Equities

Beyond the potential small cap profit margin squeeze yellow flag that we highlighted in the previous Insight, the small/large ratio also appears technically stretched. The chart shows that every time the NFIB survey soars to beyond the 105 level, relative share prices hit a wall soon thereafter. The implication is that significant optimism in Trump's expected, but untested, policy changes is discounted in small vs. large cap relative performance. If margin pressures don't soon improve for small businesses, we will recommend taking profits. Bottom Line: More gains are likely in store for the small/large share price ratio in the near term, but be prepared to lock in profits. Stay tuned.

President-elect Trump and the euphoria surrounding his small government plans along with tax reform are reverberating across the small business sector. The latest NFIB survey surged to the highest level in years, recording the largest m/m increase since the history of the data in the mid-1970s. In fact, the top panel of the chart shows that the NFIB outlook for business conditions vs. the CEO confidence survey has also vaulted to multi-year highs, signaling that small cap stocks should retain the upper hand compared with their large cap brethren. Nevertheless, before getting too excited, two more NFIB survey subcomponents are also worth noting: planned price hikes and labor compensation. While the small business selling price outlook has firmed, labor input cost inflation is more than offsetting pricing power (middle panel). This is reflected in the still wide gap between small and large cap profit margin backdrop and is worth monitoring (please see the next Insight).

Special Report

"That as the only possible policy in our day for a conqueror to pursue is to leave the wealth of a territory in the complete possession of the individuals inhabiting that territory, it is a logical fallacy and an optical illusion in Europe to regard a nation as increasing its wealth when it increases its territory, because when a province or state is annexed, the population, who are the real and only owners of the wealth therein, are also annexed, and the conqueror gets nothing." 1 Norman Angell's "The Great Illusion" posited in the early 1910s that war would be futile for developed nations, especially given the rising importance of economic and financial ties. Nevertheless, the arms race from the late-1800s gained momentum and eventually led to the Great War, dealing a devastating blow to his arguments. The European armament dynamics of the late-19th century/early 20th century are eerily reminiscent of the current post-Great Recession global arms race. Back then Germany, Austria-Hungary and Italy on one side, and Britain, France and Russia on the other, were fiercely trying to outpace each other in military expenditures. The crumbling Ottoman Empire along with the newly created smaller states in Greece, Serbia, Bulgaria and Romania were also eager weapons purchasers. Today, a fresh military expenditure-related development pops up almost daily. Not only are the U.S. and China boosting military spending, but also Japan, Australia, India, Vietnam, Saudi Arabia, Turkey, Russia, etc (Chart 1).2 The list goes on and on. The driving factor is "multipolarity," i.e. the emergence of multiple competing great powers, which BCA's Geopolitical Strategy service has shown to be a key investment theme.3 Chart 1U.S. Defense Spending Is More Than The Rest Of The World Combined While we are not arguing that WWIII will erupt in the coming years, the purpose of this Special Report is to identify the winning global equity sectors from the intensifying global arms race (Chart 2): global defense stocks come atop of our list, but also global space-related equities and cyber security firms would be beneficiaries of the secular increase in military outlays. On a regional basis, the U.S. defense stocks are the only game in town, but undiscovered Chinese, and to a lesser extent Russian, defense stocks are intriguing as are Israeli defense and tech stocks (please refer to the Appendix below for ticker symbols). Chart 2Intensifying Global Arms Race Late 19th/Early 20th Century: Militarism, Globalization & Finance Back in the late-1800s, the ascendancy of Germany was challenging the hegemony of Britain, fueling a European-wide arms race. Smaller newly formed states were also on the hunt for the latest and greatest weaponry. During the Balkan Wars of 1912-13 airplanes were deployed in combat for the very first time, highlighting the importance of new technology. Behind this explosive European rearmament were a few large British companies (Vickers Sons & Maxim Ltd, Armstrong and Whitworth, and Coventry Ordnance Works). "By 1905, its capital of £7.4 million ranked Vickers sixth amongst British companies; Armstrong Whitworth, with 5.3 million pounds capital was eleventh".4 Basil Zaharoff, who acted as general representative for business abroad for Vickers,5 was reputedly one of the richest men in the world.6 Moreover, globalization was on the rise in the late 19th century, as evidenced by global imports as a percentage of GDP (Chart 3). Industrialization coupled with imperialism and the colonization of Asia and sub-Saharan Africa along with population growth and rising demand for commodities were key drivers behind the jump in 19th century globalization. Finally, all of this was made possible by cross-boarder finance. Trade finance and credit growth skyrocketed in the late-1800s and the rising interconnectedness of global financial centers was most evident in the 1907 stock market panic that originated in the U.S., but spread like wildfire to the rest of the world. Chart 3Twin Peaks Of Globalization? Chart 4Heeding The Early 1960s Parallel What About The 1960s? The idea of militarily outspending opponents was very evident in the early-1960s when U.S. defense spending surged by 20% on a year-over-year basis (Chart 4), bolstering demand once again for military contractors. The mutually assured destruction (MAD) doctrine of military strategy and national security policy declared overtly in the early-1960s by U.S. defense secretary Robert McNamara and the Space Race competition between the Cold War rivals also have striking similarities with today, as far as investment implications are concerned. Parallels With Today China's ascendency to a world power large enough to challenge the hegemony of the U.S. is a sea change.7 The rearmament of East Asia is reminiscent of late 19th and early 20th century Europe and involves Japan, Australia, South Korea, Vietnam and India. All of the Middle East, along with Turkey and Russia, are on a structural military spending spree. European NATO fringe states are also arming furiously (Chart 5), trying to thwart Russia's regional ambitions. In the U.S., despite the Budget Control Act of 2011 (sequestration), the CBO projects that defense spending will rise gradually from $586 billion in 2015 to $739 billion by 2026 (Chart 6). This is before any push for a fiscal spending thrust that both presidential candidates have proposed, which would include increased defense outlays. While as a percentage of GDP defense spending may drift sideways, in absolute terms it will likely rise, and thus boost demand for defense contractors. Chart 5Stealthy Rise In Defense Outlays Chart 6CBO Estimates New Defense Spending Highs Globalization has hit an apex recently (Chart 3).8 The world is still licking its wounds from the recent GFC, where U.S. financials stocks were so intertwined with their global peers that the crisis effectively brought down to its knees the global financial system and gave birth to unorthodox monetary policy that Central Banks are still currently deploying. Global Rearmament Beneficiaries If our hypothesis that a global arms race will continue to heat up in coming years pans out, then owning global defense stocks as a structural bet will pay handsome dividends. The global push away from austerity and toward more fiscal spending should also support aggregate defense demand. Thus, there are high odds that global defense stocks are primed to deliver absolute positive returns, irrespective of where the broad global equity market drifts in the next five years. Similar to Vickers and Armstrong and Whitworth making impressive stock market strides early last century, global defense stocks should continue to be high flyers. The early-1960s U.S. aerospace & defense (A&D) stocks are the only close stock market parallel we have come across in our analysis (given data constraints) and comparing this index's available metrics of that era with today is in order. A big pushback to the U.S. Equity Strategy service's constructive view on the U.S. defense index (since the late-2015 inception) has been that the valuations of these stocks are already full, leaving no valuation cushion for any mishaps (Chart 7). True, defense stocks are on the expensive side, but not if they manage to grow into their valuations, as we expect. Relative performance was up over 100% in a span of four years in the 1960s (Chart 8), as U.S. aerospace & defense industrial production (IP) swelled to a 20% per annum clip with utilization rates running at 95% (Chart 8). A&D factories were humming, racing to fulfill orders as U.S. military expenditures were thriving (Chart 4). Chart 7Buy Global Defense Stocks Chart 8In The 1960s A&D Factories Were Humming... This demand surge translated into a jump in sector sales momentum (Chart 4), and given the industry's high operating leverage, earnings and book values soared. From trough to peak, sector EPS rose more than 400%, margins expanded from sub 2% to nearly 8%, and book value doubled (Chart 9). That stellar performance justified initial valuation premiums at the time. Using that period as a guide would imply that there is ample upside left for relative performance of the global defense index (that is a pure play on global defense spending). For comparison consistency, we use U.S. A&D figures. Currently, U.S. A&D IP is contracting, with resource utilization running at 80%. U.S. A&D relative performance has risen a mere 30% since the Great Recession (Chart 10). Chart 9...Boosting The Allure Of ##br## A&D Stocks Chart 10If History At Least Rhymes, ##br## There Is Still Ample Upside... Likely, the advance is still in the early innings, and analysts have been very slow to upgrade their EPS estimates accentuating the apparent overvaluation. Importantly, 5-year forward relative EPS growth estimates are deep in negative territory which is very perplexing given the upward trajectory of industry demand (Chart 11). Given that we only have access to data for MSCI All-Country World aerospace & defense long-term EPS expectations the caveat is that some of the poor expectations and performance could be because of the waning aerospace delivery cycle. Unlike the deteriorating health of the broad corporate sector, profit margins are expanding and net debt-to-EBITDA is a comfortable 1.2x. Similarly, interest coverage ratio is near an all-time high of 8x (Chart 12), while the overall markets EBIT/interest expense ratio is half that. Chart 11...Especially ##br## Given Depressed Analysts' Expectations Chart 12Defense ##br## Wins Championships Global defense sector return on equity (ROE) is almost 30% and rising (Chart 13), whereas global non-financial corporate (NFC) ROE is hitting multi-year lows, with the U.S. NFC ROE plumbing all-time lows (Chart 14). Free cash flow is also growing briskly and the industry is making greenfield investments, with capex growing 9.5% year-over-year, the mirror image of the global NFC sector that is pruning capital outlays (middle and bottom panels, Chart 13). Chart 13Defense Flexing ##br## Its Muscles... Chart 14...Vs. The Atrophy In The U.S. ##br## Non-Financial Corporate Sector On the valuation front, modest overvaluation exists, as portrayed by the high relative price-to-cash flow and price-to-book multiples. However, the global defense stocks forward P/E ratio and EV/EBITDA multiple are on an even keel with the broad market (Chart 15), and if our thesis that a secular uptrend in defense-related demand looms proves accurate, then these stocks are not expensive, but on the contrary still represent a buying opportunity. Chart 15Mixed Signals On The Relative Valuation Front Chart 16Defense Is The Best Offense The Rise In Terrorism, Global Space Race And Cyber Security Threat The unfortunate structural increase in terrorist activity will also embolden governments around the world to step up defense spending (top panel, Chart 16).9 The latter tends to move in long cycles. U.S. defense industry revenues have already begun to outpace those of the overall S&P 500, and a prolonged upturn lies ahead, based on the message from the previous upcycle. From a cyclical perspective, the defense capital goods shipments-to-inventories ratio is outpacing the overall manufacturing sector (second panel. Chart 16), reinforcing the case for ongoing earnings outperformance. The same also holds true in Europe. Western European terrorist attacks have increased, heralding further relative gains for the euro area aerospace & defense index (bottom panel, Chart 16). Beyond the disastrous spike in terrorism, the global space race is also gaining traction, with China spearheading the charge. There is a good chance that China will attain geosynchronous orbit satellites (residing more than 20,000 miles above the earth), challenging U.S. space dominance. India's space aspirations are grand and it is slowly and stealthily rising up the ranks on the space race. Moreover, as more countries aim to have manned space missions, that translates into higher space budgets and thus firming demand for space-related expenditures (Chart 17). Chart 17Space, The Final Frontier Finally, the number of cyber-attacks is also on the rise globally. Defending against attacks is a challenge. Not only does the cyber space domain definition remain elusive, but tracking hackers down is also increasingly difficult given the vastest of the internet, lack of global uniform policing methods and physical country borders. Crudely put, it is a lot easier for a Chinese or Russian hacker to deal a blow, for example, to U.S. nuclear infrastructure rather than physically deliver an attack. All of this suggests that investment in anti-hacking and counter cyber-attack capabilities is necessary around the globe in order to thwart cyber-terrorism. Risks To Our View While there is conceivably a risk that China will abruptly halt its intense militarization and make a U turn in its long-term strategy of becoming a military superpower, we assign a very low probability to such a turn of events. The global push for more fiscal spending may not materialize, which would be a risk to our sanguine global defense spending view. As Paul Volcker and Peter Peterson recently opined in a NY Times article10 - offering a different view from the always-articulate Larry Summers - prudent and fiscally responsible spending is in order given the excessive debt-to-GDP ratio that is probing war-like levels (Chart 18). This excessive debt overhang is not only a U.S. phenomenon, but also a global one spanning both advanced and emerging economies. Chart 18Excessive Debt Is A Risk To Bullish View On Global Defense Stocks One final risk is that the world will enter a prolonged peace phase and global terrorism will get quashed, with conflicts dying down in the Middle East, Russia reining in its imperialistic ambitions and China ceasing to stir the waters in the South and East China Seas. We would also assign low odds to this optimistic "no conflict phase" scenario, but it would indeed be welcome. Investment Conclusion Factors are falling into place for a structural outperformance period in the global defense index. The early-1900s and early-1960s parallels, coupled with the trifecta of terrorism, space race and cyber security all point to upbeat demand for defense-related goods and services. Expressing this buoyant view can be done from a bottom up perspective. The Appendix below highlights all the companies in the global defense index we track from Datastream and the alternative one from Bloomberg. An investable proxy is the U.S. aerospace & defense index as the U.S. dominates global A&D indexes and aerospace outfits also sport significant defense corporate segments (please see the Appendix below for relevant tickers). There are also three fairly liquid ETFs mimicking the U.S. A&D index: ITA:US, PPA:US & XAR:US. Moreover, below are a few more speculative investment ideas. Given China's dominance of global defense spending (ex-U.S.) we are confident that Chinese A&D stocks will also be eagerly sought after and deliver alpha in the coming years (please refer to the Appendix below for a list of China plays). If one has the resilience and the stomach to invest in Russian equities given high political and currency risk, then Russian A&D stocks may be a desirable vehicle. Russia remains a massive weapons exporter with a large sphere of influence. We would not underestimate the returns in local currency of some Russian A&D stocks (the Appendix below lists some Russian A&D listed firms). Finally, Israel A&D and IT companies either listed on NASDAQ or domestically in Tel Aviv offer some great opportunities for investors that can handle riskier investments. Not only Israel's geography, but also its intense IT/military focus and entrepreneurial culture imply that a number of these companies will be long-term winners (please see the Appendix below for relevant tickers). While most of the drones, space-related, and highly specialized IT companies are private, there is a drone and an anti-hacking ETF (IFLY:US & HACK:US). On the space front, we are tracking an index that comprises a number of space-related constituents that we show in the Appendix below. Nevertheless, most of these companies are categorized under A&D. Bottom Line: We are initiating a structural overweight in the global defense index with a longer-than-usual five year secular investment horizon. The re-rating phase in this index is still in the early innings. Anastasios Avgeriou, Vice President Global Alpha Sector Strategy anastasios@bcaresearch.com Appendix Table A1BI Global Defense Primes Competitive Peers Table A2World Defense Index (DS: DEFENWD) Table A3S&P 500 Aerospace & Defense Index ##br## (S5AERO Index) Table A4China ##br## Aerospace & Defense Table A5Russia & Israel Aerospace & Defense Table A6Kensho Space Index 1 Angell, Norman (1911), The Great Illusion: A Study of the Relation of Military Power in Nations to their Economic and Social Advantage, (3 ed.), New York and London: G.P. Putnam's & Sons. 2 Please see BCA Geopolitical Strategy Monthly Report, "The Great Risk Rotation," dated December 11, 2013, available at gps.bcaresearch.com 3 Please see BCA Geopolitical Strategy Monthly Report, "Multipolarity And Investing," dated April 9, 2014, available at gps.bcaresearch.com 4 Angell, Warren, Kenneth (1989), Armstrongs of Elswick: Growth In Engineering And Armaments To The Merger with Vickers, London, The Macmillan Press Ltd. 5 http://www.oxforddnb.com/index/38/101038270/ 6 https://www.britannica.com/biography/Basil-Zaharoff 7 Please see BCA Geopolitical Strategy Special Report, "Sino-American Conflict: More Likely Than You Think, Part II," dated November 6, 2015, available at gps.bcaresearch.com 8 Please see BCA Geopolitical Strategy, "The Apex Of Globalization - All Downhill From Here," in Monthly Report, "Winter Is Coming," dated November 12, 2014, available at gps.bcaresearch.com 9 Please see BCA Geopolitical Strategy Special Report, "A Bull Market For Terror," dated August 5, 2016, available at gps.bcaresearch.com 10 http://www.nytimes.com/2016/10/22/opinion/ignoring-the-debt-problem.html?_r=0

Highlights The U.S. dollar will likely overshoot. This is negative for EM. China by and large has a choice between two potential roadmaps: (1) short-term pain / long-term gain and (2) growth stagnation with mini-cycles around it. Regardless of which scenario transpires - so far the second scenario has been in effect - the medium-term outlook is downbeat. Given we are already advanced in this mini-cycle, the risk-reward for China plays in financial markets is negative. Feature Chart I-1Equity Investors Are ##br##Bullish With Minimum Hedges The U.S. dollar is overbought, but the primary trend remains up. A confluence of cyclical and structural economic forces, along with geopolitical and political risks, argue for further upside in the greenback. As the dollar grinds higher, emerging markets (EM) will suffer. EM stocks, currencies, and credit markets will not only underperform their developed market (DM) peers, but also relapse in absolute terms in the months ahead. Additional U.S. dollar strength and ongoing complacency in the U.S. equity market (Chart I-1) means that the 6-12 month outlook for global equity markets is poor. While momentum can carry DM markets higher in the very near term, EM share prices have already topped out, and the path of the least resistance is down. Dollar appreciation will be brought on by both global/EM and U.S. dynamics. Global Factors Supporting The U.S. Dollar The following global factors support the greenback's strength: Global demand for U.S. dollars is rising faster than the supply of U.S. dollars. We computed two measures of U.S. dollar liquidity. Measure 1 is the sum of the U.S. monetary base and U.S. Treasury securities held in custody for foreign official and international accounts. Measure 2 is the sum of the U.S. monetary base and U.S. Treasury securities held by all foreign residents (Chart I-2A and Chart I-2B). Chart I-2AU.S. Dollar Liquidity (Measure 2) Chart I-2BU.S. Dollar Liquidity (Measure 1) Notably, the U.S. monetary base and the amount of U.S. Treasury securities held by foreign official and international accounts are contracting, while the amount of U.S. Treasury securities held by all foreigners has stalled (Chart I-3). The monetary base shrinkage manifests the rise in reverse repos by the Fed, i.e., the Fed is siphoning in the banks' excess reserves (Chart I-3, bottom panel). The weakness in foreign holdings of U.S. Treasury securities is largely due to the selling of U.S. securities by EM central banks to provide U.S. dollars in order to meet strong dollar demand locally. China is the largest contributor to the surge in U.S. dollar demand as the depletion of its international reserves has been enormous. In short, the drop in U.S. dollar liquidity does not mean that U.S. dollar supply is shrinking. Instead, it implies that the demand for U.S. dollars is accelerating relative to its supply. When the pace of demand growth outpaces that of supply, the price of that commodity, good/service, or asset, rises. This will be the case for the greenback - it will appreciate further. Importantly, the RMB will remain under downward pressure, which will drag down other Asian currencies. China's unaccounted net capital outflows - measured by the balance of payment's net errors and omissions - have swelled to a record level of US$ 205 billion, or 2% of GDP (Chart I-4). Furthermore, the PBoC has been conducting full-out "reverse" sterilization of its U.S. dollar sales. By selling U.S. dollars to defend the RMB, the PBoC initially shrunk local currency liquidity. To preclude onshore interbank interest rates from spiking, the mainland monetary authorities have simultaneously re-injected RMB into the system via outright lending to banks and open-market operations (Chart I-5). Chart I-3Components Of U.S. Dollar Liquidity Chart I-4China: Unrecorded Capital Outflows Chart I-5The PBoC: By doing so, they have kept interest rates low, but the supply of high-powered money has been restored. It is reasonable to expect such RMB liquidity injections to continue. This, in turn, will allow commercial banks to continue creating money/credit/deposits out of thin air. As such, the mushrooming supply of yuan will weigh on the currency's value. We discussed these issues in detail in our November 23, 2016 Special Report, titled China: Money Creation Redux and RMB.1 U.S. dollar borrowing costs are rising: Not only have U.S. bond yields spiked but the LIBOR rate has also continued its unrelenting uptrend, especially when compared to the EURIBOR (Chart I-6). Higher borrowing costs and expectations for further U.S. dollar strength will make non-American debtors with U.S. dollar liabilities reluctant to keep their short dollar exposure. They will try to either repay U.S. dollar debt or hedge it. This will ultimately increase the demand for U.S. dollars in the months ahead. Importantly, EM countries (outside of China) have US$ 5 trillion of foreign currency debt outstanding. Thus, higher U.S. borrowing costs will raise the demand for U.S. dollars as debtors rush to repay or hedge their U.S. dollar liabilities. We published an extensive review of EM foreign currency debt on January 4 in our Weekly Report titled EM: Overview of External Debt.2 This report provides information about various categories of borrowers (government, nonfinancial companies and financials), types of debt (loans versus bonds) and debt maturity (short- versus long-term) for each individual developing economy. The report also ranks countries according to their foreign debt burdens and short-term funding pressures. This report can be accessed by clicking on the link on page 19. The yield differential between EM local bonds and U.S. Treasurys has narrowed (Chart I-7), as U.S. bond yields have risen more than duration-adjusted EM domestic bond yields. Such a compression in the spread has reduced the attractiveness of EM local bonds. As U.S. bond yields resume their ascent, odds are that inflows into EM local bonds will diminish, and EM bonds will sell off. Chart I-8 illustrates that the J.P. Morgan EMLI EM currency total return index (including carry) has failed to break above an important technical resistance. When such a technical profile transpires, it is often followed by a major breakdown. Chart I-6Rising LIBOR Will Hurt Debtors ##br##With U.S. Dollar Liabilities Chart I-7The EM-U.S. Bond Yield ##br##Gap Has Narrowed Chart I-8EM Currency Return With ##br##Carry: More Downside Trade protectionism is bound to rise. The proposed U.S. Border-Adjusted Corporate Tax and any potential U.S. import tariffs will lead many exporter countries to devalue their currencies substantially to offset the loss in exporter revenues in local- currency terms. For example, Chart I-9 shows that U.S. import prices from China have been deflating in U.S. dollar terms but have risen a lot in RMB terms. The latter is what matters to producers. Hence, China and many other exporters to the U.S. will seek to devalue their currencies further to offset import tariffs and the resulting drop in US. dollar revenues from their sales in America. Finally, the outlook for foreign capital inflows (both FDI and equity flows) into EM remains very poor. EM growth is weak and will remain so. The growth acceleration in advanced economies will not help EM economies much for reasons we discussed at length in our December 14, 2016 Weekly Report.3 Remarkably, the worsening trend in relative manufacturing PMIs between EM and DM suggests EM growth and share prices will continue to underperform DM (Chart I-10). Chart I-9Deflation In U.S. Dollars, Rising In RMB Terms Chart I-10EM Will Continue Underperforming DM Bottom Line: The current confluence of global economic forces and rising trade protectionism in the U.S. will propel the U.S. dollar higher. Domestic Underpinnings Of The U.S. Dollar Rising U.S. interest rate expectations will extend the U.S. dollar rally: The U.S. labor market is tight, and wage growth is accelerating (Chart I-11). This is what the Federal Reserve has been waiting for years, and the central bank will now gradually but steadily ramp up its hawkishness. This will push up U.S. interest rate expectations and prop up the dollar. The exchange rate appreciation will cool off the manufacturing sector at a time when the rest of the economy will be robust. In brief, a strong dollar will be needed to avoid overheating in the U.S. economy. While an overshoot in the dollar will certainly have a deflationary impact on the U.S. economy, especially its manufacturing sector, the negative impact will be somewhat offset because of potential trade protectionist measures introduced by the U.S. authorities. Remarkably, U.S. interest rates are still too low. In particular, 10-year TIPS yields are a mere 0.5%, and long-term bond yields are low relative to wage growth (Chart I-12). Chart I-11U.S. Labor Market Is Tight Chart I-12U.S. Bond Yields Are Low U.S. credit growth is strong and the real estate market is vibrant. There is no reason for U.S. interest rates to stay at emergency low levels that have prevailed since the Lehman crisis. Notably, potential fiscal stimulus from the incoming Trump administration warrants higher interest rates to avoid boom-bust cycles. The Fed will tighten policy sooner rather than later, as policymakers know that policy works with time lags and they will not wait for the economic impact of fiscal spending to works its way through the economy. We believe the 50 basis points hikes over the next 12 months currently priced into the U.S. fixed income market are too low, and interest rate expectations will climb by about 50 basis points in the months ahead. Finally, the U.S. dollar has not yet overshot. It is only modestly above its fair value, according to the real effective exchange rate based on unit labor costs. Typically, bull and bear markets do not end at fair value; financial markets tend to over- and under-shoot. We believe the U.S. dollar is primed to overshoot before this current bull run peters out. Bottom Line: Robust U.S. growth and tight labor market conditions put the U.S. in a unique global position to tolerate a stronger currency, for a while. We continue recommending short positions in a basket of the following EM currencies: KRW, IDR, MYR, TRY, ZAR, BRL, CLP and COP. We are also short the RMB via 12-month NDFs. China: Growth Revival And Hard Choices Ahead China's growth has revived, spurred by another round of credit and fiscal stimulus. However, BCA's Emerging Markets Strategy team maintains that the latest improvement in growth will prove unsustainable and vulnerabilities abound. In particular: Despite improving economic data, the Chinese equity indexes have fared extremely poorly. China's MSCI Investable index was essentially flat during 2016, and domestic A-shares were down 20% in the U.S. dollar terms. This compares with 9.5%, 5.7% and 8.5% gains in the S&P 500, global, and EM share prices in U.S. dollar terms, respectively, over the course of 2016. The relative performance of the Chinese MSCI Investable index to the global stock index has rolled over after failing to break above its technical resistance (Chart I-13, top panel). The same is true for share prices in absolute terms (Chart I-13, bottom panel). These chart profiles hint that Chinese stocks have failed to enter a bull market, and downside is material. How do we explain the divergence between weak Chinese share prices and the rally in commodities prices and commodities stocks globally? Chart I-14 demonstrates that apart from the 2014-'15 bubble run in Chinese equities, the latter's relative performance versus global stocks has been a good forward-looking indicator for industrial metals prices. Chart I-13Chinese Stocks Have ##br##Failed To Break Out Chart I-14Underperformance Of Chinese ##br##Stocks Bodes Ill For Commodities Based on this chart and our qualitative analysis, our bias is to argue that the poor performance of Chinese share prices signals lingering downside risks in Chinese growth, and an associated drop in commodities prices and commodities related equities. Besides, the rally in both oil and metals can largely be explained by investor buying rather than by the real economy demand exceeding supply. Chart I-15 shows that net long positions of non-commercial traders (investors) in oil and copper are overextended. In addition, OECD oil product inventories continue their unrelenting uptrend, suggesting that supply is still exceeding consumption (Chart I-16). Following property market restrictions, China's home purchases have dived (Chart I-17). This will depress construction activity, which will weigh on demand for industrial goods/equipment and commodities over course of 2017. Chart I-15Traders Are Very Long Oil And Copper Chart I-16Global Oil Inventories Continue Rising Chart I-17China: Home Sales Have Plummeted Onshore bond yields, including corporate bond yields, have spiked, and the PBoC has allowed the repo rate for non-bank financial organizations to rise. This will, at a minimum, dampen non-bank (shadow) credit growth. Given that non-bank credit (entrusted loan, trusted loan, bank acceptance bill and net corporate bond issuance) accounts for 30% of total outstanding claims on companies and households, a deceleration in non-bank (shadow) credit will have a non-trivial impact on growth. Finally, there are considerable geopolitical and political risks in and around China. Many investors have become sanguine about China-related political risks, assuming the authorities will guarantee growth remains robust going into the fall 2017 Party Congress, which will decide on the leadership transition. However, a drop in perceived China-linked risks could be a sign of the calm before the storm. First off, the Chinese government might strive for economic stability ahead of this fall's Party Congress, but political volatility ahead of that time cannot be ruled out. It is an open secret that President Xi Jinping's aggressive consolidation of power and "non-collegial" decision-making has created opposition within the Communist party. The opposition cannot wait past the Party Congress when President Xi further strengthens his grip on power. The opposition, if it is able, will likely attempt to strike preemptively in order to prevent a further consolidation of power by President Xi. While it is impossible to know details or forecast the dynamics of the Communist Party's internal discourse, investors should not be complacent. Second, China will retaliate in some form against U.S. trade protectionist measures. It is difficult to know how this trade standoff between the U.S. and China will unfold, but our sense is that risks are underpriced in global financial markets. U.S.-China trade disputes could evolve into broader geopolitical tensions in Asia. BCA's Geopolitical Strategy service has written about geopolitical risks in Asia at great length.4 In short, political and geopolitical risks abound in and around China. Remarkably, in recent years financial markets have been more preoccupied by political rather than economic developments. Examples include Brazil, Turkey, Malaysia, Russia, the Philippines, Mexico, and South Africa. In these countries, financial markets have been much more sensitive to political changes than economic fundamentals. This may be the case in China too. Growth could stay firm for a while, but the markets will sell off based on heightened political and geopolitical volatility and tensions. Apart from the above-mentioned downside risks, China's growth model is facing two major ways forward from a big-picture perspective: 1. Short-Term Pain / Long-Term Gain: If the authorities were to allow market forces to prevail, the state should withdraw meaningfully from the credit allocation process. In that case, credit markets will bring discipline to both debtors and creditors - in effect, an emerging perception of potential losses rather government-led bailouts will make creditors less willing to lend, and debtors less willing to borrow and expand. The result will be a considerable dampening in credit origination. In this scenario, it is very likely that credit growth slows from 12% currently to the level of potential nominal GDP growth of 7-8% or lower (Chart I-18), leading to a classic credit-driven economic downtrend (Chart I-19). In that case, cyclical growth will undershoot. Chart I-18China: Credit Is Outpacing GDP ##br##Growth By Wide Margin Capitalist-Style Credit-Driven Downtrend However, potential GDP growth (the red line in Chart I-19) - which has been falling in recent years - will stabilize and probably improve. The reason being that by allowing market forces to prevail in credit allocation and corporate restructuring/reorganization, China will ultimately improve its capital allocation and productivity. In brief, potential GDP growth - which equals productivity growth plus labor force growth - will stop falling and, in fact, could improve as productivity growth ameliorates. 2. No Short-Term Pain But Long-Term Stagnation: It is essential to differentiate cyclical growth drivers from structural ones. If the government does not allow credit growth to slow, cyclical growth will hold up. However, in this scenario, structural growth will tumble and China will embark on a path of economic stagnation. As we have argued in past reports,5 banks in any country can originate unlimited amounts of credit/money/deposits if and when the central bank accommodates them, and shareholders and regulators do not object. China has been following this model over the past several years. Yet, this model does not bring about lasting prosperity. On the contrary, it leads to economic stagnation. China would be no different in this scenario, though the growth deceleration would be gradual, as depicted in Chart I-20. Toward Socialism = Secular Stagnation A rising role of state and government officials in capital allocation and business decision-making guarantees suboptimal capital allocation, resulting in poor efficiency and declining productivity growth. Since China's labor force growth is projected to be flat-to-negative (Chart I-21), the sole source of potential GDP growth going forward will be productivity growth. If the authorities do not allow market forces to play a larger role in resource allocation, including credit, the former will contract. The bullish camp on China argues that the authorities have a firm grip and control over the economy, and that they will never allow it to slow by injecting an unlimited amount of credit and fiscal stimulus. While this may be true, policymakers can do that, it is not a reason to be bullish. Quite the opposite: it is a reason to be structurally bearish on Chinese growth. Unrelenting credit and fiscal stimulus, and a resurging role of government in resource allocation, corporate restructuring, and increasingly in business decision-making, means the economy is moving back toward its socialist bend. In socialist economies, productivity growth is weak or sometimes negative. China's success over the past 30 years was based on a move towards private enterprise, entrepreneurism, and transition toward a more market-based model, and not on government credit injections. As China refuses to give greater say to market forces, and state officials and bureaucrats gets even more involved in credit and resource allocation to prevent genuine deleveraging and bankruptcies, economic efficiency and productivity will suffer. If we assume China's productivity is now about 6% (which is already a very high number) (Chart I-22), and if the country embarks down this path, odds are that productivity growth might drop by 100 basis points in each of the following years. In five years or so, productivity growth would be only around 1%. Given that labor force growth will be zero, if not contracting, in five years' time, potential GDP will drop to 1% or so, as shown in Chart I-20 on page 14. Hence, this path is the ultimate recipe for economic stagnation in China. Chart I-21China: Labor Force Is Projected To Contract Chart I-22Socialist Put Will Depress Productivity Growth The only thing the authorities can do in this scenario is to boost growth from time to time via credit and fiscal stimulus. This will produce mini-recovery cycles around a falling primary growth trend. The latest acceleration in China's growth is probably the first mini-cycle. How can investors invest in this scenario? The mini-cycles depicted in Chart I-20 on page 14 look nice, because we drew them ourselves. In reality, they will not be symmetric or smooth. Besides, financial market swings for China-related plays will differ from the economy's growth mini-cycles because markets can be driven by factors other than growth like politics, geopolitics, credit events, and other global variables such as the U.S. dollar and bond yields. In short, this analysis explains why we have been and remain bearish on China-related financial markets despite the stimulus that has been injected about a year ago. Investing around economic mini-cycles is difficult because it assumes near-perfect timing. Without that, investors cannot make money. Bottom Line: China by and large has two potential roadmaps going forward: (1) Short-term pain / long-term gain and (2) growth stagnation with mini-cycles around it. Regardless of which scenario transpires - so far, the second scenario has been in effect - the medium-term outlook is negative. Given that we are already advanced in the mini-cycle, the risk-reward for China plays in financial markets is negative. Arthur Budaghyan, Senior Vice President Emerging Markets Strategy arthurb@bcaresearch.com 1 Please refer to the Emerging Markets Strategy Special Report, titled "China's Money Creation Redux And The RMB," dated November 23, 2016, link available on page 19. 2 Please refer to the Emerging Markets Strategy Weekly Report, titled "EM: Overview Of External Debt," dated January 4, 2017, link available on page 19. 3 Please refer to the Emerging Markets Strategy Weekly Report, titled "Key EM Issues Going Into 2017," dated December 14, 2016, link available on page 19. 4 Please see BCA Geopolitical Strategy Special Report, "Sino-American Conflict: More Likely Than You Think, Part II," dated November 6, 2015, available at gps.bcaresearch.com. 5 Please refer to the Emerging Markets Strategy Special Report, titled "Misconceptions About China's Credit Excesses," dated October 26, 2016, and Emerging Markets Strategy Special Report, titled "China's Money Creation Redux And The RMB," dated November 23, 2016, links available on page 19. Equity Recommendations Fixed-Income, Credit And Currency Recommendations

Overweight One of the most glaring divergences between our macro indicators and relative share price performance exists in the consumer staples sector. Since the U.S. election, this sector has been used as a source of capital to fund more speculative investments in areas levered to global economic growth, such as industrials. An exploitable undershoot has developed in a sector with one of the best 12 and 24-month track records during Fed tightening cycles. The sector is undervalued, and is resting at an oversold extreme, based on our Technical Indicator. Our Cyclical Macro Indicator for the sector is grinding higher, supported by consumers' persistent preference for saving vs. spending, a plus for retail sales at non-discretionary stores. Tack on a budding recovery in consumer staples exports (bottom panel), and the nascent acceleration in sector sales growth should strengthen further, supporting earnings outperformance. For our complete list of high-conviction calls, please refer to yesterday's Weekly Report.

Yesterday, we introduced our top ten high conviction calls for 2017. The turn of the calendar does not require a change in strategy. Navigating a Fed tightening cycle, a divergence between economic and profit performance and significant patience with respect to the rollout of fiscal stimulus will all be critical to driving sub-surface equity performance this year. Moreover, we expect the U.S. dollar to remain firm, based on the relentless widening in interest rate differentials and policy divergences with the rest of the world. As such, our key themes of favoring domestic vs. globally-exposed equities, and consumer-geared vs. corporate spending-dependent industries remain intact. Perhaps our biggest out of consensus call is to overweight the much maligned consumer staples sector, please see the next Insight.

Highlights The economy is near full employment, but betting on significant inflation is premature. Market-based inflation expectations have risen substantially in recent weeks but these moves are not corroborated by survey measures of inflation expectations. Consumer inflation expectations are very well anchored due to ongoing deflation in many frequently purchased goods and services. We are on high alert for a near-term equity pullback, with Chinese liquidity tightening as a potential catalyst. Feature Chart 1Market-Based Inflation ##br##Expectations Breaking Out After years of focusing on deflation, the possibility of inflation has made a comeback on investors' radars. The shift makes sense, given that the labor market is now operating near full employment. The December payroll report showed that payrolls increased by 156,000, slightly lower than the 3-month average of 165,000. But, average hourly earnings increased by 0.4%, suggesting that slightly weaker employment growth is not due to sluggish demand, and reflects a smaller available pool of workers. However, as we explain below, the potential for a major inflation surge is low in 2017 and is premature as an investment theme. We are on high alert for a near-term pullback to the equity bull market, given that valuation and sentiment are stretched. But as we outline, the threat to the equity market is less likely to be domestic inflation than an external event, such as the fallout from tightening liquidity in China (similar to what occurred in mid-2015 and early 2016). In the past few weeks, one-year inflation expectations have moved to their highest level since mid-2014, when oil prices were above $110/bbl. Long-run inflation expectations have also spiked since the U.S. election (Chart 1). The extent to which this trend is judged sustainable, and provides an accurate forecast for general inflation, has important investment implications. Our view is that, although TIPS could move a bit higher, the market move should not be interpreted as a harbinger for a broad-based inflation acceleration. Policymakers consider a range of inflation expectations measures, but in recent years, market-based measures have garnered a lot of attention. The 5-year/5-year forward TIPS breakeven rate in particular is often viewed as the market's assessment of whether the Fed can successfully achieve its inflation target. According to the Minutes of the December FOMC meeting, the recent rise in market-based inflation expectations was discussed at length. On this basis, the rise in TIPS is important as it could have a significant role in setting monetary policy. Beyond that, we have argued for some time that a major challenge for firms this cycle will be to raise selling prices, i.e. a lack of pricing power will restrain profit margins and, ultimately, earnings growth. If the recent pick-up in market-based inflation expectations heralds a more robust rise in actual inflation, then profits could positively surprise this year. The Rise In TIPS Is Partially Energy-Driven... Since 2010, there has been a strong correlation between oil prices and TIPS (Chart 2). The correlation has somewhat confounded policymakers.1 In theory, any oil price shock, even if it is considered to be permanent, should not exert any lasting impact on long-dated forward measures of inflation expectations. The reason is that as long as the Fed is committed to its 2% inflation target, then the market should expect that monetary policy will prevent a one-time shock to oil prices from having any permanent effect on the overall inflation rate. This is why, in theory, the 5-year/5-year forward TIPS breakeven rate is a good indicator for policymakers. Chart 2Oil Prices And Breakevens As our fixed income team explained in a report last year,2 the main reason for the tight correlation between TIPS and oil prices stems from the market perception that monetary policy has been constrained. Prior to the financial crisis, oil prices rose from below $40 in 2003 to $140 in 2008. During that time, long-dated breakevens remained stable. One possible explanation for this lack of correlation is that the Fed tightened policy during this period, offsetting the inflationary impact from higher oil prices. But in 2015-2016, when oil prices fell from above $100 to below $40, breakevens plunged alongside. If the market perceives monetary policy to be constrained by the zero lower bound, then it could be the case that the cost of inflation compensation is highly sensitive to falling oil prices because the market perceives that the Fed has no ability to offset the deflationary shock. In other words, the 5-year/5-year TIPS breakeven rate has fallen because the zero lower bound is challenging the credibility of the Fed's inflation target. Our U.S. fixed income team forecasted that breakevens will head higher once oil prices move up and that the correlation between oil prices and breakevens will eventually weaken as the fed funds rate moves further away from the zero lower bound. The bottom line is that TIPS are most likely being unduly affected by energy price movements. ..And Only Thinly Corroborated By Alternative Inflation Indicators Despite our bias that the recent moves in market-based inflation expectations are exaggerated, TIPS are not the only gauge sending a more inflationary signal. This week's ISM manufacturing and non-manufacturing surveys both reported an uptick in prices paid (Chart 3). According to the manufacturing survey, 18 out of 21 recorded inputs were up in price over the past month. However, the bulk of these are commodities that have gone up in price alongside other financial market prices, and it is not clear the extent that the price rise is physical demand-driven, or financial demand-driven. In the non-manufacturing survey, the price rise was not quite as broad-based, but is nonetheless suggestive of upward price pressure. The NFIB small business survey also hinted at higher prices, although much more modestly than the ISM surveys (Chart 3). The Atlanta Fed's Business Inflation Expectations Survey has not broken out of the range that has held since 2011. There was no change in inflation expectations from the most recent survey of professional forecasters. Meanwhile, as we noted last week, consumers are not at all worried about inflation. In fact, according to the Conference Board survey, consumer inflation expectations are at a new cyclical low! At least part of the reason that consumers do not expect more inflation is likely due to their experience with frequently-purchased items. Table 1 shows inflation rates for selected high-frequency spending items, which account for about 30% of the total CPI basket. The table makes it easy to understand why perceptions about inflation are low: almost half of the items in the table are in deflation and only two are above the Fed's target of 2%. It may not matter that a good or service accounts for a small share of spending: if its price is going up/down at a steady pace, then there will be an impact on perceptions about inflation. Currently, very low or negative rates of inflation among frequently purchased items are likely pulling down consumers' perceptions of broad-based inflation. In this sense, one could argue that inflation expectations are very well-anchored. Chart 3Survey-Based Inflation ##br##Expectations More Mixed Table 1Inflation Rates For Selected ##br## High-Frequency Spending Items Actual Inflation Will Stay Subdued In 2017... Chart 4Only Mild Uptrend Likely In 2017 For many years, we have deconstructed core CPI and core PCE into their three major components to better understand and forecast the trend in consumer price inflation (Chart 4). Performing this exercise today continues to give a fairly benign forecast for inflation. Shelter, the largest component of core CPI, is mostly determined by rental vacancies which appear to be stabilizing just as market rents are rolling over. Our model suggests that shelter will not drive inflation higher in 2017. Core goods inflation (25% of core CPI) will also remain very low and possibly stay in deflationary territory. This component of inflation is most tightly correlated with the trade-weighted dollar (Chart 4, panel 3), and so will stay depressed as long as the bull market in the dollar remains intact. Wage growth is most tightly correlated with service sector inflation excluding shelter and medical care (Chart 4, bottom panel). This component, which accounts for 25% of core CPI, is the most likely source of inflation pressure now that wages are beginning to rise. But as we wrote in a Special Report on November 28, 2016, any wage inflation and pass-through is likely to be very gradual based on several structural headwinds at play this cycle. All in all, core PCE may converge on the Fed's target of 2% in the second half of 2017, but an inflation overshoot should not be a major driver of investment decision-making over the next six - twelve months. ...And Don't Blame Government Spending For Higher Inflation When It Does Come One missing ingredient from the above analysis is the likelihood that the political environment will become inflationary. This subject has been thoroughly covered by the financial press. Our own view has been that upcoming policies may not turn out to be particularly inflationary, at least not this year. For example, Trump's fiscal package may not boost aggregate demand by as much as the more optimistic estimates suggest. There simply are not enough marquee "shovel-ready" projects around that can make use of the public-private partnership structure that Trump's plan envisions in 2017. As for proposed personal tax cuts, the impact is likely to be modest, given that the benefits are tilted towards higher income groups that tend to save much of their earnings. Likewise, corporate tax cuts will have only an incremental effect on business capex, given that many companies are already flush with cash and effective tax rates are well below statutory levels. Our benign view about the impact of government spending on inflation is shared by researchers at the St Louis Federal Reserve. In a recent paper,3 researchers looked at periods when the central bank was not working to offset the potentially inflationary effects of fiscal policy, e.g. between 1959 and 1979, when the Fed followed a policy in which it accommodated increases in inflation. They found almost no effect of government spending on inflation. For example, a 10 percent increase in government spending during that period led to an 8 basis point decline in inflation. Note that this period covers years of when the economy was operating at full employment and below. As the researchers point out, this does not imply that countercyclical government spending is ineffective at boosting output, but it simply demonstrates that empirical evidence of inflation related to government spending is thin. The bottom line is that we view the likelihood of significant inflation pressure as low in 2017. The implication is that under this scenario, the Fed can afford to adjust their "dots" gradually, diminishing the risk for stocks and bonds of an aggressive adjustment to the policy backdrop. Equity Correction: Will China Be A Contributing Factor? Chart 5Is China Liquidity Tightening##br## A Repeat Threat To U.S. Equities? Over the past few weeks, we have argued that the odds of a meaningful equity correction are running high, given the aggressive rise in bond yields and exaggerated move in sentiment relative to only minor upside surprises in economic and earnings growth. We are still on high alert for this outcome and believe that one possible trigger is tighter liquidity conditions in China, which are aimed at supporting the renminbi. Indeed, just like the start of 2016, the Chinese renminbi is kicking off 2017 on a weak note. Chinese policymakers are again tightening rules to limit capital outflows: earlier this week, they adjusted the FX basket used to set the CNY's official daily fix. The new FX basket will include 24 currencies (up from 13). Consequently, the weight of the U.S. dollar drops from 26.4% to 22.4%. This will make it easier for the authorities to target a relatively stable renminbi versus the basket even as USD/CNY pushes higher. These attempts to support the renminbi is leading to tighter liquidity conditions and higher interbank interest rates. In Hong Kong, 3-month CNH Hibor has spiked to 10%. In the past, a combination of a weaker renminbi and rising interbank rates has spelled trouble for U.S. and global equities (Chart 5). There is no guarantee that history will repeat itself and one big difference with the sharp market sell-offs in mid-2015 and early 2016 is that the Chinese economy is not as weak as it was then. The PMIs released this week were generally firm. Overall, we are positive on equities and negative on bonds on a 12-month horizon but still see the risk of a correction to the Trump trade as elevated. Thus, investors should continue to stick close to benchmark tactically, looking to implement positions after a pullback in stock prices. Like in 2015 and early 2016, China could provide the trigger to that pullback if the authorities give up on capital controls and allow a sharp depreciation of the RMB. Lenka Martinek, Vice President U.S. Investment Strategy lenka@bcaresearch.com 1 https://www.stlouisfed.org/~/media/Files/PDFs/Bullard/remarks/Bullard-N… 2 Please see U.S. Bond Strategy Weekly Report "A Tale Of Two Rallies", dated March 29, 2016, available at usbs.bcaresearch.com 3 https://www.stlouisfed.org/on-the-economy/2016/may/how-does-government-…

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 Chart 2Warning 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 Chart 424-Month Performance After Fed Hikes 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 Chart 6Mind##br## 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 Chart 8Consumers 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 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 Chart 11China 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 Chart 13Healthy Consumer Is A Boon##br## 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 Chart 15More Than##br## 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 Chart 17Shy 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 Chart 19Advance 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).