Equities

Leisure product stocks have taken a beating this summer to nearly their lowest level since the GFC (top panel). The slide followed a tough Q2 earnings season that saw the industry miss top line and margin estimates. Unsurprisingly, forward earnings estimates have fallen off a cliff (second panel). We think there is cause to remain optimistic. Consumer spending on toys and games has been firmly in expansion mode since the '09 trough and industry sales have been growing steadily for the past four years (third panel). The result has been leisure gaining a growing slice of the retail pie (fourth panel). The collapse in forward earnings has caused a valuation spike (bottom panel). If higher outlays translate into increasing EPS as we expect, then a playable recovery rally is likely, similar to early 2015. Stay overweight. The ticker symbols for the stocks in this index are: BLBG: S5LEPR - MAT, HAS.

Special Report

Feature There have been two major milestones in China's financial market liberalization in recent months. In June, MSCI Inc. moved to include Chinese domestic A shares in its widely followed world and emerging market equity indices. In July, regulators in Hong Kong and on the Mainland jointly launched the "bond connect" program, allowing foreign investors easier access to China's massive onshore bond market.1 The immediate impact of these measures will likely be muted, but they mark China's continued efforts to deregulate capital account transactions, opening up Chinese domestic financial assets that a mere few years ago were still completely isolated from the rest of the world. Over the years, we have published and periodically updated our Research Note, "China Shop," as a practical guide for investors looking for exposure to Chinese assets. The guide has come a long way since its first edition more than a decade ago, when investing in China was extremely difficult and very limited for foreigners, and we were struggling to find the best "China play" proxies. Over the years, various indexes, tracker funds and derivatives have been established outside China, making investing in Chinese equities a lot easier and more straightforward. The China ETF universe not only covers broad market indexes but also specific sectors and different market caps, allowing for discretionary sector allocations and investment styles for China-focused portfolios (Box 1). Box 1 A Primer On Chinese Stocks A shares are stocks traded on the Shanghai and Shenzhen stock exchanges. These shares are denominated and traded in RMB, and are restricted to local investors and Qualified Foreign Institutional Investors (QFII). B shares are Chinese companies traded on the Shanghai and Shenzhen stock exchanges. This equity class was originally open to foreign investors only, but was made available to domestic investors in 2001. These stocks are denominated in the Chinese currency but traded in U.S. dollars on the Shanghai Stock Exchange and in Hong Kong dollars on the Shenzhen Stock Exchange. H shares are mainland-registered state-owned companies listed in Hong Kong and denominated in Hong Kong dollars. The term N shares refers to stocks listed on the New York Stock Exchange. Red Chips are stocks listed on the Hong Kong Exchange. These companies are usually domiciled outside China but have at least 30% of their stakes held by state-owned organizations or provincial and municipal governments of China. P Chips refer to shares of companies which are majority-owned by entrepreneurs from China and derive the bulk of their revenues in the mainland. These companies are typically incorporated in offshore tax havens and are listed in Hong Kong and other major exchanges outside of China. Since our last update a year ago, the China ETF universe that we've been tracking has continued to evolve, with a few interesting developments. The number of ETFs on our list witnessed the first decline since it was created about 10 years ago. Two new ETFs have been added to the list since our last update, but 16 have been suspended or de-listed (Appendix Below). This means the Chinese ETF boom in recent years has entered a period of "consolidation." It also means that global investors' appetite for Chinese assets has been rather weak. Investors' weak appetite for Chinese assets is also reflected in the constant net withdrawals from these China-related ETFs - a remarkable development considering the sharp rally in Chinese equities, both domestic and investable, since early 2016. Total assets under management (AUM) of these ETFs have increased slightly so far this year compared with a year ago. However, the increases have been entirely due to price increases (Chart 1). Indeed, net capital flows have constantly been negative since 2013, according to our calculations. Investors' lukewarm attitude toward Chinese ETFs stands in stark contrast to other EM bourses. AUMs of EM equity ETFs have been chasing the market rally to new records of late (Chart 2). It appears that investors, especially smaller retail investors, have remained highly uncomfortable with China's macro conditions, despite improving growth figures, and have been left out of the bull market. This could be a contrarian sign that Chinese equities are underweighted and under owned - confirmed by depressed equity multiples. Chart 1Constant Negative Fund Flows To China ETFs Chart 2China ETFs: Out Of Favor Looking forward, the Chinese ETF universe will continue to expand, and the recent market liberalization efforts will likely lead to increasing supplies of ETFs focused on the Chinese onshore bond market. Despite cyclical swings in both economic growth and financial markets, it is almost a sure bet that foreign ownership in Chinese assets will grow over time. Yan Wang, Senior Vice President China Investment Strategy yanw@bcaresearch.com 1 Please see China Investment Strategy Weekly Report, "Embracing Chinese Bonds," dated July 6, 2017, available at cis.bcaresearch.com. Appendix Broad Market By Market Cap - A Share By Market Cap - Investible By Sector - A Share By Sector - Investible Leveraged Plays Currency Fixed Income - Mainland Fixed Income - Offshore Cyclical Investment Stance Equity Sector Recommendations

Overweight This year has proven a tough one for the consumer finance index, a result of the hangover following the Trump election ebullience. However, the path has been generally upward since the post-Q1 trough; we expect more of the same. The data is unambiguously positive for consumer finance growth and profitability. Vibrant equity markets and a bounce back in house prices have driven household net worth to a ten year-high (top panel), while debt service payments are very near their decade-low (second panel). The upshot is a long runway for consumer outlays. With chargeoffs at historically low levels (third panel), expanding credit should deliver outsized profits to consumer finance providers. Despite the bright outlook, the market is pricing in a steep profit recession with multiples 35% below their ten-year average (bottom panel). We think this has created an excellent buying opportunity; stay overweight. The ticker symbols for the stocks in the S&P consumer finance index are: BLBG: S5CFINX-AXP, COF, DFS, SYF, NAVI.

The post-election surge in optimism following Donald Trump's election has not eroded, according to the latest NFIB small business survey, and remains very close to its decade-high (top panel). Importantly, healthy consumer spending appears to be presenting small businesses with the best pricing environment of the past three years. However, we are keeping our eyes on a few factors that may presage a decline in optimism. First, labor shortages for small businesses have become extreme; firms reporting unfilled jobs are at the highest level since 2001 (second panel). This could have the double impact of constraining business expansion and raising wages. Firms planning to increase salaries have already been outpacing those planning to increase prices for several years (third panel). This tight labor market could exacerbate the already-wide small cap profit gap versus their large cap peers (bottom panel). Deferred tax reform could also present a headwind to optimism. Taxes (and large government) are the single most important problem SMEs face. The post-election euphoria was based in large part on an anticipated reduction in the corporate tax bill; the longer Washington takes in passing a tax bill the higher the chance small business sentiment sours. In spite of these potential headwinds, we continue to believe the margin gap between small and large cap should normalize, especially if cooler heads prevail in D.C., favoring a small cap bias. Stay tuned.

Special Report

Highlights Dear Clients, We are publishing a Special Report prepared by my colleague Jonathan LaBerge who examines the case for allocating capital to EM stocks within a global equity portfolio. I hope you will find this report insightful. Best regards, Garry Evans The relative performance of emerging market equities is challenging the downward trend channel that has been in place for the past seven years. This has led to renewed interest in EM from global investors, and warrants a revisit of the role of emerging market equities within a global equity portfolio. While EM recorded the highest regional equity return last cycle (2002-07), they were surprisingly not the "ideal" regional equity market in an efficient portfolio allocation. Recently, several compositional changes within the EM equity universe give the appearance of much lower commodity exposure than is truly the case. But EM equities will still be correlated with broad commodities prices because the later reflect Chinese growth dynamics. Cyclical indicators for China's economy suggest that the broad trend in commodities prices is likely to be lackluster over the coming year, at best. Consequently, EM stocks offer a poor risk/return profile, justifying an underweight stance within a global equity portfolio. Feature Chart I-1Change In Trend, Or Another Failed Rally? In U.S. dollar terms, the relative performance of emerging market (EM) stocks has been in an uptrend for over 18 months, and now appears to be challenging the downward trend channel that has been in place for the past seven years (Chart I-1). This has led to a renewed interest in EM, particularly among global investors. This report takes the recent outperformance of EM stocks as an opportunity to revisit their past and future contribution to a global equity portfolio, and what this might mean for an allocation to EM equities over the coming year. We conclude that EM's return behavior during the last economic cycle (2002-2007), its continued link to commodities prices, and China's growth dynamics all contribute to a poor risk/return profile for EM over the coming year. Barring compelling signs of a durable commodity bull market, investors should underweight EM stocks within a global equity portfolio. EM Equities In A Global Context: Some Historical Perspective When examining whether emerging markets are attractive from the perspective of global equity allocation, a starting point is to analyze the fundamental drivers of regional earnings. One major driver of global earnings over the past 20 years has been commodities prices; Chart I-2 highlights how 12-month forward EPS for stocks in all major regions have been correlated with commodities since the late-1990s. Chart I-2ACommodities Prices Are Correlated With Earnings... Chart I-2B...Even In Developed Markets This can be largely explained by the fact that commodities tend to be a pro-cyclical asset class. However, the super cycle in commodities prices in the 2000s not only bolstered the earnings of global resource companies, it also powered earnings growth for export-oriented industrials as well as domestic demand plays in commodity-producing countries. Chart I-3Strong Correlation Between ##br##Commodities And EM Emerging markets were among the largest beneficiaries of the commodity boom; net commodity-exporting countries made up roughly 45% of EM market capitalization throughout the last economic cycle, whereas stocks in the resource sector made up between 25-30% of the index by weight. Unsurprisingly, the relative performance of EM stocks closely tracked commodities prices over this period (Chart I-3). But despite this, EM was surprisingly not the "ideal" regional equity market last cycle within an active portfolio, even though it had the highest return. Chart I-4A presents a scatterplot of annualized regional equity volatility and return from 2002 - 2007, measured in US$ terms. The chart also shows the ex-post Modern Portfolio Theory (MPT) efficient frontier, with Chart I-4B presenting the efficient regional allocation at each point along the frontier. Chart I-4AEmerging Market Stocks Had The Highest Return Last Cycle... Chart I-4B...But Were Only The Favored Market For High-Risk Portfolios Chart I-5From 2002-2007, Earnings Drove More ##br##Of The Rally In DCM Than EM While the charts show that the efficient allocation to emerging market stocks did rise to a maximum of 100% during the last economic cycle, it did not become the dominant region until the portfolio became considerably more volatile than the global equity benchmark. Indeed, Chart I-4B shows that developed commodity markets (DCM) were the preferred commodity play for most of the efficient frontier, owing to their superior performance in risk-adjusted terms. This risk-adjusted outperformance may have occurred because DCM returns last cycle were driven more by earnings than by multiple expansion; Chart I-5 highlights that EM stock prices benefitted from multiple expansion last cycle by outpacing forward earnings, versus the opposite in the case of DCM. Since the onset of the U.S. recession in 2008, Chart I-6A and Chart I-6B highlight that the ex-post efficient portfolio has been much more skewed than during the last economic cycle. The charts show that the frontier since 2008 has been extremely short, with efficient allocations only accruing to three countries with typically defensive stock markets: the U.S., Japan, and Switzerland, with a heavy bias towards the former. From the perspective of a global equity portfolio, this historical review leads to two conclusions: 1) investors should not allocate to EM unless they are bullish on commodities prices and, 2) if investors are bullish towards commodities, developed commodity markets have historically been a better risk-adjusted bet than emerging markets as a commodity play. Chart I-6ASince 2008, The Efficient Frontier Has Been Highly Skewed... Chart I-6B...Towards Defensive Markets (Mostly The U.S.) Chart I-7These Trends Give The False Appearance ##br##Of Lower EM Commodity Exposure EM And Commodities Prices: Has The Relationship Really Changed? More recently, a narrative has developed in the market that EM stocks are now far less sensitive to commodities prices than used to be the case. Proponents of this theory point to the following changes in the composition of emerging market equity benchmarks: First, the market capitalization weight of net commodity exporting countries has fallen precipitously since the onset of the collapse in oil prices in 2014 (Chart I-7, panel 1). On average, net commodity exporters made up between 40-45% of EM equity market cap from 2000 to 2013, but their share now stands at 27%. Second, Chart I-7, panel 2, shows that the market cap weight of resource sectors (energy plus materials) in emerging markets has fallen from roughly 30% to 14% over the past five years, a trend that pre-dated the decline in the share of net commodity exporters. Third, the enormous rise in the market capitalization of technology companies as a share of total EM market cap has been specifically cited by many market participants (Chart I-7, panel 3), especially since EM is now heavily overweight the tech sector relative to the global average. Broadly speaking, a fourth compositional change within the EM equity benchmark generally captures all of the shifts noted above, and is the focus of our remaining analysis below: the rise in the weight of emerging Asia as a share of overall EM (Chart I-7, panel 4). Among emerging markets, net commodity exporters tend to be located outside of Asia (with the exception of Indonesia and Malaysia), and emerging Asia accounts for essentially all of EM tech market cap. Consequently, investors who argue that EM equities have largely or fully decoupled from commodities prices are essentially arguing that emerging Asian equities are far less affected by changes in commodity markets than they used to be. This idea is deeply flawed, as shown below: Based on export share, Chart I-8 highlights that emerging Asia is far more economically exposed to China than developed markets and EM ex-Asia. While China is gradually becoming more of a services-oriented economy, Chart I-9 highlights that the sum of primary industry (raw material extraction), secondary industry (manufacturing and construction), and real estate services still account for over half of China's economic activity, well above that of industrialized nations such as the U.S. This underscores that emerging Asia's trade exposure to China is fundamentally rooted in economic activity that is closely linked to commodity demand. Chart I-8Emerging Asia Has High ##br##Trade Exposure To China Chart I-9Chinese Growth Still Largely ##br##Reflects Industrial Activity Within the commodity-linked segment of China's economy, Chart I-10 shows that there is little evidence of a weaker relationship between output and commodities prices. Simple regression analysis underscores that the Li Keqiang index, a growth proxy for China's industrial sector, is strongly linked to the year-over-year % change in spot commodities prices since the beginning of the commodity bull market, and that this relationship has in fact been increasing in strength over time. In addition, Chart I-11 underscores that China remains by far the largest consumer of base metals globally. Demand in the global oil market is considerably more diversified than the market for base metals, but China is the second-largest end market for oil (14% of global oil consumption), and accounted for over a quarter of the growth in total oil demand in 2016.1 Chart I-10Moderating Chinese Growth Will ##br##Be Negative For Commodities Chart I-11China Is By Far The Most Important ##br##End Market For Base Metals Finally, Chart I-12 shows a regression model between forward earnings expectations for emerging Asia and commodities prices, both at the overall index level and even for the financial sector (which, along with real estate, accounts for almost 25% of emerging Asian market capitalization). The fit for both models is extremely strong and, similar to the increasing strength of the Li Keqiang / commodity price relationship, the chart shows that commodities prices have begun to lead the growth in forward earnings, when the relationship used to be much more coincident. Chart I-12Emerging Asian Earnings Are Strongly ##br##Correlated With Commodities Prices The bottom line for investors is that Charts I-8-12 show emerging Asian economies are strongly linked economically to China, and that China remains the dominant driver of aggregate commodity demand. This means that while EM stocks may not have as much direct commodity exposure as they used to, they will continue to experience a high correlation with commodities prices because that the latter will be driven by swings in China's business cycle. In brief, Chinese growth fluctuations are instrumental to emerging Asia's economic and equity market performance. This is the rationale behind the very strong link between earnings expectations for emerging Asia and commodities prices: the latter reflect cyclical variations in the Chinese economy. EM Stocks: A Lackluster Bet Given The Outlook For Commodities Our earlier discussion of EM's historical contribution to a global equity portfolio revived elements of Modern Portfolio Theory (MPT), at least from an ex-post perspective. Ex-ante, investors need to make judgements about the likely risk, return, and cross-correlation of an asset when assessing its likely contribution to a diversified portfolio. Regarding the latter factor, Chart I-13 highlights that EM's correlation with global ex-EM has actually fallen quite substantially over the past year, which is a potential argument in the minds of some investors in favor of an increased allocation to EM. When recalling the lessons from Modern Portfolio Theory, most investors tend to focus on the key insight that lowly-correlated assets are valuable from the perspective of constructing a portfolio with an attractive risk/return profile. While this is true, many investors often forget that this is only valid given an expectation of a positive return. The efficient allocation to an asset that has a strongly negative correlation with other assets but has a negative return expectation is basically zero. This means that global investors eying an increased allocation to emerging markets should be squarely focused on EM equities' absolute performance, which as we have highlighted above are likely to be closely linked to commodity returns. Over the coming 6-12 months, Chart I-14 paints an uninspiring picture for commodities prices based on two measures of China's money supply. In turn, interest rates lead money growth and the rise in the former over the past nine months heralds further deceleration in the latter. This implies that the Chinese economy will likely continue to moderate, which is negative for the broad trend in commodities prices. Chart I-13A Significant Decline, But Focus On Return ##br##Expectations, Not Correlation Chart I-14Interest Rates And Money Growth Paint ##br##A Poor Picture For Commodities As noted above, China's share of the global oil market is much lower than that of base metals, and we do not expect China's oil demand to shrink even if its industrial sector slumps. But from the perspective of allocating to EM equities within a global portfolio, Table I-1 highlights that broad spot commodity price indexes tend to be more relevant predictors of forward earnings growth than energy prices alone. This means that a rise in oil prices (were it to occur for idiosyncratic supply reasons) might be positive for major oil producers such as Russia,2 but is unlikely to provide a broad-based catalyst for EM stocks. Table I-1Explanatory Power Of Commodity Price Indexes In Modeling ##br##12-Month Forward Earnings Per Share Growth (2002-2016) Finally, our analysis above has focused on the fundamental drivers of EM stocks, and has shown how DM investors are likely to have little basis to be bullish about emerging markets earnings over the coming 6-12 months. Chart I-15 highlights how this is also true about the potential for EM multiple expansion relative to their global peers. The chart shows that periods of relative EM multiple expansion have, like relative earnings expectations, tended to be associated with rising commodities prices, implying that a significant re-rating of EM equities is unlikely over the coming year. This is in addition the fact that EM stocks are neither cheap nor expensive in absolute terms,3 meaning that there is less room for multiple expansion in EM than many investors believe. Chart I-15No Relative Multiple Expansion ##br##Without Rising Commodities Prices Investment Conclusions In terms of gauging the contribution of EM equities to a global equity portfolio, this report has highlighted the following points: While EM stocks had the highest return of any regional equity market during the last economic cycle (2002-2007), this return profile was accompanied by an outsized degree of volatility. For all but the riskiest portfolios, developed commodity markets were preferred as a commodity play over emerging markets. Several compositional changes within the EM equity universe give the outward appearance of much lower commodity exposure, but this exposure has merely become indirect. While EM's weight towards net commodity exporters and resource sectors has declined, this has shifted benchmark exposure to emerging Asia which has significant economic exposure to China and its industrial sector (the dominant driver of global commodities prices). As such, share prices in EM overall and emerging Asia in particular will still be strongly correlated with commodities prices even given the region's significant weight towards the technology sector.4 Cyclical indicators for China's economy suggest that broad commodity price gains over the coming year are likely to be lackluster, at best (and may very well be negative). Even if global oil prices were to rise, this is unlikely to provide a broad-based catalyst for EM stocks if industrial metals prices relapse, as we expect. These conclusions underscore that it is highly unlikely emerging market stocks will sustainably decouple from commodities prices over the cyclical investment horizon, and that the uptrend in EM relative performance since early-2016 has likely been driven significantly by expectations of further China's growth acceleration and commodity gains. In our judgement, these circumstances have created a poor risk/return profile for emerging market equities, justifying an underweight stance within a global equity portfolio over the coming year. Jonathan LaBerge, CFA, Vice President Special Reports jonathanl@bcaresearch.com 1 Source: BP Statistical Review of World Energy, June 2017. 2 Note that we recommend an overweight stance towards Russian equities within an EM equity portfolio. 3 Please refer to the Emerging Markets Strategy Weekly Report titled, "EM Equity Valuations Revisited," dated March 29, 2017, link available on page 15. 4 For a further discussion of the impact of the technology sector on the relative performance of emerging market stocks, please see Emerging Markets Strategy Weekly Report titled, "Can Tech Drive EM Stocks Higher?" dated May 17, 2017, link available on page 15.

Special Report

Highlights Dear Clients, We are publishing a Special Report prepared by my colleague Jonathan LaBerge who examines the case for allocating capital to EM stocks within a global equity portfolio. I hope you will find this report insightful. Best regards, Arthur Budaghyan The relative performance of emerging market equities is challenging the downward trend channel that has been in place for the past seven years. This has led to renewed interest in EM from global investors, and warrants a revisit of the role of emerging market equities within a global equity portfolio. While EM recorded the highest regional equity return last cycle (2002-07), they were surprisingly not the "ideal" regional equity market in an efficient portfolio allocation. Recently, several compositional changes within the EM equity universe give the appearance of much lower commodity exposure than is truly the case. But EM equities will still be correlated with broad commodities prices because the latter reflect Chinese growth dynamics. Cyclical indicators for China's economy suggest that the broad trend in commodities prices is likely to be lackluster over the coming year, at best. Consequently, EM stocks offer a poor risk/return profile, justifying an underweight stance within a global equity portfolio. Feature Chart I-1Change In Trend, Or Another Failed Rally? In U.S. dollar terms, the relative performance of emerging market (EM) stocks has been in an uptrend for over 18 months, and now appears to be challenging the downward trend channel that has been in place for the past seven years (Chart I-1). This has led to a renewed interest in EM, particularly among global investors. This report takes the recent outperformance of EM stocks as an opportunity to revisit their past and future contribution to a global equity portfolio, and what this might mean for an allocation to EM equities over the coming year. We conclude that EM's return behavior during the last economic cycle (2002-2007), its continued link to commodities prices, and China's growth dynamics all contribute to a poor risk/return profile for EM over the coming year. Barring compelling signs of a durable commodity bull market, investors should underweight EM stocks within a global equity portfolio. EM Equities In A Global Context: Some Historical Perspective When examining whether emerging markets are attractive from the perspective of global equity allocation, a starting point is to analyze the fundamental drivers of regional earnings. One major driver of global earnings over the past 20 years has been commodities prices; Chart I-2 highlights how 12-month forward EPS for stocks in all major regions have been correlated with commodities since the late-1990s. Chart I-2ACommodities Prices Are Correlated With Earnings... Chart I-2B...Even In Developed Markets This can be largely explained by the fact that commodities tend to be a pro-cyclical asset class. However, the super cycle in commodities prices in the 2000s not only bolstered the earnings of global resource companies, it also powered earnings growth for export-oriented industrials as well as domestic demand plays in commodity-producing countries. Chart I-3Strong Correlation Between ##br##Commodities And EM Emerging markets were among the largest beneficiaries of the commodity boom; net commodity-exporting countries made up roughly 45% of EM market capitalization throughout the last economic cycle, whereas stocks in the resource sector made up between 25-30% of the index by weight. Unsurprisingly, the relative performance of EM stocks closely tracked commodities prices over this period (Chart I-3). But despite this, EM was surprisingly not the "ideal" regional equity market last cycle within an active portfolio, even though it had the highest return. Chart I-4A presents a scatterplot of annualized regional equity volatility and return from 2002 - 2007, measured in US$ terms. The chart also shows the ex-post Modern Portfolio Theory (MPT) efficient frontier, with Chart I-4B presenting the efficient regional allocation at each point along the frontier. Chart I-4AEmerging Market Stocks Had The Highest Return Last Cycle... Chart I-4B...But Were Only The Favored Market For High-Risk Portfolios Chart I-5From 2002-2007, Earnings Drove More ##br##Of The Rally In DCM Than EM While the charts show that the efficient allocation to emerging market stocks did rise to a maximum of 100% during the last economic cycle, it did not become the dominant region until the portfolio became considerably more volatile than the global equity benchmark. Indeed, Chart I-4B shows that developed commodity markets (DCM) were the preferred commodity play for most of the efficient frontier, owing to their superior performance in risk-adjusted terms. This risk-adjusted outperformance may have occurred because DCM returns last cycle were driven more by earnings than by multiple expansion; Chart I-5 highlights that EM stock prices benefitted from multiple expansion last cycle by outpacing forward earnings, versus the opposite in the case of DCM. Since the onset of the U.S. recession in 2008, Chart I-6A and Chart I-6B highlight that the ex-post efficient portfolio has been much more skewed than during the last economic cycle. The charts show that the frontier since 2008 has been extremely short, with efficient allocations only accruing to three countries with typically defensive stock markets: the U.S., Japan, and Switzerland, with a heavy bias towards the former. From the perspective of a global equity portfolio, this historical review leads to two conclusions: 1) investors should not allocate to EM unless they are bullish on commodities prices and, 2) if investors are bullish towards commodities, developed commodity markets have historically been a better risk-adjusted bet than emerging markets as a commodity play. Chart I-6ASince 2008, The Efficient Frontier Has Been Highly Skewed... Chart I-6B...Towards Defensive Markets (Mostly The U.S.) Chart I-7These Trends Give The False Appearance ##br##Of Lower EM Commodity Exposure EM And Commodities Prices: Has The Relationship Really Changed? More recently, a narrative has developed in the market that EM stocks are now far less sensitive to commodities prices than used to be the case. Proponents of this theory point to the following changes in the composition of emerging market equity benchmarks: First, the market capitalization weight of net commodity exporting countries has fallen precipitously since the onset of the collapse in oil prices in 2014 (Chart I-7, panel 1). On average, net commodity exporters made up between 40-45% of EM equity market cap from 2000 to 2013, but their share now stands at 27%. Second, Chart I-7, panel 2, shows that the market cap weight of resource sectors (energy plus materials) in emerging markets has fallen from roughly 30% to 14% over the past five years, a trend that pre-dated the decline in the share of net commodity exporters. Third, the enormous rise in the market capitalization of technology companies as a share of total EM market cap has been specifically cited by many market participants (Chart I-7, panel 3), especially since EM is now heavily overweight the tech sector relative to the global average. Broadly speaking, a fourth compositional change within the EM equity benchmark generally captures all of the shifts noted above, and is the focus of our remaining analysis below: the rise in the weight of emerging Asia as a share of overall EM (Chart I-7, panel 4). Among emerging markets, net commodity exporters tend to be located outside of Asia (with the exception of Indonesia and Malaysia), and emerging Asia accounts for essentially all of EM tech market cap. Consequently, investors who argue that EM equities have largely or fully decoupled from commodities prices are essentially arguing that emerging Asian equities are far less affected by changes in commodity markets than they used to be. This idea is deeply flawed, as shown below: Based on export share, Chart I-8 highlights that emerging Asia is far more economically exposed to China than developed markets and EM ex-Asia. While China is gradually becoming more of a services-oriented economy, Chart I-9 highlights that the sum of primary industry (raw material extraction), secondary industry (manufacturing and construction), and real estate services still account for over half of China's economic activity, well above that of industrialized nations such as the U.S. This underscores that emerging Asia's trade exposure to China is fundamentally rooted in economic activity that is closely linked to commodity demand. Chart I-8Emerging Asia Has High ##br##Trade Exposure To China Chart I-9Chinese Growth Still Largely ##br##Reflects Industrial Activity Within the commodity-linked segment of China's economy, Chart I-10 shows that there is little evidence of a weaker relationship between output and commodities prices. Simple regression analysis underscores that the Li Keqiang index, a growth proxy for China's industrial sector, is strongly linked to the year-over-year % change in spot commodities prices since the beginning of the commodity bull market, and that this relationship has in fact been increasing in strength over time. In addition, Chart I-11 underscores that China remains by far the largest consumer of base metals globally. Demand in the global oil market is considerably more diversified than the market for base metals, but China is the second-largest end market for oil (14% of global oil consumption), and accounted for over a quarter of the growth in total oil demand in 2016.1 Chart I-10Moderating Chinese Growth Will ##br##Be Negative For Commodities Chart I-11China Is By Far The Most Important ##br##End Market For Base Metals Finally, Chart I-12 shows a regression model between forward earnings expectations for emerging Asia and commodities prices, both at the overall index level and even for the financial sector (which, along with real estate, accounts for almost 25% of emerging Asian market capitalization). The fit for both models is extremely strong and, similar to the increasing strength of the Li Keqiang / commodity price relationship, the chart shows that commodities prices have begun to lead the growth in forward earnings, when the relationship used to be much more coincident. Chart I-12Emerging Asian Earnings Are Strongly ##br##Correlated With Commodities Prices The bottom line for investors is that Charts I-8-12 show emerging Asian economies are strongly linked economically to China, and that China remains the dominant driver of aggregate commodity demand. This means that while EM stocks may not have as much direct commodity exposure as they used to, they will continue to experience a high correlation with commodities prices because that the latter will be driven by swings in China's business cycle. In brief, Chinese growth fluctuations are instrumental to emerging Asia's economic and equity market performance. This is the rationale behind the very strong link between earnings expectations for emerging Asia and commodities prices: the latter reflect cyclical variations in the Chinese economy. EM Stocks: A Lackluster Bet Given The Outlook For Commodities Our earlier discussion of EM's historical contribution to a global equity portfolio revived elements of Modern Portfolio Theory (MPT), at least from an ex-post perspective. Ex-ante, investors need to make judgements about the likely risk, return, and cross-correlation of an asset when assessing its likely contribution to a diversified portfolio. Regarding the latter factor, Chart I-13 highlights that EM's correlation with global ex-EM has actually fallen quite substantially over the past year, which is a potential argument in the minds of some investors in favor of an increased allocation to EM. When recalling the lessons from Modern Portfolio Theory, most investors tend to focus on the key insight that lowly-correlated assets are valuable from the perspective of constructing a portfolio with an attractive risk/return profile. While this is true, many investors often forget that this is only valid given an expectation of a positive return. The efficient allocation to an asset that has a strongly negative correlation with other assets but has a negative return expectation is basically zero. This means that global investors eying an increased allocation to emerging markets should be squarely focused on EM equities' absolute performance, which as we have highlighted above are likely to be closely linked to commodity returns. Over the coming 6-12 months, Chart I-14 paints an uninspiring picture for commodities prices based on two measures of China's money supply. In turn, interest rates lead money growth and the rise in the former over the past nine months heralds further deceleration in the latter. This implies that the Chinese economy will likely continue to moderate, which is negative for the broad trend in commodities prices. Chart I-13A Significant Decline, But Focus On Return ##br##Expectations, Not Correlation Chart I-14Interest Rates And Money Growth Paint ##br##A Poor Picture For Commodities As noted above, China's share of the global oil market is much lower than that of base metals, and we do not expect China's oil demand to shrink even if its industrial sector slumps. But from the perspective of allocating to EM equities within a global portfolio, Table I-1 highlights that broad spot commodity price indexes tend to be more relevant predictors of forward earnings growth than energy prices alone. This means that a rise in oil prices (were it to occur for idiosyncratic supply reasons) might be positive for major oil producers such as Russia,2 but is unlikely to provide a broad-based catalyst for EM stocks. Table I-1Explanatory Power Of Commodity Price Indexes In Modeling ##br##12-Month Forward Earnings Per Share Growth (2002-2016) Finally, our analysis above has focused on the fundamental drivers of EM stocks, and has shown how DM investors are likely to have little basis to be bullish about emerging markets earnings over the coming 6-12 months. Chart I-15 highlights how this is also true about the potential for EM multiple expansion relative to their global peers. The chart shows that periods of relative EM multiple expansion have, like relative earnings expectations, tended to be associated with rising commodities prices, implying that a significant re-rating of EM equities is unlikely over the coming year. This is in addition the fact that EM stocks are neither cheap nor expensive in absolute terms,3 meaning that there is less room for multiple expansion in EM than many investors believe. Chart I-15No Relative Multiple Expansion ##br##Without Rising Commodities Prices Investment Conclusions In terms of gauging the contribution of EM equities to a global equity portfolio, this report has highlighted the following points: While EM stocks had the highest return of any regional equity market during the last economic cycle (2002-2007), this return profile was accompanied by an outsized degree of volatility. For all but the riskiest portfolios, developed commodity markets were preferred as a commodity play over emerging markets. Several compositional changes within the EM equity universe give the outward appearance of much lower commodity exposure, but this exposure has merely become indirect. While EM's weight towards net commodity exporters and resource sectors has declined, this has shifted benchmark exposure to emerging Asia which has significant economic exposure to China and its industrial sector (the dominant driver of global commodities prices). As such, share prices in EM overall and emerging Asia in particular will still be strongly correlated with commodities prices even given the region's significant weight towards the technology sector.4 Cyclical indicators for China's economy suggest that broad commodity price gains over the coming year are likely to be lackluster, at best (and may very well be negative). Even if global oil prices were to rise, this is unlikely to provide a broad-based catalyst for EM stocks if industrial metals prices relapse, as we expect. These conclusions underscore that it is highly unlikely emerging market stocks will sustainably decouple from commodities prices over the cyclical investment horizon, and that the uptrend in EM relative performance since early-2016 has likely been driven significantly by expectations of further China's growth acceleration and commodity gains. In our judgement, these circumstances have created a poor risk/return profile for emerging market equities, justifying an underweight stance within a global equity portfolio over the coming year. Jonathan LaBerge, CFA, Vice President Special Reports jonathanl@bcaresearch.com 1 Source: BP Statistical Review of World Energy, June 2017. 2 Note that we recommend an overweight stance towards Russian equities within an EM equity portfolio. 3 Please refer to the Emerging Markets Strategy Weekly Report titled, "EM Equity Valuations Revisited," dated March 29, 2017, link available on page 15. 4 For a further discussion of the impact of the technology sector on the relative performance of emerging market stocks, please see Emerging Markets Strategy Weekly Report titled, "Can Tech Drive EM Stocks Higher?" dated May 17, 2017, link available on page 15.

Underweight Late-2013 saw all the right economic conditions moving in favor of insurers: the economy was entering a soft patch, the yield curve was flattening and the U.S. dollar was gaining momentum. The insurance market began hardening and the industry went on a hiring spree to capitalize on a much improved outlook (second panel). With the exception of the yield curve, those macro conditions reversed in 2017; the economy is booming, the dollar bull market has paused and BCA expects at least a modest yield curve steepening in the coming months (third panel). However, the insurers index has performed in line with the broad market so far this year (top panel). The hard pricing market of the past three years has recently turned flaccid (bottom panel) and organic revenue growth should soften. Meanwhile, sector employment remains elevated, implying weakening margins. In the context of the S&P 500 growing earnings by low-double digits, the insurers index should underperform. Stay underweight. The ticker symbols for the stocks in this index are: BLBG: S5INSU - AIG, CB, MET, MMC, PRU, TRV, AFL, AON, ALL, PGR, WLTW, HIG, PFG, L, CINF, LNC, XL, AJG, UNM, TMK, AIZ.

Special Report

Highlights Over the years, BCA has created numerous macro (and other) indicators and models to forecast U.S. equity markets. These models are designed to include both cyclical and structural cycles, i.e. mini-cycles within longer-term trends. Feature Recently, we have been inundated by client requests to update these indicators, which has spurred us to put together this Special Report (there will also be a Part II in the near future). We compiled the most sought after Indicators in one place (accessible also from BCA's EDGE platform for seamless continual updates) and used three time horizons: tactical (1-3 months), cyclical (3-12 months) and structural (1-3 years). Historically, sentiment-based high-frequency indicators have done an excellent job in forecasting the tactical outlook (top panel, Chart 1). By cyclical backdrop, we refer to the mini-equity market cycles and sub-surface sector rotations within the business cycle (middle panel, Chart 1).Finally, we reserved the structural time horizon for forecasting the end/beginning of the business cycle (i.e. commencement or ending of recession, bottom panel, Chart 1). Chart 1 This Special Report is split into three time frame-driven sections: tactical, cyclical and structural. Within each time horizon, we provide a brief description of each Indicator, the rationale behind it, and comment on the Indicator's current signal. This White Paper of overall equity market indicators and models is by no means exhaustive. Rather, it represents a roadmap of Indicators we track to gauge the direction of equity markets in all three time frames. We trust you will find this Special Report useful and insightful. Anastasios Avgeriou, Vice President U.S. Equity Strategy & Global Alpha Sector Strategy anastasios@bcaresearch.com Dulce Cruz, Senior Analyst dulce@bcaresearch.com Tactical Indicators (1-3 months) BCA Complacency-Anxiety Index BCA's Complacency-Anxiety index tracks the bullish/bearish equity market sentiment. It includes the CBOE's VIX index, the S&P 500 put/call ratio, bull/bear ratio and the emerging markets high yield bond spread. When this indicator nears one standard deviation above the historical mean, greed takes over. When it falls to one standard deviation below the mean, fear dominates markets. Currently, complacency reigns (Chart 2). Chart 2 BCA Equity Speculation Index The BCA Equity Speculation Index (ESI) measures the speculative activity in the stock market incorporating measures of leverage, sentiment, valuation and supply. The leverage component includes margin debt and security credit; the sentiment component is a composite of sentiment measures; valuation includes the proprietary BCA Secular Valuation Index (not shown); and finally the supply component measures the supply of new issues and secondary offerings. Presently, the ESI signals that the equity market advance is at a very high risk stage. However, the chart shows that the ESI can stay in elevated territory for a prolonged period, as occurred in 2014/2015, before a correction unfolds (bottom panel, Chart 2). Volatility-Adjusted Valuation Metrics (Part I) Chart 3 shows the price-to-earnings (P/E) ratio (12-month forward and cyclically adjusted P/E) and momentum (year-over-year percentage change) of S&P 500 index adjusted for volatility. While we prefer not to use valuations as stock market timing tools, currently, the reward/risk tradeoff of the volatility-adjusted P/E multiple is more than two standard deviations above normal, implying market mania. We would note that this is driven by record low volatility (see the Complacency-Anxiety Index above) rather than extreme valuations. Chart 3 Volatility-Adjusted Valuation Metrics (Part II) Chart 4 shows the high yield corporate bond total return index controlled for the bond market's volatility. The message in both the equity and bond market is clear: we are in stretched territory, near a level that has historically led to a mean reversion phase. Chart 4 Equity And Bond Market Volatility Curves CBOE 3-Month Volatility Index / 30-Day Volatility Index (VXV/VIX) is a technical indicator that moves in lockstep with stock prices. When the volatility market is in steep contango, complacency reigns and vice versa. Similarly, when the 3-Month Merrill Lynch bond market volatility (MOVE) index is higher than the front MOVE index, euphoria is evident. When this volatility curve flips to backwardation, panic grips markets. At the current juncture, waters are calm both in the equity and bond markets (Chart 5). Chart 5 TED Spread Vs. VXO Index TED spread is the difference between the three-month LIBOR and the three-month T-bill interest rate. The TED spread is an indicator of perceived credit risk in the economy. The VXO is volatility on the S&P 100. These indexes tend to move in tandem, but steep divergences do occur from time-to-time, during which the TED spread has leading properties and tends to exert pull on the VXO. Currently, both measures of risk are quiet (Chart 6). Chart 6 CBOE SKEW Index / VIX Index The SKEW index (tail risk measure), controlled for the VIX, has an excellent track record in forecasting market corrections. This indicator has risen above 12, warning that at least a tactical pullback is near at hand (Chart 7). In contrast, when this relative risk measure plunges below 5, a buying opportunity in equities emerges. Chart 7 Currency Implied Volatility Currency implied volatility is an average of Yen, Euro and Sterling (all versus the U.S. dollar) 3-month option implied volatility. Chart 8 shows the S&P 500 Index and currency volatility are inversely correlated, reflecting the impact of currency swings on policy decisions and corporate competiveness/profits. Presently, this measure of volatility is calm. Chart 8 AUD/JPY Historically, the AUD/JPY FX cross does an excellent job in tracking risk-on/risk-off phases in the equity market. Investors use the zero-yielding Yen as a funding currency and buy the higher yielding Australian dollar in order to generate a positive carry. In times of duress, investors scramble to repatriate Yen and shed Australian dollars and vice versa. Also the "Aussie" in general is a great China/commodity indicator that rises when the global economy picks up steam. The growth sensitive AUD/JPY cross rate has picked up recently, sending a positive signal (Chart 9). Chart 9 BCA Equity Market Internal Dynamics Indicator The BCA Equity Market Internal Dynamics Indicator (shown as an equally weighted z-score) comprises relative bank and transports performance, the small/large ratio and industrials/utilities (or cyclicals/defensives), and captures shifting internal forces that drive market returns. It is a coincident-to-leading market indicator. Currently, this economically sensitive indicator signals that the broad equity market may suffer a setback (Chart 10). Chart 10 BCA's U.S. Sell-Off Indicator BCA's Sell-Off Indicator is a composite of market-based measures of risk appetite that are regularly featured in our Weekly Reports, including credit spreads, currencies, government bond yields and cyclical and defensive equities. This market-based measure of risk appetite is not sending any warning signals yet. Financial Conditions Index The Financial Conditions Index tracks the overall level of financial stress in the money, bond, and equity markets to help assess the availability and cost of credit. A positive value indicates accommodative financial conditions, while a negative value indicates tighter financial conditions. Financial conditions have been easing recently, underpinning the broad equity market (Chart 11). Chart 11 5Y/5Y CPI Swap Forward Rate This is a measure of expected inflation over the five-year period that begins five years from today. Historically, equity markets have been positively correlated with this inflation expectation measure and the current fall in the latter suggests that equities are fully priced (Chart 12). Chart 12 Confirming Equity Indicator The Confirming Equity Indicator (CEI) is a composite of economic data that has provided useful validation for broad equity market trends, and it was designed so that a positive reading is generally bullish while a negative reading is bearish. The CEI is well into bullish territory; more recently, the economic variables in the model have firmed, providing an additional lift to our CEI (Chart 13). Chart 13 BCA Investor Sentiment Composite This gauge comprises surveys of traders, individuals and investment professional sentiment. The sentiment indicator shows the percent of bulls. When the majority is optimistic, the equity market is nearing a peak. Conversely, when psychology is pessimistic, prices are near a low. Bullish individual investor sentiment has also eclipsed the 50% zone in advance of the two largest post-GFC drawdowns. Individual investors are currently upbeat, though not so much that we are concerned (Chart 14). Chart 14 S&P 500 Measures Of Breadth The Advance/Decline line and the net new highs indicator (the difference between stocks at their 52-week high and those at their low) are measures of market breadth. The technical backdrop is positive when breadth and prices are rising. Conversely, weakness in breadth, i.e. a loss of market participation, heralds lower prices. In contrast, the proportion of sub-indexes with a positive 52-week rate of change and/or trading above their 40-week moving average remain well above 60% (Chart 15). Our breadth indicators are currently positive. Chart 15 Cyclical Indicators (3-12 months) BCA Intermediate Equity Indicator Our Intermediate Equity Indicator (IEI) is designed to help anticipate intermediate term trends (3 to 6 months and rises or falls of at least 10%) with the primary bull and bear markets. Buy signals are generated by the indicator rising substantially above 1 while sell signals are generated by declines below zero. The IEI remains near bullish territory (Chart 16). Chart 16 BCA Cyclical Macro Indicator Our broad equity market Cyclical Macro Indicator (CMI) is a mix of fundamental macro and financial variables that lead profits, and has tracked the S&P 500 for the past two and half decades. The CMI is used as a check, rather than as a definitive catch-all, because every business cycle has unique characteristics (Chart 17). Chart 17 BCA Valuation Indicator Our VI is based on P/E, Price/Sales, Price/Dividends and Price/Book. It is currently at one standard deviation above the historical mean (Chart 17) which would typically signal a pullback is near at hand. We would caution that valuations can remain extended for prolonged periods and the one standard deviation level is not necessarily a trigger point. BCA Technical Indicator Our TI is driven primarily by momentum components, gauges the trend in equities and determines if the market is at an extreme in terms of momentum or investor psychology. Overbought conditions are signaled once it hits one standard deviation above the mean. Currently, the TI remains slightly below this threshold. Importantly, when the TI swings quickly from deeply oversold to overbought levels, there can be a multi month lead before the broad market crests or suffers a sustained setback, and the bulk of those moves are associated with economic recessions and/or growth disappointments (Chart 17). U.S. Equity Capitulation Indicator Our Equity Capitulation Indicator (comprising measures of equity breadth, trader sentiment, insider Sell/Buy ratio and momentum) is used to predict cyclical equity turning points. A reading above the zero line is positive for equity markets. When this Indicator plunges to -1 or lower, capitulation is evident. Currently, this proprietary Indicator says there is no capitulation (Chart 18). Chart 18 U.S. S&P 500 Earnings Growth Diffusion Index The S&P 500 Index earnings growth diffusion index is based on the percentage of equity subsectors with an improving 12-month forward earnings growth figure compared with the prior year. At the current juncture, this diffusion index is pointing to a broad-based brightening profit backdrop, underpinning an equity melt-up phase (Chart 19). Chart 19 Global Equity Market EPS Diffusion Index The Global Equity Market EPS Diffusion Index comprises 44 country (DM and EM) forward EPS and gauges the percentage of countries that are experiencing negative year-over-year EPS growth. Chart 20 shows this index on an inverted scale: as fewer and fewer regions have contracting forward EPS, global equity prices tend to rise and vice versa. Currently, a synchronized EPS recovery is unfolding, heralding more gains for the overall equity market. Chart 20 U.S. M&A Number Of Deals U.S. merger & acquisition activity usually moves with the ebb and flow of equity markets. High stock prices, low interest rates and high valuations are a boon for M&A. The opposite is also true. Presently, the number of M&A deals has rolled over, and this coincident indicator is waving a yellow flag for the U.S. equity market (Chart 21). Chart 21 Global Equities Cross Correlation Index BCA's Global Equities Cross Correlation Index is based on an equally weighted average of 26-week pairwise moving correlation of weekly returns between the S&P 500, EUROSTOXX 600, TOPIX and MSCI emerging market stock price indexes. Receding global equity index correlations have been associated with positive S&P 500 returns, as is currently the case (Chart 22). This inverse correlation is also mirrored in the CBOE's implied correlation index, which tracks the correlation of the S&P 500 stocks with one another: tumbling correlations imply solid overall equity returns (not shown). Chart 22 U.S. S&P 500 Cyclical / Defensives Cyclical sectors include materials, energy, industrials and technology. Defensive sectors include telecom, consumer staples, health care and utilities. Chart 23 shows that, broadly speaking, the S&P 500 is positively correlated with the cyclicals/defensives (C/D) ratio. Currently, the C/D ratio has negatively diverged from the broad market warning that an indigestion phase may loom. Chart 23 Global Net Earnings Revisions Indicators Sell side analysts' forward net EPS revisions (NER, upward minus downward revisions as a percent of total revisions) are an excellent indicator of the stage of the profit cycle. Historically, regional NERs have been inversely correlated with the respective currencies with the exception of the EM index where the correlation is a positive one. In the EM a rising FX rate represents capital flowing back to those economies, and stocks, bonds and FX markets tend to all move together. In the DM, given increasingly foreign sourced profits, a rising currency caps EPS and vice versa. Currently, a synchronized global EPS revival is in order with the exception of the Eurozone (Chart 24). Chart 24 U.S. High-Yield Bond Yield, Option Adjusted Spread And Total Return Index The high yield bond market total return index has a positive correlation with equity markets as high yielding corporates are a good proxy for the overall stock market, while the high yield bond OAS is inversely correlated with stock prices. The bond market tends to sniff out equity market tops and bottoms. Currently, there is no trouble for equity markets according to this bond market indicator. However, spreads are getting extremely tight. A push to all-time lows in the global junk OAS would be a red flag (Chart 25). Chart 25 U.S. Corporate Bond Migration Index BCA's U.S. corporate bond migration index is calculated as the number of bond ratings downgrades minus upgrades by Moody's. Historically, credit quality and stock market momentum have been joined at the hip: the current message is to expect recent stock market euphoria to persist (ratings migration shown inverted, Chart 26). Chart 26 Economic Surprise Indexes A positive reading of the CITIGROUP Economic Surprise Index suggests that economic releases on balance beat expectations. The indexes are calculated daily in a rolling three-month window. Currently, the G10 is in a mini economic surprise soft patch with the U.S. leading the way and the EM as an exception, holding on to recent positive surprises (Chart 27). Chart 27 "Soft Data" Vs. "Hard Data" The so-called "soft data" surprise index comprises survey measures of economic activity: business and consumer surveys surprise indexes. The "hard data" index includes five surprise indexes: housing, industrial, labor, household and retail. Historically, the soft/hard (S/H) data index has been positively correlated with the S&P 500. Unsurprisingly, therefore, it remains near all-time high levels along with the S&P 500. The S/H index has been a leading-to-coincident indicator and as long as it avoids a collapse below the zero line, the equity market overshoot phase should remain intact (Chart 28). Chart 28 BCA Boom / Bust Indicator BCA's boom/bust indicator measures the ratio of a basket of commodity equities, the CRB Raw Industrials Index and unemployment claims. A move above zero signals that reflation is dominating global economies and represents fertile ground for equities. A fall below the zero line indicates that deficient demand and economic trouble are brewing, warning that investors should lighten up on equities. Currently, the boom/bust indicator is comfortably above zero, signaling that the equity blow off phase has more legs (Chart 29). Chart 29 Global Trade Activity Indicator Our Global Trade Activity Indicator (GTAI) comprises the Baltic Dry Index and lumber prices, two hypersensitive economic yardsticks, and gauges the stage of the global trade/inventory/export cycle. Historically, the GTAI has been an excellent leading indicator of global export volume growth, and the latest reading points to a reacceleration in global trade (Chart 30). Chart 30 Korean & Taiwanese Exports Taiwan and Korea are two small open economies, with net exports dominating GDP. Thus, export growth figures from these two countries are a microcosm of the state of the affairs of global trade. Exports in Korea and Taiwan are positively correlated with equity momentum. Currently, booming exports in both regions are a boon for U.S. equities (Chart 31). Chart 31 ISM New Orders-To-Inventories Ratio The ISM manufacturing new orders-to-inventories (NOI) ratio tends to lead the overall ISM manufacturing survey. When the ratio crosses below 1 it signals that economic strains exist. A move above 1 signals that end-demand is firing on all cylinders. Historically, the ISM NOI ratio has also been positively correlated with S&P 500 and the current message is that momentum in the latter should hold up (Chart 32). Chart 32 BCA U.S. Capital Spending Indicator BCA's U.S. Capital Spending Indicator (CSI) is a leading indicator of capital formation. The indicator comprises a labor market series, a measure of momentum in the broad equity market and a capex intention survey data series. Our CSI snapped back into positive territory early in 2016 and recently made fresh cyclical highs. A durable global capex revival is looming (Chart 33). Chart 33 G7 Policy Uncertainty Index The G7 policy uncertainty index is a GDP-weighted index of U.K., Germany, France, Italy, Japan, Canada, and U.S. policy uncertainty indexes, developed by Baker, Bloom & Davis. These indexes measure uncertainty of economic policy-making. Empirical evidence suggests that low G7 policy uncertainty underpins global equity performance. Similarly, surging policy uncertainty spells trouble for the broad equity market. Currently, global policy uncertainty has receded, heralding a fertile global equity market backdrop (Chart 34). Chart 34 BCA Bank Loans & Leases Growth Model Our U.S. bank loan growth model suggests that banks could enjoy the largest upswing in credit growth of the past 30 years. Soaring consumer and business confidence, rising corporate profits and a potential capital spending revival are the key model drivers (Chart 35). Chart 35 This matters for the broad equity market as a vibrant banking sector - representing the nervous system of the economy - is a necessary requirement for sustainable long term broad equity market gains. Global Credit Impulse The global credit impulse is calculated as a 12-month change of the annual percentage change in total global credit, using BIS data. Since the late-1970s there has been a tight positive correlation between BCA's global credit impulse and global EPS momentum. In fact, global loan creation has, more often than not, been an excellent leading indicator for global profit growth. Currently, our global credit impulse has surged signaling that the synchronized global EPS recovery remains intact (Chart 36). Chart 36 BCA's Global & Regional Earnings Growth Models Our global earnings model (comprising interest rates, oil prices, global manufacturing PMI and the U.S. dollar) has recently shown tentative signs of cresting, but that is at a high level and difficult year-over-year comparisons will only arise later this year, especially in the U.S. The bottom three panels of Chart 37 show our EPS models in the major regions of the world. All three regional EPS models are expanding. Chart 37 Margins, Financial Conditions & Monetary Indicator Our Margins, Financial Conditions & Monetary Indicators in Chart 38 demonstrate the close inverse relationship between the former and each of the two latter. Chart 38 Since mid-December, both the U.S. dollar and 10-year Treasury yields have fallen in tandem. As a result monetary conditions have eased, reversing the tightening that occurred in the second half of 2016. Further, the recent downswing in the U.S. Monetary Indicator is bullish for S&P 500 margins. S&P 500 40 Sector Cross-Correlation Index In Chart 39, we show an average of the pairwise 52- week moving correlations between 40 equity sectors using S&P return data starting in the late-1990s, alongside the S&P 500 (correlation index shown inverted). Usually, falling correlations imply diminished macro tail risks and earnings fundamentals coming to the forefront as the key driver of returns. Chart 39 Our 40 sector cross-correlation is currently in steep decline; the message is positive for the S&P 500. Equity Risk Premium In Chart 40, we show the near-perfect inverse correlation between changes in the Equity Risk Premium (ERP) and the ISM manufacturing index. The implication is that an improving economy is synonymous with a receding ERP and vice versa. We further show the average ERP's of the past 3 business cycles which are all well below the current cycle. Overall, declining ERP's are positive for the S&P 500; there appears to be considerable room for the ERP to fall and this indicator is bullish for the S&P 500. Chart 40 Global Synchronicity Indicator Our Global Synchronicity Indicator, presented in Chart 41, shows the degree to which a global economic revival is coordinated. Highly synchronized global growth implies a strong export market and domestic earnings growth. Chart 41 The indicator is currently reading nearly as high as possible as virtually all G20 economies are in expansion mode. Consumer Drag Indicator The Consumer Drag Indicator comprises mortgage rates and gasoline prices and is a strong indicator for consumer discretionary earnings (Chart 42). Chart 42 The drag indicator is currently very low, implying strong consumption resilience, which should translate into ongoing consumer discretionary EPS gains. Recreational Goods & Consumption Expenditure Recreational goods & vehicles represent the most cyclical corner of U.S. personal consumption expenditure (PCE), easily surpassing it during expansions, and significantly trailing it in times of distress (Chart 43). An upswing in spending in this segment indicates strong consumer confidence and heralds an increase in overall PCE. Currently, according to the BEA, recreational goods & vehicles outlays are expanding at a healthy clip, underscoring that overall PCE will likely rebound in the coming quarters. Chart 43 Unconventional Indicators (Part I) How can investors differentiate between a minor correction and a major trend change? We showcase several useful, but somewhat unconventional, indicators to monitor that have been helpful at past bull market peaks. None of these indicators are meant to be foolproof and/or a substitute for the valuation, profit and global economic and policy outlook. But they do provide additional tools to help investors distinguish between temporary and sustained equity market pullbacks. They are meant to augment rather than replace fundamental factors. Each of the indicators measures either: profits, business confidence, investor confidence and/or reflects how liquidity conditions are impacting market dynamics. Investor confidence can be measured through margin debt. While extremely elevated, there is no concrete sign that access to funds is being undermined by the modest backup in interest rates. When the cost of borrowing becomes too onerous, it will manifest in reduced margin debt and forced selling, which will be a serious threat to stocks given that leverage is challenging levels experienced at prior peaks, as a share of nominal income (Chart 44A). Chart 44A Unconventional Indicators (Part II) The relative performance of consumer discretionary to consumer staples can provide a read on purchasing power and/or the marginal propensity to spend. This share price ratio does not suggest any consumption concerns exist. If consumer staples begin to outperform, then it would warn of a more daunting economic outlook. Temporary employment continues to rise. When temp workers shrink, it is often an early warning sign that companies are entering retrenchment mode, given the ease and low cost of reducing this source of labor costs. If temporary employment falls at the same time as share prices, that would be a red flag. Current economic signals are mostly positive (Chart 44B). Chart 44B Pricing Power And Wage Growth Indicators Our corporate pricing power proxy compiles the relevant CPI, PPI, PCE or underlying commodity price for 60 S&P 500 industry groups. On a broad basis, growth in pricing power has slowed. On the flip side, rising labor costs look set to take a breather, with the net effect of modest margin expansion. 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. Overall, there are strong odds that resilient forward operating margin expectations can be met (Chart 45). Chart 45 BCA Reflation Gauge The RG is a combination of oil prices, Treasury yields and the U.S. dollar and has recently exploded to the highest level since 2010 and just shy of all-time highs. The RG leads both the U.S. economic surprise index and equity sentiment. If, as we expect, economic activity continues to accelerate, irrespective of tax reform success, the window is open for additional equity market gains (Chart 46). Chart 46 Total Returns: Stock-To-Bond The Stock-to-Bond (S/B) ratio is not signaling any trouble ahead. History shows that the time to worry about the bond market's message is when the S/B ratio contracts; the opposite is currently underway. Part of the decline in long-term interest rates reflects a slower expected pace of fed funds rate increases. The bond market doubts the FOMC's 2.125% interest rate estimate for 2018, forecasting a fed funds rate roughly 63bps lower. If the bond market is accurate and the Fed recalibrates its 18-month rate outlook even modestly lower, then the S/B ratio has more upside (Chart 47). Chart 47 Structural Indicators (1-3 years) U.S. Equity Net Debt/EBITDA & Interest Coverage Zero and negative interest rate policies have enticed CEOs to issue debt and retire equity (and increase dividend payments) and effectively change the capital structure of the firm over the past 7 years. Recently, net debt/EBITDA has reversed some of the significant increases of the past 5 years as earnings have been growing faster than leverage. Historically, net debt/EBITDA has been inversely correlated with the equity market; the current trend of declining leverage ratios is positive for equity markets (Chart 48). Chart 48 U.S. Dollar-Based Liquidity Indicator BCA's U.S. dollar-based liquidity is calculated as Federal Reserve assets plus foreign central bank U.S. government security purchases held by the Federal Reserve. When U.S. Treasurys are sold by Central Banks it represents a defacto tightening in global monetary conditions. Moreover, the Fed recently announced that it will likely commence renormalizing its balance sheet later this year, further tightening global monetary conditions. This matters most for EM that hold a large stock of hard currency debt. Why? Because historically a collapse in U.S. dollar based liquidity has been associated with a rise in the U.S. dollar. As a result, if such tightening goes unchecked then a traditional EM crisis is inevitable. Currently, U.S. dollar based liquidity has plunged to a level associated with recession, warning that the broad equity market rests on a shaky foundation especially given lofty valuations (Chart 49). Chart 49 BCA Credit Bust Indicator Using BIS data, we constructed a BCA Credit Bust Indicator by averaging and aligning seven previous non-financial corporate debt cycles at respective peaks, both in EM and DM. The common denominator in the four DM busts was a burst housing market bubble, while the three EM crises were related to currency devaluations. While Chart 50 shows that 17 EM non-financial corporate debt levels as a percentage of GDP have not yet reached the average of previous cycle busts, one important insight from our analysis is that it pays to get out of the stock market while the leverage cycle is still on the upswing, potentially leaving some money on the table, but protecting wealth from an inevitable crunch once the leverage cycle hits the point of economic instability. Chart 50 U.S./Eurozone 10-Year Sovereign Bond Spread The U.S./Eurozone 10-year sovereign bond spread has been an excellent leading indicator of the broad equity market, and the current message is to expect at least a tactical pullback. In fact, every time the spread has hit 100 basis points, relative bond market mean reversion has subsequently occurred, leading also to a broad equity market wobble (top panel, Chart 51). Chart 51 The rationale of this indicator is that Central Bank policy divergence is not sustainable for prolonged periods. Currently, the Fed is, with a few exceptions, going it alone and tightening monetary policy, while the ECB, BOJ and BOE are still extremely accommodative. If policy divergence continues, then the U.S. dollar will make a run to fresh all-time highs and will come to haunt equity markets via an EM accident. As Chart 50 shows, EM debt is quickly building and a spike in the U.S. dollar is destabilizing especially for the "fragile five" twin deficit economies that also have a hard currency debt burden to service. U.S. Yield Curve Corporate profits and the yield curve are joined at the hip. The yield curve is the ultimate leading indicator of revenue growth and earnings health, underscoring that EPS caution is warranted, especially when the yield curve inverts and signals that a recession is nearing. We are not there yet, but there are good odds that if the Fed continues to tighten monetary policy and lift rates near the neutral rate, the economy will suffer. Likely this is a late-2018 early-2019 narrative (Chart 52). Chart 52 Industrial Production Minus Money Supply A simple liquidity indicator (industrial production (IP) minus money supply growth) has had a tight positive correlation with EPS for decades. This indicator gauges how quickly money created gets translated into economic growth. Given the current state of affairs of recovering IP growth and decelerating M2 growth, a sustained profit recovery is in the cards in the back half of 2017 and in 2018 (Chart 53). Chart 53 Federal Reserve Bank Of Philadelphia Coincident U.S. State Activity Diffusion Index The coincident U.S. State activity diffusion index is a one-month diffusion index of state coincident indexes produced by the Federal Reserve Bank of Philadelphia. The index includes nonfarm payroll employment, the unemployment rate, average hours worked in manufacturing, the consumer price index, wages and salary disbursements and gross domestic product.1 Empirical evidence shows that every time this index falls through the 45% level the global equity market hits a wall as the odds of a U.S. recession skyrocket. While there have been some false positives over the past three decades, this diffusion index has a great track record in predicting recessions. Currently, the steep fall is a cause for concern, but until the 45% level is breached, the equity market will be smooth sailing (Chart 54). Chart 54 Federal Funds Rate In times of crisis, the Federal Reserve cuts the federal funds rate to stimulate demand and the economy. Similarly, when the economy is heating up and inflation is rising, the Fed raises rates to slow down economic activity. Historically, a peak in the fed funds rate has been an excellent leading indicator of recession. Chart 55 shows that since the early-1970s a tick down in the fed funds rate following a series of hikes signifies the end of the business cycle. There have been two false positives, once in the mid-1980s and one in the late-1990s. Chart 55 This June the Fed hiked for the fourth time this tightening cycle and more hikes are to follow according to the Fed's own estimates of interest rate projections into 2019. A reversal of interest rate policy will be significant and likely mark the end of the current business expansion. Stay tuned. BCA U.S. 10-Year Bond Valuation Index The Treasury market can provide clues as to when vulnerabilities in the equity market will intensify. According to BCA's Treasury Bond Valuation Model, yields usually need to be at least one standard deviation above normal before stocks, and the economy, are at risk of a major downturn (Chart 56). Chart 56 Global Auto Sales Indicator Global auto sales have tentatively peaked. While this indicator has been coincident at times, it has also correctly forewarned of global equity market peaks both in 2000 and 2007 (Chart 57). As a highly priced durable good, vehicle sales provide an excellent read on both consumer confidence and their ability/willingness to finance a long-term purchase. The implication of slowing sales is that some doubt about the rate of consumption growth will contribute to a higher equity risk premium. Nevertheless, the equity bull market should remain on track until consumer confidence takes a turn for the worse. Chart 57 GDP Growth Minus Treasury Yield GDP growth minus the Treasury yield is a simple yet reliable measure of excess liquidity. Bear markets have only typically occurred when this gauge downshifts into negative territory, given that slumping GDP usually coincides with a profit recession. Currently, nominal GDP growth is comfortably above the 10-year Treasury yield, signaling that financial conditions will stay sufficiently easy for some time, barring a major bond selloff (Chart 58). Chart 58 Cross-Sector Correlation Equity correlations have often led the business cycle. When correlations drop precipitously, recession warnings abound, with the notable exceptions of the mid-80s and mid-to-late-90s when commodity deflation (particularly energy) morphed into a mid-cycle economic slowdown, but the broad market stayed resilient because the economy skirted recession. While we are in the midst of a steep fall in correlations, we are not worried about a U.S. recession just yet. Instead, equities have likely navigated through a mid-cycle correction, as in the mid-80s and mid-to-late-90s (Chart 59). Chart 59 Long-Term Total Return/GDP Our long-term total return indicator inverts and advances market capitalization/GDP by 10-years, and plots that with 10-year rolling equity returns. The relationship indicates the economic growth the market is discounting into the future (Chart 60). Chart 60 The current soaring growth expectations mean that a volatile equity validation phase is inevitable. The timing is difficult to pinpoint, however, because momentum can be a powerful and seductive force. In other words, performance anxiety and fear of missing out are strong cyclical warning flags. 1 https://www.philadelphiafed.org/research-and-data/regional-economy/indexes/coincident/

This week's GDP report contained good news for domestic manufacturers; nonresidential fixed investment expanded at a 5.2% annualized rate in Q2, slower than the 7.2% expansion of Q1 but still well above the overall economy at 2.6%. The implication is that confidence in the U.S. economy is high enough that firms are increasingly deploying productive capital into their businesses. Loan growth cycles are typically synchronous with improved business sentiment which, in turn, coincides with firms feeling confident enough to expand the balance sheet. Accordingly, growth in capex and growth in bank loans move in lockstep (second, third and fourth panels). Pre-GFC, the financials index and capex/loan growth moved broadly together. The relationship has broken down, however, in the post-GFC world. We expect above-normal earnings growth in financials to eventually drive a renormalization of valuation multiples and the gap to close. We reiterate our overweight financials recommendation.

Overweight The cable & satellite index heavyweights Comcast and Charter Communications both reported their results last week, announcing that they had churned 34,000 and 90,000 of the traditional video customers, respectively. Still, neither company saw a decline in video revenue, reflecting still-strong sector pricing (second panel) and an unabated willingness of the consumer to purchase their content (third panel). The dominant theme from cable & satellite earnings was a transition to high-speed internet (unchanged from the past number of years), a lower revenue but higher margin business. This drove both of the aforementioned companies to each grow their customer relationships by mid-single digits in the quarter. Importantly, the customer additions were made without significantly increasing capital outlays (bottom panel) that, when combined with an overall higher margin business, implies more efficient returns on capital. This should ultimately drive more free cash flow, higher valuation multiples and ongoing share price increases. We reiterate our overweight recommendation for cable & satellite. The ticker symbols for the stocks in the S&P cable & satellite index are: BLBG: S5CBST - CMCSA, CHTR, DISH.