Sectors

Highlights The U.K. and EU may get a technical divorce, but the underlying economic and financial relationship may not end up changing dramatically - which is good news for the pound in the long term. Our 6-12 month preference for currencies is euro first, pound second, dollar third. The euro area economy will perform at least in line with the U.S. economy through 2017, so the T-bond/German bund yield spread will continue to compress. Long euro area retailers, short U.S. retailers has catch-up potential. The focussed stock pair-trade would be long Hornbach (Germany), short Home Depot (U.S.) Feature Brexit Will Become A Fake Divorce Theresa May's stinging reversal at the ballot box last Thursday has left some people wondering: will Brexit actually happen? The answer is very likely yes, but this is no longer the right question to ask. Jeremy Corbyn's resurgent Labour Party, the Scottish National Party, the Liberal Democrats and pro-European Conservatives now form a parliamentary majority which proposes that a non-EU U.K. negotiates tariff-free access to the single market and customs union.1 In such an arrangement, the U.K. and EU would be technically divorced. But economically and financially, the relationship would not be so different to being married. In effect, Brexit would become a fake divorce. Unfortunately, there is a flipside. The U.K. would be unable to reclaim swathes of sovereignty over its borders and its law. This is because the tariff-free movement of goods, services and capital is, in theory, indivisible from the free movement of people. Furthermore, EU law would transcend national law in the regulation and policing of the single market's so-called 'four freedoms'. Admittedly, the four freedoms are an unachieved - and arguably unachievable - ideal. But they are an aspiration which EU policymakers do not want Brexit to threaten. Angela Merkel recently put it in very strong terms: "Cherry-picking (from the four freedoms) would have disastrous consequences for the other 27 member countries... Tariff-free access to the single market can only be possible on the conditions of respecting the four basic freedoms. Otherwise one has to talk about limits to access" Hence, Brexit reduces to a trade-off between the extent of tariff-free access to the European single market that the U.K. wants to keep, and the extent of national sovereignty it is willing to concede (Chart of the Week). Economically and financially, it is largely irrelevant whether the U.K. gets tariff-free access to the single market via a bespoke free-trade arrangement or via membership of an off-the-shelf structure like EFTA or the EEA.2 The much bigger question is: in order to keep most of its tariff-free access to the single market, will the U.K. now downgrade its plans to "take back full control" of its borders and law? Following last Thursday's stunning election result - and its impact on parliamentary composition (Chart I-2 and Chart I-3) - the answer seems to be yes. The U.K. and EU may get a technical divorce, but the underlying economic and financial relationship might not end up changing dramatically. Euro First, Pound Second, Dollar Third Avoiding a dramatic change in the U.K./EU economic and financial relationship reduces the risk of a major disruption to the U.K. economy and the need for further emergency easing from the Bank of England. Thereby, it is good news for the pound in the long term. That said, our 6-12 month preference for currencies is euro first, pound second, dollar third. The crucial point is that currencies and bond market relative performance depends front and centre on the evolution of relative interest rate expectations. In turn, the evolution of relative interest rate expectations must ultimately follow relative economic performance, as evidenced in hard data such as GDP growth, inflation and job creation. Over a period of a few months, central banks can look through hard data on the basis that the data is noisy or "transient". But over periods of 6 months and longer, the noisy and transient excuse wears thin. Central banks' strong commitment to data-dependency means that their actions and/or words must follow the hard data. No ifs, buts or maybes. Hence, relative interest rate expectations ultimately follow relative economic performance (Chart I-4 and Chart I-5). We are unashamedly republishing these two charts from last week because they prove the point so powerfully. Based on the latest PMIs which capture current economic sentiment, and on 6-month credit impulses which lead activity, euro area hard data will continue to perform at least in line with those in the U.S. (Chart I-6). In which case, relative interest rate expectations will continue to converge, the T-bond/German bund yield spread will continue to compress, and euro/dollar will ultimately drift higher. Chart I-4Relative Interest Rate Expectations Must Follow ##br##Relative Economic Performance Chart I-5Relative Bond Yields Must Follow Relative##br## Economic Performance Chart I-6Only A Modest Decline In The Euro Area ##br##6-Month Credit Impulse The Eurostoxx50 Is Not A Play On The Euro Area Economy. So What Is? Does it follow that the Eurostoxx50 equity index will outperform? Not necessarily. Unlike for currencies, interest rates and bond yields, the connection between relative economic performance and relative equity market performance is weak, or even non-existent. Note that the Eurostoxx50 has underperformed the S&P500 this year even though the euro area economy has outperformed. Chart I-7The Global Growth Pause ##br##Has Hurt Cyclicals The reason is that the over-arching driver of an equity market's relative performance is its skew to dominant international sectors and international stocks. The Eurostoxx50 has a higher exposure to the global growth cycle via its dominant weighting in Financials and Resources; conversely the S&P500 has a higher exposure to the less globally-sensitive Technology and Healthcare sectors. The defining sector skew has penalised the Eurostoxx50 versus the S&P500 because globally-sensitive cyclicals have strongly underperformed in a very clear global growth pause. Furthermore, the ever-reliable global 6-month credit impulse strongly suggests that the global growth pause will persist through the summer (Chart I-7). This begs the question: is there a way for equity investors to play the resilient performance of the euro area economy? The answer is yes. But before explaining how, a quick note of caution. An aggregate small cap equity index is not a good way to play a domestic economy. This is because the dominant characteristic of small cap stocks - in aggregate - is their very high beta. Hence, rather than a strong play on the domestic economy, investors are effectively buying highly leveraged exposure to market direction. Great when markets are rising, but painful when they are falling, irrespective of how the domestic economy is faring. Instead, a good equity play on relative economic performance is the relative performance of retailers (Chart I-8). Drilling down further, the relative performance of home improvement retailers is an even purer play (Chart I-9) - given that household spending on home improvement is closely tied to the domestic economic cycle. Chart I-8Retailers Are A Good Play On Relative ##br##Economic Performance Chart I-9Euro Area Home Improvement Retailers ##br##Can Now Ourperform Those In The U.S. On the expectation that the euro area economy will perform at least in line with the U.S. economy,3 the equity market play would be long euro area retailers, short U.S. retailers. In particular, long euro area home improvement retailers, short U.S. home improvement retailers has a lot of catch-up potential. And the focussed stock pair-trade would be long Hornbach (Germany), short Home Depot (U.S.) Dhaval Joshi, Senior Vice President European Investment Strategy dhaval@bcaresearch.com 1 In simple terms, the single market defines the zone of tariff-free trade for European countries with each other. Whereas the customs union defines the zone of a single set of rules and tariffs for European countries to trade with the rest of the world. Membership of the customs union allows goods and services that enter from the rest of the world to then move around Europe unhindered. 2 The European Free Trade Association (EFTA) is a free trade area consisting of Iceland, Liechtenstein, Norway and Switzerland. Iceland, Liechtenstein, and Norway participate in the EU single market through their membership of the European Economic Area (EEA). Whereas Switzerland participates through a set of bilateral agreements with the EU. 3 Based on growth in real GDP per head. Fractal Trading Model* Long nickel / short tin hit its 6.5% profit target and is now closed. This week's trade is to switch to long nickel / short palladium with a 10% profit target. For any investment, excessive trend following and groupthink can reach a natural point of instability, at which point the established trend is highly likely to break down with or without an external catalyst. An early warning sign is the investment's fractal dimension approaching its natural lower bound. Encouragingly, this trigger has consistently identified countertrend moves of various magnitudes across all asset classes. Chart I-10 The post-June 9, 2016 fractal trading model rules are: When the fractal dimension approaches the lower limit after an investment has been in an established trend it is a potential trigger for a liquidity-triggered trend reversal. Therefore, open a countertrend position. The profit target is a one-third reversal of the preceding 13-week move. Apply a symmetrical stop-loss. Close the position at the profit target or stop-loss. Otherwise close the position after 13 weeks. Use the position size multiple to control risk. The position size will be smaller for more risky positions. * For more details please see the European Investment Strategy Special Report "Fractals, Liquidity & A Trading Model," dated December 11, 2014, available at eis.bcaresearch.com Fractal Trading Model Recommendations Equities Bond & Interest Rates Currency & Other Positions Closed Fractal Trades Trades Closed Trades Asset Performance Currency & Bond Equity Sector Country Equity Indicators Bond Yields Chart I-1Indicators To Watch - Bond Yields Chart I-2Indicators To Watch - Bond Yields Chart I-3Indicators To Watch - Bond Yields Chart I-4Indicators To Watch - Bond Yields Interest Rate Chart II-5Indicators To Watch##br## - Interest Rate Expectations Chart II-6Indicators To Watch##br## - Interest Rate Expectations Chart II-7Indicators To Watch##br## - Interest Rate Expectations Chart II-8Indicators To Watch##br## - Interest Rate Expectations

Highlights Trump's failures have helped fuel the bull market; Yet inflation and Trump legislative wins will embolden the Fed; The U.K. will have yet another election by 2019; Dodd-Frank repeal is a no go ... but small banks may get relief; The Tea Party just found its hard constraint ... in Kansas. Feature Investors in South Africa surprised us last week. The first question on everyone's mind was "Will Trump be impeached?" Our answer that impeachment is highly unlikely at least until the midterm elections was received with suspicion.1 The perspective of our South African clients is understandable. Their domestic assets have been underpinned since Trump's election by a phenomenon we like to call "the Trump put." The thesis posits that 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. The result is a weak dollar, lower 10-year Treasury yields, and a rally in global risk assets (Chart 1). Of course, stubbornly weak inflation and disappointing Q1 GDP numbers bear responsibility as well as Trump (Chart 2). Chart 1The 'Trump Put' Chart 2Weak Inflation Fueling Bull Market For our South African clients, the fate of President Trump is irrelevant. What matters is that the American political imbroglio continues, reducing the likelihood of a hawkish mistake from the Fed, and thus keeping EM risk assets well bid. The market has generally agreed. Several assets associated with Trump's populist agenda have reversed their gains since the election. The yield curve, small caps, and high tax rate equities have all shown signs of disappointment with the Trump agenda (Chart 3). If the Trump put were to continue, we would expect U.S. bonds and stocks to rally, DXY to continue to face headwinds, and international stocks to outperform U.S. stocks. That said, the proxies for Trump's agenda in Chart 3 are starting to perk up. They may be sniffing out some positive political signs, such as the movement in the Senate on the bill repealing the Affordable Care Act (Obamacare). The budget reconciliation procedure - a process by which Republicans in Congress intend to avoid the Democrat filibuster in the Senate - requires Obamacare to be resolved before the House and the Senate can take up tax reform.2 If Obamacare clears Congress's calendar by the August recess, the odds of tax reform (or merely tax cuts) being passed by the end of 2017 will rise considerably. Second, former Director of the FBI James Comey's testimony was a non-event. We refused to cover it in these pages as we expected it to be theatre. The market had already digested everything that Comey was going to say, given that he had leaked the juiciest components of his testimony weeks ahead of the event. Chart 3Consensus On Trump Policy Failure? Third, President Trump's approval rating with Republican voters remains resilient (Chart 4). If the worst has passed with the Russian collusion investigation - which we expect to be the case now that Comey's testimony has come and gone with little relevance - we could see GOP voters rally around the president. Several clients have pointed out that our measure is less relevant given the decline in voters who identify as Republicans (Chart 5). We disagree. As long as Republican voters vote in Republican primaries, they can act as a constraint on GOP members in Congress who are thinking of abandoning the president's populist agenda. This brings us to the main event: the economy. Our colleague Ryan Swift, who writes BCA's U.S. Bond Strategy, could not care less about the ongoing political drama. As Ryan has argued in a cogent report that we highly recommend to clients, the Fed's median projection for two more 25 basis point rate hikes before the end of the year, and for PCE inflation to reach 1.9% (Chart 6), is not going to happen if inflation continues to disappoint over the summer.3 The market seems to be saying that a PCE of 1.9% is unlikely. Core PCE inflation is running at only 1.54% year-over-year through April, and will probably stay low in May given that year-over-year core CPI fell from 2% in March to 1.89% in April. Chart 5Fewer People Call Themselves Republicans Chart 6Inflation Relapse Would Scratch Fed Hikes Ryan's Philips Curve model, however, disagrees with the market. The model looks to approximate Chair Yellen's own philosophy for forecasting inflation, which she outlined in a September 2015 speech.4 Specifically, BCA's U.S. Bond Strategy models core PCE as a function of: 12-month lag of core PCE; Long-run inflation expectations from the Survey of Professional Forecasters; Resource utilization; Non-oil import prices relative to overall core PCE. BCA's core PCE model is sending a strong signal that the market's inflation expectations are overly pessimistic (Chart 7). Even after stressing the model under several adverse scenarios, Ryan concludes that it is very likely that core PCE inflation will indeed approach the Fed's 1.9% forecast by year-end. The U.S. economy is quickly running out of slack, with unemployment at a 16-year low of 4.3%. The broader U-6 rate, which includes marginally attached workers and those in part-time employment purely for economic reasons, has dropped to its pre-recession print of 8.4% (Chart 8). Chart 7Market Too Pessimistic On Inflation Chart 8U.S. Labor Market Running Out Of Slack Wages are also rising, with the underlying trend in wage growth having accelerated from 1.2% in 2010 to 2.4% (Chart 9). The acceleration has been broad-based, occurring across most industries, regions, and worker characteristics (Chart 10). Chart 9Wages Heating Up Chart 10Wage Improvements Broad-Based BCA's Chief Global Strategist, Peter Berezin, therefore expects the Fed to raise rates in line with its own expectations. In fact, the Fed could expedite the pace of rate hikes if aggregate demand accelerates later in the year.5 It will be difficult for the Fed to ignore macroeconomic data, even if, from a political perspective, the Trump put continues. The analogy we use with clients in meetings is that of the U.S. economy as a camp fire around which the various market participants - bond and equity investors, foreign and domestic, etc. - are huddled. According to our sister publications that conduct macroeconomic research, that campfire is well lit. And according to our political research, "Uncle Donny" had a few too many drinks and is about to pour some bourbon on the fire to show the kids a good time. Chart 11Bond Bulls Feeding On Trump Failures For the Trump put to continue, we would have to see a combination of the following: GOP voters begin to abandon President Trump; Congress remains embroiled in Obamacare debates through FY2017, only seriously picking up on tax reform and other agenda items in FY2018. Greater doubts would undermine the recent uptick in assets tied to Trump's policy agenda (Chart 11). Impeachment concerns heat up again due to new revelations that implicate President Trump directly. So far impeachment talk has not correlated with the rally in Treasuries but it could do so if new evidence comes to light. Perhaps Robert Mueller, the former FBI director and special counsel investigating Russia's role in the election, will drop another bombshell later this year. In addition, for the Trump put to continue our colleagues Ryan and Peter would have to be wrong about the economy and inflation. For investors interested in playing the Trump put, and allocating funds to EM assets in particular, we would caution against it. However, given that BCA's bond and FX views have been challenged over the past several months by the Trump put, we understand why many of our clients are itching to chase the global asset rally. The summer months will be critical. Does Brexit Still Mean Brexit? We posited last week that the extraordinary election in the U.K. was about austerity and, more importantly, about repudiating the Conservative Party's fiscal policies.6 This remains our view. The most investment-relevant message to take from the election is that U.K. fiscal policy will become easier over the life of the coalition government, while monetary policy remains stuck in D - for dovish. This should weigh on the pound over the course of the year. That said, investors will begin to wonder about the longevity of the coalition between the U.K. Conservative Party and Northern Ireland's Democratic Unionist Party (DUP). In practice the coalition will have only a five-seat majority, which would be tied for the second-smallest margin since Harold Wilson in 1964 (Chart 12). Technically it is an even smaller one-seat majority. U.K. governments with a majority of fewer than ten seats are rare and usually only last one-to-two years (Harold Wilson's four-seat 1974-79 run is an exception). This bodes ill for May's government - that is, if she survives today's brewing leadership challenge from within her party. We have no idea if the election means a softer Brexit as we have no idea - and neither does anyone else - what that means. Generally speaking, the wafer-thin majority for the Tories means the following: "No deal is better than a bad deal" is no longer going to be acceptable to the government or the public; London will end up paying a larger "exit fee" than it probably thinks it will; There will be no favorable deal for the U.K.'s financial industry. In essence, the U.K. clearly has the weaker hand in the upcoming negotiations. Cheers went up in Brussels. Does this change anything? First, we never bought the argument that the U.K. had a strong negotiating position because continental Europeans want to export BMWs to consumers in Britain. The EU is a far bigger market for the U.K. than the U.K. is for the EU (Chart 13). On this measure alone, the U.K. was always going to be the underdog in the negotiations. Chart 13The U.K. Lacks Leverage Second, the influence of Tory Euroskeptics has been reduced. That might appear counterintuitive, given that May wanted to reduce their influence by getting a bigger majority. However, it is highly unlikely that she will get the ultimate EU deal through Westminster, with a five-seat majority, without at least some votes from the opposition. Euroskeptics will therefore either remain quiet and compliant or force May to seek a deal that Labour MPs could agree to. Which brings us to the very likely scenario that the final deal will not pass Westminster without a new election. As we argued right after the referendum, the U.K. will likely have a "Brexit election" sometime in 2019.7 There is no way around it now. At very least the ruling alliance will face a contradiction in trying to soften Brexit while maintaining a strict stance on immigration. And given the weak majority, if Labour does not play ball, the Tories will have to call a new election on the basis of the deal they conclude. The good news for the Conservative Party is that the polls continue to show that a majority of U.K. voters support Brexit (Chart 14). Furthermore, the two Brexit-lite campaign promises by the Labour Party and the Liberal Democrats were the least preferred policies ahead of the election (Chart 15, see next page). However, the election also saw a complete collapse in support for Euroskeptic-leaning parties, in terms of share of the overall vote (Chart 16). Could Brexit ultimately be reversed? Certainly the odds have risen. Furthermore, there does appear to be some regret amongst U.K. voters, with a recent survey showing a decline in national identification: now more Britons identify as "also European" than ever (Chart 17). Nonetheless, a full reversal of Brexit will still require an exogenous shock, such as a recession or a geopolitical calamity that convinces the U.K. that they need Europe. Investors should remain vigilant of the polls. A clear trend reversal in Chart 14 would constitute a political opportunity for the opposition parties to campaign on a new referendum. Chart 16Euroskeptics Collapsed In The U.K. Bottom Line: Odds of a softer Brexit have certainly risen as the Tories face considerable domestic constraints in their negotiating strategy with the EU. We continue to believe that the negotiations will not be acrimonious and therefore the pound will not fall below its lows on January 16. However, it may re-test that 1.2 level due to a coming mix of easy fiscal and monetary policy over the course of the year. U.S.: Doing A Number On Dodd-Frank Better put a strong fence 'round the top of the cliff, Than an ambulance down in the valley! - Joseph Malins, "The Fence or the Ambulance," 1895 The Republican-controlled U.S. House of Representatives passed the Financial CHOICE Act of 2017 by a vote of 233-186 on June 8. This is the GOP's second major attempt, after the Affordable Care Act, to rewrite a signature law of President Obama's administration. This time it is the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010, known simply as "Dodd-Frank," that is on the docket. The bill's prospects in the Senate are dim. President Trump promised to "do a number" on Dodd-Frank shortly after coming into office, by which he meant dismantling the law. The so-called "CHOICE Act" put forward by Jeb Hensarling (R-TX) now goes to the Senate, where it faces a high hurdle because Democrats can filibuster it, forcing the GOP to summon 60 votes. So the question is what kind of a "number" can the GOP actually do to Dodd-Frank, and does it matter? First a little bit of background.8 Dodd-Frank cleared Congress in the wake of the subprime financial crisis, July 2010. It had both a quixotic and a more pragmatic aim: the first to reduce the likelihood of future financial crises, and the second to improve the ability of regulators to stem risks as they emerge. The law has never been fully implemented and is best understood as a work in progress. The law grants the Federal Reserve and other agencies greater powers of oversight, prevention, and crisis management. In particular it ensures that the Fed would regulate not only banks but also non-bank investment companies and other financial firms (such as the giant insurance company AIG that had to be bailed out at the height of the crisis). It also frees the Fed of the responsibility to rescue failing institutions or dismantle them, handing those duties over to others, while still enabling the Fed to act as lender of last resort. The key provisions are as follows: Impose tougher capital standards: In keeping with the international Basel III banking reforms,9 Dodd-Frank tried to ensure that banks were better fortified against liquidity shortages in future. The new standards would apply both to domestic banks and foreign banks with American subsidiaries. Orderly Liquidation Authority: The Federal Deposit Insurance Corporation (FDIC), a major institution born amidst the Great Depression, would take over the responsibility of liquidating failing firms in the event of a crisis - assuming Treasury's go-ahead due to the systemic importance of the failing firm. Additional measures would hold the entire financial sector responsible for the bill if the FDIC made losses in the process. Each firm would have to maintain a "living will" to make the resolution process easier in the event of disaster. A new Financial Stability Oversight Council: Chaired by the Treasury Secretary and consisting of the various financial regulatory bodies, this council would identify systemically important financial companies, monitor them, and take actions to prevent crises. A new Consumer Financial Protection Bureau: The brainchild of Senator Elizabeth Warren (D-MA), the anti-Wall Street firebrand, the bureau would be funded by the Fed but otherwise entirely independent of it, and tasked with patrolling the banks on behalf of consumers. The Volcker Rule: The rule, named after former Fed Chair Paul Volcker, would force banks to curtail a number of short-term, high-risk trading activities on their own accounts, including derivatives, futures, and options, unless to hedge risks or serve bank customers. This was viewed as a partial reinstatement of the Glass-Steagall law, a Depression-era law that separated commercial and investment banking but was repealed by President Clinton in 1999. Republicans want to overturn Dodd-Frank to increase financial sector profits, credit growth, economic growth, and animal spirits. Lending has arguably suffered as a result of the new regulations (Chart 18). The share of bank loans to overall bank credit has remained subdued, reflecting bank behavior under QE and possibly also risk-aversion under tighter regulation (Chart 19). Chart 18Lending Growth Hampered By Dodd-Frank? Chart 19Banks Holding Reserves Instead Of Lending Republicans would also satisfy an ideological goal of reducing state involvement, which grew as a result of the law. In addition, the CBO estimates that the proposed rewrite would cut the budget deficit by a net $22.3 billion over a ten-year period.10 A very small amount, but again in line with GOP's political bent. The way the CHOICE Act would work is to create an "escape hatch" that would allow banks that maintain capital-to-asset ratio of over 10% to bypass Dodd-Frank regulations. Financial companies that do not meet the 10% leverage ratio could either raise funds or remain subject to Dodd-Frank oversight, including required capital ratios, stress tests, living wills, and other regulations. Critically, the 10% leverage ratio for those banks that opt out of Dodd-Frank would not be calculated using risk-weightings for different assets (whereas Dodd-Frank requires both risk-weighted and non-risk-weighted capital ratios to be maintained). Therefore, banks that opt out would be able to take on greater risk while still fulfilling minimum capital requirements. This is supposed to boost lending, earnings, and growth. About 70% of the $18 trillion in U.S. banking assets belongs to banks defined by Dodd-Frank as "systemically important." The eight U.S. banks defined as "globally systemic important banks" account for about $9 trillion in assets and are unlikely to take advantage of the Republicans' escape hatch because they would then have to raise new capital and yet would still be subject to international Basel III regulations even if exempted from Dodd-Frank. The CBO estimates that banks holding about 2% of the bank assets held by systemically important banks (i.e. $252 billion) would opt out of Dodd-Frank (Chart 20). Further, the CBO estimates that, among non-systemically important banks (30% of $18 trillion total banking assets), the banks that both meet the 10% leverage ratio and would opt out of Dodd-Frank account for about 7% of U.S. banking assets ($1.26 trillion) (see Chart 20 above). Community banks (with assets under $10 billion each) and credit unions are especially likely to do so. Therefore, if the Republican bill were to become law, banks comprising something like $1.5 trillion in U.S. banking assets would become less restricted and eligible to adopt riskier trading practices free of Dodd-Frank policing. The greatest impact will be in areas with a higher concentration of small banks and credit unions than elsewhere. These U.S. banks would also, arguably, become more likely to take excessive risks and fail at some future point. Using probabilistic models for bank failures, the CBO found that the U.S.'s Deposit Insurance Fund would only suffer an additional $600 million in losses over the next ten years as a result of this increase in risk. It is a credible estimate but the reality could be far costlier if more and more banks gain the ability to bypass regulation or if banks significantly change their behavior to take advantage of the regulatory loophole. Other aspects of the bill would: Repeal the FDIC's orderly liquidation fund: The private sector would largely take over the responsibility for managing liquidations. The CBO estimates that the federal government would save an estimated $14.5 billion in liquidation costs over ten years. Eliminate the Volcker Rule: Banks would be able to trade riskier assets on their own accounts and forge closer relationships with private equity and hedge funds. Audit the Fed: Within one year of passage, the Government Accountability Office (GAO) would audit the Fed's board of governors and the Federal Reserve regional banks, including their handling of monetary policy. The Fed's open market committee (FOMC) would also have to establish a new interest rate target, based on economic parameters, which the GAO would monitor. Reshape the Consumer Financial Protection Board: The agency would have its powers neutered and funding dependent on the Congress, rather than transfers from the Fed. It would be re-branded as the Consumer Law Enforcement Agency and have its power to oversee institutions with more than $10 billion in assets taken away, making it, in effect, a monitor of small banks only. Cut penalties for violating regulations: However, outright criminality would be punished more severely. Various authorities and institutions would be tweaked, mostly in accordance with the general aim of reducing regulatory burdens on the financial sector. So, what options do the Republicans have going forward?11 Republicans either need 60 votes to defeat a Senate filibuster or they need procedural work-arounds like budget reconciliation. Chart 21Small Banks Benefit From Dodd-Frank Repeal Some Republicans claim that certain elements of the rewrite can be tucked into a reconciliation bill. However, reconciliation requires a single, concentrated policy focus. The GOP is currently undertaking an unprecedented two budget reconciliation bills in a single year: first, the FY2017 reconciliation procedure to repeal Obamacare, and second, the FY2018 procedure to cut taxes. Rewriting Dodd-Frank is a far cry from either health care or tax reform. Dodd-Frank measures crammed into either of these bills would likely be revoked under the so-called "Byrd Rule" which keeps the reconciliation process focused and excludes extraneous material.12 So it is unlikely that this method will work. The FY2018 budget resolution will be a critical signpost. Second, it is hard to see how a bipartisan rewrite of Dodd-Frank is possible. Dodd-Frank was the Democrats' signature response to the subprime mortgage debacle and broader financial crisis. They will not participate in dismantling it. We cannot see eight Democrats joining Republicans in the Senate for what Senator Sherrod Brown (D-OH) has called "collective amnesia." However, there is one general principle that could find its way into law: the idea of giving small, regional banks a reprieve from Dodd-Frank requirements. Even Fed Chair Janet Yellen has tentatively supported giving these banks a break.13 These banks, with under $10 billion in assets, face the most difficulty in meeting Dodd-Frank's requirements and yet tend to meet the 10% leverage ratio. Politicians could at least attempt to make a popular argument for easing the burden on small community banks and credit unions, which are often vital to local communities. The same cannot be said for the Dodd-Frank rewrite as a whole, which smacks of granting impunity to Wall Street. Still, we think that even a bill focused exclusively on helping small banks would have trouble passing on its own. The legislative agenda is too busy in 2017; while 2018 will see midterm elections, when few candidates will want to appear soft on Wall Street. Instead, a provision helping small banks could pass if tacked onto the larger budget bill or bills for FY2018, if not later. It would have to be made palatable to Democrats, or else it would be perceived as a "poison pill" and risk adding to the numerous risks of government shutdown over the budget this fall. Other than these legislative options, the Trump administration can ease regulation, or relax enforcement, through executive action, as it has already promised to do. Assuming America's financial sector will get a reprieve, investors could capitalize on it by favoring small U.S. bank equities over large bank equities. The share price of small banks relative to large banks, which rallied in the aftermath of Trump's election only to fall back in the subsequent months, has recently perked up (Chart 21). Relative earnings have been flat over the same period. If Dodd-Frank is partially watered down, these banks should see earnings improve, which should drive up their share prices. Our colleagues at BCA's U.S. Equity Strategy are positive on global bank equities, particularly European and American ones. The latter are still relatively affordable as they undertake the long trek of recovery after a once-in-a-generation crisis (Chart 22). U.S. banks have notably better fundamentals than peers in Europe and Japan - more capital, higher net interest margins, lower or equal NPL ratios. They also stand to benefit from relatively faster rising interest rates (Chart 23).14 Chart 22The Long, Hard Road Of Recovery Chart 23U.S. Banks Well Positioned Globally In addition, the FiscalNote Financial Sector Index suggests that the flow of legislative and regulatory proposals has been steadily getting less onerous on the financial sector.15 Chart 24 is an aggregation of the favorability scores - which assess whether the bill is likely to be favorable or unfavorable to the sector - for all U.S. Congressional legislation that is determined to be relevant to the financial sector since 2006. It provides a snapshot of the regulatory environment for the financial sector at any given point in time. Chart 24Financial Sector Scrutiny Softening Risks to the view? Republicans could somehow squeeze a broader Dodd-Frank rewrite through the budget reconciliation process. We think the probability of this is less than 10%. Financially, this would deliver a bigger jolt to the financial sector, and financial stocks, than currently expected. But it would still benefit small banks more than large ones. Politically, a full repeal could add to Republican woes in 2018 - particularly if it is their only legislative achievement. It may well be political suicide to contest the 2018 midterm election on two pieces of legislation: one that denies millions of Americans health insurance and another that favors Wall Street. A full rewrite would also probably increase systemic financial risks. Even deregulation just for the small banks would do so. Lawmakers, focused on restraining the "too big to fail" giants, could end up clearing the way for excesses among the pygmies. That said, excessive regulation can also fuel shadow banking, a risk in itself. And the next crisis may well emanate from somewhere other than the financial sector. Bottom Line: Repealing Dodd-Frank faces procedural hurdles and would yield few political benefits even for Republicans in an environment of populism. However, a bill focused on lightening the regulatory load on small banks has a chance of passing if tacked onto the budget process. Large banks would remain subject to closer scrutiny and stricter international standards. The Trump election rally for bank stocks has mostly fallen back. Now is an opportunity to favor small banks versus large ones on expectations of Trump getting tax cuts passed and regulatory easing of some kind. Kansas: Where Seldom Is Heard A Discouraging Word A chill went through the Tea Party's collective spine on June 6 when two-thirds of the GOP-controlled Kansas legislature overrode the veto of GOP Governor Sam Brownback to repeal a 2012 budget law that slashed taxes on income, small business, and retail sales. You heard that right: Republicans in one of America's reddest states just overrode their leader in order to increase taxes. And it was the largest tax hike in state history. We will spare our readers the nitty-gritty details of the Brownback saga. Suffice it to say that the Tea Party-friendly Kansas legislature slashed state taxes and spending under Brownback's leadership in May 2012. Brownback called it a "real live experiment" of conservative economic principles and argued that the tax cuts would pay for themselves through faster growth. Art Laffer, of "Laffer Curve" fame, allegedly consulted on these measures via the conservative American Legislative Exchange Council. The medicine proved more dangerous than the illness. Since 2012, the state has burned through a budget surplus and growth has slowed (Chart 25). Both Moody's and S&P downgraded Kansas debt. Employment gains have lagged those of neighboring states. Beginning in October 2013, Brownback began to slip in public opinion polls (Chart 26). Cuts to core government services, especially education, caused a tide of criticism. In an extraordinary development, a hundred establishment Republicans supported his Democratic opponent in the 2014 gubernatorial election. He won by a margin of 3.7% but soon afterwards fell out of favor with the public. A series of confrontations with the Kansas Supreme Court hastened his decline, mostly over education funding, which is guaranteed by the state constitution. Brownback, the legislature, and various activist groups attempted to strong-arm the courts, including by ousting four members of the Supreme Court in the 2016 elections. All four retained their posts. The new budget law raises $1.2 billion in income taxes over two years by revoking swathes of the 2012 law, particularly the income tax exemption for business owners and professionals. Brownback duly vetoed the legislation and was promptly overridden by two-thirds of a legislature that is 70% Republican. This is a remarkable event for a state as ideologically conservative as Kansas. What does it mean nationally? There are two reasons that the Kansas experiment will have a limited impact on Republican thinking nationally: Kansas has a balanced budget law (Section 75-3722), while D.C. does not ... and this helped increase the pressure on the administration; Brownback is the least popular governor of any governor in the United States (Chart 27). The blame for the whole fiasco may fall on him personally, distracting from the policy failure. Nevertheless, we think Kansas has set the high-water mark for an aggressive Tea Party agenda in the U.S. that focuses on fiscal conservativism to the exclusion of everything else. Republicans will take note that even as conservative of a state as Kansas has a limit when it comes to spending cuts. It was the cuts to education - which resulted in shorter schoolyears in some districts, and various other disruptions - that fatally wounded Brownback's public standing. Thus public demand for core services is a real constraint on the extent to which taxes can be slashed. Bottom Line: We expect the Trump administration to go forward with tax cuts. But we also think that Trump will get far less in spending cuts than his budget proposals pretend. As such, we expect the GOP tax reform agenda to blow out the budget deficit, a path that Kansas could not legally (or politically) take. This will be the path of least resistance for Congressional Republicans who want to slash taxes yet fear they may not survive the spending cuts necessary to pay for them.16 Marko Papic, Senior Vice President Chief Geopolitical Strategist marko@bcaresearch.com Matt Gertken, Associate Vice President Geopolitical Strategy mattg@bcaresearch.com Jim Mylonas, Vice President Client Advisory & BCA Academy jim@bcaresearch.com 1 Please see BCA Geopolitical Strategy Special Report, "Break Glass In Case Of Impeachment," dated May 17, 2017, available at gps.bcaresearch.com. 2 Please see BCA Geopolitical Strategy Weekly Report, "Reconciliation And The Markets - Warning: This Report May Put You To Sleep," dated May 31, 2017, available at gps.bcaresearch.com. 3 Please see BCA U.S. Bond Strategy Weekly Report, "Two Challenges For U.S. Policymakers," dated May 23, 2017, available at usbs.bcaresearch.com. 4 Please see Janet L. Yellen, "Inflation Dynamics and Monetary Policy," Philip Gamble Memorial Lecture, University of Massachusetts-Amherst, September 24, 2015, available at www.federalreserve.gov. 5 Please see BCA Global Investment Strategy Weekly Report, "When Doves Cry," dated June 9, 2017, available at gps.bcaresearch.com. 6 Please see BCA Geopolitical Strategy Client Note, "U.K. Election: The Median Voter Has Spoken," dated June 9, 2017, and Geopolitical Strategy Weekly Report, "Has Europe Switched From Reward To Risk?" dated June 7, 2017, available at gps.bcaresearch.com. 7 Please see BCA Geopolitical Strategy Special Report, "Brexit - Next Steps," dated July 1, 2016, available at gps.bcaresearch.com. 8 We are particularly indebted to Ben S. Bernanke's account in The Courage To Act: A Memoir Of A Crisis And Its Aftermath (New York: Norton, 2015), pp. 435-66. 9 Please see BCA U.S. Investment Strategy Special Report, "Preparing For Basel III: Who Will Win, Who Will Lose?" dated September 12, 2011, available at usis.bcaresearch.com. 10 Congressional Budget Office, "H.R. 10, Financial CHOICE Act of 2017," CBO Cost Estimate, May 18, 2017, available at www.cbo.gov. 11 The Republicans managed to repeal one aspect of Dodd-Frank with a simple majority via the Congressional Review Act, an option that is now closed. U.S. oil, gas, and mineral companies can now be somewhat less transparent about payments made to foreign governments to gain access to resources. Proponents claim U.S. resource companies will gain competitiveness; opponents claim corruption will increase, particularly in foreign countries. 12 Please see Bill Heniff Jr., "The Budget Reconciliation Process: The Senate's 'Byrd Rule,'" Congressional Research Service, November 22, 2016, available at fas.org. 13 Please see Yellen's February testimony to the Senate Banking Committee, e.g. "Yellen Wants To Ease Regulations For Small Banks," Associated Press, February 14, 2017, available at www.usnews.com. 14 Please see BCA U.S. Equity Strategy Weekly Report, "Girding For A Breakout," dated May 1, 2017, available at uses.bcaresearch.com, and Global Alpha Sector Strategy Weekly Report, "Buy The Breakout," dated May 5, 2017, and "Wind Of Change," dated November 11, 2016, available at gss.bcaresearch.com. 15 The FiscalNote Policy Index measures regulatory risk daily for sectors, industries, and individual companies from every legislative and regulatory proposal. Using proprietary machine-learning-enabled natural language processing algorithms, FiscalNote ingests and processes thousands of legislative and regulatory policy events, scoring each for relevance, favorability, and importance to affected sectors. 16 Please see BCA Geopolitical Strategy Special Report, "Constraints And Preferences Of The Trump Presidency," dated November 30, 2016, available at gps.bcaresearch.com.

Bank stocks have recently caught a bid, surging relative to the broad market in the last few trading sessions. There are good odds that an overly pessimistic loan growth outlook has been discounted, arguing for additional outperformance. Our U.S. bank loan growth model suggests that banks could enjoy the largest upswing in credit growth of the past 30 years. Soaring consumer and business confidence, rising corporate profits and a potential capital spending revival are the key model drivers. With the credit quality outlook still bright and prospects for at least a modest yield curve steepening in the coming quarters, bank profits should easily outpace those of the overall market. We reiterate our recent upgrade to overweight. The ticker symbols for the stocks in this index are: BLBG: S5BANKX - WFC, JPM, BAC, C, USB, PNC, BBT, STI, MTB, FITB, CFG, RF, KEY, HBAN, CMA, ZION, PBCT.

Consumer staples equities in general and beverage stocks in particular have been stellar outperformers this year. Nevertheless, this strength may prove fleeting as our leading profit indicators have all taken a decisive turn for the worse. The biggest risk centers on weakness in beverage shipments, which is a cause for concern given the correlation with relative performance. Our beverage industry activity proxy confirms this bearish message: relative profitability is under attack. There is some hope that a weaker U.S. dollar, especially against emerging market (EM) currencies, may partially neutralize soft domestic consumption. But we are reluctant to forecast an export resurgence, given that EM consumption growth has continued to ease. Adding it up, leading indicators of beverage demand remain muted at a time when industry price deflation has intensified. This is a toxic brew for profitability, and we recommend using recent outperformance to sell down positions to underweight. Downgrade the S&P soft drinks index to underweight. The ticker symbols for the stocks in this index are: BLBG: S5SOFD - PEP, KO, DPS, MNST.

In early-April we upgraded the S&P utilities sector to a tactical (1-3 month) overweight courtesy of five key drivers that have now largely played out (please see our Weekly Report of April 3, 2017 for more details). As a result, we are booking modest profits and downgrading to a benchmark allocation. The composite ISM export index and our U.S. capex indicator, both indicators that have historically varied inversely with the utilities sector, have catapulted higher recently (second & third panels). Meanwhile, electricity production growth has crested and natural gas price inflation has rolled over, suggesting that pricing power gains have peaked. In sum, utilities leading profit indicators have crested and all five of the driving forces behind our tactical overweight recommendation have largely transpired. Downgrade to neutral.

Highlights Portfolio Strategy The latest wobble in the financials sector is a buying opportunity, with the exception of the defensive insurance index. Our tactical overweight in utilities has played out. Take profits and downgrade to neutral. Weak beverage operating metrics argue for a reduction in premium valuations. We recommend a full downgrade from overweight to underweight. Recent Changes S&P Utilities - Downgrade to neutral, locking in gains of 1% on this tactical position. S&P Soft Drinks - Downgrade to underweight. Table 1 Feature The S&P 500 remained undaunted in the face of a geopolitical firestorm last week. Instead, vibrant global growth and easy monetary conditions continue to underpin investor confidence in the durability of the earnings upcycle. Our thesis remains intact: a recovery in top-line growth, powered by both volume and pricing power gains, will generate sufficient profit growth to sustain the equity market overshoot. While actual inflation has surprised to the downside, weighing on inflation expectations (bottom panel, Chart 1), this has not translated into a loss of business sector pricing power. Corporate selling prices have diverged markedly from the Fed's preferred measure of inflation (middle panel, Chart 1), reflecting a goldilocks scenario where more restrictive monetary conditions will not impede the path to improved profitability. In recent research we showed that operating leverage in S&P 500 constituents runs at 1.4x. In other words, a 5% increase in sales results in a 7% rise in operating EPS, based on our regression analysis. While every cycle is different, when revenues initially recover from a slump, as is currently the case, operating leverage can be even higher, with profits often outpacing sales by two or even three times. Since mid-December, both the U.S. dollar and 10-year Treasury yields have fallen in tandem. As a result monetary conditions have eased, reversing the tightening that occurred in the second half of 2016. Our U.S. Monetary Indicator (USMI) and momentum in corporate profit margins are perfectly inversely correlated. The recent downswing in the USMI is bullish for S&P 500 margins (USMI shown inverted, bottom panel, Chart 2). True, a fall in bond yields can also be reflective of a deteriorating economy, such that investors should become worried about profitability. However, the stock-to-bond (S/B) ratio is not signaling any trouble ahead. History shows that the time to worry about the bond market's earnings message is when the S/B ratio contracts (see shaded areas, third panel, Chart 3). Chart 1Corporate Pricing Power Reigns Chart 2Easy Financial Conditions Boost Margins Chart 3Goldilocks Equity Scenario In addition, part of the decline in long-term interest rates also reflects a slower expected pace of fed funds rate increases. The bond market doubts the FOMC's 2.125% interest rate estimate for 2018, forecasting a fed funds rate roughly 63bps lower. If the bond market is accurate and the Fed recalibrates its 18-month rate outlook even modestly lower later this week, then the S/B ratio has more upside. This week we reiterate our recent financials sector upgrade to overweight, make two tweaks to our portfolio and downshift our defensive exposure another notch. Financials Are At A Critical Juncture Financials stocks have performed as if the U.S. economy is headed for a protracted slowdown, or even recession. Uncertainty with the U.S. Administration's ability to pass bills and enact reforms, a string of U.S. economic disappointments and related yield curve flattening, and sinking inflation expectations have all weighed on relative performance. Rather than extrapolate recent weakness, our inclination is to view the latest wobble as a buying opportunity. A number of forward looking loan growth indicators suggest that credit and capital formation are on an upward trajectory, which will support ongoing profit outperformance. Chart 4 shows that our U.S. capex indicator is an excellent leading indicator of loan growth, with a forty year track record. Soaring confidence implies a more expansionary mindset, and increased demand for external funds (third panel, Chart 4). Similarly, the ISM survey leads loan growth. Both the ISM manufacturing and services surveys are sending a positive signal (fourth panel, Chart 4). Specifically, our sister U.S. Bond Strategy's credit growth model captures all of these positive forces: the recent nascent recovery in bank credit growth should morph into a sustained recovery in the second half of 2017 (bottom panel, Chart 4). Meanwhile, financial conditions have continued to ease, aided by tightening credit spreads, a decline in oil prices, U.S. dollar softness and rise in equity prices (top panel, Chart 5). Easier monetary conditions should ensure that the recovery in overall corporate sector profits stays on track, thereby sustaining both consumer and corporate credit quality at high levels. It is notable that relative performance and the Bloomberg Financial Conditions Index are positively correlated (second panel, Chart 5). Credit quality is already showing signs of improvement: financials sector ratings migration has swung roughly 50 percentage points since last October (second panel, Chart 6). The implication is that reserve building should not become a profit drag over a cyclical investment horizon. Chart 4Credit Growth##br## Will Pivot Chart 5Easy Monetary Conditions ##br##Are A Boon For Financials Chart 6Financials Catch-Up##br## Phase Looms In sum, as long as the global economic expansion persists, as we expect, then the recent inflation expectations-related selloff in the sector should prove transitory. We continue to recommend above-benchmark exposure to areas with leverage to increased capital formation, with one notable exception in the sector's most defensive component: insurance. Continue To Avoid Insurers While financial companies levered to capital formation and credit creation are well positioned to thrive if the U.S. and global economies continue to improve, the same is not true for the broad S&P insurance index. This is a defensive group with a fairly stable recurring revenue stream that typically thrives when the economy is slowing, the yield curve is flattening and the U.S. dollar is on an upward trajectory. Relative performance has edged higher in concert with the recent yield curve flattening, but as detailed above, we don't expect the latter to continue. Ergo, the only external support for the group is likely to crumble, especially now that the U.S. dollar is softening (Chart 7). If the domestically-focused insurance index could not gain traction throughout the latest U.S. dollar bull market, what will happen if a mild currency depreciation occurs? Based on its own merits, the insurance industry likely heads toward a profit soft patch. The ebb and flow of overall business activity drives revenue growth, particularly in the interest rate-sensitive auto and housing sectors. Chart 8 combines sales growth for the latter two sectors into one series, which has recently slipped into negative territory, warning of a similar fate for insurance top-line growth. Consumer spending on insurance products is also contracting relative to total spending (Chart 8), corroborating the cautious message from housing and autos. There are also cracks forming in pricing power. The CPI for motor vehicle insurance remains robust, but that of household tenants insurance has sunk into the deflation zone. If the hard market turns soft, it will further undermine underwriting premium growth. To make matters worse, insurance companies have been on a hiring binge for the past several years. Headcount exploded higher beginning in 2014, and continues to make new highs. Rising cost structures coincided with the downturn in insurance book value growth (Chart 9). Book values have recently started to shrink, with little prospect for a reversal unless labor costs ease and/or underwriting activity revives. As a result, our preference is to focus exposure on non-insurance financials, as insurance remains a high-conviction underweight. Chart 7'Dollar ##br##Trouble' Chart 8Pricing ##br##Power Blues Chart 9Beware The Bull Market ##br## In Insurance Employment Book Profits In Utilities In early-April we upgraded the S&P utilities sector to a tactical (1-3 month) overweight courtesy of five key drivers that have now largely played out.1 As a result, we are booking profits of 1% and downgrading to a benchmark allocation. The U.S. economy is on the cusp of a capex revival. While Q1/2017 GDP growth was unduly weak, investment spending was a bright spot. Our U.S. Capex Indicator has accelerated sharply, signaling that investment should continue to gain traction. Historically, business spending and utilities relative performance have been inversely correlated (the Capex Indicator is shown inverted, top panel, Chart 10). Similarly, the composite ISM export index has recently catapulted to the highest level since the late-1990s. Should the U.S. dollar continue to depreciate, U.S. exporters will remain busy filling foreign orders. That is a relative performance drag for the domestically-exposed utilities sector (ISM exports shown inverted, bottom panel, Chart 10). Meanwhile, electricity production growth has crested and natural gas price inflation has rolled over, suggesting that pricing power gains have peaked (Chart 11). The implication is that there will be no earnings follow through to support the recent breakout attempt (third panel, Chart 12). Chart 10Capex Revival Is Bearish For Utilities Chart 11Soft Demand With Weak Selling Prices Chart 12Why Pay Up For Lack Of EPS Follow Through? Importantly, the total return of the bond-to-stock ratio continues to contract. While both stocks and bond prices have risen in tandem of late, persistent stock market outperformance warns that flows into this fixed income proxy will soon peter out (Chart 12). Thus, in the absence of an earnings acceleration, it will be difficult to sustain premium valuations (bottom panel, Chart 12). In sum, utilities leading profit indicators have crested and all five of the driving forces behind our tactical overweight recommendation have largely transpired. Bottom Line: Execute the downgrade alert and book 1% profits since our tactical overweight of the S&P utilities sector, initiated in early-April. Time To Liquidate Beverage Stocks Consumer staples equities in general and beverage stocks in particular have been stellar outperformers this year. Nevertheless, this strength may prove fleeting in the absence of a revival in relative profit fortunes. Since the mid-1990s, relative performance has followed the ebb and flow of relative forward profit estimates. However, a gap has opened, as analyst estimates have continued to drift lower as share prices have climbed (top panel, Chart 13). The gravitational pull from fading earnings confidence may be too powerful to overcome over the next six months, given that our leading profit indicators have all taken a decisive turn for the worse. There is a rising risk that premium valuations will normalize (bottom panel, Chart 13). Instead, household products and packaged foods stocks offer a better risk/reward tradeoff. The biggest risk that we first identified in March centers around beverage shipments. The top panel of Chart 14 shows that industry shipments have plunged on the back of anemic end-demand. Shipment weakness is cause for concern given the correlation with relative performance. Chart 13Mind The Gap Chart 14Beverage Deflation... Our beverage industry activity proxy confirms this bearish message: relative profitability is under attack (middle panel, Chart 14). Worrisomely, soft drink manufacturers have tried hard to arrest the fall in shipments via steep price concessions (third panel, Chart 14). Even price deflation has been unable to reverse the contraction in industry volumes. If S&P soft drink sales continue to soften on the back of both volume and price cuts, then profit margins will take a hit (third panel, Chart 15). True, input cost inflation remains well contained, as both ethylene and raw food commodity prices are non-threatening. Moreover, labor cost inflation is subdued. Still, history shows that deflation typically leads to a margin squeeze. There is some hope that the export relief valve may partially neutralize soft domestic consumption. Consumer goods exports have contracted, but the depreciation in the U.S. dollar, especially against emerging market (EM) currencies, provides a glimmer of light that a turnaround lies ahead (third panel, Chart 16). But we are reluctant to forecast an export resurgence, given that EM consumption growth has continued to ease. Chart 16 shows that beverage sales growth closely follows the trend in real Asian retail sales, and the current message is bearish. Chart 15Mind The Gap Chart 16Do Not Bet On An Export-Led Recovery Adding it up, leading indicators of beverage demand remain muted (second panel, Chart 16), at a time when industry price deflation has intensified. This is a toxic brew for profitability, and we recommend using recent outperformance and sell down positions to underweight. Bottom Line: Downgrade the S&P soft drinks index to underweight. 1 Please see BCA U.S. Equity Strategy Weekly Report "Great Expectations?", dated April 3, 2017, available at uses.bcaresearch.com Current Recommendations Current Trades Size And Style Views Favor small over large caps and stay neutral growth over value.

The relative performance of the chemicals index has been sideways for two years, despite significant moves in some historically strongly correlated indicators. The U.S. dollar, with which the index varies negatively, has softened without a positive share price response (first panel). Further, the industrial production picture is generally more optimistic. Global purchasing manager survey sentiment remains near 20 year highs, boosting analyst sales expectations (second panel). However, the key headwind to the industry is not sales, it's the perennial overcapacity (third panel) which seems likely to worsen before it improves. The recent wave of mega M&A activity in the sector should (eventually) help alleviate the situation but it is still too early for us to be constructive on the sector. Stay underweight. The ticker 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.

The S&P hotels index has gone vertical since our upgrade to neutral in November of last year. Worryingly, sector valuations appear misleadingly attractive (second panel) as forward earnings revisions have spiked much faster than the index, leading to some concern about analyst overenthusiasm; periods of analyst exuberance have typically presaged corrections. The fall in hours worked underpins this concern. Net earnings revisions have historically moved in step with hours worked, but the relationship has broken down in the last 2 years as earnings estimates have whipsawed (third panel). Still, the profit outlook remains favorable for hoteliers. Pricing power has moved positively and the wage bill looks under control (fourth panel), all in line with our prior expectations. Thus, while the index is showing definite signs of flying too high, positive earnings momentum means a soft landing is the most likely result. Stay neutral and remove the upgrade alert. The ticker symbols for the stocks in this index are: BLBG: S5HOTL - MAR, CCL, RCL, WYN.

The S&P materials sector has been unable to hold its ground, despite the softening U.S. dollar and boost to global manufacturing output this year. Instead, the sector has taken its cue from commodity prices, and leading indicators thereof, such as the ratio of Latin American to Emerging Asian equities (bottom panel). The latter has collapsed in recent weeks, which is notable because it has been highly correlated with materials sector relative performance for over a decade. While it is tempting to lean into materials sector weakness given that global output growth is on the mend, we are resisting any urge to upgrade given the negative message from commodity-sensitive equities and prospects for a cooling in Chinese economic growth in the second half of the year. Materials sector operating leverage is unlikely to become a positive force until the pricing power outlook brightens. Stay underweight.

Highlights Although it is tempting to argue that emerging markets are in a new era where past correlations no longer matter, our belief is that it is only a matter of time until fundamentals reassert themselves. Several measures of equity markets have reached or are close to their previous structural peaks. In the second half of 1990s, booming U.S. and European growth as well as the tech mania, did not preclude a bear market in commodities and EM financial markets. Overall, EM risk assets will not be immune to selling off considerably from the current overbought levels if Chinese growth and commodities prices surprise to the downside, as we expect. Falling commodities prices will weigh on Indonesia's terms of trade. Equity investors should maintain an underweight position in this market and currency traders should continue shorting the rupiah. Feature A New Era? Money has been flowing into EM financial markets, irrespective of the evolution of many economic and financial variables that have in the past shaped markets dynamics. Indeed, EM share prices and currencies have refused rolling over despite a relapse in a number of variables they have historically been correlated with. EM share prices have continued to surge, even though the aggregate EM manufacturing PMI has rolled over (Chart I-1). Chart I-1Unsustainable Decoupling The recent relapse in the EM manufacturing PMI has not hurt EM currencies either (Chart I-2, top panel). In addition, EM currencies have diverged from commodities prices, an unprecedented historical occurrence (Chart I-2, bottom panel). The same applies to EM versus DM relative equity performance. Chart I-3 demonstrates that EM share prices have outperformed their DM counterparts year to date, even though the EM manufacturing PMI considerably underperformed DM's. Chart I-2Untenable Divergence Chart I-3Relative Share Prices And Relative PMIs Notably, EM stock prices have even defied the recent setback in EM net earnings revisions (Chart I-4). Typically, the latter correlate with swings in share prices, but this time both variables have diverged. Finally, it is important to note that this phenomena of decoupling cannot be explained by the performance of technology stocks. EM share prices excluding technology companies have still rallied, albeit much less, despite the decline in EM net earnings revisions and the EM manufacturing PMI. Remarkably, China's H shares - the index that does not include U.S.-listed Chinese internet/social media companies and is instead "heavy" in banks and "old economy" stocks - have still ignored both the drop in China's manufacturing PMI and rising local interest rates (Chart I-5). Chart I-4Even Analysts' Net EPS ##br##Revisions Have Rolled Over Chart I-5Puzzling... One could argue that the dominant macro drivers of EM in recent months have been the U.S. dollar and U.S. bond yields, both of which have downshifted since mid-December 2016. If the greenback and expectations of Federal Reserve policy continue to shape EM performance, the outlook is not much better. The basis is that the Fed will likely continue to hike interest rates if global stocks continue to rally. Notably, U.S. corporate bond yields/spreads are very low, the dollar is already down quite a bit, U.S. asset prices are reflating and U.S. economic growth is decent. If the Fed does not normalize interest rates now, when and under what conditions will it? Similarly, investor sentiment on the U.S. dollar is no longer bullish, and the market expects only 44 basis points in Fed rate hikes over the next 12 months. The latter is a low bar. We maintain that the dollar's selloff - even though it has lasted longer than we previously expected - is late, especially versus EM currencies. Bottom Line: Although it is tempting to argue that emerging markets are in a new era where past correlations no longer matter, our belief is that it is only a matter of time until fundamentals reassert themselves. As and when this happens - our hunch is that it is a matter of weeks not months - EM risk assets will sell off materially and underperform their DM counterparts. Signs Of A Top? Or Is This Time Different? The EM equity rally has been facilitated by the tech mania occurring worldwide as well as by falling financial market volatility and risk premia - leading investors to bet on EM carry trades. A relevant question is whether these trends are close to the end or have much further to go. We have the following observations: EM share prices in local currency terms, as well as the KOSPI and Taiwanese TSE indexes in U.S. dollar terms, all are testing their previous highs which they have never broken out from (Chart I-6). The question we would ask is: Why should this time be different, or why would these indexes break out this time around? In our opinion, EM fundamentals, including the outlook for EPS growth, remain poor. We have elaborated on this issue at length in previous reports1 and stand by our assessment. On many metrics, the U.S. equity market is expensive, and the rally is overstretched (Chart I-7). Chart I-6Facing A Major ##br##Technical Resistance Chart I-7U.S. Stocks Are Expensive ##br##And Overstretched These charts do not provide clues for the timing of a reversal, but when all these ratios reach their previous secular tops, investors should be critically examining the investment outlook. Our take is as follows: Without a broad-based U.S. corporate profit recession, a major bear market in the S&P 500 is not likely, but share prices could soon hit a major resistance and correct meaningfully from the current expensive and overbought levels. While EM stocks are not expensive, the outlook for their share prices is negative because we expect EM earnings to shrink again by early next year1. Finally, not only is U.S. equity market volatility extremely muted but EM equity as well as U.S. bond market volatility are testing their previous lows (Chart I-8). When implied volatility reached these low levels in the past, it marked a major market reversal. Bottom Line: Several measures of equity market performance have reached or are close to their previous structural peaks and financial markets volatility is at record lows. While one can make the case that this time is different and this EM equity rally will persist, we continue to err on the side of caution. Tech Mania And EM In The 1990s A recent narrative in the marketplace has been as follows: given the share of tech stocks' market cap has risen to 26%, and commodities sectors presently account for only 14% of the EM MSCI benchmark, it makes sense that EM equities have decoupled from commodities prices and have become correlated with tech stocks and DM growth. In this respect, it is instrumental to revisit what happened in the second half of the 1990s, when global tech/internet and telecom stocks were in the midst of a mania like social media/tech stocks nowadays. We have the following observations on this matter: EM share prices, currencies, and bonds plunged in the second half of the 1990s, even though U.S. and European real GDP growth was extremely strong - 4.5% and 3% on average, respectively (Chart I-9, top panel) - and the S&P 500 was in a full-fledged bull market. Chart I-8Volatility: As Low As It Gets Chart I-9EM Stocks And DM Growth In The 1990s EM share prices collapsed in 1997-'98, even though U.S. and European import volumes were expanding at a double-digit rates (Chart I-9, middle panel). Furthermore, the crises originated in emerging Asian countries such as Thailand, Korea and Malaysia that were large exporters to advanced economies. Besides, the share and importance of the U.S. and European economies was much larger 20 years ago than it is now. Back then, China was negligible in terms of its impact on EM in general and commodities in particular. The question is, if an economic boom in the U.S., and Europe in the second half of the 1990s did not preclude crises in export-oriented economies in East Asia, why would moderate DM growth today - as well as their much smaller share of global trade - boost EM share prices from already elevated levels. Twenty years ago, EM share prices fell along with declining U.S. bond yields (Chart I-10). The Fed hiked rates only once by 25 basis points in March 1997. In the past 18 months, the Fed has already hiked 3 times. In fact, the U.S. dollar was in a bull market in the second half of the 1990s, despite falling U.S. bond yields during that period. EM stocks collapsed along with falling commodities prices in 1997-'98 (Chart I-11, top panel) even though the S&P 500 was in the midst of a major bull market (Chart I-11, bottom panel). Chart I-10The 1990s: EM Bear Market ##br##Was Not Due To Rising U.S. Bond Yields Chart I-11EM Stocks, Commodities And The S&P 500 Importantly, the mania sectors of the late 1990s - technology and telecom - accounted for approximately 33% of EM market cap in January 2000. Presently, following an exponential rally and outperformance, technology and social media/internet stocks make up 27% of the EM MSCI benchmark. In addition, the market cap of energy and materials companies stood at 19% of the MSCI EM equity benchmark in January 2000, compared with 14% presently (Chart I-12). Hence, the market cap of commodities sectors was not substantially larger in the late 1990s than today. Finally, Korean and Taiwanese bourses have historically had a high positive correlation with both oil and industrial metals prices (Chart I-13). The reason for this relationship is that both economies are leveraged to the global business cycle, and commodities prices are often driven by global trade cycles. Chart I-13Asian Bourses And Commodities Prices Bottom Line: In the late 1990s, EM crises/bear markets occurred despite booming U.S. and European growth, and at a time when these economies were much more important to EM than they are today. The EM bear market also occurred amid the S&P 500 bull market and falling U.S. bond yields. To be sure, we are not suggesting that everything is identical between today and the 1990s, but all the above suggests to us that EM risk assets will not be immune to selling off considerably from the current overbought levels if Chinese growth and commodities prices surprise to the downside, as we expect. Arthur Budaghyan, Senior Vice President Chief Emerging Markets Strategist arthurb@bcaresearch.com 1 Please refer to the Emerging Markets Strategy Weekly Report titled, "EM Profits, China And Commodities Redux", dated May 31, 2017, link available on page 16. Indonesia: Facing Commodities Headwinds (Again) Decelerating Chinese growth and falling commodities prices will weigh on Indonesia's exchange rate (Chart II-1). In turn, not only will the currency depreciation undermine foreign currency returns to investors in stocks and local bonds, but it will also exert upward pressure on local rates. The latter will extend the credit downturn and weigh on domestic demand. Chinese imports of Indonesian coal have begun falling in volume terms (Chart II-2). Consistently, Chinese thermal coal prices - the type of coal that China buys from Indonesia - have also rolled over decisively after rallying sharply in 2016. Chart II-1Indonesia Currency ##br##And Commodities Prices Chart II-2Indonesia's Coal Exports ##br##To China And Coal Prices Indonesia's exports of base metals and oil/gas to China are also declining in U.S. dollar terms. Commodities exports account for around 30% of Indonesia's total exports. As such, falling commodities prices will lead to negative terms of trade for this nation. On the domestic front, consumer demand remains sluggish. Although auto sales have revived, motorcycles sales are still declining for a fourth consecutive year (Chart II-3). Meanwhile, capital expenditures are tame. Capital goods imports are no longer contracting, but there has been no recovery so far (Chart II-4). Chart II-3Consumer Spending: ##br##Auto And Motorcycle Sales Chart II-4Indonesia: Capex Is Sluggish Bank loan growth has not recovered much (Chart II-5) despite low interest rates and a benign external backdrop since early 2016, specifically the revival in commodities prices and large foreign portfolio inflows. NPLs on banks' balance sheet will rise further due to weak growth and lower commodities prices. That, in turn, will dent banks' willingness to grow their loan book. In regard to the credit cycle, Indonesia might be following India's example with a several year lag. In India's banking system, high NPLs have curtailed public banks' desire to lend and, consequently, capital spending has been in disarray. Similarly, Indonesia's credit-sensitive consumer spending and investment expenditure growth will disappoint in the next 12 months as credit growth slows anew. Finally, at a trailing price-earnings ratio of 19.6, equity valuations are not attractive. The poor growth outlook that we foresee does not justify such high multiples. Besides, relative performance of this bourse versus the overall EM equity benchmark is stuck between technical support and resistance (Chart II-6). We are biased to believe that it will relapse from the current juncture. Chart II-5Indonesia's Credit Cycle Is Not Out Of The Woods Chart II-6Indonesian Equity Relative Performance Bottom Line: Weaker commodities prices emanating from slower Chinese growth will hurt Indonesia's currency. We recommend equity investors to keep an underweight position in this bourse. Also, we remain short IDR versus the U.S. dollar and underweight local currency bonds within the EM universe. Ayman Kawtharani, Associate Editor ayman@bcaresearch.com Equity Recommendations Fixed-Income, Credit And Currency Recommendations