Sectors

Overweight (High Conviction) America's largest banks are set to kickstart earnings season at the end of this week/beginning of next week and, with a 25% improvement in EPS forecast by sell side analysts this year, expectations are high. We think deservedly so. Our high-conviction overweight thesis remains unchanged; bank profits should outperform the broad market as the price of credit, loan growth and credit quality are all tailwinds in 2018. Rising inflation expectations (second panel) should support the 10-year yield, driving improving net interest margins. Positive sentiment should mean that bankers keep the credit taps open to sustain the broad capex upcycle (third panel). Combined with record low unemployment and the associated low default rates, margins should widen. Our banks EPS model (bottom panel) incorporates these factors and continues to point to significant earnings upside in the year to come. Accordingly, we reiterate our high conviction overweight recommendation. The ticker symbols for the stocks in this index are: BLBG: S5BANKX - WFC, JPM, BAC, C, USB, PNC, BBT, STI, MTB, FITB, CFG, RF, KEY, HBAN, CMA, ZION, PBCT.

Highlights Capacity cuts in China's steel and aluminum industries over the winter produced little in the way of output reductions, confounding our expectations. The resulting unintended inventory accumulation in Asian markets, reflecting high production relative to demand, and slowing Chinese steel exports are a downside risk to our neutral view. U.S. sanctions against Russian oligarchs close to President Putin could tighten the aluminum market, countering the unintended inventory accumulations. For now, we remain neutral base metals. Energy: Overweight. We are closing our long put spread position in Dec/18 Brent options at tonight's close. The fast-approaching May 12 deadline for President Trump to renew sanctions waivers against Iran shifts the balance of price risks to the upside. Base Metals: Neutral. COMEX copper rallied above $3.10/lb on the back of Chinese President Xi's remarks at the Boao Forum earlier this week, which re-hashed plans to open China's economy to imports. Precious Metals: Neutral. Gold likely becomes better bid as the May 12 deadline to waive Iran sanctions nears. Our long gold portfolio hedge is up 8.9%. Ags/Softs: Underweight. European buyers are scooping up U.S. soybeans, as Chinese purchases of Brazilian beans makes U.S.-sourced crops relatively cheaper, according to Reuters.1 China also announced plans to start selling corn stocks from state reserves this week, offering an alternative protein for animals to partially offset the price impact of tariffs on their imports of U.S. soybeans. Feature Chart of the WeekAluminum Rebounds On U.S. Sanctions Despite much-ballyhooed capacity reductions in China's steel and aluminum capacity, these markets - both in China and globally - remained relatively well supplied over the winter. Higher global supplies, and falling Chinese steel exports, will result in unintended inventory accumulation, which already is showing up in Shanghai Futures Exchange (SHFE) inventories. While we remain neutral base metals, continued unintended inventory accumulation could cause us to downgrade the sector. The MySteel Composite Index we use to track steel prices is down more than 10% since the beginning of the year (Chart of the Week). Similarly, the first-nearby primary aluminum contract on the LME was down ~ 12% year-to-date (ytd) early last week, before regaining most of these losses on news of U.S. sanctions against Russian oligarchs, which hit shares of Rusal very hard. Given that these sanctions will restrict access to up to 6% of global aluminum supply, ex-China supply dynamics will dominate the aluminum market this year making the outlook relatively favorable, putting a floor beneath the London Metal Exchange Index (LMEX).2 Ex-Post Winter Production Production cuts over the winter - when Chinese mills in 28 smog-prone northern cities were ordered to reduce capacity by up to 50% - did not live up to our expectations.3 China's steel and aluminum sectors have undergone major supply-side reforms, particularly re the removal of outdated capacity, most of which has been completed. In addition to the winter capacity cuts, past reforms that have already been implemented, and have shaped current market conditions, are as follows: In an effort to eliminate outdated and unlicensed facilities, China removed an estimated 3-4 mm MT of annual capacity in 2017 - amounting to approximately 10% of total aluminum smelting capacity. In the case of steel, Beijing announced plans to shut down 150 mm MT of annual steel capacity between 2016 and 2020. To date, 115 mm MT of capacity have already been eliminated. Another estimated 80-120 mm MT of induction furnace capacity was shuttered in 1H17. Going forward, China's steel and aluminum markets will be driven by: An estimated 3-4 mm MT of updated aluminum capacity is expected to come on line this year, offsetting constraints from last year's supply cuts. 30 mm MT of steel capacity shutdowns are planned this year, putting Beijing on track to meet its five-year target two years ahead of schedule. The Chinese National Development and Reform Commission (NDRC) has communicated its resolve to keep shuttered capacity offline. Major steelmaking cities in Hebei province - accounting for 22% of 2017 Chinese crude steel output - have announced plans to extend the capacity cuts to November 2018. The mid-November to mid-March capacity cuts implemented this past season are expected to be a recurring event. Winter Shutdowns Minimally Impact China's Steel Output ... According to steel production data released by the World Steel Association (WSA), winter capacity closures in China did not significantly affect overall output levels. Crude steel output from China was up 3.9% year-on-year (y/y) in the November to February period (Chart 2). At the same time, production from the rest of the world increased by 3.6% y/y in the November to February. Thus global crude steel supply remained in excess over the winter season, as global steel output increased 3.8% y/y. A caveat to these data: China does not account for the historical output of induction furnaces, which produced an estimated ~30-50 mm MT of steel in 2016. As mentioned in our previous research, the output of these furnaces was illegal and thus not carried in statistics we use to track supply.4 These data problems mean it is possible that actual output in the November 2016 to February 2017 period was higher than suggested by the data, and as a result, actual output during this year's winter season may actually be lower than last year. As induction-furnace data lie in the statistical shadows, we cannot ascertain this with certainty. Nevertheless, a buildup in China inventories - which we discuss below - indicates an oversupplied market. It is also likely producers - incentivized by high steel prices earlier this year - kept capacity utilization at maximum levels throughout the winter. ... And Aluminum Output According to International Aluminum Institute data, primary aluminum output in China fell 2.3% y/y in the November to February period, suggesting the winter cuts likely had an impact on aluminum supply (Chart 3). Data from the World Bureau of Metal Statistics (WBMS) show an even sharper decline in winter aluminum output: primary production in China fell 8.7% y/y in the November to January period. Chart 2Steel Output Grew##BR##Amid Winter Cuts Chart 3China Aluminum Market In Surplus##BR##Despite Production Decline Both sources reveal an especially pronounced contraction in November, at the onset of the winter cuts. Despite reduced supply, WBMS data indicate a positive Chinese aluminum market balance throughout the winter. A large contraction in demand offset the supply shortfall, and kept primary aluminum in a physical surplus throughout the winter, ultimately leading to a buildup in domestic inventories. A Look At The Trade Data Despite our disappointment regarding the impact of the winter cuts on steel and aluminum markets, trade data increasingly suggests China's steel exports have peaked. Aluminum exports from China, on the other hand, are likely to continue rising. Chinese Steel Exports Continue To Fall ... Chinese steel product net exports have been falling since mid-2016, and have continued falling in y/y terms throughout the winter. According to Chinese customs data, steel product net exports fell 35.1% y/y in the November to February period, driven by both falling exports as well as rising imports (Chart 4). Steel product exports plunged 30% y/y in the November to February period, more or less in line with the 2017 average. The decline mirrors the 2017 contraction in domestic supply, bringing exports to their lowest level since 2012. This indicates fears of a China slowdown leading to a flood of metal onto global markets have not materialized, at least not yet. In fact, Customs data show a 1.7% y/y increase in Chinese steel imports during the November to February period - a reversal from falling imports prior to the winter season. The conclusion we draw from this is that, while in the past, China was a source of supply for the world, ongoing capacity cuts and production controls could mean China will lack the ability to ramp up output in case of a global physical supply deficit. If this becomes the new normal, price volatility will likely increase. This trend is important, especially given our expectation of strong world ex-China demand this year. As such, global steel prices may find support amid this new normal. ... But Aluminum Exports Move Higher In the case of aluminum, Chinese net exports were up 28.7% y/y during the winter, continuing their upward trend. Customs data show a 14.8% y/y increase in aluminum exports in November to February, bringing exports in this period to their highest level since 2014/15 (Chart 5). At the same time, imports of aluminum have come down during this period - by 37.2% y/y. According to China customs data, 2017 imports over these winter months registered their lowest level since 1994. Chart 4Steel Exports Continue Falling ... Chart 5...While Aluminum Exports Are On the Uptrend The combination of growing exports amid falling imports puts China's net exports in expansionary territory. This will be especially true given the planned increase in capacity this year amid weak Chinese demand. All in all, ceteris paribus global supply of aluminum looks set to increase. However, we do not live in a ceteris paribus world and, as we explore below, sanctions against the top aluminum producer outside of China will have massive implications on the global aluminum supply chain. Are Inventories Due For A Turnaround? Chart 6Larger Than Expected##BR##Seasonal Inventory Buildup China Iron and Steel Association data indicate that since the beginning of the year, steel product inventories have been re-stocked to levels last seen in 1Q14. Inventories of the five main steel products we track have more than doubled since the beginning of the year (Chart 6). Although the Q1 build is seasonal, the re-stocking since the beginning of the year has been especially pronounced. This buildup occurred in an environment of stable supply - with minimal impact from the winter capacity cuts - amid weak exports, indicating domestic demand for the metal was subdued. However, steel inventories have turned around, and we expect further destocking as demand accelerates post the Chinese New Year. The question remains whether this destocking will bring inventories back down to their 5-year average. Aluminum inventories on the SHFE show similar dynamics. However in this case, it is part of the larger trend of rising stocks since the beginning of last year. Aluminum inventories at SHFE warehouses are up more than nine-fold - or 0.87 mm MT - since the end of 2016. In fact, the pace of buildup seems to have accelerated: the average weekly build of 16.6k MT of aluminum coming into warehouse inventories since the beginning of the year stands above the 2017 average weekly build of 12.6k MT. This brought SHFE aluminum inventories to almost 1 mm MT, more than double their previous record in 2010. Although the Chinese physical aluminum surplus weighed down on prices in 1Q18, we expect global aluminum prices to remain supported from here due to the impact of U.S. sanctions on world ex-China aluminum supply. U.S. Russian Sanctions Could Be A Game-Changer Chart 7Sanctions Will Restrict##BR##Marketable Aluminum Supply Last Friday, the U.S. announced sanctions on Russian oligarchs close to President Vladimir Putin. Among those sanctioned is Oleg Deripaska who controls EN+ Group, which owns a controlling interest in top aluminum producer United Company Rusal. Given that UC Rusal accounts for ~6% of global aluminum production, we view this move as significant to global aluminum markets. As the top producer of the metal outside China, Rusal aluminum likely makes up the majority of Russian supply, which account for 14% of U.S. imports (Chart 7). In fact, almost 15% of Rusal's revenues comes from its business with the U.S. While it is clear that these sanctions will, in effect, terminate aluminum trade between Russia and the U.S., more significant are the implications on the global supply chain. A clause in the U.S. Treasury Department's order extending the restrictions to non-U.S. citizens dealing with U.S. entities means the impact could be far-reaching, requiring a major re-shuffle in global aluminum trade. Earlier this week, the LME announced that it will no longer accept Rusal aluminum produced after April 6, effectively preventing the company's products from being delivered on the LME. These sanctions will likely turn global aluminum buyers off from Rusal products, as they can no longer deliver it to the LME. The net effect will be a contraction in global usable aluminum supply. Furthermore, these sanctions will likely disrupt supply chains as aluminum users scramble to avoid purchasing metal from the Russian producer. While the details of these restrictions are still unclear, the sanctions are a game changer in the global aluminum market - effectively restricting access to a major source of the metal. As such, primary aluminum on the LME is up more than 10% since the announcement last Friday. Bottom Line: While China's crude steel output increased y/y during government-mandated output cuts over the winter, seasonally weak demand meant that the metal piled up in inventories. Falling exports indicates that at least for now, the domestic surplus is not flooding global markets. The main risk to our neutral view here is that demand in China remains weak, and that this will lead to the offloading of Chinese metal to global markets, i.e. a pickup in exports. This has not yet materialized, so we are holding on to our neutral view for now. China's primary aluminum production declined y/y during the winter cuts. However the decline in domestic demand was greater - likely due to the decline in auto production and sales following the loss of tax credit incentives. Consequently, China's aluminum market remained in surplus throughout the winter. Some of the excess supply was exported, but SHFE inventories continued building. Our outlook on the aluminum market had been bearish, due to additional capacity coming online this year amid an uncertain China demand environment. However, the sanctions on Rusal could be a game changer, putting a floor beneath aluminum prices. This improves our near term outlook for the aluminum market. This makes our outlook on aluminum prices much more favorable. Roukaya Ibrahim, Associate Editor Commodity & Energy Strategy RoukayaI@bcaresearch.com 1 Please see "As U.S. and China trade tariff barbs, others scoop up U.S. soybeans," published by reuters.com on April 8, 2018. 2 The six non-ferrous metals represented in the LMEX and their respective weights are as follows: aluminum: 42.8%, copper: 31.2%, zinc: 14.8%, lead: 8.2%, nickel: 2.0%, and tin: 1.0%. 3 China's winter smog "battle plan" targeted polluting industries in the northern China region by mandating cuts on steel, cement and aluminum production during the smog-prone mid-November to mid-March months. Steel and aluminum production cuts targeted a range between 30-50% during this period. This event is expected to be an annually recurring event until 2020. 4 Please see BCA Research's Commodity & Energy Strategy Weekly Report titled "China's Environmental Reforms Drive Steel & Iron Ore," dated January 11, 2018, available at ces.bcaresearch.com. Investment Views and Themes Recommendations Strategic Recommendations Tactical Trades Commodity Prices and Plays Reference Table Trades Closed in 2018 Summary of Trades Closed in 2017

Overweight (High Conviction) As highlighted in this week's Weekly Report, we are moving to a benchmark allocation in the S&P information technology sector. The way we are executing the upgrade is by lifting the S&P tech hardware, storage & peripherals (THSP) index to an overweight stance. We are also adding this index to our high conviction overweight list. Building on the capex upcycle theme, U.S. tech hardware manufacturers also benefit from improving animal spirits and rising capital expenditures. U.S. capex intentions are as good as they can get, hanging near multi-decade highs (second panel). Importantly, global trade remains buoyant and signals that the global export pie is increasing in size. The tech-laden Korean and Taiwanese stock markets have positive momentum and are an excellent leading indicator of tech-heavy EM Asian exports. The current message is to expect a durable export growth phase in the coming months (third panel). Meanwhile, this industry that generates excessive amounts of free cash flow and sports a net debt/EBITDA ratio below par (bottom panel) will continue to be extremely generous to shareholders by continuing to aggressively retire equity and boost dividend payouts. Bottom Line: Boost the S&P THSP index to an overweight stance and add it to the high-conviction overweight list. The ticker symbols for the stocks in the S&P THSP index are: BLBG: S5CMPE - HPQ, WDC, STX, XRX, AAPL, HPE, NTAP.

Neutral We have been offside on tech sector positioning, but are not dogmatic and given recent market action and positive changes in a number of key drivers, we recommend acting on our mid-January upgrade alert, booking losses and lifting exposure to neutral. The core driver of our upgrade is to capitalize on one of BCA's key themes for 2018: synchronized global capex upcycle, of which the broad tech sector is a core beneficiary (second panel). There is still pent up demand for tech spending that is being unleashed following over a decade of severe underinvestment. In addition, consumer spending on tech goods is also at the highest level since the history of the data, underscoring that end demand is upbeat (third panel). On the global demand front, EM Asian exports are climbing at the fastest clip in ten years; tech sales and EM Asian exports are historically joined at the hip and the current message is positive (bottom panel). Despite the good news, crucial sector risks, including a bounce in the U.S. dollar, higher interest rates (another key BCA theme for 2018) and regulatory/political risks (the source of the recent tech sector wobble) prevent us from turning outright positive. Netting it all out, we are compelled to lift exposure in the S&P information technology sector to neutral; see yesterday's Weekly Report for more details.

Highlights Portfolio Strategy The capex upcycle, a soft U.S. dollar and improving end demand signal that it no longer pays to underweight the S&P tech sector. Lift exposure to neutral. Firming domestic and global final demand, the synchronized global capex upcycle, an overly pessimistic sell-side analyst community and cheap valuations compel us to upgrade the S&P tech hardware, storage & peripherals index to overweight. Recent Changes S&P Technology - Upgrade to neutral today. S&P Tech Hardware, Storage & Peripherals - Boost to overweight and add to the high-conviction overweight list today. Table 1 Feature The S&P 500 seesawed last week, and continues to absorb the early February drawdown. While global growth cannot continue its breakneck pace indefinitely and a soft patch is inevitable, global output growth remains significant and above trend. Our constructive cyclical equity market view remains intact, premised upon the longevity of the business cycle, at least for the next 9-12 months. In the U.S. specifically, the ISM manufacturing survey is perched closer to 60 than to 50, unemployment insurance claims hover near 50-year lows and the muted 10-year Treasury yield moves all signal that generalized fear has yet to grip markets (Chart 1). In fact, if one looks back at the 2015, 2011 and 2010 global growth scares, investors took shelter in U.S. Treasuries as the SPX sold off, sending the 10-year UST yield lower by 50, 70 and 70 bps respectively in a very short time span. The fact that the 10-year yield is only 15 bps below its peak should cause us to question whether the recent equity drawdown is really about slowing global growth. On the monetary policy front, while the Fed is increasing the fed funds rate and decreasing the size of its balance sheet and volatility is making a comeback (please see Chart 1 from the March 5th Special Report), the real fed funds rate remains below the zero line and the real 10-year UST yield is also close to nil (Chart 2). Economic slack measures confirm that the Fed remains behind the curve. The output and unemployment gaps have been closed for a while now, and BCA's unemployment diffusion index and the Taylor rule both signal that monetary policy is extremely accommodative (Chart 3). Chart 1Macro Conditions... Chart 2...Remain Conducive... Chart 3...To A Rising SPX The implication is that macro conditions remain conducive to a rising equity market from a cyclical time horizon perspective. Meanwhile, sifting through the noise reveals that the market is likely coming to grips with a calendar 2019 EPS growth of a more reasonable 10% annual rate compared with this year's near 20% peak growth rate. This transition, as we highlighted in recent research, will be turbulent,1 and likely an earnings validation phase will pave the way higher for the broad equity market. In fact, dissecting the tax relief impact on different sectors is in order. Charts 4 & 5 show the calendar 2018 forward estimates on December 31st, 2017 and what analysts pencil in today, respectively. Charts 6 & 7 highlight the delta in absolute terms and percentage change terms. Chart 42018 EPS Growth On March 30, 2018 Chart 52018 EPS Growth On December 31, 2017 Chart 6Delta Chart 7Delta % Change Telecom services will likely benefit tenfold from the lower corporate tax rate (shown truncated, Chart 7), and consumer discretionary stocks are also prime beneficiaries. But this also means that 2018 after-tax profit data are masking the negative underlying trend growth rate for both of these sectors which also sport grim operating metrics. The S&P telecom services sector is a high-conviction underweight,2 and we reiterate our recent downgrade to a below benchmark allocation in the S&P consumer discretionary sector.3 Industrials, energy and financials, also benefit greatly from tax relief (Chart 7), but higher commodity prices along with improving industry operating metrics contribute to the EPS euphoria for these sectors. Nevertheless, we have identified three key risks to our sanguine equity market view: Escalating geopolitical/regulatory uncertainty Severe global growth slowdown U.S. dollar surge All three risks are intertwined and could infiltrate profit growth in the coming months. As we have posited in recent research, U.S. dollar softness begets higher global growth and the two feed off of each other in a virtuous cycle. A depreciating currency is a profit fillip for SPX constituents with heavy export exposure, the opposite is also true (Chart 8). Chart 8S&P 500: Aggregate Sector International Revenue Exposure (%) If the Trump Administration continues to slap on tariffs with China retaliating, as we experienced last week, eventually triggering a global trade war, then all bets are off on the sustainability of global growth (Chart 9). Such an outcome would weigh heavily on both market sentiment and profits, as our Geopolitical Strategists argued last week.4 Chart 9Don't Throw In The Towel On Global Growth Yet Finally, regulatory clampdown on the tech sector specifically is also on our radar screen, especially given the monopolistic powers that a handful of U.S. tech titans command. This is not only a U.S. risk, but also a global one. However, the 2000s Microsoft and recent Google precedents suggest that a corporate breakup is a low probability event à la "Ma Bell" in 1983, and heavy fines are the most likely outcome (we will be covering this regulatory risk in an upcoming Special Report in conjunction with our sister Geopolitical Strategy publication, stay tuned). Adding it up, we assign low probabilities to all three risks. This week we are taking advantage of recent market weakness and adding some cyclical exposure to our portfolio. Lift Tech To Neutral... We have been offside on tech sector positioning, but are not dogmatic and given recent market action and positive changes in a number of key drivers, we recommend acting on our mid-January upgrade alert, booking losses and lifting exposure to neutral.5 Before exploring our thesis on why we are becoming more constructive on the largest S&P sector in terms of market capitalization weight, it is instructive to look back and identify what we missed. Two reasons for the tech sector's outperformance stand out. First, BCA's constructive view on the U.S. dollar has weighed heavily on our underweight positioning in the tech sector, especially since the greenback's peak in level terms in December 2016. U.S. tech firms garner 60% of their total revenues from abroad - the highest among the GICS1 sectors (Chart 8) - and the positive P&L translation gain effects have been a tonic to EPS. Irrespective of where the dollar will end 2018, due to lagged effects, the U.S. dollar's significant depreciation will continue to boost tech sector EPS. Second, the lack of inflation at this stage of the cycle has perplexed economists and presented a goldilocks macro backdrop for the tech sector that thrives in deflation/disinflation. This benign inflation backdrop has also coincided with the V-shaped global growth recovery following the late-2015/early-2016 global manufacturing recession and propelled technology stocks. Nevertheless, in mid-September we lifted the S&P software index to a benchmark allocation and subsequently to a high-conviction overweight in late-November in order to capitalize on one of BCA's key themes for 2018: synchronized global capex upcycle. Building on this thesis, the broad tech sector also benefits from rising capex (Chart 10). In fact, there is still pent up demand for tech spending that is being unleashed following over a decade of severe underinvestment. Not only is the tech sector gaining capex market share, largely at the expense of basic resources (Chart 11), but also in absolute terms tech spending is on fire and vaulting to fresh all-time highs (Chart 10). Chart 10Prime Capex Beneficiary Chart 11Sector Capex % Of Total National accounts confirm the stock market-reported capital outlays data and tech investment is firing on all cylinders (middle panel, Chart 12). In addition, consumer spending on tech goods is also at the highest level since the history of the data, underscoring that end-demand is upbeat (fourth panel, Chart 12). The San Francisco Fed's Tech Pulse Index encapsulates all this tech optimism underpinning tech stocks (second panel Chart 12).6 On the global demand front, EM Asian exports are climbing at the fastest clip in ten years, despite the smart rebound in the ADXY. Historically, tech sales and EM Asian exports are joined at the hip and the current message is positive (bottom panel, Chart 12). Importantly, a rising revenue backdrop is necessary, especially in the context of rising capital outlays, as they sustain the virtuous upcycle. A simple final demand indicator combining tech exports and new orders is also flashing green (Chart 13). Tack on the sizable losses in the U.S. dollar over the past year and resurgent tech exports will be a boon to tech EPS (bottom panel, Chart 13). Chart 12Firm End-Demand Chart 13Soft U.S. Dollar Helps Our tech profit model does an excellent job capturing all of these positive forces and is pointing to healthy growth for the rest of 2018 (second panel, Chart 14). However, there are also a few headwinds that the tech sector has to contend with and that prevent us from lifting exposure all the way to overweight. First, any knee-jerk bounce in the U.S. dollar is a clear negative for technology stocks. Second, BCA's second key theme we are exploring calls for higher interest rates in 2018 on the back of rising inflation (Chart 15). Were the selloff in the bond market to gain steam in the coming months as inflation rears its ugly head, then tech stocks would come under intense pressure. Third, as we highlighted above, regulatory/political risks have been at the epicenter of the recent tech sector wobble, and heightened regulatory uncertainty will continue to muddy the tech waters. Finally, while tech stocks are nowhere near as overvalued as in late-1999/early 2000, they are more expensive than the broad market on a number of valuation measures (third panel, Chart 14). Chart 14Our Tech Profit Model Flashes Green... Chart 15...But Interest Rates Are A Big Headwind Netting it all out, we are compelled to lift exposure in the S&P information technology sector to neutral, by augmenting the S&P tech hardware, storage & peripherals (THSP) index to an overweight stance. ...Via Boosting Tech Hardware To Overweight The way we are executing the upgrade to neutral on the broad S&P tech sector is by lifting the S&P THSP index to an overweight stance. We are also adding this index to our high-conviction overweight list. Building on the capex upcycle theme, U.S. tech hardware manufacturers also benefit from improving animal spirits and rising capital expenditures. U.S. capex intentions are as good as they can get, hanging near multi-decade highs (second panel, Chart 16). Already, U.S. factories are humming trying to fulfill perky end-demand. Industry production is far outpacing capacity growth and this represents a boon to pricing power that has exited deflation for the first time ever (bottom panel, Chart 16). The implication is that S&P THSP profits will overwhelm. Beyond U.S. shores, global fixed capital formation is also climbing sharply. This synchronized global capex upcycle represents a tailwind for this industry and will continue to underpin U.S. computer exports (Chart 17). Add on the depreciating greenback and U.S. manufacturers are well positioned for export market share gains (third panel, Chart 17). Chart 16Capex To The Rescue Chart 17Enticing Global ... Importantly, global trade remains buoyant and signals that the global export pie is increasing in size. In particular, EM Asian exports are expanding at a healthy clip, in spite of rising EM currencies, underpinning S&P THSP net earnings revisions (middle panel, Chart 18). The tech-laden Korean and Taiwanese stock markets have positive momentum and are an excellent leading indicator of tech-heavy EM Asian exports. The current message is to expect a durable export growth phase in the coming months (Chart 18). All of this suggests that S&P THSP sales and profits will shine in 2018, easily surpassing the extremely low relative hurdles that sell-side analysts are penciling in for the coming 12 months (second & third panels, Chart 19). Meanwhile, this industry that generates excessive amounts of free cash flow and sports a net debt/EBITDA ratio below par (Chart 20) will continue to be extremely generous to shareholders by continuing to aggressively retire equity and boost dividend payouts. Return on equity is also probing all-time highs. Chart 18...Demand Backdrop Chart 19Unwarranted Pessimism... Chart 20...Given Pristine B/S And Sky-High ROE Finally on the relative valuation front, this tech sub-index trades at a 20% discount to the broad market (and below the S&P tech sector) both on a forward P/E and EV/EBITDA basis, offering an appealing entry point. Bottom Line: Boost the S&P THSP index to an overweight stance for a loss of 16% since inception, and add it to the high-conviction overweight list. This shift also lifts the overall S&P tech sector to a benchmark allocation for a loss of 18% since inception. The ticker symbols for the stocks in the S&P THSP index are: BLBG: S5CMPE - HPQ, WDC, STX, XRX, AAPL, HPE, NTAP. Anastasios Avgeriou, Vice President U.S. Equity Strategy anastasios@bcaresearch.com 1 Please see BCA U.S. Equity Strategy Weekly Report, "Bumpier Ride," dated March 26, 2018, available at uses.bcaresearch.com. 2 Please see BCA U.S. Equity Strategy Weekly Report, "Manic-Depressive?" dated February 12, 2018, available at uses.bcaresearch.com. 3 Please see BCA U.S. Equity Strategy Weekly Report, "Reflective Or Restrictive?" dated March 12, 2018, available at uses.bcaresearch.com. 4 Please see BCA Geopolitical Strategy Weekly Report, "Trump's Demands On China," dated April 4, 2018, available at gps.bcaresearch.com. 5 Please see BCA U.S. Equity Strategy Special Report, "White Paper: Introducing Our U.S. Equity Sector Earnings Models," dated January 16, 2018, available at uses.bcaresearch.com. 6 "The Tech Pulse Index is an index of coincident indicators of activity in the U.S. information technology sector. It can be interpreted as a summary statistic that tracks the health of the tech sector in a timely manner. The indicators used to compute the index are investment in IT goods, consumption of personal computers and software, employment in the IT sector, as well as industrial production of and shipments by the technology sector. The index extracts the common trend that drives these series." https://www.frbsf.org/economic-research/indicators-data/tech-pulse/ Current Recommendations Current Trades Size And Style Views Favor value over growth. Stay neutral small over large caps (downgrade alert).

Special Report

Highlights In China, the central bank and commercial banks conducted outright monetization of real estate inventories, which caused the property markets' recovery post 2015. Despite destocking, aggregate property inventories remain excessive. Elevated inventories, poor affordability, and policy tightening will depress property demand and lead to a contraction in construction activity. Slumping construction, along with a slowdown in infrastructure investment, pose downside risks to China's demand for commodities, materials and industrial goods. This is the main risk to EM stocks and currencies and the primary reason we maintain our negative stance on EM risk assets. Continue shorting Chinese property developers stocks versus U.S. homebuilders. Feature With a flurry of policy tightening directed at the real estate market in the past year, property demand in China has weakened. The latter typically leads property starts and real estate investment, and is coincident with real estate prices (Chart I-1). Is China entering another property downturn, and if so will it be shallow, or severe? Answers to these questions are important not only for Chinese stocks, but also for China-plays throughout the rest of the world. To shed light on this issue, this week we re-examine how large the imbalances in the Chinese real estate market actually are - with respect to both affordability and supply (the stock of housing and inventories). We also discuss policy objectives and investment implications. Proper Measures Of Inventories And Housing Stock Both purchases and prices of Chinese residential properties surged between 2015 and 2017, when the authorities implemented a property de-stocking policy. As a result, housing inventories declined significantly. Does this mean that one of the major imbalances, namely swelling inventories, has been eliminated? If imbalances, namely inventories and prices, in a property market are very minor, one can expect an ensuing adjustment to be benign. Conversely, if imbalances are large, it is reasonable to bet on a meaningful property market downturn. With respect to China's real estate inventory levels, data from the National Bureau of Statistics (NBS) which many analysts follow, indicates inventories of residential buildings have indeed declined, with a significant 33% drop in residential vacant floor space for sale (Chart I-2). The term "vacant" is used by the data provider to denote the floor space completed but not sold. Clearly, China's de-stocking strategy since 2015 has worked well. Chart I-1China: Real Estate Is Slowing Down Chart I-2Property Developers' Inventories: ##br##Completed But Not Sold However, data from the NBS on vacant space for sale is not all-encompassing. First, it includes only commodity buildings - i.e., those developed by real estate developers - and does not include buildings built by non-real estate developers. For example, companies, universities, organizations and even a group of individuals can construct both residential and non-residential buildings for their own use. Commodity buildings are just a small subset of total constructed buildings in China. According to NBS data, residential buildings by property developers account for only 26% of total constructed residential buildings in terms of floor space area completed. In brief, the inventory data that the majority of analysts use covers only a part of property construction (Figure I-1). Figure I-1The Breakdown Of Residential ##br##Real Estate Inventory Second, the vacant floor space data - shown in Chart I-2 and used by many analysts - only measures commodity buildings that have been completed but not sold. It does not account for those units that are under construction and have not been sold. The latter should also be counted as inventory because in China both residential and non-residential properties can be sold even when they are in the construction phase. Unlike advanced economies, in China the housing market is by far dominated by new construction. In particular, about 80% of residential commodity floor space sold are properties that are still under construction. This is drastically different from real estate markets in the U.S. and other developed countries, where the secondary housing market is a major source of supply. Given the above,1 we propose several alternative measures that aim to more accurately reflect the real picture of Chinese property inventory. Real Estate Inventory To capture the flow of the entire residential property supply in China, we calculate the difference between cumulative floor space started and cumulative floor space sold over the period of 1995-2017. This produces a new measure of total space not yet sold (i.e., available for sale), which includes areas both under construction and completed. This is a much more comprehensive measure of the total inventory than other commonly used measures. It is important to note that this measure takes into account both types of floor space available for sale: under construction and completed. The top panel of Chart I-3 illustrates that our derived measure of residential inventory - cumulative floor space started minus cumulative floor space sold - currently stands at 2.5 billion square meters or 27 billion square feet. This is about eight times greater than the NBS measure of vacant floor space - completed by property developers but not sold, which presently amounts to only 0.3 billion square meters or 3.23 billion square feet. On the bottom panel of Chart I-3, we estimate how many months of sales it will take to clear this housing inventory. Our findings reveal that even though our new inventory measure for the residential sector has fallen sharply due to the de-stocking policy, it still takes 22 months of last year sales to clear it. This is much higher than the completed by property developers but unsold vacant space, which presently stands at 2.5 months of last year sales. Provided that (1) most housing for sale in China is new construction, and (2) it can be sold at any stage of the construction cycle, we believe our new estimate of residential inventory that is equal to 22 months of last year sales is a more accurate reflection of reality. We computed a similar measure of inventory for non-residential properties that includes malls, offices, and warehouses. The top panel of Chart I-4 shows that the proper inventory levels for the non-residential sector have kept rising to new record highs in absolute terms. Relative to floor space sold last year, inventories still stand at 170 months of sales (Chart I-4, bottom panel). Chart I-3Our Measure Of Residential Inventories: ##br##Floor Space Available For Sale Chart I-4Our Measure Of Non-Residential Inventories: ##br##Floor Space Available For Sale Clearly, China's non-residential markets still carry excessive inventories. It would be misleading to use completed but unsold data for the non-residential sector, which accounts for roughly 14 months of sales. Similar to the residential commodity buildings market, about 65% of non-residential commodity buildings sold are those that are still under construction. In short, despite the decline from 2015's exceptionally high levels, inventories for both residential and commercial properties are still extremely elevated. Furthermore, the inventory-to-sales ratio is not a good indicator for the property market outlook because it is heavily influenced by sales. When sales - the denominator of this ratio - are weak, this inventory ratio is high, and vice versa. In particular, this ratio has been a poor indicator for the property market in China, where sales of properties have been deeply influenced by government policies. Whenever sales dropped and this ratio surged, the authorities would begin easing policies, spurring sales to rise and allowing the market - prices, floor space starts and construction - to recover. As a final note, these inventory data show floor space built by property developers only. Stock Of Housing The measure of per-capita living space gauges the existing stock of housing. Hence, it is a structural measure. Still being a low-income country, China is often perceived to offer enormous construction potential. However, some statistics on per-capita living space are revealing. The NBS data show that the 2016 per-capita living space for both urban and rural area has risen to 36.6 square meters and 45.8 square meters, respectively (Chart I-5). By comparison, in Korea and Japan, living space per capita (the entire population average) is only 33 and 22 square meters, respectively. Chart I-5China: Per Capita Living ##br##Has Grown Dramatically Our calculation of per-capita urban living space based on the NBS building construction data also show similar results - 38 square meters for 2017. Consequently, these statistics on per-capita living space are supported by historical construction data, and hence are reliable. Both NBS per-capita living space data and our calculated per-capita living space data confirm that there is already massive stock of residential property in China - the nation's current existing residential floor space area already amounts to 30.8 billion square meters (332 billion square feet). Furthermore, the stock of housing is relatively new with 88% of this living space built in the past 20 years. Assuming the floor space area of each house is on average 90 square meters (970 square feet), we infer that on average every urban household already owns 1.3 houses. This is actually in line with the results of several domestic household surveys, which conclude that 20-25% of houses owned by urban residents are neither being used for living nor for renting out. Provided not every household in China owns a house, and that a meaningful share of the population still lives in smaller and older housing, these data suggest there have been considerable speculative/investor purchases of housing over the past 10 years. Many high-income individuals own multiple properties (that are often kept vacant) while a still-considerable number of families live in poor conditions. Bottom Line: China has constructed enormous amounts of real estate since 2002. Furthermore, inventories are vast for residential and non-residential sectors alike. Such an oversupply of properties poses a considerable risk to construction activity going forward. Property Demand Weakness: Cyclical Or Structural? Very poor affordability, slowing rural-to-urban migration, demographic changes, tightening mortgage lending, a successful government-led clampdown on speculative activity and the promotion of the rental housing all point to both a cyclical and structural slippage in housing purchases in China. House Price-Income Ratios and Affordability House prices in China remain extremely high relative to disposable income. By using NBS 70-city residential average price, our calculation shows for an average household (assuming double income earners) it will take 10.5 years of its disposable income to buy a 90-square-meter (equivalent to 970 square feet) house at current prices (Chart I-6). The same ratio for the U.S. is presently 3.4 and at the peak of U.S. housing bubble in 2006 it was 4. In regard to the ability to service mortgage payments, annual interest costs account for 45% of average household disposable income (assuming a double income household) when buying a 90 square meter house and assuming 20% down payment (Table I-1). Chart I-6House Price-Income Ratio: ##br##China & The U.S. Table I-1House Price-To-Income Ratios ##br##And Affordability If we use another data provider - Choice, covering 100 cities, house price per a square meter is 60% higher than the NBS 70-city residential average price. Using Choice house price data, the house price-to-income ratio is 17, and affordability - the share of interest payments as a percentage of disposable household income - is 72%. Clearly, there is a huge gap between these two aggregate measures of residential property prices. In this report, we use conservative (low) prices from the NBS, which still reveals that house prices and interest payments are exceptionally high relative to disposable income for a double-income family. Table I-1 contains house price-to-income ratios and affordability ratios for 31 provinces using the house prices from NBS. Given the average urban household already owns more than one property, it is reasonable to expect that a considerable proportion of potential future demand for housing will come from rural residents as urbanization continues, or as rural residents seek to buy homes in the city for access to better quality education in the urban areas for their children. However, rural residents' current and potential (when they move to cities) disposable income is much lower than the urban's. Therefore, housing affordability is a bigger challenge for them. Rural-to-Urban Migration Even though urbanization is an ongoing process in China and will continue for many years, the pace is slowing (Chart I-7). The number of individuals moving from rural areas to cities as a percentage of the urban population is decreasing. This will translate into decelerating growth rate in demand for urban residential properties. Chart I-7China: The Pace Of Urbanization Is Slowing The second panel of Chart I-7 illustrates that rural-to-urban net migration accelerated in the early 1990s and has been between 15-18 million people per year over the past 20 years. However, as a share of the urban population, net migration has fallen from 4.5% in the late 1990s to 2% today (Chart I-7, third panel). Overall, urban population growth has slowed below 3% (Chart I-7, bottom panel). In brief, the slowdown in net migration and, consequently, decelerating urban population growth will cap structural housing demand that has been booming over the past 20 years. Poor Demographics The Chinese population is aging rapidly. The proportion of citizens who are over the age of 65 has risen from 8% of the population in 2007 to 11.4% as of last year and will continue rising rapidly. Given Chinese life expectancy is currently at about 76 years, senior citizens cohort will leave a large number of houses to their children or grandchildren over the next 10-15 years. The reason behind this is because the former demographic cohort (11.4% of the total population) is larger than the 10-19-year-age group which accounts for only 10.5% of the total population. The latter would have been a major source of property demand over the next 10 years, as Chinese tradition requires them to own a house before marriage. However, this is no longer the case. For this generation - born in the late 1990s and 2000s and by the time they get married (in general at the age of around 25 or a bit later), each newly-formed family could potentially inherit four houses from their parents and grandparents. Tightening mortgage lending As part of the current property related restrictive policies, mortgage interest rates have been on the rise for both first- and second-home buyers. Mortgage rates have risen by 74 basis points in the past 12 months - from 4.52% to 5.26%. Additionally, banks have been tightening credit standards. Given house prices are very high relative to income, a small increase in mortgage rates meaningfully increases the share of disposable income that must be allocated to interest payments on mortgages. For example, with the house price-to-income ratio at 10.5 and down payment of 20% of house price for the average home buyer in China, a 75-basis-point increase in mortgage rates would lift the share of interest payments on a mortgage from 45% to 51% of disposable income. Hence, higher borrowing costs over the past year as well as the ongoing tightening in credit standards will continue to discourage property buyers. Mortgage loan growth has rolled over after booming between 2015 and 2017, yet at a 22% annual growth rate, it remains very high (Chart I-8). Policy-led clamp-down of speculation President Xi Jinping's mantra that "housing is for living in, not for speculation" - proclaimed in December 2016 - is the focal point of the government's current policies. Many regulations implemented by both the central government and local governments over the past 15 months have been aimed at reducing speculative purchases. The promotion of the housing rental market In large cities residential rental yields fluctuate between 1-2.5% (Chart I-9). This compares with mortgage rate of 5.3%. Currently, renting is significantly cheaper than buying. This may encourage renting in the long term. Rising demand for rental housing might be met by the available stock of empty apartments that investors have been accumulating over the years. If this occurs, it will reduce demand for new home purchases. Chart I-8China: Mortgage Lending Has Been Booming Chart I-9China: Residential Rental Yields Are Very Low Meanwhile, the central government is determined to develop a rental market by constructing rental housing. If building of rental housing offsets the potential decline in property construction, it will make our negative view on construction volumes widely off the mark. The crucial factor to watch is financing. If credit supply slows meaningfully, there will be less available financing for overall construction, including rental. Any gains by rental construction will be overwhelmed by a decline in the building of residential and commercial real estate. In turn, financing is contingent on the government deleveraging campaign. If the authorities adhere to their pledge of deleveraging, a slowdown in credit growth will dampen overall construction activity. There can be no construction without credit. Furthermore, it takes only a deceleration in credit growth, i.e., a negative credit impulse, to depress construction volumes. That is why we cover China's credit cycle dynamics in such details in our regular reports. Bottom Line: Chinese property demand is facing numerous cyclical and structural headwinds. Policy Driven Market China's central and local government policies have over time and in different combinations substantially influenced the country's housing market on both the supply and demand sides. Over the past two decades, each time the government implemented restrictive policies (for example, raising down-payment ratios, increasing policy or mortgage rates, setting restrictions on mortgage lending, and so on), the real estate market slowed and housing prices softened. The opposite has also held true - each time the government introduced stimulus, housing prices surged as buyers quickly dove into the market. Chart I-10 illustrates the interaction between government property related regulations and the domestic housing market. Chart I-10China: Policy-Driven Property Market The biggest problem with such policies in the long run is that the authorities want to control both prices and volume - they want flat prices and moderately rising volumes. However, no government can control both prices and volumes simultaneously in any industry. China's real estate market is not an exception. Even in a completely closed socialist system, controlling prices and volume simultaneously is almost impossible. As the authorities adhere to their policy objectives of controlling financial risks and unwinding financial excesses, thereby focusing on property price control over the next 12 months, we believe property starts and construction activity will shrink. Monetization of Housing Inventories In 2015-'17 Understanding what was behind the housing market's strong recovery since late 2015 is critical to assessing the outlook. Since the summer of 2015, authorities were not only easing purchasing restrictions and lowering mortgage rates, but they were also implementing outright monetization of housing inventories. After inventories of both residential and non-residential properties swelled, the central government commenced a de-stocking strategy in 2015, mainly through a monetized slum reconstruction program and by encouraging migrant workers to buy housing in smaller cities near their hometowns. The de-stocking strategy focused on smaller cities where inventories had mushroomed. Given tier-1 cities account for only 6% of floor space started by property developers, and most construction in recent years has been taking place in tier-2 and smaller cities, these policies had a substantial positive impact on national sales, as well as drawing down inventories - ultimately spurring a construction recovery. 1. The government's slum area reconstruction policy has been the major driver behind de-stocking within the residential property market. The People's Bank of China (PBoC) has provided a significant amount of financing in the form of pledged supplementary lending (PSL) directly to homebuyers that was intermediated by three policy banks (China Development Bank, Agricultural Development Bank of China and Export-Import Bank of China). To shed more detail on the PSL mechanism, the central bank lends credit to the three policy banks at very low interest rates. These policy banks in turn lend directly to local government and regional property developers (mainly in tier-2 and smaller cities). These entities then turn and buy slums from their owners which puts cash in the hands of these sellers. Consequently, a large number of households suddenly receive large cash infusions - essentially disbursed by the central bank - that can be used to purchase new and better properties. The outstanding amount - total financing - via the PSL has risen from RMB 383 billion in 2014 to RMB 971 billion in 2016. The total amount of the PSL disbursed for the slum reconstruction program over 2014-2017 amounted to 3 trillion, or 3.6% of 2017 GDP, as of March 31, 2018. The interest rate on the PSL currently stands at a mere 2.75%. It appears that huge amounts of cheap money have been directly injected into the real estate market by the central bank alone. This slum reconstruction program has had a material impact on construction activity. Chart I-11 portends that slum area reconstruction accounted for about 20% of floor space sold in 2017. Chart I-11China: Slum Reconstruction ##br##Has Had Meaningful Impact 2. In addition to the PSL financing, Chinese housing mortgages have increased by 85%, or by 11 trillion RMB in the past two and a half years - since the beginning of China's de-stocking policy. The sum of PSL financing and mortgage lending has been RMB 14 trillion (or $2.2 trillion) during the same period. Hence, not only has the PBoC financed the real estate market directly, but it has also allowed banks to flood the system with money to liquidate housing inventories. As we have argued in our series of reports, bank credit does not come from anyone's savings. Commercial banks originate loans out of thin air.2 In short, altogether these actions constitute outright monetization of real estate inventories and that caused the property markets' recovery post 2015. A Downturn Ahead? Since early 2017 and especially in the wake of last October's Party Congress, the authorities have shifted their policy focus from "de-stocking" to "eliminating speculative demand". Recent weakness in both demand and prices are a reflection of the current policy focus. This time, the government seems to have more determination to break popular perception that property prices will rise forever, and that investing in property markets cannot go wrong. Therefore, we sense the government's objective is to achieve flat or mildly declining property prices to prevent the return of speculators. In order to avoid a further ballooning of the real estate bubble, the government will raise the bar for another round of property stimulus. Therefore, if the authorities are successful in persuading speculators that prices will not rise much further in the years to come, speculative demand will wane. At the same time, not many first-time homebuyers can afford to buy at current prices. This will create an air pocket in sales and prices will deflate, at least modestly. Facing shrinking revenues and being overleveraged, real estate developers will reduce new starts, and property construction volumes will likely contract by 10% or so. Notably, floor space started by property developers in aggregate declined by 27% between 2012 and 2016 (Chart I-12). The construction slump in China, in tandem with rising supplies of commodities, led to a collapse in commodities prices in 2012-'15 (Chart 12). Hence, a decline in property construction is not unprecedented, even amid robust national income growth. We believe the acute structural imbalances will likely result in a property market downturn commensurable if not worse than those that occurred in 2011-'12 and 2014-'15. While the government will try to avoid a sudden bust, a 10% decline in both property prices and construction volumes in the next 12-18 months is our baseline scenario. The budding contraction in cement and plate glass production suggests that overall construction activity is already decelerating (Chart I-13). Chart I-12China: Property Cycles ##br##And Commodities Prices Chart I-13China: Nascent Contraction In Cement ##br##And Plate Glass Production Bottom Line: The Chinese authorities will for now maintain their current restrictions on the property market to contain financial excesses and risks in the system. This, amid lingering elevated inventories and price excesses, poses considerable downside risks to the mainland real estate market. Investment Implications Our view remains that construction activity in China is set to slump from a cyclical perspective, at least. At 13.2 billion square-meter (142 billion square-feet) the total 2017 residential and non-residential floor area under construction was immense (Chart I-14). This, along with a slowdown in infrastructure investment due to tighter control on local government finances, pose downside risks to China's demand for commodities, materials and industrial goods. This is the reason why we have been and remain bearish on commodities, Asian trade and EM risk assets. It appears that several commodities prices are finally beginning to roll over which is consistent with a slowdown in the mainland's construction activity (Chart I-15). Chart I-14China's Total Building Construction: ##br##Level And Annual Growth Chart I-15A Budding Downtrend In ##br##Commodities Prices China's construction activity is much larger than exports to the U.S. and EU combined. Hence, overall industrial activity in China is set to decelerate dragging down Asian trade flows and commodities prices despite robust domestic demand in the U.S. and EU. This heralds underweighting/shorting EM stocks, currencies and credit versus their DM counterparts. We also reiterate our long-standing recommendation of shorting Chinese property developers versus U.S. homebuilders. Chart I-16 depicts that the Chinese property developers listed in A-share market have a debt-to-equity ratio of 6 and the cash flow from operations for the median of 76 property developers has begun contracting again. Further relapse in property sales will cause their financial position to deteriorate and limit their ability to launch new or complete existing construction. In regard to U.S. homebuilders, the fundamentals in the U.S. housing market are much better than those in China. While rising U.S. interest rates could be a headwind for U.S. homebuilder share prices, they stand to resume their outperformance versus Chinese property developers (Chart I-17). Chart I-16China: Median Property Developer's ##br##Financial Ratios Are Worsening Chart I-17Short Chinese Property Developers / ##br##Long U.S. Homebuilders Ellen JingYuan He Senior Editor/Associate Vice President EllenJ@bcaresearch.com Arthur Budaghyan, Senior Vice President Emerging Markets Strategy arthurb@bcaresearch.com 1 Other oft-used measures of inventories are not correct either. Some analysts use floor space under construction data as a proxy for inventory - this is technically not correct as the data includes both the area that has already been sold in advance and the area that has been completed and sold. Others use cumulative floor space started minus cumulative floor space completed - this is also not correct as cumulative floor space completed includes areas that have not yet been sold. 2 Please see Emerging Markets Strategy Weekly Report "Is Investment Constrained By Savings? Tales Of China And Brazil," dated March 22, 2018, the link is available on page 20. Equity Recommendations Fixed-Income, Credit And Currency Recommendations

Neutral The S&P health care equipment (HCE) index has caught a bid recently, reflecting the sector's strong profit momentum, following nearly a decade of decline (second panel). We fear, however, that investors have become somewhat overzealous as the run up in stock prices has dramatically outpaced earnings expectations, pushing the forward price/earnings multiple to its highest level since the GFC (third panel). Such excitement, particularly when industry pricing power is lagging far behind the rest of the broad corporate sector (bottom panel) seems misplaced. Net, we continue to think the catalyst for a sustainable move higher in the index will be a recovery in pricing power and, in the absence of evidence of this, we reiterate our benchmark allocation. The ticker symbols for the stocks in this index are: BLBG: S5HCEP: MDT, ABT, DHR, BDX, SYK, ISRG, BSX, BAX, EW, ZBH, IDXX, RMB, VAR, HOLX.

Overweight (High-Conviction) The S&P software index caught a bid last week, led by heavyweight Microsoft (representing a bit more than 50% of the index) following a positive sell-side report that put a one-year price target implying a $1 trillion market cap. The basis for the (very) high expectations was Microsoft's dominant position in cloud computing and its rapid adoption in the marketplace; we are very much in agreement as we believe software spending is in the early days of an acceleration. CEO confidence, despite having peaked, remains near decade-highs, typically a precursor of greater software spending (second panel). Bank loan growth, another leading indicator of loosening purse strings, has just turned a corner (third panel). Our optimism is clearly shared by the analyst consensus view as earnings revisions have reached a seven-year high (bottom panel). Adding it up, we think more outperformance is in store for this technology subsector; stay overweight. The ticker symbols for the stocks in this index are: BLBG: S5SOFT-MSFT, ORCL, ADBE, CRM, ATVI, INTU, EA, ADSK, RHT, SYMC, SNPS, ANSS, CDNS, CTXS, TTWO, CA, CDNS.

Feature Japan's economic experience in the post bubble era is often described as a fate to avoid at all costs. We would like to turn this common notion on its head. Rather than something to avoid, Japan's post bubble experience is a fate that other major economies should actively try to emulate, at least in parts. This report focusses on three specific lessons for European investors. Japan's so-called 'lost decades' describe the weak growth in its nominal GDP since the mid-1990s. But this emphasis on aggregate nominal income is grossly misleading. Standards of living do not depend on nominal GDP. What matters is real GDP per head combined with the absence of extreme income inequality. Real income must grow and this growth must benefit the majority, rather than a small minority. Since the late 1990s, the growth in Japan's real GDP per head has outperformed every other major economy (Chart Of The Week). And unlike other major economies, income inequality in Japan has not increased, remaining amongst the lowest in the developed world (Chart I-2). This is not surprising. Credit booms inflate bubbles in financial assets, which exacerbate income and wealth inequalities. Chart Of The WeekJapan Has Outperformed Everybody Chart I-2Income Inequality In Japan Has Not Increased Admittedly, the government has been running persistent deficits, but this is to counterbalance private sector de-levering. Total indebtedness as a share of GDP has not been rising. In the post credit boom era, Japan's real growth has come entirely from productivity improvements. Mankind's persistent ability to learn, experiment, and innovate produces more and/or better output from a fixed set of inputs. Unlike the unsustainable growth that is fuelled by credit booms and asset bubbles, real growth that comes from productivity improvements is sustainable. Genuine Price Stability: Something To Celebrate, Not Fear Japanese consumer prices are at the same level today as they were in 1992, meaning that Japan has experienced genuine price stability for two and a half decades (Chart I-3). But this is neither new, nor alarming - Britain enjoyed genuine price stability for two and a half centuries! At the height of the British Empire in 1914, consumer prices were little different to where they stood at the end of the English Civil War in 1651 (Chart I-4). Chart I-3Japan Has Experienced Genuine Price ##br## Stability For Two And A Half Decades... Chart I-4...But Britain Experienced Genuine Price Stability For Two And A Half Centuries! Nevertheless, central banks continue with the deception that price stability means an inflation rate of 2%. This is clearly nonsense. Think about it - if prices rise by 2% a year, then your money will lose a quarter of its purchasing power every decade. And after a typical working life, your money will have lost two-thirds of its value.1 How exactly does that qualify as price stability?2 Still, we frequently hear a strong counterargument - in a highly indebted economy, inflation and growth in nominal GDP do matter. As debt is a nominal amount, it is nominal incomes that determine the ability to service and repay the high level of debt. So given a free choice, policymakers would prefer to have inflation at 2% rather than at zero; and nominal GDP growth at 3.5% rather than at 1.5%. Unfortunately, policymakers do not have this free choice. Contrary to what central bankers promise, inflation and nominal GDP growth cannot be dialled up or down at will to hit a point target. As we explained a while back in The Case Against Helicopters, inflation is a non-linear phenomenon which is extremely difficult, if not impossible, to point target.3 Look at the standard identity of monetary economics: MV = PT M is the broad money supply, V is its velocity of circulation, P is the price level and T is the volume of transactions. PT is effectively nominal GDP. The big problem is that both the broad money supply M and its velocity V - whose product determines nominal GDP - are highly non-linear. Chart I-5The Money Multiplier Is Non-Linear M is non-linear because the commercial banking system money multiplier - the ratio of loans to bank reserves - is non-linear. At a tipping point of inflation, the onus suddenly flips from lending as little as possible to lending as much as possible (Chart I-5). Admittedly, the central bank (in cahoots with the government) could by-pass the commercial banking system to control the money supply M directly. But it can do nothing to change the extreme non-linearity of the other driver of nominal GDP, the velocity of money V. Again, at a tipping point, the onus suddenly flips to spending money - both newly created and pre-existing balances - as fast as possible. At this point, nominal GDP growth and inflation suddenly and uncontrollably phase-shift from ice to fire with little in between. What is the Japanese lesson for Europeans? Simply that just like the BoJ, the ECB will keep moving the 2% inflation goalpost further and further into the future, as it realises the impossibility of achieving and sustaining the 2% point target. So even with inflation in the 1-2% channel, the ECB will create a loophole to exit NIRP and ZIRP very soon after it exits QE. This will structurally support the euro. Do Not Own Banks For The Long Term (Or Now) Japanese financial sector profits stand at less than half their peak level in 1990. For euro area financial sector profits which peaked in 2007, the interesting thing is that they are tracking the Japanese experience with a 17-year lag. If euro area financial profits continue to follow in Japan's footsteps, expect no sustained growth through the next 17 years (Chart I-6). Chart I-6Euro Area Financial Profits May Experience No Sustained Growth In a post credit boom era, banks lose the lifeblood of their business: credit creation. This loss becomes a multi-decade headwind to financial sector profit growth and share price performance. Bank profits are dependent on two other drivers. One is operational leverage - the amount of equity held against the balance sheet. More stringent European regulation will make this a headwind too. Banks will have to hold more equity capital against assets, diluting their profitability. The other driver is the net interest margin - the difference between rates received on loans and rates paid on deposits, effectively a function of the yield curve slope. However, this is a cyclical driver, and as explained last week in Market Turbulence: What Lies Ahead? this driver is unlikely to be positive in the coming months.4 What is the Japanese lesson for Europeans? Simply that euro area financials is not a sector to buy and hold for the long term. Rather, it is a sector to play during periodic strong countertrend rallies, albeit now is not the time for such a cyclical play. A Surge In Female Participation Chart I-7Sales Of Personal Products Have Boomed Over the past twenty years, Japanese sales of skin cosmetics and beauty products have almost tripled (Chart I-7). This has helped the personal products sector to outperform very strongly. The personal products sector is dominated by female spending. So it is significant that in 1995, the Japanese government introduced a raft of policies to encourage women to join the labour force: paid maternity leave, subsidised childcare, and paid parental leave for both parents. Today in Japan, both mothers and fathers can take more than a year of paid parental leave at an average rate of 60% of earnings. The policies had their desired effect. The proportion of Japanese women in the labour force has surged from 57% to 67%, while the male labour participation rate has held at 85%. Therefore, all of the growth in the Japanese labour force through the past twenty years has come from women. Europe tells a similar tale. Through the past couple of decades, parental leave policies have become steadily more generous. Unsurprisingly, the proportion of European women in the labour force has also surged from 57% to 67%, while the male labour participation rate has held at 78%. So just as in Japan, all of the growth in European labour force participation through the past twenty years has come from women (Chart I-8). But for the ultimate end-point in the European trend, look to the Scandinavian countries which have had generous parental leave policies since the 1970s. As a result, labour force participation for Swedish women is almost identical to that for men: 80% versus 83%. If the EU eventually reaches the Scandinavian end-point, it would mean another 20 million women in the EU labour force. What is the Japanese lesson for Europeans? While Japanese financial profits have halved since 1990, Japanese personal products profits have quintupled. Once again, the useful thing is that euro area personal product profits are uncannily tracking the Japanese experience with a 17-year lag (Chart I-9). If euro area personal product profits continue to follow in Japan's footsteps, expect them to almost triple over the next 17 years. Stay overweight the European personal products sector. Chart I-8A Surge In Female Participation Chart I-9Personal Products Profits Set To Grow Very Strongly Dhaval Joshi, Senior Vice President Chief European Investment Strategist dhaval@bcaresearch.com 1 Assuming you work for 50 years. 2 Admittedly, measured inflation probably overstates true inflation. However, estimates put this measurement error at no more than 0.3-0.5 percentage points. 3 Please see the European Investment Strategy Weekly Report 'The Case Against Helicopters' published on May 5 2016 and available at eis.bcaresearch.com 4 Please see the European Investment Strategy Weekly Report 'Market Turbulence: What Lies Ahead?' published on March 29 2018 and available at eis.bcaresearch.com Fractal Trading Model* This week’s trade recommendation is to go long the Australian dollar versus the Norwegian krone. The profit target is 2% with a symmetrical stop-loss. For any investment, excessive trend following and groupthink can reach a natural point of instability, at which point the established trend is highly likely to break down with or without an external catalyst. An early warning sign is the investment’s fractal dimension approaching its natural lower bound. Encouragingly, this trigger has consistently identified countertrend moves of various magnitudes across all asset classes. Chart I-10 * For more details please see the European Investment Strategy Special Report “Fractals, Liquidity & A Trading Model,” dated December 11, 2014, available at eis.bcaresearch.com The post-June 9, 2016 fractal trading model rules are: When the fractal dimension approaches the lower limit after an investment has been in an established trend it is a potential trigger for a liquidity-triggered trend reversal. Therefore, open a countertrend position. The profit target is a one-third reversal of the preceding 13-week move. Apply a symmetrical stop-loss. Close the position at the profit target or stop-loss. Otherwise close the position after 13 weeks. Use the position size multiple to control risk. The position size will be smaller for more risky positions Recommendations Equities Bond & Interest Rates Currency & Other Positions Closed Fractal Trades Trades Closed Trades Asset Performance Currency & Bond Equity Sector Country Equity Indicators Bond Yields Chart II-1Indicators To Watch - Bond Yields Chart II-2Indicators To Watch - Bond Yields Chart II-3Indicators To Watch - Bond Yields Chart II-4Indicators To Watch - Bond Yields Interest Rate Chart II-5Indicators To Watch - Interest Rate Expectations Chart II-6Indicators To Watch - Interest Rate Expectations Chart II-7Indicators To Watch - Interest Rate Expectations Chart II-8Indicators To Watch - Interest Rate Expectations

Special Report

Highlights Hong Kong's leverage burden is a corporate sector rather than a household sector problem. But this corporate sector debt is highly concentrated in the finance and real estate industries, meaning that investors should be legitimately concerned over Hong Kong's extremely elevated debt service ratio. Our BCA Hong Kong Debt Risk Monitor serves as an important tool to help investors gauge the risk of a serious credit-driven downturn in the region. While the risk from excessive leverage is real, the current message from our DRM is that the odds of a deleveraging event over the coming year are low. Due to the importation of U.S. monetary policy, Hong Kong may "enjoy" easy monetary policy on a permanent basis. This suggests that Hong Kong's private sector may continue to leverage itself even in the face of rising interest rates, setting up the potential for a cataclysmic future recession. Stay neutral Hong Kong stocks versus the global benchmark over the coming 6-12 months. While equities may rise in relative terms if earnings momentum converges with that of the global benchmark, it is not a sufficiently compelling prospect to outweigh the significant structural risk facing the region. Feature Hong Kong has appeared in the headlines of the financial press for two reasons over the past few months. The first is due to the recent weakness in the Hong Kong dollar (HKD), a topic that we addressed last week.1 The second was prompted by the BIS' March 2018 Quarterly Review, which noted that mainland China, Hong Kong, and Canada stood out among 26 jurisdictions as being the most vulnerable to a banking crisis according to their research. The BIS's warning is rooted in the fact that Hong Kong is a highly leveraged economy, but there are two additional reasons for investors to be cautious about the region: China's industrial sector is slowing, and monetary policy is tightening due to the region's direct link to U.S. interest rates. While Hong Kong has avoided the full brunt of rising U.S. rates over the past year thanks to plentiful interbank liquidity (which has limited the rise in 3-month HIBOR), we noted in last week's report that the weakness in the HKD likely means that gap between interbank rates and the base rate cannot get much wider. This means that further Fed rate hikes over the coming year are likely to feed more fully into tighter Hong Kong monetary conditions. In this report we review the extent and disposition of Hong Kong's indebtedness, and develop an indicator for investors to monitor in order to gauge the risk of a serious private sector deleveraging event. We conclude that while it is too early to position aggressively against Hong Kong stocks, the risk from excessive leverage is real and is very likely to eventually cause a serious credit-driven downturn. For now, however, that appears to be a story for another day, and as we explain below, potentially a distant one. Breaking Down Hong Kong's Debt Chart 1 presents the basis for concern about Hong Kong's debt. The chart shows the BIS' nonfinancial private sector debt service ratio ("DSR", which includes both households and nonfinancial corporations) for the G10 countries alongside that of China, Hong Kong, and Canada. The chart shows that Hong Kong's DSR has risen nearly to 26%, a full 10 percentage points higher than the G10 average, and is now the highest among the 32 economies that the BIS has debt service data for. One important point to note is that among the three countries that the BIS recently singled out for concern, the disposition of Hong Kong's private sector debt is more similar to that of China than Canada. Chart 2 highlights that the private sector debt in China and Hong Kong is predominantly owed by the nonfinancial corporate sector, whereas in Canada the debt is more equally split among the two sectors, with households owing more in total. Chart 1Hong Kong's Debt Burden Hits##br## A New High Chart 2Unlike In Canada, Hong Kong's Leverage##br## Is A Corporate Sector Problem Normally we would be inclined to suggest that the skew in Hong Kong's debt towards the corporate sector makes it less risky than in other jurisdictions where elevated leverage is a household sector problem. The rationale is that while corporations can (and often do) misallocate their capital, firm borrowing is usually employed to acquire income-producing assets, with problems arising only when the value of those assets (or their potential to generate income) declines sharply. Household leverage problems, on the other hand, are almost always the result of a sharp rise in residential mortgage credit, and our view is that the purchase of residential property is fundamentally an act of consumption rather than a true investment. In addition, the past experiences of several countries have shown that housing-related leverage busts are particularly pernicious, in that the resulting recessions tend to be followed by long periods of subpar economic growth. But unlike in China where the majority of nonfinancial corporate sector debt is held on the balance sheets of state-owned enterprises, Hong Kong's corporate debt does not have de-facto state backing and appears to be enormously concentrated in the real estate and financial sector. Over 80% of Hong Kong's total nonfinancial sector debt (which includes households) is provided by domestic banks, and Chart 3 shows that among bank loans to firms, 35% have been granted to property building & construction companies and another 22% to "financial concerns" and stockbrokers. This high concentration of corporate sector debt in the real estate sector means that investors should be legitimately concerned over Hong Kong's extremely high DSR. On the household side, we have made the case in a previous report that a replay of another spectacular housing bust (similar to what occurred in 1997) is highly unlikely despite the fact that Hong Kong house prices have vastly outstripped income over the past decade2 (Chart 4). Chart 3Loans To Businesses Are Highly Concentrated ##br##And Exposed To Property Chart 4Lofty House Prices Are A Red Herring: ##br##The Risk Is On The Business Side This suggests that, despite extremely elevated residential property prices, investors should be more concerned about a shock that will destabilize the commercial real estate market. Hong Kong households would not likely escape the impact of such a shock, since commercial and residential real estate prices move strongly in tandem (Chart 5). But in terms of watching for a "tipping point" that could push Hong Kong's private sector into a balance sheet recession, the trigger seems more likely to occur in the market for the former, rather than the latter. Bottom Line: Hong Kong's leverage burden is a corporate sector rather than a household sector problem. But this corporate sector debt is extremely concentrated in the finance and real estate industries, meaning that investors should be legitimately concerned over Hong Kong's extremely high debt service ratio. Chart 5Still, Households Will Be Hurt##br## If CRE Prices Fall Chart 6The BIS' Warning Thresholds ##br##Don't Seem To Apply To Hong Kong Timing The Onset Of A Balance Sheet Recession Our analysis above supports the recent warnings from the BIS that the risk of a banking crisis / private sector deleveraging event in Hong Kong is nontrivial. This raises the obvious question of how to gauge the timing of such an event in order for investors to properly position their exposure towards Hong Kong's financial markets. The BIS has itself investigated this question, and has published several reports on its "Early Warning Indicator" (EWI) approach.3 Table 1 presents a list of these indicators for several countries, and highlights that the two of the most informative measures (the credit-to-GDP gap4 and the overall debt service ratio) are flashing red for Hong Kong. In fact, Table 1 served as the basis for the BIS' warning in their most recent Quarterly Review that we noted above. The BIS' EWI research has focused on identifying thresholds for these measures that can predict a banking crisis within a three-year window based on the historical record. But in the case of Hong Kong, it is not clear that these thresholds apply. Chart 6 shows the credit-to-GDP gap and overall private sector DSR along with the more stringent BIS threshold noted in Table 1, and highlights that these measures have been flashing red for 4-8 years. Based on this approach, Hong Kong should have experienced a banking crisis long ago. Table 1BIS Early Warning Indicators For Stress In Domestic Banking Systems Rather than relying on the BIS' framework, we have instead constructed our own private-sector debt risk monitor for Hong Kong. In contrast to the BIS' measures, which have been specifically constructed to predict a banking crisis, the goal of our indicator is to help predict a serious credit-driven downturn regardless of its character (i.e. we abstract from whether the result of the downturn is a full-blown financial crisis or simply a prolonged period of economic stagnation). Chart 7Low Risk Of A Serious Credit-Driven ##br##Downturn, For Now Chart 7 presents our BCA Hong Kong Debt Risk Monitor (DRM) and its five equally-weighted components, a summary of which is provided below. All series have been scaled such that an increase in the DRM represents higher risk. Alpha: We have highlighted the importance of examining the alpha as well as the beta of regional equity returns in a previous report,5 and we include a composite indicator of Hong Kong's rolling alpha versus the global benchmark as a measure of Hong Kong-specific stock performance that adjusts for Hong Kong's riskiness. While this component of our DRM was quite elevated in early-2016 (signaling weak Hong Kong stock performance), it is presently in line with its historical average, and thus is not flashing a warning sign. Property Prices: Given the high concentration of Hong Kong's corporate sector debt in the real estate sector, our DRM includes the deviation of office & retail property prices from their 9-month moving average. Similar to the first component of our indicator, Hong Kong property prices are roughly in line with their trend and are not signaling serious economic weakness. Credit Impulse: The third component of our DRM is a simple bank credit impulse, calculated as the flow of credit over the past year as a percent of GDP. While this component has fallen well into "low risk" territory, over the past year, there are some tentative signs of a reversal that investors should monitor. Monetary Policy Stance: The fourth component of our DRM is a structural variable that attempts to measure whether U.S. (and thus Hong Kong) interest rates are either consistent or out of alignment with economic conditions in Hong Kong. This component is an average of two measures of the stance of monetary policy: 1) the difference between U.S. 10-year government bond yields and Hong Kong nominal GDP growth, and 2) the difference between the base rate and a Taylor Rule estimate for the region (with the latter acting purely as an estimate of the cyclical equilibrium interest rate).6 The chart shows that despite the onset of tighter monetary policy in the U.S. over the past few years, our gauge of Hong Kong's policy stance suggests that conditions are still easy, and that material further increases would likely be required in order to see this component rise to +1 sigma territory. Debt Service Ratio: The final component of our DRM is the BIS' total private sector DSR shown in Chart 6, acting as a second structural variable that captures the underlying debt servicing risk that the BIS has warned about. We extent the BIS' series back to the early-1990s on a best efforts basis, by adjusting the product of Hong Kong's prime rate and the total private sector debt-to-GDP ratio to best align with the official DSR series over the course of its history. Our extended series suggests that Hong Kong's debt servicing burden is indeed the highest that it has been over the past three decades, underscoring that our DRM is likely to rise materially if the cyclical factors included in the indicator deteriorate. The overall message of our DRM is that a threat to Hong Kong's economy from excessive debt does not appear to be imminent, despite the underlying risks highlighted by the BIS. While the risk from excessive leverage is real and is very likely to eventually cause a serious credit-driven downturn, the odds of this occurring over the coming 6-12 months appear to be low. Bottom Line: Our BCA Hong Kong Debt Risk Monitor serves as an important tool to help investors gauge the risk of a serious credit-driven downturn in the region. While the risk from excessive leverage is real, the message from our DRM is that the odds of a deleveraging event over the coming year are low. The Spooky Implications Of The Natural Interest Rate Gap Interestingly, at least part of the benign reading of our DRM is due to the fourth component of the indicator, our gauge of Hong Kong's monetary policy stance, which suggests that there is ample room for further rate increases. In fact, in our view this observation carries much deeper significance than many may initially perceive, as it may explain why the BIS' early warning indicator thresholds have not worked in the case of Hong Kong, and why the region may avoid a debt crisis for a further significant period (but ultimately experience a much more painful collapse when it finally arrives). At root, the reason that U.S. 10-year Treasury yields remain exceedingly low relative to U.S. nominal GDP growth is because investors believe that real U.S. policy rates are likely to be much lower on average over the next 10-years than they have been historically (Chart 8). Abstracting from calendar-based cyclical considerations (such at the timing of the next U.S. recession), this fundamentally reflects the prevalent view among fixed-income investors that the U.S. natural rate of interest (or "r-star") has likely permanently declined. If true, this is of enormous importance for Hong Kong, as it suggests that the region will permanently "enjoy" easy monetary policy. This is because the substantial leveraging that has occurred in Hong Kong in response to low interest rates implies that there has been no impairment (yet) to Hong Kong's natural rate of interest (Chart 9). Chart 8A Low Estimate Of R-Star Has Depressed##br## U.S. Bond Yields Chart 9No Evidence Of A Low R-Star##br## In Hong Kong In some ways the dynamic we are describing is not new: the importation of easy monetary policy from the U.S. via competitive currency devaluation over the past decade has been a well-known phenomenon that was quite prominent during the early phase of the global economic recovery. But the fixed exchange rate regime in Hong Kong means that this process cannot be avoided without abandoning the peg, an event that itself could trigger a deleveraging event via a sharp decline in asset prices. The key point for investors is that if the U.S. natural rate of interest has indeed fallen materially and permanently below potential GDP growth, then Hong Kong will not experience tight monetary conditions even once the Fed has normalized short-term interest rates, unless it raises them well above equilibrium levels. This suggests that Hong Kong's private sector may perpetually leverage itself until debt service burdens reach some, as yet, unknown maximum level, precipitating what would likely become a cataclysmic recession. The fact that no crisis erupted in late-2015/early-2016 when the cyclical components of our DRM deteriorated significantly suggests that this level may be materially higher than is presently the case. Bottom Line: Due to the importation of U.S. monetary policy, Hong Kong may "enjoy" easy monetary policy on a permanent basis. This suggests that Hong Kong's private sector may continue to leverage itself even in the face of rising interest rates, setting up the potential for a cataclysmic future recession. Investment Implications: Stay Neutral, For Now Chart 10Room For A Rise In Relative Earnings Momentum The picture painted by our above analysis suggests that a benign cyclical outlook for Hong Kong is arrayed against a negative (and potentially horrific) structural outlook. How should investors position towards Hong Kong equities in response? First, as noted above, our Debt Risk Monitor does not signal that there is an imminent threat facing the Hong Kong economy that would herald the potential for a major deleveraging event over the near-term. Second, while Hong Kong's earnings momentum is stretched in absolute terms, Chart 10 highlights there is room for a catchup versus global stocks, which could boost relative performance over the coming year. Third, relative valuation and technical conditions are at neutral levels (Chart 11), and thus do not provide any compelling basis to avoid Hong Kong stocks. But to us, the weight of this modestly positive assessment over the coming year is overshadowed by the structural outlook, meaning that we continue to recommend a neutral allocation towards Hong Kong stocks over the coming 6-12 months. The most investment-relevant conclusion from our analysis is that investors will one day be able to earn significant risk-adjusted returns from underweighting / shorting Hong Kong stocks once a serious credit-driven downturn begins. As an example, Chart 12 shows the impact of the Asian financial crisis on Hong Kong's relative performance, a period where our DRM rose sharply and persistently into "high risk territory". It took 12½ years for Hong Kong to rise to a new high in relative total return terms, and it has yet to do so in price terms. Chart 11Neutral Relative Valuation And ##br##Technical Conditions Chart 12One Day, Shorting Hong Kong Stocks##br## Will Be Enormously Profitable So while the economic and financial market conditions are not yet in place to act on a bearish structural view, we will be closely watching our Debt Risk Monitor over the coming months and years for signs of a significant deterioration, as it will likely provide a major opportunity for investors to earn outsized returns. Stay tuned! Bottom Line: Stay neutral Hong Kong stocks versus the global benchmark over the coming 6-12 months. While equities may rise in relative terms if earnings momentum converges with that of the global benchmark, it is not a sufficiently compelling prospect to outweigh the significant structural risk facing the region. Jonathan LaBerge, CFA, Vice President Special Reports jonathanl@bcaresearch.com 1 Please see China Investment Strategy Weekly Report, "Chinese Stocks: Trade Frictions Make For A Tenuous Overweight", dated March 28, 2018, available at cis.bcaresearch.com. 2 Pease see China Investment Strategy Weekly Report "Hong Kong Housing Bubble: A Replay Of 1997?", dated June 29, 2017, available at cis.bcaresearch.com. 3 For example, please see "Evaluating early warning indicators of banking crises: Satisfying policy requirements" by Mathias Drehmann and Mikael Juselius, BIS Working Paper No. 421, August 2013. 4 The BIS defines the credit-to-GDP gap as the difference between the credit-to-GDP ratio and its long-run trend, derived using a one-sided (i.e. backward-looking) Hodrick-Prescott (HP) filter. 5 Pease see China Investment Strategy Special Report "China: No Longer A Low-Beta Market", dated January 11, 2018, available at cis.bcaresearch.com. 6 Our Taylor Rule estimate for Hong Kong is constructed in a fashion similar to what we showed for China in our January 18 Weekly Report, using a neutral policy rate estimate of 5%. Cyclical Investment Stance Equity Sector Recommendations