Sectors

Equities have melted up in recent weeks, celebrating the tax bill passage, synchronized upswing in global economic data, still quiescent inflation and near vanishing tail risk. On July 10th when we penned the "SPX 3,000?" report, the S&P 500 was close to 2400.1 Over the past six months stocks have been in an uninterrupted upleg, moving to within 10% of our SPX 3,000 target. Table 1 White Paper: Introducing Our U.S. Equity Sector Earnings Models White Paper: Introducing Our U.S. Equity Sector Earnings Models Stocks have run "too far too fast" for our liking and there are increasing odds of a healthy pullback, especially now that no pundits are talking of a correction. In addition, were the selloff in the bond markets to accelerate in a short time frame, at some point it will cause equity market consternation. But, bonds still remain extremely overvalued versus stocks (Chart 1). Late last year, we began to modestly de-risk the portfolio via booking impressive gains in tactical market-neutral trades, as our upbeat cyclical view remains intact.2 Our cyclical strategy is to "buy the dip", as we do not foresee a recession in the coming 9-12 months. Importantly, profits will dictate the S&P 500's direction and the cyclical path of least resistance is higher still. Our SPX profit model continues to forecast healthy EPS growth in 2018 (Chart 2) and as we posited in the last report of 2017, earnings will do the heavy lifting at the current juncture with the forward P/E multiple likely moving laterally (Chart 3). Chart 1Simple Bond Valuation Metric Says:##br## Bonds Are Overvalued Vs. Stocks Simple Bond Valuation Metric Says: Bonds Are Overvalued Vs. Stocks Simple Bond Valuation Metric Says: Bonds Are Overvalued Vs. Stocks Chart 2All ##br##Clear All Clear All Clear Chart 3EPS Will Do The##br## Heavy Lifting In 2018 EPS Will Do The Heavy Lifting In 2018 EPS Will Do The Heavy Lifting In 2018 A simple decomposition shows that equity returns could reasonably reach a low-to-mid double digit level this year. Our assumptions are the following: nominal GDP can grow near 5% (3% real plus 2% inflation) and thus we estimate organic EPS growth that typically mimics GDP at this stage of the cycle of ~5%, ~2% dividend yield, ~2% buyback yield, ~5% tax related boost to EPS and no multiple expansion. The above assumptions are based on four key drivers: energy and financials will command a larger slice of the earnings pie,3 synchronized global capex upcycle will boost EPS,4 delayed positive translation effects from the U.S. dollar will lift profits5 and easy fiscal policy will also act as a tonic to EPS.6 On this note, this White Paper officially introduces the U.S. Equity Strategy earnings models for the eleven GICS1 equity sectors. We have identified key macro earnings drivers for each sector and incorporated them into individual sector models. The objective is to forecast the direction of earnings growth. Beyond introducing our EPS models, the purpose of this White Paper is to also compare and contrast the cyclical readings of our equity sector models with sell-side analysts' profit growth (Charts 4 & 5) and margin expectations and help clients position portfolios for the rest of 2018. The earnings models carry the most weight in determining our sector positioning, with our macro overlay and our valuation and technical indicators rounding out our methodology. Currently, our earnings models are consistent with maintaining a mostly cyclically biased portfolio structure (top panel, Chart 6), and thus participating in the broad market's overshoot. Chart 4What EPS Are Priced In... What EPS Are Priced In... What EPS Are Priced In... Chart 5...Per Sector For 2018 ...Per Sector For 2018 ...Per Sector For 2018 Chart 6Continue To Prefer Cyclicals Over Defensives Continue To Prefer Cyclicals Over Defensives Continue To Prefer Cyclicals Over Defensives Encouragingly, an equal weight of the 10 GICS1 sector model outputs (we are excluding real estate due to lack of history), accurately forecasts the S&P 500's profit growth (bottom panel, Chart 6), and currently also confirms the broad market's upbeat four factor macro EPS model (Chart 2). Anastasios Avgeriou, Vice President U.S. Equity Strategy anastasios@bcaresearch.com Financials (Overweight) Our financials earnings growth model comprises bank credit growth, the U.S. dollar index and net earnings revisions. The U.S. credit impulse is gaining traction, indicating that the market has digested the almost doubling in long-term rates over the past 18 months. Bankers are willing extenders of C&I credit and, with the economy humming north of 3% in real GDP terms, the outlook for loan growth is excellent. Loosening U.S. banking regulatory requirements, and pent up demand for shareholder friendly activities are all welcome news for financials profitability. Tack on BCA's higher interest rate view in 2018 and net interest margins will also get a bump, further adding to the sector's EPS euphoria. Credit quality is the third key profit driver for bank profitability and pristine credit quality is a harbinger of increased profits. The unemployment rate is plumbing generational lows and suggests that non-performing loans as a percentage of total loans will remain on a downward trajectory. Our profit model is expanding at twice the current profit growth rate (second panel, Chart 7) and 10 percentage points above the Street's 12-month forward estimates (top panel, Chart 5). In fact, the latter have gone vertical of late playing catch up to our model's estimates. The S&P financials sector remains a core portfolio overweight and we reiterate our high-conviction overweight status in the heavyweight S&P banks index. Chart 7Financials (Overweight) Financials (Overweight) Financials (Overweight) Energy (Overweight) The three drivers behind the S&P energy sector EPS growth model are oil-related currencies, the U.S. oil & gas rig count and WTI crude oil prices. A depreciating greenback, whittling down OECD oil stocks and rising global oil demand are all boosting energy profitability. OPEC 2.0 cutbacks have not only helped stabilize oil markets, but also paved the way for a breakout in oil prices above the $62.50/bbl stiff resistance level. Sustained OPEC output restraint will counterbalance U.S. shale oil production increases and coupled with rising global demand likely continue to underpin oil prices. Our synchronized global capex upcycle theme included the basic resources following a multi-year drubbing in outlays. Energy capex cannot contract at double digit rates indefinitely. Already a V-shaped capex momentum recovery is in store, as 2018 capital spending budgets are on track to at least match 2017. Our EPS growth model (second panel, Chart 8) matches sell-side analyst optimism (third panel, Chart 5). Keep in mind that only recently did the energy space become profit positive, making a solid recovery from an extremely low base. Margins are only now renormalizing above the zero line and breakneck pace EPS growth should continue in 2018. Following a negative 2017 return, the S&P energy sector is the best performing sector year-to-date, and we reiterate the high-conviction overweight stance. Chart 8Energy (Overweight) Energy (Overweight) Energy (Overweight) Industrials (Overweight) Our S&P industrials EPS model comprises the ISM manufacturing survey, raw industrials commodity prices and interest rates. It has an excellent track record in forecasting industrials EPS momentum, and sports one of the highest explanatory powers amongst all sector EPS models. While industrials EPS growth has been bouncing off the zero line for the better part of the past five years, our profit model has spoken: forecast EPS are in a V-shaped recovery since the end of the recent manufacturing recession (second panel, Chart 9). Commodity prices are recovering and increasing final demand, coupled with a soft U.S. dollar suggest that more gains are in store. Tack on the global virtuous capex upcycle, and the stars are aligned for this deep cyclical sector to break out of its multi-year trading range funk on the back of a surge in profits. China is a wild card, but signs of stability are enough to sustain the upward trajectory in the commodity-levered complex, including industrials stocks. Our industrials sector EPS model suggests that industrials profits will easily surpass the low (and below the overall market) analysts' EPS growth hurdle (third panel, Chart 4). The late-cyclical S&P industrials sector remains an overweight. Chart 9Industrials (Overweight) Industrials (Overweight) Industrials (Overweight) Consumer Staples (Overweight) The S&P consumer staples EPS growth model key drivers are: food exports, non-discretionary retail sales and analysts' net earnings revision ratio. Overall industry exports are expanding at a healthy clip as a consequence of a softening U.S. dollar and robust European and rebounding emerging markets demand. Deflating raw food commodity prices are offsetting rising energy and labor input costs, heralding a sideways move to margins. Sell side analysts are also currently penciling in a lateral profit margin move (middle panel, Chart 10). Our model is expanding at a near double digit rate, and is in line with 12-month forward EPS growth estimates (second panel, Chart 4). Investors have been vehemently avoiding staples stocks during the board market's uninterrupted run up, and have put out positioning offside. However, in the context of our cyclical over defensive portfolio bent we refrain from putting all our eggs in one basket, and prefer to keep consumer staples as our sole defensive sector overweight. This small hedge will serve our portfolio well if we do indeed get a healthy Q1/2018 pullback, as we expect. Chart 10Consumer Staples (Overweight) Consumer Staples (Overweight) Consumer Staples (Overweight) Consumer Discretionary (Neutral - Downgrade Alert) Measures of consumer confidence, consumer discretionary exports and the net earnings revisions ratio comprise BCA's global consumer discretionary EPS growth model, which has an excellent track record in forecasting the path of consumer discretionary profits. Consumer confidence is rolling over, albeit from a nose-bleed level, signaling that, at the margin, discretionary consumer outlays will remain tame. Worrisomely, rising interest rates coupled with a breakout in crude oil prices are net negatives for consumer spending. Our consumer drag indicator captures these consumer headwinds and warns that the sector is not out of the woods yet (bottom panel, Chart 11). The Fed is on track to raise rate three more times in 2018 and continue to mop up liquidity via renormalizing its balance sheet. This dual tightening backdrop bodes ill for early cyclical discretionary stocks as we highlighted in the September 25th Weekly Report. Our consumer discretionary EPS growth model is making an effort to bounce, signaling that contracting earnings will likely reverse course and come out of their recent funk (second panel). But, analysts are overly optimistic penciling in a near double-digit profit growth backdrop for the consumer discretionary sector (fourth panel, Chart 5). Netting it all out, the anemic message from our profit model along with the ongoing Fed tightening cycle and spiking energy prices warrant a downgrade alert. Stay tuned. Chart 11Consumer Discretionary (Neutral-Downgrade Alert) Consumer Discretionary (Neutral-Downgrade Alert) Consumer Discretionary (Neutral-Downgrade Alert) Telecom Services (Neutral) Telecom pricing power and capital expenditures expectations comprise our S&P telecom services EPS growth model. Telecom capital expenditures have bounced off the zero line and are growing at 4% per annum while sector sales growth has been nil. This capital-intensive industry must continually invest to stay relevant. A push by telecom carriers into TV offerings as part of a quad-play (internet, wireline, wireless and TV) has rekindled an M&A boom, and capex is slated to increase. However, margins will suffer if increased investment fails to translate into new sales (bottom panel, Chart 12). Steeply contracting pricing power is a bad omen both for top and bottom line growth prospects (fourth panel). Hopefully, industry consolidation will lead to a better pricing backdrop, but the jury is still out. Our EPS model has sunk into the contraction zone (second panel). Analysts are a little bit more sanguine, penciling in low single-digit profit growth (bottom panel, Chart 4). Industry deflation is not alone as a headwind as the bond market selloff is weighing on the high dividend yielding telecom services stocks. Despite all the bearish news, near all-time lows in relative valuation and washed out technicals are keeping us on the sidelines. Chart 12Telecom Services (Neutral) Telecom Services (Neutral) Telecom Services (Neutral) Materials (Neutral) Materials EPS growth is a far cry from the near 100% year-over-year mark hit during the commodity super-cycle the mid-2000s and the reflex rebound following the Great Recession (second panel, Chart 13). Our S&P materials EPS model inputs include the U.S. currency, metals commodity prices and a measure of borrowing costs. The model has been steadily decelerating recently, and moving in the opposite direction compared with sell-side analysts' optimistic estimates (bottom panel, Chart 5). Consequently, there is scope for downward revisions. Materials stocks are reflationary beneficiaries and also high fixed cost high operating leverage deep cyclicals that benefit most during the later stages of the business cycle when a virtuous capex/EPS upcycle takes root. A number of both developed and developing central banks have recently embarked on tightening monetary policy following in the Fed's footsteps. Global liquidity is on the verge of getting mopped up as even the ECB and the BoJ have started to hint that they would remove some of their ultra-accommodative and unconventional policy measures. These opposing forces keep us at bay and we continue to recommend a benchmark allocation in the S&P materials index. Chart 13Materials (Neutral) Materials (Neutral) Materials (Neutral) Real Estate (Neutral) Commercial real estate loan demand, a labor market measure and the EUR/USD comprise our S&P real estate profit growth model (second panel, Chart 14). The 10-year Treasury yield and real estate relative performance have been nearly perfectly inversely correlated since the GFC as REITs sport a hefty dividend yield and thus are considered a fixed income proxy. BCA's higher interest rate 2018 theme suggests that more downside looms for this rate-sensitive sector. Similarly, a firming EUR/USD reflecting the nearly 100% domestic exposure of the sector weighs on real estate relative performance. Our EPS model has recently sunk into the contraction zone and is in sync with sell-side analysts' negative profit growth figures for calendar 2018 (second panel, Chart 5). While all this signals that an underweight stance is appropriate, we would rather stay on the sidelines for three reasons: First, sector pricing power (mostly rents) has not eroded yet, despite the surge in multi-family housing construction. Second, most of the bad news is likely already discounted in sinking valuations and extremely oversold technicals. Finally, we would rather concentrate our interest rate related underweight in the pure play fixed income proxy, the utilities sector (please see page 15). Stick with a benchmark allocation in the S&P real estate index. Chart 14Real Estate (Neutral) Real Estate (Neutral) Real Estate (Neutral) Health Care (Underweight) Our S&P health care EPS growth model consists of health care pricing power, labor costs and a measure of health care outlays. Health care demand is fairly inelastic, signaling that health care spending prospects remain upbeat, especially given the aging population. However, the industry's up-to-recently structurally robust pricing power backdrop is under intense scrutiny. Medical commodity cost inflation is melting and drug pricing power has nearly halved since early 2016. Democrats and Republicans alike, despise the pharmaceutical/biotech industry's pricing tactics and drug price containment is on nearly every legislator's agenda. Add on the generic drug inroads, and Big Pharma/biotech resilient profits appear vulnerable, weighing heavily on the sector's relative performance. From a secular perspective, there is scope for health care sector profit gains. Developing countries are only just starting to institute social "safety nets" that the developed world already has in place. Our profit model is decelerating (second panel, Chart 15) and forecasting single digit EPS growth, in line with the Street's 12-month forward profit estimates (fourth panel, Chart 4). The S&P health care sector is a core underweight portfolio holding and we reiterate the high-conviction underweight status in the heavy weight S&P pharma sub index. Chart 15Health Care (Underweight) Health Care (Underweight) Health Care (Underweight) Utilities (Underweight) Utilities pricing power, the yield curve and analysts' net earnings revisions are the key inputs in our S&P utilities EPS growth model (second panel, Chart 16). While natgas prices, the industry's marginal price setter, have been stuck in a trading range between $2.6 and $3.4/mmbtu over the past 18 months, they are currently contracting and weighing heavily on industry pricing power. The U.S. economy is firing on all cylinders (bottom panel, Chart 16) and a selloff in the 10-year Treasury market near 3% is BCA's base-case scenario for 2018. Under such a backdrop, fixed income proxied defensive equities lose their luster, and thus utilities stocks will likely remain under intense downward pressure, Our S&P utilities EPS growth model is expanding at a mid-single digit growth rate, broadly in line with sell-side analysts' forecasts (fifth panel, Chart 4) and roughly 700bps below the broad market. The S&P utilities sector is a high-conviction underweight. Chart 16Utilities (Underweight) Utilities (Underweight) Utilities (Underweight) Technology (Underweight - Upgrade Alert) Our three-factor global technology EPS growth model includes capex intentions, the trade-weighted U.S. dollar and sell-side analysts' net earnings revision ratio. While the tech sector is still largely considered a deep cyclical, we view it as more defensive. The majority of large capitalization tech companies are mature, cash rich, cash flow generating, dividend paying and high margin. Tech firms thrive in a deflationary backdrop as business models have been built to withstand the inherently disinflationary "creative destruction" process. BCA's interest rate view calls for an inflationary driven sell off in bonds for 2018, suggesting that investors avoid high-flying tech stocks. Weakness in basic resources explains most of the delta in cyclical capital outlays. Encouragingly, technology's share of the U.S. capex pie is making inroads rising to roughly 10% (bottom panel, Chart 17). Tech investment has been so abysmal for so long that it is hard to get any worse. In fact, it has started to improve both on an absolute and relative basis, as pent-up tech demand is being unleashed. Our synchronized global capex upcycle theme is gaining traction and the tech sector will continue to make gains at the expense of resource-related spending. Our global tech EPS model is forecasting modest double-digit growth in the coming quarters (second panel, Chart 17), largely aligned with sell-side analysts' profit growth expectations (fifth panel, Chart 5). On balance, we are putting the S&P tech sector on upgrade alert reflecting the capex tailwind offsetting the rising interest rate backdrop, and reiterate our capex-related high-conviction overweight in the S&P software sub-index. Chart 17Technology (Underweight-Upgrade Alert) Technology (Underweight-Upgrade Alert) Technology (Underweight-Upgrade Alert) 1 Please see BCA U.S. Equity Strategy Weekly Report, "SPX 3,000?," dated July 10, 2017, available at uses.bcaresearch.com. 2 Please see BCA U.S. Equity Strategy Weekly Report, "EPS And "Nothing Else Matters"," dated December 18, 2017, available at uses.bcaresearch.com. 3 Please see BCA U.S. Equity Strategy Weekly Report, "Dissecting Profit Composition," dated July 24, 2017, available at uses.bcaresearch.com. 4 Please see BCA U.S. Equity Strategy Weekly Report, "Invincible," dated November 6, 2017, available at uses.bcaresearch.com. 5 Please see BCA U.S. Equity Strategy Weekly Report, "Dollar The Great Reflator," dated September 18, 2017, available at uses.bcaresearch.com. 6 Please see BCA U.S. Equity Strategy Weekly Report, "Can Easy Fiscal Offset Tighter Monetary Policy?," dated October 9, 2017, available at uses.bcaresearch.com.

Highlights An increase in the "synthetic" supply of bitcoins via financial derivatives, along with the launch of bitcoin-like alternatives by large established tech companies, will cause the cryptocurrency market to collapse under its own weight. Other areas that could see supply-induced pressures over the coming years include oil, high-yield debt, global real estate, and low-volatility trades. In contrast, the U.S. stock market has seen an erosion in the supply of shares due to buybacks and voluntary delistings. Investors should consider going long U.S. equities relative to high-yield credit, while positioning for higher volatility. Such an outcome would be similar to what happened in the late 1990s, a period when the VIX and credit spreads were trending higher, while stocks continued to hit new highs. A breakdown in NAFTA talks remains the key risk for the Canadian dollar and Mexican peso. Feature Bubbles Burst By Too Much Supply The "cure" for higher prices is higher prices. The dotcom and housing bubbles did not die fully of their own accord. Their demise was expedited by a wave of new supply hitting the market. In the case of the dotcom bubble, a flood of shares from initial and secondary public offerings inundated investors in 2000 (Chart 1). This put significant downward pressure on the prices of internet stocks. The housing boom was similarly subverted by a slew of new construction - residential investment rose to a 55-year high of 6.6% of GDP in 2006 (Chart 2). Chart 1Burst By Too Much Supply: Example 1 Burst By Too Much Supply: Example 1 Burst By Too Much Supply: Example 1 Chart 2Burst By Too Much Supply: Example 2 Burst By Too Much Supply: Example 2 Burst By Too Much Supply: Example 2 Is bitcoin about to experience a similar fate? On the surface, the answer may seem to be "no." As more bitcoins are "mined," the computational cost of additional production rises exponentially. In theory, this should limit the number of bitcoins that can ever circulate to 21 million, about 80% of which have already been created (Chart 3). Yet if one looks beneath the surface, bitcoin may also be vulnerable to a variety of "supply-side" factors. Chart 3Bitcoin: Most Of It Has Been Mined Bitcoin: Most Of It Has Been Mined Bitcoin: Most Of It Has Been Mined First, the expansion of financial derivatives tied to the value of bitcoin threatens to create a "synthetic" supply of the cryptocurrency. When someone writes a call option on a stock, the seller of the option is effectively taking a bearish bet while the buyer is taking a bullish bet. The very act of writing the option creates an additional long position, which is exactly offset by an additional short position. Moreover, to the extent that a decision to sell a particular call option will depress the price of similar call options, it will also depress the underlying price of the stock. This is simply because one can have long exposure to a stock either by owning it outright or owning a call option on it. Anything that hurts the price of the latter will also hurt the price of the former. As bitcoin futures begin to trade, investors who are bearish on bitcoin will be able to create short positions that cause the effective number of bitcoins in circulation to rise. This will happen even if the official number of bitcoins outstanding remains the same. Imitation Is The Sincerest Form Of Flattery An increase in synthetic forms of bitcoin supply is one worry for bitcoin investors. Another is the prospect of increased competition from bitcoin-like alternatives. There are now hundreds of cryptocurrencies, most of which use a slight variant of the same blockchain technology that underpins bitcoin. Chart 4Governments Will Want Their Cut Governments Will Want Their Cut Governments Will Want Their Cut So far, the proliferation of new currencies has been largely driven by technologically savvy entrepreneurs working out of their bedrooms or garages. But now companies are getting in on the act. The stock price of Kodak, which apparently is still in business, tripled earlier this week when it announced the launch of its own cryptocurrency. That's just a small taste of what's to come. What exactly is stopping giants such as Facebook, Amazon, Netflix, and Google from issuing their own cryptocurrencies? After all, they already have secure, global networks. Amazon could start giving out a few coins with every sale, and allow shoppers to purchase goods from the online retailer using its new currency. It's simple.1 The only plausible restriction is a legal one: The threat that governments will quash upstart cryptocurrencies for fear that will drive down demand for their own fiat monies. As we noted several weeks ago, the U.S. government derives $100 billion per year in seigniorage revenue from its ability to print currency and use that money to buy goods and services (Chart 4).2 As large companies get into the cryptocurrency arena, governments are likely to respond harshly - sooner rather than later. This week's news that the South Korean government will consider banning the trading of cryptocurrencies on exchanges is a sign of what's to come. Who Else? What other areas are vulnerable to an eventual tsunami of new supply? Four come to mind: Oil: BCA's bullish oil call has paid off in spades. Brent has climbed from $44 last June to $69 currently. Further gains may not be as easily attainable, however. Our energy strategists estimate that the breakeven cost of oil for U.S. shale producers is in the low-$50 range.3 We are now well above this number, which means that shale supply will accelerate. This does not mean that prices cannot go up further in the near term, but it does limit the long-term potential for crude. Real estate: Ultra-low interest rates across much of the world have fueled sharp rallies in home prices. Inflation-adjusted home prices in Canada, Australia, New Zealand, and parts of Europe are well above their pre-Great Recession levels (Chart 5). U.S. real residential home prices are still below their 2006 peak, but commercial real estate (CRE) prices have galloped to new highs (Chart 6). Rent growth within the U.S. CRE sector is starting to slow, suggesting that supply is slowly catching up with demand (Chart 7). Chart 5Where Low Rates Have ##br##Fueled House Prices Where Low Rates Have Fueled House Prices Where Low Rates Have Fueled House Prices Chart 6Commercial Real Estate Prices Have ##br##Surpassed Pre-Recession Levels Commercial Real Estate Prices Have Surpassed Pre-Recession Levels Commercial Real Estate Prices Have Surpassed Pre-Recession Levels Chart 7Rent Growth Is Cooling Rent Growth Is Cooling Rent Growth Is Cooling Corporate debt: Low rates have also encouraged companies to feast on credit. The ratio of corporate debt-to-GDP in the U.S. and many other countries is close to record-high levels (Chart 8A and Chart 8B). Credit spreads remain extremely tight, but that may change as more corporate bonds reach the market. Chart 8ACorporate Debt-To-GDP ##br##Is Close To Record Highs Corporate Debt-To-GDP Is Close To Record Highs Corporate Debt-To-GDP Is Close To Record Highs Chart 8BCorporate Debt-To-GDP ##br##Is Close To Record Highs Corporate Debt-To-GDP Is Close To Record Highs Corporate Debt-To-GDP Is Close To Record Highs Low-volatility trades: A recent Bloomberg headline screamed "Short-Volatility Funds Are Being Flooded With Cash."4 The number of volatility contracts traded on the Cboe has increased more than tenfold since 2012. Net short speculative positions now stand at record-high levels (Chart 9). Traders have been able to reap huge gains over the past few years by betting that volatility will decline. The problem is that if volatility starts to rise, those same traders could start to unload their positions, leading to even higher volatility. In contrast to the aforementioned areas, the stock market has seen an erosion in the supply of shares due to buybacks and voluntary delistings. The S&P divisor is down by over 8% since 2005. The number of U.S. publicly-listed companies has nearly halved since the late 1990s (Chart 10). This trend is unlikely to reverse any time soon, given the elevated level of profit margins and the temptation that many companies will have to use corporate tax cuts to step up the pace of share repurchases. Chart 9Low Volatility Is In High Demand Low Volatility Is In High Demand Low Volatility Is In High Demand Chart 10Erosion Of Supply In The Stock Market Erosion Of Supply In The Stock Market Erosion Of Supply In The Stock Market Bet On Higher Equity Prices, But Also Higher Volatility And Higher Credit Spreads The discussion above suggests that the relationship between equity prices and both volatility and credit spreads may shift over the coming months. This would not be the first time. Chart 11 shows that the VIX and credit spreads began to trend higher in the late 1990s, even as the S&P 500 continued to hit new record highs. We may be entering a similar phase now. Continued above-trend growth in the U.S. and rising inflation will push up Treasury yields. We declared "The End Of The 35-Year Bond Bull Market" on July 5, 2016 - the exact same day that the 10-year Treasury yield hit a record closing low of 1.37%.5 Higher interest rates will punish financially-strapped borrowers, leading to wider credit spreads. Equity volatility is also likely to rise as corporate health deteriorates and the timing of the next downturn draws closer. Our baseline expectation is that the U.S. and the rest of the world will fall into a recession in late 2019. Financial markets will sniff out a recession before it happens. However, if history is any guide, this will only happen about six months before the start of the recession (Table 1). This suggests that global equities can continue to rally for the next 12 months. With this in mind, we are opening a new trade going long the S&P 500 versus high-yield credit. Chart 11Volatility Can Increase And Spreads ##br##Can Widen As Stock Prices Rise Volatility Can Increase And Spreads Can Widen As Stock Prices Rise Volatility Can Increase And Spreads Can Widen As Stock Prices Rise Table 1Too Soon To Get Out Will Bitcoin Be DeFANGed? Will Bitcoin Be DeFANGed? Four Currency Quick Hits Four items buffeted currency and fixed-income markets this week. The first was a news story suggesting that China will slow or stop its purchases of U.S. Treasury debt. China's State Administration of Foreign Exchange (SAFE) decried the report as "fake news." Lost in the commotion was the fact that China's holdings of Treasurys have been largely flat since 2011 (Chart 12). China still has a highly managed currency. Now that capital is no longer pouring out of the country, the PBoC will start rebuilding its foreign reserves. Given that the U.S. Treasury market remains the world's largest and most liquid, it is hard to see how China can avoid having to park much of its excess foreign capital in the United States. The second item this week was the Bank of Japan's announcement that it will reduce its target for how many government bonds it buys. This just formalizes something that has already been happening for over a year. The BoJ's purchases of JGBs have plunged over the past twelve months, mainly because its ¥80 trillion target is more than double the ¥30-35 trillion annual net issuance of JGBs (Chart 13). Chart 12China's Holdings Of Treasurys: ##br##Largely Flat Since 2011 China's Holdings Of Treasurys: Largely Flat Since 2011 China's Holdings Of Treasurys: Largely Flat Since 2011 Chart 13BoJ Has Been Reducing ##br##Its Bond Purchases BoJ Has Been Reducing Its Bond Purchases BoJ Has Been Reducing Its Bond Purchases Ultimately, none of this should matter that much. The Bank of Japan can target prices (the yield on JGBs) or it can target quantities (the number of bonds it owns), but it cannot target both. The fact that the BoJ is already doing the former makes the latter irrelevant. And with long-term inflation expectations still nowhere near the BoJ's target, the former is unlikely to change. What does this mean for the yen? The Japanese currency is cheap and its current account surplus has swollen to 4% of GDP (Chart 14). Speculators are also very short the currency (Chart 15). This increases the likelihood of a near-term rally, as my colleague Mathieu Savary flagged this week.6 Nevertheless, if global bond yields continue to rise while Japanese yields stay put, it is hard to see the yen moving up and staying up a lot. On balance, we expect USD/JPY to strengthen somewhat this year. Chart 14Yen Is Already Cheap... Yen Is Already Cheap... Yen Is Already Cheap... Chart 15...And Unloved ...And Unloved ...And Unloved The third item was the revelation in the ECB's December meeting minutes that the central bank will be revisiting its communication stance in early 2018. The speculation is that the ECB will renormalize monetary policy more quickly than what the market is currently discounting. If that were to happen, EUR/USD would strengthen further. All this is possible, of course, but it would likely require that euro area growth surprise on the upside. That is far from a done deal. The euro area economic surprise index has begun to edge lower, and in relative terms, has plunged against the U.S. (Chart 16). Unlike in the U.S., the euro area credit impulse is now negative (Chart 17). Euro area financial conditions have also tightened significantly relative to the U.S. (Chart 18). Chart 16Euro Area Economic ##br##Surprises Edging Lower Euro Area Economic Surprises Edging Lower Euro Area Economic Surprises Edging Lower Chart 17Negative Credit Impulse In The Euro ##br##Area Will Weigh On Growth Negative Credit Impulse In The Euro Area Will Weigh On Growth Negative Credit Impulse In The Euro Area Will Weigh On Growth Chart 18Diverging Financial Conditions ##br##Favor U.S. Over The Euro Area Diverging Financial Conditions Favor U.S. Over The Euro Area Diverging Financial Conditions Favor U.S. Over The Euro Area Meanwhile, EUR/USD has appreciated more since 2016 than what one would expect based on changes in interest rate differentials (Chart 19). Speculative positioning towards the euro has also gone from being heavily short at the start of 2017 to heavily long today (Chart 20). Reasonably cheap valuations and a healthy current account surplus continue to work in the euro's favor, but our best bet is that EUR/USD will give up some of its gains over the coming months. Chart 19The Euro Has Strengthened More Than ##br##Justified By Interest Rate Differentials The Euro Has Strengthened More Than Justified By Interest Rate Differentials The Euro Has Strengthened More Than Justified By Interest Rate Differentials Chart 20Euro Positioning: From Deeply ##br##Short To Record Long Euro Positioning: From Deeply Short To Record Long Euro Positioning: From Deeply Short To Record Long Lastly, the Canadian dollar and Mexican peso came under pressure this week on news reports that the U.S. will be pulling out of NAFTA negotiations. Of the four items discussed in this section, this is the one that worries us most. The global supply chain has become highly integrated. Anything that sabotages it would be greatly disruptive. At some level, Trump realizes this, but he also knows that his base wants him to get tough on trade, and unless he does so, his chances of reelection will be even slimmer than they are now. Ultimately, we expect a new NAFTA deal to be reached, but the path from here to there will be a bumpy one. Housekeeping Notes Our long global industrials/short utilities trade is up 12.4% since we initiated it on September 29. We are raising the stop to 10% to protect gains. We are also letting our long 2-year USD/Saudi Riyal forward contract trade expire for a loss of 2.9%. Given the recent improvement in Saudi Arabia's finances, we are not reinstating the trade. Peter Berezin, Chief Global Strategist Global Investment Strategy peterb@bcaresearch.com 1 My thanks to Igor Vasserman, President of SHIG Partners LLC, for his valuable insights on this topic. 2 Please see Global Investment Strategy Special Report, "Bitcoin's Macro Impact," dated September 15, 2017; and Global Investment Strategy Weekly Report, "Don't Fear A Flatter Yield Curve," dated December 22, 2017. 3 Please see Energy Sector Strategy Weekly Report, "Breakeven Analysis: Shale Companies Need ~$50 Oil To Be Self-Sufficient," dated March 15, 2017. 4 Dani Burger, "Short-Volatility Funds Are Being Flooded With Cash," Bloomberg, November 6, 2017. 5 Please see Global Investment Strategy Special Alert, "End Of The 35-year Bond Bull Market," dated July 5, 2016. 6 Please see Foreign Exchange Strategy, "Yen: QQE Is Dead! Long Live YCC!" dated January 12, 2018. Tactical Global Asset Allocation Recommendations Strategy & Market Trends Tactical Trades Strategic Recommendations Closed Trades

Highlights Environmental reforms in China continue to reduce steelmaking capacity. The shuttering of illegal induction facilities in China also is tightening markets. Although official Chinese steel output is higher, this likely reflects the fact that output from illegal induction mills went unreported - and thus uncounted - while production from legal mills is increasing to fill the gap left by closures. Steelmakers' profits are surging, which means demand for iron ore in China will remain stout at least through 1H18. Copper has been well bid since June 2017, following supply disruptions and strong demand growth driven by the global economic upturn. We expect it will get an additional lift in 1H18, as wiring and plumbing in construction projects now absorbing steel in China get underway. Later, global growth will make up for any slowdown in China. Our analysis indicates the global steel market will be tightening in 1H18, as it already is doing in China. Consistent with this, we are opening a tactical long position in Mar/18 steel rebar futures on the Shanghai Futures Exchange, which are quoted in RMB/ton. We are including a 10% stop loss on this recommendation. Energy: Overweight. Our once-out-of-consensus oil view is now the consensus, so we are taking profits on Brent and WTI $55 vs. $60/bbl call spreads on May- and July-delivery oil at tonight's close. These positions were up 109.2% and 123.5% at Tuesday's close. Any sell-offs will present an opportunity to re-establish length along these forward curves. Base Metals: Neutral. Copper will remain well bid this year as the global economic recovery rolls on. A large number of contract renegotiations at mines is an additional upside risk to copper prices this year. Precious Metals: Neutral. Given our expectation of four rate hikes by the Fed, it is difficult to get too bullish gold. However, any indication the central bank is tilting dovish - particularly if we fail to see higher inflation this year - will rally the metal. Ags/Softs: Underweight. Markets will tread water until Friday's USDA WASDE. We remain underweight, except for corn. Feature Chart of the WeekIron Ore And Steel Prices Diverged In 2017 Iron Ore And Steel Prices Diverged In 2017 Iron Ore And Steel Prices Diverged In 2017 China's environmental policy actions have reduced world steel-making capacity by 100 mm MT between 1H16 and 1H18. This is most visible in Chinese steel prices, which gained more than 30% in 2017, following an almost 80% increase in 2016. The total gain in steel prices since the start of Beijing's focus on steel-market reforms is a resounding 135%. Iron ore prices posted similar gains to steel in 2016 but diverged sharply in 2017, slumping more than 40% between mid-March and mid-June - ending almost 8% lower year-on-year (yoy) (Chart of the week). Soaring steel prices pushed profit margins at Chinese mills higher, which, of course, fed through to demand for iron ore, the critical steel-making ingredient in China, toward year-end: Iron ore prices were up 20% in the last two months of 2017. How Did We Get Here? A Recap Of China's Steel Sector Reforms As part of its reforms aimed at reducing air pollution by eliminating outdated, excess industrial capacity, Beijing pledged to eliminate 100-150 mm MT of steel capacity over the 2016-2020 period. To date it has shuttered an estimated 100 mm MT of capacity. In addition to these reforms Beijing pledged to shut down smaller induction furnaces in China, which melt scrap steel, and produce steel of shoddy quality. These induction furnaces are estimated to account for 80-120 mm MT worth of annual capacity, although their actual output is far less: They produced an estimated 30-50 mm MT in 2016, according to S&P Global Platts.1 This is less than 7% of China's total crude-steel output. Production cuts from induction mills are not evident in official data - China's crude steel production figures have continued to rise amid these cuts, as we discussed in previous research (Chart 2).2 Data from the International Iron and Steel Institute shows global steel output was at a record high for the first 11 months of 2017, increasing by more than 5% yoy. Likewise, crude steel output from China - which accounts for 50% of global output - peaked in August: Output over the same period was the highest on record, increasing by 5.28% compared to the same period in 2016. This production paradox can be put down to the fact that many Chinese induction furnaces are illegal, and, as a result their output is not accounted for in official production data. As legal steelmakers ramped up their output to offset declines from the closed down induction furnaces, official crude production figures climbed. In fact, further examination of Chinese steel data makes it clear that China's steel market is in fact tighter than what can be inferred from the crude production figures (Chart 3). The following observations point to a strained market: While China's crude steel production has been paving new record highs, China Stat Info data reveals a contradictory picture about steel products. Output of steel products in the March to November period of 2017 came in 3.46% lower yoy, marking the first yoy decline for that period since 1995! While crude steel produced by induction furnaces would not be included in official crude steel figures, the metal would eventually be used to manufacture steel products - wires, rods, rails and bars, and are represented in this data. Thus the decline in steel products indicates that lower crude supply has weighed down on the output of steel products. China's steel exports have been on a downtrend. In theory, this can be due to either an increase in domestic demand or a decrease in foreign demand. Given the healthy state of the global economy, and what we know about steel production in China, we are believers in the former theory. China's exports of steel products are down 30% yoy in the first 11 months of 2017. Aside from the 3.04% yoy decline in 2016, these mark the first annual declines in exports since 2009. In face of lower domestic supply, China has likely reduced its exports in order to satisfy demand from local steel users. China's scrap steel imports fell in 2H17. Unlike blast furnaces which use iron ore as the main input in steelmaking, the shuttered illegal steelmakers use scrap steel which they melt in an induction furnace. Coincident with the elimination of these furnaces, China's imports of scrap steel fell 14.35% yoy in 2H17. This is further evidence of reduced demand for the scrap steel from these furnaces. China steel inventories are falling. In fact steel product inventories in major industrial cities are at record lows (Chart 4). This is a symptom of a tight market with demand outpacing supply, contradicting China's crude steel production figures. Chart 2Record Chinese Production Of Crude Steel##BR##Amid Falling Steel Products Output Record Chinese Production Of Crude Steel Amid Falling Steel Products Output Record Chinese Production Of Crude Steel Amid Falling Steel Products Output Chart 3China Trade Data Evidence##BR##Of Tight Market China Trade Data Evidence Of Tight Market China Trade Data Evidence Of Tight Market Chart 4Steel Inventories##BR##In China Are Falling Steel Inventories In China Are Falling Steel Inventories In China Are Falling Furthermore, according to World Steel Association (WSA), capacity utilization in the 66 countries for which they collect data increased by 3.12 percentage points yoy for the July to November 2017 period to average 72.64%, up from the 69.52% average in the same period of 2016. These observations are evidence that despite the increase in official crude steel production figures, the actual output has in fact fallen and supply is tighter. Whether steel prices will remain buoyed by tight supply hinges on whether China is successful in permanently shuttering excess capacity and shoddy steel producers, or if induction furnace operators are able to circumvent these policies and bring illegal steel back to the market. China's Reforms To Dominate Steel Market, At Least This Winter Following the conclusion of the mid-December Central Economic Work Conference, Chinese authorities announced the "three tough battles" for the next three years, which they see as crucial for future economic prosperity. These battles are summarized as (1) preventing major risks, (2) targeted poverty alleviation, and (3) pollution control. The International Energy Agency (IEA) estimates that air pollution has led to ~1 million premature deaths while household air pollution caused an additional 1.2 million premature deaths in China annually.3 Because of this, improving China's air quality is a chief social and health target for China. Chart 5Lower Chinese Steel Production##BR##Will Impact Global Output Lower Chinese Steel Production Will Impact Global Output Lower Chinese Steel Production Will Impact Global Output This will mean that measures to reduce pollution and clear China's skies will be critically important to the steel sector. According to the Ministry of Environmental Protection, China has pledged a 15% yoy reduction in the concentration of airborne particles smaller than 2.5 microns in diameter - known as PM2.5 - in 28 smog-prone northern cities. The steel industry, which is mostly concentrated in the northern China region of Beijing-Tianjin-Hebei, is one of the top sources of air polluting emissions in that region. In fact, industrial emissions - most notably from the steel and cement sectors - are reportedly responsible for 40-50% of these small airborne particles. China's winter smog "battle plan" will target these polluting industries by mandating cuts on steel, cement, and aluminum production during the smog-prone mid-November to mid-March months, as well as restricting household coal use, diesel trucks and construction projects. Steel production cuts target a range between 30-50%, which, according to Platts estimates, will take 33 mm MT of steel production - equivalent to ~3.9% of China's projected 2017 crude steel output - offline during the winter. In fact, according to China's environment minister, Li Ganjie, "these special campaigns are not a one-off, instead it is an exploration of long-term mechanisms."4 Thus, these cuts may become a recurring event in China's steel sector. China's official crude steel figures are beginning to show the impact of these cuts with November crude production falling 8.6% month-on-month (mom) and growing by just 2.2% yoy - significantly slower than the 7.6% yoy average experienced since July. As a consequence, although crude production in the rest of the world grew in line with previous months, global steel output fell almost 6% month-on-month in November, while yoy production grew 3.7% – a significant deceleration from the average 6.6% yoy rate witnessed since the beginning of 2H17 (Chart 5). Risks to this outlook come from weak compliance with these cuts. There are recent reports of evasions by aluminum and steel producers in Shandong. Nonetheless, given China's focus on these reforms, we do not foresee widespread violations. Another risk comes from the demand side. As part of its environmental agenda, Beijing announced plans put off the construction of major public projects in the city - road and water projects - until springtime. The suspension is not intended to impact "major livelihood projects" such as railways, airports, and affordable housing. Construction is the largest end user for steel - according to WSA more than half of global steel is used for buildings and infrastructure - a slowdown in the construction sector would weigh on steel demand.5 If other major construction zones adopt a similar policy, the impact of lower steel supply will be offset by weak demand, muting the overall effect on the steel market. Bottom Line: We expect to see lower steel production and exports from China in the coming months. Given Xi Jinping's resolve to improve air quality, we expect compliance to environmental reforms among steelmakers to be strong this winter. This, along with lower output from induction furnaces in China, indicates the market could be tighter than is commonly supposed at least in 1H18. The likelihood the global economic recovery and expansion persists through 2018 suggests steel markets could remain well bid in 2H18, particularly if, as we expect, growth ex-China picks up the slack resulting from any slowdown in China. However, we will need to see what the actual reforms for the industry look like following the National People's Congress in March 2018.6 Steel Profit Margins Spur Iron Ore Demand Given steel's exceptional price gains over the past two years, and iron ore's lackluster performance in 2017, profit margins at China's steel producers reached multi-year highs (Chart 6). Ordinarily, this would normally encourage steel production, which would flood the market with supply and push prices down. However, China's environmental reforms will cap output from the country's most productive steelmaking region in coming months. Consequently, unless there are mass policy violations by steel producers this winter, we do not anticipate a swift price adjustment lower. Instead, steel producers are preparing to run on all cylinders when production restrictions are lifted in the spring. As such, they are filling iron ore inventories and taking advantage of weaker iron ore prices, before the iron ore market catches up with steel. China's iron ore imports reached an all-time record in September, while the latest data shows a 19% month-on-month (mom) jump in imports, corresponding with a 2.8% yoy increase (Chart 7). Chart 6Healthy Steel##BR##Profit Margins Healthy Steel Profit Margins Healthy Steel Profit Margins Chart 7Steel Producers Stocking Up On Iron Ore##BR##In Preparation For Spring Steel Producers Stocking Up On Iron Ore In Preparation For Spring Steel Producers Stocking Up On Iron Ore In Preparation For Spring This runs counter to what we expect during a period of muted steel production. Especially in an environment of healthy iron ore inventories, as China is in currently. Although Chinese inventories came down from mid-year peaks, they resumed their upward trend in 4Q17. This coincides with the steel winter capacity cuts, and is likely due to reduced demand for the ore from steel mills. There are two theories to explain this phenomenon: 1. Chinese steelmakers are taking advantage of lower iron ore prices and locking in higher profit margins, in anticipation of higher iron ore prices once steel production picks up again in the spring. 2. Amid the winter cuts, China's steelmakers are demanding high-grade iron ore, imported from Brazil and Australia. This will help them ensure that they are able to maximize their output without violating environmental policies. Environmental Consciousness Widens Iron Ore Spreads A consequence of the steel winter capacity cuts is stronger demand for higher grade raw materials to cut down on the most polluting phases of steel production. Higher-grade iron ore, which is defined by its purity or iron content, is more efficient for blast furnaces to use, allowing them to produce more steel from each tonne of iron ore they consume, maximizing output and profit. This is especially true in a tight steel market, with healthy profit margins: Steelmakers are able to afford the higher grades and are favoring productive efficiency. The discount for lower grade iron ore fines - 58% iron content - as well as the premium for higher grade 65% iron content have widened (Chart 8). This is because mills have found a way to legally circumvent the winter environmental restrictions, and still remain compliant. Furthermore, purer ores are less polluting, which helps serve China's environmental agenda. In addition, the premiums for iron ore pellets and iron ore lumps have also widened. Unlike lumps and pellets which can be fed directly into blast furnaces, fines require a sintering process which is highly polluting. Thus, China's environmental reforms have increased demand for higher grade, less polluting ores. An additional factor that could be driving up spreads is higher metallurgical coke prices (Chart 6). Higher grade iron ore contains less silica and thus requires less met coke to purify the ores. According to anecdotal evidence from China, Carajas fines from Brazil - which have the highest iron ore content and lowest silica content- are reportedly in high demand.7 Furthermore, China's imports show a decline in iron ore from India - which is of the lower grades. In the July to October period, imports fell 11.26% yoy with October imports falling almost 25% yoy and 30% mom. This is consistent with the theory that steel makers are shunning lower grade ores. On the other hand, imports from Brazil and Australia are expected to remain strong (Chart 9). The latest Australian Resources and Energy Quarterly forecasts Australian and Brazilian iron ore exports to grow 5.4% and 4.2% respectively in 2018, while Indian exports are projected to fall 57.5% yoy. Chart 8Wide Iron Ore##BR##Price Spreads Wide Iron Ore Price Spreads Wide Iron Ore Price Spreads Chart 9Environmental Concerns Will Support##BR##Demand For High Grade Iron Ore Environmental Concerns Will Support Demand For High Grade Iron Ore Environmental Concerns Will Support Demand For High Grade Iron Ore Bottom Line: In an effort to keep production high and profit from strong steel prices in face of the winter production cuts, steel producers are turning to higher-grade iron ore, pushing up the spread between high vs. low grade ores. The extent to which steel producers are able to successfully keep production going on the back of higher-grade ores will dampen the impact of the winter production cuts on the steel sector. Given that China's environmental focus is a long term plan, we expect these spreads to remain wide, rather than reverting back to their historic average. Steel Prices And Copper Markets Chart 10Steel Consumption Helps##BR##Predict Copper Prices Steel Consumption Helps Predict Copper Prices Steel Consumption Helps Predict Copper Prices The copper market had a roller coaster fourth quarter. Prices for the red metal were on a general uptrend since May, and first peaked in early September at $3.13/lb before bottoming at $2.91/lb by the second half of that month. Shortly thereafter, copper prices peaked at a new high of $3.22/lb by mid October - their highest in more than three years. Fears of a slowdown in China following messaging from the 19th Communist Party Congress caused the metal to lose almost 10% of its value, when it bottomed for the second time in early December. In fact, this coincided with a 4.65% decline in the price on December 5. While there is no clear justification for this fall, it can be put down to a mix of factors including a ~10 th MT increase in LME inventories, worries about a China slowdown, as well as a liquidation of positions ahead of the new year. Nonetheless, copper has since regained these losses to end the year at $3.28/lb. In our modelling of copper, we find that steel consumption is significant in forecasting future copper price behavior. More specifically, China's steel consumption has a significant positive relationship with copper prices 6 months into the future (Chart 10). This can be explained by the importance of the construction sector as an end user of both materials. However, each metal goes into the construction site at different time frames. While steel products are used in the construction of the structures, and thus are needed at the beginning of the project, copper is used in the electrical wiring and plumbing, and is thus needed later (6 months or so) in the project. This is in line with our findings that steel is most significant with a six-month lag - reflecting the average time period between which the structure is built and the plumbing and wiring are needed. Steel consumption in China is a useful leading indicator of copper markets when demand side fundamentals are dominating steel and copper markets. Government stimulus and a solid construction sector boosted China's steel demand in 2017. However, according to the WSA Short Range Outlook, demand for steel will moderate this year on the back of reflation in China, partially offset by strong global growth. WSA notes that the closure of induction furnaces skewed up steel demand growth figures to 12.4% yoy, and instead cite a more reasonable estimate along the lines of 3% yoy steel demand growth from China in 2017, bringing the global steel demand growth rate to 2.8%. While steel demand outside of China grew by an estimated 2.6% in 2017, they foresee it reaching 3% in 2018. In contrast, they expect flat demand from China in 2018, bringing world steel demand growth to 1.6% in 2018 (Table 1). Table 1Steel Demand (yoy Growth Rates) China's Environmental Reforms Drive Steel & Iron Ore China's Environmental Reforms Drive Steel & Iron Ore Moderating demand from China and the stability (or lack thereof) of the supply-side will dominate the copper market this year. On the demand side, China's steel market offers insight about the future direction of the red metal. Bottom Line: Given China's appetite for steel has remained healthy to date and is projected to maintain its 2017 level this year, we do not expect a demand-induced plunge in copper prices in the 6 month horizon. Roukaya Ibrahim, Associate Editor Commodity & Energy Strategy RoukayaI@bcaresearch.com 1 Please see "Will China's induction furnace steel whac-a-mole finally come to an end?" published by S&P Global Platts March 6, 2017. 2 Please see BCA Research's Commodity & Energy Strategy Weekly Report "Slow-Down In China's Reflation Will Temper Steel, Iron Ore In 2018," published September 7, 2017, available at ces.bcaresearch.com. 3 Please see IEA World Energy Outlook 2016 Special Report titled "Energy and Air Pollution," available at iea.org. 4 Please see "Provincial China officials used fake data to evade aluminium, steel capacity curbs - China Youth Daily," published on December 26, 2017, available at reuters.com. 5 Please see "Steel Markets" at worldsteel.org. 6 For additional discussion, please see "Shifting Gears in China: The Impact On Base Metals," in the November 9, 2017, issue of BCA Research's Commodity & Energy Strategy. It is available at ces.bcaresearch.com. 7 Please see "High-medium grade iron ore fines spread widens to all-time high of $23.55/dmt," published August 22, 2017, available at platts.com. Investment Views and Themes Recommendations Strategic Recommendations Tactical Trades Commodity Prices and Plays Reference Table China's Environmental Reforms Drive Steel & Iron Ore China's Environmental Reforms Drive Steel & Iron Ore Trades Closed in 2017

Late last year, we downgraded the S&P homebuilders index to high-conviction underweight, citing three reasons: rising borrowing costs impacting affordability, pending homeowner-unfriendly tax reform and high (and rising) costs. With respect to the first of these, housing affordability has been edging downward as the 30-year mortgage rate has been moving in the opposite direction (second panel). Tack on the now-passed lower mortgage interest deductibility cap, lower property tax deductibility and the elimination of vacation home mortgage interest deductions and affordability should take a major step down in 2018. At the same time, costs have been rising at an unsustainable pace, with construction earnings growing at their fastest pace since the housing bust and lumber prices well in excess of the key $400 level. This signals that homebuilders will either have to raise prices, further suppressing affordability, or take a hit to margins, which we think is more likely. Either scenario is bad for homebuilder EPS; stay underweight. The ticker symbols for the stocks in this index are: BLBG: S5HOME-DHI, LEN, PHM, LEN / B. Homebuilders Should Go On The Block Homebuilders Should Go On The Block

Highlights The beta of Chinese stocks has been steadily increasing over the past few years, versus both emerging markets and global stocks. Rising relative currency volatility has likely durably increased the cyclicality of Chinese stock prices. The high-beta nature of Chinese investable stocks suggests that they should be favored when the EM and global stock benchmarks are rising. This supports our current overweight stance. A portfolio strategy that favors equity sectors with high alpha significance has outperformed the broad investable market by a non-trivial amount over time, without adding to portfolio risk. Barring a few exceptions, the model's current allocation is generally consistent with our theme of a benign slowdown in Chinese economic growth. Feature Chart 1Beta Matters, But So Does Alpha Beta Matters, But So Does Alpha Beta Matters, But So Does Alpha While concepts such as alpha, beta, and correlation are frequently applied by investment managers at the security or sector level, they are less commonly employed from a top-down regional equity perspective and are rarely examined as a time series. In addition, the concept of alpha persistence (i.e. alpha that is persistently positive or negative) is also frequently ignored by investors, despite it having significant implications for portfolio returns. This is vividly illustrated by the relative performance of developed commodity markets during the last economic expansion: these countries resoundingly outperformed a rising global benchmark from 2000 to 2007, despite having a market beta that averaged one over the period (Chart 1). This seeming inconsistency is explained by persistent volatility-adjusted outperformance throughout the period (panel 3), underscoring the importance of tracking this measure from a top-down perspective. In this report we examine the recent evolution of MSCI China's alpha and beta versus both the emerging market (EM) and global benchmarks. We conclude that China is no longer a low-beta market (supporting an overweight stance), and also present a simple alpha-based sector model for Chinese investable stocks that has generated impressive outperformance over time without adding to portfolio risk. The Evolution Of China's Alpha & Beta Chart 2 presents the evolution of alpha and beta for Chinese investable stocks since 2010, versus the emerging market and global index. Given the significant outperformance of the technology sector over the past year, we also present this analysis in ex-tech terms. The values shown in Chart 2 are calculated using a standard single-factor model approach to estimating alpha and beta, namely a regression of weekly stock price returns in US$ terms in excess of the return from U.S. short-term Treasury bills on excess returns of the benchmark index.1 The chart yields the following observations: The beta of Chinese stocks has been steadily increasing over the past few years, versus both emerging markets and global stocks, regardless of whether the tech sector is removed from the picture. Chinese stocks had a beta of 1.4 versus their global peers in 2017, placing it in the 80th percentile of all country equity market betas for the year. Chinese stocks earned a modestly negative alpha vs global stocks in 2016, which was even larger when compared to the EM benchmark. This likely occurred because of lower exposure to resource-oriented sectors, given the significant rebound in commodity prices in 2016. Chinese stocks experienced a surge in alpha in 2017, even excluding technology stocks. In 2017, in all cases (vs EM and global, including or excluding tech) Chinese equities moved into the top right alpha/beta quadrant, which is the quadrant that offers the highest return to investors when the benchmark is rising. This is a remarkable development given that there were indications of a peak in Chinese economic momentum in the first half of the year, and suggests that investors do not view the ongoing slowdown as being problematic for investable equity performance. Chart 2 raises the obvious question of why China has become a higher beta market. We have two theories, but only the second one appears to fit the data. The first theory is that the establishment of the stock connect in late-2014 caused a volatility spillover from China's domestic stock market into the investable market. But while it is true that A-shares were considerably riskier than investable stocks in late-2015 / early-2016, Chart 3 makes it clear that A-shares have not historically been much more volatile than investable stocks. In addition, Chart 2 underscores that the rise in China's market beta since 2014 has been persistent, whereas A-shares in 2017 recorded their lowest share price volatility in over 15 years. So to us, this does not appear to be the most probable explanation. Chart 2China Has Become A High-Beta Market China: No Longer A Low-Beta Market China: No Longer A Low-Beta Market The second theory, which seems much more likely, is that the rising currency volatility has increased the cyclicality of Chinese stock prices. China's decision to devalue the RMB in August 2015 clearly led to a period of significantly increased capital controls, but Chart 4 highlights that the CNY/USD exchange rate has steadily become more volatile. This is especially true when compared with a basket of emerging market currencies, with CNY/USD actually being more volatile than the basket over the past year. Chart 3The Stock Connect Does Not Explain##br## The Rise In China's Beta The Stock Connect Does Not Explain The Rise In China's Beta The Stock Connect Does Not Explain The Rise In China's Beta Chart 4Rising Relative Currency Volatility ##br##= Higher Beta Rising Relative Currency Volatility = Higher Beta Rising Relative Currency Volatility = Higher Beta While it is certainly true that Chinese policymakers have stepped up their management of the currency by tightening capital controls over the past year, the PBOC's decision to pursue its "partial" version of the impossible trinity still implies, in our view, that RMB volatility will now be structurally higher than what prevailed on average prior to August 2015.2 This suggests that China's equity market beta will be durably higher than before, absent a presently negative correlation between CNY/USD and EM or global stock prices. Bottom Line: The beta of Chinese stocks has been steadily increasing over the past few years, versus both emerging markets and global stocks. Rising relative currency volatility has likely durably increased the cyclicality of Chinese stock prices. Investment Implications Of China's Recent Relative Performance There are two clear investment strategy implications from Chinese equities becoming a high-beta asset. The first is that Chinese investable stocks are now a pro-risk asset to be favored when the EM and global stock benchmarks are rising. Chart 5 shows that both are currently well above their 200-day moving averages, which supports our overweight stance towards China. The second is that when comparing the performance of China's overall investable index versus that excluding technology, it is clear that a non-trivial amount of the alpha earned by China's overall index in 2017 came from the tech sector. This suggests that a reversal of the high-flying performance of Chinese technology stocks is a material risk to our overweight stance towards Chinese equities. For now, this high-alpha outperformance appears to be fundamentally-based: Chart 6 highlights that forward earnings for Chinese tech shares have risen enormously relative to the investable benchmark over the past three years, a trend that we have noted appears to be driven by Chinese consumer demand (and thus unlikely to decline over the coming year).3 In addition, the relatively modest but positive alpha earned by Chinese ex-tech stocks in 2017 was likely driven by extremely cheap valuation, and these multiples remain quite low relative to other countries. We highlighted in our December 7 Weekly Report that the relative re-rating of Chinese investable ex-tech stocks was a key theme for 2018,4 suggesting that there is room for further re-rating/alpha if China's economic slowdown remains benign (as we expect). Chart 5Investors Should Overweight ##br##Chinese Stocks In This Environment Investors Should Overweight Chinese Stocks In This Environment Investors Should Overweight Chinese Stocks In This Environment Chart 6Tech's Recent Alpha Appears ##br##Fundamentally-Based Tech's Recent Alpha Appears Fundamentally-Based Tech's Recent Alpha Appears Fundamentally-Based Bottom Line: The now high-beta nature of Chinese investable stocks suggests that they are a pro-risk asset to be favored when the EM and global stock benchmarks are rising. This supports our current overweight stance. Alpha, Applied: A Simple Sector Model For Chinese Investable Stocks We noted earlier that the concept of alpha has had significant implications for regional equity portfolio returns in the past. In order to test the predictive power of alpha within the context of a Chinese equity portfolio, we evaluate the returns of an investment strategy that allocates to China's investable equity sectors based on the significance of alpha. Table 1 presents statistics summarizing the performance of this sector alpha portfolio relative to the overall investable market, Table 2 shows the portfolio's current sector allocation, and Chart 7 illustrates the cyclical behavior of the portfolio's relative performance trend since 2004. Several important conclusions emerge: Table 1An Alpha-Based Sector Model Has Historically Outperformed ##br##China's Investable Stock Market China: No Longer A Low-Beta Market China: No Longer A Low-Beta Market Table 2Sector Alpha Portfolio Weights Are Generally Consistent With ##br##A Benign Growth Slowdown China: No Longer A Low-Beta Market China: No Longer A Low-Beta Market The model has outperformed the broad investable market by an impressive 235 bps per year without appearing to take on any additional risk. Measured either as volatility or drawdown, the riskiness of the portfolio appears to be the same as that of the overall investable market. The outperformance of the model occurs in spurts, but sustained periods of underperformance are not common. The 2007-2009 period served as an exception to this rule, but even in this case the cumulative underperformance of the model vs the investable index was not large (roughly 6%). Chart 7Impressive Outperformance Over Time Impressive Outperformance Over Time Impressive Outperformance Over Time The model is currently underweight financials (significantly), energy, industrials, telecoms, and utilities. Overweights are concentrated in the tech sector, real estate, health care, and consumer stocks. For now, these weights are generally consistent with our benign slowdown scenario, although there are some potential exceptions to monitor (such as the overweight stance towards real estate and materials). Bottom Line: A portfolio strategy that favors equity sectors with high alpha significance has outperformed the broad investable market by a non-trivial amount over time, without adding to portfolio risk. Barring a few exceptions, the model's current allocation is generally consistent with our theme of a benign slowdown in Chinese economic growth. Jonathan LaBerge, CFA, Vice President Special Reports jonathanl@bcaresearch.com 1 China: No Longer A Low-Beta Market China: No Longer A Low-Beta Market 2 Please see China Investment Strategy Weekly Report, "How Will China Manage The Impossible Trinity", dated December 8, 2016, available at cis.bcaresearch.com. 3 Please see China Investment Strategy Special Report, "The Data Lab: Testing The Predictability of China's Business Cycle", dated November 30, 2017, available at cis.bcaresearch.com. 4 Please see China Investment Strategy Weekly Report, "Three Themes For China In The Coming Year", dated December 7, 2017, available at cis.bcaresearch.com. Cyclical Investment Stance Equity Sector Recommendations

Fed data released this week showed consumer credit growth surging at close to its fastest pace since the turn of the century, driven in large part by exceptional growth in revolving consumer credit (second panel). The last time this kind of growth was seen on a consistent basis was 2007, which would be potentially concerning were it not for the historically low household debt service ratios and the resulting pristine credit quality of credit card borrowers (third panel). Add on a widening credit card interest rate spread (bottom panel), typically an excellent leading indicator of earnings improvements and 2018 should be an exceptionally powerful earnings growth year for consumer finance stocks; stay overweight. The ticker symbols for the stocks in the S&P consumer finance index are: BLBG: S5CFINX-AXP, COF, DFS, SYF, NAVI. Consumers Are Levering Up - Investors Should Pay Attention Consumers Are Levering Up - Investors Should Pay Attention

Highlights Chart 1Bond Bear On Pause? Bond Bear On Pause? Bond Bear On Pause? The start of a new year often brings optimism and nowhere is this more evident than in economic projections. In three of the past four years (2017 being the exception) Bloomberg consensus GDP growth expectations ended the year lower than where they began. A related pattern played itself out in the Treasury market. At the turn of each of the past four years the average yield on the Bloomberg Barclays Treasury Index increased in December only to fall back in January. In two of those instances the January decline exceeded the December increase. Should we expect a similar January bond rally this year? Our favorite short-term indicators are not sending a strong signal (Chart 1). Net speculative futures positions weakly suggest that the 10-year yield will be lower in three months, but our auto regressive model suggests the Economic Surprise Index will still be in positive territory at the end of the month. In a recent report we showed that yields tend to rise in months where the Surprise Index is above zero.1 Perhaps most importantly, our 2-factor Treasury model shows that yields are significantly lower than is suggested by global economic fundamentals. Maintain below-benchmark duration. Feature Investment Grade: Overweight Chart 2Investment Grade Market Overview Investment Grade Market Overview Investment Grade Market Overview Investment grade corporate bonds outperformed the duration-equivalent Treasury index by 49 basis points in December and by 335 bps in 2017. At 94 bps, the average index spread is 28 bps tighter than at the beginning of 2017 and investment grade corporate spreads are extremely expensive compared to history (Chart 2). After adjusting for changes in the average duration of the index over time, we calculate that A-rated corporate spreads have only been tighter 5% of the time since 1989 (panel 2), and Baa-rated spreads have only been tighter 7% of the time (panel 3). Essentially, at this stage of the credit cycle we should expect excess returns no greater than carry. As for the credit cycle itself, we noted in our last report that with corporate balance sheets deteriorating, low inflation and still-accommodative monetary policy are the sole supports for corporate spreads.2 We expect spreads will start to widen later this year once inflation rises and policy becomes more restrictive. With excess returns likely to be lower in 2018 than in 2017, we should also expect a lower marginal return from increasing the riskiness within credit portfolios.3 For investors looking to scale back on credit risk, our model shows that Financials and Technology are the most attractive low-risk sectors. Energy, Basic Industry and Communications are all attractive high-risk sectors (Table 3). Table 3ACorporate Sector Relative Valuation And Recommended Allocation* January Effect January Effect Table 3BCorporate Sector Risk Vs. Reward* January Effect January Effect High-Yield: Overweight Chart 3High-Yield Market Overview High-Yield Market Overview High-Yield Market Overview High-Yield outperformed the duration-equivalent Treasury index by 23 basis points in December and by 602 bps in 2017. The average index option-adjusted spread tightened 1 bp on the month and 66 bps in 2017. Though spreads appear somewhat more attractive than for investment grade corporates, there is still not much room for spread compression in high-yield. In fact, we calculate that if the high-yield index spread tightens another 117 bps, junk bonds will be the most expensive they have been since 1995. In an optimistic scenario where the index spread tightens 100 bps, bringing it close to all-time expensive levels, then we would expect junk excess returns to be in the range of 600 bps (annualized). Given trends in corporate leverage, another 100 bps of spread tightening should be viewed as unlikely. More realistically, we expect excess returns in the range of 200 bps to 500 bps (annualized) between now and the end of the credit cycle (Chart 3). Given our forecast for default losses, flat spreads translate to a 12-month excess return of 213 bps. An additional warning sign for junk spreads is that the slope of the 2/10 Treasury curve is hovering around 50 bps. We showed in a recent report that when the 2/10 slope is between 0 bps and 50 bps, junk bonds underperform Treasuries in 48% of months, and average monthly excess returns (though still positive) are much lower than when the curve is steeper.4 MBS: Neutral Chart 4MBS Market Overview MBS Market Overview MBS Market Overview Mortgage-Backed Securities outperformed the duration-equivalent Treasury index by 16 basis points in December and by 51 bps in 2017. The conventional 30-year zero-volatility MBS spread narrowed 2 bps in December, the combination of a flat option-adjusted spread (OAS) and a 2 bps decline in the compensation for prepayment risk (option cost). The Z-spread widened 2 bps in 2017, as an 8 bps OAS widening was offset by a decline of 6 bps in the compensation for prepayment risk. The substantial OAS widening in early 2017 was almost certainly caused by investors pricing-in the eventual run-off of the securities on the Fed's balance sheet. Now that run-off has begun we see no obvious catalyst for further OAS widening in the months ahead. Turning to the compensation for prepayment risk, with Treasury yields biased higher as the Fed continues to lift rates, we see little risk of a material increase in refinancing activity. This will ensure that overall MBS spreads stay capped near historically low levels (Chart 4). All in all, with MBS OAS looking more attractive relative to Aaa-rated credit than at any time since 2015 (panel 3), we think this is an opportune time for investors looking to de-risk their portfolios to shift some of their spread product allocation away from corporate bonds and into MBS. We already upgraded our recommended allocation to MBS from underweight to neutral in October, and will likely further increase exposure as we advance toward the end of the credit cycle. 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 5 basis points in December, but outperformed by 216 bps in 2017. Sovereign bonds underperformed the Treasury benchmark by 36 bps in December, Foreign Agencies and Domestic Agencies underperformed by 8 bps and 1 bp, respectively. Local Authorities outperformed the benchmark by 17 bps, and Supranationals underperformed by 1 bp. Sovereign bonds were the best performers within the Government-Related index in 2017, delivering excess returns of 538 bps relative to duration-matched U.S. Treasuries. This outperformance was concentrated early in the year and was driven by the sharp depreciation of the U.S. dollar (Chart 5). With the market still priced for a relatively modest 63 bps of Fed rate hikes during the next 12 months, further sharp dollar depreciation appears unlikely. We recommend an underweight allocation to Sovereign debt. We remain overweight Local Authority and Foreign Agency bonds, sectors that delivered excess returns of 420 bps and 248 bps, respectively in 2017. Despite the outperformance, both of these sectors still offer attractive spreads after adjusting for credit rating and duration. We remain underweight Domestic Agency and Supranational bonds. Though both sectors offer low risk and high credit quality, they also only offer 15 bps and 17 bps of option-adjusted spread, respectively. We much prefer Agency-backed MBS and CMBS which are also relatively low risk and offer option-adjusted spreads of 28 bps and 42 bps, respectively. Municipal Bonds: Underweight Chart 6Municipal Market Overview Municipal Market Overview Municipal Market Overview Municipal bonds outperformed the duration-equivalent Treasury index by 99 bps in December and by 332 bps in 2017 (before adjusting for the tax advantage). The average Aaa Municipal / Treasury (M/T) yield ratio fell 5% in December, and is 12% below where it began 2017 (Chart 6). The recent decline follows a sharp increase that was driven by fluctuating supply trends related to the passage of U.S. tax legislation. The final tax bill ends the practice of advance refunding municipal bonds. As a result, December set a new high of $55.6 billion for municipal issuance as issuers rushed to get their advance refunding deals to market before the bill was passed (panel 3). Now that the bill has passed, visible supply has evaporated and the average M/T yield ratio has fallen back to one standard deviation below its post-crisis mean. The absence of advance refunding will bias municipal bond issuance lower in 2018, thus removing one potential risk for yield ratios. The M/T yield ratio for short maturity debt has risen considerably relative to the yield ratio for long maturity debt in recent months (panel 2), and the risk/reward trade-off now appears more balanced. We close our recommendation to favor long maturities versus short maturities on the Aaa Muni curve. The third quarter update of our Muni Health Monitor showed a slight improvement (panel 5), but still no clear reversal of trend. Although health remains supportive for now - and consistent with municipal upgrades outpacing downgrades - with yield ratios close to their lows we maintain an underweight allocation to Municipal bonds.  Treasury Curve: Favor 5-Year Bullet Over 2/10 Barbell Chart 7Treasury Yield Curve Overview Treasury Yield Curve Overview Treasury Yield Curve Overview The Treasury curve bear-flattened in December. The 2/10 Treasury slope flattened 13 bps on the month, and the 5/30 Treasury slope flattened 15 bps. The evolution of the Treasury curve in 2018 will come down to a trade-off between how quickly inflation rises versus how quickly the Fed lifts rates. For example, in a recent report we showed that the 10-year Treasury yield will likely settle into a range between 2.80% and 3.25% by the time that core PCE inflation reaches the Fed's 2% target.5 That same report shows that if that adjustment occurs relatively quickly, and the Fed has only lifted rates once or twice between now and then, then the 2/10 Treasury slope is much more likely to steepen than to flatten. Conversely, if the Fed lifts rates three or four more times between now and the time that inflation returns to target, then the curve is more likely to flatten. For our part, we think it is wise to maintain a position long the 5-year bullet and short a duration-neutral 2/10 barbell. Such a position profits from a steeper curve, and our model shows that the butterfly spread is currently priced for significant curve flattening (Chart 7). According to our model, the 2/5/10 butterfly spread is discounting 27 bps of 2/10 flattening during the next six months.6 In other words, if the 2/10 slope steepens or flattens by less than 27 bps, then our recommended position will profit. TIPS: Overweight Chart 8TIPS Market Overview TIPS Market Overview TIPS Market Overview TIPS outperformed the duration-equivalent nominal Treasury index by 41 basis points in December, but underperformed by 43 bps in 2017. The 10-year TIPS breakeven inflation rate went on a wild ride last year. It started 2017 at 1.95% and, driven by strong inflation prints and continued post-election euphoria, reached as high as 2.09% in January. The breakeven dropped to a low of 1.66% in June, as inflation started to disappoint in the second quarter, but has rebounded during the past couple of months and just recently broke back above 2%. The 10-year TIPS breakeven rate is currently 2.02%, above where it began 2017. According to our TIPS Financial Model, the recent widening in breakevens is in line with the message from other related financial market instruments (Chart 8). Specifically, oil prices, the trade-weighted dollar and the stock-to-bond total return ratio. Further, measures of pipeline inflation pressure continue to signal an increase in inflationary pressures (panels 3 and 4), and the trimmed mean PCE shows that the realized inflation data are forming a tentative bottom (bottom panel). The annualized 6-month rate of change in the trimmed mean PCE ticked up to 1.68% in November, higher than the 12-month rate of change (1.67%). The 1-month rate of change is higher still at 2.19%, annualized. We continue to see signs that inflation will start to rebound in the coming months, and this will cause long-maturity TIPS breakeven inflation rates to reach a range between 2.4% and 2.5% by the time that inflation returns to the Fed's target. Remain overweight TIPS versus nominal Treasury securities. ABS: Neutral Chart 9ABS Market Overview ABS Market Overview ABS Market Overview Asset-Backed Securities performed in line with the duration-equivalent Treasury index in December and outperformed by 92 basis points in 2017. In 2017, Aaa-rated ABS outperformed the Treasury benchmark by 79 bps and non-Aaa ABS outperformed by 217 bps. The index option-adjusted spread for Aaa-rated ABS widened 1 bp in December, but tightened 21 bps in 2017. It now sits at 31 bps, only 4 bps above its all-time low (Chart 9). At 31 bps, Aaa-rated ABS now offer only a 3 bps spread advantage over Agency-backed MBS, and offer 11 bps less spread than Agency-backed CMBS. With consumer lending standards tightening and delinquency rates rising, we view no more than a neutral allocation to ABS as appropriate. On lending standards, the Fed's October Senior Loan Officer's Survey showed a continued tightening in lending standards on both credit cards and auto loans (panel 4), and also that demand for credit card and auto loans was essentially unchanged from the prior quarter. It also included a set of special questions regarding the reasons for changes in the supply and demand for consumer credit. Banks cited a less favorable or more uncertain economic outlook, a deterioration in existing loan quality and a general reduced risk tolerance as reasons for tightening the supply of credit. The hard data confirm that banks are seeing a deterioration in the quality of their consumer loan books (bottom panel). Although delinquencies remain depressed compared to history, with ABS spreads near all-time tights, rising delinquencies and tightening lending standards make for a poor risk/reward trade-off in the sector. 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 20 basis points in December and by 201 bps in 2017. The index option-adjusted spread for non-agency Aaa-rated CMBS tightened 2 bps in December and 13 bps in 2017. At its current level of 64 bps, the index spread is about one standard deviation below its pre-crisis mean, and only 13 bps above its all-time low reached in 2004 (Chart 10). With spreads at such low levels in an environment of tightening commercial real estate (CRE) lending standards and falling CRE loan demand, we continue to view the risk/reward trade-off in non-Agency CMBS as unfavorable. Agency CMBS: Overweight Agency CMBS outperformed the duration-equivalent Treasury index by 21 basis points in December and by 133 bps in 2017. The index option-adjusted spread for Agency CMBS tightened 3 bps in December and 13 bps in 2017. At its current level of 42 bps, the sector offers greater option-adjusted compensation than a position in Agency-backed MBS (28 bps) and Aaa-rated consumer ABS (31 bps). Such an attractive spread pick-up in a sector that benefits from Agency backing is surely worth grabbing.   Treasury Valuation Chart 11Treasury Fair Value Models Treasury Fair Value Models Treasury Fair Value Models The current reading from our 2-factor Treasury model (based on Global PMI and dollar sentiment) pegs fair value for the 10-year Treasury yield at 2.94% (Chart 11). Our 3-factor version of the model (not shown), which also incorporates the Global Economic Policy Uncertainty Index, places fair value at 2.92%. PMIs across the world continue to surge. December PMI data show increases in the four largest economic blocs (U.S., Eurozone, China, Japan), and more broadly show that 86% of the 36 countries with available data currently have PMIs above the 50 boom/bust line. Meanwhile, bullish sentiment toward the U.S. dollar continues to trend lower in response to strong growth in the rest of the world (bottom panel). This is also a bearish development for U.S. bonds. For further details on our Treasury models please refer to U.S. Bond Strategy Weekly Report, "The Message From Our Treasury Models", dated October 11, 2016, available at usbs.bcaresearch.com. At the time of publication the 10-year Treasury yield was 2.48%. Ryan Swift, Vice President U.S. Bond Strategy rswift@bcaresearch.com Alex Wang, Research Analyst alexw@bcaresearch.com Jeremie Peloso, Research Assistant jeremiep@bcaresearch.com 1 Please see U.S. Bond Strategy Weekly Report, "How Much Higher For Yields?", dated October 31, 2017, available at usbs.bcaresearch.com 2 Please see U.S. Bond Strategy Weekly Report, "Ill Placed Trust?", dated December 19, 2017, available at usbs.bcaresearch.com 3 Please see U.S. Bond Strategy Weekly Report, "Proactive, Reactive Or Right?", dated December 12, 2017, available at usbs.bcaresearch.com 4 Please see U.S. Bond Strategy Weekly Report, "Proactive, Reactive Or Right?", dated December 12, 2017, available at usbs.bcaresearch.com 5 Please see U.S. Bond Strategy Weekly Report, "Ill Placed Trust?", dated December 19, 2017, available at usbs.bcaresearch.com 6 For further details on the model please see U.S. Bond Strategy Special Report, "Bullets, Barbells And Butterflies", dated July 25, 2017, 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)

Overweight Sales departments in the S&P industrial machinery index have been exceptionally busy in the past several months as order bookings have been soaring with both domestic and global orders pouring in (second panel). With growth accelerating around the world and a tax change at home that could shift the capex cycle into overdrive, the path of least resistance for industrial machinery new orders is higher. At the same time as orders have been surging, the industry has been ramping production to meet them, keeping the new orders to inventory relationship surprisingly stable over the past 4 years (third panel). However, growth in production has not been matched by an equivalent increase in employment, resulting in our productivity proxy moving much higher (bottom panel). This bodes well for profits, particularly in the context of a swelling top line in this relatively high fixed cost industry. The upshot is that EPS growth should outperform the market in 2018; stay overweight. The ticker symbols for the stocks in this index are: BLBG: S5INDM - ITW, IR, SWK, PH, FTV, DOV, PNR, XYL, SNA, FLS. Soaring Orders Point To Bumper 2018 For Industrial Machinery Soaring Orders Point To Bumper 2018 For Industrial Machinery

Underweight - High Conviction In our high conviction calls roundup for 2018 (please see our Weekly Report from Nov. 27, 2017 for more details), we identified our two key investment themes for the year to come, namely higher interest rates and synchronized global capex growth. Both of these themes bode ill for the S&P utilities index. On the heels of the Fed's most recent hike and the impending unwinding of its balance sheet, combined with a host of global central banks hiking, global interest rates look set to climb this year. In line with this weak outlook for bonds, fixed income proxies like the S&P utilities index should suffer (top panel). At the same time, global capex is pointing to its best year in more than a decade (third panel), a backdrop that heralds weakness for utilities. Much could be forgiven if valuations were compelling but alas this is not the case (bottom panel); fair value does not reflect the negative backdrop. We reiterate our high conviction underweight recommendation. Part III The Lights Are Still Out For Utilities Part III The Lights Are Still Out For Utilities

The S&P 500 both finished 2017 and started 2018 in style, vaulting to new heights. However, what makes the most recent jumps particularly notable is that they mark a divergence from what had been a valuation multiple-expansion led rally to an earnings led rally. S&P 500 earnings growth expectations for the year to come have reached 11% while the multiple expansion has started to decelerate in recent months (second panel). In our recent Weekly Report,1 we highlight the historical relationship between earnings growth and multiple expansion in carrying the load for S&P 500 gains. Our analysis shows that when forward profit growth was in its current range (i.e. between 8% and 12%), over the last four decades, earnings growth explained roughly 80% of the S&P 500's 12.9% average annual return, with modest multiple expansion explaining the balance. Barring a total collapse in valuation multiples, which seems unlikely when earnings are growing apace, an EPS-driven low double-digit S&P 500 return seems likely for 2018. This underlies our continued risk-on approach with a cyclicals-heavy portfolio allocation for the new year and we also reiterate our high conviction calls for the year2 (please see table at the bottom and the next Insight). Part I Earnings Are Still Taking Over Part I Earnings Are Still Taking Over Part I - Earnings Are Still Taking Over Part I - Earnings Are Still Taking Over 1 Please see BCA U.S. Equity Strategy Weekly Report, "EPS And 'Nothing Else Matters'" dated December 18, 2017, available at uses.bcaresearch.com. 2 Please see BCA U.S. Equity Strategy Weekly Report, "High-Conviction Calls" dated November 27, 2017, available at uses.bcaresearch.com.