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Feature The purpose of this Special Report is to identify and provoke a healthy debate on the prevailing investment themes for the 2020s and to speculate on what the key US sector beneficiaries and likely losers may be. Every decade a dominant theme captures investors’ imaginations and morphs into a bubble. Massive speculation typically propels the relevant asset class into the stratosphere as investors extrapolate the good times far into the future and go on a buying frenzy. Chart 1 shows previous manic markets starting with the Nifty Fifty, gold bullion, the Nikkei 225, the NASDAQ 100, crude oil and most recently the FAANGs. Chart 1Manias: An Historical Roadmap What will be the dominant themes of the next decade? How should investors capitalize on some of these big trends? The purpose of this Special Report is to identify and provoke a healthy debate on the prevailing investment themes for the 2020s and to speculate on what the key US sector beneficiaries and likely losers may be. Theme #1: De-Globalization Picks Up Steam The first investment theme for the upcoming decade is the “apex of globalization” or “de-globalization”. We have written about this theme extensively at BCA Research and it is the mega-theme of our sister Geopolitical Strategy (GPS) service. Odds are high that countries will continue looking inward as the US adopts a more aggressive trade policy, China’s trend growth slows, and US-China strategic tensions intensify. The three pillars of globalization are the free movement of goods, capital, and people across national borders. We expect to see marginally less of each in the future. Chart 2 shows that we are at the conclusion of a period of tranquility. Pax Americana underpinned globalization as much as Pax Britannica before it. The US is in a relative decline after decades of geopolitical stability allowed countries like China to rise to “great power” status and rivals like Russia to recover from the chaos of the 1990s. Chart 2De-globalization Has Commenced De-globalization has become the consensus since the election of Donald Trump. But Trump is not the prophet of de-globalization; he is its acolyte. Globalization is ending because of structural factors, not cyclical ones. And its decline was pre-written into its “source code.” Three factors stand at the center of this assessment, outlined in our 2014 Special Report, “The Apex Of Globalization – All Downhill From Here”: multipolarity, populism and protectionism. Events have since confirmed this view. The three pillars of globalization are the free movement of goods, capital, and people across national borders. We expect to see marginally less of each in the future. Investment Implication #1: Profit Margin Peak The most profound and provocative investment implication from de-globalization is that SPX profit margins have peaked and will likely come under intense pressure, especially for US conglomerates that – on a relative basis to international peers – most enthusiastically embraced globalization. Reconstructed S&P 500 profits and sales data date back to the late-1920s. Historically, corporate profit margins and globalization (depicted as global trade as a percentage of GDP) have been positively correlated (Chart 3). Chart 3Profit Margin Trouble As countries are more outward looking, trade flourishes and openness to trade allows the free flow of capital to take advantage of profit-maximizing projects. Following the Great Recession and similar to the Great Depression, trade has suffered and trade barriers have risen. The Sino-American trade war has accelerated the inward movement of countries, including Korea and Japan, and has had negative knock-on effects on trade as evidenced by the now two-year old global growth deceleration. China’s response to President Trump’s election was to redouble its pursuit of economic self-sufficiency, which meant a crackdown on corporate debt and a fiscal boost to household consumption. Trump’s tariffs then damaged sentiment and trade between the two countries. Any deal reached prior to the 2020 US election will remain in doubt among global investors. The longer the trade war remains unresolved, the deeper the cracks will be in the foundations of the global trading system. Such a backdrop is negative for profit margins, as inward looking countries prevent capital from being allocated most efficiently. Moreover, the uprooting of supply chains due to the trade war hurts margins and the redeployment of equipment in different jurisdictions will do the same at a time when final demand is suffering a setback. In addition, rising profit margins are synonymous with wealth accruing to the top 1% of US families and vice versa. This relationship dates back to the late-1920s, as far back as our dataset goes. Using Piketty and Saez data, which exclude capital gains, it is clear that profit margin expansion exacerbates income inequality (top panel, Chart 4). Chart 4Heightened Risk Of Wealth Re-distribution Expanding margins lead to higher profits. Because families at the top of the income distribution are more often than not business owners, income disparities are the widest when margins are in overshoot territory. Eventually this income chasm comes to a head and generates political discontent. Populism has emerged on both the right and left wings of the US political spectrum – and since the rise of Trump, even Republicans complain about inequality and the excesses of “corporate welfare” and laissez-faire capitalism. Because inequality is extreme – relative to America’s developed peers – and political forces are mobilizing against it, the probability of wealth re-distribution is rising in the coming decades (middle panel, Chart 4). Labor’s share of national income has nowhere to go but higher in coming years and that is negative for profit margins, ceteris paribus (bottom panel, Chart 4). Drilling beneath the surface, the three secular US equity sector/factor implications of the apex of globalization paradigm shift are: prefer small caps over large caps prefer value over growth overweight the pure-play BCA Defense Index Investment Implication #2: Small Is Beautiful While a small cap bias is contrary to the cyclical US Equity Strategy view of preferring large caps to small caps, the issue is timing: the small cap preference is a secular view with a time horizon that spans the next decade. The small versus large cap share price ratio’s ebbs and flows persist over long cycles. Small caps outshined large caps uninterruptedly from 1999 to 2010. Since then large caps have had the upper hand (Chart 5). Were the apex of globalization theme to gain traction in the 2020s, small caps should reclaim the lead from large caps, especially in the wake of the next US recession. Similar to the death of the global banking model, companies with global footprints will suffer the most, especially compared with domestically focused outfits. One way to explore this theme is via domestic versus global sector preference. But a more investable way to position for this sea change, is to buy small caps (or microcaps) at the expense of large caps (or mega caps). Small caps are traditionally domestically geared compared with large caps that have significantly more foreign sales exposure. Chart 5It’s A Small World After All The closest ETF ticker symbols resembling this trade is long IWM:US/short SPY:US. Investment Implication #3: Buy Value At The Expense Of Growth Similar to the size bias, the style bias also moves in secular ways. Value outperformed growth from the dot com bust until the GFC. Since then growth has crushed value, even temporarily breaking below the year 2000 relative trough. This breakneck pace of appreciation for growth stocks is clearly unsustainable and offers long-term oriented investors a compelling entry point near two standard deviations below the historical mean (Chart 6). Chart 6Value Has The Upper Hand Versus Growth Financials populate value indexes, a similarity with small cap outfits. Traditionally, financials are a domestically focused sector with export exposure registering at half of the S&P’s average 40% level of internationally sourced revenues. On the flip side, tech stocks sit atop the growth table and they garner 60% of their revenue from abroad. This value over growth style preference will pay handsome dividends if the de-globalization theme becomes more main stream as countries become more hawkish on trade and the Sino-American war continues to erect barriers to trade that took decades to lift. The caveat? If President Trump strikes a short-term deal with China ahead of the 2020 election, the de-globalization theme will suffer a setback. But our geopolitical strategists expect a ceasefire at best, not a durable deal, and also expect the trade war to resume in some way, shape or form in 2021-22, regardless of the outcome of the US election. The closest ETF ticker symbols resembling this trade is long IVE:US/short IVW:US.  Investment Implication #4: Defense Fortress One final long-term playable investment idea from the apex of globalization is a structural bull market in defense stocks (Chart 7). Our October 2016 “Brothers In Arms” Special Report drew parallels with the late nineteenth century period of European rearmament, and the American and Soviet arms race of the 1960s. These movements were greatly beneficial to the aerospace and defense industry. Currently, the move by several countries to adopt more independent foreign policies, i.e. to move away from collaboration and cooperation toward isolationism and self-sufficiency, entails an accompanying arms race. Chart 7Stick With Pure-play Defense Stocks Table 1 China’s challenge to the regional political status quo motivates a boost to defense spending globally. In fact SIPRI data on global military spending by 2030 (Table 1) increases our conviction that this trade will succeed on a five-to-ten year horizon. Beyond the global arms race, two additional forces are at work underpinning pure-play defense contractors. A global space race with China, India and the US wanting to have manned missions to the moon, and the rise of global cybersecurity breaches. Defense companies are levered to both of these secular forces and should be prime sales and profit beneficiaries to rising space budgets and increasing cybersecurity combat budgets. The ticker symbols for the stocks in the pure-play BCA defense index are: LMT, RTN, NOC, GD, HII, AJRD, BWXT, CW, MRCY. Theme #2: Tech Sector Regulation, US Enacts Privacy Laws The second long-term geopolitical theme that we are exploring is the regulatory or “stroke of pen” risk that is rising on FAANG stocks – Facebook, Apple, Amazon, Netflix, and Google. These companies were this decade’s undisputed stock market winners. The US anti-trust regulatory framework was designed to curb broad anti-competitive actions of trusts. As Lina Khan discusses in her seminal article, these actions “include not only cost but also product quality, variety, and innovation.” However, through subsequent regulatory evolution, the Chicago School has focused the US anti-trust process on consumer welfare and prices. If President Reagan and the courts could change how anti-trust laws were administered in the 1980s, so too can future administrations and courts. Today the US Congress, on both sides of the aisle, is looking into regulatory tightening, while the judicial system will take longer to change its approach. Moreover, the impetus for tougher anti-trust policy is here. It comes from a long period of slow growth, income inequality, and economic volatility – such as in the 1870s-80s. This was certainly the case for Standard Oil in 1911, which became a nation-wide boogeyman despite most of its transgressions occurring in the farm belt states. Today, income inequality is a prominent political theme and source of consumer discontent. A narrative is emerging – which will be super-charged during the next recession – that growth has been unequally distributed between the old economy and the twenty-first century technology leaders. With regard to privacy, the news is equally grim for large tech outfits. The EU General Data Protection Regulation (GDPR), which came into force on May 2018, imposes compliance burdens on any company handling user data. In the US, California has signed its own version of the law – the Consumer Privacy Act – which will go into effect in January 2020. These laws give consumers the right to know what information companies are collecting about them and what companies that data is being shared with. They also allow consumers to ask technology companies to delete their data or not to sell it. While tech companies are likely to fight the new California law, and the US court system is a source of uncertainty, we believe the writing is on the wall. The EU is by some measures the largest consumer market on the planet. California is certainly the largest US market of the states. It is unlikely that the momentum behind consumer protection will change, especially with the EU and California taking the lead. The odds of a federal privacy law, following in the footsteps of the Consumer Privacy Act, are also rising. Investment Implication #5: Shun Interactive Media & Services Stocks These risks introduce a severe overhang for FAANG stocks. We are especially worried for the S&P interactive media & services index that includes GOOGL and FB. Tack on the threat of federal regulation and this represents another major headwind for profits and net profit margins that are extremely elevated for these near monopolies. Given that advertising revenue is crucial to the business model of social media companies (GOOGL and FB included), a significant uptick in privacy regulation will likely hurt their bottom line. With regard to profit margins, tech stocks in general command a profit margin twice as high as the SPX. Specifically, FB and GOOGL enjoy margins that are 500 basis points higher than the broad tech sector (Chart 8)! This is unsustainable and will likely serve as easy prey for policymakers. Our view does not necessarily call for breaking up these monopolies. The US will have to weigh the economic consequences of anti-trust policy in a context of multipolarity in which China’s national tech champions are emerging to compete with American companies for global market share. Nevertheless increased regulation is inevitable and some forced sales of crown jewel assets may take place. Moreover, the threat of a breakup will lurk in the background, creating uncertainty until key legislative and judicial battles have already been fought. That will take years. Finally, we doubt the tech sector will be left alone to “self-regulate” its incumbents and negotiate a price on consumers’ privacy. More likely, a new privacy law will loom overhead, serving as a negative catalyst for profit growth. Uncertainty will weigh on the S&P interactive media & services relative performance. Chart 8Regulation Will Squeeze Tech Margins The ticker symbols to short/underweight the S&P interactive media & services index are an equally weighted basket of GOOGL and FB (they command a 98% market cap weight in the index). Theme #3: SaaS, Artificial Intelligence, Augmented Reality And Autonomous Driving Are Not Fads The third big theme that will even outlive the upcoming decade is the proliferation of software as a service (SaaS). The move to cloud computing and SaaS, the wider adoption of artificial intelligence, machine learning, autonomous driving and augmented reality are not fads, but enjoy a secular growth profile. In the grander scheme of things today’s world is surrounded by software. Millions of lines of code go even into gasoline powered automobiles, let alone electric vehicles. Autonomous driving is synonymous with software, the Internet of Things (IoT) needs software, the space race depends on software, modern manufacturing and software are closely intertwined, phone calls for quite some time have been a software solution, and the list goes on and on. This tidal effect is hard to reverse and is already embedded in workflows across industries. Opportunities to penetrate health care and financial services more deeply remain unexplored and it is difficult to envision another competing industry unseating “king software”. These secular trends are not only productivity enhancing, but will also most likely prove recession-proof. When growth is scarce investors flock to any source of growth they can come by and we are foreseeing that when the next recession arrives, investors will likely seek shelter in pure play SaaS firms. Investment Implication #6: Software Is Eating The World Buying software stocks for the long haul seems like a bulletproof investment idea. But the recent stellar performance of software stocks that has moved valuations to overshoot territory. Our recommended strategy is to buy or add software stock exposure on any weakness with a 10-year investment time horizon. All of these secular trends have pushed capital outlays on software into a structural uptrend. Software related capex is not only garnering a larger slice of the tech spending budgets but also of the overall capex pie. If it were not for software capex, the contraction in non-residential investment in recent quarters would have been more severe (Chart 9). Private sector software capex is near all-time highs as a share of total outlays. Government investment in software is also reaccelerating at the fastest pace since the tech bubble. When productivity gains are anemic, both the business and government sectors resort to software upgrades in order to boost productivity. Cyber security is another more recent source of software related demand as governments around the globe are taking such risks extremely seriously (bottom panel, Chart 9). Given this upbeat demand backdrop and ongoing equity retirement, software stocks are primed to grow into their pricey valuations. Chart 9Software Is Eating The World Finally, this long-term trade will also serve as a hedge to the short/underweight position we recommend in the S&P interactive media & services index. The closest ETF ticker symbol resembling the S&P software index is IGV:US. Theme #4: Millennials Already Are The Largest Cohort And Will Dominate Spending The fourth long-term theme we anticipate will gain traction in the 2020s is the demographic rise of the Millennial generation. Much has been made of preparing for the arrival of the Millennial generation, accompanied by well-worn stereotypes of general "failure to launch" as they reach adulthood. However, "arrival" is a misnomer as this age cohort is already the largest and "failure" is simply untrue. According to the U.S. Census Bureau, Millennials are the US’s largest living generation. Millennials (or Echo Boomers) defined as people aged 18 to 37 (born 1982 to 2000), now number more than 80mn and represent more than one quarter of the US’s population. Baby Boomers (born 1946 to 1964) number about 75mn. Stealthily becoming the largest age group in the US over the last few years, Millennials per-year-birth-rate peaked at 4.3mn in 1990. Surprisingly, the pace matched that of the post-war Baby Boom peak-per-year-birth-rate in 1957 - the per-year average over the period was higher for the Baby Boomers (Chart 10). Chart 10Millennials Are The Largest Cohort This gap is now set to grow rapidly as the death rate of Baby Boomers accelerates. What is more, the largest one-year age cohort is only 25 years old, thus, Millennials will be the dominant generation for many years. It is unclear how these “kids” will impact the market as they become the most important consumers, borrowers and investors, but make no mistake: this is a seismic shift in economic power and it is here to stay. The Echo Boom is a big, generational demographic wave. A difficult and painful delay has not tempered its looming importance. Finally, this wave of echo-boomers is educated, relatively unburdened by debt (please see BOX in the June 11, 2018 Special Report on demystifying the student debt load as it pertains to Millennials), and as they inevitably “grow up”, form new households and have kids. They will borrow, spend, earn, but not necessarily save and invest to the same extent as the Boomers. And this will be an important long-term theme going forward. Near term we might already be seeing signs of their arrival and firms have begun to pivot accordingly. Investment Implication #7: Buy The BCA Millennials Equity Basket Millennials will boost consumption spending in a number of different ways. The relatively unburdened Millennial cohort will be entering prime home acquisition age soon and this should underpin the long-term prospects of the US housing market and derivative industries. Further, Millennials consume differently from their parents; social media, online shopping and smart phones are not the consumption categories of the Baby Boomers. With this in mind, we have created a basket of ten stocks that we think will be driven over the long term by the demographic rise of the Millennial. We note that these stocks are heavily weighted to the technology and consumer discretionary sectors, which is logical as Millennial consumption habits tend to be discretionary focused and technology-based. Beginning with consumer discretionary, we are highlighting AMZN, NFLX and SPOT as core holdings in our Millennials basket. AMZN’s heft dwarfs consumer discretionary indexes but it could fall in several categories; the acquisition of Whole Foods makes it a Millennials-focused consumer staples retailer and its cloud computing web services segment is a tech leader. NFLX and SPOT represent the means by which Millennials consume media, by streaming movies and music over the internet. The idea of owning physical media is rapidly becoming an anachronism. The home ownership themes noted in the report above lead us to add HD and LEN to the basket. Millennials are “doers” and are set to be the dominant DIYers in the next few years, making HD a logical choice. LEN, as the nation’s largest home builder, should benefit from the Millennials coming of age into home buyers. We are also adding TSLA to our basket as a lone clean tech-oriented equity. TSLA capitalizes on the increasing shift to clean energy of Millennials (the key reason why no traditional energy companies have a spot in our basket). The technology stocks in our Millennials basket are AAPL, UBER (which replaces FB as of today) and MSFT, together representing more than 9% of the total value of the S&P 500. AAPL’s inclusion in the list is predictable as the leading domestic purveyor of devices on which Millennials consume media content. FB is a predictable holding, with more than half of all Americans being monthly active users, dominated by the Millennial cohort. It has served our basket well since inception, but today we are compelled to remove it and replace it with UBER. UBER is a Millennial favorite and the epitome of the sharing economy. In reality UBER is a logistics company and while it is losing money it is eerily reminiscent of AMZN in its early days. Maybe UBER will dominate all means of transportation and its ease of use will propel it to a mega cap in the coming decade. Our inclusion of MSFT is based on its leadership in cloud computing, a rapidly growing industry. We expect the connectivity and mobile computing demands of Millennials will accelerate. The last stock we are adding to our basket is also the only financial services equity. Though avid consumers, Millennials have shown an aversion to cash, preferring card payment systems, including both debit and credit-based. Accordingly, we are adding the leader in both of these, V, to our Millennials basket (Chart 11). Chart 11Buy BCA’s Millennial Equity Basket Investors seeking long term exposure to stocks lifted by the supremacy of the Millennial generation should own our Millennial basket (AAPL, AMZN, UBER, HD, LEN, MSFT, NFLX, SPOT, TSLA, V). We would not hesitate to add other sharing economy stocks, including Airbnb, to this basket should they become investable in the near future. Theme #5: ESG Becomes Mainstream Investors are increasingly looking at allocating assets based on environmental, social, and governance (ESG) considerations, and this mini-theme has the potential to become a big trend in the 2020s. There are a number of factors that underpin ESG investing. First, Millennials are climate conscious and given that they already are the largest cohort in the US they will not only dominate spending, but also influence election results. Moreover, via social media Millennials can sway public opinion and participate in the ESG conversation. Second, ECB President Christine Lagarde recent speech to the Economic and Monetary Affairs Committee of the European Parliament is a must read.1 If the ECB were to explicitly focus on climate change policy as part of its monetary policy operations then this is a game changer. Green investment financing including “green bonds” could become mainstream. Keep in mind the as reported in the FT “the European Parliament has declared a climate emergency; the new European Commission (EC) has taken office on a promise of an imminent “green new deal”, and Commission president Ursula von der Leyen has vowed to accelerate emissions cuts.” Last Wednesday, the EC released “The European Green Deal” with a pretty aggressive time table. The EC president said “The green deal is Europe’s man on the moon moment” and presented 50 policies slated to get rolled by 2022 to meet revamped climate goals. The implication is that once ESG takes center stage at a number of these institutions it will be easier to become mainstream and propagate the world over. Third, large institutional investors are starting to adopt an ESG mindset, especially pension plans. These investors with trillions of dollars at their disposal can not only disfavor fossil fuel investment, but also undertake investments in “green projects” via private and public equity markets. Banks are also moving in the “greening of finance” direction and given that they are the pipelines of the global plumbing system, swift adoption will go a long way in taking ESG mainstream. Finally, the electric vehicle (EV) proliferation is another key driver on how the ESG theme will play out in the 2020s. As a reminder, in the US 50% of all energy consumption is gasoline related linked to automobiles. While battery technology still has limitations, EV is no longer a fad as the German and Japanese automakers are starting to make inroads on TSLA. These car manufacturers do not want to be left out, especially if this shift toward EV becomes mainstream in the 2020s. The Chinese are not far behind on the EV manufacturing front, however government policy can really become a game changer. If a number of countries and/or California mandate a large share of all new vehicles sold be EV, then the investment implications will be massive. Investment Implication #8: Avoid Fossil Fuels, Gambling, Alcohol And Tobacco… While there are a few ESG related ETFs, we would rather explore this theme’s investment implications of sectors to avoid in the coming decade. We are believers that ESG criteria will continue to gain in importance in institutional investment management decisions. Accordingly, we would tend to avoid ‘sin stocks’, including gambling, tobacco and alcohol; demand for their services is unlikely to decline but investment weightings should mean that share prices will underperform. Further, we think a clean energy shift will mean energy stocks will likely continue to be long-term underperformers (Chart 12). Chart 12Areas To Avoid As ESG Becomes Mainstream Final Thoughts On The US Dollar In this report, we tried to focus on the upcoming decade’s big themes that we deem will play out, and centered recommendations on US equities/sectors. We do not want to neglect some macroeconomic variables that tend to mean revert over time. Specifically, the US dollar, interest rates and most importantly US indebtedness, will also be key drivers of investment theses in the 2020s. Currently, debt is rising faster than nominal GDP growth with the government and non-financial business debt-to-GDP profiles on an unsustainable path (second panel, Chart 13). Granted, the saving grace has been generationally low interest rates as the debt service ratios have fallen (top panel, Chart 13). However, if the four decade bull market in Treasury bonds is over, or may end definitively with the next US recession sometime in the early 2020s, then rising interest rates are the only mechanism to concentrate CEOs’ and politicians’ minds. On the dollar front, Chart 14 highlights the ebbs and flows of the trade-weighted US dollar since it floated in the early-1970s. The DXY index has moved in six-to-ten year bull and bear markets. The most recent trough was during the depths of the Great Recession, while the (tentative?) peak was in late-2016. If history repeats, eventually the dollar will mean revert lower in the 2020s, especially given the fiscal profligacy of the current administration that may continue into 2024, assuming President Trump gets re-elected next November. Chart 13Unsustainable Debt Profiles Chart 14Greenback’s Historical Ebbs And Flows The US dollar remains the reserve currency of the world today, but that exorbitant privilege is clearly fraying on the edges as the balance-of-payments dynamics are heading in the wrong direction. Over the next five years, the US Congressional Budget Office (CBO) estimates that the US budget deficit will swell to 4.8% of GDP. Assuming the current account deficit widens a bit then stabilizes (usually happens when global growth improves), this will pin the twin deficits at 8% of GDP. This assumes no recession, which would have the potential to swell the deficit even further. The US saw its twin deficits swell to almost 13% of GDP following the financial crisis, but the difference then was that in the wake of the commodity boom the dollar was cheap (and commodity currencies overvalued). The subsequent shale revolution also greatly cushioned the US trade deficit. Shale productivity remains robust and US output will continue to rise, but the low-hanging fruit has already been plucked.   Another dollar-negative force is its expensiveness. By rising 35% since its trough, the USD has sapped the competitiveness of the US manufacturing sector, which is accentuating the American trade deficit outside of the commodity sector. If the ESG trend ends up hurting oil prices, the US current account will follow the widening deficit in manufactured products. Moreover, the US is lagging Europe on the green revolution. Either the US will have to import green technologies, or the US government will have to provide more subsidies to the private sector. Either way, both of these dynamics will hurt the US current account deficit further. Historically, the currency market is the main vehicle to correct such imbalances. Chart 15Twin Deficits Will Weigh On The US Dollar The apex of globalization will also hurt the greenback. In a world where all the markets are integrated, borrowers in EM nations often use the reserve currency to issue liabilities at a lower cost. This boosts the demand by EM central banks for US dollar reserves to protect domestic banking systems funded in USD. Moreover, some countries like China implement pegs (both official and unofficial) to the US dollar in order to maintain their competitiveness and export their production surpluses to the US. To do so they buy US assets. If the global economy becomes more fragmented and the Sino-US relationship continues to deteriorate structurally as we expect, then these sources of demand for the dollar will recede. Overlay the widening US current account deficit, and you have the perfect recipe for a depreciating trade-weighted US dollar. Finally, the US is likely to experience more inflation than the rest of the world following the next recession. The US economy has a smaller capital stock as a share of GDP than Europe or Japan, and American demographics are much more robust. This means that the neutral rate of interest is higher in the US than in other advanced economies. As a result, the Fed will have an easier time generating inflation by cutting real rates than both the ECB and the BoJ. Higher inflation will ultimately erode the purchasing power of the dollar and prove to be a structurally negative force for the USD.   Anastasios Avgeriou US Equity Strategist anastasios@bcaresearch.com Matt Gertken Geopolitical Strategist mattg@bcaresearch.com Marko Papic Chief Strategist, Clocktower Group marko@clocktowergroup.com Chester Ntonifor Foreign Exchange Strategist chestern@bcaresearch.com Mathieu Savary The Bank Credit Analyst mathieu@bcaresearch.com   References Please click on the links below to view reports: Peak Margins - October 7, 2019 The Polybius Solution - July 5, 2019 War! What Is It Good For? Global Defense Stocks! - October 31, 2018 The Dollar: Will The U.S. Invoke A "Nuclear" Option? - August 30, 2018 Is The Stock Rally Long In The FAANG? - August 1, 2018 Millennials Are Not Coming Of Age; They Are Already Here - June 11, 2018 Brothers In Arms - October 31, 2016 The End Of The Anglo-Saxon Economy?  - April 13, 2016 Apex of Globalization  - November 12, 2014 Footnotes 1           https://www.imf.org/en/News/Articles/2019/09/04/sp090419-Opening-Statement-by-Christine-Lagarde-to-ECON-Committee-of-European-Parliament

Highlights OPEC 2.0 agreed to cut output by another 500k b/d at its Vienna meeting last week, bringing the total official cuts by the producer coalition to 1.7mm b/d. Saudi Arabia added 400k b/d of additional voluntary cuts, bringing its total cuts to almost 900k b/d vs. its October 2018 production level. We think the market will tighten, as a result, and are getting long 2H20 Brent vs. short 2H21 Brent; this is the backwardation trade that worked well this year, producing an average return of 180%. There was no extension of OPEC 2.0 output cuts beyond end-March, although an extraordinary meeting of the coalition was scheduled for March 5, 2020. Anti-government civil unrest in Iraq and Iran has resulted in the killing of hundreds of protesters in both countries by state security forces. The unrest raises the threat of disruptions to oil supplies from Iraq and to ships transiting the Strait of Hormuz. Clashes between pro-Iranian protesters and Iraqi nationalists in Baghdad prompted a visit to the city by Iran’s top military commander, Qassem Soleimani, over the weekend. Soleimani reportedly is participating in talks to find a new prime minister for Iraq. Soleimani’s visit drew criticism from Grand Ayatollah Ali al-Sistani, the most prominent Shia religious leader in Iraq. Feature OPEC 2.0’s deepening of production cuts to 1.7mm b/d will be largely ceremonial, unless free riders in the producer coalition – led by the Kingdom of Saudi Arabia (KSA) and Russia – fully comply with the new levels agreed last week in Vienna (Chart of the Week).1 Contrary to our expectation, the production cuts were not extended beyond end-March, although an extraordinary meeting of the coalition was scheduled for March 5, 2020, in Vienna to review market conditions prior to the deal’s expiry.2 The market was not expecting anything other than symbolism in the just-concluded discussions among OPEC 2.0 members regarding production cuts. The bulk of the cuts in the coalition’s production are the result of US sanctions against Venezuela and Iran, which have removed ~ 1.8mm b/d from the market and KSA's cuts, which will total ~ 900k b/d following OPEC 2.0's Vienna meeting.  We believe this will lead to a tighter market, and will steepen the backwardation in the Brent forward curve.  We are, therefore, recommending a longer 2H20 Brent position vs. a short 2H21 Brent position. The sanctions-induced cuts are squeezing the economies of both Venezuela and Iran, which, in the case of the latter, is producing a blowback on Iraq. Chart of the WeekOPEC 2.0 Raises Output Cuts To 1.7mm b/d In Vienna Iran Fights To Maintain Influence In Iraq Following an unexpected increase in gasoline prices last month, violent anti-government protests erupted around Iran, which provoked a deadly crackdown by the state. The ongoing unrest has resulted in the death of hundreds of protesters, which, by the US’s estimate, stand at more than 1,000. This claim was refuted by Iranian officials.3 It is impossible to overstate the importance of maintaining freedom of navigation through the Strait of Hormuz. The unrest that followed the gasoline price hike was the deadliest since that country’s Islamic Revolution in 1979, according to the New York Times. The Times reported that the Islamic Revolutionary Guards Corps opened fire on protestors calling for the removal of leadership, killing scores.4 Protests also erupted in states closely aligned with Iran in the past couple of months – i.e., Lebanon, Iraq.5 For the oil market, Iraq matters most: It is difficult to overstate the importance of keeping Iraq’s 4.7mm b/d of crude oil production flowing to global markets. Likewise, it is impossible to overstate the importance of maintaining freedom of navigation through the Strait of Hormuz, which connects the Persian Gulf with the Arabian Sea and the rest of the world’s oil-consuming markets (Map 1). Map 1The Persian Gulf And Strait of Hormuz More than 20% of the world’s crude oil and condensates supplies transit the Strait on any given day (Chart 2). The anti-government protests in Iraq and Iran raise the threat level to production in Iraq, and attacks on shipping transiting the Strait of Hormuz by the latter, or a direct confrontation with the US and its Gulf allies. Our colleagues in BCA Research’s Geopolitical Strategy (GPS) are following the evolution of events in Iran and Iraq closely. Following is their assessment of what led to the most recent unrest in Iraq.6 Chart 2Violence Again Threatens Gulf Oil Supply Chart 3AFertile Ground For Unrest In Iraq Deadlock In Iraq While both the grievances and demands of the protesters in Lebanon and Iraq are similar, the unrest in Iraq is of much greater consequence from a global investor’s perspective. The trigger was the removal of the highly revered Lieutenant General Abdul-Wahab al-Saadi from his position in the Iraqi army by Prime Minister Adel Abdul-Mahdi.7 The popular general was unceremoniously transferred to an administrative role in the Ministry of Defense. Iraqi protesters are united in their economic grievances, frustrated at a political and economic system that is unwilling to translate economic gains to improved livelihoods for its people. The sacking of al-Saadi – considered a neutral figure – was interpreted as evidence of Iranian influence and the greater sway of the Iran-backed Popular Mobilization Forces (PMF), an umbrella organization of various paramilitary groups. Iraqis all over the country responded by attacking the Iranian consulate in Karbala and offices linked to Iranian-backed militias. Iraqi protesters are united in their economic grievances, frustrated at a political and economic system that is unwilling to translate economic gains to improved livelihoods for its people. The May 2018 parliamentary elections, which ushered in Prime Minster Abdul-Mahdi, failed to generate much improvement. The country continues to be plagued by high unemployment, corruption, and an utter lack of basic services (Charts 3A & 3B). This has ultimately resulted in a lack of confidence in Iraqi leadership who are being increasingly perceived as benefiting from the status quo at the expense of the populace. Chart 3BFertile Ground For Unrest In Iraq Most importantly, the ruling elite has failed to respond to key trends that emerged in last year’s parliamentary elections. The extremely low voter turnout reveals that Iraqis are disenchanted with the government's ability to meet their needs. Meanwhile the success of Shia cleric Moqtada al-Sadr’s Sairoon coalition – running on a platform stressing non-sectarianism and national unity – in securing the largest number of seats highlights the desire for a reduction of foreign interference (both Iranian as well as US/Saudi) in domestic politics. Neither the US nor Saudi Arabia have an appetite to step in and provide the support necessary to counteract Iran. Moreover, Iran and its proxies in Iraq will not back down easily. Thus, the ongoing protests are to a great extent the result of the new government’s failure to heed the warnings brought about by the 2018 election and protests. They have served to deepen the rift between the rival Shia blocs, particularly those Iraqi nationalists who deeply resent the intrusion of Iran into its political structures. Iraq is in a state of deadlock. That said, Iran is unlikely to stand by idly as its influence wanes. As a result, we are likely to witness greater unrest as the rift between the two Shia blocs intensifies. Neither the US nor Saudi Arabia have an appetite to step in and provide the support necessary to counteract Iran. Moreover, Iran and its proxies in Iraq will not back down easily. At the same time, the geographical spread of the protest movement demonstrates that Iraqis are fed up with the current system.8 This points to greater instability in Iraq as no side is backing down and the only foreign power willing and able to interfere is Iran. US Sanctions Continue To Pressure Iran The Trump administration’s crippling “maximum pressure” sanctions have sent Iran’s Economy reeling. The Trump administration continues to enforce its “maximum pressure” sanctions, which have reduced Iranian oil exports from 1.8 million barrels per day at their recent peak to 100,000 barrels per day in November (Chart 4). These are crippling sanctions that have sent Iran’s economy reeling. Chart 4Iran Remains Under “Maximum Pressure” Iran’s Supreme Leader Ayatollah Ali Khamenei has ruled out negotiations with Trump. They would be unpopular at home without a major reversal on sanctions from Trump (Chart 5). Chart 5 Major US Reversal Prerequisite For Iran Talks Trump presumably aims to avoid an oil shock ahead of the election. The US and its allies have visibly shied away from conflict in the wake of Iran’s provocations, including the spectacular attack on eastern Saudi Arabia's oil infrastructure that knocked 5.7 million barrels of oil per day offline in September. However, this does not mean the odds of war are zero. Opinion polls show that the Iranian public primarily blames the government for the collapsing economy. The Americans or the Iranians could miscalculate. Both sides might think they can improve their standing at home by flexing military muscle abroad. Iran is a rational actor and would not normally court American airstrikes or antagonize a potentially lame duck president. Yet it is under extreme pressure due to the sanctions, as the riots and protests following the gasoline price hikes indicate. Iran also faces significant unrest in its sphere of influence, as discussed above. Opinion polls show that the Iranian public primarily blames the government for the collapsing economy, and yet that American sanctions are siphoning off some of this anger (Chart 6). This could tempt Iran’s leaders to continue staging provocations in the Strait of Hormuz or elsewhere in the region, perhaps with attacks on US assets or those of its GCC allies. Chart 6Iranians Blame Tehran, Tehran Blames America Hardline Iranian military leaders and politicians currently receive the most favor in polling, while the reformist President Rouhani – undercut by the American withdrawal from the 2015 deal – is among the least popular. Elections for the Majlis, or Parliament, in February will likely reverse the reformist turn in Iranian politics that began in 2012. The regime stalwarts are gearing up for the supreme leader’s succession in the coming years. While a Democratic White House could restore the 2015 deal Trump unilaterally abrogated, that ship may have sailed. Trump, under impeachment, could seek to distract the public. This was Bill Clinton’s tactic with Operations Infinite Reach, Desert Fox, and Allied Force in 1998-99. These operations were minor and not comparable to a conflict with Iran. However, Trump may be emboldened. On paper the US Strategic Petroleum Reserve – along with OPEC and other petroleum reserves and spare capacity – could cover most major oil-shock scenarios. A supply outage the size of the Abqaiq attack in September would have to persist for four months to cause enough price pressure to harm the US economy and decrease Trump’s chances of winning re-election. The simulations in Chart 7 overstate the gasoline price impact by assuming that global strategic oil reserves remain untapped, along with spare capacity. Chart 7Desperation Could Force Iran To Take Excessive Risks Thus while the Iranians may take excessive risks, the Trump administration may not refrain this time from airstrikes. Bottom Line: While the Middle East is always full of risks to oil supply, Iran’s vulnerability and Trump’s status at home make the situation unusually precarious. We continue to believe an historic oil-supply disruption is a fatter tail risk than investors realize, or are pricing in currently. Market Round-Up Energy: Overweight Following the long-awaited OPEC 2.0 meeting held last week, the group “surprised” the market by announcing it will deepen its production cut by ~ 500k b/d, pushing the total cut to 1.7mm b/d. The bulk of the additional adjustments comes from Saudi Arabia (Chart of the Week). Importantly, the group emphasizes the importance of full compliance by every member – this would imply a ~225k b/d reduction from Iraq alone. We remain overweight oil in 2020. Base Metals: Neutral Copper prices rose sharply over the past week, reaching $2.71/lb at Tuesday's close, a level last seen in July 2019. US-China trade optimism last Friday sparked the rally. Copper’s physical market remains tight, inventories are low globally, and demand is set to rebound on the back of major central banks’ accommodative monetary policy. Even so, sentiment and positioning remain weak (Chart 8). We expect this to reverse, further supporting prices over the short term. Precious Metals: Neutral Risk-on sentiment following President Trump’s upbeat comments on US-China trade negotiations pushed gold prices down by $18/oz last Friday – one of the largest single-day declines YTD. Precious metals markets continue to follow the ups and downs of trade-war headlines and global growth-related news. Nonetheless, our fair-value model suggests gold is fairly priced at ~ $1,465/oz (Chart 9). Any significant drop below that level would provide an entry opportunity for investors to add gold as a portfolio hedge in 2020. Ags/Softs: Underweight The USDA released its final crop progress update on Monday. Corn was 8% behind full harvest, with North Dakota remaining the laggard with only 43% of the corn picked. Markets ignored this as March Corn futures slid close to 1.5% on a weekly basis. Chinese purchases of at least five bulk cargo shipments of U.S. soybeans lifted prices above $9/bu on Tuesday in anticipation of the USDA monthly crop production report. Wheat prices were flat on a weekly basis, as traders awaited results of an Egyptian purchase tender on Tuesday. Chart 8Copper Sentiment And Positioning Remain Weak Chart 9Gold Fair Value Is ~ 5/oz   Robert P. Ryan Chief Commodity & Energy Strategist rryan@bcaresearch.com     Footnotes 1     Please see On OPEC 2.0’s Agenda In Vienna: More Production Cuts, Longer Deal, published December 5, 2019.  We noted  most of the production cuts that matter to the market already are in place – i.e., Saudi Arabia’s over-compliance of ~ 400k b/d, along with Venezuela’s and Iran’s involuntary production cuts of ~ 1.8mm b/d resulting from US sanctions, as of October 2019.  Under the amended production cuts, KSA agreed to remove close to 170k b/d more, lifting its total official voluntary quota and over-compliance, which brings its total cuts to close to 900k b/d.  The total OPEC 2.0 additional cuts come to just over 500k b/d.  Based on media reports going into the Vienna meeting last week, it would appear Russia prevailed on the producer coalition in its effort to keep the expiry of the production deal at end-March.  However, the March 5 extraordinary meeting of the coalition states indicates KSA was successful in keeping the discussion re extending the deal alive. 2     In our current modeling, we assume the original 1.2mm b/d of cuts will remain in place to year-end 2020.  We will be updating our balances and price forecasts in next week’s Commodity & Energy Strategy. 3    Please see U.S. says Iran may have killed more than 1,000 in recent protests, published by uk.reuters.com December 5, 2019.   Iranian leaders blamed “thugs” aligned with the US and rebels for the violence, and, in a separate report citing an Amnesty International claim that 143 protesters were killed, said “several people, including members of the security forces, were killed and more than 1,000 people arrested.”  Please see Iran says hundreds of banks were torched in 'vast' unrest plot published November 27, 2019, by uk.reuters.com.  The size of the price increase is difficult to ascertain: The government says gasoline costs were increased by 50% with a goal of raising $2.55 billion/year, while other reports claim the hike amounted to as much as 300% in different parts of the country last month. 4    Please see With Brutal Crackdown, Iran Is Convulsed by Worst Unrest in 40 Years, published by the New York Times December 1, 2019. 5    The extent to which these states are entwined with Iran recently came to light via a cache of leaked Iranian diplomatic cables obtained by The Intercept, a not-for-profit news organization established by Pierre Omidyar, a founder of eBay.  The cables were published jointly by The Intercept and the New York Times November 19, 2019.  Please see The Iran Cables: Secret Documents Show How Tehran Wields Power in Iraq, published by the Times.  The article claims “The unprecedented leak exposes Tehran’s vast influence in Iraq, detailing years of painstaking work by Iranian spies to co-opt the country’s leaders, pay Iraqi agents working for the Americans to switch sides and infiltrate every aspect of Iraq’s political, economic and religious life.” 6    This analysis in the remainder of this report is an abridged version of original work published by BCA Research’s GPS service in reports entitled Iraq's Challenge To Iran Is Underrated and 2020 Key Views: The Anarchic Society published November 8 and December 6, 2019.  We believe events over the past week and weekend warrant this in-depth examination of the ongoing unrest and instability in Iraq and Iran.  Both reports are available at gps.bcaresearch.com. 7     Lt. Gen. Abdul-Wahab al-Saadi was recognized and respected among Iraqis for fighting terrorism and his role in ridding the country of the Islamic State. The Iran-backed Popular Mobilization Forces were uneasy with Saadi’s close relationship with the US military. His abrupt removal was likely a result of the Iraqi government’s growing concern over al-Saadi’s popularity and rumors of a potential military coup. 8    Protests are occurring in all regions in Iraq. They are supported by Grand Ayatollah Ali al-Sistani. This is a significant development from the 2018 protests which were mainly concentrated in Iraq’s southern region.   Investment Views and Themes Recommendations Strategic Recommendations Tactical Trades TRADE RECOMMENDATION PERFORMANCE IN 2019 Q3 Commodity Prices and Plays Reference Table Trades Closed in 2019 Summary of Closed Trades

Highlights A 400k b/d addition to OPEC 2.0’s official production cut of 1.2mm b/d will have little effect on actual supplies. The market already has seen ~ 2.0mm to 2.5mm b/d of output removed from the market via excess voluntary cuts (e.g., from Saudi Arabia and others) and involuntary cuts (e.g., from Iran and Venezuela). The incremental 400k b/d would just be another target for free-rider states to ignore. However, if Iraq and other states with on-and-off compliance at the margin can be persuaded to follow through on producing at lower quotas following OPEC 2.0’s meetings today and tomorrow, markets could rally as actual output falls (Chart of the Week). A rally on the back of lower OPEC 2.0 production would support the IPO of Saudi Aramco, which is expected to price while the producer coalition is meeting in Vienna. Production from the “Other Guys” – our moniker for all producers excluding Gulf OPEC, US shale and Russia – will account for a lesser and lesser share of global output. New production – much of it from the last of the big conventional projects sanctioned prior to the 2014 price collapse – from Norway, Brazil, Guyana and the US Gulf of Mexico will come on strong in 2020 – but most of this has been priced in already. The rate of growth of US shale-oil production will slow. Feature Brent crude oil prices could get a boost from OPEC 2.0, if free-rider states – specifically Iraq and states with marginal quota compliance shown in the Chart of the Week – actually were to abide by production cuts they agree to. This would be amplified if cuts are extended to end-June, from end-March. The impact would be marginal, to be sure, given most of the production cuts that matter to the market already are in place – i.e., Saudi Arabia’s overcompliance of ~ 400k b/d, and Iran and Venezuela’s involuntary production cuts of ~ 1.8mm b/d resulting from US sanctions, as of October 2019. Ahead of the Vienna meetings today and tomorrow, the putative leaders of the producer coalition – the Kingdom of Saudi Arabia (KSA) and Russia – have been lobbying at cross purposes. KSA is seeking support for deeper cuts and an extension to mid-year of the deal. Russia is lobbying to keep the original deal’s expiry at end-March, and also is seeking to have its ultra-light crude (i.e., condensates) production excluded from its quota, as it is from OPEC members’ production calculations. Russia is creating additional volumes of condensate – ~ 800k b/d this year of its total 11.2mm b/d output – to dispose of as it ramps natural gas production to new feed markets, particularly China.1 Our expectation is the production-cutting deal will be extended to end-June with an official target of 1.6mm b/d removed from the market. Whether the new deal matters to the market will depend on the actions of heretofore free-rider OPEC 2.0 states. Prices could go up, but market share for the producer coalition will remain under pressure (Chart 2). Chart of the WeekAdditional OPEC 2.0 Cuts Could Be Bullish For Crude Oil Chart 2OPEC 2.0 Market Share Under Pressure Saudi Aramco IPO Due To Price Follow-through by all OPEC 2.0 members on additional production cuts would benefit Saudi Arabia, as it is expected to price the Saudi Aramco IPO while the producer coalition is meeting in Vienna. The Aramco IPO price is expected to value the company between $1.5 and $1.8 trillion. We recently looked at the IPO and believe Aramco will be valued closer to $2 trillion than to $1 trillion, the literal range in which the offering was being valued by banks and analysts.2 To briefly recap, in the first six months of this year, Aramco produced 10.0mm b/d of crude oil and condensates. Aramco accounted for 12.5% of global crude output in 2016 - 18 and reported in its red herring that its proved liquids reserves were ~ five times larger than the combined proved liquids reserves of the five major independent oil companies. Aramco’s 3.1mm b/d of refining capacity makes it the fourth largest integrated refiner in the world. In 2018, Aramco’s free cash flow amounted to almost $86 billion. Net income last year was $111 billion, more than the combined profits of the next six largest oil companies in the world. For its first year as a public company, Aramco has indicated it will pay an annual dividend of $75 billion. Improving compliance with the OPEC 2.0 production-cutting deal is of obvious importance for the Aramco IPO. The member states are quick to stress they support the deal and will do their part, but free riding has been a problem in terms of compliance. As we noted above, full compliance will lower OPEC 2.0 crude oil production from current levels, but Saudi Arabia’s voluntary over-compliance, coupled with the involuntary production losses from Iran and Venezuela already are doing most of the work in restraining production. The “Other Guys” Continue Treading Water Since 2010, most of the growth in world oil production came from three regions: US onshore shale-oil producers, Gulf OPEC and Russia. These regions added 14mm b/d of supply between 2010 and 2019. The “Other Guys” often are overlooked in the oil market, but they still accounted for 45% of global oil production this year on average. Production from the “Other Guys” – our moniker for all producers excluding Gulf OPEC, US shale and Russia – has been falling as a share of global production for years, due to a lack of domestic and foreign direct investment in their energy sectors. We expect their production will remain flat next year and could start falling in 2021. The “Other Guys” often are overlooked in the oil market, but they still accounted for 45% of global oil production this year on average: Their combined output was ~ 45mm b/d of crude and liquids (Chart 3). The “Other Guys’” production is mostly long-cycle projects and these countries do not possess spare capacity. Thus, they are reacting to oil prices and maximizing production now, if they can. Even so, their share of global production continues to fall (Chart 4). Chart 3The "Other Guys" Production Is Stagnant Chart 4The "Other Guys" Market Share Plummets The 3- to 5-year lag between final investment decisions and first production for projects in these states strongly suggests the global oil market is entering a period of lower supply additions from the “Other Guys,” given the last mega-projects were probably sanctioned in 2014 while prices still were above $100/bbl for both Brent and WTI. The "Other Guys’" rig count recovered, along with oil prices, since the 2016 downturn. However, this is still a low level of rigs vs. the 2010-2014 period – a period during which production from this group barely grew despite prices averaging more than $100/bbl. We expect their rig count to remain weak next year (Chart 5). Conventional production takes time to ramp up, therefore we should not expect a large increase in production over the next few years. Chart 5The "Other Guys" Rig Counts Will Remain Under Pressure Oil Supply Looks Tighter Toward 2021 Globally, the last of the big projects sanctioned prior to the oil-price collapse beginning in 2H14 and lasting to 1H16 are coming online in Norway, Brazil, Guyana and the US Gulf. Up to this year, US onshore production was the sole growing region globally. If capital discipline caps growth prospects in key US shale basins, global oil supply will grow only modestly in 2020 and 2021. For the most part, the “Other Guys” haven't been attracting the capital needed to sustain and grow their production. Given the ongoing drive by E&P companies globally to return capital to shareholders via buybacks or dividends, and the insistence of capital markets to fund only solid, profitable projects, capital likely will remain constrained for the “Other Guys.” States that were able to attract capital prior to the 2014 oil price collapse – Canada, Brazil, Norway, Guyana and the US – are expected to increase production next year; however, we believe much of this production increase already has been priced in by the market, as it has been by BCA (Chart 6). In our balances, we have oil production for Canada up 50k b/d next year vs 2019; Brazil +330k b/d and Norway +360k b/d. This is 740k b/d ex-Guyana in 2020. Guyana is still doing exploratory drilling and recently announced they expect to have their first commercial flows online this month. Oil markets are expecting initial commercial flows of ~ 120k b/d between December and 1Q20, and a ramp to 750k b/d by 2025, which would be significant. We will be updating our balances in two weeks, in our final publication of the year. Up to this year, US onshore production was the sole growing region globally. If capital discipline caps growth prospects in key US shale basins, global oil supply will grow only modestly in 2020 and 2021 (Chart 7). US shale output reaches ~ 9.35mm b/d on average next year in the Big Five basins (Permian, Eagle Ford, Bakken, Niobrara and Anadarko), in our modeling. This amounts to an 800k b/d increase in our US lower 48 production estimate for the US, vs. a 900k b/d increase we expected earlier.3 Chart 6"The New Guys" Production vs. The "Other Guys" Production Chart 7US Shale Oil Production Growth Will Slow Going forward, it is important to re-emphasize that even the prolific shales in the US are being constrained by investors demanding the shale guys either return capital to shareholders via share buybacks or steady dividends and dividend increases. If they don’t accommodate investor interests, these shale producers – and all oil producers for that matter – will simply be denied access to funding markets. Capital is, finally, the binding constraint on the growth of global oil supplies. This has not always been the case, as we’ve noted. 2020 Could See Stronger Prices Markets generally are responding as expected to more accommodative financial conditions globally, which will allow oil demand growth, particularly in the EM economies, to revive in 2020. As a result, we are maintaining our expectation for growth of 1.4mm b/d next year, which is up 300k b/d from our expectation for growth this year. The rebound in demand we expect next year will force prices higher to incentivize additional supply and the release of inventories – mostly in 2H20. This will push the entire futures curve up, especially nearby futures, which will steepen the backwardation in Brent and WTI futures. Bottom Line: Further actual production cuts by OPEC 2.0, emerging threats to US shale growth, and stagnant output from the “Other Guys” facing off against higher demand growth next year could result in higher prices than we currently expect for 2020 – i.e., $67/bbl for Brent and $63/bbl for WTI.   Robert P. Ryan Chief Commodity & Energy Strategist rryan@bcaresearch.com Hugo Bélanger Senior Analyst Commodity & Energy Strategy HugoB@bcaresearch.com   Market Round-Up Energy: Overweight Brent prices remain stuck between $60/bbl and $65/bbl awaiting clear signals about the US-China trade negotiations and OPEC 2.0’s decisions on its supply management beyond March 2020. Money managers are increasing their net long position, expecting bullish news on both these developments. They are increasing their Brent exposure to 414k long contracts vs. 64k short. Base Metals: Neutral SHFE copper inventories fell 11% on a week on week basis to 120k MT as of last Friday. Combined, the LME, COMEX and SHFE fell by 6%. The larger decline in Chinese inventory is partly attributed to the reduced import quotas on copper scraps, which limited the total available supply to meet domestic demand. As discussed in last week’s report, fundamentals in the two largest components of the LMEX – i.e. copper and aluminum – are tight and the rebound in demand showing up in our proprietary indicators will support prices. We remain long the LMEX tactically. Last week, we recommended getting long the LMEX index. We have subsequently learned the LME ceases trading the index. We will, nonetheless, continue to track the reported level of the index, as if it were tradeable. Precious Metals: Neutral Closing at $1479/bbl on Tuesday, gold prices broke out of the narrow range in which the metal has traded over the past month. Gold’s daily-return 1-year rolling correlation with the U.S. dollar is at its weakest level since 2011 and is below the 5th percentile of its distribution since 2004. On the other hand, the correlation with U.S. 10-year TIPS yields is strengthening and is now above the 95th percentile of its distribution. As safe-haven demand dissipates – alongside the rebound in global growth we expect – we believe these correlations will move back to their historical relationships, supporting gold as the U.S. dollar depreciates. Ags/Softs: Underweight CBOT Corn March Futures Contracts rallied at the beginning of the week on the back of a blizzard in the Midwest that stalled the already delayed corn harvest, which the USDA reported to be 89% complete as of Dec. 1, well behind the five-year average of 98%. After reaching multi-months highs last week, wheat futures fell due to profit taking and weaker than expected export figures. Soybean fell for the eighth straight day on Monday, with the most active contract closing at $8.73/Bu, the lowest in six months. A possible delay in the US-China trade deal together with expectations of a bumper crop in Brazil remain headwinds to prices.   Footnotes 1     Please see Russia to press OPEC+ to change its oil output calculations published by reuters.com November 27, 2019. 2     Please see our Special Report Aramco’s IPO: The Tie That Binds KSA And China, published November 15, 2019.  It is available at ces.bcaresearch.com. 3    We discuss further risks to shale oil production growth in Lingering Oil-Demand Weakness Will Fade, including the high levels of flaring in the Permian and Bakken basins.  This report is available at ces.bcaresearch.com. Investment Views and Themes Recommendations Strategic Recommendations Tactical Trades TRADE RECOMMENDATION PERFORMANCE IN 2019 Q3 Commodity Prices and Plays Reference Table Trades Closed in 2019 Summary of Closed Trades

特別レポート

Highlights Building on a previous special report focused on the investable market, in this report we construct and present models designed to predict the odds of Chinese domestic equity sector outperformance. BCA Research's China Investment Strategy service will aim to use our newly developed sector outperformance probability models to better understand the drivers of performance at any given moment, and to make more active equity sector recommendations in the future. Episodes of domestic equity sector outperformance over the past decade appear to be more idiosyncratic (or sector specific) than has been the case for the investable market, suggesting that periods of “abnormal” relative sector performance may occur more frequently than in the investable universe. Among the predictors included in our model, our Li Keqiang leading indicator (based on monetary conditions, money, and credit growth) has been the most important. Our base case view argues in favor of domestic cyclicals over defensives over the coming year, but recent sector performance suggests that domestic consumer discretionary and tech should be favored within a cyclical equity portfolio over energy, materials, and industrials barring a surge in oil prices or a capitulation by Chinese policymakers in favor of “flood irrigation-style” stimulus. Over the long-term, we argue that investors have a good reason to favor domestic defensives over cyclicals until the latter demonstrates meaningfully better earnings performance. Feature We examined China’s investable equity sector performance in detail in our October 30 Special Report,1 with a particular emphasis on understanding the specific macroeconomic or equity market factors that have historically predicted relative sector performance. In today’s report, we extend our approach to China’s A-share market. Our research focused 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 find that episodes of domestic equity sector outperformance over the past decade appear to be more idiosyncratic (or sector specific) that has been the case for the investable market, suggesting that periods of “abnormal” relative sector performance may occur more frequently than in the investable universe. Among the macroeconomic and equity market factors that we found to be important predictors, our Li Keqiang leading indicator was the most significant. This confirms that China’s domestic market is more sensitive to monetary conditions, money, and credit growth than its investable peer. We also note the sharp difference in the relative performance of cyclicals versus defensives in the domestic market compared with the investable market, and what this means for investors over the coming 6-12 months. Finally, we argue that investors should maintain a structural bias towards defensive stocks in the domestic market until cyclicals demonstrate meaningfully better earnings performance, and point to an existing position in our trade book for investors interested in strategically allocating to the A-share market. Detailing Our Approach In our effort to better understand historical periods of domestic sector performance, 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 Report).2 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”). We find that episodes of domestic equity sector outperformance over the past decade appear to be more idiosyncratic (or sector specific) than has been the case for the investable market. Chart I-1A and Chart 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 ##br##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 (LKI) 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. Chart I-2A and Chart 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 three months in order to reduce the need to forecast. 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, is detailed in Box I-1 of our October 30 Special Report (please see footnote 1). Key Drivers Of Sector Performance: Domestic Versus Investable Pages 11-22 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 11-22 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. Following a review of our domestic equity sector outperformance models, differences in the results from those presented in our previous report can be organized into three distinct elements: 1) the breadth of macro & equity market factors in predicting sector performance, 2) the relative importance of our LKI leading indicator, and 3) the difference between domestic/investable cyclical versus defensive performance. The Breath Of Predictive Factors Chart I-3In The Domestic Market, The Breadth Of Predictive Factors Is Narrower Compared with the models for investible sector performance that we detailed in our previous report, our work modeling domestic equity sector performance highlights that the breadth of predictive factors is narrower, particularly among cyclical sectors (Chart I-3). Our model for domestic materials (shown on page 12) is one exception to this rule, but we found that our models for energy, industrial, and consumer discretionary relative performance were all focused on fewer predictors than is the case for the investable market. In addition, our domestic utilities model has considerably worse predictive power than our model for investable utilities. The case of industrials is particularly notable: our model for investable industrials highlighted the importance of tight monetary policy, rising core inflation, rising broad market stock prices & earnings, and overbought and oversold technical conditions in explaining past periods of industrial sector outperformance. By contrast, our domestic industrials model is quite simple: the sector has been more likely to outperform, with a lag, when our BCA China Activity Index and LKI leading indicator have been rising, and underperform following periods of extreme overvaluation. One of the core conclusions of our previous report was that investors should view the relative performance of investable industrials versus consumer staples as a reflationary barometer, given the strong sensitivity of both sectors to tight monetary policy. We explained this sensitivity by pointing to the substantial difference in corporate health between the two sectors: industrial firms are heavily debt-laden and thus experience deteriorating operating performance and an environment of rising interest rates. In comparison, food and beverage firms appear to have the strongest balance sheets among the sub-sectors that we have examined, suggesting that they would benefit less from easier monetary conditions than firms in other industries. Our leading indicator for Chinese economic activity has been considerably more important in predicting domestic equity sector outperformance than in the investable market. However, these dynamics appear to be completely absent in influencing performance in China’s domestic equity market. Not only has domestic industrial sector relative performance not been negatively linked to periods of tight monetary policy, but our model for consumer staples (shown on page 15) highlights that periods of staples performance have been driven by two simple factors: the relative trend in staples EPS  (positive sign), and the trend in broad market EPS (negative sign). The Relative Importance Of Monetary Conditions, Money, And Credit Growth Chart I-4 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 our LKI leading indicator is the most important signal of sector performance that emerged from our analysis, followed by rising core inflation, rising broad market stock prices, rising economic activity, and oversold technical conditions. The ranking of results shown in Chart I-4 is fairly similar to those that we listed for the investable market, with two exceptions. First, for the domestic market, periods of tight monetary policy were considerably less important than in the investable market as an important predictor of relative sector performance. Instead, our LKI leading indicator was by far the most important predictor, which underscores a point that we have made in previous reports: domestic stocks appear to be much more sensitive to the trend in monetary conditions, money, and credit growth than for the investable market. This increased sensitivity has helped explain the difference in performance this year between the investable and domestic market, underscoring that the former has more catch-up potential than the latter in a trade truce scenario. Chart I-4Monetary Conditions, Money, & Credit Growth Drive A-Share Performance Second, in the investable market, episodes of significant overvaluation had essentially no power to predict future episodes of equity market underperformance. But this factor was an important or very important contributor to our domestic industrials, health care, and tech models. This finding is consistent with our May 23 Special Report, which noted that value stocks have outperformed in China’s domestic equity market over the past five years and underperformed in the investable market (Chart I-5). Chart I-5Value Has Been A More Successful ##br##Factor In The Domestic Market   Major Differences In The Performance Of Cyclicals Versus Defensives The results of our models for domestic equity sector performance did not change the cyclical & defensive labels that we applied in our previous report. The signs of the predictors shown in the tables on pages 11-22 clearly highlight that the domestic energy, materials, industrials consumer discretionary, and information technology sectors are cyclical sectors, and that consumer staples, health care, financials, telecom services, utilities, and real estate are defensive. What is striking, however, is that there is a major difference in the relative performance of equally-weighted domestic cyclicals versus defensives compared with what has occurred in the investable market over the past decade. Chart I-6A and Chart I-6B illustrate the different relative performance trends, along with their corresponding trends in relative P/E and relative EPS. Whereas the relative performance of investable cyclicals versus defensives has had somewhat of a stable mean over the past decade, domestic cyclicals have badly underperformed since early-2011. The charts also make it clear that this underperformance has been driven by a downtrend in relative EPS, not due to trend differences in relative valuation. Chart I-6ACyclicals/Defensives Somewhat Mean-Reverting In The Investable Market... Chart I-6B...But Not So In The Domestic##br## Market Digging further, it appears that this discrepancy can be largely explained by the significant difference in performance between investable and domestic tech over the past decade (Chart I-7). Whereas the former has outperformed the overall investable index by roughly 4-5 times since 2010, the relative performance of the latter has only very modestly risen. In effect, Charts I-6 and I-7 highlight that Chinese cyclical sectors have been structurally impaired over the past decade and have only been “saved” in the investable market by massive outsized outperformance of the tech sector. The fact that investable tech sector performance itself has been largely driven by 2 extremely successful firms underscores how narrowly based the investible cyclical versus defensives performance trend has been. Chart I-7A Huge Gap In Tech Explains Domestic Cyclical Underperformance Investment Conclusions There are three conclusions that investors can draw from our analysis. First, our research shows that episodes of domestic equity sector outperformance over the past decade appear to be more idiosyncratic (or sector specific) that has been the case for the investable market. This does not mean that domestic sector performance is not significantly impacted by macro and top down equity market factors, but it suggests that periods of “abnormal” relative sector performance may occur more frequently than in the investable universe. As such, investors should be prepared to include episode-specific investigation of abnormal performance as a regular part of their domestic equity sector allocation decisions. Investors should favor domestic cyclicals over the coming year, with exposure focused on consumer discretionary and tech. Second, the fact that our LKI leading indicator is in an uptrend suggests that investors should favor domestic cyclicals over defensives over the coming year, with a caveat. We have noted in several previous reports that our indicator is in a shallow uptrend, and the slower pace of money and credit growth than during previous economic upswings suggests that the bar may be higher for some cyclical sectors to outperform. We would advise investors to watch closely over the coming 3-6 months for signs of a technical breakout in all cyclical sectors. But sector performance in Q1 of this year, when the overall A-share market rose sharply versus global stocks, suggests that domestic consumer discretionary and tech should be favored within a cyclical equity portfolio over energy, materials, and industrials barring a surge in oil prices or a capitulation by Chinese policymakers in favor of “flood irrigation-style” stimulus (Chart I-8). Within resources, we prefer the investable energy sector to its domestic peer, due to a sizeable valuation advantage. Chart I-8Favor Select Domestic Cyclical Sectors Over The Coming Year As a third and final point, abstracting from our bullish outlook for select cyclical sectors over the coming year, Charts 6 and 7 clearly argue for investors to maintain a structural bias towards defensive stocks in the domestic market until cyclicals demonstrate meaningfully better earnings performance. In the May 23 Special Report that we referred to above, we noted that an A-share portfolio formed of industry groups with above-median return on equity and below-median ex-post beta has significantly outperformed over the past decade. Table I-1 presents the current industry group weights of this portfolio, and shows that overweight exposure is concentrated in the health care, consumer staples, and real estate sectors (all of which are defensive), and a heavy underweight towards industrials. Table I-1Current High ROE / Low Beta Factor Industry Group Portfolio Weights* For clients who are interested in strategically allocating to the A-share market, we maintain a long position in this portfolio relative to the MSCI China A Onshore index in our trade book, and plan to continue to update the performance of the trade on a weekly basis. Energy Chart II-1 Table II-1 Similar to the investable energy sector, periods of domestic energy sector outperformance are strongly positively related to rising oil prices and rising headline inflation in China. We noted in our previous report that this is a behavioral relationship, rather than a fundamental one. Domestic energy stocks are negatively associated with rising broad market stock prices, unlike their investable peers. This largely reflects the fact that the relative performance of domestic energy stocks has been in a structural downtrend over the past decade. From 2010 to mid-2016, this decline was caused by a persistent underperformance in earnings. Since mid-2016, domestic energy sector EPS have been rising in relative terms, meaning that more recent underperformance has been due to multiple contractions. While not as relatively cheap as their investable peers, domestic energy stocks are heavily discounted versus the broad domestic market based on both the price/earnings ratio and the dividend yield. Consequently, it is possible that domestic energy stocks may at some point begin to outperform in a rising broad equity market environment. For now, our model argues for an underweight stance towards domestic energy due to the lack of a clear uptrend in oil prices. As a pure value play, investable energy stocks maintain a dividend yield of nearly 6.5%, and are thus more attractive than their domestic peers. Materials Chart II-2 Table II-2 Our model for the domestic materials highlights that the sector’s performance has been related to strengthening economic activity and strongly related to a rising Li Keqiang leading indicator. Among the equity market variables that we tested, materials outperformance has been positively associated with rising relative EPS, rising broad market EPS, and prior oversold technical conditions. Similarly, the investable materials sector, these results show that domestic materials are a strong play on accelerating Chinese economic activity. The factors included in our domestic materials sector model are similar to those included in our investable material, except that relative material earnings have also been a significant predictor of sector relative performance. In addition, the macro & equity market predictors included in our domestic materials model have done a better job of leading material sector performance. The odds of domestic materials outperformance rose twice above the 50% mark this year according to our model, without any corresponding improvement in relative stock prices. The spikes in the model occurred largely because domestic materials became significantly oversold; technical conditions for the sector have only twice been weaker over the past decade. This underscores that investors should be watching domestic materials closely in Q1 of next year for signs of a relative rebound. Industrials Chart II-3 Table II-3 The results of our model for domestic industrial sector outperformance are interesting, as they imply that the drivers of performance are different between the domestic and investable markets. In the investable index, we found that industrials were heavily sensitive to monetary policy, rising core inflation, relative sector earnings, and periods of rising broad market stock prices. Our domestic model is considerably simpler: industrials outperform, with a lag, when our activity index and Li Keqiang leading indicator are rising. Periods of strong overvaluation have also been significant in predicting future episodes of domestic industrial sector underperformance. It is not clear to us why the drivers of relative performance for domestic industrials have been different than in the investable equity index, But the good news is that the relative simplicity of the model makes the investment decision making process for domestic industrials considerably easier. Today, domestic industrials are significantly undervalued, and our Li Keqiang leading indicator is in a shallow uptrend. This suggests that domestic industrials are likely to begin outperforming at some point in early-2020 following a bottoming in Chinese economic activity, unless policymakers are quick to tighten once activity begins to improve (which would be contrary to our expectations). Consumer Discretionary Chart II-4 Table II-4 Our domestic consumer discretionary model highlights that the sector’s relative performance is positively associated with a rising Li Keqiang leading indicator, rising core inflation, and rising broad market stock prices. Similar to its investable peers, domestic consumer discretionary stocks are cyclical, and positive relationship with core inflation may reflect improved pricing power for the sector. Unlike investable consumer discretionary, the domestic consumer discretionary has not been meaningfully impacted by the December 2018 changes to the global industry classification standard. Hence, our model does not exclude the internet & direct marketing retail sector as we did in our previous report on investable sectors. For now, our model suggests that the domestic consumer discretionary sector is likely to continue to underperform, given decelerating core inflation and the lack of a clear uptrend in the broad domestic equity index. However, as a cyclical sector, we will be watching closely for an upside breakout in domestic consumer discretionary performance in the first quarter as a signal to increase exposure to the sector. Consumer Staples Chart II-5 Table II-5 Our domestic consumer staples model is significantly different than that shown in our previous report for investable staples. This reflects sizeable differences in investable/domestic staples relative performance over the past decade, particularly from mid-2015 to late-2017 (where domestic staples outperformed significantly and investable staples languished). Of the two predictors found to be significant in explaining historical periods of domestic staples performance, a negative relationship with the trend in broad market EPS has been the most important. This underscores that staples are defensive sector. The trend in staples relative earnings has closely followed in importance, showing that the tremendous outperformance in domestic consumer staples over the past several years has, at least in part, been driven by fundamentals. Still, domestic consumer staples are currently priced at 34x earnings per share, compared with 15x for the overall domestic market. While our model currently argues for continued staples outperformance, the risk of a valuation mean reversion next year, against the backdrop of an improving economy, is above average. Over the coming 6-12 months, investors should be closely monitoring domestic staples for signs of waning earnings momentum and/or a major technical breakdown as potential signals to reduce domestic staples exposure. Health Care Chart II-6 Table II-6 Over the past decade, periods of domestic health care outperformance have been negatively associated with rising economic activity, rising core inflation, and rising broad market stock prices. Oversold technical conditions and periods of overvaluation have also helped predict future episodes of health care relative performance. These factors clearly point to the defensive nature of domestic health care, similar to health care stocks in the investable index. However, one clear difference between investable and domestic health care is that the former appears to have leading properties and the latter does not. We noted in our previous report that periods of investable health care underperformance appeared to lead, on average, our BCA Activity Index, periods of rising core inflation, and uptrends in the broad investable index. By contrast, domestic health care lags the Activity Index and core inflation by just over a year, and also lags the trend in broad market EPS. Our model points to further health care outperformance, but we would expect domestic health care stocks to underperform at some point next year following an improvement in economic activity and a resumed uptrend in broad domestic EPS. Financials Chart II-7 Table II-7 Our outperformance probability model for domestic financials highlights that the sector is countercyclical: periods of outperformance have been negatively related to our LKI leading indicator, rising core inflation, and rising broad market stock prices. Similar to the case of the investable index and unlike the case globally, financials are clearly defensive. Investable financials have exhibited atypical performance this year according to the model presented in our previous report. By contrast, domestic financials have performed in line with what our model has suggested: our LKI leading indicator is in a shallow uptrend, and the relative performance of domestic financials has trended flat-to-down since late-2018. Barring a major shift by the PBoC towards a hawkish stance in the coming year (which we do not expect), our base case view for the Chinese economy implies that domestic financials are likely to continue to underperform. Banks Chart II-8 Table II-8 Our model for domestic banks is similar to that of financials, with some important differences. In addition to being sensitive to our LKI leading indicator, domestic bank performance is negatively related to our Activity Index. Oversold technical conditions have also been quite important in predicting future episodes of domestic bank outperformance. The model is currently forecasting domestic bank underperformance, although it was late in predicting the selloff in bank stocks that began late last year. Similar to the case for domestic financials, our baseline view for the Chinese economy implies that domestic bank are likely to continue to underperform over the coming year. Information Technology Chart II-9 Table II-9 Our model for the domestic technology sector is different than that of investable tech, which reflects the vast difference in performance between the two sectors. While the relative performance of domestic tech has trended sideways over the past decade, investable tech stock prices have risen fourfold relative to the broad investable index. This difference is largely accounted for by the absence of the BAT stocks (Baidu, Alibaba, Tencent) from the domestic market. Similar to investable tech, domestic technology stocks are negatively related to tight monetary policy, and positively linked with a pro-cyclical economic variable (a rising LKI leading indicator). However, strangely, domestic tech has been strongly and negatively related to rising headline inflation, a finding with no clear fundamental basis. The model has been less successful in predicting domestic tech performance over the past year than in the past, which appears to be linked to the inclusion of headline inflation in the model. Rising headline inflation has been clearly associated with three major episodes of domestic tech underperformance since 2010, but over the past year domestic tech has outperformed as headline inflation accelerated. For now we would advise investors to focus on the other factors in the model: the lack of overvaluation, and our view that policy will remain easy on a measured basis, supports an overweight stance towards domestic tech over the coming year. Telecom Services Chart II-10 Table II-10 Our domestic telecom services relative performance model highlights that the sector is defensive like its investable peer, but the factors driving performance are somewhat different. The only similarity between the two models is that periods of outperformance are negatively related to rising broad market stocks prices for both investable and domestic telecom services, with domestic telecom stocks responding with a lag. Among the macro factors included in the model, periods of domestic telecom services outperformance are negatively and coincidently related to our LKI leading indicator, and positively related to tight monetary policy (with a slight lead). Oversold technical conditions have also proven to help predict future episodes of outperformance. The model failed to predict a brief period of outperformance in mid-2018, but has generally accurately predicted underperformance of domestic telecom stocks since early-2017. Barring a collapse in the US/China trade talks or considerably weaker near-term economic conditions than we expect, domestic telecom services will likely continue to underperform until the specter of tighter monetary policy emerges. This is unlikely to occur until the middle of 2020, at the earliest. Utilities Chart II-11 Table II-11 Overall, our domestic utilities model has considerably worse predictive power than our model for investable utilities. The model shows that the performance of domestic utilities is negatively related to rising core inflation (with a lag) and rising broad market EPS, but these relationships are not particularly strong. We noted in our June 19 Special Report that domestic utilities ranked highly on the impact that relative EPS had on predicting relative stock prices , yet relative sector earnings did not register as a significant predictor in our model. This apparent discrepancy is resolved by differences in the time horizon between these two approaches. The analysis that we presented in our June 19 Special Report examined the relationship between earnings and stock prices over the entire sample period (2011-2018), meaning that it examined the predictive power of earnings over the long-term. The models built in this report have focused strongly on explaining periods of outperformance over a 6-12 month time horizon, there have been enough deviations in the trend between the relative performance of utilities and relative utilities earnings that the relationship between the two was not sufficiently strong to show up in the model. In other words, the long-term link between utilities relative earnings and stock prices is strong, but the short-term link is fairly weak. Real Estate Chart II-12 Table II-12 Similar to investable real estate, our model shows that domestic real estate is a counter-cyclical sector in that it is negatively related to periods of rising economic activity, a rising LKI leading indicator, tight monetary policy, and rising core inflation. Overbought technical conditions have also aided in predicting future episodes of domestic real estate underperformance. Our model for domestic real estate stocks has performed quite well on average, but its predictive success since late-2017 has been mixed. This period of atypical underperformance has coincided with a considerably weaker rebound in residential floor space sold than has occurred in previous recoveries in the real estate market. This suggests that domestic real estate stocks are more susceptible to trends in housing sales than their investable peers (which appear to be mostly sensitive to rising house prices). We noted in our November 6 Weekly Report that floor space sold is picking up , but it still remains weak when compared with history. This, in combination with our view that the Chinese economy will improve over the coming year, suggests that investors should avoid domestic real estate exposure relative to the overall domestic equity market. Footnotes 1  Please see China Investment Strategy Special Report "A Guide To Chinese Investable Equity Sector Performance," dated October 30, 2019, available at cis.bcaresearch.com 2  Please see China Investment Strategy "Six Questions About Chinese Stocks," dated January 16, 2019, available at cis.bcaresearch.com 3  Please see China Investment Strategy Special Report "Chinese Equity Sector Earnings: Predictability, Cyclicality, And Relevance," dated June 19, 2019, available at cis.bcaresearch.com 4  Please see China Investment Strategy Weekly Report "China Macro And Market Review," dated November 6, 2019, available at uses.bcaresearch.com Cyclical Investment Stance Equity Sector Recommendations