Equities

Highlights Coincident measures of economic activity suggest that China’s economy continued to slow in July. The August manufacturing PMIs were positive, but they more likely reflect tariff front-running activity than a genuine improvement in the export outlook. The decline in the RMB will have a positive reflationary effect for Chinese producers, but it will not likely be enough to prevent a further slowdown in activity if the export outlook continues to deteriorate (as we expect). Our investment strategy recommendations remain unchanged: underweight Chinese stocks over a tactical (i.e. 0-3 month) time horizon, but overweight cyclically (6-12 months) on the basis that policymakers will ultimately act on the need to ease further. Feature Tables 1 and 2 on pages 2 and 3 highlight key developments in China’s economy and its financial markets over the past month. On the growth front, coincident measures of economic activity suggest that China’s economy continued to slow in July. The August manufacturing PMIs were positive (especially the Caixin PMI), but the absence of a pickup in manufacturing outside of China suggests that the August improvement (and the recent trend in China’s export data) reflects the same kind of tariff front-running activity that has occurred on more than one occasion over the past 18 months (and which sharply unwound in late-2018 / early-2019). On the housing front, July’s update saw a narrowing in the gap between lofty housing construction and depressed sales volume, suggesting that housing-related activity is unlikely to provide a ballast to counter a weakening external demand outlook absent further policy support for the sector. Table 1China Macro Data Summary Table 2China Financial Market Performance Summary Within financial markets, the continued decline in the RMB is the most noteworthy development, with USD-CNH having risen roughly 4.5% since we initiated our long position in mid-May. The still-controlled decline is likely to have a reflationary effect for Chinese producers, but not likely enough to prevent a further slowdown in activity if the export outlook continues to deteriorate in Q4 (as we expect). Consequently, our investment strategy recommendations remain unchanged: the near-term outlook remains bearish for China-related assets, but Chinese policymakers will be forced over the coming 3-6 months to recognize the need to ease further. Investors should remain overweight Chinese stocks over a 6-12 month horizon, but should continue to hedge RMB exposure by being long USD-CNH. In reference to Tables 1 and 2, we provide below several detailed observations concerning developments in China’s macro and financial market data: Chart 1The Chinese Economy Continues To Slow Based on coincident activity indicators such as the Li Keqiang index (LKI), China’s economy continued to slow in July (Chart 1). While the pace of growth remains stronger today than it did during the depths of the 2015/2016 slowdown, momentum is clearly negative and a further deceleration is likely over the coming few months. In short, Chinese growth has not yet bottomed. Our leading indicator for the LKI remains in a shallow uptrend, but slowed in July. The sequential decline occurred in nearly all of the components of the indicator; credit was particularly disappointing, with adjusted total social financing growth having decelerated nearly a half a percentage point on a YoY basis. Our indicator underscores that more easing will ultimately be needed in order to stabilize economic activity, even though we acknowledge that it will only likely arrive in piecemeal fashion until policymakers are pressured with a further significant slowdown in growth. The July housing data update was significant, as it featured a narrowing of the gap between lofty housing construction and depressed sales volume (Chart 2). While both the pace of pledged supplementary lending as well as sales volume growth marginally improved in July, floor space started decelerated to mid-single-digit territory (from 10+%). We have noted in several reports that the gap between starts and sales is unsustainable, suggesting that housing-related activity is unlikely to provide a ballast to counter a weakening external demand outlook absent further policy support. At first blush, China’s August PMIs were surprisingly positive. While the official manufacturing PMI slightly declined, the new export orders component improved as did the overall Caixin manufacturing PMI. The improvement in the latter was particularly significant, as it brought the index back into expansionary territory. However, our view of the pickup is less sanguine, and we expect it to reverse over the coming few months. August’s trade data has yet to be released, but the divergence between export and import growth in July provides a clue that the pickup in manufacturing/export sentiment is likely to be temporary. Ex-China, the global PMI has not meaningfully improved (Chart 3), which implies that the acceleration in Chinese export growth is indicative of the same kind of tariff front-running activity that has occurred on more than one occasion over the past 18 months (and which sharply unwound in late-2018 / early-2019). As a result, investors should view the near-term improvement in Chinese export-related data as a sign of an impending slowdown in trade activity, rather than an indication that the underlying trade situation is improving. Chart 2The Unsustainable Pace Of Housing Starts Is Slowing Chart 3China's August PMI Likely Reflects Tariff Front-Running Chart 4A-Shares Are Trading More Off Domestic Stimulus Odds Than Investable Stocks The most relevant high-level insight emanating from China’s equity markets continues to be the divergence in performance between investable and domestic stocks over the past three months. While investable stocks have trended lower due to the strong focus of foreign investors on the trade war, domestic stocks have moved sideways versus the global benchmark in US$ terms (Chart 4). To us, this suggests that domestic stocks are acting as a better barometer of domestic reflation than their investable peers and, for now, A-shares are acting as if reflationary efforts will just offset weak external demand. The likelihood of a further growth slowdown coupled with the reluctance of Chinese policymakers to aggressively stimulate implies that the domestic market is at risk of a near-term relapse, but global investors should watch closely for a breakout to the upside as an indication that policy is becoming considerably easier (and that investable stocks may soon follow the domestic market higher). Over the past month, sector performance within the investable equity market has mostly been along cyclical/defensive lines, with the former underperforming the latter. One notable exception is the investable consumer discretionary sector, which has risen more than 7% over the past month in absolute US$ terms, and has been rising in relative terms since the beginning of the year. Alibaba now accounts for a sizeable portion of the investable consumer discretionary sector, and its outperformance may be signaling a stable outlook for domestic consumer spending. China’s interbank and government bond market has been little changed over the past month. After having declined roughly 20 bps from late-July to early-August, Chinese government bond yields remain at a nearly 3-year low as part of ongoing investor expectations that monetary policy in China will remain easy. The PBOC’s mid-August reform of the loan prime rate (LPR) was a small step in the direction of further easing, but was not likely large enough to have a material impact on credit growth. More fiscal spending remains the most likely avenue for significant additional stimulus, but we do not expect it to materialize before economic activity slows further. Chart 5Onshore Corporate Bond Returns: Negligant Impact Of Defaults Chinese onshore corporate bond spreads fell slightly over the past month, reversing part of a modest uptrend in spreads that had begun in May. Abstracting from the day-to-day changes in spreads, the bigger story is that acute concerns over the potential for widespread corporate defaults have not led to any material impact on onshore corporate bond performance at any point over the past 18 months (which is in line with what we argued several times last year). In RMB terms the ChinaBond Corporate Bond Total Return Index has risen nearly 8% over the past year, or roughly 2.6% in unhedged US$ terms using spot exchange rates (Chart 5). While we would not advise an unhedged currency position in onshore corporate bonds at this time given our long stance towards USD-CNH, the bottom line for investors is that onshore corporate bond spreads already account for rising defaults, and probably overstate the risk. China’s controlled but very significant currency depreciation has continued over the past month, with USD-CNH having nearly reached 7.2 this week. Our earnings recession model for the MSCI China index suggests that the depreciation is likely to have a stimulative effect; holding the current pace of credit growth and the outlook for new export orders constant, the decline in the RMB has probably cut the odds of an ongoing contraction in EPS from roughly two-thirds to slightly over one-half over the past month. However, we noted above that the modest improvement in China’s manufacturing PMIs likely reflects unsustainable trade frontrunning, signaling that further stimulus will likely be required. This will have to come either through a more intense pace of credit growth, or meaningful further currency depreciation (or both). As such, investors should stay long USD-CNH for now, despite the significant rise over the past month. Jonathan LaBerge, CFA, Vice President Special Reports jonathanl@bcaresearch.com Jing Sima China Strategist jings@bcaresearch.com   Cyclical Investment Stance Equity Sector Recommendations

Highlights An inevitable and imminent U.K. general election will be one of the most unpredictable and ‘non-linear’ elections ever. This non-linearity makes it difficult to take a high-conviction view on sterling’s direction because a tiny vote swing in one direction or another could be the difference between a no-deal Brexit – and the pound below parity against the euro – or a solid coalition for remain – and the pound at €1.30. Instead, a good strategy is to buy sterling volatility on the announcement of the election. The easiest way to implement this is simultaneously to buy at-the-money call and put options (versus either the euro or dollar). In a soft Brexit or remain, the U.K. equity sectors most likely to outperform the overall market are real estate and general retailers. In a hard Brexit, a U.K. sector likely to outperform the overall market is clothing and accessories. Feature Chart of the WeekSterling Volatility Could Go Up A Lot Lyndon B Johnson famously said that that the first rule of politics is to learn to count. A government is a lame duck if it does not have a majority of legislators to drive and set its policy. Fifty years on, LBJ’s namesake is learning this first rule of politics. Boris Johnson is running a minority U.K. government. The irony is that this makes it impossible for a pro-Brexit Johnson to pass legislation for the Brexit process itself! Ending the free movement of EU citizens was supposedly one of the biggest ambitions of the Brexit vote. But astonishingly, even after a no-deal Brexit, free movement would not end – because EU law continues to apply until its legal foundation is repealed. The U.K. government wanted to end free movement through a new law, the immigration bill, but the proposed legislation, along with several other key new laws, cannot make it through parliament. The Most Non-Linear Election Looms The only way out of the impasse is to change the parliamentary arithmetic via a snap general election. The trouble is that the outcome of such an election is near impossible to predict. This is because the U.K.’s first past the post electoral system is designed for a head-to-head between two dominant parties. But right now, there are four parties in play – from left to right: Labour, Liberal Democrat, Conservative, and Brexit. While in Scotland, the SNP is resurgent. Making the next U.K. general election one of the most unpredictable and ‘non-linear’ elections ever. The outcome of a snap general election is near impossible to predict. For example, in the recent Brecon and Radnorshire by-election, the 10 percent of votes that went to the Brexit party syphoned just enough ‘leave’ votes from the Conservatives to hand the seat to the Lib Dems. Repeated nationwide, such a swing could inflict mortal damage to the Conservatives. On the other hand, the staunchly pro-remain Lib Dems could also syphon crucial votes from a Labour party that is prevaricating on its Brexit policy. Understanding this, Johnson isn’t using the next election to resolve Brexit; quite the opposite, he is using Brexit to resolve the next election – in his favour – with the ancient strategy of ‘divide and rule’. Unite ‘leave’ by tacking to the hard right, and divide ‘remain’ between Labour, Lib Dem, Green, SNP, and Plaid Cymru. However, it is a very risky strategy. A small but critical rump of Brexit party voters are diehard anti-establishment rather than pure leave votes; furthermore, remainers almost certainly will vote tactically as they did in 2017 when they obliterated the Conservatives’ overall majority. For U.K. investments, the inevitable imminent election dominates all other considerations, as its outcome will determine the U.K.’s ultimate trading relationship with the EU and rest of the world, as well as establish the U.K’s overarching economic policy and strategy. But to reiterate, the outcome is highly non-linear. A tiny vote swing in one direction or another could be the difference between a no-deal Brexit – and the pound below parity against the euro – or a solid coalition for remain – and the pound at €1.30, as sterling’s ‘Brexit discount’ is unwound (Chart I-2 and Chart I-3). Chart I-2Sterling's Brexit Discount Is 15 Percent, Based On Real Interest Rate Differentials... Chart I-3...And Expected Interest Rate ##br##Differentials The non-linearity makes it difficult to take a high-conviction view on sterling’s direction. Instead, as soon as an election is announced, a good strategy is to buy sterling volatility. Although it has risen recently, sterling volatility is only in the foothills relative to the heights of 2016, meaning plenty of upside (Chart I-1). The easiest way to implement this is simultaneously to buy at-the-money call and put options (versus either the euro or dollar). Brexit Investments  A common question we get is what are the most Brexit-impacted investments, in both directions? As mentioned, the most obvious is sterling. Relative to the established relationship with interest rate differentials prior to the Brexit vote in 2016, the pound now carries a Brexit discount of around 15 percent. For U.K. investments, the inevitable imminent election dominates all other considerations. Related to this, the FTSE100 has outperformed the Eurostoxx600. This is exactly as theory would suggest. The FTSE100 and Eurostoxx600 are just a collection of global multi-currency earning companies quoted in pounds and euros respectively. So when sterling weakens, the multi-currency earnings increase more in FTSE100 index terms than in Eurostoxx600 index terms, resulting in FTSE100 outperformance (Chart I-4). Chart I-4The FTSE100 Outperforms When Sterling Weakens Turning to U.K. equity sectors, those most likely to outperform the overall market in a soft Brexit are real estate and general retailers (Chart I-5 and Chart I-6). Chart I-5U.K. Real Estate Outperforms In A Soft Brexit Chart I-6U.K. General Retailers Outperform In A Soft Brexit While a sector likely to outperform the overall market in a hard Brexit is clothing and accessories (Chart I-7). Chart I-7U.K. Clothing And Accessories Could Outperform In A Hard Brexit Four Disruptors Revisited The final section this week revisits the wider context for Brexit and other recent examples of populism. Specifically, they are backlashes to four structural disruptors to economies and financial markets. Disruptor 1: Protectionism. Since the Great Recession, an extremely polarised distribution of economic growth has left many people’s standard of living stagnant – despite seemingly decent headline economic growth and job creation (Chart I-8). Chart I-8Disruptor 1: Income Inequality Leads To Protectionism Looking to find a scapegoat, economic nationalism and protectionism have resonated very strongly with voters in several major economies: the U.S., U.K., Italy, and Brazil. Other voters could follow in the same vein. But history teaches us that protectionism ends up hurting many more people than it helps. Disruptor 2: Technology. The bigger danger is that the malaise is being misdiagnosed. Many middle-income job losses are not due to globalization, but due to technology. A polarised distribution of economic growth has left many people’s standard of living stagnant. Specifically, Artificial Intelligence (AI) is replacing secure middle-income jobs and displacing workers into insecure low-income manual jobs – like bartending and waitressing – which AI cannot (yet) replace (Table I-1). And AI’s impact on middle-income jobs is only in its infancy.1 The worry is that by misdiagnosing the illness as globalization and wrongly responding with protectionism, the illness will get worse, rather than improve. Table I-1Disruptor 2: Technology Disruptor 3: Debt super-cycles have reached exhaustion. Protectionism carries a further danger. Just like developed economies did a decade ago, major emerging market economies are now coming to the end of structural credit booms and need to wean themselves off their credit addictions (Chart I-9). At this point of vulnerability, aggressive protectionism risks tipping these emerging economies into a sharp slowdown.  Chart I-9Disruptor 3: Debt Super-Cycles Have Reached Exhaustion Disruptor 4: Financial markets are richly valued. Disruptors one, two and three come at a time when equities are valued to generate feeble total nominal returns over the next decade (Chart I-10). Extremely compressed risk premiums are justified so long as bond yields remain ultra-low. Otherwise, the rich valuations will come under pressure.  Chart I-10Disruptor 4: Financial Markets Are Richly Valued The long-term investment message is crystal clear. With the four disruptors in play, we strongly advise long-term investors not to follow passive (equity) index-tracking strategies. Instead, we advise long-term investors to follow bespoke structural investment themes as shown in our structural recommendations section. Please note that owing to my travelling there is no fractal trading system this week. Normal service will resume next week.   Dhaval Joshi, Chief European Investment Strategist dhaval@bcaresearch.com Footnotes 1 Please see the European Investment Strategy Special Report ‘The Superstar Economy: Part 2’ January 19, 2017 available at eis.bcaresearch.com Cyclical Recommendations Structural Recommendations Closed Fractal Trades Trades Closed Trades Asset Performance Currency & Bond Equity Sector Country Equity Indicators Bond Yields Chart II-1Indicators To Watch - Bond Yields Chart II-2Indicators To Watch - Bond Yields Chart II-3Indicators To Watch - Bond Yields Chart II-4Indicators To Watch - Bond Yields   Interest Rate Chart II-5Indicators To Watch - Interest Rate Expectations Chart II-6Indicators To Watch - Interest Rate Expectations Chart II-7Indicators To Watch - Interest Rate Expectations Chart II-8Indicators To Watch - Interest Rate Expectations  

The SPX moved laterally last week, and remains below the critical 50-day moving average. Recession worries intensified on the back of the first sustained 10/2 yield curve slope inversion. Coupled with the trade war re-escalation, they remain the dominant macro themes (top panel). Clearly, the trade war is a boon to the U.S. dollar and it further sabotages exports (greenback shown inverted, middle panel). Yesterday, adding insult to injury, the economically hyper-sensitive U.S. manufacturing sector convulsed and the ISM manufacturing survey broke below the boom/bust line for the first time since the late-2015/early-2016 manufacturing recession. These exporters are in retrenchment and if CEOs continue to prune capex plans, more pain lies ahead (for additional details on the capex outlook, please see yesterday’s Weekly Report). Bottom Line: We reiterate our cautious overall equity market stance on a cyclical 3-12 month time horizon.  ​​​​​​​ ​​​​​​​

Highlights Portfolio Strategy Intensifying recession fears, rising risks of ineffectual monetary policy, and escalating trade policy uncertainty that is shattering corporate America’s capex plans, warn that sizable drawdown risks persist in the broad U.S. equity market in the upcoming 3-12 months. The transition from a virtuous to a vicious EPS-to capex cycle, souring global growth, the firming U.S. dollar that is weighing on cyclical/defensive pricing power and exports, and deteriorating relative balance sheet (b/s) and relative operating metrics compel us to put the cyclicals/defensives portfolio bent on downgrade alert. Recent Changes The cyclicals/defensives portfolio bent is now on our downgrade watch list. Table 1 Feature The SPX moved laterally last week, and remains below the critical 50-day moving average. Recession worries intensified on the back of the first sustained 10/2 yield curve slope inversion. Coupled with the trade war re-escalation, they remain the dominant macro themes. Worrisomely, BCA’s Equity Selloff Indicator captures these dynamics and continues to emit a distress signal (Chart 1). Equities have been relatively resilient in the face of these headwinds. Investors are hoping not only for a U.S./China trade deal, but also that the Fed’s cutting cycle will save the day. Chart 1Mind The Gap What caught our attention from all the speeches at the recent Jackson Hole Symposium was RBA Governor Philip Lowe’s speech, especially the section titled “Elevated Expectations That Monetary Policy Can Deliver Economic Prosperity”.1 Lowe highlighted that “When easing monetary policy, all central banks know that part of the transmission mechanism is a depreciation of the exchange rate. But if all central banks ease similarly at around the same time, there is no exchange rate channel: we trade with one another, not with Mars. There are, of course other transmission mechanisms, but once we cancel out the exchange rate channel, the overall effect for any one economy is reduced. If firms don't want to invest because of elevated uncertainty, we can't be confident that changes in monetary conditions will have the normal effect (stress ours).” The perception that the Fed is going to be the savior of the economy is a big risk, and when reality hits that President Trump’s tariffs are a shock to global final demand and presage profit contraction, volatility will skyrocket (please refer to Chart 3 from the August 19 Weekly Report). Importantly, the virtuous capex upcycle that has been in motion since the Trump inauguration when CEOs voted with their feet and started investing, has ground to a halt according to national accounts (Chart 2). U.S. non-residential fixed investment subtracted from GDP growth last quarter, and we doubt the Fed’s fresh interest rate cutting cycle will arrest the fall. Leading indicators of capital outlays point to additional pain in coming quarters (Chart 2). As a reminder, generationally low interest rates and a real fed funds rate near zero hardly restrict expansion plans. Chart 2Free Falling The shift from a virtuous to a vicious capex cycle is a theme that will start gaining traction as the year draws to a close. While pundits are dismissing the recent steep fall in capex as a one off, our indicators suggest otherwise. The middle panel of Chart 3 clearly depicts this emerging dynamic. Profit growth peaked in 2018 on the back of the massive fiscal easing package and capex is following suit, albeit with a slight lag. There are high odds that a looming profit contraction will further shatter frail animal spirits, sabotage the capex upcycle and tilt into a down cycle. Tack on the ongoing trade uncertainty, and CEOs are certain to, at least, postpone deploying longer-term oriented capital. Worryingly, this transition from a virtuous to a vicious capex cycle is not limited to a few cyclical sectors as we would have expected on the back of the re-escalating Sino-American trade tussle. In fact, basic resources’ and non-capital goods producers’ capital outlays are decelerating, warning that corporate America is in the early stages of retrenchment (bottom panel, Chart 3). Chart 3EPS-To-Capex Down Cycle Chart 4Capex… Charts 4, 5 & 6 break down sectorial capex growth using financial statement reported data from Refinitiv. Seven out of eleven sectors are steeply decelerating from near 20%/annum growth to half that; given that these sectors comprise more than 72% of the total capex pie, they will continue to weigh on overall stock market reported investment. Chart 5…Per… Chart 6…Sector Similarly, the news on the cyclicals versus defensives capex profile is grim. Trade uncertainty and the global growth soft patch has dealt a blow to deep cyclical expansion plans and leading indicators signal that the cyclicals/defensives capex will flirt with the contraction zone in the coming quarters (Chart 7). In sum, intensifying recession fears, rising risks of ineffectual monetary policy, and escalating trade policy uncertainty that is shattering corporate America’s capex plans, warn that sizable drawdown risks persist in the broad U.S. equity market in the upcoming 3-12 months. As a reminder, this is U.S. Equity Strategy’s view, which contrasts BCA’s sanguine equity market house view. Chart 7Relative Capex Blues This week we update our cyclicals versus defensives bias (we are currently neutral) and are compelled to put this portfolio bent on our downgrade watch list. Put The Cyclical/Defensive Tilt On Downgrade Alert Roughly two years ago, when nobody was talking about the brewing capex upcycle, we penned a report titled “Underappreciated Capex” and posited that: “It would be unprecedented if the current business cycle ended without a visible capex upcycle. Since the 1980s recession, all four recessions were preceded by stock market reported capex soaring to roughly a 20% annual growth rate. At the current juncture, capex is merely on the cusp of entering expansion territory and, if history at least rhymes, a significant capex upcycle is looming.” Fast forward to today and as historical empirical evidence had suggested, capex growth peaked near the 20%/annum mark (Chart 3 above). If our assessment is accurate that capex has now likely hit a wall and the virtuous EPS-to-capex cycle reverses to a vicious down cycle as EPS are now contracting, then deep cyclical high-operating leverage sectors are in for a rough ride. This will especially be true if the global recession warnings also morph into an actual recession on the back of the re-escalating Sino-American trade war. More specifically, our capex indicators are firing warning shots. Capex intentions according to a plethora of regional Fed surveys are sinking steadily, which bodes ill for cyclicals versus defensives (Chart 8). One key driver of the capex cycle is China and the emerging markets (EM). News on both fronts is grim. Our real-time indicator that gauges China’s reflation efforts (monetary and fiscal) turning into actual economic activity is Chinese excavator sales that remain in the doldrums (top panel, Chart 9). Chart 8Drop In Capex Will Weigh On Relative Profits Chart 9Elusive Global Growth Granted, global growth remains elusive as we highlighted last week and while softening Chinese economic activity is weighing on global growth, European and Japanese GDP growth is also decelerating with a number of economies already in the contraction zone (bottom panel, Chart 9). Melting global bond yields reflect these growth fears and warn that the relative share price ratio has more downside (middle panel, Chart 9). Export growth is an important indicator that closely tracks the ebbs and flows of global trade. When the trade-weighted U.S. dollar appreciates it dampens trade, the opposite is also true. Currently the Fed’s trade-weighted greenback based on goods has vaulted to cyclical highs, warning that the path of least resistance is lower for trade, thus a net negative for relative export and profit prospects (Chart 10). Similarly, EM capital outflows exacerbate the ongoing global growth blues and put additional strain on EM economies as depreciating currencies sap consumer purchasing power (top panel, Chart 10). The implication is that EM final demand is in retreat. The rising U.S. dollar not only deals a blow to basic resource exports via making them less competitive and leading to market share losses, but it also undermines cyclical sectors' pricing power. The top panel of Chart 11 shows that deflating commodity prices are exerting downward pull on relative share prices. The ISM manufacturing survey’s prices paid subcomponent corroborates this deflationary backdrop. Keep in mind that operating leverage cuts both ways, and now that the pendulum is swinging the opposite way revenue contraction in these high fixed costs industries will fall straight off the bottom line (Chart 11). Chart 10Rising Dollar Dollar Dampens Trade And… Chart 11…Saps Pricing Power Our macro-based cyclicals/defensives EPS growth models do an excellent job in capturing all these moving parts and signal that defensives have the upper hand in the coming quarters (bottom panel, Chart 8). Turning to operating metrics, the inventory buildup in the past few quarters coupled with a softness in overall business sales underscore that relative share prices will continue to trend lower (top panel, Chart 12). On the balance sheet front, relative net debt-to-EBITDA has troughed and widening junk spreads and the inverted yield curve warn that a further relative b/s degrading looms (second & third panels, Chart 12). If our thesis pans out in the coming months, then cash flow growth will come under pressure as the vicious capex cycle flexes its muscles foreshadowing a rise in bankruptcy filings. Already, the news on the profit margin front is disconcerting. Historically, the ISM manufacturing index and relative operating profit margins have been joined at the hip and the recent flirting of the former with the boom/bust line points toward an ominous relative margin squeeze (bottom panel, Chart 12). Chart 12Poor Financial & Operating Backdrop… Chart 13…But Excellent Valuations And Technicals Finally, soft versus hard data surprise oscillations have an excellent track record in forecasting relative share price movements. The current message is to expect additional weakness in relative share prices (second panel, Chart 13). While most of the indicators we track signal that the time is ripe to downgrade this portfolio bent to an underweight stance, bombed out relative valuations, and oversold technicals keep us at bay, at least for the time being (third & bottom panels, Chart 13). However, we are compelled to put the cyclicals/defensives ratio on downgrade alert to reflect the transition from a virtuous to a vicious EPS-to-capex cycle, souring global growth, the firming U.S. dollar that is weighing on cyclical/defensive pricing power and exports, and deteriorating b/s and operating metrics. The way we will execute this downgrade will be via a downgrade of the S&P tech sector (for additional details on the S&P tech sector's downgrade mechanics please refer to last Friday’s U.S. Equity Strategy Insight Report). Bottom Line: Stay on the sidelines in the S&P cyclicals/S&P defensives ratio, but put it on downgrade alert.     Anastasios Avgeriou, U.S. Equity Strategist anastasios@bcaresearch.com     Footnotes 1      https://www.rba.gov.au/speeches/2019/sp-gov-2019-08-25.html Current Recommendations Current Trades Size And Style Views Stay neutral cyclicals over defensives (downgrade alert) Favor value over growth Favor large over small caps

Feature In investment, there are times when your view and your strategy should not be the same. Our view remains that the global economy is likely to avoid recession over the next 18 months, that the Fed will cut rates once or twice more as an “insurance” but not enter a full easing cycle, that global bond yields will rise, and that risk assets will outperform over the next 12 months. But the risks to that view have increased, and so we want to bolster the hedge against our view being wrong. We don’t see Recommended Allocation Chart 1GAA Portfolio Volatility Relative To Benchmark government bonds as an attractive hedge at this level of yield, and so are moving to a “barbell” strategy, with overweights in equities and cash, and an underweight in fixed income. This lowers the volatility of our recommended portfolio to close to that of the benchmark (Chart 1). First, the good news. Although the manufacturing sector globally continues to deteriorate, with many PMIs falling to below 50, services and consumption remain robust almost everywhere (Chart 2). With central banks easing monetary policy, and in some countries (Italy, the U.S., the U.K., maybe even Germany) governments loosening fiscal policy, financial conditions are improving, which will eventually support growth (Chart 3). Intra-cyclical manufacturing downturns typically last around 18 months, and this one is close to its sell-by date (Chart 4). Chart 2Manufacturing Weak, Services Fine So what has changed? First, manufacturing has continued to decline for longer than we expected. In the early summer, there were signs of a bottoming in Europe, but these are no longer evident. The diffusion index of the global manufacturing PMI (i.e. the percentage of countries with a rising versus falling PMI), which typically leads the PMI by six months, suggests the PMI has further to fall (Chart 5). Chart 3Easing Financial Conditions Will Help Chart 4Close To The Bottom?   Chart 5Further Downside For PMIs? Chart 6China's Reluctant Monetary Stimulus   The most likely cause of this is that China has been more reluctant to ramp up monetary stimulus than we expected. It has eased fiscal policy, but monetary policy has been tentative: despite a moderate increase in credit creation this year, M3 money supply growth has barely accelerated (Chart 6). This has been enough to stabilize Chinese growth, but has been insufficient to give the sort of boost to global growth that China provided in 2016. There are two reasons for China’s reluctance to stimulate. The authorities seemingly continue to prioritize debt deleveraging and clamping down on shadow banking. And, also, maybe they do not want to give a boost to the global economy that would help the U.S. avoid recession and increase the probability of President Trump’s being reelected. China has been more reluctant to ramp up monetary stimulus than we expected. The Trade War is an increasing risk. BCA’s geopolitical strategists continue to assign a 40% probability to a resolution by year-end,1 but it is becoming harder to see how (or, indeed, why) President Xi would offer concessions to the U.S. that would lead to a deal. Ultimately, if Chinese growth slows significantly and U.S. stocks fall sharply, China will boost monetary stimulus and President Trump will push for even a superficial trade agreement. But things will need to get worse first. Meanwhile, the rise in global political uncertainty – and the mercurial nature of Trump’s foreign and trade policies – are a risk for markets (Chart 7). Chart 7Global Political Risks Rising Chart 8Consumers (Mostly) Remain Confident   We are also concerned about how long consumption can remain robust in this environment. So far, consumer confidence has remained resilient in the U.S., though it has dipped a little in Europe and Japan (Chart 8). But, if corporate profits remain weak, companies will start to delay hiring decisions and begin to lay off workers. This would be the transmission mechanism for the manufacturing slowdown to spread into the broader economy. So far, fortunately, there are few signs it is happening: German unemployment is at a record low, and U.S. initial claims continue to run at or below last year’s level (Chart 9). Chart 9No Signs Of Weakening Labor Market Table 1GAA Recession Checklist     In the recession checklist we have published for the past two or more years, we are starting to have to tick off more warning signs (Table 1 and Chart 10). Chart 10Some Worrying Signs Chart 11Risk Of Recession No Longer Negligible   For example, the yield curve has inverted both for the 3-month/10 year and 2-year/10-year. Although the yield curve has been an almost infallible predictor of recession in the past 70 years, there are some reasons to argue that it may not be as good this time: for example, central bank purchases have artificially pulled down long-term rates. But inversion is probably a self-fulfilling prophesy. For example, in a recent Fed Senior Bank Loan Officers Survey, 40% of banks said they would tighten credit standards simply because of a moderate inversion of the yield curve. Formal models of recession 12 months ahead that incorporate the yield curve slope, put recession risk now at about 25% (Chart 11).   Chart 1218 Months Of Ups And Downs Given all this, we think it is appropriate to take some risk off. As far back as February 2018, we argued that “investors primarily concerned with capital preservation might look to dial down risk or hedge exposure now”.2 Given the ups and down of markets in the past 18 months, we suspect that those risk-averse investors would not have been unhappy with that advice (Chart 12), although they would also have missed some nice equity rallies over that time, if they had been nimble enough to time entry and exit points. Since a majority of the subscribers to this service are rather conservative, we are now extending that advice to all clients. On a 12-month time horizon, we raise cash to overweight. We are also reducing somewhat both our equity overweight and bond underweight. In this period of increased uncertainty, a portfolio closer than usual to benchmark makes sense. (BCA’s House View is a little more bullish, remaining neutral on cash and overweight equities on the 12-month horizon). Fixed Income: Absent recession, we see little room for rates to fall further. The U.S. 10-year Treasury yield (now 1.5%) should stay above its July 2016 historic low of 1.37%. The Fed is unlikely to cut rates by 100 basis points over the next 12 months, as futures imply. We would expect only two 25 bp rate cuts: in September and either October or December. Yields are likely eventually to move up over the next 12 months (particularly given that inflation continues to trend higher). But they may not move much for a while, and so we move from underweight to neutral on duration for now. Eventually, we see investors understanding that government bonds are no longer an attractive hedge at current yields. Even if German 10-year yields fell to -1.2% (probably around the lowest possible), one-year total return would only be 5% (Table 2). The U.S. looks a little better, though. One could imagine the yield falling to zero in the next recession, which would give a return of 16%. On credit, we remain neutral: it represents a low-beta play on equities. So far this year, both investment-grade and high-yield bonds have eked out a small positive excess return (Chart 13). Table 2Not Much Room For Positive Returns Chart 13Credit Returns Have Not Been Bad Chart 14Downside For Cyclicals?   Equities: To offset our overweight on equities, we continue with a low-beta country/regional tilt. We recommend an overweight on the U.S., and underweight on Emerging Markets. The key for upside to U.S. equities remains earnings. Analysts have a pessimistic forecast of only 2.5% EPS growth in 2019 for the S&P500. A rough proxy for earnings growth (nominal GDP growth of 4.5%, wage growth of 3.5% leading to some margin expansion, 2% buybacks) points to EPS growth of around 7-8%. Q3 earnings (where analysts forecast -2% year-on-year) are likely to surprise on the upside, as did Q1 and Q2, though the strong dollar and weak overseas growth are risks. In our next Quarterly, to be published on October 1, we may make some adjustments to further dial down risk, for example in our equity sector recommendations, which currently have a slight cyclical tilt. The relative performance of cyclicals has started to wobble, and the message from bond markets is that cyclicals have further to fall in relative terms (Chart 14). Investors will come to understand that government bonds are no longer an attractive hedge at current yields. Currencies: The trade-weighted dollar has broadly moved sideways in the past year (Chart 15), weakening against the yen, but strengthening against the euro and EM currencies. We remain neutral on the dollar. It will continue to be pulled by two opposing forces: weak global growth is a positive, but the Fed has more room to cut rates than the rest of the world and so interest rate differentials will shift against the dollar. The renminbi is likely to continue to weaken, as the Chinese use currency policy as the least painful offset against U.S. tariffs. The latest  set of tariffs suggests that the CNY needs to fall to around 7.5-7.6 to the USD to offset their impact but, if Trump implements all the tariffs he has threatened, it could fall as far as 8.0 (Chart 16). This would pull other EM currencies down further. GBP will continue to be buffeted by Brexit scenarios. A no-deal Brexit could bring it down to 1.00 against the USD, whereas Remain or a very soft Brexit would take it back to PPP, 1.43. The current level is a probability weighted average of the two. Chart 15Dollar Has Moved Broadly Sideways Chart 16CNY Could Fall Much Further     Commodities: The oil price has been hurt by a slowing of demand in developed economies (Chart 17). Supply, however, remains tight, and our energy strategists have cut their forecast for Brent this year only modestly to an average of $66 a barrel (from an earlier forecast of $70, and from a current spot price of $60).3 Industrial commodities continue to struggle because of China’s slowdown (Chart 18) and are unlikely to recover until China’s stimulus is beefed up. Gold remains a good insurance for investors worried about geopolitical risk, recession, and inflation.   Chart 17EM Oil Demand Has Been Weak   Chart 18Industrial Commodities Hurt By China       Garry Evans, Senior Vice President Chief Global Asset Allocation Strategist garry@bcaresearch.com 1      Please see Geopolitical Strategy Weekly, “Big Trouble In Greater China,” dated August 23, 2019, available at gps.bcareseach.com 2      Please see Global Asset Allocation, “GAA Monthly Portfolio Update,” dated February 1, 2018, available at gaa.bcaresearch.com. 3      Please see Commodity & Energy Strategy, “USD Strength Slows Oil Demand Growth; 2020 Brent Forecast Remains At $75/bbl,” dated August 22, 2019, available at ces.bcaresearch.com Recommended Asset Allocation  

The GAA DM Equity Country Allocation model is updated as of August 31, 2019.   Currently, the model still favors Spain, Italy, Germany, the Netherlands, Switzerland, and Australia at the expense of the U.S., Japan, the U.K., France and Canada, as shown in Table 1.  Table 1Model Allocation Vs. Benchmark Weights Table 2Performance (Total Returns In USD %) As shown in Table 2 and Chart 1,  Chart 2 and  Chart 3, the overall model underperformed the MSCI World benchmark by 6 bps in August, driven by 1 bp of outperformance from Level 2 model, and 6 bps of underperformance from Level 1. Since going live, the overall model has outperformed by 82 bps, with 290 bps of outperformance by Level 2 model, offset by 51 bps of underperformance from Level 1. Chart 1GAA DM Model Vs. MSCI World Chart 2GAA U.S. Vs. Non U.S. Model (Level 1)   Chart 3GAA Non U.S. Model (Level 2)   Please see also the website http://gaa.bcaresearch.com/trades/allocation_performance. For more details on the models, please see Special Report, “Global Equity Allocation: Introducing The Developed Markets Country Allocation Model,” dated January 29, 2016, available at https://gaa.bcaresearch.com. Please note that the overall country and sector recommendations published in our Monthly Portfolio Update and Quarterly Portfolio Outlook use the results of these quantitative models as one input, but do not stick slavishly to them. We believe that models are a useful check, but structural changes and unquantifiable factors need to be considered too in making overall recommendations.   GAA Equity Sector Selection Model Chart 4Overall Model Performance The GAA Equity Sector Model (Chart 4) is updated as of August 31, 2019. The model’s relative tilts between cyclicals and defensives have changed compared to last month. The model continues to favor a mixed bag of sectors, given the current increased level of uncertainty, and continued lack of evidence that global growth is bottoming. Despite the current liquidity phase tilting the model to favor high-beta sectors, weak growth and momentum inputs offset that. The valuation component continues to remain muted across all sectors. The model is now overweight five sectors in total, two cyclical versus three defensive sectors. The overweight sectors are Consumer Discretionary, Information Technology, Consumer Staples, Healthcare and Utilities. For more details on the model, please see the Special Report “Introducing the GAA Equity Sector Selection Model,” dated July 27, 2016, as well as the Sector Selection Model section in the Special Alert “GAA Quant Model Updates,” dated March 1, 2019 available at https://gaa.bcaresearch.com. Table 3Model’s Performance (March 1, 2019 - Current) Table 4Current Model Allocations   Xiaoli Tang, Associate Vice President xiaoliT@bcaresearch.com Amr Hanafy, Research Associate amrh@bcaresearch.com              

Global equities peaked in late-January 2018 when the U.S. fiscal easing-related euphoria “positively infected” global investor sentiment. Since then, the SPX has moved laterally, closing higher by 0.52% (as of August 28, 2019 close). But, looking underneath the hood is revealing. The top panel of the chart shows the unweighted returns of the S&P 500 GICS1 sectors since January 2018. The bottom panel shows the weighted returns. Clearly the tech sector is the only pillar keeping equities afloat given the higher than 20% SPX weight they command. Within tech, software stocks have the largest weight and that juggernaut explains most of the tech sector’s returns since January 2018. One key reason why these secular growth stocks are near all-time highs (along with utilities and real estate outperformance) is the drubbing in U.S. Treasury yields, especially since the November 2018 peak. Nevertheless, there is a big risk looming: the trade war infiltrating tech stocks similar to the rest of their cyclical brethren. Already, two tech stocks (bellwether CSCO and ADSK) blamed the trade war for their soft guidance, and the longer the war lasts, the larger the list of profit warnings will get. Tack on the rising U.S. dollar, and profit expectations are at risk of disappointment, as the tech sector’s international sales exposure stands near 60%. As a reminder, we remain overweight the S&P software index, but we have increased our trailing stops in order to protect gains. Such a downgrade to neutral will also trigger the downgrade alert on the S&P tech sector and push this index to underweight from currently neutral. Bottom Line: The broad market is skating on thin ice and if the tech sector breaks down, so will the SPX. We reiterate our cautious overall equity market stance on a cyclical 3-12 month time horizon. ​​​​​​​​​​​​​​