Construction & Engineering

Highlights Portfolio Strategy The sustained global growth slowdown, widening junk spreads, along with the risk of a U.S. recession becoming a self-fulfilling prophecy suggest that caution is still warranted in the broad equity market on a 3-12 month time horizon. Weakening consumer sentiment, softening hotel industry operating metrics that point to a margin squeeze, anemic relative outlays on lodging and a decelerating ISM non-manufacturing index, all signal that more pain lies ahead for the S&P hotels, resorts & cruise lines index.   Waning industry operating metrics, a bearish signal from our EPS growth model along with the mighty U.S. dollar warns against bottom fishing in the S&P electrical components & equipment (EC&E) index.  Recent Changes There are no changes to the portfolio this week. Table 1 Elusive Growth Elusive Growth Feature The S&P 500 traded in an uncharacteristically tight range last week before falling apart on Friday on the back of a re-escalation in the U.S./China trade war. Worries of recession also resurfaced. Not only did the MARKIT flash manufacturing PMI break below the 50 expansion/contraction line, but it also pulled down the MARKIT flash services PMI survey that barely held above the boom/bust line. Adding insult to injury, the 10/2 yield curve slope inverted anew last week further fanning these recession fears. Worrisomely, consumer sentiment took a hit recently according to the University of Michigan survey (top panel, Chart 1). Importantly, what caught our attention was the following commentary: “The main takeaway for consumers from the first cut in interest rates in a decade was to increase apprehensions about a possible recession. Consumers concluded, following the Fed’s lead, that they may need to reduce spending in anticipation of a potential recession.” While the consumer is the last and most significant pillar standing for the U.S. economy, reflexivity may spoil the party and a recession may become a self-fulfilling prophecy. This is the message the bond market is sending and it is warning that the path of least resistance is a lot lower for stocks (bottom panel, Chart 1). Chart 1“The First Cut Is The Deepest” “The First Cut Is The Deepest” “The First Cut Is The Deepest” Economists are also downgrading their U.S. real GDP growth estimates and that forecast now stands at 2.3% for the current year according to Bloomberg. While the recession alarm bells are not sounding off, these downward revisions bode ill for stocks (Chart 2)  Chart 2Watch Out Down Below Watch Out Down Below Watch Out Down Below Moving to another part of the fixed income market, stress is slowly building in the high yield market especially given the recent tick up in bankruptcies and the blind sides that cove-lite loans now pose to bond investors. As a reminder, the U.S. high yield option adjusted spread (OAS) troughed last September and continues to emit a distress signal for the broad equity market (junk OAS shown inverted, top panel, Chart 3). Chart 3Mind The Gaps Mind The Gaps Mind The Gaps With regard to global growth, it is still missing in action, and given that Dr. Copper is on the verge of a breakdown, a global growth recovery is a Q1/2020 story at the earliest. This week we update a consumer discretion­ary subindex and also highlight an industrials sector subgroup. Chart 4SPX: The Next Shoe To Drop? SPX: The Next Shoe To Drop? SPX: The Next Shoe To Drop? Chart 5Risk To View Risk To View Risk To View Other financial market variables concur that global growth is elusive. J.P. Morgan’s EM FX index has broken down and EM equities are also hanging from a thread. The EM high yield OAS has broken out signaling that the risk off phase has yet to fully run its course (EM junk OAS shown inverted, bottom panel, Chart 4). Finally, there is a short-term risk to our cautious equity market view. Indiscriminate buying in U.S. Treasurys has now pushed the 10-year yield down almost 180bps from last November’s peak deeply in overvalued territory. While such a move is not unprecedented, buying may be exhausted and in need of at least a short-term breather (Chart 5).     Netting it all out, the sustained global growth slowdown, widening junk spreads, along with the risk of a U.S. recession becoming a self-fulfilling prophecy suggest that caution is still warranted in the broad equity market on a 3-12 month time horizon. As a reminder, this is U.S. Equity Strategy’s view, which contrasts BCA’s sanguine equity market house view. This week we update a consumer discretionary subindex and also highlight an industrials sector subgroup. Empty Spaces When the consumer is worried about a possible recession as the latest survey revealed, the knee jerk reaction is to tighten the purse strings and marginally retrench. The latest University of Michigan consumer sentiment survey made for grim reading and such souring in confidence will continue to weigh on lodging equities (Chart 6). As a result, we remain underweight the niche S&P hotels, resorts & cruise lines consumer discretionary subgroup. When the consumer is worried about a possible recession as the latest survey revealed, the knee jerk reaction is to tighten the purse strings and marginally retrench. Chart 6Stay Checked Out Of Hotels Stay Checked Out Of Hotels Stay Checked Out Of Hotels   Already discretionary retail sales have taken the back seat and non-discretionary retail sales are in the driver’s seat. In fact, the top panel of Chart 7 shows that the relative retail sales backdrop has plunged to levels last seen during the GFC, warning that relative share prices have ample room to fall. Drilling deeper in the consumption data is instructive. Lodging outlays are decelerating and are also trailing overall PCE. The implication is that relative profits will likely underwhelm sustaining the 18-month long de-rating phase (middle & bottom panels, Chart 7). On the operating front the news is equally dour. While selling prices are expanding, the relentless construction binge will lead to a mean reversion sooner rather than later (bottom panel, Chart 8).   Chart 7De-rating Phase To Gain Steam De-rating Phase To Gain Steam De-rating Phase To Gain Steam Chart 8Margin Squeeze Looming Margin Squeeze Looming Margin Squeeze Looming   Tack on the ongoing assault from the new sharing economy unicorns like Airbnb, and industry pricing power will remain in check in coming quarters. Similarly, the ISM non-manufacturing price subcomponent is warning that a deflation scare is looming in the lodging industry (second panel, Chart 8). Not only are selling prices under attack, but also labor-related input costs are on fire. The sector’s wage inflation is climbing at a 3.9%/annum pace or roughly 120bps higher that the overall employment cost index (third panel, Chart 8). Taken together, there are high odds that a profit margin squeeze will weigh on profits and on relative share prices (top panel, Chart 8). Importantly, the overall ISM services survey best encapsulates the bearish backdrop of the S&P hotels, resorts & cruise lines index. Historically, relative share prices have been moving in tandem with the ISM non-manufacturing survey and the current message is that selling pressures on relative share prices will persist in the coming months (Chart 9). Chart 9Heed The Message From The ISM Services Survey Heed The Message From The ISM Services Survey Heed The Message From The ISM Services Survey In sum, weakening consumer sentiment, softening hotel industry operating metrics that point to a margin squeeze, anemic relative outlays on lodging and a decelerating ISM non-manufacturing index signal that more pain lies ahead for the S&P hotels, resorts & cruise lines index. Bottom Line: Continue to avoid the S&P hotels, resorts & cruise lines index. The ticker symbols for the stocks in this index are: BLBG: S5HOTL – MAR, HLT, RCL, CCL, NCLH. Short Circuited The S&P EC&E index broke down recently (top panel, Chart 10) and we reiterate our underweight recommendation in this industrials sector subgroup. While it is tempting to bottom fish here especially given oversold technical and bombed out valuations (bottom panel, Chart 11), a number of the indicators we track suggest that more losses are around the corner. Chart 10Sell The Weakness Sell The Weakness Sell The Weakness Chart 11Good Reasons For Valuation Discount Good Reasons For Valuation Discount Good Reasons For Valuation Discount   First the trade-weighted dollar has broken out to fresh cyclical highs despite the collapse in the 10-year yield. Historically, relative share prices and the greenback are tightly inversely correlated and the current weak global growth message the U.S. dollar is emitting is bearish for the S&P EC&E index (U.S. dollar shown inverted, middle panel, Chart 10). This global growth soft patch is not only negative for new orders owing to deficient foreign demand, but the appreciating currency also makes EC&E exports less competitive in the global market place (U.S. dollar shown inverted, bottom panel, Chart 10). Second, while industry new orders have been resilient, the massive inventory buildup dwarfs new order growth and warns that a deflationary liquidation phase is looming (middle panel, Chart 11). In fact, the recent drubbing in the ISM manufacturing prices paid subcomponent portends a deflationary industry phase (third panel, Chart 12). Adding it all up, waning industry operating metrics, a bearish signal from our EPS growth model along with the mighty U.S. dollar warns against bottom fishing in the S&P EC&E index. Other operating metrics are also warning that EC&E profits will underwhelm. Industry weekly hours worked have plunged and sell-side analysts have been aggressively cutting EPS estimates (bottom panel, Chart 13). On the productivity front, executives have not adjusted labor cost structures to lower running rates yet (second panel, Chart 13) and, thus, our EC&E productivity gauge (industrials production versus employment) is contracting which bodes ill for industry earnings (third panel, Chart 13). Chart 12Weak Profit Backdrop Weak Profit Backdrop Weak Profit Backdrop Chart 13Deteriorating Operating Metrics Deteriorating Operating Metrics Deteriorating Operating Metrics   Finally, our S&P EC&E EPS growth model does an excellent job in encapsulating all these moving parts and is signaling that the path of least resistance is lower for EPS growth in the coming months (bottom panel, Chart 12). Adding it all up, waning industry operating metrics, a bearish signal from our EPS growth model along with the mighty U.S. dollar warns against bottom fishing in the S&P EC&E index. Bottom Line: Stay underweight the S&P EC&E index. BLBG: S5ELCO – AME, EMR, ETN, ROK.     Anastasios Avgeriou, U.S. Equity Strategist anastasios@bcaresearch.com   Current Recommendations Current Trades Size And Style Views Favor value over growth Favor large over small caps

Highlights China’s infrastructure investment growth rate could rebound moderately from its current nominal 3% pace, but will remain well below the double-digit rate it has registered for most of the past decade.  A lack of funding for local governments and their financing vehicles will somewhat cap the upside in infrastructure fixed-asset investment (FAI) in the next six to nine months. Special bond issuance will be insufficient to ensuring a major recovery in infrastructure spending. Investors should tread cautiously on infrastructure plays in financial markets. Feature Chart I-1Chinese Infrastructure Investment: Double-Digit Growth Again? Chinese Infrastructure Investment: Double-Digit Growth Again? Chinese Infrastructure Investment: Double-Digit Growth Again? Nominal infrastructure investment growth in China has slowed from over 15% in 2017 to 3% currently (Chart I-1). This is the weakest growth rate since 2005 excluding the late 2011-early 2012 period. Over the past decade, each time the Chinese economy experienced a considerable slowdown, infrastructure construction was ramped up to revive growth. Infrastructure spending growth skyrocketed in 2009 and was also boosted in 2012. In 2015-2016, it was not allowed to decelerate with the issuance of nearly RMB 2 trillion of special infrastructure bonds. This time the government has also reacted. Since mid-2018, the Chinese authorities have dramatically raised local governments’ special bonds balance limits, prompted local governments to front-load their issuance this year, and also encouraged the private sector to participate in public-private partnership (PPP) infrastructure projects. Will Chinese infrastructure FAI growth accelerate over the next six to nine months from its current nominal 3% pace to double digits? The short answer is no. Chart I-2 We believe Chinese infrastructure investment growth could rebound moderately in the next six to nine months, but will still remain below the double-digit growth seen in the past and well below the 18% average growth of the past 15 years. For purposes of this report, the composition of “infrastructure” includes three categories – (1) Transport, Storage and Postal Service, (2) Water Conservancy, Environment & Utility Management, and (3) Electricity, Gas & Water Production and Supply. Chart I-2 presents the breakdown of the nominal infrastructure FAI by category. Funding Constraint Preceding both the 2011-2012 and 2018 infrastructure investment slumps, the Chinese central government increased its scrutiny on local government debt and tightened funding conditions for infrastructure projects. As a result, all three categories of infrastructure spending experienced a sharp deceleration (Chart I-3). Overall, financing and qualitative limitations that Beijing imposes on local government infrastructure spending hold the key to the outlook. We believe Chinese infrastructure investment growth could rebound moderately in the next six to nine months, but will still remain below the double-digit growth seen in the past and well below the 18% average growth of the past 15 years. Looking forward, without a considerable recovery in available financing, there will be no meaningful rebound in Chinese infrastructure investment and construction activity. For now, we are not very optimistic on financing. Chart I-4 shows the breakdown of the major funding sources of Chinese infrastructure investment. All of them are likely to face considerable funding constraints over the next six to nine months. Chart I-3Chinese Infrastructure Investment Growth Has Decelerated Across The Board Chinese Infrastructure Investment Growth Has Decelerated Across The Board Chinese Infrastructure Investment Growth Has Decelerated Across The Board Chart I-4   1. Self-Raised Funds Self-raised funds contribute nearly 60% of overall infrastructure funding. They include net local government special bond issuance, PPP financing and government-managed funds’ (GMFs) revenues excluding proceeds from special bond issuance. A. Local government special bond issuance, which is exclusively used to fund infrastructure projects, has been the major source of financing for local governments in the past 12 months. The authorities significantly boosted net local government bond issuance to RMB 1.2 trillion in the first six months of this year from only RMB 361 billion in the same period in 2018. However, the amount of special bond issuance in the second half of this year will unlikely be significant enough to boost infrastructure FAI greatly. First, the central government has not only set a limit on the aggregate local government special bond balance, but it also set limits for each of the 31 provinces/provincial-level cities.1 In the past three years, nearly all provinces did not use up their special bond issuance quotas. This resulted in an outstanding aggregate amount of special bonds of only about 85% of the limit.2 In both 2017 and 2018, local governments were left with RMB 1.1 trillion special bond issuance quota unused for that year. Second, based on the limit on outstanding amount special bonds set by the central government for the end of 2019, local governments could issue another RMB 0.8-1 trillion of special bonds in the second half of this year. In comparison, in 2018, the issuance was heavily concentrated in the second half of the year with RMB 1.6 trillion. Our estimate shows there will be only RMB 400-600 billion increase in net total special bond issuance in 2019 versus 2018.3 This will translate into a merely 2-3% growth in Chinese infrastructure investment. Third, net local government special bond issuance made up only 15% of overall infrastructure FAI over the past 12 months. Hence, there is still a huge financing gap to be filled (Chart I-5). B. Public-private partnerships (PPP) are unlikely to meet the financing shortage either. PPPs have become an important financing model for Chinese local governments to fund infrastructure investments since 2014. Nevertheless, to control rising local government debt risks, the central government has tightened regulations on PPP projects since early last year. A series of tightened rules have resulted in a sharp deceleration in both PPP investment and overall infrastructure investment growth. Consequently, PPPs contributions to total infrastructure FAI have plunged from over 30% in 2017 to 10% currently (Chart I-6). Chart I-5Special Bond Issuance Accounted For Only 15% Of Infrastructure FAI Special Bond Issuance Accounted For Only 15% Of Infrastructure FAI Special Bond Issuance Accounted For Only 15% Of Infrastructure FAI Chart I-6Public-Private Partnerships: Too Small To Meet The Financing Shortage Public-Private Partnerships: Too Small To Meet The Financing Shortage Public-Private Partnerships: Too Small To Meet The Financing Shortage   So far, the rules on PPP projects on local governments remain tight. In March, the central government tightened its rule on local government participation in PPP projects. The new rule states that, if a local government has already spent more than 5% of its overall general expenditures on PPP projects excluding sewage and waste disposal PPP projects, it will not be allowed to invest in any new PPP projects. Before March, the threshold was over 10%. In early July, the National Development and Reform Commission (NDRC) demanded all PPP projects undertake a thorough feasibility study. The NDRC emphasized that PPP projects that do not follow standard procedures will not be allowed. Chart I-7Government-Managed Funds: Headwinds From Falling Land Sales Government-Managed Funds: Headwinds From Falling Land Sales Government-Managed Funds: Headwinds From Falling Land Sales C. Government-managed funds (GMF) excluding special bond issuance accounts, which contribute about 15% of overall infrastructure financing, are also facing constraints. According to the country’s Budget Law, the GMF budget refers to the budget for revenues and expenditures of the funds raised for specific developmental objectives. In brief, GMFs constitute de-facto off-balance-sheet government revenues and spending. Land sales by local governments are one major revenue source for GMFs. Contracting property floor space sold is likely to depress real estate developers’ land purchases, further reducing local governments’ revenues from selling land (Chart I-7). This will curb local governments’ ability to finance their infrastructure projects through GMFs. 2. Domestic Loans Domestic loans contribute to about 15% of overall infrastructure financing. Infrastructure projects are generally long term in nature. Presently, the impulse of non-household medium- and long-term (MLT) lending has stabilized but has not yet improved (Chart I-8). While not all of MLT loans are used for infrastructure, sluggish MLT lending reflects commercial banks’ reluctance to finance infrastructure projects. We believe a decelerating economy, mounting local government debt, and often-low returns on infrastructure projects will continue to constrain loan funding of infrastructure projects from both banks and the private sector. 3. General Government Budget The general government budget (which includes central and local governments) accounts for about 15% of overall infrastructure financing. The general budget is also facing headwinds from declining revenue due to recent tax cuts and lower corporate profit growth (Chart I-9). Chart I-8Sluggish Medium/Long-Term Bank Lending Sluggish Medium/Long-Term Bank Lending Sluggish Medium/Long-Term Bank Lending Chart I-9Government General Budget: Large Deficit Government General Budget: Large Deficit Government General Budget: Large Deficit   Bottom Line: Funding constraints will likely linger, making any recovery in Chinese infrastructure investment growth moderate over the next six to nine months. Local government special bonds will not be a game-changer. Their net issuance accounted for only 15% of overall infrastructure FAI over the past 12 months. While local governments could issue another RMB 0.8-1 trillion of special bonds in the second half of 2019, it would be well below the RMB 1.4 trillion of special bond issuance that was rolled out in the second half of 2018. FAI In Transportation: In Nominal Terms… The transportation sector accounts for about 31% of total Chinese infrastructure investment. It includes railway, highway, urban public transit, air and water transport. Table I-1 shows the 13th five-year (2016-2020) transportation investment plan released by the government in February 2017,4 which excludes urban public transit. Chart I- The authorities planned to invest RMB 15 trillion in the transportation sector over the five-year period between 2016 and 2020, with highways accounting for over half of the investment, followed by railways (23%), air transportation (4.3%) and water transportation (3.3%). The table also shows our calculation of the realized investment amount in these four sub-sectors for the period of January 2016 to June 2019. Local government special bonds will not be a game-changer. Their net issuance accounted for only 15% of overall infrastructure FAI over the past 12 months. Table I-1 suggests the remaining FAI for the transportation sector for the July 2019 to December 2020 period will be considerably smaller than the FAI amount over the past 18 months. This entails a major drag on infrastructure investment at least over the next 18 months. It is important to emphasize that this is conditional on the central planners in Beijing sticking to their five-year plan for infrastructure FAI. As of now, there has been no announcement of revisions to these five-year FAI targets. Bottom Line: China has already completed the overwhelming majority of its planned transportation FAI for 2016-2020. Consequently, without revisions to the targets and budgets by central planners in Beijing, transportation investment will likely contract year-on-year over the next 18 months. …And Real Terms Table I-2 summarizes the 2020 targets for major Chinese infrastructure development (urban rail transit, railway, highway and airport) in real terms. Chart I- Chart I-10Transportation 2020 Targets: Not Far Away Transportation 2020 Targets: Not Far Away Transportation 2020 Targets: Not Far Away In real terms, the annual growth of transportation infrastructure will likely be 4.2% in both 2019 and 2020. We illustrated in the previous section that the five-year budget plan had been front-loaded, leaving a very small budget for transportation investment over the next 18 months. This may suggest that without considerably exceeding the budget, transportation infrastructure will fail to achieve the 4.2% annual growth in real terms both this year and next. In brief, more funding should be dispatched/allowed by the central planners in Beijing for infrastructure FAI not to shrink. Second, urban rail transit, high-speed railways, highways and airports will reach their respective 2020 targets, while non-high-speed railway construction will likely be a little bit off its 2020 target. Third, based on the 2020 targets, urban rail transit will enjoy very fast growth over the next one and a half years. Fourth, the growth of high-speed railways and highways will be very low, at around 1-2% in real terms (Chart I-10). Finally, while the number of airports will increase at a faster pace, their contribution to overall infrastructure investment will remain insignificant as they only account for about 1.4% of overall infrastructure investment. Bottom Line: In real terms, transport infrastructure growth will likely be only about 4% over the next six to nine months. Future Infrastructure Investment Focus Urban rail transit, environmental management and public utility management will likely be the major driving forces for Chinese infrastructure investment over the next 18 months. Urban rail transit line length will likely register fast growth of around 10% over the next six to nine months. As the central government enforces increasingly stringent rules on environmental protection, investment in environmental management will likely experience continued growth acceleration (Chart I-11). China has already completed the overwhelming majority of its planned transportation FAI for 2016-2020. Consequently, without revisions to the targets and budgets by central planners in Beijing, transportation investment will likely contract year-on-year over the next 18 months. Meanwhile, as the country’s urbanization continues and more townships and city suburbs become urbanized,5 public utility management investment will also grow moderately. Public utility management investment, contributing a massive 45% of overall infrastructure investment, includes sewer systems, sewer treatment facilities, waste treatment and disposal, streetlights, city roads construction, parks, bridges and tunnels in the city. Investment Implications Investors should not hold their breath expecting a major upswing in infrastructure FAI and a major rally in related financial markets. Chinese steel demand is sensitive to construction of railways and urban rail transit lines (Chart I-12, top panel). In turn, mainland cement demand is dependent on highway construction (Chart I-12, bottom panel). Chart I-11Environment Management: Will Continue Booming Environment Management: Will Continue Booming Environment Management: Will Continue Booming Chart I-12Chinese Infrastructure Spending Will Moderately Boost Steel & Cement Demand... Chinese Infrastructure Spending Will Moderately Boost Steel & Cement Demand... Chinese Infrastructure Spending Will Moderately Boost Steel & Cement Demand...   Chart I-13...And Steel & Cement Prices At The Margin ...And Steel & Cement Prices At The Margin ...And Steel & Cement Prices At The Margin The infrastructure sector accounts for about 10-15% of total Chinese steel use, and about 30-40% of Chinese cement consumption. Nevertheless, given that we believe Chinese infrastructure spending will only have a moderate recovery, the positive effect on steel and cement prices will be muted as well (Chart I-13). The same holds true for spending on industrial machinery, equipment, chemicals and various materials. Notably, risks to this baseline scenario of a muted recovery are to the downside because of the lack of funding. Barring a substantial increase in the special bond issuance quota this year or a major credit binge, infrastructure FAI growth could in fact stall. Ellen JingYuan He, Associate Vice President ellenj@bcaresearch.com   Footnotes 1  Please note that the central government only set the special bond balance limit (not the quota) for local governments. The often-cited “quota” in the news is derived by calculating the difference between the current limit and the previous year’s limit. The “quota” used in this report is the difference between the current special bond balance limit and the actual special bond balance of the previous year end. 2  At the end of 2018, Chinese special bond balance was RMB 7.4 trillion, only 85.8% of the special bond balance limit of RMB 8.6 trillion. This ratio was 84.6% in 2017 and 85.5% in 2016. On average, the ratio was 85.3% in the past three years. 3  Given that the central government is aiming to somewhat stimulate infrastructure spending by increasing special bond issuance, we assume special bond balance at the end of 2019 to reach 88%-90% of the limit (RMB 10.8 trillion) that it has set for 2019. This will be higher than the 85% average of the past three years. In turn, this means that the special bond balance at the end of this year will likely be RMB 9.5-9.7 trillion. Since the balance at the end of last year was RMB 7.4 trillion, this results that net special bond issuance will be around RMB 2.1-2.3 trillion in 2019. Given the net special bond issuance last year was RMB 1.7 trillion, it follows that there will only be a RMB 400-600 billion increase in total special bond issuance in 2019 versus 2018. 4  Please see www.gov.cn/xinwen/2017-02/28/content_5171576.htm, published February 28, 2017, by the Chinese central government website. 5  Please see Emerging Markets Strategy/China Investment Strategy Special Report “Industrialization-Driven Urbanization In China Is Losing Steam,” dated January 2, 2019, available on ems.bcaresearch.com

The previous Insight showed that the industrial sector share price spike was in danger of a reversal. The S&P electrical equipment and components index looks equally vulnerable. Hefty short positions likely played a large role in powering the spike, and we are uncomfortable with paying a premium valuation for a dubious earnings outlook, particularly given the sector's brutal long-term track record during U.S. dollar bull markets (the currency is shown inverted, top panel). From a cyclical perspective, new orders for electric equipment are sensitive to EM currency movements. The current message is that new orders are likely to languish. Relief is not imminent from domestic sources. Real investment spending on electrical equipment is contracting at a steep rate. That is consistent with the trend in overall construction spending. Ergo, the productivity contraction is likely to persist. Downshift to underweight. The ticker symbols for the stocks in these indexes are: BLBG: S5ELCO - AME AYI EMR ETN ROK. bca.uses_in_2016_11_22_002_c1 bca.uses_in_2016_11_22_002_c1

Highlights Portfolio Strategy The strong U.S. dollar is tightening global liquidity conditions, putting the post-election jump in stock prices at risk unless growth imminently accelerates. The spike in large cap industrial stocks represents a massive knee-jerk overreaction and we are adding the sector on our high conviction underweight list. Take profits in the S&P air freight & logistics group and cut to neutral, and downgrade the S&P electrical components & equipment group to underweight. Recent Changes S&P Air Freight & Logistics - Take profits of 6% and reduce to neutral. S&P Electrical Components & Equipment - Trim to underweight from neutral. S&P Industrials Sector - Add to our high-conviction underweight list. Table 1 Don't Disregard The Dollar Don't Disregard The Dollar Feature Equities are still in a post-election honeymoon phase. The savage reaction in the bond market has not yet backlashed onto the broad stock market. Instead it has sparked a rapid and powerful rotation in intra-sector capital flows. The danger is that an unwinding of the momentum trade in the bond market is being misinterpreted as a pro-growth, pro-cyclical investment shift. Investors appear to be equating a potential increase in economic growth with better profitability. However, basing equity strategy on unknown future policies is fraught with risk, as is equating GDP with corporate profits. Trump's signature policies, protectionism and fiscal spending, are inflationary and U.S. dollar bullish, and the timing of implementation and ultimate size of spending programs, remain anyone's guess. In a closed economy driven more by consumption than investment, a strong currency can be supportive via increased purchasing power and a dampening in corporate sector input costs. But what's good for the economy should not be automatically extrapolated through to profits. Net earnings revisions fall when the currency is strong (Chart 1). Capital has won out handily vs. labor since the Great Recession, which allowed profits to boom even though economic growth was below-potential. This is changing. Labor costs are now on the upswing, and productivity has deteriorated. If the economy strengthens, it may only serve to boost wage inflation. If labor expenses accelerate, it becomes even more critical for corporate sector sales to regain traction in order to offset the squeeze on profit margins. However, just under half of S&P 500 sales come from abroad. A strong U.S. dollar means the U.S. will be importing deflationary pressures, undermining pricing power. U.S. dollar appreciation also saps growth in developing countries. Emerging market capital spending is already contracting (Chart 2), and as shown last week, financial strains are flaring back up. Ergo, U.S. companies will be less competitive, and selling into weaker demand growth abroad. Chart 1A Strong Dollar Will Sink Profits... A Strong Dollar Will Sink Profits... A Strong Dollar Will Sink Profits... Chart 2... And Hit Global Growth ... And Hit Global Growth ... And Hit Global Growth Chart 3 shows that S&P 500 sales typically contract during major dollar bull markets. A recovery has only occurred once currency depreciation occurs. The equity market reaction has been mixed during these periods, as a strong dollar has capped growth and pushed down Treasury yields, supporting a valuation expansion. We do not recommend positioning for a bullish equity outlook, given already overvalued conditions and the rise in government bond yields. It is notable that the inflation component of yields has done the heavy lifting, rather than an upgrading in economic expectations (Chart 4). In other words, there is a sequencing issue, a strong currency saps profits now, while stimulus may only arrive much later. U.S. dollar-based global financial liquidity is now contracting as a consequence of U.S. dollar strength (Chart 4). If excess liquidity and low rates were the argument for supporting high valuations previously, tighter liquidity and rising rates can't also justify current multiples, especially if global growth is soft. As discussed in our November 3, 2014 Special Report, currency strength favors a mostly non-cyclical, domestically-oriented portfolio structure. One of our favored themes over the past few months has been to tilt portfolios in favor of domestic vs. globally-oriented industries. With the U.S. dollar breaking above its trading range, a catalyst now exists to spur an imminent recovery in the domestic vs. global share price ratio. The latter had become extremely oversold as the U.S. dollar consolidated and the Chinese economy began to stabilize, but economic fundamentals are shifting decisively back in favor of the U.S. The U.S. PMI is already making small strides vs. the Chinese and euro area PMI (Chart 5, second panel), heralding a rebound in the cyclical share price momentum. Chart 3No Sales Recovery Ahead No Sales Recovery Ahead No Sales Recovery Ahead Chart 4Tighter Liquidity, Rising Inflation bca.uses_wr_2016_11_21_c4 bca.uses_wr_2016_11_21_c4 Chart 5Domestic Will Beat Global bca.uses_wr_2016_11_21_c5 bca.uses_wr_2016_11_21_c5 World export growth remains anemic, and world export prices continue to deflate, albeit at a lesser rate. Sagging Asian currencies warn that trade is at risk, over and above protectionist rhetoric and/or policies. When compared with the reacceleration in U.S. retail sales, the outlook for domestic-sourced profits is even brighter. We reiterate our theme of tilting to domestic vs. globally-oriented industries. The bottom line is that the outlook for the broad averages has soured as a consequence of a strong dollar, rising yields and the prospect for tighter Fed policy. These dynamics augur well for domestic vs. global bias, small vs. large caps and defensive vs. cyclical sector strategy. This week we are taking some cyclicality out of our portfolio following the wild market gyrations in the past two weeks. Taking Advantage Of The Industrials Sector Overreaction... Industrials have vaulted higher, in relative terms, on the back of hopes for rampant fiscal stimulus and infrastructure spending as far as the eye can see, ignoring any negatives that may arise from protectionist policies and tighter monetary conditions. While defense contractors may see an increase in activity (we continue to recommend an overweight in the BCA defense index), in aggregate, the surge in the large cap industrials sector is an opportunity to retool exposure from a position of strength. Large cap industrials companies garner approximately 45% of their revenue from outside the U.S. The industrials sector has the second worst track record among all sectors during U.S. dollar bull phases, trailing only the materials sector. Regression analysis shows that industrial sectors sales would contract by 4.5% for every 10% in the trade-weighted dollar (Chart 6). Without revenue growth, it is hard for industrial companies to generate good profitability, given high operating leverage. The U.S. dollar surge is a direct threat to any benefit from an increase in domestic infrastructure spending. Commodity prices key off the U.S. dollar. Emerging markets (EM) are also sensitive to the currency. A strong U.S. dollar undermines income in commodity producing countries, creates financial strains related to EM foreign currency denominated debt and reins in domestic liquidity in countries that need to intervene to stop their currencies falling too far lest capital flight and inflation occur. As noted last week, emerging market currencies are already rolling over, and CDX spreads have begun to widen (Chart 7). EM equity markets are underperforming the global benchmark, reinforcing the lack of a regional growth impulse (Chart 7). It is rare for the industrial sector to deviate from relative EM equity performance. There has been no evidence of EM deleveraging, and the back up in global bond yields represents a financial stress. If U.S. industrials stocks are a high-beta play on EM, then contrarians should beware recent sector action. Chart 6Top-Line Trouble Ahead Top-Line Trouble Ahead Top-Line Trouble Ahead Chart 7Sell The Spike bca.uses_wr_2016_11_21_c7 bca.uses_wr_2016_11_21_c7 Importantly, capital spending is in retreat. Business investment is a function of confidence and expected return on investment. The gap between the return on and cost of capital is narrowing fast (Chart 8). Free cash flow is paltry, especially in resource sectors, major industrial sector end markets. It is hard to envision a major capital spending turnaround if the U.S. dollar keeps climbing and the cost of capital backs up further. Policy ambiguity will act as a weight for at least the next few quarters. During this period, the negative profit impact of the contraction in private and public sector construction activity will ultimately re-exert a major influence on sector risk premia. It will take at least several quarters before any hoped for fiscal spending will benefit industrial companies. Industrials sector pricing power has shifted from a deep negative to neutral. However, that appears to represent an unwinding of the rate of change shock more than a resumption of conditions conducive to companies lifting selling prices. Chart 9 shows that capital goods import price are still deflating. As the Chinese currency devalues, putting downward pressure on its regional counterparts, deflationary pressures will re-intensify for U.S. industrial firms (Chart 9). Chart 8Fiscal Stimulus Is Needed... Right Now! bca.uses_wr_2016_11_21_c8 bca.uses_wr_2016_11_21_c8 Chart 9The Dollar Will Do Damage bca.uses_wr_2016_11_21_c9 bca.uses_wr_2016_11_21_c9 ...By Selling Electrical Components & Equipment ... In terms of specifics, were we not underweight machinery shares already, we would institute a high conviction underweight today. In addition, the S&P electrical equipment and components (ECE) index looks equally vulnerable. While less exposed to commodity prices than machinery stocks, ECE shares have benefited alongside the overall sector from the post-election buying frenzy. Hefty short positions likely played a large role in powering the spike (Chart 10), and we are uncomfortable with paying a premium valuation for a dubious earnings outlook, particularly given the sector's brutal long-term track record during U.S. dollar bull markets (Chart 11, top panel, the currency is shown inverted). From a cyclical perspective, it is premature to position for a reversal in the relative earnings bear market. New orders for electric equipment are sensitive to EM currency movements. The current message is that new orders are likely to languish (Chart 11). Relief is not imminent from domestic sources. Chart 11 shows that real investment spending on electrical equipment is contracting at a steep rate. That is consistent with the trend in overall construction spending, which represents a long-term headwind. It is no surprise that industry productivity growth is contracting (Chart 11), reinforcing that the path of least resistance for profits is lower. It would take a major resurgence in top-line growth to restore productivity to positive levels. The ECE industry is one of the few 'smokestack' parts of the economy to have added capacity in recent years. That is confirmed by persistent growth in ECE wage inflation (Chart 12). Without a pickup in demand, this backdrop is conducive to ongoing deflation (Chart 12, bottom panel). Sell into strength. Chart 10Short Covering Will Not Last... Short Covering Will Not Last... Short Covering Will Not Last... Chart 11... As Fundamentals Erode ... As Fundamentals Erode ... As Fundamentals Erode Chart 12Cost Structures Are Too High Cost Structures Are Too High Cost Structures Are Too High ...And Taking Profits In Air Freight Stocks ... Elsewhere, we are taking profits on our overweight S&P air freight & logistics index. While we only recently went overweight in early-September, a much shorter time horizon than our desired cyclical calls, we are concerned that the index has front run an improvement in global trade that may be slow to materialize. Our upgrade was predicated on a tightening in inventories relative to GDP, which boosts the need for just-in-time air freight services, as well as a pickup in emerging markets activity. However, our confidence in the latter has been shaken. Air freight stocks are a reflation play, and a surging U.S. dollar is a threat to global liquidity (Chart 13). Global revenue ton miles have already crested after a muted rebound (Chart 14, second panel). Chart 13A Reflation Play A Reflation Play A Reflation Play Chart 14Take Profits Take Profits Take Profits Moreover, protectionist/anti-globalization sentiment may heat up, representing a risk to a recovery in global trade. The IFO export expectations index continues to sink, a warning for relative forward earnings estimates (Chart 14). The contraction in transport and warehousing hours worked confirms that transport activity is not yet on the mend (Chart 14). Relative performance has a history of violent oscillations, and the price ratio has soared to the top end of its multiyear range. Thus, even though the structural increase in online sales bodes well for long-term growth, and value remains appealing, we are booking profits and reducing positions in this globally-exposed group back to neutral in order to de-risk in our portfolio. Bottom Line: Take profits of 6% in the S&P air freight & logistics index and reduce to neutral. Downgrade the S&P electrical equipment index to underweight and add the overall industrial sector to our high conviction underweight list. The ticker symbols for the stocks in these indexes are: BLBG: S5AIRF - UPS, FDX, CHRW, EXPD, and BLBG: S5ELCO - AME AYI EMR ETN ROK. Current Recommendations Current Trades Size And Style Views Favor small over large caps and growth over value.

Fed hawkishness reinforces the need for an imminent profit recovery to justify current valuations. Our Indicators do not signal such an outcome. Stay defensive, and return to an underweight stance in the industrials sector.

The S&P electrical equipment & components (EEC) group has comparatively less resource exposure than many other industrial sub-industries. The EEC index is comprised of mature, diversified manufacturing businesses with exposure across a broad range of end markets. This provides stability in periods of macro volatility, but limits upside potential during the initial phase of an economic expansion. The group was savaged by the relentless advance in the U.S. dollar, creating deeply oversold and undervalued conditions. To be sure, electrical equipment sales have been pressured by the global manufacturing recession. However, new orders have stabilized. Shipments are far outstripping inventories, which are contracting, and unfilled orders have held steady. Importantly, our EEC productivity proxy has been very strong throughout the general manufacturing malaise. Productivity gains will help offset the loss of competitiveness from the strong U.S. dollar, and also suggests that earnings expectations are far too bearish. If the U.S. dollar begins to soften as a consequence of U.S. economic disappointment, than a valuation normalization is probable. Upgrade to overweight. This pulls up our overall industrial sector weighting to neutral. The ticker symbols for the stocks in this index are: EMR, ETN, ROC, AME. bca.uses_in_2016_02_17_003_c1 bca.uses_in_2016_02_17_003_c1

U.S. dollar softness may be sparking a subtle shift in sub-surface dynamics, to the benefit of select deep cyclical industries. Switch from rails into electrical equipment, and take profits in data processing.