Sectors

Out of the gate, our financials versus tech sector pair trade has caught fire, returning 6.2% in the last 2 weeks. This reflects the tightening of the historically wide relative market capitalization differential (second and third panels), as we expected. Despite the solid return since we put the trade on, we think we are in the early stages of an earnings-driven rotational correction, with greater gains ahead. Pricing power in financials has continued to strengthen at the expense of deflating tech selling prices (bottom panel) which should start closing the profit gap. We expect early validation of this thesis to begin this week with the opening of earnings season for financials on Friday. Net, investors should gain exposure to S&P financials using S&P tech as a source of funds. This Trade Has Legs This Trade Has Legs

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

Highlights Duration: Investor optimism about U.S. growth and inflation will return in the coming months. Remain at below-benchmark duration and enter a short position in the July fed funds futures contract. Close short positions in the January contract for a small gain. Credit Spreads: Spreads are at risk of widening as Fed rate hike expectations ramp up in the second half of the year, though we would be inclined to view a Fed-driven back-up in spreads as a buying opportunity. Bank Bonds: Banks continue to shore up their balance sheets and are likely to see rising profits in the coming months. Bank bonds also offer a spread advantage compared to other similarly risky sectors. Feature Chart 1Synchronized Global Selloff Synchronized Global Selloff Synchronized Global Selloff The bond selloff is now two weeks old. What began as a reaction to perceived hawkish policy shifts from central banks outside of the U.S. - the European Central Bank in particular - is now morphing into a selloff built on optimism about U.S. growth. Needless to say, we think the recent bearish price action has further to run. Global participation makes it more likely that the weakness in U.S. Treasuries will persist because it prevents the dollar from strengthening as yields move higher (Chart 1). In recent years, most U.S. bond selloffs have been met with an appreciating exchange rate. The stronger dollar then caused investors to lower their U.S. growth expectations, and capped the upside in yields. We view the dollar's current stability as a bearish signal for U.S. bonds. But it has not just been non-U.S. factors driving the uptrend in yields. Last week's positive ISM and employment figures are ushering in renewed optimism about U.S. growth. We also think that U.S. growth is poised to bounce back in the second half of the year, and the Fed is inclined to agree. The Fed's median projection calls for one more 25 basis point rate hike before the end of the year, and we also expect the committee to announce the run-off of the balance sheet in September. With the market still only priced for 15 bps of hikes between now and year-end, there remains scope for further upside surprises. Of course, this forecast for balance sheet run-off in September and another rate hike in December hinges on a second-half snapback in growth, continued strength in labor markets and a rebound in core inflation. Growth Is On The Way Although GDP growth averaged just 1.75% during past two quarters, all signs suggest that the next two quarters will be much stronger. As was mentioned above, both the manufacturing and non-manufacturing ISM surveys delivered strong readings in June. The manufacturing ISM came in at 57.8 and the non-manufacturing survey came in at 57.4, both signal stronger GDP growth in the coming months (Chart 2). The crucial new orders-to-inventories figure calculated from the manufacturing survey is also displaying remarkable strength (Chart 2, bottom panel). We can also infer the current trend in growth from the employment and productivity data. In fact, aggregate hours worked - a combination of total employment and average weekly hours - plus labor productivity growth is more or less equivalent to GDP (Chart 3). After last week's payrolls report, aggregate hours worked are now growing at 1.99% year-over-year. If we combine that growth rate with quarterly productivity growth of 0.7%, the average since 2012, we get a tracking estimate of just below 2.7% for GDP growth. The Atlanta Fed's GDPNow model also currently expects that second quarter growth will be 2.7%. Chart 2PMIs Point To Stronger Growth... PMIs Point To Stronger Growth... PMIs Point To Stronger Growth... Chart 3...As Does The Labor Market ...As Does The Labor Market ...As Does The Labor Market Labor Markets: Watching The Participation Rate Last week's jobs report showed that the economy added 222k jobs in June, and that the prior two months were also revised higher. This pushed the 3-month moving average up to +180k jobs per month, right in line with the +187k jobs per month averaged in 2016. However, despite robust payroll gains, the unemployment rate actually ticked higher in June. This is because many previously sidelined workers re-entered the labor force, pushing the labor force participation rate up to 62.8%. Going forward, for the Fed to have confidence that wage growth and inflation will continue to rise, the unemployment rate will have to remain under downward pressure (Chart 4). As long as the labor force participation rate remains flat (or declines) this should be relatively easy to achieve. We calculate that the economy needs to add just above 117k jobs per month for the unemployment rate to continue falling. However, if we assume a higher labor force participation rate of 63.2%, we would need to add 195k jobs per month, a much higher hurdle.1 We detailed the main drivers of the labor force participation rate in a recent report,2 and while we do not see much potential for a significant increase in the participation rate, its trend is critical for the monetary policy outlook and should be monitored closely going forward. Inflation: Is The Fed Too Sanguine? The most important question for policymakers is whether inflation will rebound in the second half of the year. While the Fed will probably start winding down its balance sheet in September no matter what, another rate hike in December is likely contingent on core inflation showing some signs of strength in the next few months. We have previously written3 that if the Fed were to proceed with a December rate hike in the face of low and falling inflation, the market would start to price in a "policy mistake" scenario. The yield curve would flatten, credit spreads would widen, TIPS breakevens would narrow and long-dated Treasury yields could even decline. However, we do expect that core inflation will trend higher in the coming months, mostly driven by strength in the core services (excluding shelter and medical care) component. That component is historically the most sensitive to tight labor markets and rising wage growth (Chart 5). Chart 4Falling Unemployment Rate = ##br##Rising Inflation Falling Unemployment Rate = Rising Inflation Falling Unemployment Rate = Rising Inflation Chart 5A Boost From Import##br## Prices Is Coming A Boost From Import Prices Is Coming A Boost From Import Prices Is Coming Although it is unlikely to be a long-run driver of inflation, the core goods component also has some upside in the coming months in response to recent dollar weakness and rising non-oil import prices (Chart 5, bottom 2 panels). Investment Strategy Chart 6Too Few Hikes In The Price Too Few Hikes In The Price Too Few Hikes In The Price We think U.S. growth and inflation are poised to snap back during the second half of the year, probably by enough for the Fed to deliver another hike before year-end. We therefore continue to recommend that investors maintain below-benchmark portfolio duration. We have also been advising clients to hold short positions in the January 2018 fed funds futures contract since March 21.4 That contract is now priced for the fed funds rate to increase 15 bps between now and the end of the year. Given that even an optimistic economic scenario would likely only result in a 25 bps increase in the funds rate, there is not much potential for further gains in this trade. We close this position, booking a small profit of +1 bp. Looking further out, we now see an attractive opportunity to short the July 2018 fed funds futures contract. That contract is currently priced for 32 bps of rate hikes between now and next June (Chart 6), and would therefore turn a profit in the event of two or more rate hikes during that timeframe. Bottom Line: Investor optimism about U.S. growth and inflation will return in the coming months. Remain at below-benchmark duration and enter a short position in the July fed funds futures contract. Close short positions in the January contract for a small gain. Credit Spreads: When Good News Is Bad News Chart 7High Risk Of A Near-Term Selloff High Risk Of A Near-Term Selloff High Risk Of A Near-Term Selloff Renewed optimism on U.S. growth and inflation could ironically pose a problem for credit spreads, at least in the very short term. As we have often discussed in the context of our Fed Policy Loop,5 hawkish shifts in Fed policy tend to result in wider credit spreads and tighter financial conditions more broadly. Fortunately, these periods are usually short lived. Once financial conditions tighten, the Fed backs away from its hawkish stance, allowing financial conditions to ease once again. An extreme example of this dynamic is the 2014/15 selloff in credit markets. Of course, the plunge in oil prices and related stress in the energy sector was the chief catalyst, but what is often overlooked is that Fed rate hike expectations were also quite elevated during that period (Chart 7). It is the combination of stress in the energy sector and unsupportive Fed policy that resulted in the prolonged rise in spreads. A more benign example is the price action from this past March. Junk spreads widened from 344 bps on March 2 to 406 bps on March 22, as rate hike expectations ramped up heading into the March FOMC meeting. Ultimately, this period of spread widening represented a buying opportunity in credit markets. It is a March 2017 style selloff that we see as quite likely in the coming months as growth recovers by just enough to give the Fed cover for another rate increase. Bottom Line: Credit spreads are at risk of widening as Fed rate hike expectations ramp up in the second half of the year. But with inflation and inflation expectations still well below target, the Fed will ultimately be forced to remain supportive. We would therefore view any period of Fed-driven weakness in credit markets as a buying opportunity. Bank Bonds: Still A Strong Buy The Federal Reserve released the results of its annual bank stress tests last month and for once it did not object to the capital plans of any of the 34 participating bank holding companies, a recognition of the fact that banks have dramatically boosted their capital ratios since the first round of stress tests in 2009 (Chart 8). For the most part bank profit growth has also outpaced debt growth during this period, with the exception of last year when profit growth turned negative and debt growth surged (Chart 8, panel 2). A large portion of last year's increase in debt growth was likely a response to the new Total Loss Absorbing Capital (TLAC) regulations which require banks to issue a specified minimum amount of securities that can be easily written off in case of bankruptcy. This includes capital and long-term unsecured debt. Regardless, bank debt growth has already fallen back close to zero and we see upside for bank profits in the next 6-12 months. Meanwhile, non-financial corporate profits have had a much more difficult time outpacing debt growth in recent years (Chart 8, bottom panel). Bank Profits On The Rise A number of forward looking loan growth indicators suggest that credit and capital formation are on an upward trajectory (Chart 9). Our U.S. Equity Strategy service's proprietary Capex Indicator,6 consumer and business confidence, manufacturing new orders and our own C&I loan growth model all point to accelerating loan growth in the coming months. Net interest margins also have scope to widen. A recent blog post from the Federal Reserve Bank of New York7 showed that net interest margins are sensitive to both the level of interest rates and the slope of the yield curve (Chart 10). Lower rates and a flatter curve have both compressed margins in recent years. In addition, net interest margins tend to narrow when banks take less risk on the asset side of their balance sheets, we proxy this by showing banks' risk-weighted assets as a percent of total assets (Chart 10, bottom panel). Chart 8Bank Health Still Improving Bank Health Still Improving Bank Health Still Improving Chart 9Loan Growth Will Accelerate Loan Growth Will Accelerate Loan Growth Will Accelerate Chart 10A Higher, Steeper Curve Will Help NIMs A Higher, Steeper Curve Will Help NIMs A Higher, Steeper Curve Will Help NIMs Going forward, higher rates and a steeper yield curve8 will apply widening pressure to net interest margins. Similarly, risk-weighted assets have already risen considerably as a fraction of total assets and will increase further as the Fed starts to drain reserves from the banking system. Bank Bonds Are Still Cheap The truly remarkable thing is that even though banks have been raising capital while the non-financial sector has been taking on leverage, bank spreads still look attractive compared to most non-financial sectors after adjusting for credit rating and duration (Chart 11). This is true for both senior and subordinated bank debt. As can be seen in Chart 11, senior bank debt has a low duration-times-spread (DTS) compared to the overall index. This means that it acts as a "low-beta" sector, underperforming the investment grade benchmark during rallies and outperforming during selloffs. Conversely, subordinate bank bonds are a high-DTS sector. They tend to outperform during rallies and underperform during selloffs (Chart 12). Chart 11Corporate Sector Risk Vs. Reward* Summer Snapback Summer Snapback LegendCorporate Sector Abbreviations Summer Snapback Summer Snapback Chart 12Add "Beta" With Subordinate Bank Debt Add "Beta" With Subordinate Bank Debt Add "Beta" With Subordinate Bank Debt While we strongly recommend grabbing the extra spread available in both senior and subordinate bank debt relative to other similarly risky alternatives, subordinate bank bonds look particularly attractive in the current environment. This is because they both add some pro-cyclical risk ("beta") to a corporate bond portfolio and offer a spread advantage compared to other similarly risky bonds. Bottom Line: Banks continue to shore up their balance sheets and are also likely to see rising profits in the coming months. Meanwhile, bank bonds still offer a spread advantage compared to other similarly risky sectors. Remain overweight both senior and subordinate bank debt. Ryan Swift, Vice President U.S. Bond Strategy rswift@bcaresearch.com 1 These calculations assume population growth of 0.08% per month, or 1% per year. 2 Please see U.S. Bond Strategy Weekly Report, "Three Scenarios For Treasury Yields In 2017", dated June 20, 2017, available at usbs.bcaresearch.com 3 Please see U.S. Bond Strategy Weekly Report, "Three Scenarios For Treasury Yields In 2017", dated June 20, 2017, available at usbs.bcaresearch.com 4 Please see U.S. Bond Strategy Weekly Report, "The Yield Curve On A Cyclical Horizon", dated March 21, 2017, available at usbs.bcaresearch.com 5 Please see U.S. Bond Strategy Weekly Report, "Risk Rally Extended", dated June 27, 2017, available at usbs.bcaresearch.com 6 Please see U.S. Equity Strategy Weekly Report, "Unfazed", dated June 12, 2017, available at uses.bcaresearch.com 7 http://libertystreeteconomics.newyorkfed.org/2017/06/low-interest-rates-and-bank-profits.html 8 For further details on the case for a bear-steepening yield curve please see U.S. Bond Strategy Weekly Report, "The Yield Curve On A Cyclical Horizon", dated March 21, 2017, available at usbs.bcaresearch.com Fixed Income Sector Performance Recommended Portfolio Specification

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

The U.S. Census Bureau released their factory shipments and inventories data and the message from beverage makers was bleak. The steep decline in shipments that started at the end of Q1 has accelerated and inventories have continued to pile up (second panel). This has driven the weakest industry pricing power of the last decade as manufacturers clear out backlog (third panel). This clear indication of weakening margins has not been lost on the analyst community and earnings estimates have been falling (top panel). However, relative share prices have been unexpectedly resilient, pushing valuation multiples higher (bottom panel). These multiples fail to discount the sector's future earnings weakness and should herald a hard landing coming out of this earnings season. Stay underweight. The ticker symbols for the stocks in this index are: BLBG: S5SOFD - PEP, KO, DPS, MNST. Not So Refreshing Not So Refreshing

U.S. light vehicle sales continued their slump last month, falling to the lowest annual rate since 2014; full-year forecasts have been revised downward across the board. This year has seen banks significantly tighten vehicle-related credit standards and consumer confidence appears to have crested, further adding to the bleak outlook facing the industry. A bright spot for domestic auto components makers was the mix shift toward light trucks as, in the absence of a high fuel price constraint, consumers continued to sate their appetite for large vehicles. Still, overall sales have been declining at a much faster rate than production, implying a growing excess inventory position. With weak consumer demand unlikely to pick up the inventory slack, significant production cuts in the second half of the year look certain, impacting directly the top line of components makers. We reiterate our underweight position. The ticker symbols for the stocks in this index are: BLBG: S5AUTC -DLPH, BWA, GT. Pumping The Brakes Pumping The Brakes

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

Highlights Chart 1Too Pessimistic On Growth Too Pessimistic On Growth Too Pessimistic On Growth Treasury yields bounced sharply last week and the yield curve steepened. As a result the Bloomberg Barclays Treasury index posted a negative return in June, only the second month of negative Treasury returns so far in 2017. Last week's increase in yields could signal that growth expectations have finally become overly pessimistic. Our U.S. Investment Strategy service has calculated that after the U.S. Economic Surprise Index rises above 40, its average peak to trough decline lasts 90 days. Given that the surprise index peaked above 40 in mid-March, a bottoming-out in the coming weeks would be right on schedule (Chart 1). Net speculative positioning in the futures market has also capitulated, swinging sharply from net short to net long. In recent years, extreme net long positioning has led to higher Treasury yields during the following three months (bottom panel). Our assessment is that U.S. growth will remain above trend for the remainder of the year, and the Treasury curve will continue to bear-steepen as the economic data start to outperform downbeat expectations. Stay at below-benchmark duration, in curve steepeners, overweight spread product versus Treasuries, and overweight TIPS versus nominals. 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 50 basis points in June. The index option-adjusted spread tightened 4 bps to end the month at 109 bps. Though below its historical mean, the investment grade spread is actually somewhat elevated compared to the early stages of prior Fed tightening cycles (Chart 2). We calculate that in the early stages of the past two tightening cycles (February 1994 to July 1994 & June 2004 to December 2005), the index option-adjusted spread averaged 90 bps and traded in a range between 66 bps and 107 bps. While spreads are currently more attractive than is typical for this stage of the cycle, there is good reason for investors to demand some extra risk premium. In a recent report1 we observed that non-financial corporate debt as a percent of GDP is already as high as it was during the past two recessions. Further, the majority of this debt has been issued to finance direct payments to shareholders (dividends & buybacks) as opposed to capital investment. This unfavorable shift in corporate capital structures means that bond investors should demand somewhat greater compensation. All in all, we do not see potential for much spread tightening from current levels. However, a large spread widening would be equally unlikely given the favorable back-drop of steady growth and muted inflation. Small positive excess returns, consistent with carry, remains the most likely scenario. Energy debt underperformed duration-matched Treasuries by 12 bps in June. The sector still looks cheap after adjusting for credit rating and duration (Table 3), and our commodity strategists remain bullish on oil. Table 3ACorporate Sector Relative Valuation And Recommended Allocation* Inflection Point? Inflection Point? Table 3BCorporate Sector Risk Vs. Reward* Inflection Point? Inflection Point? 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 35 basis points in June. The index option-adjusted spread widened 1 bp to end the month at 364 bps, 20 bps above its 2017 low. Energy sector spreads widened sharply in June, alongside falling oil prices, once again de-coupling from the overall index spread (Chart 3). Junk-rated energy credits underperformed the duration-equivalent Treasury index by 190 bps in June, while the High-Yield index excluding energy outperformed by 70 bps. In a report published today,2 our Energy Sector Strategy service takes a detailed look at credit risk among high-yield energy issuers, concluding that while the worst of the energy bankruptcy cycle is behind us, $23 billion of high-yield energy debt remains in distress. 91% of that distressed debt is in the Exploration & Production and Offshore Drilling & Transportation sectors. The continued moderation in energy sector defaults will ensure that the overall speculative grade default rate trends lower for the rest of the year, probably settling below 3% (bottom panel). The decline in defaults means that the current compensation offered by junk spreads in excess of expected default losses stands at 221 bps, right in line with its historical average (panel 3). In last week's report,3 we showed that a default-adjusted spread of 221 bps is consistent with excess returns close to 150 bps during the next 12 months. MBS: Underweight Chart 4MBS Market Overview MBS Market Overview MBS Market Overview Mortgage-Backed Securities underperformed the duration-equivalent Treasury index by 20 basis points in June, dragging year-to-date excess returns down to -20 bps. The conventional 30-year MBS yield rose 11 bps on the month, driven by a 7 bps increase in the rate component and a 6 bps widening of the option-adjusted spread (OAS). This was partially offset by a 2 bps decline in the compensation for prepayment risk (option cost). In last week's report,4 we examined the risk/reward trade-off in different Aaa-rated spread products. We found that despite some recent widening in MBS OAS, you still need to move into 4% coupons or higher to find competitive spreads relative to Aaa-rated corporates, consumer ABS, agency CMBS and non-agency CMBS. Further, MBS OAS are still too tight compared to the trend in net issuance (Chart 4), and even though depressed refi activity will continue to hold down the option cost component of spreads, it is unlikely that a lower option cost will be able to completely offset wider OAS during the next 12 months. The Fed released more details about its balance sheet run-off plan at the June FOMC meeting. We now know that the Fed will start by allowing only $4 billion of MBS per month to run off its balance sheet, but this cap will increase by $4 billion every 3 months until it reaches $20 billion per month. This means that even if the Fed starts to wind down its balance sheet following the September meeting, which is our base case expectation, then it will still be some time before a significant amount of extra supply shifts into the private market. Government-Related: Underweight Chart 5Government-Related Market Overview Government-Related Market Overview Government-Related Market Overview The Government-Related index outperformed the duration-equivalent Treasury index by 21 basis points in June, bringing year-to-date excess returns up to +107 bps. Sovereigns and Local Authorities outperformed the Treasury benchmark by 65 bps and 73 bps, respectively. The low-beta Supranational and Domestic Agency sectors outperformed by 2 bps and 10 bps, respectively. The Foreign Agency sector underperformed duration-matched Treasuries by 4 bps, alongside the dip in oil prices. A weakening U.S. dollar has led to the outperformance of USD-denominated sovereign debt so far this year. Year-to-date, the Sovereign index has outperformed the duration-equivalent Treasury index by 300 bps. This is better than the equivalently-rated Baa U.S. Corporate index, which has outperformed by 195 bps year-to-date. However, there are already signs that the trade-weighted dollar is starting to moderate its downtrend (Chart 5), and we expect the trade-weighted dollar will strengthen as the economic data surprise to the upside in the back half of the year, as discussed on the first page of this report. Granted, the Mexican peso continues to strengthen versus the dollar (panel 3) and this currency pair is particularly important since Mexico is the largest issuer in the Sovereign index. On the heels of its recent outperformance, the Sovereign sector once again looks expensive compared to U.S. corporate sectors, after adjusting for credit rating and duration. Meanwhile, the Local Authority and Foreign Agency sectors continue to look cheap. Supranationals and Domestic Agencies offer very little additional compensation relative to Treasuries, and as we discussed last week,5 there are better options available for investors in need of high-quality spread product. Municipal Bonds: Underweight Chart 6Municipal Market Overview Municipal Market Overview Municipal Market Overview Municipal bonds underperformed the duration-equivalent Treasury index by 18 basis points in June (before adjusting for the tax advantage). Last month we observed that Municipal / Treasury (M/T) yield ratios had become very tight, and we advised reducing municipal bond exposure to underweight. The average M/T yield ratio ticked higher in June, but at 85%, it remains more than one standard deviation below its post-crisis average (Chart 6). There is more compensation available at the long-end of the muni curve than at the short-end (panel 2), and investors should continue to favor long maturities over short maturities on the Aaa Muni curve. The National Association of State Budget Officers recently released its Fiscal Survey of the States and it showed that overall general fund expenditures are expected to increase by only 1% in the 2018 fiscal year, the slowest rate of growth since 2009/10. Meanwhile, 23 states have already enacted mid-year budget cuts in 2017. Budget cutting measures are clearly a response to disappointing tax revenues, which should bounce back somewhat in fiscal year 2018.6 This will help reduce net borrowing, though probably not by enough to justify current municipal bond valuations (panel 3). The state of Illinois avoided a ratings downgrade to junk this week, as the State House of Representatives voted to approve an income tax increase. This measure will keep the rating agencies at bay for now, but a downgrade is still possible in the coming months if the state fails to pass a budget for fiscal year 2018. 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 bull-flattened for most of June, before suddenly reversing course and bear-steepening late in the month. The 2/10 slope flattened 15 basis points between the end of May and June 26, and then steepened 15 bps between June 26 and the end of the month. All told, the 2/10 slope was unchanged in June, while the 5/30 slope flattened 17 bps. The abrupt transition from bull-flattening to bear-steepening was prompted by comments from European Central Bank (ECB) President Mario Draghi that suggested a much more hawkish bias from the ECB. Higher rate expectations in the rest of the world should put downward pressure on the U.S. dollar, and historically, bearish sentiment toward the U.S. dollar has led to a steeper U.S. yield curve (Chart 7, bottom panel). This correlation has not held up so far this year, and we suspect this is because a weaker dollar has not translated into higher U.S. inflation and inflation expectations, as it usually does. We have previously made the case that inflation and inflation expectations, and not Fed tightening, are the main determinants of the slope of the yield curve (panel 4).7 As such, we attribute the bulk of this year's curve flattening to disappointing core inflation which has dragged TIPS breakevens lower. This should reverse in the coming months.8 Investors should continue to position for a steeper curve by favoring the 5-year bullet versus a duration-matched 2/10 barbell. TIPS: Overweight Chart 8TIPS Market Overview TIPS Market Overview TIPS Market Overview TIPS underperformed the duration-equivalent nominal Treasury index by 86 basis points in June. The 10-year TIPS breakeven rate fell 8 bps on the month and, at 1.75%, it remains well below its pre-crisis trading range of 2.4% to 2.5%. In a recent report9 we outlined three possible scenarios for Treasury yields between now and the end of the year based on the interaction between incoming inflation data and Fed policy. In our base case scenario inflation will start to rebound in the coming months, heeding the message from our Phillips Curve model (Chart 8), leading to wider TIPS breakevens and keeping the Fed on its current tightening path. Even if realized inflation remains depressed, the next most likely scenario is that the Fed will capitulate later this year and adopt a shallower expected rate hike path. Such a dovish reaction from the Fed would lend support to long-maturity breakeven wideners, even though real yields would decline. The least likely scenario, in our view, is one where realized inflation remains low but the Fed sticks to its hawkish rhetoric. This is also the scenario that would lead to the most downside in the cost of inflation protection. May PCE inflation data were released last Friday, with year-over-year core PCE decelerating from 1.50% to 1.39%, and trimmed mean PCE decelerating from 1.70% to 1.66% (panel 4). One bright spot is that our PCE Diffusion Index swung sharply into positive territory. Historically, this index has a strong track record signaling turning points in core inflation (bottom panel). ABS: Overweight Chart 9ABS Market Overview ABS Market Overview ABS Market Overview Asset-Backed Securities outperformed the duration-equivalent Treasury index by 2 basis points in June, bringing year-to-date excess returns up to +54 bps. The index option-adjusted spread for Aaa-rated ABS tightened 2 bps on the month, and remains well below its average pre-crisis level. Despite low spreads relative to history, in a recent report10 we showed that Aaa-rated ABS appear quite attractive compared to other Aaa-rated spread product. Specifically, Aaa consumer ABS offer greater compensation per unit of duration than Agency bonds, agency MBS and Aaa Credit. They offer similar compensation per unit of duration to Agency CMBS, but less than non-Agency Aaa CMBS. Within consumer ABS, auto loan-backed securitizations offer slightly greater compensation than the credit card-backed variety (Chart 9). However, we still prefer credit card ABS over auto loan ABS. While credit card charge-offs remain historically low, auto net loss rates are rising. Auto lending standards also moved deeper into "net tightening" territory in the first quarter, according to the Fed's Senior Loan Officer Survey, while credit card lending standards dipped back into "net easing" territory (bottom panel). We continue to recommend that investors favor Aaa-rated credit cards over Aaa-rated auto loans within an overall overweight allocation to consumer ABS. 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 5 basis points in June, bringing year-to-date excess returns up to +57 bps. The index option-adjusted spread for non-agency Aaa-rated CMBS tightened 1 bp on the month, and remains below its average pre-crisis level (Chart 10). In last week's report,11 we showed that non-agency CMBS offer by far the most compensation per unit of duration of any Aaa-rated spread sector. However, we are concerned that non-agency CMBS spreads will widen on a 6-12 month horizon. Commercial real estate lending standards are tightening and property prices are decelerating. Both of these developments tend to correlate with wider spreads. Despite lower spreads, we are much more comfortable in the Agency CMBS market. Agency CMBS: Overweight Agency CMBS outperformed the duration-equivalent Treasury index by 4 basis points in June, bringing year-to-date excess returns up to +54 bps. Agency CMBS offer somewhat lower spreads than their non-agency counterparts, but this sector should be more insulated from spread widening in the months ahead. Not only do these securities benefit from agency backing, but they also mostly comprise multi-family loans. Multi-family property prices have been stronger than those in the retail and office sectors, and delinquencies have been lower (bottom 2 panels). Treasury Valuation Chart 11Treasury Fair Value Models Treasury Fair Value Models Treasury Fair Value Models The current reading from our 2-factor Treasury model (which is based on Global PMI and dollar sentiment) places fair value for the 10-year Treasury yield at 2.52% (Chart 11). Our 3-factor version of the model, which also includes the Global Economic Policy Uncertainty Index, places fair value at 2.45%. The lower fair value results from the large spike in the uncertainty index last November, which has only been partially unwound. The U.S. PMI has dipped lower in recent months, but remains firmly entrenched above the 50 boom/bust line. Meanwhile, the Eurozone PMI continues to surge ahead. China's PMI sent a worrying signal when it dipped below 50 in May, but it bounced back to 50.4 last month (bottom panel). Overall, the Global PMI came in at 52.6 in June, no change from the prior month. For further details on our Treasury models please refer to the 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 2.35%. Ryan Swift, Vice President U.S. Bond Strategy rswift@bcaresearch.com Alex Wang, Research Analyst alexw@bcaresearch.com 1 Please see U.S. Bond Strategy Weekly Report, "Low Inflation And Rising Debt", dated June 13, 2017, available at usbs.bcaresearch.com 2 Please see Energy Sector Strategy Weekly Report, "HY Debt Update: Offshore Drilling & Transportation Getting Left Behind", dated July 5, 2017, available at nrg.bcaresearch.com 3 Please see U.S. Bond Strategy Weekly Report, "Risk Rally Extended", dated June 27, 2017, available at usbs.bcaresearch.com 4 Please see U.S. Bond Strategy Weekly Report, "Risk Rally Extended", dated June 27, 2017, available at usbs.bcaresearch.com 5 Please see U.S. Bond Strategy Weekly Report, "Risk Rally Extended", dated June 27, 2017, available at usbs.bcaresearch.com 6 For further details please see U.S. Bond Strategy Weekly Report, "Will The Fed Stick To Its Guns?", dated May 16, 2017, available at usbs.bcaresearch.com 7 Please see U.S. Bond Strategy Weekly Report, "The Yield Curve On A Cyclical Horizon", dated March 21, 2017, available at usbs.bcaresearch.com 8 Please see U.S. Bond Strategy Weekly Report, "Three Scenarios For Treasury Yields In 2017", dated June 20, 2017, available at usbs.bcaresearch.com 9 Please see U.S. Bond Strategy Weekly Report, "Three Scenarios For Treasury Yields In 2017", dated June 20, 2017, available at usbs.bcaresearch.com 10 Please see U.S. Bond Strategy Weekly Report, "Risk Rally Extended", dated June 27, 2017, available at usbs.bcaresearch.com 11 Please see U.S. Bond Strategy Weekly Report, "Risk Rally Extended", dated June 27, 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)

GAA DM Equity Country Allocation Model Update The GAA DM Equity Country Allocation model is updated as of June 30th, 2017. The model has continued to reduce its allocation to the U.S. and now for the first time the U.S. allocation is slightly below benchmark. Within the non-U.S. universe of the 11 countries, the model has also made significant adjustments to shift weights to Italy (now the largest overweight) and Australia (now for the first time it is overweight by the model), while underweight Germany and France. These adjustments are mainly due to liquidity and technical indicators, as shown in Table 1. As shown in Table 2 and Charts 1, 2 and 3, the overall model underperformed its benchmark by 14 bps in June, largely due to the underperformance of Level 2 model where the overweight of the Euro area v.s. the underweight of Australia and Canada hurt the performance. Since going live, the overall model has outperformed its benchmark by 139 bps. Table 1Model Allocation Vs. Benchmark Weights GAA Model Updates GAA Model Updates Table 2Performance (Total Returns In USD) GAA Model Updates GAA Model Updates Chart 1GAA DM Model Vs. MSCI World GAA DM Model Vs. MSCI World GAA DM Model Vs. MSCI World Chart 2GAA U.S. Vs. Non U.S. Model (Level 1) GAA U.S. Vs. Non U.S. Model (Level1) GAA U.S. Vs. Non U.S. Model (Level1) Please see also on the website http://gaa.bcaresearch.com/trades/allocation_performance. For more details on the models, please see the January 29th, 2016 Special Report "Global Equity Allocation: Introducing the Developed Markets Country Allocation Model". http://gaa.bcaresearch.com/articles/view_report/18850. GAA Equity Sector Selection Model The GAA Equity Sector Selection Model (Chart 4) is updated as of June 30, 2017. Chart 3GAA Non U.S. Model (Level 2) GAA Non U.S. Model (Level 2) GAA Non U.S. Model (Level 2) Chart 4Overall Model Performance Overall Model Performance Overall Model Performance Table 3Allocations GAA Model Updates GAA Model Updates Table 4Performance Since Going Live GAA Model Updates GAA Model Updates The model continues to overweight cyclicals versus defensives. Additionally, the model has turned overweight financials and underweight consumer discretionary on the back of momentum. This overweight in financials is now in line with our global sector recommendations published yesterday. For more details on the model, please see the Special Report "Introducing The GAA Equity Sector Selection Model," July 27, 2016 available at https://gaa.bcaresearch.com. Xiaoli Tang, Associate Vice President xiaoli@bcaresearch.com Aditya Kurian, Research Analyst adityak@bcaresearch.com

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