Industrials

This week we upgraded the S&P railroads index to neutral locking in 6.4% in relative gains since inception. The defensive nature of rails is most evident in industry pricing power (third panel). Railroad selling prices are holding their own despite a sizable drop in volumes. Moreover, CEOs exercised caution and refrained from adding to headcount. Taken together, they are boosting our profit margin proxy, which can serve as a catalyst to lift relative share price momentum out of its recent funk (second panel). Similarly, our three factor S&P rail EPS growth model is heralding a pickup in profits in the back half of the year (bottom panel). Bottom Line:  Lift the S&P railroads index to neutral. Please refer to the most recent Weekly Report for the headwinds that prevent us from going overweight rail stocks.  

Highlights Portfolio Strategy The Fed’s unorthodox monetary policy is aimed at quashing volatility, lifting asset prices and debasing the currency, all of which are equity market bullish. Grim, but backward looking, macro data are already reflected in the significant restaurant relative share price correction. Upgrade to neutral. Book profits in the underweight S&P rails portfolio position and lift exposure to neutral on the back of: a.) already reflected grim ISM services data, b.) resilient industry pricing power, c.) firming railroad profit margin backdrop and d.) encouraging signs from our EPS growth model.   Recent Changes Augment the S&P restaurants index to neutral, today. Upgrade the S&P railroads index to a benchmark allocation, today. Table 1 Feature The SPX made a fresh run to recovery highs last week, cheering forward looking news of reopening of the economy and neglecting backward looking downbeat employment and PMI releases. Extremely easy fiscal and monetary policies remain the dominant macro themes, and underpin our sanguine equity market view for the coming 9-12 months. While Bill Martin’s infamous 1955 portrayal of the Fed as “the chaperone who ordered the punch bowl removed just when the party was really warming up”,1 the Jay Powell led Fed has done the opposite, and rightly so: it has ordered and delivered a bottomless punchbowl. The Fed’s unorthodox monetary policy is aimed at quashing volatility (Chart 1), lifting asset prices and debasing the currency, all of which are equity market bullish. According to Leo Krippner’s shadow short rates (SSR) estimate, the shadow fed funds rate is negative and should continue to support the SPX (SSR shown inverted, Chart 2). Chart 1Vol Will Melt Chart 2Crumbling Shadow Rates Underpin The SPX…   In fact, there are two distinct avenues that declining interest rates underpin equities: First, falling interest rates are a boon to equities via a rising price-to-earnings multiple (SSR shown inverted, Chart 3). While the 12-month forward multiple is above a 20 handle, the highest point since the dotcom bubble era, using second and third fiscal year sell-side profit estimates – which better resemble trend EPS – results in a more tame forward P/E multiple with more upside (Chart 4). Second, while the Fed would never admit to it, it is trying to devalue the US dollar and reflate the global economy, which will indirectly boost S&P 500 revenues. As a reminder, 40% of SPX sales are internationally sourced and thus a falling greenback is a boon to S&P 500 turnover (bottom panel, Chart 5). Chart 3…Via Higher Valuations Keep in mind that most of global trade is conducted in USD and when trade collapses it creates a US dollar shortage (i.e. fewer US dollars are circulating around) that lifts the value of the reserve currency and vice versa. Cognizant of that, the Fed is trying to provide ample US dollar liquidity and aid in pushing the greenback lower (top panel, Chart 5). Chart 4Peer Across The EPS Valley, And Valuations Have Room To Rise Chart 5Depreciating USD Is A Boon For SPX Sales Drilling beneath the SPX’s surface, early-cyclical consumer discretionary equities are the primary beneficiaries of negative SSR. The top panel of Chart 6 shows that over the past three decades relative share prices are the mirror image of interest rates. This cycle, household finances are in order and coupled with generationally low interest rates signal that consumer spending will recover smartly as the economy opens up in coming quarters. Thus, consumer discretionary stocks should sustain their outperformance (middle & bottom panels, Chart 6). A small digression with regard to the reopening of the economy is in order. Pundits have been discussing and showing the three distinct waves of the Spanish flu as the closest parallel with the current pandemic. Chart 7 shows these three waves using UK data, but the UK equity market (and the DOW for that matter) did not really budge back then. Keep in mind this was in the midst of a recession as the Great War was about to end on November 11, 1918 (Remembrance Day). Chart 6Stick With Consumer Discretionary Exposure Chart 7The 1918 UK Parallel, Including Equities   While no one really knows how in the long-term this pandemic will affect the economy, the stock market, society in general and consumer behavior in particular, our sense is that uncertainty will continue to recede in the coming months irrespective of the second and third likely waves. Why? Because not only do governments know more about this invisible enemy, but they (and hospitals) will also be more prepared to deal with any future outbreaks. Moreover, given that there is a race to get a novel coronavirus vaccine (and treatment) the world over, a breakthrough will soon materialize; MRNA’s recent FDA phase II clinical trial for their vaccine candidate is a case in point. Receding uncertainty is great news for stock investors. Meanwhile, in recent research we highlighted that early-cyclical interest rate-sensitive equities do in fact lead the GICS1 sector pack in recessionary recoveries based on empirical evidence.2 As a reminder, in mid-April we lifted the S&P consumer discretionary sector to overweight and this week we are updating our views on a hard hit subindex. We are also upgrading a deep cyclical services industry to neutral. Preparing To Dine Out It no longer pays to be underweight the S&P restaurants index; upgrade to neutral today. Not only the reopening of the economy will, at the margin, bring back diners (take out mostly) to restaurants, but the two heavyweights that comprise 80% of the market cap of the S&P restaurants group are anything but discretionary. In our view, MCD is defensive and SBUX has become a staple. Thus, as the economy slowly reopens and store traffic picks up, these bellwether stocks will lead this index higher. Relative share prices have corrected to the twenty-year uptrend line and hover near the previous two breakout points in 2011/12 and 2015/16 where they should find enough support (top panel, Chart 8). With regard to macro data, most of the restaurant-relevant releases are looking in the rear view mirror. In other words, the trouncing in restaurant retail sales and employment, food-away-from-home PCE and even the collapse in the Restaurant Performance Index were “known knowns” (Chart 8). Therefore, all of this grim news is already reflected in the 30% drubbing in relative performance from peak-to-trough. Chart 8Grim Data Priced In Chart 9Dollar The Reflator Domestic restaurant sales should stabilize in the coming months. If the Fed manages to devalue the US dollar (please see discussion above), then even international revenues in general and Chinese sourced sales in particular will rekindle overall industry turnover (Chart 9). Keep in mind that China’s economy reopening is leading the global economy by about six weeks. Importantly, construction spending on restaurants is falling like a stone and this decline in supply and industry capex will provide a much needed offset to free cash flow generation (middle panel, Chart 10). Nevertheless, three key concerns keep us at bay and prevent us from turning outright bullish. First, net debt-to-EBITDA has taken a steep turn for the worst of late, and while it is mostly driven by the shortfall in cash flow, it is still quite unnerving (bottom panel, Chart 11). Second, there is margin trouble that restauranteurs have yet to work out, and a rising wage bill will continue to weigh on profit growth (second panel, Chart 11). Finally, relative valuations are lofty for our liking. On a 12-month forward P/E basis the S&P restaurants index is trading at 53% premium to the SPX and 26% above the historical mean (third panel, Chart 11). Chart 10Supply Restraint Is Positive Chart 11Watch These Risks Netting it all out, grim but backward looking macro data are already reflected in the significant restaurant relative share price correction. Lift exposure to a benchmark allocation. Bottom Line: Lift the S&P restaurants index to neutral for a relative loss of 13.7% since inception. The ticker symbols for the stocks in this index are: BLBG: S5REST – MCD, SBUX, YUMB, CMG, DRI. Upgrade Rails To Neutral Over the past three years we have been mostly on the right side of rails both in bull and bear phases; today we recommend cementing relative gains of 6.4% since inception, and lifting exposure to neutral. Rails are the largest transports subgroup and this services industry is showcasing impressive resilience in times of adversity. True, the latest ISM non-manufacturing survey made for grim reading. Both the headline number and most of the key subcomponents of the survey were tough to digest: the overall survey fell near the GFC lows (bottom panel, Chart 12), the Business Activity Index collapsed to 26%, an all-time low. While this survey can fall anew next month, we deem that extreme pessimism reigns supreme, and as the US economy is slated to reopen some semblance of normality will return in coming months. Tack on the improving export data out of China, and we are cautiously optimistic that rail hauling services will soon stage a comeback (middle panel, Chart 12). Chart 12As Bad As It Gets Chart 13Green Shoots The defensive nature of rails is most evident in industry pricing power (third panel, Chart 13). Railroad selling prices are holding their own despite a sizable drop in volumes. Moreover, CEOs exercised caution and refrained from adding to headcount. Taken together, they are boosting our profit margin proxy, which can serve as a catalyst to lift relative share price momentum out of its recent funk (second panel, Chart 13). Similarly, our 3 factor S&P rail EPS growth model is heralding a pickup in profits in the back half of the year (bottom panel, Chart 13). Despite all these tailwinds, there are some powerful offsets that tame our optimism on railroards. Intermodal rail shipments are a major freight category and thus a key determinant of rail profitability. As consumer confidence remains in freefall, downbeat retail sales will cast a dark shadow on this essential rail freight category (Chart 14). Finally, the industry’s rising debt profile is still a primary concern. Rail executives neglected capex in recent years and instead raised debt in order to retire equity and enhance shareholder value. We continue to view this “investment” backdrop with skepticism and prior to further augmenting exposure to an overweight stance we would want to see an easing on the debt uptake directed at these shareholder friendly activities (Chart 15). Chart 14The Consumer Is A Sore Spot Chart 15Debt Burden Flashing Red In sum, we are compelled to take profits in our underweight S&P rails portfolio position and lift exposure to neutral on the back of: a.) already reflected grim ISM services data, b.) resilient industry pricing power, c.) firming railroad profit margin backdrop and d.) encouraging signs from our EPS growth model. Bottom Line: Lift the S&P railroads index to a benchmark allocation today booking a profit of 6.4% since inception. The ticker symbols for the stocks in this index are: BLBG: S5RAIL – UNP, NSC, CSX, KSU.   Anastasios Avgeriou US Equity Strategist anastasios@bcaresearch.com       Footnotes 1     https://fraser.stlouisfed.org/title/statements-speeches-william-mcchesney-martin-jr-448/address-new-york-group-investment-bankers-association-america-7800 2     Please see BCA US Equity Strategy Weekly Report, “Fight Central Banks At Your Own Peril” dated April 14, 2020, available at uses.bcaresearch.com.   Current Recommendations Current Trades Strategic (10-Year) Trade Recommendations Size And Style Views June 3, 2019 Stay neutral cyclicals over defensives (downgrade alert)  January 22, 2018 Favor value over growth April 28, 2020  Stay neutral large over small caps  June 11, 2018 Long the BCA Millennial basket  The ticker symbols are: (AAPL, AMZN, UBER, HD, LEN, MSFT, NFLX, SPOT, TSLA, V).

Highlights US Corporates: The Fed continues to expand the reach of its extraordinary monetary policies designed to combat the COVID-19 recession, now giving itself the ability to hold BB-rated US high-yield bonds within its corporate bond buying programs. Raise allocations to US BB-rated corporates to overweight, within a neutral overall strategic (6-12 months) allocation to US high-yield. Euro Area Corporates: European investment grade corporate debt has seen significant spread widening over the past month, but spreads have stabilized with the ECB introducing a new asset purchase program with fewer restrictions. Upgrade euro area investment grade corporates to neutral from underweight on both a tactical (0-6 months) and strategic (6-12 months) basis. Favor debt from beaten-up sectors that are already priced for severe economic weakness like Energy, Transportation and non-bank Financials. Central Banks Are A Corporate Bond Investor’s Best Friend Right Now Chart of the WeekThe Fed & ECB Are Supporting Bond Markets The actions of policymakers worldwide to help mitigate the severe economic shock from the COVID-19 recession have helped boost global risk assets over the past couple of weeks. This is particularly notable in US corporate bond markets, where credit spreads have tightened for both shorter-maturity investment grade bonds and Ba-rated high-yield (Chart of the Week). It is not a coincidence that those are the parts of the US corporate bond market that the Fed is now explicitly backstopping through its off-balance-sheet investment programs. Last week, the Fed unveiled yet another “bazooka” to help ease US financial conditions, broadening the scope of its previously investment grade-only corporate bond purchase programs to include Ba-rated high-yield corporate bonds and high-yield ETFs. In Europe, meanwhile, the European Central Bank (ECB) is also providing additional monetary support through increased asset purchases of both government and corporate debt. Those purchases are focused more on the weakest links in the euro area financial and economic chain like Italian sovereign bonds. This has helped to stabilize credit spreads for both Italian government bonds and euro area investment grade corporate debt. This support from policymakers is critical to prevent a further tightening of financial conditions during a severe global recession (Chart 2). The excess return (over government bonds) for the Bloomberg Barclays global high-yield bond index is now down 15% on a year-over-year basis. High-yield corporate bond spreads are well above the lows seen earlier this year on both sides of the Atlantic, across all credit quality tiers. In the US, spreads between credit quality tiers had widened to levels not seen in several years. Within the US investment grade universe, the gap between Baa-rated and Aa-rated spreads had widened from 20bps to 60bps (Chart 3), a level last seen in September 2011, but now sits at 39bps. Chart 2Junk Bonds Already Discount A Big Recession Chart 3The Fed Wants These Spreads To Tighten Looking in the other direction of the credit quality spectrum, the spread between Baa-rated and Ba-rated corporates – the line of demarcation between investment grade and high-yield bonds – had blown out from 132bps in February to 556bps, but is now at 360bps. This is the market pricing in the growing risk of fallen angels being downgraded from investment grade to junk. In our view, the Ba-Baa spread is the best indicator to follow to see if the Fed’s extension of its bond purchase program to high-yield is working to reduce borrowing costs for lower-rated US companies. Both in the US and Europe, we continue to recommend a credit investment strategy that favors the parts of the markets that the Fed and ECB are most directly involved in now. That means staying overweight US investment grade corporate bonds with maturities of less than five years (the Fed’s maturity limit for its bond buying program). It also means staying overweight Italian government debt versus core European equivalents. The Fed’s new extension into high-yield corporates within its buying programs means we need to upgrade our recommendation on US BB-rated high-yield to overweight within our recommended neutral strategic (6-12 months) allocation to US junk bonds. We are making that change on a tactical basis in our model bond portfolio, as well, as can be seen on pages 14-15. As the title of this Weekly Report suggests, buy what the central banks are buying. The Fed’s new extension into high-yield corporates within its buying programs means we need to upgrade our recommendation on US BB-rated high-yield to overweight within our recommended neutral strategic (6-12 months) allocation to US junk bonds. In Europe, there is now scope to also raise allocations to euro area corporate bonds, as well, as we discuss over the remainder of this report. Bottom Line: The Fed continues to expand the reach of its extraordinary monetary policies designed to combat the COVID-19 recession, now giving itself the ability to hold BB-rated US high-yield bonds within its corporate bond buying programs. Raise allocations to US BB-rated corporates to overweight within a neutral overall strategic (6-12 months) allocation to US high-yield. Looking For Value In Euro Area Investment Grade Bonds The outlook for euro area spread product does not have as clean-cut a story as is the case for US credit. The ECB is not explicitly supporting European corporate credit markets to the same degree as the Fed is with its open-ended off-balance sheet investment vehicles. While the ECB has introduced a new large €750bn asset purchase program, the Pandemic Emergency Purchase Program (PEPP), to help ease financial conditions in the euro area, no specific details have yet been provided specifying how much of the PEPP will go towards corporate debt versus sovereign bonds. The ECB has already loosened the country and issuer limit restrictions it has imposed on its existing Asset Purchase Program (APP), however, which means that the central bank will be very flexible with the PEPP purchases. That means helping reduce sovereign risk premiums in Peripheral Europe by buying greater amounts of Italian, Spanish and even Greek government debt. That also likely means buying more corporate debt in the most stressed sectors of the euro area economy, as needed. Greater ECB bond purchases would make euro area investment grade credit – which has seen some value restored after the recent bout of spread widening - more attractive over both tactical and strategic investment horizons. This is true even with much of the euro area now in a deep recession because of COVID-19 lockdowns, which has already been discounted in the poor investment performance of euro area corporates. Greater ECB bond purchases would make euro area investment grade credit – which has seen some value restored after the recent bout of spread widening - more attractive over both tactical and strategic investment horizons. Year-to-date, euro area corporate credit markets have been hit hard by the global credit selloff (Table 1). In total return terms denominated in euros, the Bloomberg Barclays euro area investment grade corporate bond index is down -5.0% so far in 2020. The numbers are slightly better relative to duration-matched euro area government bonds (the pure credit component), with the index excess return down -5.5% year-to-date. At the broad sector level, the laggards so far in 2020 have been the sectors most exposed to the sharp downturn in European (and global) economic growth. In excess return terms, the worst performing sectors year-to-date within the eleven major groupings shown in Table 1 have been Consumer Cyclicals (-8.5%), Transportation (-8.1%), Energy (-7.2%). The best performing sectors are those that would be categorized as less cyclical and more “defensive”, like Utilities (-4.3%), Technology (-4.3%) and Financials (-4.7%). In many ways, this is a mirror image of 2019, when Consumer Cyclicals and Transportation were among the top performers while Technology was the worst performer. Table 1Euro Area Investment Grade Corporate Bond Returns Chart 4Euro Area Corporate Spreads Are Relatively Subdued Vs. Past Credit Cycles When looking at the differences in spreads between credit tiers in the euro area, the gaps are not as wide as in the US (Chart 4). The index spread on Baa-rated euro area corporates is only 44bps above that of Aa-rated credit, far below the 100bps gap seen at the peak of the 2001 and 2011 spread widening episodes and well below the 200bps witnessed in 2008. Looking at the difference between Ba-rated and Baa-rated euro area spreads paints a similar picture, with the gap between the highest high-yield credit tier and lowest investment grade credit tier now sitting at 297bps after getting as wide as 431bps in late March – close to the 500bps peak seen in 2011 but far below the 1000bps levels seen in 2001 and 2007 The broad conclusion looking strictly at credit tiers is that euro area corporates have cheapened up a bit during the COVID-19 selloff, but on a more modest scale compared to previous euro area credit cycles. A similar conclusion is reached when looking at industry-level credit spreads. The broad conclusion looking strictly at credit tiers is that euro area corporates have cheapened up a bit during the COVID-19 selloff, but on a more modest scale compared to previous euro area credit cycles. A similar conclusion is reached when looking at industry-level credit spreads. In Charts 5 & 6, we show the history of option-adjusted spreads (OAS) for the major industrial sub-groupings of the Bloomberg Barclays euro area investment grade corporate indices. Unsurprisingly, spreads look relatively wide for the biggest underperforming sectors like Energy, Consumer Cyclicals and Transportation. The spread widening has been more contained in the better performing sectors like Technology. Chart 5A Mixed Performance For Euro Area Investment Grade Spreads By Industry … Chart 6…. With Spreads Well Below 2001 And 2008 Credit Cycle Peaks When looking at the individual country corporate bond indices within the euro area, the current levels of spreads do not look particularly wide in an historical context. In Chart 7, we show a bar chart of the range of index OAS for the six largest euro area countries (Germany, France, Italy, Spain, the Netherlands, Belgium and Austria). The current OAS is shown within that historical range. The chart shows that current spreads are in the middle of that range for most countries, suggesting some better value has been restored by the COVID-19 selloff but with spreads remaining relatively subdued compared to past euro area credit cycles.1 Chart 7Euro Area Investment Grade Corporate Spreads By Country On a relative basis, investment grade spreads are tightest in France (203bps), the Netherlands (202bps) and Belgium (226bps), and widest in Germany (255bps), Italy (255bps), Austria (251bps) and Spain (234bps). With the ECB already promising greater flexibility in the country allocations of its sovereign bond purchases within the PEPP, Italian corporates may offer the best value within the major euro area countries. With the ECB already promising greater flexibility in the country allocations of its sovereign bond purchases within the PEPP, Italian corporates may offer the best value within the major euro area countries. We can get a better sense of relative corporate bond spread valuation at the country level by looking at the 12-month breakeven spread percentile rankings of those spreads. This is one of the tools we use to assess value in global credit spreads, as measured by historical “spread cushions”. Specifically, we calculate how much spread widening is required over a one-year horizon to eliminate the yield advantage of owning corporate bonds versus duration-matched government debt. We then show those breakeven spreads as a percentile ranking versus its own history, to allow comparisons over periods with differing underlying spread volatility. In Charts 8 & 9, we show the 12-month breakeven spread percentile rankings for Germany, France, Italy, Spain, Belgium and Austria. On this basis, the current level of spreads looks most historically attractive in Germany, Italy and France, with the breakeven spread in the upper quartile versus its history dating back to the year 2000. Spreads in Spain, Belgium and Austria also look relatively wide versus their own history, but to a lesser extent than in Germany, France and Italy. Chart 8German, Italian & French Investment Grade Corporates Offer Better Value On A Breakeven Spread Basis …. Chart 9… Than Spanish, Belgian & Austrian Investment Grade Corporates Chart 10Euro Area Investment Grade Corporate Spreads Are Relatively Wide Across All Credit Tiers So while there are some modest differences in value to exploit within the euro area investment grade corporate bond universe at the country level, there is less to choose from across credit tiers. The 12-month breakeven spreads for Aaa-rated, Aa-rated, A-rated and Baa-rated euro area corporates are all within the upper quartiles of their own history (Chart 10). One other tool we can use to assess value across euro area investment grade corporates is our sector relative value framework. Borrowing from the methodology used by our colleagues at BCA Research US Bond Strategy to assess US investment grade corporates, the sector relative value framework determines “fair value” spreads for each of the major and minor industry level sub-indices of the overall euro area investment grade universe. The methodology takes each sector's individual OAS and regresses it in a cross-sectional regression with all other sectors. The independent variables in the model are each sector's duration, trailing 12-month spread volatility, and credit rating - the primary risk factors for any corporate bond. Using the common coefficients from that regression, a risk-adjusted "fair value" spread is calculated. The difference between the actual OAS and fair value OAS is our valuation metric used to inform our sector allocation ranking. The latest output from the euro area relative value spread model can be found in Table 2. We also show the duration-times-spread (DTS) for each sector in those tables, which we use as the primary way to measure the riskiness (volatility) of each sector. The scatterplot in Chart 11 shows the tradeoff between the valuation residual from our model and each sector's DTS. Table 2Euro Area Investment Grade Corporate Sector Valuation & Recommended Allocation We can then apply individual sector weights based on the model output and our desired level of overall spread risk to come up with a recommended credit portfolio. The weights are determined at our discretion and are not the output from any quantitative portfolio optimization process. The only constraints are that all sector weights must add to 100% (i.e. the portfolio is fully invested with no use of leverage) and the overall level of spread risk (DTS) must equal our desired target. The strongest overweight candidates (a DTS score equal to or greater than that of the overall index with the highest positive valuation residual) are the following euro area investment grade sectors: Packaging, Tobacco, Other Industrials, Media Entertainment, Supermarkets, Integrated Energy, Consumer Cyclical Services and all non-bank Financials (Insurance, REITs, Brokerages and Finance Companies). Against the current backdrop of euro area corporate spreads offering relatively wide spreads on a breakeven spread basis, and with the ECB providing a highly accommodative monetary backdrop that includes more purchases of both government and corporate debt, we think targeting an overall portfolio DTS greater than that of the euro area investment grade corporate bond index is reasonable. On that basis, we are looking to go overweight sectors with relatively higher DTS and positive risk-adjusted spread residuals from our relative value model (and vice versa). Those overweight candidates would ideally be located in the upper right quadrant of Chart 11. Chart 11Euro Area Investment Grade Corporate Sectors: Valuation Versus Risk Based on the latest output from the relative value model, the strongest overweight candidates (a DTS score equal to or greater than that of the overall index with the highest positive valuation residual) are the following euro area investment grade sectors: Packaging, Tobacco, Other Industrials, Media Entertainment, Supermarkets, Integrated Energy, Consumer Cyclical Services and all non-bank Financials (Insurance, REITs, Brokerages and Finance Companies). The least attractive sectors within this framework (negative risk-adjusted valuations) are: Senior Bank Debt, Natural Gas, Other Utilities, Metals and Mining, Chemicals, Construction Machinery, Lodging, Cable and Satellite, Restaurants, Food/Beverage, Health Care, Oil Field Services, Building Materials and Aerospace/Defense. Bottom Line: European investment grade corporate debt has seen significant spread widening over the past month, but spreads should stabilize with the ECB introducing a new asset purchase program with fewer restrictions. Upgrade euro area investment grade corporates to neutral from underweight on both a tactical (0-6 months) and strategic (6-12 months) basis. Favor debt from beaten-up sectors that are already priced for severe economic weakness like Energy, Transportation and non-bank Financials.   Robert Robis, CFA Chief Fixed Income Strategist rrobis@bcaresearch.com Footnotes 1 For the Netherlands, there is a much shorter history of corporate bond index data available from Bloomberg Barclays than the other euro area countries shown in Chart 7. The OAS range only encompasses about seven years of data, while the other countries go back as far as the early 2000s. Recommendations The GFIS Recommended Portfolio Vs. The Custom Benchmark Index Duration Regional Allocation Spread Product Tactical Trades Yields & Returns Global Bond Yields Historical Returns

Special Report

Highlights China’s capital spending is likely to gradually recover in the second half of 2020. We project 6-8% growth in Chinese traditional infrastructure investment and a 30-50% increase in tech-related infrastructure investment by the end of 2020. There will not be much stimulus to boost housing demand. Commodities and related global equity sectors as well as global industrial stocks are approaching buy territory in absolute terms. Semiconductor stocks are attractive on a 12-month time horizon but still face near-term risks. Chinese property developer stocks remain at risk. Feature Chart I-1Chinese Growth Is Worse Now Than In 2008 Lockdowns during the Covid-19 outbreak have already caused much larger and more widespread damage to the Chinese economy than what occurred both in 2008 and in 2015 (Chart 1). Even though the spread of Covid-19 looks to be largely under control, China’s domestic economy is only in gradual recovery mode, and Chinese authorities are preparing to inject more stimulus to reinvigorate growth. The important questions are where and how large the stimulus will likely be. Infrastructure development will be the major focus this year, including both traditional and tech-related infrastructure. The former includes three categories: (1) Transport, Storage and Postal Services, (2) Water Conservancy, Environment & Utility Management, and (3) Electricity, Gas and Water Production and Supply. The latter encompasses Information Transmission, Software and Information Technology Services, such as 5G networks, industrial internet, and data centers. The current emphasis of stimulus differs from the 2009 one which was more broad-based and spanned across not only infrastructure but also the property and auto sectors. It also differs from the 2016 stimulus measures, which had a heavy emphasis on the property market. Overall, the scale of combined traditional infrastructure and property market stimulus in 2020 will be smaller than what was put forward in 2009, 2012 and 2015-‘16. We estimate Chinese traditional infrastructure investment will increase by about RMB1 trillion to RMB1.5 trillion (6-8% year-on-year), while tech-related new infrastructure investment will be boosted by RMB 240 billion to RMB400 billion (30-50% year-on-year) (Chart 2).  Together, the infrastructure stimulus will be about RMB1.3 trillion to 1.9 trillion, amounting to 3.2-4.5% of nominal gross fixed capital formation (GFCF) and 1.3-1.9% of nominal GDP (Table 1). The Chinese property market is unlikely to receive much stimulus on the demand side this time as, “houses are for living in, not for speculation,” will remain the main policy mantra. That said, there will be some support for developers, helping somewhat ease extremely tight financing conditions. Chart 2Chinese Infrastructure Investment: A Boost Ahead Table 1Projections Of Traditional And Tech Infrastructure Investment In 2020 Restarting The Infrastructure Engine Tech Infrastructure: The authorities recently repeatedly emphasized the importance of “new infrastructure”1 development. This includes 5G networks, the industrial internet, inter-city transit systems, vehicle charging stations, and data centers. Strategic investment in indigenously produced leading technologies, the ongoing geopolitical confrontation with the US and the need to boost growth are behind the government’s aim for an acceleration in “new infrastructure” investment this year. China will significantly boost the pace of its strategic 5G network deployment as well as other tech-related investment. The growth of total tech infrastructure investment was 30-40% during the 4G-network development ramp-up in 2014. As the 5G network is much more costly to build than 4G, we expect growth within tech infrastructure investment to be 30-50% this year. This translates to an increase of RMB 240 billion to RMB400 billion in tech infrastructure investment in 2020, equaling around 0.2% to 0.4% of the country’s 2019 GDP (Table 1 on page 3). Chart 3Components Of Traditional Infrastructure Investment Traditional Infrastructure: Growth in traditional infrastructure has been weak at around 3% year-on-year in 2019, in line with our analysis last August. However, we are now expecting growth to accelerate to 6-8% by the end of this year, across all three categories of traditional infrastructure (Chart 3). In the past two months, the central government has clearly sped up the pace in reviewing and approving infrastructure projects related to power generation and distribution, transportation (railways, highways, waterways, airports, subways, etc.), and new energy. As the central government enforces increasingly stringent rules on environmental protection, investment in environmental management is likely to accelerate. Public utility management investment, which accounts for a massive 45% of overall infrastructure investment, includes sewer systems, sewer treatment facilities, waste treatment and disposal, streetlights, city roads construction, parks, bridges and tunnels. As the country’s urbanization process continues and more townships and city suburbs are developed, public utility management investment will register solid growth. The 6-8% year-on-year growth in traditional infrastructure investments by the end of this year equals to an increase of RMB1 trillion to RMB1.5 trillion in 2020. Adding up the increase of RMB 240 billion to RMB400 billion for tech-related infrastructure investment, total infrastructure spending will be RMB1.3 trillion to RMB1.9 trillion, or 1.3-1.9% of GDP (Table 1 on page 3). Bottom Line: We project 6-8% year-on-year growth in Chinese traditional infrastructure investment and a 30-50% year-on-year increase in tech-related infrastructure investment. Sources Of Infrastructure Financing Significant increases in special bond issuance, loosening public-private-partnerships (PPP) restrictions and possible Pledged Supplementary Lending (PSL) injections should enable local governments to provide sufficient funding for planned infrastructure investment projects. Net Special Bond Issuance Local government net special bond issuance, which is mainly used to fund infrastructure projects, has been one main source of financing. Last year, the amount of net special bond issuance was about RMB 2 trillion,2 accounting for about 11% of total infrastructure investment (both tech-related and traditional).  This year, the annual quota on local government special bonds is still unknown, as the NPC meeting has been postponed due to the Covid-19 outbreak. Given that last year’s quota was RMB2.15 trillion, RMB 800 billion higher than in the previous year (25% growth over 2018), it is reasonable to expect the quota for 2020 will be set at RMB 3.15-3.65 trillion, a 30-35% increase from 2019. This increase alone will be able to finance 70-80% of the RMB1.3 trillion to RMB1.9 trillion additional funding required for the infrastructure investments planned for this year. Consequently, the share of special bonds in total infrastructure spending in 2020, if these projections materialize, will rise to 15-17% from 11% in 2019. Chart 4Public-Private-Partnerships Financing Will Recover This Year   Public-Private-Partnerships (PPP) PPPs involve a collaboration between local governments and private companies. The PPP establishment can allow the local governments to reduce local governments’ burden of financing infrastructure. Due to tightened regulations on PPP projects since late 2017, PPP financing plunged 75% from about RMB 5 trillion in 2017 to RMB 1.2 trillion in 2019. Its share of total infrastructure investment had also tumbled from nearly 30% in early 2017 to 6% in 2019 (Chart 4). However, in recent months, the Chinese government has started to loosen up the restrictions on PPP projects, by releasing three announcements within a month (Box 1). We believe recent government actions will lead to a pickup in PPP financing.             Box 1 The Authorities: Loosening Up of PPP-Related Policies On February 12, the Finance Ministry released a notice demanding local governments “accelerate and strengthen PPP projects’ reserve management.” On February 28, the Finance Ministry released a contract sample of sewage water and garbage disposal projects, aiming to help local governments to more effectively proceed with such projects. On March 10, the website of the National Development and Reform Commission demanded local governments utilize the national PPP project information management and monitoring platform, actively attracting private capital and starting the projects as soon as possible. In addition, the government will likely make efforts to reduce financial and operating costs of some infrastructure projects in order to increase the risk-to-return attractiveness of such projects for private investors. The authorities may order both policy banks and commercial banks to give preferential loans to certain infrastructure projects (i.e., low-interest and long-term loans from policy banks). Moreover, the government can also provide tax breaks, offer land at a reduced cost,  and other supportive policies to certain infrastructure projects. Putting it all together, we expect PPP financing to grow 10-20% and provide additional funding of RMB120 billion to RMB240 billion to China’s infrastructure development in 2020. Pledged Supplementary Lending Chart 5Possible Pledged Supplementary Lending Injections In Infrastructure Projects Some Chinese government officials have hinted that policy banks may start using PSL injections to boost domestic infrastructure investment.3  Speculation among China watchers is that the scale of PSL injections will be RMB600 billion this year (Chart 5). In comparison, PSL net lending for the property market ranged from RMB 630 to 980 billion in the years 2015-2018. Bottom Line: Odds are that a significant increase in special bond issuance, loosening PPP restrictions and possible PSL injections will be sufficient to offset the decline in other funding sources. Consequently, a moderate acceleration in traditional infrastructure investment and very strong growth in tech-related infrastructure expenditures is likely. What About Stimulus In The Property Sector? Stimulus for the property sector this time will be less forceful than the ones in both 2009 and 2016. In addition, structural property demand in China has already entered a saturation phase, drastically different from previous episodes when demand still had strong underlying growth. Altogether, the outlook for property sales in China is not promising.  “Houses are for living in, not for speculation” will remain the main policy focus in the Chinese property market. That said, authorities will help ease developers’ extremely tight financing conditions. No stimulus on demand: Three cities (Zhumadian, Baoji, Guangzhou) that had released policies to loosen up restrictions on the demand side (e.g., cutting down payment from 30% to 20%, allowing larger amounts of borrowing for homebuyers) were ordered to retract their announcements within a week. There will be very little PSL lending into the property market in 2020, in line with the government’s goal of curbing speculation in the property market. Some supportive polices for developers: Over 60 cities have released policies on the supply side (e.g., delaying developers’ land transaction payments, waiving fines for breaches of start and completion dates, etc.), mainly helping property developers overcome their extreme funding shortages. Given housing unaffordability and lack of demand, we expect floor space sold to contract slightly in 2020 (Chart 6, top panel). In the meantime, we expect a slight pickup in property starts (Chart 6, middle panel). In order to stay afloat, property developers have to maintain rising floor space starts for presales to gain some funding – a fund-raising scheme for Chinese real estate developers that we discussed in detail in prior reports. In addition, we also expect moderate growth in property completions in the commodity buildings market (Chart 6, bottom panel). The pace of property completion has to be accelerated as property developers are currently under increased pressure to deliver units that were pre-sold about two years ago. This will lift construction activity in the commodity buildings market (Chart 7). Chart 6Commodity Buildings: Divergences Among Sales, Starts And Completions Chart 7Commodity Buildings: Construction Activities Please note that commodity buildings are a small subset of total constructed buildings in China, and as a subset do not provide a full picture of construction activity. The official data show that commodity buildings account for only 24% of total constructed buildings in terms of floor space area completed. In terms of a broader measure of the Chinese property market, we still expect a continuing contraction – albeit less than last year – in “building construction” floor area started and completed (Chart 8). Bottom Line: There will not be much stimulus to boost housing demand. Yet authorities will ease financial constraints on property developers that will allow them to complete housing currently under construction. Chart 8Building Construction Versus Commodity Housing Chart 9Commodities And Related Equity Sectors Are Approaching A Bottom Investment Implications Traditional infrastructure spending in China will post a moderate recovery in 2020, with most gains occurring in the second half of the year. Consistently, we believe the segments of Chinese and global markets leveraged to the infrastructure cycle – commodities and related equity sectors as well as industrial stocks – are approaching buying territory in absolute terms. Prices of segments have collapsed, creating a good entry point in the coming weeks (Chart 9, 10 and 11). Chart 10A Buying Time May Be Not Far For Industrial Stocks… Chart 11…And Machinery Stocks China’s spending on itech-related infrastructure will post very strong growth in 2020. Even though global semiconductor stocks have sold off considerably, they have not underperformed the global equity benchmark. In the near term, we believe risks are still to the downside for technology and semi stocks (Chart 12). However, this down-leg will create a good buying opportunity. We are watching for signs of capitulation in this sector to buy. Finally, concerning Chinese property developers, their share prices will likely underperform their respective Chinese equity benchmarks in the next nine months (Chart 13). Meanwhile, the absolute performance of property stocks listed on the domestic A-share market remains at risk (Chart 13, bottom panel). Chart 12Semi Stocks: Final Down-leg Is Possible Chart 13Chinese Property Developers Are Still At Risk  Ellen JingYuan He Associate Vice President ellenj@bcaresearch.com   Footnotes   1    To gauge the scale of the “new infrastructure”, we are using the National Bureau of Statistics data of “investment in information transmission, software and information technology service”. This tech-related infrastructure investment measure includes 5G networks, industrial internet, and data centers, while inter-city transit systems and vehicle charging stations may be included in the transportation investment. 2   Please note that the amount of net special bond issuance was the actual amount of funding used in infrastructure projects. It was smaller than the RMB 2.15 trillion quota because a small proportion of issuance were used to repay some existing special bonds due in the year. 3   http://www.xinhuanet.com/money/2020-02/19/c_1125593807.htm

Special Report

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

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

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