Pharmaceuticals

...Pharmas Pain ...Pharmas Pain Underweight In mid-2017, we went underweight the S&P pharma index and booked healthy gains roughly a year later when we lifted exposure to neutral. Since then, Big Pharma has enjoyed a reprieve on the back of congressional inaction and the fact that the Trump Administration’s drug pricing wrath was less severe than initially feared. However, the time has come to trim the S&P pharma index to underweight. The top panel shows that pharmaceutical companies have been nearly uninterruptedly raising prices for the past four decades. Higher selling prices have been synonymous with higher profits and thus higher share prices. However, profit margins crested in the midst of the late-1990’s M&A boom and have never reclaimed their previous zenith (middle panel). Neither have relative share prices. Worryingly, pharma prices have hit a wall during the past four years and can barely keep up with overall inflation, despite still being opaque (bottom panel). As both Democrats and Republicans are united to bring down health care costs in general and drug prices in particular, pharma profits will likely suffer a secular downdraft. The implication is that, as pharma revenues erode they will deal a blow to profits. Consequently, the outlook for relative share prices is dim. Bottom Line: We trimmed the S&P pharma index to underweight yesterday; please see our Weekly Report for more details. The ticker symbols for the stocks in this index are: BLBG: S5PHAR – JNJ, PFE, MRK, LLY, BMY, ZTS, AGN, MYL, NKTR, PRGO.

Highlights Portfolio Strategy The path of least resistance is higher for the broad equity market on the back of a reflationary impulse and a less dogmatic Fed. Now that the SPX forward EPS bar has been lowered to the ground, upward surprises loom, especially if the third catalyst we have been highlighting in recent research materializes: a positive resolution to the U.S./China trade spat. The recent M&A fever, a less dogmatic Fed that has suppressed the 10-year Treasury yield and a pick up in the U.S. credit impulse can serve as catalysts to unlock excellent value in the S&P biotech index. Upgrade to overweight. A profit margin squeeze on the back of soft pharma pricing power, weak operating conditions and a race to buy out biotech stocks to build up drug pipelines warn that the derating phase has just began for the S&P pharma index. Downgrade to underweight. Recent Changes Boost the S&P biotech index to overweight today. Trim the S&P pharma index to underweight today. Table 1 Reflating Away Reflating Away Featured The S&P 500 has been flirting with its 200 day moving average and once it categorically clears this hurdle there are high odds that previous resistance will turn into support. The next important level is 2,800, as we highlighted in recent research, a level where the SPX failed numerous times last year.1 Encouragingly, the character of the market has changed from December’s extreme daily weakness to this year’s significant daily resilience. As we first posited on January 18, while everyone is looking for a retest to re-enter the equity market, we already had the retest in December and are now in a slingshot recovery eerily similar to the 2016 and 1998 episodes.2 Importantly, what has changed since the post-December Fed meeting carnage is that the bond market has completely priced out Fed hikes for 2019 and the 10-year Treasury yield is 15bps lower. Chart 1 highlights this reflationary backdrop for U.S. stocks. Our proprietary Reflation Gauge (RG, comprising oil prices, interest rates and the U.S. dollar) is probing levels last hit in 2012. Historically, our RG and equity momentum have been joined at the hip and the current message is to expect a rebound in the latter. Chart 1Heed The Reflation Message Heed The Reflation Message Heed The Reflation Message The latest ISM manufacturing survey also corroborates the signal from our RG. The jump in the ISM new orders-to-inventories ratio underscores that the rebound in stocks has further to run (bottom panel, Chart 1). Granted, a lot rests on EPS and in order for stocks to propel to fresh all-time highs later this year, as we expect, profits will have to deliver. On that front, despite recent steep downward EPS revisions across the board, we believe the level of quarterly EPS will hit fresh all-time highs in the back half of the year, carrying stocks into uncharted territory (Chart 2). As a reminder, BCA’s view remains that the U.S. will avoid recession in 2019. Chart 2Joined At The Hip Joined At The Hip Joined At The Hip One key profit driver that has put pressure on recent earnings releases and will continue to weigh on internationally-exposed P&Ls is the greenback. With a delayed effect, the first two quarters of this year should bear the brunt of last year’s steep U.S. dollar climb, but that effect will reverse in the back half of 2019. Not only is the greenback inversely correlated with the SPX, but also with the global manufacturing PMI (trade-weighted U.S. dollar shown inverted and advanced, Chart 3). Chart 3Dollar The Reflator... Dollar The Reflator... Dollar The Reflator... Thus, the greenback is a key macro variable that we are closely monitoring. On that front, global U.S. dollar based liquidity is one of the most important determinants/drivers of global growth. The longer U.S. dollar liquidity gets drained, the more downward pressure it will put on SPX momentum and SPX EPS (Chart 4). Once U.S. dollar based liquidity starts to get replenished at the margin, it can serve as a catalyst for a global growth recovery. A Fed tightening cycle pause and recent acknowledgment that the balance sheet asset roll off is important and the Fed stands ready to tweak it, are a net positive for at least a trough in global U.S. dollar liquidity. Chart 4...But Watch Global Dollar Liquidity ...But Watch Global Dollar Liquidity ...But Watch Global Dollar Liquidity Adding it up, the path of least resistance is higher for the broad equity market on the back of a reflationary impulse and a less dogmatic Fed. Now that the SPX forward EPS bar has been lowered to the ground, upward surprises loom, especially if the third catalyst we have been highlighting in recent research materializes: a positive resolution to the U.S./China trade spat.3 This week we make a couple of subsurface changes to a defensive sector; these changes do not alter our recommended benchmark allocation to the overall sector. Biotech’s Gain Is... Biotech stocks have been the center of attention recently as the BMY/CELG deal put the whole sector in play, and today we are boosting exposure to overweight in the S&P biotech index. We doubt the merger mania is over and we continue to believe that more mega deals are in store, either intra or inter-industry, with Big Pharma hungry and in a hurry to replenish their drug pipeline. While this is not the sole reason for an above benchmark allocation, 50-60% M&A deal premia are a boon for investors (Chart 5). Chart 5M&A Frenzy M&A Frenzy M&A Frenzy From a long-term macro perspective biotech stocks have been the primary beneficiaries of the 35-year bond bull market. In other words, the multi-decade grind lower in the U.S. Treasury yield has been synonymous with biotech outperformance (10-year U.S. Treasury yield shown inverted, Chart 6). Chart 6Biotech Equities And Rates Move In Opposite Direction Biotech Equities And Rates Move In Opposite Direction Biotech Equities And Rates Move In Opposite Direction The Fed’s recent monetary policy U-turn is a welcome development and these high growth stocks will benefit from the 55bps fall in the 10-year Treasury yield since the early-November peak. In addition, another macro tailwind is working in the S&P biotech index’s favor. The resurgent U.S. credit impulse is unambiguously bullish for this health care index that excels when margin debt availability is rising and liquidity is plentiful (bottom panel, Chart 7). Chart 7Revving Credit Impulse Says Buy Biotech Stocks Revving Credit Impulse Says Buy Biotech Stocks Revving Credit Impulse Says Buy Biotech Stocks Surprisingly, the sell-side community does not share our enthusiasm on any of these positive catalysts. Relative profit growth is forecast to be nil in the next year. In the coming five years, biotech stocks are expected to trail the overall market’s profit growth by 4%/annum (middle panel, Chart 8). This is extremely pessimistic and a first in the 24-year history of the I/B/E/S data set, and it is contrarily positive. Relative revenue growth forecasts are also grim for the upcoming 12 months and both revenue and profit forecasts present low hurdles to overcome (fourth panel, Chart 8). Chart 8Analysts Have Thrown In The Towel Analysts Have Thrown In The Towel Analysts Have Thrown In The Towel With regard to technicals and valuations, investors are doubtful that biotech stocks can stage a playable turnaround. Cyclical momentum remains moribund, printing below the zero line. Meanwhile, the S&P biotech index trades at a 25% discount to the SPX forward P/E and well below the historical mean (second & bottom panels, Chart 8). Chart 9 shows that biotech stocks are also cheap on a relative dividend yield basis. The S&P biotech index has been so oversold that it now sports a dividend yield higher than the S&P 500. Nevertheless, there is one key risk we are closely monitoring. Biotech initial public offerings are at all-time highs, with private equity and venture capital funds rushing for the exit doors. This is worrisome as it offsets the supply reduction owing to the M&A fever and has historically coincided with biotech relative share price peaks (Chart 10). Chart 9Compelling Relative Value Compelling Relative Value Compelling Relative Value Chart 10Watch This Risk Watch This Risk Watch This Risk Netting it all out, the recent M&A fever, a less dogmatic Fed that has suppressed the 10-year Treasury yield and a pick up in the U.S. credit impulse can serve as catalysts to unlock excellent value in the S&P biotech index. Bottom Line: Boost the S&P biotech index to overweight today. The ticker symbols for the stocks in this index are: BLBG: S5BIOT – ABBV, AMGN, GILD, BIIB, CELG, VRTX, REGN, ALXN, INCY. …Pharma’s Pain In mid-2017 we went underweight the S&P pharma index and booked healthy gains roughly a year later when we lifted exposure to neutral. Since then, Big Pharma has enjoyed a reprieve on the back of congressional inaction and the fact that the Trump Administration’s drug pricing wrath was less severe than initially feared. However, the time has come to trim the S&P pharma index to underweight. Chart 11 shows that pharmaceutical companies have been nearly uninterruptedly raising prices for the past four decades. Higher selling prices have been synonymous with higher profits and thus higher share prices. Chart 11Margin Trouble Margin Trouble Margin Trouble But, something happened in the new millennium. Relative performance peaked as pharma embarked on a mega M&A boom in the late-1990s with the Pfizer/Warner Lambert deal breaking all-time industry M&A records. Why? Because profit margins crested and have never reclaimed their previous zenith (top and middle panels, Chart 11). Neither have relative share prices. Worryingly, pharma prices have hit a wall during the past four years and can barely keep up with overall inflation, despite still being opaque (bottom panel, Chart 11). As both Democrats and Republicans are united to bring down health care costs in general and drug prices in particular, pharma profits will likely suffer a secular downdraft. The implication is that, as pharma revenues erode they will deal a blow to profits. Consequently, the outlook for relative share prices is dim. Importantly, pharma executives have not been frugal enough to offset the soft pricing power backdrop. Headcount has been expanding consistently since 2012 and a wide gap has opened up relative to industry selling price inflation, akin to the one in the mid-2000s that suppressed relative share prices (Chart 12). Chart 12Pricing Power Pressure Pricing Power Pressure Pricing Power Pressure Similar to the M&A boom of the late-1990s, there has been a global pharma M&A race with multiple deal announcements in the past few months, underscoring that the industry is not standing still. As Big Pharma CEOs compete to outdo their peers and buy drug pipelines mostly in the biotech space (Chart 5), they will continue to degrade the industry balance sheet (third panel, Chart 12). Our strategy is to overweight the hunted (biotech) and avoid the hunters (Big Pharma). On the operating front, a supply check reveals that pharma wholesale and manufacturing inventories are growing, whereas shipments are on the verge of contraction. Pharma industrial production has petered out and industry productivity gains are waning (Chart 13). This deteriorating operating backdrop will weigh on relative profits. Chart 13Deteriorating Operating Metrics... Deteriorating Operating Metrics... Deteriorating Operating Metrics... With regard to the macro front, a vibrant U.S. economy – with the ISM manufacturing survey ticking higher and the labor market firing on all cylinders – suggests that defensive pharma relative profits will resume their downtrend (bottom panel, Chart 13). Tack on the U.S. dollar’s reversal since the November peak and defensive pharma equities will remain under pressure (second panel, Chart 14). Chart 14...But EPS Bar Is On The Floor ...But EPS Bar Is On The Floor ...But EPS Bar Is On The Floor Nevertheless, there are three risks to our negative S&P pharma view. First, the M&A fever dies down and there are no additional purchases of biotech outfits. Second, Congress and the President drag their feet and fail to agree on new hawkish pharma pricing legislation. Finally, sell-side analysts have thrown in the towel and maybe most of the bad news is reflected in bombed out relative profit and sales growth estimates (third & fourth panels, Chart 14). In sum, a profit margin squeeze on the back of soft pharma pricing power, weak operating conditions and a race to buy out biotech stocks to build up drug pipelines warn that the derating phase (bottom panel, Chart 14) has just began for the S&P pharma index. Downgrade to underweight. Bottom Line: Trim the S&P pharma index to underweight. The ticker symbols for the stocks in this index are: BLBG: S5PHAR – JNJ, PFE, MRK, LLY, BMY, ZTS, AGN, MYL, NKTR, PRGO. Health Care Remains In The Neutral Column Despite these two subsurface health care sector moves, our overall exposure to the S&P health care sector remains intact at neutral. Please look forward to reading our upcoming research where we will be updating the S&P managed health care, S&P health care facilities and S&P health care equipment subsectors.   Anastasios Avgeriou, Vice President U.S. Equity Strategy anastasios@bcaresearch.com Footnotes 1      Please see BCA U.S. Equity Strategy Weekly Report, “Trader’s Paradise” dated January 28, 2019, available at uses.bcaresearch.com. 2      Please see BCA U.S. Equity Strategy Insight Report, “Don’t Bet On A Retest” dated January 18, 2019, available at uses.bcaresearch.com. 3      Please see BCA U.S. Equity Strategy Weekly Report, “Dissecting 2019 Earnings” dated January 22, 2019, available at uses.bcaresearch.com. Current Recommendations Current Trades Size And Style Views Favor value over growth Favor large over small caps

  Neutral The pharma space has been exploding with merger mania as the largest pharma deal ever (Bristol-Myers Squibb buying Celgene for approximately $90 billion) was followed up by Eli Lilly acquiring Loxo Oncology for nearly $8 billion. These fall on the back of other notable global deals including GlaxoSmithKline buying Tesaro for $5.1 billion last month and Takeda buying Shire for $62 billion mid-last year. Such exuberance has clearly confirmed that merger premia are alive and well in the S&P pharma index. It is not merely rising premia that have taken pharma higher either. Pricing power has entered the early innings of a recovery (top panel) while the key export channel points to increasingly bright days ahead (second panel). However, pharma’s consolidation phase has come at a cost to sector leverage ratios that have dramatically expanded (bottom panel). The $33.5 billion loan taken on by Bristol-Myers Squibb to fund the cash portion of their acquisition and Eli Lilly’s all-cash offer are unlikely to help this ratio, regardless of a rosier EBITDA outlook. Bottom Line: Things are looking up for pharma but an expensive consolidation cycle will stretch balance sheets; stay neutral. The ticker symbols for the stocks in the S&P pharma index are: BLBG: S5PHAR - JNJ, PFE, MRK, BMY, AGN, LLY, ZTS, MYL, PRGO, NKTR. Size Is The Prescription But Beware The Dosage Size Is The Prescription But Beware The Dosage   ​​​​​​​​​​​​​​

Neutral In our July 3rd Weekly Report, we made good on our recent upgrade alerts and raised the S&P pharma and biotech groups to neutral from underweight, locking in relative gains of 14.5% and 13.9%, respectively. In our report, we highlighted five key drivers for our more sanguine view, namely firming operating metrics, late cycle dynamics, likelihood of pricing power regulatory relief, the rising U.S. dollar and investor and analyst capitulation. With respect to the first of these, our pharma productivity proxy (industrial production / employment) is putting in its best performance of the past several years, implying that earnings seem likely to exceed the pessimistic sell-side estimates (second panel). This seems particularly likely as the pace of improvement in drug shipments exceeds inventory growth by a fairly wide margin (third and bottom panels). Bottom Line: Lift the S&P pharma and S&P biotech indexes to a benchmark allocation and remove the S&P pharma group from the high-conviction underweight list; see our Weekly Report for more details. The ticker symbols for the stocks in the S&P biotech and S&P pharma indexes are: BLBG: S5BIOTX - ABBV, AMGN, GILD, CELG, BIIB, VRTX, REGN, ALXN, INCY and BLBG: S5PHAR - JNJ, PFE, MRK, BMY, AGN, LLY, ZTS, MYL, PRGO, NKTR, respectively. Operating Improvements Could Cure Pharmas Ills Operating Improvements Could Cure Pharmas Ills

Highlights Portfolio Strategy Five key drivers - late cycle dynamics, likelihood of pricing power regulatory relief, the rising U.S. dollar, firming operating metrics and investor and analyst capitulation- all suggest that it no longer pays to be bearish the S&P pharma and S&P biotech indexes. Lift to neutral. This also raises the S&P health care sector exposure to neutral, as these two heavyweight health care sub-indexes command a 49% weighting in the sector. Recent Changes Act on the upgrade alert and lift the S&P pharma and S&P biotech indexes to neutral today for a profit of 14.5% and 13.9%, respectively since inception (we are also removing the S&P pharma index from our high-conviction underweight list). Lock in gains in the S&P health care sector of 5.3% since inception and upgrade exposure to a benchmark allocation today. Table 1 Recalibrating Recalibrating Feature Stocks continued to wrestle with escalating geopolitical threats last week, but remained resilient. While the global trade soft patch could morph into a steep contraction if protectionism proliferates, our working assumption is that the executive branch's bark will be worse than its bite. The SPX is in the midst of a recalibration to a cooling in EPS momentum in calendar 2019 as we have been highlighting in recent research, and were the U.S. dollar to continue its ascent in the back half of the year, the sell-side's calendar 2019 almost 10% growth estimate will sink like a stone. This remains our number one downside risk that we are closely monitoring, though it should be reasonably contained by mounting signs of a healthier corporate sector and an easing in financial stress (Chart 1). This week we are updating our corporate pricing power proxy that has reaccelerated. Importantly, the breadth of the surge has gone parabolic, which bodes well for its staying power (second panel, Chart 2). This firming corporate inflation backdrop suggests that businesses have been successful in passing on skyrocketing input costs down the supply chain, and thus implies that final demand remains robust. Chart 1Reset Reset Reset Chart 2Pricing Power Flexing Its Muscles Pricing Power Flexing Its Muscles Pricing Power Flexing Its Muscles On the flip side, rising labor costs have stabilized. Compensation growth remains contained, and according to our diffusion index, just over half of the 44 industries we track have to contend with rising wages. In addition, the Atlanta Fed Wage Growth Tracker switcher/stayer index provides a reliable leading indication for the trend in overall labor expenses and it recently ticked down. In other words, pricing power is rising on a broad basis while wage inflation is moving laterally. Consequently, there are decent odds that upbeat forward operating margin expectations are attainable, further prolonging the near two year margin expansion phase (bottom panel, Chart 2). Delving deeper into our corporate pricing power update is revealing. Table 2 summarizes the results. As a reminder, we calculate industry group pricing power from the relevant CPI, PPI, PCE and commodity growth rates for each of the 60 industry groups we track. Table 2 also highlights shorter term pricing power trends and each industry's spread to overall inflation. Table 2Industry Group Pricing Power Recalibrating Recalibrating 80% of the industries we cover are lifting selling prices, and 45% are doing so at a faster clip than overall inflation. This is on a par with our late-April report. Chart 3Cyclicals Come Out On Top Cyclicals Come Out On Top Cyclicals Come Out On Top Outright deflating sectors increased by two to 12 since our last update. Encouragingly, only 7 industries are still experiencing a downtrend in selling price inflation, in line with our most recent report. Impressively, deep cyclicals/commodity-related industries continue to dominate the top ranks, occupying the top 7 slots (top panel, Chart 3). Despite the ongoing global export jitters, escalating trade war fears and year-to-date gains in the greenback, the commodity complex's ability to increase prices is extraordinary. In contrast, airlines, soft drinks, telecom, autos and tech populate the bottom ranks of Table 2. In sum, accelerating business sector selling prices will continue to underpin top line growth in the back half of the year. Recent evidence of a slight letdown in wage inflation is welcome news for corporate sector profit margins and earnings. In fact, it will be critical for labor costs to remain tame or at least continue to trail pricing power gains, otherwise profit margins will be at risk of a squeeze. This week we are locking in gains and lifting a defensive sector to a benchmark allocation by acting on our recent upgrade alert on two of its key subcomponents. Upgrade Pharma & Biotech To Neutral... We are pulling the trigger on our recent upgrade alerts and are upgrading the S&P pharma and biotech groups to neutral from underweight, locking in relative gains of 14.5% and 13.9%, respectively since inception, and we are also removing the S&P pharma index from our high-conviction underweight list. As a reminder, we set the heavyweight S&P pharmaceuticals and S&P biotech indexes on upgrade alert, and thus the overall S&P health care sector, on May 22nd following the insight from our Special Report titled 'Portfolio Positioning For A Late Cycle Surge'. In more detail, health care stocks excel in both phases we examined - ISM peak-to-SPX peak and SPX peak-to-recession commencement (Tables 3, 4 & 5). This is largely due to the high-beta biotech sub-sector outperforming early with the more defensive pharma sub-group sustaining the outperformance following the SPX peak. Table 3Health Care Outperforms In The Late Cycle Recalibrating Recalibrating Table 4High Beta Stocks Outperform Early... Recalibrating Recalibrating Table 5...Defensive Stocks Beat Late Recalibrating Recalibrating Moreover, recent pricing power developments point to a softer than previously expected blow to drug pricing practices revealed in the President's recent speech. This is music to the ears of Big Pharma executives and can serve as a catalyst to unlock latent buying power in this traditionally considered defensive sector. While no bill has been drafted yet and we are awaiting more details, at the margin, this is a net positive for pharma and biotech top line growth at least from a cyclical perspective (Chart 4). The thesis we postulated last July was that the easy pricing power gains were behind the pharma and biotech industries and likely a secular decline in the ability of these groups to raise prices at a faster pace than overall inflation was in order (Chart 5). While this thesis remains intact from a structural perspective, in the next 9-12 months there is scope for some relief. Chart 4Overdone Cyclically... Overdone Cyclically... Overdone Cyclically... Chart 5...But Structural Issues Remain ...But Structural Issues Remain ...But Structural Issues Remain Beyond these two drivers, the trade-weighted U.S. dollar's year-to-date gains also signal that it no longer pays to be bearish this safe haven group. Chart 6 shows that relative pharma profits are positively correlated with the greenback as Big Pharma's domestically-derived earnings dwarf foreign sourced EPS. Keep in mind that the industry still dictates terms to the U.S. government, a key end-market. The opposite is true with regard to other governments around the world, especially in the key European markets, where the industry is a price taker. This partially explains the positive correlation with the currency. On the operating front, there are also signs of a bottom. Not only are pharmaceutical factories humming, but also our pharma productivity proxy (industrial production / employment) is gaining steam, underscoring that profits can surprise to the upside (second panel, Chart 7). Chart 6Appreciating Dollar Helps Appreciating Dollar Helps Appreciating Dollar Helps Chart 7Bullish Operating Metrics Bullish Operating Metrics Bullish Operating Metrics With regard to demand, pharma retail sales are expanding nicely and overall industry shipments are also rising at a healthy clip, at a time when inventories are whittled down (third and bottom panels, Chart 7). This represents a positive pharma pricing power backdrop in the coming quarters. In terms of investor and analyst sentiment, a near full capitulation has taken root. Relative share price momentum is steeply contracting close to 15%/annum, a rate that has previously coincided with cyclical troughs (second panel, Chart 4). Sell-side pessimism reigns supreme as pharma profits are slated to trail the broad market by a wide margin both for the next year and on a 3-5 year time frame. In fact, the latter just sunk to all-time lows (Chart 8). Analyst gloom is pervasive as relative top line growth expectations also call for a contraction in the coming twelve months. Valuations are as good as they get with the relative forward price-to-earnings ratio trading way below par and the historical mean (bottom panel, Chart 8). Finally, the S&P pharma and S&P biotech indexes are more alike than different, as biotech stocks have long had blockbuster billion dollar selling drugs and therefore have substantial earnings (unlike 78% of the NASDAQ biotech index that do not even have forward earnings) and are really disguised pharma outfits hiding under the biotech label. The biotech index also offers a near 2% dividend yield, on par with the SPX, but still trailing the S&P pharma index roughly by 70bps (Chart 9). As such, there is an inverse correlation of both indexes with interest rates. Not only are higher interest rates punitive to growth stocks, but also fierce competitors to fixed income proxies. The implication is that if the broad equity market reset continues for a while longer and the 10-year Treasury yield continues to fall, relative share prices will likely come out of their recent funk (Chart 10). Chart 8Full Capitulation Full Capitulation Full Capitulation Chart 9Close Siblings... Close Siblings... Close Siblings... Chart 10...That Despise Higher Rates ...That Despise Higher Rates ...That Despise Higher Rates Adding it up, five key drivers - late cycle dynamics, likelihood of pricing power regulatory relief, the rising U.S. dollar, firming operating metrics and investor and analyst capitulation- all suggest that it no longer pays to be bearish the S&P pharma and S&P biotech indexes. Bottom Line: Lock in profits of 14.5% and 13.9% in the S&P pharma and S&P biotech indexes respectively since inception and lift to a benchmark allocation. Also remove the S&P pharma group from the high-conviction underweight list. The ticker symbols for the stocks in the S&P biotech and S&P pharma indexes are: BLBG: S5BIOTX - ABBV, AMGN, GILD, CELG, BIIB, VRTX, REGN, ALXN, INCY and BLBG: S5PHAR - JNJ, PFE, MRK, BMY, AGN, LLY, ZTS, MYL, PRGO, NKTR, respectively. ...Which Lifts Health Care To A Benchmark Allocation The S&P pharma and biotech indexes command roughly a 50% weighting in the S&P health care sector. As a result, their profit fortunes are closely tied and relative share prices tend to move in lockstep (Chart 11). Today's upgrade to a benchmark allocation in both of these sub-groups also lifts the health care sector to a neutral portfolio weighting. Relative share prices have been in correction mode for the better part of the past year and may now have found support near their upward sloping long-term trend line (top panel, Chart 12). Importantly, our S&P health care EPS growth model is making an effort to trough (bottom panel, Chart 12), and if the Trump Administration does not clamp down on pharma pricing power as initially feared and recently hinted at, then overall health care sector profits will likely overwhelm. Keep in mind that the bar for upward surprises is extremely low as analysts have thrown in the towel on the sector. Similar to the S&P pharma index, health care long-term EPS growth expectations have never been lower in the history of the I/B/E/S/ data. This is contrarily positive (third panel, Chart 13). Chart 11Joined At The Hip Joined At The Hip Joined At The Hip Chart 12EPS Model Says Trough Is Near EPS Model Says Trough Is Near EPS Model Says Trough Is Near Chart 13Underappreciated And Unloved Underappreciated And Unloved Underappreciated And Unloved We would not hesitate to lift exposure further to overweight were the Trump Administration to put forth a bill with minimal damage inflicted upon drug prices, were the green back to keep on appreciating and were a steep 'risk off' phase to grip the broad equity market. Bottom Line: We are acting on our May 22nd upgrade alert and lifting the S&P health care sector to neutral, crystalizing relative profits of 5.3% since the July 31st, 2017 inception. Anastasios Avgeriou, Vice President U.S. Equity Strategy anastasios@bcaresearch.com Current Recommendations Current Trades Size And Style Views Favor value over growth Favor large over small caps

For much of the past twelve years, pharmaceutical pricing power has been a reliable predictor of the S&P pharma relative share price ratio, both to the up and down sides (top panel). In 2018, this relationship appears to be breaking down somewhat as pricing power growth has stabilized at a relatively low level but the index has continued to fall. We think a more pressing concern than falling pricing power has taken over investor's attention, namely the soaring industry leverage ratios (shown inverted on second panel). With a declining share of both domestic (third panel) and foreign (bottom panel) wallets, the sustainability of even this low level of pricing power is questionable. As such, it seems likely that leverage will get worse before it gets better; in the context of a rising interest rate environment, weak operating metrics and high financing costs all bode poorly for industry EPS growth. Stay underweight. The ticker symbols for the stocks in the S&P pharmaceuticals index are: BLBG: S5PHAR - JNJ, PFE, MRK, BMY, AGN, LLY, ZTS, MYL, PRGO. Feeling The Pain Feeling The Pain

Highlights Portfolio Strategy Synchronized global capex growth and higher interest rates are two key themes that will continue to dominate this year. Three high-conviction calls are levered to the former theme and two to the latter. A special situation completes our sextet. Reinstate the S&P construction machinery & heavy truck index to the high-conviction overweight list. We also reiterate our high-conviction underweight call in the newcomer S&P telecom services sector. Recent Changes S&P Construction Machinery & Heavy Truck - Add back to high-conviction overweight list. Table 1 Semblance Of Calm Semblance Of Calm Feature Chart 1Market Bounced Smartly Market Bounced Smartly Market Bounced Smartly Equities regained their footing last week, as volatility took a breather. There are high odds that the technical, mostly-sentiment driven, pullback that we have been flagging since January 22nd is nearly over, as the market smartly bounced off the 200-day moving average (top panel, Chart 1).1 A consolidation/absorption phase is looming and, according to our "buy the dip" cycle-on-cycle analysis, a retest of the recent lows is likely before the market gets out of the woods (please refer to Chart 1 from last week's publication). While inflation expectations, crude oil prices and financial conditions are all tightly linked with and weighing on the S&P 500 (second and third panels, Chart 1), a number of tactical high-frequency financial market indicators suggest that the cyclical SPX bull market remains intact. First, SPX e-mini futures positioning is an excellent leading indicator of market momentum, and the current message is positive (net speculative positions are advanced by 40 weeks, Chart 2). Second, bond market internal dynamics suggest that this mini "risk off" episode is an isolated one and not a precursor to a real tremor. The high yield bond ETF outperformed the long dated Treasury bond ETF (bottom panel, Chart 3). It would be unprecedented for an equity market downdraft to morph into a fully blown bear market without junk bonds sinking compared with the ultimate risk free asset. Even when adjusted for its lower duration, the high yield bond ETF remained resilient versus the 3-7 year Treasury bond ETF (top panel, Chart 3). Chart 2Futures Positioning... Futures Positioning... Futures Positioning... Chart 3...Junk Bonds... ...Junk Bonds... ...Junk Bonds... Third, the calmness in the TED spread corroborates the message from the bond market. Were a systemic risk to materialize, the TED spread should have widened and not come in as it did in the past two weeks (Chart 4). Put differently, quiet interbank markets are a healthy sign. Chart 4...And TED Spread All Flashing Green Semblance Of Calm Semblance Of Calm Finally, relative valuations have corrected not only on an absolute basis (please refer to the bottom panel of Chart 2A from last week's Report), but also controlled for equity market volatility. In fact, Chart 5 shows that both the VIX-adjusted Shiller P/E and the 12-month forward P/E have returned to the neutral zone. Meanwhile, two key macro indicators we track are also flashing green. Chart 6 shows momentum in money velocity or how fast "one unit of currency is used to purchase domestically-produced goods and services".2 Historically, velocity of M2 money stock has been positively correlated with stock market momentum. The recent spike in this indicator suggests that the longevity of the business cycle remains intact, and investors with a cyclical (9-12 month) investment horizon should start "buying the dip", as we suggested on February 8th.3 Another yield curve-type macro indicator confirms this buoyant business cycle message: real GDP growth is easily outpacing real interest rates, as per the 10-year TIPS market (Chart 7). In other words, real rates are not yet restrictive enough to choke off GDP growth, despite the recent 35bps increase. Were this spread to plunge below the zero line, it would predict recession. Thus, the recent widening underscores that recession is not imminent. Chart 5Valuations Return To Earth Valuations Return To Earth Valuations Return To Earth Chart 6Money Velocity... Money Velocity... Money Velocity... Chart 7...And Yield Curve Emit Bullish Signal ...And Yield Curve Emit Bullish Signal ...And Yield Curve Emit Bullish Signal Under such a backdrop, the upshot is that earnings will remain upbeat in 2018 and continue to underpin equity prices. This week we revisit our 2018 high-conviction call list and reinstate one sector to the overweight column. Chart 8Both Themes Remains Intact Both Themes Remains Intact Both Themes Remains Intact The Themes Two key BCA themes formed the cornerstone of our 2018 high conviction call list: Synchronized global capex upcycle Higher interest rates Last autumn, we started to articulate the synchronized global capital spending macro theme4 that, despite still flying under the radar, will likely dominate this year. Both advanced and emerging economies are simultaneously expanding gross fixed capital formation (middle panel, Chart 8). As a result, we reiterate our cyclical over defensive portfolio bent,5 and continue to tie three high-conviction overweight calls to this theme. Similarly, late last year we started to highlight BCA's U.S. Bond Strategy view of a higher 10-year yield on the back of rising inflation expectations for 2018 (bottom panel, Chart 8). Back in late-November we posited that if BCA's constructive crude oil view pans out then inflation and rates may get an added boost. Two high-conviction calls remain levered to this theme. Finally, a special situation rounds up our call this year. But before we update the call list and make a small tweak, a quick housekeeping note is in order. Taking The Tally Early this year, we added trailing stops to our high-conviction call list as a risk management tool. The goal was to help protect profits as a number of our calls were showing outsized gains for such a short time span. Our tactically souring view of the overall market also compelled us to introduce this risk management metric. As a result of the recent careening in the SPX, half of our calls got stopped out with lofty double digit gains since inception a mere two and a half months ago. Namely, our speculative underweights in the S&P semi equipment and S&P homebuilders registered gains of 20% and 10%, respectively. The high-conviction underweight in the S&P utilities sector got called at an 18% gain, and our high-conviction overweight call in the S&P construction machinery & heavy truck (CMHT) index got stopped out at the 10% mark. (Please refer to page 15 for the closed trades table). Last week we added the S&P telecom services sector as a high-conviction underweight replacing the S&P utilities sector, and now that the worst is likely behind us, we are reinstating the S&P CMHT index to the high-conviction overweight list. Anastasios Avgeriou, Vice President U.S. Equity Strategy anastasios@bcaresearch.com Construction Machinery & Heavy Truck (Overweight, Capex Theme) The capex upcycle is underpinning machinery stocks. Not only are expectations for overall capital outlays as good as they get (Chart 9), but there are also tentative signs that even the previously moribund mining and oil & gas complexes will be capex upcycle participants. While we are not calling for a return to the previous cycle's peak, even a modest renormalization of capital spending plans in these two key machinery client segments would rekindle industry sales growth. Recent news of oil majors accelerating their capex plans is a step in the right direction. This machinery end-demand improvement is not only a U.S. phenomenon, but also a global one. The middle panel of Chart 9 shows Caterpillar's global machinery sales to dealers hitting a decade high. Tack on the drubbing in the U.S. dollar and related commodity price inflation and the ingredients are in place for a global machinery export boom. While most of the countries we track enjoy a sizable rebound in machinery orders, Japan's machine tools orders have surged to an all-time high confirming that machinery global end demand is brisk (bottom panel, Chart 9). Finally, our machinery EPS model is firing on all cylinders, underscoring that the earnings-led recovery has more running room (fourth panel, Chart 9). Reinstate the S&P CMHT index to the high-conviction overweight list. The ticker symbols for the stocks in this index are: BLBG: S5CSTF - CAT, CMI, PCAR. Energy (Overweight, Capex Theme) The S&P energy sector is a key beneficiary of our synchronized global capex theme. The Dallas Fed manufacturing outlook survey is firing on all cylinders and, given the importance of oil to the state of Texas, it serves as an excellent gauge for oil activity. Importantly, the capital expenditures part of the survey hit its highest level in a decade, and capex intentions in the coming six months are also probing multi-year highs. The overall message is that the budding recovery in energy capital budgets will likely gain steam (second panel, Chart 10). Following the late-2015/early-2016 drubbing in oil prices, energy projects ground to a halt and only now are green shoots appearing (middle panel, Chart 10). Recent news that Exxon Mobil would bump domestic capital spending up to $50bn over the next five years is encouraging. New projects/investments comprise 70% of this figure. OECD oil stocks are receding steadily and so are U.S. crude oil inventories. OPEC 2.0 remains in place and will likely balance the oil market by continuing to constrain supply. Our Commodity & Energy Strategy service is still penciling in higher oil prices for 2018. On the demand side, emerging markets/Chinese demand is the key determinant of overall oil demand, and the news on this front is encouraging and consistent with BCA's synchronized global growth theme: following the recent lull, non-OECD demand is growing anew by roughly 1.5mn bbl/day. The upshot is that S&P energy relative revenues will climb out of the recent trough (bottom panel, Chart 10). The ticker symbols for the stocks in this index are: BLBG: S5ENRS - XLE: US. Chart 9Construction Machinery & Heavy Truck ##br##(Overweight, Capex Theme) Construction Machinery & Heavy Truck (Overweight, Capex Theme) Construction Machinery & Heavy Truck (Overweight, Capex Theme) Chart 10Energy (Overweight, Capex Theme) Energy (Overweight, Capex Theme) Energy (Overweight, Capex Theme) Software (Overweight, Capex Theme) The S&P software index is another clear capex upcycle beneficiary. If software commands a larger slice of the overall capital spending pie as we expect, then industry profits should enjoy a healthy rebound (second panel, Chart 11). Small business sector plans to expand keep on hitting fresh recovery highs, underscoring that software related outlays will likely follow them higher. Rebounding bank loan growth also corroborates the upbeat spending message and signals that businesses are beginning to loosen their purse strings (Chart 11). Reviving animal spirits suggest that demand for software upgrades will stay elevated. CEO confidence is pushing decade highs (middle panel, Chart 11). Such ebullience is positive for a pickup in software outlays. It has also rekindled software M&A activity, and pushed take out premia higher. Meanwhile, the structural pull from the proliferation of cloud computing and software-as-a-service has served as a catalyst to raise the profile of this more defensive and mature tech sub-sector. Tax reform is another bonus for this group that benefits from cash repatriation, which will likely result in increased shareholder friendly activities. The ticker symbols for the stocks in this index are: BLBG: S5SOFT-MSFT, ORCL, ADBE, CRM, ATVI, INTU, EA, ADSK, RHT, SYMC, SNPS, ANSS, CDNS, CTXS, CA. Banks (Overweight, Higher Interest Rates Theme) The S&P banks index remains a core overweight portfolio holding and there are high odds of additional relative gains in the coming quarters beyond the current 10% relative return mark since the November 27th, 2017 inception. All three key drivers of bank profits, namely price of credit, loan growth and credit quality, are simultaneously moving in the right direction. On the price front, BCA expects the 10-year yield will continue to rise more quickly than is discounted in the forward curve. Our U.S. bond strategists think that inflation expectations have more room to run, likely pushing the 10-year Treasury yield close to 3.25% (top panel, Chart 12). C&I and consumer loans, two large credit categories, are both forecast to reaccelerate in the coming months. The ISM remains squarely above the 50 boom/bust line and consumer confidence is still buoyant. Our credit growth model captures these positive forces and is sending an unambiguously positive message for loan reacceleration in the coming months (third panel, Chart 12). Finally, credit quality remains pristine despite some pockets of weakness in auto loans (especially subprime) and credit card debt. At this stage of the cycle, with a closed unemployment gap, NPLs will remain muted. The ticker symbols for the stocks in this index are: BLBG: S5BANKX - WFC, JPM, BAC, C, USB, PNC, BBT, STI, MTB, FITB, CFG, RF, KEY, HBAN, CMA, ZION, PBCT.  Chart 11Software (Overweight, Capex Theme) Software (Overweight, Capex Theme) Software (Overweight, Capex Theme) Chart 12Banks (Overweight, Higher Interest Rates Theme) Banks (Overweight, Higher Interest Rates Theme) Banks (Overweight, Higher Interest Rates Theme) Telecom Services (Underweight, Higher Interest Rates Theme) We downgraded the S&P telecom services index to underweight and added it to the high-conviction underweight list last week, filling the void left by the S&P utilities sector.6 Three main reasons are behind our dislike for this fixed income proxy sector: BCA's 2018 rising interest rate theme, both our Cyclical Macro Indicator (CMI) and our sales model send a distress signal, and a profit margin squeeze is looming. The top panel of Chart 13 shows that high dividend yielding telecom services stocks and the 10-year yield are nearly perfectly inversely correlated. In fact, telecom services stocks are prime beneficiaries of disinflation/deflation and vice versa. BCA's bond market view remains that the 10-year yield will continue to rise likely piercing through 3% and weigh heavily on this fixed income proxied sector. Our CMI has melted and relative consumer outlays on telecom services have also taken a nosedive (second & third panels, Chart 13), warning that revenue growth will be hard to come by for telecom carriers. In fact, while nearly all of the GICS1 sectors have come out of the top line growth lull of late-2015/early-2016, telecom services sales growth has relapsed. Worrisomely, our S&P telecom services revenue growth model remains deep in contractionary territory, waving a red flag (bottom panel, Chart 13). Finally, still steeply deflating selling prices are a major headwind for the sector's top and bottom line growth prospects and coupled with a still expanding wage bill, suggest that a profit margin squeeze is looming. The ticker symbols for the stocks in this index are: VZ, T, CTL. Pharmaceuticals (Underweight, Special Situation) Weak pricing power fundamentals, a soft spending backdrop, a depreciating U.S. dollar and deteriorating industry operating metrics will sustain downward pressure on pharma stocks. Industry selling prices remain soft (Chart 14). In the context of a bloated industry workforce, the profit margin outlook darkens significantly. If the Trump administration also manages to clamp down on the secular growth of pharma selling price inflation, as we expect, then industry margins will remain under chronic downward pressure. Our dual synchronized global economic and capex growth themes bode ill for this safe haven index. Nondiscretionary health care outlays jump in times of duress and underwhelm during expansions. Currently, the elevated ISM manufacturing index is signaling that pharma profits will underwhelm in the coming months as the most cyclical parts of the economy flex their muscles (the ISM survey is shown inverted, second panel, Chart 14). A depreciating currency is also synonymous with pharma profit sickness (bottom panel, Chart 14). While pharma exports should at least provide some top line growth relief during depreciating U.S. dollar phases, they are still contracting (middle panel, Chart 14), warning that global pharma demand is ill. Finally, even on the operating metric front, the outlook is dark. Pharma industrial production is nil and our productivity proxy remains muted, warning that the valuation derating phase is far from over. The ticker symbols for the stocks in this index are: BLBG: S5PHAR - JNJ, PFE, MRK, BMY, AGN, LLY, ZTS, MYL, PRGO. Chart 13Telecom Services ##br##(Underweight, Higher Interest Rates Theme) Telecom Services (Underweight, Higher Interest Rates Theme) Telecom Services (Underweight, Higher Interest Rates Theme) Chart 14Pharmaceuticals ##br##(Underweight, Special Situation) Pharmaceuticals (Underweight, Special Situation) Pharmaceuticals (Underweight, Special Situation) 1 Please see BCA U.S. Equity Strategy Weekly Report, "Too Good To Be True?" dated January 22, 2018, available at uses.bcaresearch.com. 2 https://fred.stlouisfed.org/series/M2V 3 Please see BCA U.S. Equity Strategy Insight, "Buy The Dip," dated February 8, 2018, available at uses.bcaresearch.com. 4 Please see BCA U.S. Equity Strategy Weekly Report, "Invincible," dated November 6, 2017, available at uses.bcaresearch.com. 5 Please see BCA U.S. Equity Strategy Special Report, "Top 5 Reasons To Favor Cyclicals Over Defensives," dated October 16, 2017, available at uses.bcaresearch.com. 6 Please see BCA U.S. Equity Strategy Weekly Report, "Manic Depressive?" dated February 12, 2018, available at uses.bcaresearch.com. Current Recommendations Current Trades Size And Style Views Favor value over growth. Stay neutral small over large caps (downgrade alert).

Highlights Portfolio Strategy Synchronized global capex growth, a derivative of BCA's synchronized global growth thesis, will be a dominant theme next year, benefiting cyclicals over defensives. Three high-conviction calls are levered to this theme. Higher interest rates on the back of a pickup in inflation expectations is another BCA theme that should materialize in 2018. Three calls focus on a selloff in the bond markets for the coming year. Two special situations round up our high-conviction calls for 2018. Recent Changes S&P Software index - Boost to overweight. S&P Homebuilding index - Downgrade to underweight. Table 1 High-Conviction Calls High-Conviction Calls Feature Equities continued to grind higher last week, largely ignoring tax bill passage jitters. The S&P 500 is on track to register an eighth consecutive month of positive monthly returns, an impressive feat. Firm global economic data suggests that the synchronized global growth theme is gaining traction and remains investors' focal point. While the 10/2 yield curve flattening is a bit unnerving, another curve to watch is the spread between 2-year yields and the Fed funds rate, or what BCA often refers to as the "Fed Spread". This spread has widened 50bps since early September closely tracking the Citi economic surprise index (Chart 1A), and signals that the U.S. economy remains on a solid footing. We would be most worried that a recession was imminent were both slopes concurrently flattening and approaching inversion (third panel, Chart 1A). Chart 1AThe 'Fed Spread'Is Right The 'Fed Spread'Is Right The 'Fed Spread'Is Right Chart 1BHigher Interest Rates Theme Higher Interest Rates Theme Higher Interest Rates Theme Moreover, credit growth has turned the corner, and the three, six and twelve month credit impulses are all simultaneously rising at a time when total loans outstanding have hit an all-time high. Importantly, credit breadth is also broad-based. Our six month impulse diffusion index shows that six out of the eight credit categories that the Fed tracks have a positive second derivative (Chart 1A). All of this suggests that, cyclically, the path of least resistance is higher for equities, especially given BCA's view of a recession hitting only in 2019. In this context, we are revealing our high-conviction calls for the next year. Most of our calls leverage two BCA themes: synchronized global capex growth (a derivative of our flagship publication's "The Bank Credit Analyst" synchronized global growth theme articulated in last week's outlook)1 and a higher interest rate theme ("The Bank Credit Analyst" expects yields to be under upward pressure in most major markets during 2018)2. Over the past few months we have been articulating the ongoing synchronized global capital spending macro theme3 that, despite still flying under the radar, will likely dominate in 2018. Table 2 on page 4 shows that both DM and EM countries are simultaneously expanding gross fixed capital formation. As a result, we reiterate our recent cyclical over defensive portfolio bent,4 and tie three high-conviction overweight calls to this theme. Table 2Synchronized Global Capex Growth High-Conviction Calls High-Conviction Calls Similarly in recent reports we have been highlighting BCA's U.S. Bond Strategy view of a higher 10-year yield on the back of rising inflation expectations for 2018. If BCA's constructive crude oil view pans out then inflation and rates may get an added boost (Chart 1B). Three high-conviction calls are levered to this theme. Finally, we have a couple of special situations, and this year we characterize two out of these eight calls as speculative. Anastasios Avgeriou, Vice President U.S. Equity Strategy anastasios@bcaresearch.com 1 Please see BCA The Bank Credit Analyst Monthly Report, "OUTLOOK 2018 Policy And The Markets: On A Collision Course," dated November 20, 2017, available at bca.bcaresearch.com. 2 Ibid. 3 Please see BCA U.S. Equity Strategy Weekly Report, "Invincible" dated November 6, 2017, available at uses.bcaresearch.com. 4 Please see BCA U.S. Equity Strategy Special Report, "Top 5 Reasons To Favor Cyclicals Over Defensives" dated October 16, 2017, available at uses.bcaresearch.com. 5 Please see BCA U.S. Bond Strategy Weekly Report, "Living With The Carry Trade" dated October 17, 2017, available at usbs.bcaresearch.com. Construction Machinery & Heavy Trucks (Overweight, Capex Theme) The capex upcycle will likely fuel the next machinery stock outperformance upleg. Not only are expectations for overall capital outlays as good as they get (Chart 2), but there are also tentative signs that even the previously moribund mining and oil & gas complexes will be capex upcycle participants. While we are not calling for a return to the previous cycle's peak, even a modest renormalization of capital spending plans (i.e. maintenance capex alone would suffice) in these two key machinery client segments would rekindle industry sales growth. A quick channel check also waves the green flag. Both machinery shipments and new orders are outpacing inventory accumulation (Chart 2). Moreover, backlogs are rebuilding at the quickest pace of the past five years (not shown). This suggests that client demand visibility is returning. This machinery end-demand improvement is a global phenomenon. In fact, the fourth panel of Chart 2 shows that global machinery new orders are climbing faster than domestic new order growth. Tack on the reaccelerating global credit impulse courtesy of the latest Bank for International Settlements Quarterly Review and the ingredients are in place for a global machinery export boom. Finally, our machinery EPS model is firing on all cylinders, underscoring that the earnings-led recovery has more running room (Chart 2). The ticker symbols for the stocks in this index are: BLBG: S5CSTF - CAT, CMI, PCAR. Chart 2S&P Construction Machinery & Heavy Trucks S&P Construction Machinery & Heavy Trucks S&P Construction Machinery & Heavy Trucks Energy (Overweight, Capex Theme) The slingshot recovery in basic resources investment - albeit from a very low base - suggests that there is more room for relative gains in the S&P energy index in the coming months (second panel, Chart 3). The U.S. dollar remains down significantly for the year and, irrespective of future moves, it should continue to goose energy sector profits owing to the positive impact on the underlying commodity. Importantly, energy producers are a levered play on oil prices and the latter have jumped roughly $14/bbl to $58/bbl or ~32% since July 10th, but energy stocks are up only 8% in absolute terms. Given BCA's still sanguine crude oil market view, we expect a significant catch up phase in energy equity prices into 2018. On the supply front, Cushing and OECD oil stocks are now contracting. As oil inventories get whittled down, OPEC stays disciplined and oil demand grinds higher, oil prices will remain well bid. The implication is that the relative share price advance is still in the early innings. Relative valuations have ticked up in the neutral zone according to our composite relative Valuation Indicator, but on a number of metrics value remains extremely compelling in the energy space. Finally, our EPS model heralds additional growth in the coming quarters on the back of solid industry pricing power and sustained global oil producer discipline. The ticker symbols for the stocks in this index are: BLBG: S5ENRS - XLE:US. Chart 3S&P Energy S&P Energy S&P Energy Software (Overweight, Capex Theme) The S&P software index is a clear capex upcycle beneficiary (Chart 4) and we recommend an upgrade to a high-conviction overweight stance today. If software commands a larger slice of the overall capital spending pie as we expect, then industry profits should enjoy a healthy rebound (second panel, Chart 4). Small business sector plans to expand have returned to a level last seen prior to the Great Recession, underscoring that software related outlays will likely follow them higher. Recovering bank loan growth is also corroborating this upbeat spending message: capital outlays on software are poised to accelerate based on rebounding bank loans. The latter signals that businesses are beginning to loosen their purse strings anew (Chart 4). Reviving animal spirits suggest that demand for software upgrades will stay elevated. CEO confidence is pushing decade highs. Such ebullience is positive for a pickup in software investments. It has also rekindled software M&A activity, with the number of industry deals jumping in recent months. Meanwhile, the structural pull from the proliferation of cloud computing and software-as-a-service has served as a catalyst to raise the profile of this more defensive and mature tech sub-sector. Finally, our newly introduced S&P software EPS model encapsulates this sanguine industry backdrop and heralds a bright profit outlook. The ticker symbols for the stocks in this index are: BLBG: S5SOFT-MSFT, ORCL, ADBE, CRM, ATVI, INTU, EA, ADSK, RHT, SYMC, SNPS, ANSS, CDNS, CTXS, CA. Chart 4S&P Software S&P Software S&P Software Banks (Overweight, Higher Interest Rates Theme) The S&P banks index is a core overweight portfolio holding and there are high odds of significant relative gains in the coming quarters. All three key drivers of bank profits, namely price of credit, loan growth and credit quality, are simultaneously moving in the right direction. On the price front, the market expects the 10-year yield to hit 2.47% in November 2018 from roughly 2.32% currently. BCA expects the 10-year yield will rise more quickly than is discounted in the forward curve. Our U.S. bond strategists think core inflation will soon resume its modest cyclical uptrend (Chart 5). A parallel recovery in the cost of inflation protection will impart 50-60 basis points of upside to the 10-year Treasury yield by the time core inflation reaches the Fed's 2% target.5 C&I and consumer loans, two large credit categories, are both forecast to reaccelerate in the coming months. The ISM has been on fire lately and consumer confidence has been following closely behind. Our credit growth model captures these positive forces and is sending an unambiguously positive message for loan reacceleration in the coming months (Chart 5). Finally, credit quality remains pristine despite some pockets of weakness in, subprime especially, auto loans. At this stage of the cycle, near or at full employment, NPLs will remain muted. The ticker symbols for the stocks in this index are: BLBG: S5BANKX - WFC, JPM, BAC, C, USB, PNC, BBT, STI, MTB, FITB, CFG, RF, KEY, HBAN, CMA, ZION, PBCT.  Chart 5S&P Banks S&P Banks S&P Banks Utilities (Underweight, Higher Interest Rates Theme) Increasing global economic growth expectations bode ill for defensive utilities stocks (global manufacturing PMI diffusion index shown inverted, top panel, Chart 6). Synchronized global economic and capex growth (second panel, Chart 6) and coordinated tightening in monetary policy spells trouble for bonds. Our U.S. Bond strategists expect a bond selloff to gain steam in 2018. Given that utilities essentially trade as a proxy for bonds, this macro backdrop leaves them vulnerable to a significant underperformance phase. Importantly, the stock-to-bond (S/B) ratio and utilities sector relative performance also has a tight inverse correlation. The implication is that downside risks remain acute. Without the support of continued declines in bond yields, or of indiscriminate capital flight from all riskier assets, utilities advances depend on improving fundamentals. The news on the domestic operating front is grim. Contracting natural gas prices, the marginal price setter for the industry, suggest that recent utilities pricing power gains are running on empty. Add on waning productivity, with labor additions handily outpacing electricity production, and the ingredients for a margin squeeze are in place. Finally, industry utilization rates are probing multi-decade lows and overcapacity is negative for pricing power. Turbine and generator inventories have been hitting all-time highs. This is a deflationary backdrop. The ticker symbols for the stocks in this index are: BLBG: S5UTIL - XLU:US. Chart 6S&P Utilities S&P Utilities S&P Utilities Pharmaceuticals (Underweight, Special Situation) Weak pricing power fundamentals, a soft spending backdrop, a depreciating U.S. dollar and deteriorating industry operating metrics will sustain downward pressure on pharma stocks in the coming year. Both in absolute terms and relative to overall PPI, pharma selling prices are steadily losing steam (Chart 7). In the context of a bloated industry workforce, the profit margin outlook darkens significantly. If the Trump administration also manages to clamp down on the secular growth of pharma selling price inflation, then industry margins will remain under chronic pressure. Moreover, our dual synchronized global economic and capex growth themes bode ill for defensive pharma stocks. Nondiscretionary health care outlays jump in times of duress and underwhelm during expansions. Currently, the soaring ISM manufacturing index is signaling that pharma profits will remain under pressure in the coming months as the most cyclical parts of the economy flex their muscles (the ISM survey is shown inverted, second panel, Chart 7). A depreciating currency is also synonymous with pharma profit sickness (bottom panel, Chart 7). While pharma exports should at least provide some top line growth relief during depreciating U.S. dollar phases, they are contracting at an accelerating pace (middle panel, Chart 7), warning that global pharma demand is ill. Finally, even on the operating metric front, the outlook is dark. Pharma industrial production is nil and our productivity proxy remains muted, warning that profits will likely underwhelm. The ticker symbols for the stocks in this index are: BLBG: S5PHAR - JNJ, PFE, MRK, BMY, AGN, LLY, ZTS, MYL, PRGO. Chart 7S&P Pharma S&P Pharma S&P Pharma Homebuilding (Speculative Underweight, Higher Interest Rates Theme) Year-to-date, the niche homebuilding index is the best performing sub-index within consumer discretionary stocks surpassing even the internet retail subgroup that AMZN is part of, and has bested the broad market by 50 percentage points. Such exuberance is unwarranted and we deem that stocks prices have run way ahead of earnings fundamentals. Worrisomely the trifecta of higher interest rates, high lumber prices and likely tax reform blues are substantial headwinds to the index's profit potential. The second panel of Chart 8 shows that if BCA's interest rate view materializes in 2018, then 30-year fixed mortgage rates will rise in tandem with the 10-year yield (assuming the spread stays intact) and cause, at the margin, some consternation to homeownership. Near all-time highs in lumber prices are also a cause for concern (bottom panel, Chart 8). Lumber is an input cost to new homes built and eats into homebuilder margins if they decide not to pass it on to the consumer. If they do add it as a surcharge to new home selling prices, then existing homes become a "cheaper" alternative, hurting new home demand. Finally, the GOP tax plan may change mortgage interest and property tax deductions, affecting largely new home owners and becoming a net negative to the homebuilding index. The ticker symbols for the stocks in this index are: BLBG: S5HOME-DHI, LEN, PHM, LEN / B. Chart 8S&P Homebuilding S&P Homebuilding S&P Homebuilding Semiconductor Equipment (Speculative Underweight, Special Situation) Semiconductor stocks in general and semi equipment in particular have gone parabolic. The latter have bested the market by 60 percentage points year-to-date, and over a two-year period the outperformance jumps to roughly 180 percentage points (top panel, Chart 9). Something has got to give, and we are putting the S&P semi equipment index on our speculative high-conviction underweight list. A global M&A frenzy and the bitcoin/ICO mania (bottom panel, Chart 9) have pushed chip equipment stocks to the stratosphere. In absolute terms this index is near the tech bubble peak, and relative share prices are following close behind (top panel, Chart 9). Worrisomely five year EPS growth forecasts recently surpassed the 25% mark, an all-time high. Both the tech sector's (in 2000) and the biotech index's (2001 and 2014) long term growth estimates hit a wall near such breakneck pace (second panel, Chart 9). This indefinite profit euphoria is unwarranted and we would lean against it. On the operating front, DRAM prices (a pricing power proxy) have tentatively peaked and so have semi sales (an industry end-demand proxy), warning that extrapolating the recent semi equipment V-shaped profit recovery far into the future is fraught with danger (third & fourth panels, Chart 9). The ticker symbols for the stocks in this index are: BLBG: S5SEEQ-AMAT, LRCX, KLC. Chart 9S&P Semis S&P Semis S&P Semis Current Recommendations Current Trades High-Conviction Calls High-Conviction Calls High-Conviction Calls High-Conviction Calls High-Conviction Calls High-Conviction Calls Size And Style Views Favor small over large caps and stay neutral growth over value.

Dear Client, Next week on November 20th instead of our regular weekly publication you will receive our flagship publication "The Bank Credit Analyst" with our annual investment outlook. Our regular publication service will resume on November 27th with our high-conviction trades for 2018. Kind Regards, Anastasios Avgeriou Highlights Portfolio Strategy Melting medical care input costs, sustainable enrollment gains and even modest tax relief would augment managed health care profits. Stay long health care insurers. Pharma and biotech stocks suffer from declining pricing power. Continue to avoid both. As a result, the S&P health care index remains in the underweight column. Recent Changes There are no changes to our portfolio this week. Table 1 Will The Market Test Powell? Will The Market Test Powell? Feature Equities consolidated recent gains as earnings season drew to a close last week. Recent election results coupled with the revealing of the Senate tax bill raised fresh concerns, unwarranted according to our geopolitical strategists, about the likelihood of a bill passage. While such heightened fiscal policy uncertainty is disquieting, solid EPS growth on the back of synchronized global economic and capex growth should sustain the overshoot phase in stocks. Q3 EPS vaulted to a fresh all-time high (Chart 1) and, were it not for two financials sector sub-indexes - reinsurers and multi-line insurers that were severely hit by the one off hurricane catastrophes - financials EPS growth would have been nil from -7.3%, pushing the overall SPX EPS number to 9.2% from 8.1%. Chart 2 shows that the positive EPS surprise factor remained close to the recent average. Going into earnings season, Q3 EPS growth forecasts collapsed to 4.1%, but actual results ended up 400bps higher. Chart 1Earnings-Led Advance Continues Earnings-Led Advance Continues Earnings-Led Advance Continues Chart 2Surprise Factor In Line With Recent Average Will The Market Test Powell? Will The Market Test Powell? While EPS growth cannot stay in the high teens forever, settling down close to 10%/annum EPS growth rate is possible in the near run. The softness in the U.S. dollar along with the basic resource sector commodity-related comeback, synchronized global economic and capex growth and financials contributing more than sell side analysts expect to overall EPS, suggest that such profit growth is attainable in 2018. Tack on the possibility of fiscal easing and sustained lift in animal spirits (bottom panel, Chart 1), and the odds of low double-digit EPS growth increase further. Meanwhile on the monetary policy front, news of Powell's nomination to take the helm at the Fed barely budged the equity market, but some cracks are appearing in the bond market (Chart 3). Keep in mind that going back to Volcker's late-1970s nomination, Fed Chair transitions have been volatile. In fact, the market has tested the resolve of all four previous Fed leaders (Chart 4). As soon as Volcker come into power he had to deal with the early-1980s recession (and the LatAm crisis in 1982) that saw the market fall by 17% from peak to trough. When Greenspan was confirmed Chairman in August of 1987, two months into his tenure Black Monday happened and he had to step in and reiterate the Fed's function as a lender of last resort. In 2006 Bernanke took over from the Maestro, and a recession hit by the end of 2007 that morphed into the Great Recession. Finally in early-2014, Yellen become the Fed Chairwoman and in late-2015 a global manufacturing recession had taken hold resulting in a 14% drawdown in the SPX. Chart 3Watching The Bond Market Watching The Bond Market Watching The Bond Market Chart 4Testing Times Testing Times Testing Times Inevitably, the market will test the new Fed Chairman. This expansion has been long in the tooth and given BCA's 2019 recession view, this testing time is at least a year away. This week we reiterate our underweight stance in a defensive sector and highlight its key sub-components. Stick With Managed Health Care Exposure Following a two year hiatus, managed health care stocks broke out in 2017 and the juggernaut has now resumed (Chart 5). While the recent unsuccessful intra-industry M&A attempts (breakdown of both AET/HUM and ANTM/CI deals) were a mild setback, CVS's latest announcement, to take over AET and further vertically integrate, has brought euphoria back to this health care subgroup. We have added alpha to our portfolio as relative performance is up smartly, roughly 24% since our early-April 2016 overweight recommendation, begging the question: Is the time ripe to lock in impressive profits and move to the sidelines or is there more upside left? Leading profit indicators suggest that more gains are in store for the relative share price ratio. After petering out in 2016, our managed care cost proxy (comprising physician and hospital services and medical care commodity inflation) has plummeted by over 350bps from the recent peak (shown inverted, second panel, Chart 5). Given that premiums are set on a trailing cost basis, profit margins should surprise to the upside, i.e. the industry's medical loss ratio has room to fall. Not only is our medical care input cost proxy melting, but the latest employment cost index release revealed that managed health care wage inflation is also steadily decelerating (third & bottom panels, Chart 6). Taken together, these two cost categories are heralding a solid industry EPS growth backdrop in the coming months (total cost proxy shown inverted, second panel, Chart 6). Chart 5Melting Costs Are A Boon To Margins... Melting Costs Are A Boon To Margins... Melting Costs Are A Boon To Margins... Chart 6...And EPS ...And EPS ...And EPS Importantly, health care insurers are also set to benefit from the Trump administration's push toward lowering drug prices and the proliferation of generic drugs. While drug inflation is positive for the pharma/biotech space, it is an expense incurred by managed care providers and vice versa. The upshot is that the pharmaceutical sector's pain will be the managed health care industry's gain (bottom panel, Chart 5). On the legislative front, the failed attempts to repeal and replace the ACA is positive as the newly enrolled will likely remain insured and underpin recurring industry revenues. As long as costs stay in check, the implication is ongoing earnings improvement. Tack on any relief related to a tax bill passage (the managed care index has a 47% effective tax rate or 24% higher than the overall S&P health care sector, see Table 2) and the path of least resistance is higher for profits. Table 2Tax Relief Potential Will The Market Test Powell? Will The Market Test Powell? Despite all of these positives, relative valuation remains muted, hovering near the neutral zone. On a forward P/E basis the S&P managed care index is trading on a par with the S&P 500 (Chart 7). If our thesis of sustained earnings outperformance materializes in the coming quarters, then a valuation re-rating phase looms. In sum, melting input costs, sustainable enrollment gains and even modest tax relief would augment managed health care profits. This is a recipe for a durable valuation expansion phase. Bottom Line: While we are underweight the broad health care index, our sole overweight remains the S&P managed health care index. The ticker symbols for the stocks in this index are: BLBG: S5MANH - UNH, AET, ANTM, CI, HUM, CNC. Ailing Pharma We downgraded pharma to an underweight stance on July 31 on the back of weak pricing power fundamentals, soft spending backdrop, a depreciating U.S. dollar and deteriorating industry operating metrics. The S&P pharmaceuticals index relative performance is down 5% since then as our bearish profit thesis is validated. Our dual synchronized global economic and capex growth themes bode ill for defensive pharmaceutical stocks. Nondiscretionary health care outlays jump in times of duress and underwhelm during expansions. Currently, the soaring ISM manufacturing index is signaling that pharma profits will remain under pressure in the coming months as the most cyclical parts of the economy flex their muscles (the ISM survey is shown inverted, middle panel, Chart 8). A depreciating currency is also synonymous with pharma profit ails (bottom panel, Chart 8). Historically, a soft U.S. dollar has been closely correlated with global growth, whereas greenback strength tends to slowdown the global economy. In that context, pharma exports should at least provide some top line growth relief during depreciating U.S. dollar phases. However, pharma exports are contracting at an accelerating pace (top panel, Chart 8) despite the U.S. dollar's year-to-date softness, warning that global pharma demand is sick. Importantly, the news on the pricing power front is disconcerting. Both in absolute terms and relative to overall PPI, pharma selling prices are steadily losing steam. In the context of a bloated industry workforce, the profit margin outlook darkens significantly (Chart 9). If the Trump administration also manages to clamp down on the secular growth of pharma selling price inflation, then industry margins will remain under chronic pressure. Worrisomely, were pharma prices to continue to trail overall corporate sector price inflation, as we expect, then the de-rating phase in the S&P pharmaceuticals index has a long ways to go (bottom panel, Chart 9). Finally, even on the operating metric front, the news is mostly grim. Pharma industrial production is nil and our pharma productivity proxy remains muted, warning that profits will likely underwhelm. Industry retail sales growth is also flirting with the zero line and pharma inventories have resumed growing on a short-term rate of change basis across the supply channel. Pharma shipments offer the only ray of hope. But the recent acceleration in the latter may be the result of the hurricane-related catastrophes (Chart 10). Chart 8Counter Cyclical With##br## No Export Relief Counter Cyclical With No Export Relief Counter Cyclical With No Export Relief Chart 9Weak Pricing Power And Bloated##br## Cost Structure Weighs On Margins Weak Pricing Power And Bloated Cost Structure Weighs On Margins Weak Pricing Power And Bloated Cost Structure Weighs On Margins Chart 10Operating Metrics ##br##Are Also Feeble Operating Metrics Are Also Feeble Operating Metrics Are Also Feeble Netting it out, pharma profit growth is on track to continue to disappoint as the confluence of synchronized global growth, softening U.S. dollar, pricing power losses and deteriorating operating metrics are all profit headwinds. Bottom Line: We reiterate our late-July downgrade in the S&P pharma index to underweight. The ticker symbols for the stocks in this index are: BLBG: S5PHAR - JNJ, PFE, MRK, BMY, AGN, LLY, ZTS, MYL, PRGO. A Few Words On Biotech Biotech stocks are another casualty of weakening pharmaceutical wholesale price inflation, and given that the industry's profits move neck-and-neck with their pharma siblings, revenue and EPS growth are bound to continue to surprise to the downside (Chart 11). We expect such profit woes will weigh on the S&P biotech index relative performance, and re-iterate our high-conviction underweight status. Chart 11Biotech Equities Hate Higher Rates Biotech Equities Hate Higher Rates Biotech Equities Hate Higher Rates Chart 12Technicals Say Sell Technicals Say Sell Technicals Say Sell Not only are biotech firms modestly concealed Big Pharma, i.e. they manufacture multi-billion dollar blockbuster drugs, and the Trump administration's scrutiny of drug price inflation is a profit negative, but also a rising interest rate backdrop is working against this health care sub-index. Historically, rising interest rates have been inversely correlated with biotech stocks. High flying valuations tend to gravitate back to earth when the Fed embarks on a tightening cycle. The opposite is also true. BCA's U.S. Bond Strategy view remains that in the coming 12 months interest rates will be higher, moving closer to the 3% mark on the 10-year Treasury yield front. If such a selloff materializes in the bond market, then investors will abandon biotech stocks in a heartbeat (Chart 11). Chart 13Heed The EPS Growth Model Signal Heed The EPS Growth Model Signal Heed The EPS Growth Model Signal Meanwhile, according to empirical evidence since the mid-1990s, relative momentum in biotech stocks is nearly perfectly inversely correlated with the global credit impulse (Chart 11). This negative correlation has become more pronounced in the past decade underscoring the non-discretionary/defensive nature of large biotech outfits. In other words biotech stocks behave like counter-cyclicals similar to their pharma brethren. Given BCA's view of a recession hitting some time in 2019, we recommend investors still avoid biotech stocks. Finally, technicals are also waving a red flag. Chart 12 shows that a head-and-shoulders formation has taken root and were the neckline to give way in the coming weeks, relative performance would suffer a substantial setback. Bottom Line: Biotech stocks remain a high-conviction underweight. The ticker symbols for the stocks in this index are: BLBG: S5BIOTX - ABBV, AMGN, GILD, CELG, BIIB, VRTX, REGN, ALXN, INCY. Health Care Sector Implications What does all this mean for the broad S&P health care sector? Our relative profit growth model best encapsulates these forces and is signaling that profits will remain downbeat into 2018 (Chart 13). Managed health care stocks (overweight) comprise 13% of the index, while pharma (underweight) and biotech (underweight) market capitalization weights both add up to 54% of the total. As a result of our intra-sector positioning and given our neutral weightings in the remaining health care sub-indexes, we continue to recommend a below benchmark allocation in the S&P health care index. Bottom Line: Stay underweight the S&P health care sector. Anastasios Avgeriou, Vice President U.S. Equity Strategy anastasios@bcaresearch.com Current Recommendations Current Trades Size And Style Views Favor small over large caps and stay neutral growth over value.

Pharma stock profits have moved in lockstep with consumer spending on pharmaceuticals and both have roughly doubled over the past decade. However, relative pharma consumer outlays have crested recently, causing a significant pharma profit underperformance (third panel). If our cautious drug pricing power thesis pans out as we portrayed in this week's Weekly Report, then pharma earnings will suffer and exert downward pressure on relative share prices (top panel). Industry balance sheet deterioration represents another warning signal. Net debt/EBITDA is skyrocketing at a time when the broad non-financial corporate (NFC) sector has been in balance sheet rebuilding mode (bottom panel). While this metric does not suggest that pharma stocks are in deep financial trouble, the deterioration in finances is undeniable, and, at the margin, a rising interest rate backdrop will likely slow down debt issuance for equity retirement and dividend payout purposes. Bottom Line: Trim the S&P pharmaceuticals index to underweight, which takes the S&P health care index to underweight. For additional details, please see yesterday's Weekly Report. The ticker symbols for the stocks in the S&P pharmaceuticals index are: BLBG: S5PHAR - JNJ, PFE, MRK, BMY, AGN, LLY, ZTS, MYL, PRGO. A Tough Pill To Swallow A Tough Pill To Swallow