Industrials

When Hunter Harrison took over the reins at CSX, the expectation was a repetition of his slashing of costs with the deployment of his Precision Scheduled Railroading. In his first full quarter as CEO, he appears to have done just that. However, the real surprise (and the one with direct read-through to the sector as a whole) was the pricing gains on the already-known strong quarterly volume; this bodes exceptionally well for the sector. Our upgrade of the sector to overweight last month was based on firming pricing driven by rising volumes (including coal); the CSX results confirm that expectation. In fact, the industry appears to be enjoying the best pricing power of the past 5 years, according to the latest PPI release (middle panel). Our rails EPS model captures this pricing strength and continues to indicate a surge in profit growth relative to the S&P 500. We reiterate our overweight position. The ticker symbols for the stocks in this index are: BLBG: S5RAIL -UNP, CSX, NSC, KSU. Rail Pricing Accelerating Rail Pricing Accelerating

Highlights Key Portfolio Updates Synchronized global economic growth is driving real yields higher and boosting equities (Chart 1). Meantime, core inflation remains muted which will ensure that Fed policy stays sufficiently accommodative (Chart 2). Outside of the U.S., monetary tightening cycles are kicking into high gear, and this will sustain downward pressure on the greenback for now (Chart 3). Easy financial conditions are a boon for S&P 500 profit margins, and a slow moving Fed suggests that investors will extrapolate this goldilocks equity scenario for a while longer (Chart 4). Almost all of the S&P 500's advance year-to-date has been earnings driven (Chart 5). Buoyant EPS breadth bodes well for additional gains, a message in line with our SPX profit model. In terms of how far the broad market can advance from current levels before the next recession hits, we posit three ways to SPX 3,000 (Table 1). The ongoing sector rotation is a healthy development, and is not a precursor to a more viscous and widespread correction (Chart 6). Historically, receding sector correlations represent fertile ground for the overall equity market (Chart 7). Our macro models are signaling that investors should position for a sustained rebound in economic growth. Our interest rate-sensitive models are coming out on top, deep cyclicals are attempting to trough, while defensives took a turn for the worse (Chart 8). Deep cyclical sectors are the most overvalued followed by early cyclicals, while defensives remain in undervalued territory. Interest rate sensitives have recently become overbought, while both deep cyclicals and defensives are in the oversold zone (Charts 9 & 10). The most attractive combination of macro, valuation and technical readings are in the financials and consumer discretionary sectors. The least attractive combinations are in materials, technology and utilities sectors. Prospects for a durable synchronized global economic growth, a coordinated tightening G10 central bank backdrop and cheapened U.S. currency warrant an early cyclical portfolio tilt, with the defensive/deep cyclical stance shifting to a more neutral setting. Chart 1Synchronized Global Growth Synchronized Global Growth Synchronized Global Growth Chart 2Muted Core Inflation Muted Core Inflation Muted Core Inflation Chart 3G10 Central Banks Map Cyclical Indicator Update Cyclical Indicator Update Chart 4Easy Financial Conditions Boost Margins Easy Financial Conditions Boost Margins Easy Financial Conditions Boost Margins Chart 5Buoyant Breadth Bodes Well Buoyant Breadth Bodes Well Buoyant Breadth Bodes Well Table 1SPX Dividend Discount Model Cyclical Indicator Update Cyclical Indicator Update SPX EPS & Multiple Sensitivity Cyclical Indicator Update Cyclical Indicator Update ERP Analysis Cyclical Indicator Update Cyclical Indicator Update Chart 6Healthy Rotation Healthy Rotation Healthy Rotation Chart 7Falling Correlations Boost The S&P 500 Falling Correlations Boost The S&P500 Falling Correlations Boost The S&P 500 Falling Correlations Boost The S&P500 Falling Correlations Boost The S&P 500 Chart 8Interest Rate Sensitives Come Out On Top Interest Rate Sensitives Come Out On Top Interest Rate Sensitives Come Out On Top Chart 9Underowned... Underowned... Underowned... Chart 10...And Undervalued Defensives ...And Undervalued Defensives ...And Undervalued Defensives Chart 11Earnings Growth Set To Accelerate Earnings Growth Set To Accelerate Earnings Growth Set To Accelerate Chart 12Consumers Are Feeling Flush Consumers Are Feeling Flush Consumers Are Feeling Flush Chart 13Improving Fundamentals Signal A Trough Improving Fundamentals Signal A Trough Improving Fundamentals Signal A Trough Chart 14Staples Remain The Household's Choice Staples Remain The Household's Choice Staples Remain The Household's Choice Chart 15Weaker Rents And Higher Vacancies Bode Ill Weaker Rents And Higher Vacancies Bode Ill Weaker Rents And Higher Vacancies Bode Ill Chart 16Profits Look Set To Downshift Strong Fundamental Support Profits Look Set To Downshift Strong Fundamental Support Profits Look Set To Downshift Chart 17Cyclical Recovery Driving Backlogs Lower Cyclical Recovery Driving Backlogs Lower Cyclical Recovery Driving Backlogs Lower Chart 18Margin Recovery Appears Priced In Margin Recovery Appears Priced In Margin Recovery Appears Priced In Chart 19Pricing Collapse Driving Earnings Decline Pricing Collapse Driving Earnings Decline Pricing Collapse Driving Earnings Decline Chart 20Productivity Declines Will##br## Keep A Cap On Valuations Productivity Declines Will Keep A Cap On Valuations Productivity Declines Will Keep A Cap On Valuations Chart 21Valuations At Risk##br## When Inflation Returns Valuations At Risk When Inflation Returns Valuations At Risk When Inflation Returns Feature S&P Financials (Overweight) Our financials cyclical macro indicator (CMI) has climbed to new cyclical highs, supported by broad-based improvement among its components. Firming employment data, historically a precursor to credit growth and capital formation, has been a primary contributor to the lift in the CMI. Importantly, a tight labor market has not yet driven sector costs higher, which bodes well for near term profits (Chart 11 on page 8). A budding revival in loan demand is corroborated by our bank loan growth model, which points to the largest upswing in credit growth of the past 30 years. Soaring consumer and business confidence, rising corporate profits and a potential capital spending revival underpin our loans and leases model (Chart 11 on page 8). Expanding housing prices, increased housing turnover and rebounding mortgage purchase applications support household capital formation (Chart 11 on page 8). A recent lift in share prices partially reflects this much-improved cyclical outlook. Still, the message from our valuation indicator (VI) is that there is significant running room. Our technical indicator (TI) has retreated from overbought levels, but remains solidly in the buy zone, setting the stage for the next leg up in the budding relative bull market. We expect sentiment to steadily improve, buoyed by deregulation moving closer to reality as a partial Dodd-Frank replacement passed the House. Chart 22 S&P Financials S&P Financials S&P Consumer Discretionary (Overweight) Our CMI has snapped back after a tough year, driven by improving real wage growth. Higher home prices, a tighter labor market and increasing disposable income have consumers feeling flush, which should boost discretionary outlays. Importantly, consumer deleveraging is far advanced with the debt service ratio hovering near decade lows (Chart 12 on page 9). Further, our Consumer Drag Indicator remains near its modern high, suggesting EPS gains will prove resilient (Chart 12 on page 9). Although somewhat expensive from a historical perspective, our VI remains close to the neutral zone, underscoring that profits will be the primary sector price driver. Our TI has fully recovered from oversold levels, and is flirting with the buy zone, underscoring additional recovery potential. We continue to recommend an overweight position, favoring the media-oriented sub-indices. Chart 23 S&P Consumer Discretionary S&P Consumer Discretionary S&P Energy (Overweight) Our CMI has recently ticked up from its all-time lows, and is now diverging positively from the share price ratio. Ongoing gains in domestic production, partially offset by a still-high sector wage bill, underlie the recent CMI uptick. The steepest drilling upcycle in recent memory is showing some signs of fatigue. Baker Hughes reported the first weekly decline in 24 weeks in the oil rig count for the week ending June 30th. At least a modest deceleration in shale oil production is likely. Encouragingly, U.S. crude oil inventories are contracting, which could presage a renormalization of domestic inventories, market share gains for domestic production and at least a modest rally in energy shares (Chart 13 on page 9). Our S&P energy sector relative EPS model echoes this cautiously optimistic industry backdrop, indicating a burgeoning recovery in sector earnings (Chart 13 on page 9). The TI has returned to deeply oversold levels, suggesting that an oversold bounce could soon occur at a time when valuations are gravitating back to earth. Chart 24 S&P Energy S&P Energy S&P Consumer Staples (Overweight) The consumer staples CMI has turned lower recently, held back by healthy economic data, particularly among confidence indicators. That should drive a preference for spending over saving after a long period of thrift, although a relative switch from staples into discretionary consumption has not yet taken firm hold. The savings rate has also stayed resilient, despite consumer euphoria (Chart 14 on page 10). The good news is that tamed commodity prices and a soft U.S. dollar should provide bullish offsets for this global-exposed (Chart 14 on page 10) and commodity-input dependent sector. A modestly weaker outlook for staples is more than reflected in our VI, which is still parked in undervalued territory. Technical conditions are completely washed out, signaling widespread bearishness, which is positive from a contrary perspective. Chart 25 S&P Consumer Staples S&P Consumer Staples S&P Real Estate (Neutral) Ongoing improvements in commercial & residential real estate prices continues to push our real estate CMI higher. However, the outlook for REITs has darkened; rents have crested while the vacancy rate found its nadir in 2016, suggesting further rent weakness on the horizon (Chart 15 on page 10). Further, bankers appear less willing to extend commercial real estate credit; declines in credit availability will directly impact REIT valuations. Our VI is consistent with our Treasury bond indicator, indicating that both are at fair value. Our TI is starting to firm from extremely oversold levels, a positive indication for both 12- and 24-month relative performance. Chart 26 S&P Real Estate S&P Real Estate S&P Health Care (Neutral) Our CMI has rolled over, driven by a steep decline in pharma pricing power (Chart 16 on page 11). In fact, the breadth of sector pricing power softness has spread, just as the majority of the industries we cover is enjoying a selling price revival. The divergence between the CMI and recent sector relative performance suggests that the latter has been mostly politically motivated, and may lack staying power. Worrisomely, the sector wage bill has spiked; in combination with a weaker top line, the earnings resilience of the sector could be at risk. Relative valuations remain appealing, but technical conditions are shaky, as our TI has bounced from oversold levels but is still in negative territory. Taken altogether, we would lean against the recent advance in relative performance. Chart 27 S&P Health Care S&P Health Care S&P Industrials (Neutral) The CMI has recovered smartly in the past couple of quarters, lifted mostly by a weaker U.S. dollar. The sector has moved laterally since the U.S. election. The improved export outlook is a positive, but a lack of response in hard economic data to the surge in confidence is a sizable offset. An inventory imbalance has largely unwound over the past six months, as durable goods orders are easily outpacing inventories, coinciding with a return of some pricing power to the sector (Chart 17 on page 11). Still, years of capacity growth in excess of production and the resulting low utilization rates mean that pricing gains may stay muted unless demand picks up substantially. Our valuation gauge is near the neutral zone, but there is a wide discrepancy beneath the surface, with construction & engineering trading cheaply and railroads and machinery commanding premium valuation multiples. Our TI has returned close to overbought levels, potentially setting the stage for another move higher. Chart 28 S&P Industrials S&P Industrials S&P Utilities (Neutral) Our CMI for the utilities sector remains in a long-term downtrend, albeit one with periodic countertrend moves. Most of the weakness in the CMI relates to external factors, such as robust leading indicators of global economic growth (Chart 18 on page 12). Encouragingly, the sector's wage bill has slowed from punitively high levels, and combined with improving pricing power should allow for some margin recovery (Chart 18 on page 12). Utilities have outperformed other defensive sectors, likely due to the expectation that the new U.S. administration's long-awaited tax reform will have outsized benefits to this domestic-focused industry. As a result, valuations have been creeping up, though not sufficiently enough to warrant an underweight position. Our TI has reversed its steep fall over the past year, but is unlikely to bounce through neutral levels in the absence of a negative economic shock. Ergo, our preferred strategy is to remain at benchmark, but look for tradable rally opportunities. Chart 29 S&P Utilities S&P Utilities S&P Telecom Services (Underweight) Our CMI for telecom services has moved laterally, as much-reduced wage inflation is fully offset by the sector's plummeting share of the consumer's wallet and extremely deflationary conditions (Chart 19 on page 12). Our sales model paints a much darker picture, pointing to double-digit topline declines for at least the next few quarters, owing to the plunge in pricing power deep into negative territory (Chart 19 on page 12). The sector remains chronically cheap, and has all the hallmarks of a value trap, as relative forward earnings remain in a relentless secular downtrend. It would take a recession to trigger a valuation re-rating. Our Technical Indicator has nosedived but, like the VI, cycles deep in the sell zone have not proven reliable indicators that a relative bounce is in the offing. Chart 30 S&P Telecommunication Services S&P Telecommunication Services S&P Materials (Underweight) Recent Fed rate hikes have driven down the CMI close to all-time lows. The sector has historically performed very poorly in tightening cycles owing to U.S. dollar appreciation and the ensuing strains on the emerging world. Weak signals from China have also helped take the steam out of what looked like a recovery in the CMI last year. Commodity-currencies have rallied, but not by enough to offset a relapse in pricing power and weak sector productivity (Chart 20 on page 13). The heavyweight chemicals group (comprising more than 73% of the index) continues to suffer; earnings growth relies heavily on global reflation, an elusive ingredient in the era of a globally synchronized tightening cycle. Sagging productivity warns that profitability will remain under pressure. Valuations have now spent some time in overvalued territory; without a recovery in earnings growth, a derating is a high probability outcome. Our TI has dipped into the sell zone, indicating a loss of momentum and downside relative performance risks. It would be highly unusual for the sector to stay resilient in the face of a negative TI reading. Chart 31 S&P Materials S&P Materials S&P Technology (Underweight) The technology CMI is in full retreat, driven by ongoing relative pricing power declines and new order weakness. However, the sector had been resilient, until recently, as a mini-mania in a handful of stocks and the previously red-hot semiconductor group have provided resilient support. That reflected persistently low inflation and a belief that interest rates would still low forever. After all, tech stocks thrive in a disinflationary/deflationary environment and suffer during inflationary periods (Chart 21 on page 13). Nevertheless, a recovering economy from the first quarter's lull and tight labor market suggest that an aggressive de-rating in sky-high valuations in previous juggernauts is a serious threat, especially if recent disinflation proves transitory. Our relative EPS model signals a profit slide this year. In the context of analyst estimates of double-digit earnings growth, sector downside risk is elevated. Our VI is not overdone, but that partly reflects the massive overshoot during the bubble years. Our TI is extremely overbought, suggesting that profit-taking is likely to persist. Chart 32 S&P Technology S&P Technology Size Indicator (Overweight Small Vs. Large Caps) Our size CMI has retraced some of its 2016 climb, but remains firmly above the boom/bust line. Keep in mind that this CMI is not designed as a directional trend predictor, but rather as a buy/sell oscillator. Small company business optimism is near modern highs, as pricing and consumption vigor push domestic revenues higher. A smaller government footprint, i.e. fewer regulatory hurdles, and tax relief will disproportionately benefit SMEs. The prospect of trade barriers clearly favors the domestically focused small cap universe and underlie part of the post-election euphoria. Top line growth will need to persist if small businesses are to offset a higher wage bill, as labor looks more difficult to import and the economy pushes against full employment. Valuations have improved and the share price ratio has fully unwound previously overbought conditions. We expect the recent rally to gain steam.\ Chart 33 Style View Style View Anastasios Avgeriou, Vice President U.S. Equity Strategy & Global Alpha Sector Strategy anastasios@bcaresearch.com Chris Bowes, Associate Editor chrisb@bcaresearch.com

U.S. airlines have been enjoying some of their highest profits in history, lifted by the collapse in oil prices and cheap financing and the market has rewarded them handsomely (bottom panel). However, the last year has seen a trend shift as excess profits have been eaten away at by the always-cutthroat competition. Further, the stringent labor cost control of the past decade will be difficult to maintain in such a profitable environment. Delta Air Lines (DAL) Q2 results offer some insight; unit revenues grew 2.5% while non-fuel unit costs grew 7.3%. The impact of these margin hits is likely to be magnified if, as we expect, oil prices recover. Overall, we think the sector's best days are receding into the contrails. Stay underweight. The ticker symbols for the stocks in this index are: BLBG: S5AIRL -DAL, LUV, AAL, UAL, ALK. A Hard Landing A Hard Landing

Overweight We booked gains on the rails in late-January of this year as growth worries mounted; since then, relative performance has been in consolidation mode. Now is the time to re-board the rails as these worries have largely dissipated, underpinned by the budding recovery in global trade and a favorable domestic operating backdrop for the largest S&P transportation sub-index. BCA's global industrial production (IP) growth composite is marching steadily higher (second panel). Historically, global IP and rail relative forward EPS estimates have moved in tandem, and the current message is that rail profit outperformance is still in the early stages. On the domestic front, increased freight activity coupled with capacity discipline have started to support a recovery in rail pricing power. Rail margins have significant leverage to pricing changes, and against a backdrop of well contained wage costs and low diesel fuel prices, profit margins should rebound smartly (third panel). All of these factors are captured in our rails EPS model which has surged relative to our S&P 500 profit model (bottom panel). Net, we are boosting the S&P railroads index (BLBG: S5RAIL - CSX, KSU, NSC, UNP) to overweight. Hop On The Rails For A Ride Hop On The Rails For A Ride

Highlights Portfolio Strategy Reviving global trade and an enticing domestic operating backdrop mean that, after a 5-month hiatus, it is once again time to ride the rails. Even a modest reacceleration in global export volumes and domestic food and beverage shipments should propel the S&P containers & packaging index toward cyclical highs. Recent Changes S&P Railroads - Boost to overweight. Table 1 Correlations Explained Correlations Explained Feature A rotational correction remains the dominant market theme; all of the financials sector's gains have mirrored the tech sector's losses. Our view remains that this rotation is healthy, and that consolidation rather than correction is the appropriate broad market context. One catalyst for the late week pullback and escalation of the sub-surface transitions was the Fed's stress test results, which all banks passed. That was a first, and investors cheered a slew of share buyback and dividend payout increase announcements. Meanwhile, narrowing interest rate differentials continue to put downward pressure on the U.S. dollar, allowing inflation expectations to stabilize and spurring a nascent steepening of the yield curve. In fact, a global bond selloff is gaining steam, as the era of extraordinarily easy global monetary policy is likely coming to an end. That should ensure that flows into financial stocks persist, especially given the upbeat message from our profit model (Chart 1). In recent research we have shown how receding correlations are a tonic for stock returns, but the CBOE's implied correlation index is limiting as it covers only one business cycle. Chart 2 shows an average of the pairwise 52-week correlations between 40 equity sectors using weekly S&P return data starting in the late-1990s, alongside the S&P 500 (correlation index shown inverted). The message is similar to the CBOE implied correlation index, as stock correlations collapse, i.e. stock picking gains traction and earnings fundamentals dictate the broad trend, the S&P 500 climbs higher, and vice versa. Chart 1Upbeat EPS Model Message Upbeat EPS Model Message Upbeat EPS Model Message Chart 2Falling Correlations Boost The S&P500 Falling Correlations Boost The S&P500 Falling Correlations Boost The S&P500 Chart 3 goes a step further. Using S&P GICS1 data we ran the same exercise on the top ten sector pairwise correlations all the way back to the mid-1970s. While stock correlations do move inversely with stock prices (not shown), this chart reveals another interesting trend. Chart 3Good Recession Predictor, But Not Worried Yet Good Recession Predictor, But Not Worried Yet Good Recession Predictor, But Not Worried Yet Equity correlations have often led the business cycle. When correlations drop precipitously, recession warnings abound. However, there have been two notable exceptions, in the mid-80s and mid-to-late-90s. Then, correlations fell, but the economy did not enter recession. The common denominator in both of those periods was the drubbing in the commodity pits, especially energy. In other words, commodity deflation morphed into a mid-cycle economic slowdown, but the broad market stayed resilient because the economy skirted recession. In fact, when oil hit $10/bbl in 1986 and 1998, the S&P 500 subsequently surged. The S&P 500 has once again defied oil's gravitational pull (Chart 4), because it has produced a healthy deflation/disinflation rather than a debilitating one (oil inflation shown inverted, Chart 5). Chart 4Slipping Oil Fuels Equities... Slipping Oil Fuels Equities... Slipping Oil Fuels Equities... Chart 5...And The Economy ...And The Economy ...And The Economy As a result, we are not worried about a U.S. recession just yet, despite the drop in stock correlations. Instead, equities have likely navigated through a mid-cycle correction, as in the mid-80s and mid-to-late-90s. This week we continue to add cyclical exposure to our portfolio via upgrading a transport heavyweight, and reiterating our bullish stance on a niche materials global growth play. Hop On The Rails For A Ride Railroad stocks bested the market by 40% from the Q1/2016 trough to the Q1/2017 peak, and we managed to get on board for the bulk of that ride. We booked gains in late-January and since then relative performance has been in consolidation mode. Is it time to re-board the rails now that global growth worries have largely dissipated? The short answer is yes. Two key drivers underpin our bullish thesis: the budding recovery in global trade and a favorable domestic operating backdrop for the largest S&P transportation sub-index. Last week we upped our conviction status to high in the S&P air freight & logistics group, on the back of rising global exports volumes. Rails also benefit from improving trade/economic activity. BCA's global industrial production (IP) growth composite is marching steadily higher (third panel, Chart 6). Historically, global IP and rail relative forward EPS estimates have moved in tandem, and the current message is that rail profit outperformance is still in the early stages. Credit availability is the fuel required to bolster global trade, and easy global monetary and financial conditions are enticing banks to originate loans. According to the BIS, global credit growth is on the mend, and the global credit impulse is accelerating. The implication is that world export growth should continue to climb, to the benefit of rail freight activity, and by extension, relative profitability (Chart 6). While rail shipments have surged since the late-2015/early-2016 manufacturing recession, relative forward earnings momentum has only just recently crossed into positive territory, suggesting that there is additional scope for upward revisions (second panel, Chart 6). On the domestic front, leading rail freight indicators remain upbeat. The manufacturing, wholesale and, most importantly, retail sales-to-inventories ratios continue to expand nicely, signaling buoyant intermodal demand. The CASS freight index is also gaining steam (Chart 12, in the next section) and L.A. port traffic is heavy. Our Railroad Indicator hit a 5-year high recently, and hints that more gains are in store for railroads (Chart 7). Chart 6A Play On Global Growth A Play On Global Growth A Play On Global Growth Chart 7Domestic Outlook Is Positive Domestic Outlook Is Positive Domestic Outlook Is Positive Commodity railcar loads in general, and coal in particular have also staged a recovery, albeit from an all-time low level. Coal is significant as it comprises roughly 20% of all rail shipments and is a high margin category (fourth panel, Chart 8). As the U.S. economy rebounds after a weak Q1, electricity demand should remain firm. The near doubling in natural gas prices in the past 18 months should provide an assist to coal shipments, as the latter will become an increasingly competitively priced alternative for power generation (Chart 8). Increased freight activity coupled with capacity discipline have started to support a recovery in rail pricing power. Rail margins have significant leverage to pricing changes, and against a backdrop of well contained wage costs and low diesel fuel prices, profit margins should rebound smartly (middle panel, Chart 9). Clearly, margin expansion would be a meaningful catalyst for a valuation re-rating (bottom panel, Chart 9). All of these factors are captured in our rails EPS model. The latter has surged relative to our S&P 500 profit model (Chart 10) implying that analysts have room to further upgrade their relative profit estimates. Chart 8Firming Selling Prices... Firming Selling Prices... Firming Selling Prices... Chart 9...Are A Boon For Margins ...Are A Boon For Margins ...Are A Boon For Margins Chart 10Rails EPS Model Says Buy Rails EPS Model Says Buy Rails EPS Model Says Buy In sum, recovering global trade and an enticing domestic operating backdrop underscore that after a 5-month hiatus the time is right to ride the rails once again. Bottom Line: Boost the S&P railroads index (CSX, KSU, NSC, UNP) to overweight. Don't "Pack" It In Now The global macro backdrop is fertile ground for the niche S&P containers & packaging index to stage a run at cyclical relative performance highs. If our thesis that global trade will continue to advance pans out, then packaging stocks should follow in the footsteps of both air freight & logistics and railroad stocks. Export volumes are one of the best predictors of relative profitability, given that packaging companies need high utilization rates to fully demonstrate the scope of their operating leverage. The current synchronized EM and DM economic recovery will continue to underpin global trade. Chart 11 shows that export volumes have hit all-time highs and momentum is also reaccelerating, despite the lack of response in export prices. Importantly, the lack of export price inflation may stoke additional volume gains. The steep rise in overall rail car shipments, increased activity at North American ports and the V-shaped recovery in the CASS freight shipments index also point to earnings outperformance in the coming quarters (Chart 12). Chart 11Another Play On Global Trade... Another Play On Global Trade... Another Play On Global Trade... Chart 12...With Upbeat Domestic Prospects ...With Upbeat Domestic Prospects ...With Upbeat Domestic Prospects Meanwhile, the secular shift away from brick and mortar sales and toward online shopping represents another positive EPS tailwind. The second panel of Chart 13 shows that as online sales continue to grab a rising share of overall retail sales, the packaging industry is a derivative beneficiary, albeit with a lag. Packaging manufacturers also court food and beverage-related industries as their customers. Thus, any food and beverage price swings have a direct impact on volume growth. In other words, when prices rise demand for food and beverages drops and volumes retreat, and vice versa. Now that Amazon is escalating the grocery wars and Aldi and Lidl are also expanding their U.S. footprint, food and beverage price pressure will intensify. The implication is that a volume driven relative profit recovery is brewing (Chart 13). Already, companies in the packaging index are successfully raising selling prices at a healthy clip. Indeed, firming packaging products demand has caused packaging price inflation to breach multi-year highs on a 6-month rate of change basis. If volume growth persists, as we expect, then selling prices should continue to expand and support profit margins (Chart 14). Chart 13Booming Online And Food Volumes Are A Plus Booming Online And Food Volumes Are A Plus Booming Online And Food Volumes Are A Plus Chart 14Margin Expansion Phase Looms Margin Expansion Phase Looms Margin Expansion Phase Looms Simultaneously, the industry is keeping labor costs under control. Such discipline typically aids profit margins. Tack on receding commodity-related input cost inflation and the ingredients are in place for a substantial profit margin and, as a result, EPS expansion. All of this positive news is not yet reflected in still depressed relative valuations. The industry is trading at a 10% discount to the broad market on a forward P/E basis. Even a modest reacceleration in global export volumes and domestic food and beverage shipments should propel the index toward cyclical highs (Chart 13). Bottom Line: Stay overweight the S&P containers & packaging index (IP, BLL, WRK, SEE, AVY). Current Recommendations Current Trades Size And Style Views Favor small over large caps and stay neutral growth over value.

We raised the S&P air freight & logistics group to overweight two months ago, because the budding revival in global trade was not reflected in either valuations or earnings estimates. Looking ahead, firming profit fundamentals now embolden us to add air freight stocks to our high-conviction overweight list. The synchronized DM and EM economic recovery has buoyed the global manufacturing PMI, which continues to trend well above the boom/bust line. Both global export volumes and prices are expanding. Domestically, business shipments-to-inventories ratios are expanding comfortably in all three major segments: manufacturing, wholesale and retail. Yet buoyant global trade expectations are still not baked into tumbling relative sales expectations and deeply discounted valuations remain in place. Consequently, there is scope for a dual increase in valuations and profit estimates, warranting a bump up to our high-conviction overweight list. The ticker symbols for the stocks in this index are: BLBG: S5AIRF - UPS, FDX, CHRW, EXPD. Air Freight Stocks Achieve Liftoff! Air Freight Stocks Achieve Liftoff!

Highlights Portfolio Strategy Swap consumer staples into financials in our pair trade versus the tech sector. Relative profit fundamentals signal that this relative share price ratio will soon come alive. Global growth tailwinds argue for lifting the air freight & logistics index to high-conviction overweight status. Recent Changes S&P Financials/S&P Tech - Switch the long side of the S&P Consumer Staples/S&P Tech pair trade from S&P Consumer Staples to S&P Financials. S&P Consumer Staples - Remove from the high-conviction overweight list. S&P Air Freight & Logistics - Add to the high-conviction overweight list. Table 1Sector Performance Returns (%) Disentangling Pricing Power Disentangling Pricing Power Feature Equities broke out to new highs early last week, and there are good odds that a playable rally will unfold. Investors' jitters have recently focused on the bear market in oil prices and weak core CPI, which have joined forces to push down inflation expectations (Chart 1). However, we have a more bullish interpretation. Unlike in late-2015/early-2016, oil and stock prices have decoupled. True, energy stocks are plumbing multi-decade lows relative to the broad market, but the energy sector comprises less than 6% of the S&P 500's market cap. In fact, the two largest S&P 500 constituents have a greater weight than the 34 stocks in the S&P energy index combined. In other words, the energy sector's broad market influence has been severely diluted. We think it is unlikely that the positive correlation between oil and stock prices reasserts itself. Rather, our sense is that this is likely an energy/commodity-centered deflation that will not have a serious contagion on the rest of the corporate sector. High yield energy spreads continue to widen, but the overall junk spread is flirting with cyclical lows. This stands in marked contrast with the summer of 2014 and late-2015, the last time oil prices melted (second panel, Chart 1). Chart 2 shows that the nonfarm business sector and the GDP implicit price deflators, both of which are reliable corporate sector pricing power proxies, are positively deviating from core CPI. These deflators have historically been excellent leading indicators of inflation and signal that the recent poor inflation prints will likely prove transitory. Importantly, the U.S. is a large closed economy that benefits greatly from lower oil prices, via a boost to discretionary income. Lower energy costs are adding to an already stimulative backdrop owing to the decline in the U.S. dollar and Treasury yields. At the margin, the broad corporate sector also benefits from oil price deflation: energy is a non-trivial input cost. Our more optimistic overall economic and market outlook is also borne out by survey data: economists revised higher their U.S and global GDP growth expectations both for 2017 and 2018, according to Bloomberg estimates (bottom panel, Chart 1). Finally, real yields, the bond market's gauge for economic growth expectations, have climbed close to a 2-year high, and suggest that GDP growth will soon pick up steam (Chart 1). Our view remains that this is a goldilocks scenario for equities, as it may keep the Fed at bay for a while longer and sustain easy financial conditions. This thesis also assumes that the corporate sector will maintain its pricing power gains, and likely pull consumer prices out of their lull. On that front, we have updated our corporate pricing power proxy and while it has lost some steam of late, it continues to expand at a healthy clip (Chart 3). Chart 1Decoupled Decoupled Decoupled Chart 2Implicit Price Deflators Lead Core CPI Implicit Price Deflators Lead Core CPI Implicit Price Deflators Lead Core CPI Chart 3Corporate Pricing Power Is Fine Corporate Pricing Power Is Fine Corporate Pricing Power Is Fine Table 2 shows our updated industry group pricing power gauges, which are calculated from the relevant CPI, PPI, PCE and commodity growth rates for each of the 60 industry groups we track. The table also highlights shorter term pricing power trends and each industry's spread to overall inflation in order to identify potential profit winners and losers. Table 2Industry Group Pricing Power Disentangling Pricing Power Disentangling Pricing Power Our analysis concludes that still ¾ of the industries we cover are enjoying rising selling prices and 43% are also beating overall inflation rates. Admittedly, the inflation rates have come down since our April update, and there was a tick up in the number of deflating industries from 14 to 16, but that figure is still down from the 19 registered in January. Importantly, 27 out of 60 industries have clocked a rising pricing power trend down from 31 in April, but still up from 20 in January, 14 have a flat trend and 19 are falling. Encouragingly, corporate sector selling prices are still comfortably outpacing wage inflation, which suggests that the positive momentum in profit margins has staying power (Chart 3). One theme that stands out from our analysis is that commodity related industries have either falling or flat inflation trends, with the exception of aluminum and chemicals. We take this as confirmation that resources are at the epicenter of deflation/disinflation pressures. Similarly, the majority of tech sub-sectors are still fighting deflation and suffer from a flat or down trend in selling prices. Adding it all up, the recent mild slowdown in corporate sector selling prices is transitory, mostly commodity related and unlikely to infect the broad business sector. There are high odds that an earnings-led playable break out phase in the equity market will develop from here. This week we promote an industrials sub-sector to our high-conviction overweight list and swap a safe haven sector out, and also tweak our long/short pair trade. Pair Trade Tweak: Long Financials/Short Tech Over the past month, we have reduced the extent of our consumer staples overweight, downgrading soft drinks to underweight and hypermarkets to neutral. In contrast, in May we boosted the S&P financials index to overweight on the back of improving earnings fundamentals. As a result, swapping out consumer staples for financials in our existing pair trade versus the tech sector makes sense. This relative share price ratio is at a critical juncture and has dropped to its long term support level (top panel, Chart 4). Importantly, the relative market capitalization differential is at its widest gap since the tech bubble (Chart 5) and a renormalization is in order. Chart 4Long Term Support Should Hold Long Term Support Should Hold Long Term Support Should Hold Chart 5Unsustainable Gap Unsustainable Gap Unsustainable Gap The valuation case is equally compelling: financials are deeply undervalued and unloved compared with the tech sector (Chart 4), such that even a modest shift in sentiment would drive a large relative price swing. The macro outlook is rife with catalysts to trigger a renormalization. Our respective Cyclical Macro Indicators (CMI) signal that financials profits will best tech sector earnings in the coming quarters (top panel, Chart 6). Historically, relative performance has moved in lockstep with relative profitability. The message from our CMIs is that relative earnings will move decisively in favor of the financials sector, thereby producing positive price momentum (bottom panel, Chart 6). A simple relative demand indicator concurs with our CMIs message: bank loan growth should outpace tech capital expenditures in the back half of the year. The middle panel of Chart 6 shows our recently published bank loans and leases regression model compared with our U.S. Capex Indicator (a good proxy for tech spending) and the message is to expect a catchup phase in relative share prices. If our thesis proves accurate, then relative demand will soon show up in relative top line figures. On that front, our forward looking relative sales per share models argue that the budding recovery in relative revenue is sustainable (Chart 7). Relative pricing power dynamics provide another source of support, both in terms of sales and operating profit margins. Firming financials pricing power is the mirror image of chronically deflating tech selling prices (Chart 7). Keep in mind that overall mild price inflation is a boon for financials because it will keep monetary conditions from becoming overly tight, which would undermine credit quality and availability. Using the nonfarm business sector's implicit price deflator as a proxy for overall inflation, the (third panel, Chart 7) shows that relative share prices move in lockstep with overall corporate sector prices. In terms of economic undercurrents, if geopolitical risks remain muted and financial conditions reasonably accommodative, then a further boost in economic and investor sentiment is likely. History shows that the financials/tech share price ratio has benefited when risk premia recede. The same relationship is also evident in the positive correlation with our U.S. sentiment indicator and real 10-year bond yield (Chart 8), and inverse correlation with corporate bond spreads (not shown). Chart 6Heed The Relative##br## CMI Signal Heed The Relative CMI Signal Heed The Relative CMI Signal Chart 7Financials Have##br## The Upper Hand Financials Have The Upper Hand Financials Have The Upper Hand Chart 8Improving Economy = ##br##Go Long Financials/Short Tech Improving Economy = Go Long Financials/Short Tech Improving Economy = Go Long Financials/Short Tech Finally, recent positive bank sector news suggests that financials have the upper hand in this share price ratio. Banks passed the Fed's stringent stress test with flying colors and should become more shareholder friendly, i.e. boost dividend payouts and reinstate/augment share retirement. In addition, even a modest watering down of Dodd-Frank will also lift the appeal of banks and financials at the expense of tech stocks in the coming quarters. Adding it up, we recommend swapping consumer staples with financials in our pair trade versus the tech sector. Relative profit fundamentals suggest that this relative share price ratio will soon spring into action. Bottom Line: Switch consumer staples out and sub financials in the pair trade versus tech stocks. We are also removing the S&P consumer staples index from our high-conviction overweight list for a modest gain of 0.1% since the early-January inclusion. The latter move makes room for an upgrade to high-conviction of a transportation sub-group that has caught fire since our recent upgrade to overweight. Air Freight Stocks Achieve Liftoff! We raised the S&P air freight & logistics group to overweight two months ago, reflecting a lack of recognition in either valuations or earnings estimates that a global trade revival was unfolding and washed out technical conditions. Since then, this transportation sub-group has regained its footing, and firming profit fundamentals now embolden us to add air freight stocks to our high-conviction overweight list. The relative share price ratio has smartly bounced off its GFC lows. Similarly, our Technical Indicator found support at one standard deviation below the historical mean, a typical launch point for playable rallies. Importantly, deeply discounted valuations remain in place, both in terms of P/S and P/E ratios (Chart 9). We expect the rebound in global growth to help unlock excellent value in air freight equities. Global trade is reviving. The synchronized DM and EM economic recovery has buoyed the global manufacturing PMI, which continues to trend well above the boom/bust line. Both global export volumes and prices are expanding. Yet buoyant global trade expectations are still not reflected in tumbling relative sales expectations (Chart 10). Chart 9Unwarranted ##br##Grounding Unwarranted Grounding Unwarranted Grounding Chart 10Buoyant Trade Growth Is Neither Reflected##br## In Collapsing Sales Expectations... Buoyant Trade Growth Is Neither Reflected In Collapsing Sales Expectations... Buoyant Trade Growth Is Neither Reflected In Collapsing Sales Expectations... Chart 11 highlights two additional Indicators to gauge the stage of the global trade recovery. Korea and Taiwan are two small open economies: exports in both countries are accelerating. Meanwhile, our Global Trade Activity Indicator, comprising the economically-sensitive Baltic Dry Index and lumber prices, is also waving a green flag. The upshot is that a number of Indicators confirm that a durable pickup in trade is underway, which should ultimately translate into a recovery in relative earnings expectations (Chart 11). Domestically, business shipments-to-inventories ratios are expanding comfortably in all three major segments: manufacturing, wholesale and retail (bottom panel, Chart 10). Anecdotally, recent news that FedEx beat both top and bottom line estimates also reinforces a firm global activity backdrop. All of this serves as reliable evidence that the budding recovery in global (and domestic) growth has morphed into a sustainable advance. The implication is that air freight pricing power has ample room to grow. Wholesale price momentum has reached a 5-year high. If our thesis plays out, more pricing power gains are in store, which will boost profit margins given the industry's impressive labor cost restraint and high operating leverage (Chart 12). Chart 11...Nor In Depressed##br## Forward EPS ...Nor In Depressed Forward EPS ...Nor In Depressed Forward EPS Chart 12Margin Expansion##br##Phase Looms Margin Expansion Phase Looms Margin Expansion Phase Looms Finally while investors are digesting the Walmart in-store pick up option and Amazon's push for its own delivery service plans, the persistent ascent in online shopping suggests that the structural increase in rapid delivery services will remain intact. Investors should expect pricing power to gravitate toward the long-term trend (bottom panel, Chart 12). Tack on the recent corrective action in the commodity pits and this group also benefits from the fall in fuel costs. Taken together, profit margins should resume expanding. In sum, appealing relative valuations along with a durable synchronized global growth rebound argue for increasing conviction in our overweight position in this transportation sub-group. Bottom Line: Stay overweight the S&P air freight & logistics group (UPS, FDX, CHRW, EXPD), and bump it to the high-conviction overweight list. Current Recommendations Current Trades Size And Style Views Favor small over large caps and stay neutral growth over value.

The Empire State Manufacturing and Philadelphia Fed Business Outlook surveys typically move in lockstep and their message last week was united; the domestic outlook for manufacturing is exceptionally strong. Both surveys have historically been reliable indicators for industrial machinery orders, which have only recently turned positive (second panel). A softer U.S. dollar too should lift demand with roughly 40% of revenues derived internationally. Capacity utilization should not present a roadblock to much higher production, as it remains below normal for this stage in the order cycle (third panel). As utilization rates firm, pricing power should gain strength. Despite the improving outlook, valuations have been stuck in neutral, as earnings estimates are rising faster than relative share prices. Importantly, the relative forward P/E remains well below previous bull market peaks (fourth panel). Stay overweight. The ticker symbols for the stocks in this index are: BLBG: S5INDM - ITW, IR, SWK, PH, FTV, DOV, PNR, XYL, SNA, FLS. Cranking Up The Industrial Machinery Engines Cranking Up The Industrial Machinery Engines

Highlights Portfolio Strategy The consumer staples recovery is sales-driven, underscoring that additional outperformance lies ahead. The lagging hypermarkets and retail food industries are starting to play catch up, reflecting a shift in consumer spending patterns. Use the drubbing in air freight shares to upgrade to overweight. Recent Changes S&P Air Freight & Logistics - Upgrade to overweight from neutral. Table 1Sector Performance Returns (%) Pricing Power Comeback Pricing Power Comeback Feature Equities caught a bid last week, after holding at the bottom end of their tactical trading range. The overall consolidation phase likely has further to run, but should ultimately be resolved in a positive fashion. Chart 1Ongoing Margin Expansion Ongoing Margin Expansion Ongoing Margin Expansion Real economic performance continues to lag relative to exuberant 'soft' economic survey data, while the odds of meaningful pro-cyclical U.S. fiscal largesse fade. Inflation expectations are softening as commodity prices dip, while the yield curve is narrowing. These factors are likely to sustain ambiguity about the durability and strength of the expansion. But in the background, the corporate sector continues to heal slowly, aided by the hiatus in the U.S. dollar bull market. The latter is enabling some corporate pricing power revival. Our pricing power diffusion index has surged alongside our pricing power proxy (Chart 1, second panel). The broadening of selling price inflation bodes well for the sustainability of corporate sector pricing power gains. We have updated our industry group pricing power gauges (see Table 2), comprising the respective CPI, PPI, PCE and commodity year-over-year changes for 60 industry groups. The table details the most recent annual and 3-month pricing power trends and each industry's spread to overall inflation in order to identify potential profit winners and losers. Our analysis reveals that ¾ of the industries tracked are experiencing rising selling prices, and half are also besting overall inflation rates. Only 14 of 60 industries are in outright deflation, versus 19 in January and 23 last September. Importantly, 31 of 60 industry groups are enjoying a rising pricing trend, a 50% increase from last quarter, 9 are moving laterally and only 20 are fading. The implication is that upward momentum in pricing power is gathering steam. Importantly, the rate of selling price inflation is outpacing wage bill growth, which heralds some incremental near-term torque for profit margins (Chart 1, bottom panel). Are there any themes of note? Cyclical sectors continue to dominate the table with energy and materials taking the top two spots, although recent corrective action in the commodity pits suggests that these gains may peter out. The technology sector is a notable exception within deep cyclicals, as most tech sub-groups still have to slash prices (Table 2). Early cyclicals (or interest rate-sensitives) also show strength, with banks, insurers, and media-related groups managing to lift selling prices at a decent rate. Select defensives like health care and utilities are expanding pricing power, but the overall consumer staples and telecom services sectors are lagging. Table 2Industry Group Pricing Power Pricing Power Comeback Pricing Power Comeback Adding it all up, there are tentative signs that the profit advantage may be starting to slowly shift away from defensives. In that light, we are closely monitoring several factors that could expedite a transition to a more balanced portfolio from our current defensive bias. First, the gap between hard and soft data remains unusually wide (Chart 2). The longer hard data takes to play catch up, the less likely the Fed will be re-priced more aggressively. History shows that until this gap narrows, defensive sectors are likely to retain the upper hand in terms of relative performance (Chart 2), while financials could continue to languish owing to uncertainty about the path of future Fed policy. Second, commodity prices and the U.S. dollar - especially versus emerging market (EM) currencies - are still signaling that the cyclical/defensive ratio has more downside (Chart 3). Finally, within the context of the current broad equity market consolidation, it should continue to pay to remain with a defensive over cyclical portfolio tilt for a little while longer (Chart 4, top panel). Chart 2The Gap ##br##Is Closing The Gap Is Closing The Gap Is Closing Chart 3Monitoring The U.S. ##br##Dollar And Commodities1 Monitoring The U.S. Dollar And Commodities Monitoring The U.S. Dollar And Commodities Chart 4Stick With Defensives##br## For A While Longer Stick With Defensives For A While Longer Stick With Defensives For A While Longer Nevertheless, we will likely use this phase to make additional portfolio adjustments. The wide gap between emerging/developing markets performance and the cyclical/defensive share price ratio has narrowed significantly year-to-date, suggesting that defensive outperformance may be in the late stages. In sum, equity markets are in a transition phase and we are further tweaking our intra-industrials positioning after using recent underperformance to upgrade to neutral. We are also updating our high-conviction consumer staples view, and two unloved staples sub-groups. The Consumer Staples Sector Remains Appealing As part of this year's defensive sector leadership, the consumer staples sector has confounded its critics and registered a solid year-to-date relative performance gain. We expect additional near-term upside on the back of both internal and external drivers. Consumer staples companies are enjoying a revenue renaissance. Domestically, non-discretionary retail sales are gaining market share from discretionary outlays (Chart 5), reflecting consumers structurally ingrained propensity to save vs. spend since the financial crisis. Even exports are contributing to rising revenues, despite the U.S. dollar's appreciation (Chart 5). Easing monetary conditions in the emerging markets are underpinning domestic demand, benefiting U.S. staples exporters. Improving demand and cost containment are boosting operating profit margins (Chart 5, fourth panel). This should ensure that the sector continues to register meaningful free cash flow growth, a refreshing difference with the overall corporate sector. Meanwhile, external factors also point to a further relative performance recovery. The bond-to-stock ratio is joined at the hip with relative performance momentum, and a mean reversion phase is unfolding (Chart 6). Geopolitical uncertainty, the risk of a cooling in economic momentum following the downturn in the Economic Surprise Index could fuel flows into this non-cyclical sector. Chart 5Domestic And International##br## Positive Demand Drivers Domestic And International Positive Demand Drivers Domestic And International Positive Demand Drivers Chart 6Financial Variables ##br##Reinforce Staples Bid Financial Variables Reinforce Staples Bid Financial Variables Reinforce Staples Bid There is both valuation and technical motivation for capital inflows. Chart 6 shows that our Technical Indicator has troughed near one standard deviation below the historical mean. Every time this has occurred in the last decade, a sizable relative share price recovery has ensued. There are no valuation roadblocks, countering the assertion that defensive sectors are all overvalued in relative terms (Chart 6). As a result, this sector remains a high-conviction overweight, especially with two previous lagging groups now exhibiting signs of a recovery. Hypermarket Green-Shoots The hypermarkets industry is sprouting a number of green-shoots that should further propel the recent advance in relative share price performance. The industry is enjoying profit margin support on two fronts. Import prices are still deflating (Chart 7), and the nascent rebuilding in Asian manufacturing inventories suggests that pricing pressure will persist. On the revenue front, Wal-Mart recently noted that store traffic continues to improve, albeit aided by discounting. A tight labor market is supporting aggregate wage growth, especially those in lower income brackets, which is supportive of total hypermarkets sales. Importantly, the need to slash prices to attract more customers should abate courtesy of improving demand. The overall retail sales price deflator has climbed into positive territory. Hypermarket sales growth is highly correlated with overall retail selling price inflation (Chart 8). Chart 7Input Costs Will Remain Contained Input Costs Will Remain Contained Input Costs Will Remain Contained Chart 8Low Profit Hurdle Low Profit Hurdle Low Profit Hurdle At least some of the improvement in pricing power reflects an easing in food industry deflation, which implies that the intensity of price wars with food retailers will diminish. Total outlays on food and beverages are climbing as a share of total consumer spending after falling for six consecutive years (Chart 8). These elements are captured by our hypermarkets earnings pressure gauge, which is signaling a rosier sales and EPS growth backdrop (Chart 8, fourth panel). If the border adjustment tax continues to lose momentum, the risk premium for this group should narrow. Food Retailers Are Down, But Not Out Elsewhere, the drubbing in food retailers looks overdone. The relative share price ratio is at a multi-decade low. Investor fears have concentrated on industry selling price deflation, which has weighed on already razor thin profit margins. Nevertheless, a turnaround is afoot, and we would lean against extreme bearishness. As noted previously, consumer spending on food and beverages are gaining a foothold relative to overall outlays. That is supporting a reacceleration in grocery store same-store sales. With the unemployment rate this low, wage inflation is expected to sustain recent gains. Rising incomes are synonymous with higher consumer spending power. Thus, the rebound in industry sales has more upside (Chart 9). The upshot of consumers' increased food appetite is that the food CPI is exiting deflation (Chart 10). That should go a long way in allaying investor profit margin concerns. Chart 9Buy The Wash ##br##Out In Food Retailers... Buy The Wash Out In Food Retailers... Buy The Wash Out In Food Retailers... Chart 10...Because The Deflation##br## Threat Is Diminishing ...Because The Deflation Threat Is Diminishing ...Because The Deflation Threat Is Diminishing Previous pricing pressure forced grocers to refocus on productivity. The industry's total wage bill has cooled significantly. Our productivity proxy, defined as sales/employee, is accelerating, hitting growth rates last seen more than five years ago, when share prices were trading at much higher valuations (Chart 10). Bottom Line: We reiterate our overweight stance both in the S&P hypermarkets and the compellingly valued S&P food retail index. The ticker symbols for the stocks in these indexes are: WMT, COST and KR, WFM, respectively. Air Freight Stocks Will Spread Their Wings The sell-off in transportation stocks has progressed to the point where pockets of value are materializing. Specifically, air freight and logistics stocks have been pummeled, trading down to the bottom of their post-GFC trading range (Chart 11). This is a playable opportunity. Relative performance has returned to levels first reached in the depths of the GFC. Bears have pushed valuations and technical conditions to extremely washed out levels. Both the forward P/E and price-to-sales ratios have collapsed, trading significantly below their historical means and at a steep discount to the S&P 500 (Chart 11). To be sure, a number of forces have fueled the selling. Industry activity is running below capacity, as evidenced by weakness in industry average weekly hours worked (Chart 11). The loss of momentum in internet sales compared with bricks and mortar retail sales may be causing some concern about the pace of future land deliveries (Chart 11). Walmart's news that it is offering an in-store pick up option for online orders has also spooled investors. Amazon's push for its own delivery service is a longer-term yellow flag. Nevertheless, deeply discounted valuations and depressed earnings growth expectations imply that these drags are already reflected in prices. In fact, more recently analysts have pushed the net earnings revision ratio back into positive territory. We expect additional upside as global trade improves. While we were concerned about global trade last November when we downgraded to neutral, there is more evidence now that global revenue ton miles will reaccelerate. The surge in BCA's boom/bust indicator and advance in the business sales-to-inventories (S/I) ratio are both signaling that global trade will continue to recover (Chart 12). The sustainability of the S/I improvement looks solid. The global manufacturing PMI has shot higher on the back of a synchronized developed and emerging market final demand improvement, which heralds accelerating global export volumes (Chart 12). hiatus in the U.S. dollar bull market has also provided much needed reflationary relief to the emerging world. We expect these global forces to overwhelm recent domestic freight demand concerns. Importantly, global exports have been positively correlated with air freight pricing power and the current message is to expect price hikes to stick (Chart 13, third and fourth panels). Keep in mind that air freight companies typically command greater pricing power when the supply chain is lean and lead times begin to lengthen, because companies will pay up to ensure product/parts availability. Chart 11Grim News Is Well Discounted Grim News Is Well Discounted Grim News Is Well Discounted Chart 12Recovering Global Trade... Recovering Global Trade... Recovering Global Trade... Chart 13...Is A Boon To Air Freight Pricing Power ...Is A Boon To Air Freight Pricing Power ...Is A Boon To Air Freight Pricing Power In sum, a durable recovery in global trade should ignite an earnings led relative outperformance phase in the S&P air freight & logistics index. Bottom Line: Boost exposure to overweight in the S&P air freight & logistics sub-group. The ticker symbols for the stocks in this index are: BLBG: S5AIRFX - UPS, FDX, CHRW, EXPD. Current Recommendations Current Trades Size And Style Views Favor small over large caps and stay neutral growth over value.

Portfolio Strategy Any meaningful weakness in the U.S. dollar could accelerate the budding recovery in corporate revenue growth after a multiyear malaise. Following this year's underperformance, lift the industrials sector to neutral via an upgrade in machinery stocks. The recent jump in auto parts stocks is a selling opportunity. Recent Changes S&P Industrial Machinery - Boost to overweight from underweight. S&P Construction Machinery & Heavy Trucks - Lift to neutral from underweight. S&P Industrials Sector - Remove from high conviction underweight and augment to neutral. Table 1Sector Performance Returns (%) Revenue Revival Revenue Revival Consolidation remains the dominant tactical market theme. The question is whether momentum behind the cyclical advance will fade at the same time? Our sense is that the overshoot will reassert itself once the corrective phase has run its course. Two weeks ago we updated a number of qualitative factors that suggested that a major market peak had not yet arrived, even though the rally is approaching retirement age and valuations are full. Other variables concur. For instance, while cash holdings are being depleted, they are not yet running on empty, gauging from survey data or depicted as a share of total market capitalization. Surprisingly, there are still a large number of bearish individual investors (Chart 1). Thus, drawing sidelined cash back into stocks at current stretched valuations and with buoyant expectations requires a resumption of top-line growth. Revenue growth has been conspicuously absent throughout the past few years of the bull market. Companies have supported per share profits through cost cutting and aggressive share buybacks, typically funded through debt issuance. Sustaining high valuations without reinvesting for growth is hard enough, but it becomes an even more onerous task without top-line expansion. There is room for cautious optimism. Deflation pressures have abated, and companies are enjoying a modest pricing power revival. As outlined in our regular industry group pricing power updates, the majority of sectors and industries are now able to lift selling prices, and an increasing number are able to keep pace with overall inflation. Our pricing power proxy has moved decisively back into positive territory (Chart 2), following a pattern typically reserved for when the economy exits recession. Even deflation in the chronically challenged retailing sector is ebbing. Chart 1Bears Still Have A Little Cash Bears Still Have A Little Cash Bears Still Have A Little Cash Chart 2Revenue Revival Revenue Revival Revenue Revival Importantly, both core inflation and inflation expectations remain well below the zone that would cause the Fed to tighten more aggressively than is currently expected (Chart 3). If financial conditions remain relatively easy, then business activity should stay sufficiently brisk to foster further pricing power improvement, i.e. a return to deflation is unlikely. The readings from both the ISM services and manufacturing sectors, and firming business confidence (Chart 2), indicate brighter revenue opportunities. The pickup in world trade volumes implies that goods and services are flowing more freely than they have for several years, and provided protectionist policies do not gain traction, a rebound in global growth should be supportive of total business sales. We doubt there is a vigorous top-line thrust ahead given that potential GDP growth around the world is limited, but modest growth is probable. If the U.S. dollar were to weaken substantially, especially if it occurred within the context of better economic growth abroad, then revenue upside would increase. Chart 4 shows that S&P 500 sales advanced significantly after the last two major U.S. dollar bull markets peaked. Chart 3The Fed Still Has Latitude The Fed Still Has Latitude The Fed Still Has Latitude Chart 4A Top-Line Boom ##br##Requires Dollar Depreciation A Top-Line Boom Requires Dollar Depreciation A Top-Line Boom Requires Dollar Depreciation In sum, the sales outlook has brightened, which is critical to absorbing the increase in labor costs and cushioning the profit margin squeeze. If investors begin to factor in sales-driven earnings growth, rather than buyback and cost cutting-dependent improvement, then it is plausible that the overshoot in stocks will be extended for a while longer. As outlined in recent weeks, the easing in the U.S. dollar allows for some selective bargain hunting in the lagging deep cyclical sectors, which have underperformed this year. This week we are prospecting in the industrials sector. The Wheels Are Turning: Upgrade Machinery Machinery stocks have been stronger than we anticipated. It is doubtful that an underweight position will pay off even if the broad market stays in a corrective phase. Many of the sales and earnings drags on the broad machinery industry, which comprises both industrial machinery and construction machinery & heavy trucks indexes, are lifting. Our primary concerns had been that the overhang from a lack of resource-related investment and a strong U.S. dollar would undermine sales performance (Chart 5). The former may not change much given poor resource balance sheet health, but the U.S. dollar has stopped appreciating. The currency bull market may have gone on extended hiatus if foreign growth continues to improve and the recent disappointing U.S. labor market report was the beginning of a period of economic cooling, as we expect. Despite the resilience of relative share performance, the machinery group is not overpriced based on a normalized relative forward P/E basis (Chart 5). A move to above average valuations requires an acceleration in relative profits. The objective message from our models has turned upbeat. Our Global Capital Spending Indicator has climbed back into positive territory. That primarily reflects the firming in global purchasing manager's surveys. G3 capital goods order momentum has not yet pushed above zero, but should soon recover based on our model (Chart 6). Chart 5Two Drags, But... Two Drags, But... Two Drags, But... Chart 6... Other Engines Are Revving ... Other Engines Are Revving ... Other Engines Are Revving Developing economies may soon participate to a greater degree, if the budding turnaround in long moribund Chinese loan demand gains traction (Chart 6). While China has begun to target a cooler housing market, the improvement in overall credit demand should provide an important offset. Other developing countries are easing policy and trying to spur growth, which should help machinery consumption. When global output growth recovers, machinery demand tends to demonstrate its high beta characteristics. Chart 6 shows that our global, excluding the U.S., machinery new orders proxy has jumped sharply in recent months, consistent with our global machinery exports proxy (Chart 6). While the previously strong U.S. dollar threatened to divert this demand to non-U.S. competitors, the playing field has leveled: U.S. machinery new orders have accelerated. The revival in coal prices is a major plus, given that the coal industry is a key source of domestic machinery demand (Chart 7, second panel). The new order jump, especially compared with inventories, bodes well for additional strength in machinery output (Chart 7, middle panel). Faster production should further propel our productivity proxy, which already suggests analyst earnings upgrades lie ahead (Chart 7). Better machinery sales prospects will add to the productivity gains already evident from cost control and capacity restraint. Chart 8 shows that machinery companies have had a clear focus on profit margin preservation. Headcount continues to contract, while inventories at both the wholesale and manufacturing levels are lean. Chart 7New Order Recovery New Order Recovery New Order Recovery Chart 8Lean Lean Lean There is corroborating evidence of tight supplies, as machinery selling prices are climbing anew even though factory utilization rates are not far off their lows (Chart 8). If demand strength persists, then additional pricing power upside is probable. All of this argues for making a full shift from underweight to overweight in the S&P industrial machinery group. This full upgrade does not extend to the S&P construction machinery & heavy trucks sub-component. Heavy truck sales are very weak, and the outlook for agriculture and food prices is shaky. Food commodity prices remain depressed (Chart 9), which will limit agricultural spending budgets. There is a high correlation between raw food price inflation and relative forward earnings estimates. Moreover, we remain skeptical that the resource industry is about to embark on a major expansion. Instead, only maintenance capital spending is probable, which is not conducive to driving a meaningful increase in construction machinery demand. It is notable that Caterpillar's machine sales to dealers continue to contract throughout most regions of the world. As such, chronic pricing power pressure will persist, keeping relative forward earnings under wraps (Chart 9). In sum, we are shifting our industrial machinery recommendation from underweight to overweight, to reflect the hiatus in the U.S. dollar bull market and firming in other leading top-line growth indicators. The S&P construction machinery & heavy trucks index only warrants an upgrade to neutral. These allocation changes argue for removing the overall industrials sector from our high-conviction underweight list, protecting the profit that accrued from year-to-date underperformance. From an industrials sector standpoint, it has paid to be skeptical of extrapolating the scale of the surge in leading sentiment indicators, such as capital spending intentions. However, enough evidence has now materialized to expect that the contraction in industrials sector relative forward earnings momentum should soon draw to a close. Core durable goods orders recently returned to growth territory, supporting the budding upturn in our Cyclical Macro Indicator (Chart 10). Both herald profit stabilization. Pricing power has rebounded, although capital goods import prices are still deflating, albeit at a lesser rate. Chart 9A Laggard A Laggard A Laggard Chart 10Our Models Have Perked Up Our Models Have Perked Up Our Models Have Perked Up Importantly, U.S. export price inflation is no longer lagging the rest of the world, suggesting that the U.S. manufacturers are regaining competitiveness (Chart 10). The upshot is that deflationary pressures are easing. Bottom Line: Lift the S&P industrial machinery index to overweight and the S&P construction machinery & heavy trucks index to neutral. We are also taking the industrials sector off of our high-conviction underweight list and raising allocations to neutral, partially to protect against a continued lateral move in the U.S. dollar. The ticker symbols for the stocks in the S&P construction machinery & heavy truck index are: BLBG: S5CSTF-CAT, PCAR, CMI. The ticker symbols for the stocks in the S&P industrial machinery index are: BLBG: S5INDM-ITW, IR, PH, SWK, FTV, DOV, PNR, SNA, XYL, FLS. Auto Components: Engine Trouble While we are upbeat on the broad consumer discretionary index and recently augmented restaurants to overweight, the niche S&P auto components index remains in the underweight column. Is such bearishness still warranted, especially following recent signs of life in share prices? The short answer is yes. Vehicle sales have plateaued and are unlikely to reaccelerate because pent-up demand has been fully exhausted and auto credit is harder to come by. Banks have started tightening the screws on auto loans. Auto loan delinquency rates are hooking up and charge-off rates have been rising sequentially since Q2/2016 according to the latest FDIC Quarterly Banking Profile. That reflects previous lax lending standards, especially in the sub-prime category. As credit availability dries up, auto loan growth will continue to deteriorate. Chart 11 shows that subprime auto loan originations have an excellent track record in leading light vehicle sales, given that they represent the marginal buyer. Moreover, rising interest rates are also denting affordability (Chart 11, bottom panel). All of this suggests low odds of renewed strength in vehicle demand. The last time vehicle sales flat-lined was in the middle of the last decade, from 2003 to 2007, share prices underperformed reflecting a relative valuation squeeze (Chart 11). Importantly, deflation has taken root in the auto industry and will likely intensify in the coming months. Auto factories are reasonably quiet, in sharp contrast with the recovery in overall industrial production (Chart 12). Chart 11Tighter Auto Loan Standards... Tighter Auto Loan Standards... Tighter Auto Loan Standards... Chart 12... Will Sustain Deflationary Forces ... Will Sustain Deflationary Forces ... Will Sustain Deflationary Forces The auto shipments-to-inventories ratio is probing multi-decade lows and car parts inventories both at the retail and manufacturing levels are beginning to pile up (Chart 13). Without a resurgence in vehicle sales, inventory liquidation pressures will rise, reinforcing the deflationary impulse and warning that industry earnings will likely underwhelm. Moreover, used car prices have nosedived. Used car prices tend to lead new car price inflation (Chart 12). Recent anecdotes of cutthroat competition in dealerships, with massive incentives failing to turn around sales, signal that deflation along the supply chain will likely become entrenched. Finally, international sales are unlikely to fill in the domestic void. Emerging markets (ex-China) automobile sales have been contracting, heralding an underperformance phase for the S&P auto components index (Chart 14, top panel). Chart 13Too Much Supply Too Much Supply Too Much Supply Chart 14No Global Relief No Global Relief No Global Relief There could be a respite if the U.S. dollar weakens substantially (Chart 14, second panel), but historically high relative valuations warn that optimism has already run ahead of the cloudy earnings outlook (Chart 14, bottom panel). Adding it up, auto demand will remain uninspiring as banks tighten their grip on auto loan lending standards, industry deflation is gaining steam owing to inventory accumulation, and there is no sizeable offset from foreign sales. This is recipe for an underweight position. Bottom Line: We reiterate our underweight stance in the S&P auto components index. The ticker symbols for the stocks in the S&P 1500 auto components index are: DLPH, GT, BWA, GNTX, DAN, DORM, LCII, CTB, CPS, THRM, AXL, FOXF, SMP, MPAA, SUP. Current Recommendations Current Trades Size And Style Views Favor small over large caps and stay neutral growth over value.