Aerospace & Defense

Overweight We have been overweight the pure-play BCA defense index since late-2015 and our strategy is to add exposure on any meaningful pullbacks and keep this index as a structural overweight within the GICS1 S&P industrials index. In the U.S., where military spending in absolute terms is greater than the rest of the world put together, defense spending and investment have bottomed and will continue to accelerate. In fact, the CBO continues to project that defense outlays will jump further next year (second panel). While such a breakneck pace is clearly unsustainable, this administration appears serious about upgrading and updating the U.S. military. The upshot is that defense outlays will continue to expand into the 2020s. Still, undoubtedly valuations are on the expensive side. Not only is recent M&A fever the culprit, but global investors' insatiable appetite for pure-play defense stocks has also driven valuations into overshoot territory (bottom panel), though if our thesis pans out, then these stocks will grow into their pricey valuations as happened in the back half of the 1960s.1 Bottom Line: The secular advance in pure-play defense stocks remains in place. We continue to recommend an above benchmark allocation; please see Monday's Weekly Report for more details. The ticker symbols for the stocks in the BCA defense index are: LMT, LLL, NOC, GD and RTN. Stay With Defense Stocks For The Long-Term Stay With Defense Stocks For The Long-Term 1 Please see BCA U.S. Equity Strategy Special Report, "Brothers In Arms," dated October 31, 2016, available at uses.bcaresearch.com.

Highlights Portfolio Strategy Debt saddled small caps have to wrestle with rising interest rates at a time when they lack a valuation cushion. Tack on their high beta status and investors should continue to avoid small caps and instead prefer large caps. Upbeat global demand for U.S. defense goods, firming defense industry operating metrics and a flurry of M&A will more than offset the defense contractors' valuation overshoot. Stay structurally overweight. Recent Changes There are no changes to the portfolio this week. Table 1 Icarus Moment? Icarus Moment? Feature In Greek mythology, Daedalus warned his son Icarus not to fly too close to the sun when the pair of them were escaping from Crete, as his wax-made wings would melt. Icarus ignored his father's warning and soared toward the sun that eventually led to his drowning in the Aegean Sea when his wings melted. Is the equity market experiencing an Icarus moment? The S&P 500 is undergoing a healthy reset during crash-prone October, but post-midterms it should make an attempt to vault to fresh all-time highs into year-end. The selloff in the bond market (largely driven by the real component) most likely caused the consternation in stocks, but our sense is that the backup in yields is reflective and not yet restrictive both for stocks and, most importantly, the economy. In the coming weeks we expect a retest, and hold, of the recent lows before waving the all clear sign. Nevertheless, the latest bout of volatility is a cause for concern especially given that the SPX pullback is not sentiment/technical driven as it was earlier in the year when on January 221 and again on January 292 we cautioned clients that the equity market advance was too good to be true and complacency reigned supreme. As a reminder in late-January, equities looked extremely stretched on a number of sentiment and technical indicators. This was not the case, however, heading into October (Charts 1 & 2), and it raises the question: what are stocks discounting with regard to the economic backdrop? Chart 1Leading Into The Recent Pullback Sentiment And Technicals... Leading Into The Recent Pullback Sentiment And Technicals... Leading Into The Recent Pullback Sentiment And Technicals... Chart 2...Were Not As Extended As In Late-January  ...Were Not As Extended As In Late-January  ...Were Not As Extended As In Late-January Our biggest worry is that the 2018 goosing of the economy will soon fall flat as President Trump runs out of firepower to further buoy the economy. In other words, we have likely brought demand/consumption forward which should get reflected in softer 2019 output data, especially if there is gridlock in Congress post the midterms. Keep in mind, that most of the fiscal easing that pertains to stocks is front loaded to this year. The drop in corporate taxes is a one-off EPS boost for 2018, as is the surge in buybacks that was driven by cash repatriation. Buybacks are on pace to reach $1tn in 2018, but are likely to fall back to the more typical $400bn/annum rate next year. The U.S. economy and stock market will have to grapple with both of these fading tailwinds in 2019. One simple way to depict this is our newly conceived BCA Economic Impulse Indicator (EII). Chart 3 shows six economic indicators gauging the state of the U.S. economy. The EII comprises housing, capex, manufacturing, confidence, employment and credit; it is equally weighted shown as a Z-score. At present it is wobbling and diverging negatively from euphoric SPX EPS growth rates. Chart 3 Mind The Gap  Mind The Gap  Mind The Gap Not only is the economy humming at an unsustainable pace, but the Fed is also tightening monetary policy and letting maturing securities run off its balance sheet at approximately $50bn/month. If the Fed hikes rates three more times by June 2019, as both the bond market and our fixed income strategists expect, the fed funds rate will reach a range of 2.75%-3%. It then becomes plausible that any letdown in economic data could cause the yield curve to invert. The elimination of the unemployment gap increases the probability of curve inversion (see Chart 1 from the October 23, 2017 Weekly Report), as does another indicator of labor market tightness that recently dropped below zero (Chart 4). Chart 4Full Employment And Yield Curve Joined At The Hip Full Employment And Yield Curve Joined At The Hip Full Employment And Yield Curve Joined At The Hip But, we are not there yet and want to be systematic in calling the end of the business cycle, and thus equity bull market, using the three signposts we deemed most important earlier in the year: a yield curve inversion (leading indicator), doubling in year-over-year oil prices based on monthly dataset (coincident indicator) and a mega-merger announcement either in tech or biotech space (confirming anecdotal indicator). With regard to the latter, the rumored Uber IPO fetching a valuation of $120bn may also qualify as an end of cycle anecdotal indicator. Still, none of these three boxes have yet been ticked. Moreover, two other catalysts may assist in prolonging the cycle and breathe a sigh of relief not only in U.S. equities, but also in global bourses: a trade deal with China, and/or a reversal in U.S. dollar strength that would boost global ex-U.S. growth. Netting it all out, while the recent equity market swoon is worrisome it is still too early to call the end of the cycle and we do not think we are in an "Icarus moment". Our broad equity market strategy is to "buy the dip" as we expect EPS to do all the heavy lifting next year with the multiple drifting lower, and we continue to recommend a cyclical over defensive portfolio bent. This week we highlight a deep cyclical capital goods subsector and revisit our size bias. The Bigger The Better The days in the sun are over for small cap stocks. Similar to the double top formation in the early 1980s, small cap stocks have hit a wall and are giving in to their larger brethren. There are high odds that the small over large multi-year ascendancy is over and a reversion, at least, to the historical time trend mean is in order (Chart 5). Chart 5Double Top Double Top Double Top Since changing our size bias to a large cap bias on May 10, 2018, the S&P 500 has bested the S&P 600 index by over 300bps. Small caps however remain fully valued using different metrics and are extremely overvalued versus the SPX according to the Shiller P/E (or cyclically adjusted P/E, CAPE) methodology of smoothing the earnings cycle over a decade (Chart 6). In fact, this 40% CAPE premium leaves no space for any small cap profit mishaps. Chart 6Small Caps Valuations Are Stretched... Small Caps Valuations Are Stretched... Small Caps Valuations Are Stretched... Unfortunately, on a number of fronts small cap EPS will underwhelm and significantly trail SPX EPS, the opposite of what optimistic sell-side analysts expect. First, small caps are severely debt saddled as we have highlighted in our recent research. Sustained small cap balance sheet degradation is worrying, with S&P 600 net debt-to-EBITDA close to 4 (compared with 1.5 for the SPX, middle panel, Chart 7). Such gearing is fraught with danger as the default rate has nowhere to go but higher. Chart 7...Amidst Balance Sheet Degradation... ...Amidst Balance Sheet Degradation... ...Amidst Balance Sheet Degradation... Second, small and medium businesses have a higher dependency on bank credit as opposed to the bond market access that mega caps enjoy. Most bank credit is floating rate debt and so are lines of credit, and as the Fed remains firm on tightening monetary policy, interest expense costs are skyrocketing for SMEs. In a relative sense this will weigh on net profits. More generally, given the high indebtedness, small caps are a lot more sensitive to interest rates, and the selloff in the 10-year Treasury note heralds more pain in 2019 (10-year Treasury yield shown inverted, Chart 8). Chart 8 ...And With Rates Rising...  ...And With Rates Rising...  ...And With Rates Rising... Third, relative wage costs are flashing red for small caps. Small cap margins are thin - roughly mid-single digits or 800bps below large caps, and rising labor costs (according to the latest NFIB survey) are warning that this delta will widen, further suppressing relative margins and profitability as large cap wage costs are still well contained (Chart 9). Chart 9...And Labor Costs Perking Up, A Margin Squeeze Looms ...And Labor Costs Perking Up, A Margin Squeeze Looms ...And Labor Costs Perking Up, A Margin Squeeze Looms Fourth, small caps are high(er) beta stocks and when volatility spikes they underperform large caps. When the Fed ballooned its balance sheet and dropped the fed funds rate to zero it suppressed volatility. Now that the Fed has been decreasing the size of its balance sheet and raising interest rates, this is working in reverse and volatility is making a comeback as we have been highlighting in our research, and will continue to weigh on small caps (VIX shown inverted, top panel, Chart 10). Chart 10Large Caps Have The Upper Hand Large Caps Have The Upper Hand Large Caps Have The Upper Hand Another way to showcase small caps' riskier status is the close correlation they have with the relative EM equity share price ratio. When EMs outperform the SPX, small caps follow suit and vice versa. Importantly a wide gap has opened recently and we suspect that it will narrow via small caps following the EM higher beta stocks lower (SPX vs. EM ratio shown inverted, bottom panel, Chart 10). Adding it up, a high small cap debt burden, rising interest rates, lack of a valuation cushion, and their high beta status all signal that investors should continue to avoid small caps and instead prefer large caps. Bottom Line: Stick with a large cap bias. Stay With Defense Stocks For The Long-Term We have been overweight the pure-play BCA defense index since late-2015 and there are high odds that this juggernaut that really commenced with the George Walker Bush presidency remains in a secular growth trajectory (top panel, Chart 11). Our strategy is to add exposure on any meaningful pullbacks and keep this index as a structural overweight within the GICS1 S&P industrials index. Chart 11Defense Stocks Are A Secular Growth Play Defense Stocks Are A Secular Growth Play Defense Stocks Are A Secular Growth Play The rise of global "multipolarity" - or competition between the world's great nations - and the decline of globalization, along with a global arms race and increased risk of cyber-attacks, have been documented in our "Brothers In Arms" Special Report. These trends all signal that global defense related spending will remain upbeat in the coming decade.3 In the U.S. in particular, where military spending in absolute terms is greater that the rest of the world put together, defense spending and investment have bottomed and will continue to accelerate. In fact, the CBO continues to project that defense outlays will jump further next year (middle panel, Chart 12). While such a breakneck pace is clearly unsustainable, President Trump is serious about upgrading and updating the U.S. military in order to keep China's geopolitical and military ascendancy in check (as well as to deal with Russia and Iran).4 The upshot is that defense outlays will continue to expand into the 2020s. Chart 12Upbeat Defense Outlays... Upbeat Defense Outlays... Upbeat Defense Outlays... Such a buoyant demand backdrop is music to the ears of defense contractor CEOs, and represents a boost to defense equity revenue growth prospects. This capital goods sub-industry has extremely high fixed costs and thus any increase in top line growth flows straight to the bottom line. Put differently, defense contractors enjoy high operating leverage. No wonder M&A activity is robust: at least four large deals have been announced in the past year that are underpinning both takeout premia and relative share prices (bottom panel, Chart 13). Chart 13 ...And A Flurry Of M&A Is A Boon For Defense Stocks  ...And A Flurry Of M&A Is A Boon For Defense Stocks  ...And A Flurry Of M&A Is A Boon For Defense Stocks A closer look at operating metrics corroborates that defense goods manufacturers are firing on all cylinders. New orders recently jumped to fresh all-time highs and the industry's shipments-to-inventories ratio is rising, on track to surpass the 2008 peak. Unfilled orders are also running at a high rate, signaling that factories will keep on humming at least for the next few quarters (Chart 14). Chart 14Firming Operating Metrics Firming Operating Metrics Firming Operating Metrics Importantly, the industry is not standing still and is making significant investments. U.S. defense capex as reported in the financial statements of constituent firms is growing at roughly 20%/annum or twice as fast as overall capex (Chart 15). Chart 15Industry Is Not Standing Still Industry Is Not Standing Still Industry Is Not Standing Still True, industry indebtedness is also on the rise as some of the expansion has been debt financed, but net debt-to-EBITDA trails the overall market (ex-financials). Similarly, interest coverage has been modestly deteriorating, but is twice as high as the overall market. Impressively, defense ROE is running near 30%, again roughly double the rate of the broad market (Chart 16). Chart 16Healthy B/S With High ROE... Healthy B/S With High ROE... Healthy B/S With High ROE... Nevertheless, undoubtedly valuations are on the expensive side. Not only is recent M&A fever the culprit, but global investors' insatiable appetite for pure-play defense stocks has also driven valuations into overshoot territory (Chart 17). This is a clear risk to our secular overweight view, however, if our thesis pans out, then these stocks will grow into their pricey valuations as happened in the back half of the 1960s.5 Chart 17 ...But Valuations Are Expensive  ...But Valuations Are Expensive  ...But Valuations Are Expensive In sum, upbeat global demand for U.S. defense goods, firming industry operating metrics and a flurry of M&A will more than offset the defense contractors' valuation overshoot. Bottom Line: The secular advance in pure-play defense stocks remains in place. We continue to recommend an above benchmark allocation. The ticker symbols for the stocks in the BCA defense index are: LMT, LLL, NOC, GD and RTN. Anastasios Avgeriou, Vice President U.S. Equity Strategy anastasios@bcaresearch.com 1 Please see BCA U.S. Equity Strategy Weekly Report, "Too Good To Be True?" dated January 22, 2018, available at uses.bcaresearch.com. 2 Please see BCA U.S. Equity Strategy Weekly Report, "Corporate Pricing Power Update," dated January 29, 2018, available at uses.bcaresearch.com. 3 Please see BCA U.S. Equity Strategy Special Report, "Brothers In Arms," dated October 31, 2016, available at uses.bcaresearch.com. 4 Please see BCA Geopolitical Strategy Special Report, "A Global Show Of Force?" dated October 10, 2018, available at gps.bcaresearch.com. 5 Please see BCA U.S. Equity Strategy Special Report, "Brothers In Arms," dated October 31, 2016, available at uses.bcaresearch.com. Current Recommendations Current Trades Size And Style Views Favor value over growth Favor large over small caps

Overweight On Monday of this week, President Trump signed the John S. McCain National Defense Authorization Act into law. Most significantly, the bill authorizes $717 billion in defense funding for FY2019, a small increase from the $696 billion in FY2018, which was a significant increase from the FY2016 $580 billion budget. The administration's commitment to returning military funding to wartime levels (regardless of budget constraints or geopolitical threat) are confirmed by defense spending surging at the fastest rate in nearly a decade (second panel). This is further reflected in the recovery in defense investment (bottom panel). We highlighted earlier this week that defense stocks should be winners in a trade war, particularly if such a war increases the threat of a more conventional one. Tack on above-normal earnings growth from exceptional government funding and defense stocks look even more appealing; stay overweight. The ticker symbols for the stocks in the BCA Defense index are: LMT, GD, RTN, NOC, LLL. Defense Spending Is Set To Take Off Defense Spending Is Set To Take Off

Overweight Defense stocks have been range-bound in the last week as geopolitical maneuvering has seen probabilities of conflict on the Korean peninsula swinging wildly back and forth. Using this conflict to value defense equities seems fraught with forecast risk and we would argue that focusing on domestic rearmament is a better use of investors' time. In last month's data release, Department of Defense outlays showed the longest streak of increases this decade, pointing to a continued acceleration in defense spending (second panel). This is mirrored by surging government investment in defense, now at its highest level in 5 years (third panel). The Trump administration's commitment to rearmament has now made it into the federal budget; the Congressional Budget Office (CBO) estimates defense outlays will approximate wartime levels in 2019 (bottom panel). Net, we expect earnings visibility will peak through the fog of war and be the ultimate driver of stock market returns; stay overweight. The ticker symbols for the stocks in the BCA Defense index are: LMT, GD, RTN, NOC, LLL. Defense Spending Showing No Signs Of Slowing Defense Spending Showing No Signs Of Slowing

Overweight Defense stocks were battered this week as, despite earnings exceeding expectations and both guidance and forecasts moving higher, the market sold off. It appears a softer tone from President Trump with respect to North Korean leader Kim Jong Un, combined with the latter's announcement that North Korea would no longer test nuclear weapons and intercontinental ballistic missiles, has eased geopolitical fears enough to lower defense expectations. We think this matters relatively little with respect to the top line growth of defense firms. Domestic defense spending is set to take off to unprecedented levels as the Trump administration appears committed to rearmament. Moreover, this is a global trend; the Stockholm International Peace Research Institute (SIPRI) noted late last year that global arms sales (as measured by the revenues of the largest 100 defense companies) had arrested their 6-year long decline last year, rising by 1.9% in 2017. As fears of a global trade war are receding, we think the relatively soft U.S. dollar should be supportive of international orders while domestic demand remains resilient; stay overweight. The ticker symbols for the stocks in the BCA Defense index are: LMT, GD, RTN, NOC, LLL Defense Spending Is Bulletproof Defense Spending Is Bulletproof

Overweight S&P defense shares have been enjoying a terrific streak over the past three years, solidly outperforming the S&P 500 in each of them. This is in no small part because of new orders, which have been steadily recovering (second panel) and surging demand eroding inventories (third panel), implying outsized cash generation. Adding to this excitement is President Trump's 2019 defense budget request of $686 billion, which would arrest seven years of real defense budget declines. It is thus unsurprising that threats of a global trade war have taken some of the energy out of the index, though we think recent declines are an overreaction for three reasons. First, the administration has shown a willingness to exclude allies (the principal international customer group for defense firms) from trade restrictions. Second, given high switching costs, a weaker U.S. dollar should be supportive of international orders regardless of the administration's stance. Third, as shown in the bottom panel, the fundamental performance driver of defense equities is domestic defense spending; as noted above, this is clearly biased higher from a secular perspective. Net, recent declines represent a buying opportunity; we reiterate our overweight recommendation. The ticker symbols for the stocks in the BCA Defense index are: LMT, GD, RTN, NOC, LLL Do Not Bet Against Defense Stocks In A Trade War Do Not Bet Against Defense Stocks In A Trade War

Overweight The U.S. defense complex has seen a solid recovery in orders over the last three years (second panel), a notable feat because of the absence of a major conflict driving domestic orders. In fact in the past decade, domestic real defense spending has contracted more than it has expanded and even when it is growing, it has not been at a pace faster than mid-single digits (third panel). That may soon change. If early reports are correct, the Trump administration will raise its defense spending target to $716 billion for the 2019 budget, an increase of 13% from this past year's level. Such largesse should sustain the valuation rerating defense stocks have been enjoying. Stay overweight. The ticker symbols for the stocks in the BCA Defense index are: LMT, GD, RTN, NOC, LLL Defense Stocks Are Rallying Again Defense Stocks Are Rallying Again .

Overweight The Stockholm International Peace Research Institute (SIPRI) released data earlier this week showing that global arms sales (as measured by the revenues of the largest 100 defense companies) had arrested their 6-year long decline last year, rising by 1.9%. The key driver appears to be Lockheed Martin (LMT), which saw rising sales for the international F-35 program and also purchased helicopter producer Sikorsky, thus cementing its position as the number one defense firm. Importantly, 2016 saw arms sales for South Korean companies surge by 20.6% in response to the rising tensions on the Korean peninsula, both to meet domestic demand and for international exports. There are two implications from this statistic: first, rising South Korean arms production means overall demand is increasing and second, defense demand is becoming heterogeneous. In conjunction with growth in domestic armed forces (second panel), the demand environment for U.S. defense firms remains bright and while valuations are lofty on a P/E and P/CF basis, they are not out of line with the broad market measured by EV/EBITDA (third panel); stay overweight. The ticker symbols for the stocks in the BCA Defense index are: LMT, GD, RTN, NOC, LLL. Rising Global Threats Are A Boon To Defense Stocks Rising Global Threats Are A Boon To Defense Stocks

A capex revival is underway, powered by exceptionally strong business and consumer sentiment, the breadth of which covers virtually all developed economies. This global capex upcycle should underpin top-line growth and margin expansion for the industrial conglomerates index, whose product and geographic diversification ensures exposure to the global upswing. However, the index has underperformed the broad market, dragged down by heavyweight GE and its specific headwinds. Further, the index's highest exposure sectors (namely aerospace, health care equipment, energy equipment & services and utilities) are mostly weighted negatively in our overall sector view. Adding it up, the negatives offset the positives and, in the context of fair valuations, we expect the S&P industrial conglomerates index to perform in line with the overall market. We are initiating coverage with a neutral rating. The key theme that has been driving our investment thesis in U.S. Equity Strategy in the past quarter has been accelerating global industrial production and trade, with a corresponding rotation out of defensive and into cyclical stocks. We have been adjusting our portfolio accordingly and it now has a deep cyclical bent with leverage to a burgeoning capex cycle. Enticing Macro Outlook Industrial conglomerates capitalize on most of these themes: they are globally-oriented and capex-driven, and leading indicators of final demand suggest that earnings should accelerate in the near-term. Capex Upcycle On the domestic front, regional Fed surveys of domestic capex intentions and the ISM manufacturing survey are hitting modern highs; both have been excellent indicators of a capex upcycle and the signal is unambiguously positive (Chart 1). Our Capex Indicator also corroborates this message. Durable goods orders have already surged and inventories have reverted to a more normal level, coming out of the late-2015/early-2016 manufacturing recession (Chart 2). This implies increasingly resilient pricing power from a demand-driven capital goods upcycle. Further, the capital goods cycle has significant room to run as new orders remain well below the 2013-2014 levels. Chart 1Exceptionally Strong Sentiment... Exceptionally Strong Sentiment… Exceptionally Strong Sentiment… Chart 2...Is Already Reflected In A Capex Upcycle …Is Already Reflected In A Capex Upcycle …Is Already Reflected In A Capex Upcycle Chart 3Capital Goods Demand Is Globally Synchronous Capital Goods Demand Is Globally Synchronous Capital Goods Demand Is Globally Synchronous The global picture echoes the domestic, with the global manufacturing PMI surging to a six-year high. The global strength is remarkably broad: all 46 of the economies tracked by the OECD are expected to see gains in 2017, a first since the GFC, and the BCA global leading economic indicator is signaling all-clear (Chart 3). U.S. Dollar Reflation The greenback's slide in 2017 should further boost global demand for domestic exports. In fact, given the diversity of industries served by the industrial conglomerates and the relatively high proportion of foreign sales (Table 1), the U.S. dollar is the single largest driver of both sales and earnings (Chart 4). Due to the lagged impact on results from the currency, industrial conglomerates margins should benefit from translation gains in the next two quarters, regardless of where the U.S. dollar moves. Table 1Conglomerates More Global Than Industrial Peers Industrial Conglomerates: Rebooting Industrial Conglomerates: Rebooting Chart 4U.S. Dollar Drives Conglomerate Profits U.S. Dollar Drives Conglomerate Profits U.S. Dollar Drives Conglomerate Profits But GE Weighs On The Index With the enormously supportive demand environment in mind, one could safely assume that the globally integrated niche industrial conglomerates index has been a strong performer in 2017. That would be true were it not for index heavyweight (and laggard) General Electric. Excluding GE from this index, industrial conglomerates have outperformed the S&P 500 by 20% since the start of the year (Chart 5). However, GE represents 40% of the index (Chart 5) and its current transformation continues to weigh heavily on its share price and, hence, the index at large. The new CEO, who took over earlier this month, has stated that "everything is on the table" as part of a $20 billion target for divestitures over the coming two years. The current fear among investors is that GE will need to reduce its dividend to preserve enough liquidity to continue growing despite the fairly synchronous storm in its end-markets. In March, 2009, GE's share price reached its modern nadir, a level not seen since the recession of the early 1990's, a week following its dividend cut announcement. While hardly analogous to GE today (recall that a cash crisis at GE Capital threatened to bankrupt the entire firm), the risk of a dividend cut will keep GE's share price suppressed, and likely hold the overall index hostage. Payout ratios in the industrial conglomerates index reflect GE's cash flow woes and have now surpassed the pre-dividend cut level during the GFC (Chart 6). This largely reflects cash contraction, combined with an unwillingness to even halt dividend growth. Regardless, GE investors clearly anticipate the new CEO will reduce the dividend, having pushed the yield to its highest level since the last dividend cut (Chart 6). Chart 5GE Still Dominates The Index GE Still Dominates The Index GE Still Dominates The Index Chart 6A Dividend Cut Looks To Be In The Cards A Dividend Cut Looks To Be In The Cards A Dividend Cut Looks To Be In The Cards Soft End-Markets Backdrop From the mid-1990's until 2007, the narrative of the S&P industrial conglomerates index was the rise and fall of GE Capital, as evidenced by the index' price. In 2015, the now largely complete sale of the majority of GE Capital was announced, realigning the company as an industrial manufacturer. Accordingly, analyzing the key end-market industries that the S&P industrial conglomerates cater to is in order: aerospace, healthcare, oil & gas and utilities. Chart 7Aerospace Profits Look Set To Fall Aerospace Profits Look Set To Fall Aerospace Profits Look Set To Fall Chart 8Health Care Equipment Pricing Collapsing Health Care Equipment Pricing Collapsing Health Care Equipment Pricing Collapsing Aerospace (Underweight recommendation) - We downgraded the BCA aerospace index to underweight at the end of 2015, corresponding fairly closely to the peak of the aerospace orders cycle (Chart 7). Since then, orders have fallen by half reflecting a downturn in the commercial aerospace cycle. While shipments have been falling, the decline has been much less precipitous as manufacturers have been running down backlogs. Historically, maintenance has buffered aerospace profits, repair and consumables activity, though weak current pricing power suggests that this may prove less sustainable than in previous cycles. Both GE & HON share extensive exposure to aerospace demand as it represented 23% and 38% of 2016 revenues, respectively. Health Care Equipment (Neutral recommendation) - We reduced our recommendation to neutral earlier this year as weaker demand no longer supported the thesis of an earnings-led outperformance. Since then the industry's outlook has not improved as demand has downshifted and pricing has cooled substantially; orders and production both crested last year and pricing power has contracted relative to overall since December 2016 (Chart 8). This bodes ill for medical equipment margins. Health care equipment represented 16% and 18% of GE & MMM 2016 revenues, respectively. Energy Equipment & Services (Overweight recommendation) - Energy Equipment & Services is our only overweight recommended sector relevant to the industrial conglomerates analysis. We upgraded in late 2016 (and doubled down on June 2) based on three key factors: troughing rig counts, cresting global oil inventories and falling production growth. Two of these factors have come to fruition: the global rig count bottomed in 2015, and has staged its best recovery since 2009 (Chart 9) and the growth in total OECD oil stocks is moderating rapidly with recent large storage draws. The key missing ingredient has been pricing power, which should eventually turn up if rig counts prove resilient. Energy equipment & services represented 11% of GE's 2016 revenues. Utilities (Underweight recommendation) - As previously noted, a key macro theme in U.S. Equity Strategy is accelerating global industrial production and trade. Utilities tend to move in the opposite direction of that theme given their safe haven status (top panel, Chart 10). Combined with falling domestic electricity production and capacity utilization, and rising turbine & generator inventories, the industry's outlook is bleak (middle & bottom panels, Chart 10). GE's Power segment is one of the world's largest gas and steam turbine manufacturers and delivered 24% of 2016 revenues. Investment Recommendation A roaring, globally synchronous capital goods upcycle should mostly keep sales and profits buoyant in this industrials subsector. However, high concentration in one stock, which is experiencing a greater than normal amount of flux, adds significant specific risk. Further, we are less optimistic about the key industries served by the industrial conglomerates than we are for the economy at large, implying more opportunity for outperformance from other, more focused, S&P industrials peers. If valuations were particularly compelling they could provide a cushion to any profit mishap, but this is not the case. Our Valuation Indicator is in the neutral zone and, while our Technical Indicator is in oversold territory, it has shown an ability to remain at these levels for prolonged periods (Chart 11). Chart 9Energy Services Is A Bright Spot Energy Services Is A Bright Spot Energy Services Is A Bright Spot Chart 10Utilities Are In A Deep Cyclical Decline Utilities Are In A Deep Cyclical Decline Utilities Are In A Deep Cyclical Decline Chart 11Valuations Are Not Compelling Valuations Are Not Compelling Valuations Are Not Compelling Bottom Line: Netting it out, we think the S&P industrial conglomerates index should perform broadly in line with the overall market. Accordingly, we are initiating coverage with a neutral rating. The ticker symbols for the stocks in this index are: BLBG: S5INDCX - GE, MMM, HON, ROP. Chris Bowes, Associate Editor U.S. Equity Strategy chrisb@bcaresearch.com

Underweight For most of this decade, U.S. airline pricing power and the price of jet fuel have moved in lockstep (second panel) i.e.: airlines have been able to pass through their primary input cost. However, this relationship has broken down since the end of 2016 as the industry has been locked in a price war between low cost carriers and the largely-restructured legacy airlines. The result has been a coincident fall in operating margins (bottom panel). The disruption to U.S. refining capacity and distribution of refined products from Hurricane Harvey seems likely to keep the price of jet fuel elevated and exacerbate the decline in near-term operating margins. Until recently, investors have shrugged off tumbling margins with expanding valuation multiples (bottom panel), though that appears to have turned early this summer; the S&P500 airlines index has been in freefall since. With higher costs a certainty in Q3, no relief from aggressive pricing and the longevity of higher jet fuel prices an unknown, it still doesn't pay to be long airlines. Stay underweight. The ticker symbols for the stocks in this index are: BLBG: S5AIRL: LUV, ALK, AAL, UAL, DAL. Mayday! Mayday!