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Highlights EM equity valuations are neutral. Relative to the U.S., EM share prices do offer some value, but this primarily reflects elevated valuations within the S&P 500. According to the cyclically-adjusted P/E ratio, EM stocks are cheap for investors with a long-term time horizon - longer than two to three years. Corporate profits are much more important than equity valuations in driving share prices in the next 12 months. Our outlook for EM EPS is downbeat for the next 12 months. Maintain a defensive posture and an underweight allocation in EM stocks versus DM. A new trade: go long Russian energy stocks / short global energy ones. Feature Chart I-1EM P/E Ratio And EPS EM P/E Ratio And EPS EM P/E Ratio And EPS There is ongoing debate in the investment community concerning whether emerging markets (EM) equities are or are not cheap, in both absolute terms and relative to developed markets (DM). In this week's report we review various equity valuation indicators and reiterate that EM stocks are neither cheap nor expensive in absolute terms. For example, the average of trailing and forward P/E ratios is slightly above its historical mean (Chart I-1, top panel). Relative to the U.S., EM share prices do offer value, but this reflects elevated valuations within the S&P 500. Despite this, we recommend underweighting EM vs U.S./DM because the cyclical growth dynamics is much better in DM than EM. EM stocks are cheap if one assumes a strong earnings recovery (Chart I-1, bottom panel). If earnings per share (EPS) begin contracting anew, as we expect, then the current rally will be reversed sooner than later. Overall, we continue to recommend a defensive posture for absolute-return investors and maintaining an underweight allocation in EM stocks versus DM for asset allocators. Valuation Perspectives Below we consider several valuation ratios: The equal-sector weighted trailing P/E ratio is 17.7 for EM (Chart I-2). Table I-1 displays equal-sector weighted P/E ratio, price-to-book value ratio and dividend yields for major equity markets globally. This is an apples-to-apples comparison, as it assigns equal weights to each of the 10 MSCI sectors - i.e., it removes sector biases. Chart I-2Equal-Sector Weighted Trailing P/E Ratio Equal-Sector Weighted Trailing P/E Ratio Equal-Sector Weighted Trailing P/E Ratio Table I-1Equal-Sector Weighted Valuation Ratios Across EM And DM EM Equity Valuations Revisited EM Equity Valuations Revisited Hence, on a comparable basis, EM equities are only slightly cheaper than DM stocks as is evident in Table I-1. Besides, the composite valuation indicator based on equal-sector weighted trailing and forward P/E, price-to-book value, price-to-cash earnings ratios and dividend yield indicate that EM stocks are fairly valued (Chart I-3). The cyclically-adjusted P/E (CAPE) ratio. The CAPE ratio is a structural valuation measure, i.e. it matters in the long run. Importantly, it assumes that real (inflation-adjusted) EPS will revert to its historical mean or trend. In short, the CAPE ratio tells us what the P/E ratio would be if EPS were to revert to its historical trend. Chart I-4 illustrates the EM CAPE ratio. If EM EPS in inflation-adjusted U.S. dollar terms reaches its historical time trend, one can safely assume that EM stocks are cheap and currently worth buying. In a nutshell, the current CAPE ratio of 15 assumes that EM EPS should rise by about 30% in nominal U.S. dollar terms over an investor's time horizon. Chart I-3EM Equities Valuations Are Neutral bca.ems_wr_2017_03_29_s1_c3 bca.ems_wr_2017_03_29_s1_c3 Chart I-4EM CAPE Ratio EM CAPE Ratio EM CAPE Ratio Given that our time horizon is 12 months, the assumption that EM EPS will surge by about 30% in U.S. dollar terms is in our view ambitious. Therefore, we posit that EM share prices do not offer compelling value at all in the next 12 months. If one's investment horizon were two-to-three years or longer, the assumption that EPS will rise by 30% or more in U.S. dollar terms is much more plausible. In this sense we would concur that EM share prices offer decent value from a longer-term perspective. Our methodology of calculating the CAPE ratio for EM varies from the well-known Robert Shiller's CAPE ratio for the U.S.1 However, even when applying our CAPE methodology to U.S. equities, the resulting ratio is not very different from Shiller's CAPE (Chart I-5). Trimmed-mean equity valuation ratios. Chart 6 illustrates 20% trimmed-mean trailing and forward P/E, price-to-book value, price-to-cash earnings ratios and dividend yields for the EM equity universe. A 20% trimmed-mean ratio excludes the top 10% and bottom 10% of industry groups, and then calculates the average. All calculations are based on 50 EM industry group data available from MSCI. Why look at trimmed-mean valuation ratios? Because by removing the top and bottom 10% of industry groups, this measure excludes outliers and provides a better perspective on valuation. A few observations are in order: First, according to the trimmed-mean valuation ratios, EM equities are not cheap. The trimmed-mean ratios are close to their historical mean (Chart I-6). Second, the trimmed-mean ratios are well above their market cap ones. This indicates that there are a few industry groups with large market caps that pull EM multiples lower. In other words, market-cap weighted multiples are skewed to the downside by a few large industry groups. There are reasons why some sectors and countries have low or high equity multiples. It makes sense to exclude them. Finally, the composite valuation indicator based on trimmed-mean trailing and forward P/Es, PBV and price-to-cash earnings ratios and dividend yield demonstrates that EM equity valuations are neutral (Chart I-7). Chart I-5U.S. CAPE Ratios U.S. CAPE Ratios U.S. CAPE Ratios Chart I-6EM Stocks Are Close to Fair Value EM Stocks Are Close to Fair Value EM Stocks Are Close to Fair Value Chart I-7EM Equities Have Neutral Value bca.ems_wr_2017_03_29_s1_c7 bca.ems_wr_2017_03_29_s1_c7 Bottom Line: EM equities by and large command a neutral valuation. According to the CAPE ratio, EM equities are cheap for investors with a long-term time horizon, say two-to-three years or longer. Profits Hold The Key Valuations are not a good timing tool. For low equity valuations to be realized, i.e., to produce solid price gains, corporate profits should grow. The reverse is also true: for an overvalued market to decline, company earnings should contract, or at least disappoint. When valuations are neutral - as they currently are for the EM equity benchmark - a recovery in EPS should entail higher share prices, while EPS shrinkage should lead to a selloff. EM EPS will continue to recover in the next three to six months, given the rally in commodities prices in 2016, amelioration in China's business cycle and the technology sector boom in Asia. However, this moderate and short-lived EPS recovery is already priced in. For the market to rally further, EPS will need to expand beyond the next three to six months. Remarkably, there has been little improvement in EM ex-China domestic demand. Besides, the risk to bank loan growth remains to the downside both in China and EM ex-China. Slower loan growth and the need to recognize and provision for potentially large NPLs will pressure banks' profits in many EM countries. Finally, we expect oil and industrial metals prices to decline considerably over the course of this year. If and as this view plays out, energy and materials stocks will fall. Energy and materials share prices correlate not with their past or current profits but rather with underlying commodities prices. One area where we remain bullish is the technology sector. Even though tech share prices are overbought and could correct in absolute terms in the months ahead, they will continue to outperform the benchmark. Bottom Line: Corporate profits are much more important in driving share prices in the next 12 months than equity valuations. Our outlook for EM EPS is downbeat for the next 12 months or so, even though EPS will continue to recover in the next three to six months. Timing Reversal: Watch Credit Quality Spreads Chart I-8Credit Quality Spreads: ##br##A Correction Or Reversal? Credit Quality Spreads: A Correction Or Reversal? Credit Quality Spreads: A Correction Or Reversal? Following are some of the indicators we are monitoring to gauge a reversal in EM share prices. EM corporate spreads have widened a notch relative to EM sovereign spreads (Chart I-8, top panel). Similarly, Chinese off-shore corporate spreads have widened versus Chinese sovereign spreads (Chart I-8, middle panel). Credit quality spreads - the gap between B- and BAA-grade corporate bonds - have widened slightly in the U.S. (Chart I-8, bottom panel). These moves are still very small, and do not constitute a definite sign of a major trend reversal. Nevertheless, such widening in credit quality spreads is an important development. If they persist, they will certainly sound the alarm for the reflation trade. Interestingly, this is the first time a simultaneous widening in credit quality spreads has occurred since the risk assets rally began in early 2016. Bottom Line: Major equity market selloffs will occur when lower quality credit begins to persistently underperform better quality credit. There have been budding signs of quality spread widening that are worth being monitored. Identifying Relative Value Within the EM equity universe, valuation ratios differ greatly. For example, banks trade at a trailing P/E of 9.7, while consumer staple stocks trade at 24.8. Table I-2 portrays the trailing P/E ratio and its historical mean as well as 12-month forward EPS growth and the forward P/E ratio for each sector - as well as average of trailing and forward P/E ratios. Table I-3 shows the same valuation measures but for EM countries. Table I-2Stock Valuation Snapshot: EM Sectors EM Equity Valuations Revisited EM Equity Valuations Revisited Table I-3Equity Valuation Snapshot: EM Countries EM Equity Valuations Revisited EM Equity Valuations Revisited It is difficult to draw any definitive conclusions from these tables. On a general level, a simplistic approach to investing based on trailing and forward P/E ratios would not have produced great outcomes in EM in recent years. When analyzing EM stock valuations, we prefer to use the trailing rather than forward P/E ratio because historically, EM forward EPS have had a very poor record forecasting actual EPS. One of our favorite ways to identify relative value is to compare the PBV ratio and return on equity (RoE) across countries/sectors. Chart I-9 plots RoE on the X-axis and the PBV ratio on the Y axis. Countries and sectors located in the bottom right corner (at the low end of the shaded area) have a low PBV ratio compared to their RoE. In contrast, in the north-west side of the distribution (at the upper end of the shaded zone), these have an elevated PBV ratio, taking into account their RoE. Chart I-9Searching For Relative Value EM Equity Valuations Revisited EM Equity Valuations Revisited Among countries, Korea, Russia, Hungary, the Czech Republic and China appear cheap, while Mexico, Brazil, South Africa, Colombia, Malaysia and Poland are on the expensive side. Chart I-10EMS's Recommended ##br##Equity Portfolio Performance EMS's Recommended Equity Portfolio Performance EMS's Recommended Equity Portfolio Performance Concerning equity sectors, utilities and financials/banks are cheap, yet consumer staples and consumer discretionary, health care, telecom and materials appear expensive in relative terms. Our recommended country equity allocation is based on a qualitative assessment of many variables including but not limited to valuation. Chart I-10 displays the performance of our fully invested EM Equity Portfolio Model versus the EM benchmark. Our overweights presently include: Korea, Taiwan, India, China, Thailand, Russia and central Europe. Our underweights are Brazil, Turkey, Indonesia, Malaysia and Peru. We are neutral on Mexico, Chile, Colombia, South Africa and the Philippines. The lists of our country allocation and other equity investment recommendations are presented each week at the end of our reports. Arthur Budaghyan, Senior Vice President Emerging Markets Strategy arthurb@bcaresearch.com Bet On Russia's Non-Compliance With OPEC Odds of Russia's compliance with the OPEC agreement to cut oil output by 300k b/d in the next two months are low. This poses downside risk to oil prices. Russia has so far done only 120k b/d cuts. Hence, in the next two months it should reduce its output by 180k b/d which amounts to 1.6% of the nation's oil output. One way to bet on Russia's non-compliance, regardless the direction of oil prices, is to go long Russian energy stocks / short global energy ones (Chart II-1). There are a number of political, economic and financial motives why Russia might care less about lower oil prices than Saudi Arabia in the next 12-18 months or so. As a result, Russia might not cut as much as it is expected by the OPEC agreement. Russia is able to increase oil production due to a cheaper ruble and technology advances. BCA's Energy Sector Strategy team has been highlighting that there have been concerted efforts by Russia's largest producers to employ horizontal drilling and multi-zone hydraulic fracturing in Western Siberia.2 These have stemmed declines from those aging fields and allowed production to rise (Chart II-2). Chart II-1Long Russia Energy / ##br##Short Global Energy Stocks Long Russia Energy / Short Global Energy Stocks Long Russia Energy / Short Global Energy Stocks Chart II-2Russian Oil ##br##Production Will Increase Russian Oil Production Will Increase Russian Oil Production Will Increase Russia will not shy away from being opportunistic and increase its market share when it can ramp up oil production. A rising global oil market share will allow Russian companies to outperform their global peers regardless the direction of oil prices. There are major cyclical divergences between Russian and Saudi economies. Russia's economy is gradually picking up while there is less certainty about Saudi's growth recovery. The reason is that Russia has allowed the ruble to depreciate and act as a shock absorber. Meanwhile, Sa­­­­udis have stuck to the currency peg. ­­­Oil prices are down by 27% from their top in rubles and 55% in Saudi riyals (Chart II-3). This has reflated Russia's fiscal revenues and the economy, while Saudi Arabia is still struggling with the consequences of low ­oil prices. On the fiscal front, Russia went through a notable fiscal squeeze and its budget deficit is projected to be 3.2% of GDP in 2017 (Chart II-4). In contrast, the Saudi Arabian fiscal deficit in 2016 reached an outstanding 17% of GDP, accounting for the drawdown in reserves by our estimates.3 Chart II-3Ruble's Depreciation ##br##In 2014-15 Made a Difference Ruble's Depreciation In 2014-15 Made a Difference Ruble's Depreciation In 2014-15 Made a Difference Chart II-4Fiscal Deficit: Small In ##br##Russia & Large In Saudi Fiscal Deficit: Small In Russia & Large In Saudi Fiscal Deficit: Small In Russia & Large In Saudi More importantly, Russia's federal budget for 2017 was constructed on the oil price assumption of $40/bbl. The 2017 Saudi budget assumes oil price of $50/bbl.4 Therefore, Russia would not mind if oil prices drop toward or slightly below $40 in the second half of this year. Therefore, Saudis care much more about sustaining oil prices at a higher level than Russians do. Finally, Rosneft has already conducted its IPO while Aramco's IPO has not taken place yet. As such, the need for higher oil prices is much greater in Saudi Arabia - to justify a higher value of their oil giant - than in Russia. Bottom Line: Odds are considerable that Russia will not comply with the OPEC deal and this could cause oil prices to selloff more. Regardless of direction of oil prices, we expect the Russian energy sector to outperform their global peers due to Russia's rising market share in the global oil market. Go long Russian energy stocks / short global ones. Stephan Gabillard, Research Analyst stephang@bcaresearch.com 1 For more detailed discussion on our methodology of CAPE, please refer to January 20, 2016 Emerging Markets Strategy Special Report titled "EM Equity Valuations: A CAPE Model", available at ems. bcaresearch.com 2 Please refer to the Energy Sector Strategy Weekly Report titled, "Russian Oil Production: Surpassing Expectation", dated December 14, 2016, available at nrg.bcaresearch.com 3 Please refer to the Emerging Markets Strategy Special Report titled, "Saudi Arabia: Short-Term Gain, Long-Term Pain", dated February 1, 2017, available at ems.bcaresearch.com 4 https://mof.gov.sa/en/budget2017/Documents/The_National_Budget.pdf Equity Recommendations Fixed-Income, Credit And Currency Recommendations

Highlights Portfolio Strategy Internal dynamics warn that a broad market consolidation phase has begun. The jump in growth vs. value stocks has provided an opportunity to shift to a neutral style bias. Transports have sold off sharply, but downside risks have not yet been fully expunged, especially for the airline group. Recent Changes Growth Vs. Value - Shift to a neutral stance. Table 1Sector Performance Returns (%) Heading For A Choppier Market Heading For A Choppier Market Feature The perceived dovish Fed shift and doubts about the achievability of Trump's policy goals are causing equity market consternation. To the extent that the run up in stocks has largely reflected an improvement in sentiment and other 'soft' economic data, the lack of follow through in 'hard' data has created a validation void. While a weaker U.S. dollar, lower oil prices and less hawkish Fed imply easier monetary conditions, which are ultimately positive for growth, profits and the stock market, a digestion phase still looms. Financials, and banks in particular, had been market leaders, driven up by hopes for a meaningful upward shift in the yield curve and unleashing of animal spirits. But these assumptions are being challenged and there is limited fundamental support. Indeed, bank lending growth remains non-existent and there is no tailwind from improving credit quality. Our view remains that banks carry the most downside risk of all financial groups (please see the March 6 Weekly Report for more details). Regional banks are now down on a year-to-date relative performance basis (Chart 1). In fact, our newly constructed gauge of the equity market's internal dynamics suggests that additional tactical broad market turbulence lies ahead. A composite of relative bank stock, relative transport, small/large cap and industrials/utilities share prices has been a good coincident to leading market indicator in recent years (Chart 2). While no indicator is infallible, the message is that overall market risk is elevated and a choppy period lies ahead, reinforcing our defensive vs. cyclical bias. Nevertheless, it will be important to put any corrective action into a longer-term context. Over the years, we have kept an eye on several qualitative 'unconventional indicators' that have helped time major market turning points. They are meant to augment rather than replace fundamental factors. Chart 1Market Leaders Are Stumbling Market Leaders Are Stumbling Market Leaders Are Stumbling Chart 2A Yellow Flag From Internal Dynamics A Yellow Flag From Internal Dynamics A Yellow Flag From Internal Dynamics Below we highlight five critical variables to gauge whether a correction will devolve into a sustained sell-off. Each of the indicators measures either; profits; business confidence; investor confidence; and/or reflects how liquidity conditions are impacting market dynamics. Investor confidence can be measured through margin debt. While extremely elevated (Chart 3), there is no concrete sign that access to funds is being undermined by the modest backup in interest rates. When the cost of borrowing becomes too onerous, it will manifest in reduced margin debt and forced selling, which will be a serious threat to stocks given that leverage is challenging levels experienced at prior peaks, as a share of nominal income. M&A activity is losing momentum (Chart 4). A peak in merger activity typically coincides with a rising cost of capital. If corporate sector capital availability becomes a pressing issue, then M&A activity will decline further, signaling that the corporate sector is facing growth headwinds. Economic signals are mostly positive. Durable goods orders have tentatively perked back up (Chart 5), reinforcing that profits and confidence have improved after a soft patch. Temporary employment continues to rise (Chart 5). When temp workers shrink, it is often an early warning sign that companies are entering retrenchment mode, given the ease and low cost of reducing this source of labor costs. If temporary employment falls at the same time as share prices, that would be a red flag. The relative performance of consumer discretionary to consumer staples can provide a read on purchasing power and/or the marginal propensity to spend. This share price ratio does not suggest any consumption concerns exist (Chart 4, bottom panel). If consumer staples begin to outperform, then it would warn of a more daunting economic outlook. Chart 3Borrowing Costs Are Not Yet Restrictive Borrowing Costs Are Not Yet Restrictive Borrowing Costs Are Not Yet Restrictive Chart 4M&A Is Starting To Labor M&A Is Starting To Labor M&A Is Starting To Labor Chart 5Economic Signals Are Decent Economic Signals Are Decent Economic Signals Are Decent In all, these indicators suggest that any pullback will be corrective rather than a trend change. If the profit cycle continues to improve and the Fed has no inflationary need to become restrictive, then any broad market correction could provide an opportunity to selectively add cyclical exposure to portfolios in the coming weeks. In the meantime, we are revisiting our growth vs. value view and providing an update on transports. Growth Vs. Value: Shifting To Neutral Our last style bias update in the December 19 Weekly Report concluded that we would likely recommend moving to a neutral stance over the coming weeks/months from our current growth vs. value (G/V) stance, but expected to do after growth stocks had staged a comeback. That recovery is now well underway and so we are revisiting the outlook. Growth indexes have outperformed value since the depths of the Great Recession. The preference for growth 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. In addition, the composition of the growth index is much longer duration than that of the value space. The surge in long-term earnings growth expectations suggests that investors have increased conviction in the durability of the expansion, which has aided the G/V recovery (Chart 6). That monetary experiment has recently begun to pay off, as global economic growth has finally demonstrated evidence of self-reinforcing traction, led by developed countries. As a result, most central banks are well past the point of maximum thrust, which would mean the loss, albeit not a reversal, of the primary support for the secular advance in growth vs. value indexes. Keep in mind that growth benchmarks have a massive technology sector weight, at just over 1/3 of the total index capitalization. Value indices carry only a 7% weight. As shown in previous research, the technology sector underperforms when economic growth is fast enough to create inflationary pressure and therefore, the interest rate structure. Furthermore, value benchmarks have more than 25% of their weight in the financials sector vs. less than 5% for growth indexes. The upshot is that a meaningful interest rate increase would pad the profits of financials-rich value indices while having little to no impact on growth benchmarks by virtue of their tech-dependence. It is no surprise that the G/V ratio trends with technology/financials relative sector performance (Chart 7). The latter has clearly peaked, with an assist from the renormalization in Fed policy. Chart 6Time To Shift Time To Shift Time To Shift Chart 7Two Key Sector Influences Two Key Sector Influences Two Key Sector Influences These sector discrepancies mean that a critical question for the style decision is what is the path for government bond yields? The U.S. economy is exhibiting signs of self-reinforcing behavior. The small business sector's hiring plans have surged, and the ISM employment index remains solid (Chart 8). Chart 8Economy No Longer Favors Growth Economy No Longer Favors Growth Economy No Longer Favors Growth Chart 9A Mixed Bag A Mixed Bag A Mixed Bag While at least a modest employment slowdown is probable given that the corporate sector is feeling the profit margin pinch from higher wage costs, these gauges do not suggest a major crunch is imminent. The personal savings rate is drifting lower, supporting consumption growth (Chart 8). Value indexes have a higher economic beta than growth benchmarks, owing to their exposure to shorter duration sectors. The gap between growth and value operating margins tends to close when the economy enjoys a meaningful acceleration (Chart 8). Chart 10Volatility Is A Style Driver Volatility Is A Style Driver Volatility Is A Style Driver Other markers of global economic growth are more mixed. The global manufacturing PMI survey is very strong, but oil and other commodity prices have started to diverge negatively (Chart 9). That may soon change if the U.S. dollar has crested, which would provide a much needed fillip to emerging markets and remove a source of deflationary pressure. Real global bond yields are grinding higher, suggesting that in all, economic prospects have improved, and alleviating a major constraint on value stocks. Against this backdrop, it is timely to shift to a neutral style preference after the sharp rebound in the G/V ratio since late last year. Why not a full shift into value indexes? Developing countries are conspicuously lagging developed countries, which caps the outlook for commodities and their beneficiaries. EM capital spending is still very weak in real terms. Deep cyclical sectors are much more heavily-weighted in value benchmarks. A global recovery that has a greater thrust from consumption than investment, at least at the outset, argues against expecting value stocks to outperform. Moreover, the fallout from potentially protectionist U.S. trade policies remains unknown, which could restrain economic growth momentum and unleash volatility in the equity markets. The latter has been incredibly muted in recent months. In fact, BCA's VIX model, which incorporates corporate sector health and interest rate expectations, is heralding a higher VIX. Clearly, elevated volatility has supported the G/V ratio over meaningful periods of time (Chart 10). Bottom Line: Shift to a neutral style bias. A full shift to a value preference would require BCA to forecast a much weaker U.S. dollar and/or demand-driven inflationary pressure. Transports: Stuck In Neutral The S&P transports index peaked in mid-December versus the broad market, the first major sub-group to fizzle after the post-election sugar high (Chart 11). The recent setback has been broad-based. We had been overweight both the rails and air freight & logistics industry sub-groups, but booked gains in both prior to their respective pullbacks. Is it time to get back in? Transportation equities are ultra-sensitive to swings in global economic growth. Chart 12 shows that the relative share price ratio is an excellent leading indicator of both the ISM manufacturing survey and Citi's economic surprise index. The message is that at least a mild mean reversion in both of these indexes looms in the coming months, i.e. beware of some form of economic cooling. Chart 11Transports Have Cracked... Transports Have Cracked... Transports Have Cracked... Chart 12... Signaling Economic Cooling Ahead ... Signaling Economic Cooling Ahead ... Signaling Economic Cooling Ahead Against this backdrop, we are revisiting our last remaining underweight, the S&P airlines index. While rails and air freight & logistics stocks are directly linked to global trade, the same does not hold true for the S&P airlines index. Business and consumer travel budgets are the key drivers of industry demand. A revival in animal spirits and a healthy U.S. consumer could be clear positives for air travel. Moreover, the recent pullback in fuel costs should cushion profit margins for unhedged airline operators (Chart 13). Finally, renowned investor Warren Buffett has recently become a major shareholder in the U.S. airline industry, raising its profile. While betting against Buffett is always fraught with risk, our cautious take on the airline industry boils down to our view that excess capacity will continue to hold back profitability. If the overall transport index is accurately signaling that some loss of economic momentum looms, then a rapid expansion in business and travel spending may not be quick to materialize. A pricing war has already gripped the industry, as airlines are scrambling to fill up planes. Revenue-per-available-seat-mile and U.S. CPI airfare are contracting (Chart 14), reflecting a fight for market share. That is a serious impediment to profit margins. Chart 13Airlines Are Losing Altitude... Airlines Are Losing Altitude... Airlines Are Losing Altitude... Chart 14... As Price Wars Persist ... As Price Wars Persist ... As Price Wars Persist The headwinds extend beyond the U.S. Chart 15 shows that global airfare deflation also bodes ill for top line industry growth. The lags from previous U.S. dollar strength could compound this source of drag. Absent a decisive recovery in total travel spending, there does not appear to be any catalysts to reverse deflationary conditions. Carriers are still allocating an historically high portion of cash flow to capital spending. While upgrading aging fleets to become more fuel-efficient in an era of low interest rates is a long-term positive, the payback period may be extended. Revenue has failed to keep up with the increase in capital expenditures (Chart 16, bottom panel), suggesting that capacity growth continues to outpace industry demand, a recipe for ongoing pricing pressure. Chart 15Deflation Is Global Deflation Is Global Deflation Is Global Chart 16Too Much Capacity Too Much Capacity Too Much Capacity This difficult backdrop has begun to infect analyst earnings estimates. Net earnings revisions have nosedived. Relative performance momentum is tightly lined with the trend in earnings estimates (Chart 16). The message is that the breakdown in cyclical momentum has further to run. Indeed, the 52-week rate of change rarely troughs until it reaches much lower levels, warning of additional downside relative performance risks. Bottom Line: The S&P transports group is heralding a period of economic cooling, but the airline sub-component has not yet fully discounted such an outcome. Stay underweight. The ticker symbols for the stocks in the S&P airlines index are: UAL, AAL, DAL, LUV & ALK. Current Recommendations Current Trades Size And Style Views Favor small over large caps and stay neutral growth over value.

Highlights Portfolio Strategy Contrary to popular perception, non-cyclical sectors have led the market so far this year, while deep cyclical sectors are breaking down, in relative performance terms. Our models point to more of the same ahead. The oversold rebound in the pharmaceutical group may soon run into resistance so we recommend trimming positions to neutral. Put the proceeds into restaurants, a quasi-defensive group that enjoys a brightening sales outlook without pharma's political and regulatory risk. Recent Changes S&P Pharmaceuticals - Downgrade to neutral. S&P Restaurants - Upgrade to overweight. Table 1 Reading The Market's Messages Reading The Market's Messages Feature Equities are exhibiting signs of mild fatigue. Breadth has begun to narrow, and new highs have sagged compared with new lows (Chart 1). Both of these technical developments have warned of previous tactical pullbacks. The recent reset in oil prices may also test investor nerves. Oil prices have been a critical macro variable, because they influence inflation expectations and the corporate bond market (high yield bond spreads shown inverted, Chart 1). Crude oil price corrections have accurately timed equity retreats (Chart 1), and general risk aversion phases. To be sure, the global economy is no longer on a deflationary precipice, suggesting that weaker oil prices may not foreshadow a soft patch, but they may be a good enough excuse for profit taking in the equity market after a good run. Contrary to popular perception, cyclical sectors have not led the broad market so far in 2017. In fact, energy, materials and industrials have all broken down in relative performance terms (Chart 2), after peaking in mid-December. Only the technology sector has stayed resilient. Chart 1Short-Term Fatigue Short-Term Fatigue Short-Term Fatigue Chart 2Cyclicals Have Broken Down Cyclicals Have Broken Down Cyclicals Have Broken Down Chart 3Overshoot Renormalization Overshoot Renormalization Overshoot Renormalization Insipid cyclical sector performance has occurred within the context of a synchronized lift in global economic growth and recovering corporate sector pricing power. So why are cyclical sectors lagging? It may simply be a digestion phase. However, a different interpretation is that a number of key macro factors fail to confirm the durability of last year's outperformance, suggesting that defensive outperformance could last. Concerns that the current global inventory cycle may not morph into a broad-based upturn in global final demand continue to linger: the global credit impulse remains anemic, the Fed and China are tightening monetary policy and commodity markets are cracking (Chart 3). The lack of any meaningful improvement in Chinese loan demand signals that the economy may be quick to cool as the authorities tap the breaks on credit growth. It would take a decisive depreciation in the U.S. dollar to boost the relative profit fortunes of capital spending-dependent cyclical sectors on a sustainable basis. On a more positive note, the Fed's benign forward guidance last week bears close attention. If the U.S. dollar loses upside support, particularly with the ECB contemplating a retreat from full throttle easing, it could change the investment landscape. By reminding markets that their inflation target is symmetric, the Fed signaled it will be willing to tolerate a modest inflation overshoot, which is positive for risk assets in the short run. A softer U.S. dollar would take the pressure off of developing countries, support commodity prices, and bolster our cyclical sector sales models and Cyclical Macro Indicators. However, Chart 4 shows that the objective message from our models remains consistent with continued defensive sector outperformance. With a more protectionist U.S. Administration, we remain reluctant to position exclusively for a much weaker dollar. The ongoing underperformance of emerging market equities relative to U.S. and global benchmarks reinforces that foreign-sourced profit growth continues to lag (Chart 5). Positioning for cyclical sector earnings outperformance requires healthier profits abroad, to spur a new capital investment cycle. Chart 4Heeding The Message From Our Models... Heeding The Message From Our Models... Heeding The Message From Our Models... Chart 5... And The Markets ... And The Markets ... And The Markets We will look to selectively add cyclical exposure when the objective message from our Indicators provides confirmation that earnings-driven outperformance lies ahead. At the moment, there is no such confirmation. In fact, the elevated reading in the SKEW index continues to signal that a defensive posture will optimize portfolio performance (Chart 5). In sum, we continue to characterize the broad market's current momentum as an overshoot phase, with additional technical upside potential, but the rally is starting to fray around the edges. In this environment, holding a mostly defensive basket with selective beta exposure is still recommended. Importantly, within the defensive universe, there are tweaks to be made, especially if the U.S. dollar stops rising. Fade The Pharmaceuticals Rebound Health care has been the second strongest of the eleven broad sectors year-to-date, contrary to popular perception. That is in line with the flattening yield curve, cresting in inflation expectations and a modest correction in oil prices (Chart 6), all of which have revived the allure of non-cyclical sectors. Moreover, our Cyclical Macro Indicator (CMI) for the health care sector remains firm, supported by the ongoing large pricing power advantage. Relative value is the most attractive it has been in five years. While the latter provides little timing help, it indicates low risk, especially with technical conditions still deeply oversold (Chart 7). Chart 6Health Care Is Storming Back Health Care Is Storming Back Health Care Is Storming Back Chart 7Still Cheap And Oversold Still Cheap And Oversold Still Cheap And Oversold The heavyweight pharmaceutical group has led the sector's tactical charge, recouping the ground lost, in relative performance terms, leading up to the U.S. election. While we were caught off guard by the severity of the pullback last September/October, we refrained from selling into an oversold market and noted our intention to lighten positions whenever the inevitable relief rally occurred. The time has come to execute on this thesis. Pharmaceutical stocks are very cheap and have discounted a hostile regulatory environment. The relative forward P/E is well below its historic mean, even though both 12-month and 5-year relative forward earnings growth expectations are depressed (Chart 8). Typically, the latter would serve to artificially inflate valuations. These conditions exist even though free cash flow growth remains strong; merger activity has been solid, albeit ebbing in recent months; and companies have used excess capital to reduce total shares outstanding (Chart 8). In other words, relative forward earnings would have to decline substantially to validate these expectations. Is this plausible? Much depends on the regulatory environment. While details of the U.S. Administration's proposal to replace the Affordable Care Act have started to leak out, final details are still elusive and legislative action is not imminent. So far, it appears as if a worst case scenario would see an increase in the number of uninsured Americans, with a rising cost of insurance (to the benefit of managed care companies). According to the Department of Health & Human Services, the uninsured rate of the U.S. population nearly halved from 16% in 2010 to 9% in 2015. That led to a lift in the number of procedures performed and bolstered hospital bottom lines. Hospitals are a major pharmaceutical buying group. Higher utilization rates fed increased pharmaceutical demand for a number of years. However, drug spending growth has dropped off, and if the legion of uninsured patients rises anew in the coming years, then hospital utilization rates will decline, taking drug consumption growth down with it. Moreover, Trump wants to streamline the FDA's approval process, which would ultimately boost the number of high margin new drugs coming to market. Drug stocks boomed back in the mid-1990s, the last time FDA approval rates accelerated meaningfully (Chart 9). Chart 8Full Capitulation Full Capitulation Full Capitulation Chart 9Full Capitulation Full Capitulation Full Capitulation But at the same time, if government is given leeway to negotiate drug prices directly with drug companies, then pricing power will continue to converge down toward overall corporate sector pricing power, especially if drug consumption rates ease (Chart 9). At the moment, drug consumption growth remains above the rate of overall consumption growth, but that is much slower than during the boom following the introduction of the Affordable Care Act. Retail sales at pharmacies are growing robustly, and hospitals are still adding staff, signaling that they continue to position for expansion, i.e. rising procedure volumes (Chart 10). On the downside, the strong U.S. dollar is a big drag on top-line growth. Drug imports exceed exports by a wide margin, resulting in a negative trade balance and a drag on U.S. drug company profits, all else equal. The combination of a sales growth deceleration and adequate channel inventories has capped drug output growth (Chart 10). That is a productivity and profit margin headwind. Against this background, the industry will need an external assist to deliver profit outperformance. Relative profit estimates rise when disinflationary forces reign supreme, as measured by the NFIB planned price hikes series (shown inverted, Chart 11). This measure of future corporate pricing power intentions has rolled over, but broader measures of inflation are creeping higher. Ergo, drug earnings forecasts may be challenged to keep pace with the overall corporate sector. Chart 10... But Growth Rates Are Slowing ... But Growth Rates Are Slowing ... But Growth Rates Are Slowing Chart 11Mixed Signals Mixed Signals Mixed Signals The good news is that even though U.S. dollar strength is an export drag, the negative drug trade balance suggests that it will hurt other industries more. Indeed, a rising currency often coincides with profit outperformance (Chart 11). There is not enough evidence that exogenous factors will offset slowing domestic drug consumption growth. In all, the case for a further and sustained relative performance recovery has weakened, and we are taking advantage of this year's oversold bounce to move to the sidelines. Bottom Line: Trim the S&P pharmaceuticals index to neutral. This position was deep in the money initially, but last year's downdraft pushed it into a loss position of 10%. BLBG: S5PHARX-JNJ, PFE, MRK, BMY, LLY, AGN, ZTS, MYL, PRGO, MNK. Restaurants: Increasing Appetite The broad consumer discretionary sector has been treading water, largely owing to fears that a border adjustment tax (BAT) will undermine the retailing sub-component. This consolidation has restored value and created an attractive technical entry point (Chart 12, bottom panel). Importantly, industry earnings fundamentals are on the upswing. Our consumer discretionary sector Cyclical Macro Indicator has perked up (Chart 12), supported by an increase in wages, and more recently, the decline in oil prices. The latter is freeing up disposable income, which consumers have an incentive to spend given that household net worth (HNW) has climbed to all-time highs as a percent of disposable income (Chart 13). Chart 12A Good Place To Shop A Good Place To Shop A Good Place To Shop Chart 13Piggyback The Wealth Effect Piggyback The Wealth Effect Piggyback The Wealth Effect While we remain overweight housing related equities (homebuilders and home improvement retailers) in addition to our upbeat view on the media and advertising complex, a buying opportunity has surfaced in the neglected S&P restaurants index. We booked gains on an underweight position and lifted exposure to neutral back in late-October. Since then, value has improved further, while leading sales indicators continue to firm. Stronger consumer finances should flow into the casual dining industry. Sales have already started to reaccelerate, and should climb further based on the leading message from HNW (Chart 14). The lower income, $15K-$35K, cohort is also feeling increasingly confident, according to the latest Conference Board survey data (Chart 14). Meanwhile, the National Association of Restaurants Performance Index has regained momentum (Chart 15), signaling increased activity and rising confidence among restaurateurs. While the gap between the cost of dining out and dining in remains wide, it has begun to narrow, which is a plus for store traffic, all else equal. Chart 14Buy Into Weakness Buy Into Weakness Buy Into Weakness Chart 15At A Turning Point Domestically... At A Turning Point Domestically... At A Turning Point Domestically... Chart 16... And Globally? ... And Globally? ... And Globally? Our restaurants profit margin proxy (comprising restaurants CPI versus a blend of the industry's wage bill and food commodity costs) is trending higher. That is notable because it has a good track record in leading relative earnings growth estimates (Chart 15). Nevertheless, it is not all good news. International exposure remains a headache. Typically, soft EM currencies warn of translation drags on foreign sourced revenue (Chart 16). This cycle, there is an offset, as EM interest rates have come down, which is a plus for domestic demand (Chart 16). Thus, the headwind from outside the U.S. should abate as the year progresses. Adding it all up, factors are falling into place for a playable rally in the under-owned and unloved S&P restaurants index. This group offers attractive quasi-cyclical defensive exposure to replace the S&P pharmaceuticals index, without the political and regulatory risks. Bottom Line: Redeploy funds from the pharma downgrade and boost the S&P restaurants index to overweight. BLBG: S5REST-MCD, YUM, CMG, SBUX, DRI. Current Recommendations Current Trades Size And Style Views Favor small over large caps. Favor growth over value (downgrade alert).

Highlights Portfolio Strategy A relapse in the global financials sector threatens to spill into U.S. financials as credit growth sinks. Bank equities are the most vulnerable to such a phase, given their reliance on rising interest rate expectations rather than increased lending. Take profits in the S&P health care facilities index and downgrade to neutral. Recent Changes S&P Health Care Facilities - Take profits of 12% and downgrade to neutral. Table 1Sector Performance Returns (%) As Good As It Gets? As Good As It Gets? Feature Momentum continues to trump all else, with the equity market surging to new all-time highs last week. However, in the background, the Fed is becoming steadily more hawkish, and the odds of a March rate hike have risen substantially. This should be cause for some trepidation. Chart 1Multiples Are Headed##br## Lower As The Fed Hikes Multiples Are Headed Lower As The Fed Hikes Multiples Are Headed Lower As The Fed Hikes The market advance since November has been supported primarily by valuation expansion, along with some improvement in corporate profits. The forward P/E has climbed to 18, its highest level in well over a decade. The scope for further expansion is limited. Importantly, if a transition to an earnings-led rally is in the offing, Fed funds expectations likely need to be ratcheted higher. Chart 1 shows that valuation multiples contract during Fed tightening cycles, using cycle-on-cycle analysis. Thus, the valuation expansion is inconsistent with a significant upgrade in the economic and profit outlook, particularly with return on equity so weak (Chart 1). In other words, the economy has good momentum, but that is not translating one for one to the corporate sector. Keep in mind that even a small two P/E multiple point decline requires 11% earnings growth for the market just to hold its ground. That is a tall order given the squeeze on profit margins from labor cost inflation and a strong U.S. dollar. Ironically, high multiples would be more durable if economic data softened enough for the Fed to hold its fire. Against this background, it is not surprising that a stealthy flight to safety has developed, although it is not uniform across asset classes. For instance, gold has outperformed most major currencies (note we recently upgraded the gold shares group as a portfolio hedge); global government yields have eased back while sovereign bond spreads have widened (Chart 2). In the U.S., the economically-sensitive transport group has rolled over in line with the yield curve narrowing (Chart 2), the equity SKEW index remains historically elevated, and a defensive vs. cyclical portfolio bias has outperformed handily since early December (Chart 2, bottom panel), on broad-based non-cyclical sector participation. These shifts, on the margin, signal that some investors are bracing for a bout of volatility. On the flipside, U.S. junk bond spreads have narrowed back to 2014 lows, and emerging market corporate bond spreads are testing similarly tight levels. The global purchasing manager survey recorded yet another monthly gain (Chart 3). Chart 2Contrarian##br##Alert... Contrarian Alert... Contrarian Alert... Chart 3... Defensives Can Outperform##br## When Growth Is Good ... Defensives Can Outperform When Growth Is Good ... Defensives Can Outperform When Growth Is Good Ergo, a systemic economic threat is not the main obstacle to further asset price appreciation. Rather, it is that expectations in some assets and sectors have become divorced from reality. Indeed, we have noted for the last two months the disturbing downtrend in bank credit growth and the unprecedented gap between strong 'soft' and pedestrian 'hard' economic data. Mixed economic and financial market messages suggest that any equity turbulence may be marked by a mostly rotational correction rather than a savage drawdown in the broad averages. Still, the latter cannot be ruled out given the high degree of complacency and buoyant profit and economic expectations. It is notable that defensive equities embarked on a massive outperformance phase when both U.S. and EM bond spreads were just as low as they are currently, i.e. they hit 'as good as it gets' levels (Chart 3). Any widening in corporate bond spreads would tighten financial conditions, spurring a slowdown in growth down the road. In sum, the odds of an equity market sweet spot extension beyond the very near run have diminished as a consequence of ongoing strong economic data, which reflects the easing in financial conditions a year ago. In terms of positioning portfolios, there is still a mismatch between developed and developing markets, as measured by the relative ISM indexes (Chart 3, fourth panel). The upshot is that defensives will continue to generate much more cash than their cyclical counterparts (Chart 3, bottom panel), supporting the nascent relative share price recovery. The financial sector could also be due for a correction. Financials And Banks: Where To Next? The global financials sector has cheered the firming in leading economic indicators and back up in bond yields since last autumn, but that celebration is likely drawing to a close. Euro area financials have rolled over, in line with renewed weakness in German government bond yields (Chart 4). Continued slippage in global yields could cap U.S. yields, thereby flattening the yield curve (Chart 5). U.S. financials are much more expensive than their euro area counterparts (Chart 5, bottom panel), suggesting heightened vulnerability. Chart 4Are EMU Financials ##br##Sending A Warning Signal? Are EMU Financials Sending A Warning Signal? Are EMU Financials Sending A Warning Signal? Chart 5Watch The##br## Yield Curve Watch The Yield Curve Watch The Yield Curve In our view, the S&P bank index contains the most downside vulnerability, in relative performance terms, of all the financial sector sub-components, especially if regulatory reform disappoints and/or is slow to evolve. True, as outlined in a Special Report published on October 3, 2016, interest rate expectations have a checkered history of predicting bank stock relative performance. When they do drive bank stocks, it is typically because most other profit drivers are lacking, as is currently the case (Chart 5, top panel). This cycle, interest rate spreads have been unduly suppressed by the zero lower bound. Under normal circumstances, when short-term interest rates are well above zero lower bound, banks can target a spread between rates on assets and liabilities. But when the fed funds rate is at zero, the spread is compressed, because banks generally cannot charge customers a penalty implied by negative interest rates on deposits (at least in the U.S.). As the Fed pushes interest rates back upward, banks may be able to return their spreads to their target levels, by raising deposit rates more slowly than loan rates. However, this dynamic has been fully priced in over the last few months and the risk is that higher net interest margins will not offset the lack of credit creation and/or that Fed funds rate expectations will level off if economic data start to disappoint. After all, Chart 6 shows that net interest margins can both widen and narrow when the Fed is hiking interest rates. Moreover, the yield curve is narrowing, after peaking two months ago. If rising fed interest rate expectations are the primary factor driving bank stock performance, then it follows that market expectations must continue to price in a much more hawkish rate environment in order to extend any rally in bank share prices. However, the global credit impulse is still negative, albeit less so, reflecting capital constraints and deleveraging. The Bank of International Settlements global credit impulse indicator has been an excellent leading indicator of relative bank profitability, and it is premature to expect earnings outperformance (Chart 7). U.S. credit data are also inconsistent with a major upshift in Fed funds interest rate expectations. Total loan growth is contracting, led by commercial & industrial loans (Chart 8). Commercial real estate loan growth has also turned lower. Chart 6Net Interest Margins And The Fed Net Interest Margins And The Fed Net Interest Margins And The Fed Chart 7Don't Chase Without Profit Support Don't Chase Without Profit Support Don't Chase Without Profit Support Chart 8Shrinking Balance Sheets Shrinking Balance Sheets Shrinking Balance Sheets The most recent Fed Senior Loan Officer Survey showed that banks are tightening lending standards in most categories, with the exception of mortgages (Chart 9). The number of banks reporting increased loan demand has also softened. Since the credit crisis, banks have shifted their balance sheet exposure toward businesses and away from consumers and residential mortgages, underscoring that a decent housing market is unlikely to provide an offset to lackluster corporate credit demand. Only mortgages have experienced an uptick in loan demand and availability of funds (Chart 9). This credit backdrop is not conducive to a much more aggressive Fed, reinforcing that it would be dangerous to discount a sustained and meaningful uptrend in net interest margins. To further confound the bank stock reward/risk profile, bank employment continues to rise steadily (Chart 10), even though balance sheet expansion is no longer a sure thing. We have shown in past Reports that bank stocks have almost always underperformed when bank employment is rising. Chart 9Credit Standars Are Tightening Credit Standars Are Tightening Credit Standars Are Tightening Chart 10Sagging Productivity Sagging Productivity Sagging Productivity The current combination of fading credit creation and rising employment has done a number on our bank productivity proxy. The latter is now contracting on a rate of change basis, warning that the expansion in bank stock valuations is due for a squeeze (Chart 10). Bottom Line: The run in bank stocks over the past few months is on the cusp of a reversal, based on the leading message from the euro area, sinking productivity and punk credit demand. Our financial sector preference remains skewed toward areas not dependent on credit creation, such as asset managers. Book Profits In Health Care Facilities We bought the S&P health care facilities index last December after a steep post-election sell-off created a valuation and technical undershoot relative to the fundamental outlook. The doomsday concern was that President Trump would tear up the Affordable Care Act (ACA), potentially leaving millions without insurance: treating the uninsured is the bane of any hospital's existence. At the time of purchase, the 52-week rate of change was diverging positively from the share price ratio after hitting deeply oversold levels, often a harbinger of a playable rally (Chart 11). That was particularly true given an historically high short position. The index has outperformed by 12% since then, encouraged by a jump in analyst net profit revisions following upbeat profit results and guidance from industry heavyweights such as HCA Holdings (Chart 11), and a realization that any ACA action is likely to be more of a rework than a total rebuild. Valuations remain appealing, but a technical breakout above key resistance levels requires increased confidence in the durability of profit outperformance. Is such a phase forthcoming? Our conviction level has decreased a notch. Our concern is primarily revenue based, rather than fear that provisions for doubtful accounts will suddenly deteriorate as a consequence of treating uninsured patients. Instead, the main push from the surge in the insured population and increase in procedures on the back of rising consumer confidence/job security is likely to peter out. Consumer spending on hospitals has already rolled over decisively on a growth rate basis (Chart 12, third panel), and is contracting compared with total consumer spending. The same is true of spending on physician visits. Fewer doctor visits mean a reduction in procedures performed at hospitals. Chart 11Hitting Resistance Hitting Resistance Hitting Resistance Chart 12Top-Line Trouble Ahead? Top-Line Trouble Ahead? Top-Line Trouble Ahead? Health care is a labor-intensive industry. Health care facilities staff up when they get busy and prune when capacity utilization slips. As such, slowing growth in hospital employment reinforces that patient volume growth is likely to ebb (Chart 12). In fact, the contraction in hospital hours worked signals the same ahead for hospital sales (Chart 12, bottom panel). The good news is that labor costs remain in check, as measured by the employment cost index for hospitals (Chart 13). Other input costs, such as the cost of medical equipment and supplies, have perked up (Chart 13), which may require increased pricing power in order to sustain profit margins. However, the revenue trends noted above suggest that hospitals may not experience a sufficient rise in patient volumes to the extent that restores pricing power to a more solid footing. Chart 14 shows that the consumer price index for hospitals is losing momentum relative to overall inflation. Durable outperformance phases require accelerating relative pricing power, in addition to a cooling in overall economic growth, as proxied by the ISM manufacturing index (see shading, Chart 14). Those conditions provide a durable competitive profit advantage. Chart 13A Mixed Picture For Costs A Mixed Picture For Costs A Mixed Picture For Costs Chart 14Shaky Long-Term Support Shaky Long-Term Support Shaky Long-Term Support Chart 15Macro Headwinds Macro Headwinds Macro Headwinds In addition, the ideal macro conditions for hospital stocks exist when consumer spending on overall health care services is accelerating relative to total spending. That implies that the providers of health care services have an advantage over those that pay for them, such as insurers. Total medical care spending is steadily decelerating (Chart 15), underscoring that investors are better off targeting investments in other parts of the sector. In sum, the forces required to sustain the oversold rally in the S&P 1500 health care facilities index are losing clout, so we recommend booking profits. Bottom Line: Downgrade the S&P 1500 health care facilities index to neutral, locking in a 12% profit since inception in December 2016. Current Recommendations Current Trades Size And Style Views Favor small over large caps. Favor growth over value (downgrade alert).

Highlights Since the 1950s, the trends in margins and earnings growth have been one and the same: as profit margins decline, so does earnings growth. The decline in profit margins that began in early 2015 has gone on hiatus for the past two quarters. But this rebound in margins is unlikely to be sustained. However, even if profit margins turn lower on a sustained basis, there is scope for equity returns to stay positive, based on historical precedent. Similar to a broad-based profit margin decline, further currency strength will be an earnings headwind, but not a show-stopper for profit growth. All in all, with forward multiples now at multi-decade highs, there is lots of room for earnings growth to disappoint, but the conditions for an equity bear market are not in place. Feature Equity prices continue to march higher and the S&P 500 made another all-time high last week. Q4 earnings reporting is now nearly complete, with about two-thirds of companies surprising to the upside. According to FactSet, the share of Q4 surprises is below the 5-year average, while the size of surprises (2.9% above the estimate) is also a smaller margin than the "average surprise" in the past five years (Chart 1). Nonetheless, that has not stopped analysts from getting even more bulled up about 2017 earnings. Analysts' consensus for S&P 500 operating earnings is 10.2% for the calendar year, and the forward multiple now stands at 17.5x, its highest level since 2004 (Chart 2). Chart 1Q4 Earnings Surprises: Better, ##br##But Not That Surprising Q4 Earnings Surprises: Better, But Not That Surprising Q4 Earnings Surprises: Better, But Not That Surprising Chart 2Forward P/E At ##br##Decade Highs Forward P/E At Decade Highs Forward P/E At Decade Highs A 10% rise in earnings within the year would not be an unprecedented move - there are numerous historical re-accelerations of operating earnings of that size. However, it would be unprecedented for earnings growth to move consistently higher over the next year without an upward trend in profit margins. As Charts 3A and 3B shows, the turning points in earnings growth always correspond with turning points in profit margins. True, there have been 13 minor episodes whereby profit margins have declined but earnings growth accelerated. But these periods were very short-lived, never lasting more than three months at a time. In the majority of these episodes, equity investors saw through the blip down in margins; equity prices continued to rally higher and returns for the year were larger than average. Chart 3AProfit Growth And Margins: An Iron Link Profit Growth And Margins: An Iron Link Profit Growth And Margins: An Iron Link Chart 3B Profit Growth And Margins: An Iron Link Profit Growth And Margins: An Iron Link There have been far more one-quarter episodes whereby earnings growth decelerates and profit margins continue to rise (39 times since 1951). In these cases, equities exhibit below average returns. Chart 4Slow Growth Will Stay A Profit Headwind Slow Growth Will Stay A Profit Headwind Slow Growth Will Stay A Profit Headwind The key takeaway is that when profit margins and earnings growth temporarily fail to pull in the same direction, investors have tended to focus on earnings growth. However, the caveat to the above analysis is that we rely on data going back to 1951. The current cycle is unique in that potential GDP growth has never been this low (Chart 4). In a low-growth environment, it is harder for volume expansion to compensate for any fall in margins. We believe that understanding the profit margin backdrop in this environment will remain particularly important. The Outlook For Profit Margins The trend in profit margins is determined largely by the relative growth rates of selling prices, compensation and productivity. Unit labor costs (ULC), which is compensation divided by productivity, account for about 60% of production expenses: the ratio of selling price to unit labor costs is a good proxy for profit margins (Chart 5). In terms of the denominator, unit labor costs have been choppy, but have nonetheless been on a rising trend since the beginning of the recovery. Since the early 1990s, unit labor costs tended to rise throughout the business expansion, and then fall sharply once businesses retrenched during recessions. If this cycle follows historical patterns, then unit labor costs could push higher toward 3%. In other words, labor expenses may not accelerate quickly, but it is highly unlikely that profits will benefit from a fall in ULC growth at this stage of the expansion. In a recent Special Report,1 we made the case that the economy is at full employment and there would be cyclical pressure for wages to rise, despite some structural headwinds. We do not anticipate a surge in labor costs, rather a slow creep higher. Chart 5Can Selling Prices ##br##Catch Up To Labor Cost? Can Selling Prices Catch Up To Labor Cost? Can Selling Prices Catch Up To Labor Cost? Chart 6Businesses Will Find It Hard ##br##To Pass On Price Increases Businesses Will Find It Hard To Pass On Price Increases Businesses Will Find It Hard To Pass On Price Increases Our major concern is whether or not selling prices (i.e. the numerator in our proxy) can keep up with even mild cost pressures. Traditionally, the conditions that allow companies to raise prices are also associated with rising costs of inputs and labor, and higher inflation prompts the Fed to impose monetary restraint. Thus, profit margins - and therefore equity prices - have generally done better when price inflation is low. However, the concern today is that inflation (corporate selling prices) is too low and that it is difficult for firms to pass on rising input costs, i.e. that a margin squeeze occurs because businesses cannot sufficiently pass on rising labor costs, as consumers have become conditioned to entrenched deflation, particularly at the retail level. We have written extensively in recent publications about inflation. Our bias is to expect broad-based inflation (PCE and CPI measures) as well as corporate selling price inflation (i.e. businesses pricing power) to rise slowly this cycle. The key points are as follows: Inflation expectations are extremely well anchored (Chart 6). True, there is a gap that has opened between survey and market-based inflation expectations. But as we explained in our January 9 Weekly Report, there are several reasons why market-based measures are likely overstating the rise in inflation expectations. Even so, these measures remain well below historic averages and continue to signal that even if the trend is up, the rate of inflation remains very benign. If survey-based inflation expectations are correct, then this business cycle could be a mirror opposite of the 1970s/80s. In that cycle, strong inflation expectations became self-fulfilling/self-reinforcing and lead to higher realized inflation. Today, after a long period of fearing deflation and experiencing massive price discounting at the retail level (Chart 6), consumers have become conditioned to expect prices will never go up. Even once the output gap is fully closed, it could take several years for inflation to gain traction. A strong dollar argues for constant drag on 30% of consumer price inflation (i.e. tradable goods and services). This will keep a lid on inflation for the foreseeable future. Overall, wage costs have outpaced pricing power since 2014, with the exception of the prior two quarters. We do not have a strong view on whether profit margins are finally in a sustained mean-reverting phase, but the above framework suggests that due to a very solid anchoring of inflation expectations, businesses could be faced with a tough pricing backdrop much later than is typical in the business cycle. Flat/falling margins are historically not enough to derail the bull market at this stage of the expansion. However, as we highlighted above, equities are now trading at sky-high forward valuations and have become extremely vulnerable to earnings disappointment. What About The Dollar? A frequent question from clients is about the role of the dollar in U.S. earnings and how enthusiastic can one be about earnings growth if the dollar is rising? As our U.S. Equity Strategy team has pointed out in the past, there are two distinct camps on the impact of U.S. dollar strength on equities.2 Bulls believe that dollar strength will depress commodity and import prices, tamping down inflation pressures and allowing the Fed to avoid monetary tightening. Therefore, the net monetary conditions impact will be positive for the U.S., which is a relatively closed economy. Under these conditions, capital would continue to flow into stocks. Bears see the currency as undermining profitability, given that foreign translation will take a hit along with income from foreign affiliates selling into weaker demand abroad (Chart 7). In other words, the rest of the world is exporting deflationary pressures to the U.S. via currency depreciation. This threatens the earnings outlook, particularly relative to still lofty growth expectations. Chart 7Dollar Headwind Dollar Headwind Dollar Headwind Our take is somewhere in between these two extremes. It is certainly true that a strong dollar helps contain inflation pressures, and allows for a prolonged business cycle. But as highlighted above, in an economy still struggling to grow much above 2%, inflation pressures are not an overly large concern to begin with. Meanwhile, hedging means that the currency translation effect on financial performance is not immediate. And the impact of any dollar strength surely depends on the conditions under which it is strengthening: dollar strength in a period of weak global growth will be more detrimental to returns than a dollar that is rising due to exceptionally strong domestic conditions. We are currently at neither one of these extremes (Chart 8). Chart 8U.S. And Global Economy: Not Hot, Not Cold U.S. And Global Economy: Not Hot, Not Cold U.S. And Global Economy: Not Hot, Not Cold Our Bank Credit Analyst service recently presented a matrix of different scenarios for the dollar and economic growth applied to a model for EPS growth. The key finding was that the effect of even small changes in growth assumptions dominate the effect of much larger moves in the dollar. A 10% dollar appreciation from current levels would shave about 2% from profits, assuming no change to the GDP growth outlook. The bottom line is that the recent improvement in margins has helped earnings recover from last year's profit recession. However, it is unlikely that margins have entered a lasting uptrend; firms lack pricing power and the labor market is now tight enough that unit labor costs will rise on a sustained basis. As profit margins trend lower in the coming years, this will present a headwind for profit growth. Similarly, our expectation that the currency will continue to appreciate over the next 12-18 months is a headwind to earnings growth. Current sky-high equity valuations leave little room for these risks. We expect that disappointments will eventually cause an equity price reset, but timing is uncertain. As we wrote last week, technical indicators do not currently suggest an important pullback is imminent. Looking further out, the overall backdrop of slowly building inflation, a go-slow Fed, and a mild pickup in nominal GDP growth, is a positive backdrop for long-term stocks. Lenka Martinek, Vice President U.S. Investment Strategy lenka@bcaresearch.com 1 Please see U.S. Investment Strategy Special Report "U.S. Wage Growth: Paid In Full?", dated November 28, 2016, available at usis.bcaresearch.com 2 Please see U.S. Equity Strategy Service Special Report, “Equity Sectors And The Soaring U.S. Dollar,” dated November 3, 2014, available at uses.bcaresearch.com

Highlights Nervousness and uncertainty abound within the investment community, but greed is overwhelming fear as the U.S. equity market breaks out and other stock markets test the upside. Technical conditions are stretched and a correction is overdue, but investors can at least take some comfort that earnings are rebounding and that the economic data are surprising to the upside. Upbeat leading indicators and survey data are now being reflected in a synchronized upturn of the "hard" economic data across the major economies. History shows that the risk of recession increases when the U.S. unemployment rate falls below its full employment level. Nonetheless, for extended "slow burn" expansions like the current one, inflation pressure accumulates only slowly. These late cycle phases can last for years and can be rewarding for equity investors. Stock markets are also benefiting from an earnings recovery from last year's profit recession in some of the major economies. Importantly, it is not just an energy story and is occurring even in the U.S., where companies are dealing with a strong dollar. The U.S. Administration and Congressional Republicans are considering some radical changes to the tax code and not all of them are positive for risk assets. The probability of a watered-down border tax being passed as part of a broader tax reform package is higher than the market believes. Overall, tax reform should be positive for growth and profits in the medium term, but is likely to cause near-term turbulence in financial markets. Eurozone breakup risk has re-entered investors' radar screen. Most of the political events this year will end up being red herrings. However, we are quite concerned about Italy, where support for the euro is slipping. Our Duration Checklist supports our short-duration recommendation. The FOMC will hike three times this year, while the European Central Bank and the Bank of England will adopt a more hawkish tone later in 2017 (assuming no political hiccups). The policy divergence backdrop remains positive for the U.S. dollar. Technical and valuation concerns will be a headwind, but will not block another 5-10% appreciation. The Trump Administration is very limited in its ability to engineer a weaker dollar. The robust upturn in the economic and profit data keeps us positive on the stock-to-bond total return ratio for the near term. Investors should maintain an overweight allocation to stocks versus bonds within global portfolios. The backdrop could become rockier in the second half of the year. We will be watching political trends in Italy, our leading economic indicators, and U.S. core inflation for a signal to trim risk. Feature U.S. equity markets have broken out and stock indexes in the other major markets are flirting with the top end of their respective trading ranges. Nervousness and uncertainty abound within the investment community, but greed is overwhelming fear. The latter is highlighted by the fact that our Complacency-Anxiety Indictor hit a new high for the cycle (Chart I-1). Chart I-1Complacency Indicator Signals Equity Vulnerability Complacency Indicator Signals Equity Vulnerability Complacency Indicator Signals Equity Vulnerability It is disconcerting that there has been no 15-20% equity correction for six years and that technical conditions are stretched. Nonetheless, investors can at least take some comfort that earnings are rebounding and that the economic data are surprising to the upside. As we highlight in this month's Special Report, beginning on page 22, upbeat leading indicators and survey data are now being reflected in a synchronized upturn of the "hard" economic data across the major economies. The economic and profit data are thus providing stocks with a solid tailwind at the moment. Unfortunately, the noise surrounding the Trump/GOP fiscal policy agenda is no less than it was a month ago. Investors are also dealing with another bout of euro breakup jitters ahead of upcoming elections. While most of the European pressure points will turn out to be red herrings in our view, Italy is worrisome (see below). Investors are also concerned that, even if the geopolitical risks fade and Trump's protectionist proposals get watered down, the U.S. is nearing full employment. This means that any growth acceleration this year could show up in rising U.S. wages, a more aggressive Fed and a margin squeeze. In other words, the benefits of growth could go to Main Street rather than to Wall Street. This month we research past cycles to shed some light on this concern. We remain overweight stocks versus bonds, but are watching Italy's political situation, U.S. core inflation and our leading economic indicators for signs to take profits. On a positive note, we are not concerned that the U.S. is "due" for a recession just because it has reached full employment. Late Cycle Economic And Equity Dynamics Previous economic cycles are instructive regarding the recession and margin pressure concerns. In our December 2016 issue, we presented some research in which we split U.S. post-1950 economic cycles into three sets based on the length of the expansion phase: short (about 2 years), medium (4-6 years) and long (8-10 years). What distinguishes short from medium and long expansions is the speed at which the most cyclical parts of the economy accelerated, and the time it took unemployment to reach a full employment level. Long expansions were characterized by a drawn-out rise in the cyclical parts of the economy and a very slow return to full employment, similar to what has occurred since the Great Recession. Chart I-2 and Chart I-3 compare the current cycle to the average of two of the long cycles (the 1980s and the 1990s). We excluded the long-running 1960s expansion because the Fed delayed far too long and fell well behind the inflation curve. Chart I-2Long Expansion Comparison (I) Long Expansion Comparison (I) Long Expansion Comparison (I) Chart I-3Long Expansion Comparison (II) Long Expansion Comparison (II) Long Expansion Comparison (II) We define the 'late cycle' phase to be the time period from when the economy first reached full employment to the subsequent recession (shaded portions in Chart I-2 and Chart I-3). The average late-cycle phase for these two expansions lasted almost four years, highlighting that reaching full employment does not necessarily mean that a recession is imminent. Some studies have demonstrated that the probability of recession rises once full employment is reached. We agree with this conclusion when looking across all the post-war cycles.1 However, recessions are almost always triggered by Fed tightening into rising inflationary pressures. Such pressures are slower to emerge in 'slow burn' recoveries, allowing the Fed to proceed gradually. The Fed waited an average of 25 months to tighten policy after reaching full employment in these two long expansions, in part because core CPI inflation was roughly flat (not shown). Wage growth accelerated in both cases, but healthy productivity growth kept unit labor costs in check. The result was an extended late-cycle phase that allowed profits to continue growing. Earnings-per-share for S&P 500 companies expanded by an average of 18% in inflation-adjusted terms during the two late-cycle phases, despite the twin headwinds of narrowing profit margins and a strengthening dollar (the dollar appreciated by an average of 23% in trade-weighted terms). The stock market provided an impressive average real return of 25%. Of course, no two cycles are the same. Both the 1980s and 1990s included a financial crisis in the second half that interrupted the Fed's tightening timetable, which likely extended the expansion phases (the 1987 crash and the 1998 LTCM financial crisis). Today, unit labor costs are under control, but wage and productivity growth rates are significantly lower. The implication is that nominal GDP is expanding at a significantly slower underlying pace in this cycle, limiting the upside for top line growth in the coming years. In terms of valuation, stocks are more expensive today than they were in the second half of the 1980s. Stocks were even more expensive in the late 1990s, but that provides little comfort because the market had entered the 'tech bubble' that did not end well. We are not making the case that the current late-cycle phase will be as long or rewarding for equity holders as it was for the two previous slow-burn expansions. Indeed, fiscal stimulus this year could lead to overheating and a possible recession in late 2018 or 2019. Our point is that reaching full employment does not condemn the equity market to flat or negative returns. Indeed, the previous cycles highlight that earnings growth can be decent even with the twin headwinds of narrowing margins and a strengthening dollar. The Earnings Mini-Cycle Another factor that distinguishes the current late-cycle phase from the previous two is that the main equity markets endured an earnings recession last year that did not coincide with an economic recession. Since the mid-1980s, there have been three similar episodes (shaded periods in Chart I-4). Bottom-up analysts failed to see the profit recession coming in each case, such that actual EPS fell well short of expectations set 12 months before (the 12-month forward EPS is shown with a 12-month lag to facilitate comparison). In each case, forward EPS estimates trended sideways while actual profits contracted. Chart I-4Market Dynamics During Previous Profit Recessions (But No Economic Recession) Market Dynamics During Previous Profit Recessions (But No Economic Recession) Market Dynamics During Previous Profit Recessions (But No Economic Recession) This was followed by a recovery in profit growth that eventually closed the gap again between actual and (lagged) 12-month forward EPS. This 'catch up' phase coincided with some multiple expansion and a total return to the S&P 500 of about 8% in the late 1990s and 20% in 2013/14.2 The starting point for the forward P/E is elevated today, which means that double-digit returns may be out of reach. Nonetheless, stocks are likely to outperform bonds on a 6-12 month view. A Bird's Eye View Of The Trump Agenda The U.S. Administration and Congressional Republicans are considering some radical changes to the tax code and not all of them are positive for risk assets. We have no doubt that some sort of tax bill will be passed in 2017. The GOP faces few constraints to cutting corporate taxes and there is every reason to believe it will occur quickly. The major question is whether a broader tax reform will be passed. Trying to understand all the moving parts to tax reform is a daunting task. In order to simplify things, Table I-1 lists the main policies that are being considered, along with the economic and financial consequences of each. Some policies on their own, such as ending interest deductibility, would be negative for the economy and risk assets. However, the top three items in the table will likely be combined if a broad tax reform package is passed. Together, these three items define a destination-based cash-flow tax, which some Republicans would like to replace the existing corporate income tax. The aim is to promote domestic over foreign production, stimulate capital spending and remove a bias in the tax system that favors imports over exports. Table I-1A Bird's Eye View Of The Implications Of The Trump/GOP Fiscal Policy Agenda March 2017 March 2017 Table I-1A Bird's Eye View Of The Implications Of The Trump/GOP Fiscal Policy Agenda March 2017 March 2017 Perhaps the most controversial aspect is the border-adjustment tax (BAT), which would tax the value added of imports and rebate the tax that exporters pay. We will not get into the details of the BAT here, but interested readers should see two recent BCA reports for more details.3 The implications of the BAT for the economy and financial markets depend importantly on the dollar's response. In theory, the dollar would appreciate by enough to offset the tax paid by importers and the tax advantage gained by exporters, leaving the trade balance and the distribution of after-tax corporate profits in the economy largely unchanged. This is because a full dollar adjustment would nullify the subsidy on exports, while reducing import costs by precisely the amount necessary to restore importers' after-tax profits. A 20% border tax, for example, would require an immediate 25% jump in the dollar to level the playing field. In reality, much depends on how the Fed and other countries respond to the BAT. We believe the dollar's rise would be less than fully offsetting, but would still appreciate by a non-trivial 10% in the event of a 20% border tax. If the dollar's adjustment is only partially offsetting, then it would have the effect of boosting exports and curtailing imports, thereby adding to GDP growth and overall corporate profits. It would make it more attractive for U.S. multinational firms to produce in the U.S., rather than produce elsewhere and export to the U.S. A partial dollar adjustment would also be inflationary because import prices would rise. The smaller the dollar appreciation, the more inflationary the impact. The result would be dollar strength coinciding with higher Treasury yields, breaking the typical pattern in recent years. The impact on the U.S. equity market is trickier. To the extent that dollar strength is not fully offsetting, then the resulting economic boost will lift corporate earnings indirectly. However, the BAT will reduce after-tax profits directly. One risk is that the FOMC slams the brakes on the economy in the face of rising inflation. Another is that, with the economy already operating close to full employment, faster growth might be reflected in accelerating wage inflation that eats into profit margins. However, our sense is that the labor market is not tight enough to immediately spark cost-push inflation. As noted above, it usually takes some time for wage inflation to get a head of steam once the labor market gap is closed in a slow-burn expansion. Full employment is not a hard threshold beyond which the economy suddenly changes. Moreover, the Phillips curve has been quite flat in this recovery, suggesting that it will require significant levels of excess demand to move the dial on inflation. More likely, a slow upward creep in core PCE inflation will allow the Fed to err on the side of caution. Unintended Consequences There are a number of risks and unintended consequences associated with the border tax. One major drawback of the BAT is that, to the extent that the dollar appreciates, it reduces the dollar value of the assets that Americans hold abroad. We estimate that a 25% appreciation, for example, would impose a whopping paper loss of about 13% of GDP. Moreover, a partial dollar adjustment could devastate the profits of importers, while generating a substantial negative tax rate for exporters. It would also be disruptive to multinational supply chains and to the structure of corporate balance sheets (debt becomes more expensive relative to equity finance). Partial dollar adjustment would also be bad news for countries that rely heavily on exports to the U.S. to drive growth, especially emerging economies that have piled up a lot of dollar-denominated debt. An EM crisis cannot be ruled out. Finally, it is unclear whether or not a border tax is consistent with World Trade Organization Rules. At a minimum, it will be seen as a protectionist act by America's trading partners and could trigger a trade war. President Trump has sent conflicting views on the BAT and there has been a wave of criticism from sectors that will lose from such legislation. However, the House GOP leaders signaled a greater flexibility in drafting the law so as to win over various stakeholders. Our Geopolitical Strategy team believes that Trump will ultimately hew to the Republican Party leadership on tax reform, largely because his protectionist and mercantilist vision is fundamentally aligned with the chief aims of the BAT. Critics will be won over by the use of carve-outs and/or phased implementation for key imports like food, fuel and clothing. Interestingly, the sectors that suffer the most from the import tax also tend to pay higher effective tax rates and thus stand to benefit from the rate cuts (Chart I-5). Finally, the BAT would raise revenue that can be used to offset the corporate tax cuts, helping to sell the package to Republican deficit hawks. Chart I-5Cuts In Tax Rates Mitigate A New Import Tax Somewhat March 2017 March 2017 But even if the border adjustment never sees the light of day, there will certainly be tax cuts for both corporations and households, along with specific add-ons to deal with concerns like corporate inversions and un-repatriated corporate cash held overseas. An infrastructure plan and cuts to other discretionary non-defense government spending also have a high probability, although the amounts involved may be small. An outsourcing tax has a significant, though less than 50%, chance of occurring in the absence of a border tax. On its own, an outsourcing tax would be negative for growth, profits and equity returns. We place a 50/50 chance on a broad tax reform package that includes the border adjustment. We believe that a broad tax reform package will ultimately be positive for the bottom line for the corporate sector as a whole, although unintended consequences will complicate the path to higher stock prices. Eurozone: Breakup Risk Resurfaces Investors have lots to consider on the other side of the Atlantic as well. The European election timetable is packed and plenty is at stake. Could we see a wave of populism generate game-changing political turmoil in the E.U., as occurred in the U.S. and U.K.? Our geopolitical strategists believe that European risks are largely red-herrings for 2017. Investors are overestimating most of the inherent risks:4 In the Netherlands, the Euroskeptic Party for Freedom is set to capture about 30 out of 150 seats in the March election. However, that is not enough to win a majority. Dutch support for the euro is at a very high level, while voters lack confidence in the country's future outside of the EU. Support for the euro is also elevated in France, limiting the chance that Le Pen will win the upcoming presidential election. Even if she is somehow elected, it is unlikely that she would command a majority of the National Assembly. Exiting the Eurozone and EU would necessitate changing the constitution, possibly requiring a referendum that Le Pen would likely lose. That said, these constraints may not be clear to investors, sparking a market panic if Le Pen wins the election. The German public is not very Euroskeptic either and anti-euro parties are nowhere close to governing. Markets may take a Merkel loss at the hands of the SPD negatively at first. However, the new SPD Chancellor candidate, Martin Schulz, is even more supportive of the euro than Merkel and he would be less insistent on fiscal austerity in the Eurozone. A handover of power to Schulz would ultimately be positive for European stocks. The Catlan independence referendum in September could cause knee-jerk ripples as well. Nonetheless, without recognition from Spain, and no support from EU and NATO member states, Catlonia cannot win independence with a referendum alone. Greece faces a €7 billion payment in July, by which time the funding must be released or the government will run out of cash. The IMF refuses to be involved in any deal that condones Greece's unsustainable debt path. If a crisis emerges, the likely outcome would be early elections. While markets may not like the prospect of an election, the pro-euro and pro-EU New Democratic Party (NDP) is polling well above SYRIZA. The NDP would produce a stable, pro-reform government that would be positive for growth and financial markets. It is a different story in Italy, where an election will occur either in the autumn or early in 2018. Support for the common currency continues to plumb multi-decade lows, while Italian confidence in life outside the EU is perhaps the greatest on the continent (Chart I-6 and Chart I-7). Euroskeptic parties are gaining in popularity as well. The possibility of a referendum on the euro, were a Euroskeptic coalition to win, would obviously be very negative for risk assets in Europe and around the world. Chart I-6Italians Turning Against The Euro Italians Turning Against The Euro Italians Turning Against The Euro Chart I-7Italians Confident In Life Outside The EU Italians Confident In Life Outside The EU Italians Confident In Life Outside The EU The implication is that most of the risks posed by European politics should cause no more than temporary volatility. The main exception is Italy. We will be watching the Italian polls carefully in the coming months, but we believe that the widening in French/German bond spreads presents investors with a short-term opportunity to bet on narrowing.5 Bond Bear Market Is Intact These geopolitical concerns and uncertainty over President Trump's policy priorities put the cyclical bond bear market on hold early in the New Year, despite continued positive economic surprises. Even Fed Chair Yellen's hawkish tone in her recent Congressional testimony failed to move long-term Treasury yields sustainably higher, after warning that "waiting too long to remove accommodation would be unwise." In the money markets, expectations priced into the overnight index swap curve have returned to levels last seen on the day of the December 2016 FOMC meeting (Chart I-8). The market is priced for 53 basis points of rate increases between now and the end of the year, with a 26% chance that the next rate hike occurs in March. March is too early to expect the next FOMC rate hike. One reason is that core PCE inflation has been stuck near 1.7% and we believe it will rise only slowly in the coming months. Even though the strong January core CPI print seemed to strengthen the case for a March hike, the details of the report show that only a few components accounted for most of the gains. In fact, our CPI diffusion index fell even further below the zero line. With both our CPI and PCE diffusion indexes in negative territory, inflation may even soften temporarily in the coming months. This would take some heat off of the FOMC (Chart I-9). Chart I-8Fed Rate Expectations Shift Toward Dots Fed Rate Expectations Shift Toward Dots Fed Rate Expectations Shift Toward Dots Chart I-9U.S. Inflation May Soften Temporarily U.S. Inflation May Soften Temporarily U.S. Inflation May Soften Temporarily Second, Fed policymakers will want to see how the Trump policy agenda shakes out in the next few months before moving. We still expect three rate hikes this year, beginning in June. The stance of central bank policy is on our Duration Checklist, as set out by BCA's Global Fixed Income Strategy service (Table I-2). We will not go through all the items on the checklist, but interested readers are encouraged to see our Special Report.6 Table I-2Stay Bearish On Bonds March 2017 March 2017 Naturally, leading and coincident indicators for global growth feature prominently in the Checklist. And, as we highlight in this month's Special Report, a synchronized global growth acceleration is underway that is broadly based across economies, consumer and business sectors, and manufacturing and services industries. Our indicators for private spending suggest that real GDP growth in the major countries accelerated sharply between 2016Q3 and the first quarter of 2017, to well above a trend pace. In the Euro Area, jobless rate has been declining quickly and reached 9.6% in January, the lowest level in nearly eight years. Even if economic growth is only 1½% in 2017 (i.e. below our base case), the unemployment rate could reach 9% by year-end, which would be close to full employment. Core inflation already appears to be bottoming and broad disinflationary pressures are abating. When the ECB re-evaluates its asset purchase program around the middle of this year, policymakers could be faced with rising inflation and an economy that has exhausted most of its excess slack. At that point, possibly around September, ECB members will begin to hint that the asset purchases will be tapered at the beginning of 2018. Moreover, the annual growth rate of the ECB's balance sheet will peak by around mid-year and then trend lower (Chart I-10). This inflection point, along with expectations that the ECB will taper further in 2018, will place upward pressure on both European and global bond yields. The Bank of England (BoE) may become more hawkish as well. At the February BoE meeting, policymakers re-iterated that they are willing to look through a temporary overshoot of the inflation target that is related to pass-through from the weak pound and higher oil prices. However, the BoE has its limits. The Statement warned that tighter policy may be necessary if wage growth accelerates and/or consumer spending growth does not moderate in line with the BoE's projection. In the absence of Brexit-related shocks, the BoE is unlikely to see the growth slowdown it is expecting, given healthy Eurozone economic activity and the stimulus provided by the weak pound. Investors should remain positioned for Gilt underperformance of global currency-hedged benchmarks (Chart I-11). Chart I-10Bond Strategy And ##br## The ECB Balance Sheet Bond Strategy And The ECB Balance Sheet Bond Strategy And The ECB Balance Sheet Chart I-11Gilts To Underperform Gilts To Underperform Gilts To Underperform Outside of central bank policy, a majority of items on the Duration Checklist are checked at the moment, indicating that investors with a 3-12 month view should maintain below-benchmark duration within bond portfolios. That said, technical conditions are a headwind to higher yields in the very near term. Oversold conditions and heavy short positioning suggest that yields will have a tough time rising quickly as the market continues to consolidate last year's sharp selloff. Can Trump Force Dollar Weakness? Chart I-12Trump Can't Weaken ##br## Dollar With Tweets For Long Trump Can't Weaken Dollar With Tweets For Long Trump Can't Weaken Dollar With Tweets For Long The U.S. dollar appears to have recently decoupled from shifts in both nominal and real interest rate differentials this year (Chart I-12). The dollar is expensive, but we do not believe that valuation is a barrier to an extended overshoot given the backdrop of diverging monetary policies between the U.S. and the other major central banks. The dollar's recent stickiness appears to be driven by recent comments from the new Administration that the previous 'strong dollar' policy is a relic of the past. Let us put aside for the moment the fact that expansionary fiscal policy, higher import tariffs and/or a border tax would likely push the dollar even higher. "Tweeting" that the U.S. now has a 'weak dollar' policy will have little effect beyond the near term. A lasting dollar depreciation would require changes in the underlying macro fundamentals and policies. President Trump would have to do one of the following: Force the Fed to ease policy rather than tighten. However, the impact may be short-lived because accelerating inflation would soon force the Fed to tighten aggressively. Convince the other major central banks to tighten their monetary policies at a faster pace than the Fed (principally, the People's Bank of China, the BoJ, the ECB, Banco de Mexico, and the Bank of Canada). Again, the impact on the dollar would be fleeting because premature tightening in any of these economies would undermine growth and investors would conclude that policy tightening is unsustainable. Convince these same countries to implement very expansionary fiscal policies. This has a better chance of sustainably suppressing the dollar, but foreign policy would have to be significantly more stimulative than U.S. fiscal policy. The U.S. Administration will not be able to force the Fed's hand or convince other countries to change tack. President Trump has an opportunity to stack the FOMC with doves if he wishes next year, given so many vacant positions. Nonetheless, Trump's public pronouncements on monetary policy have generally been hawkish. It will be difficult for him to make a complete U-turn on the subject, especially since Congressional Republicans would likely resist. This means that the path of least resistance for the dollar remains up. Dollar valuation is stretched and market technicals are a headwind to the rally. However, valuation signals in the currency market have a poor track record at making money on a less than 2-year horizon. The dollar is currently about 8% overvalued by our measure, which is far from the 20-25% overvaluation level that would justify short positions on valuation grounds alone (Chart I-13). What is more concerning for dollar bulls is that there is near universal unanimity on the trade. Nonetheless, both sentiment and net speculative positions are not nearly as stretched as they were at the top of the Clinton USD bull market (Chart I-14). Moreover, it took six years of elevated bullishness and long positioning to prompt the end of the bull market in 2002. We believe that the dollar will appreciate by another 5-to-10% in real trade-weighted terms by the end of the year, despite lopsided market positioning. The appreciation will be even greater if a border tax is implemented. Chart I-13Dollar is Overvalued, But Far From an Extreme Dollar is Overvalued, But Far From an Extreme Dollar is Overvalued, But Far From an Extreme Chart I-14In The 1990s, The Concensus Was Right In The 1990s, The Concensus Was Right In The 1990s, The Concensus Was Right Conclusions Many investors, including us, have been expecting an equity market correction for some time. But the longer that the market goes without a correction, the "fear of missing out" forces more investors to throw in the towel and buy. This market backdrop means that now is not the best time to commit fresh money to stocks, but we would not recommend taking profits either. On a positive note, the U.S. economy is not poised on the edge of recession just because it has reached full employment. Indeed, a synchronized growth acceleration is underway across the major countries that is broadly based across industries. Inflationary pressure is building only slowly in the U.S., which gives the Fed room to maneuver. Moreover, the Trump Administration has not labelled China a currency manipulator, and has sounded more conciliatory toward NATO and the European Union in recent days. This is all good news, but the direction of U.S. fiscal policy remains highly uncertain. Moreover, investors must navigate a host of geopolitical landmines in Europe this year, most important of which is an Italian election that may occur in the autumn. The ECB and the BoE will likely become more hawkish in tone later this year. The impressive upturn in the economic and profit data keeps us positive on the stock-to-bond total return ratio for the near term. Investors should maintain an overweight allocation to stocks versus bonds within global portfolios. The backdrop could become rockier for risk assets in the second half of the year. We will be watching political trends in Italy, our leading economic indicators, and U.S. core inflation among other factors for a signal to trim risk. Our other recommendations include: Maintain below-benchmark duration within bond portfolios. Overweight Eurozone government bonds relative to the U.S. and U.K. in currency-hedged portfolios. Overweight European and Japanese equities versus the U.S. in currency-hedged portfolios. Be defensively positioned within equity sectors to temper the risk associated with overweighting stocks versus bonds. In U.S. equities, maintain a preference for exporting companies over those that rely heavily on imports. Overweight investment-grade corporate bonds relative to government issues, but stay underweight high-yield where value is very stretched. Within European government bond portfolios, continue to avoid the Periphery in favor of the core markets. Fade the widening in French/German spreads. Overweight the dollar relative to the other major currencies. Stay cautious on EM bonds, stocks and currencies. Overweight small cap stocks versus large in the U.S. market, on expected policy changes that will disproportionately favor small companies. We are bullish on oil prices in absolute terms on a 12-month horizon, and recommend favoring this commodity relative to base metals. Mark McClellan Senior Vice President The Bank Credit Analyst February 23, 2017 Next Report: March 30, 2017 1 Indeed, this must be true by definition. 2 The S&P 500 contracted during 1987 because of the market crash. 3 Please see BCA Global Investment Strategy "U.S. Border Adjustment Tax: A Potential Monster Issue for 2017," dated January 20, 2017. Also see: BCA Geopolitical Strategy "Will Congress Pass The Border Adjustment Tax?", dated February 8, 2017. 4 Please see Global Political Strategy Special Report, "Climbing The Wall Of Worry In Europe," dated February 15, 2017. 5 Please see Global Political Strategy Special Report, "Our Views On French Government Bonds," dated February 7, 2017. 6 Please see Global Fixed Income Strategy Special Report, "A Duration Checklist For U.S. Treasurys And German Bunds," dated February 15, 2017. II. Global Growth Pickup: Fact Or Fiction? Risk assets have discounted a lot of good economic news. There is concern that the growth impulse evident in surveys of business activity and confidence has been slow to show up clearly in the "hard" economic data related to final demand. If the optimism displayed in the survey data is simply reflecting "hope" for less government red tape, tax cuts and infrastructure spending in the U.S., then risk assets are highly vulnerable to policy disappointment. After a deep dive into the economic data for the major countries, we have little doubt that a tangible growth acceleration is underway. Momentum in job creation has ebbed, but retail sales, industrial production and capital spending are all showing more dynamism in the advanced economies. Evidence of improving activity is broadly-based across countries and industrial sectors (including services). Orders and production are gaining strength for goods related to both business and household final demand. Inventory rebuilding will add to growth this year, but this is not the main story. The energy revival is not the main driver either. Indeed, energy production has lagged the overall pick-up in industrial production growth. The bottom line is that investors should not dismiss the improved tone to the global economic data as mere "hope". Our models, based largely on survey data, point to a significant acceleration in G7 real GDP growth in early 2017. Our sense is that 'animal spirits' are finally beginning to stir, following many years of caution and retrenchment. A return of animal spirits could prolong a period of robust growth, even if President Trump's growth-boosting policies are delayed or largely offset by spending cuts. This economic backdrop is positive for risk assets and bearish for bonds. Admittedly, however, we cannot point to concrete evidence that this current cyclical upturn will be any more resilient and enduring than previous mini-cycles in this lackluster expansion. Much depends on U.S. policy and European politics in 2017. The so-called Trump reflation trades lost momentum in January, but the dollar and equity indexes are on the rise again as we go to press. A lot of recent volatility is related to the news flow out of Washington, as investors gauge whether President Trump will prioritize the growth-enhancing aspects of his policy agenda over the ones that will hinder economic activity. Much is at stake because it appears that risk assets have discounted a lot of good economic news. Investors have taken some comfort from the fact that leading indicators are trending up across most of the Developed Markets (DM) and Emerging Markets (EM) economies. In the major advanced economies, only the Australian leading indicator is not above the boom/bust mark and rising. Our Global Leading Economic Indicator is trending higher and it will climb further in the coming months given that its diffusion index is well above 50 (Chart II-1). The Global ZEW indicator and the BCA Boom/Bust growth indicator are also constructive on the growth outlook (although the former ticked down in February). Consumers and business leaders are feeling more upbeat as well, both inside and outside of the U.S. (Chart II-2). The improvement in sentiment began before the U.S. election. Surveys of business activity, such as the Purchasing Managers Surveys (PMI), are painting a uniformly positive picture for near-term global output in both the manufacturing and service industries. Chart II-1A Consistent, Positive ##br## Message On Growth A Consistent, Positive Message On Growth A Consistent, Positive Message On Growth Chart II-2Surging Confidence, ##br## Production Following Suit Surging Confidence, Production Following Suit Surging Confidence, Production Following Suit While this is all good news for risk assets, there is concern that a growth impulse has been slow to show up clearly in the "hard" economic data related to final demand. Could it be that the bounce in confidence is simply based on faith that U.S. fiscal policy will be the catalyst for a global growth acceleration? Could it be that, beyond this hope, there is really nothing else to support a brighter economic outlook? Is it the case that the improved tone in the survey data only reflects the end of an inventory correction and a rebound in energy production? If the answer is 'yes' to any of these questions, then equity and corporate bond markets are highly vulnerable to U.S. policy disappointment. This month we take deep dive into the economic data for the major economies. The good news is that there is more to the cyclical upturn than hope, inventories or energy production. The improved tone in the forward-looking data is now clearly showing up in measures of final demand. The caveat is that there is no evidence yet that the cyclical mini up-cycle in 2017 is any less vulnerable to negative shocks than was the case in previous upturns since the Great Recession. The Hard Data First, the bad news. There has been a worrying loss of momentum in job creation, although the data releases lag by several months in the U.K. and the Eurozone, making it difficult to get an overall read on payrolls into year-end (Charts II-3 and II-4).1 Job gains have accelerated in recent months in Japan, Canada and Australia. The payroll slowdown is mainly evident in the U.S. and U.K. This may reflect supply constraints as both economies are near full employment, but it is difficult to determine whether it is supply or demand-related. The good news is that the employment component of the global PMI has rebounded sharply following last year's dip, suggesting that the pace of job creation will soon turn up. Chart II-3Global Employment Growth Cooling Off (I) Global Employment Growth Cooling Off (I) Global Employment Growth Cooling Off (I) Chart II-4Global Employment Growth Cooling Off (II) Global Employment Growth Cooling Off (II) Global Employment Growth Cooling Off (II) On the positive side, households are opening their wallets a little wider according to the retail sales data (Chart II-5 and Chart II-6). Year-over-year growth of a weighted average of nominal retail sales for the major advanced economies (AE) has accelerated to about 3%, and the 3-month rate of change has surged to 8%. Sales growth has accelerated sharply in all the major economies except Australia. The retail picture is less impressive in volume terms given the recent pickup in headline inflation, but the consumer spending backdrop is nonetheless improving. The major exception is the U.K., where inflation-adjusted retail sales have lost momentum in recent months. Chart II-5On Your Mark, Get Set, Shop!! (I) On Your Mark, Get Set, Shop!! (I) On Your Mark, Get Set, Shop!! (I) Chart II-6On Your Mark, Get Set, Shop!! (II) On Your Mark, Get Set, Shop!! (II) On Your Mark, Get Set, Shop!! (II) Similarly, business capital spending is finally showing some signs of life following a rocky 2015 and early 2016. An aggregate of Japanese, German and U.S. capital goods orders2 is a good leading indicator for G7 real business investment (Chart II-7). Order books began to fill up in the second half of 2016 and the year-over-year growth rate appears headed for double digits in the coming months. The pickup is fairly widespread across industries in Germany and the U.S., although less so in Japan. The acceleration of imported capital goods for our 20 country aggregate corroborates the stronger new orders reports (Chart II-7, bottom panel). Recent data on industrial production show that the global manufacturing sector is clearly emerging from last year's recession. Short-term momentum in production growth has accelerated over the past 3-4 months across most of the major advanced economies (Chart II-8 and Chart II-9). Chart II-7Global Capex Cycle Turning Positive... Global Capex Cycle Turning Positive... Global Capex Cycle Turning Positive... Chart II-8...Driving A Global Manufacturing Upturn ... Driving A Global Manufacturing Upturn ... Driving A Global Manufacturing Upturn Chart II-9Global Manufacturing Upturn Global Manufacturing Upturn Global Manufacturing Upturn The fading of the negative impacts of the oil shock and last year's inventory correction are playing some role in the manufacturing rebound, but there is more to it than that. The production upturn is broadly-based across sectors in Japan and the U.K., although less so in the Eurozone and the U.S. Industrial output related to both household and capital goods is showing increasing signs of vigor in recent months (Chart II-10). Interestingly, energy-related production is not a driving force. Indeed, energy production is lagging the overall improvement in industrial output growth, even in the U.S. where the shale oil & gas sector is tooling up again (Chart II-11). Chart II-10A Broad-Based Acceleration A Broad-Based Acceleration A Broad-Based Acceleration Chart II-11Energy Is Not The Main Driver Energy Is Not The Main Driver Energy Is Not The Main Driver The Boost From Inventories And Energy Some inventory rebuilding will undoubtedly contribute to the rebound in industrial production and real GDP growth in 2017. The inventory contribution has been negative for 6 quarters in a row for the major advanced economies, which is long for a non-recessionary period (Chart II-12). We estimate that U.S. industrial production growth will easily grow in the 4-5% range this year given a conservative estimate of manufacturing shipments and a flattening off in the inventory/shipments ratio (which will require some inventory restocking; Chart II-13). Chart II-12Global Inventory Correction Is Over Global Inventory Correction Is Over Global Inventory Correction Is Over Chart II-13U.S. Manufacturing Outlook Is Bullish U.S. Manufacturing Outlook Is Bullish U.S. Manufacturing Outlook Is Bullish Nonetheless, the inventory cycle is not the main story for 2017. The swing in inventories seldom contributes to annual real GDP growth by more than a tenth of a percentage point for the major countries as a whole outside of recessions. Moreover, inventory swings generally do not lead the cycle; they only reinforce cyclical upturns and downturns in final demand. U.S. industrial production growth this year will undoubtedly exceed the 4-5% rate discussed above because that estimate does not include a resurgence of capital spending in the energy patch. BCA's Energy Sector Strategy service predicts that energy-related capex will surge by 40% in 2017, largely in the shale sector (Chart II-13, bottom panel). Even if energy capital spending outside the U.S. is roughly flat, as we expect, this would be a major improvement relative to the 15-20% contraction last year. According to Stern/NYU data, energy-related investment spending currently represents about a quarter of total U.S. capital spending.3 Thus, a 40% jump in energy capex would boost overall U.S. business investment in the national accounts by an impressive 10 percentage points. This is a significant contribution, but at the moment the upturn in manufacturing production is being driven by a broader pickup in business spending. The acceleration in production and orders related to consumer goods in the major countries suggests that household final demand is also showing increased vitality, consistent with the retail sales data. Soft Survey Data Notwithstanding the nascent upturn in the hard data, some believe that the soft data are sending an overly constructive signal in terms of near-term growth. The soft data generally comprise measures of confidence and surveys of business activity. One could discount the pop in U.S. sentiment as simply reflecting hope that election promises to cut taxes, remove red tape and boost infrastructure spending will come to fruition. Nonetheless, improved sentiment readings are widespread across the major countries, which means that it is probably not just a "Trump" effect. Moreover, there is no reason to doubt the surveys of actual business activity. Surveys such as the PMIs, the U.K. CBI Business Survey, the German IFO current conditions index and the Japanese Tankan survey all include measures of activity occurring today or in the immediate future (i.e. 3 months). There is no reason to believe that these surveys have been contaminated by "hope" and are sending a false signal on actual spending. We analyzed a wide variety of survey data and combined the ones that best lead (if only slightly) consumer and capital spending into indicators of private final demand (Chart II-14 and Chart II-15). A wide swath of confidence and survey data are rising at the moment, with few exceptions. Moreover, the improvement is observed in both the manufacturing and services sectors, and for both households and businesses. We employed these indicators in regression models for real GDP in the four major advanced economies and for the G7 as a group (Chart II-16). The models predict that G7 real GDP growth will accelerate to 2½% on a year-over-year basis in the first quarter, from 1½% in 2016 Q3. We expect growth of close to 3% in the U.S. and about 2½% in the Eurozone, although the model for the latter has been over-predicting somewhat over the past year. Japanese growth should accelerate to about 1.7% in the first quarter based on these indicators. Chart II-14Our Consumer Indicators Have Turned Up... Our Consumer Indicators Have Turned Up... Our Consumer Indicators Have Turned Up... Chart II-15...Our Capex Indicators Too ...Our Capex Indicators Too ...Our Capex Indicators Too Chart II-16Real Growth To Accelerate Real Growth To Accelerate Real Growth To Accelerate The outlook is less impressive for the U.K. While the survey data have revealed the biggest jump of the major countries in recent months, this represents a rebound from last years' Brexit-driven plunge. Nonetheless, current survey levels are consistent with continued solid growth. The implication is that the survey data are not sending a distorted message; underlying growth is accelerating even though it is only now showing up in the hard economic data. Turning for a moment to the emerging world, output is picking up on the back of an upturn in exports. However, we do not see much evidence of a domestic demand dynamic that will help to drive global growth this year. The main exception is China, where private sector capital spending growth has clearly bottomed. Infrastructure spending in the state-owned sector is slowing, but overall industrial capital spending growth has turned up because of private sector activity. An easing in monetary conditions last year is lifting growth and profitability which, in turn, is generating an incentive for the business sector to invest. There are also budding signs of recovery in housing-related investment. Stronger Chinese capital spending in 2017 will encourage imports and thereby support activity in China's trading partners, particularly in Asia. Will The Growth Impulse Have Legs? The cyclical dynamics so far appear a lot like the rebound in global growth following the 2011/12 economic soft patch and inventory correction (Chart II-17). That mini cycle was caused by a second installment of the Eurozone financial crisis. The damage to confidence and the tightening in financial conditions sparked a recession on the European continent and a loss of economic momentum globally. The financial situation in Europe began to improve in 2013. Consumer spending growth in the major advanced economies was the first to turn up, followed by capital spending, industrial production and, finally, hiring. Then, as now, the upturn in the surveys led the hard data. Unfortunately, the growth surge was short-lived because the 2014/15 collapse in oil prices undermined confidence and tightened financial conditions once again. The result was a manufacturing recession and inventory correction in 2016. There are reasons to believe that the cyclical upturn will have legs this time. It is good news that the growth impetus is observed in both the manufacturing and service sectors, and that it is widespread across the major advanced economies. Fiscal policy will likely be less restrictive this year than in 2014/15, and our sense is that some of the lingering scar tissue from the Great Recession is beginning to fade. The latter is probably most evident in the case of the U.S.; a Special Report from BCA's U.S. Investment Strategy service highlighted that the U.S. expansion has become more self-reinforcing.4 In the U.S. business sector, it appears that "animal spirits" have been stirred by the promise of less government red tape, lower taxes and protection from external competitive pressures. Regional Fed surveys herald a surge in capital spending plans in the next six months (Chart II-18). The rebound in corporate profitability also bodes well for capital spending. Chart II-17Consumers Usually Lead At Turning Points... Consumers Usually Lead At Turning Points... Consumers Usually Lead At Turning Points... Chart II-18...But Capex Appears To Be Leading Now ...But Capex Appears To Be Leading Now ...But Capex Appears To Be Leading Now Conclusions: We have little doubt that a meaningful global growth acceleration is underway. It is possible that consumer and business confidence measures are contaminated by hopes of policy stimulus in the U.S., but there is widespread verification from survey data of current spending that real final demand growth accelerated in 2016Q4 and 2017Q1. In terms of the hard data, evidence of improving manufacturing output and capital spending is broadly-based across industrial sectors and countries, suggesting that there is more going on than the end of an inventory correction and energy rebound. The bottom line is that investors should not dismiss the improved tone to the global economic data as mere "hope". Our sense is that 'animal spirits' are finally beginning to stir, following many years of caution and retrenchment. CEOs appear to have more swagger these days. Since the start of the year there have been a slew of high-profile announcements of fresh capital spending and hiring plans from companies such as Amazon, Toyota, Walmart, GM, Lockheed Martin and Kroger. A return of animal spirits could prolong a period of stronger growth, which would be positive for risk assets and the dollar, but bearish for bonds. Admittedly, however, we cannot point to concrete evidence that this cyclical upturn will be any more enduring than previous mini-cycles in this lackluster expansion. The economy may be just as vulnerable to shocks as was the case in 2014. As discussed in the Overview, there are numerous risks that could truncate the economic and profit upswing. On the U.S. policy front, tax cuts and some more infrastructure spending would be positive for risk assets on their own. However, the addition of the border tax or the implementation of other trade restrictions would disrupt international supply chains, abruptly shift relative prices and possibly generate a host of unintended consequences. And in Europe, markets have to navigate a minefield of potentially disruptive elections this year. Any resulting damage to household and business confidence could short-circuit the upturn in growth. For now, we remain overweight equities and corporate bonds relative to government bonds in the major countries, but political dynamics may force a shift in asset allocation as we move through the year. Mark McClellan Senior Vice President The Bank Credit Analyst 1 Note that where only non-seasonally adjusted data is available, we have seasonally-adjusted the data so that we can get a sense of short-term momentum via the annualized 3-month rate of change. 2 Machinery orders used for Japan. 3 Please see http://www.stern.nyu.edu/ 4 Please see U.S. Investment Strategy Special Report "The State Of The Economy In Pictures," dated January 30, 2017. III. Indicators And Reference Charts The breakout in the S&P 500 over the past month has further stretched valuation metrics. The Shiller P/E is very elevated, and the price/sales ratio is almost back to the tech bubble peak. However, our composite valuation indicator is still slightly below the one sigma level that marks significant overvaluation. This composite indicator comprises 11 different measures of value. The monetary indicator is slightly negative, but not dangerously so for stocks. Technical momentum is positive, although several indicators suggest that the equity rally is stretched and long overdue for a correction. These include our speculation indicator, composite sentiment and the VIX. Forward earnings estimates are still rising, although it may be a warning sign that the net earnings revisions ratio has rolled over. Our Willingness-to-Pay (WTP) indicators continue to send a positive message for stock markets. These indicators track flows, and thus provide information on what investors are actually doing, as opposed to sentiment indexes that track how investors are feeling. Investors often say they are bullish but remain conservative in their asset allocation. The WTP indicators have turned up for the Japanese, Eurozone and U.S. markets, although only the latter is sending a particularly bullish message at the moment. The U.S. WTP has risen above the 0.95 level that historically provides the strongest bullish signal for the stock-to-bond total return ratio. The WTP indicator suggests that, after loading up on bonds last year, investors still have "dry powder" available to buy stocks as risk tolerance improves. Bond valuation is roughly unchanged from last month at close to fair value, as long-term yields have been stuck in a trading range. The Treasury technical indicator suggests that oversold conditions have not yet been fully unwound, suggesting that the next leg of the bear market may take some time to develop. The dollar is extremely expensive based on the PPP measure shown in this section. However, other measures suggest that valuation is not yet at an extreme (see the Overview). Technically overbought conditions are still being unwound according to our dollar technical indictor. 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-4U.S. Stock Market Valuation U.S. Stock Market Valuation U.S. Stock Market Valuation Chart III-5U.S. Earnings U.S. Earnings U.S. Earnings Chart III-6Global Stock Market ##br## And Earnings: Relative Performance Global Stock Market And Earnings: Relative Performance Global Stock Market And Earnings: Relative Performance Chart III-7Global Stock Market ##br## And Earnings: Relative Performance Global Stock Market And Earnings: Relative Performance Global Stock Market And Earnings: Relative Performance FIXED INCOME: Chart III-8U.S. Treasurys And Valuations U.S. Treasurys and Valuations U.S. Treasurys and Valuations Chart III-9U.S. Treasury Indicators U.S. Treasury Indicators U.S. Treasury Indicators Chart III-10Selected U.S. Bond Yields Selected U.S. Bond Yields Selected U.S. Bond Yields Chart III-1110-Year Treasury Yield Components 10-Year Treasury Yield Components 10-Year Treasury Yield Components Chart III-12U.S. Corporate Bonds And Health Monitor U.S. Corporate Bonds And Health Monitor U.S. Corporate Bonds And Health Monitor Chart III-13Global Bonds: Developed Markets Global Bonds: Developed Markets Global Bonds: Developed Markets Chart III-14Global Bonds: Emerging Markets Global Bonds: Emerging Markets Global Bonds: Emerging Markets CURRENCIES: Chart III-15U.S. Dollar And PPP U.S. Dollar And PPP U.S. Dollar And PPP Chart III-16U.S. Dollar And Indicator U.S. Dollar And Indicator U.S. Dollar And Indicator Chart III-17U.S. Dollar Fundamentals U.S. Dollar Fundamentals U.S. Dollar Fundamentals Chart III-18Japanese Yen Technicals Japanese Yen Technicals Japanese Yen Technicals Chart III-19Euro Technicals Euro Technicals Euro Technicals Chart III-20Euro/Yen Technicals Euro/Yen Technicals Euro/Yen Technicals Chart III-21Euro/Pound Technicals Euro/Pound Technicals Euro/Pound Technicals COMMODITIES: Chart III-22Broad Commodity Indicators Broad Commodity Indicators Broad Commodity Indicators Chart III-23Commodity Prices Commodity Prices Commodity Prices Chart III-24Commodity Prices Commodity Prices Commodity Prices Chart III-25Commodity Sentiment Commodity Sentiment Commodity Sentiment Chart III-26Speculative Positioning Speculative Positioning Speculative Positioning ECONOMY: Chart III-27U.S. And Global Macro Backdrop U.S. And Global Macro Backdrop U.S. And Global Macro Backdrop Chart III-28U.S. Macro Snapshot U.S. Macro Snapshot U.S. Macro Snapshot Chart III-29U.S. Growth Outlook U.S. Growth Outlook U.S. Growth Outlook Chart III-30U.S. Cyclical Spending U.S. Cyclical Spending U.S. Cyclical Spending Chart III-31U.S. Labor Market U.S. Labor Market U.S. Labor Market Chart III-32U.S. Consumption U.S. Consumption U.S. Consumption Chart III-33U.S. Housing U.S. Housing U.S. Housing Chart III-34U.S. Debt And Deleveraging U.S. Debt And Deleveraging U.S. Debt And Deleveraging Chart III-35U.S. Financial Conditions U.S. Financial Conditions U.S. Financial Conditions Chart III-36Global Economic Snapshot: Europe Global Economic Snapshot: Europe Global Economic Snapshot: Europe Chart III-37Global Economic Snapshot: China Global Economic Snapshot: China Global Economic Snapshot: China

Highlights Portfolio Strategy Pricing power has improved across a number of industries, with the exception of technology, a necessary development to sustain an overall profit recovery. The S&P railroads index has surged to the point where it will take massive upside earnings surprises to drive additional gains. Profit-taking is appropriate. Telecom services profit drivers have deteriorated significantly of late, and a full shift to underweight is recommended. Recent Changes S&P Railroads Index - Take profits of 22% and downgrade to neutral. S&P Telecom Services Index - Take profits of 6% and downgrade to underweight from overweight. Table 1 Pricing Power Improvement Pricing Power Improvement Feature Chart 1Pricing Power Is Profit Positive... Pricing Power Is Profit Positive... Pricing Power Is Profit Positive... Momentum remains the dominant market force. Fear of missing out is pulling sidelined cash into the market, supported by a decent earnings season to date and rising economic confidence. While consumer inflation expectations remain very low, market-derived inflation expectations have moved up markedly since the U.S. election (Chart 1), a surprising development given the surge in the U.S. dollar. Inflation expectations are back to levels that existed prior to the 2014 kickoff to the U.S. dollar rally. A shift away from deflation worries is supporting a re-pricing of stocks vs. bonds. That trend could continue until the U.S. economy begins to disappoint, potentially causing inflation expectations to retreat. Our pricing power update shows that while deflation remains prevalent, its intensity is fading. We have updated our industry group pricing power (Table 2), which compiles the relevant CPI, PPI, PCE or commodity-data for 60 S&P 500 industry groups. The table also compares those pricing power trends with overall inflation rates to help determine which areas are at a profit advantage or disadvantage. Based on our analysis, the number of groups suffering deflation in selling prices has shrunk to 19 from 23 in our update last September, and 32 last March. In all, 34 out of 60 groups are still unable to raise prices by more than 1%, but that is also an improvement from the 40 out of 60 industries that couldn't keep a 1% price hike pace last September. The bad news is that less than 1/3 have a rising selling price trend, even if the absolute level is negative, down from 50%, and another third has a flat trend. The implication is that upward momentum in pricing power may already be fading. Where is the pricing power improvement? Deep cyclical sectors such as energy and materials account for the lion's share, reflecting higher commodity prices. However, as discussed previously, 6-month growth rates have rolled over (Chart 2), signaling that the unwinding of the negative rate of change shock has run its course. The technology sector is also notable, as several groups are cutting selling prices at a faster clip. Table 2Industry Group Pricing Power Pricing Power Improvement Pricing Power Improvement Defensive sectors such as consumer staples, health care and utilities remain well represented in the positive category, while a reacceleration in consumer discretionary and financials sector selling price increases has boosted interest rate-sensitive sector pricing power (Chart 2). This would suggest that profit advantages continue to reside in these areas, rather than in cyclical sectors. That is confirmed by the uptrend in developed vs. developing market PMIs. This manufacturing gap would presumably widen further if the U.S. ever imposes import taxes. The latter would weaken developing country exports, thereby forcing currency devaluation and hurting capital inflows. Regardless, the PMI divergence reinforces that, in aggregate, cyclical sectors are not as fundamentally well supported as other sectors, and that a highly targeted and selective approach is still the right strategy (the PMI ratio is shown advanced, Chart 3). Even external factors warn against chasing lingering cyclical sector strength. Using the options market, the SKEW index provides a good read on perceived tail risk for the S&P 500. A rise toward 150 indicates significant worries about potential outlier returns. The SKEW has soared in recent weeks, which is often a harbinger of increased equity volatility and defensive vs. cyclical sector strength (Chart 4). Chart 2... But Is Not Broad-Based ... But Is Not Broad-Based ... But Is Not Broad-Based Chart 3Global PMIs Are Signaling Defense First... Global PMIs Are Signaling Defense First... Global PMIs Are Signaling Defense First... Chart 4... As Are Market-Based Indicators ... As Are Market-Based Indicators ... As Are Market-Based Indicators In sum, the broad market has a powerful head of steam and it could be dangerous to stand in its way, but the rally continues to exhibit signs of a late stage blow-off, vulnerable to sudden and sharp corrections. Maintain a healthy dose of non-cyclical exposure to protect against building and potentially sudden downside overall market risks, while being careful in terms of cyclical industry coverage. This week, we are taking advantage of exuberance in the rail space, and reversing our call on the telecom services sector in response to broad-based erosion in profit indicators. Rails Are Now Priced For Perfection For such a mundane and staid industry, railroad stocks have garnered considerable attention of late. Most recently, rumors that railroad maven Hunter Harrison will be installed at CSX to engineer yet another corporate turnaround have spurred a massive buying frenzy. We upgraded the S&P railroads index to overweight on August 1, 2016. Our analysis suggested that analysts and investors had made a full bearish capitulation, slashing long-term growth estimates to deeply negative territory and pushing valuations decisively into the undervalued zone. That pessimism overlooked efforts to cut costs and stabilize profit margins in the face of waning freight growth, setting the stage for a re-rating. While that thesis has worked out, we are concerned that the needle has now swung too far in the other direction, much like what occurred in the air freight industry. The latter had a steep run up only to disappoint newly buoyant expectations. We took air freight profits in late-November, as the soaring U.S. dollar was an anti-reflationary threat to the anticipated recovery in global trade that both investors and the industry had positioned for. Indeed, industry hiring has expanded rapidly (Chart 5). However, hours worked are contracting (Chart 5). Ergo, the hoped for increase global revenue ton miles has not materialized to the extent that was expected (Chart 5). Over-employment is a productivity and profit margin drag, and we were fortunate to take profits before the payback period. We can envision a similar scenario for railroads. There has no doubt been an improvement in freight activity, and there is more in the pipeline. The question is one of degree. Total rail shipment growth has climbed back into positive territory, and our rail shipment diffusion index, which measures the number of freight categories experiencing rising vs. falling growth, is near the 80% level (Chart 6). The key consumer-driven intermodal segment, which accounts for over half of total freight volumes, has finally begun to recover. Rising personal incomes should underpin credit availability and demand, and therefore, spending. The increase in business sales-to-inventories and growth in Los Angeles port traffic also augur well for intermodal shipments (Chart 6). One caveat is that autos represent a large portion of this segment, and pent-up demand has been fully realized at the same time that auto credit quality is beginning to crack. That could keep a lid on the magnitude of the intermodal shipment recovery. Coal volumes have also shown signs of life after a brutal contraction. Coal is a high margin product and another large freight category, and any sustained recovery would provide a meaningful profit boost. Rising natural gas prices typically bode well for coal volumes (Chart 7), via increasing the cost of competing fuels to burn for power generation. However, it is premature to celebrate, because the abnormally warm North American winter may mean that the rebound in electricity production is passed its peak. That would slow the burn rate and keep coal (and natural gas) supplies higher than otherwise would be the case. Chart 5Stay Grounded Stay Grounded Stay Grounded Chart 6Broad-Based Freight Recovery Broad-Based Freight Recovery Broad-Based Freight Recovery Chart 7Coal Is Critical Coal Is Critical Coal Is Critical History shows that pricing power and coal shipment growth are tightly linked. Selling prices have firmed in recent months, but are not at a level that heralds meaningful improvement in return on equity (Chart 8, third panel). True, rising oil prices typically lead to rail companies reinstituting fuel surcharges. But that is profit margin protective, not expansionary, as true pricing power gains come on the back of increased demand and the creation of bottlenecks. It is not clear that such a point has been reached. The Cass Freight Expenditures Index has been flat for several months, signaling that companies do not intend to raise transportation outlays. This series correlates positively with relative forward earnings estimates (Chart 8). That will make it difficult for rail freight to grow faster than GDP (Chart 9), a necessary development to drive earnings outperformance. Meanwhile, productivity gains may be slow to accrue if freight only grows modestly. Weekly train speeds have been stuck in neutral (Chart 8), and the industry may be in the early stages of a capital spending reacceleration. Rail employment growth has jumped in recent months, which is often a leading indicator of investment (Chart 9). If capital spending begins to take a larger share of sales in the coming quarters, then recent investor excitement may ease, leading to a prolonged consolidation phase. After all, valuations are stretched. Over the past two decades, whenever the relative forward P/E has crossed above a 10% premium, relative forward 12-month returns have averaged -4%, and been negative in 4 out of 5 cases. Overheated technical momentum also warns against extrapolating the latest price gains (Chart 10). Chart 8Earnings Will Only Improve Slowly... Earnings Will Only Improve Slowly... Earnings Will Only Improve Slowly... Chart 9... If Capital Spending Re-Accelerated ... If Capital Spending Re-Accelerated ... If Capital Spending Re-Accelerated Chart 10A Profit Recovery Is Discounted A Profit Recovery Is Discounted A Profit Recovery Is Discounted Bottom Line: Take profits of 22% and downgrade the S&P rails index (BLBG: S5RAIL - UNP, CSX, NSCX, KSU) to neutral, as the index appears to be setting up for a 'buy the rumor, sell the news' scenario. Stay neutral on the S&P air freight index (BLBG: S5AIRF - UPS, FDX, CHRW, EXPD). Telecom Services: Can You Hear Me Now? The niche S&P telecom services sector (comprising 3% of the S&P 500) has served our portfolio well, up 6% since inception. However, operating conditions have downshifted and we recommend lightening up a notch and reducing weightings to underweight. There are five factors driving this downgrade: the relative spending profile, sales outlook, margins pressure, interest rates and capital spending trends. First, telecom services personal consumption expenditures (PCE) have sunk anew after a brief attempt to stabilize last year. While consumer spending on telecom services has increasingly become a discretionary item, the improvement in consumer finances and vibrant labor market appear to be generating even more outlays on non-telecom goods and services (top panel, Chart 11). Second, this spending backdrop has undermined the sector sales outlook. Top line growth has retreated to nil, and BCA's telecom services sales-per-share model is signaling that a contraction phase looms (middle panel, Chart 11). Worrisomely, the latest producer price index release revealed that industry pricing power has taken a turn for the worse, which will sustain downward pressure on revenue growth. Third, profit margins are under stress. Selling prices are deflating at a time when the wage bill is still expanding at a mid-single digit rate. The implication is that margins, and thus earnings, are unlikely to improve much in the coming quarters (Chart 12). Chart 11Sales Prospects Have Dimmed Sales Prospects Have Dimmed Sales Prospects Have Dimmed Chart 12Ditto For Profit Ditto For Profit Ditto For Profit Fourth, telecom services is a high yielding sector and the recent sell-off in 10-year Treasurys (UST) is an unwelcome development. When competing investments rise in yield, the allure of telecom carriers diminishes, and vice versa. Chart 13 shows that relative performance momentum and the change in UST yields are inversely correlated, underscoring that as long as the bond market selloff persists relative share price pressures will remain intact. Finally, industry capital expenditures are reaccelerating, which is a short-term negative for profitability. This message is corroborated by the government's construction spending release, which shows a pickup in telecom facilities construction (bottom panel, Chart 13). Taken together with the deteriorating sales backdrop, higher capital spending would be negative for profit margins. While we would normally be reluctant to move an attractively valued sector all the way to underweight (Chart 14), the marked deterioration in these five drivers of relative profitability warrants such an extreme move, regardless of our reticence about the sustainability of the broad market's recent gains. Chart 13Higher Bond Yields Aren't Helping Higher Bond Yields Aren't Helping Higher Bond Yields Aren't Helping Chart 14Technical Breakdown Technical Breakdown Technical Breakdown Our Technical Indicator has crossed decisively into the sell zone, and the share price ratio has failed to break back above its 40-week moving average, providing technical confirmation of a breakdown (Chart 14). Bottom Line: Lock in profits of 6% in the S&P telecom services sector since the Nov 9th, 2015 inception and downgrade exposure all the way to underweight. Current Recommendations Current Trades Size And Style Views Favor small over large caps. Favor growth over value (downgrade alert).

Highlights U.S. policy uncertainty has increased again early in the New Year. President Trump's inaugural speech highlighted that he has not tempered his "America First" policy prescription. The Trump/GOP agenda is still a moving target, but three key risks have emerged for financial markets. A border tax could see a 10% rise in the U.S. dollar. It would also be bearish for global bonds and EM stocks. Position accordingly. Second, President Trump has his sights on China. U.S. presidents face few constraints on the trade and foreign policy side. Investors seem to be under-appreciating the risk of a trade war. Third, the plan to slash Federal government spending could completely offset the fiscal stimulus stemming from the proposed tax cuts and infrastructure spending. The good news is that the major countries, including China, appear to have entered a synchronized growth acceleration. There is more to the equity market rally than a "sugar high". The global profit recession is over and the rebound has been even more impressive than we predicted. As long as any U.S. protectionist policies do not derail the growth acceleration, corporate EPS in the major countries should rival (traditionally overly-optimistic) bottom-up expectations in 2017. The Fed will hike three times this year, one more than is discounted. The Bank of Japan will continue to target a 10-year JGB yield of 0%, but the ECB will begin hinting at another taper in the fall. Our bond team tactically took profits on a short-duration position, but expect to move back to below-benchmark duration before long. The U.S. policy backdrop is very fluid but, for now, the new Administration has boosted confidence and thereby reinforced a global cyclical upswing. As long as protectionist policies implemented this year do not unduly undermine U.S. growth (our base case), then stocks will beat bonds by a wide margin. Investors should consider long VIX positions, but add to equity exposure on dips. Feature It has become a cliché to describe the economic and financial market outlook as "unusually uncertain". Since 2007, investors have had to deal with rolling financial crises, deleveraging, recession, deflation pressures, quantitative easing, negative interest rates, re-regulation, a collapse in oil prices and Brexit. Chart I-1Stocks Decouple From Policy Uncertainty Stocks Decouple From Policy Uncertainty Stocks Decouple From Policy Uncertainty Now, there is Donald Trump. The new President's inaugural speech highlighted that he has not tempered his "America First" policy prescription. Protectionism, de-regulation and tax reform are high on the agenda but details are scant, leaving investors with very little visibility. There are many policy proposals floating around that have conflicting potential effects on financial markets. Which ones will actually be pursued and how will they be prioritized? Is the U.S. prepared to fight a trade war? Is a border tax likely? Will President Trump push for a "Plaza Accord" deal with China? Even the prospect for fiscal stimulus is a moving target because the Trump Administration is reportedly considering a plan to slash Federal spending by $10 trillion over the next decade! Some have described the global equity rally as just a "sugar high" that will soon fade. No doubt, some of the potentially growth-enhancing parts of the Trump agenda have been discounted in risk assets. Given the highly uncertain policy backdrop, it would be easy to recommend that investors err on the side of caution if the U.S. and global economies were still stuck in the mud. The level of the S&P 500 appears elevated based on its relationship with the policy uncertainty index (shown inverted in Chart I-1). Nonetheless, what complicates matters is that there is more to the equity rally than simply hope. Both growth and profits are surprising to the upside in what appears to be a synchronized global upturn. If one could take U.S. policy uncertainty out of the equation, risk assets are in an economic sweet spot where the deflation threat is waning, but inflation is not enough of a threat to warrant removing the monetary punchbowl. Indeed, the Fed will proceed cautiously and official bond purchases will continue through the year in Japan and the Eurozone. We begin this month's Overview with two key protectionist policies being considered that could have important market implications. We then turn to the good news on the economic and earnings front. The conclusion is that we remain positive on risk assets and bearish bonds on a 6-12 month investment horizon. It will likely be a rough ride, but investors should use equity pullbacks to add exposure. Protectionism Risk #1 A U.S. border tax has suddenly emerged on the U.S. policy program. More formally, it is called a destination-based cash flow tax. Under current U.S. law, corporate income taxes are assessed on worldwide profits, which are the difference the between worldwide revenues and worldwide costs. The introduction of a border tax adjustment would change the tax system to one where taxes are assessed only on the difference between domestic revenues and domestic costs (i.e., revenues derived in the U.S. minus costs incurred the U.S.). The mechanics are fairly complicated and we encourage interested clients to read a Special Report on the topic from BCA's Global Investment Strategy service.1 The result would be a significant increase in taxes on imported goods and a reduction in taxes paid by exporters. One benefit is that the border tax would generate a large amount of revenue for the Treasury, which could be used to offset the cost of corporate tax cuts. Another benefit is that the tax change would eliminate the use of international "transfer pricing" strategies that allow American companies to avoid paying tax. In theory, the dollar would appreciate by enough to offset the tax paid by importers and the tax advantage gained by exporters, leaving the trade balance and the distribution of after-tax corporate profits in the economy largely unchanged. A 20% border tax, for example, would require an immediate 25% jump in the dollar to level the playing field! In reality, there are reasons to believe that the dollar's adjustment would not be fully offsetting. First, much depends on how the Fed responds. Second, some central banks would take steps to limit the dollar's ascent. To the extent that the dollar did not rise by the full amount (25% in our example), then the border tax would boost exports and curtail imports. The resulting tailwind for U.S. growth would eventually be reflected in higher inflation to the extent that the economy is already near full employment. The result is that a border tax would be bullish the dollar and bearish for bonds. Our base case is that a 20% border tax would lift the dollar by about 10% over a 12-month period, above and beyond our current forecast of a 5% gain. The 10-year Treasury yield could reach 3% in this scenario. Subjectively, we assign a 50% probability to a border tax being introduced in some form or another, although our sense is that it will be somewhat watered down so as not to generate major dislocations for the economy. It appears that investors are underestimating the likelihood that the U.S. proceeds with this new tax, suggesting that the risks to the dollar and bond yields are to the upside. This is another reason to underweight U.S. bonds relative to Bunds on a currency-hedged basis. For stocks, any growth boost from the border tax would benefit corporate profits, at least until the Fed responded with a faster pace of rate hikes. It is another story for EM equities as a shrinking U.S. trade deficit implies less demand for EM products and shrinking international dollar liquidity. A border tax could be seen as the first volley in a global trade war, souring investor sentiment towards EM stocks. Another major upleg in the U.S. dollar could also spark a financial crisis in some EM countries with current account deficits and substantial dollar-denominated debt. Protectionism Risk #2 Chart I-2Trade War Risk Is Elevated Trade War Risk Is Elevated Trade War Risk Is Elevated While President Trump wants a smaller trade deficit generally, he has his sights on China because of the elevated U.S. bilateral trade deficit (Chart I-2). His choices for Commerce Secretary, National Trade Council and U.S. Trade Representative are all China critics. U.S. presidents face few constraints on the trade and foreign policy side. He can order tariffs on specific goods, or even impose a surcharge on all dutiable goods, as Nixon did in 1971. Congress is unlikely to be a stumbling block. Trump's election was a signal that the U.S. populace wants protectionist policies. His electoral strategy succeeded in great part because of voter demand for protectionism in key Midwestern states. We expect the Trump Administration to give a largely symbolic "shot across China's bow" in the first 100 days, setting the stage for formal trade negotiations in the subsequent months. The initial shot will likely rattle markets. A calming period will follow, but this will only give a false sense of security. The U.S. is in a relatively good negotiating position because China's exports to the U.S. are much larger than U.S. exports to China. However, tensions over the "One China" policy and international access to the South China Sea will greatly complicate the trade negotiations. The bottom line is that there is little hope that U.S./China relations will proceed smoothly.2 A long position in the VIX is prudent given that the market does not appear to be adequately discounting the possibility of a trade war. Synchronized Global Growth Upturn While the U.S. policy backdrop has become more problematic for investors, the global economic and profit picture has brightened considerably. We were predicting a pickup in global growth before last November's election based on our leading indicators and the ebbing of some headwinds that had weighed on economic activity early in 2016. As expected, the manufacturing sector is bouncing back after a protracted inventory destocking phase. The stabilization in commodity prices has given some relief to emerging market manufacturers. The drag on global growth from capex cuts in the energy patch is moderating even though the level of capital spending will contract again in 2017. Moreover, the aggregate fiscal thrust for the advanced economies turned positive in 2016 for the first time in six years. The major countries, including China, appear to have entered a synchronized growth acceleration. The pick-up is confirmed by recent data on industrial production, purchasing managers' surveys and the ZEW survey (Chart I-3). The global ZEW composite has been a good indicator for world earnings revisions and the global stock-to-bond return ratio. The synchronized uptick in global coincident and leading economic data, including business and consumer confidence, suggests that there is more going on than a simple post-election euphoria. Euro Area sentiment measures hooked up at the end of 2016 and the acceleration in growth appears to be broadly based (Chart I-4). A simple model based on the PMI suggests that Eurozone growth could be as much as 2% this year, which is well above trend. Chart I-3Positive Global Indicators bca.bca_mp_2017_02_01_s1_c3 bca.bca_mp_2017_02_01_s1_c3 Chart I-4Euro Area To Beat Growth Estimates Euro Area To Beat Growth Estimates Euro Area To Beat Growth Estimates While Japan will not be a major contributor to overall global growth given its well-known structural economic impediments, the most recent data reveal a slight uptick in consumer confidence, business confidence and the leading economic indicator (Chart I-5). We have noted the impressive rebound in China's leading and coincident growth indicators for some time. Some indicators are consistent with real GDP growth well in excess of the 6.7% official growth figure for 2016 Q4. Both the OECD leading indicator and our proprietary GDP growth model are calling for faster growth in 2017 (Chart I-6). A potential increase in trade or even military tensions between China and the U.S. is a potential risk to this sunny picture. Nonetheless, given what we know about the underlying economy at the moment, China looks poised to deliver another year of solid growth. Chart I-5Even Japanese Sentiment Is Turning Up Even Japanese Sentiment Is Turning Up Even Japanese Sentiment Is Turning Up Chart I-6Upside Risk To China's Growth Upside Risk To China's Growth Upside Risk To China's Growth In the U.S., President Trump appears to be stirring long-dormant animal spirits. CEOs are much more upbeat and several regional Fed surveys indicate a surge in investment intentions (Chart I-7). Spending on capital goods has the potential to soar given the historical relationship with the survey data shown in Chart I-8 (the caveat being that Congress will need to deliver). Even the long depressed small business sector is suddenly more optimistic. The December reading of the NFIB survey showed a spike in confidence, with capital expenditures, hiring plans and overall optimism returning to levels not seen in this expansion. Chart I-7Animal Spirits Reviving In The U.S.... Animal Spirits Reviving In The U.S.... Animal Spirits Reviving In The U.S.... Chart I-8...Which Will Spark Capital Spending ...Which Will Spark Capital Spending ...Which Will Spark Capital Spending There is a good chance that a deal between the White House and Congress on tax reform will occur in the first half of 2017, including a major tax windfall for the business sector that would boost the after-tax rate of return on equity. Nonetheless, past research shows that sustainable capital spending cycles only get underway once businesses see clear evidence that consumer demand is on the upswing. In other words, consumers need to move first. On that score, a number of cyclical tailwinds have aligned for household spending. Credit scores have largely been repaired since the recession and income growth is on track to accelerate (Chart I-9). Despite a moderation in monthly payrolls, overall income growth is likely to stay perky, now that wage gains are on an upward path. And, importantly, various surveys highlight an improvement over the past year in consumer confidence about long-term job prospects. The propensity to spend rather than save is higher when households feel secure in their jobs. Chart I-10 highlights that the saving rate tends to decline when confidence is elevated. The wealth effect from previous equity and housing price gains has been a tailwind for some time but, until now, consumers have held back because it seemed to many that the recession had never ended. Chart I-9Share Of Home Mortgage Borrowers ##br##Who Recovered Pre-Delinquency Credit Score After Foreclosure February 2017 February 2017 Chart I-10Room For U.S. Consumer To Spend Room For U.S. Consumer To Spend Room For U.S. Consumer To Spend In other words, there are increasing signs that the scar tissue from the Great Recession is finally fading, at a time when tax cuts are on the way. We expect that U.S. real GDP growth will be in the 2½-3% range this year with risks to the upside, as long as the Trump Administration does not start a trade war that undermines confidence. Corporate Earnings Liftoff Chart I-11Profits Are Bouncing Back Profits Are Bouncing Back Profits Are Bouncing Back The good news on the economy carries over to corporate earnings. The profit recession is over and the rebound has been even more impressive than we predicted (Chart I-11). Eurozone EPS "went vertical" near the end of 2016. Blended S&P 500 Q4 bottom-up estimates reveal a huge increase in EPS last year to $109 (4-quarter trailing), providing an 8.5% growth rate for 2016 as a whole. The 4-quarter trailing growth figure will likely surge again to 16% in 2017 Q1, even if the sequential EPS figure is flat. Some of the growth acceleration is technical, reflecting a particularly sharp drop in profits at the end of 2015 (which will eventually fall out of the annual growth calculation). Of course, a spike in energy earnings on the back of higher oil prices made a major contribution to the overall growth rate, but there is more to it than that. Consumer Discretionary, Financials and Health Care all posted solid earnings figures last year. Earnings momentum has also picked up in Materials, Real Estate and Utilities, although profit growth in these sectors is benefiting from favorable comparisons. Dollar strength has pushed the U.S. earnings revisions ratio slightly into negative territory, while revisions have surged into positive terrain in the other major markets (Chart I-12). The sharp upturn in our short-term EPS indicators corroborates the more upbeat earnings outlook for at least the next few months (Chart I-13). Chart I-12Earnings Revisions Earnings Revisions Earnings Revisions Chart I-13Short-Term EPS Indicators Are Bullish Short-Term EPS Indicators Are Bullish Short-Term EPS Indicators Are Bullish Our medium-term profit models also paint a constructive picture for equities. These are top-down macro models that include oil prices, exchange rates, industrial production (to capture top-line dynamics), and the difference between nominal GDP and labor compensation (to capture margin effects). Given our more optimistic economic view, the model forecasts for 2017 EPS growth have been revised higher for the global aggregate and each of the major developed markets (Chart I-14). The U.S. is tricky because of the impact of comparison effects that will add volatility to the quarterly growth profile as we move through the year. We are now calling for a 10% gain for 2017 as a whole, which is just shy of the roughly 12% increase expected by bottom-up analysts. This is impressive because actual market expectations are typically well below the perennially-optimistic bottom-up estimates. A 10% EPS growth figure might seem overly optimistic in light of the dollar appreciation that has occurred since last November. Some CEOs will no doubt guide down 2017 estimates during the current earning season. However, in terms of EPS growth, the annual change in the dollar matters more than its level. Chart I-15 shows that the year-over-year rate of change in the dollar is moderating despite the recent rise in the level. This is reflected in a diminishing dollar drag on EPS growth as estimated by our model (bottom panel in Chart I-15). We highlighted in the December 2016 monthly report that it does not require a major growth acceleration to overwhelm the negative impact of a rising dollar on earnings. Chart I-14Medium-Term Profit Models Are Also Bullish Medium-Term Profit Models Are Also Bullish Medium-Term Profit Models Are Also Bullish Chart I-15Dollar Effect On U.S. EPS Dollar Effect On U.S. EPS Dollar Effect On U.S. EPS The models for Japan and the Eurozone point to 2017 EPS growth in the mid-teens. Both are roughly in line with bottom-up estimates which, if confirmed this year, would be quite bullish for stock indexes. Keep in mind that these projections do not include our base case forecast that the U.S. dollar will appreciate by another 5% this year (more if a border tax is enacted). Incorporating a 5% dollar appreciation would trim U.S. EPS growth by 1 percentage point and add the same amount to profit growth in Japan and the Eurozone. The bottom line is that we expect corporate profits to be constructive for global bourses this year. Within an overweight allocation to equities in the advanced economies, we continue to favor the European and Japanese markets versus the U.S. As we discussed in the 2017 Outlook, political risks in the Eurozone are overblown. Currency movements and relative monetary policies will work against U.S. stocks on a relative (currency hedged) basis. FOMC: Hawks Gradually Winning The Debate Fed officials are in a state of quandary over how the policies of the incoming Administration will affect the growth and inflation outlook. Nevertheless, the last FOMC Minutes confirmed that the consensus on the Committee is still shifting in a less dovish/more hawkish direction. The tone of the discussion was decidedly upbeat, especially on the manufacturing and capital spending outlook. "Most" of the meeting participants felt that the U.S. economy has reached full employment, although there is still an ongoing debate on the benefits and costs of allowing the unemployment rate to temporarily move below estimates of full employment. Running the economy "hot" for a while might draw more discouraged workers back into the workforce and thereby expand the supply side of the economy. Other members, however, highlight that past attempts by the Fed to fine tune the economy in this way have always ended in recession. Our view is that the FOMC will not follow the Bank of Japan's example and explicitly target a temporary inflation overshoot. Conversely, the Fed will not attempt to pre-emptively offset any forthcoming fiscal stimulus either (if indeed there is any net fiscal stimulus). Policymakers will watch the labor market and, especially, wage and price inflation to guide them on the appropriate pace of rate hikes. Core PCE inflation is roughly 30 basis points below target and has only edged erratically higher over the past year. The pickup in shelter inflation has been largely offset by falling core goods prices, reflecting previous dollar strength. We expect shelter inflation to soon flatten off, but goods prices will continue to contract if the dollar rises by another 5% this year. Year-ago comparison effects will also depress the annual rate of change over the next couple of months. However, the key to the underlying inflation trend will be wage pressures, which are most highly correlated with the non-shelter part of the service component. Up until recently, the structural and cyclical forces acting on wage gains were pulling in the same downward direction. Structural factors include automation and population aging; as high-paid older workers leave the workforce, the vast majority of new entrants to full-time employment do so at below-median wages, putting downward pressure on median earnings growth.3 These structural factors will not disappear anytime soon, but the cyclical forces have clearly shifted. The main measures of U.S. wage growth are all trending higher. Excess labor market slack appears to have been largely absorbed. Only the number of people working part time for economic reasons suggests that there is some residual slack remaining. To what extent will cyclical wage pressures exert upward pressure on inflation? That will depend on the ability of companies to raise prices in order to protect profit margins. Wage inflation trends do not lead, and sometimes diverge from, inflation in goods and services. Theory suggests that there is a two-way relationship between wages and prices. Sometimes inflation starts in the labor market and spills over into consumer prices (cost-push inflation), and sometimes it is the other way around (demand-pull inflation). At the moment, the corporate sector appears to have limited ability to pass on rising wage costs. Balancing off the opposing factors, we believe that core PCE inflation will grind higher and should be near the 2% target by year end. This would end the Fed's debate over whether to run the economy hot, helping to keep upward pressure on Treasury yields. Bond Bear To Return Chart I-16Watch Bond Technicals To Short Again Watch Bond Technicals To Short Again Watch Bond Technicals To Short Again Global yields troughed a full four months before the U.S. election. As discussed above, the U.S. and global economies were showing signs of increased vigor even before Trump won the Presidency. The new President's policies reinforce the bond-bearish backdrop, especially protectionism and fiscal stimulus, at a time when the economy is already near full employment. Long-term inflation expectations imbedded in bond yields have shifted up in recent months across the major markets. Real yields have been volatile, but generally have not changed much from late last year. We remain modest bond bears over a 6-12 month horizon. Inflation and inflation expectations will continue to grind higher in the major markets and we expect the FOMC to deliver three rate hikes in 2017, one more than is discounted in the Treasury market. A rise in 10-year TIPS breakevens into a range that is consistent with the Fed's 2% inflation target (2.4%-2.5% based on history) would be a strong signal that the Fed will soon lift the 'dot plot.' ECB bond purchases will limit the increases in the real component of core European yields, but any additional weakness in the euro would result in a rise in European inflation. The ECB was able to announce a tapering of monthly purchases last year while avoiding a bond rout by extending the QE program to the end of 2017, but this will be more difficult to pull off again if inflation is on the rise and growth remains above-trend this year. We expect the ECB to provide hints in September that it will further taper its QE program early in 2018. Thus, the Eurozone bond market could take over from U.S. Treasurys as the main driver of the global bond bear market late in 2017. The Japanese economy is also performing impressively well, reducing the probability of a "helicopter drop" policy. The dollar's surge has depressed the yen and lifted inflation expectations, relieving some pressure on PM Abe to ramp up fiscal spending beyond what is already included in the supplementary budgets. In any event, the BoJ will keep the 10-year yield pinned near to zero, limiting the upside for bond yields to some extent in the other major bond markets. That said, we are neutral on JGBs, not overweight, because most of the yield curve is in negative territory. We remain overweight Bunds versus both Treasurys and JGBs on a currency-hedged basis. In terms of the duration call, our bond strategists felt in early December that the global bond selloff had progressed too far, too fast (Chart I-16). They recommended temporarily taking profits on short-duration positons and shifting to benchmark, which turned out to be excellent timing. Yields have drifted lower since then and the technicals have improved enough to warrant shifting back to below-benchmark duration. Investment Conclusions Chart I-17A Better Growth ##br##Backdrop For USD Strength A Better Growth Backdrop For USD Strength A Better Growth Backdrop For USD Strength Equity markets have gone into a holding pattern as investors weigh heightened U.S. policy risk against the improving profit and global macro backdrop. The latter appears to have broken the Fed policy loop that had been in place for some time. Expectations for a less dovish Fed helped to drive the dollar and Treasury yields higher late in 2016. But, rather than sparking a correction in risk assets as has been the case in recent years, stock indexes surged to new highs (Chart I-17). The difference this time is that there has been a meaningful improvement in the growth and profit outlook that has overwhelmed the negative impact of a stronger dollar and higher borrowing rates. The protectionist policies currently being considered are clearly dollar bullish, and bearish for global bonds and EM stocks. Investors should be positioned accordingly. It is more complicated for stocks. The passing of a major tax reform package would no doubt buttress the budding revival in private sector animal spirits, but a nasty trade war has the potential to do the opposite. The multitude of policy proposals floating around greatly complicate asset allocation. It is a very fluid situation but, for now, the new Administration has boosted confidence and thereby reinforced a global cyclical upswing. As long as protectionist policies implemented this year do not unduly undermine global growth (our base case), then corporate earnings growth will be solid in 2017 and stocks will beat bonds by a wide margin. We wish to be clear, though, that equities are on the expensive side in most of the main markets. This means that overweighting equities and underweighting cash and bonds in a balanced global portfolio is essentially playing an equity overshoot. It may end badly, but the overshoot is likely to persist for as long as the economic and profit upswing persists. Investors should consider long VIX positions, but add to equity exposure on dips. Our view on corporate bonds is unchanged this month. Poor value and deteriorating corporate balance sheet health make it difficult to recommend anything more than a benchmark position in the U.S. relative to Treasurys. However, investors can pick up a little spread in the Eurozone corporate bond market, where balance sheet health is better and the ECB is soaking up supply. Mark McClellan Senior Vice President The Bank Credit Analyst January 26, 2017 Next Report: February 23, 2017 1 U.S. Border Adjustment Tax: A Potential Monster Issue for 2017. BCA Global Investment Strategy service, January 20, 2017. 2 For more information, please see: Trump, Day one: Let the Trade War Begin. BCA Geopolitical Strategy Weekly Report, January 18, 2017. 3 For more information in the structural and cyclical wage pressures, please see: U.S. Wage Growth: Paid in Full? U.S. Investment Strategy Service, November 28, 2016. II. Global Debt Titanic Collides With Fed Iceberg? The spike in bond yields since the U.S. election has focussed investor attention on the economic implications of higher borrowing costs. In this world of nose-bleed debt levels, it seems self-evident that certain parts of the global economy will be ultra-sensitive to rising rates. The "cash flow" effect on debt service is a headwind for growth as rising interest payments trim the cash available to spend on goods and services. Some market commentators believe that the Fed will not be able to raise interest rates much because the cash-flow effect will be so severe this time that it will quickly derail the economic expansion. However, a number of factors make projecting interest payments complicated, such that back-of-the-envelope estimates are quite misleading. In order to provide a sense of the size of the cash-flow effect, in this Special Report we estimate the sensitivity of interest payments to changes in borrowing rates in the corporate, household and government sectors for four of the major economies. The key finding is that interest burdens will rise only modestly, and from a low level, over the next couple of years even if borrowing rates increase immediately by 100 basis points from today's levels. It would require a 300 basis point jump to really "move the dial". Interest rate shocks are more dramatic for the Japanese government interest burden due to the size of the JGB debt mountain, but much of the interest payments would simply make the round trip to the Bank of Japan and back again. We are not downplaying the risks posed by the rapid accumulation of debt since the Great Recession. Rather, our aim is to provide investors with a sense of the debt-service implications of a further rise in borrowing rates. Our main point is that the cash-flow effect of higher interest rates should not be included in the list of reasons for believing that Fed officials will be quickly thwarted if they proceed with their rate hike plan over the next couple of years. Investors are justifiably worried that the bond selloff will get ahead of itself, spark an economic setback and a corresponding flight out of risk assets. After all, there have been several head fakes during this recovery during which rising bond yields on the back of improving data and optimism were followed by an economic soft patch and a risk-off phase in financial markets. In this world of nose-bleed debt levels, it seems self-evident that certain parts of the global economy will be ultra-sensitive to rising rates. Indeed, global debt has swollen by 41½ percentage points of GDP since 2007 (Chart II-1). Households, corporations and governments tried to deleverage simultaneously to varying degrees in the major countries since the Great Recession and Financial Crisis, but few have been successful. Households in the U.S., U.K., Spain and Ireland have managed to reduce the level of debt relative to income. U.K. and Japanese corporations are also less geared today relative to 2007. Outside of these areas, leverage has generally increased in the private and public sectors (see Chart II-2 and the Appendix Charts beginning on page 37). The astonishing pile-up of debt in China has been particularly alarming for the investment community (Chart II-3). Chart II-1Leverage Has Increased Since 2007 Leverage Has Increased Since 2007 Leverage Has Increased Since 2007 Chart II-2Leverage In Advanced Economies Leverage In Advanced Economies Leverage In Advanced Economies Chart II-3China's Alarming Debt Pile-Up China's Alarming Debt Pile-Up China's Alarming Debt Pile-Up Governments can be excused to some extent for continuing to run fiscal deficits because automatic stabilizers require extra spending on social programs when unemployment is high. Fiscal policy was forced to at least partially offset the drain on aggregate demand from private sector deleveraging, or risk a replay of the Great Depression. More generally, history shows that it is extremely difficult for any one sector or country to deleverage when other sectors and countries are doing the same. The slow rate of nominal income growth makes the job that much harder. Borrowing Rates And The Economy There are several ways in which higher borrowing rates can affect the economy. Households will be incentivized to save rather than spend at the margin. Borrowing costs surpass hurdle rates for new investment projects, causing the business sector to trim capital spending. Uncertainty associated with rising rates might also undermine confidence for both households and firms, reinforcing the negative impact on demand. Banks, fearing a growth slowdown ahead and rising delinquencies, may tighten lending standards and thereby limit credit availability. These negative forces are normally a headwind for growth, but not something that outweighs the positive Keynesian dynamics of rising wages, profits and employment until real borrowing rates reach high levels. However, if the neutral or "equilibrium" level of interest rate is still extremely low today, then it may not require much of a rise in market rates to tip the economy over. A lot depends on confidence, which has been quite fragile in the post-Lehman world. The "cash flow" effect on debt service is another headwind for growth as rising interest payments trim the cash available to spend on goods and services. For the government sector, a swelling interest burden will add to the budget deficit and may place pressure on the fiscal authorities to cut back on spending in other areas. Some market commentators believe that the Fed will not be able to raise interest rates much because the cash-flow effect will quickly derail the expansion in the U.S. and potentially in other countries as the Treasury market selloff drags up yields across the global bond market. This is an argument that has circulated at the beginning of every Fed tightening cycle as far back as we can remember. Some even predict that central banks will be forced to use financial repression for an extended period to prevent the interest burden from skyrocketing and thereby short-circuiting the economic expansion. Back-of-the-envelope estimates that simply apply a 100 or 200 basis point increase in borrowing rates to the level of outstanding debt, for example, imply a shocking rise in the debt service burdens. Fed rate hikes could be analogous to the iceberg that took down the Titanic in 1912. Key Drivers Of Interest Sensitivity However, back-of-the-envelope calculations like the one described above paint an overly pessimistic picture for three reasons. First, the starting point for debt service burdens in the corporate, household and government sectors is low (Chart II-4). These burdens have generally trended down since 2007 because falling interest rates have more than offset debt accumulation, with the major exception of China.1 Second, the maturity distribution of debt means that it takes time for interest rate shifts to filter into debt servicing costs. For example, the average maturity of corporate investment-grade bond indexes in the major economies is between 3 and 12 years (Chart II-5). The average maturity of government indexes range from 7½ to 16 years. Moreover, the majority of household debt is related to fixed-rate mortgages. Even a significant portion of consumer debt is fixed for 5-years and more in some countries. Households have been extending the maturity structure of their debt in recent decades (Chart II-5, bottom panel). Chart II-4Debt Service Has Generally Declined Debt Service Has Generally Declined Debt Service Has Generally Declined Chart II-5Average Maturity Of Debt Is Long Average Maturity Of Debt Is Long Average Maturity Of Debt Is Long Third, even following the backup in yield curves since the U.S. election, current interest rates on new loans are still significantly below average rates on outstanding household loans, corporate debt and government debt. The implication is that most older loans and bonds coming due over the next few years will be rolled over at a lower rate compared to the loans and bonds being replaced. This will even be true if current yield curves shift up by 100 basis points in many cases (except for the U.S. where current yields are closer to average coupon and loan rates). In this Special Report, we estimate the sensitivity of interest payments to changes in borrowing rates in the corporate, household and government sectors for four of the major economies. We could not include China in this month's analysis because data limitations precluded any degree of accuracy, but the sheer size of China's debt mountain justifies continued research in this area. The key finding is that interest burdens will rise only modestly, and from a low level, over the next couple of years even if borrowing rates rise immediately by 100 basis points from today's levels. It would require a 300 basis point rise in yield curves to really "move the dial" in terms of the cash-flow impact on spending. An interest rate shock of that size would be particularly dramatic for the Japanese government interest burden given the size of its debt mountain, but much of the interest payments would simply make the round trip to the Bank of Japan and back again. Consumer Sector U.S. households have worked hard at deleveraging since their net worth was devastated by the housing bust. Still, the overall debt-to-income level is elevated by historical standards. U.S. household leverage has generally trended higher since the Second World War and has been a source of angst for investors as far back as the late 1950s. Yet, we find no evidence that U.S. consumers have become more sensitive to changes in borrowing rates over the decades.2 This counter-intuitive result partially reflects the fact that consumers have partially insulated themselves from rising interest rates by adopting a greater proportion of fixed-rate debt. The bottom panel of Chart II-6 presents the two-year change in debt service payments expressed as a percent of income (i.e. the swing or the "cash flow" effect). The fact that these swings have not grown over time suggest that the cash-flow effect of changes in interest rates on debt service has not increased.3 Chart II-6U.S. Consumers Have Not Become More Sensitive To Interest Rates U.S. Consumers Have Not Become More Sensitive To Interest Rates U.S. Consumers Have Not Become More Sensitive To Interest Rates Another way to demonstrate this point is to compare disposable income growth with a measure of "discretionary" disposable income that subtracts debt service payments (Chart II-6, top panel). This is the amount of money left over after debt servicing to purchase goods and services. The annual rate of growth in disposable income and discretionary income are nearly identical. In other words, growth in spending power is determined almost exclusively by changes in the components of income (wages, hours and employment). Moreover, the fact that some households are net receivers of interest income provides some offset to rising interest payments for other households when rates go up. This conclusion applies to households in the other major countries as well. Charts II-7 to II-10 present projections for household interest payments as a percent of GDP under three scenarios: no change in yield curves, an immediate 100 basis point parallel shift up in the yield curve and a 300 basis point shift. Assuming an immediate increase in yields across the curve is overly blunt, but the scenarios are only meant to provide a sense of how much interest payments could rise on a medium-term horizon (say, one to five years). The exact timing is less important. Chart II-7U.S. Household Sector Interest Payment Projection U.S. Household Sector Interest Payment Projection U.S. Household Sector Interest Payment Projection Chart II-8U.K. Household Sector Interest Payment Projection U.K. Household Sector Interest Payment Projection U.K. Household Sector Interest Payment Projection Chart II-9Japan Household Sector Interest Payment Projection Japan Household Sector Interest Payment Projection Japan Household Sector Interest Payment Projection Chart II-10Eurozone Household Sector Interest Payment Projection Eurozone Household Sector Interest Payment Projection Eurozone Household Sector Interest Payment Projection Unsurprisingly, household interest payments as a fraction of GDP are flat-to-slightly lower in "no change" interest rate scenario for the major countries. The interest burden increases by roughly 1 percentage point in the 100 basis point shock, although the level remains well below the pre-Lehman peak in the U.S., U.K. and Eurozone. In Japan, the interest payments ratio returns to levels last seen in the late 1990s, although this is not particularly onerous. A 300 basis point shock would see interest burdens ramp up to near, or above, the pre-Lehman peak in all economies except in the U.K. For the latter, borrowing rates would still be below the 2007 peak even if they rise by 300 basis points from current levels. This scenario would see the household interest burden surge well above 3% of GDP in Japan, a level that exceeds the entire history of the Japanese series back to the early 1990s. Also shown in the bottom panel of Chart II-7, Chart II-8, Chart II-9, Chart II-10 is the associated 2-year swing in interest expense as a percent of GDP under the three scenarios. The 2-year swing moves into positive (i.e. restrictive) territory for all economies under the 100 basis point shock, although they remain in line with previous monetary tightening cycles. It is only for the 300 basis point scenario that the cash-flow effect appears threatening in terms of consumer spending power over the next two years. Corporate Sector The starting point for interest payments and overall debt-service in the corporate sector is also quite low by historical standards, although less so in the U.S. Falling interest rates have been partially offset by the rapid accumulation of American company debt in recent years. We modeled national accounts data for non-financial corporate interest paid using the stock of corporate bonds, loans and (where relevant) commercial paper, together with the associated interest or coupon rates. The model simply sums interest payments across these types of debt to generate a grand total, after accounting for the maturity structure of the loans and debt. Chart II-11, Chart II-12, Chart II-13 and Chart II-14 present the three yield curve scenarios for corporate interest payments. The interest burden is flat-to-somewhat lower if yield curves are unchanged, as old loans and bonds continue to roll over at today's depressed levels. Even if market yields jump by 100 basis points tomorrow, the resulting interest burdens would rise roughly back to 2012-2014 levels in the U.S., Eurozone and the U.K., which would still be quite low by historical standards. The resulting two-year cash-flow effect is modest overall. The rate increase feeds into corporate interest payments somewhat more quickly in the Eurozone and Japan because of the relatively shorter average maturity of the corporate debt market, but a shock of this size does not appear threatening to either economy. Chart II-11U.S. Corporate Sector Interest Payment Projection U.S. Corporate Sector Interest Payment Projection U.S. Corporate Sector Interest Payment Projection Chart II-12U.K. Corporate Sector Interest Payment Projection U.K. Corporate Sector Interest Payment Projection U.K. Corporate Sector Interest Payment Projection Chart II-13Eurozone Corporate Sector Interest Payment Projection Eurozone Corporate Sector Interest Payment Projection Eurozone Corporate Sector Interest Payment Projection Chart II-14Japan Corporate Sector Interest Payment Projection Japan Corporate Sector Interest Payment Projection Japan Corporate Sector Interest Payment Projection It is a different story if yields rise by 300 basis points. The interest ratio approaches previous peaks set in the 2000s in the U.S. and Eurozone. The interest ratio rises sharply for the U.K. corporate sector as well, although it stays below the 2000 peak because interest rates were even higher 17 years ago. Japanese companies would also feel significant pain as the interest ratio rises back to where it was in the late 1990s. Government Sector Government finances are not at much risk from a modest increase in bond yields either (Chart II-15). We focus on the level of the interest burden rather than the cash-flow effect for the government sector since changes in interest payments probably have less impact on governments' near-term spending plans than is the case for the private sector. Chart II-15Government Sector Interest Payment Projection Government Sector Interest Payment Projection Government Sector Interest Payment Projection As discussed above, Treasury departments in the U.K., Eurozone and Japan have taken advantage of ultra-low borrowing rates by extending the average maturity of public debt. The average maturity of the Barclays U.K. government bond index has extended to 16 years, while it is close to 10 years in Japan and the Eurozone (Chart II-5). The U.S. Treasury has not followed suit; the Barclays U.S. index is about 7½ years in maturity. The lengthy average maturity means that index coupon rates will continue to fall for years to come if rates are unchanged in the U.K., Japan and the Eurozone, resulting in a declining interest burden. Even if rates rise by another 100 basis points, the interest burden is roughly flat as a percent of GDP for the U.K. and Eurozone, and rises only modestly in Japan. The limited impact reflects the fact that the starting point for current yields is well below the average coupon on the stock of government debt. In contrast, the U.S. interest burden is roughly flat in the "no change" scenario, and rises by a half percentage point by 2025 in the 100 basis point shock scenario. Keep in mind that we took the neutral assumption that the stock of government debt grows at the same pace as nominal GDP growth. This assumes that governments deal effectively with the impact of aging populations on entitlement programs in the coming years. As many studies have shown, debt levels will balloon if entitlements are not adjusted and/or taxes are not raised to cover rising health care and pension costs. We do not wish to downplay this long-term risk, but we are focused on the impact of higher interest rates on interest expense over the next five years for the purposes of this Special Report. As with the household and corporate sectors, the pain becomes much more serious in the event of a 300 basis point rise in interest rates. Interest payments rise by about 1 percentage point of GDP in the U.S. and U.K. to high levels by historically standards. It takes a decade for the full effect to unfold, although the ratios rise quickly in the early years as the short-term debt adjusts rapidly to the higher rate environment. For the Eurozone, the roughly 100 basis points rise takes the level of the interest burden back to about 2003 levels (i.e. it does not exceed the previous peak). Given Japan's extremely high government debt-to-GDP ratio, it is not surprising that a 300 basis point rise in interest rates would generate a whopping surge in the interest burden from near zero to almost 5% of GDP by the middle of the next decade. Nonetheless, this paints an overly pessimistic picture for two reasons. First, the Bank of Japan is likely to hold short-term rates close to zero for years as the authorities struggle to reach the 2% inflation target. This means that only long-term JGB yields have room to move higher in the event of a continued global bond selloff. Second, 40% of the JGB market is held by the central bank and this proportion will continue to rise until the Bank of Japan's QE program ends. Interest paid to the BoJ simply flows back to the Ministry of Finance. The net interest payments data used in our analysis are provided by the OECD. These data net out interest payments made between all arms of the government except for the central bank. The implication is that rising global bond yields in the coming years will not place the Japanese government under any fiscal strain. The same is true in the U.S., U.K. and Eurozone, where the respective central banks also hold a large portion of the stock of government debt (although this conclusion does not necessarily apply to the peripheral European governments). Conclusion The spike in bond yields since the U.S. election has focussed investor attention on the economic implications of higher borrowing costs given the sea of debt that has accumulated. As discussed in our 2017 BCA Outlook, we believe that the secular bond bull market is over but foresee only a gradual uptrend in yields in the coming years. Inflation is likely to remain subdued in the major countries and bond supply will continue to be absorbed by the ECB and Bank of Japan. The stock of government bonds available to the private sector will drop by $750 billion in 2017 for the U.S., Eurozone, Japan and the U.K. as a group. This follows a contraction of $546 billion in 2016. Forward guidance from the BoJ and ECB will also help to cap the upside for global bond yields. Still, we believe that the combination of gradually rising U.S. inflation, Fed rate hikes and the Trump fiscal stimulus plan will push Treasury yields above current forward rates in 2017. Other bond markets will outperform in local currency terms, but will suffer losses via contagion from the U.S. Despite the dizzying amount of debt accumulated since the Great Recession, it does not appear that debt service will sink the economies of the advanced economies as the Fed continues to normalize U.S. monetary policy. Debt service will rise from a low starting point and the swing in interest payments as a percent of GDP is unlikely to exceed previous cycles on a 2-year horizon for a 100 basis point rise in yields. The level of the interest payments/GDP ratio should not exceed previous peaks in most cases. The picture is much more threatening if yields were to surge by 300 basis points over the next couple of years, although this scenario would require an unexpected acceleration of inflation in the U.S. and/or the other advanced economies. We are not making the case that the buildup of debt is benign. Academic research has linked excessive leverage with slower trend economic growth and a higher risk of financial crisis. For governments, elevated debt can result in a rising risk premium that will crowd out spending in important areas, such as health and pensions, in the long run. For consumers and the corporate sector, excessive leverage could result in financial distress and a spike in defaults in the next downturn, reinforcing the contraction in output. The Bank for International Settlements agrees: "Increased household indebtedness, in and of itself, is not likely to be the source of a negative shock to the economy. Rather the primary macroeconomic implication of higher debt levels will be to amplify shocks to the economy coming from other sources, particularly those that affect household incomes, most notably rises in unemployment." 4 Debt lies at the heart of BCA's longstanding Debt Supercycle thesis. For several decades, the willingness of both lenders and borrowers to embrace credit was a lubricant for economic growth and rising asset prices and, importantly, underpinned the effectiveness for monetary policy. During times of economic and/or financial stress, it was relatively easy for the Fed and other central banks to improve the situation by engineering a new credit upcycle. That all ended with the 2007-09 meltdown. Since then, even zero policy rates have been unable to trigger a strong revival in private credit growth in the major developed countries because the starting point for leverage is already elevated. Growth headwinds finally appear to be ebbing, at least in the U.S., prompting the FOMC to begin the process of "normalizing" short-term interest rates. The U.S. economy could suffer another setback in 2017 for a number of reasons. Nonetheless, the key point of this report is that the cash-flow effect of rising interest rates should not be included in the list of reasons for believing that Fed officials will be quickly thwarted if they proceed with their rate hike plan over the next couple of years. Mark McClellan Senior Vice President The Bank Credit Analyst 1 For China, the BIS only provides an estimate of the debt service ratio for the household and non-financial corporate sectors combined. 2 See: U.S. Consumer Titanic Meets the Fed Iceberg? The BCA U.S. Fixed Income Analyst, July 2004. 3 The absence of a rise in volatility of the cash flow effect is partly due to the decline in, and the volatility of, interest rates after the 1980s. 4 Guy Debelle, "Household Debt and the Macroeconomy," BIS Quarterly Review, March 2004. Appendix Charts Chart II-16, Chart II-17, Chart II-18, Chart II-19 Chart II-16U.S. Debt By Sector U.S. Debt By Sector U.S. Debt By Sector Chart II-17U.K. Debt By Sector U.K. Debt By Sector U.K. Debt By Sector Chart II-18Japan Debt By Sector Japan Debt By Sector Japan Debt By Sector Chart II-19Euro Area Debt By Sector Euro Area Debt By Sector Euro Area Debt By Sector III. Indicators And Reference Charts Global equities have been in a holding pattern so far in 2017, consolidating the gains made at the end of last year. Our key equity indicators are mixed at the moment. The Valuation indicator continues to hover at about a half standard deviation on the expensive side. The effect of the rise in global equity indexes late last year on valuation was offset by a surge in profits. Stocks are not cheap but, at this level, valuation not a roadblock to further price gains. Our Monetary indicator deteriorated further over the past couple of months, driven by a stronger dollar and higher bond yields. A shift in this indicator below the zero line would be negative for stock markets. Sentiment is also frothy, which is bearish from a contrary perspective, although our Technical indicator is positive. Our Willingness-to-Pay (WTP) indicators continue to send a positive message for stock markets. These indicators track flows, and thus provide information on what investors are actually doing, as opposed to sentiment indexes that track how investors are feeling. Investors often say they are bullish but remain conservative in their asset allocation. The WTP indicators have all turned higher from a low level for the Japanese, the European and the U.S. markets. This suggests that investors, after loading up on bonds last year, have "dry powder" available to buy stocks as risk tolerance improves. The U.S. WTP has risen the fastest and is closing in on the 0.95 level. Our tests show that, historically, investors would have reaped impressive gains if they had over-weighted stocks versus bonds when the WTP was rising and reached 0.95. The WTPs suggest that the U.S. market should outperform the Eurozone and Japanese markets in the near term, although for macro reasons we still believe the U.S. will lag the other two. We expect the global stock-to-bond total return ratio to rise through this year. The latest selloff has pushed U.S. Treasurys slightly into "inexpensive" territory based on our Valuation model. Bonds are still technically oversold and sentiment remains bullish, suggesting that the consolidation phase may last a little longer. Nonetheless, we expect to recommend short-duration positions again once the overbought conditions unwind. The U.S. dollar is near previous secular peaks according to our valuation measure. Nonetheless, policy divergences are likely to drive the U.S. dollar to new valuation highs before the bull market is over. Technically overbought conditions have almost unwound, clearing the way for the next leg of the dollar bull run. Commodities have been on a tear on the back of improving and synchronized growth across the major countries (and some dollar weakness very recently). The commodity price outlook is clouded by the prospect of a border tax, which could send the U.S. dollar soaring. The broad commodity market is also approaching overbought levels. The cyclical growth outlook is positive for commodity demand, although supply factors favor oil to base metals. 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-4U.S. Stock Market Valuation U.S. Stock Market Valuation U.S. Stock Market Valuation Chart III-5U.S. Earnings U.S. Earnings U.S. Earnings Chart III-6Global Stock Market And Earnings: ##br##Relative Performance Global Stock Market And Earnings: Relative Performance Global Stock Market And Earnings: Relative Performance Chart III-7Global 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-8U.S. Treasurys And Valuations U.S. Treasurys and Valuations U.S. Treasurys and Valuations Chart III-9U.S. Treasury Indicators U.S. Treasury Indicators U.S. Treasury Indicators Chart III-10Selected U.S. Bond Yields Selected U.S. Bond Yields Selected U.S. Bond Yields Chart III-1110-Year Treasury Yield Components 10-Year Treasury Yield Components 10-Year Treasury Yield Components Chart III-12U.S. Corporate Bonds And Health Monitor U.S. Corporate Bonds And Health Monitor U.S. Corporate Bonds And Health Monitor Chart III-13Global Bonds: Developed Markets Global Bonds: Developed Markets Global Bonds: Developed Markets Chart III-14Global Bonds: Emerging Markets Global Bonds: Emerging Markets Global Bonds: Emerging Markets CURRENCIES: Chart III-15U.S. Dollar And PPP U.S. Dollar And PPP U.S. Dollar And PPP Chart III-16U.S. Dollar And Indicator U.S. Dollar And Indicator U.S. Dollar And Indicator Chart III-17U.S. Dollar Fundamentals U.S. Dollar Fundamentals U.S. Dollar Fundamentals Chart III-18Japanese Yen Technicals Japanese Yen Technicals Japanese Yen Technicals Chart III-20Euro/Yen Technicals Euro/Yen Technicals Euro/Yen Technicals Chart III-19Euro Technicals Euro Technicals Euro Technicals Chart III-21Euro/Pound Technicals Euro/Pound Technicals Euro/Pound Technicals COMMODITIES: Chart III-22Broad Commodity Indicators Broad Commodity Indicators Broad Commodity Indicators Chart III-23Commodity Prices Commodity Prices Commodity Prices Chart III-24Commodity Prices Commodity Prices Commodity Prices Chart III-25Commodity Sentiment Commodity Sentiment Commodity Sentiment Chart III-26Speculative Positioning Speculative Positioning Speculative Positioning ECONOMY: Chart III-27U.S. And Global Macro Backdrop U.S. And Global Macro Backdrop U.S. And Global Macro Backdrop Chart III-28U.S. Macro Snapshot U.S. Macro Snapshot U.S. Macro Snapshot Chart III-29U.S. Growth Outlook U.S. Growth Outlook U.S. Growth Outlook Chart III-30U.S. Cyclical Spending U.S. Cyclical Spending U.S. Cyclical Spending Chart III-31U.S. Labor Market U.S. Labor Market U.S. Labor Market Chart III-32U.S. Consumption U.S. Consumption U.S. Consumption Chart III-33U.S. Housing U.S. Housing U.S. Housing Chart III-34U.S. Debt And Deleveraging U.S. Debt And Deleveraging U.S. Debt And Deleveraging Chart III-35U.S. Financial Conditions U.S. Financial Conditions U.S. Financial Conditions Chart III-36Global Economic Snapshot: Europe Global Economic Snapshot: Europe Global Economic Snapshot: Europe Chart III-37Global Economic Snapshot: China Global Economic Snapshot: China Global Economic Snapshot: China Mark McClellan Senior Vice President The Bank Credit Analyst

Highlights Portfolio Strategy Media stocks are poised to challenge previous relative performance highs as sales growth reaccelerates. Stay overweight. The materials sector has lagged behind the commodity price rally, a sign of underlying weakness rather than latent strength. Chemicals overcapacity will remain a headwind until U.S. competitiveness improves. Stay clear. Recent Changes There are no changes to our portfolio this week. Table 1Sector Performance Returns (%) The "IF" Rally The "IF" Rally Feature The broad market has been very strong since the November election. While advance/decline lines have firmed, participation in the rally has been uneven and may be fraying around the edges. For example, the number of groups trading above their 40-week moving average has been diverging negatively from the broad market in the last few months, suggesting diminishing breadth (Chart 1). In fact, the industrials (I) and financials (F) sectors have carried the market since November. Other deep cyclical sectors, such as energy, materials and tech, have mostly matched market performance. The 'IF' rally is based on an expected upgrade to the economic growth plane that matches the surge in various sentiment gauges. If validation does not occur, then the IF rally will become iffy indeed, unless sector breadth improves. Last week we showed that market cap-to-GDP was so far above its long-term average that even if nominal growth boomed at 8% per annum for the next five years this valuation ratio would still not have normalized. That valuation backdrop may not upend additional short-term market momentum, but it is a true measure of just how bullish sentiment has become and should be a critical input to the portfolio construction process, because of its warning about divergences from fundamental supports. Another unconventional sentiment gauge is observed from sub-surface market patterns. Chart 1 shows that the number of defensive groups with a positive 52-week rate of change, in relative terms, is in freefall, plunged to virtually nil. In the last two decades, investors eschewing capital preservation and non-cyclical sectors so aggressively has typically preceded major market peaks (Chart 1). The steep drop in the put/call ratio confirms that euphoria and greed are trumping mistrust and fear. The put/call ratio has recently bounced, but is well below levels that signal investors are accumulating significant portfolio protection. The Fed's tightening bias, contracting U.S. dollar-based financial liquidity amid the strong U.S. dollar all threaten to keep a lid on corporate sector sales prospects. As such, we remain biased toward non-cyclical and consumer sectors, even excluding fiscal policy uncertainty. Chart 2 shows that these areas are in a base-building phase, in relative terms, following their post-election drubbing. We expect momentum to steadily build toward sustained outperformance by midyear. Conversely, a reversal in the 'IF' sectors already appears to be developing, while other capital spending-dependent sectors are unable to gain momentum (Chart 3). This week we highlight both a winning group and an area we expect to disappoint. Chart 1The Rally Is Fraying Around The Edges The Rally Is Fraying Around The Edges The Rally Is Fraying Around The Edges Chart 2Defensive Base-Building? Defensive Base-Building? Defensive Base-Building? Chart 3Cyclical Sector Distribution Cyclical Sector Distribution Cyclical Sector Distribution New Highs Ahead For Media While the consumer discretionary sector has a poor track record during Fed tightening cycles, the S&P media sub-component can buck this trend. Media stocks outperformed in the second half of the 1990s and also trended higher in the 1980s while the Fed was tightening. The key was the U.S. dollar (Chart 4). As long as the dollar was strong, media companies sustained a profit advantage over the rest of the corporate sector owing to limited external exposure. A replay is currently playing out, and has the potential to persist for at least the next few quarters based on upbeat cyclical indicators. Media sales growth is in recovery mode. Consumers have significantly boosted spending on media services, as measured by personal consumption expenditures data (Chart 5). Pricing power has surged in response to demand strength (Chart 5, bottom panel). In turn, strong demand is boosting measures of productivity: our proxy for sales/employment is accelerating toward the double-digit growth zone (Chart 5). Productivity is diverging positively from relative forward earnings expectations, implying there is room for a re-rating. As long as the U.S. economy is growing, media companies should be able to garner an increasing share of consumer wallets. Chart 6 shows that real spending on media services has been in a steady uptrend for well over a decade, reflecting its ability to continually innovate, only pausing during recessions when consumers are forced to retrench. Typically, a rise in spending pulls up pricing power (Chart 6). Chart 4Media Stocks Like Dollar Strength Media Stocks Like Dollar Strength Media Stocks Like Dollar Strength Chart 5Sales Are Set To Accelerate Sales Are Set To Accelerate Sales Are Set To Accelerate Chart 6Secular Strength Secular Strength Secular Strength All of this has spurred a recovery in media cash flow growth (Chart 7, top panel). Relative performance and cash flow move hand-in-hand. Rising cash flows also imply that the media sector can further reduce shares outstanding through buybacks and/or M&A activity (Chart 7), bolstering ROE. The S&P movies & entertainment index has been one of the driving forces behind the broader media index recovery. We upgraded the former to overweight after the vicious selloff related to Disney's ESPN woes and the takeover saga at Viacom had pushed the index to an undervalued extreme. While slightly early, this upgrade is now paying off (Chart 8). The expectations hurdle remains surmountable. Both forward earnings and sales growth estimates are deeply negative (Chart 8), reflecting the well-known cooling in cable subscriber growth. But even here, there is room for potential upside surprises. Consumer spending on recreation has been growing at a low single-digit clip, but the surge in consumer confidence, courtesy of rising wage growth and a positive wealth effect from rising real estate and financial asset prices, should support increased discretionary consumer spending. The message from the jump in the ISM services index is bullish for recreation spending (Chart 9, second panel). Chart 7Shareholder-Friendly Shareholder-Friendly Shareholder-Friendly Chart 8Cheap With Low Expectations Cheap With Low Expectations Cheap With Low Expectations Chart 9Still Early In The Recovery Still Early In The Recovery Still Early In The Recovery In turn, faster spending would support ongoing pricing power gains (Chart 9). The industry is already sporting one of the most robust selling price increases of all that we track, as advertising rate inflation is growing anew. Importantly, real outlays on cable services have recovered after a steep decline (Chart 9), suggesting that the drag from disappointing cable subscriber growth and cord cutting may be easing. Less churn implies more pricing power. Content cost inflation also remains under wraps. The implication is that the fundamental forces to propel a retest of previous relative performance highs are in place. Technical conditions are also sending a bullish signal. Cyclical momentum, as measured by the 52-week rate of change, is on the cusp of breaking into positive territory (Chart 9), while the share price ratio has already crossed decisively above key resistance at its 40-week moving average. A dual breakout would confirm a new bull trend. Bottom Line: Media stocks have good odds of retesting previous relative performance highs as discretionary consumer spending perks up. Stay overweight the overall media group, and the S&P movies and entertainment index in particular. Chemical Stocks: A Toxic Portfolio Blend The commodity price recovery has not carried over into the S&P materials sector, as relative performance has been moving laterally for much of the last twelve months. Rather than view this as an opportunity to play catch up, the more likely outcome is that the sector has missed its chance to outperform. In fact, downside risks have intensified. The strong U.S. dollar will exact a toll on U.S. exporters, particularly if emerging markets and China do not experience accelerating final demand. While there has been a massive amount of stimulus in China over the past 18 months, the thrust of that impulse is fading. Fiscal spending growth has dropped sharply and the authorities trying to cool rampant real estate speculation. The yield curve remains flat (Chart 10), as local funding costs rise on the back of the authorities attempt to mitigate capital outflows, and loan demand remains weak. Persistent weakness in the Chinese currency may reflect a lack of confidence in local returns, i.e. sub-par growth. All of that argues against expecting a major impetus to raw materials demand, at a time when the materials sector total wage bill is inflating more aggressively. Our Cyclical Macro Indicator for the materials sector is hitting new lows (Chart 10), heralding earnings underperformance, underscoring that below-benchmark allocations remain appropriate. The S&P chemicals group represents for than 70% of the overall materials market cap. It has underperformed since its peak and our underweight call in 2014, pulled lower by the soaring U.S. dollar and sagging industry productivity (Chart 11). Net earnings revisions have been consistently revised lower over the past few years, and are unlikely to recover without a reflationary push (global real yields are shown inverted, second panel, Chart 11) that revives chemical final demand. Analysts have latched on to the firming in global purchasing manager survey sentiment, aggressively pushing up sales growth expectations in recent months (Chart 12). Clearly, manufacturing sector expansion is expected to reverse the contraction in chemical output growth (Chart 12). Chart 10Higher PMIs Are Not Enough Higher PMIs Are Not Enough Higher PMIs Are Not Enough Chart 11Higher Yields Are A Bad Omen Higher Yields Are A Bad Omen Higher Yields Are A Bad Omen Chart 12Expectations Are Inflated Expectations Are Inflated Expectations Are Inflated However, this may be yet another case of analysts chronically overestimating the industry's earnings power. Global manufacturing improvement seems likely to accrue mostly to firms outside the U.S. Chart 13 shows that chemicals relative performance is heavily influenced by the U.S. dollar. Valuations and sentiment are tightly linked with chemical export growth (Chart 13), as the latter represent 14% of total U.S. exports. The U.S. dollar surge is diverting orders away from U.S. manufacturers: German chemical new orders have surged, and the IFO survey of chemical industry executives signals optimism about the future (Chart 14). Chart 13The Dollar Is Hurting The U.S. ... The Dollar Is Hurting The U.S. ... The Dollar Is Hurting The U.S. ... Chart 14... But Helping Foreign Competitors ... But Helping Foreign Competitors ... But Helping Foreign Competitors U.S. executives appear to be equally confident, but that optimism is misplaced. The American Chemical Council expects U.S. chemical exports to increase 7% a year through 2021. Over $170B is expected to be invested in U.S. chemical manufacturing capacity, representing nearly 25% of the total industry size, which is anticipated to boost the chemical trade surplus to new records. So far, roughly $76B of projects has either been completed or is under construction. If these planned projects all come to fruition, our concern is that new capacity will be idle rather than productive. The industry is in the crosshairs of anti-globalization and protectionism, and a strong U.S. dollar and rising domestic cost structures threaten to reduce competitiveness. Chemical imports are a fairly large portion of sales, rendering profitability vulnerable should an import-tax ever be introduced. From a cyclical standpoint, deflationary pressures are already very acute. Chemical capacity is growing much faster than production, warning that pricing power will be under significant pressure (Chart 15). Many chemical products are destined for interest rate-sensitive end markets such as autos, underscoring that a Fed tightening cycle is a headwind. While capacity expansion was planned when interest rates and feedstock costs were expected to remain at rock bottom levels for the foreseeable future, this is no longer the case. Chemical companies can either use natural gas (ethane) or oil (naphtha) as a primary feedstock. U.S. production is largely ethane-based, while global capacity is geared to naphtha. Rising U.S. natural gas prices are undermining the U.S. input cost advantage (Chart 16). Chart 15Persistent Deflation Pressures Persistent Deflation Pressures Persistent Deflation Pressures Chart 16U.S. Cost Structures Are Unattractive U.S. Cost Structures Are Unattractive U.S. Cost Structures Are Unattractive Increased capacity has also put significant upward pressure on wage costs, as our proxy for the total wage bill is rising at a high single-digit rate (Chart 16). With capital spending slated to stay robust in the coming years, it will likely continue to take a larger share of sales, impairing profit margins. While the planned merger between heavyweights Dow Chemical and Dupont may eventually help to rationalize costs, this is a necessary but not sufficient step in the face of a loss of global market share. Without accelerating sales, U.S. chemical makers will be hard pressed to improve productivity sufficiently to reverse the slide in relative forward earnings estimates. Bottom Line: The S&P materials sector hasn't been able to outperform during a period of improving global manufacturing activity, raising doubts about its performance potential when global output growth inevitably slows. Part of this reflects the challenging outlook for the sector heavyweight chemicals index, and we recommend staying underweight both. The symbols for the stocks in this index are: BLBG: S5CHEM - APD, ARG, CF, DOW, EMN, ECL, DD, FMC, IFF, LYB, MON, MOS, PPG, PX, SHW. Current Recommendations Current Trades Size And Style Views Favor small over large caps. Favor growth over value (downgrade alert).

Highlights BCA's U.S. Equity Strategy team would like to wish our clients a healthy, happy and prosperous New Year. Portfolio Strategy The growth vs. value style bias is due for a bounce, but beyond the near run, the outlook has become more balanced. Stick with a small vs. large cap bias for the time being, but get ready to book profits if domestic wage inflation continues to accelerate. Buy into the health care facilities sell-off. Value is surfacing as profit margin pressures subside. Recent Changes S&P 1500 Health Care Facilities - Boost to overweight today. Downgrade Alert Growth vs. Value - Downgrade alert. Table 1Sector Performance Returns (%) Contrarian Alert: Reflation Is Reversing Contrarian Alert: Reflation Is Reversing Feature Stocks look poised to maintain their momentum-fueled march higher into yearend, seemingly impervious to potential profit backlash from tightening monetary conditions, a more hawkish Fed and/or overheating sentiment. Sellers are holding back in anticipation of lower tax rates next year. In fact, our Composite Sentiment Gauge has surged to extremely bullish levels (Chart 1). This gauge comprises surveys of traders, individuals and investment professional sentiment. Overtly bullish readings have been a reliable contrary indication of building tactical risks, although not foolproof. The broad market has returned nearly 80%, excluding dividends, since the beginning of 2012, and over 5% since election night in November. Lately, earnings expectations have increased their contribution to the market's return, but the vast majority of the gains over the last five years can be explained by multiple expansion. Soaring median industry price/sales ratios are consistent with lopsidedly optimistic sentiment (Chart 1). Now that the Fed has signaled its intention to steadily raise interest rates in 2017, a critical question is whether profits can take over the reins from liquidity as the main market driver, at least partially validating the valuation increase? On this front, our confidence level is low. Profit margins are steadily narrowing. Our profit margin proxy is not signaling any imminent relief (Chart 2). With labor costs rising, faster sales are needed to halt the squeeze. But U.S. dollar appreciation is a significant headwind to top-line performance, given that 45% of sales come from abroad. As hedges fall off, the impact on 2017 revenue will become increasingly meaningful. Corporate debt levels are disturbingly high, in absolute terms and as a share of GDP (Chart 2, bottom panel). If borrowing costs continue to climb, then it will be hard for companies to turn expansionist, potentially offsetting any benefit from a reduced tax rate. Against this backdrop, it is difficult to envision a robust rebound in corporate profits. Our confidence level would be higher if monetary conditions were still reflationary. Instead, our Reflation Gauge (RG), a combination of oil prices, Treasury yields and the U.S. dollar, has plummeted at its fastest rate ever (Chart 3)! The speed and ferociousness of the plunge underscores the economic need for a massive and imminent fiscal offset. Chart 1Sentiment Is Overheating Sentiment Is Overheating Sentiment Is Overheating Chart 2Stiff Headwinds For The Corporate Sector Stiff Headwinds For The Corporate Sector Stiff Headwinds For The Corporate Sector Chart 3Reflation Is Dead Reflation Is Dead Reflation Is Dead The RG leads both equity sentiment and the U.S. Economic Surprise Index (ESI, Chart 3). If economic activity begins to disappoint in the coming months, i.e. before any meaningful fiscal stimulus arrives, there is a window of risk for the equity market because valuations will narrow as optimism fades, especially in those sectors that have gone vertical since the U.S. election. Keep in mind, last week we showed that typical Fed tightening cycles augur well for non-cyclical sector relative performance on a 12 and 24 month horizon. Surprisingly, financials and utilities have also managed to at least keep pace with the broad market, with cyclical sectors lagging behind overall market returns. The bottom line is that a number of objective indicators are signaling that the post-election rally will hit turbulence, perhaps in the first quarter of the New Year. Investors would be well served from a cyclical perspective to take advantage of value creation in defensive sectors while reaping any windfalls received in deep cyclical sectors. Will Growth Vs. Value Recover? The sudden surge in the financials and industrials sector has caused a sharp correction in the growth vs. value (G/V) share price ratio. The scope of the move has been both powerful and unnerving, catching many off guard, including us. Is this the start of a value renaissance after nearly eight years of growth stock dominance? History shows that sustained rotations into the value complex require validation from strengthening global economic growth. We have shown in previous research that G/V share price momentum is negatively correlated with the growth in durable goods orders, house prices and profits, i.e. when these variables accelerate, growth underperforms value. By virtue of the improvement in our global PMI composite (Chart 4), it would be easy to conclude that value stocks are coming back in vogue. Financials, energy and industrials account for over 50% of the value composite. These sectors only comprise roughly 15% of the growth benchmark. In addition, the technology sector weighs in at one third of the growth index, while representing only 8% of the value cohort. In addition, consumer discretionary and health care also represent about the same weight as technology in the growth composite, but only contribute about half that in the value index. It is no wonder that rising bond yields and hopes for a fiscal stimulus bonanza have triggered such a violent G/V reaction. While we are sympathetic to this view, extrapolating the last six weeks to continue over the next six months is dangerous. Much of the Treasury yield advance has been driven by inflation expectations. Global real yields are up, but not by as much as share prices have discounted (Chart 5). That is not surprising, as the soaring U.S. dollar is a deflationary force, and heralds a sharp rebound in the G/V ratio (Chart 5, top panel). Chart 4A Vicious Correction... A Vicious Correction... A Vicious Correction... Chart 5... That May Soon Reverse ... That May Soon Reverse ... That May Soon Reverse U.S. currency strength will make it difficult for developing economies to service large foreign debt obligations and could drain domestic liquidity if they are forced to sell foreign exchange reserves to defend their currencies. It is notable that EM capital spending is virtually nil in real terms, and their share prices are underperforming the global benchmark by a wide margin (Chart 5). Our Global Economic Diffusion Index has crested (Chart 5, shown inverted), perhaps picking up emerging market sluggishness. Unless the U.S. dollar begins to weaken, it is premature to forecast robust economic growth in the coming quarters, thereby raising some skepticism about the durability of the value stock rebound. The objective message from our Cyclical Macro Indicators for the growth vs. value style is slowly shifting from bullish to neutral, and the pricing power advantage no longer exists (Chart 6). However, the latter is an unwinding of the rate of change shock in the commodity complex rather than renewed demand-driven pricing power gains in the deep cyclical space. From a longer-term perspective, growth stocks should stay well supported by the increase in long-term earnings growth expectations (Chart 7). When the latter are rising, growth stocks tend to enjoy multiple expansion relative to value shares. Moreover, if equity volatility perks up on uncertainty over the path and pace of future fiscal policy and a more hawkish Fed, then growth stocks should receive another source of natural support. The VIX and G/V indices tend to correlate positively over time (Chart 7). Chart 6Mixed Signals Mixed Signals Mixed Signals Chart 7Structural Supports Structural Supports Structural Supports In sum, choosing value over growth is not a slam dunk, nor is forecasting a recovery to new highs in the G/V ratio given the large sector weightings discrepancies. Rather, a reflex rally in the G/V ratio is probable as post-election financials/industrials sector enthusiasm wanes, with a lateral move thereafter. Bottom Line: We will likely recommend moving to a neutral style bias over the coming weeks/months from our current growth vs. value stance, but expect to do so from a position of strength. A Revival In Small Business Animal Spirits? A broad-based and powerful rotation into small caps has occurred, as all the major small cap sectors have surged relative to their large cap counterparts (Chart 8), flattering our current stance. Small caps fit nicely into one of our overriding longer-term themes, namely favoring domestic over global industries. Small companies are typically domestically-geared regardless of geography, underscoring that if anti-globalization trends pick up steam, this theme could gain traction around the world. The potential for U.S. corporate tax cuts has provided another source of domestic company enthusiasm, because multinationals already have low effective tax rates. However, these developments are not assured, details remain scant, and chasing small cap relative performance on that basis alone could be a mistake from a tactical perspective. We have noted that we would recommend profit taking if evidence of a reversal in the small vs. large cap profit outlook materialized. Recent labor market and pricing power data are slightly worrying. The NFIB survey of the small business sector showed that planned labor compensation is still diverging markedly from the overall employment cost index (Chart 9, second panel). While reported price changes have also nudged higher, the discrepancy in labor cost gauges may be signaling that the massive profit margin gap between small and large companies will not be quick to close (Chart 9, bottom panel). Still, the overall NFIB survey was strong, and suggests that animal spirits in the small business sector may finally be reawakening (Chart 10, second panel). The latter may reflect an easing in worries about government red tape, excessive bureaucracy and health care costs. Chart 8Broad-based Small Cap Outperformance Broad-based Small Cap Outperformance Broad-based Small Cap Outperformance Chart 9Yellow Flag For Margins Yellow Flag For Margins Yellow Flag For Margins Chart 10Overbought, But Not Overvalued Overbought, But Not Overvalued Overbought, But Not Overvalued These sentiment shifts may allow extremely overbought technical conditions for the relative share price ratio to persist for a while longer (Chart 10, middle panel), particularly if the Trump honeymoon phase for the overall market lasts until early in the New Year. Importantly, there is no meaningful valuation roadblock at the moment (Chart 10). From a longer-term perspective, however, it is notable that the share price ratio is trading well above one standard deviation from its mean. Such a stretched technical level warns against getting too comfortable with small caps. In fact, the share price ratio is tracing out a pattern similar to the early-1980s (Chart 11), when it enjoyed a brief run to new highs in 1983 on the back of similar aspirations of meaningful fiscal thrust and as the U.S. dollar sprang higher. However, that surge was short-lived and in hindsight, was a blow-off top that marked the beginning of a massive underperformance phase. Chart 11The Big Picture The Big Picture The Big Picture Bottom Line: Stick with a small/large cap bias for now, but get ready to take profits if the relative profit margin outlook does not soon improve. Buy Into Health Care Facilities Weakness Rapid sub-surface market gyrations are creating attractive value in a number of areas, particularly in the defensive health care sector. In particular, we downshifted our view on the S&P health care facilities index at mid-year, because consumer spending on health care was decelerating, which favored moving into equities that paid for medical services (managed care) vs. those that provided them. While that trend remains intact, health care facilities stocks appear to be discounting an extreme scenario. The current concern is that the Affordable Care Act (ACA) will be repealed, leaving hospitals to foot the bill for uninsured patients. While such a scenario would potentially reverse the decline in the provision for doubtful accounts (PDA, Chart 12), a major profit margin support, the ACA is more likely to be reworked than repealed especially in the absence of a replacement plan. Importantly, there are other offsets. PDA follows the unemployment rate, which is signaling that the former will decline further. Hospital cost inflation is beginning to recede, led by drug costs (Chart 12). Physician services costs and inflation in other medical supplies is also subsiding. Health care facilities have also reduced capital spending in a bid to protect profit margins. Construction data show that hospitals have eased back on the throttle significantly (Chart 13). A shift to a profit margin preservation mentality is confirmed by the sharp reduction in headcount growth and decline in total wage inflation (Chart 13). Labor cost control provides another positive profit margin support, over and above the fillip from the reacceleration in hospital pricing power (Chart 13). Consumers are allocating an increasing portion of their spending to hospitals, which provides confidence that pricing power gains will stick. It would take massive earnings downgrades to validate the pessimism embedded in current valuations (Chart 14). Technical conditions argue that the sell-off is overshooting. The share price ratio has made new lows, but cyclical momentum is diverging positively. Given that this group is traditionally a strong U.S. dollar winner (Chart 14, top panel), there is scope for a playable relative performance rally in the coming six months. Chart 12Hospital Costs Are Easing... Hospital Costs Are Easing... Hospital Costs Are Easing... Chart 13... While Sales Improve ... While Sales Improve ... While Sales Improve Chart 14Dirt Cheap Dirt Cheap Dirt Cheap Bottom Line: Augment the S&P 1500 health care facilities index (BLBG: S15HCFA - HCA, UHS, WOOF, HLS, LPNT, SEM, SCAI, THC, ENSG, USPH, KND, CYH, QHC) to overweight. Current Recommendations Current Trades Size And Style Views Favor small over large caps. Favor growth over value (downgrade alert).