Corporate

Highlights Portfolio Strategy A stable China, a depreciating U.S. dollar, rising commodity prices and sustained synchronized global growth signal that the industrials complex, especially the most cyclical part, remains on a solid footing. Deteriorating profit prospects warn that investors should refrain from paying a premium valuation for industrial machinery; take profits and move to the sidelines. Recent Changes S&P Industrial Machinery - Book profits of 4% and downgrade to neutral today. S&P Construction Machinery & Heavy Truck - Stop triggered last week, remove from the high-conviction list for a 10% gain. Small Caps / Large Caps - Downgrade alert in a recent Insight. Table 1 Corporate Pricing Power Update Corporate Pricing Power Update Feature The S&P 500 smashed through the 2,800 mark last week, as corporate profits continued to deliver, the U.S. dollar took a dive and global economic data releases held their own. Stars could not be more aligned for a euphoric blow off phase, with equity bourses the world over already registering annual-like returns in but a few short weeks. While stocks have more room to run, especially versus bonds, on a cyclical time frame, tactically the likelihood of a short-term healthy pullback is increasing. Last week we identified five indicators we are closely monitoring that are signaling an overstretched market.1 This week we update our Complacency-Anxiety Indicator that also catapulted to all-time highs and breached the one standard deviation above the historical mean mark (Chart 1). This confirms that a Q1 setback remains likely, and our strategy since December 18 has been to monetize gains in tactical trades and institute stops to the high flyers in our high-conviction call list. Were a 5-10% correction to materialize, we would "buy the dip" as we do not foresee a recession in the coming 9-12 months. While consumer price inflation is nowhere to be found, corporate selling prices are climbing at a brisk pace. The U.S. dollar debasement and related commodity reflex rebound, especially in oil prices, are the culprits, and the latter will likely assist even the CPI basket and morph into an inflationary impulse as we posited in late-November (please see the bottom two panels of Chart 1B). Already, inflation expectations are headed higher. Chart 2 updates our corporate sector pricing power proxy and our diffusion index. It also updates the business sector's overall wage inflation and associated diffusion index from the latest BLS employment report. The middle panel of Chart 2 shows the Atlanta Fed Wage Growth Tracker and that measure of wage inflation has converged down to the AHE reading, suffering a 100bps drop in the past year. Chart 1Complacency Reigns Complacency Reigns Complacency Reigns Chart 2Margin Expansion Phase Is Intact Margin Expansion Phase Is Intact Margin Expansion Phase Is Intact Corporate pricing power is upbeat at a time when wages are decelerating. Taken together, our margin proxy indicator suggests that the ongoing profit margin expansion phase has more upside (bottom panel, Chart 2). Table 2 shows our updated industry group pricing power gauges, which we calculate 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. Table 2Industry Group Pricing Power Corporate Pricing Power Update Corporate Pricing Power Update 78% of the industries we cover are lifting selling prices, and 45% are doing so at a faster clip than overall inflation. Importantly, inflation rates have increased since our late-September update. The outright deflating sectors dropped by two to 13 since our last update. Encouragingly, only 7 industries are experiencing a downtrend in selling price inflation, or 5 fewer than our most recent report. Impressively, deep cyclicals/commodity-related industries dominate the top ranks, occupying 8 out of the top 10 slots (top panel, Chart 3). A softening greenback and rising global end demand explain the commodity complex's sustained ability to increase prices. In contrast, tech, telecom and consumer discretionary sectors populate the bottom ranks of Table 2. Netting it out, accelerating corporate sector pricing power will continue to bolster top line growth in 2018. Tack on high operating leverage kicking into higher gear at this stage of the cycle and still muted wage inflation and profit margins and EPS growth will remain upbeat. With regard to cyclicals versus defensives, diverging pricing power (Chart 3) and wage growth trends (Chart 4) suggest that cyclicals continue to have the upper hand compared with defensives (Chart 5). Chart 3Deep Cyclicals... Deep Cyclicals... Deep Cyclicals... Chart 4...Have The Upper Hand... ...Have The Upper Hand... ...Have The Upper Hand... Chart 5...Vs. Defensives ...Vs. Defensives ...Vs. Defensives This week we update our view on a deep cyclical sector and modestly tweak our intra-sector positioning. Industrials And China We lifted the S&P industrials sector to an above benchmark allocation in early October via boosting the S&P construction machinery & heavy truck sub index to overweight.2 Synchronized global growth, a capex upcycle, firming capital goods final demand, and the U.S. dollar's fall coupled with the commodity price rebound all pointed to a bright outlook for U.S. capital goods producers. Currently, all these forces remain in play and continue to bolster industrials stocks' profit prospects. However, the emerging market (EM)/Chinese economic backdrop deserves closer scrutiny. Why? Because the most cyclical parts of the industrials complex are levered to the EM in general and China in particular. These high operating leverage businesses also drive relative profit and stock performance, signaling that China's economic growth might or ails determine the overall fortunes of U.S. capital goods producers. While Chinese economic data are currently a mixed bag and we take them with a big grain of salt, global high-frequency financial market data are emitting an unambiguously positive signal. First, BCA's FX strategist, Mathieu Savary, brought to our attention that the extremely economic-sensitive Canadian TSX Venture Exchange Index is in a V-shaped recovery.3 Highly speculative basic resources issues dominate this Index and help explain the tight positive correlation with Chinese output (top panel, Chart 6). Second, the ultimate economic-sensitive indicator, Dr. Copper, is also in a violent upswing, heralding that China will be, at least, stable in 2018 (middle panel, Chart 6). Third, high-beta Australian materials stocks have been in an upward trajectory since the early 2016 trough both versus the MSCI All-Country World Index and the broad Australian market, sniffing out improving Chinese-related commodity demand (bottom panel, Chart 6). Similarly, upbeat non-Chinese economic data suggest that China's economic prospects are far from faltering. Australia's close economic ties with China signal that taking a pulse of the Australian economic juggernaut reveals the state of China's economic affairs. Down Under employment growth has been brisk of late, with annual job creation running at a 3.3% clip, a rate last hit in the mid-2000s when China's economy was roaring and the commodity super-cycle was in full swing (second panel, Chart 7). Australian CEO confidence as well as consumer confidence are pushing decade highs, and the manufacturing PMI survey recently shot to a 16 year high (third panel, Chart 7). Chart 6China Is##BR##Alright China Is Alright China Is Alright Chart 7Australian Indicators Confirm:##BR## China Is Stable Australian Indicators Confirm: China Is Stable Australian Indicators Confirm: China Is Stable All of this suggests that China will likely remain stable in 2018, barring a policy mistake a la the August 11, 2015 currency devaluation. The upshot is that industrials EPS and equities have more room to run. On that front, both our Cyclical Macro Indicator and our profit growth model corroborate that the path of least resistance for relative share prices is higher (Chart 8). U.S. dollar debasing is synonymous with capital goods producers' top line growth acceleration, as a large part of total revenues are sourced from abroad. The near 20 percentage point fall in the trade-weighted U.S. dollar since 2015 suggests that more global market share gains are in store for U.S. industrials (Chart 9). Global growth is also joined at the hip with the greenback's depreciation. Synchronized global growth along with our derivative coordinated global capex growth 2018 theme, will likely serve as catalysts for a sustained breakout in relative share prices (Chart 10). Chart 8EPS Model And CMI Flash Green EPS Model And CMI Flash Green EPS Model And CMI Flash Green Chart 9Industrials Love A Cheap Greenback Industrials Love A Cheap Greenback Industrials Love A Cheap Greenback Chart 10Levered To Global Growth Levered To Global Growth Levered To Global Growth Adding it up, a stable China is music to the ears of industrials executives. Tack on a depreciating U.S. dollar, rising commodity prices and sustained synchronized global growth and the most cyclical parts of the industrials complex will continue to lead the pack. Bottom Line: Stay overweight the S&P industrials index, but selectivity is warranted. Take Profits In Industrial Machinery We outlined above that the most cyclical parts of the S&P industrials index with high foreign sales content would benefit disproportionately from our stable-to-mildly sanguine EM/China view. While the broad machinery index fits the bill, the industrial machinery sub index less so, and we recommend monetizing gains of 4% since inception and moving to the sidelines. Chart 11 shows the relative performance of the two key drivers of the S&P machinery index: industrial machinery and construction machinery & heavy truck sub-indexes. While these indexes moved hand-in-hand since the mid-1990s, early this decade this tight positive correlation fell apart. One key determinant of the relative move of these indexes is the U.S. dollar. The greenback troughed in 2011 and since then the more "defensive", less globally-exposed S&P industrials machinery index left their brethren in the dust (bottom panel, Chart 11). Now that the U.S. dollar has peaked, the catch up phase in the S&P construction machinery & heavy truck index that is already underway will likely gain momentum (top panel, Chart 11). Beyond the depreciating currency, at the margin, softening S&P industrial machinery operating metrics argue for pruning exposure in this index. Both the Empire and Philly Fed new orders surveys have petered out, suggesting that industry new order growth will likely continue to lose steam (middle panel, Chart 12). In fact, a weak industrial machinery new orders-to-inventories ratio is also warning that sell-side analysts' relative profits forecasts are too optimistic (bottom panel, Chart 12). Chart 11Catch Up Phase Catch Up Phase Catch Up Phase Chart 12Waning End-Demand Waning End-Demand Waning End-Demand Drilling deeper into industry operating metrics is revealing. While shipments have held their own and moved mostly sideways similar to new orders, inventory accumulation is worrying. Industry inventories have risen by over 30% during the past three years (Chart 13). Simultaneously, industrial machinery backlogs have drifted steadily lower. Given the supply build up, any hiccup in demand, even a minor one, could prove very deflationary and heavily weigh on industry profitability. With regard to valuations, Chart 14 shows that both on a relative trailing price-to-sales and relative forward price-to-earnings ratio basis, the index is trading one standard deviation above the historical mean. The moderating industry demand backdrop suggests that relative valuations are expensive. Chart 13Inventory Liquidation Risk Inventory Liquidation Risk Inventory Liquidation Risk Chart 14Why Pay A Premium? Why Pay A Premium? Why Pay A Premium? Adding it all up, deteriorating profit prospects warn that investors should refrain from paying a premium valuation for the S&P industrial machinery index. Bottom Line: Book profits of 4% in the S&P industrial machinery index and downgrade to a benchmark allocation. We also recommend redeploying profits from our downgrade in the S&P industrial machinery index to their more cyclical machinery siblings the S&P construction machinery & heavy truck index, thus sustaining the overall overweight exposure in the broad S&P industrials sector. Housekeeping Last week we instituted a risk management tool for our 2018 high-conviction list: setting a stop once a call has cleared the 10% return mark.4 This past week, the S&P construction machinery & heavy truck index hit the trailing stop at the 10% mark, and thus we are booking gains and removing this index from the high-conviction list. While our confidence is not as high as in late-November given the parabolic move in this index and rising chance of a tactical overall equity market pullback, from a cyclical perspective we continue to recommend a core overweight in this industrials sector powerhouse. Anastasios Avgeriou, Vice President U.S. Equity Strategy anastasios@bcaresearch.com 1 Please see BCA U.S. Equity Strategy Weekly Report, "Too Good To Be True?" dated January 22, 2018, available at uses.bcaresearch.com. 2 Please see BCA U.S. Equity Strategy Weekly Report, "Earnings Take Center Stage," dated October 2, 2017, available at uses.bcaresearch.com. 3 Please see BCA Foreign Exchange Strategy Weekly Report, "Health Care Or Not, Risks Remain," dated March 24, 2017, available at fes.bcaresearch.com. 4 Please see BCA U.S. Equity Strategy Weekly Report, "Too Good To Be True?" dated January 22, 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 Q4 earnings are beating raised expectations, and the bar for 2018 EPS is even higher. Housing, capex and a nudge from government spending are set to boost GDP in 2018. BCA's consumer spending model shows that economic factors, not sentiment or political affiliation, are the main drivers of household consumption. Feature Risk assets continued their early 2018 surge last week, supported by better than expected Q4 corporate earnings results, solid economic growth and a weaker dollar. The headline 2.6% gain in Q4 GDP understated the strength in the U.S. economy as 2017 ended (Chart 1). Real final sales to domestic purchasers rose 4.3% in Q4, the fastest clip in nearly four years. Moreover, the economy is poised to grow well above its long term potential in the first half of 2018, aided by surging capex, the lagged effect of easy financial conditions and the tax bill. Faster growth will push down the unemployment rate and lead to higher inflation by year end. Q4 corporate earnings are beating raised expectations. However, managements have raised the bar for 2018 results, which may lead to disappointment later this year. Investors have correctly ignored the elevated level of political polarization in Washington and focused on the fundamentals. The final section of this week's bulletin suggests that despite a widening gap in consumer sentiment between political parties, economic fundamentals, not political affiliation, drives consumer behavior. Chart 1GDP Growth Remains Below Average, But Above Fed's Long Run Target As Good As It Gets? As Good As It Gets? Raising The Bar The Q4 earnings reporting season is off to a strong start, with both EPS and revenue growth ahead of consensus expectations at the start of January. Moreover, the counter-trend rally in margins remains in place. We previewed the Q4 2017 S&P 500 earnings season earlier this month.1 Table 1S&P 500: Q4 2017 Results* As Good As It Gets? As Good As It Gets? Just under 30% of companies have reported results thus far, with 80% beating consensus EPS projections, well above the long term average of 69%. Furthermore, 82% have posted Q4 revenues that topped expectations, which exceeded the long-term average of 56%. The surprise factor for Q4 stands at 5% for EPS and 1% for sales. Both readings are right at the average surprise in the past five years. The surprise figures are even more impressive given that analysts' views of Q4 results increased between the start of Q4 2017 and the start of Q4 reporting season. Analysts' estimates typically move lower as the quarter unfolds, in effect lowering the bar for results. 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 Q4 will be another quarter of margin expansion. Average earnings growth (Q4 2017 versus Q4 2016) is solid at 13% with revenue growth at 7%. However, on a four quarter basis, U.S. margins fell slightly in the fourth quarter, but remain at a high level on the back of decent corporate pricing power. A pick-up in productivity growth into year-end helped as well. Strength in earnings and revenues are broadly based (Table 1). Earnings per share increased in Q4 2017 versus Q4 2016 in 9 of the 11 sectors. EPS results are particularly stout in energy (140%), materials (28%), technology (18%) and financials (15%). The energy, materials and technology sectors likewise experienced significant sales gains (21%, 11%, and 11% respectively). The 5% year-over-year increase in financial sector earnings follows the 7% drop in Q3, owing to the impact of Hurricanes Harvey and Irma on the insurance and reinsurance industries. Excluding energy, S&P 500 profits in Q4 2017 versus Q4 2016 are a still-robust 11%. Upbeat managements have raised the bar significantly for 2018 results in the past few months (Chart 2). On October 1, 2017, before the GOP introduced the bill, the bottom-up estimate for 2018 S&P 500 EPS growth stood at 11%. As of January 26, 2018, the estimate is 17%. Moreover, the upward revisions are widespread. 2018 EPS growth rate estimates in 9 of 11 sectors are higher today than at the start of October (Table 2). 2018 consensus projections increased the most for Telecom, Financials, Energy, and Consumer Discretionary. Analysts have cut their view of 2018 results for the Utilities and Real Estate sectors since the bill was introduced. Our U.S. Equity Strategy service introduced profit models for all 11 S&P 500 sectors earlier this month.2 Chart 2Buybacks, Surging Capex Raising The Bar For 2018 EPS Growth Buybacks, Surging Capex Raising The Bar For 2018 EPS Growth Buybacks, Surging Capex Raising The Bar For 2018 EPS Growth Table 2Estimated Earnings Growth For 2018 As Good As It Gets? As Good As It Gets? The Tax Cut and Jobs Act of 2017 is behind most of this ebullience, but improving 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 we noted in last week's report,3 companies are likely to return almost all of that cash to shareholders via increased buybacks. Moreover, a few firms are marking up 2018 estimates in anticipation of a surge in capital spending, as managements pull ahead new investment into 2018 from later years to benefit from the bill. Chart 3Profit Growth Will Peak In 2018 Profit Growth Will Peak In 2018 Profit Growth Will Peak In 2018 Analysts expect EPS growth to slow significantly in 2019 from the anticipated 2018 clip, which matches BCA's view. 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 late 2019.4 Bottom Line: The BCA earnings model shows that S&P 500 EPS growth is peaking on a four-quarter moving total basis, and should begin to decelerate in 2H 2018 to a level commensurate with 3 ½-4% nominal GDP growth (Chart 3). After-tax earnings growth will be higher than this, however, due to the recently passed tax cuts. Margins will crest in mid-2018, but 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 it remains to be seen whether managements can match the lofty projections, especially in the second half of the year. BCA expects growth outside the U.S. to remain robust, an additional support for EPS growth in the coming quarters. Further weakness in the dollar, counter to our call for a 5% gain in the DXY, would also provide a modest boost to S&P 500 results in 2018. Strong domestic economic activity will also boost profits this year. Setting The Stage For 2018 Q4 GDP posted a 2.6% gain, failing to match (raised) expectations of a 2.9% increase (Chart 1 again). At 2.5%, the year-over-year change in GDP exceeded the FOMC's forecast for 2017 GDP (2.1%) at the start of 2017. Moreover, the 2.5% year-over-year reading in Q4 is well above the Fed's estimate of potential GDP (1.8%). The implication for investors is that because U.S. economic growth is faster than its long-term potential, the labor market is tightening and inflation is poised to move higher. Accordingly, market odds for a Fed hike in March are over 90%, and investors expect almost three additional hikes in the next 12 months (Chart 4). The FOMC expects to raise rates three times this year. BCA's stance is that the Fed will raise rates 4 times. Chart 4The FOMC And The Market Are Closely Aligned On Rate Hikes In 2018 The FOMC And The Market Are Closely Aligned On Rate Hikes In 2018 The FOMC And The Market Are Closely Aligned On Rate Hikes In 2018 BCA's view is that U.S. economic growth is set to accelerate in the first half of 2018 aided by the tax cut, strong global growth and the lagged effect of easier financial conditions. The direct effect of the tax cuts will likely boost U.S. real GDP growth in 2018 by 0.2 to 0.3 percentage points. It could be more, depending on the impact on animal spirits in the business sector and any fresh infrastructure spending. Full expensing of capital goods and changes to the budget sequesters would add another 0.2 percentage points. Global growth estimates are still on the upswing, which will provide U.S. capex a boost (Charts 5 and 6). Moreover, financial conditions have eased since the Fed's initial hike of the cycle (Chart 7). Financial lead GDP growth by 6 to 9 months, suggesting that real GDP growth in the U.S. will remain at or above 3% for at least the first half of 2018 (Chart 8). The New York Fed's Nowcast for Q1 2018 stands at 3.1%, while the Atlanta Fed's GDP Now reading for Q1 is 3.4% (Chart 9). Chart 5Global Growth Expectations##BR##Are Accelerating Global Growth Expectations Are Accelerating Global Growth Expectations Are Accelerating Chart 6Capex Poised##BR##For Liftoff Capex Poised For Liftoff Capex Poised For Liftoff Chart 7Financial Conditions Have Eased Since##BR##The Fed's First Rate Hike Of The Cycle Financial Conditions Have Eased Since The Fed's First Rate Hike Of The Cycle Financial Conditions Have Eased Since The Fed's First Rate Hike Of The Cycle Chart 8Easier Financial Conditions##BR##Will Boost U.S. Growth Easier Financial Conditions Will Boost U.S. Growth Easier Financial Conditions Will Boost U.S. Growth Chart 9Solid GDP Growth##BR##Expected In Q1 Solid GDP Growth Expected In Q1 Solid GDP Growth Expected In Q1 Residential investment, which surged in Q4 as communities in Texas and Florida began to rebuild after the storms, will add to growth in 2018. Inventories of new and existing homes are close to all-time lows (Chart 10). Housing affordability remains well above average, and will remain supportive of housing investment even if rates rise by 100 bps (Chart 11). Bank managements are upbeat about credit quality and loan growth,5 although the recent soundings from the Fed's Senior Loan Officers survey shows that mortgage demand has ebbed in recent quarters. However, banks' lending standards for home loans remain relatively loose (Chart 12). Moreover, household formation recovered in the past few years alongside the labor market, providing additional support for housing. Risks to housing include the impact of the limits to mortgage interest and state and local taxes imposed by the Tax Cut and Jobs Act of 2017. Chart 10Solid Housing##BR##Fundamentals In Place Solid Housing Fundamentals In Place Solid Housing Fundamentals In Place Chart 11Housing Affordability Under##BR##Various Rate Assumptions Housing Affordability Under Various Rate Assumptions Housing Affordability Under Various Rate Assumptions Chart 12Mortgage Spigot##BR##Open For Homebuyers Mortgage Spigot Open For Homebuyers Mortgage Spigot Open For Homebuyers Bottom Line: U.S. economic growth is poised to string together the longest period of above-potential GDP growth since early in the recovery. The odds of a recession in 2018 are very low (Chart 13). Housing, capital spending and a modest lift from government spending will lift GDP, pushing the output gap further into positive territory (Chart 14). The added support to the economy from the tax bill makes it more likely that the economy will overheat, and lead to higher inflation and faster rate hikes than the market, or the Fed, expects. Stay underweight duration and overweight stocks versus bonds for now, although we plan to take some risk off the table later in the year. Despite record levels of political polarization, the U.S. consumer will provide support for the economy in 2018 as well. Chart 13Odds Of A Recession Are Low Odds Of A Recession Are Low Odds Of A Recession Are Low Chart 14U.S. Economy Growing Faster Than Potential U.S. Economy Growing Faster Than Potential U.S. Economy Growing Faster Than Potential Tribal Economics Chart 15Income Inequality Fosters Polarization Income Inequality Fosters Polarization Income Inequality Fosters Polarization Many of our clients have been asking: "Why is consumer confidence so high if Americans are so angry?" BCA's view is that Americans' anger is based to some extent on "economic discontent",6 driven largely by political orientation. However, economy-wide, the negative attitude based on party affinity is more than offset by a higher level of optimism based on economic fundamentals. Moreover, the dissatisfaction among households may be about structural issues that have long-term implications, like income inequality, which fosters or nurtures polarization and where the latter continues to grow. The polarization in the cultural realm has been mirrored in the political arena. According to political scientists Keith Poole and Howard Rosenthal, polarization in Congress is currently at its highest level since World War II (Chart 15). Furthermore, BCA's Geopolitical Strategy service stance is that the long-term implications of polarization are here to stay as income inequality remains the most significant driver, among five main factors, that explain the polarization in the U.S. today.7 & 8 The election of President Trump in November 2016 ushered in a period of significant polarization and partisan conflict. Compared with other administrations, Trump effected the most change in economic expectations9 (Table 3). Moreover, even a year later, the partisan gap (Republicans minus Democrats) has widened further; Republicans are most optimistic and Democrats are most pessimistic (Chart 16). Table 3Change In Economic Assessments##BR##Pre And Post Elections As Good As It Gets? As Good As It Gets? Chart 16Partisan Gap Is Widest##BR##And Persistent, For Now Partisan Gap Is Widest And Persistent, For Now Partisan Gap Is Widest And Persistent, For Now To further understand the divergence between the elevated consumer sentiment readings and households' high level of anger, it is useful to look through the lens of the stages of "economic discontent".10 The framework pioneered by the University of Michigan identifies five typical stages of a collapse in economic confidence (Table 4). The study acknowledges that consumers are rational individuals. As such, households tend to shape their economic expectations on cyclical fundamental drivers of the economy, rather than political affiliation (Chart 17). The implication is that as long as consumers remain satisfied with the performance of the three cyclical drivers, readings on consumer sentiment will hold up, as the positive views on fundamentals outweigh any resentment they may have about long-term issues like income inequality. Finally, it is clear that households have not lost all hope (stage four), where economic discontent turns into political discontent. Consumers are very far away from total despair, not seen since the 1930s! Nonetheless, BCA's view is that with recession likely by late 2019/early 2020, the U.S. will see a revolt of some kind by the 2020 election.11 Table 4Five Stages Of##BR##Economic Discontent As Good As It Gets? As Good As It Gets? Chart 17Expectations For Cyclical##BR##Fundamental Drivers Are Solid Expectations For Cyclical Fundamental Drivers Are Solid Expectations For Cyclical Fundamental Drivers Are Solid Consumers have hope that their economic expectations will be met by the Trump administration's policies as the economy continues to deliver strong job growth/job security and tame inflation, preserving households' purchasing power. BCA's consumer spending model shows that economic factors, not sentiment, are the main drivers of household consumption (Chart 18). Several academic studies support this view. Researchers at Princeton University and the National Bureau of Economic Research find that political polarization's impact on consumer spending is trivial.12 Furthermore, a recent study by the Federal Reserve Bank of New York,13 also finds that the election of President Trump had negligible partisan impact on consumer spending patterns. Economists at the NY Fed show that consumers' expectations in surveys may include "true beliefs" based on economic factors and "some noise". They conclude that if the partisan gap does not cause economic decisions to vary significantly, then macroeconomists and policymakers should downplay the impact of consumers' political views on spending patterns. Chart 18Consumption Has##BR##Room To Grow Consumption Has Room To Grow Consumption Has Room To Grow Chart 19Lower-Lows In The Personal##BR##Savings Rate Unlikely Lower-Lows In The Personal Savings Rate Unlikely Lower-Lows In The Personal Savings Rate Unlikely Bottom Line: BCA expects consumer spending to grow by at least 2% in 2018. Consumption is well supported by record high household net worth, and accelerating wages. On the other hand, employment growth will slow later this year and we should not assume that the personal saving rate will keep falling given that it has hit a recovery low of 3.1% (Chart 19). John Canally, CFA, Senior Vice President U.S. Investment Strategy johnc@bcaresearch.com Jizel Georges, Senior Analyst jizelg@bcaresearch.com 1 Please see BCA Research's U.S. Investment Strategy Weekly Report, "A Smooth Transition" published January 15, 2018. Available at usis.bcaresearch.com. 2 Please see BCA Research's U.S. Equity Strategy Weekly Report, "White Paper: Introducing Our U.S. Equity Sector Earnings Models" published January 16, 2018. Available at uses.bcaresearch.com. 3 Please see BCA Research's U.S. Investment Strategy Weekly Report, "Variations On A Theme" published January 22, 2018. Available at usis.bcaresearch.com. 4 Please see BCA Research's Global Investment Strategy Weekly Report, "Strategy Outlook Fourth Quarter 2017: Goldilocks And The Recession Bear," October 4, 2017. Available at gis.bcaresearch.com. 5 Please see BCA Research's U.S. Investment Strategy Weekly Report, "Variations On A Theme", published January 22,2018. Available at usis.bcaresearch.com. 6 "Economic Discontent: Causes and Consequences", Richard Curtin, Director, Survey of Consumers, University of Michigan, November 12, 2008. 7 Please see BCA Research's Global Investment Strategy Special Report, "The Future Of Western Democracy: Back To Blood", dated November 18, 2016. Available at gis.bcaresearch.com. 8 Please see BCA Research's Geopolitical Strategy Special Report, "U.S. Election: Outcomes And Investment Implications", dated November 9, 2016. Available at gps.bcaresearch.com. 9 "Consumer Expectations: Politics Trumps Economics", Richard Curtin, University of Michigan, June 1, 2017. 10 "Economic Discontent: Causes and Consequences", Richard Curtin, Director, Survey of Consumers, University of Michigan, November 12, 2008. 11 Please see BCA Research's Geopolitical Strategy Special Report "Populism Blues: How And Why Social Instability Is Coming To America" June 9, 2017. Available at gps.bcaresearch.com. 12 "Partisan Bias, Economic Expectations, and Household Spending", Atif Mian, Amir Sufi and Nasim Koshkhou, Stanford University, University of Chicago Booth of Business, NBER and Argus Information and Advisory Services, July 2017. 13 "Political Polarization In Consumer Expectations", Olivier Armantier, John J. Conlon and Wilbert van der Klaauw, Federal Reserve Bank of New York, December 15, 2017.

Highlights U.S. equities 'melted up' in January as tax cuts made the robust growth/low inflation sweet spot even sweeter. Ominously, recent market action is beginning to resemble a classic late cycle blow-off phase. The fundamentals supporting the market will persist through most of the year, before an economic downturn in the U.S. takes hold in 2019. The repatriation of overseas corporate cash will also flatter EPS growth this year via buyback and M&A activity. The S&P 500 could return 14% or more this year. Unfortunately, the consensus now shares our upbeat view for 2018. Valuation is stretched and many indicators suggest that investors have become downright giddy. This month we compare valuation across the major asset classes. U.S. equities are the most overvalued, followed by gold, raw industrials and EM assets. Oil is still close to fair value. Long-term investors should already be scaling back on risk assets. Investors with a 6-12 month horizon should stay overweight equities versus bonds for now, but a risk management approach means that they should not try to squeeze out the last few percentage points of return. In terms of the sequencing of the exit from risk, the most consistent lead/lag relationship relative to previous tops in the equity market is provided by U.S. corporate bonds. For this reason, we are likely to take profits on corporates before equities. EM assets are already at underweight. We still see a window for the U.S. dollar to appreciate, although by only about 5%. A lot of good news is discounted in the euro, peripheral core inflation is slowing and ECB policymakers are getting nervous. Monetary policy remains the main risk to a pro-cyclical investment stance, although not because of the coming change in the makeup of the FOMC. The economy and inflation should justify four Fed rate hikes in 2018 no matter the makeup. The bond bear phase will continue. Feature Chart I-1Investors Are Giddy Investors Are Giddy Investors Are Giddy U.S. equities 'melted up' in January as tax cuts made the robust growth/low inflation sweet spot even sweeter. Ominously, though, recent market action is beginning to resemble the classic late cycle blow-off phase. Such blow-offs can be highly profitable, but also make it more difficult to properly time the market top. Our base case is that the fundamentals supporting the market will persist through most of the year, before an economic downturn in the U.S. takes hold in 2019. Unfortunately, the consensus now shares our upbeat view for 2018 and many indicators suggest that investors have become downright giddy (Chart I-1). These indicators include investor sentiment, our speculation index, and the bull-to-bear ratio. Net S&P earnings revisions and the U.S. economic surprise index are also extremely elevated, while equity and bond implied volatility are near all-time lows. From a contrarian perspective, these observations suggest that a lot of good news is discounted and that the market is vulnerable to even slight disappointments. It is also a bad sign that our Revealed Preference Indicator moved off of its bullish equity signal in January (see Section III for more details). Meanwhile, central banks are beginning to take away the punchbowl as global economic slack dissipates. This is all late-cycle stuff. Equity valuation does not help investors time the peak in markets, but it does tell us something about downside risk and medium-term expected returns. The Shiller P/E ratio has surged above 30 (Chart I-2). Chart I-3 highlights that, historically, average total returns were negligible over the subsequent 10-year period when the Shiller P/E was in the 30-40 range. Granted, the Shiller P/E will likely fall mechanically later this year as the collapse of earnings in 2008 begins to drop out of the 10-year EPS calculation. Nonetheless, even the BCA Composite Valuation indicator, which includes some metrics that account for extremely low bond yields, surpassed +1 standard deviations in January (our threshold for overvaluation; Chart I-2, bottom panel). An overvaluation signal means that investors should be biased to take profits early. Chart I-2BCA Valuation Indicator Surpasses One Sigma BCA Valuation Indicator Surpasses One Sigma BCA Valuation Indicator Surpasses One Sigma Chart I-3Expected Returns Given Starting Point Shiller P/E February 2018 February 2018 As we highlighted in our 2018 Outlook Report, long-term investors should already be scaling back on risk assets. We recommend that investors with a 6-12 month horizon should stay overweight equities versus bonds for now, but we need to be vigilant in terms of scouring for signals to take profits. A risk management approach means that investors should not try to get the last few percentage points of return before the peak. U.S. Earnings And Repatriation Before we turn to the timing and sequence of our exit from risk assets, we will first update our thoughts on the earnings cycle. Fourth quarter U.S. earnings season is still in its early innings, but the banking sector has set an upbeat tone. S&P 500 profits are slated to register a 12% growth rate for both Q4/2017 and calendar 2017. Current year EPS growth estimates have been aggressively ratcheted higher (from 12% growth to 16%) in a mere three weeks on the back of Congress' cut to the corporate tax rate.1 U.S. margins fell slightly in the fourth quarter, but remain at a high level on the back of decent corporate pricing power. A pick-up in productivity growth into year-end helped as well. Our short-term profit model remains extremely upbeat (Chart I-4). The positive profit outlook for the first half of the year is broadly based across sectors as well, according to the recently updated EPS forecast models from BCA's U.S. Equity Sector Strategy service.2 The repatriation of overseas corporate cash will also flatter EPS growth this year via buyback and M&A activity. Studies of the 2004 repatriation legislation show that most of the funds "brought home" were paid out to shareholders, mostly in the form of buybacks. A NBER report estimated that for every dollar repatriated, 92 cents was subsequently paid out to shareholders in one form or another. The surge in buybacks occurred in 2005, according to the U.S. Flow of Funds accounts and a proxy using EPS growth less total dollar earnings growth for the S&P 500 (Chart I-5). The contribution to EPS growth from buybacks rose to more than 3 percentage points at the peak in 2005. Chart I-4Profit Growth Still Accelerating Profit Growth Still Accelerating Profit Growth Still Accelerating Chart I-5U.S. Buybacks To Lift EPS U.S. Buybacks To Lift EPS U.S. Buybacks To Lift EPS We expect that most of the repatriated funds will again flow through to shareholders, rather than be used to pay down debt or spent on capital goods. Cash has not been a constraint to capital spending in recent years outside of perhaps the small business sector, which has much less to gain from the tax holiday. A revival in animal spirits and capital spending is underway, but this has more to do with the overall tax package and global growth than the ability of U.S. companies to repatriate overseas earnings. Estimates of how much the repatriation could boost EPS vary widely. Most of it will occur in the Tech and Health Care sectors. Buybacks appear to have lifted EPS growth by roughly one percentage point over the past year. We would not be surprised to see this accelerate by 1-2 percentage points, although the timing could be delayed by a year if the 2004 tax holiday provides the correct timeline. This is certainly positive for the equity market, but much of the impact could already be discounted in prices. Organic earnings growth, and the economic and policy outlook will be the main drivers of equity market returns over the next year. We expect some profit margin contraction later this year, but our 5% EPS growth forecast is beginning to look too conservative. This is especially the case because it does not include the corporate tax cuts. The amount by which the tax cuts will boost earnings on an after-tax basis is difficult to estimate, but we are using 5% as a conservative estimate. Adding 2% for buybacks and 2% for dividends, the S&P 500 could provide an attractive 14% total return this year (assuming no multiple expansion). Timing The Exit Chart I-6Timing The Exit (I) Timing The Exit (I) Timing The Exit (I) That said, we noted in last month's Report and in BCA's 2018 Outlook that this will be a transition year. We expect a recession in the U.S. sometime in 2019 as the Fed lifts rates into restrictive territory. Equities and other risk assets will sniff out the recession about six months in advance, which means that investors should be preparing to take profits sometime during the next 12 months. Last month we discussed some of the indicators we will watch to help us time the exit. The 2/10 Treasury yield curve has been a reliable recession indicator in the past. However, the lead time on the peak in stocks was quite extended at times (Chart I-6). A shift in the 10-year TIPS breakeven rate above 2.4% would be consistent with the Fed's 2% target for the PCE measure of inflation. This would be a signal that the FOMC will have to step-up the pace of rate hikes and aggressively slow economic growth. We expect the Fed to tighten four times in 2018. We are likely to take some money off the table if core inflation is rising, even if it is still below 2%, at the time that the TIPS breakeven reaches 2.4%. We will also be watching seven indicators that we have found to be useful in heralding market tops, which are summarized in our Scorecard Indicator (Chart I-7). At the moment, four out of the seven indicators are positive (Chart I-8): State of the Business Cycle: As early signals that the economy is softening, watch for the ISM new orders minus inventories indicator to slip below zero, or the 3-month growth rate of unemployment claims to rise above zero. Monetary and Financial Conditions: Using interest rates to judge the stance of monetary policy has been complicated by central banks' use of their balance sheet as a policy tool. Thus, it is better to use two of our proprietary indicators: the BCA Monetary Indicator (MI) and the Financial Conditions Indictor. The S&P 500 index has historically rallied strongly when the MI is above its long-term average. Similarly, equities tend to perform well when the FCI is above its 250-day moving average. The MI is sending a negative signal because interest rates have increased and credit growth has slowed. However, the broader FCI remains well in 'bullish' territory. Price Momentum: We simply use the S&P 500 relative to its 200-day moving average to measure momentum. Currently, the index is well above that level, providing a bullish signal for the Scorecard. Sentiment: Our research shows that stock returns have tended to be highest following periods when sentiment is bearish but improving. In contrast, returns have tended to be lowest following periods when sentiment is bullish but deteriorating. The Scorecard includes the BCA Speculation Indicator to capture sentiment, but virtually all measures of sentiment are very high. The next major move has to be down by definition. Thus, sentiment is assigned a negative value in the Scorecard. Value: As discussed above, value is poor based on the Shiller P/E and the BCA Composite Valuation indicator. Valuation may not help with timing, but we include it in our Scorecard because an overvalued signal means investors should err on the side of getting out early. Chart I-7Equity ScoreCard: Watch For A Dip Below 3 Equity ScoreCard: Watch For A Dip Below 3 Equity ScoreCard: Watch For A Dip Below 3 Chart I-8Timing The Exit (II) Timing The Exit (II) Timing The Exit (II) We demonstrated in previous research that a Scorecard reading of three or above was historically associated with positive equity total returns in subsequent months. A drop below three this year would signal the time to de-risk. Table I-1Exit Checklist February 2018 February 2018 To our Checklist we add the U.S. Leading Economic index, which has a good track record of calling recessions. However, we will use the LEI excluding the equity market, since we are using it as an indicator for the stock market. It is bullish at the moment. Our Global LEI is also flashing green. Table I-1 provides a summary checklist for trimming equity exposure. At the moment, 2 out of 9 indicators are bearish. Cross Asset Valuation Comparison Clients have asked our view on the appropriate order in which to scale out of risk assets. One way to approach the question is to compare valuation across asset classes. Presumably, the ones that are most overvalued are at greatest risk, and thus profits should be taken the earliest. It is difficult to compare valuation across asset classes. Should one use fitted values from models or simple deviations from moving averages? Over what time period? Since there is no widely accepted approach, we include multiple measures. More than one time period was used in some cases to capture regime changes. Table I-2 provides out 'best guestimate' for nine asset classes. The approaches range from sophisticated methods developed over many years (i.e. our equity valuation indicators), to regression analysis on the fundamentals (oil), to simple deviations from a time trend (real raw industrial commodity prices and gold). Table I-2Valuation Levels For Major Asset Classes February 2018 February 2018 We averaged the valuation readings in cases where there are multiple estimates for a single asset class. The results are shown in Chart I-9. Chart I-9Valuation Levels For Major Asset Classes February 2018 February 2018 U.S. equities stand out as the most expensive by far, at 1.8 standard deviations above fair value. Gold, raw industrials and EM equities are next at one standard deviation overvalued. EM sovereign bond spreads come next at 0.7, followed closely by U.S. Treasurys (real yield levels) and investment-grade corporate (IG) bonds (expressed as a spread). High-yield (HY) is only about 0.3 sigma expensive, based on default-adjusted spreads over the Treasury curve. That said, both IG and HY are quite expensive in absolute terms based on the fact that government bonds are expensive. Oil is sitting very close to fair value, despite the rapid price run up over the past couple of months. This makes oil exposure doubly attractive at the moment because the fundamentals point to higher prices at a time when the underlying asset is not expensive. Sequencing Around Past S&P 500 Peaks Historical analysis around equity market peaks provides an alternative approach to the sequencing question. Table I-3 presents the number of days that various asset classes peaked before or after the past major five tops in the S&P 500. A negative number indicates that the asset class peaked before U.S. equities, and a positive number means that it peaked after. Table I-3Asset Class Leads & Lags Vs. Peak In S&P 500 February 2018 February 2018 Unfortunately, there is no consistent pattern observed for EM equities, raw industrials, U.S. cyclical stocks, Tech stocks, or small-cap versus large-cap relative returns. Sometimes they peaked before the S&P 500, and sometime after. The EM sovereign bond excess return index peaked about 130 days in advance of the 1998 and 2007 U.S. equity market tops, although we only have three episodes to analyse due to data limitations. Oil is a mixed bag. A peak in the price of gold led the equity market in four out of five episodes, but the lead time is long and variable. The most consistent lead/lag relationship is given by the U.S. corporate bond market. Both investment- and speculative-grade excess returns relative to government bonds peaked in advance of U.S. stocks in four of the five episodes. High-yield excess returns provided the most lead time, peaking on average 154 days in advance. Excess returns to high-yield were a better signal than total returns. This leading relationship is one reason why we plan to trim exposure to corporate bonds within our bond portfolio in advance of scaling back on equities. But the 'return of vol' that we expect to occur later this year will take a toll on carry trades more generally. We are already underweight EM equities and bonds. This EM recommendation has not gone in our favor, but it would make little sense to upgrade them now given our positive views on volatility and the dollar. An unwinding of carry trades will also hit the high-yielding currencies outside of the EM space, such as the Kiwi and Aussie dollar. Base metal prices will be hit particularly hard if the 2019 U.S. recession spills over to the EM economies as we expect. We may downgrade base metals from neutral to underweight around the time that we downgrade equities, but much depends on the evolution of the Chinese economy in the coming months. Oil is a different story. OPEC 2.0 is likely to cut back on supply in the face of an economic downturn, helping to keep prices elevated. We therefore may not trim energy exposure this year. As for equity sectors, our recommended portfolio is still overweight cyclicals for now. Our synchronized global capex boom, rising bond yield, and firm oil price themes keep us overweight the Industrials, Energy and Financial sectors. Utilities and Homebuilders are underweight. Tech is part of the cyclical sector, but poor valuation keeps us underweight. That said, our sector specialists are already beginning a gradual shift away from cyclicals toward defensives for risk management purposes. This transition will continue in the coming months as we de-risk. We are also shifting small caps to neutral on earnings disappointments and elevated debt levels. The Dollar Pain Trade Market shifts since our last publication have largely gone in our favor; stocks have surged, corporate bonds spreads have tightened, oil prices have spiked, bonds have sold off and cyclical stocks have outperformed defensives. One area that has gone against us is the U.S. dollar. Relative interest rate expectations have moved in favor of the dollar as we expected at both the short- and long-ends of the curve. Nonetheless, the dollar has not tracked its historical relationship versus both the yen and euro. The Greenback did not even get a short-term boost from the passage of the tax plan and holiday on overseas earnings. Perhaps this is because the lion's share of "overseas" earnings are already held in U.S. dollars. Reportedly, a large fraction is even held in U.S. banks on U.S. territory. Currency conversion is thus not a major bullish factor for the U.S. dollar. The recent bout of dollar weakness began around the time of the release of the ECB Minutes in January which were interpreted as hawkish because they appeared to be preparing markets for changes in monetary policy. The European debt crisis and economic recession were the reasons for the ECB's asset purchases and negative interest rate policy. Neither of these conditions are in place now. The ECB is meeting as we go to press, and we expect some small adjustments in the Statement that remove references to the need for "crisis" level accommodations. Subsequent steps will be to prepare markets for a complete end to QE, perhaps in September, and then for rates hikes likely in 2019. The key point is that European monetary policy has moved beyond 'peak stimulus' and the normalization process will continue. Perhaps this is partly to blame for euro strength although, as mentioned above, interest rate differentials have moved in favor of the dollar. Does this mean that the dollar has peaked and has entered a cyclical bear phase that will persist over the next 6-12 months? The answer is 'no', although we are less bullish than in the past. We believe there is still a window for the dollar to appreciate against the euro and in broader trade-weighted terms by about 5%. First, a lot of euro-bullish news has been discounted (Chart I-10). Positive economic surprises heavily outstripped that in the U.S. last year, but that phase is now over. The euro appears expensive based on interest rate differentials, and euro sentiment is close to a bullish extreme. This all suggests that market positioning has become a negative factor for the currency. Chart I-10Euro: A Lot Of Bullish News Is Discounted EURO: A Lot Of Bullish News Is Discounted EURO: A Lot Of Bullish News Is Discounted Second, the chorus of complaints against the euro's strength is growing among European central bankers, including Ewald Nowotny, the rather hawkish Austrian central banker. Policymakers' concerns may partly reflect the fact that peripheral inflation excluding food and energy has already weakened to 0.6% from a high of 1.3% in April last year (Chart I-10, fourth panel). Third, U.S. consumer price and wage inflation have yet to pick up meaningfully. The dollar should receive a lift if core U.S. inflation clearly moves toward the Fed's 2% target, as we expect. The FOMC would suddenly appear to have fallen behind the curve and U.S. rate expectations would ratchet higher. Chart I-10, bottom panel, highlights that the euro will weaken if U.S. core inflation rises versus that in the Eurozone. The implication is that the Euro's appreciation has progressed too far and is due for a pullback. As for the yen, the currency surged in January when the Bank of Japan (BoJ) announced a reduction in long-dated JGB purchases. This simply acknowledged what has already occurred. It was always going to be impossible to target both the quantity of bond purchases and the level of 10-year yield simultaneously. Keeping yields near the target required less purchases than they thought. The market interpreted the BoJ's move as a possible prelude to lifting the 10-year yield target. It is perhaps not surprising that the market took the news this way. The economy is performing extremely well; our model that incorporates high-frequency economic data suggests that real GDP growth will move above 3% in the coming quarters. The Japanese economy is benefiting from the end of a fiscal drag and from a rebound in EM growth. Nonetheless, following January's BoJ policy meeting, Kuroda poured cold water on speculation that the BoJ may soon end or adjust the YCC. Recent speeches by BoJ officials reinforce the view that the MPC wants to see an overshoot of actual inflation that will lower real interest rates and thereby reinforce the strong economic activity that is driving higher inflation. Only then will officials be convinced that their job is done. Given that inflation excluding food and energy only stands at 0.3%, the BoJ is still a long way from the overshoot it desires. On the positive side, Japan's large current account surplus and yen undervaluation provide underlying support for the currency. Balancing the offsetting positive and negative forces, our foreign exchange strategists have shifted to neutral on the yen. The Euro remains underweight while the dollar is overweight. Similar to our dollar view, we still see a window for U.S. Treasurys to underperform the global hedged fixed-income benchmark as world bond yields shift higher this year. European government bonds will also sell off, but should outperform Treasurys. JGBs will provide the best refuge for bondholders during the global bond bear phase, since the BoJ will prevent a rise in yields inside of the 10-year maturity. Our global bond strategists upgraded U.K. gilts to overweight in January. Momentum in the U.K. economy is slowing, as a weaker consumer, slower housing activity, and softer capital spending are offsetting a pickup in exports. With the inflationary impulse from the 2016 plunge in the Pound now fading, and with Brexit uncertainty weighing on business confidence, the Bank of England will struggle to raise rates in 2018. FOMC Transition Monetary policy remains the main risk to a pro-cyclical investment stance, although not because of the coming change in the makeup of the FOMC. An abrupt shift in policy is unlikely. There was some support at the December 2017 FOMC meeting to study the use of nominal GDP or price level targeting as a policy framework, but this has been an ongoing debate that will likely continue for years to come. The Fed will remain committed to its current monetary policy framework once Powell takes over. Table I-4 provides a summary of who will be on the FOMC next year, including their policy bias. Chart I-11 compares the recent FOMC makeup with the coming Powell FOMC (voting members only). The hawk/dove ratio will not change much under Powell, unless Trump stacks the vacant spots with hawks. Table I-4Composition Of The FOMC February 2018 February 2018 Chart I-11Composition Of Voting FOMC Members 2017 Vs. 2018 February 2018 February 2018 In any event, history shows that the FOMC strives to avoid major shifts in policy around changeovers in the Fed Chair. In previous transitions, the previous path for rates was maintained by an average of 13 months. Moreover, Powell has shown that he is not one to rock the boat during his time on the FOMC. It will be the evolution of the economy and inflation, not the composition of the FOMC, that will have the biggest impact on markets at the end of the day. Recent speeches reveal that policymakers across the hawk/dove spectrum are moving modesty toward the hawkish side because growth has accelerated at a time when unemployment is already considered to be below full-employment by many policymakers. The melt-up in equity indexes in January did little to calm worries about financial excesses either. The Fed is struggling to understand the strength of the structural factors that could be holding down inflation. This month's Special Report, beginning on page 21, focusses on the impact of robot automation. While advances on this front are impressive, we conclude that it is difficult to find evidence that robots are more deflationary than previous technological breakthroughs. Thus, increased robot usage should not prevent inflation from rising as the labor market continues to tighten. The macro backdrop will likely justify the FOMC hiking at least as fast as the dots currently forecast. The risks are skewed to the upside. The median Fed dot calls for an unemployment rate of 3.9% by end-2018, only marginally lower than today's rate of 4.1%. This is inconsistent with real GDP growth well in excess of its supply-side potential. The unemployment rate is more likely to reach a 49-year low of 3.5% by the end of this year. As highlighted in last month's Report, a key risk to the bull market in risk assets is the end of the 'low vol/low rate' world. The selloff in the bond market in January may mark the start of this process. Conclusions We covered a lot of ground in this month's Overview of the markets, so we will keep the conclusions brief and focused on the risks. Our key point is that the fundamentals remain positive for risk assets, but that a lot of good news is discounted and it appears that we have entered a classic blow-off phase. This will be a transition year to a recession in the U.S. in 2019. Given that valuation for most risk assets is quite stretched, and given that the monetary taps are starting to close, investors must plan for the exit and keep an eye on our timing checklist. The main risk to our pro-cyclical portfolio is a rise in U.S. inflation and the Fed's response, which we believe will end the sweet spot for risk assets. Apart from this, our geopolitical strategists point to several other items that could upset the applecart this year:3 1. Trade China has cooperated with the U.S. in trying to tame North Korea. Nonetheless, President Trump is committed to an "America First" trade policy and he may need to show some muscle against China ahead of the midterm elections in November in order to rally his base. It is politically embarrassing to the Administration that China racked up its largest trade surplus ever with the U.S. in Trump's first year in office. A key question is whether the President goes after China via a series of administrative rulings - such as the recently announced tariffs on solar panels and white goods - or whether he applies an across-the-board tariff and/or fine. The latter would have larger negative macroeconomic implications. 2. Iran On January 12, President Trump threatened not to waive sanctions against Iran the next time they come due (May 12), unless some new demands are met. Pressure from the U.S. President comes at a delicate time for Iran. Domestic unrest has been ongoing since December 28. Although protests have largely fizzled out, they have reopened the rift between the clerical regime, led by Supreme Leader Ayatollah Ali Khamenei, and moderate President Hassan Rouhani. Iranian hardliners, who control part of the armed forces, could lash out in the Persian Gulf, either by threatening to close the Straits of Hormuz or by boarding foreign vessels in international waters. The domestic political calculus in both Iran and the U.S. make further Tehran-Washington tensions likely. For the time being, however, we expect only a minor geopolitical risk premium to seep into the energy markets, supporting our bullish House View on oil prices. 3. China Last month's Special Report highlighted that significant structural reforms are on the way in China, now that President Xi has amassed significant political support for his reform agenda. The reforms should be growth-positive in the long term, but could be a net negative for growth in the near term depending on how deftly the authorities handle the monetary and fiscal policy dials. The risk is that the authorities make a policy mistake by staying too tight, as occurred in 2015. We are monitoring a number of indicators that should warn if a policy mistake is unfolding. On this front, January brought some worrying economic data. The latest figures for both nominal imports and money growth slowed. Given that M2 and M3 are components of BCA's Li Keqiang Leading Indicator, and that nominal imports directly impact China's contribution to global growth, this raises the question of whether December's economic data suggest that China is slowing at a more aggressive pace than we expect. For now, our answer is no. First, China's trade numbers are highly volatile; nominal import growth remains elevated after smoothing the data. Second, China's export growth remains buoyant, consistent with a solid December PMI reading. The bottom line is that we are sticking with our view that China will experience a benign deceleration in terms of its impact on DM risk assets, but we will continue to monitor the situation closely. Mark McClellan Senior Vice President The Bank Credit Analyst January 25, 2018 Next Report: February 22, 2018 1 According to Thomson Reuters/IBES. 2 Please see U.S. Equity Sector Strategy Special Report "White Paper: Introducing Our U.S. Equity Sector Earnings Models," dated January 16, 2018, available at uses.bcaresearch.com 3 For more information, please see BCA Geopolitical Strategy Weekly Report "Upside Risks In U.S., Downside Risks In China," dated January 17, 2018, available at gps.bcaresearch.com. Also see "Watching Five Risks," dated January 24, 2018. II. The Impact Of Robots On Inflation Media reports warn of a "Robot Apocalypse" that is already laying waste to jobs and depressing wages on a broad scale. Technological advance in the past has not prevented improving living standards or led to ever rising joblessness over the decades, but pessimists argue that recent advances are different. The issue is important for financial markets. If structural factors such as automation are holding back inflation by more than in previous decades, then the Fed will have to proceed very slowly in raising rates. We see no compelling evidence that the displacement effect of emerging technologies is any stronger than in the past. Robot usage has had a modest positive impact on overall productivity. Despite this contribution, overall productivity growth has been dismal over the past decade. If automation is increasing 'exponentially' and displacing workers on a broad scale as some claim, one would expect to see accelerating productivity growth, robust capital spending and more violent shifts in occupational shares. Exactly the opposite has occurred. Periods of strong growth in automation have historically been associated with robust, not lackluster, wage gains, contrary to the consensus view. The Fed was successful in meeting the 2% inflation target on average from 2000 to 2007, when the impact of the IT revolution on productivity (and costs) was stronger than that of robot automation today. This and other evidence suggest that it is difficult to make the case that robots will make it tougher for central banks to reach their inflation goals than did previous technological breakthroughs. For investors, this means that we cannot rely on automation to keep inflation depressed irrespective of how tight labor markets become. Recent breakthroughs in technology are awe-inspiring and unsettling. These advances are viewed with great trepidation by many because of the potential to replace humans in the production process. Hype over robots is particularly shrill. Media reports warn of a "Robot Apocalypse" that is already laying waste to jobs and depressing wages on a broad scale. In the first in our series of Special Reports focusing on the structural factors that might be preventing central banks from reaching their inflation targets, we demonstrated that the impact of Amazon is overstated in the press. We estimated that E-commerce is depressing inflation in the U.S. by a mere 0.1 to 0.2 percentage points. This Special Report tackles the impact of automation. We are optimistic that robot technology and artificial intelligence will significantly boost future productivity, and thus reduce costs. But, is there any evidence at the macro level that robot usage has been more deflationary than technological breakthroughs in the past and is, thus, a major driver of the low inflation rates we observe today across the major countries? The question matters, especially for the outlook for central bank policy and the bond market. If structural factors are indeed holding back inflation by more than in previous decades, then the Fed will have to proceed very slowly in raising rates. However, if low inflation simply reflects long lags between wages and the tightening labor market, then inflation may suddenly lurch to life as it has at the end of past cycles. The bond market is not priced for that scenario. Are Robots Different? A Special Report from BCA's Technology Sector Strategy service suggested that the "robot revolution" could be as transformative as previous General Purpose Technologies (GPT), including the steam engine, electricity and the microchip.1 GPTs are technologies that radically alter the economy's production process and make a major contribution to living standards over time. The term "robot" can have different meanings. The most basic definition is "a device that automatically performs complicated and often repetitive tasks," and this encompasses a broad range of machines: From the Jacquard Loom, which was invented over 200 years ago, on to Numerically Controlled (NC) mills and lathes, pick and place machines used in the manufacture of electronics, Autonomous Vehicles (AVs), and even homicidal robots from the future such as the Terminator. Our Technology Sector report made the case that there is nothing particularly sinister about robots. They are just another chapter in a long history of automation. Nor is the displacement of workers unprecedented. The industrial revolution was about replacing human craft labor with capital (machines), which did high-volume work with better quality and productivity. This freed humans for work which had not yet been automated, along with designing, producing and maintaining the machinery. Agriculture offers a good example. This sector involved over 50% of the U.S. labor force until the late 1800s. Steam and then internal combustion-powered tractors, which can be viewed as "robotic horses," contributed to a massive rise in output-per-man hour. The number of hours worked to produce a bushel of wheat fell by almost 98% from the mid-1800s to 1955. This put a lot of farm hands out of work, but these laborers were absorbed over time in other growing areas of the economy. It is the same story for all other historical technological breakthroughs. Change is stressful for those directly affected, but rising productivity ultimately lifts average living standards. Robots will be no different. As we discuss below, however, the increasing use of robots and AI may have a deeper and longer-lasting impact on inequality. Strong Tailwinds Chart II-1Robots Are Getting Cheaper Robots Are Getting Cheaper Robots Are Getting Cheaper Factory robots have improved immensely due to cheaper and more capable control and vision systems. As these systems evolve, the abilities of robots to move around their environment while avoiding obstacles will improve, as will their ability to perform increasingly complex tasks. Most importantly, robots are already able to do more than just routine tasks, thus enabling them to replace or aid humans in higher-skilled processes. Robot prices are also falling fast, especially after quality-adjusting the data (Chart II-1). Units are becoming easier to install, program and operate. These trends will help to reduce the barriers-to-entry for the large, untapped, market of small and medium sized enterprises. Robots also offer the ability to do low-volume "customized" production and still keep unit costs low. In the future, self-learning robots will be able to optimize their own performance by analyzing the production of other robots around the world. Robot usage is growing quickly according to data collected by the International Federation of Robotics (IFR) that covers 23 countries. Industrial robot sales worldwide increased to almost 300,000 units in 2016, up 16% from the year before (Chart II-2). The stock of industrial robots globally has grown at an annual average pace of 10% since 2010, reaching slightly more than 1.8 million units in 2016.2 Robot usage is far from evenly distributed across industries. The automotive industry is the major consumer of industrial robots, holding 45% of the total stock in 2016 (Chart II-3). The computer & electronics industry is a distant second at 17%. Metals, chemicals and electrical/electronic appliances comprise the bulk of the remaining stock. Chart II-2Global Robot Usage Global Robot Usage Global Robot Usage Chart II-3Global Robot Usage By Industry (2016) February 2018 February 2018 As far as countries go, Japan has traditionally been the largest market for robots in the world. However, sales have been in a long-term downtrend and the stock of robots has recently been surpassed by China, which has ramped up robot purchases in recent years (Chart II-4). Robot density, which is the stock of robots per 10 thousand employed in manufacturing, makes it easier to compare robot usage across countries (Chart II-5, panel 2). By this measure, China is not a heavy user of robots compared to other countries. South Korea stands at the top, well above the second-place finishers (Germany and Japan). Large automobile sectors in these three countries explain their high relative robot densities. Chart II-4Stock Of Robots By Country (I) Stock Of Robots By Country (I) Stock Of Robots By Country (I) Chart II-5Stock Of Robots By Country (II) (2016) February 2018 February 2018 While the growth rate of robot usage is impressive, it is from a very low base (outside of the automotive industry). The average number of robots per 10,000 employees is only 74 for the 23 countries in the IFR database. Robot use is tiny compared to total man hours worked. Chart II-6U.S. Investment In Robots U.S. Investment in Robots U.S. Investment in Robots In the U.S., spending on robots is only about 5% of total business spending on equipment and software (Chart II-6). To put this into perspective, U.S. spending on information, communication and technology (ICT) equipment represented 35-40% of total capital equipment spending during the tech boom in the 1990s and early 2000s.3 The bottom line is that there is a lot of hype in the press, but robots are not yet widely used across countries or industries. It will be many years before business spending on robots approaches the scale of the 1990s/2000s IT boom. A Deflationary Impact? As noted above, we view robotics as another chapter in a long history of technological advancements. Pessimists suggest that the latest advances are different because they are inherently more threatening to the overall job market and wage share of total income. If the pessimists are right, what are the theoretical channels though which this would have a greater disinflationary effect relative to previous GPT technologies? Faster Productivity Gains: Enhanced productivity drives down unit labor costs, which may be passed along to other industries (as cheaper inputs) and to the end consumer. More Human Displacement: The jobs created in other areas may be insufficient to replace the jobs displaced by robots, leading to lower aggregate income and spending. The loss of income for labor will simply go to the owners of capital, but the point is that the labor share of income might decline. Deflationary pressures could build as aggregate demand falls short of supply. Even in industries that are slow to automate, just the threat of being replaced by robots may curtail wage demands. Inequality: Some have argued that rising inequality is partly because the spoils of new technologies over the past 20 years have largely gone to the owners of capital. This shift may have undermined aggregate demand because upper income households tend to have a high saving rate, thereby depressing overall aggregate demand and inflationary pressures. The human displacement effect, described above, would exacerbate the inequality effect by transferring income from labor to the owners of capital. 1. Productivity It is difficult to see the benefits of robots on productivity at the economy-wide level. Productivity growth has been abysmal across the major developed countries since the Great Recession, but the productivity slowdown was evident long before Lehman collapsed (Chart II-7). The productivity slowdown continued even as automation using robots accelerated after 2010. Chart II-7Productivity Collapsed Despite Automation Productivity Collapsed Despite Automation Productivity Collapsed Despite Automation Some analysts argue that lackluster productivity is simply a statistical mirage because of the difficulties in measuring output in today's economy. We will not get into the details of the mismeasurement debate here. We encourage interested clients to read a Special Report by the BCA Global Investment Strategy service entitled "Weak Productivity Growth: Don't Blame The Statisticians." 4 Our colleague Peter Berezin makes the case that the unmeasured utility accruing from free internet services is large, but so was the unmeasured utility from antibiotics, radio, indoor plumbing and air conditioning. He argues that the real reason that productivity growth has slowed is that educational attainment has decelerated and businesses have plucked many of the low-hanging fruit made possible by the IT revolution. Cyclical factors stemming from the Great Recession and financial crisis are also to blame, as capital spending has been slow to recover in most of the advanced economies. Some other factors that help to explain the decline in aggregate productivity are provided in Appendix II-1. Nonetheless, the poor aggregate productivity performance does not mean that there are no benefits to using robots. The benefits are evident at the industrial level, where measurement issues are presumably less vexing for statisticians (i.e., it is easier to measure the output of the auto industry, for example, than for the economy as a whole). Chart II-8 plots the level of robot density in 2016 with average annual productivity growth since 2004 for 10 U.S. manufacturing industries (robot density is presented in deciles). A loose positive relationship is apparent. Chart II-8U.S.: Productivity Vs. Robot Density February 2018 February 2018 Academic studies estimate that robots have contributed importantly to economy-wide productivity growth. The Centre for Economic and Business Research (CEBR) estimated that labor productivity growth rises by 0.07 to 0.08 percentage points for every 1% rise in the rate of robot density.5 This implies that robots accounted for roughly 10% of the productivity growth experienced since the early 1990s in the major economies. Another study of 14 industries across 17 countries by the Centre for Economic Performance (CEP) found that robots boosted annual productivity growth by 0.36 percentage points over the 1993-2007 period.6 This is impressive because, if this estimate holds true for the U.S., robots' contribution to the 2½% average annual U.S. total productivity growth over the period was 14%. To put the importance of robotics into historical context, its contribution to productivity so far is roughly on par with that of the steam engine (Chart II-9). It falls well short of the 0.6 percentage point annual productivity contribution from the IT revolution. The implication is that, while the overall productivity performance has been dismal since 2007, it would have been even worse in the absence of robots. What does this mean for inflation? According to the "cost push" model of the inflation process, an increase in productivity of 0.36% that is not accompanied by associated wage gains would reduce unit labor costs (ULC) by the same amount. This should trim inflation if the cost savings are passed on to the end consumer, although by less than 0.36% because robots can only depress variable costs, not fixed costs. There indeed appears to be a slight negative relationship between robot density and unit labor costs at the industrial level in the U.S., although the relationship is loose at best (Chart II-10). Chart II-9GPT Contribution To Productivity February 2018 February 2018 Chart II-10U.S.: Unit Labor Costs Vs. Robot Density February 2018 February 2018 In theory, divergences in productivity across industries should only generate shifts in relative prices, and "cost push" inflation dynamics should only operate in the short term. Most economists believe that inflation is a purely monetary phenomenon in the long run, which means that central banks should be able to offset positive productivity shocks by lowering interest rates enough that aggregate demand keeps up with supply. Indeed, the Fed was successful in meeting the 2% inflation target on average from 2000 to 2007, when the impact of the IT revolution on productivity (and costs) was stronger than that of robot automation today. Also, note that inflation is currently low across the major advanced economies, irrespective of the level of robot intensity (Chart II-11). From this perspective, it is hard to see that robots should take much of the credit for today's low inflation backdrop. Chart II-11Inflation Vs. Robot Density February 2018 February 2018 2. Human Displacement A key question is whether robots and humans are perfect substitutes. If new technologies introduced in the past were perfect substitutes, then it would have led to massive underemployment and all of the income in the economy would eventually have migrated to the owners of capital. The fact that average real household incomes have risen over time, and that there has been no secular upward trend in unemployment rates over the centuries, means that new technologies were at least partly complementary with labor (i.e., the jobs lost as a direct result of productivity gains were more than replaced in other areas of the economy over time). Rather than replacing workers, in many cases tech made humans more productive in their jobs. Rising productivity lifted income and thereby led to the creation of new jobs in other areas. The capital that workers bring to the production process - the skills, know-how and special talents - became more valuable as interaction with technology increased. Like today, there were concerns in the 1950s and 1960s that computerization would displace many types of jobs and lead to widespread idleness and falling household income. With hindsight, there was little to worry about. Some argue that this time is different. Futurists frequently assert that the pace of innovation is not just accelerating, it is accelerating 'exponentially'. Robots can now, or will soon be able to, replace humans in tasks that require cognitive skills. This means that they will be far less complementary to humans than in the past. The displacement effect could thus be much larger, especially given the impressive advances in artificial intelligence. However, Box II-1 discusses why the threat to workers posed by AI is also heavily overblown in the media. The CEP multi-country study cited above did not find a large displacement effect; robot usage did not affect the overall number of hours worked in the 23 countries studied (although it found distributional effects - see below). In other words, rather than suppressing overall labor input, robot usage has led to more output, higher productivity, more jobs and stronger wage and income growth. A report by the Economic Policy Institute (EPI)7 takes a broader look at automation, using productivity growth and capital spending as proxies. Automation is what occurs as the implementation of new technologies is incorporated along with new capital equipment or software to replace human labor in the workplace. If automation is increasing 'exponentially' and displacing workers on a broad scale, one would expect to see accelerating productivity growth, robust capital spending, and more violent shifts in occupational shares. Exactly the opposite has occurred. Indeed, the report demonstrates that occupational employment shifts were far slower in the 2000-2015 period than in any decade in the 1900s (Chart II-12). Box II-1 The Threat From AI Is Overblown Media coverage of AI/Deep Learning has established a consensus view that we believe is well off the mark. A recent Special Report from BCA's Technology Sector Strategy service dispels the myths surrounding AI.8 We believe the consensus, in conjunction with warnings from a variety of sources, is leading to predictions, policy discussions, and even career choices based on a flawed premise. It is worth noting that the most vocal proponents of AI as a threat to jobs and even humanity are not AI experts. At the root of this consensus is the false view that emerging AI technology is anything like true intelligence. Modern AI is not remotely comparable in function to a biological brain. Scientists have a limited understanding of how brains work, and it is unlikely that a poorly understood system can be modeled on a computer. The misconception of intelligence is amplified by headlines claiming an AI "taught itself" a particular task. No AI has ever "taught itself" anything: All AI results have come about after careful programming by often PhD-level experts, who then supplied the system with vast amounts of high quality data to train it. Often these systems have been iterated a number of times and we only hear of successes, not the failures. The need for careful preparation of the AI system and the requirement for high quality data limits the applicability of AI to specific classes of problems where the application justifies the investment in development and where sufficient high-quality data exists. There may be numerous such applications but doubtless many more where AI would not be suitable. Similarly, an AI system is highly adapted to a single problem, or type of problem, and becomes less useful when its application set is expanded. In other words, unlike a human whose abilities improve as they learn more things, an AI's performance on a particular task declines as it does more things. There is a popular misconception that increased computing power will somehow lead to ever improving AI. It is the algorithm which determines the outcome, not the computer performance: Increased computing power leads to faster results, not different results. Advanced computers might lead to more advanced algorithms, but it is pointless to speculate where that may lead: A spreadsheet from 2001 may work faster today but it still gives the same answer. In any event, it is worth noting that a tool ceases to be a tool when it starts having an opinion: there is little reason to develop a machine capable of cognition even if that were possible. Chart II-12U.S. Job Rotation Has Slowed February 2018 February 2018 The EPI report also notes that these indicators of automation increased rapidly in the late 1990s and early 2000s, a period that saw solid wage growth for American workers. These indicators weakened in the two periods of stagnant wage growth: from 1973 to 1995 and from 2002 to the present. Thus, there is no historical correlation between increases in automation and wage stagnation. Rather than automation, the report argues that it was China's entry into the global trading system that was largely responsible for the hollowing out of the U.S. manufacturing sector. We have also made this argument in previous research. The fact that the major advanced economies are all at, or close to, full employment supports the view that automation has not been an overwhelming headwind for job creation. Chart II-13 demonstrates that there has been no relationship between the change in robot density and the loss of manufacturing jobs since 1993. Japan is an interesting case study because it is on the leading edge of the problems associated with an aging population. Interestingly, despite a worsening labor shortage, robot density among Japanese firms is falling. Moreover, the Japanese data show that the industries that have a high robot usage tend to be more, not less, generous with wages than the robot laggard industries. Please see Appendix II-2 for more details. Chart II-13Global Manufacturing Jobs Vs. Robot Density February 2018 February 2018 The bottom line is that it does not appear that labor displacement related to automation has been responsible in any meaningful way for the lackluster average real income growth in the advanced economies since 2007. 3. Inequality That said, there is evidence suggesting that robots are having important distributional effects. The CEP study found that robot use has reduced hours for low-skilled and (to a lesser extent) middle-skilled workers relative to the highly skilled. This finding makes sense conceptually. Technological change can exacerbate inequality by either increasing the relative demand for skilled over unskilled workers (so-called "skill-biased" technological change), or by inducing companies to substitute machinery and other forms of physical capital for workers (so-called "capital-biased" technological change). The former affects the distribution of labor income, while the latter affects the share of income in GDP that labor receives. A Special Report appearing in this publication in 2014 focused on the relationship between technology and inequality.9 The report highlighted that much of the recent technological change has been skill-biased, which heavily favors workers with the talent and education to perform cognitively-demanding tasks, even as it reduces demand for workers with only rudimentary skills. Moreover, technological innovations and globalization increasingly allow the most talented individuals to market their skills to a much larger audience, thus bidding up their wages. The evidence suggests that faster productivity growth leads to higher average real wages and improved living standards, at least over reasonably long horizons. Nonetheless, technological change can, and in the future almost certainly will, increase income inequality. The poor will gain, but not as much as the rich. The fact that higher-income households tend to maintain a higher savings rate than low-income households means that the shift in the distribution of income toward the higher-income households will continue to modestly weigh on aggregate demand. Can the distribution effect be large enough to have a meaningful depressing impact on inflation? We believe that it has played some role in the lackluster recovery since the Great Recession, with the result that an extended period of underemployment has delivered a persistent deflationary impulse in the major developed economies. However, as discussed above, stimulative monetary policy has managed to overcome the impact of inequality and other headwinds on aggregate demand, and has returned the major countries roughly to full employment. Indeed, this year will be the first since 2007 that the G20 economies as a group will be operating slightly above a full employment level. Inflation should respond to excess demand conditions, irrespective of any ongoing demand headwind stemming from inequality. Conclusions Technological change has led to rising living standards over the decades. It did not lead to widespread joblessness and did not prevent central banks from meeting their inflation targets over time. The pessimists argue that this time is different because robots/AI have a much larger displacement effect. Perhaps it will be 20 years before we will know the answer. But our main point is that we have found no evidence that recent advances in robotics and AI, while very impressive, will be any different in their macro impact. There is little evidence that the modern economy is less capable in replacing the jobs lost to automation, although the nature of new technologies may be affecting the distribution of income more than in the past. Real incomes for the middle- and lower-income classes have been stagnant for some time, but this is partly due to productivity growth that is too low, not too high. Moreover, it is not at all clear that positive productivity shocks are disinflationary beyond the near term. The link between robot usage and unit labor costs over the past couple of decades is loose at best at the industry level, and is non-existent when looking across the major countries. The Fed was able to roughly meet its 2% inflation target in the 1990s and the first half of the 2000s, despite IT's impressive contribution to productivity growth during that period. For investors, this means that we cannot rely on automation to keep inflation depressed irrespective of how tight labor markets become. The global output gap will shift into positive territory this year for the first time since the Great Recession. Any resulting rise in inflation will come as a shock since the bond market has discounted continued low inflation for as far as the eye can see. We expect bond yields and implied volatility to rise this year, which may undermine risk assets in the second half. Mark McClellan Senior Vice President The Bank Credit Analyst Brian Piccioni Vice President Technology Sector Strategy Appendix II-1 Why Is Productivity So Low? A recent study by the OECD10 reveals that, while frontier firms are charging ahead, there is a widening gap between these firms and the laggards. The study analyzed firm-level data on labor productivity and total factor productivity for 24 countries. "Frontier" firms are defined to be those with productivity in the top 5%. These firms are 3-4 times as productive as the remaining 95%. The authors argue that the underlying cause of this yawning gap is that the diffusion rate of new technologies from the frontier firms to the laggards has slowed within industries. This could be due to rising barriers to entry, which has reduced contestability in markets. Curtailing the creative-destruction process means that there is less pressure to innovate. Barriers to entry may have increased because "...the importance of tacit knowledge as a source of competitive advantage for frontier firms may have risen if increasingly complex technologies were to increase the amount and sophistication of complementary investments required for technological adoption." 11 The bottom line is that aggregate productivity is low because the robust productivity gains for the tech-savvy frontier companies are offset by the long tail of firms that have been slow to adopt the latest technology. Indeed, business spending has been especially weak in this expansion. Chart II-14 highlights that the slowdown in U.S. productivity growth has mirrored that of the capital stock. Chart II-14U.S. Capex Shortfall Partly To Blame For Poor Productivity U.S. Capex Shortfall Partly To Blame For Poor Productivity U.S. Capex Shortfall Partly To Blame For Poor Productivity Appendix II-2 Japan - The Leading Edge Japan is an interesting case study because it is on the leading edge of the problems associated with an aging population. The popular press is full of stories of how robots are taking over. If the stories are to be believed, robots are the answer to the country's shrinking workforce. Robots now serve as helpers for the elderly, priests for weddings and funerals, concierges for hotels and even sexual partners (don't ask). Prime Minister Abe's government has launched a 5-year push to deepen the use of intelligent machines in manufacturing, supply chains, construction and health care. Indeed, Japan was the leader in robotics use for decades. Nonetheless, despite all the hype, Japan's stock of industrial robots has actually been eroding since the late 1990s (Chart II-4). Numerous surveys show that firms plan to use robots more in the future because of the difficulty in hiring humans. And there is huge potential: 90% of Japanese firms are small- and medium-sized (SME) and most are not currently using robots. Yet, there has been no wave of robot purchases as of 2016. One problem is the cost; most sophisticated robots are simply too expensive for SMEs to consider. This suggests that one cannot blame robots for Japan's lack of wage growth. The labor shortage has become so acute that there are examples of companies that have turned down sales due to insufficient manpower. Possible reasons why these companies do not offer higher wages to entice workers are beyond the scope of this report. But the fact that the stock of robots has been in decline since the late 1990s does not support the view that Japanese firms are using automation on a broad scale to avoid handing out pay hikes. Indeed, Chart II-15 highlights that wage deflation has been the greatest in industries that use almost no robots. Highly automated industries, such as Transportation Equipment and Electronics, have been among the most generous. This supports the view that the productivity afforded by increased robot usage encourages firms to pay their workers more. Looking ahead, it seems implausible that robots can replace all the retiring Japanese workers in the years to come. The workforce will shrink at an annual average pace of 0.33% between 2020 and 2030, according to the Japan Institute for Labour Policy and Training. Productivity growth would have to rise by the same amount to fully offset the dwindling number of workers. But that would require a surge in robot density of 4.1, assuming that each rise in robot density of one adds 0.08% to the level of productivity (Chart II-16). The level of robot sales would have to jump by a whopping 2½ times in the first year and continue to rise at the same pace each year thereafter to make this happen. Of course, the productivity afforded by new robots may accelerate in the coming years, but the point is that robot usage would likely have to rise astronomically to offset the impact of the shrinking population. Chart II-15Japan: Earnings Vs. Robot Density February 2018 February 2018 Chart II-16Japan: Where Is The Flood Of Robots? Japan: Where Is The Flood OF Robots? Japan: Where Is The Flood OF Robots? The implication is that, as long as the Japanese economy continues to grow above roughly 1%, the labor market will continue to tighten and wage rates will eventually begin to rise. 1 Please see Technology Sector Strategy Special Report "The Coming Robotics Revolution," dated May 16, 2017, available at tech.bcaresearch.com 2 Note that this includes only robots used in manufacturing industry, and thus excludes robots used in the service sector and households. However, robot usage in services is quite limited and those used in households do not add to GDP. 3 Note that ICT investment and capital stock data includes robots. 4 Please see BCA Global Investment Strategy Special Report "Weak Productivity Growth: Don't Blame The Statisticians," dated March 25, 2016, available at gis.bcaresearch.com 5 Centre for Economic and Business Research (January 2017): "The Impact of Automation." A Report for Redwood. In this report, robot density is defined to be the number of robots per million hours worked. 6 Graetz, G., and Michaels, G. (2015): "Robots At Work." CEP Discussion Paper No 1335. 7 Mishel, L., and Bivens, J. (2017): "The Zombie Robot Argument Lurches On," Economic Policy Institute. 8 Please see BCA Technology Sector Strategy Special Report "Bad Information - Why Misreporting Deep Learning Advances Is A Problem," dated January 9, 2018, available at tech.bcaresearch.com 9 Please see The Bank Credit Analyst, "Rage Against The Machines: Is Technology Exacerbating Inequality?" dated June 2014, available at bca.bcaresearch.com 10 OECD Productivity Working Papers, No. 05 (2016): "The Best Versus the Rest: The Global Productivity Slowdown, Divergence Across Firms and the Role of Public Policy." 11 Please refer to page 27. III. Indicators And Reference Charts As we highlight in the Overview section, the earnings backdrop for the U.S. equity market remains very upbeat, as highlighted by the rise in the net earnings revisions and net earnings surprises indexes. Bottom-up analysts will likely continue to boost after-tax earnings estimates for the year as they adjust to the U.S. tax cut news. Our main concern is that a lot of good news is now discounted. Our Technical Indicator remains bullish, but our composite valuation indicator surpassed one sigma in January, which is our threshold of overvaluation. From these levels of overvaluation, the medium-term outlook for equity total returns is negligible. Our speculation index is at all-time highs and implied volatility is low, underscoring that investors are extremely bullish. From a contrary perspective, this is a warning sign for the equity market. Our Monetary Indicator has also moved further into 'bearish' territory for equities, although overall financial conditions remain positive for growth. It is also disconcerting that our Revealed Preference Indicator (RPI) shifted to a 'sell' signal for stocks, following five straight months on a 'buy' signal. This occurred because investors may be buying based on speculation rather than on a firm belief in the staying power of the underlying fundamentals. For now, though, our Willingness-to-Pay indicator for the U.S. rose sharply in January, highlighting that investor equity inflows are very strong and are favoring U.S. equities relative to Japan and the Eurozone. This is perhaps not surprising given the U.S. tax cuts just passed by Congress. The RPI indicators track flows, and thus provide information on what investors are actually doing, as opposed to sentiment indexes that track how investors are feeling. Our U.S. bond technical indicator shows that Treasurys are close to oversold territory, suggesting that we may be in store for a consolidation period following January's surge in yields. Treasurys are slightly cheap on our valuation metric, although not by enough to justify closing short duration positions. The U.S. dollar is oversold and due for a bounce. EQUITIES: Chart III-1U.S. Equity Indicators U.S. Equity Indicators U.S. Equity Indicators Chart III-2Willingness To Pay For Risk Willingness To Pay For Risk Willingness To Pay For Risk Chart III-3U.S. Equity Sentiment Indicators U.S. Equity Sentiment Indicators U.S. Equity Sentiment Indicators Chart III-4Revealed Preference Indicator Revealed Preference Indicator Revealed Preference Indicator Chart III-5U.S. Stock Market Valuation U.S. Stock Market Valuation U.S. Stock Market Valuation Chart III-6U.S. Earnings U.S. Earnings U.S. Earnings Chart III-7Global Stock Market And Earnings: ##br##Relative Performance Global Stock Market And Earnings: Relative Performance Global Stock Market And Earnings: Relative Performance Chart III-8Global Stock Market And Earnings: ##br##Relative Performance Global Stock Market And Earnings: Relative Performance Global Stock Market And Earnings: Relative Performance FIXED INCOME: Chart III-9U.S. Treasurys And Valuations U.S. Treasurys and Valuations U.S. Treasurys and Valuations Chart III-10U.S. Treasury Indicators U.S. Treasury Indicators U.S. Treasury Indicators Chart III-11Selected U.S. Bond Yields Selected U.S. Bond Yields Selected U.S. Bond Yields Chart III-1210-Year Treasury Yield Components 10-Year Treasury Yield Components 10-Year Treasury Yield Components Chart III-13U.S. Corporate Bonds And Health Monitor U.S. Corporate Bonds And Health Monitor U.S. Corporate Bonds And Health Monitor Chart III-14Global Bonds: Developed Markets Global Bonds: Developed Markets Global Bonds: Developed Markets Chart III-15Global Bonds: Emerging Markets Global Bonds: Emerging Markets Global Bonds: Emerging Markets CURRENCIES: Chart III-16U.S. Dollar And PPP U.S. Dollar And PPP U.S. Dollar And PPP Chart III-17U.S. Dollar And Indicator U.S. Dollar And Indicator U.S. Dollar And Indicator Chart III-18U.S. Dollar Fundamentals U.S. Dollar Fundamentals U.S. Dollar Fundamentals Chart III-19Japanese Yen Technicals Japanese Yen Technicals Japanese Yen Technicals Chart III-20Euro Technicals Euro Technicals Euro Technicals Chart III-21Euro/Yen Technicals Euro/Yen Technicals Euro/Yen Technicals Chart III-22Euro/Pound Technicals Euro/Pound Technicals Euro/Pound Technicals COMMODITIES: Chart III-23Broad Commodity Indicators Broad Commodity Indicators Broad Commodity Indicators Chart III-24Commodity Prices Commodity Prices Commodity Prices Chart III-25Commodity Prices Commodity Prices Commodity Prices Chart III-26Commodity Sentiment Commodity Sentiment Commodity Sentiment Chart III-27Speculative Positioning Speculative Positioning Speculative Positioning ECONOMY: Chart III-28U.S. And Global Macro Backdrop U.S. And Global Macro Backdrop U.S. And Global Macro Backdrop Chart III-29U.S. Macro Snapshot U.S. Macro Snapshot U.S. Macro Snapshot Chart III-30U.S. Growth Outlook U.S. Growth Outlook U.S. Growth Outlook Chart III-31U.S. Cyclical Spending U.S. Cyclical Spending U.S. Cyclical Spending Chart III-32U.S. Labor Market U.S. Labor Market U.S. Labor Market Chart III-33U.S. Consumption U.S. Consumption U.S. Consumption Chart III-34U.S. Housing U.S. Housing U.S. Housing Chart III-35U.S. Debt And Deleveraging U.S. Debt And Deleveraging U.S. Debt And Deleveraging Chart III-36U.S. Financial Conditions U.S. Financial Conditions U.S. Financial Conditions Chart III-37Global Economic Snapshot: Europe Global Economic Snapshot: Europe Global Economic Snapshot: Europe Chart III-38Global Economic Snapshot: China Global Economic Snapshot: China Global Economic Snapshot: China Mark McClellan Senior Vice President The Bank Credit Analyst

Highlights Portfolio Strategy Relative sector index composition, the macro backdrop, relative operating metrics along with compelling valuations and washed out technicals suggest that a value over growth style bias is warranted. Rising interest rates and a flattening yield curve, coupled with increasing relative indebtedness and lack of relative profit growth signal that the time is right to shift the capitalization bias to a neutral setting. Recent Changes Shift the style bias and favor value over growth today. Book profits in the small over large cap size bias of 2% since the mid-August 2016 inception. Table 1 Too Good To Be True? Too Good To Be True? Feature Equities catapulted to new all-time highs last week as earnings season got underway. Upbeat bank reports set the tone, and SPX profits are slated to register a 12% growth rate for both Q4/2017 and calendar 2017. Current year EPS estimates have been aggressively ratcheted higher, on the back of the tax bill passage, rising from 12% to 16% in a mere three weeks, according to Thomson Reuters/IBES. Our SPX EPS growth model agrees that, cyclically, profits will continue to drift higher and a low-to-mid double-digit growth rate is likely for 2018, as we posited last week.1 While the synchronized and disinflationary global growth narrative continues to dominate, we are a bit uneasy. The eerie calm overtaking the markets, and headlines like this recent one from Bloomberg "The Stock Market Never Goes Down" give us cause for concern. As a reminder, the SPX is up 1000 points since the 1800 level registered in early-2016. Put differently, the SPX has been rising by roughly 25% per annum for the past two years. Such a breakneck pace is unsustainable. Our sense is that from a tactical perspective, equities are currently extremely stretched and warrant some caution. Therefore, this week we identify five key signposts we are closely monitoring that are sending clear warning signals (for a more comprehensive list please see the tactical section of our August 7th White Paper).2 First, our reflation gauge (RG) has taken a turn for the worse (Chart 1). At the margin, higher oil prices and interest rates may begin to bite. Historically, our RG has been an excellent leading indicator of both sentiment that has vaulted to multi-decade highs and CITI's economic surprise index. Our global reflation gauge emits a similar signal (not shown). Mean reversion is looming. Second, speculation runs rampant. Our Equity Speculation Index (ESI) is close to two standard deviations above the historical mean. Since the early-1960s, the ESI has only been higher during the dotcom bubble (Chart 2). While the ESI can rise further, it is at least waving a yellow flag. Investor sentiment has also gone parabolic with the bull/bear ratio reaching a level last seen right before the 1987 crash (third panel, Chart 2). Chart 1Yellow Flag Yellow Flag Yellow Flag Chart 2Extended Extended Extended Third, financial conditions are as good as they get. The St. Louis Fed Financial Stress Index recently hit an all-time low level. Similarly, Goldman Sachs' and the Chicago Fed's National Financial Conditions indexes are also near uncharted territory. This should be cause for some trepidation (Chart 3). Fourth, extended EPS breadth, all time highs in net earnings revisions, stretched median valuations and overbought technical conditions are near levels that have marked previous temporary broad market pullbacks (Chart 4). Finally, gold is behaving strangely. While the U.S. dollar's selloff explains part of the recent jump in the shiny metal, we think bullion may be sniffing out some trouble as it remains a true safe haven asset. Either real rates have to come down or gold has to reverse course; such a steep divergence is unsustainable (gold shown inverted, top panel, Chart 5). Chart 3As Good As It Gets As Good As It Gets As Good As It Gets Chart 4Peak Euphoria? Peak Euphoria? Peak Euphoria? Chart 5What's Gold Sniffing Out? What's Gold Sniffing Out? What's Gold Sniffing Out? Since December 18th our strategy has been to book gains in tactical trades and to refrain from altering our cyclical over defensive portfolio positioning bent,3 as we do not foresee a recession in the coming 9-12 months.4 We continue to pursue this strategy and were a 5-10% selloff to materialize, we would "buy the dip". In addition, this week we introduce/apply a risk management measure to our recently revealed high-conviction 2018 calls.5 Almost all of our calls are in the black outperforming the broad market on average by 640bps (Chart 6). While we are not compelled to change our views just yet, our confidence is not as high as two months ago, especially in the two calls that are registering double-digit relative returns. Thus, we suggest that clients institute a tight stop in these trades (please see the "Stop" column in the "Top High-Conviction Calls For 2018" table on page 15). Going forward, we will introduce such risk management trailing stops once a call clears the 10% relative return mark. This week we shift both our style and size biases. Chart 6Time To Set Stops Too Good To Be True? Too Good To Be True? Buy Value At The Expense Of Growth There is a once in a decade opportunity to prefer value over growth (V/G) stocks, and we recommend shifting our style bias in favor of value stocks. Typically, the V/G ratio moves in multi-year up and down cycles, and at the current juncture it is a screaming buy, if history at least rhymes. Chart 7 shows that relative share prices are not only near previous troughs, but also 1.5 standard deviations below the six-decade time trend. Chart 7Compelling Entry Point Compelling Entry Point Compelling Entry Point In fact we already have a flavor of this style preference in one of our market-neutral pair trades, long financials / short tech (for additional details on this trade please refer to our "Disentangling Pricing Power" early-summer report). Table 2 depicts why this is so: financials stocks dominate value indexes, while IT comprises 40% of growth indexes. Sector composition also suggests that a long energy / short health care trade would mimic this V/G preference, as energy stocks offer a lot of value, whereas health care stocks sit prominently in growth indexes (Table 2 & Chart 8). While we do not have this pair trade on per se, as a reminder we are overweight the energy sector and underweight health care stocks; we are also overweight financials and underweight tech (please see page 14 for a complete picture of our current sector recommendations). Table 2Sector Composition Too Good To Be True? Too Good To Be True? With regard to macro variables, these sector preferences would equate to a positive interest rate and oil price correlation. Indeed, the 10-year Treasury yield moves in lockstep with the V/G ratio and similarly oil prices are joined at the hip with relative performance (Chart 9). Chart 8Value/Growth Replicas Value/Growth Replicas Value/Growth Replicas Chart 9Rising Oil And Rates = Buy Value / Sell Growth Rising Oil And Rates = Buy Value / Sell Growth Rising Oil And Rates = Buy Value / Sell Growth One of BCA's themes for 2018 is higher interest rates, with our bond strategists still expecting an inflation-driven rise in the 10-year Treasury yield near 3%. Similarly, BCA' commodity strategists remain constructive on oil prices. Taken together, these BCA views warrant a value over growth preference. Importantly, since the depths of the GFC, value has underwhelmed growth by a wide margin. Likely, this growth over value preference reflected central bank interest rate suppression, which boosted the multiple investors were willing to pay for perceived growth at a time when growth was scarce. Now that the Fed has lifted rates five times since December 2015 and is on track to do so three more times this year, value should take the reins (Chart 10). Moreover, the Fed is unwinding its balance sheet and that tightening in monetary conditions, at the margin, favors value over growth (Chart 11). Chart 10Avoid Growth Stocks During Fed Tightening Cycles... Avoid Growth Stocks During Fed Tightening Cycles... Avoid Growth Stocks During Fed Tightening Cycles... Chart 11...And During Quantitative Tightening ...And During Quantitative Tightening ...And During Quantitative Tightening On the currency front, the V/G ratio has had a tight positive correlation with the EUR/USD foreign exchange rate (Chart 12). Once again sector composition has been underpinning this relationship. However, sector composition is constantly shifting. Currently, a larger percentage of growth stocks have international sales (especially tech) compared with more domestically-oriented value stocks. Thus, the depreciating U.S. dollar is a risk to our value over growth preference On the operating metric front, value stocks have the upper hand versus their growth siblings. Our relative composite pricing power gauge has swung by eight percentage points from trough-to-peak and heralds a deflation exit for relative top line growth (middle panel, Chart 13). Chart 12Depreciating U.S. Dollar Is ##br##Typically A Boon To The V/G Ratio Depreciating U.S. Dollar Is A Boon To The V/G Ratio Depreciating U.S. Dollar Is A Boon To The V/G Ratio Chart 13Relative Pricing Power ##br##Favors Value Over Growth Relative Pricing Power Favors Value Over Growth Relative Pricing Power Favors Value Over Growth Sell-side analysts have taken notice and have been aggressively bumping their net earnings revisions in favor of value versus growth indexes. As mentioned earlier, rising oil price inflation and better credit pricing power are a boon to V/G profit prospects (bottom panel, Chart 13). Valuations and technicals also suggest that investors should overweight value at the expense of growth. Our relative Valuation Indicator (VI) has recently sunk to a level last hit in the early-2000s, approaching one standard deviation below the historical mean. Similarly, the V/G ratio is oversold and our relative Technical Indicator (TI) has fallen to a level that has marked previous bull market phases (Chart 14). Finally, over the past thirty years V/G price moves have been a mirror image of both junk bond yields and vol. In other words, a value over growth preference has been synonymous with a "risk on" backdrop (junk yield and the VIX shown inverted, Chart 15). However, these close correlations appear to have broken down since the Great Recession as the Fed's unconventional monetary policies functioned well in keeping a lid on vol and suppressing bond yields across the fixed income spectrum. Chart 14Value Vs Growth Stocks Are Cheap And Oversold Value Vs Growth Stocks Are Cheap And Oversold Value Vs Growth Stocks Are Cheap And Oversold Chart 15Bet On Convergence Bet On Convergence Bet On Convergence As the Fed winds down its balance sheet there are good odds that volatility will make a comeback and interest rates will also shoot higher. The upshot is that these inverse correlations get reestablished in the coming quarters via a rise in the V/G ratio, an increase in vol and a selloff in the junk corporate bond market (Chart 15). Adding it up, relative sector composition, the macro backdrop, relative operating metrics along with a compelling VI reading and our washed out TI suggest that a value over growth style bias is warranted. Bottom Line: Boost value stock exposure at the expense of growth equities. The V/G ratio offers an excellent entry point with limited downside risk. Book Profits In Small Caps Vs. Large Caps And Move To The Sidelines In August 2016, we recommended a small over large cap (S/L) bias, predating the Trump election victory, on the back of five key drivers: non-inflationary growth would persist allowing central banks to stay incredibly accommodative, emerging market tail risks had eased taming equity market vol, small/large sector composition differentials, relative EPS fundamentals and restored relative valuations. Given that most of these factors have moved in favor of small versus large caps and some are starting to shift against the S/L ratio, does it still pay to have a small cap size bias? The short answer is no, and we now recommend investors book profits and move to the sidelines. While the euphoric tailwind surrounding the new administration and its promise to slash red tape and taxes tripped us up and we failed to monetize 10%+ gains, better late than never. First, from a big picture perspective, the near two decade S/L outperformance phase is running on fumes and it has likely put in a secular top in late-2016 (Chart 16). Similar to the style bias, this ratio also tends to move in long cycles. We are clearly in extended territory hovering at one standard deviation above the historical time trend. Chart 16Major Top? Major Top? Major Top? Second, interest rates bear close attention. Rising interest rates on the back of an inflationary impulse is BCA's view for the coming year and, coupled with the yield curve narrowing, are a harbinger of small cap trouble. Chart 17 shows the tight positive correlation between the S/L ratio and the yield curve, and the current message is to avoid small caps. Small caps are mostly domestically exposed and are ultra-sensitive to interest rate moves as small and medium businesses rely more heavily on their bankers for credit, rather than debt markets. When the yield curve flattens late in the cycle it is typically because the Fed is aggressively tightening monetary policy. While such a monetary backdrop is neither conducive to small nor to large firms, small caps suffer more, at the margin. Third, we are perplexed by the lack of profit growth in the small cap complex. It has now been over a year since Trump came into power and small cap EPS underperformance has been extremely prominent (top panel, Chart 18). The 12-month forward profit growth delta has also widened considerably over the past year to the detriment of small caps (middle panel, Chart 18). While the U.S. dollar's sizable depreciation explains part of the profit divergence, i.e. as the currency falls foreign sales exposed large caps enjoy a significant translation gain, relative indebtedness is also likely playing a key role. The bottom panel of Chart 19 shows the net debt-to-EBITDA ratio for the small cap and large cap indexes. The relative ratio has gone parabolic and is making all-time highs. Rising small cap indebtedness, at a time when cash flow growth is anemic, suggests that the S&P 600 is increasingly vulnerable. Not only are interest payments eating into income, but also refinancing risk is a threat in an era of rising interest rates. Under such a backdrop, small cap stocks should not trade at a valuation premium (bottom panel, Chart 18). Chart 17Yield Curve Blues Yield Curve Blues Yield Curve Blues Chart 18Small Cap Profit Trouble Small Cap Profit Trouble Small Cap Profit Trouble Chart 19Mind The Small Cap Indebtedness Mind The Small Cap Indebtedness Mind The Small Cap Indebtedness Bottom Line: The time is ripe to take profits of 2% and move to the sidelines in the capitalization bias. Were our indicators to further deteriorate, we would not hesitate to fully reverse course and prefer large to small caps. Stay tuned. Anastasios Avgeriou, Vice President U.S. Equity Strategy anastasios@bcaresearch.com 1 Please see BCA U.S. Equity Strategy Special Report, "White Paper: Introducing Our U.S. Equity Sector Earnings Models," dated January 16, 2017, available at uses.bcaresearch.com. 2 Please see BCA U.S. Equity Strategy Special Report, "White Paper: U.S. Equity Market Indicators (Part I)," dated August 7, 2017, available at uses.bcaresearch.com. 3 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. 4 Please see BCA U.S. Equity Strategy Weekly Report, "EPS And 'Nothing Else Matters'," dated December 18, 2017, available at uses.bcaresearch.com. 5 Please see BCA U.S. Equity Strategy Weekly Report, "High-Conviction Calls," dated November 27, 2017, available at uses.bcaresearch.com. Current Recommendations Current Trades Size And Style Views Favor value over growth and stay neutral small over large caps.

Highlights The Beige Book released on January 17 keeps the Fed on track to raise rates at least three times this year and highlights the impact of the tax bill on the economy. BCA's Big 5 Bank Lending Beige Book highlights several of the positive trends supporting our view of the economy, the tax bill and the Fed. The Tax Cut and Jobs Act of 2017 has the potential to generate significant supply-side benefits for consumers, shareholders and the broad economy. We decided to stay long the dollar after a lengthy internal debate, although we have revised down our view on the upside potential. Feature U.S. risk assets continued to outperform last week outside of the dollar, as S&P 500 firms started to report Q4 2017 results and provide guidance for Q1 2018 and beyond. BCA's Bank Lending Beige Book summarizes the most optimistic comments from the Big 5 banks. The Fed's Beige Book captured comments on the broad economy in December and early January that were equally ebullient. Both Beige books suggested that firms were planning to return their tax savings to shareholders in the New Year, and to continue to boost capex, which was stout even before the law was passed. Yet, despite the upbeat news, the dollar broke down last week, as the ECB sounded a hawkish note and the Japanese economy continued to improve. On balance, the Beige Book, the Q4 earnings season, the health of the U.S. economy (notably capital spending), all support BCA's stance on the U.S. stock-to-bond ratio, the Fed, duration and the dollar. However, the dollar has not behaved as we would have expected. Beige Book Barometer Bounces The Beige Book released on January 17 keeps the Fed on track to raise rates at least three times this year and highlights the impact of the tax bill on the economy. BCA's quantitative approach1 to the Beige Book's qualitative data points to underlying strength in GDP and a tighter labor market, but there is still a disconnect between the Beige Book's view of inflation and the market's stance. Moreover, references to the stronger dollar have disappeared from the Beige Book and business uncertainty is significantly reduced, reflecting the tax cut bill and President Trump's assault on regulation. Chart 1Latest Beige Book Supports##BR##The Fed's View On Rates, Economy Latest Beige Book Supports The Fed's View On Rates, Economy Latest Beige Book Supports The Fed's View On Rates, Economy Chart 1, panel 1 shows that at 66%, BCA's Beige Book Monitor stayed near its cycle highs in January, re-confirmation that the underlying economy was still upbeat in Q4 and early 2018. (The latest Beige Book covered the period from mid-November 2017 to January 8, 2018). The number of 'weak' words in the Beige Book returned to near four-year lows after ticking higher in the wake of last summer's hurricanes. Moreover, there were 12 mentions of the tax bill in the January Beige Book, up from only 3 in November (not shown). The tax bill was cast in a positive light in 75% of the remarks. In November, the references to either the tax bill (or tax reform) cited the consequent uncertainty as a constraint on growth. Based on the minimal references to a robust dollar in the past five Beige Books, the greenback should not be an issue in Q4 2017 or Q1 2018, which is in sharp contrast with 2015 and early 2016 when there was a surge in Beige Book mentions (Chart 1, panel 4). The last time that five consecutive Beige Books had so few remarks about a strong dollar was in late 2014. Business uncertainty over government policy (fiscal, regulatory and health) ticked up in the past few Beige Books as Congress debated the particulars of the tax bill. Nonetheless, comments of uncertainty in the Beige Book have dropped since Trump took office in early 2017. The implication is that the business community is correctly focused on policy and not politics in D.C. (Chart 1, panel 5). The disconnect with the Fed on inflation is evident in the Beige Book's number of inflation words (Chart 1, panel 3). Expressions regarding inflation rose to a four-month high in January and the disconnect persists between the still-elevated mentions of inflation and the soft readings on CPI and PCE. In the past, increased references to inflation have led measured inflation by a few months, suggesting that the CPI and core PCE may soon turn up. Bottom Line: The recent Beige Book backs BCA's view that the U.S. economy is poised to grow above its long-term potential in the first half of 2018. However, the Beige Book has done little to resolve the debate around why an economy growing above potential and a tightening labor market have not boosted inflation. Likewise, the latest Beige Book confirmed that at least initially, businesses and bankers across the U.S. welcomed the Tax Cut and Jobs Act. Bankers' Beige Book Returns Chart 2Banking System Shipshape Banking System Shipshape Banking System Shipshape BCA's Big 5 Bank Lending Beige Book highlights several of the positive trends supporting our view: Pristine credit quality, a positive U.S. credit impulse, loosening U.S. banking regulatory requirements, and pent up demand for shareholder friendly activities. We introduced the Big 5 Bank Lending Beige Book2 in early 2014 to interpret the health of the banking system based on comments from leaders of the Big Five banks during earnings season. Managements were upbeat on loan demand and credit quality as they unveiled Q4 results in the past two weeks, and most expressed optimism that the positive credit trends would continue to improve in 2018. Several bank executives shared their Fed rate hike expectations for this year, with most forecasting three or four increases. One institution planned for a flatter curve, while another noted that rising rates on both the short and long ends will benefit their operations. Chart 2 shows key banking related variables cited in the Bank Lending Beige Book. Appendix Table 1 shows the Big 5 Bank Lending Beige Book for Q4 2017. All five banks were uniformly upbeat in their assessments of the tax bill's impact on their operations, their customers' businesses or the overall economy. One bank noted that it took a repatriation charge in Q4, and another said it would return capital to shareholders via buybacks and dividends. A third said the bill will provide "immediate and ongoing benefit to our employees, customers, communities and our shareholders, as we invest a portion of our tax savings in each of these important constituencies." Bottom Line: The banking system is shipshape as 2018 begins and lenders are ready to extend credit to businesses and consumers to boost the economy despite higher rates. 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.3 A Different Lens On Earnings Chart 3Corporate Health Has Improved##BR##Since Start Of 2017 Corporate Health Has Improved Since Start Of 2017 Corporate Health Has Improved Since Start Of 2017 The early December release of the U.S. flow of funds report allows us to update BCA's Corporate Health Monitor (CHM) (Chart 3). The CHM's level improved slightly between Q2 and Q3, but the overall reading remains in 'deteriorating health' territory. The marginal improvement in Q3 was driven by rising profit margins. In addition, profit growth surged while debt moved up modestly in Q3. The CHM is a reliable indicator of the trend in corporate bond spreads which supports our corporate bond overweight. Given that corporate balance sheets are declining, the sole supports for corporate spreads are low inflation and accommodative monetary policy. We anticipate spreads will start to widen later this year when inflation climbs and policy turns more restrictive. BCA's U.S. Bond strategists remain overweight the U.S. high-yield bond market.4 Although spreads appear a bit more attractive than for investment-grade corporates, there is still not much room for spread compression in high-yields. We calculate that if the high-yield index spread tightens by another 117 bps, then junk bonds will be the most expensive since 1995. In an optimistic scenario where the index spread tightens 100 bps, bringing it close to all-time expensive levels, then we would expect junk excess returns to be in the range of 600 bps (annualized). Nonetheless, in view of the trends in corporate leverage, it is unlikely that there will be another 100 bps of spread tightening. More realistically, we expect excess returns between 200 bps and 500 bps (annualized) between now and the end of the credit cycle. Bottom Line: BCA's indicators suggest that we are moving into the late stages of the credit cycle, but we retain an overweight cyclical stance on corporate bonds. A shift to a more restrictive monetary policy, tightening C&I bank lending standards and/or a continued uptrend in gross corporate leverage are the main catalysts we will monitor to gauge the end of the cycle. An abrupt end to the positive capex or earnings cycle would also be concerns for our upbeat view on credit. Repatriation Redux The Tax Cut and Jobs Act of 2017 has the potential to generate significant supply-side benefits for consumers, shareholders and the broad economy. There are several uses for corporate cash, including capital spending, M&A, increasing compensation to employees, paying down debt and returning capital to shareholders. Chart 4 shows that through Q3 2017, share buybacks and dividends ran slightly ahead of prior cycles, while capex was about average. Investors wonder how that mix may change under the new law. Corporate behavior in the wake of the 2004 overseas tax holiday5 provides some guidance. Chart 4Comparison Of Corporate Outlays Across Four Economic Expansion Phases Variations On A Theme Variations On A Theme Corporations used cash generated from the 2004 tax break to return capital to shareholders. However, we found scant evidence that firms who benefited from the tax holiday increased capital spending, raised wages or hired more workers. A study by the National Bureau of Economic Research (NBER) noted that a dollar increase in repatriations "was associated with an increase of almost $1 in payouts to shareholders."6 Moreover, a 2008 IRS paper7 concluded that nearly half of all the cash repatriated in 2004 and 2005 came from only the tech and pharma sectors. A Congressional Research Service (CRS) found that small firms tended to benefit less than large firms from the tax holiday.8 A paper9 by the left-leaning, U.S.-based think tank, the Center For Budget and Policy Priorities (CBPP), stated that several firms that benefitted the most from the 2004 law laid off workers soon after the tax law was enacted. In 2018, BCA expects firms to return capital to shareholders, boost capex and continue to bump up wages. Chart 5 shows that buybacks will probably augment S&P 500 EPS by around 2% this year, while panel 2 shows that there was a noticeable upswing to buyback announcements as 2017 ended. Aside from the post-recession bounce in buybacks in 2010, the last big swell in buyback announcements occurred in 2004 and 2005. That said, corporate balance sheets were in much better shape in 2004/2005 than they are today (Chart 3 again). The implication is that management teams may decide to pay down debt before returning the cash windfall back to shareholders. However, with rates still low, most firms will chose to distribute the cash to shareholders, despite high corporate debt levels. The positive reading on BCA's Capital Structure Preference Indicator supports our stance on buybacks (Chart 6, third panel). This Indicator is defined as the equity risk premium minus the default-adjusted yield in high-yield corporate bonds. When the indicator is above zero, there is financial incentive for firms to issue debt and buy back shares. Conversely, firms are incentivized to issue stock and retire debt when the indicator is below zero. The Indicator is currently positive, although not as high as it was in 2015. Moreover, Chart 7 shows that the dividend payout ratio rebounded from the 2007-2009 financial crisis, but has moved above its pre-crisis level. However, dividend distributions remain below their pre-crisis peak reached in the early 1990s. Chart 5Still Some Room##BR##To Run For Buybacks Still Some Room To Run For Buybacks Still Some Room To Run For Buybacks Chart 6Buybacks Adding Almost##BR##2 Percentage Points To EPS Growth Buybacks Adding Almost 2 Percentage Points To EPS Growth Buybacks Adding Almost 2 Percentage Points To EPS Growth Capital spending was already on a tear in late 2017, even before the tax bill passed. Industrial production, the PMI diffusion index and advanced-economy capital goods imports, all confirm strong underlying momentum in investment spending (Chart 8). Chart 7Corporations Poised To Return##BR##Capital To Shareholders Corporations Poised To Return Capital To Shareholders Corporations Poised To Return Capital To Shareholders Chart 8Capital Spending Helping##BR##To Drive Growth Capital Spending Helping To Drive Growth Capital Spending Helping To Drive Growth Both BCA's real and nominal capex models, driven by surging capital goods orders along with elevated ISM data, roaring global exports and soaring sentiment on business spending, indicate strong investment in plant and equipment in the next few quarters (Chart 9). CEO confidence soared to a 13-year high in Q4, according to the latest Duke's Fuqua School of Business/CFO Magazine Global Business Outlook (Chart 10, panel 1). Duke noted that "Among CFOs who responded to the survey after the Senate passed its version of the tax reform bill, optimism spiked to 73, which is the highest U.S. optimism ever recorded in the history of the survey."10 Chart 9Bright Outlook##BR##For Capital Spending Bright Outlook For Capital Spending Bright Outlook For Capital Spending Chart 10CEO Confidence And##BR##Capex Plans Surging CEO Confidence And Capex Plans Surging CEO Confidence And Capex Plans Surging Surveys by the Conference Board and Business Roundtable show a similar pattern. (panel 1 again). Notably, the soundings on all three surveys have climbed since Trump's election, but then retreated as his pro-business agenda stalled in the summer months. The dip in sentiment reflected the lack of legislative progress in Washington in the first 10 months of the Trump administration. The dip in CEO sentiment in Q2 and Q3 was in sharp contrast to the easing of policy concerns in the Fed's Beige Book (Chart 1, bottom panel). The upbeat numbers in the regional FRBs' surveys of capital spending intentions further support escalating capex spending in the next few quarters. The average readings from the New York, Philadelphia and Richmond Feds' capex survey plans are at an all-time high (Chart 10, panel 2). Moreover, the regional Feds' capex spending plans diffusion index is close to a cycle high, despite a modest pullback last summer (panel 3). Bottom Line: Stay overweight stocks versus bonds, and underweight duration. The tax bill will boost returns to shareholders via buybacks and dividends. In addition, rising capex will drive up GDP, employment and EPS in the coming quarters. Dollar View Revisited The dollar fell by 4% between mid-December and mid-January, amid a hawkish market interpretation of the ECB minutes, persistently strong growth in Japan and a key technical breakdown in the DXY index. The decline has some investors questioning BCA's bullish stance on the currency (Chart 11). We were correct on the direction of interest rate differentials vis-à-vis the other major economies, but this has not translated into a stronger dollar so far. We decided to stay long the dollar after a lengthy internal debate, although we have revised down our view on the upside potential. A lot of good news on the European and Japanese economies is now discounted and investors are quite pessimistic on the dollar (which is bullish the dollar from a contrary perspective) (Chart 12). Given this technical backdrop, we would expect at least a 5% rise in the trade-weighted dollar as expectations of Fed rate hikes rise this year. We are likely to exit our long dollar position if we get such an appreciation. Chart 11We Are Sticking With##BR##Our Long Dollar View We Are Sticking With Our Long Dollar View We Are Sticking With Our Long Dollar View Chart 12The Case For Crisis Era Monetary Stimulus##BR##In Europe And Japan Is Weakening The Case For Crisis Era Monetary Stimulus In Europe And Japan Is Weakening The Case For Crisis Era Monetary Stimulus In Europe And Japan Is Weakening Bottom Line: BCA's bullish dollar trade was initiated in October 2014 and although the DXY index is up 4% since that time, we are maintaining the trade. While downside risks remain, a unilateral decision by the Trump Administration to leave NAFTA will boost the U.S. dollar versus the Canadian dollar and the peso. Italy's upcoming spring Presidential election could prompt a rally in the dollar if the Eurosceptic parties outperform expectations. 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, "The Great Debate Continues", published on April 17, 2017. Available at usis.bcaresearch.com. 2 Please see BCA Research's U.S. Investment Strategy Weekly Report, "Commitments", published January 20, 2014. Available at usis.bcaresearch.com. 3 Please see BCA Research's U.S. Investment Strategy Weekly Report, "High Conviction Calls", published November 27, 2017. Available at usis.bcaresearch.com. 4 Please see BCA Research's U.S. Bond Strategy Weekly Report, "January Effect", published January 9, 2018. Available at usbs.bcaresearch.com. 5 https://www.congress.gov/bill/108th-congress/house-bill/4520 6 http://www.nber.org/papers/w15023 7 https://www.irs.gov/pub/irs-soi/08codivdeductbul.pdf 8 https://fas.org/sgp/crs/misc/R40178.pdf 9 https://www.cbpp.org/research/tax-holiday-for-overseas-corporate-profits-would-increase-deficits-fail-to-boost-the 10 http://www.cfosurvey.org/2017q4/press-release.html Appendix: Bankers Beige Book Variations On A Theme Variations On A Theme Variations On A Theme Variations On A Theme

Equities have melted up in recent weeks, celebrating the tax bill passage, synchronized upswing in global economic data, still quiescent inflation and near vanishing tail risk. On July 10th when we penned the "SPX 3,000?" report, the S&P 500 was close to 2400.1 Over the past six months stocks have been in an uninterrupted upleg, moving to within 10% of our SPX 3,000 target. Table 1 White Paper: Introducing Our U.S. Equity Sector Earnings Models White Paper: Introducing Our U.S. Equity Sector Earnings Models Stocks have run "too far too fast" for our liking and there are increasing odds of a healthy pullback, especially now that no pundits are talking of a correction. In addition, were the selloff in the bond markets to accelerate in a short time frame, at some point it will cause equity market consternation. But, bonds still remain extremely overvalued versus stocks (Chart 1). Late last year, we began to modestly de-risk the portfolio via booking impressive gains in tactical market-neutral trades, as our upbeat cyclical view remains intact.2 Our cyclical strategy is to "buy the dip", as we do not foresee a recession in the coming 9-12 months. Importantly, profits will dictate the S&P 500's direction and the cyclical path of least resistance is higher still. Our SPX profit model continues to forecast healthy EPS growth in 2018 (Chart 2) and as we posited in the last report of 2017, earnings will do the heavy lifting at the current juncture with the forward P/E multiple likely moving laterally (Chart 3). Chart 1Simple Bond Valuation Metric Says:##br## Bonds Are Overvalued Vs. Stocks Simple Bond Valuation Metric Says: Bonds Are Overvalued Vs. Stocks Simple Bond Valuation Metric Says: Bonds Are Overvalued Vs. Stocks Chart 2All ##br##Clear All Clear All Clear Chart 3EPS Will Do The##br## Heavy Lifting In 2018 EPS Will Do The Heavy Lifting In 2018 EPS Will Do The Heavy Lifting In 2018 A simple decomposition shows that equity returns could reasonably reach a low-to-mid double digit level this year. Our assumptions are the following: nominal GDP can grow near 5% (3% real plus 2% inflation) and thus we estimate organic EPS growth that typically mimics GDP at this stage of the cycle of ~5%, ~2% dividend yield, ~2% buyback yield, ~5% tax related boost to EPS and no multiple expansion. The above assumptions are based on four key drivers: energy and financials will command a larger slice of the earnings pie,3 synchronized global capex upcycle will boost EPS,4 delayed positive translation effects from the U.S. dollar will lift profits5 and easy fiscal policy will also act as a tonic to EPS.6 On this note, this White Paper officially introduces the U.S. Equity Strategy earnings models for the eleven GICS1 equity sectors. We have identified key macro earnings drivers for each sector and incorporated them into individual sector models. The objective is to forecast the direction of earnings growth. Beyond introducing our EPS models, the purpose of this White Paper is to also compare and contrast the cyclical readings of our equity sector models with sell-side analysts' profit growth (Charts 4 & 5) and margin expectations and help clients position portfolios for the rest of 2018. The earnings models carry the most weight in determining our sector positioning, with our macro overlay and our valuation and technical indicators rounding out our methodology. Currently, our earnings models are consistent with maintaining a mostly cyclically biased portfolio structure (top panel, Chart 6), and thus participating in the broad market's overshoot. Chart 4What EPS Are Priced In... What EPS Are Priced In... What EPS Are Priced In... Chart 5...Per Sector For 2018 ...Per Sector For 2018 ...Per Sector For 2018 Chart 6Continue To Prefer Cyclicals Over Defensives Continue To Prefer Cyclicals Over Defensives Continue To Prefer Cyclicals Over Defensives Encouragingly, an equal weight of the 10 GICS1 sector model outputs (we are excluding real estate due to lack of history), accurately forecasts the S&P 500's profit growth (bottom panel, Chart 6), and currently also confirms the broad market's upbeat four factor macro EPS model (Chart 2). Anastasios Avgeriou, Vice President U.S. Equity Strategy anastasios@bcaresearch.com Financials (Overweight) Our financials earnings growth model comprises bank credit growth, the U.S. dollar index and net earnings revisions. The U.S. credit impulse is gaining traction, indicating that the market has digested the almost doubling in long-term rates over the past 18 months. Bankers are willing extenders of C&I credit and, with the economy humming north of 3% in real GDP terms, the outlook for loan growth is excellent. Loosening U.S. banking regulatory requirements, and pent up demand for shareholder friendly activities are all welcome news for financials profitability. Tack on BCA's higher interest rate view in 2018 and net interest margins will also get a bump, further adding to the sector's EPS euphoria. Credit quality is the third key profit driver for bank profitability and pristine credit quality is a harbinger of increased profits. The unemployment rate is plumbing generational lows and suggests that non-performing loans as a percentage of total loans will remain on a downward trajectory. Our profit model is expanding at twice the current profit growth rate (second panel, Chart 7) and 10 percentage points above the Street's 12-month forward estimates (top panel, Chart 5). In fact, the latter have gone vertical of late playing catch up to our model's estimates. The S&P financials sector remains a core portfolio overweight and we reiterate our high-conviction overweight status in the heavyweight S&P banks index. Chart 7Financials (Overweight) Financials (Overweight) Financials (Overweight) Energy (Overweight) The three drivers behind the S&P energy sector EPS growth model are oil-related currencies, the U.S. oil & gas rig count and WTI crude oil prices. A depreciating greenback, whittling down OECD oil stocks and rising global oil demand are all boosting energy profitability. OPEC 2.0 cutbacks have not only helped stabilize oil markets, but also paved the way for a breakout in oil prices above the $62.50/bbl stiff resistance level. Sustained OPEC output restraint will counterbalance U.S. shale oil production increases and coupled with rising global demand likely continue to underpin oil prices. Our synchronized global capex upcycle theme included the basic resources following a multi-year drubbing in outlays. Energy capex cannot contract at double digit rates indefinitely. Already a V-shaped capex momentum recovery is in store, as 2018 capital spending budgets are on track to at least match 2017. Our EPS growth model (second panel, Chart 8) matches sell-side analyst optimism (third panel, Chart 5). Keep in mind that only recently did the energy space become profit positive, making a solid recovery from an extremely low base. Margins are only now renormalizing above the zero line and breakneck pace EPS growth should continue in 2018. Following a negative 2017 return, the S&P energy sector is the best performing sector year-to-date, and we reiterate the high-conviction overweight stance. Chart 8Energy (Overweight) Energy (Overweight) Energy (Overweight) Industrials (Overweight) Our S&P industrials EPS model comprises the ISM manufacturing survey, raw industrials commodity prices and interest rates. It has an excellent track record in forecasting industrials EPS momentum, and sports one of the highest explanatory powers amongst all sector EPS models. While industrials EPS growth has been bouncing off the zero line for the better part of the past five years, our profit model has spoken: forecast EPS are in a V-shaped recovery since the end of the recent manufacturing recession (second panel, Chart 9). Commodity prices are recovering and increasing final demand, coupled with a soft U.S. dollar suggest that more gains are in store. Tack on the global virtuous capex upcycle, and the stars are aligned for this deep cyclical sector to break out of its multi-year trading range funk on the back of a surge in profits. China is a wild card, but signs of stability are enough to sustain the upward trajectory in the commodity-levered complex, including industrials stocks. Our industrials sector EPS model suggests that industrials profits will easily surpass the low (and below the overall market) analysts' EPS growth hurdle (third panel, Chart 4). The late-cyclical S&P industrials sector remains an overweight. Chart 9Industrials (Overweight) Industrials (Overweight) Industrials (Overweight) Consumer Staples (Overweight) The S&P consumer staples EPS growth model key drivers are: food exports, non-discretionary retail sales and analysts' net earnings revision ratio. Overall industry exports are expanding at a healthy clip as a consequence of a softening U.S. dollar and robust European and rebounding emerging markets demand. Deflating raw food commodity prices are offsetting rising energy and labor input costs, heralding a sideways move to margins. Sell side analysts are also currently penciling in a lateral profit margin move (middle panel, Chart 10). Our model is expanding at a near double digit rate, and is in line with 12-month forward EPS growth estimates (second panel, Chart 4). Investors have been vehemently avoiding staples stocks during the board market's uninterrupted run up, and have put out positioning offside. However, in the context of our cyclical over defensive portfolio bent we refrain from putting all our eggs in one basket, and prefer to keep consumer staples as our sole defensive sector overweight. This small hedge will serve our portfolio well if we do indeed get a healthy Q1/2018 pullback, as we expect. Chart 10Consumer Staples (Overweight) Consumer Staples (Overweight) Consumer Staples (Overweight) Consumer Discretionary (Neutral - Downgrade Alert) Measures of consumer confidence, consumer discretionary exports and the net earnings revisions ratio comprise BCA's global consumer discretionary EPS growth model, which has an excellent track record in forecasting the path of consumer discretionary profits. Consumer confidence is rolling over, albeit from a nose-bleed level, signaling that, at the margin, discretionary consumer outlays will remain tame. Worrisomely, rising interest rates coupled with a breakout in crude oil prices are net negatives for consumer spending. Our consumer drag indicator captures these consumer headwinds and warns that the sector is not out of the woods yet (bottom panel, Chart 11). The Fed is on track to raise rate three more times in 2018 and continue to mop up liquidity via renormalizing its balance sheet. This dual tightening backdrop bodes ill for early cyclical discretionary stocks as we highlighted in the September 25th Weekly Report. Our consumer discretionary EPS growth model is making an effort to bounce, signaling that contracting earnings will likely reverse course and come out of their recent funk (second panel). But, analysts are overly optimistic penciling in a near double-digit profit growth backdrop for the consumer discretionary sector (fourth panel, Chart 5). Netting it all out, the anemic message from our profit model along with the ongoing Fed tightening cycle and spiking energy prices warrant a downgrade alert. Stay tuned. Chart 11Consumer Discretionary (Neutral-Downgrade Alert) Consumer Discretionary (Neutral-Downgrade Alert) Consumer Discretionary (Neutral-Downgrade Alert) Telecom Services (Neutral) Telecom pricing power and capital expenditures expectations comprise our S&P telecom services EPS growth model. Telecom capital expenditures have bounced off the zero line and are growing at 4% per annum while sector sales growth has been nil. This capital-intensive industry must continually invest to stay relevant. A push by telecom carriers into TV offerings as part of a quad-play (internet, wireline, wireless and TV) has rekindled an M&A boom, and capex is slated to increase. However, margins will suffer if increased investment fails to translate into new sales (bottom panel, Chart 12). Steeply contracting pricing power is a bad omen both for top and bottom line growth prospects (fourth panel). Hopefully, industry consolidation will lead to a better pricing backdrop, but the jury is still out. Our EPS model has sunk into the contraction zone (second panel). Analysts are a little bit more sanguine, penciling in low single-digit profit growth (bottom panel, Chart 4). Industry deflation is not alone as a headwind as the bond market selloff is weighing on the high dividend yielding telecom services stocks. Despite all the bearish news, near all-time lows in relative valuation and washed out technicals are keeping us on the sidelines. Chart 12Telecom Services (Neutral) Telecom Services (Neutral) Telecom Services (Neutral) Materials (Neutral) Materials EPS growth is a far cry from the near 100% year-over-year mark hit during the commodity super-cycle the mid-2000s and the reflex rebound following the Great Recession (second panel, Chart 13). Our S&P materials EPS model inputs include the U.S. currency, metals commodity prices and a measure of borrowing costs. The model has been steadily decelerating recently, and moving in the opposite direction compared with sell-side analysts' optimistic estimates (bottom panel, Chart 5). Consequently, there is scope for downward revisions. Materials stocks are reflationary beneficiaries and also high fixed cost high operating leverage deep cyclicals that benefit most during the later stages of the business cycle when a virtuous capex/EPS upcycle takes root. A number of both developed and developing central banks have recently embarked on tightening monetary policy following in the Fed's footsteps. Global liquidity is on the verge of getting mopped up as even the ECB and the BoJ have started to hint that they would remove some of their ultra-accommodative and unconventional policy measures. These opposing forces keep us at bay and we continue to recommend a benchmark allocation in the S&P materials index. Chart 13Materials (Neutral) Materials (Neutral) Materials (Neutral) Real Estate (Neutral) Commercial real estate loan demand, a labor market measure and the EUR/USD comprise our S&P real estate profit growth model (second panel, Chart 14). The 10-year Treasury yield and real estate relative performance have been nearly perfectly inversely correlated since the GFC as REITs sport a hefty dividend yield and thus are considered a fixed income proxy. BCA's higher interest rate 2018 theme suggests that more downside looms for this rate-sensitive sector. Similarly, a firming EUR/USD reflecting the nearly 100% domestic exposure of the sector weighs on real estate relative performance. Our EPS model has recently sunk into the contraction zone and is in sync with sell-side analysts' negative profit growth figures for calendar 2018 (second panel, Chart 5). While all this signals that an underweight stance is appropriate, we would rather stay on the sidelines for three reasons: First, sector pricing power (mostly rents) has not eroded yet, despite the surge in multi-family housing construction. Second, most of the bad news is likely already discounted in sinking valuations and extremely oversold technicals. Finally, we would rather concentrate our interest rate related underweight in the pure play fixed income proxy, the utilities sector (please see page 15). Stick with a benchmark allocation in the S&P real estate index. Chart 14Real Estate (Neutral) Real Estate (Neutral) Real Estate (Neutral) Health Care (Underweight) Our S&P health care EPS growth model consists of health care pricing power, labor costs and a measure of health care outlays. Health care demand is fairly inelastic, signaling that health care spending prospects remain upbeat, especially given the aging population. However, the industry's up-to-recently structurally robust pricing power backdrop is under intense scrutiny. Medical commodity cost inflation is melting and drug pricing power has nearly halved since early 2016. Democrats and Republicans alike, despise the pharmaceutical/biotech industry's pricing tactics and drug price containment is on nearly every legislator's agenda. Add on the generic drug inroads, and Big Pharma/biotech resilient profits appear vulnerable, weighing heavily on the sector's relative performance. From a secular perspective, there is scope for health care sector profit gains. Developing countries are only just starting to institute social "safety nets" that the developed world already has in place. Our profit model is decelerating (second panel, Chart 15) and forecasting single digit EPS growth, in line with the Street's 12-month forward profit estimates (fourth panel, Chart 4). The S&P health care sector is a core underweight portfolio holding and we reiterate the high-conviction underweight status in the heavy weight S&P pharma sub index. Chart 15Health Care (Underweight) Health Care (Underweight) Health Care (Underweight) Utilities (Underweight) Utilities pricing power, the yield curve and analysts' net earnings revisions are the key inputs in our S&P utilities EPS growth model (second panel, Chart 16). While natgas prices, the industry's marginal price setter, have been stuck in a trading range between $2.6 and $3.4/mmbtu over the past 18 months, they are currently contracting and weighing heavily on industry pricing power. The U.S. economy is firing on all cylinders (bottom panel, Chart 16) and a selloff in the 10-year Treasury market near 3% is BCA's base-case scenario for 2018. Under such a backdrop, fixed income proxied defensive equities lose their luster, and thus utilities stocks will likely remain under intense downward pressure, Our S&P utilities EPS growth model is expanding at a mid-single digit growth rate, broadly in line with sell-side analysts' forecasts (fifth panel, Chart 4) and roughly 700bps below the broad market. The S&P utilities sector is a high-conviction underweight. Chart 16Utilities (Underweight) Utilities (Underweight) Utilities (Underweight) Technology (Underweight - Upgrade Alert) Our three-factor global technology EPS growth model includes capex intentions, the trade-weighted U.S. dollar and sell-side analysts' net earnings revision ratio. While the tech sector is still largely considered a deep cyclical, we view it as more defensive. The majority of large capitalization tech companies are mature, cash rich, cash flow generating, dividend paying and high margin. Tech firms thrive in a deflationary backdrop as business models have been built to withstand the inherently disinflationary "creative destruction" process. BCA's interest rate view calls for an inflationary driven sell off in bonds for 2018, suggesting that investors avoid high-flying tech stocks. Weakness in basic resources explains most of the delta in cyclical capital outlays. Encouragingly, technology's share of the U.S. capex pie is making inroads rising to roughly 10% (bottom panel, Chart 17). Tech investment has been so abysmal for so long that it is hard to get any worse. In fact, it has started to improve both on an absolute and relative basis, as pent-up tech demand is being unleashed. Our synchronized global capex upcycle theme is gaining traction and the tech sector will continue to make gains at the expense of resource-related spending. Our global tech EPS model is forecasting modest double-digit growth in the coming quarters (second panel, Chart 17), largely aligned with sell-side analysts' profit growth expectations (fifth panel, Chart 5). On balance, we are putting the S&P tech sector on upgrade alert reflecting the capex tailwind offsetting the rising interest rate backdrop, and reiterate our capex-related high-conviction overweight in the S&P software sub-index. Chart 17Technology (Underweight-Upgrade Alert) Technology (Underweight-Upgrade Alert) Technology (Underweight-Upgrade Alert) 1 Please see BCA U.S. Equity Strategy Weekly Report, "SPX 3,000?," dated July 10, 2017, available at uses.bcaresearch.com. 2 Please see BCA U.S. Equity Strategy Weekly Report, "EPS And "Nothing Else Matters"," dated December 18, 2017, available at uses.bcaresearch.com. 3 Please see BCA U.S. Equity Strategy Weekly Report, "Dissecting Profit Composition," dated July 24, 2017, available at uses.bcaresearch.com. 4 Please see BCA U.S. Equity Strategy Weekly Report, "Invincible," dated November 6, 2017, available at uses.bcaresearch.com. 5 Please see BCA U.S. Equity Strategy Weekly Report, "Dollar The Great Reflator," dated September 18, 2017, available at uses.bcaresearch.com. 6 Please see BCA U.S. Equity Strategy Weekly Report, "Can Easy Fiscal Offset Tighter Monetary Policy?," dated October 9, 2017, available at uses.bcaresearch.com.

Highlights The consensus expects a 12% year-over-year increase in EPS in Q4 2017 versus Q4 2016, and 14% for 2018. The repercussions of the tax bill on operating conditions in 2018 will be a focus for corporate management teams and investors when discussing Q4 2017 results. The December readings on retail sales and CPI bolster the Fed's case for a rate hike in March. We expect a smooth transition in February for incoming FOMC Chair Powell, which will ensure a gradual normalization of monetary policy. However, Federal Reserve Board (FRB) vacancies, hawk/dove shifts and dissents are concerns. Feature U.S. equities continued their winning streak last week, as investors marked up expectations for both global growth and 2018 S&P 500 profits. The next section of this report offers a preview of the Q4 2017 earning season. There was even a hint of inflation in the air, as December's core CPI rose a stronger than expected 1.8% year-over-year. The overflow of Fed speakers did little to change the market's view that the next rate hike will occur at the March meeting. We discuss the composition of the FOMC in the final section of this week's report. The 10-year Treasury yield moved nearly 10 bps higher, ending the week at 2.56%. BCA's U.S. Bond Strategists put the 10-year fair value at 2.94%.1 Moreover, the 2-year Treasury yield touched 2% last Friday for the first time since 2008. S&P 500 Earnings: Q4 2017 The consensus expects a 12% year-over-year increase in EPS in Q4 2017 versus Q4 2016, and 15% for 2018. Energy, materials and technology shares will lead the way in earnings growth, while telecom and real estate earnings will languish. Excluding the energy sector, the consensus expects Q4 2017 EPS to rise by 10% year-over-year. The upbeat profit picture for the past quarter and 2018 reflects the rebound in oil prices, which are expected to boost energy sector EPS by an impressive 138% in Q4 (Chart 1). Energy-related capex and overall S&P 500 earnings are closely linked (Chart 1, panel 2). An improving global growth environment and still muted labor costs continued to drive a counter-cyclical rally in profit margins in Q4 and in early 2018. Moreover, the direct effect of the Tax Cut and Jobs Act of 2017, enacted late last year, will likely boost U.S. real GDP growth in 2018 by 0.2 to 0.3 percentage points. Hurricane reconstruction spending and a likely congressional agreement to raise the cap on federal discretionary spending could add another 0.2 points to the growth figure this year. However, much depends on the ability of tax changes and immediate capital expensing to further lift animal spirits in the business sector and bring forward investment spending. The repercussions of the tax bill on operating conditions in 2018 will be a focus for corporate management teams and investors when discussing Q4 2017 results. Specifically, corporations' use of cash via the benefit of lower tax rates and repatriating cash from overseas will be at the forefront. Chart 2 shows that through Q3 2017, share buybacks and dividends ran slightly ahead of prior cycles, while capex was about average. BCA will continue to monitor this mix. Improving economic conditions in Europe and the emerging markets (EM), the U.S. dollar, the sustainability of margins, and the aftermath of Hurricanes Harvey and Irma, all will likely be closely vetted during Q&A conference calls. Chart 1S&P 500 Sensitive To Oil Prices##BR##And Oil Driven Capex S&P 500 Sensitive To Oil Prices And Oil Driven Capex S&P 500 Sensitive To Oil Prices And Oil Driven Capex Chart 2Comparison Of Corporate Outlays##BR##Across Four Economic Expansion Phases A Smooth Transition? A Smooth Transition? Analysts may also fix their attention on rising interest rates and the shape of the yield curve. On January 12 the 10-year Treasury yield hit its highest point since March, reaching 2.56%. Moreover, in Q4 2017 the 10-year yield was 16 bps above Q3 2017 and 26 above Q4 2016. BCA expects the 2/10 yield curve to steepen in the next six months before flattening in the final half of the year. The curve and rising rates provide a boost to the financial sector of the S&P 500. BCA's U.S. Equity Strategy team remains overweight the Financials sector since May 2017.2 As always, guidance from corporate leaders on trends in Q1 2018 and beyond are more important than the actual Q4 results (Chart 3). Investors should guard against management over-optimism because earnings growth forecasts very often move lower over time. In Q4, as in the first three quarters of 2017, firms with elevated overseas sales should benefit from the improved growth profile in Europe, Japan and the EM. Chart 4 shows that the lofty ISM figures provide a favorable backdrop for earnings and sales in 2018. Moreover, Chart 5 indicates that industrial production (IP), a proxy for S&P 500 sales, is poised to advance in 2018 and lift corporate profits. Global GDP growth projections for this year and next have steadily perked up, in sharp contrast with prior years when forecasters relentlessly lowered GDP estimates (Chart 6). Chart 32018 Estimates Turned Higher After Tax Law Passed; '19 Likely To Move Lower 2018 Estimates Turned Higher After Tax Law Passed; '19 Likely To Move Lower 2018 Estimates Turned Higher After Tax Law Passed; '19 Likely To Move Lower Chart 4Favorable Macro Backdrop For Earnings And Sales Favorable Macro Backdrop For Earnings And Sales Favorable Macro Backdrop For Earnings And Sales In addition, BCA's U.S. Equity Strategy service notes3 that following a trough in 2015, the number of positive revenue revisions has steadily outpaced the number of positive earnings revisions, despite actual earnings growth vastly outpacing revenue growth. One plausible reason for the recent very positive revenue revisions is that firms are shifting some profits from 2017 into 2018 to capture the maximum benefit from tax reform. Chart 5ISM Components Suggest IP##BR##Poised To Accelerate ISM Components Suggest IP Poised To Accelerate ISM Components Suggest IP Poised To Accelerate Chart 6Global Growth Estimates##BR##Still Accelerating Global Growth Estimates Still Accelerating Global Growth Estimates Still Accelerating The U.S. dollar, which has been only a small drag on EPS in recent quarters, should become a modest plus in Q4; the dollar is down by 3% versus a year ago against a broad basket of currencies. Moreover, in the most recent Beige Book (November 29), mentions of a "strong dollar" declined by 8 compared with a year ago. This indicates that the stronger currency has faded as a primary concern of managements in recent months (Chart 7). Nonetheless, BCA's view is that the dollar will advance by 5% in the next 12 months. 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. Another increase in the dollar, on its own, should not provide a substantial headwind for the stock market. Indeed, the dollar would only climb in the context of robust U.S. economic growth and an expanding corporate top line. Legislative progress on an infrastructure package in the U.S. and an improvement in U.S. business capital spending would boost the greenback's prospects. The effects of this past fall's major hurricanes on Q4 results will be muted for the S&P 500 and most sectors. Several weather-sensitive industries (insurance, airlines, chemicals, refining, leisure, etc.) saw significant disruptions to their Q3 results. These industries will probably see some snapback in their Q4 results. Investors are skeptical that margins can advance in Q4 2017 for the sixth 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, but the secular mean reversion of margins will resume beyond that time as wage pressures begin to percolate. The bottom line is that we expect the earnings backdrop will be supportive of equity prices in 2017Q4 and early in 2018. Beyond that, EPS growth will begin to decelerate in the second half of 2018 and will become more of a headwind for stock prices as we enter 2019 (Chart 8). Stay overweight stocks versus bonds. Chart 7The Dollar Should Not Be##BR##A Factor In Q4 Earnings Season The Dollar Should Not Be A Factor In Q4 Earnings Season The Dollar Should Not Be A Factor In Q4 Earnings Season Chart 8Strong S&P Growth Ahead,##BR##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 Fed Leadership Transition: Smooth Sailing Ahead? Chart 9December's CPI Data Will Be Met##BR##With A Sigh Of Relief From The Fed December's CPI Data Will Be Met With A Sigh Of Relief From The Fed December's CPI Data Will Be Met With A Sigh Of Relief From The Fed Following a disappointing 0.1% m/m increase in November, core CPI posted a 0.3% m/m rebound in December (Chart 9). While welcomed news, there are a few counterpoints to note. First, the gain was concentrated in two subcomponents: housing and medical care. Shelter accounts for over 40% of core CPI and our models are pointing to a moderation ahead. Second, core services (ex-shelter and medical care) inflation remains anemic at sub-2% and core goods prices are still deflating. Third, annual core inflation is running at just 1.8%. Core CPI inflation of 2.4-2.5% is consistent with the Fed's 2% target for the core PCE deflator. December's retail sales report added to the upbeat tone of the economy as 2018 ended. The Atlanta Fed's GDPNow reading for Q4 2017 stood at 3.3% on January 12, up from 2.7% on January 5. U.S. inflation should gradually revert to target by year-end. In U.S. fixed income portfolios, investors should maintain below-benchmark duration and overweight TIPS versus nominal Treasuries. Rising inflation breakevens will also exert a steeping bias to the yield curve. The bounce in core CPI is certainly encouraging, but the Fed needs to see further firm prints to gain greater confidence that inflation is indeed heading back to target. With two more CPI reports ahead of the March FOMC meeting, the Fed may have the evidence it needs by then to hike rates again. We expect a smooth transition in February for incoming FOMC Chair Powell, which will ensure a gradual normalization of monetary policy. Powell will not want to create waves as the FOMC nudges the Fed funds rate closer to its projected terminal point of 2.75%.4 There are several reasons for our unequivocal view that there will be a smooth transition in FOMC leadership: Fed Chair Precedents: In previous FOMC leadership transitions, the monetary policy path remained continuous, on average about 13 months, before changing direction (Chart 10). For example, former Chair Bernanke continued to hike rates four more times after Greenspan retired (February 2006), with the tightening cycle peaking in June 2006. Yellen maintained a steady zero-interest rate policy (ZIRP) for almost two years following the departure of Bernanke in early 2014. Greenspan retained the tightening policy path initiated by Volcker, although it was temporarily interrupted to avert a credit crunch after the 1987 stock market crash. Thereafter, Chair Greenspan resumed hiking rates for a little more than one year. Chair Powell, known as a conforming centrist, will certainly follow the lead of his predecessors. U.S. monetary policy will remain unchanged from former Chair Yellen, unless there is an unforeseen shock to global growth or a sharp deviation from the expected path for inflation. Chart 10Fed Chair Precedents: Continuous Monetary Policy Path Fed Chair Precedents: Continuous Monetary Policy Path Fed Chair Precedents: Continuous Monetary Policy Path FOMC Composition Changes: Each year ushers in a different set of voters on the FOMC linked to the rotation of regional FRB presidents. More uncertainty has been created this year with the departures of several regional presidents and vacancies on the Board of Governors. The composition of voting FOMC members will be slightly more hawkish for 2018 relative to 2017 (Chart 11). The continuity and efficacy of monetary policy will be further promoted as the path for more rate hikes (at least two) are already discounted by forward markets and three more rate increases are expected in 2018. FRB Minneapolis President Kashkari and FRB Chicago President Evans depart this year as non-voting members. Kashkari is considered the most dovish; he will return as a voter in 2020 while Evans will come back in 2019. Chart 11Composition Of Voting FOMC Members 2017 Vs. 2018 A Smooth Transition? A Smooth Transition? In contrast, the arrival of FRB Presidents Mester (Cleveland), Williams (San Francisco) and Barkin (Richmond) tip the scale somewhat towards tighter policy. Most importantly, FRB's New York Dudley, a centrist, will leave about five months after Yellen's term expires next month. Board Governor Lael Brainard, an Obama-era appointee, will remain as the most dovish voter of the two existing doves in the mix. The FOMC's hawkish bias will no longer be a matter of perception but rather a matter of reality. The nomination of Marvin Goodfriend by President Trump to the Fed's Board should move matters towards neutrality (Goodfriend is not a definite hawk as he also cautious about fighting deflation) and ensure that the Fed operates with at least four governors in 2018. Goodfriend's successful confirmation would leave only three Board vacancies: the Vice-Chair and two governors. On the margin, the voting members of the FOMC skew more hawkish in 2018, but history suggests that new Fed Chairs favor gradual transitions over sudden shifts in policy. FRB Vacancies: The three outstanding Board vacancies should not prevent the smooth transition of leadership from Yellen to Powell next month. In recent years, the duration of FRB vacancies has been longer when compared with prior years. According to a recent report by the Bipartisan Policy Center,5 lengthy vacancies are most evident at the Fed among 13 independent financial regulatory agencies. From 1986 to the present, the 67% vacancy rate at the Fed was more than triple the percentage of 21% from 1947 to 1986 (Chart 12). The Center also calculated that since January 1, 2000, there has been at least one Federal Reserve Board vacancy more than 80% of the time, emphasizing that a "full Fed Board is as rare as a vacancy used to be." While the FOMC had a full Board most of the time (79%) from 1947 to 1986, in the past 30 years this occurred only one-third of the time (33%) (Chart 13). Therefore, even the structural shift in the FOMC's composition did not deter or unhinge the lift-off from a zero interest-rate policy in December 2015 (the first rate hike since June 2006) and the eventual debut of the Fed's balance sheet normalization last September. The implication for investors is that the FOMC has been operating in an era of a higher vacancy rate for some time, and therefore used to operating that way, and the vacancies should not play a major role in the Fed's policy path this year or in the transition from Yellen to Powell. Chart 12Vacancies Are Now The Norm A Smooth Transition? A Smooth Transition? Chart 13More Than One Vacancy Is Not Uncommon Too A Smooth Transition? A Smooth Transition? FOMC Dissents: Even with less than a full slate of governors on the Fed's Board, there has not been governor dissent since 2005 (Chart 14) We expect a somewhat similar frequency of dissents as in previous cycles. In 2017, all four dissents were registered by regional Fed presidents. Chair Yellen never expressed discord when she was a member of the Board of Governors nor when she was President of the FRB San Francisco. Notably, incoming Chair Powell has not dissented since joining the Board in 2012. Moreover, any opposition declared by Board members was usually for easier policy (78% for easier policy and 28% for tighter policy). For example, in the fall of 2015, prior to the first rate hike of the cycle, two dovish Fed governors opposed Chair Yellen. Governors Brainard and Tarullo wanted to delay boosting rates into 2016 because they believed that inflation was still too low. They contended that a "wait-and-see" approach was less risky than acting prematurely, arguing that the risks to global growth and U.S. inflation remained to the downside. One reason for this disagreement came from differing views on market-based inflation expectations. Given the tight link with oil prices, market-based, long-term inflation expectations had melted. Similarly in 2017, FRB Minneapolis President Kashkari and FRB Chicago President Evans disagreed, also citing inflation concerns. They made the case that the persistence of low inflation may not be entirely due to "transitory factors" as the FOMC Committee claimed. Chart 14Dissent By Reserve Bank Presidents And Fed Governors A Smooth Transition? A Smooth Transition? Bottom Line: The path of the economy and inflation, and not the composition of the Fed, will have the most significant impact on Fed policy in 2018. There was some support at the December 2017 FOMC meeting to study the use of inflation and/or nominal GDP targeting as policy framework, but the Fed will remain committed to its current policies. Meanwhile, incoming Chairman Powell will probably maintain the same gradual approach towards rate increases as his predecessor, even though there is a slightly more hawkish tilt to the makeup of the FOMC's voting members. The Board's vacancies at the start of 2018 are a risk, but past vacancies have not led to drastic policy changes. BCA expects three or four rate gains this year, but it is still too early to decrease risk in portfolios. Remain overweight equities relative to bonds. John Canally, CFA, Senior Vice President U.S. Investment Strategy johnc@bcaresearch.com Jizel Georges, Senior Analyst jizelg@bcaresearch.com 1 Please see BCA Research's U.S. Bond Strategy Weekly Report "January Effect," published January 9, 2018. Available at usbs.bcaresearch.com. 2 Please see BCA Research's U.S. Equity Strategy Weekly Report "Girding For A Breakout," published on May 1, 2017. Available at uses.bcaresearch.com. 3 Please see BCA Research's U.S. Equity Strategy Insight "What's Up With SPX Revenue Vs. Profit Revisions," published on January 12, 2018. Available at uses.bcaresearch.com. 4 https://www.federalreserve.gov/monetarypolicy/files/fomcprojtabl20171213.pdf 5 "Financial Regulators Struggling With Longer Vacancies At The Top", Schardin, Justin and Sheth, Ashmi, Bipartisan Policy Center, March 2017.

Highlights The November jobs report keeps the Fed on track. Despite rising government debt levels, crowding out is not a significant threat. Capex as a share of GDP rises the year before a tax cut and falls in the year after. Holiday spending on track, boosted by tax bill. Feature Last week, investors assessed the ramifications of the OPEC meeting and the Senate's passage of the tax plan. The dollar was noticeably higher, and oil moved lower during the week, but other financial markets ended little changed. Chart 1 shows that the Trump trades are making a comeback, providing ample opportunity for investors who may have missed the trade the first time around. In this week's report, we examine the impact of the tax bill on the debt, deficit, and capital spending and more importantly on corporate balance sheets and financial markets. BCA's view is that the risk that rising government debt levels will crowd out private borrowing is low and that the tax cut will provide a tiny boost to an already robust capital spending environment. We also examine what signal the equity markets are sending about household spending in the holiday season. Chart 1Markets Responding To GOP Tax Plan Markets Responding To GOP Tax Plan Markets Responding To GOP Tax Plan Living In Paradise The November employment report, released last Friday, paints a Goldilocks-type macro environment for U.S. assets. Strong economic growth, muted inflation, and a go-slow Fed should prolong the bull market in U.S. equities. The economy added 228K in net new jobs, and the unemployment rate held steady at 4.1% in November. With the average work week rising by 0.1 hours, aggregate hours worked rose by a solid 0.5% m/m. Even if hours worked hold flat in December, the average for Q4 will be up 2.6% at an annualized rate from Q3. The November payroll data are easily consistent with about 3.5% GDP growth in Q4. BCA expects above-potential real GDP growth to persist well into 2018. Despite the strong growth and tight labor market, wage pressures remain contained. Average hourly earnings rose just 0.2% m/m in November, which followed a downwardly revised 0.1% m/m decline last month. Annual wage inflation is running at 2.5% (Chart 2). Last week's report will not dissuade the Fed from raising rates again next week. As long as GDP growth remains above trend and the labor market is tightening, the Fed will remain somewhat confident that wages will accelerate and inflation will gradually return to the target level. However, there is no reason yet for the Fed to turn more aggressive for fear of falling behind the curve. Chart 2November Jobs Report Keeps Fed On Track November Jobs Report Keeps Fed On Track November Jobs Report Keeps Fed On Track It's Getting Mighty Crowded The recently passed U.S. Senate tax reform bill has to be reconciled with the House bill, but it appears that the Republicans may meet their Christmas deadline after all. BCA's Geopolitical Strategy service has consistently expected a tax package to pass by the end of Q1 2018 at the latest.1 Although some technical differences between the two versions remain, the two bills are close enough that compromise should not be difficult. The Republicans are under pressure to deliver a "win" ahead of the 2018 mid-term elections. Most of the tax adjustments will occur early next year, except for a reduction in the corporate tax rate that may be delayed until 2019. The Senate version, if passed, would decrease individual taxes by about $680 billion over 10 years, trim small business taxes by just under $400 billion, and reduce corporate taxes by roughly the same amount (including the offsetting tax on currently untaxed foreign profits). The direct effect of all the tax cuts will probably boost real GDP growth in 2018 by 0.2 to 0.3 percentage points. However, much depends on the ability of the tax changes and immediate capital expensing to lift animal spirits in the business sector and bring forward investment spending. The total impact - at this stage - is difficult to estimate. According to the Joint Committee on Taxation (JCT), by the end of 2027 the legislation will add $1 trillion to the debt, including the effects of dynamic scoring. Without the boost from faster economic activity due to the tax changes, the deficit is expected to be $1.4 trillion higher than the CBO's baseline projection for 2027. While nominal economic growth would increase under the plan, the debt-to-GDP ratio would climb to 95% of GDP by 2027, up from 91% under current law (Chart 3). Chart 3Federal Debt As A Share Of GDP Set To Rise Sharply In Coming Decades Federal Debt As A Share Of GDP Set To Rise Sharply In Coming Decades Federal Debt As A Share Of GDP Set To Rise Sharply In Coming Decades So far, the Treasury market has shown little reaction to the passage of the Senate bill. Fixed-income investors do not appear to be overly concerned about the implications of the size of the public debt and do not believe that the tax changes alter the Fed's calculations. BCA is also not concerned about the size of public debt in the near term but thinks the tax changes will alter the Fed's forecasts. Nonetheless, more government red ink is likely to raise equilibrium bond yields in the long term. The Fed estimates that the equilibrium 10-year bond yield would rise on a structural basis by 3-4 basis points for each percentage point increase in the Federal government's debt-to-GDP ratio, and by 25 basis points for every percentage point increase in the deficit-to-GDP ratio.2 The implication is that if the GOP plan becomes law, then the 10-year yield will be 12-16 bps higher than under current legislation. Nonetheless, there is only a modest risk that mounting U.S. government debt will crowd out private borrowing and choke off investment on a 12-month horizon. Crowding out occurs when soaring government debt sparks competition between the public and private sectors for available savings. Increased demand for private credit, a narrowing output gap, and elevated interest payments as a percentage of GDP, are all preconditions for crowding out. While the output gap has closed, demand for private credit is mixed, at best, and federal interest payments will remain in check. Private credit demand has rebounded from the recession, but it is still tepid. At 2% of corporate sales, nonfinancial corporate borrowing is at the lower end of its post-crisis range and has downshifted since 2015 (Chart 4). Before the 2007-2009 financial crisis, there was a tight relationship between corporate demand for funds and Treasury yields. Since 2009, the link has weakened; credit demand snapped back, but Treasury yields stayed low. Soft C&I loan demand also indicates less of a risk for crowding out (panel 3). Interest payments on the Federal debt are expected to climb, but remain well below all-time highs set in the early 1990s (Chart 5). The CBO's baseline projects that interest payments on the debt as a share of nominal GDP will more than double from 1.4% in 2017 to 2.9% in 2027. These payments will triple in absolute terms from $300 billion in 2017 to more than $800 billion in 2027. The GOP tax plan will boost the 2027 projection, but the CBO has not yet released a new estimate. In a study prepared prior to the passage of the tax bill, the OECD forecast that the federal government's interest payments would climb to 2.9% by 2019. Chart 4Private Credit Demand Has Rebounded,##BR##But Remains Tepid Private Credit Demand Has Rebounded, But Remains Tepid Private Credit Demand Has Rebounded, But Remains Tepid Chart 5Gradual Rise in Net Interest Payments##BR##Not A Crowding Out Threat Gradual Rise in Net Interest Payments Not A Crowding Out Threat Gradual Rise in Net Interest Payments Not A Crowding Out Threat Moreover, the Tax Policy Center, a center-left think tank, also concluded that interest costs will move up under the new tax law.3 On balance, interest payments on federal debt obligations as a share of the economy are expected to escalate in the next 10 years to 2.5-3%. This reading is in line with the average in the past 20 years, but is still below the 4-4.5% average reached in the late 1980s and early 1990s, and the 3.5-4% range observed from 1970-2000. If nothing else changes, higher federal interest payments would absorb funds that could instead be used for areas that add to the productive capacity of the economy, such as education, training and technical innovation. That said, the impact on long-term growth from "crowding out" may only represent a partial offset to the supply-side benefits of the fiscal package to the extent that the business sector lifts capex spending as a result of a lower corporate tax rate and immediate expensing (see below). Bottom Line: Tax cuts are bond bearish but support our overweight stance on equities on the surface. The effective corporate tax rate could decline by about two percentage points, which would boost after-tax cash flows by roughly 2½%. While this is not trivial, much of the good news already appears to be discounted in the S&P 500. Moreover, to the extent that faster growth in 2018 may bring forward hikes in the Fed funds rate, the equity market will have to contend with rising bond yields next year. Investors are also wondering about the tax plan's potential impact on capital spending and corporate balance sheets. Tiny Steps As discussed above, the fiscal package has the potential to generate significant supply side benefits, to the extent that the business sector turns on the capex taps. The JCT estimates that the tax bill will boost U.S. capital stock by 1.1% in 2027, an increase of about 0.1% a year. However, it is uncertain if corporations will permanently boost capex due to increased allowances for capital spending or if the tax shift will merely bring forward future spending. BCA's view is closer to the latter. We expect higher budget and trade deficits in the coming decade as a result of the Senate plan. These deficits will limit the ability of domestic saving to fund needed capital spending projects. Foreign saving will fill the gap. U.S. domestic saving is below the low end its 1960-2008 range (Chart 6). Chart 7 shows that since 1960, there have been four distinct periods of expanding net saving by foreigners. Nominal 10-year Treasury yields rose in three of the four intervals. However, real yields declined in the 1960s, rose in the mid-1970s and early 1980s as foreign saving increased, and then fell in the 1990s and 2000s. Moreover, a rise in the share of foreign saving led to higher capex in the mid-1960s and 1980s, but lower business expenditures in the 1990s (Chart 8). Chart 6Foreigners Will Finance Capex As##BR##Domestic Saving Declines Foreigners Will Finance Capex As Domestic Saving Declines Foreigners Will Finance Capex As Domestic Saving Declines Chart 7Interest Rates As##BR##Foreign Saving Rises Interest Rates As Foreign Saving Rises Interest Rates As Foreign Saving Rises Setting aside who will finance the spending, history suggests that business capital spending tends to climb faster in the 12 months prior to a period of rising fiscal thrust than it does in the 12 months following (Chart 9 and Tables 1 and 2). Note that our analysis shows that recessions occurred in five of the seven episodes of pro-cyclical fiscal policy. Chart 8Capex And Rising Foreign Saving Capex And Rising Foreign Saving Capex And Rising Foreign Saving Chart 9Capex During Periods Of Fiscal Stimulus Capex During Periods Of Fiscal Stimulus Capex During Periods Of Fiscal Stimulus In addition, as fiscal thrust escalates, stocks in the industrial and technology sectors underperform the broad market. Small caps generally beat large caps. Since 2000, the fed funds rate fell during periods of fiscal stimulus. Prior to that, the Fed both eased and tightened policy during these episodes (not shown). Table 1Business Spending 12 Months Before Pro-Cyclical Fiscal Policy Opportunity Opportunity Table 2Capex In The Year After Stimulative Fiscal Policy Is Enacted Opportunity Opportunity BCA's Corporate Health Monitor (CHM) has a tendency to improve during phases of increased fiscal thrust; Chart 10 shows that the CHM improved in five of the seven periods. Free cash flow and return on capital are the best performers during these intervals. In contrast, corporate leverage is apt to shoot up as fiscal policy takes hold. Chart 10Stimulative Fiscal Policy And The Corporate Health Monitor Stimulative Fiscal Policy And The Corporate Health Monitor Stimulative Fiscal Policy And The Corporate Health Monitor Our fiscal thrust measure includes both personal and corporate tax cuts, and along with increases in government spending. We use fiscal thrust as a proxy because there are a very limited number (just 3 since 1970) of corporate tax cuts to analyze. The paragraphs below covers the impact of corporate tax cuts on capital spending, capital spending-related financial metrics and corporate balance sheets. Capital spending is inclined to rise faster in the 12 months before a corporate tax cut than in the year afterward. The caveat is that there have been only 3 corporate tax cuts in the past 50 years. Charts 11 and 12 and Tables 3 and 4 examine the impact of previous corporate tax reductions on nonresidential fixed investment (and its components) as a share of GDP and on several capex-related metrics in the financial market. Chart 11Corporate Tax Cuts And Capital Spending Corporate Tax Cuts And Capital Spending Corporate Tax Cuts And Capital Spending Chart 12Corporate Tax Cuts And Financial Markets Corporate Tax Cuts And Financial Markets Corporate Tax Cuts And Financial Markets Moreover, industrial stocks underperform the broad market after a tax cut, while tech stocks outperform (Chart 12 again). Small-cap performance is mixed. Both the Fed funds rate and the 10-year Treasury yield rise after corporate tax decreases take effect. Table 3Capex The Year Before A Corporate Tax Cut Opportunity Opportunity Table 4Capex In The Year After A Corporate Tax Cut Opportunity Opportunity Corporate health weakens in the year before a business tax cut is enacted, but then it improves modestly in the ensuing year. Chart 13 and Tables 5 and 6 examine the significance of previous corporate tax cuts on BCA's Corporate Health Monitor (CHM) and several of its components. The interest coverage ratio deteriorates, on average, both before and after a corporate tax reduction, but leverage increases substantially in the 12 months following a corporate tax cut. Free cash flow deteriorates in the year prior to a drop in the business tax rate, but is little changed in the subsequent year. Chart 12Corporate Tax Cuts And Financial Markets Corporate Tax Cuts And Financial Markets Corporate Tax Cuts And Financial Markets Chart 13Corporate Tax Cuts And The Corporate Health Monitor Corporate Tax Cuts And The Corporate Health Monitor Corporate Tax Cuts And The Corporate Health Monitor Bottom Line: Business capital spending was already on the upswing and the output gap was already closed before the tax cut was passed. Accelerated depreciation allowance may pull capex ahead, but not materially change its trajectory over the long term. Corporate tax cuts and fiscal stimulus, in general, boost capex and corporate health, and support BCA's view that credit will outperform Treasuries in 2018. Table 5BCA's Corporate Health Monitor A Year Before A Corporate Tax Cut... Opportunity Opportunity Table 6...And In The 12 Months After Opportunity Opportunity Boxing Day The critical holiday spending season is in full bloom. Holiday retail sales make up the bulk of total consumer spending, representing about 20% to 30% of total annual retail sales (and about 40% of total personal consumption expenditures). Moreover, according to the National Retail Federation (NRF), although 54% of consumers surveyed expect to spend the same amount in this year's holiday season as in 2016, 24% are prepared to spend more. The NRF forecasts that holiday sales will increase between 3.6% and 4.0%, exceeding last year's 3.6% rate and the 5-year average forecast of 3.5%. Holiday retail sales have faded in nominal and real terms from an average of 4.9% in the 1993-1999 period to 3.7% pre-2008 (2000-2007) and to an average of 3.3% post-2008 GFC (2009-2016). However, the baseline trend, based on average annual growth rates, remains stable at 3%, with upside potential of as much as 6% during robust economic growth phases(mid 2000s) and downside risk to as low as -4% in recessions (2008) (Chart 14). Chart 14Holiday Sales: Strong Tailwinds Intact Opportunity Opportunity Holiday sales this season may just get an unexpected boost from stout consumer finances. The implication is that U.S. economic growth should remain above potential well into 2018. Solid consumer balance sheets remain a tailwind even at this late stage of the business cycle. Household balance sheets have been repaired in an optimal way and household net worth continues to soar to new highs. The implication is that households are much less likely to forego holiday spending this season than in periods where household net worth is under downward pressure. Furthermore, stock market returns for the U.S. consumer discretionary sector, measured between the mid-September to mid-December period, are well correlated with holiday spending trends (Chart 15). The 8.6% rise in the consumer discretionary sector since mid-September heralds another healthy holiday spending season. However, global consumer discretionary retailers are a better predictor of holiday sales than domestic consumer discretionary retailers. Prices here are up 6.6% since mid-September. Chart 15Trends Of Holiday Sales And Equity Returns Opportunity Opportunity Furthermore, expectations of tax reform legislation becoming law by the end of the year will incentivize low income households to spend more this holiday season. This cohort is apt to pay for holiday purchases with cash. The NRF has likened the benefit of the tax plan to a "free Christmas".4 The NRF suggests that the cumulative savings from the tax package for an average household will offset the $967.13 projected to be spent this year by the average household in the holiday season. Moreover, a 2016 Fed study finds that the financing for holiday spending varies by income. Low income households have a tendency to source holiday spending from savings/income rather than borrowing, and if access to credit is not readily available, they simply will not spend on holiday shopping.5 To ensure that a majority of U.S. households contribute towards a robust holiday spending season, strong employment growth alongside stable wage growth (and higher real income expectations) and sturdy consumer confidence is required. With an already tight labor market and the underemployment rate (U-6) close to pre-recession lows, solid consumer fundamentals remain intact. Bottom Line: A robust holiday shopping season is likely in 2017, supported by stout consumer balance sheets, the new tax bill, and rising wages and incomes. The 8.6% run up in consumer discretionary stocks also suggests that a happy holiday for retailers is in prospect. BCA's U.S. Equity Strategy service has a neutral rating on the Consumer Discretionary sector, but recommends an overweight the advertising, home improvement retail and leisure products industry groups. Additionally, BCA maintains an overweight to the holiday-sensitive Air Freight and logistics industry within the Industrial sector.6 Strong personal spending will support above potential GDP growth in Q4 and into 2018, eliminate the output gap, push the unemployment rate further below NAIRU and push up inflation and ultimately bond yields. Stay short duration. John Canally, CFA, Senior Vice President U.S. Investment Strategy johnc@bcaresearch.com Jizel Georges, Senior Analyst jizelg@bcaresearch.com 1 Please see BCA Research's Geopolitical Strategy Weekly Report, "Xi Jinping: Chairman Of Everything," October 25, 2017. Available at gps.bcaresearch.com. 2 "New Evidence on the Interest Rate Effects of Budget Deficits and Debt", Thomas Laubach, Board of Governors of the Federal Reserve System, May 2003. https://www.federalreserve.gov/pubs/feds/2003/200312/200312pap.pdf 3 http://www.taxpolicycenter.org/sites/default/files/publication/148841/2001606-macroeconomic-analysis-of-the-tax-cuts-and-jobs-act-as-passed-by-the-house-of-representatives_1.pdf 4 https://nrf.com/media/press-releases/retailers-say-senate-passage-of-tax-reform-could-give-shoppers-free-christmas 5 https://www.federalreserve.gov/econresdata/notes/feds-notes/2016/holiday-spending-and-financing-decisions-in-2015-survey-of-household-economics-and-decisionmaking-20161201.html 6 https://uses.bcaresearch.com/trades/recommendations

Highlights Junk & The Yield Curve: The flat yield curve increases the risk of a sell-off in junk bonds. The most likely scenario is that higher inflation steepens the curve and mitigates this risk, but if inflation fails to respond then spreads will probably gap wider in the near-term. Ultimately, this would be a buying opportunity and not the end of the cycle. Junk & Corporate Health: Net debt-to-EBITDA should move lower during the next few quarters, driven by strong profit growth, but this is already in the price. Further increases in net debt-to-EBITDA would bring the end of the credit cycle closer, and this measure bears close monitoring. Junk & Fund Flows: Outflows from open-ended bond funds - especially those that invest in illiquid securities - can exacerbate periods of spread widening much in the same way as the use of leverage. Feature Anxiety in appropriate intensity makes humans intelligent - Anna Freud The remarkable run of junk bond outperformance suffered a setback last week, and it is very likely that excess returns will be negative in November for only the fourth month since spreads peaked in February 2016 (Chart 1). Chart 1A Buying Opportunity? A Buying Opportunity? A Buying Opportunity? We are inclined to view the recent price action as a temporary blip, and continue to believe that higher inflation and a more restrictive central bank reaction function are pre-conditions for a sustained period of spread widening.1 Nonetheless, if inflation trends higher as we expect, our pre-conditions for the end of the credit cycle could be in place by the middle of next year. In other words, we are much closer to the end of the credit cycle than the beginning and investors should be constantly re-assessing the risk/reward trade-off of staying invested. To aid in this process, this week we consider five reasons why investors might be nervous about their high-yield allocations and discuss how to think about each reason in the context of making a portfolio allocation decision. Reason 1: Spreads Are Tight Undoubtedly, the number one reason most people fret about high-yield bond performance is that valuation is extremely stretched. Even after last week's sell-off the average option-adjusted spread on the junk index is still 362 basis points, only 38 bps above the mid-2014 cycle lows (Chart 2). A more refined valuation measure, the 12-month breakeven spread for each credit tier, paints a similar picture.2 Chart 3 shows that valuation has been more expensive for Ba-rated securities only 23% of the time. B-rated securities have been more expensive only 39% of the time, and Caa-rated securities only 44% of the time. Chart 2Bouncing Off The Lows Bouncing Off The Lows Bouncing Off The Lows Chart 3Junk Bond Valuation Junk Bond Valuation Junk Bond Valuation Further, we calculate that if Ba-rated spreads tighten another 97 bps they will reach all-time expensive levels. This represents only 3 months of average spread tightening. The same calculation shows that B-rated spreads can tighten another 179 bps (4 months of average tightening) and Caa-rated spreads can tighten another 378 bps (5 months of average tightening). The message is quite clear. Spreads are close to all-time expensive levels and it would be unwise to hinge an investment decision on the expectation of significant capital gains. Junk is a carry trade at this point in the cycle, and the important question is how much longer we can pick up the carry before a sustained period of spread widening takes hold. However, we must also remember that valuation is not a market timing tool. Spreads can stay at low levels for extended periods, especially in the late stages of the credit cycle. Valuation is only important because it allows us to formulate expected return projections, and lower expected returns make the prospect of trying to time the exact end of the credit cycle less appealing. With that in mind, our base case scenario assumes that default losses will total 1.02% during the next 12 months. This means we should expect excess returns of 260 bps in a scenario where spreads remain flat. Even if spreads tighten another 100 bps from current levels high-yield excess returns will only reach 651 bps. That would represent a very optimistic scenario for junk returns. More realistically investors should expect excess returns between 200 bps and 500 bps (annualized) between now and the end of the credit cycle. Reason 2: The Yield Curve Is Flat The relentless flattening of the yield curve also presents a risk for junk bonds because it is a signal that monetary policy is becoming too restrictive. Restrictive monetary policy, along with deteriorating corporate health and tightening bank lending standards, is one of our three main credit cycle indicators (Chart 4). Typically we need a signal from all three of our indicators before a bear market in junk bonds kicks in. We already see such a signal from deteriorating corporate health, but accommodative Fed policy and easing bank lending standards continue to support spreads. Chart 4Credit Cycle Indicators Credit Cycle Indicators Credit Cycle Indicators That being said, during the past nine months the combination of disappointing inflation and two Fed rate hikes has caused the 2/10 Treasury slope to flatten all the way down to 62 bps. An inverted yield curve is a signal that the credit cycle is over and a slope of 62 bps is close enough to zero that market participants are jittery. We think a slope at these levels makes a near-term sell off in junk bonds more likely because investors will be inclined to view any negative news as a signal that the credit cycle is about to turn. They would be less inclined to do so if the curve was steeper. While such a flat yield curve poses a near-term risk to spreads, we have argued forcefully in recent reports that it will soon steepen.3 The most likely scenario is that inflation will start to trend higher, and this will steepen the curve while still allowing the Fed to deliver a pace of rate hikes close to its median projection. But even in a scenario where inflation fails to rise, we would still expect the curve to steepen as the Fed capitulates on its projected rate hike path. The key risk for junk spreads is a scenario where inflation fails to rise but the Fed does not react and instead continues to lift rates. This scenario would certainly lead to a risk-off episode in credit markets. At that point, however, the Fed would take note of the tightening in financial conditions and adopt a more dovish policy stance to support the recovery. In other words, while the Fed might be slow to renege on its rate hike projections in the face of low inflation, it has a strong track record of responding to shifts in financial conditions. This is because the Fed rightly understands that financial conditions lead GDP growth (Chart 5), and above-trend growth must be maintained in order for inflation to move back to target. Chart 5Financial Conditions Lead Growth Financial Conditions Lead Growth Financial Conditions Lead Growth Bottom Line: The flat yield curve increases the risk of a sell-off in junk bonds. The most likely scenario is that higher inflation steepens the curve and mitigates this risk, but if inflation fails to respond then spreads will probably gap wider in the near-term. Ultimately, this would be a buying opportunity and not the end of the cycle. Reason 3: Corporate Health Is Weak As was noted in the prior section, corporate balance sheet health is weak but this is only one of the three conditions that need to be met before defaults start to pick up and spreads start to widen. We also need to see more restrictive monetary policy and banks that are less inclined to extend credit. But it is also logical that weaker balance sheets should cause investors to demand greater compensation to hold high-yield bonds, and in general we do observe a strong correlation between junk spreads and net debt-to-EBITDA for the non-financial corporate sector as a whole (Chart 6). Worryingly, spreads have diverged from this measure since early 2016, but net debt-to-EBITDA did tick lower in Q2 and we anticipate further improvement in the coming quarters as the outlook for profit growth appears strong.4 It is important to note that any future improvement in net debt-to-EBITDA is already priced in, but further deterioration would speed up the time until the end of the credit cycle. That is, if the measure of net debt-to-EBITDA shown in the top panel of Chart 6 moves higher in the coming quarters then we will have to be quicker to shift to an underweight stance on high-yield (and investment grade) corporate bonds at the first sign of inflation. The other important issue related to corporate health is that we have seen a great deal of bond issuance during the past few years, but almost none of that issuance has been required to finance capital investment. Chart 7 shows that the financing gap - firms' capital expenditures less retained earnings - has only recently turned positive. It follows that the proceeds from most of this cycle's bond issuance must have been returned to shareholders in the form of stock buybacks. Chart 6Leverage Bears Monitoring Leverage Bears Monitoring Leverage Bears Monitoring Chart 7Less Equity, More Debt Less Equity, More Debt Less Equity, More Debt This observation does not help us figure out when the credit cycle will end, but if corporate capital structures have less of an equity cushion then it should lead to lower recovery rates when corporate defaults finally start to occur. In the bottom two panels of Chart 7 we show aggregated bottom-up data from a sample of junk rated non-financial firms. We see that the debt-to-equity ratio of the median company in the sample is much higher than during the last recession, but at similar levels to what was seen during the 2001 recession. The bottom panel of Chart 7 shows the percent of firms in our sample with a debt-to-equity ratio above 300%, and it sends a similar message. Bottom Line: Net debt-to-EBITDA should move lower during the next few quarters, driven by strong profit growth, but this is already in the price. Further increases in net debt-to-EBITDA would bring the end of the credit cycle closer, and this measure bears close monitoring. Additionally, corporate capital structures have less of an equity cushion than during the last recession but look similar to the late 1990s/early 2000s. This has more of a bearing on recovery rates during the next downturn than on the timing of the turn in the credit cycle. Reason 4: Volatility Is Low VIX and junk spreads are practically tied at the hip (Chart 8), that much is well known. The question is whether the very low reading from the VIX poses an additional risk to junk bonds beyond what is already reflected in tight spreads. For the most part we think that it does not. The low VIX appears to be driven by the same factors that cause junk spreads to tighten - stronger corporate balance sheets, accommodative monetary policy and easing bank lending standards (Chart 9). Chart 8VIX Also At Cycle Lows VIX Also At Cycle Lows VIX Also At Cycle Lows Chart 9VIX Fair Value Is Biased Higher VIX Fair Value Is Biased Higher VIX Fair Value Is Biased Higher There is one possible exception and that relates to leverage in the banking system. It has been shown that financial intermediaries manage their Value-at-Risk (VaR) so that the ratio of VaR-to-equity is stable. Since lower volatility leads to a lower calculated VaR, it suggests that banks can take on more leverage and still keep their ratio of VaR-to-equity stable.5 If low volatility mechanically leads to higher banking sector leverage, then that presents the additional risk that banks will face greater losses when spreads eventually widen. This would cause lending standards to tighten even more quickly, and exacerbate the spread widening. So while low volatility could potentially lead to a wider end-point for junk spreads once the cycle turns, it does not help us determine when that widening will occur. Also, stricter post-crisis bank capital regulations may have mitigated this risk to a certain extent, though it is difficult to know until the default cycle actually takes hold. Reason 5: Open-Ended Fund Flows Another risk that has been flagged by many investors is the ever-growing presence of open-ended mutual funds and ETFs in the corporate bond market. According to second quarter Flow of Funds data, 19% of corporate and foreign bonds were held in mutual funds or ETFs (Chart 10). This is a big change from past cycles. In a speech from 2014, then Fed Governor Jeremy Stein elucidated why this might pose a risk:6 When investor i exits [the fund] on day t, does the net asset value at the end of the day that defines investor i's exit price fully reflect the ultimate price effect of the sales created by his exit? If not, those investors who stay behind are hurt, which is what creates run incentives. And, if run incentives are strong enough, then a credit-oriented bond fund starts looking pretty bank-like. The fact that its liabilities are not technically debt claims is not all that helpful in this case - they are still demandable, and hence investors can pull out very rapidly if the terms of exit create a penalty for being last out the door. Essentially, outflows from open-ended bond funds - especially those that invest in illiquid securities - can exacerbate periods of spread widening much in the same way as the use of leverage. If fund outflows drive a gap between the price of the fund and its net asset value, then investors may be incentivized to quickly exit the fund before the gap widens even further. And in fact, even since the beginning of 2016 we have seen that periods of junk spread widening have coincided on occasion with a gap opening up between the price of the popular SPDR junk ETF and its net asset value (Chart 11). So far the effect has not been dramatic, but potentially the shock has simply not yet been large enough for the dynamic described by Stein to play out more fully. Chart 10Growing Fund Presence In Corporate Bond Market Growing Fund Presence In Corporate Bond Market Growing Fund Presence In Corporate Bond Market Chart 11A Run On Bond Funds? A Run On Bond Funds? A Run On Bond Funds? Much like with the risk from low volatility, the large presence of open-ended funds in the corporate bond market does not help us determine when the credit cycle is about to end. However, it does potentially increase the risk that once spreads start to widen they will widen much further than they would have otherwise. Investment Recommendations We continue to hold the view that we must first see stronger inflation and a more restrictive monetary policy before the credit cycle can end. We are therefore inclined to remain overweight high-yield bonds and would view last week's spread widening as a buying opportunity. That being said, if inflation starts to trend higher as we expect, then the credit cycle could come to an end as early as the middle of next year. Our first signal will be when long-maturity TIPS breakeven inflation rates return to the 2.4% to 2.5% range that has historically been consistent with inflation anchored around the Fed's target. In the meantime, the flat yield curve increases the risk of near-term spread widening. We think this risk will be mitigated as higher inflation steepens the curve, but until then investors should be on guard. Ultimately, any spread widening that occurs before inflationary pressures are more pronounced will be a buying opportunity, not the end of the credit cycle. Additionally, net debt-to-EBITDA must continue to trend lower as profit growth recovers. If it fails to do so then we will be quicker to adopt an underweight allocation to junk. Investors should also be mindful of the potential risks posed by low volatility and the large presence of open-ended funds in the corporate bond market. Both of those factors could exacerbate any spread widening once the credit cycle turns, though they do not help us determine when that turn will occur. Ryan Swift, Vice President U.S. Bond Strategy rswift@bcaresearch.com 1 Please see U.S. Bond Strategy Weekly Report, "Risk Rally Extended," dated June 27, 2017, available at usbs.bcaresearch.com 2 Looking at each credit tier individually controls for the changing average credit rating of the overall index. The 12-month breakeven spread is used in place of the option-adjusted spread to control for the changing duration of each index. 3 Please see U.S. Bond Strategy Weekly Report, "The Fed Will Fall Behind The Curve," dated October 24 2017, available at usbs.bcaresearch.com 4 Please see U.S. Bond Strategy Weekly Report, "Won't Back Down," dated September 26, 2017, available at usbs.bcaresearch.com 5 Tobias Adrian and Hyun Song Shin, "Procyclical Leverage and Value-at-Risk," Federal Reserve Bank of New York Staff Report No. 338. July 2008. 6 https://www.federalreserve.gov/newsevents/speech/stein20140228a.htm