Materials

Underweight The S&P chemicals bear market has entered its third year and we remain underweight this capital intensive basic materials subgroup. China macro dominates the direction of US chemical equities. Chinese authorities continue to ease monetary policy and are injecting liquidity in the banking system by slashing the reserve requirement ratio (RRR). The recent coronavirus epidemic almost guarantees further easing via the RRR channel. Such a monetary setting should eventually stabilize the economy. However, until a turnaround is evident, US chemical stocks will continue to follow down the path of the Chinese RRR (top panel). The Australian currency, which is hyper-sensitive to China’s growth, further corroborates that Chinese economic activity remains soft (second panel). Simultaneously, the resilient US dollar will continue to weigh on the competitiveness of US chemical exporters (bottom panel). Bottom Line: Stay underweight the S&P chemicals index. The ticker symbols for the stocks in this index are: BLBG S5CHEM – LIN, APD, ECL, SHW, DD, DOW, PPG, CTVA, LYB, IFF, CE, FMC, EMN, CF, ALB, MOS.

Highlights Portfolio Strategy China’s monetary easing, the resilient US dollar, weak operating industry metrics and a looming margin squeeze all signal that an underweight stance is still warranted in the S&P chemicals index.    Lofty valuations, overbought technicals, declining capex and weak operating metrics, are all warning that an earnings-led underperformance period is in store for the S&P tech hardware, storage & peripherals index. Recent Changes Trim the S&P tech hardware, storage & peripherals index to underweight, today. Table 1 Feature The S&P 500 fell for a second straight week and has now given back almost all of the year-to-date gains. While the coronavirus has served as an excuse to sell as we warned last week,1 we are nowhere near in unwinding the extreme overbought conditions in the broad equity market. We are no epidemiology experts, however, what concerns us most is when the news will eventually hit that coronavirus deaths are sprucing up outside of China’s borders. This will likely catalyze more equity selling and a capitulation point will subsequently ensue. Importantly, beneath the surface macro divergences remain wide. The yield curve peaked at the turn of the year. Similarly, the real 10-year Treasury yield crested around the same time and so did the hyper growth sensitive AUD/CHF cross rate all predating the coronavirus epidemic news (Chart 1). Our sense is that the bond market in particular is likely reflecting Bernie Sander’s rise in the polls along with persistently soft economic data.   Other indicators we track confirm that the handoff from liquidity-to-growth we have all been waiting for remains on hold. The oil-to-gold and copper-to-gold ratios have no pulse, warning that growth remains elusive (third & bottom panels, Chart 2). Chart 1Souring Macro Predates Coronavirus Chart 2Watch Gold Closely Moreover, in our January 13 report we highlighted that gold was sniffing out two or three fed cuts in 2020, leading the fed funds futures market, as it did in the spring of 2019.2 Since our last update, the fed funds discounter in the coming 12 months has sunk from negative 20bps to negative 42bps (year-on-year change in the fed funds rate shown inverted, second panel, Chart 2). It is disconcerting that despite the sloshing liquidity and de-escalation in the US/China trade war, CEOs remain on the sidelines. The Q4 GDP release showed that non-residential investment is now contracting on a year-over-year (yoy) basis (bottom panel, Chart 3) and has been subtracting from real output growth for three consecutive quarters. Hard data continues to warn that the manufacturing recession is not over as the 15% yoy contraction in non-defense durable goods orders revealed last week (third panel, Chart 3). Equity market internals also warn that the SPX is skating on thin ice. Worrisomely, the Philly semiconductors index (SOX) peaked versus the NASDAQ 100 last year and has been losing steam of late. The equally- versus market cap-weighted S&P 500 and NASDAQ 100 ratios remain near multi-year lows, and small caps are still stalling versus large caps (Chart 4). The implication is that, at least, an indigestion period looms for the broad equity market. Chart 3Ongoing Manufacturing Recession Chart 4Weak Market Internals Netting it all out, there are high odds that the coronavirus epidemic may serve as a catalyst and short-circuit the already frail handoff from liquidity-to-growth, warning that equity market caution is warranted at this juncture. This week we are trimming a key tech subgroup to underweight, and updating a heavyweight basic materials sub-index. To Infinity And Beyond? While we have been neutral the S&P tech hardware, storage & peripherals index and thus participating in the monster rally over the past year, the time is ripe to downgrade exposure to below benchmark. Undoubtedly, relative share prices are extremely extended. The second panel of Chart 5 shows that the relative share price ratio is at the highest level as a percentage of its 200-day moving average since the late-1990s. Shown as a z-score, this technical indicator is stretched to the tune of two standard deviations above the historical mean (third panel, Chart 5). The last three times technical conditions were so overbought, it marked a multi-year peak in relative performance (top panel, Chart 5). Importantly, the forward multiple explains all of the return in this tech sub-group’s stellar relative performance since the 2018 Christmas Eve lows (Chart 6). In fact, stagnant-to-lower relative profit growth subtracted from relative returns over the same time period (bottom panel, Chart 6). Chart 5Up, Up And Away? Moreover, the parabolic move in the forward P/E ratio that climbed from a 25% discount to the SPX to a 15% premium (i.e. a 53% multiple jump), was because the 10-year US Treasury yield plunged by 175 basis points from peak to trough (10-year US Treasury yield shown inverted, Chart 7). Chart 6EPS Have To Do The Heavy Lifting Chart 7Multiple Expansion Phase Has Run Its Course Such enormous easing in financial conditions is unlikely to repeat in the coming twelve months in order to push the forward multiple even higher and sustain the “goldilocks” conditions for the S&P tech hardware, storage & peripherals index. In contrast, BCA’s higher interest rate view is a harbinger of a multiple contraction phase and compels us to trim exposure on this high-flying tech sub group to underweight. Another market narrative substantiating the multiple expansion phase is that heavyweight AAPL is now a services oriented company and rightly so commands a sky-high multiple similar to the cloud and software stocks. While there is some truth to the push into services, the iphone and other hardware still dominates AAPL’s sales and will continue to do so for the foreseeable future especially on the eve of a 5G smartphone rollout. Turning over to the macro backdrop, this still mostly manufacturing-based industry moves with the ebbs and flows of the ISM manufacturing survey. Overall business investment is contracting and so is industry capex. Worrisomely, most of the ISM manufacturing subcomponents remain below the boom/bust line warning that investment will remain soft in the coming months, despite the Sino-American trade détente (middle panel, Chart 8). CEO confidence in capital spending remains downbeat and corroborates that at least a wait and see attitude toward greenfield expansion plans is a high probability outcome (bottom panel, Chart 8). Moreover, global export expectations continue to plumb cyclical lows. Similarly, the Emerging Asian (a key tech manufacturing hub) leading economic indicator broke below the GFC lows warning that industry exports are at risk of a further collapse (second & third panels, Chart 9). Chart 8Something’s Gotta Give Chart 9Weak Operating Metrics Chart 10Soft Pricing Power… Chart 11…Will Continue To Weigh On Margins Beyond soft exports, industry new orders are also contracting (bottom panel, Chart 9). This deficient demand backdrop will continue to weigh on industry sales, owing to the recent drubbing in pricing power (third panel, Chart 10).\ Deflating selling prices are also negative for profit margins. The wide gap between industry and SPX margins is clearly unsustainable (Chart 11). Already there is tentative evidence that S&P tech hardware, storage & peripherals margins have peaked and will remain under downward pressure, especially given our expectation of underwhelming profit growth in the coming months. In sum, lofty valuations, overbought technicals, declining capex and weak operating metrics are all warning that an earnings-led underperformance period is in store for the S&P tech hardware, storage & peripherals index. Nevertheless, there is one risk that is worth monitoring: the US consumer. A tight labor market should continue to bid up the price of labor and sustains wage gains which means more money in consumers’ wallets. As a result, brisk consumer outlays on computers & peripherals could reverse the ongoing industry sales deceleration (bottom panel, Chart 12). In sum, lofty valuations, overbought technicals, declining capex and weak operating metrics are all warning that an earnings-led underperformance period is in store for the S&P tech hardware, storage & peripherals index. Bottom Line: Downgrade the S&P tech hardware, storage & peripherals index. The ticker symbols for the stocks in this index are: BLBG S5CMPE – AAPL, HPQ, WDC, HPE, STX, NTAP, XRX. Chart 12Risk To Bearish View Hazardous Chemicals The S&P chemicals bear market has entered its third year and we remain underweight this capital intensive basic materials subgroup. Relative share prices have broken below the GFC lows and it would not surprise us if they would retest the 2006 lows (Chart 13). Now that the chemicals M&A activity dust has settled for good, China dominates the direction of chemical equities. Chinese authorities are still easing monetary policy and are injecting liquidity in the banking system by slashing the reserve requirement ratio (RRR). The recent coronavirus epidemic almost guarantees further easing via the RRR channel. Such a monetary setting should eventually stabilize the economy. However, until a turnaround is evident, US chemical stocks will continue to follow down the path of the Chinese RRR (top panel, Chart 13). The Australian currency, which is hyper-sensitive to China’s growth, corroborates that Chinese economic activity remains soft (second panel, Chart 13). Broad-based US dollar strength also confirms that global growth has yet to stage a durable comeback. The implication is that US chemical exports will continue to lose market share, weighing on industry profits (third panel, Chart 13). Chart 13China Leads The Way In fact, sell-side analysts are expecting a relative profit growth acceleration phase, but a decline in relative revenue prospects. This suggests that already uncharacteristically high chemical profit margins will continue to outpace the broad market (bottom panel, Chart 13). Our indicators suggest that it pays to lean against such relative EPS and profit margin euphoria. Importantly, our chemicals profit margin proxy is sinking, warning that a profit margin squeeze looms. Not only are selling prices deflating, but also the industry’s wage bill is gaining steam (bottom panel, Chart 14). Adding it up, China’s monetary easing, the resilient US dollar, weak operating industry metrics and a looming margin squeeze all signal that an underweight stance is still warranted in the S&P chemicals index. Moreover, chemical railcar loads are contracting at a time when the ISM manufacturing survey remains squarely below the boom/bust line (middle panel, Chart 14). This deficient chemical demand backdrop is deflationary (second panel, Chart 15) and will eat into industry profit margins. Chart 14Downbeat Demand Backdrop Chart 15Deflation Getting Entrenched On the operating front, our chemicals industry productivity proxy (industrial production/employment) is also in negative territory, underscoring that profits will likely surprise to the downside (third panel, Chart 15). Chemical industrial production is contracting at an accelerating pace and industry shipments are in retreat, warnings that the risk is high of an inventory liquidation phase (bottom panel, Chart 15). While we remain bearish on chemical stocks on a cyclical horizon, there are two key risks we are closely monitoring that would push our view offside. The global reflation handoff to actual growth is the key risk. If the global economy enters a V-shaped recovery, global bond yields will immediately reflect such a growth backdrop and push interest rates higher. This would put downward pressure on the greenback and significantly reflate chemical earnings (middle panel, Chart 16). Finally, chemical stocks are cheap and trade at a steep discount to the broad market. When our relative valuation indicator has plunged to such depressed levels in the past fifteen years, bottom-fishing buyers have come back in the market and added chemical stock exposure to their portfolios (bottom panel, Chart 16). Adding it up, China’s monetary easing, the resilient US dollar, weak operating industry metrics and a looming margin squeeze all signal that an underweight stance is still warranted in the S&P chemicals index. Bottom Line: Stay underweight the S&P chemicals index. The ticker symbols for the stocks in this index are: BLBG S5CHEM – LIN, APD, ECL, SHW, DD, DOW, PPG, CTVA, LYB, IFF, CE, FMC, EMN, CF, ALB, MOS. Chart 16Two Risks To Monitor     Anastasios Avgeriou US Equity Strategist anastasios@bcaresearch.com   Footnotes 1     Please see BCA US Equity Strategy Weekly Report, “When The Music Stops...” dated January 27, 2020, available at uses.bcaresearch.com. 2     Please see BCA US Equity Strategy Weekly Report, “Three EPS Scenarios” dated January 13, 2020, available at uses.bcaresearch.com.   Current Recommendations Current Trades Size And Style Views Stay neutral cyclicals over defensives (downgrade alert) Favor value over growth Favor large over small caps (Stop 10%)

Structural Underweight Our sixth big theme for the 2020s is a sustained deceleration of Chinese real GDP growth to a range of 4% to 2%. While this will not happen overnight, the implication is that steadily lower real GDP growth coupled with higher consumption expenditures at the expense of gross fixed capital formation will reduce Chinese appetite for commodities. At the margin, this change in consumption behavior will have knock on effects on the broad basic resources sector in general and the S&P 1500 metals & mining index in particular. Were this Chinese backdrop to pan out in the coming decade as we expect, it would sustain the relative underperformance of metals & mining equities (see chart). Bottom Line: There are high odds that China’s real GDP deceleration will continue for another decade, casting a shadow over the profit prospects of the S&P 1500 metals & mining index. A structural below benchmark allocation is warranted. The ticker symbols for the stocks in this index are: BLBG S15METL – NEM, FCX, NUE, RS, RGLD, STLD, CMC, ATI, CRS, CLF, CMP, X, KALU, WOR, MTRN, HCC, AKS, SXC, HAYN, CENX, TMST, ZEUS.

Highlights Portfolio Strategy There are high odds that China’s real GDP deceleration will continue for the next decade, casting a shadow over the profit prospects of the S&P 1500 metals & mining index. A structural below benchmark allocation is warranted. Rising total mutual fund assets under management, improved trading revenue prospects, rising investor confidence along with a revival in IPO and M&A activity, all signal that it still pays to be overweight the S&P capital markets index. Recent Changes There are no changes in our portfolio this week. Table 1 Feature “When the music stops, in terms of liquidity, things will be complicated. But as long as the music is playing, you’ve got to get up and dance. We’re still dancing.” - Charles Owen "Chuck" Prince III (ex-CEO of Citigroup) The SPX remains near all time highs and the invincible tech sector continues to lead the pack. Two weeks ago we showed that the market capitalization concentration of the top five stocks in the S&P 500 surpassed the late-1990s parallel (Chart 1), and Table 2 shows that late in the cycle a handful of stocks explain a sizable part of the broad market’s return.1 However, in terms of valuation overshoot the current forward P/E of these top five stocks is roughly half the late-1990s parabolic episode (Chart 2). Chart 1Vertigo Warning Chart 2Unlike The Late-1990s While the overall market does not fully resemble the excesses of the dot.com bubble era, at least not yet, there are elements that are eerily reminiscent of the late-1990s. Table 2Contribution To Late Cycle Rallies In The SPX Chart 3Correlation Breakdown Contrary to popular belief, during manias historical correlations break down and the forward multiple becomes positively correlated with the discount rate. So in the late 1990s, the fed funds rate and the 10-year yield jumped 200bps in a short time span and the SPX forward P/E soared 40% from roughly 18x to 25x (Chart 3) before collapsing to 14x soon thereafter. Simultaneously, the US dollar was roaring as real interest rates were 4%, but the NASDAQ 100 outperformed the emerging markets, another break in historical correlations. As Chuck Prince mused in 2007, there is a narrative in the equity market today that, “as long as the music is playing, you’ve got to get up and dance”. While the overall market does not fully resemble the excesses of the dot.com bubble era, at least not yet, there are elements that are eerily reminiscent of the late-1990s. We filtered for large cap stocks that are at all-time highs and have increased in value at a minimum 10x since 2010. Among the stocks that met these criteria, five really stand out, Apple, Tesla, Lam Research, Amd & Salesforce, and comprise our “ATLAS” index; the mania in these stocks will likely end in tears (Chart 4). Even their forward P/E ratio has gone exponential, hitting a 60 handle last year similar to top five SPX stocks in the late-1990s. Chart 4ATLAS: Holding The World On His Shoulders Currently, SPX profits are barely growing and the sole reason equities are higher is the massive injection of liquidity via the drubbing in interest rates and the restart of QE. From peak-to-trough the 10-year yield fell 175bps in nine months, and the Fed commenced expanding its balance sheet by $60bn/month since last September; yet profits have barely budged. Ultimately, profits have to show up and the news on this front remains grim. The current non-inflationary trend-growth backdrop is a “goldilocks” scenario especially for tech stocks that thrive during disinflationary periods. While stocks can go higher defying weak EPS fundamentals as they have yet to reach a fully euphoric state according to our Complacency-Anxiety Indicator (Chart 5), a sell-off in the bond market will likely cause some consternation in equities in general and tech stocks in particular similar to early- and late-2018. Chart 5Not Max Complacent Yet Other catalysts that can suddenly cause “the music to stop” are either the recent coronavirus becoming an epidemic or a geopolitical event that would result in a risk off backdrop. Ultimately, profits have to show up and the news on this front remains grim. Our mid-January “Three EPS Scenarios” analysis still suggests that the SPX is 9% overvalued.2 This week we are updating our capital markets view and adding a sixth long-term theme and a related investment implication to our mid-December 2019, Special Report titled, “Top US Sector Investment Ideas For The Next Decade”.3 Sixth Big Theme For The Decade And Investment Implications China’s ascendancy on the world scene was a mega driver of equity markets in the 2000s following its inclusion in the WTO. The commodity super-cycle captured investors’ imaginations and China’s insatiable appetite for commodities caused a massive bubble in the commodity complex in general and commodity-related equities in particular. Nevertheless, the Great Recession posed a severe threat to China and the authorities injected an extraordinary amount of stimulus into the economy (15% of GDP over two years). This succeeded in doubling real GDP growth, but only temporarily. The unintended consequence was an enormous debt binge fueled by cheap money. Moreover, this debt burden along with falling labor force growth and productivity forced the government to re-think its policies as they caused a steady down drift in real output growth. The sixth big theme for the 2020s is a sustained deceleration of Chinese real GDP growth to a range of 4% to 2% (Chart 6). Not only is the debt overhang weighing on real output growth, but Chinese leaders are adamant about transitioning the economy to developed market status, which is synonymous with higher consumption expenditures at the expense of gross fixed capital formation. Chart 6From Boom… Chart 7…To Bust In other words, China remains committed to weaning its economy off of investment and reconfiguring it toward consumption (Chart 7). This is a strategic plan but it is possible that the Chinese economy can achieve this transition in due time. While this will not happen overnight, the implication is steadily lower real GDP growth as is common among large, mature, developed market economies. China will remain one of the top commodity consumers in the world, as urbanization is ongoing, but the intensity of commodity consumption will continue to decelerate (Chart 8). At the margin, this change in consumption behavior will have knock on effects on the broad basic resources sector in general and the S&P 1500 metals & mining index in particular. Were this Chinese backdrop to pan out in the coming decade as we expect, it would sustain the relative underperformance of metals & mining equities as Chart 6 & 7 depict. Chart 8Commodity Consumption Deceleration Will… Chart 9…Continue To Weigh On Metals & Mining Profits Importantly, these commodity producers will have to adjust their still bloated cost structures to lower run rates which is de facto negative both for relative sales and profit growth (Chart 9). Tack on the large negative footprint mining extraction has on the environment, and if ESG investing (our fifth big theme for the decade4) also takes off, investors should avoid the S&P 1500 metals & mining index on a secular basis. Bottom Line: There are high odds that China’s real GDP deceleration will continue for the next decade, casting a shadow over the profit prospects of the S&P 1500 metals & mining index. A structural below benchmark allocation is warranted. The ticker symbols for the stocks in this index are: BLBG S15METL – NEM, FCX, NUE, RS, RGLD, STLD, CMC, ATI, CRS, CLF, CMP, X, KALU, WOR, MTRN, HCC, AKS, SXC, HAYN, CENX, TMST, ZEUS. Capital Markets Update Capital markets stocks have come out of hibernation recently and are on the cusp of breaking out – in a bullish fashion – of their 18-month trading range. A number of the indicators we track signal that an earnings-led outperformance period is in the cards for this financials sub-group and we reiterate our overweight stance. Sloshing liquidity has pushed investors out the risk spectrum and high yield bond option adjusted spreads are flirting with multi-year lows. Such a tame junk bond market backdrop coupled with easy financial conditions are conducive to rising M&A activity (Chart 10). Importantly, the Fed’s Senior Loan Officer Survey paints an improving profit backdrop for investment banks. Not only are bankers willing extenders of credit, but demand for credit for the majority of loan categories that the Fed tracks is squarely in positive territory (top panel, Chart 11). Chart 10Subsiding Risks Are A Boon To Capital Markets Chart 11Positive Profit Catalysts This is likely a consequence of last year’s drubbing in the price of credit. M&A activity usually goes hand in hand with loan growth, underscoring that business combinations are on track to accelerate (third panel, Chart 10). This will revive a lucrative business line for capital markets firms. Total mutual fund assets are expanding at a brisk rate and hitting fresh all-time highs, signaling an uptick in risk appetite (third panel, Chart 11). Rising investor confidence will facilitate both new and secondary share issuance, an important source of fee generation for capital markets firms. Moreover, equity trading volumes have sprang back to life in recent weeks underscoring that the recent impressive Q4 earnings results will likely continue into Q1/2020 (bottom panel, Chart 10). Meanwhile, the three Fed rate cuts last year should work through the economy and at least stem further losses in the ISM manufacturing survey. The US/China trade détente will also lead to a stabilization in global growth. In fact, the V-shaped recovery in the global ZEW survey suggests that capital markets profits will likely outpace the broad market this year (second & bottom panels, Chart 11). Finally, the recent surge in the stock-to-bond ratio reflects a massive psychological shift, from last year’s recessionary fears to growing investor confidence that tail risks are abating (Chart 12). Still depressed valuations neither reflect the firming capital markets profit outlook nor the rising industry ROE (bottom panel, Chart 12). Adding it all up, accelerating total mutual fund assets under management, improved trading revenue prospects, rising investor confidence and a revival in IPO and M&A activity, all signal that it still pays to be overweight the S&P capital markets index.  Bottom Line: Stay overweight the S&P capital markets index. The ticker symbols for the stocks in this index are: BLBG S5CAPM – GS, CME, SPGI, MS, BLK, SCHW, ICE, MCO, BK, TROW, STT, MSCI, NTRS, AMP, MKTX, CBOE, NDAQ, RJF, ETFC, BEN, IVZ. Chart 12Valuation Re-Rating Looms     Anastasios Avgeriou US Equity Strategist anastasios@bcaresearch.com     1     Please see BCA US Equity Strategy Weekly Report, “Three EPS Scenarios” dated January 13, 2020, available at uses.bcaresearch.com. 2     Ibid. 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     Ibid.   Current Recommendations Current Trades Size And Style Views Stay neutral cyclicals over defensives (downgrade alert) Favor value over growth Favor large over small caps (Stop 10%)

Neutral Our recent gold miners overweight has pushed the broad materials sector from underweight to neutral. Simultaneously, macro data also suggests that it no longer pays to be bearish materials stocks. Our materials sector profit growth model has troughed and signals that a turnaround in EPS growth is underway and should gain steam this year (second panel). Keep in mind that this niche deep cyclical sector has borne the brunt of the Sino/American trade war and the recent de-escalation can serve as a catalyst for an earnings-led recovery. Moreover, this industry is not at a standstill. Contrary to the overall economy, materials executives are investing in new projects as financial market reported materials sector capex clearly shows (third panel). These investments should bear fruit in coming quarters and translate into higher top line growth, something that is not at all discounted in bombed out relative sales growth expectations (bottom panel). Bottom Line: Book relative gains of 5% since inception and lift the S&P materials sector to a benchmark allocation. Please refer to this Monday’s Weekly Report for more details. ​​​​​​​

Highlights Portfolio Strategy Gold bullion is on the move again, and falling real yields, a soft economic backdrop, a depreciating US dollar and resurgent geopolitical uncertainty, all argue for reintroducing a modest portfolio hedge by overweighting the global gold mining index. Washed out technicals, depressed valuations, the turn in our EPS growth model, rising industry capex and bottoming EM-related financial market data, all signal that it no longer pays to be bearish materials stocks. Augment exposure to neutral. Recent Changes Boost global gold miners to overweight via the long GDX/short ACWI exchange traded funds, today. Book gains and lift the S&P materials sector to neutral, today.  Table 1Sector Performance Returns (%) Feature “There is nothing so disturbing to one's well-being and judgment as to see a friend get rich.” - Charles P. Kindleberger “The bubble involves the purchase of an asset, usually real estate or a security, not because of the rate of return on the investment but in anticipation that the asset or security can be sold to someone else at an even higher price; the term the ‘greater fool’ has been used to suggest the last buyer was always counting on finding someone else to whom the stock or the condo apartment or the baseball cards could be sold.”  - Charles P. Kindleberger Equities broke out to fresh all-time highs in the second week of the year, shrugging off the flare up in geopolitical risk. It seems that nothing can derail this juggernaut and the following narrative is now prevalent: Bad news is actually good for equities because the Fed will step in and do more QE and cut interest rates anew. Good news is great because the Fed will not hike interest rates as the economy is chugging along. No news is good news as money has to flow somewhere and equities are the default answer. Kindleberger’s quotes above are instructive.      To put the recent advance in perspective, the SPX is up 425 points uninterruptedly since early October – when the Fed commenced ramping up its Treasury purchases – and it is, at a minimum, headed for a much needed breather. Contrary to popular belief, a handful of tech stocks explain this recent meteoric rise rather than a broad-based advance (Chart 1). Currently, the top five stocks in the S&P 500 (AAPL, MSFT, GOOGL, AMZN & FB) comprise over 18% of its market cap, even higher than the late-1999/early-2000 concentration (top panel, Chart 1). On January 9, 2020, AAPL’s $30bn one day market cap increase was larger than the bottom 300 stocks’ market cap in the S&P 500 and is another anecdote that drives this return concentration point home.   Chart 1Teflon Tech Stocks   As a reminder, we are neutral the broad tech sector and overweight the largest subgroup, the S&P software index, thus participating in this euphoric rise in stocks that has been defying earnings fundamentals. Granted, such phenomena are prevalent late cycle. While this can go on for a bit longer, it is clearly unsustainable and represents a big risk especially given the proliferation of passive funds. Tack on rising geopolitical risks and the odds of a sharp drawdown increase significantly. Before we proceed to our SPX EPS analysis, however, it is worth noting some disappointing economic data. The decade low in the ISM manufacturing, the deceleration in non-farm payroll growth, the grinding higher in the 4-week average of unemployment insurance claims, the contraction in C&I loans, the sustained pessimism in CEO confidence and the down hook in average hourly earnings all warn that macro headwinds abound despite the looming signing of the “phase one” US/China trade deal (Chart 2). All of the rise in the SPX last year was due to multiple expansion. Now, in order for the SPX to continue rallying, profits will have to do the heavy lifting. However, our analysis shows that the market is fully priced and earnings will have to hit escape velocity in order for equities to grow into their pricey valuations (Chart 3). Chart 2Underwhelming Chart 3Lofty Valuations Currently, our SPX EPS growth model has no pulse. This four-factor macro model is regression based (out of sample since January 2014) and continues to forecast a contraction into mid-year (Chart 4). Chart 4No EPS Pulse Table 2 summarizes three EPS scenarios analysis, along with a forward P/E multiple and SPX forecast. Table 2Three Scenarios This week we are re-instituting a small portfolio hedge, which lifts a niche deep cyclical sector to neutral from previously underweight. Step 1: We plugged into the model our base, worse and best case estimates of these four variables into mid-year, and we got as output the model’s estimate of EPS growth for end-2020 with a range of -1% to 10% (one important assumption is that the historical correlation of the movement of these variables holds steady). Step 2: Then, we applied these growth rates to the IBES 2019 EPS forecast of $162/share and arrived at our end-2020 three scenarios EPS level estimates with a range of $160/share to $178/share. Step 3: We then assigned probabilities to those three outcomes resulting in an EPS forecast of $169/share. Step 4: In order to get an SPX expected value we needed to assign a forward P/E multiple to our EPS estimate. Thus, we introduced our base, worse and best case forward P/Es (with an equal probability of occurrence) and multiplied them with our $169/share weighted EPS forecast in order to arrive at the SPX 3,049 expected value for end-2020 (please refer to the Appendix below for additional details of our analysis and click here if you would like to request the excel file and insert your own estimates and probabilities). Chart 5 depicts the results of our analysis. Chart 5Projections Currently, sell-side analysts expect 10% profit growth in calendar 2020, a tall order in our view, and the SPX appears 8% overvalued according to our analysis. However, a potential break in historical correlations where the ISM recovers, the bond market sells off fearing an inflationary spurt pushing interest rates higher yet P/E multiples continue to expand indiscriminately, could sustain the melt-up phase in stocks in general and mega cap tech stocks in particular. While the macro data cannot fall indefinitely and a natural trough will occur sometime in the first half of the year, we doubt that a V-shaped recovery is imminent. Our base case is a stabilization of macro data equating to roughly 5% EPS growth for this year as noted above, with risks clearly titled to the downside. Under such a backdrop, perceptive equities will have to, at least, mildly deflate to this EPS reality. This week we are re-instituting a small portfolio hedge, which lifts a niche deep cyclical sector to neutral from previously underweight. In Gold We Trust While the SPX has been on an impressive run, it has failed to outshine gold bullion that has been on a tear lately. The bottom panel of Chart 6 shows that gold could be sniffing out a couple of Fed interest rate cuts, warning that the economic backdrop remains frail. This gold move is compelling us to reintroduce a modest portfolio hedge and today we recommend augmenting exposure to global gold miners to overweight. Chart 6What Is Gold Sniffing Out? Global gold miners have a lot going for them. Rising global policy uncertainty plays to their strength as investors seek the refuge of safe haven assets especially when geopolitical risks flare up (top panel, Chart 7). If our FX strategists hit the bull’s eye and the greenback loses steam this year,1 then gold related equities should outperform given the inverse correlation most commodities, including bullion, enjoy with the US dollar (bottom panel, Chart 7). Chart 7Solid Backdrop Importantly, real US bond yields have taken a beating recently underpinning gold prices and gold mining equities. This is significant, as bullion yields nothing and gold miners next to nothing so from an opportunity cost perspective it pays to hold a zero yielding asset when competing yields fall and vice versa (second panel, Chart 7). Worrisomely, this fall in real US yields is de facto pushing global real yields lower, which might indicate that investors worry that the global economy has more downside. In fact, economists’ estimates for GDP growth (as compiled by Bloomberg, third panel, Chart 7) continue to decelerate globally, and they forecast below-trend real output growth in the US for 2020. Global manufacturing also reflects this soft economic backdrop. While the global manufacturing PMI is trying to trough – it ticked down last month and is just a hair above the boom/bust line – both its momentum and diffusion are weak, heralding a catch up phase in global gold miners (PMI momentum shown inverted, Chart 8). Chart 8Global Economy Not Out Of The Woods Yet Boost global gold miners to an above benchmark allocation via the long GDX/short ACWI exchange traded funds. From a gold positioning perspective, on all three fronts we monitor (gold ETF holdings, gold net speculative positions and bullish consensus on gold) we see green lights (Chart 9). Even global gold miners’ extremely overbought positions have now been worked out according to our Technical Indicator (TI). Following the parabolic bull run from May to September last year, our TI is now drifting to the neutral zone. Relative valuations have also corrected offering investors a compelling entry point (Chart 10). Chart 9Enticing Sentiment Chart 10Compelling Entry Levels In sum, gold bullion is on the move again and falling real yields, a soft economic backdrop, a depreciating US dollar and resurgent geopolitical uncertainty, all argue for reintroducing a modest portfolio hedge by overweighting the global gold mining index. Bottom Line: Boost global gold miners to an above benchmark allocation via the long GDX/short ACWI exchange traded funds. Lift Materials To Neutral While materials stocks have broken down recently, our fresh gold miners overweight lifts the broad materials sector from previously underweight to currently neutral (Chart 11). Not only have relative share prices given way, but also breadth is weak as measured both by the percentage of groups with a positive year-over-year momentum and by the number of groups trading above their 40-week moving average (Chart 12). Moreover, relative valuations are downbeat (second panel, Chart 12), with relative P/S and P/B cratering. Chart 11Breakdown On the profit front, earnings breadth fell below neutral recently and net earnings revisions have collapsed. Wall Street analysts are even forecasting a dire relative revenue backdrop for the coming twelve months (Chart 13). Chart 12Washout Chart 13Extreme Pessimism Reigns While the sell-side has all but given up on this niche deep cyclical sector, we are going against the grain and posit that it no longer pays to be bearish materials stocks. First, our materials sector profit growth model has troughed and signals that a turnaround in EPS growth is underway and should gain steam this year (second panel, Chart 14). Keep in mind that this niche deep cyclical sector has borne the brunt of the Sino/American trade war and the recent de-escalation can serve as a catalyst for an earnings-led recovery (trade policy uncertainty shown inverted, Chart 11). Book relative gains of 5% since inception and lift the S&P materials sector to a benchmark allocation. Second, this industry is not at a standstill. Contrary to the overall economy, materials executives are investing in new projects as financial market reported materials sector capex clearly shows (third & bottom panels, Chart 14). These investments should bear fruit in coming quarters and translate into higher top line growth, something that is not at all discounted in bombed out relative sales growth expectations (bottom panel, Chart 13). Finally, there is tentative evidence that the EMs in general and China in particular are at least stabilizing. Not only are their manufacturing PMIs above the boom/bust line (not shown), but also financial market data suggest that the selling in materials stocks is nearing exhaustion. JP Morgan’s EM currency index is ticking higher, the CRB metals index is showing some signs of life and EM equities have been outperforming their global peers (Chart 15). Chart 14EPS Model Trough, Rising Capex…   Chart 15…And Firming Financial Market Data Signal It No Longer Pays To Be Bearish Netting it all out, washed out technicals, depressed valuations, the turn in our EPS growth model, rising industry capex and bottoming EM-related financial market data all signal that it no longer pays to be bearish materials stocks. Bottom Line: Book relative gains of 5% since inception and lift the S&P materials sector to a benchmark allocation.   Anastasios Avgeriou US Equity Strategist anastasios@bcaresearch.com       Appendix Appendix 1 Appendix 2 footnotes 1     Please see BCA Foreign Exchange Strategy Weekly Report, “On Oil, Growth And The Dollar” dated January 10, 2020, available at fes.bcaresearch.com.   Current Recommendations Current Trades Size And Style Views Stay neutral cyclicals over defensives (downgrade alert) Favor value over growth Favor large over small caps (Stop 10%)

Special Report

Highlights Building on a previous special report focused on the investable market, in this report we construct and present models designed to predict the odds of Chinese domestic equity sector outperformance. BCA Research's China Investment Strategy service will aim to use our newly developed sector outperformance probability models to better understand the drivers of performance at any given moment, and to make more active equity sector recommendations in the future. Episodes of domestic equity sector outperformance over the past decade appear to be more idiosyncratic (or sector specific) than has been the case for the investable market, suggesting that periods of “abnormal” relative sector performance may occur more frequently than in the investable universe. Among the predictors included in our model, our Li Keqiang leading indicator (based on monetary conditions, money, and credit growth) has been the most important. Our base case view argues in favor of domestic cyclicals over defensives over the coming year, but recent sector performance suggests that domestic consumer discretionary and tech should be favored within a cyclical equity portfolio over energy, materials, and industrials barring a surge in oil prices or a capitulation by Chinese policymakers in favor of “flood irrigation-style” stimulus. Over the long-term, we argue that investors have a good reason to favor domestic defensives over cyclicals until the latter demonstrates meaningfully better earnings performance. Feature We examined China’s investable equity sector performance in detail in our October 30 Special Report,1 with a particular emphasis on understanding the specific macroeconomic or equity market factors that have historically predicted relative sector performance. In today’s report, we extend our approach to China’s A-share market. Our research focused on constructing and presenting models that quantify a checklist-based approach to determining the odds of equity sector performance. The aim is to use these models to better understand the drivers of performance at any given moment, and to make more active equity sector recommendations in the future. These recommendations will not mechanically follow the models; rather, we plan to use them as a stand in for what typically would be expected given the macro and financial market environment, and as a basis to investigate “abnormal” relative performance. We find that episodes of domestic equity sector outperformance over the past decade appear to be more idiosyncratic (or sector specific) that has been the case for the investable market, suggesting that periods of “abnormal” relative sector performance may occur more frequently than in the investable universe. Among the macroeconomic and equity market factors that we found to be important predictors, our Li Keqiang leading indicator was the most significant. This confirms that China’s domestic market is more sensitive to monetary conditions, money, and credit growth than its investable peer. We also note the sharp difference in the relative performance of cyclicals versus defensives in the domestic market compared with the investable market, and what this means for investors over the coming 6-12 months. Finally, we argue that investors should maintain a structural bias towards defensive stocks in the domestic market until cyclicals demonstrate meaningfully better earnings performance, and point to an existing position in our trade book for investors interested in strategically allocating to the A-share market. Detailing Our Approach In our effort to better understand historical periods of domestic sector performance, we have chosen to model the probability of outperformance of each level 1 GICS sector (plus banks) based on a set of macro and equity market variables. Specifically, we use an analytical tool called a logistic regression, which forecasts the probability of a discrete event rather than forecasting the value of a dependent variable. We utilized this approach when building our earnings recession model for China (first presented in our January 16 Special Report).2 The “events” that we modeled are historical periods of individual Chinese investable sector outperformance from 2010 to 2018, relative to the MSCI China index (the “broad market”). We find that episodes of domestic equity sector outperformance over the past decade appear to be more idiosyncratic (or sector specific) than has been the case for the investable market. Chart I-1A and Chart I-1B illustrate these periods with shading in each panel. We then attempt to explain these episodes of outperformance with the following macro predictors: Chart I-1AThis Report Builds Models ##br##Aimed At... Chart I-1B...Predicting The Shaded Regions Of These Charts Periods of accelerating economic activity, represented by our BCA's China Activity Index Periods of rising leading indicators of economic activity, represented by our BCA Li Keqiang (LKI) Leading Indicator Episodes of tight monetary policy, defined as periods where China’s 3-month interbank repo rate is rising Periods of accelerating inflation, measured both by headline and core inflation We also include several equity market variables: uptrends in relative sector earnings, periods of rising broad market stock prices, uptrends in broad market earnings, and episodes of extreme technical conditions and relative over/undervaluation for the sector in question. In the case of energy stocks, we also include oil prices as a predictor. Chart I-2A and Chart I-2B illustrate these periods as well as the macro & market variables that we have included as predictors. Chart I-2AWe Use These Macroeconomic And Equity Market Factors... Chart I-2B...To Predict Periods Of Equity Sector Outperformance Our approach also accounts for the existence of any leading or lagging relationships between the macro and market variables we have used as predictors and sector relative performance. In most cases the predictors lead relative sector performance, but in some cases it is the opposite. In the case of the latter, we have limited the lead of any variable in our models to three months in order to reduce the need to forecast. Finally, our approach also limits the extent to which we consider a leading relationship between our predictors and relative sector performance, in order to avoid picking up overlapping economic cycles. This issue, and the evidence supporting the existence of a 3½-year credit cycle in China, is detailed in Box I-1 of our October 30 Special Report (please see footnote 1). Key Drivers Of Sector Performance: Domestic Versus Investable Pages 11-22 present the results of each sector’s outperformance probability model, along with a list of factors that were found to be useful predictors and a summary of the results. The importance of the factors included in the models is shown in each of the tables at the top right of pages 11-22 by a score of 1-3 stars, (loosely representing key levels of statistical significance) as well as each factor’s optimal lead or lag. A minus sign shows that the predictor leads sector relative performance, whereas a plus sign shows that it lags. Following a review of our domestic equity sector outperformance models, differences in the results from those presented in our previous report can be organized into three distinct elements: 1) the breadth of macro & equity market factors in predicting sector performance, 2) the relative importance of our LKI leading indicator, and 3) the difference between domestic/investable cyclical versus defensive performance. The Breath Of Predictive Factors Chart I-3In The Domestic Market, The Breadth Of Predictive Factors Is Narrower Compared with the models for investible sector performance that we detailed in our previous report, our work modeling domestic equity sector performance highlights that the breadth of predictive factors is narrower, particularly among cyclical sectors (Chart I-3). Our model for domestic materials (shown on page 12) is one exception to this rule, but we found that our models for energy, industrial, and consumer discretionary relative performance were all focused on fewer predictors than is the case for the investable market. In addition, our domestic utilities model has considerably worse predictive power than our model for investable utilities. The case of industrials is particularly notable: our model for investable industrials highlighted the importance of tight monetary policy, rising core inflation, rising broad market stock prices & earnings, and overbought and oversold technical conditions in explaining past periods of industrial sector outperformance. By contrast, our domestic industrials model is quite simple: the sector has been more likely to outperform, with a lag, when our BCA China Activity Index and LKI leading indicator have been rising, and underperform following periods of extreme overvaluation. One of the core conclusions of our previous report was that investors should view the relative performance of investable industrials versus consumer staples as a reflationary barometer, given the strong sensitivity of both sectors to tight monetary policy. We explained this sensitivity by pointing to the substantial difference in corporate health between the two sectors: industrial firms are heavily debt-laden and thus experience deteriorating operating performance and an environment of rising interest rates. In comparison, food and beverage firms appear to have the strongest balance sheets among the sub-sectors that we have examined, suggesting that they would benefit less from easier monetary conditions than firms in other industries. Our leading indicator for Chinese economic activity has been considerably more important in predicting domestic equity sector outperformance than in the investable market. However, these dynamics appear to be completely absent in influencing performance in China’s domestic equity market. Not only has domestic industrial sector relative performance not been negatively linked to periods of tight monetary policy, but our model for consumer staples (shown on page 15) highlights that periods of staples performance have been driven by two simple factors: the relative trend in staples EPS  (positive sign), and the trend in broad market EPS (negative sign). The Relative Importance Of Monetary Conditions, Money, And Credit Growth Chart I-4 summarizes the significance of the factors in predicting sector performance in general, by summing up each predictor’s number of stars across all of the models. The chart shows that our LKI leading indicator is the most important signal of sector performance that emerged from our analysis, followed by rising core inflation, rising broad market stock prices, rising economic activity, and oversold technical conditions. The ranking of results shown in Chart I-4 is fairly similar to those that we listed for the investable market, with two exceptions. First, for the domestic market, periods of tight monetary policy were considerably less important than in the investable market as an important predictor of relative sector performance. Instead, our LKI leading indicator was by far the most important predictor, which underscores a point that we have made in previous reports: domestic stocks appear to be much more sensitive to the trend in monetary conditions, money, and credit growth than for the investable market. This increased sensitivity has helped explain the difference in performance this year between the investable and domestic market, underscoring that the former has more catch-up potential than the latter in a trade truce scenario. Chart I-4Monetary Conditions, Money, & Credit Growth Drive A-Share Performance Second, in the investable market, episodes of significant overvaluation had essentially no power to predict future episodes of equity market underperformance. But this factor was an important or very important contributor to our domestic industrials, health care, and tech models. This finding is consistent with our May 23 Special Report, which noted that value stocks have outperformed in China’s domestic equity market over the past five years and underperformed in the investable market (Chart I-5). Chart I-5Value Has Been A More Successful ##br##Factor In The Domestic Market   Major Differences In The Performance Of Cyclicals Versus Defensives The results of our models for domestic equity sector performance did not change the cyclical & defensive labels that we applied in our previous report. The signs of the predictors shown in the tables on pages 11-22 clearly highlight that the domestic energy, materials, industrials consumer discretionary, and information technology sectors are cyclical sectors, and that consumer staples, health care, financials, telecom services, utilities, and real estate are defensive. What is striking, however, is that there is a major difference in the relative performance of equally-weighted domestic cyclicals versus defensives compared with what has occurred in the investable market over the past decade. Chart I-6A and Chart I-6B illustrate the different relative performance trends, along with their corresponding trends in relative P/E and relative EPS. Whereas the relative performance of investable cyclicals versus defensives has had somewhat of a stable mean over the past decade, domestic cyclicals have badly underperformed since early-2011. The charts also make it clear that this underperformance has been driven by a downtrend in relative EPS, not due to trend differences in relative valuation. Chart I-6ACyclicals/Defensives Somewhat Mean-Reverting In The Investable Market... Chart I-6B...But Not So In The Domestic##br## Market Digging further, it appears that this discrepancy can be largely explained by the significant difference in performance between investable and domestic tech over the past decade (Chart I-7). Whereas the former has outperformed the overall investable index by roughly 4-5 times since 2010, the relative performance of the latter has only very modestly risen. In effect, Charts I-6 and I-7 highlight that Chinese cyclical sectors have been structurally impaired over the past decade and have only been “saved” in the investable market by massive outsized outperformance of the tech sector. The fact that investable tech sector performance itself has been largely driven by 2 extremely successful firms underscores how narrowly based the investible cyclical versus defensives performance trend has been. Chart I-7A Huge Gap In Tech Explains Domestic Cyclical Underperformance Investment Conclusions There are three conclusions that investors can draw from our analysis. First, our research shows that episodes of domestic equity sector outperformance over the past decade appear to be more idiosyncratic (or sector specific) that has been the case for the investable market. This does not mean that domestic sector performance is not significantly impacted by macro and top down equity market factors, but it suggests that periods of “abnormal” relative sector performance may occur more frequently than in the investable universe. As such, investors should be prepared to include episode-specific investigation of abnormal performance as a regular part of their domestic equity sector allocation decisions. Investors should favor domestic cyclicals over the coming year, with exposure focused on consumer discretionary and tech. Second, the fact that our LKI leading indicator is in an uptrend suggests that investors should favor domestic cyclicals over defensives over the coming year, with a caveat. We have noted in several previous reports that our indicator is in a shallow uptrend, and the slower pace of money and credit growth than during previous economic upswings suggests that the bar may be higher for some cyclical sectors to outperform. We would advise investors to watch closely over the coming 3-6 months for signs of a technical breakout in all cyclical sectors. But sector performance in Q1 of this year, when the overall A-share market rose sharply versus global stocks, suggests that domestic consumer discretionary and tech should be favored within a cyclical equity portfolio over energy, materials, and industrials barring a surge in oil prices or a capitulation by Chinese policymakers in favor of “flood irrigation-style” stimulus (Chart I-8). Within resources, we prefer the investable energy sector to its domestic peer, due to a sizeable valuation advantage. Chart I-8Favor Select Domestic Cyclical Sectors Over The Coming Year As a third and final point, abstracting from our bullish outlook for select cyclical sectors over the coming year, Charts 6 and 7 clearly argue for investors to maintain a structural bias towards defensive stocks in the domestic market until cyclicals demonstrate meaningfully better earnings performance. In the May 23 Special Report that we referred to above, we noted that an A-share portfolio formed of industry groups with above-median return on equity and below-median ex-post beta has significantly outperformed over the past decade. Table I-1 presents the current industry group weights of this portfolio, and shows that overweight exposure is concentrated in the health care, consumer staples, and real estate sectors (all of which are defensive), and a heavy underweight towards industrials. Table I-1Current High ROE / Low Beta Factor Industry Group Portfolio Weights* For clients who are interested in strategically allocating to the A-share market, we maintain a long position in this portfolio relative to the MSCI China A Onshore index in our trade book, and plan to continue to update the performance of the trade on a weekly basis. Energy Chart II-1 Table II-1 Similar to the investable energy sector, periods of domestic energy sector outperformance are strongly positively related to rising oil prices and rising headline inflation in China. We noted in our previous report that this is a behavioral relationship, rather than a fundamental one. Domestic energy stocks are negatively associated with rising broad market stock prices, unlike their investable peers. This largely reflects the fact that the relative performance of domestic energy stocks has been in a structural downtrend over the past decade. From 2010 to mid-2016, this decline was caused by a persistent underperformance in earnings. Since mid-2016, domestic energy sector EPS have been rising in relative terms, meaning that more recent underperformance has been due to multiple contractions. While not as relatively cheap as their investable peers, domestic energy stocks are heavily discounted versus the broad domestic market based on both the price/earnings ratio and the dividend yield. Consequently, it is possible that domestic energy stocks may at some point begin to outperform in a rising broad equity market environment. For now, our model argues for an underweight stance towards domestic energy due to the lack of a clear uptrend in oil prices. As a pure value play, investable energy stocks maintain a dividend yield of nearly 6.5%, and are thus more attractive than their domestic peers. Materials Chart II-2 Table II-2 Our model for the domestic materials highlights that the sector’s performance has been related to strengthening economic activity and strongly related to a rising Li Keqiang leading indicator. Among the equity market variables that we tested, materials outperformance has been positively associated with rising relative EPS, rising broad market EPS, and prior oversold technical conditions. Similarly, the investable materials sector, these results show that domestic materials are a strong play on accelerating Chinese economic activity. The factors included in our domestic materials sector model are similar to those included in our investable material, except that relative material earnings have also been a significant predictor of sector relative performance. In addition, the macro & equity market predictors included in our domestic materials model have done a better job of leading material sector performance. The odds of domestic materials outperformance rose twice above the 50% mark this year according to our model, without any corresponding improvement in relative stock prices. The spikes in the model occurred largely because domestic materials became significantly oversold; technical conditions for the sector have only twice been weaker over the past decade. This underscores that investors should be watching domestic materials closely in Q1 of next year for signs of a relative rebound. Industrials Chart II-3 Table II-3 The results of our model for domestic industrial sector outperformance are interesting, as they imply that the drivers of performance are different between the domestic and investable markets. In the investable index, we found that industrials were heavily sensitive to monetary policy, rising core inflation, relative sector earnings, and periods of rising broad market stock prices. Our domestic model is considerably simpler: industrials outperform, with a lag, when our activity index and Li Keqiang leading indicator are rising. Periods of strong overvaluation have also been significant in predicting future episodes of domestic industrial sector underperformance. It is not clear to us why the drivers of relative performance for domestic industrials have been different than in the investable equity index, But the good news is that the relative simplicity of the model makes the investment decision making process for domestic industrials considerably easier. Today, domestic industrials are significantly undervalued, and our Li Keqiang leading indicator is in a shallow uptrend. This suggests that domestic industrials are likely to begin outperforming at some point in early-2020 following a bottoming in Chinese economic activity, unless policymakers are quick to tighten once activity begins to improve (which would be contrary to our expectations). Consumer Discretionary Chart II-4 Table II-4 Our domestic consumer discretionary model highlights that the sector’s relative performance is positively associated with a rising Li Keqiang leading indicator, rising core inflation, and rising broad market stock prices. Similar to its investable peers, domestic consumer discretionary stocks are cyclical, and positive relationship with core inflation may reflect improved pricing power for the sector. Unlike investable consumer discretionary, the domestic consumer discretionary has not been meaningfully impacted by the December 2018 changes to the global industry classification standard. Hence, our model does not exclude the internet & direct marketing retail sector as we did in our previous report on investable sectors. For now, our model suggests that the domestic consumer discretionary sector is likely to continue to underperform, given decelerating core inflation and the lack of a clear uptrend in the broad domestic equity index. However, as a cyclical sector, we will be watching closely for an upside breakout in domestic consumer discretionary performance in the first quarter as a signal to increase exposure to the sector. Consumer Staples Chart II-5 Table II-5 Our domestic consumer staples model is significantly different than that shown in our previous report for investable staples. This reflects sizeable differences in investable/domestic staples relative performance over the past decade, particularly from mid-2015 to late-2017 (where domestic staples outperformed significantly and investable staples languished). Of the two predictors found to be significant in explaining historical periods of domestic staples performance, a negative relationship with the trend in broad market EPS has been the most important. This underscores that staples are defensive sector. The trend in staples relative earnings has closely followed in importance, showing that the tremendous outperformance in domestic consumer staples over the past several years has, at least in part, been driven by fundamentals. Still, domestic consumer staples are currently priced at 34x earnings per share, compared with 15x for the overall domestic market. While our model currently argues for continued staples outperformance, the risk of a valuation mean reversion next year, against the backdrop of an improving economy, is above average. Over the coming 6-12 months, investors should be closely monitoring domestic staples for signs of waning earnings momentum and/or a major technical breakdown as potential signals to reduce domestic staples exposure. Health Care Chart II-6 Table II-6 Over the past decade, periods of domestic health care outperformance have been negatively associated with rising economic activity, rising core inflation, and rising broad market stock prices. Oversold technical conditions and periods of overvaluation have also helped predict future episodes of health care relative performance. These factors clearly point to the defensive nature of domestic health care, similar to health care stocks in the investable index. However, one clear difference between investable and domestic health care is that the former appears to have leading properties and the latter does not. We noted in our previous report that periods of investable health care underperformance appeared to lead, on average, our BCA Activity Index, periods of rising core inflation, and uptrends in the broad investable index. By contrast, domestic health care lags the Activity Index and core inflation by just over a year, and also lags the trend in broad market EPS. Our model points to further health care outperformance, but we would expect domestic health care stocks to underperform at some point next year following an improvement in economic activity and a resumed uptrend in broad domestic EPS. Financials Chart II-7 Table II-7 Our outperformance probability model for domestic financials highlights that the sector is countercyclical: periods of outperformance have been negatively related to our LKI leading indicator, rising core inflation, and rising broad market stock prices. Similar to the case of the investable index and unlike the case globally, financials are clearly defensive. Investable financials have exhibited atypical performance this year according to the model presented in our previous report. By contrast, domestic financials have performed in line with what our model has suggested: our LKI leading indicator is in a shallow uptrend, and the relative performance of domestic financials has trended flat-to-down since late-2018. Barring a major shift by the PBoC towards a hawkish stance in the coming year (which we do not expect), our base case view for the Chinese economy implies that domestic financials are likely to continue to underperform. Banks Chart II-8 Table II-8 Our model for domestic banks is similar to that of financials, with some important differences. In addition to being sensitive to our LKI leading indicator, domestic bank performance is negatively related to our Activity Index. Oversold technical conditions have also been quite important in predicting future episodes of domestic bank outperformance. The model is currently forecasting domestic bank underperformance, although it was late in predicting the selloff in bank stocks that began late last year. Similar to the case for domestic financials, our baseline view for the Chinese economy implies that domestic bank are likely to continue to underperform over the coming year. Information Technology Chart II-9 Table II-9 Our model for the domestic technology sector is different than that of investable tech, which reflects the vast difference in performance between the two sectors. While the relative performance of domestic tech has trended sideways over the past decade, investable tech stock prices have risen fourfold relative to the broad investable index. This difference is largely accounted for by the absence of the BAT stocks (Baidu, Alibaba, Tencent) from the domestic market. Similar to investable tech, domestic technology stocks are negatively related to tight monetary policy, and positively linked with a pro-cyclical economic variable (a rising LKI leading indicator). However, strangely, domestic tech has been strongly and negatively related to rising headline inflation, a finding with no clear fundamental basis. The model has been less successful in predicting domestic tech performance over the past year than in the past, which appears to be linked to the inclusion of headline inflation in the model. Rising headline inflation has been clearly associated with three major episodes of domestic tech underperformance since 2010, but over the past year domestic tech has outperformed as headline inflation accelerated. For now we would advise investors to focus on the other factors in the model: the lack of overvaluation, and our view that policy will remain easy on a measured basis, supports an overweight stance towards domestic tech over the coming year. Telecom Services Chart II-10 Table II-10 Our domestic telecom services relative performance model highlights that the sector is defensive like its investable peer, but the factors driving performance are somewhat different. The only similarity between the two models is that periods of outperformance are negatively related to rising broad market stocks prices for both investable and domestic telecom services, with domestic telecom stocks responding with a lag. Among the macro factors included in the model, periods of domestic telecom services outperformance are negatively and coincidently related to our LKI leading indicator, and positively related to tight monetary policy (with a slight lead). Oversold technical conditions have also proven to help predict future episodes of outperformance. The model failed to predict a brief period of outperformance in mid-2018, but has generally accurately predicted underperformance of domestic telecom stocks since early-2017. Barring a collapse in the US/China trade talks or considerably weaker near-term economic conditions than we expect, domestic telecom services will likely continue to underperform until the specter of tighter monetary policy emerges. This is unlikely to occur until the middle of 2020, at the earliest. Utilities Chart II-11 Table II-11 Overall, our domestic utilities model has considerably worse predictive power than our model for investable utilities. The model shows that the performance of domestic utilities is negatively related to rising core inflation (with a lag) and rising broad market EPS, but these relationships are not particularly strong. We noted in our June 19 Special Report that domestic utilities ranked highly on the impact that relative EPS had on predicting relative stock prices , yet relative sector earnings did not register as a significant predictor in our model. This apparent discrepancy is resolved by differences in the time horizon between these two approaches. The analysis that we presented in our June 19 Special Report examined the relationship between earnings and stock prices over the entire sample period (2011-2018), meaning that it examined the predictive power of earnings over the long-term. The models built in this report have focused strongly on explaining periods of outperformance over a 6-12 month time horizon, there have been enough deviations in the trend between the relative performance of utilities and relative utilities earnings that the relationship between the two was not sufficiently strong to show up in the model. In other words, the long-term link between utilities relative earnings and stock prices is strong, but the short-term link is fairly weak. Real Estate Chart II-12 Table II-12 Similar to investable real estate, our model shows that domestic real estate is a counter-cyclical sector in that it is negatively related to periods of rising economic activity, a rising LKI leading indicator, tight monetary policy, and rising core inflation. Overbought technical conditions have also aided in predicting future episodes of domestic real estate underperformance. Our model for domestic real estate stocks has performed quite well on average, but its predictive success since late-2017 has been mixed. This period of atypical underperformance has coincided with a considerably weaker rebound in residential floor space sold than has occurred in previous recoveries in the real estate market. This suggests that domestic real estate stocks are more susceptible to trends in housing sales than their investable peers (which appear to be mostly sensitive to rising house prices). We noted in our November 6 Weekly Report that floor space sold is picking up , but it still remains weak when compared with history. This, in combination with our view that the Chinese economy will improve over the coming year, suggests that investors should avoid domestic real estate exposure relative to the overall domestic equity market. Footnotes 1  Please see China Investment Strategy Special Report "A Guide To Chinese Investable Equity Sector Performance," dated October 30, 2019, available at cis.bcaresearch.com 2  Please see China Investment Strategy "Six Questions About Chinese Stocks," dated January 16, 2019, available at cis.bcaresearch.com 3  Please see China Investment Strategy Special Report "Chinese Equity Sector Earnings: Predictability, Cyclicality, And Relevance," dated June 19, 2019, available at cis.bcaresearch.com 4  Please see China Investment Strategy Weekly Report "China Macro And Market Review," dated November 6, 2019, available at uses.bcaresearch.com Cyclical Investment Stance Equity Sector Recommendations

Highlights The slowdown in global industrial activity appears to have bottomed. This, along with an apparent shared desire for a ceasefire in the Sino-US trade war, points toward a measured recovery in manufacturing and global trade, which will contribute to higher iron-ore and steel demand beginning in 1H20. A trade-war ceasefire, should it endure, will reduce global economic uncertainty. Along with continued monetary accommodation from systematically important central banks, reduced economic uncertainty will boost global growth and industrial-commodity demand generally by allowing the USD to weaken. We expect Beijing policymakers to remain focused on keeping GDP growth above 6.0% p.a. To that end, we believe a boost in infrastructure spending next year is likely, which also will be bullish for steel demand. Given China’s growing share of global steel production, we expect price differentials for high-grade iron ore – most of which comes from Brazil – to widen as steel demand increases next year. Given this view, we are initiating a strategic iron-ore spread trade at tonight’s close: Getting long December 2020 high-grade (65% Fe) futures traded on the Singapore Exchange vs. short the benchmark-grade (62% Fe) December 2020 futures traded on the CME. We recommend a 20% stop-loss on this recommendation. Feature Iron ore and steel demand will get a lift from the rebound our proprietary Global Industrial Activity (GIA) index has been forecasting for the past few months (Chart of the Week). The GIA index is designed to pick up changes in Chinese industrial activity, given its outsized influence on world industrial output, and also makes use of trade data, FX rates, and global manufacturing data. The rebound we are expecting will get a fillip from an apparent shared desire for a ceasefire in the Sino-US trade war, which, based on media reports, is close to being agreed. Should this ceasefire prove to be durable, it would contribute to a lowering of global economic policy uncertainty (GEPU), which, as we have shown recently, has kept the USD well bid to the detriment of industrial-commodity demand.1 Chart of the WeekBCA GIA Index Pick-Up Points To Higher Global Steel Demand While we do expect economic uncertainty to decline next year, it will remain elevated due to continued Sino-US trade tensions – even if a “phase-one” deal is agreed – ongoing hostilities in the Persian Gulf, and popular discontent with the political status quo globally. As global economic uncertainty fades, the USD broad trade-weighted index for goods (TWIBG) will fall, which will bolster EM GDP growth, and a recovery in global trade next year (Chart 2). If, as media reports suggest, this so-called “phase-one” agreement includes a relaxation – or complete removal – of tariffs by the US on Chinese imports, we would expect manufacturing activity to pick up as Chinese manufacturers spin-up capacity to meet demand. A reduction in tariffs also will lessen the deadweight loss they imposed on US households, which will support higher consumption.2 Chart 2Reduced Global Economic Uncertainty Bolsters Global Trade Volumes, EM GDP That said, economic uncertainty still remains high. This uncertainty is destructive of demand and will remain a key risk factor in 2020. While we do expect economic uncertainty to decline next year, it will remain elevated due to continued Sino-US trade tensions – even if a “phase-one” deal is agreed – ongoing hostilities in the Persian Gulf, and popular discontent with the political status quo globally. China’s Steel Demand Holds Up In Trade War China accounts for more than half of global steel production and consumption, and the lion’s share of seaborne iron-ore consumption (Chart 3). This makes its steel industry critically important to the global economy, and a key barometer of industrial activity worldwide. With global industrial activity bottoming and moving higher, and the USD expected to weaken, we expect iron ore demand and steel production in China to move higher next year as domestic and global demand for steel rises. China’s apparent steel demand held up fairly well during the slowdown observed in manufacturing and in commodity demand growth globally, averaging 8% y/y growth ytd (Chart of the Week, bottom panel). It now appears to be stalling in the wake of the global manufacturing slowdown. In addition, Chinese credit stimulus remains weak, contrary to expectations. However, with global industrial activity bottoming and moving higher, and the USD expected to weaken, we expect iron ore demand and steel production in China to move higher next year as domestic and global demand for steel rises.3 Chart 3China Dominates Global Steel Production and Consumption Chart 4Construction, Real Estate Strength Offset Lower Chinese Auto Production Greater demand for steel by the construction and real estate sectors offset lower consumption by the automobile industry in China this year, as manufacturing and trade slowed globally (Chart 4). Overall, apparent demand is still growing (Chart 5), which will continue to support iron ore imports, even though domestic production of low-grade ore picked up as steelmakers’ margins tightened earlier in the year (Chart 6). Chart 5China"s Apparent Steel Demand Growth Holds Up During Industrial Slowdown Chart 6China Iron Ore Imports Remain Stout Chinese imports from Brazil have rebounded following the Brumadinho tailings dam collapse in January at Vale’s Córrego do Feijão iron ore mine, which killed close to 300 people. The collapse in margins from steel mills combined with outages to Brazil and Australia high-grade ore exports led to a rise in imports and domestic production of low-grade iron ore. High-Grade Iron Ore Favored; Policy Uncertainty Persists Our overall view for industrial commodities – iron ore, steel, base metals and crude oil – is constructive but not wildly bullish going into next year. Our oil view, for example, calls for a rally in the average price of crude oil next year of ~ 10% from current levels for Brent crude oil, the world benchmark. While we expect global monetary stimulus to offset much of the tightening of financial conditions brought on by the Fed’s rate hikes last year, and China’s de-leveraging campaign of 2017-18, elevated economic uncertainty will keep the USD better bid that it otherwise would be absent the Sino-US trade war and global economic policy uncertainty. This translates into weaker commodity demand, generally, as a strong USD raises local-currency costs for consumers and lowers local-currency production costs for producers. At the margin, both push commodity prices lower. On a relative basis, we expect the more efficient, less-polluting technology likely will be called on to meet higher steel demand – in China and globally – next year, which means higher-grade iron ore will be favored by Chinese steel mills as profitability improves. For iron ore and steel in particular, environmental considerations also are important, given the Chinese government's “Blue Skies Policy” aimed at reducing the country’s high levels of air pollution.4 This policy has led to the forced retirement of older, highly polluting steelmaking capacity, which has been replaced with newer, less-polluting technology that favors high-grade iron ore. However, the application of regulations designed to reduce pollution has been uneven, and still relies on local compliance, which has been spotty. We expect demand for high-grade ore will increase as global manufacturing and trade also recovers. On a relative basis, we expect the more efficient, less-polluting technology likely will be called on to meet higher steel demand – in China and globally – next year, which means higher-grade iron ore will be favored by Chinese steel mills as profitability improves. The restoration of high-grade exports from Brazil means this ore will be available. It is worthwhile noting that these steelmakers account for an increasing share of global capacity. For this reason, we expect demand for high-grade ore will increase as global manufacturing and trade also recovers (Chart 7). Given our view, at tonight’s close we will get long December 2020 high-grade iron-ore futures (65% Fe) traded on the Singapore Exchange vs. short benchmark-grade iron-ore futures (62% Fe) traded on the CME. Both are quoted in USD/MT and settle basis Chinese port-delivery (CFR) indexes in cash. Given the uncertain nature of the durability and depth of the ceasefire currently being negotiated by the US and China, we will keep a stop-loss on this position of 20%. Bottom Line: China’s steel demand has held up relatively well despite the global slowdown in manufacturing and trade. Given our expectation for a pick-up in global growth – in response to global monetary and fiscal stimulus and lower economic uncertainty in the wake of a ceasefire in the Sino-US trade war – we expect Chinese steel demand to resume growing. This will support iron ore prices, particularly for high-grade ores. On the back of this expectation, we are recommending an iron-ore spread trade, going long high-grade futures vs. short benchmark-grade iron ore futures. Chart 7High-Grade Iron Ore Should Outperform Strategically   Robert P. Ryan Chief Commodity & Energy Strategist rryan@bcaresearch.com Hugo Bélanger Senior Analyst Commodity & Energy Strategy HugoB@bcaresearch.com   Market Round-Up Energy: Overweight. Bloomberg reported China is looking to invest between $5-$10 billion in the Saudi Aramco IPO through various vehicles. Such an investment would give China a deeper stake in the Kingdom’s oil industry, and a hedge to price shocks. In addition, it could open the way for deeper investment in the Saudi oil and petchems industries. For KSA, as we have argued in the past, a deepening of China’s investment and involvement in the Kingdom’s economy would diversify the states that have a vested interest in ensuring its safety.5 We will be updating our analysis of China’s pivot to the Middle East, and KSA’s pivot to Asia next week. Separately, we the last of our Brent backwardation trades – i.e., long December 2019 Brent vs. short December 2020 Brent – was closed last week with a gain of 110.8%. Base Metals: Neutral. Copper prices are up 6% vs. last month, supported by supply-side worries in Chile and, more recently, easing trade tensions. Cyclically, we believe copper prices are turning up – spurred by easy monetary conditions and fiscal stimulus directed at infrastructure and construction spending. Most of our key commodity-demand indicators have bottomed and are suggesting EM demand growth will move up. This supports a year-end base metal rally. Precious Metals: Neutral. A risk-on sentiment fueled by expectation the U.S. and China will sign a trade deal weighs on gold’s safe-haven demand. Prices fell 2% since last week. Additionally, U.S. 10-year bond yields shot higher – pushing gold prices lower – on Tuesday following a stronger-than-expect ISM services PMI data release. Gold-backed ETF holdings reached a new record in September at 2,855 MT (up 377 MT ytd), surpassing the December 2012 peak. A reversal in investors’ sentiment towards gold could send prices down. Ags/Softs: Underweight. The USDA reported that 52% of the U.S. corn has been harvested, a 13 percentage point increase relative to last week, yet the figure came shy of analysts’ expectation and far below the 2014-2018 average of 75%. On a weekly basis, corn prices are still down 2% due to drier weather forecast. Soybean harvest did better reaching 75%, and meeting expectations. Soybean price is almost unchanged on a weekly basis, despite having edged higher earlier in the week on the back of rising expectations the US and China will agree on a ceasefire in the ongoing trade war.   Footnotes 1     We measure this uncertainty using the Baker-Bloom-Davis Global Economic Policy Uncertainty (GEPU) index. This is a GDP-weighted index of newspaper headlines containing a list of words related economic uncertainty. Newspapers from 20 countries representing almost 80% of global GDP are scoured for reports reflecting economic uncertainty. Please see our October 17 and October 31, 2019, reports Policy Uncertainty Lifts USD, Stifles Global Oil Demand Growth and Global Financial Conditions Support Higher Commodity Demand for the original research on this topic. Both are available at ces.bcaresearch.com. 2    We discuss deadweight losses to US households arising from the tariffs in Waiting To Get Long Copper, In China’s Steel Slipstream, published August 29, 2019. It is available at ces.bcaresearch.com. 3    BCA Research’s China Investment Strategy expects China’s business cycle likely will bottom in 1Q20 of next year, rather than in 4Q19. This aligns with our expectation. Please see China Macro And Market Review, published November 6, 2019. It is available at cis.bcaresearch.com. 4    We examined the implications of China’s “Blue Skies” policy in China's Anti-Pollution Resolve Critical To Iron Ore Markets, published April 4, 2019. It is available at ces.bcaresearch.com. 5    We discuss these issues in our Special Report entitled ضد الواسطة published November 16, 2018. The Arabic title of the report translates as "Against Wasta." Wasta means reciprocity in formal and informal dealings. Investment Views and Themes Recommendations Strategic Recommendations Tactical Trades TRADE RECOMMENDATION PERFORMANCE IN 2019 Q3 Commodity Prices and Plays Reference Table Trades Closed in 2019 Summary of Closed Trades

Special Report

Highlights In this report, we build and present models designed to predict the odds of Chinese investable equity sector outperformance, based on a set of macroeconomic and equity market factors. BCA Research's China Investment Strategy service will aim to use our newly developed sector outperformance probability models to help investors to better understand the drivers of performance at any given moment, and to make more active equity sector recommendations in the future. Among the top six factors explaining historical periods of sector performance, three were macroeconomic in orientation, and two were directly related to the broad Chinese equity market. We see this as strongly supportive of the potential returns to be earned from active top-down sector rotation within China’s investable market. Cyclical stocks are very depressed relative to defensives, and we would favor them versus defensives over the coming year if China strikes a trade deal with the US and the Chinese economy incrementally improves, as we expect. Feature In our June 19 Special Report, we reviewed the predictability and cyclicality of equity sector earnings in China's investable & domestic markets, and examined the relevance of earnings in predicting relative sector performance over the past decade. We noted that a few sectors scored highly in terms of earnings predictability and the relevance of those earnings in predicting relative performance. But we also highlighted that most of China's equity sectors, in both the investable and domestic markets, either demonstrated earnings trends that were difficult to predict based on the trend in overall market earnings or exhibited relative performance that was difficult to explain based on the relative earnings profile. Our models are designed to predict equity sector relative performance using a series of macroeconomic and equity market factors. In short, our June report underscored that China’s equity sectors warranted a closer examination, with a particular emphasis on understanding the specific macroeconomic or equity market factors that have historically predicted relative sector performance. Today’s report examines this question in depth, focused on China’s investable equity market. We hope to extend our research to the A-share market in the near future. Our approach focuses on constructing and presenting models that quantify a checklist-based approach to determining the odds of equity sector performance. The aim is to use these models to better understand the drivers of performance at any given moment, and to make more active equity sector recommendations in the future. These recommendations will not mechanically follow the models; rather, we plan to use them as a stand in for what typically would be expected given the macro and financial market environment, and as a basis to investigate “abnormal” relative performance. We conclude by highlighting the substantial underperformance of cyclical vs defensives sectors over the past two years, and argue that it is highly unlikely that cyclicals will underperform defensives over the coming 12 months if China strikes a trade deal with the US and the economy incrementally improves, as we expect. We also explain the importance of monitoring the relative performance of health care & utilities stocks over the coming few months, and present a unique sector-based barometer for gauging China’s reflationary stance. The latter two relative performance trends are likely to assist investors in positioning for the big call: the outperformance of Chinese investable stocks vs the global benchmark. Detailing Our Approach In our effort to better understand historical periods of sector outperformance, we have chosen to model the probability of outperformance of each level 1 GICS sector (plus banks) based on a set of macro and equity market variables. Specifically, we use an analytical tool called a logistic regression, which forecasts the probability of a discrete event rather than forecasting the value of a dependent variable. We utilized this approach when building our earnings recession model for China (first presented in our January 16 Special Report1), and investors will often see it (in its conceptually different but practically similar probit form) employed when analyzing the likelihood of an economic recession. The New York Fed’s US recession model is a notable example of the latter,2 which has received much attention by market participants over the past year following the inversion of the US yield curve. The “events” that we modeled are historical periods of individual Chinese investable sector outperformance from 2010 to 2018, relative to the MSCI China index (the “broad market”). Charts I-1A and I-1B illustrate these periods with shading in each panel. We then attempt to explain these episodes of outperformance with the following macro predictors: Chart I-1AThis Report Builds Models Aimed At... Chart I-1B...Predicting The Shaded Regions Of These Charts Periods of accelerating economic activity, represented by our BCA's China Activity Index Periods of rising leading indicators of economic activity, represented by our BCA Li Keqiang Leading Indicator Episodes of tight monetary policy, defined as periods where China’s 3-month interbank repo rate is rising Periods of accelerating inflation, measured both by headline and core inflation We also include several equity market variables: uptrends in relative sector earnings, periods of rising broad market stock prices, uptrends in broad market earnings, and episodes of extreme technical conditions and relative over/undervaluation for the sector in question. In the case of energy stocks, we also include oil prices as a predictor. Charts I-2A and I-2B illustrate these periods as well as the macro & market variables that we have included as predictors. Chart I-2AWe Use These Macroeconomic And Equity Market Factors... Chart I-2B...To Predict Periods Of Equity Sector Outperformance Our approach also accounts for the existence of any leading or lagging relationships between the macro and market variables we have used as predictors and sector relative performance. In most cases the predictors lead relative sector performance, but in some cases it is the opposite. In the case of the latter, we have limited the lead of any variable in our models to 3 months in order to reduce the need to forecast. The link between tight monetary policy and industrial sector performance is one exception to this rule that we detail below. Finally, our approach also limits the extent to which we consider a leading relationship between our predictors and relative sector performance, in order to avoid picking up overlapping economic cycles. This issue, and the evidence supporting the existence of a 3½-year credit cycle in China, are detailed in Box 1. Box 1 Accounting For China’s 3½-Year Credit Cycle Over the course of the analysis detailed in this report, judgments concerning how much of a lead or lag to allow when accounting for any leading or lagging relationships between sector relative performance and either macroeconomic & stock market predictors were necessary. In cases where sector relative performance led any of our predictors, we capped the lead at 3-months to reduce the need to forecast the predictors when using the models. As explained below, the 8-month lead between industrial sector relative performance and tight monetary policy was the only exception to this rule. We also did not include any leading relationship between relative sector stock performance and the trend in relative sector EPS, and allowed at most a co-incident relationship. Limits were also required in the cases where our predictors led relative sector performance. While more lead time is usually better from the perspective of investment strategy, Chart I-B1 presents strong evidence of a 3½ -year credit cycle in China. Chart I-B2 illustrates the problem with including significant lags between predictors and relative sector performance when economic cycles are short. The chart shows the lead/lag correlation profile of the stylized cycle shown in Chart I-B1, and highlights that lags greater than 12-14 months risk picking up the impact of the previous economic cycle. Given this, we have limited the extent to which our predictors can lead relative sector performance in our models, and in practice lead times are generally less than one year. Chart I-B1Over The Past Decade, China Has Experienced A 3½-Year Credit Cycle Chart I-B2With Short Cycles, Excessive Lags Risk Picking Up The Previous Cycle The Key Drivers Of Chinese Investable Equity Sectors Pages 12-23 present the results of each sector’s outperformance probability model, along with a list of factors that were found to be useful predictors and a summary of the results. The importance of the factors included in the models is shown in each of the tables at the top right of pages 12-23 by a score of 1-3 stars, (loosely representing key levels of statistical significance) as well as each factor’s optimal lead or lag. A minus sign shows that the predictor leads sector relative performance, whereas a plus sign shows that it lags. Rising core inflation in China is the most important signal of sector performance that emerged from our analysis. Chart I-3China’s Sectors Linked Strongly To Core Inflation, Monetary Policy, And Growth Chart I-3 summarizes the significance of the factors in predicting sector performance in general, by summing up each predictor’s number of stars across all of the models. The chart shows that rising core inflation in China is the most important signal of sector performance that emerged from our analysis, followed by tight monetary policy, rising economic activity, rising broad market stock prices, oversold technical conditions, and rising broad market earnings. Chart I-3 highlights two important points: If regarded through the lens of causality alone, the strong relationship between rising core inflation and sector performance is somewhat surprising: normally, pricing power is subordinate to revenue/sales/demand as the primary factor driving fundamental performance. However, given that inflation is a lagging economic variable, we suspect that the significance of inflation in our models actually reflects the middle phase of the economic cycle in which sectors tend to best exhibit meaningful out/underperformance. It is also a stronger predictor of periods of tight monetary policy in China than headline inflation.3 This is an encouraging result for investors, as it suggests good odds that future episodes of meaningful sector outperformance can be identified given a particular macro view. Among the top six factors explaining historical periods of sector performance, three were macroeconomic in orientation, and two were directly related to the broad Chinese equity market. While Chinese equity sector performance can sometimes be idiosyncratic, we see this as strongly supportive of the idea that investors can earn positive excess returns by actively shifting between China’s equity sectors using a top-down approach. Turning to the specific results of our sector models, we present the following big-picture findings of our research: Defining China’s Cyclical & Defensive Sectors From a top-down perspective, the most important element of sector rotation typically involves shifting from defensive to cyclical stocks when economic activity is set to improve (and vice versa). In China, it is clear from the results of our models that the investable energy, materials, industrials, consumer discretionary, and information technology sectors are cyclical sectors. The relative performance of these sectors exhibits a positive relationship to pro-cyclical macro variables, or broad market trends. Following last year’s GICS changes, we also include the media & entertainment industry group (within the new communication services sector) in this list. Correspondingly, investable consumer staples, health care, financials, telecom services, utilities, and real estate are defensive sectors in China. Chart I-4Cyclical Stocks Are Bombed Out Versus Defensives Chart I-4 illustrates how these sectors have performed over the past decade by grouping them into equally-weighted cyclical and defensive stock price indexes, as well as the relative performance of cyclicals versus defensives. The chart makes it clear that cyclical stock performance is essentially as weak as it has ever been relative to defensives over the past decade, with the exception of a brief period in 2013. Panel 2 highlights that all of the underperformance of cyclicals over the past two years has been due to de-rating, rather than due to underperforming earnings. The Atypical Case Of Financials & Real Estate The fact that financial and real estate stocks are defensive in China is somewhat curious. In the case of financials, the abnormality is straightforward: most global equity portfolio managers would consider financials to be cyclical, and our work suggests that this is not true for the investable market. Our explanation for this apparent discrepancy is also straightforward: while small and medium banks in China have obviously grown in prominence over the past decade, large state-owned or state-affiliated commercial banks are still dominant in the provision of credit to China's old economy. In most cases China’s large banks lend to state-owned enterprises with implicit government guarantees, meaning that the earnings risk for Chinese banks has typically been lower than for the investable market in the aggregate. It remains to be seen whether this will remain true in a world where Chinese policymakers are keen to slow the pace at which China’s macro leverage ratio rises and to render the existing stock of debt more sustainable for the non-financial sector. Indeed, over a multi-year time horizon, the risk are not trivial that banks will be forced to recapitalize as a result of forced changes to loan terms (eg: significant increases in the amortization period of existing loans) or the recognition of sizeable loan losses, which would clearly increase the cyclicality of the Chinese investable financial sector. Chart I-5A Seeming Contradiction: Real Estate Is High-Beta, But Defensive On the real estate front, the anomaly is not that real estate stocks respond defensively to macroeconomic and stock market variables, it is that real estate stock prices are considerably more volatile than this defensive characterization would suggest. Globally (and especially in the US), real estate stocks are often viewed as bond proxies and thus are typically low-beta, but Chart I-5 shows that this is not the case in China. In our view, this issue is reconciled by the fact that Chinese investable real estate stocks are also highly positively linked to Chinese house price appreciation, with relative performance typically leading a pickup in house prices by up to 1 year. This strongly leading relationship has meant that real estate stocks have often outperformed the broad market as economic activity is slowing, in anticipation that policy easing will lead to an eventual recovery in house prices. Chart I-6Still Following The Defensive Playbook This Year In effect, investable real estate stocks are a high-beta sector that have acted counter-cyclically due to the historical interplay between economic activity, monetary policy, and the housing market. Real estate performance this year has not deviated from this playbook (Chart I-6), and so for now we are content to include real estate stocks in our defensive index. But similar to the case of financials, we can conceive of scenarios in which ongoing Chinese financial sector reform may change this relationship in the future. The Unique Monetary Policy Sensitivity Of Industrials And Consumer Staples Pages 14 and 16 highlight that industrials and consumer staples stocks have typically been sensitive to periods of tight monetary policy. In the case of industrials the relationship is negative, whereas consumer staples relative performance has been positively linked to these periods. In both cases, relative performance has led periods of tight monetary policy, significantly so in the case of industrials (by an average of 8 months). While the relative performance of banks, tech, and real estate stocks have also been linked to periods of tight monetary policy, industrials and consumer staples are the only sectors that have tended to lead these periods. Chart I-7Diverging Corporate Health Explains Industrials/Staples Monetary Policy Sensitivity This is a revelatory finding, and in our view it is explained by divergences in corporate health and leverage for the two sectors. We reviewed Chinese corporate health in our August 28 Special Report,4 and noted that the food & beverage sub-industry was a clear (positive) outlier based on our corporate health monitors. In particular, Chart I-7 highlights that food & beverage corporate health is markedly better than that for machinery companies or for industrial firms in general, supporting the notion that high (low) leverage is impacting the relative performance of industrials (consumer staples). The Leading Nature Of Health Care & Utilities Health care and utilities exhibit similar key drivers of relative performance: in both cases, periods of rising economic activity, rising core inflation, and rising broad market stock prices are all negatively associated with performance. Health care and utilities relative performance also happens to lead all three of those predictors, by 1-3 months on average depending on the variable in question. Our modeling work highlights that these are the only sectors whose relative performance has led multiple factors, suggesting that health care & utilities stocks are particularly interesting market bellwethers to monitor. Core Inflation Matters More Than Headline, Except For Energy & Real Estate As highlighted in Chart I-3, rising core inflation has been a much more important signal about relative sector performance than headline inflation. Chart I-8In China, Food Prices (Not Energy) Account For Headline/Core Differences The two exceptions to this rule relate to the energy and real estate sectors, with the former positively linked to headline inflation and the latter negatively linked. In both cases, we suspect that the relationship is a behavioral rather than a fundamental one. For energy, while rising headline inflation in developed countries is usually associated with rising energy prices, this is not true in the case of China. Chart I-8 highlights that differences between headline and core inflation over the past decade have almost always been driven by rising food prices. This implies that some investors (incorrectly) view energy stocks as a hedge against increases in consumer prices, even if those increases are not driven by rising fuel costs. In the case of real estate, investor expectations of eroding real disposable income and its impact on the housing market are likely the best explanation for the negative link between real estate relative performance and rising headline inflation. Whereas rising core inflation likely reflects a durable improvement in economic momentum (and thus would be positively correlated with income growth), episodes of rising Chinese headline inflation often reflect supply shocks that investors may perceive to be detrimental to household spending power (and thus expected housing demand). Investment Conclusions Our work aimed at explaining historical periods of Chinese investable sector outperformance has three investment implications in the current environment. Cyclicals will probably outperform defensives over the coming year if China strikes a trade deal with the US and the Chinese economy incrementally improves, as we expect. First, within China’s investable market, Chart I-4 illustrated that cyclical stocks are very depressed relative to defensives. Given our view that Chinese investable stocks are likely to outperform their global peers over a 6-12 month time horizon, we would also favor cyclicals to defensives over that period. For investors who are not yet overweight cyclical stocks in China, we would advise waiting for concrete signs that growth has bottomed (which should emerge sometime in Q1) before putting on a long position as we remain tactically neutral towards Chinese versus global stocks. But the key point is that it is highly unlikely that cyclicals will underperform defensives over the coming year if China strikes a trade deal with the US and the Chinese economy incrementally improves, as we expect. Second, the fact that investable health care and utilities stocks have particularly leading properties suggests that they should be monitored closely over the coming few months. A technical breakdown in the relative performance of these sectors would be an important sign that market participants are anticipating a bottoming in China’s economy, which may give investors a green light to position for a bullish cyclical stance. For now, both of these sectors continue to outperform (Chart I-9), supporting our decision to remain tactically neutral towards Chinese stocks. Third, the heightened negative sensitivity of industrials and positive sensitivity of consumer staples to monetary policy suggests that the relative performance trend between the two sectors may serve as a reflationary barometer for China’s economy. Chart I-10 shows that industrials outperformed staples last year once the PBOC shifted into easing mode, and anticipated the recovery in the pace of credit growth. However, industrials soon began to underperform staples, which also seems to have anticipated the fact that the recovery in credit was set to be less powerful than what has occurred during previous cycles. The fact that the relative performance trend is off its recent low is notable, and may suggest that China’s existing reflationary stance will be sufficient to stabilize economic activity if a trade deal with the US is indeed finalized in the near future. Chart I-9Key Defensive Sectors Are Still Outperforming, Supporting Our Neutral Tactical Stance Chart I-10Industrials Vs. Staples Anticipated That Easing Would Only Be Measured As a final point, BCA Research's China Investment Strategy service will aim to use our newly developed sector outperformance probability models to make more active equity sector recommendations in the future. These recommendations will not mechanically follow the models; rather, we plan to use the models as a stand in for what typically would be expected given the macro and financial market environment, and as a basis to investigate “abnormal” relative performance. We hope you will find these models to be a helpful quantification of the risk versus return prospects of allocating among China’s investable sectors. As always, we welcome any feedback that you may have about our approach.   Energy Chart II-1 Table II-1   Unsurprisingly, our energy sector model highlights that periods of energy outperformance are strongly linked to periods of rising crude oil prices. However, what is surprising is that periods of accelerating headline inflation in China are even more closely linked to periods of energy sector outperformance than episodes of rising oil prices, and that these periods of accelerating inflation are not generally caused by rising energy prices. The lack of a clear economic rationale for this relationship implies that some investors (incorrectly) view energy stocks as a hedge against increases in consumer prices, even if those increases are largely driven by rising food prices. The model also highlights that periods of strong undervaluation have historically been significant in predicting future energy sector outperformance, with a lag of roughly 8 months. The probability of energy sector outperformance has fallen sharply according to our model, but for now we continue to recommend a long absolute energy sector position on a 6-12 month time horizon. BCA’s Commodity & Energy Strategy service expects oil prices to trade at $70/barrel on average next year,5 Chinese headline inflation continues to rise, and we noted in our October 2 Weekly Report that energy stocks are heavily discounted.6 Barring a durable decline in oil prices below $55/barrel, investors should continue to favor China’s energy sector. Materials Chart II-2 Table II-2 Our model highlights that the materials sector is one of the clearest plays on accelerating industrial activity within the investable universe. Among the macro variables that we tested, periods of investable materials outperformance are strongly positively linked with periods when our BCA Activity Index and our leading indicator for the index have been rising. Periods of materials sector outperformance have also been positively correlated with prior periods of oversold technical conditions and rising broad market stock prices, underscoring that materials are a strongly pro-cyclical sector. We currently maintain no active relative sector trades, but our model suggests that investors should be underweight the investable materials sector relative to the broad investable index. Industrials Chart II-3 Table II-3 Periods of industrial sector outperformance have historically been positively correlated with relative industrial sector earnings, broad market stock prices, and prior oversold technical conditions. They have been negatively correlated with periods of tight monetary policy, rising core inflation, and prior overbought technical conditions. Since 2010, periods of industrial sector performance have led periods of tight monetary policy by 8 months, the longest lead of relative equity performance to any macro variable that we tested in our model (and the longest lead that we allowed). Industrial sector performance has also been strongly negatively linked with periods of rising core inflation. These findings, and the fact that our Activity Index and its leading indicator have not been highly successful at predicting periods of industrial sector outperformance, strongly suggest that industrials, while pro-cyclical, are primarily driven by expectations of easy monetary policy. We noted in an August 2018 Special Report that state-owned enterprises have become substantially leveraged over the past decade,7 and in a more recent report we highlighted that industries such as machinery have experienced a significant deterioration in corporate health over the past decade.8 This helps explain why industrial sector performance is so negatively impacted by tight policy. Our model suggests that the best time to be overweight industrial stocks is the early phase of an economic rebound, when Chinese stock prices are rising but market participants are not yet expecting tighter policy. These conditions may present themselves sometime in Q1, but probably not over the coming 0-3 months. Consumer Discretionary Ex-Internet & Direct Marketing Retail Chart II-4 Table II-4 Besides materials, China’s investable consumer discretionary sector has historically been the most positively associated with coincident and leading measures of industrial activity. Rising core inflation is also highly positively related to consumer discretionary outperformance, which may reflect improved pricing power for the sector. The strong link with industrial activity is in contrast to depictions of China’s consumer sector as being less correlated to money & credit trends than the overall economy, and is supportive of our view that industrial activity forms one of the three pillars of China’s business cycle.9 We ended the estimation period of our model as of December 2018, in order to avoid including the distortive effects of last year’s changes to the global industry classification standard (which resulted in Alibaba’s inclusion and overwhelming representation in the investable consumer discretionary sector). As such, the results of our model apply today to consumer discretionary stocks ex-internet & direct marketing retail. For now, the absence of an uptrend in our Activity Index and in core inflation is signaling underperformance of discretionary stocks outside of internet & direct marketing retail. Outperformance this year largely reflects a significant advance in consumer durable and apparel: by contrast, automobiles & components have underperformed the broad market by roughly 14% year-to-date. Consumer Staples Chart II-5 Table II-5 Historically, periods of consumer staples outperformance have been predicted by a falling Activity Index, periods of tight monetary policy, and over/undervalued conditions. The impact of monetary policy is particularly heavy in the model, suggesting that consumer staples are somewhat the mirror image of industrials in terms of the impact of leverage on relative equity performance. This too is supported by our August 28 Special Report,10 which noted that corporate health for the food & beverage sector was the strongest among the sectors we examined. However, the model failed to capture what has been very significant staples outperformance this year, highlighting the occasional limits of a rule-of-thumb approach to sector allocation. Investable consumer staples are reliably low-beta compared with the broad market, and we are not surprised that investors have strongly favored the sector this year amid enormous economic and policy uncertainty. An eventual improvement in economic activity, coupled with fairly rich valuation, should work against consumer staples stocks sometime in the first quarter of 2020. Investors who are positioned in favor of China-related assets should also be watching closely for any signs of a technical breakdown in the relative performance trend of investable staples. Health Care Chart II-6 Table II-6 Among the macro variables tested in our model, periods of health care outperformance are negatively related to coincident and leading measures of industrial activity and strongly negatively related to rising core inflation.  Health care outperformance is also strongly negatively related to periods of rising broad market stock prices, and positively related to prior oversold technical conditions. These results clearly signify that investable health care is a defensive sector, to be owned when the economy is slowing and when investable stocks in general are trending lower. Our model suggests that health care stocks are likely to continue to outperform, as they have been since the beginning of the year. A substantive US/China trade deal that meaningfully reduces economic uncertainty remains the key risk to health care outperformance over a 6- to 12-month time horizon. Financials Chart II-7 Table II-7 Our model highlights that periods of financial sector outperformance over the past decade have been negatively associated with periods of rising core inflation (a strong relationship), and with periods of rising index earnings. Oversold technical conditions have also helped explain future episodes of financial sector outperformance. The link between core inflation and the outperformance of financials appears to represent a behavioral rather than a fundamental relationship. When modeling periods of rising financial sector relative earnings, the trend in broad market EPS is more predictive than that of core inflation, highlighting that the latter’s explanatory power is due to investor behavior. The results of our model, and the fact that core inflation leads Chinese index earnings, suggests that financials are fundamentally counter-cyclical and that investors see rising Chinese core inflation as confirmation that an economic expansion is underway (and that broad market earnings are likely to rise). Our model is currently predicting financial sector outperformance, but investable financials have modestly underperformed since the beginning of the year. This appears to have been caused by the underperformance of financial sector earnings this year as overall index earnings growth has decelerated, contrary to what history would suggest. We suspect that the ongoing shadow banking crackdown is related to financial sector earnings underperformance, and we would advise against an overweight stance towards investable financials until signs of improving relative earnings emerge. Banks Chart II-8 Table II-8 Our model shows that periods of banking sector outperformance are more linked to macro variables than has been the case for the overall financial sector. Specifically, bank performance is negatively correlated with leading indicators of economic activity and rising core inflation, and especially negatively correlated with periods of tight monetary policy. Banks have also typically outperformed following periods of oversold technical conditions. Similar to financials, bank earnings are typically counter-cyclical, but relative bank earnings have not been good predictors of relative bank performance over the past decade. Still, the negative association of relative stock prices with leading economic indicators, rising core inflation and rising interest rates underscores that investors should normally be underweight banks if they expect overall Chinese stock prices to rise. Also similar to the overall financial sector, our model is currently predicting outperformance for bank stocks, but investable banks have underperformed year-to-date. The shadow banking crackdown is also likely impacting investable bank earnings, leading to a similar recommendation to avoid bank stocks until relative earnings look to be trending higher. “Tech+”   Chart II-9 Table II-9 Our technology model has worked well at predicting periods of tech sector outperformance over the past several years, particularly from 2015 – 2017. The model suggests that, in addition to being negatively related to prior overbought conditions, periods of technology sector outperformance are associated with improving growth conditions, easy monetary policy, and rising prices. In other words, tech stocks are a growth & liquidity play. Owing to last year’s changes to the GICS, the results of our model apply today to Chinese investable internet & direct marketing retail, the media & entertainment industry group (within the new communication services sector), and the now considerably smaller information technology sector (the sum of which could be considered the “tech+” sector). The model has been predicting tech sector outperformance since May (in response to easier monetary policy), which has occurred for the official information technology sector. However, the BAT (Baidu, Alibaba, and Tencent) stocks are only up fractionally in relative terms from their late-May low. Our expectation that China’s economy is likely to bottom in Q1 means that we may recommend upgrading “tech+” stocks relative to the investable benchmark in the coming months. Telecom Services Chart II-10 Table II-10 Our model for telecommunication services (now a level 2 industry group within the communication services sector) illustrates that telecom stocks have historically been counter-cyclical. Periods of telecom outperformance have been negatively associated with periods of rising core inflation, rising broad market stock prices, and rising broad market EPS. It is notable that telecom services stocks are driven more by cycles in overall stock prices than by cycles in economic activity. This suggests that investors tend to focus on the fact that telecom stocks are reliably low-beta compared with the overall investable market, causing out(under)performance of telecoms when the broad market is falling(rising). Similar to financials & banks, telecom stocks have not outperformed this year, in contrast to what our model would suggest. Earnings also appear to be the culprit, with the level of 12-month trailing earnings having fallen nearly 10% since the summer. China Mobile accounts for a sizeable portion of the telecom services index, and the company’s recent earnings weakness seems to be due to depreciation charges stemming from forced investment on 5G spending (mandated by the Chinese government). Our sense is that this will have only a temporary effect on telecom services EPS, meaning that investors should continue to expect the sector to behave in a counter-cyclical fashion over the coming year. Utilities Chart II-11 Table II-11 The early performance of our utilities model was mixed, as it generated several false sell signals during the 2011 – 2013 period despite recommending, on average, an overweight stance. However, over the past five years, the model has performed extremely well in terms of explaining periods of relative utilities performance. The model highlights that utilities are straightforwardly counter-cyclical. The relative performance of utilities stocks is positively related to its relative earnings trend, and negatively related to economic activity, rising core inflation, and broad market stock prices.  Consistent with a decline in the overall MSCI China index, the model has correctly predicted utilities outperformance this year. We expect utilities to underperform over a 6-12 month time horizon, but would advise against an aggressive underweight position until hard evidence of a bottom in Chinese economic activity emerges. Real Estate Chart II-12 Table II-12 Our model for the relative performance of investable real estate has been among the most successful of those detailed in this report, which is somewhat surprising given the macro factors that the model shows drive real estate performance. While periods of relative real estate performance are modestly (negatively) associated with periods of tight monetary policy, rising headline inflation is the most important macro predictor of real estate underperformance. Among market factors driving performance, real estate stocks reliably underperform when broad market EPS are trending higher, and they historically outperform for a time after becoming relatively undervalued. Real estate relative performance is also strongly linked to periods of rising house prices, but the former tends to significantly lead the latter. Given that core inflation has better predicted episodes of tight monetary policy than headline inflation, investor expectations of eroding real disposable income is likely the best explanation for the negative link between real estate relative performance and rising headline inflation. Whereas rising core inflation likely reflects a durable improvement in economic momentum (and thus would be positively correlated with income growth), episodes of rising Chinese headline inflation often reflect supply shocks that investors may perceive to be detrimental to household spending power (and thus expected housing demand). Beyond the negative link between higher inflation and interest rates on investable real estate performance, the strong negative association with broad market earnings underscores that investors treat real estate as a defensive sector. We thus expect real estate stocks to continue to outperform in the near term, but underperform over a 6-12 month time horizon.   Jonathan LaBerge, CFA Vice President jonathanl@bcaresearch.com   Footnotes 1. Please see China Investment Strategy, "Six Questions About Chinese Stocks," dated January 16, 2019. 2. Please see Federal Reserve Bank of New York, The Yield Curve as a Leading Indicator at https://www.newyorkfed.org/research/capital_markets/ycfaq.html 3. This is despite frequent concerns among investors that the PBOC is inclined to tighten in response to detrimental supply shocks. 4. Please see China Investment Strategy, "Messages From BCA’s China Industry Watch," dated August 28, 2019. 5. Please see Commodity & Energy Strategy, "Policy Uncertainty Lifts USD, Stifles Global Oil Demand Growth," dated October 17, 2019. 6. Please see China Investment Strategy, "China Macro & Market Review," dated October 2, 2019. 7. Please see China Investment Strategy, "Chinese Policymakers: Facing A Trade-Off Between Growth And Leveraging," dated August 29, 2018. 8. Please see China Investment Strategy, "Messages From BCA’s China Industry Watch," dated August 28, 2019. 9. Please see China Investment Strategy, "The Three Pillars Of China’s Economy," dated May 16, 2018. 10. Please see China Investment Strategy, "Messages From BCA’s China Industry Watch," dated August 28, 2019. Cyclical Investment Stance Equity Sector Recommendations