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Overweight As trade tensions have eased in recent weeks, we have seen a broad based recovery in trade-oriented stocks. One notable exception is the S&P containers & packaging index which has failed to rally with its peers. This is particularly surprising considering the global trade picture is nearly as good as it gets (second panel). Consumer spending on food & beverage has historically been the industry bellwether and the current message is exceptionally positive. In fact, an exploitable buying opportunity has emerged as the relative valuation of the S&P containers & packaging index and growth in consumer spending on food and beverage (advanced by 6 months), which usually move in lockstep have sharply diverged (bottom panel). Considering the former is at a decade-low, we expect a catch up phase to emerge via a valuation rerating; stay overweight. The ticker symbols for the stocks in this index are: BLBG: S5CONP - IP, WRK, BLL, PKG, SEE, AVY. It's Time For A Relief Rally In Containers & Packaging It's Time For A Relief Rally In Containers & Packaging

Highlights Portfolio Strategy Looming inflation, the synchronized global capex upcycle and rising real Treasury yields all argue for preferring oil-related to gold-exposed equities. Recent Changes Initiate a long S&P oil & gas exploration & production / short global gold miners pair trade today. Table 1 Deflation - Reflation - Inflation Deflation - Reflation - Inflation Feature Chart 1No Contagion Yet No Contagion Yet No Contagion Yet Stocks recovered smartly from the Turkey induced pullback last week, and continue to flirt with all-time highs. While the risk of contagion remains acute, three key high-frequency financial market metrics suggest that the SPX will likely escape unscathed. The second panel of Chart 1 shows that both the Japanese yen and the Swiss franc, the two ultimate safe havens, have barely budged vis-a-vis the U.S. dollar and also the junk bond market remains extremely calm (third panel, Chart 1). We will continue to closely monitor these indicators to gauge the risk of contagion in U.S. equities. The greatest risk, however, is China's economic footing, particularly its foreign exchange policy (bottom panel, Chart 1). Any further steep devaluation in the renminbi will prove destabilizing and bring back memories of August 2015 when Chinese policy easing caused the dollar to spike and short-circuited SPX EPS growth. Relatedly, there is also a risk that China moves forward more aggressively on capital account liberalization, likely leading to a renminbi devaluation at least initially. Re-reading this Bank For International Settlements paper (starting on page 35 penned by Mitsuhiro Fukao, an ex-Director of Economic Research at the Bank of Japan) and taking a cue from Japan's experience was insightful.1 But, it remains difficult to predict what China's ultimate reaction function to Trump's trade rhetoric will be (Mathieu Savary, BCA's foreign exchange strategist, will be addressing this in one of his upcoming reports). While a tactical 5-10% pullback cannot be ruled out as the seasonally weak month of September is nearing, from a cyclical perspective our strategy would be to "buy the dip" if one were to materialize. Importantly, this bulletproof equity market that refuses to go down has two stealthy allies on its side: pension plans that are forced into equities and corporate treasurers that execute buybacks. Granted, EPS have delivered and suggest that upbeat fundamentals remain the key market support pillars. As a result, the S&P 500 is on track to register a tenth consecutive positive total return year, which is unprecedented in previous expansions. The only other time that the (reconstructed) SPX rose every year for 10 years in a row was in the late 1940s, however, two recessions occurred during that equity market run (Chart 2). While we are undoubtedly in the later stages of the bull market and the business cycle, there is a big difference between "late-cycle" and "end-of-cycle". Keep in mind that the current backdrop is unusual. A large fiscal package has hit late in the game likely extending the cycle. Thus, gauging where we are in the cycle is important. Chart 3 shows a stylized liquidity cycle and our sense is that we are in the early innings of the inflation stage. The handoff from reflation to inflation has happened and during this stage excesses take root eventually morphing, more often than not, into a mania. Chart 2Impressive Streak Continues Impressive Streak Continues Impressive Streak Continues Chart 3Liquidity Cycle Deflation - Reflation - Inflation Deflation - Reflation - Inflation From a macro perspective inflation is slated to rear its ugly head. Nominal GDP is far exceeding the 10-year Treasury yield, and this yield curve type steepening is bullish for SPX top line growth (Chart 4). As a reminder, in Q2 the GDP deflator jumped to 3.35% pushing nominal GDP growth to 7.41%. Money velocity2 is also enjoying a slingshot recovery. Nominal GDP growth is outpacing M2 money supply growth by roughly 150bps. The U.S. money multiplier (M2 over the monetary base, not shown) is also at a 5-year high. This is an inflationary backdrop (bottom panel, Chart 5) and should also boost SPX revenues and thus continue to underpin the broad equity market. Similarly, the NY Fed's Underlying Inflation Gauge (UIG) is firing on all cylinders and is a harbinger of a further pickup in core inflation in the coming months. As a result, SPX sales growth remains on a solid foundation (Chart 6). Chart 4SPX Sales Rest On Solid Foundations SPX Sales Rest On Solid Foundations SPX Sales Rest On Solid Foundations Chart 5A Little Bit Of Inflation... A Little Bit Of Inflation... A Little Bit Of Inflation... Chart 6...Is A Boon For The SPX ...Is A Boon For The SPX ...Is A Boon For The SPX This week we are initiating a market and asset class neutral pair trade to benefit from the inflationary backdrop. Initiate A Long Oil & Gas E&P / Short Gold Miners Pair Trade One way to benefit from this onset of the inflation stage/mania phase is to go long oil & gas exploration & production/short global gold miners. On the underlying commodity front, the handoff from reflation to inflation has historically been a boon to the oil/gold ratio (OGR). Importantly, the prices paid subcomponent of the ISM manufacturing survey has gone parabolic compared with the new order sub index, roughly doubling since the 2016 nadir. This depicts an inflationary backdrop and is signaling that the OGR will play catch up in the coming months (Chart 7). Chart 7CHART 7 Reflation To Inflation Handoff CHART 7 Reflation To Inflation Handoff CHART 7 Reflation To Inflation Handoff Similarly, another surging inflation indicator also suggests that the OGR has ample room to run. The GDP deflator has recently eclipsed the 3% mark and since exiting deflation following the end of the recent global manufacturing recession it is up over 370bps. Chart 8 shows that if this multi-decade positive correlation were to hold then the OGR could double from current levels. Chart 8GDP Deflator On The Rise GDP Deflator On The Rise GDP Deflator On The Rise Finally, the NY Fed's UIG is also closely correlated with OGR momentum, corroborates the other firming inflation signals and hints that more gains are in store for the OGR (bottom panel, Chart 9). Global macro tailwinds are also clearly in favor of oil at the expense of gold. BCA's global industrial production gauge of 40 DM and EM countries continues to expand at a healthy clip. Oil is a global growth barometer, whereas gold represents one of the few true safe havens in times of duress. Taken together, the implication is that a catch up phase looms for the OGR (middle panel, Chart 9). The relative commodity backdrop is the most important determinant of relative share prices as it dictates the direction of relative profitability (middle panel, Chart 10). Therefore, as the OGR goes so do relative share prices. Chart 9Enticing Global Macro Backdrop Enticing Global Macro Backdrop Enticing Global Macro Backdrop Chart 10Buy Oil & Gas E&P... Buy Oil & Gas E&P... Buy Oil & Gas E&P... Beyond this enticing relative commodity complex outlook, the synchronized global capex upcycle, one of BCA's key themes for the year, is underpinning the relative share price ratio. U.S. capex in particular is outpacing GDP growth and oil & gas investment is the key driver. The V-shaped recovery in the Baker Hughes oil & gas rig count data (bottom panel, Chart 10) confirms this upbeat energy capital outlay backdrop. Moreover, capex intentions from the Dallas Fed survey point to more upside in relative share prices (bottom panel, Chart 11). Meanwhile, keep in mind that the U.S. has been at full employment for 18 months now (in other words the unemployment gap closed in February of 2017) and the economy is firing on all cylinders. Real rates have also shot the lights out recently. In fact the 5-year real Treasury yield is perched near 1%, a multi-year high. Given that gold does not yield any income, it suffers when real yields rise and vice versa (for additional details on the relationship between gold and interest rates, please refer to the early-May piece penned by our sister publication U.S. Bond Strategy titled "A Signal From Gold?").3 Similarly, relative share prices thrive when real yields advance and retreat when the TIPS yield sinks (top panel, Chart 12). Chart 11...At The Expense Of Gold Miners ...At The Expense Of Gold Miners ...At The Expense Of Gold Miners Chart 12Bullion TIPS Over Bullion TIPS Over Bullion TIPS Over Unsurprisingly, the Fed has been tightening monetary policy since December 2015. Nevertheless, the "Fed Spread" (2-year Treasury yield compared with the fed funds rate) is steepening and continues to point to additional gains in the share price ratio (bottom panel, Chart 12). Given that both the ECB and the BoJ have remained ultra-accommodative, a hawkish Fed has boosted the U.S. dollar. However, most commodities are priced in greenbacks, thus the currency effect is a washout and is neither closely correlated to the OGR nor to the share price ratio. Two risks to this high octane, high momentum pair trade are: an EM accident induced risk off phase and a global recession likely due to a flare up in the global trade war (policy uncertainty shown inverted, top panel, Chart 9). In either of these scenarios, investors will likely seek the refuge of bullion's perceived safety as the bond market will almost immediately start pricing in easier monetary policy with investors flocking into the ultimate safe haven asset, U.S. Treasurys. Netting it all out, an enticing macro backdrop with the onset of the inflation stage, the synchronized global capex upcycle and rising real Treasury yields all argue for preferring oil-related to gold-exposed equities. Bottom Line: Initiate a market- and currency-neutral long S&P oil & gas exploration & production/short global gold miners pair trade today. The ETF ticker symbols the S&P oil & gas exploration & production and the global gold mining index are: XOP and GDX, respectively. Anastasios Avgeriou, Vice President U.S. Equity Strategy anastasios@bcaresearch.com 1 BIS Papers No 15 "China's capital account liberalisation: international perspectives", Monetary and Economic Department, April 2003. 2 "The velocity of money is the frequency at which one unit of currency is used to purchase domestically- produced goods and services within a given time period. In other words, it is the number of times one dollar is spent to buy goods and services per unit of time. If the velocity of money is increasing, then more transactions are occurring between individuals in an economy". Source: Federal Reserve Bank of St. Louis. 3 Please see BCA U.S. Bond Strategy Weekly Report, "A Signal From Gold?" dated May 1, 2018, available at usbs.bcaresearch.com. Current Recommendations Current Trades Size And Style Views Favor value over growth Favor large over small caps

Highlights Seasonal capacity restrictions in China during the winter heating months - when pollution from steel mills is particularly high - and continued efforts to limit particulate emissions in major cities will drive steel prices higher. The steel rebar market in China is backwardated, indicating physical markets are tight; inventories have been falling since mid-March. We expect prices to remain elevated going into the winter months, when capacity restrictions kick in. Ongoing capacity reductions in steelmaking will favor higher-grade iron ores, which will widen price differentials versus lower-grade ores. We are recommending a long China rebar futures on the SHFE in 1Q19 vs short 62% Fe iron ore futures on the Dalian DCE in 1Q19 at tonight's close, based on our research. Energy: Overweight. Loadings of Iranian crude are expected to be curtailed beginning this month, as the November 4 deadline for the imposition of U.S. secondary sanctions kick in. Our base case calls for the loss of 500k b/d of exports from Iran; our ensemble forecast includes an estimate of 1mm b/d. Base Metals: Neutral. BHP asked the Chilean government to intervene in the strike called by unions at its Escondida mine. Union officials delayed strike action while talks are being held. Negotiators have until August 14 to reach an agreement. Reuters reported Chile's copper production was up 12.3% y/y in 1H18 to 2.83mm MT.1 Precious Metals: Neutral. U.S. sanctions on trading gold and precious metals with Iran went into effect earlier this week. Ags/Softs: Underweight. Chinese imports of U.S. soybeans could fall 10mm MT over the next year, if pig and chicken farmers switch to lower-protein feed and substitutes like sunflower seeds, and boost local production of the legume, state-run news service Xinhua reported.2 The USDA expects U.S. exports of 55.52mm MT of soybeans in the 2018 - 19 crop year, down 1.22mm MT from last year. Feature Steel prices have performed exceptionally since the beginning of 2Q18, seemingly oblivious to Sino - U.S. trade tensions, a stronger USD, and risks to China's economy roiling other metal markets (Chart of the Week). The MySteel Composite Index we use to track steel prices is up 7% since the beginning of April. With demand growth leveling off, steel's price dynamics highlight the continued relevance of the market's supply-side developments. Most notably, Beijing's battle for blue skies: Winter capacity curbs, and, to a lesser extent, ongoing efforts to retire older, highly polluting capacity will keep prices elevated over the next 9 months. Winter Curbs: China's New Normal As we highlighted in our April 12 weekly, despite the much-ballyhooed reductions in China's steel capacity over the 2017 - 18 winter months, markets in China and globally remained relatively well supplied over the winter.3 However, several key changes this year suggest the impact of these measures will intensify this time around, keeping producers constrained in their ability to ramp up production of the metal. For one, the data suggest strong production levels amid the anti-pollution curbs last winter were a result of an increase in output from regions unaffected by the capacity restrictions (Chart 2). This went a long way in muting the impact of the restrictions in the heavily industrialized Beijing-Tianjin-Hebei region of northern China. Chart of the WeekSteel Oblivious To Pessimism Steel Oblivious To Pessimism Steel Oblivious To Pessimism Chart 22017/18 Winter Cuts: A Net Non-Event Blue Skies Drive China's Steel Policy Blue Skies Drive China's Steel Policy This year's curbs will broaden the regions targeted by anti-pollution restrictions. The campaign will encompass 83 cities, up from last year's 28, thereby reducing the potential production ramp up from regions not covered by these measures (Chart 3). This coming winter's closures will cover regions where producers traditionally account for 68% of China's steel output (Chart 4). Chart 3Second Annual Winter Capacity ##br##Restrictions Will Broaden Coverage... Blue Skies Drive China's Steel Policy Blue Skies Drive China's Steel Policy Chart 4...And##br## Impact Blue Skies Drive China's Steel Policy Blue Skies Drive China's Steel Policy The anti-pollution campaign is one of the three battles prioritized in Xi Jinping's plan for the coming years. These curbs will be implemented during the October 1, 2018 to March 31, 2019 heating season, extending the duration from last year's mid-November to Mid-March period. Because the minimal effect observed per last year's closures was due to specifying too narrow a range of plants and regions, not to non-compliance, we expect the measures announced for this coming winter to be fully implemented. These measures come amid already-tight market conditions. The steel rebar market in China is in backwardation - meaning a physical shortage is pushing up prompt prices relative to those further out the curve. Inventories have been falling since mid-March, reflecting supply-demand dynamics in other steel product markets. Thus, we expect prices to remain elevated going into the winter months. Capacity Impacts Are Difficult To Gauge Opaqueness and discretionary authority in the new rules clouds the outlook on how anti-pollution reforms will impact the steel market. This makes it difficult to estimate their impact with precision. This time around, China's State Council announced that curbs will be implemented in a more scientific and targeted approach, ensuring maximum efficiency to attain the targets. This means the constraints this year will depend on emissions in each region, which will be set at the discretion of local authorities.4 For example, steel mills in six key cities including Tianjin, Shijiazhuang, Tangshan, Handan, Xingtai and Anyang will be asked to keep capacity below 50% this winter, while producers in the rest of the Beijing-Tianjin-Hebei region will keep production running at less than 70% of capacity. Furthermore, a draft plan by the city of Changzhou - which planned to implement the curbs beginning August 3 - suggests production curbs may vary by company, depending on operational situations and emission levels.5 These restrictions are applied to capacity, rather than production. Without up-to-date and accurate information on crude steel-making capacity across the different regions, it is extremely difficult to accurately quantify the impact. Specifics of the plans are up to the discretion of local authorities. Thus, these restrictions can be applied to different stages in the steel-making process (Diagram 1), impacting furnaces, pig iron or sintering plants. In some cases, the output curbs are not only restricted to the winter heating months. Several regions have been implementing curbs throughout the year on an as-needed basis. The cities of Tangshan and Changzhou are two such examples, implementing restrictions during the summer months as well. Furthermore, all industrial plants in the city of Xuzhou remain shut. High profit margins at steel mills may incentivize the shuttered illegal furnaces to restart. The industry ministry acknowledges this threat, and claims it will carry out checks on these producers to ensure they do not come back online. Diagram 1Steelmaking Production Process: Restrictions Can Be Applied To Different Stages Blue Skies Drive China's Steel Policy Blue Skies Drive China's Steel Policy Without full knowledge of these details, quantifying the impact of these restrictions is a challenge. Morgan Stanley estimates the impact of these curbs on steel output to be 78mm MT during the winter period by assuming capacity utilization is restricted to 50% in the key cities, while the rest of the areas cut capacity by 30%. The estimated production loss from these restrictions accounts for 9% of China's 2017 crude steel output.6 China's Ongoing Capacity-Reduction Reforms Most of the planned permanent capacity shutdowns have already taken place. Of the targeted 150mm MT of cuts between 2016 and 2020, 115mm MT have already taken place over the past two years. Furthermore, 1H17 witnessed the closure of all illegal induction furnaces producing sub-par quality steel, estimated to account for 140mm MT of crude steel capacity (Table 1).7 Table 1De-Capacity Reforms Still Ongoing Blue Skies Drive China's Steel Policy Blue Skies Drive China's Steel Policy We expect the magnitude of cutbacks to slow considerably. Even though the industry ministry issued a statement in February that it plans to meet steel capacity reduction targets this year - two years ahead of schedule. Furthermore, mills face restrictions on new steel capacity. China's State Council announced it intends to prevent new steel capacity additions in the Beijing-Tianjin-Hebei, Guangdong province, and Yangtze River Delta regions, and a cap set at 200mm MT in Hebei by 2020. The capacity replacement plan, which allows a maximum of 0.8 MT of new capacity for each MT of eliminated capacity, will ensure capacity does not grow going forward. In fact, not all mills are eligible to take advantage of the replacement policy. Among others, now-shuttered induction furnace capacity, as well as producers that previously benefited from cash and policy support will not meet the requirements for this program. Steel And Iron Ore Prices Will Not Reconverge As a result of China's reform policies in the steel industry, iron ore prices have diverged from steel. Reduced steel production lowers demand for raw materials, including iron ore. This is reflected in falling Chinese iron ore imports amid contracting production (Chart 5). Chart 5Weak Demand For Iron Ore Weak Demand For Iron Ore Weak Demand For Iron Ore Chart 6EAF Penetration In China: Still Some Catching Up To Do Blue Skies Drive China's Steel Policy Blue Skies Drive China's Steel Policy China's reform and anti-pollution campaigns have had serious consequences on iron ore markets. For starters, China is encouraging the adoption of electric arc furnaces (EAF), rather than additional new blast furnaces.8 While the latter primarily uses iron ore, the former uses scrap steel. EAF penetration in China's steel industry significantly lags the rest of the world (Chart 6). This means that even if the capacity-replacement program allows eliminated furnaces to be replaced with newer, more up-to-date capacity, this will not spur demand for iron ore. Instead, we expect to see higher scrap steel prices (Chart 7). Furthermore, as we first highlighted in our January report, China's anti-pollution campaign coupled with high steel profit margins has incentivized the use of higher grade iron ore and iron ore pellets, widening the price spread between high- and low- grade ores (Chart 8).9 Chart 7EAFs Support Scrap Steel Demand EAFs Support Scrap Steel Demand EAFs Support Scrap Steel Demand Chart 8IO Grade Premiums Will Remain Elevated IO Grade Premiums Will Remain Elevated IO Grade Premiums Will Remain Elevated While high-grade ores are more expensive, they emit less pollution in the steelmaking process. Similarly, unlike fines, pellets which are direct charge feedstock, are not required to undergo the highly polluting sintering stage and can be fed directly into the furnace. China's Steel Dynamics Overshadow Global Markets The ongoing supply-side reforms in China are overshadowing events in other markets. Globally, steel is expected to remain in physical deficit this year (Chart 9). This is largely on the back of an increase in world ex-China demand, and the decline in Chinese supply, despite expectations of weaker Chinese demand, and increased supply from the rest of the world (Table 2). Chart 9Physical Steel Deficit Will Persist... Blue Skies Drive China's Steel Policy Blue Skies Drive China's Steel Policy Table 2...Despite Weaker Chinese Demand And Stronger RoW Supply Blue Skies Drive China's Steel Policy Blue Skies Drive China's Steel Policy These figures do not consider the impact of the ongoing Sino - U.S. trade dispute, which could evolve into a full-blown trade war, weighing on EM incomes and demand. In such a scenario, global demand for steel would take a hit, potentially shifting global markets into surplus. In theory, trade barriers on U.S. steel imports could lead to weaker domestic supply for American users and at the same time, leave more of the metal for use by the rest of the world. The net effect of that would be a higher price for American steel relative to the rest of the world. However, since May, 20,000 requests for steel tariff exemptions have been filed in the U.S., of which the Commerce Department has denied 639. To the extent that American steel users are able to obtain tariff exemptions, the impact of the barriers on global steel markets will be muted. Bottom Line: We expect China's steel market to tighten as we go into the winter season, during which capacity cuts will be broadened to 82 cities, from last year's 28. This will keep steel prices elevated. At the same time, we expect prices of 62% Fe material and lower iron ore grades to weaken, as appetite for the steelmaking raw material contracts during these months. Mills still running in the mid-November to mid-March period will have a preference for higher-grade ores and pellets, keeping premiums on these grades elevated. Barring a significant demand-side shock, expect more upside to steel prices and downside to iron ore prices over the coming 9 months. Based on our research, we are recommending a long China rebar futures on the SHFE in 1Q19 vs. short 62% Fe iron ore futures on the Dalian DCE in 1Q19 at tonight's close. Roukaya Ibrahim, Editor/Strategist Commodity & Energy Strategy RoukayaI@bcaresearch.com 1 Please see "BHP asks for government mediation in talks at Chile's Escondida," published August 6, 2018, by uk.reuters.com. 2 Please see "Economic Watch: China can cut soybean imports in 2018 by over 10 mln tonnes," published August 5, 2018, by xinhuanet.com. 3 Please see Commodity & Energy Strategy Weekly Report titled "Chinese Steel, Aluminum Markets Well Supplied Despite Winter Capacity Cuts," dated April 12, 2018, available at ces.bcaresearch.com. 4 Please see "Chinese steel output cuts to vary from mill to mill next winter," dated July 21, 2018, available at reuters.com. 5 The restrictions will not only apply to the city's steel mills, but also to copper smelters, chemical makers as well as cement producers. Please see "China's Changzhou plans to enforce output curbs in steel, chemical plants," dated July 30, 2018, available at reuters.com. 6 Please see "Shanghai steel resumes rise, coke rallies as China eyes winter curbs," dated August 2, 2018, available at reuters.com. 7 Low-quality steel produced by induction furnaces, also referred to as ditiaogang, is made by melting scrap steel using induction heat, preventing sufficient control over the quality of the steel. Platts estimates ditiaogang production in 2016 to be 30-50mm MT. As we explain in our September 7, 2017 Weekly Report titled "Slow-Down In China's Reflation Will Temper Steel, Iron Ore In 2018," given that ditiaogang is illegal, these closures are not reflected in official steel production figures. Thus the closures of these mills have no impact on actual steel production, but instead raise the capacity utilization rates for Chinese steel producers. 8 China launched a carbon trading system in January 2018, which penalizes blast furnace operators with higher environmental taxes relative to EAF processes. 9 Please see Commodity & Energy Strategy Weekly Report titled "China's Environmental Reforms Drive Steel & Iron Ore," dated January 11, 2018, available at ces.bcaresearch.com. Investment Views and Themes Recommendations Strategic Recommendations Tactical Trades Commodity Prices and Plays Reference Table Blue Skies Drive China's Steel Policy Blue Skies Drive China's Steel Policy Trades Closed in 2018 Summary of Trades Closed in 2017 Blue Skies Drive China's Steel Policy Blue Skies Drive China's Steel Policy

Please note that our next publication will be a joint special report with BCA’s Geopolitical Service that will be published on Wednesday, August 1st instead of our usual Monday publishing schedule. Further, there will be no publication on Monday, August 6th. We will be returning to our normal publishing schedule thereafter. Highlights We continue to explore a cyclical over defensive portfolio bent, and the capex upcycle along with higher interest rates are our key investment themes for the remainder of the year. A number of sentiment indicators have broken out (Chart 1), and our sense is that the SPX will also hit fresh all-time highs in the coming quarters. While buybacks vaulted to uncharted territory in Q1/2018 (Chart 2), our profit growth model suggests that EPS will continue to expand at a healthy clip for the rest of the year (Chart 3) and 10% EPS growth is achievable in calendar 2019. Positive macro forces remain in place with the ISM - manufacturing and non-manufacturing - surveys reaccelerating. Beneath the surface, the new-orders-to-inventories ratio is gaining traction and even the trade-related subcomponents (new export orders and imports) are ticking higher. High backlogs also suggest that SPX revenue growth will remain upbeat (Chart 4). Non-farm payrolls are expanding on a month-over-month basis for 93 consecutive months, a record (Chart 5), at a time when the real fed funds rate remains near the zero line (Chart 6). As a result, the economy is overheating. Corporate selling price inflation is skyrocketing, according to our gauge, with our diffusion index catapulting to multi-decade highs. This represents a positive margin backdrop as wage inflation remains muted (Chart 7). While at first sight, valuations appear dear, a simple thought experiment suggests that soon they will deflate1 (Chart 8). And, on a forward price-to-earnings-to-growth (PEG) basis, valuations have sunk to one standard deviation below the historical mean (Chart 9). Two key risks that we are closely monitoring that can put our cyclically positive equity market view offside are: a sustained rise in the U.S. dollar infiltrating profit growth (Chart 10), and corporate balance sheet degradation short-circuiting the broad equity market (Chart 11). Chart 1Sentiment Is Breaking Out Sentiment Is Breaking Out Sentiment Is Breaking Out Chart 2Buybacks Are Soaring Buybacks Are Soaring Buybacks Are Soaring Chart 3Earnings Growth Hasnt Slowed... Earnings Growth Hasnt Slowed... Earnings Growth Hasnt Slowed... Chart 4...And Backlogs Suggest They Wont ...And Backlogs Suggest They Wont ...And Backlogs Suggest They Wont Chart 5Record Jobs Growth... Record Jobs Growth... Record Jobs Growth... Chart 6...And Still-Loose Monetary Policy ...And Still-Loose Monetary Policy ...And Still-Loose Monetary Policy Chart 7Wage Growth Is Trailing Pricing Power Flexing Its Muscles Wage Growth Is Trailing Pricing Power Flexing Its Muscles Wage Growth Is Trailing Chart 8The Market Is Not That Expensive... The Market Is Not That Expensive... The Market Is Not That Expensive... Chart 9...By Several Measures ...By Several Measures ...By Several Measures Chart 10A Strong Dollar Is A Risk A Strong Dollar Is A Risk A Strong Dollar Is A Risk Chart 11Corporate Sector Leverage Is Too High Corporate Sector Leverage Is Too High Corporate Sector Leverage Is Too High Feature S&P Industrials (Overweight) While our industrials CMI remains very near 20-year highs, it has lost its upward momentum this year due almost entirely to the strength of the U.S. dollar, though sliding global PMI surveys have also started to weigh (second panel, Chart 13). Combined with heightened fears of a trade war, the internationally geared S&P industrials have come under pressure. Chart 12S&P Industrials (Overweight) S&P Industrials S&P Industrials Chart 13Positive Industrial Growth Backdrop Positive Industrial Growth Backdrop Positive Industrial Growth Backdrop Still, demand growth has been resilient and continues to soar as the capex upcycle has not yet run its course and the implications for top line and profit growth are unambiguously positive (third and bottom panels, Chart 13). Should some let up emerge from the current break down of international trade, we would expect earnings to resume their role as the fundamental driver for industrials. Our valuation gauge has rapidly declined this year as extreme bearishness is not reflected by the strong profit backdrop. From a technical perspective, S&P industrials have been the most oversold since the Great Recession. S&P Energy (Overweight, High-Conviction) Our energy CMI has continued to push higher from the extremely depressed levels of 2016 and 2017. Still, the much better cyclical environment has started to get reflected in relative share prices with the S&P energy index besting all other GICS1 sectors in Q2. We recently refined our energy sector sub-surface positioning that sustains the broad energy complex in the overweight column, and we reiterated its high-conviction status. We believe the steep recovery in underlying commodity prices, which the market has thus far failed to show much confidence in, has started to restore some semblance of normality in the exploration & production (E&P) stocks space (top panel, Chart 15). Chart 14S&P Energy (Overweight, High Conviction) S&P Energy S&P Energy Chart 15A Capex Boom As Oil Reignites A Capex Boom As Oil Reignites A Capex Boom As Oil Reignites Similar to the broad energy complex that integrateds dominate, oil & gas E&P producers are a capital expenditure upcycle play, which remains a key BCA theme for the year (second panel, Chart 15). Accordingly, we raised the S&P oil & gas E&P index to an overweight stance. Simultaneously, weakening crack spreads (third panel, Chart 15) and rising gasoline inventories (bottom panel, Chart 15) have given us cause for concern for refiners. As a result, we trimmed the S&P oil & gas refining & marketing index to underweight, though this did not shake our high-conviction overweight position on the broad S&P energy index. Our Valuation Indicator (VI) remains near deeply undervalued territory, and indicates an attractive entry point for fresh capital. Our Technical Indicator (TI) has fully recovered from oversold levels and now sends a neutral message. S&P Financials (Overweight) The pace of improvement in our financials cyclical macro indicator (CMI) has not abated. However, the usual tight correlation between the CMI and the relative performance of the S&P financials index has broken down. An important culprit has been the heavyweight S&P banks sub-index and its transition from a correlation with the 10-year UST yield and toward the 10/2 yield curve slope earlier this year (top and second panels, Chart 17). While the former is still up year-over-year, the latter has continued to flatten and the result is likely a squeeze on banks' net interest margins, a key profit driver; we recently booked gains of 6% and removed it from the high-conviction overweight list, and the S&P banks index is currently on downgrade watch. Chart 16S&P Financials (Overweight) S&P Financials S&P Financials Chart 17Growth And Credit Quality Offset A Flat Yield Curve Growth And Credit Quality Offset A Flat Yield Curve Growth And Credit Quality Offset A Flat Yield Curve Still, our key three reasons for being overweight the S&P financials index remain unchanged. Rising yields and the accompanying higher price of credit are a boon to financials and a core BCA theme for 2018 remains higher interest rates. The global capex upcycle, another of BCA's key themes for 2018, has paused for breath, though it has been replaced by soaring U.S. demand. This exceptional willingness of U.S. CEOs to expand their balance sheets should mean capital formation will proceed at well above-trend pace, and further underpin C&I loan growth (third panel, Chart 17). Lastly, a low unemployment rate drives both expanding consumer credit and much better credit quality. At present, the unemployment rate is testing all-time lows, sending an unambiguously positive message for financials profitability (bottom panel, Chart 17). Market bearishness has more than offset the positive fundamentals and the S&P financials index has underperformed in 2018; the result has been a steep fall in our VI to nearly one standard deviation below normal. The bearishness is also reflected in our TI which has recently collapsed into oversold territory. S&P Consumer Staples (Overweight) Our consumer staples CMI has moved sideways since our last update, near a depressed level. This is reflected in the share price performance; defensives in general and staples in particular have been woefully unloved this year. However, we believe positive macro undercurrents have made bargain basement prices in consumer staples an exceptional deal, particularly for investors willing to withstand short term volatility for a long-term investment gain. We recently pointed out that, while non-discretionary demand is losing share versus overall outlays, spending on essentials as a percentage of disposable income is gaining steam. The bearish read on this would be that this could be a pre-cursor to recession, but our interpretation is that latent staples-related buying power may make a comeback from a still very depressed level and kick-start industry sales growth (top panel, Chart 19). Chart 18S&P Consumer Staples (Overweight) S&P Consumer Staples S&P Consumer Staples Chart 19Staples Are Poised For A Recovery Staples Are Poised For A Recovery Staples Are Poised For A Recovery Meanwhile consumer staples exports are flying in the face of a rising U.S. dollar, which has typically presaged relative earnings gains (second panel, Chart 19). Considering the already-strong industry return on equity, any relative earnings gains should result in a valuation rerating (third panel, Chart 19). Both our VI and TI concur; as they are both more than a standard deviation below fair value. S&P Health Care (Neutral) Earlier this month, we lifted the S&P pharma and biotech indexes to neutral and, given that these sectors command roughly a 50% weighting in the S&P health care sector, these upgrades also lifted the health care sector to a neutral portfolio weighting. Sentiment has moved squarely against the sector and the bar for upward surprises has been lowered enough to create fertile ground for upside surprises. As shown in the second panel of Chart 21, health care long-term EPS growth expectations have never been lower in the history of the I/B/E/S/ data. This is contrarily positive, particularly given how our VI has remained under pressure and our TI has sunk. Chart 20S&P Health Care (Neutral) S&P Health Care S&P Health Care Chart 21Peak Pessimism In Health Care Peak Pessimism In Health Care Peak Pessimism In Health Care Still, our health care CMI has been treading water at relatively low levels, but our S&P health care earnings model suggests that at least a bottom in profit growth has formed (bottom panel, Chart 21). S&P Technology (Neutral) We lifted the S&P technology index to neutral earlier this year to capitalize on one of BCA's key themes for 2018: synchronized global capex upcycle, of which the broad tech sector is a core beneficiary (second panel, Chart 23).2 Software and tech hardware & peripherals are the two key sub-indexes we prefer and have also put on our high-conviction overweight list. Chart 22S&P Technology (Neutral) S&P Technology S&P Technology Chart 23A Capex Upcycle Should Sustain High Valuations A Capex Upcycle Should Sustain High Valuations A Capex Upcycle Should Sustain High Valuations There is still pent up demand for tech spending that is being unleashed following over a decade of severe underinvestment. In addition, consumer spending on tech goods is also at the highest level since the history of the data, underscoring that end demand is upbeat (third panel, Chart 23). On the global demand front, EM Asian exports are climbing at the fastest clip in ten years; tech sales and EM Asian exports are historically joined at the hip and the current message is positive (bottom panel, Chart 23). The technology CMI has also turned positive this year after falling for the previous three, though an appreciating dollar and higher interest rates continue to suppress an otherwise exceptionally robust macro environment. Valuations, while still in the neutral zone, have reached their highest level in a decade. This may prove risky should inflation mount faster than expected; a de-rating phase in technology would likely follow. Our TI is in overbought territory, though it has been at this high level for several years. S&P Utilities (Neutral) Our utilities CMI appears to have found a bottom, arresting the linear downtrend of the previous decade. Declining earnings have steadied out as the industry has found some discipline; new investment has declined and turbine & generator inventories have ticked up (second panel, Chart 25). The result of declining investment has been a slight improvement in capacity utilization, albeit still at a relatively low level (third panel, Chart 25). Chart 24S&P Utilities (Neutral) S&P Utilities S&P Utilities Chart 25Earnings Are Looking For A Bottom Earnings Are Looking For A Bottom Earnings Are Looking For A Bottom The uptick in capacity utilization has driven a surge in industry pricing power, despite flat natural gas prices which have historically been the industry price setter; this could be the precursor to a recovery in sector earnings (bottom panel, Chart 25). Still, as with other defensive sectors, utilities have underperformed cyclical sectors in the last year; this has been exacerbated by utilities trading as fixed income proxies. Our VI does not provide much direction as it has been in the neutral zone for the past year, underscoring our benchmark allocation recommendation. Our TI fell steeply earlier this year, though it has recovered and offers a neutral reading. S&P Materials (Neutral) The materials CMI has come under pressure as the Fed has continued to tighten monetary policy. A further selloff in bonds remains the BCA view for 2018, implying rising real rates will weigh on the sector for at least the remainder of the year. The heavyweight chemicals component of the materials index typically sees earnings (and hence stock prices) underperform as real interest rates are moving higher (real rates shown inverted, top panel, Chart 27). Chart 26S&P Materials (Neutral) S&P Materials S&P Materials Chart 27This Time Is Different For Chemicals This Time Is Different For Chemicals This Time Is Different For Chemicals On the operating front, chemicals sector productivity has made solid gains over the past year and the sell-side bearishness for much of the past decade has finally reversed (second panel, Chart 27). Further, overcapacity, the usual death knell of the chemicals cycle, seems to be a thing of the past as the industry has massively scaled back on capital deployment on the heels of a mega global M&A cycle (third panel, Chart 27). Net, operating improvements might offset macro headwinds. Our VI echoes this neutral message and sits on the fair value line. Our TI is somewhat more bullish and is edging toward an oversold position. S&P Real Estate (Underweight) Our real estate CMI looks to have found a bottom earlier this year, though the only time it has been worse was during the Great Financial Crisis. Real estate stocks are continuing to behave like fixed income proxies, as they have since the overhang from the GFC gave way to a yield focus (top panel, Chart 29). In the context of a tightening monetary backdrop, we would need compelling operating or valuation reasons to maintain even a benchmark allocation in the sector; these are both absent. Chart 28S&P Real Estate (Underweight) S&P Real Estate S&P Real Estate Chart 29Dark Clouds Forming Dark Clouds Forming Dark Clouds Forming On the operating front, the commercial real estate (CRE) sector is waving a red flag. The occupancy rate has clearly crested and rents are headed down with it, warning of declining sector cash flows (second panel, Chart 29). While CRE credit quality shows no signs of deterioration, at this stage of the cycle and given weak industry profit fundamentals we would caution against extrapolating such good times far into the future (third panel, Chart 29). We recently initiated a trade to capitalize on relative CRE weakness by going long the S&P homebuilding index/short the S&P REITs index.3 Such overwhelming bearishness would suggest the sector would be relatively cheap, but our VI suggests that REITs are fairly valued. Our TI is has been unwinding an oversold position and is now in neutral territory. S&P Consumer Discretionary (Underweight) In early March, we identified three key factors that we expected to weigh on the consumer discretionary sector: a rising fed funds rate, quantitative tightening and higher prices at the pump. As highlighted in Chart 31, all of these factors remain intact and underlie the two-year decline in the consumer discretionary CMI. Chart 30S&P Consumer Discretionary (Underweight) S&P Consumer Discretionary S&P Consumer Discretionary Chart 31The Amazon Effect The Amazon Effect The Amazon Effect Further, were we to exclude AMZN from the day the S&P included it in the SPX and the S&P 500 consumer discretionary index (November 21st, 2005), then the vast majority of consumer discretionary stocks are actually following the typical historical relationship with the Fed's tightening cycle (fed funds rates shown inverted, top panel, Chart 31). Put differently, the equal weighted S&P consumer discretionary relative share price ratio is indeed following the Fed's historical tightening path (bottom panel, Chart 31). Meanwhile, our VI has broken out to nearly its highest level ever which we believe is largely a function of the decreasing diversification of the S&P consumer discretionary index as AMZN now represents nearly a quarter of its market value, and about to get even larger in the upcoming introduction of the Communications Services GICS1 sector, but only comprises 3% of this sector's net income. Our TI agrees with our VI and is well into overbought territory. S&P Telecommunication Services (Underweight) Our telecom services CMI, bounced off its 30-year low earlier this year, but not nearly enough for a bullish position to be established. Rather, our bearish thesis remains unchanged: A combination of still-tepid pricing power weighing on earnings (second panel, Chart 33), weak consumer spending (bottom panel, Chart 33) and higher Treasury yields (which are negatively correlated with high-dividend yielding telecom services stocks, top panel, Chart 33), should all keep relative performance suppressed. Chart 32S&P Telecommunication Services (Underweight) S&P Telecommunication Services S&P Telecommunication Services Chart 33Pricing Power Is Still On Hold Pricing Power Is Still On Hold Pricing Power Is Still On Hold Valuations have fallen significantly - our VI continues to touch new lows - and our TI has been indicating a persistently oversold position, but we think the industry is in a de-rating phase, implying the new valuation paradigm has a degree of permanence. Size Indicator (Favor Large Vs. Small Caps) Our size CMI has fallen back to 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; the current message is neutral. Despite the neutral CMI reading, we downgraded small caps earlier this year,4 and moved to a large cap preference, based on the diverging (and unsustainable) debt levels of small caps vs. their large cap peers (top and second panels, Chart 35). We expect the divergence in leverage and stock price to be rationalized as it usually has: via a fall in the latter. Chart 34Size Indicator (Favor Large Vs. Small Caps) Style View Style View Chart 35Small Cap Leverage Is Critical Small Cap Leverage Is Critical Small Cap Leverage Is Critical Our call has thus far been slightly offside as small caps have been outperforming: investors have sought the trade-friction free shelter that small caps offer compared with internationally exposed large caps. Extreme optimism also reigns throughout the small cap world (third panel, Chart 35). However, we continue to think a turn is merely a matter of time; the NFIB's "good time to expand" reading is at its highest level in the history of the survey (bottom panel, Chart 35) which means small cap CEOs are more likely to push their already-stretched balance sheets closer to the breaking point. Our TI is telling us that small caps are overbought, but the VI continues to offer a neutral message. Chris Bowes, Associate Editor chrisb@bcaresearch.com 1 Please see BCA U.S. Equity Strategy Insight Report, "How Expensive Is The SPX?" dated July 6, 2018, available at uses.bcaresearch.com. 2 Please see BCA U.S. Equity Strategy Weekly Report, "Buying Opportunity," dated April 9, 2018, available at uses.bcaresearch.com. 3 Please see BCA U.S. Equity Strategy Special Report, "UnReal Estate Opportunity," dated July 9, 2018, available at uses.bcaresearch.com. 4 Please see BCA U.S. Equity Strategy Special Report, "UnReal Estate Opportunity," dated July 9, 2018, available at uses.bcaresearch.com.

There is scant evidence that the character of the equity market advance is changing and the fact that weak balance sheet stocks are no longer outperforming strong balance sheet stocks is giving us pause (Chart 1). Chart 1Time To Pause And Reflect Time To Pause And Reflect Time To Pause And Reflect Using the Goldman Sachs equity baskets - that utilize the 'Altman Z-score' framework to select stocks - via Bloomberg, we find that the weak balance sheet over strong balance sheet share price ratio leads the broad market at both peaks and is coincident at troughs. The most recent peak occurred in early 2017 and it is rather surprising that a proxy for this ratio using the fixed income market, i.e. the total return high yield bond index versus the total return investment grade bond index, is moving in the opposite direction and not confirming the equity market's message (Chart 2). This begs the question: Which market signal is right, stocks or fixed income, and what are the equity sector investment implications? But before trying to answer these questions, we first zoom out and look at the broad U.S. debt picture. How Will It All End? In our travels and conference calls one common question keeps coming up: What will end all this? The short answer is that rising interest rates will eventually deal a blow to the debt overhang and the expansion will give way to a fresh deleveraging cycle. In other words, a whiff of inflation will entice the Fed to keep on raising the fed funds rate to the point where the business cycle turns down. As demand falters, a decreasing cash flow backdrop will not be able to service the debt overload, as both coupon payments and principal repayments will become a big burden. This will ignite a jump in the default rate, a message the yield curve is already sending (Chart 3). Chart 2Which Market Is Right? Which Market Is Right? Which Market Is Right? Chart 3Has The Junk Default Rate Troughed? Has The Junk Default Rate Troughed? Has The Junk Default Rate Troughed? Peering back to the onset of the GFC, a U.S. financial sector debt crisis engulfed the world. Subsequently, this morphed into a government sector debt problem in the Eurozone and more recently into a non-financial corporate sector debt overhang mostly in the commodity complex and the emerging markets. Debt Supercycle Lives On The investment world is obsessed with China's excess debt uptake and that is a valid concern. However, investors should also be aware that U.S. debt has not been fully purged. Rather, it has moved around between different domestic sectors. The debt supercycle lives on.1 The implication is that an interest rate-induced debt bubble pricking would be deflationary, and thus identifying the U.S. domestic sector most exposed to such risk is important. Chart 4 breaks down U.S. total debt into the four largest sectors using flow of funds data. While households and the financial sector have significantly de-levered, the government and the non-financial business sector have been picking up the slack and aggressively re-levering. While the Trump Administration has embarked on a two-year fiscal policy easing period that will add to the government debt profile, the nonfinancial corporate debt overhang is more vulnerable and thus troublesome in our view (fed funds rate shown inverted, Chart 5). Worrisomely, since the GFC, nonfinancial corporates have been issuing debt and partially using this debt to retire equity and pay handsome dividends. According to the flow of funds data, the cumulative nonfinancial net equity retirement figure stands near $4tn over the past decade (middle panel, Chart 6). Undoubtedly, this has been a large contributor to equity market returns (top panel, Chart 6), and will likely gain further momentum this year on the back of the tax repatriation holiday. Some sell side equity retirement estimates for the S&P 500 hover around $800bn for calendar 2018 or roughly twice the past decade's annual average. AAPL's recent announcement of a $100 billion share repurchase program confirms that the buyback bonanza is persevering and will continue to boost equities. Clearly, such breakneck equity retirement pace is unsustainable and will converge down to a lower trend rate in 2019 and beyond, especially given the drying liquidity as the Fed continues to pursue a tighter monetary policy. Chart 4Debt Is Moving Around Debt Is Moving Around Debt Is Moving Around Chart 5Tight Monetary Policy Pricks Bubbles, And... Tight Monetary Policy Pricks Bubbles, And… Tight Monetary Policy Pricks Bubbles, And… Chart 6...Threatens To End The Equity Retirement Binge …Threatens To End The Equity Retirement Binge …Threatens To End The Equity Retirement Binge Introducing BCA's Sector Insolvency Risk Monitor (IRM) The purpose of this Special Report is to identify debt soft spots and outliers in the U.S. GICS1 equity sectors. What follows is a financials statement-heavy analysis of sector indebtedness. We introduce the 'Altman Z-score' sector analysis that gauges sector credit strength, with a rising score indicating improving health and a declining Z-score signifying deteriorating health.2 In absolute terms, a score below 1.8 warns of a possible credit event, whereas any reading above 3 signals that bankruptcy risk is very low (see appendix below). Our analysis includes our flagship Bank Credit Analyst's Corporate Health Monitor framework that breaks down corporate health in the different sectors3 (see appendix below). We also sift through a number of different stock market reported ratios/data to gauge each sector's health, with net debt-to-EBITDA and interest coverage at the forefront of our analysis, and try to identify outliers (see appendix below). Finally, with the invaluable help of BCA's Chief Quantitative Strategist, David Boucher, we created our new insolvency risk monitor (IRM) per U.S. equity sector incorporating the respective 'Altman Z-scores', BCA's corporate health monitor readings and net debt-to-EBITDA ratios. In more detail, we ranked each sector (ex-financials and real estate) on a monthly basis on each of these three measures. Then we used a simple average of the ranked measures per sector to come up with the final sector ranking. We also selected the median sector ranking per measure and used the average of the three metrics as a proxy for the broad market.4 This way we were able to compare each sector IRM to the overall market. Note that the IRMs are designed so that a higher IRM ranking means better solvency. Charts 7 & 8 summarize the results and showcase this new all-inclusive relative ranking alongside relative share price performance. Chart 7Unsustainable... Unsustainable… Unsustainable… Chart 8...Divergences ...Divergences ...Divergences Sector Outliers Consumer discretionary stocks are the clearest outliers and the message from the relative IRM is to expect a significant underperformance phase in the coming quarters (top panel, Chart 7). AMZN's juggernaut is blurring the discretionary landscape given its 20% index weight, and artificially boosting relative share prices. Ex-AMZN, this early cyclical sector is behaving similar to previous episodes when the Fed embarked on a tightening interest rate cycle. We reiterate our recent downgrade to a below benchmark allocation.5 Consumer staples equities are steeply deviating from their increasing relative IRM score, underscoring that investors are unduly punishing staples stocks (second panel, Chart 8). We maintain our overweight stance and treat this sector as a small portfolio hedge to our otherwise general dislike of defensives (as a reminder we are underweight both the S&P health care and the S&P telecom services sectors). Chart 9Cyclicals Have The Upper Hand Cyclicals Have The Upper Hand Cyclicals Have The Upper Hand The utilities share price ratio is also deviating from the IRM relative reading (fourth panel, Chart 8). The implication is that extreme bearishness toward the sector is overdone and we reiterate our mid-February upgrade to a neutral stance.6 Energy stocks have fallen behind the energy IRM rebound reading (top panel, Chart 8). We expect a catch up phase on the back of the global capex upcycle, still improving debt profile, favorable underlying commodity supply/demand dynamics and firming oil prices. The S&P energy sector remains a high-conviction overweight. The niche materials sector is also trailing the sector's slingshot IRM recovery. Keep in mind that, as expected, the materials IRM is one of the most volatile series (second panel, Chart 8). Materials manufacturers are capital intensive and high operating leverage businesses and despite the debt dynamic betterment since the recent global manufacturing recession, this sector is still saddled with a large amount of debt that makes it extremely sensitive to the ebbs and flows of global economic growth. We continue to recommend a benchmark allocation. The remaining sectors' (tech, health care, telecom services and industrials) relative share prices are moving in tandem with their respective IRM readings (Charts 7 & 8). In addition, we have complied all the cyclical and defensive IRMs in two distinct series and the relative IRM ratio is giving the all-clear sign to continue to prefer cyclicals over defensives on a 9-12 month time horizon (Chart 9). So What? In sum, the IRM is one new additional metric we are using to gauge the validity of our sector positioning and should not be used in isolation. To answer our original question, while the weak balance sheet versus strong balance sheet stock underperformance is alarming and we will continue to closely monitor this stock price ratio, it is premature to change our constructive overall equity market view on a 9-12 month horizon. We therefore continue to recommend a cyclical over defensive portfolio bent. Finally, for completion purposes, the appendix below shows a number of debt-related indicators we track, including the absolute 'Altman Z-score' and corporate health monitor readings, in two charts per sector along with the cyclicals over defensives compilation and the overall market (ex-financials). Anastasios Avgeriou, Vice President U.S. Equity Strategy anastasios@bcaresearch.com 1 For a primer on the debt super cycle please refer to Box 1 in the BCA Special Year End Issue: "Outlook 2013: Fewer Storms, More Sunny Breaks," dated December 19, 2012, available at bca.bcaresearch.com. 2 Altman Z-Score = 1.2A + 1.4B + 3.3C + 0.6D + 1.0E. Where: A = working capital / total assets, B = retained earnings / total assets, C = earnings before interest and tax / total assets, D = market value of equity / total liabilities and E = sales / total assets. Source: https://www.investopedia.com/terms/a/altman.asp 3 Please see BCA The Bank Credit Analyst Report, "U.S. Corporate Health Gets A Failing Grade," dated January 28, 2016, available at bca.bcaresearch.com. 4 We refrained from using the top down computed S&P 500 'Altman Z-Score' and net debt-to-EBITDA as the financials sector really skewed the results and therefore opted to use the median sector 'Altman Z-score' and net debt-to-EBITDA as a proxy for the broad market because using the mean also skewed the results largely because of the tech sector. Staying consistent in our analysis, we also used the median sector BCA corporate health monitor to proxy the broad market. 5 Please see BCA U.S. Equity Strategy Weekly Report, "Reflective Or Restrictive?" dated March 12, 2018, available at uses.bcaresearch.com. 6 Please see BCA U.S. Equity Strategy Weekly Report, "Manic-Depressive?" dated February 12, 2018, available at uses.bcaresearch.com. Appendix U.S. Non-Financial Broad Market I U.S. Non-Financial Broad Market I U.S. Non-Financial Broad Market I U.S. Non-Financial Broad Market II U.S. Non-Financial Broad Market II U.S. Non-Financial Broad Market II U.S. S&P Industrials I U.S. S&P Industrials I U.S. S&P Industrials I U.S. S&P Industrials II U.S. S&P Industrials II U.S. S&P Industrials II U.S. S&P Energy I U.S. S&P Energy I U.S. S&P Energy I U.S. S&P Energy II U.S. S&P Energy II U.S. S&P Energy II U.S. S&P Consumer Staples I U.S. S&P Consumer Staples I U.S. S&P Consumer Staples I U.S. S&P Consumer Staples II U.S. S&P Consumer Staples II U.S. S&P Consumer Staples II U.S. S&P Tech I U.S. S&P Tech I U.S. S&P Tech I U.S. S&P Tech I U.S. S&P Tech I U.S. S&P Tech I U.S. S&P Utilities I U.S. S&P Utilities II U.S. S&P Utilities II U.S. S&P Utilities II U.S. S&P Utilities II U.S. S&P Utilities II U.S. S&P Materials I U.S. S&P Materials I U.S. S&P Materials I U.S. S&P Materials II U.S. S&P Materials II U.S. S&P Materials II U.S. S&P Consumer Discretionary I U.S. S&P Consumer Discretionary I U.S. S&P Consumer Discretionary I U.S. S&P Consumer Discretionary II U.S. S&P Consumer Discretionary II U.S. S&P Consumer Discretionary II U.S. S&P Telecom Services I U.S. S&P Telecom Services I U.S. S&P Telecom Services I U.S. S&P Telecom Services II U.S. S&P Telecom Services II U.S. S&P Telecom Services II U.S. S&P Health Care I U.S. S&P Health Care I U.S. S&P Health Care I U.S. S&P Health Care II U.S. S&P Health Care II U.S. S&P Health Care II U.S. S&P Cyclicals Vs. Defensives I U.S. S&P Cyclicals Vs. Defensives I U.S. S&P Cyclicals Vs. Defensives I U.S. S&P Cyclicals Vs. Defensives II U.S. S&P Cyclicals Vs. Defensives II U.S. S&P Cyclicals Vs. Defensives II

Highlights The scale of "de-capacity" reforms is diminishing considerably - old, inefficient capacity shutdowns are declining. Sizable new technologically advanced and ecologically friendly capacity is coming on stream for both steel and coal in 2018 and 2019. We project this will boost steel and coal output by 5.2% and 4.7% respectively, this year at a time when demand is set to slow. Steel, coal, iron ore and coke prices are all vulnerable to the downside. Share prices of the companies and currencies of countries that supply these commodities to China are most at risk. Feature Last November, our report titled, "China's "De-Capacity" Reforms: Where Steel & Coal Prices Are Headed," painted a negative picture for steel and coal prices over 2018 and 2019.1 Since then, after having peaked in December and February respectively, both steel and thermal coal prices have so far declined by about 20% from their respective tops (Chart 1). In the meantime, iron ore and coking coal have also exhibited meaningful weakness (Chart 2). Chart 1More Downside In Steel And Coal Prices More Downside In Steel And Coal Prices More Downside In Steel And Coal Prices Chart 2Iron Ore And Coking Coal Prices Are Also At Risk Iron Ore And Coking Coal Prices Are Also At Risk Iron Ore And Coking Coal Prices Are Also At Risk In this report, we revisit the topic of de-capacity reforms and examine how Chinese supply side reforms in 2018 will affect steel and coal prices. The key message is as follows: Having implemented aggressive capacity reduction over the past two years, the authorities are shifting the focus of supply side reforms from "de-capacity" to "replacement" of already removed capacity with technologically advanced capacity. This means the scale of "de-capacity" reforms is diminishing considerably - old, inefficient capacity shutdowns are declining. In addition, sizable new technologically advanced and ecologically friendly capacity is coming on stream for both steel and coal in 2018 and 2019. From an investing standpoint, this means both steel and coal prices are still vulnerable to the downside. Both could drop by more than 15% from current levels over the course of 2018. Diminishing Scale Of "De-Capacity" Reforms Reducing capacity (also called "de-capacity") in the oversupplied steel and coal markets has been a key priority within China's structural supply side reforms over the past two years. Steel Table 1 shows that the capacity reduction target for steel in 2018 is 30 million tons, which is much lower than the 45 million tons in 2016 and 50 million tons in 2017. Table 1Capacity Reduction: Target And Actual Achievement Revisiting China's De-Capacity Reforms Revisiting China's De-Capacity Reforms In addition, between May and September 2017, the "Ditiaogang"2 removal policy eliminated about 120 million tons of steel capacity, and sharply reduced steel products production. Most of Ditiaogang capacity was completely dismantled last year. Therefore, there is not much downside to steel production from Ditiaogang output cutbacks going forward. Furthermore, between October and December 2017, environmental policies aimed at fighting against winter smog also cut steel products output substantially, which pushed steel prices to six-year highs in December (Chart 3). Chart 3Policy Actions And Market Dynamics: Steel Sector Policy Actions And Market Dynamics: Steel Sector Policy Actions And Market Dynamics: Steel Sector In particular, in the last quarter of 2017, to ensure fewer smog days around the Beijing area, Tianjin's steel products output was reduced by 50% from a year earlier. The second biggest contribution to total steel output decline occurred in Hebei - the largest steel-producing province in China - where steel output plummeted by 7%. Excluding Tianjin and Hebei, national steel products output fell only by 3.9% from a year ago. As a long-term solution to ameliorate ecology and air quality around Beijing, the government is aiming to reduce the heavy concentration of steel production in Tianjin and Hebei by shifting a considerable portion of steel capacity to other regions in 2018 and following years. These two provinces together accounted for about 30.6% of the nation's steel products output in 2016; their share dipped to 27.6% in 2017. As a result, next winter the required production reduction from these regions to achieve the air quality targets in Beijing will be smaller. In short, the scale of specific policy driven steel output reduction in 2018 will be meaningfully lower than last year. Coal For coal, despite the same target as last year (150 million tons), the actual capacity cut this year will be much less than last year's actual reduction of 250 million tons, which exceeded the 150 million-ton target. Amid still-high coal prices, the authorities will be more tolerant of producers not cutting too much capacity. Plus, with nearly two-thirds of the 2016-2020 target for capacity cuts having already been achieved in the past two years, there is much less outdated capacity in the industry (Table 1 above). In addition, the government's environment-related policies also led to a decline in total national coal output between October-December 2017 (Chart 4), with Hebei posting the biggest cut in coal output among all provinces. Chart 4Policy Actions And Market Dynamics: Coal Sector Policy Actions And Market Dynamics: Coal Sector Policy Actions And Market Dynamics: Coal Sector However, the authorities shortly thereafter relaxed restrictions on coal output, as the country was severely lacking gas supply for heating. In January and February of this year, the authorities reversed course, demanding that producers accelerate new advanced capacity replacement and increase coal production. Bottom Line: The scale of China's "de-capacity" reforms are diminishing, resulting in a lessening production cuts. Installing Technologically Advanced Capacity China's supply side reforms have included two major components - reducing inefficient capacity and low-quality supply that damaged the environment while boosting medium-to-high-quality production that is economically efficient and ecologically friendly. In brief, having removed significant obsolete capacity in the past two years, the policy focus is now shifting to capacity replacement. The latter enables China to upgrade its steel and coal industries to become more efficient and competitive worldwide, as well as ecologically safer. To guard against excessive production capacity of steel and coal, the authorities are reinforcing the following replacement principle: the ratio of newly installed-to-removed capacity should be less or equal to one. Two important points need to be noted: First and most important, the zero or negative growth of total capacity of steel and coal does not necessarily mean zero or negative growth in steel and coal output. For example, while total capacity for crude steel and steel products declined 4.8% and 1.8% year-on-year in 2016 respectively, output actually increased 0.5% and 1%. Despite falling total capacity, rising operational capacity could still contribute to an increase in final output. Total capacity (measured in tons) for steel and coal production includes both operational capacity and non-operational capacity, the latter representing obsolete/non-profitable capacity. As more technologically advanced capacity is installed to replace the already-removed one, both the size of operational capacity and the capacity utilization rate (CUR) will rise. Typically, advanced technologies have a higher CUR - consequently, production will grow. Second, an increase in the CUR of existing operational capacity will also result in rising output. In 2018, odds are that both the steel and coal industries in China will have non-trivial output increases as a result of new advanced capacity coming on stream. Steel Since late 2015, in environmentally sensitive areas of the Beijing-Tianjin-Hebei region and the Yangtze River Delta and the Pearl River Delta, steel plants have been required to add no more than 0.8 tons of new capacity for every 1 ton of outdated capacity removed. For other areas, the same ratio is 1 or less. Electric furnace (EF) steel-producing technology - which is cleaner, more advanced and used to produce high-quality specialized steel products - has become the major type of new capacity addition. This technology is favored by both the government and steel producers. Chinese EF-based steel production accounted for only 6.4% of the nation's total steel output in 2016, far lower than the world average of 25.7% (Chart 5). The EF technology uses scrap steel as raw materials, graphite electrodes and electricity to produce crude steel. Graphite electrodes, which have high levels of electrical conductivity and the capability of sustaining extremely high levels of heat, are consumed primarily in electric furnace steel production. Chart 6 demonstrates that prices of both graphite electrode and scrap steel have surged since mid-2017. This signifies that considerable new EF production capacity has been coming on stream. Chart 5Chinese Electric Furnace Crude Steel ##br##Production Will Go Up Revisiting China's De-Capacity Reforms Revisiting China's De-Capacity Reforms Chart 6Considerable New Addition Of##br## Chinese Electric Furnace Capacity Considerable New Addition Of Chinese Electric Furnace Capacity Considerable New Addition Of Chinese Electric Furnace Capacity Indeed, in 2017 alone, 44 units of EF were installed. In comparison, between 2014 and 2016, only 47 units of EF were installed. As the completion of a new EF installation in general takes eight to 10 months, all of EF capacity installed in 2017 - about 31 million tons of crude steel production capacity - will be operational in 2018. In addition, a report from China's Natural Resource Department indicates that as of mid-December there have been 54 replacement projects with total new steel production capacity of 91 million tons (including new EF capacity, new traditional capacity and recovered capacity). This compares to 120 million tons of capacity removed in 2016-'17. Assuming 60% of this 91 million tons capacity will be operating throughout 2018 at a utilization rate of 80% (the NBS 2017 CUR for the ferrous smelting and pressing industry was 75.8%), this alone will result in 43.6 million tons more output in 2018 from a year ago (5.2% growth from 2017 output) (Table 2). Table 2Strong Profit Margins Will Encourage Steel Production Revisiting China's De-Capacity Reforms Revisiting China's De-Capacity Reforms At the same time, strong profit margins will encourage steel makers to produce as much as possible to maximize profits (Chart 7). This will be especially true if the incumbent companies have to absorb liabilities of firms that were shutdown (please refer to page 14 for the discussion on this point). Facing more debt from shutdowns of other companies, steel incumbent producers would have an incentive to ramp up their production to generate more cash. Yet, we do not assume a rise in CUR for existing steel capacity. Hence, crude steel output growth in 2018 will likely be around 5.2%, higher than the 3% growth in 2017. This is in line with the top 10 Chinese steel producers' projected crude steel output growth in 2018 of 5.5%, based on their published production guidance data. The Ditiaogang and environmental policy caused a significant contraction in steel products growth in 2017, but will have limited impact in 2018 as discussed above. Eventually, increasing crude steel output will translate into strong growth in steel products output3 (Chart 8). Chart 7Strong Profit Margins ##br##Will Encourage Steel Production Strong Profit Margins Will Encourage Steel Production Strong Profit Margins Will Encourage Steel Production Chart 8Steel Products Production ##br##Will Rebound In 2018 Steel Products Production Will Rebound In 2018 Steel Products Production Will Rebound In 2018 Coal China's current coal capacity is about 5310 million tons, with 4780 million tons as operational capacity and the remaining 530 million tons as non-operational capacity, which has not produced coal for some time. As in general it takes roughly three to five years to build a coal mine, it will take a long time to replace the obsolete capacity. Yet there is hidden coal capacity in China. The China Coal Industry Association estimated last year that there was about 700 million tons of new technologically advanced capacity that has already been built and is ready to use, but has not yet received government approval. This is greater than the 530 million tons of coal production removed in the past two years by de-capacity reforms - equivalent to about 20% of China's total 2017 coal output. This hidden capacity originated from the fact that coal producers in China historically began building mines before applying for approval. However, since 2015, all applications for new coal mines have been halted. Consequently, in the past three years a lot of capacity has already been built but has not been put into operation. Some 70% of this hidden capacity includes large-scale coal mines, each with annual capacity of above 5 million tons. In comparison, China has about 126 million tons of small mines with annual capacity of 90,000 tons that will be forced to exit the market this year as they are non-competitive due to their small scale and inferior technology. Why do we expect this hidden capacity to become operational going forward? The authorities now allows trading in the replacement quota for coal across regions. Producers having these ready-to-use high-quality mines can buy the replacement quota from the producers who have eliminated the outdated capacity. The government wants to accelerate the process of allowing the advanced capacity to be in operation as fast as possible. The following policy initiative supports this: A new policy directive released this past February does not even require coal producers with advanced capacity to pay the quota first in order to apply for approval - they can apply for approval to start the replacement process first, and then have one year to pay for it. Economically, quotas trading makes sense. The mines with advanced technology that have lower costs and higher profit margins should be able to pay a reasonably high (attractive) price for quotas to companies with inferior technologies, so that the latter will be better off selling their quotas than continuing operations. The proceeds from the selling quotas will be used to settle termination benefits for employees of low-quality coal mines. Regarding our projections for coal output in 2018, assuming 30% of the 700 million tons of capacity among high-quality mines will be operational this year at a CUR of 78% (the NBS 2017 coal industry CUR was 68.2%), this alone will bring a 164 million-ton increase in coal output (4.7% of the 2017 coal output) (Table 3). Table 3Chinese Coal Output Will Rise By 4.7% In 2018 Revisiting China's De-Capacity Reforms Revisiting China's De-Capacity Reforms In addition, still-high profit margins could encourage existing coal producers to increase their CUR this year (Chart 9). Yet, we do not assume a rise in CUR for existing coal mining capacity. In total, Chinese coal output may increase 4.7% this year, higher than last year's 3.2% growth (Chart 10). Chart 9Strong Profit Margins Will Boost Coal Production Strong Profit Margins Will Boost Coal Production Strong Profit Margins Will Boost Coal Production Chart 10Coal Output Is Already Rising Coal Output Is Already Rising Coal Output Is Already Rising Bottom Line: Sizable technologically advanced new capacity is coming on stream for both steel and coal. This will boost both steel and coal output by about 5.2% and 4.7%, respectively, this year. Impact On Global Steel And Coal Prices In addition to diminishing capacity cuts and new technologically advanced capacity additions, the following factors will also weigh on steel prices: Relatively high steel product inventories (Chart 11, top panel) Weakening steel demand, mainly due to a potential slowdown in the property market4 Declining infrastructure investment growth (Chart 11, bottom panel). Chinese net steel product exports contracted 30% last year as steel producers opted to sell steel products domestically on higher domestic steel prices (Chart 12). Chart 11Elevated Steel Product Inventory##br## And Weakening Demand bca.ems_sr_2018_04_26_c11 bca.ems_sr_2018_04_26_c11 Chart 12China's Steel Product Exports ##br##Will Rebound China's Steel Product Exports Will Rebound China's Steel Product Exports Will Rebound Falling domestic steel prices may lead steel producers to ship their products overseas. In addition, the government has reduced steel products export tariffs starting January 1, 2018, which may also help increase Chinese steel product exports this year. This will pass falling Chinese domestic steel prices on to lower global steel prices. Between 2015 and 2017, about 1.6% of all Chinese steel exports were shipped to the U.S. Even if U.S. tariffs dampen its purchases of steel from China, mainland producers will try to sell their products to other countries. In a nutshell, U.S. tariffs will not prevent the transmission of lower steel prices in China to the global steel market. With respect to coal, in early April the Chinese government placed restrictions on Chinese coal imports at major ports in major imported-coal consuming provinces including Zhejiang, Fujian and Guangdong (Chart 13). The government demanded thermal power plants in those areas to limit their consumption of imported coal and use domestically produced coal. Clearly the government is trying to avoid cheaper imports flooding into the domestic coal market amid still elevated prices. This will help prevent a big drop in domestic coal prices but will be bearish for global coal prices. For example, 40% and 30% of Chinese coal imports are from Indonesia and Australia, respectively (Chart 14). These economies and their currencies are at risk from diminishing Chinese coal imports. Chart 13Chinese Coal Imports Will Decline Chinese Coal Imports Will Decline Chinese Coal Imports Will Decline Chart 14Indonesia and Australia May Face Falling ##br##Coal Demand From China Indonesia and Australia May Face Falling Coal Demand From China Indonesia and Australia May Face Falling Coal Demand From China For the demand side, continuing strong growth in non-thermal power supplies such as nuclear, wind and solar will curb thermal power growth in the long run and thus limit thermal coal consumption growth in China. This may also weigh on domestic coal prices and discourage coal imports. Bottom Line: The downtrend in domestic steel and coal prices will weigh on the global steel and coal markets. What About Iron Ore And Coking Coal? Iron ore and coking coal prices are also at risk: Chart 15Record High Chinese Iron Ore Inventory Record High Chinese Iron Ore Inventory Record High Chinese Iron Ore Inventory Given about 40% of newly installed steel capacity is advanced electric furnace (EF) based - which requires significant amounts of scrap steel rather than iron ore and coke - rising steel output will increase demand for iron ore and coke disproportionally less. As more Chinese steel producers shift to EF technology, mainland demand for iron ore and coke will diminish structurally in the years to come. Despite weakness in both domestic iron ore production and iron ore imports, Chinese iron ore inventories at major ports, expressed in number of months of consumption, have still reached record highs (Chart 15). This suggests rising EF capacity has indeed been constraining demand for iron ore. Increasing coal output will bring more coking coal and a corresponding rise in coke supply, thereby further depressing coke prices. Bottom Line: Global iron ore and coking coal prices are also vulnerable to the downside. Investment Implications From a macro perspective, investors can capitalize on these themes via a number of strategies: Shorting iron ore and coal prices, or these commodities producers' stocks. Chart 16Chinese Steel And Coal Shares:##br## Puzzling Drop Amid High Profit Chinese Steel And Coal Shares: Puzzling Drop Amid High Profits Chinese Steel And Coal Shares: Puzzling Drop Amid High Profits Going short the Indonesian rupiah (and possibly the Australian dollar) versus the U.S. dollar. Australia and Indonesia are large exporters of coal and industrial metals to China - they account for 30% and 40% of Chinese coal imports, respectively, so their currencies are vulnerable. Notably, although steel and coal prices are still well above their 2015 levels and producers' profit margins are very elevated, share prices of Chinese steel makers and coal producers have dropped almost to their 2015 levels (Chart 16). From a top-down standpoint, it is hard to explain such poor share price performance among Chinese steel and coal companies when their profits have been booming. Our hunch is that these companies have been forced by the government to shoulder the debt of the peer companies that were shut down. This is an example of how the government can force shareholders of profitable companies to bear losses from restructuring by merging zombie companies into profitable ones. On a more granular level, rapidly expanding EF steel-making capacity in China will lead to outperformance of stocks related to EF makers, graphite electrode producers and domestic scrap steel collecting companies. First, demand for graphite electrodes continues to rise, as EF steel production expands. Prices of graphite electrodes may stay high for quite some time (Chart 6 above, top panel). Second, scrap steel prices may go higher or stay high to encourage more domestic scrap steel collection. Companies who collect domestic scrap steel may soon have beneficial policy support, which will create huge potential for expansion (Chart 6 above, bottom panel). Third, EF makers will also benefit due to strong sales of electric furnaces. As a final note, equity investors should consider going long thermal power producers versus coal producers as thermal power producers will benefit from falling coal prices. Ellen JingYuan He, Associate Vice President Frontier Markets Strategy EllenJ@bcaresearch.com 1 Please see Emerging Markets Strategy Special Report, "China's 'De-Capacity' Reforms: Where Steel & Coal Prices Are Headed", dated November 22, 2017, available at ems.bcaresearch.com. 2 "Ditiaogang" is low-quality steel made by melting scrap metal in cheap and easy-to-install induction furnaces. These steel products are of poor quality, and also lead to environmental degradation. 3 The big divergence between crude steel production expansion and steel products output contraction last year was due to both the removal of "Ditiaogang" and statistical issues. "Ditiaogang" is often converted into steel products like rebar and wire rods. As steel produced this way is illegal, it is not recorded in official crude steel production data. However, after it is converted into steel products, official steel products production data do include it. 4 Please see Emerging Markets Strategy Special Report, "China Real Estate: A New-Bursting Bubble?", dated April 6, 2018, available at ems.bcaresearch.com. Equity Recommendations Fixed-Income, Credit And Currency Recommendations

Overweight The S&P containers & packaging index has been recovering in the past few sessions. This follows being caught in the downdraft all global trade-exposed stocks have been reeling from; now fears of a generalized trade war appear to be receding. Certainly the geopolitical spats have not been making themselves present in real trade data; the global export volume index published by the CPD Netherlands Bureau for Economic Policy Analysis has, in fact, been accelerating recently to its current record high level (second panel). As global trade seems set to move higher regardless of political machinations, domestic demand remains resilient. Real spending on food and beverage, the key customer group of containers & packaging companies, has been expanding uninterrupted for the past two years, implying solid sector top line growth (third panel). At the same time, producer prices, despite having rolled over somewhat, are still rising (bottom panel). While spiking pulp prices will eat into margins, we expect a soft dollar to offset via the export channel. Net, we would buy into any weakness in this sector; we reiterate our overweight recommendation in this niche materials sector. The ticker symbols for the stocks in this index are: BLBG: S5CONP - IP, WRK, BLL, PKG, SEE, AVY. Stick With Containers & Packaging Stick With Containers & Packaging

Highlights Capacity cuts in China's steel and aluminum industries over the winter produced little in the way of output reductions, confounding our expectations. The resulting unintended inventory accumulation in Asian markets, reflecting high production relative to demand, and slowing Chinese steel exports are a downside risk to our neutral view. U.S. sanctions against Russian oligarchs close to President Putin could tighten the aluminum market, countering the unintended inventory accumulations. For now, we remain neutral base metals. Energy: Overweight. We are closing our long put spread position in Dec/18 Brent options at tonight's close. The fast-approaching May 12 deadline for President Trump to renew sanctions waivers against Iran shifts the balance of price risks to the upside. Base Metals: Neutral. COMEX copper rallied above $3.10/lb on the back of Chinese President Xi's remarks at the Boao Forum earlier this week, which re-hashed plans to open China's economy to imports. Precious Metals: Neutral. Gold likely becomes better bid as the May 12 deadline to waive Iran sanctions nears. Our long gold portfolio hedge is up 8.9%. Ags/Softs: Underweight. European buyers are scooping up U.S. soybeans, as Chinese purchases of Brazilian beans makes U.S.-sourced crops relatively cheaper, according to Reuters.1 China also announced plans to start selling corn stocks from state reserves this week, offering an alternative protein for animals to partially offset the price impact of tariffs on their imports of U.S. soybeans. Feature Chart of the WeekAluminum Rebounds On U.S. Sanctions Aluminum Rebounds On U.S. Sanctions Aluminum Rebounds On U.S. Sanctions Despite much-ballyhooed capacity reductions in China's steel and aluminum capacity, these markets - both in China and globally - remained relatively well supplied over the winter. Higher global supplies, and falling Chinese steel exports, will result in unintended inventory accumulation, which already is showing up in Shanghai Futures Exchange (SHFE) inventories. While we remain neutral base metals, continued unintended inventory accumulation could cause us to downgrade the sector. The MySteel Composite Index we use to track steel prices is down more than 10% since the beginning of the year (Chart of the Week). Similarly, the first-nearby primary aluminum contract on the LME was down ~ 12% year-to-date (ytd) early last week, before regaining most of these losses on news of U.S. sanctions against Russian oligarchs, which hit shares of Rusal very hard. Given that these sanctions will restrict access to up to 6% of global aluminum supply, ex-China supply dynamics will dominate the aluminum market this year making the outlook relatively favorable, putting a floor beneath the London Metal Exchange Index (LMEX).2 Ex-Post Winter Production Production cuts over the winter - when Chinese mills in 28 smog-prone northern cities were ordered to reduce capacity by up to 50% - did not live up to our expectations.3 China's steel and aluminum sectors have undergone major supply-side reforms, particularly re the removal of outdated capacity, most of which has been completed. In addition to the winter capacity cuts, past reforms that have already been implemented, and have shaped current market conditions, are as follows: In an effort to eliminate outdated and unlicensed facilities, China removed an estimated 3-4 mm MT of annual capacity in 2017 - amounting to approximately 10% of total aluminum smelting capacity. In the case of steel, Beijing announced plans to shut down 150 mm MT of annual steel capacity between 2016 and 2020. To date, 115 mm MT of capacity have already been eliminated. Another estimated 80-120 mm MT of induction furnace capacity was shuttered in 1H17. Going forward, China's steel and aluminum markets will be driven by: An estimated 3-4 mm MT of updated aluminum capacity is expected to come on line this year, offsetting constraints from last year's supply cuts. 30 mm MT of steel capacity shutdowns are planned this year, putting Beijing on track to meet its five-year target two years ahead of schedule. The Chinese National Development and Reform Commission (NDRC) has communicated its resolve to keep shuttered capacity offline. Major steelmaking cities in Hebei province - accounting for 22% of 2017 Chinese crude steel output - have announced plans to extend the capacity cuts to November 2018. The mid-November to mid-March capacity cuts implemented this past season are expected to be a recurring event. Winter Shutdowns Minimally Impact China's Steel Output ... According to steel production data released by the World Steel Association (WSA), winter capacity closures in China did not significantly affect overall output levels. Crude steel output from China was up 3.9% year-on-year (y/y) in the November to February period (Chart 2). At the same time, production from the rest of the world increased by 3.6% y/y in the November to February. Thus global crude steel supply remained in excess over the winter season, as global steel output increased 3.8% y/y. A caveat to these data: China does not account for the historical output of induction furnaces, which produced an estimated ~30-50 mm MT of steel in 2016. As mentioned in our previous research, the output of these furnaces was illegal and thus not carried in statistics we use to track supply.4 These data problems mean it is possible that actual output in the November 2016 to February 2017 period was higher than suggested by the data, and as a result, actual output during this year's winter season may actually be lower than last year. As induction-furnace data lie in the statistical shadows, we cannot ascertain this with certainty. Nevertheless, a buildup in China inventories - which we discuss below - indicates an oversupplied market. It is also likely producers - incentivized by high steel prices earlier this year - kept capacity utilization at maximum levels throughout the winter. ... And Aluminum Output According to International Aluminum Institute data, primary aluminum output in China fell 2.3% y/y in the November to February period, suggesting the winter cuts likely had an impact on aluminum supply (Chart 3). Data from the World Bureau of Metal Statistics (WBMS) show an even sharper decline in winter aluminum output: primary production in China fell 8.7% y/y in the November to January period. Chart 2Steel Output Grew##BR##Amid Winter Cuts Steel Output Grew Amid Winter Cuts Steel Output Grew Amid Winter Cuts Chart 3China Aluminum Market In Surplus##BR##Despite Production Decline China Aluminum Market In Surplus Despite Production Decline China Aluminum Market In Surplus Despite Production Decline Both sources reveal an especially pronounced contraction in November, at the onset of the winter cuts. Despite reduced supply, WBMS data indicate a positive Chinese aluminum market balance throughout the winter. A large contraction in demand offset the supply shortfall, and kept primary aluminum in a physical surplus throughout the winter, ultimately leading to a buildup in domestic inventories. A Look At The Trade Data Despite our disappointment regarding the impact of the winter cuts on steel and aluminum markets, trade data increasingly suggests China's steel exports have peaked. Aluminum exports from China, on the other hand, are likely to continue rising. Chinese Steel Exports Continue To Fall ... Chinese steel product net exports have been falling since mid-2016, and have continued falling in y/y terms throughout the winter. According to Chinese customs data, steel product net exports fell 35.1% y/y in the November to February period, driven by both falling exports as well as rising imports (Chart 4). Steel product exports plunged 30% y/y in the November to February period, more or less in line with the 2017 average. The decline mirrors the 2017 contraction in domestic supply, bringing exports to their lowest level since 2012. This indicates fears of a China slowdown leading to a flood of metal onto global markets have not materialized, at least not yet. In fact, Customs data show a 1.7% y/y increase in Chinese steel imports during the November to February period - a reversal from falling imports prior to the winter season. The conclusion we draw from this is that, while in the past, China was a source of supply for the world, ongoing capacity cuts and production controls could mean China will lack the ability to ramp up output in case of a global physical supply deficit. If this becomes the new normal, price volatility will likely increase. This trend is important, especially given our expectation of strong world ex-China demand this year. As such, global steel prices may find support amid this new normal. ... But Aluminum Exports Move Higher In the case of aluminum, Chinese net exports were up 28.7% y/y during the winter, continuing their upward trend. Customs data show a 14.8% y/y increase in aluminum exports in November to February, bringing exports in this period to their highest level since 2014/15 (Chart 5). At the same time, imports of aluminum have come down during this period - by 37.2% y/y. According to China customs data, 2017 imports over these winter months registered their lowest level since 1994. Chart 4Steel Exports Continue Falling ... Steel Exports Continue Falling ... Steel Exports Continue Falling ... Chart 5...While Aluminum Exports Are On the Uptrend ...While Aluminum Exports Are On the Uptrend ...While Aluminum Exports Are On the Uptrend The combination of growing exports amid falling imports puts China's net exports in expansionary territory. This will be especially true given the planned increase in capacity this year amid weak Chinese demand. All in all, ceteris paribus global supply of aluminum looks set to increase. However, we do not live in a ceteris paribus world and, as we explore below, sanctions against the top aluminum producer outside of China will have massive implications on the global aluminum supply chain. Are Inventories Due For A Turnaround? Chart 6Larger Than Expected##BR##Seasonal Inventory Buildup Larger Than Expected Seasonal Inventory Buildup Larger Than Expected Seasonal Inventory Buildup China Iron and Steel Association data indicate that since the beginning of the year, steel product inventories have been re-stocked to levels last seen in 1Q14. Inventories of the five main steel products we track have more than doubled since the beginning of the year (Chart 6). Although the Q1 build is seasonal, the re-stocking since the beginning of the year has been especially pronounced. This buildup occurred in an environment of stable supply - with minimal impact from the winter capacity cuts - amid weak exports, indicating domestic demand for the metal was subdued. However, steel inventories have turned around, and we expect further destocking as demand accelerates post the Chinese New Year. The question remains whether this destocking will bring inventories back down to their 5-year average. Aluminum inventories on the SHFE show similar dynamics. However in this case, it is part of the larger trend of rising stocks since the beginning of last year. Aluminum inventories at SHFE warehouses are up more than nine-fold - or 0.87 mm MT - since the end of 2016. In fact, the pace of buildup seems to have accelerated: the average weekly build of 16.6k MT of aluminum coming into warehouse inventories since the beginning of the year stands above the 2017 average weekly build of 12.6k MT. This brought SHFE aluminum inventories to almost 1 mm MT, more than double their previous record in 2010. Although the Chinese physical aluminum surplus weighed down on prices in 1Q18, we expect global aluminum prices to remain supported from here due to the impact of U.S. sanctions on world ex-China aluminum supply. U.S. Russian Sanctions Could Be A Game-Changer Chart 7Sanctions Will Restrict##BR##Marketable Aluminum Supply Chinese Steel, Aluminum Markets Well Supplied Despite Winter Capacity Cuts Chinese Steel, Aluminum Markets Well Supplied Despite Winter Capacity Cuts Last Friday, the U.S. announced sanctions on Russian oligarchs close to President Vladimir Putin. Among those sanctioned is Oleg Deripaska who controls EN+ Group, which owns a controlling interest in top aluminum producer United Company Rusal. Given that UC Rusal accounts for ~6% of global aluminum production, we view this move as significant to global aluminum markets. As the top producer of the metal outside China, Rusal aluminum likely makes up the majority of Russian supply, which account for 14% of U.S. imports (Chart 7). In fact, almost 15% of Rusal's revenues comes from its business with the U.S. While it is clear that these sanctions will, in effect, terminate aluminum trade between Russia and the U.S., more significant are the implications on the global supply chain. A clause in the U.S. Treasury Department's order extending the restrictions to non-U.S. citizens dealing with U.S. entities means the impact could be far-reaching, requiring a major re-shuffle in global aluminum trade. Earlier this week, the LME announced that it will no longer accept Rusal aluminum produced after April 6, effectively preventing the company's products from being delivered on the LME. These sanctions will likely turn global aluminum buyers off from Rusal products, as they can no longer deliver it to the LME. The net effect will be a contraction in global usable aluminum supply. Furthermore, these sanctions will likely disrupt supply chains as aluminum users scramble to avoid purchasing metal from the Russian producer. While the details of these restrictions are still unclear, the sanctions are a game changer in the global aluminum market - effectively restricting access to a major source of the metal. As such, primary aluminum on the LME is up more than 10% since the announcement last Friday. Bottom Line: While China's crude steel output increased y/y during government-mandated output cuts over the winter, seasonally weak demand meant that the metal piled up in inventories. Falling exports indicates that at least for now, the domestic surplus is not flooding global markets. The main risk to our neutral view here is that demand in China remains weak, and that this will lead to the offloading of Chinese metal to global markets, i.e. a pickup in exports. This has not yet materialized, so we are holding on to our neutral view for now. China's primary aluminum production declined y/y during the winter cuts. However the decline in domestic demand was greater - likely due to the decline in auto production and sales following the loss of tax credit incentives. Consequently, China's aluminum market remained in surplus throughout the winter. Some of the excess supply was exported, but SHFE inventories continued building. Our outlook on the aluminum market had been bearish, due to additional capacity coming online this year amid an uncertain China demand environment. However, the sanctions on Rusal could be a game changer, putting a floor beneath aluminum prices. This improves our near term outlook for the aluminum market. This makes our outlook on aluminum prices much more favorable. Roukaya Ibrahim, Associate Editor Commodity & Energy Strategy RoukayaI@bcaresearch.com 1 Please see "As U.S. and China trade tariff barbs, others scoop up U.S. soybeans," published by reuters.com on April 8, 2018. 2 The six non-ferrous metals represented in the LMEX and their respective weights are as follows: aluminum: 42.8%, copper: 31.2%, zinc: 14.8%, lead: 8.2%, nickel: 2.0%, and tin: 1.0%. 3 China's winter smog "battle plan" targeted polluting industries in the northern China region by mandating cuts on steel, cement and aluminum production during the smog-prone mid-November to mid-March months. Steel and aluminum production cuts targeted a range between 30-50% during this period. This event is expected to be an annually recurring event until 2020. 4 Please see BCA Research's Commodity & Energy Strategy Weekly Report titled "China's Environmental Reforms Drive Steel & Iron Ore," dated January 11, 2018, available at ces.bcaresearch.com. Investment Views and Themes Recommendations Strategic Recommendations Tactical Trades Commodity Prices and Plays Reference Table Chinese Steel, Aluminum Markets Well Supplied Despite Winter Capacity Cuts Chinese Steel, Aluminum Markets Well Supplied Despite Winter Capacity Cuts Trades Closed in 2018 Summary of Trades Closed in 2017 Chinese Steel, Aluminum Markets Well Supplied Despite Winter Capacity Cuts Chinese Steel, Aluminum Markets Well Supplied Despite Winter Capacity Cuts

Highlights Key Portfolio Highlights Our portfolio positioning remains firmly behind cyclicals over defensives, driven principally by our key 2018 investment themes: synchronized global capex growth (Chart 1A) and higher interest rates on the back of a pickup in inflation (Chart 1B). The positioning has been lifted by synchronized global growth and a soft U.S. dollar (Chart 1C), while the key risk to our portfolio of a hard landing in China looks to be mitigated (Chart 1D). A return of volatility, spurred on by Fed tightening (Chart 1E), caused an SPX pullback in February, and while the market pushed through that rough patch, it has since been replaced with fears of a trade war, exacerbated by musical chairs in the Trump administration (Chart 1F). Our buy-the-dip strategy remains appropriate on a cyclical time horizon (Chart 1G), given a dearth of evidence of a recession in the next year. SPX forward EPS estimates still show near-20% increases this calendar year (corroborated by our EPS growth model, Chart 1H) which should underpin outsized equity returns in the absence of a major valuation rerating. Still, the return of volatility warrants a review of our macro, valuation and technical indicators. The best combination in our review is S&P financials (Overweight) with an elevated and accelerating cyclical macro indicator (CMI), fed by both of our key capex growth and rising interest rate themes, combined with a modest undervaluation. The worst combination is S&P telecom services (Underweight, high-conviction), whose CMI recently touched a 30-year low as sector deflation hit acute levels. Valuations make the sector look cheap, but every indication is that telecoms are a value trap. Chart 1AGlobal Trade Is Rising... Global Trade Is Rising... Global Trade Is Rising... Chart 1B...But So Too Is Inflation ...But So Too Is Inflation ...But So Too Is Inflation Chart 1CA Weaker Dollar Is A Boon To Growth A Weaker Dollar Is A Boon To Growth A Weaker Dollar Is A Boon To Growth Chart 1DSoft Landing In China Seems Likely Soft Landing In China Seems Likely Soft Landing In China Seems Likely Chart 1EThe Return Of Vol May Spoil The Party... The Return Of Vol May Spoil The Party... The Return Of Vol May Spoil The Party... Chart 1F...And Policy Uncertainty Doesnt Help ...And Policy Uncertainty Doesnt Help ...And Policy Uncertainty Doesnt Help Chart 1GBuy The Dip Has Worked Out Nicely Buy The Dip Has Worked Out Nicely Buy The Dip Has Worked Out Nicely Chart 1HHeed The Message From A Booming EPS Model Heed The Message From A Booming EPS Model Heed The Message From A Booming EPS Model Feature S&P Financials (Overweight) Our financials cyclical macro indicator (CMI, Chart 2) has climbed to new cyclical highs with significant upward momentum, driven by broad improvement in virtually all of its underlying components. More than any other variable, rising yields and the accompanying higher price of credit are a boon to financials. Higher interest rates is one of BCA's key themes for 2018 and an ongoing selloff in the bond market bodes well for profits in the heavyweight banks sub-index and should deliver the next up leg in bank stocks performance (top panel, Chart 3). Another of BCA's key themes for 2018 is a global capex upcycle; higher demand for capital goods should drive outsized capital formation in the year to come. Our U.S. commercial banks loans and leases model echoes this positive outlook, pointing to the best loan growth of the past 30 years (middle panel, Chart 3). Lastly, a low unemployment rate drives both expanding consumer credit and much better credit quality. At present, the unemployment rate is testing all-time lows, sending an unambiguously positive message for financials profitability (bottom panel, Chart 3). Despite the much-improved cyclical outlook and a revival of overall animal spirits, our valuation indicator (VI) suggests that financials are modestly undervalued. At this point in the cycle, we would expect a modest overvaluation; the implication is that financials should be a core portfolio overweight. Our technical indicator (TI) has approached overbought levels several times over the course of this bull market, though history suggests it can stay at elevated levels for a considerable time. Chart 2S&P Financials (Overweight) S&P Financials (Overweight) S&P Financials (Overweight) Chart 3RS1 Rising Yields Are A Boon To Financials Earnings RS1 Rising Yields Are A Boon To Financials Earnings RS1 Rising Yields Are A Boon To Financials Earnings S&P Industrials (Overweight) Our industrials CMI (Chart 4) has gone vertical and is very near its all-time high. A combination of a supportive currency, a recovery in commodity prices and synchronized global growth are responsible for the rise. A falling U.S. dollar and capital goods producers' top line growth acceleration have historically moved hand-in-hand as this group is one of the most international of the S&P 500. The trade-weighted U.S. dollar has fallen by more than 10% from its most recent peak at the end of 2016 which suggests U.S. industrials should have a leg up in sales for the year to come (top panel, Chart 5). The slide in the U.S. dollar is coming at an opportune time; global growth is remarkably synchronized (and remains a key BCA theme for 2018) and has proven an excellent harbinger of industrials margins (bottom panel, Chart 5). Overall, an expanding top line and widening margins imply solid relative EPS gains. Our valuation gauge is near the neutral zone, where it has been for much of the past 3 years as the market has failed to capture the sector's outlook strength. Our TI echoes the neutral message, having unwound a significant overbought position at the beginning of last year. Chart 4S&P Industrials (Overweight) S&P Industrials (Overweight) S&P Industrials (Overweight) Chart 5Global Euphoria Should Lift Industrials Global Euphoria Should Lift Industrials Global Euphoria Should Lift Industrials S&P Energy (Overweight) Our energy CMI (Chart 6) has maintained its upward trajectory after bouncing off all-time lows last year. Importantly, the relative share performance does not yet reflect the drastically improved cyclical conditions, underpinning our overweight recommendation. Falling oil inventories and rising prices (top and second panel, Chart 7) combined with solid gains in domestic production underlie the CMI recovery. Our key themes for 2018 of a global capex expansion and synchronized global growth should be the most important drivers for energy stocks this year. With respect to the former, the capex intentions from the Dallas Fed survey hit their highest level in a decade, which usually presages domestic oil patch expansion and energy stock outperformance (third panel, Chart 7) With respect to global growth, emerging markets/Chinese demand is the swing determinant of overall oil demand, and non-OECD demand has been moving higher for most of the past year (bottom panel, Chart 7). Our VI has retreated far into undervalued territory, a result of the aforementioned failure of stocks to react to the enticing macro outlook. The TI too is in deeply oversold levels, suggesting that an oversold bounce could soon occur at a time when valuations are so appealing. Chart 6S&P Energy (Overweight) S&P Energy (Overweight) S&P Energy (Overweight) Chart 7Energy Share Prices Have Trailed Oils Recovery Energy Share Prices Have Trailed Oil's Recovery Energy Share Prices Have Trailed Oils Recovery Energy Share Prices Have Trailed Oil's Recovery Energy Share Prices Have Trailed Oils Recovery S&P Consumer Staples (Overweight) Our consumer staples CMI (Chart 8) has turned up recently, following a two year decline. Strong employment gains and positive retail sales are the key pillars underlying the modest recovery. The euphoric consumer continues to push our consumer staples EPS model higher, now pointing to the best earnings growth of the past 5 years (middle panel, Chart 9). Overall industry exports are expanding at a healthy clip as a consequence of a softening U.S. dollar and robust European and rebounding emerging markets demand. Deflating raw food commodity prices are offsetting rising energy and labor input costs, heralding a sideways move to margins. Sell side analysts are also currently penciling in a lateral profit margin move (bottom panel, Chart 9). Investors have been vehemently avoiding staples stocks during the board market's uninterrupted run up, and have put our positioning offside. However, in the context of our cyclical over defensive portfolio bent we refrain from putting all our eggs in one basket, and prefer to keep consumer staples as our sole defensive sector overweight. Further, our VI is waving a green flag as consumer staples are now nearly two standard deviations below their 30-year mean valuation. Technical conditions too are completely washed out, signaling widespread bearishness, which is positive from a contrary perspective. Chart 8S&P Consumer Staples (Overweight) S&P Consumer Staples (Overweight) S&P Consumer Staples (Overweight) Chart 9Robust Consumer Confidence Bodes Well Robust Consumer Confidence Bodes Well Robust Consumer Confidence Bodes Well S&P Utilities (Neutral) Our utilities CMI (Chart 10) has spent the last decade in a long-term downtrend, albeit one with periodic countertrend moves. The key underlying factors are natural gas prices and relative spending on utilities, both of which have been retreating since 2008 (middle panel, Chart 11). Encouragingly, the sector's wage bill has slowed from punitively high levels, though pricing power has followed it down, implying muted margin changes (bottom panel, Chart 11). Like other defensive sectors, utilities have underperformed cyclical sectors in the last year; utilities equities trade as fixed income proxies, and a rising interest rate environment is punitive. As a result of the underperformance and relatively constant earnings, valuations have collapsed to the neutral zone. We reacted by booking solid gains and upgrading to a benchmark allocation earlier this year; synchronized global growth and higher interest rates are headwinds for this niche defensive sector and prevent us from lifting positions further. Our TI has fallen steeply over the past year and is now closing in on two standard deviations below the 30-year average. Chart 10S&P Utilities (Neutral) S&P Utilities (Neutral) S&P Utilities (Neutral) Chart 11Pricing Is Falling But Margins Look Neutral Pricing Is Falling But Margins Look Neutral Pricing Is Falling But Margins Look Neutral S&P Real Estate (Neutral) Our real estate CMI (Chart 12) has been in decline since its most recent peak at the end of 2016. This is confirmed by a darkened outlook for REITs; rents have crested while the vacancy rate found its nadir in 2016, suggesting further rent weakness on the horizon (top panel, Chart 13). Further, bankers appear less willing to extend commercial real estate credit, despite recent stability in underlying prices; declines in credit availability will directly impact REIT valuations (bottom panel, Chart 13). Our VI is consistent with BCA's Treasury bond indicator (not shown), 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 12S&P Real Estate (Neutral) S&P Real Estate (Neutral) S&P Real Estate (Neutral) Chart 13Peaking Rents and Tight Credit Are Headwinds Peaking Rents and Tight Credit Are Headwinds Peaking Rents and Tight Credit Are Headwinds S&P Materials (Neutral) Our materials CMI (Chart 14) has maintained its downward trajectory, largely due to the ongoing Fed tightening cycle. The heavyweight chemicals component of the materials index typically sees earnings (and hence stock prices) underperform as rates are moving higher (top panel, Chart 15). BCA's view remains that a sizable selloff in the bond markets is the most likely scenario in 2018, representing a substantial headwind to sector performance. Still, the news is not all negative. Exceptionally strong global demand growth has revitalized chemicals prices (bottom panel, Chart 15). Combined with the industry's relatively newfound restraint, capacity has not overextended and the resulting productivity gains bode well for earnings growth. Despite the improving outlook, valuations have been retreating for much of the past year and our VI has fallen back to the neutral zone. Our TI has been hovering near the neutral line for the past year, though a recent hook downward indicates a loss of momentum and downside relative performance risks. Chart 14S&P Materials (Neutral) S&P Materials (Neutral) S&P Materials (Neutral) Chart 15Rising Rates Are Offset By Improving Demand Rising Rates Are Offset By Improving Demand Rising Rates Are Offset By Improving Demand S&P Consumer Discretionary (Underweight) Our consumer discretionary CMI (Chart 16) has fallen back after reaching highs earlier in 2017, though remains elevated relative to the long term trend. Rising interest rates (top panel, Chart 17) are more than offsetting higher home prices and real wage growth, both have which have recently stalled. This rising short-term interest rate backdrop is not conducive to owning the extremely interest rate-sensitive equities that fall into the S&P consumer discretionary index. Both the household financial obligation ratio and household debt service payments have bottomed and are actually increasing. A higher interest rate backdrop will sustain the upward pressure on both and likely weigh on consumer discretionary relative share prices (third and bottom panels, Chart 17). This underpins our recent downgrade to a below benchmark allocation. Elevated valuations support our negative thesis as our valuation indicator has been rising recently out of the neutral zone. Our TI has fully recovered from oversold levels, and is now well into overbought territory, though historically this indicator has been excessively volatile. Chart 16S&P Consumer Discretionary (Underweight) S&P Consumer Discretionary (Underweight) S&P Consumer Discretionary (Underweight) Chart 17Higher Borrowing Costs Bode Ill For Consumer Discretionary Higher Borrowing Costs Bode Ill For Consumer Discretionary Higher Borrowing Costs Bode Ill For Consumer Discretionary S&P Health Care (Underweight) Our health care CMI (Chart 18) rolled over last year and has been treading water at these lower levels, driven by weak fundamentals in the key pharmaceuticals sector. Poor pricing power, a soft spending backdrop and a depreciating U.S. dollar have been pressuring the sector and keeping a tight lid on the CMI (top and second panels, Chart 19). Other non-pharma indicators are mixed as lower healthcare consumer spending is offset by a tick up in overall pricing power. Relative valuations have fallen deep into undervalued territory and are approaching one standard deviation below the 25 year average. Our TI too has reversed course and is well into oversold territory. However, the message from our health care earnings model is that sector earnings will continue to decelerate; this environment in not conducive for a sector re-rating (bottom panel, Chart 19). Chart 18S&P Health Care (Underweight) S&P Health Care (Underweight) S&P Health Care (Underweight) Chart 19Pharma Pricing Power Continues To Collapse Pharma Pricing Power Continues To Collapse Pharma Pricing Power Continues To Collapse S&P Telecommunication Services (Underweight) Our telecom services CMI (Chart 20), after moving sideways for much of the past decade, has recently fallen to a new 30-year low. Extreme deflation continues to reign in the beleaguered sector as relative consumer outlays on telecom services have nosedived (top panel, Chart 21) which is broadly matched by melting selling prices (middle panel, Chart 21) as demand contracts. This is reflected in our S&P telecom services revenue growth model, which remains deep in contractionary territory (bottom panel, Chart 21). The sector remains chronically cheap, exacerbated by the recent sell-off, and is currently as cheap as it has ever been. Still, given the brutal operating environment, we think such valuations have created a value trap. Our Technical Indicator has sunk but, like the VI, cycles deep in the sell zone have not proven reliable indicators that a relative bounce is in the offing. We recently downgraded the sector to underweight and added it to our high-conviction underweight list based on the factors noted above.1 Chart 20S&P Telecommunication Services (Underweight) S&P Telecommunication Services (Underweight) S&P Telecommunication Services (Underweight) Chart 21Telecom Services Remain A Value Trap Telecom Services Remain A Value Trap Telecom Services Remain A Value Trap S&P Technology (Underweight, Upgrade Alert) The technology CMI (Chart 22) has been falling for the past three years, driven by ongoing relative pricing power declines and new order weakness. However, the sector has proven resilient, at least until recently, as a handful of stocks (the FANGs, excluding the consumer discretionary components) and the red-hot semiconductor group have provided support. Still, market euphoria aside, tech stocks thrive in a disinflationary/deflationary environment and suffer during inflationary periods; inflation is gradually rising after a prolonged disinflationary period (bottom panel, Chart 23). Valuations, while still in the neutral zone, have reached their highest level in a decade. This may prove risky should inflation mount faster than expected; a de-rating phase in technology would likely follow. Our TI is extremely overbought, though it has been at this high level for several years. Chart 22S&P Technology (Underweight, Upgrade ALert) S&P Technology (Underweight, Upgrade ALert) S&P Technology (Underweight, Upgrade ALert) Chart 23Inflation Is No Friend To Tech Inflation Is No Friend To Tech Inflation Is No Friend To Tech Size Indicator (Neutral Small Vs. Large Caps) Our size CMI (Chart 24) has fallen back to 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; the current message is neutral. Small company business optimism is near modern highs, as pricing and consumption vigor push domestic revenues higher (top panel, Chart 25). A smaller government footprint, i.e. fewer regulatory hurdles, and tax relief will disproportionately benefit SMEs. Earlier this year, we downgraded our recommendation on small caps vs. large caps to a neutral allocation, based on a deterioration in small cap margins and too-high leverage.2 Recent NFIB surveys would suggest this move was prescient; firms reporting planned labor compensation increases have steadied near a two decade high, while price increases are trailing far behind (middle panel, Chart 25). With "quality of labor" having overtaken "taxes" as the single most important problem facing businesses, labor compensation growth seems likely to continue moving up at an elevated pace and small cap margins should likely continue to trail large cap peers (bottom panel, Chart 25). Valuations have improved and small caps are relatively undervalued, though our TI echoes a neutral message. Chart 24Size Indicator (Neutral Small Vs. Large Caps) Size Indicator (Neutral Small Vs. Large Caps) Size Indicator (Neutral Small Vs. Large Caps) Chart 25Small Businesses Remain Exceptionally Confident Small Businesses Remain Exceptionally Confident Small Businesses Remain Exceptionally Confident Chris Bowes, Associate Editor chrisb@bcaresearch.com 1 Please see BCA U.S. Equity Strategy Weekly Report, "Manic-Depressive?" dated February 12, 2018, available at uses.bcaresearch.com. 2 Please see BCA U.S. Equity Strategy Weekly Report, "Too Good To Be True?" dated January 22, 2018, available at uses.bcaresearch.com.

Overweight The S&P containers & packaging index has been underperforming since the beginning of the year as the spiking input costs of last year materialized in soft Q4 earnings, compounded by fears over a trade war. However, those costs have fallen substantially since the end of the year (second panel) and gross margins should eventually return to normal; trade fears have moderated. In the longer term, we think the focus should remain on the drivers of demand, namely global growth (a key BCA theme for this year). Both volumes and prices have maintained a steady uptrend (third panel) and the sell side has taken notice as relative forward EPS are climbing at the fastest pace in a decade (bottom panel). Combined with the index's weak performance YTD, a sizeable buying opportunity is taking shape; stay overweight. The ticker symbols for the stocks in this index are: BLBG: S5CONP - IP, WRK, BLL, PKG, SEE, AVY. Unbottling Excess Returns Unbottling Excess Returns