Pharmaceuticals

Highlights Portfolio Strategy Factors are falling into place for an earnings-led underperformance phase in health care stocks. Trim to a below benchmark allocation and execute this downgrade via reducing the heavyweight S&P pharmaceuticals index to a below benchmark allocation. The bearish S&P telecom services narrative is more than discounted in ultra-depressed relative valuations on cyclically quashed profit estimates. Lift to neutral. Recent Changes S&P Health Care - Downgrade to underweight. S&P Pharmaceuticals - Trim to underweight. S&P Telecom Services - Lift to neutral, lock in gains of 12%. Table 1 Growth Trumps Liquidity Growth Trumps Liquidity Feature Equities stayed well bid last week, trading near all-time highs. Broad-based earnings exuberance buttressed stock prices, trumping political uncertainty. The Fed stood pat and signaled a likely September commencement to a balance sheet wind down. Our fixed income strategists do not expect another hike until the December meeting; a less hawkish Fed augments the goldilocks equities backdrop. Three weeks ago1 we posited that earnings will take center stage and serve as a catalyst to sustain the blow off phase in the S&P 500. A mini profit margin expansion phase is taking root as the most cyclical parts of the SPX are flexing their operating leverage muscle. As long as revenues continue to grow, profit margins and profits will expand, especially given muted wage pressures. The lagged effect from a softening U.S. dollar will also likely underpin EPS in the back half of the year. We are surprised that mentions of the greenback are virtually absent from Q2 conference calls; the domestic market appears front of mind for investors and management teams alike. Globally, the dominant market theme is synchronized global growth paving the way to a coordinated G10 Central Bank tightening cycle. In other words, there is a handoff from liquidity to growth. Charts 1 & 2 highlight this fertile equity backdrop: First BCA's Synchronicity Indicator is as good as it gets. In fact in the G20, only Indonesia and South Africa have a manufacturing PMI below the boom/bust line. Second, our global EPS diffusion index is also at an extreme (diffusion index shown inverted, middle panel, Chart 1). In our sample of 44 EM and DM countries, none have declining year-over-year EPS. Third, global export expectations are recovering smartly, suggesting that global trade is on a solid footing and on track to vault to fresh cyclical highs (bottom panel Chart 2). Chart 1Synchronized Global Growth... Synchronized Global Growth… Synchronized Global Growth… Chart 2...Is Bullish For Equities ...Is Bullish For Equities ...Is Bullish For Equities While the IMF recently downplayed the U.S.'s importance as a force in global GDP growth contribution, the resurgent ISM new orders-to-inventories ratio signals that U.S. output will recover in the back half of 2017 (second panel, Chart 2). Importantly, not only are cyclical U.S. businesses vibrant but also the most cyclical corner of U.S. PCE is roaring. As consumers are feeling more flush, they tend to spend more on recreational goods and vice versa. According to the BEA, recreational goods & vehicles outlays are expanding at the fastest clip since 2005, near 10% and 15% per annum in nominal and real terms, respectively. Since 1960, this nominal series has been an excellent predictor of the business cycle. Such discretionary outlays have also been moving in tandem with overall nominal PCE growth, easily surpassing it during expansions, and significantly trailing it in times of distress (Chart 3). Currently, recreational goods spending underscores that overall PCE will likely rebound in the coming quarters. Chart 3The U.S. Consumer Is Alright The U.S. Consumer Is Alright The U.S. Consumer Is Alright Resurgent global (including U.S.) growth is unambiguously bullish for U.S. equities. This week we are taking down our overall defensive sector exposure another notch by making an intra-defensive sector switch. Health Care: In The ER The health care reform circus is ongoing in Washington, and such uncertainty will likely cast a shadow on health care stocks and reverse recent euphoria. Year-to-date health care stocks have bested the broad market by over 7%, and have retraced roughly 1/3 of the relative losses from the mid-2016 peak to the end-2016 trough. Technicals are extended, with the six month momentum stalling near the upper band of the past eight year range, and breadth is as good as it gets: 70% of health care sub-groups trade above their 40-week moving average (Chart 4). We are using this opportunity to lighten up exposure on this defensive sector and downgrade to a below benchmark allocation. Drug inflation is the biggest risk for the sector. Relative pricing power contracted for the first time in seven years (top panel, Chart 5), warning that the health care top line contraction phase is far from over. This stands in marked contrast to the broad corporate sector that is growing revenues at a healthy clip. Chart 4Sell Into Strength Sell Into Strength Sell Into Strength Chart 5Selling Price Pressures Blues Selling Price Pressures Blues Selling Price Pressures Blues While investors appear content to look through this recent weakness as transitory, our sense is that robust pricing power gains of the past are history. Chart 6 shows that since 1982 drug prices have risen fivefold. In fact, since 2011 they have gone parabolic outpacing overall wholesale price inflation by 50%. Importantly, health care sector profits have skyrocketed alongside drug inflation (bottom panel, Chart 6). Such a breakneck pace is unsustainable, especially given recent intense drug price hike scrutiny. Granted, health care spending in the U.S. comprises over 17% of overall consumer outlays, the highest in the world, but it has also likely plateaued (not shown). Real health care spending is decelerating in absolute terms, and contracting compared with overall PCE. This suggests that selling price blues are demand driven and will likely continue to weigh on health care profits (second & third panels, Chart 7). Chart 6Unsustainable Pace Unsustainable Pace Unsustainable Pace Chart 7Even Demand Is Easing Even Demand Is Easing Even Demand Is Easing Worrisomely, there is no positive offset from international markets. The U.S. dollar has depreciated since the mid-December peak, but health care export growth is hovering around the zero line (bottom panel, Chart 7). News is also grim on the domestic operating front. Not only are selling prices softening, but also our health care sector wage bill is on fire, pushing multi-year highs. Taken together, operating margins will continue to compress, sustaining the recent down drift (Chart 8). Our newly introduced S&P health care sector profit model does an excellent job in capturing all of these forces. Currently, our relative EPS model suggests that the relative profit contraction phase will last into 2018 (Chart 9). Chart 8Margin Trouble Margin Trouble Margin Trouble Chart 9Heed The Model's Message Heed The Model’s Message Heed The Model’s Message Factors are falling into place for an earnings led underperformance phase in health care stocks. Downgrade to a below benchmark allocation. We are executing the health care sector downgrade via the heavyweight S&P pharmaceuticals index. Trim Pharma To Underweight Pharma stock profits have moved in lockstep with consumer spending on pharmaceuticals since the mid-1970s, and both have roughly doubled over the past decade (top panel, Chart 10). However, relative pharma consumer outlays have crested recently, causing a significant pharma profit underperformance (bottom panel, Chart 10). Is it also notable that relative spending on pharma soars in times of recession, highlighting the non-discretionary aspect of health care spending. If our cautious drug pricing power thesis pans out as we portrayed above, then pharma earnings will suffer and exert downward pressure on relative share prices (Chart 11). Similarly, BCA's view remains that recession is a 2019 story, thus a knee jerk spike in relative pharma spending and relative EPS is unlikely on a cyclical horizon. Chart 10Cresting Cresting Cresting Chart 11Soft Prices Are Bearish Soft Prices Are Bearish Soft Prices Are Bearish We doubt capital will chase this long duration group with a stable cash flow profile, especially in a synchronized global growth world. The missing ingredient is consumer price inflation, but the depreciating U.S. dollar suggests that the recent disinflationary backdrop will prove transitory. The NFIB survey of small business planned price hikes is still flirting with cyclical highs (shown inverted, middle panel, Chart 12). That helps explain the positive correlation between the greenback and relative pharma profit estimates. Synchronized global growth is giving way to a coordinated tightening Central Bank (CB) backdrop with G10 CBs taking cover now that the Fed has paved the way. As a result, the U.S. dollar may continue to grind lower, to the benefit of cyclical sectors but detriment of defensives such as pharmaceutical stocks (bottom panel, Chart 12). Worrisomely, the export relief valve has not provided any significant offsets, despite the currency's year-to-date losses (top panel, Chart 12). Taking a closer look at domestic operating conditions is revealing. Not only are relative outlays steadily sinking but pharmaceutical production is contracting. True, whittled down inventories partially explain the letdown in industry output, but contrast the climbing pharma labor footprint. The implication is that declining productivity will continue to weigh on relative valuations (Chart 13). Finally, 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 (middle panel, Chart 14). Similarly, the pharma interest coverage ratio continues to slide, moving in the opposite direction of the NFC sector (bottom panel, Chart 14). While neither of these metrics 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. Chart 12No Export Relief No Export Relief No Export Relief Chart 13Waning Productivity Waning Productivity Waning Productivity Chart 14Modest B/S Deterioration Modest B/S Deterioration Modest B/S Deterioration Bottom Line: Downgrade the S&P health care index to underweight. Trim the S&P pharmaceuticals index to 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. Book Profits And Upgrade Telecom Services To Neutral Investors have shunned telecom services stocks vehemently year-to-date (YTD) on the back of an abysmal profit showing. Telecom services stocks are down 9%, while the S&P is up 10% YTD. In fact, in Q1 telecom services stocks were the sole sector to register negative year-over-year EPS growth on trough Q1/2016 earnings comparisons. In Q2, it remains at the bottom of the GICS1 sector EPS growth table, trailing the SPX by 500bps. We have been fortunate enough to be underweight this niche sector since late January, adding alpha to our portfolio. Nevertheless, we do not want to overstay our welcome and are booking profits of 12% and lifting the S&P telecom services sector to the neutral column. Relative valuations just breached the one standard deviation below the mean mark according to our Valuation Indicator (VI), signaling that indiscriminate selling is overdone and nearly exhausted. Historically, such a depressed VI reading has led to a playable reversal. Importantly, the relative forward P/E multiple has fallen below the lows hit in the aftermath of the TMT bubble and is clocking all-time lows. Tack on washed out technicals probing a collapse close to two standard deviations below the long-term average and a reflex rebound is likely in the short-term (Chart 15). Extreme bearishness reigns in the sell-side community. Five year forward profit estimates plumbed all-time lows at a 10% decline rate versus the broad market (Chart 16). Surely the bearish story is baked into such glum readings. Chart 15Washed Out Washed Out Washed Out Chart 16Too Much Pessimism Too Much Pessimism Too Much Pessimism Meanwhile, our Cyclical Macro Indicator has arrested its fall giving us comfort that at least a lateral move in relative share prices is likely in coming months (second panel, Chart 15). The steep recalibration of cost structures to the new pricing reality is buttressing our CMI, offsetting the sector's plummeting share of the consumer's wallet (Chart 17). Encouragingly, selling prices cannot contract at 10% per annum indefinitely, and on a three month-rate of change basis, pricing power has staged a V-shaped recovery (Chart 18). Anecdotally, Verizon's first full quarter post the new pricing plans was solid and suggests that the peak deflationary impulse is likely behind the industry. Chart 17Freefalling Freefalling Freefalling Chart 18There Is A Ray Of Light There Is A Ray Of Light There Is A Ray Of Light Impressive labor cost discipline along with even a modest pricing power rebound signal that a grinding higher margin backdrop is likely in the coming months, in line with our margin proxy reading. This will also stabilize relative profitability (top and bottom panels, Chart 18). While this sector trades as a fixed income proxy and the recent sell off in the bond market has weighed on relative performance, yield hungry and value investors will start bottom fishing in these stable cash flow, high dividend yielding stocks. However, we refrain from becoming overly bullish. Pricing power is still contracting and the cable industry's veering into wireless phone plan offerings has yet to play out. A more constructive sector view would require the following two developments: a trough in our sales model on the back of firming pricing power and a leveling off in relative consumer outlays signaling that demand for telecom services is on the mend. In sum, the bearish S&P telecom services narrative is more than discounted in ultra-depressed relative valuations on cyclically quashed profit estimates. Green shoots on the industry's pricing power front and impressive management focus on cost structures argue against being bearish this niche sector. Bottom Line: Lock in gains of 12% in the S&P telecom services sector and lift exposure to neutral. The ticker symbols for the stocks in this index are: T, VZ, LVLT, CTL. Anastasios Avgeriou, Vice President U.S. Equity Strategy & Global Alpha Sector Strategy anastasios@bcaresearch.com 1 Please see BCA U.S. Equity Strategy Weekly Report, "SPX 3,000?" dated July 10, 2017, 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 Portfolio Strategy Contrary to popular perception, non-cyclical sectors have led the market so far this year, while deep cyclical sectors are breaking down, in relative performance terms. Our models point to more of the same ahead. The oversold rebound in the pharmaceutical group may soon run into resistance so we recommend trimming positions to neutral. Put the proceeds into restaurants, a quasi-defensive group that enjoys a brightening sales outlook without pharma's political and regulatory risk. Recent Changes S&P Pharmaceuticals - Downgrade to neutral. S&P Restaurants - Upgrade to overweight. Table 1 Reading The Market's Messages Reading The Market's Messages Feature Equities are exhibiting signs of mild fatigue. Breadth has begun to narrow, and new highs have sagged compared with new lows (Chart 1). Both of these technical developments have warned of previous tactical pullbacks. The recent reset in oil prices may also test investor nerves. Oil prices have been a critical macro variable, because they influence inflation expectations and the corporate bond market (high yield bond spreads shown inverted, Chart 1). Crude oil price corrections have accurately timed equity retreats (Chart 1), and general risk aversion phases. To be sure, the global economy is no longer on a deflationary precipice, suggesting that weaker oil prices may not foreshadow a soft patch, but they may be a good enough excuse for profit taking in the equity market after a good run. Contrary to popular perception, cyclical sectors have not led the broad market so far in 2017. In fact, energy, materials and industrials have all broken down in relative performance terms (Chart 2), after peaking in mid-December. Only the technology sector has stayed resilient. Chart 1Short-Term Fatigue Short-Term Fatigue Short-Term Fatigue Chart 2Cyclicals Have Broken Down Cyclicals Have Broken Down Cyclicals Have Broken Down Chart 3Overshoot Renormalization Overshoot Renormalization Overshoot Renormalization Insipid cyclical sector performance has occurred within the context of a synchronized lift in global economic growth and recovering corporate sector pricing power. So why are cyclical sectors lagging? It may simply be a digestion phase. However, a different interpretation is that a number of key macro factors fail to confirm the durability of last year's outperformance, suggesting that defensive outperformance could last. Concerns that the current global inventory cycle may not morph into a broad-based upturn in global final demand continue to linger: the global credit impulse remains anemic, the Fed and China are tightening monetary policy and commodity markets are cracking (Chart 3). The lack of any meaningful improvement in Chinese loan demand signals that the economy may be quick to cool as the authorities tap the breaks on credit growth. It would take a decisive depreciation in the U.S. dollar to boost the relative profit fortunes of capital spending-dependent cyclical sectors on a sustainable basis. On a more positive note, the Fed's benign forward guidance last week bears close attention. If the U.S. dollar loses upside support, particularly with the ECB contemplating a retreat from full throttle easing, it could change the investment landscape. By reminding markets that their inflation target is symmetric, the Fed signaled it will be willing to tolerate a modest inflation overshoot, which is positive for risk assets in the short run. A softer U.S. dollar would take the pressure off of developing countries, support commodity prices, and bolster our cyclical sector sales models and Cyclical Macro Indicators. However, Chart 4 shows that the objective message from our models remains consistent with continued defensive sector outperformance. With a more protectionist U.S. Administration, we remain reluctant to position exclusively for a much weaker dollar. The ongoing underperformance of emerging market equities relative to U.S. and global benchmarks reinforces that foreign-sourced profit growth continues to lag (Chart 5). Positioning for cyclical sector earnings outperformance requires healthier profits abroad, to spur a new capital investment cycle. Chart 4Heeding The Message From Our Models... Heeding The Message From Our Models... Heeding The Message From Our Models... Chart 5... And The Markets ... And The Markets ... And The Markets We will look to selectively add cyclical exposure when the objective message from our Indicators provides confirmation that earnings-driven outperformance lies ahead. At the moment, there is no such confirmation. In fact, the elevated reading in the SKEW index continues to signal that a defensive posture will optimize portfolio performance (Chart 5). In sum, we continue to characterize the broad market's current momentum as an overshoot phase, with additional technical upside potential, but the rally is starting to fray around the edges. In this environment, holding a mostly defensive basket with selective beta exposure is still recommended. Importantly, within the defensive universe, there are tweaks to be made, especially if the U.S. dollar stops rising. Fade The Pharmaceuticals Rebound Health care has been the second strongest of the eleven broad sectors year-to-date, contrary to popular perception. That is in line with the flattening yield curve, cresting in inflation expectations and a modest correction in oil prices (Chart 6), all of which have revived the allure of non-cyclical sectors. Moreover, our Cyclical Macro Indicator (CMI) for the health care sector remains firm, supported by the ongoing large pricing power advantage. Relative value is the most attractive it has been in five years. While the latter provides little timing help, it indicates low risk, especially with technical conditions still deeply oversold (Chart 7). Chart 6Health Care Is Storming Back Health Care Is Storming Back Health Care Is Storming Back Chart 7Still Cheap And Oversold Still Cheap And Oversold Still Cheap And Oversold The heavyweight pharmaceutical group has led the sector's tactical charge, recouping the ground lost, in relative performance terms, leading up to the U.S. election. While we were caught off guard by the severity of the pullback last September/October, we refrained from selling into an oversold market and noted our intention to lighten positions whenever the inevitable relief rally occurred. The time has come to execute on this thesis. Pharmaceutical stocks are very cheap and have discounted a hostile regulatory environment. The relative forward P/E is well below its historic mean, even though both 12-month and 5-year relative forward earnings growth expectations are depressed (Chart 8). Typically, the latter would serve to artificially inflate valuations. These conditions exist even though free cash flow growth remains strong; merger activity has been solid, albeit ebbing in recent months; and companies have used excess capital to reduce total shares outstanding (Chart 8). In other words, relative forward earnings would have to decline substantially to validate these expectations. Is this plausible? Much depends on the regulatory environment. While details of the U.S. Administration's proposal to replace the Affordable Care Act have started to leak out, final details are still elusive and legislative action is not imminent. So far, it appears as if a worst case scenario would see an increase in the number of uninsured Americans, with a rising cost of insurance (to the benefit of managed care companies). According to the Department of Health & Human Services, the uninsured rate of the U.S. population nearly halved from 16% in 2010 to 9% in 2015. That led to a lift in the number of procedures performed and bolstered hospital bottom lines. Hospitals are a major pharmaceutical buying group. Higher utilization rates fed increased pharmaceutical demand for a number of years. However, drug spending growth has dropped off, and if the legion of uninsured patients rises anew in the coming years, then hospital utilization rates will decline, taking drug consumption growth down with it. Moreover, Trump wants to streamline the FDA's approval process, which would ultimately boost the number of high margin new drugs coming to market. Drug stocks boomed back in the mid-1990s, the last time FDA approval rates accelerated meaningfully (Chart 9). Chart 8Full Capitulation Full Capitulation Full Capitulation Chart 9Full Capitulation Full Capitulation Full Capitulation But at the same time, if government is given leeway to negotiate drug prices directly with drug companies, then pricing power will continue to converge down toward overall corporate sector pricing power, especially if drug consumption rates ease (Chart 9). At the moment, drug consumption growth remains above the rate of overall consumption growth, but that is much slower than during the boom following the introduction of the Affordable Care Act. Retail sales at pharmacies are growing robustly, and hospitals are still adding staff, signaling that they continue to position for expansion, i.e. rising procedure volumes (Chart 10). On the downside, the strong U.S. dollar is a big drag on top-line growth. Drug imports exceed exports by a wide margin, resulting in a negative trade balance and a drag on U.S. drug company profits, all else equal. The combination of a sales growth deceleration and adequate channel inventories has capped drug output growth (Chart 10). That is a productivity and profit margin headwind. Against this background, the industry will need an external assist to deliver profit outperformance. Relative profit estimates rise when disinflationary forces reign supreme, as measured by the NFIB planned price hikes series (shown inverted, Chart 11). This measure of future corporate pricing power intentions has rolled over, but broader measures of inflation are creeping higher. Ergo, drug earnings forecasts may be challenged to keep pace with the overall corporate sector. Chart 10... But Growth Rates Are Slowing ... But Growth Rates Are Slowing ... But Growth Rates Are Slowing Chart 11Mixed Signals Mixed Signals Mixed Signals The good news is that even though U.S. dollar strength is an export drag, the negative drug trade balance suggests that it will hurt other industries more. Indeed, a rising currency often coincides with profit outperformance (Chart 11). There is not enough evidence that exogenous factors will offset slowing domestic drug consumption growth. In all, the case for a further and sustained relative performance recovery has weakened, and we are taking advantage of this year's oversold bounce to move to the sidelines. Bottom Line: Trim the S&P pharmaceuticals index to neutral. This position was deep in the money initially, but last year's downdraft pushed it into a loss position of 10%. BLBG: S5PHARX-JNJ, PFE, MRK, BMY, LLY, AGN, ZTS, MYL, PRGO, MNK. Restaurants: Increasing Appetite The broad consumer discretionary sector has been treading water, largely owing to fears that a border adjustment tax (BAT) will undermine the retailing sub-component. This consolidation has restored value and created an attractive technical entry point (Chart 12, bottom panel). Importantly, industry earnings fundamentals are on the upswing. Our consumer discretionary sector Cyclical Macro Indicator has perked up (Chart 12), supported by an increase in wages, and more recently, the decline in oil prices. The latter is freeing up disposable income, which consumers have an incentive to spend given that household net worth (HNW) has climbed to all-time highs as a percent of disposable income (Chart 13). Chart 12A Good Place To Shop A Good Place To Shop A Good Place To Shop Chart 13Piggyback The Wealth Effect Piggyback The Wealth Effect Piggyback The Wealth Effect While we remain overweight housing related equities (homebuilders and home improvement retailers) in addition to our upbeat view on the media and advertising complex, a buying opportunity has surfaced in the neglected S&P restaurants index. We booked gains on an underweight position and lifted exposure to neutral back in late-October. Since then, value has improved further, while leading sales indicators continue to firm. Stronger consumer finances should flow into the casual dining industry. Sales have already started to reaccelerate, and should climb further based on the leading message from HNW (Chart 14). The lower income, $15K-$35K, cohort is also feeling increasingly confident, according to the latest Conference Board survey data (Chart 14). Meanwhile, the National Association of Restaurants Performance Index has regained momentum (Chart 15), signaling increased activity and rising confidence among restaurateurs. While the gap between the cost of dining out and dining in remains wide, it has begun to narrow, which is a plus for store traffic, all else equal. Chart 14Buy Into Weakness Buy Into Weakness Buy Into Weakness Chart 15At A Turning Point Domestically... At A Turning Point Domestically... At A Turning Point Domestically... Chart 16... And Globally? ... And Globally? ... And Globally? Our restaurants profit margin proxy (comprising restaurants CPI versus a blend of the industry's wage bill and food commodity costs) is trending higher. That is notable because it has a good track record in leading relative earnings growth estimates (Chart 15). Nevertheless, it is not all good news. International exposure remains a headache. Typically, soft EM currencies warn of translation drags on foreign sourced revenue (Chart 16). This cycle, there is an offset, as EM interest rates have come down, which is a plus for domestic demand (Chart 16). Thus, the headwind from outside the U.S. should abate as the year progresses. Adding it all up, factors are falling into place for a playable rally in the under-owned and unloved S&P restaurants index. This group offers attractive quasi-cyclical defensive exposure to replace the S&P pharmaceuticals index, without the political and regulatory risks. Bottom Line: Redeploy funds from the pharma downgrade and boost the S&P restaurants index to overweight. BLBG: S5REST-MCD, YUM, CMG, SBUX, DRI. Current Recommendations Current Trades Size And Style Views Favor small over large caps. Favor growth over value (downgrade alert).

Highlights Portfolio Strategy Bank profits are unlikely to match those of the broad market if the Fed hikes interest rates and loan demand cools. Sell into strength. Gold shares are looking increasingly attractive, but we will refrain from upgrading until the U.S. dollar is closer to a peak. Drug pricing power is worse than government data suggests, warranting a downshift in our previously upbeat view toward pharmaceutical equities. Recent Changes S&P Health Care - Removed from our high conviction list. Upgrade Alert Gold Shares - Currently neutral. Downgrade Alert S&P Pharmaceuticals Index - Currently overweight. S&P Biotech Index - Currently overweight. Table 1 Wobbly Markets Wobbly Markets Feature Chart 1From Greed To Fear bca.uses_wr_2016_11_07_c1 bca.uses_wr_2016_11_07_c1 The gaping mismatch between fundamentals and broad market valuations remains intact, but will be in jeopardy of re-converging should the Fed signal an intention to tighten monetary conditions through next year. As previously outlined, our view is that the economy, particularly the corporate sector, will struggle further if financial conditions become more restrictive and/or election uncertainty persists. Indeed, investors have been scrambling to buy protection, aggressively bidding up near-term VIX contracts, especially relative to longer-term contracts. While it is tempting to view this increase in fear as a contrary positive, this measure typically sinks lower when investors turn cautious. Chart 1 shows that tactical broad market vulnerability still exists. On a more fundamental basis, the non-financial corporate sector's return on equity has already fallen to its lowest level in more than 60 years (Chart 2). Yet the median price/sales and price/earnings ratios are flirting with all-time highs (Chart 2). That divergence is not sustainable, given the direct link between ROE, profit growth and valuations. Central bank benevolence has underwritten this gap. Third quarter earnings have failed to impress thus far, keeping the equity market locked in a tight range. So far, one nascent trend is that domestic and consumer-linked equities appear to be gaining traction at the expense of global, business-dependent sectors. We expect the complexion of earnings contributions to become more lopsided in the quarters ahead, in support of most of these budding trend changes. The inevitable upshot of a strong U.S. dollar is deteriorating profit breadth. Chart 3 shows that the number of industry groups experiencing rising forward earnings estimates is likely to erode as the currency strengthens. Clearly, industries most reliant on exports and/or capital spending are most vulnerable. The corporate sector has run up debt levels and is struggling to generate profit growth. In turn, business spending has been compromised, as measured by the contraction in core durable goods orders (Chart 3). On the flipside, consumers have rebuilt their savings and are enjoying the benefits of a positive wealth effect. The increase in real wage and salary growth is underpinning real median household income. The latter surged 5.2%, posting the largest percentage increase in the history of the data. Consumer income expectations are well supported (Chart 3, top panel). The implication is that consumption-oriented plays should be well positioned to deliver profit outperformance, even if the labor market slows. From an investment theme perspective, the upshot is domestic-oriented areas are poised to make a comeback relative to globally-exposed sectors after a burst of speed in recent months (Chart 4). Net earnings revisions are already shifting in that direction, with more upside ahead based on U.S. dollar strength, as well as dirt cheap relative valuations (Chart 4). Chart 2A Disturbing Mismatch A Disturbing Mismatch A Disturbing Mismatch Chart 3Consumers Are Stronger Than Corporates bca.uses_wr_2016_11_07_c3 bca.uses_wr_2016_11_07_c3 Chart 4Favor Domestic Vs. Global bca.uses_wr_2016_11_07_c4 bca.uses_wr_2016_11_07_c4 One exception is the banking sector, where there is limited scope for earnings outperformance and/or valuation expansion. Bank Stocks Are Showing Signs Of Life, But... Bank stocks have moved higher, following the sell-off in global bond markets and steepening in yield curves sparked initially by the Bank of Japan's curve targeting shift and a reversal of incremental easing expectations from the Bank of England. However, we are not convinced that the relative performance bear market is over. A Special Report published on October 3 surveyed the performance of banks during Fed tightening cycles, to help put context around the widely held view that Fed rate hikes will bolster bank stocks on a sustained basis. History shows there has been only a loose relationship between the Fed funds rate and net interest margins. It would take rising rate expectations within the context of a steeper yield curve, improving credit quality and rapid loan growth to justify an optimistic profit outlook. Bank profits have not been able to outpace the broad corporate sector since the beginning of 2015 (Chart 5, top panel), even though loan growth has been healthy and overall earnings were crushed by the implosion in commodity prices during that period, allowing most other sectors to show earnings outperformance. Will another 25 bps interest rate hike remedy this? The Fed is keen to hike rates partially because it views them as being overly accommodative for an economy operating close to full employment, and is keen to reestablish firepower in advance of the next economic downturn. But there is scant evidence of economic overheating to support the view that rates have been 'too low'. Inflation and inflation expectations, while up from very depressed levels, are still historically low and the economy is struggling to grow at, let alone above, trend. Consequently, a strident Fed would boost the odds of a policy mistake. The market appears to share that view, given the failure of the yield curve to stop narrowing since the taper talk started, notwithstanding the recent blip up (Chart 5, bottom panel). Chart 5Why Would Bank Profits Outperform Now? bca.uses_wr_2016_11_07_c5 bca.uses_wr_2016_11_07_c5 Chart 6Beware U.S. Dollar Strength bca.uses_wr_2016_11_07_c6 bca.uses_wr_2016_11_07_c6 Now that the USD is strengthening anew, the odds of imported deflation have climbed, to the detriment of corporate profits and bank stock relative performance (Chart 6, top panel). While nominal yields have backed up, real 2-year yields have declined, which is not consistent with an upgrading in economic expectations. Indeed, C&I loan growth has dropped sharply in recent weeks (Chart 6). By extension, it is hard to envision long-term yields rising much, if at all, which will keep net interest margins thin. Furthermore, if overall earnings remain stuck in neutral, corporate credit quality will undoubtedly worsen given the debt binge in recent years. Non-performing loans have only just begun to increase. Higher interest rates will not solve these problems. Instead, the downturn in credit quality could accelerate via more onerous debt servicing requirements, given the lack of a corporate sector balance sheet cushion. Perhaps more worrying is that banks are no longer pruning cost structures, which is unusual given that credit standards are tightening on most credit products outside of traditional mortgages. In the last 25 years, or as far back as we have the data, bank stocks lagged the broad market after bank employment started rising. The only exception was in the aftermath of the tech bubble, when all non-TMT sectors outperformed (Chart 7). If banks continue to expand their wage bill, without a widening in net interest margins and/or reversal in increased loan loss reserving, bank profits will fail to match the growth rate of the overall S&P 500. The optimal, but not exclusive, time for banks to outperform is typically exiting recession, when policy is easing and the yield curve is steepening, and in the late innings of an expansion. In fact, productivity is sagging throughout the financial sector. Financial sector employment is probing new highs (Chart 8), reflecting a more onerous cost structure required to meet regulatory obligations. Employment is now growing faster than sales, a reliable indication of flagging productivity. The implication is that financial sector profits will continue to lag those of the broad market. Chart 7Beware Rising Bank Employment bca.uses_wr_2016_11_07_c7 bca.uses_wr_2016_11_07_c7 Chart 8Sectoral Productivity Drain bca.uses_wr_2016_11_07_c8 bca.uses_wr_2016_11_07_c8 Bottom Line: Strength in bank stocks is a chance to sell. Is It Time To Buy Back Gold Shares? Gold shares are bouncing after having been punished in the last few months. Overheated technical conditions and prospects for a more hawkish Fed led us to recommend taking profits in August, despite a positive long-term outlook. Indeed, the likelihood of a prolonged period of negative to ultra-low real interest rates is high given startlingly low potential GDP growth in most of the developed world. Gold shares typically do well in the aftermath of a debt binge, as proxied by our Corporate Health Monitor (CHM, shown advanced, Chart 9). It is unnerving that the CHM has suffered such a broad-based deterioration without any back up in interest rates. Low interest rates and tight credit spreads have cushioned what has otherwise been a stark erosion in debt servicing capabilities: there is little scope for a parallel upshift in the global interest rate structure. These are bullish conditions for gold shares, as captured by the upbeat reading in our Cyclical Gold Indicator (Chart 9, top panel). As such, when we took profits we advised that we would look to return to an overweight position once tactical downside risks had been reduced. Are we there yet? Chart 10 suggests that extreme bullishness toward the yellow metal has not yet fully unwound. While the share price ratio has dropped back to its 200-day moving average, cyclical momentum remains elevated, as measured by the 52-week rate of change. Sentiment in the commodity pits is still elevated, flows into gold ETFs are still strong and net speculative positions have not yet made a full retreat (Chart 10), especially in view of the recent politically-motivated pop in market volatility. The implication is that there could be additional selling pressure in the coming weeks. Chart 9Cyclically Appealing, But... bca.uses_wr_2016_11_07_c9 bca.uses_wr_2016_11_07_c9 Chart 10... Still Tactically Frothy bca.uses_wr_2016_11_07_c10 bca.uses_wr_2016_11_07_c10 Chart 11The Currency Is Critical bca.uses_wr_2016_11_07_c11 bca.uses_wr_2016_11_07_c11 In terms of potential buy triggers, anything that causes the U.S. dollar to lose its bid is a strong candidate. Ironically, a Fed rate hike could produce such an outcome, contrary to popular wisdom. In our view, the U.S. (and global) economy cannot handle tighter financial conditions, and a rise in interest rates would need to be offset by a weaker currency. Gold shares perform well when economic expectations are faltering (Chart 11, shown inverted), and a hawkish Fed would likely raise global economic fears. On the flipside, a go-slow Fed could keep the currency bid. That would allow the economy more time to heal and recover, and possibly overheat, thereby potentially boosting future returns on capital, certainly relative to other countries where output gaps remain larger. Bottom Line: Stay neutral on gold stocks, but put them on upgrade alert in recognition that an upgrade back to overweight could occur sooner rather than later, i.e. by yearend, depending on macro dynamics. What To Do With Drug Stocks? A number of drug wholesalers reported earnings misses and provided disappointing guidance, specifically citing worse than expected generic pricing pressure, enough to offset ongoing branded drug price increases. In the current environment of political uncertainty toward health care companies, the knee jerk reaction has been to abandon all pharmaceutical-related equities, regardless of exposure to branded or generic medicines. Our pharmaceutical equity view has noted that the time to worry about the pace of drug price increases would be if they sparked a change in consumption patterns and/or buyer behavior. The fact that major buying groups such as health insurers and pharmacy benefit managers are balking at generic drug price increases constitutes such a shift. Consumer spending on drugs has slowed, albeit that has not been confirmed by neither strong retail drug store sales nor booming hospital employment (Chart 12). Nor is there an unwanted inventory build (Chart 12). Nevertheless, in light of new information, which implies that company-reported pricing pressure is worse than current government data shows, we are downgrading our outlook for drug-related shares. Still, rather than sell after the index has already taken a large hit, pushing relative performance to oversold and undervalued levels (Chart 12), we will await a more opportune moment to lighten positions, especially in view of our preference for defensive equities. Keep in mind that the drug price increases are still well in excess of the overall rate of inflation as branded drug prices continue to rise (Chart 13), and earnings stability should be increasingly desirable as the U.S. dollar climbs. In the meantime, drug-related shares are now on downgrade alert and the overall health care sector is off our high-conviction list. The good news is that other parts of the health care sector should benefit if drug inflation cools. For instance, a reduction in the rate of drug price increases, and in the case of generics, outright price cuts, is a blessing for the S&P managed care industry. Cost inflation had been perking up, but should ease in the coming quarters as drug expenses abate. Health insurance premiums are growing at a faster rate than overall inflation, while job growth remains decent (Chart 14), underscoring that top-line growth is still outpacing that of the overall corporate sector. If cost inflation eases while revenue climbs, the index should move to at least a market multiple from its current discounted valuation. Importantly, technical readings have improved. Chart 12Under The Gun... bca.uses_wr_2016_11_07_c12 bca.uses_wr_2016_11_07_c12 Chart 13... But Pricing Power Remains Strong bca.uses_wr_2016_11_07_c13 bca.uses_wr_2016_11_07_c13 Chart 14Celebrating Reduced Cost Inflation bca.uses_wr_2016_11_07_c14 bca.uses_wr_2016_11_07_c14 Cyclical momentum has begun to reaccelerate from neutral levels after unwinding overbought conditions (Chart 14), suggesting that a breakout to new relative performance highs is in the offing. Bottom Line: The pain in drug-related shares should provide a gain to health care insurers. Stay overweight the S&P managed care index. However, look to lighten the S&P pharmaceutical and biotech indexes on a relative performance bounce in the coming weeks, both are now on downgrade alert. Current Recommendations Current Trades Size And Style Views Favor small over large caps and growth over value.

A number of drug wholesalers have reported earnings misses and provided disappointing guidance, specifically citing worse than expected generic drug pricing pressure, enough to offset ongoing branded drug price increases. In the current environment of political uncertainty toward health care companies, the knee jerk reaction has been to abandon all pharmaceutical-related equities, regardless of exposure to branded or generic medicines. Our pharmaceutical equity view has noted that the time to worry about the pace of drug price increases would be if they sparked a change in consumption patterns and/or buyer behavior. The fact that major buying groups such as health insurers and pharmacy benefit managers are balking at generic drug price increases constitutes such a shift. Consumer spending on drugs has slowed, albeit that has neither been confirmed by still strong retail drug store sales nor booming hospital employment. Nevertheless, in light of new information, which implies that company disclosed pricing pressure is worse than current government data show, we are downgrading our outlook for drug-related shares. However, rather than sell after the index has already taken a large hit, pushing relative performance to oversold and undervalued levels, we will await a more opportune moment to lighten positions, especially in view of our preference for defensive equities. In the meantime, the S&P pharma and biotech indexes are now on downgrade alert and the overall health care sector is off our high-conviction list. The good news is that other parts of the health care sector should benefit, see the next Insight. bca.uses_in_2016_11_02_001_c1 bca.uses_in_2016_11_02_001_c1

The mini-consolidation in equities reflects the ongoing tension between market-supportive liquidity and a sketchy corporate profit backdrop.

Stocks whipsawed violently last week. Volatility could intensify if recent whiffs of a domestic economic slowdown proliferate and the Fed still adopts a more hawkish tone.

Pharmaceutical stocks are trading at historically cheap relative valuations on the back of political pressure on a few high-profile specialty pharma companies. We see this as an opportunity to add to positions in the more traditional pharma space. Our concerns about excessive drug pricing will only materialize when there is evidence that consumption patterns are changing. So far, there is scant evidence of higher prices choking consumption. Consumer spending on drugs is hitting new highs. That is true in both real and nominal terms, underscoring that higher outlays are not simply a reflection of rising drug prices. While the growth rate of drug consumption may slow, pent up demand from years of medical procedure deferral following the Great Recession will take time to play out. As such, soaring pharmaceutical shipments should be interpreted as demand-driven. Consequently, we expect profit outperformance to persist, and drive a sustained recovery in relative share prices. The ticker symbols for the stocks in this index are: BLBG: S5PHAR - JNJ, PFE, MRK, BMY, AGN, LLY, ZTS, MYL, PRGO, MNK, ENDP. bca.uses_in_2016_05_11_001_c1 bca.uses_in_2016_05_11_001_c1

The S&P pharmaceutical index has checked back relative to the broad market, reflecting the powerful short covering and relief rally in higher beta sectors in recent weeks. While this trend may persist in the very near run, we expect relative performance to follow relative forward earnings growth. On this front, conditions are bullish. In absolute terms, pharmaceutical companies are enjoying a productivity revival, as a demand-driven surge in pricing power is underway. That stands in marked contrast with the rest of the corporate sector, which is battling deflation, as evidenced by the relentless decline in bond yields (shown inverted, top panel). The chart shows that when firms are cutting selling prices, pharmaceutical profits outperform, as is currently the case. Moreover, drug companies continue to use excess capital in a shareholder-friendly manner, as shares outstanding continue to sink. The bottom line is that pharmaceutical earnings are on track for further outperformance, which should pull up the share price ratio. Stay overweight. The ticker symbols for the stocks in this index are: AGN, BMY, LLY, ENDP, JNJ, MNK, MRK, MYL, PRGO, PFE, ZTS. Is The Pharmaceuticals Pullback Overdone? Is The Pharmaceuticals Pullback Overdone?

While high-beta equity areas have rebounded smartly in recent trading sessions, we remain skeptical that earnings-follow through will be forthcoming. Instead, our portfolio remains defensively-geared, where profit support is strongest. For instance, the latest manufacturing data showed that pharmaceutical shipments continue to boom, underscoring that top-line momentum has started on a strong foot in the first quarter. That bodes well for pharmaceutical relative performance. Elsewhere, beverage shipments have also soared on a growth rate basis, sending a similar upbeat message for the S&P soft drink index. Importantly, pricing power remains solid in both industries, underscoring that the surge in manufacturer shipments likely remains demand-driven. We reiterate our overweight position in both indexes. Defensive Industry Earnings Are On A Positive Path Defensive Industry Earnings Are On A Positive Path

The oversold bounce is not supported by policy or profits, and should be treated as countertrend. Lift machinery to neutral and differentiate between pharmaceuticals and the unwinding of the biotech mania.