Technology

Underweight Our intra-sector positioning shifts with the recent S&P tech hardware storage & peripherals downgrade to underweight1 and this Monday’s trimming of the S&P software index to neutral, reduce the S&P tech sector to a below benchmark allocation. Business investment in tech has been losing market share for the better part of the last year and according to the national accounts tech capex is contracting. Excluding the software industry, capital outlays are in dire straits (top & second panels). Meanwhile, lofty valuations, with the tech forward P/E trading at a 20% premium to the overall market, signal that there is no cushion for this deep cyclical sector that has 60% of sales originating abroad, the largest among its GICS1 peers (third panel). Tach on the coronavirus outbreak, and if supply chain breakdowns increase over the course of the next few weeks, then more tech profit warnings are looming and the resulting hit to still ultra-wide relative profit margins and EPS will likely be severe (bottom panel). Bottom Line: We trimmed the S&P tech sector to underweight. For more details, please refer to this Monday’s Weekly Report. ​​​​​​​ Footnotes 1    Please see BCA US Equity Strategy Weekly Report, "Crosscurrents" dated February 3, 2020, available at uses.bcaresearch.com.

Neutral Market events last week compelled us to take profits of 51% in the S&P software index above and beyond the S&P 500’s return since the late-2017 inception and downgrade exposure to neutral. Last Monday we wrote that AAPL’s profit warning was the tip of the iceberg and an avalanche of warnings would ensue.1 MSFT followed suit and issued their own profit warning and this negative backdrop is not yet reflected in the sell side’s S&P software profit and revenue forecasts. Tack on the message from the contracting software sector deflator and odds are high that sales will underwhelm in the coming quarters (third panel). The latest GDP report also revealed that, up to recently bulletproof, software capex growth sunk to nil in Q4 (bottom panel). Not only in absolute, but also in relative terms software outlays have petered out and have been decreasing in intensity as measured by the decelerating contribution to GDP growth (second panel). Bottom Line: We took profits of 51% since inception in the S&P software index and downgraded to neutral. The ticker symbols for the stocks in this index are: BLBG: S5SOFT – MSFT, ADBE, CRM, ORCL, INTU, NOW, ADSK, ANSS, SNPS, CDNS, FTNT, PAYC, CTXS, NLOK. For more details, please refer to this Monday’s Weekly Report.   1    Please see BCA US Equity Strategy Weekly Report, "Vertigo" dated February 24, 2020, available at uses.bcaresearch.com.

Highlights Portfolio Strategy It is still early to bottom fish, and trying to catch the proverbial falling knife does not interest us for cyclically oriented capital. Uncertainty surrounding the coronavirus epidemic and its effects on economic and profit growth, and uncertainty with regard to US elections both signal that it still pays to be cautious on the prospects of the broad equity market on a cyclical 9-12 month time horizon. Lofty valuations, stretched technicals, souring macro and cresting capex, underscore that the time is ripe to take profits in software stocks and move to the sidelines. Faltering operating metrics, stretched relative valuations, a firming greenback, looming fed funds rate cuts and a contracting capex backdrop, all suggest that an underweight stance is now warranted in tech stocks. Recent Changes Book gains of 51% in the S&P software index and downgrade to neutral, today. Downgrade the S&P tech sector to underweight, today. We got stopped out and booked gains of 10% in the Global Gold Mining index. It is now neutral, from previously overweight. Table 1 Feature The SPX convulsed last week, as investors grappled with the risk of the coronavirus epidemic becoming a true pandemic (Chart 1A), and with Bernie Sanders likely clinching the Democratic nomination (Chart 1B). While a technical reflex rebound is in order as indiscriminate selling took center stage and we are looking to deploy short term oriented capital from current SPX levels all the way down to 2714 (or 20% SPX correction from recent peak), the cyclical outlook for the broad equity market remains grim. Chart 1ABlame The Virus…. Chart 1B…And Bernie We have been cautioning investors all year long in our reports, warning that the stock market’s advance has been precarious on a number of fronts and have been recommending investors sell the market’s strength. First, the extreme concentration of returns in a handful of teflon-tech stocks has been disconcerting, heralding an equity market wobble.1 Likely, a mania has taken root in certain tech stocks and the inevitable bursting of the “ATLAS” mania (Apple, Tesla, Lam Research, AMD and Salesforce) would end in tears.2 As an update, as we went to press these five stocks were down 21% from their all-time highs. Second, on January 13 we highlighted that gold has been trumping the SPX and sniffing out two-to-three fed funds rate cuts, leading the fed fund futures market, similar to last spring (top & middle panels, Chart 2).3 Third, we highlighted that the recent positive correlation between the VIX and the SPX was disquieting and signaling that a pullback was nearing.4 Now the jump in the VIX along with the vol curve inversion and the collapse in the stock-to-bond ratio all warn that the path of least resistance for the market and the forward multiple remains lower (Chart 3). Chart 2Gold Sniffed Out Fed Cuts First Chart 3Financial Conditions Are … This has already tightened financial conditions according to the soaring junk spread (top panel, Chart 4), and we deem that unless the Fed relents and eases monetary policy, the stock market will remain in melt down mode. Fourth, market internals have been screaming “get out” of the broad equity market for some time now (bottom panel, Chart 4) and the epitome was when semi stocks stalled versus the NASDAQ 100 (middle panel, Chart 4).5 Fifth, the “tenuous trio” as we have coined it (stock prices, bond prices and the US dollar) cannot all rise simultaneously. Typically we cautioned, this gets resolved with an equity market pullback as a rising greenback is deflationary for US profits (bottom panel, Chart 2). Finally, in our “Sell The Rip” report, we worried about extreme investor complacency and showed that the economic backdrop was soft owing to the collapse in imports in Q4 2019, predating the coronavirus epidemic.6 Tying everything together, ultimately what matters most to equity investors is profit growth. On that front we have heavily relied on the message of our four-factor EPS growth model, which has consistently delivered. Chart 4…Tightening Rapidly   In mid-January, our SPX profit growth model continued to have no pulse, warning that the Street’s 10% profit growth estimate for calendar 2020 was unattainable. Our analysis of three EPS scenarios showed that at the time the SPX was overvalued by 8% according to the SPX 3,049 expected value for end-2020 that was actually hit last week.7 Recently, we have been inundated with client requests to update our analysis and incorporate the coronavirus epidemic to our adverse EPS scenario. Chart 5 shows that in our worst case scenario, EPS will contract by 2.41% in calendar 2020. Assuming final 2019 EPS comes in at 162.95, using I/B/E/S’ latest estimate, then the 2020 EPS level falls to 159.02. Assigning a trough multiple of 16x results in a 2,544 SPX ending value as a worst case outcome. Chart 5Our EPS Model Has Delivered Importantly, our newly weighted expected 2020 EPS falls to 164.48 versus 169.40 previously as we penciled in a 60% and 50% probability that our worst case scenario materializes in EPS and multiple assumptions, respectively (Chart 6). As a result our expected end-2020 SPX value falls to 2,755 which makes the S&P 500 still 4% overvalued (please find the assumptions on the four factor model along with the updated table of expected outcomes in the Appendix below). While no one really knows how this virus outbreak will evolve, there are two predominant market narratives that can serve as positive catalysts: a.) China will massively ease both on the monetary and fiscal policy fronts (Chart 7) and b.) the Fed (and likely other CBs) will be forced to cut interest rates despite the fact that lower fed funds rates will likely not fix the supply side global problems owing to the corona virus. In other words, liquidity injections will remain upbeat. However, if these measures – especially on the Fed’s side – prove ineffective to generate GDP growth, then the risk of a recession will skyrocket for 2020, a presidential election year. Chart 6Updated Three EPS Scenarios   Chart 7How Much Will China Stimulate? As a reminder, parts of the US yield curve (YC) first inverted in December 2018 and currently the 2-year/fed funds rate slope is inverted, implying that the bond market deems the Fed will ease monetary policy. In fact, the latest CME probability of a 50bps cut on March 18 last stood at 100%. Importantly, the YC inversions did not predict the oil embargoes of the 70s, or the 9/11 attacks or the sub-prime crisis or the coronavirus outbreak. Typically, the YC inverts at the point of maximum economic strength and signals that the cycle is long in the tooth, i.e. in the current episode, 2018 registered roughly 3% real GDP growth and 25% SPX EPS growth. Put differently, the YC inversion suggests that the economy is, at the margin, vulnerable to an external shock as economic growth settles down to a lower rate trajectory. While the YC inversion does not predict recession, it forewarns recession and we continue to heed this message (Chart 8). It will not be different this time. In sum, it is still early to bottom fish, and trying to catch the proverbial falling knife does not interest us for cyclically oriented capital. Uncertainty surrounding the coronavirus epidemic and its effects on economic and profit growth, and uncertainty with regard to US elections both signal that it still pays to be cautious on the prospects of the broad equity market on a cyclical 9-12 month time horizon. This week we are making some tech sector adjustments. Chart 8The Yield Curve is ALWAYS Right! Crystalize Software Gains And Downgrade To Neutral… Market events last week compel us to take profits of 51% in the S&P software index above and beyond the S&P 500’s return since the late-2017 inception and downgrade exposure to neutral. The multiyear juggernaut in software stocks is primed for a much needed pause. Its appeal is well known as within the tech space software is considered a defensive holding owing to the productivity enhancing properties it enjoys in both good and bad times. Anecdotally, it was disquieting that the Standard & Poor’s decided to add two additional cloud stocks to the S&P 500 recently, further boosting the software group’s weight in the tech sector and in the SPX. Likely, the reason was the flurry of M&A deals that has been ongoing for years. Most recently however, this M&A frenzy hit a wall (top panel, Chart 9). Meanwhile, last Monday we wrote that AAPL’s profit warning was the tip of the iceberg and an avalanche of warnings would ensue.8 MSFT followed suit and issued their own profit warning and this negative backdrop is not yet reflected in the sell side’s S&P software profit and revenue forecasts. Tack on the message from the contracting software sector deflator and odds are high that sales will underwhelm in the coming quarters (middle panel, Chart 9). The latest GDP report also revealed that, up to recently bulletproof, software capex growth sunk to nil in Q4 (bottom panel, Chart 9). Not only in absolute, but also in relative terms software outlays have petered out and have been decreasing in intensity as measured by the decelerating contribution to GDP growth (Chart 10). Chart 9Softening… Chart 10…Software Capex Beyond investment, the recent plunge in the Markit services PMI that really ignited the recent selling in equities, warns that the time is ripe to cement software gains and move to the sidelines (Chart 11). Moreover, there is a high chance that IPOs peaked last year and will dry up in 2020, which is slightly negative for overall market sentiment in general and for market darlings software stocks in particular (Chart 11). From a technical perspective, software equities went ballistic. Relative momentum surged north of 25%/annum, a nineteen-year high (middle panel, Chart 12). Similarly, relative valuations went parabolic. The S&P software index trades at a 60% premium to the broad market on a forward P/E basis (bottom panel, Chart 12). Such overvaluation was last seen in 2003. Chart 11Do Not Overstay… Chart 12…Your Welcome Finally, we refrain from getting bearish this heavyweight tech subindex. Our long-held belief is that SaaS, the broader push to the cloud, augmented reality, AI and autonomous driving, which are all software dependent, are not fads, but are here to stay.  Netting it all out, we do not want to overstay our welcome in the S&P software index and are cementing gains and moving to the sidelines, for now. Bottom Line: Take profits of 51% since inception in the S&P software index and downgrade to neutral. The ticker symbols for the stocks in this index are: BLBG: S5SOFT – MSFT, ADBE, CRM, ORCL, INTU, NOW, ADSK, ANSS, SNPS, CDNS, FTNT, PAYC, CTXS, NLOK.   …Which Pushes Tech To Underweight Our intra-sector positioning shifts with the recent S&P tech hardware storage & peripherals downgrade to underweight9 and today’s trimming of the S&P software index to neutral, reduce the S&P tech sector to a below benchmark allocation. Tech stocks are stretched, trading near two standard deviations above the historical time trend, a level that has marked three previous peaks since 1960 (top panel, Chart 13). From a macro perspective, when the Fed cuts rates as the end of the cycle is nearing it has been a treacherous time to own tech stocks. If we are entering a recession owing to the coronavirus epidemic, underweighting tech stocks is the right portfolio strategy to generate alpha (Chart 13). Chart 13End Of Cycle Dynamics Business investment in tech has been losing market share for the better part of the last year and according to the national accounts tech capex is contracting. Excluding the software industry, capital outlays are in dire straits (top & second panels, Chart 14). Meanwhile, lofty valuations, with the tech forward P/E trading at a 20% premium to the overall market, signal that there is no cushion for this deep cyclical sector that has 60% of sales originating abroad, the largest among its GICS1 peers (third panel, Chart 14). While the Fed will likely cut interest rates soon, the stampede in the US dollar, the reserve currency of the world, is unwelcome news for the heavily export-dependent US technology sector (trade-weighted US dollar shown inverted, middle panel, Chart 15). Chart 14Red Flag: Crumbling Tech Capex Chart 15Large Foreign Sales Exposure Is Problematic Turning over to tech-heavy Korean and Taiwanese exports, they peaked in 2017, and the coronavirus epidemic guarantees that they will suffer a steep decline in the coming months, dealing a blow to the tech sector’s top line growth prospects (bottom panel, Chart 15). If supply chain breakdowns increase over the course of the next few weeks as the coronavirus related shut downs accelerate, then more tech profit warnings are looming and the resulting hit to still ultra-wide relative profit margins and EPS will likely be severe (bottom panel, Chart 14). In more detail on the operating front, the coincident San Francisco Fed Tech Pulse Index is sinking like a stone and this weakness predates the coronavirus epidemic. The implication is that highly inflated relative share prices are vulnerable to a sizable pullback (second panel, Chart 16). Worrisomely, the industry’s new orders-to-inventories ratio is contracting at the fastest pace in eight years and bodes ill for still accelerating relative forward profit growth estimates (bottom panel, Chart 16). Finally, given the severity of recent market moves, when investors typically get margin calls they tend to sell their high flying stocks that currently are mostly concentrated in the tech space. Tack on the proliferation of passive investment, and as everyone is headed for the exit doors simultaneously, tech stocks that dominate hundreds of popular and large capitalization exchange traded funds are at risk of liquidation. Adding it all up, faltering operating metrics, stretched relative valuations, a firming greenback, looming fed funds rate cuts and a contracting capex backdrop, all signal that an underweight stance is now warranted in tech stocks. Bottom Line: Trim the S&P tech sector to underweight, today. Chart 16Weakening Operating Metrics Housekeeping Our long GDX:US / short ACWI:US portfolio position got stopped out at a 10% gain. The global gold mining index is now back to neutral, from previously overweight.   Anastasios Avgeriou US Equity Strategist anastasios@bcaresearch.com   Appendix Table A1 Table A2 Table A3     Footnotes 1     Please see BCA US Equity Strategy Weekly Report, “Three EPS Scenarios”, dated January 13, 2020, available at uses.bcaresearch.com. 2     Please see BCA US Equity Strategy Weekly Report, “When The Music Stops…” dated January 27, 2020, available at uses.bcaresearch.com 3    Please see BCA US Equity Strategy Weekly Report, “Three EPS Scenarios” dated January 13, 2020, available at uses.bcaresearch.com. 4    Please see BCA US Equity Strategy Weekly Report, “Will The Fed Save The Day, Again?” dated February 18, 2020, available at uses.bcaresearch.com. 5    Please see BCA US Equity Strategy Weekly Report, “Crosscurrents” dated February 3, 2020, available at uses.bcaresearch.com. 6    Please see BCA US Equity Strategy Weekly Report, “Sell The Rip” dated February 10, 2020, available at uses.bcaresearch.com. 7     Please see BCA US Equity Strategy Weekly Report, “Three EPS Scenarios”, dated January 13, 2020, available at uses.bcaresearch.com. 8    Please see BCA US Equity Strategy Weekly Report, “Vertigo” dated February 24, 2020, available at uses.bcaresearch.com. 9    Please see BCA US Equity Strategy Weekly Report, “Crosscurrents” dated February 3, 2020, available at uses.bcaresearch.com. Current Recommendations Current Trades Strategic (10-Year) Trade Recommendations Size And Style Views June 3, 2019 Stay neutral cyclicals over defensives (downgrade alert)  January 22, 2018 Favor value over growth May 10, 2018 Favor large over small caps (Stop 10%) June 11, 2018 Long the BCA  Millennial basket  The ticker symbols are: (AAPL, AMZN, UBER, HD, LEN, MSFT, NFLX, SPOT, TSLA, V).

Highlights Analyses on Asian semis, Argentina and Russia are available on pages 7, 12 and 14, respectively. The most likely trajectory for Chinese growth will be as follows: the initial plunge in business activity will be succeeded by a rather sharp snap-back due to pent-up demand. However, that quick rebound will probably be followed by weaker growth. Financial markets will soon focus on growth beyond the temporary rebound. In our opinion, it will be weaker than markets are currently pricing. Thus, risks for EM risk assets and currencies are skewed to the downside. A major and lasting selloff in EM stocks will only occur if EM corporate bond yields rise. In this week’s report we discuss what it will take for EM corporate credit spreads to widen. Feature The downside risks to EM risk assets and currencies are growing. We continue to recommend underweighting EM equities, credit and currencies versus their DM counterparts. Today we are initiating a short position in EM stocks in absolute terms. Chart I-1 illustrates that the total return index (including carry) of EM ex-China currencies versus the US dollar has failed to break above its 2019 highs, and has rolled over decisively.  In contrast, the trade-weighted US dollar has exhibited a bullish technical configuration by rebounding from its 200-day moving average (Chart I-2). Odds are the dollar will make new highs. An upleg in the greenback will foreshadow a relapse in EM financial markets. Chart I-1EM Ex-China Currencies Have Been Struggling Despite Low US Rates Chart I-2The US Dollar Remains In A Bull Market   Growth Trajectory After The Dust Settles The evolution of the coronavirus remains highly uncertain and unpredictable. As with any pandemic or virus outbreak, its evolution will be complex with non-trivial odds of a second wave. Even under the assumption that the epidemic will be fully contained by the end of March, its economic impact on the Chinese and Asian economies will likely be greater than global financial markets are currently pricing. As investors come to the realization that this initial pick-up in economic activity after the virus outbreak will be followed by weaker growth, the odds of a selloff in equities and credit markets will rise. In our January 30 report titled Coronavirus Versus SARS: Mind The Economic Differences, we argued that using the framework from the SARS outbreak to analyze the current epidemic is inappropriate. First, only a small portion of the Chinese economy was shut down in 2003, and for a brief period of time. The current closures and limited operations are much more widespread and likely more prolonged. Table I-1China’s Importance Now And In 2003 Second, China accounts for a substantially larger share of the global economy today than it did in 2003 (Table I-1). Hence, the global business cycle is presently much more sensitive to demand and production in the mainland than it was during the SARS outbreak. Global financial markets have rebounded following the initial selloff in late January on expectations that the Chinese and global economies will experience a V-shaped recovery. In last week’s report, we discussed why the odds favor a tepid recovery for the Chinese business cycle and global trade. The main point of last week’s report was as follows: with the median company and household in China being overleveraged, any reduction in cash flow or income will undermine their ability to service their debt and will dent their confidence for some time. Hence, consumption, investment and hiring over the next several months will be negatively affected, even after the outbreak is contained. This in turn will diminish the multiplier effect of policy stimulus in China. Chart I-3Our Expectations Of China’s Business Cycle The most likely pattern for Chinese growth will likely resemble the trajectory demonstrated in Chart I-3. It assumes the plunge in business activity will be succeeded by a rather sharp snap-back due to pent-up demand. However, that snap-back will likely be followed by weaker growth, for reasons discussed in last week’s report. Equity and credit markets in Asia and worldwide have been sanguine because they have so far focused exclusively on expectations of a sharp rebound. As investors come to the realization that this initial pick-up in economic activity will be followed by weaker growth, the odds of a selloff in equities and credit markets will rise. Bottom Line: The most likely trajectory for Chinese and Asian growth will be as follows: the initial plunge in business activity will be succeeded by a rather sharp snap-back due to pent-up demand. However, that quick rebound will probably be followed by weaker growth. Financial markets are not pricing in this scenario. Thus, risks are skewed to the downside for EM risk assets and currencies. The Missing Ingredient For An Equity Selloff The missing ingredient for a selloff in EM equities is rising EM corporate bond yields. Chart I-4 illustrates that bear markets in EM stocks typically occur when EM US dollar corporate bond yields are rising. Hence, what matters for the direction of EM share prices is not risk-free rates/yields but EM corporate borrowing costs. Chart I-4The Destiny Of EM Equities Is DependEnt On EM Corporate Bond Yields EM (and US) corporate bond yields can rise under the following circumstances: (1) when US Treasury yields are ascending more than corporate credit spreads are tightening; (2) when credit spreads are widening more than Treasury yields are falling; or (3) when both government bond yields and corporate credit spreads are increasing simultaneously. Provided the backdrop of weaker growth is bullish for government bonds, presently corporate bond yields can only rise if credit spreads widen by more than the drop in Treasury yields. In short, the destiny of EM equities currently relies on corporate spreads. A major and lasting selloff in EM stocks will only occur if their respective corporate bond yields rise. From a historical perspective, EM and US corporate credit spreads are currently extremely tight (Chart I-5). A China-related growth scare could trigger a widening in EM corporate credit spreads. As this occurs, corporate bond yields will climb, causing share prices to plummet. EM corporate spreads have historically been correlated with EM exchange rates, the global/Chinese business cycle, and commodities prices (Chart I-6). The Chinese property market plays an especially pivotal role for the outlook of EM corporate spreads. Chart I-5EM And US Corporate Spread Remain Tame Chart I-6EM Corporate Spreads Inversely Correlate With EM Currencies And Commodities Prices   First, offshore bonds issued by mainland property developers account for a large share of the EM corporate bond index. Chart I-7China Property Market Will Continue Disappointing Second, swings in China’s property markets often drive the mainland’s business cycle and its demand for resources, chemicals and industrial machinery. In turn, Chinese imports of commodities affect both economic growth and exchange rates of EM ex-China. Finally, the latter two determine the direction of EM ex-China corporate spreads. China’s construction activity and property developers were struggling before the coronavirus outbreak (Chart I-7). Given their high debt burden, the ongoing plunge in new property sales and their cash flow will not only weigh on their debt sustainability but also force them to curtail construction activity. The latter will continue suppressing commodities prices. The sensitivity of EM corporate spreads to these variables have in recent years diminished because of the unrelenting search for yield by global investors. As QE policies by DM central banks have removed some $9 trillion of high-quality securities from circulation, the volume of securities available in the markets has shrunk. This has distorted historical correlations of EM corporate spreads with their fundamental drivers – namely, China’s construction activity, commodities prices, EM exchange rates and the global trade cycle. Nonetheless, EM corporate credit spreads’ sensitivity to these variables has diminished, but has not vanished outright. If EM currencies depreciate meaningfully, commodities prices plunge and China’s growth and the global trade cycle disappoint, odds are that EM corporate spreads will widen. Given that credit markets are already in overbought territory, any selloff could trigger a cascading effect, resulting in meaningful credit-spread widening. Bottom Line: A major and lasting selloff in EM stocks will only occur if their respective corporate bond yields rise. The timing is uncertain, but the odds of EM corporate credit spreads widening are mounting as Chinese growth underwhelms, commodities prices drop and EM currencies depreciate. If these trends persist, they will push EM shares prices over the cliff. As to today’s recommendation to short the EM stock index, we anticipate at least a 10% selloff in EM stocks in US-dollar terms. For currency investors, we are maintaining our shorts in a basket of EM currencies versus the dollar. This basket includes the BRL, CLP, COP, ZAR, KRW, IDR and PHP. Arthur Budaghyan Chief Emerging Markets Strategist arthurb@bcaresearch.com   Are Semiconductor Stocks Facing An Air Pocket? Global semiconductor share prices have continued to hit new highs, even though there has not been any recovery (positive growth) in global semiconductor sales or in their corporate earnings (EPS). The coronavirus outbreak and the resulting delay in 5G phone sales in China in the first half of 2020 will trigger a pullback in semiconductor equities. Global semiconductor sales bottomed on a rate-of-change basis in June, but their annual growth rate was still negative in December. In the meantime, global semi share prices have been rallying since January 2019. This divergence between stock prices and revenue of global semiconductor stocks is unprecedented (Chart II-1). Chart II-1Over-Hyped Global Semi Share Prices Odds are that global semi stocks in general, and Asian ones in particular, will experience a pullback in the coming weeks. The coronavirus outbreak will likely dampen expectations related to the speed of 5G adoption and penetration in China. Critically, China accounted for 35% of global semiconductor sales in 2019, versus 19% for the US and 10% for the whole of Europe. In brief, semiconductor demand from China is now greater than the US and European demand combined. Furthermore, the latest news that the US administration is considering changing its regulations to prevent shipments of semiconductor chips to China’s Huawei Technologies from global companies - including Taiwan's TSMC - could hurt chip stocks further. Since Huawei Technologies is the global leader in 5G networks and smartphones, the ban, if implemented, will instigate a sizable setback to 5G adoption in China and elsewhere. Table II-1Industry Forecasts Of The 2020 Global 5G- Smartphone Shipments Our updated estimate of global 5G smartphone shipments is between 160 million and 180 million units in 2020, which is below the median of industry expectations of 210 million units (Table II-1). The key reasons why the industry’s expectations are unreasonably high, in our opinion, are as follows: Chinese demand for new smartphones will likely stay weak (Chart II-2). The mainland smartphone market has become extremely saturated, with 1.3 billion units having been sold in just the past three years – nearly equaling the entire Chinese population. Chinese official data show that each Chinese household owned 2.5 phones on average in 2018, and that the average household size was about three persons (Chart II-3). This suggests that going forward nearly all potential phone demand in China is for replacement phones, and that there is no urgent need for households to buy new phones. Chart II-2Chinese Smartphone Demand: Further Decline In 2020 Chart II-3Chinese Households: No Urgent Need For A New Phone   The Chinese government’s boost to 5G infrastructure investment will likely increase annual installed 5G base stations from 130,000 units last year to about 600,000 to 800,000 this year. However, the total number of 5G base stations will still only account for about 7-9% of total base stations in China in 2020. Hence, geographical coverage will not be sufficiently wide enough to warrant a very high rate of 5G smartphone adoption and penetration. From Chinese consumers’ perspectives, a 5G phone in 2020 will be a ‘nice-to-have,’ but not a ‘must-have.’ Given increasing economic uncertainty and many concerns related to the use of 5G phones, mainland consumers may delay their purchases into 2021 when 5G phone networks will have more geographic coverage.  The number of 5G phone models on the market is expanding, but not that quickly. Consumers may take their time to wait for more models to hit the market before making a 5G phone purchase. For example, Apple will release four 5G phone models, but only in September 2020. Moreover, the price competition between 5G and 4G phones is getting increasingly intense. Smartphone producers have already started to cut prices of their 4G phones aggressively. For example, the price of Apple’s iPhone XS, released in September 2018, has already dropped by about 50% in China. Outside of China, 5G infrastructure development will be much slower. The majority of developed countries will likely give in to pressure from the US and limit their use of Huawei 5G equipment. This will delay infrastructure installation and adoption of 5G throughout the rest of the world because Huawei has the leading and cheapest 5G technology. In 2019, China accounted for about 70% of worldwide 5G smartphone shipments. We reckon that in 2020 Chinese 5G smartphone shipments will be between 120 million and 130 million units. Assuming this accounts for about 70-75% of the world shipment of 5G phones this year, we arrive at our estimate of global 5G smartphone shipments of between 160 million and 180 million units. We agree that 5G technology is revolutionary. Nevertheless, we still believe global semi share prices are presently overhyped by unreasonably optimistic 2020 projections. Overall, investors are pricing global semi stocks using the pace and trajectory of 4G smartphones adoption. However, in 2020 the number and speed of 5G phone penetration will continue lagging that of 4G ones when the latter were introduced in December 2013 (Chart II-4). We agree that 5G technology is revolutionary, and its adoption and penetration will surge in the coming years. Nevertheless, we still believe global semi share prices are presently overhyped by unreasonably optimistic 2020 projections (Chart II-5).  Chart II-4China 5G-Adoption Pace: Slower Than The Case With 4G Chart II-5Net Earnings Of Global Semi Sector: Too Optimistic?   Investment Implications Global semi stocks’ valuations are very elevated, as shown in Chart II-6 and Chart II-7. Besides, semi stocks are overbought, suggesting they could correct meaningfully if lofty growth expectations currently baked into their prices do not materialize in the first half of this year. Chart II-6Global Semi Stocks Valuations: Very Elevated Chart II-7Global Semi Stocks’ Valuations: Very Elevated   The coronavirus outbreak and the resulting delay in 5G phone sales in China in the first half of 2020, along with US pressure on global semi producers not to sell to Huawei, will likely trigger a pullback in semiconductor equities. We recommend patiently waiting for a better entry point for absolute return investors. Within the EM equity universe, we have not been underweight Asian semi stocks because of our negative outlook for the overall EM equity benchmark. The Argentine government will drag out foreign debt negotiations with the IMF and foreign private creditors to secure a more favorable settlement. We remain neutral on Taiwan and overweight Korea. The reason is that DRAM makers such as Samsung and Hynix have rallied much less than TSMC. Besides, geopolitical risks in relation to Taiwan in general and TSMC in particular are rising, warranting a more defensive stance on Taiwanese stocks relative to Korean equities. Ellen JingYuan He Associate Vice President ellenj@bcaresearch.com Argentina’s Eternal Tango With Foreign Creditors Chart III-1Downside Risks To Bond Prices Our view remains that debt negotiations will be drawn-out because the Argentine government is both unwilling and lacks the financial capacity to service public foreign debt. The administration’s recent attitude toward foreign creditors and the IMF have startled markets: sovereign Eurobond bond prices have tanked (Chart III-1). The reasons why the Fernandez administration will play tough ball with creditors and the IMF are as follows: The country’s foreign funding and the public sector debt situations are precarious. Hence, the lower the recovery rate they negotiate with creditors, the more funds will be available to expand social programs and secure domestic political support. Given Fernandez’s and Peronist’s voter base, the government is inclined to please the population at expense of foreign creditors. Moreover, Alberto Fernandez is facing increasing scrutiny from radical Peronists, who want to dissolve the debt altogether. Vice-president Fernandez de Kirchner stated that Argentina should not pay international agents until the economy escapes a recession. To further add to creditors’ frustration, the government has yet to announce a comprehensive economic plan to revive the economy and service outstanding debt. The public foreign currency debt burden is unsustainable – its level stands at $250 billion, about 4 times larger than exports. The country is still in a recession, and economic indicators do not show much improvement. Committing to fiscal austerity to service foreign debt would entail further economic suffering for Argentine businesses and households, something Fernandez rejected throughout his campaign. The authorities are singularly focused on reviving the economy: government expenditures have grown by over 50% annually under the current administration (Chart III-2). Crucially, Argentina has already achieved a large trade surplus and its current account balance is approaching zero (Chart III-3). Assuming exports stay flat, the economy can afford to maintain its current level of imports. This makes the authorities less willing to compromise and more inclined to adopt a tough stance in debt negotiations. Chart III-2Peronist Government Has Again Boosted Fiscal Spending Chart III-3Argentina: Current Account Is Almost Balanced   The risk of this negotiation strategy is that the nation will not be able to raise foreign funding for a while. Nevertheless, the country is currently de facto not receiving any external financing. Hence, this risk is less pressing. Moreover, the administration has already delayed all US$ bond payments until August. This allows them to extend negotiations with creditors over the next six months, thereby increasing uncertainty and further pushing down bond prices. A lower market price on Argentine bonds is beneficial for the government’s negotiation strategy as it implies lower expectations for foreign creditors. Thus, the Fernandez administration’s strategy will be to play hardball and draw-out negotiations as long as possible. We expect Argentina to reach a settlement with creditors no earlier than in the third quarter of this year and at recovery rates below current prices of the nation’s Eurobonds. Russian financial assets will be supported due to improving public sector governance, accelerating domestic demand growth and healthy macro fundamentals. Bottom Line: The government will drag out foreign debt negotiations with the IMF and foreign private creditors to secure a more favorable settlement. Continue to underweight Argentine financial assets over the next several months. Juan Egaña Research Associate juane@bcaresearch.com Russia: Harvesting The Benefits Of Macro Orthodoxy Russian financial markets have shown resilience in face of falling oil prices. This has been the upshot of the nation’s prudent macro policies in recent years. We have been positive on Russia and overweight Russian markets over the past two years and this stance remains intact. Going forward, Russian financial assets will be supported due to improving public sector governance, accelerating domestic demand growth and healthy macro fundamentals: Fiscal policy will be relaxed substantially – both infrastructure and social spending will rise. Specifically, the Kremlin is eager to ramp up the national projects program. This is bullish for domestic demand. Russia’s public finances are currently in a very healthy state. Public debt (14% of GDP) is minimal and foreign public debt (4% of GDP) is tiny. The overall fiscal balance is in large surplus (2.7% of GDP). The current account is also in surplus. Hence, a major boost in fiscal spending will not undermine Russia’s macro stability for some time. As a major sign of policy change, President Putin has sidelined or reduced the authority of policymakers who have been advocating tight fiscal policy. This policy change has been overdue as fiscal policy has been unreasonably tight for longer than required (Chart IV-1). Chart IV-1Russia: Government Spending Has Been Extremely Weak Importantly, the recent changes at the highest levels of government are also positive for governance and productivity. The new Prime Minister Mishustin has earned this appointment for his achievements as the head of the federal tax authority. He has restructured and reorganized the tax department in a way that has boosted its efficiency/productivity substantially and increased tax collection. By promoting him to the head of government, Putin has boosted Mishustin’s authority to reform the entire federal governance system. Given his record of accomplishment, odds are that the new prime minister will succeed in implementing some reforms and restructuring. Thereby, productivity growth that has been stagnant in Russia for a decade could revive modestly. Also, Putin was reluctant to boost infrastructure spending as he was afraid of money being misappropriated without a proper monitoring system. Putin now hopes Mishustin can introduce an efficient governance system of fiscal spending to assure infrastructure projects can be realized with reasonably minimal losses. As to monetary policy, real interest rates are still very high. The prime lending rate is 10%, the policy rate is 6% and nominal GDP growth is 3.3% (Chart IV-2). Weak growth (Chart IV-3) and low inflation will encourage the central bank to continue cutting interest rates. Chart IV-2Russia: Interest Rates Remain Excessively High Chart IV-3Russia's Growth Is Very Sluggish   Finally, the economy does not have any structural excesses and imbalances. The central bank has done a good job in cleansing the banking system and the latter is in healthy shape. Bottom Line: The ruble will be supported by improving productivity, cyclical growth acceleration and a healthy fiscal position. We continue recommending overweighting Russian stocks, local currency bonds and sovereign credit relative to their respective EM benchmarks. Last week, we also recommended a new trade: Short Turkish bank stocks / long Russian bank stocks. The main risk to the absolute performance of Russian markets is another plunge in oil prices and a broad selloff in EM. On November 14, 2019 we recommended absolute return investors to go long Russian local currency bonds and short oil. This strategy remains intact. Finally, we have been recommending the long ruble / short Colombian peso trade since May 31, 2018. This position has generated large gains and we are reiterating it. Arthur Budaghyan Chief Emerging Markets Strategist arthurb@bcaresearch.com Footnotes Equities Recommendations Currencies, Credit And Fixed-Income Recommendations

Highlights Chinese stocks made a comeback as soon as the speed of COVID-19 transmitting outside of the epicenter somewhat moderated. Inside the epicenter, the pandemic has not shown clear signs of easing, and could significantly prolong the region’s lockdown. Despite being a large manufacturing hub, Hubei-based companies represent relatively limited significance in China’s equity market. A protracted regional lockdown in Hubei may disrupt company-specific supply chains, but so far there is little evidence suggesting such disruptions will spill over to China’s broad equity market. Feature The stringent containment measures taken by China in its battle against the COVID-191  epidemic are indeed having economic consequences, both domestically and globally. However, the full extent of the repercussions remains to be seen. In the financial market, Chinese stocks regained significant ground following a sharp selloff when the financial markets reopened after an extended Chinese New Year holiday (Chart 1). The number of confirmed COVID-19 cases continues to rise. On the other hand, the number of new cases outside of Hubei province appears to have peaked on February 3rd and the official number within the province has plateaued (Chart 2). Chart 1Chinese Equities Rebounded Despite The Ongoing Epidemic Chart 2Has The Peak Arrived? Not Within The Epicenter The latest official data reinforces our view that the epidemic outside of Hubei is considerably less severe than within Hubei. While it is still too early to confirm that the number of new cases elsewhere in China has peaked, the epidemic in Hubei - particularly in Wuhan - is far from contained despite what the official data suggests. The near-collapsing municipal system in the epicenter leaves a large margin for error in recording and confirming the number of cases. The region’s strained medical resources also mean that the number of both new infections and fatalities may not reach a sustained peak in the weeks to come. Most cities in China’s 31 provinces and municipalities had partially resumed business activities by February 10, but we think that Hubei and especially Wuhan will likely remain in lockdown through the end of March, a month longer than scheduled by the provincial government. Will an extended lockdown of the Hubei province prevent a budding recovery in China’s economy from manifesting itself? In our view, the answer is no. And even in the case of a prolonged region-wide lockdown, our assessment is that the spillover effects from supply-chain disruptions in Hubei on the domestic equity market are unlikely to be significant. Quantifying The Potential Impact Of An Extended Lockdown In Hubei Hubei accounted for only 4.6% of China’s aggregate economy in 2019. If the majority of businesses in Hubei remain closed until March 20 and we assume no growth in the province in Q1 on an annual basis,2 it will shave 0.3 percentage points from China's total nominal growth in the quarter. Furthermore, if the manufacturing sector restarts production in Q2, but most activities in the service sector such as retail, hotel, transportation and real estate remain depressed, then China’s tertiary sector output growth in that quarter will be reduced by 0.4 percentage points. This will only reduce the country’s overall economic growth in Q2 by 0.2 percentage points. Hubei’s protracted but isolated lockdown will also have a minor impact on China’s overall financial market. Within the MSCI China Onshore Index, there are 16 Hubei-based companies representing only 1.2% of total market capitalization. In the offshore market, there are 14 listed companies registered in Hubei and their market value accounts for a mere 0.3% of the offshore MSCI China Index.3  Chart 3Chinese Equity Performance Rationally Reflects Economic Fundamentals So Far Given the small market capitalization of these Hubei-based companies, China’s index performance simply will not be affected on a fundamental basis by a longer shutdown of the province (Chart 3).   Bottom Line: We expect a more protracted shutdown of business in Hubei than is currently scheduled, which has the potential to weigh negatively on investor sentiment. But from a fundamental perspective, this will not derail the economic and stock market recoveries underway in China. Confirming Signals From The Equity Market Chart 4 shows that the relative performance of cyclicals versus defensives is improving in both China’s onshore and offshore markets, which suggests investors share our view that outbreak will subside to a Hubei-specific phenomenon, and that a longer-than-expected shutdown of the province is unlikely to threaten China's overall economic recovery. Chart 4Risk-On Sentiment Ticking Up Chart 5Auto And Tech Manufacturers Having Large Presence In Wuhan ​​​​​​​ Importantly, supply chain disruptions due to a shutdown of Hubei’s production plants have not had significant spillover effects on industry performance in China’s equity markets.  Hubei, and more specifically Wuhan-based manufacturers, is a manufacturing hub and key supplier in the automobile and electronic equipment industries (Chart 5). Despite the region’s significant manufacturing presence, Hubei-based manufacturers have relatively limited impact on the equity performance of their industry groups, both onshore and offshore: The stocks of Hubei-based automobile and tech companies have mostly been underperforming relative to their respective industries and the broad Chinese market. Nevertheless, these industries and their overall sectors have managed to outperform relative to the broad market, which indicates that the supply chain constraints have not spilled over to Chinese companies outside of Hubei.  For example, Dongfeng Motor Co., a leading state-owned auto manufacturer located in Hubei, is a key supplier for Nissan and Honda. Dongfeng represents 6% of the automobile and components industry in the MSCI China Index. Chart 6 shows that while Dongfeng has been underperforming the industry and the broad market since the onset of the COVID-19 epidemic, performance in the auto industry relative to the broad market picked up last week when the number of new cases in the epidemic peaked. This suggests that supply-chain constraints are limited to Dongfeng and Hubei, and the downside risks in the automobile and components industry elsewhere in China are abating. Hubei-based tech companies account for 5% of the technology, hardware, and equipment industry group in China’s onshore equity market. Due to production cuts and transportation constraints, four of the five companies listed in the MSCI China onshore index have significantly underperformed both the industry and the broad market since the start of the COVID-19 epidemic (Chart 7).  The only Hubei-based constituent in the sector that has had large gains is a company that produces thermal imaging systems, an equipment widely used in monitoring contagious diseases. But the company’s 1% weight in the industry equity group means the industry’s outperformance is mostly from gains in companies outside of Hubei.  This suggests that despite disruptions inside Hubei, China’s domestic supply chains in the tech industry are relatively agile with manufacturers outside of Hubei stepping in to fill production shortages. Chart 6Supply Disruptions In Hubei's Auto Sector Not Affecting China's Overall Auto Industry Performance Chart 7Flexible Supply Chains In China Domestic Tech Industry Help Offset Production Shortages In Hubei   Bottom Line: While it is too early to conclusively say that the risk of further contagion outside of Hubei has abated, we think the positive equity market performance over the past week is warranted.  The negative impact of supply-chain disruptions in Hubei on China’s domestic overall equity market and industry performance has been minor. Hence, in the case of a prolonged region-wide lockdown, we think the broad financial market implications will not be significant. Investment Conclusions Chart 8Chinese Stocks Are Still Priced At A Deep Discount We maintain our bullish view on Chinese stocks, both in the near term and in the next 6-12 months. Despite regaining considerable ground in the past week, onshore and offshore equities are still priced at deep discounts (Chart 8). Cities and regions outside of the Hubei epicenter have partially resumed business activities this week. This, coupled with a reduction in the number of new cases, should further boost investors’ confidence in the recovery of China’s economy and risk assets. The reopening of businesses in Hubei could be delayed as late as the end of March. While this will have a devastating impact on the region’s economy and corporate profits, the spillover effects will most likely be contained within the region and not derail China’s economy. In addition, for now the resilience at both China’s industry and broad level equity performance appears to be outweighing the risk of a longer-than-announced shutdown.   Jing Sima China Strategist jings@bcaresearch.com   Footnotes 1    Previously labeled as coronavirus or 2019-nCoV, the disease was officially named COVID-19 by the World Health Organization (WHO) on February 11, 2020. 2   We consider this an overestimate of the economic damage caused by the COVID-19 epidemic. Even though manufacturing activities can potentially grind to a halt, healthcare-related investment and consumption will likely skyrocket. 3   As of February 10, 2020, according to the MSCI. Cyclical Investment Stance Equity Sector Recommendations

Underweight This week we downgraded exposure to below benchmark in the S&P tech hardware, storage & peripherals (THS&P) index. Undoubtedly, relative share prices are extremely extended. The second panel of the chart shows that the relative share price ratio is at the highest level as a percentage of its 200-day moving average since the late-1990s. Shown as a z-score, this technical indicator is stretched to the tune of two standard deviations above the historical mean (third panel). The last three times technical conditions were so overbought, it marked a multi-year peak in relative performance (top panel). Meanwhile, as we pointed out in the most recent Weekly Report, profit fundamentals are waning, warning that trouble is brewing for the S&P THS&P index. Bottom Line: Trim the S&P tech hardware, storage & peripherals index to underweight. The ticker symbols for the stocks in this index are: BLBG S5CMPE – AAPL, HPQ, WDC, HPE, STX, NTAP, XRX. ​​​​​​​

Highlights Portfolio Strategy China’s monetary easing, the resilient US dollar, weak operating industry metrics and a looming margin squeeze all signal that an underweight stance is still warranted in the S&P chemicals index.    Lofty valuations, overbought technicals, declining capex and weak operating metrics, are all warning that an earnings-led underperformance period is in store for the S&P tech hardware, storage & peripherals index. Recent Changes Trim the S&P tech hardware, storage & peripherals index to underweight, today. Table 1 Feature The S&P 500 fell for a second straight week and has now given back almost all of the year-to-date gains. While the coronavirus has served as an excuse to sell as we warned last week,1 we are nowhere near in unwinding the extreme overbought conditions in the broad equity market. We are no epidemiology experts, however, what concerns us most is when the news will eventually hit that coronavirus deaths are sprucing up outside of China’s borders. This will likely catalyze more equity selling and a capitulation point will subsequently ensue. Importantly, beneath the surface macro divergences remain wide. The yield curve peaked at the turn of the year. Similarly, the real 10-year Treasury yield crested around the same time and so did the hyper growth sensitive AUD/CHF cross rate all predating the coronavirus epidemic news (Chart 1). Our sense is that the bond market in particular is likely reflecting Bernie Sander’s rise in the polls along with persistently soft economic data.   Other indicators we track confirm that the handoff from liquidity-to-growth we have all been waiting for remains on hold. The oil-to-gold and copper-to-gold ratios have no pulse, warning that growth remains elusive (third & bottom panels, Chart 2). Chart 1Souring Macro Predates Coronavirus Chart 2Watch Gold Closely Moreover, in our January 13 report we highlighted that gold was sniffing out two or three fed cuts in 2020, leading the fed funds futures market, as it did in the spring of 2019.2 Since our last update, the fed funds discounter in the coming 12 months has sunk from negative 20bps to negative 42bps (year-on-year change in the fed funds rate shown inverted, second panel, Chart 2). It is disconcerting that despite the sloshing liquidity and de-escalation in the US/China trade war, CEOs remain on the sidelines. The Q4 GDP release showed that non-residential investment is now contracting on a year-over-year (yoy) basis (bottom panel, Chart 3) and has been subtracting from real output growth for three consecutive quarters. Hard data continues to warn that the manufacturing recession is not over as the 15% yoy contraction in non-defense durable goods orders revealed last week (third panel, Chart 3). Equity market internals also warn that the SPX is skating on thin ice. Worrisomely, the Philly semiconductors index (SOX) peaked versus the NASDAQ 100 last year and has been losing steam of late. The equally- versus market cap-weighted S&P 500 and NASDAQ 100 ratios remain near multi-year lows, and small caps are still stalling versus large caps (Chart 4). The implication is that, at least, an indigestion period looms for the broad equity market. Chart 3Ongoing Manufacturing Recession Chart 4Weak Market Internals Netting it all out, there are high odds that the coronavirus epidemic may serve as a catalyst and short-circuit the already frail handoff from liquidity-to-growth, warning that equity market caution is warranted at this juncture. This week we are trimming a key tech subgroup to underweight, and updating a heavyweight basic materials sub-index. To Infinity And Beyond? While we have been neutral the S&P tech hardware, storage & peripherals index and thus participating in the monster rally over the past year, the time is ripe to downgrade exposure to below benchmark. Undoubtedly, relative share prices are extremely extended. The second panel of Chart 5 shows that the relative share price ratio is at the highest level as a percentage of its 200-day moving average since the late-1990s. Shown as a z-score, this technical indicator is stretched to the tune of two standard deviations above the historical mean (third panel, Chart 5). The last three times technical conditions were so overbought, it marked a multi-year peak in relative performance (top panel, Chart 5). Importantly, the forward multiple explains all of the return in this tech sub-group’s stellar relative performance since the 2018 Christmas Eve lows (Chart 6). In fact, stagnant-to-lower relative profit growth subtracted from relative returns over the same time period (bottom panel, Chart 6). Chart 5Up, Up And Away? Moreover, the parabolic move in the forward P/E ratio that climbed from a 25% discount to the SPX to a 15% premium (i.e. a 53% multiple jump), was because the 10-year US Treasury yield plunged by 175 basis points from peak to trough (10-year US Treasury yield shown inverted, Chart 7). Chart 6EPS Have To Do The Heavy Lifting Chart 7Multiple Expansion Phase Has Run Its Course Such enormous easing in financial conditions is unlikely to repeat in the coming twelve months in order to push the forward multiple even higher and sustain the “goldilocks” conditions for the S&P tech hardware, storage & peripherals index. In contrast, BCA’s higher interest rate view is a harbinger of a multiple contraction phase and compels us to trim exposure on this high-flying tech sub group to underweight. Another market narrative substantiating the multiple expansion phase is that heavyweight AAPL is now a services oriented company and rightly so commands a sky-high multiple similar to the cloud and software stocks. While there is some truth to the push into services, the iphone and other hardware still dominates AAPL’s sales and will continue to do so for the foreseeable future especially on the eve of a 5G smartphone rollout. Turning over to the macro backdrop, this still mostly manufacturing-based industry moves with the ebbs and flows of the ISM manufacturing survey. Overall business investment is contracting and so is industry capex. Worrisomely, most of the ISM manufacturing subcomponents remain below the boom/bust line warning that investment will remain soft in the coming months, despite the Sino-American trade détente (middle panel, Chart 8). CEO confidence in capital spending remains downbeat and corroborates that at least a wait and see attitude toward greenfield expansion plans is a high probability outcome (bottom panel, Chart 8). Moreover, global export expectations continue to plumb cyclical lows. Similarly, the Emerging Asian (a key tech manufacturing hub) leading economic indicator broke below the GFC lows warning that industry exports are at risk of a further collapse (second & third panels, Chart 9). Chart 8Something’s Gotta Give Chart 9Weak Operating Metrics Chart 10Soft Pricing Power… Chart 11…Will Continue To Weigh On Margins Beyond soft exports, industry new orders are also contracting (bottom panel, Chart 9). This deficient demand backdrop will continue to weigh on industry sales, owing to the recent drubbing in pricing power (third panel, Chart 10).\ Deflating selling prices are also negative for profit margins. The wide gap between industry and SPX margins is clearly unsustainable (Chart 11). Already there is tentative evidence that S&P tech hardware, storage & peripherals margins have peaked and will remain under downward pressure, especially given our expectation of underwhelming profit growth in the coming months. In sum, lofty valuations, overbought technicals, declining capex and weak operating metrics are all warning that an earnings-led underperformance period is in store for the S&P tech hardware, storage & peripherals index. Nevertheless, there is one risk that is worth monitoring: the US consumer. A tight labor market should continue to bid up the price of labor and sustains wage gains which means more money in consumers’ wallets. As a result, brisk consumer outlays on computers & peripherals could reverse the ongoing industry sales deceleration (bottom panel, Chart 12). In sum, lofty valuations, overbought technicals, declining capex and weak operating metrics are all warning that an earnings-led underperformance period is in store for the S&P tech hardware, storage & peripherals index. Bottom Line: Downgrade the S&P tech hardware, storage & peripherals index. The ticker symbols for the stocks in this index are: BLBG S5CMPE – AAPL, HPQ, WDC, HPE, STX, NTAP, XRX. Chart 12Risk To Bearish View Hazardous Chemicals The S&P chemicals bear market has entered its third year and we remain underweight this capital intensive basic materials subgroup. Relative share prices have broken below the GFC lows and it would not surprise us if they would retest the 2006 lows (Chart 13). Now that the chemicals M&A activity dust has settled for good, China dominates the direction of chemical equities. Chinese authorities are still easing monetary policy and are injecting liquidity in the banking system by slashing the reserve requirement ratio (RRR). The recent coronavirus epidemic almost guarantees further easing via the RRR channel. Such a monetary setting should eventually stabilize the economy. However, until a turnaround is evident, US chemical stocks will continue to follow down the path of the Chinese RRR (top panel, Chart 13). The Australian currency, which is hyper-sensitive to China’s growth, corroborates that Chinese economic activity remains soft (second panel, Chart 13). Broad-based US dollar strength also confirms that global growth has yet to stage a durable comeback. The implication is that US chemical exports will continue to lose market share, weighing on industry profits (third panel, Chart 13). Chart 13China Leads The Way In fact, sell-side analysts are expecting a relative profit growth acceleration phase, but a decline in relative revenue prospects. This suggests that already uncharacteristically high chemical profit margins will continue to outpace the broad market (bottom panel, Chart 13). Our indicators suggest that it pays to lean against such relative EPS and profit margin euphoria. Importantly, our chemicals profit margin proxy is sinking, warning that a profit margin squeeze looms. Not only are selling prices deflating, but also the industry’s wage bill is gaining steam (bottom panel, Chart 14). Adding it up, China’s monetary easing, the resilient US dollar, weak operating industry metrics and a looming margin squeeze all signal that an underweight stance is still warranted in the S&P chemicals index. Moreover, chemical railcar loads are contracting at a time when the ISM manufacturing survey remains squarely below the boom/bust line (middle panel, Chart 14). This deficient chemical demand backdrop is deflationary (second panel, Chart 15) and will eat into industry profit margins. Chart 14Downbeat Demand Backdrop Chart 15Deflation Getting Entrenched On the operating front, our chemicals industry productivity proxy (industrial production/employment) is also in negative territory, underscoring that profits will likely surprise to the downside (third panel, Chart 15). Chemical industrial production is contracting at an accelerating pace and industry shipments are in retreat, warnings that the risk is high of an inventory liquidation phase (bottom panel, Chart 15). While we remain bearish on chemical stocks on a cyclical horizon, there are two key risks we are closely monitoring that would push our view offside. The global reflation handoff to actual growth is the key risk. If the global economy enters a V-shaped recovery, global bond yields will immediately reflect such a growth backdrop and push interest rates higher. This would put downward pressure on the greenback and significantly reflate chemical earnings (middle panel, Chart 16). Finally, chemical stocks are cheap and trade at a steep discount to the broad market. When our relative valuation indicator has plunged to such depressed levels in the past fifteen years, bottom-fishing buyers have come back in the market and added chemical stock exposure to their portfolios (bottom panel, Chart 16). Adding it up, China’s monetary easing, the resilient US dollar, weak operating industry metrics and a looming margin squeeze all signal that an underweight stance is still warranted in the S&P chemicals index. Bottom Line: Stay underweight the S&P chemicals index. The ticker symbols for the stocks in this index are: BLBG S5CHEM – LIN, APD, ECL, SHW, DD, DOW, PPG, CTVA, LYB, IFF, CE, FMC, EMN, CF, ALB, MOS. Chart 16Two Risks To Monitor     Anastasios Avgeriou US Equity Strategist anastasios@bcaresearch.com   Footnotes 1     Please see BCA US Equity Strategy Weekly Report, “When The Music Stops...” dated January 27, 2020, available at uses.bcaresearch.com. 2     Please see BCA US Equity Strategy Weekly Report, “Three EPS Scenarios” dated January 13, 2020, available at uses.bcaresearch.com.   Current Recommendations Current Trades Size And Style Views Stay neutral cyclicals over defensives (downgrade alert) Favor value over growth Favor large over small caps (Stop 10%)

Overweight The latest MSFT report was very robust and surprised to the upside on nearly every metric, and helped push the S&P software index to uncharted territory. Nevertheless, we do not want to overstay our welcome and a number of yellow flags compel us to further increase the trailing stop to the 37% relative return mark. As we went to press this position was generating alpha to the tune of 46%, since inception. First, software capex has been slowing over the course of 2019 both in absolute and relative terms (top & bottom panels). Second, M&A activity is running out of fuel, and is at the margin diluting a previously bullish backdrop (second panel). Third, despite the heavyweight status this tech subgroup enjoys, the Standard & Poor’s has recently added two newcomers to the software index, NOW and PAYC, further lifting the index’s market cap weight within the tech sector and the SPX. As we highlighted in an Insight two weeks ago, the S&P software index alone accounts for 18% of the entire SPX return since December 24, 2018. This concentration represents another yellow flag. Bottom Line: Remain overweight the S&P software index, but tighten the trailing stop to the 37% relative return mark. The ticker symbols for the stocks in this index are: BLBG – S5SOFT: MSFT, ADBE, CRM, ORCL, INTU, NOW, ADSK, ANSS, SNPS, CDNS, NLOK, FTNT, CTXS, PAYC.