Market Capitalization: Large / Small

Highlights It's ok to ignore the September jobs report. Is the small cap comeback sustainable? Assessing the threat to the consumer from higher rates and oil prices. The ISM is over 60, now what? Feature Risk assets outperformed again last week, as the S&P 500, the dollar, and the 10 year- Treasury yield all moved higher. Oil was an exception, as WTI dipped back below $50 per barrel, but BCA's Commodity & Energy Strategy service expects WTI to end the year over $55/bbl. Small-cap stocks outperformed as well and conditions are in place for the rise in small caps to continue. The rise in risk assets in recent weeks occurred alongside a marked improvement in the Citi Economic Surprise Index (Chart 1), which moved into positive territory last week for the first time since April, despite the impacts of Hurricanes Harvey and Irma. Chart 1S&P And 10 Year Treasury Yield Tracks Economic Surprise S&P And 10 Year Treasury Yield Tracks Economic Surprise S&P And 10 Year Treasury Yield Tracks Economic Surprise The lack of impact from the hurricanes on the economic data is surprising. Before Hurricane Harvey made landfall, the Atlanta Fed GDP Now reading for Q3 was 3.4%, but moved as low as 2.1% in late September as the August economic data was reported. The most recent Atlanta Fed forecast pegged Q3 GDP at 2.5%. The 60+ readings on September's manufacturing ISM composite and 70+ reading on prices were notably strong, as was the 18.6 million reading on September vehicle sales, the strongest in 12 years. That said, the impact of the storms was evident in the employment data released last week (See below). U.S. Jobs Report: All Noise, No Signal U.S. nonfarm payrolls fell 33,000 in September, which was entirely due to the hurricanes. According to the BLS, 1.47 million workers could not show up for their jobs due to the weather. Because this data series is not seasonally adjusted, one cannot simply add it back to the headline payrolls number. Unfortunately, the separate household survey does not help to shed any better light on the state of the labor market. The household survey is known to be much more volatile than the establishment survey. This was quite apparent with the 906,000 surge in jobs, which followed a 74,000 decline in the previous month. The outsized and unbelievable surge in household employment was the main reason for the decline in the jobless rate to 4.2% from 4.4%. The labor force actually grew by a hefty 575,000 and the participation rate rose to 63.1%, the highest since March 2014 (Chart 2). The 0.5% m/m gain in average hourly earnings needs to be discounted as well. Employment in the low-paying leisure and hospitality sector fell by 111,000 in September, helping to boost the aggregate average hourly wage. As these workers return to their jobs, average hourly wages will correct lower. Bottom Line: Investors should ignore the September jobs report. The 3-month average of payrolls growth from June to August was 172K. This is probably the best gauge of underlying jobs growth and this pace is above the trend growth in the labor force. To the extent that the Fed believes the tightening labor market will push inflation to its 2% target, the calculus for the December FOMC should not change after today's report. Small Caps Make A Comeback Rising prospects for tax cuts have lifted the Trump trades, including small-cap equities. We first initiated an overweight to small caps on November 14, 20161 (Chart 3). Since then, small caps have underperformed large by 162 bps, but not uniformly. The trade was successful from the start through to late January, but faded by late summer along with the prospects for Trump's tax cuts. Starting in mid-August, small cap made a comeback as odds of the tax cut troughed. Chart 2The September Jobs Report Is More Noise Than Signal The September Jobs Report Is More Noise Than Signal The September Jobs Report Is More Noise Than Signal Chart 3The Trump Trades Are Back On The Trump Trades Are Back On The Trump Trades Are Back On Several factors support our overweight view. According to BCA's U.S. Equity Strategy service S&P 600 valuation indicator, small caps are even more undervalued today than when we last discussed them in June2 (Chart 4). Moreover, the Cyclical Capitalization Indicator (CCI) moved sharply into positive territory following the U.S. election despite a modest dip in subsequent months (Chart 5). In addition, small cap stocks have been a reliably high-beta segment of U.S. capital markets since the middle of the last economic cycle (Chart 5, panel 2). That characteristic of small caps argues for a bullish stance given our upbeat view on growth and our overweight positions in U.S. equities versus bonds. BCA's outlook for regulation, inflation, the dollar, the Fed and the consumer also favor small over large caps. Trump has already made significant progress in slowing the pace of new regulations,3 which has long been a concern for small businesses. We expect inflation to move back to 2% in the coming quarters and then begin to climb higher in 2018. Chart 6 shows that small caps often thrive when inflation accelerates. BCA's outlook is that the dollar will see modest appreciation over the next 12 months. Small-cap stocks are less sensitive to dollar movements than large caps. Gradually rising rates will not impede small caps and credit conditions remain favorable. Finally, small caps are more closely linked to the consumer than the S&P 500, and BCA's view on household spending remains upbeat. Chart 4Small Caps Are Cheap, But Not Historically Cheap Small Caps Are Cheap, But Not Historically Cheap Small Caps Are Cheap, But Not Historically Cheap Chart 5Our CCI Supports Small Caps Our CCI Supports Small Caps Our CCI Supports Small Caps Chart 6Accelerating Inflation Usually Supports Small Caps Accelerating Inflation Usually Supports Small Caps Accelerating Inflation Usually Supports Small Caps Despite the upbeat prospects for small caps, some risks linger. Tighter credit conditions for consumers and businesses, an abrupt pullback in housing that would trigger a consumer retrenchment, persistent weakness in the dollar, and a "risk off" environment would see small caps underperform large caps. Bottom Line: It is too early to abandon our bullish bias toward small caps. Conditions remain in place for small caps to outpace large caps. Favorable valuation and encouraging prospects for Trump's pro-small business platform are key to BCA's view, as our favorable outlook for the U.S. consumer. Will Higher Rates And Oil Prices Crush The Consumer? Supports remain in place for continued strength in U.S. consumer spending despite rising interest rates and oil prices. That support was confirmed by September's reports on employment and vehicle sales, and August's personal income and spending data, all released in the past two weeks. However, investors should be aware of hurricane-related distortions in the August and September figures.4 Moreover, BCA's position is reinforced by elevated readings on consumer confidence and booming household net worth statistics, and record high FICO scores (Chart 7). The conditions that crushed the consumer ahead of the 2007-2008 recession are not in place and will not be for some time. Chart 8 shows that at 41%, household purchases of essentials as a percentage of disposable income are near an all-time low and have dropped by 1.3 percentage points since 2012. In contrast, spending on necessities rose by a record 3.5% in the five years ending in 2008, matching the bruising impact of higher rates, surging inflation and soaring oil prices seen by the end of 1980. Wrenching consumer-driven economic downturns ensued after both episodes. We see gradual increases ahead for both oil prices and interest rates, but nothing that would trigger the collapse of the consumer.5 Furthermore, BCA forecasts only a modest rise in inflation and an acceleration in wage growth; both will provide a boost to disposable income. Personal tax cuts as part of the plan Trump proposed last month would also enhance incomes. Chart 7Plenty Of Support For The Consumer Plenty Of Support For The Consumer Plenty Of Support For The Consumer Chart 8Consumer In Good Shape Despite Rise In Oil, Rates Consumer In Good Shape Despite Rise In Oil, Rates Consumer In Good Shape Despite Rise In Oil, Rates BCA's research shows that sustainable capital spending cycles get underway only when businesses see evidence that consumer final demand is on the upswing. The latest reading on the manufacturing ISM composite and the 60+ readings on the new orders component of ISM since February suggest that managements are starting to note the robust pace of consumer spending. Signals From Elevated ISM Readings September's numbers on the ISM manufacturing index support BCA's case for accelerating corporate profits in the coming quarters. The ISM is a good proxy for industrial production, which in turn tracks S&P 500 sales. The recent strong data on ISM suggests that IP should pick up in the next six months (Chart 9). A rollover in the 12-month change in IP would challenge our constructive stance on earnings. While a decline is possible given that the index is already lofty, the leading components of the ISM, including the new orders index and the new orders-to-inventory ratio, indicate that the ISM will remain above 50 in the months ahead (Chart 10). Chart 9Favorable Macro Backdrop For Earnings And Sales Favorable Macro Backdrop For Earnings And Sales Favorable Macro Backdrop For Earnings And Sales Chart 10ISM Components Suggest IP Poised To Accelerate ISM Components Suggest IP Poised To Accelerate ISM Components Suggest IP Poised To Accelerate Some investors question how long the composite and new orders indices will remain beyond 60 and what that will mean for risk assets. Additionally, the second 70+ reading on the ISM Prices index this year challenges the notion that inflation is dormant. Other investors are concerned about what will happen after these ISM components are so elevated. Others may fear that the index will soon fall below 50. We analyze the historical periods when the ISM and its sub-indexes were above the 60 threshold, and then what happens to the returns of risk assets 12 months after they fall below the 60 threshold (Chart 11A, Chart 11B and Chart 11C). Chart 11AComposite ISM And Risk Assets Composite ISM And Risk Assets Composite ISM And Risk Assets Chart 11BISM New Orders And Risk Assets ISM New Orders And Risk Assets ISM New Orders And Risk Assets Chart 11CISM Prices And Risk Assets ISM Prices And Risk Assets ISM Prices And Risk Assets Historically, the relative performance of large cap equities to Treasuries is typically poor when the ISM Manufacturing Composite Index is over 60, but investment-grade credit outperforms and both gold and oil usually gain. The performance of these assets is similar even excluding the period around the 1973 OPEC oil embargo and the 1987 stock market crash (Chart 11A and Appendix Table 1). The ISM Manufacturing Composite Index ticked up to 60.8 in September, the first 60+ reading since 2004. The indicator also reached 60 three times in the 1970s and twice in the 1980s, and it stayed above 60 on average for 8 months. The last time it breached 60, it remained at that level for 6 months (December 2003 through June 2004). That interval, along with most of the others, was accompanied by tightening monetary policy and accelerating inflation late in the latter half of economic cycles. Gold and oil perform strongly in the 12 months after ISM Composite Index goes below 60, large-cap equities barely do better than Treasuries, while investment-grade credit underperforms. Surprisingly, high-yield bonds and small-cap stocks outperform 12 months after the ISM falls back below 60, although the sample size is limited. In 1974-1975, the economy was in recession. In all but one other instance (the mid- 1980s), the economy was in a late stage of the cycle, nearing full employment and inflation was on the rise. Risk assets also are strong performers when the New Orders component of the ISM exceeds the 60 threshold (Chart 11B and Appendix Table 2). Moreover, the episodes are more numerous (14 since 1971 versus only 6 for the composite) but, on average, they persist as long as the signal from the ISM Composite. New Orders have been above 60 since February 2017 (7 months), just shy of the 46-year average (8 months). Large cap equities and credit (both investment-grade and high-yield) have outperformed Treasuries, and gold has climbed since February. This performance matches the historical pattern when the New Orders index exceeds 60. In the past 8 months, the underperformance of small caps and the drop in oil prices in that span runs counter to history. The performance of risk assets in the year after the new orders index moves below 60 is mixed, at best. In these periods, while the S&P 500 outperforms Treasuries on average, and small caps outperform large caps, credit underperforms. The big winners when the New Orders index is falling from over 60 are gold (average 14% gain) and oil (22%). Chart 11C and Appendix Table 3 shows the performance of risk assets when the ISM Prices index is greater than 70 and then 12 months after the index crosses below 70. Gold and oil are standouts in the first case, and small cap tends to outperform large. Note that 3 of these 11 episodes coincided with recessions (early 1970s, 1980 and 2008) and 1 occurred during the 1987 stock market crash. Small-cap equities continue to outperform as the Prices index fades, and returns on gold and oil are muted. High-yield bonds underperform Treasuries when the ISM Prices index dips back below 70, and the total return on investment-grade corporate struggles, but it beats Treasuries. Moreover, 3 of these 11 occurred during recessions (early 1980s, 2001, 2008-2009). Separately, there has been a tight relationship between the 12-month change in the 10-year Treasury yield and both the overall ISM, the New Orders and Prices component of the ISM in the past 25 years (Chart 12). Nonetheless, the relationship between the ISM Prices component and the 10-year Treasury has broken down since oil prices peaked in 2014. The 12-month jump in ISM Prices surge in 2016 was met with a decline in Treasury yields. Prior to that, a rise in Prices index was almost always accompanied by a move higher in bond yields. BCA's view is that the ISM manufacturing Composite will remain elevated (although not necessarily more than 60 in the months ahead), supporting our bullish stance on corporate sales and earnings. However, if we are wrong and the ISM dips below 60 and then down to 50, would that signal a downturn and concomitant selloff in risk assets? The ISM has a mixed track record as a leading indicator of recessions (Chart 13). Since 1948, the ISM has provided 9 false signals, using 3 consecutive months below 50 as the indication of an economic decline. Furthermore, 5 of the 9 examples occurred since 1985, as the U.S. economy became less reliant on manufacturing. In the 6 instances that the ISM warned of contractions, the average lead time was 4 months. In the 4 other economic slumps, the ISM moved and stayed below 50 for 3 consecutive months only after the start of recession. The lag averaged 4 months. This was the case in the 2007-2009 episode when the ISM did not send a recession signal until May 2008, 5 months after the official start of the downturn. Chart 1210 Year Treasury Vs. ISM 10 Year Treasury Vs. ISM 10 Year Treasury Vs. ISM Chart 13The Rocky Relationship Between ISM And Recessions The Rocky Relationship Between ISM And Recessions The Rocky Relationship Between ISM And Recessions Bottom Line: Elevated readings on ISM support BCA's view that profit growth will accelerate for a few more quarters while the recent rise in the ISM Prices index confirms the move higher in Treasury yields. Stay overweight stocks versus bonds and underweight duration. John Canally, CFA, Senior Vice President U.S. Investment Strategy johnc@bcaresearch.com 1 Please see BCA's U.S. Investment Strategy Weekly Report, "Easier Fiscal, Tighter Money?," November 14, 2016. Available at usis.bcaresearch.com. 2 Please see BCA's U.S. Investment Strategy Weekly Report, "Waiting For The Turn," June 26, 2017. Available at usis.bcaresearch.com. 3 Please see BCA's U.S. Investment Strategy Weekly Report, "Still Waiting for Inflation, "August 14, 2017. Available at usis.bcaresearch.com. 4 Please see BCA's U.S. Investment Strategy Weekly Report, "Shelter From the Storm," September 5, 2017. Available at usis.bcaresearch.com. 5 Please see The Bank Credit Analyst Monthly Report, "Global Debt Titanic Collides With Fed Iceberg?," February 2017. Available at bca.bcaresearch.com. Appendix: Table 1 Small Cap Surge Small Cap Surge Table 2 Small Cap Surge Small Cap Surge Table 3 Small Cap Surge Small Cap Surge

Highlights Economic Outlook: Global growth will stay strong over the next 12 months, with the U.S. surprising on the upside. Unfortunately, the global economy will succumb to a recession in 2019. Stagflation will become a major problem in the 2020s. Portfolio Strategy: We are sticking with our pro-risk stance for the time being, but are trimming our overweight recommendations to global equities and high-yield credit. Fixed Income: Maintain below benchmark duration exposure over the next 12 months. Underweight U.S., euro area, and Canadian government bonds; stay neutral the U.K., Australia, and New Zealand; overweight Japan. Equities: Favor cyclicals over defensives, but look to turn outright bearish on stocks late next year. For now, stay overweight the euro area and Japan relative to the U.S. in local-currency terms. In the EM universe, Chinese H-shares will outperform. Currencies and Commodities: While the recent dollar rebound has further to run, oil-sensitive currencies and the yuan will hold their ground against the greenback. It is too early to buy gold. Feature I. Global Macro Outlook: Reflation, Recession, And Stagflation The economic outlook over the coming years can be summarized in three words: reflation, recession, and stagflation. Reflation A Broad-Based Recovery Global growth is firing on all cylinders. The OECD estimates that all 46 of the economies that it tracks will see positive growth this year, the first time this has happened since 2007. Most leading economic indicators remain upbeat (Chart 1). This has left analysts scrambling to revise up their global GDP growth forecasts (Chart 2). Chart 1Most Leading Economic Indicators Remain Upbeat Most Leading Economic Indicators Remain Upbeat Most Leading Economic Indicators Remain Upbeat Chart 2Global Growth Has Accelerated Global Growth Has Accelerated Global Growth Has Accelerated The acceleration in global growth has occurred against the backdrop of tame inflation, which has allowed most central banks to keep interest rates at exceptionally low levels. Not surprisingly, risk assets have reacted positively. These goldilocks conditions should remain in place for the next 12 months. While most economies are growing at an above-trend pace, there is still plenty of spare capacity around the world. This means that inflation in countries such as the U.S. - where the labor market has returned to full employment - is likely to rise only gradually, as excess demand is satiated through higher imports. Such a redistribution of demand from countries with low levels of spare capacity to those with high levels is a win-win outcome for the global economy. Recession Running Out Of Room Unfortunately, all good things must come to an end. Weak productivity growth across most of the world is likely to cause bottlenecks to emerge over time, and this will cause inflation to move higher (Chart 3). Output gaps in the main developed economies would actually be higher today than at the height of the Great Recession had potential GDP grown at the rate the IMF projected back in 2008 (Chart 4). This is a testament to just how exceptionally weak potential growth has been. Chart 3Productivity Growth Has Slowed Across The Globe Productivity Growth Has Slowed Across The Globe Productivity Growth Has Slowed Across The Globe Chart 4Weak Supply Growth Has Narrowed Output Gaps Weak Supply Growth Has Narrowed Output Gaps Weak Supply Growth Has Narrowed Output Gaps U.S. growth will surprise to the upside over the next 12 months, leading to an unwelcome burst of inflation in late 2018 or early 2019. Financial conditions have eased sharply this year thanks to lower bond yields, narrower credit spreads, a weaker dollar, and a surging stock market. Changes in financial conditions lead growth by around 6-to-9 months, implying that U.S. growth could reach 3% early next year (Chart 5). This could take the unemployment rate down to 3.5% by end-2018, more than a full point below the Fed's estimate of full employment and even lower than the 2008 low of 3.8%. The unemployment rate could fall even further if Congress succeeds in passing legislation to cut taxes, as we expect it will. Our geopolitical team estimates that the GOP proposal would reduce federal revenues by $1.1-to-$1.2 trillion over ten years, or about 0.5% of GDP.1 In order to appease moderates, the final bill is likely to scale back the size of the tax cuts and shift more of the benefits to middle class households. Under the current proposal, the top 1% of taxpayers would receive 50% of the tax benefits (Chart 6). Our best bet is that the legislation will be enshrined into law in early 2018. Chart 5Easier Financial Conditions Will Boost U.S. Growth Easier Financial Conditions Will Boost U.S. Growth Easier Financial Conditions Will Boost U.S. Growth Chart 6Republican Tax Would Disproportionately Benefit The Top 1% Strategy Outlook Fourth Quarter 2017: Goldilocks And The Recession Bear Strategy Outlook Fourth Quarter 2017: Goldilocks And The Recession Bear Welcome To The Steep Side Of The Phillips Curve The so-called Phillips curve, which depicts the relationship between unemployment and inflation, tends to become quite steep once unemployment falls to very low levels (Chart 7). It is easy to see why: When spare capacity is high, a modest decline in slack will still leave many workers idle. In such a setting, inflation is unlikely to rise. However, once the output gap is fully closed, any further decline in slack will cause bottlenecks to emerge, pushing wages and prices higher. The 1960s provide a useful lesson in that regard. Just like today, inflation hovered below 2% during the first half of that decade, even though unemployment was trending downward over this period. To most observers back then, the Phillips curve would have also seemed defunct. However, once the unemployment rate fell below 4%, core inflation took off, rising from 1.5% in early 1966 to nearly 4% in 1967 (Chart 8). The kink in the Phillips curve had been reached. Inflation ultimately made its way to 6% in 1970, four years before the first oil shock struck. Chart 7U.S. Economy Has Moved Into The 'Steep' Side Of The Phillips Curve Strategy Outlook Fourth Quarter 2017: Goldilocks And The Recession Bear Strategy Outlook Fourth Quarter 2017: Goldilocks And The Recession Bear Chart 8Inflation In The 1960s Took Off Once The Unemployment Rate Fell Below 4% Inflation In The 1960s Took Off Once The Unemployment Rate Fell Below 4% Inflation In The 1960s Took Off Once The Unemployment Rate Fell Below 4% Many commentators have questioned the relevance of the sixties template on the grounds that the U.S. economy was less open to the rest of the world back then, trade unions had greater bargaining power, inflation expectations were not as well anchored, and the deflationary effects of new technologies were not as pervasive. We discussed these arguments in a report published earlier this month, concluding that they are not nearly as persuasive as one might think.2 The Difficulty Of Achieving A Soft Landing Rising inflation will compel the Fed to hike rates aggressively starting late next year in order to push the unemployment rate back towards NAIRU. A turn towards hawkishness is especially likely if Janet Yellen is replaced by someone such as former Fed Governor Kevin Warsh, whom betting markets now think has a 40% chance of becoming the next Fed chair (Chart 9). The problem for whoever ends up running the Fed is that it is very difficult to raise the unemployment rate by just a little bit. Modern economies are subject to massive feedback loops. When unemployment begins rising, households lose confidence and reduce spending. This prompts firms to slow hiring, leading to even less spending. The U.S. has never averted a recession in the post-war era whenever the unemployment rate has increased by more than one-third of a percentage point (Chart 10). Chart 9Who Will The Next Fed Chair Be? Who Will The Next Fed Chair Be? Who Will The Next Fed Chair Be? Chart 10Even A Small Uptick In The Unemployment Rate Is Bad News For The Business Cycle Even A Small Uptick In The Unemployment Rate Is Bad News For The Business Cycle Even A Small Uptick In The Unemployment Rate Is Bad News For The Business Cycle Lofty valuations are likely to exacerbate the adverse feedback loop described above during the next downturn. As growth slows, risk asset prices will tumble. This will cause business investment spending to dry up. Given America's dominant role in global financial markets, the U.S. recession will spread like wildfire to the rest of the world. Stagflation The Doves Reassert Control The next recession will probably be more painful for Wall Street than for Main Street. Fed-induced downturns tend to be swift but short-lived. The subsequent recoveries are usually V-shaped, rather than the elongated U-shaped recoveries that follow financial crises. Nevertheless, central banks around the world will undoubtedly start slashing rates again, perhaps even restarting their QE programs. Traumatized by the Great Recession, central bankers will overreact. The hawks will be blamed for the recession and forced to turn tail. The doves will reassert control. Fiscal policy will be significantly eased. This will be particularly the case if the next recession coincides with Trump's re-election campaign, brewing populism in Europe, and the spectre of military conflict in a variety of hotspots around the planet. Structural Forces Will Boost Inflation Meanwhile, millions of baby boomers will be in the process of leaving the workforce. This will lead to slower income growth, but not to slower spending growth - spending actually rises late in life due to spiraling health care costs (Chart 11). An increase in spending relative to income tends to push up prices. A recent IMF research report estimated that population aging has been highly deflationary over the past few decades, but will be very inflationary over the coming years (Chart 12). Chart 11Savings Over The Life Cycle Strategy Outlook Fourth Quarter 2017: Goldilocks And The Recession Bear Strategy Outlook Fourth Quarter 2017: Goldilocks And The Recession Bear Chart 12Demographic Shifts: From Highly Deflationary To Highly Inflationary Strategy Outlook Fourth Quarter 2017: Goldilocks And The Recession Bear Strategy Outlook Fourth Quarter 2017: Goldilocks And The Recession Bear All this suggests that the dip in inflation during the next recession will be fleeting. As the recovery from the shallow recession unfolds, inflation will reaccelerate. Of course, at that point, central banks could step in to aggressively quell inflationary pressures. However, they are unlikely to do so. After the next recession-induced burst of fiscal stimulus, debt levels will be even higher than they are now. The temptation to inflate away this debt will intensify. And, in an environment of anemic real potential GDP growth, the means to generate inflation will become available: Central banks will simply need to keep rates below their "neutral" level. Central bankers will rationalize their actions on the grounds that higher inflation will allow them to bring real interest rates deeper into negative territory in the event of another economic downturn. A growing chorus of eminent economists has begun to argue that a 2% inflation target is too low. For example, just this week, Larry Summers stated that "I think we probably need to adjust our monetary policy framework ... to [one] that provides for higher nominal rates during normal times, so there's more room to cut rates during downturns."3 II. Financial Markets As with the economic outlook, the three words reflation, recession, and stagflation guide our views of where financial markets are heading over the coming years. We continue to maintain a pro-risk stance, but are trimming our overweight recommendation to equities and high-yield credit due to the fact that valuations have gotten stretched and we are entering the last innings of the business-cycle expansion (Table 1). Table 1BCA's Tactical Global Asset Allocation Recommendations* Strategy Outlook Fourth Quarter 2017: Goldilocks And The Recession Bear Strategy Outlook Fourth Quarter 2017: Goldilocks And The Recession Bear Equities Sticking With Bullish ... For Now Recessions and bear markets tend to go hand-in-hand (Chart 13). None of our recession timing indicators are warning of an imminent downturn, suggesting that the cyclical global equity bull market has further room to run (Chart 14). Chart 13Recessions And Bear Markets Usually Overlap Recessions And Bear Markets Usually Overlap Recessions And Bear Markets Usually Overlap Chart 14AThis Business Cycle Has Further To Run This Business Cycle Has Further To Run This Business Cycle Has Further To Run Chart 14BThis Business Cycle Has Further To Run This Business Cycle Has Further To Run This Business Cycle Has Further To Run Strong growth in corporate earnings continues to underpin the rally in equities. The MSCI All-Country World index has increased by 11.9% in the first 9 months of the year, only slightly more than the 9.1% gain in earnings. As a result, the forward P/E ratio has only risen from 15.7 at the start of the year to 16.1 (Table 2). Table 2Earnings-Backed Price Appreciation Strategy Outlook Fourth Quarter 2017: Goldilocks And The Recession Bear Strategy Outlook Fourth Quarter 2017: Goldilocks And The Recession Bear Favor Cyclicals Over Defensives Above-trend global growth should boost profits over the next 12 months. We favor cyclical sectors over defensives, and are expressing this view through our long global industrial stocks/short utilities trade recommendation. The trade is up 0.9% since we initiated it last Friday and up 2.3% since I previewed it at BCA's annual New York Investment Conference earlier the same week. Capital spending tends to accelerate in the mature phase of business-cycle expansions, as a growing number of firms realize that they have insufficient capacity to meet rising demand. Our model predicts that global capex will grow at the fastest pace in six years (Chart 15). This should benefit industrial stocks. On the flipside, rising global yields will hurt rate-sensitive utilities (Chart 16). Chart 15Global Capex On The Upswing Global Capex On The Upswing Global Capex On The Upswing Chart 16Higher Bond Yields Will Hurt Utilities Higher Bond Yields Will Hurt Utilities Higher Bond Yields Will Hurt Utilities Higher Bond Yields Will Hurt Utilities Higher Bond Yields Will Hurt Utilities Financials should also outperform. Banks, in particular, will benefit from steeper yield curves, faster credit growth, and ongoing declines in nonperforming loans. Energy stocks are also attractive. As discussed below, we continue to maintain a generally upbeat view on the direction of oil prices. Prefer DM Over EM, Europe And Japan Over The U.S. While it is a close call, we see more upside for DM than EM stocks, as the former are less vulnerable to a dollar rebound and an increasingly hawkish Fed. Emerging market equities have had a good run over the past year, and are due for a breather. Our favorite EM equity idea for the fourth quarter is to be long Chinese H-shares. H-shares are heavily tilted toward financials and deep cyclicals, two sectors that we like. They also trade at a mere seven-times forward earnings and one-times book value (Chart 17). Within the DM space, European and Japanese equities should outperform U.S. stocks in currency-hedged terms. The sector composition of both the European and Japanese market is tilted toward stocks that will gain the most from strong global growth and increased capital spending. As our European strategists have documented, the European stock market is dominated by large multinationals whose fortunes are tied more to the global economy than to domestic prospects. This is largely true for the Japanese stock market as well. If our prediction for a somewhat weaker euro and yen comes to pass, profits in both regions will benefit from the currency translation effect. Valuations in Europe and Japan are also generally more attractive than in the U.S, even if one adjusts for different sector weights (Chart 18). Chart 17Chinese H-Shares: A Valuation Snapshot Chinese H-Shares: A Valuation Snapshot Chinese H-Shares: A Valuation Snapshot Chart 18U.S. Stocks Look Pricey Strategy Outlook Fourth Quarter 2017: Goldilocks And The Recession Bear Strategy Outlook Fourth Quarter 2017: Goldilocks And The Recession Bear Small Cap Value Trumps Large Cap Growth Style-wise, we prefer small cap value over large cap growth. Value stocks generally do better in environments where cyclicals are outperforming defensives, while small caps tend to be high-beta bets on global growth (Chart 19). U.S. small caps will disproportionately benefit from cuts to statutory corporate taxes, since smaller companies typically have less ability to game the tax code in their favor. Timing The Next Bear Market As one looks beyond the next 12 months, the skies begin to darken for global equities. The stock market usually sniffs out recessions before they happen, but the lead time is quite variable and generally not that long (Table 3). For example, the S&P 500 peaked only two months before the start of the Great Recession in December 2007. Chart 19Favor Cyclicals And Value Plays Favor Cyclicals And Value Plays Favor Cyclicals And Value Plays Table 3Stocks And Recessions: Case-By-Case Strategy Outlook Fourth Quarter 2017: Goldilocks And The Recession Bear Strategy Outlook Fourth Quarter 2017: Goldilocks And The Recession Bear Chart 20Stagflation Was Devastating For Stocks Stagflation Is Not A Stock-Friendly Environment Stagflation Was Devastating For Stocks Stagflation Is Not A Stock-Friendly Environment Stagflation Was Devastating For Stocks Stagflation Is Not A Stock-Friendly Environment If the next recession begins in the second half of 2019, global equities will probably peak earlier that year or in late 2018. Given the starting point for valuations, U.S. equities are likely to fall 20%-to-30% peak-to-trough. While other global bourses are generally not as expensive, their higher-beta nature means that they will probably face similar if not worse declines. The fact that correlations tend to rise during risk-off episodes will only add to the bloodshed. Stocks And Stagflation If the experience of the 1970s is any guide, equities perform poorly in stagflationary environments (Chart 20). Investors tend to see stocks as a riskier substitute for bonds. When nominal bond yields rise, the dividend yield offered by stocks becomes less attractive. In theory, the increase in the nominal value of corporate net worth resulting from higher inflation should generate enough capital gains over time to compensate for the wider gap between dividend yields and bond yields. In practice, due to "money illusion" and other considerations, that does not fully occur, requiring that stocks become cheaper so that their expected return can rise. The Long-Term Outlook For Profit Margins A complicating factor going into the next decade will be what happens to profit margins. S&P 500 operating margins are close to their all-time highs (Chart 21). While margins will undoubtedly fall during the next recession, their subsequent recovery is likely to be encumbered by a number of shifting structural forces. A slew of labor-saving technological innovations depressed labor's share of income over the past few decades. So did the entry of over one billion new workers into the global labor force following the collapse of the Berlin Wall and China's transition to a capitalist economy. The fixation of central banks on bringing down inflation may have led to higher unemployment than what would otherwise have been the case, thereby undermining the bargaining power of workers. All this may change during the next decade. China's labor force has peaked and is on track to decline by over 400 million workers by the end of the century - a larger decline than the entire U.S. population (Chart 22). A shift towards persistently more expansionary monetary policy could also keep the labor market fairly tight. Chart 21U.S. Profit Margins Are Close To All-Time Highs U.S. Profit Margins Are Close To All-Time Highs U.S. Profit Margins Are Close To All-Time Highs Chart 22China On Course To Lose More Than 400 Million Workers China On Course To Lose More Than 400 Million Workers China On Course To Lose More Than 400 Million Workers Technological innovation will persist, but the firms that benefit from it are likely to attract more scrutiny from regulators. Republican voters - the traditional defenders of corporate America's God-given right to make a buck - are growing increasingly wary of big business. Wall Street, Silicon Valley, and the rest of the corporate establishment tend to be liberal on social issues and conservative on economic ones. Very few voters actually share this configuration of views (Chart 23). The Democratic Party's "Better Deal" moves it to the left on many economic issues. This runs the risk of leaving the U.S. without any major party actively pushing a pro-business agenda. That can't be good for profit margins. Bottom Line: Investors should stay overweight global equities, but trim exposure from moderate overweight to small overweight due to rising business-cycle risk, and look to get outright bearish late next year. The long-term outlook for equities is poor, especially in the U.S. where valuations are highly stretched. Chart 24 presents a stylized sketch of how we think the major stock market indices will evolve over the coming years. Chart 23An Absence Of Libertarians Strategy Outlook Fourth Quarter 2017: Goldilocks And The Recession Bear Strategy Outlook Fourth Quarter 2017: Goldilocks And The Recession Bear Chart 24Market Outlook: Equities Strategy Outlook Fourth Quarter 2017: Goldilocks And The Recession Bear Strategy Outlook Fourth Quarter 2017: Goldilocks And The Recession Bear Fixed Income Above-trend GDP growth and rising inflation are likely to push up long-term bond yields in most economies over the next few quarters, as flagged by our Central Bank Monitors (Chart 25). Bond yields will fall during the next recession and then begin to inexorably rise higher as stagflationary forces intensify (Chart 26). Looking out over the next 12 months, our regional allocation recommendations are as follows: Chart 25Our Central Bank Monitors Point To Growing Pressures To Tighten Our Central Bank Monitors Point To Growing Pressures To Tighten Our Central Bank Monitors Point To Growing Pressures To Tighten Chart 26Market Outlook: Bonds Strategy Outlook Fourth Quarter 2017: Goldilocks And The Recession Bear Strategy Outlook Fourth Quarter 2017: Goldilocks And The Recession Bear Underweight The U.S., Euro Area, And Canada Chart 27Canada Enjoys Robust Growth Canada Enjoys Robust Growth Canada Enjoys Robust Growth We remain underweight U.S. Treasurys in a global fixed-income portfolio. The market is pricing in only 44 basis points in Fed hikes between now and the end of next year, well below the 100 basis points of hikes implied by the dots in the Summary of Economic Projections. The U.S. yield curve has flattened since the start of the year. This should change over the next 12 months, as inflation expectations rebound from currently depressed levels. The yield curve in the euro area should steepen more than in the U.S., since the ECB has pledged not to raise rates until well after its asset purchase program is complete - something that is unlikely to happen until the end of next year. This implies that the 2-year spread between the two regions will widen in favor of the U.S., which should be bullish for the dollar. Canadian bond yields are likely to rise further (Chart 27). The unemployment rate has fallen to a nine-year low and the Bank of Canada expects the output gap to be fully closed by the end of this year. The economy grew by 3.7% year-over-year in the second quarter, well above the BoC's estimate of potential real GDP growth of 1.5%. The Bank's most recent Business Outlook Survey points to continued robust growth ahead. The bubbly housing market remains a concern, but delaying withdrawal of monetary accommodation risks exacerbating the problem. Neutral On Gilts And Aussie And Kiwi Bonds In contrast to most other developed economies, leading indicators point to slower U.K. growth in the months ahead (Chart 28). This undoubtedly reflects the ongoing uncertainty over Brexit negotiations, which are likely to drag on for quite some time. Core inflation has surged to 2.7% on the back of the sharp depreciation of the pound, but market expectations suggest that it is about to roll over. Nevertheless, with 10-year gilts fetching just 1.35%, the downside for yields is limited. The cheap pound should also prop up exports, partly offsetting the impact of diminished market access to the rest of the EU. The unemployment rate stands at 4.3%, slightly below the Bank of England's estimate of NAIRU. One way or another, the uncertainty over Brexit will fade, allowing gilt yields to move higher. As with gilts, the outlook for Australian and New Zealand bonds is mixed. Strong global growth should boost commodity prices. This will help the Australian economy. The unemployment rate in Australia has fallen to 5.6%, but involuntary part-time employment is high and wage growth has been stagnant. Industrial capacity utilization remains low, as reflected in a fairly large output gap (Chart 29). The market expects the RBA to deliver 38 basis points in rate hikes over the next 12 months. We think that's about right. New Zealand's 10-year yield stands at a relatively generous 2.96%, which makes it difficult to be too bearish on kiwi bonds. However, we do not see much scope for yields to fall from current levels. Nominal GDP is growing at over 5% and retail sales are expanding at nearly 7% (Chart 30). The terms of trade have risen to their highest level since the 1970s. The output gap is now fully closed and core inflation is edging higher. Despite this good news, the policy rate remains at a record low of 1.75%. We concur with market expectations that the RBNZ will start raising rates next year. Chart 28U.K. Growth Is Slowing U.K. Growth Is Slowing U.K. Growth Is Slowing Chart 29There Is Still Slack In The Australian Economy There Is Still Slack In The Australian Economy There Is Still Slack In The Australian Economy Chart 30New Zealand: Upbeat Indicators New Zealand: Upbeat Indicators New Zealand: Upbeat Indicators Overweight JGBs CPI swaps predict that inflation in Japan will average only 0.5% over the next twenty years. As we argued last week, this is far too low.4 The secular drivers of deflation are fading and inflation will begin to surprise to the upside over the coming years (Chart 31). However, the path between here and there will be a choppy one. Considering that deflationary expectations remain deeply entrenched, the Bank of Japan is unlikely to abandon its yield curve targeting regime for at least the next few years. As government bond yields rise elsewhere in the world, 10-year JGBs will be the default winners. Investors thinking of going short Japanese government bonds should focus on 20-year or 30-year maturities, which are not subject to the BoJ's cap. Credit: Still Overweight, But Trimming Back Exposure High-yield credit spreads have fallen back near their post-recession lows after widening in the wake of the global manufacturing recession (Chart 32). We see little scope for further spread compression. Our U.S. Corporate Health Monitor remains in deteriorating territory (Chart 33), and higher Treasury yields will put downward pressure on corporate bond prices even if spreads remain constant. Nevertheless, the default-adjusted spread on U.S. high-yield debt of 212 basis points is still large enough to warrant a modest overweight to credit, especially since banks have started to loosen lending standards again. Chart 31Japan: Fading Deflationary Forces Japan: Fading Deflationary Forces Japan: Fading Deflationary Forces Chart 32High-Yield Spreads Have Narrowed High-Yield Spreads Have Narrowed High-Yield Spreads Have Narrowed Chart 33U.S. Corporate Health Continues To Deteriorate U.S. Corporate Health Continues To Deteriorate U.S. Corporate Health Continues To Deteriorate Our Global Fixed Income Strategists prefer U.S. over European credit, given that spreads are lower in Europe, and the tapering of ECB asset purchases could reduce the demand for spread product. Currencies And Commodities The Dollar: Comeback Kid? Charts 34 and 35 show our expectations about the future path of the major currencies and commodities. Chart 34Market Outlook: Currencies Strategy Outlook Fourth Quarter 2017: Goldilocks And The Recession Bear Strategy Outlook Fourth Quarter 2017: Goldilocks And The Recession Bear Chart 35Market Outlook: Commodities Strategy Outlook Fourth Quarter 2017: Goldilocks And The Recession Bear Strategy Outlook Fourth Quarter 2017: Goldilocks And The Recession Bear BCA's Global Investment Strategy service went long the dollar in October 2014. We reiterated our bullish stance before the U.S. presidential elections, controversially arguing that "Trump Will Win And The Dollar Will Rally."5 Unfortunately, we remained long the dollar over the course of this year, which turned out to be a mistake. Strong growth abroad, weaker-than-expected inflation readings in the U.S., and the fizzling of the "Trump Trade" all contributed to dollar weakness. Technicals also played a role. Sentiment was extremely bullish towards the dollar at the start of the year, but extremely bearish towards the euro (Chart 36). The reversal of these technical trends helps explain why the euro appreciated a lot more than what one would have expected based simply on changes in interest rate differentials (Chart 37). Chart 36Euro: Long Positions Are Getting Stretched Euro: Long Positions Are Getting Stretched Euro: Long Positions Are Getting Stretched Chart 37The Euro Has Overshot Interest Rate Spreads The Euro Has Overshot Interest Rate Spreads The Euro Has Overshot Interest Rate Spreads Of course, if the spread between U.S. and euro area interest rates continues to narrow, it is likely that EUR/USD will strengthen. We are skeptical that it will. For one thing, financial conditions have eased sharply in the U.S. since the start of the year, but have tightened in the euro area (Chart 38). This suggests that U.S. growth will surprise on the upside whereas euro area growth could begin to disappoint. Chart 38U.S. Versus Euro Area Diverging Financial Conditions U.S. Versus Euro Area Diverging Financial Conditions U.S. Versus Euro Area Diverging Financial Conditions The five-year, five-year forward OIS spread between the two regions stands at 87 basis points in nominal terms, and 25 basis points in real terms. The five-year forward spread is even lower if one calculates a GDP-weighted bond yield for the euro area rather than looking at the expected path of interbank rates. Such a small spread is inconsistent with the fact that the neutral rate is substantially higher in the U.S.6 We expect EUR/USD to fall to $1.15 by the end of 2017, and potentially decline further in 2018 as the Fed picks up the pace of rate hikes. The dollar is also likely to strengthen against the yen, as Treasury yields rise relative to JGB yields. We see less downside for the British pound and the Swedish krona against the greenback. This is reflected in our long GBP/EUR and long SEK/CHF trade recommendations, both of which remain in the black. Upside For Oil-Sensitive Currencies Our energy strategists still see further upside for crude oil prices, owing to favorable supply and demand conditions. They point to the fact that official forecasts by the EIA have consistently underestimated oil demand. They also note that compliance with OPEC 2.0 production cuts has been remarkably good, and that estimates of how much new shale output will hit the market over the next 12 months are too optimistic. Additionally, they believe that the decline in production from conventional oil fields around the world - especially offshore fields, where there has been a dearth of new investment in recent years - could be larger than expected.7 Geopolitical risks in Iraq, Libya, and Venezuela could also adversely affect supply. Firmer demand and lackluster supply will lead to further drawdowns in OECD oil inventories, which should be supportive of prices (Chart 39). We recently took profits of 13.8% on our recommendation to go long the December-2017 Brent oil futures contract, but are maintaining exposure to oil through our long CAD/EUR and RUB/EUR positions, as well as through our bias towards cyclical equities. Resilient Chinese Economy Should Support Metal Prices And The RMB Recent Chinese data have been on the soft side, giving rise to fears that the economy is heading towards a major slowdown. We are more optimistic. While growth has clearly slowed since the start of the year, it remains at an above-trend pace, as evidenced by numerous real-time measures of economic activity (Chart 40). Chart 39Falling Oil Inventories Should Lead To Higher Crude Prices Falling Oil Inventories Should Lead To Higher Crude Prices Falling Oil Inventories Should Lead To Higher Crude Prices Chart 40Chinese Economy: No Need To Be Pessimistic Chinese Economy: No Need To Be Pessimistic Chinese Economy: No Need To Be Pessimistic Even the housing market has managed to stay resilient, despite widespread predictions of imminent doom (Chart 41). The share of households planning to buy a new home remains close to all-time highs. The amount of land purchased by developers - a good leading indicator for housing starts - is accelerating. Reflecting these developments, property stocks are surging. Financial conditions have tightened, but so far this has largely bypassed the real economy. In fact, long-term bank lending to nonfinancial institutions has accelerated since the start of the year (Chart 42). The recently announced cuts to reserve requirements for small business loans should facilitate this trend. Chart 41Chinese Housing Market Remains Resilient Chinese Housing Market Remains Resilient Chinese Housing Market Remains Resilient Chart 42Credit To Real Economy And Profit Rebound Bode Well For Capex Credit To Real Economy And Profit Rebound Bode Well For Capex Credit To Real Economy And Profit Rebound Bode Well For Capex Meanwhile, industrial profits have rebounded, as rampant producer price deflation last year has given way to modest price gains this year. Increased retained earnings will give Chinese companies the wherewithal to spend more on capital equipment. A recovery in global trade should also help stoke export growth. (Chart 43). Despite strengthening this year, our indicators suggest the yuan is still in undervalued territory (Chart 44). Buoyant economic growth should alleviate capital flight and reduce the pressure on the authorities to engineer a further depreciation of the currency. This, in turn, should help support metal prices and other EM currencies, even in a setting where the dollar remains well bid. Chart 43Positive Global Trade Momentum: A Tailwind For Chinese Exports Positive Global Trade Momentum: A Tailwind For Chinese Exports Positive Global Trade Momentum: A Tailwind For Chinese Exports Chart 44The Chinese Yuan Is Undervalued The Chinese Yuan Is Undervalued The Chinese Yuan Is Undervalued Chart 45Gold: Waiting For Drivers Of Sustained Price Appreciation Gold: Waiting For Drivers Of Sustained Price Appreciation Gold: Waiting For Drivers Of Sustained Price Appreciation Buy Gold ... But Not Yet Lastly, a few words on gold. Gold does well in situations where real rates are falling and the dollar is weakening (Chart 45). That's not the environment we find ourselves in today. Gold will have its day in the sun, but probably not before the stagflationary era begins in earnest after the next recession. Peter Berezin, Chief Global Strategist Global Investment Strategy peterb@bcaresearch.com 1 This revenue loss is measured against a baseline where a number of tax breaks, which are currently set to expire, are extended. Please see BCA Geopolitical Strategy Weekly Report, "Is King Dollar Back?" dated October 4, 2017, available at gps.bcaresearch.com. 2 Please see Global Investment Strategy Weekly Report, "Is The Phillips Curve Dead Or Dormant?" dated September 22, 2017. 3 Summers, Lawrence, H. (@LHSummers). "Great piece by @jasonfurman in today's @WSJ: The U.S. can no longer afford deficit-increasing tax cuts." 01 Oct 2017. Tweet. 4 Please see Global Investment Strategy Weekly Report, "Three Tantalizing Trades," dated September 29, 2017. 5 Please see Global Investment Strategy Special Report, "Three (New) Controversial Calls," dated September 30, 2016. 6 Please see Global Investment Strategy Weekly Report, "Central Bank Showdown," dated September 8, 2017. 7 Please see Commodity & Energy Strategy, "OPEC 2.0 Will Extend Cuts to June 2018," dated September 21, 2017. Strategy & Market Trends Tactical Trades Strategic Recommendations Closed Trades

The post-election surge in optimism following Donald Trump's election has not eroded, according to the latest NFIB small business survey, and remains very close to its decade-high (top panel). Importantly, healthy consumer spending appears to be presenting small businesses with the best pricing environment of the past three years. However, we are keeping our eyes on a few factors that may presage a decline in optimism. First, labor shortages for small businesses have become extreme; firms reporting unfilled jobs are at the highest level since 2001 (second panel). This could have the double impact of constraining business expansion and raising wages. Firms planning to increase salaries have already been outpacing those planning to increase prices for several years (third panel). This tight labor market could exacerbate the already-wide small cap profit gap versus their large cap peers (bottom panel). Deferred tax reform could also present a headwind to optimism. Taxes (and large government) are the single most important problem SMEs face. The post-election euphoria was based in large part on an anticipated reduction in the corporate tax bill; the longer Washington takes in passing a tax bill the higher the chance small business sentiment sours. In spite of these potential headwinds, we continue to believe the margin gap between small and large cap should normalize, especially if cooler heads prevail in D.C., favoring a small cap bias. Stay tuned. Small Business Optimism Is Resilient, But Can It Last? Small Business Optimism Is Resilient, But Can It Last?

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

Highlights The rollover in the economic surprise index is not sending a near-term recession signal and should trough in the next month or so, as decent economic data begins to surpass now lowered expectations. Investors should be prepared for a mild recession in 2019, but odds of a recession are low in the next 12-18 months. Oil prices will move higher from the mid $40s per barrel as investors start to see the inventory drawdowns we expect in the coming months. We expect that the Fed will stick to its plan to begin shrinking its balance sheet in September and hike rates again in December. Still, a stubbornly low inflation rate in the next few months would likely see the Fed postpone any further tightening until early 2018. Small cap stocks have underperformed large caps this year, but investors should not interpret this as a sign of that start of sell-off in risk assets. Feature The Citi Economic Surprise Index (CESI) is not sending a near-term recession signal and should trough in the next month as decent economic data begin to surpass lowered economic expectations. The index is nearly two standard deviations below its mean after peaking in early March in the wake of the election and has been falling for 71 days. It typically takes 90 days for the surprise index to find a footing after readings above 40. Moreover, the mean reverting nature of the index suggests a rebound at two standard deviations, absent a recession that we do not foresee (Chart 1). Chart 1Economic Surprise Index Approaching A Turning Point Economic Surprise Index Approaching A Turning Point Economic Surprise Index Approaching A Turning Point CESI is composed of two components, whose composition and recent behavior are crucial to interpreting the weakness in the overall surprise metric. A positive reading on the "consensus change" index, which tracks economists' forecasts, means that expectations have improved relative to their one-year average. A positive reading on the "data change" component suggests that economic releases have been stronger than their one-year average. The overall surprise index combines these two elements/factors (Chart 2). Chart 2Post Election, Economic Expectations For Soft Data Hit An Eight Year High Post Election, Economic Expectations For Soft Data Hit An Eight Year High Post Election, Economic Expectations For Soft Data Hit An Eight Year High Lofty expectations, rather than poor data, account for much of CESI's weakness in the past three months. This is most pronounced in the soft economic surprise index, where outlooks moved sharply in the wake of the U.S. election when forecasters were swept up in Trump euphoria. By early March 2017, the economic consensus index for soft data was at its highest in seven years, topping out just shy of the all-time record set in late 2009. Prognosticators also ratcheted up their forecasts for the hard data, but not by nearly as much. The inevitable result of elevated expectations, combined with economic reports that signaled that overall growth remained close to 2%, was a prolonged spell of economic disappointment. This type of divergence between heightened expectations and weakness in the overall surprise index has occurred several times in the past 13 years (2004, 2010, 2011, 2012 and 2017). Each episode took place before a bottom in the economic surprise index and our view is that this time is no different (Chart 2). Despite the dismal surprise index, forecasts for U.S. and global GDP in 2017 and 2018 have held up, which is a positive sign for profits (Chart 3). The stability of these forecasts is in sharp contrast to 2012, 2013, 2015 and 2016 when global growth estimates sunk at the same time as the economic surprise index. As we stated in our recent report,1 GDP growth in 1H 2017 in the U.S. is on track to match the Fed's modest 2.1% target for the year. Moreover, in years when Q1 GDP is weak, 2H growth is faster than 1H growth 70% of the time. Chart 3U.S. & Global GDP Estimates For 2017 & 2018 Have Held Up Well U.S. & Global GDP Estimates For 2017 & 2018 Have Held Up Well U.S. & Global GDP Estimates For 2017 & 2018 Have Held Up Well Falling oil prices are another worry for investors concerned that global growth is on the wane. We take a different view and expect oil prices to increase in the coming months. In a recent report,2 our Energy Sector Strategy team noted that investors are confused about conflicting supply signals in oil markets. Traders do not see the physical shortage that the IEA/EIA/OPEC and BCA's top-down supply & demand analyses argue should prevail (Chart 4). Investors are cautious amid the uncertainty. We view the investment environment as overly pessimistic and anticipate that oil prices (and oil-focused upstream equities) will improve as inventory withdrawals escalate in the coming months. The latest 3.5% year-over-year reading on LEI for May points to low odds of a near-term recession (Chart 2, panel 3). However, BCA's Global Investment Strategy service has raised the possibility of a U.S. recession commencing in 2019. Financial markets would move ahead of a recession, thus investors should begin to adjust their portfolios3 for a recession scenario in the latter half of 2018, as economic and profit growth begins to weaken. Until then, we favor stocks over bonds, but we remain vigilant for any signs of imbalances that typically precipitate a recession. Our Global Investment Strategy service points out that in the post-war era the unemployment rate's three-month moving average has never risen by more than one-third of a percentage point without a recession. A good leading indicator of the unemployment rate is the weekly unemployment claims data, and they suggest continued tightening in the labor market (Chart 5). Chart 4We Expect The Oil Balance To Tighten Later This Year We Expect The Oil Balance To Tighten Later This Year We Expect The Oil Balance To Tighten Later This Year Chart 5Claims Not Even Close To Sending A Recession Signal Claims Not Even Close To Sending A Recession Signal Claims Not Even Close To Sending A Recession Signal A tighter labor market will lead to the familiar vicious cycle of a more aggressive Fed, a margin squeeze, slower and eventually falling profits, rising corporate defaults and layoffs. The resulting economic downturn would be mild compared with the 2007-2009 recession because the current imbalances are not as severe as those in 2007. Even so, with valuations stretched, the pain of the recession may be most felt in the financial markets, with a likelihood of a 20-30% equity bear market. Bottom Line: Despite signs to the contrary, the sweet spot that has buoyed risk assets remains in place: a beneficial combination of moderate economic growth, healthy corporate profit growth, stable margins, low inflation and a Fed prepared to only gradually hike rates. We remain overweight stocks versus bonds in the next 6-12 months. Threats to this risk-asset friendly environment include a further drop in core inflation, an over-aggressive central bank, and signs that negative economic shocks are leading to a significant markdown of global growth prospects. Is The Fed's Inflation Target Credible? The recent drop in oil prices has undermined our short-duration recommendation. But more than that, investors are questioning whether the Fed even has the ability to reach its inflation goals, following the surprising May CPI report and the softening in some of the wage data. Is it possible that the U.S. is following Japan's roadmap where even an over-heated labor market is insufficient to generate any meaningful inflation? The sharp flattening of the Treasury curve indicates that the bond market has already rendered its judgement. As we noted last week, the energy component pulled down the headline CPI rate again in May, but the softening of inflation this year is widespread in the index. This is contrary to Fed Chair Yellen's assertion that recent weak readings are due largely to special factors, such as wireless telecommunications prices. The deceleration in inflation began around the start of the year. The 3-month rate of change of the headline index fell by more than five percentage points between January and May, of which energy accounts for 3.3 percentage points. The deceleration in the core rate was a less severe, but still substantial, 2.8 percentage points. Table 1 presents the components of the CPI that made the largest contribution to the deceleration in core inflation. Motor vehicles, owners' equivalent rent, apparel, recreation, wireless telecom and medical care services accounted for 1.2 percentage points as a group. However, many other sectors contributed in a small way to the overall deceleration of core inflation in the first five months of the year. Table 1Key Drivers Of Core Inflation Deceleration In 2017 Waiting For The Turn Waiting For The Turn Some special factors were at play. The moderation in rent inflation likely reflects the bottoming of the vacancy rate. Discounting in the auto sector is not a surprise given weak sales. Wireless prices can be viewed as a special case as well. Nonetheless, the breadth and suddenness of the deceleration in core inflation across such diverse sectors, some unrelated to labor markets, commodity prices, the weak dollar or on-line shopping, is startling. The disinflation this year in the Fed's preferred measure, the PCE price index, is not as extended but the data lag the CPI by roughly a month. A diffusion index made up of the components of the PCE index is still in positive territory, unlike the CPI's diffusion index (Chart 6). Nonetheless, the CPI data suggest that core PCE inflation will edge lower when the May data are released at the end of June. There has also been a moderation in some of the wage inflation data, such as average hourly earnings (Chart 7). The slowdown has been fairly widespread across manufacturing and services. The good news is that the soft patch appears to be over; 3-month rates of change have firmed almost across the board (retail is a major exception). Chart 6CPI, PCE Diffusion##BR##Indices Are Mixed CPI, PCE Diffusion Indices Are Mixed CPI, PCE Diffusion Indices Are Mixed Chart 7Wages Have Accelerated##BR##Over Past Three Months Wages Have Accelerated Over Past Three Months Wages Have Accelerated Over Past Three Months There is no slowdown evident at all in the better-constructed Employment Cost Index (ECI) as of the first quarter (Chart 8). The related diffusion indexes also remain constructive. The ECI is adjusted to avoid compositional effects that can distort the aggregate index. We conclude from these and other wage measures that the Phillips curve is still operating. Admittedly, the curve appears to be quite flat, which means it is difficult to generate inflation even when the labor market overheats. Nonetheless, the relationship between the ECI and measures of labor market tightness, such as the quit rate, the "jobs plentiful" index and NFIB compensation plans, does not appear to have broken down (Chart 9). The percentage of U.S. states with unemployment below the Fed's estimate of full employment is above 70%. Anything over 60% in the past has been associated with wage pressure (Chart 10). The percentage jumped from 58% in March to 71% in April, blasting through the 60% threshold. Chart 8No Slowdown##BR##In ECI Data No Slowdown In ECI Data No Slowdown In ECI Data Chart 9Labor Market Tight Enough##BR##To Push Up Inflation Labor Market Tight Enough To Push Up Inflation Labor Market Tight Enough To Push Up Inflation The bottom line is that, while we are concerned about the breadth of the soft patch in the consumer price data, we are in agreement with the Fed that the labor market is tight enough to gradually push up inflation. We are willing at this point to chalk up the recent drop in core inflation partly to randomness in the data, and partly to lagged effects of the slowdown in real GDP growth in the first half of 2016 (Chart 11). The PPI for services and for core goods are not suggesting there is deflationary pressure in the pipeline (Chart 8). Chart 10Rise In State Level Diffusion Indices Consistent With Higher Compensation Costs Rise In State Level Diffusion Indices Consistent With Higher Compensation Costs Rise In State Level Diffusion Indices Consistent With Higher Compensation Costs Chart 11Inflation Lags Economic Growth By 18 Months Inflation Lags Economic Growth By 18 Months Inflation Lags Economic Growth By 18 Months What Will The Fed Do? The CPI data have rattled some on the FOMC. Federal Reserve Bank of Dallas President Kaplan, for example, believes that the Fed needs to be patient to ensure that the inflation pullback is temporary. However, the June FOMC Statement and Yellen's press conference suggested that the consensus is determined to stick with the current tightening timetable in terms of rate hikes and balance sheet adjustment. FOMC Vice Chairman Dudley echoed this view in comments he made last week to the press. The Fed has been quick to ease or back away from planned rate hikes at the first hint of trouble since the Lehman shock. However, it appears that the reaction function has changed, now that the labor market is at full employment. This is especially the case because financial conditions have eased further since the June rate hike. Unemployment will edge further below the full-employment level if the FOMC does not slow the economy. Policymakers know that the Fed has had little success in the past when it tried to nudge unemployment higher in order to relieve inflation pressure and achieve a soft landing; these attempts almost always ended in recession. Dudley added that "...pausing policy now could raise the risk of inflation surging and hurting the economy." Other FOMC members are worried that financial stability risk will rise if the low-rate environment extends much further. The bottom line is that we expect the Fed will stick with the game-plan for now. The FOMC will begin shrinking the balance sheet in September, but will wait until December for the next rate hike. That said, a stubbornly low inflation rate in the coming months would likely see the FOMC postpone the next rate increase into next year. Where Next For Bonds? Our fixed-income strategists see three possible scenarios for the bond market:4 Base Case: Weak recent inflation readings are nothing more than a lagged response to last year's deceleration in economic growth. U.S. growth accelerates in the second half, unemployment falls further and both wage growth and inflation pick up. Oil inventories begin to contract and prices head higher. The FOMC is vindicated in its inflation view and proceeds with the current rate hike and balance sheet adjustment agenda. Investors receive a "wake up call" from the Fed, bond prices get hit and recent curve-flattening trend reverses. Fed Capitulates: The U.S. labor market continues to tighten, but core PCE inflation is still close to 1½% by the September FOMC meeting. We would expect the Fed to lower its forecasted rate hike path, signaling that no further rate hikes are likely in 2017. Long-maturity real yields would fall in this scenario, although long-term inflation expectations could rise to the extent that the Fed's more dovish tilt will weaken the dollar and generate more inflation in the medium term. Nominal yields may not end up moving much in this scenario. A Policy Mistake: If core inflation remains low between now and the September FOMC meeting and the Fed continues to write-off low inflation as transitory, signaling its intention to stick to its current projected rate hike path, then the market would price-in a policy mistake scenario. The yield curve would flatten and long-maturity nominal yields would fall, led by tighter TIPS breakevens. In terms of likelihoods, we would characterize Scenario 1 as our base case scenario, Scenario 2 as unlikely and Scenario 3 as a tail risk. The bottom line is that short-duration positions have been a "pain trade" in recent weeks, but it appears to us that the rally is overdone. We remain short-duration. No Signal From Small Caps Chart 12Small Caps Are No Longer Expensive Small Caps Are No Longer Expensive Small Caps Are No Longer Expensive The underperformance of small cap stocks since December is not sending a signal about the broader equity market. In fact, small cap relative performance has a mixed track record calling the peak in large cap equities. We maintain our view from a 2014 report:5 There is no basis for concluding that small cap underperformance heralds a fragile economy, stock market weakness or heightened risk aversion. Investors should note the sector/compositional, domestic/international, cyclical/defensive, and valuation discrepancies between small and large cap stocks before drawing any conclusions about the signals from small caps. The S&P 500 small cap index has more exposure to financials, industrials and materials than its large cap cousins, and has lower weights in energy, staples and healthcare. This mix makes small caps more cyclically oriented. Moreover, small caps have less exposure to overseas economies and, therefore, less sensitivity to fluctuations in the U.S. dollar. Plus, our small cap valuation indicator has moved even further into undervalued territory since our discussion of small cap equities in this publication on April 246 (Chart 12). Chart 13Small Caps Are Not Great##BR##Market Prognosticators Small Caps Are Not Great Market Prognosticators Small Caps Are Not Great Market Prognosticators Small-cap stocks outperformed large cap by 12% from November 8 through December 8, 2016, but have lagged since, as investors unwound the Trump trade. The implication is that the recent sell-off in small caps is not a signal that the broader market is poised for a downturn. Instead, it reflects the market's view that Trump's pro-small business agenda has stalled. Moreover, history shows that the relative performance of small caps versus large caps is not a good predictor of the future performance of risk assets versus bonds. The small-to-large ratio sent plenty of mixed signals in the '80s and '90s when the economy was in a long expansion, fostered by low inflation and a gradualist Fed (Chart 13, panels 1 and 2). On the other hand, local peaks and troughs in small cap performance provided solid signals for turns in stock versus bond performance from the early '70s through the mid-80s, a period characterized by soaring inflation that is not present today (Chart 13, panel 1). Small-cap outperformance starting in late 2008 did presage an upturn in the stock-to-bond total return ratio in 2009, and captured a few of the risk on/risk off periods from 2010 through 2012, while the Fed engineered QE2, Operation Twist and QE3. More recently, the relative performance of small versus large has been range-bound and has not provided a consistent signal for turns in the overall market (Chart 13, panel 3). Bottom Line: The underperformance of small caps to large is a reaction to the market's perception that Trump's pro-small business agenda will disappoint, not a sign that U.S. growth is waning. While several planned policies of the Trump administration have been delayed, a legislative agenda that appears to be pro-business is in place. As such, our view is that it is too early to abandon a bullish bias towards small cap stocks, especially given the major improvement in relative valuation noted above. John Canally, CFA, Senior Vice President U.S. Investment Strategy johnc@bcaresearch.com Mark McClellan, Senior Vice President The Bank Credit Analyst markm@bcaresearch.com 1 Please see U.S. Investment Strategy Weekly Report "Can The Service Sector Save The Day?", June 5, 2017, available at usis.bcaresearch.com. 2 Please see Energy Sector Strategy Weekly Report, "Views From The Road", June 21, 2017, available at nrg.bcaresearch.com. 3 Please see Global Investment Strategy Weekly Report "The Timing Of The Next Recession", June 16, 2017, available at gis.bcaresearch.com. 4 Please see U.S. Bond Strategy Weekly Report "Three Scenarios For Treasury Yields In 2017", June 20, 2017, available at usbs.bcaresearch.com. 5 Please see U.S. Investment Strategy Weekly Report "On The Road Again", June 2, 2014, available at usis.bcaresearch.com. 6 Please see U.S. Investment Strategy Weekly Report "Spring Snapback", April 24, 2017, available at usis.bcaresearch.com.

Highlights Increased regulatory scrutiny on the domestic financial sector may continue to create some headline risks and financial volatility, but the real economic impact should be marginal. The recent regulatory crackdown has mainly caused liquidity issues in the domestic market rather than any sort of real growth issue. Chinese shares listed overseas will continue to grind higher. Domestic A shares will remain largely trendless. Domestic corporate bonds are starting to look attractive after the most recent panic selloff. Feature Chinese domestic stocks and bonds have taken a beating of late as the authorities ramped up scrutiny to rein in excesses in the country's financial sector. While it is warranted to control accumulated financial risk - especially associated with shadow banking activity - the "campaign" style administrative crackdown has caused widespread confusion and mini-panics among domestic investors. The actions and corresponding reactions illustrate the authorities' primitive control tools, which are increasingly at odds with the rapidly developing financial sector, and how blanket actions can spur undue financial volatility and provoke unintended consequences. For now, we expect the economic fallout to be limited, unless the financial crackdown causes further spikes in interest rates and a sudden halt in credit flows. Chinese shares listed overseas will continue to grind higher in the absence of a major policy mishap that short-circuits the broad growth improvement and the profit cycle upturn. Domestic A shares will remain largely trendless, while the more richly valued bubbly segments of the market will continue to deflate. Domestic corporate bonds are starting to look attractive after the most recent panic selloff. What Do They Want To Achieve? Policymakers' primary focus has been on cracking down on excessive speculation in financial markets and restricting lending activities that are not in compliance with legal and regulatory requirements. Financial sector deregulation in recent years has increasingly blurred the lines between banks, insurance companies, brokers and trust companies, and regulators are constantly challenged to monitor all the increasingly sophisticated moving parts. From the banking sector's point of view, regulators are concerned that lenders have been aggressively boosting their exposure to other banks and non-bank financial institutions instead of providing credit to the "real economy." Overall commercial banks' claims on other banks and non-bank financial institutions have increased from 12% of their total assets in 2006 to over 25% as of January 2017, while their liabilities to other banks and non-bank financial firms have increased from 7% to 12% (Chart 1). Smaller banks are even more dependent on interbank financing for loanable funds. Interbank transactions and repo activities account for about 14% of smaller lenders' total source of funding, compared with 2% for large banks (Chart 2). Some small banks regularly borrow at lower costs through the interbank market or use negotiable certificate of deposits to purchase "wealth management products" offering higher returns issued by other banks or financial institutions. The duration mismatch leads to constant pressure to roll over these short-term financial instruments. The increasing interdependence among the country's financial institutions also creates the risk of a chain reaction in the financial system should some type of credit event erupt. Chart 1Increasing Interdependence Among Financial Institutions China: Financial Crackdown And Market Implications China: Financial Crackdown And Market Implications The Chinese authorities have long regarded preventing systemic financial risk as a top priority, and the recent growth improvement has provided a window of opportunity for some housecleaning without a major adverse impact on the economy. Therefore, it is unlikely that regulators will back off from tightening regulatory supervision going forward. Overall, the authorities will continue to discourage overtrading within the financial system, and enforce full disclosure of off-balance-sheet items and shadow lending activities. The saving grace is that tightened macro prudential measures have already begun to curtail banks' aggressive expansion to non-bank financial institutions. Commercial banks' claims to these firms have slowed sharply since last year's peak (Chart 3). Meanwhile, the recent rise in interbank rates should also further discourage the perceived "risk-free" funding arbitrage to play the interest rate gap between long- and short-dated financial assets. All of this reduces the pressure of an escalation in the regulatory crackdown. Chart 2Smaller Banks Depend More On##br## Wholesale Funding Smaller Banks Depend More On Wholesale Funding Smaller Banks Depend More On Wholesale Funding Chart 3Banks' Exposure To Non-Bank Financial Firms ##br##Has Been Scaled Back Banks' Exposure To Non-Bank Financial Firms Has Been Scaled Back Banks' Exposure To Non-Bank Financial Firms Has Been Scaled Back Should Investors Be Concerned? In essence, banks' rising claims to other financial institutions means a lengthening of the credit intermediation channel, in which financing goes from credit providers through multiple layers of intermediaries to reach final borrowers in the real economy. In other words, banks, instead of lending directly to borrowers, channel loans to trust companies or securities brokers, who in turn transfer the funds to the real economy through "shadow banking" activities such as trust loans or various forms of "wealth management products", typically at higher rates. From this perspective, cracking down on lending excesses within the financial system in of itself should not have a material impact on credit flows to final corporate borrowers. In fact, streamlining the financial intermediation channel holds the promise of increasing accessibility to bank credit for the corporate sector and reducing its funding cost, which should benefit the overall economy in the long run. In the near term, liquidity tightening and the regulatory crackdown could push up interest rates and disrupt credit flows, which should be closely monitored to assess near-term negative impact on the economy. So far, the impact does not appear material. Chart 4Regulatory Crackdown ##br## Has Not Interrupted Credit Flows Regulatory Crackdown Has Not Interrupted Credit Flows Regulatory Crackdown Has Not Interrupted Credit Flows Interbank rates have increased by about 100 basis points across the board since the beginning of this year, and 10-year government bond yields have risen by 50 basis points - both of which pale in comparison to the significant improvement in overall business activity. Nominal GDP growth expanded by 11.8% in the first quarter, compared with 9.6% in Q4, 2016. Furthermore, the central bank early this week re-started its medium-term lending facility (MLF), which was designed to avoid liquidity overkill in the domestic financial sector. Overall, the risk of overtightening of liquidity is not high. The regulatory crackdown since early this year has not had a meaningful impact on credit expansion. Banks' claims to other financial institutions have slowed sharply, but overall loan growth has been rather stable. Importantly, medium- and long-term loans to the corporate sector, pivotal for overall capital spending, have in fact accelerated (Chart 4). In short, increased regulatory scrutiny on the domestic financial sector may continue to create some headline risks and financial volatility, but the real economic impact should be marginal. We expect the authorities to remain highly vigilant and avoid policy overkill. Reading Market Tea Leaves There have been some notable divergences among different classes of Chinese stocks (Chart 5). Chinext, the domestic small-cap venture board, has suffered heavy losses of late, while large-cap A shares have been much more resilient. Meanwhile, offshore Chinese shares have barely felt any pressure at all. H shares have moved higher of late, while Chinese firms listed in the U.S. have decisively broken out. The divergence between onshore and offshore Chinese stocks' performance confirms the recent regulatory crackdown has mainly caused liquidity issues in the domestic market rather than any sort of real growth issue. Barring major policy mistakes, we expect the Chinese economy to stay buoyant, as discussed in detail in our recent report.1 As such, a few investment conclusions can be drawn. Tighter liquidity will likely continue to place downward pressure on domestic stock prices, but the downside is limited by overall buoyant activity and improving profits. We expect the broad-A share market will remain narrowly range-bound. Overseas-listed Chinese shares are not subject to domestic liquidity constraints, and will likely continue to grind higher supported by growth improvement, profit recovery and low valuation multiples. The small-cap Chinext market has long been viewed as the more speculative segment of the domestic financial market, with higher multiples and greater volatility than large-cap A shares. As such, this market will remain vulnerable to domestic liquidity tightening. Even after the most recent selloff, the bourse's trailing price-to-earnings ratio and price-to-book ratio are still at 38.4 and 4.6, respectively, much higher than for broader onshore and offshore Chinese stocks. The recent selloff in the onshore corporate bond market has also been driven by liquidity pressure, which in our view is overdone. While it's true that economic acceleration justifies higher yields, corporate spreads have also widened sharply, which is at odds with the broad growth acceleration and profit recovery. In addition, after the most recent selloff, Chinese corporate spreads are significantly higher than in most other major markets (Chart 6). In the near term, tighter liquidity may continue to induce more selling pressure in the domestic bond market. Cyclically we expect Chinese corporate bond spreads to narrow. Chart 5Diverging Market Trends Diverging Market Trends Diverging Market Trends Chart 6The Sharp Spike In Chinese Corporate ##br##Spreads Is Overdone The Sharp Spike In Chinese Corporate Spreads Is Overdone The Sharp Spike In Chinese Corporate Spreads Is Overdone Yan Wang, Senior Vice President China Investment Strategy yanw@bcaresearch.com 1 Please see China Investment Strategy Weekly Report, "Has China's Cyclical Recovery Peaked?" dated May 5, 2017, available at cis.bcaresearch.com. Cyclical Investment Stance Equity Sector Recommendations

Highlights It is difficult to judge how much of the recent unwind of the Trump Trades has been due to data disappointments versus rising geopolitical tensions. We do not believe that an attack on North Korea is imminent. Rather, U.S. military muscle-flexing is designed to force the rogue state to the negotiating table. On the economic front, the U.S. "hard" data have disappointed surveys in Q1. However, we believe this largely reflects weather and seasonal adjustment distortions. The Leading Economic Indicator and our new Beige Book Monitor support this view. Our profit growth model is very bullish for earnings this year, and is supported by our proxies for corporate pricing power. The latter is improving relative to wage growth recently, suggesting that there is more upside for margins this year. Returning cash to shareholders has not been particularly strong in this expansion relative to past expansions, contrary to popular belief. Nonetheless, buyback activity will continue to boost EPS growth by about 2 percentage points. Cyclical conditions and a significant improvement in relative valuation suggests that investors should continue to favor small over large cap stocks. Feature Treasury yields fell to their lowest level last week since just after the U.S. Presidential election. The solid start to the Q1 earnings reporting season was not enough to offset the disappointing economic reports and geopolitical fears, leaving U.S. equity prices mostly lower on the week (Chart 1). We thought that the "hard" data would improve to meet the accelerating "soft" data, but that clearly didn't occur last week. Unusual weather in March may have been a factor. We will return to the outlook for the economy and corporate profits later in the report. Chart 1Q1 Growth Disappoints Q1 Growth Disappoints Q1 Growth Disappoints It is difficult to judge how much of the bond rally has been due to data disappointments versus rising geopolitical tensions. President Trump's military show of force in Asia and comments about "losing patience" with North Korea have the world on edge. The U.S. has acted tough with the regime before, but nothing beyond economic sanctions ever materialized. The balance of power vis-à-vis China and the military threat to South Korea made North Korea a stalemate. Nonetheless, our geopolitical team argues that the calculus of the standoff is changing. Most importantly, the rogue regime is getting closer to being capable of hitting the U.S. with long-range missiles. Second, China is unhappy with the increased U.S. military presence in its backyard that North Korea is inviting. China also sees North Korea's missile tests as a threat to its own security. Third, the U.S. is prepared to use the threat of trade sanctions as leverage with Beijing. It is demanding that China use its own economic leverage to convince North Korea to freeze its nuclear and missile programs. We do not believe that an attack on North Korea is imminent. But doing nothing is not an option either. Our base case is that the U.S. military's muscle-flexing is designed to force North Korea to the negotiating table. Over the next four years, the North might be persuaded to freeze its nuclear and missile programs in exchange for a non-aggression pact from the U.S. and a lifting of sanctions. That said, this is probably North Korea's last chance to show it can be pragmatic. A failure of negotiations would induce a real crisis in which the U.S. contemplates unilateral action. It would be a bad sign if North Korea's long-range missile tests continue, are successful, and show greater distances.1 The market's political focus will likely turn back to Washington this week. Congress has until April 28 to pass a bill to keep the U.S. government running through the end of fiscal year 2017. Our Geopolitical Strategy Service continues to expect a deal to get done, but a partial government shutdown lasting a few weeks could occur. Separately, Congress will need to approve an increase in the debt ceiling by July-September in order for the Treasury to avoid defaulting on payments. While the negotiations surrounding both of events could weigh on Treasury yields in the near term, our view is that they are unlikely to prevent an uptrend in yields over the coming 6-12 months. As for North Korea, the safe-haven bid in the Treasury market will moderate if Kim Jong-un agrees to negotiations. But, near term, this situation is a huge wildcard. We cannot rule out another wave of risk aversion in financial markets. As this week's publication goes to press, the results of the first round of the French presidential election are being tabulated. Please consult BCA's Daily Insight on Monday, April 24, 2017 for our first take on the election results. A Temporary Soft Patch Or Something Worse? In last week's report, we wrote that the weak readings from the "hard" economic data would soon catch up with the surging "soft" economic data. In fact, the opposite has occurred since mid-April. Is this the start of a prolonged weak patch in the U.S. economy? Or is the softness perhaps related to weather and poor seasonal adjustment? We favor the later explanation for now. The first quarter GDP report is due out this Friday, April 28. The Bloomberg consensus is looking for just a 1.2% gain in the quarter after the 2.1% increase in Q4 2016. The Atlanta Fed's "GDP Nowcast" puts Q1 GDP at just 0.5% (Chart 1). The New York Fed's "Nowcast" is at 2.7%. Both estimates have been moving consistently lower since early March, dragging down 10-year Treasury yields (with U.S. stock prices along for the ride). Financial markets should be used to weak readings on first quarter GDP by now. Between 1950 and 1996, Q1 GDP was the weakest quarter of the year in just 14 of 47 years, or 30% of the time (Table 1). Q2 growth was stronger than Q1 growth about half the time. This is just about what you would expect if the U.S. Bureau of Economic Analysis' (BEA) seasonal adjustment program was functioning properly. But something has gone awry since 1997, despite the government statisticians' recent attempts to correct the problem. Over the past 20 years, the first quarter has been the weakest GDP reading of the year 10 times, or 50% of the time, and Q2 GDP growth has been faster than Q1 growth 70% of the time. Table 1The Gap Between GDP Growth In Q1 And Q2 Has Widened In The Past 20 Years Spring Snapback? Spring Snapback? A recent study by the staff at the Federal Reserve Bank of Cleveland2 suggests that the main culprits in this anomaly are in the private investment and government consumption components of GDP. More specifically, the Cleveland Fed cites defense spending as the key driver of the weakness in Q1 GDP relative to other quarters. We'll expand on this theme in next week's U.S. Investment Strategy report, but for now our view remains that the weakness in U.S. economic growth is temporary. The March reading of the Conference Board's Leading Economic Indicator provided no warning that underlying growth is about to trail off, although a couple of the regional Fed surveys have backed off of their recent highs. With April shaping up to be warmer than usual across the U.S., we expect a bounce back in weather-impacted "hard" data like retail sales, housing starts and industrial production. The April update of our Beige Book Monitor, which we introduced last week, confirms that the economy is stronger than the GDP data suggest (Chart 2). The Monitor is simply the difference between the percentage of "strong" versus "weak" descriptors for growth in the document. Chart 2BCA Beige Book Monitor Upbeat For Growth BCA Beige Book Monitor Upbeat For Growth BCA Beige Book Monitor Upbeat For Growth The Monitor edged higher in April to 65%, from 51% in the March reading. "Weather" was mentioned 18 times, after just 6 mentions in March. More than two thirds of the 18 mentions of weather in April cited it as having a negative impact on economic activity. This supports our view that weather had a non-negligible impact on the hard data in March. Thus, if the weather in the first three weeks of April persists into the final week of the month, the stage is set for a noticeable improvement in U.S. economic data released in May. All else equal, this should temper fears that the U.S. economic expansion has lost momentum, supporting stock prices and allowing the recent bond rally to unwind (depending on geopolitics). The soft March CPI also appeared to be quirky, revealing that the core measure actually contracted in March (Chart 3). We note, however, that the weak March reading followed two months of extremely strong gains. In addition, it still appears as though measures of core inflation put in a cyclical bottom in early 2015. While our CPI diffusion index is still below zero, signaling that inflation is likely to remain soft during the next couple of months, it would be premature to suggest that the gradual uptrend in core inflation has reversed. Our "inflation words" indicator based on the Beige Book remains in an uptrend (Chart 2). Chart 3Has U.S. Inflation Peaked? Has U.S. Inflation Peaked? Has U.S. Inflation Peaked? A rebound in the activity data in the coming months should keep the Fed on track to raise rates at least two more times in 2017. A rate hike in next month is unlikely, but we would not rule out June if the economic data firm as we expect. Positive Signs For U.S. Corporate Pricing Power Another 82 S&P 500 companies report first quarter results this week, making it the busiest week of the season. The consensus for Q1 earnings growth remains near 10% on a 4-quarter trailing basis. That forecast is likely to be met. We highlighted the positive 2017 outlook for U.S. corporate profits in the April 10, 2017 Weekly Report. The U.S. experienced a profit recession in 2016 that did not coincide with an economic recession. Oil prices were part of the story, but we have seen this pattern occur several time since the late 1990s; nominal GDP growth (a proxy for top line growth) decelerates temporarily relative to labor compensation growth. Margins get squeezed but, since the economy manages to avoid a recession, nominal GDP growth subsequently rebounds relative to labor compensation. This resulted in a 'catch up' phase when earnings-per-share growth accelerated sharply and equity returns were favorable. We believe that U.S. earnings are in the same type of catch-up phase now, which has been accentuated by the rebound in oil prices. Proprietary indicators from our sister publication, the U.S. Equity Strategy service, confirm our thesis. First, deflation pressures appear to be abating. A modest revival in corporate pricing power is underway according to our Pricing Power Proxy (Chart 4). It is constructed from proxies for selling prices in almost 50 industries. Importantly, the rise in the Proxy is broadly based across industries (as shown by the diffusion index in the chart). As a side note, the Proxy provides some evidence that softness in core CPI will not last. At the same time, the upward march of wage growth appears to be taking a breather (Chart 4). Average hourly earnings growth has softened in recent months. Broader measures, such as the Atlanta Fed Wage Tracker, tell a similar story. We do not expect wage growth to decelerate much given tightness in the labor market. Nonetheless, the combination of firming pricing power and contained wage growth (for now) suggests that margins will continue to expand modestly in the first half of the year. Our model even suggests that U.S. EPS growth has a very good shot at matching (perpetually optimistic) bottom-up estimates for 2017 (Chart 5). Chart 4Corporate Sector Gaining ##br##Some Pricing Power Corporate Sector Gaining Some Pricing Power Corporate Sector Gaining Some Pricing Power Chart 5Profit Model##br## Is Very Bullish Profit Model Is Very Bullish Profit Model Is Very Bullish Companies have supported per share profits in this expansion in part via share buybacks, often funded through debt issuance. This has generated some angst that companies are sacrificing long-term earnings growth potential for short-term EPS growth. This appeared to be the case early in the expansion, but the story is less compelling today. Chart 6 compares the cumulative dollar value of equity buybacks and dividends in this expansion with the previous three expansion phases. The cumulative dollar values are divided by cumulative nominal GDP to make the data comparable across cycles. By this metric, capital spending has lagged previous expansion, but not by much. While capital spending growth has been weak, the same has been true for GDP growth. Chart 6Comparison Of Corporate Outlays Across Four Economic Expansion Phases Spring Snapback? Spring Snapback? Dividend payments have been stronger than the three previous expansions. Buyback activity was also more aggressive compared with the 1990s and 2000s, although repurchase activity has been roughly in line with the expansion that ended in 2007. Net equity withdrawal since 2009, which includes the net impact of IPOs, share buybacks and M&A activity, has not been out of line with previous expansions. Bottom Line: CFOs have not been radically different in this cycle in terms of apportioning funds between capital spending and returning cash to shareholders. Buyback Tailwind To Continue How important are buybacks to EPS growth? Chart 7 (second panel) presents a rough proxy for the historical impact of equity withdrawal that is based on the S&P 500 divisor. It is the difference between EPS growth and growth in total dollar earnings. When the line is above zero, it means that EPS growth has been lifted above dollar earnings growth via equity withdrawals. Chart 7Buybacks Adding Almost ##br##2 Percentage Points To EPS Growth Buybacks Adding Almost 2 Percentage Points To EPS Growth Buybacks Adding Almost 2 Percentage Points To EPS Growth This proxy must be taken with a grain of salt due to the manner in which the divisor is calculated. Nonetheless, it suggests that buybacks have boosted EPS growth by 2 percentage points in the year to 2016Q4. We expect that buyback activity will continue to be a mild tailwind in the coming quarters given the positive reading from our Capital Structure Preference Indicator (Chart 7, third panel). This Indicator is defined as the equity risk premium minus the default adjusted high-yield corporate bond yield. When the indicator is above zero, there is financial incentive for firms to issue debt and buy back shares. Conversely, firms are incentivized to issue stock and retire debt when the indicator is below zero. The Indicator is currently positive, although not as high as it was in 2015. Bottom Line: Buybacks have not had an outsized impact on EPS growth in this cycle, but the good news is that this tailwind is likely to continue. Capitalization Strategy: Stick With Small Caps The relative performance of U.S. small vs large cap stocks surged following the November election, but has since retraced about two-thirds of its post-election gains and has recently been trading below its 200-day moving average. Small cap stocks have been one of several "Trump trades" that have waned over the past three months, but our view is that several positive tailwinds for small cap relative performance continue to warrant an overweight stance: Panel 1 of Chart 8 highlights that our cyclical capitalization indicator has moved sharply into positive territory following the election, and has remained positive despite the recent weakness in small cap relative performance. Small cap stocks have been a reliably high-beta segment of U.S. capital markets since the middle of the last economic cycle (panel 2), which argues for a bullish stance given our overweight positions in U.S. equities versus bonds. Our relative valuation indicator for U.S. small caps has moved back towards neutral valuation territory, which is a significant change from the conditions that prevailed in the early part of the U.S. economic recovery. Chart 9 shows that the indicator was consistently elevated from 2009 until early-2015, but has since fallen back to zero. While relative prices have accounted for some of this adjustment, the relative (trailing) earnings trend for small cap stocks remains in an uptrend and has recently risen to an all-time high, despite a disappointing Q1. Chart 10 highlights one risk to the small cap trade that will be important to monitor. The chart shows the NFIB's outlook survey along with the percentage of respondents citing "red tape" as the most important problem facing their business. The consistent rise in concerns about red tape under the Obama administration, especially the strong rise that began in 2010, suggests that small firms have found elements of the Affordable Care Act to be particularly burdensome for their business. This suggests that a portion of the sharp rise in the outlook for small businesses following the election has occurred due to expectations that the ACA will be repealed, in turn implying that confidence may wither following the failure of the American Health Care Act (AHCA) to even be subjected to a vote in the House. Chart 8Beta And The Cycle Argue ##br##For Small Caps Beta And The Cycle Argue For Small Caps Beta And The Cycle Argue For Small Caps Chart 9Small Caps Are##br## No Longer Expensive Small Caps Are No Longer Expensive Small Caps Are No Longer Expensive Chart 10Watch The Change Of A "Trump Slump" ##br##In Small Business Sentiment Watch The Change Of A "Trump Slump" In Small Business Sentiment Watch The Change Of A "Trump Slump" In Small Business Sentiment While several planned policies of the Trump administration have indeed been delayed due to the failure of the AHCA, we remain of the view that a legislative agenda that at least appears to be pro-business remains in place. As such, our view is that it is too early to abandon a bullish bias towards small cap stocks, especially given the major improvement in relative valuation that we noted above. Bottom Line: Cyclical conditions and a significant improvement in relative valuation suggests that investors should continue to favor small over large cap stocks. The failure of the AHCA may cause a near-term pullback in small business confidence, but we doubt that this will be sustained over the coming 6-12 months. John Canally, CFA, Senior Vice President U.S. Investment Strategy johnc@bcaresearch.com Mark McClellan, Senior Vice President The Bank Credit Analyst markm@bcaresearch.com Jonathan LaBerge Vice President, Special Reports jonathanl@bcaresearch.com 1 Please see BCA Geopolitical Strategy Special Report, "North Korea: Beyond Satire," dated April 19, 2017, available at gps.bcaresearch.com. 2 "Lingering Residual Seasonality in GDP Growth," Federal Reserve Bank of Cleveland, March 28, 2017.

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

Highlights Small caps have not consistently outperformed large caps. However, the cyclical nature of small-cap relative performance may provide tactical timing opportunities. Index methodology plays a very important role in the behavior of small-cap performance. Currently, we recommend being neutral on size in a balanced global equity portfolio because risk/reward between small and large caps is balanced, and because GAA is overweight cyclicals versus defensives, a similar play but with a better risk/reward profile. Feature The Academic Evidence On Size Premium In academic research, the size premium, or the outperformance of small-cap common stocks relative to large-cap common stocks, has been calculated mostly based on the difference between the return of the smallest cap portfolio and that of the largest cap portfolio. Since the first academic paper that "discovered" the "size premium" in 1981, by Rolf Banz of the University of Chicago,1 a great deal of research has been devoted to this subject, both for and against the validity of the size premium.2 Table 1 comes from Asness et al.3 It summarizes the statistics of monthly size premium over time using the two most widely used zero-cost portfolio approaches to capture the returns to size. 1) The "small minus big" (SMB) stock factor return of Fama and French:4 the average return of three small portfolios minus the average return of three large portfolios obtained from Ken French's website;5 and 2) the return spread between size-sorted and market cap-weighted decile portfolios. The universe is all the stocks listed on the NYSE, AMEX and NASDAQ, including delisted securities from the CRSP (Center for Research in Security Prices) database. Table 1Size Premium Over Time* Small Cap Outperformance: Fact Or Myth? Small Cap Outperformance: Fact Or Myth? The size premium is statistically significant at the 5% level with a t-stat of 2.27 for SMB and 2.32 for D1-D10 for the full sample period from 19266 to 2012;7 However, most of the size premium comes from January, while in the rest of the year the size return is economically and statistically not different from zero; The size premium was not always positive over time, as evidenced during the period 1980-1999 when small cap suffered a 20-year underperformance right after the size premium was "discovered" in 1981. Compared to SMB, the more extreme approach, Decile 1 minus Decile 10, has produced a larger positive size premium (as well as a larger negative size premium in periods of underperformance), suggesting that micro caps, the most volatile segment of the market, may have a significant impact on the overall size premium. However, for non-quant practitioners, especially asset allocators, the portfolio approaches used in academic research may not be practical. In this report, we will study a series of small cap and large cap benchmark indexes in the U.S. and globally that are commonly used by practitioners to shed some light on the size premium and how it can be harvested, if it indeed exists. Not All Small-Cap Indexes Are Created Equal, Even In The U.S. There is no definitive definition of small cap. The general consensus is that it refers to companies with market value between US$300 and US$2 billion in the U.S., while in other markets this may vary. In the U.S., the first small-cap index, the Russell 2000 (R2K), was created in 1984, after the size premium was discovered in 1981 by Rolf Banz. While Banz was not sure if size per se was responsible for the effect or if size was just a proxy for one or more true unknown factors correlated with size, Fama and French published their ground breaking work in 19926 and 19934 confirming the existence of size and value factors. Then in 1994 the S&P launched its own small-cap index, the S&P 600. Chart 1U.S. Small Cap Performance Divergence U.S. Small Cap Performance Divergence U.S. Small Cap Performance Divergence Chart 1 shows that the performance of these two indexes has been quite different even though they have been highly correlated. Since December 1994, the S&P 600 has outperformed the R2K by about 50%-about 2% per year on a compound basis. From 1980 to 1994, however, the back-calculated8 S&P 600 significantly underperformed the R2K. So what has contributed to such significant performance difference between these two U.S. small-cap indexes? The answer may lie in the different methodologies used in constructing them. Different Universe And Size Distribution: FTSE Russell9 and S&P Dow Jones10 use different eligibilitFy conditions to define their respective universes for the U.S. equity market. Russell 3000 (R3K) contains the 3000 largest publicly traded companies in the U.S. by market cap. The smallest 2000 names go into the R2K, which currently accounts for about 8% of the R3K by market cap weight.11 The S&P 1500 contains the 1500 largest names, also by market cap, with the S&P 600 being the smallest 600 of these names, which account for less than 3.5% of the S&P 1500. Even though the stated target market-cap range is US$30 million to US$2 billion for the R2K, and US$450 million to US$2.1 billion for the S&P 600, respectively, currently about 50% and 40% of the companies in the R2K and the S&P 600 respectively have a market cap over US$2 billion, as shown in Chart 2. The R2K even has 25% over US$3 billion, about 15% more than the S&P 600. Different Sector Compositions: Both indexes' sector composition has evolved over the years due to changes in the economy and financial markets. Their current sector compositions are shown in Table 2. Most notably, the S&P 600 has higher weights in industrials and consumer discretionary, while R2K has higher weights in technology, financials, real estate and utilities. Chart 2U.S. Small-Cap Index Market Cap Distribution Small Cap Outperformance: Fact Or Myth? Small Cap Outperformance: Fact Or Myth? Table 2Canadian Small-Cap Index Sector Composition Small Cap Outperformance: Fact Or Myth? Small Cap Outperformance: Fact Or Myth? Global Small Caps Have Not Consistently Outperformed Large Caps MSCI also produces small-cap indexes for each country. According to the MSCI Global Investable Markets Index methodology,12 the size cut-off for each size segment needs to be a balance between the minimum size requirement and the target coverage range, in addition to other requirements such as liquidity and free float. As shown in Table 3, large caps comprise the top 70% of the investable universe, mid caps the next 15%, and small caps a further 14%. As of October 2016, the market-cap range for the DM small-cap index is from US$527 million to US$5 billion, and about half that for the EM small-cap index. Table 3MSCI Size Cut-Offs* Small Cap Outperformance: Fact Or Myth? Small Cap Outperformance: Fact Or Myth? MSCI indexes apply the same rules to all markets, which aids the global comparison analysis. Unfortunately, MSCI indexes have very short histories. Chart 3 shows the relative performance of small caps vs. large caps based on the MSCI indexes, and also local exchange indexes (where available). All panels are rebased to 1 as of March 2009 when the S&P 500 reached its low during the most recent financial crisis. The shaded areas are U.S. recession periods as defined by NBER. Several observations from Chart 3: U.S., U.K. and Japan have relatively long histories for the small-cap indexes. Based on the three countries' local indexes, small caps have barely outperformed large caps over the full history available; From the index inceptions until 1999, small-cap indexes broadly underperformed large caps in the U.S., U.K. and Japan, in line with the findings of the academic research shown in Table 1; Since 2000, however, small caps have outperformed large caps in most countries (in line with the academic findings shown in Table 1) with the exception of Canada and Australia, which both have extremely skewed sector composition. As shown in Table 4, a bet on Canadian small caps vs. large caps is essentially a bet on materials, real estate and industrials versus financials and telecoms; In the most recent cycle from March 2009, small-cap outperformance has been most prominent outside the U.S., especially in the U.K. and euro area. This might be due to the fact that the U.S. is the most academically researched market and that most small-cap funds are U.S. oriented. In the U.S., the MSCI and the S&P small-cap indexes have performed better than the Russell indexes, which is likely due to the fact that Russell does not have a midcap segment, with both the R2K and R1K including stocks that would elsewhere be classified as mid caps. Table 4Canadian Small-Cap Index Sector Composition Small Cap Outperformance: Fact Or Myth? Small Cap Outperformance: Fact Or Myth? Drivers Of Small/Large Cap Performance Even though small-cap stocks have not consistently outperformed large-cap stocks over the long run, Chart 3 indicates that the relative performance does have cycles, which may provide tactical opportunities for investors. In line with our investment approach across all asset classes, we try to identify the key factors that drive the relative performance of small caps versus large caps based on economic fundamentals, valuation metrics, and technical conditions. Economic Conditions: Compared to large-cap companies, small-cap firms are usually smaller-scale enterprises with a more domestic focus and less tried-and-tested business models. On average, they have less predictable cash flows, lower profit margins and lower credit ratings. As such, their ability to withstand hard times is lower, while their likelihood to prosper in good times is higher. Chart 4 (panel 1) shows that the rate of change in the small/large cap performance ratio has a good correlation with the PMI, indicating that stronger economic growth is indeed better for the more cyclically-oriented small-cap firms. Other factors such as credit spreads and small enterprise confidence also have good correlations with small/large cap performance in the most recent cycle, but historical correlations were much looser (panels 2 and 3). Chart 3Small Vs. Large Cap Performance Small Vs. Large Cap Performance Small Vs. Large Cap Performance Chart 4What Drives Size Performance? What Drives Size Performance? What Drives Size Performance? Valuation Metrics: Asness et al4 labelled 2000-2012 as the "resurrection" period for small-cap outperformance. Chart 4 (panel 4), shows that the first uninterrupted outperformance from 2000 to 2006 started at an extremely cheap valuation in 2000 when small caps were trading at a 36% discount to large caps, two standard deviations below the five-year average discount of 8%. The six-year uninterrupted outperformance was largely driven by relative valuation expansion such that by 2006, when the outperformance peaked, small caps were trading at a 20% premium, two standard deviations above the five-year average, which was a discount of 4%. The unwinding of the excessive valuation over the next two years brought the valuation metrics back to an extremely cheap level again in 2008, which kick-started another strong period of outperformance for small caps. However, since 2012 valuation has failed to expand even though small caps continued to outperform, albeit at a slower pace. This might be due to the fact that, on an absolute basis, small caps have been trading at a premium to large caps, and because valuation expansion became more difficult given how low small-cap profit margins have been (panel 5). Technically, based on our factor studies on momentum, a simple 12-month rate of change has generated positive alpha in a statistically significant way. We use the standardized 12-month rate of change of the relative performance ratio to gauge the relative momentum (panel 6) Portfolio Recommendation: Neutral On Size Over The Next 9-12 Months Chart 5There Is A Better Alternative There Is A Better Alternative There Is A Better Alternative The top panel of Chart 5 shows that the relative performance of global small caps versus large caps had a close correlation with cyclicals/defensives from 1995 to 2011, but that the two have diverged over the past five years, during which time small caps have outperformed large caps by 7%, but cyclicals have underperformed defensives by 4%, despite a strong reversal in 2016. This divergence could be explained by relative earnings growth, as shown in panel 2: small-cap earnings outpaced large-cap over the past five years, while cyclicals' earnings growth lagged defensives' until 2016 when a reversal occurred. Given our view on global growth and the historical correlation shown in panel 3, it's likely that cyclical earnings growth will further outpace the defensive earnings growth over the next 12 months. GAA's portfolio approach is to take risk where risk is most likely to be rewarded. We already have overweights on equities versus bonds at the asset class level, and on cyclicals versus defensives in our global equity sector positioning, on a 12-month investment horizon. As such, we do not feel comfortable adding a similar, but less rewarding, risk into our recommended global equity portfolio. In addition, current readings on the key performance drivers also support a neutral rating: as shown in Chart 4, both valuation and technical indicators are at the neutral level. The Global PMI is strong, but credit spreads are tight and small enterprise surveys in the U.S. and Japan are already at extremely optimistic levels. Xiaoli Tang, Associate Vice President xiaolit@bcaresearch.com 1 Banz, Rolf (1981), "The relationship between Return and Market Value of Common Stocks," Journal of Financial Economics, vol.6, 103-126 2 Van Dijk, Mathijs A, (2011), "Is size dead? A review of the size effect in equity returns," Journal of Banking and Finance, 35, 3263-3274. 3 Asness, Clifford S., Andrea Frazzini, Ronen Israel, Tobias Moskowitz and Lasse H. Pedersen, "Size Matters, If You Control Your Junk", AQR Working Paper, 2015. 4 Fama, Eugene F. and Kenneth R. French (1993), "Common Risk Factors in the Returns to Stocks and Bonds", The Journal of Financial Economics, vol 33, pp.3-56. 5 Kenneth R. French website: http://mba.tuck.dartmouth.edu/pages/faculty/ken.french/Data_Library/f-f_bench_factor.html 6 Fama, Eugene F. and Kenneth R. French (1992), "The Cross Section of Expected Stock Returns," Journal of Finance 47, 427-465 7 Fama, Eugene F. and Kenneth R. French (1993), "Common Risk Factors in the Returns to Stocks and Bonds," The Journal of Financial Economics, vol 33, pp.3-56. 8 S&P600 history before October 1994 was back calculated by Datastream, Russell 2000 history before 1984 was back calculated by FTSE Russell. 9 Please see "Construction and Methodology : Russell U.S. Equity Indexes, v.2.4," FTSE Russell, March 2017. 10 Please see "S&P U.S. Indices Methodology," S&P Dow Jones, March 2017. 11 https://en.wikipedia.org/wiki/Russell_2000_Index 12 Please see "MSCI Global Investable Market Indexes Methodology," MSCI, Feb 2017.

The latest NFIB small business survey revealed that broad based small business optimism is holding up after an incredible post-election surge. This resilience provides confidence that small businesses are experiencing a sustainable increase in business activity. Complaints regarding government regulation and red tape have deflated back to 2011 levels, resulting in some much needed breathing room for small enterprises. Similarly, margins are set to expand according to our proxy, as price hikes are materializing and planned labor compensation increases are coming off the boil (bottom panel). Importantly, in terms of small/large cap relative performance, the latest global manufacturing PMI releases signaled that the U.S. is firing on all cylinders with the U.S. survey coming in 9% higher (or about 5 PMI points) than the rest of the world. Historically, a lopsided relative manufacturing backdrop has been an excellent leading indicator of the small/large share price ratio, given that small companies garner most of the revenue at home (top panel). Bottom Line: Continue to overweight small caps versus large caps. Small Caps Optimism Abounds Small Caps Optimism Abounds