Materials

The S&P materials sector has been unable to hold its ground, despite the softening U.S. dollar and boost to global manufacturing output this year. Instead, the sector has taken its cue from commodity prices, and leading indicators thereof, such as the ratio of Latin American to Emerging Asian equities (bottom panel). The latter has collapsed in recent weeks, which is notable because it has been highly correlated with materials sector relative performance for over a decade. While it is tempting to lean into materials sector weakness given that global output growth is on the mend, we are resisting any urge to upgrade given the negative message from commodity-sensitive equities and prospects for a cooling in Chinese economic growth in the second half of the year. Materials sector operating leverage is unlikely to become a positive force until the pricing power outlook brightens. Stay underweight. The Materials Sector Is Still Not A Buy The Materials Sector Is Still Not A Buy

GAA DM Equity Country Allocation Model Update The model has increased its allocation to Netherland, Italy, France and Germany, the underweight in Australia is also reduced by half. All these are financed by a large reduction in the U.S. overweight, mostly due to the change in liquidity and technical indicators, compared to previous month as shown in Table 1 As shown in Table 2 and Charts 1, 2 and 3, Level 2 model ( the allocation among the 11 non-U.S. DM countries) outperformed its benchmark by 119 basis points (bps) in May, largely a result from the overweight of the euro area versus the underweight in Canada and Australia. Level 1 model, the allocation between U.S. and non-U.S., underperformed by 22 bps in May due to the large overweight in the U.S. Overall, the aggregate GAA model outperformed its MSCI World benchmark by 13 bps in May and by 157 bps since going live. Please see also on the website http://gaa.bcaresearch.com/trades/allocation_performance. For more details on the models, please see the January 29th, 2016 Special Report "Global Equity Allocation: Introducing the Developed Markets Country Allocation Model". http://gaa.bcaresearch.com/articles/view_report/18850. Table 1Model Allocation Vs. Benchmark Weights GAA Model Updates GAA Model Updates Table 2Performance (Total Returns In USD) GAA Model Updates GAA Model Updates Chart 1 GAA DM Model Vs. MSCI World GAA DM Model Vs. MSCI World Chart 2 GAA U.S. Vs. Non U.S. Model (Level1) GAA U.S. Vs. Non U.S. Model (Level1) Chart 3 GAA Non U.S. Model (Level 2) GAA Non U.S. Model (Level 2) GAA Equity Sector Selection Model The GAA Equity Sector Selection Model (Chart 4) is updated as of May 31, 2017. The model continues to overweight cyclical versus defensive sectors. However, the model has turned overweight utilities on the back of improved technicals. For more details on the model, please see the Special Report "Introducing The GAA Equity Sector Selection Model," July 27, 2016 available at https://gaa.bcaresearch.com. Chart 4Overall Model Performance Overall Model Performance Overall Model Performance Table 3Allocations GAA Model Updates GAA Model Updates Table 4Performance Since Going Live GAA Model Updates GAA Model Updates Xiaoli Tang, Associate Vice President xiaoli@bcaresearch.com Aditya Kurian, Research Analyst adityak@bcaresearch.com

Highlights Portfolio Strategy Upgrade packaged food stocks to overweight. Enough value creation has occurred to create an attractive entry point in this consumer goods sub-index. Our tactical overweight in the S&P utilities sector is beginning to bear fruit. Get ready to book profits. Resist the temptation to bottom fish in steel stocks. Tightening Chinese monetary and financial conditions along with domestic demand blues should weigh on steel profits. Recent Changes S&P Packaged Foods - Upgrade to overweight. S&P Utilities - Downgrade Alert. Table 1 Focus On Financial Conditions Focus On Financial Conditions Feature The market waffled last week, but quickly recovered. The upshot is that investors still appear content to look through the circus in Washington, focused instead on the positive reflationary dynamics supporting the corporate sector. Financial conditions have eased considerably ever since the Fed resumed its tightening campaign last December. Equity price gains, narrowing credit spreads and a weaker U.S. dollar have more than offset the negative impact of the back-up in bond yields. Cheap equity capital also remains easily accessible. While the labor market is tightening, BCA argues that the headline unemployment rate may understate slack given the large number of part-time workers that want to work full-time and prime-age workers that are still out of work. With core inflation surprising to the downside in recent months, there is no urgency for the Fed to slam the brakes. In other words, there is more than enough monetary fuel to sustain the equity overshoot. Easy financial conditions will allow investors to extrapolate the profit recovery (Chart 1), especially since it has been sales driven for the first time in years. It is notable that while consumer price inflation has softened, in aggregate, businesses are not feeling any renewed deflationary pressure. The depreciation in the U.S. dollar has been a critical support for U.S. businesses. Our corporate sector pricing power proxy continues to accelerate (Chart 1), arguing that revenue growth should persist. The combination of muted consumer price inflation yet positive corporate sector inflation is a stock market positive, all else equal. Digging beneath the surface, divergent sector inflation trends are increasingly evident. The commodity-linked energy and materials sectors have lost upward pricing power momentum (Chart 2), courtesy of the cooling in China. Technology sector selling prices are sinking deeper into deflationary territory, albeit the FANG juggernaut pays no attention to sector specific forces. Telecom services pricing power has also taken a header (Chart 2). On the plus side, other defensive sectors, including utilities, are still able to raise prices at a much greater rate than overall inflation. Even the pace of financial sector price hikes is at the top end of its long-term range (Chart 3). Chart 1Sustained Profit Expansion ##br##Requires Easy Financial Conditions Sustained Profit Expansion Requires Easy Financial Conditions Sustained Profit Expansion Requires Easy Financial Conditions Chart 2Some Softness In ##br##Cyclical Pricing Power... Some Softness In Cyclical Pricing Power... Some Softness In Cyclical Pricing Power... Chart 3...But Defensive Selling##br## Prices Are Resilient ...But Defensive Selling Prices Are Resilient ...But Defensive Selling Prices Are Resilient The upshot is that selectivity remains a critical portfolio input rather than simply tracking the broad S&P 500. These forces should allow the market to continue grinding higher into overshoot territory. The latter means that the market is increasingly vulnerable to minor external shocks. Ergo, we continue to recommend a selective weighting in some 'safe' areas, such as consumer staples, which are undervalued in relative terms and will buffet portfolios should volatility escalate further. This week we are taking advantage of the drubbing in food stocks to augment positions. Packaged Foods: Going Against The Grain After a surge to all-time relative performance highs in mid-2016, the S&P packaged foods index has deflated by roughly 20%. Two key reasons are behind the downdraft: the allure to hold stable cash flow companies has diminished since the November election, and weak industry-specific metrics - in particular pricing power and sales contraction amid private label competition. Despite these negatives, our sense is that enough value destruction has occurred to create an attractive entry point in this consumer goods sub-index. Relative valuations reflect most of these investor worries. The relative forward P/E ratio has de-rated to below the two-decade average, and our Valuation Indicator (VI) is near one standard deviation below the historical mean. In fact, every time the VI falls to such an undervalued extreme, relative performance stages a sizable comeback (Chart 4). Technical conditions are also washed out. Relative performance momentum has plunged to the lowest level in a decade, and likely fully reflects investor angst. Deeply oversold readings and undervaluation suggest that a full bearish capitulation has occurred, which is contrarily positive. Encouragingly, there is light at the end of the tunnel. Grain price deflation (shown inverted, third panel, Chart 4) suggests that industry input costs are well contained, and will underpin profit margins. It is normal for falling grain prices to coincide with upward revisions to analyst profit estimates (second panel, Chart 4). While industry sales are mired in deflation, there are high odds that top line growth will exit deflation by early 2018. Consumer outlays on food and beverages are brisk, and wholesale food manufacturing prices have recently reaccelerated. Chart 5 shows that industry revenues follow the trend in consumption and pricing power, underscoring that profitability is set to expand anew. True, private label competition and grocery store market share wars have put pressure on industry pricing power. But as long as food manufacturers can keep input costs under control, profit margins should remain wide. A simple industry profit margin gauge (PPI food manufacturing versus PPI crude food) gives us comfort that margins will remain resilient (bottom panel, Chart 5). Importantly, packaged food producers are well positioned to fight back against food retailers' demands for price concessions. Robust consumer outlays on food and beverages are corroborated by real retail sales at food stores, which are bucking the deceleration in overall retail sales (third panel, Chart 6). The hook up in food manufacturing hours worked confirms that industry activity is on the mend, which bodes well for productivity gains. Sell-side analysts have taken notice. Positive earnings revisions will continue to outstrip negative ones. Chart 4Buy Against The Grain Buy Against The Grain Buy Against The Grain Chart 5End Of The Revenue Lull... End Of The Revenue Lull... End Of The Revenue Lull... Chart 6...As Demand Recovers ...As Demand Recovers ...As Demand Recovers Finally, food and beverage exports have held onto recent double-digit growth gains despite the strong greenback. Now that the U.S. dollar is under some pressure, especially against the euro and emerging market currencies, foreign sales should provide a further relief valve should domestic pricing pressures persist for a little longer than we expect (second panel, Chart 6). In sum, while investors have rushed for the exits in the defensive S&P packaged foods index, a buying opportunity has emerged. Relative valuations have corrected to the lower end of their historic range and already reflect investor profitability worries. Our thesis is that a domestic demand-driven recovery has commenced and strict cost control, along with food commodity deflation, should sustain profit margins. Bottom Line: Start a buy program in the S&P packaged foods index, and boost exposure to overweight. The ticker symbols for the stocks in this index are: BLBG: S5PACK - MDLZ, SJM, KHC, CPB, MKC, CAG, TSN, MJN, GIS, HSY, HRL, K. Our Utilities Overweight Is Starting To Pay Off Our tactical overweight in the S&P utilities sector is beginning to bear fruit. Importantly, the five factors that drove this decision are starting to play out1, albeit in varying degrees of magnitude. Chart 7 shows that the U.S. economic soft patch has persisted. Hard data have not yet caught up to the surge in 'soft' data, such as sentiment and confidence surveys. The Citi Economic Surprise Index is inversely correlated with the relative share price ratio. Similarly, the ISM manufacturing index has crested. Our analysis shows that forward relative returns are strong after the ISM manufacturing survey hits extremely high levels, given that mean reversion ultimately occurs. The upshot is that utilities relative performance has more upside. The yield curve has also moved favorably for utilities stocks. The 10/2 Treasury curve has flattened since early January, as economic data continue to surprise to the downside, underscoring that the tactical utilities buy signal remains intact. The third reason to augment utilities exposure was the ebbing in inflation expectations. The latter continues unabated (Chart 7). Our recent Special Report highlighted that utilities suffer in times of inflation2. But the opposite is also true: utilities stocks outperform in times of disinflation/deflation. This reflects the stable rate of return regulated utilities enjoy, in addition to the increased appeal of dividend yields and cash flow during times of economic volatility and uncertainty. Finally, natural gas prices are firm. Utilities pricing power moves in lockstep with natural gas prices (middle panel, Chart 8). The latter are the marginal price setter for non-regulated utilities, and the recent price reacceleration could be a positive catalyst (bottom panel, Chart 8). Nevertheless, the utilities share price reaction has been more muted than we had expected, at least so far, perhaps reflecting the ongoing outperformance of stocks vs. bonds, and the weakness in electricity production growth (Chart 9). If the five factors begin to lose momentum, we will recommend booking profits in this tactical overweight position. Chart 7Prepare To Book Profits... Prepare To Book Profits... Prepare To Book Profits... Chart 8...When Utilities Turbocharge ...When Utilities Turbocharge ...When Utilities Turbocharge Chart 9Two Utilities Risks To Monitor Two Utilities Risks To Monitor Two Utilities Risks To Monitor Bottom Line: Stick with overweight exposure in the S&P utilities sector for now, but get ready to book profits in the coming weeks. Put utilities on downgrade alert. Rusting Steel Stocks Steel stocks have come full circle. Following the initial euphoria since the Trump election, the relative share price ratio is now roughly where it was in early November. There is more downside ahead. China is tapping the monetary brakes, attempting to contain the shadow banking system. However, it is difficult to target one segment of the economy through monetary policy. Tight policy is starting to backlash onto commodity prices, including steel and iron ore. A number of indicators suggest that China's internal dynamics will further undermine global steel share prices. The top panel of Chart 10 shows that the recent Chinese yield curve inversion is pointing toward more pain ahead for U.S. steel producers. Further, the Chinese credit impulse is waning. Historically, BCA's Chinese Credit Impulse Indicator (CII) has an excellent track record forecasting relative performance momentum. The latest grim CII reading warns that U.S. steel stocks have more downside (second panel, Chart 10). Slower Chinese credit creation will continue to weigh on infrastructure spending. Chinese capital expenditure and loan growth are joined at the hip. Feeble loan growth suggests that fewer projects will come to fruition (third panel, Chart 10). Sinking iron ore prices reflect this grim outlook. The implication is that overly optimistic relative profit estimates are vulnerable to disappointment (bottom panel, Chart 10). True, Chinese steel exports and domestic production have eased, which suggests that the risk of a steel inventory glut has receded. Nevertheless, U.S. steel imports have climbed anew, despite ongoing steel tariffs. As steel imports command a larger share of U.S. domestic production, price deflation is necessary to resolve this imbalance (Chart 11). This will cast a shadow on steel profit prospects. Steel industry troubles are not endemic to China. Worrisomely, U.S. steel demand dynamics remain unfavorable. Two key domestic end-markets are quickly losing steam. Commercial real estate and automobile excesses are starting to correct. Banks are reining in credit to both loan categories according to the Fed's latest Senior Loan Officer Survey (second panel, Chart 12). Simultaneously, within commercial real estate, construction and land development credit demand is also anemic. With regard to consumer loan categories, auto loan demand has registered the worst showing. Chart 10China Macro Weighs On Steel bca.uses_wr_2017_05_23_c10 bca.uses_wr_2017_05_23_c10 Chart 11Steel Deflation Looms Steel Deflation Looms Steel Deflation Looms Chart 12Weak Domestic End-Markets Provide No Relief Weak Domestic End-Markets Provide No Relief Weak Domestic End-Markets Provide No Relief Already, non-residential construction is flirting with contraction and light vehicle sales are sinking like a stone (third panel, Chart 12). As a result the steel industry's new orders-to-inventories ratio has come off the boil, exerting a gravitational pull on scrap steel prices (bottom panel, Chart 12). The implication is that steel price deflation will undermine industry profits. Adding it up, the U.S. steel industry's earnings hurdle is sky-high. Tightening Chinese monetary and financial conditions along with domestic demand blues signal that U.S. steel producers' profits will surprise to the downside. Bottom Line: Continue to avoid steel stocks. The ticker symbols for the stocks in the S&P 1500 steel index are: BLBG: S15STEL - TMST, ATI, CMC, X, AKS, CRS, HAYN, RS, ZEUS, WOR, SXC, STLD, NUE. 1 Please see BCA U.S. Equity Strategy Weekly Report, "Great Expectations?" dated April 3, 2017, available at uses.bcaresearch.com. 2 Please see BCA U.S. Equity Strategy Special Report, "Equity Sector Winners And Losers When Inflation Climbs," dated December 5, 2016, available at uses.bcaresearch.com. Current Recommendations Current Trades Size And Style Views Favor small over large caps and stay neutral growth over value.

Highlights Global manufacturing inventories are low but this does not guarantee higher share prices for global cyclical stocks. If an increase in inventories is accompanied by strengthening final demand, it will be very bullish for the global business cycle. If final demand growth falters, global cyclical plays will relapse amid rising inventories. China's inventory depletion has been due to the large fiscal and credit impulse in the past 12 months - i.e., improving final demand has been instrumental to inventory shedding. Looking forward, the mainland's aggregate credit and fiscal impulse seems to have topped out raising the odds of a reversal in EM/China plays sooner than later. The risk/reward of EM/China plays remains unattractive. Feature Global Manufacturing Inventories Global manufacturing inventories have been depleted over the past 12 months, and inventory levels are generally low (Chart I-1 and Chart I-2). Chart I-1Global Manufacturing Inventories Are Low Global Manufacturing Inventories Are Low Global Manufacturing Inventories Are Low Chart I-2Global Manufacturing Inventories Are Low Global Manufacturing Inventories Are Low Global Manufacturing Inventories Are Low Could inventory re-stocking extend the current manufacturing cycle recovery worldwide? Will low inventories and re-stocking in China lengthen the nation's business cycle upswing? Chart I-3 demonstrates inventory cycles and manufacturing production within manufacturing-intensive economies. The correlation is not stable. Currently, this entails that low manufacturing inventories and a potential rise in inventories over the course of this year do not guarantee acceleration in industrial output growth. Having reviewed manufacturing inventory cycles and their correlation with share prices, we conclude that the key to share prices is final demand - not inventory swings. Manufacturing inventories have dropped in the past 12 months because final demand has been robust (Chart I-4). Historically, periods of re-stocking have often coincided with poor equity market performance. Indeed, Taiwanese, Korean, Japanese and German non-financial share prices have no stable correlation with their respective manufacturing inventory cycles (Chart I-5). In short, manufacturing inventories could rise in the months ahead, but this does not guarantee higher share prices in cyclical industries. Chart I-3Inventories And Production ##br##Are Not Always Correlated Inventories And Production Are Not Always Correlated Inventories And Production Are Not Always Correlated Chart I-4Robust Demand Has Led ##br##To Inventory Depletion Robust Demand Has Led To Inventory Depletion Robust Demand Has Led To Inventory Depletion Chart I-5Non-Financial Share Prices And##br## Inventories: Little Correlation Non-Financial Share Prices And Inventories: Little Correlation Non-Financial Share Prices And Inventories: Little Correlation By and large, the outlook for corporate profits is contingent on final demand rather than re-stocking. All of the above confirms that inventories are a residual of demand and supply. Stronger-than-expected demand is bullish for share prices, though it also often coincides with declining inventories. By contrast, rising inventories typically reflect demand falling behind output growth (one can define it as involuntary re-stocking) and these periods are not favorable for share price gains in cyclical industries. One caveat is that there could be a re-stocking cycle amid strengthening demand or, in other words, voluntary re-stocking. If this transpires in the coming months, it will be extremely bullish for share prices as it will supercharge output growth. While the latter scenario - inventory re-stocking amid strengthening final demand - could very well occur within the advanced economies this year, odds of such positive dynamics are low in EM/China. Bottom Line: Share prices in global cyclical sectors are driven by swings in final demand - not in inventories. Going forward, global manufacturing inventories will rise. If this rise is accompanied by strengthening demand, it will be very bullish for the global business cycle. Otherwise, global cyclical plays will relapse as inventories rise. What Drives China's Inventory Cycles Chart I-6 shows that China's manufacturing inventories typically deplete when the credit and fiscal impulse is rising, and vice versa. China's manufacturing inventories have been exhausted because demand has been strong in the past 12 months. In turn, demand strength has originated from the country's massive fiscal and credit stimulus push from the first half of 2016. Chart I-6China: Strong Policy Stimulus Led To Manufacturing Inventories Reduction China: Strong Policy Stimulus Led To Manufacturing Inventories Reduction China: Strong Policy Stimulus Led To Manufacturing Inventories Reduction That said, China's aggregate fiscal and credit impulse seems to have recently rolled over, pointing to a top in its manufacturing mini-cycle and commodities prices (Chart I-7). This signals a potential deceleration in final demand. On the whole, the ongoing modest tightening by the People's Bank of China and by the bank regulator (the China Banking Regulatory Commission) amid a lingering credit bubble is raising the odds of a moderate credit slowdown in the months ahead. Even modest credit growth deceleration will result in a negative credit impulse (Chart I-8, top panel). Meanwhile, the mainland's fiscal impulse has already dropped (Chart I-8, bottom panel). Chart I-7China: Aggregate Credit And Fiscal##br## Stimulus Has Topped Out China: Aggregate Credit And Fiscal Stimulus Has Topped Out China: Aggregate Credit And Fiscal Stimulus Has Topped Out Chart I-8China: A Breakdown Of Credit ##br##And Fiscal Impulses China: A Breakdown Of Credit And Fiscal Impulses China: A Breakdown Of Credit And Fiscal Impulses On the whole, these developments are leading us to maintain our negative bias toward EM risk assets and China plays. What has gone wrong in our view/analysis on China in the past 12 months is that the nation's credit growth has stayed much stronger than we expected. In our April 13, 2016 report,1 we did a scenario analysis and argued that China's large fiscal stimulus push would be offset by a negative credit impulse if credit growth slowed from 11.5% to below 10%. In reality, credit growth has been between 11.5-12.5%, producing a positive credit impulse. Barring tightening by the central bank or bank regulators, mainland banks can continue originating loans/money at a double-digit pace, as they have been doing for many years (Chart I-9). In general, commercial banks do not need savings to create money/loans and there are few limits on Chinese banks originating loans "out of thin air," as we argued in our Trilogy of Special Reports on money/loan creation, savings and investment.2 Chart I-9China's Credit/Money Growth##br## Remains Rampant China's Credit/Money Growth Remains Rampant China's Credit/Money Growth Remains Rampant Therefore, if credit growth does not slow, our negative view on China's growth will be off-the-mark again. The pressure point in such a case will be the exchange rate. Unlimited money creation/oversupply of local currency is bearish for the value of the RMB. The RMB will continue depreciating, but it is not certain if it will hurt EM risk assets. It is a major consensus view nowadays that the Chinese authorities will not allow growth to suffer ahead of the Party Congress in autumn of this year. Yet, the PBoC and bank regulators are modestly tightening to "normalize" credit growth. Some clients may wonder why we are placing so much emphasis on the rollover of credit and fiscal impulses now, while placing little emphasis on these same indicators in 2016 when they were recovering. The rationale is as follows: when there is a credit bubble - as there is in China now - we tend to downplay the importance of policy easing and put more significance on policy tightening. The opposite also holds true: when the credit/banking system is healthy, we tend to downplay the impact of moderate policy tightening and put greater emphasis on policy easing. In a credit bubble, it does not take much tightening to trigger a downtrend that unwinds excesses. Similarly, moderate tightening in a healthy credit system should not be feared. From a big picture perspective, we turned bearish on China's growth several years ago due to the formation of a credit bubble. The bubble has only gotten larger and an adjustment has not yet even started. This does not justify altering our fundamental assessment of China's growth outlook. It would have been ideal to turn positive tactically on EM/China plays a year ago. Unfortunately, we did not do that. Presently, chasing the market higher might not be the best investment idea. Based on all this and given: the sharp rally in EM/China plays and widespread investor complacency and consensus that "everything" will be fine before the end of this year; modest tightening in Chinese monetary policy amid lingering credit and asset (property and the corporate bond market) bubbles; our outlook for higher U.S. bond yields and a stronger U.S. dollar; the fact that financial markets are forward looking, and timing is impossible; We believe the risk/reward of EM/China plays remains unattractive. In regard to EM ex-China, as we documented in last week's report, domestic demand in the developing economies has not recovered at all, or is mixed at best. DM final demand strength and global manufacturing inventory rebuilding will certainly help Korea and Taiwan, but not other emerging economies. The most important variables for other EM economies including China are domestic demand and/or commodities prices. If commodities prices relapse along with China's credit and fiscal impulse (Chart I-7, bottom panel), EM financial markets will suffer regardless of the growth trends within advanced economies. In fact, strong U.S. growth could lead to higher U.S. interest rate expectations and prop up the U.S. dollar. This will also be a bad omen for EM and commodities. Bottom Line: China's inventory depletion has been due to the large fiscal and credit impulse in the past 12 months - i.e., improving final demand has been instrumental to inventory shedding. Looking forward, the mainland's aggregate credit and fiscal impulse seems to have topped out, raising the odds of a reversal in EM/China plays sooner than later. Industrial Metals Inventories And Prices There is no good data reflecting industrial metals inventories globally. London Metal Exchange and Shanghai Futures Exchange data are likely not indicative of global metals stockpiles. China accounts for close to 50% of global demand for industrial metals, and its demand is critical to prices. Given that the large spike in metals prices in the past several months has coincided with improving Chinese economic data, one would expect the mainland to be the driving force behind the rally. However, Chart I-10 demonstrates that China's imports of industrial metals actually contracted in 2016. This is puzzling, but we have to take it at face value. The top panel of Chart I-11 depicts that traders' net long positions in copper are at a six-year high. This might partially explain the rally in copper in the recent months. Chart I-10China's Import Of Base Metals##br## And Base Metals Prices China's Import Of Base Metals And Base Metals Prices China's Import Of Base Metals And Base Metals Prices Chart I-11Traders Are Long ##br##Copper And Oil Traders Are Long Copper And Oil Traders Are Long Copper And Oil Clearly, China has been depleting its stock of industrial metals, and is likely primed to increase its imports. Nevertheless, periods of metals re-stocking by the mainland have historically not entailed higher industrial metals prices (Chart I-10). On the contrary, rising Chinese imports of metals have actually coincided with falling prices. One can interpret this relationship as China buying industrial metals when prices are falling. This is consistent with China attempting to buy commodities on dips. As to metals inventories in China, the picture is as follows: Steel inventories have plummeted and are low (Chart I-12). One can safely argue that there will be an inventory re-stocking cycle in China. Nevertheless, it is highly uncertain if this will be bullish for steel prices and steel stocks. In fact, there has been a mild negative correlation between steel prices and inventories; historically, when inventories have risen, prices declined (Chart I-12, top panel). This confirms that inventory levels are a residual of demand and supply, and prices are often driven by final demand - not inventories. This is also corroborated by the bottom panel of Chart I-12, which illustrates that share prices of global steel companies are sometimes negatively correlated with China's steel inventories. Stock prices occasionally sell off when inventories rise, and rally when inventories are shrinking. In contrast to steel and steel products, iron ore inventories have risen, and it seems the re-stocking cycle is well advanced (Chart I-13). Chart I-12China: Steel Inventories And Prices China: Steel Inventories And Prices China: Steel Inventories And Prices Chart I-13China: Iron Ore Inventories And Prices China: Iron Ore Inventories And Prices China: Iron Ore Inventories And Prices Yet, again there is no strong correlation between inventories and prices of iron ore (Chart I-13). In our discussions with clients, investors often attribute the rally in industrial metals in general and steel prices in particular over the past 12 months to supply cutbacks in China. While supply reductions have helped in the case of certain metals, it is also evident that the rally in industrial commodities has been driven by rising demand globally and in China. First, China's aggregate credit and fiscal impulse was positive until very recently, implying strengthening demand and thereby higher metals prices. Second, if there were only production cutbacks in steel and other commodities and not demand recovery, the mainland's manufacturing PMI would not have risen (Chart I-14). Finally, steel production has risen both in China and the rest of the world (Chart I-15). Hence, world steel supplies have expanded in the past 12 months. Given this has coincided with rising steel prices, it confirms there has been notable improvement in demand for steel. Chart I-14China: Steel Prices Are Up ##br##Because Of Strong Demand China: Steel Prices Are Up Because Of Strong Demand China: Steel Prices Are Up Because Of Strong Demand Chart I-15Chinese And Global ##br##Steel Production Chinese And Global Steel Production Chinese And Global Steel Production We are not experts in the ebbs and flows of commodities supplies, but it seems the Chinese government's mandated steel capacity cutbacks have not prevented rising steel output in China. In the meantime, rising prices amid rising production and falling inventories are indicative of robust final demand for many metals. Bottom Line: Industrial metals prices have risen because demand in the real economy and among financial investors has been strong. That said, a rollover in China's fiscal and credit impulse and a strong U.S. dollar will likely create headwinds for industrial metals prices over the course of this year. A Word About Oil Inventories OECD oil product inventories have continued to rise, despite supply cuts (Chart I-16, top panel). At the same time, our proxy for change in China's oil inventories has been very elevated for a while, depicting strategic and/or commercial inventory building on the mainland (Chart I-16, bottom panel). It is true that supply curtailments have been instrumental to the rally in oil prices, but the continued inventory buildup also indicates that supply is still outpacing demand. Besides, traders' net long positions in crude have spiked close to their 2014 highs (Chart I-11, bottom panel). This corroborates that demand for crude, like for copper, has partially been financial rather than from final consumers. Finally, U.S. rig counts have recovered somewhat, which may be indicative of a continued rise in America's oil output (Chart I-17). Chart I-16Oil Inventories Keep On Rising Oil Inventories Keep On Rising Oil Inventories Keep On Rising Chart I-17U.S. Rig Counts And Oil Production U.S. Rig Counts And Oil Production U.S. Rig Counts And Oil Production Bottom Line: While we do not have expertise to follow or forecast oil supply dynamics, we are biased in believing that the risk-reward for oil prices is unattractive because of a strong U.S. dollar and potentially weak EM/China asset prices, which could trigger a reduction in net long positions in crude. Investment Conclusions Complacency reigns in the global financial markets. EM equity volatility has fallen close to its cycle lows, the U.S. VIX is depressed, U.S. equity investor sentiment is very elevated and EM corporate credit spreads have plummeted to a ten-year low (Chart I-18). While the timing of a reversal is impossible, the risk-reward profile of EM financial markets is greatly unattractive. The U.S. trade-weighted dollar has consolidated recently, and might be primed for another upleg. As the U.S. dollar resumes its uptrend, EM risk assets will likely sell off. Finally, EM share prices have failed to outperform the developed bourses much, despite the rally in commodities and amelioration in Chinese growth (Chart I-19). Chart I-18Complacency Reigns Complacency Reigns Complacency Reigns Chart I-19EM Equities Have Not Yet Outperformed EM Equities Have Not Yet Outperformed EM Equities Have Not Yet Outperformed Remarkably, analysts' net earnings revisions for EM stocks have so far failed to turn positive (Chart I-20). Either analysts' EPS expectations were originally still too high, or companies are failing to deliver profits. Whatever the reason, the implication is that the consensus is more bullish on EM than is suggested by the underlying fundamentals. Within an EM equity portfolio, our overweights remain Taiwan, Korea, India, China, Thailand, Russia and central Europe. Our underweights are Malaysia, Indonesia, Turkey, Brazil and Peru. We are neutral on other bourses. Finally, the EM equity benchmark is at a critical technical resistance level (Chart I-21) but odds do not favor a sustainable breakout. Chart I-20EM EPS Net Revisions Are Still Negative EM EPS Net Revisions Are Still Negative EM EPS Net Revisions Are Still Negative Chart I-21EM Stocks: A Breakout Attempt EM Stocks: A Breakout Attempt EM Stocks: A Breakout Attempt Arthur Budaghyan, Senior Vice President Emerging Markets Strategy arthurb@bcaresearch.com 1 Please refer to the Emerging Markets Strategy Special Report titled, "Revisiting China's Fiscal And Credit Impulses", dated April 13, 2016, available at ems.bcaresearch.com 2 Trilogy of Special Reports on money/loan creation, savings and investment, titled, "Misconceptions About China's Credit Excesses" dated October 26, 2016, "China's Money Creation Redux And The RMB", dated November 23, 2016 and "Do Credit Bubbles Originate From High National Savings?", dated January 18, 2017, available at ems.bcaresearch.com Equity Recommendations Fixed-Income, Credit And Currency Recommendations

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

Highlights Portfolio Strategy Food price deflation bodes well for increased volumes, and by extension, packaging stocks. Upgrade to overweight. Prospects for intensifying market and economic volatility argue for reestablishing a portfolio hedge in gold shares. The tech sector underperforms when there is upward pressure on inflation, and the next twelve months is unlikely to prove an exception. Stay clear. Recent Changes S&P Containers & Packaging - Upgrade to overweight from neutral. Gold Mining Shares - Upgrade to overweight from neutral. Table 1 Bridging The Gap Bridging The Gap Feature Equity markets finally took a breather last week, as investors digested spotty earnings and began to discount the possible economic downside of U.S. isolationism. While profits should dictate the trend in stocks over the long haul, equity valuations have soared since the election, it is critical to consider the durability of this trend and other influences at this juncture. The recent string of positive economic surprises raises the risk that monetary conditions will tighten further, especially amidst rising inflation pressures and a tight labor market. As such, the broad market remains in a dangerous overshoot phase, predicated on hopes for a sustained non-inflationary global economic mini-boom. The risk is that these hopes are dashed by nationalistic policy blunders (i.e. protectionism and trade barriers) or a more muted and drawn out improvement in global economic growth than double-digit earnings growth forecasts would imply. There appears to be full buy-in to a durable bullish economic/profit outcome. We have constructed a 'Complacency-Anxiety' Indicator (CAI), using a number of variables that gauge investor positioning, sentiment and risk on/off biases (Chart 1). The CAI is at its highest level ever, signaling extreme confidence/conviction in the outlook for equities. While timing market peaks is difficult, because momentum can persist for longer than seems rational, the level of investor complacency is disturbingly high given that policy uncertainty is such a large economic threat. Global economic growth has never accelerated when global economic policy uncertainty has been this high (Chart 2, shown inverted). Chart 1Complacency Reigns Complacency Reigns Complacency Reigns Chart 2Uncertainty Is A Growth Impediment Uncertainty Is A Growth Impediment Uncertainty Is A Growth Impediment If rhetoric about anti-globalization measures turns into reality, that will deal a serious blow to burgeoning economic confidence before it translates into actual economic growth. Thus, the risk of sudden market downdrafts has risen to its highest level of this bull market. Chart 3 shows that positive economic surprises remain primarily sentiment/confidence driven, rather than from upside in hard economic data. To be sure, the stock market trades off of 'soft data' given its leading properties, but the size of the current gap is unusually large and reinforces that a big jump in 'hard data' surprises is already discounted. This gap represents a latent risk, as it did in the spring of 2011 just before the summertime equity market swoon. Chart 3A Big Gap Means Big Shoes To Fill A Big Gap Means Big Shoes To Fill A Big Gap Means Big Shoes To Fill Worryingly, the behavior of corporate insiders suggests that their confidence does not match their share price valuations. According to Barron's1, the insider sell/buy ratio has soared to an extremely bearish level for markets. For context, their gauge is close to 60; anything over 20 is deemed bearish while less than 12 falls into the bullish zone. Chart 4An Increasing Supply Of Stock An Increasing Supply Of Stock An Increasing Supply Of Stock The spike in secondary issuance corroborates insider selling (Chart 4). Insiders would not be unloading their shares if they felt earnings prospects would outperform what is discounted in current valuations. Even the pace of share buybacks has slowed considerably, to the point where the number of shares outstanding (excluding financials) has moved higher for the first time in 6 years (Chart 4). An increase in the supply of shares, from sources that have incentive to sell when the reward/risk tradeoff is unattractive, is a yellow flag. All of this argues for maintaining a capital preservation mindset rather than chasing market euphoria in the near run. Elevated complacency suggests that the consensus is focused solely on return rather than risk. It will be more constructive to put money to work when anxiety levels are higher than at present. This week we recommend adding a defensive materials sector gem, buying some portfolio insurance and we update our tech sector views. Packaging Stocks Are Gift Wrapped While our materials sector Cyclical Macro Indicator is hitting new lows, this is often a sign that the countercyclical S&P containers & packaging index deserves a second look. We have shown in past research that its strongest relative performance phases often occur when the overall materials sector is struggling. This group offers a more attractively valued alternative to play a transportation recovery than either rails or air freight, as discussed in last week's Report. From a macro perspective, deflation in global export prices should provide a strong tailwind. Why? Low prices spur volume growth. Global export volumes have begun to rebound, consistent with the increase in U.S. port traffic and intermodal (consumer) goods shipments (Chart 5). Any increase in global trade would bolster sentiment toward this high volume industry. Companies in this index are also highly exposed to the food and beverage business since the bulk of consumable non-durable goods products require packaging materials. As such, its fortunes rise and fall with swings in food prices. When food inflation is rising, consumers spend less in real terms, undermining the volume of food packaging demand. The opposite is also true. The current contraction in the food CPI has spawned a boom in food consumption, as measured by the surge in real (volumes) personal outlays on food & beverage products (Chart 6). This phenomenon is also true on a global basis, as food exports are booming (Chart 6, bottom panel), a remarkable development given U.S. dollar appreciation. Chart 5Stealth Play On Volume Growth Stealth Play On Volume Growth Stealth Play On Volume Growth Chart 6Booming Food Demand... Booming Food Demand... Booming Food Demand... Chart 7... Should Drive Up Multiples ... Should Drive Up Multiples ... Should Drive Up Multiples If food and beverage consumption stays robust, then the relative valuation expansion in packaging stocks will persist (food demand shown advanced, Chart 7). Increased demand for packaging products has become evident in the budding rebound in pricing power (Chart 8). The producer price index for containers has picked up nicely on a 6-month rate of change basis, albeit it is still low in annual growth terms. Nevertheless, any increase in pricing power would support profit margins if volume expansion persists, given the industry's disciplined productivity focus. Headcount remains in check, likely reflecting automation and investment, and is falling decisively relative to overall employment (Chart 8). The implication is that profit margins have a chance to outperform, particularly if energy prices stay range-bound (Chart 8). U.S. protectionism, and/or a continued rise in bond yields on the back of improving global economic momentum constitute relative performance risks to this position. Chart 9 shows that relative performance is mostly inversely correlated with global bond yields, given that it is a disinflationary winner. Chart 8Productivity Gains Productivity Gains Productivity Gains Chart 9A Risk Factor A Risk Factor A Risk Factor However, the global economy has already been through a phase of upside surprises. Moreover, now that China has moved to cool housing, investors should temper expectations for more stimulus to cause Chinese growth to accelerate. Conversely, economic disappointment could materialize before midyear if financial conditions tighten further. In sum, packaging stocks offer attractive exposure within an otherwise unattractive S&P materials sector. Bottom Line: Raise the S&P containers & packaging index to overweight. Gold: Back To Overweight As A Portfolio Hedge Gold mining shares look increasingly attractive, at least as a portfolio hedge. We took profits on our overweight position in the middle of last summer, just prior to the share price crunch, because tactical sentiment and positioning had gotten too stretched. Thereafter, the equity risk premium melted, dimming appetite for portfolio insurance (Chart 10). Moreover, bond yields rose in response to firming economic expectations, increasing the opportunity cost of holding an income-free asset like gold. However, in the absence of a global economic boom, which seems unlikely, and if trade barriers are erected and policy uncertainty continues to escalate, there is a limit to how high real rates can rise. Potential GDP growth remains low throughout the world, weighed down by excessive debt, weak productivity and deflationary demographics (Chart 11, second panel). Chart 10End Of Correction? End Of Correction? End Of Correction? Chart 11Structurally Bullish Structurally Bullish Structurally Bullish A revival in market volatility and an unwinding of previously frothy technical conditions have created an attractive re-entry point in gold shares. The yield curve stopped steepening when the Fed raised interest rates last month (Chart 12). The last playable rally began when the yield curve started to flatten, signaling doubts about the longevity of the business cycle. If the yield curve does not steepen anew, and interest rate expectations move laterally, then the U.S. dollar is less likely to be a barrier to gold price gains. Sentiment toward the yellow metal is no longer overheated, as evidenced by both surveys and investor behavior. Flows into gold ETFs have been trending lower in recent months, reversing last summer's buying frenzy (Chart 12). Speculative positions have also been unwound (Chart 12). Netting it out, the surge in U.S. policy uncertainty, prospects for economic disappointment relative to increasingly elevated expectations and any pause in the U.S. dollar rally support reestablishing overweight positions in gold mining stocks as a portfolio hedge, especially now that overbought conditions have been unwound (Chart 13). Chart 12No Longer Frothy No Longer Frothy No Longer Frothy Chart 13Time To Buy Hedges Time To Buy Hedges Time To Buy Hedges Bottom Line: Return to an overweight position in gold mining shares, using the GDX as a proxy. A Tec(h)tonic Shift Our Special Report published in early-December showed that the tech sector underperforms when inflation pressures accelerate. Companies in the S&P technology sector are typically mature and have shifted from reinvesting for growth to paying dividends and buying back stock. Thus, the rise in bond yields and headline inflation imply higher discount rates and by extension, lower valuations, all other things equal, for the long duration tech sector (Chart 14). Tech companies exist in a deflationary business model mindset. While relative pricing power had been in an uptrend since 2011, it has recently relapsed into the deflationary zone (Chart 15, middle panel). As shown in last Monday's Weekly Report, the tech sector is one of the few suffering from deteriorating pricing power. Chart 14Stiff Headwinds Stiff Headwinds Stiff Headwinds Chart 15Pricing Power Disadvantage Pricing Power Disadvantage Pricing Power Disadvantage Among the broad eleven sectors, tech stocks have the highest international sales exposure, so a higher dollar is also a net negative for exports, revenues and by extension profit growth, relative to the broad market. Industry sales growth is nil, significantly trailing the S&P 500's recent pick up in top line growth rate. History shows that tech relative performance is negatively correlated with the U.S. dollar in the latter stages of a currency bull market. While the temptation to position for an increase in capital spending via the tech sector is high, data do not show any demand improvement. Tech new order growth is decelerating. The tech new orders-to-inventories ratio is on the verge of contracting, and further weakness would herald downward pressure on forward earnings estimates (Chart 16). Net earnings revisions have swung violently downward recently. Any prolonged de-rating would warn of negative share price momentum given the tight correlation between the two (Chart 16). Meanwhile, the loss of tech sector competitiveness and a retreat from globalization via protectionism de-globalization pose serious headwinds to the industry's longer-term prospects. Return on equity is already ebbing, reflecting more intense profit margin pressure from the surge in wage growth and a lack of revenue gains. As a result, EBITDA growth has been non-existent (Chart 17). Chart 16Momentum Is Fading Momentum Is Fading Momentum Is Fading Chart 17Growth Remains Elusive Growth Remains Elusive Growth Remains Elusive Chart 18Profits Set To Underperform Profits Set To Underperform Profits Set To Underperform All of these factors are encapsulated in our S&P technology operating profit model, which has an excellent record in forecasting tech earnings. Chart 18 shows that tech profits are likely to contract as the year progresses, a far cry from what is expected for the broad market and the 450bps of profit outperformance embedded in analyst forecasts in the coming 12 months. Bottom Line: Reducing tech exposure on price strength is a prudent strategy. Stay underweight. 1 http://www.barrons.com/public/page/9_0210-instrans.html Current Recommendations Current Trades Size And Style Views Favor small over large caps. Favor growth over value (downgrade alert).

Chemicals stocks have significantly underperformed the broad market since our underweight call in 2014, pulled lower by the soaring U.S. dollar and sagging industry productivity. Net earnings revisions have been consistently revised lower over the past few years, and are unlikely to recover without a reflationary push that revives chemical final demand (global real yields are shown inverted, second panel). However, global manufacturing improvement seems likely to accrue mostly to firms outside the U.S. German chemical new orders have surged, and the IFO survey of chemical industry executives signals optimism about the future. U.S. executives appear to be equally confident, but that optimism is misplaced. The American Chemical Council expects U.S. chemical exports to increase 7% a year through 2021. Over $170B is expected to be invested in U.S. chemical manufacturing capacity, representing nearly 25% of the total industry size, which is anticipated to boost the chemical trade surplus to new records. So far, roughly $76B of projects has either been completed or is under construction. If these planned projects all come to fruition, our concern is that new capacity will be idle rather than productive. Capacity is already growing much faster than output, unleashing significant deflationary and productivity-draining forces. We expect chemicals stocks to continue to lag the broad market. Stay clear and please see yesterday's Weekly Report for more details. The ticker symbols for the stocks in this index are: BLBG: S5CHEM - APD, ARG, CF, DOW, EMN, ECL, DD, FMC, IFF, LYB, MON, MOS, PPG, PX, SHW. Chemicals: Too Much Capacity, Not Enough Competitiveness Chemicals: Too Much Capacity, Not Enough Competitiveness

Highlights Portfolio Strategy Media stocks are poised to challenge previous relative performance highs as sales growth reaccelerates. Stay overweight. The materials sector has lagged behind the commodity price rally, a sign of underlying weakness rather than latent strength. Chemicals overcapacity will remain a headwind until U.S. competitiveness improves. Stay clear. Recent Changes There are no changes to our portfolio this week. Table 1Sector Performance Returns (%) The "IF" Rally The "IF" Rally Feature The broad market has been very strong since the November election. While advance/decline lines have firmed, participation in the rally has been uneven and may be fraying around the edges. For example, the number of groups trading above their 40-week moving average has been diverging negatively from the broad market in the last few months, suggesting diminishing breadth (Chart 1). In fact, the industrials (I) and financials (F) sectors have carried the market since November. Other deep cyclical sectors, such as energy, materials and tech, have mostly matched market performance. The 'IF' rally is based on an expected upgrade to the economic growth plane that matches the surge in various sentiment gauges. If validation does not occur, then the IF rally will become iffy indeed, unless sector breadth improves. Last week we showed that market cap-to-GDP was so far above its long-term average that even if nominal growth boomed at 8% per annum for the next five years this valuation ratio would still not have normalized. That valuation backdrop may not upend additional short-term market momentum, but it is a true measure of just how bullish sentiment has become and should be a critical input to the portfolio construction process, because of its warning about divergences from fundamental supports. Another unconventional sentiment gauge is observed from sub-surface market patterns. Chart 1 shows that the number of defensive groups with a positive 52-week rate of change, in relative terms, is in freefall, plunged to virtually nil. In the last two decades, investors eschewing capital preservation and non-cyclical sectors so aggressively has typically preceded major market peaks (Chart 1). The steep drop in the put/call ratio confirms that euphoria and greed are trumping mistrust and fear. The put/call ratio has recently bounced, but is well below levels that signal investors are accumulating significant portfolio protection. The Fed's tightening bias, contracting U.S. dollar-based financial liquidity amid the strong U.S. dollar all threaten to keep a lid on corporate sector sales prospects. As such, we remain biased toward non-cyclical and consumer sectors, even excluding fiscal policy uncertainty. Chart 2 shows that these areas are in a base-building phase, in relative terms, following their post-election drubbing. We expect momentum to steadily build toward sustained outperformance by midyear. Conversely, a reversal in the 'IF' sectors already appears to be developing, while other capital spending-dependent sectors are unable to gain momentum (Chart 3). This week we highlight both a winning group and an area we expect to disappoint. Chart 1The Rally Is Fraying Around The Edges The Rally Is Fraying Around The Edges The Rally Is Fraying Around The Edges Chart 2Defensive Base-Building? Defensive Base-Building? Defensive Base-Building? Chart 3Cyclical Sector Distribution Cyclical Sector Distribution Cyclical Sector Distribution New Highs Ahead For Media While the consumer discretionary sector has a poor track record during Fed tightening cycles, the S&P media sub-component can buck this trend. Media stocks outperformed in the second half of the 1990s and also trended higher in the 1980s while the Fed was tightening. The key was the U.S. dollar (Chart 4). As long as the dollar was strong, media companies sustained a profit advantage over the rest of the corporate sector owing to limited external exposure. A replay is currently playing out, and has the potential to persist for at least the next few quarters based on upbeat cyclical indicators. Media sales growth is in recovery mode. Consumers have significantly boosted spending on media services, as measured by personal consumption expenditures data (Chart 5). Pricing power has surged in response to demand strength (Chart 5, bottom panel). In turn, strong demand is boosting measures of productivity: our proxy for sales/employment is accelerating toward the double-digit growth zone (Chart 5). Productivity is diverging positively from relative forward earnings expectations, implying there is room for a re-rating. As long as the U.S. economy is growing, media companies should be able to garner an increasing share of consumer wallets. Chart 6 shows that real spending on media services has been in a steady uptrend for well over a decade, reflecting its ability to continually innovate, only pausing during recessions when consumers are forced to retrench. Typically, a rise in spending pulls up pricing power (Chart 6). Chart 4Media Stocks Like Dollar Strength Media Stocks Like Dollar Strength Media Stocks Like Dollar Strength Chart 5Sales Are Set To Accelerate Sales Are Set To Accelerate Sales Are Set To Accelerate Chart 6Secular Strength Secular Strength Secular Strength All of this has spurred a recovery in media cash flow growth (Chart 7, top panel). Relative performance and cash flow move hand-in-hand. Rising cash flows also imply that the media sector can further reduce shares outstanding through buybacks and/or M&A activity (Chart 7), bolstering ROE. The S&P movies & entertainment index has been one of the driving forces behind the broader media index recovery. We upgraded the former to overweight after the vicious selloff related to Disney's ESPN woes and the takeover saga at Viacom had pushed the index to an undervalued extreme. While slightly early, this upgrade is now paying off (Chart 8). The expectations hurdle remains surmountable. Both forward earnings and sales growth estimates are deeply negative (Chart 8), reflecting the well-known cooling in cable subscriber growth. But even here, there is room for potential upside surprises. Consumer spending on recreation has been growing at a low single-digit clip, but the surge in consumer confidence, courtesy of rising wage growth and a positive wealth effect from rising real estate and financial asset prices, should support increased discretionary consumer spending. The message from the jump in the ISM services index is bullish for recreation spending (Chart 9, second panel). Chart 7Shareholder-Friendly Shareholder-Friendly Shareholder-Friendly Chart 8Cheap With Low Expectations Cheap With Low Expectations Cheap With Low Expectations Chart 9Still Early In The Recovery Still Early In The Recovery Still Early In The Recovery In turn, faster spending would support ongoing pricing power gains (Chart 9). The industry is already sporting one of the most robust selling price increases of all that we track, as advertising rate inflation is growing anew. Importantly, real outlays on cable services have recovered after a steep decline (Chart 9), suggesting that the drag from disappointing cable subscriber growth and cord cutting may be easing. Less churn implies more pricing power. Content cost inflation also remains under wraps. The implication is that the fundamental forces to propel a retest of previous relative performance highs are in place. Technical conditions are also sending a bullish signal. Cyclical momentum, as measured by the 52-week rate of change, is on the cusp of breaking into positive territory (Chart 9), while the share price ratio has already crossed decisively above key resistance at its 40-week moving average. A dual breakout would confirm a new bull trend. Bottom Line: Media stocks have good odds of retesting previous relative performance highs as discretionary consumer spending perks up. Stay overweight the overall media group, and the S&P movies and entertainment index in particular. Chemical Stocks: A Toxic Portfolio Blend The commodity price recovery has not carried over into the S&P materials sector, as relative performance has been moving laterally for much of the last twelve months. Rather than view this as an opportunity to play catch up, the more likely outcome is that the sector has missed its chance to outperform. In fact, downside risks have intensified. The strong U.S. dollar will exact a toll on U.S. exporters, particularly if emerging markets and China do not experience accelerating final demand. While there has been a massive amount of stimulus in China over the past 18 months, the thrust of that impulse is fading. Fiscal spending growth has dropped sharply and the authorities trying to cool rampant real estate speculation. The yield curve remains flat (Chart 10), as local funding costs rise on the back of the authorities attempt to mitigate capital outflows, and loan demand remains weak. Persistent weakness in the Chinese currency may reflect a lack of confidence in local returns, i.e. sub-par growth. All of that argues against expecting a major impetus to raw materials demand, at a time when the materials sector total wage bill is inflating more aggressively. Our Cyclical Macro Indicator for the materials sector is hitting new lows (Chart 10), heralding earnings underperformance, underscoring that below-benchmark allocations remain appropriate. The S&P chemicals group represents for than 70% of the overall materials market cap. It has underperformed since its peak and our underweight call in 2014, pulled lower by the soaring U.S. dollar and sagging industry productivity (Chart 11). Net earnings revisions have been consistently revised lower over the past few years, and are unlikely to recover without a reflationary push (global real yields are shown inverted, second panel, Chart 11) that revives chemical final demand. Analysts have latched on to the firming in global purchasing manager survey sentiment, aggressively pushing up sales growth expectations in recent months (Chart 12). Clearly, manufacturing sector expansion is expected to reverse the contraction in chemical output growth (Chart 12). Chart 10Higher PMIs Are Not Enough Higher PMIs Are Not Enough Higher PMIs Are Not Enough Chart 11Higher Yields Are A Bad Omen Higher Yields Are A Bad Omen Higher Yields Are A Bad Omen Chart 12Expectations Are Inflated Expectations Are Inflated Expectations Are Inflated However, this may be yet another case of analysts chronically overestimating the industry's earnings power. Global manufacturing improvement seems likely to accrue mostly to firms outside the U.S. Chart 13 shows that chemicals relative performance is heavily influenced by the U.S. dollar. Valuations and sentiment are tightly linked with chemical export growth (Chart 13), as the latter represent 14% of total U.S. exports. The U.S. dollar surge is diverting orders away from U.S. manufacturers: German chemical new orders have surged, and the IFO survey of chemical industry executives signals optimism about the future (Chart 14). Chart 13The Dollar Is Hurting The U.S. ... The Dollar Is Hurting The U.S. ... The Dollar Is Hurting The U.S. ... Chart 14... But Helping Foreign Competitors ... But Helping Foreign Competitors ... But Helping Foreign Competitors U.S. executives appear to be equally confident, but that optimism is misplaced. The American Chemical Council expects U.S. chemical exports to increase 7% a year through 2021. Over $170B is expected to be invested in U.S. chemical manufacturing capacity, representing nearly 25% of the total industry size, which is anticipated to boost the chemical trade surplus to new records. So far, roughly $76B of projects has either been completed or is under construction. If these planned projects all come to fruition, our concern is that new capacity will be idle rather than productive. The industry is in the crosshairs of anti-globalization and protectionism, and a strong U.S. dollar and rising domestic cost structures threaten to reduce competitiveness. Chemical imports are a fairly large portion of sales, rendering profitability vulnerable should an import-tax ever be introduced. From a cyclical standpoint, deflationary pressures are already very acute. Chemical capacity is growing much faster than production, warning that pricing power will be under significant pressure (Chart 15). Many chemical products are destined for interest rate-sensitive end markets such as autos, underscoring that a Fed tightening cycle is a headwind. While capacity expansion was planned when interest rates and feedstock costs were expected to remain at rock bottom levels for the foreseeable future, this is no longer the case. Chemical companies can either use natural gas (ethane) or oil (naphtha) as a primary feedstock. U.S. production is largely ethane-based, while global capacity is geared to naphtha. Rising U.S. natural gas prices are undermining the U.S. input cost advantage (Chart 16). Chart 15Persistent Deflation Pressures Persistent Deflation Pressures Persistent Deflation Pressures Chart 16U.S. Cost Structures Are Unattractive U.S. Cost Structures Are Unattractive U.S. Cost Structures Are Unattractive Increased capacity has also put significant upward pressure on wage costs, as our proxy for the total wage bill is rising at a high single-digit rate (Chart 16). With capital spending slated to stay robust in the coming years, it will likely continue to take a larger share of sales, impairing profit margins. While the planned merger between heavyweights Dow Chemical and Dupont may eventually help to rationalize costs, this is a necessary but not sufficient step in the face of a loss of global market share. Without accelerating sales, U.S. chemical makers will be hard pressed to improve productivity sufficiently to reverse the slide in relative forward earnings estimates. Bottom Line: The S&P materials sector hasn't been able to outperform during a period of improving global manufacturing activity, raising doubts about its performance potential when global output growth inevitably slows. Part of this reflects the challenging outlook for the sector heavyweight chemicals index, and we recommend staying underweight both. The symbols for the stocks in this index are: BLBG: S5CHEM - APD, ARG, CF, DOW, EMN, ECL, DD, FMC, IFF, LYB, MON, MOS, PPG, PX, SHW. Current Recommendations Current Trades Size And Style Views Favor small over large caps. Favor growth over value (downgrade alert).

Highlights China's supply-side structural reforms will focus mainly on its coal and steel markets this year. In addition, environmental policies will become stricter in 2017, as Beijing puts more weight on environmental protection than economic development. As as result, supply growth will slow, particularly in steel markets, which will be good news for global steel producers and bad news for iron ore exporters in Australia and Brazil. While we are more bearish on iron ore than steel due to supply-side reforms and stricter environmental policies, we remain cautious getting short iron ore, given the Dalian Commodity Exchange's iron-ore futures are backwardated (prompt prices exceed deferred prices). This indicates buyers are willing to pay more for prompt delivery (e.g., next week) than they are for deferred delivery (e.g., next year). Energy: Overweight. The Saudi-Russia production deal will slow the rate of growth in supply relative to demand, which will tighten physical markets. This will cause inventories to draw, and the backwardation in crude to deepen. Our long Dec/17 vs. short Dec/18 WTI recommendation is up 700%. We are long at +$0.04/bbl, and will risk the spread going to -$0.05/bbl. We will take profits at $0.50/bbl. Base Metals: Neutral. Supply-side reforms, coupled with environmental restrictions will slow the growth of steel production in China this year, benefiting producers ex-China. Precious Metals: Neutral. Gold markets will become increasing volatile, with the Fed likely to keep any rate-hike decision on hold until it has greater clarity re the incoming Trump administration's fiscal policy intentions. Ags/Softs: Underweight. The USDA's most recent supply-demand balances continue to paint a bearish picture for grains, with global ending stocks expected to grow. Feature China will continue its supply-side structural reforms this year, focusing mainly on its coal and steel markets. China environmental policies will become stricter in 2017. This year will mark the first time the central government puts more weight on environmental protection over economic development in evaluating officials' performance since 1949, when the People's Republic of China was established. Supply growth will be slower than last year due to continuing reforms, and stricter environmental policies in the country. Among base metals and bulks, the steel and iron ore markets will be most affected. This will be good news for global steel producers and bad news for global iron ore producers. We are more bearish on iron ore than steel strategically, due to these supply-side reforms, stricter environmental policies, scrap steel substitution, and rising global iron ore supply. That said, we remain cautious getting short iron ore, given the Dalian Commodity Exchange's iron-ore futures are backwardated (prompt prices exceed deferred prices). This indicates buyers are willing to pay more for prompt delivery (e.g., next week) than they are for deferred delivery (e.g., next year). We are downgrading nickel from bullish to neutral, both tactically and strategically. We also are downgrading our tactically bullish stance on aluminum to neutral, as the Indonesian government on January 12 unexpectedly allowed exports of nickel ore and bauxite under certain conditions. China's Supply-Side Reforms In 2017 In 2016, steel prices rallied more than 90% from year-end 2015 levels, but Chinese crude steel and steel products production rose a mere 0.4% and 1.3% yoy, respectively. Back in 2009, when steel prices rose about 30% from November 2008 to August 2009, production grew 12.9% and 17.8% yoy for Chinese crude steel and the output of steel products, respectively (Chart 1). Chart 1China: A Slower Steel Production##br## Recovery Than In 2009 China: A Slower Steel Production Recovery Than In 2009 China: A Slower Steel Production Recovery Than In 2009 One reason for these disparate performances can be found in the massive production cuts made in China last year to crude steel capacity. In February 2016, China's central government announced that it planned to cut 100 to 150 million metric tons (mmt) of crude steel capacity over the five-year period of 2016-2020. While the country aimed to cut 45 mmt in 2016, the actual reduction accelerated in 2016H2 making the full year decrease much larger. According to the China Iron and Steel Association (CISA), 70 mmt of crude steel capacity was taken off line last year, equivalent to 6.2% of total crude steel production capacity in China. This explains, in part, the much slower crude steel production recovery last year when compared to the post-Global Financial Crisis (GFC) recovery in 2009. How much crude steel production capacity will China cut in 2017? Even though last year's 70 mmt capacity cut means about half of the five-year 100-150 mmt capacity-cut target was already achieved, the Chinese government does not show any sign of moderating its desire to see additional cuts. The Chinese Central Economic Work Conference (December 14-16, 2016) emphasized that 2017 will be a year to deepen supply-side structural reforms. Although the central government still has not finalized its 2017 target, we believe a further 40-50 mmt cut in 2017 is possible. For example, China's largest steel producing province - Hebei - has already announced its 2017 crude steel capacity reduction target, which will be 14.39 mmt, similar to its 2016 target of 14.22 mmt. We would note here that the actual cut for the Hebei province in 2016 was 16.24 mmt, much higher than the target, indicating officials will seek to err on the high side when it comes to taking production off line. In December 2016, the country launched a nationwide crackdown on production of so-called shoddy steel, also known as ditiaogang in Chinese - low-quality crude steel made from scrap metal, which is commonly used to produce substandard construction steel products. This material accounts for about 4% of Chinese crude steel output. Last week, the Chinese government ordered a full ban on "shoddy steel" production to be completed before June 30, 2017. This month, 12 inspection groups were sent to major shoddy steel producing provinces to oversee the implementation of the directive. In 2017, the Chinese government also plans to: rein in new steel production capacity; scrutinize new projects; push for more mergers; and generally tighten supervision in the steel sector. In early January, China's top economic planner - the National Development and Reform Commission (NDRC) - toughened its tiered electricity pricing to limit availabilities to outdated steel producers, and to advance its goal of capacity cuts. According to the NRDC website, the new measures raised the price paid by "outdated" steelmakers by 66.7% to 0.5 yuan per kWh, effective on Jan. 1, 2017. Outdated steelmakers, in the government's reckoning, are those scheduled to be phased out - for example, those shoddy steel producers - most of which are privately owned small- or medium- scale mills. Bottom Line: A further capacity cut will limit Chinese steel production growth in 2017. China's Environmental Policies In 2017 In 2016, the Chinese government increased the frequency at which it sent environmental inspection teams to major metal-producing provinces and cities, to ensure the smelters and refiners comply with state environmental rules. Factories that failed to meet environmental standards were ordered to permanently or temporarily shut down, depending on the severity of their violations. This year, with persistent and intensifying smog becoming a greater threat to the health of China's population, environmental policies will only get stricter, resulting in more frequent supply disruptions, especially in its steel industry. In addition to plant-specific environmental measures, in late 2016, China rolled out rules to evaluate the "green" efforts of local governments. For the first time since 1949, when the People's Republic of China was established, the central government indicated it would put more weight on environmental protection than on economic development, as measured by GDP, in evaluating local government officials' performance. This likely will reduce the local governments' incentive to support unqualified or unprofitable steel/aluminum production. Bottom Line: China's stricter environmental policies will cause more supply disruptions and increase production costs for the Chinese metal sector, especially the steel industry. Our Views On Iron Ore And Steel In 2017 We are strategically neutral on steel prices and bearish on iron ore prices. Supply-side reforms and stricter environmental policies in China likely will result in zero growth or even a small contraction in Chinese steel production, which may well support steel prices while reducing iron ore demand. This will be good news for global steel producers ex-China, and bad news for global iron ore producers. China is determined to cull all "shoddy steel" production by the end of June, which will make considerable volumes of scrap steel available to be used in good-quality steel production. Chinese steel producers are currently willing to replace iron ore with scrap steel in their steel production, given scrap steel prices are cheap versus iron ore and steel product prices (Chart 2). In addition, using scrap as an input to produce crude steel will save steel producers money on coking coal, the price of which has surged over the past year. Chinese steel demand growth may remain robust in 2017H1. Last year's stimulus still has not run out of steam, and this year's fiscal and monetary policy will stay accommodative.1 Raw-material costs in the form of iron ore, coking coal and oil soared versus levels seen last year, which means the production costs of steel now are much higher than last year. This will support steel prices (Chart 3). Chart 2More Scrap Steel Will Replace##br## Iron Ore In Steel Production More Scrap Steel Will Replace Iron Ore In Steel Production More Scrap Steel Will Replace Iron Ore In Steel Production Chart 3Cost Push Will Support ##br##Steel Prices Cost Push Will Support Steel Prices Cost Push Will Support Steel Prices Steel product inventories at the major cities in China are still low; producers' inventory holdings have declined to levels last seen in 2014, which also will be supportive of steel prices (Chart 4). China's iron ore inventories are high, while domestic iron ore production is recovering (Chart 5, panels 1 and 2). With slowing domestic steel production, Chinese iron ore import growth likely will be subdued this year (Chart 5, panel 3). Global iron ore supplies are increasing. The "Big Three" producers - Vale, Rio Tinto, and BHP - all plan to boost production in response to profitable iron ore prices this year. Indeed, this month, Vale started its first iron-ore shipments from the giant new S11D mine. Chart 4Low Inventory Supports Steel Prices As Well Low Inventory Supports Steel Prices As Well Low Inventory Supports Steel Prices As Well Chart 5Limited Chinese Iron Ore Import Growth In 2017 Limited Chinese Iron Ore Import Growth In 2017 Limited Chinese Iron Ore Import Growth In 2017 Bottom Line: The outlook for steel prices this year is brighter relative to iron ore in 2017, although, the backwardation in the Dalian Commodity Exchange's iron-ore futures suggests markets may be pricing in tighter iron-ore supply in the near term. We will explore this in future research. Downgrading Our Nickel And Aluminum Views We are downgrading nickel from bullish to neutral, both tactically and strategically. Chart 6Downgrading Nickel And Aluminum View Downgrading Nickel And Aluminum View Downgrading Nickel And Aluminum View In November, we expected the global nickel supply deficit to widen on rising stainless steel demand and falling nickel ore supply. One major reason we were bullish nickel was that there was no sign Indonesia's export ban - imposed in January 2014 - would be removed. With elevated global nickel output, surging Chinese nickel pig iron (NPI) imports, and rebounding Indonesian nickel ore exports, Chinese NPI production will recover in 2017, which will reduce the country's need for refined nickel imports (Chart 6). Our long Dec/17 LME nickel contract versus Dec/17 LME zinc contract was stopped out for a 5.1% loss this week. We are no longer bullish nickel versus zinc. We also are downgrading our tactically bullish stance on aluminum to neutral, after the Indonesian government unexpectedly allowed exports of nickel ore and bauxite under certain conditions earlier this month. We are removing our buy limit order to go long Mar/17 aluminum contracts if it falls to $1,640/MT from our shopping list. Ellen JingYuan He, Editor/Strategist ellenj@bcaresearch.com 1 Please see Commodity & Energy Strategy Weekly Report "China Commodity Focus: How China's Monetary And Fiscal Policy Will Affect Metal Markets," dated January 12, 2017, available at ces.bcaresearch.com Grains/Softs Global Grain Stocks Set To Rise Overall: Despite some positive developments in the U.S. - where corn supplies are falling faster than demand - we remain underweight grains. This is largely because of the continued growth of production relative to consumption globally, which looks like it will lift global stocks by the end of the 2016-17 crop year in September. While we do expect a slight decrease in output this year, it is difficult to upgrade our view at this point (Table 1). Table 1World Grains Estimates - January 2017 China Commodity Focus: Supply Cuts, Environmental Restrictions Will Hit Metals China Commodity Focus: Supply Cuts, Environmental Restrictions Will Hit Metals Wheat: Worldwide, output growth in Argentina, Russia and the EU added 1.3mm tons of production to global supplies. In the U.S., ending stocks are projected to reach levels not seen since the late 1980s, according to the USDA. Global consumption, meanwhile, is projected to increase a mere 100k tons, according to the USDA, which will lift ending stocks 1.2mm tons by the end of the crop year to a record 253.3mm tons. Corn: U.S. production is expected to fall, which, along with higher usage in the ethanol market, will contribute to lower stocks. However, on a global basis, production is set to outstrip consumption resulting in higher ending stocks at the end of the crop year. Soybeans: Same story here: Production growth outstripping consumption, leaving ending stocks higher by close to 7% yoy, based on the USDA's estimates. Rice: In relative terms, the rice market has the most bullish fundamentals - global production and consumption are roughly balanced, leaving expected ending stocks slightly above last year's level. We continue to favor rice over the other grains (save wheat) for this reason. Investment Views and Themes Recommendations Strategic Recommendations Tactical Trades Commodity Prices and Plays Reference Table Trades Closed In 2017 China Commodity Focus: Supply Cuts, Environmental Restrictions Will Hit Metals China Commodity Focus: Supply Cuts, Environmental Restrictions Will Hit Metals

The S&P materials sector is rolling over relative to the broad market after a brief bout of strength. Downside risks remain acute. The strong U.S. dollar will exact a toll on U.S. exporters, particularly if emerging markets and China do not experience an acceleration in final demand. While there has been a massive amount of stimulus in China over the past twelve months, this appears to be fading. Fiscal spending growth has dropped sharply. The yield curve remains flat, as local funding costs rise on the back of the authorities attempt to control capital outflows, and loan demand remains weak. This argues against expecting a major impetus to raw materials demand, at a time when the materials sector total wage bill is inflating more aggressively. Our Cyclical Macro Indicator for the materials sector is hitting new lows, diverging negatively from the share price ratio, underscoring that below-benchmark allocations remain appropriate. The ticker symbols for the stocks in this index are: BLBG: S5MATR. It Is Not A Material World It Is Not A Material World