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

Highlights The banks got the current earnings season off to a good start, … : Lending growth may be running in place, and net interest margins are under pressure, but positive operating leverage helped the banks beat expectations, and they are returning gobs of cash to their shareholders. … are quite constructive about the economy, … : The big banks’ CFOs and CEOs were uniformly bullish about the U.S. economy based on their perceptions of household and corporate health. … expect stellar credit performance to continue for the foreseeable future, … : Net charge-off and non-performing loan ratios are near all-time lows and the banks don’t see them rising any time soon. … and appear to be willing to extend loans in all categories except commercial real estate: Every bank sees unattractive competition in commercial real estate lending and plans to continue shrinking its CRE loan book. Nothing To See Here Two-fifths of the companies in the S&P 500 have now reported their quarterly earnings, and after this week the share will be two-thirds. At the aggregate level, it appears as if investors’ worst fears will not be realized, just as they weren’t in the first two quarters of the year. 2018’s greater than 20% year-on-year growth, powered by the sharp cut in the top corporate income tax rate, has rolled off, but earnings have yet to contract. They were projected to fall by a little over 3% at the beginning of this reporting season, but repeated practice has allowed corporate managements to hone their underpromise-and-overdeliver skills to a fine point, and we won’t be surprised if they avert an outright contraction. Chart 1Profit Margins Are Being Squeezed, ... Chart 2... But Neither Growing Compensation, ... Earnings growth has been stagnant this year (Chart 1, bottom panel), though revenues have grown a little faster than nominal GDP (Chart 1, top panel), with which they should converge over time. Profit margins have finally come under pressure, though it’s not exactly clear why. Employee compensation is businesses’ biggest expense by far, and while it has risen from its lows, its growth decelerated last quarter (Chart 2). Dollar strength is a headwind for U.S.-based multinationals, but the dollar only really moved last quarter, after ending the first half where it started the year (Chart 3). Dollar gains weigh on revenues just as surely as they do on profits, though we would not be at all surprised if the share of non-dollar expenses is a good bit smaller than the widely quoted 33-40% estimate of S&P 500 constituents’ foreign sales. Chart 3... Nor A Stronger Dollar Is A Clear-Cut Culprit Rate cuts have sparked a wave of mortgage refinancings, shifting wealth from mortgage investors to homeowners, who are more likely to spend it. Easier monetary conditions should help grease the skids for future earnings growth, both in the U.S. and abroad, and we expect the Fed will cut the fed funds rate by another 25 basis points when it meets this week. We have sympathy for the argument that since interest rates were not a meaningful constraint on growth, cutting them is not likely to provide much of a catalyst. Falling rates have provoked a wave of mortgage refinancings (Chart 4), however, so even if they don’t drive a big lending increase, they are already on their way to putting more money in the pockets of homeowners. Lower rates also reduce the risk of default by lowering debt-service costs for adjustable-rate borrowers, and by encouraging investors who need income to venture further out the risk curve, providing ample capital for borrowers seeking to extend their maturing obligations. Chart 4Putting More Money In Homeowners' Pockets Follow The Money Chart 5Bank Stocks Are Probing Resistance For two years, beginning in 2014, we reviewed the biggest banks’ earnings calls every quarter. The goal was to observe the give and take between bank management and sell-side analysts to gain some insight into the lending market and where it might be headed. We specifically sought information about banks’ willingness to lend, consumers’ and businesses’ appetite for credit, borrower performance, and the banks’ bottom-up perspective on the economy. We were also trying to glean insight into mortgage lending and what it might imply for residential investment. Studying the banks is a natural pursuit for a firm that was founded upon the insight that following money flows through the banking system would provide us with a window into the future direction of the economy and financial markets, and we return to it today. Our analysis is not meant to evaluate the banks’ own investment potential, though we note that they are testing resistance once again (Chart 5), and our Global Investment Strategy and U.S. Equity Strategy services both recommend overweighting them. This round of calls found bank management teams eager to ramp up their distributions to shareholders and optimistic about their ability to deploy technology to drive further efficiency gains. Big Banks Beige Book As a group, the banks were constructive on the economy. Despite widespread recession concerns, they do not see evidence of a looming slowdown from their interactions with consumers and businesses. Overall loan growth has remained around 5% over the last year and a half (Chart 6), while corporate and industrial (C&I) loan growth has ground to zero over the last thirteen weeks (Chart 7). The CEOs and CFOs do not see the C&I slump as the beginning of a worrisome trend, though, and global corporate bond issuance hit an all-time high in September, led by sizable issues from mega-cap U.S. companies. Businesses seeking credit are having no trouble getting it, though all the banks expressed an intention to continue cutting back their exposure to commercial real estate (CRE) loans. Chart 6Bank Lending Is Supporting Activity Without Risking Overheating Chart 7Lending Momentum Has Slowed, But It's Okay Another commercial real estate issue emerged across the calls: several of the biggest banks are consolidating their branch footprints. Prompted by questioning from one analyst, they touted branch closures as a way to enhance efficiency. We do not know if a reduction in bank demand for branch space would have an observable effect on demand for retail space across the country, but it certainly would in Manhattan. It seems possible that branch closures could pressure some retail lessors’ profitability, and thereby act as a drag on CRE whole-loan and CMBS performance at the margin. The Economy [C]onsumer spend and … confidence continue to be strong. I think business activity continues to be strong. I think it’s moderated somewhat because of … trade policy, but generally, I think the economy is solid. (Dolan, USB CFO) I think it’s fair to say that perhaps marginal investment is being impacted by trade fatigue in terms of the uncertainty, but … [there’s] still growth. … [T]he consumer is incredibly strong, … spending is strong, sentiment is strong, … credit is good. [I]t is true that [the recent ISM manufacturing and non-manufacturing surveys] were disappointing[,] so [there are] cautionary signs, but credit remains very good and there is still very healthy business activity. (Piepszak, JPM CFO) In general, our commercial customers continue to see moderate demand and no widespread issues related to trade uncertainty and interest rate changes. … [W]hile our customers are cautious, the most common concern they identify is their ability to hire enough qualified workers. (Shrewsberry, WFC CFO) Consumer payments up 6% year-to-date … [and 6% year-over-year 3Q growth in both our small business segment and total commercial loans] are tangible examples that the U.S. economy is still in solid shape, despite the worries and concerns about trade wars, capital investment slowdowns or other global macro conditions. (Moynihan, BAC CEO) Borrower Performance [W]e’ve had growth in the United States for the better part of 10 years [a]nd … credit is extraordinarily good. … [C]onsumer credit, commercial credit, wholesale is extraordinarily good, it can only get worse if you have a [turn in the] cycle. [Our guidance relates to expected performance across a full cycle.] We’re at the over-earning part of the cycle [beating the through-the-cycle expectation] in credit today, and [at] one point we’ll be at the under-earning part [pulling the full result down to our expectation]. (Dimon, JPM CEO) Our net charge-off rate remains near historic lows at 27 basis points (Chart 8). (Shrewsberry, WFC) Chart 8C&I Charge-Off Rates Are Near Their Historic Lows Credit quality remains stable, and we are not seeing any early indicators in our portfolio that cause us concern. (Cecere, USB CEO) Banks see no broad credit warning signs, but they're perfectly happy to let non-bank lenders take some commercial real estate share at this point of the cycle. We closely monitor our commercial portfolio for signs of weakness and credit quality indicators remain strong. (Shrewsberry, WFC) Lender Willingness [W]e are mindful that at some point, the industry will experience a credit downturn, and we remain disciplined in terms of origination quality and our long-term strategy of remaining within our defined credit box regardless of the competitive environment. (Cecere, USB) [Commercial] real estate banking [declined] as we remain selective, given where we are in the cycle. (Piepszak, JPM) [Commercial real estate lending] is one market where there’s late cycle behavior, there’s lots of non-bank competitors, … more than bank competitors. And so we really have to pick our spots in order to maintain our risk/reward, credit and pricing in loan terms quality. … I wouldn’t look for it to grow meaningfully until the cycle turns and our best customers have really interesting opportunities to put their own capital to work. (Shrewsberry, WFC) [Our declining commercial real estate lending is] really a function of [competition] that we’re not comfortable with. (Cecere, USB) Banks’ Real Estate Demand [C]ustomer behaviors are changing. The amount of transaction activity that’s happening in the branches is significantly less[.] In fact, … roughly 70, 80% of it goes through the digital channel today. So that gives us the opportunity to really reconfigure the branch network, both in terms of size and numbers[.] I think those trends are going to continue … , and … we may accelerate or increase some of [our right-sizing] activity[.] (Dolan, USB) Teller and ATM transactions declined 6% from a year ago, reflecting continued customer migration to digital channels. We’ve consolidated 130 branches in the first nine months of this year, including 52 branches in the third quarter. (Shrewsberry, WFC) [D]o we continue to work on real estate configurations that were down 50 million square feet from the start of 2010[?] [C]an we push [the occupancy rate] up, can we densify the space[?] (Moynihan, BAC) Investment Implications While rereading the April 2014 U.S. Investment Strategy that reviewed the big banks’ 1Q14 earnings calls, we were struck by how similar the picture is today. Back then, we described the central challenge for investors as choosing between mushy fundamentals and generous monetary policy that might be expected to inspire a valuation overshoot. As we do now, we anticipated that activity would soon pick up, providing markets with a fundamental boost, but we also had the sense that “policy settings are such that no much more than the status quo may be required to keep the party going.” We reiterated our equity overweight and our preference for spread product over Treasuries. Between inflection points, investing is an exercise in trend following, and there's no reason to believe that the monetary policy trend is about to change without clear advance notice. Although we are congenitally optimistic about our species and our country, we are not perma-bulls. We simply recognize that, between inflection points, investing is an exercise in trend following, no matter how uncomfortable it may make an investor to leave the portfolio dials alone for a while. As long as the monetary policy backdrop remains extremely accommodative across all of the major developed economies, and central banks are set to add even more accommodation before they start removing it, the bullish trend will remain in place. The prospective real returns of cash and highly-rated sovereign bonds are likely to remain negative for a while against that backdrop, encouraging investors to direct their marginal investment dollar to risk assets as long as a fundamental reversal is not imminent. We think a fundamental inflection is at least two years away, and therefore continue to believe that it is too early to de-risk investment portfolios. We reiterate our recommendation that investors remain at least equal weight equities in balanced portfolios, and at least equal weight spread product within their fixed-income allocations. Doug Peta, CFA Chief U.S. Investment Strategist dougp@bcaresearch.com

The latest Standard & Poor’s update of Q2 buybacks revealed that one of the largest equity buyers since the Great Recession went on a buyer’s strike. The chart shows that SPX buybacks are actually contracting. Not only has the fiscal impulse died down from the 2018 zenith, but also the economic soft patch is re-concentrating CEO minds. In other words, there is evidence that not only are CEOs pruning capex (as a reminder investment spending contracted in Q2), but also they are cutting back on equity retirement. Such prudent cash management typically happens when confidence in the longevity of the business cycle is low. Historically, the ISM manufacturing and the Conference Board CEO surveys are excellent leading indicators of SPX buybacks and the current message is to expect further contraction in the latter. Bottom Line: This “slaying of animal spirits” as we highlighted in recent research1 represents a red flag and warrants caution on the prospects of the broad equity market in the coming months.​​​​​​​ 1 Please See U.S. Equity Strategy, "Slaying Animal Spirits," dated October 10, 2019.

Highlights Portfolio Strategy Soft housing demand, the trough in interest rates, new home price deflation and weak industry employment prospects suggest that an underweight stance is now warranted in the S&P homebuilding index.      Firming demand/supply dynamics, IMO Sulfur 2020 regulations, and bombed out relative profit expectations all signal that further gains are in store for pure-play refining equities. Recent Changes Downgrade the S&P homebuilding index to underweight, today. Table 1 Feature Equities made a run for fresh all-time highs last week, continuing to cheer the trade war “phase one” deal and breathing a big sigh of relief on better-than-expected bank earnings. We doubt a real deal will materialize which would include Intellectual Property and the tech sector. Instead all we got was a trade truce, at best. Larry Kudlow’s recent football analogy is worth repeating: “It's like being on the seven-yard line at a football game…And as a long suffering New York Giants fan, they could be on the seven and they never get the ball to the end zone…When you get down to the last 10 percent, seven-yard line, it's tough". As a reminder, steep tariffs remain in place and there are high odds that the damage already done to global trade is severe enough that it will be months before the emergence of any green shoots. Meanwhile, following up on our “chart of the year candidate” we published two weeks ago, we drilled deeper and discovered two additional economically sensitive indexes that have consistently peaked prior to the SPX in the past three cycles (Chart 1). They now comprise the U.S. Equity Strategy’s Equity Leading Indicator – an equally weighted composite of the S&P Banks index, the Russell 2000 index and the Value Line Geometric index – which signals that the easy money has already been made this cycle in the SPX (Chart 2). Chart 1Three Bulletproof Signals... Chart 2...Combined Into One Leading Equity Indicator Importantly, absent profit growth, it remains extremely difficult for equities to embark on a sustainable fresh leg up by solely relying on multiple expansion. Chart 3 shows our updated Corporate Pricing Power Indicator (CPPI) and it continues to deflate. In fact the steep fall in our CPPI more than offsets the fall in wage growth warning that the margin contraction in the S&P 500 has staying power1 (bottom panel, Chart 3). Drilling beneath the surface, our CPPI is waving a red flag. As a reminder, we calculate industry group pricing power from the relevant CPI, PPI, PCE and commodity growth rates for each of the 60 industry groups we track. Table 2 also highlights shorter term pricing power trends and each industry's spread to overall inflation. Only 42% of the industries we cover are lifting selling prices by more than 1%, and 33% are outright deflating. Worrisomely, only 26% of sectors are raising prices at a faster clip than overall inflation. With regard to pricing power trends, two thirds of the industries we cover are either flat or in a downtrend (Table 2). Chart 3Nil Corporate Pricing Power Table 2Industry Group Pricing Power Gold has jumped to the top of our table galloping at a 26%/annum rate (keep in mind it was deflating in our early July update), and only three additional commodity-related industries made it to the top twenty (Table 2). The disappearance of the commodity complex from the top ranks is consistent with global PPI ills and U.S. dollar strength. This week we update two groups, one early and one deep cyclical. Interestingly, defensive sectors have a healthy showing in the top ten spots with five entries. On the flip side, commodities in general and energy-related industries in particular occupy the bottom of the ranks as WTI crude oil is steeply deflating from the October 2018 peak. Adding it up, corporate sector selling price inflation is sinking in line with depressed inflation expectations. As we posited in our recent profit margin Special Report, profit margins have already peaked for the cycle. We reiterate our cautious overall equity market view on a cyclical 9-to-12 month time horizon. This week we update two groups, one early and one deep cyclical. Cracking Homebuilding Foundations We recommend downgrading the niche S&P homebuilding index to underweight, as most, if not all, positive profit drivers are already reflected in relative share prices. Specifically, the drop in interest rates has been more than accounted for by the year-to-date outperformance in homebuilders. Since the Great Recession, homebuilders have been in clearly defined mini up-and-down cycles, and there are high odds we will soon enter a down oscillation (bottom panel, Chart 4). Interest rates bottomed in early September and there is little additional push they can exert to relative share prices (10-year Treasury yield shown inverted, top panel, Chart 4). Chart 4Relative Gains Are Exhausted Worrisomely, consumers’ expectations to purchase a new home nosedived last month according to The Conference Board’s survey, and that demand softness will weigh on housing starts and ultimately homebuilding revenues (Chart 5). Chart 5Cracks Forming Adding insult to injury, new house selling prices are losing ground to existing home prices, but such discounting is no longer boosting volumes as new home sales market share gains have stalled recently. Already, S&P homebuilding sales are contracting and the risk is that deflation gets entrenched in this construction industry (Chart 6). While the mortgage application purchase index (MAPI) has been rising on the back of the plunge in interest rates, the 30bps rise in the 10-year Treasury yield since September 1 signals that the MAPI has tentatively crested (second panel, Chart 7). Chart 6Contracting Sales Chart 7Margin Trouble Simultaneously, lumber prices are gaining steam and coupled with contracting new home prices signal that homebuilding profits will suffer a setback (middle & fourth panels, Chart 7). This stands in marked contrast to the sell-side community that has been ratcheting up profit estimates for the S&P homebuilding index (bottom panel, Chart 7). Netting it all out, soft housing demand, the trough in interest rates, deflating new home prices and weakening industry employment prospects suggest that an underweight stance is now warranted in the S&P homebuilding index. On the operating front, the labor market is also emitting a distress signal. Job openings in the construction industry are sinking like a stone and residential construction employment growth is flirting with the contraction zone. Historically, the ebbs and flows in construction jobs have moved in lockstep with relative share price performance and the current message is to expect a drawdown in the latter (Chart 8). Most of the indicators we track underscore a challenging homebuilding backdrop in the coming months. However, there is a key risk to our view: interest rates. Were the 30-year fixed mortgage rate to fall further from current levels, it would entice first time home buyers and cushion the blow to homebuilding demand (mortgage rates shown inverted, top panel, Chart 9). Similarly, bankers are willing extenders of mortgage credit and are reporting rising demand for residential real estate loans as a lagged consequence of falling rates. But, our sense is that the easy gains are exhausted and a reversal is in the offing in most of these measures (Chart 9). Chart 8Heed The Labor Market's Message Chart 9Potentially Lower Rates Are A Key Risk Netting it all out, soft housing demand, the trough in interest rates, deflating new home prices and weakening industry employment prospects suggest that an underweight stance is now warranted in the S&P homebuilding index. Bottom Line: Downgrade the S&P homebuilding index to underweight, today. The ticker symbols for the stocks in this index are: BLBG – S5HOME – DHI, LEN, PHM, NVR. Stick With Refiners While our bullish take on refiners got to a slippery start, it has recovered all the losses and this position is now in the black. Factors are falling into place for additional gains in the coming months and we recommend investors stick with this overweight recommendation in pure-play downstream stocks. Encouragingly, refining stocks have been trouncing the overall energy index of late and have resumed their multi-year relative uptrend (top panel, Chart 10). With regard to the export relief valve, U.S. net exports of refined products are on a secular uptrend and surprisingly unaffected by the greenback’s moves (bottom panel, Chart 10). Tack on the soon to be adopted International Maritime Organization (IMO) Sulfur 2020 regulations in maritime transportation fuel, and U.S. refiners that produce lower-sulfur fuel oil are well positioned to outearn the SPX. Chart 10Resumed Uptrend Domestic refined product consumption remains upbeat and should serve as a catalyst to unlock excellent value in this niche energy subgroup (middle panel, Chart 11). In fact, gasoline consumption is expanding anew on the back of rising vehicle miles travelled (bottom panel, Chart 11). Chart 11Solid Demand... Refining product supply dynamics are also moving in the right direction. Gasoline inventories are getting whittled down and should boost beaten down refining relative profit expectations (inventories shown inverted, bottom panel, Chart 12). Importantly, this firming demand/supply backdrop has been a boon to refining margins and should continue to underpin relative share price momentum (middle panel, Chart 12). In terms of what is baked in the cake for this industry, the expected profit growth bar is extremely low and falling and relative value has been fully restored. First in terms of relative valuations, the relative trailing price-to-sales ratio has corrected 35% from the mid-2018 peak (middle panel, Chart 11). On a forward PE ratio basis refiners are extremely appealing compared with the SPX following a near halving in the relative forward PE in the past fifteen months (second panel, Chart 13). Chart 12...Supply Backdrop Is Boosting Crack Spreads  Chart 13Profit Hurdle Is Uncharacteristically Low Second, relative EPS growth has sunk below the zero line both twelve months and five years forward. Such pessimism is overdone and we would lean against sell-side bearishness (bottom panel, Chart 13). Even the refining industry’s net earnings revisions ratio has collapsed, which is contrarily positive (third panel, Chart 13). Adding it all up, firming demand/supply dynamics, IMO Sulfur 2020 regulations, and bombed out relative profit expectations all signal that further gains are in store for pure-play refining equities. Bottom Line: Stay overweight the S&P oil & gas refining & marking index. The ticker symbols for the stocks in this index are: BLBG – S5OILR – MPC, VLO, PSX, HFC.   Anastasios Avgeriou, U.S. Equity Strategist anastasios@bcaresearch.com   Footnotes 1      Please see BCA U.S. Equity Strategy Special Report, “Peak Margins” dated October 7, 2019, available at uses.bcaresearch.com. Current Recommendations Current Trades Size And Style Views Stay neutral cyclicals over defensives   (downgrade alert) Favor value over growth Favor large over small caps (Stop 10%)

ハイライト 先週合意された暫定的な「フェーズ1」貿易協定は、米中貿易戦争におけるデタントに向けた重要な一歩を示しています。 ブレグジット交渉の今後にかかわらず、ハード・ブレグジットは回避される見込みです。ポンドをロングで保有し続けてください。 米国の企業業績の伸びは第3四半期に横ばいとなる可能性が高く、ボトムアップの予想にある前年比減少とは対照的です。 世界成長が年末までに再加速すれば、企業業績の伸びは回復するはずです。 世界成長の強まりは米ドルに下押し圧力をかけるでしょう。 12か月の期間では、債券に対してグローバル株式をオーバーウェイトのまま維持してください。 景気循環株はディフェンシブ株をアウトパフォームし始めるはずです。金融セクターはついに日の目を見るでしょう。 好ましい追い風 2週間前に公表した第4四半期ストラテジー・アウトルックでは、グローバル株式が「見せて」フェーズに入ったと主張しました。つまり、株価指数が上昇するには、貿易戦争のエスカレーションの緩和と世界成長の回復を示す具体的な証拠が必要だという意味です。1  先週金曜、貿易面でいくつかの好材料がありました。2500億ドル相当の中国からの輸入品に対し10月15日に25％から30％へ引き上げる予定だった関税の実施を見送ることと引き換えに、中国は年間で400～500億ドル分の米国農産物を購入し、米国の金融サービス企業への市場アクセスを改善し、為替管理の透明性を高めることに合意しました。 確かに、やるべきことはまだ多く残っています。協定文はまだ最終化されていません。両国は、11月16–17日のチリ・サンティアゴでのAPECサミットまでに合意をまとめることを目指しています。しかし、どのような執行・解決メカニズムが協定に盛り込まれるかなど多くの重要課題が未解決のままであることを考えると、さらに遅延したり、交渉が決裂したりする可能性もあります。 先週の暫定合意は、知的財産保護の扱いという厄介な問題を「フェーズ2」に先送りする形にもなっています。「フェーズ1」がまとまり次第、間もなく「フェーズ2」が始まる予定です。 独立かつ超党派の米国知的財産の窃盗に関する委員会によれば、米国の生産者は知的財産の窃盗により年間で約$225～$600 billionの損失を被っているとされています。2 中国はしばしば最悪の加害国の一つと見なされてきました。 知的財産問題の重要性を考えれば、約1600億ドル相当の中国からの輸入に対して15％の関税が12月15日に導入されないようにするには、実質的な進展が必要となるでしょう。 トランプは合意を望んでいる 多くの障害が残るものの、先週の展開は18か月に及ぶ貿易戦争のデタントの見込みを大きく高めました。自称「マスター交渉人」であるトランプ大統領は、交渉を「ラブフェスト」と表現し、この貿易協定は「我が偉大なる愛国的農家のために結ばれたこれまでで最大かつ最高の取引だ」と呼び、最終合意が達成されることに「ほとんど疑いはない」と述べて自らの信頼性を賭けています。NAFTAの後継であるUSMCAと同様に、トランプは交渉を自らの功績として宣伝するマーケティングモードに入る可能性が高く、米国民のために交渉した「驚くべき」新協定を大々的に宣伝するでしょう。 政治的観点から見ると、これは非常に理にかなっています。正否は別として、トランプ大統領は有権者から経済運営について他のどの分野よりも高い評価を受けています（チャート 1）。長引く貿易戦争は米国経済を弱体化させ、トランプの再選の見通しを損なうことになります。 チャート 1 トランプは経済運営について比較的高評価を得ているが、他はそれほどではない クンバヤ クンバヤ チャート 2 中国企業は関税の大部分を負担していない クンバヤ クンバヤ トランプの主張に反して、証拠は明確に米国の消費者が関税の大部分を負担していることを示唆しています。チャート 2は、対中輸入品に対する関税率が上昇する一方で、米国の輸入価格はほとんど下がっていないことを示しています。最近の関税の多くが米国や第三国に競合相手がほとんどいない中国製品に焦点を当てている以上、中国の生産者が関税コストを転嫁する能力はさらに高まります。 もし発表されたすべての関税引き上げが実施されれば、対中輸入品の実効関税率は8月下旬時点の約15％から12月には最大約25％にまで上昇することになります（チャート 3）。そのような関税率は、米国の可処分所得を1000億ドル以上減少させ、2017年の減税によるほとんどの恩恵を消し去ることになります。トランプは貿易戦争をそこまで進行させるわけにはいきません。 チャート 3 度重なる関税引き上げが積み重なり始めている 相次ぐ関税が積み重なり始めている 相次ぐ関税が積み重なり始めている 中国は強硬策に出るか？ 貿易戦争を有利に解決する上でのリスクの一つは、中国側がトランプを「合意に飢えている」と見なし、交渉で強硬姿勢をとる可能性があることです。このリスクは無視できませんが、我々は次の三つの理由でそれを過度に重視しません。 第一に、貿易戦争の期間、中国の輸出業者はある程度の価格決定力を維持してきたとしても、貿易量は依然として悪化しており、9月の対米輸出は前年同月比でほぼ22％減少しています。 第二に、ZTEに対する強力な制裁が示したように、中国は依然として米国の技術に大きく依存しています。これがトランプに交渉上の大きなレバレッジを与えています。 チャート 4 誰が2020年の民主党指名を勝ち取るか？ クンバヤ クンバヤ 第三に、トランプ自身がよく言うように、中国は彼の第1期目の任期中に彼と交渉する方が、第2期目になってから交渉するよりも容易だと考えるでしょう。数か月前、ジョー・バイデンが世論調査で高支持率だったときにはトランプの再選を望まない方が中国にとって理にかなっていたかもしれませんが、エリザベス・ウォーレンが民主党指名を獲得する有力候補として浮上したことで、その希望は消えました（チャート 4）。数週間前に述べたように、中国はウォーレンが貿易問題でトランプよりも手ごわくないとは考えないでしょう。3  これらすべてを総合すると、中国もトランプ同様、今後数週間で貿易緊張を和らげる方法を模索するだろうと示唆しています。 ブレグジットの突破口か？ 記事執筆時点で、ブレグジット合意の見通しは明るくなっています。詳細はまだ公表されていませんが、提案された合意は北アイルランドを事実上、欧州単一市場の一部でありながら同時に英国の一部でもあるという量子的な重ね合わせ状態に置くことになります。これは北アイルランドを英国の政治的管轄下に置きつつ、EUの規制基準と整合させ続けることで実現されます。 交渉が破綻する可能性は依然としてあります。ジョンソン首相が「素晴らしい新協定を取り付けた」と確約したにもかかわらず、保守党の連立相手である北アイルランドの民主統一党は依然として協定への支持を留保しています。労働党のジェレミー・コービン党首もこれを拒否し、テリーザ・メイが当初提案した協定よりもさらに悪いと述べています。 今後数日に何が起きようとも、我々はハード・ブレグジットは回避されると引き続き考えています。ブレグジット問題を通じて、英国の支配階級の中に無協議離脱を支持する十分な政治的支持は存在しないと我々は主張してきました。世論調査が示すように、再度国民投票が行われればEU残留を選ぶ有権者の割合が増えていることが明らかになるにつれ、その確信はさらに強まっています（チャート 5）。 我々は2017年8月3日以来、ユーロに対してポンドをロングしています。このトレードはこの期間で6.6％上昇しました。投資家はこのポジションを維持すべきです。実質金利差に基づけば、GBP/EURは現在の1.16ではなく1.30付近で取引されるべきであると考えられます（チャート 6）。ハード・ブレグジットリスクがさらに後退すれば、クロスは公正価値に向かうと予想します。 チャート 5 ブレグジット不安：後悔の事例 ブレグジット不安：ブレモースの場合 ブレグジット不安：ブレモースの場合 チャート 6 ポンドには大きな上値余地がある ポンドの大幅な上昇余地 ポンドの大幅な上昇余地   世界成長見通しは改善 チャート 7 成長減速はソフトデータでより顕著だった 景気の減速はソフト指標でより顕著になっている 景気の減速はソフト指標でより顕著になっている チャート 8 ISMの低迷の中で製造業生産は反発している 製造業の生産高がISM指数の低迷の中で反発 製造業の生産高がISM指数の低迷の中で反発 貿易戦争のデタントとブレグジット問題の解決は世界成長を下支えするはずです。経済データの弱さは、事業調査のような「ソフト」指標でより明確に現れており、工業生産などの「ハード」指標ほど顕著ではありません（チャート 7）。特に、ISM製造業指数が低迷する中でも、過去3か月間で米国の製造業生産は安定しています（チャート 8）。センチメントが回復すれば、ソフトデータも改善するでしょう。 世界の金融環境は、主に多くの中央銀行によるハト派転換のおかげで過去5か月で大幅に緩和されました（チャート 9）。政策金利を引き下げた中央銀行の純数は、一般に6～9か月先行して世界の製造業PMIをリードします（チャート 10）。加えて、FRBが再び国債買入れを開始した決定はドル流動性を増やし、金融環境の更なる緩和に寄与するでしょう。 チャート 9 緩和された金融環境が世界成長を押し上げる 金融環境の緩和が世界経済の成長を後押しする 金融環境の緩和が世界経済の成長を後押しする   チャート 10 金融緩和の効果は間もなく実体経済に波及するはずだ 金融緩和の効果は間もなく経済に波及するはずだ。 金融緩和の効果は間もなく経済に波及するはずだ。 中国による景気刺激の強化も世界成長の再加速を後押しするはずです。中国のマネーおよびクレジットの伸びは9月に予想を上回りました。中国人民銀行は預金準備率を引き下げており、これがインターバンク金利の低下に寄与しています。残りの今年期間で中期貸出制度（MLF）への更なる利下げが予想されます。中国のクレジット成長の変化は世界成長を約9か月先行します（チャート 11）。 チャート 11 中国の信用拡大が世界成長の回復を支える 中国のクレジットは世界経済の成長回復を支えるはずだ 中国のクレジットは世界経済の成長回復を支えるはずだ グローバル株式をオーバーウェイトのまま APECサミットまでに「フェーズ1」貿易協定をまとめる道のりはでこぼこ道である可能性が高いものの、我々は12か月の投資期間において債券に対してグローバル株式をオーバーウェイトするという推奨を引き続き強調します。 世界成長が底打ちしているという証拠をもう少し確認でき次第、数週間以内に新興国（EM）および欧州株式の評価を引き上げる見込みです。 最終的に株式の軌道は業績の動向に依存します。米国の決算シーズンは今週始まりました。先週時点でFactSetがまとめたデータによれば、アナリストはS&P500のEPSが第3四半期に前年同期比で4.6％減少すると予想していました。ただし、2015年以降、EPS成長は概ね予想を約4ポイント上回ってきたことを念頭に置いてください（チャート 12）。したがって、妥当な見方は、米国の業績は今四半期横ばいとなり、低い期待値のハードルをクリアするというものです。 チャート 12 実際のEPSは概ね予想を上回っている クンバヤ クンバヤ チャート 13 利益と名目GDP成長は同じ動きをする傾向がある 収益と名目GDP成長率は歩調を合わせて動く傾向がある 収益と名目GDP成長率は歩調を合わせて動く傾向がある これまでに決算を発表した63社のS&P500構成銘柄のうち83％が予想を上回っており、これは歴史的平均の64％を上回っています。これにより現在の第3四半期の見積りは悲観的すぎるという見方が支持されます。 先を見れば、名目GDP成長が加速するにつれて業績成長は回復するはずです（チャート 13）。 世界成長が加速すると、新興国（EM）と欧州株式は一般にグローバルベンチマークをアウトパフォームする傾向があります（チャート 14）。これはそれらの株式市場がより景気循環的であるためです。加えて、ドルは逆循環的通貨として、高成長環境では弱含む傾向があります。ドル安は景気循環株に対して相対的に大きな恩恵をもたらします（チャート 15）。  チャート 14 新興国およびユーロ圏の株式は世界成長が改善すると通常アウトパフォームする 世界経済の成長が改善すると、新興国株式とユーロ圏株式は通常アウトパフォームする 世界経済の成長が改善すると、新興国株式とユーロ圏株式は通常アウトパフォームする チャート 15 ドルが弱含めば景気循環株がアウトパフォームする ドル安になれば景気循環株がアウトパフォームする ドル安になれば景気循環株がアウトパフォームする 我々は金融株を景気循環セクターの定義に含めます。世界成長が改善すると、長期国債利回りは限界的に上昇します。中央銀行が急いで利上げする状況にはないため、イールドカーブはスティープ化するでしょう。これが銀行の利益と株価を押し上げます（チャート 16）。 景気循環株は現在ディフェンシブ株と比べてかなり割安です（チャート 17）。同様に、非米国株式は地域間のセクター構成の違いを調整しても、米国株に比べてかなり割安です。米国株はフォワードEPS倍率で17.5倍で取引されているのに対し、国際株式はより魅力的な13.7倍のフォワードPEで取引されています。より高い利益利回りとより低い海外金利の組み合わせは、米国外の株式リスクプレミアムが概ね2パーセントポイント高いことを示唆しています（チャート 18）。 チャート 16 利回り曲線の急勾配化は金融株に恩恵をもたらす より急勾配なイールドカーブは金融セクターに恩恵をもたらす より急勾配なイールドカーブは金融セクターに恩恵をもたらす チャート 17 景気循環株はディフェンシブ株より魅力的だ 景気循環株はディフェンシブ株より魅力的だ 景気循環株はディフェンシブ株より魅力的だ   チャート 18 株式リスクプレミアムはかなり高く、特に米国外で顕著だ 株式リスクプレミアムはかなり高く、特に米国外で顕著です。 株式リスクプレミアムはかなり高く、特に米国外で顕著です。 世界成長が底打ちするという証拠をもう少し確認でき次第、我々は数週間以内に新興国および欧州株式の評価を引き上げる見込みです。  ピーター・ベレジン、 チーフ・グローバル・ストラテジスト グローバル・インベストメント・ストラテジー peterb@bcaresearch.com 脚注 1本文は、グローバル・インベストメント・ストラテジーの「第4四半期2019 ストラテジー・アウトルック：『見せて』市場」（2019年10月4日）を参照してください。 2 「Update to IP Commission Report: The Report of the Commission on the Theft of American Intellectual Property」（2017年）、The National Bureau of Asian Research。 3本文は、グローバル・インベストメント・ストラテジー週次レポートの「エリザベス・ウォーレンと市場」（2019年9月13日）を参照してください。 ストラテジー＆マーケット動向 マクロクォント・モデルと現在の主観的スコア クンバヤ クンバヤ 戦略的推奨 クローズドトレード

特別レポート

Highlights A recovery in Chinese auto sales is not imminent. Car sales will likely stage only a rate-of-change improvement, moving from deep to mild contraction or stagnation over the next three-to-six months. Low-speed electric vehicles are a cheap substitute for regular low-end cars. Their production requires fewer inputs and parts compared to cars. Hence, their rising penetration will be negative for economic activity at the margin. Auto ownership will continue to rise in China in the years to come. However, this does not necessitate rising car sales. In fact, auto ownership can increase with car sales contracting in each consecutive year. This scenario represents a major risk to auto stock prices. Feature Chart 1Chinese Auto Sales: An Extended Downturn Chinese automobile sales have been deep under water for 15 consecutive months. The magnitude of the contraction has been even worse than the one that occurred in 2008-‘09. Annualized sales1 have declined from a peak of nearly 30 million units in June 2018 to 26 million this September (Chart 1). To put this 4-million-unit decline into perspective, only about 5 million units of automobiles were produced in Germany last year. Given the already long and deep contraction, does this mean Chinese auto sales and production are about to stage an imminent recovery? Although a revival sometime next year is plausible, we are not positive in the near term. Car sales will stage a rate-of-change improvement only, moving from deep to mild contraction or stagnation (i.e. zero growth) the next three to six months (Chart 1, bottom panel). Gauging The Demand Outlook Chart 2Marginal Propensity To Spend Is Falling Reluctance to purchase a car and curtailed financing are the causes of the deep auto sales contraction in China. The factors that have weighed on consumers’ willingness to purchase cars remain intact. First, our indicator for household marginal propensity to spend continues to fall, indicating no immediate signs of a turnaround (Chart 2). Cyclically, decelerating economic activity is weighing on income expectations, prompting consumers to delay their discretionary spending. Besides, the growth rate of disposable income per capita is at the lower end of its historical range and is falling in real (inflation-adjusted) terms (Chart 3). In addition, Chinese households are more leveraged now than their U.S. counterparts (Chart 4). Their debt levels have reached over 120% of annual disposable income. Chart 3Real Disposable Income Growth Is Weakening Chart 4Chinese Households Are Increasingly Indebted   Meanwhile, the U.S.-China confrontation continues to foster uncertainty among consumers and businesses in the Middle Kingdom. Although some sort of agreement was reached last week, the future of longer-term U.S.-China relations remains highly uncertain. Hence, the potential “phase-one” trade agreement is unlikely to shift Chinese consumers’ and businesses’ overall cautious sentiment. These factors will continue to weigh on consumers’ purchasing behavior, especially on big-ticket items like automobiles. Reluctance to purchase a car and curtailed financing are the causes of the deep auto sales contraction in China. Second, Chinese auto financing penetration rate – measured as the proportion of autos bought using borrowed funds – has risen from 20% in 2014 to about 48%2 last year. This remains well below the 70%-plus penetration rate in major western countries (the U.S., Germany and France), but is not far from the 50% rate in Japan. The rapid increase in the use of auto financing has facilitated auto sales in China over the past several years. Financing for auto purchases has been provided by banks via loans and credit cards, dealer/manufacturer loans and peer-to-peer lending (P2P). While banks contribute about 40% of auto financing and auto dealers/manufacturers account for about 30%, the peer-to-peer platform has become the third major source of auto loans in recent years. Chart 5Limited Auto Financing From Peer-To-Peer Platforms However, since early last year, bankruptcies and closures of P2P platforms have significantly reduced available auto financing. P2P financing continues to shrink, further depressing loans for auto purchases (Chart 5). Third, there is an ongoing structural decline in consumers’ willingness to purchase cars due to greater traffic congestion, limited parking and improved public transportation. In addition, greater use of ride-sharing and car-sharing services, which the government is aiming to promote, will also continue to reduce the need to buy a car. Concerning government incentives for auto buyers, auto sales have failed to recover, so far this year, despite policy support and significant auto price cuts (Box 1). Although the government recently loosened some restrictive auto sales policies in certain cities,3 the scale was much smaller than what was done earlier this year. As in any market, production decisions are driven by sales, not inventories. Box 1 Policy Support And Auto Price Cut During January-September 2019 Since late January, Chinese authorities have released a set of pro-auto-consumption measures aimed at spurring auto sales. These measures include the approval of 100,000 new license plates in Guangzhou province and an additional 80,000 in Shenzhen. Since May, auto dealers in China have slashed prices of their Emission Standard 5 cars in order to liquidate inventories, as 15 provinces/provincial level cities have been implementing the new emissions standards since July 1, 2019 – one year earlier than the national implementation deadline. According to the law, vehicles that do not meet the new standard will not be allowed to be sold or registered once the new standard is implemented. Another pertinent question to address is whether inventories can be used to identify a bottom in this industry. This is difficult to gauge in China, as inventories at different stages of the supply chain are currently sending conflicting signals. Manufacturers’ inventories have dropped to low levels (Chart 6). Yet, dealers’ inventories remain elevated according to the newly released inventory data for September (Chart 7). Chart 6Auto Manufacturers Inventories Are Low... Chart 7...But Dealers Inventories Remain Elevated   Chart 8Auto Demand Drives Production As in any market, production decisions are driven by sales, not inventories. The chain reaction always starts from demand: rising sales lead to rising production. Producers do not typically ramp up output when sales are falling, even if inventories are low (Chart 8). Without a strong and durable rise in demand, manufacturers will not significantly increase their inventories. In short, low car inventories among manufacturers could lead to a short-term rise in output. A sustainable and lasting recovery in production, however, is contingent on a cyclical revival in auto sales. Bottom Line: A cyclical recovery in auto sales is not imminent in the next three-to-six months. A Threat From A Cheap Substitute In many small cities (from Tier 3 to Tier 6 cities), towns and villages where auto buyers are more sensitive to prices, consumers are opting to purchase low-speed electric vehicles (LSEVs) – a cheap substitute for regular autos. Last year, LSEV makers sold about 1.5 million units in China, accounting for about 6% of passenger vehicle sales for the year. In comparison, even with massive government subsidies, total new energy vehicle (NEV, mainly including pure electric vehicles and plug-in hybrids) sales only reached 1.2 million units in 2018, 20% lower than LSEV sales. In many small cities, towns and villages consumers are opting to purchase low-speed electric vehicles (LSEVs) – a cheap substitute for regular autos. LSEVs are small, short-range electric vehicles (three- or four-wheeled cars) with top driving speeds below 80km per hour and with a similar look to regular cars.4 They have much lower technical and safety standards: LSEVs are not considered automobiles by the country’s motor vehicle management system. Consequently, official auto production and sales data released by authorities do not include LSEV figures. Chart 9Significant Output Expansion In Low-Speed Electric Vehicles Technically, these vehicles are within some sort of grey area of Chinese regulations, but that has not stopped the industry's remarkable growth. Shandong province accounts for about 40% of the country’s LSEV output. The dramatic LSEV production expansion in the province gives a glimpse into the booming LSEV industry in China (Chart 9). Last year’s LSEV production drop was due to the government’s tightening of LSEV output policies and greater competition from small-size pure electric vehicles, which benefited from government subsidies. Both factors have diminished this year due to policy changes and the termination of subsidies for the small-size pure electric vehicle. Looking forward, consumers will continue purchasing LSEVs as a substitute for lower-end cars. They will have negative effect on low-end car sales, especially when household budgets tighten. Table 1 lays out the main differences between an LSEV and a lower-end passenger car. Clearly, the most attractive feature of an LSEV is its price, which can be as cheap as 10,000 RMB (less than US$2,000) with a big proportion of LSEVs ranging from 20,000 RMB to 30,000 RMB. In comparison, prices of lower-end passenger vehicles in general range from 50,000RMB to 80,000 RMB, more expensive than LSEVs. As nearly half of Chinese households already own an automobile, the potential of future auto sales clearly lies in lower-income households. However, the 2018 NBS household survey showed the annual household disposable income for the lowest 60% percentile rural households was lower than the low-end price of regular auto – 50,000 RMB (US$ 7,050) (Chart 10). In comparison, a much cheaper LSEV will be affordable for them. Given that they are inferior goods, LSEVs could become even more attractive at times of weak disposable income growth. In addition to cheap prices, Box 2 reveals other attractive features that will make LSEVs the most convenient and affordable form of transportation for many potential auto buyers. This will also help promote the popularity of the LSEVs in small cities and rural areas. Table 1The Comparison Between LSEVs And Lower-End Passenger Cars Chart 10Low-Speed Electric Vehicles: Affordable For Lower-Income Households   Further, this year’s regulatory changes are also favorable for the LSEV industry (Box 3). This marked a clear policy reversal from last year when the government executed a crackdown on LSEV production and issued a policy prohibiting new capacity of LSEVs. Box 2 The Non-Price Reasons For The Increasing Popularity Of The LSEVs The LSEV is more convenient as it is easy to drive and to park because of its small size. The drive range of 100 km per charge of the battery is sufficient for a person who only uses it to go to work or pick up the kids from school. It is particularly useful in small cities and rural areas where the public transportation network is poor. The speed of 40-60 km per hour is also fast enough to drive in small cities and rural area where there are not much road traffic and the roads are often designed for low driving speed. LSEVs also have the benefit of being able to charge from home electrical outlets, eliminating the need to use public charging/fueling infrastructure. Box 3 Policy On LSEV Industry: More Favorable In 2019 Than In 2018 In March, the Ministry of Industry and Information Technology announced that by 2021 the national standards of the “Technical Conditions of Four-Wheel Low-Speed Electric Vehicles” would be established. This will eventually bring the LSEV market under the government’s supervision while giving LSEV makers two years to improve their technology. This will help improve the quality and safety measures of LSEVs. In May and June, over 20 cities started to issue car plates for LSEVs and approved of the LSEVs right to be on the road. This signals that the government is aiming to regulate the LSEV sector in a positive way, rather than simply banning production. Bottom Line: Cheap LSEVs will be a low-cost substitute for regular low-end cars. Their production requires fewer inputs and parts compared to cars. Hence, their rising penetration will be negative for economic activity at the margin. What About NEV Demand? New Electric Vehicle (NEV) sales were a bright spot among all categories of auto sales in China last year, with year-on-year growth of 62%. However, NEV sales growth has decelerated considerably this year as the government began cutting subsidies (Chart 11). NEV sales will remain under pressure. Table 2 shows the timeline of China’s NEV subsidy exit plan, which was released in late March. The subsidy is set to be phased out by 2021. Chart 11New Electric Vehicle Sales Growth Will Slow But Remain Positive Table 2The China’s New Electric Vehicle Subsidy Exit Plan   In comparison to last year, there will be no subsidy at all for pure electric vehicles (PEVs) with recharge mileage of 250 kilometers and lower. This will make it more difficult for mini-PEVs to compete with LSEVs with respect to price. For PEVs with recharge mileage of 250 kilometers and above, the subsidy has also been cut significantly. However, we still expect NEV demand growth to remain positive. The government will continue to maintain zero sales tax on NEVs until the end of 2020. This gives it a major advantage over non-NEV vehicles, which carry the 10% sales tax. In addition, NEVs are exempt from license restrictions on car sales and time or area restrictions on on-road autos, in cities where such policies apply. This is an attractive privilege for car buyers to consider. Current NEVs that can achieve recharge mileage of 300-450 kilometers, sell at a price of RMB 100,000 to RMB 150,000 per unit. They are both affordable and appealing for upper-middle-income and high-income urban households who prefer either green options or energy cost savings. The recharge mileage is sufficient for most daily use, and prices are in line with prices of traditional gasoline or diesel cars. If and as auto sales fail to stage a notable recovery in the next several months, Chinese auto stock  prices will likely break down. Bottom Line: With the gradual phasing out of subsidies, the period of exponential NEV sales growth is over. Nevertheless, NEV demand growth will likely remain positive. Investment Implications Chart 12Chinese Auto Stock Prices Could Break Down There are three pertinent investment implications to consider. First, Chinese auto stock prices in the domestic A-share market have dropped by 60% from their 2017 highs, and have lately been moving sideways (Chart 12). Notably, these listed automakers’ per-share earnings have plunged, and the companies have cut dividends by more than the drop in their share prices (Chart 13). As a result, their trailing P/E ratio has risen and the dividend yield has dropped (Chart 14). This implies that investors are looking through the current sales contraction and expecting an imminent recovery. Chart 13A Major Contraction In Corporate Earnings And Dividends Chart 14Rising Trailing P/E And Falling Dividend Yield   If and as auto sales fail to stage a notable recovery in the next several months, these share prices will likely break down. Second, petroleum demand growth from the transportation sector will be decelerating in China over the coming years. Rising NEV sales as a share of total auto sales, substituting autos for LSEVs and a slower pace of growth in the number of vehicles on roads imply diminishing demand for gasoline in the coming years (Chart 15). Today BCA’s Emerging Markets Strategy service is also publishing a Special Report discussing India’s demand for oil. The report argues for slowing growth in Indian oil demand. Combined, China and India make up 19% of the world’s oil consumption (slightly lower than the 21% accounted for by the U.S.), and weaker demand growth in these economies is negative for oil prices. Third, investors should differentiate between a long-term economic view and investment strategy. We do not disagree with the economic viewpoint that auto ownership will rise in China in the years to come. But this will happen even if auto sales decline on an annual basis over the next 10 years. Chart 16 illustrates this point: if annual auto sales drop by 2% during each consecutive year over the next decade, and the scrap rate is around 3%, car ownership, defined as the share of households owning one car, will continue to rise from the current 50% level, reaching 80% by 2030. Chart 15Falling Growth In Existing Vehicles Entails Slower Growth In Gasoline Demand Chart 16Stimulation: Car Ownership Can Rise With Shrinking Auto Sales   Nevertheless, such a scenario – a 2% annual drop in car sales in each consecutive year over the next decade - is bearish for automakers’ share prices. Any stock price is very sensitive to long-term growth expectations for corporate earnings.5 A 2% recurring annual drop in car sales will be disastrous for auto stock valuations. This is a case when the long-term economic view on rising prosperity and car ownership in China stands in contrast with a negative investment outcome for the auto sector and its shareholders. Ellen JingYuan He, Associate Vice President ellenj@bcaresearch.com   Footnotes 1      Sales of total automobiles, including passenger vehicles and commercial vehicles. 2      From Chinese Banking Association Report on June 18, 2019. https://www.china-cba.net/Index/show/catid/14/id/26688.html 3      Guangzhou further added 10,000 car plates open to the public while Guiyang eliminated cap on new-vehicle sales. 4      https://www.wsj.com/video/big-in-china-tiny-electric-cars/CF7E986A-7C70-4EE3-8F7B-441621F10C94.html 5      The reason is that both interest rates and earnings long-term growth rate are present in the denominator of any cash flow discount model (Stock Price = Expected Dividends / (Interest rate – Earnings long-term growth rate)). Hence, they have the potential to affect share prices exponentially while dividends/profits are present in the numerator so their impact on equity prices is linear.

Highlights New structural recommendation: long GBP/USD. The substantial Brexit discount in the pound makes it a long-term buy for investors who can tolerate near-term volatility. The most powerful equity play on a fading Brexit discount would be the U.K. homebuilders. Specifically, Persimmon still has a further 25 percent of upside. Take profits in long Euro Stoxx 50 versus Shanghai Composite. Within Europe, close the overweight to Switzerland and the underweight to the Netherlands. Stay overweight banks versus industrials. Stay overweight the Euro Stoxx 50 versus the Nikkei 225. Fractal trade: long NZD/JPY. Feature Chart of the WeekThe Pound Has Substantial Upside If The Brexit Discount Fades Carnival Says The Pound Is Cheap Carnival, the world’s largest cruise liner company, lists its shares on both the London and New York stock exchanges. But there is an apparent riddle: in London the shares trade on a forward PE of 8.8, while in New York they trade on 9.4. How can Carnival trade at different valuations on the two sides of the Atlantic when the market should instantly arbitrage the difference away? The answer to the riddle is that the London listing is quoted in pounds, the New York listing is quoted in dollars, while Carnival’s sales and profits are denominated in a mix of international currencies. Neither Brexit developments nor a potential Jeremy Corbyn led government will prevent the pound from rallying in the longer term.  Carnival is trading on a higher valuation in New York versus London because the market is expecting its mixed currency earnings to appreciate more in dollar terms than in pound terms. Put another way, the valuation differential is expecting the pound to appreciate versus the dollar to a ‘fair value’ of around $1.40 (Chart I-2). Likewise, BHP Billiton shares are trading on a higher valuation in their Sydney listing compared to their London listing. This valuation differential is expecting the pound to appreciate versus the Australian dollar to around A$2.00 (Chart I-3). Chart I-2Carnival Says The Pound Is Cheap Chart I-3BHP Billiton Says The Pound Is Cheap In other words, the market believes that neither Brexit developments nor a potential Jeremy Corbyn led government will prevent the pound from rallying in the longer term. We tend to agree. The Wrong Way To Pick Stock Markets… And The Right Way Before continuing with the pound’s prospects, let’s wander into the wider investment landscape. One important lesson from dual-listed companies like Carnival and BHP Billiton is that a multinational’s valuation will appear attractive in a market where the currency is structurally cheap.1 This lesson has deep ramifications. Today, multinationals dominate all the major stock markets, meaning that the entire stock market will appear cheap if its currency is cheap. The stock market will also appear cheap if it is skewed towards lower-valued sectors. But sectors trade on a low valuation for a reason – poor long-term growth prospects. Through the past decade, Japanese banks seemed a relative bargain, trading on a forward PE of less than half of that on personal products companies (Chart I-4). Yet Japanese banks were not a relative bargain. Quite the contrary. Through the past decade Japanese personal products have outperformed the banks by 500 percent! (Chart I-5) Chart I-4Japanese Banks Seemed A Relative Bargain... Chart I-5...But Japanese Banks Were Not A Relative Bargain Hence, beware of picking stock markets on the basis of observations such as ‘European stocks are cheaper than U.S. stocks’. Given that a stock market valuation is the result of its currency valuation and its sector composition, assessing relative value across major stock markets is extremely difficult, if not impossible. To repeat, Carnival appears to be trading at a valuation discount in London versus New York, but the cheapness is illusory. Here’s the right way to pick major stock markets. Identify your preferred sectors and currencies, and then pick the regional and country stock markets that are skewed to these preferred sectors and currencies. In this regard, large underweight sector skews also matter. For example, China and EM have a near-zero exposure to healthcare equities, so their performances tend to correlate negatively with that of the global healthcare sector – albeit the causality could run in either direction. Identify your preferred sectors and currencies, and then pick the regional and country stock markets that are skewed to these preferred sectors and currencies. In early May, we noticed that the extreme outperformance of technology versus healthcare was at a critical technical point at which there was a high probability of a trend reversal. This high conviction sector view implied overweight Europe versus China, as well as overweight Switzerland and underweight Netherlands within Europe (Chart I-6 and Chart I-7). Chart I-6When Tech Underperforms Healthcare, China Underperforms Switzerland Chart I-7When Tech Underperforms Healthcare, The Netherlands Underperforms Switzerland   Given that this sector trend reversal has played out exactly as anticipated, it is time to bank the profits:   Close long Euro Stoxx 50 versus Shanghai Composite. And within Europe, close the overweight to Switzerland and the underweight to the Netherlands. Right now, it is appropriate to overweight banks versus industrials. It is the pace of the bond yield’s decline that has weighed on bank performance this year. But if the sharpest decline in bond yields is behind us, as seems likely, then banks should fare better versus other cyclicals (Chart I-8). Chart I-8If The Sharpest Decline In Bond Yields Is Over, Banks Will Outperform Industrials Once again, this sector view carries an equity market implication: stay overweight the Euro Stoxx 50 versus the Nikkei 225 (Chart I-9). Chart I-9Euro Stoxx 50 Vs. Nikkei 225 = Global Banks In Euros Vs. Global Industrials In Yen The Pound Is A Long-Term Buy Back to the pound. The message from the dual listings of Carnival and BHP Billiton is that the pound is cheap, and this is neatly corroborated by the relationship between relative interest rates and the pound versus the euro and dollar. Based on the pre-Brexit relationship between relative real interest rates and the pound’s exchange rate, we can quantify the ‘Brexit discount’. Absent this discount, the pound would now be trading close to €1.30 and well north of $1.40 (Chart of the Week and Chart I-10). Chart I-10The Pound Has Substantial Upside If The Brexit Discount Fades In the Brexit psychodrama, we do not claim to know exactly how the next few days or weeks will play out. In the short term, Brexit is a classic non-linear system, and non-linear systems are inherently unpredictable. However, in the longer term we expect the Brexit discount to fade in any sort of transitioned resolution that allows the U.K. to adapt to a new trading relationship with the world, or alternatively to stay in a relationship broadly similar to the current one. Whatever the eventual endpoint is, the key requirement to remove the Brexit discount is to avoid a cliff-edge. We expect the Brexit discount to fade in any sort of transitioned resolution. The stumbling block to a resolution is that the three key actors – the EU, the U.K. government, and the U.K. parliament – have conflicting red lines, so the Brexit ‘Venn diagram’ has had no overlap. The EU will not countenance a customs border that divides Ireland; the current U.K. government wants a Free Trade Agreement, which implies casting away Northern Ireland into the EU customs union; and the current U.K. parliament – unless its intentions suddenly change – wants the whole of the U.K., including Northern Ireland, to remain in the EU customs union.   Given that the EU will not budge its red line, the only way to a lasting resolution is for the government and parliament red lines to realign, This could happen via parliament being willing to sacrifice Northern Ireland, via a second referendum, or via a general election in which the government’s intentions and/or the composition of parliament changed. Given a long enough investment horizon – 2 years or more – it is likely that the government and parliament will realign their red lines to a Free Trade Agreement or to a customs union, one way or another. On this basis, the substantial Brexit discount in the pound makes it a long-term buy for investors who can tolerate near-term volatility. Accordingly, today we are initiating a new structural recommendation: long GBP/USD.  For equity investors, the most powerful play on a fading Brexit discount would be the U.K. homebuilders (Chart I-11). Specifically, if the pound reached $1.40, Persimmon still has a further 25 percent of upside. Chart I-11U.K. Homebuilders Have Substantial Upside If The Brexit Discount Fades Fractal Trading System*  Based on its collapsed fractal structure, we anticipate a countertrend rally in NZD/JPY within the next 130 days. Accordingly, go long NZD/JPY setting a profit target of 3 percent and a symmetrical stop-loss. Chart I-12 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. 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 There are also several companies with dual listings in the U.K. and the euro area. Unfortunately, these valuation differentials have been temporarily distorted by the risk of a no-deal Brexit, in which EU27 investors may have been forbidden from trading in the U.K. listed shares. Fractal Trading System Cyclical Recommendations Structural Recommendations Fractal 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  

Dear Client, In lieu of our regular Weekly Report this week, tomorrow we will be publishing a joint Special Report on the Chinese automobile industry outlook with our Emerging Markets Strategy service, authored by my colleague Ellen JingYuan He. Best regards, Jing Sima China Strategist Feature Chart 1Chinese Economy Likely To Bottom In Q1 President Trump announced last Friday the first phase of a potential trade agreement with China. For now, the most concrete aspect of the announcement has been the deferral of an increase in tariffs that had been scheduled to occur this week, in exchange for agriculture purchase commitments from China. Market participants initially reacted with caution to the news, given the U.S. administration’s about-face in early-May and given signs from Beijing that China “needs time” to finalize a deal. However, Chinese policymakers have subsequently played up the progress made during the negotiations, and characterized both sides as being on “the same page”. We noted in last week’s report that China’s economy was likely to stabilize in Q1 of next year (Chart 1), but that a further shock to China’s external sector and/or internal policy missteps could easily tip the Chinese economy into a deeper growth slowdown.1 This, to us, justified a tactically bearish stance towards Chinese stocks, despite our positive cyclical bias. Indeed, following our tactical underweight call initiated on July 24,2 relative to global stocks, Chinese investable stocks dropped nearly 3% in the months of August and September in reaction to intensified trade tension. Chart 2Chinese Stocks Have Been Underperforming Since Late April While it is not yet clear how substantive the final deal between the U.S. and China will be, it is our judgment that the odds of a further escalation in the trade war have legitimately fallen over the past week. Both sides of the negotiating table have strong incentives to reach a deal (particularly the U.S.), and both U.S. and Chinese policymakers may finally be acting in a way that is consistent with each side’s respective constraints. As such, we no longer feel that a tactical underweight stance is warranted, and we recommend that clients maintain a neutral stance towards Chinese stocks over the near term. The potential for the talks to collapse once again is keeping us from recommending an outright overweight tactical stance, as well as the small but still non-trivial chance that the final deal is not meaningful enough to help revive economic activity. Cyclically, a substantive trade deal would be bullish for Chinese stocks, as the relative performance of both the investable and domestic markets are meaningfully below their late-April highs (Chart 2). The stimulus that policymakers have already provided should be enough to stabilize Chinese domestic demand, and a trade deal should help reinforce a stabilization in sentiment and activity over the coming year. However, one risk to our cyclical positioning is that the removal of uncertainty for China’s exporters strengthens the will of Chinese policymakers to curb “excess” credit growth. For now, this remains “a story for another day”, as investors will almost certainly bid up Chinese stocks (particularly the investable market) in reaction to a deal. But the behavior of China’s credit impulse following the surge in Q1 of this year underscores that policymakers are very serious about preventing another significant rise in the macro leverage ratio. This could lead to a less optimistic outlook over the coming 6-12 months than we originally expected when we recommended upgrading Chinese stocks earlier this year, and is a risk that we will be continually monitoring over the coming months. Stay tuned!   Jing Sima China Strategist JingS@bcaresearch.com   Footnotes 1      Please see China Investment Strategy Weekly Report, “Mild Deflation Means Timid Easing”, dated October 9, 2019, available at cis.bcaresearch.com 2      Please see China Investment Strategy Weekly Report, “Threading A Stimulus Needle (Part 2): Will Proactive Fiscal Policy Lose Steam?”, dated July 24, 2019, available at cis.bcaresearch.com   Cyclical Investment Stance Equity Sector Recommendations