企業利益

Highlights Portfolio Strategy A stable China, a depreciating U.S. dollar, rising commodity prices and sustained synchronized global growth signal that the industrials complex, especially the most cyclical part, remains on a solid footing. Deteriorating profit prospects warn that investors should refrain from paying a premium valuation for industrial machinery; take profits and move to the sidelines. Recent Changes S&P Industrial Machinery - Book profits of 4% and downgrade to neutral today. S&P Construction Machinery & Heavy Truck - Stop triggered last week, remove from the high-conviction list for a 10% gain. Small Caps / Large Caps - Downgrade alert in a recent Insight. Table 1 Feature The S&P 500 smashed through the 2,800 mark last week, as corporate profits continued to deliver, the U.S. dollar took a dive and global economic data releases held their own. Stars could not be more aligned for a euphoric blow off phase, with equity bourses the world over already registering annual-like returns in but a few short weeks. While stocks have more room to run, especially versus bonds, on a cyclical time frame, tactically the likelihood of a short-term healthy pullback is increasing. Last week we identified five indicators we are closely monitoring that are signaling an overstretched market.1 This week we update our Complacency-Anxiety Indicator that also catapulted to all-time highs and breached the one standard deviation above the historical mean mark (Chart 1). This confirms that a Q1 setback remains likely, and our strategy since December 18 has been to monetize gains in tactical trades and institute stops to the high flyers in our high-conviction call list. Were a 5-10% correction to materialize, we would "buy the dip" as we do not foresee a recession in the coming 9-12 months. While consumer price inflation is nowhere to be found, corporate selling prices are climbing at a brisk pace. The U.S. dollar debasement and related commodity reflex rebound, especially in oil prices, are the culprits, and the latter will likely assist even the CPI basket and morph into an inflationary impulse as we posited in late-November (please see the bottom two panels of Chart 1B). Already, inflation expectations are headed higher. Chart 2 updates our corporate sector pricing power proxy and our diffusion index. It also updates the business sector's overall wage inflation and associated diffusion index from the latest BLS employment report. The middle panel of Chart 2 shows the Atlanta Fed Wage Growth Tracker and that measure of wage inflation has converged down to the AHE reading, suffering a 100bps drop in the past year. Chart 1Complacency Reigns Chart 2Margin Expansion Phase Is Intact Corporate pricing power is upbeat at a time when wages are decelerating. Taken together, our margin proxy indicator suggests that the ongoing profit margin expansion phase has more upside (bottom panel, Chart 2). Table 2 shows our updated industry group pricing power gauges, which we calculate from the relevant CPI, PPI, PCE and commodity growth rates for each of the 60 industry groups we track. Table 2 also highlights shorter-term pricing power trends and each industry's spread to overall inflation. Table 2Industry Group Pricing Power 78% of the industries we cover are lifting selling prices, and 45% are doing so at a faster clip than overall inflation. Importantly, inflation rates have increased since our late-September update. The outright deflating sectors dropped by two to 13 since our last update. Encouragingly, only 7 industries are experiencing a downtrend in selling price inflation, or 5 fewer than our most recent report. Impressively, deep cyclicals/commodity-related industries dominate the top ranks, occupying 8 out of the top 10 slots (top panel, Chart 3). A softening greenback and rising global end demand explain the commodity complex's sustained ability to increase prices. In contrast, tech, telecom and consumer discretionary sectors populate the bottom ranks of Table 2. Netting it out, accelerating corporate sector pricing power will continue to bolster top line growth in 2018. Tack on high operating leverage kicking into higher gear at this stage of the cycle and still muted wage inflation and profit margins and EPS growth will remain upbeat. With regard to cyclicals versus defensives, diverging pricing power (Chart 3) and wage growth trends (Chart 4) suggest that cyclicals continue to have the upper hand compared with defensives (Chart 5). Chart 3Deep Cyclicals... Chart 4...Have The Upper Hand... Chart 5...Vs. Defensives This week we update our view on a deep cyclical sector and modestly tweak our intra-sector positioning. Industrials And China We lifted the S&P industrials sector to an above benchmark allocation in early October via boosting the S&P construction machinery & heavy truck sub index to overweight.2 Synchronized global growth, a capex upcycle, firming capital goods final demand, and the U.S. dollar's fall coupled with the commodity price rebound all pointed to a bright outlook for U.S. capital goods producers. Currently, all these forces remain in play and continue to bolster industrials stocks' profit prospects. However, the emerging market (EM)/Chinese economic backdrop deserves closer scrutiny. Why? Because the most cyclical parts of the industrials complex are levered to the EM in general and China in particular. These high operating leverage businesses also drive relative profit and stock performance, signaling that China's economic growth might or ails determine the overall fortunes of U.S. capital goods producers. While Chinese economic data are currently a mixed bag and we take them with a big grain of salt, global high-frequency financial market data are emitting an unambiguously positive signal. First, BCA's FX strategist, Mathieu Savary, brought to our attention that the extremely economic-sensitive Canadian TSX Venture Exchange Index is in a V-shaped recovery.3 Highly speculative basic resources issues dominate this Index and help explain the tight positive correlation with Chinese output (top panel, Chart 6). Second, the ultimate economic-sensitive indicator, Dr. Copper, is also in a violent upswing, heralding that China will be, at least, stable in 2018 (middle panel, Chart 6). Third, high-beta Australian materials stocks have been in an upward trajectory since the early 2016 trough both versus the MSCI All-Country World Index and the broad Australian market, sniffing out improving Chinese-related commodity demand (bottom panel, Chart 6). Similarly, upbeat non-Chinese economic data suggest that China's economic prospects are far from faltering. Australia's close economic ties with China signal that taking a pulse of the Australian economic juggernaut reveals the state of China's economic affairs. Down Under employment growth has been brisk of late, with annual job creation running at a 3.3% clip, a rate last hit in the mid-2000s when China's economy was roaring and the commodity super-cycle was in full swing (second panel, Chart 7). Australian CEO confidence as well as consumer confidence are pushing decade highs, and the manufacturing PMI survey recently shot to a 16 year high (third panel, Chart 7). Chart 6China Is##BR##Alright Chart 7Australian Indicators Confirm:##BR## China Is Stable All of this suggests that China will likely remain stable in 2018, barring a policy mistake a la the August 11, 2015 currency devaluation. The upshot is that industrials EPS and equities have more room to run. On that front, both our Cyclical Macro Indicator and our profit growth model corroborate that the path of least resistance for relative share prices is higher (Chart 8). U.S. dollar debasing is synonymous with capital goods producers' top line growth acceleration, as a large part of total revenues are sourced from abroad. The near 20 percentage point fall in the trade-weighted U.S. dollar since 2015 suggests that more global market share gains are in store for U.S. industrials (Chart 9). Global growth is also joined at the hip with the greenback's depreciation. Synchronized global growth along with our derivative coordinated global capex growth 2018 theme, will likely serve as catalysts for a sustained breakout in relative share prices (Chart 10). Chart 8EPS Model And CMI Flash Green Chart 9Industrials Love A Cheap Greenback Chart 10Levered To Global Growth Adding it up, a stable China is music to the ears of industrials executives. Tack on a depreciating U.S. dollar, rising commodity prices and sustained synchronized global growth and the most cyclical parts of the industrials complex will continue to lead the pack. Bottom Line: Stay overweight the S&P industrials index, but selectivity is warranted. Take Profits In Industrial Machinery We outlined above that the most cyclical parts of the S&P industrials index with high foreign sales content would benefit disproportionately from our stable-to-mildly sanguine EM/China view. While the broad machinery index fits the bill, the industrial machinery sub index less so, and we recommend monetizing gains of 4% since inception and moving to the sidelines. Chart 11 shows the relative performance of the two key drivers of the S&P machinery index: industrial machinery and construction machinery & heavy truck sub-indexes. While these indexes moved hand-in-hand since the mid-1990s, early this decade this tight positive correlation fell apart. One key determinant of the relative move of these indexes is the U.S. dollar. The greenback troughed in 2011 and since then the more "defensive", less globally-exposed S&P industrials machinery index left their brethren in the dust (bottom panel, Chart 11). Now that the U.S. dollar has peaked, the catch up phase in the S&P construction machinery & heavy truck index that is already underway will likely gain momentum (top panel, Chart 11). Beyond the depreciating currency, at the margin, softening S&P industrial machinery operating metrics argue for pruning exposure in this index. Both the Empire and Philly Fed new orders surveys have petered out, suggesting that industry new order growth will likely continue to lose steam (middle panel, Chart 12). In fact, a weak industrial machinery new orders-to-inventories ratio is also warning that sell-side analysts' relative profits forecasts are too optimistic (bottom panel, Chart 12). Chart 11Catch Up Phase Chart 12Waning End-Demand Drilling deeper into industry operating metrics is revealing. While shipments have held their own and moved mostly sideways similar to new orders, inventory accumulation is worrying. Industry inventories have risen by over 30% during the past three years (Chart 13). Simultaneously, industrial machinery backlogs have drifted steadily lower. Given the supply build up, any hiccup in demand, even a minor one, could prove very deflationary and heavily weigh on industry profitability. With regard to valuations, Chart 14 shows that both on a relative trailing price-to-sales and relative forward price-to-earnings ratio basis, the index is trading one standard deviation above the historical mean. The moderating industry demand backdrop suggests that relative valuations are expensive. Chart 13Inventory Liquidation Risk Chart 14Why Pay A Premium? Adding it all up, deteriorating profit prospects warn that investors should refrain from paying a premium valuation for the S&P industrial machinery index. Bottom Line: Book profits of 4% in the S&P industrial machinery index and downgrade to a benchmark allocation. We also recommend redeploying profits from our downgrade in the S&P industrial machinery index to their more cyclical machinery siblings the S&P construction machinery & heavy truck index, thus sustaining the overall overweight exposure in the broad S&P industrials sector. Housekeeping Last week we instituted a risk management tool for our 2018 high-conviction list: setting a stop once a call has cleared the 10% return mark.4 This past week, the S&P construction machinery & heavy truck index hit the trailing stop at the 10% mark, and thus we are booking gains and removing this index from the high-conviction list. While our confidence is not as high as in late-November given the parabolic move in this index and rising chance of a tactical overall equity market pullback, from a cyclical perspective we continue to recommend a core overweight in this industrials sector powerhouse. Anastasios Avgeriou, Vice President U.S. Equity Strategy anastasios@bcaresearch.com 1 Please see BCA U.S. Equity Strategy Weekly Report, "Too Good To Be True?" dated January 22, 2018, available at uses.bcaresearch.com. 2 Please see BCA U.S. Equity Strategy Weekly Report, "Earnings Take Center Stage," dated October 2, 2017, available at uses.bcaresearch.com. 3 Please see BCA Foreign Exchange Strategy Weekly Report, "Health Care Or Not, Risks Remain," dated March 24, 2017, available at fes.bcaresearch.com. 4 Please see BCA U.S. Equity Strategy Weekly Report, "Too Good To Be True?" dated January 22, 2018, available at uses.bcaresearch.com. Current Recommendations Current Trades Size And Style Views Favor value over growth. Stay neutral small over large caps (downgrade alert).

Highlights Q4 earnings are beating raised expectations, and the bar for 2018 EPS is even higher. Housing, capex and a nudge from government spending are set to boost GDP in 2018. BCA's consumer spending model shows that economic factors, not sentiment or political affiliation, are the main drivers of household consumption. Feature Risk assets continued their early 2018 surge last week, supported by better than expected Q4 corporate earnings results, solid economic growth and a weaker dollar. The headline 2.6% gain in Q4 GDP understated the strength in the U.S. economy as 2017 ended (Chart 1). Real final sales to domestic purchasers rose 4.3% in Q4, the fastest clip in nearly four years. Moreover, the economy is poised to grow well above its long term potential in the first half of 2018, aided by surging capex, the lagged effect of easy financial conditions and the tax bill. Faster growth will push down the unemployment rate and lead to higher inflation by year end. Q4 corporate earnings are beating raised expectations. However, managements have raised the bar for 2018 results, which may lead to disappointment later this year. Investors have correctly ignored the elevated level of political polarization in Washington and focused on the fundamentals. The final section of this week's bulletin suggests that despite a widening gap in consumer sentiment between political parties, economic fundamentals, not political affiliation, drives consumer behavior. Chart 1GDP Growth Remains Below Average, But Above Fed's Long Run Target Raising The Bar The Q4 earnings reporting season is off to a strong start, with both EPS and revenue growth ahead of consensus expectations at the start of January. Moreover, the counter-trend rally in margins remains in place. We previewed the Q4 2017 S&P 500 earnings season earlier this month.1 Table 1S&P 500: Q4 2017 Results* Just under 30% of companies have reported results thus far, with 80% beating consensus EPS projections, well above the long term average of 69%. Furthermore, 82% have posted Q4 revenues that topped expectations, which exceeded the long-term average of 56%. The surprise factor for Q4 stands at 5% for EPS and 1% for sales. Both readings are right at the average surprise in the past five years. The surprise figures are even more impressive given that analysts' views of Q4 results increased between the start of Q4 2017 and the start of Q4 reporting season. Analysts' estimates typically move lower as the quarter unfolds, in effect lowering the bar for results. We anticipate the secular mean-reversion of margins to re-assert itself in the S&P data, perhaps beginning in mid-2018. Nonetheless, initial results imply that Q4 will be another quarter of margin expansion. Average earnings growth (Q4 2017 versus Q4 2016) is solid at 13% with revenue growth at 7%. However, on a four quarter basis, U.S. margins fell slightly in the fourth quarter, but remain at a high level on the back of decent corporate pricing power. A pick-up in productivity growth into year-end helped as well. Strength in earnings and revenues are broadly based (Table 1). Earnings per share increased in Q4 2017 versus Q4 2016 in 9 of the 11 sectors. EPS results are particularly stout in energy (140%), materials (28%), technology (18%) and financials (15%). The energy, materials and technology sectors likewise experienced significant sales gains (21%, 11%, and 11% respectively). The 5% year-over-year increase in financial sector earnings follows the 7% drop in Q3, owing to the impact of Hurricanes Harvey and Irma on the insurance and reinsurance industries. Excluding energy, S&P 500 profits in Q4 2017 versus Q4 2016 are a still-robust 11%. Upbeat managements have raised the bar significantly for 2018 results in the past few months (Chart 2). On October 1, 2017, before the GOP introduced the bill, the bottom-up estimate for 2018 S&P 500 EPS growth stood at 11%. As of January 26, 2018, the estimate is 17%. Moreover, the upward revisions are widespread. 2018 EPS growth rate estimates in 9 of 11 sectors are higher today than at the start of October (Table 2). 2018 consensus projections increased the most for Telecom, Financials, Energy, and Consumer Discretionary. Analysts have cut their view of 2018 results for the Utilities and Real Estate sectors since the bill was introduced. Our U.S. Equity Strategy service introduced profit models for all 11 S&P 500 sectors earlier this month.2 Chart 2Buybacks, Surging Capex Raising The Bar For 2018 EPS Growth Table 2Estimated Earnings Growth For 2018 The Tax Cut and Jobs Act of 2017 is behind most of this ebullience, but improving global growth, a steeper yield curve and higher energy prices are also responsible. The tax bill lowered the corporate tax rate for 2018 and the repatriation holiday provides firms with excess cash. As we noted in last week's report,3 companies are likely to return almost all of that cash to shareholders via increased buybacks. Moreover, a few firms are marking up 2018 estimates in anticipation of a surge in capital spending, as managements pull ahead new investment into 2018 from later years to benefit from the bill. Chart 3Profit Growth Will Peak In 2018 Analysts expect EPS growth to slow significantly in 2019 from the anticipated 2018 clip, which matches BCA's view. However, unlike estimates for 2017 and 2018, we anticipate that EPS estimates for 2019 will move lower throughout 2018 and 2019, ahead of a recession in late 2019.4 Bottom Line: The BCA earnings model shows that S&P 500 EPS growth is peaking on a four-quarter moving total basis, and should begin to decelerate in 2H 2018 to a level commensurate with 3 ½-4% nominal GDP growth (Chart 3). After-tax earnings growth will be higher than this, however, due to the recently passed tax cuts. Margins will crest in mid-2018, but BCA believes that the earnings backdrop will remain a tailwind for the equity market. The Tax Cut and Job Act raised expectations for 2018 in most sectors, and it remains to be seen whether managements can match the lofty projections, especially in the second half of the year. BCA expects growth outside the U.S. to remain robust, an additional support for EPS growth in the coming quarters. Further weakness in the dollar, counter to our call for a 5% gain in the DXY, would also provide a modest boost to S&P 500 results in 2018. Strong domestic economic activity will also boost profits this year. Setting The Stage For 2018 Q4 GDP posted a 2.6% gain, failing to match (raised) expectations of a 2.9% increase (Chart 1 again). At 2.5%, the year-over-year change in GDP exceeded the FOMC's forecast for 2017 GDP (2.1%) at the start of 2017. Moreover, the 2.5% year-over-year reading in Q4 is well above the Fed's estimate of potential GDP (1.8%). The implication for investors is that because U.S. economic growth is faster than its long-term potential, the labor market is tightening and inflation is poised to move higher. Accordingly, market odds for a Fed hike in March are over 90%, and investors expect almost three additional hikes in the next 12 months (Chart 4). The FOMC expects to raise rates three times this year. BCA's stance is that the Fed will raise rates 4 times. Chart 4The FOMC And The Market Are Closely Aligned On Rate Hikes In 2018 BCA's view is that U.S. economic growth is set to accelerate in the first half of 2018 aided by the tax cut, strong global growth and the lagged effect of easier financial conditions. The direct effect of the tax cuts will likely boost U.S. real GDP growth in 2018 by 0.2 to 0.3 percentage points. It could be more, depending on the impact on animal spirits in the business sector and any fresh infrastructure spending. Full expensing of capital goods and changes to the budget sequesters would add another 0.2 percentage points. Global growth estimates are still on the upswing, which will provide U.S. capex a boost (Charts 5 and 6). Moreover, financial conditions have eased since the Fed's initial hike of the cycle (Chart 7). Financial lead GDP growth by 6 to 9 months, suggesting that real GDP growth in the U.S. will remain at or above 3% for at least the first half of 2018 (Chart 8). The New York Fed's Nowcast for Q1 2018 stands at 3.1%, while the Atlanta Fed's GDP Now reading for Q1 is 3.4% (Chart 9). Chart 5Global Growth Expectations##BR##Are Accelerating Chart 6Capex Poised##BR##For Liftoff Chart 7Financial Conditions Have Eased Since##BR##The Fed's First Rate Hike Of The Cycle Chart 8Easier Financial Conditions##BR##Will Boost U.S. Growth Chart 9Solid GDP Growth##BR##Expected In Q1 Residential investment, which surged in Q4 as communities in Texas and Florida began to rebuild after the storms, will add to growth in 2018. Inventories of new and existing homes are close to all-time lows (Chart 10). Housing affordability remains well above average, and will remain supportive of housing investment even if rates rise by 100 bps (Chart 11). Bank managements are upbeat about credit quality and loan growth,5 although the recent soundings from the Fed's Senior Loan Officers survey shows that mortgage demand has ebbed in recent quarters. However, banks' lending standards for home loans remain relatively loose (Chart 12). Moreover, household formation recovered in the past few years alongside the labor market, providing additional support for housing. Risks to housing include the impact of the limits to mortgage interest and state and local taxes imposed by the Tax Cut and Jobs Act of 2017. Chart 10Solid Housing##BR##Fundamentals In Place Chart 11Housing Affordability Under##BR##Various Rate Assumptions Chart 12Mortgage Spigot##BR##Open For Homebuyers Bottom Line: U.S. economic growth is poised to string together the longest period of above-potential GDP growth since early in the recovery. The odds of a recession in 2018 are very low (Chart 13). Housing, capital spending and a modest lift from government spending will lift GDP, pushing the output gap further into positive territory (Chart 14). The added support to the economy from the tax bill makes it more likely that the economy will overheat, and lead to higher inflation and faster rate hikes than the market, or the Fed, expects. Stay underweight duration and overweight stocks versus bonds for now, although we plan to take some risk off the table later in the year. Despite record levels of political polarization, the U.S. consumer will provide support for the economy in 2018 as well. Chart 13Odds Of A Recession Are Low Chart 14U.S. Economy Growing Faster Than Potential Tribal Economics Chart 15Income Inequality Fosters Polarization Many of our clients have been asking: "Why is consumer confidence so high if Americans are so angry?" BCA's view is that Americans' anger is based to some extent on "economic discontent",6 driven largely by political orientation. However, economy-wide, the negative attitude based on party affinity is more than offset by a higher level of optimism based on economic fundamentals. Moreover, the dissatisfaction among households may be about structural issues that have long-term implications, like income inequality, which fosters or nurtures polarization and where the latter continues to grow. The polarization in the cultural realm has been mirrored in the political arena. According to political scientists Keith Poole and Howard Rosenthal, polarization in Congress is currently at its highest level since World War II (Chart 15). Furthermore, BCA's Geopolitical Strategy service stance is that the long-term implications of polarization are here to stay as income inequality remains the most significant driver, among five main factors, that explain the polarization in the U.S. today.7 & 8 The election of President Trump in November 2016 ushered in a period of significant polarization and partisan conflict. Compared with other administrations, Trump effected the most change in economic expectations9 (Table 3). Moreover, even a year later, the partisan gap (Republicans minus Democrats) has widened further; Republicans are most optimistic and Democrats are most pessimistic (Chart 16). Table 3Change In Economic Assessments##BR##Pre And Post Elections Chart 16Partisan Gap Is Widest##BR##And Persistent, For Now To further understand the divergence between the elevated consumer sentiment readings and households' high level of anger, it is useful to look through the lens of the stages of "economic discontent".10 The framework pioneered by the University of Michigan identifies five typical stages of a collapse in economic confidence (Table 4). The study acknowledges that consumers are rational individuals. As such, households tend to shape their economic expectations on cyclical fundamental drivers of the economy, rather than political affiliation (Chart 17). The implication is that as long as consumers remain satisfied with the performance of the three cyclical drivers, readings on consumer sentiment will hold up, as the positive views on fundamentals outweigh any resentment they may have about long-term issues like income inequality. Finally, it is clear that households have not lost all hope (stage four), where economic discontent turns into political discontent. Consumers are very far away from total despair, not seen since the 1930s! Nonetheless, BCA's view is that with recession likely by late 2019/early 2020, the U.S. will see a revolt of some kind by the 2020 election.11 Table 4Five Stages Of##BR##Economic Discontent Chart 17Expectations For Cyclical##BR##Fundamental Drivers Are Solid Consumers have hope that their economic expectations will be met by the Trump administration's policies as the economy continues to deliver strong job growth/job security and tame inflation, preserving households' purchasing power. BCA's consumer spending model shows that economic factors, not sentiment, are the main drivers of household consumption (Chart 18). Several academic studies support this view. Researchers at Princeton University and the National Bureau of Economic Research find that political polarization's impact on consumer spending is trivial.12 Furthermore, a recent study by the Federal Reserve Bank of New York,13 also finds that the election of President Trump had negligible partisan impact on consumer spending patterns. Economists at the NY Fed show that consumers' expectations in surveys may include "true beliefs" based on economic factors and "some noise". They conclude that if the partisan gap does not cause economic decisions to vary significantly, then macroeconomists and policymakers should downplay the impact of consumers' political views on spending patterns. Chart 18Consumption Has##BR##Room To Grow Chart 19Lower-Lows In The Personal##BR##Savings Rate Unlikely Bottom Line: BCA expects consumer spending to grow by at least 2% in 2018. Consumption is well supported by record high household net worth, and accelerating wages. On the other hand, employment growth will slow later this year and we should not assume that the personal saving rate will keep falling given that it has hit a recovery low of 3.1% (Chart 19). John Canally, CFA, Senior Vice President U.S. Investment Strategy johnc@bcaresearch.com Jizel Georges, Senior Analyst jizelg@bcaresearch.com 1 Please see BCA Research's U.S. Investment Strategy Weekly Report, "A Smooth Transition" published January 15, 2018. Available at usis.bcaresearch.com. 2 Please see BCA Research's U.S. Equity Strategy Weekly Report, "White Paper: Introducing Our U.S. Equity Sector Earnings Models" published January 16, 2018. Available at uses.bcaresearch.com. 3 Please see BCA Research's U.S. Investment Strategy Weekly Report, "Variations On A Theme" published January 22, 2018. Available at usis.bcaresearch.com. 4 Please see BCA Research's Global Investment Strategy Weekly Report, "Strategy Outlook Fourth Quarter 2017: Goldilocks And The Recession Bear," October 4, 2017. Available at gis.bcaresearch.com. 5 Please see BCA Research's U.S. Investment Strategy Weekly Report, "Variations On A Theme", published January 22,2018. Available at usis.bcaresearch.com. 6 "Economic Discontent: Causes and Consequences", Richard Curtin, Director, Survey of Consumers, University of Michigan, November 12, 2008. 7 Please see BCA Research's Global Investment Strategy Special Report, "The Future Of Western Democracy: Back To Blood", dated November 18, 2016. Available at gis.bcaresearch.com. 8 Please see BCA Research's Geopolitical Strategy Special Report, "U.S. Election: Outcomes And Investment Implications", dated November 9, 2016. Available at gps.bcaresearch.com. 9 "Consumer Expectations: Politics Trumps Economics", Richard Curtin, University of Michigan, June 1, 2017. 10 "Economic Discontent: Causes and Consequences", Richard Curtin, Director, Survey of Consumers, University of Michigan, November 12, 2008. 11 Please see BCA Research's Geopolitical Strategy Special Report "Populism Blues: How And Why Social Instability Is Coming To America" June 9, 2017. Available at gps.bcaresearch.com. 12 "Partisan Bias, Economic Expectations, and Household Spending", Atif Mian, Amir Sufi and Nasim Koshkhou, Stanford University, University of Chicago Booth of Business, NBER and Argus Information and Advisory Services, July 2017. 13 "Political Polarization In Consumer Expectations", Olivier Armantier, John J. Conlon and Wilbert van der Klaauw, Federal Reserve Bank of New York, December 15, 2017.

Bank Credit Analyst

Highlights U.S. equities 'melted up' in January as tax cuts made the robust growth/low inflation sweet spot even sweeter. Ominously, recent market action is beginning to resemble a classic late cycle blow-off phase. The fundamentals supporting the market will persist through most of the year, before an economic downturn in the U.S. takes hold in 2019. The repatriation of overseas corporate cash will also flatter EPS growth this year via buyback and M&A activity. The S&P 500 could return 14% or more this year. Unfortunately, the consensus now shares our upbeat view for 2018. Valuation is stretched and many indicators suggest that investors have become downright giddy. This month we compare valuation across the major asset classes. U.S. equities are the most overvalued, followed by gold, raw industrials and EM assets. Oil is still close to fair value. Long-term investors should already be scaling back on risk assets. Investors with a 6-12 month horizon should stay overweight equities versus bonds for now, but a risk management approach means that they should not try to squeeze out the last few percentage points of return. In terms of the sequencing of the exit from risk, the most consistent lead/lag relationship relative to previous tops in the equity market is provided by U.S. corporate bonds. For this reason, we are likely to take profits on corporates before equities. EM assets are already at underweight. We still see a window for the U.S. dollar to appreciate, although by only about 5%. A lot of good news is discounted in the euro, peripheral core inflation is slowing and ECB policymakers are getting nervous. Monetary policy remains the main risk to a pro-cyclical investment stance, although not because of the coming change in the makeup of the FOMC. The economy and inflation should justify four Fed rate hikes in 2018 no matter the makeup. The bond bear phase will continue. Feature Chart I-1Investors Are Giddy U.S. equities 'melted up' in January as tax cuts made the robust growth/low inflation sweet spot even sweeter. Ominously, though, recent market action is beginning to resemble the classic late cycle blow-off phase. Such blow-offs can be highly profitable, but also make it more difficult to properly time the market top. Our base case is that the fundamentals supporting the market will persist through most of the year, before an economic downturn in the U.S. takes hold in 2019. Unfortunately, the consensus now shares our upbeat view for 2018 and many indicators suggest that investors have become downright giddy (Chart I-1). These indicators include investor sentiment, our speculation index, and the bull-to-bear ratio. Net S&P earnings revisions and the U.S. economic surprise index are also extremely elevated, while equity and bond implied volatility are near all-time lows. From a contrarian perspective, these observations suggest that a lot of good news is discounted and that the market is vulnerable to even slight disappointments. It is also a bad sign that our Revealed Preference Indicator moved off of its bullish equity signal in January (see Section III for more details). Meanwhile, central banks are beginning to take away the punchbowl as global economic slack dissipates. This is all late-cycle stuff. Equity valuation does not help investors time the peak in markets, but it does tell us something about downside risk and medium-term expected returns. The Shiller P/E ratio has surged above 30 (Chart I-2). Chart I-3 highlights that, historically, average total returns were negligible over the subsequent 10-year period when the Shiller P/E was in the 30-40 range. Granted, the Shiller P/E will likely fall mechanically later this year as the collapse of earnings in 2008 begins to drop out of the 10-year EPS calculation. Nonetheless, even the BCA Composite Valuation indicator, which includes some metrics that account for extremely low bond yields, surpassed +1 standard deviations in January (our threshold for overvaluation; Chart I-2, bottom panel). An overvaluation signal means that investors should be biased to take profits early. Chart I-2BCA Valuation Indicator Surpasses One Sigma Chart I-3Expected Returns Given Starting Point Shiller P/E As we highlighted in our 2018 Outlook Report, long-term investors should already be scaling back on risk assets. We recommend that investors with a 6-12 month horizon should stay overweight equities versus bonds for now, but we need to be vigilant in terms of scouring for signals to take profits. A risk management approach means that investors should not try to get the last few percentage points of return before the peak. U.S. Earnings And Repatriation Before we turn to the timing and sequence of our exit from risk assets, we will first update our thoughts on the earnings cycle. Fourth quarter U.S. earnings season is still in its early innings, but the banking sector has set an upbeat tone. S&P 500 profits are slated to register a 12% growth rate for both Q4/2017 and calendar 2017. Current year EPS growth estimates have been aggressively ratcheted higher (from 12% growth to 16%) in a mere three weeks on the back of Congress' cut to the corporate tax rate.1 U.S. margins fell slightly in the fourth quarter, but remain at a high level on the back of decent corporate pricing power. A pick-up in productivity growth into year-end helped as well. Our short-term profit model remains extremely upbeat (Chart I-4). The positive profit outlook for the first half of the year is broadly based across sectors as well, according to the recently updated EPS forecast models from BCA's U.S. Equity Sector Strategy service.2 The repatriation of overseas corporate cash will also flatter EPS growth this year via buyback and M&A activity. Studies of the 2004 repatriation legislation show that most of the funds "brought home" were paid out to shareholders, mostly in the form of buybacks. A NBER report estimated that for every dollar repatriated, 92 cents was subsequently paid out to shareholders in one form or another. The surge in buybacks occurred in 2005, according to the U.S. Flow of Funds accounts and a proxy using EPS growth less total dollar earnings growth for the S&P 500 (Chart I-5). The contribution to EPS growth from buybacks rose to more than 3 percentage points at the peak in 2005. Chart I-4Profit Growth Still Accelerating Chart I-5U.S. Buybacks To Lift EPS We expect that most of the repatriated funds will again flow through to shareholders, rather than be used to pay down debt or spent on capital goods. Cash has not been a constraint to capital spending in recent years outside of perhaps the small business sector, which has much less to gain from the tax holiday. A revival in animal spirits and capital spending is underway, but this has more to do with the overall tax package and global growth than the ability of U.S. companies to repatriate overseas earnings. Estimates of how much the repatriation could boost EPS vary widely. Most of it will occur in the Tech and Health Care sectors. Buybacks appear to have lifted EPS growth by roughly one percentage point over the past year. We would not be surprised to see this accelerate by 1-2 percentage points, although the timing could be delayed by a year if the 2004 tax holiday provides the correct timeline. This is certainly positive for the equity market, but much of the impact could already be discounted in prices. Organic earnings growth, and the economic and policy outlook will be the main drivers of equity market returns over the next year. We expect some profit margin contraction later this year, but our 5% EPS growth forecast is beginning to look too conservative. This is especially the case because it does not include the corporate tax cuts. The amount by which the tax cuts will boost earnings on an after-tax basis is difficult to estimate, but we are using 5% as a conservative estimate. Adding 2% for buybacks and 2% for dividends, the S&P 500 could provide an attractive 14% total return this year (assuming no multiple expansion). Timing The Exit Chart I-6Timing The Exit (I) That said, we noted in last month's Report and in BCA's 2018 Outlook that this will be a transition year. We expect a recession in the U.S. sometime in 2019 as the Fed lifts rates into restrictive territory. Equities and other risk assets will sniff out the recession about six months in advance, which means that investors should be preparing to take profits sometime during the next 12 months. Last month we discussed some of the indicators we will watch to help us time the exit. The 2/10 Treasury yield curve has been a reliable recession indicator in the past. However, the lead time on the peak in stocks was quite extended at times (Chart I-6). A shift in the 10-year TIPS breakeven rate above 2.4% would be consistent with the Fed's 2% target for the PCE measure of inflation. This would be a signal that the FOMC will have to step-up the pace of rate hikes and aggressively slow economic growth. We expect the Fed to tighten four times in 2018. We are likely to take some money off the table if core inflation is rising, even if it is still below 2%, at the time that the TIPS breakeven reaches 2.4%. We will also be watching seven indicators that we have found to be useful in heralding market tops, which are summarized in our Scorecard Indicator (Chart I-7). At the moment, four out of the seven indicators are positive (Chart I-8): State of the Business Cycle: As early signals that the economy is softening, watch for the ISM new orders minus inventories indicator to slip below zero, or the 3-month growth rate of unemployment claims to rise above zero. Monetary and Financial Conditions: Using interest rates to judge the stance of monetary policy has been complicated by central banks' use of their balance sheet as a policy tool. Thus, it is better to use two of our proprietary indicators: the BCA Monetary Indicator (MI) and the Financial Conditions Indictor. The S&P 500 index has historically rallied strongly when the MI is above its long-term average. Similarly, equities tend to perform well when the FCI is above its 250-day moving average. The MI is sending a negative signal because interest rates have increased and credit growth has slowed. However, the broader FCI remains well in 'bullish' territory. Price Momentum: We simply use the S&P 500 relative to its 200-day moving average to measure momentum. Currently, the index is well above that level, providing a bullish signal for the Scorecard. Sentiment: Our research shows that stock returns have tended to be highest following periods when sentiment is bearish but improving. In contrast, returns have tended to be lowest following periods when sentiment is bullish but deteriorating. The Scorecard includes the BCA Speculation Indicator to capture sentiment, but virtually all measures of sentiment are very high. The next major move has to be down by definition. Thus, sentiment is assigned a negative value in the Scorecard. Value: As discussed above, value is poor based on the Shiller P/E and the BCA Composite Valuation indicator. Valuation may not help with timing, but we include it in our Scorecard because an overvalued signal means investors should err on the side of getting out early. Chart I-7Equity ScoreCard: Watch For A Dip Below 3 Chart I-8Timing The Exit (II) We demonstrated in previous research that a Scorecard reading of three or above was historically associated with positive equity total returns in subsequent months. A drop below three this year would signal the time to de-risk. Table I-1Exit Checklist To our Checklist we add the U.S. Leading Economic index, which has a good track record of calling recessions. However, we will use the LEI excluding the equity market, since we are using it as an indicator for the stock market. It is bullish at the moment. Our Global LEI is also flashing green. Table I-1 provides a summary checklist for trimming equity exposure. At the moment, 2 out of 9 indicators are bearish. Cross Asset Valuation Comparison Clients have asked our view on the appropriate order in which to scale out of risk assets. One way to approach the question is to compare valuation across asset classes. Presumably, the ones that are most overvalued are at greatest risk, and thus profits should be taken the earliest. It is difficult to compare valuation across asset classes. Should one use fitted values from models or simple deviations from moving averages? Over what time period? Since there is no widely accepted approach, we include multiple measures. More than one time period was used in some cases to capture regime changes. Table I-2 provides out 'best guestimate' for nine asset classes. The approaches range from sophisticated methods developed over many years (i.e. our equity valuation indicators), to regression analysis on the fundamentals (oil), to simple deviations from a time trend (real raw industrial commodity prices and gold). Table I-2Valuation Levels For Major Asset Classes We averaged the valuation readings in cases where there are multiple estimates for a single asset class. The results are shown in Chart I-9. Chart I-9Valuation Levels For Major Asset Classes U.S. equities stand out as the most expensive by far, at 1.8 standard deviations above fair value. Gold, raw industrials and EM equities are next at one standard deviation overvalued. EM sovereign bond spreads come next at 0.7, followed closely by U.S. Treasurys (real yield levels) and investment-grade corporate (IG) bonds (expressed as a spread). High-yield (HY) is only about 0.3 sigma expensive, based on default-adjusted spreads over the Treasury curve. That said, both IG and HY are quite expensive in absolute terms based on the fact that government bonds are expensive. Oil is sitting very close to fair value, despite the rapid price run up over the past couple of months. This makes oil exposure doubly attractive at the moment because the fundamentals point to higher prices at a time when the underlying asset is not expensive. Sequencing Around Past S&P 500 Peaks Historical analysis around equity market peaks provides an alternative approach to the sequencing question. Table I-3 presents the number of days that various asset classes peaked before or after the past major five tops in the S&P 500. A negative number indicates that the asset class peaked before U.S. equities, and a positive number means that it peaked after. Table I-3Asset Class Leads & Lags Vs. Peak In S&P 500 Unfortunately, there is no consistent pattern observed for EM equities, raw industrials, U.S. cyclical stocks, Tech stocks, or small-cap versus large-cap relative returns. Sometimes they peaked before the S&P 500, and sometime after. The EM sovereign bond excess return index peaked about 130 days in advance of the 1998 and 2007 U.S. equity market tops, although we only have three episodes to analyse due to data limitations. Oil is a mixed bag. A peak in the price of gold led the equity market in four out of five episodes, but the lead time is long and variable. The most consistent lead/lag relationship is given by the U.S. corporate bond market. Both investment- and speculative-grade excess returns relative to government bonds peaked in advance of U.S. stocks in four of the five episodes. High-yield excess returns provided the most lead time, peaking on average 154 days in advance. Excess returns to high-yield were a better signal than total returns. This leading relationship is one reason why we plan to trim exposure to corporate bonds within our bond portfolio in advance of scaling back on equities. But the 'return of vol' that we expect to occur later this year will take a toll on carry trades more generally. We are already underweight EM equities and bonds. This EM recommendation has not gone in our favor, but it would make little sense to upgrade them now given our positive views on volatility and the dollar. An unwinding of carry trades will also hit the high-yielding currencies outside of the EM space, such as the Kiwi and Aussie dollar. Base metal prices will be hit particularly hard if the 2019 U.S. recession spills over to the EM economies as we expect. We may downgrade base metals from neutral to underweight around the time that we downgrade equities, but much depends on the evolution of the Chinese economy in the coming months. Oil is a different story. OPEC 2.0 is likely to cut back on supply in the face of an economic downturn, helping to keep prices elevated. We therefore may not trim energy exposure this year. As for equity sectors, our recommended portfolio is still overweight cyclicals for now. Our synchronized global capex boom, rising bond yield, and firm oil price themes keep us overweight the Industrials, Energy and Financial sectors. Utilities and Homebuilders are underweight. Tech is part of the cyclical sector, but poor valuation keeps us underweight. That said, our sector specialists are already beginning a gradual shift away from cyclicals toward defensives for risk management purposes. This transition will continue in the coming months as we de-risk. We are also shifting small caps to neutral on earnings disappointments and elevated debt levels. The Dollar Pain Trade Market shifts since our last publication have largely gone in our favor; stocks have surged, corporate bonds spreads have tightened, oil prices have spiked, bonds have sold off and cyclical stocks have outperformed defensives. One area that has gone against us is the U.S. dollar. Relative interest rate expectations have moved in favor of the dollar as we expected at both the short- and long-ends of the curve. Nonetheless, the dollar has not tracked its historical relationship versus both the yen and euro. The Greenback did not even get a short-term boost from the passage of the tax plan and holiday on overseas earnings. Perhaps this is because the lion's share of "overseas" earnings are already held in U.S. dollars. Reportedly, a large fraction is even held in U.S. banks on U.S. territory. Currency conversion is thus not a major bullish factor for the U.S. dollar. The recent bout of dollar weakness began around the time of the release of the ECB Minutes in January which were interpreted as hawkish because they appeared to be preparing markets for changes in monetary policy. The European debt crisis and economic recession were the reasons for the ECB's asset purchases and negative interest rate policy. Neither of these conditions are in place now. The ECB is meeting as we go to press, and we expect some small adjustments in the Statement that remove references to the need for "crisis" level accommodations. Subsequent steps will be to prepare markets for a complete end to QE, perhaps in September, and then for rates hikes likely in 2019. The key point is that European monetary policy has moved beyond 'peak stimulus' and the normalization process will continue. Perhaps this is partly to blame for euro strength although, as mentioned above, interest rate differentials have moved in favor of the dollar. Does this mean that the dollar has peaked and has entered a cyclical bear phase that will persist over the next 6-12 months? The answer is 'no', although we are less bullish than in the past. We believe there is still a window for the dollar to appreciate against the euro and in broader trade-weighted terms by about 5%. First, a lot of euro-bullish news has been discounted (Chart I-10). Positive economic surprises heavily outstripped that in the U.S. last year, but that phase is now over. The euro appears expensive based on interest rate differentials, and euro sentiment is close to a bullish extreme. This all suggests that market positioning has become a negative factor for the currency. Chart I-10Euro: A Lot Of Bullish News Is Discounted Second, the chorus of complaints against the euro's strength is growing among European central bankers, including Ewald Nowotny, the rather hawkish Austrian central banker. Policymakers' concerns may partly reflect the fact that peripheral inflation excluding food and energy has already weakened to 0.6% from a high of 1.3% in April last year (Chart I-10, fourth panel). Third, U.S. consumer price and wage inflation have yet to pick up meaningfully. The dollar should receive a lift if core U.S. inflation clearly moves toward the Fed's 2% target, as we expect. The FOMC would suddenly appear to have fallen behind the curve and U.S. rate expectations would ratchet higher. Chart I-10, bottom panel, highlights that the euro will weaken if U.S. core inflation rises versus that in the Eurozone. The implication is that the Euro's appreciation has progressed too far and is due for a pullback. As for the yen, the currency surged in January when the Bank of Japan (BoJ) announced a reduction in long-dated JGB purchases. This simply acknowledged what has already occurred. It was always going to be impossible to target both the quantity of bond purchases and the level of 10-year yield simultaneously. Keeping yields near the target required less purchases than they thought. The market interpreted the BoJ's move as a possible prelude to lifting the 10-year yield target. It is perhaps not surprising that the market took the news this way. The economy is performing extremely well; our model that incorporates high-frequency economic data suggests that real GDP growth will move above 3% in the coming quarters. The Japanese economy is benefiting from the end of a fiscal drag and from a rebound in EM growth. Nonetheless, following January's BoJ policy meeting, Kuroda poured cold water on speculation that the BoJ may soon end or adjust the YCC. Recent speeches by BoJ officials reinforce the view that the MPC wants to see an overshoot of actual inflation that will lower real interest rates and thereby reinforce the strong economic activity that is driving higher inflation. Only then will officials be convinced that their job is done. Given that inflation excluding food and energy only stands at 0.3%, the BoJ is still a long way from the overshoot it desires. On the positive side, Japan's large current account surplus and yen undervaluation provide underlying support for the currency. Balancing the offsetting positive and negative forces, our foreign exchange strategists have shifted to neutral on the yen. The Euro remains underweight while the dollar is overweight. Similar to our dollar view, we still see a window for U.S. Treasurys to underperform the global hedged fixed-income benchmark as world bond yields shift higher this year. European government bonds will also sell off, but should outperform Treasurys. JGBs will provide the best refuge for bondholders during the global bond bear phase, since the BoJ will prevent a rise in yields inside of the 10-year maturity. Our global bond strategists upgraded U.K. gilts to overweight in January. Momentum in the U.K. economy is slowing, as a weaker consumer, slower housing activity, and softer capital spending are offsetting a pickup in exports. With the inflationary impulse from the 2016 plunge in the Pound now fading, and with Brexit uncertainty weighing on business confidence, the Bank of England will struggle to raise rates in 2018. FOMC Transition Monetary policy remains the main risk to a pro-cyclical investment stance, although not because of the coming change in the makeup of the FOMC. An abrupt shift in policy is unlikely. There was some support at the December 2017 FOMC meeting to study the use of nominal GDP or price level targeting as a policy framework, but this has been an ongoing debate that will likely continue for years to come. The Fed will remain committed to its current monetary policy framework once Powell takes over. Table I-4 provides a summary of who will be on the FOMC next year, including their policy bias. Chart I-11 compares the recent FOMC makeup with the coming Powell FOMC (voting members only). The hawk/dove ratio will not change much under Powell, unless Trump stacks the vacant spots with hawks. Table I-4Composition Of The FOMC Chart I-11Composition Of Voting FOMC Members 2017 Vs. 2018 In any event, history shows that the FOMC strives to avoid major shifts in policy around changeovers in the Fed Chair. In previous transitions, the previous path for rates was maintained by an average of 13 months. Moreover, Powell has shown that he is not one to rock the boat during his time on the FOMC. It will be the evolution of the economy and inflation, not the composition of the FOMC, that will have the biggest impact on markets at the end of the day. Recent speeches reveal that policymakers across the hawk/dove spectrum are moving modesty toward the hawkish side because growth has accelerated at a time when unemployment is already considered to be below full-employment by many policymakers. The melt-up in equity indexes in January did little to calm worries about financial excesses either. The Fed is struggling to understand the strength of the structural factors that could be holding down inflation. This month's Special Report, beginning on page 21, focusses on the impact of robot automation. While advances on this front are impressive, we conclude that it is difficult to find evidence that robots are more deflationary than previous technological breakthroughs. Thus, increased robot usage should not prevent inflation from rising as the labor market continues to tighten. The macro backdrop will likely justify the FOMC hiking at least as fast as the dots currently forecast. The risks are skewed to the upside. 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%. This is inconsistent with real GDP growth well in excess of its supply-side potential. The unemployment rate is more likely to reach a 49-year low of 3.5% by the end of this year. As highlighted in last month's Report, a key risk to the bull market in risk assets is the end of the 'low vol/low rate' world. The selloff in the bond market in January may mark the start of this process. Conclusions We covered a lot of ground in this month's Overview of the markets, so we will keep the conclusions brief and focused on the risks. Our key point is that the fundamentals remain positive for risk assets, but that a lot of good news is discounted and it appears that we have entered a classic blow-off phase. This will be a transition year to a recession in the U.S. in 2019. Given that valuation for most risk assets is quite stretched, and given that the monetary taps are starting to close, investors must plan for the exit and keep an eye on our timing checklist. The main risk to our pro-cyclical portfolio is a rise in U.S. inflation and the Fed's response, which we believe will end the sweet spot for risk assets. Apart from this, our geopolitical strategists point to several other items that could upset the applecart this year:3 1. Trade China has cooperated with the U.S. in trying to tame North Korea. Nonetheless, President Trump is committed to an "America First" trade policy and he may need to show some muscle against China ahead of the midterm elections in November in order to rally his base. It is politically embarrassing to the Administration that China racked up its largest trade surplus ever with the U.S. in Trump's first year in office. A key question is whether the President goes after China via a series of administrative rulings - such as the recently announced tariffs on solar panels and white goods - or whether he applies an across-the-board tariff and/or fine. The latter would have larger negative macroeconomic implications. 2. Iran On January 12, President Trump threatened not to waive sanctions against Iran the next time they come due (May 12), unless some new demands are met. Pressure from the U.S. President comes at a delicate time for Iran. Domestic unrest has been ongoing since December 28. Although protests have largely fizzled out, they have reopened the rift between the clerical regime, led by Supreme Leader Ayatollah Ali Khamenei, and moderate President Hassan Rouhani. Iranian hardliners, who control part of the armed forces, could lash out in the Persian Gulf, either by threatening to close the Straits of Hormuz or by boarding foreign vessels in international waters. The domestic political calculus in both Iran and the U.S. make further Tehran-Washington tensions likely. For the time being, however, we expect only a minor geopolitical risk premium to seep into the energy markets, supporting our bullish House View on oil prices. 3. China Last month's Special Report highlighted that significant structural reforms are on the way in China, now that President Xi has amassed significant political support for his reform agenda. The reforms should be growth-positive in the long term, but could be a net negative for growth in the near term depending on how deftly the authorities handle the monetary and fiscal policy dials. The risk is that the authorities make a policy mistake by staying too tight, as occurred in 2015. We are monitoring a number of indicators that should warn if a policy mistake is unfolding. On this front, January brought some worrying economic data. The latest figures for both nominal imports and money growth slowed. Given that M2 and M3 are components of BCA's Li Keqiang Leading Indicator, and that nominal imports directly impact China's contribution to global growth, this raises the question of whether December's economic data suggest that China is slowing at a more aggressive pace than we expect. For now, our answer is no. First, China's trade numbers are highly volatile; nominal import growth remains elevated after smoothing the data. Second, China's export growth remains buoyant, consistent with a solid December PMI reading. The bottom line is that we are sticking with our view that China will experience a benign deceleration in terms of its impact on DM risk assets, but we will continue to monitor the situation closely. Mark McClellan Senior Vice President The Bank Credit Analyst January 25, 2018 Next Report: February 22, 2018 1 According to Thomson Reuters/IBES. 2 Please see U.S. Equity Sector Strategy Special Report "White Paper: Introducing Our U.S. Equity Sector Earnings Models," dated January 16, 2018, available at uses.bcaresearch.com 3 For more information, please see BCA Geopolitical Strategy Weekly Report "Upside Risks In U.S., Downside Risks In China," dated January 17, 2018, available at gps.bcaresearch.com. Also see "Watching Five Risks," dated January 24, 2018. II. The Impact Of Robots On Inflation Media reports warn of a "Robot Apocalypse" that is already laying waste to jobs and depressing wages on a broad scale. Technological advance in the past has not prevented improving living standards or led to ever rising joblessness over the decades, but pessimists argue that recent advances are different. The issue is important for financial markets. If structural factors such as automation are holding back inflation by more than in previous decades, then the Fed will have to proceed very slowly in raising rates. We see no compelling evidence that the displacement effect of emerging technologies is any stronger than in the past. Robot usage has had a modest positive impact on overall productivity. Despite this contribution, overall productivity growth has been dismal over the past decade. If automation is increasing 'exponentially' and displacing workers on a broad scale as some claim, one would expect to see accelerating productivity growth, robust capital spending and more violent shifts in occupational shares. Exactly the opposite has occurred. Periods of strong growth in automation have historically been associated with robust, not lackluster, wage gains, contrary to the consensus view. The Fed was successful in meeting the 2% inflation target on average from 2000 to 2007, when the impact of the IT revolution on productivity (and costs) was stronger than that of robot automation today. This and other evidence suggest that it is difficult to make the case that robots will make it tougher for central banks to reach their inflation goals than did previous technological breakthroughs. For investors, this means that we cannot rely on automation to keep inflation depressed irrespective of how tight labor markets become. Recent breakthroughs in technology are awe-inspiring and unsettling. These advances are viewed with great trepidation by many because of the potential to replace humans in the production process. Hype over robots is particularly shrill. Media reports warn of a "Robot Apocalypse" that is already laying waste to jobs and depressing wages on a broad scale. In the first in our series of Special Reports focusing on the structural factors that might be preventing central banks from reaching their inflation targets, we demonstrated that the impact of Amazon is overstated in the press. We estimated that E-commerce is depressing inflation in the U.S. by a mere 0.1 to 0.2 percentage points. This Special Report tackles the impact of automation. We are optimistic that robot technology and artificial intelligence will significantly boost future productivity, and thus reduce costs. But, is there any evidence at the macro level that robot usage has been more deflationary than technological breakthroughs in the past and is, thus, a major driver of the low inflation rates we observe today across the major countries? The question matters, especially for the outlook for central bank policy and the bond market. If structural factors are indeed holding back inflation by more than in previous decades, then the Fed will have to proceed very slowly in raising rates. However, if low inflation simply reflects long lags between wages and the tightening labor market, then inflation may suddenly lurch to life as it has at the end of past cycles. The bond market is not priced for that scenario. Are Robots Different? A Special Report from BCA's Technology Sector Strategy service suggested that the "robot revolution" could be as transformative as previous General Purpose Technologies (GPT), including the steam engine, electricity and the microchip.1 GPTs are technologies that radically alter the economy's production process and make a major contribution to living standards over time. The term "robot" can have different meanings. The most basic definition is "a device that automatically performs complicated and often repetitive tasks," and this encompasses a broad range of machines: From the Jacquard Loom, which was invented over 200 years ago, on to Numerically Controlled (NC) mills and lathes, pick and place machines used in the manufacture of electronics, Autonomous Vehicles (AVs), and even homicidal robots from the future such as the Terminator. Our Technology Sector report made the case that there is nothing particularly sinister about robots. They are just another chapter in a long history of automation. Nor is the displacement of workers unprecedented. The industrial revolution was about replacing human craft labor with capital (machines), which did high-volume work with better quality and productivity. This freed humans for work which had not yet been automated, along with designing, producing and maintaining the machinery. Agriculture offers a good example. This sector involved over 50% of the U.S. labor force until the late 1800s. Steam and then internal combustion-powered tractors, which can be viewed as "robotic horses," contributed to a massive rise in output-per-man hour. The number of hours worked to produce a bushel of wheat fell by almost 98% from the mid-1800s to 1955. This put a lot of farm hands out of work, but these laborers were absorbed over time in other growing areas of the economy. It is the same story for all other historical technological breakthroughs. Change is stressful for those directly affected, but rising productivity ultimately lifts average living standards. Robots will be no different. As we discuss below, however, the increasing use of robots and AI may have a deeper and longer-lasting impact on inequality. Strong Tailwinds Chart II-1Robots Are Getting Cheaper Factory robots have improved immensely due to cheaper and more capable control and vision systems. As these systems evolve, the abilities of robots to move around their environment while avoiding obstacles will improve, as will their ability to perform increasingly complex tasks. Most importantly, robots are already able to do more than just routine tasks, thus enabling them to replace or aid humans in higher-skilled processes. Robot prices are also falling fast, especially after quality-adjusting the data (Chart II-1). Units are becoming easier to install, program and operate. These trends will help to reduce the barriers-to-entry for the large, untapped, market of small and medium sized enterprises. Robots also offer the ability to do low-volume "customized" production and still keep unit costs low. In the future, self-learning robots will be able to optimize their own performance by analyzing the production of other robots around the world. Robot usage is growing quickly according to data collected by the International Federation of Robotics (IFR) that covers 23 countries. Industrial robot sales worldwide increased to almost 300,000 units in 2016, up 16% from the year before (Chart II-2). The stock of industrial robots globally has grown at an annual average pace of 10% since 2010, reaching slightly more than 1.8 million units in 2016.2 Robot usage is far from evenly distributed across industries. The automotive industry is the major consumer of industrial robots, holding 45% of the total stock in 2016 (Chart II-3). The computer & electronics industry is a distant second at 17%. Metals, chemicals and electrical/electronic appliances comprise the bulk of the remaining stock. Chart II-2Global Robot Usage Chart II-3Global Robot Usage By Industry (2016) As far as countries go, Japan has traditionally been the largest market for robots in the world. However, sales have been in a long-term downtrend and the stock of robots has recently been surpassed by China, which has ramped up robot purchases in recent years (Chart II-4). Robot density, which is the stock of robots per 10 thousand employed in manufacturing, makes it easier to compare robot usage across countries (Chart II-5, panel 2). By this measure, China is not a heavy user of robots compared to other countries. South Korea stands at the top, well above the second-place finishers (Germany and Japan). Large automobile sectors in these three countries explain their high relative robot densities. Chart II-4Stock Of Robots By Country (I) Chart II-5Stock Of Robots By Country (II) (2016) While the growth rate of robot usage is impressive, it is from a very low base (outside of the automotive industry). The average number of robots per 10,000 employees is only 74 for the 23 countries in the IFR database. Robot use is tiny compared to total man hours worked. Chart II-6U.S. Investment In Robots In the U.S., spending on robots is only about 5% of total business spending on equipment and software (Chart II-6). To put this into perspective, U.S. spending on information, communication and technology (ICT) equipment represented 35-40% of total capital equipment spending during the tech boom in the 1990s and early 2000s.3 The bottom line is that there is a lot of hype in the press, but robots are not yet widely used across countries or industries. It will be many years before business spending on robots approaches the scale of the 1990s/2000s IT boom. A Deflationary Impact? As noted above, we view robotics as another chapter in a long history of technological advancements. Pessimists suggest that the latest advances are different because they are inherently more threatening to the overall job market and wage share of total income. If the pessimists are right, what are the theoretical channels though which this would have a greater disinflationary effect relative to previous GPT technologies? Faster Productivity Gains: Enhanced productivity drives down unit labor costs, which may be passed along to other industries (as cheaper inputs) and to the end consumer. More Human Displacement: The jobs created in other areas may be insufficient to replace the jobs displaced by robots, leading to lower aggregate income and spending. The loss of income for labor will simply go to the owners of capital, but the point is that the labor share of income might decline. Deflationary pressures could build as aggregate demand falls short of supply. Even in industries that are slow to automate, just the threat of being replaced by robots may curtail wage demands. Inequality: Some have argued that rising inequality is partly because the spoils of new technologies over the past 20 years have largely gone to the owners of capital. This shift may have undermined aggregate demand because upper income households tend to have a high saving rate, thereby depressing overall aggregate demand and inflationary pressures. The human displacement effect, described above, would exacerbate the inequality effect by transferring income from labor to the owners of capital. 1. Productivity It is difficult to see the benefits of robots on productivity at the economy-wide level. Productivity growth has been abysmal across the major developed countries since the Great Recession, but the productivity slowdown was evident long before Lehman collapsed (Chart II-7). The productivity slowdown continued even as automation using robots accelerated after 2010. Chart II-7Productivity Collapsed Despite Automation Some analysts argue that lackluster productivity is simply a statistical mirage because of the difficulties in measuring output in today's economy. We will not get into the details of the mismeasurement debate here. We encourage interested clients to read a Special Report by the BCA Global Investment Strategy service entitled "Weak Productivity Growth: Don't Blame The Statisticians." 4 Our colleague Peter Berezin makes the case that the unmeasured utility accruing from free internet services is large, but so was the unmeasured utility from antibiotics, radio, indoor plumbing and air conditioning. He argues that the real reason that productivity growth has slowed is that educational attainment has decelerated and businesses have plucked many of the low-hanging fruit made possible by the IT revolution. Cyclical factors stemming from the Great Recession and financial crisis are also to blame, as capital spending has been slow to recover in most of the advanced economies. Some other factors that help to explain the decline in aggregate productivity are provided in Appendix II-1. Nonetheless, the poor aggregate productivity performance does not mean that there are no benefits to using robots. The benefits are evident at the industrial level, where measurement issues are presumably less vexing for statisticians (i.e., it is easier to measure the output of the auto industry, for example, than for the economy as a whole). Chart II-8 plots the level of robot density in 2016 with average annual productivity growth since 2004 for 10 U.S. manufacturing industries (robot density is presented in deciles). A loose positive relationship is apparent. Chart II-8U.S.: Productivity Vs. Robot Density Academic studies estimate that robots have contributed importantly to economy-wide productivity growth. The Centre for Economic and Business Research (CEBR) estimated that labor productivity growth rises by 0.07 to 0.08 percentage points for every 1% rise in the rate of robot density.5 This implies that robots accounted for roughly 10% of the productivity growth experienced since the early 1990s in the major economies. Another study of 14 industries across 17 countries by the Centre for Economic Performance (CEP) found that robots boosted annual productivity growth by 0.36 percentage points over the 1993-2007 period.6 This is impressive because, if this estimate holds true for the U.S., robots' contribution to the 2½% average annual U.S. total productivity growth over the period was 14%. To put the importance of robotics into historical context, its contribution to productivity so far is roughly on par with that of the steam engine (Chart II-9). It falls well short of the 0.6 percentage point annual productivity contribution from the IT revolution. The implication is that, while the overall productivity performance has been dismal since 2007, it would have been even worse in the absence of robots. What does this mean for inflation? According to the "cost push" model of the inflation process, an increase in productivity of 0.36% that is not accompanied by associated wage gains would reduce unit labor costs (ULC) by the same amount. This should trim inflation if the cost savings are passed on to the end consumer, although by less than 0.36% because robots can only depress variable costs, not fixed costs. There indeed appears to be a slight negative relationship between robot density and unit labor costs at the industrial level in the U.S., although the relationship is loose at best (Chart II-10). Chart II-9GPT Contribution To Productivity Chart II-10U.S.: Unit Labor Costs Vs. Robot Density In theory, divergences in productivity across industries should only generate shifts in relative prices, and "cost push" inflation dynamics should only operate in the short term. Most economists believe that inflation is a purely monetary phenomenon in the long run, which means that central banks should be able to offset positive productivity shocks by lowering interest rates enough that aggregate demand keeps up with supply. Indeed, the Fed was successful in meeting the 2% inflation target on average from 2000 to 2007, when the impact of the IT revolution on productivity (and costs) was stronger than that of robot automation today. Also, note that inflation is currently low across the major advanced economies, irrespective of the level of robot intensity (Chart II-11). From this perspective, it is hard to see that robots should take much of the credit for today's low inflation backdrop. Chart II-11Inflation Vs. Robot Density 2. Human Displacement A key question is whether robots and humans are perfect substitutes. If new technologies introduced in the past were perfect substitutes, then it would have led to massive underemployment and all of the income in the economy would eventually have migrated to the owners of capital. The fact that average real household incomes have risen over time, and that there has been no secular upward trend in unemployment rates over the centuries, means that new technologies were at least partly complementary with labor (i.e., the jobs lost as a direct result of productivity gains were more than replaced in other areas of the economy over time). Rather than replacing workers, in many cases tech made humans more productive in their jobs. Rising productivity lifted income and thereby led to the creation of new jobs in other areas. The capital that workers bring to the production process - the skills, know-how and special talents - became more valuable as interaction with technology increased. Like today, there were concerns in the 1950s and 1960s that computerization would displace many types of jobs and lead to widespread idleness and falling household income. With hindsight, there was little to worry about. Some argue that this time is different. Futurists frequently assert that the pace of innovation is not just accelerating, it is accelerating 'exponentially'. Robots can now, or will soon be able to, replace humans in tasks that require cognitive skills. This means that they will be far less complementary to humans than in the past. The displacement effect could thus be much larger, especially given the impressive advances in artificial intelligence. However, Box II-1 discusses why the threat to workers posed by AI is also heavily overblown in the media. The CEP multi-country study cited above did not find a large displacement effect; robot usage did not affect the overall number of hours worked in the 23 countries studied (although it found distributional effects - see below). In other words, rather than suppressing overall labor input, robot usage has led to more output, higher productivity, more jobs and stronger wage and income growth. A report by the Economic Policy Institute (EPI)7 takes a broader look at automation, using productivity growth and capital spending as proxies. Automation is what occurs as the implementation of new technologies is incorporated along with new capital equipment or software to replace human labor in the workplace. If automation is increasing 'exponentially' and displacing workers on a broad scale, one would expect to see accelerating productivity growth, robust capital spending, and more violent shifts in occupational shares. Exactly the opposite has occurred. Indeed, the report demonstrates that occupational employment shifts were far slower in the 2000-2015 period than in any decade in the 1900s (Chart II-12). Box II-1 The Threat From AI Is Overblown Media coverage of AI/Deep Learning has established a consensus view that we believe is well off the mark. A recent Special Report from BCA's Technology Sector Strategy service dispels the myths surrounding AI.8 We believe the consensus, in conjunction with warnings from a variety of sources, is leading to predictions, policy discussions, and even career choices based on a flawed premise. It is worth noting that the most vocal proponents of AI as a threat to jobs and even humanity are not AI experts. At the root of this consensus is the false view that emerging AI technology is anything like true intelligence. Modern AI is not remotely comparable in function to a biological brain. Scientists have a limited understanding of how brains work, and it is unlikely that a poorly understood system can be modeled on a computer. The misconception of intelligence is amplified by headlines claiming an AI "taught itself" a particular task. No AI has ever "taught itself" anything: All AI results have come about after careful programming by often PhD-level experts, who then supplied the system with vast amounts of high quality data to train it. Often these systems have been iterated a number of times and we only hear of successes, not the failures. The need for careful preparation of the AI system and the requirement for high quality data limits the applicability of AI to specific classes of problems where the application justifies the investment in development and where sufficient high-quality data exists. There may be numerous such applications but doubtless many more where AI would not be suitable. Similarly, an AI system is highly adapted to a single problem, or type of problem, and becomes less useful when its application set is expanded. In other words, unlike a human whose abilities improve as they learn more things, an AI's performance on a particular task declines as it does more things. There is a popular misconception that increased computing power will somehow lead to ever improving AI. It is the algorithm which determines the outcome, not the computer performance: Increased computing power leads to faster results, not different results. Advanced computers might lead to more advanced algorithms, but it is pointless to speculate where that may lead: A spreadsheet from 2001 may work faster today but it still gives the same answer. In any event, it is worth noting that a tool ceases to be a tool when it starts having an opinion: there is little reason to develop a machine capable of cognition even if that were possible. Chart II-12U.S. Job Rotation Has Slowed The EPI report also notes that these indicators of automation increased rapidly in the late 1990s and early 2000s, a period that saw solid wage growth for American workers. These indicators weakened in the two periods of stagnant wage growth: from 1973 to 1995 and from 2002 to the present. Thus, there is no historical correlation between increases in automation and wage stagnation. Rather than automation, the report argues that it was China's entry into the global trading system that was largely responsible for the hollowing out of the U.S. manufacturing sector. We have also made this argument in previous research. The fact that the major advanced economies are all at, or close to, full employment supports the view that automation has not been an overwhelming headwind for job creation. Chart II-13 demonstrates that there has been no relationship between the change in robot density and the loss of manufacturing jobs since 1993. Japan is an interesting case study because it is on the leading edge of the problems associated with an aging population. Interestingly, despite a worsening labor shortage, robot density among Japanese firms is falling. Moreover, the Japanese data show that the industries that have a high robot usage tend to be more, not less, generous with wages than the robot laggard industries. Please see Appendix II-2 for more details. Chart II-13Global Manufacturing Jobs Vs. Robot Density The bottom line is that it does not appear that labor displacement related to automation has been responsible in any meaningful way for the lackluster average real income growth in the advanced economies since 2007. 3. Inequality That said, there is evidence suggesting that robots are having important distributional effects. The CEP study found that robot use has reduced hours for low-skilled and (to a lesser extent) middle-skilled workers relative to the highly skilled. This finding makes sense conceptually. Technological change can exacerbate inequality by either increasing the relative demand for skilled over unskilled workers (so-called "skill-biased" technological change), or by inducing companies to substitute machinery and other forms of physical capital for workers (so-called "capital-biased" technological change). The former affects the distribution of labor income, while the latter affects the share of income in GDP that labor receives. A Special Report appearing in this publication in 2014 focused on the relationship between technology and inequality.9 The report highlighted that much of the recent technological change has been skill-biased, which heavily favors workers with the talent and education to perform cognitively-demanding tasks, even as it reduces demand for workers with only rudimentary skills. Moreover, technological innovations and globalization increasingly allow the most talented individuals to market their skills to a much larger audience, thus bidding up their wages. The evidence suggests that faster productivity growth leads to higher average real wages and improved living standards, at least over reasonably long horizons. Nonetheless, technological change can, and in the future almost certainly will, increase income inequality. The poor will gain, but not as much as the rich. The fact that higher-income households tend to maintain a higher savings rate than low-income households means that the shift in the distribution of income toward the higher-income households will continue to modestly weigh on aggregate demand. Can the distribution effect be large enough to have a meaningful depressing impact on inflation? We believe that it has played some role in the lackluster recovery since the Great Recession, with the result that an extended period of underemployment has delivered a persistent deflationary impulse in the major developed economies. However, as discussed above, stimulative monetary policy has managed to overcome the impact of inequality and other headwinds on aggregate demand, and has returned the major countries roughly to full employment. Indeed, this year will be the first since 2007 that the G20 economies as a group will be operating slightly above a full employment level. Inflation should respond to excess demand conditions, irrespective of any ongoing demand headwind stemming from inequality. Conclusions Technological change has led to rising living standards over the decades. It did not lead to widespread joblessness and did not prevent central banks from meeting their inflation targets over time. The pessimists argue that this time is different because robots/AI have a much larger displacement effect. Perhaps it will be 20 years before we will know the answer. But our main point is that we have found no evidence that recent advances in robotics and AI, while very impressive, will be any different in their macro impact. There is little evidence that the modern economy is less capable in replacing the jobs lost to automation, although the nature of new technologies may be affecting the distribution of income more than in the past. Real incomes for the middle- and lower-income classes have been stagnant for some time, but this is partly due to productivity growth that is too low, not too high. Moreover, it is not at all clear that positive productivity shocks are disinflationary beyond the near term. The link between robot usage and unit labor costs over the past couple of decades is loose at best at the industry level, and is non-existent when looking across the major countries. The Fed was able to roughly meet its 2% inflation target in the 1990s and the first half of the 2000s, despite IT's impressive contribution to productivity growth during that period. For investors, this means that we cannot rely on automation to keep inflation depressed irrespective of how tight labor markets become. The global output gap will shift into positive territory this year for the first time since the Great Recession. Any resulting rise in inflation will come as a shock since the bond market has discounted continued low inflation for as far as the eye can see. We expect bond yields and implied volatility to rise this year, which may undermine risk assets in the second half. Mark McClellan Senior Vice President The Bank Credit Analyst Brian Piccioni Vice President Technology Sector Strategy Appendix II-1 Why Is Productivity So Low? A recent study by the OECD10 reveals that, while frontier firms are charging ahead, there is a widening gap between these firms and the laggards. The study analyzed firm-level data on labor productivity and total factor productivity for 24 countries. "Frontier" firms are defined to be those with productivity in the top 5%. These firms are 3-4 times as productive as the remaining 95%. The authors argue that the underlying cause of this yawning gap is that the diffusion rate of new technologies from the frontier firms to the laggards has slowed within industries. This could be due to rising barriers to entry, which has reduced contestability in markets. Curtailing the creative-destruction process means that there is less pressure to innovate. Barriers to entry may have increased because "...the importance of tacit knowledge as a source of competitive advantage for frontier firms may have risen if increasingly complex technologies were to increase the amount and sophistication of complementary investments required for technological adoption." 11 The bottom line is that aggregate productivity is low because the robust productivity gains for the tech-savvy frontier companies are offset by the long tail of firms that have been slow to adopt the latest technology. Indeed, business spending has been especially weak in this expansion. Chart II-14 highlights that the slowdown in U.S. productivity growth has mirrored that of the capital stock. Chart II-14U.S. Capex Shortfall Partly To Blame For Poor Productivity Appendix II-2 Japan - The Leading Edge Japan is an interesting case study because it is on the leading edge of the problems associated with an aging population. The popular press is full of stories of how robots are taking over. If the stories are to be believed, robots are the answer to the country's shrinking workforce. Robots now serve as helpers for the elderly, priests for weddings and funerals, concierges for hotels and even sexual partners (don't ask). Prime Minister Abe's government has launched a 5-year push to deepen the use of intelligent machines in manufacturing, supply chains, construction and health care. Indeed, Japan was the leader in robotics use for decades. Nonetheless, despite all the hype, Japan's stock of industrial robots has actually been eroding since the late 1990s (Chart II-4). Numerous surveys show that firms plan to use robots more in the future because of the difficulty in hiring humans. And there is huge potential: 90% of Japanese firms are small- and medium-sized (SME) and most are not currently using robots. Yet, there has been no wave of robot purchases as of 2016. One problem is the cost; most sophisticated robots are simply too expensive for SMEs to consider. This suggests that one cannot blame robots for Japan's lack of wage growth. The labor shortage has become so acute that there are examples of companies that have turned down sales due to insufficient manpower. Possible reasons why these companies do not offer higher wages to entice workers are beyond the scope of this report. But the fact that the stock of robots has been in decline since the late 1990s does not support the view that Japanese firms are using automation on a broad scale to avoid handing out pay hikes. Indeed, Chart II-15 highlights that wage deflation has been the greatest in industries that use almost no robots. Highly automated industries, such as Transportation Equipment and Electronics, have been among the most generous. This supports the view that the productivity afforded by increased robot usage encourages firms to pay their workers more. Looking ahead, it seems implausible that robots can replace all the retiring Japanese workers in the years to come. The workforce will shrink at an annual average pace of 0.33% between 2020 and 2030, according to the Japan Institute for Labour Policy and Training. Productivity growth would have to rise by the same amount to fully offset the dwindling number of workers. But that would require a surge in robot density of 4.1, assuming that each rise in robot density of one adds 0.08% to the level of productivity (Chart II-16). The level of robot sales would have to jump by a whopping 2½ times in the first year and continue to rise at the same pace each year thereafter to make this happen. Of course, the productivity afforded by new robots may accelerate in the coming years, but the point is that robot usage would likely have to rise astronomically to offset the impact of the shrinking population. Chart II-15Japan: Earnings Vs. Robot Density Chart II-16Japan: Where Is The Flood Of Robots? The implication is that, as long as the Japanese economy continues to grow above roughly 1%, the labor market will continue to tighten and wage rates will eventually begin to rise. 1 Please see Technology Sector Strategy Special Report "The Coming Robotics Revolution," dated May 16, 2017, available at tech.bcaresearch.com 2 Note that this includes only robots used in manufacturing industry, and thus excludes robots used in the service sector and households. However, robot usage in services is quite limited and those used in households do not add to GDP. 3 Note that ICT investment and capital stock data includes robots. 4 Please see BCA Global Investment Strategy Special Report "Weak Productivity Growth: Don't Blame The Statisticians," dated March 25, 2016, available at gis.bcaresearch.com 5 Centre for Economic and Business Research (January 2017): "The Impact of Automation." A Report for Redwood. In this report, robot density is defined to be the number of robots per million hours worked. 6 Graetz, G., and Michaels, G. (2015): "Robots At Work." CEP Discussion Paper No 1335. 7 Mishel, L., and Bivens, J. (2017): "The Zombie Robot Argument Lurches On," Economic Policy Institute. 8 Please see BCA Technology Sector Strategy Special Report "Bad Information - Why Misreporting Deep Learning Advances Is A Problem," dated January 9, 2018, available at tech.bcaresearch.com 9 Please see The Bank Credit Analyst, "Rage Against The Machines: Is Technology Exacerbating Inequality?" dated June 2014, available at bca.bcaresearch.com 10 OECD Productivity Working Papers, No. 05 (2016): "The Best Versus the Rest: The Global Productivity Slowdown, Divergence Across Firms and the Role of Public Policy." 11 Please refer to page 27. III. Indicators And Reference Charts As we highlight in the Overview section, the earnings backdrop for the U.S. equity market remains very upbeat, as highlighted by the rise in the net earnings revisions and net earnings surprises indexes. Bottom-up analysts will likely continue to boost after-tax earnings estimates for the year as they adjust to the U.S. tax cut news. Our main concern is that a lot of good news is now discounted. Our Technical Indicator remains bullish, but our composite valuation indicator surpassed one sigma in January, which is our threshold of overvaluation. From these levels of overvaluation, the medium-term outlook for equity total returns is negligible. Our speculation index is at all-time highs and implied volatility is low, underscoring that investors are extremely bullish. From a contrary perspective, this is a warning sign for the equity market. Our Monetary Indicator has also moved further into 'bearish' territory for equities, although overall financial conditions remain positive for growth. It is also disconcerting that our Revealed Preference Indicator (RPI) shifted to a 'sell' signal for stocks, following five straight months on a 'buy' signal. This occurred because investors may be buying based on speculation rather than on a firm belief in the staying power of the underlying fundamentals. For now, though, our Willingness-to-Pay indicator for the U.S. rose sharply in January, highlighting that investor equity inflows are very strong and are favoring U.S. equities relative to Japan and the Eurozone. This is perhaps not surprising given the U.S. tax cuts just passed by Congress. The RPI indicators track flows, and thus provide information on what investors are actually doing, as opposed to sentiment indexes that track how investors are feeling. Our U.S. bond technical indicator shows that Treasurys are close to oversold territory, suggesting that we may be in store for a consolidation period following January's surge in yields. Treasurys are slightly cheap on our valuation metric, although not by enough to justify closing short duration positions. The U.S. dollar is oversold and due for a bounce. EQUITIES: Chart III-1U.S. Equity Indicators Chart III-2Willingness To Pay For Risk Chart III-3U.S. Equity Sentiment Indicators Chart III-4Revealed Preference Indicator Chart III-5U.S. Stock Market Valuation Chart III-6U.S. Earnings Chart III-7Global Stock Market And Earnings: ##br##Relative Performance Chart III-8Global Stock Market And Earnings: ##br##Relative Performance FIXED INCOME: Chart III-9U.S. Treasurys And Valuations Chart III-10U.S. Treasury Indicators Chart III-11Selected U.S. Bond Yields Chart III-1210-Year Treasury Yield ComponentsChart III-13U.S. Corporate Bonds And Health Monitor Chart III-14Global Bonds: Developed Markets Chart III-15Global Bonds: Emerging Markets CURRENCIES: Chart III-16U.S. Dollar And PPP Chart III-17U.S. Dollar And Indicator Chart III-18U.S. Dollar Fundamentals Chart III-19Japanese Yen Technicals Chart III-20Euro Technicals Chart III-21Euro/Yen Technicals Chart III-22Euro/Pound Technicals COMMODITIES: Chart III-23Broad Commodity Indicators Chart III-24Commodity Prices Chart III-25Commodity Prices Chart III-26Commodity Sentiment Chart III-27Speculative Positioning ECONOMY: Chart III-28U.S. And Global Macro Backdrop Chart III-29U.S. Macro Snapshot Chart III-30U.S. Growth Outlook Chart III-31U.S. Cyclical Spending Chart III-32U.S. Labor Market Chart III-33U.S. Consumption Chart III-34U.S. Housing Chart III-35U.S. Debt And Deleveraging Chart III-36U.S. Financial Conditions Chart III-37Global Economic Snapshot: Europe Chart III-38Global Economic Snapshot: China Mark McClellan Senior Vice President The Bank Credit Analyst

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

特別レポート

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.

ハイライト コンセンサスは2017年第4四半期の1株当たり利益（EPS）が前年同期比で12%の増加、2018年は14%を見込んでいる。税制改正法案が2018年の営業環境に与える影響は、2017年第4四半期の決算を議論する際に企業経営陣や投資家の注目点となるだろう。 12月の小売売上高とコアCPIの数値は、FRBの3月利上げの理論を後押ししている。 我々は来たる2月のFOMC議長交代は円滑に進むと予想しており、それは金融政策の段階的正常化を確実にするだろう。ただし、連邦準備制度理事会（FRB）の空席、タカ派/ハト派のシフトおよび反対票は懸念事項である。 特集 米国株式は先週も上昇を続け、投資家は世界成長と2018年のS&P 500収益に対する期待を切り上げた。本レポートの次節では2017年第4四半期の決算シーズンのプレビューを提供する。12月のコアCPIが前年比で予想より強い1.8%上昇したことから、インフレの気配も見られた。多くのFRB関係者の発言が相次いだが、市場の見方──次回の利上げは3月会合で行われる──を変えるほどではなかった。今週のレポートの最終節ではFOMCの構成について論じる。10年物米国債利回りは約10ベーシスポイント上昇し、週末は2.56%で終えた。BCAの米国ボンド・ストラテジストは10年物の公正価値を2.94%と見積もっている。1 さらに、2年物米国債利回りは先週金曜日に2008年以来初めて2%に到達した。 S&P 500の業績：2017年第4四半期 コンセンサスは2017年第4四半期のEPSが2016年第4四半期比で12%増加、2018年は15%増を見込んでいる。エネルギー、資本財・素材、そしてテクノロジー株が収益成長を牽引する一方、通信および不動産セクターの収益は伸び悩むだろう。エネルギーセクターを除くと、コンセンサスは2017年第4四半期のEPSが前年比で10%上昇すると見ている。 過去四半期と2018年に関する楽観的な利益見通しは、原油価格の回復を反映しており、原油高は2017年第4四半期のエネルギーセクターEPSを印象的な138%押し上げると予想される（チャート1）。エネルギー関連の設備投資とS&P 500全体の収益は密接に関連している（チャート1、パネル2）。世界成長環境の改善と抑制された労働コストは、2017年第4四半期および2018年初めに利益率のカウンタ―サイクリカルな上昇を引き続き促した。さらに、昨年末に成立したTax Cut and Jobs Act of 2017の直接的効果は、2018年の米国実質GDP成長率を0.2〜0.3ポイント押し上げる可能性が高い。ハリケーン復興支出と連邦裁量的支出の上限引き上げに関する議会の合意が得られれば、今年の成長率にさらに0.2ポイント程度上乗せされる可能性がある。しかし、税制変更や即時の資本償却が企業部門のセンチメントをさらに高め、投資支出を前倒しさせる能力に大きく依存する。 税制改正法案が2018年の営業環境に与える影響は、2017年第4四半期の決算を議論する際に企業経営陣や投資家の関心事となるだろう。具体的には、企業が低い税率の恩恵や海外からの資金還流を通じて現金をどのように活用するかが前面に出るだろう。チャート2は2017年第3四半期までのデータで、株式買戻しと配当が過去の景気循環をやや上回る一方、設備投資はほぼ平均的であったことを示している。BCAはこのミックスを引き続き注視する。欧州と新興市場（EM）での経済状況の改善、米ドル、マージンの持続可能性、そしてハリケーン・ハーベイやイルマの影響は、決算説明会で厳しく検証されるだろう。 Chart 1 S&P 500 Sensitive To Oil Prices##BR##And Oil Driven Capex S&P 500は原油価格および原油主導の設備投資に敏感 S&P 500は原油価格および原油主導の設備投資に敏感 Chart 2 Comparison Of Corporate Outlays##BR##Across Four Economic Expansion Phases 円滑な移行？ 円滑な移行？ アナリストはまた、金利上昇とイールドカーブの形状にも注目するだろう。1月12日に10年物米国債利回りは3月以来の高水準となる2.56%に達した。さらに、2017年第4四半期の10年物利回りは第3四半期比で16ベーシスポイント高く、2016年第4四半期比では26ベーシスポイント高かった。BCAは2年物と10年物のイールドカーブが今後6か月で急勾配化（steepen）し、その後年後半にフラット化すると予想している。カーブと上昇する金利はS&P 500の金融セクターに追い風を与える。BCAのU.S. エクイティ・ストラテジーチームは2017年5月以来、金融セクターをオーバーウェイトで継続している。2 いつものように、2018年第1四半期以降のトレンドに関する経営陣のガイダンスは、実際の第4四半期結果よりも重要である（チャート3）。投資家は経営陣の過度な楽観に警戒すべきだ。というのも収益成長の予想は時間とともに下方修正されることが多いからである。 2017年第4四半期も2017年前3四半期と同様に、海外売上が高い企業は欧州、日本および新興市場での成長改善の恩恵を受けるはずだ。チャート4は高いISM数値が2018年の収益と売上にとって好ましい背景を提供していることを示している。さらに、チャート5はS&P 500の売上の代替指標である鉱工業生産（IP）が2018年に加速し企業収益を押し上げる態勢にあることを示している。今年および来年の世界GDP成長予測は着実に上向いており、過去に予想が容赦なく下方修正され続けた年とは対照的である（チャート6）。 Chart 3 2018 Estimates Turned Higher After Tax Law Passed; '19 Likely To Move Lower 税制改正法が可決された後、2018年の見積もりは上方に転じた；2019年は下方に動く可能性が高い。 税制改正法が可決された後、2018年の見積もりは上方に転じた；2019年は下方に動く可能性が高い。 Chart 4 Favorable Macro Backdrop For Earnings And Sales 利益および売上高にとって好ましいマクロ環境 利益および売上高にとって好ましいマクロ環境 加えて、BCAのU.S. エクイティ・ストラテジーサービスは3、2015年の谷の後、売上高のポジティブな改定数が収益のポジティブ改定数を着実に上回っていることを指摘している。これは実際の収益成長が売上成長を大きく上回っているにもかかわらず起きている現象である。最近の売上高に対する非常にポジティブな改定の一因として、企業が税制改革の最大の恩恵を受けるために一部の利益を2017年から2018年に移している可能性が考えられる。 Chart 5 ISM Components Suggest IP##BR##Poised To Accelerate ISMの構成要素は鉱工業生産（IP）の加速を示唆 ISMの構成要素は鉱工業生産（IP）の加速を示唆 Chart 6 Global Growth Estimates##BR##Still Accelerating 世界の成長見通しはなお加速している 世界の成長見通しはなお加速している 米ドルは最近数四半期ではEPSに対して小幅な悪影響にとどまってきたが、第4四半期はややプラスに転じる見込みだ。米ドルは広範な通貨バスケットに対して1年前より3%下落している。さらに、最新のベージュブック（11月29日）では「強いドル」に関する言及が1年前と比べて8件減少した。これは強い通貨がここ数か月で経営陣の主要な懸念事項として薄れてきたことを示している（チャート7）。 それでもBCAの見解は、米ドルは今後12か月で5%上昇するとしている。ドル高はEPS成長を概ね1〜2ポイント押し下げるが、その大部分はラグのため来年に生じるだろう。単独でのドル上昇は株式市場にとって大きな逆風にはならないはずだ。実際にドルが上昇するのは、米国の堅調な経済成長と企業の売上拡大という文脈においてのみである。米国におけるインフラ投資パッケージの立法進展や米国の企業設備投資の改善は、ドルの見通しを高めるだろう。 昨秋の大規模ハリケーンが第4四半期の決算に与える影響は、S&P 500およびほとんどのセクターにとって限定的だろう。天候に敏感な複数の産業（保険、航空、化学、精製、レジャー等）は第3四半期の結果に大きな混乱を受けた。これらの産業は第4四半期にいくばくかの反動増が見られる可能性が高い。 投資家は2017年第4四半期にマージンが6四半期連続で改善することに懐疑的だ。BCAの見解では、我々はマージンにとって一時的な「甘いスポット」にあり、これは今後数四半期続くはずだが、賃金上昇圧力が表面化するにつれてその後はマージンの長期的な平均回帰が再開するだろう。 結論として、我々は2017年第4四半期および2018年初頭にかけて収益環境は株価を下支えすると予想する。その先では、EPS成長は2018年後半に減速を始め、2019年に入ると株価にとってより逆風となるだろう（チャート8）。株式を債券に対してオーバーウェイトのまま維持せよ。 Chart 7 The Dollar Should Not Be##BR##A Factor In Q4 Earnings Season 第4四半期の決算シーズンにおいて、ドルは要因とならないはずだ 第4四半期の決算シーズンにおいて、ドルは要因とならないはずだ Chart 8 Strong S&P Growth Ahead,##BR##Will Start To Slow Soon S&Pは今後強い成長が見込まれるが、まもなく減速し始めるだろう S&Pは今後強い成長が見込まれるが、まもなく減速し始めるだろう FRB議長交代：順風満帆か？ Chart 9 December's CPI Data Will Be Met##BR##With A Sigh Of Relief From The Fed 12月のCPIデータはFRBに安堵のため息をもたらすだろう 12月のCPIデータはFRBに安堵のため息をもたらすだろう 11月の月次で0.1%と期待外れだった伸びの後、12月のコアCPIは月次で0.3%の反発を示した（チャート9）。歓迎すべきニュースだが、いくつか留意点がある。第一に、伸びは住宅と医療ケアの2つのサブコンポーネントに集中していた。住宅はコアCPIの40%以上を占め、我々のモデルは今後の緩和を示唆している。第二に、コアサービス（住居と医療を除く）インフレは依然として2%未満と弱く、コア財の価格はなおデフレ傾向にある。第三に、年率のコアインフレ率はわずか1.8%である。コアCPIの2.4〜2.5%はコアPCEデフレーターに対するFRBの2%目標と整合的である。 12月の小売売上高のリポートは、2018年末時点での景気の明るいトーンを補強した。アトランタ連銀のGDPNowによる2017年第4四半期の推定は1月12日時点で3.3%と、1月5日の2.7%から上方修正された。 米国のインフレは年末までに徐々に目標に戻るはずである。米国のフィクスト・インカム・ポートフォリオでは、投資家はベンチマークを下回るデュレーションを維持し、名目国債に対してTIPSをオーバーウェイトにすべきだ。インフレ・ブレークイーブンの上昇はイールドカーブをスティーピングさせるバイアスも生むだろう。コアCPIの反発は確かに心強いが、FRBがインフレが本当に目標に向かっていると一層自信を持つには、さらに確かな数値が必要だ。3月のFOMC会合までにあと2件のCPI公表があるため、FRBはその時までに利上げを決断するための証拠を得るかもしれない。 我々は来たる2月のFOMC議長就任に関して、パウエル氏への移行は円滑に進むと予想しており、それにより金融政策の段階的正常化が確実となるだろう。パウエル氏はFF金利を推定の終点である2.75%に徐々に近づける過程で波風を立てたくないはずだ。4 我々がFOMC指導部の移行が円滑に行われると断言する理由はいくつかある： FRB議長の前例：過去のFOMC指導部交代において、平均すると金融政策の軌道は約13か月間継続してから方向転換した（チャート10）。例えば、グリーンスパン退任（2006年2月）の後、バーナンキ前議長はさらに4回の利上げを続け、引き締めサイクルは2006年6月にピークに達した。イエレン前議長は2014年初めにバーナンキが去った後、ほぼ2年間ゼロ金利政策（ZIRP）を維持した。グリーンスパン議長はボルカーが始めた引き締めの軌道を維持したが、1987年の株式市場クラッシュ後にクレジットクランチを回避するため一時的に中断した。その後グリーンスパン議長は1年以上にわたり利上げを再開した。コンフォーミングな中道派として知られるパウエル議長も先人の流れに従うだろう。米国の金融政策は、世界成長に対する予期せぬショックやインフレの想定外の軌道の逸脱がない限り、イエレン前議長の政策から大きく変わらないだろう。 Chart 10 Fed Chair Precedents: Continuous Monetary Policy Path FRB議長の先例：継続的な金融政策の道筋 FRB議長の先例：継続的な金融政策の道筋 FOMCの構成変化：地域連銀総裁のローテーションに伴い、毎年FOMCの投票メンバーは異なる顔ぶれになる。今年は複数の地域総裁の退任と理事会の空席で不確実性が高まっている。2018年の投票FOMCメンバーの構成は2017年に比べややタカ寄りになるだろう（チャート11）。金融政策の連続性と有効性は、先物市場で既に織り込まれている今後の追加利上げ（少なくとも2回）や2018年に期待されるさらに3回の利上げ見込みによりさらに促進されるだろう。ミネアポリス連銀総裁カシュカリとシカゴ連銀総裁エバンスは今年、投票権のないメンバーとして退任する。カシュカリは最もハト派と見なされ、2020年に投票権を持つメンバーとして戻る予定であり、エバンスは2019年に復帰するだろう。 Chart 11 Composition Of Voting FOMC Members 2017 Vs. 2018 円滑な移行？ 円滑な移行？ 対照的に、クリーブランドのメスター、サンフランシスコのウィリアムズ、リッチモンドのバーキンの到着は政策をややタイト寄りに傾ける。最も重要なのは、ニューヨーク連銀のダドリー（中道派）がイエレンの任期が来月満了してから約5か月後に退任することである。オバマ政権時代に任命された理事のレール・ブレイナードは、現存する2人のハト派のうち最もハト派の投票者として残るだろう。FOMCのタカ派寄りの傾向はもはや認識の問題ではなく現実のものになる。トランプ大統領によるマーウィン・グッドフレンドの理事指名は中立化に向けた動きを促すはずだ（グッドフレンドは必ずしも明確なタカ派ではなく、デフレ対策にも慎重である）とともに、2018年に少なくとも4人の理事でFRBが運営されることを確実にするだろう。グッドフレンドの承認が成功すれば、副議長と残る2名の理事の合計3つの空席だけが残ることになる。限界的には、2018年のFOMC投票メンバーは若干タカ派寄りに傾くが、歴史は新議長が急激な政策転換よりも段階的な移行を好むことを示唆している。 FRBの空席：理事会の3つの未埋めの空席は、来月のイエレンからパウエルへの円滑な指導権移行を妨げるべきではない。近年、FRBの空席の継続期間は過去の年と比べて長くなっている。超党派政策センターの最近の報告によれば5、長期にわたる空席は13の独立金融規制機関の中でFRBに最も顕著に見られる。1986年以降のFRBの空席率67%は、1947年〜1986年の21%を大きく上回っている（チャート12）。同センターはまた、2000年1月1日以降、連邦準備理事会に少なくとも1つの空席がある期間が80%以上であったと計算しており、「満員のFRB理事会はかつての空席ほど珍しい」という点を強調している。FOMCは1947年〜1986年の間は大部分（79%）で満員であったが、過去30年ではその割合は3分の1（33%）に過ぎなかった（チャート13）。したがって、FOMC構成の構造的変化でさえ、2015年12月のゼロ金利政策からの離陸（2006年6月以来の初の利上げ）や昨年9月のFRBバランスシート正常化の開始を妨げることはなかった。投資家への示唆は、FOMCはかなり前から高い空席率の下で運営しており、そのような状況に慣れているため、空席は今年のFRBの政策軌道やイエレンからパウエルへの移行において大きな役割を果たすべきではないということである。 Chart 12 Vacancies Are Now The Norm スムーズな移行？ スムーズな移行？ Chart 13 More Than One Vacancy Is Not Uncommon Too スムーズな移行ですか？ スムーズな移行ですか？ FOMCにおける反対意見：FRB理事会の定員未満であっても、2005年以降理事による反対はなかった（チャート14）。我々は過去のサイクルと同程度の頻度の反対があると予想している。2017年の4件の反対はいずれも地域連銀総裁によるものであった。イエレン議長は理事会のメンバー時代にも、サンフランシスコ連銀総裁時代にも意見の不一致を表明したことはない。注目すべきは、パウエル次期議長は2012年に理事会に加わって以来、反対票を投じたことがないことである。さらに、理事会メンバーによる反対表明は通常より緩和的な政策を求めるものであった（78%が緩和志向で、28%が引き締め志向）。例えば、2015年秋のサイクル最初の利上げ前に、2人のハト派のFRB理事がイエレン議長に反対した。ブレイナード理事とタルーロ理事は、インフレが依然として低すぎると考え、利上げを2016年に先送りすべきだと主張した。彼らは先行きリスクが下振れ要因として残るため、早まって行動するより「待って様子を見る」方がリスクが低いと考えた。この意見の相違の一因は、市場ベースのインフレ期待に関する見解の相違にあった。原油価格と密接に関連して、市場ベースの長期インフレ期待は低下していた。同様に2017年にはミネアポリス連銀総裁カシュカリとシカゴ連銀総裁エバンスが懸念を示して意見を異にした。彼らは、低インフレの持続がFOMCが述べたような純粋に「一時的な要因」によるものとは限らないと主張した。 Chart 14 Dissent By Reserve Bank Presidents And Fed Governors スムーズな移行？ スムーズな移行？ 結論：2018年にFRB政策に最も重大な影響を与えるのは、FRBの構成ではなく経済とインフレの軌跡だ。2017年12月のFOMC会合ではインフレや名目GDPターゲティングの採用を検討する支持が一部にあったが、FRBは現行の政策にコミットし続けるだろう。一方、パウエル新議長は前任者と同様に利上げに対して段階的なアプローチを維持する可能性が高いが、FOMC投票メンバーの構成はわずかにタカ寄りである。2018年初めの理事会の空席はリスクではあるが、過去の空席が劇的な政策変更を引き起こしたことはない。BCAは今年3〜4回の利上げを予想しているが、ポートフォリオのリスクを軽減するにはまだ時期尚早である。株式を債券に対してオーバーウェイトで維持せよ。 John Canally, CFA, シニア・バイス・プレジデント 米国インベストメント・ストラテジー johnc@bcaresearch.com Jizel Georges, シニア・アナリスト jizelg@bcaresearch.com 1 BCAリサーチのU.S. ボンド・ストラテジー ウィークリー・レポート「January Effect」、2018年1月9日掲載を参照のこと。usbs.bcaresearch.comで入手可能。 2 BCAリサーチのU.S. エクイティ・ストラテジー ウィークリー・レポート「Girding For A Breakout」、2017年5月1日掲載を参照のこと。uses.bcaresearch.comで入手可能。 3 BCAリサーチのU.S. エクイティ・ストラテジー インサイト「What's Up With SPX Revenue Vs. Profit Revisions」、2018年1月12日掲載を参照のこと。uses.bcaresearch.comで入手可能。 4 https://www.federalreserve.gov/monetarypolicy/files/fomcprojtabl20171213.pdf 5 "Financial Regulators Struggling With Longer Vacancies At The Top", Schardin, Justin and Sheth, Ashmi, Bipartisan Policy Center, March 2017.

Highlights The BCA earnings model shows that S&P 500 EPS growth is peaking and should decelerate through 2018. Synchronous global growth remains in place in 2017 and will persist into 2018, providing a tailwind for U.S. growth, equity markets and, ultimately, inflation. The labor market continues to tighten, which suggests that wage pressures should accelerate soon. Is another "Great Moderation" at hand? Feature Uncertainty around the GOP tax plan led to a weaker dollar last week, but U.S. equities and Treasuries were little changed. The tax plan could fail if enough Republican voters turn against it. BCA's Geopolitical Strategy team notes1 that as long as President Trump remains more popular with Republican voters than his Republican peers in Congress, he will be able to force the tax plan through both the Senate and the House. Moreover, we could even see some Democrats in the Senate supporting these tax changes. Ahead of the OPEC meeting on November 30, the weaker dollar along with the ongoing political turmoil boosted oil prices. Closer to home, corporate profits for Q3 2017 and guidance for Q4 2017 and beyond remains supportive for risk assets, although BCA expects S&P 500 earnings growth to peak in the next couple of quarters on a 4-quarter moving average basis. Global growth remains supportive for S&P 500, U.S. economic growth, and ultimately, higher inflation. Meanwhile, investors are still asking when price and wage inflation will turn higher toward the Fed's 2% forecast. BCA's answer: Be patient. In the final section of this week's report, we examine whether the recent period of low economic and financial market volatility will persist and herald a return to the Great Moderation. Q3 Earnings Season: Margins Still Expanding EPS and sales growth in Q3 ran well ahead of consensus expectations as forecasted in our October 2 preview. Moreover, the counter-trend rally in profit margins is still in place. Over 90% of companies have reported results so far, with 72% beating consensus EPS projections, just above the long-term average of 69%. Furthermore, 67% have posted Q3 revenues that topped expectations, which exceeded the long-term average of 55%. The surprise factor for year-over-year results in Q3 stands at 5% for EPS and 1% for sales. These compare favorably with the average EPS (4%) and sales (1%) in the past five years. We anticipate the secular mean-reversion of margins to re-assert itself in the S&P data, perhaps beginning early in 2018. Margins tend to peak halfway through late-cycle periods.2 Nonetheless, the results imply that Q3 will be another quarter of margin expansion. Earnings growth (Q3 2017 versus Q3 2016) is solid at 8%, and in revenues, 5%. Strength in earnings and revenues is broad based (Table 1). Earnings per share increased in Q3 2017 versus Q3 2016 in 8 of the 11 sectors. The 7.3% year-over-year drop in the financial sector is attributed to the impact of the hurricanes on the insurance and reinsurance industries. Excluding those industries, financial EPS is up by 6% from a year ago. EPS results are particularly impressive in energy (162%), and strong in technology (24%), healthcare (8%), and materials (7%). These sectors likewise experienced significant sales gains (17%, 10%, 4%, and 9%, respectively). Corporate managements are more focused on the message in Washington than on the President (Chart 1). Trump's name was mentioned only twice in the Q3 earnings calls held through November 10, doubling the total in Q2. CEOs and CFOs have cited Trump's name at least once in each earnings season since Q2 2016. The zenith in mentions occurred immediately after Trump took office in early 2017. Table 1S&P 500:##BR##Q3 2017 Results* Chart 1Managements Focused On The Message##BR##Not The Man In DC In contrast, "tax" and "reform" have appeared 13 times so far in Q3 conference calls, most often in a positive light. There were only five mentions in Q2 when investors were skeptical that a tax plan would pass this year. In the Q4 2016 reporting season following the November election, tax and reform were cited 16 times. BCA's Geopolitical Strategy service has consistently expected a tax package to pass by the end of Q1 2018.3 We are encouraged by the upward trajectory of EPS estimates for 2017 and 2018 (Chart 2). It is odd that the recent downtick in 2017 EPS is mirrored by an uptick in the 2018 projection. The divergence can be explained by the effect of the hurricanes on the financial sector's earnings in 2017 and the probable snapback in early 2018. Analysts expect 2019 EPS growth to slow from the anticipated 2018 clip, which matches BCA's view. However, unlike estimates for 2017 and 2018, we anticipate that EPS estimates for 2019 will move lower throughout 2018 and 2019, ahead of a recession in late 2019.4 Bottom Line: The BCA earnings model shows that S&P 500 EPS growth is peaking and should decelerate through 2018 to a level commensurate with 3 ½-4% nominal GDP growth (Chart 3). Margins will crest in 2018. Accordingly, BCA believes that the earnings backdrop will remain a tailwind for the equity market, albeit a smaller tailwind. This forecast excludes any encouraging effect on growth from tax cuts, which would be positive for EPS and the S&P 500 price index in the short term, but would bring forward Fed rate hikes. BCA expects growth outside the U.S. to remain robust, an additional support for EPS growth in the coming quarters. Chart 2Stability In '17 & '18 EPS Estimates, But '19 Likely To Move Lower Chart 3Strong EPS Growth Ahead,##BR##Will Start To Slow Soon Global Growth Update Synchronous global growth remains in place in 2017 and will persist into 2018,5 providing a tailwind for U.S. growth, equity markets and, ultimately, inflation. Global real GDP estimates continue to move higher, a welcome departure from the past when estimates slid relentlessly lower (Chart 4). Since the start of 2017, GDP estimates for this year have increased from 2.6% to 3.2%, while 2018 forecasts have accelerated from 2.8% to 3%. The 2019 growth projection is steady at 2.9%. This upward trajectory for 2017 and 2018 has occurred despite a recalibration by many major central banks away from accommodative policies. The improving growth forecasts could be short-circuited by aggressive central bank actions, a worldwide trade war, or escalating tensions in Northeast Asia (or a combination of all three). Falling oil prices would also challenge a quickening of world growth, but BCA's stance is that oil prices will move up significantly in the coming year.6 Chart 4Global Growth Estimates Accelerating Global leading indicators are on the upswing. The most recent update of our Global Leading Indicator (excluding the U.S.) was the strongest since 2010 when it slowed after a sharp rebound from the 2007-2009 financial crisis. Moreover, the global LEI diffusion index turned positive after a worrisome dip below 50% earlier this year. It will be a warning sign for wide-reaching growth if the diffusion index moves back below 50% (Chart 5). Industrial production (IP) overseas is expanding at nearly three times the U.S. rate (Chart 6). This suggests that U.S. economic activity will be pulled up by foreign demand. Additionally, G3 capital goods orders are climbing at the fastest pace since 2014. A stronger dollar may dampen U.S. exports and earnings, but this will be a modest offset, rather than something that derails the recovery in U.S. industrial production. Chart 5Global LEI's Pointing Higher Chart 6Supports For Global Growth In Place Global growth is important to large cap U.S. equities because 43% of S&P 500 sales in 2016 came from outside the U.S. (Table 2). Remarkably, this figure moved lower in the past 5 years and 10 years. In 2012, 47% of S&P 500 sales came from outside the U.S.; in 2007, it was only 1% less. The drop in overseas sales since 2012 masks shifts by region. In 2016, 8% of S&P 500 sales were to Asia, up 100 bps from 2012. Europe, excluding the U.K., accounted for 6% sales in 2016 and the U.K., a mere 1%. These numbers dropped from the 2012 figures of 10% and 2% respectively. While Standard and Poor's does not separate out sales to China, that country represents a large portion of sales to Asia, which makes China and Europe the two most important regions for overseas sales. In contrast, only 3% of S&P 500 sales are made in Canada and Mexico. Table 2Most S&P 500 Sales Go To Asia And Europe While BCA's European strategists remain upbeat about growth prospects in the Eurozone,7 our outlook on China is more sanguine. BCA's Geopolitical Strategy service notes that Chinese politics have shifted from tailwind to headwind for global growth in the wake of China's 19th National Party Congress.8 Meanwhile, BCA's China Investment Strategy states that the weak external demand environment faced by China in 2015 was a function of severe dislocations in the commodity and currency markets that probably will not recur in the coming 6-12 months. While Chinese export growth will moderate in the coming year, the absence of these shocks is an important factor supporting a gradual deceleration.9 Moreover, China's economic momentum is on the upswing. Real-time measures of economic activity such as electricity production, excavator sales, and railway freight traffic, all are expanding at double-digit rates, albeit down from recent peaks (Chart 7). Various price indexes also show a broadly based pickup in inflation to levels that will unnerve the authorities. Nonetheless, economic growth will slow in 2018 as policymakers continue to pare back stimulus. BCA does not foresee a substantial downturn in growth next year, but it could be hard on base metals prices. Bottom Line: Improving economic activity outside the U.S. is a tailwind for both domestic economic growth and profits of U.S. firms with significant foreign business. Moreover, surging world growth is a precondition for higher inflation. BCA's Global Fixed Income Strategy service notes10 that 68% of OECD nations have unemployment rates under the organization's assessment of "global NAIRU", which has not occurred since before the Great Recession when inflation expanded in both the goods and service sectors (Chart 8). Solid foreign demand will help the economy hit the Fed's GDP target and support the central bank's additional but gradual tightening stance. Stay overweight U.S. equities and remain short duration. BCA's view that inflation is poised to turn higher also supports our duration call. Chart 7China: Healthy Growth Indicators Chart 8NAIRU Is Not Dead Yet Still Waiting For Wage Inflation Table 3Inflation Reacts With A Lag The labor market continues to tighten, which suggests that wage pressures should accelerate soon. Given that inflation is a lagging indicator, investors must remain patient. Table 311 illustrates the time lag from when full employment is reached to the turning point for consumer price inflation. During long expansions, the gap is 26 months. The U.S. unemployment rate dipped below NAIRU 12 months ago in November 2016. The implication is that investors (and the Fed) are too eager as they wait for inflation's inflection point. BCA approaches wage growth - or the lack of it - in another way. Like inflation, wage growth takes time to materialize in protracted recoveries. Charts 9 and 10 provide updates on inflation and its leading indicators that we published in August 2017. These charts reiterate that price pressures take time to emerge in "slow burn" expansions. Chart 11 shows that the ECI has trended higher since 2009, matching increases in quit rates, NFIB compensation plans, and the Conference Board's measure of jobs hard to get less jobs easy to get. Moreover, the top panel of Chart 11 shows that the ECI gains are widespread and at 73%, the percentage of states reporting unemployment rates below NAIRU suggests that wage gains are imminent (Chart 12). Chart 9In the 80s And 90s Wage Growth Did Not##BR##Provide And Early Warning On Inflation Chart 10Patience Is Required On##BR##Inflation In Long Cycles Chart 11Labor Market Is Tight Enough##BR##To Push Up Inflation Chart 1270%+ Of States Have Unemployment Rates Below NAIRU The Atlanta Fed Wage Tracker,12 which is not compromised by compositional shifts in the labor market, stabilized in the past few months after rolling over in the spring and early summer. Moreover, the Tracker remains in a distinct uptrend; at 3.6% year-over-year, it is at the lower end of the 3.3% to 4.3% year-over-year range in place before the global financial crisis (Chart 13, panel 2). Chart 13Wage Pressures Mounting Bottom Line: Wage inflation is on the upswing as the output gap turns positive for the first time in a decade and the unemployment rate moves even further below NAIRU. A persistent buildup in wages will allow the Fed to bump up rates in December and three times again next year. This supports BCA's underweight stance on duration. That said, a sudden surge in consumer price or wage inflation would trigger a more aggressive response from the Fed, and a signal of "the beginning of the end" for the recent return of the Great Moderation. Great Moderation, Interrupted? The Great Recession was eight years ago, but investors are now ruminating about the return of the Great Moderation era (mid-1980s to mid-2007), when subdued macroeconomic volatility often coincided with low market volatility. Then, as now, inflation was muted and stable, but unlike today, economic growth was much faster in a long expansion phase with two mild recessions (Chart 14). There have been many studies rationalizing the Great Moderation, which was observed in most advanced economies (G7 countries and Australia) roughly at the same time though not fully synchronized (Chart 15).The phenomenon13 was initially forged in 2002 by Stock and Watson and then publicized by former Fed Chair Bernanke14 in a 2004 speech.15 Chart 14Return Of The Great Moderation? Chart 15The Great Moderation: A Global Phenomenon Too! Three main causes were identified: Structural changes in the economy: improvement in inventory management as the U.S. moved away from a manufacturing-based economy towards a service-based economy, the latter less volatile. Financial innovations, for example, increased credit availability to households through the rise of securitization, allowing consumption to be more balanced; Higher efficacy of monetary policy: increased transparency and predictability of FOMC actions, which augmented the Fed's credibility to tame inflation (price stability) and foster full employment; Good Luck (smaller shocks): post mid-1980s (and up to the global financial crisis-GFC), the economy did not experience outsized shocks such as the surge in oil prices in the 1960s and the 1970s. Most investors and/or economists agree that structural changes and better monetary policy were significant drivers of the decline in macroeconomic volatility. Good luck also seems to have been a factor and there is empirical research to support it. The persistence and length of the current expansion is an indication that good luck still plays a role, with investors taking on risk and becoming complacent. That said, there does not seem to be a consensus on the single most important driver of the "Great Moderation". Interestingly, complacency in the financial markets creates vulnerability at the late stage in this expansion. It has caught the Fed's attention as evidenced in the September 19-20 FOMC minutes: "Broad U.S. equity price indexes increased over the intermeeting period. One-month-ahead option-implied volatility of the S&P 500 index - the VIX - remained at historically low levels despite brief spikes associated with increased investor concerns about geopolitical tensions and political uncertainties." Since Chair Yellen took office in February 2014, this is the most direct reference about low volatility and therefore, complacency in the financial markets. Chart 16Back To Low Correlations Among Stocks The November 2017 Bank Credit Analyst Monthly Report16 discussed complacency in the context of a return of the Great Moderation. BCA believes significant complacency is signaled by the good news already discounted in equity prices, the depressed level of the VIX and the decline this year in risk asset correlations. Moreover, large institutional investors are reportedly selling volatility and thus, dampening implied volatility across asset classes. The "Great Moderation" in macro volatility is also contributing to low correlations among stocks (Chart 16). The idea is that low perceived macroeconomic volatility during the "Great Moderation" had diminished the dispersion of growth and inflation forecasts, thereby trimming the variance of interest rate projections. This allowed equity investors to focus on alpha rather than beta, given less uncertainty about the macro outlook. The focus on alpha contributed to the decline in stock price correlation. Today, dispersion in the outlooks for growth and interest rates have returned to pre-Lehman levels, helping to explain the low levels of implied volatility and correlation in the equity market (Chart 17). Some of the reduced dispersion can be justified by the fundamentals. The onset of a broadly based global expansion has calmed lingering fears that the world economy is constantly teetering on the edge of the abyss. Investor uncertainty regarding economic policy has also moderated (bottom panel). Historically, implied volatility tended to fall when global industrial production was strong and global earnings were rising in a broad swath of countries (Chart 18). Our U.S. Equity Sector Strategy service points out that, during the later stages of the cycle, equity sector correlations tend to drop. The lower correlations occur as earnings fundamentals become more important performance drivers, and sector differentiation generates alpha.17 Similarly, the VIX can fluctuate at low levels for an extended time when global growth is broadly based. Chart 17A Less Uncertain Macro Outlook? Chart 18Broad-Based Growth Lowers Implied Volatility Still, the current readings of equity market correlation and the VIX are unnerving given a plethora of potential geopolitical crises and the pending unwinding of the Fed's balance sheet. Moreover, any meaningful pickup in inflation would upset the 'low vol' applecart. Table 4 shows the drop in the S&P 500 index during non-recessionary periods when the VIX surges by more than 10% in a 13-week period. The equity price index fell by an average of 7% during those nine episodes, with a range of -3.6 to -18.1%. Table 4Episodes When VIX Spiked Bottom Line: Longer expansions and shorter recessions, alongside the decline in market volatility, may stay for a while, the result of the perceived return to the Great Moderation. Risk assets are thus vulnerable because a lot of good news is discounted. Nonetheless, we would view any pullback in equities as a healthy correction rather than the beginning of a bear market. If the next recession is not expected before 2019 (our base case), then it is too early for the equity market to begin to discount the next bear market because profits will continue to expand well into 2018. Stay overweight stocks versus bonds in the next 12 months. John Canally, CFA, Senior Vice President U.S. Investment Strategy johnc@bcaresearch.com Mark McClellan, Senior Vice President The Bank Credit Analyst markm@bcaresearch.com Jizel Georges, Senior Analyst jizelg@bcaresearch.com 1 Please see BCA Research's Geopolitical Strategy Weekly Report, "Tax Cuts Are Here... So Much for Populism," November 8, 2017. Available at gps.bcaresearch.com. 2 Please see BCA Research's U.S. Investment Strategy Weekly Report, "The Late Cycle View," October 16, 2017. Available at usis.bcaresearch.com. 3 Please see BCA Research's Geopolitical Strategy Weekly Report, "Xi Jinping: Chairman Of Everything," October 25, 2017. Available at gps.bcaresearch.com. 4 Please see BCA Research's Global Investment Strategy Weekly Report, "Strategy Outlook Fourth Quarter 2017: Goldilocks And The Recession Bear," October 4, 2017. Available at gis.bcaresearch.com. 5 Please see BCA Research's U.S. Investment Strategy Weekly Report, "Synchronicity," September 25, 2017. Available at usis.bcaresearch.com. 6 Please see BCA Research's Commodity & Energy Strategy Weekly Report, "Still Some Upside In The Nickel Market," November 2, 2017. Available at ces.bcaresearch.com. 7 Please see BCA Research's European Investment Strategy Weekly Report, "The Great Resynchronization," September 21, 2017. Available at eis.bcaresearch.com 2017. 8 Please see BCA Research's Geopolitical Strategy Special Report, "China: Party Congress Ends ... So What?," November 1, 2017. Available at gps.bcaresearch.com. 9 Please see BCA Research's China Investment Strategy Weekly Report, "China's Economy - 2015 Vs. Today (Part I): Trade," October 26, 2017. Available at cis.bcaresearch.com. 10 Please see BCA Research's Global Fixed Income Strategy Weekly Report, "Have Bond Yields Peaked For The Cycle? No," September 12, 2017. Available at gfis.bcaresearch.com. 11 Please see The Bank Credit Analyst Monthly Report, November 2017. Available at bca.bcaresearch.com. 12 https://www.frbatlanta.org/chcs/wage-growth-tracker.aspx?panel=1 13 Peter M. Summers, "What Caused the Great Moderation" Some Cross-Country Evidence", 2005, Federal Reserve Bank of Kansas City www.kansascityfed.org/ROkYZ/OcgaZ/Publicat/econrev/PDF/3q05summ.pdf 14 James H. Stock and Mark W. Watson, "Has the Business Cycle Changed? Evidence and Explanations", August 2003 https://www.kansascityfed.org/publicat/sympos/2003/pdf/Stockwatson2003.pdf 15 Governor Ben S. Bernanke, "The Great Moderation," Washington, DC, February 20, 2004, https://www.federalreserve.gov/boarddocs/speeches/2004/20040220/ 16 Please see The Bank Credit Analyst Monthly Report, November 2017. Available at bca.bcaresearch.com. 17 Please see BCA Research's U.S. Equity Strategy Weekly Report, "Later Cycle Dynamics," published October 23, 2017. Available at uses.bcaresearch.com.

Highlights Powell's nomination will not change the Fed's gradual rate hike path, but open Board seats are a worry. Household debt growth is slower than usual, but auto debt levels are a concern. Stocks will beat bonds and oil will rise after EPS growth peaks next year. Funding liquidity should remain adequate as the Fed unwinds its balance sheet. Feature Last week was an extraordinarily busy week for U.S. financial markets, but BCA's view on the economy, the Fed and asset class returns remains the same. President Trump named Jerome Powell to replace Janet Yellen as Fed Chair and the GOP released additional details of their tax plan. The October readings on employment, manufacturing, and wage growth fell short of expectations. However, data on consumer confidence, non-manufacturing ISM and vehicle sales for October exceeded expectations. The Q3 Employment Cost Index will give Fed policymakers confidence that the Phillips curve is not dead, but the persistent weakness in unit labor costs (the Q3 data was released last week) will concern the FOMC. The Fed remains on track to raise rates by 0.25% in December and three more times in 2018, matching their dot plot. While average hourly earnings disappointed in October, the impacts of Hurricanes Harvey and Irma make the data difficult to interpret. Nonetheless, the year-over-year growth in the 3-month moving average of average hourly earnings was 2.6% in October, up from 2.5% in July, before Harvey made landfall in Texas. Moreover, real GDP is growing faster than the economy's long term potential (1.8% per the Fed), and at 4.1%, the unemployment rate is well below the Fed's measure of full employment (4.6%) (Chart 1). Jerome Powell will continue to pursue the gradual rate hikes preferred by his predecessor. However, Powell is the first Fed Chair since G. William Miller (1978-79) to not have a PhD in economics. He is not known as a policy hawk or a dove, and this lack of conviction in his own policy suggests that he will rely on more on his Board colleagues for direction than recent chairs. The potential power shift from the chair to the committee may make FOMC communications more difficult to interpret. After Yellen departs the Fed early next year, the seven-member board will be down to just four, providing Trump the opportunity to further shape monetary policy. Table 1 provides Powell's comments on key aspects of the economy, monetary and regulatory policy. Chart 1Labor Market Conditions Tightening##BR##And Support More Rate Hikes Table 1Powell On Monetary Policy, The Economy And Regulation BCA expects that Powell, a Republican, will be confirmed by the Senate and preside over the FOMC meeting in March 2018. Powell already sits on the Fed Board. In 2012 President Obama appointed Powell to the Fed to fill an unexpired term. The Senate voted 74-21 to confirm. Two years later, Powell was confirmed 67-21 for a full term (14 years) as a governor. Fifty-one votes are required for confirmation. BCA's Chief Economist, Martin Barnes, wrote about the potential for change at Federal Reserve Board earlier this year.1 The bottom line is that looming changes in the composition of the Fed's Board of Governors are important, but we doubt that the overall integrity of the Fed will be seriously compromised by bad appointments. However, at this stage, it is futile to guess who the Administration will choose. Regardless of who controls the Fed, there always will be the potential for errors because their economic models (along with everybody else's) are imprecise, data can be unreliable, and the policy tools are crude. Some uptick in inflation is likely and would even be desirable, but it will not be allowed to get out of control. The bigger uncertainty is what will happen after the next economic downturn because even the most hawkish policymakers may be forced to embrace inflationary policies that will make the past cycle's actions pale by comparison. Subprime Auto Sector Signals Household deleveraging has ended, but consumers are reticent to take on new debt despite an improving labor market and record household net worth. Household debt is growing at under 2% a year, less than half the pre-crisis pace. Moreover, household debt relative to disposable income remains well below a decade ago, but the household indebtedness profile is not uniform. While the debt-to-disposable income ratio of mortgage and revolving consumer credit has moved lower, the ratio of non-revolving credit (which includes both auto and student loan debt) has moved up since 2010 and surpassed the 15.8% pre-crisis peak in 2012 (Chart 2). Chart 2Household Debt By Sector In 2016, 34% of U.S. families had vehicle loans, up from a low of 30% in 2010. In 2004-2007, more than one-third of U.S. families carried auto debt (Chart 3). The median value of households' auto loans is $13,000 (in 2016 dollars), up from $11,000 in 2010, but still below the 2004-2007 peak of $14,000 (Chart 4). However, delinquency rates are on the rise in those areas where consumers have been adding debt (credit cards, auto loans and student loans) (Chart 5). Chart 3Rise In % Of Families With Auto Loan Debt... Chart 4...But Auto Debt Levels Are Manageable In particular, default rates in auto and student loans are above their mid-2000s readings, but are below their 2010-2012 zenith. Lending standards for vehicle loans were easy at the start of the decade, became less so recently and then turned restrictive in mid-2016. In the mid-2000s, borrowing guidelines for student loans and credit cards (data on bank lending standards for auto loans began in 2011) were easy in 2004-2007. Banks are taking a cautious approach to consumer lending in this cycle. The gradual tightening of lending criteria between 2010 and 2016 led to a drop in the average FICO score for new auto loans. However, as standards tightened in 2016 and into the first quarter of 2017, the average FICO escalated. FICO scores for new vehicle loans moved sharply lower in Q2; it may be a new trend or perhaps a blip in the data. Even with the latest dip, the FICO for new auto loans (698) is well above the 675-685 range that prevailed in 2004-2006 (Chart 6, bottom panel). Chart 5Consumer Loan Metrics Chart 6ABS Market Overview Subprime auto loans as a percentage of all auto loans remain well below pre-crisis levels and should limit a wave of subprime auto defaults in the years ahead. Only 22% of the $148 billion in new vehicle loans recorded in Q2 2017 were issued to borrowers with FICO scores below 620. The latest reading is in the middle of the range that has been in effect since 2010 (18-25%). Between 2004 and 2007, the share of auto loans issued to subprime borrowers was as high as 32% in 2006 and averaged 28%. The FOMC has elevated financial stability in its recent deliberations2 and is watching for imbalances. The September 20-21 FOMC meeting minutes noted that "Subprime auto loan balances have declined so far this year, partly reflecting the tighter lending standards, and the average credit score of all borrowers who obtained an auto loan in the second quarter remained near the upper end of its range of the past few years." We expect the Fed to remain vigilant on this issue. Bottom Line: Household debt ratios are well below the pre-2007 peak, but consumers are piling on more auto debt. While delinquency rates for auto debt are rising, banks are tightening lending requirements and have not extended auto credit to subprime borrowers outside of historical norms. If household incomes, the stock market and housing prices rise, and banks and regulators remain vigilant, then the subprime auto sector would not pose a systemic risk to the U.S. economy or financial system.3 BCA's U.S. Bond Strategy service prefers Aaa-rated credit card ABS over Aaa-rated auto loan ABS (Chart 6). Investment Direction After EPS Peak Chart 7Strong EPS Growth Ahead,##BR##Will Start To Slow Soon The BCA earnings model shows that S&P 500 EPS growth is peaking and should slow through 2018 toward a level commensurate with 3½-4% nominal GDP growth (Chart 7). Accordingly, BCA believes that the earnings backdrop will remain a tailwind for the equity market, albeit a smaller force. This forecast excludes any positive effects on growth from tax cuts that would encourage EPS and the S&P 500 index in the short term, although this would also bring forward Fed rate hikes. We will provide an update on the Q3 earnings reporting season in next week's report. Investors are questioning what will happen to risk assets after earnings growth peaks, but before it slips below zero (Table 2). BCA has identified seven episodes between 1973 and 2015 when S&P 500 EPS growth reached a top and subsequently dipped below zero. Four of the seven periods (1973-75, 1976-80, 1988-1991, and 1993-2001) partially overlapped with recessions. The U.S. economy was in recession during the entire 1973-75 period but the recession occurred at or near the end in the other three occurrences. U.S. stocks, Treasuries and oil behave consistently during these periods. The performance of gold, the dollar, small caps (relative to large) and high yield (relative to Treasuries) is not consistent, and investment-grade corporate debt underperformed Treasuries in six of the seven intervals. On average, stocks beat bonds by 3,000 bps after earnings decelerate, but before they turn negative. Oil (+8,310 basis points) and gold (+6,950 bps) are the standouts; both commodities beat stocks) as earnings growth fades. Small caps barely outperform large, and the dollar, on average, is flat across all seven periods. Investment-grade corporate debt underperforms Treasuries by an average of 50 bps during these episodes. Table 2U.S. Asset Class Performance As EPS Growth Slows The three occasions when EPS growth crested and then slowed to zero, but the economy avoided a recession, were in the mid-1980s, the mid-2000s and the early part of the current decade. These mid-cycle slowdowns were triggered by Fed rate hikes in the mid-1990s and mid-2000s; in the early 2010s, there were similar fears of a rate increase, coupled with a stronger dollar and a collapse in oil prices. The performance of risk assets during these mid-cycle earnings corrections was similar to the entire sample, although the magnitude of the asset class performances shifted. Oil (+12,560 bps) and gold (+8,400 bps) were standouts; equity and Treasury prices both rose, but equities beat Treasuries by nearly 10,000 bps, easily surpassing the 3,000 bps outperformance in all periods. Small caps underperformed large caps and the dollar climbed (Chart 8). Chart 8U.S. Asset Class Performance As EPS Growth Slows Bottom Line: S&P 500 earnings growth will peak in 2018. Stocks will outperform bonds as profit growth slows, which matches BCA's stance for the next 12 months. Gold and oil have both outpaced equities as earnings abate; this supports BCA's bullish position and above-consensus view of oil for 2018. BCA's modestly bullish stance on the dollar in the next 12-18 months aligns with the historical achievements of the dollar as earnings moderate, but BCA's bullish view on small caps runs counter to history after EPS growth crests. The Great Balance Sheet Unwind Given that the era of quantitative easing has been a positive one for risk assets, it is unsurprising that investors are concerned about the looming unwind of the Fed's massive balance sheet. For example, Chart 9 demonstrates the correlation between the change in G4 balances sheets and both the stock market and excess returns in the U.S. high-yield market. In an October 2017 Special Report,4 the Bank Credit Analyst outlines how the pending shrinkage of the Fed's balance sheet could affect overall liquidity conditions. Liquidity falls into four categories: monetary, balance sheet, financial market transaction liquidity, and funding liquidity. Overall liquidity conditions are reasonably constructive for risk assets at the moment. Financial market and balance sheet liquidity are adequate. Monetary policy is extremely easy, although the low level of money and credit growth underscores that the credit channel of monetary policy is still somewhat impaired and/or constrained relative to the pre-Lehman years. Funding liquidity is as important as monetary liquidity for financial markets. It has recovered from the Great Financial Crisis (GFC) lows, but it is far from frothy. More intense regulation means that funding liquidity will probably never again be as favorable for risk assets as it was before the crisis. But, hopefully, efforts by the authorities to reduce perceived systemic risk mean that funding liquidity may not be as quick to dry up as was the case in 2008, in the event of another negative shock. Unwinding the Fed's balance sheet represents a risk to investors because QE played such an important role in reducing risk premia in financial markets. The unwind should not affect transactions liquidity or balance sheet liquidity. It should not affect the broad monetary aggregates either. Chart 10 presents our forecast for how quickly the Fed's balance sheet will contract. Following the September 19-20 FOMC meeting we learned that balance sheet reduction will begin October 1. For the first three months the Fed will allow a maximum of $6 billion in Treasuries and $4 billion in MBS to run off each month. Those caps will increase in steps of $6 billion and $4 billion, respectively, every three months until they level off at $30 billion per month for Treasuries and $20 billion per month for MBS. Chart 9G4 Central Bank Balance Sheets Chart 10Fed Balance Sheet We have received no official guidance on the level of bank reserves the Fed will target for the end of the run-off process. However, New York Fed President William Dudley recently recommended that this level should be higher than during the pre-QE period, and should probably fall in the $400 billion to $1 trillion range.5 In our forecasts we assume that bank reserves will level-off once they reach $650 billion. In that scenario, the Fed's balance sheet will shrink by roughly $1.4 trillion by 2021. The level of excess reserves in the banking system will decline by a somewhat larger amount ($1.75 trillion). The technical impact of balance sheet unwind on the inner workings of the credit market is very complicated and difficult to forecast. Asset sales could lead to a shortage of short-term high quality assets. However, this is more a problem in terms of the Fed's ability to raise interest rates than for funding liquidity. A smaller balance sheet could, in fact, improve funding liquidity to the extent that it frees up space on banks' balance sheets. In terms of asset prices, some investors believe that when the excess reserves were created, a portion of it found its way out of the banking system and was used to buy assets directly. That is not the case. The excess reserves were left idle, sitting on deposit at the Fed. They did not "leak" out and were not used to purchase assets. Thus, fewer excess bank reserves do not imply any forced selling. Nonetheless, the QE program certainly affected asset prices indirectly via the portfolio balance effect. The risk is that the portfolio balance effect goes into reverse as the Fed unwinds the asset purchases. The negative impact on risk assets will depend importantly on the bond market's response. The bond market's reaction will be far more important than balance sheet shrinkage. Empirical estimates suggest that the Fed's shedding of Treasuries could boost the 10-year yield by about 80 basis points because the private sector will require a higher term premium to absorb the higher flow of bonds. However, the impact on yields is likely to be tempered by two factors: Banks are required by regulators to hold more high-quality assets than they did in the pre-Lehman years in order to meet the new Liquidity Coverage Ratio; As the FOMC dials back monetary stimulus it will be concerned with overall monetary conditions, including short-term rates, long-term rates and the dollar. If long-term rates and/or the dollar rise too quickly, policymakers will moderate the pace of rate hikes and use forward guidance to talk down the long end of the curve so as to avoid allowing financial conditions to tighten too quickly. The bottom line is that the impact on monetary liquidity of a smaller Fed balance sheet should be minimal, although long-term bond yields will be marginally higher as a result. As long as the Fed can limit the bond market damage via forward guidance, then funding liquidity should remain adequate and risk assets should take the Fed's unwind in stride. However, it will be a whole different story if inflation lurches higher. If the core PCE inflation rate were to suddenly shift up to the 2% target or above, then bond prices will be hit hard, the VIX will surge and risk assets will sustain some damage. The prospect of a more aggressive pace of monetary tightening would undermine funding liquidity, compounding the negative impact on risk assets. John Canally, CFA, Senior Vice President U.S. Investment Strategy johnc@bcaresearch.com Mark McClellan, Senior Vice President The Bank Credit Analyst markm@bcaresearch.com Jizel Georges, Senior Analyst jizelg@bcaresearch.com 1 Please see The Bank Credit Analyst Special Report, "Should You Fear Looming Changes At The Federal Reserve?", September 21, 2017. Available at bca.bcaresearch.com. 2 Please see BCA's U.S. Investment Strategy Weekly Report, "The Fed's Third Mandate," July 24, 2017. Available at usis.bcaresearch.com. 3 Please see BCA's U.S. Bond Strategy Portfolio Allocation Summary, "Return Of The Trump Trade," October 3, 2017. Available at usbs.bcaresearch.com. 4 Please see The Bank Credit Analyst Special Report, "Liquidity And The Great Balance Sheet Unwind," In the October Monthly Report. Available at bca.bcaresearch.com. 5 William C. Dudley, "The U.S. Economic Outlook and the Implications for Monetary Policy," Federal Reserve Bank of New York (September 07, 2017).

Highlights Risk assets are responding well to better data and rising rates. Q3 EPS results beating lowered expectations, but growth earnings will peak soon. The conditions are in place for robust capital spending. Financial assets are adhering to the post-Hurricane playbook, with a few notable exceptions. Feature Chart 1Risk Assets Higher Despite Higher Rates Risk assets rose last week for the 6th week in a row (Chart 1). A solid start to Q3 earnings season, more legislative progress on the GOP's tax plan and a narrowing of President Trump's choice for Fed Chair (Jerome Powell, John Taylor and incumbent Janet Yellen) all added to the positive backdrop. The 4 bps rise in the 10 year Treasury yield last week (and 37 bps since early September) was not an impediment to higher equity and oil prices, and gains for small caps and high yield bonds. The positive reaction likely reflected the fact that yields rose more because of increased growth expectations than higher inflation expectations. Despite the impact of Hurricanes Harvey and Irma, Q3 GDP posted an impressive 3% gain. The composition of the Q3 readings suggests an even stronger report in Q4 (Chart 2). At 2.3%, the year-over-year change in real GDP is close to the Fed's 2017 forecast (2.4%) and above the long run forecast (1.8%). The implication for investors is that because U.S. economic growth is faster than its long-term potential, the labor market is tightening and inflation is poised to move higher. Accordingly, market odds for a Fed hike in December are near 90% and participants expect 51 bps more hikes in the next 12 months (Chart 1, panel 3). BCA's view is that U.S. economic growth is set to accelerate in the coming quarters aided by a post hurricane rebound in housing. The Fed will raise rates in December and three more times next year as inflation returns to 2% and perhaps beyond. Corporate profit growth will peak in the next few quarters, but remain supportive of higher stock prices for now. The rise in the Economic Surprise Index will continue for another few months, and provide another lift for risk assets. A surge in capital spending adds to the upbeat tone. Chart 2GDP Growth Remains Below Average, But Above Fed's Long Run Target Capital Spending Blasts Off Business capital spending is on the upswing. The robust readings in September on core durable goods orders (7.8% year-over-year) and shipments reported last week were paybacks for the Hurricane-weakened August report. Nonetheless, the impressive soundings on the three -month change in both orders and shipments were not distorted by the storms. Moreover, the durable goods report was one of the latest in a series of data points brightening capex's outlook (Chart 3). Both BCA's real and nominal capex models, driven by surging capital goods orders along with elevated ISM readings and soaring sentiment on business spending, indicate strong investment in plant and equipment in the next few quarters. CEO confidence soared to a 13-year high in Q1 according to the latest Duke University/CFO Magazine Business Outlook, but retreated modestly in Q2 and Q3 (Chart 4). Surveys by the Conference Board and Business Roundtable show a similar pattern. Notably, readings on all three surveys have climbed since Trump's election in November 2016, but then retreated as his pro-business agenda stalled. The drop in sentiment reflects the lack of legislative progress in Washington (Chart 5). The dip in CEO sentiment in Q2 and Q3 is in sharp contrast with the easing of policy concerns in the Beige Book. Chart 3Bright Outlook For Capital Spending Chart 4Capital Spending Plans Upbeat Chart 5Managements Remain Upbeat The upbeat numbers in the regional Federal Reserve Banks' surveys of capital spending intentions further support rising capex spending in the next few quarters. The average readings from the New York, Philadelphia and Richmond Feds' capex survey plans are close to cycle highs, despite a modest pullback in the summer months. Moreover, the regional Feds' capex spending plans diffusion index hit an eight-year high in October (Chart 5, panel 3). Bottom Line: Stay overweight stocks versus bonds, and underweight duration. Rising capex will drive up GDP, employment and EPS in the coming quarters. Q3 Earnings Beating Lowered Expectations The Q3 earnings reporting season is off to a strong start, with both EPS and sales growth well ahead of consensus expectations as we forecast in our October 2 preview. Moreover, the counter-trend rally in profit margins is still in place. Just under 55% of companies have reported results so far, with 74% beating consensus EPS projections just above the long-term average of 55%. Furthermore, 67% have posted Q3 revenues that topped expectations, which exceeded the LT average of 69%. The surprise factor for Q3 stands at 5% for EPS and 2% for sales. These compare favorably with the average EPS (4.2%) and sales (1.2%) in the past five years. We anticipate the secular mean-reversion of margins to re-assert itself in the S&P data, perhaps beginning early in 2018. Nonetheless, initial results imply that Q2 will be another quarter of margin expansion. Average earnings growth (Q3 2017 versus Q3 2016) is solid at 7% with revenue growth at 5%. Strength in earnings and revenues is broad based (Table 1). Earnings per share increased in Q3 2017 versus Q3 2016 in eight of the 11 sectors. The 7.3% year-over-year drop in the financial sector is linked to the impact of the hurricanes on the insurance and reinsurance industries. Excluding those industries, financial EPS is up 4.7% from a year ago. EPS results are particularly stout in energy (164%), technology (18%) and healthcare (7%). Those sectors likewise experienced significant sales gains (16%, 9% and 5% respectively). Corporate managements are more focused on the message in Washington than on the President (Chart 6). Trump's name was mentioned just once in the Q3 earnings calls held through October 27, matching Q2's reporting period. CEOs and CFOs have cited Trump's name at least once in each earnings season since Q2 2016. The peak in mentions occurred immediately after Trump took office in early 2017. Table 1S&P 500:##BR##Q3 2017 Results* Chart 6Managements Focused On##BR##The Message Out Of DC In contrast, the words "tax" and "reform" have appeared 39 times thus far in Q3 conference calls, most often in a positive light. There were only five mentions in Q2, when there was skepticism that a tax plan would pass this year. In the Q4 2016 reporting season following the November election, tax and reform were cited 16 times. BCA's Geopolitical Strategy service has consistently expected a tax package to pass by the end of Q1 2018.1 We are encouraged by the upward trajectory of EPS estimates for 2017 and 2018 (Chart 7). It is odd that the recent downtick in 2017 EPS is mirrored by an uptick in the 2018 figure. That said, the divergence can be explained by the impact of the hurricanes on the financial sector's earnings in 2017 and probable snapback in early 2018. Analysts expect 2019 EPS growth to slow from 2018's clip, which matches BCA's view. However, unlike estimates for 2017 and 2018, we anticipate that EPS estimates for 2019 will move lower throughout 2018 and 2019, ahead of a recession in late 2019.2 Bottom Line: The BCA earnings model shows that S&P 500 EPS growth is peaking and should decelerate through 2018 toward a level commensurate with 3 ½-4% nominal GDP growth (Chart 8). Accordingly, BCA believes that the earnings backdrop will remain a tailwind for the equity market, albeit a smaller tailwind. This forecast excludes any positive effect on growth from tax cuts, which would be positive for EPS and the S&P 500 price index in the short term, although this would also bring forward Fed rate hikes. The entire Treasury curve has readjusted to reflect this view. Chart 7Stability In '17 & '18 EPS Estimates,##BR##But '19 Likely To Move Lower Chart 8Strong EPS Growth Ahead,##BR##Will Start To Slow Soon 10-Year Treasury Update BCA's view is that the 10-year Treasury yield will head higher in the coming months. However, is the move from 2.03% in early September to 2.43% last week sustainable? BCA's fair value model for the 10-year Treasury yield (based on Global PMI and dollar sentiment) places fair value at 2.65% (Chart 9, panel 1). Moreover, BCA's three-factor version of the model (that includes the Global Economic Policy Uncertainty Index), puts fair value slightly higher at 2.63% (Chart 9, panel 3). Investors should continue to position for a steeper curve by favoring the 5-year bullet versus a duration-matched 2/10 barbell. Chart 9Treasury Fair Value Models BCA's U.S. Bond Strategy service will publish updated fair models after the November 1 release of October's global PMI data. The latest readings on Citi's Economic Surprise index also support BCA's stance on rates. How Long Can The Economic Surprise Index Stay Positive? The Citi Economic Surprise Index crossed into positive territory on October 2nd, remaining above zero for 20 business days, and risk assets are responding (Chart 10). Since 2010, once the Index turns positive, it continues to rise for 46 days. The implication for investors is that the economic data will continue to be remarkable for another two months. Table 2 shows that risk assets outperform as the economic surprise index rises from zero toward its zenith. Risk assets have also outperformed since the June bottom in economic surprises, matching the historical performance.3 Oil (+17%), small caps and investment grade corporates are all standouts and the gains may not be over. The track record of risk assets as the Economic Surprise Index climbs suggests that additional increases are in prospect for risk assets. On average, equities (relative to treasuries) and oil are the best performers during these intervals. Chart 10May Still Be Room To Run On Economic Surprise Table 2Risk Assets Perform Well As Economic Surprise Rises Post-Hurricane Macro Backdrop The strength of the Citi Economic Surprise Index following the hurricanes duplicates the historical trend and supports the rise in risk assets. The Index moves higher for the first month post-storm, and then remains above zero for an additional three weeks (Chart 11, panel 4). This bolsters BCA's stance that the direction of the Index will continue to lift risk assets in the next few months. Financial assets are also adhering to the post-Hurricane playbook,4 with a few notable exceptions (Chart 12). The stock-to-bond ratio moved higher and the VIX has declined since Hurricane Harvey, matching the typical post-storm performance. However, the 10-year Treasury yield, the S&P 500 and the Fed funds rate, all have bucked historical trends. The S&P 500 rose by 5.6% since late August; stocks typically drift lower in the first few months after a major storm. In addition, the 10-year Treasury yield climbed but it usually moves down in the two months following a hurricane. Post- storm, the Fed typically continues to do whatever it was doing prior to the storm. Accordingly, we expect the Fed to hike rates at its December meeting. Chart 11Major Hurricane Impact##BR##On Activity Data Chart 12Major Hurricane Impact On##BR##Financial Markets And The Fed The economic, inflation and sentiment data are also mixed. Housing data frequently lags in the wake of a storm, but both new and existing home sales moved up in the month after Harvey and Irma; housing starts declined in recent months which is counter to the historical pattern (Chart 13). Both IP and employment plunged after the storms, however, these indicators tend to rise after major weather. Initial claims for unemployment insurance were typically volatile in the six weeks since Harvey hit Texas, but have resumed their downtrend. Average hourly earnings in inflation climbed after Harvey and Irma, while consumer confidence dipped, matching history. However, the bump in gasoline prices since late August runs counter to historical precedent. Gasoline prices tend to decline after major storms (Chart 14). Chart 13Major Hurricane Impact##BR##On Housing Data Chart 14Major Hurricane Impact On##BR##Sentiment And Inflation Data Investment Conclusions: The macro backdrop remains bullish for risk assets, especially since synchronized growth has reduced fears of secular stagnation. Bond yields will rise, but won't be a headwind for stocks yet.5 Rising bond yields because of growth, without rising inflation, are bullish for risk assets, but this will change as inflation reaches 2% and inflation expectations start to rise. At that point, the Fed will be behind the curve. This will lead to faster Fed rate hikes, historically a headwind for equities. John Canally, CFA, Senior Vice President U.S. Investment Strategy johnc@bcaresearch.com 1 Please see BCA's Geopolitical Strategy Weekly Report, "Xi Jinping: Chairman Of Everything," October 25, 2017. Available at gps.bcaresearch.com. 2 Please see BCA's Global Investment Strategy Weekly Report, "Strategy Outlook Fourth Quarter 2017: Goldilocks And The Recession Bear," October 4, 2017. Available at gis.bcaresearch.com. 3 Please see BCA's U.S. Investment Strategy Weekly Report, "Global Monetary Policy Recalibration," April 17, 2017. Available at usis.bcaresearch.com. 4 Please see BCA's U.S. Investment Strategy Weekly Report, "Shelter From The Storm," September 5, 2017. Available at usis.bcaresearch.com. 5 Please see BCA's U.S. Investment Strategy Weekly Report, "Still In The Sweet Spot" June 19, 2017. Available at usis.bcaresearch.com.