Consumer Staples

Highlights Portfolio Strategy The consumer staples recovery is sales-driven, underscoring that additional outperformance lies ahead. The lagging hypermarkets and retail food industries are starting to play catch up, reflecting a shift in consumer spending patterns. Use the drubbing in air freight shares to upgrade to overweight. Recent Changes S&P Air Freight & Logistics - Upgrade to overweight from neutral. Table 1Sector Performance Returns (%) Pricing Power Comeback Pricing Power Comeback Feature Equities caught a bid last week, after holding at the bottom end of their tactical trading range. The overall consolidation phase likely has further to run, but should ultimately be resolved in a positive fashion. Chart 1Ongoing Margin Expansion Ongoing Margin Expansion Ongoing Margin Expansion Real economic performance continues to lag relative to exuberant 'soft' economic survey data, while the odds of meaningful pro-cyclical U.S. fiscal largesse fade. Inflation expectations are softening as commodity prices dip, while the yield curve is narrowing. These factors are likely to sustain ambiguity about the durability and strength of the expansion. But in the background, the corporate sector continues to heal slowly, aided by the hiatus in the U.S. dollar bull market. The latter is enabling some corporate pricing power revival. Our pricing power diffusion index has surged alongside our pricing power proxy (Chart 1, second panel). The broadening of selling price inflation bodes well for the sustainability of corporate sector pricing power gains. We have updated our industry group pricing power gauges (see Table 2), comprising the respective CPI, PPI, PCE and commodity year-over-year changes for 60 industry groups. The table details the most recent annual and 3-month pricing power trends and each industry's spread to overall inflation in order to identify potential profit winners and losers. Our analysis reveals that ¾ of the industries tracked are experiencing rising selling prices, and half are also besting overall inflation rates. Only 14 of 60 industries are in outright deflation, versus 19 in January and 23 last September. Importantly, 31 of 60 industry groups are enjoying a rising pricing trend, a 50% increase from last quarter, 9 are moving laterally and only 20 are fading. The implication is that upward momentum in pricing power is gathering steam. Importantly, the rate of selling price inflation is outpacing wage bill growth, which heralds some incremental near-term torque for profit margins (Chart 1, bottom panel). Are there any themes of note? Cyclical sectors continue to dominate the table with energy and materials taking the top two spots, although recent corrective action in the commodity pits suggests that these gains may peter out. The technology sector is a notable exception within deep cyclicals, as most tech sub-groups still have to slash prices (Table 2). Early cyclicals (or interest rate-sensitives) also show strength, with banks, insurers, and media-related groups managing to lift selling prices at a decent rate. Select defensives like health care and utilities are expanding pricing power, but the overall consumer staples and telecom services sectors are lagging. Table 2Industry Group Pricing Power Pricing Power Comeback Pricing Power Comeback Adding it all up, there are tentative signs that the profit advantage may be starting to slowly shift away from defensives. In that light, we are closely monitoring several factors that could expedite a transition to a more balanced portfolio from our current defensive bias. First, the gap between hard and soft data remains unusually wide (Chart 2). The longer hard data takes to play catch up, the less likely the Fed will be re-priced more aggressively. History shows that until this gap narrows, defensive sectors are likely to retain the upper hand in terms of relative performance (Chart 2), while financials could continue to languish owing to uncertainty about the path of future Fed policy. Second, commodity prices and the U.S. dollar - especially versus emerging market (EM) currencies - are still signaling that the cyclical/defensive ratio has more downside (Chart 3). Finally, within the context of the current broad equity market consolidation, it should continue to pay to remain with a defensive over cyclical portfolio tilt for a little while longer (Chart 4, top panel). Chart 2The Gap ##br##Is Closing The Gap Is Closing The Gap Is Closing Chart 3Monitoring The U.S. ##br##Dollar And Commodities1 Monitoring The U.S. Dollar And Commodities Monitoring The U.S. Dollar And Commodities Chart 4Stick With Defensives##br## For A While Longer Stick With Defensives For A While Longer Stick With Defensives For A While Longer Nevertheless, we will likely use this phase to make additional portfolio adjustments. The wide gap between emerging/developing markets performance and the cyclical/defensive share price ratio has narrowed significantly year-to-date, suggesting that defensive outperformance may be in the late stages. In sum, equity markets are in a transition phase and we are further tweaking our intra-industrials positioning after using recent underperformance to upgrade to neutral. We are also updating our high-conviction consumer staples view, and two unloved staples sub-groups. The Consumer Staples Sector Remains Appealing As part of this year's defensive sector leadership, the consumer staples sector has confounded its critics and registered a solid year-to-date relative performance gain. We expect additional near-term upside on the back of both internal and external drivers. Consumer staples companies are enjoying a revenue renaissance. Domestically, non-discretionary retail sales are gaining market share from discretionary outlays (Chart 5), reflecting consumers structurally ingrained propensity to save vs. spend since the financial crisis. Even exports are contributing to rising revenues, despite the U.S. dollar's appreciation (Chart 5). Easing monetary conditions in the emerging markets are underpinning domestic demand, benefiting U.S. staples exporters. Improving demand and cost containment are boosting operating profit margins (Chart 5, fourth panel). This should ensure that the sector continues to register meaningful free cash flow growth, a refreshing difference with the overall corporate sector. Meanwhile, external factors also point to a further relative performance recovery. The bond-to-stock ratio is joined at the hip with relative performance momentum, and a mean reversion phase is unfolding (Chart 6). Geopolitical uncertainty, the risk of a cooling in economic momentum following the downturn in the Economic Surprise Index could fuel flows into this non-cyclical sector. Chart 5Domestic And International##br## Positive Demand Drivers Domestic And International Positive Demand Drivers Domestic And International Positive Demand Drivers Chart 6Financial Variables ##br##Reinforce Staples Bid Financial Variables Reinforce Staples Bid Financial Variables Reinforce Staples Bid There is both valuation and technical motivation for capital inflows. Chart 6 shows that our Technical Indicator has troughed near one standard deviation below the historical mean. Every time this has occurred in the last decade, a sizable relative share price recovery has ensued. There are no valuation roadblocks, countering the assertion that defensive sectors are all overvalued in relative terms (Chart 6). As a result, this sector remains a high-conviction overweight, especially with two previous lagging groups now exhibiting signs of a recovery. Hypermarket Green-Shoots The hypermarkets industry is sprouting a number of green-shoots that should further propel the recent advance in relative share price performance. The industry is enjoying profit margin support on two fronts. Import prices are still deflating (Chart 7), and the nascent rebuilding in Asian manufacturing inventories suggests that pricing pressure will persist. On the revenue front, Wal-Mart recently noted that store traffic continues to improve, albeit aided by discounting. A tight labor market is supporting aggregate wage growth, especially those in lower income brackets, which is supportive of total hypermarkets sales. Importantly, the need to slash prices to attract more customers should abate courtesy of improving demand. The overall retail sales price deflator has climbed into positive territory. Hypermarket sales growth is highly correlated with overall retail selling price inflation (Chart 8). Chart 7Input Costs Will Remain Contained Input Costs Will Remain Contained Input Costs Will Remain Contained Chart 8Low Profit Hurdle Low Profit Hurdle Low Profit Hurdle At least some of the improvement in pricing power reflects an easing in food industry deflation, which implies that the intensity of price wars with food retailers will diminish. Total outlays on food and beverages are climbing as a share of total consumer spending after falling for six consecutive years (Chart 8). These elements are captured by our hypermarkets earnings pressure gauge, which is signaling a rosier sales and EPS growth backdrop (Chart 8, fourth panel). If the border adjustment tax continues to lose momentum, the risk premium for this group should narrow. Food Retailers Are Down, But Not Out Elsewhere, the drubbing in food retailers looks overdone. The relative share price ratio is at a multi-decade low. Investor fears have concentrated on industry selling price deflation, which has weighed on already razor thin profit margins. Nevertheless, a turnaround is afoot, and we would lean against extreme bearishness. As noted previously, consumer spending on food and beverages are gaining a foothold relative to overall outlays. That is supporting a reacceleration in grocery store same-store sales. With the unemployment rate this low, wage inflation is expected to sustain recent gains. Rising incomes are synonymous with higher consumer spending power. Thus, the rebound in industry sales has more upside (Chart 9). The upshot of consumers' increased food appetite is that the food CPI is exiting deflation (Chart 10). That should go a long way in allaying investor profit margin concerns. Chart 9Buy The Wash ##br##Out In Food Retailers... Buy The Wash Out In Food Retailers... Buy The Wash Out In Food Retailers... Chart 10...Because The Deflation##br## Threat Is Diminishing ...Because The Deflation Threat Is Diminishing ...Because The Deflation Threat Is Diminishing Previous pricing pressure forced grocers to refocus on productivity. The industry's total wage bill has cooled significantly. Our productivity proxy, defined as sales/employee, is accelerating, hitting growth rates last seen more than five years ago, when share prices were trading at much higher valuations (Chart 10). Bottom Line: We reiterate our overweight stance both in the S&P hypermarkets and the compellingly valued S&P food retail index. The ticker symbols for the stocks in these indexes are: WMT, COST and KR, WFM, respectively. Air Freight Stocks Will Spread Their Wings The sell-off in transportation stocks has progressed to the point where pockets of value are materializing. Specifically, air freight and logistics stocks have been pummeled, trading down to the bottom of their post-GFC trading range (Chart 11). This is a playable opportunity. Relative performance has returned to levels first reached in the depths of the GFC. Bears have pushed valuations and technical conditions to extremely washed out levels. Both the forward P/E and price-to-sales ratios have collapsed, trading significantly below their historical means and at a steep discount to the S&P 500 (Chart 11). To be sure, a number of forces have fueled the selling. Industry activity is running below capacity, as evidenced by weakness in industry average weekly hours worked (Chart 11). The loss of momentum in internet sales compared with bricks and mortar retail sales may be causing some concern about the pace of future land deliveries (Chart 11). Walmart's news that it is offering an in-store pick up option for online orders has also spooled investors. Amazon's push for its own delivery service is a longer-term yellow flag. Nevertheless, deeply discounted valuations and depressed earnings growth expectations imply that these drags are already reflected in prices. In fact, more recently analysts have pushed the net earnings revision ratio back into positive territory. We expect additional upside as global trade improves. While we were concerned about global trade last November when we downgraded to neutral, there is more evidence now that global revenue ton miles will reaccelerate. The surge in BCA's boom/bust indicator and advance in the business sales-to-inventories (S/I) ratio are both signaling that global trade will continue to recover (Chart 12). The sustainability of the S/I improvement looks solid. The global manufacturing PMI has shot higher on the back of a synchronized developed and emerging market final demand improvement, which heralds accelerating global export volumes (Chart 12). hiatus in the U.S. dollar bull market has also provided much needed reflationary relief to the emerging world. We expect these global forces to overwhelm recent domestic freight demand concerns. Importantly, global exports have been positively correlated with air freight pricing power and the current message is to expect price hikes to stick (Chart 13, third and fourth panels). Keep in mind that air freight companies typically command greater pricing power when the supply chain is lean and lead times begin to lengthen, because companies will pay up to ensure product/parts availability. Chart 11Grim News Is Well Discounted Grim News Is Well Discounted Grim News Is Well Discounted Chart 12Recovering Global Trade... Recovering Global Trade... Recovering Global Trade... Chart 13...Is A Boon To Air Freight Pricing Power ...Is A Boon To Air Freight Pricing Power ...Is A Boon To Air Freight Pricing Power In sum, a durable recovery in global trade should ignite an earnings led relative outperformance phase in the S&P air freight & logistics index. Bottom Line: Boost exposure to overweight in the S&P air freight & logistics sub-group. The ticker symbols for the stocks in this index are: BLBG: S5AIRFX - UPS, FDX, CHRW, EXPD. Current Recommendations Current Trades Size And Style Views Favor small over large caps and stay neutral growth over value.

Feature The on-going Second Machine Age - the ushering in of Artificial Intelligence (AI) - is obsoleting human jobs at an alarming pace. But an analysis of the data reveals an interesting pattern. Jobs typically done by men have suffered disproportionately, and continue to be in grave danger. On the other hand, jobs that are typically performed by women are thriving. Chart I-1AFemale Labour Participation ##br##Can Rise A Lot Further Female Labour Participation Can Rise A Lot Further Female Labour Participation Can Rise A Lot Further Chart I-1BFemale Labour Participation ##br##Can Rise A Lot Further Female Labour Participation Can Rise A Lot Further Female Labour Participation Can Rise A Lot Further AI Is A Greater Threat To Men Despite decades of progress in workplace equality, most jobs and professions still have a very strong gender bias. The big problem for men is that automation is ideally suited to replace jobs in male-dominated middle-income jobs in manufacturing, construction and transport (Table I-1). For example, the advent of autonomous or semi-autonomous vehicles will destroy livelihoods that involve driving. And 95% of truck drivers are men. Table I-1AI Is A Greater Threat To Men Female Participation: Another Mega-Trend Female Participation: Another Mega-Trend Even among more-skilled jobs, male-dominated professions - such as finance - are under threat. As we explained in The Superstar Economy: Part 2,1 seemingly difficult human tasks that AI finds very easy are those that require the application of complex algorithms and pattern recognition to large quantities of data. This includes tasks such as calculating a credit score or insurance premium, or managing a stock portfolio. Conversely, seemingly easy human tasks that AI finds very difficult are those that require everyday human sensorimotor skills. Tasks such as walking up a flight of stairs or picking up random objects from random places. AI is also incapable (thus far) of reading and responding to peoples' emotions and intentions. A job that requires a range of these human skills is especially secure. This is because AI excels at replicating a narrowly defined task rather than a job which needs a breadth of talents. If your job involves controlling and teaching a disruptive class of seven year olds, or calming a nervous patient before giving an injection, AI will not threaten your livelihood for the foreseeable future. Hence, Education, Human Health and Social Work - the employment sectors that most require a combination of sensorimotor, emotional and communication skills - have seen the strongest job gains over the past two decades. And almost 80% of workers in Education, Human Health and Social Work are women. With AI still in its infancy, the established pattern of job destruction and creation will continue to favour women over men. Improved Parental Leave Helps Women Chart I-2Japan: Labour Force Participation Rate Japan: Labour Force Participation Rate Japan: Labour Force Participation Rate A second structural driver that is boosting female employment is improved parental leave policies. Japan provides an excellent example of what is possible. Starting in 1995, the Japanese government introduced a raft of policies to encourage women to join the labour force: paid maternity leave, subsidised childcare, and paid parental leave for both parents. Today in Japan, both mothers and fathers can take more than a year of paid parental leave at an average rate of 60% of earnings. The policies have had their desired effect. The proportion of Japanese women in the labour force has surged from 57% to 67%, while the male labour participation rate has stayed unchanged at 85%. Therefore, all of the growth in the Japanese labour force through the past 20 years has come from women (Chart I-2). Europe tells a similar tale. Through the past couple of decades, parental leave policies have become steadily more generous. Today, new mothers are guaranteed 58 weeks of paid leave in Germany, 48 in Italy, and 42 in France (Table I-2). New fathers are guaranteed 28 weeks in France and 9 weeks in Germany (Table I-3). Moreover, even after the paid parental leave ends, heavily subsidised childcare costs in the major euro area countries are affordable, averaging around a tenth of the average wage (Table I-4). Table I-2Generous Maternity Pay ##br##In Europe And Japan Female Participation: Another Mega-Trend Female Participation: Another Mega-Trend Table I-3Improving Paternity Pay##br## In Europe And Japan Female Participation: Another Mega-Trend Female Participation: Another Mega-Trend Table I-4Affordable Childcare##br## In Europe And Japan Female Participation: Another Mega-Trend Female Participation: Another Mega-Trend Unsurprisingly, the proportion of European women in the labour force has also surged from 57% to 67%, while the male labour participation rate has stayed flat at 78%. As in Japan, all of the growth in European labour force participation through the past 20 years has come from women (Chart I-3). The surge in female participation also explains why the percentage of the euro area working-age population in employment now stands close to at an all-time high (Chart I-4) - a fact which stuns many people. Chart I-3EU28: Labour Force##br## Participation Rate EU28: Labour Force Participation Rate EU28: Labour Force Participation Rate Chart I-4Increased Female Participation Lifts Euro Area ##br##Employment To Population Near An All Time High Increased Female Participation Lifts Euro Area Employment To Population Near An All Time High Increased Female Participation Lifts Euro Area Employment To Population Near An All Time High The trend is for further improvements in parental leave, with the focus now on improving paternity leave. The important point is that the sharing of parental responsibilities between mothers and fathers allows more women to enter and stay in the labour force. Therefore, we expect the structural rise in European female labour force participation to continue. France at 67% and especially Italy at 55% are still some way behind Germany at 73% and Spain at 70% (Chart I-5, Chart I-6, Chart I-7, Chart I-8 and Chart I-9). For the ultimate end-point in the trend, look to the Scandinavian countries which have had generous parental leave policies for decades. In Sweden, labour force participation for women is almost identical to that for men: 80% versus 83%. If the EU eventually reaches the Scandinavian end-point, it would mean another 20 million women in the EU labour force (Feature Chart). The one major world economy that goes against the trend is the United States. Over the past 20 years, the proportion of American women who are in the labour force has actually declined from 70% to 67%. Why? Possibly because in the U.S. new parents have no guarantee of paid leave. And the cost of childcare has been increasing much faster than overall inflation. Childcare now costs close to half the average wage, making it unaffordable for many low-income workers. Nevertheless, even in the U.S., labour force participation for women is outperforming that for men. Because the decline in participation for women is mild, whereas the decline for men is more severe (Chart I-10). Chart I-5Germany:##br## Labour Force Participation Rate Germany: Labour Force Participation Rate Germany: Labour Force Participation Rate Chart I-6France: ##br##Labour Force Participation Rate France: Labour Force Participation Rate France: Labour Force Participation Rate Chart I-7Italy:##br## Labour Force Participation Rate Italy: Labour Force Participation Rate Italy: Labour Force Participation Rate Chart I-8Spain:##br## Labour Force Participation Rate Spain: Labour Force Participation Rate Spain: Labour Force Participation Rate Chart I-9U.K.:##br## Labour Force Participation Rate U.K.: Labour Force Participation Rate U.K.: Labour Force Participation Rate Chart I-10U.S.: ##br##Labour Force Participation Rate U.S.: Labour Force Participation Rate U.S.: Labour Force Participation Rate The Structural Investment Theme: Personal Products The two factors driving increased female participation in the total labour force have much further to run. First, AI is a much greater threat to jobs and professions that are male-dominated than to those that are female-dominated. Second, further improvements in parental leave policies will allow labour force participation for women to gradually converge with that for men. All mega-trends have an associated structural investment theme. And in this case the theme is the Personal Products sector. According to Euromonitor, 90% of personal product sales are to women. For cosmetics, the proportion is close to 100%. Therefore, as the percentage of women in the labour force continues to rise, the sales and profits of Personal Products will continue to outperform those from other sectors. The highly defensive nature of personal product demand is also a big advantage in a lower-growth world. Once again, Japan provides an excellent example of what is possible. Since its crisis in 1990, overall equity market profits and prices have gone nowhere, but the profits of the Personal Products sector - led by Shiseido and Kao - have increased fivefold. The European Personal Products sector is now following the Japanese template with a reassuring similarity (Chart I-11). Chart I-11Japan Is The Template Japan Is The Template Japan Is The Template Buy and hold L'Oréal, Beiersdorf and Unilever as long-term investments. Dhaval Joshi, Senior Vice President European Investment Strategy dhaval@bcaresearch.com 1 Published on January 19, 2017 and available at eis.bcaresearch.com

Highlights Portfolio Strategy A window has opened up for utilities outperformance. Upgrade to overweight on a short-term (1-3 month) view. Leading indicators of beverage sales have improved, heralding an upgrading in depressed expectations. Stay overweight. The pullback in consumer finance stocks appears to be contagion from the overall financial sector selloff than a reflection of deteriorating industry-specific fundamentals. Buy on weakness. Recent Changes S&P Utilities - Boost to overweight from neutral on a tactical basis. Table 1 Great Expectations? Great Expectations? Feature Our view remains that stocks are in a consolidation phase, waiting for economic/profit confirmation that earnings will grow into the latest valuation expansion. Thin equity market risk premia can be justified if the economy has embarked on an extended and strong non-inflationary growth path that will spawn robust corporate profitability. Chart 1A Second Half Squeeze? A Second Half Squeeze? A Second Half Squeeze? On this note, the third mini-economic up-cycle since the Great Recession has been underway since last year. The first two bursts of economic strength fizzled quickly, eventually requiring a new dose of stimulus to reinvigorate growth. The current up-cycle may have more legs given that the rest of the world is now participating and the U.S. economy at full employment, but it would be dangerous to become complacent. The stock-to-bond ratio has crested on a growth rate basis, and its mean reversion properties suggest that key macro gauges such as the ISM index may cool as the year progresses (Chart 1). Odds of growth-propelling fiscal stimulus, that equities have already bought and paid for, may now fade following Congress' failure to move on health care reform. Total bank credit growth is decelerating on a broad basis. Chart 1 shows that of the 8 major bank loan categories, only 1 has a positive credit impulse (the annual change in the 52-week rate of change), the other 7 are negative, i.e. it isn't simply C&I loan weakness driving the credit deceleration. Traditionally, credit and economic growth move together, so the current gap warrants close attention. Meanwhile, the reflationary impulse over the past 18 months from China is set to fade as the authorities tap the brakes, particularly in the housing market, which may throw a wrench into new construction. Chinese property prices have been especially correlated with global economic up-cycles. Real estate inflation downturns have been important global economic signals (Chart 1). Consequently, the second half of the year may 'feel' slower from a growth perspective and challenge the reflation hypothesis. Some trepidation about the durability/breadth of the economic expansion is becoming evident in internal market behavior. Our Intermediate Equity Indicator (IEI) has continued to weaken as breadth and participation thin (Chart 2). If the IEI drops below zero, the odds of a meaningful pullback will rise substantially. Keep in mind there is a lot of air between the S&P 500 index and its 40-week moving average. The number of S&P 500 groups with a positive 52-week rate of change has pulled back to post-Great Recession lows (Chart 2). Last week we showed a composite of relative industry and sector performance that also heralded a choppy period ahead for the broad averages. All of these factors suggest that a tactical consolidation needs time to play out, especially with first quarter reporting season fast approaching and optimism in the outlook bursting at the seams. While trading sentiment is not overly stretched, the truest measure of sentiment is asset valuations and expectations. On this front, our Global Economic Sentiment Index, which contrasts equity and government bond valuations in the major economies, has reached the 'extreme optimism' zone (Chart 3, middle panel). Such a reading does not automatically foretell of an imminent major equity peak, but reinforces that there is little margin for disappointment. Chart 2Deteriorating Internals Deteriorating Internals Deteriorating Internals Chart 3Early Signs Of Overconfidence? Early Signs Of Overconfidence? Early Signs Of Overconfidence? In addition, the trend in analyst earnings expectations is also consistent with an overriding theme of exuberance. Cyclical earnings estimates have tentatively peaked after a steep upgrade over the last few quarters, and are now sitting below 5-year growth expectations, suggesting overwhelming confidence in the longevity of the expansion. The last three times that cyclical (12-month) profit growth estimates diverged negatively from lofty long-term estimates was in 2000, 2007 and 2015 (Chart 3). Each episode coincided with ebullient global economic sentiment, and heralded market turbulence, with varying lags. The point is that when financial conditions tighten enough to undermine the cyclical growth outlook but fail to dent conviction in the long-term outlook, it is a signal of overconfidence. The good news is that financial conditions have remained historically easy and should only tighten gradually, such that the risk of a policy-induced slowdown is not acute. In sum, we expect the tactical consolidation phase to persist, especially if economic momentum cools. Exuberant expectations argue for a digestion phase, which should continue to broadly support defensive over cyclical sector positioning, a stance that has paid off nicely since late last year. We may look to selectively increase cyclical and financial sector exposure in the coming weeks if the U.S. dollar remains tame and inflation expectations perk back up, but for now, we are making a tactical addition to the defensive side of the ledger. Utilities Are Powering Up We booked sizable gains in the S&P utilities index and downgraded to neutral last summer, because of our view that bond yields were bottoming on the back of economic stabilization. Since then, relative performance collapsed by 20%, but it has recently started showing some signs of life. Is it time to re-enter this overweight position on a tactical basis? The short answer is yes. There are five reasons to buy utilities at the current juncture with a tactical (1-3 month) time horizon. A possible cooling in economic momentum will redirect capital into the sector. Last week we highlighted that the economically-sensitive transportation index may be heralding mean reversion in key activity gauges, such as the ISM manufacturing index (Chart 4). If the run of positive economic surprises reverses, utilities stocks should receive a sizeable relative performance boost. Transport stock underperformance typically means utility stock outperformance (Chart 4, bottom panel). A cycle-on-cycle analysis of relative utilities performance and the ISM manufacturing survey reveals that is pays to overweight utilities when the latter hits the current level. This has occurred seven times since the early 1990s, and the S&P utilities sector outperformed in the subsequent 3 and 6 months by an average of 3 and 5%, respectively. Only one period generated negative returns (Table 2). Chart 4Utilities Win When Transports Lose Utilities Win When Transports Lose Utilities Win When Transports Lose Table 2Contrary Alert: Buy Utilities Great Expectations? Great Expectations? Market-based inflation expectations have crested, aided by the dip in oil prices. Relative share prices have been inversely correlated with inflation expectations, owing to the link to long-dated Treasury yields. Importantly, the University of Michigan's survey inflation expectations, both short and long term, have been drifting lower signaling that the recent backup in CPI headline inflation will likely prove transitory (inflation expectations shown inverted, Chart 5). The flattening yield curve is also sending a tactical buy signal for utilities stocks (shown inverted, Chart 5). Natural gas prices are strengthening. Nat gas prices are the marginal price setter for non-regulated utilities, and the recent price spike has boosted utilities pricing power. Sell-side analysts have taken notice, aggressively ratcheting EPS numbers higher. Nevertheless, the relative EPS growth bar still remains low, signaling that a relative profit outperformance period looms (Chart 6). Chart 5External Support As... External Support As... External Support As... Chart 6... Earnings Recover ... Earnings Recover ... Earnings Recover One risk to our tactically bullish utilities view is stagnant electricity generation growth. However, if overall output growth recedes in the next quarter or two, then the non-cyclical power demand profile will shine through, offsetting low utility utilization rates in absolute terms. Bottom Line: There is scope for a playable relative performance rally in the coming one-to-three months. Boost the niche S&P utilities sector to overweight. Soft Drinks Are About To Pop Indiscriminate selling of all consumer staples immediately after the Trump victory restored value in a number of defensive consumer groups. They have stealthily outperformed for most of this year. Chart 7 shows a number of valuation yardsticks. Soft drink stocks are yielding more than both 10-year Treasurys and the broad market. Similarly, the relative P/S and P/E ratios have dipped comfortably below their respective historical means. From a technical standpoint, relative share price momentum has been pushed to a bearish extreme (Chart 7). Against this valuation and technical backdrop, any whiff of operating traction should trigger a playable outperformance phase. Industry pricing power has rebounded smartly, exiting the deflation zone (Chart 8). This firming in selling prices appears to be demand driven. Growth in relative consumer outlays on food and non-alcoholic beverages has improved. Actual industry sales growth has returned to positive territory and beverage output growth is outpacing other non-durable goods industries (Chart 8). While export trends have been a sore spot for beverage companies, the tide should soon turn. The greenback has depreciated versus emerging market (EM) currencies since mid-December, permitting EM central banks to ease monetary policy. That heralds a recovery in consumer goods exports and a reversal of negative translation FX effects (Chart 9, middle panel). Chart 7Cheap And Washed Out Cheap And Washed Out Cheap And Washed Out Chart 8Inflection Point Inflection Point Inflection Point Chart 9Export Drag Should Reverse Export Drag Should Reverse Export Drag Should Reverse The improvement in top-line leading indicators is particularly noteworthy given that cost inflation remains muted. Food input prices are contracting and ethylene prices, a primary packaging ingredient, are also deflating. With headcount under control (Chart 9, bottom panel), there is scope for margin expansion at a time when overall profit margins face a steady squeeze from rising wage inflation. This brightening backdrop, especially in relative terms, has not yet been embraced by the analyst community. Not only are earnings slated to trail the broad market by 7% in the coming year, but 5-year relative EPS growth has plummeted to all-time lows. Such pessimism is unwarranted. All of this implies that while recent beverage shipment growth has been soft, a recovery is likely as the year progresses. That will set the stage for a series of positive surprises, supporting share price outperformance. Bottom Line: The compellingly valued S&P soft drinks index has troughed and has a very attractive reward/risk profile. Were we not already overweight, we would lift exposure to above benchmark today. The ticker symbols for the stocks in the S&P soft drinks index are: BLBG: S5SOFD-KO, PEP, MNST, DPS. Consumer Finance: Cast Aside, But For No Good Reason Like all financials, consumer finance stocks have underperformed the broad market in recent weeks. High intra-financial sector correlations are understandable early in a corrective phase, especially given the magnitude of the initial post-election rally. However, as time passes, correlations should recede because significant discrepancies exist among industry profit drivers. For instance, any meaningful broad market correction could undermine capital markets activity via reduced appetite for new equity issues, less M&A activity and smaller trading fees, taking a bite out of investment banking profits. Elsewhere, banks have been riding hopes for higher net interest margins and an easing regulatory burden. However, without any corresponding improvement in credit growth they are now giving back those gains because bond yields have stalled, the yield curve has narrowed and expectations for deregulation are being watered down to a dilution of terms These factors justify the pullback in both banks and capital markets stocks, even if temporary. On the flipside, the consumer finance group has also been dragged down, even though leading indicators of profitability have continued to improve. As shown in past research, the credit card interest rate spread has low sensitivity to shifts in the yield curve. As such, receivables growth matters more to profits than the slope of the yield curve. Whether consumers embark on debt-financed consumption is heavily dependent on job security, debt-servicing costs, and household wealth. When consumer comfort rises, the personal savings rate tends to decline, indicating a greater propensity to spend. Household net worth has set a new all time high on the back of buoyant financial markets and recovery in house prices (Chart 10). Debt service payments remain historically depressed as a share of disposable income, underscoring that the means to re-leverage exist (Chart 10). Typically credit card charge-offs stay muted until well after debt servicing requirements hit a much higher level, either through reduced incomes or higher interest rates, or a combination of the two. At the moment, both are working in favor of credit quality, not against it. In fact, house prices have reaccelerated sharply in the past few months, which heralds share price outperformance (Chart 11, top panel). Moreover, the steady increase in housing starts bodes well for additional gains in outlays on durable goods, a positive omen for consumer credit demand. Chart 10Credit Quality Remains Strong Credit Quality Remains Strong Credit Quality Remains Strong Chart 11Bullish Leading Indicators Bullish Leading Indicators Bullish Leading Indicators The latter is already growing at a solid clip, in contrast with other lending categories such as C&I loan growth (Chart 11), which is weak and dragging down total bank credit. The surge in consumer income expectations points to an expanded appetite for debt (Chart 11). Consequently, the sell-off in the S&P consumer finance index should be treated as indiscriminate contagion from the rest of the financials sector rather than a reflection of deteriorating fundamentals. Recent value creation represents a buying opportunity. Bottom Line: Stick with a high-conviction overweight in the S&P consumer finance index. The ticker symbols for the stocks in the S&P consumer index are: BLBG: S5CFINX-AXP, COF, DFS, SYF, NAVI. Current Recommendations Current Trades Size And Style Views Favor small over large caps and stay neutral growth over value.

The hypermarkets industry is enjoying a number of green shoots, indicative of an imminent recovery in relative sales growth. Wal-Mart noted that store traffic continues to improve, albeit aided by discounting. Still, the need to slash prices to attract more customers should abate. According to the Conference Board's latest release, lower income consumers are more confident than the more highly compensated cohort (bottom panel). Moreover, overall job certainty has increased with the economy near full employment, paving the way for additional wage gains. More dollars in consumers' pockets tend to loosen purse strings (third panel). Meanwhile, depressed gasoline prices are a harbinger of both increased store traffic and marginal propensity to consume (gasoline prices are shown inverted, second panel). Finally, the rising dollar is still pushing import prices lower, suggesting that industry margins and earnings are on a solid footing (top panel). Bottom Line: The broad S&P consumer staples index is a high-conviction overweight and the S&P hypermarkets sub-group remains an overweight within this positioning (WMT, COST). It's Time To Shop For Hypermarkets Equities It's Time To Shop For Hypermarkets Equities

Highlights Portfolio Strategy Add the S&P asset manager & custody banks index to the high-conviction overweight list. Prospects for higher interest rates bode well for a catch up phase with the rest of the financials sector. Initiate a long S&P consumer staples/short S&P technology pair trade, a truly out of consensus call. Housing-related equities are likely to gain ground as housing activity should stay resilient amidst rising borrowing costs. Recent Changes S&P Asset Managers & Custody Banks - Added to our high-conviction overweight list on February 16th. Long S&P Consumer Staples/Short S&P Technology - Initiate this pair trade today. Table 1Sector Performance Returns (%) Overbought, But... Overbought, But... Feature Momentum continues to drive the broad market trend. The drag from a reduction in global liquidity courtesy of depleting foreign exchange reserves continues to be overwhelmed by economic optimism. The latter is fueling a major rotation from bonds to stocks, which is the dominant market force. Valuations have taken a backseat, emblematic of blow-off phases. Two weeks ago we introduced our Complacency-Anxiety Indicator, which hit a new high. Another way to measure greed overwhelming fear is the relentless rise of the forward P/E over the VIX. The spread between these two measures can also gauge complacency. This Indicator has also soared to an all-time high (Chart 1). Chart 2 applies this methodology for the broad S&P sectors, using forward P/E and implied equity volatility, and then standardizes the result to remove biases from perennially low and high P/E sectors. A low reading suggests lower risk, and vice versa. Chart 1Buy At Your Own Risk Buy At Your Own Risk Buy At Your Own Risk Chart 2Sector Vulnerabilities And Opportunities Overbought, But... Overbought, But... At the moment, financials, telecom, utilities, REITs and health care have the lowest implicit vulnerability, while cyclical sectors carry the most risk. How long can this overshoot phase last? There are obviously no easy answers. However, from a purely technical perspective and in the absence of any major monetary, economic and/or geopolitical shocks, an examination of our Composite Technical Indicator (CTI) suggests some running room remains. Our CTI is driven primarily by momentum components. Overbought conditions are signaled once it hits one standard deviation above the mean. Currently, the TI remains slightly below this threshold (Chart 3). Even then, it can cross decisively into the danger zone before the S&P 500 eventually sells off in a meaningful fashion. Chart 3Overbought Conditions Can Persist Overbought Conditions Can Persist Overbought Conditions Can Persist Importantly, when the CTI swings quickly from deeply oversold to overbought levels, there can be a multi month lead before the broad market crests or suffers a sustained setback (Chart 3), and the bulk of those moves are associated with economic recessions and/or growth disappointments. The implication is that even though extended broad market valuations virtually guarantee paltry long-term returns and economic expectations are now sky-high, technical conditions suggest that momentum may continue to carry the day for a while longer. That does not mean investors should abandon a largely defensive portfolio structure, given that this is where the reward/risk tradeoff is most attractive and timing corrections is inherently difficult. Two weeks ago we recommended buying both gold and packaging stocks. As part of our ongoing rebalancing, this week we are further tweaking our portfolio. We recommend a pair trade to position for the inevitable sub-surface mean reversion heralded by our Indicators in the coming 3-6 months. Asset Managers: Shifting To High-Conviction Status The interest rate and market-sensitive S&P asset managers & custody banks index (AMCB) has lagged most other financials sub-indexes at a time when macro forces are lining up bullishly, particularly in view of the sector's attractive ranking on a forward P/E to volatility basis. While the capital markets and banks groups are seen as having higher torque to these positive forces, these three groups tend to move together. Lately, a divergence has opened, but a number of factors point to an imminent AMCB catch up phase (Chart 4), especially given that AMCB is not levered to overall credit growth, which has dried up. Fed Chair Yellen's testimony last week was interpreted to be slightly more on the hawkish side. That, coupled with the recent upside surprise in core inflation, raises the possibility of more 2017 tightening than currently discounted. That would provide further relief for custody banks, as ultra-low interest rates have been an anchor on this group's profitability as fees earned on funds held in trust have been minimal. The increase in short-term Treasury yields heralds a share price rally (Chart 5, top panel). Chart 4Catch Up Ahead Catch Up Ahead Catch Up Ahead Chart 5Time To Rally Time To Rally Time To Rally Moreover, the boost in economic expectations signals scope for an increase in fee generating activity, such as M&A, stock issuance and even stock lending. BCA's Global Economic Sentiment Index also indicates that the share price ratio has undershot (Chart 5). Most importantly, the asset preference shift from bonds to stocks reverses another major drag on profitability (Chart 5, third panel). Fixed income products carry lower margins than equity products, so as equity assets under management grow, profit margins should expand. If so, then we would anticipate a relative valuation re-rating, especially if the pace and scale of financial sector deregulation disappoints. The latter has been a key factor propelling capital markets and banks, and any disappointment could cause a capital rotation into the lagging AMCB index. Bottom Line: We are already overweight the S&P asset management & custody banks index, and added it to our high-conviction list in a daily Sector Insight on February 16th. New Pair Trade This week we are recommending what can be considered a highly contrarian pair trade: long the S&P consumer staples sector and short the S&P technology sector. It may be difficult to swallow executing such a non-consensus position while the broad market is going gangbusters. However, the objective message from our Indicators and increasing odds of a vicious, un-telegraphed correction, argue that the reward/risk trade-off is too attractive to ignore. As outlined in last week's Cyclical Indicator Update, the technology sector's relative earnings profile has deteriorated, because the corporate sector is not spending much yet and tech companies have suffered a serious loss of pricing power. Conversely, the consumer staples sector has a better chance of earnings outperformance, according to our model (Chart 6). Both sectors appear to have discounted the opposite outcome. Moreover, from a technical perspective, tech stocks are overbought and consumer staples are extremely oversold (Chart 6). Even a simple technical/momentum renormalization would imply a sharp jump in the share price ratio. Both sectors lose competitiveness when the U.S. dollar rise, but given that the technology sector's share of foreign sales (58%) is much higher than that of consumer staples (28%), the pain is disproportional. Importantly, consumer staples exports are accelerating, whereas tech exports are shrinking (Chart 7). Chart 6Contrasting Profiles Contrasting Profiles Contrasting Profiles Chart 7The Strong Dollar Is Worse For Tech The Strong Dollar Is Worse For Tech The Strong Dollar Is Worse For Tech Non-durable consumer goods are less sensitive to emerging market prospects, and thus when their currencies weaken, momentum in the consumer staples/tech share price ratio tends to accelerate (EM currencies shown inverted and advanced, bottom panel, Chart 7). Moreover, a strong U.S. dollar tends to reduce input costs for many consumer staples vendors, both through lower commodity prices and a reduced cost of imported goods sold. We have shown that tech stocks fare poorly toward the latter stages of a U.S. dollar bull market, when consumer staples start to shine. This dynamic reflects the economic fallout abroad from a strong U.S. dollar, particularly on developing economies, as well as the drag on U.S. corporate profits, and by extension, capital spending. While the U.S. dollar and stocks have risen in tandem in recent months, that cannot continue indefinitely, and when the correlation breaks down, the defensive consumer staples sector should outperform. In terms of economic dynamics, this share price ratio tends to accelerate when consumer spending outperforms capital spending. Consumer confidence is outpacing business confidence (Chart 8, top panel), signaling such an environment ahead. That sentiment mismatch has already translated into faster consumption than business investment on tech goods (Chart 8, second panel). Unless the gap between the return on and cost of capital reverses course and widens anew, then this trend is likely to persist. As a result, the surge in consumer staples vs. technology pricing power will continue, ultimately flattering the share price ratio through relative profit performance (Chart 8, bottom panel). The message is that consumer staples profits can have the upper hand over tech even when overall GDP growth is positive, provided the underlying driver is consumption rather than capital spending. From an external standpoint, it is notable that consumer staples have a better track record than tech stocks during inflationary periods. Chart 9 shows that the uptrend in long-term inflation expectations and increase in actual inflation both forecast a revival in this pair trade. Chart 8Unsustainable Divergences Unsustainable Divergences Unsustainable Divergences Chart 9Inflation Pressures? Buy This Ratio Inflation Pressures? Buy This Ratio Inflation Pressures? Buy This Ratio Rising inflation ultimately heralds tighter monetary policy, which is a precursor to elevated broad market volatility and a rise in the discount rate, to the detriment of long duration sectors. History shows that the high priced tech sector is more vulnerable than the safe haven staples sector in such an environment. In sum, the time is ripe for a contrary pair trade favoring consumer staples vs. technology. Notable risks to this trade are that the U.S. dollar weakens meaningfully and/or global capital spending re-accelerates decisively, relative to consumer spending. Bottom Line: We recommend a market neutral long consumer staples/short technology pair trade. The time horizon for this trade is 3-6 months. Will Housing Stocks Go Through The Roof? Housing-related stocks have delivered positive earnings surprises, but anxiety about rising mortgage rates challenges the outlook. While the latter is a risk, cheap valuations and consumers' underappreciated ability to absorb rising borrowing costs offset these concerns. Sensitivity analysis shows that even a 200 basis point (bps) spike in interest rates from current levels would fail to push housing affordability back to the long-term average (Chart 10). Moreover, mortgage payments as a percentage of incomes and effective borrowing costs would also remain below their respective historic means even with such a spike. Importantly, housing market fundamentals are improving. Lumber prices are on fire. Lumber has been the best performing commodity year-to-date. This is a real time indicator of housing demand (Chart 11). Similarly, railroad carloads of lumber are also firming, signaling that the price rise is demand-driven rather than a speculative bet in the trading pits. Sustained house price inflation, solid housing turnover and the acceleration in building permits reinforce that housing activity remains robust (Chart 11). Chart 10Higher Rates Are Not A Show Stopper Higher Rates Are Not A Show Stopper Higher Rates Are Not A Show Stopper Chart 11Lumber Strength Is Housing Bullish Lumber Strength Is Housing Bullish Lumber Strength Is Housing Bullish The credit tap to sustain strong activity is still open. According to the latest Fed Senior Bank Loan Officer Survey, banks are willing and able to extend residential mortgage credit (bottom panel, Chart 11). This contrasts with many other credit categories, where banks are tightening the screws and credit demand is faltering: C&I loans have shrunk over the past three months, as has total bank credit. First time home buyers are also reappearing and anecdotes of increased house flipping activity signal a vibrant market with unobstructed access to credit. All of this should continue to support earnings-led outperformance from both homebuilders and home improvement retailers (HIR). The bullish outlook for the S&P homebuilding index rests on four pillars. The latest National Association of Home Builders (NAHB) survey revealed that sales expectations remain over 20 points above the boom/bust line and just shy of recent cyclical highs (Chart 12). Homebuilders are clearly still seeing strong traffic. New home prices are still expanding at a healthy clip (Chart 12). Sales growth and new home price inflation are tightly linked. The mortgage application purchase index has picked up steam despite the mortgage rate increase, confirming that first time homebuyers are entering the market after a long hiatus as the financial motivation to buy vs. rent has improved. This optimism is causing an aggressive re-rating in earnings estimates from chronically bearish levels (Chart 12), a harbinger of further gains in relative share prices. The S&P HIR index also has a concrete foundation. Higher lumber prices flow straight to the bottom line, because HIR companies typically earn a set margin on lumber-related sales. Moreover, higher housing turnover is a boon for industry sales volumes (Chart 13). Historically, home sales momentum has been an excellent leading indicator of renovation activity. Chart 12Buy Homebuilders... Buy Homebuilders... Buy Homebuilders... Chart 13... And Building Supply Retailers ... And Building Supply Retailers ... And Building Supply Retailers Encouragingly, the NAHB remodeling survey is still in expansion territory, and tends to follow the trend in home sales, underscoring that home renovation activity is set to improve (Chart 13). Our HIR model encapsulates many of these key drivers, and has climbed anew (Chart 13). The message is that profits, and share prices, are on track to outperform. Adding it all up, the housing backdrop remains attractive, and even a steady increase in borrowing costs should not disrupt momentum. The time to become concerned will be if inflation becomes a serious risk, causing the Fed to get 'tight' and credit availability to dry up. The next few interest rate hikes won't move the monetary settings to that phase yet. Until then, we recommend erring on the bullish side. Bottom Line: We reiterate our high-conviction overweight in the S&P home improvement retail index (HD, LOW) and continue to recommend an above benchmark allocation in the S&P homebuilding index (PHM, DHI, LEN). Current Recommendations Current Trades Size And Style Views Favor small over large caps. Favor growth over value (downgrade alert).

Highlights Key Portfolio Highlights Improved world economic growth and rising inflation expectations have buoyed global equities (Chart 1). The downside is that financial conditions are tightening and U.S. dollar-based liquidity is contracting, which is growth restrictive (Chart 2). The massive outperformance of the financials and industrials sectors since the U.S. election implies that U.S. markets have been largely politically-motivated. Positive economic surprises remain mostly sentiment/confidence driven, rather than from upside in hard economic data (Chart 3). That unusually large gap implies that a big jump in 'hard data' surprises is already discounted and represents a latent risk, as it did in the spring of 2011 just before the summertime equity market swoon. Federal income tax receipts are contracting, suggesting that an economic boom is not forthcoming (Chart 4). In fact, there has never been a contraction in tax receipts without a corresponding slump in employment growth. Corporate sector pricing power gains have not been evenly distributed. Deep cyclicals gains came off a low base and may already be experiencing a relapse. Conversely, defensive and interest rate-sensitive sectors are demonstrating the most strength (Chart 5). Our macro models are not signaling that investors should position as if robust and self-reinforcing economic growth lies ahead. Our Deep Cyclical indicators are the weakest, while defensive and interest rate-sensitive models are grinding higher (Chart 6). Deep cyclical sectors are very overvalued and overbought, while defensives are deeply undervalued and oversold (Charts 7 and 8). Mean reversion is an apt theme for the next few months. The most attractive combination of macro, valuation and technical readings are in the consumer staples, health care sectors. The financials sector is a close second, but it is overbought. The least attractive combinations are in energy, materials and industrials. Prospects for elevated market volatility, stronger economic growth in developed vs developing economies, a tighter Fed and expensive U.S. dollar are consistent with maintaining a largely defensive portfolio structure (Charts 9-12). Chart 1Pricing Power Revival... Pricing Power Revival... Pricing Power Revival... Chart 2... But A Liquidity Drain ... But A Liquidity Drain ... But A Liquidity Drain Chart 3Show Me The Money Show Me The Money Show Me The Money Chart 4Yellow Flag Yellow Flag Yellow Flag Chart 5Pricing Recovery Is Not Broad Based Pricing Recovery Is Not Broad Based Pricing Recovery Is Not Broad Based Chart 6Indicator Snapshot Indicator Snapshot Indicator Snapshot Chart 7Focus On Value Focus On Value Focus On Value Chart 8Mean Reversion Ahead Mean Reversion Ahead Mean Reversion Ahead Chart 9Fundamentals Favor Defensives... Fundamentals Favor Defensives... Fundamentals Favor Defensives... Chart 10... As Do Market Signals ... As Do Market Signals ... As Do Market Signals Chart 1112-Month Performance After Fed Hikes Cyclical Indicator Update Cyclical Indicator Update Chart 1224-Month Performance After Fed Hikes Cyclical Indicator Update Cyclical Indicator Update Chart 13Staples Will Cushion A Volatility Resurgence Staples Will Cushion A Volatility Resurgence Staples Will Cushion A Volatility Resurgence Chart 14Media Stocks Like A Strong Currency Media Stocks Like A Strong Currency Media Stocks Like A Strong Currency Chart 15Unduly Punished Unduly Punished Unduly Punished Chart 16Strong Fundamental Support Strong Fundamental Support Strong Fundamental Support Chart 17Less Production... Less Production... Less Production... Chart 18... Means More Rigs ... Means More Rigs ... Means More Rigs Chart 19End Of Sugar High End Of Sugar High End Of Sugar High Chart 20A Toxic Mix A Toxic Mix A Toxic Mix Chart 21Tech Stocks Don't Like Inflation Tech Stocks Don't Like Inflation Tech Stocks Don't Like Inflation Chart 22Time To Disconnect Time To Disconnect Time To Disconnect Feature S&P Consumer Staples (Overweight - High Conviction) The Cyclical Macro Indicator (CMI) has been grinding higher for several months, even climbing through last year's share price shellacking. The CMI has been supported by the uptrend in relative consumer spending on essential items and consumer preference for saving vs. spending. More recently, a pricing power recovery in a number of groups has provided an assist as has a rebound in staples export growth. Booming consumer confidence and business confidence have held the CMI in check. The strong U.S. currency, particularly bilaterally against China, also implies a reduction in the cost of imported goods sold, and has also been an indication of relative valuation expansion because it often signals increased financial market volatility (Chart 13 on page 6). The attractive valuation starting point this cycle, and historic outperformance when the Fed raises interest rates (Chart 13 on page 6), were key factors behind our upgrade to high conviction status in January. Technical conditions are completely washed out. Sector breadth and momentum have reached oversold extremes. That signals widespread bearishness, which is positive from a contrary perspective. Chart 23 S&P Consumer Staples S&P Consumer Staples S&P Consumer Discretionary (Overweight) Our CMI is forming a tentative trough, supported by rebounding relative outlays on media services, low prices at the pump, a budding recovery in mortgage equity withdrawal and firming wage growth. The biggest drags over the past few months have come from higher Treasury yields and consumers increased propensity to save. However, rising job certainty and a vibrant residential real estate market suggest that consumers should loosen their purse strings. The VI has deflated toward the neutral zone, although remains moderately expensive from a long-term perspective. Our TI started to rebound from oversold levels. History shows that a recovery in the TI from one standard deviation below the mean has heralded a playable relative performance rally. Overweight positions should remain concentrated in housing-related equities and the media space, both of which benefit from U.S. dollar appreciation (Chart 14 on page 6). Chart 24 S&P Consumer Discretionary S&P Consumer Discretionary S&P REITs (Overweight - High Conviction) Our new REIT CMI has ticked lower, but the share price ratio has over-exaggerated this small move down. REITs have traded as if the back up in global bond yields will persist indefinitely, and that they are the only factor that drives relative performance. Improving cash flows and cheap valuations suggest that REITs can decouple from bond yields. Banks have tightened standards on commercial real estate loans, but this appears more likely to limit supply growth than create a slowdown. Commercial property prices are hitting new highs and our REIT Demand Indicator (RDI) has climbed into positive territory, signaling higher rental inflation. The latter is already outpacing overall CPI by a wide margin (Chart 15 on page 7). While REITs are back to fair value from a long-term perspective, on a shorter term basis the sector is very undervalued (Chart 15 on page 7), particularly with Treasury yields now in undervalued territory. Our REIT TI is extremely oversold, at a point which forward relative returns typically shine on a 12 and 24 month basis, even excluding the dividend yield kicker. Chart 25 S&P Real Estate S&P Real Estate S&P Health Care (Overweight) Our CMI continues to grind higher, opening a massive divergence with relative performance. This gap can be explained by the political attack on the pharmaceutical industry, the sector's heavyweight, rather than by a downturn in relative earnings drivers. Pharmaceutical shipments are hitting new highs and pricing power continues to grow at a robust mid-single digit rate. Future pricing gains may slow if government gets more heavily involved in setting prices, but this is already discounted. Pricing power in the rest of the sector remains strong, while wage inflation is tame. Health care spending is still growing as a share of total spending, but the pace is decelerating. Typically, this backdrop signals outperformance for health care insurers, who may also receive a risk premium reduction from a potential revamp of the Affordable Care Act, albeit the timing will likely be drawn out. Relative valuations are very attractive. The sector has been used as a source of capital to fund purchases in areas expected to benefit from increased fiscal stimulus. That is an overreaction, and flows should be restored to reflect the sector's appealing investment profile, particularly given the sector's track record during Fed tightening cycles (Chart 16 on page 7). The TI is deeply oversold. Breadth measures are beginning to recover from completely washed out levels. These conditions reinforce that an exploitable undershoot has occurred. Chart 26 S&P Health Care S&P Health Care S&P Financials (Neutral) Our Financial CMI has surged, underscoring that the advance in relative performance reflects more than just a reaction to anticipated sector deregulation by the Trump Administration. Leading indicators of capital formation, such as the stock-to-bond ratio, have jumped sharply. Moreover, the yield curve has steepened in recent months, bolstering the CMI. An improvement in overall profit growth and the tight labor market suggest that the credit cycle may not become a profit drag until the economy begins to cool. While not yet evident, the restrictive move in oil, the dollar and bond yields warn that disappoint may emerge in the coming months. It is notable that bank loan growth has dropped to nil over the last 3 months. C&I loan growth is contracting over that time period. Banks are hiring more aggressively, yet are tightening lending standards, suggesting productivity disappointment ahead. Despite the share price jump, value remains attractive after 8 years of financial repression. Our TI is overbought and breadth is beginning to recede, which is often a precursor to a consolidation phase. We are not willing to move beyond a market weight allocation at this juncture. Chart 27 S&P Financials S&P Financials S&P Energy (Neutral) Our CMI has plunged, probing all-time lows. Rising oil inventories and spiking wage inflation are exerting severe gravitational pull on the CMI, more than offsetting the budding recovery in domestic production. Refining margins are probing six year lows as the Brent/WTI spread has evaporated. Nevertheless, OPEC is finally curtailing production, joining non-OPEC producers (Chart 17 on page 8), which should ultimately help eat into excess global oil supply. History shows that once supply growth peaks, the rig count typically firms. That is a plus for energy services (Chart 18 on page 8), even though rising oil production will prove self-limiting for oil prices. High yield spreads have narrowed significantly from nosebleed levels, but industry balance sheets remain bruised. Net debt is historically elevated, EBITDA has yet to return to its glory days, and interest coverage remains anemic and vulnerable to any downside energy price surprises. The surge in our VI reflects depressed cash flow, and is overstating the degree of overvaluation. The TI has returned to the neutral zone, and will need to hold at current levels otherwise a relapse in the share price ratio toward previous lows is probable. Selectivity is still warranted in the energy complex. We remain underweight refiners and overweight the energy services index. Chart 28 S&P Energy S&P Energy S&P Utilities (Neutral) Our utilities sector CMI is stabilizing. That is a surprise, given the rebound in inflation expectations and firming global leading economic indicators, which are typically bearish for this defensive, fixed-income proxy. The latter negative exogenous factors are being offset by falling wage inflation, better pricing power and rising electricity output growth. Power demand is linked with manufacturing activity, underscoring that there is an element of cyclicality to sector profits. The share price ratio has held up better than most other defensive sectors since the U.S. election, perhaps on the hope that an overhaul of the tax code will benefit this domestic sector. Regardless, valuations have retreated from the extremely expensive zone where we took profits and downgraded to neutral last summer, but are not yet at a level that warrants re-establishing overweight positions. An upgrade could occur once our TI becomes fully washed out, provided that occurs within the context of additional CMI strength and a peak in global growth and inflation momentum. Chart 29 S&P Utilities S&P Utilities S&P Industrials (Underweight - High Conviction) The CMI has edged lower after a modest recovery in recent months. The strong U.S. dollar, relapse in short-term pricing power measures and sector productivity contraction are offsetting improvement in global PMI surveys. The lack of confirmation of an industrial sector revival from emerging markets is also holding back the CMI. There continues to be a deflationary undercurrent in the form of more rapid capacity than industrial sector output growth, suggesting that durable pricing power gains may remain elusive (Chart 19 on page 9). The post-election surge in share prices is slowly being unwound, as the sector was quick to discount expectations for massive domestic fiscal stimulus. Our valuation gauge is not at an extreme, although a number of individual groups are trading at historically rich multiples, such as machinery and railroads. Participation is beginning to fray around the edges, as our relative advance/decline line has rolled over, as has breadth. Our TI is pulling back from overbought levels, warning that a further correction in the share price ratio looms. It would be nearly unprecedented for the share price ratio to trough before our TI hits oversold levels. Industrials fare poorly when the Fed tightens. Chart 30 S&P Industrials S&P Industrials S&P Materials (Underweight) The CMI has nosedived, reflecting China's diminishing fiscal thrust and the recent tightening in monetary policy. Commodity price inflation peaked in mid-December concurrent with the Fed raising rates, signaling that emerging markets end-demand, in general and Chinese in particular, is likely past its prime. The nascent rebound in EM currencies represents a positive offset, but not by enough to turn around the CMI. Select heavyweight EM manufacturing PMIs are still below the boom/bust line. Relative valuations are becoming extended according to our VI, and stretched technical conditions are waving a red flag. Keep in mind the materials sector has an abysmal performance history after the Fed starts tightening (Chart 20 on page 9). The heavyweight chemical index (75% of the sector) bears the brunt of the downside risks owing to excess capacity (Chart 20 on page 9). On the flipside, overweight exposure in gold mining (via the GDX:US ETF) and the niche containers & packaging sub-indexes is recommended. Chart 31 S&P Materials S&P Materials S&P Technology (Underweight) The CMI has rolled over, driven lower by contracting relative pricing power, decelerating new orders-to-inventories growth, lack of capital expenditure traction and the appreciating greenback. Tech stocks thrive in a disinflationary/deflationary environment and suffer during inflationary periods (Chart 21 on page 10). Inflation is making a comeback, so it will be an uphill battle for tech companies to successfully raise selling prices at a fast enough pace to keep profits on a par with the broad corporate sector. While a capital spending cycle would be a welcome development, the narrowing gap between the return on and cost of capital warns against extrapolating improvement in business sentiment just yet. Our S&P technology operating profit model warns that tech profits are likely to trail the broad market as the year progresses, a far cry from what is embedded in analysts' forecasts. The good news is that valuations are not demanding nor are technical conditions overbought, which should cushion the magnitude and sharpness of downside risks. Chart 32 S&P Technology S&P Technology S&P Telecom Services (Underweight) Our CMI for telecom services has gained ground of late, primarily on the back of a sharp decline in wage inflation. However, we recently downgraded exposure to underweight, because of a frail spending backdrop. Our telecom services sales model is extremely weak (Chart 22 on page 10). Softening outlays on telecom services have reinvigorated the industry price war, and our pricing power gauge is sinking like a stone (Chart 22 on page 10). Telecom carrier capital expenditures have been running at a healthy clip, which could further pressure profit margins. Undervaluation exists, but this has been a chronic feature for the sector over the past decade, and does not foretell of cyclical upside or downside risks. Our TI has plunged into the sell zone, but remains above levels that would signal that a countertrend rally is imminent. Chart 33 S&P Telecommunication Services S&P Telecommunication Services Size Indicator (Overweight Small Vs. Large Caps) The small/large cap ratio is correcting short-term overbought conditions. The dip in the U.S. dollar has provided a fundamental reason for corrective action in this domestically-oriented asset class. However, we doubt a trend change is at hand. Our style CMI is climbing steadily. Small company business optimism has soared, partly because of an increase in planned price hikes, but also from an anticipated reduction in the regulatory burden. If small company price hikes persist, then rising labor costs will be more easily absorbed. That is critical to narrowing the profit margin gap between small and large firms. A stronger domestic vs. global economy and the potential for trade barriers is also unambiguously positive for small firms that do the bulk of their business at home. Despite the surge in the share price ratio post-U.S. election, our valuation gauge is not yet at an overvalued extreme. The lack of extreme overvaluation suggests that positive momentum will persist, perhaps similar to the 2004-2006 period, when the share price ratio stayed in overbought territory for years. Chart 34 Size Indicator (Small Vs. Large Caps) Size Indicator (Small Vs. Large Caps)

The S&P containers & packaging group offers a more attractively valued alternative to play a transportation recovery than either rails or air freight. Global export volumes have begun to rebound, consistent with the increase in U.S. port traffic and intermodal (consumer) goods shipments. Any increase in global trade would bolster sentiment toward this high volume industry. Companies in this index are also highly exposed to the food and beverage business since the bulk of consumable non-durable goods products require packaging materials. As such, its fortunes rise and fall with swings in food prices. The current contraction in the food CPI has spawned a boom in food consumption, as measured by the surge in real (volumes) personal outlays on food & beverage products. This phenomenon is also true on a global basis, as food exports are booming, a remarkable development given U.S. dollar appreciation. If food and beverage consumption stays robust, then the relative valuation expansion in packaging stocks will persist. In sum, packaging stocks offer attractive exposure within an otherwise unattractive S&P materials sector. Please see yesterday's Weekly Report for more details on our upgrade to overweight. The ticker symbols for the stocks in this index are: BLBG: S5CONP - IP, WRK, BLL, SEE, AVY. Packaging Stocks Are Gift Wrapped Packaging Stocks Are Gift Wrapped

The sharp packaged food share price decline means that difficult conditions are now being discounted. Sales growth expectations have cratered, reflecting the negative impact of food price deflation and the strong U.S. dollar on this export-dependent industry. However, the strong currency no longer appears to be crimping demand: real exports of food and beverage products have surged in recent months. On the flipside, imports have declined, suggesting less fierce foreign competition. In addition, a strong U.S. dollar should continue to keep a lid on raw food prices. Low input commodity costs have helped propel our profit margin proxy to new cyclical highs, heralding ongoing margin expansion. The latter demonstrates impressive operating discipline amidst a tough sales backdrop. We recommend using the sell-off to lift underweight positions up to neutral. The ticker symbols for the stocks in this index are: BLBG: S5PACK-MDLZ, KHC, GIS, K, TSN, CAG, SJM, HSY, MJN, CPB, MKC, HRL. Time To Nibble On Packaged Food Stocks Time To Nibble On Packaged Food Stocks

Highlights Portfolio Strategy The elevated ratio of market cap-to-GDP discounts strong growth far into the future, suggesting that a market validation phase may be lurking. Capital markets-sensitive stocks have had a good run, but the six month outlook is more mixed than bullish. Lift the packaged food group to neutral following the price plunge, because expectations have undershot. Recent Changes S&P Packaged Foods Index - Lift to neutral, locking in a profit of 3%. Table 1 Performance Anxiety Performance Anxiety Feature Equities are approaching their first fundamental test since the post-election surge. Fourth quarter earnings season will soon begin in earnest, with the strong U.S. dollar threatening to temper forward guidance, based on its tight inverse correlation with future net earnings revisions (Chart 1). The post-election stock market valuation expansion has been sentiment-driven: our Equity Sentiment Composite is at a bullish extreme, powering the advance in multiples. That echoes the massive growth forecast upgrade on the back of expectations of a more business friendly, reflationary fiscal policy. The NFIB survey of small business optimism has soared to levels typically reserved for a V-shaped rebound exiting recession (Chart 1). Soaring growth expectations mean that a volatile, equity validation phase is inevitable. The timing is difficult to pinpoint, however, because momentum can be a powerful and seductive force. In other words, performance anxiety and fear of missing out are overwhelming cyclical warning flags. For instance, the total market capitalization (MC) of the U.S. stock market is more than 120% of (nominal) GDP, more than double the 2008 trough (Chart 2). MC as a share of GDP has only been higher during the TMT bubble in the late-1990s. Since the 2008 low, central bank balance sheet expansion and the accrual of earnings to the corporate sector rather than to laborers have powered this remarkable surge. Low interest rates have also incented investors to bid up MC using leverage. Margin debt is now at previous peaks relative to GDP (Chart 2). It is possible that a repeat of TMT period could be unfolding, but betting on a multi-standard deviation event is high risk and low reward, especially given already elevated margin debt, and more recently, rising debt-servicing costs. MC to GDP has averaged 75% over the last forty five years. Even if nominal GDP boomed at 8% per annum for the next five years, market cap would still be over 80% of GDP, or well above the average. It may be too optimistic to expect market cap to stay above average over the next five years even if economic growth booms, because strong growth would imply a shift from interest rate normalization to restrictive settings, and wages would take an ever increasing share of corporate profits, removing two key valuation supports. What is clear is that subsequent long-term returns from current levels of MC/GDP have been poor. Chart 3 inverts and advances MC/GDP by 10-years, and plots that with 10-year rolling equity returns: long-term return potential looks paltry. Admittedly, this valuation gauge does little to forecast short-term market moves, but over the next 3-6 months, our concern is that economic euphoria will prove to have overshot reality. Chart 1Too Many Bulls? Too Many Bulls? Too Many Bulls? Chart 2Investors Already Fully Committed Investors Already Fully Committed Investors Already Fully Committed Chart 3Paltry Long-Term Returns Ahead Paltry Long-Term Returns Ahead Paltry Long-Term Returns Ahead The steady decline in total bank loan growth to nil and slide in federal income tax receipts to zero growth is worrying. The latter is an excellent confirming indicator for overall employment and economic growth (Chart 2, bottom panel). The current message does not confirm the budding economic boom currently discounted by the stock market. Consequently, we recommend a capital preservation mindset and a focus on controlling risk, as opposed to chasing short-term momentum driven returns. Against this backdrop, this week we highlight an undervalued consumer-dependent area and revisit the red-hot financials sector. Where To Next For Capital Markets? Anything financials-related surged after the election. A short covering rally morphed into optimism that the sector's regulatory burden will be loosened, ultimately allowing companies to earn a higher return on equity, thereby warranting increased valuations. In response, we upgraded our overall financial sector view in November, boosting our exposure to the previously lagging asset management & custody bank (AMCB) group to overweight and the capital markets group to neutral. The surge in equities relative to bonds has provided a catalyst for these groups to outperform (Chart 4), and that has the potential to become a longer-term asset preference shift amidst Fed tightening. That dynamic bodes well for a continued re-rating of the AMCB index. Does the same hold true for the higher beta capital markets group? The jury is still out. Capital markets stocks have historically gotten off to a slow start during Fed tightening cycles. Table 2 shows the average relative 6-, 12- and 24-month returns once the Fed begins hiking interest rates. Capital market stocks have underperformed during the first six months, regaining that in the subsequent 6 months, before finally accelerating meaningfully in year two. Using this as a guide (and the most recent hike as the true start to a Fed tightening cycle) would suggest that the initial relative performance surge is vulnerable to a pullback in the first half of this year. Meanwhile, the bull case for capital markets includes more than just higher rates and a steeper yield curve. The share price jump suggests that industry profit outperformance looms (Chart 5). A similar relative performance surge in 2013 was accompanied by a massive earnings surge. Chart 4Good News For Capital Markets... Good News For Capital Markets... Good News For Capital Markets... Chart 5... But Already Discounted? ... But Already Discounted? ... But Already Discounted? Table 2Capital Markets & Fed Tightening Cycles Performance Anxiety Performance Anxiety Earnings outperformance requires a sustained increase in capital formation, but we are reluctant to extrapolate the recent improvement in market and economic sentiment to an actual increase in demand for capital just yet. Typically, a rise in the stock-to-bond (S/B) ratio foretells of an increase in animal spirits. A rise in the S/B ratio signals that deflationary risks are receding, and points to a re-acceleration in new stock issuance (Chart 4), a plus for fee generation. But companies have already been taking advantage of cheap financing to issue equity and debt to fund M&A and buybacks, reflecting the lack of organic growth opportunities in recent years. Incremental equity raises will require a validation of growth-sponsored capital needs, rather than more financial engineering. As a share of GDP, M&A has already reached levels that coincided with previous peaks in speculative activity (Chart 6). At best, a period like 1999 could occur, when M&A stayed at a high level for two years, helping profits and share prices to outperform. But that period was a massive speculative asset bubble, and positioning for a replay is fraught with risk. Chart 6Already Past The Peak? Already Past The Peak? Already Past The Peak? Chart 7Limited New Capital Formation Limited New Capital Formation Limited New Capital Formation We are more concerned that capital formation might not live up to what is quickly becoming embedded in share prices. Chart 7 shows that the yield curve already appears to be peaking, suggesting that economic expectations have hit a ceiling. Moreover, bank loan growth has dropped to nil over the past three months, led by the commercial & industrial credit category (Chart 7). The sharp decline in C&I loan demand implies that business funding requirements are diminishing. This is corroborated by the plunge in corporate bond issuance, which has occurred within the context of narrowing corporate bond spreads and increase in risk appetites, ideal conditions for companies to issue debt (Chart 7). All of this is consistent with the message from the corporate sector financing gap, which is signaling that companies are no longer spending in excess of their cash flow (Chart 7). The corporate sector is not in a financial position to embark on a major expansion phase. Our Corporate Health Monitor remains in deteriorating health territory, underscoring limited balance sheet capacity for growth. That is consistent with a rising corporate bond default rate and more subdued M&A activity (Chart 8). Directionally, M&A activity has a critical influence on swings in capital markets return on equity, given generous profit margins for this vertical (Chart 8). Chart 8Hard To Envision A Continued M&A Boom Hard To Envision A Continued M&A Boom Hard To Envision A Continued M&A Boom Chart 9Firms Are Not Positioning For Growth Firms Are Not Positioning For Growth Firms Are Not Positioning For Growth Even the capital markets industry itself is not yet putting its money to work in anticipation of an upturn in business activity. Staff level changes are pro-cyclical. Companies hire to meet increase demand on their resources and are quick to slash when revenue opportunities diminish. As such, capital markets employment provides a good confirming indicator for earnings momentum. Chart 9 shows that capital markets hiring has dried up, similar to loan demand. The implication is that the expected upturn in relative forward earnings momentum may not materialize in the short run. Perhaps lags will eventually close these gaps, but with valuations now more dear than at any time since the Great Financial Crisis (Chart 9), prudence warrants patience before adopting a more optimistic positioning. Bottom Line: The S&P AMCB index continues to represent a more attractive risk-adjusted exposure to the improvement in market and economic sentiment than the capital markets group, because a meaningful increase in capital formation is still not assured. Stay overweight the former, and neutral on the latter. Time To Nibble On Packaged Foods Packaged foods stocks have been through the grinder in the last few months. We have been underweight this group, because it had not corrected alongside the rest of the consumer products complex (Chart 10), while leading revenue metrics had softened and employment costs had increased. However, the sharp share price decline means that difficult conditions are now being discounted. Chart 11 shows that the relative forward P/E ratio is well under the long-term average. Sales growth expectations have cratered, reflecting the negative impact of food price deflation and the strong U.S. dollar on this export-dependent industry. Chart 10Food Stocks Have Spoiled Food Stocks Have Spoiled Food Stocks Have Spoiled Chart 11Expectations Have Undershot Expectations Have Undershot Expectations Have Undershot We doubt conditions will worsen, especially relative to depressed expectations. In fact, previous drags are stabilizing, on the margin. For instance, the consumer price index for food products has troughed on a growth rate basis, suggesting that the de-rating in sales expectations has run its course (Chart 11). On the downside, capacity utilization rates are still low as a consequence of the previous retrenchment in food spending and increase in capacity. Indeed, the food production footprint has expanded over the last several years, which has been a contributing factor to the rise in labor costs and constraints on profitability. The good news is that industry wage inflation has crested and utilization rates appear to have troughed. Importantly, the U.S. dollar is not undermining growth prospects as much as dire forecasts suggest. Real exports of food and beverage products have surged in recent months (Chart 12). On the flipside, imports have declined, suggesting less fierce foreign competition. Chart 12The Strong Dollar Is Not A Death Knell... The Strong Dollar Is Not A Death Knell... The Strong Dollar Is Not A Death Knell... Chart 13... Especially If It Keeps Costs Down ... Especially If It Keeps Costs Down ... Especially If It Keeps Costs Down Total food demand growth has improved, as measured by the combination of export growth and real domestic food spending (Chart 12). Even the food shipments-to-inventories ratio has edged back into positive territory, a plus for future selling price increases. In addition, a strong U.S. dollar should continue to keep a lid on raw food prices (Chart 13). Low input commodity costs have helped propel our profit margin proxy to new cyclical highs, heralding ongoing margin expansion. The latter demonstrates impressive operating discipline amidst a tough sales backdrop. More recently, sales growth at food and beverage stores has reaccelerated (Chart 13), suggesting that factories will get busier, providing additional support to profit margins and reversing sagging return on equity. If ROE stabilizes, then the valuation compression will end. Bottom Line: Lift the S&P packaged food index to neutral, locking in a 3% profit since our underweight call in September 2015. A further upgrade is possible if utilization rates begin to improve, heralding an increase in pricing power. Current Recommendations Current Trades Size And Style Views Favor small over large caps. Favor growth over value (downgrade alert).