Corporate

As interest rates rise, investors are looking for the leveraged pressure points in the global economy to identify the sectors most likely to show strain. We previously identified the U.S. corporate bond market as a definite candidate. This month we look at European corporates. European corporations are still well behind the U.S. in the leveraging cycle. Relative trends in corporate financial health have generally favored European credit quality relative to U.S. issuers. Below the surface, balance sheet repair in the Eurozone has been concentrated in domestic issuers; financial trends among foreign issuers have resembled those in the U.S. market. Foreign issuers are much more vulnerable to higher interest rates and an economic downturn. Interest- and debt-coverage ratios are likely to fall to levels that will spark a raft of downgrades for foreign firms issuing into the Eurozone market, in the event that interest rates rise and a recession follows. Investors should concentrate their European corporate bond portfolios in domestic securities. That said, trends in financial health are unlikely to be the key driver of corporate bond relative returns this year. More important will be the end of the ECB's asset purchase program. We recommend an underweight position in Eurozone IG and HY relative to Eurozone government bonds, and relative to U.S. corporates. Risk assets remain on a collision course with monetary policy, which is the main reason why the "return of vol" is a key theme in the BCA 2018 Outlook. In the U.S., rising inflation is expected to limit the FOMC's ability to cushion soft patches in the economic data or negative shocks from abroad. We expect that ECB tapering will add to market stress, especially now that Eurozone breakup risks are again a concern. We also believe that geopolitics will remain a major source of uncertainty and volatility. All this comes at a time when corporate bond spreads offer only a thin buffer against bad news. On a positive note, we remain upbeat on the earnings outlook in the major countries. The U.S. recession that we foresaw in 2019 has been delayed into 2020 by fiscal stimulus. The longer runway for earnings to grow keeps us nervously overweight corporate bonds, at least in the U.S. That said, corporates are no more than a carry trade now that the lows in spreads are in place for the cycle. We are keeping a close eye on a number of indicators that will help us to time the next downgrade to our global corporate bond allocation. Profitability is just one, albeit important, aspect of the financial backdrop. What about the broader trend in financial health? Does the trend justify wider spreads even if the economy and profits hold up over the next year? We reviewed U.S. corporate financial health in the March 2018 monthly Bank Credit Analyst, using our bottom-up sample of companies. We also stress-tested these companies for higher interest rates and a medium-sized recession. We concluded that the U.S. corporate sector's heavy accumulation of debt in this expansion will result in rampant downgrade activity during the next economic downturn. As interest rates rise, investors are looking for the leveraged pressure points in the global economy to identify the sectors most likely to show strain. The U.S. corporate bond market is a definite candidate. This month we extend the analysis to the European corporate sector. The European Corporate Health Monitor The bottom-up version of the Corporate Health Monitor (CHM) is a complement to our top-down CHM, which uses macro data from the ECB to construct an index of six financial ratios for the non-financial corporate sector. While useful as an indicator of the overall trend in corporate financial health, it does not shed light on underlying trends across credit quality, countries and sectors. It also fails to distinguish between domestic versus foreign issuers in the Eurozone market. A number of features of the European market limit the bottom-up analysis to some extent relative to what we are able to do for the U.S.: the Eurozone market is significantly smaller and company data typically do not have as much history; foreign issuers comprise almost 50% of the market, a much higher percentage than in the U.S.; and the Financial sector features more prominently in the Eurozone index, but we exclude it because our CHM methodology does not lend itself well to this sector. We analyzed only domestic issuers in our study of U.S. corporate health. However, we decided to include foreign issuers in our Eurozone analysis in order to maximize the sample size. Moreover, it is appropriate for some bond investors to consider the whole picture, given that important benchmarks such as Barclay's corporate indexes include both foreign and domestic issuers. The relative composition of domestic versus foreign, investment-grade versus high-yield, and industrial sectors in our sample are comparable with the weights used in the Barclay's index. The CHM is calculated using the median value for each of six financial ratios (Table II-1). We then standardize1 the median values for the six ratios and aggregate them into a composite index using a simple average. The result is an index that fluctuates between +/- 2 standard deviations. A rising index indicates deteriorating health, while a downtrend signals improving health. We defined it this way in order to facilitate comparison with trends in corporate spreads. Table II-1Definitions Of Ratios That Go Into The CHMs June 2018 June 2018 One has to be careful in interpreting our Eurozone Monitor. The bottom-up version only dates back to 2005. Thus, while both the level and change in the U.S. CHM provide important information regarding balance sheet health, for the Eurozone Monitor we focus more on the change. Whether it is a little above or below the zero line is less important than the trend. Top-Down Versus Bottom-Up Chart II-1 compares the top-down and bottom-up Eurozone CHMs for the entire non-financial corporate sector.2 The levels are different, although the broad trends are similar. Key differences that help to explain the divergence include the following: the top-down CHM defines leverage to be total debt as a percent of the market value of equity, while our bottom-up CHM defines it to be total debt as a percent of the book value of the company. The second panel of Chart II-1 highlights that the two measures of leverage have diverged significantly since 2012; the top-down CHM defines profit margins as total cash flow as a percent of sales. For data-availability reasons, our bottom-up version uses operating income/total sales; and most importantly, the top-down CHM uses ECB data, which includes only companies that are domiciled in the Eurozone. Thus, it excludes foreign issuers that make up a large part of our company sample and the Barclay's index. When we recalculate the bottom-up CHM using only domestic investment-grade issuers, the result is much closer to the top-down version (Chart II-2). Both CHMs have been in 'improving health' territory since the end of the Great Financial Crisis. The erosion in the profitability components during this period was offset by declining leverage, rising liquidity and improving interest coverage for domestic issuers. Chart II-1Top-Down Vs. Bottom-Up Top-Down Vs. Bottom-Up Top-Down Vs. Bottom-Up Chart II-2Top-Down Vs. Domestic Bottom-Up Top-Down Vs. Domestic Bottom-Up Top-Down Vs. Domestic Bottom-Up It has been a different story for foreign IG issuers (Chart II-3). These firms have historically enjoyed a higher return on capital, operating margins, interest coverage, debt coverage and liquidity. Nonetheless, heavy debt accumulation has undermined their interest- and debt-coverage ratios in absolute terms and relative to their domestic peers until very recently. In other words, while domestic issuers have made an effort to clean up their balance sheets since the Great Recession, financial trends among foreign issuers look more like the trends observed in the U.S. No doubt, this is in part due to U.S. companies issuing Euro-denominated debt, but there are many other foreign issuers in our sample as well. Some analysts prefer total debt/total assets to the leverage measure we use in constructing our CHMs. However, the picture is much the same; leverage among IG domestic and foreign firms has diverged dramatically since 2010 (Chart II-4). Chart II-3Bottom-Up: Domestic Vs. Foreign IG Bottom-Up: Domestic Vs. Foreign IG Bottom-Up: Domestic Vs. Foreign IG Chart II-4Diverging Leverage Trends Diverging Leverage Trends Diverging Leverage Trends Over the past year or so there has been some reversal in the post-Lehman trends; domestic health has stabilized, while that of foreign issuers has improved. Leverage among foreign companies has leveled off, while margins and the liquidity ratio have bounced. The results for high-yield (HY) issuers must be taken with a grain of salt because of the small sample size. Chart II-5 highlights that the HY CHM is improving for both domestic and foreign issuers. Impressively, leverage is declining for both the domestic and foreign components. The return on capital, interest coverage, and debt coverage have also improved, although only for foreign issuers. Chart II-5Bottom-Up: Domestic Vs. Foreign HY Bottom-Up: Domestic Vs. Foreign HY Bottom-Up: Domestic Vs. Foreign HY Corporate Sensitivity The bottom line is that, while there have been some relative shifts below the surface, the European corporate sector's finances are generally in good shape in absolute terms and relative to the U.S. This is particularly the case for domestic issuers that have yet to catch the equity buyback bug. However, less accommodative monetary policy and rising borrowing rates have focused investor attention on corporate sector vulnerability. Downgrade risk will mushroom if corporate borrowing rates continue rising and, especially, if the economy contracts. If there is a recession in Europe in the next few years it will likely be as a result of a downturn in the U.S. We expect a traditional end to the U.S. business cycle; the Fed overdoes the rate hike cycle, sending the economy into a tailspin. The U.S. downturn would spill over to the rest of the world and could drag the Eurozone into a mild contraction. We estimated the change in the interest coverage ratio for the companies in our bottom-up European sample for a 100 basis-point rise in interest rates across the corporate curve, taking into consideration the maturity distribution of the debt (i.e. the coupons reset only for the bonds, notes and loans that mature in the next three years). We make the simplifying assumptions that all debt and loans maturing in the next three years are rolled over, but that companies do not take on net new obligations. We also assume that EBIT is unchanged in order to isolate the impact of higher interest rates. The 'x' in Chart II-6 denotes the result of the interest rate shock only. The 'o' combines the interest rate shock with a recession scenario, in which EBIT contracts by 15%. The interest coverage ratio declines sharply when rates rise by 100 basis points, but the ratio moves to a new post-2000 low only for foreign issuers. The ratio for domestic issuers falls back to the range that existed between 2009 and 2013. The median interest coverage ratio drops further when we combine this with a 15% earnings contraction in the recession scenario. Again, the outcome is far worse for foreign than it is for domestic issuers. Chart II-7 presents a shock to the median debt coverage ratio. Since debt coverage (cash flow divided by total debt) does not include interest payments, we show only the recession scenario result that reflects the decline in profits. Once again, foreign issuers appear to be far more exposed to an economic downturn than their domestic brethren. Chart II-6Interest Coverage Shocks Interest Coverage Shocks Interest Coverage Shocks Chart II-7Debt Coverage Shock Debt Coverage Shock Debt Coverage Shock Indeed, the results for foreign issuers are qualitatively similar to the shocks we previous published for our bottom-up sample of IG corporates in the U.S. (Chart II-8 and Chart II-9). In both cases, higher interest rates and contracting earnings will take the interest coverage and debt coverage ratios into uncharted territory. Chart II-8U.S. Interest Coverage Shocks U.S. Interest Coverage Shocks U.S. Interest Coverage Shocks Chart II-9U.S. Debt Coverage Shock U.S. Debt Coverage Shock U.S. Debt Coverage Shock Conclusions European corporations are still well behind the U.S. in the leveraging cycle. Relative trends in corporate financial health have generally favored European credit quality relative to U.S. issuers, where balance sheet activity has focused on lifting shareholder value since the last recession. Below the surface, balance sheet repair in the Eurozone has been concentrated in domestic issuers; financial trends among foreign issuers have resembled those in the U.S. market. There has been a small convergence of financial health between Eurozone domestic and foreign issuers over the past year or so, but the latter are still much more vulnerable to higher interest rates and an economic downturn. Interest- and debt-coverage ratios are likely to fall to levels that will spark a raft of downgrades for foreign firms issuing into the Eurozone market, in the event that interest rates rise and a recession follows. Investors should concentrate their European corporate bond portfolios in domestic securities. That said, trends in financial health are unlikely to be the key driver of corporate bond returns relative to European government bonds or to U.S. corporates this year. More important will be the end of the ECB's asset purchase program later in 2018. We expect spreads to widen as this important liquidity tailwind fades. For the moment, our Global Fixed Income Strategy service recommends an underweight position in Eurozone IG and HY relative to Eurozone government bonds, and relative to U.S. corporates. Mark McClellan Senior Vice President The Bank Credit Analyst 1 Standardizing involves taking the deviation of the series from the 18 quarter moving average and dividing by the standard deviation of the series. 2 Note that a rising CHM indicates deteriorating health to facilitate comparison with quality spreads.

Highlights Portfolio Strategy A near-term pullback in U.S. Treasury yields, still robust housing fundamentals and compelling valuations that reflect most, if not all, of the bad homebuilding news and offset thorny input cost inflation, entice us to lift the S&P homebuilding index to neutral. Troughing health care outlays versus overall PCE, minor cracks in small business hiring plans, drug pricing uncertainty and the late stages of industry M&A activity suggest that managed health care relative share prices are as good as they get. Recent Changes Book profits of 24% and augment the S&P Homebuilding Index to a benchmark allocation. Downgrade the S&P Managed Health Care Index to neutral, locking in profits of 28%. Take the S&P Telecom Services Index off the high-conviction underweight list for a gain of 10% (please see the Insight Report on May 24, 2018). Table 1 Seeing The Light Seeing The Light Feature Stocks held on to their early-May gains and are on track to end the month with handsome returns. While the SPX is not out of the woods yet, still shaking off the early-February tremor, our cyclically upbeat view remains intact. Recent data suggest that earnings will remain healthy, and we expect this will propel the S&P 500 to a fresh all-time high in the back half of the year. It's true that elevated corporate debt levels are a cause for concern, as we detailed in a recent Special Report titled 'Til Debt Do Us Part', and this week we highlight that the Bank for International Settlements (BIS) private non-financial business sector debt-to-GDP ratio confirms the Fed data we presented in that report (Chart 1). Similarly, BIS's debt service ratio1 for non-financial corporates also confirms the Datastream Worldscope stock market data of a deteriorating interest coverage ratio (EBIT/interest expense) for non-financial equities (Chart 1). While we are closely monitoring unfolding debt dynamics, high debt levels are probably a longer-term problem (beyond the next 9-12 months) for the U.S. equity market. Higher interest rates are required in order for a debt crisis to unravel. With that in mind we were pleasantly surprised to notice that net bond ratings migration is moving in the right direction i.e. upgrades are outpacing downgrades. This is impressive as the V-shaped recovery following the late-2015/early-2016 manufacturing recession is already reflected in the data and the most recent uptick likely represents a fresh/different mini credit cycle (downgrades minus upgrades as a percent of total shown inverted, bottom panel, Chart 2). Chart 1Saddled With Debt... Saddled With Debt... Saddled With Debt... Chart 2...But Ratings Migration Moving In The Right Direction ...But Ratings Migration Moving In The Right Direction ...But Ratings Migration Moving In The Right Direction Either bond rating agencies are lowering their standards or euphoric rating agencies just reflect the recent fiscal policy easing, extremely low starting point of interest rates and an overall recovery in animal spirits. We side with the latter, and the implication is that SPX momentum will reaccelerate in the coming months, if history at least rhymes (bottom panel, Chart 2). Other indicators we monitor corroborate the positive equity backdrop suggested by the ratings migration data. For example, tracking tax revenue provides an excellent near real-time gauge on corporate sector cash flows. Federal income tax receipts have spiked into double-digit territory. Even state and local government tax coffers are surging, although this dataset is quarterly and trails the monthly released Federal series by four months. Government tax receipt growth has either led or coincided with previous major and sustainable overall profit recoveries (Chart 3). This suggests that S&P 500 second quarter earnings growth will surprise to the upside, despite an already high bar, in-line with our still expanding EPS growth model; the ISM, interest rates, the U.S. dollar and house prices comprise our four factor model (Chart 4). Nevertheless, the latest bout of EM currency weakness spreading beyond the 'fragile five' is a risk to our sanguine EPS growth view, especially in the back half of the year and into 2019. In other words, if this episode mostly resembles the 2013 'taper tantrum' induced devaluations then most of the damage is already done (Chart 5). However, if all of a sudden China falls off a cliff and is forced to devalue à la 2015 then all bets are off and a 'risk off' phase will ensue leading to a spike in the U.S. dollar. Chart 3Money Flowing Into Government Coffers Takes##br## A Real Time Pulse Of Corporate Profits Money Flowing Into Government Coffers Takes A Real Time Pulse Of Corporate Profits Money Flowing Into Government Coffers Takes A Real Time Pulse Of Corporate Profits Chart 4Q2 Profits Will Likely ##br##Surprise To The Upside... Q2 Profits Will Likely Surprise To The Upside... Q2 Profits Will Likely Surprise To The Upside... Chart 5...But A U.S. Dollar##br## Spike Is A Risk ...But A U.S. Dollar Spike Is A Risk ...But A U.S. Dollar Spike Is A Risk As a reminder, the greenback is a key input to our EPS growth regression model and any sustained gains will eventually weigh on SPX profits. This is clearly a risk, but our sense is that there are more parallels with 2013 than with 2015 and one big difference is the bond market's response. The third panel of Chart 5 shows that spreads have not blown out to an alarming level, at least not yet, and signal that a generalized emerging market currency crisis will be averted. Finally, another big difference with the 2015 episode is that the commodity complex is not reeling (bottom panel, Chart 5). This week we are acting on two alerts, one downgrade and one upgrade, and crystalizing outsized gains in a defensive subsector and also taking profits in a niche early cyclical sub-index. Enough Is Enough, Upgrade Homebuilders To Neutral We put the niche S&P homebuilding index on upgrade watch in late-March,2 and today we recommend pulling the trigger and monetizing our 24% relative gains since the late-November 2017 inception. Three main reasons underpin our upgrade to a benchmark allocation: 1. Bond market selloff taking a breather 2. Housing fundamentals remain robust 3. Compelling valuations reflect most, if not all, of the bad news In March we posited that "any rise above 3.05% on the 10-year Treasury yield in a short timeframe would likely prove restrictive for the U.S. economy".3 Fast forward to today and BCA's U.S. Bond Strategists believe that the likelihood of a near-term pullback in U.S. Treasury yields has increased on the back of largely discounted Fed rate hikes, extended net short positioning and the recent moderation in economic data. This backdrop should, at the margin, give some breathing room to this interest rate-sensitive index. True, refinancing mortgage application activity has nearly ground to a halt, but the MBA's mortgage purchase index continues to climb to fresh cycle highs defying rising 30-year fixed mortgage rates (top panel, Chart 6). The MBA weekly survey is nearly exhaustive as it "covers over 75 percent of all U.S. retail residential mortgage applications".4 Importantly, examining the relative volume of purchase activity is instructive. Currently, purchase applications comprise over 2/3 of total applications. There is a positive correlation between interest rates and the purchase share of overall mortgage activity as the middle panel of Chart 6 clearly depicts. This is because refinancing takes the back seat as mortgage rates rise, whereas first time home buyers are less sensitive to the level of interest rates. Wage growth and job security are most important when undertaking the first mortgage. Put differently, a pick up in economic growth that is synonymous with higher interest rates entices rather than dissuades would-be first time home buyers. The U.S. economy is currently at full employment, underscoring that the unemployment rate should move inversely with the purchase share of mortgage activity. Indeed, empirical evidence confirms this negative correlation (bottom panel, Chart 6). Similarly, the firming economic backdrop should also lead to a renormalization of the residential housing market. Household formation is still running at a higher clip than housing starts, signaling that there is little slack in the residential housing market (middle panel, Chart 7). Homebuilder confidence is as good as it gets and home prices are expanding at a healthy pace (bottom panel, Chart 7). Chart 6Housing Fundamentals... Housing Fundamentals... Housing Fundamentals... Chart 7...Remain On A Solid Footing ...Remain On A Solid Footing ...Remain On A Solid Footing Importantly, new home prices have exited the deflation zone versus existing home prices which is significant for the relative profitability of homebuilding stocks (third panel, Chart 8). The tightness in the new home market is also evident in the relative sales backdrop: new home sales are outshining existing home sales which is conducive to a further increase in relative top line growth and thus relative share prices (top and second panels, Chart 8). Finally, relative valuations have undershot the historical mean on a price-to-sales basis with homebuilders trading at a 50% discount to the broad market (bottom panel, Chart 8). We deem that most of the bad news is likely reflected in cheap valuations and the message is that it no longer pays to be bearish the niche S&P homebuilding index. Nevertheless, we refrain from swinging all the way to an above benchmark allocation as spiking building material costs are starting to bite, according to the latest NAHB sentiment survey (middle panel, Chart 9). Moreover, long-term EPS euphoria pushing 30%, or twice the rate of the SPX, has hit a level that typically marks relative share price tops, not troughs (bottom panel, Chart 9). Were lumber prices to give way either courtesy of a rising U.S. dollar and/or a positive resolution in the NAFTA negotiations we would not hesitate to boost this index to an overweight stance. Chart 8Firming Top And Bottom Line Growth Prospects Firming Top And Bottom Line Growth Prospects Firming Top And Bottom Line Growth Prospects Chart 9Surging Building Supply Costs Are A Big Risk Surging Building Supply Costs Are A Big Risk Surging Building Supply Costs Are A Big Risk Netting it all out, a near-term pullback in U.S. Treasury yields, still robust housing fundamentals and compelling valuations that reflect most, if not all, of the bad homebuilding news and offset thorny input cost inflation, entice us to move to a neutral stance in the S&P homebuilding index. Bottom Line: We are acting on our upgrade alert and booking gains of 24% in the S&P homebuilding index and lifting exposure to neutral. The ticker symbols for the stocks in this index are: BLBG: S5HOME - DHI, LEN, PHM. Managed Health Care: Don't Overstay Your Welcome Relative share price gains for the S&P managed health care index are nearly exhausted. We are acting on our late-March downgrade alert and taking profits of 28% versus the S&P 500 since inception. At the margin, macro drivers have turned from a tailwind to a mild headwind. Long-term trends in HMOs move in distinct cycles tied with overall health care spending. When overall health care outlays begin to accelerate relative to total consumption the pressure increases on payers of medical services (i.e. health insurance) relative to the providers of those services. The opposite is also true (relative health care outlays shown inverted, Chart 10). Chart 10Rising Relative Health Care##br## Outlays Weigh On HMOs Rising Relative Health Care Outlays Weigh On HMOs Rising Relative Health Care Outlays Weigh On HMOs If relative health care spending has troughed for the cycle, then there are high odds that the decade long relative bull market has run its course and a major top is in place. Industry top-line growth is also fraying around the edges. The second panel of Chart 11 shows that the hiring plans subcomponent of the NFIB survey of small business owners has sunk recently. Despite an overall stable and growing employment backdrop, this letdown is disconcerting as roughly 65% of all net new job gains occur in the SME space.5 The implication is that enrollment may also be nearing a peak. Meanwhile, on the input cost front, a softer than expected blow to drug pricing practices revealed in the President's recent speech was music to the ears of Big Pharma executives, but cacophony to HMO CEOs. While no bill has been drafted yet and we are awaiting more details, at the margin, this is a net negative for managed health care profits. Historically, our medical care cost proxy has been inversely correlated with industry operating margins and the current message is that the mini margin expansion phase may be short-circuited (middle panel, Chart 12). Tack on a tick up in HMO labor costs and profits will likely underwhelm analysts' optimistic forecasts: the sell-side expects S&P managed health care index profits to outperform the SPX by 330bps in the coming twelve months (bottom panel, Chart 12). We deem it a tall order. Finally, the recent industry M&A frenzy is ebbing, signaling that the M&A premia may soon come out of this health care sub-group (top panel, Chart 13). Importantly, all this euphoria is likely reflected in relative valuations with the relative forward P/E trading one standard deviation above the historical mean (middle panel, Chart 13). Chart 11Early Signs Of... Early Signs Of... Early Signs Of... Chart 12...Margin Pressures ...Margin Pressures ...Margin Pressures Chart 13M&A Frenzy Fully Priced Into Expensive Valuations M&A Frenzy Fully Priced Into Expensive Valuations M&A Frenzy Fully Priced Into Expensive Valuations In sum, we do not want to overstay our welcome in the HMO space that has added considerable alpha to our portfolio since our overweight inception in April 2016. Troughing health care outlays versus overall PCE, minor cracks in the small business hiring plans, drug pricing uncertainty and the late stages of industry M&A activity suggest relative share prices are as good as they get. Bottom Line: Downgrade the S&P managed health care index to neutral for a gain of 28% since inception. The ticker symbols for the stocks in this index are: BLBG: S5MANH - UNH, AET, ANTM, CI, HUM, CNC. Anastasios Avgeriou, Vice President U.S. Equity Strategy anastasios@bcaresearch.com 1 "The DSR reflects the share of income used to service debt, given interest rates, principal repayments and loan maturities," https://www.bis.org/statistics/dsr.htm. 2 Please see BCA U.S. Equity Strategy Report, "Bumpier Ride," dated March 26, 2018, available at uses.bcaresearch.com. 3 Ibid. 4 https://www.mba.org/2018-press-releases/may/mortgage-rates-increase-applications-decrease-in-latest-mba-weekly-survey 5 https://www.stlouisfed.org/publications/regional-economist/april-2011/are-small-businesses-the-biggest-producers-of-jobs Current Recommendations Current Trades Size And Style Views Favor value over growth Favor large over small caps

Feature Chart I-1Recent Defaults Have Focused Attention ##br##On Corporate Health Recent Defaults Have Focused Attention On Corporate Health Recent Defaults Have Focused Attention On Corporate Health The recent spike in defaults on bonds and loans in China, including missed debt repayments by local government financing vehicles (LGFV) and some listed companies, has unsettled investors over the past few weeks.1 The yield spread between 5-year government bonds and 5-year corporate bonds AA minus in China's domestic bond market, has recently hit their widest level in nearly two years (Chart I-1). As a result, some investors are concerned about the possibility of widespread defaults as the Chinese government's deleveraging campaign continues to roll out, and sweeping new rules on shadow banking take effect. Given the report focus on corporate health, this week we are updating our China Industry Watch thematic chartpack to present a visual presentation of the changing situation in China's corporate sector, and its relevance to the broader stock market performance. Overall, the Chinese corporate sector has continued to deleverage and its financial situation has improved modestly. Our Corporate Health Monitor (CHM),2 which is an equally weighted average of net income margin, return on capital, EBIT-to-debt ratio, debt-to-asset ratio and interest coverage ratio, shows that the health of most sectors are improving. Specifically, for steel, construction materials, automobile, food& beverage and tech, our CHMs are in healthy territory. For oil & gas, coal, non-ferrous metals and machinery, CHMs are still below zero but are recovering. In terms of profit growth, it has remained robust for most of the sectors shown in the report. In particular, profit growth has accelerated substantially in the coal and steel sectors, as higher selling prices helped offset the impact of production constraints on revenue and aggressive cost cutting increased gross margins. Firms in the energy sector have also enjoyed higher profit growth as oil prices rebounded. In terms of the leverage picture, the liabilities-to-assets ratio has continued to decline broadly across sectors (Chart I-2). However, in regards of debt sustainability, the interest-to-sales ratio has increased substantially in coal, steel, and non-ferrous sectors, due to dramatic decline in sales resulting from production constraints. The interest coverage ratio in these sector is less problematic because of improving gross margins. For the tech sector, however, there has been a spike in the interest-to-sales ratio and a sharp decline in interest coverage. Looking beyond the fairly broad-based improvement in our overall non-financial CHM, we doubt that a broad-based default wave will occur in response to the crackdown on shadow banking. First, by our estimation, the recent defaults cited above account for only 0.09% of outstanding corporate bonds. Second, the latest PBOC monetary report changed the tone from emphasizing "deleveraging" to "stabilizing leverage and restructuring", which shows that regulators are as concerned about the stability of the economy as they are about reducing excessive debts. One problem that is worth monitoring is the negative trend in overall industrial enterprises sales, which had a negative growth rate in Q1 relative to the same quarter last year. Part of this negative growth rate is likely due to base effects, given that Q1 2017 itself was abnormally strong. Nevertheless, comparing first three month of the sales this year to that of previous years, it is clear that 2018's value did not reflect an uptrend in the data (Chart I-3). This weak top line performance is somewhat worrisome and we will continue to watch for signs of a further slowdown. Chart I-2A Continued Decline In Debt-To-Assets A Continued Decline In Debt-To-Assets A Continued Decline In Debt-To-Assets Chart I-3Tepid Topline Growth Is Worrisome Tepid Topline Growth Is Worrisome Tepid Topline Growth Is Worrisome Lin Xiang, Research Analyst linx@bcaresearch.com Jonathan LaBerge, CFA, Vice President Special Reports jonathanl@bcaresearch.com BCA China Industry Watch includes four categories of financial ratios to monitor a sector's leverage, profitability, growth and efficiency, respectively. Some of these ratios, as shown in Table 1, are slightly tweaked from conventional definitions due to data availability. The financial data in our exercise are from the official statistics on overall industrial firms, of which the listed companies are a subset, but most financial ratios based on the two sets of data are very similar, especially for the heavy industries that dominate the Chinese stock markets - both onshore and offshore. The financial ratios on leverage, growth and profitability are almost identical for some sectors, while some other sectors that are not well represented in the stock market, such as technology, healthcare and consumer sectors, show notable divergences. As the Chinese equity universe continues to expand, we expect that the two sets of data will increasingly converge. Table 1The China Industry Watch Messages From BCA's China Industry Watch Messages From BCA's China Industry Watch 1 More than 10 companies, several of them listed, from a variety of industries have defaulted on 17 bonds worth more than 16.5 billion yuan (US$2.6 billion), according to figures from Choice. 2 Please see China Investment Strategy Special Report, “Introducing The BCA China Industry Watch,” dated February 10, 2016, available at cis.bcaresearch.com. Appendix: China Industry Watch All Firms Chart II-1Non-Financial Firms: Stock Price & Valuation Indicators Non-Financial Firms: Stock Price & Valuation Indicators Non-Financial Firms: Stock Price & Valuation Indicators Chart II-2Non-Financial Firms: Relative Performance Of Valuation Indicators Non-Financial Firms: Relative Performance Of Valuation Indicators Non-Financial Firms: Relative Performance Of Valuation Indicators Chart II-3Non-Financial Firms: Leverage Indicators Non-Financial Firms: Leverage Indicators Non-Financial Firms: Leverage Indicators Chart II-4Non-Financial Firms: Growth Indicators Non-Financial Firms: Growth Indicators Non-Financial Firms: Growth Indicators Chart II-5Non-Financial Firms: Profitability Indicators Non-Financial Firms: Profitability Indicators Non-Financial Firms: Profitability Indicators Chart II-6Non-Financial Firms: Efficiency Indicators Non-Financial Firms: Efficiency Indicators Non-Financial Firms: Efficiency Indicators Oil & Gas Sector Chart II-7Oil&Gas Sector: Stock Price & Valuation Indicators Oil&Gas Sector: Stock Price & Valuation Indicators Oil&Gas Sector: Stock Price & Valuation Indicators Chart II-8Oil&Gas Sector: Relative Performance Of Valuation Indicators Oil&Gas Sector: Relative Performance Of Valuation Indicators Oil&Gas Sector: Relative Performance Of Valuation Indicators Chart II-9Oil&Gas Sector: Leverage Indicators Oil&Gas Sector: Leverage Indicators Oil&Gas Sector: Leverage Indicators Chart II-10Oil&Gas Sector: Growth Indicators Oil&Gas Sector: Growth Indicators Oil&Gas Sector: Growth Indicators Chart II-11Oil&Gas Sector: Profitability Indicators Oil&Gas Sector: Profitability Indicators Oil&Gas Sector: Profitability Indicators Chart II-12Oil&Gas Sector: Efficiency Indicators Oil&Gas Sector: Efficiency Indicators Oil&Gas Sector: Efficiency Indicators Coal Sector Chart II-13Coal Sector: Stock Price & Valuation Indicators Coal Sector: Stock Price & Valuation Indicators Coal Sector: Stock Price & Valuation Indicators Chart II-14Coal Sector: Relative Performance Of Valuation Indicators Coal Sector: Relative Performance Of Valuation Indicators Coal Sector: Relative Performance Of Valuation Indicators Chart II-15Coal Sector: Leverage Indicators Coal Sector: Leverage Indicators Coal Sector: Leverage Indicators Chart II-16Coal Sector: Growth Indicators Coal Sector: Growth Indicators Coal Sector: Growth Indicators Chart II-17Coal Sector: Profitability Indicators Coal Sector: Profitability Indicators Coal Sector: Profitability Indicators Chart II-18Coal Sector: Efficiency Indicators Coal Sector: Efficiency Indicators Coal Sector: Efficiency Indicators Steel Sector Chart II-19Steel Sector: Stock Price & Valuation Indicators Steel Sector: Stock Price & Valuation Indicators Steel Sector: Stock Price & Valuation Indicators Chart II-20Steel Sector: Relative Performance Of Valuation Indicators Steel Sector: Relative Performance Of Valuation Indicators Steel Sector: Relative Performance Of Valuation Indicators Chart II-21Steel Sector: Leverage Indicators Steel Sector: Leverage Indicators Steel Sector: Leverage Indicators Chart II-22Steel Sector: Growth Indicators Steel Sector: Growth Indicators Steel Sector: Growth Indicators Chart II-23Steel Sector: Profitability Indicators Steel Sector: Profitability Indicators Steel Sector: Profitability Indicators Chart II-24Steel Sector: Efficiency Indicators Steel Sector: Efficiency Indicators Steel Sector: Efficiency Indicators Non Ferrous Metals Sector Chart II-25Non Ferrous Metals Sector: Stock Price & Valuation Indicators Non Ferrous Metals Sector: Stock Price & Valuation Indicators Non Ferrous Metals Sector: Stock Price & Valuation Indicators Chart II-26Non Ferrous Metals Sector: Relative Performance Of Valuation Indicators Non Ferrous Metals Sector: Relative Performance Of Valuation Indicators Non Ferrous Metals Sector: Relative Performance Of Valuation Indicators Chart II-27Non Ferrous Metals Sector: Leverage Indicators Non Ferrous Metals Sector: Leverage Indicators Non Ferrous Metals Sector: Leverage Indicators Chart II-28Non Ferrous Metals Sector: Growth Indicators Non Ferrous Metals Sector: Growth Indicators Non Ferrous Metals Sector: Growth Indicators Chart II-29Non Ferrous Metals Sector: Profitability Indicators Non Ferrous Metals Sector: Profitability Indicators Non Ferrous Metals Sector: Profitability Indicators Chart II-30Non Ferrous Metals Sector: Efficiency Indicators Non Ferrous Metals Sector: Efficiency Indicators Non Ferrous Metals Sector: Efficiency Indicators Construction Material Sector Chart II-31Construction Material Sector: Stock Price & Valuation Indicators Construction Material Sector: Stock Price & Valuation Indicators Construction Material Sector: Stock Price & Valuation Indicators Chart II-32Construction Material Sector: Relative Performance Of Valuation Indicators Construction Material Sector: Relative Performance Of Valuation Indicators Construction Material Sector: Relative Performance Of Valuation Indicators Chart II-33Construction Material Sector: Leverage Indicators Construction Material Sector: Leverage Indicators Construction Material Sector: Leverage Indicators Chart II-34Construction Material Sector: Growth Indicators Construction Material Sector: Growth Indicators Construction Material Sector: Growth Indicators Chart II-35Construction Material Sector: Profitability Indicators Construction Material Sector: Profitability Indicators Construction Material Sector: Profitability Indicators Chart II-36Construction Material Sector: Efficiency Indicators Construction Material Sector: Efficiency Indicators Construction Material Sector: Efficiency Indicators Machinery Sector Chart III-37Machinery Sector: Stock Price & Valuation Indicators Machinery Sector: Stock Price & Valuation Indicators Machinery Sector: Stock Price & Valuation Indicators Chart III-38Machinery Sector: Relative Performance Of Valuation Indicators Machinery Sector: Relative Performance Of Valuation Indicators Machinery Sector: Relative Performance Of Valuation Indicators Chart III-39Machinery Sector: Leverage Indicators Machinery Sector: Leverage Indicators Machinery Sector: Leverage Indicators Chart III-40Machinery Sector: Growth Indicators Machinery Sector: Growth Indicators Machinery Sector: Growth Indicators Chart III-41Machinery Sector: Profitability Indicators Machinery Sector: Profitability Indicators Machinery Sector: Profitability Indicators Chart III-42Machinery Sector: Efficiency Indicators Machinery Sector: Efficiency Indicators Machinery Sector: Efficiency Indicators Automobile Sector Chart III-43Automobile Sector: Stock Price & Valuation Indicators Automobile Sector: Stock Price & Valuation Indicators Automobile Sector: Stock Price & Valuation Indicators Chart III-44Automobile Sector: Relative Performance Of Valuation Indicators Automobile Sector: Relative Performance Of Valuation Indicators Automobile Sector: Relative Performance Of Valuation Indicators Chart III-45Automobile Sector: Leverage Indicators Automobile Sector: Leverage Indicators Automobile Sector: Leverage Indicators Chart III-46Automobile Sector: Growth Indicators Automobile Sector: Growth Indicators Automobile Sector: Growth Indicators Chart III-47Automobile Sector: Profitability Indicators Automobile Sector: Profitability Indicators Automobile Sector: Profitability Indicators Chart III-48Automobile Sector: Efficiency Indicators Automobile Sector: Efficiency Indicators Automobile Sector: Efficiency Indicators Food & Beverage Sector Chart III-49Food&Beverage Sector: Stock Price & Valuation Indicators Food&Beverage Sector: Stock Price & Valuation Indicators Food&Beverage Sector: Stock Price & Valuation Indicators Chart III-50Food&Beverage Sector: Relative Performance Of Valuation Indicators Food&Beverage Sector: Relative Performance Of Valuation Indicators Food&Beverage Sector: Relative Performance Of Valuation Indicators Chart III-51Food&Beverage Sector: Leverage Indicators Food&Beverage Sector: Leverage Indicators Food&Beverage Sector: Leverage Indicators Chart III-52Food&Beverage Sector: Growth Indicators Food&Beverage Sector: Growth Indicators Food&Beverage Sector: Growth Indicators Chart III-53Food&Beverage Sector: Profitability Indicators Food&Beverage Sector: Profitability Indicators Food&Beverage Sector: Profitability Indicators Chart III-54Food&Beverage Sector: Efficiency Indicators Food&Beverage Sector: Efficiency Indicators Food&Beverage Sector: Efficiency Indicators Information Technology Sector Chart III-55Information Technology Sector: Stock Price & Valuation Indicators Information Technology Sector: Stock Price & Valuation Indicators Information Technology Sector: Stock Price & Valuation Indicators Chart III-56Information Technology Sector: Relative Performance Of Valuation Indicators Information Technology Sector: Relative Performance Of Valuation Indicators Information Technology Sector: Relative Performance Of Valuation Indicators Chart III-57Information Technology Sector: Leverage Indicators Information Technology Sector: Leverage Indicators Information Technology Sector: Leverage Indicators Chart III-58Information Technology Sector: Growth Indicators Information Technology Sector: Growth Indicators Information Technology Sector: Growth Indicators Chart III-59Information Technology Sector: Profitability Indicators Information Technology Sector: Profitability Indicators Information Technology Sector: Profitability Indicators Chart III-60Information Technology Sector: Efficiency Indicators Information Technology Sector: Efficiency Indicators Information Technology Sector: Efficiency Indicators Utilities Sector Chart III-61Utilities Sector: Stock Price & Valuation Indicators Utilities Sector: Stock Price & Valuation Indicators Utilities Sector: Stock Price & Valuation Indicators Chart III-62Utilities Sector: Relative Performance Of Valuation Indicators Utilities Sector: Relative Performance Of Valuation Indicators Utilities Sector: Relative Performance Of Valuation Indicators Chart III-63Utilities Sector: Leverage Indicators Utilities Sector: Leverage Indicators Utilities Sector: Leverage Indicators Chart III-64Utilities Sector: Growth Indicators Utilities Sector: Growth Indicators Utilities Sector: Growth Indicators Chart III-65Utilities Sector: Profitability Indicators Utilities Sector: Profitability Indicators Utilities Sector: Profitability Indicators Chart III-66Utilities Sector: Efficiency Indicators Utilities Sector: Efficiency Indicators Utilities Sector: Efficiency Indicators Cyclical Investment Stance Equity Sector Recommendations

Highlights So long as EM corporate and sovereign bond yields continue to rise, EM share prices will remain in a downtrend. EM corporate earnings growth has peaked while EM corporate profitability remains structurally weak. We recommend re-establishing a short Brazilian bank stocks position, and to continue shorting the BRL versus the U.S. dollar. Put Malaysian stocks on an upgrade watch list as the elections outcome is a long-term positive. However, its financial markets will likely face meaningful headwinds in the months ahead. Stay short MYR versus the U.S. dollar. Feature Monitoring Market Signals Rising U.S. bond yields are wreaking havoc on EM risk assets. Not only are EM currencies plunging, but sovereign and corporate bond yields are also spiking. In fact, EM share prices always decline when EM corporate and sovereign bond yields rise (Chart I-1). There is less correlation between EM equity and U.S. bond yields. Chart I-1EM Share Prices Always Decline When EM Corporate Bond Yields Rise EM Share Prices Always Decline When EM Corporate Bond Yields Rise EM Share Prices Always Decline When EM Corporate Bond Yields Rise The basis: So long as the rise in U.S. bond yields is offset by compressing EM credit spreads, EM corporate bond yields decline and EM share prices rally. But when EM corporate (or sovereign) yields rise, irrespective of whether this is due to rising U.S. Treasury yields or widening EM credit spreads, EM equity prices come under considerable selling pressure. Lately, both EM credit spreads have been widening and U.S. bond yields have been mounting. That said, EM sovereign and corporate credit spreads still remain tight by historical standards, suggesting this asset class is still pricing in little risk. Hence, as EM currencies continue to sell off, EM credit spreads will widen further (Chart I-2). Meanwhile, U.S. government bond yields in our view have more upside: U.S. growth is robust (nominal GDP growth is 5%) and inflationary pressures are heightening. Long-term Treasury yields have risen much less than 2- and 5-year bond yields. Therefore, it is not surprising that a bit of catch-up is now underway. Rising U.S. bond yields will inevitably inflict more damage on EM risk assets. EM share prices are sitting on their 200-day moving average (Chart I-3, top panel). Relative to DM, EM share prices have decisively broken below their 200-day moving average (Chart I-3, bottom panel). Chart I-2Weaker EM Currencies = Wider Credit Spreads Weaker EM Currencies = Wider Credit Spreads Weaker EM Currencies = Wider Credit Spreads Chart I-3A Breakdown In The Making? A Breakdown In The Making? A Breakdown In The Making? In addition to widening EM corporate and sovereign bond yields, there are some other market-based indicators that investors should monitor: The ratio of total return (including carry) of commodities currencies relative to safe-haven currencies1 is hovering around 200-day moving average (Chart I-4). A breakdown in this ratio will herald that the rally in EM risk assets is over and a bear market is underway. Chinese offshore and onshore corporate spreads are widening (Chart I-5). This could be the canary in the proverbial coal mine predicting a nascent downturn in Chinese share prices and China-related plays globally. Chart I-4Watch This Market Indicator bca.ems_wr_2018_05_17_s1_c4 bca.ems_wr_2018_05_17_s1_c4 Chart I-5China' On- And Off-Shore Credit Spreads China' On- And Off-Shore Credit Spreads China' On- And Off-Shore Credit Spreads Finally, investor sentiment on EM equities remains bullish. For example, net long positions of asset managers and leveraged funds in EM stock index futures was still extremely elevated as of May 11th (Chart I-6). Bottom Line: We continue to recommend a bearish stance on EM risk assets in absolute terms and underweighting EM stocks, currencies and credit markets versus their DM counterparts. The list of our recommended fixed-income and currency positions is available on page 19. EM Corporate Profits And Profitability It appears that EM profit growth has topped out, regardless of whether we consider net profits (Chart I-7, top panel), EBITDA or cash earnings2 (Chart I-7, bottom panel). These data are for EM non-financial companies included in the MSCI EM overall equity index. The blue lines are from Datastream's World Scope database, and the dotted lines are from MSCI. Chart I-6Investors Remain Positive On EM Equities Investors Remain Positive On EM Equities Investors Remain Positive On EM Equities Chart I-7EM Corporate Earnings Have Topped Out EM Corporate Earnings Have Topped Out EM Corporate Earnings Have Topped Out The last data points for World Scope's net income and EBITDA are as of the end of March 2018, before EM currencies began to plunge. It seems that net income and EBITDA data from World Scope slightly leads the comparable series from MSCI at turning points. This is due to statistical data compilation processes these sources employ. We examine non-financials' corporate profits because EM financials/banks' earnings are often distorted by provisions and other adjustments.3 As a result, they are a poor timing tool for profit cycle turning points. Our negative viewpoint on EM equities is contingent on a significant slowdown, and probably an outright contraction in EM corporate profits in the next 12 months. We have several observations on the EM profit cycle: China's credit plus fiscal spending as well as broad money impulses nicely lead EM corporate profit cycles, and they presently point to an impending cyclical downturn (Chart I-8). As a top-line slowdown transpires, consistent with our expectations, EM profit margins will shrink. If this indeed occurs, EM non-financial profit margins will roll over at levels on par with previous bottoms (Chart I-9). This holds when using both net income and EBITDA. Chart I-8China's Credit Cycle And ##br##EM Non-Financial Profits bca.ems_wr_2018_05_17_s1_c8 bca.ems_wr_2018_05_17_s1_c8 Chart I-9EM Non-Financials: ##br##Profit Margins Are Still Low EM Non-Financials: Profit Margins Are Still Low EM Non-Financials: Profit Margins Are Still Low The same point is pertinent for return on assets (RoA) of listed EM non-financial companies. Chart I-10 portends two versions of RoA measures using net income and EBITDA. If RoA were to peak now in this cycle - which is our baseline scenario - it would roll over at levels on par with previous bottoms reached in 2002 and 2008. Chart I-10EM Non-Financials: Return On Assets EM Non-Financials: Return On Assets EM Non-Financials: Return On Assets Bottom Line: If our outlook for a considerable slowdown in EM revenue growth this year materializes, EM non-financials' profit margins and RoA will relapse at very low levels - the levels that prevailed at previous cycle lows. Hence, EM corporate profitability remains structurally weak, consistent with our view that there has been little corporate restructuring in recent years. Among EM bourses, we are overweighting Taiwan, Korea, Thailand, India, central Europe, Mexico and Chile. Our underweights are Brazil, Turkey, South Africa, Peru, Malaysia and Indonesia. Brazil: Reinstate Short Bank Stocks Position Brazilian markets have sold off sharply of late. The currency has been the main culprit of the selloff. As we have repeatedly argued in the past, the exchange rate holds the key in Brazil. The country's stocks and local bonds as well as sovereign and corporate credit do well when the currency is strong or stable, and sell off during periods of real depreciation. We expect more downside in the currency, which will lead to escalating selling pressure in equity, credit and probably fixed-income markets. We are therefore reiterating our negative stance on Brazilian financial markets: The pace of real economic activity might be rolling over (Chart I-11A). This is occurring at a time when levels of economic activity are still severely depressed, well below their 2012 peak (Chart I-11B). Chart I-11ABrazil: Signs Of Growth Rollover... Brazil: Signs Of Growth Rollover... Brazil: Signs Of Growth Rollover... Chart I-11B...At Low Levels ...At Low Levels ...At Low Levels Business confidence also remains weak amid uncertainty ahead of this fall's presidential elections, which will continue to inhibit hiring and investment. In the meantime, the export sector, which has led growth since 2015, is facing headwinds. Exports in terms of volumes as well as value (U.S. dollars) have decelerated considerably (Chart I-12). As China's growth slows and commodities prices dwindle in the second half of this year, Brazil exports will contract. Nominal GDP growth has relapsed to its 2015 lows - a period when the country's financial markets were rioting (Chart I-13, top panel). Even though economic activity in real terms has rebounded, inflation has plunged resulting in extremely weak nominal income growth. Chart I-12Brazil: Exports Are Slowing Brazil: Exports Are Slowing Brazil: Exports Are Slowing Chart I-13Brazil Suffers From Low Inflation Brazil Suffers From Low Inflation Brazil Suffers From Low Inflation The GDP deflator and core consumer price inflation have plummeted to 20-year lows (Chart I-13, bottom panel). As a result, interest rates deflated by inflation - i.e., real interest rates - remain extremely high. Fiscal policy is restrained by a rule that limits current year spending growth to last year's inflation rate. This year's fiscal expenditure growth is going to be 3% in nominal terms. Given that inflation is still very depressed, this means that fiscal spending growth will be extremely low next year too. Furthermore, the central bank is unlikely to cut interest rates amid the turmoil in the currency market. The central bank also typically shrinks the banking system's reserves - tightens liquidity - during periods of exchange rate depreciation, as illustrated in Chart I-14. Therefore, the combination of weak nominal growth and high real interest rates will slip Brazil into a debt deflation dynamic - where indebtedness rises as nominal income/revenue growth remains below borrowing costs (Chart I-15). Chart I-14Falling BRL = Tighter Liquidity Falling BRL = Tighter Liquidity Falling BRL = Tighter Liquidity Chart I-15Brazil: An Unsustainable Gap Brazil: An Unsustainable Gap Brazil: An Unsustainable Gap This is especially true for government debt in Brazil. We maintain that the nation's public debt dynamics will remain on an unsustainable trajectory as long as government revenue growth does not exceed the level of nominal interest rates. In turn what Brazil needs are much lower real interest rates and a weaker currency to boost nominal GDP/income growth. This would ultimately stabilize public and private debt dynamics and improve debtors' ability to service debt. However, a sizable exchange rate depreciation, which is all but required to boost nominal growth, will in the interim be bad for financial markets, especially foreign investors. Chart I-16Brazil: Markets Have Hit Critical Levels Brazil: Markets Have Hit Critical Levels Brazil: Markets Have Hit Critical Levels Finally, there are a number of technical patterns that suggest a major top has been reached in Brazilian financial markets, and that downside from current levels will likely be significant. In particular, Brazil share prices in U.S. dollar terms have failed to break above their multi-year moving average, which has served as both a support and resistance in the past (Chart I-16, top panel). Likewise the real's total return including carry versus the dollar has been unable to break above its previous high. This, combined with the head-and-shoulder pattern of BRL (Chart I-16, bottom panel), suggests the real might be entering a bear market. Bank stocks are a large part of the equity index, and they have lately been under severe selling pressure. We are reinstating our short position in Brazilian banks. We closed this position last week when we removed our short Brazilian banks / long Argentine banks equity recommendation due to the selloff in Argentine banks.4 The currency depreciation is forcing local interest rates to rise, which is causing liquidity to tighten in Brazil. High borrowing costs in real terms are inhibiting credit demand. In particular, banks' aggregate loans to companies and households in both nominal and real terms are still shrinking. Although consumer loans are rising, the contraction in corporate lending has more than offset the recovery in household credit. Further, Chart I-17 demonstrates that the relapse in nominal GDP growth (shown inverted in the chart) heralds a rise in the rate of change of non-performing loans (NPL) as well as their provisions. As provisions begin to rise, banks' earnings will take a hit. Chart I-18 illustrates that banks have been reducing NPL provisions to boost profits and a rate of change in provisions has been a decisive factor driving bank equity prices in recent years. Chart I-17Slower Nominal Growth = Higher Provisions & NPLs Slower Nominal Growth = Higher Provisions & NPLs Slower Nominal Growth = Higher Provisions & NPLs Chart I-18NPL Provisions And Bank Stocks NPL Provisions And Bank Stocks NPL Provisions And Bank Stocks Bottom Line: Re-establish a short bank stocks position, and continue to short the BRL versus the U.S. dollar and MXN. Remain underweight Brazilian stocks as well as sovereign and corporate credit within respective EM portfolios. Arthur Budaghyan, Senior Vice President Emerging Markets Strategy arthurb@bcaresearch.com Andrija Vesic, Research Analyst andrijav@bcaresearch.com Malaysia: Short-Term Challenges, Long-Term Opportunities Chart II-1Malaysia: Banks Have Been ##br##'Cooking Their Books' Malaysia: Banks Have Been 'Cooking Their Books' Malaysia: Banks Have Been 'Cooking Their Books' The election victory by the Malaysian opposition coalition, Pakatan Harapan, offers a major opportunity to reverse the significant deterioration in Malaysia's governance and, hence, poor productivity growth that has occurred under the former Prime Minister Najib Razak. The political change is therefore a bullish development for Malaysia in the long-run. As such, we are placing the Malaysian bourse on an upgrade watch list. Yet the performance of Malaysia's financial markets in the coming months will remain challenged by vulnerabilities emanating from the country's weak banking system and potential negative forces that will subdue its external sector. These factors will slow growth in the months ahead, hurt the ringgit and exert downward pressures on Malaysian share prices: The health of Malaysian commercial banks is questionable. Since the economic downturn started in 2014, banks have grossly underreported their non-performing loans (NPLs) (Chart II-1). Additionally, they have been lowering NPL provisions to artificially boost their earnings in the past year or so (Chart II-1, bottom panel). Hence, banks' reported earnings are inflated. The former government tolerated these actions to ensure "economic and financial stability". Yet this sense of false "stability" will reverse under the new government. The latter headed by incoming Prime Minister Mahathir Mohamad will likely attempt to change leadership of state institutions and SOEs and also clean the financial system in order to improve its transparency and soundness. We suspect as a part of this restructuring, the authorities and the central bank will begin exerting pressure on commercial banks to recognize and provision for NPLs. It is always new leadership within financial regulatory institutions or banks that opt to open the books and recognize NPLs. Higher provisioning will cause bank earnings to slump considerably, jeopardizing their share prices (Chart II-2). Malaysian banks account for 34% of the MSCI Malaysia index and 40% of its total earnings. Finally, bank stocks are not cheap with a price-to-book value ratio of 1.6 and a trailing P/E ratio at 15. On the external front, rising U.S. bond yields will cause the U.S. dollar to strengthen versus the ringgit, which will not bode well for Malaysian financial assets. Chart II-3 shows that spreads of Malaysian local government bond yields over U.S. Treasurys have reached new cyclical lows. As such, local yields offer little caution for foreign bond investors. Given that around 29% of domestic currency bonds are owned by foreigners, the ringgit depreciation will likely generate selling pressure in the local bond market. Chart II-2Malaysia: Bank Stocks Are At Risk Malaysia: Bank Stocks Are At Risk Malaysia: Bank Stocks Are At Risk Chart II-3Malaysia: Local Bond Yields ##br##Spreads Over U.S. Treasurys Malaysia: Local Bond Yields Spreads Over U.S. Treasurys Malaysia: Local Bond Yields Spreads Over U.S. Treasurys Further, the outlook for Malaysia's trade balance is negative due to potential cracks in the semiconductors industry and in commodities. Semiconductors account for 15% of Malaysia's exports while commodities account for around a quarter of its exports; with energy making up 14% exports and palm oil accounting for 8%. Malaysian exports of semiconductors are likely peaking. Chart II-4 shows that the average of Taiwan's and Korea's semiconductors shipment-to-inventory ratios is pointing to a deceleration in Malaysia's semiconductor exports. Taiwan and Korea are major semiconductor manufacturing hubs that ship some of their chips to Malaysia for testing and assembly. On this note, Chart II-5 shows that Taiwanese semiconductor exports to Malaysia are decelerating. This is confirming a forthcoming slump in Malaysia's semiconductor exports. And finally, various semiconductor prices are beginning to decline. Chart II-4Malaysia's Semiconductor Industry At Risk Malaysia's Semiconductor Industry At Risk Malaysia's Semiconductor Industry At Risk Chart II-5Malaysia's Semi Exports To Slow Malaysia's Semi Exports To Slow Malaysia's Semi Exports To Slow As for commodities, palm oil prices have been weak (Chart II-6). The industry is facing significant headwinds due to import restrictions from India and the EU. Besides, Malaysia is probably bound to lose palm oil market share to Indonesia. China and Indonesia signed an agreement last week with the former agreeing to purchase more of this commodity from Indonesia. Chart II-6Unusual Divergence Between ##br##Oil And Palm Oil Prices Unusual Divergence Between Oil And Palm Oil Prices Unusual Divergence Between Oil And Palm Oil Prices Meanwhile, as our colleagues from the Geopolitical Strategy service argued this week, the incoming Prime Minister Mahathir Mohamad plans to review some Chinese investments in Malaysia that were undertaken by his predecessor.5 Doing so could induce China to retaliate by limiting Malaysian palm oil imports and reducing imports of other Malaysian products as well. Around 13% of Malaysian exports are shipped to China. A final word on oil is warranted. The surge in oil prices is unambiguously bullish for this economy. However, it is important to realize that this price surge is driven by escalating geopolitical risks and mushrooming traders' net long positions in crude rather than global demand. The former might persist for some time as U.S.-Iran hostilities linger. Continued strength in the dollar, however, could trigger a considerable decline in oil prices as traders head for the exits. On the whole, Malaysia's current account balance will deteriorate which will weigh on the Malaysian currency and hurt U.S. dollar returns of Malaysian financial assets. Faced with currency depreciation, the Malaysian central bank is unlikely to defend the currency by hiking interest rates or selling its foreign exchange reserves (doing so would also tighten banking system liquidity). The Malaysian economy cannot bear much higher interest rates as private-sector debt-to-GDP stands at a whopping 134%. In the meantime, currency depreciation will inflict pain on debtors with foreign currency liabilities. Malaysian companies are amongst the largest foreign currency borrowers in the developing economies univers. In short, the ringgit will come under material selling pressure like many other EM currencies and this will hurt the economy. This will also weigh on the equity index - which is dominated by banks. Bottom Line: While we recommend investors to maintain an underweight position in Malaysian equities for now, we are placing this bourse on upgrade watch list given the positive election results. We are waiting for the following to occur before upgrading Malaysia's stock market: (1) Commodities prices to fall and the semiconductor cycle to slow and (2) Malaysian commercial banks to recognize more NPLs and increase provisioning for bad loans. Meanwhile, currency traders should stay short MYR versus the U.S. dollar and equity investors should remain short banks. Finally, for fixed-income traders we continue to recommend long Thai / short Malaysia local bonds. Credit portfolios should underweight this sovereign credit for now. Ayman Kawtharani, Associate Editor ayman@bcaresearch.com 1 This index is constructed using an equal-weighted index of six total return commodities currencies such as BRL, CLP, ZAR, AUD, NZD and CAD divided by the total returns of the safe-haven currencies: JPY and CHF. 2 Cash earnings are defined and calculated by MSCI as earnings per share including depreciation and amortization as reported by the company - i.e. depreciation and amortization expenses are added to earnings in order to calculate cash earnings. 3 For example, please refer to discussion on Brazilian and Malaysian banks on pages 7 and 13, respectively. 4 Please refer to Emerging Markets Strategy Weekly Report "EM: A Correction Or Bear Market?" dated May 10, 2018, link is available on page 20. 5 Pleas see Geopolitical Strategy Weekly Report "Are You Ready For "Maximum Pressure?" dated May 16, 2018, available on gps.bcaresearch.com Equity Recommendations Fixed-Income, Credit And Currency Recommendations

There is scant evidence that the character of the equity market advance is changing and the fact that weak balance sheet stocks are no longer outperforming strong balance sheet stocks is giving us pause (Chart 1). Chart 1Time To Pause And Reflect Time To Pause And Reflect Time To Pause And Reflect Using the Goldman Sachs equity baskets - that utilize the 'Altman Z-score' framework to select stocks - via Bloomberg, we find that the weak balance sheet over strong balance sheet share price ratio leads the broad market at both peaks and is coincident at troughs. The most recent peak occurred in early 2017 and it is rather surprising that a proxy for this ratio using the fixed income market, i.e. the total return high yield bond index versus the total return investment grade bond index, is moving in the opposite direction and not confirming the equity market's message (Chart 2). This begs the question: Which market signal is right, stocks or fixed income, and what are the equity sector investment implications? But before trying to answer these questions, we first zoom out and look at the broad U.S. debt picture. How Will It All End? In our travels and conference calls one common question keeps coming up: What will end all this? The short answer is that rising interest rates will eventually deal a blow to the debt overhang and the expansion will give way to a fresh deleveraging cycle. In other words, a whiff of inflation will entice the Fed to keep on raising the fed funds rate to the point where the business cycle turns down. As demand falters, a decreasing cash flow backdrop will not be able to service the debt overload, as both coupon payments and principal repayments will become a big burden. This will ignite a jump in the default rate, a message the yield curve is already sending (Chart 3). Chart 2Which Market Is Right? Which Market Is Right? Which Market Is Right? Chart 3Has The Junk Default Rate Troughed? Has The Junk Default Rate Troughed? Has The Junk Default Rate Troughed? Peering back to the onset of the GFC, a U.S. financial sector debt crisis engulfed the world. Subsequently, this morphed into a government sector debt problem in the Eurozone and more recently into a non-financial corporate sector debt overhang mostly in the commodity complex and the emerging markets. Debt Supercycle Lives On The investment world is obsessed with China's excess debt uptake and that is a valid concern. However, investors should also be aware that U.S. debt has not been fully purged. Rather, it has moved around between different domestic sectors. The debt supercycle lives on.1 The implication is that an interest rate-induced debt bubble pricking would be deflationary, and thus identifying the U.S. domestic sector most exposed to such risk is important. Chart 4 breaks down U.S. total debt into the four largest sectors using flow of funds data. While households and the financial sector have significantly de-levered, the government and the non-financial business sector have been picking up the slack and aggressively re-levering. While the Trump Administration has embarked on a two-year fiscal policy easing period that will add to the government debt profile, the nonfinancial corporate debt overhang is more vulnerable and thus troublesome in our view (fed funds rate shown inverted, Chart 5). Worrisomely, since the GFC, nonfinancial corporates have been issuing debt and partially using this debt to retire equity and pay handsome dividends. According to the flow of funds data, the cumulative nonfinancial net equity retirement figure stands near $4tn over the past decade (middle panel, Chart 6). Undoubtedly, this has been a large contributor to equity market returns (top panel, Chart 6), and will likely gain further momentum this year on the back of the tax repatriation holiday. Some sell side equity retirement estimates for the S&P 500 hover around $800bn for calendar 2018 or roughly twice the past decade's annual average. AAPL's recent announcement of a $100 billion share repurchase program confirms that the buyback bonanza is persevering and will continue to boost equities. Clearly, such breakneck equity retirement pace is unsustainable and will converge down to a lower trend rate in 2019 and beyond, especially given the drying liquidity as the Fed continues to pursue a tighter monetary policy. Chart 4Debt Is Moving Around Debt Is Moving Around Debt Is Moving Around Chart 5Tight Monetary Policy Pricks Bubbles, And... Tight Monetary Policy Pricks Bubbles, And… Tight Monetary Policy Pricks Bubbles, And… Chart 6...Threatens To End The Equity Retirement Binge …Threatens To End The Equity Retirement Binge …Threatens To End The Equity Retirement Binge Introducing BCA's Sector Insolvency Risk Monitor (IRM) The purpose of this Special Report is to identify debt soft spots and outliers in the U.S. GICS1 equity sectors. What follows is a financials statement-heavy analysis of sector indebtedness. We introduce the 'Altman Z-score' sector analysis that gauges sector credit strength, with a rising score indicating improving health and a declining Z-score signifying deteriorating health.2 In absolute terms, a score below 1.8 warns of a possible credit event, whereas any reading above 3 signals that bankruptcy risk is very low (see appendix below). Our analysis includes our flagship Bank Credit Analyst's Corporate Health Monitor framework that breaks down corporate health in the different sectors3 (see appendix below). We also sift through a number of different stock market reported ratios/data to gauge each sector's health, with net debt-to-EBITDA and interest coverage at the forefront of our analysis, and try to identify outliers (see appendix below). Finally, with the invaluable help of BCA's Chief Quantitative Strategist, David Boucher, we created our new insolvency risk monitor (IRM) per U.S. equity sector incorporating the respective 'Altman Z-scores', BCA's corporate health monitor readings and net debt-to-EBITDA ratios. In more detail, we ranked each sector (ex-financials and real estate) on a monthly basis on each of these three measures. Then we used a simple average of the ranked measures per sector to come up with the final sector ranking. We also selected the median sector ranking per measure and used the average of the three metrics as a proxy for the broad market.4 This way we were able to compare each sector IRM to the overall market. Note that the IRMs are designed so that a higher IRM ranking means better solvency. Charts 7 & 8 summarize the results and showcase this new all-inclusive relative ranking alongside relative share price performance. Chart 7Unsustainable... Unsustainable… Unsustainable… Chart 8...Divergences ...Divergences ...Divergences Sector Outliers Consumer discretionary stocks are the clearest outliers and the message from the relative IRM is to expect a significant underperformance phase in the coming quarters (top panel, Chart 7). AMZN's juggernaut is blurring the discretionary landscape given its 20% index weight, and artificially boosting relative share prices. Ex-AMZN, this early cyclical sector is behaving similar to previous episodes when the Fed embarked on a tightening interest rate cycle. We reiterate our recent downgrade to a below benchmark allocation.5 Consumer staples equities are steeply deviating from their increasing relative IRM score, underscoring that investors are unduly punishing staples stocks (second panel, Chart 8). We maintain our overweight stance and treat this sector as a small portfolio hedge to our otherwise general dislike of defensives (as a reminder we are underweight both the S&P health care and the S&P telecom services sectors). Chart 9Cyclicals Have The Upper Hand Cyclicals Have The Upper Hand Cyclicals Have The Upper Hand The utilities share price ratio is also deviating from the IRM relative reading (fourth panel, Chart 8). The implication is that extreme bearishness toward the sector is overdone and we reiterate our mid-February upgrade to a neutral stance.6 Energy stocks have fallen behind the energy IRM rebound reading (top panel, Chart 8). We expect a catch up phase on the back of the global capex upcycle, still improving debt profile, favorable underlying commodity supply/demand dynamics and firming oil prices. The S&P energy sector remains a high-conviction overweight. The niche materials sector is also trailing the sector's slingshot IRM recovery. Keep in mind that, as expected, the materials IRM is one of the most volatile series (second panel, Chart 8). Materials manufacturers are capital intensive and high operating leverage businesses and despite the debt dynamic betterment since the recent global manufacturing recession, this sector is still saddled with a large amount of debt that makes it extremely sensitive to the ebbs and flows of global economic growth. We continue to recommend a benchmark allocation. The remaining sectors' (tech, health care, telecom services and industrials) relative share prices are moving in tandem with their respective IRM readings (Charts 7 & 8). In addition, we have complied all the cyclical and defensive IRMs in two distinct series and the relative IRM ratio is giving the all-clear sign to continue to prefer cyclicals over defensives on a 9-12 month time horizon (Chart 9). So What? In sum, the IRM is one new additional metric we are using to gauge the validity of our sector positioning and should not be used in isolation. To answer our original question, while the weak balance sheet versus strong balance sheet stock underperformance is alarming and we will continue to closely monitor this stock price ratio, it is premature to change our constructive overall equity market view on a 9-12 month horizon. We therefore continue to recommend a cyclical over defensive portfolio bent. Finally, for completion purposes, the appendix below shows a number of debt-related indicators we track, including the absolute 'Altman Z-score' and corporate health monitor readings, in two charts per sector along with the cyclicals over defensives compilation and the overall market (ex-financials). Anastasios Avgeriou, Vice President U.S. Equity Strategy anastasios@bcaresearch.com 1 For a primer on the debt super cycle please refer to Box 1 in the BCA Special Year End Issue: "Outlook 2013: Fewer Storms, More Sunny Breaks," dated December 19, 2012, available at bca.bcaresearch.com. 2 Altman Z-Score = 1.2A + 1.4B + 3.3C + 0.6D + 1.0E. Where: A = working capital / total assets, B = retained earnings / total assets, C = earnings before interest and tax / total assets, D = market value of equity / total liabilities and E = sales / total assets. Source: https://www.investopedia.com/terms/a/altman.asp 3 Please see BCA The Bank Credit Analyst Report, "U.S. Corporate Health Gets A Failing Grade," dated January 28, 2016, available at bca.bcaresearch.com. 4 We refrained from using the top down computed S&P 500 'Altman Z-Score' and net debt-to-EBITDA as the financials sector really skewed the results and therefore opted to use the median sector 'Altman Z-score' and net debt-to-EBITDA as a proxy for the broad market because using the mean also skewed the results largely because of the tech sector. Staying consistent in our analysis, we also used the median sector BCA corporate health monitor to proxy the broad market. 5 Please see BCA U.S. Equity Strategy Weekly Report, "Reflective Or Restrictive?" dated March 12, 2018, available at uses.bcaresearch.com. 6 Please see BCA U.S. Equity Strategy Weekly Report, "Manic-Depressive?" dated February 12, 2018, available at uses.bcaresearch.com. Appendix U.S. Non-Financial Broad Market I U.S. Non-Financial Broad Market I U.S. Non-Financial Broad Market I U.S. Non-Financial Broad Market II U.S. Non-Financial Broad Market II U.S. Non-Financial Broad Market II U.S. S&P Industrials I U.S. S&P Industrials I U.S. S&P Industrials I U.S. S&P Industrials II U.S. S&P Industrials II U.S. S&P Industrials II U.S. S&P Energy I U.S. S&P Energy I U.S. S&P Energy I U.S. S&P Energy II U.S. S&P Energy II U.S. S&P Energy II U.S. S&P Consumer Staples I U.S. S&P Consumer Staples I U.S. S&P Consumer Staples I U.S. S&P Consumer Staples II U.S. S&P Consumer Staples II U.S. S&P Consumer Staples II U.S. S&P Tech I U.S. S&P Tech I U.S. S&P Tech I U.S. S&P Tech I U.S. S&P Tech I U.S. S&P Tech I U.S. S&P Utilities I U.S. S&P Utilities II U.S. S&P Utilities II U.S. S&P Utilities II U.S. S&P Utilities II U.S. S&P Utilities II U.S. S&P Materials I U.S. S&P Materials I U.S. S&P Materials I U.S. S&P Materials II U.S. S&P Materials II U.S. S&P Materials II U.S. S&P Consumer Discretionary I U.S. S&P Consumer Discretionary I U.S. S&P Consumer Discretionary I U.S. S&P Consumer Discretionary II U.S. S&P Consumer Discretionary II U.S. S&P Consumer Discretionary II U.S. S&P Telecom Services I U.S. S&P Telecom Services I U.S. S&P Telecom Services I U.S. S&P Telecom Services II U.S. S&P Telecom Services II U.S. S&P Telecom Services II U.S. S&P Health Care I U.S. S&P Health Care I U.S. S&P Health Care I U.S. S&P Health Care II U.S. S&P Health Care II U.S. S&P Health Care II U.S. S&P Cyclicals Vs. Defensives I U.S. S&P Cyclicals Vs. Defensives I U.S. S&P Cyclicals Vs. Defensives I U.S. S&P Cyclicals Vs. Defensives II U.S. S&P Cyclicals Vs. Defensives II U.S. S&P Cyclicals Vs. Defensives II

Highlights BCA's call is that the robust labor market will boost wages and incomes, and insulate the consumer from rising energy costs and interest rates. Residential investment will add to GDP growth this year and support housing-related investments. Q1 results for S&P 500 earnings and revenues are exceeding raised expectations amid increase in tariff talk. Feature Last Friday's employment report shows a strong U.S. labor market with moderate wage pressures. The Fed can continue with a leisurely pace of rate hikes, which do not disrupt risk assets. The U.S. economy added 164,000 of net new jobs in April. Taking into account the 30,000 upward revision to the prior months, the increase in payrolls was in line with the consensus forecast of 195,000. With the 3-month moving average at 208,000 the pace of jobs growth is running comfortably above the trend growth in the labor force. This is reflected in the unemployment rate dropping from 4.1% to a new cyclical low of 3.9%. The jobless rate is nearing the 3.8% low seen during the height of the tech bubble in 2000. Even though the pace of jobs growth is strong and the unemployment rate is probing new lows, wage gains remain moderate. Average hourly earnings increased by just 0.1% m/m in April. Moreover, last month's gain was revised down to 0.2% m/m from an initially reported 0.3% m/m. As a consequence, the annual rate of wage inflation has slowed slightly to 2.6% from a recent high of 2.8% in January. The underlying trend in wage inflation is higher, but it is fairly shallow (Chart 1). The April employment report is "Goldilocks" for U.S. equities. The labor market is strong and the economy is growing about 3%. With modest wage and inflation pressures, there is no need for the Fed to turn more aggressive to cool a rapidly overheating economy. The modest trajectory of Fed rate hikes alongside modest income gains and stout consumer balance sheets will insulate the largest segment of the economy from higher interest payments and rising gasoline costs. Residential construction will also benefit from a gradual central bank, and housing-related assets are poised to outperform. Corporate profits can also continue to grow while the Fed maintains a gradual pace of rate hikes. The Q1 earnings and revenue reports for S&P 500 firms are outstanding. BCA's call is that the robust labor market will boost wages and incomes, and insulate the consumer from rising energy costs and interest rates. As we stated in our report on April 2,1 conditions that crushed the consumer ahead of the 2007-2008 recession are not in place and will not be for some time. Chart 2 shows that at 41.8%, household purchases of essentials as a percentage of disposable income are near all-time lows and have dropped by more than 1% since early 2013. In contrast, spending on necessities rose by a record 3% in the five years ending 2008. This matches levels reached at the end of the 1980s when interest rates, inflation and oil prices all soared. Wrenching consumer-driven economic downturns ensued after both episodes. Chart 1Another Goldilocks##BR##Jobs Report For U.S. Risk Assets Another Goldilocks Jobs Report For U.S. Risk Assets Another Goldilocks Jobs Report For U.S. Risk Assets Chart 2Consumer Is Not Stressed##BR##Despite Higher Energy Costs Consumer Is Not Stressed Despite Higher Energy Costs Consumer Is Not Stressed Despite Higher Energy Costs While investors remain concerned that rising rates and higher energy costs could derail the consumer and slow the economy, we take a different view. Energy represents 3.8% of consumers' spending on essentials while interest costs account for 15.9%. BCA expects that the Fed will continue to raise rates gradually in the next 12 months, in lockstep with the market's stance. However, we anticipate that the Fed will be more aggressive from mid-2019 through mid-2020 as inflation moves beyond the Fed's 2% target. BCA's U.S. Bond Strategy service notes that if we assume that the equilibrium fed funds rate is approximately 3%, then the cyclical peak for the 10-year Treasury yield will occur between 3.35% and 3.52%,2 roughly 35 to 50 bps higher than current levels. In previous research, we stated that a modest rise in rates would not be a burden on consumers.3 BCA's Commodity & Energy Strategy team forecasts that West Texas Intermediate oil prices will average $70/bbl. in 2018 and $64/bbl. in 2019. However, it also notes that tight balances in global oil make it likely those numbers will make excursions to $80/bbl.4 If production in Venezuela deteriorates more than expected or the supply in Iran or Libya is compromised, then oil could move beyond $80/bbl and, depending on the supply disruptions, to $90/bbl. Chart 3 shows that the consumer can easily withstand a rise in oil prices to $90/bbl. BCA's assumption is that natural gas and electricity prices will remain at current readings. Chart 3U.S. Consumer Is Well Insulated From Rising Energy Costs U.S. Consumer Is Well Insulated From Rising Energy Costs U.S. Consumer Is Well Insulated From Rising Energy Costs Bottom Line: Tighter labor markets and rising incomes will overcome rising interest rates and higher oil prices, and allow consumers to contribute to above-trend GDP growth. We see gradual upturns ahead for both oil prices and interest rates, but nothing so significant to trigger the collapse of consumer spending. Housing and housing-related assets will also flourish in the next year. Housing-Related Assets: An Update Residential investment will add to GDP growth this year and support housing-related investments. Chart 4 shows that housing in this cycle lagged previous slow-burn recoveries5 by a wide margin. Inventories of new and existing homes are near all-time lows, and the homeownership rate has turned higher alongside incomes and household formation (Chart 5). BCA's view is that escalating mortgage rates are not an impediment to housing construction. Nonetheless, housing did not contribute to economic growth in Q1 2018, but it did add 0.46% to real GDP in Q4 2017 as construction activity surged following last summer's hurricanes in Florida and Texas. Chart 4Residential Investment's Share##BR##Of GDP Has Lagged Prior Long Cycles Residential Investment's Share Of GDP Has Lagged Prior Long Cycles Residential Investment's Share Of GDP Has Lagged Prior Long Cycles Chart 5Solid Housing##BR##Fundamentals In Place Solid Housing Fundamentals In Place Solid Housing Fundamentals In Place Chart 6 estimates the remaining pent-up demand for housing, based on the deviation from its 1990-2007 trend in the ratio of the number of households to the total population. A closing of the gap implies an extra 1.35 million housing units. The equilibrium number of housing starts that cover underlying population growth, plus the units lost to scrappage, is estimated at about 1.4 million annually. If the household formation 'catch up' fully occurs in the next two years, which would add another 675,000 units per year, then total demand could be close to 2 million in each of the next two years. This compares with March's housing starts of 1.3 million. Clearly, this is an aggressive forecast, and we doubt starts will advance at this pace in the next few years, but it does suggest that housing construction is likely to perk up. Chart 6A Catch-Up Housing Construction##BR##Will Occur If This Gap Closes A Catch-Up Housing Construction Will Occur If This Gap Closes A Catch-Up Housing Construction Will Occur If This Gap Closes The above analysis suggests that residential investment will contribute to GDP growth this year and next. There are favorable implications for housing-related financial assets. We originally examined the implications of a rebound in residential construction activity in 2012.6 Our approach was to test the historical excess return performance of several financial assets as a function of key housing market variables. We concluded that housing-related financial assets were set to outperform their respective benchmarks in a bullish housing scenario in the following year (and beyond). Our original analysis is updated in this report, with a few modifications. First, we examine the relationship between key housing market variables and excess returns of housing-related assets since the onset of the U.S. economic expansion in June 2009, given the structural change in the housing market that occurred following the Great Recession. Secondly, our analysis is based on a more focused set of housing market indicators, given the relatively poor predictive power of new home sales and the months' supply of houses for sale following the crisis period on housing-related asset returns. Table 1 presents the list of housing-related assets that we examined,7 along with the key housing market variables used to forecast excess returns (and whether they were significant predictors in the post-crisis era). The table highlights that most of the variables contain useful information, with the exception of the two noted above, sales of new homes and inventories of unsold homes. The right-most column presents the share of excess returns explained by a composite model of the factors noted as significant for each asset that varies from a low of 14% to a high of 22%. Table 1Important Predictors Of Housing-Related Asset Excess Returns* (June 2009-December 2017) Stressing The Housing And Consumer Sectors Stressing The Housing And Consumer Sectors Charts 7 and 8 present a set of relatively conservative assumptions for the key housing market variables shown in Table 1, based on a rise in housing starts only modestly above the scrappage rate referred to in the previous section. We assume that house price appreciation and housing affordability are moderate due to further rate hikes from the Fed and mounting inflation. We also suppose that the homebuilders' confidence index stays flat, refi applications remain low linked to the uptrend in mortgage rates, and purchase applications rise in conjunction with housing starts. Chart 7A Set Of Conservative Assumptions... A Set Of Conservative Assumptions... A Set Of Conservative Assumptions... Chart 8...For Key Housing Market Variables ...For Key Housing Market Variables ...For Key Housing Market Variables Finally, Table 2 illustrates the predicted excess returns of housing-related assets in the coming 12 months, along with the annualized excess returns in 2017 and, for reference, in the entire sample period. It is important to note that excess returns of corporate bonds are presented relative to duration-matched government bonds, not a speculative- or investment-grade corporate bond aggregate. Table 2Excess Returns Of Housing-Related Assets* (%) Stressing The Housing And Consumer Sectors Stressing The Housing And Consumer Sectors Investors can draw several important conclusions from our analysis: All but one of the housing-related assets are expected to outperform their respective benchmarks in the next year, even given our conservative assumptions about the pace of gains in the housing market. Our model predicts outperformance for the three corporate bond assets (shown in Tables 1 and 2) relative to their respective corporate bond benchmarks, albeit only marginally in the case of investment-grade banks. Moreover, the model projects modest outperformance for agency MBS. With the exception of S&P 500 banks, the model's predicted excess returns are lower in the coming year than they have been on an annualized basis since the onset of the recovery. This highlights that housing-related assets have moved ahead at least some of the expected normalization in the housing market over the next few years. However, a full rise to our equilibrium estimate of 2 million starts during the next two years could potentially lead to an even larger outperformance than the model forecasts. Moreover, Charts 9A and 9B suggest that valuation will not be an impediment to the outperformance of housing-related assets. Chart 9AValuation Won't Be An Impediment... Valuation Won't Be An Impediment... Valuation Won't Be An Impediment... Chart 9B...For Housing Related Assets ...For Housing Related Assets ...For Housing Related Assets Bottom Line: Investors should look to housing-related assets as a source of potential outperformance in 6-12 months. The historical relationship between key housing market variables and the excess returns of these assets implies the latter is set to outperform, even given conservative assumptions about the housing factors. Stunning Results More than 80% of S&P 500 companies have reported Q1 results, and EPS and sales growth are well ahead of consensus expectations at the start of April. Moreover, the counter-trend rally in margins remains in place. We previewed the Q1 2018 S&P 500 earnings season earlier this year.8 82% of companies have released results so far, with 79% beating consensus EPS projections, which is well above the long-term average of 69%. Moreover, 76% have posted Q1 revenues that topped expectations, exceeding the long-term average of 56%. The surprise factor for year-over-year numbers in Q1 stands at a robust 7% for EPS and 1.5% for sales. The earnings surprise reading is well above the long-term average of 5%, while the sales surprise figure is right at the long-term average. Both the earnings and sales surprise figures are even more impressive given that analysts' views of Q1 results increased between the start of Q1 2018 and the actual Q1 reporting season. Analysts' estimates typically move lower as a quarter unfolds, in effect lowering the bar for results. Table 3S&P 500: Q1 2018 Results* Stressing The Housing And Consumer Sectors Stressing The Housing And Consumer Sectors We anticipate the secular mean-reversion of margins to re-assert itself in the S&P data, perhaps beginning in mid-2018. Even so, the results to date suggest that Q1 will be another quarter of margin expansion. Average earnings growth (Q1 2018 versus Q1 2017) is a stunning 26% with revenue growth at 8%. However, on a four-quarter basis, U.S. margins fell slightly in the fourth quarter. Still, they remain high on the back of decent corporate pricing power. Strength in earnings and revenues is broadly based (Table 3). Earnings per share rose in Q1 2018 versus Q1 2017 in all 11 sectors. EPS results are particularly stout in energy (84%), technology (35%), financials (30%), materials (30%) and industrials (25%). The technology, materials, real estate and industrial sectors likewise all experienced substantial sales gains (16%, 13%, 14% and 11% respectively). Excluding energy, S&P 500 profits in Q1 2018 versus Q1 2017 are still vigorous at 24%. BCA's U.S. Equity Strategy service introduced profit models for all 11 S&P 500 sectors in January.9 Optimistic managements have raised the bar significantly for 2018 results in the past few months (Chart 10). On October 1, 2017, before the GOP introduced the tax bill, the bottom-up estimate for the S&P 500's 2018 EPS growth stood at 11%. The assessment grew to 20% at the start of the earnings reporting season in early April. As of May 4, 2018, the figure climbed slightly to 22%. Moreover, the upward revisions are widespread. Calendar year 2018 EPS growth rate estimates in 10 of 11 sectors are higher today than at the start of October 2017. Chart 10High Bar For 2018... But Focus Will Quickly Turn To 2019 High Bar For 2018... But Focus Will Quickly Turn To 2019 High Bar For 2018... But Focus Will Quickly Turn To 2019 While the ebullience is linked to the tax bill, other factors such as solid global growth, a steeper yield curve and higher energy prices are also responsible. The tax bill lowered the corporate tax rate for 2018 and the repatriation holiday provides firms with excess cash. However, U.S. trade policy is a concern in several industries. Chart 11 shows that through April 27, 45 companies cited tariffs in their Q1 earnings calls, a jump from 5 in the Q4 2017 reporting season. The Fed's business and banking contacts mentioned either tariffs or trade policy 44 times in the latest Beige Book (April 18); there were only 3 mentions in the March edition.10 Analysts expect EPS growth to slow significantly in 2019 (9%) from the anticipated 2018 clip, which matches BCA's stance (Chart 12). However, unlike estimates for 2017 and 2018, we anticipate that EPS estimates for 2019 will move lower throughout 2018 and 2019, ahead of a recession in early 2020. Chart 11Plenty Of Tariff Talk##BR##In Q1 Earnings Calls Plenty Of Tariff Talk In Q1 Earnings Calls Plenty Of Tariff Talk In Q1 Earnings Calls Chart 12Strong S&P 500 EPS Growth Ahead,##BR##Will Start To Slow Soon Strong S&P 500 EPS Growth Ahead, Will Start To Slow Soon Strong S&P 500 EPS Growth Ahead, Will Start To Slow Soon Bottom Line: EPS growth is expected to peak at over 20% later this year (4-quarter moving total basis using S&P 500 data) and subsequently decelerate because of a modest margin squeeze as U.S. wage growth picks up (Chart 11). A slowdown in global growth will also crimp profit growth later this year. Incorporating the fiscal stimulus lifted the EPS growth profile relative to our previous forecast. Nonetheless, BCA believes that the earnings backdrop will remain a tailwind for the equity market. The Tax Cut and Job Act raised expectations for 2018 in most sectors and so far, corporate managements have exceeded the lofty projections. However, it may be more difficult to maintain in the second half of 2018. Stay overweight stocks versus bonds. John Canally, CFA, Senior Vice President U.S. Investment Strategy johnc@bcaresearch.com 1 Please see BCA Research's U.S. Investment Strategy Weekly Report, "Has Global Growth Peaked?", published April 2, 2018. Available at usis.bcaresearch.com. 2 Please see BCA Research's U.S. Bond Strategy Weekly Report "A Signal From Gold?", published May 1, 2018. Available at usbs.bcaresearch.com. 3 Please see BCA Research's The Bank Credit Analyst Monthly Report from February 2017. Available at bca.bcaresearch.com. 4 Please see BCA Research's Commodity & Energy Strategy Weekly Report, "Tighter Balances Make Oil Price Excursions To $80/bbl Likely", published April 19, 2018. Available at ces.bcaresearch.com. 5 Please see BCA Research's The Bank Credit Analyst Monthly Report from March 2017. Available at bca.bcaresearch.com. 6 Please see BCA Research's U.S. Investment Strategy Weekly Report," U-3 Or U-6?," published February 13, 2012. Available at usis.bcaresearch.com. 7 Note that we have excluded fixed- and floating-rate home equity loan ABS from our list of housing-related assets because of a lack of data, as well as investment-grade REITs because of a very low degree of return predictability from key indicators of the housing market. 8 Please see BCA Research's U.S. Investment Strategy Weekly Report, "Has Global Growth Peaked?", published April 2, 2018. Available at usis.bcaresearch.com. 9 Please see BCA Research's U.S. Equity Strategy Special Report, "White Paper: Introducing Our U.S. Equity Sector Earnings Models," published January 16, 2018. Available at uses.bcaresearch.com. 10 Please see BCA Research's U.S. Investment Strategy Weekly Report, "Short Term Caution Warranted", published April 23, 2018. Available at usis.bcaresearch.com.

Highlights Portfolio Strategy Reviving global machinery end-demand alongside a global capex upcycle, are the key pillars of our high-conviction overweight call in the S&P construction machinery & heavy truck index. The current macro backdrop is unforgiving for defensive insurance stocks. Leading indicators of pricing power warn that softening prices coupled with expanding headcount will weigh on insurance profits in the coming quarters. Recent Changes There are no changes to our portfolio this week. Table 1 Lifting SPX Target Lifting SPX Target Feature Equities moved laterally last week and continued to consolidate the early-February tremor, unimpressed by better than expected profit growth across the board. The SPX has been oscillating in a 10% range over the past three months and has been a trader's (and bank's) paradise. There are high odds that this trading range will stay in place and the market will churn until the summer before breaking out (Chart 1). Chart 1Breakout Looming? Breakout Looming? Breakout Looming? Nevertheless, the anemic equity market response to solid earnings is slightly unnerving. Soft EPS guidance and perky input cost inflation are two thorny issues revealed this earnings season. With that in mind, we have identified three key brewing equity market headwinds: EPS growth deceleration toward 10%. Rising interest rates. U.S. dollar reflex rebound. Chart 2Monitoring The Correlation Monitoring The Correlation Monitoring The Correlation 20% profit growth is this cycle's peak rate, and we have been flagging in recent research1 that, beneath the surface, investors are slowly starting to revise expectations lower toward the 10% growth projection for calendar 2019 EPS. Simultaneously, interest rates continue their ascent and may cause some consternation in stocks. Not only does a higher discount rate weigh on valuations, but also the Fed's tightening cycle will eventually slam the brakes on the economy, with housing and the consumer feeling the higher interest rate knock-on effects most intensely. As we highlighted recently,2 we are closely monitoring the correlation between stocks and the 10-year Treasury yield and looking out for a collapse into negative territory to signal an economic (and market) choke point (Chart 2). Finally, recent ECB and BoJ chatter of easy monetary policies for as far as the eye can see, may have put a floor on the greenback, at least temporarily, with the Fed going it alone and lifting the fed funds rate into 2019 and beyond. While all three headwinds suggest that the market may have trouble breaking out of its funk in the next few months, on a cyclical 9-12 month horizon we remain upbeat on equity return prospects. Any U.S. dollar advance is likely a bear market rally and will take time to filter negatively through to earnings. Rising interest rates are also a consequence of higher economic growth which is a positive, i.e. real rates are rising alongside inflation expectations. And, if the SPX attains 10% EPS growth in 2019 as we expect, that is an above trend EPS growth rate and twice as high as nominal GDP growth, an impressive feat at this stage of the cycle. This week we are updating our SPX target to 3,200. We first came up with our SPX end-of-cycle target last July using three different methods:3 a traditional dividend discount model (DDM), EPS and multiple sensitivity analysis and forward equilibrium equity risk premium (ERP) analysis. As a reminder, this 3,200 SPX level is a peak number before the next recession hits and Table 2 summarizes our updated results (if you would like to receive the excel spreadsheet with the three models so you can tweak our inputs/assumptions please click here). In our DDM, our discount rate assumptions remain intact and very conservative. We use an up-to-date annual dividend per share number and back out dividends in U.S. dollars via the updated SPX divisor and make a conservative assumption of no buybacks in the coming years. The recession-related 10% dividend cut has moved to 2020, in line with BCA's view. Finally, we rolled over our estimates to 2023 resulting in a roughly 3,200 SPX peak value estimate. Our EPS and multiple sensitivity analysis starting point is $191 EPS in 2020 (this is in line with the sell-side bottom up estimate according to IBES data) and a 16.5 multiple. That equates to an SPX ending value of near 3200. Table 2SPX Target Using Three Different Methods Lifting SPX Target Lifting SPX Target With regard to the ERP analysis (Chart 3), our forward ERP equilibrium remains at 200bps. 2020 EPS come in at $191, and we also pencil in 100bps selloff in the bond market, resulting in an SPX 3,200 estimate. Chart 3ERP Has Room To Fall ERP Has Room To Fall ERP Has Room To Fall This week we are updating a high-conviction overweight call in a deep cyclical index, and reiterate a below benchmark allocation in a financials sub-index. The CAT Is Roaring, Is The Market Listening? Early last October we upgraded the S&P construction machinery & heavy truck (CMHT) index to overweight, and two months later we added it to the high-conviction overweight call list. On January 29th, right after the broad market hit its all-time highs, we managed to book impressive 10% relative gains as we introduced a risk management tool and instituted trailing stops to the high-conviction calls that cleared the 10% relative return mark. Subsequently, we reinstated the S&P CMHT index to the high-conviction overweight call list, at a deflated price point, as our constructive cyclical backdrop never wavered. Currently, our thesis remains intact: reviving global machinery end-demand alongside a global capex upcycle are a harbinger of sustained profit outperformance. While some leading indicators of global growth have recently crested, global output will remain brisk and above trend. When global growth is expanding, machinery demand typically demonstrates its high beta characteristics. Our global machinery exports proxy is firing on all cylinders rising to multi-year highs and sell side analysts have taken notice: S&P CMHT net earnings revisions are as good as they get (bottom panel, Chart 4). Encouragingly, the softening dollar suggests that U.S. exports have the upper hand and are grabbing market share. BCA's global machinery new orders proxy corroborates the trade data and underscores that machinery profits will overwhelm (middle panel, Chart 4). Dissecting global machinery demand is revealing. Importantly, previously moribund Chinese loan demand has reversed course and is now gaining traction. Tack on the recent steep fall in interest rates and factors are falling into place for a durable pick up in Chinese machinery consumption. Indeed, hypersensitive Chinese excavator sales continue to expand at a breakneck pace (Chart 5). Elsewhere in Asia, highly-cyclical Japanese machine tool orders likewise defy gravity vaulting to fresh all-time highs (Chart 5). The commodity complex also confirms the enticing global machinery end-demand backdrop. The broad commodity index in general and crude oil prices in particular have been reaccelerating of late. The energy space is a key end-customer for the machinery industry and $75/bbl global oil prices have reignited a fresh drilling cycle (Chart 6). Chart 4Global Machinery End-Demand Is Upbeat... Global Machinery End-Demand Is Upbeat... Global Machinery End-Demand Is Upbeat... Chart 5...And Asia Is Leading The Pack ...And Asia Is Leading The Pack ...And Asia Is Leading The Pack Chart 6Commodities Give The All Clear Sign Commodities Give The All Clear Sign Commodities Give The All Clear Sign Even the U.S. machinery demand backdrop is vibrant. The V-shaped recovery in U.S. machinery order books remains intact. Fiscal easing is reviving animal spirits and CEOs are voting with their feet: overall capital outlays are rising at a healthy clip, positively contributing to GDP growth, with machinery fixed capital formation growth recently clearing the 20%/annum hurdle (Chart 7). Capex intentions according to the regional Fed surveys are also holding near recent cyclical highs, and were Congress to pass an infrastructure bill that would be an additional boon to machinery top and bottom line growth (Chart 7). On the domestic operating front, machinery factories are humming and given that capacity is contracting, the industry is regaining its pricing power footing (Chart 8). The upshot is that this high-operating leverage industry should continue to enjoy outsized profit gains. Chart 7Even U.S. Machinery Demand Is Firming Even U.S. Machinery Demand Is Firming Even U.S. Machinery Demand Is Firming Chart 8Operating Metrics Flashing Green Operating Metrics Flashing Green Operating Metrics Flashing Green Nevertheless, there are two key risks to our otherwise bullish machinery thesis that we are closely monitoring. First, input costs are on the rise both in terms of labor and raw commodities (bottom panel, Chart 9). If the industry fails to pass this input cost inflation down the supply chain, then a margin squeeze is likely. Second, and most importantly, a hard landing in China would put our constructive machinery view offside, but we assign low odds to a gap down in Chinese economic activity (middle panel, Chart 9). Finally, given the recent consolidation phase, the S&P CMHT index has a valuation cushion as per the neutral reading in our relative valuation indicator. Similarly overbought conditions have been worked out and our technical indicator is also hovering near the neutral zone offering a compelling entry point to commit fresh capital (Chart 10). Chart 9Two Risks To Bullish View Two Risks To Bullish View Two Risks To Bullish View Chart 10Compelling Entry Point Compelling Entry Point Compelling Entry Point Bottom Line: We reiterate our high-conviction overweight call in the S&P construction machinery & heavy truck index. The ticker symbols for the stocks in this index are: BLBG: S5CSTF - CAT, CMI, PCAR. Insurance Expiry Notice While we continue to recommend a core portfolio overweight in the S&P financials index via the banks (high-conviction), asset managers and investment banks sub-indexes, the S&P insurance index remains our sole underweight. Unlike its financials brethren, the insurance industry is defensive rather than cyclical and thrives when the economy is slowing. Fairly stable, recurring and, most of the time, predictable revenue streams are sought after attributes when economic growth is scarce. Currently, the U.S. and global economies are expanding above trend, the global capex upcycle is running at full steam and CEOs and consumers alike exude confidence. Under such a backdrop, investors have historically avoided insurance equities. Chart 11 drives this point home. Over the past four decades the greenback and relative share prices have been positively correlated. The U.S. dollar peaked in December 2016 and since then it has been goosing global output, and simultaneously weighing on insurance stocks. Similarly, a rising 10-year Treasury yield reflecting improving economic growth also anchors insurance stocks (10-year Treasury yield shown inverted, Chart 12). While higher interest rates are positive for investment portfolio income, they also imply mark-to-market losses on bond portfolios. Higher interest rates also incent insurers to underwrite at a faster pace with more lenient standards, which is often a precursor to increased competition and diminishing pricing power, eventually sapping profits. Chart 11Insurance Is Defensive Insurance Is Defensive Insurance Is Defensive Chart 12Higher Yields Hurt More Than Help Higher Yields Hurt More Than Help Higher Yields Hurt More Than Help On the pricing front, there seems to be a bifurcated market. Auto insurance pricing is hardening, but home insurance is moving in the opposite direction (Chart 13). The slingshot recovery in auto loans versus residential real estate loans partially explains the big delta in pricing as subprime auto loans excesses have, at the margin, boosted new and used vehicle sales. This is not sustainable and there are high odds that this extra demand will level off in the coming months as the subprime auto credit screws inevitably tighten, eventually dampening car insurance prices. Worrisomely, the latest Fed Senior Loan Officer Survey revealed that not only is demand for auto loans waning, but also bankers are no longer willing extenders of auto related credit. Taken together, momentum in housing and auto sales is nil, warning that insurance top line growth will trail the broad market (Chart 14). Unsurprisingly, relative consumer outlays on insurance remain moribund, and a far cry from the previous cyclical peak, warning that it is premature to expect a valuation re-rating (second panel, Chart 15). Chart 13Margin Trouble? Margin Trouble? Margin Trouble? Chart 14Softening Demand Softening Demand Softening Demand Chart 15Insurance Indicator Message: Shy Away Insurance Indicator Message: Shy Away Insurance Indicator Message: Shy Away With regard to input costs, insurance labor additions continue unabated, trumping overall non-farm payrolls and the broad financial services industry since the GFC trough. Our insurance wage bill proxy is closing in on 4%/annum (bottom panel, Chart 13), warning that a margin squeeze looms. Our Insurance Indicator does an excellent job encapsulating all of these different signals and has recently taken a turn for the worse (third panel, Chart 15), underscoring that the path of least resistance is lower for relative share prices in the coming months. Bottom Line: We reiterate our underweight stance in the S&P insurance index. The ticker symbols for the stocks in this index are: BLBG: S5INSU - AIG, CB, MET, MMC, PRU, TRV, AFL, AON, ALL, PGR, WLTW, HIG, PFG, L, CINF, LNC, XL, AJG, UNM, TMK, AIZ, RE, BHF. Anastasios Avgeriou, Vice President U.S. Equity Strategy anastasios@bcaresearch.com 1 Please see BCA U.S. Equity Strategy Weekly Report, "Bumpier Ride," dated March 26, 2018, available at uses.bcaresearch.com. 2 Please see BCA U.S. Equity Strategy Weekly Report, "Reflective Or Restrictive?" dated March 12, 2018, available at uses.bcaresearch.com. 3 Please see BCA U.S. Equity Strategy Weekly Report, "SPX 3,000?" dated July 10, 2017, available at uses.bcaresearch.com. Current Recommendations Current Trades Size And Style Views Favor value over growth Stay neutral small over large caps (downgrade alert)

Highlights Our indicators suggest that investors should be especially cautious in the next month or two. April's Beige Book supports our view that higher inflation will lead to at least three more Fed rate hikes this year. However, the nation's trade policy is a concern for businesses. BCA's Bankers' Beige Book is booming. The Q1 earnings reporting season is off to a strong start, with both EPS and revenue growth exceeding consensus expectations at the start of April. Feature U.S. equity prices may struggle in the next few months. BCA's base case is that global growth will stabilize at an above-trend pace. Fiscal policy is a tailwind and global monetary policy remains easy, although several central banks are removing some of the accommodation. Moreover, the Fed sees only moderate risks to financial stability at home and abroad, its latest Beige Book is upbeat amid concerns over trade and labor shortages, and the Q1 earnings season is off to a strong start. BCA's Bankers' Beige Book for Q1 is booming. Nonetheless, BCA's Global Investment Strategy's MacroQuant model1 suggests that equities will struggle in the short-term. In our Bank Credit Analyst publication, the Equity Scorecard (Chart 1) and its Bear Market Checklist (Table 1) are both flashing red.2 The U.S.-China trade spat will linger for several more months and trade protectionism remains a risk. BCA's Geopolitical Strategy service notes that the stock market will likely seesaw during the summer as confusion grows amidst the upcoming geopolitical event risk (Table 2).3 Markets could also dip on Iran-U.S. tensions, an escalation of the conflict in Syria and a Russia-West confrontation. Indeed, sanctions on Russia are already pushing some base metal prices higher. Moreover, oil prices are more susceptible to supply disruptions given the tightness of global oil markets (Chart 2). BCA views any spike in oil prices as a tax on U.S. consumers. Chart 1Equity Scorecard: Flashing Red Equity Scorecard: Flashing Red Equity Scorecard: Flashing Red Table 1Exit Checklist Short-Term Caution Warranted Short-Term Caution Warranted Table 2Protectionism: Upcoming Dates To Watch Short-Term Caution Warranted Short-Term Caution Warranted Chart 2Oil Markets Are Tight Oil Markets Are Tight Oil Markets Are Tight Bottom Line: The 12-month cyclical outlook is still reasonably positive for risk assets such as stocks. Nonetheless, the near-term is fraught with risk. Our indicators suggest that investors should be especially cautious in the next month or two. Focus On Financial Stability Chart 3FOMC Is Closely Monitoring##BR##Financial Stability FOMC Is Closely Monitoring Financial Stability FOMC Is Closely Monitoring Financial Stability BCA views financial stability as a third mandate4 for the Fed, along with low and stable inflation, and full employment. Financial stability was not discussed at the FOMC's March 20-21 meeting, despite the spike in financial market volatility in early February. At the prior meeting in January, Fed staff continued to characterize financial vulnerabilities of the U.S. financial system as moderate on balance, but they declined to provide an assessment of foreign financial stability (Chart 3). However, in November 2017, Fed staff highlighted specific vulnerabilities in various foreign economies, including weak banks, heavy indebtedness in the corporate and/or household sector, rising property prices, overhangs of sovereign debt and significant susceptibility to various political developments. The Fed does not provide a financial stability grade at every meeting. Fed staff described financial conditions as moderate in September and December 2013, and then again in April 2014. The next assessment was only in January 2016 but since then, it has upped its discussions. Fed staff provided an assessment of financial stability in 8 of its 16 subsequent meetings. FOMC participants debated the issue at all but 1 of its 8 meetings in 2017, and in 13 of the 16 since April 2016. Fed Chair Jay Powell has followed his predecessor's lead in highlighting financial stability. Former Chair Janet Yellen elevated the topic during her tenure, leading discussions or staff briefings in 26 of the 32 meetings she presided over. The February 2018 edition of the Fed's semiannual Monetary Policy Report (MPR),5 which was the first one in Powell's tenure, has a full section devoted to financial stability. The report characterized the vulnerabilities of the financial system as moderate. Every MPR since July 2013 has provided an update on financial stability. Powell addressed financial stability in a June 2017 speech when he was a Fed governor and also reviewed the concern at his Senate confirmation hearing in November 2017. Moreover, in March's post-FOMC news conference, Powell answered a question about market bubbles by detailing the FOMC's approach to financial stability, and reiterated that financial vulnerabilities were "moderate." The San Francisco Fed noted that a more restrictive monetary policy could pose risks to financial stability.6 A surprise tightening can pressure U.S. bank balance sheets via higher market leverage. Moreover, a higher fed funds rate often leads to an expansion of assets held by money market funds (MMFs) (Chart 4). It concluded that during the 2007-2009 crisis, funding problems for MMFs spread across to the financial system and infected the real economy. In October 2016, the SEC introduced reforms aimed at targeting instability in the MMF sector. Still, the FOMC will closely watch MMF flows as the tightening cycle continues. Chart 4Money Market Funds And The Fed Funds Rate Money Market Funds And The Fed Funds Rate Money Market Funds And The Fed Funds Rate Bottom Line: BCA expects the Fed to remain vigilant about financial stability, but this means that rates will increase only gradually despite below-target inflation. The central bank must find the optimal pace to encourage employment and stable prices while guarding against financial excesses developing if policy stays too loose for too long. Beige Book Highlights The Beige Book released last week ahead of the FOMC's May 1-2 meeting suggested that uncertainty surrounding U.S. trade policy was an important headwind in March and early April. The Fed's business and banking contacts mentioned either tariffs or trade policy 44 times in the Beige Book; there were only 3 mentions in the March edition. Moreover, uncertainty came up nine times in April (Chart 5, panel 5) and eight were related to trade policy. There were just two mentions of the word in the March Beige Book. BCA's view is that trade-related uncertainty will persist through at least mid-year.7 Chart 5Latest Beige Book Supports##BR##The Fed's View On Rates, Inflation and Economy Latest Beige Book Supports The Fed's View On Rates, Inflation and Economy Latest Beige Book Supports The Fed's View On Rates, Inflation and Economy BCA's quantitative approach8 to the Beige Book's qualitative data continues to point to underlying strength in the U.S. economy, a tighter labor market and higher inflation. Moreover, references to a stronger dollar have disappeared from the Beige Book. Chart 5, panel 1 shows that at 55% in April, BCA's Beige Book Monitor dipped to its lowest level since November 2017 when doubts over the tax bill weighed on business sentiment. The number of "weak" words in the Beige Book remained near four-year lows; the number of strong words returned to last summer's hurricane levels. The tax bill was noted five times in the latest Beige Book, down from 15 in March and 12 in January. The legislation was cast in a positive light in five of six mentions. Based on minimal references to a robust dollar in the past seven Beige Books, the greenback should not be an issue for corporate profits in Q1 2018. The handful of references sharply contrasts with 2015 and early 2016 when there were surges in Beige Book comments (Chart 5, panel 4). The last time that seven consecutive Beige Books had so few remarks about a strong dollar was in late 2014. BCA's stance is that the dollar will move modestly higher in 2018. The disagreement on inflation between the Beige Book and the Bureau of Labor Statistics widened in April's Beige Book (Chart 5, panel 3). The number of inflation words in the Beige Book rose to a nine-month peak in April, nearly matching the cycle high hit in July 2017. Core PCE also increased in early 2018. However, in the past year, inflation measured by the PCE deflator and CPI failed to match the escalation in inflation references. In the past, increased remarks about inflation have led measured inflation by a few months, suggesting that the CPI and core PCE may soon turn up. April's Beige Book continued to highlight labor shortages, especially among skilled workers in key areas of the economy. Several contacts noted trouble finding moderately skilled workers in the manufacturing sector. Additionally, a lack of truck drivers, IT and software employees, and construction workers were often cited. Table 3 shows industries with labor shortages. In the year ended March 2018, the gain in average hourly earnings in most of the industries was faster than average. Moreover, in nearly all these categories, labor market conditions are currently the tightest since before the onset of the 2007-2009 recession. More details can be found in a recent Fed study on labor shortages in the manufacturing sector.9 BCA's Beige Book Commercial Real Estate (CRE) Monitor10 remains in a downtrend (Chart 6). The Fed has highlighted valuation concerns in CRE and BCA's Global Investment Strategy service recently stated that the sector is increasingly vulnerable.11 Table 3Labor "Shortages" Identified##BR##In The Beige Book Short-Term Caution Warranted Short-Term Caution Warranted Chart 6Beige Book Commercial##BR##Real Estate Monitor Beige Book Commercial Real Estate Monitor Beige Book Commercial Real Estate Monitor Bottom Line: April's Beige Book supports our view that higher inflation will lead to at least three more Fed rate hikes by the end of the year. Labor shortages may be spreading from highly skilled to moderately skilled workers. The nation's tax policy still gets high marks from the business community, but ongoing concerns over trade policy will restrain growth. Bankers' Beige Book Booming Chart 7Bankers' Beige Book Bankers' Beige Book Bankers' Beige Book BCA's Big 5 Bank Lending Beige Book12 for Q1 2018 highlights several positive trends in the financial sector. All five banks were uniformly upbeat about loan growth, although there was some unease about commercial real estate loans. Chart 7 shows key banking-related variables cited in the Bank Lending Beige Book. Appendix Table 1 shows the Big 5 Bank Lending Beige Book for Q1 2018. Several bank executives noted that Q1 was a seasonally weak time for loan growth. Comments on the credit quality of the banks' loan and credit card portfolios were equally positive. Bank managements highlighted how higher rates have improved their net interest margins in Q1 and noted that further Fed rate hikes would benefit operations. Moreover, our panel of bank CFOs and CEOs cited the positive impact of the 2017 Tax Cut and Jobs Act on their businesses via better loan growth, stronger capital market activity and more capital spending. Several noted that their corporate clients are also experiencing benefits from the tax bill. Bottom Line: The banking system is humming. Lenders are ready to extend credit to businesses and consumers to boost the economy despite higher rates. The tax bill continues to be a positive for banks and their corporate clients. BCA's U.S. Equity strategists recommend an overweight position in the S&P 500's financial sector, with a high conviction overweight on banks.13 Strong Start The Q1 reporting season is off to a strong start, with both EPS and revenue growth exceeding consensus expectations at the start of April. We previewed the S&P 500's Q1 2018 earnings earlier this month.14 Just under 15% of companies have reported results thus far, with 77% beating consensus EPS projections, which is well above the long-term average of 69%. Furthermore, 75% posted Q4 revenues over expectations, exceeding the long-term average of 56%. The surprise factor for Q1 stands at 5% for EPS and 2% for sales. Both readings are right at the average surprise recorded in the past five years. The surprise figures are even more impressive given that analysts bumped up their Q1 assessments in 10 of 11 sectors between the start of 2018 and the beginning of the Q1 reporting season. Analysts' estimates typically move lower as a quarter unfolds, which has the effect of lowering the bar for results. Table 4S&P 500: Q1 2018 Results* Short-Term Caution Warranted Short-Term Caution Warranted We anticipate the secular mean-reversion of margins to re-assert itself in the S&P data, perhaps beginning in mid-2018. Nonetheless, initial results imply that Q1 will be another quarter of margin expansion. Average earnings growth (Q1 2018 versus Q1 2017) is stout at 19% with revenue growth at 8%. However, on a four-quarter basis, U.S. margins fell slightly in the fourth quarter. Still, they remain at a high level on the back of decent corporate pricing power. Strength in earnings and revenues is broadly based (Table 4). Earnings per share rose in Q1 2018 versus Q1 2017 in all 11 sectors. EPS results are particularly robust in energy (71%), financials (29%), materials (27%) and technology (24%). The energy, materials and technology sectors likewise all experienced substantial sales gains (14%, 12% and 14% respectively). Excluding energy, S&P 500 profits in Q1 2018 versus Q1 2017 are still vigorous at 18%. Our U.S. Equity Strategy service introduced profit models for the S&P 500's sectors in January.15 Optimistic managements have raised the bar significantly for 2018 results in the past few months (Chart 8). On October 1, 2017, before the GOP introduced the tax bill, the bottom-up estimate for the S&P 500's 2018 EPS growth stood at 11%. As of April 19, 2018, the estimate is 20%. Moreover, the upward revisions are widespread. Calendar year 2018 EPS growth rate estimates in 10 of 11 sectors are higher today than at the start of October 2017. Chart 8The Bar Is High For 2018 EPS; Focus Should Shift To 2019 Soon The Bar Is High For 2018 EPS; Focus Should Shift To 2019 Soon The Bar Is High For 2018 EPS; Focus Should Shift To 2019 Soon While the ebullience is due to the tax bill, solid global growth, a steeper yield curve and higher energy prices are also responsible. The tax bill lowered the corporate tax rate for 2018 and the repatriation holiday provides firms with excess cash. As noted in the previous section, U.S. trade policy is a concern in several industries. Table 5 reports the Q4 2017 profit and sales performance of globally - and domestically - oriented firms (Q1 data will be available later this quarter). At year-end, domestic firms' earnings and revenue surprise outpaced that of global industries. However, global firms saw more robust sales and EPS growth than companies with sales mainly from domestic sources. Analysts expect EPS growth to slow considerably in 2019 from the anticipated 2018 clip, which matches BCA's view (Chart 9). However, unlike estimates for 2017 and 2018, we anticipate that EPS estimates for 2019 will move lower throughout 2018 and 2019, ahead of a recession in early 2020. Table 52017 Q4 Earnings##BR##Breakdown Short-Term Caution Warranted Short-Term Caution Warranted Chart 9Strong S&P 500 EPS Growth Ahead,##BR##Will Start To Slow Soon Strong S&P 500 EPS Growth Ahead, Will Start To Slow Soon Strong S&P 500 EPS Growth Ahead, Will Start To Slow Soon Bottom Line: EPS growth is expected to peak at over 20% later this year (4-quarter moving total basis using S&P 500 data). Growth is expected to decelerate thereafter since we have factored in a modest margin squeeze as U.S. wage growth picks up (Chart 9). The incorporation of the fiscal stimulus lifted the U.S. EPS growth profile relative to our previous forecast. Nonetheless, BCA believes that the earnings backdrop will remain a tailwind for the equity market. The Tax Cut and Job Act raised expectations for 2018 in most sectors and so far, corporate managements have exceeded the lofty projections. However, it may be more difficult to maintain in the second half of 2018. John Canally, CFA, Senior Vice President U.S. Investment Strategy johnc@bcaresearch.com 1 Please see BCA Research's Global Investment Strategy Weekly Report "Is China Headed For A Minsky Moment?," dated April 13, 2018. Available at gis.bcaresearch.com. 2 Please see BCA Research's Bank Credit Analyst Monthly Report, dated February, 2018. Available at bca.bcaresearch.com. 3 Please see BCA Research's Geopolitical Strategy Weekly Report "Expect Volatility... Of Volatility," dated April 11, 2018. Available at gps.bcaresearch.com. 4 Please see BCA Research's U.S. Investment Strategy Weekly Report, "The Fed's Third Mandate," July 24, 2017. Available at usis.bcaresearch.com. 5 https://www.federalreserve.gov/monetarypolicy/2018-02-mpr-summary.htm 6 https://www.frbsf.org/economic-research/publications/economic-letter/2018/february/monetary-policy-cycles-and-financial-stability/ 7 Please see BCA Research's Geopolitical Strategy Weekly Report, "Trump's Demands On China," April 4, 2018. Available at gps.bcaresearch.com. 8 Please see BCA Research's U.S. Investment Strategy Weekly Report, "The Great Debate Continues," April 17, 2017. Available at usis.bcaresearch.com. 9 https://www.federalreserve.gov/econres/notes/feds-notes/evaluating-labor-shortages-in-manufacturing-20180309.htm 10 Please see BCA Research's U.S. Investment Strategy Weekly Report, "Summer Stress Out", dated July 3, 2017. Available at usis.bcaresearch.com. 11 Please see BCA Research's Global Investment Strategy Weekly Report, "Three Tantalizing Trades - Four Months On", dated January 19, 2018. Available at gis.bcaresearch.com. 12 Please see BCA Research's U.S. Investment Strategy Weekly Report, "Commitments," January 20, 2014. Available at usis.bcaresearch.com. 13 Please see BCA Research's U.S. Equity Strategy Weekly Report, "High Conviction Calls," dated November 27, 2017. Available at uses.bcaresearch.com. 14 Please see BCA Research's U.S. Investment Strategy Weekly Report, "Policy Peril," dated April 9, 2018. Available at usis.bcaresearch.com. 15 Please see BCA Research's U.S. Equity Strategy Special Report, "White Paper: Introducing Our U.S. Equity Sector Earnings Models," January 16, 2018. Available at uses.bcaresearch.com. Appendix: Bankers Beige Book Short-Term Caution Warranted Short-Term Caution Warranted

Highlights Portfolio Strategy Expensive valuations leave no room to maneuver in the S&P real estate index that has to contend with a higher interest rate backdrop and deteriorating cash flow growth fundamentals. Trim to underweight. In contrast, capital markets stocks are firing on all cylinders and the return of animal spirits, the capex upcycle, booming M&A activity and a brighter operating backdrop auger well for this highly cyclical financials sub-index. Stay overweight. Recent Changes S&P Real Estate - Downgrade to underweight today. Table 1 Earnings Juggernaut Earnings Juggernaut Feature Equities rebounded in the past two weeks, as earnings took center stage and they delivered beyond expectations. Impressively, the blended Q1 EPS growth rate is running at 20% (versus 18.5% expected on April 1) with roughly 18% of the S&P 500 constituents reporting profit numbers. This earnings validation served as a catalyst for the SPX to briefly reclaim the key 50-day moving average and, most importantly, the Advance/Decline (A/D) line hit fresh all-time highs. Historically, the A/D line and the S&P 500 move hand-in-hand and there is a high chance that the SPX will follow suit in the coming quarters (top panel, Chart 1). Our upbeat cyclical 9-12 month equity market view remains intact, as the odds of a recession are close to nil. Despite fears of a generalized global trade war, global trade volumes have been resilient vaulting to multi-year highs on a short-term rate of change basis (middle panel, Chart 2). While a global growth soft patch cannot be ruled out, as long as manufacturing PMIs can stay above the 50 boom/bust line, synchronized global growth will remain the dominant macro theme. Chart 1New Highs Ahead? New Highs Ahead? New Highs Ahead? Chart 2What Slowdown? What Slowdown? What Slowdown? The IMF concurred in its April, 2018 World Economic Outlook: "The global economic upswing that began around mid-2016 has become broader and stronger. This new World Economic Outlook report projects that advanced economies as a group will continue to expand above their potential growth rates this year and next before decelerating, while growth in emerging market and developing economies will rise before leveling off." 1 The bond market is also not sending a distress signal as very sensitive junk bond spreads have nosedived of late (shown inverted, bottom panel, Chart 1). Under such a backdrop, EPS will continue to shine and underpin stocks (Chart 2). Nevertheless, steeply decelerating money supply growth is slightly disconcerting. This is not only a U.S. only phenomenon, but G7 money supply growth is also losing momentum. Chinese and overall emerging markets money growth numbers are also stuck in a rut (Chart 3). While this could be the precursor to a global growth slowdown, we would expect commodity prices to be the first to sniff it out (Chart 4). Clearly this is not the case as commodities spiked last week. Moreover, keep in mind that money growth tends to peak before recessions and what we are currently observing is likely a typical late cycle phenomenon. We will continue to closely monitor money growth around the globe, as this steep deceleration represents a risk to our sanguine equity market view. This week we are updating our corporate pricing power indicators. Chart 5 shows that our corporate sector pricing power proxy and our diffusion index are holding on to recent gains. On the labor front, the business sector's overall wage inflation and associated diffusion index from the latest BLS employment report ticked lower (fourth panel, Chart 5). Chart 3Money Growth Yellow Flag... Money Growth Yellow Flag... Money Growth Yellow Flag... Chart 4... But Commodities Are Resilient ... But Commodities Are Resilient ... But Commodities Are Resilient Chart 5No Margin Trouble Yet No Margin Trouble Yet No Margin Trouble Yet However, the spread between job switchers and stayers (courtesy of the Atlanta Fed Wage Growth Tracker) suggests that wage inflation should pick up steam in the coming months. While rising pay would eat into profit margins and thus dent profits ceteris paribus, this would be problematic only if businesses failed to lift selling prices in the coming months. We assign low odds to this outcome as domestic (and global) final demand is firm, suggesting that companies will manage to pass on rising input prices either down the supply channel, to the government and/or the consumer. Table 2Industry Group Pricing Power Earnings Juggernaut Earnings Juggernaut Table 2 summarizes the sectorial results. We calculate industry group pricing power from the relevant CPI, PPI, PCE and commodity growth rates for each of the 60 industry groups we track. Table 2 also highlights shorter term pricing power trends and each industry's spread to overall inflation. Chart 6Cyclicals Have The Upper Hand Cyclicals Have The Upper Hand Cyclicals Have The Upper Hand Over 83% of the industries we cover are lifting selling prices, and 45% are doing so at a faster clip than overall inflation. This is a slight improvement compared with our late-January report The number of outright deflating sectors dropped by three to 10 since our last update. Encouragingly, only 7 industries are experiencing a downtrend in selling price inflation, on par with our most recent report. Impressively, deep cyclicals/commodity-related industries continue to dominate the top ranks, occupying the top 7 slots (top panel, Chart 6). Improving global trade dynamics and sustained softness in the greenback are behind the commodity complex's ability to increase prices. In contrast, tech, telecom, autos and airlines populate the bottom ranks of Table 2. In sum, firming corporate sector pricing power will continue to boost sales growth for the rest of the year. Tack on operating leverage kicking into higher gear at this stage of the cycle, especially for the high fixed cost deep cyclical businesses, and still modest wage inflation, and profit margins and EPS growth will remain upbeat. This week we downgrade a niche interest rate-sensitive sector and update our view on a very cyclical financials sub-sector. DowngREITing There are good odds that laggard REITs will suffer the same fate as telecom services and utilities stocks and plumb relative all-time lows, breaching the early 2000s nadir (Chart 7). A higher interest rate backdrop, a key BCA theme for 2018, along with deteriorating profit fundamentals compel us to downgrade the niche S&P real estate sector to an underweight stance. Real estate stocks are behaving like fixed income proxied equities, given that, by construction, REITs are high dividend yielding. Thus, a tightening monetary backdrop serves as a noose around their necks (top panel, Chart 8). Not only is the Fed slated to raise interest rates two or three more times this year, but FOMC median projections also assume an additional two to three hikes in 2019. At the margin, competing higher yielding risk free assets will eat into demand for REITs. On the operating front, a number of indicators we track are sending an outright bearish signal for the commercial real estate (CRE) sector. The occupancy rate has crested just shy of 90% or 160bps below the previous cycle's peak. Rising vacancies are emblematic of decreasing rents and thus CRE related cash flows (middle panel, Chart 8). Chart 7New Lows Looming New Lows Looming New Lows Looming Chart 8Rental Deflation Alert Rental Deflation Alert Rental Deflation Alert Importantly, CRE prices continue to defy gravity and are steeply deviating from our petered out occupancy rate composite (bottom panel, Chart 8). This supply/demand imbalance typically resolves itself via deflating prices. Industry overbuilding explains this disequilibrium, as ZIRP and loose credit standards encouraged a construction boom. Overall non-residential construction is probing all-time highs and multi-family housing starts are expanding close to 400K/annum, a level that has coincided with previous peaks in the CRE market (third & fourth panels, Chart 9). This industry oversupply should weigh heavily on rents especially given the slackening demand backdrop, according to the message from our REITs Demand Indicator (RDI). The softening RDI reading also bodes ill for CRE price inflation (bottom panel, Chart 10). The latest Fed Senior Loan Officer Survey (FSLOS) corroborates that demand for CRE loans is in a steady decline and bankers are not willing extenders of CRE credit, exerting a downward pull on CRE prices (middle panel, Chart 10). Chart 9Rents Are Under Attack Rents Are Under Attack Rents Are Under Attack Chart 10CRE Prices Skating On Thin Ice CRE Prices Skating On Thin Ice CRE Prices Skating On Thin Ice Historically, demand for CRE loans as per the FSLOS has been an excellent leading indicator of actual CRE loan growth, and the current message is grim (second panel, Chart 11). It would be unprecedented for another upleg to take root in the CRE market with the absence of credit growth to fuel such an overshoot phase. Worrisomely, there is no valuation cushion to absorb the plethora of possible CRE mishaps. Cap rates have troughed for the cycle and a rising interest rate backdrop warns that a de-rating in expensive valuations is looming (third panel, Chart 11). While CRE credit quality shows no signs of deterioration, at this stage of the cycle and given weak industry profit fundamentals we would caution against extrapolating such good times far into the future (bottom panel, Chart 11). Adding it all up, our S&P real estate profit growth model does an excellent job encapsulating all of these forces, and it is currently sending an unambiguous sell signal (Chart 12). Chart 11Happy Days Are Over Happy Days Are Over Happy Days Are Over Chart 12Model Says Sell Model Says Sell Model Says Sell Bottom Line: Downgrade the niche S&P real estate index to a below benchmark allocation. Capital Markets: Stay The Bull Course We upgraded capital markets stocks to an above benchmark allocation mid-May last year. Our thesis, recovering overall market top and bottom line growth would prolong the overshoot phase in equities at a time when monetary conditions would stay sufficiently loose, has panned out and this hyper sensitive early-cyclical index has added alpha to our portfolio raising the question: is it time to book profits or are there more gains in store? The short answer is that it is too soon to crystalize gains. This financials sub-index thrives when animal spirits are rising, CEOs embrace an expansionary mindset, and investor risk appetites are healthy. The opposite is also true. We first started exploring the underappreciated global capex upcycle theme in mid-October2 and by late-November it became one of our two core themes for 2018 (rising interest rate backdrop is the other).3 The second panel of Chart 13 shows that capex intentions move in tandem with relative EPS and are pointing toward a profit reacceleration in the coming months. Bankers are also willing extenders of credit, a necessary fuel for the capex upcycle phase, and demand for loans is upbeat as per our commercial loans & leases model. Historically, such a macro backdrop has been a sweet spot for capital markets stocks (Chart 13). Not only business, but investor confidence is also sky high. Junk bond spreads have once again plumbed multi-year lows and even investment grade bond spreads are tight (high-yield spread shown inverted, Chart 1). Corporate bond issuance remains resilient. The Equity Risk Premium has also narrowed by 200bps since the end of the manufacturing recession (shown inverted, top panel, Chart 14), reducing the cost of equity capital. This is fertile ground both for IPOs and secondary stock offerings. Chart 13Solid Foundation Solid Foundation Solid Foundation Chart 14Enticing Operating Backdrop Enticing Operating Backdrop Enticing Operating Backdrop Meanwhile, the return of volatility has caused revenue generating equity trading desks to breathe a huge sigh of relief, as we had posited in early March,4 and this earnings season made abundantly clear. Trading volumes have soared and margin debt continues to climb both in absolute terms and relative to GDP (Chart 14). If volatility stays elevated as the year progresses, as we expect, then more gains are likely for investment bank trading desks. The upshot is that the capital markets' EPS upswing is in the early innings. Another key earnings driver, M&A activity, is booming around the globe. Still sloshing global liquidity with near generationally low interest rates is fueling an M&A spree. In the U.S. alone, M&A has hit a fresh cycle high and is running near $3.1Tn/annum. Even relative to output, M&A has returned to the previous cycle's peak (bottom panel, Chart 14), and is music to the ears of investment bankers. The implication is that a capital markets ROE expansion phase looms (bottom panel, Chart 15). On the operating front, capital markets employment is hyper-cyclical. Investment banks are quick to slash labor costs during a downturn and equally swift to expand headcount in anticipation of good times. Currently, industry payrolls are rising steadily and outpacing overall non-farm payroll growth, and represent a positive backdrop (Chart 16). Chart 15M&A Fever Is Positive... M&A Fever Is Positive... M&A Fever Is Positive... Chart 16...And So Is Rising Headcount ...And So Is Rising Headcount ...And So Is Rising Headcount Sell-side analysts have taken notice and EPS pessimism has violently swung into extreme optimism in the past 18 months. Granted, President Trump's election and tax reform euphoria are part of the slingshot recovery in EPS expectations. However, firming industry-specific EPS growth prospects are also driving analysts' upward revisions (bottom panel, Chart 16). Bottom Line: We recommend an above benchmark allocation in the still compellingly valued S&P investment banks & brokers index. The ticker symbols for the stocks in this index are: BLBG: S5INBK - ETFC, GS, MS, RJF, SCHW. Anastasios Avgeriou, Vice President U.S. Equity Strategy anastasios@bcaresearch.com 1 http://www.imf.org/en/Publications/WEO/Issues/2018/03/20/world-economic-outlook-april-2018 2 Please see BCA U.S. Equity Strategy Special Report, "Top 5 Reasons To Favor Cyclicals Over Defensives," dated October 16, 2017, available at uses.bcaresearch.com. 3 Please see BCA U.S. Equity Strategy Weekly Report, "High-Conviction Calls," dated November 27, 2017, available at uses.bcaresearch.com. 4 Please see BCA U.S. Equity Strategy Special Report, "Top 10 Reasons We still Like Banks," dated March 5, 2018, available at uses.bcaresearch.com. Current Recommendations Current Trades Size And Style Views Favor value over growth Stay neutral small over large caps (downgrade alert)

Highlights Q1 earnings season looks robust, but trade policy is an uncertainty. Sizeable shifts in equity technicals and sentiment since the start of the year; valuation still stretched. Global growth may have peaked but fiscal, monetary and legislative backdrop remains supportive. The market is coming to terms with President Trump's willingness to put his policies where his campaign rhetoric was, at least on trade policy. Feature Chart 1Despite Setback In March, ##br## U.S. Labor Market Remains Strong Despite Setback In March, U.S. Labor Market Remains Strong Despite Setback In March, U.S. Labor Market Remains Strong U.S. equity prices fell last week as trade policy remained on the front pages. Gold was one of the few beneficiaries of the tariff talk. Investors hope to turn the page this week as the Q1 2018 earnings season kicks into high gear, but trade-related market volatility is here to stay. The bar is high for 2018 earnings growth, and the focus may shift to the prospects for 2019 sooner rather than later. The modest selloff in the S&P 500 since late January led to a shift in sentiment, but the technical picture for U.S. equities is mixed. Global growth may be rolling over, but we find that risk assets perform well anyway, if fiscal, monetary and legislative policy is aligned. Trump's actions on tariffs do not mean that we are necessarily headed for a trade war. The tariffs proposed but both sides have not yet been implemented and there is still time for compromise. We do not see March's modest 103,000 increase in non-farm payrolls as signaling a weaker labor market. First, the monthly data can be volatile. The soft increase in March follows an outsized 326,000 gain in February. The 3-month average, more reflective of the underlying trend, is a solid 202,000. Second, average hourly earnings increased by 0.3% m/m, which nudged the annual wage inflation rate to 2.7% from 2.6%. Firming earnings growth is a sign of a strong labor market (Chart 1). Despite the soft increase in March payrolls, the U.S. labor market and economy are on a firm footing. Aggregate hours worked increased by 2.0% at a quarterly annualized rate in Q1. Such a pace is consistent with about 3% GDP growth. Firm growth will allow inflation to head back to the 2% target and allow the Fed to continue with its gradual rate hikes. S&P 500 Earnings: Q1 2018 The consensus expects an 18% year-over-year increase in the S&P 500's EPS in Q1 2018 versus Q1 2017, and 20% in 2018. Energy, materials, financials and technology will lead the way in earnings growth in Q1, while real estate and consumer discretionary will struggle. Excluding the energy sector, the consensus expects a stout 17% increase in profits. The robust profit environment for Q1 2018 and the year ahead reflects sharply higher oil prices compared with early 2017 and the impact of last year's Tax Cut and Jobs Act. Moreover, improved global growth and still modest labor costs will support the Q1 results. Trade policy will likely replace tax cuts as a key topic when corporate managements report Q1 outcomes and provide guidance for Q2 and beyond. While no tariffs have yet been imposed, analysts will want to understand the impact that the proposed actions will have on input costs and margins. Moreover, investors must gauge to what extent trade policy-related uncertainty is weighing on business sentiment (details below in "Trade Skirmish...Or Trade War?"). Market volatility, rising interest rates and the modest upswing in U.S. labor costs will also be discussed during the Q1 earnings calls. As always, guidance from corporate leaders for Q2 2018 and ahead are more important than the actual results for Q1 2018. The markets probably have already priced in a robust 2018 earnings profile due to the Tax Cut and Jobs Act, and are looking ahead to 2019 (Chart 2). Investors typically stay focused on the current calendar year's EPS through to at least Q3 before turning their attention to the next year. However, this year may be different. The consensus is looking for 10% EPS growth in 2019, a sharp deceleration from the 20% increase expected this year. Chart 2The Bar Is High For 2018 EPS, But The Focus Is On 2019 The Bar Is High For 2018 EPS, But The Focus Is On 2019 The Bar Is High For 2018 EPS, But The Focus Is On 2019 Chart 3 shows that elevated readings on the ISM provide a very favorable backdrop for EPS in 2018. As indicated in Chart 4, industrial production (IP), a proxy for S&P 500 sales, is poised to advance in 2018 and lift corporate profits. Industrial production growth may be peaking, but we don't expect it to soften much on a year-over-year basis. Chart 3Elevated ISM Good News For 2018 EPS Growth Elevated ISM Good News For 2018 EPS Growth Elevated ISM Good News For 2018 EPS Growth Chart 4Stout Readings On IP Support S&P 500 Revenue Gains Stout Readings On IP Support S&P 500 Revenue Gains Stout Readings On IP Support S&P 500 Revenue Gains Global GDP growth estimates for 2018 and 2019 continue to move steadily higher in sharp contrast with prior years when forecasters relentlessly lowered GDP estimates (Chart 5). Chart 5U.S. And Global Growth Estimates Are Still Accelerating... ##br## But For How Much Longer? U.S. And Global Growth Estimates Are Still Accelerating... But For How Much Longer? U.S. And Global Growth Estimates Are Still Accelerating... But For How Much Longer? Chart 6The Dollar Should Not Be A Big Concern ##br## In Q1 Earnings Season The Dollar Should Not Be A Big Concern In Q1 Earnings Season The Dollar Should Not Be A Big Concern In Q1 Earnings Season The greenback should not be an issue for corporate results in Q1 2018 based on minimal references to a robust dollar in the past six Beige Books. This significantly differs from 2015 and early 2016 when there were surges in Beige Book mentions (Chart 6). The last time that six consecutive Beige Books had so few remarks about a strong dollar was in late 2014. BCA's stance is that the dollar will move modestly higher in 2018. The appreciation would trim EPS growth by roughly 1 to 2 percentage points, although most of this would occur next year due to lagged effects. Movements in the U.S. dollar also explain the divergent paths of profits, sales and margins of domestically focused corporations versus globally oriented ones. In recent quarters, a modestly weaker dollar has allowed profit and sales gains of global firms to rebound and outpace those of domestic businesses (Chart 7). Margins for U.S. companies have been steady at record heights since 2014, while margins for global businesses dipped along with oil prices in 2014-2016, but rebounded last year and are higher than margins of domestic companies. Nonetheless, a slowdown in growth outside the U.S. may reverse these trends (Please read below, "Global Growth Has Peaked, Now What?"). Investors are skeptical that margins can advance in Q1 2018 for the seventh consecutive quarter. BCA's view is that we are in a temporary sweet spot for margins, which should continue for the next couple of quarters. However, the secular mean reversion of margins will resume beyond that time as wage pressures begin to percolate. Chart 7Global EPS, Margins Outpacing Domestic Global EPS, Margins Outpacing Domestic Global EPS, Margins Outpacing Domestic Chart 8Strong S&P Growth Ahead, Will Start To Slow Soon Strong S&P Growth Ahead, Will Start To Slow Soon Strong S&P Growth Ahead, Will Start To Slow Soon Bottom Line: BCA expects that the earnings backdrop will be supportive of equity prices in 2018 (Chart 8). However, investors may have already priced in the benefits of the Tax Cut and Jobs Act on corporate results and are focused on 2019 figures. EPS growth will be more of a headwind for stock prices as we enter 2019 (Chart 8). Stay overweight stocks versus bonds. Technical, Sentiment And Valuation Update BCA's Technical Indicator is not at an extreme (Chart 9, panel 1) and the 7.8% pullback in the S&P 500 since January 26, 2018 leaves the index in the middle of its recovery trend channel (panel 2). The failure of the index to break out of this channel earlier this year suggests that a period of consolidation for equities awaits. Moreover, the upward slope in the NYSE advance/decline line (panel 3) is in jeopardy. The final panel of Chart 9 shows that stocks are no longer extremely overvalued, but they remain overvalued nonetheless. Stretched valuations say more about medium- and long-term returns than near-term performance.1 Chart 9Technicals And Valuations For U.S. Equities Technicals And Valuations For U.S. Equities Technicals And Valuations For U.S. Equities Chart 10Bullish Sentiment Took A Hit In Early 2018 But Is Still Elevated Bullish Sentiment Took A Hit In Early 2018 But Is Still Elevated Bullish Sentiment Took A Hit In Early 2018 But Is Still Elevated The shift in the equity sentiment since the market top in January is notable. BCA's investor sentiment composite index, which hit an all-time high at the end January, has pulled back in the past few months (Chart 10, panel 1). However, this metric has not yet returned to its long-term average (solid line on top panel of Chart 10). The drop in sentiment is broadly based; individual investors and advisors who serve them (panels 2 and 4) along with traders (panel 3) have lately curtailed their bullishness. Recent shifts in several other sentiment surveys are also worth noting: The American Association of Individual Investors, a contrary indicator of sentiment, turned bullish in recent weeks. The percentage of respondents who were bearish moved above 30%, while the percentage of bulls dipped to 32%. Neither measure is at an extreme (Chart 11). The National Association of Active Investment Managers (NAAIM) says that active managers have reduced equity risk since the beginning of Q4 2017 (Chart 12). At 52%, the average equity exposure of institutional investors is at the lowest level since March 2016 and is nearly half the 102% exposure at the start of 2017. In contrast, the March 2017 reading was the highest since 2007, just before the S&P 500 peak in October 2007. As in previous bear markets, BCA's equity speculation index moved into "high speculation" territory in early 2017 and has remained there. The index is at its highest point since the 2000 market peak (Chart 13, panel 1). Moreover, net speculative positions of S&P 500 stocks are roughly in balance, but have turned net short in recent weeks. Nonetheless, this metric is not at an extreme (panel 3). Chart 11Individual Investors Have Turned More Bearish Individual Investors Have Turned More Bearish Individual Investors Have Turned More Bearish Chart 12Active Managers Still Overweight Equities... Active Managers Still Overweight Equities... Active Managers Still Overweight Equities... Chart 13Equity Speculation Is High... Equity Speculation Is High... Equity Speculation Is High... Chart 14Pullback Has Relieved Some Technical Pressure Pullback Has Relieved Some Technical Pressure Pullback Has Relieved Some Technical Pressure The S&P 500 is close to its 200-day moving average. In late 2017, this indicator was at the upper end of its post-2000 range (Chart 14, panel 1). BCA's composite technical measure is in the middle of the 2007-2017 range and is not a concern (Chart 14, panel 5). Moreover, the percentage of NYSE stocks above their 10- and 30-week highs are below average and at the low end of their recent ranges. Furthermore, new highs minus new lows is at neutral (panel 2). Bottom Line: The 7.8% pullback in the S&P 500 since January 26 has relieved some technical pressure on the market, and sentiment levels are less stretched than at the late January 2018 peak. Moreover, institutions have cut their equity exposures. Nonetheless, stock speculation is rampant and valuations are elevated, which suggests lower returns in the coming decade. Moreover, a slowdown in global growth in ongoing trade tensions suggest that the risk/reward balance for equities has deteriorated. Global Growth Has Peaked, Now What? Chart 15Is Global Growth Peaking? bca.usis_wr_2018_04_09_c15 bca.usis_wr_2018_04_09_c15 In last week's report we stated that while BCA expects global growth to be solid this year, there are signs that global growth may near a top.2 March's PMI data support that view. Chart 15 shows that the Markit Global PMI dipped to 53.4 in March from 54.1 in February; the 0.7 drop was the largest since February 2016 (panel 2). Last month,3 we discussed 5 episodes in the past 35 years when global growth surged and fiscal, monetary and regulatory policies were aligned to boost the U.S. economy. The current episode of synchronized policy commenced in January 2016. Risk assets perform well when these policy tailwinds are in place, but these assets tend to struggle for 12 months after the tailwinds abate. BCA expects the ongoing era of pro-growth policies to end next year as the Fed raises rates into restrictive territory. However, some investors wonder if the peak in global growth changes our view of how risk assets will perform during periods of harmonized policy. We do not expect the peak in global growth to lead to a recession this year or next. Chart 16 and Table 1 show the performance of U.S.-based financial assets, gold, oil, the dollar and S&P 500 earnings when Fed, fiscal and legislative policies are stimulative and global growth is rolling over but still positive. There has been only a handful of such episodes, so investors should be cautious when interpreting these results. The S&P 500 beats Treasuries, investment-grade and high-yield credit outperforms Treasuries, and small caps outpace large caps. Gold and oil perform well in these periods, perhaps aided by a weaker dollar. S&P 500 earnings are positive. Chart 16Positive Policy Backdrop As Global Growth Is Rolling Over Positive Policy Backdrop As Global Growth Is Rolling Over Positive Policy Backdrop As Global Growth Is Rolling Over Table 1Three Periods Where Global Growth Rolled Over But Policy Backdrop Was Stimulative Policy Peril? Policy Peril? Bottom Line: A peak in global growth reduces the risk/reward balance for risk assets, and provides another reason to be cautious. Equity valuation, although improved recently, is still stretched. Central banks are slowly removing the punchbowl, margins have limited upside and the economic cycle is at a late stage. Long-term investors should already be scaling back on risk. Short-term investors should stay overweight risk for now, on the view that fiscal stimulus will provide a tailwind for earnings for the remainder of the year. Trade Skirmish...Or Trade War? BCA's Geopolitical Strategy service notes4 that the market is coming to terms with President Trump's willingness to put his policies where his campaign rhetoric was, at least on trade policy. U.S. equities are down by 5.7% since the White House announced tariffs on steel and aluminum and 2.34% since it declared impending levies against China. Although we have cautioned clients since November 2016 that protectionism is a real risk to global growth and risk assets, the U.S. demands on China justify the moniker of a trade skirmish, rather than a full-on war. In view of our position, we think the 5.7% drawdown is appropriate, if a bit sanguine. President Trump remains unconstrained on trade policy, giving him leeway to be tougher than the market expects. Therefore, it is appropriate for the market to price in a 20%-30% probability of a trade war developing. Given that the market drawdown in such a scenario could be 20% or more, the market is appropriately discounting the risks. Why would a trade war between the U.S. and China elicit a bear market in U.S. equities when a similar confrontation in the 1980s between Japan and the U.S. did not? First, the overvaluation of stocks is much greater today. Secondly, interest rates are much lower, restricting how much policymakers can react to adverse risks. Thirdly, supply chains are much more integrated, both globally and between China and the U.S. The U.S. Administration's trade policy is not haphazard. President Trump and U.S. Trade Representative Robert Lighthizer are on the same page: they have made China, and not NAFTA trade partners or South Korea, the target of U.S. protectionism (Chart 17). Chart 17China, Not NAFTA, In The Crosshairs China, Not NAFTA, In The Crosshairs China, Not NAFTA, In The Crosshairs Table 2U.S. Gradually Exempting Allies From Tariffs Policy Peril? Policy Peril? The rapid pace at which the Administration pivoted from global tariffs to targeting China is an indication of what lies ahead. The U.S. uses the threat of tariffs to cajole its allies into tougher trade enforcement against China (Table 2). This strategy can work, as outlined last week,5 but there is plenty of room for mistakes. Trump also wants to change the U.S. policy on immigration and he may use NAFTA negotiations to gain leverage over Mexico. Therefore, there is a slight probability that Trump may trigger Article 2205 to leave NAFTA, but we believe the risk has declined substantively since our 50% estimate in November 2017. Bottom Line: The Trump Administration has pursued a well-considered but tough trade policy toward China. Nonetheless, Trump's actions do not mean that we are necessarily headed for a trade war. The tariffs proposed by both sides have not yet been implemented and there is still time for compromise. The U.S. Treasury will release a list of exemptions on May 1. On May 21, Treasury will reassess its list of China's investments in the U.S. and China will likely retaliate. June 5 marks the end of a 60-day negotiation period when the Administration must decide whether to implement the announced tariffs. There still is a 30% chance that the trade skirmish will morph into a trade war. Trump could significantly escalate matters if he declares a national emergency on trade in June. Expect more trade-related volatility in U.S. financial markets until that time. John Canally, CFA, Senior Vice President U.S. Investment Strategy johnc@bcaresearch.com Matt Gertken, Associate Vice President Geopolitical Strategy mattg@bcaresearch.com 1 Please see BCA Global Asset Allocation Special Report, "What Returns Can You Expect?", dated November 15, 2017, available at gaa.bcaresearch.com. 2 Please see BCA U.S. Investment Strategy Weekly Report, "Has Global Growth Peaked?", dated April 2, 2018, available at usis.bcaresearch.com. 3 Please see BCA U.S. Investment Strategy Weekly Report, "Policy Line Up", dated March 12, 2018, available at usis.bcaresearch.com. 4 Please see BCA Geopolitical Strategy Weekly Report, "Trump's Demands On China", dated April 4, 2018, available at gps.bcaresearch.com. 5 Please see BCA Geopolitical Strategy Special Report, "Taiwan Is A Potential Black Swan", dated March 30, 2018, available at gps.bcaresearch.com.