Sectors

Highlights The recent improvement in China's housing data has been mainly driven by the central bank's direct lending to the real estate sector. This improvement is unlikely to last, as the authorities are scaling down this form of financing. Structural imbalances remain acute in the Chinese real estate market, and the path of least resistance is still down. Diminishing direct financing from the central bank, low affordability, slowing rural-to-urban migration, the promotion of the housing rental market and the government's continuing emphasis on clamping down speculation will all lead to weaker property sales over the next 12 months. Both weakening sales and tightening funding sources for real estate developers point to declining growth of property starts and construction. This will be negative for construction-related commodity markets (steel, cement, copper, aluminum and glass) and construction-related machinery. Stay neutral Chinese versus global stocks and favor low-beta sectors within the Chinese investable universe. Avoid Chinese property developers, though favor large versus small. Feature Chart 1Property Sales And Starts: Will Recent Growth Acceleration Continue? Property Sales And Starts: Will Recent Growth Acceleration Continue? Property Sales And Starts: Will Recent Growth Acceleration Continue? BCA's China Investment Strategy service has argued for the better part of the past year that China's old economy has been in the midst of a benign, controlled slowdown. Since then, our leading indicators have continued to deteriorate, and now China is facing a potentially significant shock to its export sector due to U.S. policy. This has caused many investors to focus on domestic demand, and whether there are any meaningful signs of improvement that could act as a reflationary bridge for the economy to weather the looming external shock. We have argued that housing has stood out as the best potential candidate for a domestic demand upturn and, at first blush, recent data suggests that a material uptrend in activity may be in the cards1 (Chart 1). However, in this report, we argue that the central bank's direct lending to the real estate sector has been the major force behind the recent improvement in the housing data, and will be unwinding. Barring new policy measures, the improvement is unlikely to last. What Has Driven Housing Sales? Chart 2Chinese Housing Monetization Policy: The Main Driver Of Property Market Since 2015 Chinese Housing Monetization Policy: The Main Driver Of Property Market Since 2015 Chinese Housing Monetization Policy: The Main Driver Of Property Market Since 2015 The growth acceleration in both floor space sold and floor space started, shown in Chart 1, warrants scrutiny of the Chinese property market. Will housing sales and starts growth continue to accelerate as it did in 2013 and 2016, or are the most recent gains just a temporary rebound? To answer this question, one needs to understand China's pledged supplementary lending (PSL) scheme, which refers to China's central bank's direct lending to the real estate market. In this report, we also use "housing monetization policy" as an interchangeable term to the "PSL scheme." Our research suggests that the central bank's PSL injections have been the major determinant of sales and prices in the Chinese real estate market over the past three years (Chart 2). The People's Bank of China (PBoC) injected 698 billion RMB in 2015 and 971 billion RMB in 2016 in the form of PSL injections into the real estate market as part of its attempts to revive the property market. The massive fund injection boosted floor space sold from a deep contraction in 2015 to a 30% year-over-year growth rate in 2016. This burst in sales volume drove up already-elevated housing prices even higher. In 2017, the government shrank the PSL amount by 35% and implemented other tightening policies to cool down the domestic property market. As a result, both property price growth and floor space sold growth decelerated significantly. Both floor space started growth and floor space sold growth bottomed last October as PSL injections re-accelerated again in November 2017. The most recent acceleration was also mainly because of the front-loaded PSL injection program, which was ramped back up 4.8% year-on-year in the first five months of 2018. In general, it takes several months for PSL lending to make its way into final purchase of properties. Clearly the PSL program has been responsible for boosting housing sales in the past three years. So, how does the PSL scheme work, and will it continue to boost property sales going forward? PSL = Housing Monetization Chart 3 illustrates how the PSL scheme works. The government designed the policy in 2014 with two objectives in mind: supplying sufficient funds for slum area reconstruction (also called shantytown redevelopment) and de-stocking the housing market. The PSL facility allows the PBoC to lend funds earmarked for slum area reconstruction to the three policy banks (China Development Bank, Agricultural Development Bank of China and Export-Import Bank of China) at very low interest rates. These policy banks in turn lend directly to local governments (mainly in tier-2 and smaller cities). Chart 3How Does Chinese Housing Monetization Scheme work? China's Property Market: Where Will It Go From Here? China's Property Market: Where Will It Go From Here? From there, to buy the land from slum owners, the local government can adopt one of three approaches: Give cash directly to slum owners in exchange for their land, and then the owners can go to real estate developers to buy properties; Use the funds to pay property developers for their existing housing inventories, and then use the purchased properties to exchange the land with slum owners; A combination of 1 and 2. This policy has empowered the PBoC to be able to inject a significant amount of liquidity directly into the Chinese property market. Consequently, the PSL scheme has boosted floor space sold as well as facilitated floor space started by providing more funds to real estate developers. The PSL program has been the main reason why housing inventories have dropped since 2015. Our calculations indicate that about 20% of floor space sold (in volume terms) in 2017 was due to the PSL facility designed for slum area reconstruction (Chart 4). Various reports have also suggested that, for some cities with strong monetization policies, this ratio has reached over 50%. Deposits and advance payments of property sales, which closely correlates with floor space sold, is the major source of funds available for real estate investment (Chart 5). It has contributed 30-40% of total fund growth every year in the past three years. Chart 4Housing Monetization: The Main Driver For Property Sales Since 2015 Housing Monetization: The Main Driver For Property Sales Since 2015 Housing Monetization: The Main Driver For Property Sales Since 2015 Chart 5More Property Sales = More Fund Inflows To Property Developers More Property Sales = More Fund Inflows To Property Developers More Property Sales = More Fund Inflows To Property Developers Last year, in RMB terms, PSL injections were equivalent to 94% of the annual increase in deposits and advance payments. Looking forward, while we do not think the government will completely halt the PSL scheme, we do believe the monetization scale is set to diminish considerably over the next 12 months: First, since this past June, when the central bank signaled it would restrict the scale of monetization, the year-over-year growth of PSL injections has already declined three months in a row with 36% contraction for the period from June-August from a year ago. Chart 6Destocking Is At Late Stage Destocking Is At Late Stage Destocking Is At Late Stage Second, in the government's 2018-2020 slum area reconstruction plan, the authorities aim to reconstruct 15 million units of flats. This year's goal is 5.8 million units, leaving 9.2 million units for the two years of 2019 and 2020 combined. Assuming an equal split of 9.2 million flats over the next two years, this will imply that the number of flats for the slum area reconstruction will decline to 4.6 million units in 2019, a 20% drop from this year's 5.8 million units. Third, the monetization policy has already successfully reduced residential inventories by 42% from their peak, based on the government's measure of property inventories (defined as completed and waiting for sale) (Chart 6). Lastly, if there had been no PSL scheme, the Chinese housing market and economy would have been much weaker. In this aspect, the policy was beneficial. However, it has had unintended consequences: The country's property bubble has become even more inflated. Overall, our view is that the authorities are likely to scale down the scheme. Bottom Line: Recent improvement in the housing data - mainly driven by the government's PSL scheme - is unlikely to last. The scale of housing monetization (i.e., PSL injections) will diminish. Structural Imbalances With diminishing tailwinds from the housing PSL program, will any other drivers emerge to boost floor space sales and started growth? We are quite pessimistic. Structural imbalances remain acute in the Chinese real estate market, suggesting the path of least resistance for the market is still down. The outlook for property sales growth Beyond the prospect of diminishing housing monetization over the next 12 months, structural factors including falling affordability, slowing rural-to-urban migration, demographic changes, the promotion of the rental market and the government's continuing emphasis on clamping down on speculation will all lead to weaker property sales. House prices in China remain extremely high relative to disposable income. Using the NBS 70-city residential average price, our calculation shows that it will take an average two-income household 11 years of disposable income to buy a 90-square-meter (equivalent to 970 square feet) house at current prices, much higher than the same ratio in the U.S. (Chart 7). With respect to the ability to service mortgage payments, on a 90-square-meter house with a 20% down payment, our calculations show that annual interest costs account for nearly half of average household disposable income levels (again, assuming a two-income household) (Table 1). Chart 7Poor Affordability For Chinese Home Buyers Poor Affordability For Chinese Home Buyers Poor Affordability For Chinese Home Buyers Table 1House Price-To-Income Ratios And Affordability China's Property Market: Where Will It Go From Here? China's Property Market: Where Will It Go From Here? A joint report released by the central bank and the finance department shows that the number of delinquent mortgages on housing provident funds2 - loans that are much cheaper than market mortgage loans - rose by 35% year over year last year, validating the extremely poor affordability of Chinese properties. The pace of urbanization is slowing (Chart 8). The number of individuals moving from rural areas to cities as a percentage of the urban population is decreasing. Net migration as a share of the urban population has fallen to 2% today. Overall urban population growth has slowed below 3%. The Chinese population is aging rapidly. The proportion of citizens who are over the age of 65 has risen from 8% of the population in 2007 to 11.4% as of last year, larger than the 10 to 19-year-old age group, which accounts for only 10.5% of the total population. Given Chinese life expectancy is currently at about 76 years, over the next 10 to 15 years the former cohort will leave a large number of houses to the latter cohort, most of whom will get married with high demand for shelter but likely little need to buy due to inheritance. This also indicates the number of second-hand properties available for either rent or sale will rise. The government is currently aiming to develop the domestic rental market. For example, the authorities are encouraging the private sector to convert excess office and commercial buildings and/or use currently empty apartments for housing rentals. President Xi Jinping's mantra that "housing is for living in, not for speculation" - proclaimed in December 2016 - remains the focal point of the government's current policies. Chart 8China: Slowing Pace Of Urbanization China: Slowing Pace Of Urbanization China: Slowing Pace Of Urbanization Chart 9Tightening Funding Sources For Chinese Property Developers Tightening Funding Sources For Chinese Property Developers Tightening Funding Sources For Chinese Property Developers The outlook for property starts growth Falling growth of sold area and the authorities' current de-leveraging focus all point to declining growth of floor space started. Real estate developers need funds to invest in and develop new buildings. Their main source of funds includes deposits and advance payments from property sales, bank loans, foreign investment (i.e., foreign borrowings and foreign direct investment), self-raised (i.e., equity financing), and capital raised through bond issuance. The government's current deleveraging focus has led to a sharp drop in bank loans and foreign investment for domestic real estate developers (Chart 9). In such an environment, developers have been facing increasing difficulty raising funds through issuing bonds - bond issuance both on- and offshore have plunged this year. Diminishing housing monetization will also slow fund growth from property sales. Hence, weakening sales and tightening financing sources available for investment entail floor space starts growth should decelerate. There are several signs suggesting unsustainability of the recent growth acceleration in floor space started. Excluding land purchases, real estate investment has showed contraction across the board - from construction and installation to equipment purchases (Chart 10). Despite the strong growth of floor space started, this may indicate the strength of actual construction activity of recent new starts has actually been weak due to slowing pace of construction because of lack of funds. Otherwise, strong floor space started growth should coincide with robust growth in non-land real estate investment. For projects under construction, completed floor space has also been in deep contraction across the board - from residential to commercial, office and others (Chart 11). This again signals that property developers are slowing the pace of construction. This could also be due to deficient financing. For the first seven months of this year, seven provinces (Jiangsu, Shandong, Hunan, Guizhou, Guangdong, Chongqing, and Fujian), which account for only about 40% of total national floor space started, contributed 80% of floor space started year over year growth. There were still 11 provinces experiencing contraction in floor space started so far this year. This suggests the breadth of the latest improvement in sales has been weak. Chart 10Real Estate Investment Ex. Land: Falling Across Board Real Estate Investment Ex. Land: Falling Across Board Real Estate Investment Ex. Land: Falling Across Board Chart 11Property Completed: Falling Across Board Property Completed: Falling Across Board Property Completed: Falling Across Board Moreover, for all these seven provinces, only this year floor space started growth has surpassed floor space sold growth (Chart 12). Chart 12AProperty Starts Growth Looks Shaky Property Starts Growth Looks Shaky Property Starts Growth Looks Shaky Chart 12BProperty Starts Growth Looks Shaky Property Starts Growth Looks Shaky Property Starts Growth Looks Shaky This raises questions on the sustainability of the recent growth acceleration in floor space started. Our bet is that the lagging relationship between floor space started and floor space sold is still valid. If our projection of weaker demand materializes, floor space started growth will likely soon fall back. Bottom Line: Structural imbalances in the Chinese real estate market point to a downtrend in both floor space sold growth and floor space started growth. Investment Implications From a macro perspective, it is unlikely that housing will act as a significant reflationary offset for the economy without a notable reversal on several policies described above (and then a lag for flow-through to real economy). This suggests that the primary trend for Chinese stock prices and CNY-USD remains captive to the ongoing U.S./China trade war. Stay neutral on Chinese stocks versus global equities and favor low-beta sectors within the Chinese investable universe. In addition, we can also draw the following investment strategy conclusions: Construction-related commodity markets (steel, cement, copper, aluminum and glass) and construction-related machinery may have more downside (Chart 13). As Chinese property developers' stocks are facing rising downside risks, we suggest avoiding Chinese property developers. However, China may have intense consolidation in its real estate market, so some large property developers may outperform. The fundamentals in the U.S. housing market are much better than in China. While rising U.S. interest rates could be a headwind for U.S. homebuilders' share prices, they stand to resume their outperformance versus Chinese property developers (Chart 14). Chart 13Commodities Prices Still Face Downside Risks Commodities Prices Still Face Downside Risks Commodities Prices Still Face Downside Risks Chart 14Chinese Property Developers Equities: More Downside Ahead Chinese Property Developers Equities: More Downside Ahead Chinese Property Developers Equities: More Downside Ahead Ellen JingYuan He, Associate Vice President Emerging Markets Strategy EllenJ@bcaresearch.com 1 Pease see China Investment Strategy Weekly Reports "Is China's Housing Market Stabilizing?", dated February 8, 2018, "China: A Low-Conviction Overweight", dated May 2, 2018, "11 Charts To Watch", dated May 30, 2018, available at cis.bcaresearch.com. 2 The housing provident fund is a long-term housing savings plan made up of compulsory monthly deposits by both employers and employees. It aims to help middle and low-income workers meet their housing needs. Cyclical Investment Stance Equity Sector Recommendations

Overweight The S&P home improvement retail index (HIR) has historically benefitted from rebuilding efforts following costly hurricanes hitting the U.S. However, these spikes in relative performance largely track the earnings impact of the disasters; that is to say that they are one-off and do not provide much staying power. The impending arrival of Hurricane Florence today appears to have been priced into the index already as the stocks have already spiked. We would recommend against playing into this noise. Rather, we think investors should remain focused on the core profit profile of the index which has shown no sign of let up in its six-year run of earnings growth outpacing the S&P 500. Accordingly, we reiterate our overweight recommendation on the S&P HIR index. The ticker symbols for the stocks in this index are: BLBG: S5HOMI - HD, LOW. Hurricane Spikes In Home Improvement Should Be Ignored Hurricane Spikes In Home Improvement Should Be Ignored

Neutral Despite rising rates, homebuilders remain highly optimistic about the prospects for the domestic housing market, with the homebuilder survey persistently pushing near decade-highs (second panel). The message from Q2 earnings calls echoed this positivity, with the public homebuilders indicating demand was resilient even in a rising price environment. Still, the niche S&P homebuilding index has been moving sideways since our late-May upgrade to neutral. The cue from lumber prices is equally mixed; while the fall from the stratospheric levels of late-2017 is certainly a boon to profits, such a fall may be indicative of declining demand (third panel). At the same time, the tight labor market has seen wages in construction accelerating at the fastest rate since the rebound coming out of the financial crisis (bottom panel). The margin implication is thus unclear; we remain comfortable on the fence and reiterate our benchmark allocation. The ticker symbols for the stocks in this index are: BLBG: S5HOME - DHI, LEN, PHM. Mixed Signals In Homebuilding Mixed Signals In Homebuilding

Highlights Chart 1Wage Growth Playing Catch-Up To Curve Wage Growth Playing Catch-Up To Curve Wage Growth Playing Catch-Up To Curve Last Friday's employment report confirmed that the U.S. economy remained on a solid footing through August, even as leading indicators outside of the U.S. have weakened. Our back-of-the-envelope GDP tracking estimate - the year-over-year growth in aggregate weekly hours worked (2.14%) plus average quarterly productivity growth since 2012 (0.86%, annualized) - points to U.S. growth of approximately 3%. But strong GDP growth is old news for markets. Rather, it was the 0.4% month-over-month increase in average hourly earnings that caused bond yields to jump last Friday. Rising wage growth is usually a bear-flattener, consistent with both higher yields and a flatter curve (Chart 1). But in recent years the yield curve has flattened considerably while wage growth has lagged. The curve's front-running suggests that continued gains in wage growth will keep the Fed on its current tightening path, but may not translate into much curve flattening. Investors should maintain below-benchmark duration, but look for attractively valued curve steepeners. We also recommend only a neutral allocation to spread product to hedge the risk from weakening global growth. Feature Investment Grade: Neutral Chart 2Investment Grade Market Overview Investment Grade Market Overview Investment Grade Market Overview Investment grade corporate bonds underperformed the duration-equivalent Treasury index by 43 basis points in August, dragging year-to-date excess returns down to -93 bps. The index option-adjusted spread widened 5 bps on the month, and currently sits at 113 bps. Despite recent spread widening, corporate bonds remain expensive with 12-month breakeven spreads for both the A and Baa-rated credit tiers near their 25th percentiles since 1989 (Chart 2). Further, with inflation now close to the Fed's target, monetary policy will provide much less support for corporate bond returns going forward. These are the two main reasons we downgraded our cyclical corporate bond exposure to neutral in June.1 On a positive note, gross leverage for the non-financial corporate sector likely declined for the third consecutive quarter in Q2 (panel 4), but we remain pessimistic that such declines will continue in the back-half of the year. As we noted in a recent report, weaker foreign economic growth and the resultant dollar strength will eventually weigh on corporate revenues.2 Accelerating wage growth will also hurt profits if it is not completely passed through to higher prices. Table 3ACorporate Sector Relative Valuation And Recommended Allocation* Playing Catch-Up Playing Catch-Up Table 3BCorporate Sector Risk Vs. Reward* Playing Catch-Up Playing Catch-Up High-Yield: Neutral Chart 3High-Yield Market Overview High-Yield Market Overview High-Yield Market Overview High-Yield outperformed the duration-equivalent Treasury index by 14 basis points in August, bringing year-to-date excess returns up to +220 bps. The average index option-adjusted spread widened 2 bps on the month, and currently sits at 336 bps. Our measure of the excess spread available in the High-Yield index after accounting for expected default losses is currently 226 bps, slightly below the long-run mean of 247 bps (Chart 3). This tells us that if default losses are in line with our expectations during the next 12 months, we should expect excess high-yield returns of 226 bps over duration-matched Treasuries, assuming also that there are no capital gains/losses from spread tightening/widening. However, we showed in a recent report that the default loss expectations embedded in our calculation are extremely low relative to history (panel 4).3 Our assumption, derived from the Moody's baseline default rate forecast and our own forecast of the recovery rate, calls for default losses of 1.15% during the next 12 months. The only historical period to show significantly lower default losses was 2007, a time when corporate balance were in much better shape than today. While most indicators suggest that default losses will in fact remain low for the next 12 months, historical context clearly demonstrates that the risks are to the upside. It will be critical to track real-time indicators of the default rate such as job cut announcements, which have increased since mid-2017 (bottom panel), for signals about whether current default forecasts are overly optimistic. MBS: Neutral Chart 4MBS Market Overview MBS Market Overview MBS Market Overview Mortgage-Backed Securities underperformed the duration-equivalent Treasury index by 14 basis points in August, dragging year-to-date excess returns down to -18 bps. The conventional 30-year zero-volatility MBS spread widened 5 bps on the month, driven by a 3 bps increase in the compensation for prepayment risk (option cost) and a 2 bps widening of the option-adjusted spread. The excess return Bond Map shows that MBS offer a relatively poor risk/reward trade-off, particularly compared to Aaa-rated non-Agency CMBS, High-Yield and Sovereigns. However, our Bond Map does not account for the macro environment, which remains very favorable for the sector. In a recent report we showed that the two main factors that influence MBS spreads are mortgage refinancing activity and residential mortgage lending standards.4 Refi activity is tepid, and continued Fed rate hikes will ensure that it stays that way (Chart 4). Meanwhile, lending standards have been slowly easing since 2014 (bottom panel), but the Fed's most recent Senior Loan Officer Survey reports that standards remain at the tighter end of the range since 2005. The still-tight level of lending standards suggests that further easing is likely going forward. The amount of MBS running off the Fed's balance sheet has failed to exceed its cap in recent months, meaning that the Fed has not needed to enter the market to purchase MBS. This will probably continue to be the case going forward, due to both limited run-off and increases in the monthly cap. Government-Related: Underweight Chart 5Government-Related Market Overview Government-Related Market Overview Government-Related Market Overview The Government-Related index underperformed the duration-equivalent Treasury index by 12 basis points in August, dragging year-to-date excess returns down to -10 bps. Sovereign debt underperformed the Treasury benchmark by 48 bps on the month, dragging year-to-date excess returns down to -83 bps. Foreign Agencies underperformed by 14 bps on the month, dragging year-to-date excess returns down to -36 bps. Local Authorities underperformed by 20 bps on the month, dragging year-to-date excess returns down to +41 bps. Supranationals performed in line with Treasuries in August, keeping year-to-date excess returns at +12 bps. Domestic Agency bonds outperformed by 5 bps, bringing year-to-date excess returns up to +4 bps. Despite poor returns relative to Treasuries, Sovereign debt managed to outperform similarly-rated U.S. corporate debt in recent months. The outperformance is particularly puzzling given the unattractive relative valuation and the strengthening U.S. dollar (Chart 5). We reiterate our underweight allocation to Sovereign debt. The excess return Bond Map shows that both Local Authorities and Foreign Agencies offer exceptional risk/reward trade-offs compared to other U.S. bond sectors. We remain overweight both sectors. The excess return Bond Map also shows that while Supranational and Domestic Agency sectors are very low risk, expected returns are feeble. Both sectors should be avoided. Municipal Bonds: Overweight Chart 6Municipal Market Overview Municipal Market Overview Municipal Market Overview Municipal bonds underperformed the duration-equivalent Treasury index by 70 basis points in August, dragging year-to-date excess returns down to +116 bps (before adjusting for the tax advantage). The average Aaa-rated Municipal / Treasury (M/T) yield ratio rose 3% in August, and currently sits at 85% (Chart 6). This is more than one standard deviation below its post-crisis mean and only slightly higher than the average of 81% that was observed in the late stages of the previous cycle, between mid-2006 and mid-2007. In a recent report we demonstrated that while M/T yield ratios are low, municipal bonds offer attractive yields compared to corporate bonds.5 For example, we observe that a 5-year Aa-rated municipal bond carries a yield of 2.29% versus a yield of 3.35% for a comparable corporate bond index. This implies that an investor with an effective tax rate of 32% should be indifferent between the two bonds. Moving further out the curve, the breakeven tax rate falls to 23% at the 10-year maturity point and is even lower at the 20-year maturity point. What's more, municipal bonds are also more insulated from the risk of weak foreign growth than the U.S. corporate sector, and recent enacted revenue increases at the state level should lead to lower net borrowing in the coming quarters (bottom panel). All in all, attractive relative yields and lower risk make municipal bonds preferable to corporates in the current environment. Remain overweight. Treasury Curve: Favor The 7-Year Bullet Over The 1/20 Barbell Chart 7Treasury Yield Curve Overview Treasury Yield Curve Overview Treasury Yield Curve Overview The Treasury curve has flattened since the end of July, with yields at the short-end of the curve slightly higher and yields at the long-end slightly lower. The 2/10 Treasury slope currently sits at 23 bps and the 5/30 slope is currently 29 bps. The yield curve is already quite flat, consistent with a late-cycle economy. However, the economic data do not yet synch up with the curve's assessment. Chart 1 shows that wage growth is lagging the yield curve, while another yield curve indicator - nominal GDP growth less the fed funds rate - is moving in the opposite direction (Chart 7). We are likely to see both accelerating wage growth and decelerating nominal GDP growth during the next few quarters, but such outcomes are to a large extent in the price. In other words, the pace of curve flattening is likely to moderate in the coming months. With that in mind, we maintain our position long the 7-year bullet versus a duration-matched 1/20 barbell. That position is priced for 20 bps of 1/20 flattening during the next six months (Table 5). Table 4Butterfly Strategy Valuation (As Of August 3, 2018) Playing Catch-Up Playing Catch-Up Table 5Discounted Slope Change During Next 6 Months (BPs) Playing Catch-Up Playing Catch-Up Curve flatteners look more attractive at the long-end of curve. For example, the 5/30 barbell over 10-year bullet is priced for no change in 5/30 slope during the next six months. We also continue to hold this position to take advantage of the attractive value, and as a partial hedge to our position in the 1/7/20. TIPS: Overweight Chart 8TIPS Market Overview Inflation Compensation Inflation Compensation TIPS underperformed the duration-equivalent nominal Treasury index by 17 basis points in August, dragging year-to-date excess returns down to +122 bps. The 10-year TIPS breakeven inflation rate declined 4 bps on the month and currently sits at 2.10%. The 5-year/5-year forward TIPS breakeven inflation rate declined 6 bps on the month and currently sits at 2.22%. Both the 10-year and 5-year/5-year forward TIPS breakeven inflation rates remain below the 2.3% to 2.5% range that has historically been consistent with inflation expectations that are well-anchored around the Fed's 2% target. TIPS breakevens have remained relatively firm in recent weeks even as commodity prices have declined sharply (Chart 8). This suggests that breakevens are increasingly taking cues from the U.S. inflation data, and might now be less sensitive to the global growth outlook. Core inflation should remain close to the Fed's 2% target going forward. This will gradually wring deflationary expectations out of the market, allowing long-dated TIPS breakevens to reach our 2.3% to 2.5% target range. While the macro back-drop remains highly inflationary - pipeline inflation measures are elevated (panel 4) and the labor market is tight - we noted in a recent report that the rate of increase in year-over-year core inflation will probably moderate in the months ahead, due to base effects that have become less supportive.6 ABS: Neutral CHart 9ABS Market Overview ABS Market Overview ABS Market Overview Asset-Backed Securities outperformed the duration-equivalent Treasury index by 8 basis points in August, bringing year-to-date excess returns up to 18 bps. The index option-adjusted spread for Aaa-rated ABS narrowed 1 basis point on the month and now stands at 37 bps, 10 bps above its pre-crisis low. The excess return Bond Map shows that consumer ABS offer attractive return potential compared to other high-rated spread products - such as Agency CMBS and Domestic Agencies - but also carry a greater risk of losses. Further, credit quality trends have been slowly moving against the sector and we think caution is warranted. The consumer credit delinquency rate bottomed in 2015, albeit from a very low level, and it should continue to head higher based on the trend in household interest coverage (Chart 9). Average consumer credit bank lending standards have also been tightening for nine consecutive quarters (bottom panel). The New York Fed's Household Debt and Credit report showed that consumer credit growth increased at an annualized rate of 4.6% in the second quarter, compared to 3.3% in Q1. However, the prospects for further acceleration in consumer credit are probably limited. A rising delinquency rate and tightening lending standards will both weigh on future credit growth (panel 3). Non-Agency CMBS: Underweight Chart 10CMBS Market Overview CMBS Market Overview CMBS Market Overview Non-Agency Commercial Mortgage-Backed Securities outperformed the duration-equivalent Treasury index by 28 basis points in August, bringing year-to-date excess returns up to +126 bps. The index option-adjusted spread for non-agency Aaa-rated CMBS tightened 2 bps on the month and currently sits at 68 bps (Chart 10). In a recent report we showed that the macro picture for CMBS is decidedly mixed.7 A typical negative environment for CMBS is characterized by tightening bank lending standards for commercial real estate loans and falling demand. At present, both lending standards and demand for nonresidential real estate loans are close to unchanged (bottom two panels). Agency CMBS: Overweight Agency CMBS outperformed the duration-equivalent Treasury index by 10 basis points in August, bringing year-to-date excess returns up to +41 bps. The index option-adjusted spread was flat on the month and currently sits at 45 bps. The Bond Maps show that Agency CMBS offer high potential return compared to other low risk spread products. An overweight allocation to this defensive sector continues to make sense. The BCA Bond Maps The following page presents excess return and total return Bond Maps that we use to assess the relative risk/reward trade-off between different sectors of the U.S. fixed income market. The Maps employ volatility-adjusted breakeven spread/yield analysis to show how likely it is that a given sector will earn/lose money during the subsequent 12 months. The Maps do not impose any macroeconomic view. The Excess Return Bond Map The horizontal axis of the excess return Bond Map shows the number of days of average spread widening required for each sector to lose 100 bps versus a position in duration-matched Treasuries. Sectors plotting further to the left require more days of average spread widening and are therefore less likely to see losses. The vertical axis shows the number of days of average spread tightening required for each sector to earn 100 bps in excess of duration-matched Treasuries. Sectors plotting further toward the top require fewer days of spread tightening and are therefore more likely to earn 100 bps in excess of Treasuries. The Total Return Bond Map The horizontal axis of the total return Bond Map shows the number of days of average yield increase required for each sector to lose 5% in total return terms. Sectors plotting further to the left require more days of yield increases and are therefore less likely to lose 5%. The vertical axis shows the number of days of average yield decline required for each sector to earn 5% in total return terms. Sectors plotting further toward the top require fewer days of yield decline and are therefore more likely to earn 5%. Chart 11Excess Return Bond Map (As Of September 7, 2018) Playing Catch-Up Playing Catch-Up Chart 12Total Return Bond Map (As Of September 7, 2018) Playing Catch-Up Playing Catch-Up Ryan Swift, Vice President U.S. Bond Strategy rswift@bcaresearch.com Jeremie Peloso, Research Analyst jeremiep@bcaresearch.com 1 Please see U.S. Bond Strategy Special Report, "Go To Neutral On Spread Product", dated June 26, 2018, available at usbs.bcaresearch.com 2 Please see U.S. Bond Strategy Weekly Report, "An Oasis Of Prosperity?", dated August 21, 2018, available at usbs.bcaresearch.com 3 Please see U.S. Bond Strategy Weekly Report, "Out Of Sync", dated July 3, 2018, available at usbs.bcaresearch.com 4 Please see U.S. Bond Strategy Weekly Report, "The Fed's Balance Sheet Problem", dated July 17, 2018, available at usbs.bcaresearch.com 5 Please see U.S. Bond Strategy Weekly Report, "An Oasis Of Prosperity?", dated August 21, 2018, available at usbs.bcaresearch.com 6 Please see U.S. Bond Strategy Weekly Report, "The Powell Doctrine Emerges", dated September 4, 2018, available at usbs.bcaresearch.com 7 Please see U.S. Bond Strategy Weekly Report, "The Fed's Balance Sheet Problem", dated July 17, 2018, available at usbs.bcaresearch.com Fixed Income Sector Performance Recommended Portfolio Specification Corporate Sector Relative Valuation And Recommended Allocation Total Return Comparison: 7-Year Bullet Versus 2-20 Barbell (6-Month Investment Horizon)

Following up from our inaugural U.S. Equity Market Indicators Report in early-August 2017, this week we introduce the second part in our Indicators series. In this Special Report we have drilled down to the ten GICS1 S&P 500 sectors (excluding the real estate sector) and have compiled the most important Indicators in four broad categories: earnings, financial statement reported, valuations and technicals. Once again this is by no means exhaustive, but contains a plethora of Indicators - roughly thirty Indicators per sector condensed in seven charts per sector - we deem significant in aiding us in our decision making process of setting/changing a view on a certain sector. The way we have structured this Special Report is by sector and we start with the early cyclicals continue with the deep cyclicals and finish with the defensives. Within each sector we then show the four broad categories. In more detail, the first three charts depict earnings Indicators including our EPS growth model, EPS breadth, profit margins, relative forward EPS and EBITDA growth forecasts and ROE and its deconstruction into its components. The following two charts relate to financial statement Indicators including indebtedness, cash flow growth and capital expenditures. And conclude with one valuation and one technical chart. As a reminder, the charts in this Special Report are also made available through BCA's Analytics platform for seamless continual updates. Due to length constraints, Part III of our Indicators series, expected in mid-October, will introduce a style and size flavor along with cyclicals versus defensives and end with the S&P 500, again highlighting Indicators in these four broad categories. Finally, likely before the end of 2018, we aim to conclude our Indicators series with Part IV that would feature our most sought after Macro Indicators per the ten GICS1 S&P 500 sectors, along with value/growth, small/large and cyclicals/defensives. We trust you will find this comprehensive Indicator chartbook useful and insightful. Anastasios Avgeriou, Vice President U.S. Equity Strategy anastasios@bcaresearch.com Dulce Cruz, Senior Analyst dulce@bcaresearch.com Consumer Discretionary Chart 1Consumer Discretionary: Earnings Indicators Consumer Discretionary: Earnings Indicators Consumer Discretionary: Earnings Indicators Chart 2Consumer Discretionary: Earnings Indicators Consumer Discretionary: Earnings Indicators Consumer Discretionary: Earnings Indicators Chart 3Consumer Discretionary: ROE And Its Components Consumer Discretionary: ROE And Its Components Consumer Discretionary: ROE And Its Components Chart 4Consumer Discretionary: Financial Statement Indicators Consumer Discretionary: Financial Statement Indicators Consumer Discretionary: Financial Statement Indicators Chart 5Consumer Discretionary: Financial Statement Indicators Consumer Discretionary: Financial Statement Indicators Consumer Discretionary: Financial Statement Indicators Chart 6Consumer Discretionary: Valuation Indicators Consumer Discretionary: Valuation Indicators Consumer Discretionary: Valuation Indicators Chart 7Consumer Discretionary: Technical Indicators Consumer Discretionary: Technical Indicators Consumer Discretionary: Technical Indicators Financials Chart 8Financials: Earnings Indicators Financials: Earnings Indicators Financials: Earnings Indicators Chart 9Financials: Earnings Indicators Financials: Earnings Indicators Financials: Earnings Indicators Chart 10Financials: ROE And Its Components Financials: ROE And Its Components Financials: ROE And Its Components Chart 11Financials: Financial Statement Indicators Financials: Financial Statement Indicators Financials: Financial Statement Indicators Chart 12Financials: Financial Statement Indicators Financials: Financial Statement Indicators Financials: Financial Statement Indicators Chart 13Financials: Valuation Indicators Financials: Valuation Indicators Financials: Valuation Indicators Chart 14Financials: Technical Indicators Financials: Technical Indicators Financials: Technical Indicators Energy Chart 15Energy: Earnings Indicators Energy: Earnings Indicators Energy: Earnings Indicators Chart 16Energy: Earnings Indicators Energy: Earnings Indicators Energy: Earnings Indicators Chart 17Energy: ROE And Its Components Energy: ROE And Its Components Energy: ROE And Its Components Chart 18Energy: Financial Statement Indicators Energy: Financial Statement Indicators Energy: Financial Statement Indicators Chart 19Energy: Financial Statement Indicators Energy: Financial Statement Indicators Energy: Financial Statement Indicators Chart 20Energy: Valuation Indicators Energy: Valuation Indicators Energy: Valuation Indicators Chart 21Energy: Technical Indicators Energy: Technical Indicators Energy: Technical Indicators Industrials Chart 22Industrials: Earnings Indicators Industrials: Earnings Indicators Industrials: Earnings Indicators Chart 23Industrials: Earnings Indicators Industrials: Earnings Indicators Industrials: Earnings Indicators Chart 24Industrials: ROE And Its Components Industrials: ROE And Its Components Industrials: ROE And Its Components Chart 25Industrials: Financial Statement Indicators Industrials: Financial Statement Indicators Industrials: Financial Statement Indicators Chart 26Industrials: Financial Statement Indicators Industrials: Financial Statement Indicators Industrials: Financial Statement Indicators Chart 27S&P Industrials: Valuation Indicators S&P Industrials: Valuation Indicators S&P Industrials: Valuation Indicators Chart 28S&P Industrials: Technical Indicators S&P Industrials: Technical Indicators S&P Industrials: Technical Indicators Materials Chart 29Materials: Earnings Indicators Materials: Earnings Indicators Materials: Earnings Indicators Chart 30Materials: Earnings Indicators Materials: Earnings Indicators Materials: Earnings Indicators Chart 31Materials: ROE And Its Components Materials: ROE And Its Components Materials: ROE And Its Components Chart 32Materials: Financial Statement Indicators Materials: Financial Statement Indicators Materials: Financial Statement Indicators Chart 33Materials: Financial Statement Indicators Materials: Financial Statement Indicators Materials: Financial Statement Indicators Chart 34Materials: Valuation Indicators Materials: Valuation Indicators Materials: Valuation Indicators Chart 35Materials: Technical Indicators Materials: Technical Indicators Materials: Technical Indicators Tech Chart 36Technology: Earnings Indicators Technology: Earnings Indicators Technology: Earnings Indicators Chart 37Technology: Earnings Indicators Technology: Earnings Indicators Technology: Earnings Indicators Chart 38ROE And Its Components ROE And Its Components ROE And Its Components Chart 39Technology: Financial Statement Indicators Technology: Financial Statement Indicators Technology: Financial Statement Indicators Chart 40Technology: Financial Statement Indicators Technology: Financial Statement Indicators Technology: Financial Statement Indicators Chart 41Technology: Valuation Indicators Technology: Valuation Indicators Technology: Valuation Indicators Chart 42Technology: Technical Indicators Technology: Technical Indicators Technology: Technical Indicators Health Care Chart 43Health Care: Earnings Indicators Health Care: Earnings Indicators Health Care: Earnings Indicators Chart 44Health Care: Earnings Indicators Health Care: Earnings Indicators Health Care: Earnings Indicators Chart 45Health Care: ROE And Its Components Health Care: ROE And Its Components Health Care: ROE And Its Components Chart 46Health Care: Financial Statement Indicators Health Care: Financial Statement Indicators Health Care: Financial Statement Indicators Chart 47Health Care: Financial Statement Indicators Health Care: Financial Statement Indicators Health Care: Financial Statement Indicators Chart 48Health Care: Valuation Indicators Health Care: Valuation Indicators Health Care: Valuation Indicators Chart 49Health Care: Technical Indicators Health Care: Technical Indicators Health Care: Technical Indicators Consumer Staples Chart 50Consumer Staples: Earnings Indicators Consumer Staples: Earnings Indicators Consumer Staples: Earnings Indicators Chart 51Consumer Staples: Earnings Indicators Consumer Staples: Earnings Indicators Consumer Staples: Earnings Indicators Chart 52Consumer Staples: ROE And Its Components Consumer Staples: ROE And Its Components Consumer Staples: ROE And Its Components Chart 53Consumer Staples: Financial Statement Indicators Consumer Staples: Financial Statement Indicators Consumer Staples: Financial Statement Indicators Chart 54Consumer Staples: Financial Statement Indicators Consumer Staples: Financial Statement Indicators Consumer Staples: Financial Statement Indicators Chart 55Consumer Staples: Valuation Indicators Consumer Staples: Valuation Indicators Consumer Staples: Valuation Indicators Chart 56Consumer Staples: Technical Indicators Consumer Staples: Technical Indicators Consumer Staples: Technical Indicators Telecom Services Chart 57Telecom Services: Earnings Indicators Telecom Services: Earnings Indicators Telecom Services: Earnings Indicators Chart 58Telecom Services: Earnings Indicators Telecom Services: Earnings Indicators Telecom Services: Earnings Indicators Chart 59Telecom Services: ROE And Its Components Telecom Services: ROE And Its Components Telecom Services: ROE And Its Components Chart 60Telecom Services: Financial Statement Indicators Telecom Services: Financial Statement Indicators Telecom Services: Financial Statement Indicators Chart 61Telecom Services: Financial Statement Indicators Telecom Services: Financial Statement Indicators Telecom Services: Financial Statement Indicators Chart 62Telecom Services: Valuation Indicators Telecom Services: Valuation Indicators Telecom Services: Valuation Indicators Chart 63Telecom Services: Technical Indicators Telecom Services: Technical Indicators Telecom Services: Technical Indicators Utilities Chart 64Utilities: Earnings Indicators Utilities: Earnings Indicators Utilities: Earnings Indicators Chart 65Utilities: Earnings Indicators Utilities: Earnings Indicators Utilities: Earnings Indicators Chart 66Utilities: ROE And Its Components Utilities: ROE And Its Components Utilities: ROE And Its Components Chart 67Utilities: Financial Statement Indicators Utilities: Financial Statement Indicators Utilities: Financial Statement Indicators Chart 68Utilities: Financial Statement Indicators Utilities: Financial Statement Indicators Utilities: Financial Statement Indicators Chart 69Utilities: Valuation Indicator Utilities: Valuation Indicator Utilities: Valuation Indicator Chart 70Utilities: Technical Indicator Utilities: Technical Indicator Utilities: Technical Indicator

The S&P communications equipment index received a substantial leg up in the past month as the quarterly results issued by index giant Cisco proved more resilient than anticipated and growth surpassed analyst expectations. However, on the earnings call management noted that pricing power continued to erode in the quarter and margins were under pressure from rising input costs. This is corroborated by the macro data we track which shows that communications equipment pricing power remains stubbornly in decline; the recent collapse in Asian currencies points to more of the same. Further, the industry wage bill is rapidly moving in the opposite direction of pricing power, pointing to a margin squeeze. Tack on valuations that have fully recovered and the message comes through clearly: stay underweight. The ticker symbols for the stocks in this index are: BLBG: S5COMM - CSCO, MSI, JNPR, FFIV. An Overwhelming Signal An Overwhelming Signal

  Overweight It has been in vogue to be bearish on industrials this year as they are relatively easy targets for investors fearful of a blowback over trade rhetoric. We think a negative positioning is not constructive. Our Cyclical Macro Indicator remains upbeat, diverging from relative profitability (second panel). Domestic ex-tech output is firing on all cylinders (third panel), which has helped to drive firming pricing power (bottom panel). Tack on the reacceleration in our U.S. capital expenditure indicator - capex upcycle remains a key BCA theme for the remainder of 2018 - and industrials sector stars are aligned. The upshot is that depressed relative profit growth will easily surprise to the upside. While we caution a rising U.S. dollar presents a risk to our sanguine view on industrials, a sturdily supportive macro view puts the chips squarely in the overweight column. Bottom Line: Firming domestic and encouraging global macro conditions along with neutral valuations and washed out technical suggest that the path of least resistance is higher for the S&P industrials sector. Please see this week's Weekly Report for more details. Are Industrials Running On Empty Are Industrials Running On Empty  

Highlights German real estate and real estate equities remain a worthwhile multi-year position, especially in relative terms. The dominant stocks are Vonovia, Deutsche Wohnen, LEG, and GSW. Swedish real estate and real estate equities are likely to face harder times. The dominant stocks are Lundbergforetagen, Castellum, Fastighets, and Fabege. The structural pair-trade is long German real estate equities, short Swedish real estate equities. Italian real estate offers distressed opportunities. The long-term equity play is Covivio. We remain reluctant to own U.K. residential real estate or real estate equities. Chart of the WeekExtremes In European Real Estate Extremes In European Real Estate Extremes In European Real Estate Feature Nowadays, the best way to play the relative performance of an individual economy is through real estate. Indeed, European real estate offers compelling structural opportunities for investors who want to go long, and for investors who want to go short. By contrast, the opportunities to play intra-European economic divergences through other asset-classes have become limited. Nineteen European countries share one currency and one policy interest rate; and the mega-cap companies that drive the major equity indexes are multinationals exposed to the global economy. Meaning that a stock market's relative performance is no longer defined by its home economy; it is now defined instead by its dominant sectors and stocks.1 This leaves real estate as the purest play on the domestic economy. The evidence comes from the huge divergences in real estate market performances across Europe through the past two decades (Chart I-2-Chart I-4). While house prices in Sweden and Norway have more than trebled in real terms, house prices in Germany and Italy are at the same real level today as in 1995 (Chart of the Week). Chart I-2Winners And Losers In##br## European Real Estate Winners And Losers In European Real Estate Winners And Losers In European Real Estate Chart I-3Winners And Losers In##br## European Real Estate Winners And Losers In European Real Estate Winners And Losers In European Real Estate Chart I-4Winners And Losers In##br## European Real Estate Winners And Losers In European Real Estate Winners And Losers In European Real Estate How can German real estate be such a massive structural underperformer when the German economy has been one of Europe's star performers? The answer is that house prices take their cue from wages. German wages were suppressed for more than a decade, from which they are now playing a long catch up. A Tale Of Two Real Estate Markets: Germany And Sweden The two long-term drivers of house prices, assuming no supply bottlenecks, are: Real wages. The availability and price of bank credit. Real rents should trend higher to reflect the increasing quality of accommodation. For example, kitchens and bathrooms, heating and cooling systems and home security should all get better. In essence, the quality of accommodation benefits from productivity improvements. Of course, such improvements require investment expenditure. But a real estate investor requires a return on this investment. Therefore, rents - even after expenses - should increase in real terms. Given that house prices must maintain some long-term connection with rents, house prices should also trend higher in real terms, reflecting the improvements in home quality. But if real wages are not rising, it is impossible for tenants to absorb higher real rents, and so real rents and house prices stagnate. This describes the situation in Germany through 1995-2010 when labour market reforms resulted in real wages going nowhere, despite major gains in workers' real productivity (Chart I-5). Furthermore, as nominal adjustments to rents occur infrequently, German real rents and house prices actually fell through this extended period (Chart I-6). Chart I-5Through 1995-2010 German##br## Real Wages Stagnated... Through 1995-2010 German Real Wages Stagnated... Through 1995-2010 German Real Wages Stagnated... Chart I-6...So German Real Rents And ##br##House Prices Declined ...So German Real Rents And House Prices Declined ...So German Real Rents And House Prices Declined Since 2010, the dynamic has reversed. Needing to catch up with the economic fundamentals, German real wages, real rents and house prices have all rebounded very strongly. Nevertheless, based on the long-term connection with real productivity gains, German real rents and house prices have considerable further catch up potential. Just fifty miles across the Baltic Sea, the opposite is true. In Sweden - and Norway - house prices appear to have run well ahead of the economic fundamentals. For this, blame the central banks. In recent years, Sweden's Riksbank and the Norges Bank have had to shadow the ECB's ultra-loose policy to prevent a sharp appreciation of their currencies. The trouble is that the flood of bank credit has been absurdly inappropriate for the booming Scandinavian economies. So the ECB's policy may indeed have generated bank credit fuelled bubbles... albeit in Sweden and Norway. Real estate equities are just a leveraged play on rents - and thereby real estate capital values - because the companies take on debt to finance their property portfolios. This means that in the short term, they are (inversely) sensitive to bond yields, but in the long term the main driver is rental growth. Hence, in the German real estate market's post-2011 rebound, German real estate equities - now dominated by Vonovia, Deutsche Wohnen, LEG, and GSW - have trebled (Chart I-7), and the market relative trade is up a very pleasing 75 percent since we initiated it. Any rise in bond yields would be a short term drag, but given that real rents and house prices have further catch-up potential, the sector remains a worthwhile multi-year position, especially in relative terms. Chart I-7German Real Estate Equities ##br##Have Trebled Since 2012 German Real Estate Equities Have Trebled Since 2012 German Real Estate Equities Have Trebled Since 2012 Interestingly, Swedish real estate equities have also trebled in the post-2011 period (Chart I-8). But in Sweden's case, house prices are extended relative to the economic fundamentals. Swedish real estate equities - now dominated by Lundbergforetagen, Castellum, Fastighets, and Fabege - are likely to face harder times. Chart I-8Swedish Real Estate Equities ##br##Have Also Trebled Since 2012 Swedish Real Estate Equities Have Also Trebled Since 2012 Swedish Real Estate Equities Have Also Trebled Since 2012 Hence, the structural pair-trade is long German real estate equities, short Swedish real estate equities. Italian Real Estate Offers Distressed Opportunities Turning to Italian real estate, it has exhibited the mirror-image pattern of Germany. From the late nineties to 2008, Italian house prices almost doubled in real terms - only then to enter a ten year bear market. In recent years, Italian real wages have been growing again, raising the question: what is holding back Italian house prices? The answer is a banking system that will not lend, making it difficult for anybody to finance a house purchase (Chart I-9). Chart I-9Italian Banks Haven't Been Lending... Italian Banks Haven't Been Lending... Italian Banks Haven't Been Lending... This lack of bank financing means that the natural flow of real estate that has to find a new owner is not receiving any bids. The upshot is that a long-term investor who can access financing can pick up property at highly distressed valuations, often at a fraction of the market price a few years ago. Some investors cannot remove a nagging fear about an 'Italexit' from the monetary union and the deep crisis that would follow. It is precisely because of the deep crisis that would ensue from a euro breakup that its likelihood remains low - though admittedly not zero. But even in that extreme eventuality, as long as Italy did not become an outlaw state in which property rights were dismantled, a long-term investor might still fare well. Because he would own a real asset bought at a very distressed price. Within the stock market, the real estate equity sector in Italy - just as in Germany and Sweden - has been a leveraged play on the house price cycle (Chart I-10). But there are two caveats: the sector is tiny with one dominant company, Beni Stabili; and Beni Stabili has just been taken over by the French property company Covivio. Still, now that Covivio owns a large portfolio of Italian real estate assets, it would be the appropriate equity to play this multi-year theme. And the bonus is that it offers a dividend yield of 5 percent. Chart I-10...Creating Distressed Opportunities In Italian Real Estate ...Creating Distressed Opportunities In Italian Real Estate ...Creating Distressed Opportunities In Italian Real Estate U.K. Real Estate Faces Headwinds Finally, the recent pressure on U.K. house prices is likely to persist (Chart I-11) - with the housing market facing at least one of three potential headwinds: Chart I-11U.K. Real Estate Faces Headwinds U.K. Real Estate Faces Headwinds U.K. Real Estate Faces Headwinds A disorderly Brexit, though not our central case, would pose a huge risk for the U.K. economy. On the other hand, an orderly and smooth transition to Brexit would liberate the Bank of England to hike interest rates further in 2019. Bear in mind that in the U.K., wage pressures and CPI inflation are not dissimilar to those in the U.S., where the Federal Reserve has already hiked the policy rate seven times. So it is largely the uncertainties surrounding Brexit that are staying the BoE's hands. The precarious path to leaving the EU on March 29 2019 is littered with landmines for Theresa May. Any of these landmines could trigger a snap General Election, a Jeremy Corbyn led Labour government, and the spectre of a high-end 'land value' tax. Hence, we remain reluctant to own U.K. residential real estate or real estate equities. Dhaval Joshi, Senior Vice President Chief European Investment Strategist dhaval@bcaresearch.com 1 For the compelling evidence, please see Charts 1-6 in the European Investment Strategy Weekly Report 'The Eight Components Of Equity Market Allocation' July 26 2018 available at eis.bcaresearch.com. Fractal Trading Model* The 30% outperformance of India versus China during the recent EM shock is technically stretched, hitting a fractal dimension that signals a potential reversal, assuming no further deterioration in news flow. On this technical basis, the countertrend trade would be long China/short India with a profit target of 9% and symmetrical stop-loss. In other trades, long platinum/short nickel reached the end of its 65 day holding period very comfortably in profit. However, short consumer services versus consumer goods hit its stop-loss. This leaves five open trades. For any investment, excessive trend following and groupthink can reach a natural point of instability, at which point the established trend is highly likely to break down with or without an external catalyst. An early warning sign is the investment's fractal dimension approaching its natural lower bound. Encouragingly, this trigger has consistently identified countertrend moves of various magnitudes across all asset classes. Chart I-12 India vs. China India vs. China The post-June 9, 2016 fractal trading model rules are: When the fractal dimension approaches the lower limit after an investment has been in an established trend it is a potential trigger for a liquidity-triggered trend reversal. Therefore, open a countertrend position. The profit target is a one-third reversal of the preceding 13-week move. Apply a symmetrical stop-loss. Close the position at the profit target or stop-loss. Otherwise close the position after 13 weeks. Use the position size multiple to control risk. The position size will be smaller for more risky positions. * For more details please see the European Investment Strategy Special Report "Fractals, Liquidity & A Trading Model," dated December 11, 2014, available at eis.bcaresearch.com Fractal Trading Model Recommendations Equities Bond & Interest Rates Currency & Other Positions Closed Fractal Trades Trades Closed Trades Asset Performance Currency & Bond Equity Sector Country Equity Indicators Bond Yields Chart II-1Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Chart II-2Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Chart II-3Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Chart II-4Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Interest Rate Chart II-5Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Chart II-6Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Chart II-7Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Chart II-8Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations

Highlights Portfolio Strategy Firming domestic and encouraging global macro conditions along with neutral valuations and washed out technicals suggest that the path of least resistance is higher for the S&P industrials sector. A looming positive global growth impulse, easy Chinese monetary conditions, a still buoyant energy end-market, enticing industry operating metrics and compelling valuations all suggest that now is not the time to throw in the towel on the S&P construction machinery & heavy truck (CMHT) index. Recent Changes There are no changes to our portfolio this week. Table 1 Bulletproof? Bulletproof? Feature Chart 1All-time Highs Everywhere All-time Highs Everywhere All-time Highs Everywhere The SPX catapulted to fresh all-time highs last week following an eight month hiatus, as a de-escalation in the global trade war gained further traction. Chart 1 shows that this is a broad based equity market advance as a slew of major equity market indexes have simultaneously vaulted to new highs. Even the high-yield corporate bond market confirms this breakout with the total return index also vaulting to new all-time highs (not shown). Any further moderation in trade rhetoric from the U.S. administration could serve as a catalyst for additional gains in the SPX, and trade-affected sectors would likely lead the charge, especially post the mid-term elections.1 While the U.S./China trade spat will prove the ultimate equity market litmus test, the longevity and magnitude of the profit upcycle remain the key equity market advance pillars. On that front, a deeper dive into profit margins is in order. The S&P 500's profit margins are benefiting from the one-time fillip of lower corporate taxes in calendar 2018. Nevertheless, it is important to remember that this year's strong profits are not the result of any massaging from CEOs/CFOs of the share count. In other words, profit margins (earnings per share / sales per share) are not impacted by changes in the number of shares outstanding, unlike simple EPS growth. Chart 2 shows that SPX margins recently slingshot to all-time highs. However, excluding tech they remain below the previous cycle's mid-2007 peak. While we are not fans of excluding sectors from our analysis, the sheer size and persistence of the tech sector's profit margin expansion is surprising. Tech sector profit margins are twice the SPX's margins, and tech stocks have been pulling SPX margins higher consistently for the past 8 years as tech giants are flexing their oligopolistic/monopolistic muscle. The implication is that SPX EPS growth of 10% is likely in 2019, but the tech sector has to continue doing most of the heavy lifting given the high profit and market cap weight in the SPX. Keep in mind that the commodity complex in general and energy in particular are also adding to the recent margin euphoria. The late-2015/early-2016 global manufacturing recession-induced collapse in margins is now re-normalizing across basic resources, with margins in the S&P energy sector increasing by 11 percentage points since the Q2 2016 trough (Chart 2). Beyond the sector-related margin implications, from a macro point of view, U.S. stock market-reported employment has also been a significant contributor to the phenomenal profit margin expansion phase. Typically, stock market constituents reported job count growth peaks right before the NBER designated recession commences, on average at over an 8% year-over-year growth rate. The current labor market, while vibrant, has been trailing previous cycles by a wide margin. The most recent year-over-year growth rate clocked in at 3.5% (second panel, Chart 3). Chart 2Tech Margins Leading##br## The Pack Tech Margins Leading The Pack Tech Margins Leading The Pack Chart 3Smaller Than Usual Labor Footprint##br## Is A Boon For Margins Smaller Than Usual Labor Footprint Is A Boon For Margins Smaller Than Usual Labor Footprint Is A Boon For Margins National accounts data also corroborate this enticing profit margin backdrop. Average hourly earnings (AHE) have crested north of 4% in the past three cyclical peaks. Currently AHE are 130bps below that level (top panel, Chart 3). The implication is that as long as top line growth remains solid and corporate pricing power stays upbeat, profit margins will continue to underpin profits. Unlike the tech sector's excessive contribution to the SPX profit margin, the opposite rings true with regard to analysts' forward profit projections. Both on a 12-month and 5-year forward basis the S&P tech sector is trailing the SPX (Chart 4). Importantly, the latter has been at the center of a healthy debate within BCA, and decomposing this seemingly high number is instructive. A 16% long-term EPS growth rate is a tall order. However, sell-side analysts never get the shorter-term, let alone longer-term, forecasts correct. In hindsight, analysts' 5-year forward EPS growth forecasts back in 2016 sunk to an all-time low, even lower than the depths of the Great Recession (top panel, Chart 4). Currently, all we are experiencing is a move from one extreme to the other, and while we are clearly in overshoot territory, it is impossible to predict where this number will peak. Decomposing the broad market's projected long-term EPS growth rate is revealing. First, we note that the tech sector is projected to grow at half the rate predicted during the tech bubble. Second, four sectors comprise the outliers (i.e. forecast to surpass the 16% SPX growth rate) and such a breakneck pace will surely fail to materialize. Another common characteristic these four sectors share is that they all surpassed their tech bubble peak rates, something that the broad market has yet to achieve. Thus, consumer discretionary, financials, industrials and especially energy are in uncharted territory (Chart 5). On the opposite end of the spectrum, Chart 6 highlights the sectors that have yet to overtake their respective peaks and are sporting long-term EPS growth rates below the broad market. Chart 4Putting Tech Long-term Profit##br## Growth Rate In Context Putting Tech Long-term Profit Growth Rate In Context Putting Tech Long-term Profit Growth Rate In Context Chart 5Decomposing... Decomposing... Decomposing... Chart 6...Long-Term EPS Growth ...Long-Term EPS Growth ...Long-Term EPS Growth Netting it all out, we continue to have a sanguine cyclical (9-12 month horizon) SPX view, and our price target for 2019 remains 10% higher, assuming the multiple moves sideways leaving the onus on EPS to do all the heavy lifting.2 The week we are highlighting a deep cyclical sector that can benefit from a further de-escalation of the trade war and update one of its key subcomponents that remains a high-conviction overweight. Are Industrials Running On Empty? Last week, in a Special Report on President Trump's trade rhetoric impact on equity markets, we showed that trade policy uncertainty has risen to the highest level with the exception of the 1994 Clinton-era trade spat with the Japanese.3 While U.S. stocks have come out on top versus their global peers, within the U.S. equity market industrials have borne the brunt of the President's trade wrath (Chart 7). Chart 7Trade Uncertainty Weighing On Industrials Trade Uncertainty Weighing On Industrials Trade Uncertainty Weighing On Industrials In more detail, since peaking on January 26th, 2018, two stocks explain over 62% of the S&P industrials sector's fall: GE and MMM, two industrial conglomerates highly exposed to global trade. However, transports in general and rails in particular have been rising smartly almost entirely offsetting the industrial conglomerates' weakness. As a reminder, we are overweight the rails and air freight & logistics, underweight the airlines, neutral on industrial conglomerates and remain comfortable with that intra-sector positioning. Importantly, green shoots are emerging, warning that it does not pay to become bearish on this deep cyclical sector. Our Cyclical Macro Indicator remains upbeat, diverging from relative profitability (Chart 8). Domestic ex-tech output is firing on all cylinders (Chart 8), a message reviving core capital goods orders corroborate (Chart 9). All of this has resulted in firming pricing power. Tack on the reacceleration in our U.S. capital expenditure indicator (second panel, Chart 8) - capex upcycle remains a key BCA theme for the remainder of 2018 - and industrials sector stars are aligned. The upshot is that depressed relative profit growth will easily surprise to the upside (bottom panel, Chart 8). Chart 8Green Shoots... Green Shoots... Green Shoots... Chart 9...Appearing ...Appearing ...Appearing Not only are there U.S. macro tailwinds, but also a global growth recovery is in the offing that will herald a snapback in relative share prices. The global manufacturing PMI remains squarely above the 50 boom/bust line (fourth panel, Chart 9), and there are early signs of a budding recovery in China. The Li-Keqiang index is ticking higher, Chinese monetary conditions have eased significantly via a depreciating currency and a drop in interest rates, excavator sales continue to expand at a healthy clip, industrial profits are reaccelerating and even Chinese share prices have likely troughed. Expanding Chinese wholesale selling prices also suggest that a reflationary impulse is looming (bottom panel, Chart 9). Were trade tensions to further de-escalate, especially post the midterm elections that could serve as a powerful tonic for relative share prices. Our Industrials EPS growth model does an excellent job in capturing all these forces and is currently signaling that profits will continue to grow into 2019 (Chart 10). Valuations have returned to the neutral zone, but technicals have plunged to one standard deviation below the mean, a level that has historically been associated with playable rallies (bottom panel, Chart 10). One key risk to our optimistic take on the S&P industrials sector is the U.S. dollar. Chart 11 highlights that capital goods revenues, exports and multiples are in jeopardy if the greenback continues to appreciate. Add to that a full blown trade war between the U.S. and China - which is dollar positive - and industrials stocks would suffer another blow. Chart 10Great Entry Point Great Entry Point Great Entry Point Chart 11Further U.S. Dollar Appreciation Is A Risk Further U.S. Dollar Appreciation Is A Risk Further U.S. Dollar Appreciation Is A Risk Bottom Line: Firming domestic and encouraging global macro conditions along with neutral valuations and washed out technicals suggest that the path of least resistance is higher for the S&P industrials sector. What To Do With Construction Machinery? Early in the year, following our risk management implementation of a 10% stop on our high conviction call list, we got stopped out with a 10% gain from the high-conviction overweight call in the S&P CMHT index. We were subsequently compelled to reinstitute this high-conviction call as all of the fundamental drivers remained in place. However, our timing was not perfect, and given that bellwether Caterpillar has a near 60% foreign sourced revenue exposure, this industrial subsector also bore the brunt of the President's hawkish trade rhetoric. The key question currently is: does it still make sense to be overweight this highly cyclical industrials sub group? The short answer is yes. First, while global growth has decelerated, global trade is still expanding and the signal from the Baltic Dry Index is that the risk of an abrupt halt in global trade similar to the late-2015/early-2016 episode is small (second panel, Chart 12). In addition, the global capex upcycle remains in place and is one of BCA's two themes we continue to explore for the rest of the year. The upshot is that it still pays to remain invested in the S&P CMHT index. Demand for machinery remains upbeat across the globe. Both our global exports and orders proxies for machinery continue to grow, underscoring that a profit-led recovery in construction machinery stocks is looming (third & fourth panels, Chart 12). Second, while China is the administration's primary trade target, easy monetary conditions there will provide much needed breathing room for the Chinese economy. Already, Chinese housing construction data and the rebounding Li-Keqiang Index are pointing to a brighter backdrop for relative share prices (top two panels, Chart 13). Moreover, Chinese excavator sales are advancing at a brisk year-over-year rate, highlighting that construction machinery end-demand remains solid. Chart 12Global Growth & CAPEX Are Tailwinds... Global Growth & CAPEX Are Tailwinds... Global Growth & CAPEX Are Tailwinds... Chart 13...And So Is The Troughing Chinese Economy ...And So Is The Troughing Chinese Economy ...And So Is The Troughing Chinese Economy Third, the key energy end-market shows no signs of deceleration. The steeply recovering global oil rig count on the back of a $78 Brent crude oil price suggests that demand for oil & gas field machinery remains on the recovery path and is a harbinger of a rising relative share price ratio (Chart 14). Fourth, industry operating metrics are overheating and signal that profits will continue to surprise to the upside. Rising capex budgets have reduced industry slack (second & third panels, Chart 15). As a result, machinery selling prices have soared to the highest level since the Great Recession (bottom panel, Chart 15) and will underpin industry profits. Chart 14Energy End-market To The Rescue? Energy End-market To The Rescue? Energy End-market To The Rescue? Chart 15Vibrant Operating Metrics Vibrant Operating Metrics Vibrant Operating Metrics Finally, relative valuations have plunged to near one standard deviation below the average and so have relative technicals. While both can sink further, we would be taking a punt here (Chart 16). Despite our optimistic view on the S&P CMHT index's profit prospects, the appreciating U.S. dollar and recent cresting in the CRB raw industrials index represent key downside risks to our overweight call. This commodity price index is a crucial input to our machinery EPS growth model that has petered out, but at a high level. Any further steep appreciation in the greenback will likely deal a blow to the commodity complex and jeopardize the virtuous machinery profit upcycle (Chart 17). Chart 16Compelling Valuations And Washed Out Technicals Compelling Valuations And Washed Out Technicals Compelling Valuations And Washed Out Technicals Chart 17Risk To Monitor: Commodity Price Relapse Risk To Monitor: Commodity Price Relapse Risk To Monitor: Commodity Price Relapse Adding it up, a looming global growth pick up, easy Chinese monetary conditions, a still buoyant energy end-market, enticing industry operating metrics and compelling valuation and technical conditions all suggest that now is not the time to throw in the towel in the S&P CMHT index. Bottom Line: Were we not overweight already we would not hesitate to initiate a new above benchmark position in the S&P CMHT index. We reiterate our high-conviction overweight status. The ticker symbols for the stocks in this index are: BLBG: S5CSTF - CAT, PCAR, CMI. Anastasios Avgeriou, Vice President U.S. Equity Strategy anastasios@bcaresearch.com 1 Please see BCA U.S. Equity Strategy Special Report, "Trump, Trade, Tweets & Tumult - Does The Stock Market Care?" dated August 22, 2018, available at uses.bcaresearch.com. 2 Please see BCA U.S. Equity Strategy Weekly Report, "Lifting SPX Target" dated April 30, 2018, available at uses.bcaresearch.com. 3 Please see BCA U.S. Equity Strategy Special Report, "Trump, Trade, Tweets & Tumult - Does The Stock Market Care?" dated August 22, 2018, available at uses.bcaresearch.com. Current Recommendations Current Trades

Highlights 2018 YTD Summary: Investment grade corporate debt in the developed economies has performed poorly so far in 2018, led by lagging returns in Financials and some steepening of credit curves. U.S. credit has outperformed European equivalents. These trends are likely to continue over at least the next six months. Our Sector Portfolios: Our investment grade sector model portfolios have underperformed modestly so far in 2018 (-3bps each in the U.S., euro area & U.K.) - primarily due to our overweight stance on Financials which have performed poorly. Looking Ahead: We are maintaining a neutral level of target spread risk (i.e. duration-times-spread equal that of the benchmark index) in our sector model portfolios for the U.S., euro area and U.K. We will look to reduce that spread risk on signs of a deeper global growth slowdown, which we expect will unfold in 2019. Feature Chart of the WeekReversal Of Fortune Reversal Of Fortune Reversal Of Fortune The performance of investment grade (IG) corporate bonds in the developed markets, as an asset class, has been underwhelming so far in 2018. Using the total return indices from Bloomberg Barclays, IG corporates in the U.S., euro area and U.K. - the regions with the three largest corporate bond markets among the developed economies - have lost -2.0%, -0.3% and -1.1%, respectively. The numbers do not look much better when shown on an excess return basis versus duration-matched government bonds: U.S. IG -0.8%, euro area -1.2% and the U.K. -1.3%. The sluggish performance for IG corporates is a mirror image of the strong showing in 2017 when looking at credit spreads, which reached very tight levels at the end of last year (Chart of the Week). The 2017 rally left global corporates exposed to any negative shocks, of which there have been many so far in 2018 (the February VIX spike, the Q1 global growth slowdown, intensifying U.S.-China trade tensions, ongoing Fed tightening, a strengthening U.S. dollar, less dovish non-U.S. central banks, Italian politics, emerging market turmoil). Given the more challenging environment for overall corporate bond performance, the role of sector selection as a way to generate alpha, by mitigating losses from beta, is critical. In this Weekly Report, we take a brief look at IG sector performance so far this year and update our sector allocations based on our relative value models for IG corporates in the U.S., euro area and U.K. 2018 YTD Global Corporates Performance: A Down Year The major IG sector groupings for the U.S., euro area and U.K. are presented in Table 1, ranked by the 2018 year-to-date excess returns (all are shown in local currency terms). The overall index return for each region is also shown (highlighted in gray) in the table, to highlight how individual sectors have performed relative to the overall IG index. Table 12018 Year-To-Date Investment Grade Sector Returns For The U.S., Euro Area & U.K. A Performance Update On Global Corporate Bond Sectors A Performance Update On Global Corporate Bond Sectors As is always the case with IG corporates, the performance of the broad Financials grouping (which includes banks, insurance companies, REITs, etc.) heavily influences the returns of the overall IG index given the large weighting of Financials within the Corporates index across all three regions. In both the euro area and U.K., the sharp underperformance of Financials seen year-to-date (-1.3% and -1.4%, respectively) has created a somewhat odd situation where the majority of sectors have outperformed the overall index. That could only happen given the large weight of Financials in the euro area index (40%) and U.K. index (43%). Financials are also a big part of the U.S. index (32%), but there is more balance in the U.S. IG index which has helped boost the "beta" return from U.S. corporates. Specifically, the weightings of the top three largest U.S. broad sector groupings - Energy (9%), Technology (8%) and Communications (9%) - are a combined 26% of the overall U.S. IG index. Those three sectors are also among upper tier of the 2018 performance table in the euro area and U.K., but only represent a combined 15% and 8%, respectively, of each region's IG index. The conclusion is that index composition has flattered the performance of U.S. IG corporates versus European equivalents, given the latter's heavier weighting in Financials. The poor performance of Financials can be attributed to flattening global government bond yield curves (which is a negative for banks) and poor returns from global credit, especially in emerging markets (which is a negative for insurers that invest in spread product). We do not anticipate either of those trends reversing anytime soon - particularly the ongoing selloff in emerging market assets - thus Financials are likely to remain a drag on corporate bond performance for at least the next 3-6 months. One other factor that has weighed on overall IG corporate performance has been the steepening of credit spread curves. The gaps between credit spreads for Baa- and A-rated corporates have widened since the end of January, most notably in the euro area and the U.K. where growth has been slower than in the fiscal-policy fueled U.S. economy (Chart 2). With Baa-rated debt now representing one-half of the IG index for the U.S., euro area and U.K. (Chart 3) - a function of rising corporate leverage - continued underperformance of lower quality sectors will negatively impact the future overall returns from IG corporates. Chart 2Spread Curves Are##BR##Steepening In Europe Spread Curves Are Steepening In Europe Spread Curves Are Steepening In Europe Chart 31/2 Of Investment Grade Corporate Indices##BR##Are Now Baa-Rated 1/2 Of Investment Grade Corporate Indices Are Now Baa-Rated 1/2 Of Investment Grade Corporate Indices Are Now Baa-Rated Looking ahead, credit investors should be wary of the potential for downgrade risk in their portfolios given the high proportion of Baa-rated debt in the IG benchmark indices. This risk will become more acute when the global business cycle runs out of steam (a 2019 story, at the earliest, in our view). Bottom Line: Investment grade corporate debt in the developed economies has performed poorly so far in 2018, led by lagging returns in Financials and some steepening of credit curves. U.S. credit has outperformed European equivalents. These trends are likely to continue over at least the next six months. Our Corporate Sector Valuation Models: Winners & Losers Our recommended IG sector allocations come from our relative value model, which measures the valuation of each individual sector compared to the overall Bloomberg Barclays corporate bond index for each region. The methodology takes each sector's individual option-adjusted spread (OAS) and regresses it in a panel regression with all other sectors in each region. The dependent variables in the model are each sector's duration, convexity (duration squared) and credit rating - the primary risk factors for any corporate bond. Using the common coefficients from that panel regression, a risk-adjusted "fair value" spread is calculated. The difference between the actual OAS and fair value OAS is our valuation metric used to inform our sector allocation ranking. The latest output from the models can be found in the tables and charts in the Appendix starting on Page 13. We also show the duration-times-spread (DTS) for each sector in those tables, which we use as the primary way to measure the riskiness (volatility) of each sector. The scatterplot charts in the Appendix show the tradeoff between the valuation residual from our model and each sector's DTS. We then apply individual sector weights based on the model output and our desired level of overall spread risk in our recommended credit portfolio. The weights are determined at our discretion and are not the output from any quantitative portfolio optimization process. The only constraints are that all sector weights must add to 100% (i.e. the portfolio is fully invested with no use of leverage) and the overall level of spread risk (DTS) must equal our desired target. That target portfolio DTS is the first decision in our discretionary allocation process, which is informed by our strategic views on corporate credit in each region. For example, if we were recommending an overweight allocation to U.S. IG corporates, then we would target a portfolio DTS that was greater than the index DTS. If we then became a bit more cautious on U.S. corporates, we could reduce the target DTS (spread risk) of our model sector portfolio while maintaining an overall overweight allocation to U.S. corporates versus U.S. Treasuries. That is exactly what we did one year ago, when we began to target a weighted DTS of all our individual sector tilts that was roughly equal to the overall IG corporate index DTS for each region (U.S. euro area, U.K.) while maintaining an overall overweight stance on global corporate credit versus government debt. More recently, we have downgraded our stance on global spread product to neutral, while continuing to favor the U.S. over Europe, in response to growing tensions from emerging markets and the brewing U.S.-China trade war.1 Chart 4Performance Of Our IG Sector Allocations A Performance Update On Global Corporate Bond Sectors A Performance Update On Global Corporate Bond Sectors We last presented a performance update for our global IG corporate sector allocations back on April 12th of this year. Since then, our recommended tilts have modestly underperformed the benchmark index in excess return terms by a combined -3bps (Chart 4). This came entirely from the euro area, with both the U.S. and U.K. sector allocations simply matching the benchmark index. Year-to-date, our IG sector allocations have underperformed the benchmark by a combined -9bps in excess return terms, split equally among the U.S., euro area and U.K. This is a result entirely consistent with our long-standing stance to overweight Financials in all three regions, which continue to appear cheap in our valuation framework. Also, an increasing number of sectors had become expensive within that framework, in all three regions, so some portion of that overweight to global Financials was "by default" given that our model portfolios must be fully invested (finding value has been a persistent problem for credit investors over the past year). The return numbers for our U.S. sector allocations can be found in Table 2. Since our last update in April, the best performing sectors (in excess return terms) within our recommended tilts have all been underweights: Pharmaceuticals (+1.2bps), Electric Utilities (+1.1bps), Retailers (+0.6bps), Health Care (+0.6bps), Diversified Manufacturing (+0.5bps) and Chemicals (+0.4bps). These were fully offset, however, by underperformance from our large overweights to Energy (-4.1bps) and Financials (-2.7bps). Table 2U.S. Investment Grade Performance A Performance Update On Global Corporate Bond Sectors A Performance Update On Global Corporate Bond Sectors The return numbers for our euro area sector allocations - shown here hedged into U.S. dollars as is the case when we present all our model portfolio returns - can be found in Table 3. Since our last update in April, the best performing sectors (in excess return terms) within our recommended tilts have been underweights to Transportation (+2.0bps) and Electric Utilities (+0.6bps), with underperformance coming from our underweight to Food/Beverage (-2.4bps) and overweight to Life Insurers (-3.1bps). Table 3Euro Area Investment Grade Performance A Performance Update On Global Corporate Bond Sectors A Performance Update On Global Corporate Bond Sectors The return numbers for our U.K. sector allocations (again, hedged into U.S. dollars) can be found in Table 4. Since our last update in April, the best performing sectors (in excess return terms) within our recommended tilts have been our underweight to Utilities (+2.0bps) and Consumer Non-Cyclicals (+0.9bps), but this was nearly fully offset by our large overweight to Financials (-2.6bps). Table 4U.K. Investment Grade Performance A Performance Update On Global Corporate Bond Sectors A Performance Update On Global Corporate Bond Sectors Despite the underperformance of our sector portfolios year-to-date, the cumulative alpha from the portfolios since we began tracking the performance of the recommendations remains positive (+2bps in the U.S., +9bps in the euro area, +42bps in the U.K.). Bottom Line: Our investment grade sector model portfolios have underperformed modestly so far in 2018 (-3bps each in the U.S., euro area & U.K.) - primarily due to our overweight stance on Financials which have performed poorly. Changes To Our Sector Model Portfolios As mentioned earlier, the first choice we make when determining the recommended sector allocations within our model portfolios is how much spread risk (DTS) to take. For the U.S., euro area and U.K., we have already been maintaining a portfolio DTS that is close to the index DTS since August 2017. After our recent decision to downgrade global spread product allocations to neutral versus government bonds, we do not feel a need to further reduce our spread risk by targeting a below-index DTS. That would likely be our next decision when we wish to get more defensive on credit, which would await evidence that global leading economic indicators are sharply slowing and/or global monetary policy is becoming restrictive. Within that neutral level of spread risk, we are making the following portfolio changes based on the updated output from our valuation models presented in the Appendix Tables on pages 13-18. The goal is to favor sectors that have a DTS close the index DTS but have positive valuation residuals from our model: U.S.: We downgrade Tobacco and Wireless to Neutral; we downgrade Paper to Underweight. Euro Area: We upgrade Transportation, Other Industrials, Natural Gas, Brokerages/Asset Managers and Finance Companies to Overweight; we upgrade Automotive, Retailers and Tobacco to Neutral; we downgrade Wireless to Neutral; we downgrade Diversified Manufacturing & Media Entertainment to Underweight. U.K.: We upgrade Health Care, Transportation and Other Industrials to Overweight; we upgrade Integrated Energy to Neutral; we downgrade Technology & Wireless to Neutral; we downgrade Metals & Mining and Supermarkets to underweight. Robert Robis, Senior Vice President Global Fixed Income Strategy rrobis@bcaresearch.com 1 Please see BCA Global Fixed Income Strategy Weekly Report, "Time To Take Some Chips Off The Table: Downgrade Global Corporate Bond Exposure To Neutral", dated June 26th 2018, available at gfis.bcaresearch.com. Appendix Appendix Table 1U.S. Corporate Sector Valuation And Recommended Allocation* A Performance Update On Global Corporate Bond Sectors A Performance Update On Global Corporate Bond Sectors Appendix Chart 1U.S. Corporate Sector Risk Vs. Reward* A Performance Update On Global Corporate Bond Sectors A Performance Update On Global Corporate Bond Sectors Appendix Table 2Euro Area Corporate Sector Valuation And Recommended Allocation* A Performance Update On Global Corporate Bond Sectors A Performance Update On Global Corporate Bond Sectors Appendix Chart 2Euro Area Corporate Sector Risk Vs. Reward* A Performance Update On Global Corporate Bond Sectors A Performance Update On Global Corporate Bond Sectors Appendix Table 3U.K. Corporate Sector Valuation And Recommended Allocation* A Performance Update On Global Corporate Bond Sectors A Performance Update On Global Corporate Bond Sectors Appendix Chart 3U.K. Corporate Sector Risk Vs. Reward* A Performance Update On Global Corporate Bond Sectors A Performance Update On Global Corporate Bond Sectors Recommendations The GFIS Recommended Portfolio Vs. The Custom Benchmark Index A Performance Update On Global Corporate Bond Sectors A Performance Update On Global Corporate Bond Sectors Duration Regional Allocation Spread Product Tactical Trades Yields & Returns Global Bond Yields Historical Returns