Equities

We downshifted our view on the S&P health care facilities index at mid-year, because consumer spending on health care was decelerating, which favored moving into equities that paid for medical services (managed care) vs. those that provided them. While this trend remains intact, health care facilities stocks appear to be discounting an extreme scenario. The current concern is that the Affordable Care Act (ACA) will be repealed, leaving hospitals to foot the bill for uninsured patients. While such a scenario would potentially reverse the decline in the provision for doubtful accounts (PDA), a major profit margin support, the ACA is more likely to be reworked than repealed especially in the absence of a replacement plan. Importantly, there are other offsets. PDA follows the unemployment rate, which is signaling that the former will decline further. Hospital cost inflation is beginning to recede, led by drug costs. It would take massive earnings downgrades to validate the pessimism embedded in current valuations. We will look to buy this group opportunistically in the coming months.

After the Trump election victory, we immediately upgraded our financial sector view to neutral to protect against the benefit of rising interest rates and the potential for a clear asset preference shift in favor of stocks over bonds. Trump's inflationist policy rumblings have kickstarted a steep advance in the total return of equity vs. bonds (E/B). BCA's strategists believe that this trend has long-term staying power. The E/B ratio has an excellent track record in heralding the relative performance of the S&P asset manager & custody bank (AMCB) index. If investors shift assets from bond products and into equity mutual funds and ETFs, from the current extremely depressed skew (bottom panel), then there is scope for cyclical profit margin upside at asset management firms. Current valuations do not fully discount such a shift, and we recommend an overweight position in the S&P AMCB index. The ticker symbols for the stocks in this index are: BLBG: S5AMGT - BK, BLK, STT, TROW, AMP, NTRS, BEN, IVZ, AMG.

Highlights The Chinese authorities have progressively tightened capital account control regulations to staunch capital outflows, which will likely slow the drawdown of the country's official reserves in the near term. Rising yields in China are largely reflective rather than restrictive. Monetary easing through interest rate cuts has likely run its course, but it is highly unlikely that the PBoC will raise rates to protect the RMB. The Shenzhen-Hong Kong connect program is yet another step towards China's capital account liberalization. In the near term it could give a boost to Hong Kong-listed shares due to the large valuation gap. The direct impact on the RMB is marginal. Feature The mighty U.S. dollar occupied the cover of this week's Economist magazine - it has also clearly occupied the top spot on our clients' 'worry lists'. We were in China last week talking to clients and conducting some "field research", and the yuan's depreciation was a key focal point of the discussions. Historically, Economist magazine cover stories have mostly turned out to be perfect contrarian signals, and it remains to be seen whether this one will be a blessing or curse for the greenback. What's more certain is that there is a clear consensus among Chinese investors on the one-way descent of the RMB against the dollar going forward, and the People's Bank of China (PBoC) is facing an uphill battle in containing domestic capital outflows. The latest program linking Chinese equities and the overseas market is the Shenzhen-Hong Kong connect program, which debuted early this week. This suggests the Chinese authorities are still committed to capital account deregulation. In the near term, however, capital control measures have been tightened progressively to preserves official reserves and maintain domestic liquidity. Full-Court Press Heightened concerns over the CNY/USD cross rate of late have ignored the fact that the RMB has remained one of the stronger currencies among a synchronized plunge against the seemingly unstoppable dollar. The trade-weighted RMB has picked up notably in recent weeks, even though it has depreciated against the greenback (Chart 1). Nonetheless, Chinese investors' perception of the currency matters greatly, as it could potentially create a self-fulfilling downward spiral between capital outflows and exchange rate depreciation. It is both naïve and highly risky to expect the RMB to settle down at a "market clearing" level against the dollar without a chaotic undershoot. The "Impossible Trinity" theory in international finance dictates that a country cannot simultaneously control its exchange rate with independent monetary policy and free flow of capital. Among these conditions, free flow of capital has been the least expensive sacrifice for the Chinese authorities.1 In basketball, full-court press refers to a defensive tactic in which members of a team cover their opponents throughout the court, and not just near their own basket. This is what the Chinese authorities appear to be doing in terms of their efforts at staunching capital outflows. Cracking down on underground money smugglers facilitating RMB conversions with other currencies, particularly in regions neighboring Hong Kong. Anecdotal evidence suggests a sharp slowdown in illegal money transfers. Tightening scrutiny on trade invoicing verifications to crack down on "fake" international trades. Chinese imports from Hong Kong, sky-high last year as Chinese local firms fabricated import businesses to move money offshore, have tumbled to a fraction of last year's peak level (Chart 2). Restricting Chinese nationals from purchasing insurance policies issued by Hong Kong insurance firms. The massive boom of Hong Kong insurance sales to mainland residents in recent years will likely see a significant setback (Chart 3). Chart 1The RMB's Depreciation In Perspective Chart 2Blocking Capital Leakage In Trade... Chart 3...Services... These restrictive measures have been either targeting illegal channels or activities that are of minor importance to the economy as a whole. More recently, the authorities have also begun tightening rules on direct overseas investment by Chinese firms. Projects over US$10 billion and investments in "non-core" businesses are being tightly scrutinized. As companies' overseas expansion efforts are largely strategic in nature and tend to be long term, policymakers are potentially sacrificing long-term economic interests for a near-term fix of capital leakage. This underscores the authorities' increasing anxiety over capital outflows. Chart 4 shows net FDI outflows have become a major source of China's capital outflows in recent quarters, while Chinese firms paying off foreign liabilities was previously the main reason.2 Moreover, there has been a rush to acquire foreign assets among large Chinese firms this year, which is probably partially motivated by avoiding exchange rate losses (Chart 5). Chinese overseas investment activity will likely slow down significantly in the near term. Chart 4...And Outward Direct Investment Chart 5Overseas M&A Under Scrutiny Yesterday's data release show Chinese official reserves dropped to USD 3.05 trillion in November, down USD 69 billion from October. On surface, this is a marked deterioration from previous months. Underneath, however, our calculation shows that the decline in the headline official reserve number is more than explained by the mark-to-market paper losses from both a strengthening dollar and rising interest rates in the U.S. in the past month. Non-dollar assets account for about half of Chinese official reserves, and the 5% surge in the U.S. dollar index last month alone should have led to about $75 billion paper losses in the dollar value of Chinese reserves. Meanwhile, Chinese holdings of U.S. treasuries and agency bonds amount to about USD 1.4 trillion, and the sharp spike in U.S. risk free rates last month should have shaved off at least USD 30 billion in value. Taken together, the mark-to-market losses of Chinese reserve holdings are should be substantially higher than the decline in reserves last month. This may suggest that China's all-out efforts to stabilize capital outflows have been effective and should further reduce the drawdown of the country's official reserves. P.S. Over the years, we have been running a series of Special Reports tracking the composition and evolvement of China's foreign reserves. This year's update will be published next week. Stay tuned. Chart 6Interest Rate Vs Exchange Rate Will Interest Rates Be The Next Shoe To Drop? Chinese interest rates have also begun to pick up in recent weeks, as the RMB has continued to depreciate against the dollar (Chart 6). The increase in interest rates so far has been much milder compared with mid-2015, when RMB/USD depreciation sparked widespread financial volatility. Some have attributed China's higher interest rates to a weakening currency - as a sign that the country's monetary policy independence has been undermined. Recently, a senior PBoC official hinted that the central bank can raise interest rates if necessary to counter the downward pressure of the RMB, which further reinforces this view. Raising interest rates has been a typical policy response, especially among emerging countries look to defend their exchange rates, but it has rarely been proven successful. Hiking rates at a time of currency weakness further weakens domestic growth, which can in turn reinforce additional downward pressure on the exchange rate. The PBoC could certainly raise its benchmark rate, but we doubt the central bank is at all considering this option. In our view, the recent rise in Chinese interest rates may be attributable to both domestic and global factors: Globally, the synchronized selloff of bonds in major countries may have also pushed up Chinese interest rates. Chinese 10-year government bond yields have increased by 45 basis points since their August lows, not extraordinary considering the 102-basis-point selloff in U.S. Treasurys (Chart 7). Domestically, stronger growth numbers reported of late are providing additional evidence of growth improvement, which may have led to an adjustment in Chinese interest rate expectations (Chart 8). The latest PMI numbers point to further acceleration in both manufacturing and service industries, while the growth "surprise index" has been gradually improving and the yield curve has been steepening. Chart 7Higher Chinese Yields Reflect Global Factors... Chart 8... And Growth Improvement In short, we view rising yields in China as largely reflective rather than restrictive. As such, the PBoC is unlikely to rush in to push yields down just yet. In terms of monetary policy, we maintain the view that China's monetary easing through interest rate cuts has likely run its course, at least in the near term. Nonetheless, raising interest rates to protect the RMB would be a major policy mistake that would further undermine the exchange rate. Chart 9Cheaper Hong Kong Valuation Attracts ##br##Chinese Domestic Capital The Shenzhen-Hong Kong Connect Compared with the Shanghai-Hong Kong program that started over two years ago, the Shenzhen-Hong Kong connect program that debuted early this week has been received with much less enthusiasm from investors on both sides. The muted response in the marketplace likely reflects generally depressed sentiment within both Chinese and Hong Kong bourses. Given the large gap between Chinese domestic A shares and Hong Kong-listed stocks and well-entrenched expectorations of further RMB weakness, Chinese investors' purchases of Hong Kong-listed shares, or southbound purchases, will likely continue to increase (Chart 9). The establishment of the Shenzhen-Hong Kong connect program is also another step in liberalizing China's capital account controls. While in the near term this contradicts the authorities' recent efforts to block capital outflows, the new stock connect channel is subject to daily quotas, and capital movement is under close scrutiny. Meanwhile, capital flows through the stock exchanges are tiny compared with economic activity. In the past two years, Chinese domestic investors' cumulative "southbound" net purchases of Hong Kong-listed stocks only amounted to RMB 200 billion, or US$30 billion, a fraction of the country's capital movement and foreign reserve holdings. As far as investors are concerned, a major difference between the two Chinese domestic exchanges is their sectoral composition. The Shanghai Stock Exchange is heavily concentrated in the financial sector and state-controlled enterprises (Table 1). The Shenzhen Stock Exchange, on the other hand, is more tech-heavy with larger representation of private firms, and therefore has been more dynamic, which is also reflected in its stock prices. The Shenzhen stock index has outperformed that of Shanghai massively in recent years (Chart 10). In this vein, opening Shenzhen stocks directly gives overseas investors another option to tap into some of China's fastest growing sectors. This could also increase the odds that MSCI Inc. may include Chinese domestic stocks in its widely followed EM and global indices in its next review. Table 1Sectoral Components Of Shanghai And ##br##Shenzhen Exchanges Chart 10Shenzhen Market's Secular Outperformance##br## Against Shanghai The bottom line is that the Shenzhen-Hong Kong connect program is yet another step towards China's capital account liberalization, allowing freer access between Chinese and overseas investors to each other's financial assets. In the near term it could give a boost to Hong Kong-listed shares due to the large valuation gap. The direct impact on the RMB is marginal. Yan Wang, Senior Vice President China Investment Strategy yanw@bcaresearch.com 1 Please see China Investment Strategy Weekly Report, "The RMB's Near-Term Dilemma And Long-Term Ambition", dated October 20, 2016, available at cis.bcaresearch.com 2 Please see China Investment Strategy Special Report, "Mapping China's Capital Outflows: A Balance Of Payment Perspective", dated February 3, 2016, available at cis.bcaresearch.com Cyclical Investment Stance Equity Sector Recommendations

The S&P railroad index has vaulted higher, along with many other industrial groups, but it may be starting to overshoot fundamental improvement. Technical conditions are becoming overbought. The 52-week rate of change is nearing previous peaks, with the exception of the spike during the GFC in 2008/2009. Relative valuations are also stretching to the point where imminent earnings improvement may be required to sustain outperformance. While rail freight growth has improved, and coal is shifting away from acting as a major drag, productivity growth is not yet showing through. For instance, weekly train speeds have eased. Meanwhile, this capital-intensive industry may be about to boost investment. The chart shows that railroad employment leads our capital spending-to-sales proxy. The latter had plunged as railroads moved aggressively to protect margins during the downturn, and any premature reversal could cut short the earnings recovery. We are overweight this group, but are putting it on downgrade alert. The ticker symbols for the stocks in this index are: BLBG: S5RAIL-UNP, CSX, NSC, KSU.

The financials sector has cheered President-elect Trump's anticipated policy changes as if they will all be enacted within very short order. While the yield curve has steepened modestly, the widening pales in comparison with the violence of the relative performance rise in financial share prices. We caution against extrapolating recent sector gains. If yields rise much further, they will be in danger of moving ahead of the rate of GDP growth, as the latter is unlikely to benefit from any fiscal stimulus for at least a few quarters. Financials (and the broad market), have trouble when this measure of liquidity tightens. The financial sector is already facing a cooling in the pace of credit creation and a decline in credit quality: financials sector ratings migration is steadily deteriorating. The bottom line is that the upward spike in financials sector relative performance is due for a breather, and only neutral weightings are recommended.

Health care stocks have consistently outperformed during the six inflationary periods we studied (top panel). Over the long haul it has paid to overweight this sector given the structural uptrend in relative share prices. Spending on health care services is non-cyclical and demand for such services is also on a secular rise around the globe: in the developed markets driven largely by the aging population and in the emerging markets by the adoption of health care safety nets. Health care pricing power is expanding at a healthy clip, outshining overall CPI (bottom panel). Importantly, recent geopolitical uncertainty had cast a shadow on the sector's pricing power prospects that suffered from a constant derating. Now that political and pricing power uncertainty is lifting, a rerating looms. Finally, the health care sector's dividend yield allure is the lowest among defensive sectors and remains 44bps below the broad market, somewhat insulating the sector from the inflation driven selloff in the bond market. Bottom Line: Stay overweight the S&P health care sector.

President-elect Trump and the specter of his spendthrift policy proposals have generated significant client interest/inquiries on equities and inflation - not asset price, but of the more traditional kind: consumer price inflation. Accelerating inflation is a modest risk, but not our base case forecast. Nevertheless, for investors that are more worried about the prospect of higher inflation, the purpose of yesterday's Special Report is to serve as an equity sector positioning roadmap if inflationary pressures become more acute sooner than we anticipate. Historically, inflation has been synonymous with an aggressive Fed and hard asset outperformance, suggesting that deep cyclical sectors would be primary beneficiaries. The table shows that over the last six major inflationary cycles, energy, materials, real estate and health care have been consistent outperformers. Utilities, tech and telecom have been clear underperformers. The remaining sectors have been a mixed bag (please see the next Insight).

Highlights The rise in both bond yields and the U.S. dollar represents significant tightening in monetary conditions, which will be difficult for stock prices to digest. Technical indicators suggest that the rally could persist in the near term, but investors should nonetheless prepare a shopping list once prices correct. Both consumer discretionary and health care stocks are appealing longer-term plays that are less expensive than the broad market. Feature The current rally in equity prices is high risk. Since the summer, our main worry for the stock market has been the likelihood of profit disappointments, given that corporations lack pricing power and that the outlook for top-line growth is lackluster. That worry has not gone away, but now the more pressing issue has become the impact on equity prices of the swift and aggressive tightening in monetary conditions via both the bond market sell-off and rise in the dollar (Chart 1). The 10-year Treasury yield is now trading above fair value. True, in the past, equity prices have sustained gains until yields rose much further into undervalued territory, but the big difference this time is that the dollar is rising in tandem. Simultaneous powerful rises in the currency and yields are rare, and typically result in steep market pullbacks. Investors should be on high-alert for this outcome. The possibility that equity market euphoria persists for another month or two should not be ruled out, i.e. until the Fed's next meeting and until there is more clarity on the course of fiscal and trade policy. Indeed, a simple read of technical indicators and market sentiment suggest that the rally could continue, but the risk/reward balance is poor (Chart 2). Chart 1Monetary Conditions Have Changed Chart 2Technicals: Not Flashing A Warning Yet With that in mind, one of the most frequently asked (and difficult) questions we receive is, Where is the value in U.S. equities? Presently, this is akin to looking for deals on New York's Upper 5th Avenue.1 As Chart 3 shows, U.S. equity multiples remain near or at historic (ex. TMT mania) highs. This is true for both small and large caps. And relative to global equity valuations, U.S. stocks appear even more expensive. There are few sectors that we believe offer compelling absolute value today. However, on a relative basis, the Trump rally has caused a flight out of traditional safe havens that has gone too far. For instance, consumer products stocks (household products, beverages and packaged food) are now trading below the broad market P/E multiple, in aggregate, on a trailing 12-month basis (Chart 4). According to our U.S. Equity Strategy service, forward relative returns are typically very robust when the group trades at a discount to the market. Importantly, consumer products stocks have a positive correlation with the U.S. dollar, which means that recent share price weakness represents a buying opportunity. Chart 3No Deals Here Chart 4Good Entry Point To Consumer Products? As highlighted above, we are on high-alert for an equity shakeout, triggered by the rapid rise in bond yields, and reinforced by profit disappointment. Still, we have assembled a short shopping list of sectors that we believe offer long-term upside. Health care and consumer discretionary stocks already offer better value than other areas of the market. Consumer Discretionary Will Last Longer This Cycle We have recommended favoring domestic over global exposure within U.S. equities and, in-line with our U.S. Equity Strategy service, we have favored non-cyclical holdings. But the cyclical interest rate-sensitive consumer discretionary sector deserves more attention, especially given good relative valuations. The recent back-up in bond yields has sent the relative performance of consumer discretionary stocks to a four-year low, once heavyweight Amazon is excluded (Chart 5). Admittedly, this comes on the back of an almost uninterrupted run higher since 2010. Still, since we believe it unlikely that the current back-up in yields can continue much longer, any cooling in bond yields could start a rotation back into consumer discretionary stocks. In last week's Special Report,2 we outlined the case as to why structural headwinds make it highly unlikely that the Fed will need to aggressively tighten in the coming year. In our view, the interest rate backdrop is unlikely to be an insurmountable headwind for this sector. Most importantly, fundamentals for consumer spending have been slowly improving. The labor market is now tight enough that consumers have job security (Chart 6). Incidentally, consumer confidence is now back to historically buoyant levels. The greatest ramification of this is that higher job security historically goes hand in hand with greater demand for credit. Until this point of the cycle, consumption growth has been capped by income growth trends because there has been no appetite to borrow in the aftermath of the Great Recession. We highly doubt that a new debt-fuelled spending spree will get underway, but rising job security should help fuel some credit growth. Chart 5Consumer Discretionary Stocks##br## Should Resume Outperformance Chart 6Consumers: The Future##br## Is Brighter Alongside improved job security, consumers are enjoying a tailwind from a historically light drag on their finances (Chart 6). Consumer spending on essential items, which includes energy costs, interest expense, insurance, taxes, etc. is at multi-decade lows. If BCA's benign forecast for energy prices (around $50 per barrel) and rate backdrop pans out, then there should continue to be ample spending room on discretionary items. The bottom line is that consumer discretionary stocks are one of the few sectors that are trading at historically reasonable valuations. We believe that a combination of a benign rate backdrop, better consumer confidence and a strong dollar will help this sector outperform late into the business cycle. Particular emphasis should be placed on industry groups and companies that can maintain positive pricing power. This includes movie & entertainment and restaurant stocks. Retailers should be de-emphasized until deflationary pressures ease, as we discuss on page 9. Follow The Baby Boomers To...Health Care Stocks In our Special Report last week, we explained how the aging population will continue to have implications for the labor market and wages. We also believe that demographics will eventually have important implications for equity sector outperformance. BCA Research periodically puts forward investment mania candidates. Charles Kindleberger described three conditions that must be met in order to create a financial mania and bubble: a powerful theme that captures the imagination of investors which is often the result of a major economic displacement; low interest rates; and finally, investment vehicles that allow rampant speculation (Chart 7). We believe that the aging of the population and the need for increased resources to service that population could be a powerful theme that captures investors' attention in the coming years. Chart 7A History Of Manias Since the baby boomers came of age (in the 1960s), their massive numbers relative to other age cohorts has given this generation an outsized influence on political, social and economic trends. Put simply, the baby boom generation has had the most clout because of their sheer numbers. And what do baby boomers want now? This age cohort is now focused on prolonging good health for as long as possible! It makes sense, then, any coming pent-up demand for goods and services will focus on health-related spending. As Chart 8 shows, spending on health care increases significantly for the 65-year and over cohort. This massive increase in health care spending has already begun but is likely to increase much more in the coming years. Chart 8Spending On Health Care Accelerates With Age To further highlight this point, in a Special Report last year,3 we made the case that health care will be one of the greatest sources of innovation this cycle. As we highlighted then, government R&D spending on basic research tends to lead practical applications, such as in the 1950s innovation boom after WWII (Chart 9). Currently, government R&D spending is growing much faster in healthcare than in tech. The private sector is also in agreement with tech VC investment still well below its 2000 peak, whereas healthcare is hitting new highs. Chart 9Health Care R&D Spending Is An Outlier Health care relative valuations are significantly below their post-2008 mean (Chart 10). We will explore the potential for health care as a mania candidate in an upcoming Special Report, but our preliminary work suggests that health care stocks should be on the top of investors' shopping lists. Chart 10Long-Term Value In Health Care Stocks Economic Momentum Heating Up? The surprising election results have stolen the financial media's focus away from economic and profit fundamentals in the past few weeks. Admittedly, investors who were focused on the elections did not miss much: the overall picture of economic growth has not changed in recent weeks. Indeed, the Fed's Beige Book of anecdotes on the state of the U.S. economy, released last week, indicates that growth remains mediocre, although sufficient enough for the Fed to raise rates later this month. Nevertheless, we have been monitoring consumer and business confidence closely, as we believe that this will be a key gauge to the likelihood that a more virtuous economic cycle is underway. There is some improvement: Consumer Confidence: A missing ingredient thus far in the recovery has been optimism among households. But that may be finally changing. Surveys of consumer sentiment ticked up markedly in November. As discussed above, this appears mainly to be attributed to better job security as the labor market tightens. If sustained, we view this as a very positive development, since a rising confidence in the outlook allows consumers to take on debt - or at least reduce their savings rate (Chart 6). Business Confidence: Business confidence has mirrored - and even lagged - soggy consumer confidence throughout this cycle. This makes sense, since optimism about a company's future hinges on prospects for demand for its products. In an economy where 70% of GDP is consumption, it is rational that businesses take their cue from consumer sentiment. The most recent ISM manufacturing survey was positive; new orders are rising. Respondent comments were particularly sunny. The bulk of survey responses were collected after the November 8 election and so should be reflective of business attitudes toward the new political administration. Consumer Spending: Black Friday/Cyber Monday sales were reported as lackluster relative to last year, according to the National Retail Federation (NRF). Apparently, about 3 million more shoppers than in 2015 were enticed into stores and onto their computers, but they spent about 3.5% less, while overall sales were down about 1.5% over last year. But the survey also picked up on one of our critical themes: deflation in the retailing sector is still rampant. Price discounting remains a dominant tactic to entice shoppers and over half of the NRF survey respondents reported that deals were "too good to pass up." In real terms, annual consumer spending growth has trended sideways at 2.5%. We see little risk of a slowdown, and in fact as highlighted above, now that consumer confidence has improved, any modest wage gains could lead to an improved spending outlook. All in all, the modest growth backdrop that has characterized the economic recovery since to date is still intact. We are closely watching consumer and business confidence for signs that the economy can or cannot handle the rise in bond yields and dollar: if recent optimism can be maintained, the odds of a more virtuous economic cycle will improve. Lenka Martinek, Vice President U.S. Investment Strategy lenka@bcaresearch.com 1 According to Cushman & Wakefield, New York's Upper 5th Avenue had the highest average rents of any shopping street in the world in 2015. A square foot of retail space cost $3,500. 2 Please see U.S. Investment Strategy Special Report "U.S. Wage Growth: Paid In Full?," dated November 28, 2016, available at usis.bcaresearch.com 3 Please see U.S. Investment Strategy Special Report "The Next Big Thing: How To Profit From Disruptive Innovation," dated March 9, 2015, available at usis.bcaresearch.com

Special Report

President-elect Trump and the specter of his spendthrift policy proposals have generated significant client interest/inquiries on equities and inflation - not asset prices, but of the more traditional kind: consumer price inflation. Chart 1 shows that a little bit of inflation would be positive for the broad equity market, further fueling the high-risk, liquidity-driven blow off phase. However, when inflation has reached 3.7%-4% in the past, the broad equity market has stumbled (Chart 2). Sizeable tax cuts, increased infrastructure and defense spending (i.e. loose fiscal policy), protectionism and a tougher stance on immigration are inherently inflationary policies (and bond price negative) ceteris paribus. Chart 1A Whiff Of Inflation##br## Is Good For Stocks... Chart 2...But Too Much ##br##Is Restrictive However, our working assumption is that in the next 9-12 months, CPI headline inflation will only renormalize, rather than surge. Importantly, the magnitude and timing of the implementation of Trump's policy pledges is unknown. Moreover, the Fed's reaction function is also uncertain, and the resulting economic growth and U.S. dollar impact will be critical in determining whether any lasting inflation acceleration occurs. Table 1 For global inflation to take root beyond the short term, Europe and Japan would also have to follow Canada's and America's fiscal largesse to swing the global deflation/inflation pendulum toward sustained inflation. The Fed's Reaction Function Our sense is that a Yellen-led Fed will allow for some inflation overshoot to materialize. This view was originally posited in her 2012 "optimal control"1 speech and more recently reiterated with her mid-October speech emphasizing "temporarily running a "high-pressure economy," with robust aggregate demand and a tight labor market."2 The Fed has credible tools to deal with inflation. If economic growth does not soar, but rather sustains its post-GFC steady 2-2.5% real GDP growth profile as we expect, then taking some inflation risk is a high-probability. The implication is that the Fed will likely not rush to abruptly tighten monetary policy, a view confirmed by the bond market , which is penciling in only 40bps for 2017 (Chart 3). A sustainable breakout in bond yields would require inflation (and to a lesser extent real GDP growth) to significantly surprise to the upside and thus compel the Fed to aggressively raise the fed funds rate. Is that on the horizon? While wage inflation has perked up, unit labor cost inflation has a spotty track record in terms of leading core consumer goods prices. Why? About 20% of the CPI and PCE inflation baskets are produced abroad, underscoring that domestic costs are not a factor in setting prices. There is a tighter correlation between unit labor costs and service sector inflation, but even here there is not a consistent relationship (Chart 4). Consequently, there is minimal pressure on the Fed to get aggressive, suggesting that most of the cyclical back up in long-term yields may have already occurred. Chart 3Fed Will Be Late, As Always Chart 4Wage And CPI Inflation Often Diverge The 1960s Analogy The 1960s period provides an instructive guide for today. Then, an extremely tight labor market and a positive output gap was initially ignored by the Fed, i.e. the economy was allowed to overheat (Chart 5). This ultimately led to the surge of inflation in the 1970s, especially given the then highly unionized labor market (see appendix Chart A1). While there are similarities between the current backdrop and the 1960s, namely an extended business cycle, full employment, narrowing output gap, easy monetary and a path to easing fiscal policies, and rising money multiplier, there are also striking differences. At the current juncture, wage inflation is half of what it was in the mid-1960s. Even unit labor costs heated up to over 8% back then, nearly four times the current level. Chart 5The 1960's... Chart 6... And Today Full employment has only been recently attained (Chart 6) and in order to pose a long-term inflation worry, it would have to stay near 5% for another three years. True, the output gap is almost closed, and is forecast to turn marginally positive in 2017/2018, but much will depend on the timing of fiscal stimulus. Industrial production has diverged negatively from the output gap of late, suggesting that excess capacity still lingers in some parts of the economy (Chart 7). The upshot is that inflationary pressures may stay contained for some time, especially if the U.S. dollar continues to firm. The global environment remains marked by deficient demand, not scarce resources. Chart 8 shows that the NFIB survey of the small business sector has a good track record in leading core inflation. The survey shows that businesses are still finding it difficult to lift selling prices. That is confirmed by deflation in the retail price deflator. Chart 7Divergent Economic Slack Messages Chart 8Pricing Power Trouble Finally, while the money multiplier has troughed, it would have to jump to a level of 4.9 to parallel the 1960s (Chart 9). This is a tall order and it would really require the Fed to very aggressively wind down its balance sheet. Chart 9Monitoring The Money Multiplier Therefore, a 1960s repeat would be a tail risk, and not our base case forecast. What About The Greenback? Chart 10 shows that inflation decelerates during U.S. dollar bull markets. Our Foreign Exchange Strategy service believes that the currency has more cyclical upside3, given that it has not yet overshot on a valuation basis and interest rate differentials will favor the U.S. for the foreseeable future. Accordingly, it may be difficult for inflation to rise on a sustained basis. Chart 10Appreciating Dollar Is##br## Always Disinflationary So What? Accelerating inflation is a modest risk, but not our base case forecast. Nevertheless, for investors that are more worried about the prospect of higher inflation, the purpose of this Special Report is to serve as an equity sector positioning roadmap if inflationary pressures become more acute sooner than we anticipate. Historically, inflation has been synonymous with an aggressive Fed and hard asset outperformance, suggesting that deep cyclical sectors would be primary beneficiaries. Table 1 on Page 2 shows that over the last six major inflationary cycles, energy, materials, real estate and health care have been consistent outperformers. Utilities, tech and telecom have been clear underperformers. The remaining sectors have been a mixed bag. However, this cycle, potential growth is much lower than in the past, underscoring that the hit to overall profits from tighter monetary policy could be pronounced, potentially undermining equity market risk premiums. If inflation rises too quickly and the Fed hits the economic brakes, then it is hard to envision cyclical sectors putting in a strong market performance, especially given their high debt loads and shaky balance sheets, i.e. they are at the epicenter of corporate sector vulnerability if interest rates rise too quickly. Owning shaky balance sheets in a sluggish global economy is a strategy fraught with risk. On the flipside, the recent knee jerk sell off in more defensive sectors represents a reversal of external capital flows, and is not representative of an underlying vulnerability in their earnings prospects. As a result of this shift, valuations now favor more defensive sectors by a wide margin. Ultimately, we expect relative profit trends to dictate relative performance on a cyclical investment horizon, and are not rushing to position our portfolio for accelerating inflation. Anastasios Avgeriou, Vice President Global Alpha Sector Strategy anastasios@bcaresearch.com 1 https://www.federalreserve.gov/newsevents/speech/yellen20120411a.htm 2 https://www.federalreserve.gov/newsevents/speech/yellen20161014a.htm 3 https://fes.bcaresearch.com/articles/view_report/20812 Health Care (Overweight) Health care stocks have consistently outperformed during the six inflationary periods we studied. Over the long haul it has paid to overweight this sector given the structural uptrend in relative share prices. Spending on health care services is non-cyclical and demand for such services is also on a secular rise around the globe: in the developed markets driven largely by the aging population and in the emerging markets by the adoption of health care safety nets (Chart 11). Health care pricing power is expanding at a healthy clip, outshining overall CPI. Importantly, recent geopolitical uncertainty had cast a shadow on the sector's pricing power prospects that suffered from a constant derating. Now that political and pricing power uncertainty is lifting, a rerating looms. Finally, the health care sector's dividend yield allure is the lowest among defensive sectors and remains 44bps below the broad market, somewhat insulating the sector from the inflation driven selloff in the bond market (Chart 12). Chart 11Health Care Chart 12Health Care Consumer Staples (Overweight) Similar to the health care sector, consumer staples stocks have been stellar outperformers over the past 55 years. The sector's track record during the six inflationary periods we studied is split down the middle. Most consumer staples companies are global conglomerates and their efforts have been focused on building global consumer brands, allowing them to implement a stickier pricing strategy. As a result, overall inflation/deflation pressures are more benign (Chart 13). Relative consumer staples pricing power is expanding and has been in an uptrend for the past five years. As the U.S. dollar has been in a bull market since 2011, short-circuiting the commodity super cycle, consumer staples manufacturers have been beneficiaries of falling commodity input costs. The implication is that profit margins have been expanding due to both rising pricing power and lower input costs (Chart 14). Chart 13Consumer Staples Chart 14Consumer Staples Telecom Services (Overweight - High Conviction) Relative telecom services performance and inflation appear broadly inversely correlated since the early 1970s, underperforming 60% of the time when core PCE prices accelerate. Importantly, in two of the periods we studied (during the late-70s and the TMT bubble) the drawdowns were massive, skewing the mean results portrayed in Table 1 on page 2. This fixed income proxy sector tends to suffer in times of inflation as competing assets dilute its yield appeal and vice versa (Chart 15). Telecom services pricing power has been declining over time as the government deregulated this once monopolistic industry. As more entrants forayed into the sector boosting competition, pricing power erosion accelerated. While relative sector pricing power has been mostly mired in deflation with a few rare expansionary spurts, there is an offset as the industry has entered a less volatile selling price backdrop: communications equipment costs are also constantly sinking (they represent a major input cost), counterbalancing the industry's profit margin outlook (Chart 16). Chart 15Telecom Services Chart 16Telecom Services Consumer Discretionary (Overweight) While the overall trend in consumer discretionary stocks has been higher since the mid-1970s, relative performance mostly declines during inflationary times. Consumer spending takes the backseat as a performance driver when interest rates rise on the back of higher inflation. In addition, previous inflationary periods have also coincided with surging energy prices, representing another source of diminishing consumer discretionary purchasing power (Chart 17). Consumer discretionary selling prices are expanding relative to overall wholesale price inflation, but they have been losing some steam of late. Were energy prices to sustain their recent cyclical advance, as BCA's Commodity & Energy Strategy service expects, that would represent a minor headwind to discretionary outlays. True, the tightening in monetary conditions could also be a risk, but we doubt the Yellen-led Fed would slam on the brakes at a time when the greenback is close to 15 year highs. The latter continues to suppress import prices and act as a tailwind to consumer spending and more than offsetting the energy and interest rate headwinds (Chart 18). Chart 17Consumer Discretionary Chart 18Consumer Discretionary Real Estate (Overweight) REITs have been outperforming the overall market during the five inflationary periods we analyzed, exemplifying their hard asset profile. While the 1976-81 iteration skewed the mean results, REITs still come out with the third best showing among the top eleven sectors even on median return basis (see Table 1 on page 2). Real estate prices tend to appreciate when inflation is accelerating, because landlords have consistently raised rents at least on a par with inflation (Chart 19). REITs pricing power has outpaced overall CPI. Apartment REITs rental inflation has been on a tear since the GFC, and the multi-family construction boom will eventually act as a restraint. The selloff in the bond market represents another risk to REITs relative returns as this index falls under the fixed income proxied equity basket, but the sector is now attractively valued (Chart 20). Chart 19Real Estate Chart 20Real Estate Energy (Neutral) The energy sector comes out on top of the median relative return results in times of inflation, and second best in average terms (Table 1 on page 2). Oil price surges are typically synonymous with other forms of inflation. During the six inflationary periods we analyzed, all but one period were associated with relative share price outperformance. Oil producers in particular benefit from the increase in the underlying commodity almost immediately (assuming little to no hedging), which also serves as an excellent inflation hedge (Chart 21). While relative energy pricing power had stabilized following the tumultuous GFC, Saudi Arabia's decision in late 2014 to refrain from balancing the oil market triggered a plunge in oil prices, similar to the mid-1980s collapse. The OPEC deal reached last week to curtail oil production should rebalance the market more quickly, assuming OPEC cheating will be limited, removing downside price risks. Nevertheless, any oil price acceleration to the $60/bbl level will likely prove self-limiting, as supply will come to the market and producers would rush to lock in prices by hedging forward (Chart 22). Chart 21Energy Chart 22Energy Financials (Neutral) Financials relative returns are neither hot nor cold when inflation rears its ugly head. In fact they sit in the middle of the pack in terms of relative median and mean returns. This lack of consistency reflects different factors that exerted significant influence in some of these inflationary periods. Moreover, Chart 23 shows that relative share prices have been mean reverting since the 1960s, likely blurring the inflation influence. Ultimately, the yield curve, credit growth and credit quality determine the path of least resistance for the relative share price ratio of this early cyclical sector. Financials sector pricing power has jumped by about 400bps over the past 18 months. Given the recent steepening of the yield curve, the odds are high that sector pricing power will remain firm via rising net interest margins. Any easing in the regulatory backdrop could also provide a fillip to margins (Chart 24). Chart 23Financials Chart 24Financials Utilities (Neutral) Utilities relative returns during inflationary bouts are the second worst among the top eleven sectors on an average basis and dead last on a median return basis. In five out of the six inflationary phases we examined, utilities stocks suffered a setback. The industry's lack of economic leverage and fixed income attributes anchor the relative share price ratio during inflationary times (Chart 25). Our utilities sector pricing power proxy has sprung to life recently moderately outpacing overall inflation. Natural gas prices, the industry's marginal price setter, have experienced a V-shaped recovery since the March trough, as excess inventories have been whittled down, signaling that recent pricing power gains have more upside. Nevertheless, the recent inflation driven jack up in interest rates has dealt a blow to this high dividend yielding defensive sector. Barring a sustained selloff in the bond market at least a technical rebound in relative share prices is looming (Chart 26). Chart 25Utilities Chart 26Utilities Tech (Underweight) Technology stocks have underperformed every time inflation has accelerated with two exceptions, in the mid-to-late 1960s and mid-to-late 1970s. Creative destruction forces in the tech industry are inherently deflationary. As a result, tech business models have evolved to thrive during disinflationary periods. Moreover, tech stocks have become more mature than typically perceived, having more stable cash flows and paying dividends. The implication is that the negative correlation with inflation will likely remain in place (Chart 27). Tech companies are constantly mired in deflation. While relative pricing power has been in an uptrend since 2011, it has recently relapsed into the deflationary zone. Worrisomely, deflation pressures are likely to intensify as the U.S. dollar appreciates, eating into the sector's earnings growth prospects. Finally, as a reminder, among the top eleven sectors tech stocks have the highest international sales exposure (Chart 28). Chart 27Tech Chart 28Tech Industrials (Underweight - High Conviction) The industrials sector tends to outperform during inflationary periods. In fact, relative share prices have risen 50% of the time since the mid-1960s when inflation was accelerating. The two oil shocks in the 1970s raised the profile of all commodity-related sectors as investors were scrambling to find reliable inflation hedges (Chart 29). Industrials pricing power is sinking steadily, weighed down by the multi-year commodity plunge on the back of China's economic growth deceleration, rising U.S. dollar and increasing supplies. While infrastructure spending is slated to increase at some point in late-2017 or early-2018, we doubt a lot of shovel ready projects will get off the ground quickly enough to satisfy the recent spike in expectations. We are in a wait and see period and remain skeptical that all this fiscal spending enthusiasm will translate into a sustainable earnings driven outperformance phase (Chart 30). Chart 29Industrials Chart 30Industrials Materials (Underweight) Materials equities have a tight positive correlation with accelerating inflation. Resource-related stocks are the closest representation of hard assets, given their ability to store value among the eleven GICS1 sectors. As inflation takes root and commodity prices rise, materials sales and EPS growth get a boost with relative share prices following right behind (Chart 31). From peak-to-trough relative materials prices collapsed by over 35 percentage points and only recently have managed to stage a modest comeback. Our relative pricing power gauge is flirting with the zero line, but may not move much higher. Deleveraging has not even commenced in the emerging markets, and the soaring U.S. dollar is highly deflationary. It will be extremely difficult for materials prices to advance sustainably if EM financial stress intensifies, given the inevitable backlash onto regional economic growth (Chart 32). Chart 31Materials Chart 32Materials Appendix Chart A1 Chart A2 Chart A3 Chart A4 Chart A5 Chart A6

GAA DM Equity Country Allocation Model Update The GAA DM Equity Country Allocation model is updated as of November 30, 2016. The model further augmented the overweight to the U.S. despite the fact that the U.S. had already been the largest overweight, at the expenses of the Euro Area. Japan's underweight is reduced again, albeit slightly. The model continues to dislike Canada and Australia even though the two countries have outperformed year to date. U.K. remains the largest underweight (Table 1). Table 1Model Allocation Vs. Benchmark Weights As shown in Table 2 and Chart 1, Chart 2 and Chart 3, the large overweight of the U.S. versus the non-U.S. (Level 1 model) worked well in November with 49 bps of outperformance versus the MSCI World benchmark, the level 2 (allocation within the 11 non-U.S. countries), however, underperformed significantly, resulting the overall model to underperform by 16 bps. Please see also on the website http://gaa.bcaresearch.com/trades/allocation_performance. Table 2Performance (Total Returns In USD) Chart 1GAA DM Model Vs. MSCI World Chart 2GAA U.S. Vs. Non U.S. Model (Level1) Chart 3GAA Non U.S. Model (Level 2) For more details on the models, please see the January 29th, 2016 Special Report "Global Equity Allocation: Introducing the Developed Markets Country Allocation Model." http://gaa.bcaresearch.com/articles/view_report/18850. GAA Equity Sector Selection Model The GAA Equity Sector Selection Model (Chart 4) is updated as of November 30, 2016. Table 3AllocationsTable 4Performance Since Going Live Chart 4Overall Model Performance The momentum component has shifted Consumer Discretionary from underweight to overweight. For mode details on the model, please see the Special Report "Introducing The GAA Equity Sector Selection Model," July 27, 2016 available at https://gaa.bcaresearch.com. Xiaoli Tang, Associate Vice President xiaoli@bcaresearch.com Patrick Trinh, Senior Analyst patrick@bcaresearch.com Aditya Kurian, Research Analyst adityak@bcaresearch.com