Telecommunication Services

Underweight In early-2018, some green shoots appeared for telecom services that an end was in sight for the nearly two years of pricing deflation hitting industry profits as some year-on-year pricing gains were eked out. However, as shown in the second panel of the chart, those year-on-year gains have petered out and, in fact, pricing is in deflation again on a three-month rate of change basis. At the same time, industry wages have fully reversed their declines and have accelerated for the past year (third panel). The combination implies increasing margin pressure, which is reflected in sell-side earnings growth estimates continuing to underperform the broad market (bottom panel). Tack on the tight inverse correlation between the high dividend yielding telecom services stocks and the 10-year yield, paired with BCA's expectation for rising yields, and the ingredients are all in place to remain bearish; stay underweight the S&P telecom services index. The ticker symbols for the stocks in this index are: BLBG: S5TELSX - T, VZ, CTL. Pricing Power Weighs On Telcos Pricing Power Weighs On Telcos

Underweight In our previous Insight, we highlighted the S&P REITs index’s tight inverse correlation with UST yields, but it is far from the only group with this trait. The S&P telecom services index (now a subsector within the S&P communication services index, please see our recent Special Report1), with its predictable earnings stream and dividend payout, trades on the same basis. The spike in yields is thus a negative omen for telco stock prices. It is worth noting that the S&P telecom services index has been bucking its inverse correlation with UST yields since hitting their nadir in mid-2017 (second panel). We expect the beaten-up sector to reestablish the correlation, particularly since telecom’s share of the consumer’s wallet is at a decade low with momentum to continue lower. Bottom Line: Stay underweight the telecom services index. The ticker symbols for the stocks in this index are: BLBG: S5TELSX - T, VZ, CTL. Yields Are Causing Static For Telecoms Yields Are Causing Static For Telecoms   1 Please see BCA U.S. Equity Strategy Special Report, “New Lines Of Communication” dated October 1, 2018, available at uses.bcaresearch.com.

Underweight At the market's close last Friday, investors welcomed a new (rather, a renamed) GICS1 sector to the industry taxonomy: the S&P communication services sector. The change had long been overdue as the progenitor sector, telecommunication services, had been hollowed down to three companies and represented approximately 2% of the S&P 500. Further, finding homes for various new media and technology companies had left a hodgepodge of consumer discretionary and information technology subsectors that bore little resemblance to their respective peers. In short, we welcome the new taxonomy. That said, we are not changing our recommendations on the sub-sectors that are changing or moving in to the new GICS1 sector (with the exception of the new S&P interactive media & services index that we initiated coverage on yesterday with a neutral rating ). Accordingly, telecom services remains an underweight subsector under the new banner. We are moving four indexes from consumer discretionary to communication services: advertising (overweight), cable & satellite (neutral), movies & entertainment (neutral) and publishing (neutral). Though the new sector has one overweight subsector (advertising) and one underweight subsector (telecom services), the much greater weight of the latter subsector biases our recommendation on the communication services sector to underweight. Bottom Line: Our initial recommendation for the new S&P communication services sector is underweight. For investors seeking tech exposure we continue to recommend the S&P software and S&P tech hardware, storage & peripherals tech sub-indexes that are high-conviction overweights. Please see yesterday's Special Report for more details, including our initiation of coverage on the new S&P interactive media & services. New Lines Of Communication New Lines Of Communication

Highlights Recommended Allocation Quarterly - October 2018 Quarterly - October 2018 We don't see any change over the next six to 12 months to the current trends of strong U.S. growth, continuing Fed hikes, rising long-term interest rates, and an appreciating dollar. We stay neutral on global equities and continue to favor the U.S. and, to a degree, Japan. Given rising rates, a strengthening dollar, ongoing trade war and moderate slowdown in China, we expect EM assets to sell off further. We forecast the 10-year U.S. Treasuries yield to rise to 3.5% by H1 2019, and so we stay underweight fixed income, short duration, and continue to prefer TIPs. We are only neutral on credit within the (underweight) fixed-income bucket. We shift our equity sector weightings to reflect the GICS recategorization. We recommend a neutral on the new internet-heavy Communication sector, and underweight on Real Estate. We have a somewhat defensive sector bias, with overweights in Consumer Staples and Healthcare. Alternative risk assets, such as private equity and real estate, look increasingly overheated. We prefer hedge funds and farmland at this stage of the cycle. Overview More Of The Same When there's been a strong trend, it's always tempting to be contrarian and argue for a reversal. Tempting but, at the moment, we think wrong. This year has been characterized by a strong U.S. economy but slowing growth elsewhere, the outperformance of U.S. equities (up 10% year-to-date, compared to a 4% decline in the rest of the world), rising U.S. interest rates, dollar appreciation, and a big sell-off in emerging markets. While a short-term correction is always possible, we don't see a fundamental end to these trends over the next 6 to 12 months. Chart 1U.S. Growth Still Looks Strong U.S. Growth Still Looks Strong U.S. Growth Still Looks Strong Chart 2Growth In Europe And Japan Has Slipped Growth In Europe And Japan Has Slipped Growth In Europe And Japan Has Slipped U.S. growth is likely to remain strong. Consumer and business sentiment are both close to record highs; wage growth is beginning (finally) to accelerate; capex intentions are buoyant; and fiscal stimulus will add 0.7% to GDP growth this year and 0.8% next, as the budget deficit widens to close to 6% of GDP (Chart 1). Europe and Japan, by contrast, have slowed this year: both are more exposed to emerging markets than is the U.S.; fiscal policy in neither is particularly accommodative; and European banks suffer from weak loan growth and their EM exposure (Chart 2). The one trigger that would cause global ex-U.S. growth to accelerate relative to U.S. growth is a massive stimulus in China similar to 2009 and 2015. We think this unlikely because the authorities have reiterated their commitment to deleveraging and structural reform. Chinese credit growth and money supply data have as yet shown no signs of picking up, but they should be monitored carefully (Chart 3). Chart 3Chinese Stimilus, What Stimilus? Chinese Stimilus, What Stimilus? Chinese Stimilus, What Stimilus? Chart 4Republicans Like Trump's Tough Trade Talk Quarterly - October 2018 Quarterly - October 2018 An end to the trade war might also reverse the trends. U.S. markets have shrugged off the risk of escalating retaliatory tariffs on the (reasonable) grounds that trade has relatively little impact on the U.S. It is hard to see an end-game to the tariff war. President Trump's popularity has risen since he got tough on trade (Chart 4). He has changed his mind on many areas of policy during his career, but he's always consistently argued that the U.S. deficit shows that its trading partners treat it unfairly. The probability is high that the 10% tariff on $200 billion of Chinese goods will rise to 25% in January, and is eventually extended to all Chinese imports. It is equally unlikely that Xi Jinping will make concessions, since he can't be seen to bend to U.S. pressure and won't put at risk the crucial "Made in China 2025" plan. Chart 5Phillips Curve Working Again Phillips Curve Working Again Phillips Curve Working Again Although tariffs may not hurt U.S. growth much, they could be inflationary. The price of washing machines, the subject of the earliest tariffs in January, rose by 18% over the next four months. This is just another reason why it's unlikely that the Fed will slow its pace of rate hikes. With the labor market now clearly tight, there are signs that the Phillips curve is beginning to reassert itself (Chart 5), and wage growth is accelerating. With core PCE inflation at its 2% target and the impact of fiscal stimulus still coming through, the Fed will feel comfortable about maintaining its current schedule of one 25 basis point hike a quarter until there are signs that the economy is slowing.1 Could the sell-off in emerging markets cause the Fed to move to hold? In the 1990s Asia Crisis, only when the fall in Asian stocks started to affect the U.S. economy (with, for example, the manufacturing ISM going below 50) and the U.S. stock market, did the Fed ease policy (Chart 6). Eventually, the slowdown in the rest of the world might start to hurt the U.S. In the past, when the global ex-U.S. Leading Economic Indicator has fallen below zero, it has usually been followed by U.S. growth also faltering (Chart 7). Chart 6In 1998, Fed Cut Only When EM Hurt The U.S. In 1998, Fed Cut Only When EM Hurt The U.S. In 1998, Fed Cut Only When EM Hurt The U.S. Chart 7When The World Slows, Often U.S. Does Too When The World Slows, Often U.S. Does Too When The World Slows, Often U.S. Does Too Table 1What To Watch For Quarterly - October 2018 Quarterly - October 2018 Having in June lowered our recommendation on global equities to neutral (but keeping our overweight on U.S. stocks), we continue to monitor the factors that would make us turn negative on risk assets (Table 1 and Chart 8). None of them is yet flashing a warning signal, but it seems likely that we will need to move to an outright defensive stance sometime in H1 2019. One final key thing to watch: any signs that U.S. earnings growth is slipping. Much of the outperformance of U.S. equities this year is simply explained by better earnings growth, partly due to the tax cuts. Analysts' forecasts for 2019 have so far been very stable. If they start to be revised down, perhaps because of higher wages and export sales being dampened by the strong dollar, that would also be a signal to switch out of U.S. equities (Chart 9). Chart 8What To Watch For? What To Watch For? What To Watch For? Chart 9Will Analysts Revise Down EPS Forecasts? Will Analysts Revise Down EPS Forecasts? Will Analysts Revise Down EPS Forecasts? Garry Evans, Senior Vice President Global Asset Allocation garry@bcaresearch.com What Our Clients Are Asking Is The Fed Turning Dovish? Chart 10Fed Policy Still Accomodative Fed Policy Still Accomodative Fed Policy Still Accomodative Many investors interpreted Fed Chair Powell's speech at Jackson Hole in August dovishly. Powell questioned whether "policymakers should navigate by [the] stars": r* (the neutral rate of interest) and u* (the natural rate of unemployment), since these are uncertain. He emphasized that policy will be data dependent. We read it differently. Powell also pointed out that "inflation is near our 2 percent objective, and most people who want a job are finding one", and concluded that a "gradual process of normalization remains appropriate". A speech in September by Lael Brainard, a dovish FOMC member, reinforced this. She separated the long-run neutral rate (the terminal rate in the Fed dot plot) from the short-term neutral rate (Chart 10, panel 1). Her conclusion was that "with fiscal stimulus in the pipeline and financial conditions supportive of growth, the shorter-run neutral interest rate is likely to move up somewhat further, and it may well surpass the long-run equilibrium rate." In other words, the Fed needs to continue its gradual pace of hikes. The market does not see it that way. Futures markets have priced in that the Fed will raise rates until June (when the Fed Funds Rate will be 2.75-3% in nominal terms) and then stop (panel 2). But this implies that the Fed will halt once the FFR is at the (current estimate of the) neutral rate. But inflation is likely to pick up further over the next 12 months. And the Fed is worried that, despite rate hikes, financial conditions haven't tightened much (panel 3). So we expect the Fed to keep tightening until there are signs that growth is slowing. Is The Worst Over For Emerging Markets? Chart 11Excess Debt Is Underlying Cause Of EM Sell-Off Excess Debt Is Underlying Cause Of EM Sell-Off Excess Debt Is Underlying Cause Of EM Sell-Off Since the plunge in the Argentinian peso and Turkish lira, currencies in most emerging markets have fallen sharply. Does this present a buying opportunity for investors, or is there more contagion to come? While a short-term rebound is not impossible, we remain very negative on the outlook for most emerging market assets. Fed policy and rising U.S. interest rates can be seen as the trigger for, but not the underlying cause of, the recent sell-off. Since 1980 (Chart 11), there have been only two instances where EM stock prices collapsed amid rising U.S. rates: the 1982 Latin American debt crisis and the 1994 Mexican Tequila crisis. But both occurred because of poor EM fundamentals. We see similar underlying problems today. EM dollar-denominated debt as a share of GDP and exports is as high as it was during the Asia Crisis in the late 1990s. In addition, the EM business cycle will continue to decelerate in the medium term, as evidenced by falling manufacturing PMIs. Consequently, EM corporate earnings growth is slowing, and we expect it to fall meaningfully in this downturn. EM economies have become increasingly dependent on Chinese growth for their export demand. China is slowing, but we expect limited credit and fiscal stimulus from the authorities given their shift in focus towards de-leveraging and reforming the financial sector. Additionally, global trade is also weakening as seen by falling Asian exports and sluggish container freight movements. EM central banks have responded to currency weakness by raising rates, which in turn will lead to rising local currency bond yields and tightening financial conditions. A tightening of liquidity will slow money and credit creation, ultimately weighing on domestic demand. Moreover, with an accelerating U.S. economy, the U.S. dollar will continue to strengthen, eventually tightening global liquidity. We continue to advocate an underweight position in EM assets. Share prices will not bottom until EM interest rates fall on a sustainable basis, or until valuations reach clearly over-sold levels, which they have not yet. Chart 12The New Sectors Look Very Different Quarterly - October 2018 Quarterly - October 2018 What Just Happened To GICS? Following Real Estate's 2016 separation from Financials to become the 11th sector within GICS, September 28 2018 marked an even more disruptive change to equity classification. The change, aimed at keeping up with innovation and the current market structure, affects three of the 11 sectors: Telecommunication Services, Consumer Discretionary, and Information Technology (Chart 12). In short, the Telecommunication Services sector, once a value, low-weight, low-beta, high-yield, defensive sector is broadened and renamed Communication Services, offering broad-based coverage of content on various internet and media platforms. It includes the Media group, as well as selected companies from Internet & Direct Marketing Retail, taken out of Consumer Discretionary. Additionally, selected companies from the Internet Software & Services, as well as Application and Home Entertainment Software move into the new sector from IT. The E-commerce group also grows, with selected companies moving out of IT into Consumer Discretionary. Telecom/Communication, which previously behaved like Utilities, has turned into a high-growth, low-dividend sector. It is also a cyclical rather than defensive. It should trade at much higher multiples than its previous incarnation. IT is also no longer be the same. The sector, which once represented nearly 20% of the ACWI index, has shrunk to 13%, now mostly comprises hardware and software companies, after losing constituents such as Alphabet, Facebook, and Tencent. Chart 13Three Ideas To Enhance Risk-Adjusted Return Three Ideas To Enhance Risk-Adjusted Return Three Ideas To Enhance Risk-Adjusted Return Where To Find Yield In A Low-Return Environment? BCA's House View in June downgraded equities to neutral and moved cash to overweight. For U.S. investors, holding cash is quite attractive, as the yield on three-month Treasury bills is above 2%, higher than the 1.8% dividend yield on equities. But investors in Europe and Japan face negative yields on cash. Our recent Special Report analyzed three investment instruments that could enhance a balanced portfolio's risk-adjusted returns (Chart 13).2 Floating-Rate Notes. FRNs tend to be issued by government-sponsored enterprises and investment-grade corporations. They offer a nice yield pick-up over short-term U.S. Treasuries with significantly shorter duration. However, they do carry credit risk and so performed poorly in the 2007-9 recession. We, therefore, recommend investors fund these positions from their high-yield bucket. Leveraged Loans. These are floating-rate senior-secured bank loans. However, secured does not mean safe. Most are sub-investment grade and can be very illiquid, because physical delivery is often needed. They tend to be positively correlated with junk bonds but negatively correlated with the aggregate bond index. This suggests that adding bank loans to a portfolio can add diversification, and that replacing some high-yield holdings with bank loans can generate a sub-investment grade basket with a better risk/reward profile. Danish Mortgage Bonds. DMBs are covered mortgage bonds, with an average duration of five years and offering a yield to maturity of around 2% in Danish Krone. They have a strong track record: not a single bond has defaulted in the 200-year history of the market. This makes the market very attractive to euro zone and Japanese investors struggling with low bond yields. We find that adding DMBs to a standard bond portfolio significantly improves its risk/return profile. The main snags are that this is a fairly small market with a total outstanding market value of DKR2.7 trillion (around USD400 billion) - and is already 23% owned by foreigners. Global Economy Overview: The global economy will continue to be characterized by significant divergences. U.S. growth remains robust, pushing up inflation to the Fed's 2% target. By contrast, European and Japanese growth has weakened so far this year, meaning that central banks there remain cautious about tightening. Meanwhile, emerging markets will continue to deteriorate, faced with an appreciating dollar, rising U.S. interest rates, and lack of a big stimulus in China. U.S.: The ISM manufacturing index hit a 14-year high, above 60, in September before falling back slightly, to 59.8, in October. Core PCE inflation has reached 2%, the Fed's target. Wage growth, as measured by average hourly earnings, has finally begun to accelerate, reaching 2.9% YoY. With consumption and capex likely to remain robust, and the effect of fiscal stimulus not peaking until early next year, the U.S. economy will continue to grow strongly through 2019 (Chart 14). Only the recent slowdown in housing (probably caused by higher interest rates) remains a concern, but the sector is probably too small to derail overall economic growth. Chart 14Divergences Continue: U.S. Strong... Divergences Continue: U.S. Strong... Divergences Continue: U.S. Strong... Chart 15...Rest Of The World Weakening ...Rest Of The World Weakening ...Rest Of The World Weakening Euro Area: The decline in growth momentum seen since the start of the year has probably now bottomed. Both the PMI and ZEW indexes appear to have stabilized at a moderately positive level (Chart 15, panel 1). Core CPI inflation remains stable at about 1%, though headline inflation has been pushed up by higher oil prices. In this environment the ECB will be slow to raise rates, probably waiting until September next year and then hiking by only 10 basis points. Japan: The external sector has weakened, as shown by the industrial production data and leading economic indicators, probably because of slowing growth in China. However the domestic sector is showing signs of life, with corporate profits growing by more than 20% year-on-year, and capex rising at a rapid pace (6.4% YoY in Q2). However core inflation remains barely above zero, and therefore the Bank of Japan will continue its Yield Curve Control policy for the foreseeable future. Emerging Markets: Chinese growth continues to slow moderately, with the Caixin manufacturing PMI exactly at 50 (Chart 15, panel 3). The key question now is whether the authorities will implement massive stimulus, as they did in 2009 and 2015. The PBOC has cut rates and the government announced that it is bringing forward some fiscal spending. But the priority remains to deleverage and push ahead with structural reform. We do not expect, therefore, to see a significant acceleration of credit growth. Elsewhere in EM, central banks have significantly raised interest rates to defend their currencies, and this is likely to trigger recession in many countries within the next six months. Interest rates: Monetary policy divergences are likely to continue. The Fed will hike by 25 basis points a quarter until there are signs that growth is slowing and that tightness in the labor market is easing. Inflation is not showing signs of dramatic acceleration but, with the labor market so tight, the Fed will want to take out insurance against a future sharp rise. By contrast, the ECB and BOJ have no need to tighten (Chart 15, panel 4). Accordingly, we expect to see US long-term interest rates rise, with the 10-year Treasury bond yield reaching 3.5% in the first half of 2019. Chart 16When Will Earnings Turn Down? When Will Earnings Turn Down? When Will Earnings Turn Down? Global Equities Stay Cautious: We turned cautious on equities in the previous Quarterly Strategy Outlook,3 by upgrading the low-beta U.S. equity market to overweight at the expense of the high-beta euro area, by taking profit in our pro-cyclical tilt and moving to more defensive sectors, and by maintaining our core position of overweight DM relative to EM. Those moves proved to be effective as DM outperformed EM by 6%, the U.S. outperformed the euro area by 7.5%, and defensives outperformed cyclicals by 1.2%. Because of the sharp underperformance of EM equities relative to DM peers, it's tempting to bottom-fish EM equities. However, we suggest investors refrain from such an urge because we think it's too early to take such risk (see nexts section below). We therefore maintain our defensive tilts in both regional and country allocation and global sector allocation (see table at the end of the report). Equity valuations are less stretched than at the beginning of the year, due to strong earnings growth. However, BCA's global earnings model shows that earnings growth will slow significantly next year (Chart 16, panels 1 & 2). With earnings growth for every sector in positive territory, and the DM profit margin near a historical high, it would not take much for analysts to revise down earnings expectations (bottom 3 panels). Reflecting the GICS sector reclassification, we have initiated a neutral on the Communication sector and an underweight on the Real Estate sector. Chart 17EM Underperformance To Continue EM Underperformance To Continue EM Underperformance To Continue Continue To Underweight EM Vs. DM Equities Underweight EM equities vs. the DM counterparts has been a core position in GAA's global equity portfolio (in U.S. dollars and unhedged) this year. Despite the significant performance divergence over the past few months, we recommend investors continue to underweight EM equities, for the following reasons: First, BCA's House View is for the U.S. dollar to strengthen further, especially against EM currencies. This does not bode well for the EM equity performance relative to DM equities, given the close correlation of this with EM currencies (Chart 17, panel 1); Second, Chinese economic growth plays an important role in the EM economy. China's large weight in the EM equity index also makes the link prominent. With increasing concern from the trade war with the U.S., Chinese imports are likely to deteriorate, implying the sell-off in EM shares may have further to go (panel 2); Third, EM earnings growth is closely correlated with money supply as shown in panel 3. Forward earnings growth will have to be revised down given the slowing in money growth. Finally, even though EM equity valuations are now cheap on an absolute basis, EM equities have mostly traded in history at a discount to DM. Currently, the discount is still in line with historical averages (panel 4). Chart 18Real Estate Sector Looks Vulnerable Real Estate Sector Looks Vulnerable Real Estate Sector Looks Vulnerable Sector Allocation: Underweight on Real Estate and Neutral on Communication With the recently implemented GICS reclassification, involving the creation of a new Communication Services Sector by moving the media component in Consumer Discretionary and the internet companies in IT to the old Telecom Services sector (see section below for more details), we are reviewing our global sector allocations. Since we were already neutral on IT and Telecom Services, and since the new Communication sector is dominated by internet companies, it's natural to be neutral on the new Communication sector. Real Estate was lifted out of the Financials sector in 2016 to be a separate sector. But we did not include this sector previously in our recommendations because it mostly consists of commercial real estate (CRE) investment trusts. In our alternative asset coverage, we had preferred direct real estate due to its lower correlation with equities in general. In July this year, however, we downgraded exposure to direct real estate.4 It's much easier to reduce REITS holdings than direct CREs. As such, we take this opportunity to initiate an underweight on the Real Estate sector, mainly because of the less favorable conditions in both the macro backdrop and industry fundamentals. From a macro perspective, the tailwind from declining interest rates has turned into a headwind as interest rates rise. Over the past few years, the relative performance of Real Estate to the overall equity index has been closely correlated with the rise and fall of the long-term interest rates. BCA expects 10-year interest rates to trend higher. This does not bode well for the sector's equity performance going forward (Chart 18, panel 1). Industry fundamentals look vulnerable as well. The occupancy rate has already started to decline (panel 2). CRE prices have been making new highs on an inflation-adjusted basis, fueled by a historically high level of CRE loans and low level of loan delinquencies (Chart 18, panels 3 and 4). All these make the CRE sector extremely vulnerable. Government Bonds Maintain Slight Underweight On Duration. The U.S. 10-year government bond yield traded in a tight range in Q3 between 2.8% and 3.1%. With the current yield at 3.07% and the most recent inflation reading below expectations, it's tempting to take a less bearish view on duration, especially given the weakness in EM economies and EM asset prices. We agree that the spillover from weak global growth into the U.S. might cause the Fed to pause its gradual 25bps-per-quarter rate hike cycle at some point in 2019; however, markets currently have priced in only two rate hikes in the entire year of 2019, which means the risk is already priced in. With increasing pressure from rising supply, we still see rates rising over the next 9-12 months and so our short duration recommendation for government bonds is unchanged (Chart 19). Chart 19Rising Supply Will Push Up Rates Rising Supply Will Push Up Rates Rising Supply Will Push Up Rates Chart 20TIPS Breakevens Have A Little Further To Go TIPS Breakevens Have A Little Further To Go TIPS Breakevens Have A Little Further To Go Favor Linkers Vs. Nominal Bonds. BCA's U.S. Bond Strategy still believes that the U.S. TIPS break-evens will reach to our target range of 2.3%-2.5% because core inflation should remain close to the Fed's 2% target going forward. The latest NFIB survey supports this view as wage pressure is still on the rise, with reports of compensation increases near a record high (Chart 20). Compared to the current breakeven level of 2.1%, this means 10-year TIPS have upside of 20-40bp, an important source of return in the low-return fixed-income space. Maintain overweight TIPS vs. nominal bonds. However, TIPS are no longer cheap. For those who have not already moved to overweight TIPS, we suggest "buying TIPS on dips". Inflation-linked bonds (ILBs) in Australia and Japan are also still very attractive vs. their respective nominal bonds. Overweighting ILBs in those two markets also fits well with our macro themes. Corporate Bonds Chart 21Spreads Not Attractive Spreads Not Attractive Spreads Not Attractive After being overweight for over two years, last quarter we turned neutral on corporates, including high-yield credits, within a global bond portfolio. Developed market corporate bonds have performed poorly in 2018 led by weak returns in the Financials sector and steepening credit curves.5 On the positive side, global corporate health (Chart 21) has been improving, led by the resilience of the U.S. economy and tax cuts that have put corporations in a cyclically healthier position. However, this may not be sustainable as the tightening labor market is pushing up wage growth, which will pressure margins. Interest coverage has fallen in recent years despite strong profitability and low borrowing costs. The risk of downgrades will rise when the earnings outlook weakens or borrowing costs start to rise. An additional concern is that weaker global ex-U.S. growth and a stronger dollar will weigh on U.S. corporate revenues. In the euro area, interest coverage and liquidity continue to improve, supported by easy monetary policies that have lowered borrowing costs. However, with the ECB set to end its corporate bond purchase program along with purchases of sovereign bonds at the end of the year, euro area corporate bonds will lose a major support. In Japan, leverage has been steadily falling and return on capital rising, pushing up the interest coverage multiple to 9.6x, the highest in developed markets. With Japanese corporate profits at an all-time high, default risk is low. The BoJ's forward guidance suggests no tightening until 2020, giving corporates a low cost of borrowing and probably a weak currency. Excess spread from U.S. high-yield bonds after adjusting for expected default losses is 226 bps, slightly below the long-run mean of 247 bps. Most indicators suggest that default losses will remain low for the next 12 months, but it will be critical to track real-time indicators such as job cuts to see if there is any deterioration in growth which might start to push up default rates. With a global corporate bond portfolio, we prefer Japanese and U.S. credits to euro area corporates. Chart 22Prefer Oil Over Metals Prefer Oil Over Metals Prefer Oil Over Metals Commodities Energy (Overweight): Oil prices will continue to be driven by demand/supply fundamentals. We believe that that supply shocks will have more influence on the crude oil price over the coming months than will lower demand from EM (Chart 22, panel 2). U.S. sanctions on Iranian oil exports are estimated to take 800K-1M barrels a day out of global supply. We also factor in the risk of political collapse in Venezuela and outages in Iraqi and Libyan production, which would push oil prices higher. BCA's energy team forecasts that Brent crude will average $80 until year-end, and $95 by the end of the first half of next year.6 Industrial Metals (Neutral): An appreciating dollar along with weaker consumption of base metals in China, the world's largest consumer, are likely to keep industrial metals' prices depressed and to increase volatility over the next few months (panel 3). Additionally, the easing of U.S. sanctions on some Russian oligarchs connected with aluminum producer Rusal is likely to keep a lid on aluminum prices for now. Precious Metals (Neutral): Gold has been weak despite global uncertainties and political tensions arising from the U.S.-China trade spat, Middle East politics, and EM weakness. Since we see further upside in inflation in the coming months and remain concerned about global risk, gold remains an attractive hedge. However, rising real interest rates and the strong dollar will limit the upside (panel 4). Chart 23Further Upside For The Dollar Further Upside For The Dollar Further Upside For The Dollar Currencies U.S. Dollar: The dollar has continued its appreciation over the past couple of months, propelled by a moderately hawkish Fed and strong economic data. We see further upside to inflation, though the latest print fell short of expectations. Tighter financial conditions in the U.S. will add further upside to the currency on a broad trade-weighted basis, as well as against other majors (Chart 23, panels 1 and 2). EM Currencies: Dollar appreciation, higher interest rates, increasing trade tensions, and a slowdown in China, have put pressure on EM currencies. We expect these conditions to continue. Sharp interest rate hikes in Argentina and Turkey have not stopped the fall, probably because markets anticipate that the hikes will trigger recessions in these countries. Euro: Weak European economic data and downward growth revisions have put downward pressure on the currency. Additionally, looming political uncertainty in Italy, Europe's large exposure to EM, and continuing trade-war tensions make it likely that the euro will decline further (panel 4). The ECB confirmed its plan to end asset purchases by year-end, but is likely to raise rates only in late 2019. We maintain our view that EUR/USD will weaken to at least 1.12. GBP: Brexit issues continue to affect the pound: the only driver that could push GBP higher would be if both the European Union and the U.K. parliament agree to Theresa May's "Chequers plan". However, with strong opposition from both pro-Brexit Conservative MPs and the Labour Party, the chance of approval seem low. We remain bearish on the pound until there is more clarity on how Brexit will pan out and expect increasing volatility until then. Chart 24Signs Of Overheating In Alts? Signs Of Overheating In Alts? Signs Of Overheating In Alts? Alternatives Alternative assets under management continue to grow to record highs, driven by positive sentiment, the global search for yield, and the need for uncorrelated returns. However, there are increasing signs of overheating in the core areas of this market. We analyze our allocation recommendations using a framework of three buckets: 1) return enhancers, 2) inflation hedges, 3) volatility dampeners. Return Enhancers: In H1 2018, private equity (PE) outperformed hedge funds by 6.4% (Chart 24). However, last quarter we recommended investors pare back on their PE allocations and increase hedge funds. Rising competition in PE has pushed deal valuations to new highs, and we expect to see funds raised in 2018-2019 produce poor long-term returns because of higher entry valuations.7 Within the hedge fund space, we recommend investors shift to macro hedge funds, as the end of the business cycle approaches. Inflation Hedges: In H1 2018, commodity futures outperformed direct real estate by over 7%. We remain cautious on commercial real estate (CRE). Loans to CRE have reached a record $4.3 trillion, 11% higher than at the pre-crisis peak. As central banks tighten monetary policy, financial stress is likely to appear in CRE. CRE prices peaked in late 2016 and have subsequently moved sideways, partly due to the downturn in shopping malls and retail. Commodity futures, on the other hand, have performed well on the back of rising energy prices. However, we expect increased volatility in commodities due to supply disruptions in oil, and a further slowdown in EM demand. Volatility Dampeners: In H2 2018, farmland and timberland outperformed structured products by 3%. Timberland has a stronger correlation with economic growth via the U.S. housing market. This year, lumber prices have fallen from over $600 to $340, mostly due to speculative action in the futures market. However, this will ultimately impact income from timber sales. Farmland is more insulated from the economy since food demand is autonomous consumption. Structured products face pressures as rising rates push lower-quality tranches closer to default. Investors should favor farmland over timberland, and maintain only a minimum allocation to structured products. Risks To Our View Our main scenario, as outlined in the Overview, is that this year's trends will continue. What might cause them to change? Chart 25China Has Cut Rates A Bit China Has Cut Rates A Bit China Has Cut Rates A Bit Chart 26...But Fiscal Spending Not Yet Picking Up ...But Fiscal Spending Not Yet Picking Up ...But Fiscal Spending Not Yet Picking Up The biggest risk is Chinese policy. A big stimulus, in line with those in 2009 and 2015, would boost growth in emerging markets, Europe and Japan, push up commodity prices, and weaken the dollar. The PBoC has cut rates (Chart 25) and lowered the reserve requirement. The government has said it will bring this year's budget plans forward, though for now fiscal spending is slowing compared to last year (Chart 26). Faced with a major slowdown and devastating trade war, the Chinese authorities would doubtless throw everything at the problem. But, up until that point, their priority remains deleverage and reform, and so we expect them to do no more than moderately cushion the downside. Chart 27Are Speculators Too Long The Dollar? Quarterly - October 2018 Quarterly - October 2018 As always, a major factor is the U.S. dollar, which we expect to appreciate further, as the Fed tightens more than the market expects, and U.S. growth outpaces the rest of the world. What's the most likely reason we're wrong? Probably a situation like 2017, when speculators were very long the dollar just as growth in Europe started to accelerate relative to the U.S. Today, speculative positions are moderately long the dollar, but against the euro and yen not as much as in early 2017 (Chart 27). Aside from a Chinese reflation, it is hard to see what would propel an ex-U.S. growth spurt. True, Japanese capex and wages are showing some signs of life. But Japan worryingly intends to raise VAT in late 2019. And Europe faces considerable political risks - Brexit, Italy, troubled banks, contagion from Turkey - that make it unlikely that confidence will rebound. 1 For more details on this, please see section “What Our Clients Are Asking: Is The Fed Turning Dovish?” in this report. 2 Please see Global Asset Allocation Special Report, "Searching For Yield In A Low Return Environment," dated September 14, 2018 available at gaa.bcaresearch.com 3 Please see Global Asset Allocation "Quarterly - July 2018," dated July 2, 2018 available at gaa.bcaresearch.com 4 Please see Global Asset Allocation "Quarterly - July 2018," dated July 2, 2018 available at gaa.bcaresearch.com 5 Please see Global Fixed Income Strategy Weekly Report titled "A Performance Update On Global Corporate Bond Sectors," dated September 4, 2018 available at gfis.bcaresearch.com 6 Please see Commodity & Energy Strategy Weekly Report, "Odds of Oil-Price Spike in 1H19 Rise; 2019 Brent Forecast Lifted $15 To $95/bbl," dated September 20, 2018. 7 Please see Global Asset Allocation Special Report on private equity, "Private Equity: Have We Reached The Top?," dated September 26, 2018 available at gaa.bcaresearch.com GAA Asset Allocation

Highlights The renaming of telecommunication services and reallocation of some tech and consumer discretionary stocks ends a long run of a purely domestic, defensive GICS1 sector. Our initial recommendation is underweight for the newly minted S&P communication services sector. Interactive media & services, formerly (mostly) internet software & services, is moving from tech to communication services where it promises to be the core revenue and profit driver of the sector. However, regulatory risk, a rapid pace of change with extremely low switching costs and currency exposure in a very international sector keep us on the fence. We are initiating coverage on the S&P interactive media & services index with a neutral recommendation. Feature Several Indexes Have Found New Homes At the market's close last Friday, investors welcomed a new (rather, a renamed) GICS1 sector to the industry taxonomy: the S&P communication services sector (Table 1). The change had long been overdue as the progenitor sector, telecommunication services, had been hollowed down to three companies and represented approximately 2% of the S&P 500. Further, finding homes for various new media and technology companies had left a hodgepodge of consumer discretionary and information technology subsectors that bore little resemblance to their respective peers. In short, we welcome the new taxonomy. Table 1Classification Changes New Lines Of Communication New Lines Of Communication However, this change brings a good deal of uncertainty with it. The most recent GICS1 change was the reallocation of real estate (mostly REITs) from a financials sub-index to their own GICS1 classification; this change involved a relatively simple carve-out. The creation of communication services includes carve-outs as well as stock-by-stock changes for a brand new index with a core sub-index, interactive media & services, that we initiate coverage on later in this report. Importantly, the reshuffling dilutes an up-to-recently pure-play safe haven index. Previously, telecommunications services was an ultra-low beta, high-dividend yielding, zero currency-exposed prototypical defensive index. Communication services will be dominated by relatively high beta, low dividend yielding and heavily international stocks. In more detail, it morphs into a roughly 45% deep cyclical, 37.5% early cyclical and 17.5% defensive index. MSCI has proposed classifying communication services as cyclical, with no new defensive offset, meaning the market has lost a GICS1 defensive sector. Further, we estimate roughly 20% of the communication services index is value-oriented, a fairly drastic change from the 100% value-oriented former telecommunication services index. Now approximately 60% will be growth-oriented and the balance a blend of the two. One would presume that adding many new stocks to the sector would alleviate telecommunication services' lack of breadth (two companies split 95% of the market cap weight roughly evenly). However, the sheer dominance of Alphabet and Facebook, which will combine to represent approximately 40% of the S&P communication services sector, means that the absence of breadth is being replaced with less absence of breadth (Chart 1). Chart 1Before... And After New Lines Of Communication New Lines Of Communication Further impacting the cyclicality of the new index is the source of revenues. Telecommunication services revenues are relatively inelastic as the service they provide is very much a consumer staple. Communication services in general and interactive media & services in particular have much more volatile revenue profiles, relying heavily on ad sales (Facebook & Google) or consumer discretionary spending (Netflix & Disney). We have not covered the index that includes Facebook and Alphabet, so we have been de facto at a benchmark allocation. As detailed in the following section, we are not changing that recommendation with our initiation of coverage. Our telecom services recommendation remains underweight (though obviously now a subsector within communication services). Our recommendations on the other material industries moving into communication services (movies & entertainment and cable & satellite, collectively the media indexes) are similarly remaining unchanged at a benchmark allocation. Bottom Line: The net result is that we are negatively biased on the new S&P communication services sector and our initial recommendation is underweight. For investors seeking tech exposure we continue to recommend the S&P software and S&P tech hardware, storage & peripherals tech sub-indexes that are high-conviction overweights. Please see the housekeeping section at the end of this report for more details. Interactive Media & Services - Breaking Out? The new interactive media & services index broadly matches the former internet software & services index (that used to be a subsector of the information technology GICS1 sector), but with a twist. Facebook & Alphabet comprised more than 90% of the old index and will command a similar share of the new. However, eBay has found a new home alongside Amazon in the consumer discretionary index, swapping places with TripAdvisor. Meanwhile, Akamai and Verisign are moving to a new index, internet services & infrastructure. Still, the vast majority of the index was, and remains, weighted to two companies. Accordingly, and in the absence of new forward looking data, we will be basing much of our analysis on the old internet software & services index and extrapolating it to the new interactive media & services. It comes as no shock to market observers that the internet services & software index has been gaining share of the S&P 500 as its component stocks have been roaring ahead. In fact, the streak of outperformance has been uninterrupted from the beginning of 2017 until very recently (Chart 2). The usual conclusion is that this is the result of a dramatic surge in valuation. While it is true that the internet services & software index trades at a hefty valuation multiple from an absolute perspective, the valuation has in fact declined relative to the broad market since the beginning of 2017 (Chart 3). Underlying the meteoric rise in market share of the internet software & services stocks without a corresponding relative valuation increase has been a step higher in relative earnings. As shown in Chart 4, earnings growth in this index has vaulted higher in the past five years, dramatically outpacing the growth in the share price for most of the past three years. Chart 2Rising Prices Amidst... Rising Prices Amidst... Rising Prices Amidst... Chart 3... Falling Valuations ... Falling Valuations ... Falling Valuations Chart 4EPS Growth Has Outpaced Price EPS Growth Has Outpaced Price EPS Growth Has Outpaced Price A key differentiator between this index and virtually every other index we cover is the source of revenues and earnings, namely advertising. Despite years of acquisitions and organic R&D building non-advertising businesses, last year saw 86% of Alphabet's revenues derived from advertising. The number is even larger at Facebook, where nearly all of its revenues are generated through selling advertising placements. This revenue quite obviously comes with a high margin and extremely high operating leverage. As such, the past decade of economic expansion has been excellent for the index. In fact, Facebook's entire history as a public company has been in the midst of a bull market. The elevated degree of cyclicality of internet software & services profits largely explains the earnings outperformance in the expansion to date, though clearly presents a risk to relative profitability when the cycle turns. Profit Growth Has A Long Runway... Consumer confidence, which is still pushing up against multi-decade highs, combined with online's growing share of advertising dollars, will continue to drive revenue growth of interactive media & services well ahead of the broad market. Such historically high consumer confidence is supported by generationally low unemployment (Charts 5 and 6). In other words, as long as everyone who wants a job has a job, interactive media & services revenues are relatively secure. Chart 5Ad Revenues Are Solid... Ad Revenues Are Solid... Ad Revenues Are Solid... Chart 6... When Jobs Are Plenty ... When Jobs Are Plenty ... When Jobs Are Plenty A rebuttal to that bullish thesis that has grown more common since Facebook issued downbeat guidance in July that subsequently knocked more than $130 billion of market cap off the stock (it has since fallen even further) is that growth is decelerating and margins are tightening considerably. Google too has been downplaying cresting EPS growth rates. We counter with the argument we postulated in our mid-summer analysis of the impact of regulatory reform on the technology sector that negativity coming from management at these firms may be sandbagging to defray some of the elevated regulatory scrutiny into their outrageous profitability.1 Further, the sell side does not appear to believe the guidance; current estimates for revenue growth at Facebook & Google for the next three years are a 20% and 17% compounded annual growth rate (CAGR), respectively, or three times as high as the broad market. Nevertheless, even the always-optimistic sell side is calling for EPS growth rates that trail revenue growth, implying the message of declining profitability is hitting home; Facebook and Google have three-year EPS CAGRs of 16% and 12%, respectively. Under the watchful eye of regulators across the world, both firms are investing heavily in safety & security that each has flagged as a significant headwind to margins. While these growth rates are a far cry from earlier profitability, they broadly match the current S&P 500 long-term EPS growth rate of 16%. ...But Three Key Risks Keep Us On The Fence The declining profitability of the sector brings us to the first of three key risks that prevent us from turning positive on interactive media & services: regulation. In the previously noted analysis of regulatory reform on the tech sector,2 our colleagues in BCA's Geopolitical Strategy service noted that both concentration and privacy concerns should present significant sources of apprehension for investors. We would certainly agree. The stock market reaction to regulation (or regulatory action in the form of fines) has thus far been muted, but that does not put us completely at ease. We are conscious that an antitrust breakup of Google or a privacy/data sharing/first amendment issue action against Facebook or Twitter could be potentially business model-breaking. Accordingly, we weigh this against the index's spectacular profitability. With respect to our second key risk, we are reminded of a quote from Donald Rumsfeld in 2002: "there are things we know we know. We also know there are known unknowns; that is to say we know there are some things we do not know. But there are also unknown unknowns -- the ones we don't know we don't know". At BCA, we are neither technologists nor trend experts. Accordingly, there is a great deal of potential changes in consumer tastes or technology that we are unaware of that could deliver the same fate to Facebook and/or Google as the fallen tech giants of the past. In an environment where switching costs appear to be close to nil, this is particularly risky. This could come about either from within Silicon Valley where Schumpeter's creative destruction process is alive and well (keep in mind Google did not exist prior to 1998 and Facebook was born in 2004), or even from China that apparently has jumped ahead of the U.S. in terms of AI capabilities. Some early signs are worrying. A survey from the Pew Research Center last month said that 26% of respondents had deleted the Facebook app from their phone in the past year.3 While the core Facebook application is just one of several of the company's properties, recent news that the founders of Instagram, Facebook's second largest social media network, were exiting amidst internal turmoil reinforces our fears. We are unable to put our finger on how social media tastes or the technology used to consume content will change, but we are confident that any change will be both rapid and unpredictable. Chart 7U.S. Dollar Risk U.S. Dollar Risk U.S. Dollar Risk Our third risk is also the biggest: the U.S. dollar. One of BCA's key views for the next year is the appreciation of the U.S. dollar; we have been flagging this as the key source of risk to our otherwise sanguine view on the broad U.S. equity market in general and the heavily international tech sector (the early-cyclical semi and semi equipment sectors are the most exposed and we are underweight both4) in particular. Overseas sales for Facebook and Google represented 51% and 53% of overall sales, respectively, in 2017 and both companies have indicated growth outside North America will outpace domestic sales. Google's recent rumored foray into China is not only encouraging more government scrutiny of the search giant, but it would also exacerbate the EPS sensitivity to forex fluctuations. As long as the U.S. dollar is appreciating, the translation of foreign sales and profits to the home currency will further dampen EPS growth (Chart 7). In the context of the elevated valuations these companies share, combined with the empirical reactions when earnings or guidance have disappointed in the past, any headwinds to growth may drive a valuation derating. Bottom Line: Innovation and supportive macro trends are likely to keep driving profit growth in interactive media & services that, though slower than in the past, still outpaces the broad market. However, three key risks keep us on the sidelines: a renewed regulatory focus, rapid unpredictable changes in tastes & technology and an appreciating U.S. dollar that threatens to sap growth in the key foreign segments. We are initiating coverage with a neutral rating. The tickers in this index are BLBG: S5INMS - GOOG, GOOGL, FB, TWTR, TRIP. Housekeeping Items With the exception of the new neutral recommendation on interactive media & services, we are not changing any recommendations on any other sector with this report. However, in accordance with the GICS changes, we are shifting a number of sectors today. First, we are renaming telecommunication services to communication services; telecom services remains an underweight subsector under the new banner. We are moving four indexes from consumer discretionary to communication services: advertising (overweight), cable & satellite (neutral), movies & entertainment (neutral) and publishing (neutral). Though the new sector has one overweight subsector (advertising) and one underweight subsector (telecom services), the much greater weight of the latter subsector biases our recommendation on the communication services sector to underweight. Within consumer discretionary, our recommendation prior to this change was underweight. As we are moving only neutral- and overweight-recommended subsectors out of the larger index, our underweight recommendation for consumer discretionary is unchanged (modestly more negative, especially if we consider our recent intra-housing market sub sector swap5). Chris Bowes, Associate Editor chrisb@bcaresearch.com 1 Please see BCA U.S. Equity Strategy Special Report, "Is The Stock Rally Long In The FAANG?" dated August 1, 2018, available at uses.bcaresearch.com. 2 Ibid. 3 Pew Research Center http://www.pewresearch.org/fact-tank/2018/09/05/americans-are-changing-their-relationship-with-facebook/ 4 Please see BCA U.S. Equity Strategy Weekly Report, "Party Like It's 2004!" dated September 17, 2018, available at uses.bcaresearch.com. 5 Please see BCA U.S. Equity Strategy Weekly Report, "Indurated," dated September 24, 2018, available at uses.bcaresearch.com. Current Recommendations

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

Please note that our next publication will be a joint special report with BCA’s Geopolitical Service that will be published on Wednesday, August 1st instead of our usual Monday publishing schedule. Further, there will be no publication on Monday, August 6th. We will be returning to our normal publishing schedule thereafter. Highlights We continue to explore a cyclical over defensive portfolio bent, and the capex upcycle along with higher interest rates are our key investment themes for the remainder of the year. A number of sentiment indicators have broken out (Chart 1), and our sense is that the SPX will also hit fresh all-time highs in the coming quarters. While buybacks vaulted to uncharted territory in Q1/2018 (Chart 2), our profit growth model suggests that EPS will continue to expand at a healthy clip for the rest of the year (Chart 3) and 10% EPS growth is achievable in calendar 2019. Positive macro forces remain in place with the ISM - manufacturing and non-manufacturing - surveys reaccelerating. Beneath the surface, the new-orders-to-inventories ratio is gaining traction and even the trade-related subcomponents (new export orders and imports) are ticking higher. High backlogs also suggest that SPX revenue growth will remain upbeat (Chart 4). Non-farm payrolls are expanding on a month-over-month basis for 93 consecutive months, a record (Chart 5), at a time when the real fed funds rate remains near the zero line (Chart 6). As a result, the economy is overheating. Corporate selling price inflation is skyrocketing, according to our gauge, with our diffusion index catapulting to multi-decade highs. This represents a positive margin backdrop as wage inflation remains muted (Chart 7). While at first sight, valuations appear dear, a simple thought experiment suggests that soon they will deflate1 (Chart 8). And, on a forward price-to-earnings-to-growth (PEG) basis, valuations have sunk to one standard deviation below the historical mean (Chart 9). Two key risks that we are closely monitoring that can put our cyclically positive equity market view offside are: a sustained rise in the U.S. dollar infiltrating profit growth (Chart 10), and corporate balance sheet degradation short-circuiting the broad equity market (Chart 11). Chart 1Sentiment Is Breaking Out Sentiment Is Breaking Out Sentiment Is Breaking Out Chart 2Buybacks Are Soaring Buybacks Are Soaring Buybacks Are Soaring Chart 3Earnings Growth Hasnt Slowed... Earnings Growth Hasnt Slowed... Earnings Growth Hasnt Slowed... Chart 4...And Backlogs Suggest They Wont ...And Backlogs Suggest They Wont ...And Backlogs Suggest They Wont Chart 5Record Jobs Growth... Record Jobs Growth... Record Jobs Growth... Chart 6...And Still-Loose Monetary Policy ...And Still-Loose Monetary Policy ...And Still-Loose Monetary Policy Chart 7Wage Growth Is Trailing Pricing Power Flexing Its Muscles Wage Growth Is Trailing Pricing Power Flexing Its Muscles Wage Growth Is Trailing Chart 8The Market Is Not That Expensive... The Market Is Not That Expensive... The Market Is Not That Expensive... Chart 9...By Several Measures ...By Several Measures ...By Several Measures Chart 10A Strong Dollar Is A Risk A Strong Dollar Is A Risk A Strong Dollar Is A Risk Chart 11Corporate Sector Leverage Is Too High Corporate Sector Leverage Is Too High Corporate Sector Leverage Is Too High Feature S&P Industrials (Overweight) While our industrials CMI remains very near 20-year highs, it has lost its upward momentum this year due almost entirely to the strength of the U.S. dollar, though sliding global PMI surveys have also started to weigh (second panel, Chart 13). Combined with heightened fears of a trade war, the internationally geared S&P industrials have come under pressure. Chart 12S&P Industrials (Overweight) S&P Industrials S&P Industrials Chart 13Positive Industrial Growth Backdrop Positive Industrial Growth Backdrop Positive Industrial Growth Backdrop Still, demand growth has been resilient and continues to soar as the capex upcycle has not yet run its course and the implications for top line and profit growth are unambiguously positive (third and bottom panels, Chart 13). Should some let up emerge from the current break down of international trade, we would expect earnings to resume their role as the fundamental driver for industrials. Our valuation gauge has rapidly declined this year as extreme bearishness is not reflected by the strong profit backdrop. From a technical perspective, S&P industrials have been the most oversold since the Great Recession. S&P Energy (Overweight, High-Conviction) Our energy CMI has continued to push higher from the extremely depressed levels of 2016 and 2017. Still, the much better cyclical environment has started to get reflected in relative share prices with the S&P energy index besting all other GICS1 sectors in Q2. We recently refined our energy sector sub-surface positioning that sustains the broad energy complex in the overweight column, and we reiterated its high-conviction status. We believe the steep recovery in underlying commodity prices, which the market has thus far failed to show much confidence in, has started to restore some semblance of normality in the exploration & production (E&P) stocks space (top panel, Chart 15). Chart 14S&P Energy (Overweight, High Conviction) S&P Energy S&P Energy Chart 15A Capex Boom As Oil Reignites A Capex Boom As Oil Reignites A Capex Boom As Oil Reignites Similar to the broad energy complex that integrateds dominate, oil & gas E&P producers are a capital expenditure upcycle play, which remains a key BCA theme for the year (second panel, Chart 15). Accordingly, we raised the S&P oil & gas E&P index to an overweight stance. Simultaneously, weakening crack spreads (third panel, Chart 15) and rising gasoline inventories (bottom panel, Chart 15) have given us cause for concern for refiners. As a result, we trimmed the S&P oil & gas refining & marketing index to underweight, though this did not shake our high-conviction overweight position on the broad S&P energy index. Our Valuation Indicator (VI) remains near deeply undervalued territory, and indicates an attractive entry point for fresh capital. Our Technical Indicator (TI) has fully recovered from oversold levels and now sends a neutral message. S&P Financials (Overweight) The pace of improvement in our financials cyclical macro indicator (CMI) has not abated. However, the usual tight correlation between the CMI and the relative performance of the S&P financials index has broken down. An important culprit has been the heavyweight S&P banks sub-index and its transition from a correlation with the 10-year UST yield and toward the 10/2 yield curve slope earlier this year (top and second panels, Chart 17). While the former is still up year-over-year, the latter has continued to flatten and the result is likely a squeeze on banks' net interest margins, a key profit driver; we recently booked gains of 6% and removed it from the high-conviction overweight list, and the S&P banks index is currently on downgrade watch. Chart 16S&P Financials (Overweight) S&P Financials S&P Financials Chart 17Growth And Credit Quality Offset A Flat Yield Curve Growth And Credit Quality Offset A Flat Yield Curve Growth And Credit Quality Offset A Flat Yield Curve Still, our key three reasons for being overweight the S&P financials index remain unchanged. Rising yields and the accompanying higher price of credit are a boon to financials and a core BCA theme for 2018 remains higher interest rates. The global capex upcycle, another of BCA's key themes for 2018, has paused for breath, though it has been replaced by soaring U.S. demand. This exceptional willingness of U.S. CEOs to expand their balance sheets should mean capital formation will proceed at well above-trend pace, and further underpin C&I loan growth (third panel, Chart 17). Lastly, a low unemployment rate drives both expanding consumer credit and much better credit quality. At present, the unemployment rate is testing all-time lows, sending an unambiguously positive message for financials profitability (bottom panel, Chart 17). Market bearishness has more than offset the positive fundamentals and the S&P financials index has underperformed in 2018; the result has been a steep fall in our VI to nearly one standard deviation below normal. The bearishness is also reflected in our TI which has recently collapsed into oversold territory. S&P Consumer Staples (Overweight) Our consumer staples CMI has moved sideways since our last update, near a depressed level. This is reflected in the share price performance; defensives in general and staples in particular have been woefully unloved this year. However, we believe positive macro undercurrents have made bargain basement prices in consumer staples an exceptional deal, particularly for investors willing to withstand short term volatility for a long-term investment gain. We recently pointed out that, while non-discretionary demand is losing share versus overall outlays, spending on essentials as a percentage of disposable income is gaining steam. The bearish read on this would be that this could be a pre-cursor to recession, but our interpretation is that latent staples-related buying power may make a comeback from a still very depressed level and kick-start industry sales growth (top panel, Chart 19). Chart 18S&P Consumer Staples (Overweight) S&P Consumer Staples S&P Consumer Staples Chart 19Staples Are Poised For A Recovery Staples Are Poised For A Recovery Staples Are Poised For A Recovery Meanwhile consumer staples exports are flying in the face of a rising U.S. dollar, which has typically presaged relative earnings gains (second panel, Chart 19). Considering the already-strong industry return on equity, any relative earnings gains should result in a valuation rerating (third panel, Chart 19). Both our VI and TI concur; as they are both more than a standard deviation below fair value. S&P Health Care (Neutral) Earlier this month, we lifted the S&P pharma and biotech indexes to neutral and, given that these sectors command roughly a 50% weighting in the S&P health care sector, these upgrades also lifted the health care sector to a neutral portfolio weighting. Sentiment has moved squarely against the sector and the bar for upward surprises has been lowered enough to create fertile ground for upside surprises. As shown in the second panel of Chart 21, health care long-term EPS growth expectations have never been lower in the history of the I/B/E/S/ data. This is contrarily positive, particularly given how our VI has remained under pressure and our TI has sunk. Chart 20S&P Health Care (Neutral) S&P Health Care S&P Health Care Chart 21Peak Pessimism In Health Care Peak Pessimism In Health Care Peak Pessimism In Health Care Still, our health care CMI has been treading water at relatively low levels, but our S&P health care earnings model suggests that at least a bottom in profit growth has formed (bottom panel, Chart 21). S&P Technology (Neutral) We lifted the S&P technology index to neutral earlier this year to capitalize on one of BCA's key themes for 2018: synchronized global capex upcycle, of which the broad tech sector is a core beneficiary (second panel, Chart 23).2 Software and tech hardware & peripherals are the two key sub-indexes we prefer and have also put on our high-conviction overweight list. Chart 22S&P Technology (Neutral) S&P Technology S&P Technology Chart 23A Capex Upcycle Should Sustain High Valuations A Capex Upcycle Should Sustain High Valuations A Capex Upcycle Should Sustain High Valuations There is still pent up demand for tech spending that is being unleashed following over a decade of severe underinvestment. In addition, consumer spending on tech goods is also at the highest level since the history of the data, underscoring that end demand is upbeat (third panel, Chart 23). On the global demand front, EM Asian exports are climbing at the fastest clip in ten years; tech sales and EM Asian exports are historically joined at the hip and the current message is positive (bottom panel, Chart 23). The technology CMI has also turned positive this year after falling for the previous three, though an appreciating dollar and higher interest rates continue to suppress an otherwise exceptionally robust macro environment. Valuations, while still in the neutral zone, have reached their highest level in a decade. This may prove risky should inflation mount faster than expected; a de-rating phase in technology would likely follow. Our TI is in overbought territory, though it has been at this high level for several years. S&P Utilities (Neutral) Our utilities CMI appears to have found a bottom, arresting the linear downtrend of the previous decade. Declining earnings have steadied out as the industry has found some discipline; new investment has declined and turbine & generator inventories have ticked up (second panel, Chart 25). The result of declining investment has been a slight improvement in capacity utilization, albeit still at a relatively low level (third panel, Chart 25). Chart 24S&P Utilities (Neutral) S&P Utilities S&P Utilities Chart 25Earnings Are Looking For A Bottom Earnings Are Looking For A Bottom Earnings Are Looking For A Bottom The uptick in capacity utilization has driven a surge in industry pricing power, despite flat natural gas prices which have historically been the industry price setter; this could be the precursor to a recovery in sector earnings (bottom panel, Chart 25). Still, as with other defensive sectors, utilities have underperformed cyclical sectors in the last year; this has been exacerbated by utilities trading as fixed income proxies. Our VI does not provide much direction as it has been in the neutral zone for the past year, underscoring our benchmark allocation recommendation. Our TI fell steeply earlier this year, though it has recovered and offers a neutral reading. S&P Materials (Neutral) The materials CMI has come under pressure as the Fed has continued to tighten monetary policy. A further selloff in bonds remains the BCA view for 2018, implying rising real rates will weigh on the sector for at least the remainder of the year. The heavyweight chemicals component of the materials index typically sees earnings (and hence stock prices) underperform as real interest rates are moving higher (real rates shown inverted, top panel, Chart 27). Chart 26S&P Materials (Neutral) S&P Materials S&P Materials Chart 27This Time Is Different For Chemicals This Time Is Different For Chemicals This Time Is Different For Chemicals On the operating front, chemicals sector productivity has made solid gains over the past year and the sell-side bearishness for much of the past decade has finally reversed (second panel, Chart 27). Further, overcapacity, the usual death knell of the chemicals cycle, seems to be a thing of the past as the industry has massively scaled back on capital deployment on the heels of a mega global M&A cycle (third panel, Chart 27). Net, operating improvements might offset macro headwinds. Our VI echoes this neutral message and sits on the fair value line. Our TI is somewhat more bullish and is edging toward an oversold position. S&P Real Estate (Underweight) Our real estate CMI looks to have found a bottom earlier this year, though the only time it has been worse was during the Great Financial Crisis. Real estate stocks are continuing to behave like fixed income proxies, as they have since the overhang from the GFC gave way to a yield focus (top panel, Chart 29). In the context of a tightening monetary backdrop, we would need compelling operating or valuation reasons to maintain even a benchmark allocation in the sector; these are both absent. Chart 28S&P Real Estate (Underweight) S&P Real Estate S&P Real Estate Chart 29Dark Clouds Forming Dark Clouds Forming Dark Clouds Forming On the operating front, the commercial real estate (CRE) sector is waving a red flag. The occupancy rate has clearly crested and rents are headed down with it, warning of declining sector cash flows (second panel, Chart 29). While CRE credit quality shows no signs of deterioration, at this stage of the cycle and given weak industry profit fundamentals we would caution against extrapolating such good times far into the future (third panel, Chart 29). We recently initiated a trade to capitalize on relative CRE weakness by going long the S&P homebuilding index/short the S&P REITs index.3 Such overwhelming bearishness would suggest the sector would be relatively cheap, but our VI suggests that REITs are fairly valued. Our TI is has been unwinding an oversold position and is now in neutral territory. S&P Consumer Discretionary (Underweight) In early March, we identified three key factors that we expected to weigh on the consumer discretionary sector: a rising fed funds rate, quantitative tightening and higher prices at the pump. As highlighted in Chart 31, all of these factors remain intact and underlie the two-year decline in the consumer discretionary CMI. Chart 30S&P Consumer Discretionary (Underweight) S&P Consumer Discretionary S&P Consumer Discretionary Chart 31The Amazon Effect The Amazon Effect The Amazon Effect Further, were we to exclude AMZN from the day the S&P included it in the SPX and the S&P 500 consumer discretionary index (November 21st, 2005), then the vast majority of consumer discretionary stocks are actually following the typical historical relationship with the Fed's tightening cycle (fed funds rates shown inverted, top panel, Chart 31). Put differently, the equal weighted S&P consumer discretionary relative share price ratio is indeed following the Fed's historical tightening path (bottom panel, Chart 31). Meanwhile, our VI has broken out to nearly its highest level ever which we believe is largely a function of the decreasing diversification of the S&P consumer discretionary index as AMZN now represents nearly a quarter of its market value, and about to get even larger in the upcoming introduction of the Communications Services GICS1 sector, but only comprises 3% of this sector's net income. Our TI agrees with our VI and is well into overbought territory. S&P Telecommunication Services (Underweight) Our telecom services CMI, bounced off its 30-year low earlier this year, but not nearly enough for a bullish position to be established. Rather, our bearish thesis remains unchanged: A combination of still-tepid pricing power weighing on earnings (second panel, Chart 33), weak consumer spending (bottom panel, Chart 33) and higher Treasury yields (which are negatively correlated with high-dividend yielding telecom services stocks, top panel, Chart 33), should all keep relative performance suppressed. Chart 32S&P Telecommunication Services (Underweight) S&P Telecommunication Services S&P Telecommunication Services Chart 33Pricing Power Is Still On Hold Pricing Power Is Still On Hold Pricing Power Is Still On Hold Valuations have fallen significantly - our VI continues to touch new lows - and our TI has been indicating a persistently oversold position, but we think the industry is in a de-rating phase, implying the new valuation paradigm has a degree of permanence. Size Indicator (Favor Large Vs. Small Caps) Our size CMI has fallen back to the boom/bust line. Keep in mind that this CMI is not designed as a directional trend predictor, but rather as a buy/sell oscillator; the current message is neutral. Despite the neutral CMI reading, we downgraded small caps earlier this year,4 and moved to a large cap preference, based on the diverging (and unsustainable) debt levels of small caps vs. their large cap peers (top and second panels, Chart 35). We expect the divergence in leverage and stock price to be rationalized as it usually has: via a fall in the latter. Chart 34Size Indicator (Favor Large Vs. Small Caps) Style View Style View Chart 35Small Cap Leverage Is Critical Small Cap Leverage Is Critical Small Cap Leverage Is Critical Our call has thus far been slightly offside as small caps have been outperforming: investors have sought the trade-friction free shelter that small caps offer compared with internationally exposed large caps. Extreme optimism also reigns throughout the small cap world (third panel, Chart 35). However, we continue to think a turn is merely a matter of time; the NFIB's "good time to expand" reading is at its highest level in the history of the survey (bottom panel, Chart 35) which means small cap CEOs are more likely to push their already-stretched balance sheets closer to the breaking point. Our TI is telling us that small caps are overbought, but the VI continues to offer a neutral message. Chris Bowes, Associate Editor chrisb@bcaresearch.com 1 Please see BCA U.S. Equity Strategy Insight Report, "How Expensive Is The SPX?" dated July 6, 2018, available at uses.bcaresearch.com. 2 Please see BCA U.S. Equity Strategy Weekly Report, "Buying Opportunity," dated April 9, 2018, available at uses.bcaresearch.com. 3 Please see BCA U.S. Equity Strategy Special Report, "UnReal Estate Opportunity," dated July 9, 2018, available at uses.bcaresearch.com. 4 Please see BCA U.S. Equity Strategy Special Report, "UnReal Estate Opportunity," dated July 9, 2018, available at uses.bcaresearch.com.

Telecom services stocks rallied Tuesday, following positive news coming out of VZ's sellside analyst presentation. The mood was generous enough that our high-conviction underweight recommendation was stopped out at a 10% relative return.1 We are accordingly compelled to remove the S&P telecom services index from our high-conviction list for an impressive relative gain of 10% in the three months since we initiated the trade.2 Still, our bearish thesis remains unchanged: A combination of still-contracting pricing power weighing on earnings (second panel) and higher Treasury yields (which are negatively correlated with high-dividend yielding telecom services stocks, top panel) should keep relative performance suppressed. Valuations have fallen significantly (the reason we added the stop in the first place, bottom panel) but we think the industry is in a de-rating phase, implying the new valuation paradigm has a degree of permanence. Bottom Line: Stay underweight the telecom services index but remove it from the high-conviction list. The ticker symbols for the stocks in this index are: BLBG: S5TELS - T, VZ, CTL. A Telco Rally Ends Our Trade A Telco Rally Ends Our Trade 1 Please see BCA U.S. Equity Strategy Insight Report, "Merger Mania Keeps The Telco Bears Happy," dated May 11, 2018, available at uses.bcaresearch.com. 2 Please see BCA U.S. Equity Strategy Weekly Report, "Manic-Depressive?" dated February 12, 2018, available at uses.bcaresearch.com.

Underweight (High Conviction) News of a renewed attempt at a merger between Sprint and T-Mobile has weighed heavily on shares in the S&P telecom services index. Shares sold off on fears that a mightier competitor with the heft to invest in a 5G network would continue the price deflation of the past several years, which has only recently started to turn a corner (second panel). It has only been three months since we downgraded the S&P telecom services index to underweight and added it to our high-conviction list. A combination of negative headlines and higher Treasury yields (which are negatively correlated with high-dividend yielding telecom services stocks, top panel) has meant that our trade has racked up an impressive 13.5% gain versus the broad market in a short time. While S&P telecom services remains a high-conviction underweight, such rapid gains are likely unsustainable, particularly in the context of already-deeply discounted valuations (bottom panel). Bottom Line: Stay underweight the telecom services index. From a portfolio management perspective, this morning we suggest that clients institute a stop in this high-conviction call at the 10% relative return mark, in line with our late-January introduced risk management policy.1 The ticker symbols for the stocks in this index are: BLBG: S5TELS - T, VZ, CTL. 1 Please see BCA U.S. Equity Strategy Weekly Report, "Too Good To Be True?" dated January 22, 2018, available at uses.bcaresearch.com. Merger Mania Keeps The Telco Bears Happy Merger Mania Keeps The Telco Bears Happy