Consumer Finance

Financials stocks have taken it on the chin, reflecting the unwinding of the 'Trump Trade' following the Administration's inability to tackle health care reform. As a result, the financials sector is reverting from hopes for deregulation to fundamentals for support. Worrisomely, credit growth has stalled. The middle panel of the chart shows that the credit impulse is sinking quickly. While this may prove a temporary/transitory phenomenon, the breadth of the credit contraction is broad-based, and thus, worthy of close attention. Of the eight loan categories tracked by the Fed, only one loan segment has a positive credit impulse: consumer loans. Historically, both the credit impulse and our diffusion index for the credit impulse have been solid leading indicators for relative financials EPS growth. Consequently, there is no confirmation that earnings momentum has turned the corner on a sustained basis. Bottom Line: Within a neutral overall financials stance we remain underweight the S&P banks index and continue to overweight the S&P consumer finance sub-group, which has high-conviction status. (If you would like to receive the breakdown of the credit impulse per loan category please email us at clientservices@bcaresearch.com and we will email you the chart.) The ticker symbols for the stocks in the S&P consumer finance and S&P banks index are: BLBG: BLBG: S5CFINX-AXP, COF, DFS, SYF, NAVI and BLBG: S5BANKX -WFC, JPM, BAC, C, USB, PNC, BBT, STI, MTB, FITB, CFG, RF, KEY, HBAN, CMA, ZION, PBCT, respectively. Financials Selectivity Is Warranted Financials Selectivity Is Warranted

Highlights The uptrend in consumer confidence has the potential to be lasting, and therefore lead to an acceleration in real consumption over the next several quarters. In contrast, the rise in business optimism is thus far built on shakier fundamentals, and therefore vulnerable to disappointment - at least until corporate executives see signs of a pickup in consumer demand. Some of the cyclical tailwinds that have aligned for consumers are: very low essential spending burdens, rising incomes, a positive wealth effect, and improved credit scores. Several areas of the U.S. equity market are set to outperform on the back of this improved consumer profile. Feature Financial markets continue to be optimistic about a more fertile business backdrop under a Trump presidency. At current valuations, equities are likely to undergo a testing phase. Indeed, the equity market's reaction to President-elect's press conference last week - the first in months - may be an omen of what is in store should Trump disappoint relative to what appears like very high expectations for the early days of his Presidency. At first blush, it appears that the surge in sentiment among a broad range of economic agents was precipitated by just one factor: Donald Trump's victory in the presidential election. Measures of both business and consumer confidence all rose sharply after November 8th (Chart 1). An important question is how sustainable and how far-reaching is this new-found optimism? After all, a major missing ingredient in the recovery to date has been faith that the economic future would get better. Last year, over half of respondents to a Nielsen global confidence survey still believed the world was in recession. Our take is that the uptrend in consumer confidence has the potential to be lasting, and therefore lead to an acceleration in real consumption over the next several quarters. In contrast, the rise in business optimism is thus far built on shakier fundamentals, and therefore vulnerable to disappointment - at least until corporate executives see signs of a pickup in consumer demand. This view runs counter to the current popular narrative, where businesses - and therefore their stock prices - perform better once a new era of pro-business policies are ushered in. We have noted in past weekly reports that we believe the equity market has overshot and that policy is likely to under-deliver; it is a high bar to assume that the new American government will succeed in implementing a pro-business strategy of lower corporate taxes, increased infrastructure spending and a lighter regulatory burden, while simultaneously avoiding any negative shocks from trade reform and foreign policy blunders.1 Thus, we interpret the surge in business confidence, as reported in various surveys, to be exaggerated and prone to a pullback. On the flipside, a number of cyclical tailwinds have aligned for consumers. Although consumer sentiment surveys also spiked higher since November, this merely extends an already rising trend. Below, we outline the fundamental factors that support stronger consumption growth in the coming quarters. Cost Of Essentials Is Ultra-Low First, the cost of many essential items have declined throughout the recovery, particularly energy prices (Chart 2). The decline in energy prices since 2014 means that spending on energy as a percent of disposable income is near thirty year lows. Likewise, spending on food and interest payments as a share of income is also as low as it has been in thirty years. It is only the seemingly incessant climb in medical payments that keeps overall spending on essential items above 40% of disposable income. Still, at 41% of total disposable income, spending on essential items is far from burdensome relative to historical norms. Chart 1Confidence Surge: Some Trump, ##br##Some Fundamentals Confidence Surge: Some Trump, Some Fundamentals Confidence Surge: Some Trump, Some Fundamentals Chart 2Essential Spending Burden##br## Is Very Low Essential Spending Burden Is Very Low Essential Spending Burden Is Very Low Incomes Are Rising And Jobs Are Secure Much more importantly, the main driver of consumption trends, income, is on track to accelerate (Chart 3). Despite a moderation in payroll growth, overall income growth is likely to stay perky, now that wage growth is rising. Indeed, as we highlighted in a Special Report in November, the labor market has reached full employment, which is the necessary threshold for a broad-based acceleration in wages (Chart 4). Although there are structural factors that will mitigate rapid wage hikes, it is likely that mild upward pressure on wages will continue throughout 2017 (Chart 5). This is obviously good news because higher wages means that consumers will have the wherewithal to spend more. In addition to this, a tighter job market has boosted job security. Various measures of consumer confidence highlight that over the past year, consumers now have much greater confidence in long-term job prospects. This is important because when job security is high, the propensity to spend instead of save is much higher (Chart 3, bottom panel). Chart 3Income Properties Drives Spending##br## More Than Any Other Factor Income Properties Drives Spending More Than Any Other Factor Income Properties Drives Spending More Than Any Other Factor Chart 4(Part I) Full Employment Calls##br## For Gradually Higher Wages (Part I) Full Employment Calls For Gradually Higher Wages (Part I) Full Employment Calls For Gradually Higher Wages Chart 5Part (II) Full Employment Calls##br## For Gradually Higher Wages Part (II) Full Employment Calls For Gradually Higher Wages Part (II) Full Employment Calls For Gradually Higher Wages Although income is the primary driver of consumption, the trend can be enhanced by several factors, including consumer wealth, the ability of consumer to finance purchases and fiscal handouts. The Wealth Effect Will Remain A Tailwind The wealth effect is the change in spending that accompanies a change, or perceived change, in wealth. The combined wealth effect from real estate and financial markets has been positive for some time (Chart 6). Thus, it is not a new driver of consumer spending, but is nonetheless positive that wealth positions continue to improve. If our forecasts for financial markets and house prices pan out, i.e. that the bull market in stocks continues over time, that bonds experience only a mild bear market and that house price appreciation remains in the mid-single digits, then a positive wealth effect will continue to support consumption in 2017. Debt/Deleveraging Cycle Is Advanced One of the major headwinds to consumer spending since 2008 has been the long, dark shadow of deleveraging. But that process is now well-advanced for the consumer sector. Consumer debt levels as a percent of disposable income peaked in 2008 at over 120%, but are now back under 100%, i.e. at the level that existed prior to the housing bubble and bust. Indeed, the financial obligation ratio for households (both renters and homeowners) is lower today than at any time in the past thirty-five years (Chart 7). Of course, part of this is due to very low interest rates, but our Bank Credit Analyst will show in their February publication that even a 100 basis point rise in borrowing rates from current levels would not lift the interest payment burden to elevated levels by historical standards. Chart 6Wealth Effect Will Remain Positive Wealth Effect Will Remain Positive Wealth Effect Will Remain Positive Chart 7Credit Conditions Are Not Problematic Credit Conditions Are Not Problematic Credit Conditions Are Not Problematic Finally, access to credit remains favorable. In late 2016, lending standards for consumer loans tightened slightly in late 2016, but access to credit generally is not a constraint on spending. A second important point is the ability of those scarred from the housing bust to re-enter the credit market. By law, information about any credit payment delinquencies, including mortgage payment delinquencies, must be removed from an individual's credit record after seven years. Therefore, if no other delinquencies occurred, individuals who experienced a foreclosure see their credit scores recover in seven years and can once again become candidates for mortgage purchases and therefore homeownership. According to research by the Chicago Federal Reserve, since the peak of foreclosures occurred prior to 2011, the bulk of borrowers that foreclosed during the housing bubble and bust are now seeing their credit scores improve. By 2016, both prime and sub-prime borrowers who entered foreclosure between six and nine years earlier (in 2007-10) appear to have recovery rates that are converging with the historical rates of recovery among their predecessor cohorts: nearly 100% of sub-prime borrowers from 2007-2010 who foreclosed have re-attained their previous credit scores, while over 60% of prime borrowers from 2007-2010 re-attained theirs (Chart 8). This means that in large part, the massive drag on housing demand due to poor credit scores from the previous housing bust have been alleviated. Chart 8Share Of Home Mortgage Borrowers Who Recovered ##br##Pre-Delinquency Credit Score After Foreclosure U.S. Consumer: The Comeback Kid U.S. Consumer: The Comeback Kid Fiscal Help? President-elect Donald Trump has promised fiscal stimulus in the form of infrastructure spending, corporate tax cuts and personal income tax cuts. The latter could have a positive impact on consumption, although it would likely be small. According to the Tax Policy Centre, if enacted, the highest income taxpayers (0.1 percent of the population, or those with incomes over $3.7 million in 2016 dollars) would experience an average tax cut of nearly $1.1 million, over 14 percent of after tax income. Households in the middle fifth of the income distribution would receive an average tax cut of $ 1,010, or 1.8 percent of after -tax income, while the poorest fifth of households would see their taxes go down an average of $110 or 0.8 percent of their after-tax income.2 The bottom line is that fiscal policy, if Trump's plan is enacted, could be a small positive tailwind for consumption in 2017. Overall, there are increasing signs that the scar tissue from the Great Recession is finally fading and that the improvement in consumer confidence is sustainable. This, combined with better income prospects will give households the wherewithal to spend more freely and will push real GDP growth up to 2.5% or perhaps slightly stronger. Our past research shows that sustainable capital spending cycles only get underway once businesses see clear evidence that consumer final demand is on the upswing. Thus, perhaps a healthier capex cycle will get underway, and businesses will have a fundamental reason to be more upbeat about their prospects. But for now, it seems more likely that businesses are at risk of being disappointed with the speed and efficacy of federal policy changes. On this basis, favoring equity sectors geared to the consumer rather than capex still makes sense. Favor Consumer-Geared Equity Sectors An acceleration in consumer spending will benefit consumer-sensitive equity sectors and would also support our domestic-over-global equity tilt. In our December 5th report, we outlined the bullish prospects and compelling value on offer in the consumer discretionary sector. In addition, our sister publication, U.S. Equity Strategy service just published their annual high conviction equity list. Home improvement retail, and consumer finance stocks were top of the list of high conviction overweights: Home Improvement Retail (Chart 9): Enticing long-term housing prospects argue for looking through the recent rise in mortgage rates. And as highlighted above, consumers have only recently started re-levering, with banks more than willing to facilitate renewed appetite for mortgage debt. In addition, remodeling activity is booming and anecdotes of house flipping activity picking up steam are corroborating that the housing market is vibrant. Now that house prices have recently overtaken the 2006 all-time highs, the incentive to upgrade and remodel should accelerate. While the recent backup in bond yields has been a setback for housing affordability, the U.S. consumer is not priced out of the housing market. Yields are rising in tandem with job security and wages. Mortgage payments remain below the long-term average as a share of income and effective mortgage rates remain near generationally low levels. Consumer Finance (Chart 10): This group offers early-cyclical exposure and is levered to the rising interest rate environment and debt-financed consumer spending. Chart 9Home Improvement Retail Stocks Home Improvement Retail Stocks Home Improvement Retail Stocks Chart 10Consumer Finance Stocks Consumer Finance Stocks Consumer Finance Stocks Importantly, higher interest rates have boosted credit card interest rate spreads (the industry's equivalent net interest margin metric), underscoring that the next leg up in relative share prices will be earnings led. This group is well-placed to take advantage of the improving consumer trends discussed above. Lenka Martinek, Vice President U.S. Investment Strategy lenka@bcaresearch.com 1 Please see U.S. Investment Strategy Weekly Report "Q&A: The Top Ten", dated November 21, 2016, available at usis.bcaresearch.com 2 http://www.taxpolicycenter.org/publications/analysis-donald-trumps-revised-tax-plan/full Appendix Monthly Asset Allocation Model Update Our Asset Allocation (AA) model provides an objective assessment of the outlook for relative returns across equities, Treasuries and cash. It combines valuation, cyclical, monetary and technical indicators. The model was constructed as a capital preservation tool, and has historically outperformed the benchmark in large part by avoiding major equity bear markets. Please note that our official cyclical asset allocation recommendations deviate at times from the model's recommendation. The model is just one input to our decision process. The model's recommended weightings for the major asset classes are unchanged: neutral equity exposure at 60% (benchmark 60%), slightly overweight Treasury allocation at 40% (benchmark 30%) and underweight cash at 0% (benchmark 10%). The diffusion index of the three components for The Equity Model remained neutral. The technical component retained its "buy" signal, with slightly more advancement in the breadth & trend indicators relative to the momentum indicator. The monetary component, which measures overall liquidity conditions, is still favorable for equities, albeit is moving into less bullish territory. However, on the cyclical front, the earnings-driven component still warrants caution. Even as real operating earnings have marginally improved, they remain at a significant distance from positive economic expectations. Earnings momentum is also sluggish, based on our earnings diffusion index. Our qualitative stance for the allocation of Treasuries in balanced portfolios is neutral (since November 7, 2016) in contrast to the slightly overweight recommendation from our quantitative model, unchanged from last month. Although the valuation and technical components of the bond model are still constructive, the cyclical component is significantly less bullish this month. Chart 11Portfolio Total Returns Portfolio Total Returns Portfolio Total Returns Chart 12Current Model Recommendations Current Model Recommendations Current Model Recommendations Note: The asset allocation model is not necessarily consistent with the weighting recommendations of the Cyclical Investment Stance. For further information, please see our Special Report "Presenting Our U.S. Asset Allocation Model", February 6, 2009.

Highlights Portfolio Strategy A battle between tighter monetary conditions and the anticipation of fiscal largesse will be a dominant market theme this year. Our high-conviction equity allocation calls do not require making a major directional global economic bet, or second guessing the Fed's desire to continue tightening. The bulk of our calls could currently be considered contrarian, based on recent market momentum and sub-surface relative valuation swings. Recent Changes S&P Insurance Index - Downgrade to high-conviction underweight. Nasdaq Biotech Index - Downgrade to high-conviction underweight. Feature Stocks have already paid for a significant acceleration in earnings and economic growth this year and beyond. Fourth quarter earnings season will be the first real test of investor expectations since the post-election market surge. While recent data have been encouraging, forward corporate profit guidance is unlikely to be robust in the face of the U.S. dollar juggernaut. Currently, the hope is that fiscal stimulus will offset tighter monetary settings, ultimately delivering a higher plane of economic activity. The major risks are that the economy loses momentum before fiscal spending cranks up, and/or that profits diverge from a more resilient economic performance than liquidity conditions forecast. Indeed, fiscal stimulus isn't slated to accelerate until next year (Chart 1), while the impact of anti-growth market moves is far more imminent. Our Reflation Gauge has plunged, heralding economic disappointment (Chart 1). With the economy near full employment, Fed hawkishness could persist even in the face of any initial evidence of economic cooling. Under these conditions, the gap between nominal GDP and 10-year Treasury yields could turn negative in the first half of the year (Chart 2), which would be a major warning sign for stocks. Chart 1Fiscal Stimulus Is Still A Long Way Off Fiscal Stimulus Is Still A Long Way Off Fiscal Stimulus Is Still A Long Way Off Chart 2Warning Signal Warning Signal Warning Signal As a result, while the market has recently been focused almost solely on return, our emphasis at this juncture is on minimizing risk. That is consistent with the historic market performance during Fed tightening cycles. Going back to the early-1970s and using the last seven Fed interest rate hiking periods, it is evident that non-cyclical sector relative performance benefits immensely on both a 12 and 24 month horizon from the onset of Fed tightening (Charts 3 and 4). Cyclical sectors typically lag the broad market, while financials generally market perform1. Chart 312-Month Performance After Fed Hikes 2017 High-Conviction Calls 2017 High-Conviction Calls Chart 424-Month Performance After Fed Hikes 2017 High-Conviction Calls 2017 High-Conviction Calls Some of the other major macro forces that are likely to influence the broad market and sectoral trends are: Ongoing strength in the U.S. dollar and its drag on top-line growth: loose fiscal policy and tight monetary policy is a classic recipe for currency strength. Tack on high and rising interest rate differentials due to policy divergences with the rest of the world (Chart 5), and exchange rate strength is likely to persist in the absence of a major domestic economic downturn. A tough-talking Fed. Wage growth is accelerating and broadening out, and will sharpen the Fed's focus on inflation expectations. With dollar strength constraining revenue growth potential, strong wage gains are profit margin sapping (Chart 2). A divergence between economic growth and profit performance, i.e. stronger growth is unlikely to feed into equal growth in corporate sector earnings given the squeeze on profit margins from a recovery in labor's ability to garner a larger share of aggregate income. Disappointment and/or uncertainty as to the timing and rollout of the much anticipated fiscal spending programs and unfunded tax cuts. Favoring domestic vs. global exposure will remain a key theme. Emerging markets (EM) have not validated the sharp jump in the global vs. domestic stocks, nor cyclical vs. defensives (Chart 6). Chart 5Greenback Is A Drag##br## On S&P 500 Top Line Growth Greenback Is A Drag On S&P 500 Top Line Growth Greenback Is A Drag On S&P 500 Top Line Growth Chart 6Mind##br## The Gap Mind The Gap Mind The Gap EM stocks are pro-cyclical, and outperform when economic growth prospects are perceived to be improving. The surging U.S. dollar is a growth impediment for many developing countries with large foreign liabilities to service. The U.S. PMI is gaining vs. the Chinese and euro area PMI (Chart 7, second panel), heralding a rebound in cyclical share price momentum. World export growth remains anemic and will remain so based on EM currency trends (Chart 7). When compared with the reacceleration in U.S. retail sales, the outlook for domestically-sourced profits is even brighter. The other key sectoral theme is to favor areas geared to the consumer rather than the corporate sector. Consumer income statements and balance sheets are far healthier than those of the corporate sector (Chart 8). As a result, they are in a more propitious position to spend and expand. Chart 7Domestics Will Rise To The Occasion Domestics Will Rise To The Occasion Domestics Will Rise To The Occasion Chart 8Consumers Trump The Corporate Sector Consumers Trump The Corporate Sector Consumers Trump The Corporate Sector We expect all of these forces to truncate rally attempts in 2017. The market is already stretching far enough technically to flag risk of a potentially sizeable correction in the first quarter, i.e. greater than 10%, particularly given the significant tightening in monetary conditions and overheating bullish sentiment that have developed. In other words, it is not an environment to chase the post-election winners, nor turn bearish on the losers that have been eschewed. Against this backdrop, we are introducing our top ten high-conviction calls for 2017. As always, these calls are fundamentally-based and we expect them to have longevity and/or meaningful relative return potential, rather than just reflect recent momentum trends. We recognize the difficulty of trading in and out of positions on a short-term basis. Energy Services - Overweight Chart 9Playable Rally Playable Rally Playable Rally The energy sector scores well in relative performance terms when the Fed is hiking interest rates2, supporting a high-conviction overweight in the energy services group. OPEC's agreement to curtail production should hasten supply/demand rebalancing that was already slated to occur via non-OPEC production declines through 2017. U.S. shale producers slashed capital expenditures by 65% from 2014 to 2016, and the International Oil Companies reduced capital expenditures by 40% over the same period. OPEC's decision to trim output should mitigate downside commodity price risks, providing debt and equity markets with confidence to restore capital availability to the sector. With easier access to capital, producers, especially shale, will be able to accelerate drilling programs in a stable commodity price environment. The three factors traditionally required to sustain a playable rally are now in place. The rig count has troughed. The growth in OECD oil inventories has crested. The latter is consistent with a gradual rise in the number of active drilling rigs. Finally, global oil production growth is falling steadily. Pricing power is likely to be slow to recover this cycle given the scope of previous capacity excesses, but even a move to neutral would remove a major drag and reduce the associated share price risk premium (Chart 9). Consumer Staples - Overweight 2016 delivered a number of company specific body blows to the consumer staples sector, most notably concerns about the pharmacy benefit manger pricing model, which undermined the retail drug store group. Thereafter, the sector was shunned on a macro level following the election, as it was used as a source of capital to fund aggressive purchases in more cyclical sectors. This has set the stage for a contrarian buying opportunity in a high quality, defensive sector with one of the best track records during Fed tightening cycles3. The sector is now closing in on an undervalued extreme, in relative terms, having already reached such a reading in technical terms (Chart 10). Our Cyclical Macro Indicator is climbing, supported by the persistent rise in consumers' preference for saving. The latter heralds an increase in outlays at non-cyclical retailers relative to sales at more discretionary stores. Importantly, consumer staples exports have reaccelerated, despite the strong U.S. dollar, pointing to a further acceleration in sector sales growth, and by extension, free cash flow. The strong U.S. dollar is a major boon, from an historical perspective, given that it typically creates increased global economic and market volatility. The latter is starting to pick up (Chart 10). A strong currency, particularly bilaterally against China, also implies a reduction in the cost of imported goods sold, and heralds a relative performance rebound (Chart 11). Chart 10Contrarian Buy Contrarian Buy Contrarian Buy Chart 11China To The Rescue? China To The Rescue? China To The Rescue? Home Improvement Retail - Overweight Enticing long-term housing prospects argue for looking through the recent rise in mortgage rates. Household formation is reaccelerating, as full employment is boosting consumer confidence, and clocking at a higher speed than housing starts. The implication is that pent-up housing demand will be unleashed. In fact, consumers have only recently started re-levering, with banks more than willing to facilitate renewed appetite for mortgage debt. Remodeling activity is booming and anecdotes of house flipping activity picking up steam are corroborating that the housing market is vibrant. Now that house prices have recently overtaken the 2006 all-time highs, the incentive to upgrade and remodel should accelerate. While the recent backup in bond yields has been a setback for housing affordability, the U.S. consumer is not priced out of the housing market. Yields are rising in tandem with job security and wages. Mortgage payments remain below the long-term average as a share of income and effective mortgage rates remain near generationally low levels. Building supply store construction growth has plumbed to the lowest level since the history of the data. Historically, capacity restraint has represented a boost to home improvement retail (HIR) profit margins and has been inversely correlated with industry sales growth. Stable housing data and improving operating industry metrics entice us to put the compellingly valued S&P HIR on our high-conviction buy list for 2017 (Chart 12). Chart 12Benefiting From Enticing##br## Long-Term Housing Prospects Benefiting From Enticing Long-Term Housing Prospects Benefiting From Enticing Long-Term Housing Prospects Chart 13Healthy Consumer Is A Boon##br## To Consumer Finance Stocks Healthy Consumer Is A Boon To Consumer Finance Stocks Healthy Consumer Is A Boon To Consumer Finance Stocks Consumer Finance - Overweight We are focusing our early-cyclical exposure on overweighting the still bruised S&P consumer finance index. This group is levered to the rising interest rate environment and debt-financed consumer spending. The selloff in the 10-year Treasury bond has been closely correlated with relative performance gains and the current message is to expect additional firming in the latter (Chart 13, top panel). Importantly, higher interest rates have boosted credit card interest rate spreads (the industry's equivalent net interest margin metric), underscoring that the next leg up in relative share prices will be earnings led (Chart 13, bottom panel). On the consumer front, consumer finances are healthy, the job market is vibrant and consumer income expectations are on the rise. In addition, house prices have vaulted to fresh all-time highs and are still expanding on a y/y basis. The positive wealth effect provides motivation for consumers to run down savings rates (Chart 13, second & third panels). Health Care Equipment - Overweight Health care equipment (HCE) stocks have been de-rated alongside the broad health care index, trading at a mere market multiple and below the historical mean, representing a buy opportunity. Revenue growth has been climbing at a double digit clip (Chart 14, third panel) and the surging industry shipments-to-inventories ratio is signaling that still depressed relative sales growth expectations will surprise to the upside (Chart 14, top panel). Synchronized global growth is also encouraging for U.S. medical equipment exports, despite the U.S. dollar's recent appreciation. The ageing population in the developed markets along with pent up demand for health care services in the emerging markets where a number of countries are developing public safety nets, bode well for HCE long-term demand prospects. The bottom panel of Chart 14 shows that the global PMI has been an excellent leading indicator of HCE exports and the current message is positive. The recent contraction in valuation multiples suggests that sales are expected to disappoint in the coming year, an outlook that appears overly cautious, especially within the context of the nascent improvement in industry return on equity (Chart 14, second panel). Chart 14HCE Stocks Are Cheap Given##br## Improving Final Demand Outlook HCE Stocks Are Cheap Given Improving Final Demand Outlook HCE Stocks Are Cheap Given Improving Final Demand Outlook Chart 15More Than##br## Meets The Eye More Than Meets The Eye More Than Meets The Eye REITs - Overweight REITs have traded as if the back up in global bond yields will persist indefinitely, and that the level of interest rates is the only factor that drives relative performance. Improving cash flows and cheap valuations suggest that REITs can decouple from bond yields. Our REIT Demand Indicator (RDI) has climbed into positive territory, signaling higher rental inflation. The latter is already outpacing overall CPI by a wide margin. The RDI is also positively correlated with commercial property prices, implying more new highs ahead. That will support higher net asset values. While increased supply is a potential sore spot, particularly in the residential space, multifamily housing starts have rolled over relative to the total, suggesting that new apartment builds are diminishing. As discussed in previous research reports, contrary to popular perception, relative performance is also depressed from a structural perspective. REIT relative performance is trading well below its long-term trend, a starting point which has historically overwhelmed any negative pressure from a Fed tightening cycle (Chart 15). Tech Hardware Storage & Peripherals - Underweight The S&P technology hardware storage & peripherals (THSP) sector is a disinflationary play (10-year treasury yield change shown inverted, second panel, Chart 16) and benefits when prices are deflating, not when there are whiffs of inflation4. The tech sector has the highest foreign sales/EPS exposure among the top 11 sectors, and the persistent rise in the greenback is weighing on export prospects for the THSP sub-index (Chart 16, third panel), and by extension top and bottom line growth. Computer and electronic products new order growth has fallen sharply recently, warning that THSP sales growth will remain downbeat. Industry investment is also probing multi-year lows (not shown). Asian inventory destocking is ongoing, which will pressure selling prices, but the end of this liquidation phase would be a signal that the worst will soon be over. Technical conditions are bearish. A pennant formation signals that a breakdown looms. Chart 16Tech Stocks Hate Reflation Tech Stocks Hate Reflation Tech Stocks Hate Reflation Chart 17Shy Away, Don't Be Brave Shy Away, Don’t Be Brave Shy Away, Don’t Be Brave Biotech - Underweight The Nasdaq biotech index is following the BCA Mania Index, which includes previous burst bubbles in a broad array of asset classes. The top panel of Chart 17 shows that if history at least rhymes, biotech bubble deflation is slated to continue. Only 45 stocks in the NASDAQ biotech index have positive 12-month forward earnings estimates, comprising 27% of the 164 companies in the index according to Bloomberg. There is still a lot of air to be taken out of the biotech bubble. Historically, interest rates and relative performance have been inversely correlated. The back up in bond yields and Fed tightening represent a draining in liquidity conditions which bodes ill for higher beta and more speculative investments. The biotech derating has been earnings driven and a sustained multiple compression period looms, especially given the sector's poor sales prospects (Chart 17, bottom panel) Worrisomely, not only have biotech stocks fallen despite Trump's win, but recent speculative zeal (buoyant equity sentiment and resurging margin debt, not shown) has also failed to reinvigorate biotech equities. The NASDAQ biotech index is a sell (ETF ticker: IBB:US). Industrials - Underweight The industrials sector was added to our high-conviction underweight list late last year so the turn in calendar does not require a change in outlook. The sector has discounted massive domestic fiscal stimulus and disregarded the competitive drag on earnings from the U.S. dollar, trading as if a profit boom is imminent. Recent traction in surveys of industrial activity is a plus, but is more a reflection of an improvement in corporate sentiment and is unlikely to translate into imminent industrials sector profit improvement. The U.S. dollar surge is a direct threat to any benefit from an increase in domestic infrastructure or private sector investment spending. Commodity prices and EM drag when the dollar is strong. Chronic surplus EM industrial capacity remains a source of deflationary pressure for their currencies, economies and U.S. industrial companies. U.S. dollar strength warns of renewed pricing power pressure (Chart 18). Non-tech industrial capacity is growing faster than output, and capital goods imports prices are contracting (Chart 18). Tack on the relentless surge in the U.S. dollar, and a new deflationary wave appears inevitable. Relative forward earnings momentum is already negative, and is likely to remain so given the barriers to a top-line recovery, and a soaring domestic wage bill. The sector is not priced for lackluster earnings. Chart 18Fade The Bounce Fade The Bounce Fade The Bounce Chart 19Advance Is Precarious Advance Is Precarious Advance Is Precarious Insurance - Underweight Insurance stocks have benefited from the upward shift in the yield curve and the re-pricing of the overall financials sector, but the advance is precarious. Previously robust insurance pricing power has cracked. The CPI for household insurance is barely growing. The latter is typically correlated with auto premiums, underscoring that they may also slip (Chart 19). While higher interest rates are positive for investment portfolio income, they also imply mark-to-market losses on bond portfolios and incent insurers to underwrite at a faster pace with more lenient standards, which is often a precursor to increased competition and less pricing power. Insurance companies have added massively to cost structures in recent years (Chart 19), while the rest of the financials sector was shedding labor costs. Relative valuations have enjoyed a step-function upshift, but the path of least resistance will be lower for as long as relative consumer spending on insurance products retreats on the back of pricing pressure (Chart 19). 2016 Review... Last year's high-conviction calls were hot out of the gate, and generally had very strong gains until the late-summer/early-fall, but were hijacked by the post-election surge in a few sectors. As a result of the end of year fireworks, our high conviction calls trailed the market by just under 2% for the year ending 2016. Had we had the foresight to predict a Trump win and a massive market rally, we could have closed our positions in early November for comfortably positive gains. In total, our average booked gains in the year were 3% in excess of the broad market since the positions were initiated. We are also closing our pair trades, and will re-introduce a number of new trades in the near future. Anastasios Avgeriou, Vice President Global Alpha Sector Strategy & U.S. Equity Strategy anastasios@bcaresearch.com 1 Please see the U.S. Equity Strategy Special Report titled: "Sector Performance And Fed Tightening Cycles: An Historical Roadmap", available at uses.bcaresearch.com. 2 Ibid 3 Ibid 4 Please see the U.S. Equity Strategy Special Report titled: "Equity Sector Winners And Losers When Inflation Climbs", available at uses.bcaresearch.com. Current Recommendations Current Trades Size And Style Views Favor small over large caps. Favor growth over value (downgrade alert).

The previous Insight showed that businesses remain a weak link for the banking sector, as C&I loan demand has cooled and the corporate sector is the primary source of credit quality concerns following the multi-year credit binge. As such, our preference to play rising interest rates and a modest steepening in the yield curve is through the consumer finance group. Valuations remain dirt cheap, and have not discounted the widening in credit card net interest margins close to historic peaks. That is a far cry from banks, where net interest margins have improved, but only slightly and from still razor thin levels. Importantly, consumers have room to re-leverage after years of de-leveraging, an outcome predicted by the improvement in consumer income expectations. The bottom line is that the consumer finance group provides a cleaner play than banks on the sudden bullish sentiment shift in the overall financial sector. The ticker symbols for the stocks in this index are: BLBG: S5CFINX-AXP, COF, DFS, SYF, NAVI. bca.uses_in_2016_12_14_002_c1 bca.uses_in_2016_12_14_002_c1

While the corporate sector has run up debt levels and is struggling to generate profit growth, consumers have rebuilt their savings and are enjoying the benefits of a positive wealth effect. The increase in real wage and salaries growth is supporting consumer income expectations, according to the latest consumer confidence survey (top panel). The implication is that consumption-oriented plays should be well positioned to deliver profit outperformance. Consumer finance stocks provide an attractively valued play on this theme, as does the S&P data processing index. The latter is levered to total transaction volumes, and a healthy consumer should translate into positive sales momentum. We are overweight both indexes. bca.uses_in_2016_10_27_001_c1 bca.uses_in_2016_10_27_001_c1

Yesterday we showed an Insight with financial sector relative performance and the yield curve, with the message that the sector's more defensive components outperform while the curve is flattening, as is currently the case. We view the consumer finance group as a positive exception. An extremely attractive valuation starting point and a low correlation between the industry's net interest margins and the government yield curve provide confidence that a new bull run is getting underway. Indeed, the chart shows that the credit card interest rate spread has widened in recent months, even as the Treasury curve has narrowed. Importantly, the personal savings rate has room to decline (top panel), if a decent job market continues to lift consumer income expectations (bottom panel). That will support ongoing growth in revolving consumer credit and low delinquencies, two critical profit drivers. The bottom line is that consumer finance stocks should follow a similar bullish path to the consumer discretionary, media and most domestic consumption-oriented plays, and we reiterate an overweight stance. The ticker symbols for the stocks in this index are: BLBG: S5CFIN - AXP, COF, DFS, SYF, NAVI. Consumer Finance Is A Positive Financials Exception Consumer Finance Is A Positive Financials Exception

With the broad market poking above the top end of its long-term trading range, investors may be on the lookout for sectors and groups that will benefit from improving market sentiment. While the financial sector has been pounded in the last few months and is due for an oversold rebound, we would prefer making more targeted purchases rather than lifting exposure to the whole sector. The consumer finance group warrants bottom fishing. Credit card interest rate spreads have widened in recent weeks, diverging massively from the overall yield curve and signaling that historically cheap relative valuations are not sustainable. Importantly, consumer income expectations have perked up on the back of labor market tightness, suggesting that revolving consumer credit will continue to grow. We reiterate our overweight stance on this group. The ticker symbols for the stocks in this index are: BLBG: S5CFIN - AXP, COF, SYF, DFS, NAVI. bca.uses_in_2016_07_13_002_c1 bca.uses_in_2016_07_13_002_c1

In March we recommended doubling down on our overweight S&P consumer finance index call, because company-specific factors had caused relative performance to undershoot the bulk of our macro indicators. Since then, the share price ratio has climbed, aided by the largest monthly gain in revolving consumer credit growth in well over a decade (second panel). However, the latest consumer confidence survey showed that consumer income expectations have receded, which may forewarn of a cooling in rapid debt growth. This bears close attention, as rising credit card receivables are a major profit lever. Still, consumers are in much better financial shape than the business sector, and banks remain willing to extend consumer credit, especially relative to corporate sector loans, underscoring that revolving credit growth should remain robust. Importantly, the narrowing Treasury yield curve is not having a negative impact on industry earnings, as the credit card interest rate spread is widening anew. Against a backdrop of attractive relative valuations, we continue to recommend an overweight position, as well as a long/short position vs. the S&P bank index. The ticker symbols for the stocks in this index are: BLBG: S5CFIN - AXP, COF, SYF, DFS, NAVI. bca.uses_in_2016_06_02_002_c1 bca.uses_in_2016_06_02_002_c1

Last month, we highlighted that the S&P consumer finance index had far undershot bullish readings from our macro indicators, reflecting company specific issues. As the latter fade into the rearview mirror, relative performance should reengage with its upbeat outlook. For instance, the tighter U.S. labor market is pushing up wage & salary growth, supporting robust gains in revolving consumer credit (second panel). Rising income growth also suggests credit quality is unlikely to become a profit drag, paving the way for a re-rating in historically attractive relative valuations. That contrasts with the corporate sector, which is struggling with highly-indebted balance sheets and faltering profit growth (our Corporate Health Monitor is shown advanced, bottom panel). It is no wonder that personal loans are outpacing C&I credit growth (third panel) This backdrop is bullish for consumer finance stocks relative to the market, and relative to the S&P bank index. We reiterate our overweight S&P consumer finance index recommendation as well as our recently established pair trade vs. banks. The ticker symbols for the stocks in this index are: BLBG: S5CFINX - AXP, COF, SYF, DFS, NAVI. bca.uses_in_2016_04_22_001_c1 bca.uses_in_2016_04_22_001_c1

Both the demand for and availability of capital favors consumers over businesses, on the margin. The latest Fed senior loan officer survey showed that banks are tightening standards on C&I loans, the most rapidly growing component of bank assets. This reflects the broad-based deterioration in corporate sector balance sheet health. Conversely, willingness to extend consumer credit remains high. Previous deleveraging has vastly improved household balance sheets. Debt servicing payments are historically low as a share of income. Consumer spending is outpacing capital spending, which is driving a rise in personal loans relative to business credit. A narrowing yield curve has much more bearish implications for banks than it does for credit card companies, whose interest rate spreads are far less susceptible to yield curve swings. This is borne out in the tight inverse correlation between the yield curve and the share price ratio (bottom panel). Consequently, we recommend initiating a pair trade in the undervalued consumer finance/banks share price ratio. Please see yesterday's Weekly Report for more details. bca.uses_in_2016_03_22_002_c1 bca.uses_in_2016_03_22_002_c1