REITs

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

REITs have marked time year-to-date, but recently operating conditions have downshifted a notch. Three key drivers argue for lightening up exposure on this newly formed S&P GICS1 sector. First, REITs have been unable to materially benefit from the 50bps fall in the 10-year Treasury yield from the mid-December peak to the mid-June trough. As the economy recovers from the first quarter lull, Treasury yields will resume their advance. This is a net negative for the fixed income proxy real estate sector (top panel). Second, real estate occupancy rates have crested and generationally high supply additions in the apartment space are all but certain to push vacancies higher still. The implication is that rental inflation will remain under intense downward pressure (middle panel). Finally, according to the Fed's latest Senior Loan Officer Survey, bankers are less willing to extend CRE credit. If banks continue to close the credit taps, CRE prices will suffer a setback (bottom panel). Net, we are trimming the niche S&P real estate sector to neutral and concurrently removing it from the high-conviction overweight list. Downgrade REITs Downgrade REITs

Highlights Portfolio Strategy The energy bear market is drawing to a close. Lift exposure to above benchmark. Firming refining operating conditions, at the margin, suggest that it no longer pays to underweight this energy sub-group. Book gains and lift to neutral. Softening profit fundamentals are weighing on the real estate outlook. Trim REITs to neutral. Recent Changes S&P Energy - Lift to overweight. S&P Oil & Gas Refining & Marketing - Upgrade to neutral, lock in profits of 14.3%. S&P Real Estate - Trim to neutral and remove from high-conviction overweight list. Table 1 SPX 3,000? SPX 3,000? Feature Equities wrestled to hold on to gains last week, fighting a spike in geopolitical tensions, synchronized global central bank hawkish rhetoric and sector rotation. Investors continued to shed tech stocks in favor of financials, pushing our recently initiated long financials/short tech pair trade return near double digits. Our view remains that a rotational correction is the dominant market theme. Nevertheless, on the eve of earnings season, profits will soon take center stage and serve as a catalyst for the overshoot equity phase to resume. Our sense is that before the end of the business cycle, there are high odds that the S&P 500 will hit the 3,000 mark. That does not mean it will be a straight line advance from here. Garden variety 5-10% corrections are all but inevitable. Rather, our point is that before the next recession hits late in the decade, the SPX can attain 3,000. How did we come up with this figure? We derived the S&P 500's peak cycle value using three different methods: Dividend Discount Model (DDM) Forward P/E and EPS growth sensitivity analysis Equity Risk Premium (ERP) Table 2SPX Dividend Discount Model SPX 3,000? SPX 3,000? Table 2 shows our DDM on the S&P 500. It assumes healthy dividend growth in 2017 and 2018. Our expectation of a 2019 recession drives a steep decline in dividends that year, followed by a slow climb in 2020 and 2021, in line with the 2009-2011 experience (Chart 1). 2022 is our terminal year when dividend growth settles at 6.6%, close to the long-term average. Our discount rate assumes a 3.2% 10-year Treasury yield and a 5% equity risk premium (the past decade's average, Chart 2). This discount rate mirrors the historical average corporate junk bond yield. This valuation model delivers an S&P 500 value of 2904. Chart 1Joined At##br## The Hip Joined At The Hip Joined At The Hip Chart 2FX10 ERP And The Economy##br## Are Inversely Correlated ERP And The Economy Are Inversely Correlated ERP And The Economy Are Inversely Correlated Alternatively, we examine the S&P 500's sensitivity to EPS growth rates and forward valuation multiples. If we use the street's 160.8 (or 10.6% implied CAGR) S&P 500 2019 EPS estimate and assign the current 12-month forward multiple as a starting point, Table 3 shows an S&P 500 value of just under 3,000. Downside risks look limited. Using this EPS forecast, even a 2-turn multiple contraction results in the S&P 500 appreciating 10% from here. Table 3SPX EPS & Multiple Sensitivity SPX 3,000? SPX 3,000? Lastly, a conservative ERP analysis reveals that SPX 3,000 is a realistic peak cycle estimate. Our assumptions include: a 200 bps ERP, a 3.2% 10-year Treasury yield and 160.8 SPX EPS. These assumptions result in an S&P 500 value of slightly over 3,000. How do we justify a decline in the ERP from its current level of 338 bps to our assumed 200 bps? G10 central banks are no longer putting out GFC-related fires; in fact, a slew of them are briskly turning from dovish to hawkish following the Fed's lead (Chart 3). As a result, a sustained decline in the ERP should follow as interest rates rise. Chart 3G10 Central Banks Map SPX 3,000? SPX 3,000? Chart 4Negative Correlation Is Re-Established Negative Correlation Is Re-Established Negative Correlation Is Re-Established The bottom panel of Chart 2 drives this point home. Since the history of SPX forward EPS data, the year-over-year change in the ERP has been almost perfectly inversely correlated with the ISM manufacturing index, i.e. an improving economy is synonymous with a receding ERP and vice versa. Lastly, keep in mind that a 200 bps ERP is still significantly higher than the 80 bps mean ERP that prevailed in the 1998-2007 decade (middle panel, Chart 2). The depreciating greenback is another source of support for our SPX 3,000 view. The yearlong positive correlation between the U.S. dollar and commodities has likely come to an end and the three plus decade inverse correlation has been re-established (Chart 4). As the cycle matures and enters its late stages, commodities and resource-related equities tend to pick up steam as profits rebound. Even energy stocks may catch a bid. Buy Energy Stocks... Energy equities are down roughly 20% year-to-date versus the broad market. In fact, the energy sector has broken down to a level last seen in 2004, when oil traded near $30/bbl (Chart 5). The three main culprits have been rising U.S. shale oil production, inventory accumulation, and investor doubts about whether all nations will comply with OPEC's mandated production cuts. While going overweight the energy space has been a "widow maker" trade recently, we are now tempted to take a punt on the S&P energy sector from the long side. There are tentative signs that this relative performance bear phase is drawing to a close. Three main drivers support our modestly sanguine view of energy stocks. First, as we mentioned above, the inverse correlation between the U.S. dollar and the commodity complex has been re-established after a one-year hiatus. Synchronized global growth suggests that a corresponding tightening interest rate cycle is brewing (Chart 3). Thus, there are high odds that a number of G10 central banks will hike rates later this summer or early this fall, now that the Fed has paved the path.1 As long as the greenback drifts lower, even energy stocks should catch a bid (Chart 6). Chart 5Crude Oil... Crude Oil... Crude Oil... Chart 6...And The Dollar Say Buy Energy Stocks ...And The Dollar Say Buy Energy Stocks ...And The Dollar Say Buy Energy Stocks Second, on the domestic operating front, the steepest drilling upcycle in recent memory is showing signs of fatigue. Baker Hughes reported the first weekly decline in 24 weeks in the oil rig count for the week ending June 30th. At least a modest deceleration in shale oil production is likely. Encouragingly, Cushing crude oil inventories are contracting on a year-over-year basis and OECD oil stocks appear poised to contract in late autumn/early winter (Chart 7). Predicting OPEC's compliance is tricky. However, BCA's Commodity & Energy Strategy service believes that little to no cheating will occur and in a worst case scenario Saudi Arabia will step in and curtail production were Libya and/or Iraq to pump oil above quota. Finally, our S&P energy sector Valuation Indicator has gravitated back to the neutral zone. Technicals are also washed out with our Technical Indicator breaching one standard deviation below its historical mean, a level that typically heralds a reversal (Chart 8). Recent anecdotes that the sell-side is throwing in the towel on their bullish oil forecasts for the remainder of the year are also contrarily positive. Chart 7Improving Supply Dynamics Improving Supply Dynamics Improving Supply Dynamics Chart 8S&P Energy Unloved And Fairly Valued Unloved And Fairly Valued Unloved And Fairly Valued Our newly introduced S&P energy sector relative EPS model encapsulates this cautiously optimistic industry backdrop (Chart 9). Simultaneously, the budding recovery in our S&P energy Cyclical Macro Indicator also signals that profits should best those of the overall market (second panel, Chart 8), giving us comfort to lift the S&P energy sector to a modest overweight position. ... As Refiners Are No Longer Cracking Under Pressure We are executing the upgrade to overweight in the broad energy sector via booking gains of 14.3% since inception in the S&P oil & gas refining & marketing sub-group and lifting exposure to neutral from underweight. It no longer pays to remain bearish on the pure play downstream energy business. Back in late September 2015, when we turned negative on refiners, we were anticipating a cyclical earnings downturn on the back of a refined product glut in this low margin / high volume industry. Fast forward to 2017 and that bearish profit view has materialized as relative EPS have fallen by roughly 60 percentage points from the most recent peak, and have only lately managed to stabilize (Chart 10). Chart 9EPS Model Waves Green Flag EPS Model Waves Green Flag EPS Model Waves Green Flag Chart 10Refining Profit Contraction Is Over Refining Profit Contraction Is Over Refining Profit Contraction Is Over If relative EPS have indeed troughed, then relative performance should soon find a bottom. Relative profit fortunes move with the ebb and flow of gasoline consumption. The latter is on the cusp of expanding for the first time since last November, heralding the same for relative profitability (bottom panel, Chart 10). Industry shipments tell a similar story. After recently bottoming at levels similar to those reached during the GFC, refinery shipments have staged a mini V-shaped recovery (top panel, Chart 11). Crack spreads have not collapsed to razor thin levels as the nearly eliminated Brent/WTI spread would suggest, but have remained resilient in the high-teens per barrel (third panel, Chart 11). Three forces are likely in play. First, not only is domestic gasoline demand underpinning refining margins, but petroleum products are also finding their way into foreign markets with net exports running at over 3 million bbl/day (bottom panel, Chart 11). Second, the U.S. dollar selloff since mid-December is making U.S. refined products more competitive in global markets. Finally, crude oil inventories are nearly 40% higher than gasoline inventories. Lower industry feedstocks represent a boost to refining margins (third, Chart 11). Nevertheless, we refrain from turning outright bullish on refiners. Refinery production hit all-time highs recently, refinery runs are climbing steadily and utilization rates are running hot north of 90%. Tack on, historically high refined products inventories and rising industry capacity growth and the profit backdrop darkens (Chart 12). Chart 11Three Positives... Three Positives... Three Positives... Chart 12...But Do Not Get Carried Away ...But Do Not Get Carried Away ...But Do Not Get Carried Away Netting it out, we expect a balanced refining profit outlook in the coming quarters. Bottom Line: Upgrade the S&P oil & gas refining & marketing index (PSX, VLO, TSO, MPC) to neutral and lock in profits of 14.3%. This also pushes the S&P energy index to an above benchmark allocation. Downgrade REITs We are making space for the energy sector upgrade to overweight via trimming the niche S&P real estate sector to neutral and concurrently removing it from the high-conviction overweight list. REITs have marked time year-to-date, but recently operating conditions have downshifted a notch. Three key drivers argue for lightening up exposure on this newly formed S&P GICS1 sector. First, REITs have been unable to materially benefit from the 50bps fall in the 10-year Treasury yield from the mid-December peak to the mid-June trough. As the economy recovers from the first quarter lull, Treasury yields will resume their advance. This is a net negative for the fixed income proxy real estate sector (top panel, Chart 13). Second, real estate occupancy rates have crested and generationally high supply additions in the apartment space are all but certain to push vacancies higher still. The implication is that rental inflation will remain under intense downward pressure (Chart 13). Worrisomely, credit quality in select commercial real estate (CRE) segments is deteriorating at the margin. The bottom panel of Chart 13 shows that retail and office delinquency rates have taken a turn for the worse, and represent a yellow flag. Finally, according to the Fed's latest Senior Loan Officer Survey, bankers are less willing to extend CRE credit. In fact, if one excludes the GFC spike, the tightening in CRE lending standards is near the two previous recessionary highs. If banks continue to close the credit taps, CRE prices will suffer a setback (Chart 14). Chart 13Time To Move To the Sidelines Time To Move To the Sidelines Time To Move To the Sidelines Chart 14Conflicting Signals Conflicting Signals Conflicting Signals Chart 15 puts the CRE price appreciation in historical perspective. Currently, CRE prices are on track to climb to two standard deviations above the long-term trend. Such exuberance is a cause for concern as it has historically marked the beginning of a corrective phase in CRE prices. Nevertheless, there are some positive offsets that prevent us from throwing in the towel in the S&P real estate sector. The tight labor market and accelerating industrial production explain the reacceleration in our REITs Demand Indicator, while the recent selloff in the bond market is a modest offset. If CRE appetite remains upbeat, this in turn suggests that CRE prices have a bit more room to run before reaching a cyclical peak (bottom panel, Chart 14). In addition, compelling relative valuations and washed out technicals argue against becoming overly bearish on REITs (Chart 16), as some of the bad news is already reflected in relative share prices. Chart 15An Historical Perspective An Historical Perspective An Historical Perspective Chart 16Positive Offsets Positive Offsets Positive Offsets Bottom Line: Trim the S&P real estate sector to neutral and remove it from the high-conviction overweight list. Anastasios Avgeriou, Vice President U.S. Equity Strategy & Global Alpha Sector Strategy anastasios@bcaresearch.com 1 Please see the June 30th, 2017 Foreign Exchange Strategy Service Special Report titled "Who Hikes Next?", available at www.bcaresearch.com Current Recommendations Current Trades Size And Style Views Favor small over large caps and stay neutral growth over value.

Highlights Portfolio Strategy Operating leverage could surprise on the strong side this year, based on the message from our pricing power and wage growth indicators. REITs are experiencing a playable recovery following the Fed-induced sell-off earlier this year, and overweight positions will continue to pay off. Energy services activity is set to steadily accelerate this year, powering an earnings-led share price outperformance phase. Recent Changes There are no changes to our portfolio this week. Table 1 Operating Leverage To The Rescue? Operating Leverage To The Rescue? Feature Volatility has climbed to the highest level since the U.S. election, signaling that the broad market is not yet out of the woods. As stocks recalibrate to a cooling in economic growth momentum and an escalation in geopolitical threats, downside risks should be reasonably contained by mounting signs of a healthier corporate sector. Last week we posited that stronger top line revenue growth is necessary to sustain the profit upcycle, and provide justification for historically rich valuations. Chart 1 shows sales and EPS growth over the long-term. Chart 1Joined At The Hip Joined At The Hip Joined At The Hip Obviously, the two move closely together, with earnings enjoying more powerful growth phases when revenue accelerates. Since 1960, regression analysis shows that operating leverage for the S&P 500's is 1.4X. In other words, a 5% increase in sales growth typically leads to 7% EPS growth. When sales are initially recovering from a deep slump operating leverage can be even higher, with earnings often rising two to three times as fast as revenue. Clearly, that is not sustainable, but can give the illusion of powerful and sustained growth for brief periods of time. At the current juncture, there are reasons to expect investors to embrace the durability of the profit expansion. Our corporate pricing power proxy has vaulted higher. Importantly, the breadth of this surge has been impressive, which bodes well for its staying power (Chart 2, second panel). On the flip side, rising labor costs look set to take a breather. Compensation growth has crested, and according to our diffusion index, fewer than half of the 18 industries tracked have higher wages than last year. The wage growth diffusion index provides a reliable leading indication for the trend in labor expenses. In other words, pricing power is rising on a broad basis while wage inflation is decelerating on a broad basis. Consequently, there are decent odds that resilient forward operating margin expectations can be matched (Chart 2, bottom panel). Elsewhere, a revival in animal spirits, the potential for easier fiscal policy and prospects for a hiatus in the U.S. dollar bull market bode well for brisk business activity. While the budding recovery in global trade could sputter if protectionism proliferates, our working assumption is that the U.S. Administrations' bark will be worse than its bite. Thus, a self-reinforcing sales and profit upcycle could be materializing. The objective message from our S&P 500 EPS model concurs (Chart 3), underscoring that high single digit/low double digit profit growth could be broadly perceived as attainable this year. Chart 2Profit Margins Can Expand Profit Margins Can Expand Profit Margins Can Expand Chart 3Few Sectors Control The Fate Of S&P 500 EPS Few Sectors Control The Fate Of S&P500 EPS Few Sectors Control The Fate Of S&P500 EPS True, our model has recently shown tentative signs of cresting, but difficult comparisons will only arise later this year. Indeed, Q3 and Q4 2016 were all-time high EPS numbers, implying that 12% estimated growth rates are a tall order (Chart 3, middle panel). Importantly, dissecting the profit growth sectorial contribution is instructive. Calendar 2017 over 2016 S&P 500 earnings growth is concentrated in four sectors: tech, energy, health care and financials comprise over 87% of the incremental profit growth expected (Chart 3, bottom panel). The upshot is that there is a high degree of concentration risk to fulfilling overall profit growth expectations. Energy profits are wholly dependent on the oil price, and financial sector profit optimism appears to have embedded a healthy increase in both interest rates and capital markets activity. In addition, tech sector earnings are heavily influenced by the U.S. dollar. Consequently, it will be critical for monetary conditions to stay loose, otherwise estimates will be at risk of downward revisions. Adding it up, the corporate sector sales pendulum is finally swinging in a positive direction, which should support the cyclical overshoot in stocks for a while longer, notwithstanding our expectation that the current corrective phase has further to run. This week we are updating our high-conviction overweight views on both the lagging energy services index and REIT sector. Revisiting REITs REITs have staged a mini V-shaped rebound after being punished alongside rising bond yields and worries about aggressive Fed rate hikes earlier this year. As outlined in recent Weekly Reports, the reflation theme is likely to lose steam in the second half of the year as economic momentum cools, providing additional impetus for capital inflows into the more stable income profile of REITs. Even if the economy proves more resilient and Treasury yields move higher, there are few barriers to additional outperformance. Our Technical Indicator, a combination of rates of change and moving average divergences, is extremely oversold. Forward intermediate and cyclical relative returns from current readings have been solid, as occurred in 2004, 2008 and 2014 (Chart 4). REIT valuations are more than one standard deviation below normal, according to our gauge. This suggests that poor operating performance and/or higher discount rates are already expected. There may be a limit as to how high bond yields can climb, given that they are already deep in undervalued territory according to the BCA 10-year Treasury Bond Valuation Index (Chart 4). Regardless, history shows that REITs have typically had a more positive than negative correlation with bond yields. The inverse correlation has only been in place since the financial crisis, when zero interest rate policies pushed massive capital flows into all yield generating assets. Chart 5 shows that prior to 2008, REITs outperformed during periods of both rising and falling Treasury yields. Chart 4Unloved And Undervalued Unloved And Undervalued Unloved And Undervalued Chart 5No Concrete Correlation Pre GFC No Concrete Correlation Pre GFC No Concrete Correlation Pre GFC Similarly, REITs have a solid track record during periods of rising inflation pressures. Since 1975, there have been six periods of rising core PCE inflation: REITs have enjoyed meaningful rallies during five of these phases (Chart 6). Hard assets tend to hold their stock market value well when overall inflation moves higher, with REIT net asset values providing solid support to share price performance. Chart 6Buy REITs In Times Of Inflation Buy REITs In Times Of Inflation Buy REITs In Times Of Inflation Looking ahead, REITs should continue to enjoy success in boosting rental rates. Occupancy rates continue to rise (Chart 7). The unemployment rate is low, consumption is decent and businesses are growing increasingly confident. That is a recipe for higher rental demand. Our Rental Rate Composite has crested on a growth rate basis, but the advance in the CPI for homeowner's equivalent rent, a good proxy for REITs, suggests that the path of least resistance remains higher (Chart 7). REIT supply growth has also leveled off, which provides additional confidence that rental inflation will remain solid. Nevertheless, there are some areas of concern. Banks are tightening lending standards on commercial real estate loans. Some sub-categories are experiencing a mild deterioration in credit quality. For instance, Chart 8 shows that delinquency rates in the retail and office spaces have edged higher. Retail and mall REITs are likely under structural pressure owing to online competition from the likes of Amazon. Chart 7Rental Demand##br## Is Solid Rental Demand Is Solid Rental Demand Is Solid Chart 8Watch Delinquencies As ##br##Banks Tighten Credit Standards Watch Delinquencies As Banks Tighten Credit Standards Watch Delinquencies As Banks Tighten Credit Standards Overall vacancy rates are still very low (Chart 8), but if credit becomes too tight, then the relentless advance in commercial property prices may cool. For now, our REIT Demand Indicator is not signaling any imminent stress. In fact, the economy is strong enough to expect occupancy rates to keep climbing, to the benefit of underlying property valuations and rental income (Chart 7, bottom panel). In sum, the budding rebound in REIT relative performance should be embraced as the start of a sustained trend. Total return potential is very attractive on a relative basis. Bottom Line: REITs remain a very attractive high-conviction overweight. Energy Servicers Are Cleaning Up Their Act We put the S&P energy services index on our high-conviction overweight list at the start of the year, because three critical factors that typically lead to a playable rally existed, namely; the global rig count had hit an inflection point, oil supplies were easing and global oil production growth had begun to decelerate. While the pullback in oil prices has undermined relative performance for the time being, there is scope for a full recovery, and more. Oil prices have firmed, underpinned by a revival in the geopolitical risk premium following the U.S. bombing campaign in Syria. There is already a wide gap between share prices and oil prices (Chart 9, top panel), and a narrowing is probable, especially as earnings drivers reaccelerate. There are tentative signs that capital spending cuts are finally reversing. The global rig count has rebounded, and is a good leading indicator for investment (Chart 10). This message is corroborated by our Global Capex Indicator, which has recently surged anew (Chart 10). Chart 9Room For ##br##Margin Improvement... Room For Margin Improvement... Room For Margin Improvement... Chart 10...As Deflation Eases ##br##And Capex Rebounds ...As Deflation Eases And Capex Rebounds ...As Deflation Eases And Capex Rebounds The longer that oil prices can stay in their current trading range, or beyond, the more time E&P balance sheets have to heal and the greater the odds that the cost of capital will be reduced. Against this backdrop, there are high odds that previously mothballed exploration projects will be restored. The V-shaped recovery in the global oil rig count, albeit from a very low base, will eventually absorb excess capacity and allow the industry to escape deflation. A major improvement in day rates is unlikely given the scale of the previous capacity boom, but even a modest pricing power improvement should provide a nice boost given high operating leverage. EBITDA margins have considerable room to improve if pricing power grows anew (Chart 9, bottom panel). Importantly, the shifting composition of global production will allow service companies with domestic exposure to shine. Shale oil producers should recapture lost market share, given that the onus to rebalance markets has been taken on by OPEC. OPEC production is contracting, while non-OPEC output is starting to recover (Chart 11, bottom panel), culminating in a widening in the Brent-WTI oil price spread. Production restraint is helping to rebalance physical oil markets. Total OECD inventory growth is reversing, and anecdotal reports are surfacing that floating storage is rapidly being depleted. Oil supply at Cushing is on the cusp of contracting, which is notable given that this has had a high correlation with relative share price performance for the past decade (oil supply shown inverted, Chart 11). On a global basis, global inventory drawdowns have been correlated with a firming industry relative profitability, and vice versa. OECD oil supply growth is rapidly receding, which augurs well for an extension of budding earnings outperformance (Chart 12, middle panel). Chart 11Receding Inventories ##br##Should Boost Performance... Receding Inventories Should Boost Performance… Receding Inventories Should Boost Performance… Chart 12...EPS And##br## Valuations ...EPS And Valuations ...EPS And Valuations The rise in clean tanker rates reinforces that oil demand is rising quickly enough to expect additional inventory depletion (Chart 12, bottom panel). Typically, tanker rates and energy service relative valuations are positively correlated. Adding it up, a rising global rig count, decelerating inventories and restrained oil production continue to bode well for a playable rally in the high-beta S&P energy services group. Bottom Line: We reiterate our high-conviction overweight stance in the S&P energy services index. The ticker symbols for the stocks in this index are: BLBG: S5ENRE - SLB, HAL, BHI, NOV, FTI, HP, RIG. Current Recommendations Current Trades Size And Style Views Favor small over large caps and stay neutral growth over value.

Highlights Recommended Allocation Quarterly - April 2017 Quarterly - April 2017 The sweet spot of non-inflationary accelerating growth is likely to continue. European politics will fade as a risk, and Trump should still be able to get tax cuts through. We continue to be positive on risk assets on a one-year horizon, though returns are unlikely to be as good as in the past 12 months and there is a risk of the next recession arriving in 2019. Our portfolio tilts are generally pro-risk and pro-cyclical. We are overweight equities versus fixed income. We move overweight euro area equities, which should benefit from inexpensive valuations, higher beta and a falling political risk premium. Within fixed income, we prefer credit over government bonds, and raise high-yield debt to overweight on improved valuations. We expect the dollar to appreciate further, which makes us cautious on emerging market assets and industrial commodities. Feature Overview No Reasons To Turn Cautious Markets have paused for breath following the reflation trade that began a year ago and that was given an extra boost by the election of Donald Trump in November. Since the turn of the year, the dollar, U.S. 10-year Treasury yields, credit spreads and (to a degree) equities have all eased back a little (Chart 1). We don't think the risk-on rally is over, but the going will undoubtedly get tougher from here. The momentum of global growth cannot continue to rise at the same pace, with the Global PMI already at its highest level since 2011 (Chart 2). Global equities, therefore, are unlikely to return the 16% over the next 12 months, that they have over the past 12. Chart 1A Pause For Breath A Pause For Breath A Pause For Breath Chart 2Growth Momentum Must Slow From Here Growth Momentum Must Slow From Here Growth Momentum Must Slow From Here Nonetheless, we see nothing that is likely to stop risk assets continuing to outperform over the one-year horizon: Growth is likely to rise further. While the initial pick-up was in "soft" data such as consumer sentiment and business confidence, signs are emerging that "hard" data such as household spending and production are now also improving (Chart 3). Models developed by our colleagues on The Bank Credit Analyst indicate that real GDP growth in the U.S. this year will come in above 3% and in the euro area above 2% (Chart 4),1 compared to consensus forecasts of 2.2% and 1.6% respectively. Chart 3Hard Data Also Not Picking Up Hard Data Also Not Picking Up Hard Data Also Not Picking Up Chart 4GDP Growth Could Beat Consensus GDP Growth Could Beat Consensus GDP Growth Could Beat Consensus For now, this growth is unlikely to prove inflationary. In the U.S. the diffusion index for PCE inflation shows more prices in the basket falling than rising; in the eurozone, the rise to 2% in headline inflation in January was temporary, mainly because of higher oil prices, and core inflation remains at only 0.7%. The U.S. output gap will close soon, but the eurozone's is still deeply negative (Chart 5). We see the Fed raising rates twice more this year, in line with its dots, though it may have to accelerate the pace next year if the Trump administration succeeds in passing fiscal stimulus. The ECB, however, is unlikely to raise rates until 2019 and will taper asset purchases only slowly.2 Misplaced worries that it will tighten more quickly than this have recently dragged on European equities and strengthened the euro. We think the market is wrong to price out the probability of a tax cut in the U.S. just because of the Trump administration's failure to reform healthcare. Our Geopolitical strategists argue that Republicans in Congress (even the Freedom Caucus) are united behind the idea of cutting taxes, even if these are not funded by tax reforms or spending cuts (they can be justified on the grounds of "dynamic scoring").3 We see a cut in corporate and personal taxes passing before year-end to take effect in 2018. And Trump has not abandoned the idea of infrastructure spending. The market no longer expects any of this: the prices of stocks that would most benefit from lower corporate taxes or from government spending have reverted to their pre-election levels. European political risk is likely to wane. The market continues to worry about the possibility of Marine Le Pen winning the French Presidential election, as shown in the spread of OATs over Bunds (which has widened to 60-80 bp from 20 bp last summer). We think this very unlikely: polls show her consistently at least 20 points behind Emmanuel Macron in the second round of voting (Chart 6). While Italian politics remain a risk, the parliamentary election there is unlikely to take place until March 2018. Brexit is a threat to the U.K., but should have minimal impact on the eurozone. We retain, therefore, our pro-cyclical and pro-risk tilts on a 12-month time horizon. We have even added a little more beta to our recommended portfolio by raising high-yield bonds to overweight (since their valuations now look more attractive after a recent sell-off) and by going overweight eurozone stocks (paid for by notching down our double-overweight in U.S. stocks). The eurozone has consistently been a higher beta (Chart 7), more cyclical equity market than the U.S. and, once the political risks (at least temporarily) subside, should be able to outperform for a while. Chart 5Eurozone Output Gap Still Very Negative Eurozone Output Gap Still Very Negative Eurozone Output Gap Still Very Negative Chart 6Can Le Pen Really Win From Here? Can Le Pen Really Win From Here? Can Le Pen Really Win From Here? Chart 7Eurozone Is A High Beta Stock Market Eurozone Is A High Beta Stock Market Eurozone Is A High Beta Stock Market But we warn that the good times may not last for long. Tax cuts in the U.S. would add stimulus to an economy already at full capacity. The Fed might have to raise rates sharply next year (although the timing might depend on how President Trump tries to affect monetary policy, for example whom he appoints as Fed chair to replace Janet Yellen next February). U.S. recessions have typically come two or three years after the output gap turns positive (Chart 5). As Martin Barnes, BCA's chief economist, recently wrote,4 that may point to next recession arriving as soon as 2019. Garry Evans, Senior Vice President Global Asset Allocation garry@bcaresearch.com What Our Clients Are Asking Chart 8Expensive, But Not At An Extreme Expensive, But Not At An Extreme Expensive, But Not At An Extreme Aren't You Worried About U.S. Equity Valuations? Valuation is a poor timing tool in the short term but, when it reaches extremes, it has historically added value. The valuation metrics we watch show that U.S. equities are expensive, but not at the extreme levels that have historically warranted an outright sell or underweight. First, according to MSCI, U.S. equities are currently trading at 24.4 times 12-month trailing earnings, and 25.7 times 10-year cyclically-adjusted earnings; both measures are about one standard deviation from their 10-year averages. Second, U.S. equities are trading at a premium to global equities, but the premium to the developed markets is in line with the 10-year average (Chart 8, panel 1), while the premium to emerging markets is about 1.5 standard deviations from the 10-year average (panel 2). Third, equities are cheap compared to fixed income: the earnings yield is still higher than the yields on both 10-year government bonds and investment grade corporate bonds, and the yield gaps are currently only slightly lower (more expensive) than their respective 10-year averages (panels 3 and 4). In the long run, the 10-year cyclically-adjusted PE (CAPE) has had relatively good forecasting power for 10 year forward returns. Currently, the regression indicates 143% (9.3% annualized) total returns over the next 10 years. This could be on the optimistic side given that we are no longer in an environment of declining bond yields and margins are elevated compared to the 1990s. That said, we have cut our U.S. equity overweight by half, partly due to valuation concerns. Is EM Debt Attractive? Chart 9Avoid EM Debt Avoid EM Debt Avoid EM Debt Emerging market debt has continued its run from last year, with sovereign and local currency debt providing YTD returns of 3% and 2% respectively. Over long periods, EM debt has displayed the ability to provide substantial returns while also providing robust diversification benefits to a 50/50 DM equity/bond portfolio, even more so than EM equities.5 However, over the cyclical horizon, we remain bearish on EM debt both in absolute terms and relative to global equities. EM fixed income markets have been able to defy deteriorating fundamentals for some time, but this is unsustainable. After years of leveraging, credit excesses will need to be unwound. Decelerating credit growth will be enough to dampen economic growth and damage emerging markets' ability to service their debt. Risks in EM sovereign debt markets are high. Historical returns have shown negative skewness and fat tails, suggesting high vulnerability to large downswings. This is particularly concerning given that yields are one standard deviation lower than their long-term average (Chart 9). While EM local currency debt is more fairly priced and has a more favorable risk/return profile than its sovereign debt counterpart, local currency debt returns are even more heavily influenced by their currencies. Above-trend growth in the U.S. leading to additional rate hikes, as well as rising U.S. bond yields and softer commodity prices will add further downward pressure to EM currencies. For EM dedicated investors, we suggest overweight positions in low beta/defensive markets. Regions that are less susceptible to currency weakness with high yields and low foreign funding requirements include Russia, India and Indonesia. How Will The Fed Shrink Its Balance Sheet, And Does It Matter? After the Fed's third rate hike, attention is turning to when it will begin to reduce its balance sheet. This has grown to $4.5 trillion, up from $900 billion before the Global Financial Crisis. Assets currently include $2.5 trillion of Treasury securities and $1.8 trillion of mortgage-related securities. Since asset purchases ended in October 2014, the Fed has rolled over maturing bonds to maintain the size of the balance sheet. The FOMC statement last December committed to maintaining this policy "until normalization of the level of the federal funds rate is well under way". The market takes this to mean 1-1.5%, a level likely to be reached by year-end. The view of BCA's fixed income team6 is that the Fed will start by ceasing reinvestment of Agency bonds and mortgage-backed securities (MBS) in 2018, at the same time reducing excess bank reserves on the liability side of the balance sheet (Chart 10). This will worry markets to a degree and the Fed will need to be careful how it communicates the policy: for example what size it thinks its balance sheet should ultimately be. It may also need to skip a rate hike or two in the first months of the shrinkage. The MBS market is likely to suffer from the increased supply. But the only historical precedent - the BoJ's unwinding of its 2000-3 QE - is reassuring: this had no discernible effect on rates or the yen (Chart 11). Chart 10Fed Will Cut MBSs First Fed Will Cut MBSs First Fed Will Cut MBSs First Chart 11Nobody Noticed The BoJ Taper Nobody Noticed The BoJ Taper Nobody Noticed The BoJ Taper When Will ECB Taper? Chart 12Recovery Not Permanent Recovery Not Permanent Recovery Not Permanent Euro area growth is recovering and headline inflation has hit the ECB's 2% target (Chart 12). Investors are wondering how rapidly the ECB will taper its asset purchases and when it will raise rates. Our view is that the ECB will move only slowly. The pickup in inflation is mostly driven by the base effect and by the rise in energy prices. The failure of core inflation, which remains below 1%, to pick up appreciably suggests that underlying price pressures are weak. The current program has the ECB purchasing EUR 60 Bn of assets each month until December 2017. Markets have recently become more hawkish with regards to the likely path of policy: currently futures are pricing in the first hike only 19 months away versus an expectations in January of 44 months. We expect the ECB to remain more dovish than that, given weak underlying inflation, political uncertainty, and banking system troubles. We think the ECB will announce around September this year a taper of its asset purchases in 2018. However, it is not clear whether it will cut them to, say EUR 30 Bn a month, or whether it will reduce the amount steadily each month or quarter. But we don't see an interest rate hike soon, since the euro area economy is not expected to reach full employment until 2019. Ewald Novotny, president of the Austrian central bank, spooked markets by suggesting a hike before complete withdrawal of asset purchases but, in our view, that would will send a confusing signal to investors. Nowotny has long been hawkish and we think his view is untypical of ECB council members. If our analysis is correct, ECB policy should be positive for euro area equities and bearish for the euro over the next 12 months. Will REIT Underperformance Continue? Chart 13Underweight REITs Underweight REITs Underweight REITs Relative REIT performance has continued its downtrend, underperforming the broad index by 5% YTD. While valuations have become more attractive and rental income is still robust, we expect the decline to continue given unsupportive macro factors. We previously argued that real estate is in a sweet spot, where economic growth was sufficient to generate sustainable tenant demand without triggering a new supply cycle.7 This is no longer the case. Office completions increased substantially over the past quarter and apartment completions remain in an uptrend. As we expect growth to remain robust in the U.S., the likelihood is that these two trends remain in place. REIT relative performance peaked at the beginning of August, shortly after long-term interest rates bottomed. REITs have historically outperformed when yields are falling and inflation is low (Chart 13). However, long-term rates should continue to rise over the cyclical horizon, primarily due to higher inflation expectations. Additionally, REITs typically benefit from increasing central bank asset purchases, as increased liquidity and lower interest rates boost real estate values. With the Fed clearly in tightening mode and the strong likelihood of ECB tapering next year, slowing asset purchases will be a considerable headwind to REIT performance. Within REITs, we maintain our sector tilts. Continue to favor Industrials, which will benefit in a rising USD environment and provide considerable income. Maintain underweight position in Apartments, due to rising completions and a low absorption ratio. Additionally, we continue to favor trophy over non-trophy markets given more stable rent growth as well as geopolitical risks in Europe and potential Washington disappointments. Global Economy Overview: The global economy has continued to recover from its intra-cycle slowdown in late 2015 and early 2016. Economic surprise indexes have everywhere surprised significantly on the upside since mid-2016 (Chart 14, panel 1). Although "hard" data (consumption, production etc.) have lagged "soft" data (consumer sentiment, business confidence), the former also have begun to recover recently. Although there are few negative indicators, it will get harder to beat expectations. U.S.: Lead indicators continue to improve, with the manufacturing ISM at 57.7 and new orders at 65.1. Sentiment quickly turned bullish after the presidential election, and hard data has now started to follow, with personal consumption expenditure rising 4.7% year on year and capital goods orders (+2.7% YoY in February) growing for the first time since 2014. With steady wage growth, continuing employment improvements, and a likely pick-up in capex, we expect 2017 GDP growth to beat the current consensus expectations of 2.2%. For now inflation remains quiescent, with core PCE inflation stuck at around 1.8%, below the Fed's 2% target. Euro Area: Leading indicators, such as PMIs, have rebounded in Europe too (Chart 15), suggesting that the consensus 2017 GDP forecast of 1.6% is achievable. Inflation has picked up, with the headline CPI 2.0% for the Eurozone in January, but core inflation remains low at 0.7% and headline fell back to 1.5% in February. However, the recent slowdown in bank loan growth (new credit creation is 36% below the level six months ago) suggests that continuing weakness in the banking sector is likely to keep growth sluggish. Chart 14How Long Can Growth Continue To Surprise? How Long Can Growth Continue To Surprise? How Long Can Growth Continue To Surprise? Chart 15A Synchronized Global Growth Rebound A Synchronized Global Growth Rebound A Synchronized Global Growth Rebound Japan is a tale of two segments. International-oriented data have recovered, with IP up 3.7% (Chart 15, panel 2) and exports +5.4% year on year. But domestic demand remains weak: wages are rising only 0.5% YoY (despite a tight labor market), which is holding back household spending (-1.2% YoY in January). Core inflation has shown the first signs of picking up, but remains very low at 0.1% YoY. Emerging Markets: The effects of China's reflationary policies from early 2016 continue to boost activity (Chart 15, panel 3). But the excess liquidity they triggered worries the authorities, who have clamped down on real estate purchases and capital outflows, slowed fiscal spending, and tightened monetary policy. China will prioritize stability until the Party Congress in the fall, but the impact of reflation on commodity prices and on other emerging markets will fade. Interest rates: The Fed is likely to hike twice more this year in line with its "dot plot", unless inflation surprises significantly to the upside. This, plus an acceleration of nominal GDP growth to 4.5-5%, should push the 10-year bond yield above 3% by year end. The ECB will not be as hawkish as the market expects (futures markets indicate a rate hike by end-2018), since Mario Draghi expects headline inflation to fall back once the oil price stabilizes and is concerned about political risk especially in Italy. Consequently, rates are unlikely to rise as quickly as in the U.S. The Bank of Japan will keep its 0% yield target for 10-year JGB for the foreseeable future. Global Equities Global equities continued to make impressive gains in Q1 2017, after a strong 2016. The price appreciation since the low in February 2016 has been driven by both multiple expansion and earnings growth, roughly in equal proportion, as shown in Chart 16, panel 1. Chart 16Earnings Improving But Valuation Stretched Earnings Improving But Valuation Stretched Earnings Improving But Valuation Stretched Equity valuation is expensive by historical standards but, as an asset class, equities are still attractively valued compared to bonds (see the "What Our Clients Are Asking" section on page 6). In this "TINA" (There Is No Alternative) world, we remain overweight equities versus bonds. Within equities, we maintain our call of favoring DM equities versus EM equities despite of the 6% EM outperformance in Q1, which was supported by attractive valuations. About half of that outperformance came from the appreciation of EM currencies versus the USD. Our house view is that the USD will strengthen further versus the EM currencies. Within EM, we have been more positive on China and remain so on a 6-9 month horizon. The only adjustment we make now is to upgrade euro area equities to overweight by reducing half of our large overweight in the U.S. so that now we are equally overweight the U.S. and euro area (see details on the next page). In terms of global sector positioning, we maintain a pro-cyclical tilt. Our largest overweight in Healthcare panned out very well in Q1 but the overweight in Energy did not, due to the drop in oil prices. Our Energy strategists believe this was caused by one-off technical factors on the supply side, and argue that the oil price will soon revert to $55 a barrel. Euro Area Equities: A Cheaper Alternative To The U.S. Political risks related to elections in some eurozone countries are receding. The ECB is likely to maintain its easy monetary policies, while the Fed is on track to normalize interest rates in the U.S. We have had a large overweight of 6 percentage points (ppts) on U.S. equities while being neutral on the euro area. We upgrade the eurozone to overweight by 3 ppts, so that we are now equally overweight the U.S. and the euro area. The following are the reasons: First, the relative performance of total returns between eurozone and the U.S. equities is at its lowest since 1987. Since April 2015, when the most recent brief period of eurozone outperformance ended, eurozone equities have underperformed the U.S. by over 16% in common currency terms (Chart 17, panel 1), while the euro lost only about 4% versus the USD over the same period. Second, eurozone equities are trading at a 22% discount to the U.S., compared to the five-year average discount of 17% (panel 3). Third, eurozone equities have lower margins than the U.S., but the profit margin in the eurozone has been improving (panel 2). Lastly, the PMIs in the euro area have been improving (panel 4) and this improvement is faster than the global aggregate PMI (panel 5), which implies - based on the close correlation between PMIs and earnings growth - that profitability in the eurozone should improve at a faster pace than the global average. Sector Allocation: We have had a relatively pro-cyclical tilt in our global sector positioning, overweight three cyclical sectors (Energy, Industrials and Info Tech) plus Healthcare, while underweight three defensive sectors (Consumer Staples, Telecoms and Utilities) as well as Consumer Discretionary. We have been neutral on Financials and Materials. After very strong performance in 2016, cyclical sectors underperformed in Q1 2017 (Chart 18, panel 1). The underperformance of cyclicals versus defensives can be largely attributed to the polar-opposite performance of Energy and Healthcare (Chart 19). Going forward, we maintain our current sector positioning for the following reasons: Chart 17Earnings Growth At Lower Valuation Earnings Growth At Lower Valuation Earnings Growth At Lower Valuation Chart 18Maintain The Cyclical Tilt Maintain The Cyclical Tilt Maintain The Cyclical Tilt Chart 19Global Sector Performance Quarterly - April 2017 Quarterly - April 2017 First, Energy was the only sector which fell in Q1, largely due to the decline in oil prices. BCA's Energy and Commodity Strategy attributes the oil price weakness to inventory buildup related to the production rush before the OPEC agreement to cut production, and therefore expects the WTI oil price to return to the $50-55 range. Energy stocks should benefit once oil prices turn back up. Chart 20Relative Factor Performance Relative Factor Performance Relative Factor Performance Second, the relative profitability between cyclicals and defensives is underpinned by global economic conditions, as represented by the global PMI. The PMI is on track to recover further, which bodes well for the profit outlook for cyclicals versus defensives. Third, our pro-cyclical tilt in sector positioning is hedged by an overweight in Healthcare (a defensive sector) and underweight in Consumer Discretionary (a cyclical). Smart Beta Update: No Style Bet Q1 2017 saw some significant performance reversals in the five most enduring factors: quality, minimum volatility, momentum, value, and size (Chart 20, panels 2-6). Quality and Momentum performed the best, outperforming the global benchmark by over 200 bps in Q1. The star performer in 2016, the Value factor, performed the worst, underperforming by 190 bps. According to the findings in our Special Report,8 recent factor performance seems to be pricing in a "Goldilocks" environment in which growth is rising and inflation falling. We have shown that it is very difficult to time the shift in factor performance cycles and so have advocated an equal weight in the five factors (Chart 20, panel 1) for long-term investors. We reiterate this view. Government Bonds Maintain slight underweight duration. Our 2-factor model made up of global PMI and U.S. dollar sentiment indicates the current fair value of the 10-year Treasury yield is 2.4% (Chart 21). While this suggests bonds are currently correctly priced, we still expect that long-term yields will rise over a cyclical horizon. The long end should grind higher given improving growth, rising equity prices and renewed "animal spirits." Additionally, large net short positions have been unwound, allowing for another leg higher in yields. Overweight TIPS vs. Treasuries. Diffusion indexes for both PCE and CPI inflation shifted into negative territory, suggesting realized inflation will soften in the near term. Nevertheless, with headline and core CPI readings of 2.7% and 2.2% respectively, U.S. inflation has clearly bottomed for the cycle (Chart 22). This trend should continue as a result of cost-push inflation driven by faster wage growth. Very gradual Fed hikes will not be enough to derail the upward momentum in consumer prices. Euro area growth is stable, but expectations of a rate hike from the ECB are premature (Chart 23). While the central bank opened the door slightly to a less-accommodative policy stance, it is unlikely that the ECB will hike until full employment is reached. Our expectation is for a tapering of asset purchases to occur in 2018. Once tapering is complete, rate hikes will follow by approximately 6-12 months. The implication is upward pressure on European bond yields and wider spreads for peripheral government debt. Chart 2110-Year Treasury Fair Value Model 10-Year Treasury Fair Value Model 10-Year Treasury Fair Value Model Chart 22Inflation Has Bottomed Inflation Has Bottomed Inflation Has Bottomed Chart 23Will the ECB Hike Soon? Will the ECB Hike Soon? Will the ECB Hike Soon? Corporate Bonds The BCA Corporate Health Monitor remains deeply in "Deteriorating Health" territory, indicating weakness within corporate balance sheets (Chart 24). Over the last quarter, the indicator worsened, as profit margins, return-on-capital and liquidity declined. However, leverage did improve slightly. The trend toward weaker corporate health has been firmly established over the past 12 quarters. This is consistent with the very late stages of past credit cycles. Maintain overweight to Investment Grade debt. The U.S. is in a self-reinforcing, low-inflation recovery. Economic growth should accelerate throughout 2017, with strong consumer spending, rising capex intentions, and still accommodative monetary policy. The potential sell-off from rate hikes this year should be fairly mild given that the market is already close to pricing in three. Additionally, credit has historically outperformed in the early stages of the Fed tightening cycle. Expect low but positive excess returns (Chart 25). Shift to overweight in high-yield debt. Our default model is showing improvement due to elevated interest coverage, a robust PMI reading, declining job cut announcements, softening lending standards and a rising sales/inventory ratio. The recent backup in yields has made junk bond valuations more attractive. The default adjusted spread, calculated by subtracting an ex-ante estimate of default losses from the average spread, is now approximately 220bps (Chart 26). Chart 24Balance Sheets Deteriorating Balance Sheets Deteriorating Balance Sheets Deteriorating Chart 25A Supportive Backdrop A Supportive Backdrop A Supportive Backdrop Chart 26High Yield: Valuations Becoming More Attractive High Yield: Valuations Becoming More Attractive High Yield: Valuations Becoming More Attractive Commodities Chart 27Upside To Resource Prices Limited Upside To Resource Prices Limited Upside To Resource Prices Limited Secular Perspective: Bearish A slowdown in Chinese activity, led by its transition to a services economy, coupled with unfavorable global demographics, will continue to constrain demand for commodities. This slack in demand coupled with excess capacity will continue to limit the upside in resource prices and prolong the commodities bear market which began in 2012 (Chart 27). Cyclical Perspective: Neutral Energy markets have moved from excess supply to excess demand, and so we remain positive on oil. But, with the impact of Chinese fiscal stimulus waning, excess supply in the metals market will persist, putting downward pressure on prices. Our divergent outlook for energy vs metals gives us an overall neutral view for commodities over the cyclical horizon. Energy: With a synchronized upturn in global growth and inflation, both OECD and non-OECD demand will remain strong. Following Saudi Arabia's production cuts, we expect the OPEC agreement to be honored by all members, including Russia. With strengthening demand and falling production, storage should draw through the year. We expect the oil-USD divergence to persist as improving fundamentals override the stronger dollar. Base Metals: With Chinese government spending slowing from 24% growth year on year in January 2016 to only 4%, the country's fiscal impulse has ended. Tightening in Chinese liquidity conditions have led to higher borrowing rates for the real estate sector, which is dampening its demand for materials. At the same time, inventories for key metals such as copper and steel have risen. We expect metals prices to correct over the coming months. Precious Metals: Gold has rallied 10% from last December, and another 4% following the Fed's March rate hike. These were responses to the dovish nature of the hike and continuing political risk. We expect the Fed to turn more hawkish in coming weeks, sending the dollar and real yields higher, thereby holding back the gold price from rising much further. Currencies Chart 28Return Of The Dollar Return Of The Dollar Return Of The Dollar USD: The last Fed meeting resulted in a dovish hike, as evidenced by the subsequent fall in the dollar. However, as the U.S. economy nears full employment, we expect a more hawkish tone from FOMC members in the coming weeks which will push the dollar up (Chart 28). The Fed continues to be data dependent, and sees the recent synchronized global upturn as an opportunity to deliver hikes in line with market expectations. Euro: As the economy stabilizes, as evidenced by rising headline inflation, stronger retail sales and improving PMI numbers, the ECB has opened the window for reducing monetary accommodation. However, since the economy is expected to reach full employment only in 2019, we expect rates to be kept low even after the tapering of ECB asset purchases starts next year. This will add further downward pressure on the euro. Yen: The Bank of Japan will continue its highly accommodative monetary policy, centered on its 0% yield target for 10-year government bonds, because Japanese growth and inflation is lagging the global upturn. Japan is benefitting from global growth, as seen in the improvement in its manufacturing PMI, but domestic demand remains weak as consumer confidence and retail sales stagnate. Continued downward pressure on relative interest rates will drive the only reliable source of inflation: a weaker yen. EM: A more hawkish Fed and rising bond yields will tighten global liquidity conditions, making it difficult for emerging nations that run current account deficits. The rising threat of protectionism could affect EM exports and create a new wave of deflationary pressure, forcing central banks to engineer currency devaluation. The fact that commodity prices have risen, yet EM currencies have remained weak, is a clear indications that EM fundamentals are weak. Alternatives Overweight private equity / underweight hedge funds. Leading indicators suggest that global growth continues to improve. In the absence of a recession, private equity typically outperforms as the illiquidity premium should provide a boost to returns. Additionally, surveys suggest that managers are planning on increasing their allocation percentage toward private equity over the rest of the year. Hedge funds, on the other hand, have displayed a negative correlation with global growth. Historically, they have outperformed private equity only during recessions or periods of high credit market stress (Chart 29). Overweight direct real estate / underweight commodity futures. Demand for commercial real estate (CRE) assets remains robust but the increase in completions is worrying. Favor Industrials for its income potential and Retail given resilient consumer spending. Overweight trophy markets, as demand remains robust given multiple macro risks. Commodities have bounced, but remain in a secular bear market caused by a supply glut and exacerbated by a market-share war (Chart 30). Overweight farmland & timberland / underweight structured products. The potential for trade wars, geopolitical risk in Europe and concerns over an equity market correction have increased the importance of volatility reduction. Favor farmland & timberland. Substantial portfolio diversification benefits, resulting from low correlations with traditional assets, coupled with a positive skew, make these assets highly attractive. As the most bond-like alternative, the end of the 35-year bull market in bonds presents a substantial headwind. Structured products also tend to outperform during recessions, which is not our base case (Chart 31). Chart 29PE: Tied To Real Growth PE: Tied To Real Growth PE: Tied To Real Growth Chart 30Commodities: A Secular Bear Market Commodities: A Secular Bear Market Commodities: A Secular Bear Market Chart 31Structured Products Outperform In Recessions Structured Products Outperform In Recessions Structured Products Outperform In Recessions Risks To Our View Our pro-cyclical pro-risk tilts are based on the premise that global growth will remain strong over the next 12 months. We do not see many risks to this view: leading indicators suggest that consumption and capex are likely to continue to rebound. The one major indicator that suggests downside risk is loan growth. In the U.S., loans to firms have slowed to 5.4% from over 10% last summer, and in the euro area the meager pickup in corporate loan growth seems to have faltered (Chart 32). There may be some special factors: oil companies that borrowed in early 2016 when in difficulty no longer need to tap credit lines, and U.S. companies may be holding back to see details of tax cuts. But loan growth needs to be watched closely. More granularly, our country and sector preferences - in particular, our cautious views on Emerging Markets and industrial commodities - are based partly on the expectation that the U.S. dollar will appreciate further. If the global expansion remains highly synchronized (Chart 33) this might instigate all G7 central banks to tighten, allowing the Fed to raise rates without appreciating the dollar. However, we expect continuing divergences in growth and monetary policy to push the dollar up further. Finally, some indicators suggest that investors have become too positive on the outlook for stocks (Chart 34). Sentiment has in the past not been a reliable indicator of stock market peaks, but excess euphoria could trigger a short-term correction. Chart 32Why Is Bank Loan Growth Slowing? Why Is Bank Loan Growth Slowing? Why Is Bank Loan Growth Slowing? Chart 33Could Synchronized Growth Push Down USD? Could Synchronized Growth Push Down USD? Could Synchronized Growth Push Down USD? Chart 34Are Investors Too Euphoric? Are Investors Too Euphoric? Are Investors Too Euphoric? 1 Please see The Bank Credit Analyst, March 2017, page 33, available at bca.bcaresearch.com 2 Please see What Our Clients Are Asking: When Will The ECB Taper? on page 9 of this report for a full explanation of why we think this. 3 Please see Geopolitical Strategy Weekly Report, "Donald Trump Is Who We Thought He Was", dated March 8, 2017, available at gps.bcaresearch.com 4 Please see BCA Special Report titled "Beware The 2019 Trump Recession", dated March 7, 2017, available at bca.bcaresearch.com 5 Please see Global Asset Allocation Strategy Special Report, "EM Asset Allocation: Is There Any Reason To Own Stocks?," dated November 27, 2012, available at gaa.bcaresearch.com. 6 Please see Global Fixed Income Strategy Special Report, "The Way Forward For The Fed's Balance Sheet," dated February 28, 2017, available at gfis.bcaresearch.com. 7 Please see Global Asset Allocation Strategy Special Report, "REITs Vs. Direct: How To Get Exposure To Real Estate," dated September 15, 2016, available at gaa.bcaresearch.com. 8 Please see Global Asset Allocation Strategy Special Report, "Is Smart Beta A Useful Tool In Global Asset Allocation?," dated July 8, 2016, available at gaa.bcaresearch.com. Recommended Asset Allocation Model Portfolio (USD Terms)

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

The Treasury bond sell has undermined the REIT sector, but that has created excellent value. Our REIT valuation gauge is one standard deviation below the mean, an excellent starting point for forward relative returns. Now that Treasury yields are also in undervalued territory, the drag from this source is likely to diminish. Importantly, payouts remain well supported by rising pricing power, as proxied by new cyclical highs in the CPI component for homeowners equivalent rent. Importantly, multifamily housing starts continue to trend lower as a share of total housing starts, underscoring the future residential supply growth should subside. While banks have tightened standards on commercial real estate loans, this appears more likely to limit supply growth than create a slowdown, given that commercial property prices are hitting new highs. The bottom line is that both Net Asset Values and payouts remain well supported, setting the stage for a playable outperformance phase. We reiterate our high conviction overweight. REITs Are On Sale REITs Are On Sale

Highlights Portfolio Strategy A battle between tighter monetary conditions and the anticipation of fiscal largesse will be a dominant market theme this year. Our high-conviction equity allocation calls do not require making a major directional global economic bet, or second guessing the Fed's desire to continue tightening. The bulk of our calls could currently be considered contrarian, based on recent market momentum and sub-surface relative valuation swings. Recent Changes S&P Insurance Index - Downgrade to high-conviction underweight. Nasdaq Biotech Index - Downgrade to high-conviction underweight. Feature Stocks have already paid for a significant acceleration in earnings and economic growth this year and beyond. Fourth quarter earnings season will be the first real test of investor expectations since the post-election market surge. While recent data have been encouraging, forward corporate profit guidance is unlikely to be robust in the face of the U.S. dollar juggernaut. Currently, the hope is that fiscal stimulus will offset tighter monetary settings, ultimately delivering a higher plane of economic activity. The major risks are that the economy loses momentum before fiscal spending cranks up, and/or that profits diverge from a more resilient economic performance than liquidity conditions forecast. Indeed, fiscal stimulus isn't slated to accelerate until next year (Chart 1), while the impact of anti-growth market moves is far more imminent. Our Reflation Gauge has plunged, heralding economic disappointment (Chart 1). With the economy near full employment, Fed hawkishness could persist even in the face of any initial evidence of economic cooling. Under these conditions, the gap between nominal GDP and 10-year Treasury yields could turn negative in the first half of the year (Chart 2), which would be a major warning sign for stocks. Chart 1Fiscal Stimulus Is Still A Long Way Off Fiscal Stimulus Is Still A Long Way Off Fiscal Stimulus Is Still A Long Way Off Chart 2Warning Signal Warning Signal Warning Signal As a result, while the market has recently been focused almost solely on return, our emphasis at this juncture is on minimizing risk. That is consistent with the historic market performance during Fed tightening cycles. Going back to the early-1970s and using the last seven Fed interest rate hiking periods, it is evident that non-cyclical sector relative performance benefits immensely on both a 12 and 24 month horizon from the onset of Fed tightening (Charts 3 and 4). Cyclical sectors typically lag the broad market, while financials generally market perform1. Chart 312-Month Performance After Fed Hikes 2017 High-Conviction Calls 2017 High-Conviction Calls Chart 424-Month Performance After Fed Hikes 2017 High-Conviction Calls 2017 High-Conviction Calls Some of the other major macro forces that are likely to influence the broad market and sectoral trends are: Ongoing strength in the U.S. dollar and its drag on top-line growth: loose fiscal policy and tight monetary policy is a classic recipe for currency strength. Tack on high and rising interest rate differentials due to policy divergences with the rest of the world (Chart 5), and exchange rate strength is likely to persist in the absence of a major domestic economic downturn. A tough-talking Fed. Wage growth is accelerating and broadening out, and will sharpen the Fed's focus on inflation expectations. With dollar strength constraining revenue growth potential, strong wage gains are profit margin sapping (Chart 2). A divergence between economic growth and profit performance, i.e. stronger growth is unlikely to feed into equal growth in corporate sector earnings given the squeeze on profit margins from a recovery in labor's ability to garner a larger share of aggregate income. Disappointment and/or uncertainty as to the timing and rollout of the much anticipated fiscal spending programs and unfunded tax cuts. Favoring domestic vs. global exposure will remain a key theme. Emerging markets (EM) have not validated the sharp jump in the global vs. domestic stocks, nor cyclical vs. defensives (Chart 6). Chart 5Greenback Is A Drag##br## On S&P 500 Top Line Growth Greenback Is A Drag On S&P 500 Top Line Growth Greenback Is A Drag On S&P 500 Top Line Growth Chart 6Mind##br## The Gap Mind The Gap Mind The Gap EM stocks are pro-cyclical, and outperform when economic growth prospects are perceived to be improving. The surging U.S. dollar is a growth impediment for many developing countries with large foreign liabilities to service. The U.S. PMI is gaining vs. the Chinese and euro area PMI (Chart 7, second panel), heralding a rebound in cyclical share price momentum. World export growth remains anemic and will remain so based on EM currency trends (Chart 7). When compared with the reacceleration in U.S. retail sales, the outlook for domestically-sourced profits is even brighter. The other key sectoral theme is to favor areas geared to the consumer rather than the corporate sector. Consumer income statements and balance sheets are far healthier than those of the corporate sector (Chart 8). As a result, they are in a more propitious position to spend and expand. Chart 7Domestics Will Rise To The Occasion Domestics Will Rise To The Occasion Domestics Will Rise To The Occasion Chart 8Consumers Trump The Corporate Sector Consumers Trump The Corporate Sector Consumers Trump The Corporate Sector We expect all of these forces to truncate rally attempts in 2017. The market is already stretching far enough technically to flag risk of a potentially sizeable correction in the first quarter, i.e. greater than 10%, particularly given the significant tightening in monetary conditions and overheating bullish sentiment that have developed. In other words, it is not an environment to chase the post-election winners, nor turn bearish on the losers that have been eschewed. Against this backdrop, we are introducing our top ten high-conviction calls for 2017. As always, these calls are fundamentally-based and we expect them to have longevity and/or meaningful relative return potential, rather than just reflect recent momentum trends. We recognize the difficulty of trading in and out of positions on a short-term basis. Energy Services - Overweight Chart 9Playable Rally Playable Rally Playable Rally The energy sector scores well in relative performance terms when the Fed is hiking interest rates2, supporting a high-conviction overweight in the energy services group. OPEC's agreement to curtail production should hasten supply/demand rebalancing that was already slated to occur via non-OPEC production declines through 2017. U.S. shale producers slashed capital expenditures by 65% from 2014 to 2016, and the International Oil Companies reduced capital expenditures by 40% over the same period. OPEC's decision to trim output should mitigate downside commodity price risks, providing debt and equity markets with confidence to restore capital availability to the sector. With easier access to capital, producers, especially shale, will be able to accelerate drilling programs in a stable commodity price environment. The three factors traditionally required to sustain a playable rally are now in place. The rig count has troughed. The growth in OECD oil inventories has crested. The latter is consistent with a gradual rise in the number of active drilling rigs. Finally, global oil production growth is falling steadily. Pricing power is likely to be slow to recover this cycle given the scope of previous capacity excesses, but even a move to neutral would remove a major drag and reduce the associated share price risk premium (Chart 9). Consumer Staples - Overweight 2016 delivered a number of company specific body blows to the consumer staples sector, most notably concerns about the pharmacy benefit manger pricing model, which undermined the retail drug store group. Thereafter, the sector was shunned on a macro level following the election, as it was used as a source of capital to fund aggressive purchases in more cyclical sectors. This has set the stage for a contrarian buying opportunity in a high quality, defensive sector with one of the best track records during Fed tightening cycles3. The sector is now closing in on an undervalued extreme, in relative terms, having already reached such a reading in technical terms (Chart 10). Our Cyclical Macro Indicator is climbing, supported by the persistent rise in consumers' preference for saving. The latter heralds an increase in outlays at non-cyclical retailers relative to sales at more discretionary stores. Importantly, consumer staples exports have reaccelerated, despite the strong U.S. dollar, pointing to a further acceleration in sector sales growth, and by extension, free cash flow. The strong U.S. dollar is a major boon, from an historical perspective, given that it typically creates increased global economic and market volatility. The latter is starting to pick up (Chart 10). A strong currency, particularly bilaterally against China, also implies a reduction in the cost of imported goods sold, and heralds a relative performance rebound (Chart 11). Chart 10Contrarian Buy Contrarian Buy Contrarian Buy Chart 11China To The Rescue? China To The Rescue? China To The Rescue? Home Improvement Retail - Overweight Enticing long-term housing prospects argue for looking through the recent rise in mortgage rates. Household formation is reaccelerating, as full employment is boosting consumer confidence, and clocking at a higher speed than housing starts. The implication is that pent-up housing demand will be unleashed. In fact, consumers have only recently started re-levering, with banks more than willing to facilitate renewed appetite for mortgage debt. Remodeling activity is booming and anecdotes of house flipping activity picking up steam are corroborating that the housing market is vibrant. Now that house prices have recently overtaken the 2006 all-time highs, the incentive to upgrade and remodel should accelerate. While the recent backup in bond yields has been a setback for housing affordability, the U.S. consumer is not priced out of the housing market. Yields are rising in tandem with job security and wages. Mortgage payments remain below the long-term average as a share of income and effective mortgage rates remain near generationally low levels. Building supply store construction growth has plumbed to the lowest level since the history of the data. Historically, capacity restraint has represented a boost to home improvement retail (HIR) profit margins and has been inversely correlated with industry sales growth. Stable housing data and improving operating industry metrics entice us to put the compellingly valued S&P HIR on our high-conviction buy list for 2017 (Chart 12). Chart 12Benefiting From Enticing##br## Long-Term Housing Prospects Benefiting From Enticing Long-Term Housing Prospects Benefiting From Enticing Long-Term Housing Prospects Chart 13Healthy Consumer Is A Boon##br## To Consumer Finance Stocks Healthy Consumer Is A Boon To Consumer Finance Stocks Healthy Consumer Is A Boon To Consumer Finance Stocks Consumer Finance - Overweight We are focusing our early-cyclical exposure on overweighting the still bruised S&P consumer finance index. This group is levered to the rising interest rate environment and debt-financed consumer spending. The selloff in the 10-year Treasury bond has been closely correlated with relative performance gains and the current message is to expect additional firming in the latter (Chart 13, top panel). Importantly, higher interest rates have boosted credit card interest rate spreads (the industry's equivalent net interest margin metric), underscoring that the next leg up in relative share prices will be earnings led (Chart 13, bottom panel). On the consumer front, consumer finances are healthy, the job market is vibrant and consumer income expectations are on the rise. In addition, house prices have vaulted to fresh all-time highs and are still expanding on a y/y basis. The positive wealth effect provides motivation for consumers to run down savings rates (Chart 13, second & third panels). Health Care Equipment - Overweight Health care equipment (HCE) stocks have been de-rated alongside the broad health care index, trading at a mere market multiple and below the historical mean, representing a buy opportunity. Revenue growth has been climbing at a double digit clip (Chart 14, third panel) and the surging industry shipments-to-inventories ratio is signaling that still depressed relative sales growth expectations will surprise to the upside (Chart 14, top panel). Synchronized global growth is also encouraging for U.S. medical equipment exports, despite the U.S. dollar's recent appreciation. The ageing population in the developed markets along with pent up demand for health care services in the emerging markets where a number of countries are developing public safety nets, bode well for HCE long-term demand prospects. The bottom panel of Chart 14 shows that the global PMI has been an excellent leading indicator of HCE exports and the current message is positive. The recent contraction in valuation multiples suggests that sales are expected to disappoint in the coming year, an outlook that appears overly cautious, especially within the context of the nascent improvement in industry return on equity (Chart 14, second panel). Chart 14HCE Stocks Are Cheap Given##br## Improving Final Demand Outlook HCE Stocks Are Cheap Given Improving Final Demand Outlook HCE Stocks Are Cheap Given Improving Final Demand Outlook Chart 15More Than##br## Meets The Eye More Than Meets The Eye More Than Meets The Eye REITs - Overweight REITs have traded as if the back up in global bond yields will persist indefinitely, and that the level of interest rates is the only factor that drives relative performance. Improving cash flows and cheap valuations suggest that REITs can decouple from bond yields. Our REIT Demand Indicator (RDI) has climbed into positive territory, signaling higher rental inflation. The latter is already outpacing overall CPI by a wide margin. The RDI is also positively correlated with commercial property prices, implying more new highs ahead. That will support higher net asset values. While increased supply is a potential sore spot, particularly in the residential space, multifamily housing starts have rolled over relative to the total, suggesting that new apartment builds are diminishing. As discussed in previous research reports, contrary to popular perception, relative performance is also depressed from a structural perspective. REIT relative performance is trading well below its long-term trend, a starting point which has historically overwhelmed any negative pressure from a Fed tightening cycle (Chart 15). Tech Hardware Storage & Peripherals - Underweight The S&P technology hardware storage & peripherals (THSP) sector is a disinflationary play (10-year treasury yield change shown inverted, second panel, Chart 16) and benefits when prices are deflating, not when there are whiffs of inflation4. The tech sector has the highest foreign sales/EPS exposure among the top 11 sectors, and the persistent rise in the greenback is weighing on export prospects for the THSP sub-index (Chart 16, third panel), and by extension top and bottom line growth. Computer and electronic products new order growth has fallen sharply recently, warning that THSP sales growth will remain downbeat. Industry investment is also probing multi-year lows (not shown). Asian inventory destocking is ongoing, which will pressure selling prices, but the end of this liquidation phase would be a signal that the worst will soon be over. Technical conditions are bearish. A pennant formation signals that a breakdown looms. Chart 16Tech Stocks Hate Reflation Tech Stocks Hate Reflation Tech Stocks Hate Reflation Chart 17Shy Away, Don't Be Brave Shy Away, Don’t Be Brave Shy Away, Don’t Be Brave Biotech - Underweight The Nasdaq biotech index is following the BCA Mania Index, which includes previous burst bubbles in a broad array of asset classes. The top panel of Chart 17 shows that if history at least rhymes, biotech bubble deflation is slated to continue. Only 45 stocks in the NASDAQ biotech index have positive 12-month forward earnings estimates, comprising 27% of the 164 companies in the index according to Bloomberg. There is still a lot of air to be taken out of the biotech bubble. Historically, interest rates and relative performance have been inversely correlated. The back up in bond yields and Fed tightening represent a draining in liquidity conditions which bodes ill for higher beta and more speculative investments. The biotech derating has been earnings driven and a sustained multiple compression period looms, especially given the sector's poor sales prospects (Chart 17, bottom panel) Worrisomely, not only have biotech stocks fallen despite Trump's win, but recent speculative zeal (buoyant equity sentiment and resurging margin debt, not shown) has also failed to reinvigorate biotech equities. The NASDAQ biotech index is a sell (ETF ticker: IBB:US). Industrials - Underweight The industrials sector was added to our high-conviction underweight list late last year so the turn in calendar does not require a change in outlook. The sector has discounted massive domestic fiscal stimulus and disregarded the competitive drag on earnings from the U.S. dollar, trading as if a profit boom is imminent. Recent traction in surveys of industrial activity is a plus, but is more a reflection of an improvement in corporate sentiment and is unlikely to translate into imminent industrials sector profit improvement. The U.S. dollar surge is a direct threat to any benefit from an increase in domestic infrastructure or private sector investment spending. Commodity prices and EM drag when the dollar is strong. Chronic surplus EM industrial capacity remains a source of deflationary pressure for their currencies, economies and U.S. industrial companies. U.S. dollar strength warns of renewed pricing power pressure (Chart 18). Non-tech industrial capacity is growing faster than output, and capital goods imports prices are contracting (Chart 18). Tack on the relentless surge in the U.S. dollar, and a new deflationary wave appears inevitable. Relative forward earnings momentum is already negative, and is likely to remain so given the barriers to a top-line recovery, and a soaring domestic wage bill. The sector is not priced for lackluster earnings. Chart 18Fade The Bounce Fade The Bounce Fade The Bounce Chart 19Advance Is Precarious Advance Is Precarious Advance Is Precarious Insurance - Underweight Insurance stocks have benefited from the upward shift in the yield curve and the re-pricing of the overall financials sector, but the advance is precarious. Previously robust insurance pricing power has cracked. The CPI for household insurance is barely growing. The latter is typically correlated with auto premiums, underscoring that they may also slip (Chart 19). While higher interest rates are positive for investment portfolio income, they also imply mark-to-market losses on bond portfolios and incent insurers to underwrite at a faster pace with more lenient standards, which is often a precursor to increased competition and less pricing power. Insurance companies have added massively to cost structures in recent years (Chart 19), while the rest of the financials sector was shedding labor costs. Relative valuations have enjoyed a step-function upshift, but the path of least resistance will be lower for as long as relative consumer spending on insurance products retreats on the back of pricing pressure (Chart 19). 2016 Review... Last year's high-conviction calls were hot out of the gate, and generally had very strong gains until the late-summer/early-fall, but were hijacked by the post-election surge in a few sectors. As a result of the end of year fireworks, our high conviction calls trailed the market by just under 2% for the year ending 2016. Had we had the foresight to predict a Trump win and a massive market rally, we could have closed our positions in early November for comfortably positive gains. In total, our average booked gains in the year were 3% in excess of the broad market since the positions were initiated. We are also closing our pair trades, and will re-introduce a number of new trades in the near future. Anastasios Avgeriou, Vice President Global Alpha Sector Strategy & U.S. Equity Strategy anastasios@bcaresearch.com 1 Please see the U.S. Equity Strategy Special Report titled: "Sector Performance And Fed Tightening Cycles: An Historical Roadmap", available at uses.bcaresearch.com. 2 Ibid 3 Ibid 4 Please see the U.S. Equity Strategy Special Report titled: "Equity Sector Winners And Losers When Inflation Climbs", available at uses.bcaresearch.com. Current Recommendations Current Trades Size And Style Views Favor small over large caps. Favor growth over value (downgrade alert).

The REIT index is oversold and undervalued on a cyclical basis, and fundamentals are improving, as shown in the previous Insight. Contrary to popular perception, relative performance is also depressed from a structural perspective. The chart shows that REIT relative performance is trading well below its long-term trend. In other words, the past few years of the search for yield did not trigger a stampede into the REIT sector, suggesting that a further rise in bond yields may not trigger additional REIT selling pressure. While Fed interest rate hikes may provide some pause for potential buyers, it is notable that relative performance has a decent track during Fed tightening cycles (see the shading), especially when the starting point for the share price ratio is below-trend. The implication is that the vicious correction in the S&P REIT sector is an excellent buying opportunity. Stay overweight. (Part II) Buy Into REIT Weakness (Part II) Buy Into REIT Weakness

The backup in global bond yields has provided investors with an excuse to sell any high yielding sector or group, regardless of valuation. For instance, the short-term relative performance of the S&P REIT index has been highly correlated (inversely) with 10-year Treasury yields. The sell-off has pushed our REIT valuation gauge to extremely undervalued levels, on a par with previous playable relative performance recoveries. We expect a replay, as REIT fundamentals are improving. The chart shows that our REIT Demand Indicator has popped back into positive territory, which bodes well for future rental income. The latter is also directionally correlated with commercial property prices, which are hitting new highs. Importantly, concerns about excess supply should start to wane, particularly in the residential space, given that multifamily housing starts are rapidly losing momentum compared with total housing starts. On a long-term basis, REITs are far from extended, please see the next Insight. bca.uses_in_2016_12_15_001_c1 bca.uses_in_2016_12_15_001_c1