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Geopolitical tensions in the South China Sea are here to stay; China has reached the ability to impose massive costs on any state that tries to roll back its control; U.S. advantages in the region are significant, but declining and overrated. We put together a portfolio of stocks that give investors exposure to the ongoing tensions in the South China Sea. Dear Client, Today's Special Report is jointly authored by BCA's Geopolitical Strategy and Emerging Markets Equity Strategy services and focuses on the tail risks around the South China Sea conflict. In this report, our colleagues Matt Gertken of the Geopolitical Strategy and Oleg Babanov of the Emerging Markets Equity Sector Strategy ask whether China has "won" the South China Sea, and what the implications might be for investors. At the end of the report, we provide detailed investment recommendations for both EM-dedicated as well as global investors. Kindest Regards, Garry Evans Senior Vice President EM Equity Sector Strategy Marko Papic Senior Vice President, Geopolitical Strategy "We're going to war in the South China Sea in five to 10 years ... There's no doubt about that." - Steve Bannon, prior to becoming President Donald Trump's Chief Strategist, Breitbart News, March 2016 The South China Sea is a headline grabber that has failed to produce any market-disruptions despite years of rising tensions. In fact, it would appear that the issue has been relegated to the backburner, with the Trump administration laying off its earlier aggressive rhetoric and America's Asian allies focusing on building a trade relationship with China. Compared to the Koreas, in particular, where geopolitical risk is spiking due to political turmoil in the South and weapons advances in the North, the South China Sea seems relatively calm.1 We are not so sanguine, however, and advise investors to take the tail-risk of a conflict in the South China Sea seriously. First, there has been a general "rotation" of global geopolitical risk from the Middle East to Asia Pacific, as BCA's Geopolitical Strategy has chronicled over the years.2 China's transformation into a "peer" or "near-peer" competitor to the United States, and the U.S.'s various reactions, are transforming the region and sowing the seeds of a new Cold War. Second, despite a thaw in the relationship between China and the Trump Administration, the latest positive signals have not extended to the South China Sea.3 In North Korea, China is offering to enforce sanctions. In Taiwan, Trump has backed away from hints of encouraging independence. But in the South China Sea, the two sides have increased activity even as they have made reassuring statements.4 Third, fact remains that despite headline grabbers, China has managed to expand its military installations in the region over the past half-decade and now possesses a layered-defense system in the region. In this report, we ask whether China has "won" the South China Sea, and what the implications might be for investors, particularly EM-dedicated investors, on the sectoral level. We find that China has reached the ability to impose massive costs on any state that should try to roll back its control of the disputed islands. We also do not think that the U.S. is ready to accept this new Chinese "sphere of influence." This means that the two countries are in a "gray zone" in which policy mistakes could occur. This uncertainty is driving the odds of a crisis higher. China is flush with recent victories in the islands, and yet the United States will continue to insist on free passage and the defense of allies and partners. Nationalism and rising jingoism in both countries also raises the odds of misunderstanding and miscalculation. Until the Trump and Xi administrations agree to a robust strategic deal that arranges for de-escalation, the South China Sea will remain a source of low-probability, high-impact geopolitical risk for investors. It is only one aspect of a broader deterioration in U.S.-China relations that we see as the ultimate driver of a secular rise in geopolitical risk in Asia Pacific.5 Unfortunately, history also teaches us that such "strategic resets" are normally motivated by a dramatic crisis. At the end of this report, we provide investment recommendations for investors in emerging markets (and a couple for the U.S. as well). Why Not Ignore The South China Sea? Map 1Nine-Dash Line Reaches Far Beyond China The South China Sea: Smooth Sailing? The South China Sea: Smooth Sailing? Maritime territorial disputes between China and several of its neighbors - Taiwan, Vietnam, the Philippines, Malaysia, Brunei, and partly Indonesia - have a long history. China declared its "Nine Dash Line," an expansionist claim of sovereignty over almost the entirety of the sea, in 1947 (Map 1). Since then, conflicts have flared up sporadically. The most notable skirmishes illustrate that the maritime disputes are always simmering but tend to boil over only when larger geopolitical issues heat up.6 Since the 1990s, China and the other claimants have raced to "grab what they can," particularly in the Spratly Islands. However, conflicts have especially intensified since the mid-2000s (Charts 1 and 2). A major factor has been the rise in competition for subsea resources: Chart 1Territorialism Rising In South China The South China Sea: Smooth Sailing? The South China Sea: Smooth Sailing? Chart 2Rising Number Of Confrontations The South China Sea: Smooth Sailing? The South China Sea: Smooth Sailing? Energy and minerals - Although estimates vary widely, the South China Sea contains respectable reserves of oil and natural gas (Chart 3) and there are also hopes of extracting other minerals from the sea floor. Most of the region's states are net importers. Several conflicts have been sparked by exploration, test drilling, and unilateral development.7 It is a fact that the past decade's buildup in tensions has coincided with a global bull market for energy prices and offshore energy investment and capex (Chart 4). Chart 3Not Insignificant Reserves Of Oil And Gas In South China Sea The South China Sea: Smooth Sailing? The South China Sea: Smooth Sailing? Fishing Grounds - The South China Sea holds vast fish resources, a source of food security, exports, and jobs for littoral countries. It is estimated that over 10% of global fishing catches come from here. Fishing as a whole accounts for about 1-3% of GDP for the countries involved in the disputes (Chart 5), and the South China Sea is a large chunk of that. A quick glance at recent skirmishes reveals that fishing rights are a major cause of conflict (Table 1). Chart 4Offshore Oil Production In Decline Offshore Oil Production In Decline Offshore Oil Production In Decline Chart 5Fisheries Non-Negligible For Asian States Fisheries Non-Negligible For Asian States Fisheries Non-Negligible For Asian States Table 1Notable Incidents In The South China Sea (2010-16) The South China Sea: Smooth Sailing? The South China Sea: Smooth Sailing? Nevertheless, resource extraction is not the main driver of discord. Frictions spiked in 2015-16 despite the collapse in China's and other countries' offshore rig counts (Chart 6). And fishing rights are also clearly a pretext for attempts to assert control over waters and rocks.8 Chart 6Energy Interest Declining, Tensions Still Elevated Energy Interest Declining, Tensions Still Elevated Energy Interest Declining, Tensions Still Elevated Moreover, China's conversion of the sea's various geographical features into artificial islands through a process of land reclamation, and its construction of military facilities and stationing of armaments on these islands, points not to strictly economic interests but to broader strategic security interests. Similarly, the United States' enforcement of international rights of free navigation and overflight is not related to oil and fish. What is really at stake is national security, supply-line control, and international prestige. First, the United States has long executed a grand strategy of preventing any country from forming a regional empire and denying the U.S. access. China has the long-term potential to make this happen, and the South China Sea is its earliest foray into empire-building abroad. (Taiwan, Xinjiang, and Tibet are all old news and expand Chinese hegemony into the largely useless Eurasian hinterland.) Second, the main global trading lines from Eurasia and Africa to and from Asia mostly go through the South China Sea and the Spratly Islands. We illustrate this process through our diagram of the sea as a large traffic roundabout (Diagram 1). China is attempting to control the centerpiece of the roundabout, which - in combination with China's southern mainland forces - would eventually give it veto power over transit. Diagram 1South China Sea As A Vital Supply Roundabout The South China Sea: Smooth Sailing? The South China Sea: Smooth Sailing? The economic value of the trade potentially affected by power struggles is what makes this all highly market relevant if a full-blown war ever occurs. We estimate that roughly $4.8 trillion worth of trade flowed through this area in 2015, which is comparable to the $5.3 trillion estimate from 2012 frequently cited in news media.9 Moreover, the trade does not consist merely of manufactured goods from Asian manufacturing centers but also basic commodities vital to the Asian countries' economic and political stability. Essential commodities account for about 20-35% of Northeast and Southeast Asian imports, and almost all of this by definition flows through the South China Sea (Charts 7 and 8). Chart 7Commodity Imports Go Through South China Sea... Commodity Imports Go Through South China Sea... Commodity Imports Go Through South China Sea... Chart 8...And Greatly Affect Asian Economies ...And Greatly Affect Asian Economies ...And Greatly Affect Asian Economies The numbers belie how vital the supply lanes are for individual countries: Japan, for instance, gets 80% of its oil via the South China Sea. A total cutoff would be devastating after strategic reserves were exhausted; and even a marginal hindrance of energy imports would bite into the current account surpluses that grease the wheels of high-debt Asian economies. The South China Sea is therefore vital even to countries like Japan and South Korea that are not party to the maritime-territorial disputes. A commerce-destroying war could strangle their economies. Military access is another reason states seek control. This is separate but related to the need to secure economic supplies. Chinese military planners are clear that they want to be able to deny access to foreign powers if need be, in order to secure the southern half of the country, or cut off Taiwan's or Japan's supply lines. American military planners are equally clear that they will not allow a state to deny them access to international commons, or to coerce others through supply-lane control.10 Finally, there are political and legal aspects to the South China Sea disputes. China's successful alteration of the status quo in the face of opposition from the U.S., Asian neighbors, and a high-profile international tribunal (the Permanent Court of Arbitration at the Hague), has undermined international legal institutions and the U.S. prestige in the region. Over time, regional states, perceiving that "might makes right," may feel the need to cling more closely to China or the U.S., giving rise to proxy battles.11 With supply security and national defense at risk - and China in the process of "militarizing" the islands - there is a rising probability of a major "Black Swan" incident. The involvement of a number of major powers and minor allies means that a small incident could escalate into something significant. The friction between U.S. global dominance and China's rising regional sway is the chief source of instability. China could agree to a "Code of Conduct" with the Asian states possibly as early as this year. But without improvement in U.S.-China relations, the geopolitical consequences of such a code will be moot. Southeast Asian risk assets could benefit temporarily, but the chief tail-risks of the U.S. and China falling out would be unresolved. Bottom Line: He who controls the sea routes controls the traffic. China has made an overt bid for the ability to govern the sea routes and deny foreign powers access to the sea. The U.S. has threatened forceful responses to acts of "area-denial" or military coercion. Thus, geopolitical uncertainty and risks in the region remain elevated. How Do The Contenders Size Up? If China had clearly achieved full control of the waterways, airways, and geographical features of the South China Sea, then geopolitical risk over the area might decline. Countries would adjust to Beijing's rules of the game and the region would enter a period of hegemonic stability. The reason we are in a gray area today is that China has not yet reached dominance. China's advantages are significant, growing rapidly, and underrated; meanwhile the U.S.'s advantages are significant, declining, and overrated. A simple comparison of the U.S.'s and China's military advantages and disadvantages will make this clear. China Considering that the South China Sea is China's backyard, the country has a major advantage of playing on its "home court" versus the United States. China can afford to concentrate its military capabilities and planning specifically on its near seas, whereas American resources are dispersed globally and reduced to an "expeditionary force" when operating in China's neighborhood.12 Even so, the People's Liberation Army (PLA), Navy (PLAN), and Air Force (PLAAF) have major obstacles to overcome if they are to contend with American forces. Until relatively recently, China's defense buildup focused on traditional ground capabilities, creating weak spots in its ability to project military power over the South China Sea. What matters is whether China has addressed these shortfalls sufficiently to raise the costs of U.S. intervention to a prohibitive level. So far, it is attempting to do so in the following ways: Sea Power - China's naval capabilities have generally lagged far behind those of the U.S. and Japan. An important step was the commissioning of China's first aircraft carrier, the Liaoning, in 2012. It is a renovated Soviet carrier of the type that Russia has recently used in Syria. A second carrier, Shandong, is 85% complete and set to be commissioned in 2018 - it is an indigenously produced copy of the former. It is set to be stationed in Hainan, which will influence the balance of power given that the U.S. only has one carrier permanently in the region (though several more dock in San Diego). A third carrier is slated for 2022 and expected to be stationed in the South China Sea. The navy has also significantly increased China's logistic and support capabilities in the area, with amphibious warships and air cover. China has also vastly expanded its destroyers and smaller ships. Only its submarine capabilities face serious doubts about the degree of improvement and capability. Air Transport - China's naval and air force lifting capabilities, necessary to transport troops and equipment quickly to disputed territories, were initially very limited. But in recent years, China has improved these capabilities. Considering satellite pictures of the Spratly and Paracel Islands with new hangars and landing strips, China has made considerable progress toward the goal of quick material and troop supply for the islands. Of course, it is notoriously difficult to resupply small scattered islands amid enemy disruptions, but it is also difficult to disrupt without committing more than one aircraft carrier wing to the problem. Clearly China's capacity has improved. Infrastructure - China has converted Hainan, its southernmost island (and smallest province) into a major military and logistics base. Its new Yulin Naval Base can host up to 20 nuclear submarines as well as two carrier groups and several assault ships. This is China's "Pearl Harbor," and unlike the American version, it is in the South China Sea. Meanwhile, on the disputed islands, China had not built infrastructure until very recently. It was in fact the last of the island claimants to pave an airstrip. But its construction has been bigger, faster, and more ambitious - including for air transport, fighter jets, and surface-to-air and anti-ship missiles, all of which have added greatly to its ability to deny the U.S. access to the sea. Air Power - One of the main issues the PLAAF had over the years was the limited radius of its fighter planes, which would not allow full air superiority in the South China Sea. Airfield infrastructure was built on the disputed islands so that fighter planes could be stationed closer to the area. China therefore does not possess just one aircraft carrier, but rather numerous ones if we think of islands as aircraft carriers. Also, Russia is delivering to China a number of multirole fighters that can cover the South China Sea from bases on the mainland. And China's fifth-generation fighter is coming along. By far the most significant military development in China's arsenal, however, is its development of short- and medium-range missiles. This development greatly increases the danger to American ships and aircraft seeking access to the region. First, China has concentrated on building short-range, DF-21D "Carrier Killer" anti-ship missiles, which pack enough punch to take out an American aircraft carrier with one hit, and which the U.S. has limited means to defend against.13 China has also paraded around the DF-26 intermediate-range ballistic missile, or "Guam Killer," which can reach as far as Guam, can carry a nuclear charge, and has a mobile launch platform that would be difficult for U.S. forces to detect and knock out before the launch. In turn, the U.S. has deployed Terminal High-Altitude Area Defense (THAAD) missile systems in Guam and South Korea in preparation for precisely this kind of attack.14 Second, China has amassed around 500 surface-to-air missiles on Hainan Island, waiting to be shipped to the disputed rocks. The armory consists of a combination of short-, medium-, and long-range missiles to create a layered air-defense perimeter. Satellite images of the islands show that China has also positioned short-range and medium-range missile systems on some of the islands, namely Woody Island in the Paracels. Finally, China has fielded better radar systems to gain full coverage of the South China Sea (as well as other nearby waters) in order to find or guide friendly or hostile ships or planes and to support the various activities of its air and ship defenses. This combination of radar and missile capabilities amounts to a game changer. They make it possible for China to raise the costs of conflict to such a level that the United States might balk. Will the U.S. seek to change the balance of power with force? No. But Washington has reaffirmed its "red lines" in the region, namely freedom of passage. This was the takeaway from Secretary of Defense James Mattis's first foreign trip, not incidentally to Japan and South Korea. Mattis indicated that freedom of passage is "absolute" not only for the U.S. merchant fleet but also for the navy. However, he also said the U.S. will exhaust "diplomatic efforts" and eschew "any dramatic military moves" in the South China Sea, while maintaining the U.S.'s neutrality on sovereignty disputes. This is status quo, and the status quo favors China's rapidly growing ability to deny others' access to the area. The United States The U.S. has several bases in the Indo-Pacific area, with ground, air, naval, and marine assets. It also has extensive experience conducting wars and special operations in East Asia. Yet despite this dispersed and historic basing, China poses a challenge the likes of which it has not seen in the region. The distances to be covered, the complexities of the logistics, and China's growing strengths, make any U.S. intervention in the South China Sea harder than is typically assumed. The U.S.'s key five bases make these advantages and disadvantages clear: Guam, with almost 6,000 troops, will most likely be the first base to respond to a threat in the South China Sea, or to become engaged in a conflict there. It hosts part of the Seventh Fleet, including a ballistic-missile submarine squadron. It would be a key launch pad for regional operations. It could also be an early target for China's long-range ballistic missiles in a major conflict. Guam sits almost 3,000km from the South China Sea. South Korea hosts one of the U.S.'s oldest and largest regional deployments, with about 28,000 troops. Korea hosts the Eighth U.S. Army and Seventh Air Force, as well as Special Operations Command Korea. Its chief advantage is its proximity to China. However, assuming a conflict involves no direct engagement with mainland China, Korea comes with some disadvantages. Most of the ground staff is located around the North Korea border. The U.S. command in the region will be wary of lifting troops from the border and exposing its northern flank. North Korea (or conceivably China itself) could take advantage of U.S. distraction in the South China Sea. At the same time, the operational radius of planes on the Osan Air Base would not allow direct engagement in the South China Sea, though they could cover the southeast to hinder any maneuvers of the Chinese air force. Japan is the United States' largest overseas deployment with about 49,000 troops - heavily tilted toward naval and air power. The Fifth U.S. Air Force is spread across three main bases in Misawa, Yokota, and Kadena, while the Seventh Fleet is the largest forward-deployed U.S. fleet. It has several powerful task forces including the aircraft carrier USS Ronald Reagan and naval special warfare, amphibious assault, mine warfare, and marine expeditionary forces. The strong presence and firepower of this fleet as well as its maneuverability make it the prime candidate for any sort of engagement in the South China Sea (or East China Sea for that matter). The air bases around Tokyo and Okinawa can provide air support down to Taiwan and run airlift operations down to China's Hainan Island, the base of China's southern fleet. The only disadvantages stem from vulnerability to layered air defense and long supply lines for the navy, which will become targets after any lengthy engagement. Moreover, U.S. Forces Japan lack large ground units to organize landing operations, which will need to be sourced from South Korea or Hawaii. Hawaii is the home of the U.S. Pacific Command, which oversees regional forces, and contains sizable ground units to reinforce regional bases. It hosts the U.S. Army Pacific, U.S. Pacific Air Forces, and the U.S. Pacific Fleet stationed in Pearl Harbor (with a second base in San Diego). Hawaii has a large ground troop presence, which, together with U.S. air-lift capabilities, would provide the main ground forces for offensive operations. The large fleet secures U.S. presence in the region. Hawaii would host and resupply the core of any naval operations in the South China Sea. The only disadvantage is geographic: the distance to any U.S. ally's territory is significant, and main operational areas in the South China Sea cannot be reached in a single lift. This means that troop and equipment movement will take time and will not go unmolested. In any scenario involving land operations, the redeployment of troops will give the other side time to prepare. Alaska is also worth mention as it houses infantry brigades and air force combat units, albeit no significant naval presence. We only give small consideration to the base here because of its proximity to Russia. Assuming the neutrality of Russia during a hypothetical conflict, the U.S. would still be unlikely to draw resources from Alaska to aid operations in the South China Sea, since that would leave its own territory exposed to some degree. Other Allied Bases - We do not feature other allied bases in the region mainly because of the small numbers of troops that can be deployed and the low capabilities of U.S. allies. Some countries, such a Singapore, which has a respectably army, could disappoint the U.S. by trying to remain neutral. The most reliable help would come from Japan and Australia, but even Australia would face a very intense internal dilemma as a result of its economic dependency on China. South Korea would also be preoccupied with North Korea's ability to take advantage. A quick survey of the "order of battle" of the U.S. and China in the region would make our assertion that China has gained supremacy laughable. Then again, geopolitics does not work in ceteris paribus terms. Yes, the U.S. maintains military hegemony in the region, but China's abilities to impose real pain on American naval forces creates a complicated political dilemma for the U.S.: is Washington prepared to expend blood and treasure to defend allies and their supply lines in case of a conflict over this area? China is not yet looking to project power globally. It is not actively trying to compete for supremacy with the U.S. in the Persian Gulf, Indian Ocean, or Caribbean Sea. As such, it can concentrate its forces in the South and East China Seas and dedicate its entire naval strategy to the sole purpose of denying the U.S. navy access there. The U.S., meanwhile, has to plan for a global confrontation and then dedicate a portion of its forces to China's home court. Japan may very well hold the balance of power in a potential conflict over the region. Its import dependency is at the core of its national psyche and it would view a Chinese blockade of the South China Sea as an existential threat - not unlike the American threat of oil embargo that precipitated war in the early 1940s. Japan is not likely to go rogue, but it would be a tremendous addition to the American effort, even in a situation where other states refrained from action out of fear. However, while China will see the above as a reason not to initiate armed conflict with the United States, it will not be able to retrench in the South China Sea in the face of domestic nationalism either. These pressures virtually ensure that it is locked into the assertive foreign policy it has pursued over the past ten years. Bottom Line: A simple analysis of the current disposition shows that the military capabilities of the two countries - in this limited theater - are not as disparate as one might think. Both sides have weaknesses: the U.S. is bound to a handful of distant bases and has a global range of obligations and constraints, while China lacks technology, experience, and cooperation among its military branches. Nevertheless, China is approaching full air and sea cover of the area within the Nine Dash Line (Map 1) and is rapidly gaining greater ability through radar and missiles to inflict politically unacceptable damage on the U.S. The U.S.'s interest in the South China Sea is ultimately limited to free passage and the defense of treaty allies. The Trump administration is primed to strengthen the country's rights and deterrence, namely through a large increase in defense spending that focuses heavily on the navy - aiming at a 600-ship fleet - and likely on Asia Pacific. In the context of a massive new assertion of U.S. regional presence and power, it is significant that China has not yet given any concrete indication of slowing down its island reclamation, militarization, or control techniques. Investment Implications BCA's Geopolitical Strategy has been warning clients of the rising risks in the South China Sea, and East China in general, since 2012. However, it has been a challenge to construct an investment strategy based on our view. For starters, it is unclear when the crisis could emerge. It is difficult to know when accidents and miscalculations will happen. What we can say with some degree of certainty, however, is that the window of opportunity for any realistic campaign to reverse the militarization of the disputed islands will probably be closed by the end of this year. By "realistic," we mean operations that would promise control over the disputed territory with a calculated degree of risk and an acceptable degree of casualties. At the same time, the U.S. still has the ability to win a full-blown war with China. We have not addressed scenarios like cutting off China's oil supplies at the Strait of Hormuz, for instance, but have limited our discussion to a conflict in the South China Sea over control of the newly militarized islands. In that context, the American threshold for pain is low and its military advantages are narrowing. We are therefore entering a danger zone now because both China and the U.S. stand at risk of becoming overly assertive in the near future: Chart 9Will Trump Seek Political Recapitalization Via Conflict? The South China Sea: Smooth Sailing? The South China Sea: Smooth Sailing? China because it has domestic nationalist pressures that the Communist Party needs to vent as the economy slows; The U.S. because it has an unpopular (Chart 9), nationalist leadership that seeks to increase its defense presence in the region and may fall to brinkmanship in order to extract major trade concessions from Beijing. The tail-risk in the South China Sea suggests that global investors should also continue to hedge their exposure to risk assets with exposure to safe-haven assets receptive to geopolitical risk, like gold, Swiss bonds, though perhaps not U.S. Treasuries. The persistence of Sino-American distrust - beyond whatever happy encounter Trump and Xi may have at Mar-a-Lago in April - suggests that Chinese economic policy uncertainty will remain elevated and global financial volatility to rise. U.S.-China tension also feeds our broader narrative of rising mercantilism and protectionism. Investors will want to overweight domestic-oriented economies, consumer-oriented sectors, and small cap companies relative to their export-oriented, manufacturing, and large cap counterparts. We also recommend that EM-dedicated investors be wary about Asian states caught in the middle of de-globalization and vulnerable to geopolitical tail-risks. We are neutral to bearish on South Korea, Taiwan, and the Philippines. Our long Vietnam equities trade has been downgraded to tactical. We prefer Thailand and Japan, U.S. allies that are removed from conflict zones (Thailand) or domestically oriented and reflationary (Japan). We are also long China relative to Hong Kong and Taiwan, given the risks of both de-globalization and Chinese political troubles for the latter two. We are bullish on U.S. defense stocks.15 The U.S. defense establishment is conducting extensive reviews of the navy's force structure and future strategic needs - the fleet peaked in 1987 and fell below 300 battle force ships in 2003, but has projected that 355 battle force ships is necessary. This would require a major injection of funds in the coming decade. The Trump administration has endorsed this assessment in principle and is planning a significant increase in defense spending, marked by a requested increase of $50 billion in his first annual budget. Trump has signaled that defense manufacturing, notably shipbuilding, will be one of the ways in which he seeks to boost American manufacturing and jobs. This plays to his blue-collar base of support and could move the needle in battleground states like Virginia. It should be beneficial on the margin for U.S. defense companies.16 Below are our corporate-level recommendations for both EM-dedicated and global investors. The Companies Given the likelihood that tensions in the SCS will continue, and the projected build up in defense spending in both the U.S. and China, EMES recommends investors look to take exposure to defense stocks. We have put together a portfolio of such stocks that is intended to give exposure to the developments between China and the U.S. in the South China Sea. We recommend the following basket of companies: AviChina Industry & Technology (2357 HK); AVIC Jonhon Optronic (002179 CH); AVIC Helicopter Company (600038 CH); AVIC Aviation Engine Corporation (600893 CH); China Avionics Systems (600372 CH); Huntington Ingalls Industries (HII US); General Dynamics Corporation (GD US). The basket consists of four Chinese defense companies, mostly centered around the aviation industry. The choice of listed companies in China is constrained and hence we have been forced to gain exposure through aviation companies rather than naval. We recommend two companies in the U.S. that are involved in military vessel production for the U.S. Navy. We believe that the main ramp-up in defense spending from the U.S. side will come through a significant increase in the number of ships in the Asian region. Chart 10Performance Since March 2016: ##br## AviChina Vs. MSCI EM Performance Since March 2016: AviChina Vs. MSCI EM Performance Since March 2016: AviChina Vs. MSCI EM AviChina Industry & Technology (2357 HK): Chinese aviation holding company (Chart 10). AviChina is the listed subsidiary of the government-controlled Aviation Industry Corporation of China (AVIC). Airbus is another large shareholder, with over 11% of the free float. The company produces dual-purpose aircraft - civil and military -- including helicopters, trainers, parts and components (including radio-electronic), avionics and electrical products and components. AviChina itself is a holding company with a rather complicated structure, which makes it difficult for investors to access its market value. Listed subsidiaries include AVIC Helicopter Company (600038 CH), China Avionics (600372 CH), AVIC Jonhon Optronic (002179 CH) and Hongdu Aviation (600316 CH). In terms of the revenue stream, 49% is generated from whole aircraft production, 28% from engineering services and another 23% from parts and components manufacturing. The company reports semi-annual results. The latest full-year report released on March 15 came out mixed. Revenues were strong, up 39% year over year, but costs accelerated at a faster pace (+45% year over year). Operating income was still strong, growing 12.3% year over year, but margins declined across the board. EBITDA margin contracted by 257 basis points to 9.94%, while operating margin fell by 170 basis points to 7.32%. Despite this, the bottom line still managed to grow by 18.75% year over year. AviChina is currently trading at a forward P/E of 21.2x, whilst the market estimates an EPS CAGR of 9.5% for the next three years. Chart 11Performance Since March 2016: ##br## AVIC Jonhon Optronic Vs. MSCI EM Performance Since March 2016: AVIC Jonhon Optronic Vs. MSCI EM Performance Since March 2016: AVIC Jonhon Optronic Vs. MSCI EM AVIC Jonhon Optronic (002179 CH): Profiting from growing military and EV spending (Chart 11). A subsidiary of AVIC and AviChina, the company specializes in production of optical and electric connectors (third largest in China), and cable components. Jonhon is unrivalled in the defense market. It profits from rising electronic content and from supplying major components to other parts of the AVIC group, shipbuilders, railways and aerospace. It is also successfully developing its civil offering, specifically for the fast-growing electric vehicle market and the 4G space in the telecoms industry. Looking at the revenue composition, 54% is generated by sales of electric connectors, a further 24% from fiber-optic cables, and 19% from conventional cable and assembly products. As for the civil-military split, the company is expected to receive 60% of total revenues from its civil applications, growing approximately 10% per annum. Jonhon Optronics reported its full-year results on March 15. Revenues saw a strong increase, jumping 23.7% year over year. Cost growth was also higher, though it slowed from the previous year (up 23.8% year over year). This led to an operating profit increase of 19.7%, but slight margin deterioration. EBITDA margin fell by 77 basis points to 16.98%, and operating margin was down 5 basis points to 14.32. On the other hand, profit margins improved to 12.6% (up 54 basis points) as the bottom line grew by 29.8% year over year. Jonhon Optronics is currently trading at a forward P/E of 24.4x, whilst the market estimates an EPS CAGR of 15.2% for the next three years. Chart 12Performance Since March 2016: ##br## AVIC Helicopter Company Vs. MSCI EM Performance Since March 2016: AVIC Helicopter Company Vs. MSCI EM Performance Since March 2016: AVIC Helicopter Company Vs. MSCI EM AVIC Helicopter Company (600038 CH): AVIC's helicopter arm (Chart 12). As the name already suggests, the company specializes in helicopter production, which accounts for almost 100% of the overall revenue stream. The main helicopters currently marketed are from the AC series, in particular the AC311, AC312 and AC313, the Z series - Z-8, Z-9 and Z-11. We expect further tailwinds for the company stemming from China's future defense budget. The country's helicopter fleet is still only a tenth of the size of the U.S.'s fleet. It will continue to ramp up production. Export contracts will also support revenue growth for AVIC Helicopter Co. With a strong advance on the Asian military helicopter market, the company is looking to expand in the region. Furthermore, we see some promising developments in the civil helicopter space, with Chinese emergency services and the Civil Aviation Administration ramping up demand. The main headwind might come from the transition to new models, with the new production cycle to be in full force in 2018. AVIC Helicopter Co reported full year results on March 15, which came out weaker than expected. Revenues were virtually flat, contracting by 0.3% year over year, while cost of revenue grew 1.3% year over year. Operating income was also stable relative to last year, contracting 0.4% year over year, helped by an operating expense reduction of 12% year over year. Nevertheless, EBITDA margin declined slightly by 19 basis points to 6.77%, while operating margin fell by 131 basis points to 13.99%. A marginally lower income tax in FY16 allowed the firm to eke out 1.3% year-over-year bottom-line growth. AVIC Helicopters is currently trading at a forward P/E of 48.2x, whilst the market estimates an EPS CAGR of 13.8% for the next two years. Chart 13Performance Since March 2016: ##br## AVIC Aviation Engine Vs. MSCI EM Performance Since March 2016: AVIC Aviation Engine Vs. MSCI EM Performance Since March 2016: AVIC Aviation Engine Vs. MSCI EM AVIC Aviation Engine Corporation (600893 CH): Sole leader in Chinese engine production (Chart 13). Aviation Engine Corporation is part of the government-controlled Aeroengine Corporation of China (AECC), which was established in August 2016 and contributes just under 50% to Being in a monopolistic position on the Chinese market, the company profits from rising military aircraft procurement and prices. As part of the AECC, the company also receives tailwinds from scale effects within the company as well as cost savings in the supply chain. AVIC Aviation Engine Corporation reported weak full year results on March 16. Revenue slid 5.5% year over year, but management kept costs under control (down 7.3% year over year). Operating expenses grew only marginally (up 5.2% year over year), which left operating profit flat compared to last year. Margin trends have been strong; EBITDA margin improved by 78 basis points to 13.05%, while operating margin grew by 42 basis points to 7.78%. However, high net interest expense depressed the bottom line, which fell 13.3% year over year. At the same time the company managed to decrease its debt level for the fourth year in a row. AVIC Aviation Engine Corporation is currently trading at a forward P/E of 52.0x, whilst the market estimates an EPS CAGR of 14.4% for the next two years. Chart 14Performance Since March 2016: ##br## China Avionics Systems Vs. MSCI EM Performance Since March 2016: China Avionics Systems Vs. MSCI EM Performance Since March 2016: China Avionics Systems Vs. MSCI EM China Avionics Systems (600372 CH): Leading developer and producer of avionics equipment (Chart 14). China Avionics Systems is also a subsidiary of AviChina, which controls 43% of the free float. The company is active in R&D, running several research institutes in the fields of radar, aviation and navigation control as well as aviation computers and software. China Avionics enjoys a near-monopoly on the Chinese aviation electronics market, and also controls over 90% of the military market for air data systems. Looking at the revenue breakdown, 80% of total revenues come from military contracts, while it is expected that the share of civil revenues will increase with the development of civil aircraft in the country. Aircraft data acquisition devices contribute the most to overall revenue, at 25% of total, followed by airborne sensors at 15%, auto-pilot systems at 14%, distance-sensing alarm systems at 9.5%, and air data systems at 9%. The company reported full year results on March 16. Revenues experienced a mild increase of 1.9% year over year, while costs increased at the same pace (2% year over year). On the operating side, costs increased by 3% year over year, suppressing income by 1% year over year. EBITDA margin fell 37 basis points to 15.15%, while operating margin contracted 30 basis points to 10.60%. The bottom line contracted 3.5% year over year. China Avionics Systems is currently trading at a forward P/E of 55.0x, whilst the market estimates an EPS CAGR of 13% for the next two years. Chart 15Performance Since March 2016: ##br## Huntington Ingalls Industries Vs. S&P 500 Performance Since March 2016: Huntington Ingalls Industries Vs. S&P 500 Performance Since March 2016: Huntington Ingalls Industries Vs. S&P 500 Huntington Ingalls Industries (HII US): Largest listed U.S. military shipbuilder (Chart 15). Initially a part of Northrop Grumman, Huntington was spun off and listed in 2011. Huntington enjoys a monopolistic market position, as over 70% of the current U.S. Navy fleet was designed and built by the company's Newport News or Ingalls divisions in Virginia and Mississippi. Huntington is currently the sole designer, builder and re-fueler of nuclear-powered aircraft carriers in the U.S. In the nuclear submarines space, the company has one competitor: the Electric Boat unit of General Dynamics. The company also provides a range of services through its Technical Solutions division, centered around fleet support, integrated missions solutions and nuclear and oil and gas operations. Huntington reported full-year results on February 16. Full year revenue was virtually flat (+1% on quarterly basis), while costs increased slightly by 1.6% year over year. The company managed to reduce operating expenses, which fell by 16% to the lowest level since 2010. This helped boost operating profit by 13% year over year. EBITDA margin improved by an impressive 125 basis points to 14.77%, and operating margin was up by 119 basis points to 12.14%. New orders grew by US$5.2 billion, bringing the total pipeline to US$21 billion. The bottom line jumped by 45% year over year, helped by a lower income tax bill and a one-off after-tax adjustment. Huntington Ingalls Industries is currently trading at a forward P/E of 18.1x, whilst the market estimates an EPS CAGR of 4.2% for the next two years. Chart 16Performance Since March 2016: ##br## General Dynamics Vs. S&P 500 Performance Since March 2016: General Dynamics Vs. S&P 500 Performance Since March 2016: General Dynamics Vs. S&P 500 General Dynamics (GD US): Primary contractor for U.S. Navy submarines (Chart 16). General Dynamics is a multinational defense corporation and currently the fourth-largest defense company in the world. The company has four business segments, from which we are mainly interested in the marine systems segment, contributing 25% of overall group revenue. The marine systems segment is represented by General Dynamics' unlisted subsidiary, GD Electric Boat. Electric Boat has long been the main builder of nuclear submarines for the U.S. Navy out of Connecticut, and is expected to be one of the main beneficiaries of the U.S. Navy expansion program under the Trump administration. General Dynamics reported full-year results on January 27, which generally came in flat. Revenue fell by a marginal 0.4% year over year (after the adoption of a new revenue-recognition standard), but the company did a good job in managing costs, which contracted by 1% year over year. Operating income grew by 4% year over year, helped by lower operating costs. Margins improved across the board; EBITDA margin went up 45 basis points to 15.19%, while operating margin was up 54 basis points to 13.74%. The bottom line grew 5% year over year. Management seem confident in their guidance through 2020, including detailed but conservative estimates. Especially promising was the good pipeline visibility in the marine segment, driven by the company's Columbia-class submarine sales. General Dynamics is currently trading at a forward P/E of 19.3x, whilst the market estimates an EPS CAGR of 6.5% for the next two years. How To Trade? The GPS/EMES team recommends gaining exposure to the sector through a basket of the listed equities, which would consist of five Chinese companies and two U.S. companies. The main goal is active alpha generation by excluding laggards and including out-of-benchmark plays, to avoid passive index hugging via an ETF. Direct: Equity access through the tickers (Bloomberg): AviChina Industry & Technology (2357 HK); AVIC Jonhon Optronic (002179 CH); AVIC Helicopter Company (600038 CH); AVIC Aviation Engine Corporation (600893 CH); China Avionics Systems (600372 CH); Huntington Ingalls Industries (HII US); General Dynamics Corporation (GD US). ETFs: At current time there is one listed ETF covering the China defense sector: Guotai CSI National Defense ETF (512660 CH); And three listed ETFs covering the U.S. defense sector: iShares U.S. Aerospace & Defense ETF (ITA US); SPDR S&P Aerospace & Defense ETF (XAR US); PowerShares Aerospace & Defense Portfolio (PPA US). Funds: At current time there are no funds with significant defense sector exposure. Please note that the trade recommendation is long-term (1Y+) and based on a straight long trade. We don't see a need for specific market timing for this call (for technical indicators please refer to our website link). For convenience, the performance of both market cap-weighted and equally-weighted equity baskets will be tracked (please see upcoming updates as well as the website link to follow performance). Risks To The Investment Case The largest risk to our investment case - leaving aside company-specific risks - would be an unexpected fading away of the tensions in China's near seas, and of China's and America's military spending ambitions. Such a development - which would require a robust diplomatic agreement and an about-face from what the leaders have stated - would hit the weapons producers. Though such a settlement would not necessarily occur overnight, or receive immediate publicity, it would be observable over the course of negotiations between the Trump and Xi administrations. A key event to watch is the upcoming April summit between the two leaders. At the same time, the large momentum in the defense industry (with very long production pipelines), and the very low flexibility of defense budgeting, means that we are comfortable in terms of timing an exit should geopolitical tensions begin to recede. Another risk might come from a slowdown in economic growth in China or the U.S., which could lead to cuts in defense budgets. Nevertheless, in a case of a further escalation in China's near-abroad, we would most likely see defense spending continue to grow despite any weak economic performance, warranted by strategic needs. This is a key dynamic that investors should understand. Strategic distrust between the U.S. and China has worsened since the Great Recession, indicating that the preceding period of strong growth helped keep a lid on U.S.-China tensions. Now the two countries have entered a dilemma in which relations have soured despite their economic recoveries, since both sides are using growth to fuel military development, yet an economic relapse would fuel further distrust. Only a high-level political settlement can break this spiral and such settlements between strategic rivals traditionally require a "crisis." Matt Gertken, Associate Editor mattg@bcaresearch.com Oleg Babanov, Editor/Strategist obabanov@bcaresearch.co.uk Marko Papic, Senior Vice President marko@bcaresearch.com 1 Please see BCA Geopolitical Strategy Weekly Report, "Donald Trump Is Who We Thought He Was," dated March 8, 2016, available at gps.bcaresearch.com. 2 Please see BCA Geopolitical Strategy Monthly Report, "The Great Risk Rotation," dated December 11, 2013, and Geopolitical Strategy Special Report, "Power And Politics In East Asia: Cold War 2.0?" dated September 25, 2012, available at gps.bcaresearch.com. 3 Please see BCA Geopolitical Strategy Weekly Report, "How To Play The Proxy Battles In Asia," dated March 1, 2017, available at gps.bcaresearch.com. 4 The United States sent the USS Carl Vinson carrier group to the South China Sea as part of Freedom of Navigation Operations that the Trump administration may intensify; China is involved in a new spat about "environmental" monitoring stations in the Paracel Islands and in Scarborough Shoal, and is also increasing activity east of the Philippines; it is threatening to impose a new law that would govern foreign ships' access; the question of a Chinese Air Defense Identification Zone lingers; and China has also begun sending large tourist groups to the Paracels. 5 Please see BCA Geopolitical Strategy Strategic Outlook, "We Are All Geopolitical Strategists Now," dated December 14, 2017, and Geopolitical Strategy Special Reports, "Sino-American Conflict: More Likely Than You Think," dated October 4, 2013 and "Sino-American Conflict: More Likely Than You Think, Part II," dated November 6, 2015, available at gps.bcaresearch.com. 6 Most notably in 1971, 1974, 1988, 1995, 2001, and 2011-14. In the two biggest "battles," 1974 and 1988, China kicked Vietnamese forces out of the Paracel Islands and parts of the Spratly Islands, respectively. These conflicts took place in the context of Vietnam's wars with itself, the U.S., and China, just as the recent rise in tensions takes place in the context of China's emergence as a global power - in other words, international tensions are the cause and maritime-territorial disputes are but a symptom. 7 Most notably the HS981 showdown between China and Vietnam in 2014, which occurred when China National Offshore Oil Corporation (CNOOC) moved a large mobile drilling rig into the farthest southwest island of the Paracel Islands, near Triton Island, triggering a months-long skirmish with Vietnamese coast guard ships and fishermen that involved Chinese warships and aircraft and the sinking of at least one Vietnamese fishing boat. 8 In fact, officers from China's People's Liberation Army-Navy's southern fleet have recently written publicly and approvingly of the well-known Chinese tactic of fighting "behind a civilian front" to establish control over the sea - which has involved a host of private and public actions covering fishing, energy, coast guard, administration, science and environment, and tourism. Please see "Chinese Military's Dominance in S. China Sea Complete: Report," Kyodo News, March 20, 2017. 9 Please see Bonnie S. Glaser, "Armed Clash In The South China Sea," Council on Foreign Relations, Contingency Planning Memorandum No. 14, April 2012, available at cfr.org. Separately, an American diplomatic estimate from 2016 claims that "more than half the world's merchant fleet tonnage" passes through these waters; see Colin Willett, "Statement ... Before the House Foreign Affairs Committee ... 'South China Sea Maritime Disputes,'" July 7, 2016, available at docs.house.gov [http://docs.house.gov/meetings/AS/AS28/20160707/105160/HHRG-114-AS28-Wstate-WillettC-20160707.pdf]. A Chinese study estimates that 47.5% of China's total foreign trade in goods transited the sea in 2014; see Du D. B., Ma Y. H. et al, "China's Maritime Transportation Security And Its Measures Of Safeguard," World Regional Studies 24:2 (2015), pp. 1-10. 10 When President Trump's Secretary of State Rex Tillerson clarified remarks at his senate confirmation hearing in which he threatened that the U.S. would deny China's access to the islands in the South China Sea, he reformulated his statement to say that in the event of a contingency the U.S. needed to be "capable of limiting China's access to and use of its artificial islands" to threaten the U.S. and its allies and partners. 11 Please see footnote 3 above. Another potential implication might be a weaker U.S. position in the partition of the Arctic shelf (which has far more hydrocarbon reserves than the South China Sea), which U.S. rivals like Russia will pursue next against the claims of the U.S. and its allies Norway, Canada, and Denmark. 12 Please see Robert Haddick, Fire on the Water: China, America, and the Future of the Pacific (Annapolis, MD: Naval Institute Press, 2014). 13 It is understood by multiple sources that these missiles cannot be defended successfully against by current anti-missile technology, with one potential exclusion - the recently tested SM-6 Dual I. Otherwise, possible defense methods would lie in the realm of electronic countermeasures. 14 We believe, with medium conviction, that the incoming administration in South Korea will remove the THAAD missile defense sometime in 2017 or 2018 in what would be a major diplomatic quarrel between Seoul and Washington. This is because the soon-to-be ruling Minjoo Party (Democratic Party) will seek to engage North Korea and mend relations with China, and the latter countries' top demand will be removal of the missile defense system that was only put in place in a rushed manner in the final days of the discredited and impeached Park Geun-hye administration. Such a removal would illustrate the U.S.'s disadvantages relative to China in having to deal with alliances, basing, and force structure in a foreign region. 15 Please see BCA Geopolitical Strategy and Global Alpha Sector Strategy Joint Special Report, "Brothers In Arms," dated January 11, 2017, available at gps.bcaresearch.com. 16 Please see "2016 Navy Force Structure Assessment (FSA)," dated December 14, 2016, and Ronald O'Rourke, "Navy Force Structure and Shipbuilding Plans: Background and Issues for Congress," Congressional Research Service, September 21, 2016.

Highlights Portfolio Strategy Internal dynamics warn that a broad market consolidation phase has begun. The jump in growth vs. value stocks has provided an opportunity to shift to a neutral style bias. Transports have sold off sharply, but downside risks have not yet been fully expunged, especially for the airline group. Recent Changes Growth Vs. Value - Shift to a neutral stance. Table 1Sector Performance Returns (%) Heading For A Choppier Market Heading For A Choppier Market Feature The perceived dovish Fed shift and doubts about the achievability of Trump's policy goals are causing equity market consternation. To the extent that the run up in stocks has largely reflected an improvement in sentiment and other 'soft' economic data, the lack of follow through in 'hard' data has created a validation void. While a weaker U.S. dollar, lower oil prices and less hawkish Fed imply easier monetary conditions, which are ultimately positive for growth, profits and the stock market, a digestion phase still looms. Financials, and banks in particular, had been market leaders, driven up by hopes for a meaningful upward shift in the yield curve and unleashing of animal spirits. But these assumptions are being challenged and there is limited fundamental support. Indeed, bank lending growth remains non-existent and there is no tailwind from improving credit quality. Our view remains that banks carry the most downside risk of all financial groups (please see the March 6 Weekly Report for more details). Regional banks are now down on a year-to-date relative performance basis (Chart 1). In fact, our newly constructed gauge of the equity market's internal dynamics suggests that additional tactical broad market turbulence lies ahead. A composite of relative bank stock, relative transport, small/large cap and industrials/utilities share prices has been a good coincident to leading market indicator in recent years (Chart 2). While no indicator is infallible, the message is that overall market risk is elevated and a choppy period lies ahead, reinforcing our defensive vs. cyclical bias. Nevertheless, it will be important to put any corrective action into a longer-term context. Over the years, we have kept an eye on several qualitative 'unconventional indicators' that have helped time major market turning points. They are meant to augment rather than replace fundamental factors. Chart 1Market Leaders Are Stumbling Market Leaders Are Stumbling Market Leaders Are Stumbling Chart 2A Yellow Flag From Internal Dynamics A Yellow Flag From Internal Dynamics A Yellow Flag From Internal Dynamics Below we highlight five critical variables to gauge whether a correction will devolve into a sustained sell-off. Each of the indicators measures either; profits; business confidence; investor confidence; and/or reflects how liquidity conditions are impacting market dynamics. Investor confidence can be measured through margin debt. While extremely elevated (Chart 3), there is no concrete sign that access to funds is being undermined by the modest backup in interest rates. When the cost of borrowing becomes too onerous, it will manifest in reduced margin debt and forced selling, which will be a serious threat to stocks given that leverage is challenging levels experienced at prior peaks, as a share of nominal income. M&A activity is losing momentum (Chart 4). A peak in merger activity typically coincides with a rising cost of capital. If corporate sector capital availability becomes a pressing issue, then M&A activity will decline further, signaling that the corporate sector is facing growth headwinds. Economic signals are mostly positive. Durable goods orders have tentatively perked back up (Chart 5), reinforcing that profits and confidence have improved after a soft patch. Temporary employment continues to rise (Chart 5). When temp workers shrink, it is often an early warning sign that companies are entering retrenchment mode, given the ease and low cost of reducing this source of labor costs. If temporary employment falls at the same time as share prices, that would be a red flag. The relative performance of consumer discretionary to consumer staples can provide a read on purchasing power and/or the marginal propensity to spend. This share price ratio does not suggest any consumption concerns exist (Chart 4, bottom panel). If consumer staples begin to outperform, then it would warn of a more daunting economic outlook. Chart 3Borrowing Costs Are Not Yet Restrictive Borrowing Costs Are Not Yet Restrictive Borrowing Costs Are Not Yet Restrictive Chart 4M&A Is Starting To Labor M&A Is Starting To Labor M&A Is Starting To Labor Chart 5Economic Signals Are Decent Economic Signals Are Decent Economic Signals Are Decent In all, these indicators suggest that any pullback will be corrective rather than a trend change. If the profit cycle continues to improve and the Fed has no inflationary need to become restrictive, then any broad market correction could provide an opportunity to selectively add cyclical exposure to portfolios in the coming weeks. In the meantime, we are revisiting our growth vs. value view and providing an update on transports. Growth Vs. Value: Shifting To Neutral Our last style bias update in the December 19 Weekly Report concluded that we would likely recommend moving to a neutral stance over the coming weeks/months from our current growth vs. value (G/V) stance, but expected to do after growth stocks had staged a comeback. That recovery is now well underway and so we are revisiting the outlook. Growth indexes have outperformed value since the depths of the Great Recession. The preference for growth reflected central bank interest rate suppression, which boosted the multiple investors were willing to pay for perceived growth at a time when growth was scarce. In addition, the composition of the growth index is much longer duration than that of the value space. The surge in long-term earnings growth expectations suggests that investors have increased conviction in the durability of the expansion, which has aided the G/V recovery (Chart 6). That monetary experiment has recently begun to pay off, as global economic growth has finally demonstrated evidence of self-reinforcing traction, led by developed countries. As a result, most central banks are well past the point of maximum thrust, which would mean the loss, albeit not a reversal, of the primary support for the secular advance in growth vs. value indexes. Keep in mind that growth benchmarks have a massive technology sector weight, at just over 1/3 of the total index capitalization. Value indices carry only a 7% weight. As shown in previous research, the technology sector underperforms when economic growth is fast enough to create inflationary pressure and therefore, the interest rate structure. Furthermore, value benchmarks have more than 25% of their weight in the financials sector vs. less than 5% for growth indexes. The upshot is that a meaningful interest rate increase would pad the profits of financials-rich value indices while having little to no impact on growth benchmarks by virtue of their tech-dependence. It is no surprise that the G/V ratio trends with technology/financials relative sector performance (Chart 7). The latter has clearly peaked, with an assist from the renormalization in Fed policy. Chart 6Time To Shift Time To Shift Time To Shift Chart 7Two Key Sector Influences Two Key Sector Influences Two Key Sector Influences These sector discrepancies mean that a critical question for the style decision is what is the path for government bond yields? The U.S. economy is exhibiting signs of self-reinforcing behavior. The small business sector's hiring plans have surged, and the ISM employment index remains solid (Chart 8). Chart 8Economy No Longer Favors Growth Economy No Longer Favors Growth Economy No Longer Favors Growth Chart 9A Mixed Bag A Mixed Bag A Mixed Bag While at least a modest employment slowdown is probable given that the corporate sector is feeling the profit margin pinch from higher wage costs, these gauges do not suggest a major crunch is imminent. The personal savings rate is drifting lower, supporting consumption growth (Chart 8). Value indexes have a higher economic beta than growth benchmarks, owing to their exposure to shorter duration sectors. The gap between growth and value operating margins tends to close when the economy enjoys a meaningful acceleration (Chart 8). Chart 10Volatility Is A Style Driver Volatility Is A Style Driver Volatility Is A Style Driver Other markers of global economic growth are more mixed. The global manufacturing PMI survey is very strong, but oil and other commodity prices have started to diverge negatively (Chart 9). That may soon change if the U.S. dollar has crested, which would provide a much needed fillip to emerging markets and remove a source of deflationary pressure. Real global bond yields are grinding higher, suggesting that in all, economic prospects have improved, and alleviating a major constraint on value stocks. Against this backdrop, it is timely to shift to a neutral style preference after the sharp rebound in the G/V ratio since late last year. Why not a full shift into value indexes? Developing countries are conspicuously lagging developed countries, which caps the outlook for commodities and their beneficiaries. EM capital spending is still very weak in real terms. Deep cyclical sectors are much more heavily-weighted in value benchmarks. A global recovery that has a greater thrust from consumption than investment, at least at the outset, argues against expecting value stocks to outperform. Moreover, the fallout from potentially protectionist U.S. trade policies remains unknown, which could restrain economic growth momentum and unleash volatility in the equity markets. The latter has been incredibly muted in recent months. In fact, BCA's VIX model, which incorporates corporate sector health and interest rate expectations, is heralding a higher VIX. Clearly, elevated volatility has supported the G/V ratio over meaningful periods of time (Chart 10). Bottom Line: Shift to a neutral style bias. A full shift to a value preference would require BCA to forecast a much weaker U.S. dollar and/or demand-driven inflationary pressure. Transports: Stuck In Neutral The S&P transports index peaked in mid-December versus the broad market, the first major sub-group to fizzle after the post-election sugar high (Chart 11). The recent setback has been broad-based. We had been overweight both the rails and air freight & logistics industry sub-groups, but booked gains in both prior to their respective pullbacks. Is it time to get back in? Transportation equities are ultra-sensitive to swings in global economic growth. Chart 12 shows that the relative share price ratio is an excellent leading indicator of both the ISM manufacturing survey and Citi's economic surprise index. The message is that at least a mild mean reversion in both of these indexes looms in the coming months, i.e. beware of some form of economic cooling. Chart 11Transports Have Cracked... Transports Have Cracked... Transports Have Cracked... Chart 12... Signaling Economic Cooling Ahead ... Signaling Economic Cooling Ahead ... Signaling Economic Cooling Ahead Against this backdrop, we are revisiting our last remaining underweight, the S&P airlines index. While rails and air freight & logistics stocks are directly linked to global trade, the same does not hold true for the S&P airlines index. Business and consumer travel budgets are the key drivers of industry demand. A revival in animal spirits and a healthy U.S. consumer could be clear positives for air travel. Moreover, the recent pullback in fuel costs should cushion profit margins for unhedged airline operators (Chart 13). Finally, renowned investor Warren Buffett has recently become a major shareholder in the U.S. airline industry, raising its profile. While betting against Buffett is always fraught with risk, our cautious take on the airline industry boils down to our view that excess capacity will continue to hold back profitability. If the overall transport index is accurately signaling that some loss of economic momentum looms, then a rapid expansion in business and travel spending may not be quick to materialize. A pricing war has already gripped the industry, as airlines are scrambling to fill up planes. Revenue-per-available-seat-mile and U.S. CPI airfare are contracting (Chart 14), reflecting a fight for market share. That is a serious impediment to profit margins. Chart 13Airlines Are Losing Altitude... Airlines Are Losing Altitude... Airlines Are Losing Altitude... Chart 14... As Price Wars Persist ... As Price Wars Persist ... As Price Wars Persist The headwinds extend beyond the U.S. Chart 15 shows that global airfare deflation also bodes ill for top line industry growth. The lags from previous U.S. dollar strength could compound this source of drag. Absent a decisive recovery in total travel spending, there does not appear to be any catalysts to reverse deflationary conditions. Carriers are still allocating an historically high portion of cash flow to capital spending. While upgrading aging fleets to become more fuel-efficient in an era of low interest rates is a long-term positive, the payback period may be extended. Revenue has failed to keep up with the increase in capital expenditures (Chart 16, bottom panel), suggesting that capacity growth continues to outpace industry demand, a recipe for ongoing pricing pressure. Chart 15Deflation Is Global Deflation Is Global Deflation Is Global Chart 16Too Much Capacity Too Much Capacity Too Much Capacity This difficult backdrop has begun to infect analyst earnings estimates. Net earnings revisions have nosedived. Relative performance momentum is tightly lined with the trend in earnings estimates (Chart 16). The message is that the breakdown in cyclical momentum has further to run. Indeed, the 52-week rate of change rarely troughs until it reaches much lower levels, warning of additional downside relative performance risks. Bottom Line: The S&P transports group is heralding a period of economic cooling, but the airline sub-component has not yet fully discounted such an outcome. Stay underweight. The ticker symbols for the stocks in the S&P airlines index are: UAL, AAL, DAL, LUV & ALK. Current Recommendations Current Trades Size And Style Views Favor small over large caps and stay neutral growth over value.

The large gap between the BCA Defense and BCA Aerospace indexes is likely to grow much larger. The U.S. is aiming to boost defense spending as part of its stimulus efforts, and is pressuring other NATO members to boost defense spending after a long contraction. While U.S. defense spending has been through a soft patch for the past several years, new orders for defense goods have been one of the strongest components of overall durable goods orders (second panel). Even global demand has boomed, even in the face of the strong U.S. dollar, as evidenced by surge in exports of military goods (bottom panel). On the flipside, aerospace new orders are on a downward trajectory, reflecting a downturn in the commercial aerospace cycle. While long lead times and lengthy delivery schedules offer some earnings protection, dwindling order backlogs will ultimately undermine confidence in the long-term outlook. Our global airline consumer price index, a composite of airline pricing power in a number of major countries, is in negative territory. A negative CPI reflects excess capacity, and warns of grim prospects for a recovery in new airplane orders. The bottom line is that earnings support remains intact for the defense index, but is rapidly dwindling for aerospace equities. Stay overweight the former and underweight the latter. The ticker symbols for the stocks in the BCA defense index are: LMT, GD, RTN, NOC, LLL and the BCA aerospace index are: BA, UTX, HON, TXT. Aerospace And Defense Are Going Their Separate Ways Aerospace And Defense Are Going Their Separate Ways

Highlights Portfolio Strategy The market has quietly adopted a less cyclical sectoral tone since yearend, a trend that could amplify over the coming months, even if overall appreciation persists. Defense stocks have grown into previously extended valuations, warranting ongoing above-benchmark exposure. The opposite is true for aerospace equities. Data processing shares are more likely to roll over than break out and we recommend paring positions to underweight. Recent Changes S&P Data Processing - Downgrade to underweight from overweight. Table 1 Shifting Internal Dynamics Shifting Internal Dynamics Feature The stock market has cheered the broad-based rebound in earnings and improvement in corporate sector pricing power (Chart 1). Unbridled optimism about growth friendly policy tilts including potential tax reform and select regulatory relief combined with an easing in financial conditions have encouraged investors to make large down payments against expected future profit gains. Indeed, extreme economic and earnings bullishness is evident in record setting price/sales (P/S) multiples: Chart 1 shows that on a median basis, the industry group (P/S) ratio is far above the 2000 peak, providing yet another metric in a long list of yardsticks signaling that greed is the overriding market emotion. Nosebleed valuation levels are cause for significant cyclical concern, but as discussed last week, momentum and a valuation-agnostic transition from fixed income to equities are the dominant tactical forces at the moment. Since it is difficult to reconcile valuations at odds with realistic expectations about future earnings growth, we remain focused on sub-surface positioning to indemnify against disappointment. Since late last year, the market has adopted a more defensive than cyclically-oriented tenor. Defensive sectors have troughed at extremely attractive relative valuation levels, based on our models (Chart 2). Conversely, cyclical sectors have rolled over, meeting resistance at very demanding valuation levels of more than two standard deviations above normal (Chart 2). Chart 1Future Growth Has Been Paid For Already Future Growth Has Been Paid For Already Future Growth Has Been Paid For Already Chart 2The Market Tone Is Changing The Market Tone Is Changing The Market Tone Is Changing Contrarians should take note. These nascent trend changes have developed even though economic data have generally surprised on the upside, which may be an indication that a more forceful response will occur once the string of upside surprises loses momentum. The global PMI has been very strong, but any hint of a reversal would provide a catalyst for a full-fledged recovery in defensive vs. cyclical stocks (Chart 3). The contraction in U.S. bank lending growth may be heralding slippage in hard economic data (Chart 3), to the benefit of defensive vs. cyclical sectors. Keep in mind that the market is priced for non-inflationary growth nirvana, such that even modest economic disappointment could short circuit the buying binge. The yield curve has stopped widening and financial conditions are no longer easing (Chart 3), providing additional confirmation that the defensive vs. cyclical equity sector trough is more likely a budding trend change than a pause in a downtrend. A trend change is also consistent with the relentless downgrading in emerging market vs. developed country GDP growth expectations (Chart 4). Chart 3Forward Looking Yellow Flags Forward Looking Yellow Flags Forward Looking Yellow Flags Chart 4No EM Confirmation For Cyclicals No EM Confirmation For Cyclicals No EM Confirmation For Cyclicals The lack of a durable and credible growth thrust in EM is confirmed by regional share price performance, as EM equities have significantly lagged their developed country counterparts (Chart 4). Now that China's fiscal stimulus impulse has rolled over amidst ongoing currency depreciation, EM lacks a catalyst for incremental growth outperformance vs. developed markets. Adding it up, evidence of a sub-surface trend change continues to materialize, even in the face of upward momentum in the broad market. We expect a mostly defensive along with select interest rate-sensitive exposure to provide optimal portfolio performance in the next 3-6 months. Defense Stocks Will Continue To Protect Portfolios... A Special Report sent to clients on October 31 outlined the long-term appeal of defense stocks, prior to the installment of a new, bellicose U.S. Administration. If anything, the latter threatens to exacerbate the decline in globalization that was already in progress (as discussed since 2014 by BCA's Geopolitical Strategy Service), potentially creating a leadership vacuum that will raise the specter of open military conflict. More nationalistic foreign policies in a number of countries, i.e. moving away from collaboration and cooperation and toward isolationism and self-sufficiency, is a recipe for increased geopolitical instability. China's challenge to the status quo is also likely to motivate a boost to defense spending globally. The recent World Economic Forum estimates of global military spending by 2030 cite both China and India planning to quadruple military outlays over this time frame (Table 2). The U.S. Administration is already pressuring other NATO members to boost defense spending after a long contraction (Chart 5), which should eventually spillover into rising defense contractor sales. Reportedly, only 5 out of 28 NATO members reached the targeted goal of spending 2% of GDP on defense. Ergo, there is room for an increase, especially in some larger countries with fiscal room to maneuver. More imminently, the conditions that have created the gap between aerospace and defense relative performance are growing even stronger (Chart 6). Table 2A New Arms Race Underway Shifting Internal Dynamics Shifting Internal Dynamics Chart 5Lots Of Upside Lots Of Upside Lots Of Upside Chart 6A Growing Gap A Growing Gap A Growing Gap While U.S. defense spending has been through a soft patch for the past several years, new orders for defense goods have been one of the strongest components of overall durable goods orders (Chart 6). The unfortunate reality is that the incentive to boost defense and security spending has never been higher. Terrorist activity continues to proliferate around the world (Chart 7), raising a sense of geopolitical uncertainty and mistrust. With defense new orders continuing to make new cyclical highs, factory output should run at levels flattering operating margins. Shipments of defense goods are outpacing inventories by a wide margin, which is consistent with solid pricing power. Even exports of military goods are booming (Chart 7), despite the strong U.S. dollar, reflecting a strong undercurrent of global demand. Domestic defense spending has room to expand. Real defense outlays are only just starting to recover (Chart 8). President Trump ran on a campaign to protect the U.S. from terrorism. That should make it comparatively easy to increase defense spending in the years to come. It is normal for defense stocks to retain momentum as defense spending growth accelerates (Chart 8, top panel). Increased staffing at the U.S. Department of Defense (DOD) implies that purse strings may already be loosening in anticipation of heightened activity. DOD employment growth often provides a good leading indication for real defensive spending trends (Chart 8, bottom panel). Thus, while share prices have been on a tear and valuations are not cheap, rapid earnings growth has pushed down forward multiples to manageable, below-market, levels (Chart 9, shown as an average of the companies in the BCA Defense Index). Chart 7Powerful Momentum... Powerful Momentum... Powerful Momentum... Chart 8... With Long-Term Durability ... With Long-Term Durability ... With Long-Term Durability Chart 9Growing Into Valuations Growing Into Valuations Growing Into Valuations Prospects for strong multiyear growth should support a move to a premium valuation as margins expand (Chart 9), similar to what occurred during past defense spending booms, as chronicled in our October 31 Special Report. ...But Aerospace Stocks Are Out Of Fuel In terms of aerospace equities, the outlook is more challenging. New orders have been sinking steadily, reflecting a downturn in the commercial aerospace cycle. While long lead times and lengthy delivery schedules offer some earnings protection, dwindling order backlogs will ultimately undermine confidence in the long-term outlook. Chart 10 shows that aerospace unfilled orders are contracting, an environment typically associated with share price underperformance, or at least elevated volatility. Shipments of aerospace goods are falling, a rare occurrence (Chart 10). The implication is that aerospace industrial production is also shrinking (Chart 10). With a heavily unionized labor force, it will be difficult to maintain profitability. Will increased global growth translate into a recovery in aerospace new orders? Doubtful. Aerospace cycles tend to be long and are not always correlated with the business cycle. Aerospace new order growth has little correlation with the global leading economic indicator. In fact, if anything, it is more countercyclical. Ominously, there are signs of excess capacity. Our global airline consumer price index, a composite of airline pricing power in a number of major countries, is in negative territory. A negative CPI reflects excess capacity, and warns of grim prospects for a recovery in new airplane orders (Chart 11). Chart 10Running On Empty Running On Empty Running On Empty Chart 11Too Much Capacity Too Much Capacity Too Much Capacity Against this backdrop, aerospace profits will become increasingly reliant on maintenance, repair and consumables activity. However, weak pricing power suggests that this source of revenue is soft (Chart 11). Aerospace valuations are close to a par with those of defense stocks. Divergent profit outlooks imply that the latter should expand while the former get squeezed. Bottom Line: We remain confident that the BCA defense index (LMT, GD, RTN, NOC, LLL) will continue to generate above market returns, whereas the BCA aerospace index (BA, UTX, HON, TXT) exhibits asymmetric downside risk. Data Processors Are Losing Their Allure After a consolidation phase that restored value to a more neutral level, we upgraded the S&P data processing index to overweight in late-September, because it fit into our consumption vs. capital spending theme, outperforms in disinflationary environments and would benefit from a recovery in industry sales growth. While several of those factors still exist, the share price ratio has been unable to gain traction and the window for outperformance may be closing. The economic backdrop is no longer conducive to capital inflows. Data processing companies enjoy hefty recurring revenue and high returns on equity, warranting persistent above market valuations (Chart 12). However, the flipside of predictability is lower operating leverage than many other industries and a pattern of underperformance during periods of rising inflation expectations. Indeed, cyclical share price momentum tends to take its cue, inversely, from inflation expectations (inflation expectations shown inverted, middle panel, Chart 12). Renewed traction in global economic growth, as evidenced by the upturn in the global leading economic indicator (GLEI, shown inverted, top panel, Chart 13), represents a headwind to capital inflows and relative multiple expansion. The improvement in business sentiment has also boosted our capital spending model, albeit we are doubtful as to whether increased animal spirits will translate into much of a capital spending cycle in a world of deficient final demand and soft free cash flow. Still, any rise in capital spending would put the services-based data processing group at a disadvantage, in relative terms. The downturn in the ISM services index compared with the ISM manufacturing index reinforces that the external environment has become more challenging (Chart 13). All of these factors could be overcome if operating trends were set to improve. Data processing revenue trends are tightly linked with consumer spending (Chart 14). The personal savings rate has room to fall, facilitating an increase in outlays, particularly now that the labor market has tightened. Rising job security has buoyed consumer confidence, which has historically augured well for data processing sales growth. Chart 12The Window Has Closed The Window Has Closed The Window Has Closed Chart 13Sell Signals Sell Signals Sell Signals Chart 14Margin Squeeze Margin Squeeze Margin Squeeze But top-line growth has been in a funk of late, even with firming pricing power (second panel, Chart 14). Companies have made a significant investment to boost marketing, as evidenced by the surge in SG&A, but so far, this has sapped margins more than stoked revenue. Importantly, Visa has recently provided a fee break to retailers, who are increasingly banding together to put pressure on the industry to lower fees. Amidst increased competition on the payments processing side, this trend is likely to be structural and put downward pressure on profit margins. Thus, we are reluctant to embrace the jump in the producer price index, as future readings could be much weaker. The implication is that operating performance will not overcome macro hurdles. Bottom Line: Reduce the S&P data processing index (V, MA, PYPL, ADP, FIS, FISV, PAYX, ADS, GPN, WU, TSS) from overweight to underweight. Current Recommendations Current Trades Size And Style Views Favor small over large caps. Favor growth over value (downgrade alert).

Our Industrials sector Cyclical Macro Indicator has edged lower after a modest recovery in recent months. The strong U.S. dollar, relapse in short-term pricing power measures and sector productivity contraction are offsetting improvement in global PMI surveys. The lack of confirmation of an industrial sector revival from emerging markets is also holding back the CMI. The post-election surge in share prices is slowly being unwound, as the sector was quick to discount expectations for massive domestic fiscal stimulus. Participation is beginning to fray around the edges, as our relative advance/decline line has rolled over, as has breadth. Our TI is pulling back from overbought levels, warning that a further correction in the share price ratio looms. It would be nearly unprecedented for the share price ratio to trough before our TI hits oversold levels. We retain our high conviction underweight position in the S&P industrials sector. Cyclical Indicator Update Cyclical Indicator Update

Highlights Key Portfolio Highlights Improved world economic growth and rising inflation expectations have buoyed global equities (Chart 1). The downside is that financial conditions are tightening and U.S. dollar-based liquidity is contracting, which is growth restrictive (Chart 2). The massive outperformance of the financials and industrials sectors since the U.S. election implies that U.S. markets have been largely politically-motivated. Positive economic surprises remain mostly sentiment/confidence driven, rather than from upside in hard economic data (Chart 3). That unusually large gap implies that a big jump in 'hard data' surprises is already discounted and represents a latent risk, as it did in the spring of 2011 just before the summertime equity market swoon. Federal income tax receipts are contracting, suggesting that an economic boom is not forthcoming (Chart 4). In fact, there has never been a contraction in tax receipts without a corresponding slump in employment growth. Corporate sector pricing power gains have not been evenly distributed. Deep cyclicals gains came off a low base and may already be experiencing a relapse. Conversely, defensive and interest rate-sensitive sectors are demonstrating the most strength (Chart 5). Our macro models are not signaling that investors should position as if robust and self-reinforcing economic growth lies ahead. Our Deep Cyclical indicators are the weakest, while defensive and interest rate-sensitive models are grinding higher (Chart 6). Deep cyclical sectors are very overvalued and overbought, while defensives are deeply undervalued and oversold (Charts 7 and 8). Mean reversion is an apt theme for the next few months. The most attractive combination of macro, valuation and technical readings are in the consumer staples, health care sectors. The financials sector is a close second, but it is overbought. The least attractive combinations are in energy, materials and industrials. Prospects for elevated market volatility, stronger economic growth in developed vs developing economies, a tighter Fed and expensive U.S. dollar are consistent with maintaining a largely defensive portfolio structure (Charts 9-12). Chart 1Pricing Power Revival... Pricing Power Revival... Pricing Power Revival... Chart 2... But A Liquidity Drain ... But A Liquidity Drain ... But A Liquidity Drain Chart 3Show Me The Money Show Me The Money Show Me The Money Chart 4Yellow Flag Yellow Flag Yellow Flag Chart 5Pricing Recovery Is Not Broad Based Pricing Recovery Is Not Broad Based Pricing Recovery Is Not Broad Based Chart 6Indicator Snapshot Indicator Snapshot Indicator Snapshot Chart 7Focus On Value Focus On Value Focus On Value Chart 8Mean Reversion Ahead Mean Reversion Ahead Mean Reversion Ahead Chart 9Fundamentals Favor Defensives... Fundamentals Favor Defensives... Fundamentals Favor Defensives... Chart 10... As Do Market Signals ... As Do Market Signals ... As Do Market Signals Chart 1112-Month Performance After Fed Hikes Cyclical Indicator Update Cyclical Indicator Update Chart 1224-Month Performance After Fed Hikes Cyclical Indicator Update Cyclical Indicator Update Chart 13Staples Will Cushion A Volatility Resurgence Staples Will Cushion A Volatility Resurgence Staples Will Cushion A Volatility Resurgence Chart 14Media Stocks Like A Strong Currency Media Stocks Like A Strong Currency Media Stocks Like A Strong Currency Chart 15Unduly Punished Unduly Punished Unduly Punished Chart 16Strong Fundamental Support Strong Fundamental Support Strong Fundamental Support Chart 17Less Production... Less Production... Less Production... Chart 18... Means More Rigs ... Means More Rigs ... Means More Rigs Chart 19End Of Sugar High End Of Sugar High End Of Sugar High Chart 20A Toxic Mix A Toxic Mix A Toxic Mix Chart 21Tech Stocks Don't Like Inflation Tech Stocks Don't Like Inflation Tech Stocks Don't Like Inflation Chart 22Time To Disconnect Time To Disconnect Time To Disconnect Feature S&P Consumer Staples (Overweight - High Conviction) The Cyclical Macro Indicator (CMI) has been grinding higher for several months, even climbing through last year's share price shellacking. The CMI has been supported by the uptrend in relative consumer spending on essential items and consumer preference for saving vs. spending. More recently, a pricing power recovery in a number of groups has provided an assist as has a rebound in staples export growth. Booming consumer confidence and business confidence have held the CMI in check. The strong U.S. currency, particularly bilaterally against China, also implies a reduction in the cost of imported goods sold, and has also been an indication of relative valuation expansion because it often signals increased financial market volatility (Chart 13 on page 6). The attractive valuation starting point this cycle, and historic outperformance when the Fed raises interest rates (Chart 13 on page 6), were key factors behind our upgrade to high conviction status in January. Technical conditions are completely washed out. Sector breadth and momentum have reached oversold extremes. That signals widespread bearishness, which is positive from a contrary perspective. Chart 23 S&P Consumer Staples S&P Consumer Staples S&P Consumer Discretionary (Overweight) Our CMI is forming a tentative trough, supported by rebounding relative outlays on media services, low prices at the pump, a budding recovery in mortgage equity withdrawal and firming wage growth. The biggest drags over the past few months have come from higher Treasury yields and consumers increased propensity to save. However, rising job certainty and a vibrant residential real estate market suggest that consumers should loosen their purse strings. The VI has deflated toward the neutral zone, although remains moderately expensive from a long-term perspective. Our TI started to rebound from oversold levels. History shows that a recovery in the TI from one standard deviation below the mean has heralded a playable relative performance rally. Overweight positions should remain concentrated in housing-related equities and the media space, both of which benefit from U.S. dollar appreciation (Chart 14 on page 6). Chart 24 S&P Consumer Discretionary S&P Consumer Discretionary S&P REITs (Overweight - High Conviction) Our new REIT CMI has ticked lower, but the share price ratio has over-exaggerated this small move down. REITs have traded as if the back up in global bond yields will persist indefinitely, and that they are the only factor that drives relative performance. Improving cash flows and cheap valuations suggest that REITs can decouple from bond yields. Banks have tightened standards on commercial real estate loans, but this appears more likely to limit supply growth than create a slowdown. Commercial property prices are hitting new highs and our REIT Demand Indicator (RDI) has climbed into positive territory, signaling higher rental inflation. The latter is already outpacing overall CPI by a wide margin (Chart 15 on page 7). While REITs are back to fair value from a long-term perspective, on a shorter term basis the sector is very undervalued (Chart 15 on page 7), particularly with Treasury yields now in undervalued territory. Our REIT TI is extremely oversold, at a point which forward relative returns typically shine on a 12 and 24 month basis, even excluding the dividend yield kicker. Chart 25 S&P Real Estate S&P Real Estate S&P Health Care (Overweight) Our CMI continues to grind higher, opening a massive divergence with relative performance. This gap can be explained by the political attack on the pharmaceutical industry, the sector's heavyweight, rather than by a downturn in relative earnings drivers. Pharmaceutical shipments are hitting new highs and pricing power continues to grow at a robust mid-single digit rate. Future pricing gains may slow if government gets more heavily involved in setting prices, but this is already discounted. Pricing power in the rest of the sector remains strong, while wage inflation is tame. Health care spending is still growing as a share of total spending, but the pace is decelerating. Typically, this backdrop signals outperformance for health care insurers, who may also receive a risk premium reduction from a potential revamp of the Affordable Care Act, albeit the timing will likely be drawn out. Relative valuations are very attractive. The sector has been used as a source of capital to fund purchases in areas expected to benefit from increased fiscal stimulus. That is an overreaction, and flows should be restored to reflect the sector's appealing investment profile, particularly given the sector's track record during Fed tightening cycles (Chart 16 on page 7). The TI is deeply oversold. Breadth measures are beginning to recover from completely washed out levels. These conditions reinforce that an exploitable undershoot has occurred. Chart 26 S&P Health Care S&P Health Care S&P Financials (Neutral) Our Financial CMI has surged, underscoring that the advance in relative performance reflects more than just a reaction to anticipated sector deregulation by the Trump Administration. Leading indicators of capital formation, such as the stock-to-bond ratio, have jumped sharply. Moreover, the yield curve has steepened in recent months, bolstering the CMI. An improvement in overall profit growth and the tight labor market suggest that the credit cycle may not become a profit drag until the economy begins to cool. While not yet evident, the restrictive move in oil, the dollar and bond yields warn that disappoint may emerge in the coming months. It is notable that bank loan growth has dropped to nil over the last 3 months. C&I loan growth is contracting over that time period. Banks are hiring more aggressively, yet are tightening lending standards, suggesting productivity disappointment ahead. Despite the share price jump, value remains attractive after 8 years of financial repression. Our TI is overbought and breadth is beginning to recede, which is often a precursor to a consolidation phase. We are not willing to move beyond a market weight allocation at this juncture. Chart 27 S&P Financials S&P Financials S&P Energy (Neutral) Our CMI has plunged, probing all-time lows. Rising oil inventories and spiking wage inflation are exerting severe gravitational pull on the CMI, more than offsetting the budding recovery in domestic production. Refining margins are probing six year lows as the Brent/WTI spread has evaporated. Nevertheless, OPEC is finally curtailing production, joining non-OPEC producers (Chart 17 on page 8), which should ultimately help eat into excess global oil supply. History shows that once supply growth peaks, the rig count typically firms. That is a plus for energy services (Chart 18 on page 8), even though rising oil production will prove self-limiting for oil prices. High yield spreads have narrowed significantly from nosebleed levels, but industry balance sheets remain bruised. Net debt is historically elevated, EBITDA has yet to return to its glory days, and interest coverage remains anemic and vulnerable to any downside energy price surprises. The surge in our VI reflects depressed cash flow, and is overstating the degree of overvaluation. The TI has returned to the neutral zone, and will need to hold at current levels otherwise a relapse in the share price ratio toward previous lows is probable. Selectivity is still warranted in the energy complex. We remain underweight refiners and overweight the energy services index. Chart 28 S&P Energy S&P Energy S&P Utilities (Neutral) Our utilities sector CMI is stabilizing. That is a surprise, given the rebound in inflation expectations and firming global leading economic indicators, which are typically bearish for this defensive, fixed-income proxy. The latter negative exogenous factors are being offset by falling wage inflation, better pricing power and rising electricity output growth. Power demand is linked with manufacturing activity, underscoring that there is an element of cyclicality to sector profits. The share price ratio has held up better than most other defensive sectors since the U.S. election, perhaps on the hope that an overhaul of the tax code will benefit this domestic sector. Regardless, valuations have retreated from the extremely expensive zone where we took profits and downgraded to neutral last summer, but are not yet at a level that warrants re-establishing overweight positions. An upgrade could occur once our TI becomes fully washed out, provided that occurs within the context of additional CMI strength and a peak in global growth and inflation momentum. Chart 29 S&P Utilities S&P Utilities S&P Industrials (Underweight - High Conviction) The CMI has edged lower after a modest recovery in recent months. The strong U.S. dollar, relapse in short-term pricing power measures and sector productivity contraction are offsetting improvement in global PMI surveys. The lack of confirmation of an industrial sector revival from emerging markets is also holding back the CMI. There continues to be a deflationary undercurrent in the form of more rapid capacity than industrial sector output growth, suggesting that durable pricing power gains may remain elusive (Chart 19 on page 9). The post-election surge in share prices is slowly being unwound, as the sector was quick to discount expectations for massive domestic fiscal stimulus. Our valuation gauge is not at an extreme, although a number of individual groups are trading at historically rich multiples, such as machinery and railroads. Participation is beginning to fray around the edges, as our relative advance/decline line has rolled over, as has breadth. Our TI is pulling back from overbought levels, warning that a further correction in the share price ratio looms. It would be nearly unprecedented for the share price ratio to trough before our TI hits oversold levels. Industrials fare poorly when the Fed tightens. Chart 30 S&P Industrials S&P Industrials S&P Materials (Underweight) The CMI has nosedived, reflecting China's diminishing fiscal thrust and the recent tightening in monetary policy. Commodity price inflation peaked in mid-December concurrent with the Fed raising rates, signaling that emerging markets end-demand, in general and Chinese in particular, is likely past its prime. The nascent rebound in EM currencies represents a positive offset, but not by enough to turn around the CMI. Select heavyweight EM manufacturing PMIs are still below the boom/bust line. Relative valuations are becoming extended according to our VI, and stretched technical conditions are waving a red flag. Keep in mind the materials sector has an abysmal performance history after the Fed starts tightening (Chart 20 on page 9). The heavyweight chemical index (75% of the sector) bears the brunt of the downside risks owing to excess capacity (Chart 20 on page 9). On the flipside, overweight exposure in gold mining (via the GDX:US ETF) and the niche containers & packaging sub-indexes is recommended. Chart 31 S&P Materials S&P Materials S&P Technology (Underweight) The CMI has rolled over, driven lower by contracting relative pricing power, decelerating new orders-to-inventories growth, lack of capital expenditure traction and the appreciating greenback. Tech stocks thrive in a disinflationary/deflationary environment and suffer during inflationary periods (Chart 21 on page 10). Inflation is making a comeback, so it will be an uphill battle for tech companies to successfully raise selling prices at a fast enough pace to keep profits on a par with the broad corporate sector. While a capital spending cycle would be a welcome development, the narrowing gap between the return on and cost of capital warns against extrapolating improvement in business sentiment just yet. Our S&P technology operating profit model warns that tech profits are likely to trail the broad market as the year progresses, a far cry from what is embedded in analysts' forecasts. The good news is that valuations are not demanding nor are technical conditions overbought, which should cushion the magnitude and sharpness of downside risks. Chart 32 S&P Technology S&P Technology S&P Telecom Services (Underweight) Our CMI for telecom services has gained ground of late, primarily on the back of a sharp decline in wage inflation. However, we recently downgraded exposure to underweight, because of a frail spending backdrop. Our telecom services sales model is extremely weak (Chart 22 on page 10). Softening outlays on telecom services have reinvigorated the industry price war, and our pricing power gauge is sinking like a stone (Chart 22 on page 10). Telecom carrier capital expenditures have been running at a healthy clip, which could further pressure profit margins. Undervaluation exists, but this has been a chronic feature for the sector over the past decade, and does not foretell of cyclical upside or downside risks. Our TI has plunged into the sell zone, but remains above levels that would signal that a countertrend rally is imminent. Chart 33 S&P Telecommunication Services S&P Telecommunication Services Size Indicator (Overweight Small Vs. Large Caps) The small/large cap ratio is correcting short-term overbought conditions. The dip in the U.S. dollar has provided a fundamental reason for corrective action in this domestically-oriented asset class. However, we doubt a trend change is at hand. Our style CMI is climbing steadily. Small company business optimism has soared, partly because of an increase in planned price hikes, but also from an anticipated reduction in the regulatory burden. If small company price hikes persist, then rising labor costs will be more easily absorbed. That is critical to narrowing the profit margin gap between small and large firms. A stronger domestic vs. global economy and the potential for trade barriers is also unambiguously positive for small firms that do the bulk of their business at home. Despite the surge in the share price ratio post-U.S. election, our valuation gauge is not yet at an overvalued extreme. The lack of extreme overvaluation suggests that positive momentum will persist, perhaps similar to the 2004-2006 period, when the share price ratio stayed in overbought territory for years. Chart 34 Size Indicator (Small Vs. Large Caps) Size Indicator (Small Vs. Large Caps)

Highlights France is on the verge of pro-market structural reforms; Marine Le Pen will not win the presidency. Her odds are 15%; The French economic upswing will continue to surprise; Overweight French stocks relative to German; Buy the euro on any election-related dip. Feature Le courage consiste à savoir choisir le moindre mal, si affreux soit-il encore. - Stendhal La France ne peut être la France sans la grandeur. - Charles de Gaulle Every decade, a country defies stereotypes and surprises investors with ambitious, pro-market and pro-business, structural reforms (Chart 1). Margaret Thatcher's laissez-faire reforms pulled Britain out of the ghastly 1970s and into the wild 1980s. Sweden surprised the world in the 1990s when voters turned against the generous social welfare system under the stewardship of the center-right Moderate Party. At the turn of the century, Germany's Social Democratic Party (SPD) defied its own label and moved the country to the right of the economic spectrum. Finally, this decade's reform surprise is Spain, which undertook painful labor and pension reforms that have underpinned its impressive recovery. What do all of these episodes have in common? Investors - and the public at large - didn't see them coming. Our favorite example is the Hartz IV labor reforms in Germany. The SPD government of Gerhardt Schröder completely re-wired Germany's labor market, leading to the export boom that has lasted to this day (Chart 2). And yet The Economist welcomed the Schroeder government with a scathing critique that is a textbook example of how the media often confuses stereotyping for data-driven analysis.1 Chart 1Each Decade Has A Reform Surprise Each Decade Has A Reform Surprise Each Decade Has A Reform Surprise Chart 2The German Miracle The German Miracle The German Miracle We think that this decade will belong to France. Yes, France. While the dominant narrative today is whether Marine Le Pen will win the presidential elections on April 23 (with a possible runoff on May 7), we think the real story is that the two other serious candidates are pro-growth, pro-reform, pro-market candidates. François Fillon and Emmanuel Macron are both running platforms of structural reforms. They are not hiding the fact that the reforms would be painful. On the contrary, their campaigns revel in the self-flagellation narrative. Most of our clients either politely roll their eyes when we present this view or counter that the French are ______ (insert favorite stereotype). We welcome the pessimism! It shows that the market is not yet pricing in a pro-market revolution that guillotines a long list of French inefficiencies. In this analysis, we present what is wrong with France, whether the presidential candidates running in the election plan to fix the problems, and our view of who is likely to win. Forecasting elections is a Bayesian process, which means that the probabilities must be constantly updated with new information. As such, we intend to keep a very close eye on the developments in the country over the next four months. What Is Wrong With France? France has a growth problem. While this is partly a cyclical issue, the reality is that its real per-capita GDP growth has been closer to Greek levels than German over the last two decades (Chart 3). In addition, France has lost competitiveness in the global marketplace, judging by its falling share of global exports relative to peers (Chart 4). Chart 3France's Lost Millennium The French Revolution The French Revolution Chart 4Export Performance Is A Disaster Export Performance Is A Disaster Export Performance Is A Disaster Three issues underpin the French malaise of the past two decades: The state is too large; The cost of financing the large state falls on the corporate sector; The labor market is inflexible. First, the French state relative to GDP is the largest in the developed world. In 2016, public spending was estimated to be 56% of GDP, compared with 44% of GDP in Germany and just 36% in the U.S. (Chart 5)! What is most concerning is that the state has actually grown in the past two decades from already unsustainable levels (Chart 6). Government employment as share of total employment is naturally very high (Chart 7). Chart 5The French State Is Large... The French Revolution The French Revolution Chart 6... And Continues To Be In Charge The French Revolution The French Revolution Chart 7French Talent Is Wasted In The Public Sector The French Revolution The French Revolution Such a large public sector requires very high levels of taxation. Government tax revenues are also second-largest in the developed world at 45% of GDP (Chart 8) and, like the size of the overall public sector, continue to grow (Chart 9). Chart 8French Tax Burden Is Large... The French Revolution The French Revolution Chart 9...And Growing The French Revolution The French Revolution Part of the problem is the labyrinth of administrative layers beneath the central government. France has 13 regional governments, 96 departments, 343 arrondissements, 4,058 cantons, and 35,699 municipalities.2 What do they all do? We have no idea. Reforms in 2015 have sought to reduce the number of sub-federal layers, but the process ought to go much further and faster. The French social welfare state is also inefficient. To be fair, it has kept income inequality in check, which has not been the case in more laissez-faire countries (Chart 10). This is an important part of our political analysis. French "socialism" is what keeps populism at bay, which was the intention of the expensive welfare state in the first place.3 However, there is a lot of room to trim the fat. The French welfare state is essentially an "insurance program" for the middle class, with more transfers going to the households in the top 30% income bracket than in the bottom 30% (Chart 11)! France could cut its massive social spending by means-testing the benefits that accrue to the upper middle class.4 Somebody ultimately must pay for the enormous public sector. In France, a large burden falls on employers. The French "tax wedge" - the difference between the cost of labor for the employer and the take-home pay of the employee as a percent of total remuneration - is one of the largest in the OECD (Chart 12). The heavy tax burden on employers, combined with a relatively high minimum wage, means that business owners are wary of hiring new workers. The tax wedge is ultimately passed on to the consumer by businesses, which hurts competitiveness and contributes to the poor performance of French exports.5 Chart 10A Positive: ##br##No Income Inequality A Positive: No Income Inequality A Positive: No Income Inequality Chart 11French Welfare State##br## Protects...The Rich! The French Revolution The French Revolution Chart 12Employees Are Too Expensive ##br##For Employers The French Revolution The French Revolution The French labor market remains inflexible and overprotected (Chart 13), which not only hurts competitiveness but also discourages youth employment (Chart 14). According to the OECD Employment Protection Index, both regular and temporary contracts have some of the highest levels of protection in the developed world. Germany actually has a higher level of protection in regular contracts, but not in temporary employment, thanks to ambitious reforms. Chart 13French Labor Market##br## Is Too Rigid The French Revolution The French Revolution Chart 14French Youth Underperforms ##br##OECD Peers The French Revolution The French Revolution Chart 15Starting A Business In France? ##br##Bonne Chance! The French Revolution The French Revolution Finally, France suffers from too much red-tape (Chart 15), too much regulation (Chart 16), high wealth taxes that force capital out of the country, and too many barriers to entry for medium-sized enterprises, the lifeblood of innovation and productivity gains (Chart 17). Part of the reason that France suffers from a lack of German-styled Mittelstand (small and medium-sized enterprises) is that the effective tax rate of the medium-sized businesses is greater than that of large enterprises (Chart 18). This is a problem given the already high levels of corporate tax rates in the country (Chart 19).6 Chart 16Too Much Regulation The French Revolution The French Revolution Chart 17France Needs A Mittelstand The French Revolution The French Revolution François Hollande's government tried to address many problems facing France. However, Hollande largely spent his term treating the symptoms and not trying to cure the disease. France can reduce regulatory barriers and tinker with labor flexibility. It can even shift the tax burden from employers to consumers. But the fundamental problem is the large state, which forces the government to raise lots of taxes one way or another. Chart 18French SMEs Are Punished ##br##With High Taxes The French Revolution The French Revolution Chart 19French Corporate Taxes ##br## Are High By European Standards The French Revolution The French Revolution Bottom Line: The French state is too big. Up to this point, reforms have largely focused on tinkering with how the government raises funds for the welfare state. But what France needs is to alleviate the tax burden in the first place. The state, therefore, must be cut. Why Will France Reform? Our clients and colleagues challenge our view on France by rightly pointing out that painful structural reforms are easiest following a "market riot" or deep recession. Neither has befallen France. It actually did remarkably well in weathering the 2008 Great Recession, compared to OECD peers, and it has not faced the extraordinary housing or unemployment busts of neighboring Spain. Yet crises are not necessarily a must for successful reforms. Australia, starting in the mid-1980s and throughout the 1990s, pursued broad-based reforms due to a prolonged period of mediocre growth.7 So did Germany in the 2000s. We think that it is precisely this underperformance that is today motivating France. In particular we see three broad motivations: Competition with Germany: France did not lead the creation of European institutions in the twentieth century in order to cede leadership to Germany. As Charles de Gaulle said, "France is not France without greatness." The economic underperformance versus Germany is not geopolitically sustainable (Chart 20). If France continues to lose economic ground to Germany, it will continue to play second-fiddle to Berlin in the governing of the EU. At some point, but not likely in 2017, this will reinforce the populist logic that France should go it alone, sans the European institutions. Change impetus: It is difficult to imagine how François Fillon and Emmanuel Macron can run on an anti-establishment, "change" platform. Fillon proudly calls himself a Thatcherite (in 2017!) and Macron is a former Rothschild investment banker. And yet they are doing so. This is especially astonishing after the successes of Donald Trump and the Brexit campaign, which specifically targeted elitist policymakers like Fillon and Macron. But in France, the status quo is a large state, dirigiste economy, and a generous welfare system. In other words, the French are turning against their status quo. Laissez-faire is change in France. Social welfare fatigue: Our colleague Peter Berezin argued in a recent Special Report that Europeans will turn against the welfare state due to the breakdown in social cohesion. Significant populations of immigrant descent - as well as recent arrivals - fail to properly integrate in countries where the welfare state is large.8 Resentment against immigrants, and citizens of immigrant descent, could therefore be fueling resentment against the expensive welfare state. Chart 20France Is Not France Without Greatness France Is Not France Without Greatness France Is Not France Without Greatness Chart 21"Silent Majority" Wants Reform The French Revolution The French Revolution Polls suggest that we are on to something. Chart 21 illustrates that there may be a Nixonian "silent majority" in France favoring supply side reforms. Per January 2017 polling, "blue collar" and "left leaning" employees oppose reforms. But surprisingly by extremely narrow margins (Chart 21, bottom panel)! Thus, there is demand for structural reforms, but is there supply? According to a review of the platforms of Macron and Fillon, we think the answer is a resounding yes (Table 1). Generally speaking, François Fillon's proposed reforms are the deepest, but Macron would also pursue reforms aimed at reducing the size of the state. Marine Le Pen, too, promises to reduce the size of the public sector, suggesting that the narrative of reform is now universal. However, it is not clear how she would do so. Her views on the EU and the euro are also not positive for growth or the markets, as they would precipitate a recession and an immediate redenomination crisis. As we discuss below, it is likely that her opposition to European integration is precisely what is preventing her from being a much more competitive opponent against Fillon and Macron in the second round. Table 1French Presidential Election: Policy Positions Of Chief Contenders The French Revolution The French Revolution What of implementation? In France, several reform efforts - the 1995 Juppé Plan, 2006 labor reforms and 2010 Sarkozy pension reforms in particular - prompted significant social unrest. However, unrest is having diminishing returns for unions and left-wing activists. While unrest forced the government to fully reverse both the 1995 Juppé Plan and the 2006 labor reforms, it did not manage to hold back retirement reforms in 2010. The Sarkozy government made some concessions, but the core of the reforms remained in place despite severe unrest that brought the country to a standstill. Most recently, in spring 2016, the El Khomri law - proposing modest changes to the French labor code - was rammed through by Prime Minister Manuel Valls using Article 49.3 of the French constitution. Despite significant unrest, the law passed and became law in August. Protests remained peaceful - unlike the 2010 unrest - and eventually fizzled out. Investors should not be afraid of unrest. Unrest is a sign that reforms are being enacted. We would be far more concerned if the election of Fillon or Macron did not lead to strikes and protests! That would be a sign that their reform efforts are not ambitious. But our review of the unrest and strikes in France since 1995 suggests that the last two events - in 2010 and 2016 - ultimately did lead to reforms. In addition, most significant international reform efforts lead to protests. The U.K. miners' strike (1984-85) led to over 10,000 arrests and significant violence. German labor reforms in the 2000s led to a spike in strikes. And the 2011 Spanish reforms under PM Rajoy led to the rise of Indignados, student protesters occupying public spaces, who ultimately gave the world Occupy Wall Street. When it comes to reforms, the adage "no pain, no gain" rings true. Most effective reforms, however, will come right after the election. The incoming president will have about 12 months to convince investors that he is serious about reforms, as this is when the new government has the most political capital and legitimacy for reforms. In addition, much will depend on whether Fillon and Macron have parliamentary majorities with which to work to enact reforms. France's parliamentary election will follow the presidential (two rounds, June 10 and 17). Every president has managed to gain the majority in parliament since the two elections were brought to the same year (2002). Macron's new third party - En Marche! - will likely struggle to gain a foothold in the parliament, even if he wins. However, we suspect that both Les Républicains and centrist members of the Socialist Party will support his reforms. Macron's reforms are more modest than Fillon, at least according to Table 1 and his rhetoric, but they would still be a net positive. Ultimately, investors will have plenty of opportunity to reassess the reform efforts as the new government proposes them. In this analysis, we have sought to simplify what we think is wrong with France. If the government does not address our three core issues - how big is the state, how the state is funded, and the flexibility of the labor market - then we will know that our optimism was misplaced. Bottom Line: We believe that the support for reform exists. A review of electoral platforms reveals that all three major candidates are promising reforms that reduce the size of the French state. This can only mean that French politicians recognize that the "median voter" wants it to be reduced.9 Can Le Pen Win? Although Marine Le Pen, leader of National Front (FN), wants to reduce the size of the state as much as her counterparts, her broader approach poses an obvious risk to the stability of France, Europe, and potentially the world. Her position on the EU and the euro is extreme. She seeks to replace the EU with a strategic alliance with Russia, that she thinks would then include Germany. In the process, the euro would be abandoned. The extreme nature of Le Pen's proposals may ironically increase the likelihood of pro-market reforms in France. François Fillon's problem - aside from the ongoing corruption scandal involving his wife - is that 62% of the French public believes that "his program is worrisome."10 He may therefore win purely because Le Pen's proposal of dissolving the EU and the euro is even more worrisome. What are Le Pen's chances of overcoming the population's fear of abandoning the euro and EU institutions? We think they are very slim. Fillon's corruption scandal could grow, but we think that it is too little too early. With three months ahead of the first round, the spotlight on Fillon may have come too soon. Meanwhile, Le Pen's FN is not without skeletons in her closet. The party's main financial backer has been a Russian bank whose license was revoked by Russia's central bank in June. Le Pen refuses to disclose the details of her campaign funding, unlike Fillon and Macron.11 So what are the chances of a Le Pen presidency? Following the U.S. election, many of our clients wonder where populism will triumph next. In meetings and at conference panels, clients ask whether Marine Le Pen can replicate the success of Donald Trump and the anti-establishment Brexit campaign. Our view has not changed since our Client Note on the topic last November: Le Pen has a very low probability of winning.12 Our subjective figure is 15%. This view is not necessarily based on the strength of her opponents. In other words, if François Fillon stumbles in the first round, we believe that Emmanuel Macron will win in the second round. Our view is focused more on the structural constraints that Le Pen faces. There are three reasons for this view: The Euro The French support the euro at a high level. Marine Le Pen wants to take France out of the euro. Thus, her popularity is inversely correlated with the support for the euro (Chart 22). Euro support bottomed in France in 2013 at 62%, the same year when Le Pen's popularity peaked at 36%. The populist and nationalist Le Pen has not regained her 2013 levels of support despite a massive immigration crisis in Europe and numerous terrorist attacks against French citizens. This is surprising and important. Chart 22The Euro Is Le Pen's Foil The Euro Is Le Pen's Foil The Euro Is Le Pen's Foil The only way we can explain her lackluster performance in the face of crises that should have helped her popularity is her ideological and rhetorical consistency on the euro. For several different reasons,13 the French public supports the common currency as well as the EU - like most Europeans. Le Pen's insistence on "Frexit" is a major hurdle to her chances of winning. The Polls Before we dive into the French presidential polls we should remind our readers of our view that polls did not get Brexit and Trump wrong. Pundits, the media, and data-journalists did. Polls were actually showing the Brexit camp ahead throughout the first two weeks of June. It was only once MP Jo Cox was tragically murdered on June 16 that polls favored the "Stay" vote for the final days of the campaign. Yet on the day of the vote, the "Stay" camp was ahead by only 4%. That should not have given investors the level of confidence they had in the pro-EU vote. The probability of Brexit, in other words, should have been a lot higher than the 30% estimated by the markets (Chart 23). Chart 23ASmart Money Got Brexit Wrong... Smart Money Got Brexit Wrong... Smart Money Got Brexit Wrong... Chart 23B...Despite Close Polling ...Despite Close Polling ...Despite Close Polling Similarly, the national polls in the U.S. election were not wrong. Rather, the pundits and quantitative models overstated the probability of a Clinton victory. What the modelers missed was the unfavorable structural backdrop for Clinton: the challenges associated with one party holding the White House for three terms, lackluster economic growth, lukewarm approval ratings for Barack Obama and his policies, and general discontent, partly signaled by the non-negligible polling of third-party challengers. In addition, the modelers ignored that American polls have a track record of underestimating, or overestimating, performance by about 2-3% (Chart 24). And crucially, the 2016 election was different in that the number of undecided voters at the cusp of the vote was nearly triple the average of the previous three elections (Chart 25). Chart 24Election Polls Usually Miss By A Few Points The French Revolution The French Revolution Chart 25Undecided Voters Decided The Election Undecided Voters Decided The Election Undecided Voters Decided The Election The polls were much closer, in other words, than the dominant media narrative revealed. With four months until the election, Donald Trump actually took a slight lead against Hillary Clinton, following the July GOP convention. In aggregate polling, he never trailed Clinton by more than 7% from that point onwards (Chart 26). With four months until the second round of the French election in May, Marine Le Pen is trailing her two centrist opponents by 20-30% (Chart 27)! In other words, Trump at this point in the campaign was roughly three times more competitive than Le Pen! Chart 26Le Pen Is No Trump Le Pen Is No Trump Le Pen Is No Trump Chart 27Second Round Polls Are All That Matters The French Revolution The French Revolution We will therefore agree with the narrative that Le Pen could be the next Trump or Brexit when she starts performing in the polls as well as Trump and Brexit! Right now, she is nowhere close to that. Could Marine Le Pen close the gap in the next four months? It is unlikely. Le Pen is not a political "unknown" like Trump. She is not going to "surprise" voters into voting for her in 2017. She was her party's presidential candidate in the 2012 election. Her father, Jean-Marie Le Pen, contested elections in 1988, 1995, 2002, and 2007. The National Front has contested elections in France since the 1970s. Voters know what they are getting with Le Pen. The best-case scenario for Le Pen is that Fillon gets into the second round, and then during the two-week interval between the first and second rounds (April 23, May 7) more corruption is revealed by Fillon and his popularity tanks. This is the "Clinton model" and it is certainly plausible. But it would have to be egregious corruption given that Le Pen's popularity ceiling appears to be the same percentage of French population not in favor of the euro. We suspect that this ceiling is hard. Which is why we have Le Pen's probability of winning the election at only 15%. In addition, there is no vast pool of the undecided in France. French turnouts for the presidential election are consistently 80%. Therefore, translating polling data to actual turnout data will be relatively straightforward. The polls are real. Le Pen may be able to outperform her polls by several points. But not by the 20-30% by which she trails Fillon and Macron in polling for the crucial second round. In fact, Le Pen could even struggle to get into the second round given that the winner of the Socialist Party primary - Benoit Hamon - could bleed left-wing voters away from Le Pen, leaving Fillon and Macron to enter the second round instead. At that point, the election becomes a coin toss between two reformers, but we would give the less "worrisome" Macron a slight edge. Precedent History is important because there is a precedent for solid Euroskpetic performances in France. In fact, Euroskeptic candidates - broadly defined - have won around 32% of the vote in the first round of the presidential election since 1995 (Chart 28). As such, Le Pen's current polling in the first round - 26% level of support - and second round - 37% of support - is within the historical average. It is on the high end, but still within the norm. Her father, for example, got 17% in the first round of the 2002 election and 18% in the second. Chart 28French Euroskepticism ##br##Is Not A Novel Concept The French Revolution The French Revolution We also have a very good recent case study - a natural experiment if you will - of the anti-establishment's electoral performance: the December 2015 regional elections. The two-round regional elections occurred only 23 days following the November 2015 terrorist attack in Paris and at the height of that year's migration crisis. They should have favored the Front National (FN). They also should have favored the FN for these technical and political reasons: Rules: The second round in the regional elections has a participation threshold of 10%, unlike the presidential and parliamentary elections which eliminate all but the top two candidates. This means that FN faced off against multiple candidates, reducing the probability that "strategic voting" drove centrist voters to choose the one remaining establishment candidate over the anti-establishment candidate, as will be the case in the upcoming presidential election. Protest vote: The regions of France have no authority to negotiate international treaties. As such, voters could freely vote for the anti-establishment FN as a sign of protest, without fear that the FN councilors would then take the country out of the euro and the EU. Voters faced no clear downside risk of sending a harsh message to the establishment. Context: Both the ruling Socialists and the opposition Union for a Popular Movement (now renamed Les Républicains) were in disarray ahead of the regional elections for a number of reasons, including the aforementioned terrorist attacks, unpopularity of President Hollande, leadership struggle within UMP, and EU mismanagement of the migration crisis. The National Front ended the first round with a slight lead in total votes, but captured the lead in six out of the 13 regions. The financial press went wild, calling it an extraordinary win for the anti-establishment in France. Yet despite the near optimal circumstances and a strong showing in the first round, FN was obliterated in the second round, a mere one week later. The populists won none of the regions that they captured in the first round! Why? Participation increased in the second round from 49% to 59%, signaling that many French voters were motivated to vote in less-relevant regional elections purely to keep FN out of power. The National Front share of the total vote remained stable at 27%, despite the increase in the turnout. This means that almost none of the "new" voters cast their support for FN, an incredible development. Socialist Party candidates withdrew from the contest in several regions where FN candidates were high profile politicians (Nord Pas de Calais led by Marine Le Pen herself and Province Alpes Cote d'Azur led by Le Pen's niece Marion Marechal Le Pen). Most importantly, Socialist voters did not swing to the economically left-leaning FN in these contest, but rather either stayed home or swung to the center-right rival, the UMP. If French voters decided to cast a strategic vote against FN in an election where the downside risk to a protest vote was non-existent, why would they do any different in a vote that clearly and presently matters? Furthermore, the fact that the higher turnout hurt FN should concern Le Pen. As we mentioned above, presidential election turnouts in France are around 80%. The 2015 election also should teach us an important lesson about France: polls work. Based on IFOP polling conducted two weeks before the election, the average polling error in the December 2015 regional election was 2.5%. Bottom Line: Marine Le Pen's support is precisely the inverse of the French support for the euro. Her anti-European stance is apparently a "deal breaker" for many voters who would otherwise support her candidacy. If she asked us for advice, we would say to flip-flop on the euro. It would make her far more competitive in 2017. Le Pen is trailing her centrist opponents by a massive margin in the second round. Polls can be wrong when they suggest that the contest is within the margin of error. But that is definitely not the case in the upcoming French election. Finally, the 2015 election teaches us that strategic voting continues in France, even when the establishment parties are in disarray and the geopolitical and political context favors populists. Cyclical View The French economy is currently experiencing an economic upswing. This upswing is not much of a mystery. It is explained by three factors: Easing monetary conditions in Europe, pent-up demand, and reflationary policies in China. Let's start with monetary conditions. The easing began in July 2012, with ECB president Mario Draghi's now famous pronouncement that he would do "Whatever it takes" to ensure the survival of the euro. Thanks to these soothing words, risk premia in the region collapsed, with a massive narrowing of government bond spreads between the periphery and Germany. France too benefited from that phenomenon, with its own spreads moving from a max of 190 basis points in late 2011, to 21 basis points seven months ago. Thanks to this normalization, lending rates to the private sector collapsed from 4.6% to 2% (Chart 29) This meant that the fall in the repo rate engineered by the ECB was finally passed on to the private sector. Additionally, the ECB stress tests of 2014 played a major role. In anticipation of that exercise, euro area banks curtailed credit in order to clean up their balance sheets. This resulted in a large contraction of the European credit impulse. However, once the tests were passed, euro area banks, with somewhat healthier balance sheets, normalized credit conditions, letting credit growth move closer in line with trend GDP growth. The result was a surge in the credit impulse that lifted growth in Europe (Chart 30). Chart 29Whatever It Takes Equals##br## Lower Private Sector Rates Whatever It Takes Equals Lower Private Sector Rates Whatever It Takes Equals Lower Private Sector Rates Chart 30Credit Impulse Dynamics##br## And Growth Credit Impulse Dynamics And Growth Credit Impulse Dynamics And Growth The euro also was an important factor. In mid-2014, investors started to speculate on a major easing by the ECB, maybe even QE. Through this discounting process, the euro collapsed from a high of 1.39 in May 2014 to a low of 1.05 in March 2015, when the ECB indeed began implementing asset purchases. This incredible 25% collapse in the currency boosted net exports, and helped GDP, while limiting existing deflationary pressures in Europe. The final reflationary impulse came from fiscal policy. In the wake of 2008, French fiscal deficits ballooned. As a result, from 2011 to 2013, the French fiscal thrust was negative and subtracted an average 1% from GDP growth. However, starting 2014, this drag vanished, arithmetically lifting growth in the country (Chart 31). Ultimately, with the accumulated pent-up demand resulting from the double-dip recession, France was able to capitalize on these developments. First, after having contracted by 14% between 2008 and 2009, and then by another 3% between 2011 and 2013, capex growth was able to resume in earnest in 2015 . This was necessary because, due to the subpar growth in capital stock, even the current tepid economic improvement was able to push capacity utilization above its 5-year moving average. When this happens, the economy ends up displaying the clearest sign of capacity constraint, i.e. higher prices, which we are seeing today. It also results in growing orders (Chart 32). Chart 31The Vanishing Of ##br##French Fiscal Drag The Vanishing Of French Fiscal Drag The Vanishing Of French Fiscal Drag Chart 32French Capacity Utilization Has Tightened ##br##And Orders Are Improving French Capacity Utilization Has Tightened And Orders Are Improving French Capacity Utilization Has Tightened And Orders Are Improving Second, we have witnessed a stabilization in employment and wages. The unemployment rate has fallen by 1% from 10.5% in 2015 to 9.5% today. Most importantly, our wage and employment models are pointing toward higher salaries and job growth in the coming quarters (Chart 33). This is crucial. The French economy remains fundamentally driven by domestic demand and household consumption in particular. In fact, these signs of coming higher household income suggest that the consumer can once again begin to support economic activity in France. First, we expect real retail sales to improve in the coming quarter. Second, because of the combined effect of rising labor income, consumer confidence, and housing prices, the recent upswing in housing activity should gather momentum (Chart 34), creating a further floor under economic activity. Chart 33Improving French Labor Market Conditions Improving French Labor Market Conditions Improving French Labor Market Conditions Chart 34Housing Will Contribute More To Growth Housing Will Contribute More To Growth Housing Will Contribute More To Growth Third, the improvement in credit growth corroborates these developments. In fact, being supported by easing credit standards, it even suggests that broad economic activity in France could accelerate further in the coming months. The key question mark at this point in time is China. France exports to China are only 3.7% of total exports, or 0.7% of GDP, below Belgium. However, the largest single export market for France is Germany, at 16.2% of total exports or 3.3% of GDP (Chart 35). Most interestingly, combined French exports to Germany and China are an important source of economic volatility for France. However, because French exports to Germany are a function of broader German income shocks and demand for German exports, the result is that French exports to Germany and China are a direct function of Chinese industrial activity, as illustrated with their tight correlation with the Keqiang index (Chart 36). As a result, French manufacturing conditions have displayed co-relationship with Chinese LEIs since 2002. Chart 35French Export ##br## Distribution The French Revolution The French Revolution Chart 36French Business Cycle And China: ##br##Germany Is The Key Link French Business Cycle And China: Germany Is The Key Link French Business Cycle And China: Germany Is The Key Link So going forward, what to expect? The recent surge in the ZEW expectation index is likely to be validated and French GDP growth is likely to improve from 1% today to nearly 2% in mid-2017, well above the current expectation of 1.3%. We are more confident about the robustness of domestic demand than international demand. The support created by higher wages and rising credit will have a lagged effect for a few more quarters. In fact, the up-tick to 0.5% from -0.2% in underlying inflation suggests that French real borrowing costs for the private sector should remain well contained despite the recent improvement in capacity utilization. This means the support to housing activity remains solid, especially as France has some of the strongest demographics of the whole euro zone, and thus demand for housing is solid. Chart 37France Too Would Be Affected##br## By A Chinese Deceleration France Too Would Be Affected By A Chinese Deceleration France Too Would Be Affected By A Chinese Deceleration Fillon's threat to cut public sector employment by 500,000 thousand could at face value derail the improvement in the labor market - if such measures were implemented today and in one shot, the unemployment rate would spike from 9.5% to 11.2%. However, Fillon's victory is not yet baked in the cake, and even if he wins, this risk is unlikely to materialize in 2017 as it will take time to get the required laws passed. Moreover, the progressive nature of the cut, along with the tax cuts and regulatory easing for the private sector, suggest that firms would likely create many jobs during the same time frame, mitigating the pain created by such drastic job cutting. Nonetheless, some downside to growth should be expected from Fillon's policies. China and EM represent a more palpable risk. The Chinese uptake of machinery has recently spiked and real estate activity and prices have surged (Chart 37). Beijing is currently uneasy with this development and the PBoC has already increased medium-term lending-facility rates in recent weeks despite low loan demand and disappointing fixed-asset investment numbers. Moreover, China has also massively curtailed the fiscal stimulus that has been a key component of its recent powerful rebound in industrial activity. Finally, the strength in the dollar along with rising real rates globally could put a lid on commodity price appreciation, which means that the rise in Chinese producer prices that has greatly contributed to lower Chinese real rates and thus easier Chinese monetary conditions could be waning. French exports to Germany and China might be seeing their heyday as we write. Bottom Line: The French economy is enjoying a healthy upswing powered by easier monetary conditions in Europe, slight fiscal thrust, pent-up demand and improving credit conditions. While these domestic factors will prove durable, the improvement in external demand faced by France in 2016 raises a slight question mark. Nonetheless, we expect French economic growth to move toward 2% in 2017, a sharp beat of currently depressed expectations. On the political front, robust growth should help centrist candidates and hurt the anti-establishment Le Pen. Investment Implications While reforms, tax cuts, strong domestic demand, and potentially falling political risk premia point to an outperformance of French small cap equities, the story is more complex. Indeed, French small caps are heavily weighted toward IT and biotech firms, and have been mimicking the performance of the Nasdaq, corrected for currency developments (Chart 38). Thus, they do not represent a play on the story above. Instead, we favor buying French industrial equities relative to Germany's. Both sectors are exposed to similar global risk factors as their sales are a function of commodity prices and EM developments. However, French unit labor costs should be contained relative to German ones going forward. French competitiveness has been hampered by decades of rigidities while German competitiveness benefited greatly following the implementation of the Hartz IV labor reforms. Not only should the potential for reform help France over Germany, but the fact that the French unemployment rate remains elevated while that of Germany is at generational lows points also toward rising German labor costs vis-à-vis France (Chart 39). Additionally, our secular theme of overweighting defense stocks plays in France's favor, given that France is the world's fourth largest global defense exporter.14 Finally, adding to the attractiveness of the trade, French industrial equities are trading near the low of their 12-year trading range against German ones (Chart 40). Chart 38French Small Cap Equals Nasdaq##br## (And The Euro, Of Course) French Small Cap Equals Nasdaq (And The Euro, Of Course) French Small Cap Equals Nasdaq (And The Euro, Of Course) Chart 39Reforms Could ##br##Close This Gap Reforms Could Close This Gap Reforms Could Close This Gap Chart 40Industrials: Buy France / ##br##Short Germany Industrials: Buy France / Short Germany Industrials: Buy France / Short Germany In a broader sense, the implementation of the Hartz IV reforms in Germany resulted in a general outperformance of German stocks over French stocks. Now that reforms have been fully implemented and priced in Germany, while investors remain highly skeptical of the outlook for French reforms (and indeed, fear an anti-establishment revolution), today may be the time to begin overweighting French equities at the expense of German ones in European portfolios on a structural basis. Finally, the spike in French yield differentials against German suggest that investors are imbedding a risk premium for the probability of a Le Pen win in the May election. A Le Pen victory would represent a death knell for the euro. As such, the euro countertrend bounce could find further support from a falling risk premium. Any selloff in the euro if Le Pen wins the first round of the election would represent a tactical buying opportunity in EUR/USD. Bottom Line: French industrials should be the key outperformers vis-a-vis Germany in the event of a Fillon or Macron electoral victory. However, French stocks in general should be able to outperform. Buy the euro on any election-related dip, particularly following the first round of the election on April 23. Marko Papic, Senior Vice President Geopolitical Strategy marko@bcaresearch.com Mathieu Savary, Vice President Foreign Exchange Strategy mathieu@bcaresearch.com 1 Please see The Economist, "The sick man of the euro," dated June 3, 1999, available at economist.com. 2 The figures presented here are actually the reduced numbers from the 2013 Acte III de la decentralization. 3 Please see BCA Research Geopolitical Strategy Special Report, "The End Of The Anglo-Saxon Economy?" dated April 13, 2016, available at gps.bcaresearch.com. 4 A generous pension system is part of the problem. The effective retirement age is around 61 years, well below the legal age of 65. According to the OECD, the French spend 25 years in retirement, the longest in the developed world. 5 To address this problem, President François Hollande's Responsibility and Solidarity Pact has begun to shift the burden of financing the public purse away from payroll taxes and onto consumption (via higher VAT taxes). But a greater effort is needed. 6 Oddly, France does not do that badly in the World Bank Ease of Doing Business ranking - it is 29th out of 190, ahead of Switzerland and Japan and only one place behind the Netherlands. 7 Please see Gary Banks, OECD, "Structural reform Australian-style: lessons for others?" presentations to the IMF and World Bank, May 26-27, 2005, and OECD, May 31, 2005, available at oecd.org. 8 Please see BCA Research Global Investment Strategy, "Après Paris," dated November 20, 2015, available at gis.bcaresearch.com. 9 Please see Geopolitical Strategy Monthly Report, "Introducing: The Median Voter Theory," dated June 8, 2016, available at gps.bcaresearch.com. 10 IFOP poll from December 2016. 11 To be fair, French law does not require parties to publish their donations and spending. Please see Bloomberg, "Le Pen Struggling to Fund French Race as Russian Bank Fails," dated December 22, 2016, available at Bloomberg.com. 12 Please see Geopolitical Strategy Special Report, "Will Marine Le Pen Win?" dated November 16, 2016, available at gps.bcaresearch.com. 13 Please see BCA Research Geopolitical Strategy Special Report, "After BREXIT, N-Exit?" dated July 13, 2016, and The Bank Credit Analyst, "Europe's Geopolitical Gambit: Relevance Through Integration," dated November 2011, available at gps.bcaresearch.com. 14 Please see Global Alpha Sector Strategy and Geopolitical Strategy Special Report, "Brothers In Arms," dated January 11, 2017, available at gps.bcaresearch.com.

Highlights Portfolio Strategy Pricing power has improved across a number of industries, with the exception of technology, a necessary development to sustain an overall profit recovery. The S&P railroads index has surged to the point where it will take massive upside earnings surprises to drive additional gains. Profit-taking is appropriate. Telecom services profit drivers have deteriorated significantly of late, and a full shift to underweight is recommended. Recent Changes S&P Railroads Index - Take profits of 22% and downgrade to neutral. S&P Telecom Services Index - Take profits of 6% and downgrade to underweight from overweight. Table 1 Pricing Power Improvement Pricing Power Improvement Feature Chart 1Pricing Power Is Profit Positive... Pricing Power Is Profit Positive... Pricing Power Is Profit Positive... Momentum remains the dominant market force. Fear of missing out is pulling sidelined cash into the market, supported by a decent earnings season to date and rising economic confidence. While consumer inflation expectations remain very low, market-derived inflation expectations have moved up markedly since the U.S. election (Chart 1), a surprising development given the surge in the U.S. dollar. Inflation expectations are back to levels that existed prior to the 2014 kickoff to the U.S. dollar rally. A shift away from deflation worries is supporting a re-pricing of stocks vs. bonds. That trend could continue until the U.S. economy begins to disappoint, potentially causing inflation expectations to retreat. Our pricing power update shows that while deflation remains prevalent, its intensity is fading. We have updated our industry group pricing power (Table 2), which compiles the relevant CPI, PPI, PCE or commodity-data for 60 S&P 500 industry groups. The table also compares those pricing power trends with overall inflation rates to help determine which areas are at a profit advantage or disadvantage. Based on our analysis, the number of groups suffering deflation in selling prices has shrunk to 19 from 23 in our update last September, and 32 last March. In all, 34 out of 60 groups are still unable to raise prices by more than 1%, but that is also an improvement from the 40 out of 60 industries that couldn't keep a 1% price hike pace last September. The bad news is that less than 1/3 have a rising selling price trend, even if the absolute level is negative, down from 50%, and another third has a flat trend. The implication is that upward momentum in pricing power may already be fading. Where is the pricing power improvement? Deep cyclical sectors such as energy and materials account for the lion's share, reflecting higher commodity prices. However, as discussed previously, 6-month growth rates have rolled over (Chart 2), signaling that the unwinding of the negative rate of change shock has run its course. The technology sector is also notable, as several groups are cutting selling prices at a faster clip. Table 2Industry Group Pricing Power Pricing Power Improvement Pricing Power Improvement Defensive sectors such as consumer staples, health care and utilities remain well represented in the positive category, while a reacceleration in consumer discretionary and financials sector selling price increases has boosted interest rate-sensitive sector pricing power (Chart 2). This would suggest that profit advantages continue to reside in these areas, rather than in cyclical sectors. That is confirmed by the uptrend in developed vs. developing market PMIs. This manufacturing gap would presumably widen further if the U.S. ever imposes import taxes. The latter would weaken developing country exports, thereby forcing currency devaluation and hurting capital inflows. Regardless, the PMI divergence reinforces that, in aggregate, cyclical sectors are not as fundamentally well supported as other sectors, and that a highly targeted and selective approach is still the right strategy (the PMI ratio is shown advanced, Chart 3). Even external factors warn against chasing lingering cyclical sector strength. Using the options market, the SKEW index provides a good read on perceived tail risk for the S&P 500. A rise toward 150 indicates significant worries about potential outlier returns. The SKEW has soared in recent weeks, which is often a harbinger of increased equity volatility and defensive vs. cyclical sector strength (Chart 4). Chart 2... But Is Not Broad-Based ... But Is Not Broad-Based ... But Is Not Broad-Based Chart 3Global PMIs Are Signaling Defense First... Global PMIs Are Signaling Defense First... Global PMIs Are Signaling Defense First... Chart 4... As Are Market-Based Indicators ... As Are Market-Based Indicators ... As Are Market-Based Indicators In sum, the broad market has a powerful head of steam and it could be dangerous to stand in its way, but the rally continues to exhibit signs of a late stage blow-off, vulnerable to sudden and sharp corrections. Maintain a healthy dose of non-cyclical exposure to protect against building and potentially sudden downside overall market risks, while being careful in terms of cyclical industry coverage. This week, we are taking advantage of exuberance in the rail space, and reversing our call on the telecom services sector in response to broad-based erosion in profit indicators. Rails Are Now Priced For Perfection For such a mundane and staid industry, railroad stocks have garnered considerable attention of late. Most recently, rumors that railroad maven Hunter Harrison will be installed at CSX to engineer yet another corporate turnaround have spurred a massive buying frenzy. We upgraded the S&P railroads index to overweight on August 1, 2016. Our analysis suggested that analysts and investors had made a full bearish capitulation, slashing long-term growth estimates to deeply negative territory and pushing valuations decisively into the undervalued zone. That pessimism overlooked efforts to cut costs and stabilize profit margins in the face of waning freight growth, setting the stage for a re-rating. While that thesis has worked out, we are concerned that the needle has now swung too far in the other direction, much like what occurred in the air freight industry. The latter had a steep run up only to disappoint newly buoyant expectations. We took air freight profits in late-November, as the soaring U.S. dollar was an anti-reflationary threat to the anticipated recovery in global trade that both investors and the industry had positioned for. Indeed, industry hiring has expanded rapidly (Chart 5). However, hours worked are contracting (Chart 5). Ergo, the hoped for increase global revenue ton miles has not materialized to the extent that was expected (Chart 5). Over-employment is a productivity and profit margin drag, and we were fortunate to take profits before the payback period. We can envision a similar scenario for railroads. There has no doubt been an improvement in freight activity, and there is more in the pipeline. The question is one of degree. Total rail shipment growth has climbed back into positive territory, and our rail shipment diffusion index, which measures the number of freight categories experiencing rising vs. falling growth, is near the 80% level (Chart 6). The key consumer-driven intermodal segment, which accounts for over half of total freight volumes, has finally begun to recover. Rising personal incomes should underpin credit availability and demand, and therefore, spending. The increase in business sales-to-inventories and growth in Los Angeles port traffic also augur well for intermodal shipments (Chart 6). One caveat is that autos represent a large portion of this segment, and pent-up demand has been fully realized at the same time that auto credit quality is beginning to crack. That could keep a lid on the magnitude of the intermodal shipment recovery. Coal volumes have also shown signs of life after a brutal contraction. Coal is a high margin product and another large freight category, and any sustained recovery would provide a meaningful profit boost. Rising natural gas prices typically bode well for coal volumes (Chart 7), via increasing the cost of competing fuels to burn for power generation. However, it is premature to celebrate, because the abnormally warm North American winter may mean that the rebound in electricity production is passed its peak. That would slow the burn rate and keep coal (and natural gas) supplies higher than otherwise would be the case. Chart 5Stay Grounded Stay Grounded Stay Grounded Chart 6Broad-Based Freight Recovery Broad-Based Freight Recovery Broad-Based Freight Recovery Chart 7Coal Is Critical Coal Is Critical Coal Is Critical History shows that pricing power and coal shipment growth are tightly linked. Selling prices have firmed in recent months, but are not at a level that heralds meaningful improvement in return on equity (Chart 8, third panel). True, rising oil prices typically lead to rail companies reinstituting fuel surcharges. But that is profit margin protective, not expansionary, as true pricing power gains come on the back of increased demand and the creation of bottlenecks. It is not clear that such a point has been reached. The Cass Freight Expenditures Index has been flat for several months, signaling that companies do not intend to raise transportation outlays. This series correlates positively with relative forward earnings estimates (Chart 8). That will make it difficult for rail freight to grow faster than GDP (Chart 9), a necessary development to drive earnings outperformance. Meanwhile, productivity gains may be slow to accrue if freight only grows modestly. Weekly train speeds have been stuck in neutral (Chart 8), and the industry may be in the early stages of a capital spending reacceleration. Rail employment growth has jumped in recent months, which is often a leading indicator of investment (Chart 9). If capital spending begins to take a larger share of sales in the coming quarters, then recent investor excitement may ease, leading to a prolonged consolidation phase. After all, valuations are stretched. Over the past two decades, whenever the relative forward P/E has crossed above a 10% premium, relative forward 12-month returns have averaged -4%, and been negative in 4 out of 5 cases. Overheated technical momentum also warns against extrapolating the latest price gains (Chart 10). Chart 8Earnings Will Only Improve Slowly... Earnings Will Only Improve Slowly... Earnings Will Only Improve Slowly... Chart 9... If Capital Spending Re-Accelerated ... If Capital Spending Re-Accelerated ... If Capital Spending Re-Accelerated Chart 10A Profit Recovery Is Discounted A Profit Recovery Is Discounted A Profit Recovery Is Discounted Bottom Line: Take profits of 22% and downgrade the S&P rails index (BLBG: S5RAIL - UNP, CSX, NSCX, KSU) to neutral, as the index appears to be setting up for a 'buy the rumor, sell the news' scenario. Stay neutral on the S&P air freight index (BLBG: S5AIRF - UPS, FDX, CHRW, EXPD). Telecom Services: Can You Hear Me Now? The niche S&P telecom services sector (comprising 3% of the S&P 500) has served our portfolio well, up 6% since inception. However, operating conditions have downshifted and we recommend lightening up a notch and reducing weightings to underweight. There are five factors driving this downgrade: the relative spending profile, sales outlook, margins pressure, interest rates and capital spending trends. First, telecom services personal consumption expenditures (PCE) have sunk anew after a brief attempt to stabilize last year. While consumer spending on telecom services has increasingly become a discretionary item, the improvement in consumer finances and vibrant labor market appear to be generating even more outlays on non-telecom goods and services (top panel, Chart 11). Second, this spending backdrop has undermined the sector sales outlook. Top line growth has retreated to nil, and BCA's telecom services sales-per-share model is signaling that a contraction phase looms (middle panel, Chart 11). Worrisomely, the latest producer price index release revealed that industry pricing power has taken a turn for the worse, which will sustain downward pressure on revenue growth. Third, profit margins are under stress. Selling prices are deflating at a time when the wage bill is still expanding at a mid-single digit rate. The implication is that margins, and thus earnings, are unlikely to improve much in the coming quarters (Chart 12). Chart 11Sales Prospects Have Dimmed Sales Prospects Have Dimmed Sales Prospects Have Dimmed Chart 12Ditto For Profit Ditto For Profit Ditto For Profit Fourth, telecom services is a high yielding sector and the recent sell-off in 10-year Treasurys (UST) is an unwelcome development. When competing investments rise in yield, the allure of telecom carriers diminishes, and vice versa. Chart 13 shows that relative performance momentum and the change in UST yields are inversely correlated, underscoring that as long as the bond market selloff persists relative share price pressures will remain intact. Finally, industry capital expenditures are reaccelerating, which is a short-term negative for profitability. This message is corroborated by the government's construction spending release, which shows a pickup in telecom facilities construction (bottom panel, Chart 13). Taken together with the deteriorating sales backdrop, higher capital spending would be negative for profit margins. While we would normally be reluctant to move an attractively valued sector all the way to underweight (Chart 14), the marked deterioration in these five drivers of relative profitability warrants such an extreme move, regardless of our reticence about the sustainability of the broad market's recent gains. Chart 13Higher Bond Yields Aren't Helping Higher Bond Yields Aren't Helping Higher Bond Yields Aren't Helping Chart 14Technical Breakdown Technical Breakdown Technical Breakdown Our Technical Indicator has crossed decisively into the sell zone, and the share price ratio has failed to break back above its 40-week moving average, providing technical confirmation of a breakdown (Chart 14). Bottom Line: Lock in profits of 6% in the S&P telecom services sector since the Nov 9th, 2015 inception and downgrade exposure all the way to underweight. Current Recommendations Current Trades Size And Style Views Favor small over large caps. Favor growth over value (downgrade alert).

After the election, machinery stocks jumped sharply on the hope that only Trump's growth-oriented policies will be successful while growth-restrictive proposals will be watered down, supporting commodity prices and ultimately reinvigorating machinery demand. However, the risk is that the waiting period will prove longer than expected, testing investor patience. While global manufacturing surveys have perked up on the back of inventory restocking, global machinery orders are still sinking, and U.S. machinery new orders are contracting. The strong U.S. dollar makes it dangerous to extrapolate firming global surveys into strong U.S. corporate performance. The chart shows that relative machinery EPS estimates have moved in the opposite direction of relative share prices. As a result, the bottom panel of the chart shows that relative valuations have skyrocketed. The S&P machinery sector's forward P/E is now trading at a 20% premium to the broad market (over a two decade high, excluding the Great Recession) spiking 6% since November. If earnings fail to live up to extremely optimistic expectations, as we expect, then relative share prices are at risk of a retracement. Bottom Line: Continue to underweight the S&P machinery index. Fade The Machinery Rally Fade The Machinery Rally

In early 2016, our sister publication Global Alpha Sector Strategy did a cycle-on-cycle analysis on the ISM manufacturing index and relative industrials performance in the following twelve months every time the ISM sank below the boom/bust line for 5 or more consecutive months. The conclusion was that it did not pay to underweight industrials stocks, as too much bearishness was already baked in the cake. The opposite is also true. We analyzed relative industrials performance since the early 1990s every time the ISM manufacturing new orders sub-index hit 60. The bottom panel of the chart shows median relative performance in the ensuing twelve months. The implication is that industrials stocks will suffer in the coming quarters as too much optimism is already discounted since the post-election reflex advance. Bottom Line: We reiterate our recent high-conviction underweight stance on the S&P industrials sector. Industrials: Honeymoon Is Over Industrials: Honeymoon Is Over