Equities

Bank Credit Analyst

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

Bank Credit Analyst

As 2019 draws to a close, we thank you for your ongoing readership and support. We wish you and your loved ones a happy holiday season and all the best for a healthy and prosperous 2020. Highlights We explore the principal risks to our optimistic 2020 outlook. Trade and the 2020 US Presidential election remain potential landmines. A stronger dollar would tighten global financial conditions and be deflationary. Credit market tremors would end buybacks. Stronger-than-expected inflation would force a cycle-ending Federal Reserve tightening. Weaker-than-expected inflation would first allow for larger bubbles to form at the expense of a more painful recession and deeper a bear market down the road. Hedging against those risks warrants overweighting cash, TIPs and gold. Feature Chart I-1Timing is Ripe For A Recovery As always, this year’s visit from Ms. and Mr. X was thought-provoking and generated diverse investment ideas.1 While we did not share Mr. X’s fears, his caution may be justified because an aging business cycle, elevated equity multiples and extremely expensive government bonds do not mesh with pro-risk portfolio positioning. With this in mind, we will explore the greatest risks to our positive market outlook, which include politics, the US dollar, problems in the credit market, a quicker resumption of inflation and lower inflation. The Central Scenario To understand how these five risks affect our central thesis, let’s review the key views and themes that underpin our bullish outlook. BCA expects global economic activity to recover in 2020. First, the global inventory contraction is advanced, which increases the chance that the manufacturing cycle will track its usual pattern of an 18-month decline followed by an 18-month acceleration (Chart I-1). Secondly, Chinese policymakers are putting a floor under domestic economic activity and the stabilization in credit growth and the climbing fiscal impulse already augur well for global growth (Chart I-2). Thirdly, global liquidity is in a major upswing, thanks to easing by central banks around the world (Chart I-3). Finally, the trade détente between the US and China agreed last week reduces the odds of a destructive trade war. Chart I-2China's Policy Turnaround Chart I-3Easing Abound!   US monetary policy will remain accommodative next year. US inflation will remain subdued in the first half of 2020 in response to both the global growth slowdown underway since mid-2018 and the lagged effect of a stronger dollar. Moreover, Fed policy will remain sensitive to inflation expectations. According to BCA’s US Bond Strategy’s model, it could take an extended overshoot in realized inflation before inflation expectations move back to the 2.3% to 2.5% range consistent with achieving a 2% inflation target (Chart I-4). Thus, the Fed will remain on pause for all of 2020. BCA’s positive outlook depends on both China and the US respecting their trade truce. In this context, the dollar will depreciate. The USD is a countercyclical currency and typically suffers when global economic activity rebounds, especially if inflation remains tame (Chart I-5). This behavior is due to the low share of the US economy dedicated to manufacturing and exports, which makes the US less sensitive to global trade and industrial activity. Moreover, when the world economy strengthens, safe-haven flows that boost the dollar in times of duress reverse, which accentuates the selling pressure on the USD. Chart I-4Realized Inflation Will Guide Expectations Chart I-5The Dollar Won't Respond Well To Stronger Global Growth   Global bond prices will be another victim of an improving economic outlook. Global safe-haven securities are extremely expensive and investors are too bullish toward this asset class (Chart I-6). This puts government bonds at risk in the face of positive economic surprises. However, the upside in Treasury yields will be capped between 2.25 and 2.5% because the Fed will be cautious about lifting rates. This move will likely be led by inflation expectations. As a result, we favor TIPs over nominal Treasurys. Chart I-6Safe-Haven Yields Have Upside Chart I-7Investors Aren't Feeling Exuberant About Earnings Growth   Equities will outperform bonds. The S&P 500 is trading at 18-times forward earnings and 2.3-times sales. However, those elevated multiples are due to depressed risk-free rates. Long-term growth expectations embedded in stock prices are only 1%, toward the bottom of this series’ historical distribution (Chart I-7). Therefore, investors are not particularly optimistic on the long-term prospects of per-share earnings. This lack of euphoria implies that stocks are not as expensive as bonds, and that if yields climb because of improving global economic activity, then equities will outperform bonds. Moreover, with a backdrop of easy money and no recession forecast until 2022, the timing still favors positive returns for equities in the coming 12 to 18 months (Table I-1).   Table I-1The End Game Can Be Rewarding Finally, we favor European equities over US stocks. This regional slant is as much a reflection of the better value offered by European stocks as it is of their sector composition. European stocks are trading at a forward PE of 14, implying an equity risk premium of 846 basis points versus 546 basis points in the US. Moreover, our preference for industrials, energy and financials favors European equities (Table I-2). Additionally, European banks are our favorite equity bet worldwide because they trade at a price-to-book ratio of only 0.6 and the drivers of their return on tangible equity are perking up (Chart I-8). Table I-2Europe: Overweight In The Right Sectors Chart I-8Brightening Prospects For Euro Area Banks     Risk 1: Politics BCA’s positive outlook depends on both China and the US respecting their trade truce. However, the two countries are long-term rivals and the rising geopolitical power of China relative to the US will cause tensions to escalate in the coming decades (Chart I-9). This also suggests that China and the US are highly unlikely to ever have an agreement that fully covers intellectual property transfers. Chart I-9China/US Tensions Are Structural The US could still renege on the “Phase One” deal. President Trump faces an election in 2020 and the majority of Democratic hopefuls are also hawkish on China. If Trump’s low approval rating does not improve soon (Chart I-10), he could become a more war-like president, in the hope that electors will rally around the flag. A renewed trade war would hurt business sentiment and undermine consumer spending (Chart I-11). A bellicose approach to international relations, especially on trade, would spark another spike in global policy uncertainty that will hurt global capex intentions. Meanwhile, companies could cut employment, which would weigh on household incomes. A rising unemployment rate could also hurt household confidence, reinforcing the slowdown in consumer spending. This would guarantee an earlier recession. Stocks would decline along with global government bond yields. Chart I-10President Trump Can Still Make It Chart I-11Households On The Edge   The US election creates an additional political risk. Democratic candidates are touting higher corporate taxes, a wealth tax, a greater regulatory burden, antitrust actions, and so on. These policies are worrisome to corporate leaders and business owners. For the time being, our Geopolitical Strategy team favors a Trump victory in 2020 (Chart I-12).2 However, if his odds deteriorate significantly, then business executives would likely curtail capex and hiring. This could also result in a US recession that would invalidate our central scenario for 2020. Chart I-12Our Model Still Favors President Trump Risk 2: A Strong Dollar A strong US dollar would hurt growth. A continued dollar rally would counteract a large proportion of the easing in liquidity conditions created by accommodative central banks around the world. The dollar affects the global cost of capital. Both advanced economies and emerging markets have USD-denominated foreign currency debt totaling around $6 trillion each. A strong USD raises the cost of servicing this large debt load, which could force borrowers to curtail their spending. A continued dollar rally would counteract a large proportion of the easing in liquidity conditions created by accommodative central banks around the world. Despite our conviction that the US dollar will depreciate in 2020, the following factors may invalidate our thesis: The USD still possesses the highest carry in the G10. When the dollar is supported by some of the highest interest rates in the G10, it often continues to rally (Chart I-13). Chart I-13The Dollar Offers An Elevated Carry The global growth rebound may be led by the US. If the US leads the rest of the world higher, then rates of return in the US would climb quicker than in the rest of the world. The resulting capital inflows would bid up the dollar. The shortage of USDs in offshore markets may flare up again. The September seize-up in the repo market was a reminder that because of the Basel III rules, global banks have a strong appetite for high-quality collateral and reserves. This generates substantial demand for the USD, which could put upward pressure on its exchange rate. The US dollar is a momentum currency. Among the G10 currencies, the USD responds most strongly to the momentum factor (Chart I-14).3 The dollar’s strength in the past 18 months could initiate another wave of appreciation. The dollar may not be as expensive as suggested by purchasing power parity (PPP) models. According to PPP estimates, the trade-weighted dollar is 24.2% overvalued. However, according to behavioral effective exchange rate models (BEER), the dollar may be trading closer to its fair value (Chart I-15). Chart I-14The Dollar Is A Momentum Currency Chart I-15Is The Dollar Expensive?   Why are the five items listed above risks for the dollar, but not our central scenario? Regarding the dollar’s carry, in 1985, 1999, and 2006, the US still offered some of the highest short-term interest rates among advanced economies, nevertheless the dollar began to depreciate. In those three instances, an acceleration in foreign economic activity relative to the US was the key culprit behind the USD’s weakness. In 2020, we expect foreign economies to lead the US higher. Since mid-2018, the manufacturing sector has been at the center of the global slowdown. But now, inventory and monetary dynamics point towards a re-acceleration in manufacturing activity. The US was the last nation to be hit by the growth slowdown; it will also be the last to reap a dividend from the recovery. The marginal buyers of US equities have been US firms. On the danger created by the dollar and the collateral shortage, the Fed is tackling the lack of excess reserves head-on by injecting $60 billion per month of reserves via its asset purchases. Moreover, the US fiscal deficit, which is tabulated to reach $1.1 trillion in 2020, will add a similar amount of dollars to the pool of high-quality collateral around the world, especially as the US current account deficit is widening anew. On the momentum tendency of the USD, the dollar’s momentum seems to be petering off. A move in the Dollar Index below 96 would indicate a major change in the trend for the DXY. Finally, estimates of a currency’s fair value based on BEER fluctuate much more than those based on PPP. If the global growth pick-up allows foreign neutral rates to increase relative to the US over the coming 12 to 24 months, then the dollar’s BEER equilibrium will likely converge toward PPP, putting downward pressure on the USD. Risk 3: Credit Market Tremors A credit market selloff is not our base case, but it would be damaging to risk assets. A deterioration in credit quality would be the main culprit behind a widening in credit spreads. Our Corporate Health Monitor already shows that the credit quality of US firms is worsening (Chart I-16). Moreover, the return on capital of the US corporate sector is rapidly deteriorating. Accentuating these risks, US profit margins have begun to decline because a tight labor market is exerting an upward pull on real unit labor costs (Chart I-17). Furthermore, the near-total disappearance of covenants in new corporate bond issuance increases the risks to lenders and will likely depress recovery rates when a default wave emerges. Chart I-16Deteriorating Fundamentals For US Corporates Chart I-17A Tight Labor Market Is Biting Into Margins     Widening credit spreads would signal a darkening economic outlook. Historically, wider spreads have been an excellent leading indicator of recessions (Chart I-18). Wider spreads have a reflexive relationship with the economy: they reflect anticipation of rising defaults by investors, but they also represent a price-based measure of lenders’ willingness to extend credit. Therefore, wider spreads force open the underlying cracks in the economy by depriving funds to weak borrowers. The resulting deterioration in capex and hiring would prompt a decline in consumer confidence and spending, ultimately leading to a recession. Chart I-18Widening Spreads Foreshadow Recessions Chart I-19Who Is Buying Stocks? Businesses! US equities may prove to be even more sensitive to the health of the credit market than in previous cycles. The marginal buyers of US equities have been US firms, which have engaged in equity retirements totaling $16.5 trillion since 2010. Since that date, pension plans, foreigners and households have sold a total of $7.7 trillion in US equities (Chart I-19). Both internally generated cash flows and borrowings have allowed for a decline in the equity portion of funding among US firms. Therefore, a weak credit market would hurt equities because a recession would depress firms’ free cash flows and hamper the capacity of firms to buy back their shares. Finally, the tendency of US firms to borrow to buy back their shares means that newly issued debt has not been matched by as much asset growth as in previous cycles. Therefore, borrowing is not backed by the same degree of collateral as in past cycles. If the credit market seizes up, then default and recovery rates will suffer even more than suggested by our corporate health monitor. The VIX will blow up and equities could suffer. Higher US inflation is potentially the most important downside risk for next year. While a widening in credit spreads would have a profound impact on stocks, it is unlikely to materialize when the Fed conducts a very accommodative monetary policy and global growth recovers. Risk 4: Higher Inflation Chart I-20The US Labor Market Is Tight Higher US inflation is potentially the most important downside risk for next year as it would catalyze the aforementioned dangers. Inflation could surprise to the upside because the labor market is tight. At 3.5%, the unemployment rate is well below equilibrium estimates that range between 4.1% and 4.6%. Small firms are increasingly citing their inability to find qualified labor as the biggest constraint to expand production. In the Conference Board Consumer Confidence survey, the number of households reporting that jobs are easily procured is near a record high relative to those preoccupied by poor job prospects. Finally, the voluntary quit rate is at 2.3%, a near record high (Chart I-20). Core PCE remains at only 1.6% year-on-year, but investors should recall the experience of the late 1960s. Through the 1960s, the labor market was tight, yet core inflation remained between 1% and 2%. However, in 1966, inflation suddenly accelerated to 4% before peaking near 7% in 1970. Some inflation dynamics warrant close monitoring. The three-month annualized rate of service inflation excluding rent of shelter has already surged to 4.5% and the same metric for medical care inflation stands at 5.9%. A continued tightening in the labor market could solidify a broadening of these trends because a rising employment-to-population ratio for prime-age workers points toward stronger salaries and ultimately higher domestic demand (Chart I-21). A very weak dollar would also allow this scenario to develop. Chart I-21Household Income Growth Will Accelerate A sudden flare in inflation would prompt an abrupt tightening in liquidity conditions that would be lethal for the economy. An out of the blue surge in CPI would likely cause a swift reassessment of inflation expectations by households and investors. Under these circumstances, the Fed could tighten monetary policy much faster than we currently envision. If interest rate markets are forced to price in a prompt removal of monetary accommodation, Treasury yields could easily spike above 3.5% by year end, which would hurt both the economy and the expensive equity market. If realized inflation turns out weaker than we expect in 2020, then central banks will maintain accommodative policies beyond next year. For now, this scenario remains a tail risk because the recent economic slowdown will probably continue to act as a dampener on US inflation in the first half of the year. Additionally, we do not expect the USD to collapse by 40% and fan inflation and inflation expectations, as occurred from 1985 to 1987. Instead, inflation expectations are much better anchored than they were in either the 1960s or 1980s, decreasing the risk that the Fed will suddenly have to tighten policy. Risk 5: Weaker-Than-Expected Inflation Chart I-22An Aggressive BoJ Did Not Achieve Inflation The last risk is paradoxical, but it is the one with the highest probability. It is paradoxical because it involves greater upside for stocks next year than we currently anticipate, but at the expense of a much deeper bear market in the future. The labor market may be tight, but Japan’s experience cautions us against extrapolating that inflation is necessarily around the corner. In Japan, the unemployment rate has been below 3.5% since 2014 and minimal domestically generated inflation has emerged. Inflation excluding food and energy remains at a paltry 0.7% year-on-year, even as the Bank of Japan has kept the policy rate at -0.1% and expanded its balance sheet from 20% of GDP in 2008 to 102% today (Chart I-22). If realized inflation turns out weaker than we expect in 2020, then central banks will maintain accommodative policies beyond next year. Central banks are currently toying with their inflation targets, discussing allowing inflation overshoots and displaying deep paranoia in the face of deflation. By weighing on inflation expectations, low realized inflation would nail policy rates around the world at currently depressed levels or even lower. Chart I-23Bubbles Destroy Long-Term Return On Capital In this context, bond yields would have even more limited upside than we envision and risk assets could experience higher multiples than today. In other words, we would have a perfect scenario for another stock market bubble. Vulnerability would escalate as valuations balloon and the perceived risk of monetary tightening dissipates from both investors’ and economic agents’ minds. Elevated asset valuations portend lower long-term expected returns (Chart I-23) and a larger share of the capital stock would become misallocated. Ultimately, the stimulative impact of such a bubble would create its own inflationary pressures. Consumers and companies would accumulate more debt and cyclical spending would rise (Chart I-24). In the end, the Fed would raise rates more aggressively, but the economy would be more vulnerable to those higher rates. Chart I-24Higher Cyclical Spending Creates Vulnerabilities Therefore, we would see a larger recession and, because assets are more expensive, a greater decline in prices. This would be extremely destabilizing for the global economy, potentially much more so than if a recession were to emerge today. Moreover, since the resulting slump would be yet another balance-sheet recession, it would likely entail a lack of capacity by central banks to reflate their economies. Conclusion The scenarios above are all risks to our benign view for 2020. The first four represent downside threats for assets next year, but the last one (weaker-than-expected inflation) entails upside potential to our forecast next year with significantly more painful results down the line. These risks are important to consider when protecting our portfolio, which has a pro-cyclical bias. It is overweight stocks, underweight bonds, and favors cyclical equities as well as foreign bourses at the expense of the US. BCA’s Global Asset Allocation service recently published an article on safe havens, which studied the profile of risk assets under various circumstances.4 Treasurys normally are the best safe haven, however, at current levels of yields, this benefit will be small compared with previous cycles. Instead, we favor an overweight position in cash, TIPs and gold. The best defense against short-term gyrations is to think about long-term strategic asset allocation. In this regard, this month’s Special Report – co-authored with BCA’s Equity, Geopolitical and Foreign Exchange Strategists, and Marko Papic, Chief Strategist at Clocktower Group – discusses our top sector calls for the upcoming decade. Mathieu Savary Vice President The Bank Credit Analyst December 20, 2019 Next Report: January 30, 2020   II. Top US Sector Investment Ideas For The Next Decade Every decade a dominant theme captures investors’ imaginations and morphs into a bubble. Massive speculation typically propels the relevant asset class into the stratosphere as investors extrapolate the good times far into the future and go on a buying frenzy. Chart II-1 shows previous manic markets starting with the Nifty Fifty, gold bullion, the Nikkei 225, the NASDAQ 100, crude oil and most recently the FAANGs. Chart II-1Manias: An Historical Roadmap What will be the dominant themes of the next decade? How should investors capitalize on some of these big trends? The purpose of this Special Report is to identify and provoke a healthy debate on the prevailing investment themes for the 2020s and to speculate on what the key US sector beneficiaries and likely losers may be. Theme #1: De-Globalization Picks Up Steam The first investment theme for the upcoming decade is the “apex of globalization” or “de-globalization”. We have written about this theme extensively at BCA Research and it is the mega-theme of our sister Geopolitical Strategy (GPS) service. Odds are high that countries will continue looking inward as the US adopts a more aggressive trade policy, China’s trend growth slows, and US-China strategic tensions intensify. The small cap preference is a secular view with a time horizon that spans the next decade. Chart II-2 shows that we are at the conclusion of a period of tranquility. Pax Americana underpinned globalization as much as Pax Britannica before it. The US is in a relative decline after decades of geopolitical stability allowed countries like China to rise to “great power” status and rivals like Russia to recover from the chaos of the 1990s. Chart II-2De-globalization Has Commenced De-globalization has become the consensus since the election of Donald Trump. But Trump is not the prophet of de-globalization; he is its acolyte. Globalization is ending because of structural factors, not cyclical ones. Three factors stand at the center of this assessment, outlined in our 2014 Special Report, “The Apex Of Globalization – All Downhill From Here”: multipolarity, populism and protectionism. Events have since confirmed this view. One final long-term playable investment idea from the apex of globalization is a structural bull market in defense stocks. The three pillars of globalization are the free movement of goods, capital, and people across national borders. We expect to see marginally less of each in the future. Investment Implication #1: Profit Margin Peak The most profound and provocative investment implication from de-globalization is that SPX profit margins have peaked and will likely come under intense pressure, especially for US conglomerates that – on a relative basis to international peers – most enthusiastically embraced globalization. Chart II-3 shows reconstructed S&P 500 profits and sales data back to the late-1920s. Historically, corporate profit margins and globalization (depicted as global trade as a percentage of GDP) have been positively correlated. Chart II-3Profit Margin Trouble As countries are more outward looking, trade flourishes and openness to trade allows the free flow of capital to take advantage of profit-maximizing projects. Following the Great Recession and similar to the Great Depression, trade has suffered and trade barriers have risen. The Sino-American trade war has accelerated the inward movement of countries, including Korea and Japan, and has had negative knock-on effects on trade as evidenced by the now two-year old global growth deceleration. China’s response to President Trump’s election was to redouble its pursuit of economic self-sufficiency, which meant a crackdown on corporate debt and a fiscal boost to household consumption. Trump’s tariffs then damaged sentiment and trade between the two countries. Any deal reached prior to the 2020 US election will remain in doubt among global investors. The longer the trade war remains unresolved, the deeper the cracks will be in the foundations of the global trading system. We are especially worried for the S&P interactive media & services index that includes GOOGL and FB. Such a backdrop is negative for profit margins, as inward looking countries prevent capital from being allocated most efficiently. Moreover, the uprooting of supply chains due to the trade war hurts margins and the redeployment of equipment in different jurisdictions will do the same at a time when final demand is suffering a setback. In addition, rising profit margins are synonymous with wealth accruing to the top 1% of US families and vice versa. This relationship dates back to the late-1920s, as far back as our dataset goes. Using Piketty and Saez data, which exclude capital gains, it is clear that profit margin expansion exacerbates income inequality (top panel, Chart II-4). Chart II-4Heightened Risk Of Wealth Re-distribution Expanding margins lead to higher profits. Because families at the top of the income distribution are often business owners, income disparities are the widest when margins are in overshoot territory. Eventually this income chasm comes to a head and generates political discontent. Populism has emerged on both the right and left wings of the US political spectrum – and since the rise of Trump, even Republicans complain about inequality and the excesses of “corporate welfare” and laissez-faire capitalism. Because inequality is extreme – relative to America’s developed peers – and political forces are mobilizing against it, the probability of wealth re-distribution is rising in the coming decades (middle panel, Chart II-4). Labor’s share of national income has nowhere to go but higher in coming years and that is negative for profit margins, ceteris paribus (bottom panel, Chart II-4). Buy or add software stock exposure on any weakness with a 10-year investment time horizon. Drilling beneath the surface, the three secular US equity sector/factor implications of the apex of globalization paradigm shift are: prefer small caps over large caps prefer value over growth overweight the pure-play BCA Defense Index Investment Implication #2: Small Is Beautiful Chart II-5It's A Small World After All While a small cap bias is contrary to the cyclical US Equity Strategy view of preferring large caps to small caps, the issue is timing: the small cap preference is a secular view with a time horizon that spans the next decade. The small versus large cap share price ratio’s ebbs and flows persist over long cycles. Small caps outshined large caps uninterruptedly from 1999 to 2010. Since then large caps have had the upper hand (Chart II-5). Were the apex of globalization theme to gain traction in the 2020s, small caps should reclaim the lead from large caps, especially in the wake of the next US recession. Similar to the death of the global banking model, companies with global footprints will suffer the most, especially compared with domestically focused outfits. One way to explore this theme is via domestic versus global sector preference. But a more investable way to position for this sea change, is to buy small caps (or microcaps) at the expense of large caps (or mega caps). Small caps are traditionally domestically geared compared with large caps that have significantly more foreign sales exposure. The closest ETF ticker symbols resembling this trade is long IWM:US/short SPY:US. Investment Implication #3: Buy Value At The Expense Of Growth Similar to the size bias, the style bias also moves in secular ways. Value outperformed growth from the dot com bust until the GFC. Since then growth has crushed value, even temporarily breaking below the year 2000 relative trough. This breakneck pace of appreciation for growth stocks is clearly unsustainable and offers long-term oriented investors a compelling entry point near two standard deviations below the historical mean (Chart II-6). Chart II-6Value Has The Upper Hand Versus Growth Financials populate value indexes, a similarity with small cap outfits. Traditionally, financials are a domestically focused sector with export exposure registering at half of the S&P’s average 40% level of internationally sourced revenues. On the flip side, tech stocks sit atop the growth table and they garner 60% of their revenue from abroad. This value over growth style preference will pay handsome dividends if the de-globalization theme becomes more mainstream as countries become more hawkish on trade and the Sino-American war continues to erect barriers to trade that took decades to lift. We have created a basket of ten stocks that we think will be driven over the long term by the demographic rise of the Millennial. The caveat? President Trump's recent short-term deal with China could set back the de-globalization theme. But our geopolitical strategists do not anticipate it to be a durable deal, and they also expect the trade war to resume in some way, shape or form in 2021-22, regardless of the outcome of the US election. The closest ETF ticker symbols resembling this trade is long IVE:US/short IVW:US. Investment Implication #4: Defense Fortress Chart II-7Stick With Pure-play Defense Stocks One final long-term playable investment idea from the apex of globalization is a structural bull market in defense stocks (Chart II-7). The US Equity Sector service's October 2016 “Brothers In Arms” Special Report drew parallels with the late nineteenth century period of European rearmament, and the American and Soviet arms race of the 1960s.5 These movements were greatly beneficial to the aerospace and defense industry. Currently, the move by several countries to adopt more independent foreign policies, i.e. to move away from collaboration and cooperation toward isolationism and self-sufficiency, entails an accompanying arms race. Table II-1 China’s challenge to the regional political status quo motivates a boost to defense spending globally. In fact, SIPRI data on global military spending by 2030 (Table II-1) increases our conviction that this trade will succeed on a five-to-ten year horizon. Beyond the global arms race, two additional forces are at work underpinning pure-play defense contractors. A global space race with China, India and the US wanting to have manned missions to the moon, and the rise of global cybersecurity breaches. Defense companies are levered to both of these secular forces and should be prime sales and profit beneficiaries of rising space budgets and increasing cybersecurity combat budgets. The ticker symbols for the stocks in the pure-play BCA defense index are: LMT, RTN, NOC, GD, HII, AJRD, BWXT, CW, MRCY. Theme #2: Tech Sector Regulation, US Enacts Privacy Laws The second long-term geopolitical theme that we are exploring is the regulatory or “stroke of pen” risk that is rising on FAANG stocks – Facebook, Apple, Amazon, Netflix, and Google. These companies were this decade’s undisputed stock market winners. The US anti-trust regulatory framework was designed to curb broad anti-competitive actions of trusts. As Lina Khan discusses in her seminal article, these actions “include not only cost but also product quality, variety, and innovation.” However, through subsequent regulatory evolution, the Chicago School has focused the US anti-trust process on consumer welfare and prices. If President Reagan and the courts could change how anti-trust laws were administered in the 1980s, so too can future administrations and courts. Today the US Congress, on both sides of the aisle, is looking into regulatory tightening, while the judicial system will take longer to change its approach. Moreover, the impetus for tougher anti-trust policy is here. It comes from a long period of slow growth, income inequality, and economic volatility – such as in the 1870s-80s. This was certainly the case for Standard Oil in 1911, which became a nation-wide boogeyman despite most of its transgressions occurring in the farm belt states. Today, income inequality is a prominent political theme and source of consumer discontent. A narrative is emerging – which will be super-charged during the next recession – that growth has been unequally distributed between the old economy and the twenty-first century technology leaders. While there are a few ESG related ETFs, we would rather explore this theme’s investment implications of sectors to avoid in the coming decade. With regard to privacy, the news is equally grim for large tech outfits. The EU General Data Protection Regulation (GDPR), which came into force on May 2018, imposes compliance burdens on any company handling user data. In the US, California has signed its own version of the law – the Consumer Privacy Act – which will go into effect in January 2020. These laws give consumers the right to know what information companies are collecting about them and who that data is shared with. They also allow consumers to ask technology companies to delete their data or not to sell it. While tech companies are likely to fight the new California law, and the US court system is a source of uncertainty, we believe the writing is on the wall. The EU is by some measures the largest consumer market on the planet. California is certainly the largest US market. It is unlikely that the momentum behind consumer protection will change, especially with the EU and California taking the lead. The odds of a federal privacy law, following in the footsteps of the Consumer Privacy Act, are also rising. Investment Implication #5: Shun Interactive Media & Services Stocks These risks introduce a severe overhang for FAANG stocks. We are especially worried for the S&P interactive media & services index that includes GOOGL and FB. Chart II-8Regulation Will Squeeze Tech Margins Tack on the threat of federal regulation and this represents another major headwind for profits and margins that are extremely elevated for these near monopolies. Given that advertising revenue is crucial to the business model of social media companies (GOOGL and FB included), a significant uptick in privacy regulation will likely hurt their bottom line. With regard to profit margins, tech stocks in general command a profit margin twice as high as the SPX. Specifically, FB and GOOGL enjoy margins that are 500 basis points higher than the broad tech sector (Chart II-8)! This is unsustainable and they will likely serve as easy prey for policymakers. Our view does not necessarily call for breaking up these monopolies. The US will have to weigh the economic consequences of anti-trust policy in a context of multipolarity in which China’s national tech champions are emerging to compete with American companies for global market share. Nevertheless, increased regulation is inevitable and some forced sales of crown jewel assets may take place. Moreover, the threat of a breakup will lurk in the background, creating uncertainty until key legislative and judicial battles have already been fought. That will take years. Finally, we doubt the tech sector will be left alone to “self-regulate” its incumbents and negotiate a price on consumers’ privacy. More likely, a new privacy law will loom, serving as a negative catalyst for profit growth. Uncertainty will weigh on the S&P interactive media & services relative performance. The ticker symbols to short/underweight the S&P interactive media & services index are an equally weighted basket of GOOGL and FB (they command a 98% market cap weight in the index). Theme #3: SaaS, Artificial Intelligence, Augmented Reality And Autonomous Driving Are Not Fads The third big theme that will even outlive the upcoming decade is the proliferation of software as a service (SaaS). The move to cloud computing and SaaS, the wider adoption of artificial intelligence, machine learning, autonomous driving and augmented reality are not fads, but enjoy a secular growth profile. In the grander scheme of things today’s world is surrounded by software. Millions of lines of code go even into gasoline powered automobiles, let alone electric vehicles. Autonomous driving is synonymous with software, the Internet of Things (IoT) needs software, the space race depends on software, modern manufacturing and software are closely intertwined, phone calls for quite some time have been a software solution, and the list goes on and on. This tidal effect is hard to reverse and is already embedded in workflows across industries. Opportunities to penetrate health care and financial services more deeply remain unexplored and it is difficult to envision another competing industry unseating “king software”. These secular trends are not only productivity enhancing, but will also most likely prove recession-proof. When growth is scarce investors flock to any source of growth they can come by and we are foreseeing that when the next recession arrives, investors will likely seek shelter in pure play SaaS firms. Investment Implication #6: Software Is Eating The World Chart II-9Software Is Eating The World Buying software stocks for the long haul seems like a bulletproof investment idea. But the recent stellar performance of software stocks has moved valuations to overshoot territory. Our recommended strategy is to buy or add software stock exposure on any weakness with a 10-year investment time horizon. All of these secular trends have pushed capital outlays on software into a structural uptrend. Software related capex is not only garnering a larger slice of the tech spending budgets but also of the overall capex pie. If it were not for software capex, the contraction in non-residential investment in recent quarters would have been more severe (Chart II-9). Private sector software capex is near all-time highs as a share of total outlays. Government investment in software is also reaccelerating at the fastest pace since the tech bubble. When productivity gains are anemic, both the business and government sectors resort to software upgrades in order to boost productivity. Cyber security is another more recent source of software related demand as governments around the globe are taking such risks extremely seriously (bottom panel, Chart II-9). Given this upbeat demand backdrop and ongoing equity retirement, software stocks are primed to grow into their pricey valuations. Finally, this long-term trade will also serve as a hedge to the short/underweight position we recommend in the S&P interactive media & services index. The closest ETF ticker symbol resembling the S&P software index is IGV:US. Theme #4: Millennials Already Are The Largest Cohort And Will Dominate Spending The fourth long-term theme we anticipate to gain traction in the 2020s is the demographic rise of the Millennial generation. Much has been made of preparing for the arrival of the Millennial generation, accompanied by well-worn stereotypes of general "failure to launch" as they reach adulthood. However, "arrival" is a misnomer as this age cohort is already the largest and "failure" is simply untrue. According to the US Census Bureau, Millennials are the US’s largest living generation. Millennials (or Echo Boomers) defined as people aged 18 to 37 (born 1982 to 2000), now number more than 80mn and represent more than one quarter of the US’s population. Baby Boomers (born 1946 to 1964) number about 75mn. Stealthily becoming the largest age group in the US over the last few years, Millennials per-year-birth-rate peaked at 4.3mn in 1990. Surprisingly, the pace matched that of the post-war Baby Boom peak-per-year-birth-rate in 1957 - the per-year average over the period was higher for the Baby Boomers (Chart II-10). Chart II-10Millennials Are The Largest Cohort This gap is now set to grow rapidly as the death rate of Baby Boomers accelerates. What is more, the largest one-year age cohort is only 25 years old, thus, Millennials will be the dominant generation for many years. It is unclear how these “kids” will impact the market as they become the most important consumers, borrowers and investors, but make no mistake: this is a seismic shift in economic power and it is here to stay. The Echo Boom is a big, generational demographic wave. A difficult and painful delay has not tempered its looming importance. Finally, this wave of echo-boomers is educated, relatively unburdened by debt (please see BOX in the June 11, 2018 Special Report on demystifying the student debt load as it pertains to Millennials), and as they inevitably “grow up”, form new households and have kids. They will borrow, spend, earn, but not necessarily save and invest to the same extent as the Boomers. And this will be an important long-term theme going forward. Near term, we might already be seeing signs of their arrival and firms have begun to pivot accordingly. Investment Implication #7: Buy The BCA Millennials Equity Basket Millennials will boost consumption spending in a number of different ways. The relatively unburdened Millennial cohort will be entering prime home acquisition age soon and this should underpin the long-term prospects of the US housing market and related industries. Furthermore, Millennials consume differently from their parents; social media, online shopping and smart phones are not the consumption categories of the Baby Boomers. With this in mind, we have created a basket of ten stocks that we think will be driven over the long term by the demographic rise of the Millennial. We note that these stocks are heavily weighted to the technology and consumer discretionary sectors, which is logical as Millennial consumption habits tend to be discretionary focused and technology-based. Beginning with consumer discretionary, we are highlighting AMZN, NFLX and SPOT as core holdings in our Millennials basket. AMZN’s heft dwarfs consumer discretionary indexes but it could fall in several categories; the acquisition of Whole Foods makes it a Millennials-focused consumer staples retailer and its cloud computing web services segment is a tech leader. NFLX and SPOT represent the means by which Millennials consume media, by streaming movies and music over the internet. The idea of owning physical media is rapidly becoming an anachronism. The home ownership theme noted in this report leads us to add HD and LEN to the basket. Millennials are “doers” and are set to be the dominant DIYers in the next few years, making HD a logical choice. LEN, as the nation’s largest home builder, should benefit from the Millennials coming of age into home buyers. We are also adding TSLA to our basket as a lone clean tech-oriented equity. TSLA capitalizes on the increasing shift to clean energy of Millennials (the key reason why no traditional energy companies have a spot in our basket). Chart II-11Buy BCA's Millennial Equity Basket The technology stocks in our Millennials basket are AAPL, UBER (which replaces FB as of today) and MSFT, together representing more than 9% of the total value of the S&P 500. AAPL’s inclusion in the list is predictable as the leading domestic purveyor of devices on which Millennials consume media content. FB is a predictable holding, with more than half of all Americans being monthly active users, dominated by the Millennial cohort. It has served our basket well since inception, but today we are compelled to remove it and replace it with UBER. UBER is a Millennial favorite and the epitome of the sharing economy. In reality UBER is a logistics company and while it is losing money, it is eerily reminiscent of AMZN in its early days. Maybe UBER will dominate all means of transportation and its ease of use will propel it to a mega cap in the coming decade. Our inclusion of MSFT is based on its leadership in cloud computing, a rapidly growing industry. We expect the connectivity and mobile computing demands of Millennials will accelerate. The last stock we are adding to our basket is also the only financial services equity. Though avid consumers, Millennials have shown an aversion to cash, preferring card payment systems, including both debit and credit-based. Accordingly, we are adding the leader in both of these, V, to our Millennials basket (Chart II-11). Investors seeking long-term exposure to stocks lifted by the supremacy of the Millennial generation should own our Millennial basket (AAPL, AMZN, UBER, HD, LEN, MSFT, NFLX, SPOT, TSLA, V). We would not hesitate to add other sharing economy stocks, including Airbnb, to this basket should they become investable in the near future. Theme #5: ESG Becomes Mainstream Investors are increasingly looking at allocating assets based on environmental, social, and governance (ESG) considerations, and this mini-theme has the potential to become a big trend in the 2020s. There are a number of factors that underpin ESG investing. First, Millennials are climate conscious and given that they already are the largest cohort in the US they will not only dominate spending, but also influence election results. Moreover, via social media Millennials can sway public opinion and participate in the ESG conversation. Second, ECB President Christine Lagarde recent speech to the Economic and Monetary Affairs Committee of the European Parliament is a must read.6 If the ECB were to explicitly focus on climate change policy as part of its monetary policy operations then this is a game changer. Green investment financing including “green bonds” could become mainstream. Keep in mind that as reported in the FT, “the European Parliament has declared a climate emergency; the new European Commission (EC) has taken office on a promise of an imminent “green new deal”, and Commission president Ursula von der Leyen has vowed to accelerate emissions cuts.” Last week, the EC released “The European Green Deal” with a pretty aggressive time table. The EC president said “The green deal is Europe’s man on the moon moment” and presented 50 policies slated to get rolled by 2022 to meet revamped climate goals. The implication is that once ESG takes center stage at a number of these institutions, it will be easier to become mainstream and propagate the world over. Third, large institutional investors are starting to adopt an ESG mindset, especially pension plans. These investors with trillions of dollars at their disposal can not only disfavor fossil fuel investment, but also undertake investments in “green projects” via private and public equity markets. Banks are also moving in the “greening of finance” direction and given that they are the pipelines of the global plumbing system, swift adoption will go a long way in taking ESG mainstream. Finally, the electric vehicle (EV) proliferation is another key driver on how the ESG theme will play out in the 2020s. As a reminder, in the US 50% of all energy consumption is gasoline related linked to automobiles. While battery technology still has limitations, EV is no longer a fad as the German and Japanese automakers are starting to make inroads on TSLA. These car manufacturers do not want to be left out, especially if this shift toward EV becomes mainstream in the 2020s. The Chinese are not far behind on the EV manufacturing front, however government policy can really become a game changer. If a number of countries and/or California mandate a large share of all new vehicles sold be EV, then the investment implications will be massive. Investment Implication #8: Avoid Fossil Fuels, Gambling, Alcohol And Tobacco… While there are a few ESG related ETFs, we would rather explore this theme’s investment implications of sectors to avoid in the coming decade. We are believers that ESG criteria will continue to gain in importance in institutional investment management decisions. Accordingly, we would tend to avoid ‘sin stocks’, including gambling, tobacco and alcohol; demand for their services is unlikely to decline but investment weightings should mean that share prices will underperform. Further, we think a clean energy shift will mean energy stocks will likely continue to be long-term underperformers (Chart II-12). Final Thoughts On The US Dollar In this report, we tried to focus on the upcoming decade’s big themes that we expect to play out, and centered our recommendations on US equities/sectors. We do not want to neglect some macroeconomic variables that tend to mean revert over time. Specifically, the US dollar, interest rates and most importantly US indebtedness, will also be key drivers of investment theses in the 2020s. Currently, debt is rising faster than nominal GDP growth with the government and non-financial business debt-to-GDP profiles on an unsustainable path (second panel, Chart II-13). Chart II-12Areas To Avoid As ESG Becomes Mainstream Chart II-13Unsustainable Debt Profiles   Granted, the saving grace has been generationally low interest rates as the debt service ratios have fallen (top panel, Chart II-13). However, if the four decade bull market in Treasurys is over, or may end definitively with the next US recession sometime in the early 2020s, then rising interest rates are the only mechanism to concentrate CEOs’ and politicians’ minds. On the dollar front, Chart II-14 highlights the ebbs and flows of the trade-weighted US dollar since it floated in the early-1970s. The DXY index has moved in six-to-ten year bull and bear markets. The most recent trough was during the depths of the Great Recession, while the (tentative?) peak was in late-2016. If history repeats, eventually the dollar will mean revert lower in the 2020s, especially given the fiscal profligacy of the current administration that may continue into 2024, assuming President Trump gets re-elected next November. Chart II-14Greenback's Historical Ebbs And Flows The US dollar remains the reserve currency of the world today, but that exorbitant privilege is clearly fraying on the edges as the balance-of-payments dynamics are heading in the wrong direction. Over the next five years, the US Congressional Budget Office (CBO) estimates that the US budget deficit will swell to 4.8% of GDP. Assuming the current account deficit widens a bit then stabilizes (usually happens when global growth improves), this will pin the twin deficits at 8% of GDP. This assumes no recession, which would have the potential to swell the deficit even further. The US saw its twin deficits swell to almost 13% of GDP following the financial crisis, but the difference then was that in the wake of the commodity boom the dollar was cheap (and commodity currencies overvalued). The subsequent shale revolution also greatly cushioned the US trade deficit. Shale productivity remains robust and US output will continue to rise, but the low-hanging fruit has already been plucked. Chart II-15Twin Deficits Will Weigh On The US Dollar For one reason or another, foreign central banks are diversifying out of dollars. If due to the changing landscape in trade, this is set to continue. If it is an excuse to shy away from the rapidly rising US twin deficits, this will continue as well. In a nutshell, there has been hardly a time in recent history when the twin deficits in the US were rising and the dollar was in a secular uptrend (Chart II-15). Another dollar-negative force is its expensiveness. By rising 35% since its trough, the USD has sapped the competitiveness of the US manufacturing sector, which is accentuating the American trade deficit outside of the commodity sector. If the ESG trend ends up hurting oil prices, the US current account will follow the widening deficit in manufactured products. Moreover, the US is lagging Europe on the green revolution. Either the US will have to import green technologies, or the US government will have to provide more subsidies to the private sector. Either way, both of these dynamics will hurt the US current account deficit further. Historically, the currency market is the main vehicle to correct such imbalances. The apex of globalization will also hurt the greenback. In a world where all the markets are integrated, borrowers in EM nations often use the reserve currency to issue liabilities at a lower cost. This boosts the demand by EM central banks for US dollar reserves to protect domestic banking systems funded in USD. Moreover, some countries like China implement pegs (both official and unofficial) to the US dollar in order to maintain their competitiveness and export their production surpluses to the US. To do so they buy US assets. If the global economy becomes more fragmented and the Sino-US relationship continues to deteriorate structurally as we expect, then these sources of demand for the dollar will recede. Overlay the widening US current account deficit, and you have the perfect recipe for a depreciating trade-weighted US dollar. Finally, the US is likely to experience more inflation than the rest of the world following the next recession. The US economy has a smaller capital stock as a share of GDP than Europe or Japan, and American demographics are much more robust. This means that the neutral rate of interest is higher in the US than in other advanced economies. As a result, the Fed will have an easier time generating inflation by cutting real rates than both the ECB and the BoJ. Higher inflation will ultimately erode the purchasing power of the dollar and prove to be a structurally negative force for the USD.   Anastasios Avgeriou US Equity Strategist Matt Gertken Geopolitical Strategist Marko Papic Chief Strategist, Clocktower Group Chester Ntonifor Foreign Exchange Strategist Mathieu Savary Vice President The Bank Credit Analyst   III. Indicators And Reference Charts With a breakthrough in trade talks and Fed officials changing their language to suggest that policy will remain accommodative until inflation meaningfully overshoots 2%, the S&P 500 decisively broke out. Because it eases global financial conditions and boosts the profit outlook, the recent breakdown in the dollar should fuel the equity rally. Tactically, the S&P 500 may have overshot the mark, but on a cyclical basis, stronger growth and an easy Fed will propel US and global stocks higher. Our Revealed Preference Indicator (RPI) remains cautious towards equities. The RPI combines the idea of market momentum with valuation and policy measures. However, our Willingness-to-Pay (WTP) indicator for the US and Japan continues to improve. In Europe, this indicator has finally hooked up. The WTP indicator tracks flows, and thus provides information on what investors are actually doing, as opposed to sentiment indexes that track how investors are feeling. This broad-based improvement therefore bodes well for equities. Moreover, the pickup in Europe suggests that European stocks are increasingly ripe to outperform their US counterparts. Global yields have turned higher but they remain at exceptionally stimulating levels. Moreover, money and liquidity growth remains very strong as global central banks have adopted strongly dovish slants. Additionally, a Fed that will allow inflation to overshoot before tightening policy is adding to this supportive monetary backdrop. As a result, our Monetary Indicator remains at extremely elevated levels. Furthermore, our Composite Technical Indicator is still flashing a buy signal. Finally, our BCA Composite Valuation index is suggesting that stocks are expensive, but not so much as to cancel out the supportive monetary and technical backdrop. As a result, our Speculation Indicator remains in the neutral zone. 10-year Treasurys yields are becoming slightly less expensive, however, they are no bargain. Moreover, our Composite Technical Indicator is quickly moving away from overbought territory but has yet to flash oversold conditions, indicating that yields are roughly half way through their move. The strengthening of the Commodity Index Advance/Decline line and higher natural resource prices further confirm the upside for yields. Therefore, the current setup argues for a below-benchmark duration in fixed-income portfolios. Small signs that global growth is bottoming, such as the stabilization in the global PMIs, the pick-up in the German ZEW and IFO surveys, or the acceleration in Singapore’s container throughput growth, point to a worsening outlook for the counter-cyclical US dollar. Moreover, the dollar trades at a large premium of 24% relative to its purchasing-power parity equilibrium. Additionally, our Composite Technical Indicator is quickly deteriorating after having formed a negative divergence with the Greenback’s level. Since the dollar is a momentum currency, this represents a dark omen for the USD. In fact, we continue to believe that a breakdown in the dollar will be the clearest signal that global growth is rebounding for good. 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 II-16US Dollar And PPP Chart II-17US Dollar And Indicator Chart II-18US Dollar Fundamentals Chart II-19Japanese Yen Technicals Chart II-20Euro Technicals Chart II-21Euro/Yen Technicals Chart II-22Euro/Pound Technicals   COMMODITIES: Chart II-23Broad Commodity Indicators Chart II-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 Please see The Bank Credit Analyst "OUTLOOK 2020: Heading Into The End Game," dated November 22, 2019, available at bca.bcaresearch.com 2 Please see Geopolitical Strategy Special Report "US Election 2020: Civil War Lite," dated November 22, 2019, available at gps.bcaresearch.com 3 Please see Foreign Exchange Strategy Special Report "Riding The Wave: Momentum Strategies In Foreign Exchange Markets," dated December 8, 2017, available at fes.bcaresearch.com 4 Please see Global Asset Allocation Special Report "Safe Haven Review: A Guide To Portfolio Protection In The 2020s," dated October 29, 2019, available at gaa.bcaresearch.com. 5 Please see US Equity Strategy Special Report "Brothers In Arms," dated October 31, 2016, available at uses.bcaresearch.com 6 https://www.imf.org/en/News/Articles/2019/09/04/sp090419-Opening-Statement-by-Christine-Lagarde-to-ECON-Committee-of-European-Parliament

Underweight Heavily indebted utilities are a high-conviction underweight call for next year. Relative share prices and the 10-year Treasury yield are closely inversely correlated. Now that the risk free asset is having a more competitive yield, investors will likely start to abandon this niche defensive sector. The jury is still out on the final outcome of the Sino-American trade war. However, there has been a decisive change of heart in US exporters and the ISM manufacturing survey’s new export orders subcomponent reflects an, at the margin, improvement in the US/China trade relationship. This bodes ill for safe haven utilities stocks. Utilities command a 19.4 forward P/E multiple representing roughly a 10% premium to the broad market, but their forecast EPS growth rate at 5% trails the SPX by 400bps. Our composite relative Valuation Indicator has surged to one standard deviation above the historical mean, a level typically associated with recession. On the operating front, natural gas prices are contracting at the steepest pace of the past four years, and electricity capacity utilization is in a multi-decade downtrend, warning that the relative profitability will remain under pressure in 2020. The implication is that this crowded trade is at risk of deflating, especially if the breakout in bond yields gains steam as BCA expects. The ticker symbols for the stocks in this index are: BLBG – S5UTIL– PPL, PNW, ATO, PEG, FE, EIX, AEE, SO, SRE, AEP, XEL, DTE, EVRG, WEC, AES, CMS, LNT, ED, NRG, D, AWK, DUK, ETR, EXC, NEE, CNP, NI, ES. ​​​​​​​

An analysis on Ukraine is available below.   Highlights A number of liquidity and technical reasons have led us to give benefit of the doubt to the bullish market action and chase this EM rally. We still doubt that the US-China trade truce alone is sufficient to propel a cyclical recovery in global trade and manufacturing. However, it seems the market is operating on a “buy now, ask questions later” principle. Therefore, we are initiating a long position in the EM equity index as of today. Despite the potential for higher EM share prices in absolute terms, we are still reluctant to upgrade EM versus DM stocks. The basis is that EM corporate profits will continue lagging those in DM. Feature We could be in for a replay of the 2012-2014 DM equity rally, where EM stocks rebounded in absolute terms but massively underperformed DM on a relative basis. Chart I-1EM Share Prices: In Absolute Terms And Relative To DM EM share prices have spiked on the announcement of a trade truce between the US and China. As a result, our buy stop at 1075 on the EM MSCI Equity Index has been triggered, and we are initiating a long position in EM stocks as of today (Chart I-1, top panel). That said, we are still reluctant to upgrade EM versus DM stocks. Regardless of the direction of the market (bull, bear or sideways), EM share prices will likely underperform the global equity benchmark. As we discussed in our report, the primary risk to our view has been that EM share prices get pulled higher as a result of rallying DM markets. Nevertheless, our fundamental assessment remains that EM corporate profits will lag those in DM, heralding EM relative equity underperformance. In fact, we could be in a replay of the 2012-2014 DM equity rally where EM stocks massively underperformed (Chart I-1, bottom panel), as we elaborated in our November 28 report. In this report, we review the indicators that support a bullish stance, the ones that are inconclusive and those that are not confirming the current rally in China-plays in general and EM risk assets in particular. Bullish Liquidity And Technical Settings The following points have led us to give benefit of the doubt to recent market action and to chase this rally: The global liquidity backdrop appears to be conducive for higher share prices. Global narrow and broad money growth have accelerated (Chart I-2). That said, a caveat is in order: These money measures do not always strongly correlate with both global share prices and the global business cycle. There are numerous times when they gave a false signal or were too early or late at turning points. Chart I-2Global Narrow And Broad Money: A Useful But Not Always Reliable Indicator   The technical profile of EM equities is rather bullish. As shown on the top panel of Chart I-1 on page 1, EM share prices have found a support at their six-year moving average. When a market fails to break down below its long-term technical support line, odds are that a major bottom has been reached, and the path of the least resistance is up. The reason we look at these long-term (multi-year) moving averages is because they have historically worked very well for key markets like the S&P 500 and 10-year US Treasury bond yields (Chart I-3A & I-3B). Chart I-3AThe Reason Why We Use Multi-Year Moving Averages Chart I-3BThe Reason Why We Use Multi-Year Moving Averages   As another positive development, both EM share prices in local currency terms and the EM equity total return index in US dollar terms have bounced from their three-year moving averages (Chart I-4). Chart I-4A Bullish Chart Formation For EM Equities In addition, when a market does not drop below its previous top, this creates a bullish chart configuration (Chart I-4). This seems to be the case with EM share prices currently. Bottom Line: A number of liquidity and technical reasons have led us to give benefit of the doubt to the bullish market action and to chase this rally. Inconclusive Indicators It is rare that all types of indicators – directional market, business cycle, valuation and technical – all line up together to convey the same investment recommendation. Below we present the market indicators and signals that we have been watching to get confirmation of sustainability in the bull market in EM risk assets, commodities and global cyclical equity sectors. They are still inconclusive: The US broad trade-weighted dollar has recently sold off, but it has not broken down technically (Chart I-5). A decisive relapse below its 200-day moving average will signify that the greenback has entered a major bear market. The latter would be consistent with a sustainable and extended bull market in EM risk assets, commodities and global cyclical equity sectors.  Chart I-5The US Dollar Has Fallen But Not Broken Down Chart I-6Indecisive Signals From Commodities And Commodity Currencies   Even though copper prices have recently rebounded, they have not yet broken above their three-year moving average (Chart I-6, top panel). The latter can be viewed as the neckline of the head-and-shoulders pattern that has formed in recent years. The same holds true for the overall London Metals Exchange Industrial Metals Price Index, as well as our Risk-On/Safe-Haven currency ratio1 (Chart I-6, middle and bottom panels). Barring a decisive break above their three-year moving averages, the jury is still out on the durability of the rally in commodities prices and EM/China plays.   Finally, global industrial share prices and US high-beta stocks have advanced to their 2018 highs, but have not yet broken out (Chart I-7). The same is true for the euro area aggregate stock index in local currency terms (Chart I-8). A decisive breakout above these levels will confirm that global equities in general and cyclical segments in particular are in an enduring bull market. Chart I-7Decisive Breakouts Here Are Needed To Confirm The EM Rally Chart I-8European Share Prices Are At A Critical Juncture   Bottom Line: Several cyclical and high-beta segments of global financial markets are at a critical juncture. A decisive breakout from these key technical levels is required for us to uphold that EM risk assets and global cyclical plays are in a medium-term bull market. The Eye Of The Storm? There are a number of leading indicators and market signals that do not corroborate the common narrative of a sustainable improvement in global manufacturing/trade in general and China’s industrial cycle in particular: First, China’s narrow and broad money growth appear to be rolling over (Chart I-9). Notably, the money impulses lead the credit impulse, as illustrated in Chart I-10. Consequently, we expect the credit impulse – which is the main indicator currently portraying a revival in the Chinese economy as well as in the global business cycle – to roll over in early 2020. Chart I-9China: Narrow And Broad Money Growth Are Rolling Over Chart I-10China: Money Impulses Are Coincident Or Lead Credit Impulse   This entails that the recent tentative improvements in China’s manufacturing, its imports and global trade will not be sustained going forward. Crucially, China’s narrow money (M1) growth point to the lack of a cyclical upturn in EM corporate profits in H1 2020 (Chart I-11). In short, EM listed companies’ profit growth rate stabilizing at around -10% is not a recovery. Second, government bond yields in both China and Korea are not corroborating a revival in their respective business cycles (Chart I-12). Chart I-11EM Corporate Profit Growth To Remain Negative In H1 2020 Chart I-12Asian Rates Are Not Confirming A Recovery   Chinese onshore interest rates have been a reliable compass for both its business cycle as well as EM share prices and currencies as we illustrated in Chart 15 of the November 28 report. For now, the mainland fixed-income market is not predicting an upturn in China’s industrial economy (Chart I-12, top panel). In Korea, exports account for 40% of GDP. Hence, without a considerable export recovery, there cannot be a business cycle revival in Korea. In brief, the latest relapse in local bond yields could be sending a downbeat signal for global trade (Chart I-12, bottom panel). Third, the four-month rise in the Chinese Caixin manufacturing PMI can be partially explained by front-running production and shipments of smartphones, laptops, computers and other electronics ahead of the December 15 round of US tariffs on imports from China. Right after President Trump announced these tariffs in the summer, businesses likely did not take a chance to wait and see. In fact, whether or not these tariffs would have come into effect was unknown till December 13. Manufacturers and US importers of these electronic goods initiated orders, produced and shipped these goods to the US ahead of December 15. Chart I-13Caixin And Taiwanese PMIs Benefited From Front Running Given the focus on that particular round of tariffs was electronics, producers of these goods got a temporary but notable boost from such front-running. Smartphone and electronics manufacturers and their suppliers are predominantly located in Shenzhen and Taiwan. The Caixin manufacturing PMI is a survey of 500 companies, many of which are private enterprises located in Shenzhen. Not surprisingly, the Caixin manufacturing PMI index often fluctuates with Taiwan’s electronics and optical PMI (Chart I-13). In brief, there has been meaningful improvement in China’s and Taiwan’s tech manufacturing. Yet it can be attributed to front-running of production and shipments of electronic products to the US ahead of the December 15 tariff deadline as well as stockpiling of semiconductors by China. The odds are that these measures of manufacturing will slump in early 2020 as the front-running ends. Chart I-14Commodities Prices In China Finally, several commodities prices in China, that troughed in late 2015 ahead of the bottom in global and EM/Chinese equities in early 2016, continue to drift lower or exhibit only a mild uptick. Specifically, these include prices of nickel, steel, iron ore, thermal coal, coke, polyethylene and rubber (Chart I-14). They corroborate that there has been no broad-based amelioration in the mainland’s industrial sector. Bottom Line: In China, narrow and broad money growth has rolled over, onshore interest rates are subsiding and many commodities prices are weak. All of these signify the lack of sustainable growth revival in China in the coming months.  Putting It All Together EM risk assets have rallied on the consensus market narrative that the temporary truce between the US and China will lift global growth. We have written at length that China’s domestic demand – not its exports – has been the epicenter of and basis for the global slowdown over the past two years. Without Chinese domestic demand and imports, not exports, staging a material amelioration, global trade and manufacturing are unlikely to experience a cyclical upturn.   In short, we doubt that the US-China trade truce is alone sufficient to propel a cyclical recovery in global trade and manufacturing. Yet, when the majority of investors perceive things the same way and act on these perceptions, asset prices can move a lot. We continue to believe that China’s industrial sector, global trade, EM ex-China domestic demand and consequently EM corporate profits will continue to disappoint in the first half of 2020. Nevertheless, we presently concede that we need to give benefit of the doubt to markets. We still doubt that the US-China trade truce alone is sufficient to propel a cyclical recovery in global trade and manufacturing. It could be that the EM equity and currency market rallies are not driven by their fundamentals – i.e., corporate profits/exports do not matter. However, it is rather possible that this rally is only stoked by the worst-kept secret in the investment industry: the search for yield. If that is the case, then there is no dichotomy between our fundamental thesis – that EM/China profits/growth will disappoint in H1 2020 – and the rally in EM markets. It seems the market is operating on a “buy now, ask questions later” principle. We had thought that the ongoing and enduring contraction in EM corporate profits (please refer to Chart I-11 on page 8) amid various structural malaises would overwhelm the impact of the global search for yield. However, it seems the market is operating on a “buy now, ask questions later” principle. Overall, we are initiating a long position in the EM equity index as of today. Provided the high uncertainty over the outlook, we are also instituting a stop point at 1050 for the MSCI EM equity index, 5% below its current level. For global equity investors, we continue recommending favoring DM over EM stocks. Finally, our country equity overweights are Korea, Thailand, Russia, central Europe, Pakistan, Vietnam and Mexico. A basket of these bourses is likely to outperform the EM equity benchmark in any market scenario in terms of EM absolute share price performance. We have been and remain neutral on Chinese, Indian, Taiwanese and Brazilian equities. As always, our list of overweight, underweight and market weight recommendations for EM equities, local and US dollar government bonds and currencies are available at the end of our report on pages 17-18 and on our website.   Arthur Budaghyan Chief Emerging Markets Strategist arthurb@bcaresearch.com     Ukraine: Buy Local Currency Bonds EM fixed-income investors should buy Ukraine local currency government bonds as well as overweight Ukraine sovereign credit within an EM credit portfolio. The exchange rate is the key for EM fixed-income investors. The Ukrainian hryvnia will be supported by high real interest rates, improving public debt and balance of payment dynamics, as well as abating geopolitical risks. In turn, a stable currency will keep inflation at bay. In such an environment, investors should favor local currency government bonds, as local interest rates will continue falling.  Chart II-1Inflation Will Fall Further In turn, a stable currency will keep inflation at bay (Chart II-1). In such an environment, investors should favor local currency government bonds, as local interest rates will continue falling. The primary risk of owning Ukrainian domestic bonds is a major depreciation in the hryvnia stemming from a risk-off phase in EM. However, as a periphery country, Ukraine’s financial markets might not correlate with their EM peers. Besides, these bonds offer high carry, which protects them against moderate currency depreciation. Overall, the case for buying Ukraine local currency government bonds is based on the following: First, Ukraine satisfies the two prerequisites for public debt sustainability, namely (1) it runs a robust primary fiscal surplus and/or (2) the government’s borrowing costs are below nominal GDP growth. The public debt-to-GDP ratio stands at 56% and will continue to fall so long as the above two conditions are satisfied. The primary consolidated fiscal surplus currently amounts to 1.8% of GDP (Chart II-2). The recently approved 2020 budget projects the primary surplus to be above 1% of GDP and the overall fiscal deficit to be close to 2% of GDP.  Local currency interest rates are below nominal GDP growth (Chart II-3). In addition, public debt servicing is at 3.2% and 9% as a share of GDP and total government expenditures, respectively. According to the new budget, the government plans to use close to 12% of total spending for debt repayments in 2020. This will further help reduce the public debt load. Chart II-2A Healthy Fiscal Position Chart II-3Interest Rates Are Below Nominal GDP Growth And Are Falling Second, the central bank has more scope to cut interest rates because various measures of inflation will continue falling. Real (adjusted for inflation) interest rates are still very elevated. In particular, the prime lending rate is at 17% for companies and 35% for households, both in nominal terms. Provided core inflation is running at 6%, lending rates are extremely high in real terms. Not surprisingly, narrow and broad money growth are sluggish (Chart II-4). Commercial banks are undergoing major balance sheet deleveraging: their asset growth is in the low single digits in nominal terms, while their value is dropping relative to nominal GDP (Chart II-5). Chart II-4Money Growth Is Sluggish Chart II-5Deleveraging In The Banking Sector Meanwhile, tighter regulations are forcing banks to recognize bad assets and boost their capital. This has led to a sharp drop in the number of registered banks. Such a structural overhaul of the banking system is cyclically deflationary and warrants lower interest rates. Critically, these reforms are a positive for the exchange rate in the long run. Third, receding foreign funding pressures are helping the balance of payments dynamics and are supportive for the currency. Ukrainian exports have been outperforming global exports since 2017 (Chart II-6). Agricultural exports – which represent 40% of total exports – are an important source of foreign currency revenue for the country. Chart II-6Ukraine Exports Are Outperforming Global Trade Chart II-7Tight Fiscal And Monetary Policies Are Good For The Current Account Balance The current account deficit has been narrowing due to slowing domestic demand, arising from tight fiscal and monetary policies (Chart II-7). Foreign ownership of local currency government bonds is $4.6 billion and it makes only 12% of total outstanding amount. Consequently, risk of major foreign portfolio capital outflows due to a risk-off phase in global markets is low. Lastly, Ukraine’s foreign debt obligations – the sum of short-term claims, interest payment and amortization – have been declining and are presently well covered by exports. They comprise 34% of total exports. Finally, geopolitical risks will continue to subside over the coming months. Peace talks between Ukraine and Russia will continue. Importantly, two sets of constraints could force Ukraine and Russia towards resolving the conflict. Specifically: Russia is constrained by its commitment to be a reliable gas supplier to the EU. Half of its gas export capacity passes through Ukraine. European demand for Russian gas is falling and Gazprom gas revenues are decelerating. Cutting transit of gas through Ukraine could now severely jeopardize Russia’s relations with Europe. Therefore, as much as Europe is dependent on Russian gas, Russia is as dependent on European demand for its natural gas.   The EU’s support for Ukraine is contingent on reliable transits of Russian gas into EU countries. As such, President Zelensky is under pressure from Europe to assure transmission of Russian gas to Europe. This has led Zelensky into opening a dialogue with Russia and motivated him to seek a new gas transit deal with Gazprom. Given President Zelensky’s high popularity at home, he has political capital to pursue a rapprochement with Russia and attempt to find a resolution to end the conflict in the Donbass. All of these developments have been, and will continue to be, positively perceived by international investors, sustaining the recent stampede into Ukraine’s fixed-income markets. Investment Recommendation We recommend investors purchase 5-year local currency government bonds currently yielding 12%. EM fixed-income investors should also consider overweighting US dollar sovereign bonds in an EM credit portfolio on the back of improving public debt and balance of payments dynamics.   Andrija Vesic Research Analyst andrijav@bcaresearch.com     Footnotes 1    The Risk-On/Safe-Haven currency ratio is the average of high-beta commodity currencies such as the CAD, AUD, NZD, BRL, CLP and ZAR total return (including carry) indices relative to the average of JPY and CHF total returns (including carry). This ratio is dollar-agnostic. Equities Recommendations Currencies, Credit And Fixed-Income Recommendations

Special Report

Highlights Mega-theme 1: A hypersensitivity to higher interest rates. Overweight equities versus bonds until 10-year bond yields rise 75 bps. At which point, switch into bonds. Mega-theme 2: Europe conquers its disintegration forces. Overweight European currencies, and underweight core European bonds within a fixed income portfolio. Mega-theme 3: Non-China exposed investments outperform structurally. Overweight non-China plays, underweight materials and resources, and underweight commodity currencies. Mega-theme 4: The rise of blockchain and alternative energy. Overweight alternative energy, underweight oil and gas, and underweight financials. Feature Feature ChartUnderweight Materials And Resources In The 2020s “Study the past if you would divine the future” – Confucius To paraphrase Confucius, we must study the mega-themes of the 2010s if we are to identify the mega-themes of the 2020s. From an economic, financial, and political perspective, the mega-themes of the past decade were: ‘universal QE’; Europe’s threatened disintegration; China becoming the world’s ‘stimulator of last resort’; and the decentralization of information, which threatened the established hierarchies in politics and society. These mega-themes of the 2010s point the way to four mega-themes for the 2020s: A hypersensitivity to higher interest rates. Europe conquers its disintegration forces. Non-China exposed investments outperform structurally. The rise of blockchain and alternative energy. Mega-Theme 1: A Hypersensitivity To Higher Interest Rates The 2010s was the decade of ‘universal QE’. One after another, the world’s major central banks bought trillions of dollars of government bonds (Chart I-2). Yet for all its apparent mystique, QE is nothing more than a signalling mechanism – signalling that central banks intend to keep policy interest rates depressed for a long time. Thereby, QE depresses long-term bond yields – which themselves are nothing more than the expected path of policy interest rates. Chart I-2The 2010s Was The Decade Of 'Universal QE' Something else happens. Close to the lower bound of interest rates, bonds become riskier investments. As holders of Swiss bonds discovered in 2019, low-yielding bonds become a ‘lose-lose’ proposition: prices can no longer rise much, but they can fall a lot. The upshot is that all long-duration assets become risky, and the much higher return required on formerly riskier assets – such as equities – collapses to the feeble return offered on equally-risky bonds. 'Universal QE' has boosted the valuation of all risky assets. Ten years ago, when the global 10-year bond yielded 3.5 percent, equities offered a prospective 10-year return of 9 percent (per annum). Today, when the bond is yielding around 1.5 percent, equities are offering a paltry 3 percent (Chart I-3 and Chart I-4). Meaning that while the present value of the 10-year bond is up around 20 percent, the present value of equities has surged by 60 percent.1 Chart I-3Equities Are Offering A Paltry 3 Percent Return Chart I-4The Return Offered By Equities Has Collapsed To The Feeble Return Offered By Bonds This exponential dynamic has applied to all risky assets in the 2010s. Most notably, real estate prices have sky-rocketed: Shenzhen 325 percent; Beijing 285 percent; Berlin 125 percent; Bangkok 120 percent; San Francisco 90 percent; Los Angeles 85 percent; Sydney 75 percent; and so on. From 2010 to 2020, the value of global real estate surged from an estimated $160 trillion to $300 trillion.2 The market value of equities also doubled from $35 trillion to $70 trillion.3 But global GDP grew by less than a third from $66 trillion to $85 trillion.3 The upshot is that in 2010 the value of real estate plus equities stood at 2.9 times GDP, whereas in 2020 it stands at 4.5 times GDP. Now add in the aforementioned exponentiality of risk-asset valuations at low bond yields. In 2010, a 1 percent rise in yields required a 10 percent decline in present values, whereas in 2020 it might require a 30 percent decline. In 2010, this meant a decline equivalent to 29 percent of global GDP, but in 2020 it means a decline equivalent to a staggering 135 percent of global GDP.4 So mega-theme 1 for the early 2020s is that any monetary policy tightening – in response to, say, wage inflation fears – will unleash a massive deflationary impulse into the economy from falling stock and real estate prices. This deflationary sledgehammer will annihilate the inflationary peanut, and almost certainly trigger the next major recession. But the good news is that it is unlikely to be a 2020 story, as all the major central banks are in ‘wait-and-see’ mode. Structural recommendation: Overweight equities versus bonds until 10-year bond yields rise 75 bps. At which point, switch into bonds. Mega-Theme 2: Europe Conquers Its Disintegration Forces In sub-atomic physics, a nucleus disintegrates when the electrostatic forces pulling it apart becomes stronger than the nuclear forces holding it together. Using the nucleus as a metaphor for Europe, two of the forces pulling it apart have weakened, while one of the forces holding it together has strengthened. We now know that Europe’s biggest rebel – the UK – is leaving the European Union in 2020. In the sub-atomic metaphor, the UK has become a free radical which will try and attach itself to the largest attractive body it can find. But in losing its most wayward member the European nucleus has, by definition, become more cohesive. A second destructive force has been the economic divergences between the ‘core’ and ‘periphery’ European member states. But over the past decade, these divergences have narrowed substantially. Relative to Germany, unit labour costs have declined by 25 percent in Spain, and 15 percent in Italy. More convergence is needed, but the economic forces pulling the European nucleus apart are much weaker in 2020 than they were in 2010 (Chart I-5). Chart I-5The Economic Divergence Between Europe's Core And Periphery Has Narrowed Meanwhile, a force holding the European nucleus together has strengthened. In 2010, the Target2 banking imbalance stood at €0.3 trillion; in 2020, it stands close to €1.5 trillion. In simple terms, this means Germany’s exposure to ‘Italian euro’ assets has surged via the ECB’s massive purchases of Italian BTPs. At the same time, Italian investors have parked their cash in German banks, meaning they are owed ‘German euros’ (Chart I-6). Chart I-6Europe’s Target2 Banking Imbalance Stands Close To €1.5 Trillion With such a massive Target2 imbalance, the biggest casualty of the euro’s disintegration would be Germany, whose 2008 recession would look like a stroll in the park. Giving Germany a huge incentive to become more conciliatory to its partners, for example on the use of fiscal stimulus. The best way to play mega-theme 2 is through the currency and bond markets. European equity markets are plays on their dominant sectors, and as we are about to see, many of the sectors over-weighted in Europe face structural headwinds. Structural recommendation: Overweight European currencies, and underweight core European bonds within a fixed income portfolio. Mega-Theme 3: Non-China Exposed Investments Outperform Structurally The 2010s was the decade when China became the global ‘stimulator of last resort’. Prior to the 2010s, the credit impulse in China was inconsequential compared to the credit impulses in the US and Europe. But in the 2010s the tables turned. The credit impulses in the US and Europe became inconsequential, as the amplitude of China’s waves of stimulus swamped all others (Chart I-7). Chart I-7In The 2010s, China Became The Global 'Stimulator Of Last Resort' China became the global stimulator of last resort because in 2010 its indebtedness was significantly less than in other major economies. But today, China’s indebtedness has overtaken the others, and is levelling off at a point that has proved to be a reliable upper bound (Chart I-8). Chart I-8China's Indebtedness Is Reaching Its Upper Bound An upper bound to indebtedness exists because further debt creates mal-investments whose returns are lower than the cost of the debt. And as indebtedness approaches the upper bound, each wave of stimulus loses potency compared to the preceding wave. For example, in 2011 China’s nominal GDP growth accelerated to 20 percent, but in 2017 it accelerated to 10 percent. In the financial markets, China’s waves of stimulus enabled short bursts of countertrend outperformance within the structural bear market in materials and resources – sectors which feature large in European markets. However, as Chinese stimulus loses its potency in the 2020, the structural bear markets in China-exposed investments will re-establish (Chart I-1). Structural recommendation: Overweight non-China plays, underweight materials and resources, and underweight commodity currencies. Mega Theme 4: The Rise Of Blockchain And Alternative Energy Historian Niall Ferguson describes history as a perpetual oscillation between periods dominated by centralized hierarchies and periods dominated by decentralized networks. And quite often, he says, the switch is enabled by a revolutionary new technology. For example, the advent of the printing press in the mid-15th century catalysed the Protestant Reformation and turbocharged the Renaissance by unleashing a decentralization of knowledge, information, and news. Sound familiar? In the early-21st century the internet has similarly decentralized the production and consumption of knowledge, information, and news. And the new networked age has threatened the established hierarchies in politics and society, fuelled populism, and disrupted many sectors in the economy. Yet Ferguson points out that it is futile (as well as Luddite) to resist such shifts from hierarchical structures towards decentralized networks. In the 2020s the decentralization baton will pass from the internet to the blockchain. Just as the internet decentralizes information, the blockchain decentralizes intermediation and trust functions. Hence, the blockchain will be maximally disruptive to any economic sector whose raison d’être is intermediation and trust – most notably finance and law. The blockchain will be maximally disruptive to any economic sector whose raison d’être is intermediation and trust – most notably finance and law.  By the end of the decade, you will no longer need a bank to intermediate your excess savings to a borrower. And you will no longer need a lawyer to oversee a change of ownership. The blockchain will do these for you just as securely and much more cost effectively. One consequence is that the nature of the world’s energy requirements will change. The blockchain is very energy intensive, but unlike the internal combustion engine, the energy does not have to be portable. Hence, there will be a structural shift towards energy in the form of ‘moving electrons’ and away from energy in the form of the ‘chemical bonds’ in fossil fuels. This will be a boon for the alternative energy sector at the expense of oil and gas (Chart I-9). Chart I-9Underweight Oil And Gas In The 2020s We will cover this mega-theme in more detail in a Special Report next year. Structural recommendation: Overweight alternative energy, underweight oil and gas, underweight financials. And with that, it’s time to sign off for this year and for this decade. I do hope that you have found the past decade’s reports insightful, sometimes provocative, but always enjoyable. We promise to continue in the same vein in the 2020s. It just remains for me and the team to wish you a happy new year and a happy new decade! Fractal Trading System* The Conservatives won a surprise landslide victory in the UK election last week, but fractal structures suggest that some of the market euphoria is now overdone. Specifically, the 30 percent rally in UK homebuilders through the last 65 days is vulnerable to a short-term countertrend move. Accordingly, this week’s recommended trade is short UK homebuilders / long UK oil and gas. Set the profit target at 9 percent with a symmetrical stop-loss. Chart I-10UK: Homebuilders Vs. Oil and Gas In other trades, short MSCI AC World versus the global 10-year bond was closed at its 2.5 percent stop-loss, leaving three trades in comfortable profit, one neutral, and one in loss. When the fractal dimension approaches the lower limit after an investment has been in an established trend it is a potential trigger for a liquidity-triggered trend reversal. Therefore, open a countertrend position. The profit target is a one-third reversal of the preceding 13-week move. Apply a symmetrical stop-loss. Close the position at the profit target or stop-loss. Otherwise close the position after 13 weeks. Use the position size multiple to control risk. The position size will be smaller for more risky positions. * For more details please see the European Investment Strategy Special Report “Fractals, Liquidity & A Trading Model,” dated   December 11, 2014, available at eis.bcaresearch.com.   Dhaval Joshi Chief European Investment Strategist dhaval@bcaresearch.com Footnotes 1 In simple terms, if the 10-year yield declines by 2 percent, a 2 percent a year lower return for 10 years requires the present value to rise by 2 percent times 10, which equals 20 percent. In the case of equities, the equivalent calculation is 6 percent times 10, which equals 60 percent. 2 Source: Savills 3 Source: Thomson Reuters 4 2.9 times 10 percent equals 29 percent, 4.5 times 30 percent equals 135 percent. Fractal Trading System   Cyclical Recommendations Structural Recommendations Trades Closed Trades Asset Performance Currency & Bond Equity Sector Country Equity

  Overweight The large cap size bias is our sole hold out from last year’s high-conviction list despite getting stopped out and booking a handsome 9% profit. We recommend reinstating a large cap size bias. This call actually represents a slight hedge on BCA’s overall higher interest rates view for next year. Financials comprise 13% of the SPX, but the weight jumps to 18% in small cap indexes. Thus, if the rising interest view is off the mark, the large cap bias will provide an offset. Relative forward profit growth favors mega caps and by a wide margin. One key factor underpinning this increasing profit gap is the massive profit margin divergence. Tack on the fact that index providers omit negative forward profits from their index EPS calculations and the narrative that small caps have cheapened versus large caps falls flat on an adjusted basis. Why? Because a large number of small caps have negative forward EPS. Moreover, we recently created a relative employment proxy that is firing on all cylinders. Not only is the small business labor market crumbling according to the latest NFIB survey, but hard data also suggest that nonfarm private small business payroll employment has ground to a halt. Finally, small caps are debt saddled compared with large caps and small cap b/s have actually been degrading of late.

Dear Clients, In our final publication of the year, we bring you a recap of this past week’s significant events in Sino-US relations and the key messages from the Central Economic Work Conference. Accordingly, we are upgrading our tactical stance towards Chinese stocks from neutral to overweight.  Our publishing schedule will resume on January 9, 2020 with our monthly Macro and Market Review. Our China Investment Strategy team wishes you a happy holiday season and a prosperous New Year! Best regards, Jing Sima, China Investment Strategist Highlights We are upgrading our tactical call on Chinese stocks from neutral to overweight. Recent developments in the Chinese investable equity market point to a risk-on sentiment. The fact the US and China have reached an agreement likely marks the beginning of a truce, which could potentially last through the US presidential election in November 2020. The CEWC statement from last week reinforces our view that China's leadership feels the urgency to stabilize the economy now outweighs the desire to continue financial deleveraging.  Feature Signals from the Chinese investable equity market have titled in a bullish direction. This shift is accompanied by two modestly bullish developments:  First, the annual China Economic Work Conference (CEWC) concluded on December 12 with support for a more reflationary stance for the coming year. Then, a day later, the US and Chinese officials confirmed they have agreed on a Phase One trade deal.  The combination of these developments provides a sufficient basis to upgrade our tactical (0-3 month) stance on Chinese stocks from neutral to overweight (within a global equity portfolio), to be consistent with our bullish cyclical (6-12 month) stance. Equity Market Signals Have Become Bullish In our previous reports, we highlighted that the relative performance of some sectors in the Chinese investable equity market reflects China’s policy direction and financial market conditions, supporting our bullish/bearish calls on Chinese stocks. Recently, two of the three equity market telltale signs that we have been watching have turned favorable for a bullish view on Chinese stocks (Chart 1A and 1B): Chart 1ACountercyclical Sector Stock Performance Points To Improvement In Economic Activity Chart 1BThe Breakdown Of Defensive Stocks Suggests A Return Of Risk-On Sentiment Chart 1A (top panel) shows that the relative performance of investable utility stocks have broken down, signifying that market participants anticipate the slowdown in China’s economy will soon bottom.  Investable healthcare stocks have not breached their 200-day trend, but are headed in that direction (Chart 1A, bottom panel). Key equity market signs have turned supportive for a bullish tactical call on Chinese stocks. Cyclical stocks are outperforming defensives in both China’s onshore and offshore markets, reflecting improved investor sentiment towards China’s economic outlook (Chart 1B). Bottom Line: Key equity market signs have turned supportive for a bullish call on Chinese stocks for the next 0 to 3 months. Phase One Trade Deal: Unimpressive But Pragmatic Adding to this bullish shift in equity market signals was the first of two positive fundamental improvements over the past week. The US and China reached agreement on a Phase One deal just a few days before the 15% tariff increase on $160 billion of Chinese export goods to the US was scheduled to come into effect. Reportedly, the two sides agreed to pause the 15% tariff scheduled for December 15 and lower the tariff on about $120 billion of Chinese imports to 7.5%.  However, the 25% tariffs on the first $250 billion of Chinese imports will remain in place (Chart 2). Chart 2Tariff Rollbacks Unimpressive... Chart 3...But China's Promise To Buy American Goods Helps Trump Claim Victory In return, China agrees to, in the next two years, boost imports of American goods and services by a total of $200 billion from their levels in 2017 (Chart 3).  While no specific number has been confirmed from the Chinese side, in a news conference, Chinese officials said that China “will expand imports of some agriculture products currently in urgent need, such as pork and poultry.” Given that both sides picked low hanging fruit in the Phase One deal, the tougher issues to be discussed in Phase Two could lead to a breakdown in negotiations, which potentially could unravel the Phase One tariff rollbacks. Nevertheless, the agreement serves an interim purpose for both President Trump and President Xi: it allows Trump to claim a short-term political victory on his trade negotiations with China, and gives Xi some breathing space to focus on domestic economic challenges.  Bottom Line: While the Phase Two negotiations, when commencing, will be a risk to the Phase One trade deal, the current agreement likely marks the beginning of a truce, which could potentially last through the November’s presidential election in 2020. CEWC: Reinforcing Reflationary Bias For 2020 In addition to the trade deal, another bullish factor for stocks is the fact that Chinese policymakers will proactively fine-tune economic policy to mitigate the impact from the US tariffs that remain in effect and to ensure stable economic growth in the coming year. President Xi at last week’s Central Economic Work Conference (CEWC) urged that Chinese policymakers must “make contingency plans” to combat challenges from both domestic and external environment. At the three-day annual CEWC this year, Chinese central and local government officials set the direction and strategy of China’s economic policy for the coming year. The meeting also reveals the challenges Chinese policymakers are facing, and the areas they will likely mobilize monetary resources to tackle. Investors can therefore benefit from insights into both the direction and constraints of China’s near-term policy framework. We highlight four investment-relevant messages from this year’s CEWC: A Greater Emphasis On Growth Stability The tone from this year’s CEWC reflects an urgency to stabilize the economy and meet growth targets. The tone from this year’s CEWC reflects an urgency to stabilize the economy and meet growth targets. The statement from the meeting mentioned “stability” 31 times, compared with 22 in 2018.1  The statement also reiterated the importance of doubling GDP and per capita income by 2020. This suggests that a growth imperative remains the top priority and reinforces the leadership’s reflationary policy stance for next year. We previously projected that the Chinese government would allow a lower GDP growth target for 2020, between 5.5 and 6.0%. However, we think growth targets to be set at next March’s National People’s Congress (NPC) are more likely to be in a “reasonable range” (verbiage used in the CEWC statement) between 5.8 and 6.2%. As noted in our December 11 report,2 the Chinese economy needs to increase by 6% in 2020 to double its size from the 2010 level in real terms. While China’s real GDP statistics are suspiciously smooth and largely invalid when it comes to equity market pricing, the deviation between market expectations and the actual GDP growth target range set at NPC can help investors gauge how much more (or less) ammunition Chinese policymakers are willing to deploy to support the economy in that year. China is falling short of its target to double real urban per capita income next year from 10 years ago (Chart 4). Nominal wage and salary per capita growth has experienced a sharp drop since the third quarter of 2018 and probably contributed to the subdued appetite for consumption (Chart 5). Chart 4Household Income: Rural Overshooting; Urban Falling Short Chart 5Wage Growth Only Started Stabilizing Recently   To meet the target, urban per capita income will need to grow at an above-real GDP rate of 10% in 2020, almost doubling the growth in 2018 and 2019.  Given the still weak domestic economic conditions, we are not optimistic that China will be able to double the growth rate of urban income per capita in 2020 from 2019. Additionally, income typically lags economic activity. Even if China’s economic slowdown bottoms in the first quarter of 2020, it is unlikely we will see significant improvement in income until a few quarters later. Therefore, we think policymakers will likely focus on overall economic and employment growth stability, and poverty reduction through improving rural income in 2020 (Chart 4, top panel). A Shift In Policy Priorities The new year marks the final year of the “Three Major Battles” against financial deleveraging, poverty elimination, and pollution. In this year’s CEWC statement, for the first time in three years, the order of the battles has been rearranged with financial deleveraging ranked behind poverty reduction and environment protection. The PBoC will stay on a mild rate-cutting cycle throughout next year. The shift in policy priorities suggests that the pressure to deleverage has greatly eased. Banks’ asset balance sheets will expand at a faster rate, while the pace of reduction in shadow banking will likely continue to moderate (Chart 6). The description of monetary policy stance was amended to “maintaining a flexible and appropriate monetary policy” from last year’s “appropriately loose or tight.” The change points to a more dovish tone, confirming our assessment that the PBoC will stay on a mild rate-cutting cycle to lower corporate funding costs throughout the next year3 (Chart 7). Chart 6In 2020, Expect Faster Bank Balance Sheet Expansion Chart 7The PBoC's Rate-Cutting Cycle Will Continue Next Year   At this stage, we do not anticipate the Chinese policymakers will entirely abandon financial risk containment or significantly loosen financial regulations. Rather, we think the reduced pressure on deleveraging and lowering of funding costs will provide moderate support for the private sector, specifically small- and medium-sized enterprises.  A slew of new policies announced before the CEWC, including an adjustment to some of the parameters in the Macro-Prudential Assessment (MPA) framework to encourage lending to the private sector,4 will help strengthen the impact of PBoC’s countercyclical measures. A Bigger Fiscal Push This year’s CEWC statement indicated policymakers will continue to fine-tune a proactive fiscal policy, but unlike last year, the meeting did not specify further cuts to taxes. The statement suggests fiscal support to the economy will mainly focus on infrastructure, and listed transportation, urban and rural development, and the 5G networks to be the government’s main investment projects next year. Chart 8Local Governments Have Borrowed More Than They Spent In 2019, infrastructure investment was subdued, despite increased quotas for local government special-purpose bond issuance. Our research shows that local government infrastructure expenditures in 2019 have consistently lagged behind their borrowing (Chart 8). The gap between local government infrastructure funding deficit and borrowing has only started flattening in the third quarter of this year. The delayed conversion from borrowing to spending means local governments have accumulated more spending power for 2020. In order to encourage local governments to speed up spending, the central government is also likely to further loosen up project restrictions. A bigger fiscal push by the central government, coupled with a frontloading of 2020 local government special-purpose bond issuance, will likely boost infrastructure spending to around 10% in the first two quarters, doubling the growth in the first eleven months of 2019.5  More robust fiscal stimulus will lead to an increase in the debt load of local governments, but Chinese policymakers are caught between a rock and a hard place and therefore must choose the least risky tools to stimulate the economy.  In our view, local government bonds are still a better option over local government financing vehicles (LGFVs) or other illicit channels. Social Housing Gets Another Boost Surprisingly,6 last week’s CEWC statement again emphasized the importance of shantytown renovation (Chart 9). While this implies there would likely be a significant monetary boost to social housing in the coming year, the statement also indicated that policymakers would not want property prices to dramatically change in either direction. Even though local governments have been granted more flexibility to fine-tune their local housing policies, we think the possibility of a broad-based regulatory easing in the housing market remains low in 2020. Therefore, government subsidies in social housing in 2020 will unlikely to lead to another property market boom like that of 2016. Chart 9Social Housing Gets Another Fiscal Boost If the scale of the cyclical policy support in 2020 is still moderate, then we think the stimulus may delay, but not entirely derail China’s progress in structural rebalancing, particularly if the current financial regulations remain in place. The CEWC statement also mentioned deepening reforms of state-owned enterprises (SOEs), and a “three-year SOE reform executive plan”, which we will be closely monitoring in the coming year. Last year’s reference to “striving for stronger, better and larger state assets” was replaced this year by “accelerating the reform of SOEs and optimization of SOE resource allocation”, implying there will be a greater emphasis on the quality and efficiency of SOEs’ assets. These plans can potentially impact SOE profit margins and accelerate the pace of industry consolidation among SOEs. The statement also dedicated a lengthy and detailed segment to "promoting high-quality development", covering topics ranging from the reform of the agricultural supply side to accelerating the implementation of regional development strategies. Further details are expected after next March’s NPC in Beijing. At that time, we will have a Special Report to consider some of the strategic and regional planning initiatives discussed at the meeting and their market implications. Bottom Line: The past week’s CEWC reinforces our view, that the Chinese leadership’s urgency to stabilize the economy has shifted to overweigh the desire to continue financial deleveraging.  Monetary policy will only moderately loose further, but fiscal stimulus may overshoot in the first half of 2020.  Investment Conclusions We have been cyclically overweight Chinese stocks on the basis of a bottoming in the economy in the first quarter of 2020, and the likelihood of an eventual trade deal.  Tactically however, we have been more cautious because of the potential for further near-term downside in the economic data, and the uncertainty surrounding the timing and nature of a trade deal. While the tariff reduction in the trade deal announced last week is somewhat disappointing, the combination of a trade agreement, bullish equity market signals, and the positive messages from last week’s CEWC warrant an upgrade to our tactical stance on Chinese stocks from neutral to overweight. As such, our cyclical and tactical calls are now both aligned in favor of Chinese stocks within a global equity portfolio. As a final point, we noted in last week's report that there are decent odds that all of the outperformance of Chinese stocks in 2020 will be frontloaded in the first half of the year. In the new year, we look forward to providing an ongoing assessment of whether Chinese economic growth has more or less potential upside than we currently expect, along with the attendant investment implications of our analysis. Stay tuned!   Jing Sima China Strategist jings@bcaresearch.com   Footnotes 1   http://www.gov.cn/xinwen/2019-12/12/content_5460670.htm http://www.xinhuanet.com/english/2019-12/12/c_138626531.htm 2   Please see China Investment Strategy Weekly Report "2020 Key Views: Four Themes For China In The Coming Year," dated December 11, 2019, available at cis.bcaresearch.com 3, 5 Please see China Investment Strategy Weekly Report "Questions From The Road: Timing The Turn," dated November 20, 2019, available at cis.bcaresearch.com 4   http://www.gov.cn/premier/2019-12/14/content_5461147.htm 6   In our last week’s China Investment Strategy 2020 Outlook report, we had projected less monetary support to this sector in 2020. Cyclical Investment Stance Equity Sector Recommendations