Equities

Dear Client, I participated in a webinar earlier this week with my fellow BCA Research strategists to discuss the coronavirus outbreak and other timely issues. A replay can be accessed from this link. In lieu of our regular report next week, we will be sending you a Special Report from Matt Gertken, BCA’s Research Chief Geopolitical Strategist. Matt will discuss the state of the Democratic Party’s presidential nomination process in the wake of “Super Tuesday” and address the market implications. Best regards, Peter Berezin, Chief Global Strategist Highlights The decline in the number of new infections in China suggests that the coronavirus can be contained, provided that governments are both able and willing to impose severe quarantine measures on their own citizens. It is far from clear whether all countries can introduce such measures. And even among those who can, the economic damage from prolonged work stoppages could end up being too much to bear. The spike in supplier delivery times in various purchasing manager indices suggests that the global supply chain is already showing signs of strain. If the outbreak morphs into a global pandemic, a recession on the scale of the 2008/09 downturn would likely ensue. The only economic consolation from such an outcome is that once everyone is in the same boat, the need for mass quarantines and business shutdowns will diminish. While stock valuations have improved markedly over the past week, we would still recommend that investors refrain from significantly adding to equity positions at the moment. Once COVID-19 cases start popping up all over the US, stocks could come under further pressure. That said, we would only become more constructive on the near-term outlook for global equities if prices were to fall another 5%-to-8% from current levels or if the risks of a pandemic recede. The Power Of Exponential Change Humans tend to think in linear rather than exponential terms. Thus, it is easy to forget that when dealing with exponential growth, what appears exceedingly slow at first can become exceedingly fast later on. Take the example of the COVID-19 outbreak. Suppose that R0 is 2, meaning that someone who contracts the virus will spread it to two other people on average. Also suppose that it takes one week to pass it on to someone else. In week 1, one person is infected; in week 2, two new people are infected; in week 3, four new people; in week 4, eight new people, and so on. If only a small percentage of people who are infected get sick enough to have to go to the hospital, it might not be until after the end of week 8, when 128 new people have been infected, that the authorities become aware of the epidemic. Once we reach this stage, the only two options left are to impose extreme quarantine measures in an effort to drive Ro below 1, or stand back and let the outbreak run its natural course. Not surprisingly, most governments have chosen the first approach in the hopes of limiting the outbreak to a few regional clusters. A vigilant approach also buys some time to develop a vaccine. Time will tell if this strategy succeeds. On the positive side, the number of new infections in China continues to trend lower. Outside of Hubei, only 66 new cases have been reported since February 22nd. This has allowed an increasing number of Chinese companies to resume operations. It is also encouraging that a few countries such as Japan, Singapore, and Thailand, which at one point seemed on track to experience major epidemics, have gotten the problem under some degree of control. Chart 1The Number Of New Cases Has Declined In China, But Has Jumped In South Korea, Italy, And Iran On the negative side, the number of cases in South Korea, Iran, and Italy has surged (Chart 1). In South Korea, there are now 1261 confirmed cases, up from 31 early last week. South Korea’s population is less than 4% of China’s. If the current trend continues, the infection rate in Korea could surpass that of China over the next two weeks. The situation in Iran appears to be out of control. Two people from Iran have already tested positive in Canada. Bahrain has recorded 33 cases linked to Iran. In perhaps one of the most surreal moments of the crisis, Iranian deputy health minister Iraj Harirchi, who had been charged with leading the nation’s efforts to stem the epidemic, was filmed wiping his brow one day before it was confirmed he had contracted the virus. None of this prevented President Rouhani from declaring that Iran must “not allow enemies to convert the coronavirus into a weapon in their hand in order to disrupt work and production in Iran”. He went on to denounce the US for failing to “pay attention to the 16,000 American victims who died after having the influenza virus.” Worse Than The Swine Flu? Looking at the global data in aggregate, the number of confirmed cases is increasing in a manner more similar to the swine flu (H1N1) outbreak in 2009/10 than the SARS outbreak in 2003 (Chart 2). The H1N1 virus ended up infecting 61 million people in the US and between 700 million-to-1.4 billion globally. Chart 2COVID-19: More Like Swine Flu Than SARS? Unlike SARS, the COVID-19 coronavirus appears to be extremely contagious and can be spread by people who show few or no symptoms. SARS was generally spread only by people who were already visibly ill. In terms of fatality rates, COVID-19 is not as lethal as SARS, but appears to be at least ten times as fatal as H1N1. At present, there are no effective vaccines for coronaviruses. While concerted efforts are underway to develop a vaccine for COVID-19, most medical professionals agree that it will take at least a year before one is widely available. Unfortunately, given the exponential dynamic described above, most of the people on the planet could be infected by then. Pandemic Risk No one knows what the probability of a pandemic is, but it is clearly not zero. As workers return to their jobs in China, the outbreak may flare up again, leading to a new wave of business closures. Countries that do not have the will or the means to quarantine their citizens on a massive scale may find themselves unable to keep the virus at bay. Investors are finally waking up to this reality. As we discussed in last week’s report entitled “Markets Too Complacent About The Coronavirus,” even in a best-case scenario where the virus is successfully corralled over the next month or so, sequential global growth will still fall to zero in the first quarter. If the outbreak is not contained and a full-fledged pandemic ensues, the world is likely to experience a recession on the scale of the 2008/09 downturn. Table 1COVID-19 Fatality Rates By Age The only economic consolation from such an outcome is that once everyone is in the same boat, the need for mass quarantines and business shutdowns will diminish. Table 1 shows preliminary age-specific estimates of the fatality rate from the COVID-19 virus, provided by the Chinese Center for Disease Control and Prevention (China CDC).1 The results are based on 44,672 confirmed cases.   Stocks Won’t Get Much Relief From Bonds Given that investors have known about the risks from the coronavirus for some time, why did it take so long for stocks to buckle? Part of the answer has to do with the sigh of relief investors breathed after the number of new COVID-19 cases peaked in China. As in the SARS episode, the peak in new cases marked a bottom in risk assets (Chart 3). Unfortunately, now that the number of cases has accelerated outside of China, this sanguine narrative has been dashed. Chart 3AJust As In The SARS Episode, Stocks Bottomed Around The Same Time The Number Of Infections Peaked... Chart 3B… But The Number Of New Cases Outside China Has Surged While the news flow about the coronavirus has been the dominant driver of stocks, there has also been another important factor at work. As Chart 4 shows, global bond yields have dropped sharply since the start of the year. Up until this week, equity investors clung to the hope that falling yields would cushion the blow to growth and earnings. They also figured that a decline in the discount rate applied to future cash flows would boost equity valuations. Not surprisingly, growth stocks, which are most sensitive to changes in the discount rate, led the charge higher (Chart 5).   Chart 4Global Bond Yields Are Back Near Record Lows Chart 5Growth Stocks Have Outperformed On Falling Yields           These rosy expectations could still be realized if the global outbreak is quickly contained. If it is not, there is not much more central banks can do. Easier monetary policy can help offset demand shocks. However, it cannot do much about supply shocks. Stocks sold off in late 2018 because investors concluded that the Fed had erred in raising interest rates four times over the course of nine months. As soon as the Fed pivoted in a more dovish direction, equities rallied. This time is different. The Fed is not responsible for the current sell-off; the virus is. Thus, while the Fed would almost certainly cut rates if the outbreak turns into a pandemic, this would have less of a soothing effect than it did in early 2019. Supply Chains At Risk The modern global economy is powered by an intricate division of labor. Widespread work stoppages across many countries would eviscerate the global supply chain. Ironically, investors were worried at the start of the year that manufacturing inventories were too high. As it turned out, excess inventories have proven to be a blessing rather than a curse because they have allowed companies to weather the supply shock longer than they could have otherwise. The grace period will expire soon. According to the latest PMI data, supplier delivery times have soared in the major economies. The latest Markit Flash Eurozone PMI noted “a marked lengthening of supplier delivery times, with delays for inputs the most widespread since December 2018, attributed in many cases to supply chain issues arising from the COVID-19 outbreak.”  In the UK, Markit reported that UK manufacturers had disclosed the “the largest month-on-month slide in supply chain performance since the survey began in 1992, exceeding the previous record seen during the UK fuel protests in September 2000.” Monetary policy will come in handy only after the outbreak subsides. The dislocations caused by the virus could push many businesses towards the brink of bankruptcy. This could trigger a feedback loop of reduced spending, less hiring, and even lower spending. Timely stimulus would short-circuit this vicious cycle. That said, given that interest rates are already close to zero in most countries, much of the burden of preventing an extended downturn will have to fall on fiscal policy. It's Not Just About The Risk-Free Rate Chart 6Risk-Off Has Been On Fire What about the valuation boost to stocks from falling bond yields? It is certainly true that, all things equal, lower bond yields are good for stocks. However, all things are rarely equal. We need to ask why yields have fallen. The value of the stock market does not just depend on the risk-free rate. It also depends on the additional return investors demand to hold stocks – the so-called equity risk premium – as well as expected earnings growth. If bond yields decline because skittish investors pile into safe-haven US Treasuries, while simultaneously cutting their earnings projections, this will almost certainly result in lower equity prices. What we have seen this past week is a classic risk-off event (Chart 6). Gold has surged to the highest level since 2013. Term premia in government bond markets have plunged. Tech stocks have underperformed other sectors despite the ostensible support from lower bond yields. The US dollar has rallied, even as interest rate differentials have moved against the greenback (Chart 7).   Chart 7The Dollar Has Rallied, Even As Interest Rate Differentials Have Moved Against The Greenback What are investors to do? While stock valuations have improved markedly over the past week, we would warn against deploying significant fresh capital to equities at the moment. Stocks were technically overbought going into this correction. Some degree of profit taking was likely no matter what transpired. Once COVID-19 cases start popping up all over the US, stocks could come under further pressure. Hence, we would only become more constructive on the near-term outlook for global equities if prices were to fall another 5%-to-8% from current levels or if the risks of a pandemic recede. Peter Berezin Chief Global Strategist peterb@bcaresearch.com Footnotes 1The Novel Coronavirus Pneumonia Emergency Response Epidemiology Team, "The Epidemiological Characteristics of an Outbreak of 2019 Novel Coronavirus Diseases (COVID-19) — China, 2020[J]," China CDC Weekly, 2020, 2(8): 113-122. Global Investment Strategy View Matrix MacroQuant Model And Current Subjective Scores Strategic Recommendations

Highlights Global growth will quickly recover if the Covid-19 outbreak is soon controlled. If the virus's spread doesn't slow, a worldwide recession will take hold in 2020. BCA remains cyclically bullish, but tactical caution is warranted as long as uncertainty around Covid-19 remains high. A strong dollar is generally good for the US, except for exporters. The dollar possesses greater cyclical upside, a trend that will affect global asset allocation. The dollar will correct in 2020, which could allow cyclical stocks and value stocks to outperform growth equities in the short term. Foreign equities will also temporarily outperform US stocks this year. Feature 10-year Treasury yields hit an all-time low of 1.26% this morning, and the S&P 500 finally buckled under the pressure. Meanwhile, the US dollar seems unstoppable and commodity prices are still hobbling near recent lows. The economic and financial outlook for 2020 is unusually divided. On the positive front, economic momentum slowly turned the corner after a soft 2019. Liquidity aggregates have been improving, economic sentiment is bottoming and inventories are melting away. However, if Covid-19 morphs into a global pandemic, then these nascent positives will disappear. Faced with mounting uncertainty, the S&P 500 could still face additional tactical downward pressure. However, if Covid-19 does not turn into a global pandemic, then equities should recover in the second quarter. Additionally, the dollar’s strength remains a great concern, and for 2020, it too will depend on Covid-19's continued spread. While the next 12 months are likely to be painful for the dollar, its cyclical highs still lie ahead. The dollar’s trend will affect relative sector and regional performance. Covid-19 Under Control? The Covid-19 outbreak is key to the 2020 outlook. If Covid-19 is contained, then global growth can recover after a dismal first quarter. However, if the recent uptick in cases outside of China continues to increase beyond the coming two to three weeks, 2020 will witness a quick but painful recession as governments will impose quarantines and consumer confidence will collapse. If Covid-19 is contained, then global growth can recover after a dismal first quarter. Our colleagues from BCA Research’s Global Investment Strategy service estimate that Covid-19 could easily curtail global growth by more than 1% this quarter. China’s economy is experiencing a severe contraction, which should result in negative seasonally adjusted quarterly growth in Q1.1 Live indicators, such as the number of traffic jams in Shanghai streets or daily coal consumption are very weak, standing 20% and 32% below last year’s levels. Moreover, China accounts for 19.3% of global GDP, and its imports account for 12.5% of the rest of the world’s exports. China’s weak domestic activity has a ripple effect around the world. Making matters worse, the recent factory closings are scuttling global supply chains, which further lowers non-Chinese output. Finally, Chinese tourism accounts for 4.7% of global service exports, which will be deeply negatively impacted by the current immobility of Chinese citizens. As severe as the impact of Covid-19 will be in Q1, it will be fleeting. Epidemics and natural disasters may stop economic activity for a finite time, but they create pent-up demand that boosts economic growth in the following quarters. In the case of SARS, the lost output was recovered over the subsequent two quarters. Excess money is expanding at a brisk pace, which confirms that both the quantity and price of global output can rebound quickly (Chart I-1). The same is true of various liquidity measures, such as BCA Research’s US Financial Liquidity Index, which has an excellent record of forecasting the Global Leading Economic Indicator, the US ISM, and EM export prices. Most importantly, deleveraging is a tertiary concern for Chinese policymakers for the next two years. PMIs show that inventory levels are rapidly falling around the world. A purge in inventory allows pent-up demand to boost economic activity. Nowhere is this trend more powerful than in Sweden. Manufactured goods, especially intermediate and capital goods, represent a large percentage of Sweden’s output and exports. Thus, Sweden sits early in the global supply chains. Today, the decline in Swedish inventories is so deep that the country’s new orders-to-inventories ratio is surging, which historically indicates increases in our Global Industrial Activity Nowcast as well as US and global capital expenditures (Chart I-2). Chart I-1Ample Liquidity Will Cushion The Blow Chart I-2Positive Signal From Inventories   Improving liquidity and purged inventory bode very well for global economic activity. Our Global Growth Indicator, a variable mainly based on commodity prices and the bond yields of cyclical economies, has already predicted an improvement in global industrial production (Chart I-3). Our models showed that even Germany’s economy, which is largely driven by global economic gyrations, will experience a turnaround despite abysmal industrial production readings (Chart I-4). Chart I-3The Global Growth Indicator Continues To Rebound Chart I-4There's Hope Even For Germany The Federal Reserve is prepared to nurture the recovery. Falling job ads in the US, along with the New York Fed Underlying Inflation Gauge and BCA Research’s Pipeline Inflation Indicator point to a slowdown in core CPI (Chart I-5). Additionally, the FOMC wants to see inflation expectations recover toward the 2.3% to 2.5% zone reached when economic agents believe in the Fed’s capacity to sustain core PCE near 2%. BCA Research’s US Bond Strategy service’s adaptive expectations models show that based on current realized inflation trends, it would take a substantially long time for inflation expectations to move back into that zone. Chart I-5Disinflationary Pressures In The US The current health crisis is unleashing a wave of global stimulus. EM central banks, particularly in the Philippines and Indonesia, are cutting rates, thanks to low global and domestic inflation. Fiscal stimulus is expanding. Singapore has announced an SGD 800 million package aimed at fighting the impact of Covid-19; South Korea, Malaysia and Indonesia are also boosting spending. Even Germany is considering fiscal stimulus to support its economy. In China, the PBoC has injected RMB 2.3 trillion so far this year and cut rates. Most importantly, deleveraging is a tertiary concern for Chinese policymakers for the next two years. Factions opposed to President Xi will use his handling of the virus crisis to capitalize on discontent and gain more seats on the Politburo and Central Committee at the 2022 Communist Party Congress. To combat this opposition, President Xi is abandoning the deleveraging campaign and is generously stimulating the economy to generate greater income gains. The news is not all positive however, as the risk of a global pandemic remains elevated. There is no consensus in the medical community as to whether or not the pandemic is in remission. Chinese factories are re-opening and people are on the move, which is giving the virus an opportunity to spread again. Worryingly, new clusters of cases have popped up in South Korea, Iran, and Italy. In the US too, an individual without any links to previously known cases has fallen ill. These developments must be monitored closely. As BCA Research’s Global Investment Strategy service recently showed, the 2009/10 H1N1 outbreak (known as swine flu) affected between 700 million and 1 billion people worldwide.2 According to the Lancet, it resulted in 151,700 to 575,400 deaths or a fatality rate of 0.01% to 0.08%, well below current estimates of 2.3% for Covid-19. Thus, if Covid-19 spreads as much as H1N1, it could kill between 16 and 23 million people worldwide in a short amount of time. If such an outcome comes to pass, then we are looking at a global recession. Factory closures will grow in length and prevalence, which will paralyze global supply chains. International tourism will collapse and consumers around the world will shun crowded public places, which will hurt consumption substantially. Prudence forces us to not be cavalier and protect ourselves against what would be an extremely adverse outcome if Covid-19 were to spread much further. The uncertainty around such binary outcomes is hard to price for markets. As we argued last month, investors must input large risk premia in asset prices to compensate for this lack of visibility. When we last wrote, we saw no such margin of safety in the S&P 500, but its 11.5% collapse since February 19 has gone a long way in adjusting this mispricing. In fact, some bargains in the industrial, energy or transport sectors have emerged. Bottom Line: Investors should continue to hedge their exposure to risk assets until the situation becomes clearer. For now, our central scenario remains that new cases will soon peak and economic activity will recover. In this case, stocks and bond yields now have very limited downside, and they will recover later this year. Equities will ultimately reach new highs. However, prudence forces us to not be cavalier and protect ourselves against what would be an extremely adverse outcome if Covid-19 were to spread much further. The US Benefits From A Strong Dollar Looking beyond Covid-19, BCA Research expects the US dollar to correct in 2020. However, we increasingly view this downdraft as a temporary phenomenon. The dollar’s cyclical highs remain ahead in the next two to three years. Ultimately, the US is a consumer-driven economy and households benefit from a firm currency. A higher dollar also acts as a tax cut for consumers. Surprisingly, the dollar does not have a negative impact on employment. The unemployment rate and the dollar are negatively correlated (Chart I-6). The 27% dollar rally since 2011 is not antithetical with a US unemployment rate at a 51-year low of 3.6%. Less than 10% of US jobs are in the manufacturing sector, compared with 14.4% and 15.8% in Europe and Japan respectively (Chart I-7). Moreover, 93.6% of jobs created since the labor market troughed in 2010 have been in the service sector. Given that the service sector is domestically driven and is immune to the deflationary impact of a stronger dollar, the low share of manufacturing in the US’s GDP means that the labor market is resistant to a firm USD. Chart I-6The Labor Market Does Not Abhor A Strong Dollar... Chart I-7...Because The US Is Manufacturing Light   A higher dollar also acts as a tax cut for consumers. A dollar rally leads to a rapid decline in the share of disposable income spent on food and energy (Chart I-8). As a result, households have more discretionary disposable income to spend on services that generate domestic jobs. A strong dollar makes job creation less inflationary and permits the Fed to keep monetary policy easier for longer. A strengthening dollar redistributes income to the middle class, which supports consumption. When the dollar rallies, the share of salaries in national income increases because the dollar creates a headwind for profit margins (Chart I-9). Rich households garner more than 50% of their income from profits and rents. Therefore, if a stronger dollar increases the share GDP accounted for by wages, then a rising greenback redistributes income to middle-class households away from the rich. This redistribution is positive for consumption because middle-class households have a marginal propensity to consume of 90%, compared with 60% for households in the top decile of the income distribution. Furthermore, the more consumption can grow as a share of GDP, the more the economy can withstand a rallying currency. Chart I-8A Firm Dollar Cut "Taxes" Chart I-9The Dollar Is A Redistributor   Chart I-10A Strong Dollar Boosts Real Incomes A strong dollar also weighs on inflation, which has positive ramifications for consumers and the economy. By mid-2015, the dollar had rallied by an impressive 13.8%. While nominal wages grew at 2.2%, well below today’s rate of 3.8%, real wages were expanding at their highest rate in this cycle, courtesy of low inflation. Real consumption was also enjoying its largest gain in this cycle, expanding at 4.6% per annum (Chart I-10). A firm dollar also dampens inflation expectations (Chart I-11), allowing a flattening of the Phillips Curve, which links inflation to the unemployment rate. In other words, a strong dollar makes job creation less inflationary and permits the Fed to keep monetary policy easier for longer, delaying the inevitable date when the Fed kills the business cycle. Moreover, the disinflationary impact of a rising dollar puts downward pressure on interest rates (Chart I-12). In turn, lower rates keep financial conditions easier than would have otherwise been the case, which supports growth. Chart I-11A Hard Currency Dampens Inflation Expectations Chart I-12A Strong Dollar Depresses Interest Rates   A counterargument to the view that a strong US dollar is good for the business cycle is that it will hurt capex. While true, it is easy to overestimate this impact on growth. Not only does capex represent a much lower share of GDP than consumption, it most often contributes less to changes in GDP than consumer spending (Chart I-13). Moreover, lower interest rates triggered by a firm dollar support residential activity, which in turn mitigates some of the drag created by lower corporate capex. Finally, as Chart I-14 illustrates, 74.7% of the US’s capex emanates from sectors that are minimally affected by the dollar, creating greater resilience to a stronger currency than many realize. Chart I-13Consumption Dominates Capex Chart I-14Even Within Capex, The Dollar Is Not As Dominant As Believed   Chart I-15Symptoms Of US Resilience The US economy is indeed robust in the face of the strong dollar. If the dollar was hurting the US, then Germany should benefit from a falling euro. However, German net exports are weakening. Moreover, US profits are not lagging European ones as US firms continue to benefit from stronger global pricing power than their European counterparts. Finally, capex intentions in the US are surprisingly resilient (Chart I-15). Three forces increase the US’s economic capacity to withstand a strong dollar this cycle. First, the structural improvement in the US’s energy trade balance allows the US current account to remain stable at -2.5% of GDP despite a widening non-oil trade deficit. Secondly, the Trump Administration’s profligate spending boosts demand and insulates the economy from a rising dollar. BCA Research’s Geopolitical Strategy service expects President Trump to win the election, albeit with a conservative probability of 55%, but also believes a Democratic victory would lead to larger spending increases than tax hikes. The current expansive fiscal policy set up will thus remain in place going forward. Finally, the Sino-US Phase One deal will provide a welcome relief valve for US manufacturers, who are victims of the stronger dollar. While economic reality probably will not allow the deal to boost China’s purchases of US goods by $200 billion vis-à-vis the higher water mark of $186 billion of 2017 (Chart I-16), nonetheless it will force China to substitute goods purchases away from Europe and Japan in favor of the US. A hard dollar can feed on itself by widening the gap between US and foreign growth, a trend currently underway. Our favorite structural valuation measure also does not suggest that the dollar is currently a major hurdle for the US economy. BCA Research's Foreign Exchange Strategy service’s Long-Term Fair Value models, which account for differences in the productivity and neutral rate of interest of the US and its trading partners, show that the dollar is still roughly fairly valued and that its equilibrium is trending up (Chart I-17). Chart I-16The Phase One Deal Is Ambitious Chart I-17The Dollar Is Not Expensive Enough To Cause Pain   In this context, the US dollar has further cyclical upside. A strong dollar may not be as negative to the US economy as investors believe, but it hurts emerging economies. According to the Bank for International Settlements, there is more than US$12 trillion of USD-denominated foreign currency debt in the world. Therefore, a firm dollar tightens financial conditions outside the US. A hard dollar can feed on itself by widening the gap between US and foreign growth, a trend currently underway. Investment Implications For The Remainder Of The Cycle… Chart I-18The S&P 500 Likes A Firm Dollar The dollar’s additional cyclical upside is good news for US capital markets over the next few years. The S&P 500 performs better when the dollar is firm (Chart I-18). US stocks generated average annual returns of 12% during the 53% dollar rally of 1978 to 1985, 12% during the 33% dollar rally of 1995 to 2002, and 11% as the USD appreciated 27% during the past nine years. This compares well to an annualized return of 4% when the dollar suffers cyclical bear markets. The following observations explain why the US stock market performs better when the dollar appreciates: A strong dollar allows interest rates to remain lower than would have been the case otherwise, which also allows stock multiples to remain elevated. A strong dollar elongates the US business cycle by delaying the Fed’s tightening of monetary conditions. A longer business cycle dampens volatility and invites investors to bid down the equity risk premium. A strong dollar supports the US corporate bond market. A robust dollar may negatively impact bonds issued by energy or natural resources companies, but it also keeps the Fed at bay, which prevents a generalized increase in volatility and spreads. Lower rates allow for easy financial conditions and plentiful buybacks, a helpful combination for equities. Chart I-19The Dollar Holds The Key To Growth Vs Value A hard dollar is fundamental to the outperformance of US equities relative to global stocks. Global investors usually not do not hedge the currency component of equity returns. A firm USD automatically creates a powerful advantage for US stocks that invites greater inflows. In addition, a climbing dollar hurts value stocks (Chart I-19). Value stocks overweight cyclical sectors such as financials, industrials, materials and energy, sectors which depend on higher inflation, expanding EM economies and higher yields to outperform, three variables that suffer from an appreciating USD. An underperformance of value stocks also causes a poor outcome for foreign markets, which heavily overweight value over growth (Table I-1).   Table I-1Key Overweights By Market Chart I-20A Strong Dollar Fuels Tech Multiples The tech sector also benefits from a firm dollar. Tech stocks generate long-term earnings growth and they are generally not as sensitive to the global business cycle as traditional cyclical equities are. When the global business cycle weakens, yields decline and the dollar appreciates, then earnings growth becomes scarce. In this environment, investors willingly bid up assets that can generate a structural earning expansion. Tech multiples become the prime beneficiary of that phenomenon (Chart I-20), which allows US stocks to meaningfully outperform the rest of the world when the dollar hardens. Bottom Line: A firm dollar will allow the business cycle to expand for longer, which suggests that the dollar will make greater highs over the coming two to three years. Within this time frame, US stocks will likely continue to outperform their global counterparts, despite their valuations disadvantage. … And For 2020 In 2020, the dominant driver for the US dollar will be global growth. The pickup in BCA’s Global Growth Indicator and the elevated chance of a rising Chinese combined credit and fiscal impulse will lift global activity and thus, force down the USD (Chart I-21). Additionally, existing trends in global money supply growth reinforce the near-term downside risk to the dollar, assuming Covid-19 does not become a global pandemic (Chart I-22). Chart I-21China Stimulus Will Lift Growth Chart I-22Bearish Monetary Dynamics For The Dollar In 2020   Chart I-23The Euro Is Not The Best Anti-Dollar Bet For 2020 The euro is unlikely to be the main beneficiary from a dollar correction. EUR/USD does not yet trade at a discount to our fair value estimates consistent with an intermediate-term bottom (Chart I-23). Moreover, the euro lags pro-cyclical currencies such as the AUD, CAD, NZD, or SEK, when global growth starts to recover but inflation remains weak. Finally, the Phase One Sino-US trade deal will create a drag on the positive impact of a Chinese recovery on European exports for machinery.3 Bottom Line: A dollar correction in 2020 is congruent with a period of underperformance for tech stocks relative to industrials, financials, materials and energy stocks. The correction also supports value relative to growth equities this year, as well as foreign bourses relative to the S&P 500. Investors who elect to bet against the dollar in 2020 should only do so with great caution as they will be betting against the broader cyclical trend. A correction in the dollar, by definition, is transitory. Thus, the aforementioned equity implications will also likely be temporary. Ultimately, the US economy remains the global growth leader in the post-2008 environment. Mathieu Savary Vice President The Bank Credit Analyst February 27, 2020 Next Report: March 26, 2020 II. Labor Strikes Back The balance of power in US labor negotiations has shifted infrequently in the industrial age. Successful strikes beget strikes. Key factors that have bolstered management for decades are poised to reverse. Public opinion has a significant impact on labor-management outcomes. Elections have consequences. Organized labor isn’t dead. Where will inflation come from, and when will it arrive? An investor who answers these questions will have advance notice of the end of the expansion and the bull markets in equities and credit. Per our base-case scenario, the expansion won’t end until monetary policy settings become restrictive, and the Fed won’t pursue restrictive policy unless inflation pressures force its hand. The fur flies when each party thinks the other should make the bulk of the concessions: labor negotiations over the next couple of years could be interesting. Inured by a decade of specious warnings that “money printing” would let the inflation genie out of the bottle, investors are skeptical that inflation will ever re-emerge. The inflation backdrop has become much more supportive in the last few years, however, upon the closing of the output gap, and the stimulus-driven jolt in aggregate demand. Output gaps in other major economies will have to narrow further (Chart II-1) for global goods inflation to gain traction, and mild inflation elsewhere in the G7 (Chart II-2) suggests that goods prices are not about to surge. Chart II-1There's Still Enough Spare Capacity ... Chart II-2... To Restrain Global Goods Inflation Services are not so easily imported, though, and services inflation is a more fully domestic phenomenon. Rising wages could be the spur for services inflation, and the labor market is tight on several counts: the unemployment rate is at a 50-year low; the broader definition of unemployment, also encompassing discouraged workers and the underemployed, reached a new all-time (25-year) low in December; the JOLTS job openings and quits rates at or near their all-time (19-year) highs; and the NFIB survey and a profusion of anecdotal reports suggest that employers are having a hard time finding quality candidates. With labor demand exceeding supply, wages for nonsupervisory workers have duly risen (Chart II-3). Gains in other compensation series have been muted, however, and investors have come to yawn and roll their eyes at any mention of the Phillips Curve. Chart II-3Wage Growth Is Solid, But It's Lost A Good Bit Of Momentum Perhaps it’s not the Phillips Curve that’s broken, but workers’ spirits. A supine organized labor movement could explain why the Phillips Curve itself is so flat. As the old saying goes, if you don’t ask, you know what you’re going to get, and beleaguered unions and their memberships, cowed by two decades of woe coinciding with China’s entry into the WTO (Chart II-4), have been afraid to ask. Strikes are the most potent weapon in labor’s arsenal; if it can’t credibly wield them, it is sure to be steamrolled. Chart II-4Globalization Has Been Unkind To Labor Two years of high-profile strike victories by public- and private-sector employees may suggest that the sands have begun to shift, however, and inspired our examination of labor’s muscle. An Investor’s Guide To US Labor History Let's begin our exercise with a review of US labor relations. The Colosseum Era (1800-1933) We view US industrial labor history as having three distinct phases. We label the first, which lasted until the New Dealers took over Washington, the Colosseum era (Figure II-1), because labor and management were about as evenly matched as the Christians and the lions in ancient Rome. Uprisings in textile mills, steel factories, and mines were swiftly squelched, often violently. Management was able to draw on public resources like the police and state National Guard units to put down strikes, or was able to unleash its own security or ad hoc militia forces on strikers or union organizers without state interference. The public, staunchly opposed to anarchists and Communists, generally sided with employers. Figure II-1Significant Events In The Colosseum Era Unions won some small-bore victories during the period, but they nearly all proved fleeting as companies regularly took back concessions and public officials and courts failed to enforce the loose patchwork of laws aimed at ameliorating industrial workers’ plight. Labor inevitably suffered the brunt of the casualties when conflicts turned violent. Workers were hardly choir boys, and seem to have initiated violence as often as employers’ proxies, but they were inevitably outgunned, especially when police, guardsmen or soldiers were marshaled against them. Societal norms have changed dramatically since the Colosseum era, but the lore of past “battles” encourages an us-versus-them union mentality that occasionally colors negotiations. Employees and employers need each other, and their tether can only be stretched so far before it starts pulling them back together. The UAW Era (1933-1981) Established presumptions about the employer-employee relationship were upended when FDR entered the White House. Viewing labor organization as a way to ease national suffering, New Dealers passed the Wagner Act to grant private-sector workers unionization and collective bargaining rights, and created the National Labor Relations Board to ensure that employers respected them. The Wagner Act greatly aided labor organization, enabling unions to build up the heft to engage with employers on an equal footing. Unionized workers still fought an uphill battle in the wake of the Depression, but tactics like the sit-down strike (Box II-1) produced some early labor victories that paved the way for more. BOX II-1 David Topples Goliath: The Flint Sit-Down Strike   The broad mass of factory workers had not been organized to any meaningful degree before the New Deal, and the United Auto Workers (UAW) was not formed until 1935. Despite federal protections, the fledgling UAW had to conduct its operations covertly, lest its members face employer reprisals. At the end of 1936, when it took on GM, only one in seven GM employees was a dues-paying member. The strike began the night of December 30th when workers in two of GM’s Flint auto body plants sat down at their posts, ignoring orders to return to work. The sit-down action was more effective than a conventional strike because it prevented GM from simply replacing the workers with strikebreakers. It also made GM think twice about attempting to remove them by force, lest valuable equipment be damaged. GM was unsure how to dislodge the workers after a court injunction it obtained on January 2nd went nowhere once the UAW publicized that the presiding judge held today’s equivalent of $4 million in GM shares. It turned off the heat in one of the plants on January 11th, before police armed with tear gas and riot guns stormed it. The police were rebuffed by strikers who threw bottles, rocks, and car parts from the plant’s upper windows while spraying torrents of water from its fire hoses. No one died in the melee, but the strike was already front-page news across the country, and the attack helped the strikers win public sympathy. Michigan’s governor responded by calling out the National Guard to prevent a rematch, shielding the strikers from any further violence. The strike was finally settled on February 11th when GM accepted the UAW as the workers’ exclusive bargaining agent and agreed not to hinder its attempts to organize its work force. The UAW signed a similar accord with Chrysler immediately after the Flint sit-down strike, and the CIO (the UAW’s parent union) swiftly reached an agreement with US Steel that significantly improved steelworkers’ pay and hours. Labor unions’ path wasn’t always smooth – Ford fiercely resisted unionization until 1941, and ten protesters were killed, and dozens injured, by Chicago police at a peaceful Memorial Day demonstration in support of strikers against the regional steelmakers that did not follow US Steel’s conciliatory lead – but it generally trended upward after the New Deal (Figure II-2). From the 1950 signing of the Treaty of Detroit, a remarkably generous five-year agreement between the UAW and the Big Three automakers, the UAW ran roughshod over the US auto industry for three-plus decades. The New Deal’s encouragement of unionization had given labor a fighting chance, and was the foundation on which all of its subsequent gains were built. Figure II-2Significant Events In The UAW Era The Reagan-Thatcher Era (1981 - ??) The disastrous strike by the air traffic controllers’ union (PATCO) is the watershed event that heralded the end of unions’ golden age. Strikes by federal employees were illegal, so PATCO broke the law when it went on strike in April 1981, spurning the generous contract terms its leaders had negotiated with the Reagan administration. PATCO had periodically held the flow of air traffic hostage throughout the seventies to extract concessions from its employer, earning the lasting enmity of airlines, government officials and the public. Other unions were aghast at PATCO’s openly contemptuous attitude, and declined to support it with sympathy strikes, while conservatives blasted the new administration behind closed doors for the profligacy of its initial PATCO offer. President Reagan therefore had an unfettered opportunity to make an example out of the controllers, and he seized it, firing those who failed to return to work within 48 hours and banning them from ever returning to government employment. A fed-up public supported the president’s hard line, and employers and unions got the message that a new sheriff was in town. His deputies were not inclined to enforce labor-friendly statues, or investigate labor grievances, with much vigor, and they would not necessarily look the other way when public sector unions illegally struck. Management has been in the driver's seat, but the factors that have kept it there have a high risk of reversing. Unions also found themselves on the wrong side of the growing disaffection with bureaucracy that was bound up with the push for deregulation. The globalization wave further eroded labor’s power. Unskilled workers in the developed world would be hammered by the flat world that allowed people, capital and information to hopscotch around the globe. Eight years of a Democratic presidency brought no relief, as the “Third Way” Clinton administration embraced the free-market tide (Chart II-5), and the unionized share of employees has receded all the way back to mid-thirties levels (Chart II-6). Chart II-5Inequality Took Off ... Chart II-6... As Unions Lost Their Way A Fourth Phase? A handful of data points do not make a trend, especially in a series that stands out for its persistence, but the bargaining power pendulum could be shifting. Public school teachers won improbable statewide victories with illegal strikes in three highly conservative states in the first half of 2018 (Table II-1); a canny hotel workers union steered its members to big gains in their contract negotiations with Marriott in the second half of 2018; and the UAW bested General Motors and the rest of the Big Three automakers last fall. Unions may have more bargaining power than markets and employers realize, and they could be on the cusp of becoming more aggressive in flexing it. Table II-1Teachers' Unions Conquer The Red States Takeaways (I) There are two key takeaways from our historical review: 1. US industrial history makes it clear that employees are unlikely to gain ground if government sides with employers. Employees no longer have to fear that the state will look the other way while strikers are beaten, or fail to prosecute those responsible for loss of life, but they face especially long odds when the government is inclined to favor employers. Its thumb weighs heavily on the scale when it drags its feet on enforcement; cuts funding to agencies policing workplace standards; and appoints agency or department heads that are conditioned to see things solely from employers’ perspective, shaped by long careers in management. 2. Successful strikes beget strikes, and the converse is also true. Withholding their labor is employees’ most powerful weapon, and when employers can’t replace them cheaply and easily, strikes often succeed. Striking is frightening for an individual, however, because it cuts off his or her income (or sharply reduces it, if the striker’s union has a strike fund) until the strike is over. If the strike fails, the employee may find him/herself blacklisted, impairing his/her long-term income prospects on top of his/her short-term losses. Prudent workers should therefore strike sparingly, with the due consideration that a prudent poker player exercises before going all-in. Companies will do whatever they perceive to be socially acceptable in conflicts with employees, but no more. When other unions facing comparable conditions pull off successful strikes, it makes it much easier for another union to take the leap, in addition to making success more likely, provided conditions truly are comparable. “Before they occur, successful strikes appear impossible. Afterward, they seem almost inevitable .”4 The retrospective inevitability stiffens the spine of potential strikers who observe successful outcomes, and raises the bar for action among potential strikers who observe failures. “Just as defeats in struggle lead to demoralization and resignation, victories tend to beget more victories .”5 Public opinion matters just as surely as momentum, and it proved decisive in the Flint sit-down strike and in the air traffic controllers’ showdown with President Reagan. According to Gallup’s annual poll, Americans now regard unions as favorably as they did before Thatcher and Reagan came to power (Chart II-7). Chart II-7Could Unions Make A Comeback? Where Strikes Come From And Who Wins Them Since strikes are such an important determinant of the support for labor, what drives successful labor actions? The Origin Of Strikes Strikes (and lockouts) occur when labor and management cannot reach a mutually acceptable settlement, often because at least one side overestimates its bargaining power. It is easy to agree when labor and management hold similar views about each side’s relative power, as when both perceive that one of them is considerably stronger. In that case, a settlement favoring the stronger side can be reached fairly quickly, especially if the stronger side exercises some restraint and does not seek to impose terms that the weaker side can scarcely abide. Restraint is rational in repeated games like employer-employee bargaining, and when both parties recognize that relative bargaining positions are fluid, they are likely to exercise it. It's no surprise that unions have started to look pretty good to workers after a decade of sluggish growth and widening inequality. History shows that the pendulum between labor and management swings, albeit slowly, as societal views evolve6 and the business cycle fluctuates. As a general rule, management will have the upper hand during recessions, when the supply of workers exceeds demand, and labor will have the advantage when expansions are well advanced, and capacity tightens. A high unemployment rate broadly favors employers, and a low unemployment rate favors employees. Neither the number of work stoppages (Chart II-8, top panel), nor the number of workers involved (Chart II-8, middle panel) correlates very well with the unemployment gap (Chart II-8, bottom panel), in the Reagan-Thatcher era, however, as work stoppages have dwindled almost to zero. Chart II-8Swamped By The Legal And Regulatory Tide Game theory is better equipped than simple regression models to offer insight into the origin of strikes. We posit a simple framework in which each side can hold any of five perceptions of its own bargaining power, resulting in a total of 25 possible joint perceptions. Management (M) can believe it is way stronger than Labor (L), M >> L; stronger than Labor, M > L; roughly equal, M ≈ L; weaker than Labor, L > M; or way weaker than Labor, L >> M. Labor also holds one of these five perceptions, and the interaction of the two sides’ perceptions establishes the path negotiations will follow. Limiting our focus to today’s prevailing conditions, Figure II-3 displays only the outcomes consistent with management’s belief that it has the upper hand. For completeness, the exhibit lists all of labor’s potential perceptions, but we deem the two in which labor is feeling its oats (circled) to be most likely, given the success of recent high-profile strikes.7 Management’s confidence follows logically from four decades of victories, but may prove to be unfounded if its power has already peaked. Figure II-3The Eye Of The Beholder Strike outcomes turn on which side has overestimated its leverage. The broad factors we use to assess leverage are overall labor market slack; economic concentration; regulatory and legal trends; and the sustainability of either side’s accumulated advantage, which we describe as the labor-management rubber band. Other factors that matter on a case-by-case basis, but are beyond the scope of our analysis, include industry-level slack, a labor input’s susceptibility to automation, and the degree of labor specialization/skill involved in that input. For these micro-level factors, a given group of workers’ leverage is inversely related to the availability of substitutes for their input. Labor Market Slack              Despite muted wage growth, the labor market is demonstrably tight. The unemployment rate is at a 50-year low, the broader definition of unemployment is at the lowest level in its 26-year history, and the prime-age employment-to-population ratio is back to its 2001 levels, having surpassed the previous cycle’s peak (Chart II-9). The job openings rate is high, indicating that demand for workers is robust, and so is the quits rate, indicating that employers are competing vigorously to meet it. The NFIB survey’s job openings and hiring plans series (Chart II-10) echo the JOLTS findings. Chart II-9Prime-Age Employment Is At An 18-Year High ... Chart II-10... But There Are Still Lots Of Help Wanted Signs The lack of labor market slack decisively favors workers’ negotiating position. It is a sellers’ market when demand outstrips supply, and labor victories tend to be self-reinforcing. Successful strikes beget strikes, and management volunteers concessions as labor peace becomes a competitive advantage during strike waves. Given that the crisis-driven damage to the labor force participation rate has healed as the gap between the actual part rate (Chart II-11, solid line) and its demographically-determined structural proxy has closed (Chart II-11, dashed line), the burden of proof rests squarely with those who argue that there is an ample supply of workers waiting to come off the sidelines. Chart II-11The Labor Force Participation Gap Has Closed Economic Concentration The trend toward economic concentration (Chart II-12) has endowed the largest companies with greater market power, as evidenced by surging corporate profit margins. The greater the concentration of employment opportunities in local labor markets, the more closely they resemble monopsonies.8 Unfortunately for labor, monopsonies restrain prices just as monopolies inflate them. As we have shown,9 there is a robust inverse relationship between employment concentration and real wages (Chart II-13). Chart II-12Less Competition = More Power Chart II-13One Huge Buyer + Plus Multiple Small Sellers = Low Prices Economic concentration has been a major driver of management’s Reagan-Thatcher era dominance. Sleepy to indifferent antitrust enforcement has helped businesses capture market power, and it will continue to prevail through 2024 unless the Democrats take the White House in November. The silver lining for workers is that concentration could have the effect of promoting labor organization in services, where unions have heretofore made limited progress. The only way for employees to combat employers’ monopsony power is to organize their way to becoming a monopoly supplier of labor. Regulatory And Legal Trends Over the last four decades, unions have endured a near-constant drubbing from state capitols, federal agencies and the courts, as union and labor protections have been under siege from all sides. Since the air traffic controllers’ disastrous strike, labor’s regulatory and legal fortunes have most closely resembled the competitive fortunes of the Harlem Globetrotters’ beleaguered opposition. But the regulatory and legal tide has been such a huge benefit for management since the beginning of the Reagan administration that it cannot continue to maintain its pace. If the electorate has had enough of Reagan-Thatcher policies, elected officials will stop implementing them. Investors seem to assume that it will, however, to the extent that they think about it at all. It stands to reason that employers may be similarly complacent. We will look more closely at the presidential election and its potential consequences in Part 3, but labor concerns and inequality are capturing more attention, even among Republicans. With Republicans’ inclination to side with business only able to go in one direction, the chances are good that it has peaked. The Labor-Management Rubber Band For all of the romantic allure of labor’s battles with management in the Colosseum era, employees and employers have a deeply symbiotic relationship. One can’t exist without the other, and pursuing total victory in negotiations is folly. Even too many incremental wins can prove ruinous, as the UAW discovered to its chagrin in 2008. A half-century of generous compensation and stultifying work rules saddled Detroit automakers with a burden that would have put them out of business had the federal government not intervened. Table II-2Average Salaries Of Public School Teachers By State We think of labor and management as being linked by a tether with a finite range. Since neither side can thrive for long if the other side is suffering, the tether pulls the two sides closer together when the gap between them threatens to become too wide. When labor does too well for too long at management’s expense, profit margins shrink and the company’s viability as a going concern is threatened. When management does too well, deteriorating living standards drive the best employees away, undermining productivity and profitability. Before the low-paying entity’s work force becomes a listless dumping ground for other firms’ castoffs, it may rise up and strike out of desperation. Teachers’ unions might have appeared to be setting themselves up for a fall in 2018 by illegally striking in staunchly conservative West Virginia, Oklahoma and Arizona, but desperate times call for desperate measures. Per the National Education Association’s data for the 2017-18 academic year, average public school teacher pay in West Virginia ranked 50th among the 50 states and the District of Columbia, Oklahoma ranked 49th and Arizona ranked 45th (Table II-2). Adjusting the nominal salaries for cost disparities across states, West Virginia placed 41st, Oklahoma 44th and Arizona 48th. Given that real teacher salaries had declined by 8% and 9% since 2009-10 in West Virginia and Arizona, respectively, the labor-management rubber band had stretched nearly to the breaking point. Consolidating The Macro Message Parties to negotiations derive leverage from the availability of substitutes. When alternative employment opportunities are prevalent, workers have a lot of leverage, because they can credibly threaten to avail themselves of them. Teaching is a skill that transfers easily, and every state has a public school system, so teachers in low-salary states have a wealth of ready alternatives. The converse is true for low-salary states; despite much warmer temperatures, it is unlikely that teachers from top-quintile states will be willing to take a 25-33% cost-of-living-adjusted pay cut to decamp to Arizona (Table II-3). Table II-3Cost Of Living-Adjusted Public School Teacher Salaries By State It is easy to see from Figure II-4 why management has had the upper hand. Economic concentration and the legal and regulatory climate have increasingly favored it for decades. The immediate future seems poised to favor labor, however, as the legal and regulatory climate cannot get materially better for employers, and the labor-management rubber band has become so stretched that some sort of mean reversion is inevitable. We have high conviction that labor’s one current advantage, a tight labor market, will remain in its column over the next year or two. On a forward-looking basis, the macro factors as a whole are poised to support labor. Figure II-4Macro Drivers Of Negotiating Leverage Takeaways (II) We think it is more likely than not that the labor movement in the United States will remain weak relative to its 1950s to 1970s heyday. We do think, however, that the probability that unions could rise up to exert the leverage that accrues to workers in a tight labor market is considerably larger than the great majority of investors perceive. Alpha – market-beating return – arises from surprises. An investor captures excess returns when s/he successfully anticipates something that the consensus does not. If the disparity involves a trivial outcome, then any excess return is likely to be trivial, but if the outcome is significant, the investor who zigged when the rest of the market zagged stands to separate him/herself from the pack. We think the outcome of a shift in leverage from employers to employees would be very large indeed. We would expect that aggregate wage gains of 4% or higher would quickly drive the Fed to impose restrictive monetary policy settings, eventually inducing the next recession and the end of the bull markets in equities, credit and property. A union revival may be a low-probability event, but it would have considerable impact on markets and the economy. Given our conviction that the probability, albeit low, is much greater than investors expect, we think the subject is well worth sustained attention. The Public-Approval Contest The last question to approach is how does labor or management win in the court of public opinion? Capturing Hearts And Minds Public opinion has shaped the outcomes of labor-management contests throughout US labor relations history. Labor was continually outgunned before the New Deal, coming up against private security forces, local police and/or the National Guard when they struck. Employers were able to turn to hired muscle, or request the deployment of public resources on their behalf, because the public had few qualms about using force to break strikes. College athletes were even pressed into service as strikebreakers after the turn of the century for what was viewed at the time as good, clean fun.10 Public opinion is not immutable, however, and by the time of the Flint sit-down strike, it had begun to shift in the direction of labor. The widespread misery of the Depression went a long way to overcoming Americans’ deep-seated suspicion of the labor movement and the fringe elements associated with it. Some employers were slow to pick up on the change in the public mood, however, and Ford’s security force thuggishly beat Walter Reuther and other UAW organizers while they oversaw the distribution of union leaflets outside a massive Ford plant just three months after Flint. Ford won the Battle of the Overpass, but its heavy-handed, retrograde tactics helped cost it the war. Reuther, who later led the UAW in its ‘50s and ‘60s golden age, was a master strategist with a knack for public relations. Writing the playbook later used to great effect by civil rights leaders, Reuther invited clergymen, Senate staffers and the press to accompany the largely female team of leafleteers. When the Ford heavies commenced beating the men, and roughly scattering the women, photographers were on hand to document it all.11 The photos helped unions capture public sympathy, just as televised images of dogs and fire hoses would later help secure passage of landmark civil rights legislation. Unions’ Fall From Grace Figure II-5Unions' 1980s Public Opinion Vortex Labor unions enjoyed their greatest public support in the mid-fifties, and largely maintained it well into the sixties, until rampant corruption and ties to organized crime undermined their public appeal. The shoddy quality of American autos further turned opinion against the UAW, the nation’s most prominent union, and a college football star named Brian Bosworth caused a mid-eighties furor by claiming that he had deliberately sought to prank new car buyers during his summer job on a Chevrolet assembly line. Bosworth later retracted the claim that GM workers had shown him how to insert stray bolts in inaccessible parts of car bodies to create a maddening mystery rattling, but the fact that so many Sports Illustrated readers found it credible eloquently testified to the UAW’s image problem. President Reagan accelerated the trend when he successfully stood up to the striking air traffic controllers, but his administration could not have taken such a hard line if unions hadn’t already been weakened by declining public support. Together, the public’s waning support for unions and the Reagan administration’s antipathy for them were powerfully self-reinforcing, and they fueled a vicious circle that powered four decades of union reversals (Figure II-5). As a prescient November 1981 Fortune report put it, “‘Managers are discovering that strikes can be broken, … and that strike-breaking (assuming it to be legal and nonviolent) doesn’t have to be a dirty word. In the long run, this new perception by business could turn out to be big news.’”12 Emboldened by the federal government’s replacement of the controllers, and the growing public perception that unions had devolved into an insular interest group driving the cost of living higher for everyone else, businesses began turning to permanent replacement workers to counter strikes.13 As an attorney that represented management in labor disputes told The New York Times in 1986, “If the President of the United States can replace [strikers], this must be socially acceptable, politically acceptable, and we can do it, also.”14 Labor’s New Face … Polling data indicate that unions have been recovering in the court of public opinion since the crisis, when the public presumably soured on them over the perception that the UAW was selfishly impeding the auto industry bailout. Their image got a boost in 2018 (Chart II-14), as striking red-state teachers embodied the shift from unions’ factory past to their service-provider present. “The teachers, many of them women, are redefining attitudes about organized labor, replacing negative stereotypes of overpaid and underperforming blue-collar workers with a more sympathetic face: overworked and underappreciated nurturers who say they’re fighting for their students as much as they’re fighting for themselves.”15 Chart II-14Feeling The Bern? Several commentators have heard organized labor’s death knell in US manufacturing’s irreversible decline. Unions gained critical mass on docks, factory floors, steel mills and coal mines, but few of today’s workers make their living there. Those who remain have little recourse other than to accept whatever terms management offers, as their jobs can easily be outsourced to lower-cost jurisdictions. The decline in private-sector union membership has traced the steady diminution of factory workers’ leverage (Chart II-15). Chart II-15Tracking Manufacturing's Slide Service workers represent unions’ future, and they have two important advantages over their manufacturing counterparts: many of their functions cannot be offshored, and a great deal of them are customer-facing. When MGM’s chairman was ousted from his job after clashing with Las Vegas’ potent UNITE-HERE local over the new MGM Grand Hotel’s nonunion policy, his successor explained why he immediately came to terms with the union. “‘The last thing you want is for people who are coming to enjoy themselves to see pickets and unhappy workers blocking driveways. … When you’re in the service business, the first contact our guests have is with the guest-room attendants or the food and beverage servers, and if that person’s [sic] unhappy, that comes across to the guests very quickly.’”16 … Management’s New Leaf … The Business Roundtable’s latest statement on corporate governance principles laid out a new stakeholder vision, displacing the Milton Friedman view that corporations are solely responsible for maximizing shareholder wealth. The statement itself is pretty bland, but the preamble in the press release accompanying it sounds as if it had been developed with labor advocates’ help (Box II-2). It is a stretch to think that the ideals in the Roundtable’s communications will take precedence over investment returns, but they may signal that management fears the labor-management rubber band has been stretched too far.17 The Environmental, Social and Governance (ESG) movement has the potential to improve rank-and-file workers’ wages and working conditions. ESG proponents have steadily groused about outsized executive pay packages, but if asset owners and institutional investors were to begin pushing for higher entry-level pay to narrow the income-inequality gap, unions could gain some powerful allies. BOX II-2 Farewell, Milton Friedman   America’s economic model, which is based on freedom, liberty and other enduring principles of our democracy, has raised standards of living for generations, while promoting competition, consumer choice and innovation. America’s businesses have been a critical engine to its success. Yet we know that many Americans are struggling. Too often hard work is not rewarded, and not enough is being done for workers to adjust to the rapid pace of change in the economy. If companies fail to recognize that the success of our system is dependent on inclusive long-term growth, many will raise legitimate questions about the role of large employers in our society. With these concerns in mind, Business Roundtable is modernizing its principles on the role of a corporation. Since 1978, Business Roundtable has periodically issued Principles of Corporate Governance that include language on the purpose of a corporation. Each version of that document issued since 1997 has stated that corporations exist principally to serve their shareholders. It has become clear that this language on corporate purpose does not accurately describe the ways in which we and our fellow CEOs endeavor every day to create value for all our stakeholders, whose long-term interests are inseparable. We therefore provide the following Statement on the Purpose of a Corporation, which supersedes previous Business Roundtable statements and more accurately reflects our commitment to a free market economy that serves all Americans. This statement represents only one element of Business Roundtable’s work to ensure more inclusive prosperity, and we are continuing to challenge ourselves to do more. Just as we are committed to doing our part as corporate CEOs, we call on others to do their part as well. In particular, we urge leading investors to support companies that build long-term value by investing in their employees and communities. … And The Public’s Left Turn Chart II-16Help! As our Geopolitical Strategy colleagues have argued since the 2016 primaries, the median voter in the US has been moving to the left as the financial crisis, the hollowing out of the middle class and the widening wealth gap have dimmed the luster of Reagan-Thatcher free-market policies.18 Globalization has squeezed unskilled labor everywhere in the developed world, and white-collar workers are starting to look over their shoulders at artificial intelligence programs that may render them obsolete as surely as voice mail and word processing decimated secretaries and typists. Banding together hasn’t sounded so good since the Depression, and nearly half of all workers polled in 2017 said they would join a union if they could (Chart II-16). Millennials are poised to become the single biggest voting bloc in the country. They were born between 1981 and 1996, and their lives have spanned two equity market crashes, the September 11th attacks, and the financial crisis, instilling them with a keen awareness of the way that remote events can upend the best-laid plans. Many of them emerged from college with sizable debt and dim earnings prospects. They would welcome more government involvement in the economy, and their enthusiastic embrace of Bernie Sanders and Elizabeth Warren (Chart II-17) indicates they’re on unions’ side. Chart II-17No 'Third Way' For Millennials Elections Have (Considerable Regulatory) Consequences Electoral outcomes influence the division of the economic pie between employers and employees. Labor-friendly presidents, governors and legislatures are more likely to expand employee protections, while more vigilantly enforcing the employment laws and regulations that are already on the books. The White House appoints top leadership at the Labor Department, the National Labor Review Board (NLRB), and the Occupational Safety and Health Administration (OSHA), along with the attorney general, who dictates the effort devoted to anti-trust enforcement. The differences can be stark. Justice Scalia’s son would no more have led the Obama Department of Labor than Scott Pruitt (EPA), Wilbur Ross (Commerce) or Betsy Devos (Education) would have found employment anywhere in the Obama administration. McDonald’s has good reason to be happy with the outcome of the 2016 election; its business before the NLRB wound up being resolved much more favorably in 2019 than it would have been when it began in 2014 (Box II-3). At the state level, Wisconsin public employees suffered a previously unimaginable setback when Scott Walker won the 2010 gubernatorial election, along with sizable legislative majorities (Box II-4). BOX II-3 The Right Referee Makes All The Difference The Fight for $15 movement that began in 2012 aimed to nearly double the median fast-food worker’s wages. A raise of that magnitude would pose an existential threat to fast-food’s business model, and McDonald’s and its franchisees sought to stymie the movement’s momentum. The NLRB opened an investigation in 2014 following allegations that employees were fired for participating in organizing activities. McDonald’s vigorously contested the case in an effort to avoid the joint-employer designation that would open the door for franchise employees to bargain collectively with the parent company. (Absent a joint-employer ruling, a union would have to organize the McDonald’s work force one franchise at a time.) When the case was decided in McDonald’s favor in December, the headline and sub-header on the Bloomberg story reporting the outcome crystallized our elections-matter thesis: McDonald’s Gets Win Under Trump That Proved Elusive With Obama Board led by Trump appointees overrules judge in case that threatened business model BOX II-4 Wisconsin Guts Public-Sector Unions Soon after Wisconsin Governor Scott Walker took office in January 2011, backed by sizable Republican majorities in both houses of the legislature, he sent a bill to legislators that would cripple the state’s public-sector unions. Protestors swarmed Madison and filled the capitol building every day for a month to contest the bill, and Democratic legislators fled the state to forestall a vote, but it eventually passed nonetheless. The bill struck at a rare union success story; nearly one-third of public-sector employees are union members and that ratio has remained fairly steady over the last 40 years (Chart II-18). Wisconsin’s public-sector unions now do little more than advocate for their members in disciplinary and grievance proceedings, and overall union membership in the state has fallen by a whopping 43% since the end of 2009. Judicial appointments make a difference, too. The Supreme Court’s Janus decision in April 2018, banning any requirement that public employees pay dues to the unions that bargain for them on not-so-readily-apparent First Amendment grounds,19 was widely viewed as a body blow to public-sector unions. The 5-4 decision would certainly have gone the other way had President Obama’s nominee to succeed the late Justice Scalia been confirmed by the Senate. Chart II-18Public-Sector Union Membership Has Held Up Well Final Takeaways We do not anticipate that organized labor will regain the position it enjoyed in the fifties and sixties, when global competition was weak and shareholders and consumers were anything but vigilant about corporate operations. Even a more modest flexing of labor muscle that pushes wages higher across the entire economy has a probability of less than one half. Investors seem to think the probability is negligible, though, and therein lies an opportunity. Elected officials deliver what their constituents want, as do the courts, albeit with a longer lag. Society’s view of striking/strikebreaking tactics heavily influences how they’re deployed and whether or not they’ll be successful. We believe that public opinion is beginning to coalesce on employees’ side as labor puts on a more appealing face; as businesses increasingly fret about inequality’s consequences; and as millennials swoon over progressives, undeterred by labels that would have left their Cold War ancestors reaching for weapons. The median voter theory has importance beyond predicting future outcomes; it directly influences them. As the center of the electorate leans to the left, elected officials will have to deliver more liberal outcomes if they want to keep their jobs. If the electorate has given up on Reagan-Thatcher principles, organized labor is bound to get a break from the four-decade onslaught that has left it shrunken and feeble. There is one overriding market takeaway from our view that a labor recovery is more likely than investors realize: long-run inflation expectations are way too low. Although we do not expect wage growth to rise enough this year to give rise to sustainable upward inflation pressures that force the Fed to come off of the sidelines, we do think investors are overly complacent about inflation. We continue to advocate for below-benchmark duration positioning over a cyclical timeframe and for owning TIPS in place of longer-maturity Treasury bonds over all timeframes. Watch the election, as it may reveal that labor’s demise has been greatly exaggerated. Doug Peta, CFA Chief US Investment Strategist Bibliography Aamidor, Abe and Evanoff, Ted. At The Crossroads: Middle America and the Battle to Save the Car Industry. Toronto: ECW Press (2010). Allegretto, S.A.; Doussard, M.; Graham-Squire, D.; Jacobs, K.; Thompson, D.; and Thompson, J. Fast Food, Poverty Wages: The Public Cost of Low-Wage Jobs in the Fast-Food Industry. Berkeley, CA. UC-Berkeley Center for Labor Research and Education, October 2013. Bernstein, Irving. The Lean Years: A History of the American Worker, 1920-1933. Boston: Houghton Mifflin (1960). Blanc, Eric. Red State Revolt: The Teachers’ Strike Wave and Working-Class Politics. Brooklyn, NY: Verso (2019). Emma, Caitlin. “Teachers Are Going on Strike in Trump’s America.” Politico, April 12, 2018, accessed January 20, 2020. Finnegan, William. “Dignity: Fast-Food Workers and a New Form of Labor Activism.” The New Yorker, September 15, 2014 Greenhouse, Steven. Beaten Down, Worked Up: The Past, Present and Future of American Labor. New York: Alfred A. Knopf (2019). Greenhouse, Steven. “The Return of the Strike.” The American Prospect, Winter 2019 Ingrassia, Paul. Crash Course: The American Auto Industry’s Road from Glory to Disaster. New York: Random House (2010). King, Gilbert. “How the Ford Motor Company Won a Battle and Lost Ground.” smithsonianmag.com, April 30, 2013, accessed January 24, 2020. Loomis, Erik. A History of America in Ten Strikes. New York: The New Press (2018). Manchester, William. The Glory and the Dream: A Narrative History of America, 1932-1972. New York: Bantam (1974). Norwood, Stephen H. “The Student As Strikebreaker: College Youth and the Crisis of Masculinity in the Early Twentieth Century. Journal of Social History Winter 1994: pp. 331-49. Sears, Stephen W. “Shut the Goddam Plant!” American Heritage Volume 33, Issue 3 (April/May 1982) Serrin, William. “Industries, in Shift, Aren’t Letting Strikes Stop Them.” The New York Times, September 30, 1986 Wolff, Leon. “Battle at Homestead.” American Heritage Volume 16, Issue 3 (April 1965) *Current newspaper and Bloomberg articles omitted. III. Indicators And Reference Charts Last month, we warned that the S&P 500 rally looked increasingly vulnerable from a tactical perspective and that the spread of Covid-19 was likely to be the catalyst of a pullback that could cause the S&P 500 to retest its October 2019 breakout. Since then, the S&P 500 has corrected significantly. As long as new cases of Covid-19 continue to grow quickly outside of China, the S&P 500 can suffer additional downside. Limited inflationary pressures, accommodative global central banks, and the potential for a large policy easing in China suggest that stocks have significant upside once Covid-19 becomes better contained. Nonetheless, despite the positive signals from our Willingness-To-Pay measure or our Monetary and Composite Technical Indicators, we recommend a cautious tactical stance on equities. Our BCA Composite Valuation index is not depressed enough to warrant closing our eyes when the risk of a recession caused by a global pandemic remains as high as it is today. Either valuations will have to cheapen further or Covid-19 will have to be clearly contained before we buy stocks without strong fears. 10-year Treasurys yields remain extremely expensive. However, our Composite Technical Indicator suggests that in such an uncertain climate, yields can fall a little more. Nonetheless, Treasurys seem like an asset that has nearly fully priced in the full impact of Covid-19, and thus, any downside in yield will be very limited.  The rising risk premia linked to the coronavirus is also helping the dollar right now, but as we have highlighted before, many signs show that global growth was in the process of bottoming before the outbreak took hold. As a result, we anticipate that the dollar could suffer plentiful downside if Covid-19 passes soon. Moreover, the rising probability that Senator Bernie Sanders wins the Democratic nomination could hurt the greenback over the remainder of the year. Finally, commodity prices have corrected meaningfully in response to the stronger dollar and the growth fears created by the spread of Covid-19. However, they have not pullback below the levels where they traded when they broke out in late 2019. Moreover, the advanced/decline line of the Continuous Commodity Index remains at an elevated level, indicating underlying strength in the commodity complex. Natural resources prices will likely become the key beneficiaries of both the eventual pullback in virus-related fears and the weaker dollar. EQUITIES: Chart III-1US Equity Indicators Chart III-2Willingness To Pay For Risk Chart III-3US Equity Sentiment Indicators   Chart III-4Revealed Preference Indicator Chart III-5US Stock Market Valuation Chart III-6US Earnings Chart III-7Global Stock Market And Earnings: Relative Performance Chart III-8Global Stock Market And Earnings: Relative Performance   FIXED INCOME: Chart III-9US Treasurys And Valuations Chart III-10Yield Curve Slopes Chart III-11Selected US Bond Yields Chart III-1210-Year Treasury Yield ComponentsChart III-13US Corporate Bonds And Health Monitor Chart III-14Global Bonds: Developed Markets Chart III-15Global Bonds: Emerging Markets   CURRENCIES: Chart III-16US Dollar And PPP Chart III-17US Dollar And Indicator Chart III-18US Dollar Fundamentals Chart III-19Japanese Yen Technicals Chart III-20Euro Technicals Chart III-21Euro/Yen Technicals Chart III-22Euro/Pound Technicals   COMMODITIES: Chart III-23Broad Commodity Indicators Chart III-24Commodity Prices Chart III-25Commodity Prices Chart III-26Commodity Sentiment Chart III-27Speculative Positioning   ECONOMY: Chart III-28US And Global Macro Backdrop Chart III-29US Macro Snapshot Chart III-30US Growth Outlook Chart III-31US Cyclical Spending Chart III-32US Labor Market Chart III-33US Consumption Chart III-34US Housing Chart III-35US Debt And Deleveraging   Chart III-36US Financial Conditions Chart III-37Global Economic Snapshot: Europe Chart III-38Global Economic Snapshot: China   Mathieu Savary Vice President The Bank Credit Analyst Footnotes 1 Non-seasonally adjusted growth is always negative in Q1, due to the impact of the Chinese Lunar New Year Celebration. This is why we emphasize the seasonal adjustment. 2 Please see Global Investment Strategy Weekly Report "Markets Too Complacent About The Coronavirus," dated February 21, 2020, available at gis.bcaresearch.com 3 Please see The Bank Credit Analyst "February 2020," dated January 30, 2020 available at bca.bcaresearch.com 4 Blanc, Eric. Red State Revolt: The Teachers’ Strike Wave and Working-Class Politics, Verso: New York (2019), p. 204. 5 Ibid, p. 209. 6 We will discuss public opinion, and its impact on elected officials and courts, in Part 3. 7 Please see the January 13, 2020 US Investment Strategy Special Report, “Labor Strikes Back, Part 1: An Investor’s Guide To US Labor History,” available at www.bcaresearch.com. 8 A monopsony is a market with a single buyer, akin to a monopoly, which is a market with only one seller. 9 Please see the July 2019 Bank Credit Analyst Special Report, “ The Productivity Puzzle: Competition Is The Missing Ingredient,” available at bcaresearch.com. 10 Students were excused from classes and exams and sometimes even received academic credit for their work. 11 King, Gilbert, “How The Ford Motor Company Won a Battle and Lost Ground,” Smithsonian.com, April 30, 2013. 12 Greenhouse, Steven, Beaten Down, Worked Up, Alfred A. Knopf: New York (2019), pp. 137-8. 13 High unemployment, in addition to declining respect for unions, helped erase the stigma of crossing picket lines. 14 Serrin, William, “Industries, in Shift, Aren’t Letting Strikes Stop Them,” New York Times, September 30, 1986, p. A18. 15 Emma, Caitlin, “Teachers Are Going on Strike in Trump’s America,” Politico, April 12, 2018. 16 Greenhouse, p. 44. 17 Please see the January 20, 2020 US Investment Strategy Special Report, “Labor Strikes Back, Part 2: Where Strikes Come From And Who Wins Them,” available at usis.bcaresearch.com. 18 Please see the June 8, 2016 Geopolitical Strategy Monthly Report, “Introducing The Median Voter Theory,” available at gps.bcaresearch.com. 19 The Court found for the plaintiff in Janus, who bridled at the closed-shop law that forced him to join the union that bargained on his and his colleagues’ behalf, because the union’s espousal of views with which he disagreed constituted a violation of his free-speech rights as guaranteed by the First Amendment.

Highlights For stock markets, the best inoculation against Covid-19 is ultra-low bond yields. Our tactical underweight to equities versus bonds achieved its 5 percent profit target and is now closed. We are now awaiting the fractal signal to go tactically overweight (Chart of the Week). Price to sales is a much better predictor of 10-year returns than is price to earnings, especially when profit margins are stretched as they are now. New long-term recommendation: overweight Swedish equities versus bonds. Germany and Switzerland also offer attractive excess 10-year equity returns over bonds. Fractal trade: the 130 percent outperformance of palladium versus nickel in just six months is now technically stretched. Chart of the WeekStocks Are Approaching Oversold – Stay Tuned For Stock Markets, The Best Inoculation Against Covid-19 Is Ultra-Low Bond Yields A global slowdown, exacerbated by the Covid-19 virus contagion, is dominating the news and financial headlines. There are worries that the stock market is still in denial and has a long way to fall – rather like Wile E. Coyote suspended in disbelief as he runs over the cliff-edge. In fact, some of the most economically sensitive equity sectors have already fallen a long way. For example, the oil and gas sector is down by 20 percent (Chart 2). Chart I-2Economically Sensitive Sectors And Bond Yields Have Plunged Meanwhile, bond yields have plunged to new lows, and in some cases all-time lows. Hence, we are pleased to report that our tactical underweight to equities versus 10-year bonds, initiated on January 9, has achieved its 5 percent profit target and is now closed.1 We are now awaiting the fractal signal to go tactically overweight. Bond yields have plunged to new lows. Having said that, when the world economy is set to grind to a halt in the first quarter, and halfway to a recession, is a 5 percent underperformance of equities versus bonds enough? There is certainly scope for some further downside, but for investors with a multi-year horizon, equities still win the ugly contest versus bonds. Where bond yields are approaching the lower limit to their yields – around -1 percent – it means they are approaching the upper limit to their prices. Hence, bonds become a ‘lose-lose’ proposition. Bond prices cannot rise much further, even in an economic slump, but they can fall a lot if sentiment suddenly recovers. As the riskiness of bonds rises relative to equities, the prospective return that investors will accept from equities rapidly collapses to the ultra-low level of bond yields. And as valuation is just the inverse of prospective return, this underpins and justifies an exponentially higher valuation of equities. How can we best gauge the prospective (long-term) returns that equities now offer? To answer this question, we need to take a Japanese lesson. A Japanese Lesson: Price To Sales Is The Best Predictor Of Prospective Return A great advantage of being a European investor is that the difficult investment questions have already been asked and answered by our friends in Japan – so we just need to take some Japanese lessons. One of the most important lessons is that the Japanese stock market’s price to sales multiple has a near-perfect predictive record for Japanese 10-year returns since the 1980s.2 For world equities, market capitalisation to GDP (which broadly equates to price to sales at a world level) also has a near-perfect predictive record for 10-year returns since the late 1990s.3 The corollary lesson is that the price to earnings multiple – either based on 12-month trailing or 12-month forward earnings – is not such a good predictor of prospective return. Price to earnings wrongly pinpointed Japan’s highest valuation in 1994 rather than at the peak of the bubble in 1989. Moreover, since 2000, price to earnings has suggested that Japan’s stock market is cheaper than it truly is, and grossly overestimated prospective returns. Price to earnings made the same mistake for world equities in the mid-noughties, understating valuations and thereby overestimating prospective returns. The trouble with price to earnings is that it takes no account of the likely evolution of profit margins – treating a stock market multiple of, say, 30 on a high profit margin the same as 30 on a low profit margin. The problem is that when the market is trading at 30 on a low margin it has the capacity for higher profit growth through margin expansion – and thereby a higher prospective return – than when it is trading at 30 on a high margin (Chart 3). Chart I-3Price To Earnings Takes No Account Of Changing Profit Margins It follows that a high price to earnings on a low profit margin makes the market appear more expensive than it truly is, and thereby underestimates prospective returns. In 1994, Japan appeared to be more expensive than at the peak of the bubble in 1989 because profit margins halved through 1989-94. The trouble with price to earnings is that it takes no account of the likely evolution of profit margins. Conversely, a low price to earnings on a high profit margin makes the market appear less expensive that it truly is, and thereby overestimates prospective returns (Chart 4 and Chart 5). Chart I-4Price To Sales Has An Excellent Predictive Record In Japan… Chart I-5…Whereas Price To Earnings Has Made Many Mistakes   In the mid-noughties, Japan appeared to be less expensive than it truly was because profit margins surged through 2001-07. The same was true for world equities. Hence, price to earnings grossly overestimated the prospective long-term return in 2007 (Chart 6). Chart I-6Profit Margins Are At Generational Highs Price to sales avoids the mistakes of price to earnings by removing profit margins from the equation. Put another way, it is like using price to earnings with a constant long-term profit margin. This tends to be more prudent – especially today when margins are close to generational highs and facing several threats in the coming years. One threat to profit margins comes from a growing populist backlash against record high corporate profitability, especially in the most profitable sectors. The threat manifests through populist politicians or parties which vow to rein in runaway profitability through higher taxes and/or regulation and/or nationalisation. Think Bernie Sanders. A second threat comes from environmental, social, and corporate governance (ESG). Think carbon taxes. A third threat comes the possible break-up of the pseudo-monopoly tech behemoths, killing both their pricing power and market penetration. Think antitrust suit against Google or Facebook. Admittedly, this is likely to be a US focussed threat, but the impact on stock markets would be felt worldwide. Given these threats, long-term investors should assume some pressure on profit margins from today’s generational highs. Accordingly, just as in 2007, price to sales is likely to be a much better predictor of prospective returns than is price to earnings (Chart 7 and Chart 8). Chart I-7At A World Level, Market Cap To GDP Has An Excellent Predictive Record… Chart I-8…Whereas Price To Earnings Was Very Wrong In 2007 Sweden Is An Attractive Long-Term Opportunity Price to sales predicts that stock markets, on average, are set to deliver feeble single-digit total nominal returns over the coming decade. Nevertheless, with bond yields even closer to zero, and the riskiness of bonds much higher at ultra-low yields, equities still beat bonds in the ugly contest of long-term prospective returns. In fact, in those countries where bond yields are approaching their lower limit of around -1 percent – meaning bond prices are approaching their upper limit – equities win the contest more handsomely. On this basis, the stock markets in Germany and Switzerland offer attractive excess 10-year returns over their bond markets. But the most attractive long-term opportunity is Sweden. Based on its price to sales multiple, Sweden’s stock market is set to deliver around 6 percent a year over the coming decade (Chart 9). Chart I-9Sweden’s Stock Market Is Set To Deliver 6 Percent A Year Given that Sweden’s 10-year bond yield is negative, Sweden’s stock market takes the honour of offering one of the world’s highest excess 10-year returns over its bond market (Chart 10). Chart I-10Sweden’s Stock Market Has The Highest Excess Return Over Bonds Accordingly, we are adding Sweden to our existing structural overweight to equities versus long-dated bonds in Germany, in a 50:50 combination. Fractal Trading System* As discussed, we are pleased to report that underweight S&P 500 versus the 10-year T-bond achieved its 5 percent profit target and is now closed. Elsewhere, the palladium price has surged. In just six months, palladium has outperformed nickel by 130 percent, making its 130-day fractal structure extremely fragile. Accordingly, this week’s recommended trade is short palladium versus nickel, setting a profit target of 32 percent with a symmetrical stop-loss. The rolling 1-year win ratio now stands at 60 percent. When the fractal dimension approaches the lower limit after an investment has been in an established trend it is a potential trigger for a liquidity-triggered trend reversal. Therefore, open a countertrend position. The profit target is a one-third reversal of the preceding 13-week move. Apply a symmetrical stop-loss. Close the position at the profit target or stop-loss. Otherwise close the position after 13 weeks.   Dhaval Joshi Chief European Investment Strategist dhaval@bcaresearch.com   * For more details please see the European Investment Strategy Special Report “Fractals, Liquidity & A Trading Model,” dated December 11, 2014, available at eis.bcaresearch.com Footnotes 1 Our expression of this was underweight S&P 500 versus US 10-year T-bond. 2 Prospective returns are nominal total (capital plus income) 10-year returns, shown as an annualised rate. 3 Price/sales per share = (price*number of shares)/(sales per share * number of shares) = market capitalisation/total sales. At a global level, total sales broadly equal GDP, so price/sales per share = market capitalisation/GDP. But note that this does not apply at a regional or country level because sales can originate from outside the domestic economy.. Fractal Trading System Cyclical Recommendations Structural Recommendations Trades Closed Trades Asset Performance Currency & Bond Equity Sector Country Equity Indicators Bond Yields Chart II-1Indicators To Watch - Bond Yields Chart II-2Indicators To Watch - Bond Yields   Chart II-3Indicators To Watch - Bond Yields Chart II-4Indicators To Watch - Bond Yields Interest Rate Chart II-5Indicators To Watch - Interest Rate Expectations Chart II-6Indicators To Watch - Interest Rate Expectations Chart II-7Indicators To Watch - Interest Rate Expectations Chart II-8Indicators To Watch - Interest Rate Expectations  

Highlights In the past week, it is becoming evident that the Chinese leadership is willing to abandon its financial de-risking agenda in exchange for a rapid economic recovery. Monetary conditions are already more accommodative than during the last easing cycle in 2015/2016. The recently announced policy initiatives on infrastructure, housing, and automobile sectors also resemble policy supports that led to a V-shaped economic recovery in 2016. As manufacturers in regions other than Hubei are returning to work and their production capacity continues to rise, the outbreak-induced economic shock may be smaller than investors currently fear. Hence, the odds are rising that the upcoming “insurance stimulus” may end up overshooting the short-term economic shock. As such, we maintain a constructive view on Chinese stocks over the next 6-12 months. Feature A surge in the number of COVID-19 infections outside of China (including South Korea, Japan, Iran, and Italy) risks delaying a global economic recovery, and has cast doubt on the outlook for the global economy beyond Q1 (Chart 1). Chart 1Pandemic Threats Expanding Globally Despite the sharp uptick in global investor concern, our constructive view on Chinese stocks remains unchanged for the next 6-12 months. Our view on Chinese risk assets is based on a simple arithmetic framework that we described last year when the trade war tensions between the US and China were escalating. In short, when gauging the net impact of an economic shock, investors should determine which of the following two scenarios is most likely: Scenario 1 (Bearish): Stimulus – Shock ≤ 0 Scenario 2 (Bullish): Stimulus – Shock > 0 While this framework is quite simplistic, the point is to underscore that economic shocks are almost always met with a policy response, and the goal is to determine whether this response is sufficient enough to offset the impact of the shock. If the Chinese leadership underestimates the severity of the shock and undershoots on the stimulus, this would be bearish for Chinese stocks (Scenario 1). In the current situation, however, even if the near-term economic outlook is deeply negative, investors should maintain a bullish cyclical (i.e. 6-12 month) outlook for China-related assets as long as the impact of China’s reflationary efforts more than offsets the negative shock to aggregate demand (Scenario 2). Major Stimulus Around The Corner? It is becoming evident that the Chinese policymakers, when dealing with an unprecedented public health crisis, are returning to aggressive fiscal and monetary easing. In fact, the odds are rising that the magnitude of the upcoming stimulus may resemble that of 2015/2016, and has an increasing possibility to overshoot in the next 6-12 months. In the past week, there has been a clear shift of policy focus from “financial de-risking” to “mitigating the economic damage from shocks at all costs”, as indicated by high-profile policy announcements. In an unprecedented large-scale teleconference on February 23,1 President Xi stated that China will not lower its economic growth target for this year, and that fiscal policy will be “more proactive” while monetary policy was upgraded from “prudent” to “flexible and moderate". Chart 2PBoC Looks Set For Massive Stimulus Xi also pledged to “introduce new policy measures in a timely manner”. China’s central bank, the PBoC, issued a statement signaling further cuts ahead in the bank reserve requirement ratio rate and interest rate.2 The PBoC has already aggressively eased monetary conditions in the past two weeks, and both the central bank policy and average lending rates are now lower than they were during the last massive easing cycle in 2015/2016 (Chart 2).  Other policy initiatives also suggest the Chinese authorities are stepping up coordinated efforts to boost the economy, beyond short-term and targeted financial support. The stimulative measures now span from infrastructure to housing and automobile sectors, the exact “three prongs” that supported a V-shaped economic recovery in 2016.3 This is in sharp contrast with last year, when Chinese policymakers largely resisted resorting to large-scale stimulus, despite immense pressure from the US-China trade war and tariff impositions.4 The ongoing COVID-19 epidemic seems to have forced China to return to its old economic playbook, as the Xi administration is clearly unwilling to tolerate economic hardships driven by an endogenous crisis. The ongoing epidemic seems to have forced China to return to its old economic playbook, as the Xi administration is clearly unwilling to tolerate economic hardships driven by an endogenous crisis. As we predicted in November last year,5 China was to frontload additional fiscal stimulus in Q1 this year to secure an economic recovery, which started to bud in Q4 last year. The increase in January’s credit numbers confirms our projection: local government bond issuance picked up significantly from last year while the contraction in shadow bank lending continued to ease, signaling a less restrictive policy bias on both the monetary and fiscal fronts (Chart 3).  Chart 3Stronger Fiscal Support Likely To Soon Follow The exact economic and monetary expansion growth targets will be officially set at the National People’s Congress meeting, which has been postponed from its usual schedule on March 5. Compared with the 6.1% real GDP growth achieved in 2019, we now think a growth target of 5.6% would be conservative for this year. According to an estimate by BCA’s Global Investment Strategy,6 China’s real GDP growth in Q1 could slow to 3.5% on a year-over-year basis. To achieve 5.6% growth, China would need at least 6.3% average real growth (year-over-year) for the next three quarters, 0.3 percentage points higher than in the second half of 2019. The growth in credit expansion, infrastructure spending and government expenditures will need to significantly outpace last year in the next 6-12 months. Bottom Line: The government appears to be willing to abandon its financial de-risking agenda to secure economic recovery. There is an increasing possibility that the stimulus may overshoot the economic shock this year. China’s Economic Engine Warms Up There are increasing signs that the scale of the upcoming stimulus may match that of the 2015/2016 cycle. The likely magnitude of the shock, on the other hand, might be smaller than investors fear as the evidence is mounting that production is returning to normality in China. Despite a lack of employees and raw materials, industrial activity in regions outside of Hubei is resuming. Chart 4…Small Companies Are Not Far Behind A survey of China’s 500 top manufacturers by China Enterprise Confederation7 indicated that most of the 342 respondents had resumed production as of February 20. They also reported that more than half of their employees had returned to work and the average capacity utilization rate had reached nearly 60% (Table 1). Furthermore, the China Association of Small and Medium Enterprises8 survey of 6,422 small businesses showed that as of February 14, more than half of the companies have resumed operations (Chart 4). By February 21, the daily coal consumption in China’s six largest power plants has reached 62% of the consumption from the same period last year (adjusted for Lunar Year calendar), 14 percentage points higher than February 10 - the first day officially scheduled for people to return to work.9 Table 1Large Manufacturers Have Reached More Than Half Of Their Production Capacity… The resurgence in the number of new infections has not slowed those regions down from reopening businesses, particularly along the manufacturing belt in China’s coastal regions (Chart 5). China’s leadership has repeatedly urged local governments to relax aggressive containment measures to allow production to resume. Unless the number of new cases in China picks up again, we expect business operations in regions outside of Hubei to continue re-opening in the coming weeks. Chart 580% Of China’s Coastal Regions Are Back To Work Most manufacturers in regions other than Hubei are returning to work and are running at about half of last year’s production capacity. Bottom Line: The aggressive containment measures seem to be effective inside China. Most manufacturers in regions other than Hubei are returning to work and are running at about half of last year’s production capacity. We expect the rate to improve. This will mitigate the impact of the virus outbreak on the Chinese economy.  “Scenario 2” Implies An Upturn In The Corporate Earnings Cycle The impact of the COVID-19 outbreak on China’s economy may be smaller than investors currently fear. The country is also in a better economic condition than in 2015/2016. If the Chinese leadership believes an “insurance stimulus” is warranted and allows credit growth in 2020 to reach near 28% of GDP, as in 2015-2016, then the stimulus will more than offset the outbreak-induced economic shock from Q1 and lead to a meaningful rise in this year’s corporate earnings (Chart 6): China’s households and corporates are actually more willing to spend now than in 2015-2016. We agree that China’s households and companies are both highly leveraged, and re-leveraging may further diminish their debt-servicing ability and willingness to invest or spend. Debt as a share of Chinese household disposable income has climbed by 33 percentage points compared with five years ago (Chart 7). The increase in debt load makes Chinese households particularly vulnerable to income reductions. But this supports our view that policymakers will make every reflationary effort to avoid massive layoffs. Additionally, the willingness to spend among Chinese households is not less than during the down cycle in 2015-2016 (Chart 7 bottom panel). Chart 6A 2015/2016-Style Stimulus Will Likely Triumph Over Short-Term Economic Shocks Chart 7Chinese Households Are More Indebted, But Are Also More Willing To Spend Than In 2015/2016 The debt-to-GDP ratio and debt-servicing cost-to-income ratio in China’s non-financial private sector have trended sideways in the past five years (Chart 8). The corporate cash flow situation is only slightly worse than in 2015 (Chart 9). The virus outbreak and drastic containment measures will temporarily weaken the corporates’ cash positions, but this negative situation can be partially offset by tax, fee and interest relief measures.10 Chart 8Chinese Corporates Are In Fact Not More Indebted Than In 2015/2016... Chart 9...And Their Cash Flow Situation Is Only Slightly Worse   Furthermore, China’s non-financial corporates’ marginal propensity to spend is actually higher than in 2015-2016 (Chart 10). This may be due to the more accommodative monetary backdrop than in 2015-2016. If Chinese authorities are to significantly step up their reflationary efforts, the easy monetary policy stance may be here to stay throughout 2020. Prior to the COVID-19 outbreak, the mild deflation in China’s PPI growth was already turning slightly positive on the heels of an improving economy. The historical relationship between China’s producer prices and industrial profits suggests that profit growth for both China’s onshore and offshore markets is highly linked to fluctuations in producer prices (Chart 11). An ultra-easy monetary policy, a weak RMB, and a more forceful boost to domestic demand will provide strong reflationary support to producer prices and industrial profits. Chart 10Chinese Corporates' Willingness To Spend Also Higher Than In 2015/2016 Chart 11A 2015/2016-Style Reflation Will Likely Lead To A Strong Rebound In Corporate Profits   Bottom Line: Despite a short-term economic shock, China’s economy is at a better starting point than in 2015-2016. If monetary and fiscal easing in 2020 reaches the same magnitude as five years ago, then the economy and corporate profits will likely begin to respond to the stimulus. Investment Conclusions The clear sign of policy shift to shoring up the economy suggests that, our Scenario 2 is the most likely outcome. The fiscal and monetary easing initiatives seem to resemble those of 2015/2016. The short-term outbreak-induced economic shock, on the other hand, looks to be smaller than the market anticipates. Manufacturers in China continue to resume production in regions outside of Hubei, a trend we believe will go on unless there is a significant threat that the virus will break out again in these Chinese regions. This supports our constructive view on China-related assets over a 6-12 month time horizon. The fiscal and monetary easing initiatives seem to resemble those of 2015/2016, and will likely overshoot the short-term economic shock. There is a risk to our constructive view, though, that the more forceful policy response from the Chinese leadership may imply a greater than anticipated short-term economic shock from the outbreak. This would challenge our bullish stance on Chinese stocks in the next three months. Substantially weaker economic data in Q1 would likely trigger a selloff in Chinese risk assets, both onshore and offshore. However, a severe short-term economic shock, followed by a burst of stimulus, would create strong investment opportunities. If the scale of Chinese policymakers’ reflationary measures ramps up significantly in the coming months, they will likely overshoot the short-term economic shock. Another reflationary cycle would certainly have a positive impact on global investors’ sentiment and Chinese financial assets. Stay tuned.   Jing Sima China Strategist jings@bcaresearch.com   Footnotes 1    http://english.www.gov.cn/news/topnews/202002/23/content_WS5e5286cdc6d0… 2   http://www.pbc.gov.cn/goutongjiaoliu/113456/113469/3975864/index.html 3   Please see China Investment Strategy Weekly Report "Threading A Stimulus Needle (Part 2): Will Proactive Fiscal Policy Lose Steam?," dated July 24, 2019, available at cis.bcaresearch.com 4   Please see China Investment Strategy Weekly Reports "Threading A Stimulus Needle (Part 1): A Reluctant PBoC," dated July 10, 2019, "Threading A Stimulus Needle (Part 2): Will Proactive Fiscal Policy Lose Steam?," dated July 24, 2019, "Don’t Bottom-Fish Chinese Assets (Yet)," dated August 14, 2019 and "Mild Deflation Means Timid Easing," dated October 9, 2019. available at cis.bcaresearch.com 5   Please see China Investment Strategy Weekly Report "Questions From The Road: Timing The Turn," dated November 20, 2019, available at cis.bcaresearch.com 6   Please see Global Investment Strategy Weekly Report "Markets Too Complacent About The Coronavirus," dated February 21, 2020, available at cis.bcaresearch.com 7   http://www.cec-ceda.org.cn/view_sy.php?id=42633 8   http://www.ce.cn/xwzx/gnsz/gdxw/202002/18/t20200218_34298844.shtml 9   http://www.21jingji.com/2020/2-21/wOMDEzNzhfMTUzNjAwOA.html 10  China has announced targeted measures to defer or lower taxes and administrative fees. It will also provide interest rate subsidies to affected businesses. Cyclical Investment Stance Equity Sector Recommendations

Special Report

Highlights Demand for construction machinery in China will contract by 10-15% over the next 12-18 months. Diminishing replacement demand, deteriorating property construction activity and only a moderate acceleration in infrastructure investment will weigh on construction machinery sales in China. We recommend avoiding or underweighting global construction machinery stocks. Feature China is the largest manufacturer and consumer of construction machinery in the world. The country accounts for about 30% of global construction machinery demand in unit terms. Construction machinery includes heavy-duty vehicles performing earthwork operations or other hefty construction tasks. In this report, our coverage of construction machinery refers to the seven most-used construction machines in the world – excavators, loaders, cranes, road rollers, bulldozers, ball-graders and spreaders. Between 2016 and 2019, machinery sales surged by  close to 170%. However, unlike during the 2009-2011 boom, sales were not  widespread across all types of machinery. Sales of these machines are often used by investors and strategists as a microcosm to detect the potency of an economy’s business cycle. An increase in machine sales is usually interpreted as a sign of an acceleration in real estate construction and/or infrastructure spending. Chart I-1Excavators In China: Robust Sales Vs. Diminishing Working Hours Are machinery sales a good measure of construction activity in both the real estate and infrastructure development? Not really. In this report we make the point that sales of construction machinery do not always reflect construction activity in the mainland. Specifically, Chart I-1 demonstrates that sales of excavators in China have differed from Komatsu’s Komtrax index for China. The latter is the average hours of operation per excavator. What explains this gap between resilient excavator sales and diminishing hours of excavator usage? This divergence has been due to the fact that robust excavator sales numbers have been supported by replacement demand as well as a changing product mix (a rising share of smaller and cheaper excavators bought by small entrepreneurs). China’s machinery imports have also been crowded out by a growing roster of domestically made models (import substitution). Boom-Bust Machinery Cycles Chart I-2Chinese Construction Machinery Demand Is Likely To Shrink Chinese sales1 of construction machinery (thereafter, machinery) skyrocketed between 2009 and 2011, when China drastically boosted its infrastructure spending and property construction surged. The 2009-2011 boom was followed by a bust: Between 2012 and 2015, total machinery sales dropped by nearly 70%, (Chart I-2). That bust was succeeded by another boom: between 2016 and 2019, machinery sales surged by close to 170%. However, unlike during the 2009-2011 boom, sales were not widespread across all types of machinery: only excavator and crane sales boomed (Chart I-3). The other five categories – loaders, road rollers, bulldozers, ball-graders and spreaders – experienced a relatively muted sales recovery; their 2019 unit sales were well below their respective 2011 highs (Chart I-4). Chart I-3The 2016-2019 Boom: Only Sales Excavators And Cranes Hit A New High...Going forward, we expect sales of construction machinery in China to experience a 10-15% downturn over the next 12-18 months (Chart I-2 on page 2). The basis for such a contraction is diminishing replacement demand, deteriorating property construction and only a moderate acceleration in infrastructure investment growth. Chart I-4...While Many Others Had A Relatively Muted Sales Recovery   Understanding Construction Machinery Demand China’s property construction and infrastructure development have been the main drivers behind construction machinery demand. Chart I-5 shows construction machinery sales in China are highly correlated with building floor space started. Meanwhile, Chart I-6 reveals that infrastructure investment distinctively led construction machinery sales between 2007 and 2013, but that relationship has broken down since 2014. Chart I-5Main Drivers For Construction Machinery Demand In China: Property Construction... Chart I-6...And Infrastructure Spending   Crucially, in the past three years, property and infrastructure development alone have not been enough to explain the surge in construction machinery sales. In particular, between 2018 and 2019, growth of both building floor areas started and infrastructure investment were weak, yet construction machinery sales still surged by an astonishing 50%. Crucially, in the past three years, property and infrastructure development alone have not been enough to explain the surge in construction machinery sales. Specific developments in the excavator market were behind this surge. Excavators are the largest component of China’s construction machinery market, with a 52% market share (Chart I-7). The decoupling of excavator sales from property construction and infrastructure investment has been due to non-macro forces such as: Replacement demand: Given the average lifespan of an excavator is about eight years, the excavators bought in 2009-2011 were likely replaced during 2017-2019. Meanwhile, strengthening environmental regulations on emissions of heavy construction machinery also accelerated the pace of replacement. According to the China Construction Machinery Association, replacement demand accounted for about 60% of all excavator sales last year. Price drop: The significant reduction in excavator prices, ranging from 15%-30% since the middle of 2018, spurred more purchases. Prices of excavators imported into China have also dropped about 30% in the past 18 months (Chart I-8). The fundamental reason behind excavator producers cutting prices was weak demand amid lingering excess capacity. Chart I-7The Breakdown Of China’s Construction Machinery Sales Chart I-8A Sizeable Drop In Prices Of Imported Excavators   Cranes are the only other construction machinery whose sales reached an all-time high last year. Similar to excavators, replacement demand has been the main factor behind sales. Excluding excavators and cranes, machinery sales have been lackluster, as illustrated in Chart I-4 on page 3. Bottom Line: Property construction and infrastructure development alone do not explain the strong growth in construction machinery sales between 2017 and 2019. Considerable replacement demand prompted by a sizable reduction in excavator prices also facilitated sales in China. A Downbeat Cyclical Demand Outlook Chart I-9Chinese Property Construction Is Very Weak We remain downbeat on Chinese construction machinery demand going forward. Chinese sales of construction machinery will likely contract 10-15% over the next 12-18 months (Chart I-2 on page 2). First, the Chinese property market remains vulnerable to the downside in 2020. A comprehensive measure of Chinese property construction activity – the “building construction” dataset2 – shows that “building construction” floor area started, under construction and completed are all either stagnant or in contraction (Chart I-9). Real estate is still facing considerable headwinds. The COVID-19 outbreak will reduce household income growth and hence weigh on home purchases in the months to come. In the meantime, structural impediments such as poor housing affordability, slowing rural-to-urban migration, demographic changes and the promotion of the housing rental market will also curtail housing demand. Further, the drop in sales will shrink developers’ cash flow, curbing their already feeble financial position to undertake new construction or complete already started projects. Second, the growth rate of China’s infrastructure investment will likely rebound only moderately from its current nominal 3% pace (Chart I-6 on page 4). Even though the central government is likely to implement more fiscal stimulus due to the current coronavirus outbreak, the infrastructure investment growth rate will still be well below the double digits it registered for most of the past decade. Local government special bond quotas are currently a moving target. No doubt, if economic conditions continue to deteriorate, the central government will continue to increase quotas. However, there are several critical points about the importance of special bond issuance that are worth emphasizing: Special bonds accounted for 14% of total infrastructure investment in 2019. Special bond issuance amounted to 7% of combined local government and government-managed funds expenditures last year. Aggregate infrastructure spending was equal to 30% of fixed asset investment excluding the value of land, and 18% of nominal GDP in 2019. It is roughly equal to property construction. Therefore, modest acceleration in infrastructure spending will likely be offset by shrinking property construction. On the whole, barring irrigation-style fiscal and credit stimulus – which has been repeatedly rejected by Beijing – infrastructure spending is unlikely to surge to the extent it did in 2009-‘10, 2013 and 2016-‘17. It is critical to realize that infrastructure spending during those episodes was funded not by Beijing-approved debt but via bank and shadow-banking credit that was beyond Beijing's control. Chart I-10Excavator Sales Are Likely To Fall Third, two specific factors below may result in a considerable reduction in excavator sales. Replacement demand will crater starting in 2020. Excavator sales in 2012 were 35% below their 2011 peak. Given the average eight-year replacement cycle, demand for excavators in 2020 and 2021 will be significantly below 2019 levels (Chart I-10). The price war in the excavator sector will continue, but it will fail to lift overall excavator demand. There are signposts that there is an oversupply of excavators in operation. Last year, excavator drivers (individual entrepreneurs) accounted for a large share of purchases, with the bulk of them opting for small-sized machines – the latter contributed about 70% of the total excavator sales growth. The surge in small service providers amid stagnant construction activity has intensified competition and hence depressed income among these individual owners. This will discourage new demand in the coming one to two years. A risk to this view is that replacement demand could be supported to some extent by increasingly stringent environmental rules. This year, the government will accelerate the scrapping process of off-road heavy vehicles below National III emission standards. Bottom Line: Chinese sales of construction machinery will likely experience a 10-15% downturn over the next 12-18 months, with the largest category – excavator sales – falling by 20% or more. Rising Competitiveness Of Chinese Machinery Producers China’s machinery producers have significantly enhanced their competitiveness. This has led to import substitution. For instance, sales of domestic-brand excavators accounted for 65% of total Chinese excavator sales, a considerable rise from 43% in 2014 and only 26% in 2009. Chinese sales of construction machinery will likely  experience a 10-15% downturn over  the next 12-18 months,  with the largest category  – excavator  sales – falling by  20% or  more. The increasing competitiveness of domestic producers has resulted in not only shrinking imports but also rising exports of construction machinery. As a result, Chinese construction machinery net exports have been on the rise (Chart I-11). In fact, excavators, loaders, cranes, and spreaders have all shown increasing net exports in both volume and value terms (Chart I-12). Chart I-11Chinese Construction Machinery: Flat Exports, Less Imports Chart I-12Increasing Net Exports Of Chinese Construction Machinery   We expect this trend to continue in the coming years. The ongoing Belt and Road Initiative (BRI) will facilitate construction machinery exports to BRI recipient countries. For example, on January 12, Chinese construction machinery manufacturer Zoomlion delivered its first batch of an order of 100 excavators to Ghana as part of a BRI agreement. Total BRI investment with Chinese financing will fall moderately in 2020, as the Chinese government will be applying greater scrutiny and tighter oversight over lending for BRI projects. However, we believe this moderate decline in BRI investment will not affect the country’s construction machinery exports by much. Chinese construction machinery companies are highly focused on technology improvements and 5G applications for their products. This will continue to increase the competitiveness of Chinese construction machinery producers. For example, last May, the 5G-based unmanned mining truck made its debut in China’s Bayan Obo mining region. Autonomous vehicles are more efficient and cheaper to maintain. The Bayan Obo mining area plans to purchase more unmanned mining trucks and transform existing traditional vehicles, with plans to make over 65% of its future fleet of mining cars autonomous. Technology improvements and 5G application will further enhance Chinese construction machinery producers’ productivity, making their products more competitive in the global marketplace. Bottom Line: China’s construction machinery net exports will continue to rise, implying a rising market share for mainland producers. This is a bad sign for foreign producers. Investment Implications Global construction machinery stock prices correlate closely with China’s domestic machinery sales (Chart I-13). This confirms the importance of the mainland, which accounts for 30% of global construction machinery demand. There are 30 stocks in the MSCI global construction machinery stock index, including Caterpillar, Komatsu, Paccar, Cummins and Volvo B.  China’s construction machinery  net exports  will continue to rise, implying a rising market share for  mainland producers. This is a bad sign for  foreign producers. Global machinery producers will likely suffer from both shrinking demand in China and a loss of market share to mainland producers. In fact, both Caterpillar and Komatsu excavator sales are already in contraction, even though mainland excavator sales did not contract in 2019 (Chart I-14). Chart I-13Global Construction Machinery Stocks: Closely Correlate With Chinese Demand Chart I-14Caterpillar And Komatsu Sales: Shrinking   However, a caveat is in order: both Caterpillar and Komatsu have manufacturing factories in China, ranking the third and seventh place in terms of domestic excavator sales, respectively. Hence, domestic producers also include some multinationals that have established operations on the mainland. A point on equity valuations is also in order: Chart I-15 demonstrates the cyclically adjusted P/E ratio for Caterpillar. This stock is not yet cheap. As its sales contract, the stock price will fall further. Chart I-15Cyclically-Adjusted P/E Ratio For Caterpillar: Not Cheap Chart I-16Global Machinery Stocks Are At Risk Overall, trailing EPS of both global construction machinery companies and mainland producers listed on the A-share market are beginning to contract (Chart I-16). This entails that their share prices are at risk.   On the whole, we recommend avoiding or underweighting global machinery stocks. Ellen JingYuan He Associate Vice President ellenj@bcaresearch.com     Footnotes 1 Please note that all the Chinese construction machinery sales data used in this report are compiled by China Construction Machinery Association. Based on the Association’s definition, its sales data Include exports and domestic sales of domestically produced machineries, but exclude imports. However, exports are small so this sales data can be used as a proxy of domestic demand. 2 This measure includes not only “commodity buildings” but also buildings built by non-real estate developers.

Highlights Portfolio Strategy Boeing’s 737 MAX grounding, China’s looming slowdown on the back of the coronavirus epidemic and weak industry operating metrics, all warrant a downgrade alert in the US aerospace index. Red hot demand for defense capital goods, defense industrial production that is firing on all cylinders, enticing industry operating metrics and pristine balance sheets, all suggest that it still pays to be long the pureplay defense index. Recent Changes There are no changes to our portfolio this week. Table 1 Feature Equities remained untethered last week, and floated skyward to fresh all-time highs. The second panel of Chart 1 shows that from a technical perspective the SPX has returned close to the early-2018 blow-off top level, when the deviation from its 200-day moving average reached a zenith. Similarly, drilling beneath the surface the percentage of S&P 500 groups trading above their 50-day and 200-day moving averages in absolute terms is also running high (third panel, Chart 1). Investor complacency reigns supreme. The coronavirus scare lasted a few days and despite AAPL’s recent warning, which is likely the tip of the iceberg and other companies are slated to issue Q1 profit warnings, investors are ignoring all the bad news and piling into equities in general and teflon-tech stocks in particular. Keep in mind that 12-month forward profit growth remains positively correlated with the 10-year US treasury yield. The former crested in early 2020, predating the coronavirus epidemic (bottom panel, Chart 1). The end result is a new multiple expansion phase with the S&P 500 forward P/E clearing the 19 handle. Chart 1Dizzying Heights Such complacency transcends the equity market and spills over to the junk bond market. The hunt for yield remains intact and the Barclays US total return high yield index is following up the path of the SPX. Momentum is also tracking closely the broad equity market (top & middle panels, Chart 2). Nevertheless, we remain cautious. Last week we highlighted that the “tenuous trio” cannot go up indefinitely and a simultaneous rise in all three asset classes (stock prices, bond prices and the US dollar) typically portends an equity market crack.1 The big risk is that a surging greenback will short-circuit EPS growth and our worst case EPS scenario of -1% profit growth in calendar 2020 as we highlighted in mid-January will materialize.2 Worrisomely, while the S&P 500 made fresh all-time highs last week, the DXY came close to breaking above par, the VIX stayed stubbornly glued near 15 and gold bullion eclipsed $1,600/oz (third & bottom panels, Chart 2). Something has got to give. Meanwhile, Chart 3 updates our Corporate Pricing Power Indicator (CPPI) that recently came out of the deflation zone. This tick up in the CPPI coupled with still softening wage inflation have pushed our S&P 500 profit margin proxy slightly higher but still below the zero line, signaling that the margin contraction phase will likely run its course this year (bottom panel, Chart 3). Chart 2Spiking Greenback And Bullion Signal Trouble Chart 3Modest Profit Margin Improvement Drilling beneath the surface, our CPPI remains soft and vulnerable to a deflationary shock if the coronavirus epidemic severely wounds the global economy. As a reminder, we calculate industry group pricing power from the relevant CPI, PPI, PCE and commodity growth rates for each of the 60 industry groups we track. Table 2 also highlights shorter term pricing power trends and each industry's spread to overall inflation. Table 2Industry Group Pricing Power A bit less than half of the industries we cover are lifting selling prices by more than 1%, and 35% are outright deflating. Worrisomely, 60% of the sectors we cover fail to raise prices at a faster clip than overall inflation. With regard to pricing power trends, roughly half of the industries we cover are either flat or in a downtrend (Table 2). Gold bullion remains on top of our table climbing at a 22%/annum rate despite the greenbacks recent rise, and only five additional commodity-related industries made it to the top thirty (Table 2). Most of the commodity complex is deflating courtesy of the appreciating US dollar, and the recent coronavirus epidemic will definitely sustain the downward pressure on commodity inflation as demand will likely suffer a major setback. Importantly, defensive sectors still occupy half of the top ten spots, similar to our last update in October 2019. On the flip side, four of the bottom eight industries are commodity related, a trend we expect to pick up steam in the coming quarters. This week we update our views on the two industrials sub-groups that are moving in opposite directions. Put The Aerospace Index On Downgrade Watch We are compelled to put the pureplay aerospace subgroup (currently rated neutral) on downgrade alert. A little over four years ago, we split the aerospace & defense coverage into pureplay aerospace and pureplay defense, as the profit drivers of these two industries started to steeply diverge. True, the yet to be completed UTX acquisition of RTN will re-complicate matters, but we will continue to cover these two groups independently. From a technical perspective, a head and shoulders pattern has likely formed, warning that the next leg down will be a rather painful one, especially if support at current levels gives way (top panel, Chart 4). Boeing (BA) dominates the pureplay aerospace subgroup and sustained delays to recertify the 737 MAX have weighed heavily on share prices. While the FAA and other country air safety regulators may give the green light for flights to resume for Boeing’s workhorse commercial jetliner, consumers may be reluctant to board this plane given all the negative publicity. This remains a big risk to BA and thus to the aerospace index. Chart 4Prior To Coronavirus Epidemic… On the macro front, prior to the coronavirus epidemic, the global PMI was on the path to recovery with a plethora of countries climbing above the boom/bust line (middle & bottom panels, Chart 4). In China specifically, Bloomberg’s story count of China slowdown has returned to the historical lower band of this time series, at a time when BCA’s Chinese credit & fiscal easing impulses were ticking higher (second & third panels, Chart 5). Tack on the ongoing Chinese monetary easing, and factors were falling into place for a robust recovery in demand for US aerospace products (bottom panel, Chart 5). Chart 6 shows why China is so important to this industry. Not only is future commercial aircraft demand growth centered round China, but also China at the recent peak accounted for 15% of total US aerospace exports. In fact, aerospace exports to China tripled since the GFC. Chart 5…Macro Data Were Firming Chart 6China Matters Most To Aerospace Unfortunately, the coronavirus epidemic changes all the China-related calculus and will further dampen demand for aerospace products, at least in the near-term. Granted, US aerospace sales are already nosediving and so are operating profits. Industry new orders are in a freefall of late courtesy of the 737 MAX grounding and halt in production (second & third panels, Chart 7). As a result, profit margins have collapsed probing the Great Recession lows (bottom panel, Chart 7). Similarly, aerospace shipments have taken it to the chin and inventories are sky high, whereas backlogs are contracting, albeit mildly (top, middle and fourth panels, Chart 8). Worrisomely, aerospace industrial production ground to a halt last month, with the resource utilization rate gaping down a whopping 560bps on a month-over-month basis (second & bottom panels, Chart 8). Boeing’s production ails will likely remain in place for the next three months, and sustain the downward pressure on output growth and capacity utilization. All of this suggests that profits are in for a rough ride. Chart 7737 MAX Ills… Chart 8…Weighing Heavily Executives’ knee-jerk reaction has been to tap credit lines in order to fend off this profit contraction phase, which has pushed the industry’s leverage to the stratosphere. In fact, the aerospace industry’s 3.5x net debt-to-EBITDA reading is the highest since the history of the data set, even higher than the aftermath of the 9/11 induced recession Chart 9). Finally, valuations have skyrocketed, rising to over three standard deviations above the past four decade mean. In marked contrast, relative technicals are washed out, probing two decade lows (Chart 10). Chart 9Rapid B/S Degradation Chart 10Overvalued, But Oversold In sum, Boeing’s 737 MAX grounding, China’s looming slowdown on the back of the coronavirus epidemic and weak industry operating metrics, all warrant a downgrade alert in the US aerospace index. Bottom Line: We are awaiting a bounce before downgrading the US aerospace index to a below benchmark allocation. It is now on our downgrade watch list. The ticker symbols for the stocks in the pureplay US aerospace index are: BA, UTX, TDG, TDY, TXT, HEI, SPR, HEI.A. Defense Rules Unlike their aerospace brethren, pureplay defense stocks are on fire on multiple fronts, and we reiterate our cyclical and secular (ten-year time horizon) overweight recommendations.3 Defense industrial production (IP) surpassed the end of the Cold War highs and is now in uncharted territory. On a year-over-year rate of change basis IP is running over 7% or fifteen percentage points higher than aerospace IP (Chart 11). This is a remarkable feat as overall IP is contracting and the US is still fighting off a manufacturing recession. Meanwhile, relative defense performance is in a V-shaped recovery, whereas relative aerospace performance is moving down along the right side of a lambda formation (top panel, Chart 11). As we mentioned above, M&A activity is also boosting takeover premia and the reduction of defense stock supply is bullish for stock prices (Chart 12). Chart 11Defense Is The Mirror Image Of Aerospace Chart 12Supportive M&A Upbeat defense outlays underpin relative share prices. Given that a global arms race is ongoing, demand for weapons will remain robust for the duration of this decade according to SIPRI’s estimates (Chart 13). Importantly, defense capital goods new orders are flirting with all-time highs, industry backlogs are not far behind and defense related exports are running red hot (Chart 14). Chart 13Insatiable… Chart 14…Demand… Besides the global rearmament, a global space race along with the real threat of cyberattacks – especially on governments – underscores that defense companies are well positioned to benefit from these two additional sources of revenues for years to come. This firm demand backdrop is reflected in near double digit sales growth outshining the broad market by a factor of 2:1. The last time defense sales were growing so briskly was during the Iraqi war in the early 2000s (Chart 15). However, one key difference between now and 2002 is margins. Back then profit margins were falling in the aftermath of the 9/11 induced recession. Fast forward to today and profit margins have doubled even eclipsing non-financial corporate sector margins (Chart 15). Given the industry’s high operating leverage, robust top line growth will flow straight to the bottom line and sustain the earnings-led relative share price outperformance phase. Keep in mind that not only are non-financial corporate sector profits contracting, but the sell-side community also expects defense EPS to continue to deflate in the coming twelve months (fourth & bottom panels, Chart 15). This represents a low bar for the defense industry to surpass. Defense stocks also have a fortress of a balance sheet: the net debt-to-EBITDA ratio runs below the broad market and the interest coverage ratio trounces the overall market. Tack on a soaring return-on-equity, and there is a long runway ahead for pureplay defense stocks (Chart 16). Chart 15…Underpins Operating Metrics Finally on the relative valuation front, while defense stocks trade at a massive premium to the broad market on a P/B basis, they are changing hands at a discount on both an EV/EBITDA and P/E basis. Defense stocks also command a higher dividend yield compared with the non-financial corporate sector (Chart 17). If our thesis continues to pan out, we deem that defense stocks will grow into their pricey P/B valuations, similar to what happened during the MAD doctrine era of the 1960s.4 Chart 16Fortress Of A B/S Chart 17Far From Overvalued On Most Ratios Netting it all out, red hot demand for defense capital goods, defense industrial production that is firing on all cylinders, enticing industry operating metrics and pristine balance sheets, all suggest that it still pays to be long the pureplay defense index. Bottom Line: Stay overweight the pureplay defense index both on a cyclical and secular time horizon. The ticker symbols for the stocks in this index are: LMT, RTN, NOC, GD, HII, AJRD, BWXT, CW, MRCY.   Anastasios Avgeriou US Equity Strategist anastasios@bcaresearch.com     Footnotes 1     Please see BCA US Equity Strategy Weekly Report, “Will The Fed Save The Day, Again?” dated February 18, 2020, available at uses.bcaresearch.com. 2     Please see BCA US Equity Strategy Weekly Report, “Three EPS Scenarios”, dated January 13, 2020, available atuses.bcaresearch.com. 3    Please see BCA US Equity Strategy Special Report, “Top US Sector Investment Ideas For The Next Decade” dated December 16, 2019, available at uses.bcaresearch.com. 4    Please see BCA US Equity Strategy Special Report, “Brothers In Arms” dated October 31, 2016, available at uses.bcaresearch.com. Current Recommendations Current Trades Strategic (10-Year) Trade Recommendations Size And Style Views June 3, 2019 Stay neutral cyclicals over defensives (downgrade alert)  January 22, 2018 Favor value over growth May 10, 2018 Favor large over small caps (Stop 10%) June 11, 2018 Long the BCA  Millennial basket  The ticker symbols are: (AAPL, AMZN, UBER, HD, LEN, MSFT, NFLX, SPOT, TSLA, V).

Overweight Investors tend to overreact to events such as virus epidemics, but we deem that such fears typically create trading opportunities, especially in the hardest-hit sectors. Similar to hotels (that we upgraded to neutral last week), airlines are part of the tourism-related industries that have suffered disproportionately. Were we not overweight the S&P airlines index, we would not hesitate to initiate such a position. True, consumer and business demand for air transportation services will come under pressure in the near-term, however, looking further out such demand destruction will likely prove transitory. The chart on the right highlights that the cyclical demand backdrop is robust for the US airline industry. Overall consumer outlays jumped recently, PCE services momentum is perking up, airfare PCE is outpacing overall consumer spending – an impressive feat – and consumer confidence is perched near cycle highs sustaining a wide gap with relative share prices. Bottom Line: Stay overweight the S&P airlines index. The ticker symbols for the stocks in this index are: BLBG S5AIRLX – LUV, DAL, UAL, AAL, ALK. For additional details please refer to this Monday’s Weekly Report.