Equipment & Services

Highlights Portfolio Strategy Firming industry demand at a time when global energy capital spending budgets are renormalizing, along with rising crude oil prices, signal that high-beta energy services equities have more running room. Our confidence in additional significant bank relative price gains has decreased. There is budding evidence that the bank/yield curve correlation is getting re-established, as we had posited last autumn, and coupled with later cycle dynamics signal that the bank outperformance is getting long in the tooth. Recent Changes Crystalize gains of 6% in the S&P banks index and remove from the high-conviction overweight call list. Put the S&P banks index on downgrade alert. Prefer large caps to small caps (please refer to the May 10th Sector Insight). Table 1 Resilient Resilient Feature Equities staged a breakout attempt last week and the SPX reclaimed the 50-day moving average, with the energy sector leading the pack. However, the lateral move in place over the past quarter is not over yet as the market is still digesting the February 5th drawdown. Importantly, EPS euphoria cannot last forever and the inevitable profit growth deceleration post the calendar 2018 onetime tax reform fillip is weighing on the market. The 12-month forward EPS growth rate has come down to 15%, and as we move into the back half of 2018 it will continue to glide toward a still impressive 10% (or two times nominal GDP growth), which is where the calendar 2019 estimate currently stands (Chart 1). Following up from last week's 'Til Debt Do Us Part' Special Report, the overall market's (ex-financials and ex-real estate) 'Altman Z-score' is waving a mini yellow flag. Cyclical momentum in this indicator is giving way and the broad market's deteriorating creditworthiness is also, at the margin, anchoring profit growth (Chart 2). Chart 1Unsustainable EPS Euphoria Unsustainable EPS Euphoria Unsustainable EPS Euphoria Chart 2Watching Balance Sheets... Watching Balance Sheets… Watching Balance Sheets… Nevertheless, we remain constructive on the broad market from a cyclical 9-12 month horizon as the odds of recession are close to nil, and interpret recent market action as a sign of resiliency. The SPX refuses to give way to the bearish narrative plagued by geopolitical uncertainty/fears and slowing global growth. Chart 3 shows an extremely economically sensitive indicator, lumber, alongside the ISM manufacturing survey. Since 1969 when lumber futures first commenced trading, these two series have been tightly positively correlated. Recently, a rare and steep divergence is visible and our inclination is to expect all-time high lumber prices to arrest the ISM's fall in the coming months. True, lumber prices reflect a NAFTA-related premium and at the current juncture cannot be fully trusted that they are emitting an accurate economic signal. We, thus, resort to another - daily reported - global growth barometer, the Baltic Dry Index (BDI). The third panel of Chart 3 shows that a wide gap has opened between the ISM manufacturing index and the BDI. If our assessment is correct and this global growth soft patch is transitory, then the ISM will remain squarely clear of the 50 boom/bust line. Taken together, these two economically sensitive high frequency series comprise our Global Trade Indicator which is underscoring that global export growth will pick up in the back half of the year (bottom panel, Chart 3). Finally, on the domestic freight front,1 the composite freight index is also reaccelerating, signaling that domestic demand conditions are firing on all cylinders (fourth panel, Chart 3). Circling back to profit growth, long-term S&P 500 EPS growth expectations have vaulted to the highest level since the dotcom bubble (bottom panel, Chart 4). While in isolation, this measure signals we are in overshoot territory and such breakneck EPS growth is clearly unsustainable, the SPX PEG ratio tells a different story (we divide the 12-month forward price to earnings ratio by the long-term EPS growth rate to arrive at the current reading near 1 on the S&P 500 PEG ratio, Chart 4). Chart 3...But Economy Is Humming …But Economy Is Humming …But Economy Is Humming Chart 4Market Is Cheap According To PEG Ratio Market Is Cheap According To PEG Ratio Market Is Cheap According To PEG Ratio On this valuation measure the SPX appears cheap. Historically, every time the PEG ratio has sunk to one standard deviation below the mean, at least a reflex rebound ensued. Table 2 summarizes the five most recent iterations we included in the analysis since 1985. While we cannot rule out a steep undershoot, if history at least rhymes, the S&P should be higher in the subsequent 12 months (Chart 5). Chart 5SPX Cycle-On-Cycle Return Profile When The PEG Ratio Gets Depressed SPX Cycle-On-Cycle Return Profile When The PEG Ratio Gets Depressed SPX Cycle-On-Cycle Return Profile When The PEG Ratio Gets Depressed Table 2S&P 500 Yearly Returns* Resilient Resilient This week we are removing an early cyclical index from our high-conviction call list, locking in handsome profits, and updating a high-beta energy sub-index. Put Banks On Downgrade Watch Despite a blockbuster earnings season, banks have come under pressure recently. Worrisomely, they have not followed the 10-year Treasury yield higher and that is cause for concern. We first cautioned last October that banks would shatter their near one-to-one relationship with the 10-year UST yield and re-establish it with the yield curve likely in the back half of 2018 as the Fed would further lift the fed funds rate away from the zero lower bound.2 This positive correlation shift from interest rates to the yield curve slope is important as it will likely squeeze banks' net interest margins, a key profit driver (Chart 6). Charts 7 & 8 show that there is increasing empirical evidence that banks have already started making this transition away from the 10-year UST yield and toward the 10/2 yield curve, and we are thus compelled to book profits of 6% and remove this early cyclical index from the high-conviction overweight call list. The S&P banks index is now also on downgrade alert. Chart 6NIM Trouble? NIM Trouble? NIM Trouble? Chart 7Monitoring Shifting... Monitoring Shifting… Monitoring Shifting… Chart 8...Correlations …Correlations …Correlations What would cause us to change our yearlong cyclical constructive view and move to a benchmark allocation, is a lack of relative price outperformance in the next 10-year Treasury yield jump. Crudely put, if banks fail to best the market when the bond market further sells off roughly to 3.25%, as BCA's fixed income strategists expect, we will pull the trigger and downgrade to a neutral stance. Another reason we are likely to become more wary of bank relative performance in the coming quarters is the stage of the business cycle. Importantly, we wanted to test our hypothesis that in the late/later stages of the expansion early cyclicals, banks included, fare poorly. Therefore, at some point we should move away from our sanguine view on this index and not overstay our welcome as the current expansion has become the second longest on record according to the NBER designated recessions. In more detail, what we did to test this hypothesis was to document relative bank performance from when the ISM manufacturing peaked for the cycle until the recession commenced going back to the 1960s (Chart 9). Table 3 aggregates the results using monthly data. What is clear is that if the recession is a financial crisis related recession, then shy away from banks. But, in 4 out of the 7 last cycles dating back to the 1960s, banks outperformed the broad market in the later stages of the business cycle. Chart 9Banks Tend To Slump In Later Stages Of The Cycle Banks Tend To Slump In Later Stages Of The Cycle Banks Tend To Slump In Later Stages Of The Cycle Table 3Late Cycle Analysis Resilient Resilient Nevertheless, breaking down the results in two periods is instructive. One period recalibrates the bank relative returns from the ISM peak until the SPX peak, and the second one from the SPX peak until the recession commences (Table 3). Banks clearly underwhelm 4 out of the 7 iterations as the SPX crests, confirming our negative return hypothesis. Subsequently, as the SPX deflates when the economy heads into recession, relative bank performance significantly improves with the caveat that during financial crises, banks continue to bleed (in an upcoming Special Report we will be performing the same analysis on the GICS1 U.S. equity sectors, stay tuned). Two weeks ago we lifted our peak SPX target to 3200,3 and the implication is that banks' best days have likely passed, if history at least rhymes. Bottom Line: Stay overweight banks for now, but lock in gains of 6% and remove the S&P banks index from the high-conviction overweight call list, as our confidence is not as high as in late-November.4 Further, we are putting this key financials sub index on downgrade alert reflecting the negative implication from our later stages of the business cycle analysis. We are closely monitoring the yield curve slope and interest rate correlation with bank performance, and if banks refrain from participating in the next leg up in interest rates it will serve as a catalyst to prune exposure to neutral. The ticker symbols for the stocks in this index are: BLBG: S5BANKX - WFC, JPM, BAC, C, USB, PNC, BBT, STI, MTB, FITB, CFG, RF, KEY, HBAN, CMA, ZION, PBCT, SIVB. Energy Servicers: The Phoenix Is Rising Quarter-to-date the S&P energy services index is up 12% compared with the 2% rise in the broad market. Even year-to-date, oil servicing companies have bested the market by 600bps. The steep rebound in oil prices primarily lies behind such stellar outperformance, and BCA's Commodity & Energy Strategy still-upbeat crude oil view is a harbinger of even brighter days ahead for this high-beta energy sub sector (Chart 10). While we are exploring our capex upcycle theme via a high-conviction overweight in the broad S&P energy index, oil services companies are also a prime beneficiary of our synchronized global capital outlays upcycle theme. In fact, relative share price momentum does not yet fully reflect the rebound in industry investment (using national accounts) that remains in a V-shaped recovery since the Q1/2016 oil market trough (second panel, Chart 11). Importantly, OPEC 2.0 and $70/bbl oil prices have resulted in a semblance of normality in the E&P space (a key industry client) that has lifted spending budgets (bottom panel, Chart 11). The upshot is that energy services revenues will continue to expand (Chart 11). Energy related capital spending budgets are not only rising in the U.S. (primarily in shale oil), but also globally. The global rig count is breaking out, and declining OECD oil stocks suggest that drilling activity will remain robust (top and second panel, Chart 12). Chart 10Catch up Phase Catch up Phase Catch up Phase Chart 11Capex Upcycle... Capex Upcycle… Capex Upcycle… Chart 12...Beneficiary …Beneficiary …Beneficiary Taking the pulse of oil services industry slack is extremely important for profitability. Our global idle rig proxy is also making a breakout attempt following a massive two year plus retrenchment phase (top panel, Chart 13). Keep in mind that energy servicers have only recently exited deflation, that wreaked havoc in the sector's financial metrics. Now as a renormalization period is unfolding with higher underlying commodity prices breathing life into industry new order growth, even a modest pricing power rebound will go a long way in lifting depressed profits. In fact, new orders-to-inventories are in a reflex rebound. While such an exponential rise is unsustainable, firming oil services demand should continue to remove excess slack, a boon for industry selling prices and profits (middle and bottom panels, Chart 13). Sentiment toward this energy sub-index remains bombed out and there is widespread disbelief that this rebound is sustainable. Rather, the risk of a deflationary relapse has kept investors at bay pushing relative valuations deep into undervalued territory. Both our composite relative Valuation Indicator (VI) and relative price-to-book are hovering near all-time lows (bottom panel, Chart 12). Technicals are not as depressed as the VI reading, with the recent relative share price bounce lifting our relative Technical Indicator to the neutral zone (Chart 14). Chart 13Deflation Is Over Deflation Is Over Deflation Is Over Chart 14Unloved And Underowned Unloved And Underowned Unloved And Underowned In sum, there are more gains in store for the S&P energy services index. Firming industry demand at a time when global energy capital spending budgets are renormalizing, along with rising crude oil prices, signal that high-beta energy services equities have more running room. Bottom Line: Stay overweight the S&P energy service index. The ticker symbols for the stocks in this index are: BLBG: S5ENRE -NOV, SLB, FTI, BHGE, HAL, HP. Anastasios Avgeriou, Vice President U.S. Equity Strategy anastasios@bcaresearch.com 1 The freight transportation services index consists of: For-hire trucking (parcel services are not included); Freight railroad services (including rail-based intermodal shipments such as containers on flat cars); Inland waterway traffic; Pipeline movements (including principally petroleum and petroleum products and natural gas); and Air freight. 2 Please see BCA U.S. Equity Strategy Weekly Report, "Later Cycle Dynamics," dated October 23, 2017, available at uses.bcaresearch.com. 3 Please see BCA U.S. Equity Strategy Weekly Report, "Lifting SPX Target," dated April 30, 2018, available at uses.bcaresearch.com. 4 Please see BCA U.S. Equity Strategy Weekly Report, "High-Conviction Calls," dated November 27, 2017, available at uses.bcaresearch.com. Current Recommendations Current Trades Size And Style Views Favor value over growth Favor large over small caps

Overweight In a welcome reversal of fortunes, the S&P energy services index caught a bid last month, lifted by rising oil prices, healthy earnings and bullish 2018 forecasts. We think this is just the beginning for the beleaguered sector. OPEC crude oil production remains firmly in contraction territory with the mantle being taken up by non-OPEC producers (second panel), the key customer group for the energy services index. However, the increases have not been enough to offset the declines and OECD oil stocks have fallen for the past year, a trend that has sparked the biggest revival in oil patch capex in the last five years (third panel). In the context of the valuation pounding the sector has taken during the oil downturn, the rebound has a very long runway. We reiterate our overweight recommendation. The ticker symbols for the stocks in this index are: BLBG: S5ENRE- SLB, HAL, FTI, NOV, BHGE, HP. Energy Services Are Just Getting Warmed Up Energy Services Are Just Getting Warmed Up

A capex revival is underway, powered by exceptionally strong business and consumer sentiment, the breadth of which covers virtually all developed economies. This global capex upcycle should underpin top-line growth and margin expansion for the industrial conglomerates index, whose product and geographic diversification ensures exposure to the global upswing. However, the index has underperformed the broad market, dragged down by heavyweight GE and its specific headwinds. Further, the index's highest exposure sectors (namely aerospace, health care equipment, energy equipment & services and utilities) are mostly weighted negatively in our overall sector view. Adding it up, the negatives offset the positives and, in the context of fair valuations, we expect the S&P industrial conglomerates index to perform in line with the overall market. We are initiating coverage with a neutral rating. The key theme that has been driving our investment thesis in U.S. Equity Strategy in the past quarter has been accelerating global industrial production and trade, with a corresponding rotation out of defensive and into cyclical stocks. We have been adjusting our portfolio accordingly and it now has a deep cyclical bent with leverage to a burgeoning capex cycle. Enticing Macro Outlook Industrial conglomerates capitalize on most of these themes: they are globally-oriented and capex-driven, and leading indicators of final demand suggest that earnings should accelerate in the near-term. Capex Upcycle On the domestic front, regional Fed surveys of domestic capex intentions and the ISM manufacturing survey are hitting modern highs; both have been excellent indicators of a capex upcycle and the signal is unambiguously positive (Chart 1). Our Capex Indicator also corroborates this message. Durable goods orders have already surged and inventories have reverted to a more normal level, coming out of the late-2015/early-2016 manufacturing recession (Chart 2). This implies increasingly resilient pricing power from a demand-driven capital goods upcycle. Further, the capital goods cycle has significant room to run as new orders remain well below the 2013-2014 levels. Chart 1Exceptionally Strong Sentiment... Exceptionally Strong Sentiment… Exceptionally Strong Sentiment… Chart 2...Is Already Reflected In A Capex Upcycle …Is Already Reflected In A Capex Upcycle …Is Already Reflected In A Capex Upcycle Chart 3Capital Goods Demand Is Globally Synchronous Capital Goods Demand Is Globally Synchronous Capital Goods Demand Is Globally Synchronous The global picture echoes the domestic, with the global manufacturing PMI surging to a six-year high. The global strength is remarkably broad: all 46 of the economies tracked by the OECD are expected to see gains in 2017, a first since the GFC, and the BCA global leading economic indicator is signaling all-clear (Chart 3). U.S. Dollar Reflation The greenback's slide in 2017 should further boost global demand for domestic exports. In fact, given the diversity of industries served by the industrial conglomerates and the relatively high proportion of foreign sales (Table 1), the U.S. dollar is the single largest driver of both sales and earnings (Chart 4). Due to the lagged impact on results from the currency, industrial conglomerates margins should benefit from translation gains in the next two quarters, regardless of where the U.S. dollar moves. Table 1Conglomerates More Global Than Industrial Peers Industrial Conglomerates: Rebooting Industrial Conglomerates: Rebooting Chart 4U.S. Dollar Drives Conglomerate Profits U.S. Dollar Drives Conglomerate Profits U.S. Dollar Drives Conglomerate Profits But GE Weighs On The Index With the enormously supportive demand environment in mind, one could safely assume that the globally integrated niche industrial conglomerates index has been a strong performer in 2017. That would be true were it not for index heavyweight (and laggard) General Electric. Excluding GE from this index, industrial conglomerates have outperformed the S&P 500 by 20% since the start of the year (Chart 5). However, GE represents 40% of the index (Chart 5) and its current transformation continues to weigh heavily on its share price and, hence, the index at large. The new CEO, who took over earlier this month, has stated that "everything is on the table" as part of a $20 billion target for divestitures over the coming two years. The current fear among investors is that GE will need to reduce its dividend to preserve enough liquidity to continue growing despite the fairly synchronous storm in its end-markets. In March, 2009, GE's share price reached its modern nadir, a level not seen since the recession of the early 1990's, a week following its dividend cut announcement. While hardly analogous to GE today (recall that a cash crisis at GE Capital threatened to bankrupt the entire firm), the risk of a dividend cut will keep GE's share price suppressed, and likely hold the overall index hostage. Payout ratios in the industrial conglomerates index reflect GE's cash flow woes and have now surpassed the pre-dividend cut level during the GFC (Chart 6). This largely reflects cash contraction, combined with an unwillingness to even halt dividend growth. Regardless, GE investors clearly anticipate the new CEO will reduce the dividend, having pushed the yield to its highest level since the last dividend cut (Chart 6). Chart 5GE Still Dominates The Index GE Still Dominates The Index GE Still Dominates The Index Chart 6A Dividend Cut Looks To Be In The Cards A Dividend Cut Looks To Be In The Cards A Dividend Cut Looks To Be In The Cards Soft End-Markets Backdrop From the mid-1990's until 2007, the narrative of the S&P industrial conglomerates index was the rise and fall of GE Capital, as evidenced by the index' price. In 2015, the now largely complete sale of the majority of GE Capital was announced, realigning the company as an industrial manufacturer. Accordingly, analyzing the key end-market industries that the S&P industrial conglomerates cater to is in order: aerospace, healthcare, oil & gas and utilities. Chart 7Aerospace Profits Look Set To Fall Aerospace Profits Look Set To Fall Aerospace Profits Look Set To Fall Chart 8Health Care Equipment Pricing Collapsing Health Care Equipment Pricing Collapsing Health Care Equipment Pricing Collapsing Aerospace (Underweight recommendation) - We downgraded the BCA aerospace index to underweight at the end of 2015, corresponding fairly closely to the peak of the aerospace orders cycle (Chart 7). Since then, orders have fallen by half reflecting a downturn in the commercial aerospace cycle. While shipments have been falling, the decline has been much less precipitous as manufacturers have been running down backlogs. Historically, maintenance has buffered aerospace profits, repair and consumables activity, though weak current pricing power suggests that this may prove less sustainable than in previous cycles. Both GE & HON share extensive exposure to aerospace demand as it represented 23% and 38% of 2016 revenues, respectively. Health Care Equipment (Neutral recommendation) - We reduced our recommendation to neutral earlier this year as weaker demand no longer supported the thesis of an earnings-led outperformance. Since then the industry's outlook has not improved as demand has downshifted and pricing has cooled substantially; orders and production both crested last year and pricing power has contracted relative to overall since December 2016 (Chart 8). This bodes ill for medical equipment margins. Health care equipment represented 16% and 18% of GE & MMM 2016 revenues, respectively. Energy Equipment & Services (Overweight recommendation) - Energy Equipment & Services is our only overweight recommended sector relevant to the industrial conglomerates analysis. We upgraded in late 2016 (and doubled down on June 2) based on three key factors: troughing rig counts, cresting global oil inventories and falling production growth. Two of these factors have come to fruition: the global rig count bottomed in 2015, and has staged its best recovery since 2009 (Chart 9) and the growth in total OECD oil stocks is moderating rapidly with recent large storage draws. The key missing ingredient has been pricing power, which should eventually turn up if rig counts prove resilient. Energy equipment & services represented 11% of GE's 2016 revenues. Utilities (Underweight recommendation) - As previously noted, a key macro theme in U.S. Equity Strategy is accelerating global industrial production and trade. Utilities tend to move in the opposite direction of that theme given their safe haven status (top panel, Chart 10). Combined with falling domestic electricity production and capacity utilization, and rising turbine & generator inventories, the industry's outlook is bleak (middle & bottom panels, Chart 10). GE's Power segment is one of the world's largest gas and steam turbine manufacturers and delivered 24% of 2016 revenues. Investment Recommendation A roaring, globally synchronous capital goods upcycle should mostly keep sales and profits buoyant in this industrials subsector. However, high concentration in one stock, which is experiencing a greater than normal amount of flux, adds significant specific risk. Further, we are less optimistic about the key industries served by the industrial conglomerates than we are for the economy at large, implying more opportunity for outperformance from other, more focused, S&P industrials peers. If valuations were particularly compelling they could provide a cushion to any profit mishap, but this is not the case. Our Valuation Indicator is in the neutral zone and, while our Technical Indicator is in oversold territory, it has shown an ability to remain at these levels for prolonged periods (Chart 11). Chart 9Energy Services Is A Bright Spot Energy Services Is A Bright Spot Energy Services Is A Bright Spot Chart 10Utilities Are In A Deep Cyclical Decline Utilities Are In A Deep Cyclical Decline Utilities Are In A Deep Cyclical Decline Chart 11Valuations Are Not Compelling Valuations Are Not Compelling Valuations Are Not Compelling Bottom Line: Netting it out, we think the S&P industrial conglomerates index should perform broadly in line with the overall market. Accordingly, we are initiating coverage with a neutral rating. The ticker symbols for the stocks in this index are: BLBG: S5INDCX - GE, MMM, HON, ROP. Chris Bowes, Associate Editor U.S. Equity Strategy chrisb@bcaresearch.com

Our thesis of a playable rally in energy services stocks (see our Weekly Report of 11 October, 2016 for more details) was based on three key factors: troughing rig counts, cresting global oil inventories and falling production growth. Clearly, our upgrade was early, but a review of leading profit indicators continues to signal that value creation abounds. The global rig count hit its nadir in 2015, and has staged its best recovery since 2009 (second panel), with a greater than 50% increase in oil-directed rig count since November, 2016. Importantly, the growth in total OECD oil inventories is moderating quickly with recent large storage draws. The OPEC 2.0 agreement to extend current production cuts through March 2018 means that non-OPEC production growth will need to accelerate to satisfy climbing global demand. Ongoing inventory rebalancing augurs well for even more robust oil field services demand. The key missing ingredient has been pricing power. The prior cycle's excesses created a large overhang. However, our pricing power proxy is finally exiting the deflation zone, and further gains loom later this year as utilization rates rise with rig counts. This should unlock the industry's substantial operating leverage. We are doubling down on our high-conviction overweight in the S&P energy services index. The ticker symbols for the stocks in this index are: BLBG: S5ENRE- BHI, CAM, DO, ESV, FTI, HAL, HP, NOV, SLB, RIG. Playable Rally Can Energy Services Stage A Comeback? Playable Rally Can Energy Services Stage A Comeback?

Highlights This week, Commodity & Energy Strategy is publishing a joint report with our colleagues at BCA's Energy Sector Strategy. Driven by the leadership of the Kingdom of Saudi Arabia (KSA) and Russia, OPEC 2.0 formalized the well-telegraphed decision to extend its production cuts for another nine months, carrying the cuts through the seasonally weak demand period of Q1 2018. The extension is will be successful in bringing OECD inventories down to normalized levels, even assuming some compliance fatigue (cheating) setting in later this year. Energy: Overweight. We are getting long Dec/17 WTI vs. short Dec/18 WTI at tonight's close, given our expectation OPEC 2.0's extension of production cuts, and lower exports by KSA to the U.S., will cause the U.S. crude-oil benchmark to backwardate. Base Metals: Neutral. Despite "catastrophic flooding" in March, 1Q17 copper output in Peru grew almost 10% yoy to close to 564k MT, according to Metal Bulletin. This occurred despite strikes at Freeport-McMoRan's Cerro Verde mine, where production was down 20.5% yoy in March. Precious Metals: Neutral. Our strategic gold portfolio hedge is up 2.61% since it was initiated on May 4, 2017. Ags/Softs: Underweight. The USDA's Crop Progress report indicates plantings are close to five-year averages, despite harsh weather in some regions. We remain bearish. Feature Chart 1Real OPEC Cuts Of ~1.0 MMb/d##BR##For Over 400 Days Real OPEC Cuts Of ~1.0 MMb/d For Over 400 Days Real OPEC Cuts Of ~1.0 MMb/d For Over 400 Days OPEC 2.0's drive to normalize inventories by early 2018 will be accomplished with last week's agreement to extend current production cuts through March 2018. In total, OPEC has agreed to remove over 1 MMb/d of producible OPEC oil from the market for over 400 days (Chart 1), supplemented by an additional 200,000-300,000 b/d of voluntary restrictions of non-OPEC oil through Q3 2017 at least, perhaps longer if Russia can resist the temptation to cheat after oil prices start to respond. Many of the participants in the cut, from both OPEC and non-OPEC, are not actually reducing output voluntarily, but have had quotas set for them that merely reflect the natural decline of their productive capacity, limitations that will be even more pronounced in H2 2017 than in H1 2017. With production restricted by the OPEC 2.0 cuts, global demand growth will outpace supply expansion by another wide margin in 2017, just as it did last year (Chart 2). As shown in Chart 3, steady demand expansion and the slowdown in supply growth allowed oil markets to move from oversupplied in 2015 to balanced during 2016; demand growth will increasingly outpace production growth in 2017, creating sharp inventory draws (Chart 4) that bring stocks down to normalized levels by the end of 2017 (Chart 5). Chart 2 Chart 3Production Cuts And Demand##BR##Growth Will Draw Inventories Production Cuts And Demand Growth Will Draw Inventories Production Cuts And Demand Growth Will Draw Inventories Chart 4Higher Global Inventory##BR##Withdrawals Through Rest Of 2017 Higher Global Inventory Withdrawals Through Rest Of 2017 Higher Global Inventory Withdrawals Through Rest Of 2017 Chart 5OECD Inventories To Be##BR##Reduced To Normal OECD Inventories To Be Reduced To Normal OECD Inventories To Be Reduced To Normal The extension of the cut through Q1 2018 will help prevent a premature refilling of inventories during the seasonally weak first quarter next year. The return of OPEC 2.0's production to full capacity in Q2 2018 will drive total production growth above total demand growth for 2018, returning oil markets from deliberately undersupplied during 2017 to roughly balanced markets in 2018, with stable inventory levels that are below the rolling five-year average. 2018 inventory levels will still be 5-10% above the average from 2010-2014, in line with the ~7% demand growth between 2014 and 2018. Compliance Assessment: Only A Few Players Matter In OPEC 2.0 OPEC's compliance with the cuts announced in November 2016 has been quite good, with KSA anchoring the cuts by surpassing its 468,000 b/d cut commitment. In addition to KSA, OPEC is getting strong voluntary compliance from the other Middle Eastern producers (except Iraq), while producers outside the Middle East lack the ability to meaningfully exceed their quotas in any case. OPEC's Core Four Remain Solid. The core of the OPEC 2.0 agreement has delivered strong compliance with their announced cuts. Within OPEC, the core Middle East countries Kingdom of Saudi Arabia, Kuwait, Qatar, and UAE have delivered over 100% compliance of their 800,000 b/d agreed-to cuts. We expect these countries to continue to show strong solidarity with the voluntary cuts through March 2018 (Chart 6). Iraq And Iran Make Small/No Sacrifices. Iraq and Iran were not officially excluded from cuts, but they were not asked to make significant sacrifices either. We estimate Iran has little-to-no capability to materially raise production in 2017 anyhow, and KSA is leaning on Iraq to better comply with its small cuts. Chart 7 shows our projections for Iran and Iraq production levels through 2018. Chart 6KSA, Kuwait, Qatar & UAE Carrying##BR##The Load Of OPEC Cuts KSA, Kuwait, Qatar & UAE Carrying The Load Of OPEC Cuts KSA, Kuwait, Qatar & UAE Carrying The Load Of OPEC Cuts Chart 7Iran And Iraq Production##BR##Near Full Capacity Iran And Iraq Production Near Full Capacity Iran And Iraq Production Near Full Capacity Iraq surged its production above 4.6 MMb/d for two months between OPEC's September 2016 indication that a cut would be coming and the late-November formalization of the cut. Iraq's quota of 4.35 MMb/d is nominally a 210,000 b/d cut from its surged November reference level, but is essentially equal to the country's production for the first nine months of 2016, implying not much of a real cut. Despite the low level of required sacrifice, Iraq has produced about 100,000 b/d above its quota so far in 2017 at a level we estimate is near/at its capacity anyway. KSA and others in OPEC are not pleased with Iraq's overproduction and have pressured it to comply with the agreement. We forecast Iraq will continue producing at 4.45 MMb/d. Iran's quota represented an allowed increase in production, reflecting the country's continued recovery from years of economic sanctions. We project Iran will continue to slowly expand production, but since the country is almost back up to pre-sanction levels, there is little remaining easily-achievable recovery potential. South American & African OPEC Capacity Eroding On Its Own. Chart 8 clearly shows how production levels in Venezuela, Angola and Algeria started to deteriorate well before OPEC formalized its production cuts, with productive capacity eroded by lack of reinvestment rather than voluntary restrictions. The quotas for these three countries (as well as for small producers Ecuador and Gabon) are counted as ~258,000 b/d of "cuts" in OPEC's agreement, but they merely represent the declines in production that should be expected anyway. With capacity deteriorating and no ability to ramp up anyway, these OPEC nations will deliver improving "compliance" (i.e. under-producing their quotas) in H2 2017, and are happy to have the higher oil prices created by the extension of production cuts by the core producers within OPEC 2.0. Libya and Nigeria Exclusions Unlikely To Result In Big Production Gains. Both Libyan and Nigerian production levels have been constrained by above-ground interference. Libyan production has been held below 1.0 MMb/d since 2013 principally by chronic factional fighting for control of export terminals, while Nigerian production--on a steady natural decline since 2010--has been further limited by militants sabotaging pipelines in 2016-2017. While each country has ebbs and flows to the amount of oil they are able to produce, we view both countries' problems as persistent risks that will continue to keep production below full potential (Chart 9). Chart 8 Chart 9Libya And Nigeria Production Could Go Higher##BR##Under Right (But Unlikely) Circumstances Libya And Nigeria Production Could Go Higher Under Right (But Unlikely) Circumstances Libya And Nigeria Production Could Go Higher Under Right (But Unlikely) Circumstances For Nigeria, we estimate the country's crude productive capacity has eroded to about 1.8 MMb/d from 2.0 MMb/d five years ago due to aging fields and a substantial reduction in drilling (offshore drilling is down ~70% since 2013). Within another year or two, this capacity will dwindle to 1.7 MMb/d or below. On top of this natural decline, we have projected continued sabotage / militant obstruction will limit actual crude output to an average of 1.55 MMb/d for the foreseeable future. Libyan production averaged just 420,000 b/d for 2014-2016, a far cry from the 1.65 MMb/d produced prior to the 2011 Libyan Revolution that ousted strongman Muammar Gaddafi. Since Gaddafi was deposed and executed, factional strife and conflict has persisted. Each faction wants control over oil export revenues and, just as importantly, wants to deny the opposition those revenues, resulting in a chronic state of conflict that has limited production and exports. If a détente were reached, we expect Libyan oil production could quickly rise to about 1.0 MMb/d of production within six months; however, we put the odds of a sustainable détente at less than 30%. As such, we forecast Libyan crude production will continue to struggle, averaging about 600,000 b/d in 2017-2018. Non-OPEC Cuts Hang On Russia In November, ten non-OPEC countries nominally agreed to restrict production by a total of 558,000 b/d, but Russia--with 300,000 b/d of pledged cuts--is the big fish that KSA and OPEC are relying on. Mexico's (and several others') agreements are window dressing, reframing natural production declines as voluntary action to rebalance markets. Through H1 2017, Russia has delivered on about 60-70% of its cut agreement, with compliance growing in Q2 (near 100%) versus Q1 (under 50%). From the start, Russia indicated it would require some time to work through the physical technicalities of lowering production to its committed levels, implying that now that production has been lowered, Russia could deliver greater compliance over H2 2017 than it delivered in H1 2017. We are a little more skeptical, expecting some weakening in Russia's compliance by Q4, especially if the extended cuts deliver the expected results of bringing down OECD inventories and lifting prices. Russia surprised us with stronger-than-expected production during 2016. Some of the outperformance was clearly due to a lower currency and improved shale-like drilling results in Western Siberia, but it is unclear whether producers also pulled too hard on their fields to compensate for lower prices, and are using the OPEC 2.0 cut as a way to rest their fields a bit. We have estimated Russian production returning to 11.3 MMb/d by Q4 2017 (50,000 b/d higher than 2016 average production) and holding there through 2018 (Chart 10), but actual volumes could deviate from this level by as much as 100,000-200,000 b/d. Mexico, the second largest non-OPEC "cutter," is in a position similar to Angola, Algeria, and Venezuela. Mexican production has been falling for years (Chart 11), and the nation's pledge to produce 100,000 b/d less in H1 2017 than in Q4 2016 is merely a reflection of this involuntary decline. As it has happened, Mexican production has declined by only ~60,000 b/d below its official reference level, but continues to deteriorate, promising higher "compliance" with their production pledge in H2 2017. Chart 10Russia Expected##BR##To Cheat By Q4 Russia Expected To Cheat By Q4 Russia Expected To Cheat By Q4 Chart 11Mexican Production Deterioration##BR##Unaffected By Cut Pledges Mexican Production Deterioration Unaffected By Cut Pledges Mexican Production Deterioration Unaffected By Cut Pledges Kazakhstan and Azerbaijan are not complying with any cuts, and we don't expect them to. Despite modest pledges of 55,000 b/d cuts combined, the two countries have produced ~80,000 b/d more during H1 2017 than they did in November 2016. We don't expect any voluntary contributions from these nations in the cut extension, but Azerbaijan's production is expected to wane naturally (Chart 12). While contributing only a small cut of 45,000 b/d, Oman has diligently adhered to its promised cuts, supporting its OPEC and Gulf Cooperation Council (GCC) neighbors. We expect Oman's excellent compliance will be faithfully continued through the nine-month extension (Chart 13). Chart 12Kazakhstan And Azerbaijan Not Expected##BR##To Comply With Any Cut Extension Kazakhstan And Azerbaijan Not Expected To Comply With Any Cut Extension Kazakhstan And Azerbaijan Not Expected To Comply With Any Cut Extension Chart 13Oman Has Faithfully Complied##BR##With Cut Promises To Date Oman Has Faithfully Complied With Cut Promises To Date Oman Has Faithfully Complied With Cut Promises To Date OPEC Extension Will Continue To Support Increased Shale Drilling Energy Sector Strategy believed OPEC's original cut announced in November 2016 was a strategic mistake for the cartel, as it would accelerate the production recovery from U.S. shales in return for "only" six months of modestly-higher OPEC revenue. As we cautioned at the time, the promise of an OPEC-supported price floor was foolish for them to make; instead, OPEC should have let the risk of low prices continue to restrain shale and non-Persian Gulf investment, allowing oil markets to rebalance more naturally. However, despite our unfavorable opinion of the strategic value of the original cut, since the cut has not delivered the type of OECD inventory reductions expected (seemingly due to a larger-than-expected transfer of non-OECD inventories into OECD storage), we view the extension of the cut as a necessary, and logical, next step. OPEC 2.0's November 2016 cut agreement signaled to the world that OPEC (and Russia) would abandon KSA's professed commitment to a market share war, and would instead work together to support a ~$50/bbl floor under the price of oil. Such a price floor dramatically reduced the investment risk for shale drilling, and emboldened producers (and supporting capital markets) to pour money into vastly increased drilling programs. Now that the shale investment genie has already been let out of the bottle, extending the cuts is unlikely to have nearly the same stimulative impact on shale spending as the original paradigm-changing cut created. The shale drilling and production response has been even greater than we estimated six months ago, and surely greater than OPEC's expectations. The current horizontal (& directional) oil rig count of 657 rigs is nearly twice the 2016 average of 356 rigs, is 60% higher than the level of November 2016 (immediately before the cut announcement), and is still rising at a rate of 25-30 rigs per month (Chart 14). The momentum of these expenditures will carry U.S. production higher through YE 2017 even if oil prices were allowed to crash today. Immediately following OPEC's cut, we estimated 2017 U.S. onshore production could increase by 100,000 - 200,000 b/d over levels estimated prior to the cut, back-end weighted to H2 2017, with a greater 300,000-400,000 b/d uplift to 2018 production levels. Drilling activity has roared back so much faster than we had expected, indicative of the flooding of the industry with external capital, that we have raised our 2017 production estimate by 500,000 b/d over our December estimate, and raised our 2018 production growth estimate to 1.0 MMb/d (Chart 15). Chart 14Rig Count Recovery Dominated##BR##By Horizontal Drilling Rig Count Recovery Dominated By Horizontal Drilling Rig Count Recovery Dominated By Horizontal Drilling Chart 15Onshore U.S. Production##BR##Estimates Rising Sharply Onshore U.S. Production Estimates Rising Sharply Onshore U.S. Production Estimates Rising Sharply Other Guys' Decline Requires Greater Growth From OPEC, Shales, And Russia We've written before about "the Other Guys' in the oil market, defined as all producers outside of the expanding triumvirate of 1) U.S. shales, 2) Russia, and 3) Middle East OPEC. While the growers receive the vast majority of investors' focus, the Other Guys comprise nearly half of global production and have struggled to keep production flat over the past several years (Chart 16). Chart 17 shows the largest offshore basins in the world, which should suffer accelerated declines in 2019-2020 (and likely beyond) as the cumulative effects of spending constraints during 2015-2018 (and likely beyond) result in an insufficient level of projects coming online. This outlook requires increasing growth from OPEC, Russia and/or the shales to offset the shrinkage of the Other Guys and simultaneously meet continued demand growth. Chart 16The Other Guys' Production##BR##Struggling To Keep Flat The Other Guys' Production Struggling To Keep Flat The Other Guys' Production Struggling To Keep Flat Chart 17 Risks To Rebalancing Our expectation global oil inventories will draw, and that prices will, as a result, migrate toward $60/bbl by year-end is premised on the continued observance of production discipline by OPEC 2.0. GCC OPEC - KSA, Kuwait, Qatar, and the UAE - Russia and Oman are expected to observe their pledged output reduction, but we are modeling some compliance "fatigue" all the same. Even so, this will not prevent visible OECD oil inventories from falling to their five-year average levels by year-end or early next year. Obviously, none of this can be taken for granted. We have consistently highlighted the upside and downside risks to our longer term central tendency of $55/bbl for Brent crude, with an expected trading range of $45 to $65/bbl out to 2020. Below, we reprise these concerns and our thoughts concerning OPEC 2.0's future. Major Upside Risks Chief among the upside risks remains a sudden loss of supply from a critical producer and exporter like Venezuela or Nigeria, which, respectively, we expect will account for 1.9 and 1.5 MMb/d of production over the 2017-18 period. Losing either of these exporters would sharply rally prices above $65/bbl as markets adjusted and brought new supply on line. Other states - notably Algeria and Iraq - highlight the risk of sustained production losses due to a combination of internal strife and lack of FDI due to civil unrest. Algeria already appears to have entered into a declining production phase, while Iraq - despite its enormous potential - remains dogged by persistent internal conflict. We are modeling a sustained, slow decline in Algeria's output this year and next, which takes its output from 1.1 MMb/d in 2015 down to slightly more than 1 MMb/d on average this year and next. For Iraq, where we expect a flattening of production at ~ 4.4 MMb/d this year and a slight uptick to ~ 4.45 MMb/d in 2018, continued violence arising from dispersed terrorism in that country in the wake of a defeat of ISIS as an organized force, will remain an ongoing threat to production. Longer term - i.e., beyond 2018 - we remain concerned the massive $1-trillion-plus cutbacks in capex for projects that would have come online between 2015 and 2020 brought on by the oil-price collapse in 2015-16 will force prices higher to encourage the development of new supplies. The practical implication of this is some 7 MMb/d of oil-equivalent production the market will need, as this decade winds down, will have to be supplied by U.S. shales, Gulf OPEC and Russia, as noted above. Big, long-lead-time deep-water projects requiring years to develop cannot be brought on fast enough to make up for supply that, for whatever reason, fails to materialize from these sources. In addition, as shales account for more of global oil supplies and "The Other Guys" continue to lose production to higher depletion rates, more and more shale - in the U.S. and, perhaps, Russia - and conventional Persian Gulf production will have to be brought on line simply to make up for accelerating declines. This evolution of the supply side is significantly different from what oil and capital markets have been accustomed to in previous cycles. Because of this, these markets do not have much historical experience on which to base their expectations vis-à-vis global supply adjustment and the capacity these sources of supply have for meeting increasing demand and depletion rates. Lower-Cost Production, Demand Worries On The Downside Downside risks, in our estimation, are dominated by higher production risks. Here, we believe the U.S. shales and Russia are the principal risk factors, as the oil industry in both states is, to varying degrees, privately held. Because firms in these states answer to shareholders, it must be assumed they will operate for the benefit of these interests. So, if their marginal costs are less than the market-clearing price of oil, we can expect them to increase production up to the point at which marginal cost is equal to marginal revenue. The very real possibility firms in these countries move the market-clearing price to their marginal cost level cannot be overlooked. For the U.S., this level is below $53/bbl or so for shale producers. For Russian producers, this level likely is lower, given their production costs are largely incurred in rubles, and revenues on sales into the global market are realized in USD; however, given the variability of the ruble, this cost likely is a moving target. While a sharp increase in unconventional production presently not foreseen either in the U.S. or Russian shales will remain a downside price risk, an increase in conventional output - chiefly in Libya - remains possible. As discussed above, we believe this is a low risk to prices at present; however, if an accommodation with insurgent forces in the country can be achieved, output in Libya could double from the 600k b/d of production we estimate for this year and next. We reiterate this is a low-risk probability (less than 25%), but, in the event, would prove to be significant additions to global balances over the short term requiring a response from OPEC 2.0 to keep Brent prices above $50/bbl. Also on the downside, an unexpected drop in demand remains at the top of many lists. This is a near-continual worry for markets, which can be occasioned by fears of weakening EM oil-demand growth from, e.g., a hard landing in China, or slower-than-expected growth in India. These are the two most important states in the world in terms of oil-demand growth, accounting for more than one-third of global growth this year and next. We do not expect either to meaningfully slow; however, we continue to monitor growth in both closely.1 In addition, we continue to expect robust global oil-demand growth, averaging 1.56 MMb/d y/y growth in 2017 and 2018. This compares with 1.6 MMb/d growth last year. OPEC 2.0's Next Move Knowing the OPEC 2.0 production cuts will be extended to March 2018 does not give markets any direction for what to expect after this extension expires. Once the deal expires, we expect production to continue to increase from the U.S. shales, and for the key OPEC states to resume pre-cut production levels. Along with continued growth from Russia, this will be necessary to meet growing demand and increasing depletion rates from U.S. shales and "The Other Guys." Yet to be determined is whether OPEC 2.0 needs to remain in place after global inventories return to long-term average levels, or whether its formation and joint efforts were a one-off that markets will not require in the future. Over the short term immediately following the expiration of the production-cutting deal next year, OPEC 2.0 may have to find a way to manage its production to accommodate U.S. shales without imperiling their own revenues. This would require a strategy that keeps the front of the WTI and Brent forward curves at or below $60/bbl - KSA's fiscal breakeven price and $20/bbl above Russia's budget price - and the back of the curve backwardated, in order to exert some control over the rate at which shale rigs return to the field.2 As we've mentioned in the past, we have no doubt the principal negotiators in OPEC 2.0 continue to discuss this. Toward the end of this decade, such concerns might be moot, if growing demand and accelerating decline curves require production from all sources be stepped up. Matt Conlan, Senior Vice President Energy Sector Strategy mattconlan@bcaresearchny.com Robert P. Ryan, Senior Vice President Commodity & Energy Strategy rryan@bcaresearch.com 1 Please see the May 18, 2017, issue of BCA Research's Commodity & Energy Strategy article entitled "Balancing Oil-Shale's Resilience And OPEC 2.0's Production Cuts," in which we discuss the outlook for China's and India's growth. Together, these states account for more than 570k b/d of the 1.56 MMb/d growth we expect this year and next. The article is available at ces.bcaresearch.com. 2 A backwardated forward curve is characterized by prompt prices exceeding deferred prices. Our research indicates a backwardated forward curve results in fewer rigs returning to the field than a flat or positively sloped forward curve. We explored this strategy in depth in the April 6, 2017, issue of BCA Research's Commodity & Energy Strategy, in an article entitled "The Game's Afoot In Oil, But Which One?" It is available at ces.bcaresearch.com. Investment Views and Themes Recommendations Strategic Recommendations Tactical Trades Commodity Prices and Plays Reference Table Trades Closed In 2017 Summary of Trades Closed in 2016 Extending OPEC 2.0's Production Cuts Will Normalize Global Oil Inventories Extending OPEC 2.0's Production Cuts Will Normalize Global Oil Inventories Extending OPEC 2.0's Production Cuts Will Normalize Global Oil Inventories Extending OPEC 2.0's Production Cuts Will Normalize Global Oil Inventories

Highlights Venezuela's economic implosion accelerated with the oil price crash. The petrodollar collapse is suffocating consumption as well as oilfield investment, creating a "death spiral" of falling production. The military has already begun assuming more powers as Maduro becomes increasingly vulnerable, and will likely take over before long. OPEC's cuts may help Maduro delay, but not avoid, deposition. Civil unrest/revolution could cause a disruption in oil production, profoundly impacting oil markets. Feature The wheels on the bus go round and round, Round and round, Round and round ... The story of Venezuela's decline under the revolutionary socialist government of deceased dictator Hugo Chavez is well known. The country went from being one of the richest South American states to one of the poorest and from being reliant on oil exports to being entirely dependent on them (Chart 1). The straw that broke the back of Chavismo was the end of the global commodity bull market in 2014 (Chart 2). Widespread shortages of essential goods, mass protests, opposition political victories, and a slide into overt military dictatorship have ensued.1 Chart 1Venezuela Suffers Under Chavismo Venezuela Suffers Under Chavismo Venezuela Suffers Under Chavismo Chart 2Commodity Bull Market Ended Commodity Bull Market Ended Commodity Bull Market Ended The acute social unrest at the end of 2016 and beginning of 2017 raises the question of whether Venezuela will cause global oil-supply disruptions that boost prices this year.2 One of the reasons we have been bullish oil prices is the fact that the world has little spare production capacity (Chart 3). This means that political turmoil in Venezuela, Libya, Nigeria, or other oil-producing countries could take enough supply out of the market to accelerate the global rebalancing process and drawdown of inventories, pushing up prices. Image Image The longer oil prices stay below the budget break-even levels of the politically unstable petro-states (mostly $80/bbl and above), the more likely some of them will be to fail. Venezuela, with a break-even of $350/bbl, has long been one of our prime candidates (Chart 4).3 Venezuela is on the verge of total regime collapse and a massive oil production shutdown. This is not a low-probability outcome. However, the fact that the military is already taking control of the situation, combined with our belief that OPEC and Russia will continue cutting oil production to shore up prices, suggest that the regime may be able to limp along. Therefore a continuation of the gradual decline in oil output is more likely than a sharp cutoff this year. Investors should stay short Venezuelan 10-year sovereign bonds and be aware of the upside risks to global oil prices. A Brief History Of PDVSA State-owned oil company PDVSA is the lifeblood of Venezuela. It once was a well-run company that allowed foreign investment with a reasonable government take, but now it is shut off from direct foreign investment. In 1996-1997, prior to Chavez being elected in late 1998, Venezuela was a rampant cheater on its OPEC quota, producing 3.1-3.3 MMB/d versus a quota of ~2.4 MMB/d in 1996 and ~2.8 in 1997. The oil-price crash that started in late 1997 and bottomed in early 1999 (remember the Economist's "Drowning In Oil" cover story on March 4, 1999 predicting $5 per barrel crude prices?) was a critical event propelling the rise of Chavez (Chart 5). One of the planks in Chavez's platform was that Venezuela had to stop cheating on OPEC quotas because that strategy had helped cause the oil-price decline and subsequent economic misery. Without the oil-price crash, Chavez would not have had such strong public support in the run-up to the 1998 elections, which he won. Chavez did in fact rein in Venezuela's production to 2.8 MMB/d in 1999, which had a positive impact on oil prices and reinforced OPEC. In 2002 and 2003, there were two labor strikes at PDVSA and a two-day coup that displaced Chavez. When Chavez returned to power, he fired 18,000 experienced workers at PDVSA and replaced them with political loyalists. Since then, the total number of employees at PDVSA has swelled from about 46,000 people in 2002, when PDVSA was producing 3.2 MMB/d, to about 140,000 people today, when it is producing slightly below 2 MMB/d. Average oil revenue per employee was over $500,000/person in 2002 at $20 oil, versus about $100,000/person today at $50 oil. Suffice it to say, PDVSA is stuffed to the gills with political patronage, and a strike or a revolution inside PDVSA against President Nicolas Maduro is unlikely. However, if opposition forces manage to seize control of government, the Chavistas in control of PDVSA may attempt to shut down operations to deprive them of oil revenues and blackmail them into a better deal going forward. Chart 5Oil Bust Catapulted Chavez Oil Bust Catapulted Chavez Oil Bust Catapulted Chavez Image Venezuela is estimated to have the world's largest proved oil reserves at about 300 billion barrels (Chart 6). In addition, there are 1.2-1.4 trillion barrels estimated to rest in heavy-oil deposits in the Orinoco Petroleum Belt (at the mouth of the Orinoco river) that is difficult to extract and has barely been touched. Chart 7Venezuela Cuts Forced By Economic Disaster Venezuela Cuts Forced By Economic Disaster Venezuela Cuts Forced By Economic Disaster These reserves are somewhat similar to Canada's oil sands. It is estimated that 300-500 billion barrels are technically recoverable. In the early 2000s, there were four international consortiums involved in developing these reserves: Petrozuata (COP-50%), Cerro Negro (XOM), Sincor (TOT, STO) and Hamaca (COP-40%). However, Chavez nationalized the Orinoco projects in 2007, paying the international oil companies (IOCs) a pittance. XOM and COP contested the taking and "sued" Venezuela at the World Bank. XOM sought $14.7 billion and won an arbitrated decision for a $1.6 billion settlement in 2014. Venezuela continues to litigate the case and the amount awarded to investors has apparently been reduced by a recent ruling. Over the past decade, as Venezuelan industry declined due to dramatic anti-free market laws, including aggressive fixed exchange rates absurdly out of keeping with black market rates, the government nationalized more and more private assets in order to get the wealth they needed to maintain profligate spending policies. The underlying point of these policies is to garner support from low-income Venezuelans, the Chavista political base. In addition to the Orinoco nationalization, the government appropriated equipment and drilling rigs from several oilfield service companies that had stopped working on account of not being properly paid. In 2009, Petrosucre (a subsidiary of PDVSA) appropriated the ENSCO 69 jackup rig, although the rig was returned in 2010. In 2010, the Venezuelan government seized 11 high-quality land rigs from Helmerich & Payne, resulting in nearly $200MM of losses for the company. These rigs were "easy" for Venezuela to appropriate because they did not require much private-sector expertise to operate. As payment failures continued, relationships with the country's remaining contractors continued to be strained. In 2013, Schlumberger (SLB), the largest energy service company in the world, threatened to stop working for PDVSA due to lack of payment in hard currency. PDVSA paid them in depreciating Venezuelan bolivares, but tightened controls over conversion into U.S. dollars. Some accounts receivables were partially converted into interest-bearing government notes. Promises for payment were made and broken. SLB has taken over $600MM of write-downs for the collapse of the bolivar (Haliburton, HAL, has taken ~$150MM in losses). With accounts receivable balances now stratospherically high at approximately $1.2 billion for SLB, $636 million for HAL (plus $200 million face amount in other notes), and $225 million for Weatherford International, the service companies have already taken write-offs on what they are owed and have refused to extend Venezuela additional credit. Unlike the "dumb iron" of drilling rigs, the service companies provide highly technical proprietary goods and services, from drill bits and fluids to measuring services. The lack of these proprietary technical services diminishes PDVSA's ability to drill new wells and properly maintain its legacy production infrastructure. Venezuela's production started falling in late 2015 - well before OPEC and Russia coordinated their January 2017 production cuts (Chart 7). Drought contributed to the problem in 2016 by causing electricity shortages and forced rationing of electricity (60-70% of Venezuela's electricity generation is hydro); water levels at key dams are still very low, but the condition has eased a bit in 2017. After watching crude oil production fall from 2.4 MMB/d in 2015 to 2.05 MMB/d in 2016, OPEC gave Venezuela a production quota of 1.97 MMB/d for the first half of 2017, which is about what they were expected to be capable of producing. In essence, Venezuela was exempt from production cuts, like other compromised OPEC producers Libya, Nigeria and Iran. So far, Venezuela has produced 1.99 MMB/d in the first quarter, according to EIA. Venezuela's falling production is not cartel behavior but indicative of broader economic and political instability. Venezuela is losing control of oil output, the pillar of regime stability. Bottom Line: The double-edged sword for energy companies is that if the regime utterly fails, the country's 2MM b/d of production may be disrupted. However, if government policy shifts - whether through the political opposition finally gaining de facto power or through the military imposing reforms - Venezuela could ramp up its production, perhaps by 1MMB/d within five years, and more after that if Orinoco is developed. How Long Can Maduro Last? Chavez's model worked like that of Louis XIV, who famously said, "après nous, le déluge." Chavez benefited from high oil prices throughout his reign and died in 2013 just before the country's descent into depression began (Chart 8). He won his last election in 2012 by a margin of 10.8%, while Maduro, his hand-picked successor, won a special election only half a year later by a 1.5% margin, which was contested for all kinds of fraud (Chart 9). Chart 8A Hyperflationary Depression A Hyperflationary Depression A Hyperflationary Depression Image Thus Maduro has suffered from "inept successor" syndrome from the beginning, compounding the fears of the ruling United Socialist Party of Venezuela (PSUV) that the succession would be rocky. Maduro lacked both the political capital and the originality to launch orthodox economic reforms to address the country's mounting inflation and weak productivity, but instead doubled down on Chavez's rapid expansion of money and credit to lift domestic consumption (Chart 10).4 Chart 10Excessive Monetary And Credit Expansion Excessive Monetary And Credit Expansion Excessive Monetary And Credit Expansion Chart 11Exports Recovered, Reserves Did Not Exports Recovered, Reserves Did Not Exports Recovered, Reserves Did Not The economic collapse was well under way even before commodities pulled the rug out from under the government.5 Remarkably, the recovery in export revenue since 2010 did not occasion a recovery in foreign exchange reserves - these two decoupled, as Venezuela chewed through its reserves to finance its growing domestic costs (Chart 11). This means Venezuela's ability to recover even in the most optimistic oil scenarios is limited. Another sign that the economic break is irreversible is the fact that, since 2013, private consumption has fallen faster than oil output - a reversal of the populist model that boosted consumption (Chart 12). Chart 12Consumption Falls Faster Than Oil Output Consumption Falls Faster Than Oil Output Consumption Falls Faster Than Oil Output Chart 13Oil-Price Crash Hobbles Maduro Oil-Price Crash Hobbles Maduro Oil-Price Crash Hobbles Maduro Critically, the external environment turned against Maduro and PSUV as oil prices declined after June 2014. In November 2014 Saudi Arabia launched its market-share war against Iran and U.S. shale producers, expanding production into a looming global supply overbalance. Brent crude prices collapsed to $29/bbl by early 2016 (Chart 13). This pushed Venezuela over the brink.6 First, hyperinflation: Currency in circulation - already expanding excessively - has exploded upward since 2014. The 100 bolivar note has exploded in usage while notes of lower denominations have dropped out of usage. Total deposits in the banking system are growing at a pace of over 200%, narrow money (M1) at 140%, and consumer price index at 150% (see Chart 10 above). Real interest rates have plunged into an abyss, with devastating results for the financial system. The real effective exchange rate illustrates the annihilation of the currency's value. Monetary authorities have repeatedly devalued the official exchange rate of the bolivar against the dollar (Chart 14). However, the currency remains overvalued, which creates a huge gap between the official rate and the black market rate, which currently stands at about 5,400 bolivares to the dollar. Regime allies have access to hard USD, for which they charge high rents, and the rest suffer. Chart 14Official Forex Devaluations Official Forex Devaluations Official Forex Devaluations Chart 15Domestic Demand Collapses Domestic Demand Collapses Domestic Demand Collapses Second, the real economy has gone from depression to worse: Exports peaked in October 2008, nearly recovered in March 2012, and plummeted thereafter. Imports have fallen faster as domestic demand contracted (Chart 15). Venezuela must import almost everything and the currency collapse means staples are either unavailable or exorbitantly expensive. Venezuelan exports to China reached 20% of total exports in 2012 but have declined to about 14% (Chart 16). This means that Venezuela has lost a precious $10 billion per year. The state has also been trading oil output for loans from China, resulting in an ever higher share of shrinking oil output devoted to paying back the loans, leaving less and less exported production to bring in hard currency needed to pay for production, imports, and debt servicing. Both private and government consumption are shrinking, according to official statistics (Chart 17). Again, the consumption slump removes a key regime support. Chart 16Chinese Demand Is Limited Chinese Demand Is Limited Chinese Demand Is Limited Chart 17Public And Private Consumption Shrink Public And Private Consumption Shrink Public And Private Consumption Shrink Third, Venezuela is rapidly becoming insolvent: Venezuela's total public debt is high. It stood at 102% of GDP as of August 2014, and GDP has declined by 25%-plus since then. Total external debt, which becomes costlier to service as the currency depreciates, was about $139 billion, or 71% of GDP, in Q3 2015 (Chart 18). It has risen sharply ever since the fall in export revenues post-2011. The destruction of the currency by definition makes the foreign debt burden grow. Chart 18External Debt Soars... External Debt Soars... External Debt Soars... Chart 19...While Forex Reserves Dwindle ...While Forex Reserves Dwindle ...While Forex Reserves Dwindle The regime's hard currency reserves are rapidly drying up - they have fallen from nearly $30 billion in 2013 to just $10 billion today (Chart 19). Without hard cash, Venezuela will be unable to meet import costs and external debt payments. In Table 1, we assess the country's ability to make these payments at different oil-price and output levels. Assuming the YTD average Venezuelan crude price of $44/bbl, export revenue should hit about $32 billion this year, while imports should hover around $21 billion, leaving $11 billion for debt servicing costs of roughly $10 billion (combining the state's $8 billion with PDVSA's $2 billion). Thus if global oil prices hold up - as we think they will - the regime may be able to squeak by another year. Image In short, the regime could have about $11 billion in revenues left at the end of the year if the Venezuela oil basket hovers around $44/bbl and production remains at about 2 MMB/d. That is a "minimum cash" scenario for the regime this year, though it by no means guarantees regime survival amid the widespread economic distress of the population. Chart 20Foreign Asset Sales Will Continue Foreign Asset Sales Will Continue Foreign Asset Sales Will Continue If production drops to 1.25 MMb/d or lower as a result of the economic crisis - or if Venezuelan oil prices settle at $28/bbl or below - the regime will be unable to meet its import costs and debt payments. It will have to sell off more of its international assets as rapidly as it can (Chart 20), restrict imports further, and eventually default. Moreover, the calculation becomes much more negative for Venezuela if we assume, conservatively, $10 billion in capital outflows, which is far from unreasonable. Outflows could easily wipe out any small remainder of foreign reserves. So far, the government has chosen to deprive the populace of imports rather than default on external debt, wagering that the military and other state security forces can suppress domestic opposition for longer than the regime can survive under an international financial embargo. This strategy is fueling mass protests, riots, and clashes with the National Guard and Bolivarian colectivos (militias). An extension of the OPEC-Russia production cuts in late May, which we expect, will bring much-needed relief for Venezuela's budget. Thus, there is a clear path for regime survival through 2017 on a purely fiscal basis, though it is a highly precarious one - the reality is that the state is bound to default sooner or later. Moreover, the socio-political crisis has already spiraled far enough that a modest boost to oil prices this year will probably be too little, too late to save Maduro and the PSUV in its current form. As we discuss below, the question is only whether the military takes greater control to perpetuate the current regime, or the opposition is gradually allowed to take power and renovate the constitutional order. Bottom Line: Even if oil production holds up, and oil prices average above $44/bbl as we expect, the country's leaders will have to take extreme measures to avoid default. Domestic shortages and military-enforced rationing will compound. As economic contraction persists, social unrest will intensify. Will The Military Throw A Coup? Explosive popular discontent this year shows no sign of abating. It is a continuation of the mass protests and sporadic violence since the economic crisis fully erupted in 2014. However, as recession deepens - and food, fuel, and medicine shortages become even more widespread - unrest will spread to a broader geographic and demographic base. Protests since September 2016 have drawn numbers in the upper hundreds of thousands, possibly over a million on two occasions. Security forces have increasingly cracked down on civilians, raising the death toll and provoking a nasty feedback loop with protesters. Reports suggest that the poorest people - the Chavista base - are increasingly joining the protests, which is a new trend and bodes ill for the ruling party's survival. Already the public has turned against the United Socialist Party, as evinced by the December 2015 legislative election results and a range of public opinion polls, which show Maduro's support in the low-20% range. In the 2015 vote, the opposition defeated the Chavistas for the first time since 1998. The Democratic Unity Roundtable won a majority of the popular vote and a supermajority of the seats in the National Assembly. Since then, however, Maduro has used party-controlled civilian institutions like the Supreme Court and National Electoral Council - backed by the military and state security - to prevent the opposition's exercise of its newfound legislative power. Key signposts to watch will be whether Maduro is pressured into restoring the electoral calendar. The opposition has so far been denied local elections (supposedly rescheduled for later this year) and a popular referendum on recalling Maduro. So it has little reason to expect that the government will hold the October 2018 elections on time. The government is likely to keep delaying these votes because it knows it will lose them. In the meantime, the opposition has few choices other than protests and street tactics to try to pressure the government into allowing elections after all. Further, oil prices are low, so the regime is vulnerable, which means that the opposition has every incentive to step up the pressure now. If it waits, higher prices could give Maduro a new infusion of revenues and the ability to prolong his time in power. The question at this point is: will the military defect from the government? The military is the historical arbiter of power in the country. Maduro - who unlike Chavez does not hail from a military background - has only managed to make it this far by granting his top brass more power. Crucially, in July 2016, Maduro handed army chief Vladimir Padrino Lopez control over the country's critical transportation and distribution networks, including for food supplies. He has also carved out large tracts of land for a vast new mining venture, supposed to focus on gold, which the military will oversee and profit from.7 What this means is that the government and military are becoming more, not less, integrated at the moment. The army has a vested interest in the current regime. It is also internally coherent, as recent political science research shows, in the sense that the upper-most and lower-most ranks are devoted to Chavismo.8 Economic sanctions and human rights allegations from the U.S. and international community reinforce this point, making it so that officials have no future outside of the regime and therefore fight harder for the regime to survive.9 Still, there are fractures within the military that could get worse over time. Divisions within the ranks: An analysis of the Arab Spring shows that militaries that defected from the government (Egypt, Tunisia), or split up and made war on each other (Syria, Libya, Yemen), exhibited certain key divisions within their ranks.10 Looking at these variables, Venezuela's military lacks critical ethno-sectarian divisions, but does suffer from important differences between the military branches, between the army and the other state security forces, and between the ideological and socio-economic factions that are entirely devoted to Chavismo versus the rest. Thus, for example, it is possible that Bolivarian militias committing atrocities against unarmed civilians could eventually force the military to change its position to preserve its reputation.11 Popular opinion: Massive protests have approached 1 million people by some counts (of a population of 31 million) and have combined a range of elements within the society - not only young men or violent rebels/anarchists. Also, public opinion surveys suggest that supporters of Maduro have a more favorable view of the army, and opponents have a less favorable view.12 This implies that Maduro's extreme lack of popular support is a liability that will weigh on the military over time. Military funds shrinking: Because of the economic crisis, Maduro has been forced to slash military spending by a roughly estimated 56% over the past year (Chart 21). The military may eventually decide it needs to fix the economy in order to fix its budget. Image Autonomous military leader: That General Lopez has considerable autonomy is another variable that increases the risk of military defection or fracture. As the country slides out of control Lopez will likely intervene more often. He already did so recently when the Chavista-aligned Supreme Court tried to usurp the National Assembly's legislative function. The attorney general, Luisa Ortega Diaz, broke with party norms by criticizing the court's ruling. Maduro was forced to order the court to reverse it, at least nominally restoring the National Assembly's authority. Lopez supposedly had encouraged Maduro to backtrack in this way, contrary to the advice of two notable Chavistas, Diosdado Cabello and Vice President Tareck El Aissami. Ultimately, military rule for extended periods is common in Venezuelan history. Chavez always deeply integrated the party and military leadership, so the regime could persist through greater military assertion within it, or the military could take over and initiate topical political changes. Finally, if Lopez is ready to stage a coup, he may still wait for oil prices to recover. It makes more sense to let the already discredited ruling party suffer the public consequences of the recession than to seize power when the country is in shambles. Previous coup attempts have occurred not only when oil prices were bottoming but also when they bounded back after bottoming (Chart 22). It would appear that the Venezuelan military is as good at forecasting oil prices as any Wall Street analyst! For oil markets, the military's strong grip over the country suggests that even if Maduro and the PSUV collapse, the party loyalists at PDVSA may not have the option of going on strike. The military will still need the petro dollars to stay in power, and it will have the guns to insist that production keeps up, as long as economic destitution does not force operations to a halt. Bottom Line: There is a high probability that the military will expand its overt control over the country. As long as the leaders avoid fundamental economic reforms, the result of any full-out military coup against Maduro may just mean more of the same, which would be politically and economically unsustainable. Chart 22Coups Can Come After Oil Price Recovers Coups Can Come After Oil Price Recovers Coups Can Come After Oil Price Recovers Chart 23Stay Short Venezuelan Sovereign Bonds Stay Short Venezuelan Sovereign Bonds Stay Short Venezuelan Sovereign Bonds Investment Implications Any rebound in oil prices as a result of an extension of OPEC's and Russia's production cuts at the OPEC meeting on May 25 will be "too little, too late" in terms of saving Maduro and the PSUV. They may be able to play for time, but their legitimacy has been destroyed - they will only survive as long as the military sustains them. To a great extent, the ruling party has already handed the keys over to the military, and military rule can persist for some time. Hence oil production is more likely to continue its slow decline than experience a sudden shutdown, at least this year. This is because it is likely that military control will tighten, not diminish, when Maduro falls. Incidentally, the military is also more capable than the current weak civilian government of forcing through wrenching policy adjustments that are necessary to begin the process of normalizing economic policy - such as floating the currency and cutting public spending. But any such process would bring even more economic pain and unrest in the short term, and it has not begun yet. Even if the ruling party avoids defaulting on government debts this year - which is possible given our budget calculations - it is on the path to default before long. We remain short Venezuelan 10-year sovereign bonds versus emerging market peers. This trade is down 330 basis points since initiation in June 2015, but Venezuelan bonds have rolled over and the outlook is dim (Chart 23). Within the oil markets, our base case is that global oil producers have benefitted and will benefit from the marginally higher prices derived from Venezuela's slow production deterioration. Should a more sudden and severe production collapse occur, the upward price response would be much more acute. A sustained outage of Venezuelan production would send oil prices quickly towards $80-$100/bbl as a necessary price signal to curb demand growth, creating a meaningful recessionary force around the globe. Oil producers, specifically U.S. shale producers that can react quickly to these price signals, would stand to benefit temporarily from the higher prices, but would again suffer from falling oil prices in the inevitable post-crisis denouement. Matt Gertken, Associate Vice President Geopolitical Strategy mattg@bcaresearch.com Matt Conlan, Senior Vice President Energy Sector Strategy mattconlan@bcaresearchny.com 1 For the military takeover, please see "Venezuelan Debt: The Rally Is Late," in BCA Emerging Markets Strategy, "EM: From Liquidity To Growth?" dated August 24, 2016, available at ems.bcaresearch.com. 2 Please see BCA Geopolitical Strategy Strategic Outlook, "Strategic Outlook 2017: We Are All Geopolitical Strategists Now," dated December 14, 2016, available at gps.bcaresearch.com. 3 Please see BCA Geopolitical Strategy Special Report, "The Energy Spring," dated December 10, 2014, available at gps.bcaresearch.com; BCA Commodity and Energy Strategy Weekly Report, "Tactical Focus Again Required In 2017," dated January 5, 2017, available at ces.bcaresearch.com; and Energy Sector Strategy Weekly Report, "The Other Guys In The Oil Market," dated April 5, 2017, available at nrg.bcaresearch.com. 4 Please see BCA Geopolitical Strategy and Emerging Markets Strategy Special Report, "Venezuelan Chavismo: Life After Death," dated April 2, 2013, available at gps.bcaresearch.com. 5 Please see BCA Geopolitical Strategy, "Strategic Outlook 2013," dated January 16, 2013, and Monthly Report, "The Reflation Era," dated December 10, 2014, available at gps.bcaresearch.com. 6 Please see BCA Emerging Markets Strategy Weekly Report, "Assessing Political And Financial Landscapes In Argentina, Venezuela And Brazil," dated January 6, 2016, available at ems.bcaresearch.com. 7 For Lopez's taking control, please see "Venezuelan Debt: The Rally Is Late" in BCA Emerging Markets Strategy Weekly Report, "EM: From Liquidity To Growth?" dated August 24, 2016, available at ems.bcaresearch.com. For the gold mine, please see Edgardo Lander, "The Implosion of Venezuela's Rentier State," Transnational Institute, New Politics Papers 1, September 2016, available at www.tni.org. 8 The junior officers have advanced through special military schools set up by Chavez, while the senior officials have been carefully selected over the years for their loyalty and ideological purity. Please see Brian Fonseca, John Polga-Hecimovich, and Harold A. Trinkunas, "Venezuelan Military Culture," FIU-USSOUTHCOM Military Culture Series, May 2016, available at www.johnpolga.com. 9 Please see David Smilde, "Venezuela: Options for U.S. Policy," Testimony before the United States Senate Committee on Foreign Relations, March 2, 2017, available at www.foreign.senate.gov. 10 Please see Timothy Hazen, "Defect Or Defend? Explaining Military Responses During The Arab Uprisings," doctoral dissertation, Loyola University Chicago, December 2016, available at ecommons.luc.edu. 11 Civilian deaths caused by the National Guard and Chavez's loyalist militias triggered the aborted 2002 military coup. Please see Steven Barracca, "Military coups in the post-cold war era: Pakistan, Ecuador and Venezuela," Third World Quarterly 28: 1 (2007), pp. 137-54. 12 See footnote 8 above.

Highlights Portfolio Strategy Operating leverage could surprise on the strong side this year, based on the message from our pricing power and wage growth indicators. REITs are experiencing a playable recovery following the Fed-induced sell-off earlier this year, and overweight positions will continue to pay off. Energy services activity is set to steadily accelerate this year, powering an earnings-led share price outperformance phase. Recent Changes There are no changes to our portfolio this week. Table 1 Operating Leverage To The Rescue? Operating Leverage To The Rescue? Feature Volatility has climbed to the highest level since the U.S. election, signaling that the broad market is not yet out of the woods. As stocks recalibrate to a cooling in economic growth momentum and an escalation in geopolitical threats, downside risks should be reasonably contained by mounting signs of a healthier corporate sector. Last week we posited that stronger top line revenue growth is necessary to sustain the profit upcycle, and provide justification for historically rich valuations. Chart 1 shows sales and EPS growth over the long-term. Chart 1Joined At The Hip Joined At The Hip Joined At The Hip Obviously, the two move closely together, with earnings enjoying more powerful growth phases when revenue accelerates. Since 1960, regression analysis shows that operating leverage for the S&P 500's is 1.4X. In other words, a 5% increase in sales growth typically leads to 7% EPS growth. When sales are initially recovering from a deep slump operating leverage can be even higher, with earnings often rising two to three times as fast as revenue. Clearly, that is not sustainable, but can give the illusion of powerful and sustained growth for brief periods of time. At the current juncture, there are reasons to expect investors to embrace the durability of the profit expansion. Our corporate pricing power proxy has vaulted higher. Importantly, the breadth of this surge has been impressive, which bodes well for its staying power (Chart 2, second panel). On the flip side, rising labor costs look set to take a breather. Compensation growth has crested, and according to our diffusion index, fewer than half of the 18 industries tracked have higher wages than last year. The wage growth diffusion index provides a reliable leading indication for the trend in labor expenses. In other words, pricing power is rising on a broad basis while wage inflation is decelerating on a broad basis. Consequently, there are decent odds that resilient forward operating margin expectations can be matched (Chart 2, bottom panel). Elsewhere, a revival in animal spirits, the potential for easier fiscal policy and prospects for a hiatus in the U.S. dollar bull market bode well for brisk business activity. While the budding recovery in global trade could sputter if protectionism proliferates, our working assumption is that the U.S. Administrations' bark will be worse than its bite. Thus, a self-reinforcing sales and profit upcycle could be materializing. The objective message from our S&P 500 EPS model concurs (Chart 3), underscoring that high single digit/low double digit profit growth could be broadly perceived as attainable this year. Chart 2Profit Margins Can Expand Profit Margins Can Expand Profit Margins Can Expand Chart 3Few Sectors Control The Fate Of S&P 500 EPS Few Sectors Control The Fate Of S&P500 EPS Few Sectors Control The Fate Of S&P500 EPS True, our model has recently shown tentative signs of cresting, but difficult comparisons will only arise later this year. Indeed, Q3 and Q4 2016 were all-time high EPS numbers, implying that 12% estimated growth rates are a tall order (Chart 3, middle panel). Importantly, dissecting the profit growth sectorial contribution is instructive. Calendar 2017 over 2016 S&P 500 earnings growth is concentrated in four sectors: tech, energy, health care and financials comprise over 87% of the incremental profit growth expected (Chart 3, bottom panel). The upshot is that there is a high degree of concentration risk to fulfilling overall profit growth expectations. Energy profits are wholly dependent on the oil price, and financial sector profit optimism appears to have embedded a healthy increase in both interest rates and capital markets activity. In addition, tech sector earnings are heavily influenced by the U.S. dollar. Consequently, it will be critical for monetary conditions to stay loose, otherwise estimates will be at risk of downward revisions. Adding it up, the corporate sector sales pendulum is finally swinging in a positive direction, which should support the cyclical overshoot in stocks for a while longer, notwithstanding our expectation that the current corrective phase has further to run. This week we are updating our high-conviction overweight views on both the lagging energy services index and REIT sector. Revisiting REITs REITs have staged a mini V-shaped rebound after being punished alongside rising bond yields and worries about aggressive Fed rate hikes earlier this year. As outlined in recent Weekly Reports, the reflation theme is likely to lose steam in the second half of the year as economic momentum cools, providing additional impetus for capital inflows into the more stable income profile of REITs. Even if the economy proves more resilient and Treasury yields move higher, there are few barriers to additional outperformance. Our Technical Indicator, a combination of rates of change and moving average divergences, is extremely oversold. Forward intermediate and cyclical relative returns from current readings have been solid, as occurred in 2004, 2008 and 2014 (Chart 4). REIT valuations are more than one standard deviation below normal, according to our gauge. This suggests that poor operating performance and/or higher discount rates are already expected. There may be a limit as to how high bond yields can climb, given that they are already deep in undervalued territory according to the BCA 10-year Treasury Bond Valuation Index (Chart 4). Regardless, history shows that REITs have typically had a more positive than negative correlation with bond yields. The inverse correlation has only been in place since the financial crisis, when zero interest rate policies pushed massive capital flows into all yield generating assets. Chart 5 shows that prior to 2008, REITs outperformed during periods of both rising and falling Treasury yields. Chart 4Unloved And Undervalued Unloved And Undervalued Unloved And Undervalued Chart 5No Concrete Correlation Pre GFC No Concrete Correlation Pre GFC No Concrete Correlation Pre GFC Similarly, REITs have a solid track record during periods of rising inflation pressures. Since 1975, there have been six periods of rising core PCE inflation: REITs have enjoyed meaningful rallies during five of these phases (Chart 6). Hard assets tend to hold their stock market value well when overall inflation moves higher, with REIT net asset values providing solid support to share price performance. Chart 6Buy REITs In Times Of Inflation Buy REITs In Times Of Inflation Buy REITs In Times Of Inflation Looking ahead, REITs should continue to enjoy success in boosting rental rates. Occupancy rates continue to rise (Chart 7). The unemployment rate is low, consumption is decent and businesses are growing increasingly confident. That is a recipe for higher rental demand. Our Rental Rate Composite has crested on a growth rate basis, but the advance in the CPI for homeowner's equivalent rent, a good proxy for REITs, suggests that the path of least resistance remains higher (Chart 7). REIT supply growth has also leveled off, which provides additional confidence that rental inflation will remain solid. Nevertheless, there are some areas of concern. Banks are tightening lending standards on commercial real estate loans. Some sub-categories are experiencing a mild deterioration in credit quality. For instance, Chart 8 shows that delinquency rates in the retail and office spaces have edged higher. Retail and mall REITs are likely under structural pressure owing to online competition from the likes of Amazon. Chart 7Rental Demand##br## Is Solid Rental Demand Is Solid Rental Demand Is Solid Chart 8Watch Delinquencies As ##br##Banks Tighten Credit Standards Watch Delinquencies As Banks Tighten Credit Standards Watch Delinquencies As Banks Tighten Credit Standards Overall vacancy rates are still very low (Chart 8), but if credit becomes too tight, then the relentless advance in commercial property prices may cool. For now, our REIT Demand Indicator is not signaling any imminent stress. In fact, the economy is strong enough to expect occupancy rates to keep climbing, to the benefit of underlying property valuations and rental income (Chart 7, bottom panel). In sum, the budding rebound in REIT relative performance should be embraced as the start of a sustained trend. Total return potential is very attractive on a relative basis. Bottom Line: REITs remain a very attractive high-conviction overweight. Energy Servicers Are Cleaning Up Their Act We put the S&P energy services index on our high-conviction overweight list at the start of the year, because three critical factors that typically lead to a playable rally existed, namely; the global rig count had hit an inflection point, oil supplies were easing and global oil production growth had begun to decelerate. While the pullback in oil prices has undermined relative performance for the time being, there is scope for a full recovery, and more. Oil prices have firmed, underpinned by a revival in the geopolitical risk premium following the U.S. bombing campaign in Syria. There is already a wide gap between share prices and oil prices (Chart 9, top panel), and a narrowing is probable, especially as earnings drivers reaccelerate. There are tentative signs that capital spending cuts are finally reversing. The global rig count has rebounded, and is a good leading indicator for investment (Chart 10). This message is corroborated by our Global Capex Indicator, which has recently surged anew (Chart 10). Chart 9Room For ##br##Margin Improvement... Room For Margin Improvement... Room For Margin Improvement... Chart 10...As Deflation Eases ##br##And Capex Rebounds ...As Deflation Eases And Capex Rebounds ...As Deflation Eases And Capex Rebounds The longer that oil prices can stay in their current trading range, or beyond, the more time E&P balance sheets have to heal and the greater the odds that the cost of capital will be reduced. Against this backdrop, there are high odds that previously mothballed exploration projects will be restored. The V-shaped recovery in the global oil rig count, albeit from a very low base, will eventually absorb excess capacity and allow the industry to escape deflation. A major improvement in day rates is unlikely given the scale of the previous capacity boom, but even a modest pricing power improvement should provide a nice boost given high operating leverage. EBITDA margins have considerable room to improve if pricing power grows anew (Chart 9, bottom panel). Importantly, the shifting composition of global production will allow service companies with domestic exposure to shine. Shale oil producers should recapture lost market share, given that the onus to rebalance markets has been taken on by OPEC. OPEC production is contracting, while non-OPEC output is starting to recover (Chart 11, bottom panel), culminating in a widening in the Brent-WTI oil price spread. Production restraint is helping to rebalance physical oil markets. Total OECD inventory growth is reversing, and anecdotal reports are surfacing that floating storage is rapidly being depleted. Oil supply at Cushing is on the cusp of contracting, which is notable given that this has had a high correlation with relative share price performance for the past decade (oil supply shown inverted, Chart 11). On a global basis, global inventory drawdowns have been correlated with a firming industry relative profitability, and vice versa. OECD oil supply growth is rapidly receding, which augurs well for an extension of budding earnings outperformance (Chart 12, middle panel). Chart 11Receding Inventories ##br##Should Boost Performance... Receding Inventories Should Boost Performance… Receding Inventories Should Boost Performance… Chart 12...EPS And##br## Valuations ...EPS And Valuations ...EPS And Valuations The rise in clean tanker rates reinforces that oil demand is rising quickly enough to expect additional inventory depletion (Chart 12, bottom panel). Typically, tanker rates and energy service relative valuations are positively correlated. Adding it up, a rising global rig count, decelerating inventories and restrained oil production continue to bode well for a playable rally in the high-beta S&P energy services group. Bottom Line: We reiterate our high-conviction overweight stance in the S&P energy services index. The ticker symbols for the stocks in this index are: BLBG: S5ENRE - SLB, HAL, BHI, NOV, FTI, HP, RIG. Current Recommendations Current Trades Size And Style Views Favor small over large caps and stay neutral growth over value.

Energy services shares have pulled back as oil prices have marked time over the last few weeks, but in the background, the conditions to sustain a rally are falling into place. The growth in total OECD oil stocks has rolled over decisively, and a continued supply/demand rebalancing should occur given that world oil production growth has slipped to nil courtesy of OPEC output cuts. The bond market has increased confidence that oil prices will not tumble anew, as reflected in the sharp narrowing in energy corporate bond spreads. Many companies have used the recovery in oil prices to refinance and bolster balance sheets, underscoring that the financial means to boost exploration exist. With energy services pricing power trying to make an early exit from deflation on only a small boost to the global rig count, there is scope for the attractively valued S&P oil & gas field services index to surprise on the upside. We have this at high-conviction overweight. The ticker symbols for the stocks in the S&P oil & gas field services index are: BLBG: S5ENRE - SLB, HAL, BHI, NOV, FTI, HP, RIG. Energy Services Have Lagged, But Not For Long Energy Services Have Lagged, But Not For Long

Highlights Portfolio Strategy A battle between tighter monetary conditions and the anticipation of fiscal largesse will be a dominant market theme this year. Our high-conviction equity allocation calls do not require making a major directional global economic bet, or second guessing the Fed's desire to continue tightening. The bulk of our calls could currently be considered contrarian, based on recent market momentum and sub-surface relative valuation swings. Recent Changes S&P Insurance Index - Downgrade to high-conviction underweight. Nasdaq Biotech Index - Downgrade to high-conviction underweight. Feature Stocks have already paid for a significant acceleration in earnings and economic growth this year and beyond. Fourth quarter earnings season will be the first real test of investor expectations since the post-election market surge. While recent data have been encouraging, forward corporate profit guidance is unlikely to be robust in the face of the U.S. dollar juggernaut. Currently, the hope is that fiscal stimulus will offset tighter monetary settings, ultimately delivering a higher plane of economic activity. The major risks are that the economy loses momentum before fiscal spending cranks up, and/or that profits diverge from a more resilient economic performance than liquidity conditions forecast. Indeed, fiscal stimulus isn't slated to accelerate until next year (Chart 1), while the impact of anti-growth market moves is far more imminent. Our Reflation Gauge has plunged, heralding economic disappointment (Chart 1). With the economy near full employment, Fed hawkishness could persist even in the face of any initial evidence of economic cooling. Under these conditions, the gap between nominal GDP and 10-year Treasury yields could turn negative in the first half of the year (Chart 2), which would be a major warning sign for stocks. Chart 1Fiscal Stimulus Is Still A Long Way Off Fiscal Stimulus Is Still A Long Way Off Fiscal Stimulus Is Still A Long Way Off Chart 2Warning Signal Warning Signal Warning Signal As a result, while the market has recently been focused almost solely on return, our emphasis at this juncture is on minimizing risk. That is consistent with the historic market performance during Fed tightening cycles. Going back to the early-1970s and using the last seven Fed interest rate hiking periods, it is evident that non-cyclical sector relative performance benefits immensely on both a 12 and 24 month horizon from the onset of Fed tightening (Charts 3 and 4). Cyclical sectors typically lag the broad market, while financials generally market perform1. Chart 312-Month Performance After Fed Hikes 2017 High-Conviction Calls 2017 High-Conviction Calls Chart 424-Month Performance After Fed Hikes 2017 High-Conviction Calls 2017 High-Conviction Calls Some of the other major macro forces that are likely to influence the broad market and sectoral trends are: Ongoing strength in the U.S. dollar and its drag on top-line growth: loose fiscal policy and tight monetary policy is a classic recipe for currency strength. Tack on high and rising interest rate differentials due to policy divergences with the rest of the world (Chart 5), and exchange rate strength is likely to persist in the absence of a major domestic economic downturn. A tough-talking Fed. Wage growth is accelerating and broadening out, and will sharpen the Fed's focus on inflation expectations. With dollar strength constraining revenue growth potential, strong wage gains are profit margin sapping (Chart 2). A divergence between economic growth and profit performance, i.e. stronger growth is unlikely to feed into equal growth in corporate sector earnings given the squeeze on profit margins from a recovery in labor's ability to garner a larger share of aggregate income. Disappointment and/or uncertainty as to the timing and rollout of the much anticipated fiscal spending programs and unfunded tax cuts. Favoring domestic vs. global exposure will remain a key theme. Emerging markets (EM) have not validated the sharp jump in the global vs. domestic stocks, nor cyclical vs. defensives (Chart 6). Chart 5Greenback Is A Drag##br## On S&P 500 Top Line Growth Greenback Is A Drag On S&P 500 Top Line Growth Greenback Is A Drag On S&P 500 Top Line Growth Chart 6Mind##br## The Gap Mind The Gap Mind The Gap EM stocks are pro-cyclical, and outperform when economic growth prospects are perceived to be improving. The surging U.S. dollar is a growth impediment for many developing countries with large foreign liabilities to service. The U.S. PMI is gaining vs. the Chinese and euro area PMI (Chart 7, second panel), heralding a rebound in cyclical share price momentum. World export growth remains anemic and will remain so based on EM currency trends (Chart 7). When compared with the reacceleration in U.S. retail sales, the outlook for domestically-sourced profits is even brighter. The other key sectoral theme is to favor areas geared to the consumer rather than the corporate sector. Consumer income statements and balance sheets are far healthier than those of the corporate sector (Chart 8). As a result, they are in a more propitious position to spend and expand. Chart 7Domestics Will Rise To The Occasion Domestics Will Rise To The Occasion Domestics Will Rise To The Occasion Chart 8Consumers Trump The Corporate Sector Consumers Trump The Corporate Sector Consumers Trump The Corporate Sector We expect all of these forces to truncate rally attempts in 2017. The market is already stretching far enough technically to flag risk of a potentially sizeable correction in the first quarter, i.e. greater than 10%, particularly given the significant tightening in monetary conditions and overheating bullish sentiment that have developed. In other words, it is not an environment to chase the post-election winners, nor turn bearish on the losers that have been eschewed. Against this backdrop, we are introducing our top ten high-conviction calls for 2017. As always, these calls are fundamentally-based and we expect them to have longevity and/or meaningful relative return potential, rather than just reflect recent momentum trends. We recognize the difficulty of trading in and out of positions on a short-term basis. Energy Services - Overweight Chart 9Playable Rally Playable Rally Playable Rally The energy sector scores well in relative performance terms when the Fed is hiking interest rates2, supporting a high-conviction overweight in the energy services group. OPEC's agreement to curtail production should hasten supply/demand rebalancing that was already slated to occur via non-OPEC production declines through 2017. U.S. shale producers slashed capital expenditures by 65% from 2014 to 2016, and the International Oil Companies reduced capital expenditures by 40% over the same period. OPEC's decision to trim output should mitigate downside commodity price risks, providing debt and equity markets with confidence to restore capital availability to the sector. With easier access to capital, producers, especially shale, will be able to accelerate drilling programs in a stable commodity price environment. The three factors traditionally required to sustain a playable rally are now in place. The rig count has troughed. The growth in OECD oil inventories has crested. The latter is consistent with a gradual rise in the number of active drilling rigs. Finally, global oil production growth is falling steadily. Pricing power is likely to be slow to recover this cycle given the scope of previous capacity excesses, but even a move to neutral would remove a major drag and reduce the associated share price risk premium (Chart 9). Consumer Staples - Overweight 2016 delivered a number of company specific body blows to the consumer staples sector, most notably concerns about the pharmacy benefit manger pricing model, which undermined the retail drug store group. Thereafter, the sector was shunned on a macro level following the election, as it was used as a source of capital to fund aggressive purchases in more cyclical sectors. This has set the stage for a contrarian buying opportunity in a high quality, defensive sector with one of the best track records during Fed tightening cycles3. The sector is now closing in on an undervalued extreme, in relative terms, having already reached such a reading in technical terms (Chart 10). Our Cyclical Macro Indicator is climbing, supported by the persistent rise in consumers' preference for saving. The latter heralds an increase in outlays at non-cyclical retailers relative to sales at more discretionary stores. Importantly, consumer staples exports have reaccelerated, despite the strong U.S. dollar, pointing to a further acceleration in sector sales growth, and by extension, free cash flow. The strong U.S. dollar is a major boon, from an historical perspective, given that it typically creates increased global economic and market volatility. The latter is starting to pick up (Chart 10). A strong currency, particularly bilaterally against China, also implies a reduction in the cost of imported goods sold, and heralds a relative performance rebound (Chart 11). Chart 10Contrarian Buy Contrarian Buy Contrarian Buy Chart 11China To The Rescue? China To The Rescue? China To The Rescue? Home Improvement Retail - Overweight Enticing long-term housing prospects argue for looking through the recent rise in mortgage rates. Household formation is reaccelerating, as full employment is boosting consumer confidence, and clocking at a higher speed than housing starts. The implication is that pent-up housing demand will be unleashed. In fact, consumers have only recently started re-levering, with banks more than willing to facilitate renewed appetite for mortgage debt. Remodeling activity is booming and anecdotes of house flipping activity picking up steam are corroborating that the housing market is vibrant. Now that house prices have recently overtaken the 2006 all-time highs, the incentive to upgrade and remodel should accelerate. While the recent backup in bond yields has been a setback for housing affordability, the U.S. consumer is not priced out of the housing market. Yields are rising in tandem with job security and wages. Mortgage payments remain below the long-term average as a share of income and effective mortgage rates remain near generationally low levels. Building supply store construction growth has plumbed to the lowest level since the history of the data. Historically, capacity restraint has represented a boost to home improvement retail (HIR) profit margins and has been inversely correlated with industry sales growth. Stable housing data and improving operating industry metrics entice us to put the compellingly valued S&P HIR on our high-conviction buy list for 2017 (Chart 12). Chart 12Benefiting From Enticing##br## Long-Term Housing Prospects Benefiting From Enticing Long-Term Housing Prospects Benefiting From Enticing Long-Term Housing Prospects Chart 13Healthy Consumer Is A Boon##br## To Consumer Finance Stocks Healthy Consumer Is A Boon To Consumer Finance Stocks Healthy Consumer Is A Boon To Consumer Finance Stocks Consumer Finance - Overweight We are focusing our early-cyclical exposure on overweighting the still bruised S&P consumer finance index. This group is levered to the rising interest rate environment and debt-financed consumer spending. The selloff in the 10-year Treasury bond has been closely correlated with relative performance gains and the current message is to expect additional firming in the latter (Chart 13, top panel). Importantly, higher interest rates have boosted credit card interest rate spreads (the industry's equivalent net interest margin metric), underscoring that the next leg up in relative share prices will be earnings led (Chart 13, bottom panel). On the consumer front, consumer finances are healthy, the job market is vibrant and consumer income expectations are on the rise. In addition, house prices have vaulted to fresh all-time highs and are still expanding on a y/y basis. The positive wealth effect provides motivation for consumers to run down savings rates (Chart 13, second & third panels). Health Care Equipment - Overweight Health care equipment (HCE) stocks have been de-rated alongside the broad health care index, trading at a mere market multiple and below the historical mean, representing a buy opportunity. Revenue growth has been climbing at a double digit clip (Chart 14, third panel) and the surging industry shipments-to-inventories ratio is signaling that still depressed relative sales growth expectations will surprise to the upside (Chart 14, top panel). Synchronized global growth is also encouraging for U.S. medical equipment exports, despite the U.S. dollar's recent appreciation. The ageing population in the developed markets along with pent up demand for health care services in the emerging markets where a number of countries are developing public safety nets, bode well for HCE long-term demand prospects. The bottom panel of Chart 14 shows that the global PMI has been an excellent leading indicator of HCE exports and the current message is positive. The recent contraction in valuation multiples suggests that sales are expected to disappoint in the coming year, an outlook that appears overly cautious, especially within the context of the nascent improvement in industry return on equity (Chart 14, second panel). Chart 14HCE Stocks Are Cheap Given##br## Improving Final Demand Outlook HCE Stocks Are Cheap Given Improving Final Demand Outlook HCE Stocks Are Cheap Given Improving Final Demand Outlook Chart 15More Than##br## Meets The Eye More Than Meets The Eye More Than Meets The Eye REITs - Overweight REITs have traded as if the back up in global bond yields will persist indefinitely, and that the level of interest rates is the only factor that drives relative performance. Improving cash flows and cheap valuations suggest that REITs can decouple from bond yields. Our REIT Demand Indicator (RDI) has climbed into positive territory, signaling higher rental inflation. The latter is already outpacing overall CPI by a wide margin. The RDI is also positively correlated with commercial property prices, implying more new highs ahead. That will support higher net asset values. While increased supply is a potential sore spot, particularly in the residential space, multifamily housing starts have rolled over relative to the total, suggesting that new apartment builds are diminishing. As discussed in previous research reports, contrary to popular perception, relative performance is also depressed from a structural perspective. REIT relative performance is trading well below its long-term trend, a starting point which has historically overwhelmed any negative pressure from a Fed tightening cycle (Chart 15). Tech Hardware Storage & Peripherals - Underweight The S&P technology hardware storage & peripherals (THSP) sector is a disinflationary play (10-year treasury yield change shown inverted, second panel, Chart 16) and benefits when prices are deflating, not when there are whiffs of inflation4. The tech sector has the highest foreign sales/EPS exposure among the top 11 sectors, and the persistent rise in the greenback is weighing on export prospects for the THSP sub-index (Chart 16, third panel), and by extension top and bottom line growth. Computer and electronic products new order growth has fallen sharply recently, warning that THSP sales growth will remain downbeat. Industry investment is also probing multi-year lows (not shown). Asian inventory destocking is ongoing, which will pressure selling prices, but the end of this liquidation phase would be a signal that the worst will soon be over. Technical conditions are bearish. A pennant formation signals that a breakdown looms. Chart 16Tech Stocks Hate Reflation Tech Stocks Hate Reflation Tech Stocks Hate Reflation Chart 17Shy Away, Don't Be Brave Shy Away, Don’t Be Brave Shy Away, Don’t Be Brave Biotech - Underweight The Nasdaq biotech index is following the BCA Mania Index, which includes previous burst bubbles in a broad array of asset classes. The top panel of Chart 17 shows that if history at least rhymes, biotech bubble deflation is slated to continue. Only 45 stocks in the NASDAQ biotech index have positive 12-month forward earnings estimates, comprising 27% of the 164 companies in the index according to Bloomberg. There is still a lot of air to be taken out of the biotech bubble. Historically, interest rates and relative performance have been inversely correlated. The back up in bond yields and Fed tightening represent a draining in liquidity conditions which bodes ill for higher beta and more speculative investments. The biotech derating has been earnings driven and a sustained multiple compression period looms, especially given the sector's poor sales prospects (Chart 17, bottom panel) Worrisomely, not only have biotech stocks fallen despite Trump's win, but recent speculative zeal (buoyant equity sentiment and resurging margin debt, not shown) has also failed to reinvigorate biotech equities. The NASDAQ biotech index is a sell (ETF ticker: IBB:US). Industrials - Underweight The industrials sector was added to our high-conviction underweight list late last year so the turn in calendar does not require a change in outlook. The sector has discounted massive domestic fiscal stimulus and disregarded the competitive drag on earnings from the U.S. dollar, trading as if a profit boom is imminent. Recent traction in surveys of industrial activity is a plus, but is more a reflection of an improvement in corporate sentiment and is unlikely to translate into imminent industrials sector profit improvement. The U.S. dollar surge is a direct threat to any benefit from an increase in domestic infrastructure or private sector investment spending. Commodity prices and EM drag when the dollar is strong. Chronic surplus EM industrial capacity remains a source of deflationary pressure for their currencies, economies and U.S. industrial companies. U.S. dollar strength warns of renewed pricing power pressure (Chart 18). Non-tech industrial capacity is growing faster than output, and capital goods imports prices are contracting (Chart 18). Tack on the relentless surge in the U.S. dollar, and a new deflationary wave appears inevitable. Relative forward earnings momentum is already negative, and is likely to remain so given the barriers to a top-line recovery, and a soaring domestic wage bill. The sector is not priced for lackluster earnings. Chart 18Fade The Bounce Fade The Bounce Fade The Bounce Chart 19Advance Is Precarious Advance Is Precarious Advance Is Precarious Insurance - Underweight Insurance stocks have benefited from the upward shift in the yield curve and the re-pricing of the overall financials sector, but the advance is precarious. Previously robust insurance pricing power has cracked. The CPI for household insurance is barely growing. The latter is typically correlated with auto premiums, underscoring that they may also slip (Chart 19). While higher interest rates are positive for investment portfolio income, they also imply mark-to-market losses on bond portfolios and incent insurers to underwrite at a faster pace with more lenient standards, which is often a precursor to increased competition and less pricing power. Insurance companies have added massively to cost structures in recent years (Chart 19), while the rest of the financials sector was shedding labor costs. Relative valuations have enjoyed a step-function upshift, but the path of least resistance will be lower for as long as relative consumer spending on insurance products retreats on the back of pricing pressure (Chart 19). 2016 Review... Last year's high-conviction calls were hot out of the gate, and generally had very strong gains until the late-summer/early-fall, but were hijacked by the post-election surge in a few sectors. As a result of the end of year fireworks, our high conviction calls trailed the market by just under 2% for the year ending 2016. Had we had the foresight to predict a Trump win and a massive market rally, we could have closed our positions in early November for comfortably positive gains. In total, our average booked gains in the year were 3% in excess of the broad market since the positions were initiated. We are also closing our pair trades, and will re-introduce a number of new trades in the near future. Anastasios Avgeriou, Vice President Global Alpha Sector Strategy & U.S. Equity Strategy anastasios@bcaresearch.com 1 Please see the U.S. Equity Strategy Special Report titled: "Sector Performance And Fed Tightening Cycles: An Historical Roadmap", available at uses.bcaresearch.com. 2 Ibid 3 Ibid 4 Please see the U.S. Equity Strategy Special Report titled: "Equity Sector Winners And Losers When Inflation Climbs", available at uses.bcaresearch.com. Current Recommendations Current Trades Size And Style Views Favor small over large caps. Favor growth over value (downgrade alert).

Highlights Portfolio Strategy If the Fed is about to begin interest rate re-normalization in earnest, then investors should heed the message from historic sector performance during tightening cycles. The tech sector remains vulnerable to tighter monetary conditions. Downshift communications equipment to neutral and stay clear of software. The OPEC supply agreement reinforces our current energy sector bias, overweight oil services and underweight refiners. Recent Changes S&P Communications Equipment - Reduce to neutral. Table 1 Prepare For The Return Of Equity Volatility Prepare For The Return Of Equity Volatility Feature Chart 1Why Is Equity Vol So Low? bca.uses_wr_2016_12_12_c1 bca.uses_wr_2016_12_12_c1 The equity market has been in a remarkably low volatility uptrend in recent weeks, powered by hopes that political regime shifts will invigorate growth. Signs of economic life have also played a role. The risk is that investors have pulled forward profit growth expectations on the basis of anticipated fiscal stimulus that may disappoint. In the meantime, the tighter domestic monetary conditions get, the less likely equity resilience can persist, especially in the face of rising instability in other financial markets. Volatility has jumped across asset classes, with the bond market leading the charge. The MOVE index of Treasury bond volatility has spiked. Typically, the MOVE leads the VIX index of implied equity market volatility (Chart 1, second panel). Currency and commodity price volatility has also picked up. It would be dangerous to assume that the equity market can remain so sedate. If the economy is about to grow in line with analysts double-digit profit growth expectations and/or what the surge in some cyclical sectors would suggest, then a re-pricing of Fed interest rate hike expectations is likely to persist. Against this backdrop, it is instructive to revisit historic sector performance during past Fed tightening cycles. If one views the next interest rate hike as the start of a sustained trend based on the steep trajectory of expected profit growth embedded in valuations and forecasts, then it is useful to use that as a starting point rather than last year's token 'one and done' interest rate hike. Charts 2 and 3 show the one-year and two-year average sector relative returns after Fed tightening cycles have commenced. A clear pattern is evident: defensive sectors have been the best performers by a wide margin, followed by financials, while cyclical sectors have underperformed over both time horizons. To be sure, every cycle is different, but this is a useful frame of reference for investors that have ramped up growth and cyclical sector earnings expectations in recent months. There has already been considerable tightening based on the Shadow Fed Funds Rate, a bond market-derived fed funds rate not bound by zero percent (Chart 4, shown inverted, top panel). The latter foreshadows a much tougher slog for the broad market. The point is that tighter monetary conditions can overwhelm valuation multiples and growth expectations. Chart 212-Month Performance After Fed Hikes Prepare For The Return Of Equity Volatility Prepare For The Return Of Equity Volatility Chart 324-Month Performance After Fed Hikes Prepare For The Return Of Equity Volatility Prepare For The Return Of Equity Volatility Chart 4A Blow-Off Top? A Blow-Off Top? A Blow-Off Top? The violent sub-surface equity rotation has presented a number of rebalancing opportunities. The defensive health care and consumer staples sectors have been shunned in recent weeks, with capital rotating into financials and industrials. As discussed previously, the industrials and materials sectors cannot rise in tandem for long with the U.S. dollar. These sectors should be used as a source of funds to take advantage of value creation in consumer discretionary, staples and health care where value has reappeared. Chart 5It's Not A ''Growth'' Trade bca.uses_wr_2016_12_12_c5 bca.uses_wr_2016_12_12_c5 Indeed, the abrupt jump in the cyclical vs. defensive share price ratio appears to have been driven solely by external forces, i.e. the sell-off in the bond market, rather than a shift in underlying operating profit drivers. For instance, emerging market (EM) equities and the cyclical vs. defensive share price ratio have tended to move hand-in-hand (Chart 5). The former are pro-cyclical, and outperform when economic growth prospects are perceived to be improving. Recent sharp EM underperformance has created a large negative divergence with the U.S. cyclical vs. defensive share price ratio. The surging U.S. dollar is a growth impediment for many developing countries with large foreign debt liabilities, and the lack of EM equity participation reinforces that the recent rise in industrials is not a one way bet. As a result, our preferred cyclical sector exposure lies in the consumer discretionary sector, and not in capital spending-geared deep cyclical sectors. A market weight in financials, utilities and energy is warranted, as discussed below, while the tech sector is vulnerable. A Roundtrip For The Tech Sector? After a semiconductor M&A-driven spurt of strength, the S&P technology sector has stumbled. As a long duration sector, technology has borne a disproportionate share of the backlash from a higher discount rate, similar to the taper-tantrum period in 2013. Then, bond yields soared as the Fed floated trial balloons about tapering QE. Tech stocks did not trough until yields peaked (Chart 6). In addition, a recovery in tech new orders confirmed that the sales outlook had brightened. Now, the capital spending outlook remains shaky, and tech new order growth is nil (Chart 6). Meanwhile, tech pricing power has nosedived (Chart 6). Domestic deflationary pressures are likely to intensify as the U.S. dollar appreciates, particularly against the manufacturing and tech-sensitive emerging Asian currencies. Tech sales growth is already sliding rapidly toward negative territory (Chart 7), with no reprieve in sight based on the contraction in emerging market exports, as well as U.S. consumer and capital goods import prices. Chart 6Tech Doesn't Like Rising Bond Yields bca.uses_wr_2016_12_12_c6 bca.uses_wr_2016_12_12_c6 Chart 7No Sales Growth bca.uses_wr_2016_12_12_c7 bca.uses_wr_2016_12_12_c7 True, tech stocks have a solid relative performance track record when the U.S. dollar initially embarks on a long-term bull market (Chart 8). Why? Because tech business models incorporate deflationary conditions, investors have been comfortable bidding up valuations in excess of the negative sales impact from a stronger U.S. dollar. Nevertheless, history shows that this relationship becomes untenable the longer currency appreciation persists. Chart 8 shows that in the final phase of the past two U.S. dollar bull markets, tech stocks have abruptly reversed course, rapidly ceding the previously accrued gains. Apart from a loss of competitiveness from currency strength, the new anti-globalization trend is bad for tech as it has the highest foreign sales exposure. The bottom line is that there is no rush to lift underweight tech sector allocations. In fact, we are further tweaking weightings to reduce exposure. For instance, software companies are worth another look through a bearish lens. Software sales growth is at risk from pricing power slippage amidst cooling final demand (Chart 9). Chart 8Beware Phase II Of Dollar Bull Markets bca.uses_wr_2016_12_12_c8 bca.uses_wr_2016_12_12_c8 Chart 9Sell Software... bca.uses_wr_2016_12_12_c9 bca.uses_wr_2016_12_12_c9 The financial sector is an influential technology sector end market. On the margin, financial companies are likely to reduce capital spending on the back of deteriorating credit quality. Chart 9 demonstrates that when financial sector corporate bond ratings start to trend negatively, it is a sign that software investment will stumble. A similar message is emanating from the decline in overall CEO confidence (Chart 10), which mirrors the relentless narrowing in the gap between the return on and cost of capital (Chart 8, bottom panel). Even C&I bank loans, previously an economic bright spot, are signaling that corporate sector demand for external funds and working capital are softening, consistent with slower capital spending. Against a backdrop of fading software M&A activity, we are skeptical that the S&P software index can maintain its premium valuation (Chart 11). Chart 10... Before Sales Erode bca.uses_wr_2016_12_12_c10 bca.uses_wr_2016_12_12_c10 Chart 11Not Worth A Premium bca.uses_wr_2016_12_12_c11 bca.uses_wr_2016_12_12_c11 Elsewhere, the communications equipment industry will have trouble sustaining this summer's outperformance. Communications equipment stocks broke out of a long-term downward sloping trend-line on the back of productivity improvement. Chart 12 shows that after a period of intense cost cutting, wage inflation was negative. Our productivity proxy, defined as sales/employment, is growing rapidly. These trends are supportive of profit margins, and at least a modest valuation re-rating from washed out levels. Nevertheless, our confidence that a major bullish trend change has occurred after years of underperformance has been shaken. The budding reacceleration in top-line growth has hit a snag. New orders for communications equipment have rolled over relative to inventories. Investment in communications equipment has dipped (Chart 13). The telecom services sector has scaled back capital spending (Chart 13, third panel), suggesting that final demand will continue to soften. It will be difficult for companies to maintain high productivity if revenue growth stagnates. Chart 12Productivity Strength... bca.uses_wr_2016_12_12_c12 bca.uses_wr_2016_12_12_c12 Chart 13... May Be Pressured bca.uses_wr_2016_12_12_c13 bca.uses_wr_2016_12_12_c13 Consequently, the most likely scenario is that relative performance is entering a base-building phase rather than a new bull market, warranting benchmark weightings. Bottom Line: Reduce the S&P communications equipment index (BLBG: S5COMM - CSCO, MSI, HRS, JNPR, FFIV) to neutral, in a move to further reduce underweight tech sector exposure. Stay underweight software (BLBG: S5SOFT - MSFT, ORCL, ADBE, CRM, INTU, ATVI, EA, ADSK, SYMC, RHT, CTXS, CA). Energy Strategy Post-OPEC Production Cut Chart 14Energy Stocks Need Rising Oil Prices bca.uses_wr_2016_12_12_c14 bca.uses_wr_2016_12_12_c14 The energy sector continues to mark time relative to the broad market, but that has masked furious sub-surface movement. We have maintained a benchmark exposure to the broad sector since the spring, but shifted our sub-industry exposure in October to favor oil field services over producers, while underemphasizing refiners. OPEC's recent agreement to trim flatters this positioning. Whether OPEC's announcement actually feeds through into meaningfully lower production next year and higher oil prices remains to be seen, but at a minimum, supply discipline should put a floor under prices. Rather than expecting the overall energy sector to break out of its lateral move relative to the broad market, we continue to recommend a targeted approach. The energy sector requires sustained higher commodity prices to outperform, and our concern is that a trading range is more likely (Chart 14). OPEC producers suffered considerable pain over the last two years as they overproduced in order to starve marginal producers of the capital needed for reinvestment. U.S. shale producers slashed capital expenditures by 65% from 2014 to 2016, and the International Oil Companies (IOCs) cut capital expenditures by 40% over the same period. Chart 15 shows that only OPEC has been expanding production. That has set the stage for limited global production growth, allowing for demand growth to eat into overstocked crude inventories in the coming years. OPEC's decision to trim output should mitigate downside commodity price risks, providing debt and equity markets with confidence to increase capital availability to the sector. With a lower cost and easier access to capital, producers, especially shale, will be able to accelerate drilling programs. The rig count has already troughed. The growth in OECD oil inventories has crested, which is consistent with a gradual rise in the number of active drilling rigs. As oversupply is absorbed, investment in oil field services will accelerate, unlocking relative value in the energy services space (Chart 16). Chart 15OPEC Cuts Would Help... bca.uses_wr_2016_12_12_c15 bca.uses_wr_2016_12_12_c15 Chart 16... Erode Excess Oil Supply bca.uses_wr_2016_12_12_c16 bca.uses_wr_2016_12_12_c16 This overweight position is still high risk, because it will take time to absorb the excesses from the previous drilling cycle. There is still considerable overcapacity in the oil field services industry, as measured by our idle rig proxy. Pricing power does not typically return until the latter rises above 1 (Chart 17). Companies will be eager to put crews to work and better cover overhead, and may accept suboptimal pricing, at least initially. Meanwhile, if EM currencies continue to weaken, confidence in EM oil demand growth may be shaken, eroding valuations. Still, we are willing to accept these risks, but will keep this overweight position on a tight leash and will take profits if OPEC does not follow through with plans to limit production. On the flipside, refiners will not receive any relief in feedstock prices, which should ensure that the gap between Brent and WTI prices remains non-existent (Chart 18). That is a strain on refining margins. Our model warns that there is little profit upside ahead. That is confirmed by both domestic and global trends. Chart 17Risks To A Sustained Rally bca.uses_wr_2016_12_12_c17 bca.uses_wr_2016_12_12_c17 Chart 18Sell Refiners bca.uses_wr_2016_12_12_c18 bca.uses_wr_2016_12_12_c18 Chart 19Global Capacity Growth bca.uses_wr_2016_12_12_c19 bca.uses_wr_2016_12_12_c19 Refiners have continued to produce flat out, even as domestic crude production has dropped (Chart 18). As a result, inventories of gasoline and distillates have surged, despite solid consumption growth. In fact, refined product output is about to eclipse the rate of consumption growth, which implies persistently swelling inventories. There is no export outlet to relieve excess supply. U.S. exports are becoming much less competitive on the back of U.S. dollar strength and the elimination of the gap between WTI and Brent input costs (Chart 19). Moreover, rising capacity abroad has trigged an acceleration of refined product exports in a number of low cost producer countries, including India, China and Saudi Arabia (Chart 19). Increased global refining capacity is a structural trend, and will keep valuation multiples lower than otherwise would be the case. The relative price/sales ratio is testing cyclical peaks, warning that downside risks remain acute. Bottom Line: Maintain a neutral overall sector weighting, with outsized exposure to the oil & gas field services industry (BLBG: S5ENRE - SLB, HAL, BHI, NOV, HP, FTI, RIG), and undersized allocations to the refining group (BLBG: S5OILR - PSX, VLO, MPC, TSO). Current Recommendations Current Trades Size And Style Views Favor small over large caps and growth over value.