Health Care

For much of the past twelve years, pharmaceutical pricing power has been a reliable predictor of the S&P pharma relative share price ratio, both to the up and down sides (top panel). In 2018, this relationship appears to be breaking down somewhat as pricing power growth has stabilized at a relatively low level but the index has continued to fall. We think a more pressing concern than falling pricing power has taken over investor's attention, namely the soaring industry leverage ratios (shown inverted on second panel). With a declining share of both domestic (third panel) and foreign (bottom panel) wallets, the sustainability of even this low level of pricing power is questionable. As such, it seems likely that leverage will get worse before it gets better; in the context of a rising interest rate environment, weak operating metrics and high financing costs all bode poorly for industry EPS growth. Stay underweight. The ticker symbols for the stocks in the S&P pharmaceuticals index are: BLBG: S5PHAR - JNJ, PFE, MRK, BMY, AGN, LLY, ZTS, MYL, PRGO. Feeling The Pain Feeling The Pain

Highlights Portfolio Strategy Synchronized global capex growth and higher interest rates are two key themes that will continue to dominate this year. Three high-conviction calls are levered to the former theme and two to the latter. A special situation completes our sextet. Reinstate the S&P construction machinery & heavy truck index to the high-conviction overweight list. We also reiterate our high-conviction underweight call in the newcomer S&P telecom services sector. Recent Changes S&P Construction Machinery & Heavy Truck - Add back to high-conviction overweight list. Table 1 Semblance Of Calm Semblance Of Calm Feature Chart 1Market Bounced Smartly Market Bounced Smartly Market Bounced Smartly Equities regained their footing last week, as volatility took a breather. There are high odds that the technical, mostly-sentiment driven, pullback that we have been flagging since January 22nd is nearly over, as the market smartly bounced off the 200-day moving average (top panel, Chart 1).1 A consolidation/absorption phase is looming and, according to our "buy the dip" cycle-on-cycle analysis, a retest of the recent lows is likely before the market gets out of the woods (please refer to Chart 1 from last week's publication). While inflation expectations, crude oil prices and financial conditions are all tightly linked with and weighing on the S&P 500 (second and third panels, Chart 1), a number of tactical high-frequency financial market indicators suggest that the cyclical SPX bull market remains intact. First, SPX e-mini futures positioning is an excellent leading indicator of market momentum, and the current message is positive (net speculative positions are advanced by 40 weeks, Chart 2). Second, bond market internal dynamics suggest that this mini "risk off" episode is an isolated one and not a precursor to a real tremor. The high yield bond ETF outperformed the long dated Treasury bond ETF (bottom panel, Chart 3). It would be unprecedented for an equity market downdraft to morph into a fully blown bear market without junk bonds sinking compared with the ultimate risk free asset. Even when adjusted for its lower duration, the high yield bond ETF remained resilient versus the 3-7 year Treasury bond ETF (top panel, Chart 3). Chart 2Futures Positioning... Futures Positioning... Futures Positioning... Chart 3...Junk Bonds... ...Junk Bonds... ...Junk Bonds... Third, the calmness in the TED spread corroborates the message from the bond market. Were a systemic risk to materialize, the TED spread should have widened and not come in as it did in the past two weeks (Chart 4). Put differently, quiet interbank markets are a healthy sign. Chart 4...And TED Spread All Flashing Green Semblance Of Calm Semblance Of Calm Finally, relative valuations have corrected not only on an absolute basis (please refer to the bottom panel of Chart 2A from last week's Report), but also controlled for equity market volatility. In fact, Chart 5 shows that both the VIX-adjusted Shiller P/E and the 12-month forward P/E have returned to the neutral zone. Meanwhile, two key macro indicators we track are also flashing green. Chart 6 shows momentum in money velocity or how fast "one unit of currency is used to purchase domestically-produced goods and services".2 Historically, velocity of M2 money stock has been positively correlated with stock market momentum. The recent spike in this indicator suggests that the longevity of the business cycle remains intact, and investors with a cyclical (9-12 month) investment horizon should start "buying the dip", as we suggested on February 8th.3 Another yield curve-type macro indicator confirms this buoyant business cycle message: real GDP growth is easily outpacing real interest rates, as per the 10-year TIPS market (Chart 7). In other words, real rates are not yet restrictive enough to choke off GDP growth, despite the recent 35bps increase. Were this spread to plunge below the zero line, it would predict recession. Thus, the recent widening underscores that recession is not imminent. Chart 5Valuations Return To Earth Valuations Return To Earth Valuations Return To Earth Chart 6Money Velocity... Money Velocity... Money Velocity... Chart 7...And Yield Curve Emit Bullish Signal ...And Yield Curve Emit Bullish Signal ...And Yield Curve Emit Bullish Signal Under such a backdrop, the upshot is that earnings will remain upbeat in 2018 and continue to underpin equity prices. This week we revisit our 2018 high-conviction call list and reinstate one sector to the overweight column. Chart 8Both Themes Remains Intact Both Themes Remains Intact Both Themes Remains Intact The Themes Two key BCA themes formed the cornerstone of our 2018 high conviction call list: Synchronized global capex upcycle Higher interest rates Last autumn, we started to articulate the synchronized global capital spending macro theme4 that, despite still flying under the radar, will likely dominate this year. Both advanced and emerging economies are simultaneously expanding gross fixed capital formation (middle panel, Chart 8). As a result, we reiterate our cyclical over defensive portfolio bent,5 and continue to tie three high-conviction overweight calls to this theme. Similarly, late last year we started to highlight BCA's U.S. Bond Strategy view of a higher 10-year yield on the back of rising inflation expectations for 2018 (bottom panel, Chart 8). Back in late-November we posited that if BCA's constructive crude oil view pans out then inflation and rates may get an added boost. Two high-conviction calls remain levered to this theme. Finally, a special situation rounds up our call this year. But before we update the call list and make a small tweak, a quick housekeeping note is in order. Taking The Tally Early this year, we added trailing stops to our high-conviction call list as a risk management tool. The goal was to help protect profits as a number of our calls were showing outsized gains for such a short time span. Our tactically souring view of the overall market also compelled us to introduce this risk management metric. As a result of the recent careening in the SPX, half of our calls got stopped out with lofty double digit gains since inception a mere two and a half months ago. Namely, our speculative underweights in the S&P semi equipment and S&P homebuilders registered gains of 20% and 10%, respectively. The high-conviction underweight in the S&P utilities sector got called at an 18% gain, and our high-conviction overweight call in the S&P construction machinery & heavy truck (CMHT) index got stopped out at the 10% mark. (Please refer to page 15 for the closed trades table). Last week we added the S&P telecom services sector as a high-conviction underweight replacing the S&P utilities sector, and now that the worst is likely behind us, we are reinstating the S&P CMHT index to the high-conviction overweight list. Anastasios Avgeriou, Vice President U.S. Equity Strategy anastasios@bcaresearch.com Construction Machinery & Heavy Truck (Overweight, Capex Theme) The capex upcycle is underpinning machinery stocks. Not only are expectations for overall capital outlays as good as they get (Chart 9), but there are also tentative signs that even the previously moribund mining and oil & gas complexes will be capex upcycle participants. While we are not calling for a return to the previous cycle's peak, even a modest renormalization of capital spending plans in these two key machinery client segments would rekindle industry sales growth. Recent news of oil majors accelerating their capex plans is a step in the right direction. This machinery end-demand improvement is not only a U.S. phenomenon, but also a global one. The middle panel of Chart 9 shows Caterpillar's global machinery sales to dealers hitting a decade high. Tack on the drubbing in the U.S. dollar and related commodity price inflation and the ingredients are in place for a global machinery export boom. While most of the countries we track enjoy a sizable rebound in machinery orders, Japan's machine tools orders have surged to an all-time high confirming that machinery global end demand is brisk (bottom panel, Chart 9). Finally, our machinery EPS model is firing on all cylinders, underscoring that the earnings-led recovery has more running room (fourth panel, Chart 9). Reinstate the S&P CMHT index to the high-conviction overweight list. The ticker symbols for the stocks in this index are: BLBG: S5CSTF - CAT, CMI, PCAR. Energy (Overweight, Capex Theme) The S&P energy sector is a key beneficiary of our synchronized global capex theme. The Dallas Fed manufacturing outlook survey is firing on all cylinders and, given the importance of oil to the state of Texas, it serves as an excellent gauge for oil activity. Importantly, the capital expenditures part of the survey hit its highest level in a decade, and capex intentions in the coming six months are also probing multi-year highs. The overall message is that the budding recovery in energy capital budgets will likely gain steam (second panel, Chart 10). Following the late-2015/early-2016 drubbing in oil prices, energy projects ground to a halt and only now are green shoots appearing (middle panel, Chart 10). Recent news that Exxon Mobil would bump domestic capital spending up to $50bn over the next five years is encouraging. New projects/investments comprise 70% of this figure. OECD oil stocks are receding steadily and so are U.S. crude oil inventories. OPEC 2.0 remains in place and will likely balance the oil market by continuing to constrain supply. Our Commodity & Energy Strategy service is still penciling in higher oil prices for 2018. On the demand side, emerging markets/Chinese demand is the key determinant of overall oil demand, and the news on this front is encouraging and consistent with BCA's synchronized global growth theme: following the recent lull, non-OECD demand is growing anew by roughly 1.5mn bbl/day. The upshot is that S&P energy relative revenues will climb out of the recent trough (bottom panel, Chart 10). The ticker symbols for the stocks in this index are: BLBG: S5ENRS - XLE: US. Chart 9Construction Machinery & Heavy Truck ##br##(Overweight, Capex Theme) Construction Machinery & Heavy Truck (Overweight, Capex Theme) Construction Machinery & Heavy Truck (Overweight, Capex Theme) Chart 10Energy (Overweight, Capex Theme) Energy (Overweight, Capex Theme) Energy (Overweight, Capex Theme) Software (Overweight, Capex Theme) The S&P software index is another clear capex upcycle beneficiary. If software commands a larger slice of the overall capital spending pie as we expect, then industry profits should enjoy a healthy rebound (second panel, Chart 11). Small business sector plans to expand keep on hitting fresh recovery highs, underscoring that software related outlays will likely follow them higher. Rebounding bank loan growth also corroborates the upbeat spending message and signals that businesses are beginning to loosen their purse strings (Chart 11). Reviving animal spirits suggest that demand for software upgrades will stay elevated. CEO confidence is pushing decade highs (middle panel, Chart 11). Such ebullience is positive for a pickup in software outlays. It has also rekindled software M&A activity, and pushed take out premia higher. Meanwhile, the structural pull from the proliferation of cloud computing and software-as-a-service has served as a catalyst to raise the profile of this more defensive and mature tech sub-sector. Tax reform is another bonus for this group that benefits from cash repatriation, which will likely result in increased shareholder friendly activities. The ticker symbols for the stocks in this index are: BLBG: S5SOFT-MSFT, ORCL, ADBE, CRM, ATVI, INTU, EA, ADSK, RHT, SYMC, SNPS, ANSS, CDNS, CTXS, CA. Banks (Overweight, Higher Interest Rates Theme) The S&P banks index remains a core overweight portfolio holding and there are high odds of additional relative gains in the coming quarters beyond the current 10% relative return mark since the November 27th, 2017 inception. All three key drivers of bank profits, namely price of credit, loan growth and credit quality, are simultaneously moving in the right direction. On the price front, BCA expects the 10-year yield will continue to rise more quickly than is discounted in the forward curve. Our U.S. bond strategists think that inflation expectations have more room to run, likely pushing the 10-year Treasury yield close to 3.25% (top panel, Chart 12). C&I and consumer loans, two large credit categories, are both forecast to reaccelerate in the coming months. The ISM remains squarely above the 50 boom/bust line and consumer confidence is still buoyant. Our credit growth model captures these positive forces and is sending an unambiguously positive message for loan reacceleration in the coming months (third panel, Chart 12). Finally, credit quality remains pristine despite some pockets of weakness in auto loans (especially subprime) and credit card debt. At this stage of the cycle, with a closed unemployment gap, NPLs will remain muted. The ticker symbols for the stocks in this index are: BLBG: S5BANKX - WFC, JPM, BAC, C, USB, PNC, BBT, STI, MTB, FITB, CFG, RF, KEY, HBAN, CMA, ZION, PBCT.  Chart 11Software (Overweight, Capex Theme) Software (Overweight, Capex Theme) Software (Overweight, Capex Theme) Chart 12Banks (Overweight, Higher Interest Rates Theme) Banks (Overweight, Higher Interest Rates Theme) Banks (Overweight, Higher Interest Rates Theme) Telecom Services (Underweight, Higher Interest Rates Theme) We downgraded the S&P telecom services index to underweight and added it to the high-conviction underweight list last week, filling the void left by the S&P utilities sector.6 Three main reasons are behind our dislike for this fixed income proxy sector: BCA's 2018 rising interest rate theme, both our Cyclical Macro Indicator (CMI) and our sales model send a distress signal, and a profit margin squeeze is looming. The top panel of Chart 13 shows that high dividend yielding telecom services stocks and the 10-year yield are nearly perfectly inversely correlated. In fact, telecom services stocks are prime beneficiaries of disinflation/deflation and vice versa. BCA's bond market view remains that the 10-year yield will continue to rise likely piercing through 3% and weigh heavily on this fixed income proxied sector. Our CMI has melted and relative consumer outlays on telecom services have also taken a nosedive (second & third panels, Chart 13), warning that revenue growth will be hard to come by for telecom carriers. In fact, while nearly all of the GICS1 sectors have come out of the top line growth lull of late-2015/early-2016, telecom services sales growth has relapsed. Worrisomely, our S&P telecom services revenue growth model remains deep in contractionary territory, waving a red flag (bottom panel, Chart 13). Finally, still steeply deflating selling prices are a major headwind for the sector's top and bottom line growth prospects and coupled with a still expanding wage bill, suggest that a profit margin squeeze is looming. The ticker symbols for the stocks in this index are: VZ, T, CTL. Pharmaceuticals (Underweight, Special Situation) Weak pricing power fundamentals, a soft spending backdrop, a depreciating U.S. dollar and deteriorating industry operating metrics will sustain downward pressure on pharma stocks. Industry selling prices remain soft (Chart 14). In the context of a bloated industry workforce, the profit margin outlook darkens significantly. If the Trump administration also manages to clamp down on the secular growth of pharma selling price inflation, as we expect, then industry margins will remain under chronic downward pressure. Our dual synchronized global economic and capex growth themes bode ill for this safe haven index. Nondiscretionary health care outlays jump in times of duress and underwhelm during expansions. Currently, the elevated ISM manufacturing index is signaling that pharma profits will underwhelm in the coming months as the most cyclical parts of the economy flex their muscles (the ISM survey is shown inverted, second panel, Chart 14). A depreciating currency is also synonymous with pharma profit sickness (bottom panel, Chart 14). While pharma exports should at least provide some top line growth relief during depreciating U.S. dollar phases, they are still contracting (middle panel, Chart 14), warning that global pharma demand is ill. Finally, even on the operating metric front, the outlook is dark. Pharma industrial production is nil and our productivity proxy remains muted, warning that the valuation derating phase is far from over. The ticker symbols for the stocks in this index are: BLBG: S5PHAR - JNJ, PFE, MRK, BMY, AGN, LLY, ZTS, MYL, PRGO. Chart 13Telecom Services ##br##(Underweight, Higher Interest Rates Theme) Telecom Services (Underweight, Higher Interest Rates Theme) Telecom Services (Underweight, Higher Interest Rates Theme) Chart 14Pharmaceuticals ##br##(Underweight, Special Situation) Pharmaceuticals (Underweight, Special Situation) Pharmaceuticals (Underweight, Special Situation) 1 Please see BCA U.S. Equity Strategy Weekly Report, "Too Good To Be True?" dated January 22, 2018, available at uses.bcaresearch.com. 2 https://fred.stlouisfed.org/series/M2V 3 Please see BCA U.S. Equity Strategy Insight, "Buy The Dip," dated February 8, 2018, available at uses.bcaresearch.com. 4 Please see BCA U.S. Equity Strategy Weekly Report, "Invincible," dated November 6, 2017, available at uses.bcaresearch.com. 5 Please see BCA U.S. Equity Strategy Special Report, "Top 5 Reasons To Favor Cyclicals Over Defensives," dated October 16, 2017, available at uses.bcaresearch.com. 6 Please see BCA U.S. Equity Strategy Weekly Report, "Manic Depressive?" dated February 12, 2018, available at uses.bcaresearch.com. Current Recommendations Current Trades Size And Style Views Favor value over growth. Stay neutral small over large caps (downgrade alert).

Overweight A key beneficiary of a tight job market are managed health care providers who see lifts in both employer-sponsored health plans and newly-affordable individual and family health plans. With the unemployment rate touching new lows and small-business hiring plans hitting new highs (unemployment rate shown inverted, second panel), the direction for premium revenue for this niche health care sub-index is clearly higher. At the same time as the top line is moving higher, cost inflation has dramatically decelerated, driven by collapsing pharma price inflation (third panel). The implication is outsized earnings growth this year. The market has clearly taken notice, rewarding the S&P managed health care index with a premium valuation (bottom panel). While this is an improvement from the discount multiple of much of the past decade, it remains a far cry from previous cyclical highs. We think an exceptional earnings growth phase should make this valuation expansion durable; stay overweight. The ticker symbols for the stocks in this index are: BLBG: S5MANH - UNH, AET, ANTM, CI, HUM, CNC. Managed Health Care Looks Healthy As Ever Managed Health Care Looks Healthy As Ever

Equities have melted up in recent weeks, celebrating the tax bill passage, synchronized upswing in global economic data, still quiescent inflation and near vanishing tail risk. On July 10th when we penned the "SPX 3,000?" report, the S&P 500 was close to 2400.1 Over the past six months stocks have been in an uninterrupted upleg, moving to within 10% of our SPX 3,000 target. Table 1 White Paper: Introducing Our U.S. Equity Sector Earnings Models White Paper: Introducing Our U.S. Equity Sector Earnings Models Stocks have run "too far too fast" for our liking and there are increasing odds of a healthy pullback, especially now that no pundits are talking of a correction. In addition, were the selloff in the bond markets to accelerate in a short time frame, at some point it will cause equity market consternation. But, bonds still remain extremely overvalued versus stocks (Chart 1). Late last year, we began to modestly de-risk the portfolio via booking impressive gains in tactical market-neutral trades, as our upbeat cyclical view remains intact.2 Our cyclical strategy is to "buy the dip", as we do not foresee a recession in the coming 9-12 months. Importantly, profits will dictate the S&P 500's direction and the cyclical path of least resistance is higher still. Our SPX profit model continues to forecast healthy EPS growth in 2018 (Chart 2) and as we posited in the last report of 2017, earnings will do the heavy lifting at the current juncture with the forward P/E multiple likely moving laterally (Chart 3). Chart 1Simple Bond Valuation Metric Says:##br## Bonds Are Overvalued Vs. Stocks Simple Bond Valuation Metric Says: Bonds Are Overvalued Vs. Stocks Simple Bond Valuation Metric Says: Bonds Are Overvalued Vs. Stocks Chart 2All ##br##Clear All Clear All Clear Chart 3EPS Will Do The##br## Heavy Lifting In 2018 EPS Will Do The Heavy Lifting In 2018 EPS Will Do The Heavy Lifting In 2018 A simple decomposition shows that equity returns could reasonably reach a low-to-mid double digit level this year. Our assumptions are the following: nominal GDP can grow near 5% (3% real plus 2% inflation) and thus we estimate organic EPS growth that typically mimics GDP at this stage of the cycle of ~5%, ~2% dividend yield, ~2% buyback yield, ~5% tax related boost to EPS and no multiple expansion. The above assumptions are based on four key drivers: energy and financials will command a larger slice of the earnings pie,3 synchronized global capex upcycle will boost EPS,4 delayed positive translation effects from the U.S. dollar will lift profits5 and easy fiscal policy will also act as a tonic to EPS.6 On this note, this White Paper officially introduces the U.S. Equity Strategy earnings models for the eleven GICS1 equity sectors. We have identified key macro earnings drivers for each sector and incorporated them into individual sector models. The objective is to forecast the direction of earnings growth. Beyond introducing our EPS models, the purpose of this White Paper is to also compare and contrast the cyclical readings of our equity sector models with sell-side analysts' profit growth (Charts 4 & 5) and margin expectations and help clients position portfolios for the rest of 2018. The earnings models carry the most weight in determining our sector positioning, with our macro overlay and our valuation and technical indicators rounding out our methodology. Currently, our earnings models are consistent with maintaining a mostly cyclically biased portfolio structure (top panel, Chart 6), and thus participating in the broad market's overshoot. Chart 4What EPS Are Priced In... What EPS Are Priced In... What EPS Are Priced In... Chart 5...Per Sector For 2018 ...Per Sector For 2018 ...Per Sector For 2018 Chart 6Continue To Prefer Cyclicals Over Defensives Continue To Prefer Cyclicals Over Defensives Continue To Prefer Cyclicals Over Defensives Encouragingly, an equal weight of the 10 GICS1 sector model outputs (we are excluding real estate due to lack of history), accurately forecasts the S&P 500's profit growth (bottom panel, Chart 6), and currently also confirms the broad market's upbeat four factor macro EPS model (Chart 2). Anastasios Avgeriou, Vice President U.S. Equity Strategy anastasios@bcaresearch.com Financials (Overweight) Our financials earnings growth model comprises bank credit growth, the U.S. dollar index and net earnings revisions. The U.S. credit impulse is gaining traction, indicating that the market has digested the almost doubling in long-term rates over the past 18 months. Bankers are willing extenders of C&I credit and, with the economy humming north of 3% in real GDP terms, the outlook for loan growth is excellent. Loosening U.S. banking regulatory requirements, and pent up demand for shareholder friendly activities are all welcome news for financials profitability. Tack on BCA's higher interest rate view in 2018 and net interest margins will also get a bump, further adding to the sector's EPS euphoria. Credit quality is the third key profit driver for bank profitability and pristine credit quality is a harbinger of increased profits. The unemployment rate is plumbing generational lows and suggests that non-performing loans as a percentage of total loans will remain on a downward trajectory. Our profit model is expanding at twice the current profit growth rate (second panel, Chart 7) and 10 percentage points above the Street's 12-month forward estimates (top panel, Chart 5). In fact, the latter have gone vertical of late playing catch up to our model's estimates. The S&P financials sector remains a core portfolio overweight and we reiterate our high-conviction overweight status in the heavyweight S&P banks index. Chart 7Financials (Overweight) Financials (Overweight) Financials (Overweight) Energy (Overweight) The three drivers behind the S&P energy sector EPS growth model are oil-related currencies, the U.S. oil & gas rig count and WTI crude oil prices. A depreciating greenback, whittling down OECD oil stocks and rising global oil demand are all boosting energy profitability. OPEC 2.0 cutbacks have not only helped stabilize oil markets, but also paved the way for a breakout in oil prices above the $62.50/bbl stiff resistance level. Sustained OPEC output restraint will counterbalance U.S. shale oil production increases and coupled with rising global demand likely continue to underpin oil prices. Our synchronized global capex upcycle theme included the basic resources following a multi-year drubbing in outlays. Energy capex cannot contract at double digit rates indefinitely. Already a V-shaped capex momentum recovery is in store, as 2018 capital spending budgets are on track to at least match 2017. Our EPS growth model (second panel, Chart 8) matches sell-side analyst optimism (third panel, Chart 5). Keep in mind that only recently did the energy space become profit positive, making a solid recovery from an extremely low base. Margins are only now renormalizing above the zero line and breakneck pace EPS growth should continue in 2018. Following a negative 2017 return, the S&P energy sector is the best performing sector year-to-date, and we reiterate the high-conviction overweight stance. Chart 8Energy (Overweight) Energy (Overweight) Energy (Overweight) Industrials (Overweight) Our S&P industrials EPS model comprises the ISM manufacturing survey, raw industrials commodity prices and interest rates. It has an excellent track record in forecasting industrials EPS momentum, and sports one of the highest explanatory powers amongst all sector EPS models. While industrials EPS growth has been bouncing off the zero line for the better part of the past five years, our profit model has spoken: forecast EPS are in a V-shaped recovery since the end of the recent manufacturing recession (second panel, Chart 9). Commodity prices are recovering and increasing final demand, coupled with a soft U.S. dollar suggest that more gains are in store. Tack on the global virtuous capex upcycle, and the stars are aligned for this deep cyclical sector to break out of its multi-year trading range funk on the back of a surge in profits. China is a wild card, but signs of stability are enough to sustain the upward trajectory in the commodity-levered complex, including industrials stocks. Our industrials sector EPS model suggests that industrials profits will easily surpass the low (and below the overall market) analysts' EPS growth hurdle (third panel, Chart 4). The late-cyclical S&P industrials sector remains an overweight. Chart 9Industrials (Overweight) Industrials (Overweight) Industrials (Overweight) Consumer Staples (Overweight) The S&P consumer staples EPS growth model key drivers are: food exports, non-discretionary retail sales and analysts' net earnings revision ratio. Overall industry exports are expanding at a healthy clip as a consequence of a softening U.S. dollar and robust European and rebounding emerging markets demand. Deflating raw food commodity prices are offsetting rising energy and labor input costs, heralding a sideways move to margins. Sell side analysts are also currently penciling in a lateral profit margin move (middle panel, Chart 10). Our model is expanding at a near double digit rate, and is in line with 12-month forward EPS growth estimates (second panel, Chart 4). Investors have been vehemently avoiding staples stocks during the board market's uninterrupted run up, and have put out positioning offside. However, in the context of our cyclical over defensive portfolio bent we refrain from putting all our eggs in one basket, and prefer to keep consumer staples as our sole defensive sector overweight. This small hedge will serve our portfolio well if we do indeed get a healthy Q1/2018 pullback, as we expect. Chart 10Consumer Staples (Overweight) Consumer Staples (Overweight) Consumer Staples (Overweight) Consumer Discretionary (Neutral - Downgrade Alert) Measures of consumer confidence, consumer discretionary exports and the net earnings revisions ratio comprise BCA's global consumer discretionary EPS growth model, which has an excellent track record in forecasting the path of consumer discretionary profits. Consumer confidence is rolling over, albeit from a nose-bleed level, signaling that, at the margin, discretionary consumer outlays will remain tame. Worrisomely, rising interest rates coupled with a breakout in crude oil prices are net negatives for consumer spending. Our consumer drag indicator captures these consumer headwinds and warns that the sector is not out of the woods yet (bottom panel, Chart 11). The Fed is on track to raise rate three more times in 2018 and continue to mop up liquidity via renormalizing its balance sheet. This dual tightening backdrop bodes ill for early cyclical discretionary stocks as we highlighted in the September 25th Weekly Report. Our consumer discretionary EPS growth model is making an effort to bounce, signaling that contracting earnings will likely reverse course and come out of their recent funk (second panel). But, analysts are overly optimistic penciling in a near double-digit profit growth backdrop for the consumer discretionary sector (fourth panel, Chart 5). Netting it all out, the anemic message from our profit model along with the ongoing Fed tightening cycle and spiking energy prices warrant a downgrade alert. Stay tuned. Chart 11Consumer Discretionary (Neutral-Downgrade Alert) Consumer Discretionary (Neutral-Downgrade Alert) Consumer Discretionary (Neutral-Downgrade Alert) Telecom Services (Neutral) Telecom pricing power and capital expenditures expectations comprise our S&P telecom services EPS growth model. Telecom capital expenditures have bounced off the zero line and are growing at 4% per annum while sector sales growth has been nil. This capital-intensive industry must continually invest to stay relevant. A push by telecom carriers into TV offerings as part of a quad-play (internet, wireline, wireless and TV) has rekindled an M&A boom, and capex is slated to increase. However, margins will suffer if increased investment fails to translate into new sales (bottom panel, Chart 12). Steeply contracting pricing power is a bad omen both for top and bottom line growth prospects (fourth panel). Hopefully, industry consolidation will lead to a better pricing backdrop, but the jury is still out. Our EPS model has sunk into the contraction zone (second panel). Analysts are a little bit more sanguine, penciling in low single-digit profit growth (bottom panel, Chart 4). Industry deflation is not alone as a headwind as the bond market selloff is weighing on the high dividend yielding telecom services stocks. Despite all the bearish news, near all-time lows in relative valuation and washed out technicals are keeping us on the sidelines. Chart 12Telecom Services (Neutral) Telecom Services (Neutral) Telecom Services (Neutral) Materials (Neutral) Materials EPS growth is a far cry from the near 100% year-over-year mark hit during the commodity super-cycle the mid-2000s and the reflex rebound following the Great Recession (second panel, Chart 13). Our S&P materials EPS model inputs include the U.S. currency, metals commodity prices and a measure of borrowing costs. The model has been steadily decelerating recently, and moving in the opposite direction compared with sell-side analysts' optimistic estimates (bottom panel, Chart 5). Consequently, there is scope for downward revisions. Materials stocks are reflationary beneficiaries and also high fixed cost high operating leverage deep cyclicals that benefit most during the later stages of the business cycle when a virtuous capex/EPS upcycle takes root. A number of both developed and developing central banks have recently embarked on tightening monetary policy following in the Fed's footsteps. Global liquidity is on the verge of getting mopped up as even the ECB and the BoJ have started to hint that they would remove some of their ultra-accommodative and unconventional policy measures. These opposing forces keep us at bay and we continue to recommend a benchmark allocation in the S&P materials index. Chart 13Materials (Neutral) Materials (Neutral) Materials (Neutral) Real Estate (Neutral) Commercial real estate loan demand, a labor market measure and the EUR/USD comprise our S&P real estate profit growth model (second panel, Chart 14). The 10-year Treasury yield and real estate relative performance have been nearly perfectly inversely correlated since the GFC as REITs sport a hefty dividend yield and thus are considered a fixed income proxy. BCA's higher interest rate 2018 theme suggests that more downside looms for this rate-sensitive sector. Similarly, a firming EUR/USD reflecting the nearly 100% domestic exposure of the sector weighs on real estate relative performance. Our EPS model has recently sunk into the contraction zone and is in sync with sell-side analysts' negative profit growth figures for calendar 2018 (second panel, Chart 5). While all this signals that an underweight stance is appropriate, we would rather stay on the sidelines for three reasons: First, sector pricing power (mostly rents) has not eroded yet, despite the surge in multi-family housing construction. Second, most of the bad news is likely already discounted in sinking valuations and extremely oversold technicals. Finally, we would rather concentrate our interest rate related underweight in the pure play fixed income proxy, the utilities sector (please see page 15). Stick with a benchmark allocation in the S&P real estate index. Chart 14Real Estate (Neutral) Real Estate (Neutral) Real Estate (Neutral) Health Care (Underweight) Our S&P health care EPS growth model consists of health care pricing power, labor costs and a measure of health care outlays. Health care demand is fairly inelastic, signaling that health care spending prospects remain upbeat, especially given the aging population. However, the industry's up-to-recently structurally robust pricing power backdrop is under intense scrutiny. Medical commodity cost inflation is melting and drug pricing power has nearly halved since early 2016. Democrats and Republicans alike, despise the pharmaceutical/biotech industry's pricing tactics and drug price containment is on nearly every legislator's agenda. Add on the generic drug inroads, and Big Pharma/biotech resilient profits appear vulnerable, weighing heavily on the sector's relative performance. From a secular perspective, there is scope for health care sector profit gains. Developing countries are only just starting to institute social "safety nets" that the developed world already has in place. Our profit model is decelerating (second panel, Chart 15) and forecasting single digit EPS growth, in line with the Street's 12-month forward profit estimates (fourth panel, Chart 4). The S&P health care sector is a core underweight portfolio holding and we reiterate the high-conviction underweight status in the heavy weight S&P pharma sub index. Chart 15Health Care (Underweight) Health Care (Underweight) Health Care (Underweight) Utilities (Underweight) Utilities pricing power, the yield curve and analysts' net earnings revisions are the key inputs in our S&P utilities EPS growth model (second panel, Chart 16). While natgas prices, the industry's marginal price setter, have been stuck in a trading range between $2.6 and $3.4/mmbtu over the past 18 months, they are currently contracting and weighing heavily on industry pricing power. The U.S. economy is firing on all cylinders (bottom panel, Chart 16) and a selloff in the 10-year Treasury market near 3% is BCA's base-case scenario for 2018. Under such a backdrop, fixed income proxied defensive equities lose their luster, and thus utilities stocks will likely remain under intense downward pressure, Our S&P utilities EPS growth model is expanding at a mid-single digit growth rate, broadly in line with sell-side analysts' forecasts (fifth panel, Chart 4) and roughly 700bps below the broad market. The S&P utilities sector is a high-conviction underweight. Chart 16Utilities (Underweight) Utilities (Underweight) Utilities (Underweight) Technology (Underweight - Upgrade Alert) Our three-factor global technology EPS growth model includes capex intentions, the trade-weighted U.S. dollar and sell-side analysts' net earnings revision ratio. While the tech sector is still largely considered a deep cyclical, we view it as more defensive. The majority of large capitalization tech companies are mature, cash rich, cash flow generating, dividend paying and high margin. Tech firms thrive in a deflationary backdrop as business models have been built to withstand the inherently disinflationary "creative destruction" process. BCA's interest rate view calls for an inflationary driven sell off in bonds for 2018, suggesting that investors avoid high-flying tech stocks. Weakness in basic resources explains most of the delta in cyclical capital outlays. Encouragingly, technology's share of the U.S. capex pie is making inroads rising to roughly 10% (bottom panel, Chart 17). Tech investment has been so abysmal for so long that it is hard to get any worse. In fact, it has started to improve both on an absolute and relative basis, as pent-up tech demand is being unleashed. Our synchronized global capex upcycle theme is gaining traction and the tech sector will continue to make gains at the expense of resource-related spending. Our global tech EPS model is forecasting modest double-digit growth in the coming quarters (second panel, Chart 17), largely aligned with sell-side analysts' profit growth expectations (fifth panel, Chart 5). On balance, we are putting the S&P tech sector on upgrade alert reflecting the capex tailwind offsetting the rising interest rate backdrop, and reiterate our capex-related high-conviction overweight in the S&P software sub-index. Chart 17Technology (Underweight-Upgrade Alert) Technology (Underweight-Upgrade Alert) Technology (Underweight-Upgrade Alert) 1 Please see BCA U.S. Equity Strategy Weekly Report, "SPX 3,000?," dated July 10, 2017, available at uses.bcaresearch.com. 2 Please see BCA U.S. Equity Strategy Weekly Report, "EPS And "Nothing Else Matters"," dated December 18, 2017, available at uses.bcaresearch.com. 3 Please see BCA U.S. Equity Strategy Weekly Report, "Dissecting Profit Composition," dated July 24, 2017, available at uses.bcaresearch.com. 4 Please see BCA U.S. Equity Strategy Weekly Report, "Invincible," dated November 6, 2017, available at uses.bcaresearch.com. 5 Please see BCA U.S. Equity Strategy Weekly Report, "Dollar The Great Reflator," dated September 18, 2017, available at uses.bcaresearch.com. 6 Please see BCA U.S. Equity Strategy Weekly Report, "Can Easy Fiscal Offset Tighter Monetary Policy?," dated October 9, 2017, available at uses.bcaresearch.com.

As we near the end of an impressive year for equities, the relationship between price growth and earnings growth and how to best position a portfolio for 2018 bears some reflection. The purpose of this report, rather than take a position on inflation or growth, is to create a roadmap such that investors can allocate according to their expectations for both and also avoid potential pitfalls and embrace likely winners. Diagram 1Four Quadrants Of Earnings And Inflation Equity Sector Winners And Losers When Inflation Climbs; A Deeper Dive Equity Sector Winners And Losers When Inflation Climbs; A Deeper Dive In framing our analysis, we will focus on the top half of a well-known growth/inflation matrix presented in Diagram 1 below (stay tuned for a follow-up Special Report when we examine the sector impacts of deflation). We have used S&P 500 earnings as our measure of growth for two reasons: first, they lead GDP and IP growth and second, they are most relevant in a discussion of S&P 500 sector allocations. While inflation and earnings growth tend to move together, this has not always been the case. We have identified six time periods in which inflation has been visibly rising (shaded in Chart 1) and compared it with S&P 500 EPS growth. The mean reverting nature of S&P 500 earnings growth makes discerning a pattern difficult but, more often than not, there is a positive correlation with rising inflation. Over the last 60 years S&P 500 earnings growth has averaged 7.6%, while core PCE prices increased on average by 3.3%. As shown in Table 1 below, S&P 500 earnings outpaced core inflation in four periods (indeed, they grew much faster) and fell behind in two periods. We thus place 1965-1971 and 1998-2002 in the top-left quadrant of our matrix (Stagflation) and 1973-1975, 1976-1981, 1987-1989 and 2003-2006 in the top-right (Boom Times). It is important to qualify that, for the purposes of this report, we are considering all periods in which inflation is increasing, not necessarily periods when it is elevated on an absolute basis. Chart 1Earnings And Inflation Usually Move Together... Earnings And Inflation Usually Move Together... Earnings And Inflation Usually Move Together... Table 1...But Not Always Equity Sector Winners And Losers When Inflation Climbs; A Deeper Dive Equity Sector Winners And Losers When Inflation Climbs; A Deeper Dive In our examination of inflation and sector winners last year1, we presented Table 2 below, now modified to tie sector earnings growth to relative share price performance. Breaking down sector performance in boom and bust periods is revealing. The first and most obvious observation is that stock performance tracks earnings growth in all periods, implying that fundamentals lead valuation, as they should. The second observation is that empirical evidence supports sector allocation theory in inflationary boom/bust periods. Table 2Sector Performance When Inflation Rises Equity Sector Winners And Losers When Inflation Climbs; A Deeper Dive Equity Sector Winners And Losers When Inflation Climbs; A Deeper Dive In theory, the best performing stocks in a stagflation environment would have low economic sensitivity but high pricing power. This is borne out with S&P health care being the top performing sector both from an earnings growth and, predictably, relative stock performance perspective. By contrast, the top performing boom time stocks should be the most economically sensitive yet still stores of value. In these periods, the top overall performer was energy which checks all the boxes. This year, we are expanding our analysis to the GICS2 sectors which have shared the same cyclical return profile as their GICS1 peers (Table 3). In the inflationary busts, defensive stocks including healthcare equipment and food & beverage outperformed. As expected, the inflationary booms saw traditional cyclical indices including energy and transportation outperform. Table 3GICS2 Sector Performance When Inflation Rises Equity Sector Winners And Losers When Inflation Climbs; A Deeper Dive Equity Sector Winners And Losers When Inflation Climbs; A Deeper Dive In the next section, we will take a deeper look at three of the GICS2 top and two bottom quartile performers when inflation is rising. Energy - (Currently Overweight) The S&P energy index has been a stellar performer in all six high inflation periods we have examined and has the highest average return of all GICS2 sectors. This is logical, considering the sector's revenue, profit and share price leverage to the underlying commodity. During periods of high inflation, all stores of value tend to increase and oil is no exception. An additional tailwind for energy prices with inflation is the associated elevated industrial production; the current synchronized global growth backdrop should sustain a healthy level of demand for energy. Keep in mind oil prices are an excellent gauge of global growth. In the context of a falling rig count and contracting oil stocks (Chart 2), energy prices and stocks seem likely to remain well bid, underpinning our overweight recommendation on the S&P energy index. Transportation - (Currently Overweight) Transportation can largely be summarized as S&P railroads (currently overweight) and S&P air freight & logistics (currently overweight) which together comprise 75% of the index. The index has been a very strong performer in periods of rising inflation, driven by coincident accelerating global trade volumes (Chart 3). Historically, global industrial production and both rail and air freight EPS have moved in tandem as relatively fixed supply drives pricing power firmly on the side of logistics providers (Chart 3). This pricing power allows the transportation to mitigate the usually coincidentally highly volatile energy price via oil surcharges, offsetting what is typically the largest input cost. Together, firming volumes and pricing gains support an outsized earnings outlook and our overweight recommendation in transportation. Chart 2Inflation, IP And Oil Prices Move Together Inflation, IP And Oil Prices Move Together Inflation, IP And Oil Prices Move Together Chart 3Rising Inflation Is A Boon To Global Trade Volume Rising Inflation Is A Boon To Global Trade Volume Rising Inflation Is A Boon To Global Trade Volume Health Care Equipment - (Currently Neutral) The S&P health care equipment index has consistently been an outperformer in each of the six high inflation impulse periods we analyzed. This is all the more interesting, considering it is the least cyclical of the top quartile relative performers. Health care equipment sales are largely driven by new facility construction which is, in turn, driven at least in part by consumer spending on health care. Consumer health care expenditure has a demonstrated propensity to follow (with significantly greater amplitude) overall inflation (Chart 4). Further, health care equipment is highly levered to global demand; the latter clearly rises hand in hand with inflation and should be EPS accretive to the former. Elevated relative valuations offsetting the positive operating environment keep us on the sidelines. Chart 4Health Care Spending Tracks Inflation Health Care Spending Tracks Inflation Health Care Spending Tracks Inflation Automotive - (Currently Underweight) Returns in the S&P automotive index are by far the most consistently negative when inflation is rising. Rising interest rates driving the costs of ownership higher, combined with the rational avoidance of a depreciating asset when stores of value are preferable, have historically impaired light vehicle sales as inflation climbs. In fact, the two have a tight negative correlation (Chart 5). In an industry where margins are razor thin at the best of times and fixed costs are relatively high, a shrinking top line implies significant profit contraction. Add on a highly geared balance sheet in a rising rate environment and the ingredients are all in place for underperformance. The current environment echoes this analysis; inventories are still elevated despite manufacturer incentives hitting their highest level in history and seven-year auto loans becoming the norm, something unheard of in previous cycles. Chart 5Inflation And Auto Sales Are Inversely Correlated Inflation And Auto Sales Are Inversely Correlated Inflation And Auto Sales Are Inversely Correlated Utilities - (Currently Underweight) Utilities, as the prototypical defensive sector, have unsurprisingly performed poorly as inflation is rising. Rising inflation expectations go hand in hand with rising bond yields (Chart 6); as a fixed-income proxy, utilities are likely to be subject to the same drubbing as the bond market when yields rise. Further, surging global trade is a notable boon to the three outperformers previously highlighted with their exceptional international exposure; utilities are a domestic-only investment and are bound to underperform. Overall, we recommend an underweight position in utilities. Chart 6Inflation Is A Headwind To Fixed Income Proxies Inflation Is A Headwind To Fixed Income Proxies Inflation Is A Headwind To Fixed Income Proxies Chris Bowes, Associate Editor U.S. Equity Strategy chrisb@bcaresearch.com 1 Please see BCA U.S. Equity Strategy Weekly Report, "Equity Sector Winners And Losers When Inflation Climbs," dated December 5, 2016, available at uses.bcaresearch.com.

Highlights Portfolio Strategy Synchronized global capex growth, a derivative of BCA's synchronized global growth thesis, will be a dominant theme next year, benefiting cyclicals over defensives. Three high-conviction calls are levered to this theme. Higher interest rates on the back of a pickup in inflation expectations is another BCA theme that should materialize in 2018. Three calls focus on a selloff in the bond markets for the coming year. Two special situations round up our high-conviction calls for 2018. Recent Changes S&P Software index - Boost to overweight. S&P Homebuilding index - Downgrade to underweight. Table 1 High-Conviction Calls High-Conviction Calls Feature Equities continued to grind higher last week, largely ignoring tax bill passage jitters. The S&P 500 is on track to register an eighth consecutive month of positive monthly returns, an impressive feat. Firm global economic data suggests that the synchronized global growth theme is gaining traction and remains investors' focal point. While the 10/2 yield curve flattening is a bit unnerving, another curve to watch is the spread between 2-year yields and the Fed funds rate, or what BCA often refers to as the "Fed Spread". This spread has widened 50bps since early September closely tracking the Citi economic surprise index (Chart 1A), and signals that the U.S. economy remains on a solid footing. We would be most worried that a recession was imminent were both slopes concurrently flattening and approaching inversion (third panel, Chart 1A). Chart 1AThe 'Fed Spread'Is Right The 'Fed Spread'Is Right The 'Fed Spread'Is Right Chart 1BHigher Interest Rates Theme Higher Interest Rates Theme Higher Interest Rates Theme Moreover, credit growth has turned the corner, and the three, six and twelve month credit impulses are all simultaneously rising at a time when total loans outstanding have hit an all-time high. Importantly, credit breadth is also broad-based. Our six month impulse diffusion index shows that six out of the eight credit categories that the Fed tracks have a positive second derivative (Chart 1A). All of this suggests that, cyclically, the path of least resistance is higher for equities, especially given BCA's view of a recession hitting only in 2019. In this context, we are revealing our high-conviction calls for the next year. Most of our calls leverage two BCA themes: synchronized global capex growth (a derivative of our flagship publication's "The Bank Credit Analyst" synchronized global growth theme articulated in last week's outlook)1 and a higher interest rate theme ("The Bank Credit Analyst" expects yields to be under upward pressure in most major markets during 2018)2. Over the past few months we have been articulating the ongoing synchronized global capital spending macro theme3 that, despite still flying under the radar, will likely dominate in 2018. Table 2 on page 4 shows that both DM and EM countries are simultaneously expanding gross fixed capital formation. As a result, we reiterate our recent cyclical over defensive portfolio bent,4 and tie three high-conviction overweight calls to this theme. Table 2Synchronized Global Capex Growth High-Conviction Calls High-Conviction Calls Similarly in recent reports we have been highlighting BCA's U.S. Bond Strategy view of a higher 10-year yield on the back of rising inflation expectations for 2018. If BCA's constructive crude oil view pans out then inflation and rates may get an added boost (Chart 1B). Three high-conviction calls are levered to this theme. Finally, we have a couple of special situations, and this year we characterize two out of these eight calls as speculative. Anastasios Avgeriou, Vice President U.S. Equity Strategy anastasios@bcaresearch.com 1 Please see BCA The Bank Credit Analyst Monthly Report, "OUTLOOK 2018 Policy And The Markets: On A Collision Course," dated November 20, 2017, available at bca.bcaresearch.com. 2 Ibid. 3 Please see BCA U.S. Equity Strategy Weekly Report, "Invincible" dated November 6, 2017, available at uses.bcaresearch.com. 4 Please see BCA U.S. Equity Strategy Special Report, "Top 5 Reasons To Favor Cyclicals Over Defensives" dated October 16, 2017, available at uses.bcaresearch.com. 5 Please see BCA U.S. Bond Strategy Weekly Report, "Living With The Carry Trade" dated October 17, 2017, available at usbs.bcaresearch.com. Construction Machinery & Heavy Trucks (Overweight, Capex Theme) The capex upcycle will likely fuel the next machinery stock outperformance upleg. Not only are expectations for overall capital outlays as good as they get (Chart 2), but there are also tentative signs that even the previously moribund mining and oil & gas complexes will be capex upcycle participants. While we are not calling for a return to the previous cycle's peak, even a modest renormalization of capital spending plans (i.e. maintenance capex alone would suffice) in these two key machinery client segments would rekindle industry sales growth. A quick channel check also waves the green flag. Both machinery shipments and new orders are outpacing inventory accumulation (Chart 2). Moreover, backlogs are rebuilding at the quickest pace of the past five years (not shown). This suggests that client demand visibility is returning. This machinery end-demand improvement is a global phenomenon. In fact, the fourth panel of Chart 2 shows that global machinery new orders are climbing faster than domestic new order growth. Tack on the reaccelerating global credit impulse courtesy of the latest Bank for International Settlements Quarterly Review and the ingredients are in place for a global machinery export boom. Finally, our machinery EPS model is firing on all cylinders, underscoring that the earnings-led recovery has more running room (Chart 2). The ticker symbols for the stocks in this index are: BLBG: S5CSTF - CAT, CMI, PCAR. Chart 2S&P Construction Machinery & Heavy Trucks S&P Construction Machinery & Heavy Trucks S&P Construction Machinery & Heavy Trucks Energy (Overweight, Capex Theme) The slingshot recovery in basic resources investment - albeit from a very low base - suggests that there is more room for relative gains in the S&P energy index in the coming months (second panel, Chart 3). The U.S. dollar remains down significantly for the year and, irrespective of future moves, it should continue to goose energy sector profits owing to the positive impact on the underlying commodity. Importantly, energy producers are a levered play on oil prices and the latter have jumped roughly $14/bbl to $58/bbl or ~32% since July 10th, but energy stocks are up only 8% in absolute terms. Given BCA's still sanguine crude oil market view, we expect a significant catch up phase in energy equity prices into 2018. On the supply front, Cushing and OECD oil stocks are now contracting. As oil inventories get whittled down, OPEC stays disciplined and oil demand grinds higher, oil prices will remain well bid. The implication is that the relative share price advance is still in the early innings. Relative valuations have ticked up in the neutral zone according to our composite relative Valuation Indicator, but on a number of metrics value remains extremely compelling in the energy space. Finally, our EPS model heralds additional growth in the coming quarters on the back of solid industry pricing power and sustained global oil producer discipline. The ticker symbols for the stocks in this index are: BLBG: S5ENRS - XLE:US. Chart 3S&P Energy S&P Energy S&P Energy Software (Overweight, Capex Theme) The S&P software index is a clear capex upcycle beneficiary (Chart 4) and we recommend an upgrade to a high-conviction overweight stance today. If software commands a larger slice of the overall capital spending pie as we expect, then industry profits should enjoy a healthy rebound (second panel, Chart 4). Small business sector plans to expand have returned to a level last seen prior to the Great Recession, underscoring that software related outlays will likely follow them higher. Recovering bank loan growth is also corroborating this upbeat spending message: capital outlays on software are poised to accelerate based on rebounding bank loans. The latter signals that businesses are beginning to loosen their purse strings anew (Chart 4). Reviving animal spirits suggest that demand for software upgrades will stay elevated. CEO confidence is pushing decade highs. Such ebullience is positive for a pickup in software investments. It has also rekindled software M&A activity, with the number of industry deals jumping in recent months. Meanwhile, the structural pull from the proliferation of cloud computing and software-as-a-service has served as a catalyst to raise the profile of this more defensive and mature tech sub-sector. Finally, our newly introduced S&P software EPS model encapsulates this sanguine industry backdrop and heralds a bright profit outlook. The ticker symbols for the stocks in this index are: BLBG: S5SOFT-MSFT, ORCL, ADBE, CRM, ATVI, INTU, EA, ADSK, RHT, SYMC, SNPS, ANSS, CDNS, CTXS, CA. Chart 4S&P Software S&P Software S&P Software Banks (Overweight, Higher Interest Rates Theme) The S&P banks index is a core overweight portfolio holding and there are high odds of significant relative gains in the coming quarters. All three key drivers of bank profits, namely price of credit, loan growth and credit quality, are simultaneously moving in the right direction. On the price front, the market expects the 10-year yield to hit 2.47% in November 2018 from roughly 2.32% currently. BCA expects the 10-year yield will rise more quickly than is discounted in the forward curve. Our U.S. bond strategists think core inflation will soon resume its modest cyclical uptrend (Chart 5). A parallel recovery in the cost of inflation protection will impart 50-60 basis points of upside to the 10-year Treasury yield by the time core inflation reaches the Fed's 2% target.5 C&I and consumer loans, two large credit categories, are both forecast to reaccelerate in the coming months. The ISM has been on fire lately and consumer confidence has been following closely behind. Our credit growth model captures these positive forces and is sending an unambiguously positive message for loan reacceleration in the coming months (Chart 5). Finally, credit quality remains pristine despite some pockets of weakness in, subprime especially, auto loans. At this stage of the cycle, near or at full employment, NPLs will remain muted. The ticker symbols for the stocks in this index are: BLBG: S5BANKX - WFC, JPM, BAC, C, USB, PNC, BBT, STI, MTB, FITB, CFG, RF, KEY, HBAN, CMA, ZION, PBCT.  Chart 5S&P Banks S&P Banks S&P Banks Utilities (Underweight, Higher Interest Rates Theme) Increasing global economic growth expectations bode ill for defensive utilities stocks (global manufacturing PMI diffusion index shown inverted, top panel, Chart 6). Synchronized global economic and capex growth (second panel, Chart 6) and coordinated tightening in monetary policy spells trouble for bonds. Our U.S. Bond strategists expect a bond selloff to gain steam in 2018. Given that utilities essentially trade as a proxy for bonds, this macro backdrop leaves them vulnerable to a significant underperformance phase. Importantly, the stock-to-bond (S/B) ratio and utilities sector relative performance also has a tight inverse correlation. The implication is that downside risks remain acute. Without the support of continued declines in bond yields, or of indiscriminate capital flight from all riskier assets, utilities advances depend on improving fundamentals. The news on the domestic operating front is grim. Contracting natural gas prices, the marginal price setter for the industry, suggest that recent utilities pricing power gains are running on empty. Add on waning productivity, with labor additions handily outpacing electricity production, and the ingredients for a margin squeeze are in place. Finally, industry utilization rates are probing multi-decade lows and overcapacity is negative for pricing power. Turbine and generator inventories have been hitting all-time highs. This is a deflationary backdrop. The ticker symbols for the stocks in this index are: BLBG: S5UTIL - XLU:US. Chart 6S&P Utilities S&P Utilities S&P Utilities Pharmaceuticals (Underweight, Special Situation) Weak pricing power fundamentals, a soft spending backdrop, a depreciating U.S. dollar and deteriorating industry operating metrics will sustain downward pressure on pharma stocks in the coming year. Both in absolute terms and relative to overall PPI, pharma selling prices are steadily losing steam (Chart 7). In the context of a bloated industry workforce, the profit margin outlook darkens significantly. If the Trump administration also manages to clamp down on the secular growth of pharma selling price inflation, then industry margins will remain under chronic pressure. Moreover, our dual synchronized global economic and capex growth themes bode ill for defensive pharma stocks. Nondiscretionary health care outlays jump in times of duress and underwhelm during expansions. Currently, the soaring ISM manufacturing index is signaling that pharma profits will remain under pressure in the coming months as the most cyclical parts of the economy flex their muscles (the ISM survey is shown inverted, second panel, Chart 7). A depreciating currency is also synonymous with pharma profit sickness (bottom panel, Chart 7). While pharma exports should at least provide some top line growth relief during depreciating U.S. dollar phases, they are contracting at an accelerating pace (middle panel, Chart 7), warning that global pharma demand is ill. Finally, even on the operating metric front, the outlook is dark. Pharma industrial production is nil and our productivity proxy remains muted, warning that profits will likely underwhelm. The ticker symbols for the stocks in this index are: BLBG: S5PHAR - JNJ, PFE, MRK, BMY, AGN, LLY, ZTS, MYL, PRGO. Chart 7S&P Pharma S&P Pharma S&P Pharma Homebuilding (Speculative Underweight, Higher Interest Rates Theme) Year-to-date, the niche homebuilding index is the best performing sub-index within consumer discretionary stocks surpassing even the internet retail subgroup that AMZN is part of, and has bested the broad market by 50 percentage points. Such exuberance is unwarranted and we deem that stocks prices have run way ahead of earnings fundamentals. Worrisomely the trifecta of higher interest rates, high lumber prices and likely tax reform blues are substantial headwinds to the index's profit potential. The second panel of Chart 8 shows that if BCA's interest rate view materializes in 2018, then 30-year fixed mortgage rates will rise in tandem with the 10-year yield (assuming the spread stays intact) and cause, at the margin, some consternation to homeownership. Near all-time highs in lumber prices are also a cause for concern (bottom panel, Chart 8). Lumber is an input cost to new homes built and eats into homebuilder margins if they decide not to pass it on to the consumer. If they do add it as a surcharge to new home selling prices, then existing homes become a "cheaper" alternative, hurting new home demand. Finally, the GOP tax plan may change mortgage interest and property tax deductions, affecting largely new home owners and becoming a net negative to the homebuilding index. The ticker symbols for the stocks in this index are: BLBG: S5HOME-DHI, LEN, PHM, LEN / B. Chart 8S&P Homebuilding S&P Homebuilding S&P Homebuilding Semiconductor Equipment (Speculative Underweight, Special Situation) Semiconductor stocks in general and semi equipment in particular have gone parabolic. The latter have bested the market by 60 percentage points year-to-date, and over a two-year period the outperformance jumps to roughly 180 percentage points (top panel, Chart 9). Something has got to give, and we are putting the S&P semi equipment index on our speculative high-conviction underweight list. A global M&A frenzy and the bitcoin/ICO mania (bottom panel, Chart 9) have pushed chip equipment stocks to the stratosphere. In absolute terms this index is near the tech bubble peak, and relative share prices are following close behind (top panel, Chart 9). Worrisomely five year EPS growth forecasts recently surpassed the 25% mark, an all-time high. Both the tech sector's (in 2000) and the biotech index's (2001 and 2014) long term growth estimates hit a wall near such breakneck pace (second panel, Chart 9). This indefinite profit euphoria is unwarranted and we would lean against it. On the operating front, DRAM prices (a pricing power proxy) have tentatively peaked and so have semi sales (an industry end-demand proxy), warning that extrapolating the recent semi equipment V-shaped profit recovery far into the future is fraught with danger (third & fourth panels, Chart 9). The ticker symbols for the stocks in this index are: BLBG: S5SEEQ-AMAT, LRCX, KLC. Chart 9S&P Semis S&P Semis S&P Semis Current Recommendations Current Trades High-Conviction Calls High-Conviction Calls High-Conviction Calls High-Conviction Calls High-Conviction Calls High-Conviction Calls Size And Style Views Favor small over large caps and stay neutral growth over value.

Dear Client, Today we are sending you a two-part Special Report prepared by my colleague Billy Zicheng Huang of our Emerging Markets Equity Sector Strategy team, entitled “A Sector Guide To A-shares”. Part I of the report was published in September, and emphasized the key takeaways from MSCI’s decision to include A-shares in the MSCI EM index beginning in June 2018. More importantly, it provided a comprehensive analysis of the financials, industrials, consumer discretionary, and consumer staples sectors. Part II of the report was published at the end of October, and provided an analysis of the remaining sectors not included in Part I. The reports underscore that while the top-down impact of MSCI’s decision is limited, it is significant in terms of expanding potential alpha from security selection. I trust that you will find this report to be useful. Best regards, Jonathan LaBerge, CFA, Vice President Special Reports Part I of the Special Report discussed the market impact of MSCI's decision to include A-shares in the MSCI Emerging Markets Index, followed by a comprehensive analysis of the four most investment-relevant sectors with corresponding company calls in each sector. In the second part of the Special Report, the EMES team will analyze the remaining sectors, and provide investment recommendations. We will publish an Investment Case by the end of this year, highlighting our best sector picks from Part I and Part II of the Special Reports to construct an A-share portfolio. A Recap In the first part of our A-shares special report, the EMES team discussed the key takeaways from A-shares' inclusion in the MSCI EM index and concluded that, despite a limited near-term impact on the market from a passive investment standpoint, the MSCI's decision will provide an expansion of the investable universe for active EM investors, and more opportunities to allocate assets and generate alpha.1 Moreover, we looked at the four sectors most relevant for investors - financials, industrials, consumer discretionary, and consumer staples - analyzing valuations, profitability, leverage, and the growth outlook. In this special report, we will continue our journey through the remaining sectors: energy, healthcare, IT, materials, real estate, and utilities. Please note that only one company, Dr.Peng Telecom & Media (CH 600804), will be added to telecoms, and will not result in material changes to the sector. Thus we omitted analysis of this sector. Energy Seven companies from the energy sector will be included into the MSCI EM index, including six from the oil & gas industry. The equally weighted basket of the seven A-share energy companies has underperformed the MSCI EM index year to date by 26.2%, and by 19.8% over a one-year period (Table 1). With the Chinese government's mandate to cut excess capacity, capex growth in the energy sector will continue to be weak, which will weigh on the growth outlook for the sector. Image In terms of valuation, stripping out two dual-listed names that are already in the MSCI EM Index (Sinopec and PetroChina - please see Appendix I for the full list), Lu'an Environmental and Xishan Coal & Electric Power are trading at significantly cheaper valuations than their peers. On the other end of the spectrum, Guanghui Energy and Wintime Energy's P/Es have expensive valuations. Looking at profitability, low P/E names tend to have high ROEs, while Guanghui Energy suffers from the weakest ROE (Charts 1A & 1B). From a profitability-versus-valuation perspective, Lu'an Environmental offers a superior risk-reward profile, while Guanghui Energy has the least favorable risk-reward profile (Chart 1C). Image Image Image Wintime and Lu'an reported the strongest operating margins, while Offshore Oil Engineering has the weakest margin among peers (Chart 1D). On leverage, Offshore Oil Engineering has the lowest debt-to-equity (D/E) ratio, mainly because its core business is energy equipment and service rather than oil & gas exploration. All energy producers are highly leveraged, with Wintime and Guanghui topping the list. On free cash flow yield, Lu'an leads the table, while both Guanghui and Wintime have negative yields which, together with high leverage, is a negative combination (Charts 1E, 1F, 1G). Image Image Image Image The A-share Energy companies have a dividend yield of less than 2%, with Offshore Oil Engineering enjoying the highest yield among peers, while Xishan Coal & Electric Power has the lowest yield (Chart 1H). Screening the earnings forecasts, all companies' EPS are expected to growth by more than 10%, led by Offshore Oil Engineering and Guanghui Energy (Chart 1I). Image Image Taking all the factors into consideration, we suggest investors should be cautious on the energy sector, and should be especially cautious about betting on the likelihood of Guanghui Energy's turnaround. The company registered surprising positive bottom-line growth in 1H17, but this was mainly due to a low base in 2016. The commencement of its new liquefied natural gas (LNG) terminal in Jiangsu Province will not help much to lift sales volumes or margins, given little LNG price recovery and growing competition from well-positioned larger players such as Kunlun and CNOOC. Healthcare There are 13 companies in the A-share healthcare sector. Stocks in the sector have a heavy tilt towards pharmaceutical producers. The equally weighted basket has underperformed the MSCI EM index year to date by 1.8%, and outperformed by 0.9% over a one-year period (Table 2). On an absolute return basis performance was resilient across various time horizons. The EMES team has been bullish on healthcare sector on a long-term investment horizon, with overweight calls on Fosun Pharma (2196 HK) from among the current MSCI EM constituents.2 We prefer companies with innovative drug R&D pipelines, which will more likely take advantage of the new China FDA rule encouraging biopharmaceutical innovation. Image Shanghai Pharma and Fosun Pharma are excluded from our analysis, as their H-listed shares are already in the MSCI EM index. Examining valuations, on a trailing P/E basis we favor Sanjiu Medical and Dong-E-E-Jiao. By contrast, Hengrui Medicine and Guizhou Bailing look expensive (Chart 2A). Looking at the profitability side, Salubris Pharma and Dong-E-E-Jiao have the strongest ROE, while Tongrentang and Baiyunshan Pharma lie on the other end of the spectrum (Chart 2B). In summary, Salubris Pharma and Dong-E-E-Jiao will likely outperform, based on a valuation-versus-profitability comparison (Chart 2C). Image Image Image Furthermore, Salubris Pharma and Dong-E-E-Jiao also lead by operating margin, with relatively safe leverage levels at the same time (Chart 2D). On the other hand, Jointown suffers from the highest debt level, the only one with debt-to-equity surpassing 100%. In terms of free cash flow, Sanjiu Medical and Salubris have the most attractive FCF yield, while Jointown and Tasly, both companies with the highest debt levels, also display a worryingly negative FCF yield (Charts 2E, 2F, 2G). Salubris and Baiyun Shan dominate the dividend yield rank (Chart 2H). Image Image Image Image Concerning the earnings outlook, Huadong Medicine and Kangmei are expected to see fast bottom-line growth in 2018, driven by robust antibiotic and cardiovascular sales respectively, while Tongrentang and Baiyunshan are likely to fall behind the industry average (Chart 2I). Image Image In summary, we prefer Salubris Pharma among the A-share healthcare basket, supported by its stronger fundamentals and the bullish outlook on innovative drug R&D and sales in China, in which Salubris Pharma is specialized. IT 14 names from the IT sector will be added to the MSCI EM index. The equally weighted basket has outperformed the MSCI EM index year to date by 22.3%, and outperformed by 23.3% over a one-year period (Table 3), with most stocks performing strongly across various investment horizons. We believe the A-share IT basket provides investors with attractive opportunities in the investable universe given that it is less expensive than its H-share counterpart. The inclusion will also dilute the weight of IT sector ADRs, such as Alibaba and Sina Weibo, in the index. Please note that Protruly Vision Tech has been suspended from trading due to legal issues, with no further detail released by the court. Stripping out ZTE because of its H-share listing already in the MSCI EM index, there are 12 names left. Image Regarding valuations, most companies are trading at a below-50 trailing P/E, with the exceptions of Hundsun Tech and iFlytek, both of which are above 150x, while Aisino and BOE are relatively undervalued compared to other names in the sector. It is worth mentioning that Hundsun is 100% owned by Zhejiang Finance Credit Network Technology, a company 99% owned by Alibaba. From a profitability perspective, Hikvision Digital and Dahua Tech have the highest ROE, while Hundsun Tech and Tsinghua Unisplendour lie at the other end of the spectrum (Charts 3A & 3B). Taking these two factors into consideration, we highlight Hikvision Digital and Dahua Tech as the most attractive based on their risk-reward profile (Chart 3C). Image Image Image When looking at the income statement, Sanan Optoelectronics displays robust operating margins, with 2345 Network following suit. By contrast, Hundsun Tech and Tsinghua Unisplendour report the most disappointing margins (Chart 3D). On the positive side, Hundsun Tech has virtually zero debt on the balance sheet, while Dongxu Optoelectronic is more than 80% leveraged. Meanwhile, only four companies register positive FCF yields. Taking both metrics into account, Aisino can most easily service its debt with free cash flow (Charts 3E, 3F, 3G). By dividend yield, Aisino and Hikvision rank top (Chart 3H). Image Image Image Image With respect to forward EPS growth, iFlytek and Hundsun Tech are expected to see the fastest bottom-line expansion, while Aisino's and BOE Tech's bottom lines will increase at the slowest pace (Chart 3I). Image Image Based on our criteria, we like video surveillance manufacturers Hikvision and Dahua Tech for their robust fundamentals and reasonable valuations. In particular, Hikvision is likely to have the largest market cap among A-share tech companies newly included in the MSCI indexes. Materials Currently only seven Chinese companies from the materials sector are included into the MSCI EM Index. After the inclusion, some 26 more companies will be added, substantially expanding the investable universe. Two subsectors will most likely draw investors' attention due to the significant exposure increase: metals & mining, and chemicals. The equally weighted basket has underperformed the MSCI EM index year to date by 2%, but outperformed by 4.6% over a one-year period (Table 4). We exclude five names, which are already in the current MSCI EM index: Sinopec Shanghai Petrochem, Anhui Conch Cement, Aluminum Corp of China, Jiangxi Copper, and Zijin Mining. Among the other companies, we have been underweight Maanshan Iron & Steel (H-share listing) and Aluminum Corp of China (H-share listing) in our China Materials trade, and overweight Tianqi Lithium in the lithium supply chain trade. Image Maanshan Iron & Steel and Angang Steel have attractive valuations, with trailing P/Es below 15. On the other end of this scale, China Northern Rare Earth and Baotou Steel appear very expensive (Chart 4A). On profitability, Wanhua Chemical and Tianqi Lithium top the ROE rank, while Jinduicheng Molybdenum and Baotou Steel sit at the bottom (Chart 4B). Screening the risk-reward profile, it is noticeable that chemicals normally demonstrate a better ROE vs. P/E metric than companies from the metals & mining industry. Specifically, Wanhua Chemical and Tianqi Lithium are the most attractive, while Jindiucheng Molybdenum is the least attractive (Chart 4C). Image Image Image In terms of operations, Tianqi Lithium reported the strongest operating margin, followed by Junzheng, while Hainan Rubber and Jinduicheng Molybdenum are the only companies that registered negative operating margins (Chart 4D). Looking at the balance sheet, Jinduicheng Molybdenum has the healthiest leverage, while Hesteel shows the most worrisome leverage. Moreover, it has the lowest FCF yield. In terms of FCF yield versus leverage, Kingenta offers the best tradeoff, while Hesteel is the least attractive (Charts 4E, 4F, 4G). Furthermore, dividend yield favors Longsheng and disfavors Northern Rare Earth (Chart 4H). Image Image Image Image In terms of projected EPS growth, Jinduicheng Molybdenum and Shandong Gold Mining have the strongest outlook for next year, while Maanshan Iron & Steel and Angang Steel are likely to report profit declines (Chart 4I). Image Image In summary, apart from Maanshan Iron & Steel, Hainan Rubber is a good candidate for the underweight basket due to its relatively expensive valuation, negative margin and FCF yield. Moreover, its focus on the rubber business diversifies the portfolio risk from metal & mining-concentrated underweight exposure. China Molybdenum, with its above-average risk-reward profile, moderately strong operations and financial position, as well as robust growth outlook, is a good candidate for the overweight basket of our lithium supply trade to replace Ganfeng Lithium. The company has a strong market presence in Congo, where over 60% of cobalt is mined. Real Estate Some 14 developers will be added to the existing MSCI EM index. Among the top 10 Chinese developers, measured by contracted sales and floor space sold, existing MSCI EM constituents account for six, while the A-share list will add two (Poly Real Estate and China Fortune Land). In the environment of property market tightening in China, primary land supply has remained stagnant. The government is unlikely to ease the supply restrictions in the near-term, especially in the residential land space. In this vein, we believe large market players will be better-positioned in this market, due to their bargaining power. Also, developers with heavy exposure to commercial property will be less affected by policy uncertainty than their residential counterparts. Looking at historical performance, the equally weighted basket has underperformed the MSCI EM index year to date by 20.5%, and by 17.1% over a one-year period (Table 5). Image Xinhu Zhongbao and Financial Street are trading at the cheapest valuations, while Zhejiang China Commodities and China Fortune Land seem to be slightly overpriced compared to peers. The ROE for Xinhu Zhongbao is remarkable, while Zhangjiang High-tech Park is the only company with ROE under 10% (Charts 5A, 5B). Taking both dimensions into account, Xinhu Zhongbao and Gemdale display an attractive risk-reward profile (Chart 5C). Image Image Image Looking at operational metrics, Zhejiang China Commodities and Financial Street enjoy the highest margin, while Xinhu Zhongbao and Tahoe lie on the other end of the spectrum (Chart 5D). Due to the nature of business, leverage is high across the sector. In particular, Oceanwide and Tahoe have a high debt-to-equity ratio, while Zhejiang China Commodities and Gemdale have a more prudent capital structure. Furthermore, FCF yields vary a lot across companies, with Financial Street and Xinhu Zhongbao on the positive end, and Tahoe and Oceanwide on the negative. Financial Street also beats other developers in terms of cash generation for debt payment (Charts 5E, 5F, 5G). Image Image Image Image Gemdale and Risesun have the highest dividend yield, while Tahoe and Zhejiang China Commodities have the lowest (Chart 5H). Image Regarding the full-year 2018 expectations, Financial Street and Zhejiang China Commodities have a robust growth outlook with respect to funds from operations (FFO) and EPS respectively, while Gemdale is likely to see sluggish growth on both metrics (Charts 5I & 5J). In summary, we believe Financial Street Holding is likely to outperform in the real estate sector, given its appealing risk-reward profile, decent dividend yield, superior cash flow yield and operating margin, reasonable debt ratio, and robust FFO growth. Its large-scale and commercial property exposure is expected to be more immune to policy tightening in China. Image Image Utilities Some 12 utility companies will be added to the existing MSCI EM index, most of which are in power generation and renewables. EMES published in July an investment case on China utilities, underlining our preference toward companies with a focus on the environment and clean power, in line with the Chinese government's emphasis in the 13th five-year plan.3 In the A-share basket, we highlight Yangtze Power, the hydro power large cap, National Nuclear, as its name suggests the state-owned nuclear power operator, and Beijing Capital, the water utility provider. The equally weighted basket has underperformed the MSCI EM index year to date by 19.2%, and by 14.2% over a one-year period (Table 6). Image Huaneng Power is excluded from our analysis, as its H-share is already in the MSCI EM Index. Screening valuations, the trailing P/E factor favors Shenery and Chuantou Energy. By contrast, Huadian Power and Beijing Capital look expensive (Chart 6A). On profitability, Yangtze Power and Chuantou Energy have the strongest ROE, while Huadian Power and Shenzhen Energy fall far behind the average (Chart 6B). Based on valuation versus profitability, Chuantou Energy, Yangtze Power, and SDIC Power will likely outperform (Chart 6C). Image Image Image Yangtze Power and SDIC Power have remarkably high operating margins, while Shenery and Beijing Capital are at the other end of the spectrum (Chart 6D). Concerning leverage, most large-scale players such as Datang International Power and National Nuclear Power are highly leveraged. By contrast, low leveraged players, such as Hubei Energy and Shenergy, tend to have small market caps of around US$ 5 bn. In terms of FCF yield, we highlight Yangtze Power and Chuantou Energy, while we are cautious on Shenzhen Energy and National Nuclear Power due to their deeply negative yields. In summary, we like Chuantou Energy, Yangzte Power, Zheneng Electric, and Shenergy with respect to FCF yield versus leverage, which also coincides with dividend yield rank (Charts 6E, 6F, 6G, 6H). Image Image Image Image Finally, Huadian Power and Datang are expected to show the fastest bottom-line growth next year, while Yangtze Power and Chuantou Energy are likely to see limited earnings expansion (Chart 6I). Image Image Therefore, within utilities sector, we expect Yangtze Power to outperform in the long term, supported by its appealing risk-reward profile, margin expansion, and debt service ability. We also like the fact that the company's dominant strength of hydropower is the Yangtze River Delta. Billy Zicheng Huang, Research Analyst billyh@bcaresearch.com 1 Please see EM Equity Sector Strategy Special Report "A Sector Guide To A-shares - Part I ", dated September 19, 2017, available at emes.bcaresearch.com 2 Please see EM Equity Sector Strategy Investment case "China Healthcare, Getting Healthier", dated August 9, 2016, available at emes.bcaresearch.com 3 Please see EM Equity Sector Strategy Investment case "Budding Green Equities In China", dated July 11, 2017, available at emes.bcaresearch.com Appendix - I Image Appendix - II Overweight Company Profile Image Image Image Image Underweight Company Profile Image Image

Managed health care stocks have performed exceptionally well since our early-April 2016 overweight recommendation, besting the market by roughly 24%. This begs the question: Is the time ripe to lock in impressive profits and move to the sidelines or is there more upside left? Leading profit indicators suggest that more gains are in store for the relative share price ratio. After petering out in 2016, our managed care cost proxy has plummeted by over 350bps from the recent peak (shown inverted, second panel). Given that premiums are set on a trailing cost basis, profit margins should surprise to the upside. Further, drug price deflation should prove a boon to managed care providers' bottom lines and the pharmaceutical sector's pain this year will be the managed health care industry's gain (bottom panel). Bottom Line: Melting input costs should augment managed health care profits, supporting a durable valuation expansion phase. Stay overweight and see this week's Weekly Report for more details. The ticker symbols for the stocks in this index are: BLBG: S5MANH - UNH, AET, ANTM, CI, HUM, CNC. Stick With Managed Health Care Exposure Stick With Managed Health Care Exposure

Dear Client, Next week on November 20th instead of our regular weekly publication you will receive our flagship publication "The Bank Credit Analyst" with our annual investment outlook. Our regular publication service will resume on November 27th with our high-conviction trades for 2018. Kind Regards, Anastasios Avgeriou Highlights Portfolio Strategy Melting medical care input costs, sustainable enrollment gains and even modest tax relief would augment managed health care profits. Stay long health care insurers. Pharma and biotech stocks suffer from declining pricing power. Continue to avoid both. As a result, the S&P health care index remains in the underweight column. Recent Changes There are no changes to our portfolio this week. Table 1 Will The Market Test Powell? Will The Market Test Powell? Feature Equities consolidated recent gains as earnings season drew to a close last week. Recent election results coupled with the revealing of the Senate tax bill raised fresh concerns, unwarranted according to our geopolitical strategists, about the likelihood of a bill passage. While such heightened fiscal policy uncertainty is disquieting, solid EPS growth on the back of synchronized global economic and capex growth should sustain the overshoot phase in stocks. Q3 EPS vaulted to a fresh all-time high (Chart 1) and, were it not for two financials sector sub-indexes - reinsurers and multi-line insurers that were severely hit by the one off hurricane catastrophes - financials EPS growth would have been nil from -7.3%, pushing the overall SPX EPS number to 9.2% from 8.1%. Chart 2 shows that the positive EPS surprise factor remained close to the recent average. Going into earnings season, Q3 EPS growth forecasts collapsed to 4.1%, but actual results ended up 400bps higher. Chart 1Earnings-Led Advance Continues Earnings-Led Advance Continues Earnings-Led Advance Continues Chart 2Surprise Factor In Line With Recent Average Will The Market Test Powell? Will The Market Test Powell? While EPS growth cannot stay in the high teens forever, settling down close to 10%/annum EPS growth rate is possible in the near run. The softness in the U.S. dollar along with the basic resource sector commodity-related comeback, synchronized global economic and capex growth and financials contributing more than sell side analysts expect to overall EPS, suggest that such profit growth is attainable in 2018. Tack on the possibility of fiscal easing and sustained lift in animal spirits (bottom panel, Chart 1), and the odds of low double-digit EPS growth increase further. Meanwhile on the monetary policy front, news of Powell's nomination to take the helm at the Fed barely budged the equity market, but some cracks are appearing in the bond market (Chart 3). Keep in mind that going back to Volcker's late-1970s nomination, Fed Chair transitions have been volatile. In fact, the market has tested the resolve of all four previous Fed leaders (Chart 4). As soon as Volcker come into power he had to deal with the early-1980s recession (and the LatAm crisis in 1982) that saw the market fall by 17% from peak to trough. When Greenspan was confirmed Chairman in August of 1987, two months into his tenure Black Monday happened and he had to step in and reiterate the Fed's function as a lender of last resort. In 2006 Bernanke took over from the Maestro, and a recession hit by the end of 2007 that morphed into the Great Recession. Finally in early-2014, Yellen become the Fed Chairwoman and in late-2015 a global manufacturing recession had taken hold resulting in a 14% drawdown in the SPX. Chart 3Watching The Bond Market Watching The Bond Market Watching The Bond Market Chart 4Testing Times Testing Times Testing Times Inevitably, the market will test the new Fed Chairman. This expansion has been long in the tooth and given BCA's 2019 recession view, this testing time is at least a year away. This week we reiterate our underweight stance in a defensive sector and highlight its key sub-components. Stick With Managed Health Care Exposure Following a two year hiatus, managed health care stocks broke out in 2017 and the juggernaut has now resumed (Chart 5). While the recent unsuccessful intra-industry M&A attempts (breakdown of both AET/HUM and ANTM/CI deals) were a mild setback, CVS's latest announcement, to take over AET and further vertically integrate, has brought euphoria back to this health care subgroup. We have added alpha to our portfolio as relative performance is up smartly, roughly 24% since our early-April 2016 overweight recommendation, begging the question: Is the time ripe to lock in impressive profits and move to the sidelines or is there more upside left? Leading profit indicators suggest that more gains are in store for the relative share price ratio. After petering out in 2016, our managed care cost proxy (comprising physician and hospital services and medical care commodity inflation) has plummeted by over 350bps from the recent peak (shown inverted, second panel, Chart 5). Given that premiums are set on a trailing cost basis, profit margins should surprise to the upside, i.e. the industry's medical loss ratio has room to fall. Not only is our medical care input cost proxy melting, but the latest employment cost index release revealed that managed health care wage inflation is also steadily decelerating (third & bottom panels, Chart 6). Taken together, these two cost categories are heralding a solid industry EPS growth backdrop in the coming months (total cost proxy shown inverted, second panel, Chart 6). Chart 5Melting Costs Are A Boon To Margins... Melting Costs Are A Boon To Margins... Melting Costs Are A Boon To Margins... Chart 6...And EPS ...And EPS ...And EPS Importantly, health care insurers are also set to benefit from the Trump administration's push toward lowering drug prices and the proliferation of generic drugs. While drug inflation is positive for the pharma/biotech space, it is an expense incurred by managed care providers and vice versa. The upshot is that the pharmaceutical sector's pain will be the managed health care industry's gain (bottom panel, Chart 5). On the legislative front, the failed attempts to repeal and replace the ACA is positive as the newly enrolled will likely remain insured and underpin recurring industry revenues. As long as costs stay in check, the implication is ongoing earnings improvement. Tack on any relief related to a tax bill passage (the managed care index has a 47% effective tax rate or 24% higher than the overall S&P health care sector, see Table 2) and the path of least resistance is higher for profits. Table 2Tax Relief Potential Will The Market Test Powell? Will The Market Test Powell? Despite all of these positives, relative valuation remains muted, hovering near the neutral zone. On a forward P/E basis the S&P managed care index is trading on a par with the S&P 500 (Chart 7). If our thesis of sustained earnings outperformance materializes in the coming quarters, then a valuation re-rating phase looms. In sum, melting input costs, sustainable enrollment gains and even modest tax relief would augment managed health care profits. This is a recipe for a durable valuation expansion phase. Bottom Line: While we are underweight the broad health care index, our sole overweight remains the S&P managed health care index. The ticker symbols for the stocks in this index are: BLBG: S5MANH - UNH, AET, ANTM, CI, HUM, CNC. Ailing Pharma We downgraded pharma to an underweight stance on July 31 on the back of weak pricing power fundamentals, soft spending backdrop, a depreciating U.S. dollar and deteriorating industry operating metrics. The S&P pharmaceuticals index relative performance is down 5% since then as our bearish profit thesis is validated. Our dual synchronized global economic and capex growth themes bode ill for defensive pharmaceutical stocks. Nondiscretionary health care outlays jump in times of duress and underwhelm during expansions. Currently, the soaring ISM manufacturing index is signaling that pharma profits will remain under pressure in the coming months as the most cyclical parts of the economy flex their muscles (the ISM survey is shown inverted, middle panel, Chart 8). A depreciating currency is also synonymous with pharma profit ails (bottom panel, Chart 8). Historically, a soft U.S. dollar has been closely correlated with global growth, whereas greenback strength tends to slowdown the global economy. In that context, pharma exports should at least provide some top line growth relief during depreciating U.S. dollar phases. However, pharma exports are contracting at an accelerating pace (top panel, Chart 8) despite the U.S. dollar's year-to-date softness, warning that global pharma demand is sick. Importantly, the news on the pricing power front is disconcerting. Both in absolute terms and relative to overall PPI, pharma selling prices are steadily losing steam. In the context of a bloated industry workforce, the profit margin outlook darkens significantly (Chart 9). If the Trump administration also manages to clamp down on the secular growth of pharma selling price inflation, then industry margins will remain under chronic pressure. Worrisomely, were pharma prices to continue to trail overall corporate sector price inflation, as we expect, then the de-rating phase in the S&P pharmaceuticals index has a long ways to go (bottom panel, Chart 9). Finally, even on the operating metric front, the news is mostly grim. Pharma industrial production is nil and our pharma productivity proxy remains muted, warning that profits will likely underwhelm. Industry retail sales growth is also flirting with the zero line and pharma inventories have resumed growing on a short-term rate of change basis across the supply channel. Pharma shipments offer the only ray of hope. But the recent acceleration in the latter may be the result of the hurricane-related catastrophes (Chart 10). Chart 8Counter Cyclical With##br## No Export Relief Counter Cyclical With No Export Relief Counter Cyclical With No Export Relief Chart 9Weak Pricing Power And Bloated##br## Cost Structure Weighs On Margins Weak Pricing Power And Bloated Cost Structure Weighs On Margins Weak Pricing Power And Bloated Cost Structure Weighs On Margins Chart 10Operating Metrics ##br##Are Also Feeble Operating Metrics Are Also Feeble Operating Metrics Are Also Feeble Netting it out, pharma profit growth is on track to continue to disappoint as the confluence of synchronized global growth, softening U.S. dollar, pricing power losses and deteriorating operating metrics are all profit headwinds. Bottom Line: We reiterate our late-July downgrade in the S&P pharma index to underweight. The ticker symbols for the stocks in this index are: BLBG: S5PHAR - JNJ, PFE, MRK, BMY, AGN, LLY, ZTS, MYL, PRGO. A Few Words On Biotech Biotech stocks are another casualty of weakening pharmaceutical wholesale price inflation, and given that the industry's profits move neck-and-neck with their pharma siblings, revenue and EPS growth are bound to continue to surprise to the downside (Chart 11). We expect such profit woes will weigh on the S&P biotech index relative performance, and re-iterate our high-conviction underweight status. Chart 11Biotech Equities Hate Higher Rates Biotech Equities Hate Higher Rates Biotech Equities Hate Higher Rates Chart 12Technicals Say Sell Technicals Say Sell Technicals Say Sell Not only are biotech firms modestly concealed Big Pharma, i.e. they manufacture multi-billion dollar blockbuster drugs, and the Trump administration's scrutiny of drug price inflation is a profit negative, but also a rising interest rate backdrop is working against this health care sub-index. Historically, rising interest rates have been inversely correlated with biotech stocks. High flying valuations tend to gravitate back to earth when the Fed embarks on a tightening cycle. The opposite is also true. BCA's U.S. Bond Strategy view remains that in the coming 12 months interest rates will be higher, moving closer to the 3% mark on the 10-year Treasury yield front. If such a selloff materializes in the bond market, then investors will abandon biotech stocks in a heartbeat (Chart 11). Chart 13Heed The EPS Growth Model Signal Heed The EPS Growth Model Signal Heed The EPS Growth Model Signal Meanwhile, according to empirical evidence since the mid-1990s, relative momentum in biotech stocks is nearly perfectly inversely correlated with the global credit impulse (Chart 11). This negative correlation has become more pronounced in the past decade underscoring the non-discretionary/defensive nature of large biotech outfits. In other words biotech stocks behave like counter-cyclicals similar to their pharma brethren. Given BCA's view of a recession hitting some time in 2019, we recommend investors still avoid biotech stocks. Finally, technicals are also waving a red flag. Chart 12 shows that a head-and-shoulders formation has taken root and were the neckline to give way in the coming weeks, relative performance would suffer a substantial setback. Bottom Line: Biotech stocks remain a high-conviction underweight. The ticker symbols for the stocks in this index are: BLBG: S5BIOTX - ABBV, AMGN, GILD, CELG, BIIB, VRTX, REGN, ALXN, INCY. Health Care Sector Implications What does all this mean for the broad S&P health care sector? Our relative profit growth model best encapsulates these forces and is signaling that profits will remain downbeat into 2018 (Chart 13). Managed health care stocks (overweight) comprise 13% of the index, while pharma (underweight) and biotech (underweight) market capitalization weights both add up to 54% of the total. As a result of our intra-sector positioning and given our neutral weightings in the remaining health care sub-indexes, we continue to recommend a below benchmark allocation in the S&P health care index. Bottom Line: Stay underweight the S&P health care sector. Anastasios Avgeriou, Vice President U.S. Equity Strategy anastasios@bcaresearch.com Current Recommendations Current Trades Size And Style Views Favor small over large caps and stay neutral growth over value.

The biotech complex has had a tough earnings season, having given up almost all of the gains made earlier this year as companies warned that intensifying competition would hurt top line growth. This corresponds with pharma pricing power hitting a five-year low, typically a strong predictor of the index's top line growth prospects (second panel). Tack on a tougher government-related pricing stance and a margin squeeze is likely. There is a bull case to be made that bad news in the biotech square has largely been priced in to the index, which has seen significant compression since the heady heights of 2013-14 (third panel). We disagree; relative to its growth prospects, and compared with the broad market, the S&P biotech index valuation has spiked well above normal levels. This leaves room for further margin compression as investors digest the bleak outlook. Biotech stocks remain a high-conviction underweight. The ticker symbols for the stocks in this index are: BLBG: S5BIOTX-AMGN, ABBV, GILD, CELG, BIIB, REGN, ALXN, VRTX. Heightened Competition Should Keep Biotech Growth Muted Heightened Competition Should Keep Biotech Growth Muted