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Highlights Portfolio Strategy Interest rates are one of the most important macro drivers of overall equity returns via valuations. BCA’s view of a selloff in the bond market is a key factor underpinning most of our 2020 high-conviction calls. A 50bps to 75bps rise in the 10-year Treasury yield in 2020, as BCA predicts, will have significant knock on effects on sector selection. Recent Changes There are no changes to our portfolio this week. Table 1 Feature As 2019 draws to a close, this week we reveal our high-conviction calls for the coming year. But before proceeding, a brief market comment is in order. As 2019 draws to a close, this week we reveal our high-conviction calls for the coming year. But before proceeding, a brief market comment is in order. We remain perplexed by the market’s euphoric rise and near total neglect of weak profit growth fundamentals. This “hope rally”, as we have characterized it in the recent past, may have some more legs with the traditional Santa Rally around the corner, but the set up for stocks could not be more treacherous for 2020. Importantly, we deem the risk of not getting a Sino-American trade deal to be significantly greater than a relief rally in case of a successful deal. Most of the positive trade-related news is already reflected into equities. This complacent backdrop is reminiscent of the early 2018 SPX catapult to 2,870 as back then the fresh fiscal easing package was all priced into stocks in the first 20 trading days of that year. Chart 1 vividly depicts this euphoric melt-up in stocks with the longest dated VIX future trouncing the squashed front month VIX future. While this ratio is not at the stratospheric level hit in late-December 2017, it hit a wall recently forewarning that equities are skating on thin ice. Chart 1VOL... Similarly, speculators are net short vol, but a snap can occur at any time. This is eerily reminiscent of February 2018. Since 2017, this vol positioning measure has consistently troughed prior to the SPX peak on three occasions and a “four-peat” likely looms (vol net spec positions shown inverted, bottom panel, Chart 2).   On the profit front, sector earnings breadth is sinking like a stone confirming the negatively anchored S&P 500 net EPS revisions ratio (Chart 3). We doubt that 10% EPS growth for calendar 2020 is even plausible, especially given the looming steep deceleration in equity retirement that we highlighted recently.1 Tack on the mighty US dollar, and profit headwinds abound. Chart 2...A Coiled Spring Chart 3No Earnings Pulse Market internals are also screaming that something is off in the equity markets. Small caps are trailing large caps, transports are at stall speed, weak balance sheet stocks are underperforming strong balance sheet stocks, the median stock as per the Value Line Geometric Index is far from all-time highs and high yield bonds (especially CCC rated) are also not confirming the SPX breakout (Chart 4). Importantly, the CBOE’s S&P 500 implied correlation index, which gauges “the expected average correlation of price returns of S&P 500 Index components, implied through SPX option prices and prices of single-stock options on the 50 largest components of the SPX”,2 is rising again over the 40% mark, underscoring that stocks are more and more beginning to move in tandem. Historically this has been a negative omen (implied correlation index shown inverted, top panel, Chart 5). Chart 4Watch Market Internals Chart 5Reflation No More? Downtrodden M&A activity is also firing a warning shot. A steep divergence of M&A deals from stock prices is atypical at this late stage of the business cycle (middle panel, Chart 5). In fact, out Reflation Gauge comprising the greenback, oil prices and the 10-year Treasury yield has taken a turn for the worse, signaling that economic surprises will likely suffer the same fate (bottom panel, Chart 5). All of this, warns that the risks of a significant pullback in the SPX are rising. What follows is four high-conviction overweight and four underweight calls. Similar to last year, we are using BCA’s view of a selloff in the bond market is a key factor underpinning most of our 2020 high-conviction calls.3 While last year this was offside, the collapse in the 10-year US Treasury yield from 3% last December to 1.75% currently offers a better backdrop for this view to pan out. A 50bps to 75bps rise in the 10-year Treasury yield in 2020, as our BCA house view predicts, will have significant knock on effects on sector selection.4 As a reminder, interest rates are one of the most important macro drivers of overall equity returns via valuations (10-year Treasury yield shown inverted, Chart 6). Moreover on a sector basis, the ebbs and flows of the risk free asset directly influence utilities, real estate, financials, consumer discretionary and tech growth stocks or more than half of the S&P 500’s market capitalization. Chart 6Priced To Perfection What follows is four high-conviction overweight and four underweight calls.     Anastasios Avgeriou US Equity Strategist anastasios@bcaresearch.com   S&P Managed Health Care (Overweight) We upgraded the S&P managed health care group to overweight in April shortly after Bernie Sanders re-introduced his revamped “Medicare For All” bill. Despite the recent explosive run up in relative share prices – partly owing to the drop in Elizabeth Warren’s odds of winning the Democratic candidacy and partly given her watering down of her “Medicare For All” take up plan – we are adding this health care sub-group to our high-conviction overweight call list. HMOs are finally raising prices at the steepest rate of the past fifteen years and while such breakneck pace is unsustainable, profit margins are set to expand smartly (Chart 7). The profit margin backdrop is enticing for health insurers for another reason: labor cost containment. CEOs have been extremely prudent refraining from adding to headcount. One final profit margin booster is the rising 10-year Treasury yield, as roughly 10% of the industry’s operating income is tied to “investment income”. In other words, as insurers receive the premia they typically invest it in Treasurys and that explains the high EPS and margin sensitivity on interest rate moves. Thus, if BCA’s bond view materializes, it will prove a tonic to both margins and profits. With regard to technicals, relative share prices are not as oversold as they were mid-year, but remain below the neutral zone still offering investors a compelling entry point to this position (bottom panel, Chart 7). The ticker symbols for the stocks in this index are: BLBG: S5MANH – UNH, ANTM, HUM, CNC, WCG.  Chart 7S&P Managed Health Care S&P Machinery (Overweight) A tentative up-tick in EM data in general and China in particular along with improving operating metrics signal that the US/China trade war wounded machinery stocks deserve a high-conviction overweight status for 2020. In more detail, the budding recoveries in the EM and Chinese manufacturing PMIs herald a brighter outlook for relative share prices. China’s fiscal and credit impulse also signals that a bottom in relative share prices is likely already in place. If this leading indicator proves accurate in the coming months, then relative share prices can reclaim the early-2018 highs. On the operating front, the new orders-to-inventories momentum has traced a bottom. Assuming that the Chinese manufacturing PMI reading stays on an upward trajectory, machinery demand will make a durable comeback. None of these green shoots are reflected in sell-side analysts’ bombed out relative profit and sales growth expectations (bottom panel, Chart 8). The ticker symbols for the stocks in this index are: BLBG – S5MACH – CAT, DE, ITW, IR, CMI, PCAR, PH, SWK, FTV, DOV, XYL, IEX, WAB, SNA, PNR, FLS.  Chart 8S&P Machinery S&P Banks (Overweight) The expected price of credit, still pristine credit quality, and a looming reacceleration in credit growth all argue for including the S&P banks index in our high-conviction overweight list. Banks stocks troughed in mid-August, sniffing out a sell-off in the bond market. As the bond sell-off gained steam, the bank outperformance phase also caught on fire. BCA’s view for next year calls for a 50-75bps selloff in the 10-year Treasury yield, further boosting the allure of bank equities (top panel, Chart 9). Beyond the rising price of credit, credit growth is another key industry profit driver. Importantly, the latest Fed Senior Loan Officer Survey painted a bright picture on both the demand and supply of credit. In more detail, bankers reported that a rising number of credit categories reversed course and demand for loans slingshot higher. The upshot is that bank credit growth will likely reaccelerate in the first half of 2020 (third panel, Chart 9). Finally, credit quality, the third key bank profit driver, is also emitting a positive signal. While a few loan categories have deteriorated recently in absolute terms, as percentage of loans outstanding, credit quality remains pristine. Despite all this enticing news, bank valuations remain anchored near rock bottom levels and a resurgent ROE is signaling that there is a long runway ahead for relative bank valuations (bottom panel, Chart 9). The ticker symbols for the stocks in this index are: BLBG: S5BANKX – WFC, JPM, BAC, C, USB, PNC, BBT, STI, MTB, FITB, CFG, RF, KEY, HBAN, CMA, ZION, PBCT, SIVB, FRC.  Chart 9S&P Banks Long Large Caps/Short Small Caps (Overweight) The large cap size bias is our sole hold out from last year’s high-conviction list despite getting stopped out and booking a handsome 9% profit. Today we recommend reinstating a large cap size bias. This call actually represents a slight hedge on BCA’s overall higher interest rates view for next year. Financials comprise 13% of the SPX, but the weight jumps to 18% in small cap indexes. Thus, if the rising interest view is off the mark, the large cap bias will provide an offset. Relative forward profit growth favors mega caps and by a wide margin. One key factor underpinning this increasing profit gap is the massive profit margin divergence (Chart 10). Tack on the fact that index providers omit negative forward profits from their index EPS calculations and the narrative that small caps have cheapened versus large caps falls flat on an adjusted basis. Why? Because a large number of small caps have negative forward EPS. Moreover, we recently created a relative employment proxy that is firing on all cylinders. Not only is the small business labor market crumbling according to the latest NFIB survey, but hard data also suggest that nonfarm private small business payroll employment has ground to a halt. Finally, small caps are debt saddled compared with large caps and small cap b/s have actually been degrading of late (Chart 10). Chart 10Long Large Caps/Short Small Caps S&P Homebuilding (Underweight) We downgraded homebuilders to underweight in late-October, and today we are adding it to our high-conviction underweight call list. Most, if not all, positive profit drivers are already reflected in relative share prices. Specifically, the drubbing in interest rates has been more than accounted for by the year-to-date outperformance in homebuilders. Now that interest rates are moving in reverse, more pain lies ahead for the S&P homebuilding index (Chart 11). Worrisomely, consumers’ expectations to purchase a new home plunged anew last month according to The Conference Board’s survey, and that demand softness will weigh on housing starts and ultimately homebuilding revenues (Chart 11). Adding insult to injury, new house selling prices are losing ground to existing home prices, but such discounting is no longer boosting volumes as new home sales market share gains have stalled. Already, S&P homebuilding sales are contracting and the risk is that deflation gets entrenched in this construction industry (Chart 11). Simultaneously, lumber prices are gaining steam and coupled with contracting new home prices signal that homebuilding profits will suffer a setback. The ticker symbols for the stocks in this index are: BLBG – S5HOME – DHI, LEN, PHM, NVR.  Chart 11S&P Homebuilding S&P Semi Equipment (Underweight) While year-to-date chip equipment stocks are the best performing index in the SPX, we deem them a mania, and include them in our high-conviction underweight basket for 2020. The top panel of Chart 12 shows this irrational exuberance that has permeated the semi equipment universe is similar to the dotcom era excesses. Back in the late-1990s relative profit growth was sky high, but today it is flirting with the zero line, warning that gravity will pull these stocks back down to earth (second panel, Chart 12). The contracting ISM manufacturing survey signals that relative share price momentum running at a breakneck pace is unwarranted. The same holds true for relative forward profit and revenue growth expectations, especially given the ongoing contraction in global semi sales (middle panel, Chart 12). This deficient demand for semis and therefore semi equipment manufacturers is also apparent in deflating DRAM prices, our industry pricing power proxy. Historically, relative profit expectations and pricing power have moved in lockstep and the current message is to fade sell-side analysts’ buoyancy. Net earnings revisions have slingshot from extreme pessimism to extreme optimism during the past quarter and are vulnerable to disappointment (bottom panel, Chart 12). In sum, lack of profit growth, deficient industry demand, perky valuations and extremely overbought conditions all suggest that the mania in the S&P chip equipment index will likely turn into a panic next year. The ticker symbols for the stocks in this index are: BLBG – S5SEEQ – AMAT, LRCX, KLAC. Chart 12S&P Semi Equipment S&P Utilities (Underweight) Heavily indebted utilities are a high-conviction underweight call for next year. · Relative share prices and the 10-year Treasury yield are closely inversely correlated. Now that the risk free asset is having a more competitive yield, investors will likely start to abandon this niche defensive sector. The jury is still out on the final outcome of the Sino-American trade war. However, there has been a decisive change of heart in US exporters and the ISM manufacturing survey’s new export orders subcomponent reflects an, at the margin, improvement in the US/China trade relationship. This bodes ill for safe haven utilities stocks (Chart 13). Utilities command a 19.4 forward P/E multiple representing roughly a 10% premium to the broad market, but their forecast EPS growth rate at 5% trails the SPX by 400bps. Our composite relative Valuation Indicator has surged to one standard deviation above the historical mean, a level typically associated with recession (Chart 13). On the operating front, natural gas prices are contracting at the steepest pace of the past four years, and electricity capacity utilization is in a multi-decade downtrend, warning that the relative profitability will remain under pressure in 2020. The implication is that this crowded trade is at risk of deflating, especially if the breakout in bond yields gains steam as BCA expects. The ticker symbols for the stocks in this index are: BLBG – S5UTIL– PPL, PNW, ATO, PEG, FE, EIX, AEE, SO, SRE, AEP, XEL, DTE, EVRG, WEC, AES, CMS, LNT, ED, NRG, D, AWK, DUK, ETR, EXC, NEE, CNP, NI, ES.  Chart 13S&P Utilities S&P Real Estate (Underweight) We would refrain from chasing high yielding real estate stocks higher, and instead we are including them in our high-conviction underweight call list for 2020. The commercial real estate (CRE) sector is a bubble candidate that exemplifies this cycle’s excesses. CRE prices sit at roughly two standard deviations above both the historical time trend and the previous cycle’s peak (not shown). Worryingly, CRE demand is waning. Not only our proprietary real estate demand indicator has sunk recently, but also the latest Fed Senior Loan Officer survey revealed that demand for CRE loans remains feeble. Simultaneously, fewer bankers are willing to extend CRE credit according to the same quarterly Fed survey (Chart 14). Occupancy rates have crested and there are increasing anecdotes of credit quality deterioration. As a result, CRE rents are also failing to keep up with inflation which eats into relative cash flow growth prospects. The supply side build up tilts this delicate balance further into deficit. Non-residential construction shows no signs of abating, with multi-family housing starts still running at an historically high rate of roughly 400K/annum (Chart 14). Finally, interest rate related headwinds will also weigh on this high-yielding sector in coming quarters, especially if the selloff in the bond market gains steam as BCA expects. (Chart 14). The ticker symbols for the stocks in this index are: BLBG – S5RLST – AMT, PLD, CCI, SPG, EQIX, WELL, PSA, EQR, AVB, SBAC, O, DLR, WY, VTR, ESS, BXP, CBRE, ARE, PEAK, MAA, UDR, EXR, DRE, HST, REG, VNO, IRM, FRT, KIM, AIV, SLG, MAC. Chart 14S&P Real Estate Footnotes 1     Please see BCA US Equity Strategy Weekly Report, “Gasping For Air” dated November 18, 2019, available at uses.bcaresearch.com. 2    https://www.cboe.com/micro/impliedcorrelation/impliedcorrelationindicator.pdf 3    Please see BCA The Bank Credit Analyst Monthly Report, “OUTLOOK 2020: Heading Into The End Game” dated November 22, 2019, available at bca.bcaresearch.com. 4    Ibid. 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%)

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

Underweight We reiterate our recent downgrade in the S&P semi equipment index to underweight. Our previous mid-year attempt to fight this rally in chip equipment stocks fell short, but thankfully our prudent risk management metric limited our losses. While still early, there is tentative evidence that our underweight stance is starting to bear fruit as the position has moved in our favor. We expect to harvest more gains down the road as a potential trade tension flare up and sustained capex blues leave no room for error in the perfectly priced S&P semi equipment index. Please refer to this Weekly Report for additional details. Bottom Line: We remain underweight the S&P semi equipment index, and maintain the stop loss at the -10% relative return mark. The ticker symbols for the stocks in the index are: BLBG – S5SEEQ – AMAT, LRCX, KLAC.

Neutral (Downgrade Alert) Tech stocks have been on a tear with the sector besting the SPX by over 40% since 2015. While such a breakneck pace is unsustainable, what is missing from this outperformance is relative forward earnings participation. Specifically, on a sub sector level, our newly created S&P semiconductors earnings model is flashing a red light as it forecasts the steepest contraction in semi earnings since the GFC. Meanwhile, relative share prices have rallied ~15% since the mid-2019 lows highlighting the prevalent euphoria in semi equities. Bottom Line: We remain on the sidelines in the S&P semiconductors index, but we have entered into a tactical S&P semi equipment underweight position. Please see the recent Weekly Report for more details.

Underweight Bellwether CSCO’s latest guidance was weak and confirmed that the capex-laden S&P communications equipment tech sub-index is in for a rough ride. Worryingly, CSCO’s key enterprise segment has no pulse. Historically, this data series has been positively correlated with telecom carrier capital outlays and the current message is grim (second panel). Tack on the ongoing manufacturing recession with CEOs canceling/postponing capital spending plans and the outlook dims further for the revenue prospects of communications equipment vendors (third & bottom panels). Adding insult to injury, the US/China trade war is further complicating the picture as the ongoing tariffs have exacerbated the global growth slowdown, and global capex plans have come under intense scrutiny. Bottom Line: Continue to avoid the S&P communications equipment index. The ticker symbols for the stocks in this index are: BLBG – S5COMM – CSCO, JNPR, MSI, ANET, FFIV. Please refer to this Monday’s Weekly Report for more details.

Dear Client, Instead of our regular weekly report next Monday, this Friday November 22, you will receive our flagship publication “The Bank Credit Analyst” with our annual investment outlook. Our regular publication service will resume on December 2  with our high-conviction calls for 2020. Kind regards, Anastasios Avgeriou Highlights Portfolio Strategy Weakening supply/demand dynamics, pricing pressures, macro headwinds and pricey valuations are all warning that REITs are headed south. Global capex blues and the ongoing manufacturing recession, the resilient US dollar and weak operating metrics all confirm that an underweight stance is still warranted in the S&P communications equipment index. Recent Changes There are no changes to our portfolio this week. Table 1 Feature The S&P 500 made fresh all-time highs again last week, as investors focused on hopes of a US/China trade deal and continued to ignore negative data/news at their own peril. Domestically, unemployment insurance claims jumped to the highest level since June, and none of the major market and industry groups showed a gain in output on a month-over-month basis in October according to the latest Fed industrial production release. Internationally, Korean exports remain in the doldrums, Chinese data releases were weak across the board, and the mighty US dollar is making multi-decade highs versus a slew of EM currencies. Chart 1Disquieting Gap All of this begs the question is global growth going to recover and aid the equity market grow into its lofty valuation? Our indicators suggest that a definitive earnings trough is now pushed out to Q2/2020. Thus, equity market caution is still warranted.   Given all the recent equity market euphoria, we feel more and more like “the lone calf standing on the desolate, dangerous, wolf-patrolled prairie of contrary opinion” as – arguably the greatest trader of all time – Jesse Livermore mused roughly a century ago. Share buybacks have been a key pillar underpinning stocks since the GFC averaging roughly $500bn/annum since 2010. But, last year equity retirement jumped to nearly $1tn/annum. That is clearly unsustainable, warning that there is a disconnect between the S&P 500 and already steeply decelerating share buybacks. Our equity retirement estimate for next year is a return to the 10-year average, signaling that the market may hit a significant air pocket (top panel, Chart 1). Another perplexing recent phenomenon has been the lack of buying on margin that typically confirms SPX breakouts. While this episode may be similar to the 2015/16 episode, if margin debt does not recover soon it will exert downward pull on the broad market (bottom panel, Chart 1). Turning over to earnings, revenues, margins and the forward multiple is instructive. Turning over to earnings, revenues, margins and the forward multiple is instructive. Chart 2 highlights the S&P 500 earnings growth surprise factor. In more detail, this IBES/Refinitiv data show how accurate the sell side analysts’ 12-month forward EPS forecasts have been over time: a reading above zero implies the analyst community was too timid, while a fall below zero signals analysts were too optimistic. Chart 2Unhinged From The EPS Accuracy Signal Equity market momentum moves with the ebb and flow of this factor and given the still downbeat message both from our SPX profit model (please refer to our recent webcast slides) and our simple liquidity indicator (please see Chart 4 from last week’s publication), we doubt 10% profit growth is even plausible for 2020. On the margin front, all four key profit margin drivers are on the brink of turning from tailwinds to headwinds as we recently highlighted in our “Peak Margins?” Special Report. Revenue growth is also at risk of a standstill. Domestic producer prices are deflating, and the ISM prices paid index has been clobbered. German, Japanese, Korean and Chinese wholesale prices are contracting and the OECD’s composite PPI measure is also sinking, suggesting that final demand is anemic at best. Under such a dire global pricing backdrop, it will be challenging for SPX sales to sustain their positive momentum, especially if the greenback remains well bid (Chart 3). Chart 3Top Line Growth Troubles Forward multiples have slingshot higher despite a near 40bps increase in the 10-year yield since Labor Day. When the discount rate rises the multiple should come in and vice versa. Thus, we would lean against the recent spike in the S&P 500 forward P/E (10-year yield shown inverted, Chart 4). This week we are updating our negative views on a niche high-yielding sector and a tech subgroup. Finally, while sifting through market internals, we recently stumbled upon the GICS2 S&P consumer services index. Digging deeper into services was revealing. This relative share price ratio has gapped down of late. One of the reasons is that the services component of the personal consumption expenditure (PCE) data is decelerating (PCE services shown advanced, middle panel, Chart 5). The ISM non-manufacturing survey is also an excellent leading indicator of the S&P consumer services index, and warns that things will likely get worse before they get better (bottom panel, Chart 5).       Chart 4Lofty Valuations Chart 5Market Internals Signal: Sit This One Out This week we are updating our negative views on a niche high-yielding sector and a tech subgroup. Getting Real With Real Estate We would refrain from chasing high yielding real estate stocks higher, and would rather avoid them altogether at the current juncture. Similar to utilities, REITs have come to the forefront lately as they have populated the top return sector ranks. However, real estate stocks, which have split out of the financials sector, are a niche GICS1 sector with a mere 3% market capitalization weight in the SPX, and have not driven the S&P 500 to all-time highs. Instead, tech stocks have, owing to their 23% market capitalization weight, as we have shown in recent research.1 Importantly, several key factors continue to signal that investors should shed public market real estate exposure. Namely, weakening supply/demand dynamics, pricing pressures, macro headwinds and still pricey valuations (primarily rock bottom cap rates) are all firing warning shots. The commercial real estate (CRE) sector is a bubble candidate that exemplifies this cycle’s excesses. As we have highlighted in the past, CRE prices sit at roughly two standard deviations above both the historical time trend and the previous cycle’s peak (not shown).2 Worryingly, CRE demand is waning. Not only our proprietary real estate demand indicator has sunk recently, but also the latest Fed Senior Loan Officer survey revealed that demand for CRE loans remains feeble (third & bottom panels, Chart 6). Simultaneously, fewer bankers are willing to extend CRE credit according to the same quarterly Fed survey (Chart 7). This tightening backdrop is weighing on CRE credit growth and CRE prices (second panel, Chart 6). In fact, absent credit growth providing the necessary fuel to sustain the CRE price inflation frenzy, there are rising odds that investors pull the plug on REITs (top panel, Chart 7). Chart 6Demand Ails Chart 7Time To... Already, occupancy rates have crested and there are increasing anecdotes of credit quality deterioration. As a result, CRE rents are also failing to keep up with inflation which eats into relative cash flow growth prospects (Chart 8). The supply side build up tilts this delicate balance further into deficit. Non-residential construction shows no signs of abating, with multi-family housing starts still running at an historically high rate of roughly 400K/annum (Chart 9). Such relentless overbuilding sows the seeds of the eventual felling in CRE prices and rents, which should also dent the S&P real estate sector. Chart 8...Lighten Up On Real Estate Chart 9Supply Build Up Is Deflationary Meanwhile, interest rate related headwinds will also weigh on this high-yielding sector in coming quarters, especially if the selloff in the bond market gains steam as BCA’s fixed income strategists continue to expect. While in the 2000s REITs were positively correlated with the 10-year Treasury yield, since 2010 this relationship has flipped and is now a tight inverse correlation (Chart 10). Chart 10Rising Yields = Sell REITs Finally, our proprietary Valuation Indicator (VI) has enjoyed an impressive run since the 2017 trough and despite the recent relative selloff remains in overvalued territory. Our Technical Indicator (TI) hit a wall of late near one standard deviation above the historical mean and has only partially unwound the overbought reading since the early 2018 bottom. If our thesis pans out, we expect heightened selling pressure to weigh further on our VI and TI (Chart 11). Chart 11Still Too Pricey Bottom Line: We reiterate our underweight rating in the S&P real estate sector. The ticker symbols for the stocks in this index are: BLBG – S5RLST – AMT, PLD, CCI, SPG, EQIX, WELL, PSA, EQR, AVB, SBAC, O, DLR, WY, VTR, ESS, BXP, CBRE, ARE, PEAK, MAA, UDR, EXR, DRE, HST, REG, VNO, IRM, FRT, KIM, AIV, SLG, MAC . Lost Signal The communications equipment rally stalled early in the summer and has since morphed into a bear market. We are sticking with our underweight recommendation, especially given a darkening profit outlook for this niche tech sub-group. Bellwether CSCO’s latest guidance was weak and confirmed that this capex-laden tech sub-index is in for a rough ride. Worryingly, CSCO’s key enterprise segment has no pulse. Historically, this data series has been positively correlated with telecom carrier capital outlays and the current message is grim (second panel, Chart 12). Tack on the ongoing manufacturing recession with CEOs canceling/postponing capital spending plans and the outlook dims further for the revenue prospects of communications equipment vendors (third & bottom panels, Chart 12). Chart 12Heed The CSCO Warning Adding insult to injury, the US/China trade war is further complicating the picture. The ongoing tariffs have exacerbated the global growth slowdown and global capex plans have come under intense scrutiny. The IFO’s World Economic Outlook capex intentions survey has plunged, warning that global exports of telecom gear have ample downside (Chart 13). Chart 13Global Capex Blues Chart 14US Dollar The Deflator The greenback’s resilience is also sapping business purchasing power, especially in the emerging markets, denting final-demand. Therefore, the US dollar’s appreciation robs communications equipment manufacturers’ pricing power, makes their goods more expensive in the global market place, and as a consequence forces market share losses on them (Chart 14). The greenback’s resilience is also sapping business purchasing power, especially in the emerging markets, denting final-demand. The implication of weakening pricing power is that profits will likely underwhelm. Currently, the sell-side is penciling in roughly 10% EPS growth for the S&P communications equipment index over and above the SPX in the next twelve months. This is a tall order and we would lean against such extreme analyst optimism (bottom panel, Chart 15). Operating metrics are quickly losing steam, another harbinger of profit ails for this tech sub-group. In more detail, our productivity proxy has taken a steep turn for the worse and industry executives have also put investment projects on hold (middle panel, Chart 15). Moreover, the communication equipment new orders-to-inventories ratio is contracting and industry resource utilization is probing multi-year lows, according to the Fed’s latest industrial production release. Under such a backdrop, relative top line growth is on track to level off and likely flirt with the contraction zone (Chart 16). Chart 15Operating Metric... Chart 16...Dysphoria Netting it all out, global capex blues, the resilient US dollar and weak operating metrics all confirm that an underweight stance is still warranted in the S&P communications equipment index.    Bottom Line: Continue to avoid the S&P communications equipment index. The ticker symbols for the stocks in this index are: BLBG – S5COMM – CSCO, JNPR, MSI, ANET, FFIV. Anastasios Avgeriou US Equity Strategist anastasios@bcaresearch.com Footnotes 1 Please see BCA US Equity Strategy Insight Report, “Deciphering Sector Returns” dated August 30, 2019, available at uses.bcaresearch.com. 2 Please see BCA US Equity Strategy Special Report, “10 Most FAQs From The Road” dated April 8, 2019, available at uses.bcaresearch.com. Current Recommendations Current Trades Size And Style Views Stay neutral cyclicals over defensives (downgrade alert) Favor value over growth Favor large over small caps (Stop 10%)

Dear Client, I will be visiting clients in Paris, Amsterdam, and London next week. In lieu of our regular report, we will be sending you a Special Report from Matt Gertken, BCA’s Chief Geopolitical Strategist. Matt argues that US politics and the 2020 election represent the greatest source of geopolitical risk over the coming year, and possibly beyond. Best regards, Peter Berezin Highlights Having underperformed for more than ten years, non-US stocks are set to gain the upper hand over their US peers. A reacceleration in global growth, a weaker US dollar, and favorable valuations should all support non-US stocks next year. Meanwhile, one of the greater drivers of US equity outperformance – the stellar returns of tech stocks – is likely to dissipate. Investors should remain overweight global equities relative to bonds, but start increasing allocations to non-US stocks at the expense of US stocks. US Stocks: From Leaders To Laggards? US equities have handily outperformed their global peers since 2008. About half of that outperformance was due to faster sales-per-share growth in the US, a third was due to faster growth in US margins, and the rest was due to relative P/E expansion in favor of the US (Chart 1). Looking ahead, non-US stocks are set to gain the upper hand over their US peers thanks to an improving global growth backdrop, a weaker US dollar, and an increasingly irresistible valuation tailwind. Chart 1Faster Sales Growth, Rising Margins, And Relative PE Expansion Helped Drive US Outperformance Over The Past Decade Improving Global Growth Outlook Global growth should benefit next year from the dovish pivot by most central banks. The share of central banks cutting/raising rates leads global growth by about 6-to-9 months (Chart 2). Chart 2Lower Rates Should Help Spur Growth Chart 3The Effects Of Easing Monetary Policy Should Soon Trickle Down To The Economy The global manufacturing downturn is also coming to end as inventories continue to be run down. The auto sector, which has been at the forefront of the manufacturing slowdown, is finally showing signs of life. US banks stopped tightening lending standards for auto loans in the third quarter. They are also reporting stronger demand for vehicle financing (Chart 3). In Europe, the new orders-to-inventory ratio of the Markit Europe Automobile PMI has moved back to parity for the first time since the autumn of 2018. In China, vehicle production and sales are rebounding on a rate-of-change basis (Chart 4). Both automobile ownership and vehicle sales in China are still a fraction of what they are in most other economies (Chart 5). Chart 4Chinese Auto Sector Is Bottoming Out Chart 5China: Structural Outlook For Autos Is Bright The trade war is a clear and present danger to our bullish outlook on global growth. The good news is that President Trump has a strong incentive to make a deal. A resurgence in the trade war would hurt the economy, which is Trump’s best selling point (Chart 6). As a self-described master negotiator, Trump has to produce a “tremendous” deal for the American people. Had he negotiated an agreement a year or two ago, he would currently be on the hook for showing that it resulted in a smaller trade deficit with China. But with the presidential election only a year away, he can semi-credibly claim that the trade balance will improve only after he is re-elected. Assuming a “Phase 1” agreement is concluded, global business sentiment should improve. Chart 6Trump Gets Reasonably High Marks On His Handling Of The Economy, But Not Much Else A détente in the trade war is unlikely to cause China to restart its deleveraging campaign. Credit growth is currently only a few points above trend nominal GDP growth, implying that the ratio of credit-to-GDP is barely increasing (Chart 7). The combined Chinese credit and fiscal impulse is still rising; it reliably leads global growth by about nine months (Chart 8). Chart 7China: The Deleveraging Campaign Has Been Put On The Backburner Chart 8Chinese Stimulus Should Boost Global Growth Faster Global Growth Should Disproportionately Benefit Non-US stocks The sector composition of international stocks is more skewed towards cyclicals than defensives compared to US stocks (Table 1). As a result, non-US stocks generally outperform their US peers when global growth accelerates (Chart 9). Table 1Cyclicals Are More Heavily Weighted Outside The US Stock Market We would include financials in our definition of cyclical sectors. As global growth improves, long-term bond yields will increase at the margin (Chart 10). Since central banks are in no hurry to raise rates, yield curves will steepen. This will boost bank net interest margins, flattering profits and share prices (Chart 11). Chart 9Non-US Equities Usually Outperform When Global Growth Improves Chart 10Stronger Economic Growth Will Put Upward Pressure On Government Bond Yields   The US Dollar Should Weaken Compared to most other economies, the United States has a large service sector and a small manufacturing base. This makes the US a “low beta” play on global growth. As a result, capital tends to flow from the US to the rest of the world when global growth picks up, putting downward pressure on the US dollar in the process (Chart 12). Chart 11Steeper Yield Curves Will Benefit Financials Chart 12The Dollar Is A Countercyclical Currency   Interest-rate differentials have been moving against the dollar for most of this year (Chart 13). This makes the greenback more vulnerable to a correction. Chart 13The Dollar Has Been Diverging From Rate Differentials This Year Chart 14Long Dollar Is A Crowded Trade Bullish sentiment towards the dollar also remains somewhat stretched. Net long speculative positions are near the top of their historic range (Chart 14). Our tactical MacroQuant model, which has an excellent track record of predicting short-to-medium term moves in the dollar, has dropped its bullish bias towards the currency (Chart 15).   Chart 15MacroQuant Has Soured On The US Dollar A weaker dollar will help boost commodity prices, which is usually good news for cyclical stocks (Chart 16). A softer dollar will also raise the USD value of overseas shares, thus making international stocks more attractive in common-currency terms. Valuations Favor Non-US Stocks There is an old investment adage which says that valuations are useless as a short-term timing tool. That is only partially true. While valuations by themselves offer little guidance as to where the stock market is going in the short run, combined with a catalyst, valuations can make a big difference. When stocks are cheap, a bullish catalyst can cause prices to surge; whereas when stocks are expensive, a bearish catalyst can cause them to plunge. Looking ahead, non-US stocks are set to gain the upper hand over their US peers thanks to an improving global growth backdrop, a weaker US dollar, and an increasingly irresistible valuation tailwind. Non-US stocks are currently trading at 13.8-times forward earnings. This represents a significant discount to US stocks, which trade at a forward PE ratio of 17.7. The valuation discount is even greater if one looks at other measures such as the cyclically-adjusted PE, price-to-book, price-to-sales, and the dividend yield (Chart 17). Chart 16A Weaker Dollar Tends To Support Commodity Prices Chart 17US Stocks Are More Expensive...   Differences in sector weights account for about a quarter of the valuation gap between the US and the rest of the world (Chart 18). The rest of the gap is due to cheaper valuations within sectors. Financials, utilities, and consumer discretionary stocks, in particular, are quite a bit more expensive in the US than elsewhere (Chart 19). Chart 18…Even When Adjusting For Sector Weights Chart 19AEquity Sector Valuations: US Versus The Rest Of The World (I) Chart 19BEquity Sector Valuations: US Versus The Rest Of The World (II)   The valuation gap between the US and the rest of the world is even starker if we compare earnings yields with bond yields. Since bond yields are lower outside the US, the implied equity risk premium is markedly higher for non-US stocks (Chart 20). An examination of the relative performance of US vs non-US companies over the past 50 years reveals two major tops, and one potential top. Some commentators have argued that the loftier valuations enjoyed by US stocks are warranted due to their superior growth prospects. While there may be some truth to that, it is worth noting that the IMF projects GDP growth (based on MSCI country weights) will be faster outside the US over the next five years (Chart 21). Chart 20Equity Risk Premia Remain Quite High Chart 21Growth Prospects Brighter Outside The US   One should also keep in mind that relatively fast US earnings growth is a fairly recent phenomenon. Between 1970 and 2008, European EPS actually grew slightly faster than US EPS (Chart 22). Earnings in emerging markets also increased more rapidly than in the US during the two decades leading up to the Global Financial Crisis. Chart 22US Earnings Have Not Always Outperformed The Role Of US Tech The large weight of the tech sector in the US stock market explains much of the superior performance of US stocks over the past decade. As Chart 23 illustrates, EPS in the I.T. sector has grown a lot more quickly than in other sectors. Chart 23US Earnings: Who Has Been Doing The Heaving Lifting? Chart 24S&P 500: Much Of The Increase In Margins Has Occurred In The I.T. Sector Looking out, there are four reasons why US tech stocks may be due for a breather. First, tech valuations have gotten stretched relative to the broader market. Second, tech margins have risen to unprecedented high levels. We estimate that about half of the increase in S&P 500 profit margins since 2007 has been due to I.T. (Chart 24). Even that understates the role of tech in the expansion of profit margins because Standard & Poor’s no longer classifies some large-cap behemoths such as Google and Facebook as I.T. companies. Third, tech companies may face increased regulatory scrutiny in the years ahead stemming from alleged privacy violations, perceived monopolistic behavior, and worries about the censorship of online speech. This could weigh on sales and earnings growth. Fourth, the growth in private equity funds is likely to limit the number of tech companies that go public at a very early stage. Stock market investors were very lucky that companies such as Microsoft, Cisco, Nvidia, Qualcomm, Oracle, Amazon, and Netflix issued shares to the public at a young stage in their development (Table 2). All seven had market caps below $1 billion when they went public. Such hidden gems are becoming less common: The number of publicly listed companies in the US has fallen by more than half over the past two decades (Chart 25). The median age of tech companies at the time of IPO has risen from around 7 in the 1990s to 12 years today (Chart 26). Table 2Big Gains From Once Small Companies Chart 25The Number Of Publicly Listed Companies Fell   Chart 26Tech Companies Entering The Public Arena Are Now More Mature Had Uber gone public as a small, upstart company not long after it was founded in 2009, it probably would have also made public shareholders a lot of money. Instead, it ended up going public this year with a market cap of $75 billion, only to see it shrink to as low as $40 billion in the ensuing six months. We won’t even mention what would have happened if WeWork had gone public. Investment Conclusions An examination of the relative performance of US vs non-US companies over the past 50 years reveals two major tops, and one potential top: The first during the “Nifty 50” era of the late 1960s, the second during the 1990s dotcom boom, and the third during the recent FAANG craze (Chart 27). It is too early to say whether FAANG stocks have peaked, but it is worth noting that the group has underperformed the S&P 500 since May (Chart 28). Chart 27Putting The Recent FAANG Craze Into Context Chart 28FAANG Stocks And The Market Chart 29Has The Underperformance Of Value Run Its Course?   Regardless of whether the secular outperformance of US equities is ending, the cyclical backdrop that we foresee over the next 12-to-18 months – characterized by faster global growth, a weakening dollar, and higher commodity prices – is likely to favor non-US stocks. As such, investors should remain overweight global equities relative to bonds, but start increasing allocations to non-US stocks at the expense of US stocks. Consistent with this, we are initiating a new recommendation to go long the MSCI ACWI ex USA index versus the MSCI USA index in dollar terms. Looking across the various stock markets outside the US, we are particularly fond of Europe. Net profit margins among companies in the STOXX Europe 600 index are about three percentage points below the S&P 500. This gives European companies greater scope to boost earnings. European banks are especially attractive, sporting a forward PE of 8.3, a price-to-book ratio of 0.6, and a dividend yield of 6.1%. Lastly, on the question of style investing, we would note that the relative performance of the MSCI value and growth indices closely tracks the performance of global financials versus I.T. (Chart 29). Given our preference for the former over the latter, we suspect that value will outperform growth next year.   Peter Berezin Chief Global Strategist peterb@bcaresearch.com   Footnotes   Strategy & Market Trends MacroQuant Model And Current Subjective Scores Tactical Trades Strategic Recommendations Closed Trades

特別レポート

Dear Client, Over the past two weeks, I have been in Asia visiting BCA’s clients. Next week’s Report, on November 20 will be a recap of my observations from the road. This week we are sending you a Special Report on global semiconductor stock performance published by our Emerging Markets Strategy service, authored by my colleague Ellen JingYuan He.  This Special Report offers great insights on the development of 5G network industry, global demand beyond 5G smartphones, as well as investment implications derived from the research. I hope you find it interesting and insightful. Best regards, Jing Sima, China Strategist   Highlights Since early this year, global semiconductor stock prices have been front-running a demand recovery that has not yet begun. There is strong industry optimism surrounding a potential demand boost for semiconductors from the rollout of 5G networks and phones in 2020. Yet we expect actual 2020 Chinese 5G smartphone shipments to fall considerably short of what industry observers expect, especially in the first half of the year. Global semiconductor stocks are over-hyped. Even though momentum could push them higher in the short term, we believe there will be a better entry point in the coming months. Given that Korean semiconductor stocks have lagged, we are upgrading Korean tech stocks and the KOSPI to overweight within the EM equity benchmark. Feature Global semiconductor stock prices have been rallying strongly, increasingly diverging from global semiconductor sales since early January. The former have risen to new highs, while the latter have remained in deep contraction (Chart 1). Chart 1A Puzzle: Semiconductors Stock Prices Skyrocketed When Sales Remain In A Deep Contraction We are puzzled by such a dramatic divergence between share prices and the industry’s top line. After all, the ongoing contraction in worldwide semiconductor sales has been broad-based across both regions and the majority of top 10 semiconductor companies (Charts 2 and 3). Chart 2A Broad-Based Contraction Across All Regions… Chart 3…And Most Top Semiconductor Companies   In our June1 report, we argued that world semiconductor sales would continue to shrink through the remainder of 2019. This view has played out, but global semiconductor share prices have surged and outperformed the global equity benchmark.  Global semiconductor stock prices have been front-running a demand recovery that has not yet begun. It seems the market has been looking beyond the current weakness. It currently expects a potential demand boost for semiconductors from 5G phones in 2020 on the back of rising hopes of a US-China trade conflict resolution. Is such hype about 5G network and corresponding shipments justified? Our research leads us to contend that global semiconductor sales will likely post only low- to middle-single-digit growth in 2020, with most of the recovery back loaded in the second half of the year. Hype over 5G phones among industry participants and investors may continue pushing semiconductor share prices higher in the near term. However, the odds are that the reality of tepid semiconductor sales growth will likely set in early next year, and semiconductor stocks will correct considerably. In short, we do not recommend chasing the rally. There will be a better entry point in the months ahead. 5G-Smartphones: The Savior Of Semiconductor Demand? Chart 4Semiconductor Sales Are Still Contracting At A Double-Digit Rate The primary driver behind the rally in semiconductor share prices is strong optimism among major semiconductor producers and investors about a rapid ramp-up of global 5G-smartphone adoption. In addition, the market is also holding onto a good amount of hope for a US-China trade conflict resolution, which will also facilitate the pace of global 5G deployment. Mobile phones account for the largest share (29%) of global semiconductor revenue. The industry expects strong global 5G-smartphone shipments in 2020 to spur a meaningful recovery in semiconductor demand (Chart 4). Table 1 shows a list of estimates for 2020 global 5G-smartphone shipments by major semiconductor companies, industry analysts and investors, ranging from 120 million to 225 million units, with a mean of 180 million units. Table 1Market Forecasts Of In 2020 Global 5G-Smartphone Shipments In particular, Taiwan Semiconductor Manufacturing Company (TSMC), the world’s largest dedicated integrated circuit (IC) foundry, recently almost doubled its forecast for 5G smartphone penetration for 2020 to a mid-teen percentage from a single-digit percentage forecast made just six months ago. Given that global smartphone shipments currently stand at roughly 1.4 billion units per year, a 15% penetration rate would translate into 210 million units of 5G smartphone shipments in 2020. Meanwhile, Qualcomm, the world's largest maker of mobile application processors and baseband modems, last week predicted that 2020 global 5G smartphone shipments will range between 175 million units and 225 million units. We agree that 5G smartphone sales in 2020 will increase sharply from currently very low levels, but we also believe the penetration pace estimated by the industry is optimistic. The basis for our conclusion is as follows: Chart 5So Far, China 5G-Adoption Pace Has Been Much Slower Than Its 4G 5G-smartphone shipments in China will largely determine the pace of worldwide 5G-phone shipments. The country will be the world leader in the 5G smartphone market due to the government’s promotion of it and the advanced 5G technology held by China's largest telecom equipment producer, Huawei. China announced the debut of the 5G-era on June 6. Since then, total 5G-smartphone shipments have been only about 800,000 units through the end of September. In terms of the pace of penetration (5G-smartphone shipments as a share of total mobile phone shipments during the first three months of launch), the rate was a mere 0.3%. In comparison with the debut of the 4G-era in December 2013, shipments of 4G phones in China were significantly larger, and their adoption rate was much faster (Chart 5). During the first three months of the 4G launch, 4G phone shipments were 9.7 million units, reaching 10% of total smartphone shipments. Here are the most important reasons behind what will be a much slower penetration pace for 5G smartphones in China compared with the 4G rollout. We agree that 5G smartphone sales in 2020 will increase sharply from currently very low levels, but we also believe the penetration pace estimated by the industry is optimistic. Market saturation: The Chinese smartphone market has become much more saturated than it was six years ago when 4G was launched. Since then, there have been about 2.3 billion units of 4G smartphones sold, with 1.3 billion units sold in the past three years – nearly equaling the total Chinese population. This means the replacement need in China is low. High prices: 5G smartphones in China are currently much more expensive than 4G ones. 5G phone prices range from RMB 4000-7000 in China, while most of the 4G ones sell within the range of RMB 1000-3000. According to data from QuestMobile, a professional big data intelligence service provider in China's mobile internet market, in the first half of 2019, about 41% of smartphones were sold at RMB 1000-2000, about 30% at RMB 2000-3000, and only 10% at RMB 4000 and above. Functionality: At the moment, except for faster data download/upload speed, 5G smartphones do not offer much more functionality than 4G ones. Back in 2014, 4G phones had much more attractive features than 3G. For example, while 3G smartphones only allowed audio and picture transmission, those with 4G enabled video chatting and high-quality streaming video. In addition, for now, there are very few smartphone apps that can only be used for 5G phones. 5G Infrastructure: Presently, there is only very limited geographical coverage of 5G base stations. The number of 5G base stations is estimated to be 130 thousand units this year, only accounting for 1.6% of total base stations in China. In comparison, 65% of all Chinese base stations are 4G-enabled.  Meanwhile, to cover the same region, the number of 5G base stations needs to at least double that of 4G ones. It will take at a minimum two or three years to develop decent coverage of 5G base stations. Besides, the cost of building 5G-enabled infrastructure is much more expensive than the deployment of the 4G ones. There are two types of 5G networks: Non-standalone (NSA) and Standalone (SA). The 5G data transmission speed is significantly faster in SA mode than in NSA mode. However, the deployment cost of the SA network is much higher than the cost for NSA networks, as the latter can be built from existing 4G networks, but the former cannot. Critically, the Chinese government recently announced only SA-compatible 5G smartphones will be allowed to have access to the 5G network in China, starting January 1, 2020. This signals that the focus of future 5G network development will be centered around SA mode instead of this year’s NSA mode. Over 90% of China’s 5G network was NSA mode in 2019. Building a 5G SA network will take longer and cost more.  The market expects China to build as much as 1 million units of 5G base stations in 2020. Even if this goal is achieved, it only accounts for about 11% of total Chinese base stations. Chart 6Chinese Smartphone Sales: Still In Contraction Lack of variety of SA-compatible 5G-phone models. There are also limited options for SA-compatible 5G smartphones models. So far, even though Huawei, Xiaomi, Vivo, Oppo, ZTE and Samsung have all released 5G smartphones, only models from Huawei work under SA networks.2 All others only work under the NSA network. Hence, the variety of SA-compatible 5G phone models is very limited. This will likely delay sales of 5G phones in China. Many more models of SA-compatible 5G smartphones will likely be released only in the second half of next year, which may both drive down 5G smartphone prices and attract more buyers. Consumer spending slowdown: 4G smartphones can meet the needs of the majority of users, and most users have purchased a new phone within the past three years. With elevated economic uncertainty and slowing income growth, a larger proportion of people in China may decide to delay upgrading from 4G-phones to much more expensive 5G ones. This echoes a continuing decline in Chinese smartphone sales (Chart 6). Overall, from Chinese consumers’ perspective, a 5G phone in 2020 will be a nice-to-have, but not a must-have. Given all the aforementioned factors, our best guess for 2020 Chinese 5G smartphone shipments is 40-60 million units, with a larger proportion occurring in the second half of the year.  From Chinese consumers’ perspective, a 5G phone in 2020 will be a nice-to-have, but not a must-have. As China is much more aggressive in moving to 5G network adaptation than other large economies, we share industry experts’ forecasts that China will account for 50% of total global 5G shipments. Provided our estimate for China is about 50 million units, our global forecast for 5G phone shipments in 2020 comes to about 100 million units worldwide. This is substantially lower than industry and analyst average estimates of 180 million units (see Table 1 on page 4). Notably, rising 5G smartphone sales will cannibalize some 4G-phone demand. Consequently, aggregate demand for semiconductors will not grow, but the share of high-valued-added chips in the overall product mix will rise. Bottom Line: The penetration pace of 5G smartphones will be meaningfully slower than both the semiconductor producers and analysts expect. Most likely, a meaningful recovery in global aggregate smartphone sales will not occur over the next six months. We suspect the positive impact of 5G phone sales will be felt by global semiconductor producers largely in the second half of 2020. Semiconductor Demand Beyond 5G In terms of end usage, except smartphones, the top five end uses for semiconductors are personal computers (PCs) (12%), servers (11%), diverse consumer products (12%), automotive (10%), and industrial electronics (9%). Structural PC demand is down, but sales have been more or less flat in the past three years (Chart 7). Next year, commercial demand may accelerate as enterprises work through the remainder of their Windows 10 migration. However, household demand is still facing strong competition from tablets. Overall, we expect PC demand to remain stagnant. Global server shipments sank deeper into contraction in the second quarter of this year due to a slowdown in purchasing from cloud providers and hyperscale customers. They may stay in moderate contraction over the next six months as global economic uncertainty remain elevated, which may discourage enterprises’ investment plans (Chart 8). Chart 7Structural PC Demand Is Stagnant And Will Remain So In 2020 Chart 8Global Server Shipments: A Moderate Contraction In 2020 Chart 9Automotive-Related Semiconductor Demand: A Moderate Growth Ahead Chinese auto sales – about 30% of the world total – will likely stage a rate-of-change improvement, moving from deep to mild contraction or stagnation over the next six months.3 Increasing penetration of new energy vehicles and continuing 5G deployment may still result in moderate growth in auto-related semiconductor demand (Chart 9). Semiconductor demand from diverse consumer products slightly declined in the third quarter, with robust growth in tablets, eReaders and portable navigation devices, and contraction in all other subsectors including TV sets, gaming, printers and images, cameras and set-top boxes (Chart 10). This may remain in slight contraction or stagnation over the next three to six months. Automation and 5G deployment will likely continue to increase semiconductor sales in the industrial sector (Chart 11).  Chart 10Semiconductor Demand From Consumer Products: A Slight Contraction Or Stagnation Ahead Chart 11Industrial Semiconductor Demand: More Upside Ahead   Chart 12Memory Prices Still Signal Sluggish Semiconductor Demand Overall, demand recovery has not yet begun. The lack of price recovery in DRAM prices after 18 months of declines and still-low NAND prices are also signaling sluggish semiconductor demand (Chart 12). Bottom Line: Odds are that global semiconductor demand in sectors other than smartphones will show improvement in terms of rate of change, but will still likely be flat in 2020. TSMC Sales: A Harbinger Of Industry Recovery? TSMC, the world’s biggest semiconductor company, posted a revival in sales over four consecutive months from June to September. Do TSMC sales lead global semiconductor sales? The answer is not always. TSMC sales do not always correlate well with global semiconductor sales (Chart 13). For example, TSMC sales diverged from global semiconductor sales in 2017-‘18 and 2013-‘14. So what are the reasons for strong increase in TSMC sales? First, it reflects market share rotation in the global smartphone market in favor of smartphone producers that use TSMC-fabricated chips. Chart 13TSMC Sales Do Not Always Lead Global Semiconductor Sales Demand from the global smartphone sector contributes to almost half of TSMC’s total revenue. Apple and Huawei are TSMC’s two top customers. The most recent report from market research firm Canalys shows that while Apple’s smartphone shipments declined 7% year-on-year last quarter, Huawei’s shipments soared 29%.4 Combined, smartphone shipments from these two companies still jumped nearly 12% year-on-year in the third quarter of the year. This has increased their market share in the global smartphone market to 31% now from 28% a year ago. Second, rising TSMC sales also reflect market share rotation in the global server market, in particular rising shipments and growing market share of servers using AMD high-performing-computing (HPC) chips instead of Intel ones. AMD’s 7nm Epyc CPU, launched this August and manufactured by TSMC, has been taking share from Intel in the global server market. This has driven the increase in TSMC’s revenue from the HPC sector.  Third, the share of value-added products (high-end chips) in TSMC’s product mix has been rising rapidly. TSMC’s share of revenue from 7nm technology jumped from 21% to 27% in the third quarter, as most of Apple’s and Huawei’s chips and all of AMD’s Epyc CPUs are 7nm-based. Back in the third quarter of 2018, TSMC’s 7nm business only accounted for 11% of its total revenue. Chart 14Both TSMC Sales And Taiwanese PMI Could Continue To Improve While Global Semiconductor Sales Remain In Contraction Finally, although internet of things (IoT) and automotive chips only account for 9% and 4% of TSMC’s total share of revenue respectively, strong growth in both segments –33% year-on-year in IoT and 20% year-on-year in automotive – indeed shows exceptional demand in these two sectors in a weakening global economic environment. As IoT and automotive development will highly rely on global 5G infrastructure development, their impact will be meaningful once the global 5G network becomes well advanced and widely installed. To conclude, while a 40% boost in TSMC’s capital spending indeed paints a positive picture on global semiconductor demand over the longer term, rising TSMC sales do not mean an imminent and strong recovery in the global semiconductor sector is in the works. Huawei is the global 5G technology leader and the major supplier in both 5G-network equipment and 5G smartphones; the company will be a major revenue contributor to TSMC. As Huawei will likely place more orders to TSMC for chip fabrication, this will likely result in further improvement in TSMC’s sales (Chart 14). Bottom Line: Rising TSMC sales do not necessarily herald an imminent and robust cyclical recovery in the global semiconductor sector.  Investment Conclusions Global semiconductor stock prices have been front running a recovery that has not yet begun. In addition, there is still uncertainty about the technology aspect of US-China trade negotiations. The US will likely continue to have Huawei and other Chinese high-tech companies on its trade-ban list – its so-called Entity List. TSMC sales do not always correlate well with global semiconductor sales. Notably, global semiconductor sales and profits are still in deep contraction, while share prices are at all-time highs (Chart 15). As a result, semiconductor stocks’ multiples have spiked to their previous highs (Chart 16). Chart 15Semiconductor Companies Profits: Still In Deep Contraction Chart 16Elevated Semiconductor Stocks Multiples     While it is common for share prices to rally ahead of a business cycle/profit revival, we believe a true recovery will only emerge in spring 2020, and it will initially be much more subdued than industry watchers and investors expect. In the near term, strong momentum could still push semiconductor stock prices higher. However, the reality will then set in and there will be an air pocket before a more sustainable bull market emerges.   Our US Equity Investment Strategy earlier this week downgraded S&P semiconductor equipment companies to underweight and put the S&P Semiconductors Index on a downgrade alert.5 Their newly created top-down semiconductor profit growth model warns that an earnings recovery is not yet imminent (Chart 17). For EM-dedicated equity managers, we have been neutral on Asian semiconductor sectors. We continue to recommend a market-weight allocation to Taiwan’s overall market, while we are upgrading the Korean technology sector from a neutral allocation to overweight. Korean semiconductor stocks have rallied much less than their global peers. Hence, the risk of a major relapse is lower. Given that we have been overweight non-tech Korean stocks, upgrading tech stocks to overweight means we will be overweight the KOSPI within the EM equity benchmark (Chart 18). Chart 17Semiconductor Earnings Recovery: Not Imminent Chart 18Upgrade Korean Tech Stocks And Overweight KOSPI Within EM   Meanwhile, we remain long the Bloomberg Asia-Pacific Semiconductor Index and short the S&P 500 Semiconductor Index. This trade has produced a 7% gain since its initiation on June 13, 2019. The Bloomberg Asia-Pacific Semiconductor index has 12 stocks. Samsung and TSMC account for 38% and 37% of the index, respectively. The S&P 500 Semiconductor Index has 13 stocks. Intel, Broadcom, Texas Instruments and Qualcomm are the top five constituents, together accounting for nearly 77% of the index. Although the US and China may reach a temporary trade deal, the US will continue to restrict sales of tech products and high-end semiconductors to China. As a result, these US semiconductor companies, most of which are IC designing companies, will likely experience a more subdued than expected recovery in sales. Ellen JingYuan He Associate Vice President ellenj@bcaresearch.com Footnotes   1 Please see Emerging Markets Strategy Special Report "The Global Semiconductor Sector: Is A Cyclical Upturn Imminent?" dated June 13, 2019, available at ems.bcaresearch.com 2 https://www.guancha.cn/ChanJing/2019_09_21_518748.shtml http://www.cac.gov.cn/2019-10/23/c_1573361796389322.htm 3 Please see Emerging Markets Strategy Special Report "Chinese Auto Demand: Time For A  Recovery?" dated October 17, 2019, available at ems.bcaresearch.com 4 https://www.canalys.com/analysis/smartphone+analysis 5 Please see US Equity Strategy Special Report "Defying Gravity," dated November 4, 2019, available at uses.bcaresearch.com   Cyclical Investment Stance Equity Sector Recommendations