Railroads

  Overweight Rail stocks in general, and Union Pacific (UNP) in particular, got a major lift yesterday when UNP announced a plan to implement the principles of Precision Scheduled Railroading (PSR) in its push to improve customer deliveries and profitability. Recall that PSR was developed by Hunter Harrison first at CN Rail, then CP Rail and finally at CSX where its implementation took industry profit laggards to profit leadership. Though his recent passing was untimely, the 9% year-over-year improvement in CSX’s Q2/18 operating ratio is a testament to the success of Mr. Harrison’s strategy. The timing for a renewed approach at UNP could scarcely be better. Both demand and pricing are soaring (second and third panels) and the resulting congestion is threatening profitability. We expect the ongoing supportive macro backdrop, combined with operating improvements such as these, to sustain the operating margin improvement trend of the past two years (bottom panel). Stay overweight, despite the 20% in relative return since inception. The ticker symbols for the stocks in this index are: BLBG: S5RAIL - UNP, CSX, NSC, KSU. A Plan That Works A Plan That Works  

Overweight The Cass Freight Expenditures Index, a barometer of the total amount spent on freight, recorded an all-time high reading in the latest monthly report, rising by an astonishing 17.3% year-over-year on already firm comparable numbers (second panel). While this is partly a function of much improved volumes, the explosion in expenditures is largely due to higher prices. In fact, the Cass Freight Index Report noted that "demand is exceeding capacity in most modes of transportation by a significant amount. In turn, pricing power has erupted in those modes to levels that continue to spark overall inflationary concerns in the broader economy." This is well reflected in railroad operating metrics. Shipments have been steadily improving but pricing power has been enjoying multiple years of above-inflation growth, driven by tight capacity and accelerating demand (third panel). Our rails profit margin proxy (pricing power versus employment additions) echoes this positive earnings backdrop, pointing to margin improvements in this year and beyond (bottom panel). Though inflation represents a longer term risk to rails and the broad S&P transportation index, near-term earnings growth should be well beyond trend. Accordingly, we reiterate our overweight recommendation for the S&P railroads index. The ticker symbols for the stocks in this index are: BLBG: S5RAIL - UNP, CSX, NSC, KSU. Prices Will Push Rail Margins Higher Prices Will Push Rail Margins Higher

Overweight CSX Corp led off the S&P railroads index in reporting results for the first quarter of 2018 yesterday; the markets were not disappointed and the stock jumped substantially higher. Most notably, the company's operating ratio (the ratio of operating expenses to revenues and a standard measure of industry profitability) leaped down by nearly 10% from 73.2% to 63.7% (lower means better profitability) year-over-year. Further, the company was able to increase prices in the key intermodal segment without impacting volumes; the resilience of the current business cycle should support more of the same for the rest of the year (second panel). Unsurprisingly, there is a tight correlation between the S&P railroads index relative performance and the industry’s operating ratio (operating ratio shown inverted in top panel). We expect ongoing efficiency gains and exceptionally strong demand to keep the latter suppressed (possibly delivering the most profitable year in railroad history), implying outsized EPS gains. With a valuation only slightly above the 16-year average and in line with the market multiple (bottom panel), such EPS strength should point to stock price outperformance; stay overweight. The ticker symbols for the stocks in this index are: BLBG: S5RAIL - UNP, CSX, NSC, KSU. Stoking The Boiler For 2018 Stoking The Boiler For 2018

Overweight Railroad stocks have recently seen a spike in forward EPS which has eliminated the valuation premium and now the rails are trading on par with the SPX on a forward P/E basis (second panel). The track is now clear and more gains are in store for relative share prices in the coming quarters. Industry operating metrics point to a profit resurgence this year. Importantly, our rails profit margin proxy (pricing power versus employment additions) has recently reaccelerated both because selling prices are expanding at a healthy clip and due to labor restraint (third panel). Demand for rail hauling remains upbeat and our rail diffusion indicator has surged to a level last seen in 2009, signaling that there is a broad based firming in rail carload shipments (bottom panel), particularly the ever-important coal and intermodal segments. Bottom Line: Continue to overweight the broad S&P transportation index, and especially the heavyweight S&P railroads sub-index; please see yesterday's Weekly Report for more details. The ticker symbols for the stocks in this index are: BLBG: S5RAIL - UNP, CSX, NSC, KSU. Stay On Board The Rails Stay On Board The Rails

Highlights Portfolio Strategy Synchronized global growth, a soft U.S. dollar, our resurgent Boom/Bust Indicator and avoidance of a Chinese economic hard landing, are all signaling that it still pays to overweight cyclicals at the expense of defensives. Economically hyper-sensitive transports also benefit from synchronous global growth and capex. We expect a rerating phase in the coming months. Within transports, we reiterate our overweight stance in the key railroads sub-index as enticing macro tailwinds along with firming operating metrics underscore that profits will exit deflation in calendar 2018. Recent Changes There are no portfolio changes this week. Table 1 Staying Focused On The Dominant Macro Themes Staying Focused On The Dominant Macro Themes Feature The S&P 500 continued to consolidate last week, still digesting the early February tremor. Policy uncertainty is slowly returning and sustained Administration reshufflings are becoming slightly unnerving (bottom panel, Chart 1). Nevertheless, the dual themes of synchronized global growth and budding evidence of coordinated tightening in global monetary policy, i.e. rising interest rate backdrop, continue to dominate and remain intact. Importantly in the U.S., the latest non-farm payrolls (NFP) report was a goldilocks one. Month-over-month NFPs surpassed the 300K hurdle for the first time since late-2014, on an as-reported-basis, while wage inflation settled back down. The middle panel of Chart 2 shows that both in the 1980s and 1990s expansions, NFPs were growing briskly, easily clearing the 300K mark. The 2000s was the "jobless recovery" expansion and likely the exception to the rule. In all three business cycle expansions wage growth touched the 4%/annum rate before the recession hit. The yield curve slope also supports this empirical evidence, forecasting that wage inflation will likely attain 4%/annum before this cycle ends (wages shown inverted, Chart 3). Chart 1Watch Policy Uncertainty Watch Policy Uncertainty Watch Policy Uncertainty Chart 2Goldilocks NFP Report... Goldilocks NFP Report... Goldilocks NFP Report... Chart 3...But Wage Growth Pickup Looms ...But Wage Growth Pickup Looms ...But Wage Growth Pickup Looms One key element in the current cycle is that the government is easing fiscal policy to the point where both NFPs and wages will likely surge in the coming months as the fiscal thrust gains steam, likely extending the business cycle. This is an inherently inflationary environment, especially when the economy is at full employment and the Fed in slow and steady tightening mode. Last autumn, we showed that the SPX performs well in times of easy fiscal and tight money iterations, rising on average 16.7% with these episodes, lasting on average 16 months (Table 2).1 The latest flagship BCA monthly publication forecasts that the current fiscal impulse will last at least until year-end 2019, contributing positively to real GDP growth. Thus, if history at least rhymes, SPX returns will be positive and likely significant for the next couple of years (Chart 4). With regard to the composition of the equity market's return, we reiterate our view - backed by empirical evidence - that EPS will do the heavy lifting whereas the forward P/E multiple will continue to drift sideways to lower.2 Not only will rising fiscal deficits cause the Fed to remain vigilant and continue to raise interest rates and weigh on the equity market multiple (Chart 5), but also heightened volatility will likely suppress the forward P/E multiple. Table 2SPX Returns During Periods Of Loose##br## Fiscal And Tight Monetary Policy Staying Focused On The Dominant Macro Themes Staying Focused On The Dominant Macro Themes Chart 4Stimulative Fiscal Policy##br## Extends The Business Cycle... Stimulative Fiscal Policy Extends The Business Cycle... Stimulative Fiscal Policy Extends The Business Cycle... Chart 5...But Weighs On ##br##The Multiple ...But Weighs On The Multiple ...But Weighs On The Multiple This week we revisit our cyclical versus defensive portfolio bent and update the key transportation overweight view. Cyclicals Thrive When Global Growth Is Alive And Well... While retaliatory tariff wars are dominating the media headlines, global growth is still resilient. Our view remains that the odds of a generalized trade war engulfing the globe are low, and in that light we reiterate our cyclical over defensive portfolio positioning, in place since early October.3 Global growth is firing on all cylinders. Our Global Trade Indicator is probing levels last hit in 2008, underscoring that cyclicals will continue to have the upper hand versus defensives (Chart 6). Synonymous with global growth is the softness in the U.S. dollar. In fact, the two are in a self-feeding loop where synchronized global growth pushes the greenback lower, which in turn fuels further global output growth. Tack on the rising likelihood that the trade-weighted dollar has crested from a structural perspective, according to the 16-year peak-to-peak cycle4 (Chart 7) and the news is great for cyclicals versus defensives (Chart 8). Chart 6Global Trade Is Alright Global Trade Is Alright Global Trade Is Alright Chart 7Dollar The Great Reflator... Dollar The Great Reflator... Dollar The Great Reflator... Chart 8...Is A Boon For Cyclicals Vs. Defensives ...Is A Boon For Cyclicals Vs. Defensives ...Is A Boon For Cyclicals Vs. Defensives Related to the greenback's likely secular peak is the booming commodity complex, as the two are nearly perfectly inversely correlated. Commodity exposure is running very high in the deep cyclical sectors and thus any sustained commodity price inflation gains will continue to underpin the cyclicals/defensives share price ratio. BCA's Boom/Bust Indicator (BBI) corroborates this upbeat message for cyclicals versus defensives. The BBI is on the verge of hitting an all-time high and, while this could serve as a contrary signal, there are high odds of a breakout in the coming months if synchronized global growth stays intact as BCA expects, rekindling cyclicals/defensives share prices (Chart 9). Finally, if China avoids a hard landing, and barring an EM accident, the cyclicals/defensives ratio will remain upbeat. Chart 10 shows that China's LEI is recovering smartly from the late-2015/early-2016 manufacturing recession trough, and the roaring Chinese stock market - the ultimate leading indicator - confirms that the path of least resistance for the U.S. cyclicals/defensive share price ratio is higher still. Chart 9Boom/Bust indicator Is Flashing Green Boom/Bust indicator Is Flashing Green Boom/Bust indicator Is Flashing Green Chart 10China Is Also Stealthily Firming China Is Also Stealthily Firming China Is Also Stealthily Firming Bottom Line: Stick with a cyclical over defensive portfolio bent. ...As Do Transports, Thus... Transportation stocks have taken a breather recently on the back of escalating global trade war fears. But, we are looking through this soft-patch and reiterate our barbell portfolio approach: overweight the global growth-levered railroads and air freight & logistics stocks at the expense of airlines that are bogged down by rising capacity and deflating airfare prices (Chart 11). Leading indicators of transportation activity are all flashing green. Transportation relative share prices and manufacturing export expectations are joined at the hip, and the current message is to expect a reacceleration in the former (top panel, Chart 12). Similarly, capital expenditures, one of the key themes we are exploring this year, are as good as they can be according to the regional Fed surveys, and signal that transportation profits will rev up in the coming months (middle panel, Chart 12). The possibility of an infrastructure bill becoming law later this year or in 2019 would also represent a tailwind for transportation EPS. Not only is U.S. trade activity humming, but also global trade remains on a solid footing. The global manufacturing PMI is resilient and sustaining recent gains, suggesting that global export volumes will resume their ascent. This global manufacturing euphoria is welcome news for extremely economically sensitive transportation profits (Chart 13). All of this heralds an enticing transportation services end-demand outlook. In fact, industry pricing power is gaining steam of late and confirms that relative EPS will continue to expand (Chart 12). Under such a backdrop, a rerating phase looms in still depressed relative valuations (bottom panel, Chart 13). Chart 11Stick With Transports Exposure Stick With Transports Exposure Stick With Transports Exposure Chart 12Domestic... Domestic... Domestic... Chart 13...And Global Growth/Capex Beneficiary ...And Global Growth/Capex Beneficiary ...And Global Growth/Capex Beneficiary ...Stay On Board The Rails Railroad stocks have worked off the overbought conditions prevalent all of last year, and momentum is now back at zero. In addition, forward EPS have spiked, eliminating the valuation premium and now the rails are trading on par with the SPX on a forward P/E basis (Chart 14). The track is now clear and more gains are in store for relative share prices in the coming quarters. Despite trade war jitters, we are looking through the recent turbulence. If the synchronized global growth phase endures, as we expect, then rail profits will remain on track. In fact, BCA's measure of global industrial production (hard economic data) is confirming the euphoric message from the global manufacturing PMI (soft economic data) and suggests that rails profits will overwhelm (Chart 15). Our S&P rails profit model also corroborates this positive global trade message and forecasts that rail profit deflation will end in 2018 (bottom panel, Chart 15). Beyond these macro tailwinds, operating industry metrics also point to a profit resurgence this year. Importantly, our rails profit margin proxy (pricing power versus employment additions) has recently reaccelerated both because selling prices are expanding at a healthy clip and due to labor restraint (second panel, Chart 15). Demand for rail hauling remains upbeat and our rail diffusion indicator has surged to a level last seen in 2009, signaling that there is a broad based firming in rail carload shipments (second panel, Chart 16). Chart 14Unwound Both Overbought Conditions And Overvaluation Unwound Both Overbought Conditions And Overvaluation Unwound Both Overbought Conditions And Overvaluation Chart 15EPS On Track To Outperform EPS On Track To Outperform EPS On Track To Outperform Chart 16Intermodal Resilience Intermodal Resilience Intermodal Resilience The significant intermodal segment that comprises roughly half of all shipments is on the cusp of a breakout. The retail sales-to-inventories ratio is probing multi-year highs on the back of the increase in the consumer confidence impulse and both are harbingers of a reacceleration in intermodal shipments (Chart 16). Coal is another significant category that takes up just under a fifth of rail carload volumes and bears close attention. While natural gas prices have fallen near the lower part of the trading range in place since mid-2016 and momentum is back at neutral, any spike in nat gas prices will boost the allure of coal as a competing fuel for energy generation (middle panel, Chart 17). Keep in mind that coal usage is highly correlated with electricity demand and the industrial business cycle, and the current ISM manufacturing survey message is upbeat for coal demand. Tack on the whittling down in coal inventories at utilities and there is scope for a tick up in coal demand (third panel, Chart 18). Finally, the export relief valve has reopened for coal with the aid of the depreciating U.S. dollar, and momentum in net exports has soared to all-time highs, even surpassing the mid-1982 peak (bottom panel, Chart 18). Chart 17Key Coal Shipments Underpin Selling Prices Key Coal Shipments Underpin Selling Prices Key Coal Shipments Underpin Selling Prices Chart 18Upbeat Leading Indicators Of Coal Demand Upbeat Leading Indicators Of Coal Demand Upbeat Leading Indicators Of Coal Demand All of this suggests that coal shipments will make a comeback later in 2018, and continue to underpin industry pricing power, which in turn boost rail profit prospects (bottom panel, Chart 17). Bottom Line: Continue to overweight the broad S&P transportation index, and especially the heavyweight S&P railroads sub-index. The ticker symbols for the stocks in this index are: BLBG: S5RAIL - UNP, CSX, NSC, KSU. Anastasios Avgeriou, Vice President U.S. Equity Strategy anastasios@bcaresearch.com 1 Please see BCA U.S. Equity Strategy Weekly Report, "Can Easy Fiscal Offset Tighter Monetary Policy?" dated October 9, 2017, available at uses.bcaresearch.com. 2 Please see BCA U.S. Equity Strategy Weekly Report, "EPS And 'Nothing Else Matters'," dated December 18, 2017, available at uses.bcaresearch.com. 3 Please see BCA U.S. Equity Strategy Special Report, "Top 5 Reasons To Favor Cyclicals Over Defensives," dated October 16, 2017, available at uses.bcaresearch.com. 4 Please see BCA Foreign Exchange Strategy Weekly Report, "The Euro's Tricky Spot," dated February 2, 2018, available at fes.bcaresearch.com. Current Recommendations Current Trades Size And Style Views Favor value over growth. Stay neutral small over large caps (downgrade alert).

Overweight Last week saw some sad news as Hunter Harrison, the CEO of CSX and legendary railroad captain, passed away. While we are overweight the S&P railroads index, we did not upgrade when Mr. Harrison joined CSX and we will not change our rating as a result of his passing. Rather, we continue to focus on surging global trade volume (second panel) as the fundamental revenue driver. Our rail shipment commodity group diffusion indicator is sending a nearly unanimous message of rising volumes (third panel), which should correlate with continued overall industry volume gains. Further, industry pricing power is soaring while employment is declining (bottom panel) which, in conjunction with the previously noted volume growth, implies solid productivity improvements to come. This means margins have a powerful tailwind, irrespective of the operating leverage that topline growth should deliver. In sum, railroads remain a core industrial and transports holding; stay overweight. The ticker symbols for the stocks in this index are: BLBG: S5RAIL - UNP, CSX, NSC, KSU. Global Trade Keeps Rails On Track Global Trade Keeps Rails On Track

Earlier this week, CSX led off railroad Q3 earnings, managing to beat expectations while overcoming hurricanes and derailments. Of particular note was solid pricing gains despite somewhat lagging domestic inflation and CSX-specific service issues. Even modest growth bodes exceptionally well for the industry as pricing moves have historically been good indicators of margin gains (second panel). Further, firming in intermodal shipping specifically portends ongoing EPS improvements. Intermodal is broadly a reflection of global production & trade, which is tightly correlated with profit growth (third panel). Our rails EPS model captures all this, and it continues to indicate a surge in profit growth relative to the S&P 500 (bottom panel). We reiterate our overweight position. The ticker symbols for the stocks in this index are: BLBG: S5RAIL - UNP, CSX, NSC, KSU. Stay On The Rails Stay On The Rails

When Hunter Harrison took over the reins at CSX, the expectation was a repetition of his slashing of costs with the deployment of his Precision Scheduled Railroading. In his first full quarter as CEO, he appears to have done just that. However, the real surprise (and the one with direct read-through to the sector as a whole) was the pricing gains on the already-known strong quarterly volume; this bodes exceptionally well for the sector. Our upgrade of the sector to overweight last month was based on firming pricing driven by rising volumes (including coal); the CSX results confirm that expectation. In fact, the industry appears to be enjoying the best pricing power of the past 5 years, according to the latest PPI release (middle panel). Our rails EPS model captures this pricing strength and continues to indicate a surge in profit growth relative to the S&P 500. We reiterate our overweight position. The ticker symbols for the stocks in this index are: BLBG: S5RAIL -UNP, CSX, NSC, KSU. Rail Pricing Accelerating Rail Pricing Accelerating

Overweight We booked gains on the rails in late-January of this year as growth worries mounted; since then, relative performance has been in consolidation mode. Now is the time to re-board the rails as these worries have largely dissipated, underpinned by the budding recovery in global trade and a favorable domestic operating backdrop for the largest S&P transportation sub-index. BCA's global industrial production (IP) growth composite is marching steadily higher (second panel). Historically, global IP and rail relative forward EPS estimates have moved in tandem, and the current message is that rail profit outperformance is still in the early stages. On the domestic front, increased freight activity coupled with capacity discipline have started to support a recovery in rail pricing power. Rail margins have significant leverage to pricing changes, and against a backdrop of well contained wage costs and low diesel fuel prices, profit margins should rebound smartly (third panel). All of these factors are captured in our rails EPS model which has surged relative to our S&P 500 profit model (bottom panel). Net, we are boosting the S&P railroads index (BLBG: S5RAIL - CSX, KSU, NSC, UNP) to overweight. Hop On The Rails For A Ride Hop On The Rails For A Ride

Highlights Portfolio Strategy Reviving global trade and an enticing domestic operating backdrop mean that, after a 5-month hiatus, it is once again time to ride the rails. Even a modest reacceleration in global export volumes and domestic food and beverage shipments should propel the S&P containers & packaging index toward cyclical highs. Recent Changes S&P Railroads - Boost to overweight. Table 1 Correlations Explained Correlations Explained Feature A rotational correction remains the dominant market theme; all of the financials sector's gains have mirrored the tech sector's losses. Our view remains that this rotation is healthy, and that consolidation rather than correction is the appropriate broad market context. One catalyst for the late week pullback and escalation of the sub-surface transitions was the Fed's stress test results, which all banks passed. That was a first, and investors cheered a slew of share buyback and dividend payout increase announcements. Meanwhile, narrowing interest rate differentials continue to put downward pressure on the U.S. dollar, allowing inflation expectations to stabilize and spurring a nascent steepening of the yield curve. In fact, a global bond selloff is gaining steam, as the era of extraordinarily easy global monetary policy is likely coming to an end. That should ensure that flows into financial stocks persist, especially given the upbeat message from our profit model (Chart 1). In recent research we have shown how receding correlations are a tonic for stock returns, but the CBOE's implied correlation index is limiting as it covers only one business cycle. Chart 2 shows an average of the pairwise 52-week correlations between 40 equity sectors using weekly S&P return data starting in the late-1990s, alongside the S&P 500 (correlation index shown inverted). The message is similar to the CBOE implied correlation index, as stock correlations collapse, i.e. stock picking gains traction and earnings fundamentals dictate the broad trend, the S&P 500 climbs higher, and vice versa. Chart 1Upbeat EPS Model Message Upbeat EPS Model Message Upbeat EPS Model Message Chart 2Falling Correlations Boost The S&P500 Falling Correlations Boost The S&P500 Falling Correlations Boost The S&P500 Chart 3 goes a step further. Using S&P GICS1 data we ran the same exercise on the top ten sector pairwise correlations all the way back to the mid-1970s. While stock correlations do move inversely with stock prices (not shown), this chart reveals another interesting trend. Chart 3Good Recession Predictor, But Not Worried Yet Good Recession Predictor, But Not Worried Yet Good Recession Predictor, But Not Worried Yet Equity correlations have often led the business cycle. When correlations drop precipitously, recession warnings abound. However, there have been two notable exceptions, in the mid-80s and mid-to-late-90s. Then, correlations fell, but the economy did not enter recession. The common denominator in both of those periods was the drubbing in the commodity pits, especially energy. In other words, commodity deflation morphed into a mid-cycle economic slowdown, but the broad market stayed resilient because the economy skirted recession. In fact, when oil hit $10/bbl in 1986 and 1998, the S&P 500 subsequently surged. The S&P 500 has once again defied oil's gravitational pull (Chart 4), because it has produced a healthy deflation/disinflation rather than a debilitating one (oil inflation shown inverted, Chart 5). Chart 4Slipping Oil Fuels Equities... Slipping Oil Fuels Equities... Slipping Oil Fuels Equities... Chart 5...And The Economy ...And The Economy ...And The Economy As a result, we are not worried about a U.S. recession just yet, despite the drop in stock correlations. Instead, equities have likely navigated through a mid-cycle correction, as in the mid-80s and mid-to-late-90s. This week we continue to add cyclical exposure to our portfolio via upgrading a transport heavyweight, and reiterating our bullish stance on a niche materials global growth play. Hop On The Rails For A Ride Railroad stocks bested the market by 40% from the Q1/2016 trough to the Q1/2017 peak, and we managed to get on board for the bulk of that ride. We booked gains in late-January and since then relative performance has been in consolidation mode. Is it time to re-board the rails now that global growth worries have largely dissipated? The short answer is yes. Two key drivers underpin our bullish thesis: the budding recovery in global trade and a favorable domestic operating backdrop for the largest S&P transportation sub-index. Last week we upped our conviction status to high in the S&P air freight & logistics group, on the back of rising global exports volumes. Rails also benefit from improving trade/economic activity. BCA's global industrial production (IP) growth composite is marching steadily higher (third panel, Chart 6). Historically, global IP and rail relative forward EPS estimates have moved in tandem, and the current message is that rail profit outperformance is still in the early stages. Credit availability is the fuel required to bolster global trade, and easy global monetary and financial conditions are enticing banks to originate loans. According to the BIS, global credit growth is on the mend, and the global credit impulse is accelerating. The implication is that world export growth should continue to climb, to the benefit of rail freight activity, and by extension, relative profitability (Chart 6). While rail shipments have surged since the late-2015/early-2016 manufacturing recession, relative forward earnings momentum has only just recently crossed into positive territory, suggesting that there is additional scope for upward revisions (second panel, Chart 6). On the domestic front, leading rail freight indicators remain upbeat. The manufacturing, wholesale and, most importantly, retail sales-to-inventories ratios continue to expand nicely, signaling buoyant intermodal demand. The CASS freight index is also gaining steam (Chart 12, in the next section) and L.A. port traffic is heavy. Our Railroad Indicator hit a 5-year high recently, and hints that more gains are in store for railroads (Chart 7). Chart 6A Play On Global Growth A Play On Global Growth A Play On Global Growth Chart 7Domestic Outlook Is Positive Domestic Outlook Is Positive Domestic Outlook Is Positive Commodity railcar loads in general, and coal in particular have also staged a recovery, albeit from an all-time low level. Coal is significant as it comprises roughly 20% of all rail shipments and is a high margin category (fourth panel, Chart 8). As the U.S. economy rebounds after a weak Q1, electricity demand should remain firm. The near doubling in natural gas prices in the past 18 months should provide an assist to coal shipments, as the latter will become an increasingly competitively priced alternative for power generation (Chart 8). Increased freight activity coupled with capacity discipline have started to support a recovery in rail pricing power. Rail margins have significant leverage to pricing changes, and against a backdrop of well contained wage costs and low diesel fuel prices, profit margins should rebound smartly (middle panel, Chart 9). Clearly, margin expansion would be a meaningful catalyst for a valuation re-rating (bottom panel, Chart 9). All of these factors are captured in our rails EPS model. The latter has surged relative to our S&P 500 profit model (Chart 10) implying that analysts have room to further upgrade their relative profit estimates. Chart 8Firming Selling Prices... Firming Selling Prices... Firming Selling Prices... Chart 9...Are A Boon For Margins ...Are A Boon For Margins ...Are A Boon For Margins Chart 10Rails EPS Model Says Buy Rails EPS Model Says Buy Rails EPS Model Says Buy In sum, recovering global trade and an enticing domestic operating backdrop underscore that after a 5-month hiatus the time is right to ride the rails once again. Bottom Line: Boost the S&P railroads index (CSX, KSU, NSC, UNP) to overweight. Don't "Pack" It In Now The global macro backdrop is fertile ground for the niche S&P containers & packaging index to stage a run at cyclical relative performance highs. If our thesis that global trade will continue to advance pans out, then packaging stocks should follow in the footsteps of both air freight & logistics and railroad stocks. Export volumes are one of the best predictors of relative profitability, given that packaging companies need high utilization rates to fully demonstrate the scope of their operating leverage. The current synchronized EM and DM economic recovery will continue to underpin global trade. Chart 11 shows that export volumes have hit all-time highs and momentum is also reaccelerating, despite the lack of response in export prices. Importantly, the lack of export price inflation may stoke additional volume gains. The steep rise in overall rail car shipments, increased activity at North American ports and the V-shaped recovery in the CASS freight shipments index also point to earnings outperformance in the coming quarters (Chart 12). Chart 11Another Play On Global Trade... Another Play On Global Trade... Another Play On Global Trade... Chart 12...With Upbeat Domestic Prospects ...With Upbeat Domestic Prospects ...With Upbeat Domestic Prospects Meanwhile, the secular shift away from brick and mortar sales and toward online shopping represents another positive EPS tailwind. The second panel of Chart 13 shows that as online sales continue to grab a rising share of overall retail sales, the packaging industry is a derivative beneficiary, albeit with a lag. Packaging manufacturers also court food and beverage-related industries as their customers. Thus, any food and beverage price swings have a direct impact on volume growth. In other words, when prices rise demand for food and beverages drops and volumes retreat, and vice versa. Now that Amazon is escalating the grocery wars and Aldi and Lidl are also expanding their U.S. footprint, food and beverage price pressure will intensify. The implication is that a volume driven relative profit recovery is brewing (Chart 13). Already, companies in the packaging index are successfully raising selling prices at a healthy clip. Indeed, firming packaging products demand has caused packaging price inflation to breach multi-year highs on a 6-month rate of change basis. If volume growth persists, as we expect, then selling prices should continue to expand and support profit margins (Chart 14). Chart 13Booming Online And Food Volumes Are A Plus Booming Online And Food Volumes Are A Plus Booming Online And Food Volumes Are A Plus Chart 14Margin Expansion Phase Looms Margin Expansion Phase Looms Margin Expansion Phase Looms Simultaneously, the industry is keeping labor costs under control. Such discipline typically aids profit margins. Tack on receding commodity-related input cost inflation and the ingredients are in place for a substantial profit margin and, as a result, EPS expansion. All of this positive news is not yet reflected in still depressed relative valuations. The industry is trading at a 10% discount to the broad market on a forward P/E basis. Even a modest reacceleration in global export volumes and domestic food and beverage shipments should propel the index toward cyclical highs (Chart 13). Bottom Line: Stay overweight the S&P containers & packaging index (IP, BLL, WRK, SEE, AVY). Current Recommendations Current Trades Size And Style Views Favor small over large caps and stay neutral growth over value.