Equities

Highlights Portfolio Strategy We reiterate our recent overweight calls in banks/financials and energy. Chemicals/materials and telecom services no longer deserve a below benchmark allocation. Pharma/health care and utilities are now in the underweight column. Recent Changes There are no changes to our portfolio this week. Table 1Sector Performance Returns (%) Feature Equities poked higher early last week on the eve of a robust earnings season as quarterly EPS vaulted to all-time highs (Chart 1), only to give up those gains and then some as North Korea jitters spoiled the party and ignited a mini selloff later in the week. While geopolitical uncertainty is dominating the news flow and an escalation is possible, we doubt North Korea tensions in isolation can significantly derail the stock market. With regard to the SPX's future return composition, our view remains intact that the onus falls on earnings to do the heavy lifting. In other words, the multiple expansion phase has mostly run its course, and explains the bulk of the board market's return since the 2011 trough (Chart 2). Now it is time for profits to shine. Chart 1Earnings-Led Advance Chart 2EPS Has To Do The Heavy Lifting Low double-digit EPS growth is likely in calendar 2018. Three key factors drive our sanguine profit view. First, as we posited three weeks ago, financials and energy will command a larger slice of the earnings pie, a backdrop not yet discounted in sell-side analysts' estimates (please see Table 2 from the July 24th Weekly Report). Second, irrespective of where the U.S. dollar heads in the coming months, SPX earnings will benefit from positive FX translation gains in Q3 and Q4. Finally, as the corporate sector flexes its operating leverage muscle, even modest sales growth will go a long way in terms of profit growth generation. Operating profit margins are poised to expand especially given muted wage inflation (Chart 3). Nevertheless, lack of profit validation is a key risk to our bullish S&P 500 thesis. Considering the post-GFC period, global growth scares (and resulting anemic earnings follow through) were the primary catalysts for the 2010, 2011 and late-2015/early-2016 equity corrections. The SPX fell 16%, 19% and 14% in each of those episodes, respectively. As a reminder, early in 2010 the Fed's QE ended and the ECB was scrambling to contain the government debt crisis as the Eurozone and the IMF bailed out Greece, Portugal and Ireland. In 2011, recession fears gripped the world economy, when then ECB President Jean-Claude Trichet tightened monetary policy twice in the euro area, while in the U.S. QE2 ended (Chart 4) and the debt ceiling fiasco spiraled out of control in the late-summer. More recently, a global manufacturing recession took hold in late-2015/early-2016 and the commodity drubbing re-concentrated investor's minds. Chart 3Margin Expansion Phase Chart 4Liquidity Removal = Market Turmoil A persistent flare up in geopolitical risk (i.e. in addition to the possible escalation of North Korea tensions) may lead consumers and CEOs alike to pull in their horns and short circuit the synchronized global economic recovery. Putting this risk in perspective is instructive. Table 2 documents the historical precedent of geopolitical crises since the mid-1950s, the maximum SPX drawdowns, and bid up of safe haven assets courtesy of our Geopolitical Strategy Service.1 Under such a backdrop, low-double digit EPS growth would be at risk, also causing some equity market consternation. Table 2Safe-Haven Demand Rises During Crises Table 2Safe-Haven Demand Rises During Crises, Continued Importantly, the Chinese Congress is quickly approaching in October and the dual tightening in Chinese monetary conditions (rising currency and interest rates) is unnerving. A related Chinese/EM relapse represents a risk to our bullish overall equity market thesis. Commodity producers/sectors would suffer a setback, jeopardizing the broad-based earnings recovery. Chart 5Mini Capex Upcycle Second, lack of tax reform is another risk we are closely monitoring that could put our upbeat SPX view offside. Lack of traction on this front as the year draws to a close will likely sabotage business confidence and put capex plans on the backburner anew. Moreover, this would shatter the confidence of small and medium businesses, especially given their greatest bugbears: high taxes and big government. Finally, repatriation tax holiday blues would cast a double dark shadow primarily over the tech and health care sectors: not only would shareholder-friendly activities like dividends and buybacks get postponed, but so would capex plans (Chart 5). One final risk worth monitoring is the handoff of liquidity to growth. Historically, there has been significant turmoil every time the Fed has removed balance sheet accommodation in the post-GFC era. We are in uncharted territory and the unwinding of the Fed's balance sheet, likely to be announced next month, may have unintended consequences. Unlike QE and QE2 ending, this time around the ECB is also on the cusp of removing balance sheet liquidity, at the margin. Chart 6A shows that the equity market may come under pressure if history at least rhymes. While we doubt that a larger than 10% correction is in the cards -- in line with the historical S&P 500 average drawdown during geopolitical crises (middle panel, Chart 6B)2 -- and our strategy will be to "buy the dip", the time to purchase portfolio insurance is now when the S&P 500 is near all-time highs, especially given the seasonally-weak and accident-prone months of September and October. Chart 6ADay Of Reckoning? Chart 6BAsset Class Returns During Crises We are comfortable with our overall early-cyclical portfolio exposure, while simultaneously maintaining a bit of defense in the form of our overweight consumer staples and underweight tech positions. This week we are recapping and reiterating all the major portfolio moves we have made since early May. Banking On Faster Growth Bank profit growth is supported by three main pillars: the quantity, price and quality of credit. All three are set to improve. Solid house price inflation and a tight labor market should ensure that consumer credit growth also firms (Chart 7A), pointing to the potential for a broad-based bank balance sheet expansion. Our U.S. bank loan growth model suggests that banks could enjoy the largest upswing in credit growth of the past 30 years (Chart 7B). Soaring consumer and business confidence, rising corporate profits and a potential capital spending revival are the key model drivers. BCA's view is that a better economy and rising inflation will materialize in the back half of the year, and serve as a catalyst to higher interest rates and a steeper yield curve. Banks profit from overall rising interest rates in two ways: reinvesting at higher yields and assets repricing at a faster pace than deposits. Thus, a steepening yield curve would signal that bank profit estimates should experience a re-rating, provided the yield lift at the long end of the curve was gradual and did not choke off growth via a sudden spike (Chart 7A). Chart 7ABanks Flexing Their Muscle Chart 7BBCA Bank Loans & Leases Growth Model In terms of credit quality, non-performing loans and charge-offs are sinking from already low levels. It would take a significant deterioration in the labor market to warn that credit quality was about to become a profit drag. Importantly, the reserve coverage ratio has climbed to near 100%, as non-current loans have fallen faster than banks have released reserves. Historically, credit quality improvement has been positively correlated with rising valuations (Chart 7A). Finally, even a modest easing in the regulatory backdrop along with a more shareholder friendly outlook now that the banks aced the Fed's stress test should help unlock excellent value in bank equities. Bottom Line: We reiterate our overweight stance in the S&P banks index that also lifted the S&P financials sector to overweight. Buy Energy Stocks Chart 8Energy EPS Model Says Buy Energy equities are down roughly 20% year-to-date versus the broad market, driven by rising U.S. shale oil production, inventory accumulation, and investor doubts about whether all nations will comply with OPEC's mandated production cuts. There are tentative signs that this relative performance bear phase is drawing to a close. Three main drivers support our modestly sanguine view of energy stocks. First, the long term inverse correlation between the U.S. dollar and the commodity complex has been reestablished; global growth suggests that a tightening interest rate cycle is brewing which should be supportive to energy stocks (top panel, Chart 8). Second, the steepest drilling upcycle in recent memory is showing signs of fatigue with Baker Hughes reporting flattening growth in domestic oil rig count; At least a modest deceleration in shale oil production is likely (Chart 8). Finally, our S&P energy sector Valuation Indicator has gravitated back to the neutral zone. Technicals are also washed out with our Technical Indicator breaching one standard deviation below its historical mean, a level that typically heralds a reversal. Recent anecdotes that the sell-side is throwing in the towel on their bullish oil forecasts for the remainder of the year are also contrarily positive. Bottom Line: Our newly introduced S&P energy sector relative EPS model encapsulates this cautiously optimistic industry backdrop (Chart 8), and gave us comfort to lift the S&P energy sector to a modest overweight position. DeREITing Chart 9Lighten Up On REITs REITs have marked time year-to-date, but recently operating conditions have downshifted a notch. Three key drivers argue for lightening up exposure on this newly formed S&P GICS1 sector. First, REITs had been unable to materially benefit from the 50bps fall in the 10-year Treasury yield from the mid-December peak to the mid-June trough. As the economy recovers from the first half lull, Treasury yields will resume their advance. This is a net negative for the fixed income proxy real estate sector (Chart 9). Second, real estate occupancy rates have crested and generationally high supply additions in the apartment space are all but certain to push vacancies higher still. The implication is that rental inflation will remain under intense downward pressure (Chart 9). Finally, according to the Fed's latest Senior Loan Officer Survey, bankers are less willing to extend CRE credit. If banks continue to close the credit taps, CRE prices will suffer a setback. Bottom Line: We reiterate our downgrade of the niche S&P real estate sector to a benchmark allocation. Positive Chemical Reaction? Chart 10Chemicals Are No Longer Toxic In the summer of 2014 we went underweight the S&P chemicals index, anticipating an earnings underperformance phase, driven by weak revenues as chemicals manufacturers were furiously adding capacity to benefit from lower domestic feedstocks. This view has largely panned out, and now three factors underpin our more neutral bias: synchronized global growth, receding global capacity and improving domestic operating conditions. The global manufacturing PMI has recently reaccelerated and jumped to a six year high. Similarly, the U.S. ISM manufacturing survey also vaulted higher. Synchronized global growth suggests that final demand is on the upswing and should bode well for chemical top- and bottom-line growth (Chart 10). This has driven a relative weakening of the U.S. dollar, much to the benefit of U.S. chemical producers, whose exports appear to be displacing German exports. Global chemicals M&A supports our expectation of demand-driven pricing power gains. We think the benefits of consolidation are twofold: First, reduced revenues of the past decade have left the industry with outsized cost structures; consolidation should sweep that away under the guise of synergy, driving margins higher. Second, industry overcapacity has historically impaired profitability due to soaring overhead and more competitive pricing; greater scale should impose greater capital discipline. Finally, domestic operating conditions have taken a turn for the better. This improving domestic final demand backdrop is reflected in higher resource utilization rates and solid pricing power gains have staying power (Chart 10). Bottom Line: Tentative evidence suggests that the bear market in chemicals producers is over. We reiterate our recent upgrade to neutral. Given that chemicals stocks comprise over 73% of the broad materials index, this bump also moved the S&P materials sector to a benchmark allocation. Utilities: Blackout Warning Chart 11Utilities Get Short Circuited While chemicals and materials are beneficiaries of an upgrading in global economic expectations, utilities sit at the opposite end of the table (global manufacturing PMI shown inverted, top panel, Chart 11), and therefore warrant a downgrade to a below benchmark allocation. Now that the Fed is ready to start unwinding its balance sheet, the ECB is preparing the waters for QE tapering and a slew of CBs are on the cusp of a new tightening interest rate cycle, there are high odds that still overvalued fixed income proxies will continue to suffer. Synchronized global growth and coordinated tightening in monetary policy spells trouble for bonds. Our sister publication U.S. Bond Strategy expects a bond selloff for the remainder of the year. Given that utilities essentially trade as a proxy for bonds, this macro backdrop leaves them vulnerable to a significant underperformance phase (Treasury yield shown inverted, bottom panel, Chart 11). Importantly, the stock-to-bond (S/B) ratio and utilities sector relative performance also has a tight inverse correlation (S/B shown inverted, second panel, Chart 11). The implication is that downside risks remain acute. Without the support of continued declines in bond yields, or of indiscriminate capital flight from all riskier assets, utilities advances depend on improving fundamentals. The news on the domestic operating front is grim. Contracting natural gas prices, the marginal price setter for the industry, suggest that recent utilities pricing power gains are running on empty. Tack on waning productivity, with labor additions handily outpacing electricity production, and the ingredients for a margin squeeze are in place. Bottom Line: We reiterate our recent downgrade to underweight. Pharma: Tough Pill To Swallow Chart 12Pharma Relapse Pharma stock profits have moved in lockstep with consumer spending on pharmaceuticals and both have roughly doubled over the past decade. However, relative pharma consumer outlays have crested recently, causing a significant pharma profit underperformance (Chart 12). If our cautious drug pricing power thesis pans out as we portrayed in the July 31st Weekly Report, then pharma earnings will suffer and exert downward pressure on relative share prices (Chart 12). Industry balance sheet deterioration represents another warning signal. Net debt/EBITDA is skyrocketing at a time when the broad non-financial corporate (NFC) sector has been in balance sheet rebuilding mode (bottom panel). While this metric does not suggest that pharma stocks are in deep financial trouble, the deterioration in finances is undeniable, and, at the margin, a rising interest rate backdrop will likely slow down debt issuance for equity retirement and dividend payout purposes. Bottom Line: We recently trimmed the S&P pharmaceuticals index to underweight, which also took the S&P health care index to underweight. Telecom Services: Signs Of Life Chart 13Telecom: Climbing Out Of Deflation2 Investors have shunned telecom services stocks vehemently year-to-date (YTD) on the back of an abysmal profit showing. We had been fortunate enough to underweight this niche sector since late January, adding alpha to our portfolio. Nevertheless, we did not want to overstay our welcome and recently booked profits of 12% and lifted the S&P telecom services sector to the neutral column. Our Cyclical Macro Indicator has arrested its fall giving us comfort that at least a lateral move in relative share prices is likely in coming months (Chart 13). The steep recalibration of cost structures to the new pricing reality is buttressing our CMI, offsetting the sector's plummeting share of the consumer's wallet (Chart 13). Encouragingly, selling prices cannot contract at 10% per annum indefinitely, and on a three month-rate of change basis, pricing power has staged a V-shaped recovery (Chart 13). Anecdotally, Verizon's first full quarter post the new pricing plans was solid and suggests that the peak deflationary impulse is likely behind the industry. Impressive labor cost discipline along with even a modest pricing power rebound signal that a grinding higher margin backdrop is likely in the coming months, in line with our margin proxy reading. This will also stabilize relative profitability. In sum, the bearish S&P telecom services narrative is more than discounted in ultra-depressed relative valuations on cyclically quashed profit estimates. Green shoots on the industry's pricing power front and impressive management focus on cost structures argue against being bearish this niche sector. Bottom Line: We reiterate the recent bump to neutral in the S&P telecom services sector. Anastasios Avgeriou, Vice President U.S. Equity Strategy & Global Alpha Sector Strategy anastasios@bcaresearch.com 1 Please see BCA Geopolitical Strategy Special Report, "Geopolitics And Safe Havens," dated November 11, 2015, available at gps.bcaresearch.com. 2 Ibid. Current Recommendations Current Trades Size And Style Views Favor small over large caps and stay neutral growth over value.

Highlights The GOP can bolster its case for re-election in 2018 by passing tax cuts and rolling back regulation. With U.S. equity valuations stretched, prolonged uncertainty in Northeast Asia may be a catalyst for a pullback. The global economic outlook is brightening and will be a tailwind for U.S. economic growth and equities. Rising wage pressure will be another headwind for EPS growth in 2018, although wages appear quite benign at the moment. Wages are not always a good leading indicator for the inflation cycle. Indeed, sometimes upturns in wage growth lags that of consumer prices. Feature Safe haven assets caught a bid last week while risk assets sold off as investors weighed geopolitical tensions in Northeast Asia and more uncertainty over fiscal policy in Washington. Last week's U.S. economic data highlighted the disconnect between a tighter labor market and a lack of wage pressures. Meanwhile, the data suggest that growth outside the U.S. is accelerating. Nonetheless, history shows that investors should be patient while waiting for an upturn in inflation. Next Up: Tax Cuts The GOP will deliver on tax cuts this year despite disarray at the White House and an incompetent Congress, but fiscal stimulus may fail to live up to its hype. Furthermore, a fiscal lift from infrastructure spending is unlikely anytime soon. Republicans need a win ahead of the 2018 mid-term elections and they have already laid the groundwork for tax reform via the budget reconciliation process. Moreover, cutting taxes is easier to justify politically than removing an entitlement program (i.e. Obamacare). Tax rates probably will not be lowered by as much as originally promised because conservative Republicans in the House will demand "revenue offsets" to pay for tax cuts. Internal GOP battles over how to fund tax cuts could spill over into some tension regarding raising the debt ceiling. However, it is in neither political party's interests to create another "fiscal cliff" out of thin air. The GOP needs Democratic votes to pass this legislation in the Senate and the Democratic leadership has indicated it is willing to support it. At what price? House Minority leader Nancy Pelosi and Senate Minority leader Chuck Schumer may link the debt ceiling and spending bill to tax reform, and push for the tax cuts to extend to the middle class and to be revenue neutral. There is a chance that both parties will agree to temporarily eliminate the debt ceiling, perhaps beyond the 2018 mid-term elections. In any event, we expect a last minute resolution to both the U.S. debt ceiling and the potential government shutdown in September. Thus, there should be no lasting impact on financial markets from the debt ceiling debate. Turning to government regulation, the NFIB survey shows that small businesses are pleased with the Trump administration's attack on red tape. President Trump has made progress on slowing regulation and is on track to enact one-tenth the amount of economically significant regulation1 passed by the Obama administration (Chart 1). By this metric, Trump is even more frugal than Reagan. Trump and the GOP-held Congress have rolled back Obama-era rules and delayed others. Still, regulatory change is slow to impact the economy and it may take years for the regulatory rollback to provide any meaningful lift to growth. Accordingly, the "Trump Put"2 is still in place. U.S. politics will remain a mess for much of the year, delaying any progress on populist economic policies that would have buoyed U.S. nominal GDP growth and given the Fed a reason to hike interest rates more aggressively (Chart 2). Chart 1Trump Has Had Success In Slowing Regulation Chart 2The Trump Put Bottom Line: Trump will not be impeached until after the 2018 mid-term election, and only then if the Democrats manage to take control of the House. The GOP can bolster its case for re-election in 2018 by passing tax cuts and rolling back regulation. The intensifying Mueller investigation and White House incompetence will only fuel the "Trump Put", which has been positive for U.S. equities, neutral for Treasuries, and bad for the dollar, all else equal. A significant uptick in inflation could overwhelm the "Trump Put" and spark a dollar rally. As such, investors should focus on inflation prospects rather than on White House politics. Fire And Fury Investors are on high alert and with the Q2 earnings season over, may look beyond the positive news on corporate profits for direction. Our colleagues in the BCA Geopolitical Strategy service have long maintained that Northeast Asia is ripe for economic/political risk.3 The underlying driver of uncertainty on the Korean Peninsula is the Sino-American rivalry. China is an emerging "great power" that threatens the global dominance of the U.S. and its allies. The immediate consequence is mounting friction in China's periphery. That is why Taiwan, the South China Sea, and North Korea, are all heating up. North Korea's regime is highly unpredictable as evidenced by events in the past few weeks. In that sense, it is more significant than the other "proxy battles" between the U.S. and China. In essence, North Korea is no longer merely an object of satire. A new round of negotiations over North Korea's nuclear and missile programs is about to begin. The potential for a military conflict is high unless diplomacy succeeds in convincing North Korea to freeze its weapons programs. The events on the Korean peninsula are unfolding as we expected they would. North Korea has a history of rational action. It wants a nuclear deterrent and a peace treaty, but not a regime change. The U.S. has forsworn regime change as an intention and China has recommitted to new sanctions. South Korea is pro-engagement. Moreover, we are seeing the U.S. establish a credible military as part of the "arc of diplomacy," comparable to U.S.-Iran relations 2010-15. Bottom Line: We do not expect a pre-emptive strike by the U.S. on North Korea, as the constraints to conflict are extremely high and not all diplomatic options have been exhausted. Nonetheless, with U.S. equity valuations stretched, prolonged uncertainty in the region may be a catalyst for a pullback. A Rosy Global Picture The global economic outlook is brightening and will be a tailwind for U.S. economic growth and equities. Global real GDP estimates continue to move higher, a welcome departure from years past when estimates slid relentlessly lower (Chart 3). Since the start of 2017, global GDP estimates for this year have increased from 2.8% to 3%, while 2018 forecasts have accelerated from 2.7% to 2.9%. This upward trajectory has occurred despite a recalibration by many major central banks away from accommodative policies. Aggressive central bank actions or escalating tensions in Northeast Asia, or both, may halt the improving growth forecasts. Falling oil prices would also challenge a quickening of global growth, but our view is that oil prices will move higher in the coming months.4 Chart 3Global Growth Estimates Accelerating Despite Stalled U.S. Growth Global leading indicators are on the upswing (Chart 4). The BCA Global Leading Indicator Index (excluding the U.S.) in July 2017 was the strongest since 2010 when it slowed after a sharp rebound from the global financial crisis. The increase in growth still has room to run. Admittedly, the LEI's diffusion index has dipped below 50%. It would be a warning sign for global growth if the diffusion index does not soon turn up. Nominal global GDP growth is speeding up, boosted by improving consumer and business confidence, rising capital spending and declining policy uncertainty (Chart 5). The global economic surprise index is also climbing, which provides additional support. Investors may be concerned that the global PMIs have peaked (Chart 6), but they remain at levels consistent with above-trend GDP growth and we see no reason why they should drop below 50. Chart 4LEIs Pointing Higher Chart 5Supports For Global Growth In Place Chart 6Global Economic Activity Brightening Industrial production (IP) overseas is expanding nearly twice as fast as in the U.S. (Chart 5). This suggests that U.S. economic activity will be pulled up by foreign demand. A stronger dollar (as much as a 10% appreciation in the next year) may dampen U.S. exports and earnings, but this will be more a problem for 2018 than 2017. Bottom Line: Improving economic activity outside the U.S. is a tailwind for both U.S. economic growth and profits of U.S. firms with significant business abroad. Solid foreign demand will help the economy hit the Fed's GDP target and also support additional, but gradual, tightening by the central bank. Stay overweight U.S. equities and remain short duration. Waiting For Wages Rising wage pressure will be another headwind for EPS growth in 2018, although wages appear quite benign at the moment. Both primary and secondary indicators point to a tighter U.S. labor market. The July jobs report (released in early August) was yet another sign that the slack in the jobs market is vanishing.5 Data released last week on job openings (JOLTS) and the National Federation of Independent Business (NFIB) further supported this trend, and indicated that the labor market may tighten even more. Job openings rose to a new all-time high along with BCA's quit rate less layoffs indicator (Chart 7). The hire rate remained at a cycle peak. The NFIB data was equally impressive, with hiring plans and job openings surging in July. Small businesses are also finding it increasingly difficult to find quality labor. (Chart 7, panel 4) The strength in the labor market has not yet translated into accelerating wages, but patience is required. The July NFIB survey noted that "while a tight job market may point to higher wages and rising consumer spending down the road, which is also good for small businesses, the current expansion efforts by small business owners are being choked by their difficulties in hiring and keeping workers." The NFIB's compensation plans (Chart 7) provided quantitative support for the group's qualitative assessment. However, the latest readings on labor compensation from the Q2 productivity report, the tepid July average hourly earnings data and the Atlanta Fed wage tracker suggest that the labor market is still not tight enough to generate much wage pressure (Chart 8). Chart 7Widespread Evidence That##BR##Labor Market Is Tightening Chart 8Not Much Wage##BR##Pressure Yet Inflation And Long-Expansion Dynamics That said, wages are not always a good leading indicator for the inflation cycle. Indeed, sometimes upturns in wage growth lag that of consumer prices. In previous research we split U.S. post-1950 economic cycles into three sets based on the length of the expansion phase: short (about 2 years), medium (4-6 years) and long (8-10 years). What distinguishes short from medium and long expansions is the speed at which the most cyclical parts of the economy accelerated, and the time it took unemployment to reach a full employment level. Long expansions were characterized by a drawn-out rise in the cyclical parts of the economy and a very slow return to full employment, similar to what has occurred since the Great Recession. Chart 9 compares the current cycle to the average of two of the long cycles (the 1980s and the 1990s). We excluded the long-running 1960s expansion because the Fed delayed far too long and fell well behind the inflation curve. We define the 'late cycle' phase to be the time period from when the economy first reached full employment to the subsequent recession (shaded portions in Chart 9). The average late-cycle phase for these two expansions lasted almost four years, highlighting that reaching full employment does not necessarily mean that a recession is imminent. Inflation pressures are slower to emerge in 'slow burn' recoveries, allowing the Fed to proceed slowly. The Fed waited an average of 25 months to tighten policy after reaching full employment in these two long expansions, in part because core CPI inflation was roughly flat. The result was an extended late-cycle phase that was very rewarding for equity investors because the economy and earnings continued to grow. Of course, inflation eventually did turn higher, signaling the beginning of the end for the expansion and equity bull phase. In Chart 10, we compare the core PCE inflation rate in the current cycle with the average of the previous two long expansion episodes (the inflection point for inflation in the previous cycles are aligned with June 2017 for comparison purposes). The other panels in the chart highlight that, in the 1980s and 1990s, wage growth gave no warning that an inflation upturn was imminent. Indeed, wages were a lagging indicator of consumer price inflation. Chart 9Labor Market, Inflation And Stocks##BR##In The Long 80's & 90's Expansions Chart 10In The 80's & 90's Wage Growth##BR##Gave No Early Warning On On Inflation Market commentators often assume that inflation is driven exclusively by "cost push" effects, such that the direction of causation runs from wage pressure to price pressure. However, causation runs in the other direction as well. Households see rising prices and then demand better wages to compensate for the added cost of living. Chart 11Leading Indicators Of Inflation##BR##In "Slow Burn" Recoveries This is not to say that we should totally disregard wage information. But it does suggest that we must keep an eye on a wider set of data. Indicators that provided some leading information for inflation in the previous two long cycles are shown in Chart 11. To this list we would also add the St. Louis Fed's Price Pressure index, which is not shown in Chart 11 because it does not have enough history. All of these indicators have moved higher over the past 18 months, after bottoming at extremely low levels in 2015 and early 2016. However, they have all pulled back to some extent in recent months. This year's pipeline inflation "soft patch" continued into July, according to last week's release of the Producer Price Index. The easing in cost pressures at the producer level has been broadly based (i.e. one cannot blame special factors). These indicators suggest that consumer price inflation, according to either the CPI or the PCE, will struggle to rise in the next few months. The July CPI report revealed another tepid 0.1% monthly rise in the core price index, while the year-over-year rate remained at 1.7%. Rising prices for health care goods and services were offset by price declines for new and used cars. The diffusion index for the CPI moved up to the zero line in July, indicating that disinflation was a little less broadly based in the month. Bottom Line: Our base case is that core PCE inflation edges higher in the coming months, which will be enough for the FOMC to justify a rate hike in December. We also expect that inflation will be high enough in 2018 for the Fed to hike rates by more than is discounted in the bond market. Nonetheless, the warning signs of an inflation upturn are mixed at best. It would flatter our stocks-over-bonds recommendation if we are wrong on the inflation outlook, but our short duration stance would not be profitable in this case. John Canally, CFA, Senior Vice President U.S. Investment Strategy johnc@bcaresearch.com Mark McClellan, Senior Vice President The Bank Credit Analyst markm@bcaresearch.com 1 Office of Information and Regulatory Affairs (OIRA) of Office of Management and Budget (OMB): https://www.reginfo.gov/public/do/eAgendaMain and https://www.reginfo.gov/public/do/eoCountsSearchInit?action=init 2 Please see Geopolitical Strategy Weekly Report, "How Long Can The Trump Put Last" dated June 14, 2017, available at gps.bcaresearch.com. 3 Please see Geopolitical Strategy Weekly Report, "North Korea: Beyond Satire, dated April 18, 2017, available at gps.bcaresearch.com. 4 Please see Commodity & Energy Strategy Weekly Report, "KSA's Tactics Advance OPEC' 2.0's Agenda," dated August 10, 2017, available at ces.bcaresearch.com. 5 Please see U.S. Investment Strategy Weekly Report, "Stay The Course" dated August 7, 2017, available at usis.bcaresearch.com.

Leisure product stocks have taken a beating this summer to nearly their lowest level since the GFC (top panel). The slide followed a tough Q2 earnings season that saw the industry miss top line and margin estimates. Unsurprisingly, forward earnings estimates have fallen off a cliff (second panel). We think there is cause to remain optimistic. Consumer spending on toys and games has been firmly in expansion mode since the '09 trough and industry sales have been growing steadily for the past four years (third panel). The result has been leisure gaining a growing slice of the retail pie (fourth panel). The collapse in forward earnings has caused a valuation spike (bottom panel). If higher outlays translate into increasing EPS as we expect, then a playable recovery rally is likely, similar to early 2015. Stay overweight. The ticker symbols for the stocks in this index are: BLBG: S5LEPR - MAT, HAS.

Special Report

Feature There have been two major milestones in China's financial market liberalization in recent months. In June, MSCI Inc. moved to include Chinese domestic A shares in its widely followed world and emerging market equity indices. In July, regulators in Hong Kong and on the Mainland jointly launched the "bond connect" program, allowing foreign investors easier access to China's massive onshore bond market.1 The immediate impact of these measures will likely be muted, but they mark China's continued efforts to deregulate capital account transactions, opening up Chinese domestic financial assets that a mere few years ago were still completely isolated from the rest of the world. Over the years, we have published and periodically updated our Research Note, "China Shop," as a practical guide for investors looking for exposure to Chinese assets. The guide has come a long way since its first edition more than a decade ago, when investing in China was extremely difficult and very limited for foreigners, and we were struggling to find the best "China play" proxies. Over the years, various indexes, tracker funds and derivatives have been established outside China, making investing in Chinese equities a lot easier and more straightforward. The China ETF universe not only covers broad market indexes but also specific sectors and different market caps, allowing for discretionary sector allocations and investment styles for China-focused portfolios (Box 1). Box 1 A Primer On Chinese Stocks A shares are stocks traded on the Shanghai and Shenzhen stock exchanges. These shares are denominated and traded in RMB, and are restricted to local investors and Qualified Foreign Institutional Investors (QFII). B shares are Chinese companies traded on the Shanghai and Shenzhen stock exchanges. This equity class was originally open to foreign investors only, but was made available to domestic investors in 2001. These stocks are denominated in the Chinese currency but traded in U.S. dollars on the Shanghai Stock Exchange and in Hong Kong dollars on the Shenzhen Stock Exchange. H shares are mainland-registered state-owned companies listed in Hong Kong and denominated in Hong Kong dollars. The term N shares refers to stocks listed on the New York Stock Exchange. Red Chips are stocks listed on the Hong Kong Exchange. These companies are usually domiciled outside China but have at least 30% of their stakes held by state-owned organizations or provincial and municipal governments of China. P Chips refer to shares of companies which are majority-owned by entrepreneurs from China and derive the bulk of their revenues in the mainland. These companies are typically incorporated in offshore tax havens and are listed in Hong Kong and other major exchanges outside of China. Since our last update a year ago, the China ETF universe that we've been tracking has continued to evolve, with a few interesting developments. The number of ETFs on our list witnessed the first decline since it was created about 10 years ago. Two new ETFs have been added to the list since our last update, but 16 have been suspended or de-listed (Appendix Below). This means the Chinese ETF boom in recent years has entered a period of "consolidation." It also means that global investors' appetite for Chinese assets has been rather weak. Investors' weak appetite for Chinese assets is also reflected in the constant net withdrawals from these China-related ETFs - a remarkable development considering the sharp rally in Chinese equities, both domestic and investable, since early 2016. Total assets under management (AUM) of these ETFs have increased slightly so far this year compared with a year ago. However, the increases have been entirely due to price increases (Chart 1). Indeed, net capital flows have constantly been negative since 2013, according to our calculations. Investors' lukewarm attitude toward Chinese ETFs stands in stark contrast to other EM bourses. AUMs of EM equity ETFs have been chasing the market rally to new records of late (Chart 2). It appears that investors, especially smaller retail investors, have remained highly uncomfortable with China's macro conditions, despite improving growth figures, and have been left out of the bull market. This could be a contrarian sign that Chinese equities are underweighted and under owned - confirmed by depressed equity multiples. Chart 1Constant Negative Fund Flows To China ETFs Chart 2China ETFs: Out Of Favor Looking forward, the Chinese ETF universe will continue to expand, and the recent market liberalization efforts will likely lead to increasing supplies of ETFs focused on the Chinese onshore bond market. Despite cyclical swings in both economic growth and financial markets, it is almost a sure bet that foreign ownership in Chinese assets will grow over time. Yan Wang, Senior Vice President China Investment Strategy yanw@bcaresearch.com 1 Please see China Investment Strategy Weekly Report, "Embracing Chinese Bonds," dated July 6, 2017, available at cis.bcaresearch.com. Appendix Broad Market By Market Cap - A Share By Market Cap - Investible By Sector - A Share By Sector - Investible Leveraged Plays Currency Fixed Income - Mainland Fixed Income - Offshore Cyclical Investment Stance Equity Sector Recommendations

Overweight This year has proven a tough one for the consumer finance index, a result of the hangover following the Trump election ebullience. However, the path has been generally upward since the post-Q1 trough; we expect more of the same. The data is unambiguously positive for consumer finance growth and profitability. Vibrant equity markets and a bounce back in house prices have driven household net worth to a ten year-high (top panel), while debt service payments are very near their decade-low (second panel). The upshot is a long runway for consumer outlays. With chargeoffs at historically low levels (third panel), expanding credit should deliver outsized profits to consumer finance providers. Despite the bright outlook, the market is pricing in a steep profit recession with multiples 35% below their ten-year average (bottom panel). We think this has created an excellent buying opportunity; stay overweight. The ticker symbols for the stocks in the S&P consumer finance index are: BLBG: S5CFINX-AXP, COF, DFS, SYF, NAVI.

The post-election surge in optimism following Donald Trump's election has not eroded, according to the latest NFIB small business survey, and remains very close to its decade-high (top panel). Importantly, healthy consumer spending appears to be presenting small businesses with the best pricing environment of the past three years. However, we are keeping our eyes on a few factors that may presage a decline in optimism. First, labor shortages for small businesses have become extreme; firms reporting unfilled jobs are at the highest level since 2001 (second panel). This could have the double impact of constraining business expansion and raising wages. Firms planning to increase salaries have already been outpacing those planning to increase prices for several years (third panel). This tight labor market could exacerbate the already-wide small cap profit gap versus their large cap peers (bottom panel). Deferred tax reform could also present a headwind to optimism. Taxes (and large government) are the single most important problem SMEs face. The post-election euphoria was based in large part on an anticipated reduction in the corporate tax bill; the longer Washington takes in passing a tax bill the higher the chance small business sentiment sours. In spite of these potential headwinds, we continue to believe the margin gap between small and large cap should normalize, especially if cooler heads prevail in D.C., favoring a small cap bias. Stay tuned.

Special Report

Highlights Dear Clients, We are publishing a Special Report prepared by my colleague Jonathan LaBerge who examines the case for allocating capital to EM stocks within a global equity portfolio. I hope you will find this report insightful. Best regards, Garry Evans The relative performance of emerging market equities is challenging the downward trend channel that has been in place for the past seven years. This has led to renewed interest in EM from global investors, and warrants a revisit of the role of emerging market equities within a global equity portfolio. While EM recorded the highest regional equity return last cycle (2002-07), they were surprisingly not the "ideal" regional equity market in an efficient portfolio allocation. Recently, several compositional changes within the EM equity universe give the appearance of much lower commodity exposure than is truly the case. But EM equities will still be correlated with broad commodities prices because the later reflect Chinese growth dynamics. Cyclical indicators for China's economy suggest that the broad trend in commodities prices is likely to be lackluster over the coming year, at best. Consequently, EM stocks offer a poor risk/return profile, justifying an underweight stance within a global equity portfolio. Feature Chart I-1Change In Trend, Or Another Failed Rally? In U.S. dollar terms, the relative performance of emerging market (EM) stocks has been in an uptrend for over 18 months, and now appears to be challenging the downward trend channel that has been in place for the past seven years (Chart I-1). This has led to a renewed interest in EM, particularly among global investors. This report takes the recent outperformance of EM stocks as an opportunity to revisit their past and future contribution to a global equity portfolio, and what this might mean for an allocation to EM equities over the coming year. We conclude that EM's return behavior during the last economic cycle (2002-2007), its continued link to commodities prices, and China's growth dynamics all contribute to a poor risk/return profile for EM over the coming year. Barring compelling signs of a durable commodity bull market, investors should underweight EM stocks within a global equity portfolio. EM Equities In A Global Context: Some Historical Perspective When examining whether emerging markets are attractive from the perspective of global equity allocation, a starting point is to analyze the fundamental drivers of regional earnings. One major driver of global earnings over the past 20 years has been commodities prices; Chart I-2 highlights how 12-month forward EPS for stocks in all major regions have been correlated with commodities since the late-1990s. Chart I-2ACommodities Prices Are Correlated With Earnings... Chart I-2B...Even In Developed Markets This can be largely explained by the fact that commodities tend to be a pro-cyclical asset class. However, the super cycle in commodities prices in the 2000s not only bolstered the earnings of global resource companies, it also powered earnings growth for export-oriented industrials as well as domestic demand plays in commodity-producing countries. Chart I-3Strong Correlation Between ##br##Commodities And EM Emerging markets were among the largest beneficiaries of the commodity boom; net commodity-exporting countries made up roughly 45% of EM market capitalization throughout the last economic cycle, whereas stocks in the resource sector made up between 25-30% of the index by weight. Unsurprisingly, the relative performance of EM stocks closely tracked commodities prices over this period (Chart I-3). But despite this, EM was surprisingly not the "ideal" regional equity market last cycle within an active portfolio, even though it had the highest return. Chart I-4A presents a scatterplot of annualized regional equity volatility and return from 2002 - 2007, measured in US$ terms. The chart also shows the ex-post Modern Portfolio Theory (MPT) efficient frontier, with Chart I-4B presenting the efficient regional allocation at each point along the frontier. Chart I-4AEmerging Market Stocks Had The Highest Return Last Cycle... Chart I-4B...But Were Only The Favored Market For High-Risk Portfolios Chart I-5From 2002-2007, Earnings Drove More ##br##Of The Rally In DCM Than EM While the charts show that the efficient allocation to emerging market stocks did rise to a maximum of 100% during the last economic cycle, it did not become the dominant region until the portfolio became considerably more volatile than the global equity benchmark. Indeed, Chart I-4B shows that developed commodity markets (DCM) were the preferred commodity play for most of the efficient frontier, owing to their superior performance in risk-adjusted terms. This risk-adjusted outperformance may have occurred because DCM returns last cycle were driven more by earnings than by multiple expansion; Chart I-5 highlights that EM stock prices benefitted from multiple expansion last cycle by outpacing forward earnings, versus the opposite in the case of DCM. Since the onset of the U.S. recession in 2008, Chart I-6A and Chart I-6B highlight that the ex-post efficient portfolio has been much more skewed than during the last economic cycle. The charts show that the frontier since 2008 has been extremely short, with efficient allocations only accruing to three countries with typically defensive stock markets: the U.S., Japan, and Switzerland, with a heavy bias towards the former. From the perspective of a global equity portfolio, this historical review leads to two conclusions: 1) investors should not allocate to EM unless they are bullish on commodities prices and, 2) if investors are bullish towards commodities, developed commodity markets have historically been a better risk-adjusted bet than emerging markets as a commodity play. Chart I-6ASince 2008, The Efficient Frontier Has Been Highly Skewed... Chart I-6B...Towards Defensive Markets (Mostly The U.S.) Chart I-7These Trends Give The False Appearance ##br##Of Lower EM Commodity Exposure EM And Commodities Prices: Has The Relationship Really Changed? More recently, a narrative has developed in the market that EM stocks are now far less sensitive to commodities prices than used to be the case. Proponents of this theory point to the following changes in the composition of emerging market equity benchmarks: First, the market capitalization weight of net commodity exporting countries has fallen precipitously since the onset of the collapse in oil prices in 2014 (Chart I-7, panel 1). On average, net commodity exporters made up between 40-45% of EM equity market cap from 2000 to 2013, but their share now stands at 27%. Second, Chart I-7, panel 2, shows that the market cap weight of resource sectors (energy plus materials) in emerging markets has fallen from roughly 30% to 14% over the past five years, a trend that pre-dated the decline in the share of net commodity exporters. Third, the enormous rise in the market capitalization of technology companies as a share of total EM market cap has been specifically cited by many market participants (Chart I-7, panel 3), especially since EM is now heavily overweight the tech sector relative to the global average. Broadly speaking, a fourth compositional change within the EM equity benchmark generally captures all of the shifts noted above, and is the focus of our remaining analysis below: the rise in the weight of emerging Asia as a share of overall EM (Chart I-7, panel 4). Among emerging markets, net commodity exporters tend to be located outside of Asia (with the exception of Indonesia and Malaysia), and emerging Asia accounts for essentially all of EM tech market cap. Consequently, investors who argue that EM equities have largely or fully decoupled from commodities prices are essentially arguing that emerging Asian equities are far less affected by changes in commodity markets than they used to be. This idea is deeply flawed, as shown below: Based on export share, Chart I-8 highlights that emerging Asia is far more economically exposed to China than developed markets and EM ex-Asia. While China is gradually becoming more of a services-oriented economy, Chart I-9 highlights that the sum of primary industry (raw material extraction), secondary industry (manufacturing and construction), and real estate services still account for over half of China's economic activity, well above that of industrialized nations such as the U.S. This underscores that emerging Asia's trade exposure to China is fundamentally rooted in economic activity that is closely linked to commodity demand. Chart I-8Emerging Asia Has High ##br##Trade Exposure To China Chart I-9Chinese Growth Still Largely ##br##Reflects Industrial Activity Within the commodity-linked segment of China's economy, Chart I-10 shows that there is little evidence of a weaker relationship between output and commodities prices. Simple regression analysis underscores that the Li Keqiang index, a growth proxy for China's industrial sector, is strongly linked to the year-over-year % change in spot commodities prices since the beginning of the commodity bull market, and that this relationship has in fact been increasing in strength over time. In addition, Chart I-11 underscores that China remains by far the largest consumer of base metals globally. Demand in the global oil market is considerably more diversified than the market for base metals, but China is the second-largest end market for oil (14% of global oil consumption), and accounted for over a quarter of the growth in total oil demand in 2016.1 Chart I-10Moderating Chinese Growth Will ##br##Be Negative For Commodities Chart I-11China Is By Far The Most Important ##br##End Market For Base Metals Finally, Chart I-12 shows a regression model between forward earnings expectations for emerging Asia and commodities prices, both at the overall index level and even for the financial sector (which, along with real estate, accounts for almost 25% of emerging Asian market capitalization). The fit for both models is extremely strong and, similar to the increasing strength of the Li Keqiang / commodity price relationship, the chart shows that commodities prices have begun to lead the growth in forward earnings, when the relationship used to be much more coincident. Chart I-12Emerging Asian Earnings Are Strongly ##br##Correlated With Commodities Prices The bottom line for investors is that Charts I-8-12 show emerging Asian economies are strongly linked economically to China, and that China remains the dominant driver of aggregate commodity demand. This means that while EM stocks may not have as much direct commodity exposure as they used to, they will continue to experience a high correlation with commodities prices because that the latter will be driven by swings in China's business cycle. In brief, Chinese growth fluctuations are instrumental to emerging Asia's economic and equity market performance. This is the rationale behind the very strong link between earnings expectations for emerging Asia and commodities prices: the latter reflect cyclical variations in the Chinese economy. EM Stocks: A Lackluster Bet Given The Outlook For Commodities Our earlier discussion of EM's historical contribution to a global equity portfolio revived elements of Modern Portfolio Theory (MPT), at least from an ex-post perspective. Ex-ante, investors need to make judgements about the likely risk, return, and cross-correlation of an asset when assessing its likely contribution to a diversified portfolio. Regarding the latter factor, Chart I-13 highlights that EM's correlation with global ex-EM has actually fallen quite substantially over the past year, which is a potential argument in the minds of some investors in favor of an increased allocation to EM. When recalling the lessons from Modern Portfolio Theory, most investors tend to focus on the key insight that lowly-correlated assets are valuable from the perspective of constructing a portfolio with an attractive risk/return profile. While this is true, many investors often forget that this is only valid given an expectation of a positive return. The efficient allocation to an asset that has a strongly negative correlation with other assets but has a negative return expectation is basically zero. This means that global investors eying an increased allocation to emerging markets should be squarely focused on EM equities' absolute performance, which as we have highlighted above are likely to be closely linked to commodity returns. Over the coming 6-12 months, Chart I-14 paints an uninspiring picture for commodities prices based on two measures of China's money supply. In turn, interest rates lead money growth and the rise in the former over the past nine months heralds further deceleration in the latter. This implies that the Chinese economy will likely continue to moderate, which is negative for the broad trend in commodities prices. Chart I-13A Significant Decline, But Focus On Return ##br##Expectations, Not Correlation Chart I-14Interest Rates And Money Growth Paint ##br##A Poor Picture For Commodities As noted above, China's share of the global oil market is much lower than that of base metals, and we do not expect China's oil demand to shrink even if its industrial sector slumps. But from the perspective of allocating to EM equities within a global portfolio, Table I-1 highlights that broad spot commodity price indexes tend to be more relevant predictors of forward earnings growth than energy prices alone. This means that a rise in oil prices (were it to occur for idiosyncratic supply reasons) might be positive for major oil producers such as Russia,2 but is unlikely to provide a broad-based catalyst for EM stocks. Table I-1Explanatory Power Of Commodity Price Indexes In Modeling ##br##12-Month Forward Earnings Per Share Growth (2002-2016) Finally, our analysis above has focused on the fundamental drivers of EM stocks, and has shown how DM investors are likely to have little basis to be bullish about emerging markets earnings over the coming 6-12 months. Chart I-15 highlights how this is also true about the potential for EM multiple expansion relative to their global peers. The chart shows that periods of relative EM multiple expansion have, like relative earnings expectations, tended to be associated with rising commodities prices, implying that a significant re-rating of EM equities is unlikely over the coming year. This is in addition the fact that EM stocks are neither cheap nor expensive in absolute terms,3 meaning that there is less room for multiple expansion in EM than many investors believe. Chart I-15No Relative Multiple Expansion ##br##Without Rising Commodities Prices Investment Conclusions In terms of gauging the contribution of EM equities to a global equity portfolio, this report has highlighted the following points: While EM stocks had the highest return of any regional equity market during the last economic cycle (2002-2007), this return profile was accompanied by an outsized degree of volatility. For all but the riskiest portfolios, developed commodity markets were preferred as a commodity play over emerging markets. Several compositional changes within the EM equity universe give the outward appearance of much lower commodity exposure, but this exposure has merely become indirect. While EM's weight towards net commodity exporters and resource sectors has declined, this has shifted benchmark exposure to emerging Asia which has significant economic exposure to China and its industrial sector (the dominant driver of global commodities prices). As such, share prices in EM overall and emerging Asia in particular will still be strongly correlated with commodities prices even given the region's significant weight towards the technology sector.4 Cyclical indicators for China's economy suggest that broad commodity price gains over the coming year are likely to be lackluster, at best (and may very well be negative). Even if global oil prices were to rise, this is unlikely to provide a broad-based catalyst for EM stocks if industrial metals prices relapse, as we expect. These conclusions underscore that it is highly unlikely emerging market stocks will sustainably decouple from commodities prices over the cyclical investment horizon, and that the uptrend in EM relative performance since early-2016 has likely been driven significantly by expectations of further China's growth acceleration and commodity gains. In our judgement, these circumstances have created a poor risk/return profile for emerging market equities, justifying an underweight stance within a global equity portfolio over the coming year. Jonathan LaBerge, CFA, Vice President Special Reports jonathanl@bcaresearch.com 1 Source: BP Statistical Review of World Energy, June 2017. 2 Note that we recommend an overweight stance towards Russian equities within an EM equity portfolio. 3 Please refer to the Emerging Markets Strategy Weekly Report titled, "EM Equity Valuations Revisited," dated March 29, 2017, link available on page 15. 4 For a further discussion of the impact of the technology sector on the relative performance of emerging market stocks, please see Emerging Markets Strategy Weekly Report titled, "Can Tech Drive EM Stocks Higher?" dated May 17, 2017, link available on page 15.

Special Report

Highlights Dear Clients, We are publishing a Special Report prepared by my colleague Jonathan LaBerge who examines the case for allocating capital to EM stocks within a global equity portfolio. I hope you will find this report insightful. Best regards, Arthur Budaghyan The relative performance of emerging market equities is challenging the downward trend channel that has been in place for the past seven years. This has led to renewed interest in EM from global investors, and warrants a revisit of the role of emerging market equities within a global equity portfolio. While EM recorded the highest regional equity return last cycle (2002-07), they were surprisingly not the "ideal" regional equity market in an efficient portfolio allocation. Recently, several compositional changes within the EM equity universe give the appearance of much lower commodity exposure than is truly the case. But EM equities will still be correlated with broad commodities prices because the latter reflect Chinese growth dynamics. Cyclical indicators for China's economy suggest that the broad trend in commodities prices is likely to be lackluster over the coming year, at best. Consequently, EM stocks offer a poor risk/return profile, justifying an underweight stance within a global equity portfolio. Feature Chart I-1Change In Trend, Or Another Failed Rally? In U.S. dollar terms, the relative performance of emerging market (EM) stocks has been in an uptrend for over 18 months, and now appears to be challenging the downward trend channel that has been in place for the past seven years (Chart I-1). This has led to a renewed interest in EM, particularly among global investors. This report takes the recent outperformance of EM stocks as an opportunity to revisit their past and future contribution to a global equity portfolio, and what this might mean for an allocation to EM equities over the coming year. We conclude that EM's return behavior during the last economic cycle (2002-2007), its continued link to commodities prices, and China's growth dynamics all contribute to a poor risk/return profile for EM over the coming year. Barring compelling signs of a durable commodity bull market, investors should underweight EM stocks within a global equity portfolio. EM Equities In A Global Context: Some Historical Perspective When examining whether emerging markets are attractive from the perspective of global equity allocation, a starting point is to analyze the fundamental drivers of regional earnings. One major driver of global earnings over the past 20 years has been commodities prices; Chart I-2 highlights how 12-month forward EPS for stocks in all major regions have been correlated with commodities since the late-1990s. Chart I-2ACommodities Prices Are Correlated With Earnings... Chart I-2B...Even In Developed Markets This can be largely explained by the fact that commodities tend to be a pro-cyclical asset class. However, the super cycle in commodities prices in the 2000s not only bolstered the earnings of global resource companies, it also powered earnings growth for export-oriented industrials as well as domestic demand plays in commodity-producing countries. Chart I-3Strong Correlation Between ##br##Commodities And EM Emerging markets were among the largest beneficiaries of the commodity boom; net commodity-exporting countries made up roughly 45% of EM market capitalization throughout the last economic cycle, whereas stocks in the resource sector made up between 25-30% of the index by weight. Unsurprisingly, the relative performance of EM stocks closely tracked commodities prices over this period (Chart I-3). But despite this, EM was surprisingly not the "ideal" regional equity market last cycle within an active portfolio, even though it had the highest return. Chart I-4A presents a scatterplot of annualized regional equity volatility and return from 2002 - 2007, measured in US$ terms. The chart also shows the ex-post Modern Portfolio Theory (MPT) efficient frontier, with Chart I-4B presenting the efficient regional allocation at each point along the frontier. Chart I-4AEmerging Market Stocks Had The Highest Return Last Cycle... Chart I-4B...But Were Only The Favored Market For High-Risk Portfolios Chart I-5From 2002-2007, Earnings Drove More ##br##Of The Rally In DCM Than EM While the charts show that the efficient allocation to emerging market stocks did rise to a maximum of 100% during the last economic cycle, it did not become the dominant region until the portfolio became considerably more volatile than the global equity benchmark. Indeed, Chart I-4B shows that developed commodity markets (DCM) were the preferred commodity play for most of the efficient frontier, owing to their superior performance in risk-adjusted terms. This risk-adjusted outperformance may have occurred because DCM returns last cycle were driven more by earnings than by multiple expansion; Chart I-5 highlights that EM stock prices benefitted from multiple expansion last cycle by outpacing forward earnings, versus the opposite in the case of DCM. Since the onset of the U.S. recession in 2008, Chart I-6A and Chart I-6B highlight that the ex-post efficient portfolio has been much more skewed than during the last economic cycle. The charts show that the frontier since 2008 has been extremely short, with efficient allocations only accruing to three countries with typically defensive stock markets: the U.S., Japan, and Switzerland, with a heavy bias towards the former. From the perspective of a global equity portfolio, this historical review leads to two conclusions: 1) investors should not allocate to EM unless they are bullish on commodities prices and, 2) if investors are bullish towards commodities, developed commodity markets have historically been a better risk-adjusted bet than emerging markets as a commodity play. Chart I-6ASince 2008, The Efficient Frontier Has Been Highly Skewed... Chart I-6B...Towards Defensive Markets (Mostly The U.S.) Chart I-7These Trends Give The False Appearance ##br##Of Lower EM Commodity Exposure EM And Commodities Prices: Has The Relationship Really Changed? More recently, a narrative has developed in the market that EM stocks are now far less sensitive to commodities prices than used to be the case. Proponents of this theory point to the following changes in the composition of emerging market equity benchmarks: First, the market capitalization weight of net commodity exporting countries has fallen precipitously since the onset of the collapse in oil prices in 2014 (Chart I-7, panel 1). On average, net commodity exporters made up between 40-45% of EM equity market cap from 2000 to 2013, but their share now stands at 27%. Second, Chart I-7, panel 2, shows that the market cap weight of resource sectors (energy plus materials) in emerging markets has fallen from roughly 30% to 14% over the past five years, a trend that pre-dated the decline in the share of net commodity exporters. Third, the enormous rise in the market capitalization of technology companies as a share of total EM market cap has been specifically cited by many market participants (Chart I-7, panel 3), especially since EM is now heavily overweight the tech sector relative to the global average. Broadly speaking, a fourth compositional change within the EM equity benchmark generally captures all of the shifts noted above, and is the focus of our remaining analysis below: the rise in the weight of emerging Asia as a share of overall EM (Chart I-7, panel 4). Among emerging markets, net commodity exporters tend to be located outside of Asia (with the exception of Indonesia and Malaysia), and emerging Asia accounts for essentially all of EM tech market cap. Consequently, investors who argue that EM equities have largely or fully decoupled from commodities prices are essentially arguing that emerging Asian equities are far less affected by changes in commodity markets than they used to be. This idea is deeply flawed, as shown below: Based on export share, Chart I-8 highlights that emerging Asia is far more economically exposed to China than developed markets and EM ex-Asia. While China is gradually becoming more of a services-oriented economy, Chart I-9 highlights that the sum of primary industry (raw material extraction), secondary industry (manufacturing and construction), and real estate services still account for over half of China's economic activity, well above that of industrialized nations such as the U.S. This underscores that emerging Asia's trade exposure to China is fundamentally rooted in economic activity that is closely linked to commodity demand. Chart I-8Emerging Asia Has High ##br##Trade Exposure To China Chart I-9Chinese Growth Still Largely ##br##Reflects Industrial Activity Within the commodity-linked segment of China's economy, Chart I-10 shows that there is little evidence of a weaker relationship between output and commodities prices. Simple regression analysis underscores that the Li Keqiang index, a growth proxy for China's industrial sector, is strongly linked to the year-over-year % change in spot commodities prices since the beginning of the commodity bull market, and that this relationship has in fact been increasing in strength over time. In addition, Chart I-11 underscores that China remains by far the largest consumer of base metals globally. Demand in the global oil market is considerably more diversified than the market for base metals, but China is the second-largest end market for oil (14% of global oil consumption), and accounted for over a quarter of the growth in total oil demand in 2016.1 Chart I-10Moderating Chinese Growth Will ##br##Be Negative For Commodities Chart I-11China Is By Far The Most Important ##br##End Market For Base Metals Finally, Chart I-12 shows a regression model between forward earnings expectations for emerging Asia and commodities prices, both at the overall index level and even for the financial sector (which, along with real estate, accounts for almost 25% of emerging Asian market capitalization). The fit for both models is extremely strong and, similar to the increasing strength of the Li Keqiang / commodity price relationship, the chart shows that commodities prices have begun to lead the growth in forward earnings, when the relationship used to be much more coincident. Chart I-12Emerging Asian Earnings Are Strongly ##br##Correlated With Commodities Prices The bottom line for investors is that Charts I-8-12 show emerging Asian economies are strongly linked economically to China, and that China remains the dominant driver of aggregate commodity demand. This means that while EM stocks may not have as much direct commodity exposure as they used to, they will continue to experience a high correlation with commodities prices because that the latter will be driven by swings in China's business cycle. In brief, Chinese growth fluctuations are instrumental to emerging Asia's economic and equity market performance. This is the rationale behind the very strong link between earnings expectations for emerging Asia and commodities prices: the latter reflect cyclical variations in the Chinese economy. EM Stocks: A Lackluster Bet Given The Outlook For Commodities Our earlier discussion of EM's historical contribution to a global equity portfolio revived elements of Modern Portfolio Theory (MPT), at least from an ex-post perspective. Ex-ante, investors need to make judgements about the likely risk, return, and cross-correlation of an asset when assessing its likely contribution to a diversified portfolio. Regarding the latter factor, Chart I-13 highlights that EM's correlation with global ex-EM has actually fallen quite substantially over the past year, which is a potential argument in the minds of some investors in favor of an increased allocation to EM. When recalling the lessons from Modern Portfolio Theory, most investors tend to focus on the key insight that lowly-correlated assets are valuable from the perspective of constructing a portfolio with an attractive risk/return profile. While this is true, many investors often forget that this is only valid given an expectation of a positive return. The efficient allocation to an asset that has a strongly negative correlation with other assets but has a negative return expectation is basically zero. This means that global investors eying an increased allocation to emerging markets should be squarely focused on EM equities' absolute performance, which as we have highlighted above are likely to be closely linked to commodity returns. Over the coming 6-12 months, Chart I-14 paints an uninspiring picture for commodities prices based on two measures of China's money supply. In turn, interest rates lead money growth and the rise in the former over the past nine months heralds further deceleration in the latter. This implies that the Chinese economy will likely continue to moderate, which is negative for the broad trend in commodities prices. Chart I-13A Significant Decline, But Focus On Return ##br##Expectations, Not Correlation Chart I-14Interest Rates And Money Growth Paint ##br##A Poor Picture For Commodities As noted above, China's share of the global oil market is much lower than that of base metals, and we do not expect China's oil demand to shrink even if its industrial sector slumps. But from the perspective of allocating to EM equities within a global portfolio, Table I-1 highlights that broad spot commodity price indexes tend to be more relevant predictors of forward earnings growth than energy prices alone. This means that a rise in oil prices (were it to occur for idiosyncratic supply reasons) might be positive for major oil producers such as Russia,2 but is unlikely to provide a broad-based catalyst for EM stocks. Table I-1Explanatory Power Of Commodity Price Indexes In Modeling ##br##12-Month Forward Earnings Per Share Growth (2002-2016) Finally, our analysis above has focused on the fundamental drivers of EM stocks, and has shown how DM investors are likely to have little basis to be bullish about emerging markets earnings over the coming 6-12 months. Chart I-15 highlights how this is also true about the potential for EM multiple expansion relative to their global peers. The chart shows that periods of relative EM multiple expansion have, like relative earnings expectations, tended to be associated with rising commodities prices, implying that a significant re-rating of EM equities is unlikely over the coming year. This is in addition the fact that EM stocks are neither cheap nor expensive in absolute terms,3 meaning that there is less room for multiple expansion in EM than many investors believe. Chart I-15No Relative Multiple Expansion ##br##Without Rising Commodities Prices Investment Conclusions In terms of gauging the contribution of EM equities to a global equity portfolio, this report has highlighted the following points: While EM stocks had the highest return of any regional equity market during the last economic cycle (2002-2007), this return profile was accompanied by an outsized degree of volatility. For all but the riskiest portfolios, developed commodity markets were preferred as a commodity play over emerging markets. Several compositional changes within the EM equity universe give the outward appearance of much lower commodity exposure, but this exposure has merely become indirect. While EM's weight towards net commodity exporters and resource sectors has declined, this has shifted benchmark exposure to emerging Asia which has significant economic exposure to China and its industrial sector (the dominant driver of global commodities prices). As such, share prices in EM overall and emerging Asia in particular will still be strongly correlated with commodities prices even given the region's significant weight towards the technology sector.4 Cyclical indicators for China's economy suggest that broad commodity price gains over the coming year are likely to be lackluster, at best (and may very well be negative). Even if global oil prices were to rise, this is unlikely to provide a broad-based catalyst for EM stocks if industrial metals prices relapse, as we expect. These conclusions underscore that it is highly unlikely emerging market stocks will sustainably decouple from commodities prices over the cyclical investment horizon, and that the uptrend in EM relative performance since early-2016 has likely been driven significantly by expectations of further China's growth acceleration and commodity gains. In our judgement, these circumstances have created a poor risk/return profile for emerging market equities, justifying an underweight stance within a global equity portfolio over the coming year. Jonathan LaBerge, CFA, Vice President Special Reports jonathanl@bcaresearch.com 1 Source: BP Statistical Review of World Energy, June 2017. 2 Note that we recommend an overweight stance towards Russian equities within an EM equity portfolio. 3 Please refer to the Emerging Markets Strategy Weekly Report titled, "EM Equity Valuations Revisited," dated March 29, 2017, link available on page 15. 4 For a further discussion of the impact of the technology sector on the relative performance of emerging market stocks, please see Emerging Markets Strategy Weekly Report titled, "Can Tech Drive EM Stocks Higher?" dated May 17, 2017, link available on page 15.

Underweight Late-2013 saw all the right economic conditions moving in favor of insurers: the economy was entering a soft patch, the yield curve was flattening and the U.S. dollar was gaining momentum. The insurance market began hardening and the industry went on a hiring spree to capitalize on a much improved outlook (second panel). With the exception of the yield curve, those macro conditions reversed in 2017; the economy is booming, the dollar bull market has paused and BCA expects at least a modest yield curve steepening in the coming months (third panel). However, the insurers index has performed in line with the broad market so far this year (top panel). The hard pricing market of the past three years has recently turned flaccid (bottom panel) and organic revenue growth should soften. Meanwhile, sector employment remains elevated, implying weakening margins. In the context of the S&P 500 growing earnings by low-double digits, the insurers index should underperform. Stay underweight. The ticker symbols for the stocks in this index are: BLBG: S5INSU - AIG, CB, MET, MMC, PRU, TRV, AFL, AON, ALL, PGR, WLTW, HIG, PFG, L, CINF, LNC, XL, AJG, UNM, TMK, AIZ.