Equities

There is a once in a decade opportunity to prefer value over growth (V/G) stocks, and we recommend shifting our style bias in favor of value stocks. Typically, the V/G ratio moves in multi-year up and down cycles, and at the current juncture it is a screaming buy, if history at least rhymes (top panel). Relative sector composition implies a value over growth preference would equate to a positive interest rate and oil price correlation. Indeed, the 10-year Treasury yield moves in lockstep with the V/G ratio and similarly oil prices are joined at the hip with relative performance (second and third panels). One of BCA’s themes for 2018 is higher interest rates, with our bond strategists still expecting an inflation-driven rise in the 10-year Treasury yield near 3%. Similarly, BCA’ commodity strategists remain constructive on oil prices. Taken together, these BCA views warrant a value over growth preference. Bottom Line: Boost value stock exposure at the expense of growth equities. The V/G ratio offers an excellent entry point with limited downside risk.

Highlights Portfolio Strategy Relative sector index composition, the macro backdrop, relative operating metrics along with compelling valuations and washed out technicals suggest that a value over growth style bias is warranted. Rising interest rates and a flattening yield curve, coupled with increasing relative indebtedness and lack of relative profit growth signal that the time is right to shift the capitalization bias to a neutral setting. Recent Changes Shift the style bias and favor value over growth today. Book profits in the small over large cap size bias of 2% since the mid-August 2016 inception. Table 1 Feature Equities catapulted to new all-time highs last week as earnings season got underway. Upbeat bank reports set the tone, and SPX profits are slated to register a 12% growth rate for both Q4/2017 and calendar 2017. Current year EPS estimates have been aggressively ratcheted higher, on the back of the tax bill passage, rising from 12% to 16% in a mere three weeks, according to Thomson Reuters/IBES. Our SPX EPS growth model agrees that, cyclically, profits will continue to drift higher and a low-to-mid double-digit growth rate is likely for 2018, as we posited last week.1 While the synchronized and disinflationary global growth narrative continues to dominate, we are a bit uneasy. The eerie calm overtaking the markets, and headlines like this recent one from Bloomberg "The Stock Market Never Goes Down" give us cause for concern. As a reminder, the SPX is up 1000 points since the 1800 level registered in early-2016. Put differently, the SPX has been rising by roughly 25% per annum for the past two years. Such a breakneck pace is unsustainable. Our sense is that from a tactical perspective, equities are currently extremely stretched and warrant some caution. Therefore, this week we identify five key signposts we are closely monitoring that are sending clear warning signals (for a more comprehensive list please see the tactical section of our August 7th White Paper).2 First, our reflation gauge (RG) has taken a turn for the worse (Chart 1). At the margin, higher oil prices and interest rates may begin to bite. Historically, our RG has been an excellent leading indicator of both sentiment that has vaulted to multi-decade highs and CITI's economic surprise index. Our global reflation gauge emits a similar signal (not shown). Mean reversion is looming. Second, speculation runs rampant. Our Equity Speculation Index (ESI) is close to two standard deviations above the historical mean. Since the early-1960s, the ESI has only been higher during the dotcom bubble (Chart 2). While the ESI can rise further, it is at least waving a yellow flag. Investor sentiment has also gone parabolic with the bull/bear ratio reaching a level last seen right before the 1987 crash (third panel, Chart 2). Chart 1Yellow Flag Chart 2Extended Third, financial conditions are as good as they get. The St. Louis Fed Financial Stress Index recently hit an all-time low level. Similarly, Goldman Sachs' and the Chicago Fed's National Financial Conditions indexes are also near uncharted territory. This should be cause for some trepidation (Chart 3). Fourth, extended EPS breadth, all time highs in net earnings revisions, stretched median valuations and overbought technical conditions are near levels that have marked previous temporary broad market pullbacks (Chart 4). Finally, gold is behaving strangely. While the U.S. dollar's selloff explains part of the recent jump in the shiny metal, we think bullion may be sniffing out some trouble as it remains a true safe haven asset. Either real rates have to come down or gold has to reverse course; such a steep divergence is unsustainable (gold shown inverted, top panel, Chart 5). Chart 3As Good As It Gets Chart 4Peak Euphoria? Chart 5What's Gold Sniffing Out? Since December 18th our strategy has been to book gains in tactical trades and to refrain from altering our cyclical over defensive portfolio positioning bent,3 as we do not foresee a recession in the coming 9-12 months.4 We continue to pursue this strategy and were a 5-10% selloff to materialize, we would "buy the dip". In addition, this week we introduce/apply a risk management measure to our recently revealed high-conviction 2018 calls.5 Almost all of our calls are in the black outperforming the broad market on average by 640bps (Chart 6). While we are not compelled to change our views just yet, our confidence is not as high as two months ago, especially in the two calls that are registering double-digit relative returns. Thus, we suggest that clients institute a tight stop in these trades (please see the "Stop" column in the "Top High-Conviction Calls For 2018" table on page 15). Going forward, we will introduce such risk management trailing stops once a call clears the 10% relative return mark. This week we shift both our style and size biases. Chart 6Time To Set Stops Buy Value At The Expense Of Growth There is a once in a decade opportunity to prefer value over growth (V/G) stocks, and we recommend shifting our style bias in favor of value stocks. Typically, the V/G ratio moves in multi-year up and down cycles, and at the current juncture it is a screaming buy, if history at least rhymes. Chart 7 shows that relative share prices are not only near previous troughs, but also 1.5 standard deviations below the six-decade time trend. Chart 7Compelling Entry Point In fact we already have a flavor of this style preference in one of our market-neutral pair trades, long financials / short tech (for additional details on this trade please refer to our "Disentangling Pricing Power" early-summer report). Table 2 depicts why this is so: financials stocks dominate value indexes, while IT comprises 40% of growth indexes. Sector composition also suggests that a long energy / short health care trade would mimic this V/G preference, as energy stocks offer a lot of value, whereas health care stocks sit prominently in growth indexes (Table 2 & Chart 8). While we do not have this pair trade on per se, as a reminder we are overweight the energy sector and underweight health care stocks; we are also overweight financials and underweight tech (please see page 14 for a complete picture of our current sector recommendations). Table 2Sector Composition With regard to macro variables, these sector preferences would equate to a positive interest rate and oil price correlation. Indeed, the 10-year Treasury yield moves in lockstep with the V/G ratio and similarly oil prices are joined at the hip with relative performance (Chart 9). Chart 8Value/Growth Replicas Chart 9Rising Oil And Rates = Buy Value / Sell Growth One of BCA's themes for 2018 is higher interest rates, with our bond strategists still expecting an inflation-driven rise in the 10-year Treasury yield near 3%. Similarly, BCA' commodity strategists remain constructive on oil prices. Taken together, these BCA views warrant a value over growth preference. Importantly, since the depths of the GFC, value has underwhelmed growth by a wide margin. Likely, this growth over value preference reflected central bank interest rate suppression, which boosted the multiple investors were willing to pay for perceived growth at a time when growth was scarce. Now that the Fed has lifted rates five times since December 2015 and is on track to do so three more times this year, value should take the reins (Chart 10). Moreover, the Fed is unwinding its balance sheet and that tightening in monetary conditions, at the margin, favors value over growth (Chart 11). Chart 10Avoid Growth Stocks During Fed Tightening Cycles... Chart 11...And During Quantitative Tightening On the currency front, the V/G ratio has had a tight positive correlation with the EUR/USD foreign exchange rate (Chart 12). Once again sector composition has been underpinning this relationship. However, sector composition is constantly shifting. Currently, a larger percentage of growth stocks have international sales (especially tech) compared with more domestically-oriented value stocks. Thus, the depreciating U.S. dollar is a risk to our value over growth preference On the operating metric front, value stocks have the upper hand versus their growth siblings. Our relative composite pricing power gauge has swung by eight percentage points from trough-to-peak and heralds a deflation exit for relative top line growth (middle panel, Chart 13). Chart 12Depreciating U.S. Dollar Is ##br##Typically A Boon To The V/G Ratio Chart 13Relative Pricing Power ##br##Favors Value Over Growth Sell-side analysts have taken notice and have been aggressively bumping their net earnings revisions in favor of value versus growth indexes. As mentioned earlier, rising oil price inflation and better credit pricing power are a boon to V/G profit prospects (bottom panel, Chart 13). Valuations and technicals also suggest that investors should overweight value at the expense of growth. Our relative Valuation Indicator (VI) has recently sunk to a level last hit in the early-2000s, approaching one standard deviation below the historical mean. Similarly, the V/G ratio is oversold and our relative Technical Indicator (TI) has fallen to a level that has marked previous bull market phases (Chart 14). Finally, over the past thirty years V/G price moves have been a mirror image of both junk bond yields and vol. In other words, a value over growth preference has been synonymous with a "risk on" backdrop (junk yield and the VIX shown inverted, Chart 15). However, these close correlations appear to have broken down since the Great Recession as the Fed's unconventional monetary policies functioned well in keeping a lid on vol and suppressing bond yields across the fixed income spectrum. Chart 14Value Vs Growth Stocks Are Cheap And Oversold Chart 15Bet On Convergence As the Fed winds down its balance sheet there are good odds that volatility will make a comeback and interest rates will also shoot higher. The upshot is that these inverse correlations get reestablished in the coming quarters via a rise in the V/G ratio, an increase in vol and a selloff in the junk corporate bond market (Chart 15). Adding it up, relative sector composition, the macro backdrop, relative operating metrics along with a compelling VI reading and our washed out TI suggest that a value over growth style bias is warranted. Bottom Line: Boost value stock exposure at the expense of growth equities. The V/G ratio offers an excellent entry point with limited downside risk. Book Profits In Small Caps Vs. Large Caps And Move To The Sidelines In August 2016, we recommended a small over large cap (S/L) bias, predating the Trump election victory, on the back of five key drivers: non-inflationary growth would persist allowing central banks to stay incredibly accommodative, emerging market tail risks had eased taming equity market vol, small/large sector composition differentials, relative EPS fundamentals and restored relative valuations. Given that most of these factors have moved in favor of small versus large caps and some are starting to shift against the S/L ratio, does it still pay to have a small cap size bias? The short answer is no, and we now recommend investors book profits and move to the sidelines. While the euphoric tailwind surrounding the new administration and its promise to slash red tape and taxes tripped us up and we failed to monetize 10%+ gains, better late than never. First, from a big picture perspective, the near two decade S/L outperformance phase is running on fumes and it has likely put in a secular top in late-2016 (Chart 16). Similar to the style bias, this ratio also tends to move in long cycles. We are clearly in extended territory hovering at one standard deviation above the historical time trend. Chart 16Major Top? Second, interest rates bear close attention. Rising interest rates on the back of an inflationary impulse is BCA's view for the coming year and, coupled with the yield curve narrowing, are a harbinger of small cap trouble. Chart 17 shows the tight positive correlation between the S/L ratio and the yield curve, and the current message is to avoid small caps. Small caps are mostly domestically exposed and are ultra-sensitive to interest rate moves as small and medium businesses rely more heavily on their bankers for credit, rather than debt markets. When the yield curve flattens late in the cycle it is typically because the Fed is aggressively tightening monetary policy. While such a monetary backdrop is neither conducive to small nor to large firms, small caps suffer more, at the margin. Third, we are perplexed by the lack of profit growth in the small cap complex. It has now been over a year since Trump came into power and small cap EPS underperformance has been extremely prominent (top panel, Chart 18). The 12-month forward profit growth delta has also widened considerably over the past year to the detriment of small caps (middle panel, Chart 18). While the U.S. dollar's sizable depreciation explains part of the profit divergence, i.e. as the currency falls foreign sales exposed large caps enjoy a significant translation gain, relative indebtedness is also likely playing a key role. The bottom panel of Chart 19 shows the net debt-to-EBITDA ratio for the small cap and large cap indexes. The relative ratio has gone parabolic and is making all-time highs. Rising small cap indebtedness, at a time when cash flow growth is anemic, suggests that the S&P 600 is increasingly vulnerable. Not only are interest payments eating into income, but also refinancing risk is a threat in an era of rising interest rates. Under such a backdrop, small cap stocks should not trade at a valuation premium (bottom panel, Chart 18). Chart 17Yield Curve Blues Chart 18Small Cap Profit Trouble Chart 19Mind The Small Cap Indebtedness Bottom Line: The time is ripe to take profits of 2% and move to the sidelines in the capitalization bias. Were our indicators to further deteriorate, we would not hesitate to fully reverse course and prefer large to small caps. Stay tuned. Anastasios Avgeriou, Vice President U.S. Equity Strategy anastasios@bcaresearch.com 1 Please see BCA U.S. Equity Strategy Special Report, "White Paper: Introducing Our U.S. Equity Sector Earnings Models," dated January 16, 2017, available at uses.bcaresearch.com. 2 Please see BCA U.S. Equity Strategy Special Report, "White Paper: U.S. Equity Market Indicators (Part I)," dated August 7, 2017, available at uses.bcaresearch.com. 3 Please see BCA U.S. Equity Strategy Special Report, "Top 5 Reasons To Favor Cyclicals Over Defensives," dated October 16, 2017, available at uses.bcaresearch.com. 4 Please see BCA U.S. Equity Strategy Weekly Report, "EPS And 'Nothing Else Matters'," dated December 18, 2017, available at uses.bcaresearch.com. 5 Please see BCA U.S. Equity Strategy Weekly Report, "High-Conviction Calls," dated November 27, 2017, available at uses.bcaresearch.com. Current Recommendations Current Trades Size And Style Views Favor value over growth and stay neutral small over large caps.

Highlights The Beige Book released on January 17 keeps the Fed on track to raise rates at least three times this year and highlights the impact of the tax bill on the economy. BCA's Big 5 Bank Lending Beige Book highlights several of the positive trends supporting our view of the economy, the tax bill and the Fed. The Tax Cut and Jobs Act of 2017 has the potential to generate significant supply-side benefits for consumers, shareholders and the broad economy. We decided to stay long the dollar after a lengthy internal debate, although we have revised down our view on the upside potential. Feature U.S. risk assets continued to outperform last week outside of the dollar, as S&P 500 firms started to report Q4 2017 results and provide guidance for Q1 2018 and beyond. BCA's Bank Lending Beige Book summarizes the most optimistic comments from the Big 5 banks. The Fed's Beige Book captured comments on the broad economy in December and early January that were equally ebullient. Both Beige books suggested that firms were planning to return their tax savings to shareholders in the New Year, and to continue to boost capex, which was stout even before the law was passed. Yet, despite the upbeat news, the dollar broke down last week, as the ECB sounded a hawkish note and the Japanese economy continued to improve. On balance, the Beige Book, the Q4 earnings season, the health of the U.S. economy (notably capital spending), all support BCA's stance on the U.S. stock-to-bond ratio, the Fed, duration and the dollar. However, the dollar has not behaved as we would have expected. Beige Book Barometer Bounces The Beige Book released on January 17 keeps the Fed on track to raise rates at least three times this year and highlights the impact of the tax bill on the economy. BCA's quantitative approach1 to the Beige Book's qualitative data points to underlying strength in GDP and a tighter labor market, but there is still a disconnect between the Beige Book's view of inflation and the market's stance. Moreover, references to the stronger dollar have disappeared from the Beige Book and business uncertainty is significantly reduced, reflecting the tax cut bill and President Trump's assault on regulation. Chart 1Latest Beige Book Supports##BR##The Fed's View On Rates, Economy Chart 1, panel 1 shows that at 66%, BCA's Beige Book Monitor stayed near its cycle highs in January, re-confirmation that the underlying economy was still upbeat in Q4 and early 2018. (The latest Beige Book covered the period from mid-November 2017 to January 8, 2018). The number of 'weak' words in the Beige Book returned to near four-year lows after ticking higher in the wake of last summer's hurricanes. Moreover, there were 12 mentions of the tax bill in the January Beige Book, up from only 3 in November (not shown). The tax bill was cast in a positive light in 75% of the remarks. In November, the references to either the tax bill (or tax reform) cited the consequent uncertainty as a constraint on growth. Based on the minimal references to a robust dollar in the past five Beige Books, the greenback should not be an issue in Q4 2017 or Q1 2018, which is in sharp contrast with 2015 and early 2016 when there was a surge in Beige Book mentions (Chart 1, panel 4). The last time that five consecutive Beige Books had so few remarks about a strong dollar was in late 2014. Business uncertainty over government policy (fiscal, regulatory and health) ticked up in the past few Beige Books as Congress debated the particulars of the tax bill. Nonetheless, comments of uncertainty in the Beige Book have dropped since Trump took office in early 2017. The implication is that the business community is correctly focused on policy and not politics in D.C. (Chart 1, panel 5). The disconnect with the Fed on inflation is evident in the Beige Book's number of inflation words (Chart 1, panel 3). Expressions regarding inflation rose to a four-month high in January and the disconnect persists between the still-elevated mentions of inflation and the soft readings on CPI and PCE. In the past, increased references to inflation have led measured inflation by a few months, suggesting that the CPI and core PCE may soon turn up. Bottom Line: The recent Beige Book backs BCA's view that the U.S. economy is poised to grow above its long-term potential in the first half of 2018. However, the Beige Book has done little to resolve the debate around why an economy growing above potential and a tightening labor market have not boosted inflation. Likewise, the latest Beige Book confirmed that at least initially, businesses and bankers across the U.S. welcomed the Tax Cut and Jobs Act. Bankers' Beige Book Returns Chart 2Banking System Shipshape BCA's Big 5 Bank Lending Beige Book highlights several of the positive trends supporting our view: Pristine credit quality, a positive U.S. credit impulse, loosening U.S. banking regulatory requirements, and pent up demand for shareholder friendly activities. We introduced the Big 5 Bank Lending Beige Book2 in early 2014 to interpret the health of the banking system based on comments from leaders of the Big Five banks during earnings season. Managements were upbeat on loan demand and credit quality as they unveiled Q4 results in the past two weeks, and most expressed optimism that the positive credit trends would continue to improve in 2018. Several bank executives shared their Fed rate hike expectations for this year, with most forecasting three or four increases. One institution planned for a flatter curve, while another noted that rising rates on both the short and long ends will benefit their operations. Chart 2 shows key banking related variables cited in the Bank Lending Beige Book. Appendix Table 1 shows the Big 5 Bank Lending Beige Book for Q4 2017. All five banks were uniformly upbeat in their assessments of the tax bill's impact on their operations, their customers' businesses or the overall economy. One bank noted that it took a repatriation charge in Q4, and another said it would return capital to shareholders via buybacks and dividends. A third said the bill will provide "immediate and ongoing benefit to our employees, customers, communities and our shareholders, as we invest a portion of our tax savings in each of these important constituencies." Bottom Line: The banking system is shipshape as 2018 begins and lenders are ready to extend credit to businesses and consumers to boost the economy despite higher rates. BCA's U.S. Equity strategists recommend an overweight position in the S&P 500's financial sector, with a high conviction overweight on banks.3 A Different Lens On Earnings Chart 3Corporate Health Has Improved##BR##Since Start Of 2017 The early December release of the U.S. flow of funds report allows us to update BCA's Corporate Health Monitor (CHM) (Chart 3). The CHM's level improved slightly between Q2 and Q3, but the overall reading remains in 'deteriorating health' territory. The marginal improvement in Q3 was driven by rising profit margins. In addition, profit growth surged while debt moved up modestly in Q3. The CHM is a reliable indicator of the trend in corporate bond spreads which supports our corporate bond overweight. Given that corporate balance sheets are declining, the sole supports for corporate spreads are low inflation and accommodative monetary policy. We anticipate spreads will start to widen later this year when inflation climbs and policy turns more restrictive. BCA's U.S. Bond strategists remain overweight the U.S. high-yield bond market.4 Although spreads appear a bit more attractive than for investment-grade corporates, there is still not much room for spread compression in high-yields. We calculate that if the high-yield index spread tightens by another 117 bps, then junk bonds will be the most expensive since 1995. In an optimistic scenario where the index spread tightens 100 bps, bringing it close to all-time expensive levels, then we would expect junk excess returns to be in the range of 600 bps (annualized). Nonetheless, in view of the trends in corporate leverage, it is unlikely that there will be another 100 bps of spread tightening. More realistically, we expect excess returns between 200 bps and 500 bps (annualized) between now and the end of the credit cycle. Bottom Line: BCA's indicators suggest that we are moving into the late stages of the credit cycle, but we retain an overweight cyclical stance on corporate bonds. A shift to a more restrictive monetary policy, tightening C&I bank lending standards and/or a continued uptrend in gross corporate leverage are the main catalysts we will monitor to gauge the end of the cycle. An abrupt end to the positive capex or earnings cycle would also be concerns for our upbeat view on credit. Repatriation Redux The Tax Cut and Jobs Act of 2017 has the potential to generate significant supply-side benefits for consumers, shareholders and the broad economy. There are several uses for corporate cash, including capital spending, M&A, increasing compensation to employees, paying down debt and returning capital to shareholders. Chart 4 shows that through Q3 2017, share buybacks and dividends ran slightly ahead of prior cycles, while capex was about average. Investors wonder how that mix may change under the new law. Corporate behavior in the wake of the 2004 overseas tax holiday5 provides some guidance. Chart 4Comparison Of Corporate Outlays Across Four Economic Expansion Phases Corporations used cash generated from the 2004 tax break to return capital to shareholders. However, we found scant evidence that firms who benefited from the tax holiday increased capital spending, raised wages or hired more workers. A study by the National Bureau of Economic Research (NBER) noted that a dollar increase in repatriations "was associated with an increase of almost $1 in payouts to shareholders."6 Moreover, a 2008 IRS paper7 concluded that nearly half of all the cash repatriated in 2004 and 2005 came from only the tech and pharma sectors. A Congressional Research Service (CRS) found that small firms tended to benefit less than large firms from the tax holiday.8 A paper9 by the left-leaning, U.S.-based think tank, the Center For Budget and Policy Priorities (CBPP), stated that several firms that benefitted the most from the 2004 law laid off workers soon after the tax law was enacted. In 2018, BCA expects firms to return capital to shareholders, boost capex and continue to bump up wages. Chart 5 shows that buybacks will probably augment S&P 500 EPS by around 2% this year, while panel 2 shows that there was a noticeable upswing to buyback announcements as 2017 ended. Aside from the post-recession bounce in buybacks in 2010, the last big swell in buyback announcements occurred in 2004 and 2005. That said, corporate balance sheets were in much better shape in 2004/2005 than they are today (Chart 3 again). The implication is that management teams may decide to pay down debt before returning the cash windfall back to shareholders. However, with rates still low, most firms will chose to distribute the cash to shareholders, despite high corporate debt levels. The positive reading on BCA's Capital Structure Preference Indicator supports our stance on buybacks (Chart 6, third panel). This Indicator is defined as the equity risk premium minus the default-adjusted yield in high-yield corporate bonds. When the indicator is above zero, there is financial incentive for firms to issue debt and buy back shares. Conversely, firms are incentivized to issue stock and retire debt when the indicator is below zero. The Indicator is currently positive, although not as high as it was in 2015. Moreover, Chart 7 shows that the dividend payout ratio rebounded from the 2007-2009 financial crisis, but has moved above its pre-crisis level. However, dividend distributions remain below their pre-crisis peak reached in the early 1990s. Chart 5Still Some Room##BR##To Run For Buybacks Chart 6Buybacks Adding Almost##BR##2 Percentage Points To EPS Growth Capital spending was already on a tear in late 2017, even before the tax bill passed. Industrial production, the PMI diffusion index and advanced-economy capital goods imports, all confirm strong underlying momentum in investment spending (Chart 8). Chart 7Corporations Poised To Return##BR##Capital To Shareholders Chart 8Capital Spending Helping##BR##To Drive Growth Both BCA's real and nominal capex models, driven by surging capital goods orders along with elevated ISM data, roaring global exports and soaring sentiment on business spending, indicate strong investment in plant and equipment in the next few quarters (Chart 9). CEO confidence soared to a 13-year high in Q4, according to the latest Duke's Fuqua School of Business/CFO Magazine Global Business Outlook (Chart 10, panel 1). Duke noted that "Among CFOs who responded to the survey after the Senate passed its version of the tax reform bill, optimism spiked to 73, which is the highest U.S. optimism ever recorded in the history of the survey."10 Chart 9Bright Outlook##BR##For Capital Spending Chart 10CEO Confidence And##BR##Capex Plans Surging Surveys by the Conference Board and Business Roundtable show a similar pattern. (panel 1 again). Notably, the soundings on all three surveys have climbed since Trump's election, but then retreated as his pro-business agenda stalled in the summer months. The dip in sentiment reflected the lack of legislative progress in Washington in the first 10 months of the Trump administration. The dip in CEO sentiment in Q2 and Q3 was in sharp contrast to the easing of policy concerns in the Fed's Beige Book (Chart 1, bottom panel). The upbeat numbers in the regional FRBs' surveys of capital spending intentions further support escalating capex spending in the next few quarters. The average readings from the New York, Philadelphia and Richmond Feds' capex survey plans are at an all-time high (Chart 10, panel 2). Moreover, the regional Feds' capex spending plans diffusion index is close to a cycle high, despite a modest pullback last summer (panel 3). Bottom Line: Stay overweight stocks versus bonds, and underweight duration. The tax bill will boost returns to shareholders via buybacks and dividends. In addition, rising capex will drive up GDP, employment and EPS in the coming quarters. Dollar View Revisited The dollar fell by 4% between mid-December and mid-January, amid a hawkish market interpretation of the ECB minutes, persistently strong growth in Japan and a key technical breakdown in the DXY index. The decline has some investors questioning BCA's bullish stance on the currency (Chart 11). We were correct on the direction of interest rate differentials vis-à-vis the other major economies, but this has not translated into a stronger dollar so far. We decided to stay long the dollar after a lengthy internal debate, although we have revised down our view on the upside potential. A lot of good news on the European and Japanese economies is now discounted and investors are quite pessimistic on the dollar (which is bullish the dollar from a contrary perspective) (Chart 12). Given this technical backdrop, we would expect at least a 5% rise in the trade-weighted dollar as expectations of Fed rate hikes rise this year. We are likely to exit our long dollar position if we get such an appreciation. Chart 11We Are Sticking With##BR##Our Long Dollar View Chart 12The Case For Crisis Era Monetary Stimulus##BR##In Europe And Japan Is Weakening Bottom Line: BCA's bullish dollar trade was initiated in October 2014 and although the DXY index is up 4% since that time, we are maintaining the trade. While downside risks remain, a unilateral decision by the Trump Administration to leave NAFTA will boost the U.S. dollar versus the Canadian dollar and the peso. Italy's upcoming spring Presidential election could prompt a rally in the dollar if the Eurosceptic parties outperform expectations. John Canally, CFA, Senior Vice President U.S. Investment Strategy johnc@bcaresearch.com 1 Please see BCA Research's U.S. Investment Strategy Weekly Report, "The Great Debate Continues", published on April 17, 2017. Available at usis.bcaresearch.com. 2 Please see BCA Research's U.S. Investment Strategy Weekly Report, "Commitments", published January 20, 2014. Available at usis.bcaresearch.com. 3 Please see BCA Research's U.S. Investment Strategy Weekly Report, "High Conviction Calls", published November 27, 2017. Available at usis.bcaresearch.com. 4 Please see BCA Research's U.S. Bond Strategy Weekly Report, "January Effect", published January 9, 2018. Available at usbs.bcaresearch.com. 5 https://www.congress.gov/bill/108th-congress/house-bill/4520 6 http://www.nber.org/papers/w15023 7 https://www.irs.gov/pub/irs-soi/08codivdeductbul.pdf 8 https://fas.org/sgp/crs/misc/R40178.pdf 9 https://www.cbpp.org/research/tax-holiday-for-overseas-corporate-profits-would-increase-deficits-fail-to-boost-the 10 http://www.cfosurvey.org/2017q4/press-release.html Appendix: Bankers Beige Book

Highlights Trade #1: Go Short The December 2018 Fed Funds Futures Contract. The trade has gained 64 bps since we initiated it. We are lifting the stop to 60 bps and targeting a profit of 75 bps. Trade #2: Go Long Global Industrial Stocks Versus Utilities. The trade is up 13.1%. We are targeting a profit of 15%, and are tightening the stop further to 12%. Trade #3: Go Short 20-Year JGBs Relative To Their 5-Year Counterparts. The trade is up 0.7%. We see this as a multi-year trade with significant upside potential. The unwinding of heavy short positions could cause the yen to strengthen temporarily. The euro is vulnerable to negative growth surprises. A retracement of some of its recent gains is likely. Feature Looking Back, Thinking Forward I had the pleasure of speaking at BCA's Annual Investment Conference held in New York on September 27th of last year where I offered three "tantalizing" trade ideas. Chart 1 reviews their performance. They were the following: Trade #1: Go Short The December 2018 Fed Funds Futures Contract We argued last summer that U.S. growth was likely to accelerate, taking rate expectations higher. That has indeed happened. Aggregate hours worked rose by 2.5% in Q4 over the previous quarter. Assuming that productivity increased by 1.5% in Q4 - equal to the pace recorded in Q3 - real GDP probably increased by nearly 4%. A variety of leading indicators point to continued above-trend growth in the months ahead (Chart 2). Chart 1Three Tantalizing Trades: ##br##An Update Chart 2Leading Indicators Pointing ##br##To Above-Trend U.S. Growth We think the Fed will raise rates four times this year, one more hike than projected by the dots and roughly 35 bps more in tightening than implied by current market expectations. The median Fed dot calls for an unemployment rate of 3.9% by end-2018, only marginally lower than today's rate of 4.1%. We have been saying for a while that above-trend growth will take the unemployment rate down to a 49-year low of 3.5% by the end of this year. If the unemployment rate falls this much, the Fed will probably turn more hawkish. Stronger inflation numbers should also give the Fed confidence to keep raising rates once per quarter. Core inflation surprised on the upside in December. We expect this trend to continue in the coming months, as the ISM manufacturing index, the New York Fed's Inflation Gauge, and our own proprietary pipeline inflation index are already foreshadowing (Chart 3). Chart 3U.S. Inflation ##br##Should Accelerate Chart 4A Pick-Up In Wage Growth ##br##Would Put Upward Pressure On Service Inflation As we noted two weeks ago,1 service sector inflation should get a lift from faster wage growth this year (Chart 4). Goods inflation should also rise on the back of higher oil prices and the lagged effects of a weaker dollar (Chart 5). In addition, health care inflation is likely to pick up from its current depressed level, especially if the Congressional Budget Office is correct that insurance premiums will rise due to the elimination of the individual mandate (Chart 6). Housing inflation will moderate, but this is unlikely to stymie the Fed's tightening plans since excessively low interest rates could lead to even more overbuilding in the increasingly vulnerable commercial real estate sector. Chart 5Higher Oil Prices And A Weaker Dollar ##br##Are A Tailwind For Inflation Chart 6Health Care Inflation ##br##Should Move Higher Granted, four rate hikes equal four opportunities to defer raising rates. It is easy to imagine scenarios where the Fed stands pat, but hard to conjure scenarios where the Fed has to raise rates five times or more this year. Thus, the risk to our four-hike view is to the downside. As such, we will be looking to take profits of 75 bps on the trade, and are putting in a stop of 60 bps. Trade #2: Go Long Global Industrial Stocks Versus Utilities Capital spending tends to accelerate in the late innings of business-cycle expansions. We are in such a phase now, as evidenced by capital goods orders, capex intention surveys, and our global capex model (Chart 7). Increased capital spending will benefit industrial companies. Conversely, rising bond yields will hurt rate-sensitive utilities. Valuations in the industrial sector have gotten stretched, but are not at extreme levels (Chart 8). Based on enterprise value-to-EBITDA, industrials are still only slightly more expensive than utilities compared to their post-1990 average. Chart 7Capex Is Shifting Into ##br##Higher Gear Chart 8Industrial Stocks: Valuations Are Stretched, ##br## But Not Yet Extreme While we do think global growth will slow this year from the heady pace of 2017, it should remain firmly above-trend. A bigger-than-expected slowdown - especially if it is concentrated in China - would undoubtedly hurt industrials. A stronger dollar could also be a headwind. Thus, we are keeping this trade on a short leash, with a target of 15% and a stop of 12%. Trade #3: Go Short 20-Year JGBs Relative To Their 5-Year Counterparts The Japanese economy is on fire. Growth almost reached 2% in 2017 and leading indicators suggest a solid start to 2018 (Chart 9). The unemployment rate has fallen to 2.7%, a full point below 2007 levels. The ratio of job openings-to-applicants has surpassed its bubble peak. The Tankan Employment Conditions Index is pointing to an exceptionally tight labor market. Wages excluding overtime pay are rising at the fastest pace in twenty years (Chart 10). Chart 9Japanese Growth Momentum Is Positive Chart 10Signs Of A Tight Labor Market Inflation is low but is starting to edge up. The most recent release surprised on the upside. Inflation expectations moved higher on the news, benefiting our long Japanese 10-year CPI swap trade recommendation (Chart 11). A simple scatterplot between the unemployment rate and core inflation suggests the Phillips curve remains intact in Japan -- amazingly, it even looks like Japan (Chart 12)! Chart 11Inflation Expectations Have Edged Higher Chart 12The Phillips Curve In Japan Looks Like Japan Still, with core inflation excluding food and energy running at only 0.3%, there is a long way to go before inflation reaches the BoJ's target -- and even longer if the BoJ honours its promise to generate a meaningful overshoot to compensate for the below-target inflation of prior years. This suggests the BoJ will not meaningfully water down its Yield Curve Control regime anytime soon. As such, five-year yields are likely to stay put while yields with maturities in excess of ten years should move higher. Our "tantalizing trade" being short 20-year JGBs versus their 5-year counterparts still has a long way to run. Too Risky To Short The Yen The exceptionally strong correlation between USD/JPY and U.S. Treasury yields has broken down this year (Chart 13). Had the relationship held, the yen would have actually weakened against the dollar. Still, we are reluctant to get too bearish on the yen (Chart 14). The yen real effective exchange rate is close to multi-decade lows. Positioning on the currency is heavily short. The current account surplus has mushroomed from close to zero in 2014 to 4% of GDP at present. And even if the BoJ keeps the Yield Curve Control regime in place, investors may still anticipate its demise, leading to a temporary bout of yen strength. Chart 13Strong Correlation Is Broken Chart 14Too Risky To Short The Yen What's Propping Up The Euro? The euro has been on a tear since last week, egged on by the ECB minutes, which hinted at a faster pace of monetary normalization. Growing confidence that Angela Merkel will be able to form a grand coalition also helped the common currency, along with hopes that the new government will loosen the fiscal purse strings. The euro is often thought of as the "anti-dollar." And sure enough, the euro's strength has been reflected in a broad-based decline in the dollar index in recent days. BCA's Global Investment Strategy service went long the dollar on October 31, 2014. We "doubled up" on this call in the fall of 2016, controversially arguing that "Trump will win and the dollar will rally." Obviously, in retrospect, I should have rung the register and declared victory on our long dollar view when I had the chance. EUR/USD fell to 1.04 on December 2016, within striking distance of our parity target. Bullish dollar sentiment had reached unsustainably lofty levels. That was the time to sell the greenback. But hubris got the best of me. While our other currency trade recommendations have delivered net gains of 11% since the start of 2017, the long DXY trade has stuck out like a sore thumb. Hindsight is 20/20. The key question is what to do today. EUR/USD is still trading below the level it was at when we went long the DXY. Relative to the IMF's Purchasing Power Parity exchange rate of 1.32, the euro is 7% undervalued. That said, PPP exchange rates may not be a reliable benchmark in this case. Given current market expectations, EUR/USD would need to strengthen to 1.41 over the next ten years just to cover the carry cost of being short the dollar. Even assuming lower inflation in the euro area, that would still leave the euro trading above its long-term fair value. It is possible, of course, that rate differentials will narrow further, but the scope for this is more limited than it might appear. The market currently expects policy rates ten years out to be 95 basis points higher in the U.S., down from a spread of nearly 180 basis points in late December (Chart 15). Given that euro area inflation expectations are 40-to-50 bps lower than in the U.S., this implies a real spread of about 50 bps - broadly in line with our estimate of the real neutral rate gap between the two regions. Ultimately, the fate of the euro in 2018 will rest on the same question that drove the currency in 2017: Will euro area growth surprise on the upside, prompting investors to price in a faster pace of monetary normalization? The bar for success is certainly higher at present. Chart 16 shows that euro area consensus growth estimates have risen significantly since the start of last year. The expected lift-off date for policy rates has also shifted in by more than a year to mid-2019. Considering that Jens Weidmann stated earlier this week that he thinks current market pricing is broadly consistent with when the ECB expects to hike rates, there is little scope for the lift-off date to move forward. Chart 15Little Scope For Rate Differentials ##br## To Narrow Further Chart 16Euro Area Growth Estimates Have Been Revised Up ##br##Since The Start Of 2017 Meanwhile, financial conditions have tightened significantly in the euro area relative to the U.S., the euro area credit impulse has turned negative, and the U.S. economic surprise index has jumped above that of the euro area (Chart 17). Euro area inflation has also dipped. Especially worrying is that core inflation in Italy has fallen back to a near record-low of 0.4% (Chart 18). How is Italy supposed to navigate its way out of its debt trap if nominal growth stays this weak? On top of all that, long speculative euro positions have soared to record-high levels (Chart 19). Given the choice of betting whether EUR/USD will first hit 1.30 or 1.15, we would go with the latter. If our bet turns out to be correct, we will use that opportunity to shift to neutral on the dollar. Chart 17The Euro Is Vulnerable ##br##To Negative Growth Surprises Chart 18Euro Area Core Inflation ##br##Has Dipped Chart 19Euro Positioning: From Deeply Short ##br##To Record Long Peter Berezin, Chief Global Strategist Global Investment Strategy peterb@bcaresearch.com 1 Please see Global Investment Strategy Weekly Report, "Four Key Questions On The 2018 Global Growth Outlook," dated January 5, 2018. Strategy & Market Trends Tactical Trades Strategic Recommendations Closed Trades

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Highlights We are upgrading our allocation to Indian stocks from neutral to overweight within EM equity portfolios. India's public banks are much further along in their necessary adjustment process, and the credit cycle downturn is much more advanced relative to China's. To capitalize on this theme, we recommend going long Indian banks and shorting Chinese bank stocks. India's public bank recapitalization program will allow them to slowly augment credit origination, assisting the economic recovery. Feature Chart I-1Favor Indian Banks Versus Chinese Ones Our report this week highlights the results from stress tests we conducted on Indian and Chinese public banks, and also compares their respective equity valuations. Based on our findings, we are initiating a new relative equity trade: long Indian / short Chinese bank stocks (Chart I-1). The health of the banking system, the credit cycle outlook as well as the performance of bank share prices hold the key to relative performance of any bourse in the EM universe. Provided our positive bias toward Indian banks relative to their EM peers on all the above parameters, we are upgrading our allocation to India from neutral to overweight within EM equity portfolios. Indian Versus Chinese Public Banks From 2003 to 2012, India went through a large credit binge and capital misallocation cycle in its industrial and infrastructure sectors. During this period, banks' loans to companies and bank assets rose from 12% to 23% and 63% to 85% of GDP, respectively (Chart I-2A). By comparison, Chinese (ex-policy) commercial banks' claims on companies and their total assets have surged from 85% to 110% and from under 180% to 230% of GDP, respectively, since 2009 (Chart I-2B). In both countries, the banking sector remains dominated by public banks that hold more than 50% of banking system assets. Chart I-2ACredit Boom In Perspective: India Chart I-2BCredit Boom In Perspective: China Today, Indian public banks - who were the main lenders to industrial companies during the corporate credit binge in the 2003-12 period - have been experiencing mushrooming bad loans. Total public banks' NPLs and distressed asset ratios have reached 13.5% and 2.7% of total loans, respectively (Chart I-3). By contrast, for all Chinese banks, the current NPL ratio is at a mere 1.7%, while the distressed loan ratio stands at only 3.6% of total loans. Chart I-3NPL Ratios In Perspective: India & China Further, under pressure from the central bank, Indian public banks have been raising provisioning levels for bad assets very aggressively. On the flip side, Chinese regulators have been following tolerant policies toward their own commercial banks. As such, the provisions-to-loans ratio at all public banks now stands at 3% in China, compared with 5.6% in India. In addition, Chinese banks have bought a lot of corporate bonds that are not provisioned for at all. Does this higher NPL ratio in India relative to China mean that credit allocation is much worse in India? Not quite. The thesis that Indian public banks are more poorly managed than Chinese public banks is not accurate. These banks are managed by public sector executives who often allocate credit to support government growth policies. This is why it is reasonable to assume that the quality of credit allocation among Chinese and Indian public banks is probably similar. As such, we presume that Chinese banks' current NPL ratio is severely understated, and has the potential to rise to levels currently being reported by Indian public banks. The basis is that the Chinese credit boom has dramatically exceeded that of India (see Chart I-2A and I-2B on page 2). Typically, the resulting NPL ratio is proportional to the magnitude of the preceding credit frenzy. Finally, India's central government announced a major recapitalization plan in October 2017 to assist the country's public banks in cleaning up their balance sheets and to also support them in expanding credit. It is likely, therefore, that these banks are now approaching the final stages of their balance sheet repair and deleveraging process. Bottom Line: India's public banks are much further along in their necessary adjustment, and their credit cycle downturn is also much more advanced relative to Chinese banks. The latter have been postponing the inevitable balance sheet clean-up process. To capitalize on this theme, we recommend going long Indian banks and shorting Chinese bank stocks. Banking Stress Test For India And China We have conducted stress tests for India's top seven and China's top five listed public banks. We used the following assumptions for the three scenarios we considered: Non-performing risk-weighted assets (NPA) ratios to rise to 14% (pessimistic), 12% (baseline) and 10% (optimistic scenario) of risk-weighted assets for both Indian and Chinese public banks. Risk-weighted assets adjust banks' various types of assets based on their degree of riskiness. In that way, the risk-weighted asset values are comparable between the two banking systems. We assume a 30% recovery rate in all three NPA scenarios for both countries. The recovery rate on Chinese banks' NPAs in the 2001-2005 period was 20% amid a booming economy. The assumed recovery rate of 30% is therefore not low. The outcome of the stress tests is as follows: In the baseline scenario of 12% NPA, the losses post recovery and provisions would amount to 1.3 trillion rupees in India (0.9% of GDP) and RMB 3.4 trillion in China (4.2% of GDP). This would translate into a 33% equity impairment for India's seven public banks, and 48% for China's five public banks (Table I-1 and I-2, column 7). Table I-1Stress Test For Top 7 Indian Public Banks Table I-2Stress Test For Top 5 Chinese Public Banks From a valuation standpoint, the post-impairment price-to-book value (PBV) ratio would jump to 1.44 and 1.62 for Indian- and Chinese-listed public banks, respectively. Assuming a fair PBV ratio of 1.3 - which is the average PBV ratio for all EM banks since 2011 - Indian public banks are 11% overvalued and Chinese ones are about 25% overvalued. In other words, if one were to calculate the true PBV ratio of these banks after a comprehensive "clean-up" has been done, then Indian public bank stocks would be cheaper than Chinese ones. It is important to note that the above valuation exercise does not take into consideration banks' future profits. As such, we account for their recurring profits in the following manner: Table I-3 calculates the ratio of NPA losses to banks' recurring net profits before provisioning. Losses are the amount to be written-off post provisioning and recovery. In the baseline scenario of a 12% of NPA, this ratio is 2.5 for India and 3.4 for China. In other words, it will take 2.5 and 3.4 years of net profits before provisions close the "black hole" of NPA losses (post provisions and recovery) in India and China, respectively. Hence, on this measure as well, India's listed public banks appear more appealing than those in China. Table I-3Profit Coverage Of Loan Losses There is a caveat regarding Chinese banks' stress and their post-impairment book value. Our analysis is performed based on risk-weighted assets, and does not include off-balance-sheet assets. Therefore, any losses from off-balance-sheet assets will make losses for Chinese public banks greater than our analysis captures. Further, the Chinese financial authorities are currently tightening regulations, which will likely curtail banks' off-balance-sheet activities and by extension their profitability. These risks are not present in India, where banks have less off-balance-sheet assets. Bottom Line: Public bank stocks are currently overvalued by about 11% and 25% in absolute terms in both India and China, respectively. This favors Indian bank share prices outperforming their Chinese peers. The fact that the "clean-up" has not yet begun in China reinforces this trade. Banks' Recapitalization In India Saddled with NPLs, Indian public banks have not been willing to lend in recent years. Chart I-4 demonstrates that their loan growth has stalled. Credit to large industrial companies has in particular suffered (Chart I-4, bottom panel), as most of this type of credit is typically extended by public banks. Chart I-4India: Public Bank Loan Growth Has Slumped Consequently, India's capital expenditures have languished in recent years, weighing not only on cyclical growth but also depressing long-term productivity and potential growth. In October, the Indian government announced an estimated 2.11 trillion rupees public bank recapitalization program that will be implemented over the next two years. The program is for all public banks, while the above stress test was performed for only the top seven listed public banks. The latter account for around 60% of all public banks' assets, so we assume they will get around 60% of the stated recapitalization amount. The recapitalization program is designed as follows: The central government plans to inject 180 billion rupees of equity capital into all public banks via budgetary allocations. The public banks will in turn raise 580 billion rupees from the market. The remaining 1,350 billion rupees will come from government-issued Bank Recapitalization Bonds. The government will issue bonds to banks and then use the funds to buy more shares from public banks. It is important to note that in the stress test above and for the calculation of post-impairment PBV ratios, we assume the government will not subsidize existing shareholders when it injects money into public banks. This means the government will provide equity capital to public banks at post-impairment equity value - i.e., at a fair market price. It will be difficult for the Indian government to bail out its public banks without making current shareholders bear losses. If the government bails out public banks' private and foreign shareholders, the opposition parties will use the bank recapitalization program against Prime Minister Narendra Modi's government in the general elections scheduled to be held in 2019. Many investors and commentators assume that India's bank recapitalization program is automatically bullish for bank share prices. While it is positive for banks' ability to lend and drive growth in the medium and long term, the program is not necessarily bullish for share prices, particularly at their current high levels. The same is true for potential recapitalization programs in China. Overall, odds are that current shareholders of public banks will likely shoulder meaningful losses in India and possibly in China as well. How well off will capitalized public banks in India be after implementation of the recapitalization program? In the case of the seven Indian public banks we performed the stress test on, Table I-4 estimates that post-impairment and recovery, the total equity capital-to-risk-weighted assets ratio will be 8% in our baseline scenario. This is lower than the regulatory minimum of 9%. Table I-4Capital Ratios For India's Top 7 Public Banks The recapitalization will bring this equity capital adequacy ratio to 11.3%, which exceeds the regulatory minimum of 9%. Hence, after the program is completed, Indian public banks will likely become well capitalized and will be able to resume their lending and expand their assets. This in turn will facilitate the economic recovery. Bottom Line: The Indian government's recapitalization program is sufficient to raise public banks' capital adequacy ratio above the regulatory minimum. This will allow public banks to resume their lending. India's Cyclical Growth Outlook India's cyclical outlook will be one of muted recovery. Yet it is superior to other EMs, where we expect meaningful deceleration due to a potential slowdown in China and a rollover in commodities prices. Public banks' recap program will be slow in India - to be conducted over the next two years - and banks' ability to boost lending will improve only gradually. Meanwhile, private banks have and will probably continue to concentrate their lending efforts on consumers rather than on industrial companies and infrastructure. In the next 12-18 months, a slow improvement in public banks' ability to originate credit will allow only moderate improvement in capital spending growth. The latter is required to resolve bottlenecks and unleash the nation's productivity potential. Several indicators of capital spending are lukewarm (Chart I-5, top panel). However, new capex project announcements and the number of investment proposals have been dropping (Chart I-5, middle panel). Surprisingly, companies' foreign external borrowing is still contracting, despite booming capital inflows into EM (Chart I-5, bottom panel). On the consumer side, the outlook remains bright. Motorcycle sales have recovered sharply and commercial vehicle sales are beginning to pick up (Chart I-6). Chart I-5India's Capital Spending Is Sluggish Chart I-6Indian Consumer Health Is Strong Consumer/personal loans are accelerating from an already strong growth rate, largely thanks to the aggressiveness of private sector banks (Chart I-6, bottom panel). In turn, the employment outlook is finally beginning to show signs of improvement (Chart I-7). The manufacturing PMI has also risen substantially, and is currently in expansion territory (Chart I-8). Likewise, the service sector PMI has bounced above 50. Chart I-7India's Employment Is Turning The Corner Chart I-8India: PMIs Are Positive Finally, India is less exposed to China's growth and a retracement in commodities prices than many other emerging economies. This makes us upbeat on India's cyclical economic dynamics and relative equity and currency performance versus other EMs. Bottom Line: India's cyclical outlook is better than that of many other EMs. Structural Tailwinds And Impediments India holds huge promise for investors as it is a much-underinvested economy, and potential return on capital is considerably higher in those countries than in relatively overinvested ones. In addition, its population and labor force growth are among the highest in mainstream developing countries. On the other hand, for such potential to be realized, the country needs to be able to boost its productivity. On this count, the outlook is less positive. India's share of global goods and services exports has declined substantially since 2011 (Chart I-9). This should not be surprising, given weak investment spending has led to stagnation in trade competitiveness. Chart I-10 reveals that based on the UNCTAD1 dataset, India has been losing market share in both low- and high-skilled labor sectors export markets worldwide. Chart I-9India's Share In Global Trade Chart I-10India Has Been Losing Export Market Share While certain reforms such as the introduction of a sales tax will have a positive impact on the economy, other much-needed changes, such as land and labor market reforms, have so far remained unattainable. Moreover, the agriculture sector still faces material challenges. Without these vital reforms, it will be difficult to boost efficiency and productivity and build global competitiveness. Finally, in terms of education enrollment, India lags other EMs, especially China, in tertiary education (Chart I-11). This makes it even more difficult to boost productivity and growth potential. Bottom Line: India has great secular potential, but the structural advance has stalled since 2011. The jury is still out on whether it can implement additional reforms to realize this potential. Investment Conclusions India's banking sector outlook is brighter, and the deleveraging cycle is much more advanced, compared with many other EMs in general and China in particular. Therefore, we recommend a new relative equity trade: long Indian banks / short Chinese banks. Investors could buy Indian public banks or all banks with the understanding that private banks are typically in better shape than their state-owned peers, but are also much more expensive. We will be tracking this trade's performance using the Bankex index for India and the MSCI bank index for China. The Bankex index has a larger share of market cap of public banks than the MSCI India bank index. Within China, we are maintaining our short small and medium / long large banks position initiated on October 26th 2016. We are also recommending EM equity investors upgrade the Indian bourse from neutral to overweight. We shifted Indian stocks from overweight to neutral on August 23rd 2017, but the risk-reward has improved since then (Chart I-12). Chart I-11India's Education Improvement Is Lagging Chart I-12Upgrade Indian Bourse Within EM Universe Our primary concerns with EM stocks are a China slowdown, a rollover in commodities prices and a rebound in the U.S. dollar. Associated strains in countries with large foreign debt levels or wide current account deficits as well as lack of credit deleveraging and bank recapitalization will define EM financial markets' performance in the next 12-18 months. On all of these counts, India scores better than many EMs, justifying this equity upgrade. The absolute outlook for Indian stocks, however, is not inspiring. This equity market is rather expensive and overbought in absolute terms. If EM risk assets experience a setback in 2018, as we expect, Indian equities will also relapse in absolute terms. Ayman Kawtharani, Associate Editor ayman@bcaresearch.com Arthur Budaghyan, Senior Vice President Emerging Markets Strategy arthurb@bcaresearch.com   1 United Nations Conference on Trade and Development.   Equity Recommendations Fixed-Income, Credit And Currency Recommendations

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Equities have melted up in recent weeks, celebrating the tax bill passage, synchronized upswing in global economic data, still quiescent inflation and near vanishing tail risk. On July 10th when we penned the "SPX 3,000?" report, the S&P 500 was close to 2400.1 Over the past six months stocks have been in an uninterrupted upleg, moving to within 10% of our SPX 3,000 target. Table 1 Stocks have run "too far too fast" for our liking and there are increasing odds of a healthy pullback, especially now that no pundits are talking of a correction. In addition, were the selloff in the bond markets to accelerate in a short time frame, at some point it will cause equity market consternation. But, bonds still remain extremely overvalued versus stocks (Chart 1). Late last year, we began to modestly de-risk the portfolio via booking impressive gains in tactical market-neutral trades, as our upbeat cyclical view remains intact.2 Our cyclical strategy is to "buy the dip", as we do not foresee a recession in the coming 9-12 months. Importantly, profits will dictate the S&P 500's direction and the cyclical path of least resistance is higher still. Our SPX profit model continues to forecast healthy EPS growth in 2018 (Chart 2) and as we posited in the last report of 2017, earnings will do the heavy lifting at the current juncture with the forward P/E multiple likely moving laterally (Chart 3). Chart 1Simple Bond Valuation Metric Says:##br## Bonds Are Overvalued Vs. Stocks Chart 2All ##br##Clear Chart 3EPS Will Do The##br## Heavy Lifting In 2018 A simple decomposition shows that equity returns could reasonably reach a low-to-mid double digit level this year. Our assumptions are the following: nominal GDP can grow near 5% (3% real plus 2% inflation) and thus we estimate organic EPS growth that typically mimics GDP at this stage of the cycle of ~5%, ~2% dividend yield, ~2% buyback yield, ~5% tax related boost to EPS and no multiple expansion. The above assumptions are based on four key drivers: energy and financials will command a larger slice of the earnings pie,3 synchronized global capex upcycle will boost EPS,4 delayed positive translation effects from the U.S. dollar will lift profits5 and easy fiscal policy will also act as a tonic to EPS.6 On this note, this White Paper officially introduces the U.S. Equity Strategy earnings models for the eleven GICS1 equity sectors. We have identified key macro earnings drivers for each sector and incorporated them into individual sector models. The objective is to forecast the direction of earnings growth. Beyond introducing our EPS models, the purpose of this White Paper is to also compare and contrast the cyclical readings of our equity sector models with sell-side analysts' profit growth (Charts 4 & 5) and margin expectations and help clients position portfolios for the rest of 2018. The earnings models carry the most weight in determining our sector positioning, with our macro overlay and our valuation and technical indicators rounding out our methodology. Currently, our earnings models are consistent with maintaining a mostly cyclically biased portfolio structure (top panel, Chart 6), and thus participating in the broad market's overshoot. Chart 4What EPS Are Priced In... Chart 5...Per Sector For 2018 Chart 6Continue To Prefer Cyclicals Over Defensives Encouragingly, an equal weight of the 10 GICS1 sector model outputs (we are excluding real estate due to lack of history), accurately forecasts the S&P 500's profit growth (bottom panel, Chart 6), and currently also confirms the broad market's upbeat four factor macro EPS model (Chart 2). Anastasios Avgeriou, Vice President U.S. Equity Strategy anastasios@bcaresearch.com Financials (Overweight) Our financials earnings growth model comprises bank credit growth, the U.S. dollar index and net earnings revisions. The U.S. credit impulse is gaining traction, indicating that the market has digested the almost doubling in long-term rates over the past 18 months. Bankers are willing extenders of C&I credit and, with the economy humming north of 3% in real GDP terms, the outlook for loan growth is excellent. Loosening U.S. banking regulatory requirements, and pent up demand for shareholder friendly activities are all welcome news for financials profitability. Tack on BCA's higher interest rate view in 2018 and net interest margins will also get a bump, further adding to the sector's EPS euphoria. Credit quality is the third key profit driver for bank profitability and pristine credit quality is a harbinger of increased profits. The unemployment rate is plumbing generational lows and suggests that non-performing loans as a percentage of total loans will remain on a downward trajectory. Our profit model is expanding at twice the current profit growth rate (second panel, Chart 7) and 10 percentage points above the Street's 12-month forward estimates (top panel, Chart 5). In fact, the latter have gone vertical of late playing catch up to our model's estimates. The S&P financials sector remains a core portfolio overweight and we reiterate our high-conviction overweight status in the heavyweight S&P banks index. Chart 7Financials (Overweight) Energy (Overweight) The three drivers behind the S&P energy sector EPS growth model are oil-related currencies, the U.S. oil & gas rig count and WTI crude oil prices. A depreciating greenback, whittling down OECD oil stocks and rising global oil demand are all boosting energy profitability. OPEC 2.0 cutbacks have not only helped stabilize oil markets, but also paved the way for a breakout in oil prices above the $62.50/bbl stiff resistance level. Sustained OPEC output restraint will counterbalance U.S. shale oil production increases and coupled with rising global demand likely continue to underpin oil prices. Our synchronized global capex upcycle theme included the basic resources following a multi-year drubbing in outlays. Energy capex cannot contract at double digit rates indefinitely. Already a V-shaped capex momentum recovery is in store, as 2018 capital spending budgets are on track to at least match 2017. Our EPS growth model (second panel, Chart 8) matches sell-side analyst optimism (third panel, Chart 5). Keep in mind that only recently did the energy space become profit positive, making a solid recovery from an extremely low base. Margins are only now renormalizing above the zero line and breakneck pace EPS growth should continue in 2018. Following a negative 2017 return, the S&P energy sector is the best performing sector year-to-date, and we reiterate the high-conviction overweight stance. Chart 8Energy (Overweight) Industrials (Overweight) Our S&P industrials EPS model comprises the ISM manufacturing survey, raw industrials commodity prices and interest rates. It has an excellent track record in forecasting industrials EPS momentum, and sports one of the highest explanatory powers amongst all sector EPS models. While industrials EPS growth has been bouncing off the zero line for the better part of the past five years, our profit model has spoken: forecast EPS are in a V-shaped recovery since the end of the recent manufacturing recession (second panel, Chart 9). Commodity prices are recovering and increasing final demand, coupled with a soft U.S. dollar suggest that more gains are in store. Tack on the global virtuous capex upcycle, and the stars are aligned for this deep cyclical sector to break out of its multi-year trading range funk on the back of a surge in profits. China is a wild card, but signs of stability are enough to sustain the upward trajectory in the commodity-levered complex, including industrials stocks. Our industrials sector EPS model suggests that industrials profits will easily surpass the low (and below the overall market) analysts' EPS growth hurdle (third panel, Chart 4). The late-cyclical S&P industrials sector remains an overweight. Chart 9Industrials (Overweight) Consumer Staples (Overweight) The S&P consumer staples EPS growth model key drivers are: food exports, non-discretionary retail sales and analysts' net earnings revision ratio. Overall industry exports are expanding at a healthy clip as a consequence of a softening U.S. dollar and robust European and rebounding emerging markets demand. Deflating raw food commodity prices are offsetting rising energy and labor input costs, heralding a sideways move to margins. Sell side analysts are also currently penciling in a lateral profit margin move (middle panel, Chart 10). Our model is expanding at a near double digit rate, and is in line with 12-month forward EPS growth estimates (second panel, Chart 4). Investors have been vehemently avoiding staples stocks during the board market's uninterrupted run up, and have put out positioning offside. However, in the context of our cyclical over defensive portfolio bent we refrain from putting all our eggs in one basket, and prefer to keep consumer staples as our sole defensive sector overweight. This small hedge will serve our portfolio well if we do indeed get a healthy Q1/2018 pullback, as we expect. Chart 10Consumer Staples (Overweight) Consumer Discretionary (Neutral - Downgrade Alert) Measures of consumer confidence, consumer discretionary exports and the net earnings revisions ratio comprise BCA's global consumer discretionary EPS growth model, which has an excellent track record in forecasting the path of consumer discretionary profits. Consumer confidence is rolling over, albeit from a nose-bleed level, signaling that, at the margin, discretionary consumer outlays will remain tame. Worrisomely, rising interest rates coupled with a breakout in crude oil prices are net negatives for consumer spending. Our consumer drag indicator captures these consumer headwinds and warns that the sector is not out of the woods yet (bottom panel, Chart 11). The Fed is on track to raise rate three more times in 2018 and continue to mop up liquidity via renormalizing its balance sheet. This dual tightening backdrop bodes ill for early cyclical discretionary stocks as we highlighted in the September 25th Weekly Report. Our consumer discretionary EPS growth model is making an effort to bounce, signaling that contracting earnings will likely reverse course and come out of their recent funk (second panel). But, analysts are overly optimistic penciling in a near double-digit profit growth backdrop for the consumer discretionary sector (fourth panel, Chart 5). Netting it all out, the anemic message from our profit model along with the ongoing Fed tightening cycle and spiking energy prices warrant a downgrade alert. Stay tuned. Chart 11Consumer Discretionary (Neutral-Downgrade Alert) Telecom Services (Neutral) Telecom pricing power and capital expenditures expectations comprise our S&P telecom services EPS growth model. Telecom capital expenditures have bounced off the zero line and are growing at 4% per annum while sector sales growth has been nil. This capital-intensive industry must continually invest to stay relevant. A push by telecom carriers into TV offerings as part of a quad-play (internet, wireline, wireless and TV) has rekindled an M&A boom, and capex is slated to increase. However, margins will suffer if increased investment fails to translate into new sales (bottom panel, Chart 12). Steeply contracting pricing power is a bad omen both for top and bottom line growth prospects (fourth panel). Hopefully, industry consolidation will lead to a better pricing backdrop, but the jury is still out. Our EPS model has sunk into the contraction zone (second panel). Analysts are a little bit more sanguine, penciling in low single-digit profit growth (bottom panel, Chart 4). Industry deflation is not alone as a headwind as the bond market selloff is weighing on the high dividend yielding telecom services stocks. Despite all the bearish news, near all-time lows in relative valuation and washed out technicals are keeping us on the sidelines. Chart 12Telecom Services (Neutral) Materials (Neutral) Materials EPS growth is a far cry from the near 100% year-over-year mark hit during the commodity super-cycle the mid-2000s and the reflex rebound following the Great Recession (second panel, Chart 13). Our S&P materials EPS model inputs include the U.S. currency, metals commodity prices and a measure of borrowing costs. The model has been steadily decelerating recently, and moving in the opposite direction compared with sell-side analysts' optimistic estimates (bottom panel, Chart 5). Consequently, there is scope for downward revisions. Materials stocks are reflationary beneficiaries and also high fixed cost high operating leverage deep cyclicals that benefit most during the later stages of the business cycle when a virtuous capex/EPS upcycle takes root. A number of both developed and developing central banks have recently embarked on tightening monetary policy following in the Fed's footsteps. Global liquidity is on the verge of getting mopped up as even the ECB and the BoJ have started to hint that they would remove some of their ultra-accommodative and unconventional policy measures. These opposing forces keep us at bay and we continue to recommend a benchmark allocation in the S&P materials index. Chart 13Materials (Neutral) Real Estate (Neutral) Commercial real estate loan demand, a labor market measure and the EUR/USD comprise our S&P real estate profit growth model (second panel, Chart 14). The 10-year Treasury yield and real estate relative performance have been nearly perfectly inversely correlated since the GFC as REITs sport a hefty dividend yield and thus are considered a fixed income proxy. BCA's higher interest rate 2018 theme suggests that more downside looms for this rate-sensitive sector. Similarly, a firming EUR/USD reflecting the nearly 100% domestic exposure of the sector weighs on real estate relative performance. Our EPS model has recently sunk into the contraction zone and is in sync with sell-side analysts' negative profit growth figures for calendar 2018 (second panel, Chart 5). While all this signals that an underweight stance is appropriate, we would rather stay on the sidelines for three reasons: First, sector pricing power (mostly rents) has not eroded yet, despite the surge in multi-family housing construction. Second, most of the bad news is likely already discounted in sinking valuations and extremely oversold technicals. Finally, we would rather concentrate our interest rate related underweight in the pure play fixed income proxy, the utilities sector (please see page 15). Stick with a benchmark allocation in the S&P real estate index. Chart 14Real Estate (Neutral) Health Care (Underweight) Our S&P health care EPS growth model consists of health care pricing power, labor costs and a measure of health care outlays. Health care demand is fairly inelastic, signaling that health care spending prospects remain upbeat, especially given the aging population. However, the industry's up-to-recently structurally robust pricing power backdrop is under intense scrutiny. Medical commodity cost inflation is melting and drug pricing power has nearly halved since early 2016. Democrats and Republicans alike, despise the pharmaceutical/biotech industry's pricing tactics and drug price containment is on nearly every legislator's agenda. Add on the generic drug inroads, and Big Pharma/biotech resilient profits appear vulnerable, weighing heavily on the sector's relative performance. From a secular perspective, there is scope for health care sector profit gains. Developing countries are only just starting to institute social "safety nets" that the developed world already has in place. Our profit model is decelerating (second panel, Chart 15) and forecasting single digit EPS growth, in line with the Street's 12-month forward profit estimates (fourth panel, Chart 4). The S&P health care sector is a core underweight portfolio holding and we reiterate the high-conviction underweight status in the heavy weight S&P pharma sub index. Chart 15Health Care (Underweight) Utilities (Underweight) Utilities pricing power, the yield curve and analysts' net earnings revisions are the key inputs in our S&P utilities EPS growth model (second panel, Chart 16). While natgas prices, the industry's marginal price setter, have been stuck in a trading range between $2.6 and $3.4/mmbtu over the past 18 months, they are currently contracting and weighing heavily on industry pricing power. The U.S. economy is firing on all cylinders (bottom panel, Chart 16) and a selloff in the 10-year Treasury market near 3% is BCA's base-case scenario for 2018. Under such a backdrop, fixed income proxied defensive equities lose their luster, and thus utilities stocks will likely remain under intense downward pressure, Our S&P utilities EPS growth model is expanding at a mid-single digit growth rate, broadly in line with sell-side analysts' forecasts (fifth panel, Chart 4) and roughly 700bps below the broad market. The S&P utilities sector is a high-conviction underweight. Chart 16Utilities (Underweight) Technology (Underweight - Upgrade Alert) Our three-factor global technology EPS growth model includes capex intentions, the trade-weighted U.S. dollar and sell-side analysts' net earnings revision ratio. While the tech sector is still largely considered a deep cyclical, we view it as more defensive. The majority of large capitalization tech companies are mature, cash rich, cash flow generating, dividend paying and high margin. Tech firms thrive in a deflationary backdrop as business models have been built to withstand the inherently disinflationary "creative destruction" process. BCA's interest rate view calls for an inflationary driven sell off in bonds for 2018, suggesting that investors avoid high-flying tech stocks. Weakness in basic resources explains most of the delta in cyclical capital outlays. Encouragingly, technology's share of the U.S. capex pie is making inroads rising to roughly 10% (bottom panel, Chart 17). Tech investment has been so abysmal for so long that it is hard to get any worse. In fact, it has started to improve both on an absolute and relative basis, as pent-up tech demand is being unleashed. Our synchronized global capex upcycle theme is gaining traction and the tech sector will continue to make gains at the expense of resource-related spending. Our global tech EPS model is forecasting modest double-digit growth in the coming quarters (second panel, Chart 17), largely aligned with sell-side analysts' profit growth expectations (fifth panel, Chart 5). On balance, we are putting the S&P tech sector on upgrade alert reflecting the capex tailwind offsetting the rising interest rate backdrop, and reiterate our capex-related high-conviction overweight in the S&P software sub-index. Chart 17Technology (Underweight-Upgrade Alert) 1 Please see BCA U.S. Equity Strategy Weekly Report, "SPX 3,000?," dated July 10, 2017, available at uses.bcaresearch.com. 2 Please see BCA U.S. Equity Strategy Weekly Report, "EPS And "Nothing Else Matters"," dated December 18, 2017, available at uses.bcaresearch.com. 3 Please see BCA U.S. Equity Strategy Weekly Report, "Dissecting Profit Composition," dated July 24, 2017, available at uses.bcaresearch.com. 4 Please see BCA U.S. Equity Strategy Weekly Report, "Invincible," dated November 6, 2017, available at uses.bcaresearch.com. 5 Please see BCA U.S. Equity Strategy Weekly Report, "Dollar The Great Reflator," dated September 18, 2017, available at uses.bcaresearch.com. 6 Please see BCA U.S. Equity Strategy Weekly Report, "Can Easy Fiscal Offset Tighter Monetary Policy?," dated October 9, 2017, available at uses.bcaresearch.com.

Con la temporada de publicación de resultados del Q4 a punto de despegar en serio la próxima semana, la composición de las estimaciones merece cierto análisis. Como se muestra en el panel inferior, tras un mínimo en 2015, el número de revisiones positivas de ingresos ha superado de forma constante al número de revisiones positivas de ganancias, a pesar de que el crecimiento real de las ganancias ha superado con creces al crecimiento de los ingresos. Creemos que hay tres razones concebibles para esta extraña tendencia, ninguna de las cuales es mutuamente excluyente. En primer lugar, hay buenas probabilidades de que los analistas simplemente tengan mejor visibilidad de la demanda final mientras adoptan un enfoque de esperar y ver respecto a los márgenes. En segundo lugar, las revisiones netas de ingresos podrían seguir los cambios en los precios al productor, una teoría respaldada por nuestro panel inferior. Por último, las recientes revisiones muy positivas de ingresos podrían reflejar cierto traslado de beneficios de 2017 a 2018 para captar el beneficio de la reciente reforma fiscal, especialmente dada la rebaja en las estimaciones de EPS del Q4/2017 y la mejora en las estimaciones de EPS del Q1/2018 y del año calendario 2018. Si esto afecta o no el desempeño del Q4 con respecto a las estimaciones está por verse, aunque una percepción de debilitamiento del motor de ganancias actual podría ser el catalizador para la tan esperada corrección del S&P 500; permanezcan atentos. ¿Qué pasa con las revisiones de ingresos frente a beneficios del SPX? ¿Qué pasa con las revisiones de ingresos frente a beneficios del SPX?

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Highlights The beta of Chinese stocks has been steadily increasing over the past few years, versus both emerging markets and global stocks. Rising relative currency volatility has likely durably increased the cyclicality of Chinese stock prices. The high-beta nature of Chinese investable stocks suggests that they should be favored when the EM and global stock benchmarks are rising. This supports our current overweight stance. A portfolio strategy that favors equity sectors with high alpha significance has outperformed the broad investable market by a non-trivial amount over time, without adding to portfolio risk. Barring a few exceptions, the model's current allocation is generally consistent with our theme of a benign slowdown in Chinese economic growth. Feature Chart 1Beta Matters, But So Does Alpha While concepts such as alpha, beta, and correlation are frequently applied by investment managers at the security or sector level, they are less commonly employed from a top-down regional equity perspective and are rarely examined as a time series. In addition, the concept of alpha persistence (i.e. alpha that is persistently positive or negative) is also frequently ignored by investors, despite it having significant implications for portfolio returns. This is vividly illustrated by the relative performance of developed commodity markets during the last economic expansion: these countries resoundingly outperformed a rising global benchmark from 2000 to 2007, despite having a market beta that averaged one over the period (Chart 1). This seeming inconsistency is explained by persistent volatility-adjusted outperformance throughout the period (panel 3), underscoring the importance of tracking this measure from a top-down perspective. In this report we examine the recent evolution of MSCI China's alpha and beta versus both the emerging market (EM) and global benchmarks. We conclude that China is no longer a low-beta market (supporting an overweight stance), and also present a simple alpha-based sector model for Chinese investable stocks that has generated impressive outperformance over time without adding to portfolio risk. The Evolution Of China's Alpha & Beta Chart 2 presents the evolution of alpha and beta for Chinese investable stocks since 2010, versus the emerging market and global index. Given the significant outperformance of the technology sector over the past year, we also present this analysis in ex-tech terms. The values shown in Chart 2 are calculated using a standard single-factor model approach to estimating alpha and beta, namely a regression of weekly stock price returns in US$ terms in excess of the return from U.S. short-term Treasury bills on excess returns of the benchmark index.1 The chart yields the following observations: The beta of Chinese stocks has been steadily increasing over the past few years, versus both emerging markets and global stocks, regardless of whether the tech sector is removed from the picture. Chinese stocks had a beta of 1.4 versus their global peers in 2017, placing it in the 80th percentile of all country equity market betas for the year. Chinese stocks earned a modestly negative alpha vs global stocks in 2016, which was even larger when compared to the EM benchmark. This likely occurred because of lower exposure to resource-oriented sectors, given the significant rebound in commodity prices in 2016. Chinese stocks experienced a surge in alpha in 2017, even excluding technology stocks. In 2017, in all cases (vs EM and global, including or excluding tech) Chinese equities moved into the top right alpha/beta quadrant, which is the quadrant that offers the highest return to investors when the benchmark is rising. This is a remarkable development given that there were indications of a peak in Chinese economic momentum in the first half of the year, and suggests that investors do not view the ongoing slowdown as being problematic for investable equity performance. Chart 2 raises the obvious question of why China has become a higher beta market. We have two theories, but only the second one appears to fit the data. The first theory is that the establishment of the stock connect in late-2014 caused a volatility spillover from China's domestic stock market into the investable market. But while it is true that A-shares were considerably riskier than investable stocks in late-2015 / early-2016, Chart 3 makes it clear that A-shares have not historically been much more volatile than investable stocks. In addition, Chart 2 underscores that the rise in China's market beta since 2014 has been persistent, whereas A-shares in 2017 recorded their lowest share price volatility in over 15 years. So to us, this does not appear to be the most probable explanation. Chart 2China Has Become A High-Beta Market The second theory, which seems much more likely, is that the rising currency volatility has increased the cyclicality of Chinese stock prices. China's decision to devalue the RMB in August 2015 clearly led to a period of significantly increased capital controls, but Chart 4 highlights that the CNY/USD exchange rate has steadily become more volatile. This is especially true when compared with a basket of emerging market currencies, with CNY/USD actually being more volatile than the basket over the past year. Chart 3The Stock Connect Does Not Explain##br## The Rise In China's Beta Chart 4Rising Relative Currency Volatility ##br##= Higher Beta While it is certainly true that Chinese policymakers have stepped up their management of the currency by tightening capital controls over the past year, the PBOC's decision to pursue its "partial" version of the impossible trinity still implies, in our view, that RMB volatility will now be structurally higher than what prevailed on average prior to August 2015.2 This suggests that China's equity market beta will be durably higher than before, absent a presently negative correlation between CNY/USD and EM or global stock prices. Bottom Line: The beta of Chinese stocks has been steadily increasing over the past few years, versus both emerging markets and global stocks. Rising relative currency volatility has likely durably increased the cyclicality of Chinese stock prices. Investment Implications Of China's Recent Relative Performance There are two clear investment strategy implications from Chinese equities becoming a high-beta asset. The first is that Chinese investable stocks are now a pro-risk asset to be favored when the EM and global stock benchmarks are rising. Chart 5 shows that both are currently well above their 200-day moving averages, which supports our overweight stance towards China. The second is that when comparing the performance of China's overall investable index versus that excluding technology, it is clear that a non-trivial amount of the alpha earned by China's overall index in 2017 came from the tech sector. This suggests that a reversal of the high-flying performance of Chinese technology stocks is a material risk to our overweight stance towards Chinese equities. For now, this high-alpha outperformance appears to be fundamentally-based: Chart 6 highlights that forward earnings for Chinese tech shares have risen enormously relative to the investable benchmark over the past three years, a trend that we have noted appears to be driven by Chinese consumer demand (and thus unlikely to decline over the coming year).3 In addition, the relatively modest but positive alpha earned by Chinese ex-tech stocks in 2017 was likely driven by extremely cheap valuation, and these multiples remain quite low relative to other countries. We highlighted in our December 7 Weekly Report that the relative re-rating of Chinese investable ex-tech stocks was a key theme for 2018,4 suggesting that there is room for further re-rating/alpha if China's economic slowdown remains benign (as we expect). Chart 5Investors Should Overweight ##br##Chinese Stocks In This Environment Chart 6Tech's Recent Alpha Appears ##br##Fundamentally-Based Bottom Line: The now high-beta nature of Chinese investable stocks suggests that they are a pro-risk asset to be favored when the EM and global stock benchmarks are rising. This supports our current overweight stance. Alpha, Applied: A Simple Sector Model For Chinese Investable Stocks We noted earlier that the concept of alpha has had significant implications for regional equity portfolio returns in the past. In order to test the predictive power of alpha within the context of a Chinese equity portfolio, we evaluate the returns of an investment strategy that allocates to China's investable equity sectors based on the significance of alpha. Table 1 presents statistics summarizing the performance of this sector alpha portfolio relative to the overall investable market, Table 2 shows the portfolio's current sector allocation, and Chart 7 illustrates the cyclical behavior of the portfolio's relative performance trend since 2004. Several important conclusions emerge: Table 1An Alpha-Based Sector Model Has Historically Outperformed ##br##China's Investable Stock Market Table 2Sector Alpha Portfolio Weights Are Generally Consistent With ##br##A Benign Growth Slowdown The model has outperformed the broad investable market by an impressive 235 bps per year without appearing to take on any additional risk. Measured either as volatility or drawdown, the riskiness of the portfolio appears to be the same as that of the overall investable market. The outperformance of the model occurs in spurts, but sustained periods of underperformance are not common. The 2007-2009 period served as an exception to this rule, but even in this case the cumulative underperformance of the model vs the investable index was not large (roughly 6%). Chart 7Impressive Outperformance Over Time The model is currently underweight financials (significantly), energy, industrials, telecoms, and utilities. Overweights are concentrated in the tech sector, real estate, health care, and consumer stocks. For now, these weights are generally consistent with our benign slowdown scenario, although there are some potential exceptions to monitor (such as the overweight stance towards real estate and materials). Bottom Line: A portfolio strategy that favors equity sectors with high alpha significance has outperformed the broad investable market by a non-trivial amount over time, without adding to portfolio risk. Barring a few exceptions, the model's current allocation is generally consistent with our theme of a benign slowdown in Chinese economic growth. Jonathan LaBerge, CFA, Vice President Special Reports jonathanl@bcaresearch.com 1 2 Please see China Investment Strategy Weekly Report, "How Will China Manage The Impossible Trinity", dated December 8, 2016, available at cis.bcaresearch.com. 3 Please see China Investment Strategy Special Report, "The Data Lab: Testing The Predictability of China's Business Cycle", dated November 30, 2017, available at cis.bcaresearch.com. 4 Please see China Investment Strategy Weekly Report, "Three Themes For China In The Coming Year", dated December 7, 2017, available at cis.bcaresearch.com. Cyclical Investment Stance Equity Sector Recommendations