Financials

The insurance industry is battling generationally low interest rates, which has created a deep undercurrent of pessimism toward related equities. That is borne out by extremely cheap valuations, as measured by relative price/book value ratios (bottom panel). However, such a low expectations hurdle should be easily surpassed. After a prolonged slump, consumers are allocating a rising share of spending to insurance products, consistent with increased housing turnover and buoyant vehicle sales. In turn, insurance companies have been able to lift premiums at a solid rate. This shift in spending patterns bodes well for profit outperformance, and ultimately, a re-rating in dirt cheap relative valuations. The surge in our insurance relative advance/decline line heralds share price outperformance and we reiterate our high-conviction overweight. The ticker symbols for the stocks in this index are: BLBG: S5INSU. bca.uses_in_2016_05_12_001_c1 bca.uses_in_2016_05_12_001_c1

Approaching the referendum on EU membership, what are the prospects for the U.K. economy and financial markets?

While we recently downgraded financials and banks to underweight, this bearish view does not extend to each of the sector's components. REITs are a positive exception. The group is still not overvalued, despite the relentless decline in yields on competing assets. This may reflect an undercurrent of skepticism regarding the sustainability of cash flow growth and low cap rates. However, both appear sustainable. The CPI for homeowner's equivalent rent, a proxy for REIT pricing power that has a good correlation with relative performance, is still accelerating even though it is already well above the overall rate of inflation. Moreover, commercial property price inflation continues to climb. While Fed rate hikes could be construed as an impediment if they lift the cost of capital, REITs have not typically run into trouble until policy has tightened by enough to cause a cresting in commercial real estate prices, a peak in occupancy rates and by extension, a downturn in the CPI for rental inflation. None of these concerns currently exist. Consequently, we recommend maintaining an overweight position. BLBG: S5REITS bca.uses_in_2016_05_06_001_c1 bca.uses_in_2016_05_06_001_c1

Following up from yesterday's S&P banks update, as banks go so do financials, given that they comprise the highest weight in the sector. Worrisomely, financials relative EPS momentum has more downside. Using the latest Fed Senior Loan Officer survey data, we constructed a C&I loan supply/demand indicator (middle panel). The news is grim for financial sector profits. C&I loan volumes are decelerating and banks are tightening lending standards. C&I now represents the highest lending category exposure on bank balance sheets, warning of a magnified negative impact on profitability. As long as deflationary forces prevail, as proxied by persistent weakness in our global leading economic indicator (GLEI), then credit quality will continue to erode: it is no wonder that financials relative performance and the GLEI are highly correlated. Bottom Line: We reiterate our recent downgrade to underweight. BLBG: S5FINL. Financials: Banks Are Weighing Heavily Financials: Banks Are Weighing Heavily

At this stage of the business cycle, the bull case for banks rests on the ability of accelerating loan growth to offset the beginnings of deteriorating credit quality. However, the latest Fed Senior Bank Loan Officer Survey has poured cold water on such an outcome. Banks are tightening lending standards on their main source of asset growth, namely C&I and commercial real estate loans. These are the main sources of excess leverage. Consequently, it is logical for banks to become more discerning when doling out related credit when credit quality is eroding (bottom panel). While mortgage and consumer lending demand remains decent, it is unlikely to be sufficient to offset higher charge-offs and a slowdown in business-linked loan creation. We reiterate our recent downgrade to underweight. The ticker symbols for the stocks in this index are: BLBG: S5BANKX - WFC, JPM, BAC, C, USB, PNC, BBT, STI, MTB, FITB, CFG, RF, KEY, HBAN, CMA, ZION, PBCT. Banks Are Less Willing To Lend Banks Are Less Willing To Lend

Colombia's structural growth outlook is superior to many other developing economies. In the near-term, however, Colombia's economy is set to weaken materially. Upgrade Colombian equities and sovereign credit to neutral versus EM benchmarks. Continue betting on further yield curve flattening/inversion and buy 10-year domestic bonds on weakness. Go long Colombian bank stocks / short Peruvian banks, and stay short the peso.

This week <i>U.S. Equity Strategy</i> is sending you the latest <i>BCA Special Report</i>, where Mark McClellan and Anastasios Avgeriou tackle the questions of "Global Earnings Recession: How Deep? How Long?"

Earnings-per-share (EPS) for the MSCI all-country world index are estimated to have fallen by 7% in the year to March, the fourth quarter in a row of annual decline. The length and depth of the profits recession is key to the appropriate equity allocation, especially given that stocks are not cheap, downside global growth risks abound and the FOMC is biased to lift rates. We created EPS growth models for the U.S., the Eurozone, Japan and the Global aggregate using a standard set of macro variables. We then simulated these models under three scenarios: bull, bear and base case. The good news is that we do not foresee a prolonged earnings slump. Global EPS year-ago growth will bottom by around the third quarter, due to the lagged effects of higher oil prices and an end to the global manufacturing recession. The bad news is that investors should not anticipate a quick return to robust profit growth either. Global EPS growth will not reach positive territory until the first half of 2017. As usual, bottom-up estimates are way too optimistic. A key conclusion is that it will be difficult for U.S. EPS growth to outperform that of the Eurozone or Japan over the next two years. In part, this reflects margin pressure in the U.S. that is largely absent in the other two economies. This result supports our recommendation to overweight Eurozone and Japanese stocks relative to the U.S. (currency hedged). However, the currency outlook is critical to relative profit performance. We assume that the U.S. dollar has more upside potential (more downside for euro and yen) in the "strong" growth scenario as the FOMC hikes rates along the "dot plot" path. This flatters Eurozone and Japanese profits relative to the U.S. Conversely, we assume that the dollar depreciates in the "weak" growth scenario. If, instead, the dollar depreciates when growth is reasonably solid across the three economies, model simulations show that U.S. earnings will have the edge. NIRP is weighing on global financials. In global portfolios, within a neutral financials weighting, we continue to prefer U.S. to both Eurozone and Japanese financials. Energy's gain is the consumer's pain; lift global energy stocks to benchmark and simultaneously downgrade consumer discretionary to underweight. Finally, our defensive-over-cyclicals preference remains intact. Table II-1Earnings Growth May 2016 May 2016 Corporate earnings rarely shrink outside of economic contractions, so investors can be forgiven for worrying that we are on the brink of a global recession. Earnings-per-share (EPS) for the MSCI all-country world index are estimated to have fallen by 7% in the year to March, the fourth quarter in a row of annual decline (Table II-1 and Chart II-1). This is by far the worst performance since the Great Recession. EPS growth in both the U.S. and the U.K. (local currency) is deep in negative territory. Profit growth is still positive, albeit decelerating, in the Eurozone and Japan in local currencies. Chart II-1Equity Prices And EPS Equity Prices And EPS Equity Prices And EPS How much more downside is there? When will EPS bottom and how strong will the recovery be? These are obviously key questions for the appropriate equity weighting within balanced portfolios, especially given that stocks are not cheap, downside global growth risks abound and the FOMC is biased to lift rates. It is difficult to justify being overweight equities without seeing some profit relief on the horizon. In this Special Report, we take a top-down approach to projecting EPS for the global index, the U.S., the Eurozone and Japan. The rebound in oil prices and some positive economic signs out of China have raised hopes that the profit recession is close to the end. Indeed, the good news is that world EPS annual growth should bottom in the third quarter. However, the bad news is that the climb back into positive growth territory will take time. Barring very strong (and unrealistic) growth assumptions for the rest of 2016, investors should not expect positive year-on-year global EPS growth until early in 2017. Bottom-up earnings estimates currently are too optimistic. On a regional basis, U.S. earnings growth will likely trail both Japan and the Eurozone over the next two years, although much depends on currency movements. Don't Expect An Extended Earnings Recession... Profit contractions normally occur during recessions, but there have been three exceptions since 1980: 1987, 1999 and a very brief period in 2012 (shaded portions in Chart II-2). All three cases involved a mid-cycle slowdown in nominal GDP growth, while labor compensation growth trended sideways (second panel). The deceleration in sales activity was evidently perceived to be temporary, such that business leaders did not respond by limiting wage gains, trimming payrolls or slashing capital spending. The absence of Fed tightening at the time likely calmed fears of an extended slowdown. Indeed, the Fed cut rates in 1987 and 1998, and implemented QE3 in 2012. The result was that the slowdown in top line growth and the margin squeeze proved shallow and short-lived. Chart II-2Three Examples Of Profit Recessions Without Economic Recessions Three Examples Of Profit Recessions Without Economic Recessions Three Examples Of Profit Recessions Without Economic Recessions We believe a similar phase is underway today. Several of the factors driving the profit recession appear to be at or close to their nadir. Commodity prices, and oil prices most importantly, have stabilized. Many key indicators of Chinese growth are rebounding, suggesting that monetary and fiscal stimulus is beginning to pay off. The global LEI has not yet turned up, but its slow erosion is in sharp contrast to the plunge that typically occurs before recessions. Purchasing managers' surveys have ticked higher in the U.S., Japan, Canada, the U.K. and China, signaling that the global manufacturing recession is ending. Bank profits could be near the worst as well, depending on the evolution of NIRP policies and net interest margins (see below). Moreover, the manufacturing recession has not spread to the service sector in the major economies, where job creation has held up. While persistently low productivity growth and a secular bottom in the labor share of income in the U.S. will remain a headwind for global earnings, they should be dominated by even a modest cyclical revival in global growth due to high corporate operating leverage. ...But Don't Expect An Imminent And Strong Upturn Either The implication is that we do not foresee a prolonged earnings contraction. Looking again at Chart II-2, global EPS surged following the modest profit recessions in 1987 and 1999. Output growth accelerated sharply, while commodity prices entered a robust bull phase. The global output gap shifted into "excess demand" territory, providing the business sector with some pricing power. Nominal GDP growth re-accelerated in absolute terms and relative to labor costs, contributing to a substantial rise in profit margins. The aftermath of the 2012 profit dip was an altogether different affair. Margins only edged higher due to the tepid rebound in nominal GDP growth. Commodity prices were roughly flat. Meanwhile, the still-large global "excess supply" gap robbed the business sector of pricing power. The result was that EPS growth barely climbed out of negative territory in 2013 and 2014. Today, the global output gap is closer to zero than was the case in 2012/2013, especially in the U.S. However, pricing power is still left wanting at the global level, based on the continued decline in global manufactured goods prices and depressed core consumer price inflation in most of the advanced economies. Oil prices have more upside potential given that the supply-side is responding to low prices, as discussed in the Overview. Nonetheless, our commodity experts do not foresee sustained price increases outside of oil anytime soon. Finally, the global leading economic indicator, a reasonably good bellwether for global EPS growth, has yet to turn higher (Chart II-2, bottom panel). The bottom line is that, while the profit recession will not be extended or deep, investors should not expect the kind of surge in EPS growth that followed the 1987 or 1997 earnings contractions. Model Simulations There are many special factors to consider at the industry level when gauging the outlook for global earnings. We will discuss some of the most important ones below, but this Special Report tackles the question using a top-down macro approach. We created EPS growth models for the U.S., the Eurozone, Japan and the Global aggregate using a standard set of macro variables. Industrial production does a good job of capturing pure growth effects on the top line. We also included the difference between nominal GDP growth and total labor costs as a proxy for changes in margins. Finally, the price of oil and the trade-weighted exchange rate (TWI) were included for obvious reasons. Most of the explanatory variables entered the model with a lag of 3-12 months, except the margin proxy, which is contemporaneous with the profit cycle. The historical fit is quite good for three of the four models (Chart II-3). The Japanese model fit is less impressive, but it is good enough for scenario work. All four models are well specified in that all coefficients are statistically significant, have the correct sign and are of a size that makes economic sense.1 Chart II-3Historical Fit Of Four EPS Macro Growth Models bca.bca_mp_2016_05_01_s2_c3 bca.bca_mp_2016_05_01_s2_c3 We then constructed three scenarios for profit growth using the following assumptions: Brent Oil Price: The price of oil in the base case follows the current forward curve, reaching $47/bbl by the end of 2016. It is held flat thereafter. We assume that Brent rises to US$60/bbl by the end of 2016 in the bull case, and falls back to US$30 by the end of this year in the bear case. Nominal GDP And Labor Compensation: In the base case, nominal GDP growth for the OECD countries is assumed to accelerate roughly in line with the latest IMF forecast from 3.6% (Q4/Q4) in 2015 to 4.1% in 2017. Labor compensation tracks the uptrend in GDP closely in Japan and the Eurozone, implying little change in margins in the base case. Nominal GDP growth is assumed to be about a percentage point higher/lower, respectively, in the bull and bear cases. Note that the bear case is not consistent with a recession, although growth is slow enough that unemployment would edge higher. Labor compensation growth is assumed to pick up in the bull case, although not by as much as GDP growth, leading to some margin expansion (less so in the U.S.). Conversely, we assume some margin compression in the low growth scenario (especially in the U.S.). We calibrated the implied margin shifts in the bull and bear cases using historical profit cycles. Industrial Production: The three paths for industrial production are designed to be in line with the GDP scenarios described above. The base case assumes that the maximum drag from the collapse in energy investment has passed, leading to a mild rebound in global output as CEO confidence gradually recovers. Global industrial production accelerates mildly from 0.5% in February to 2% by the end of 2016, and to 3% by the end of 2017. The bull case sees a stronger rebound; IP growth accelerates to 3½% by year end and to 5½% in 2017, similar to levels last seen in the years just prior to the Lehman shock. The bear case assumes that the energy drag has not yet reached its peak, weighing on CEO confidence and dragging down IP growth to zero this year. This is followed by a mild rebound in 2017 to 2%. Again, there is no recession in the bear case, although industrial production growth is quite depressed by historical standards for the next two years. Chart II-4Three Scenarios For Oil Prices bca.bca_mp_2016_05_01_s2_c4 bca.bca_mp_2016_05_01_s2_c4 The Impact Of Oil The model estimates that the collapse in oil prices has trimmed global EPS growth by about 3 percentage points (Chart II-4, top panel). The bad news is that, even if oil prices continue to rise consistent with the forward curve, energy profits will be a significant (albeit declining) drag on global EPS until early in 2017. This drag begins to lessen late in 2016, but does not contribute positively to global EPS until mid-2017 in the base case. The delay is due to the lags from changes in oil prices to company earnings. Indeed, at previous oil troughs, it took about a year before earnings in the Energy sector began to accelerate. The peak contribution to global EPS profits if oil prices follow the forward curve is about 2 percentage points in late-2017. Energy's EPS contribution reaches zero only a little earlier in the bull case, but the maximum contribution reaches +4 percentage points in early 2018. A dip back to $30/bbl would mean that Energy profits will remain a drag on global earnings through 2017. The impact on overall EPS may seem small but readers should note that these macro estimates reflect the combined impact of the drag on Energy profits from lower oil prices and the boost to profits in other industries that consume oil. The Outlook For Global Earnings The resulting global EPS scenarios are presented in Chart II-5. Global EPS growth drifts a little lower still before bottoming in the third quarter in both the base and bull cases. It is not until the second quarter of 2017 that year-over-year EPS growth turns positive in the base case. Profit growth turns positive in the first quarter of 2017 and accelerates to about 20% by the end of next year in the strong growth scenario, a level that has not been seen since early 2011. However, even our bull case falls short of current market expectations for the next year (indicated by the circle in Chart II-5). Chart II-5Global EPS Projections Under Three Scenarios bca.bca_mp_2016_05_01_s2_c5 bca.bca_mp_2016_05_01_s2_c5 The Outlook By Region Charts II-6-II-8 present the same three outlook scenarios for the U.S., the Eurozone and Japan. The country models include the same explanatory variables as the global model, except that we add the relevant trade-weighted exchange rate. The assumed currency shifts across the three scenarios will obviously have major implications for the profit outlook. In the strong-growth scenario, we assume that the FOMC would feel comfortable lifting rates at least as quickly as the current dot-plot foresees. Market expectations for the fed funds rate would shift up toward the "dots" as it becomes clear that the U.S. economy is exceeding market expectations. In contrast, the ECB and BoJ would continue with their NIRP and QE programs, even if growth positively surprises. There would be no hurry to scale back monetary stimulus, unless inflation were to surge (unlikely in our view). The result would be upward pressure on the dollar as the U.S. yield curve shifts up relative to the Bund and JGB curves. Conversely, the dollar would likely weaken in the event that growth disappoints and the FOMC is forced to abandon plans for rate hikes over the next year. For the purposes of our simulations, we assume that the U.S. dollar appreciates by 5% in trade-weighted terms in each of 2016 and 2017 in the bull case. It is unchanged at current levels in the base case, while it depreciates by 5% in each of 2016 and 2017 in the bear case. We assume the opposite for the euro and yen: both appreciate annually by 5% in the bear case and depreciate by 5% in the bull scenario. The simulations suggest that EPS growth in the U.S. is very close to a bottom (Chart II-6). The growth profile is quite V-shaped, largely because the model suggests that the impact of previous declines in oil prices and the manufacturing recession on profit growth will soon begin to fade. Nonetheless, it will not be until year-end that annual growth moves back into positive territory in the base case. The profit growth acceleration is even faster in the bull case, despite the stronger dollar, although it still falls short of current market expectations on a one-year horizon. Chart II-6U.S. EPS Projections bca.bca_mp_2016_05_01_s2_c6 bca.bca_mp_2016_05_01_s2_c6 Eurozone EPS growth (local currency) is in positive territory at the moment, but will dip to zero by mid-year under all three of our scenarios due to the lagged effects of euro strength (Chart II-7). The base and bull cases foresee profit growth accelerating by year end, while growth remains negative through 2017 in the bear scenario. Current market expectations for Eurozone profits in early 2017 are roughly in line with our base case. Chart II-7Eurozone EPS Projections bca.bca_mp_2016_05_01_s2_c7 bca.bca_mp_2016_05_01_s2_c7 Japanese EPS growth (local currency) is projected to remain in the high single digits in the coming months before dipping a little toward year-end (Chart II-8). This profile reflects a confluence of factors. The negative effect on profits from yen strength fades, but the drag from past weakness in industrial production growth intensifies in the near term due to lagged effects. EPS growth subsequently accelerates sharply in the base case and bull scenarios on the back of stronger growth and a cheaper yen (in the bull case). Chart II-8Japan EPS Projections bca.bca_mp_2016_05_01_s2_c8 bca.bca_mp_2016_05_01_s2_c8 As a side note, the Japanese scenarios assume that the VAT increase scheduled for next year is not implemented. If the VAT goes ahead, the IMF estimates that real GDP will contract by almost 1% on a Q4/Q4 basis in 2017. For exposition purposes, Chart II-9 compares our base case with an alternative scenario that is in line with the IMF forecast. There is no earnings recession in the alternative path, but EPS growth is substantially below the base case (no VAT increase) scenario. Chart II-9Japan: A VAT Hike Next Year Would Exact A Heavy Toll bca.bca_mp_2016_05_01_s2_c9 bca.bca_mp_2016_05_01_s2_c9 All the comments below on the Japanese outlook assume no VAT increase in 2017. U.S. EPS Growth To Lag The Eurozone And Japan... Table II-2 compares the year-end EPS projections for the three economies, both in level and growth rate terms. The U.S. lags both the Eurozone and Japan in the base case and bull scenarios for the following reasons: Table II-2EPS Model Projections May 2016 May 2016 Operating Leverage: The Eurozone and Japan have higher operating leverage relative to the U.S. which means that U.S. profits benefit less from the rebound in growth assumed in the base and bull cases. Profit Margins: The U.S. labor market has reached full employment which is placing mild upward pressure on wages. Without a corresponding rise in corporate pricing power, margins have been under downward pressure. We expect U.S. margins to continue eroding in the base case and rise only slightly in the bull case. In contrast, the Eurozone still has a large excess supply gap and wage growth is not under any upward pressure. Margins thus have more upside potential. Japan is a special case. As discussed in the Overview, firms are reluctant to hand out wage hikes despite a very tight labor market. This means that margins also have some upside potential in the base case and strong growth scenarios. Currency Shifts: Our currency assumptions mean that a stronger dollar would partially offset the benefits to U.S. corporate profits of faster output growth in the bull scenario. In contrast, a weaker yen and euro would magnify the positive impact on profits from a more robust economy in the bull case. It turns out that U.S. EPS growth also underperforms in the bear scenario. The assumed depreciation of the dollar and appreciation of the euro and yen favor U.S. earnings, but this is offset by a larger hit to profit margins assumed in the weak growth scenario. ...Although The Currency Assumptions Matter Of course, these currency assumptions are far from assured. It is certainly possible for the yen or the euro to appreciate even in a global environment where growth is rebounding and financial markets are "risk on". Indeed, both currencies have strengthened relative to the U.S. dollar in recent weeks. This may be due to the unwinding of carry trades funded in the Eurozone and Japan that necessitate currency short-covering. Our currency experts also remind us that valuation and the balance of payments backdrops favor both currencies versus the U.S. dollar. Moreover, because inflation expectations are rising in the U.S. relative to Japan and the Eurozone, the resulting increase in real bond yields in the latter two economies is supporting their currencies. In order to gauge the profit implications if the dollar does not follow our base case view, we re-ran the same three scenarios described above. This time, we assumed that the dollar falls in the bull case and appreciates in the bear case (still flat in the base case scenario). The assumptions for the euro and yen are reversed as well. The results are shown in Table II-3 (the base case is the same as in Table II-2 because there is no change to the currency assumption for that scenario). The weaker U.S. dollar in the bull case adds more than 2 percentage points to U.S. EPS growth in 2017, while profits decline by 4-6 percentage points in the Eurozone and Japan. U.S. EPS thus outperforms the Eurozone, although it still trails Japan in 2017. The reason Japan still outperforms as the yen rises is because corporate profits are so highly geared to growth, which is stronger in the bull scenario. Table II-3EPS Projections Assuming USD Falls In Bull Scenario & Rises In Bear Scenario May 2016 May 2016 The EPS effects are symmetric in the bear scenario, as dollar strength trims U.S. EPS growth by 2 percentage points and adds 4-6 percentage points to growth in the Eurozone and Japan. The result is that the U.S. underperforms both of the other countries in a low growth scenario in which the dollar appreciates. The bottom line is that it is difficult to see U.S. earnings growth bettering Japan and the Eurozone in local currency terms over the coming two years under most realistic growth scenarios, unless the dollar is headed significantly lower. Japan Vs. Eurozone In terms of the Eurozone versus Japan, our scenarios suggest that Japan has the edge across the three scenarios shown in Table II-2. This is because Japanese profits have a higher beta with respect to growth, which helps in the base case and bull scenarios. Japan outperforms the Eurozone even in the bear case where global growth is the weakest. This is because the starting point for Japanese industrial production growth (-5.3% year-over-year) is so depressed that, even in a tepid world growth environment, the rate of contraction is likely to moderate fairly quickly. The starting point for Eurozone growth is positive, and thus there is less room for a "snap back" effect when the global manufacturing recession ends. Chart II-10NIRP Weighing On NIMs NIRP Weighing On NIMs NIRP Weighing On NIMs Global Equity Sector Outlook: Space constraints prevent us from providing a detailed global sector outlook. Nonetheless, BCA's Chief Equity Strategist, Anastasios Avgeriou, comments on some key sectors below. Global Financials The impact of negative interest rate policy (NIRP) and QE on bank profits could not be incorporated in our EPS models given the short history of unorthodox monetary policy. The sharp narrowing in net interest margins (NIM) since 2010 has weighed on bank profits (Chart II-10). It is difficult to estimate how this earnings headwind will evolve in the coming years, as it depends on whether or not the ECB and Bank of Japan push deposit rates further into negative territory and what longer-term impact this will have on NIMs. NIRP puts an interest rate floor on deposit taking institutions that are reluctant to pass negative deposit rates onto their customers. Concurrently, NIRP forces banks to lend out new money (or roll over existing loans) at declining interest rates. As a result, net interest margins get squeezed. In its latest Global Financial Stability Report,2 the IMF presented estimates suggesting that every 10 basis point decline in NIMs has a substantial impact on pretax profits (Chart II-11). While central banks are taking steps to shield bank profits from negative deposit rates, further cuts in these rates could flatten the yield curves even more by signaling an intention to keep rates low for longer. Curve flattening would further undermine NIMs. It is impossible to disentangle the impact of negative deposit rates from quantitative easing on yield curves and NIMs. Nonetheless, for demonstration purposes, we present in Chart II-12 the hit to bank pretax profits if NIMs fall by 3 basis points for every 10 basis point cut in the deposit rate. We present estimates for a cut in the deposit rate ranging from 10 to 30 basis points. Eurozone banks suffer the most, enduring declines in pretax profits of between 6% and 18%. This is largely because the starting point for Eurozone bank profit margins is so low, and because their loan books reprice more quickly in response to lower central bank policy rates than in other countries. The hit to U.S. banks is the least onerous of the three economies, at between 2% and 6%. Chart II-11Global Banks: The Impact Of Falling NIMs May 2016 May 2016 Chart II-12Global Banks: The Impact Of Negative Interest Rates May 2016 May 2016 Importantly, Chart II-13 shows that U.S. bank NIMs have ticked higher, whereas Japanese and Eurozone ones have nudged lower. The already wide NIM divergence (140 BPs U.S. versus Eurozone and 190 BPs U.S. versus Japan) will likely become even more pronounced in the coming months owing to divergent monetary policies. Chart II-13U.S. Has The Upper Hand U.S. Has The Upper Hand U.S. Has The Upper Hand The implication is that U.S. banks have the upper hand compared with their Eurozone and Japanese peers. While we remain neutral on global financials, we continue to overweight U.S. financials at the expense of both Eurozone and Japanese financials that warrant a below benchmark allocation in global portfolios.3 Global Energy And Consumer Discretionary BCA's view of a global oil market rebalancing taking place in the back half of the year should lead to modestly higher oil prices. As discussed in the Overview, BCA's forecast is for oil demand to significantly outpace supply in the coming two years, a reversal of the dynamic in place for the past 18 months. Chart II-14 shows that if these forecasts are accurate, the pace at which consumption outpaces production would herald steady spot oil price gains. This "less bad" underlying commodity backdrop is reflected in our global energy sector EPS model that is signaling energy profit growth woes are abating (Chart II-15). The implication is that energy relative share prices have put in a cycle bottom, compelling us to upgrade the global energy sector to a benchmark allocation. Chart II-14Supply/Demand Imbalance Bodes Well For Oil Inflation Supply / Demand Imbalance Bodes Well For Oil Inflation Supply / Demand Imbalance Bodes Well For Oil Inflation Chart II-15Lift Global Energy Exposure To Neutral Lift Global Energy Exposure To Neutral Lift Global Energy Exposure To Neutral Concurrently, if oil prices recover on a sustained basis, eventually some of the disposable income benefits enjoyed by the global consumer will start working in reverse, undermining consumer discretionary spending power at the margin. This is corroborated by the almost perfect inverse correlation between relative global consumer discretionary performance and real oil prices over the past 40 years (Chart II-16). Chart II-16Energy's Gain Is The Consumer's Pain Energy's Gain Is The Consumer's Pain Energy's Gain Is The Consumer's Pain Under such a backdrop, consumer discretionary stocks are skating on thin ice and would suffer a sizable setback. Thus, it is prudent to downgrade the global consumer discretionary sector to underweight exposure, filling in the gap left by our upgrade of global energy to neutral. Global Cyclicals Vs. Defensives How does this sector positioning adjustment affect the defensive over cyclical portfolio tilt? While we are neutral global industrials4 and energy, we remain underweight materials and overweight consumer staples and utilities. This sustains our preference of safe-haven and higher-yielding defensives versus cyclicals. The recent broad market "risk on" phase has caused a rebound in the cyclicals/defensives ratio. Nonetheless, a number of macro variables have failed to confirm that this cyclicals outperformance phase has legs. Ultimately, relative profit trends will dictate the direction of relative performance. On that front, we are acknowledging that our relative EPS models have tentatively troughed and have moved in favor of cyclical sectors (Chart II-17). Chart II-17Better... Better... Better... Nevertheless, defensives profits will continue to outpace cyclicals earnings in the absence of (Chart II-18): Chart II-18...But Not Enough To Alter Our ##br##Defensives Over Cyclicals Preference ...But Not Enough To Alter Our Defensives Over Cyclicals Preference ...But Not Enough To Alter Our Defensives Over Cyclicals Preference a sustained depreciation in the greenback and related commodity reflation, a durable pickup in global growth and trade dynamics beyond China's recent green shoots, a clear turn in the inventory cycle, and a clear improvement in debt dynamics. Adding it all up, it still pays to hold a global defensive over global cyclical portfolio tilt. Investment Conclusions: We do not subscribe to the view that the global profit recession and the contraction in U.S. profit margins foreshadow a recession. Typically, margin contractions occur when an overheating economy causes wage pressures to escalate. The Fed then targets slower economic growth by lifting interest rates. It is the monetary tightening that causes the recession, not the profit squeeze. This time, U.S. wage gains have firmed a bit and margins are under pressure, but the FOMC is in no hurry to dampen growth. Indeed, the Fed wants to normalize interest rates slowly enough that it does not undermine economic momentum. Policymakers want to see wage inflation accelerate. The Fed could make a mistake and move too quickly but, as we saw following the last FOMC meeting, policymakers appear hyper sensitive to any hint of negative economic or financial news. Our "no recession" view is supported by a number of global leading economic indicators that have turned up, supporting the case that the manufacturing recession is ending (see the Overview section). Importantly, the Chinese economy is responding to policy stimulus. We expect global growth to accelerate modestly through the year and into 2017. Given this macro backdrop, our simulation models suggest that global EPS growth will bottom around the third quarter. An upturn in year-over-year U.S. EPS growth is imminent, although growth will not turn positive until late this year. Eurozone earnings growth will continue to decelerate and may edge slightly into negative territory before bottoming later in 2016. For Japan, earnings growth will stay positive but will also dip late in the year due to the lagged effects of yen appreciation. We expect EPS growth to accelerate in 2017 across all regions. A turning point for earnings growth will be constructive for equity markets. Nonetheless, it appears that a profit turn is already discounted in stock prices and EPS growth will fall short of current bottom-up estimates over the next year. As discussed in the Overview, the risk/reward profile does not warrant overweight equity positions within balanced portfolios. Comparing the major markets, we believe it will be difficult for U.S. earnings to beat those in the Eurozone and Japan over the next two years. The main reason is that U.S. profit margins have peaked and are likely to continue eroding. Several U.S. states are lifting minimum wages and some business leaders are boosting wages voluntarily. Other tailwinds that drove U.S. margins to secular peaks are fading as well. Moreover, U.S. margins will be pressured if the U.S. dollar resumes its uptrend, as we expect. Those countries most leveraged to the global economic cycle will benefit the most from modestly better growth momentum in the coming quarters. This will also favor Eurozone and Japanese profits relative to the U.S. A key risk to our view is Japan. Our EPS projection results for Japan may be difficult to believe are possible, given that the economy is sagging at the moment. Our forecast depends on a lot of things going right for Japan. The economy is in a vicious feedback loop at the moment, as weak growth undermines inflation expectations. This lifts real rates and places upward pressure on the yen, thereby further dampening inflation expectations. The Bank of Japan must act soon to break this feedback loop, or risk even further yen appreciation. Moreover, if the Ministry of Finance does not delay the VAT increase planned for 2017, the earnings outlook will be far worse than our base case suggests. For now, however, we remain overweight Eurozone and Japanese stocks versus the U.S. Mark McClellan Managing Editor Anastasios Avgeriou Managing Editor 1 We tried to incorporate the U.S. dollar TWI in the global model. However, it was insignificant, which makes sense because currency shifts should wash out once country earnings are summed into a world aggregate. 2 IMF, "Global Financial Stability Report", April 2016. 3 For a more detailed discussion, please see BCA Global Alpha Sector Strategy Weekly Report, "Happy Days?", March 18, 2016, available at gss.bcaresearch.com 4 For more details please see Global Alpha Sector Strategy Weekly Report, "A House Of Cards?", March 4, 2016, available at bca.bcaresearch.com

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