Aerospace & Defense

The gap between the BCA Defense and BCA Aerospace indexes has widened considerably as their respective outlooks have diverged. Aerospace orders have fallen by more than half from their peak in 2013, while defense orders appear to be gaining steam. The domestic outlook for defense remains bright. The Trump administration requested an increase of nearly 10% for the 2018 DoD budget. Further, the House authorized a spending level well in excess of what the President asked for with wide bipartisan support, indicating strong political weight behind expanding defense budgets. The international picture too seems promising; exports are booming as global austerity is receding (bottom panel). Anecdotally, the last several months have seen a number of multi-billion dollar international orders which should pad backlogs for several years. Net, an earnings driven rally seems still in the early stages. Stay overweight. The ticker symbols for the stocks in the BCA Defense index are: LMT, GD, RTN, NOC, LLL. Defense Stocks Have Surged; Is The Next Up Leg Coming? Defense Stocks Have Surged; Is The Next Up Leg Coming? Defense Stocks Have Surged; Is The Next Up Leg Coming?

Geopolitical tensions in the South China Sea are here to stay; China has reached the ability to impose massive costs on any state that tries to roll back its control; U.S. advantages in the region are significant, but declining and overrated. We put together a portfolio of stocks that give investors exposure to the ongoing tensions in the South China Sea. Dear Client, Today's Special Report is jointly authored by BCA's Geopolitical Strategy and Emerging Markets Equity Strategy services and focuses on the tail risks around the South China Sea conflict. In this report, our colleagues Matt Gertken of the Geopolitical Strategy and Oleg Babanov of the Emerging Markets Equity Sector Strategy ask whether China has "won" the South China Sea, and what the implications might be for investors. At the end of the report, we provide detailed investment recommendations for both EM-dedicated as well as global investors. Kindest Regards, Garry Evans Senior Vice President EM Equity Sector Strategy Marko Papic Senior Vice President, Geopolitical Strategy "We're going to war in the South China Sea in five to 10 years ... There's no doubt about that." - Steve Bannon, prior to becoming President Donald Trump's Chief Strategist, Breitbart News, March 2016 The South China Sea is a headline grabber that has failed to produce any market-disruptions despite years of rising tensions. In fact, it would appear that the issue has been relegated to the backburner, with the Trump administration laying off its earlier aggressive rhetoric and America's Asian allies focusing on building a trade relationship with China. Compared to the Koreas, in particular, where geopolitical risk is spiking due to political turmoil in the South and weapons advances in the North, the South China Sea seems relatively calm.1 We are not so sanguine, however, and advise investors to take the tail-risk of a conflict in the South China Sea seriously. First, there has been a general "rotation" of global geopolitical risk from the Middle East to Asia Pacific, as BCA's Geopolitical Strategy has chronicled over the years.2 China's transformation into a "peer" or "near-peer" competitor to the United States, and the U.S.'s various reactions, are transforming the region and sowing the seeds of a new Cold War. Second, despite a thaw in the relationship between China and the Trump Administration, the latest positive signals have not extended to the South China Sea.3 In North Korea, China is offering to enforce sanctions. In Taiwan, Trump has backed away from hints of encouraging independence. But in the South China Sea, the two sides have increased activity even as they have made reassuring statements.4 Third, fact remains that despite headline grabbers, China has managed to expand its military installations in the region over the past half-decade and now possesses a layered-defense system in the region. In this report, we ask whether China has "won" the South China Sea, and what the implications might be for investors, particularly EM-dedicated investors, on the sectoral level. We find that China has reached the ability to impose massive costs on any state that should try to roll back its control of the disputed islands. We also do not think that the U.S. is ready to accept this new Chinese "sphere of influence." This means that the two countries are in a "gray zone" in which policy mistakes could occur. This uncertainty is driving the odds of a crisis higher. China is flush with recent victories in the islands, and yet the United States will continue to insist on free passage and the defense of allies and partners. Nationalism and rising jingoism in both countries also raises the odds of misunderstanding and miscalculation. Until the Trump and Xi administrations agree to a robust strategic deal that arranges for de-escalation, the South China Sea will remain a source of low-probability, high-impact geopolitical risk for investors. It is only one aspect of a broader deterioration in U.S.-China relations that we see as the ultimate driver of a secular rise in geopolitical risk in Asia Pacific.5 Unfortunately, history also teaches us that such "strategic resets" are normally motivated by a dramatic crisis. At the end of this report, we provide investment recommendations for investors in emerging markets (and a couple for the U.S. as well). Why Not Ignore The South China Sea? Map 1Nine-Dash Line Reaches Far Beyond China The South China Sea: Smooth Sailing? The South China Sea: Smooth Sailing? Maritime territorial disputes between China and several of its neighbors - Taiwan, Vietnam, the Philippines, Malaysia, Brunei, and partly Indonesia - have a long history. China declared its "Nine Dash Line," an expansionist claim of sovereignty over almost the entirety of the sea, in 1947 (Map 1). Since then, conflicts have flared up sporadically. The most notable skirmishes illustrate that the maritime disputes are always simmering but tend to boil over only when larger geopolitical issues heat up.6 Since the 1990s, China and the other claimants have raced to "grab what they can," particularly in the Spratly Islands. However, conflicts have especially intensified since the mid-2000s (Charts 1 and 2). A major factor has been the rise in competition for subsea resources: Chart 1Territorialism Rising In South China The South China Sea: Smooth Sailing? The South China Sea: Smooth Sailing? Chart 2Rising Number Of Confrontations The South China Sea: Smooth Sailing? The South China Sea: Smooth Sailing? Energy and minerals - Although estimates vary widely, the South China Sea contains respectable reserves of oil and natural gas (Chart 3) and there are also hopes of extracting other minerals from the sea floor. Most of the region's states are net importers. Several conflicts have been sparked by exploration, test drilling, and unilateral development.7 It is a fact that the past decade's buildup in tensions has coincided with a global bull market for energy prices and offshore energy investment and capex (Chart 4). Chart 3Not Insignificant Reserves Of Oil And Gas In South China Sea The South China Sea: Smooth Sailing? The South China Sea: Smooth Sailing? Fishing Grounds - The South China Sea holds vast fish resources, a source of food security, exports, and jobs for littoral countries. It is estimated that over 10% of global fishing catches come from here. Fishing as a whole accounts for about 1-3% of GDP for the countries involved in the disputes (Chart 5), and the South China Sea is a large chunk of that. A quick glance at recent skirmishes reveals that fishing rights are a major cause of conflict (Table 1). Chart 4Offshore Oil Production In Decline Offshore Oil Production In Decline Offshore Oil Production In Decline Chart 5Fisheries Non-Negligible For Asian States Fisheries Non-Negligible For Asian States Fisheries Non-Negligible For Asian States Table 1Notable Incidents In The South China Sea (2010-16) The South China Sea: Smooth Sailing? The South China Sea: Smooth Sailing? Nevertheless, resource extraction is not the main driver of discord. Frictions spiked in 2015-16 despite the collapse in China's and other countries' offshore rig counts (Chart 6). And fishing rights are also clearly a pretext for attempts to assert control over waters and rocks.8 Chart 6Energy Interest Declining, Tensions Still Elevated Energy Interest Declining, Tensions Still Elevated Energy Interest Declining, Tensions Still Elevated Moreover, China's conversion of the sea's various geographical features into artificial islands through a process of land reclamation, and its construction of military facilities and stationing of armaments on these islands, points not to strictly economic interests but to broader strategic security interests. Similarly, the United States' enforcement of international rights of free navigation and overflight is not related to oil and fish. What is really at stake is national security, supply-line control, and international prestige. First, the United States has long executed a grand strategy of preventing any country from forming a regional empire and denying the U.S. access. China has the long-term potential to make this happen, and the South China Sea is its earliest foray into empire-building abroad. (Taiwan, Xinjiang, and Tibet are all old news and expand Chinese hegemony into the largely useless Eurasian hinterland.) Second, the main global trading lines from Eurasia and Africa to and from Asia mostly go through the South China Sea and the Spratly Islands. We illustrate this process through our diagram of the sea as a large traffic roundabout (Diagram 1). China is attempting to control the centerpiece of the roundabout, which - in combination with China's southern mainland forces - would eventually give it veto power over transit. Diagram 1South China Sea As A Vital Supply Roundabout The South China Sea: Smooth Sailing? The South China Sea: Smooth Sailing? The economic value of the trade potentially affected by power struggles is what makes this all highly market relevant if a full-blown war ever occurs. We estimate that roughly $4.8 trillion worth of trade flowed through this area in 2015, which is comparable to the $5.3 trillion estimate from 2012 frequently cited in news media.9 Moreover, the trade does not consist merely of manufactured goods from Asian manufacturing centers but also basic commodities vital to the Asian countries' economic and political stability. Essential commodities account for about 20-35% of Northeast and Southeast Asian imports, and almost all of this by definition flows through the South China Sea (Charts 7 and 8). Chart 7Commodity Imports Go Through South China Sea... Commodity Imports Go Through South China Sea... Commodity Imports Go Through South China Sea... Chart 8...And Greatly Affect Asian Economies ...And Greatly Affect Asian Economies ...And Greatly Affect Asian Economies The numbers belie how vital the supply lanes are for individual countries: Japan, for instance, gets 80% of its oil via the South China Sea. A total cutoff would be devastating after strategic reserves were exhausted; and even a marginal hindrance of energy imports would bite into the current account surpluses that grease the wheels of high-debt Asian economies. The South China Sea is therefore vital even to countries like Japan and South Korea that are not party to the maritime-territorial disputes. A commerce-destroying war could strangle their economies. Military access is another reason states seek control. This is separate but related to the need to secure economic supplies. Chinese military planners are clear that they want to be able to deny access to foreign powers if need be, in order to secure the southern half of the country, or cut off Taiwan's or Japan's supply lines. American military planners are equally clear that they will not allow a state to deny them access to international commons, or to coerce others through supply-lane control.10 Finally, there are political and legal aspects to the South China Sea disputes. China's successful alteration of the status quo in the face of opposition from the U.S., Asian neighbors, and a high-profile international tribunal (the Permanent Court of Arbitration at the Hague), has undermined international legal institutions and the U.S. prestige in the region. Over time, regional states, perceiving that "might makes right," may feel the need to cling more closely to China or the U.S., giving rise to proxy battles.11 With supply security and national defense at risk - and China in the process of "militarizing" the islands - there is a rising probability of a major "Black Swan" incident. The involvement of a number of major powers and minor allies means that a small incident could escalate into something significant. The friction between U.S. global dominance and China's rising regional sway is the chief source of instability. China could agree to a "Code of Conduct" with the Asian states possibly as early as this year. But without improvement in U.S.-China relations, the geopolitical consequences of such a code will be moot. Southeast Asian risk assets could benefit temporarily, but the chief tail-risks of the U.S. and China falling out would be unresolved. Bottom Line: He who controls the sea routes controls the traffic. China has made an overt bid for the ability to govern the sea routes and deny foreign powers access to the sea. The U.S. has threatened forceful responses to acts of "area-denial" or military coercion. Thus, geopolitical uncertainty and risks in the region remain elevated. How Do The Contenders Size Up? If China had clearly achieved full control of the waterways, airways, and geographical features of the South China Sea, then geopolitical risk over the area might decline. Countries would adjust to Beijing's rules of the game and the region would enter a period of hegemonic stability. The reason we are in a gray area today is that China has not yet reached dominance. China's advantages are significant, growing rapidly, and underrated; meanwhile the U.S.'s advantages are significant, declining, and overrated. A simple comparison of the U.S.'s and China's military advantages and disadvantages will make this clear. China Considering that the South China Sea is China's backyard, the country has a major advantage of playing on its "home court" versus the United States. China can afford to concentrate its military capabilities and planning specifically on its near seas, whereas American resources are dispersed globally and reduced to an "expeditionary force" when operating in China's neighborhood.12 Even so, the People's Liberation Army (PLA), Navy (PLAN), and Air Force (PLAAF) have major obstacles to overcome if they are to contend with American forces. Until relatively recently, China's defense buildup focused on traditional ground capabilities, creating weak spots in its ability to project military power over the South China Sea. What matters is whether China has addressed these shortfalls sufficiently to raise the costs of U.S. intervention to a prohibitive level. So far, it is attempting to do so in the following ways: Sea Power - China's naval capabilities have generally lagged far behind those of the U.S. and Japan. An important step was the commissioning of China's first aircraft carrier, the Liaoning, in 2012. It is a renovated Soviet carrier of the type that Russia has recently used in Syria. A second carrier, Shandong, is 85% complete and set to be commissioned in 2018 - it is an indigenously produced copy of the former. It is set to be stationed in Hainan, which will influence the balance of power given that the U.S. only has one carrier permanently in the region (though several more dock in San Diego). A third carrier is slated for 2022 and expected to be stationed in the South China Sea. The navy has also significantly increased China's logistic and support capabilities in the area, with amphibious warships and air cover. China has also vastly expanded its destroyers and smaller ships. Only its submarine capabilities face serious doubts about the degree of improvement and capability. Air Transport - China's naval and air force lifting capabilities, necessary to transport troops and equipment quickly to disputed territories, were initially very limited. But in recent years, China has improved these capabilities. Considering satellite pictures of the Spratly and Paracel Islands with new hangars and landing strips, China has made considerable progress toward the goal of quick material and troop supply for the islands. Of course, it is notoriously difficult to resupply small scattered islands amid enemy disruptions, but it is also difficult to disrupt without committing more than one aircraft carrier wing to the problem. Clearly China's capacity has improved. Infrastructure - China has converted Hainan, its southernmost island (and smallest province) into a major military and logistics base. Its new Yulin Naval Base can host up to 20 nuclear submarines as well as two carrier groups and several assault ships. This is China's "Pearl Harbor," and unlike the American version, it is in the South China Sea. Meanwhile, on the disputed islands, China had not built infrastructure until very recently. It was in fact the last of the island claimants to pave an airstrip. But its construction has been bigger, faster, and more ambitious - including for air transport, fighter jets, and surface-to-air and anti-ship missiles, all of which have added greatly to its ability to deny the U.S. access to the sea. Air Power - One of the main issues the PLAAF had over the years was the limited radius of its fighter planes, which would not allow full air superiority in the South China Sea. Airfield infrastructure was built on the disputed islands so that fighter planes could be stationed closer to the area. China therefore does not possess just one aircraft carrier, but rather numerous ones if we think of islands as aircraft carriers. Also, Russia is delivering to China a number of multirole fighters that can cover the South China Sea from bases on the mainland. And China's fifth-generation fighter is coming along. By far the most significant military development in China's arsenal, however, is its development of short- and medium-range missiles. This development greatly increases the danger to American ships and aircraft seeking access to the region. First, China has concentrated on building short-range, DF-21D "Carrier Killer" anti-ship missiles, which pack enough punch to take out an American aircraft carrier with one hit, and which the U.S. has limited means to defend against.13 China has also paraded around the DF-26 intermediate-range ballistic missile, or "Guam Killer," which can reach as far as Guam, can carry a nuclear charge, and has a mobile launch platform that would be difficult for U.S. forces to detect and knock out before the launch. In turn, the U.S. has deployed Terminal High-Altitude Area Defense (THAAD) missile systems in Guam and South Korea in preparation for precisely this kind of attack.14 Second, China has amassed around 500 surface-to-air missiles on Hainan Island, waiting to be shipped to the disputed rocks. The armory consists of a combination of short-, medium-, and long-range missiles to create a layered air-defense perimeter. Satellite images of the islands show that China has also positioned short-range and medium-range missile systems on some of the islands, namely Woody Island in the Paracels. Finally, China has fielded better radar systems to gain full coverage of the South China Sea (as well as other nearby waters) in order to find or guide friendly or hostile ships or planes and to support the various activities of its air and ship defenses. This combination of radar and missile capabilities amounts to a game changer. They make it possible for China to raise the costs of conflict to such a level that the United States might balk. Will the U.S. seek to change the balance of power with force? No. But Washington has reaffirmed its "red lines" in the region, namely freedom of passage. This was the takeaway from Secretary of Defense James Mattis's first foreign trip, not incidentally to Japan and South Korea. Mattis indicated that freedom of passage is "absolute" not only for the U.S. merchant fleet but also for the navy. However, he also said the U.S. will exhaust "diplomatic efforts" and eschew "any dramatic military moves" in the South China Sea, while maintaining the U.S.'s neutrality on sovereignty disputes. This is status quo, and the status quo favors China's rapidly growing ability to deny others' access to the area. The United States The U.S. has several bases in the Indo-Pacific area, with ground, air, naval, and marine assets. It also has extensive experience conducting wars and special operations in East Asia. Yet despite this dispersed and historic basing, China poses a challenge the likes of which it has not seen in the region. The distances to be covered, the complexities of the logistics, and China's growing strengths, make any U.S. intervention in the South China Sea harder than is typically assumed. The U.S.'s key five bases make these advantages and disadvantages clear: Guam, with almost 6,000 troops, will most likely be the first base to respond to a threat in the South China Sea, or to become engaged in a conflict there. It hosts part of the Seventh Fleet, including a ballistic-missile submarine squadron. It would be a key launch pad for regional operations. It could also be an early target for China's long-range ballistic missiles in a major conflict. Guam sits almost 3,000km from the South China Sea. South Korea hosts one of the U.S.'s oldest and largest regional deployments, with about 28,000 troops. Korea hosts the Eighth U.S. Army and Seventh Air Force, as well as Special Operations Command Korea. Its chief advantage is its proximity to China. However, assuming a conflict involves no direct engagement with mainland China, Korea comes with some disadvantages. Most of the ground staff is located around the North Korea border. The U.S. command in the region will be wary of lifting troops from the border and exposing its northern flank. North Korea (or conceivably China itself) could take advantage of U.S. distraction in the South China Sea. At the same time, the operational radius of planes on the Osan Air Base would not allow direct engagement in the South China Sea, though they could cover the southeast to hinder any maneuvers of the Chinese air force. Japan is the United States' largest overseas deployment with about 49,000 troops - heavily tilted toward naval and air power. The Fifth U.S. Air Force is spread across three main bases in Misawa, Yokota, and Kadena, while the Seventh Fleet is the largest forward-deployed U.S. fleet. It has several powerful task forces including the aircraft carrier USS Ronald Reagan and naval special warfare, amphibious assault, mine warfare, and marine expeditionary forces. The strong presence and firepower of this fleet as well as its maneuverability make it the prime candidate for any sort of engagement in the South China Sea (or East China Sea for that matter). The air bases around Tokyo and Okinawa can provide air support down to Taiwan and run airlift operations down to China's Hainan Island, the base of China's southern fleet. The only disadvantages stem from vulnerability to layered air defense and long supply lines for the navy, which will become targets after any lengthy engagement. Moreover, U.S. Forces Japan lack large ground units to organize landing operations, which will need to be sourced from South Korea or Hawaii. Hawaii is the home of the U.S. Pacific Command, which oversees regional forces, and contains sizable ground units to reinforce regional bases. It hosts the U.S. Army Pacific, U.S. Pacific Air Forces, and the U.S. Pacific Fleet stationed in Pearl Harbor (with a second base in San Diego). Hawaii has a large ground troop presence, which, together with U.S. air-lift capabilities, would provide the main ground forces for offensive operations. The large fleet secures U.S. presence in the region. Hawaii would host and resupply the core of any naval operations in the South China Sea. The only disadvantage is geographic: the distance to any U.S. ally's territory is significant, and main operational areas in the South China Sea cannot be reached in a single lift. This means that troop and equipment movement will take time and will not go unmolested. In any scenario involving land operations, the redeployment of troops will give the other side time to prepare. Alaska is also worth mention as it houses infantry brigades and air force combat units, albeit no significant naval presence. We only give small consideration to the base here because of its proximity to Russia. Assuming the neutrality of Russia during a hypothetical conflict, the U.S. would still be unlikely to draw resources from Alaska to aid operations in the South China Sea, since that would leave its own territory exposed to some degree. Other Allied Bases - We do not feature other allied bases in the region mainly because of the small numbers of troops that can be deployed and the low capabilities of U.S. allies. Some countries, such a Singapore, which has a respectably army, could disappoint the U.S. by trying to remain neutral. The most reliable help would come from Japan and Australia, but even Australia would face a very intense internal dilemma as a result of its economic dependency on China. South Korea would also be preoccupied with North Korea's ability to take advantage. A quick survey of the "order of battle" of the U.S. and China in the region would make our assertion that China has gained supremacy laughable. Then again, geopolitics does not work in ceteris paribus terms. Yes, the U.S. maintains military hegemony in the region, but China's abilities to impose real pain on American naval forces creates a complicated political dilemma for the U.S.: is Washington prepared to expend blood and treasure to defend allies and their supply lines in case of a conflict over this area? China is not yet looking to project power globally. It is not actively trying to compete for supremacy with the U.S. in the Persian Gulf, Indian Ocean, or Caribbean Sea. As such, it can concentrate its forces in the South and East China Seas and dedicate its entire naval strategy to the sole purpose of denying the U.S. navy access there. The U.S., meanwhile, has to plan for a global confrontation and then dedicate a portion of its forces to China's home court. Japan may very well hold the balance of power in a potential conflict over the region. Its import dependency is at the core of its national psyche and it would view a Chinese blockade of the South China Sea as an existential threat - not unlike the American threat of oil embargo that precipitated war in the early 1940s. Japan is not likely to go rogue, but it would be a tremendous addition to the American effort, even in a situation where other states refrained from action out of fear. However, while China will see the above as a reason not to initiate armed conflict with the United States, it will not be able to retrench in the South China Sea in the face of domestic nationalism either. These pressures virtually ensure that it is locked into the assertive foreign policy it has pursued over the past ten years. Bottom Line: A simple analysis of the current disposition shows that the military capabilities of the two countries - in this limited theater - are not as disparate as one might think. Both sides have weaknesses: the U.S. is bound to a handful of distant bases and has a global range of obligations and constraints, while China lacks technology, experience, and cooperation among its military branches. Nevertheless, China is approaching full air and sea cover of the area within the Nine Dash Line (Map 1) and is rapidly gaining greater ability through radar and missiles to inflict politically unacceptable damage on the U.S. The U.S.'s interest in the South China Sea is ultimately limited to free passage and the defense of treaty allies. The Trump administration is primed to strengthen the country's rights and deterrence, namely through a large increase in defense spending that focuses heavily on the navy - aiming at a 600-ship fleet - and likely on Asia Pacific. In the context of a massive new assertion of U.S. regional presence and power, it is significant that China has not yet given any concrete indication of slowing down its island reclamation, militarization, or control techniques. Investment Implications BCA's Geopolitical Strategy has been warning clients of the rising risks in the South China Sea, and East China in general, since 2012. However, it has been a challenge to construct an investment strategy based on our view. For starters, it is unclear when the crisis could emerge. It is difficult to know when accidents and miscalculations will happen. What we can say with some degree of certainty, however, is that the window of opportunity for any realistic campaign to reverse the militarization of the disputed islands will probably be closed by the end of this year. By "realistic," we mean operations that would promise control over the disputed territory with a calculated degree of risk and an acceptable degree of casualties. At the same time, the U.S. still has the ability to win a full-blown war with China. We have not addressed scenarios like cutting off China's oil supplies at the Strait of Hormuz, for instance, but have limited our discussion to a conflict in the South China Sea over control of the newly militarized islands. In that context, the American threshold for pain is low and its military advantages are narrowing. We are therefore entering a danger zone now because both China and the U.S. stand at risk of becoming overly assertive in the near future: Chart 9Will Trump Seek Political Recapitalization Via Conflict? The South China Sea: Smooth Sailing? The South China Sea: Smooth Sailing? China because it has domestic nationalist pressures that the Communist Party needs to vent as the economy slows; The U.S. because it has an unpopular (Chart 9), nationalist leadership that seeks to increase its defense presence in the region and may fall to brinkmanship in order to extract major trade concessions from Beijing. The tail-risk in the South China Sea suggests that global investors should also continue to hedge their exposure to risk assets with exposure to safe-haven assets receptive to geopolitical risk, like gold, Swiss bonds, though perhaps not U.S. Treasuries. The persistence of Sino-American distrust - beyond whatever happy encounter Trump and Xi may have at Mar-a-Lago in April - suggests that Chinese economic policy uncertainty will remain elevated and global financial volatility to rise. U.S.-China tension also feeds our broader narrative of rising mercantilism and protectionism. Investors will want to overweight domestic-oriented economies, consumer-oriented sectors, and small cap companies relative to their export-oriented, manufacturing, and large cap counterparts. We also recommend that EM-dedicated investors be wary about Asian states caught in the middle of de-globalization and vulnerable to geopolitical tail-risks. We are neutral to bearish on South Korea, Taiwan, and the Philippines. Our long Vietnam equities trade has been downgraded to tactical. We prefer Thailand and Japan, U.S. allies that are removed from conflict zones (Thailand) or domestically oriented and reflationary (Japan). We are also long China relative to Hong Kong and Taiwan, given the risks of both de-globalization and Chinese political troubles for the latter two. We are bullish on U.S. defense stocks.15 The U.S. defense establishment is conducting extensive reviews of the navy's force structure and future strategic needs - the fleet peaked in 1987 and fell below 300 battle force ships in 2003, but has projected that 355 battle force ships is necessary. This would require a major injection of funds in the coming decade. The Trump administration has endorsed this assessment in principle and is planning a significant increase in defense spending, marked by a requested increase of $50 billion in his first annual budget. Trump has signaled that defense manufacturing, notably shipbuilding, will be one of the ways in which he seeks to boost American manufacturing and jobs. This plays to his blue-collar base of support and could move the needle in battleground states like Virginia. It should be beneficial on the margin for U.S. defense companies.16 Below are our corporate-level recommendations for both EM-dedicated and global investors. The Companies Given the likelihood that tensions in the SCS will continue, and the projected build up in defense spending in both the U.S. and China, EMES recommends investors look to take exposure to defense stocks. We have put together a portfolio of such stocks that is intended to give exposure to the developments between China and the U.S. in the South China Sea. We recommend the following basket of companies: AviChina Industry & Technology (2357 HK); AVIC Jonhon Optronic (002179 CH); AVIC Helicopter Company (600038 CH); AVIC Aviation Engine Corporation (600893 CH); China Avionics Systems (600372 CH); Huntington Ingalls Industries (HII US); General Dynamics Corporation (GD US). The basket consists of four Chinese defense companies, mostly centered around the aviation industry. The choice of listed companies in China is constrained and hence we have been forced to gain exposure through aviation companies rather than naval. We recommend two companies in the U.S. that are involved in military vessel production for the U.S. Navy. We believe that the main ramp-up in defense spending from the U.S. side will come through a significant increase in the number of ships in the Asian region. Chart 10Performance Since March 2016: ##br## AviChina Vs. MSCI EM Performance Since March 2016: AviChina Vs. MSCI EM Performance Since March 2016: AviChina Vs. MSCI EM AviChina Industry & Technology (2357 HK): Chinese aviation holding company (Chart 10). AviChina is the listed subsidiary of the government-controlled Aviation Industry Corporation of China (AVIC). Airbus is another large shareholder, with over 11% of the free float. The company produces dual-purpose aircraft - civil and military -- including helicopters, trainers, parts and components (including radio-electronic), avionics and electrical products and components. AviChina itself is a holding company with a rather complicated structure, which makes it difficult for investors to access its market value. Listed subsidiaries include AVIC Helicopter Company (600038 CH), China Avionics (600372 CH), AVIC Jonhon Optronic (002179 CH) and Hongdu Aviation (600316 CH). In terms of the revenue stream, 49% is generated from whole aircraft production, 28% from engineering services and another 23% from parts and components manufacturing. The company reports semi-annual results. The latest full-year report released on March 15 came out mixed. Revenues were strong, up 39% year over year, but costs accelerated at a faster pace (+45% year over year). Operating income was still strong, growing 12.3% year over year, but margins declined across the board. EBITDA margin contracted by 257 basis points to 9.94%, while operating margin fell by 170 basis points to 7.32%. Despite this, the bottom line still managed to grow by 18.75% year over year. AviChina is currently trading at a forward P/E of 21.2x, whilst the market estimates an EPS CAGR of 9.5% for the next three years. Chart 11Performance Since March 2016: ##br## AVIC Jonhon Optronic Vs. MSCI EM Performance Since March 2016: AVIC Jonhon Optronic Vs. MSCI EM Performance Since March 2016: AVIC Jonhon Optronic Vs. MSCI EM AVIC Jonhon Optronic (002179 CH): Profiting from growing military and EV spending (Chart 11). A subsidiary of AVIC and AviChina, the company specializes in production of optical and electric connectors (third largest in China), and cable components. Jonhon is unrivalled in the defense market. It profits from rising electronic content and from supplying major components to other parts of the AVIC group, shipbuilders, railways and aerospace. It is also successfully developing its civil offering, specifically for the fast-growing electric vehicle market and the 4G space in the telecoms industry. Looking at the revenue composition, 54% is generated by sales of electric connectors, a further 24% from fiber-optic cables, and 19% from conventional cable and assembly products. As for the civil-military split, the company is expected to receive 60% of total revenues from its civil applications, growing approximately 10% per annum. Jonhon Optronics reported its full-year results on March 15. Revenues saw a strong increase, jumping 23.7% year over year. Cost growth was also higher, though it slowed from the previous year (up 23.8% year over year). This led to an operating profit increase of 19.7%, but slight margin deterioration. EBITDA margin fell by 77 basis points to 16.98%, and operating margin was down 5 basis points to 14.32. On the other hand, profit margins improved to 12.6% (up 54 basis points) as the bottom line grew by 29.8% year over year. Jonhon Optronics is currently trading at a forward P/E of 24.4x, whilst the market estimates an EPS CAGR of 15.2% for the next three years. Chart 12Performance Since March 2016: ##br## AVIC Helicopter Company Vs. MSCI EM Performance Since March 2016: AVIC Helicopter Company Vs. MSCI EM Performance Since March 2016: AVIC Helicopter Company Vs. MSCI EM AVIC Helicopter Company (600038 CH): AVIC's helicopter arm (Chart 12). As the name already suggests, the company specializes in helicopter production, which accounts for almost 100% of the overall revenue stream. The main helicopters currently marketed are from the AC series, in particular the AC311, AC312 and AC313, the Z series - Z-8, Z-9 and Z-11. We expect further tailwinds for the company stemming from China's future defense budget. The country's helicopter fleet is still only a tenth of the size of the U.S.'s fleet. It will continue to ramp up production. Export contracts will also support revenue growth for AVIC Helicopter Co. With a strong advance on the Asian military helicopter market, the company is looking to expand in the region. Furthermore, we see some promising developments in the civil helicopter space, with Chinese emergency services and the Civil Aviation Administration ramping up demand. The main headwind might come from the transition to new models, with the new production cycle to be in full force in 2018. AVIC Helicopter Co reported full year results on March 15, which came out weaker than expected. Revenues were virtually flat, contracting by 0.3% year over year, while cost of revenue grew 1.3% year over year. Operating income was also stable relative to last year, contracting 0.4% year over year, helped by an operating expense reduction of 12% year over year. Nevertheless, EBITDA margin declined slightly by 19 basis points to 6.77%, while operating margin fell by 131 basis points to 13.99%. A marginally lower income tax in FY16 allowed the firm to eke out 1.3% year-over-year bottom-line growth. AVIC Helicopters is currently trading at a forward P/E of 48.2x, whilst the market estimates an EPS CAGR of 13.8% for the next two years. Chart 13Performance Since March 2016: ##br## AVIC Aviation Engine Vs. MSCI EM Performance Since March 2016: AVIC Aviation Engine Vs. MSCI EM Performance Since March 2016: AVIC Aviation Engine Vs. MSCI EM AVIC Aviation Engine Corporation (600893 CH): Sole leader in Chinese engine production (Chart 13). Aviation Engine Corporation is part of the government-controlled Aeroengine Corporation of China (AECC), which was established in August 2016 and contributes just under 50% to Being in a monopolistic position on the Chinese market, the company profits from rising military aircraft procurement and prices. As part of the AECC, the company also receives tailwinds from scale effects within the company as well as cost savings in the supply chain. AVIC Aviation Engine Corporation reported weak full year results on March 16. Revenue slid 5.5% year over year, but management kept costs under control (down 7.3% year over year). Operating expenses grew only marginally (up 5.2% year over year), which left operating profit flat compared to last year. Margin trends have been strong; EBITDA margin improved by 78 basis points to 13.05%, while operating margin grew by 42 basis points to 7.78%. However, high net interest expense depressed the bottom line, which fell 13.3% year over year. At the same time the company managed to decrease its debt level for the fourth year in a row. AVIC Aviation Engine Corporation is currently trading at a forward P/E of 52.0x, whilst the market estimates an EPS CAGR of 14.4% for the next two years. Chart 14Performance Since March 2016: ##br## China Avionics Systems Vs. MSCI EM Performance Since March 2016: China Avionics Systems Vs. MSCI EM Performance Since March 2016: China Avionics Systems Vs. MSCI EM China Avionics Systems (600372 CH): Leading developer and producer of avionics equipment (Chart 14). China Avionics Systems is also a subsidiary of AviChina, which controls 43% of the free float. The company is active in R&D, running several research institutes in the fields of radar, aviation and navigation control as well as aviation computers and software. China Avionics enjoys a near-monopoly on the Chinese aviation electronics market, and also controls over 90% of the military market for air data systems. Looking at the revenue breakdown, 80% of total revenues come from military contracts, while it is expected that the share of civil revenues will increase with the development of civil aircraft in the country. Aircraft data acquisition devices contribute the most to overall revenue, at 25% of total, followed by airborne sensors at 15%, auto-pilot systems at 14%, distance-sensing alarm systems at 9.5%, and air data systems at 9%. The company reported full year results on March 16. Revenues experienced a mild increase of 1.9% year over year, while costs increased at the same pace (2% year over year). On the operating side, costs increased by 3% year over year, suppressing income by 1% year over year. EBITDA margin fell 37 basis points to 15.15%, while operating margin contracted 30 basis points to 10.60%. The bottom line contracted 3.5% year over year. China Avionics Systems is currently trading at a forward P/E of 55.0x, whilst the market estimates an EPS CAGR of 13% for the next two years. Chart 15Performance Since March 2016: ##br## Huntington Ingalls Industries Vs. S&P 500 Performance Since March 2016: Huntington Ingalls Industries Vs. S&P 500 Performance Since March 2016: Huntington Ingalls Industries Vs. S&P 500 Huntington Ingalls Industries (HII US): Largest listed U.S. military shipbuilder (Chart 15). Initially a part of Northrop Grumman, Huntington was spun off and listed in 2011. Huntington enjoys a monopolistic market position, as over 70% of the current U.S. Navy fleet was designed and built by the company's Newport News or Ingalls divisions in Virginia and Mississippi. Huntington is currently the sole designer, builder and re-fueler of nuclear-powered aircraft carriers in the U.S. In the nuclear submarines space, the company has one competitor: the Electric Boat unit of General Dynamics. The company also provides a range of services through its Technical Solutions division, centered around fleet support, integrated missions solutions and nuclear and oil and gas operations. Huntington reported full-year results on February 16. Full year revenue was virtually flat (+1% on quarterly basis), while costs increased slightly by 1.6% year over year. The company managed to reduce operating expenses, which fell by 16% to the lowest level since 2010. This helped boost operating profit by 13% year over year. EBITDA margin improved by an impressive 125 basis points to 14.77%, and operating margin was up by 119 basis points to 12.14%. New orders grew by US$5.2 billion, bringing the total pipeline to US$21 billion. The bottom line jumped by 45% year over year, helped by a lower income tax bill and a one-off after-tax adjustment. Huntington Ingalls Industries is currently trading at a forward P/E of 18.1x, whilst the market estimates an EPS CAGR of 4.2% for the next two years. Chart 16Performance Since March 2016: ##br## General Dynamics Vs. S&P 500 Performance Since March 2016: General Dynamics Vs. S&P 500 Performance Since March 2016: General Dynamics Vs. S&P 500 General Dynamics (GD US): Primary contractor for U.S. Navy submarines (Chart 16). General Dynamics is a multinational defense corporation and currently the fourth-largest defense company in the world. The company has four business segments, from which we are mainly interested in the marine systems segment, contributing 25% of overall group revenue. The marine systems segment is represented by General Dynamics' unlisted subsidiary, GD Electric Boat. Electric Boat has long been the main builder of nuclear submarines for the U.S. Navy out of Connecticut, and is expected to be one of the main beneficiaries of the U.S. Navy expansion program under the Trump administration. General Dynamics reported full-year results on January 27, which generally came in flat. Revenue fell by a marginal 0.4% year over year (after the adoption of a new revenue-recognition standard), but the company did a good job in managing costs, which contracted by 1% year over year. Operating income grew by 4% year over year, helped by lower operating costs. Margins improved across the board; EBITDA margin went up 45 basis points to 15.19%, while operating margin was up 54 basis points to 13.74%. The bottom line grew 5% year over year. Management seem confident in their guidance through 2020, including detailed but conservative estimates. Especially promising was the good pipeline visibility in the marine segment, driven by the company's Columbia-class submarine sales. General Dynamics is currently trading at a forward P/E of 19.3x, whilst the market estimates an EPS CAGR of 6.5% for the next two years. How To Trade? The GPS/EMES team recommends gaining exposure to the sector through a basket of the listed equities, which would consist of five Chinese companies and two U.S. companies. The main goal is active alpha generation by excluding laggards and including out-of-benchmark plays, to avoid passive index hugging via an ETF. Direct: Equity access through the tickers (Bloomberg): AviChina Industry & Technology (2357 HK); AVIC Jonhon Optronic (002179 CH); AVIC Helicopter Company (600038 CH); AVIC Aviation Engine Corporation (600893 CH); China Avionics Systems (600372 CH); Huntington Ingalls Industries (HII US); General Dynamics Corporation (GD US). ETFs: At current time there is one listed ETF covering the China defense sector: Guotai CSI National Defense ETF (512660 CH); And three listed ETFs covering the U.S. defense sector: iShares U.S. Aerospace & Defense ETF (ITA US); SPDR S&P Aerospace & Defense ETF (XAR US); PowerShares Aerospace & Defense Portfolio (PPA US). Funds: At current time there are no funds with significant defense sector exposure. Please note that the trade recommendation is long-term (1Y+) and based on a straight long trade. We don't see a need for specific market timing for this call (for technical indicators please refer to our website link). For convenience, the performance of both market cap-weighted and equally-weighted equity baskets will be tracked (please see upcoming updates as well as the website link to follow performance). Risks To The Investment Case The largest risk to our investment case - leaving aside company-specific risks - would be an unexpected fading away of the tensions in China's near seas, and of China's and America's military spending ambitions. Such a development - which would require a robust diplomatic agreement and an about-face from what the leaders have stated - would hit the weapons producers. Though such a settlement would not necessarily occur overnight, or receive immediate publicity, it would be observable over the course of negotiations between the Trump and Xi administrations. A key event to watch is the upcoming April summit between the two leaders. At the same time, the large momentum in the defense industry (with very long production pipelines), and the very low flexibility of defense budgeting, means that we are comfortable in terms of timing an exit should geopolitical tensions begin to recede. Another risk might come from a slowdown in economic growth in China or the U.S., which could lead to cuts in defense budgets. Nevertheless, in a case of a further escalation in China's near-abroad, we would most likely see defense spending continue to grow despite any weak economic performance, warranted by strategic needs. This is a key dynamic that investors should understand. Strategic distrust between the U.S. and China has worsened since the Great Recession, indicating that the preceding period of strong growth helped keep a lid on U.S.-China tensions. Now the two countries have entered a dilemma in which relations have soured despite their economic recoveries, since both sides are using growth to fuel military development, yet an economic relapse would fuel further distrust. Only a high-level political settlement can break this spiral and such settlements between strategic rivals traditionally require a "crisis." Matt Gertken, Associate Editor mattg@bcaresearch.com Oleg Babanov, Editor/Strategist obabanov@bcaresearch.co.uk Marko Papic, Senior Vice President marko@bcaresearch.com 1 Please see BCA Geopolitical Strategy Weekly Report, "Donald Trump Is Who We Thought He Was," dated March 8, 2016, available at gps.bcaresearch.com. 2 Please see BCA Geopolitical Strategy Monthly Report, "The Great Risk Rotation," dated December 11, 2013, and Geopolitical Strategy Special Report, "Power And Politics In East Asia: Cold War 2.0?" dated September 25, 2012, available at gps.bcaresearch.com. 3 Please see BCA Geopolitical Strategy Weekly Report, "How To Play The Proxy Battles In Asia," dated March 1, 2017, available at gps.bcaresearch.com. 4 The United States sent the USS Carl Vinson carrier group to the South China Sea as part of Freedom of Navigation Operations that the Trump administration may intensify; China is involved in a new spat about "environmental" monitoring stations in the Paracel Islands and in Scarborough Shoal, and is also increasing activity east of the Philippines; it is threatening to impose a new law that would govern foreign ships' access; the question of a Chinese Air Defense Identification Zone lingers; and China has also begun sending large tourist groups to the Paracels. 5 Please see BCA Geopolitical Strategy Strategic Outlook, "We Are All Geopolitical Strategists Now," dated December 14, 2017, and Geopolitical Strategy Special Reports, "Sino-American Conflict: More Likely Than You Think," dated October 4, 2013 and "Sino-American Conflict: More Likely Than You Think, Part II," dated November 6, 2015, available at gps.bcaresearch.com. 6 Most notably in 1971, 1974, 1988, 1995, 2001, and 2011-14. In the two biggest "battles," 1974 and 1988, China kicked Vietnamese forces out of the Paracel Islands and parts of the Spratly Islands, respectively. These conflicts took place in the context of Vietnam's wars with itself, the U.S., and China, just as the recent rise in tensions takes place in the context of China's emergence as a global power - in other words, international tensions are the cause and maritime-territorial disputes are but a symptom. 7 Most notably the HS981 showdown between China and Vietnam in 2014, which occurred when China National Offshore Oil Corporation (CNOOC) moved a large mobile drilling rig into the farthest southwest island of the Paracel Islands, near Triton Island, triggering a months-long skirmish with Vietnamese coast guard ships and fishermen that involved Chinese warships and aircraft and the sinking of at least one Vietnamese fishing boat. 8 In fact, officers from China's People's Liberation Army-Navy's southern fleet have recently written publicly and approvingly of the well-known Chinese tactic of fighting "behind a civilian front" to establish control over the sea - which has involved a host of private and public actions covering fishing, energy, coast guard, administration, science and environment, and tourism. Please see "Chinese Military's Dominance in S. China Sea Complete: Report," Kyodo News, March 20, 2017. 9 Please see Bonnie S. Glaser, "Armed Clash In The South China Sea," Council on Foreign Relations, Contingency Planning Memorandum No. 14, April 2012, available at cfr.org. Separately, an American diplomatic estimate from 2016 claims that "more than half the world's merchant fleet tonnage" passes through these waters; see Colin Willett, "Statement ... Before the House Foreign Affairs Committee ... 'South China Sea Maritime Disputes,'" July 7, 2016, available at docs.house.gov [http://docs.house.gov/meetings/AS/AS28/20160707/105160/HHRG-114-AS28-Wstate-WillettC-20160707.pdf]. A Chinese study estimates that 47.5% of China's total foreign trade in goods transited the sea in 2014; see Du D. B., Ma Y. H. et al, "China's Maritime Transportation Security And Its Measures Of Safeguard," World Regional Studies 24:2 (2015), pp. 1-10. 10 When President Trump's Secretary of State Rex Tillerson clarified remarks at his senate confirmation hearing in which he threatened that the U.S. would deny China's access to the islands in the South China Sea, he reformulated his statement to say that in the event of a contingency the U.S. needed to be "capable of limiting China's access to and use of its artificial islands" to threaten the U.S. and its allies and partners. 11 Please see footnote 3 above. Another potential implication might be a weaker U.S. position in the partition of the Arctic shelf (which has far more hydrocarbon reserves than the South China Sea), which U.S. rivals like Russia will pursue next against the claims of the U.S. and its allies Norway, Canada, and Denmark. 12 Please see Robert Haddick, Fire on the Water: China, America, and the Future of the Pacific (Annapolis, MD: Naval Institute Press, 2014). 13 It is understood by multiple sources that these missiles cannot be defended successfully against by current anti-missile technology, with one potential exclusion - the recently tested SM-6 Dual I. Otherwise, possible defense methods would lie in the realm of electronic countermeasures. 14 We believe, with medium conviction, that the incoming administration in South Korea will remove the THAAD missile defense sometime in 2017 or 2018 in what would be a major diplomatic quarrel between Seoul and Washington. This is because the soon-to-be ruling Minjoo Party (Democratic Party) will seek to engage North Korea and mend relations with China, and the latter countries' top demand will be removal of the missile defense system that was only put in place in a rushed manner in the final days of the discredited and impeached Park Geun-hye administration. Such a removal would illustrate the U.S.'s disadvantages relative to China in having to deal with alliances, basing, and force structure in a foreign region. 15 Please see BCA Geopolitical Strategy and Global Alpha Sector Strategy Joint Special Report, "Brothers In Arms," dated January 11, 2017, available at gps.bcaresearch.com. 16 Please see "2016 Navy Force Structure Assessment (FSA)," dated December 14, 2016, and Ronald O'Rourke, "Navy Force Structure and Shipbuilding Plans: Background and Issues for Congress," Congressional Research Service, September 21, 2016.

The large gap between the BCA Defense and BCA Aerospace indexes is likely to grow much larger. The U.S. is aiming to boost defense spending as part of its stimulus efforts, and is pressuring other NATO members to boost defense spending after a long contraction. While U.S. defense spending has been through a soft patch for the past several years, new orders for defense goods have been one of the strongest components of overall durable goods orders (second panel). Even global demand has boomed, even in the face of the strong U.S. dollar, as evidenced by surge in exports of military goods (bottom panel). On the flipside, aerospace new orders are on a downward trajectory, reflecting a downturn in the commercial aerospace cycle. While long lead times and lengthy delivery schedules offer some earnings protection, dwindling order backlogs will ultimately undermine confidence in the long-term outlook. Our global airline consumer price index, a composite of airline pricing power in a number of major countries, is in negative territory. A negative CPI reflects excess capacity, and warns of grim prospects for a recovery in new airplane orders. The bottom line is that earnings support remains intact for the defense index, but is rapidly dwindling for aerospace equities. Stay overweight the former and underweight the latter. The ticker symbols for the stocks in the BCA defense index are: LMT, GD, RTN, NOC, LLL and the BCA aerospace index are: BA, UTX, HON, TXT. Aerospace And Defense Are Going Their Separate Ways Aerospace And Defense Are Going Their Separate Ways

Highlights Portfolio Strategy The market has quietly adopted a less cyclical sectoral tone since yearend, a trend that could amplify over the coming months, even if overall appreciation persists. Defense stocks have grown into previously extended valuations, warranting ongoing above-benchmark exposure. The opposite is true for aerospace equities. Data processing shares are more likely to roll over than break out and we recommend paring positions to underweight. Recent Changes S&P Data Processing - Downgrade to underweight from overweight. Table 1 Shifting Internal Dynamics Shifting Internal Dynamics Feature The stock market has cheered the broad-based rebound in earnings and improvement in corporate sector pricing power (Chart 1). Unbridled optimism about growth friendly policy tilts including potential tax reform and select regulatory relief combined with an easing in financial conditions have encouraged investors to make large down payments against expected future profit gains. Indeed, extreme economic and earnings bullishness is evident in record setting price/sales (P/S) multiples: Chart 1 shows that on a median basis, the industry group (P/S) ratio is far above the 2000 peak, providing yet another metric in a long list of yardsticks signaling that greed is the overriding market emotion. Nosebleed valuation levels are cause for significant cyclical concern, but as discussed last week, momentum and a valuation-agnostic transition from fixed income to equities are the dominant tactical forces at the moment. Since it is difficult to reconcile valuations at odds with realistic expectations about future earnings growth, we remain focused on sub-surface positioning to indemnify against disappointment. Since late last year, the market has adopted a more defensive than cyclically-oriented tenor. Defensive sectors have troughed at extremely attractive relative valuation levels, based on our models (Chart 2). Conversely, cyclical sectors have rolled over, meeting resistance at very demanding valuation levels of more than two standard deviations above normal (Chart 2). Chart 1Future Growth Has Been Paid For Already Future Growth Has Been Paid For Already Future Growth Has Been Paid For Already Chart 2The Market Tone Is Changing The Market Tone Is Changing The Market Tone Is Changing Contrarians should take note. These nascent trend changes have developed even though economic data have generally surprised on the upside, which may be an indication that a more forceful response will occur once the string of upside surprises loses momentum. The global PMI has been very strong, but any hint of a reversal would provide a catalyst for a full-fledged recovery in defensive vs. cyclical stocks (Chart 3). The contraction in U.S. bank lending growth may be heralding slippage in hard economic data (Chart 3), to the benefit of defensive vs. cyclical sectors. Keep in mind that the market is priced for non-inflationary growth nirvana, such that even modest economic disappointment could short circuit the buying binge. The yield curve has stopped widening and financial conditions are no longer easing (Chart 3), providing additional confirmation that the defensive vs. cyclical equity sector trough is more likely a budding trend change than a pause in a downtrend. A trend change is also consistent with the relentless downgrading in emerging market vs. developed country GDP growth expectations (Chart 4). Chart 3Forward Looking Yellow Flags Forward Looking Yellow Flags Forward Looking Yellow Flags Chart 4No EM Confirmation For Cyclicals No EM Confirmation For Cyclicals No EM Confirmation For Cyclicals The lack of a durable and credible growth thrust in EM is confirmed by regional share price performance, as EM equities have significantly lagged their developed country counterparts (Chart 4). Now that China's fiscal stimulus impulse has rolled over amidst ongoing currency depreciation, EM lacks a catalyst for incremental growth outperformance vs. developed markets. Adding it up, evidence of a sub-surface trend change continues to materialize, even in the face of upward momentum in the broad market. We expect a mostly defensive along with select interest rate-sensitive exposure to provide optimal portfolio performance in the next 3-6 months. Defense Stocks Will Continue To Protect Portfolios... A Special Report sent to clients on October 31 outlined the long-term appeal of defense stocks, prior to the installment of a new, bellicose U.S. Administration. If anything, the latter threatens to exacerbate the decline in globalization that was already in progress (as discussed since 2014 by BCA's Geopolitical Strategy Service), potentially creating a leadership vacuum that will raise the specter of open military conflict. More nationalistic foreign policies in a number of countries, i.e. moving away from collaboration and cooperation and toward isolationism and self-sufficiency, is a recipe for increased geopolitical instability. China's challenge to the status quo is also likely to motivate a boost to defense spending globally. The recent World Economic Forum estimates of global military spending by 2030 cite both China and India planning to quadruple military outlays over this time frame (Table 2). The U.S. Administration is already pressuring other NATO members to boost defense spending after a long contraction (Chart 5), which should eventually spillover into rising defense contractor sales. Reportedly, only 5 out of 28 NATO members reached the targeted goal of spending 2% of GDP on defense. Ergo, there is room for an increase, especially in some larger countries with fiscal room to maneuver. More imminently, the conditions that have created the gap between aerospace and defense relative performance are growing even stronger (Chart 6). Table 2A New Arms Race Underway Shifting Internal Dynamics Shifting Internal Dynamics Chart 5Lots Of Upside Lots Of Upside Lots Of Upside Chart 6A Growing Gap A Growing Gap A Growing Gap While U.S. defense spending has been through a soft patch for the past several years, new orders for defense goods have been one of the strongest components of overall durable goods orders (Chart 6). The unfortunate reality is that the incentive to boost defense and security spending has never been higher. Terrorist activity continues to proliferate around the world (Chart 7), raising a sense of geopolitical uncertainty and mistrust. With defense new orders continuing to make new cyclical highs, factory output should run at levels flattering operating margins. Shipments of defense goods are outpacing inventories by a wide margin, which is consistent with solid pricing power. Even exports of military goods are booming (Chart 7), despite the strong U.S. dollar, reflecting a strong undercurrent of global demand. Domestic defense spending has room to expand. Real defense outlays are only just starting to recover (Chart 8). President Trump ran on a campaign to protect the U.S. from terrorism. That should make it comparatively easy to increase defense spending in the years to come. It is normal for defense stocks to retain momentum as defense spending growth accelerates (Chart 8, top panel). Increased staffing at the U.S. Department of Defense (DOD) implies that purse strings may already be loosening in anticipation of heightened activity. DOD employment growth often provides a good leading indication for real defensive spending trends (Chart 8, bottom panel). Thus, while share prices have been on a tear and valuations are not cheap, rapid earnings growth has pushed down forward multiples to manageable, below-market, levels (Chart 9, shown as an average of the companies in the BCA Defense Index). Chart 7Powerful Momentum... Powerful Momentum... Powerful Momentum... Chart 8... With Long-Term Durability ... With Long-Term Durability ... With Long-Term Durability Chart 9Growing Into Valuations Growing Into Valuations Growing Into Valuations Prospects for strong multiyear growth should support a move to a premium valuation as margins expand (Chart 9), similar to what occurred during past defense spending booms, as chronicled in our October 31 Special Report. ...But Aerospace Stocks Are Out Of Fuel In terms of aerospace equities, the outlook is more challenging. New orders have been sinking steadily, reflecting a downturn in the commercial aerospace cycle. While long lead times and lengthy delivery schedules offer some earnings protection, dwindling order backlogs will ultimately undermine confidence in the long-term outlook. Chart 10 shows that aerospace unfilled orders are contracting, an environment typically associated with share price underperformance, or at least elevated volatility. Shipments of aerospace goods are falling, a rare occurrence (Chart 10). The implication is that aerospace industrial production is also shrinking (Chart 10). With a heavily unionized labor force, it will be difficult to maintain profitability. Will increased global growth translate into a recovery in aerospace new orders? Doubtful. Aerospace cycles tend to be long and are not always correlated with the business cycle. Aerospace new order growth has little correlation with the global leading economic indicator. In fact, if anything, it is more countercyclical. Ominously, there are signs of excess capacity. Our global airline consumer price index, a composite of airline pricing power in a number of major countries, is in negative territory. A negative CPI reflects excess capacity, and warns of grim prospects for a recovery in new airplane orders (Chart 11). Chart 10Running On Empty Running On Empty Running On Empty Chart 11Too Much Capacity Too Much Capacity Too Much Capacity Against this backdrop, aerospace profits will become increasingly reliant on maintenance, repair and consumables activity. However, weak pricing power suggests that this source of revenue is soft (Chart 11). Aerospace valuations are close to a par with those of defense stocks. Divergent profit outlooks imply that the latter should expand while the former get squeezed. Bottom Line: We remain confident that the BCA defense index (LMT, GD, RTN, NOC, LLL) will continue to generate above market returns, whereas the BCA aerospace index (BA, UTX, HON, TXT) exhibits asymmetric downside risk. Data Processors Are Losing Their Allure After a consolidation phase that restored value to a more neutral level, we upgraded the S&P data processing index to overweight in late-September, because it fit into our consumption vs. capital spending theme, outperforms in disinflationary environments and would benefit from a recovery in industry sales growth. While several of those factors still exist, the share price ratio has been unable to gain traction and the window for outperformance may be closing. The economic backdrop is no longer conducive to capital inflows. Data processing companies enjoy hefty recurring revenue and high returns on equity, warranting persistent above market valuations (Chart 12). However, the flipside of predictability is lower operating leverage than many other industries and a pattern of underperformance during periods of rising inflation expectations. Indeed, cyclical share price momentum tends to take its cue, inversely, from inflation expectations (inflation expectations shown inverted, middle panel, Chart 12). Renewed traction in global economic growth, as evidenced by the upturn in the global leading economic indicator (GLEI, shown inverted, top panel, Chart 13), represents a headwind to capital inflows and relative multiple expansion. The improvement in business sentiment has also boosted our capital spending model, albeit we are doubtful as to whether increased animal spirits will translate into much of a capital spending cycle in a world of deficient final demand and soft free cash flow. Still, any rise in capital spending would put the services-based data processing group at a disadvantage, in relative terms. The downturn in the ISM services index compared with the ISM manufacturing index reinforces that the external environment has become more challenging (Chart 13). All of these factors could be overcome if operating trends were set to improve. Data processing revenue trends are tightly linked with consumer spending (Chart 14). The personal savings rate has room to fall, facilitating an increase in outlays, particularly now that the labor market has tightened. Rising job security has buoyed consumer confidence, which has historically augured well for data processing sales growth. Chart 12The Window Has Closed The Window Has Closed The Window Has Closed Chart 13Sell Signals Sell Signals Sell Signals Chart 14Margin Squeeze Margin Squeeze Margin Squeeze But top-line growth has been in a funk of late, even with firming pricing power (second panel, Chart 14). Companies have made a significant investment to boost marketing, as evidenced by the surge in SG&A, but so far, this has sapped margins more than stoked revenue. Importantly, Visa has recently provided a fee break to retailers, who are increasingly banding together to put pressure on the industry to lower fees. Amidst increased competition on the payments processing side, this trend is likely to be structural and put downward pressure on profit margins. Thus, we are reluctant to embrace the jump in the producer price index, as future readings could be much weaker. The implication is that operating performance will not overcome macro hurdles. Bottom Line: Reduce the S&P data processing index (V, MA, PYPL, ADP, FIS, FISV, PAYX, ADS, GPN, WU, TSS) from overweight to underweight. Current Recommendations Current Trades Size And Style Views Favor small over large caps. Favor growth over value (downgrade alert).

"That as the only possible policy in our day for a conqueror to pursue is to leave the wealth of a territory in the complete possession of the individuals inhabiting that territory, it is a logical fallacy and an optical illusion in Europe to regard a nation as increasing its wealth when it increases its territory, because when a province or state is annexed, the population, who are the real and only owners of the wealth therein, are also annexed, and the conqueror gets nothing." 1 Norman Angell's "The Great Illusion" posited in the early 1910s that war would be futile for developed nations, especially given the rising importance of economic and financial ties. Nevertheless, the arms race from the late-1800s gained momentum and eventually led to the Great War, dealing a devastating blow to his arguments. The European armament dynamics of the late-19th century/early 20th century are eerily reminiscent of the current post-Great Recession global arms race. Back then Germany, Austria-Hungary and Italy on one side, and Britain, France and Russia on the other, were fiercely trying to outpace each other in military expenditures. The crumbling Ottoman Empire along with the newly created smaller states in Greece, Serbia, Bulgaria and Romania were also eager weapons purchasers. Today, a fresh military expenditure-related development pops up almost daily. Not only are the U.S. and China boosting military spending, but also Japan, Australia, India, Vietnam, Saudi Arabia, Turkey, Russia, etc (Chart 1).2 The list goes on and on. The driving factor is "multipolarity," i.e. the emergence of multiple competing great powers, which BCA's Geopolitical Strategy service has shown to be a key investment theme.3 Chart 1U.S. Defense Spending Is More Than The Rest Of The World Combined Brothers In Arms Brothers In Arms While we are not arguing that WWIII will erupt in the coming years, the purpose of this Special Report is to identify the winning global equity sectors from the intensifying global arms race (Chart 2): global defense stocks come atop of our list, but also global space-related equities and cyber security firms would be beneficiaries of the secular increase in military outlays. On a regional basis, the U.S. defense stocks are the only game in town, but undiscovered Chinese, and to a lesser extent Russian, defense stocks are intriguing as are Israeli defense and tech stocks (please refer to the Appendix below for ticker symbols). Chart 2Intensifying Global Arms Race bca.gtss_sr_2016_10_28_c2 bca.gtss_sr_2016_10_28_c2 Late 19th/Early 20th Century: Militarism, Globalization & Finance Back in the late-1800s, the ascendancy of Germany was challenging the hegemony of Britain, fueling a European-wide arms race. Smaller newly formed states were also on the hunt for the latest and greatest weaponry. During the Balkan Wars of 1912-13 airplanes were deployed in combat for the very first time, highlighting the importance of new technology. Behind this explosive European rearmament were a few large British companies (Vickers Sons & Maxim Ltd, Armstrong and Whitworth, and Coventry Ordnance Works). "By 1905, its capital of £7.4 million ranked Vickers sixth amongst British companies; Armstrong Whitworth, with 5.3 million pounds capital was eleventh".4 Basil Zaharoff, who acted as general representative for business abroad for Vickers,5 was reputedly one of the richest men in the world.6 Moreover, globalization was on the rise in the late 19th century, as evidenced by global imports as a percentage of GDP (Chart 3). Industrialization coupled with imperialism and the colonization of Asia and sub-Saharan Africa along with population growth and rising demand for commodities were key drivers behind the jump in 19th century globalization. Finally, all of this was made possible by cross-boarder finance. Trade finance and credit growth skyrocketed in the late-1800s and the rising interconnectedness of global financial centers was most evident in the 1907 stock market panic that originated in the U.S., but spread like wildfire to the rest of the world. Chart 3Twin Peaks Of Globalization? Twin Peaks Of Globalization? Twin Peaks Of Globalization? Chart 4Heeding The Early 1960s Parallel bca.gtss_sr_2016_10_28_c4 bca.gtss_sr_2016_10_28_c4 What About The 1960s? The idea of militarily outspending opponents was very evident in the early-1960s when U.S. defense spending surged by 20% on a year-over-year basis (Chart 4), bolstering demand once again for military contractors. The mutually assured destruction (MAD) doctrine of military strategy and national security policy declared overtly in the early-1960s by U.S. defense secretary Robert McNamara and the Space Race competition between the Cold War rivals also have striking similarities with today, as far as investment implications are concerned. Parallels With Today China's ascendency to a world power large enough to challenge the hegemony of the U.S. is a sea change.7 The rearmament of East Asia is reminiscent of late 19th and early 20th century Europe and involves Japan, Australia, South Korea, Vietnam and India. All of the Middle East, along with Turkey and Russia, are on a structural military spending spree. European NATO fringe states are also arming furiously (Chart 5), trying to thwart Russia's regional ambitions. In the U.S., despite the Budget Control Act of 2011 (sequestration), the CBO projects that defense spending will rise gradually from $586 billion in 2015 to $739 billion by 2026 (Chart 6). This is before any push for a fiscal spending thrust that both presidential candidates have proposed, which would include increased defense outlays. While as a percentage of GDP defense spending may drift sideways, in absolute terms it will likely rise, and thus boost demand for defense contractors. Chart 5Stealthy Rise In Defense Outlays bca.gtss_sr_2016_10_28_c5 bca.gtss_sr_2016_10_28_c5 Chart 6CBO Estimates New Defense Spending Highs bca.gtss_sr_2016_10_28_c6 bca.gtss_sr_2016_10_28_c6 Globalization has hit an apex recently (Chart 3).8 The world is still licking its wounds from the recent GFC, where U.S. financials stocks were so intertwined with their global peers that the crisis effectively brought down to its knees the global financial system and gave birth to unorthodox monetary policy that Central Banks are still currently deploying. Global Rearmament Beneficiaries If our hypothesis that a global arms race will continue to heat up in coming years pans out, then owning global defense stocks as a structural bet will pay handsome dividends. The global push away from austerity and toward more fiscal spending should also support aggregate defense demand. Thus, there are high odds that global defense stocks are primed to deliver absolute positive returns, irrespective of where the broad global equity market drifts in the next five years. Similar to Vickers and Armstrong and Whitworth making impressive stock market strides early last century, global defense stocks should continue to be high flyers. The early-1960s U.S. aerospace & defense (A&D) stocks are the only close stock market parallel we have come across in our analysis (given data constraints) and comparing this index's available metrics of that era with today is in order. A big pushback to the U.S. Equity Strategy service's constructive view on the U.S. defense index (since the late-2015 inception) has been that the valuations of these stocks are already full, leaving no valuation cushion for any mishaps (Chart 7). True, defense stocks are on the expensive side, but not if they manage to grow into their valuations, as we expect. Relative performance was up over 100% in a span of four years in the 1960s (Chart 8), as U.S. aerospace & defense industrial production (IP) swelled to a 20% per annum clip with utilization rates running at 95% (Chart 8). A&D factories were humming, racing to fulfill orders as U.S. military expenditures were thriving (Chart 4). Chart 7Buy Global Defense Stocks Buy Global Defense Stocks Buy Global Defense Stocks Chart 8In The 1960s A&D Factories Were Humming... bca.gtss_sr_2016_10_28_c8 bca.gtss_sr_2016_10_28_c8 This demand surge translated into a jump in sector sales momentum (Chart 4), and given the industry's high operating leverage, earnings and book values soared. From trough to peak, sector EPS rose more than 400%, margins expanded from sub 2% to nearly 8%, and book value doubled (Chart 9). That stellar performance justified initial valuation premiums at the time. Using that period as a guide would imply that there is ample upside left for relative performance of the global defense index (that is a pure play on global defense spending). For comparison consistency, we use U.S. A&D figures. Currently, U.S. A&D IP is contracting, with resource utilization running at 80%. U.S. A&D relative performance has risen a mere 30% since the Great Recession (Chart 10). Chart 9...Boosting The Allure Of ##br## A&D Stocks bca.gtss_sr_2016_10_28_c9 bca.gtss_sr_2016_10_28_c9 Chart 10If History At Least Rhymes, ##br## There Is Still Ample Upside... bca.gtss_sr_2016_10_28_c10 bca.gtss_sr_2016_10_28_c10 Likely, the advance is still in the early innings, and analysts have been very slow to upgrade their EPS estimates accentuating the apparent overvaluation. Importantly, 5-year forward relative EPS growth estimates are deep in negative territory which is very perplexing given the upward trajectory of industry demand (Chart 11). Given that we only have access to data for MSCI All-Country World aerospace & defense long-term EPS expectations the caveat is that some of the poor expectations and performance could be because of the waning aerospace delivery cycle. Unlike the deteriorating health of the broad corporate sector, profit margins are expanding and net debt-to-EBITDA is a comfortable 1.2x. Similarly, interest coverage ratio is near an all-time high of 8x (Chart 12), while the overall markets EBIT/interest expense ratio is half that. Chart 11...Especially ##br## Given Depressed Analysts' Expectations ...Especially Given Depressed Analysts' Expectations ...Especially Given Depressed Analysts' Expectations Chart 12Defense ##br## Wins Championships Defense Wins Championships Defense Wins Championships Global defense sector return on equity (ROE) is almost 30% and rising (Chart 13), whereas global non-financial corporate (NFC) ROE is hitting multi-year lows, with the U.S. NFC ROE plumbing all-time lows (Chart 14). Free cash flow is also growing briskly and the industry is making greenfield investments, with capex growing 9.5% year-over-year, the mirror image of the global NFC sector that is pruning capital outlays (middle and bottom panels, Chart 13). Chart 13Defense Flexing ##br## Its Muscles... Defense Flexing Its Muscles... Defense Flexing Its Muscles... Chart 14...Vs. The Atrophy In The U.S. ##br## Non-Financial Corporate Sector bca.gtss_sr_2016_10_28_c14 bca.gtss_sr_2016_10_28_c14 On the valuation front, modest overvaluation exists, as portrayed by the high relative price-to-cash flow and price-to-book multiples. However, the global defense stocks forward P/E ratio and EV/EBITDA multiple are on an even keel with the broad market (Chart 15), and if our thesis that a secular uptrend in defense-related demand looms proves accurate, then these stocks are not expensive, but on the contrary still represent a buying opportunity. Chart 15Mixed Signals On The Relative Valuation Front Mixed Signals On The Relative Valuation Front Mixed Signals On The Relative Valuation Front Chart 16Defense Is The Best Offense bca.gtss_sr_2016_10_28_c16 bca.gtss_sr_2016_10_28_c16 The Rise In Terrorism, Global Space Race And Cyber Security Threat The unfortunate structural increase in terrorist activity will also embolden governments around the world to step up defense spending (top panel, Chart 16).9 The latter tends to move in long cycles. U.S. defense industry revenues have already begun to outpace those of the overall S&P 500, and a prolonged upturn lies ahead, based on the message from the previous upcycle. From a cyclical perspective, the defense capital goods shipments-to-inventories ratio is outpacing the overall manufacturing sector (second panel. Chart 16), reinforcing the case for ongoing earnings outperformance. The same also holds true in Europe. Western European terrorist attacks have increased, heralding further relative gains for the euro area aerospace & defense index (bottom panel, Chart 16). Beyond the disastrous spike in terrorism, the global space race is also gaining traction, with China spearheading the charge. There is a good chance that China will attain geosynchronous orbit satellites (residing more than 20,000 miles above the earth), challenging U.S. space dominance. India's space aspirations are grand and it is slowly and stealthily rising up the ranks on the space race. Moreover, as more countries aim to have manned space missions, that translates into higher space budgets and thus firming demand for space-related expenditures (Chart 17). Chart 17Space, The Final Frontier Brothers In Arms Brothers In Arms Finally, the number of cyber-attacks is also on the rise globally. Defending against attacks is a challenge. Not only does the cyber space domain definition remain elusive, but tracking hackers down is also increasingly difficult given the vastest of the internet, lack of global uniform policing methods and physical country borders. Crudely put, it is a lot easier for a Chinese or Russian hacker to deal a blow, for example, to U.S. nuclear infrastructure rather than physically deliver an attack. All of this suggests that investment in anti-hacking and counter cyber-attack capabilities is necessary around the globe in order to thwart cyber-terrorism. Risks To Our View While there is conceivably a risk that China will abruptly halt its intense militarization and make a U turn in its long-term strategy of becoming a military superpower, we assign a very low probability to such a turn of events. The global push for more fiscal spending may not materialize, which would be a risk to our sanguine global defense spending view. As Paul Volcker and Peter Peterson recently opined in a NY Times article10 - offering a different view from the always-articulate Larry Summers - prudent and fiscally responsible spending is in order given the excessive debt-to-GDP ratio that is probing war-like levels (Chart 18). This excessive debt overhang is not only a U.S. phenomenon, but also a global one spanning both advanced and emerging economies. Chart 18Excessive Debt Is A Risk To Bullish View On Global Defense Stocks Excessive Debt Is A Risk To Bullish View On Global Defense Stocks Excessive Debt Is A Risk To Bullish View On Global Defense Stocks One final risk is that the world will enter a prolonged peace phase and global terrorism will get quashed, with conflicts dying down in the Middle East, Russia reining in its imperialistic ambitions and China ceasing to stir the waters in the South and East China Seas. We would also assign low odds to this optimistic "no conflict phase" scenario, but it would indeed be welcome. Investment Conclusion Factors are falling into place for a structural outperformance period in the global defense index. The early-1900s and early-1960s parallels, coupled with the trifecta of terrorism, space race and cyber security all point to upbeat demand for defense-related goods and services. Expressing this buoyant view can be done from a bottom up perspective. The Appendix below highlights all the companies in the global defense index we track from Datastream and the alternative one from Bloomberg. An investable proxy is the U.S. aerospace & defense index as the U.S. dominates global A&D indexes and aerospace outfits also sport significant defense corporate segments (please see the Appendix below for relevant tickers). There are also three fairly liquid ETFs mimicking the U.S. A&D index: ITA:US, PPA:US & XAR:US. Moreover, below are a few more speculative investment ideas. Given China's dominance of global defense spending (ex-U.S.) we are confident that Chinese A&D stocks will also be eagerly sought after and deliver alpha in the coming years (please refer to the Appendix below for a list of China plays). If one has the resilience and the stomach to invest in Russian equities given high political and currency risk, then Russian A&D stocks may be a desirable vehicle. Russia remains a massive weapons exporter with a large sphere of influence. We would not underestimate the returns in local currency of some Russian A&D stocks (the Appendix below lists some Russian A&D listed firms). Finally, Israel A&D and IT companies either listed on NASDAQ or domestically in Tel Aviv offer some great opportunities for investors that can handle riskier investments. Not only Israel's geography, but also its intense IT/military focus and entrepreneurial culture imply that a number of these companies will be long-term winners (please see the Appendix below for relevant tickers). While most of the drones, space-related, and highly specialized IT companies are private, there is a drone and an anti-hacking ETF (IFLY:US & HACK:US). On the space front, we are tracking an index that comprises a number of space-related constituents that we show in the Appendix below. Nevertheless, most of these companies are categorized under A&D. Bottom Line: We are initiating a structural overweight in the global defense index with a longer-than-usual five year secular investment horizon. The re-rating phase in this index is still in the early innings. Anastasios Avgeriou, Vice President Global Alpha Sector Strategy anastasios@bcaresearch.com Appendix Table A1BI Global Defense Primes Competitive Peers Brothers In Arms Brothers In Arms Table A2World Defense Index (DS: DEFENWD) Brothers In Arms Brothers In Arms Table A3S&P 500 Aerospace & Defense Index ##br## (S5AERO Index) Brothers In Arms Brothers In Arms Table A4China ##br## Aerospace & Defense Brothers In Arms Brothers In Arms Table A5Russia & Israel Aerospace & Defense Brothers In Arms Brothers In Arms Table A6Kensho Space Index Brothers In Arms Brothers In Arms 1 Angell, Norman (1911), The Great Illusion: A Study of the Relation of Military Power in Nations to their Economic and Social Advantage, (3 ed.), New York and London: G.P. Putnam's & Sons. 2 Please see BCA Geopolitical Strategy Monthly Report, "The Great Risk Rotation," dated December 11, 2013, available at gps.bcaresearch.com 3 Please see BCA Geopolitical Strategy Monthly Report, "Multipolarity And Investing," dated April 9, 2014, available at gps.bcaresearch.com 4 Angell, Warren, Kenneth (1989), Armstrongs of Elswick: Growth In Engineering And Armaments To The Merger with Vickers, London, The Macmillan Press Ltd. 5 http://www.oxforddnb.com/index/38/101038270/ 6 https://www.britannica.com/biography/Basil-Zaharoff 7 Please see BCA Geopolitical Strategy Special Report, "Sino-American Conflict: More Likely Than You Think, Part II," dated November 6, 2015, available at gps.bcaresearch.com 8 Please see BCA Geopolitical Strategy, "The Apex Of Globalization - All Downhill From Here," in Monthly Report, "Winter Is Coming," dated November 12, 2014, available at gps.bcaresearch.com 9 Please see BCA Geopolitical Strategy Special Report, "A Bull Market For Terror," dated August 5, 2016, available at gps.bcaresearch.com 10 http://www.nytimes.com/2016/10/22/opinion/ignoring-the-debt-problem.html?_r=0

Beyond early last century's military rearmament, the idea of militarily outspending opponents was very evident in the early-1960s when U.S. defense spending surged by 20% on a year-over-year basis. If our hypothesis that a global arms race will continue to heat up in coming years pans out, then owning global (but especially U.S.) defense stocks as a structural play will pay handsome dividends. The early-1960s experience in U.S. aerospace & defense (A&D) stocks is the closest stock market parallel we found in our analysis (given data constraints). Then, relative performance was up over 100% in a span of four years, as U.S. A&D industrial production (IP) swelled to a 20% per annum clip with utilization rates running at 95%. A&D factories were humming, racing to fulfill orders as U.S. military expenditures boomed. That demand surge translated into a jump in sector sales and given the industry's high operating leverage, earnings and book values soared. The chart shows that from trough to peak, sector EPS rose by more than 400%, margins expanded from sub 2% to nearly 8%, and book value doubled. That stellar performance justified initial valuation premiums at the time. Using that period as a guide would imply that there is ample upside left for relative performance of the BCA U.S. defense index (that is a pure play on global defense spending). Bottom Line: Stay overweight the BCA U.S. defense index (LMT, GD, RTN, NOC, LLL), and please see yesterday's Special Report for additional details. bca.uses_in_2016_11_01_002_c1 bca.uses_in_2016_11_01_002_c1

The European armament dynamics of the late-19th century/early 20th century are eerily reminiscent of the current post-Great Recession global arms race. Back then Germany, Austria-Hungary and Italy on one side, and Britain, France and Russia on the other, were fiercely trying to outpace each other in terms of military expenditures. The crumbling Ottoman Empire along with the newly created smaller states in Greece, Serbia, Bulgaria and Romania were also eager weapons purchasers. Today, a fresh military expenditure-related development pops up almost daily. The chart shows that not only are the U.S. and China boosting military spending, but also Japan, Australia, India, Vietnam, Saudi Arabia, Turkey, Russia, etc.[1] The list goes on and on. The driving factor is "multipolarity," i.e. the emergence of multiple competing great powers, which BCA's Geopolitical Strategy service views as a key investment theme.[2] While we are not arguing that WWIII will erupt in the coming years, the purpose of yesterday's Special Report is to identify the winning global equity sectors from the intensifying global arms race: global defense stocks come atop of our list, but also global space-related equities and cyber security firms would be beneficiaries of the secular increase in military outlays. On a regional basis, the BCA U.S. defense index is the only game in town (see the next Insight). (Part I) Brothers In Arms (Part I) Brothers In Arms [1] Please see BCA Geopolitical Strategy Monthly Report, "The Great Risk Rotation," dated December 11, 2013, available at gps.bcaresearch.com [2] Please see BCA Geopolitical Strategy Monthly Report, "Multipolarity And Investing," dated April 9, 2014, available at gps.bcaresearch.com

"That as the only possible policy in our day for a conqueror to pursue is to leave the wealth of a territory in the complete possession of the individuals inhabiting that territory, it is a logical fallacy and an optical illusion in Europe to regard a nation as increasing its wealth when it increases its territory, because when a province or state is annexed, the population, who are the real and only owners of the wealth therein, are also annexed, and the conqueror gets nothing." 1 Norman Angell's "The Great Illusion" posited in the early 1910s that war would be futile for developed nations, especially given the rising importance of economic and financial ties. Nevertheless, the arms race from the late-1800s gained momentum and eventually led to the Great War, dealing a devastating blow to his arguments. The European armament dynamics of the late-19th century/early 20th century are eerily reminiscent of the current post-Great Recession global arms race. Back then Germany, Austria-Hungary and Italy on one side, and Britain, France and Russia on the other, were fiercely trying to outpace each other in military expenditures. The crumbling Ottoman Empire along with the newly created smaller states in Greece, Serbia, Bulgaria and Romania were also eager weapons purchasers. Today, a fresh military expenditure-related development pops up almost daily. Not only are the U.S. and China boosting military spending, but also Japan, Australia, India, Vietnam, Saudi Arabia, Turkey, Russia, etc (Chart 1).2 The list goes on and on. The driving factor is "multipolarity," i.e. the emergence of multiple competing great powers, which BCA's Geopolitical Strategy service has shown to be a key investment theme.3 Chart 1U.S. Defense Spending Is More Than The Rest Of The World Combined Brothers In Arms Brothers In Arms While we are not arguing that WWIII will erupt in the coming years, the purpose of this Special Report is to identify the winning global equity sectors from the intensifying global arms race (Chart 2): global defense stocks come atop of our list, but also global space-related equities and cyber security firms would be beneficiaries of the secular increase in military outlays. On a regional basis, the U.S. defense stocks are the only game in town, but undiscovered Chinese, and to a lesser extent Russian, defense stocks are intriguing as are Israeli defense and tech stocks (please refer to the Appendix below for ticker symbols). Chart 2Intensifying Global Arms Race bca.gtss_sr_2016_10_28_c2 bca.gtss_sr_2016_10_28_c2 Late 19th/Early 20th Century: Militarism, Globalization & Finance Back in the late-1800s, the ascendancy of Germany was challenging the hegemony of Britain, fueling a European-wide arms race. Smaller newly formed states were also on the hunt for the latest and greatest weaponry. During the Balkan Wars of 1912-13 airplanes were deployed in combat for the very first time, highlighting the importance of new technology. Behind this explosive European rearmament were a few large British companies (Vickers Sons & Maxim Ltd, Armstrong and Whitworth, and Coventry Ordnance Works). "By 1905, its capital of £7.4 million ranked Vickers sixth amongst British companies; Armstrong Whitworth, with 5.3 million pounds capital was eleventh".4 Basil Zaharoff, who acted as general representative for business abroad for Vickers,5 was reputedly one of the richest men in the world.6 Moreover, globalization was on the rise in the late 19th century, as evidenced by global imports as a percentage of GDP (Chart 3). Industrialization coupled with imperialism and the colonization of Asia and sub-Saharan Africa along with population growth and rising demand for commodities were key drivers behind the jump in 19th century globalization. Finally, all of this was made possible by cross-boarder finance. Trade finance and credit growth skyrocketed in the late-1800s and the rising interconnectedness of global financial centers was most evident in the 1907 stock market panic that originated in the U.S., but spread like wildfire to the rest of the world. Chart 3Twin Peaks Of Globalization? Twin Peaks Of Globalization? Twin Peaks Of Globalization? Chart 4Heeding The Early 1960s Parallel bca.gtss_sr_2016_10_28_c4 bca.gtss_sr_2016_10_28_c4 What About The 1960s? The idea of militarily outspending opponents was very evident in the early-1960s when U.S. defense spending surged by 20% on a year-over-year basis (Chart 4), bolstering demand once again for military contractors. The mutually assured destruction (MAD) doctrine of military strategy and national security policy declared overtly in the early-1960s by U.S. defense secretary Robert McNamara and the Space Race competition between the Cold War rivals also have striking similarities with today, as far as investment implications are concerned. Parallels With Today China's ascendency to a world power large enough to challenge the hegemony of the U.S. is a sea change.7 The rearmament of East Asia is reminiscent of late 19th and early 20th century Europe and involves Japan, Australia, South Korea, Vietnam and India. All of the Middle East, along with Turkey and Russia, are on a structural military spending spree. European NATO fringe states are also arming furiously (Chart 5), trying to thwart Russia's regional ambitions. In the U.S., despite the Budget Control Act of 2011 (sequestration), the CBO projects that defense spending will rise gradually from $586 billion in 2015 to $739 billion by 2026 (Chart 6). This is before any push for a fiscal spending thrust that both presidential candidates have proposed, which would include increased defense outlays. While as a percentage of GDP defense spending may drift sideways, in absolute terms it will likely rise, and thus boost demand for defense contractors. Chart 5Stealthy Rise In Defense Outlays bca.gtss_sr_2016_10_28_c5 bca.gtss_sr_2016_10_28_c5 Chart 6CBO Estimates New Defense Spending Highs bca.gtss_sr_2016_10_28_c6 bca.gtss_sr_2016_10_28_c6 Globalization has hit an apex recently (Chart 3).8 The world is still licking its wounds from the recent GFC, where U.S. financials stocks were so intertwined with their global peers that the crisis effectively brought down to its knees the global financial system and gave birth to unorthodox monetary policy that Central Banks are still currently deploying. Global Rearmament Beneficiaries If our hypothesis that a global arms race will continue to heat up in coming years pans out, then owning global defense stocks as a structural bet will pay handsome dividends. The global push away from austerity and toward more fiscal spending should also support aggregate defense demand. Thus, there are high odds that global defense stocks are primed to deliver absolute positive returns, irrespective of where the broad global equity market drifts in the next five years. Similar to Vickers and Armstrong and Whitworth making impressive stock market strides early last century, global defense stocks should continue to be high flyers. The early-1960s U.S. aerospace & defense (A&D) stocks are the only close stock market parallel we have come across in our analysis (given data constraints) and comparing this index's available metrics of that era with today is in order. A big pushback to the U.S. Equity Strategy service's constructive view on the U.S. defense index (since the late-2015 inception) has been that the valuations of these stocks are already full, leaving no valuation cushion for any mishaps (Chart 7). True, defense stocks are on the expensive side, but not if they manage to grow into their valuations, as we expect. Relative performance was up over 100% in a span of four years in the 1960s (Chart 8), as U.S. aerospace & defense industrial production (IP) swelled to a 20% per annum clip with utilization rates running at 95% (Chart 8). A&D factories were humming, racing to fulfill orders as U.S. military expenditures were thriving (Chart 4). Chart 7Buy Global Defense Stocks Buy Global Defense Stocks Buy Global Defense Stocks Chart 8In The 1960s A&D Factories Were Humming... bca.gtss_sr_2016_10_28_c8 bca.gtss_sr_2016_10_28_c8 This demand surge translated into a jump in sector sales momentum (Chart 4), and given the industry's high operating leverage, earnings and book values soared. From trough to peak, sector EPS rose more than 400%, margins expanded from sub 2% to nearly 8%, and book value doubled (Chart 9). That stellar performance justified initial valuation premiums at the time. Using that period as a guide would imply that there is ample upside left for relative performance of the global defense index (that is a pure play on global defense spending). For comparison consistency, we use U.S. A&D figures. Currently, U.S. A&D IP is contracting, with resource utilization running at 80%. U.S. A&D relative performance has risen a mere 30% since the Great Recession (Chart 10). Chart 9...Boosting The Allure Of ##br## A&D Stocks bca.gtss_sr_2016_10_28_c9 bca.gtss_sr_2016_10_28_c9 Chart 10If History At Least Rhymes, ##br## There Is Still Ample Upside... bca.gtss_sr_2016_10_28_c10 bca.gtss_sr_2016_10_28_c10 Likely, the advance is still in the early innings, and analysts have been very slow to upgrade their EPS estimates accentuating the apparent overvaluation. Importantly, 5-year forward relative EPS growth estimates are deep in negative territory which is very perplexing given the upward trajectory of industry demand (Chart 11). Given that we only have access to data for MSCI All-Country World aerospace & defense long-term EPS expectations the caveat is that some of the poor expectations and performance could be because of the waning aerospace delivery cycle. Unlike the deteriorating health of the broad corporate sector, profit margins are expanding and net debt-to-EBITDA is a comfortable 1.2x. Similarly, interest coverage ratio is near an all-time high of 8x (Chart 12), while the overall markets EBIT/interest expense ratio is half that. Chart 11...Especially ##br## Given Depressed Analysts' Expectations ...Especially Given Depressed Analysts' Expectations ...Especially Given Depressed Analysts' Expectations Chart 12Defense ##br## Wins Championships Defense Wins Championships Defense Wins Championships Global defense sector return on equity (ROE) is almost 30% and rising (Chart 13), whereas global non-financial corporate (NFC) ROE is hitting multi-year lows, with the U.S. NFC ROE plumbing all-time lows (Chart 14). Free cash flow is also growing briskly and the industry is making greenfield investments, with capex growing 9.5% year-over-year, the mirror image of the global NFC sector that is pruning capital outlays (middle and bottom panels, Chart 13). Chart 13Defense Flexing ##br## Its Muscles... Defense Flexing Its Muscles... Defense Flexing Its Muscles... Chart 14...Vs. The Atrophy In The U.S. ##br## Non-Financial Corporate Sector bca.gtss_sr_2016_10_28_c14 bca.gtss_sr_2016_10_28_c14 On the valuation front, modest overvaluation exists, as portrayed by the high relative price-to-cash flow and price-to-book multiples. However, the global defense stocks forward P/E ratio and EV/EBITDA multiple are on an even keel with the broad market (Chart 15), and if our thesis that a secular uptrend in defense-related demand looms proves accurate, then these stocks are not expensive, but on the contrary still represent a buying opportunity. Chart 15Mixed Signals On The Relative Valuation Front Mixed Signals On The Relative Valuation Front Mixed Signals On The Relative Valuation Front Chart 16Defense Is The Best Offense bca.gtss_sr_2016_10_28_c16 bca.gtss_sr_2016_10_28_c16 The Rise In Terrorism, Global Space Race And Cyber Security Threat The unfortunate structural increase in terrorist activity will also embolden governments around the world to step up defense spending (top panel, Chart 16).9 The latter tends to move in long cycles. U.S. defense industry revenues have already begun to outpace those of the overall S&P 50010, and a prolonged upturn lies ahead, based on the message from the previous upcycle. From a cyclical perspective, the defense capital goods shipments-to-inventories ratio is outpacing the overall manufacturing sector (second panel. Chart 16), reinforcing the case for ongoing earnings outperformance. The same also holds true in Europe. Western European terrorist attacks have increased, heralding further relative gains for the euro area aerospace & defense index (bottom panel, Chart 16). Beyond the disastrous spike in terrorism, the global space race is also gaining traction, with China spearheading the charge. There is a good chance that China will attain geosynchronous orbit satellites (residing more than 20,000 miles above the earth), challenging U.S. space dominance. India's space aspirations are grand and it is slowly and stealthily rising up the ranks on the space race. Moreover, as more countries aim to have manned space missions, that translates into higher space budgets and thus firming demand for space-related expenditures (Chart 17). Chart 17Space, The Final Frontier Brothers In Arms Brothers In Arms Finally, the number of cyber-attacks is also on the rise globally. Defending against attacks is a challenge. Not only does the cyber space domain definition remain elusive, but tracking hackers down is also increasingly difficult given the vastest of the internet, lack of global uniform policing methods and physical country borders. Crudely put, it is a lot easier for a Chinese or Russian hacker to deal a blow, for example, to U.S. nuclear infrastructure rather than physically deliver an attack. All of this suggests that investment in anti-hacking and counter cyber-attack capabilities is necessary around the globe in order to thwart cyber-terrorism. Risks To Our View While there is conceivably a risk that China will abruptly halt its intense militarization and make a U turn in its long-term strategy of becoming a military superpower, we assign a very low probability to such a turn of events. The global push for more fiscal spending may not materialize, which would be a risk to our sanguine global defense spending view. As Paul Volcker and Peter Peterson recently opined in a NY Times article11 - offering a different view from the always-articulate Larry Summers - prudent and fiscally responsible spending is in order given the excessive debt-to-GDP ratio that is probing war-like levels (Chart 18). This excessive debt overhang is not only a U.S. phenomenon, but also a global one spanning both advanced and emerging economies. Chart 18Excessive Debt Is A Risk To Bullish View On Global Defense Stocks Excessive Debt Is A Risk To Bullish View On Global Defense Stocks Excessive Debt Is A Risk To Bullish View On Global Defense Stocks One final risk is that the world will enter a prolonged peace phase and global terrorism will get quashed, with conflicts dying down in the Middle East, Russia reining in its imperialistic ambitions and China ceasing to stir the waters in the South and East China Seas. We would also assign low odds to this optimistic "no conflict phase" scenario, but it would indeed be welcome. Investment Conclusion Factors are falling into place for a structural outperformance period in the global defense index. The early-1900s and early-1960s parallels, coupled with the trifecta of terrorism, space race and cyber security all point to upbeat demand for defense-related goods and services. Expressing this buoyant view can be done from a bottom up perspective. The Appendix below highlights all the companies in the global defense index we track from Datastream and the alternative one from Bloomberg. An investable proxy is the U.S. aerospace & defense index as the U.S. dominates global A&D indexes and aerospace outfits also sport significant defense corporate segments (please see the Appendix below for relevant tickers). There are also three fairly liquid ETFs mimicking the U.S. A&D index: ITA:US, PPA:US & XAR:US. Moreover, below are a few more speculative investment ideas. Given China's dominance of global defense spending (ex-U.S.) we are confident that Chinese A&D stocks will also be eagerly sought after and deliver alpha in the coming years (please refer to the Appendix below for a list of China plays). If one has the resilience and the stomach to invest in Russian equities given high political and currency risk, then Russian A&D stocks may be a desirable vehicle. Russia remains a massive weapons exporter with a large sphere of influence. We would not underestimate the returns in local currency of some Russian A&D stocks (the Appendix below lists some Russian A&D listed firms). Finally, Israel A&D and IT companies either listed on NASDAQ or domestically in Tel Aviv offer some great opportunities for investors that can handle riskier investments. Not only Israel's geography, but also its intense IT/military focus and entrepreneurial culture imply that a number of these companies will be long-term winners (please see the Appendix below for relevant tickers). While most of the drones, space-related, and highly specialized IT companies are private, there is a drone and an anti-hacking ETF (IFLY:US & HACK:US). On the space front, we are tracking an index that comprises a number of space-related constituents that we show in the Appendix below. Nevertheless, most of these companies are categorized under A&D. Bottom Line: We are initiating a structural overweight in the global defense index with a longer-than-usual five year secular investment horizon. The re-rating phase in this index is still in the early innings. The re-rating phase in this index is still in the early innings. We also reiterate our overweight in the BCA U.S. defense index (LMT, GD, RTN, NOC, LLL). Anastasios Avgeriou, Vice President Global Alpha Sector Strategy anastasios@bcaresearch.com 1 Angell, Norman (1911), The Great Illusion: A Study of the Relation of Military Power in Nations to their Economic and Social Advantage, (3 ed.), New York and London: G.P. Putnam’s & Sons. 2 Please see BCA Geopolitical Strategy Monthly Report, “The Great Risk Rotation,” dated December 11, 2013, available at gps.bcaresearch.com 3 Please see BCA Geopolitical Strategy Monthly Report, “Multipolarity And Investing,” dated April 9, 2014, available at gps.bcaresearch.com 4 Angell, Warren, Kenneth (1989), Armstrongs of Elswick: Growth In Engineering And Armaments To The Merger with Vickers, London, The Macmillan Press Ltd. 5 http://www.oxforddnb.com/index/38/101038270/ 6 https://www.britannica.com/biography/Basil-Zaharoff 7 Please see BCA Geopolitical Strategy Special Report, “Sino-American Conflict: More Likely Than You Think, Part II,” dated November 6, 2015, available at gps.bcaresearch.com 8 Please see BCA Geopolitical Strategy, “The Apex Of Globalization - All Downhill From Here,” in Monthly Report, “Winter Is Coming,” dated November 12, 2014, available at gps.bcaresearch.com 9 Please see BCA Geopolitical Strategy Special Report, “A Bull Market For Terror,” dated August 5, 2016, available at gps.bcaresearch.com 10 Please see U.S. Equity Strategy Weekly Report, “Wobbling,” dated December 7, 2015, available at uses.bcaresearch.com 11 http://www.nytimes.com/2016/10/22/opinion/ignoring-the-debt-problem.html?_r=0 Appendix Table A1BI Global Defense Primes Competitive Peers Brothers In Arms Brothers In Arms Table A2World Defense Index (DS: DEFENWD) Brothers In Arms Brothers In Arms Table A3S&P 500 Aerospace & Defense Index ##br## (S5AERO Index) Brothers In Arms Brothers In Arms Table A4China ##br## Aerospace & Defense Brothers In Arms Brothers In Arms Table A5Russia & Israel Aerospace & Defense Brothers In Arms Brothers In Arms Table A6Kensho Space Index Brothers In Arms Brothers In Arms

The reflation rally continues. Despite our bearish outlook for the year, we think the risks of the current rally lie to the upside given China's redoubling of stimulus at the expense of reform. Populist troubles are picking up in Europe, but we maintain our positive structural view and note that the migration crisis is slackening. Rather, the greatest risks of populism continue to flourish in the Anglo-Saxon world with Brexit and Trump.

The previous Insight showed that the overall industrials sector was in recession territory, based on the message from sinking capital goods orders. At a minimum, that argues for a highly selective investment approach. For instance, in December, we separated our coverage of the S&P aerospace & defense index into its two distinct components, underweight the former and overweighting the latter. We showed that a divergence between these two groups is typical during recessions. The latest data bear out this view. Aerospace new orders are very soft, arguing the commercial aerospace cycle is on the downswing. In turn, that implies lower plane deliveries and future profit margin pressure, as evidenced by Boeings' earnings miss. Conversely, defense orders are moving higher, which is supportive of ongoing earnings growth. We reiterate our overweight view of defense stocks, and underweight stance on aerospace names. bca.uses_in_2016_01_29_002_c1 bca.uses_in_2016_01_29_002_c1