Corporate

Highlights Portfolio Strategy Media stocks are poised to challenge previous relative performance highs as sales growth reaccelerates. Stay overweight. The materials sector has lagged behind the commodity price rally, a sign of underlying weakness rather than latent strength. Chemicals overcapacity will remain a headwind until U.S. competitiveness improves. Stay clear. Recent Changes There are no changes to our portfolio this week. Table 1Sector Performance Returns (%) Feature The broad market has been very strong since the November election. While advance/decline lines have firmed, participation in the rally has been uneven and may be fraying around the edges. For example, the number of groups trading above their 40-week moving average has been diverging negatively from the broad market in the last few months, suggesting diminishing breadth (Chart 1). In fact, the industrials (I) and financials (F) sectors have carried the market since November. Other deep cyclical sectors, such as energy, materials and tech, have mostly matched market performance. The 'IF' rally is based on an expected upgrade to the economic growth plane that matches the surge in various sentiment gauges. If validation does not occur, then the IF rally will become iffy indeed, unless sector breadth improves. Last week we showed that market cap-to-GDP was so far above its long-term average that even if nominal growth boomed at 8% per annum for the next five years this valuation ratio would still not have normalized. That valuation backdrop may not upend additional short-term market momentum, but it is a true measure of just how bullish sentiment has become and should be a critical input to the portfolio construction process, because of its warning about divergences from fundamental supports. Another unconventional sentiment gauge is observed from sub-surface market patterns. Chart 1 shows that the number of defensive groups with a positive 52-week rate of change, in relative terms, is in freefall, plunged to virtually nil. In the last two decades, investors eschewing capital preservation and non-cyclical sectors so aggressively has typically preceded major market peaks (Chart 1). The steep drop in the put/call ratio confirms that euphoria and greed are trumping mistrust and fear. The put/call ratio has recently bounced, but is well below levels that signal investors are accumulating significant portfolio protection. The Fed's tightening bias, contracting U.S. dollar-based financial liquidity amid the strong U.S. dollar all threaten to keep a lid on corporate sector sales prospects. As such, we remain biased toward non-cyclical and consumer sectors, even excluding fiscal policy uncertainty. Chart 2 shows that these areas are in a base-building phase, in relative terms, following their post-election drubbing. We expect momentum to steadily build toward sustained outperformance by midyear. Conversely, a reversal in the 'IF' sectors already appears to be developing, while other capital spending-dependent sectors are unable to gain momentum (Chart 3). This week we highlight both a winning group and an area we expect to disappoint. Chart 1The Rally Is Fraying Around The Edges Chart 2Defensive Base-Building? Chart 3Cyclical Sector Distribution New Highs Ahead For Media While the consumer discretionary sector has a poor track record during Fed tightening cycles, the S&P media sub-component can buck this trend. Media stocks outperformed in the second half of the 1990s and also trended higher in the 1980s while the Fed was tightening. The key was the U.S. dollar (Chart 4). As long as the dollar was strong, media companies sustained a profit advantage over the rest of the corporate sector owing to limited external exposure. A replay is currently playing out, and has the potential to persist for at least the next few quarters based on upbeat cyclical indicators. Media sales growth is in recovery mode. Consumers have significantly boosted spending on media services, as measured by personal consumption expenditures data (Chart 5). Pricing power has surged in response to demand strength (Chart 5, bottom panel). In turn, strong demand is boosting measures of productivity: our proxy for sales/employment is accelerating toward the double-digit growth zone (Chart 5). Productivity is diverging positively from relative forward earnings expectations, implying there is room for a re-rating. As long as the U.S. economy is growing, media companies should be able to garner an increasing share of consumer wallets. Chart 6 shows that real spending on media services has been in a steady uptrend for well over a decade, reflecting its ability to continually innovate, only pausing during recessions when consumers are forced to retrench. Typically, a rise in spending pulls up pricing power (Chart 6). Chart 4Media Stocks Like Dollar Strength Chart 5Sales Are Set To Accelerate Chart 6Secular Strength All of this has spurred a recovery in media cash flow growth (Chart 7, top panel). Relative performance and cash flow move hand-in-hand. Rising cash flows also imply that the media sector can further reduce shares outstanding through buybacks and/or M&A activity (Chart 7), bolstering ROE. The S&P movies & entertainment index has been one of the driving forces behind the broader media index recovery. We upgraded the former to overweight after the vicious selloff related to Disney's ESPN woes and the takeover saga at Viacom had pushed the index to an undervalued extreme. While slightly early, this upgrade is now paying off (Chart 8). The expectations hurdle remains surmountable. Both forward earnings and sales growth estimates are deeply negative (Chart 8), reflecting the well-known cooling in cable subscriber growth. But even here, there is room for potential upside surprises. Consumer spending on recreation has been growing at a low single-digit clip, but the surge in consumer confidence, courtesy of rising wage growth and a positive wealth effect from rising real estate and financial asset prices, should support increased discretionary consumer spending. The message from the jump in the ISM services index is bullish for recreation spending (Chart 9, second panel). Chart 7Shareholder-Friendly Chart 8Cheap With Low Expectations Chart 9Still Early In The Recovery In turn, faster spending would support ongoing pricing power gains (Chart 9). The industry is already sporting one of the most robust selling price increases of all that we track, as advertising rate inflation is growing anew. Importantly, real outlays on cable services have recovered after a steep decline (Chart 9), suggesting that the drag from disappointing cable subscriber growth and cord cutting may be easing. Less churn implies more pricing power. Content cost inflation also remains under wraps. The implication is that the fundamental forces to propel a retest of previous relative performance highs are in place. Technical conditions are also sending a bullish signal. Cyclical momentum, as measured by the 52-week rate of change, is on the cusp of breaking into positive territory (Chart 9), while the share price ratio has already crossed decisively above key resistance at its 40-week moving average. A dual breakout would confirm a new bull trend. Bottom Line: Media stocks have good odds of retesting previous relative performance highs as discretionary consumer spending perks up. Stay overweight the overall media group, and the S&P movies and entertainment index in particular. Chemical Stocks: A Toxic Portfolio Blend The commodity price recovery has not carried over into the S&P materials sector, as relative performance has been moving laterally for much of the last twelve months. Rather than view this as an opportunity to play catch up, the more likely outcome is that the sector has missed its chance to outperform. In fact, downside risks have intensified. The strong U.S. dollar will exact a toll on U.S. exporters, particularly if emerging markets and China do not experience accelerating final demand. While there has been a massive amount of stimulus in China over the past 18 months, the thrust of that impulse is fading. Fiscal spending growth has dropped sharply and the authorities trying to cool rampant real estate speculation. The yield curve remains flat (Chart 10), as local funding costs rise on the back of the authorities attempt to mitigate capital outflows, and loan demand remains weak. Persistent weakness in the Chinese currency may reflect a lack of confidence in local returns, i.e. sub-par growth. All of that argues against expecting a major impetus to raw materials demand, at a time when the materials sector total wage bill is inflating more aggressively. Our Cyclical Macro Indicator for the materials sector is hitting new lows (Chart 10), heralding earnings underperformance, underscoring that below-benchmark allocations remain appropriate. The S&P chemicals group represents for than 70% of the overall materials market cap. It has underperformed since its peak and our underweight call in 2014, pulled lower by the soaring U.S. dollar and sagging industry productivity (Chart 11). Net earnings revisions have been consistently revised lower over the past few years, and are unlikely to recover without a reflationary push (global real yields are shown inverted, second panel, Chart 11) that revives chemical final demand. Analysts have latched on to the firming in global purchasing manager survey sentiment, aggressively pushing up sales growth expectations in recent months (Chart 12). Clearly, manufacturing sector expansion is expected to reverse the contraction in chemical output growth (Chart 12). Chart 10Higher PMIs Are Not Enough Chart 11Higher Yields Are A Bad Omen Chart 12Expectations Are Inflated However, this may be yet another case of analysts chronically overestimating the industry's earnings power. Global manufacturing improvement seems likely to accrue mostly to firms outside the U.S. Chart 13 shows that chemicals relative performance is heavily influenced by the U.S. dollar. Valuations and sentiment are tightly linked with chemical export growth (Chart 13), as the latter represent 14% of total U.S. exports. The U.S. dollar surge is diverting orders away from U.S. manufacturers: German chemical new orders have surged, and the IFO survey of chemical industry executives signals optimism about the future (Chart 14). Chart 13The Dollar Is Hurting The U.S. ... Chart 14... But Helping Foreign Competitors U.S. executives appear to be equally confident, but that optimism is misplaced. The American Chemical Council expects U.S. chemical exports to increase 7% a year through 2021. Over $170B is expected to be invested in U.S. chemical manufacturing capacity, representing nearly 25% of the total industry size, which is anticipated to boost the chemical trade surplus to new records. So far, roughly $76B of projects has either been completed or is under construction. If these planned projects all come to fruition, our concern is that new capacity will be idle rather than productive. The industry is in the crosshairs of anti-globalization and protectionism, and a strong U.S. dollar and rising domestic cost structures threaten to reduce competitiveness. Chemical imports are a fairly large portion of sales, rendering profitability vulnerable should an import-tax ever be introduced. From a cyclical standpoint, deflationary pressures are already very acute. Chemical capacity is growing much faster than production, warning that pricing power will be under significant pressure (Chart 15). Many chemical products are destined for interest rate-sensitive end markets such as autos, underscoring that a Fed tightening cycle is a headwind. While capacity expansion was planned when interest rates and feedstock costs were expected to remain at rock bottom levels for the foreseeable future, this is no longer the case. Chemical companies can either use natural gas (ethane) or oil (naphtha) as a primary feedstock. U.S. production is largely ethane-based, while global capacity is geared to naphtha. Rising U.S. natural gas prices are undermining the U.S. input cost advantage (Chart 16). Chart 15Persistent Deflation Pressures Chart 16U.S. Cost Structures Are Unattractive Increased capacity has also put significant upward pressure on wage costs, as our proxy for the total wage bill is rising at a high single-digit rate (Chart 16). With capital spending slated to stay robust in the coming years, it will likely continue to take a larger share of sales, impairing profit margins. While the planned merger between heavyweights Dow Chemical and Dupont may eventually help to rationalize costs, this is a necessary but not sufficient step in the face of a loss of global market share. Without accelerating sales, U.S. chemical makers will be hard pressed to improve productivity sufficiently to reverse the slide in relative forward earnings estimates. Bottom Line: The S&P materials sector hasn't been able to outperform during a period of improving global manufacturing activity, raising doubts about its performance potential when global output growth inevitably slows. Part of this reflects the challenging outlook for the sector heavyweight chemicals index, and we recommend staying underweight both. The symbols for the stocks in this index are: BLBG: S5CHEM - APD, ARG, CF, DOW, EMN, ECL, DD, FMC, IFF, LYB, MON, MOS, PPG, PX, SHW. Current Recommendations Current Trades Size And Style Views Favor small over large caps. Favor growth over value (downgrade alert).

Special Report

Feature China's corporate debt problem has been widely perceived as an alarming systemic risk - not only to China but also to the rest of the world. This has prompted a deep concern within the investment community, and has also become a major consideration in China's policy setting in recent years. This grand judgement, however, is almost entirely derived from observing the rapid increase in China's debt-to-GDP ratio. In our previous reports, we discussed various reasons behind China's rising debt-to-GDP ratio, with focus on looking beyond this widely scrutinized conventional indicator in search of the true leverage situation.1 This week, we further explore this path with bottom-up data-mining by looking at key leverage ratios of listed companies. Our latest findings confirm our previous conclusions that the Chinese corporate sector leverage situation is not as precarious as widely perceived both historically and in a global context. A "Bottom-Up" Glance From a bottom-up perspective, we gathered several key ratios to examine the leverage situation of Chinese-listed companies in comparison to their global peers. The ratios are broadly grouped into two categories to check leverage ratios and debt servicing capacity, respectively (Please refer to Appendix 1 for description of the ratios and indexes we used in our calculation). Leverage ratios include liability-to-assets, calculated as total liabilities to total assets and total debt-to-assets, which only includes interest-bearing debt on a company's balance sheet. Moreover, we also look at the cash-to-asset ratio to evaluate the "net debt" situation. Debt servicing ratios include net debt-to-EBITDA and interest coverage ratio, which is defined as EBITDA divided by interest expenses. A higher net debt-to-EBITDA ratio means higher debt obligations relative to profits, and is therefore an indication of more financial stress. Similarly, a lower interest coverage ratio implies more difficulties in honoring interest payment obligations, let alone principal, and is therefore an indication of higher vulnerability to default. Leverage Ratios Chinese-listed companies' median liability-to-asset ratio has increased marginally, from 55% prior to the global financial crisis to about 60% currently (Chart 1). This is roughly comparable to the ratio calculated by using the top-down data provided by the Chinese National Bureau of Statistics (NBS).2 Measuring only interest-bearing debt, the median debt-to-asset ratio is about 25%, rising in recent years but largely comparable to pre-crisis levels. Moreover, companies' holdings of cash and short-term investments make up 15% of total assets. As a result, the net debt-to-asset ratio is a mere 12%, according to our calculations. In all leverage ratios, the ones of Chinese firms do not look exceptionally high compared with other major markets (Chart 2). In fact, the Chinese ratios sit almost exactly in the middle of a global comparison (Please refer to Appendix 2 on page 8 for detailed historical data of other countries). Chinese companies' cash holdings appear high compared with other countries, ranking the second highest in our sample. This is probably because Chinese companies' access to bank loans or the commercial paper market is not as easy or reliable as in other countries where financial markets are more developed. Chinese regulators frequently change policies on bank loans, making companies' access to bank loans and other credit instruments unpredictable. Therefore, Chinese companies may have been forced to hoard large sums of cash to meet working capital needs. This is obviously suboptimal and inefficient, but also gives the corporate sector more flexibility in dealing with debt. Chart 1Chinese Leverage Ratios Chart 2Leverage Ratios In Global Context Net Debt-To-EBITDA Ratio The net debt-to-EBITDA ratio measures a company's debt obligations to its income-generating ability. Chinese firms' net debt-to-EBITDA ratio has increased in the past five years, which means their debt servicing capacity has indeed deteriorated (Chart 3, to panel). Moreover, with a median ratio of 1 and an average of 2, the ratio implies that larger firms, likely state-controlled in asset-heavy industries, have a more challenging debt-servicing problem, which is consistent with anecdotal evidence. Nonetheless, Chinese firms' net debt-to-EBITDA does not appear high compared with other markets (Chart 4 top panel). In fact, the median of Chinese firms' net debt-to-EBITDA ratio is among the lowest, according to our calculation. Conventional wisdom holds that a net debt-to-EBITDA ratio higher than 4 or 5 normally raises a red flag in terms of debt servicing issues. Using this measure, the debt situation of Chinese firms has indeed deteriorated significantly. Currently, about 30% of Chinese-listed companies have a net debt-to-EBITDA of higher than 4, up from 15% before the crisis (Chart 3, bottom panel). Nonetheless, similar deterioration has also been observed in almost all of our sample markets. The bottom panel of Chart 4 shows a similar percentage of firms in other countries with a net debt-to-EBITDA ratio over the threshold of 4. Chart 3Chinese Net Debt-To-EBITDA##br## Has Deteriorated... Chart 4...But Not Exceptional ##br## In Global Context Interest Coverage Ratio Interest Coverage ratio measures EBITDA relative to interest expenses, and therefore a lower reading indicates a greater probability of default and insolvency. The median interest coverage ratio of Chinese-listed companies has dropped from a peak of over 10 to about 6 in recent years, while the average has dropped even further - from 6 to 4 - both of which underscore a notable deterioration in debt servicing capacity (Chart 5, top panel). Similarly, the gap between the average and median interest coverage ratios of Chinese firms suggests that larger firms tend to have a worse debt situation than smaller ones. Chinese firms' interest coverage ratio is also right in the middle in our global comparison (Chart 6, top panel). Moreover, a key factor to consider is interest rates in these countries, as lower interest rates certainly help improve interest coverage, and vice versa. It is therefore not surprising that Japan, with its near-zero interest rates, has the higher interest coverage ratio, and Brazil the lowest. Companies with an EBITDA lower than interest expenses certainly are much more prone to default, and are sometimes regarded as "zombie" firms. Currently, over 6% of Chinese firms cannot cover interest expenses with current-year EBITDA, roughly unchanged in the past decade (Chart 5, bottom panel). Other markets also have a similar share "zombie" firms with an interest coverage ratio lower than 1, implying that Chinese firms do not look exceptional in a global context (Chart 6, bottom panel). Chart 5Chinese Interest Coverage Ratio ##br##Has Also Deteriorated... Chart 6...But Does Not Stand Out ##br##In Global Comparison Summary And Conclusions We remain skeptical about the widely held consensus that China's corporate sector leverage is dangerously high. At minimum, we believe it is inaccurate to solely rely on the debt-to-GDP ratio to reach such a crucial conclusion. Our extensive data exercise, both from the top down and the bottom up, suggest that China's leverage situation is comparable if not superior to its global peers. There are indeed signs of deterioration in leverage ratios and debt servicing capacity in recent years among Chinese firms, but the growth slowdown is at least partially to blame, as similar deterioration is also visible in other countries.3 From policymakers' point of view, boosting aggregate demand, lowering the cost of funding and improving operational efficiency should all be part of the solution to address the debt sustainability issue. From investors' perspective, we hold the view that Chinese equities, particularly H shares, have been unduly punished by macro concerns on corporate debt, and will be re-rated as this misperception unwinds. Yan Wang, Senior Vice President China Investment Strategy yanw@bcaresearch.com Sheng Kong, Research Assistant shengk@bcaresearch.com 1 Please see China Investment Strategy Special Reports, "Chinese Deleveraging? What Deleveraging!" dated June 15, 2016, and "Rethinking Chinese Leverage," dated October 27, 2016, available at cis.bcaresearch.com. 2 Please see China Investment Strategy Special Report, "Rethinking Chinese Leverage," dated October 27, 2016, available at cis.bcaresearch.com. 3 A detailed study on U.S. corporate leverage situation was also conducted by BCA U.S. group. Please refer to "U.S. Corporate Health Gets A Failing Grade" dated January 28, 2016 published by The Bank Credit Analyst, available at bca.bcaresearch.com. Appendix 1 Table 1Indexes Used In Cross-Country Comparison Table 2Leverage Ratios Appendix 2 Chart 7 Chart 8 Chart 9 Chart 10 Chart 11 Chart 12 Chart 13 Chart 14 Chart 15 Chart 16 Chart 17 Chart 18 Chart 19 Chart 20 Chart 21 Chart 22 Cyclical Investment Stance Equity Sector Recommendations

Highlights BCA's U.S. Equity Strategy team would like to wish our clients a healthy, happy and prosperous New Year. Portfolio Strategy The growth vs. value style bias is due for a bounce, but beyond the near run, the outlook has become more balanced. Stick with a small vs. large cap bias for the time being, but get ready to book profits if domestic wage inflation continues to accelerate. Buy into the health care facilities sell-off. Value is surfacing as profit margin pressures subside. Recent Changes S&P 1500 Health Care Facilities - Boost to overweight today. Downgrade Alert Growth vs. Value - Downgrade alert. Table 1Sector Performance Returns (%) Feature Stocks look poised to maintain their momentum-fueled march higher into yearend, seemingly impervious to potential profit backlash from tightening monetary conditions, a more hawkish Fed and/or overheating sentiment. Sellers are holding back in anticipation of lower tax rates next year. In fact, our Composite Sentiment Gauge has surged to extremely bullish levels (Chart 1). This gauge comprises surveys of traders, individuals and investment professional sentiment. Overtly bullish readings have been a reliable contrary indication of building tactical risks, although not foolproof. The broad market has returned nearly 80%, excluding dividends, since the beginning of 2012, and over 5% since election night in November. Lately, earnings expectations have increased their contribution to the market's return, but the vast majority of the gains over the last five years can be explained by multiple expansion. Soaring median industry price/sales ratios are consistent with lopsidedly optimistic sentiment (Chart 1). Now that the Fed has signaled its intention to steadily raise interest rates in 2017, a critical question is whether profits can take over the reins from liquidity as the main market driver, at least partially validating the valuation increase? On this front, our confidence level is low. Profit margins are steadily narrowing. Our profit margin proxy is not signaling any imminent relief (Chart 2). With labor costs rising, faster sales are needed to halt the squeeze. But U.S. dollar appreciation is a significant headwind to top-line performance, given that 45% of sales come from abroad. As hedges fall off, the impact on 2017 revenue will become increasingly meaningful. Corporate debt levels are disturbingly high, in absolute terms and as a share of GDP (Chart 2, bottom panel). If borrowing costs continue to climb, then it will be hard for companies to turn expansionist, potentially offsetting any benefit from a reduced tax rate. Against this backdrop, it is difficult to envision a robust rebound in corporate profits. Our confidence level would be higher if monetary conditions were still reflationary. Instead, our Reflation Gauge (RG), a combination of oil prices, Treasury yields and the U.S. dollar, has plummeted at its fastest rate ever (Chart 3)! The speed and ferociousness of the plunge underscores the economic need for a massive and imminent fiscal offset. Chart 1Sentiment Is Overheating Chart 2Stiff Headwinds For The Corporate Sector Chart 3Reflation Is Dead The RG leads both equity sentiment and the U.S. Economic Surprise Index (ESI, Chart 3). If economic activity begins to disappoint in the coming months, i.e. before any meaningful fiscal stimulus arrives, there is a window of risk for the equity market because valuations will narrow as optimism fades, especially in those sectors that have gone vertical since the U.S. election. Keep in mind, last week we showed that typical Fed tightening cycles augur well for non-cyclical sector relative performance on a 12 and 24 month horizon. Surprisingly, financials and utilities have also managed to at least keep pace with the broad market, with cyclical sectors lagging behind overall market returns. The bottom line is that a number of objective indicators are signaling that the post-election rally will hit turbulence, perhaps in the first quarter of the New Year. Investors would be well served from a cyclical perspective to take advantage of value creation in defensive sectors while reaping any windfalls received in deep cyclical sectors. Will Growth Vs. Value Recover? The sudden surge in the financials and industrials sector has caused a sharp correction in the growth vs. value (G/V) share price ratio. The scope of the move has been both powerful and unnerving, catching many off guard, including us. Is this the start of a value renaissance after nearly eight years of growth stock dominance? History shows that sustained rotations into the value complex require validation from strengthening global economic growth. We have shown in previous research that G/V share price momentum is negatively correlated with the growth in durable goods orders, house prices and profits, i.e. when these variables accelerate, growth underperforms value. By virtue of the improvement in our global PMI composite (Chart 4), it would be easy to conclude that value stocks are coming back in vogue. Financials, energy and industrials account for over 50% of the value composite. These sectors only comprise roughly 15% of the growth benchmark. In addition, the technology sector weighs in at one third of the growth index, while representing only 8% of the value cohort. In addition, consumer discretionary and health care also represent about the same weight as technology in the growth composite, but only contribute about half that in the value index. It is no wonder that rising bond yields and hopes for a fiscal stimulus bonanza have triggered such a violent G/V reaction. While we are sympathetic to this view, extrapolating the last six weeks to continue over the next six months is dangerous. Much of the Treasury yield advance has been driven by inflation expectations. Global real yields are up, but not by as much as share prices have discounted (Chart 5). That is not surprising, as the soaring U.S. dollar is a deflationary force, and heralds a sharp rebound in the G/V ratio (Chart 5, top panel). Chart 4A Vicious Correction... Chart 5... That May Soon Reverse U.S. currency strength will make it difficult for developing economies to service large foreign debt obligations and could drain domestic liquidity if they are forced to sell foreign exchange reserves to defend their currencies. It is notable that EM capital spending is virtually nil in real terms, and their share prices are underperforming the global benchmark by a wide margin (Chart 5). Our Global Economic Diffusion Index has crested (Chart 5, shown inverted), perhaps picking up emerging market sluggishness. Unless the U.S. dollar begins to weaken, it is premature to forecast robust economic growth in the coming quarters, thereby raising some skepticism about the durability of the value stock rebound. The objective message from our Cyclical Macro Indicators for the growth vs. value style is slowly shifting from bullish to neutral, and the pricing power advantage no longer exists (Chart 6). However, the latter is an unwinding of the rate of change shock in the commodity complex rather than renewed demand-driven pricing power gains in the deep cyclical space. From a longer-term perspective, growth stocks should stay well supported by the increase in long-term earnings growth expectations (Chart 7). When the latter are rising, growth stocks tend to enjoy multiple expansion relative to value shares. Moreover, if equity volatility perks up on uncertainty over the path and pace of future fiscal policy and a more hawkish Fed, then growth stocks should receive another source of natural support. The VIX and G/V indices tend to correlate positively over time (Chart 7). Chart 6Mixed Signals Chart 7Structural Supports In sum, choosing value over growth is not a slam dunk, nor is forecasting a recovery to new highs in the G/V ratio given the large sector weightings discrepancies. Rather, a reflex rally in the G/V ratio is probable as post-election financials/industrials sector enthusiasm wanes, with a lateral move thereafter. Bottom Line: We will likely recommend moving to a neutral style bias over the coming weeks/months from our current growth vs. value stance, but expect to do so from a position of strength. A Revival In Small Business Animal Spirits? A broad-based and powerful rotation into small caps has occurred, as all the major small cap sectors have surged relative to their large cap counterparts (Chart 8), flattering our current stance. Small caps fit nicely into one of our overriding longer-term themes, namely favoring domestic over global industries. Small companies are typically domestically-geared regardless of geography, underscoring that if anti-globalization trends pick up steam, this theme could gain traction around the world. The potential for U.S. corporate tax cuts has provided another source of domestic company enthusiasm, because multinationals already have low effective tax rates. However, these developments are not assured, details remain scant, and chasing small cap relative performance on that basis alone could be a mistake from a tactical perspective. We have noted that we would recommend profit taking if evidence of a reversal in the small vs. large cap profit outlook materialized. Recent labor market and pricing power data are slightly worrying. The NFIB survey of the small business sector showed that planned labor compensation is still diverging markedly from the overall employment cost index (Chart 9, second panel). While reported price changes have also nudged higher, the discrepancy in labor cost gauges may be signaling that the massive profit margin gap between small and large companies will not be quick to close (Chart 9, bottom panel). Still, the overall NFIB survey was strong, and suggests that animal spirits in the small business sector may finally be reawakening (Chart 10, second panel). The latter may reflect an easing in worries about government red tape, excessive bureaucracy and health care costs. Chart 8Broad-based Small Cap Outperformance Chart 9Yellow Flag For Margins Chart 10Overbought, But Not Overvalued These sentiment shifts may allow extremely overbought technical conditions for the relative share price ratio to persist for a while longer (Chart 10, middle panel), particularly if the Trump honeymoon phase for the overall market lasts until early in the New Year. Importantly, there is no meaningful valuation roadblock at the moment (Chart 10). From a longer-term perspective, however, it is notable that the share price ratio is trading well above one standard deviation from its mean. Such a stretched technical level warns against getting too comfortable with small caps. In fact, the share price ratio is tracing out a pattern similar to the early-1980s (Chart 11), when it enjoyed a brief run to new highs in 1983 on the back of similar aspirations of meaningful fiscal thrust and as the U.S. dollar sprang higher. However, that surge was short-lived and in hindsight, was a blow-off top that marked the beginning of a massive underperformance phase. Chart 11The Big Picture Bottom Line: Stick with a small/large cap bias for now, but get ready to take profits if the relative profit margin outlook does not soon improve. Buy Into Health Care Facilities Weakness Rapid sub-surface market gyrations are creating attractive value in a number of areas, particularly in the defensive health care sector. In particular, we downshifted our view on the S&P health care facilities index at mid-year, because consumer spending on health care was decelerating, which favored moving into equities that paid for medical services (managed care) vs. those that provided them. While that trend remains intact, health care facilities stocks appear to be discounting an extreme scenario. The current concern is that the Affordable Care Act (ACA) will be repealed, leaving hospitals to foot the bill for uninsured patients. While such a scenario would potentially reverse the decline in the provision for doubtful accounts (PDA, Chart 12), a major profit margin support, the ACA is more likely to be reworked than repealed especially in the absence of a replacement plan. Importantly, there are other offsets. PDA follows the unemployment rate, which is signaling that the former will decline further. Hospital cost inflation is beginning to recede, led by drug costs (Chart 12). Physician services costs and inflation in other medical supplies is also subsiding. Health care facilities have also reduced capital spending in a bid to protect profit margins. Construction data show that hospitals have eased back on the throttle significantly (Chart 13). A shift to a profit margin preservation mentality is confirmed by the sharp reduction in headcount growth and decline in total wage inflation (Chart 13). Labor cost control provides another positive profit margin support, over and above the fillip from the reacceleration in hospital pricing power (Chart 13). Consumers are allocating an increasing portion of their spending to hospitals, which provides confidence that pricing power gains will stick. It would take massive earnings downgrades to validate the pessimism embedded in current valuations (Chart 14). Technical conditions argue that the sell-off is overshooting. The share price ratio has made new lows, but cyclical momentum is diverging positively. Given that this group is traditionally a strong U.S. dollar winner (Chart 14, top panel), there is scope for a playable relative performance rally in the coming six months. Chart 12Hospital Costs Are Easing... Chart 13... While Sales Improve Chart 14Dirt Cheap Bottom Line: Augment the S&P 1500 health care facilities index (BLBG: S15HCFA - HCA, UHS, WOOF, HLS, LPNT, SEM, SCAI, THC, ENSG, USPH, KND, CYH, QHC) to overweight. Current Recommendations Current Trades Size And Style Views Favor small over large caps. Favor growth over value (downgrade alert).

Highlights Portfolio Strategy The rise in Treasury yields is approaching a threshold that has often caused equity market indigestion. Stay focused on current monetary conditions rather than fiscal unknowns. The bear market in lodging stocks has played itself out: take profits on an underweight position. The sell-off in home improvement retail shares is overdone, and a contrarian long position should pay off despite the backup in mortgage rates. Recent Changes S&P Hotels Index - Take profits of 3% and raise to neutral. Table 1Sector Performance Returns (%) Feature Momentum may carry the market higher in the short run, but from current valuation levels, stocks, the dollar and bond yields can only climb sustainably in tandem if a non-inflationary economic boom is taking hold. In that sense, equities appear to be taking their cue solely from the anticipated U.S. political shift while ignoring the tightening in monetary conditions and hints of emerging market financial strains. The equity market outlook hinges on a judgement call as to whether the action in the currency and Treasury yields is reflective or restrictive? There are no easy answers, but below we discuss some of the variables that influence this decision. Chart 1 shows that the 10-year Treasury yield has climbed above fair value. Equity bulls may rejoice because yields have sauntered much deeper into undervalued territory before stocks have run into trouble. The big difference this time is that the greenback is also climbing. Parallel powerful rises in both the currency and yields are rare, and typically culminate in steep market pullbacks. Importantly, most of the recent yield rise reflects an increase in inflation expectations. The real component, i.e. economic growth expectations, has been far more muted (Chart 2). Chart 1Stocks, Yields, And The Dollar##br## Can't Climb Together For Long Chart 2Inflation Expectations ##br##Are Driving Up Yields Equities shrugged off the surge in yields during the 2013 taper tantrum. However, yields never rose above fair value then, and the increase was almost entirely due to the real component rather than a rise in inflation expectations, i.e. it was more reflective than restrictive (Chart 2). Meanwhile, equities had just been through a difficult stretch in 2012 on fears the euro was going to break apart, and sovereign yields in the periphery were in the early stages of a long descent (Chart 3). In other words, there was a structural tailwind for equities. In addition, the U.S. dollar was range-bound during that period, overall profit growth was strong, business lending was picking up and corporate bond spreads stayed tight (Chart 3). The outlook today is much different. Euro area periphery yields are up sharply, EM bond spreads are flaring out, profit growth is much weaker and the U.S. is importing deflation through U.S. dollar strength (Chart 3), particularly against China and other developing market currencies. Thus, we are uncomfortable making comparisons between today and 2013 broad market resilience. The speed of upward adjustment in Treasury yields also influences equity prices. At the moment, yields are rising faster than profit growth. The overall market has typically become more volatile and often corrects when the growth in yields outpaces profit growth (Chart 4). Chart 3The 2013 Taper Tantrum##br## Is Not A Good Guide Chart 4Too Far,##br## Too Fast? The most painful equity corrections have occurred when this gauge drops below -10%, as the latter suggests that inflation expectations are increasing rapidly, warning of valuation and monetary tightening ahead. This threshold is in danger of being breached on any further rise in yields. However, if the currency continues climbing, yields are unlikely to rise much further, if at all, underscoring that the next big tactical sub-surface market move may be a recovery in yield-dependent sectors as investors begin to fret about the deflationary and profit-sapping impact of a strong dollar. Against this backdrop, we caution against getting too comfortable extrapolating market momentum, because recent gains could be erased just as quickly as they accrued if monetary conditions keep tightening. On a sub-surface basis, value is being created in interest rate-sensitive sectors and destroyed in cyclical sectors, primarily industrials, as discussed last week. Meanwhile, we maintain a domestic vs. global focus, and recommend buying into the pullback in housing stocks. Buy Home Improvement Retailers Like many other interest rate-sensitive groups, home improvement retailers (HIR) have lagged recently, fueled by the surge in bond yields, and hence, mortgage rates. We doubt this is sustainable. U.S. currency strength will refocus attention on the lack of top-line growth in global-oriented industries, which will reverse recent countertrend intra-sector capital flows, and ensure that bond yields are capped. The housing market slowed this year by most metrics (housing starts, permits, sales growth), which undermined remodeling activity. In response, building supply store sales cooled (Chart 5, bottom panel). Recent earnings reports from housing-geared industries such as appliances and furniture vendors have also disappointed. Analysts have been quick to slash both sales and earnings growth estimates (Chart 5). However, as often happens, an overreaction appears to be occurring. There is little indication of a return to punitively deflationary industry conditions. In fact, the producer price index for appliance and furniture makers has shot up in recent months, heralding stronger HIR pricing power (Chart 6, second panel). Lumber prices are also up sharply, despite U.S. dollar strength, which will boost the top-line and profit margins (Chart 6). At a fixed spread over lumber prices, the higher the latter go, the more profit earned at a constant volume sold. We continue to be encouraged by the long-term outlook. Household formation is accelerating now that the unemployment rate is below 5%. Building permits are below average levels, even excluding the housing bubble period (Chart 7). Chart 5Housing Slowdown Already Reflected Chart 6No Sign Of Deflationary Stress Chart 7Still Early In The Mortgage Cycle Consumers have only recently become comfortable taking on mortgage debt, and first time buyers represent a rising share of total home sales. Banks are ready and willing to extend mortgage credit (Chart 7, bottom panel), unlike most other credit. Ergo, housing activity still has legs. While the backup in Treasury yields will no doubt make housing somewhat less affordable, Chart 8 shows that even a 100 basis point rise would not push affordability back to average levels. Mortgage payments would still be well below the long-term average as a share of income, and effective mortgage rates are still extremely low. Therefore, we would not be surprised to see stable housing metrics in the coming months, despite the yield back up. Existing house prices are flirting with new highs (Chart 7), despite the early stage of mortgage re-leveraging, which bodes well for future house price increases. If homeowners are confident that house prices will stay solid, they will be more inclined to make home improvement investments. These factors are represented in our HIR model. The model is climbing steadily, exhibiting a rare positive divergence from relative share prices (Chart 9). Our inclination is to side with the objective message from the model. The valuation case for the group has improved markedly. The forward P/E is well below the average of the last decade and the dividend yield is now on a par with that of the broad market. Typically, a positive yield differential has been a bullish relative performance signal (Chart 10). Chart 8Higher Yields Are Not A Game Changer Chart 9Our Model Remains Firm Chart 10Discounting A Weak Housing Market Most importantly, the industry continues to generate sky-high return on equity, and free cash flow is booming. The implication is that shareholder-friendly stock buybacks and dividend increases should continue apace, especially compared with the overall corporate sector. At current valuation levels, there is room for a playable recovery in relative performance, especially if Treasury yields level off on the back of relentless U.S. dollar strength. Bottom Line: Home improvement retail (BLBG: S5HOMI - HD, LOW) stock price weakness is a buying opportunity. We recommend an above-benchmark allocation. End Of The Bear Market In Hotel Stocks The S&P hotels index has been in a relative performance bear market since late last year when we reduced it to underweight, but downside risks have diminished even though a number of players have lowered 2017 guidance and revenue per room (REVPAR) expectations. Relative value has been created by the past year of underperformance. A variety of valuation metrics show that the price ratio is plumbing recessionary-type levels (Chart 11). Most notably, the relative price/sales ratio is almost on a par with the lows during the Great Recession, when a steep contraction was anticipated for the foreseeable future. Such a dire forecast is not in the cards, even if economic growth disappoints an increasingly optimistic consensus. The plunge in net earnings revisions has not been confirmed by a downturn in hours worked. Typically, these two series move hand-in-hand (Chart 12). Instead, hours worked continue to trend higher suggesting that reduced profit guidance is bringing analyst expectations to more attainable levels rather than signaling impending doom. After all, persistent hotel construction growth means that demand needs to run hot in order to keep deflationary pressures at bay. This has been a tall order in the past year, as tight business budgets and lackluster discretionary consumer spending have kept REVPAR under wraps (Chart 13). Occupancy rates remain below previous expansionary run rates, leaving revenue per room more exposed than normal to demand soft spots. Chart 11End Of Bear Market Chart 12An Undershoot In Estimates Chart 13Slow, But Steady, Growth REVPAR could be supported by decent consumer spending. Wage growth, and thus aggregate income, are perking up, job security has risen and income expectations are on the upswing. Consumers are behaving as if income gains will be permanent, given the increase in consumer loan demand. Low fuel prices and the surge in vehicle miles driven are consistent with solid lodging outlays. The latter have recently reaccelerated, and are supporting better than market hotel pricing power (Chart 13). Importantly, hotel profit margins are no longer under extreme duress. Decent pricing power gains and an easing in the industry's total wage bill inflation have combined to support an increase in our profit margin proxy (Chart 14). All of this implies that profit conditions are stabilizing, just as valuations have been squeezed, warranting an upgrade to neutral. Why not a full shift to overweight? There are a number of factors to consider. The lodging industry is battling secular crosscurrents. On the positive side, the lodging industry has consistently managed to increase its share of total consumer spending, in real terms (Chart 15), with periodic underperformance phases, typically during recessions. This likely reflects well-timed capacity investments and strong brands. As a result, hotel pricing power has also been in a structural uptrend (Chart 15). This cycle, pricing power has lagged, consistent with subdued REVPAR gains, but hotels have still managed to aggressively grow earnings per share. While buybacks have undoubtedly played a role in this advance, EPS is following a typical pattern. In the last four decades, hotels have suffered four major recession-related earnings contractions. After each contraction, profits ultimately surpassed their previous peak by more than 75%, on average. The duration of the upcycle averaged five years. This cycle the recovery has already lasted more than six years, but hotel profits have only increased 30% from the 2007 peak. That implies substantial profit upside ahead just to reach the average, albeit pricing power will need to kick in as it has in past cycles. On the downside, consumers are still showing a penchant for spending more on essentials compared with non-essentials. The ratio of retail sales at cyclical stores to non-discretionary stores has been highly correlated with relative performance (Chart 16, top panel). Chart 14The Margin Squeeze Is Over Chart 15Structural Tailwinds... Chart 16... And Headwinds That raises some question about the latest burst of strength in lodging outlays, especially in view of the pruning in business travel budgets, as confirmed by anecdotes from recent earnings reports. BCA's capital spending model is not forecasting any improvement (Chart 16, bottom panel). Lingering in the background has been the relentless increase in lodging construction. Capacity growth represents a long-term threat to pricing power (Chart 16), over and above the threat from new entrants such as AirBnB. Expansion explains why real hotel consumer prices have not come close to hitting new highs even though real hotel spending has. Hotel capacity expansion heralds intensifying deflationary pressure. Meanwhile, hotels have sizeable global operations, exposing profitability to risks of incremental U.S. dollar strength. Consequently, we would prefer to await signs of an impending improvement in capital spending, and thus, business travel, and/or a sharp downturn in hotel construction spending, before lifting positions all the way to overweight. Bottom Line: Lift the S&P hotels index (BLBG: S5HOTL - MAR, CCL, RCL, WYN) to neutral, locking in an 3% relative performance profit since our initial underweight call nearly a year ago. A further upgrade is tempting, but awaits relief from pricing power constraints. Current Recommendations Current Trades Size And Style Views Favor small over large caps and growth over value.

Highlights Portfolio Strategy The strong U.S. dollar is tightening global liquidity conditions, putting the post-election jump in stock prices at risk unless growth imminently accelerates. The spike in large cap industrial stocks represents a massive knee-jerk overreaction and we are adding the sector on our high conviction underweight list. Take profits in the S&P air freight & logistics group and cut to neutral, and downgrade the S&P electrical components & equipment group to underweight. Recent Changes S&P Air Freight & Logistics - Take profits of 6% and reduce to neutral. S&P Electrical Components & Equipment - Trim to underweight from neutral. S&P Industrials Sector - Add to our high-conviction underweight list. Table 1 Feature Equities are still in a post-election honeymoon phase. The savage reaction in the bond market has not yet backlashed onto the broad stock market. Instead it has sparked a rapid and powerful rotation in intra-sector capital flows. The danger is that an unwinding of the momentum trade in the bond market is being misinterpreted as a pro-growth, pro-cyclical investment shift. Investors appear to be equating a potential increase in economic growth with better profitability. However, basing equity strategy on unknown future policies is fraught with risk, as is equating GDP with corporate profits. Trump's signature policies, protectionism and fiscal spending, are inflationary and U.S. dollar bullish, and the timing of implementation and ultimate size of spending programs, remain anyone's guess. In a closed economy driven more by consumption than investment, a strong currency can be supportive via increased purchasing power and a dampening in corporate sector input costs. But what's good for the economy should not be automatically extrapolated through to profits. Net earnings revisions fall when the currency is strong (Chart 1). Capital has won out handily vs. labor since the Great Recession, which allowed profits to boom even though economic growth was below-potential. This is changing. Labor costs are now on the upswing, and productivity has deteriorated. If the economy strengthens, it may only serve to boost wage inflation. If labor expenses accelerate, it becomes even more critical for corporate sector sales to regain traction in order to offset the squeeze on profit margins. However, just under half of S&P 500 sales come from abroad. A strong U.S. dollar means the U.S. will be importing deflationary pressures, undermining pricing power. U.S. dollar appreciation also saps growth in developing countries. Emerging market capital spending is already contracting (Chart 2), and as shown last week, financial strains are flaring back up. Ergo, U.S. companies will be less competitive, and selling into weaker demand growth abroad. Chart 1A Strong Dollar Will Sink Profits... Chart 2... And Hit Global Growth Chart 3 shows that S&P 500 sales typically contract during major dollar bull markets. A recovery has only occurred once currency depreciation occurs. The equity market reaction has been mixed during these periods, as a strong dollar has capped growth and pushed down Treasury yields, supporting a valuation expansion. We do not recommend positioning for a bullish equity outlook, given already overvalued conditions and the rise in government bond yields. It is notable that the inflation component of yields has done the heavy lifting, rather than an upgrading in economic expectations (Chart 4). In other words, there is a sequencing issue, a strong currency saps profits now, while stimulus may only arrive much later. U.S. dollar-based global financial liquidity is now contracting as a consequence of U.S. dollar strength (Chart 4). If excess liquidity and low rates were the argument for supporting high valuations previously, tighter liquidity and rising rates can't also justify current multiples, especially if global growth is soft. As discussed in our November 3, 2014 Special Report, currency strength favors a mostly non-cyclical, domestically-oriented portfolio structure. One of our favored themes over the past few months has been to tilt portfolios in favor of domestic vs. globally-oriented industries. With the U.S. dollar breaking above its trading range, a catalyst now exists to spur an imminent recovery in the domestic vs. global share price ratio. The latter had become extremely oversold as the U.S. dollar consolidated and the Chinese economy began to stabilize, but economic fundamentals are shifting decisively back in favor of the U.S. The U.S. PMI is already making small strides vs. the Chinese and euro area PMI (Chart 5, second panel), heralding a rebound in the cyclical share price momentum. Chart 3No Sales Recovery Ahead Chart 4Tighter Liquidity, Rising Inflation Chart 5Domestic Will Beat Global World export growth remains anemic, and world export prices continue to deflate, albeit at a lesser rate. Sagging Asian currencies warn that trade is at risk, over and above protectionist rhetoric and/or policies. When compared with the reacceleration in U.S. retail sales, the outlook for domestic-sourced profits is even brighter. We reiterate our theme of tilting to domestic vs. globally-oriented industries. The bottom line is that the outlook for the broad averages has soured as a consequence of a strong dollar, rising yields and the prospect for tighter Fed policy. These dynamics augur well for domestic vs. global bias, small vs. large caps and defensive vs. cyclical sector strategy. This week we are taking some cyclicality out of our portfolio following the wild market gyrations in the past two weeks. Taking Advantage Of The Industrials Sector Overreaction... Industrials have vaulted higher, in relative terms, on the back of hopes for rampant fiscal stimulus and infrastructure spending as far as the eye can see, ignoring any negatives that may arise from protectionist policies and tighter monetary conditions. While defense contractors may see an increase in activity (we continue to recommend an overweight in the BCA defense index), in aggregate, the surge in the large cap industrials sector is an opportunity to retool exposure from a position of strength. Large cap industrials companies garner approximately 45% of their revenue from outside the U.S. The industrials sector has the second worst track record among all sectors during U.S. dollar bull phases, trailing only the materials sector. Regression analysis shows that industrial sectors sales would contract by 4.5% for every 10% in the trade-weighted dollar (Chart 6). Without revenue growth, it is hard for industrial companies to generate good profitability, given high operating leverage. The U.S. dollar surge is a direct threat to any benefit from an increase in domestic infrastructure spending. Commodity prices key off the U.S. dollar. Emerging markets (EM) are also sensitive to the currency. A strong U.S. dollar undermines income in commodity producing countries, creates financial strains related to EM foreign currency denominated debt and reins in domestic liquidity in countries that need to intervene to stop their currencies falling too far lest capital flight and inflation occur. As noted last week, emerging market currencies are already rolling over, and CDX spreads have begun to widen (Chart 7). EM equity markets are underperforming the global benchmark, reinforcing the lack of a regional growth impulse (Chart 7). It is rare for the industrial sector to deviate from relative EM equity performance. There has been no evidence of EM deleveraging, and the back up in global bond yields represents a financial stress. If U.S. industrials stocks are a high-beta play on EM, then contrarians should beware recent sector action. Chart 6Top-Line Trouble Ahead Chart 7Sell The Spike Importantly, capital spending is in retreat. Business investment is a function of confidence and expected return on investment. The gap between the return on and cost of capital is narrowing fast (Chart 8). Free cash flow is paltry, especially in resource sectors, major industrial sector end markets. It is hard to envision a major capital spending turnaround if the U.S. dollar keeps climbing and the cost of capital backs up further. Policy ambiguity will act as a weight for at least the next few quarters. During this period, the negative profit impact of the contraction in private and public sector construction activity will ultimately re-exert a major influence on sector risk premia. It will take at least several quarters before any hoped for fiscal spending will benefit industrial companies. Industrials sector pricing power has shifted from a deep negative to neutral. However, that appears to represent an unwinding of the rate of change shock more than a resumption of conditions conducive to companies lifting selling prices. Chart 9 shows that capital goods import price are still deflating. As the Chinese currency devalues, putting downward pressure on its regional counterparts, deflationary pressures will re-intensify for U.S. industrial firms (Chart 9). Chart 8Fiscal Stimulus Is Needed... Right Now! Chart 9The Dollar Will Do Damage ...By Selling Electrical Components & Equipment ... In terms of specifics, were we not underweight machinery shares already, we would institute a high conviction underweight today. In addition, the S&P electrical equipment and components (ECE) index looks equally vulnerable. While less exposed to commodity prices than machinery stocks, ECE shares have benefited alongside the overall sector from the post-election buying frenzy. Hefty short positions likely played a large role in powering the spike (Chart 10), and we are uncomfortable with paying a premium valuation for a dubious earnings outlook, particularly given the sector's brutal long-term track record during U.S. dollar bull markets (Chart 11, top panel, the currency is shown inverted). From a cyclical perspective, it is premature to position for a reversal in the relative earnings bear market. New orders for electric equipment are sensitive to EM currency movements. The current message is that new orders are likely to languish (Chart 11). Relief is not imminent from domestic sources. Chart 11 shows that real investment spending on electrical equipment is contracting at a steep rate. That is consistent with the trend in overall construction spending, which represents a long-term headwind. It is no surprise that industry productivity growth is contracting (Chart 11), reinforcing that the path of least resistance for profits is lower. It would take a major resurgence in top-line growth to restore productivity to positive levels. The ECE industry is one of the few 'smokestack' parts of the economy to have added capacity in recent years. That is confirmed by persistent growth in ECE wage inflation (Chart 12). Without a pickup in demand, this backdrop is conducive to ongoing deflation (Chart 12, bottom panel). Sell into strength. Chart 10Short Covering Will Not Last... Chart 11... As Fundamentals Erode Chart 12Cost Structures Are Too High ...And Taking Profits In Air Freight Stocks ... Elsewhere, we are taking profits on our overweight S&P air freight & logistics index. While we only recently went overweight in early-September, a much shorter time horizon than our desired cyclical calls, we are concerned that the index has front run an improvement in global trade that may be slow to materialize. Our upgrade was predicated on a tightening in inventories relative to GDP, which boosts the need for just-in-time air freight services, as well as a pickup in emerging markets activity. However, our confidence in the latter has been shaken. Air freight stocks are a reflation play, and a surging U.S. dollar is a threat to global liquidity (Chart 13). Global revenue ton miles have already crested after a muted rebound (Chart 14, second panel). Chart 13A Reflation Play Chart 14Take Profits Moreover, protectionist/anti-globalization sentiment may heat up, representing a risk to a recovery in global trade. The IFO export expectations index continues to sink, a warning for relative forward earnings estimates (Chart 14). The contraction in transport and warehousing hours worked confirms that transport activity is not yet on the mend (Chart 14). Relative performance has a history of violent oscillations, and the price ratio has soared to the top end of its multiyear range. Thus, even though the structural increase in online sales bodes well for long-term growth, and value remains appealing, we are booking profits and reducing positions in this globally-exposed group back to neutral in order to de-risk in our portfolio. Bottom Line: Take profits of 6% in the S&P air freight & logistics index and reduce to neutral. Downgrade the S&P electrical equipment index to underweight and add the overall industrial sector to our high conviction underweight list. The ticker symbols for the stocks in these indexes are: BLBG: S5AIRF - UPS, FDX, CHRW, EXPD, and BLBG: S5ELCO - AME AYI EMR ETN ROK. Current Recommendations Current Trades Size And Style Views Favor small over large caps and growth over value.

Highlights Portfolio Strategy Retail food stocks are deep into the buy zone. Deflating food costs augur well for profit margins in the coming quarters. Lift the financial sector to neutral, via the asset manager and investment bank indexes. Recent Changes S&P Financials Sector - Raise to neutral, recording a loss of 8%. S&P Asset Manager & Custody Bank Index - Raise to overweight from underweight, locking in a profit of 5%. S&P Investment Bank & Brokerage Index - Raise to neutral, recording a loss of 3%. Table 1Sector Performance Returns (%) Equity markets celebrated the surprise Republican U.S. election victory. Investors believe the regime shift will entail fiscal stimulus and a lifting in regulatory constraints that stir animal spirits and lift the economy out of its growth funk. The reality is that it is premature to make long-term assumptions. Meanwhile, the underlying fragility of the U.S. economic expansion will be tested in the coming quarters. Indeed, it is easy to envision a hit to business confidence, causing delays in decision making and investment, especially given Trump's anti-trade rhetoric and penchant for profligacy. Policy uncertainty and confidence have been reliable leading indicators for valuations, and slippage would put upward pressure on the Equity Risk Premium (Chart 1). It will be critical to monitor aggregate financial conditions. The Goldman Sachs Financial Conditions index has tentatively edged up (Chart 1), and if corporate bond spreads, long-term yields and the U.S. dollar move much higher, upside risks will intensify. The low level of overall potential growth has made the economy increasingly sensitive to swings in financial conditions and deflationary impulses from abroad. Both the high yield and investment-grade corporate bond index are languishing, perhaps picking up on the deflationary signal from U.S. dollar strength and growth drag from higher Treasury yields (Chart 2, bottom panel). It is notable that emerging markets currencies have pulled back. These exchange rates are typically pro-cyclical. Sustained currency weakness typically leads to domestic corporate bond spread widening (Chart 2, CDX spreads shown inverted). In the past five years, it has paid to bet on defensive over cyclical sectors when EM currencies weaken and CDX spreads are this tight, i.e. contrarians should take note. At a minimum, it may be a signal that global growth is less robust than the rise in global bond yields implies. As a result, forecasts for double-digit profit growth in the next twelve months look very aggressive, even if our economic outlook proves too cautious. The tentative trough in third quarter S&P 500 profits has not yet been validated by other indicators. For example, tracking tax revenue provides a good real-time gauge on corporate sector cash flows. Federal income tax receipts have dropped into negative territory. Corporate income taxes are contracting. Previous major and sustainable overall profit recoveries have been either led by, or coincident with, corporate income tax growth (Chart 3). This argues against extrapolating positive third quarter earnings growth in the S&P 500. Chart 1Watch Confidence And Financial Conditions Chart 2Don't Get Caught Up In The Hype Chart 3Taxes And Profits Rather than get overly excited about the potential for a new fiscal spending impulse, it may be more appropriate to view the latter as truncating downside economic risks, given that the corporate sector remains a key headwind to stronger growth, even excluding its balance sheet stress. Consequently, we still expect undervalued defensives to retake a leadership role from overvalued cyclical sectors and we also retain a domestic vs. global bias. If the U.S. dollar breaks above its recent trading range, the odds of the broad market making further liquidity fueled gains will diminish significantly. Importantly, the last few days of market moves have been massively exaggerated, as industrials and materials have rallied as if fiscal stimulus is about to hit next month. Even when implemented, it is not a panacea for sector earnings. Drug and biotech stocks have soared as if pricing pressures will evaporate, when in reality price pressures emerged prior to any political interference. Tech stocks have been crushed because of fears they will be forced to move production back to the U.S. All of these knee-jerk reactions should be treated with caution, with the exception of financials, where a step function reduction in the risk premium may be underway. There Is A New Sheriff In Town: Lift Financials To Neutral Financials have celebrated the modest upshift in the interest rate structure and hopes for a reversal of the regulatory framework that has been a structural noose on profitability, and risk premiums. These factors, along with our domestic vs. global bias, argue against maintaining a below benchmark weighting on a tactical basis. As discussed last week, our view on banks remains cautious, however, asset managers and investment banks have lower odds of falling back toward recent lows even after election euphoria inevitably fades. The largest earnings drags from the past year have eased. M&A activity has troughed. New and secondary stock offerings have hooked back up and margin debt is back to new highs, suggesting that investor risk appetites have stopped shrinking (Chart 4). Thus, capital formation is unlikely to dry up, even if upside is limited given poor corporate sector balance sheet health and an upward creep in the cost of capital. In terms of asset managers and custody banks (AMCB), even modestly higher interest rates would reduce a major profit impediment. Fees on funds held in trust have been decimated by ZIRP, underscoring that the latest uptick in short-term Treasury yields is a plus. Relative performance had already diverged negatively from the stock-to-bond ratio, the equity risk premium and global economic sentiment (Chart 5). This gap could close with a prospective thawing in relations between lawmakers and the industry. There is still structural downward pressure on fees as low cost ETFs gain market share, but that is being partially offset by the renewed growth in total mutual fund assets (Chart 4, bottom panel). Bear in mind that both groups tend to do well when the stocks outperform bonds, as seems likely in the near run given creeping protectionism. In sum, despite our concerns about overall financial sector productivity growth, mainly owing to rising bank cost structures, and the risks of a renewed deflationary impulse from U.S. dollar strength, we are lifting sector weightings to neutral. This will put us onside with the objective message from our Cyclical Macro Indicator, the buy signal from our Technical Indicator (Chart 6) and our broader theme of favoring domestic vs. global industries. Chart 4Earnings Drivers Have Stabilized Chart 5Recovery Candidate Chart 6Following Our Indicators Bottom Line: The Republican victory has provided a fillip to the financials sector, and underweight positions putting underweight positions offside. We are lifting allocations to neutral, via the S&P AMCB and S&P investment banks & brokerage indexes. AMCB moves to overweight, and the latter to neutral, with an eye to downgrading again once euphoria fades and investor focus returns to economic durability. Food Retailers: Too Cheap To Overlook Food retailers offer attractive value, defensive and domestic equity exposure with the potential for upside profit surprises. This group will benefit if U.S. wage inflation persists. The latter would boost consumer purchasing power and could lead to tighter financial conditions, either through U.S. dollar strength and/or a tighter Fed. The defensive appeal of retail food equities would shine through under that scenario. The starting point for grocery stocks is extremely appealing. The price ratio is extraordinarily oversold. It fell farther below its 200-day moving average than at any time since 2002, before recently bouncing (Chart 7). Valuations are cheap, return on equity is solid and share prices have diverged negatively from a number of macro indicators. For instance, relative performance has been tightly linked with the U.S. dollar, but the former plunged even as the currency firmed (Chart 8, top panel). A strong exchange rate will keep a lid on imported food costs, boost the allure of domestically-oriented industries while lifting consumer spending power. Chart 7Extraordinarily Oversold Chart 8Top-Line Improvement Ahead Outlays on food products have climbed as a share of total spending in the past six months, reversing a long-term downtrend (Chart 8). If consumer confidence stays firm as a consequence of rising wage growth and a positive wealth effect, then it is conceivable that store traffic and total grocery spending will accelerate. The surge in capital spending in recent years reflects store upgrades and a refreshed shopping experience, which could also translate into faster sales growth. Now that capital spending growth is cooling, it will reduce a profit margin drag. Profitability should also benefit from cost deflation. The food manufacturing PPI is contracting, reflecting shrinking raw food prices (Chart 9, top panel, shown inverted). It is normal for food stocks to outperform when raw food prices fall. Importantly, capacity utilization rates in the packaged food industry are very low (Chart 9), which augurs well for ongoing pricing pressure among suppliers. Tack on deflation in industry wage inflation, and it is no wonder profit margins have been able to grind back toward previous highs without a strong sales impulse. If sales rebound, as seems likely given evidence of market share gains away from hypermarkets (Chart 10, bottom panel), then grocery stores should continue to demonstrate decent pricing power gains (Chart 10, middle panel). Chart 9Cost Deflation Chart 10Gaining Market Share Adding it up, the ingredients for a powerful rally in the S&P retail food store index exist, with good downside protection should the economy disappoint on the back of tighter financial conditions. Bottom Line: We recommend an overweight position in the S&P retail food store index (BLBG: S5FDRE - KR, WFM). Current Recommendations Current Trades Size And Style Views Favor small over large caps and growth over value.

Highlights We remain positive on Chinese stocks both from structural and cyclical point of view, especially on H shares. In the near term, stay on the sidelines due to developing global uncertainty. The Q3 earnings scorecard of listed companies confirms an upturn in the Chinese profit cycle. Earnings momentum will likely be carried forward to at least early next year. The Chinese economy has improved notably, especially in the industrial sector. We expect the economy will likely continue to surprise to the upside. Feature Tuesday's U.S. election surprise sent strong shockwaves to global risk assets, including Chinese stocks. We tactically downgraded our "bullishness" rating on Chinese H shares in early October,1 partly due to brewing global uncertainty, but were still caught off guard by the election result. World financial markets have yet to fully grasp the implication and consequences of a President Trump. Yesterday, we sent clients a Special Report titled "U.S. Election: Outcomes & Investment Implications" prepared by Marko Papic, our Chief Geopolitical Strategist, providing our initial assessment on these important issues. As far as China is concerned, the biggest threat is the harsh anti-China trade policies that dominantly featured Mr. Trump's election campaign. A full-blown protectionist backlash is undoubtedly bearish for China and the rest of the world; this is a disturbing uncertainty that has to be carefully monitored and assessed going forward. However, it is also worth noting that anti-China rhetoric has been regularly featured in all U.S. presidential election campaigns by candidates from both parties as soon as the diplomatic tie between these two countries was established in 1979, but the economic integration has continued to deepen. For now, we do not advocate any kneejerk adjustment to investment strategy, as it is utterly unpredictable how much of Mr. Trump's campaign rhetoric will become real policy. An easier bet over the near term is that the Chinese authorities will likely maintain policy support to boost domestic demand in the wake of rising external uncertainty. Strategically, China will likely press forward its ongoing long-term initiatives to expand its global influence, such as the "One Belt One Road" (OBOR) project and Asian Infrastructure Development Bank. Meanwhile, China will continue to explore bilateral and multi-lateral free trade deals with its major trade partners to foster a more predictable global trade environment. We will follow up on these issues in our future research. While Chinese stocks have suffered badly from global contagion this week, Chinese domestic factors have, ironically, continued to turn more positive of late, with an improving cyclical economic profile, a largely accommodative policy stance and a strong recovery in profits. In the near term we are staying on the sidelines, as the uncertainty unleashed by the U.S. presidential elections continues to play out. Nonetheless, barring a major protectionist backlash, we remain positive on Chinese H shares both from a structural and cyclical perspective, and expect this asset class to outperform both global and EM peers. A Strong Earnings Recovery From an investor's stand point, the most important development is the sharp recovery in earnings reported by Chinese domestically listed A-share companies in the third quarter. Specifically: A share-listed companies' average earnings increased by 22% in the third quarter from Q3 2015, or by 3% for the first three quarters compared with a year ago (Table 1). Excluding financials and petroleum firms, earnings jumped by almost 50% in Q3, according to our calculations, or 21% year-to-date. While the sharp earnings recovery in Q3 is partially attributable to last year's low base, our model suggests that earnings momentum will likely be carried forward to at least early next year (Chart 1). Table 1Earnings Scorecard The earnings recovery reflects both top-line growth and margin expansion. Improving producer prices have eased deflationary pressure in the economy, particularly for the corporate sector. Total sales of A share-listed firms have benefited from the pickup in nominal GDP growth, and profit margins have also continued to widen in the last quarter, both of which are conducive for earnings growth (Chart 2). Cash flow positions have also continued to improve, especially in select sectors. Overall cash and cash equivalents held by Chinese non-bank firms as a share of assets currently stand at elevated levels, underscoring an overall cautious stance on business expansion and liquid balance sheets (Chart 3).2 Specifically, real estate developers' operating cash flow continues to increase sharply, boosted by strong sales, but capital expenditures have been muted, leading to a significant hoarding of cash. This will likely reduce financial stress among developers, even if housing policies begin to be tightened. Chart 1Strong Earnings Grow... Chart 2... Due To Rising Sales And Improving Margin Chart 3Developers' Improving Cash Flow And Balance Sheet In short, the Q3 earnings scorecard confirms our long-held view of an upturn in the Chinese profit cycle.3 We expect bottom-up analysts will continue to upgrade earnings expectations, which will provide a positive cyclical backdrop for Chinese stocks (Chart 4). The Economy Will Remain Resilient China's recent macro numbers have largely come in stronger than expected, albeit modestly. Overall, the economy has maintained positive momentum, especially in the industrial sector. The Keqiang Index - a combination of bank loan growth, railway freight activity and electricity consumption - has strengthened sharply, underscoring significant improvement in industrial activity (Chart 5). Looking forward, we expect the economy will likely continue to surprise to the upside. Chart 4Net Earnings Revision Will Continue To Improve Chart 5Keqiang Index Versus GDP Growth Business managers have largely been cautious, and have been focused on inventory destocking instead of business expansion. Industrial production has so far been muted, despite improvement in some leading indicators (Chart 6). Meanwhile, slowing capital spending among private enterprises has been one of the key reasons for slower growth in recent years; this should turn around as profitability improves (Chart 7). At minimum, downward pressure on private sector investment should diminish going forward. This, together with government-sponsored infrastructure construction, should underpin overall capital spending. Chart 6Industrial Production Has Been Muted Chart 7Profit Recovery Helps Capex On the policy front, monetary conditions continue to be accommodative. The trade-weighted exchange rate has remained low, and real interest rates have continued to drift lower through nominal declines and rising producer prices. Furthermore, inflation is unlikely to become a meaningful policy constraint anytime soon. Headline CPI picked up slightly last month, driven by food prices (Chart 8). However, this was largely due to the base effect. Agricultural wholesale prices have been mostly flat in recent years, and there is no case for generalized food inflation. The risk of any near term policy tightening has further diminished in the wake of the global uncertainty. Meanwhile, previous stimulative policies should continue to allow the economy to build forward momentum. The housing tightening policies imposed last month have begun to have a negative impact on home sales, which introduces a new risk factor for the economy, as discussed in a previous report. Anecdotal evidence suggests that property transactions in some major cities have dropped notably, even though home sales nationwide appear to remain buoyant (Chart 9).4 In addition, new housing construction has rolled over in the past few months, as developers have also focused on destocking inventories despite rising sales. However, inventories were already headed lower, which will eventually support new construction. Already, developers' land purchases have turned positive in recent months. In short, the impact of tightened housing policies should continue to be closely monitored. For now, our base case remains that housing construction will likely remain sluggish, but will not go through another major downturn. This view is further reinforced by the strong earnings and cash positions of real estate developers in the last quarter. Chart 8No Case For Food Inflation Chart 9Housing: Another Major Downturn Is Unlikely Chinese Stocks And Global Risk Aversion As far as Chinese stocks are concerned, we are positive both from structural and cyclical point of view, especially on H shares. Structurally, this asset class has been deeply depressed in recent years with an unduly high risk premium, which will eventually be renormalized through multiples expansion. Cyclically, the economy's budding forward momentum, strong profit recovery and accommodative policy stance are all supportive for stock prices. At a minimum, Chinese H shares should continue to outperform their global and EM peers. Tactically, however, we remain cautious as knee-jerk reactions in the stock market following the U.S. election surprise will continue to dominate the broader market trends. Furthermore, even as the impact of the election shock begins to fade, investors' focus may shift back over to a possible December rate hike by the Federal Reserve and another up leg in the U.S. dollar - both of which are negative for global liquidity and risk assets. Chart 10 shows that our proxy of global dollar liquidity has deteriorated significantly of late, which historically has often been accompanied by an increase in volatility in stocks. This time around, however, the market appears to have so far been rather sanguine, and is vulnerable to negative surprises. This is especially true, as global bellwether U.S. stocks are not cheap. In addition, Chinese stocks are overbought in the near term, and a period of consolidation or even correction is overdue (Chart 11). Our technical models for both A shares and H shares remain elevated even after the recent correction, which heralded further near-term difficulties. A favorable cyclical profile and large valuation buffer, particularly for H shares, should limit the downside for Chinese stocks, but the risk-return tradeoff in the near term is not particularly attractive, and warrants a more cautious stance. Chart 10Dollar Liquidity And Equity Volatility Chart 11Chinese Stocks Remain Near Term Overbought The bottom line is that we downgraded our "bullish rating" on Chinese H shares last month, and for now remain on the sidelines. Beyond near-term volatility we reiterate our positive conviction for this asset class, and expect Chinese H shares to continue to advance both in absolute terms and against the EM and global benchmarks. Yan Wang, Senior Vice President China Investment Strategy yanw@bcaresearch.com 1 Please see China Investment Strategy Weekly Report, "Housing Tightening: Now And 2010" , dated October 13, 2016, available at cis.bcaresearch.com 2 Please see China Investment Strategy Special Report, "Rethinking Chinese Leverage", dated October 27, 2016, available at cis.bcaresearch.com 3 Please see China Investment Strategy Weekly Reports, "2016: A Choppy Bottoming" , dated January 6, 2016 and "China: Four Important Charts" , dated April 13, 2016 and "Chinese Growth, Profits And Stock Prices", dated July 20, 2016, available at cis.bcaresearch.com 4 Please see China Investment Strategy Weekly Report, "Housing Tightening: Now And 2010" , dated October 13, 2016, available at cis.bcaresearch.com Cyclical Investment Stance Equity Sector Recommendations

Special Report

Highlight Growth perked up in the major economies in October, and the manufacturing recession appears to have passed without event. The October employment report testified to the underlying health of the U.S. economy and clears the way for a rate hike at the FOMC's December meeting. Markets are skeptical that December's hike will be the first in a series, opening the door for a dollar rally while the Fed moves to meet its projected timetable. Unconvinced that global growth is about to accelerate in a meaningful way, and concerned about the ripple effects of a stronger dollar, we maintain the defensive bias in our model portfolios. Feature October was a good month for growth, as highlighted by broadly encouraging data across the major developed economies. U.S. GDP had its best print in two years in the third quarter, and European PMIs, firmly ensconced above 50, point to Eurozone growth around 1.5%. The plunge in sterling appears to have sheltered the U.K. from the worst effects of Brexit, even if it has triggered some unease about inflation. Japan remains hobbled, but our Global Investment Strategy service argues that reduced fiscal drag and a weaker yen will boost growth. The October employment data painted a portrait of a vibrant U.S. labor market. Job gains remained steady while the broad U-6 measure of unemployment, including discouraged job seekers and those working part time who would prefer to be working full time, fell by two ticks to a new post-crisis low (Chart 1). Consistent with the shrinking pool of idled workers, average hourly earnings surged, notching their biggest year-over-year gains of the expansion. The pickup in wages rekindled hopes of a virtuous circle linking hiring, wages, consumption, capex and more hiring. Chart 1The Supply Of Idled Workers Is Shrinking One GDP print does not make a trend, of course, and the hoped-for inflection point has remained out of reach throughout the post-crisis period (Chart 2 and Chart 3). Aggregate demand remains mushy even if it is improving. Forward-looking markets typically take their cues from direction rather than level, and punk post-crisis growth certainly hasn't hurt U.S. equities. The valuation backdrop has become much less hospitable, however, and the Fed appears less inclined to spike the punch bowl with its most potent fuel. The unsettled picture could make for a bumpy U.S. equity ride, especially if markets have become overly complacent about the pace of rate hikes. Chart 2The Post-Crisis Inflection: Ever In Sight... Chart 3...But Always Out Of Reach Economic Growth In The U.S. And Beyond What matters most to markets, a metric's current position (level), or its path (direction)? Favoring direction is generally a reliable stock market rule of thumb, though it's not always easy to recognize in real time. The key challenge for investors today is determining if the recent improvements are short-lived wiggles or a true inflection point. It would be helpful to know if extraordinary policy measures can boost organic growth or if they will simply redistribute it via exchange-rate adjustments. Measures of global trade are inconclusive. While things look much better in hubs like Korea and Taiwan (Chart 4), aggregate global trade volume is still mired in a one-step-forward, one-step-back pattern around the zero line (Chart 5). Isolated improvements in a handful of economies against a flat global backdrop highlight that a broad rebound has yet to take hold. Signs of life in individual countries should not be written off - it is promising that Korean and Taiwanese exports have staged their rebounds despite steady exchange-rate gains - but overall global export activity remains at a level more commonly associated with recessions than quickening expansions. Chart 4Some Exporters Are Stirring... Chart 5...But Aggregate Trade Is Stagnant Global PMI data are more broadly encouraging. Major-economy manufacturing PMIs are at levels consistent with decent growth and are sending a message, echoed by G7 industrial production (Chart 6), that the manufacturing recession is over. Although manufacturing typically accounts for less than a third of major-economy activity, its cyclicality helps it punch above its weight, and industrial slowdowns have the potential to trigger recessions. This time around, manufacturing failed to heat up enough to induce a broader slowdown and reliable recession signals are quiet (Chart 7). Chart 6The End Of The Manufacturing Recession Chart 7No Recession In Sight The October employment situation report was solidly encouraging. The U.S. labor market has found firm footing. Job gains have been remarkably steady, and our employment model projects they will persist, even if at a slightly slower pace (Chart 8). Both the average hourly earnings series and the Atlanta Fed's wage tracker show that rank-and-file workers are finally capturing some real income gains (Chart 9). Chart 8When The Economy Tests NAIRU... Chart 9...Wages Get A Boost Third Quarter Earnings Season S&P 500 operating earnings present another level/direction dichotomy. Per Standard & Poor's projections,1 trailing four-quarter operating earnings will finish the quarter 11% below their 3Q14 high-water mark (Chart 10, top). But the direction is as strong as the level is weak. Not only does this quarter mark the first year-over-year earnings gain since 3Q14, it is the second strongest since the pace of earnings growth normalized in 2012 (Chart 10, bottom). Chart 10Breaking Out Of The Earnings Recession Margins widened and earnings grew broadly across sectors without a clear cyclical or defensive theme. Rate sensitives achieved the strongest top-line growth, but endured margin contraction (Chart 11). Looking ahead, margins seem more likely to contract than expand in the coming quarters, given building wage pressures. On the other hand, an end to the sharp declines in Energy earnings will remove a drag that has weighed on S&P 500 results for several quarters. Chart 11Margins' Last Gasp? Margins' seeming inability to defy budding wage gains makes it unclear exactly how investors should position themselves, but the outlook for the dollar could provide some insight. Multinationals are prominent among the S&P 500's largest constituents, and since 2011, the broad trade-weighted dollar index has exhibited a robust negative correlation with S&P 500 earnings. Peak acceleration in the dollar has led earnings troughs by a quarter or two and earnings growth has quickened when the dollar has consolidated or retraced its gains (Chart 12). In a rising-dollar environment, U.S. firms competing globally face the unpalatable choice of protecting their margins and ceding share, or ceding share to defend their margins. Chart 12Strong Dollar, Weak Earnings Fed Policy: The Known Unknown Chart 13Markets Are Sleeping On The Fed The Fed has evinced a clear desire to hike rates, and investors know that it will be withdrawing accommodation at the edges. But the terminal fed funds rate for this cycle, and the pace at which the FOMC approaches it, are unknown. Market expectations, as implied by OIS2 contracts, reveal that investors have become complacent about the pace of hikes. While the consensus expects a quarter-point hike at the FOMC's December meeting, money markets are discounting just an 11% chance of a second 25-bps hike by the end of October 2017 (Chart 13, top panel), and a 75% chance of a second hike by the end of October 2018 (Chart 13, bottom panel). The Fed's dot-plot rate hike forecasts have been laughably off the mark, and to this point investors have tuned them out to their benefit. The preconditions for a progression of hikes seem to be coming together, however, as labor slack disappears, wage pressures emerge and the output gap steadily narrows. Every FOMC voter or regional Fed president who's stepped within range of an open microphone the last few weeks has gone out of his or her way to endorse the notion that two 2017 rate hikes are reasonable, and those with a more hawkish bent appear to be comfortable with three. Viewed beside the data and the guidance, markets seem to be in denial. Currency exchange rates are subject to multiple cross-currents, but policy rate differentials have taken a leading role since the dollar's surge began in the second half of 2014. Some Fed hikes are already baked into the EUR-USD and USD-JPY crosses, but the implied expectation that it could take two years for the FOMC to lift the fed funds rate by 50 bps suggests that the path of least resistance for the dollar is up. The implications for global equity positioning point to favoring Europe- and Japan-based multinationals (on a currency-hedged basis) over their U.S. counterparts. They also argue for caution around emerging market assets, as a stronger dollar is a drag on commodity prices, makes it more difficult for domestic borrowers to service dollar-denominated debt, and imperils the supply of external capital that helps fund fiscal deficits. Investment Implications Putting it all together, we continue to favor a defensive stance. Real rates haven't budged during the post-Brexit sovereign yield backup (Chart 14, top panel), which has entirely been a function of less depressed term premiums (Chart 14, middle panel) and varying increases in inflation expectations (Chart 14, bottom panel). We are not yet convinced that the quickening in growth measures is anything other than one more of the false dawns that have been a regular feature of the last several years. We also see the uncertainty accompanying the Fed's turn away from accommodation at the margin as carrying considerable potential for disruption. It seems overly optimistic to think that policy makers will be able to shift course without causing at least a hiccup or two. With the S&P 500 trading at an elevated forward multiple (Chart 15), U.S. equities have little if any cushion against disappointment. Chart 14Bonds Aren't Pricing In Better Growth Chart 15Little Cushion Against Disappointment Maintaining a defensive portfolio bias is consistent with our qualms about growth and the potential for policy hiccups. We attribute cyclical sectors' outperformance relative to defensive sectors to technical rather than fundamental factors. Cyclicals had become oversold relative to defensives, as had emerging markets, at a time when the dollar needed to take a break from its upward sprint. We view the whole commodity/cyclical/EM complex as participating in a countertrend rally. We are vigilant, however, and we are asking ourselves where we could be getting it wrong even more frequently than usual. Many of the defensive spaces we currently favor have been bid up to levels where they would not seem to have any cushion at all. It is not comforting to invest on the basis of overshoots that are expected to become even more extended, but that is life with TINA in the ZIRP/NIRP era. Our model portfolios have underperformed over their first four weeks thanks to our income hybrids' underperformance versus plain-vanilla fixed income and defensives' underperformance versus cyclicals, but we think they will enhance the overall portfolios' risk-adjusted return profiles over time. The lack of a credible recession threat argues for maintaining our underweight in plain-vanilla fixed income products, but uncomfortably tight high-yield spreads have us concentrating our spread product exposure in the investment-grade space. We maintain our (currency-hedged) equity tilts toward Europe and Japan, and away from the U.S., largely on our expectations for ongoing dollar strength. That view also informs our allocations to mid- and small-cap U.S. equities, which are more domestically focused than their large- and mega-cap counterparts. Our Fed view underpins our dollar expectations, and any change in our policy take would result in portfolio changes. We will undertake a comprehensive view of our model portfolios in December, once they have two months of performance under their belts. Postscript: Dewey Defeats Truman Global ETF Strategy has a cyclical, not a tactical, orientation. Our process is directed toward catching cyclical moves and we avoid the chasing-our-own-tail spiral of trying to handicap short-term wiggles. As a result, when this report went to press Tuesday afternoon, we looked through the election and rejected tweaking our portfolios to position for any particular outcome. While we were surprised by the results of the election, our U.S. portfolios' domestic orientation, and the generally defensive cast to all of our portfolios, should help insulate them from any incremental volatility that may ensue over the rest of the year. The immediate market reaction soundly rejected our stance on the course of Fed rate hikes, but we think investors may change their tune given more time to reflect. We think it is far from certain that the Fed will tear up its playbook. Upheaval in the financial markets could well stay the FOMC's hand in December, but the first half hour of New York trading suggests that the potential for upheaval was rather overhyped. We do not see why the election results would have any impact on the labor market and the creeping upward pressure on wages. Markets are said to hate uncertainty and the actions of a Trump administration are surely harder to predict than the actions of a Clinton administration. We are not going to become traders, but we will be more vigilant over the two-plus months before the Inauguration and the first weeks of the new administration. We will adopt a more tactical orientation if conditions warrant, but we are not acting hastily now. We expect that there will be a lot of head fakes before markets find their true course. Doug Peta, Vice President Global ETF Strategy dougp@bcaresearch.com 1 With 84% of S&P 500 constituents having reported through November 3rd, Standard & Poor's projected year-over-year growth in operating earnings of nearly 14%. 2 Overnight index swaps (OIS) are our preferred vehicle for deriving rate hike expectations because they represent contracts between real-life market participants and are thus more reliable than survey measures.

Highlights Portfolio Strategy Bank profits are unlikely to match those of the broad market if the Fed hikes interest rates and loan demand cools. Sell into strength. Gold shares are looking increasingly attractive, but we will refrain from upgrading until the U.S. dollar is closer to a peak. Drug pricing power is worse than government data suggests, warranting a downshift in our previously upbeat view toward pharmaceutical equities. Recent Changes S&P Health Care - Removed from our high conviction list. Upgrade Alert Gold Shares - Currently neutral. Downgrade Alert S&P Pharmaceuticals Index - Currently overweight. S&P Biotech Index - Currently overweight. Table 1 Feature Chart 1From Greed To Fear The gaping mismatch between fundamentals and broad market valuations remains intact, but will be in jeopardy of re-converging should the Fed signal an intention to tighten monetary conditions through next year. As previously outlined, our view is that the economy, particularly the corporate sector, will struggle further if financial conditions become more restrictive and/or election uncertainty persists. Indeed, investors have been scrambling to buy protection, aggressively bidding up near-term VIX contracts, especially relative to longer-term contracts. While it is tempting to view this increase in fear as a contrary positive, this measure typically sinks lower when investors turn cautious. Chart 1 shows that tactical broad market vulnerability still exists. On a more fundamental basis, the non-financial corporate sector's return on equity has already fallen to its lowest level in more than 60 years (Chart 2). Yet the median price/sales and price/earnings ratios are flirting with all-time highs (Chart 2). That divergence is not sustainable, given the direct link between ROE, profit growth and valuations. Central bank benevolence has underwritten this gap. Third quarter earnings have failed to impress thus far, keeping the equity market locked in a tight range. So far, one nascent trend is that domestic and consumer-linked equities appear to be gaining traction at the expense of global, business-dependent sectors. We expect the complexion of earnings contributions to become more lopsided in the quarters ahead, in support of most of these budding trend changes. The inevitable upshot of a strong U.S. dollar is deteriorating profit breadth. Chart 3 shows that the number of industry groups experiencing rising forward earnings estimates is likely to erode as the currency strengthens. Clearly, industries most reliant on exports and/or capital spending are most vulnerable. The corporate sector has run up debt levels and is struggling to generate profit growth. In turn, business spending has been compromised, as measured by the contraction in core durable goods orders (Chart 3). On the flipside, consumers have rebuilt their savings and are enjoying the benefits of a positive wealth effect. The increase in real wage and salary growth is underpinning real median household income. The latter surged 5.2%, posting the largest percentage increase in the history of the data. Consumer income expectations are well supported (Chart 3, top panel). The implication is that consumption-oriented plays should be well positioned to deliver profit outperformance, even if the labor market slows. From an investment theme perspective, the upshot is domestic-oriented areas are poised to make a comeback relative to globally-exposed sectors after a burst of speed in recent months (Chart 4). Net earnings revisions are already shifting in that direction, with more upside ahead based on U.S. dollar strength, as well as dirt cheap relative valuations (Chart 4). Chart 2A Disturbing Mismatch Chart 3Consumers Are Stronger Than Corporates Chart 4Favor Domestic Vs. Global One exception is the banking sector, where there is limited scope for earnings outperformance and/or valuation expansion. Bank Stocks Are Showing Signs Of Life, But... Bank stocks have moved higher, following the sell-off in global bond markets and steepening in yield curves sparked initially by the Bank of Japan's curve targeting shift and a reversal of incremental easing expectations from the Bank of England. However, we are not convinced that the relative performance bear market is over. A Special Report published on October 3 surveyed the performance of banks during Fed tightening cycles, to help put context around the widely held view that Fed rate hikes will bolster bank stocks on a sustained basis. History shows there has been only a loose relationship between the Fed funds rate and net interest margins. It would take rising rate expectations within the context of a steeper yield curve, improving credit quality and rapid loan growth to justify an optimistic profit outlook. Bank profits have not been able to outpace the broad corporate sector since the beginning of 2015 (Chart 5, top panel), even though loan growth has been healthy and overall earnings were crushed by the implosion in commodity prices during that period, allowing most other sectors to show earnings outperformance. Will another 25 bps interest rate hike remedy this? The Fed is keen to hike rates partially because it views them as being overly accommodative for an economy operating close to full employment, and is keen to reestablish firepower in advance of the next economic downturn. But there is scant evidence of economic overheating to support the view that rates have been 'too low'. Inflation and inflation expectations, while up from very depressed levels, are still historically low and the economy is struggling to grow at, let alone above, trend. Consequently, a strident Fed would boost the odds of a policy mistake. The market appears to share that view, given the failure of the yield curve to stop narrowing since the taper talk started, notwithstanding the recent blip up (Chart 5, bottom panel). Chart 5Why Would Bank Profits Outperform Now? Chart 6Beware U.S. Dollar Strength Now that the USD is strengthening anew, the odds of imported deflation have climbed, to the detriment of corporate profits and bank stock relative performance (Chart 6, top panel). While nominal yields have backed up, real 2-year yields have declined, which is not consistent with an upgrading in economic expectations. Indeed, C&I loan growth has dropped sharply in recent weeks (Chart 6). By extension, it is hard to envision long-term yields rising much, if at all, which will keep net interest margins thin. Furthermore, if overall earnings remain stuck in neutral, corporate credit quality will undoubtedly worsen given the debt binge in recent years. Non-performing loans have only just begun to increase. Higher interest rates will not solve these problems. Instead, the downturn in credit quality could accelerate via more onerous debt servicing requirements, given the lack of a corporate sector balance sheet cushion. Perhaps more worrying is that banks are no longer pruning cost structures, which is unusual given that credit standards are tightening on most credit products outside of traditional mortgages. In the last 25 years, or as far back as we have the data, bank stocks lagged the broad market after bank employment started rising. The only exception was in the aftermath of the tech bubble, when all non-TMT sectors outperformed (Chart 7). If banks continue to expand their wage bill, without a widening in net interest margins and/or reversal in increased loan loss reserving, bank profits will fail to match the growth rate of the overall S&P 500. The optimal, but not exclusive, time for banks to outperform is typically exiting recession, when policy is easing and the yield curve is steepening, and in the late innings of an expansion. In fact, productivity is sagging throughout the financial sector. Financial sector employment is probing new highs (Chart 8), reflecting a more onerous cost structure required to meet regulatory obligations. Employment is now growing faster than sales, a reliable indication of flagging productivity. The implication is that financial sector profits will continue to lag those of the broad market. Chart 7Beware Rising Bank Employment Chart 8Sectoral Productivity Drain Bottom Line: Strength in bank stocks is a chance to sell. Is It Time To Buy Back Gold Shares? Gold shares are bouncing after having been punished in the last few months. Overheated technical conditions and prospects for a more hawkish Fed led us to recommend taking profits in August, despite a positive long-term outlook. Indeed, the likelihood of a prolonged period of negative to ultra-low real interest rates is high given startlingly low potential GDP growth in most of the developed world. Gold shares typically do well in the aftermath of a debt binge, as proxied by our Corporate Health Monitor (CHM, shown advanced, Chart 9). It is unnerving that the CHM has suffered such a broad-based deterioration without any back up in interest rates. Low interest rates and tight credit spreads have cushioned what has otherwise been a stark erosion in debt servicing capabilities: there is little scope for a parallel upshift in the global interest rate structure. These are bullish conditions for gold shares, as captured by the upbeat reading in our Cyclical Gold Indicator (Chart 9, top panel). As such, when we took profits we advised that we would look to return to an overweight position once tactical downside risks had been reduced. Are we there yet? Chart 10 suggests that extreme bullishness toward the yellow metal has not yet fully unwound. While the share price ratio has dropped back to its 200-day moving average, cyclical momentum remains elevated, as measured by the 52-week rate of change. Sentiment in the commodity pits is still elevated, flows into gold ETFs are still strong and net speculative positions have not yet made a full retreat (Chart 10), especially in view of the recent politically-motivated pop in market volatility. The implication is that there could be additional selling pressure in the coming weeks. Chart 9Cyclically Appealing, But... Chart 10... Still Tactically Frothy Chart 11The Currency Is Critical In terms of potential buy triggers, anything that causes the U.S. dollar to lose its bid is a strong candidate. Ironically, a Fed rate hike could produce such an outcome, contrary to popular wisdom. In our view, the U.S. (and global) economy cannot handle tighter financial conditions, and a rise in interest rates would need to be offset by a weaker currency. Gold shares perform well when economic expectations are faltering (Chart 11, shown inverted), and a hawkish Fed would likely raise global economic fears. On the flipside, a go-slow Fed could keep the currency bid. That would allow the economy more time to heal and recover, and possibly overheat, thereby potentially boosting future returns on capital, certainly relative to other countries where output gaps remain larger. Bottom Line: Stay neutral on gold stocks, but put them on upgrade alert in recognition that an upgrade back to overweight could occur sooner rather than later, i.e. by yearend, depending on macro dynamics. What To Do With Drug Stocks? A number of drug wholesalers reported earnings misses and provided disappointing guidance, specifically citing worse than expected generic pricing pressure, enough to offset ongoing branded drug price increases. In the current environment of political uncertainty toward health care companies, the knee jerk reaction has been to abandon all pharmaceutical-related equities, regardless of exposure to branded or generic medicines. Our pharmaceutical equity view has noted that the time to worry about the pace of drug price increases would be if they sparked a change in consumption patterns and/or buyer behavior. The fact that major buying groups such as health insurers and pharmacy benefit managers are balking at generic drug price increases constitutes such a shift. Consumer spending on drugs has slowed, albeit that has not been confirmed by neither strong retail drug store sales nor booming hospital employment (Chart 12). Nor is there an unwanted inventory build (Chart 12). Nevertheless, in light of new information, which implies that company-reported pricing pressure is worse than current government data shows, we are downgrading our outlook for drug-related shares. Still, rather than sell after the index has already taken a large hit, pushing relative performance to oversold and undervalued levels (Chart 12), we will await a more opportune moment to lighten positions, especially in view of our preference for defensive equities. Keep in mind that the drug price increases are still well in excess of the overall rate of inflation as branded drug prices continue to rise (Chart 13), and earnings stability should be increasingly desirable as the U.S. dollar climbs. In the meantime, drug-related shares are now on downgrade alert and the overall health care sector is off our high-conviction list. The good news is that other parts of the health care sector should benefit if drug inflation cools. For instance, a reduction in the rate of drug price increases, and in the case of generics, outright price cuts, is a blessing for the S&P managed care industry. Cost inflation had been perking up, but should ease in the coming quarters as drug expenses abate. Health insurance premiums are growing at a faster rate than overall inflation, while job growth remains decent (Chart 14), underscoring that top-line growth is still outpacing that of the overall corporate sector. If cost inflation eases while revenue climbs, the index should move to at least a market multiple from its current discounted valuation. Importantly, technical readings have improved. Chart 12Under The Gun... Chart 13... But Pricing Power Remains Strong Chart 14Celebrating Reduced Cost Inflation Cyclical momentum has begun to reaccelerate from neutral levels after unwinding overbought conditions (Chart 14), suggesting that a breakout to new relative performance highs is in the offing. Bottom Line: The pain in drug-related shares should provide a gain to health care insurers. Stay overweight the S&P managed care index. However, look to lighten the S&P pharmaceutical and biotech indexes on a relative performance bounce in the coming weeks, both are now on downgrade alert. Current Recommendations Current Trades Size And Style Views Favor small over large caps and growth over value.