Airlines

Highlights The German 10-year bund yield rising to 1%, or the U.S. 10-year T-bond yield rising to 3% would be a trigger to downgrade equities and upgrade bonds... ...especially as the blue sky expectations for global growth in H1 2018 will turn out to be overly-optimistic. On a 6-9 month horizon, upgrade Airlines to overweight. Downgrade Banks to underweight. Upgrade Germany (DAX) to neutral. Downgrade Italy (MIB) and Spain (IBEX) to underweight. Feature Where has the equity market cycle gone? Since 2012, the stock market's 6-month returns have generated an unprecedented consistency, with only a brief breakdown - at the end of 2015 - into negative territory (Chart of the Wesk and Chart I-2). Chart of the WeekSince 2012, The Equity Market ##br##Cycle Has Disappeared Since 2012, The Equity Market Cycle Has Disappeared Since 2012, The Equity Market Cycle Has Disappeared Chart I-2Much Less Cyclicality In Equities ##br##Than In Commodities Much Less Cyclicality In Equities Than In Commodities Much Less Cyclicality In Equities Than In Commodities The disappearance of the equity market cycle brings to mind the concept of the "Great Moderation", a term coined in 2002 to describe the big drop in business cycle volatility during the 1990s. In 2004, Ben Bernanke suggested that "improvements in monetary policy, though certainly not the only factor, probably were an important source of the Great Moderation." Today's Great Moderation 2.0 refers to the equity market cycle - or rather, its disappearance. And in finding a reason for the Great Moderation 2.0, Bernanke's attribution to monetary policy might be right on the money. Stick With TINA, Or Flirt With TIA? For many years, ultra-accommodative monetary policy has provided a consistent and substantial uplift to world stock market valuations. Since 2012, our preferred measure of equity market valuation - world stock market capitalisation to GDP - has almost doubled. This inexorable and relatively trouble-free rise has even spawned its own acronym: TINA - There Is No Alternative (to owning equities.) However, the uplift to stock market valuations has happened in a less obvious way than you might realise. Based on the excellent predictive power of stock market capitalisation to GDP, the prospective 10-year annualised return from world equities has collapsed from 9% in 2012 to 1.5% now (Chart I-3). Over the same period, the global 10-year bond yield has compressed from 3% to 1.5%. Hence, the collapse in prospective equity returns is not due to the decline in bond yields per se. It has happened mostly because the excess return offered by equities over bonds - the so-called 'equity risk premium' has compressed from 6% to zero (Chart I-4). Chart I-3World Equity Market Cap To GDP Implies##br## A Feeble Prospective 10-Year Return World Equity Market Cap To GDP Implies A Feeble Prospective 10-Year Return World Equity Market Cap To GDP Implies A Feeble Prospective 10-Year Return Chart I-4Prospective Equity Returns ##br##Have Become 'Bond Like' Prospective Equity Returns, Have Become "Bond Like" Prospective Equity Returns, Have Become "Bond Like" Ultra-accommodative monetary policy has caused the disappearance of the equity risk premium. The simple reason is that at low bond yields, the risk of owning bonds becomes similar to the risk of owning equities. Chart I-5Below A 2% Yield, 10-Year Bonds Have ##br##More Negative Skew Than Equities Beware The Great Moderation 2.0 Beware The Great Moderation 2.0 When bond yields approach their lower bound, bond prices have little upside but they have a lot of downside. This ratio of an investment's potential losses relative to its potential gains is the risk that most frightens investors,1 and is known as negative skew. At yields below 2%, bond returns become as negatively skewed as equity returns, or even more negatively skewed than equities (Chart I-5). As the risk of bonds increases to become 'equity-like', the prospective return from equities must compress to become 'bond-like'. Which is to say, equity valuations become substantially richer. All well and good - so long as the global 10-year bond yield stays low. Above a 2% yield, the negative skew on bond returns disappears, and equities once again require an excess prospective return over bonds. More colloquially, investors would dump TINA and start flirting with TIA (There Is an Alternative). In essence, a big threat to the Great Moderation 2.0 comes the global 10-year bond yield rising to 2% - broadly equivalent to the German 10-year bund yield rising to 1%, or the U.S. 10-year T-bond yield rising to 3%. Any moves towards these thresholds would be a trigger to downgrade equities and upgrade bonds - especially as we now explain why the blue sky expectations for global growth in H1 2018 will turn out to be overly-optimistic. The Equity Sector Cycle Is Alive And Well For the stock market in aggregate, the cycle has been moribund. But for equity sector relative performance, the cycle is very much alive and well. In The Cobweb Theory And Market Cycles 2 we showed and explained the existence of mini-cycles in economic and financial variables. To summarise, a lag between the demand for credit and its supply necessarily creates mini-cycles in both the price of credit (the bond yield) and the quantity of credit (the global credit impulse). Thereby it also creates mini-cycles in GDP growth. The useful point is that these cycles are very regular with half-cycles averaging 6-8 months. Which makes their turning points and phases predictable. Given that the global credit impulse cycle has been in a mini-upswing phase since last May, it is highly likely to turn into a mini-downswing phase through the first half of 2018. The latest data point, showing a tick down, seems to corroborate such a turning point. From an equity sector perspective, Banks versus Healthcare has closely tracked the phases of the credit impulse mini-cycle (Chart I-6). In all five of the last five mini-downswings, Banks have underperformed Healthcare, and we would expect no difference in the next mini-downswing. Hence, on a 6-9 month horizon, downgrade Banks to underweight. Unsurprisingly, exactly the same pattern applies to Basic Materials (and Energy) versus Healthcare (Chart I-7). Hence, on a 6-9 month horizon, stay underweight Basic Materials and Energy versus Healthcare. Also unsurprisingly, the performance of European Airlines is a mirror-image of the oil price cycle, given that aviation fuel comprises the sector's main variable cost (Chart I-8). As an aside, this also somewhat insulates the European Airlines against a strengthening euro, given that this variable cost is priced in dollars. Hence, on a 6-9 month horizon, upgrade European Airlines to overweight. Chart I-6Banks Vs. Healthcare Tracks The ##br##Credit Impulse Mini-Cycle Banks Vs. Healthcare Tracks The Credit Impulse Mini-Cycle Banks Vs. Healthcare Tracks The Credit Impulse Mini-Cycle Chart I-7Materials Vs. Healthcare Tracks The##br## Credit Impulse Mini-Cycle Materials Vs. Healthcare Tracks The Credit Impulse Mini-Cycle Materials Vs. Healthcare Tracks The Credit Impulse Mini-Cycle Chart I-8European Airlines Relative Performance Is A##br## Mirror-Image of The Oil Price Cycle European Airlines Relative Performance Is A Mirror-Image of The Oil Price Cycle European Airlines Relative Performance Is A Mirror-Image of The Oil Price Cycle Country Allocation Just Drops Out Of Sector Allocation Our core philosophy of investment reductionism teaches us that for most stock markets, the sector (and dominant company) skews swamp any effect that comes from the domestic economy. For example, the defining skew for Italy's MIB and Spain's IBEX is their large overweighting to banks. So unsurprisingly, MIB and IBEX relative performance reduces to: will banks outperform the market? (Chart I-9 and Chart I-10). Chart I-9Italy = Long Banks Italy = Long Banks Italy = Long Banks Chart I-10Spain = Long Banks Spain = Long Banks Spain = Long Banks Therefore, the key consideration for European equity country allocation is always: how to allocate to the vital few equity sectors that feature most often in the skews: Banks, Healthcare, Energy and Materials. To reiterate, our 6-9 month recommendation is to underweight Banks, Materials And Energy versus Healthcare, and to overweight Airlines versus the market. Then to arrive at a country allocation, combine the cyclical view on the vital few sectors with the country sector skews shown in Box I-1. Even if you disagree with our sector views, the sector-based approach is the right way to pick European equity markets. If you agree with our sector views, the result is the following updated European equity market allocation: Box I-1: The Vital Few Sector Skews That Drive Country Relative Performance For major equity indexes in the euro area, the dominant sector skews that drive relative performance are as follows: Germany (DAX) is overweight Chemicals, underweight Banks. France (CAC) is underweight Banks and Basic Materials. Italy (MIB) is overweight Banks. Spain (IBEX) is overweight Banks. Netherlands (AEX) is overweight Technology, underweight Banks. Ireland (ISEQ) is overweight Airlines (Ryanair) which is, in effect, underweight Energy. And for major equity indexes outside the euro area: The U.K. (FTSE100) is effectively underweight the pound. Switzerland (SMI) is overweight Healthcare, underweight Energy. Sweden (OMX) is overweight Industrials. Denmark (OMX20) is overweight Healthcare and Industrials. Norway (OBX) is overweight Energy. The U.S. (S&P500) is overweight Technology, underweight Banks. Overweight: France, Ireland, U.K., Switzerland and Denmark. Neutral: Germany, Netherlands. Underweight: Italy, Spain, Sweden and Norway. In terms of change, it means upgrading Germany (DAX) to neutral and downgrading Italy (MIB) and Spain (IBEX) to underweight. Dhaval Joshi, Senior Vice President Chief European Investment Strategist dhaval@bcaresearch.com 1 Please see the European Investment Strategy Weekly Report "Are Bonds A Greater Risk Than Equities", January 28, 2018 available at eis.bcaresearch.com. 2 Please see the European Investment Strategy Weekly Report "The Cobweb Theory And Market Cycles", January 11, 2018 available at eis.bcaresearch.com. Fractal Trading Model* There is a lot of optimism already priced into the South African rand, making it vulnerable to a countertrend reversal. Therefore, this week's recommended trade is to go long USD/ZAR with a profit-target of 6% and a symmetrical stop-loss. In other trades, short S&P500/long Eurostoxx50 hit its stop-loss, while short Japanese energy and short palladium moved comfortably into profit. For any investment, excessive trend following and groupthink can reach a natural point of instability, at which point the established trend is highly likely to break down with or without an external catalyst. An early warning sign is the investment's fractal dimension approaching its natural lower bound. Encouragingly, this trigger has consistently identified countertrend moves of various magnitudes across all asset classes. Chart I-11 USD/ZAR USD/ZAR The post-June 9, 2016 fractal trading model rules are: When the fractal dimension approaches the lower limit after an investment has been in an established trend it is a potential trigger for a liquidity-triggered trend reversal. Therefore, open a countertrend position. The profit target is a one-third reversal of the preceding 13-week move. Apply a symmetrical stop-loss. Close the position at the profit target or stop-loss. Otherwise close the position after 13 weeks. Use the position size multiple to control risk. The position size will be smaller for more risky positions. * For more details please see the European Investment Strategy Special Report "Fractals, Liquidity & A Trading Model," dated December 11, 2014, available at eis.bcaresearch.com Fractal Trading Model Recommendations Equities Bond & Interest Rates Currency & Other Positions Closed Fractal Trades Trades Closed Trades Asset Performance Currency & Bond Equity Sector Country Equity Indicators Bond Yields Chart II-1Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Chart II-2Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Chart II-3Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Chart II-4Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Interest Rate Chart II-5Indicators To Watch ##br##- Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Chart II-6Indicators To Watch ##br##- Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Chart II-7Indicators To Watch ##br##- Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Chart II-8Indicators To Watch ##br##- Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations

Underweight United Airlines spooked the market this week when they announced their plans to grow capacity by 4-6% per year until 2020; the stock fell by 11% that day and took the S&P airlines index down with it. Capacity additions of this magnitude force competitors to choose between matching or ceding market share. Either choice bodes poorly for airfare pricing, probably unwisely considering how consumer spending on airfares has already fallen off a cliff (second panel). Meanwhile, input prices have shot upward and have diverged sharply from airlines’ ability to pass through fuel costs (third panel). This means a reversal of the downward trend in margins remains well beyond the horizon (bottom panel). Investors should avoid the turbulence; stay underweight. The ticker symbols for the stocks in this index are: BLBG: S5AIRL - DAL, LUV, AAL, UAL, ALK. Capacity Additions Add Unwanted Headwinds Capacity Additions Add Unwanted Headwinds

Underweight While we have turned positive on the broad industrials complex and remain constructive on most transports, we continue to recommend investors avoid the S&P airlines index. A costly price war between the low cost carriers and the largely-restructured legacy airlines means airfares are stuck in deflation. The industry has been here before, and recently too. 2015 was a tumultuous year that saw pricing collapse as the ultra-low cost carriers entered the traditional hubs, triggering a scramble for market share. As a result, airlines have not been able to make price increases stick, even in the face of soaring jet fuel costs that eat into profits (second panel). At the same time as cash generation appears most threatened, the industry is in the midst of an expensive fleet renewal. The result is predictable; the hard deleveraging work the industry put in over the course of this decade is being unwound (third panel). This should, in turn, raise risk premiums and reverse the recent upturn in valuation multiples (bottom panel). Bottom Line: With no end in sight to the price war and outsized capacity additions likely to throw fuel on the fire, we think investors should stay away from the S&P airlines index. Accordingly, we reiterate our underweight recommendation; please see Monday's Weekly Report for additional details. The ticker symbols for the stocks in this index are: BLBG: S5AIRL - DAL, LUV, AAL, UAL, ALK. Airlines Update: Deadstick Airlines Update: Deadstick

Highlights Portfolio Strategy Go long industrials/short discretionary. Leading indicators of interest rates, relative sentiment, relative demand and relative exports all signal that industrials stocks will outperform their consumer discretionary peers. A price war is gripping airlines anew, and it will suck the air out of the industry. Recent Changes Long S&P Industrials/Short S&P Consumer Discretionary - Initiate this pair trade today. Table 1 Can Easy Fiscal Offset Tighter Monetary Policy? Can Easy Fiscal Offset Tighter Monetary Policy? Feature Tax relief euphoria propelled the S&P 500 to fresh all-time highs last week. While such exuberance has rekindled the "Trump trade" with small caps outshining mega caps and banks soaring (as a reminder we have a small cap size bias and are overweight financials/banks1), it will likely prove fleeting unless the tax bill becomes law. BCA's Geopolitical Strategy service believes that a tax bill passage is likely in Q1/2018.2 Were that to materialize, it would serve as a catalyst to further fuel the blow off phase in equities. Why? Empirical evidence suggests that easy fiscal policy outweighs the drag from Fed interest rate tightening. Filtering the post WWII era for periods of easing fiscal and tightening monetary policies during expansions is revealing. We define easy fiscal policy as increasing fiscal thrust (year-over-year change in cyclically-adjusted fiscal balance as a percentage of potential GDP, shown inverted, bottom panel, Chart 1) and tight monetary policy as a rising fed funds rate. Chart 1Easy Fiscal + Tight Money = Buy SPX Easy Fiscal + Tight Money = Buy SPX Easy Fiscal + Tight Money = Buy SPX While this is a rare occurrence, it has clearly happened seven times since the mid-1950s (shaded areas, Chart 1). As a clarification, we omitted the brief periods in the early-1960s, early-1970s and twice in the early-1980s as they were very close to the end of those recessions and positively skewed the results. All iterations resulted in positive stock returns with the SPX rising on average by over 16%. Table 2 details all seven periods that have an average duration of 16 months. There are high odds that a tax bill enactment coupled with a potential infrastructure spending bill will more than cushion the blow from the Fed's interest rate hikes in 2018, and sustain the overshoot phase in equities. As we recently showed in our equity market indicator White Paper, the business cycle stays intact during Fed tightening cycles, and historically a peak in the fed funds rate presages a recession.3 Importantly, the highly cyclical part of the U.S. economy is humming. The latest ISM manufacturing survey showed that new orders are running 20% higher than inventories, with the headline number soaring to a 13 year high (third panel, Chart 2). Prices paid also spiked to above 70, signaling that commodity inflation is looming. And, were the capex revival to gain steam as most of the leading indicators we track suggest (see Chart 8 from the October 2nd Weekly Report), then late cyclicals will continue to benefit from end-demand resurgence. Table 2SPX Returns During Periods Of Loose##br## Fiscal And Tight Monetary Policy Can Easy Fiscal Offset Tighter Monetary Policy? Can Easy Fiscal Offset Tighter Monetary Policy? Chart 2It's Deep##br## Cyclicals' Time It's Deep Cyclicals' Time It's Deep Cyclicals' Time As a result, we reiterate last week's upgrade of the S&P industrials sector to overweight, and this week we add more deep cyclical exposure to our portfolio by initiating a market-neutral pair trade to benefit from this enticing macro backdrop. Industrials Will Outmuscle Consumer Discretionary In the past few weeks, we have tweaked our cyclical portfolio exposure by downgrading early-cyclical consumer discretionary stocks to a benchmark allocation and lifting the late cyclical industrials complex to overweight. In fact, a once-in-a-generation opportunity to buy industrials at the expense of discretionary stocks has surfaced, and we recommend a new long S&P industrials/short S&P consumer discretionary sector pair trade to exploit this tradable opportunity. Chart 3 shows that relative share prices recently bounced near the early-1970s all-time lows and a mini V-shaped recovery is taking root. The industrials/discretionary price ratio has been in a downtrend for the better part of the past decade and the most recent peak-to-trough collapse has been a 4 standard deviation move (Chart 3). Even a modest relative performance renormalization near the historical mean would translate into impressive returns. Chart 3Compelling Entry Point Compelling Entry Point Compelling Entry Point Four key drivers underpin our warming up to this late over early cyclical pair trade: interest rates, relative sentiment, relative demand and relative export backdrop. The Fed embarked on a fresh tightening interest rate cycle almost two years ago and is on track to lift the fed funds rate another 100bps by the end of 2018 according to the FOMC's median dot forecast. Interest rate-sensitive stocks suffer when the Fed tightens monetary policy, whereas deep cyclicals disproportionately benefit from accelerating economic growth. Chart 4 confirms that over the past four decades a rising fed funds rate has been synonymous with an increase in the relative share price ratio and vice versa. Chart 4Tight Money Is Good For Industrials But Weighs On Discretionary Tight Money Is Good For Industrials But Weighs On Discretionary Tight Money Is Good For Industrials But Weighs On Discretionary The framework we use on the interest rate front is that higher interest rates represent a sizable hindrance to consumer spending (top and second panel Chart 5). Not only does the price of housing-related credit rise in lockstep with fed hikes, but also auto and credit card interest rates, two major consumer loan categories, increase on the back of the Fed's tighter monetary backdrop. True, C&I loan pricing also suffers a setback, but capital goods producers can bypass banks and raise debt in the bond markets. In fact, this cycle, the global hunt for yield and unconventional monetary policies have suppressed interest rates to the benefit of corporate borrowers. One final relative advantage industrials outfits have this cycle is rising pricing power in the form of firming commodity prices (third panel, Chart 5), while wage growth/median income (a proxy for consumer pricing power) has been subpar. Taken together, higher interest rates and rising commodity prices should continue to underpin relative share price momentum (Chart 5). Relative sentiment readings also suggest that industrials manufacturers have the upper hand versus consumer discretionary companies (Chart 6). The overall ISM manufacturing survey is easily outpacing consumer confidence readings. Importantly, the ISM survey and most of the subcomponents are making multi-year highs, while both the University of Michigan's consumer sentiment survey and The Conference Board's consumer confidence reading peaked in early 2017. Chart 5Commodity Inflation Is A Boon For##br## Industrials But Bane For Discretionary Commodity Inflation Is A Boon For Industrials But Bane For Discretionary Commodity Inflation Is A Boon For Industrials But Bane For Discretionary Chart 6Manufacturing Flexing ##br##Its Muscles Manufacturing Flexing Its Muscles Manufacturing Flexing Its Muscles With regard to the relative demand landscape, a sustained capital expenditure upcycle is promising for capital goods producers (second panel, Chart 7), at a time when personal consumption expenditures (PCE) are anemic at best. Notably, real capital outlays have been rising at a faster clip than real PCE, signaling that the upward trajectory in relative forward EPS estimates is sustainable (middle panel, Chart 7). Our relative pricing power gauge has recently come out of its funk reflecting this improving relative demand backdrop. The implication is that a rerating phase is likely in the coming months (bottom panel, Chart 7). Finally, the relative export backdrop suggests that industrials come out on top of discretionary stocks (top panel, Chart 8). According to FactSet the S&P consumer discretionary sector's foreign revenue exposure stands at 24% of total sales, and it is roughly 60% higher for the S&P industrials sector at 38% of revenues.4 While the year-to-date breakdown in the greenback is stimulative for industrials exporters, it is, at the margin, restrictive for the more domestically oriented consumer discretionary companies (trade-weighted dollar shown inverted, bottom panel, Chart 8). Our relative EPS growth models best capture all of these moving parts and suggest that the path of least resistance for relative profit growth is higher in the coming quarters (Chart 9). Chart 7Capex##br## Upcycle... Capex Upcycle... Capex Upcycle... Chart 8... And Export Markets Benefit Industrials##br## At The Expense Of Discretionary ... And Export Markets Benefit Industrials At The Expense Of Discretionary ... And Export Markets Benefit Industrials At The Expense Of Discretionary Chart 9Relative Profit Growth Models Also Say##br## Buy The Relative Share Price Ratio Relative Profit Growth Models Also Say Buy The Relative Share Price Ratio Relative Profit Growth Models Also Say Buy The Relative Share Price Ratio Adding up, all four key macro variables (interest rates, relative sentiment, relative demand and relative export exposure) signal that the time is ripe for a new industrials versus discretionary pair trade. Bottom Line: Initiate a long S&P industrials/short S&P consumer discretionary sector pair trade. Airlines Update: Mayday While we have turned positive on the broad industrials complex and remain constructive on most transports, we continue to recommend investors avoid the S&P airlines index. This decade has seen a huge recovery in consumer confidence, rising from the depths of the Great Recession. The consumer's revival has been matched by equally steep growth in airline passenger traffic (Chart 10). However, the resurgence in passenger demand has not had the expected uplift in pricing. Rather, the opposite has happened; consumers have not seen a sustainable price increase in years and airline pricing power has collapsed, even in the face of soaring jet fuel costs that eat into profits (Chart 11). The costly price war between the low cost carriers and the largely-restructured legacy airlines the industry is currently embroiled in explains deflating airfares (Chart 12). Chart 10More Passengers... More Passengers... More Passengers... Chart 11... But Higher Fuel Costs... ... But Higher Fuel Costs... ... But Higher Fuel Costs... Chart 12... And Price Concessions Crash Profits ... And Price Concessions Crash Profits ... And Price Concessions Crash Profits The industry has been here before, and recently too. 2015 was a tumultuous year that saw pricing collapse as the ultra-low cost carriers entered the traditional hubs, triggering a scramble for market share. Brave airline investors have been whipsawed as the industry recovered and then stumbled again earlier this year. From a profit perspective, airlines have been able to hide poor pricing with efficiency gains (Chart 13). Industry load factors have been steadily moving upward, though those gains appear to have plateaued at peak levels. The implication is that this current price war will hit profit margins and thus the bottom line worse than in the past (Chart 13). Expanding international air travel could provide some relief to the besieged legacy carriers as international airfares look to have pulled out of deflation (Chart 14). However, the sustainability of positive pricing is questionable as international no-frills carriers are gaining greater penetration and often have significantly lower cost structures. Once unheard of trans-Atlantic travel for below $200 is now widely available. Chart 13Masking Poor Pricing Backdrop Masking Poor Pricing Backdrop Masking Poor Pricing Backdrop Chart 14Analysts Ignore Positives Analysts Ignore Positives Analysts Ignore Positives At the same time as cash generation appears most threatened, the industry is in the midst of an expensive fleet renewal as airlines seek to replace declining prices and aging fleets with higher volume and more efficient aircraft. In fact, capex as a percentage of sales has nearly tripled since 2012. The result is predictable; the hard deleveraging work the industry put in over the course of this decade is being unwound (Chart 13). An increasingly geared balance sheet, combined with weakening margins should translate directly into a higher risk premium and lower valuation multiples. However, while multiples have fallen from the sky-high levels earlier this decade, they remain well above the lows of 2015-16 (Chart 14). This implies further downside risk should risk premiums expand as we expect. With sell-side analysts jumping on board the bear story, as evidenced by net forward earnings revisions falling off a cliff (Chart 14), this should probably happen sooner rather than later. Bottom Line: With no end in sight to the price war and outsized capacity additions likely to throw fuel on the fire, we think investors should stay away from the S&P airlines index. Accordingly, we reiterate our underweight recommendation. 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 & Global Alpha Sector Strategy anastasios@bcaresearch.com 1 Please see BCA U.S. Equity Strategy Weekly Report,"Girding For A Breakout?" dated May 1, 2017, available at uses.bcaresearch.com. 2 Please see BCA Geopolitical Strategy Weekly Report,"Can Equities And Bonds Continue To Rally?" dated September 20, 2017, available at gps.bcaresearch.com. 3 Please see Chart 55 of BCA U.S. Equity Strategy Special Report, "White Paper: U.S. Equity Market Indicators (Part I)", dated August 7, 2017, available at uses.bcaresearch.com. 4 https://www.factset.com/earningsinsight Current Recommendations Current Trades Size And Style Views Favor small over large caps and stay neutral growth over value.

U.S. airlines have been enjoying some of their highest profits in history, lifted by the collapse in oil prices and cheap financing and the market has rewarded them handsomely (bottom panel). However, the last year has seen a trend shift as excess profits have been eaten away at by the always-cutthroat competition. Further, the stringent labor cost control of the past decade will be difficult to maintain in such a profitable environment. Delta Air Lines (DAL) Q2 results offer some insight; unit revenues grew 2.5% while non-fuel unit costs grew 7.3%. The impact of these margin hits is likely to be magnified if, as we expect, oil prices recover. Overall, we think the sector's best days are receding into the contrails. Stay underweight. The ticker symbols for the stocks in this index are: BLBG: S5AIRL -DAL, LUV, AAL, UAL, ALK. A Hard Landing A Hard Landing

Transport stocks have discounted a recession, trading below trough bear market relative valuations. That is too cheap given signs of stabilization in global export growth.

Airlines have been punished lately, trailing not only the S&P 500, but also their industrials peers. News that Delta would not meet already weak passenger yield expectations underscores that analysts still remain overly optimistic. Airlines have expanded capacity too aggressively while fuel prices were low, and are now being hit with pricing pressure as travel budgets are pruned. A simple airline margin proxy juxtaposing airline selling prices with fuel prices, signals that the industry's margin expansion will turn into a much steeper correction than analysts anticipate (bottom panel). As a result, profits are slated to underwhelm. Bottom Line: We are reiterating our high-conviction underweight stance in the S&P airlines index. The ticker symbols for the stocks in this index are: BLBG: S5AIRL - DAL, LUV, AAL, UAL, ALK. bca.uses_in_2016_07_07_002_c1 bca.uses_in_2016_07_07_002_c1

Airline stocks have been walloped of late, as the downside of an industry with high operating leverage is beginning to rear its head. The past few years of low oil prices and decent demand encouraged a large investment in capacity, which is now leaving the industry with an inability to fill planes at an attractive profit margin price point. Indeed, revenue per passenger mile is contracting and our proxy for global CPI airfares has plunged. We doubt that improvement is imminent, given that fuel prices are back on the upswing, and leading business cycle indicators continue to warn that retrenchment in travel budgets is a higher probability than expansion. Against this backdrop, airfare price concessions are likely to remain intact, or even intensify, to the detriment of airline revenue and profitability. We are sticking with a high-conviction underweight stance. The ticker symbols for the stocks in this index are: BLBG: S5AIRL - DAL, LUV, AAL, UAL, ALK. bca.uses_in_2016_06_15_001_c1 bca.uses_in_2016_06_15_001_c1

Airline stocks have enjoyed some modest relief in recent weeks, but we expect this resilience to fully reverse. The main issue is overcapacity. Discretionary spending is under pressure, based on the message from global manufacturing woes and the plunge in the National Association of Restaurants survey (second panel). Airlines have been aggressively building capacity, as evidenced by the increase in airline capital spending. Long airplane production cycles mean there is a lag between spending and when new capacity will come on stream, and the tripling in airline parts & components inventory in the last eight years warns that the delivery pipeline remains full. Airlines are already resorting to price cuts to fill seats (bottom panel), which will drag on profitability. Importantly, future capacity increases signal that deflation will remain a prominent industry theme for the foreseeable future, and act as a weight on valuation multiples. Stick with a high-conviction underweight. The ticker symbols for the stocks in this index are: AAL, DAL, LUV, UAL. Airlines Are Running Out Of Fuel Airlines Are Running Out Of Fuel