Consumer Staples

The U.S. Census Bureau released their factory shipments and inventories data and the message from beverage makers was bleak. The steep decline in shipments that started at the end of Q1 has accelerated and inventories have continued to pile up (second panel). This has driven the weakest industry pricing power of the last decade as manufacturers clear out backlog (third panel). This clear indication of weakening margins has not been lost on the analyst community and earnings estimates have been falling (top panel). However, relative share prices have been unexpectedly resilient, pushing valuation multiples higher (bottom panel). These multiples fail to discount the sector's future earnings weakness and should herald a hard landing coming out of this earnings season. Stay underweight. The ticker symbols for the stocks in this index are: BLBG: S5SOFD - PEP, KO, DPS, MNST. Not So Refreshing Not So Refreshing

Dear Client, We hope that you will find value in this report, a product of collaboration between BCA’s Geopolitical Strategy and EM Equity Sector Strategy. My colleagues Oleg Babanov and Matt Gertken look for investment opportunities in the recent geopolitical changes on the Korean Peninsula. The election of President Moon Jae-in will be a boon for domestic consumer sentiment and relations with China. This will produce a tailwind for the consumer-oriented South Korean stocks, which have high exposure to the country’s trade with China. We deliver this report to you both for its investment value and as an example of BCA Research commitment to seek alpha in the intersection of economics, markets, and geopolitics. Kindest Regards, Marko Papic Senior Vice President Chief Geopolitical Strategist Overweight South Korea Consumer Staples We are recommending an overweight position in select South Korean consumer staples on a long-term (one year-plus) time horizon. A decline in geopolitical tensions between South Korea and China, and a potential improvement on the Korean peninsula, will provide tailwinds to the performance of Korean consumer staples, which have high exposure to China. We expect Chinese tourist numbers to Korea to recover gradually, and sales of South Korean products in mainland China to pick up over the rest of the year. Presidential elections in South Korea and a slowly improving economy are bolstering consumer sentiment and aiding a turnaround in retail sales in the country, with companies in the consumer space displaying better earnings momentum and trading at more attractive valuations than their EM peers (Table 1). Image Sector Backdrop We are turning cautiously positive on consumer staples in South Korea. We believe the following factors will trigger a turnaround in consumer sentiment and support share price performance of consumer-oriented South Korean stocks. Geopolitics Image The election of President Moon Jae-in by a wide margin, as well as a geopolitical shift toward more accommodative policy on China, will alleviate geopolitical risks and help consumer sentiment. Moon has already kicked off his administration's tenure with considerable political capital. For one, his administration represents a return to stable and legitimate government after over a year of turmoil surrounding the scandal, impeachment and removal of former President Park Geun-hye - a relief for South Korean voters. What's more, voter turnout was higher than usual, at 77%, and Moon's margin of victory over his closest contender was over 15%, the second-highest since South Korea became a full-fledged democracy in 1987 (Chart 1). There are also institutional factors playing to Moon's advantage. He was the leading contender for the presidency even without Park being removed from office - but if she had not been removed, he would have taken office in January 2018. Now, Moon has half a year longer in office than he otherwise would have had before he faces his first serious political hurdle in the April 2020 legislative elections. This half year could make a difference. Since Korean presidents serve a single, five-year term, they often become lame ducks in the second half of their term, and therefore move rapidly on policy in the first half while their political capital is high. The only significant domestic political constraint on Moon is the rival left-of-center party, the People's Party. It holds the kingmaker position in the legislature, with the ability to give a majority to either Moon's ruling Democratic Party or to the conservative opposition (Chart 2). However, the People's Party has serious weaknesses and has been compelled by its voting base to cooperate on much of Moon's platform of expanding social spending and thawing relations with North Korea and China. Moreover, the conservative opposition is discredited and fractured. Thus, Moon has limited political constraints. Given that his administration is competent - i.e. the clear populist elements are not joined with a lack of experience or pragmatism - the key question is what policies he will prioritize while his political capital is high. Image Chart 3THAAD Deployment Hurt ##br##Bilateral China-Korea Trade THAAD Deployment Hurt Bilateral China-Korea Trade THAAD Deployment Hurt Bilateral China-Korea Trade It is our view that China-exposed companies stand to benefit in the short term as China eases sanctions over the recently deployed U.S. THAAD missile defense system (Chart 3), and as better relations with China benefit the economy more broadly (Chart 4). However, if Moon prioritizes China and North Korea excessively, he risks squandering his political capital. Korea remains stuck in the middle of U.S.-China tensions that are growing on a secular basis. Tensions with the U.S. will rise as a result of Moon's orientation, and North Korean political risks will remain elevated over the medium and long term. Moon's attempts to engage with North Korea will collide with Trump's efforts to ratchet up pressure against it. Image Therefore, Moon is likely to find the most success in his domestic agenda of increasing government spending, hiring more public workers, raising wages and instilling worker protections, expanding the social safety net and subsidizing small- and medium-sized enterprises. These measures will boost both public and private consumption. We do not have particularly high hopes for Moon's ability to reform the so-called 'chaebol', a South Korean term denoting large, typically family-owned corporate conglomerates, but his attempt to do so will add a modicum of corporate governance and competitiveness improvements that markets will likely cheer. Macroeconomics With improvement in the geopolitical situation, stabilization in the local political system following the Park Geun-hye scandal and new elections has aided in a recovery in consumer sentiment (Chart 5). Meanwhile, a rebound in total employment numbers together with a decline in household debt is providing support to consumer spending (Charts 6A, 6B, 6C). Chart 5Consumer Confidence Is ##br##Back To A Five-Year High Consumer Confidence Is Back To A Five-Year High Consumer Confidence Is Back To A Five-Year High Chart 6ANumber Of Employed ##br##Higher Than In 2015... Number Of Employed Higher Than In 2015... Number Of Employed Higher Than In 2015... Chart 6B...While The Household Debt ##br##Burden Is Slowly Declining... ...While The Household Debt Burden Is Slowly Declining... ...While The Household Debt Burden Is Slowly Declining... Chart 6C...Aiding A Recovery##br## In Retail Sales ...Aiding A Recovery In Retail Sales ...Aiding A Recovery In Retail Sales Sector Specifics From a sector perspective, South Korean consumer staples remain highly competitive, outperforming their EM peers (Chart 7). At the same time, valuations are attractive for South Korean companies (Charts 8A & 8B). Chart 7South Korean Consumer Stocks Outperforming EM Consumer Staples' Aggregate... South Korean Consumer Stocks Outperforming EM Consumer Staples' Aggregate... South Korean Consumer Stocks Outperforming EM Consumer Staples' Aggregate... Chart 8ASouth Korean Companies Trading At Cheaper ##br##Valuations Since Mid-2016... South Korean Companies Trading At Cheaper Valuations Since Mid-2016 South Korean Companies Trading At Cheaper Valuations Since Mid-2016 Chart 8B...And At One Standard Deviation Below ##br##Their Seven-Year Average ...And At One Standard Deviation Below Their Seven-Year Average ...And At One Standard Deviation Below Their Seven-Year Average Furthermore, bottom-line expansion of South Korean companies remains strong, supported by solid margin trends (Charts 9A, 9B, 9C). Chart 9A...Earnings Growth In South Korea##br## Is Outperforming EM Peers ...Earnings Growth In South Korea Is Outperforming EM Peers ...Earnings Growth In South Korea Is Outperforming EM Peers Chart 9B...With Gross Margin Nearly Twice ##br## The EM Industry Average... ...With Gross Margin Nearly Twice The EM Industry Average... ...With Gross Margin Nearly Twice The EM Industry Average... Chart 9C...And EBTIDA Margin Is Steadily ##br## Above EM Peers ...And EBTIDA Margin Is Steadily Above EM Peers ...And EBTIDA Margin Is Steadily Above EM Peers We also like the fact that the net debt level for South Korean consumer staples companies is low to negative, while companies have managed to generate excess free cash flow. One undesirable implication, however, is notoriously low dividend yields, which are discouraging investors and raising corporate governance issues (Charts 10A, 10B, 10C). Taking into account the factors listed above, we have created a portfolio of six South Korean consumer staples stocks (Table 2). Chart 10ADebt Levels Have Fallen Significantly ##br## Over The Past Seven Years... Debt Levels Have Fallen Significantly Over The Past Seven Years... Debt Levels Have Fallen Significantly Over The Past Seven Years... Chart 10B...While Cash Generation ##br## Has Recovered... ...While Cash Generation Has Recovered... ...While Cash Generation Has Recovered... Chart 10C...But Dividend Yields ##br## Remain Disappointing Low ...But Dividend Yields Remain Disappointing Low ...But Dividend Yields Remain Disappointing Low Image The Overweight Basket Chart 11Performance Since June 2016: ##br## Amorepacific Corp Vs. MSCI EM Performance Since June 2016: Amorepacific Corp Vs. MSCI EM Performance Since June 2016: Amorepacific Corp Vs. MSCI EM Amorepacific Corp (090430 KS): A leading beauty and cosmetics producer in South Korea (Chart 11). Founded in the 1940s by Yun Dok-jeong as a company distributing camellia oil for hair treatment, the company was inherited by Yun's son and later grandson, who became the second-richest man in South Korea, controlling directly 10% of the company's free float. Today, Amorepacific is the world's 14th largest cosmetics company, with oversight of some 33 brands around the world such as Etude House, Sulwhasoo and others. In terms of revenue, the bulk is generated by beauty and cosmetic products (91%), where luxury cosmetics constitute 43%, followed by premium brands with 18%. Personal care products contribute 9% to total revenue. Geographically, 70% of revenues are generated in South Korea, and another 19% in China. Amorepacific reported weaker-than-expected first-quarter 2017 financial results on April 24. Revenue increased by 5.7% year over year, with falling Chinese tourist numbers weighing on local sales, and weaker sales in mainland China. At the same time, cost of sales went up by 10.6% year over year, which resulted in gross margin compression by 100 basis points. As a result of an operating cost increase of 8.4% year over year, mainly driven by SG&A expansion (increased labor costs and one-off bonus payments), operating profit fell 6.2% year over year. Operating margin finished at 20.2% compared to 22.8% same period last year, while EBTDA margin contracted to 17.8% from 19.5% last year. Weak operating performance and disproportionate expense growth led to the bottom line falling 15% year over year. Amorepacific is currently trading at a forward P/E of 30.0x, while the market is forecasting an EPS CAGR of 13% over the next three years. We believe the share price will continue to recover strongly, taking into account that easing tensions with China will restore demand and organic volume growth as well as strong momentum in overseas sales, supporting an earnings recovery. Chart 12Performance Since June 2016: ##br## E-Mart Vs. MSCI EM Performance Since June 2016: E-Mart Vs. MSCI EM Performance Since June 2016: E-Mart Vs. MSCI EM E-Mart (139480 KS): Number one hypermarket brand in South Korea (Chart 12). E-Mart was established in 1993 and has grown into the largest hypermarket and discount store chain in South Korea, operating over 148 branch locations locally and another 16 in China. In 2006 the company also acquired its largest competitor in the country - Wal-Mart Korea - strengthening its market share. Additionally, E-Mart runs speciality shops such as "Emart" discount stores, the "Emart Mall" online store, "Emart Traders," an everyday low-price store, as well as pet and sports/outdoor stores. In terms of revenue breakdown, the flagship E-Mart brand is responsible for 78% of total revenue, followed by the food distribution and supermarket segment with 7% each respectively. From a geographic perspective, 98% of revenue originates in South Korea and only 2% in China. E-Mart reported first-quarter 2017 financial results on May 11, missing estimates. Revenue growth was solid, up 7.4% year over year, helped by 1% same-store sales growth in the main hypermarket segment, while cost of sales increased by 6.5% year over year, which resulted in gross margin falling slightly by 20 basis points to 28.2%. Operating profit increased by 2.8% year over year, weighed on by a year-on-year jump in operating expenses of 11.1%. Operating margin stood at 4.1%, down from 4.3% in 2016, while EBITDA margin finished virtually flat at 6.7%. Thanks to better operating performance, the bottom line improved by 5% year over year. The main detraction to performance came from one-off store opening expenses and a negative calendar effect. E-Mart is currently trading at a forward P/E of 14.0x, while the market is forecasting an EPS CAGR of 9% over the next three years. A store restructuring program is currently underway, and management has done well in accelerating closures of non-performing stores, which has already led to cost savings and margin turnaround. We expect this process to continue. Together with strong performance of the discount and online segments, this should warrant a further re-rating of the share price. Chart 13Performance Since June 2016: ##br## GS Retail Vs. MSCI EM Performance Since June 2016: GS Retail Vs. MSCI EM Performance Since June 2016: GS Retail Vs. MSCI EM GS Retail (007070 KS): Number one convenience store chain in South Korea (Chart 13). GS Retail is part of the GS Group, a former part of LG Group and the sixth-largest conglomerate in South Korea, which controls just under 66% of the company. GS Retail was incorporated back in 1971 and today operates GS25 - the largest convenience store brand in South Korea - as well as other brands such as GS Supermarkets, Watsons - a health and beauty chain, and Parnas Hotel. The largest contributor to total revenue is the convenience store segment, with 77%, followed by the supermarket business with 20% and the hotel operation with 3%. Geographically, all the revenue originates in South Korea. GS Retail reported first-quarter 2017 financial results on May 11. Revenue displayed strong growth, up 12.5% year over year, driven by solid performance in the convenience store segment (+21% year over year), while cost of sales increased by 12.3% year over year, which brought gross margin up by 20 basis points to 18.4%. A 15% year-over-year increase in operating costs due to the ongoing consolidation of the Watsons business brought operating income down slightly by 1.5% year over year, suppressing operating margin by 20 basis points to 1.4%. EBITDA margin stood at 5.9% compared to 6.2% a year ago. Despite weak operating performance, the bottom line grew by 18.8%, helped by a non-operating gain and lower interest expenses. GS Retail is currently trading at a forward P/E of 19.6x, while the market is forecasting an EPS CAGR of 14% over the next three years. We expect the non-convenience store segments to contribute more to performance in the second part of the year. Furthermore, non-performing supermarket store closedowns together with seasonally strong second and third quarters, where the summer weather typically helps sales, should support stock performance. Chart 14Performance Since June 2016: ##br## H&H Vs. MSCI EM Performance Since June 2016: H&H Vs. MSCI EM Performance Since June 2016: H&H Vs. MSCI EM LG Household & Healthcare (051900 KS): Producer of the very first cosmetic products in Korea (Chart 14). LG H&H was incorporated in 1947 by Koo In-Hwoi, the founder of LG Corp., and had the initial name Lucky Chemical Industrial Corp. The company produced the first-ever Korean cosmetic product, "Lucky Cream," followed by "Lucky Toothpaste." From 1995 to 2001, LG H&H was part of LG Chem before being spun off. In addition to the cosmetics and household goods businesses, the company also acquired Coca Cola Beverage in 2007, turning itself into an exclusive bottler and distributor of Coca Cola products in South Korea. In terms of revenue breakdown, the cosmetics business contributes 53% to overall revenue, followed by personal products with 27% and the soft drink division with 20%. Geographically, 84% of revenue originates in South Korea, followed by China with 8% and Japan with 4%. LG H&H reported better-than-expected first-quarter 2017 financial results on April 28. Revenue expanded by 5.3% year over year, driven by strong sales in the luxury cosmetics and beverage segments, while cost of sales grew by 4% year over year, bringing gross margin 50 basis points higher to 60.9%. Furthermore, operating income displayed strong growth, up 11.3%, helped by good management of operating expenses (+4.5% year over year). As a result, operating margin improved by 90 basis points to 16.2% and EBITDA margin finished at 16.9%, up from 15.7% last year. The bottom line increased by 11.9% year over year, helped by strong operating performance. LG H&H is currently trading at a forward P/E of 24.1x, while the market is forecasting an EPS CAGR of 8% over the next three years. As with Amorepacific, the trigger to a re-rating in the share price of LG H&H is the improving geopolitical situation. We expect tourist numbers to South Korea to gradually increase, which will aid in both sales recovery and earnings revisions, while strong momentum in the luxury cosmetics segment will contribute to further margin expansion. Chart 15Performance Since June 2016: ##br## KT&G Vs. MSCI EM Performance Since June 2016: KT&G Vs. MSCI EM Performance Since June 2016: KT&G Vs. MSCI EM KT&G Corp (033780 KS): Korea Tobacco & Ginseng (Chart 15). Initially founded as a government monopoly with the name "Korea Tobacco & Ginseng," the company was later privatized and rebranded as the "Korea Tomorrow & Global Corporation." Today, the company is the largest tobacco company in South Korea, controlling the majority of the local market. The company also has extensive exposure to Eastern European countries. In addition to the tobacco business, KT&G also has a pharma arm, the Korea Ginseng Corp. The revenue stream is broken down into the cigarette business, which contributes 60% to overall revenue, followed by the ginseng-pharma segment, adding another 30%. KT&G reported in-line first-quarter 2017 financial results on April 27. Revenue increased by a solid 8% year over year, helped by strong ginseng sales, which expanded despite a market contraction and were also alleviated by market share gain and higher prices. Cost of sales, meantime, were up 12.7%, bringing gross margin down to 59.4% from 61.1% previously. Due to a strong increase in operating costs (+11.3% year over year), driven by higher SG&A expenses, operating income edged up only 0.6% year over year. Operating margin fell 45 basis points from last year, while EBITDA margin stood at 35.5%, or 80 basis points lower compared to the same period last year. The bottom line fell by 17.5% year over year, weighted on by higher foreign exchange losses. KT&G is currently trading at a forward P/E of 12.8x, while the market is forecasting an EPS CAGR of 6.5% over the next three years. Several factors have been weighing on the company's share price recently, including the introduction of warning messages on cigarette packages and the introduction of e-cigarettes in the domestic market - making the stock one of the cheapest among its global peers (~20% discount). We believe that worries regarding e-cigarette introduction and projections of the Japanese experience are overstated due to differences in law (e.g. prohibition of smoking indoors), as well as the age composition of the market. Furthermore, we expect a strong revival in overseas sales in the second part of the year, with less headwinds from foreign exchange swings and double-digit growth due to low base effects - as well as an offset to flat local market expansion via higher selling prices. Chart 16Performance Since June 2016: ##br## Nongshim Vs. MSCI EM Performance Since June 2016: Nongshim Vs. MSCI EM Performance Since June 2016: Nongshim Vs. MSCI EM Nongshim (004370 KS): Farmer's Heart (Chart 16). Nongshim, or Farmer's Heart, was founded in 1965 under the name Lotte Food Industrial Company, and later changed its name. The company first focused on ramyun (instant noodle) production, later expanding into snacks - it was the first to introduce the "Shrimp Cracker" as well as beverages. Today, Nongshim is the largest ramyun and snack company in South Korea, selling to over 100 countries, with production facilities in Korea, China and the U.S. From a revenue perspective, ramyun products contribute 67% to total revenue, followed by other food products with 17.5% and snacks with 15.6%. Geographically, most sales occur in South Korea, with 80%, followed by the U.S. with 10% and China with 8%. Nongshim reported slightly better-than-expected first-quarter 2017 financial results on May 15. Revenue declined slightly by 2.2% year over year due to a fall in domestic ramyun sales by 9%, while cost of sales actually declined by 5% year over year, which led to a gross margin improvement by 190 basis points to 33.7% (helped by price increases.) Operating income was virtually flat year over year, as operating costs increased by 4%. Operating margin stood at 5.85% compared to 5.70% in 2016, while EBITDA margin declined to 7.9% from 9.4% last year. Nongshim is currently trading at a forward P/E of 18.5x, while the market is forecasting an EPS CAGR of 5.6% over the next three years. We expect a reversal of weak sales in China (-5% year over year) due to an easing of the geopolitical situation. Furthermore, Nongshim has already begun to claw back market share, helped by new starts and forced price hikes among its competition, which will continue to help turn around margins and improve profitability. How To Trade? The EMES team recommends gaining exposure to the sector through a basket of listed equities consisting of six overweight recommendations. The main goal is active alpha generation by excluding laggards and including out-of-benchmark plays, to avoid passive index-hugging via an ETF. Direct: Equity access through the tickers (Bloomberg): Amorepacific Corp (090430 KS); E-Mart (139480 KS); GS Retail (007070 KS); LG Household & Healthcare (051900 KS); KT&G Corp (033780 KS); Nongshim (004370 KS). ETFs: At the moment, there are no ETFs with significant consumer staples sector exposure for South Korea. Funds: At the moment, there are no funds with significant consumer staples sector exposure for South Korea. Please note this trade recommendation is long term (1Y+) and based on an overweight trade. We do not see a need for specific market timing for this call (for technical indicators please refer to our website link). For convenience, the performance of both market cap-weighted and equal-weighted equity baskets will be tracked (please see upcoming updates as well as the website link to follow performance). Risks To Our Investment Case We believe that one of the main risks is the geopolitical situation and further developments surrounding North Korea. Although the usual springtime tensions have passed, the underlying dynamic remains highly precarious. North Korea has not moderated its behavior despite President Moon's olive branch and U.S. President Trump continues to prioritize the issue and threaten bolder action. Any kind of escalation in tensions, whether they be driven by North Korea or the U.S., would negatively affect both Chinese interests and the new South Korean administration's attempts at engagement. Given that South Korea has not yet fully reversed the THAAD missile deployment, for instance, it is possible that China could maintain or intensify its informal sanctions on South Korea, such as travel and product bans, and that renewed tensions could depress overall consumer sentiment in South Korea. We are also cognizant that debt levels in the South Korean manufacturing sector as well mass layoffs in shipyards and a slowdown in exports could continue to create pressure on household disposable income levels and, in turn, spending. However, President Moon's efforts for a supplementary budget to support employment in the public sector, if approved, should alleviate some pain from layoffs. On a company level, we see increased price competition as one of the main risks to our investment case. Since many of the companies in the basket are market leaders, they will need to defend their market share aggressively in case of increased competition. Furthermore, for companies operating abroad, we see increased expansion costs as one of the risk factors for future performance. Finally, Chinese economic policy pose a risk to our view. The fiscal spending and credit impulse in China have rolled over, suggesting that demand will slow in the coming months. Moreover, the Communist Party’s ongoing “deleveraging campaign” – a crackdown on various risky financial practices and the shadow banking sector – raises the risks of a policy mistake. A slowdown in China would have negative repercussions for the South Korean companies most exposed to China and the broader Korean economy. Nevertheless, we think Chinese authorities are willing and able to meet their growth target this year. Oleg Babanov, Senior Editor obabanov@bcaresearch.co.uk Matt Gertken, Associate Vice President Geopolitical Strategy mattg@bcaresearch.co.uk

Highlights Portfolio Strategy Swap consumer staples into financials in our pair trade versus the tech sector. Relative profit fundamentals signal that this relative share price ratio will soon come alive. Global growth tailwinds argue for lifting the air freight & logistics index to high-conviction overweight status. Recent Changes S&P Financials/S&P Tech - Switch the long side of the S&P Consumer Staples/S&P Tech pair trade from S&P Consumer Staples to S&P Financials. S&P Consumer Staples - Remove from the high-conviction overweight list. S&P Air Freight & Logistics - Add to the high-conviction overweight list. Table 1Sector Performance Returns (%) Disentangling Pricing Power Disentangling Pricing Power Feature Equities broke out to new highs early last week, and there are good odds that a playable rally will unfold. Investors' jitters have recently focused on the bear market in oil prices and weak core CPI, which have joined forces to push down inflation expectations (Chart 1). However, we have a more bullish interpretation. Unlike in late-2015/early-2016, oil and stock prices have decoupled. True, energy stocks are plumbing multi-decade lows relative to the broad market, but the energy sector comprises less than 6% of the S&P 500's market cap. In fact, the two largest S&P 500 constituents have a greater weight than the 34 stocks in the S&P energy index combined. In other words, the energy sector's broad market influence has been severely diluted. We think it is unlikely that the positive correlation between oil and stock prices reasserts itself. Rather, our sense is that this is likely an energy/commodity-centered deflation that will not have a serious contagion on the rest of the corporate sector. High yield energy spreads continue to widen, but the overall junk spread is flirting with cyclical lows. This stands in marked contrast with the summer of 2014 and late-2015, the last time oil prices melted (second panel, Chart 1). Chart 2 shows that the nonfarm business sector and the GDP implicit price deflators, both of which are reliable corporate sector pricing power proxies, are positively deviating from core CPI. These deflators have historically been excellent leading indicators of inflation and signal that the recent poor inflation prints will likely prove transitory. Importantly, the U.S. is a large closed economy that benefits greatly from lower oil prices, via a boost to discretionary income. Lower energy costs are adding to an already stimulative backdrop owing to the decline in the U.S. dollar and Treasury yields. At the margin, the broad corporate sector also benefits from oil price deflation: energy is a non-trivial input cost. Our more optimistic overall economic and market outlook is also borne out by survey data: economists revised higher their U.S and global GDP growth expectations both for 2017 and 2018, according to Bloomberg estimates (bottom panel, Chart 1). Finally, real yields, the bond market's gauge for economic growth expectations, have climbed close to a 2-year high, and suggest that GDP growth will soon pick up steam (Chart 1). Our view remains that this is a goldilocks scenario for equities, as it may keep the Fed at bay for a while longer and sustain easy financial conditions. This thesis also assumes that the corporate sector will maintain its pricing power gains, and likely pull consumer prices out of their lull. On that front, we have updated our corporate pricing power proxy and while it has lost some steam of late, it continues to expand at a healthy clip (Chart 3). Chart 1Decoupled Decoupled Decoupled Chart 2Implicit Price Deflators Lead Core CPI Implicit Price Deflators Lead Core CPI Implicit Price Deflators Lead Core CPI Chart 3Corporate Pricing Power Is Fine Corporate Pricing Power Is Fine Corporate Pricing Power Is Fine Table 2 shows our updated industry group pricing power gauges, which are calculated from the relevant CPI, PPI, PCE and commodity growth rates for each of the 60 industry groups we track. The table also highlights shorter term pricing power trends and each industry's spread to overall inflation in order to identify potential profit winners and losers. Table 2Industry Group Pricing Power Disentangling Pricing Power Disentangling Pricing Power Our analysis concludes that still ¾ of the industries we cover are enjoying rising selling prices and 43% are also beating overall inflation rates. Admittedly, the inflation rates have come down since our April update, and there was a tick up in the number of deflating industries from 14 to 16, but that figure is still down from the 19 registered in January. Importantly, 27 out of 60 industries have clocked a rising pricing power trend down from 31 in April, but still up from 20 in January, 14 have a flat trend and 19 are falling. Encouragingly, corporate sector selling prices are still comfortably outpacing wage inflation, which suggests that the positive momentum in profit margins has staying power (Chart 3). One theme that stands out from our analysis is that commodity related industries have either falling or flat inflation trends, with the exception of aluminum and chemicals. We take this as confirmation that resources are at the epicenter of deflation/disinflation pressures. Similarly, the majority of tech sub-sectors are still fighting deflation and suffer from a flat or down trend in selling prices. Adding it all up, the recent mild slowdown in corporate sector selling prices is transitory, mostly commodity related and unlikely to infect the broad business sector. There are high odds that an earnings-led playable break out phase in the equity market will develop from here. This week we promote an industrials sub-sector to our high-conviction overweight list and swap a safe haven sector out, and also tweak our long/short pair trade. Pair Trade Tweak: Long Financials/Short Tech Over the past month, we have reduced the extent of our consumer staples overweight, downgrading soft drinks to underweight and hypermarkets to neutral. In contrast, in May we boosted the S&P financials index to overweight on the back of improving earnings fundamentals. As a result, swapping out consumer staples for financials in our existing pair trade versus the tech sector makes sense. This relative share price ratio is at a critical juncture and has dropped to its long term support level (top panel, Chart 4). Importantly, the relative market capitalization differential is at its widest gap since the tech bubble (Chart 5) and a renormalization is in order. Chart 4Long Term Support Should Hold Long Term Support Should Hold Long Term Support Should Hold Chart 5Unsustainable Gap Unsustainable Gap Unsustainable Gap The valuation case is equally compelling: financials are deeply undervalued and unloved compared with the tech sector (Chart 4), such that even a modest shift in sentiment would drive a large relative price swing. The macro outlook is rife with catalysts to trigger a renormalization. Our respective Cyclical Macro Indicators (CMI) signal that financials profits will best tech sector earnings in the coming quarters (top panel, Chart 6). Historically, relative performance has moved in lockstep with relative profitability. The message from our CMIs is that relative earnings will move decisively in favor of the financials sector, thereby producing positive price momentum (bottom panel, Chart 6). A simple relative demand indicator concurs with our CMIs message: bank loan growth should outpace tech capital expenditures in the back half of the year. The middle panel of Chart 6 shows our recently published bank loans and leases regression model compared with our U.S. Capex Indicator (a good proxy for tech spending) and the message is to expect a catchup phase in relative share prices. If our thesis proves accurate, then relative demand will soon show up in relative top line figures. On that front, our forward looking relative sales per share models argue that the budding recovery in relative revenue is sustainable (Chart 7). Relative pricing power dynamics provide another source of support, both in terms of sales and operating profit margins. Firming financials pricing power is the mirror image of chronically deflating tech selling prices (Chart 7). Keep in mind that overall mild price inflation is a boon for financials because it will keep monetary conditions from becoming overly tight, which would undermine credit quality and availability. Using the nonfarm business sector's implicit price deflator as a proxy for overall inflation, the (third panel, Chart 7) shows that relative share prices move in lockstep with overall corporate sector prices. In terms of economic undercurrents, if geopolitical risks remain muted and financial conditions reasonably accommodative, then a further boost in economic and investor sentiment is likely. History shows that the financials/tech share price ratio has benefited when risk premia recede. The same relationship is also evident in the positive correlation with our U.S. sentiment indicator and real 10-year bond yield (Chart 8), and inverse correlation with corporate bond spreads (not shown). Chart 6Heed The Relative##br## CMI Signal Heed The Relative CMI Signal Heed The Relative CMI Signal Chart 7Financials Have##br## The Upper Hand Financials Have The Upper Hand Financials Have The Upper Hand Chart 8Improving Economy = ##br##Go Long Financials/Short Tech Improving Economy = Go Long Financials/Short Tech Improving Economy = Go Long Financials/Short Tech Finally, recent positive bank sector news suggests that financials have the upper hand in this share price ratio. Banks passed the Fed's stringent stress test with flying colors and should become more shareholder friendly, i.e. boost dividend payouts and reinstate/augment share retirement. In addition, even a modest watering down of Dodd-Frank will also lift the appeal of banks and financials at the expense of tech stocks in the coming quarters. Adding it up, we recommend swapping consumer staples with financials in our pair trade versus the tech sector. Relative profit fundamentals suggest that this relative share price ratio will soon spring into action. Bottom Line: Switch consumer staples out and sub financials in the pair trade versus tech stocks. We are also removing the S&P consumer staples index from our high-conviction overweight list for a modest gain of 0.1% since the early-January inclusion. The latter move makes room for an upgrade to high-conviction of a transportation sub-group that has caught fire since our recent upgrade to overweight. Air Freight Stocks Achieve Liftoff! We raised the S&P air freight & logistics group to overweight two months ago, reflecting a lack of recognition in either valuations or earnings estimates that a global trade revival was unfolding and washed out technical conditions. Since then, this transportation sub-group has regained its footing, and firming profit fundamentals now embolden us to add air freight stocks to our high-conviction overweight list. The relative share price ratio has smartly bounced off its GFC lows. Similarly, our Technical Indicator found support at one standard deviation below the historical mean, a typical launch point for playable rallies. Importantly, deeply discounted valuations remain in place, both in terms of P/S and P/E ratios (Chart 9). We expect the rebound in global growth to help unlock excellent value in air freight equities. Global trade is reviving. The synchronized DM and EM economic recovery has buoyed the global manufacturing PMI, which continues to trend well above the boom/bust line. Both global export volumes and prices are expanding. Yet buoyant global trade expectations are still not reflected in tumbling relative sales expectations (Chart 10). Chart 9Unwarranted ##br##Grounding Unwarranted Grounding Unwarranted Grounding Chart 10Buoyant Trade Growth Is Neither Reflected##br## In Collapsing Sales Expectations... Buoyant Trade Growth Is Neither Reflected In Collapsing Sales Expectations... Buoyant Trade Growth Is Neither Reflected In Collapsing Sales Expectations... Chart 11 highlights two additional Indicators to gauge the stage of the global trade recovery. Korea and Taiwan are two small open economies: exports in both countries are accelerating. Meanwhile, our Global Trade Activity Indicator, comprising the economically-sensitive Baltic Dry Index and lumber prices, is also waving a green flag. The upshot is that a number of Indicators confirm that a durable pickup in trade is underway, which should ultimately translate into a recovery in relative earnings expectations (Chart 11). Domestically, business shipments-to-inventories ratios are expanding comfortably in all three major segments: manufacturing, wholesale and retail (bottom panel, Chart 10). Anecdotally, recent news that FedEx beat both top and bottom line estimates also reinforces a firm global activity backdrop. All of this serves as reliable evidence that the budding recovery in global (and domestic) growth has morphed into a sustainable advance. The implication is that air freight pricing power has ample room to grow. Wholesale price momentum has reached a 5-year high. If our thesis plays out, more pricing power gains are in store, which will boost profit margins given the industry's impressive labor cost restraint and high operating leverage (Chart 12). Chart 11...Nor In Depressed##br## Forward EPS ...Nor In Depressed Forward EPS ...Nor In Depressed Forward EPS Chart 12Margin Expansion##br##Phase Looms Margin Expansion Phase Looms Margin Expansion Phase Looms Finally while investors are digesting the Walmart in-store pick up option and Amazon's push for its own delivery service plans, the persistent ascent in online shopping suggests that the structural increase in rapid delivery services will remain intact. Investors should expect pricing power to gravitate toward the long-term trend (bottom panel, Chart 12). Tack on the recent corrective action in the commodity pits and this group also benefits from the fall in fuel costs. Taken together, profit margins should resume expanding. In sum, appealing relative valuations along with a durable synchronized global growth rebound argue for increasing conviction in our overweight position in this transportation sub-group. Bottom Line: Stay overweight the S&P air freight & logistics group (UPS, FDX, CHRW, EXPD), and bump it to the high-conviction overweight list. Current Recommendations Current Trades Size And Style Views Favor small over large caps and stay neutral growth over value.

Neutral The S&P hypermarkets index has been a stalwart performer YTD, outshining both the broad consumer staples universe and the overall market by a wide margin. However; this impressive run-up is unsustainable. Three main headwinds suggest that some caution is warranted: soft pricing power, likely further aggravated by new German competitors expanding in/entering the U.S. market, the ongoing and recently escalated assault from online retailers and finally, improved consumer spending. These factors imply that profit margins will remain under chronic pressure, but concerns could become more acute on a cyclical basis. Consumer goods import prices have surged in recent months (second panel), and the depreciating U.S. dollar is likely to sustain this uptrend. Cutthroat competition means that retailers will likely absorb these rising costs, to the detriment of profit margins. Further, livelier consumer spending would warn of additional headwinds (third panel), as higher incomes boost the incentive for consumers to "trade up" and shop at higher ticket stores. Netting it out, we recommend booking modest profits and downgrading exposure in the S&P hypermarkets index to neutral. The ticker symbols for the stocks in this index are: BLBG: S5HYPC - WMT, COST. Time To Downgrade Hypermarkets Time To Downgrade Hypermarkets

Highlights Portfolio Strategy The rally in the S&P restaurants index has run its course and a profit recovery is fully discounted. Lock in profits and downgrade to neutral. Intensified inter-industry competition, the onslaught of online retailers and a rebounding U.S. economy are stiff headwinds for hypermarket stocks. Sell positions down to neutral. Recent Changes S&P Restaurants - Downgrade to neutral, booking profits of 11%. S&P Hypermarkets - Downgrade to neutral. Table 1 Rotation Does Not Mean Correction Rotation Does Not Mean Correction Feature The S&P 500 remained resilient in the face of the fourth Fed interest rate hike and the drubbing in the tech sector. The latter is notable given that a select few stocks have contributed roughly one quarter of the overall market's gains this year, and signals that money is not leaving equities en masse, but is merely rotating into other sectors. This suggests that consolidation rather than correction is the main watchword. Our view remains that stocks are in a sweet spot: a lack of inflation pressures has kept long-term interest rates at bay, despite decent economic momentum and rising corporate profits. The latter have been driven by impressive corporate pricing power gains (see Chart 1 from last week's Weekly Report), creating an ideal equity market scenario whereby the business sector can grow profits without any corresponding consumer price inflation pressures. Investors are likely to extrapolate this goldilocks equity scenario for a while longer, given that our Reflation Gauge (RG), a combination of oil prices, Treasury yields and the U.S. dollar, has exploded to the highest level since 2010 and just shy of all-time highs. The RG leads both the U.S. economic surprise index and equity sentiment (Chart 1). If economic activity begins to reaccelerate, as we expect and irrespective of tax reform success, the window is open for additional equity market gains. Meanwhile, the mini sector rotation that commenced two weeks ago is a healthy development and may not be a precursor to a more vicious and widespread correction. In recent Weekly Reports, we have shown that our Equity Market Internal Dynamics Indicator was signaling that upward momentum in the broad market was well supported by the character of market participation (see Chart 2 from the May 15th Weekly Report). Chart 1Coiled Spring Coiled Spring Coiled Spring Chart 2Healthy Rotation Healthy Rotation Healthy Rotation Chart 2 shows that lately the small/large ratio has sprung back to life. Growth/value stalled near the previous all-time peak, and capital has flowed out of frothy tech stocks and into the cheaper and more economic-sensitive financials sector. Against a backdrop of a budding rebound in domestic economic data, this recent market rotation is likely to stay intact. That view is corroborated by the collapse in correlations among stocks and overall assets. The CBOE's implied correlation index has fallen to fresh cyclical lows, which suggests that investors have become increasingly discerning and that earnings fundamentals/valuations should become the primary drivers of stock market returns. Keep in mind that empirical evidence shows that receding stock correlations also underpin the broad equity market (top & bottom panels, Chart 2). All of these fluctuations signal that the broad equity market is more likely to build a base before it resumes its advance to new cyclical highs, rather than suffer an imminent and major correction. As such, we continue to slowly and deliberately recalibrate our portfolio away from its previously heavy bias toward defensives. This week we make two consumer-related shifts. Restaurants: Beware Of Heartburn One quarter ago we posited that the consolidation phase in the broad consumer discretionary sector restored value and created an attractive entry point. Washed out technicals and an upswing in industry earnings fundamentals supported our thesis (Chart 3). An upgrade in the S&P restaurants sub-index to overweight provided an attractive way to execute that thesis. This view has largely played out, as restaurant shares have bested the market by double digits since March 20th. Is there any more upside left to this impressive quarterly relative return? We doubt it. While we remain constructive on the overall consumer discretionary sector (Chart 4), we recommend crystalizing gains of 11% in the S&P restaurants index and downshifting to neutral. Chart 3Stay ##br##The Course... Stay The Course... Stay The Course... Chart 4...As Our Consumer Drag ##br## Indicator Is Flashing Green ...As Our Consumer Drag Indicator Is Flashing Green ...As Our Consumer Drag Indicator Is Flashing Green Q1 industry conference calls revealed that improved store traffic and better offerings boosted same-store sales, and relative share prices followed suit from a technically depressed level. That caused sell side analysts to modestly lift relative EPS forecasts, but a valuation re-rating still explains the bulk of the stock price surge (Chart 5). We are reluctant to pay a 40% premium to the broad market on a 12-month forward P/E basis. The National Restaurant Association's Restaurant Performance Index fell to the boom/bust 100 line and downside momentum has accelerated (second panel, Chart 5). Worrisomely, the Current Situation Index (not shown) of the same survey was in the contraction zone for "the sixth time in the last seven months". Similarly, the Expectations Index also decelerated, heralding an uncertain dining outlook. Indeed, demand for away from home dining is on the decline in absolute terms and compared with overall retail sales and consumption (middle panel, Chart 6). This suggests that the first quarter increase in store traffic may not be sustainable (top panel, Chart 6). The recent spike in restaurant construction expenditures will further dilute same-store sales growth opportunities (bottom panel, Chart 6). Chart 5Too Expensive Too Expensive Too Expensive Chart 6Do Not Overstay Your Welcome Do Not Overstay Your Welcome Do Not Overstay Your Welcome Leading indicators of profit margins have also eroded. An uptick in commodity input costs and 8% growth in the industry's wage bill, stand in marked contrast with anemic industry pricing power. Our restaurants profit margin gauge captures all of these forces and warns that a squeeze looms (Chart 7). Nevertheless, it is not all bad news. The improvement in consumer finances should counterbalance some of the casual dining industry's deficient demand hiccups. Rising household net worth makes consumers feel wealthier, and therefore increases their marginal propensity to spend. Importantly, the $15-$35K income cohort also expects a sizable boost to their take home pay, according to the latest Conference Board survey data (not shown). Importantly, the earnings headwind from foreign sales exposure has likely morphed into a profit tailwind. U.S. dollar softness is not only evident against G10 currencies, but also emerging market (EM) FX rates (Chart 8). In addition, healthy EM domestic demand is the mirror image of fickle U.S. final demand. EM central banks are easing monetary policy - whereas the Fed hiked for a fourth time this cycle last week - in order to rekindle EM consumer spending/growth. As a result, EM restaurant sales should improve (Chart 8). Chart 7Rising Input Costs ##br##Are Eating Into Margins Rising Input Costs Are Eating Into Margins Rising Input Costs Are Eating Into Margins Chart 8Export ##br## Relief Valve Export Relief Valve Export Relief Valve In sum, the playable rally in the S&P restaurants index has run its course and a profit recovery is fully priced in frothy valuations. The V-shaped rebound in share prices has outpaced fundamental improvements, and a consolidation/corrective phase is inevitable. Bottom Line: While we remain overweight the S&P consumer discretionary sector, we recommend booking profits of 11% in the S&P restaurants index (MCD, SBUX, YUM, DRI, CMG), and moving to a benchmark allocation. Time To Downgrade Hypermarkets While investors have shed anything retail related year-to-date (YTD), big box retailers have been a positive exception. In fact, the S&P hypermarkets index has been a stalwart performer YTD, outshining both the broad consumer staples universe and the overall market. Is this impressive run-up sustainable? The short answer is no. Three main headwinds suggest that some caution is warranted now that index outperformance has eliminated the previous valuation appeal: soft pricing power likely further aggravated by new German competitors expanding in/entering the U.S. market, the ongoing assault from online retailers and the improving U.S. economy, especially consumer spending. These factors imply that profit margins will remain under chronic pressure, but concerns could become more acute on a cyclical basis. Consumer goods import prices have surged in recent months (Chart 9), and the depreciating U.S. dollar is likely to sustain this uptrend. Cutthroat competition means that retailers will likely absorb these rising costs, to the detriment of profit margins. While food prices are making an effort to exit the deflation zone, ALDI and Lidl, two deep-pocketed German competitors are entering the U.S. retail scene, reportedly with massive expansion plans. Tesco, Sainsbury's and ASDA in the U.K., Carrefour in Europe and Woolworth's and Coles in Australia continue to feel the wrath of German retailers. Consequently, it would be dangerous to extrapolate the nascent improvement in retail food CPI. All of this is likely to sustain the profit margin squeeze (Chart 9). Further, the online retail onslaught will continue to escalate. The Amazon juggernaut appears unstoppable. The latest news that it will take over Whole Foods Market confirms that even grocery sales are now seriously on its radar screen. Chart 10 shows that non-store retail sales continue to grow at a much faster pace than traditional retailers. The greater the market share gains for online retailers, the larger the downward pressure on hypermarkets relative profitability (relative retail sales shown inverted, second panel, Chart 10). Chart 9Margin Pressures Margin Pressures Margin Pressures Chart 10Beware Online Retailers' Onslaught Beware Online Retailers' Onslaught Beware Online Retailers' Onslaught Under such a tough operating backdrop we are reluctant to pay a premium valuation for this safe haven sector. Worrisomely, soft revenue growth argues against a further a valuation re-rating (Chart 11). Finally, macro forces required to spur better revenue no longer exist. The U.S. economy has entered a self-reinforcing recovery. While personal consumption expenditures have underwhelmed of late, buoyant job certainty and a vibrant housing market are boosting consumer confidence. Before long, consumers should loosen their purse strings and indulge anew. Historically, a lively consumer spending backdrop has been inversely correlated with relative share prices (PCE is shown inverted, Chart 12). Similarly, Federal tax coffers have started to refill following a one year hiatus (bottom panel, Chart 12). The implication is that incomes and profits are expanding, boosting the incentive for consumers to "trade up" and shop at higher ticket stores. Nevertheless, some partial offsets exist. The lower income consumer is the industry's main clientele and low interest rates, low gasoline prices and soaring income confidence for this consumer cohort should cushion store traffic woes (third panel, Chart 13). Chart 11Derating ##br## Warning Derating Warning Derating Warning Chart 12Improving Economy = ##br## Bad Omen For Hypermarkets Improving Economy = Bad Omen For Hypermarkets Improving Economy = Bad Omen For Hypermarkets Chart 13Positive ##br##Offsets Positive Offsets Positive Offsets Meanwhile, the overall retail sales price deflator has tentatively troughed, albeit it continues to deflate. Given the high volume nature of the hypermarket industry, any small positive change in pricing power tends to have a meaningful impact on sales growth (second panel, Chart 13). Multi-year highs in overall income growth signals that on average consumers will have more disposable income. The bottom panel of Chart 13 shows that income growth has been a reliable indicator for hypermarket EPS. Adding it up, this is an opportune time to book modest profits and downgrade exposure in the S&P hypermarkets index to neutral. Intensified inter-industry competition, the onslaught of online retailers and a rebounding U.S. economy argue against extrapolating recent optimism far into the future. Bottom Line: Downgrade the S&P hypermarkets index to a benchmark allocation (WMT, COST). Current Recommendations Current Trades Size And Style Views Favor small over large caps and stay neutral growth over value.

Consumer staples equities in general and beverage stocks in particular have been stellar outperformers this year. Nevertheless, this strength may prove fleeting as our leading profit indicators have all taken a decisive turn for the worse. The biggest risk centers on weakness in beverage shipments, which is a cause for concern given the correlation with relative performance. Our beverage industry activity proxy confirms this bearish message: relative profitability is under attack. There is some hope that a weaker U.S. dollar, especially against emerging market (EM) currencies, may partially neutralize soft domestic consumption. But we are reluctant to forecast an export resurgence, given that EM consumption growth has continued to ease. Adding it up, leading indicators of beverage demand remain muted at a time when industry price deflation has intensified. This is a toxic brew for profitability, and we recommend using recent outperformance to sell down positions to underweight. Downgrade the S&P soft drinks index to underweight. The ticker symbols for the stocks in this index are: BLBG: S5SOFD - PEP, KO, DPS, MNST. Time To Liquidate Beverage Stocks Time To Liquidate Beverage Stocks

Highlights Portfolio Strategy The latest wobble in the financials sector is a buying opportunity, with the exception of the defensive insurance index. Our tactical overweight in utilities has played out. Take profits and downgrade to neutral. Weak beverage operating metrics argue for a reduction in premium valuations. We recommend a full downgrade from overweight to underweight. Recent Changes S&P Utilities - Downgrade to neutral, locking in gains of 1% on this tactical position. S&P Soft Drinks - Downgrade to underweight. Table 1 Unfazed Unfazed Feature The S&P 500 remained undaunted in the face of a geopolitical firestorm last week. Instead, vibrant global growth and easy monetary conditions continue to underpin investor confidence in the durability of the earnings upcycle. Our thesis remains intact: a recovery in top-line growth, powered by both volume and pricing power gains, will generate sufficient profit growth to sustain the equity market overshoot. While actual inflation has surprised to the downside, weighing on inflation expectations (bottom panel, Chart 1), this has not translated into a loss of business sector pricing power. Corporate selling prices have diverged markedly from the Fed's preferred measure of inflation (middle panel, Chart 1), reflecting a goldilocks scenario where more restrictive monetary conditions will not impede the path to improved profitability. In recent research we showed that operating leverage in S&P 500 constituents runs at 1.4x. In other words, a 5% increase in sales results in a 7% rise in operating EPS, based on our regression analysis. While every cycle is different, when revenues initially recover from a slump, as is currently the case, operating leverage can be even higher, with profits often outpacing sales by two or even three times. Since mid-December, both the U.S. dollar and 10-year Treasury yields have fallen in tandem. As a result monetary conditions have eased, reversing the tightening that occurred in the second half of 2016. Our U.S. Monetary Indicator (USMI) and momentum in corporate profit margins are perfectly inversely correlated. The recent downswing in the USMI is bullish for S&P 500 margins (USMI shown inverted, bottom panel, Chart 2). True, a fall in bond yields can also be reflective of a deteriorating economy, such that investors should become worried about profitability. However, the stock-to-bond (S/B) ratio is not signaling any trouble ahead. History shows that the time to worry about the bond market's earnings message is when the S/B ratio contracts (see shaded areas, third panel, Chart 3). Chart 1Corporate Pricing Power Reigns Corporate Pricing Power Reigns Corporate Pricing Power Reigns Chart 2Easy Financial Conditions Boost Margins Easy Financial Conditions Boost Margins Easy Financial Conditions Boost Margins Chart 3Goldilocks Equity Scenario Goldilocks Equity Scenario Goldilocks Equity Scenario In addition, part of the decline in long-term interest rates also reflects a slower expected pace of fed funds rate increases. The bond market doubts the FOMC's 2.125% interest rate estimate for 2018, forecasting a fed funds rate roughly 63bps lower. If the bond market is accurate and the Fed recalibrates its 18-month rate outlook even modestly lower later this week, then the S/B ratio has more upside. This week we reiterate our recent financials sector upgrade to overweight, make two tweaks to our portfolio and downshift our defensive exposure another notch. Financials Are At A Critical Juncture Financials stocks have performed as if the U.S. economy is headed for a protracted slowdown, or even recession. Uncertainty with the U.S. Administration's ability to pass bills and enact reforms, a string of U.S. economic disappointments and related yield curve flattening, and sinking inflation expectations have all weighed on relative performance. Rather than extrapolate recent weakness, our inclination is to view the latest wobble as a buying opportunity. A number of forward looking loan growth indicators suggest that credit and capital formation are on an upward trajectory, which will support ongoing profit outperformance. Chart 4 shows that our U.S. capex indicator is an excellent leading indicator of loan growth, with a forty year track record. Soaring confidence implies a more expansionary mindset, and increased demand for external funds (third panel, Chart 4). Similarly, the ISM survey leads loan growth. Both the ISM manufacturing and services surveys are sending a positive signal (fourth panel, Chart 4). Specifically, our sister U.S. Bond Strategy's credit growth model captures all of these positive forces: the recent nascent recovery in bank credit growth should morph into a sustained recovery in the second half of 2017 (bottom panel, Chart 4). Meanwhile, financial conditions have continued to ease, aided by tightening credit spreads, a decline in oil prices, U.S. dollar softness and rise in equity prices (top panel, Chart 5). Easier monetary conditions should ensure that the recovery in overall corporate sector profits stays on track, thereby sustaining both consumer and corporate credit quality at high levels. It is notable that relative performance and the Bloomberg Financial Conditions Index are positively correlated (second panel, Chart 5). Credit quality is already showing signs of improvement: financials sector ratings migration has swung roughly 50 percentage points since last October (second panel, Chart 6). The implication is that reserve building should not become a profit drag over a cyclical investment horizon. Chart 4Credit Growth##br## Will Pivot Credit Growth Will Pivot Credit Growth Will Pivot Chart 5Easy Monetary Conditions ##br##Are A Boon For Financials Easy Monetary Conditions Are A Boon For Financials Easy Monetary Conditions Are A Boon For Financials Chart 6Financials Catch-Up##br## Phase Looms Financials Catch-Up Phase Looms Financials Catch-Up Phase Looms In sum, as long as the global economic expansion persists, as we expect, then the recent inflation expectations-related selloff in the sector should prove transitory. We continue to recommend above-benchmark exposure to areas with leverage to increased capital formation, with one notable exception in the sector's most defensive component: insurance. Continue To Avoid Insurers While financial companies levered to capital formation and credit creation are well positioned to thrive if the U.S. and global economies continue to improve, the same is not true for the broad S&P insurance index. This is a defensive group with a fairly stable recurring revenue stream that typically thrives when the economy is slowing, the yield curve is flattening and the U.S. dollar is on an upward trajectory. Relative performance has edged higher in concert with the recent yield curve flattening, but as detailed above, we don't expect the latter to continue. Ergo, the only external support for the group is likely to crumble, especially now that the U.S. dollar is softening (Chart 7). If the domestically-focused insurance index could not gain traction throughout the latest U.S. dollar bull market, what will happen if a mild currency depreciation occurs? Based on its own merits, the insurance industry likely heads toward a profit soft patch. The ebb and flow of overall business activity drives revenue growth, particularly in the interest rate-sensitive auto and housing sectors. Chart 8 combines sales growth for the latter two sectors into one series, which has recently slipped into negative territory, warning of a similar fate for insurance top-line growth. Consumer spending on insurance products is also contracting relative to total spending (Chart 8), corroborating the cautious message from housing and autos. There are also cracks forming in pricing power. The CPI for motor vehicle insurance remains robust, but that of household tenants insurance has sunk into the deflation zone. If the hard market turns soft, it will further undermine underwriting premium growth. To make matters worse, insurance companies have been on a hiring binge for the past several years. Headcount exploded higher beginning in 2014, and continues to make new highs. Rising cost structures coincided with the downturn in insurance book value growth (Chart 9). Book values have recently started to shrink, with little prospect for a reversal unless labor costs ease and/or underwriting activity revives. As a result, our preference is to focus exposure on non-insurance financials, as insurance remains a high-conviction underweight. Chart 7'Dollar ##br##Trouble' Dollar Trouble' Dollar Trouble' Chart 8Pricing ##br##Power Blues Pricing Power Blues Pricing Power Blues Chart 9Beware The Bull Market ##br## In Insurance Employment Beware The Bull Market In Insurance Employment Beware The Bull Market In Insurance Employment Book Profits In Utilities In early-April we upgraded the S&P utilities sector to a tactical (1-3 month) overweight courtesy of five key drivers that have now largely played out.1 As a result, we are booking profits of 1% and downgrading to a benchmark allocation. The U.S. economy is on the cusp of a capex revival. While Q1/2017 GDP growth was unduly weak, investment spending was a bright spot. Our U.S. Capex Indicator has accelerated sharply, signaling that investment should continue to gain traction. Historically, business spending and utilities relative performance have been inversely correlated (the Capex Indicator is shown inverted, top panel, Chart 10). Similarly, the composite ISM export index has recently catapulted to the highest level since the late-1990s. Should the U.S. dollar continue to depreciate, U.S. exporters will remain busy filling foreign orders. That is a relative performance drag for the domestically-exposed utilities sector (ISM exports shown inverted, bottom panel, Chart 10). Meanwhile, electricity production growth has crested and natural gas price inflation has rolled over, suggesting that pricing power gains have peaked (Chart 11). The implication is that there will be no earnings follow through to support the recent breakout attempt (third panel, Chart 12). Chart 10Capex Revival Is Bearish For Utilities Capex Revival Is Bearish For Utilities Capex Revival Is Bearish For Utilities Chart 11Soft Demand With Weak Selling Prices Soft Demand With Weak Selling Prices Soft Demand With Weak Selling Prices Chart 12Why Pay Up For Lack Of EPS Follow Through? Why Pay Up For Lack Of EPS Follow Through? Why Pay Up For Lack Of EPS Follow Through? Importantly, the total return of the bond-to-stock ratio continues to contract. While both stocks and bond prices have risen in tandem of late, persistent stock market outperformance warns that flows into this fixed income proxy will soon peter out (Chart 12). Thus, in the absence of an earnings acceleration, it will be difficult to sustain premium valuations (bottom panel, Chart 12). In sum, utilities leading profit indicators have crested and all five of the driving forces behind our tactical overweight recommendation have largely transpired. Bottom Line: Execute the downgrade alert and book 1% profits since our tactical overweight of the S&P utilities sector, initiated in early-April. Time To Liquidate Beverage Stocks Consumer staples equities in general and beverage stocks in particular have been stellar outperformers this year. Nevertheless, this strength may prove fleeting in the absence of a revival in relative profit fortunes. Since the mid-1990s, relative performance has followed the ebb and flow of relative forward profit estimates. However, a gap has opened, as analyst estimates have continued to drift lower as share prices have climbed (top panel, Chart 13). The gravitational pull from fading earnings confidence may be too powerful to overcome over the next six months, given that our leading profit indicators have all taken a decisive turn for the worse. There is a rising risk that premium valuations will normalize (bottom panel, Chart 13). Instead, household products and packaged foods stocks offer a better risk/reward tradeoff. The biggest risk that we first identified in March centers around beverage shipments. The top panel of Chart 14 shows that industry shipments have plunged on the back of anemic end-demand. Shipment weakness is cause for concern given the correlation with relative performance. Chart 13Mind The Gap Mind The Gap Mind The Gap Chart 14Beverage Deflation... Beverage Deflation… Beverage Deflation… Our beverage industry activity proxy confirms this bearish message: relative profitability is under attack (middle panel, Chart 14). Worrisomely, soft drink manufacturers have tried hard to arrest the fall in shipments via steep price concessions (third panel, Chart 14). Even price deflation has been unable to reverse the contraction in industry volumes. If S&P soft drink sales continue to soften on the back of both volume and price cuts, then profit margins will take a hit (third panel, Chart 15). True, input cost inflation remains well contained, as both ethylene and raw food commodity prices are non-threatening. Moreover, labor cost inflation is subdued. Still, history shows that deflation typically leads to a margin squeeze. There is some hope that the export relief valve may partially neutralize soft domestic consumption. Consumer goods exports have contracted, but the depreciation in the U.S. dollar, especially against emerging market (EM) currencies, provides a glimmer of light that a turnaround lies ahead (third panel, Chart 16). But we are reluctant to forecast an export resurgence, given that EM consumption growth has continued to ease. Chart 16 shows that beverage sales growth closely follows the trend in real Asian retail sales, and the current message is bearish. Chart 15Mind The Gap ...Will Weigh On Profit Margins ...Will Weigh On Profit Margins Chart 16Do Not Bet On An Export-Led Recovery Do Not Bet On An Export-Led Recovery Do Not Bet On An Export-Led Recovery Adding it up, leading indicators of beverage demand remain muted (second panel, Chart 16), at a time when industry price deflation has intensified. This is a toxic brew for profitability, and we recommend using recent outperformance and sell down positions to underweight. Bottom Line: Downgrade the S&P soft drinks index to underweight. 1 Please see BCA U.S. Equity Strategy Weekly Report "Great Expectations?", dated April 3, 2017, available at uses.bcaresearch.com Current Recommendations Current Trades Size And Style Views Favor small over large caps and stay neutral growth over value.

Our upgrade of packaged food stocks to overweight (see our Weekly Report of 23 May, 2017 for more details) was based on the expectation of near-term margin expansion followed by an eventual sales recovery. This thesis is supported by recent data showing solid consumer outlays on food & beverage and a reacceleration in wholesale food manufacturing prices; both of these indicators have historically heralded positive sales growth. Meanwhile, input costs look well contained as grain, the key commodity input, continues to get cheaper, another indicator that margin expansion is on the horizon. Further, the slide in sales of the past 2 years has reinforced strict industry cost control to maintain margins; these efforts should deliver outsized profits as the top line recovers. Net, we continue to expect domestic demand to lead a sales recovery with above-normal profit contributions and remain overweight. The ticker symbols for the stocks in this index are: BLBG: S5PACK - MDLZ, SJM, KHC, CPB, MKC, CAG, TSN, MJN, GIS, HSY, HRL, K. The Packaged Food Margin Profile Looks Appetizing The Packaged Food Margin Profile Looks Appetizing

Highlights Portfolio Strategy Upgrade packaged food stocks to overweight. Enough value creation has occurred to create an attractive entry point in this consumer goods sub-index. Our tactical overweight in the S&P utilities sector is beginning to bear fruit. Get ready to book profits. Resist the temptation to bottom fish in steel stocks. Tightening Chinese monetary and financial conditions along with domestic demand blues should weigh on steel profits. Recent Changes S&P Packaged Foods - Upgrade to overweight. S&P Utilities - Downgrade Alert. Table 1 Focus On Financial Conditions Focus On Financial Conditions Feature The market waffled last week, but quickly recovered. The upshot is that investors still appear content to look through the circus in Washington, focused instead on the positive reflationary dynamics supporting the corporate sector. Financial conditions have eased considerably ever since the Fed resumed its tightening campaign last December. Equity price gains, narrowing credit spreads and a weaker U.S. dollar have more than offset the negative impact of the back-up in bond yields. Cheap equity capital also remains easily accessible. While the labor market is tightening, BCA argues that the headline unemployment rate may understate slack given the large number of part-time workers that want to work full-time and prime-age workers that are still out of work. With core inflation surprising to the downside in recent months, there is no urgency for the Fed to slam the brakes. In other words, there is more than enough monetary fuel to sustain the equity overshoot. Easy financial conditions will allow investors to extrapolate the profit recovery (Chart 1), especially since it has been sales driven for the first time in years. It is notable that while consumer price inflation has softened, in aggregate, businesses are not feeling any renewed deflationary pressure. The depreciation in the U.S. dollar has been a critical support for U.S. businesses. Our corporate sector pricing power proxy continues to accelerate (Chart 1), arguing that revenue growth should persist. The combination of muted consumer price inflation yet positive corporate sector inflation is a stock market positive, all else equal. Digging beneath the surface, divergent sector inflation trends are increasingly evident. The commodity-linked energy and materials sectors have lost upward pricing power momentum (Chart 2), courtesy of the cooling in China. Technology sector selling prices are sinking deeper into deflationary territory, albeit the FANG juggernaut pays no attention to sector specific forces. Telecom services pricing power has also taken a header (Chart 2). On the plus side, other defensive sectors, including utilities, are still able to raise prices at a much greater rate than overall inflation. Even the pace of financial sector price hikes is at the top end of its long-term range (Chart 3). Chart 1Sustained Profit Expansion ##br##Requires Easy Financial Conditions Sustained Profit Expansion Requires Easy Financial Conditions Sustained Profit Expansion Requires Easy Financial Conditions Chart 2Some Softness In ##br##Cyclical Pricing Power... Some Softness In Cyclical Pricing Power... Some Softness In Cyclical Pricing Power... Chart 3...But Defensive Selling##br## Prices Are Resilient ...But Defensive Selling Prices Are Resilient ...But Defensive Selling Prices Are Resilient The upshot is that selectivity remains a critical portfolio input rather than simply tracking the broad S&P 500. These forces should allow the market to continue grinding higher into overshoot territory. The latter means that the market is increasingly vulnerable to minor external shocks. Ergo, we continue to recommend a selective weighting in some 'safe' areas, such as consumer staples, which are undervalued in relative terms and will buffet portfolios should volatility escalate further. This week we are taking advantage of the drubbing in food stocks to augment positions. Packaged Foods: Going Against The Grain After a surge to all-time relative performance highs in mid-2016, the S&P packaged foods index has deflated by roughly 20%. Two key reasons are behind the downdraft: the allure to hold stable cash flow companies has diminished since the November election, and weak industry-specific metrics - in particular pricing power and sales contraction amid private label competition. Despite these negatives, our sense is that enough value destruction has occurred to create an attractive entry point in this consumer goods sub-index. Relative valuations reflect most of these investor worries. The relative forward P/E ratio has de-rated to below the two-decade average, and our Valuation Indicator (VI) is near one standard deviation below the historical mean. In fact, every time the VI falls to such an undervalued extreme, relative performance stages a sizable comeback (Chart 4). Technical conditions are also washed out. Relative performance momentum has plunged to the lowest level in a decade, and likely fully reflects investor angst. Deeply oversold readings and undervaluation suggest that a full bearish capitulation has occurred, which is contrarily positive. Encouragingly, there is light at the end of the tunnel. Grain price deflation (shown inverted, third panel, Chart 4) suggests that industry input costs are well contained, and will underpin profit margins. It is normal for falling grain prices to coincide with upward revisions to analyst profit estimates (second panel, Chart 4). While industry sales are mired in deflation, there are high odds that top line growth will exit deflation by early 2018. Consumer outlays on food and beverages are brisk, and wholesale food manufacturing prices have recently reaccelerated. Chart 5 shows that industry revenues follow the trend in consumption and pricing power, underscoring that profitability is set to expand anew. True, private label competition and grocery store market share wars have put pressure on industry pricing power. But as long as food manufacturers can keep input costs under control, profit margins should remain wide. A simple industry profit margin gauge (PPI food manufacturing versus PPI crude food) gives us comfort that margins will remain resilient (bottom panel, Chart 5). Importantly, packaged food producers are well positioned to fight back against food retailers' demands for price concessions. Robust consumer outlays on food and beverages are corroborated by real retail sales at food stores, which are bucking the deceleration in overall retail sales (third panel, Chart 6). The hook up in food manufacturing hours worked confirms that industry activity is on the mend, which bodes well for productivity gains. Sell-side analysts have taken notice. Positive earnings revisions will continue to outstrip negative ones. Chart 4Buy Against The Grain Buy Against The Grain Buy Against The Grain Chart 5End Of The Revenue Lull... End Of The Revenue Lull... End Of The Revenue Lull... Chart 6...As Demand Recovers ...As Demand Recovers ...As Demand Recovers Finally, food and beverage exports have held onto recent double-digit growth gains despite the strong greenback. Now that the U.S. dollar is under some pressure, especially against the euro and emerging market currencies, foreign sales should provide a further relief valve should domestic pricing pressures persist for a little longer than we expect (second panel, Chart 6). In sum, while investors have rushed for the exits in the defensive S&P packaged foods index, a buying opportunity has emerged. Relative valuations have corrected to the lower end of their historic range and already reflect investor profitability worries. Our thesis is that a domestic demand-driven recovery has commenced and strict cost control, along with food commodity deflation, should sustain profit margins. Bottom Line: Start a buy program in the S&P packaged foods index, and boost exposure to overweight. The ticker symbols for the stocks in this index are: BLBG: S5PACK - MDLZ, SJM, KHC, CPB, MKC, CAG, TSN, MJN, GIS, HSY, HRL, K. Our Utilities Overweight Is Starting To Pay Off Our tactical overweight in the S&P utilities sector is beginning to bear fruit. Importantly, the five factors that drove this decision are starting to play out1, albeit in varying degrees of magnitude. Chart 7 shows that the U.S. economic soft patch has persisted. Hard data have not yet caught up to the surge in 'soft' data, such as sentiment and confidence surveys. The Citi Economic Surprise Index is inversely correlated with the relative share price ratio. Similarly, the ISM manufacturing index has crested. Our analysis shows that forward relative returns are strong after the ISM manufacturing survey hits extremely high levels, given that mean reversion ultimately occurs. The upshot is that utilities relative performance has more upside. The yield curve has also moved favorably for utilities stocks. The 10/2 Treasury curve has flattened since early January, as economic data continue to surprise to the downside, underscoring that the tactical utilities buy signal remains intact. The third reason to augment utilities exposure was the ebbing in inflation expectations. The latter continues unabated (Chart 7). Our recent Special Report highlighted that utilities suffer in times of inflation2. But the opposite is also true: utilities stocks outperform in times of disinflation/deflation. This reflects the stable rate of return regulated utilities enjoy, in addition to the increased appeal of dividend yields and cash flow during times of economic volatility and uncertainty. Finally, natural gas prices are firm. Utilities pricing power moves in lockstep with natural gas prices (middle panel, Chart 8). The latter are the marginal price setter for non-regulated utilities, and the recent price reacceleration could be a positive catalyst (bottom panel, Chart 8). Nevertheless, the utilities share price reaction has been more muted than we had expected, at least so far, perhaps reflecting the ongoing outperformance of stocks vs. bonds, and the weakness in electricity production growth (Chart 9). If the five factors begin to lose momentum, we will recommend booking profits in this tactical overweight position. Chart 7Prepare To Book Profits... Prepare To Book Profits... Prepare To Book Profits... Chart 8...When Utilities Turbocharge ...When Utilities Turbocharge ...When Utilities Turbocharge Chart 9Two Utilities Risks To Monitor Two Utilities Risks To Monitor Two Utilities Risks To Monitor Bottom Line: Stick with overweight exposure in the S&P utilities sector for now, but get ready to book profits in the coming weeks. Put utilities on downgrade alert. Rusting Steel Stocks Steel stocks have come full circle. Following the initial euphoria since the Trump election, the relative share price ratio is now roughly where it was in early November. There is more downside ahead. China is tapping the monetary brakes, attempting to contain the shadow banking system. However, it is difficult to target one segment of the economy through monetary policy. Tight policy is starting to backlash onto commodity prices, including steel and iron ore. A number of indicators suggest that China's internal dynamics will further undermine global steel share prices. The top panel of Chart 10 shows that the recent Chinese yield curve inversion is pointing toward more pain ahead for U.S. steel producers. Further, the Chinese credit impulse is waning. Historically, BCA's Chinese Credit Impulse Indicator (CII) has an excellent track record forecasting relative performance momentum. The latest grim CII reading warns that U.S. steel stocks have more downside (second panel, Chart 10). Slower Chinese credit creation will continue to weigh on infrastructure spending. Chinese capital expenditure and loan growth are joined at the hip. Feeble loan growth suggests that fewer projects will come to fruition (third panel, Chart 10). Sinking iron ore prices reflect this grim outlook. The implication is that overly optimistic relative profit estimates are vulnerable to disappointment (bottom panel, Chart 10). True, Chinese steel exports and domestic production have eased, which suggests that the risk of a steel inventory glut has receded. Nevertheless, U.S. steel imports have climbed anew, despite ongoing steel tariffs. As steel imports command a larger share of U.S. domestic production, price deflation is necessary to resolve this imbalance (Chart 11). This will cast a shadow on steel profit prospects. Steel industry troubles are not endemic to China. Worrisomely, U.S. steel demand dynamics remain unfavorable. Two key domestic end-markets are quickly losing steam. Commercial real estate and automobile excesses are starting to correct. Banks are reining in credit to both loan categories according to the Fed's latest Senior Loan Officer Survey (second panel, Chart 12). Simultaneously, within commercial real estate, construction and land development credit demand is also anemic. With regard to consumer loan categories, auto loan demand has registered the worst showing. Chart 10China Macro Weighs On Steel bca.uses_wr_2017_05_23_c10 bca.uses_wr_2017_05_23_c10 Chart 11Steel Deflation Looms Steel Deflation Looms Steel Deflation Looms Chart 12Weak Domestic End-Markets Provide No Relief Weak Domestic End-Markets Provide No Relief Weak Domestic End-Markets Provide No Relief Already, non-residential construction is flirting with contraction and light vehicle sales are sinking like a stone (third panel, Chart 12). As a result the steel industry's new orders-to-inventories ratio has come off the boil, exerting a gravitational pull on scrap steel prices (bottom panel, Chart 12). The implication is that steel price deflation will undermine industry profits. Adding it up, the U.S. steel industry's earnings hurdle is sky-high. Tightening Chinese monetary and financial conditions along with domestic demand blues signal that U.S. steel producers' profits will surprise to the downside. Bottom Line: Continue to avoid steel stocks. The ticker symbols for the stocks in the S&P 1500 steel index are: BLBG: S15STEL - TMST, ATI, CMC, X, AKS, CRS, HAYN, RS, ZEUS, WOR, SXC, STLD, NUE. 1 Please see BCA U.S. Equity Strategy Weekly Report, "Great Expectations?" dated April 3, 2017, available at uses.bcaresearch.com. 2 Please see BCA U.S. Equity Strategy Special Report, "Equity Sector Winners And Losers When Inflation Climbs," dated December 5, 2016, available at uses.bcaresearch.com. Current Recommendations Current Trades Size And Style Views Favor small over large caps and stay neutral growth over value.

Highlights ECB policy is set to become less dovish relative to other central banks. Stay long the euro; stay underweight German bunds within a global bond portfolio; and overweight euro area Financials within a global Financials portfolio. Female labour participation is surging. The state of the euro area labour market is not nearly as bad as many pessimists would have you believe. Play the mega-trend of rising female labour participation with a structural overweight in the Personal Products sector. Allowing for euro break-up risk, European equities are fairly valued - rather than cheap - versus U.S. equities. Prefer to gain exposure via a 50:50 combination of Germany (DAX) and Sweden (OMX). Feature "Domestic sources of risk to euro area growth have diminished while global, geo-global sources of risk have increased." - Mario Draghi The Cleanest Dirty Shirt Since the end of 2014, an unspectacular 1.9% growth rate1 has been enough to make the euro area the world's top-performing major economy - bettering the U.S., U.K. and Japan (Chart I-2). Chart of the WeekThe Percentage Of The French Population In Employment Is At An All-Time High The Percentage Of The French Population In Employment Is At An All-Time High The Percentage Of The French Population In Employment Is At An All-Time High Chart I-2The Euro Area Is The Top-Performing Economy The Euro Area Is The Top-Performing Economy The Euro Area Is The Top-Performing Economy The euro area economy has achieved this outperformance with exceptionally low volatility. For eight consecutive quarters, growth2 has remained within a very tight 1.2-2.2% band, less than half of the equivalent volatility in the U.S., U.K. and Japan. And growth is now "solid and broad", meaning that it includes all countries. The ECB's dispersion index of value-added growth in different countries stands at a historical minimum. We expect the euro area to remain the cleanest dirty shirt. As Draghi points out, the ECB is less worried about domestic risks and more worried about global risks. Specifically: "Markets are in the course of reassessment of U.S. fiscal policy" - Trumponomics will not be nearly as stimulative as first thought. "How the U.K. economy does post-Brexit has a channel of economic consequences for the euro area." "Possible negative surprises in some emerging market economies" - notably China. If any of the global risks do flare up, the ECB will sit pat, but other central banks will have to become more dovish relative to current expectations. If the risks do not flare up, the ECB will start to reduce its own extreme dovishness - at least with words, if not actions. Either way, ECB policy is set to become less dovish relative to other central banks. And the investment implications are: stay long the euro; stay underweight German bunds within a global bond portfolio; and overweight euro area Financials within a global Financials portfolio. Female Labour Participation Is Surging Chart I-3Rising Participation Boosts Employment Rising Participation Boosts Employment Rising Participation Boosts Employment As Emanuel Macron prepares to become the twenty fifth President of the French Republic, he can take heart from a statistic which may surprise you: The percentage of the French population in employment has never been this high. (Chart of the Week). How can this be when the French unemployment rate is still hovering around 10%? The answer is: as millions of formerly inactive French citizens have entered the labour market, it has lifted the percentage of the population with jobs to an all-time high (Chart I-3). But the flip side of rising participation is that it has kept the unemployment rate elevated - because some citizens who were formerly 'uncounted inactive' are now 'counted unemployed'. Remember that to count as unemployed, a person has to be in the labour market available for work. Some argue that French citizens have simply flooded into the labour market to claim generous and long-lasting unemployment benefits. This argument might hold during downturns, but it cannot explain the 25-year uptrend which also includes economic booms. Unpalatable as it might be to the pessimists, we are left with a more optimistic explanation. France has raised activity levels in the working age population with policies that encourage much greater female participation in the labour market. The important lesson is that when labour participation is rising or falling, we must interpret the headline unemployment rate with extreme care.3 If a country's unemployment rate is high because labour participation has increased - as in France - the labour market is not quite as bad as the high unemployment rate might suggest.4 Conversely, if a country's unemployment rate is low because labour participation has decreased - as in the U.S. (Chart I-4) - the labour market is not quite as good as the low unemployment rate might suggest. Counted unemployment has just been replaced with uncounted inactivity. We propose that the percentage of the working age population in employment is the truer measure of labour utilisation. With surging female participation boosting employment in France and most other European countries (Chart I-5), the state of the euro area labour market is not nearly as bad as many pessimists would have you believe. Chart I-4Participation Down In The U.S.,##br## But Up In Europe... Participation Down In The U.S., But Up In Europe... Participation Down In The U.S., But Up In Europe... Chart I-5...Led By ##br##Women ...Led By Women ...Led By Women Play the mega-trend of rising female labour participation with a structural overweight in the Personal Products sector. Political Risk Is Correctly Priced Many people saw the Brexit and Trump victories as the leading edge of a wave of economic nationalism. However, subsequent election results in the Netherlands, Austria, Finland, Bulgaria and now France have seen economic nationalists consistently underperforming their expectations. In hindsight, the Brexit and Trump victories were idiosyncratic. Both the Remain and Clinton campaigns were lacking in personality or a strong emotional message, and this proved to be their undoing. Nowadays, many voters care about personalities more than policies; emotional appeal matters more than rational appeal. Behavioural psychologist and Nobel Laureate Daniel Kahneman calls the emotional way of thinking "System 1", and the colder rational way of thinking "System 2". Crucially, in a tight contest, both the Brexit and Trump campaigns resonated with the emotional System 1 with passionate pleas such as "Take Back Control" and "Make America Great Again". By contrast, the Remain and Clinton campaigns tried to appeal mainly to the rational System 2. But as Kahneman explains, when rational System 2 competes with emotional System 1, emotional System 1 almost always wins. Chart I-6Euro Break-Up Probability = 5% A Year Euro Break-Up Probability = 5% A Year Euro Break-Up Probability = 5% A Year In more recent elections, candidates and parties opposing the nationalists - including Emanuel Macron - have used a good balance of System 1 and System 2 arguments, thereby helping to prevent shock outcomes. This is also likely to be case in the two round French legislative elections on June 11 and 18 which we do not expect to impact financial markets significantly. Does this mean that political risk is over in Europe? No. Until the euro area turns into a permanent and irreversible political union, there has to be a probability of euro break-up. To value euro area assets, investors must ask: what is this break-up probability? The sovereign bond market says it is 5% a year (Chart I-6). This shows up in a discount on German bund yields, because after a euro break-up a new deutschmark would rise; and a symmetrical premium on Italian BTP yields, because a new lira would fall. For the aggregate euro area bond, the risk largely cancels out because intra-euro currency redenomination would be zero sum. But European equities must trade at a discount for this tail-event. At the peak of the euro debt crisis in 2011, the Eurostoxx600 underperformed the S&P500 by 25% in one year. In an outright break-up, the underperformance would almost certainly be worse, let's conservatively say 30-40%. So assuming the tail-event probability is 5% a year, European equities must compensate with a valuation discount which allows a 1.5-2.0%5 excess annual return over U.S. equities. Today, the valuation discount on European equities relative to U.S. equities implies an excess annual return of 1.8%.6 This makes European equities cheap versus U.S. equities only if the annual probability of euro break-up is less than 5%. Our assessment is that a 5% annual risk is about right. Therefore, European equities are fairly valued - rather than cheap - versus U.S. equities. But to avoid the undesirable sector skews in the Eurostoxx600, a much better way to gain long-term exposure to European equities is via a 50:50 combination of Germany (DAX) and Sweden (OMX) (Chart I-7). Chart I-7Prefer A DAX/OMX Combo To The Eurostoxx50 Or Eurstoxx600 Prefer A DAX/OMX Combo To The Eurostoxx50 Or Eurstoxx600 Prefer A DAX/OMX Combo To The Eurostoxx50 Or Eurstoxx600 Dhaval Joshi, Senior Vice President European Investment Strategy dhaval@bcaresearch.com 1 At an annualized rate. 2 At an annualized rate. 3 Geek's note: the unemployment rate can be expressed as: 100*(participation rate - employment to population rate) / (participation rate). Hence, all else being equal, a rising participation rate will raise the unemployment rate and a falling participation rate will depress the unemployment rate. 4 This lesson applies equally to any studies of labour market slack such as this one: https://www.ecb.europa.eu/pub/pdf/other/ebbox201703_03.en.pdf that do not take into account the dynamics of participation rates. 5 5% multiplied by 30-40% equals 1.5-2.0% 6 Through the next ten years. Please see the European Investment Strategy Weekly Report titled "Markets Suspended In Disbelief" dated April 13, 2017 available at eis.bcaresearch.com Fractal Trading Model The rally in the CAC40 after the French election is technically extended. The recommended technical trade is to short the CAC40 versus the Eurostoxx600. For any investment, excessive trend following and groupthink can reach a natural point of instability, at which point the established trend is highly likely to break down with or without an external catalyst. An early warning sign is the investment's fractal dimension approaching its natural lower bound. Encouragingly, this trigger has consistently identified countertrend moves of various magnitudes across all asset classes. Chart I-8 Short CAC40 / Long EUROSTOXX600 Short CAC40 / Long EUROSTOXX600 The post-June 9, 2016 fractal trading model rules are: When the fractal dimension approaches the lower limit after an investment has been in an established trend it is a potential trigger for a liquidity-triggered trend reversal. Therefore, open a countertrend position. The profit target is a one-third reversal of the preceding 13-week move. Apply a symmetrical stop-loss. Close the position at the profit target or stop-loss. Otherwise close the position after 13 weeks. Use the position size multiple to control risk. The position size will be smaller for more risky positions. * For more details please see the European Investment Strategy Special Report "Fractals, Liquidity & A Trading Model," dated December 11, 2014, available at eis.bcaresearch.com Fractal Trading Model Recommendations Equities Bond & Interest Rates Currency & Other Positions Closed Fractal Trades Trades Closed Trades Asset Performance Currency & Bond Equity Sector Country Equity Indicators Bond Yields Chart II-1Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Chart II-2Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Chart II-3Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Chart II-4Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Interest Rate Chart II-5Indicators To Watch##br## - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Chart II-6Indicators To Watch ##br##- Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Chart II-7Indicators To Watch##br## - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Chart II-8Indicators To Watch##br## - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations