likely scenario at the current juncture, in our opinion. The trend in the dollar is critical to the relative performance between EM and U.S. stocks. Chart I-12 demonstrates that periods of EM equity underperformance versus the U.S. typically coincide with an appreciation in the trade-weighted greenback, and vice versa. Chart I-12When EM Stocks Outperform The Global Benchmark, U.S. Underperforms And Dollar Weakens And Vice Versa Bottom Line: The next big move in the U.S. dollar will likely be up, not down. Investment Considerations Global equity prices are already reflecting a lot of bad news; they are oversold, and investor sentiment on global growth has become downbeat (Chart I-13). This could create a window for global equities to rebound on a tactical basis. Chart I-13U.S./Global Stocks Are Oversold The majority of our colleagues at BCA believe global equities are primed for a cyclical rally. We within BCA’s EM team agree with the equity rebound narrative but on a tactical basis and believe that any rebound will be led by U.S. stocks – and that EM will lag. We are not convinced that global equities are in a cyclical bull market yet. The main difference between BCA’s house view and the EM team’s outlook is the risks related to China’s economy and their impact on global cyclical equity sectors. The U.S. is relatively unexposed to Chinese growth, EM economies, commodities producers, Japan and Germany. Therefore, U.S. stocks will outperform and the dollar will do well if Chinese growth continues disappointing. Ongoing trade talks between China and the U.S. may bring about some positive results, and the Fed may continue to sound more dovish. However, we contend that the main culprit behind the global equity selloff in 2018 was neither the trade war nor the Fed, but the slowdown in global trade/manufacturing (please refer to Chart 1 and 7 on pages 1 and 6, respectively). On this front, we do not foresee an imminent reversal, as argued above. The latest underperformance of the U.S. has created a good entry point for our relative strategies/trades to be short EM / long U.S. We reiterate the following strategies/trades (Chart I-14): Chart I-14Reiterating Four EM Vs. U.S. Strategies/Trades Short EM stocks / long the S&P 500; Short EM banks / long U.S. banks; Short EM HY corporate credit / long U.S. HY corporate credit; Short Chinese property developers / long U.S. homebuilders. Within the EM equity space, we continue to recommend underweighting emerging Asia while overweighting Latin America, Russia and Central Europe. In particular, we are reiterating our long Latin America / short Emerging Asian equities trade initiated on October 11, 2018 (please refer to Chart I-6 on page 5). The complete list of our country equity allocations is presented on page 12. Finally, the path of least resistance for the dollar is up. We continue to recommend shorting a basket of the following EM currencies against the dollar: ZAR, IDR, MYR, KRW, COP and CLP. Arthur Budaghyan, Senior Vice President Emerging Markets Strategy arthurb@bcaresearch.com Footnotes 1      Average of CAD, AUD, NZD, BRL, CLP & ZAR total return indices relative to average of JPY & CHF total returns (including carry). Equity Recommendations Fixed-Income, Credit And Currency Recommendations

Prefer Large Caps To Small Caps (High-Conviction) This week’s NFIB survey showed that small business optimism has continued to fall through the end of the year, albeit from a very high level (top panel). This has coincided with the continued slide of small cap stocks relative to their large cap peers. What stood out to us was the percentage of small businesses with planned labor compensation increases continuing to set new all-time highs and deviating substantially from the national trend (second panel). This divergence becomes more worrying when plotted against those same firms increasing prices (third panel), which has trailed for some time and recently flattened. The inference is that margin pressure is intensifying and likely to continue for the foreseeable future. In the context of the absence of balance sheet discipline small caps have shown in the past five years (bottom panel), ongoing large cap outperformance seems ever more likely. Bottom Line: We reiterate our high-conviction call favoring large over small caps.