Industrials

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.

Overweight Sales departments in the S&P industrial machinery index have been exceptionally busy in the past several months as order bookings have been soaring with both domestic and global orders pouring in (second panel). With growth accelerating around the world and a tax change at home that could shift the capex cycle into overdrive, the path of least resistance for industrial machinery new orders is higher. At the same time as orders have been surging, the industry has been ramping production to meet them, keeping the new orders to inventory relationship surprisingly stable over the past 4 years (third panel). However, growth in production has not been matched by an equivalent increase in employment, resulting in our productivity proxy moving much higher (bottom panel). This bodes well for profits, particularly in the context of a swelling top line in this relatively high fixed cost industry. The upshot is that EPS growth should outperform the market in 2018; stay overweight. The ticker symbols for the stocks in this index are: BLBG: S5INDM - ITW, IR, SWK, PH, FTV, DOV, PNR, XYL, SNA, FLS. Soaring Orders Point To Bumper 2018 For Industrial Machinery Soaring Orders Point To Bumper 2018 For Industrial Machinery

Overweight Last week saw some sad news as Hunter Harrison, the CEO of CSX and legendary railroad captain, passed away. While we are overweight the S&P railroads index, we did not upgrade when Mr. Harrison joined CSX and we will not change our rating as a result of his passing. Rather, we continue to focus on surging global trade volume (second panel) as the fundamental revenue driver. Our rail shipment commodity group diffusion indicator is sending a nearly unanimous message of rising volumes (third panel), which should correlate with continued overall industry volume gains. Further, industry pricing power is soaring while employment is declining (bottom panel) which, in conjunction with the previously noted volume growth, implies solid productivity improvements to come. This means margins have a powerful tailwind, irrespective of the operating leverage that topline growth should deliver. In sum, railroads remain a core industrial and transports holding; stay overweight. The ticker symbols for the stocks in this index are: BLBG: S5RAIL - UNP, CSX, NSC, KSU. Global Trade Keeps Rails On Track Global Trade Keeps Rails On Track

Overweight The Stockholm International Peace Research Institute (SIPRI) released data earlier this week showing that global arms sales (as measured by the revenues of the largest 100 defense companies) had arrested their 6-year long decline last year, rising by 1.9%. The key driver appears to be Lockheed Martin (LMT), which saw rising sales for the international F-35 program and also purchased helicopter producer Sikorsky, thus cementing its position as the number one defense firm. Importantly, 2016 saw arms sales for South Korean companies surge by 20.6% in response to the rising tensions on the Korean peninsula, both to meet domestic demand and for international exports. There are two implications from this statistic: first, rising South Korean arms production means overall demand is increasing and second, defense demand is becoming heterogeneous. In conjunction with growth in domestic armed forces (second panel), the demand environment for U.S. defense firms remains bright and while valuations are lofty on a P/E and P/CF basis, they are not out of line with the broad market measured by EV/EBITDA (third panel); stay overweight. The ticker symbols for the stocks in the BCA Defense index are: LMT, GD, RTN, NOC, LLL. Rising Global Threats Are A Boon To Defense Stocks Rising Global Threats Are A Boon To Defense Stocks

With the Senate Republicans passing their version of the bill on December 2, the odds that a final version of the bill will pass into law are now very high, though investors remain skeptical that there will be any stimulative economic effect from tax cuts. While we admit that the direct effect on the economy will be moderate, tax cuts have the potential to sustain the healthy sector rotation and supercharge the ongoing capex cycle. The bulk of the media's analysis to date of the impact of the impending tax reform has been focused on the reduction of the corporate tax rate and the repatriation of foreign earnings. While those are obviously critical, we think more attention should be paid to the provision allowing the immediate expensing of capital investment. Our analysis suggests that the impact of bringing forward the tax shield could, at the margin, change spending behavior for firms and drive the next up-leg for the capex cycle in 2018. We expect S&P industrials (overweight) to be the greatest beneficiary from the ongoing capex boom, considering the tight correlation between capital goods orders and EPS growth (second and third panels), followed by S&P financials (overweight) via a step function higher in loan growth to finance the outsized demand for capital. Please see this week's Special Report for more details. Tax Cuts Are Here: Equity Sector Implications Tax Cuts Are Here: Equity Sector Implications

Highlights The House and Senate have passed similar tax cut bills; passage of a compromise version seems all but certain; Combined with the Trump administration's de-regulation efforts, fundamentals point ever higher for U.S. earnings; The under-reported change, in both versions of the bill, to the expensing of capital investments could have far-reaching implications; All of these support the ongoing healthy sector rotation; The lion's share of upside from the capex upcycle should go to industrials, followed closely by financials. Feature Chart 1Republicans Are Not Fiscally Responsible Republicans Are Not Fiscally Responsible Republicans Are Not Fiscally Responsible BCA's Geopolitical Strategy has maintained a high-conviction view since November 9, 2016 that Congress would pass budget-busting tax cuts.1 With the Senate Republicans passing their version of the bill on December 2, the odds that a final version of the bill will pass into law are now very high. What should investors expect from the new tax legislation? Much as our geopolitical team faced considerable resistance to their political forecast, investors are now skeptical that there will be any stimulative economic effect from tax cuts. While we admit that the direct effect on the economy will be moderate, tax cuts have the potential to sustain the healthy sector rotation and supercharge the ongoing capex cycle. In this Special Report, we explain why. Why Did We Get Tax Cuts Right? What did our geopolitical team get right about tax cuts? First, in November 2016, right after the election, we reminded clients that the Republican Party has a spotty record on fiscal conservativism. There is no empirical evidence that GOP policymakers are actually fiscally conservative (Chart 1), nor that Republican voters have a stable preference for fiscally conservative policies (Chart 2). As such, there was not going to be a popular revolt against tax cuts. Second, in April 2017, we saw that Obamacare repeal's failure actually increased the probability of tax cuts passing. Put simply, tax cuts are about motivating the Republican base to come out and vote in the upcoming midterms, not about satisfying the median American voter. Polling currently suggests that Republicans face an uphill battle to retain majority in the House of Representatives (Chart 3). Should investors fear that the ongoing Mueller investigation will scuttle tax cuts? The short answer is no. First, former National Security Adviser Michael Flynn lied to the FBI and has been charged with that offense, but what he did for the Trump administration in the interim between the election and the inauguration is likely not illegal. Chart 2Republican Desire For Smaller Government Wanes When In Power Republican Desire For Smaller Government Wanes When In Power Republican Desire For Smaller Government Wanes When In Power Chart 3Republicans Losing Popular Support Republicans Losing Popular Support Republicans Losing Popular Support Second, White House scandals and intrigue have rarely mattered to the market. Chart 4A and Chart 4B show that both the Tea Pot Dome scandal (the greatest in U.S. history at the time) and the Lewinsky affair occurred amidst the two greatest bull markets. While the Watergate scandal appears to have shaken the markets, it also escalated simultaneously with the historic 1973 oil shock and the onset of the 1973-75 recession. Besides, why would investors turn negative on the S&P 500 if President Trump - a highly unorthodox, unpredictable, and impulsive politician - looked to be replaced by Vice President Mike Pence? Earnings fundamentals drive the market, not political intrigue. Thus, we would fade impeachment risk and stick to getting the fundamentals right. Chart 4AMassive Bull Markets... Massive Bull Markets... Massive Bull Markets... Chart 4B...Attended Massive Scandals ...Attended Massive Scandals ...Attended Massive Scandals What about upside potential? Is there any left now that the market has begun to fully price in tax cuts, or will it be a reason to sell and crystalize profits? It is difficult to say, but our sense is that the healthy rotation out of tech (U.S. Equity Strategy is underweight) and into financials (overweight) and industrials (overweight) will gain steam. Also high-effective-tax-rate stocks and mostly domestically focused small caps have likely turned the corner (Chart 5), and the "Fed Spread" (2-year yield minus the fed funds rate) continues to point toward brisk economic growth in coming quarters (Chart 6). While the S&P 500 is up 18% year-to-date, synchronized global economic growth and robust earnings explain half the rise, the other half is forward multiple expansion. Were a 5%-10% pullback to materialize after all the tax-related dust settled, we would deem it a healthy development and a reset that would propel equities higher on the back of firm EPS growth next year. Furthermore, the market has cheered Trump's de-regulation drive, which, unlike tax cuts, has been concrete policy from day one of his administration (Chart 7). Chart 5Market Has Doubted Tax Reform Market Has Doubted Tax Reform Market Has Doubted Tax Reform Chart 6Growth Prospects Still Good Growth Prospects Still Good Growth Prospects Still Good Chart 7Market Has Cheered De-Regulation Market Has Cheered De-Regulation Market Has Cheered De-Regulation De-regulation is likely to continue in parallel with lower taxes. For example, in a potentially huge blow to the enforcement powers of the federal bureaucracy, Trump's Justice Department has switched sides in a lawsuit that may shortly come before the Supreme Court (Lucia v Securities and Exchange Commission). The DOJ is now backing the plaintiffs instead of supporting the SEC as the Obama administration had. If the plaintiffs win their argument that the SEC's "administrative law judges" were unconstitutionally appointed by bureaucrats (instead of by the president, the courts, or the head of an executive department), then all of the prior decisions and penalties enforced by these judges (and their peers in other bureaucracies) may be legally invalidated, weakening the enforcement mechanisms of the federal bureaucracy.2 Bottom Line: Tax cuts are coming while the deregulation drive is set to continue. Both are bullish for the market from a cyclical time perspective. What about the economy and equity-sector-specific winners? To this question we now turn. Lighting The Afterburners On The Capex Cycle With the eye-popping numbers involved, it is no surprise that the media's analysis to date of the impact of the impending tax reform has been focused on the reduction of the corporate tax rate and the repatriation of foreign earnings. However, the impact of those headline-grabbing reforms on changing consumption behavior and, as a result, delivering real economic growth remains hotly debated. We think more attention should be paid to the provision in the versions from both chambers of Congress allowing the immediate expensing of capital investment. Unlike the reductions in tax rate (Table 1), U.S. firms only benefit from this change when they deploy capital on qualified property and equipment at home, an unambiguously stimulative change. Table 1Sector Tax Rates And Pro Forma EPS Changes From Tax Reform Tax Cuts Are Here - Equity Sector Implications Tax Cuts Are Here - Equity Sector Implications We believe most market observers have overlooked this reform as it is simply a "time value of money" shift. The IRS already allows significantly accelerated depreciation of capex (please see the Appendix on page 12 for more detailed information); this reform merely brings it forward. Our analysis suggests that the impact of bringing it forward could, at the margin, change spending behavior for firms and drive the next up-leg for the capex cycle in 2018. In our analysis, we use the example of a railroad. The current tax code allows the firm to depreciate the cost of a locomotive over 7 years, roughly the average for all assets under the depreciation schedule published by the IRS. This already incents the firm to deploy capex aggressively because fleet ages are well in excess of 7 years. Further, as long as the asset is new and to be used in the U.S., the company can depreciate a bonus 40% in the first year.3 Assume this railroad is paying the new marginal tax rate in the U.S. of 20% and has the same cost of capital as the U.S. government, approximating 2.4%. If the railroad purchases a locomotive for $10,000, the current regime offers a present value tax benefit of $1,919 (Table 2). The proposed tax reform allows the railroad to collect that benefit immediately (at least for the next 5 years), yielding a present value 4.2% greater than the current regime. Using an estimate of the S&P 500's weighted average cost of capital (8.5%) as a discount rate (an obviously more realistic scenario), and this advantage climbs to 14.2% (Table 3). Table 2Tax Shield Implications Are Modest With A Low Discount Rate... Tax Cuts Are Here - Equity Sector Implications Tax Cuts Are Here - Equity Sector Implications Table 3...But Grow Substantially As Discount Rates Rise Tax Cuts Are Here - Equity Sector Implications Tax Cuts Are Here - Equity Sector Implications In theory, any profit maximizing firm should alter their capital budgets such that returns are adjusted to incorporate a significantly higher tax shield. We, thus, expect tax reform to drive significant new order growth in the near term as foreseeable capex is pulled forward. A case could be made that this reform changes the math sufficiently that U.S. firms will add capacity that is incremental to existing plans, hinging on a positive feedback loop from the new order growth the pull-forward effect noted above. Who Wins? While our cyclical view of an ongoing EPS upcycle morphing into a virtuous broad-based capex upcycle remains intact (Chart 8)4, there are two sectors that will almost immediately benefit from the tax bill getting signed into law. The greatest, and perhaps most obvious, beneficiary of any capital largesse that will follow this reform will be S&P industrials (overweight) as the principal destination for increases in capital deployment. We expect higher capex to lead to higher sales growth courtesy of firm end-demand and high operating leverage, flow-through to the bottom line, which boosts EPS and sustains the virtuous upcycle. True, wage growth would also get a bump mildly denting profit margins. However, at this stage of the business cycle and given accelerating pricing power (Chart 9), capital goods producers will likely succeed in passing through wage inflation. S&P financials (overweight) too should be significant beneficiaries via a step function higher in loan growth to finance the outsized demand for capital and generalized lift in animal spirits (Chart 10), though they have a partial offset arising from the reduction in value of their net operating loss (NOL) tax assets. A sustained push for more bank deregulation, along with shareholder-friendly activities will also boost the allure of financials equities. Chart 8Earnings Are The Critical Capex Driver Earnings Are The Critical Capex Driver Earnings Are The Critical Capex Driver Chart 9Capex Upcycles Drive Industrial EPS... Capex Upcycles Drive Industrial EPS... Capex Upcycles Drive Industrial EPS... Chart 10...And Boost Loan Demand ...And Boost Loan Demand ...And Boost Loan Demand Bottom Line: S&P industrials and financials sectors get an early Christmas present in the form of demand-enhancing tax reform, combined with corporate tax cuts that allow them to keep their profits. The result should be outstanding EPS growth and rising stock prices. The S&P industrials and financials sectors remain core portfolio overweights. Marko Papic, Senior Vice President Chief Geopolitical Strategist marko@bcaresearch.com Matt Gertken, Associate Vice President Geopolitical Strategy mattg@bcaresearch.com Chris Bowes, Associate Editor U.S. Equity Strategy chrisb@bcaresearch.com Anastasios Avgeriou, Vice President U.S. Equity Strategy & anastasios@bcaresearch.com 1 Please see BCA Geopolitical Strategy, "U.S. Election: Outcomes & Investment Implications," dated November 9, 2016, and "Constraints & Preferences Of The Trump Presidency," dated November 30, 2016, available at gps.bcaresearch.com. 2 We thank our colleague Matt Conlan, of BCA's Energy Sector Strategy, for the tip on this crucial court case. 3 First year depreciation is set to step down to 40% from 50% in 2018, according to the phasing out of the bonus depreciation under the 2015 PATH Act. 4 Please see BCA U.S. Equity Strategy, "Top 5 Reasons To Favor Cyclicals Over Defensives," dated October 16, 2017, and "Later Cycle Dynamics," dated October 23, 2017, available at uses.bcaresearch.com. Appendix: Why Does Accelerated Depreciation Matter? Accelerated depreciation is a tax incentive for firms to invest in capital assets. In essence, the IRS provides depreciable lives of assets that are shorter than useful lives, allowing firms to gain the tax benefit of the depreciation expense earlier in the asset's life. Assuming tax reforms are passed as currently written, firms will be able to deduct 100% of the capital cost of new equipment in the first year. Using our railroad example from earlier in this report, the capital cost was $10,000 and, with a tax rate of 20%, the tax shield is thus $2,000. Continuing with that example, imagine the locomotive has an estimated useful life of 10 years. In the absence of any accelerated depreciation (including that which is already on the books), the tax shield would be roughly half of what accelerated depreciation allows (Table 4). Note that the gross tax benefit is unchanged, it is merely shifted from the future to the present. Table 4Straight Line Depreciation Halves Tax Shield Tax Cuts Are Here - Equity Sector Implications Tax Cuts Are Here - Equity Sector Implications

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.

Overweight - High Conviction A key beneficiary of the synchronized global capex growth theme that we expect to dominate next year are machinery stocks. Not only are expectations for overall capital outlays as good as they get (second panel), but there are also tentative signs that even the previously moribund mining and oil & gas complexes will be capex upcycle participants. A quick channel check also waves the green flag. Both machinery shipments and new orders are outpacing inventory accumulation (third panel). This machinery end-demand improvement is a global phenomenon. In fact, the bottom panel 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. We reiterate our high conviction overweight recommendation; see Monday's Weekly Report for more details. The ticker symbols for the stocks in this index are: BLBG: S5CSTF - CAT, CMI, PCAR. 2018 Key Views: High-Conviction Calls - Construction Machinery & Heavy Trucks 2018 Key Views: High-Conviction Calls - Construction Machinery & Heavy Trucks

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 The EMES team will be publishing a series of Special Reports in the coming weeks, analyzing sector dynamics and company highlights of Chinese A shares that MSCI has decided to include in the MSCI EM index from next June. In the first part of our report, we emphasize the key takeaways from A-shares' inclusion, followed by a comprehensive analysis of the four sectors that investors will probably most focus on. The second part of our report to be released in the coming weeks will analyze the remaining sectors. MSCI's decision to include Chinese A shares will likely have only a limited near-term impact on the market from a passive investment perspective. A 5% inclusion factor will not cause significant changes to the current sector weightings of the MSCI EM index or the MSCI China index. The symbolic effect - that global investors are becoming more confident in the Chinese market's efficiency and transparency - is likely to have a larger impact. From an active investment perspective, however, an expansion of the investable universe will give investors with EM mandates more opportunities to allocate assets and generate alpha. Impact Is Limited On A Macro Perspective... On June 20, MSCI announced its decision to include Chinese A shares in the MSCI EM index and the MSCI ACWI index on a gradual basis starting from June 2018.1 The inclusion process will be finalized in two steps following the May semi-annual index review and August quarterly review in 2018, at a 5% inclusion factor. Full inclusion of the remaining A-share universe is expected to take place gradually over five to 10 years. After three previous proposals of an A-shares inclusion having been rejected by investors surveyed by MSCI, the successful start of the inclusion process signifies that the A-share market is gaining broad support from institutional investors. This follows the Chinese government's and regulators' focus on improving market accessibility via stock connect programs (Hong Kong-Shanghai connect, and Hong Kong-Shenzhen connect) as well as improving market liquidity via loosening requirements for index-linked financial instruments. Further steps regarding capital movement and better reporting standards are expected to be implemented in due course. influence of the inclusion is minimal from a broad market perspective. As is planned, 222 A-share companies will be added to the MSCI EM index, accounting for a pro-forma weight of only 0.73% of the MSCI EM index, or 2.5% of the MSCI China index (Charts 1A and 1B). A shares will boost China's weight in the MSCI EM by approximately only 1%, given the 5% inclusion factor. Sector-wise, it will not substantially move the current weights of each sector either. Company wise, all selected stocks are large caps, with 43 being "A" and "H" dual-listed companies already included in the current MSCI EM index, mostly concentrated in the financials, industrials and materials sectors (see Appendix I). This means the inclusions are unlikely to make any meaningful contribution to index performance in the upcoming year. Similarly, capital inflows from passive fund trackers are expected to be negligible, only marginally adding to the trading income of the Hong Kong Exchange through the northbound stock connect program. refore, we believe the impact from an investor perspective is more symbolic, confirming a positive outlook on market transparency and corporate governance. Image Image ...But Significant In Stock Selection Despite immaterial near-term market impact, the 222 A-share large-cap stocks will expand the investable universe, providing active investors with plenty of opportunities to extract alpha. In particular, compared to the current weights of the 11 sectors, industrials, financials, consumer staples, materials, healthcare, utilities, and real estate would see weight expansion, while IT, telecom, energy, and consumer discretionary would see weight contraction (Table 1). Image Newly added stocks mainly come from the financial and industrial sectors, with the name count by far outpacing other sectors. Given an overall larger market cap, these two sectors will experience the most substantial incremental weight boost under the full inclusion scenario. However, this does not mean sectors with fewer companies to be added are negligible. Instead, liquidity in these sectors is expected to improve significantly, with specific stocks drawing strong interest from investors. Since the launch of BCA's EMES service, we have made several calls on A-share stocks as out-of-benchmark plays, including Yutong Bus (600066 CH) and Tianqi Lithium (002466 CH) from our best-performing trade, overweight the lithium supply chain. In this vein, in this Special Report we will identify and analyze four sectors that we believe are most investment-relevant. A second Special Report examining the remaining sectors will follow in the coming weeks. Financials Some 50 companies from the financials sector will be included in the MSCI EM index, with a strong tilt toward brokerage firms (27). The rest will be split between banks (19) and insurers (4). Banks The equally weighted basket of 19 A-share banks has underperformed the MSCI EM index year to date by 13.4%, and underperformed by 11.6% over a one-year period (Table 2). In absolute return terms, however, performance has been resilient across various time horizons. It is worth mentioning that the "big five banks" are all listed in both mainland China and Hong Kong. Therefore, investors will focus more on joint-stock banks and regional banks in the A-share universe, which makes analysis on shadow banking activities within the earnings profile crucial. Image In terms of valuation, stripping out dual-listed banks that already exist in the MSCI EM index, Huaxia Bank and CITIC Bank are trading below their book values, displaying relatively cheap valuations. Looking at profitability, three regional banks top the earnings profile: Bank of Guiyang, Bank of Ningbo, and Bank of Nanjing, while the two "cheapest" banks, Huaxia and CITIC, display the lowest ROE (Charts 2A & 2B). From a profitability versus valuation perspective, companies such as Huaxia Bank, Industrial Bank, Bank of Beijing and Pudong Development Bank offer a superior risk-reward profile (Chart 3). Image Image Image Bank of Guiyang and Ping An Bank report the highest net interest margins, but pay a relatively low dividend yield. On the other hand, Industrial Bank and Bank of Beijing have the lowest net interest margins, but relatively high dividend yields (Charts 4A & 4B). Image Image In terms of asset quality, Bank of Nanjing and Bank of Ningbo report the lowest NPL ratios, both under 1%, while Pudong Development Bank and Ping An Bank are at the top of the table. Meanwhile, Bank of Nanjing and Bank of Guiyang show the most robust loan growth, while Bank of Shanghai and Huaxia Bank suffer from the most sluggish loan growth (Charts 5A & 5B). Therefore, on a two-dimensional measure, we prefer Bank of Nanjing, and Bank of Guiyang (Chart 6). Image Image Image Screening the earnings forecast, Bank of Guiyang and Bank of Ningbo are expected to see the fastest growth in two years, while CITIC Bank and Ping An Bank will see the slowest growth (Chart 7). Image Diversified Financials The equally-weighted basket of 27 diversified financial companies has underperformed the MSCI EM index year to date by 26.5%, and by 27.8% over a one-year period (Table 3). Currently there are only nine diversified financial companies in the MSCI EM, with seven securities companies and two state-owned asset management companies specializing in distressed asset management. As mentioned, the inclusion of A shares will not improve brokerage fees dramatically in the near term, but this milestone event could trigger a positive outlook on market sentiment, especially for the broad A-share market, where the dominant players are retail investors. This could explain the subsector's resilient performance over the past three months. Therefore, it is reasonable to be bullish on diversified financials, with the largest securities names expecting a revenue boost in the longer term. Some pure A-share names include Shenwan Hongyuan, Guosen, and Avic Capital. Image Similar to banks, after stripping out dual-listed names already included in MSCI EM (CITIC, Everbright, GF, Haitong, and Huatai), Northeast Securities and Guotai Junan Securities have the cheapest valuations, while Anxin Trust seems to be the overpriced compared to its peers. Accordingly, its ROE is remarkable (Charts 8A & 8B). Taking both dimensions into account, Guotai Junan Securities and Northeast Securities display attractive risk-reward profile (Chart 9). Image Image Image Looking at the top line, performances diverge across various securities companies. Pacific and Guoyuan generate the highest net interest margin, while Orient and Northeast suffer from serious top-line contraction (Chart 10A). Meanwhile, Guoyuan and Anxin score the highest dividend yield, exceeding 2%, while Sinolink pays less than a 0.5% dividend yield (Chart 10B). Image Image Looking at the earnings forecast, Western Securities, AVIC Capital and Sealand Securities are expected to see the strongest bottom-line growth in 2018, while local securities companies Shanxi and Huaan rank at the bottom of the spectrum (Chart 11). Image Insurance The following four insurers are already constituents of the MSCI EM index: China Life, China Pacific, New China Life and Ping An. The equally weighted basket has outperformed the MSCI EM index year to date by 12.4%, and outperformed by 21.2% over a one-year period (Table 4). We will not analyze the subsector in much detail, given none of them are pure A-share companies. As such, market impact from the inclusion will not be material. EMES has been overweight Ping An's H shares since August 9, 2016.2 Image Industrials There are 44 companies in the industrials sector, the second-largest name count after financials. This sector is also expected to make the greatest impact on sector weights, assuming full A-shares inclusion. Stocks in the sector are split between airlines, national defense, machinery, construction and transportation. The equally weighted basket has underperformed the MSCI EM index year to date by 20.5%, and by 22.8% over a one-year period (Table 5). We believe increasing construction activity boosted by the 'One Belt, One Road' initiative will drive sales growth of construction equipment, while disputes in the South China Sea, India, Tibet and Xinjiang autonomous districts will continue to boost the defense industry. Image Air China, Southern Airline, China Communications Construction, China Railway Construction, China Railway Group, China State Construction Engineering, CRRC, Weichai Power, and COSCO are excluded from our analysis, as their H-listed shares are already in the MSCI EM index. Looking at valuations, the trailing P/E varies significantly across companies. Defense stocks in general are more expensive compared to other industries. By contrast, Daqin Railway stands on the lowest end of the P/E ranking, while electrical equipment companies normally display lower valuations (Chart 12A). Looking at the profitability side, Yutong Bus, one of our overweight calls, leads the ROE ranking, while Zoomlion lies on the lowest end by registering a net loss (Chart 12B). In summary, Yutong Bus, Chint Electrics, Gold Mantis and Beijing Orient Landscape will likely outperform, based on a valuation versus profitability profile comparison (Chart 13). Image Image Image Furthermore, the EV/EBITDA forecast for 2017 coincides with our overweight call on national defense stocks. It is worth noting that Eastern Airline would likely see unsatisfactory growth in terms of firm value (Chart 14A). Shanghai International Airport, Tus-sound Environment and Beijing Landscape rank as the top three measured by operating margin, while XCMG Construction Machine displays a negative margin, despite excavator sales in China surging year over year (Chart 14B). In terms of dividend and free cash flow, Yutong Bus and Zoomlion score highest on dividend yield, and Sany Heavy Industry, Daqin Railway, and XCMG secure highest free cash flow yield. On the other hand, Sany and other (check) defense stocks generate the least in dividend yields, and more than half of the companies post negative free cash flow yield (Charts 14C & 14D). Investors should be cautious on airline companies with negative free cash flow, such as Eastern Airline and Hainan Airline. Image Image Image Image Looking at leverage, Shanghai International Airport and AECC Aero-engine Control have the lowest debt-to-equity ratio, while Power Construction and China Eastern Airline are highly leveraged (Chart 14E). Image Last but not least, looking at expected growth profile, XCMG is forecast to see the highest bottom-line growth, driven by growing demand for excavators, while China Eastern Airline and Zoomlion are expected to suffer from negative growth (Chart 15). Image Consumer Discretionary Some 26 names from the consumer discretionary sector will be added to the MSCI EM index. Stripping out Fuyao Glass, BYD, Guangzhou Auto, and Haier, which are already included in the index, there are still six automakers and auto components manufacturers to be included. This should provide investors with enough investable stocks for an auto industry play. Furthermore, six A-share media companies will be added to the index over a one-year period (Table 6). Sector performance has been overall disappointing, with some exceptions being CITIC Guoan Information, Chinese Universe Publishing, Wanxiang Qianchao and China International Travel. Image Regarding valuations, CITIC Guoan Information, Suning Commerce and Alpha Group are the most expensive, with trailing P/Es surging above 50, while two automakers (SAIC and Huayu) along with a travel agency (Shenzhen Overseas Chinese Town) are relatively undervalued in the sector. From a profitability perspective, Robam Appliances and Midea Group generate solid ROE, while CITIC Guoan Information and Sunning Commerce dominate the other end of the spectrum (Charts 16A & 16B). Taking these two factors into consideration, we highlight Robam Appliances, Midea Group, and Xinhua Media as the most attractive (Chart 17) based on a risk/reward profile. Investors should be cautious on Suning Commerce, not only from a fundamental perspective but also because its acquisition of Inter Milan is unlikely to generate synergy amid the Chinese government's tightening of rules on overseas M&A in the entertainment and leisure industries. Image Image Image Looking at the income statement, Shenzhen Overseas Chinese Town displays robust operating performance, matching its high valuation. Robam Appliances and China South Publishing follow suit. By contrast, Suning Commerce suffers from negative margins (Chart 18A). When comparing free cash flow, Midea Group and China South Publishing register the highest yield, while Shenzhen Overseas Chinese Town, Gran Automotive Service, and CITIC Guoan Information have negative yields (Chart 18B). Meanwhile, autos and auto components manufacturers enjoy the highest dividend yields, such as SAIC Motor, Huayu Automotive System, Weifu High-Tech, and Grand Automotive Service (Chart 18C). Image Image Image With respect to leverage, the media industry normally displays the lowest D/E ratio, seen in firms such as China Film, Xinhua Media and China South Publishing. On the other hand, auto and auto component manufacturers as well as large retailers are highly leveraged (Chart 18D). Image Based on our criteria, Guoan Information and Robam Appliances are expected to see the fastest bottom-line growth, while Xinhua Media, Wanxiang Qiaochao, and Xinjiekou Dept.'s bottom lines would remain stagnant (Chart 19). Image Consumer Staples Currently only nine Chinese consumer staples constituents are included in the MSCI EM Index. After the inclusion, 14 more companies will be added, substantially expanding the investable universe. Two subsectors will most likely draw investors' attention: food producers such as Yili and Henan Shuanghui, as well as beverage producers, especially premium liquor producers such as Moutai, Wuliangye Yibin and Yanghe Brewery. The equally weighted basket has underperformed the MSCI EM index year to date by 19.6%, and by 11% over a one-year period (Table 7). The sector has not deviated much from the EM benchmark across the selected time horizon. In particular, premium liquor manufacturers have been the main contributor to overall sector performance. Their sales are expected to experience a seasonal peak in September and October during the Chinese mid-autumn festival and National Day. Both Wuliangye Yibin and Moutai announced robust top-line and bottom-line growth in their second-quarter financial results, largely beating market expectations. Image Stripping out the one dual-listed name already in the MSCI EM index (Tsingtao Brewery), Changyu Pioneer, New Hope Liuhe, and Shuanghui display attractive valuations, with trailing P/Es under 20. On the other end of the metrics, Yonghui Superstores, and Luzhou Laojiao are the most expensive (Chart 20A). Examining profitability measures, Shuanghui and Moutai top the ROE rank, while Bailian Group and Yonghui Superstores sit at the bottom of the rank (Chart 20B). Looking at risk/reward profile, it is noticeable that Shuanghui, Yili and Yanghe Brewery are well positioned (Chart 21). Image Image Image In terms of operations, premium liquor makers reported overall strong operating margins, led by Moutai and Yanghe Brewery, while Bailian Group and New Hope Liuhe stand at the other end of the spectrum (Chart 22A). Looking at the capex-to-sales ratio, Wuliangye and Shuanghui score the best measures, driven by strong sales with less capex. While Changyu Pioneer demonstrates a much higher ratio compared to all peers (Chart 22B), this can be partially explained by its high capex requirement, as it is the only wine maker in the sector. Nonetheless, we believe its top line is expected to be under downward pressure as the wine market in China becomes increasingly competitive, and as premium products from France, Australia, and the U.S. gain easier market access through not only traditional in-store sales but also authorized e-commerce platforms like JD.com. Similarly, free cash flow measure also indicates that Changyu Pioneer is the only liquor player that suffers from negative yield (Chart 22C). Image Image Image In terms of financial position, with the exception of COFCO Tunhe Sugar, all companies in the sector display reasonable levels of leverage (Chart 22D). Image Looking at top-line growth, sales forecasts in FY2017 are more in favor of Moutai, Dabeinong Technology, and Luzhou Laojiao, but less in favor of Bailian Group, Shuanghui, and Changyu Pioneer (Chart 23A). Moreover, when looking at bottom-line growth two years out, Luzhou Laojiao and Yonghui Superstores score the highest rankings, while Changyu Pioneer and Shuanghui are at the other end of the spectrum (Chart 23B). Image Image In summary, among food producers, we are inclined to overweight Shuanghui. Among beverage producers, we like Yanghe Brewery, and Wuliangye, but are avoiding Changyu Pioneer. What's Next? We will highlight the following sectors in part 2 of our Special Report: Materials, energy, IT, telecoms, healthcare, and real estate. Billy Zicheng Huang, Research Analyst billyh@bcaresearch.com Appendix - I Image Appendix - II Overweight Company Profile Image Image Image Image Underweight Company Profile Image Image 1 For the full MSCI press release, please visit: https://www.msci.com/eqb/pressreleases/archive/2017_Market_Classification_Announcement_Press_Release_FINAL.pdf 2 Please see EM Equity Sector Strategy - Investment case "China Healthcare, Getting Healthier", dated August 9, 2016, available at emes.bcaresearch.com