Airlines

Airlines - Soaring Airlines - Soaring Overweight An axiom we have noted numerous times is that, as oil prices decline, the share prices of airlines rise and vice versa. As such, the recent spike in airlines share prices (our upgrade of the S&P airlines index a scant 11 days ago1 has already returned 4% relative to the S&P 500) amidst the collapse in energy prices is of no surprise; relative forward EPS should start moving accordingly (second panel). Airlines typically gain outsized benefits (or losses) on rapid moves in energy, given the lag between ticket sales and the consumption of jet fuel. The current fall in jet fuel prices will thus disproportionately benefit the unhedged airlines (DAL, UAL and AAL) relative to the partially hedged airlines (LUV and ALK). Still, consumers will eventually demand some of the savings passed on to them, which may reverse what has been the best fare environment for airlines of the past four years (third panel). A significant offset will be the already very high capacity utilization at airlines (bottom panel) that lower fares will only serve to increase, preserving the bulk of the margin gains lower jet fuel prices will deliver. Bottom Line: Solid demand, tight capacity and input cost deflation all point to earnings outperformance; we reiterate our recent airlines upgrade to overweight. The ticker symbols for the stocks in this index are: BLBG: S5AIRL - DAL, LUV, UAL, AAL and ALK.   1      Please see BCA U.S. Equity Strategy Report, “Manic Market” dated November 19, 2018, available at uses.bcaresearch.com.

Up In The Air Up In The Air Overweight The recent carnage in oil markets has breathed a huge sigh of relief into the S&P airlines index (most of which do not hedge fuels costs) as the collapse in WTI crude oil prices has also taken down kerosene prices. As we noted in our early-summer report when we added an upgrade alert to this sector, a letup in jet fuel prices would be the catalyst for a change in view1; we executed this upgrade in Monday's Weekly Report. The second panel of our chart shows that input cost relief will be a key driver of a rebound in relative airline profits in the coming months. However, not only will airlines get a boost from falling jet fuel prices, but also demand for travel remains upbeat. Consumer confidence is sky high and consumer spending is running at a healthy clip, at a time when job certainty is high and wage inflation is making a comeback (third and bottom panels). Adding it up, it no longer pays to be bearish airlines. Firming pricing power on the back of recovering demand coupled with input cost deflation suggest that an earnings led recovery in the S&P airlines index is in order. Bottom Line: We crystallized gains of 18% since inception and lifted exposure to an above benchmark allocation on Monday, please see our Weekly Report for more details. The ticker symbols for the stocks in this index are: BLBG: S5AIRL - DAL, LUV, UAL, AAL and ALK. ​​​​ 1 Please see BCA U.S. Equity Strategy Insight Report, "Could Jet Fuel Be The Tailwind Airlines Need?" dated June 6, 2018, available at uses.bcaresearch.com.

Dear Client, Next week on November 26th instead of our regular weekly publication you will receive our flagship publication “The Bank Credit Analyst” with our annual investment outlook. Our regular publication service will resume on December 3rd with our high-conviction trades for 2019. Kind regards, Anastasios Avgeriou Highlights Portfolio Strategy We maintain our sanguine U.S. equity market view for the coming 9-12 months and reiterate our conviction that it is a good time to deploy longer-term oriented capital. The signal from our Economic Impulse Indicator represents a yellow flag and we will continue to monitor the economy for additional soft-patch signals, especially as the Fed remains committed to tighten monetary policy three more times by mid-2019. Firming pricing power on the back of recovering demand coupled with input cost deflation suggest that an earnings led recovery in the S&P airlines index is in order. Take profits and boost to an overweight stance today. Burgeoning domestic demand for freight services, healthy industry operating metrics, the recent margin boost owing to the crude oil price collapse along with compelling valuations and technicals, suggest that the path of least resistance is higher for the S&P air freight & logistics group. Recent Changes Book gains in the S&P Airlines index of 18% since inception and lift from below benchmark to overweight today. Table 1 Manic Market Manic Market FEATURE The SPX was rudderless last week, as the tug-of-war between bears and bulls has yet to be decided. Equities have been experiencing mini-aftershocks following October's seismic move because the Fed has injected some volatility back into the markets via raising interest rates and allowing bonds to roll off its balance sheet at an accelerating pace. While the Fed stayed pat in November, it will most definitely tighten monetary policy next month for the ninth time this cycle. Fed policy is at the epicenter of recent S&P 500 oscillations, which raises the question: is the Fed tightening monetary policy too far too fast to cause equity market consternation? To put the latest monetary tightening cycle in perspective, we examined trough-to-peak moves in the fed funds rate since the 1950s. Chart 1 shows the results of our analysis. During the past ten Fed tightening cycles, the median trough-to-peak delta in the fed funds rate heading into recession has been 495bps. The latest cycle that commenced in December 2015 is already 25bps above the median, if one uses the Wu-Xia shadow fed funds rate to capture the full quantitative easing effect (Chart 2). Were the Fed to hike three more times by the first half of 2019, as our fixed income strategists expect, this will push the current cycle 100bps above the historical median. Chart 1Too Far Too Fast? Too Far Too Fast? Too Far Too Fast? Chart 2Trough-To-Peak Tightening Cycle Already Above Historical Median Manic Market Manic Market While almost everyone raves about the stellar U.S. economic performance squarely focused on levels of different economic indicators (Chart 3), drilling beneath the surface reveals that small cracks are forming, as we first highlighted in the October 22nd Weekly Report when we introduced our Economic Impulse Indicator (EII).1 The EII is a second derivate equally-weighted composite of six indicators of the U.S. economy, highlighting that peak economy was likely hit this year in Q2, when nominal GDP grew 7.6% on a quarter-over-quarter annualized growth rate basis. Chart 3Do Not Focus On Levels Alone... Do Not Focus On Levels Alone… Do Not Focus On Levels Alone… Chart 4 shows that 5 out of the 6 indicators included in the EII are losing steam, 4 out of 6 are in outright contraction, and only capex is showing modest signs of life. While this backdrop in isolation does not portend recession, were the Fed to go ahead with three additional hikes by mid-year 2019 that would push the fed funds rate to a range of 2.75%-3% and a possible negative Q2/2019 GDP print could then easily invert the yield curve, ticking the box in one of our three recession indicators we track.2 Chart 4...Impulses Tell A Different Story …Impulses Tell A Different Story …Impulses Tell A Different Story The latest Fed Senior Loan Officer survey released last week also struck a nerve. While bankers are willing extenders of credit throughout most loan categories, demand for loans is declining across the board (Chart 5A); only other consumer (likely student) loans are in high demand, and subprime residential loans are also threatening to break above the zero line.3 Nevertheless, before getting too bearish, a bond valuation examination is in order. BCA's 10-year bond valuation index has been an excellent predictor of cycle ends dating back to the 1960s. It has accurately forecast 6 out of the last 7 recessions missing only the 1974 iteration. When this valuation metric swings to extremely undervalued territory - defined as at least one standard deviation above the historical mean - it signals that a recession is approaching. Why? Typically a selloff in the bond market is associated with a fed tightening cycle and such steep monetary tightening slams the breaks on the economy via the slowing housing market and the dent in consumer spending power. True, we are closing in on this level, but we are not there yet (Chart 5B). Chart 5ALoan Demand In Freefall Loan Demand In Freefall Loan Demand In Freefall Chart 5BWatch Bond Valuations Watch Bond Valuations Watch Bond Valuations Finally, we bought the proverbial dip on October 26th as we did not (and still do not) foresee recession in the coming 9-12 months, underscoring that likely the trough is in place.4 On that front the Minneapolis Fed's implied probability of a 20%+ correction remains tame near the 10% probability mark, corroborating our sense that the worst is behind the equity market, at least for now (Chart 6). Chart 6Risk Of A Bear Market Is Low Risk Of A Bear Market Is Low Risk Of A Bear Market Is Low Netting it all out, we maintain our sanguine equity market view for the coming 9-12 months and reiterate our conviction that it is a good time to deploy longer-term oriented capital. The signal from our EII represents a yellow flag and we will continue to monitor the economy for additional soft-patch signals especially as the Fed remains committed to tighten monetary policy three more times by mid-2019. This week we crystalize gains in the smallest transportation sub-index we cover and boost exposure to overweight, and reiterate our high-conviction overweight stance on a large transportation sub-index. Airlines: Up In The Air Within transports we have been advocating a barbell portfolio preferring air freight & logistics (see below for an update) to airlines (as a reminder we recently downgraded rails to neutral5). The recent carnage in oil markets has breathed a huge sigh of relief into the S&P airlines index (most of which do not hedge fuels costs) as the collapse in WTI crude oil prices has also taken down kerosene prices. Chart 7 shows that input cost relief will be a key driver of a rebound in relative airline profits in the coming months. Thus, we are compelled to trigger our upgrade alert and cement gains of 18% in our underweight and lift exposure to overweight in the niche S&P airlines index. Chart 7Energy Price Plunge Is Bullish For Airline EPS Energy Price Plunge Is Bullish For Airline EPS Energy Price Plunge Is Bullish For Airline EPS Not only will airlines get a boost from falling jet fuel prices, but also demand for travel remains upbeat. Consumer confidence is sky high and consumer spending is running at a healthy clip, at a time when job certainty is high and wage inflation is making a comeback (Chart 8). Chart 8Air Travel Demand... Air Travel Demand… Air Travel Demand… In fact, a larger proportion of the consumer's wallet is used for air travel, a trend that has been recently gaining steam according to national accounts. Airline load factors are pushing cyclical highs and passenger revenue per available seat mile is also gaining momentum, corroborating the U.S. government consumption expenditure data (Chart 9). Chart 9...Is Upbeat... …Is Upbeat… …Is Upbeat… As a result, airlines have been successful at raising selling prices and will soon exit the deflationary zone. International airfares are also in positive territory. Taken together, robust demand and higher selling prices along with declining fuel costs are a harbinger of rising margins and profits (Chart 10). Chart 10Firming Ticket Prices Is A Boon To Margins Firming Ticket Prices Is A Boon To Margins Firming Ticket Prices Is A Boon To Margins This is not yet reflected in depressed relative forward sales and profit growth estimates. Net earnings revisions have also recovered to the zero line and there is scope for additional positive EPS revisions, especially if jet fuel prices stay tamed and travel demand remains healthy. The implication is that relative share price momentum can lift off further (Chart 11). Chart 11Low Hurdle Low Hurdle Low Hurdle Finally, valuations are perched deeply in the undervalued zone while technicals have only recently returned to a neutral setting (Chart 12). Chart 12Unloved and Under-owned Unloved and Under-owned Unloved and Under-owned Adding it up, it no longer pays to be bearish airlines. Firming pricing power on the back of recovering demand coupled with input cost deflation suggest that an earnings led recovery in the S&P airlines index is in order. Bottom Line: Take profits in the S&P airlines index of 18% since inception and lift exposure to an above benchmark allocation. The ticker symbols for the stocks in this index are: BLBG: S5AIRL - DAL, LUV, UAL, AAL and ALK. Air Freight & Logistics: We Have Liftoff Air freight & logistics stocks have been bouncing along the bottom for the better part of the past year and have formed a base that should serve as a launch board higher in the coming months. Firming industry operating metrics tell a positive story and suggest that relative share prices will soon take off. Air freight pricing power has been healthy, in expansionary territory and above overall inflation measures, at a time when industry executives have been showing labor restraint, with employment growth decelerating steadily over the past two years (Chart 13). This is a conducive backdrop for air freight profit margins and sell-side analysts have taken notice, penciling in higher margins in the coming 12 months. Chart 13Enticing Margin Prospects Enticing Margin Prospects Enticing Margin Prospects Importantly, energy costs comprise a large chunk of freight services input costs and the recent drubbing in oil markets will boost margins especially on the eve of the busiest season for courier delivery services (top panel, Chart 14). Chart 14Holiday Selling Season Beneficiary Holiday Selling Season Beneficiary Holiday Selling Season Beneficiary On that front, there are high odds that this holiday sales season will be another record setting one, especially given that corporations have paid out bonuses and shared part of the lowering in corporate taxes and also wage inflation is underpinning discretionary incomes. Keep in mind that the accelerating domestic manufacturing shipments-to-inventories ratio confirms that demand for hauling services is upbeat. The implication is that rising demand for freight services will buoy industry profits and lift valuations out of their recent funk (middle & bottom panels, Chart 14). With regard to the global macro and trade backdrop, while global revenue ton miles and G3 capital goods orders remain near cyclical highs (Chart 15), were Trump's trade rhetoric to re-escalate then global exports would give way. Already international and U.S. export expectations are on the verge of contracting - according to the IFO World Economic Survey and ISM manufacturing survey, respectively. Tack on the appreciating U.S. currency and the clouds darken further (bottom panel, Chart 15). The U.S./China trade tussle and the greenback are clear risks to our sanguine S&P air freight & logistics transportation subindex. Chart 15Greenback And Decelerating Global Growth Are Key Risks... Greenback And Decelerating Global Growth Are Key Risks… Greenback And Decelerating Global Growth Are Key Risks… Nevertheless, most of the grim news is already reflected in depressed relative forward profit estimates, bombed out valuations and washed out technicals. In sum, firming domestic demand for freight services, healthy industry operating metrics, the recent margin boost owing to the crude oil price collapse along with compelling valuations and technicals suggest that the path of least resistance is higher for the S&P air freight & logistics group (Chart 16). Chart 16...But Already Reflected In Depressed Valuations And Washed Out Technicals …But Already Reflected In Depressed Valuations And Washed Out Technicals …But Already Reflected In Depressed Valuations And Washed Out Technicals Bottom Line: We reiterate our high-conviction overweight status in the S&P air freight & logistics index. The ticker symbols for the stocks in this index are: BLBG: S5AIRF - FDX, UPS, EXPD and CHRW. Anastasios Avgeriou, Vice President U.S. Equity Strategy anastasios@bcaresearch.com 1 Please see BCA U.S. Equity Strategy Report, "Icarus Moment?" dated October 22, 2018, available at uses.bcaresearch.com. 2 Ibid. 3 https://www.federalreserve.gov/data/documents/sloos-201810-charts.pdf 4 Please see BCA U.S. Equity Strategy Insight Report, “Time To Bargain Hunt” dated October 26, 2018, available at uses.bcaresearch.com. 5 Please see BCA U.S. Equity Strategy Report, "Critical Reset" dated October 29, 2018, available at uses.bcaresearch.com. Current Recommendations Current Trades Size And Style Views Favor value over growth Favor large over small caps

Underweight - Upgrade Alert The S&P airlines index has been buffeted by headwinds arising from the increasing cost of jet fuel; as the top panel of our chart shows, the price of jet fuel is the single largest driver of airline relative stock performance. In an environment where nearly all airlines bear the volatility of fuel costs without hedging offsets and where such costs represent roughly a quarter of the total, this correlation is logical. Airlines have been responding to rising jet fuel prices by cancelling planned capacity expansions and clamping down on controllable costs, as evidenced by Delta's strong Q3 earnings report this week. Still, the sell side has been reducing profit forecasts in parallel with falling stock prices. The upshot is that valuations have moved sideways to lower (bottom panel). As a reminder, we added an upgrade alert to the S&P airlines index this summer as these depressed valuations reflect much of the bad news. We reiterate that we would not hesitate to crystallize relative profits north of 27% since our underweight inception if fuel prices reverse direction. Bottom Line: Stay underweight the S&P airlines index for now and maintain an upgrade alert. The ticker symbols for the stocks in this index are: BLBG: S5AIRL - DAL, LUV, AAL, UAL, ALK. Fuel Pressure Is Causing Airlines To Bleed Air Fuel Pressure Is Causing Airlines To Bleed Air

Underweight The S&P airlines index got a rare respite last week when United Airlines reported strong results and, perhaps more importantly, scaled back capacity growth plans. Regarding the latter, recall that earlier this year the company had announced a significant expansion, triggering fears of a return to the bad old days of industry overindulgence and a fare war. With respect to the earnings themselves, ticket prices appear to be more resilient than we had feared and are mostly offsetting fuel price increases; airfare's declining share of the consumer's wallet looks to have bottomed (second panel). Further, higher prices are not impacting the operating efficiency gains of the past five years as load factors are still near peak levels (third panel). The upshot is that margins may soon arrest their descent (bottom panel); we reiterate our underweight recommendation with an upgrade alert. The ticker symbols for the stocks in this index are: BLBG: S5AIRL - DAL, LUV, AAL, UAL, ALK. A Break In The Clouds? A Break In The Clouds?

Underweight (Upgrade Alert) It is a well-established rule that where jet fuel prices go, airline stock prices will go the opposite direction. Thus, it is no surprise that the most recent peak in the S&P airlines index coincided with the most recent trough in jet fuel prices in early 2017; the former has since fallen steeply as the latter has soared (fuel prices shown inverted in top panel). Easing oil prices are a likely catalyst for a significant rerating in depressed relative valuations. Fuel hedges no longer play a significant role in earnings and lower fuel costs would translate directly to the bottom line. As a reminder, nearly all major players reiterated their pledge to avoid kerosene hedging earlier this year. Adding it up, we think downside risks to airlines have abated considerably and are well reflected in beaten down valuations (bottom panel). We are therefore compelled to add this transportation sub-index to our upgrade watch list. If there is any letup in jet fuel prices, we would not hesitate to crystallize relative profits north of 21% since our underweight inception. Bottom Line: Stay underweight the S&P airlines index for now, but put in on upgrade alert; please see Monday's Weekly Report for more details. The ticker symbols for the stocks in this index are: BLBG: S5AIRL - DAL, LUV, AAL, UAL, ALK. Could Jet Fuel Be The Tailwind Airlines Need? Could Jet Fuel Be The Tailwind Airlines Need?

Highlights Portfolio Strategy A virtuous software capex upcycle will continue to bolster industry sales/profits in the coming months. We reiterate our high-conviction overweight recommendation on the S&P software index. Depressed relative valuations signal that the weak airline profit margin backdrop is baked in the cake. Rising load factors and the possibility of an easing in jet fuel prices compel us to put this transportation sub-index on our upgrade watch list. Recent Changes Put the S&P Airlines Index on upgrade alert. Table 1 Unwavering Unwavering Feature Stocks took it on the chin early last week as geopolitical risks resurfaced in a big way, but managed to bounce smartly and end the week on a high note. Not only did Trump slap new tariffs reigniting trade war fears, but Italian political instability rocked global bond and stock markets. While this mini 'risk-off' phase has rattled investors, the key question hanging over markets is: will the current global growth soft patch prove transitory or morph into a severe global growth deceleration? We side with the former. While it is too early to call the end of the global growth lull, there are high odds that the U.S. will lift the world out of its year-to-date mini-slump in the back half of the year. The third panel of Chart 1 shows that the IHS Markit U.S. manufacturing PMI has been steeply diverging from the J.P. Morgan-calculated global manufacturing PMI. The latter has ticked up recently, and given recent U.S. economic greenshoots and America's heavy weighting in global output, it should pull global growth higher. Chart 1Too Soon To Bail Too Soon To Bail Too Soon To Bail Chart 2Monitor The Greenback's Impact On Profits Monitor The Greenback's Impact On Profits Monitor The Greenback's Impact On Profits Importantly, this leading U.S. economic growth indicator is also signaling that SPX momentum will resume its ascent in the coming months, a message corroborated by the latest ISM manufacturing survey print (second panel, Chart 1). What could push our still constructive cyclical 9-12 month equity view offside is a surge in the U.S. dollar. The greenback's trough coincided with last year's peak in global growth (bottom panel Chart 1), and further dollar appreciation - resulting from either stress in emerging markets or a further flare-up of Eurozone breakup risk - would necessitate downward revisions to calendar 2019 sell-side earnings forecasts (Chart 2). We are closely monitoring Eurozone geopolitical risks, and are also awaiting the ECB's response. If persistent turmoil causes the ECB to stay easier for longer than the market expects, then the euro will come under downward pressure against the dollar, especially if the Fed continues to hike as we expect. Last week alone BCA's months-to-hike gauge for the ECB jumped by five months, implying the first hike moved to mid-year 2020 (second panel, Chart 3). We recently showed the U.S. tech sector's hefty foreign sales exposure of roughly 60% of total revenues, greater than for any other GICS1 sector by a wide margin (please refer to Chart 8 from the April 9, 2018 Weekly Report titled "Buying Opportunity?"). As such the technology sector's profits serve as a great leading indicator of any U.S. dollar appreciation related blues. Up to now, tech net EPS revisions have not been sniffing out any currency related earnings trouble that could infiltrate overall SPX EPS (U.S. trade-weighted dollar shown inverted, third panel, Chart 4). Similarly, relative tech sector stock momentum and our tech sector EPS growth model are not waving any yellow flags (Chart 4). Chart 3Steadfast ##br##SPX Steadfast SPX Steadfast SPX Chart 4Tech Stocks Will Be The First To Sniff ##br##Out U.S. Dollar Profit Woes Tech Stocks Will Be The First To Sniff Out U.S. Dollar Profit Woes Tech Stocks Will Be The First To Sniff Out U.S. Dollar Profit Woes Netting it all out, there are high odds that the U.S. will lead global growth higher in the coming quarters and result in a recoupling higher of global growth, assuming the greenback stops appreciating. This would support low double digit calendar 2019 SPX profit growth. Under such a macro backdrop, it still pays to maintain a cyclicals over defensives portfolio bent. This week we are revisiting one tech sector high-conviction overweight and putting a transport sub-index on upgrade watch. Stick With Software Stocks The S&P software index is on the cusp of breaching the 2000 relative performance all-time peak, and we reiterate the high-conviction overweight status of this key tech sub-index, that is up over 11% versus the SPX since the late-November inception.1 Although this may appear exuberant, from a longer-term perspective, relative share prices only recently reclaimed the upward sloping historical time trend mean (top panel, Chart 5). The implication is that more gains are in store prior to the end of the business cycle. BCA's synchronized global capex upcycle theme is the fundamental driver of our sanguine software industry view. In the aftermath of the dotcom bust, tech investment in general and software in particular, went into hibernation for a whole decade. Currently, software investment is outpacing overall capital outlays (middle panel, Chart 5). These software capex market share gains on the back of a growing overall capex pie bode well for relative profit growth. Animal spirits remain upbeat with both consumer and most importantly CEO confidence probing multi-year highs. Tack on the still buoyant message from our capex indicator and software spending has more room to grow (second & third panels, Chart 6). In addition, the government sector may also increase spending on IT/software services on the back of easing fiscal policy and beefing up on cybersecurity (Chart 7). Chart 5Buy The Breakout Buy The Breakout Buy The Breakout Chart 6Even Uncle Sam Is Buying Software Even Uncle Sam Is Buying Software Even Uncle Sam Is Buying Software Chart 7Margin Expansion Phase Has Legs Margin Expansion Phase Has Legs Margin Expansion Phase Has Legs While our S&P software EPS growth model corroborates this encouraging news (bottom panel, Chart 5), sell side analysts do not share our optimism. In fact, software profits are forecast to trail the broad market by 500bps, a rather low hurdle. On the operating front, sales are accelerating at a time when labor costs remain contained. Importantly, software prices are on the verge of exiting deflation, underscoring that software demand is robust. Moreover, the secular advance in cloud computing and SaaS represent a long-term positive demand backdrop. The upshot is that the mini margin expansion phase in place since early-2016 has more legs (Chart 7). Meanwhile, the S&P software index has a pristine balance sheet with virtually no net debt, a high interest coverage ratio and galloping higher free cash flow (Chart 8). Unsurprisingly, this cash rich tech subsector has also been in the middle of an M&A frenzy. This supply reduction is not only bullish for industry pricing power, and thus profit growth, but it has also led to hefty M&A premia and a significant valuation rerating (bottom panel, Chart 9). Chart 8Pristine Balance Sheet Pristine Balance Sheet Pristine Balance Sheet Chart 9Software Will Grow Into Pricey Valuations Software Will Grow Into Pricey Valuations Software Will Grow Into Pricey Valuations If our virtuous capex upcycle thesis further bolsters software sales/profits in the coming months, then more gains are in store for the S&P software index that will likely grow into its pricey valuations. Bottom Line: We reiterate our high-conviction overweight status in the S&P software index. The ticker symbols for the stocks in this index are: BLBG: S5SOFT - MSFT, ORCL, ADBE, CRM, ATVI, INTU, EA, RHT, ADSK, CTXS, ANSS, SNPS, SYMC, TTWO, CDNS, CA. Could Jet Fuel Be The Tailwind Airlines Need? It is a well-established rule that where jet fuel prices go, airline stock prices will go the opposite direction. Thus it is no surprise that the most recent peak in the S&P airlines index coincided with the most recent trough in jet fuel prices in early 2017; the former has since fallen steeply as the latter has soared (top panel, Chart 10). This relationship has grown more acute as the industry, having been burned when fuel prices collapsed in 2014, has all but abandoned fuel hedging. The timing for rising jet fuel prices could scarcely be less opportune; historically, airlines have been able to pass through rising fuel costs. Now, in the midst of an industry price war, pricing power and fuel costs are diverging (second panel, Chart 10). The impact is apparent on industry margins, which have been in decline for nearly two years and more pain likely lies ahead (second panel, Chart 11). The head of airline industry group International Air Transport Association (IATA), recently noted that rising oil prices would significantly bite into airline profitability next year; IATA is widely expected to lower its industry benchmark profit forecast this week. Chart 10Mind The Gap Mind The Gap Mind The Gap Chart 11Acute Margin Trouble... Acute Margin Trouble... Acute Margin Trouble... The source of industry conflict has been an uptick in capacity growth. Airlines are adding capacity faster than the economy is growing (third and fourth panels, Chart 11) and the only relief valve to preserve market share is to cut prices. In this context, it is difficult to understand analysts' 20%+ EPS growth forecast for next year, significantly outpacing the S&P 500 (bottom panel, Chart 11). However, the news is not all bad. Despite the competitive headwinds, the industry has been successful at moving unit revenues higher and airlines have been doing so at an aggressive pace in 2018 (second panel, Chart 12). Further, industry load factors (in essence, the percentage of filled seats) are near their highest level ever, indicating capacity growth is being met with lower price-induced demand growth (bottom panel, Chart 12). Rising load factors are typically a precursor to price (and profit) increases. Investors appear to have capitulated. Airlines trade at roughly half the market multiple on an EV/EBITDA basis and a substantial discount on a price/book basis (second & third panels, Chart 13). From a valuation perspective, airlines look set to take off. Chart 12...But Demand is Firming... ...But Demand is Firming... ...But Demand is Firming... Chart 13...And Most Bad News Is Likely Priced In ...And Most Bad News Is Likely Priced In ...And Most Bad News Is Likely Priced In Easing oil prices are a likely catalyst for a significant rerating in depressed relative valuations. Fuel hedges no longer play a significant role in earnings and lower fuel costs would translate directly to the bottom line. As a reminder, nearly all major players reiterated their pledge to avoid kerosene hedging earlier this year. Adding it up, we think downside risks to airlines have abated considerably and are well reflected in beaten down valuations. We are therefore compelled to add this transportation sub-index to our upgrade watch list. If there is any letup in jet fuel prices, we would not hesitate to crystallize relative profits north of 21% since our underweight inception. Bottom Line: Stay underweight the S&P airlines index for now, but put in on upgrade alert. The ticker symbols for the stocks in this index are: BLBG: S5AIRL - DAL, LUV, AAL, UAL, ALK. Anastasios Avgeriou, Vice President U.S. Equity Strategy anastasios@bcaresearch.com 1 Please see BCA U.S. Equity Strategy Weekly Report, "2018 High-Conviction Calls," dated November 27, 2017, available at uses.bcaresearch.com. Current Recommendations Current Trades Size And Style Views Favor value over growth Favor large over small caps

Underweight As recently as three months ago, the U.S. legacy air carriers were being feted for not diving headfirst into fuel hedges, as they had done in earlier cycles to mixed results. Now, with jet fuel prices hitting 3 year highs, the shine has come off the market (top panel). AAL, who saw spectacular benefits as the price of fuel was falling, reduced their full year earnings guidance by 10% yesterday as pricing has failed to keep pace with the rising costs. Even LUV, who still maintain a modest hedge portfolio, lowered expectations, though they have some fairly specific challenges following a fatal engine incident. Rising jet fuel prices are coming at an inopportune time; the industry is binging on new capacity which has spurred a price war. Predictably, such a strategy has been stretching balance sheets (second panel). At a time when valuations have appeared to turn a corner (bottom panel), we think an excellent selling opportunity has emerged. We reiterate our underweight recommendation. The ticker symbols for the stocks in this index are: BLBG: S5AIRL - DAL, LUV, AAL, UAL, ALK. Please Look For Your Nearest Exit Please Look For Your Nearest Exit

Underweight U.S. airline stocks hit a patch of turbulence this week when Southwest, usually known for being the price disrupter amongst airline peers, dropped their Q1 revenue guidance "primarily due to the competitive fare environment". We have been flagging a looming price war since United Airlines announced a significant and prolonged capacity expansion plan earlier this year, underpinning our preference to avoid the S&P airlines index. In fact, airfares have been losing share of the customer's wallet for more than a year now and the downtrend is accelerating (second panel). This is further evidenced by airlines' eroded ability to pass through higher jet fuel prices, which have historically been the marginal price setter (third panel). The upshot of declining revenues and rising costs is stalling margins (bottom panel); investors would be wise to skip this flight and stay underweight. The ticker symbols for the stocks in this index are: BLBG: S5AIRL - DAL, LUV, AAL, UAL, ALK. Price War Is A Downdraft To Airline Earnings Price War Is A Downdraft To Airline Earnings