Cyclicals vs Defensives

Highlights Portfolio Strategy Boost restaurant stocks to neutral, as same-store sales should improve next year. A further upgrade requires evidence of top-line traction. The exodus from health care stocks represents an overreaction rather than a downshift in fundamental forces. Stay long. Recent Changes S&P Restaurants Index - Upgrade to neutral for a profit of 9%. Table 1 Profits: Is Less Bad Good Enough? Profits: Is Less Bad Good Enough? Feature Equity market buoyancy remains a liquidity rather than an earnings story. Fed commentary and the trend in global bond yields, a reflection of the global central bank narrative, continue to exert an outsize influence on short-term price action and momentum. In the background, earnings are a wildcard. Companies may be surpassing beaten down third quarter estimates, but the path of profits over the next several quarters is by no means assured and will determine the durability of any stock market advance. Even excluding the persistent drag from narrowing profit margins, courtesy of falling productivity and increasing unit labor costs, it is dangerous to look at the corporate profit outlook through rose colored glasses. The low level of economic growth, both at home and abroad, represents a major hurdle to the corporate sector. Total business sales have climbed back up to zero, but it is premature to forecast meaningful growth ahead based on moribund global export growth (Chart 1), and/or leading economic indicators. After all, sales growth has been virtually non-existent for years, reinforcing that earnings per share have been driven by cost cutting and buybacks. While measured consumer price inflation has crept higher, corporate sector pricing power remains virtually non-existent. The producer price index is still deflating, despite the rally in oil prices. U.S. import prices are very weak (Chart 1). The negative global credit impulse warns that there is still no impetus to reinvigorate final demand, and by extension, global profits (Chart 1). It is hard to envision an economic reacceleration as long as the corporate sector is more inclined to retrench than expand, as heralded by stressed balance sheets and weak durable goods orders (Chart 2). Chart 3 shows BCA's two U.S. profit models. The first one is based on reflationary variables, such as the dollar, bond yields and oil prices. It is designed to predict the trend in forward earnings momentum. This model has troughed, but is not signaling any upside ahead in already exuberant analyst earnings estimates (Chart 3, second panel). Chart 1Without Sales Growth... bca.uses_wr_2016_10_24_c1 bca.uses_wr_2016_10_24_c1 Chart 2... And Rising Costs... bca.uses_wr_2016_10_24_c2 bca.uses_wr_2016_10_24_c2 Chart 3... How Much Can Profits Improve? ... How Much Can Profits Improve? ... How Much Can Profits Improve? The second model looks at macro data such as new orders, labor costs and productivity growth to forecast the trend in actual operating earnings. This model is slightly more optimistic (Chart 3, bottom panel), and signals a decisive end to the profit contraction, albeit not a growth rate sufficient to satisfy double-digit analysts forecasts or rich valuations. The U.S. dollar is a major wildcard, as any sustained strength would compromise earnings. Typically, major profit expansions only occur after the currency begins to depreciate and labor cost inflation ebbs (Chart 2). The late-1990s was an exception, as profits climbed alongside the currency and amidst rising wage inflation (Chart 2). However, that was during an economic and credit boom, two key factors that are conspicuously absent at the moment. Nevertheless, as discussed in past Weekly Reports, the flood of central bank liquidity could sustain the overshoot in equity prices for a while longer. Investors have demonstrated a willingness to look through soggy profits as long as the liquidity taps remain open. Despite the possibility of a stubbornly resilient broad market, we do not recommend interpreting it as a sign of economic vitality, and consider it high risk. Our portfolio strategy is based on expected sectoral earnings trends, as liquidity is subject to the whims of central bankers. We recommend a largely defensive sector portfolio, with some exceptions, as discussed in last week's Special Report. Our cyclical exposure remains confined to consumption-oriented plays; this week we are lifting our view on restaurants. Restaurants: Buying Into Weakness Investors have gravitated toward washed out deep cyclical sectors rather than consumption-oriented plays in recent months. However, we doubt this trend has staying power, as outlined in our Special Report last week. Consequently, it is time to revisit the outlook for shunned consumer sectors, such as restaurants. This year's exodus from casual dining stocks has been justified on the basis of overvaluation and deteriorating industry performance. The National Association of Restaurants (NAR) survey of current performance has dipped into negative territory (Chart 4), as restaurant operators have reported a decrease in traffic. One of the major drags on restaurant same-store sales has been the gap in restaurant inflation compared with the cost of food inflation for eating at home. Relative inflation has soared (Chart 5). That has caused relative spending growth at restaurants vs. at home dining to drop sharply, in real (volumes) terms. However, next year could be different. If the inflation gap falls, as predicted by the decline in relative spending (Chart 5), then restaurant traffic should stabilize. Importantly, the odds of budgets for dining out being pruned even further are low. As long as wages and salaries growth is decent and consumer income expectations are firm, consumers should still allocate a rising share to restaurants relative to eating at home (Chart 5). There is plenty of scope for relative restaurant spending to rise on a secular basis (Chart 5, bottom panel). Clearly, if relative spending were to reaccelerate too quickly, then the inflation gap would stay wide, and same-store sales growth would stay punk. That is a risk to an optimistic view of future restaurant traffic. But the good news is that cost structures are being realigned to a more subdued sales run rate. The NAR survey shows that staffing plans are on the wane. That leads restaurant labor cost inflation (Chart 4). As the largest source of expenses, any decline in headcount would be welcome given that minimum wages in a number of states are set to climb next year. In any case, the most potent profit elixir would be a recovery in top-line growth, sourced both domestically and from abroad. Restaurant sales growth has been unimpressive for the past several years. Subdued pricing power gains, and until recently, lackluster income growth among lower income consumers have weighed on revenue growth. The good news is that consumer confidence among low income earners is on the upswing (Chart 6), which bodes well for casual dining out in the coming quarters. If our bearish view on refiners and gasoline prices continues to pan out, then a windfall from lower fuel prices may further bolster the outlook. Chart 4Expenses Set To Ease bca.uses_wr_2016_10_24_c4 bca.uses_wr_2016_10_24_c4 Chart 5Inflation Gap Should Narrow bca.uses_wr_2016_10_24_c5 bca.uses_wr_2016_10_24_c5 Chart 6Sales Set To Stabilize... bca.uses_wr_2016_10_24_c6 bca.uses_wr_2016_10_24_c6 In addition, restaurant retail sales often follow the trend in the wealth effect (Chart 7). The latter has pulled back this year, owing to the equity market consolidation and house price correction. However, financial wealth gains are rebounding, and provided the stock market does not suffer a sustained swoon, consumers' feeling of affluence may soon be bolstered. Even marginal improvements in store traffic should be impactful to same-store sales. Restaurant chains have been in retrenchment mode since the Great Recession. Construction activity is historically low, which implies limited capacity expansion (Chart 7). Contribution from abroad may become less of a drag. The industry garners roughly 67% of sales from overseas. The strong U.S. dollar, particularly against emerging market currencies, has deprived the industry of sales strength. Moreover, even in domestic currency terms, emerging markets consumption has been through a difficult period, as the Asian Hotel and Restaurant Activity Proxy spent most of the last year in negative territory (Chart 8). But EM currencies have stabilized and Asian restaurant activity has climbed back into positive territory in recent months. The upshot is that foreign revenue could make up any lingering domestic sales slack. All of this suggests that leaning into share price weakness in anticipation of improved prospects next year makes sense. Nevertheless, the S&P restaurants index does not warrant a full shift from underweight to overweight. There could still be earnings/headline risk given lackluster readings in coincident activity indicators, despite McDonald's earnings beat last week. Valuations are not cheap. On a normalized basis, the relative forward P/E ratio has dropped below its average, but still trades at a premium to the broad market. A return to above average levels is possible if operating margins expand on the back of sales improvement (Chart 9), thereby sparking higher return on equity, but it may be too soon to position for such an outcome. Chart 7... Or Even Improve In 2017 bca.uses_wr_2016_10_24_c7 bca.uses_wr_2016_10_24_c7 Chart 8End Of Foreign Drag bca.uses_wr_2016_10_24_c8 bca.uses_wr_2016_10_24_c8 Chart 9Still Not Dirt Cheap bca.uses_wr_2016_10_24_c9 bca.uses_wr_2016_10_24_c9 Bottom Line: Lift the S&P restaurant index (BLBG: S5REST - MCD, SBUX, YUM, CMG, DRI) to neutral from underweight, locking in a profit of 9% since our underweight recommendation last November. Health Care Crunch: Buying Opportunity Or Trend Change? The speed at which the health care sector has sunk toward the bottom end of this year's trading range has unnerved many investors. In fact, the sector has dropped back down to the levels where we added it to our high conviction overweight list. The question now is whether our positive views still hold, and whether would we add here if we weren't long already, or if something more sinister is at work? The hit to health care stocks reflects a rise in risk premiums related to concerns that the U.S. government will exert more control over price setting if the Democrats win the election rather than any immediate downshift in relative forward earnings drivers. While it is impossible to forecast with any precision to what extent pricing models may or may not change, the political appetite may be low for another overhaul of the sector so soon after the Affordable Care Act was implemented. Regardless, several observations suggest that the sector may already be undershooting, i.e. a Democratic victory is already discounted. Relative performance has experienced a clear uptrend over the last forty years, with cyclical swings oscillating around its upward sloping trend-line (Chart 10). It would be extremely rare for a bull phase to peak prior to hitting at least one standard deviation above trend. Instead, the price ratio hit trend and is now not far above one standard deviation below trend, a level one would normally equate with an economic boom when capital flowed to high-beta sectors. Cyclical technical measures also point to an undershoot. Our Technical Indicator has hit an oversold extreme (Chart 11), signaling that the sell-off is in the late stages. Our relative advance/decline line has also stayed firm, suggesting that the decline in the overall sector has not been broad-based (Chart 11). Chart 10Time To Buy, Not Sell bca.uses_wr_2016_10_24_c10 bca.uses_wr_2016_10_24_c10 Chart 11Buying Opportunity Buying Opportunity Buying Opportunity Whether a wholesale flight from the sector, and all defensives in general, looms is largely contingent on the path of inflation expectations, which have been in a multiyear decline. This trend reflects anemic global final demand and the repercussions from over-indebtedness. Lately, inflation expectations have firmed, but that may largely reflect the rebound in oil prices courtesy of hopes for an OPEC production cut, given the lack of confirming indicators of growth acceleration and renewed strength in the U.S. dollar. The latter is testing the top end of its recent range (Chart 11, shown inverted, bottom panel), and it would be highly unusual for inflation expectations to rise concurrent with the U.S. dollar. In a world of zero interest rates and limited aggregate demand strength, a strong currency is deflationary, especially for corporate profits. Those conditions keep bond yields low, and push capital into long duration sectors. Once the election is over, attention will refocus on the relative forward earnings outlook. Our Indicators suggest that earnings momentum will stay positive. Our health care sector pricing power proxy has rebounded after cooling from red-hot levels, and is still much stronger than overall corporate sector pricing (Chart 12, second panel). That is confirmed by the pharmaceuticals producer price index, and employment cost index for health insurance, i.e. pricing strength is broad-based. There is still scant evidence of a downshift in consumer spending patterns in reaction to rising health care sector inflation. Real (volumes) personal spending on health care goods and services continues to grow at a mid-single digit rate, well in excess of the rate of overall consumption (Chart 12). That is consistent with ongoing earnings outperformance. As noted in past research, the time to forecast negative relative earnings momentum is when consumers balk at higher prices. So far, a few high profile cases of exorbitant drug price increases have grabbed the spotlight, but in aggregate, consumers are not voting with their wallets. The biggest tangible negative for the health care sector may be that shares outstanding are no longer falling (Chart 13). That mirrors overall buyback activity, which has cooled markedly on the back of balance sheet deterioration and waning free cash flow. We doubt the supply of health care stocks is going to rise much, however, because the sector is in good financial shape, earning healthy returns and is not dependent on external financing. Chart 12Demand Driven Pricing Power Gains Demand Driven Pricing Power Gains Demand Driven Pricing Power Gains Chart 13Buybacks Are Dwindling bca.uses_wr_2016_10_24_c13 bca.uses_wr_2016_10_24_c13 Bottom Line: Health care sector risk premiums have climbed in response to polling results, but an apolitical check on relative earnings drivers and valuations points to a buying opportunity. Current Recommendations Current Trades Size And Style Views Favor small over large caps and growth over value.

Highlights The path of the least resistance for the U.S. dollar is up; this has far-reaching implications for monetary policy, global growth dynamics and asset prices. Dollar strength reinforces our view to overweight defensives vs. cyclicals and is a headwind to overall S&P 500 profits. Most of the gap between core CPI and core PCE can be explained by the medical care component. Overall, core PCE is likely to reach 2% over the next several months; a strong dollar means core goods PCE deflation will be sustained, but rising wage costs will put upward pressure on service sector inflation. Feature Amid the ongoing U.S. elections and Q3 earnings uncertainty, one of our higher conviction views is the likelihood of U.S. dollar appreciation. Our reasoning is straightforward: interest-rate differentials are the strongest 12-18 month predictor of currency trends,1 and relative economic performance between the U.S. and the rest of the world suggests that the gap between U.S. monetary policy and elsewhere will stay wide, and perhaps even widen (Chart 1). Chart 1Interest Rates And The Dollar Interest Rates And The Dollar Interest Rates And The Dollar Moreover, as we showed last week, the trade-weighted dollar provides good insurance against a variety of downside equity risks, even when a financial calamity occurs on U.S. soil. We remain dollar bulls. However, that does not mean that the outlook is without risk. The implications of further dollar strength are wide-ranging: How does dollar strength impact inflation expectations and monetary policy? How does the rest of the world cope with a rising U.S. dollar? How does the S&P 500 stand up to further dollar appreciation? Monetary Policy And The Dollar We have discussed the ramifications of the Fed Policy Loop, the interplay between Fed policy and financial conditions, since September 2015 (Chart 2). Since last year, each hawkish move from the Fed has been met by a sharp upward adjustment in the trade-weighted dollar and a sell-off in equities and credit spreads. Tighter-than-expected financial conditions have then forced the Fed to lower its outlook for future economic growth and adopt a more dovish policy stance. A more dovish Fed then caused financial conditions to ease and the dollar to fall, and this easing eventually emboldened Fed policymakers to move in a more hawkish direction. The loop then repeats itself. The reason this loop has been in place is because U.S. monetary policy is so far in advance of other central banks. For example, the ECB and BoJ continue to try to find ways to stimulate their economies, while the Fed is gearing up for a second rate hike. The point is that this feedback mechanism means that monetary conditions tighten in the form of a rising dollar, even without the Fed hiking interest rates by very much (Chart 3). The implication for investors is also clear: for equities, even though overall monetary conditions can tighten, rate-sensitive, domestically-exposed sectors such as telecoms can still perform well, because the tightening is coming mainly through the currency, rather than interest rates. For bonds, the policy loop means that sell-offs are likely to happen in fits and starts: the Fed knows that the process of normalizing interest rates will trigger bouts of volatility, because their actions are being exaggerated by movements in the dollar. This is one reason why we are not more eager to move aggressively underweight duration. Chart 2The Fed Policy Loop USD Strength: Betting Dollars To Donuts USD Strength: Betting Dollars To Donuts Chart 3Dollar To Do The Fed's Lifting? bca.usis_wr_2016_10_24_c3 bca.usis_wr_2016_10_24_c3 ROW And The Dollar Dollar strength, in the context of a robust U.S. economy, can be a good thing for some parts of the world. For example, a strong dollar means that European and Japanese exports will be more competitive. In this benign context, currency strength acts a growth re-distributor, taking growth away from the U.S., but transferring it to others, where the currency has been devalued. Our concerns focus squarely on emerging markets. Since the early 1980s, there have been no periods when EM share prices rallied amid strength in the real broad trade-weighted U.S. dollar (Chart 4). Chart 4EM Stocks Don't Like Dollar Strength EM Stocks Don't Like Dollar Strength EM Stocks Don't Like Dollar Strength It is significant that financial markets panicked in August, 2015 when the RMB was devalued by 2% ahead of the Fed's warning about a rate rise, and amid broad based U.S. dollar strength. True, the RMB has weakened periodically since then, without any real fallout for risk assets. Nonetheless, it is hard to say that the global economy - and China for that matter - is in significantly better shape than when the Fed began televising the last rate hike. We do not offer a forecast on the likelihood of further RMB devaluation. However, recent history is a reminder that dollar strength risks creating volatility in global markets. The latter would be especially true if worries about the EM credit cycle resurface. S&P 500 And The Dollar In the last major dollar bull market (1994-2002), U.S. stocks strengthened alongside the rise in the currency, offering some historical support that dollar strength does not necessarily hinder stock market performance. However, the global backdrop during that era was distinctly different from today. During the last half of the 1990s, the entire global economy experienced a supply-side, disinflationary expansion and credit binge. The U.S. was at the forefront of that expansion, and pulled the rest of the world (ROW) along for the ride. In other words, the U.S. and ROW were all moving broadly in the same direction. Today, the global economic backdrop is starkly different. Europe, Japan and China are all battling deflation and the major distinguishing trait of this business cycle is deficient demand and the need to de-lever. As we highlighted above, the U.S. has embarked on a gradual rate hike path, but most other central banks are trying new ways to reflate. In this world, currency movements act to re-distribute growth: a stronger currency can become a headwind to externally sourced profits, rather than a reflection of strong domestic demand. Indeed, the S&P 500 may become even more vulnerable to dollar strength: globally sourced profits as a share of overall S&P 500 profits has been in a steady climb over the past twenty years. Chart 5 shows that net earnings revisions are especially sensitive to currency moves, suggesting that further dollar appreciation would undermine already very lofty earnings expectations and would be a headwind for the broad market. Chart 5Beware The Dollar Drag Beware The Dollar Drag Beware The Dollar Drag From a sector perspective, dollar strength has already become problematic and is a main reason why we continue to advocate for defensive stocks relative to cyclical plays. Our U.S. Equity Strategy service published a Special Report on this topic last week.2 The Report outlined a seven item checklist of factors needed before tilting positions in favor of cyclicals. The first item on the list is dollar weakness. The full checklist is here: Chart 6Stick With Defensives Stick With Defensives Stick With Defensives Broad-based U.S. dollar weakness, particularly against emerging market currencies in countries with large current account deficits. An end to Chinese manufacturing sector deflation. A decisive upturn in global manufacturing purchasing manager's indexes. A return to growth in global export volumes and prices. A resynchronization in global profitability such that U.S. profits were not the only locomotive. A rebound in global inflation expectations. China credibly addressing banking sector weakness to the point where economic growth can reaccelerate rather than move laterally. Most of the items remain unfulfilled and our U.S. equity strategists believe that over the past several weeks, a technical adjustment has occurred in equity markets, rather than a fundamentally-driven trend change. In fact, the cyclical vs. defensive share price ratio appears to now be overshooting after having undershot. We expect leadership to revert back to non-cyclical sectors once the current rotational correction has run its course, given the lack of confirmation from the bulk of the macro variables on our checklist (Chart 6). The bottom line is that the U.S. dollar's path of least resistance is to trend higher. Dollar strength has already become restrictive for some U.S. industries, and unlike the late 1990s, we are concerned that further currency appreciation will act to restrain profit growth, rather than be reflective of a stellar domestic backdrop. Still, the Fed and other central banks' actions have proven to so far be a powerful antidote to earnings concerns: as long as the liquidity taps remain open, investors are willing to look through profit disappointment. We continue to recommend benchmark weightings to equities, but are highly attuned to this profit risk. What Is The True Inflation Rate? The Fed's target is 2% inflation. Core CPI has been above this rate for eleven months, implying that if the Fed's target was based on this measure, policymakers would have been much more aggressive in hiking interest rates. But the Fed's preferred measure, core PCE, is still stuck below the target. The CPI and PCE usually move together. The correlation between the two series is about 98% and divergences tend to be short-lived (Chart 7). Thus, the choice between the two series is often irrelevant, although the recent gap raises an issue for the Fed and the bond market: which measure is currently telling the right story? First, there are many alternative measures of inflation and in Chart 8, we show a selection of them. The median CPI uses the middle or median price change as its estimate of the underlying rate of inflation, irrespective of its share of the overall basket. The trimmed mean CPI removes the most volatile components of the index. The market-based PCE measure of inflation addresses concerns about using "imputed" prices (such as financial services furnished without payment) by leaving them out. Incidentally, this latter series, which is currently somewhat weaker than core PCE, is giving a similar inflation signal to our corporate price deflator. Together, these two measures suggest that the business sector is faced with a much tougher pricing backdrop than the core PCE and core CPI suggest. Chart 7Core CPI And Core PCE Usually Say The Same Thing bca.usis_wr_2016_10_24_c7 bca.usis_wr_2016_10_24_c7 Chart 8Various Alternative Measures Various Alternative Measures Various Alternative Measures Unfortunately, none of these alternative measures offer reliable leading information and do not help in understanding the divergence between core CPI or core PCE. However, understanding how the indexes are constructed does uncover important differences. Core CPI And Core PCE Explained The core CPI is a fixed-weight index while the personal consumption expenditure is chain-weighted. A fixed-weight index uses a constant basket of goods and tries to determine how much more an individual pays for an identical basket today versus a base year. A chain-type index measures how much it costs to a constantly evolving basket. The latter should be more representative of consumers' evolving buying habits. Historically, the different weighting methodology explains most of the gap between CPI and PCE inflation rates. The remainder of the gap is accounted for largely by the difference in the size of the weights used for the medical and housing components. Housing accounts for 40% of core CPI and only 17% of core PCE. Medical care accounts for 7% of core CPI versus 18% of core PCE. Currently, the gap between core PCE and core CPI is mostly explained by the medical care component (both the relative weights, but also the underlying prices used). In the CPI, only the portion that consumers spend on health care is taken into account, but the PCE also includes the amount that government agencies spend on consumers' behalf. The pricing information on the government funded portion is estimated from the PPI, which sometimes gives a different signal than the data supplied to the CPI from the consumer expenditure survey. The gap between medical care PCE and CPI has become particularly pronounced in the past few years. There is a lot of confusion about what is driving the spike in CPI medical care costs, with some pundits trying to find a political angle. Some blame higher insurance rates, while others blame drug costs. In fact, as Chart 9 shows, all elements of medical care CPI have contributed to the surge. Meanwhile, core PCE shows that medical care inflation has in fact been contained, some say, due to the enactment of the Affordable Care Act (a.k.a. Obamacare). It is not clear that this is the full story and forecasting future rates of inflation specifically in this sector is beyond the scope of this report. Over the next six to twelve months, we would expect some convergence between the two inflation gauges, as CPI medical care inflation peaks. More specifically, we would not be surprised to see the core PCE move slightly above 2%, but we think it is unlikely that much of an overshoot of the Fed's target can occur. Chart 10 shows the major components of CPI and we note the following: Chart 9Medical Care##br## Inflation Is Tricky bca.usis_wr_2016_10_24_c9 bca.usis_wr_2016_10_24_c9 Chart 10Major Components Of##br## Inflation At Crosscurrents Major Components Of Inflation At Crosscurrents Major Components Of Inflation At Crosscurrents Goods prices continue to fall. If our strong dollar view proves correct, deflation in this sector may persist for years. Recall that throughout the economic recovery in the first half of the previous decade, core goods price deflation persisted; that was during a dollar bear market. This time, dollar strength is likely to keep an even tighter lid on imported prices. Non-shelter service price inflation appears to be rolling over, after a surge earlier this year. The key for core service price inflation is wage pressures, since labor costs are the most significant input cost to U.S. service businesses. For core service price inflation to sustainably break above 3%, i.e. to return to the pre-Great Recession range, recent wage trends will need to be sustained, if not accelerate. Shelter prices are the most difficult segment to forecast. Our model for shelter inflation has flattened out, owing to a decline in market-tightness in multi-family properties. A reasonable working assumption is that shelter inflation stays around 3%, which is roughly the rate of shelter inflation that persisted prior to the housing bubble of the previous decade. Adding it up, core inflation is likely to drift gradually up: service sector inflation will likely trend higher with wage growth, but deflation in the goods sector will provide somewhat of an offset. The Fed has initiated interest rate hikes in the past when core PCE was under 1.5%, so there is historic precedent for policymakers to hike rates before the 2% target is achieved. Of course, this cycle is very different and there has been much talk of the need for policymakers to err on the side of ease for even longer, i.e. allow inflation to run much higher than 2%. Recent Fed communication suggests that a December rate hike is most likely, unless the data significantly worsen in the meantime. Thereafter, if our inflation view is correct, the Fed will find little reason to hike more than twice in 2017. Note: Last week, I had the pleasure of participating in our Geopolitical Strategy service's webcast on the upcoming U.S. Elections. In addition to a well-rounded debate on the U.S. political situation, we also discussed the present economic and investment landscape. To listen to the replay, please go here: www.bcaresearch.com/webcasts/index/131 Lenka Martinek, Vice President U.S. Investment Strategy lenka@bcaresearch.com 1 Please see Foreign Exchange Strategy Weekly Report "Dollar: The Great Redistributor", dated October 7, 2016, available at fes.bcaresearch.com 2 Please see U.S. Equity Strategy Special Report "Defensive Dominance Has Bent, But Will Not Break", dated October 17, 2016, available at uses.bcaresearch.com Appendix Monthly Asset Allocation Model Update Our Asset Allocation (AA) model provides an objective assessment of the outlook for relative returns across equities, Treasuries and cash. It combines valuation, cyclical, monetary and technical indicators. The model was constructed as a capital preservation tool, and has historically outperformed the benchmark in large part by avoiding major equity bear markets. Please note that our official cyclical asset allocation recommendations deviate at times from the model's recommendation. The model is just one input to our decision process. The model's recommended weightings for the major asset classes remained unchanged this month: neutral equity exposure at 60% (benchmark 60%), slightly overweight Treasury allocation at 40% (benchmark 30%) and underweight cash at 0% (benchmark 10%). The neutral portfolio recommendation for equities is in line with our qualitative defensive stance, in place since August 2015. Although the technical and monetary components of the equity model are still favorable, the earnings-driven component continues to warn that profits are likely to remain lackluster, especially relative to expectations. The allocation for a slight overweight in Treasuries continues to be supported by all three components of the bond model: valuation, cyclical and technical. While the valuation component continues trending towards expensive territory, a "buy signal" still exists for now. The cyclical and technical components of the bond model have retraced some of their bullish signals, but both still maintain a preference for Treasuries, especially relative to cash. Chart 11Portfolio Total Returns Portfolio Total Returns Portfolio Total Returns Chart 12Current Model Recommendations Current Model Recommendations Current Model Recommendations Note: The asset allocation model is not necessarily consistent with the weighting recommendations of the Cyclical Investment Stance. For further information, please see our Special Report "Presenting Our U.S. Asset Allocation Model", February 6, 2009. Market Calls

A Special Report published yesterday showed that while there have been hints of stabilization in global economic growth, there is a dearth of evidence pointing to a meaningful acceleration. Global manufacturing surveys have stabilized, but are oscillating around the boom/bust line rather than recording incremental gains. Inventory destocking may have finally run its course, based on the trough in the U.S. business sales-to-inventory ratio, but it is premature to forecast improvement in final demand. Keep in mind that ex consumption, the U.S. economy is in recession. Heavy truck sales have been an excellent business cycle indicator for decades. Truck orders tend to be an early indicator for activity. Heavy truck orders peaked in 2015, and the shipments-to-inventory ratio is heading rapidly toward recession levels. Meanwhile, both global trade volumes and prices are still languishing in the deflation zone. These trends are not conducive to cyclical sector earnings outperformance, and we reiterate our defensive portfolio position. Please see yesterday's Special Report for more details. bca.uses_in_2016_10_18_002_c1 bca.uses_in_2016_10_18_002_c1

Cyclical sectors have outperformed defensive sectors since mid-summer, but it is dangerous to draw any macro conclusions from the past few months of market action. Cyclical sector outperformance has been driven solely by the tech sector, as industrials and materials have rolled over while energy has moved laterally in relative performance terms. On the defensive side, the interest rate-sensitive utilities sector has been hit hard, as has the health care sector, which has been caught in the electoral crosshairs. Without broadening cyclical sector participation, which requires a reacceleration in global economic growth, defensive sectors will return to a leadership role, please see the next Insight. bca.uses_in_2016_10_18_001_c1 bca.uses_in_2016_10_18_001_c1

Highlights It is premature to position for an equity market handoff from liquidity to growth. Cyclical sectors have overshot the mark in recent months. There is scant evidence from macro variables that cyclical sector earnings validation will materialize, especially if the U.S. dollar continues its stealth appreciation. Defensive sectors are primed to resume their market leadership role. Feature Rotational Correction Beneath the surface, equity markets have behaved as if a handoff to growth from liquidity is underway. Since July, defensives have not benefited from the broad market consolidation and increased volatility (Chart 1). Instead, cyclical sectors have celebrated the easing in financial conditions in recent months. The bounce in oil prices, commensurate narrowing in corporate bond spreads and firming inflation expectations have provided enough fuel for cyclical vs. defensive outperformance. Other financial markets appear to corroborate such a view. The equity-to-bond ratio has firmed. Inflation expectations have risen, partly reflecting commodity price appreciation. Gold prices are down. The Fed is itching to lift interest rates. Long-term global government bond yields have climbed. Even the U.S. dollar is testing the top end of its recent range (Chart 1). All of these factors would suggest that the growth outlook is steadily improving. If so, then a rethink of our defensive portfolio positioning would be imperative. Sectoral trends have reached a critical point. Defensive sectors have unwound overbought conditions, and are close to hitting oversold levels (Chart 2). The interest rate-sensitive consumer discretionary, financials and utilities sectors have already hit deeply oversold levels on the latest blip up in Treasury yields (Chart 2). Cyclical sectors are just starting to roll over from overbought levels. Chart 1The U.S. Dollar Is A Critical Influence The U.S. Dollar Is A Critical Influence The U.S. Dollar Is A Critical Influence Chart 2End Of Rotational Correction? bca.uses_sr_2016_10_17_c2 bca.uses_sr_2016_10_17_c2 These dynamics reflect a rotational equity market correction. Indeed, there have been many episodes in the past few years when countertrend sector swings occurred, but each was fleeting and the economy's need for liquidity stayed as strong as ever, ultimately propelling defensive shares back to a leadership position. Is this time different? Below, we revisit a range of indicators that we use to help forecast and time durable shifts in the cyclical vs. defensive trade off. Cyclical Vs. Defensive Checklist Update In our March, 2016 Special Report on cyclical vs. defensive sector strategy, we outlined a checklist of factors that would trigger the need for more aggressive positioning rather than simply riding out the anticipated countertrend move: Broad-based U.S. dollar weakness, particularly against emerging market currencies in countries with large current account deficits. An end to Chinese manufacturing sector deflation. A decisive upturn in global manufacturing purchasing manager's indexes. A return to growth in global export volumes and prices. A resynchronization in global profitability such that U.S. profits were not the only locomotive. A rebound in global inflation expectations. China credibly addressing banking sector weakness to the point where economic growth can reaccelerate rather than move laterally. Of this checklist, items 1, 2, 4, 5 and 7 remain unfulfilled, while items 3 and 6 have moved from a deep negative to a more neutral setting. Financial Variables Offer Modest Cyclical Sector Hope... Financial variables that typically lead the cyclical vs. defensive share price ratio have improved, on the margin, as noted in our March 29th Special Report. Commodity prices bounced on the back of the pause in the U.S. dollar rally, aided more recently by hopes for oil market supply restraint, while developed world equities have lagged behind their emerging market counterparts. The latter is notable, because goods producing cyclical sectors have a tight link with manufacturing-intensive emerging market economies (Chart 3). However, we do not recommend extrapolating these financial market messages, especially since the greenback and commodity prices are starting to reverse. It is also worth noting the bounce in emerging market currencies has been modest, and pales in comparison with the scale of the previous slide (Chart 3). In other words, we are not convinced that EM currency moves are signaling that countries are gaining better access to global funding. Moreover, the back up in global bond yields has not yet produced any meaningful steepening in the U.S. yield curve, which would be a reliable confirming indication that U.S. growth expectations were improving. At the moment, the yield curve is signaling that defensive sectors are now undershooting (Chart 4). Chart 3Some Financial Variables Have Firmed... bca.uses_sr_2016_10_17_c3 bca.uses_sr_2016_10_17_c3 Chart 4... But Not All bca.uses_sr_2016_10_17_c4 bca.uses_sr_2016_10_17_c4 ... But There Is Still A Dearth Of Fundamental Support Financial variables are only useful when confirmed by economic variables. Global manufacturing surveys have stabilized, but are oscillating around the boom/bust line rather than recording incremental gains. Inventory destocking may have finally run its course, based on the trough in the U.S. business sales-to-inventory ratio (Chart 5, top panel), but it is premature to forecast improvement in final demand. Keep in mind that ex consumption, the U.S. economy is in recession. Heavy truck sales have been an excellent business cycle indicator for decades. Truck orders tend to be an early indicator for activity. Heavy truck orders peaked in 2015, and the shipments-to-inventory ratio is heading rapidly toward recession levels (Chart 5). The risk is that employment cools. Corporate employment decisions are profit-motivated. Wages are currently rising much faster than nominal GDP. That is never a good environment for the labor market (Chart 6). True, wages are up, but productivity is down. While broad-based labor market weakness has yet to materialize, the risks are skewed to the downside. Sinking profits and rising wages warn that the unemployment rate is headed higher (shown inverted, Chart 6). Goods producing employment is rolling over relative to service sector employment, which is often a leading indicator of cyclical vs. defensive relative performance momentum (Chart 7, middle panel). Chart 5Cyclicals Have Overshot Fundamentals bca.uses_sr_2016_10_17_c5 bca.uses_sr_2016_10_17_c5 Chart 6Buy Cyclicals When The Economy Overheats bca.uses_sr_2016_10_17_c6 bca.uses_sr_2016_10_17_c6 Chart 7Mixed Signals bca.uses_sr_2016_10_17_c7 bca.uses_sr_2016_10_17_c7 The time to tilt portfolios in favor of cyclical sectors is when profits and profit margins are expanding at a rate such that the labor market is steadily tightening, creating a self-reinforcing consumption/economic feedback loop that feeds into rising inflation pressures, i.e. when the corporate sector is in a position of financial strength. Defensives often outperform when the unemployment rate is rising. Consumers are still much stronger than the corporate sector, and should remain so even if job growth recedes. Consumer balance sheets have been repaired and savings rates are up. Conversely, the BCA Corporate Health Monitor is deep in deteriorating health territory (Chart 5), as profits are contracting and free cash flow is eroding. That divergence is reflected in economic data. For instance, the producer price index is still deep in deflation relative to the consumer price index, albeit the rate of decay has lessened. The upshot is that a meaningful pricing power advantage exists for businesses that sell to consumers rather than to other businesses. Defensives are much more consumer-oriented than deep cyclical sectors, and move in line with relative pricing power (Chart 7). Little Help From Abroad It does not appear as if external forces will take up any slack from lackluster U.S. growth. The all important emerging market PMI has edged back to the boom/bust line, reflecting the tailwind from monetary easing. However, emerging market inventories have spiked in the last two months (shown inverted, Chart 8), warning against getting too excited about growth. It is notable that emerging markets, and China, have failed to begin deleveraging (Chart 9). Chart 8Global: From Negative To Neutral bca.uses_sr_2016_10_17_c8 bca.uses_sr_2016_10_17_c8 Chart 9A Bearish Credit Impulse A Bearish Credit Impulse A Bearish Credit Impulse The global credit impulse is negative, especially in commodity-dependent developing economies (Chart 9). It is no wonder that global export prices continue to deflate, and export volumes have slipped back into negative territory (Chart 10). The message is that developed country domestic demand is not yet sufficiently robust to boost global final demand. Instead, growth will continue to be redistributed through foreign exchange resets. While China has opened the fiscal taps, the economic outlook is still only for stabilization rather than growth acceleration. Money growth has surged and the Chinese Keqiang index has climbed off its lows (Chart 11), but we are reluctant to extrapolate these signals. Chart 10Still Deflating Still Deflating Still Deflating Chart 11Not Ready To Bet On China Acceleration Not Ready To Bet On China Acceleration Not Ready To Bet On China Acceleration Credit growth continues to sink and loan demand remains anemic (Chart 11). The speed of the debt build up since the financial crisis has been breathtaking, and undoubtedly included capital misallocation. While the unknown scale of the non-performing loan implications for the banking system is cause for concern, it is notable that the growth in fixed asset investment projects started has rolled over (Chart 11), and the authorities recently introduced measures to curb house price inflation. The Chinse manufacturing sector price deflator is still below zero (Chart 11). Now that the U.S. dollar is perking back up, the pressure on the authorities to reduce prices and/or further devalue the yuan will increase, representing another headwind for global cyclical companies, especially given the recent relapse in exports. Another bout of deflationary stress would cause risk premiums to rise for global cyclical equities, which garner a significant portion of revenue from abroad. Interest coverage is already razor thin, and free cash flow growth is deeply negative (Chart 12). U.S.-sourced profits are still outpacing earnings from the rest of the world, despite the pause in the U.S. dollar bull market over the past year. Now that the U.S. dollar is quietly grinding higher, the outlook is for ongoing U.S. profit outperformance. That is conducive to defensive sector outperformance (Chart 13). In all, it appears as if a technical adjustment has occurred in equity markets, rather than a fundamentally-driven trend change. In fact, the cyclical vs. defensive share price ratio appears to now be overshooting after having undershot. Worrisomely, most of this overshoot reflects a surge in tech stocks, and to a lesser extent, energy, as both industrials and materials have rolled over in relative performance terms (Chart 14). We expect leadership to revert back to non-cyclical sectors once the current rotational correction has run its course, given the lack of confirmation from the bulk of the macro variables on our checklist. Chart 12Risk Premiums Will Stay High Risk Premiums Will Stay High Risk Premiums Will Stay High Chart 13No Turn Yet No Turn Yet No Turn Yet Chart 14Deep Cyclicals: A One Trick Pony Deep Cyclicals: A One Trick Pony Deep Cyclicals: A One Trick Pony Bottom Line: Now is not the time to chase momentum in recent outperformers, as defensives are about to reclaim the leadership role from cyclical sectors, based on a broad range of macro, valuation and financial market indicators.

History shows that premium valuations for high quality stocks are sustainable when overall final demand is sub-par. Using consumer products as a guide, when real GDP is low and/or volatile, relative P/E multiples tend to reside at the top end of their range. That makes intuitive sense, because low potential GDP growth and the persistent threat of deflation in an economy operating close to stall speed are consistent with a low neutral real interest rate. The latter is a more powerful boost to long duration non-cyclical sectors than it is for short-cycle, economically-sensitive cyclical sectors. This phenomenon can be seen globally. For instance, in Japan, defensive sectors crushed their cyclical counterparts during the deflationary 1990s. Importantly, the share price ratio has been steadily making new highs for the past few years, and is well above the peak reached at the depths of the Great Recession even as the BOJ grew its balance sheet aggressively over that period. Not surprisingly, countertrend moves in favor of Japanese cyclicals required a period of accelerating global economic growth, as measured by our global leading economic indicator (shown inverted). The lesson from Japan is that when liquidity, not economic growth, drives equity markets, long duration sectors can overshoot by a wide margin. bca.uses_in_2016_09_20_001_c1 bca.uses_in_2016_09_20_001_c1

Consumer products stocks are likely to move to an even larger valuation premium before the cyclical outperformance phase ends.

Stocks remain well bid despite the questionable fundamental rationale for price gains. The run to new highs has been driven by renewed valuation expansion a dubious trend given the lack of profit growth, the likelihood that the Fed will resume hiking interest rates this autumn and the potential for the U.S. dollar to climb anew. Still, abundant liquidity expectations are trumping earnings risks in the near run. Nominal GDP growth remains above long-term Treasury yields, a simple yet reliable measure of excess liquidity. Meanwhile, money growth is accelerating relative to output growth. When this occurs, history shows that defensive sectors outperform the broad market (top panel). Deep cyclicals underperform until after economic activity picks up enough to drain excess liquidity from the market (deep cyclicals are inversely correlated with our liquidity gauge, bottom panel). Consequently, we continue to emphasize non-cyclical sectors and groups in our portfolio strategy, with a splash of beta coming from the interest rate-sensitive consumer discretionary sector. bca.uses_in_2016_08_02_001_c1 bca.uses_in_2016_08_02_001_c1

The GAA Equity Sector Selection Model recommends tilts to the 10 GICS global sectors covered in our sector selection by applying a framework of growth, liquidity, momentum and valuation. Its mandate is to generate alpha in both cyclical upturns and downturns and does so by capturing turns in business cycles.

BCA’s defense index has been on a tear recently. The unfortunate structural increase in terrorist activity will embolden governments around the world to step up defense spending (top panel), at a time when the pressure to move away from austerity toward expansionary fiscal policy is already intense. Defense industry revenues have already begun to outpace those of the overall S&P 500, and a structural upturn in military expenditures will provide confidence that this is the start of a prolonged uptrend, as occurred throughout most of the last decade. From a cyclical perspective, we have shown that the shipments-to-inventories (SI) ratio at the wholesale, manufacturing and retail levels are collapsing, but the defense capital goods SI ratio is moving in the opposite direction (middle panel), reinforcing the case for ongoing earnings outperformance. Bottom Line: The re-rating phase in BCA’s defense index is still in the early innings. Stay overweight. The ticker symbols for the stocks in this index are: LMT, GD, RTN, NOC, LLL. bca.uses_in_2016_07_22_001_c1 bca.uses_in_2016_07_22_001_c1