Sectors

Highlights U.S. Treasury Curve: The U.S. Treasury curve has flattened to new cyclical lows as the market has moved to fully price in the Fed's interest rate forecasts. Inflation expectations must rise further for those forecasts to be fully realized, however. Expect renewed U.S. curve steepening through higher inflation expectations and longer-term Treasury yields in the next 3-6 months. UST-Bund Spread Update: Stay in our recommended 10yr UST-Bund spread widening trade. as Treasury yield increases will not be matched in Bunds given slowing euro area economic momentum and a more balanced tone from the ECB. Global IG Corporate Sector Allocation: Our investment grade (IG) sector allocations, taken from our relative value models, have added positive performance since our last update in August. Feature The unpredictable, and at times unruly, behavior of financial markets over the first few months of 2018 has been exhausting for investors. A calm January was followed by the early February volatility spike and, more recently, huge intraday swings based on the ebb and flow of news on U.S. trade and foreign policy. Yet when looking at the year-to-date returns for various asset classes, the numbers do not seem unusually alarming given the amount of surrounding noise. Chart of the WeekA Long Road Back From The VIX Spike The S&P 500 index is only down -0.7%, while both equities in both the euro area and emerging markets (EM) equities are up +1.8% and +1.1%, respectively (using MSCI data in U.S. dollar terms). Credit markets are also delivering rather boring performance so far in 2018, from U.S. high-yield (+1.2% excess return over government debt) to euro area investment grade and EM hard currency corporates (both with an -0.1% excess return in U.S. dollar terms). Admittedly, these numbers look far less flattering considering the robust rally in risk assets in January. Yet the year-to-date returns simply do not line up with our impression of how investors' feel about how this year has gone so far. The perception is much gloomier than the actual outcome. Right now, markets are looking for guidance and direction and finding little of both. A big problem is that global bond yields, most notably in the U.S., have not fallen much from the highs for the year - even with global growth clearly losing some steam in the first quarter of 2018. The reason? Global inflation is in a mild cyclical upswing, a product of persistently tight labor markets and rising oil prices (Chart of the Week). The "leadership" in government bond markets has shifted away from accelerating global growth and an upward repricing of future central bank tightening, to rising inflation and unchanged monetary policy expectations. The notion of central bankers not being friendly to the markets remains our key theme for this year. We continue to expect that policymakers will not respond to the latest softer patch of economic data and will focus more on the reacceleration of inflation. This is especially true with risk assets stabilizing and volatility measures like the U.S. VIX index continuing to drift lower and, more importantly, the "volatility of volatility" (as measured by the VVIX index) now back to the levels that prevailed before the early February volatility spike (bottom panel). Although as BCA's strategists discussed at our View Meeting yesterday, volatility can quickly return with a vengeance given softer global growth momentum, and with the geopolitical calendar heating up next month (the U.S. government must make its final decision on the China trade tariffs and investment restrictions).1 This led the group to downgrade our recommended global equity exposure and upgrade our global bond exposure on a tactical (0-3 months) basis, although our more medium-term cyclical allocations (6-12 months) were unchanged (overweight stocks versus bonds). From the point of view of global bond markets, we may now be in period of mild "stagflation" with softening growth and rising inflation. We remain of the view that the former is temporary and the latter is not. This backdrop will keep global bond yields under upward pressure for at least the next few months, with better expected performance of corporate debt over governments - albeit with the potential for higher volatility given more elevated geopolitical risks. What Next For The U.S. Treasury Curve? The Treasury curve flattened to a new cyclical low last week, with the spread between 2-year and 10-year bonds now sitting at 45bps. On the surface, this flattening seems consistent with a Fed that is maintaining a "cautiously hawkish" message and that its rate hike plans for 2018 are unchanged despite more volatile financial markets. Chart 2This UST Curve Flattening Is Different What makes this current episode different from other bouts of Treasury curve flattening over the past five years, however, is the starting point for the absolute of bond yields. According to our two-factor valuation model for the 10-year Treasury yield, yields are now just a touch above fair value, which is currently 2.78%. That yield valuation was at least +25bps before the previous flattening episodes between 2014 and 2017 (Chart 2). That distinction is critical in differentiating a bull flattener from a bear flattener. Simply put, longer-dated Treasuries are not yet cheap enough to suggest that investors should extend duration risk to benefit from any additional curve flattening from here. In fact, we see a greater risk that Treasury curve re-steepens a bit from here, as there is more room for longer-term inflation expectations to move higher than there is for the front-end of the curve to reprice an even more hawkish Fed. The recent softening of cyclical global economic data has been occurring while realized inflation rates have been slowly rising from depressed levels (Chart 3). Yet in the U.S., the slowing of growth seen in the first quarter of the year remains very modest compared to that seen in Europe or Japan, while core inflation rates (for both the CPI index and the PCE deflator) have accelerated back to 2%. The Atlanta Fed's GDPNow forecasting model is calling for Q1/2018 growth of 1.9%, while the New York Fed's Nowcast model is predicting Q1 growth of 2.8%. While both forecasts are a deceleration from the 3% rates seen in the previous three quarters in 2017, neither is below U.S. potential GDP growth, which the U.S. Congressional Budget Office now estimates to be 1.9%. Even in China, where the economy had been slowing as policymakers have aimed to tighten monetary policy and slow credit growth, cyclical indicators such as the Li Keqiang index (the preferred indicator of our China strategists) have shown a bit of a rebound of late. Right now, underlying U.S. growth and inflation momentum are still pointing towards the Fed delivering on its current projection of an additional 50bps of rate hikes in 2018, taking the funds rate to 2.25%, with even a chance of an additional hike if inflation continues to accelerate. This is essentially fully priced with a 2-year Treasury yield just under 2.4%, however, and the real funds rate is now at neutral according to measures like the Fed's r-star. Therefore, additional flattening pressures from the front end of the curve are unlikely unless the Fed is willing to signal a faster pace of rate hikes than currently laid out in its economic projections (the "dots"). At the same time, the 10-year TIPS inflation breakeven remains 25-35bps below the 2.4-2.5% range that would be consistent with the market expecting U.S. inflation to sustainably return to the Fed's 2% inflation target on the headline PCE deflator. Hence, a steeper Treasury curve is far more likely than a flatter Treasury curve from current levels. Where could this view go wrong? Perhaps the Trump administration's trade skirmishes with China could broaden into a full-on trade war that could cause deeper damage to U.S. equities, dampen growth expectations and drive longer-term yields lower. Coming at a time when there is a significant short position in the U.S. Treasury market, this could look similar to the prolonged bull-flattening seen in 2015-16. During that episode, duration exposure flipped from a big net short to very net long according to measures like the J.P. Morgan Duration Survey (Chart 4, top panel), while the market priced out all expected Fed rate hikes (2nd panel). However, that also occurred alongside a 50bp decline in inflation expectations (3rd panel) and a big deceleration of U.S. growth (bottom panel), both related to a weakening global economy and collapsing oil prices. It is uncertain if the current U.S.-China trade skirmish would have an equivalent impact on both the U.S. economy and the Treasury curve, especially given a starting point of stronger global growth a far more positive demand/supply balance in world oil markets. Chart 3A Whiff Of Stagflation? Chart 42018 Is Not 2015/16 In sum, we are sticking to our view that the Treasury curve is more likely to bear-steepen through higher longer-term yields than flatten bearishly through more discounted Fed hikes or flatten bullishly through much weaker growth and inflation. We continue to recommend a below-benchmark duration stance in the U.S., within an underweight allocation in a currency-hedged global government bond portfolio. We are also are sticking with our tactical trade of staying short the 10-year U.S. Treasury versus the 10-year German Bund, even with the spread now looking a bit too wide on our fundamentals-based valuation model (Chart 5). The unrelenting string of disappointing economic data in the euro area has already resulted in a far more cautious tone from European Central Bank (ECB) officials regarding the potential for quick rate hikes after the expected end of the asset purchase program at the end of this year. The gap between the U.S. and euro area data surprise indices has proven to be a good directional indicator for the Treasury-Bund spread (Chart 6, bottom panel). Given our views on the potential for renewed bear-steepening in the Treasury curve, which is unlikely to be matched in the German curve in the next 3-6 months, we see no reason to take profits yet on our spread trade. Chart 5UST-Bund Spread Now A Bit Too Wide... Chart 6...But Too Soon For Spread Tightening Bottom Line: The U.S. Treasury curve has flattened to new cyclical lows as the market has moved to fully price in the Fed's interest rate forecasts. Inflation expectations must rise further for those forecasts to be fully realized, however. Expect renewed U.S. curve steepening through higher inflation and longer-term Treasury yields in the next 3-6 months. Stay in our recommended 10-year Treasury-Bund spread widening trade, as Treasury yield increases will not be matched in Bunds given slowing euro area economic momentum and a more balanced tone from the ECB. A Brief (And Belated) Performance Update For Our Corporate Bond Sector Allocations It has been some time (August 2017) since we last published a performance update for our investment grade (IG) corporate sector allocations for the U.S., euro area and U.K. As a reminder, those allocations come from our relative value model, which is designed to measure the valuation of each individual sector compared to the overall Barclays Bloomberg corporate bond index for each region. The methodology takes each sector's individual option-adjusted spread (OAS) and regresses it in a panel regression with all the other sectors in each region, as a function of the sector's duration, convexity (duration squared) and credit rating - the primary risk factors for any corporate bond. Using the common coefficients from that regression, a risk-adjusted "fair value" spread is calculated. The difference between the actual OAS and the fair value OAS is our valuation metric from the model for each region. The latest output from the models can be found in the tables and charts in the Appendix starting on Page 14. We also show the duration-times-spread (DTS) for each sector in those tables, using that as our primary way to measure the volatility of each sector. The scatterplot charts in the Appendix show the tradeoff between the valuation residual from our model and each sector's DTS. Chart 7Performance Of Our IG Sector Allocations We then apply individual sector weights based on the model output and our desired level of overall spread risk that we wish to take in our recommended credit portfolio. At our last update in August 2017, we made a decision to keep the overall (weighted) DTS of our sector tilts roughly equal to the overall IG corporate DTS for each region. With credit spreads looking tight at the time, credit spread curves flat relative to history, and with the Fed in the midst of a tightening cycle, we did not see a case for taking aggressive spread risk (i.e. having a high aggregate DTS) in the portfolio. The performance of our latest sector recommendations since our last update in August 2017, and in the first quarter of 2018, are shown in Chart 7. We show both the total return and excess return of each sector versus duration-matched government bonds. Since that last review, our U.K. sector allocations have performed the best, delivering an additional 12bps of total return and 10bps of excess return versus the U.K. IG corporate index. Our euro area corporate allocations have added 2bps of total return and 3bps of excess return, while our U.S. allocations have modestly underperformed both on total return (-1bp) and excess return. We also show the performance numbers for just the first quarter of 2018 in Chart 7, and we will present the return numbers on this quarterly basis in the future as part of our regular model bond portfolio performance reviews. The sector allocations offered a modest underperformance in Q1 2018, with -5bps of total return and -8bps of excess return coming mostly from euro area and U.K. allocations. The U.S. allocations actually outperformed by +3bps on a total return basis in Q1. The return numbers for our U.S. sector allocations can be found in Table 1. Since our last update in August, the best performing sectors (in excess return terms) for our U.S. portfolio allocation were the overweights to all Energy sub-sectors (+35bps combined), Cable & Satellite (+4bps) and Banks (+4bps). Of those names, only the Independent Energy sub-sector delivered a positive excess return (+3bps) in Q1 2018. Table 1U.S. Investment Grade Performance The return numbers for our euro area sector allocations can be found in Table 2. Since our last update in August, the best performing sectors (in excess return terms) for our euro area portfolio allocation were the overweights to Financials (+35bps, coming mainly from Banks, Senior Debt and Insurance) and Integrated Energy (+13bps). Those overweights also delivered small positive excess returns (+3bps and +1bps, respectively) in Q1 2018. The return numbers for our U.K. sector allocations can be found in Table 3. Since our last update, the best performing sector (in excess return terms) was the overweight to Financials (+6bps, coming mostly from Banks). Looking ahead, credit spread curves remain very flat by historical standards (Chart 8), which suggests there is not enough spread compensation for extending credit risk to lower quality tiers. Thus, we are sticking with keeping our target DTS for our combined sector allocations equal to that of the overall IG index for each region. We will update our sector allocations in an upcoming Weekly Report. Table 2Euro Area Investment Grade Performance Table 3U.K. Investment Grade Performance Chart 8Credit Quality Curves Remain Very Flat Bottom Line: Our investment grade (IG) sector allocations, taken from our relative value models, have added positive performance since our last update in August. We continue to recommend a cautious approach to sector allocation, targeting index levels of spread risk (in aggregate) in the U.S. euro area and U.K. Robert Robis, Senior Vice President Global Fixed Income Strategy rrobis@bcaresearch.com 1 Please see BCA Geopolitical Strategy Weekly Report, "Expect Volatility ... Of Volatility", dated April 11, 2018, available at gps.bcaresearch.com. Appendix Appendix Chart 1U.S. Corporate Sector Valuation And Recommended Allocation* Appendix Chart 1U.S. Corporate Sector Risk Vs. Reward* Appendix Table 2Euro Area Corporate Sector Valuation And Recommended Allocation* Appendix Chart 2Euro Area Corporate Sector Risk Vs. Reward* Appendix Table 3U.K. Corporate Sector Valuation And Recommended Allocation* Appendix Chart 3U.K. Corporate Sector Risk Vs. Reward* Recommendations The GFIS Recommended Portfolio Vs. The Custom Benchmark Index Duration Regional Allocation Spread Product Tactical Trades Yields & Returns Global Bond Yields Historical Returns

Special Report

Markets have been uneasy recently; last month saw the Fed raise rates, combined with language indicating a steeper path for interest rate moves in the coming two years. As of writing, markets are currently assigning a nearly 75% probability of at least two further rate hikes this year alone. However, amidst the Fed's tightening, the government has been embarking on fiscal largess. The recent tax cuts, budget announcements and potential infrastructure bill mean that we have entered a fairly rare period of loose fiscal policy and tight monetary policy; in our October 9th, 2017 Weekly Report, we highlighted seven such periods since the Second World War (shaded in Chart 1). Another two-year period of fiscal easing and tight money is upon us. Bull Markets Don't Die Of Old Age... To complete the adage above, "Bull markets don't die of old age, they are killed by higher interest rates". Thus the focus of roiled markets should be whether tight monetary policy can be offset by loose fiscal policy. In other words, can the government be stimulative enough to cushion the blow from higher interest rates and extend the business cycle? With all seven iterations of simultaneous fiscal easing and monetary tightening noted above resulting in positive stock market returns and the SPX rising by 16% on average, the answer appears to be a resounding yes (Table 1). Chart 1Loose Fiscal Policy Offsets##br## Tight Monetary Conditions Table 1SPX Returns During Periods Of Loose##br## Fiscal And Tight Monetary Policy Further, the infrastructure bill has not yet become part of the fiscal thrust in this current bull market, meaning that there is still dry powder in the stock market's battle against higher rates. Depending on the timing of the infrastructure bill (and the further away, the better for sustaining the equity market blow off phase), there are good odds that this bull market could be the longest in history (Table 2). Using months without an inverted yield curve as an alternative measure, we are already there as the current streak of 131 months beats the 104 month streak of much of the '90s (Chart 2). Table 2Bull Markets Since World War II Chart 2Longest Positive Yield Curve Streak In 50 Years Look To Earnings For Direction Our view remains that earnings will have to take up the mantle to drive the SPX higher.1 At this stage in the bull market's life, the SPX is no longer discounting many years of future growth and higher rates weigh on this growth rate. The implication is a forward P/E multiple that should drift sideways to lower leaving profits to do all the heavy lifting and largely explaining the S&P 500's return (bottom panel, Chart 3). Importantly, the combination of synchronized global growth and a soft U.S. dollar underpin EPS. Tack on the effect of tax reform (at least this year) and the 20% and 10% EPS growth rates penciled in by the sell side for 2018 and 2019, respectively, are achievable, barring a recession. Considering that stocks and EPS growth move together (top panel, Chart 3), the path of least resistance is higher still for the SPX. This positive equity backdrop warrants a positioning update. Accordingly, we have analyzed the GICS1 industry groups and their average annualized performance in each of the most recent five periods for which we have data of loose fiscal and tight monetary policy. The results presented in Table 3, however, are nuanced. Chart 3Stocks And EPS Are Joined At The Hip Table 3Sector Relative Performance In Tight Monetary/Loose Fiscal Conditions In the left column, our raw data suggests that technology is dominant in the periods we have examined. However, this is skewed by the 1998-99 iteration when this sector went parabolic as the dotcom bubble was inflating, making virtually all other sectors underperform, dramatically in most cases. We have adjusted for this exceptional period in the right column. The adjusted results are telling as cyclicals and positive interest rate sensitive sectors (the S&P financials and energy indexes) are the top performers. Conversely, defensives and negative interest rate sensitive sectors (the S&P utilities and real estate indexes) are the worst performers. Such a result is intuitive; loosening fiscal policy during expansions tends to extend/prolong the business cycle and may also arrive in late/later stages of the cycle where equity returns go parabolic and deep cyclicals roar. In addition, when the Fed raises rates, financials tend to benefit and competing fixed income proxies suffer. Further, there is a positive feedback loop in these actions as loose fiscal policy in good times is typically inflationary, especially when the economy is at full employment, which thus pushes the Fed to continue to or even accelerate its tightening mode. We note that we maintain a preference for cyclicals over defensives in our portfolio, based on our key investment themes for 2018: synchronous global capex growth and rising interest rates. Our analysis here serves to confirm our hypothesis. The purpose of this report is to identify winners and losers in times of easy fiscal and tight money phases, and provide a roadmap of how sector returns may pan out in the coming two year period of fiscal expansion and liquidity withdrawal, if history at least rhymes. Accordingly, what follows is an analysis of the two adjusted top and bottom performers noted above. Chris Bowes, Associate Editor U.S. Equity Strategy chrisb@bcaresearch.com 1 Please see BCA U.S. Equity Strategy Weekly Report, "EPS And 'Nothing Else Matters'," dated December 18, 2017, available at uses.bcaresearch.com. Financials Are A Top Pick Financials benefit from both sides of a monetary tightening/fiscal loosening environment. Rising interest rates are a boon to sector EPS as the increasing price of credit translates directly into top line growth. The higher cost of borrowing should typically result in a slowdown in borrowing and consumption. With fiscal largesse serving to at least offset any natural demand declines, the result should be a banker's dream: simultaneous capital formation and better terms on the existing book of business. The benefits of monetary tightening and fiscal easing are not exclusive to businesses either; such an environment has typically been synonymous with soaring consumer confidence, keeping loan demand high (second panel, Chart 4). Further, low unemployment has historically meant peaking credit quality, implying a margin tailwind to the already-rising top lines of lenders (third panel, Chart 4. Chart 4RS2 Financials Are In A Goldilocks Scenario As operating cash flows are soaring, it is likely that financials will increasingly embark upon shareholder friendly activities. The GFC saw lenders in particular shore up weakened balance sheets with enormous equity issues; the reversal in fortunes (especially given the record number of banks passing Fed stress tests) will see accelerated equity retirement, yet another benefit to EPS growth. In sum, S&P financials should be a core holding during periods of monetary tightening and fiscal easing, (see appendix, Chart 1A); we reiterate our overweight recommendation on financials and our high-conviction overweight on the key S&P banks sub index. Energy Is Just Getting Warmed Up As noted above, one of BCA's key investment themes for 2018 is synchronized global capex, of which the S&P energy sector is a key beneficiary, at least in part fueled by lower taxes and the upcoming infrastructure bill. Recently, the capital expenditures part of the Dallas Fed manufacturing outlook survey hit its highest level in a decade, and capex intentions in the coming six months are also probing multi-year highs. The overall message is that the budding recovery in energy capital budgets will likely gain steam (second panel, Chart 5). Chart 5Energy Should Benefit From High Capex Equally importantly, the recovery in the global economy has kept a solid floor underneath oil prices, which are pushing up against 3-year highs (top panel, Chart 5). Pricing power in energy is rising at its fastest pace this decade and (for now) the sector wage bill is continuing to contract (bottom panel, Chart 5), implying not only top line gains but also a much better margin profile. Still, monetary tightening represents a headwind for the sector. Higher interest rates tend to suppress investment demand and support the U.S. dollar which could put downward force on the price of oil. Our analysis suggests the stimulative effects from fiscal easing should more than offset any pressure from monetary tightening (see appendix, Chart 1B). Accordingly, we reiterate our high-conviction overweight recommendation on the S&P energy index. Be Cautious With Utilities We recently upgraded the beaten-down S&P utilities index to a benchmark allocation, based largely on a modest improvement in operating metrics, lifted by BCA's key 2018 capex growth investment theme; expansionary fiscal thrust should only enhance these metrics. Nat gas prices appear to have mostly stabilized and, as the marginal price setter for utilities, should support the nascent turnaround in industry pricing power (second panel, Chart 6). Further, the rebound in electricity production has peaked but remains comfortably in expansionary territory (third panel, Chart 6). Chart 6Higher Rates Offset Better Fundamentals Notwithstanding the operational positives, we think BCA's key theme of higher interest rates present a hefty offset. Utilities, a high dividend yielding sector, suffer when Treasury bond yields move higher, as competing risk free assets become more appealing (bottom panel, Chart 6). We suspect this fixed income-proxy characteristic is why the S&P utilities sector is historically the worst performer as the Fed is tightening monetary policy (see appendix, Chart 1C). Still, the sector has harshly sold down already and we think the positives and negatives are broadly in balance; we reiterate our neutral recommendation on the S&P utilities index. Real Estate Is Not Immune From Monetary Tightening Much like the S&P utilities index, the S&P real estate sector trades as a fixed income proxy. Accordingly, the anticipated advance in Treasury yields should weigh heavily on REIT prices (top panel, Chart 7), regardless of the underlying fundamentals; fortunately, there is some good news there. Chart 7CRE Prices Are Rising But ##br##How Much Further Can They Go? Lending standards had been tightening from 2013 until the middle of last year; since then, they have been loosening as fears of a second real estate recession gave way to general economic optimism. Given the tight correlation between lending standards and commercial property prices, a loosening of the former bodes well for the latter (second panel, Chart 7). Still, with commercial real estate prices approaching two standard deviations above the 30-year trend (bottom panel, Chart 7), the longevity of the good times should be questioned. Regardless of the modestly improving industry fundamentals, particularly in the context of the fiscal largesse that will certainly be stimulative, monetary tightening headwinds should at least provide an offset (see appendix, Chart 1D). On balance, we reiterate our neutral recommendation on the S&P real estate index. Appendix Chart 1A Chart 1B Chart 1C Chart 1D

Overweight The S&P containers & packaging index has been recovering in the past few sessions. This follows being caught in the downdraft all global trade-exposed stocks have been reeling from; now fears of a generalized trade war appear to be receding. Certainly the geopolitical spats have not been making themselves present in real trade data; the global export volume index published by the CPD Netherlands Bureau for Economic Policy Analysis has, in fact, been accelerating recently to its current record high level (second panel). As global trade seems set to move higher regardless of political machinations, domestic demand remains resilient. Real spending on food and beverage, the key customer group of containers & packaging companies, has been expanding uninterrupted for the past two years, implying solid sector top line growth (third panel). At the same time, producer prices, despite having rolled over somewhat, are still rising (bottom panel). While spiking pulp prices will eat into margins, we expect a soft dollar to offset via the export channel. Net, we would buy into any weakness in this sector; we reiterate our overweight recommendation in this niche materials sector. The ticker symbols for the stocks in this index are: BLBG: S5CONP - IP, WRK, BLL, PKG, SEE, AVY.

Overweight (High Conviction) America's largest banks are set to kickstart earnings season at the end of this week/beginning of next week and, with a 25% improvement in EPS forecast by sell side analysts this year, expectations are high. We think deservedly so. Our high-conviction overweight thesis remains unchanged; bank profits should outperform the broad market as the price of credit, loan growth and credit quality are all tailwinds in 2018. Rising inflation expectations (second panel) should support the 10-year yield, driving improving net interest margins. Positive sentiment should mean that bankers keep the credit taps open to sustain the broad capex upcycle (third panel). Combined with record low unemployment and the associated low default rates, margins should widen. Our banks EPS model (bottom panel) incorporates these factors and continues to point to significant earnings upside in the year to come. Accordingly, we reiterate our high conviction overweight recommendation. 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.

Highlights Capacity cuts in China's steel and aluminum industries over the winter produced little in the way of output reductions, confounding our expectations. The resulting unintended inventory accumulation in Asian markets, reflecting high production relative to demand, and slowing Chinese steel exports are a downside risk to our neutral view. U.S. sanctions against Russian oligarchs close to President Putin could tighten the aluminum market, countering the unintended inventory accumulations. For now, we remain neutral base metals. Energy: Overweight. We are closing our long put spread position in Dec/18 Brent options at tonight's close. The fast-approaching May 12 deadline for President Trump to renew sanctions waivers against Iran shifts the balance of price risks to the upside. Base Metals: Neutral. COMEX copper rallied above $3.10/lb on the back of Chinese President Xi's remarks at the Boao Forum earlier this week, which re-hashed plans to open China's economy to imports. Precious Metals: Neutral. Gold likely becomes better bid as the May 12 deadline to waive Iran sanctions nears. Our long gold portfolio hedge is up 8.9%. Ags/Softs: Underweight. European buyers are scooping up U.S. soybeans, as Chinese purchases of Brazilian beans makes U.S.-sourced crops relatively cheaper, according to Reuters.1 China also announced plans to start selling corn stocks from state reserves this week, offering an alternative protein for animals to partially offset the price impact of tariffs on their imports of U.S. soybeans. Feature Chart of the WeekAluminum Rebounds On U.S. Sanctions Despite much-ballyhooed capacity reductions in China's steel and aluminum capacity, these markets - both in China and globally - remained relatively well supplied over the winter. Higher global supplies, and falling Chinese steel exports, will result in unintended inventory accumulation, which already is showing up in Shanghai Futures Exchange (SHFE) inventories. While we remain neutral base metals, continued unintended inventory accumulation could cause us to downgrade the sector. The MySteel Composite Index we use to track steel prices is down more than 10% since the beginning of the year (Chart of the Week). Similarly, the first-nearby primary aluminum contract on the LME was down ~ 12% year-to-date (ytd) early last week, before regaining most of these losses on news of U.S. sanctions against Russian oligarchs, which hit shares of Rusal very hard. Given that these sanctions will restrict access to up to 6% of global aluminum supply, ex-China supply dynamics will dominate the aluminum market this year making the outlook relatively favorable, putting a floor beneath the London Metal Exchange Index (LMEX).2 Ex-Post Winter Production Production cuts over the winter - when Chinese mills in 28 smog-prone northern cities were ordered to reduce capacity by up to 50% - did not live up to our expectations.3 China's steel and aluminum sectors have undergone major supply-side reforms, particularly re the removal of outdated capacity, most of which has been completed. In addition to the winter capacity cuts, past reforms that have already been implemented, and have shaped current market conditions, are as follows: In an effort to eliminate outdated and unlicensed facilities, China removed an estimated 3-4 mm MT of annual capacity in 2017 - amounting to approximately 10% of total aluminum smelting capacity. In the case of steel, Beijing announced plans to shut down 150 mm MT of annual steel capacity between 2016 and 2020. To date, 115 mm MT of capacity have already been eliminated. Another estimated 80-120 mm MT of induction furnace capacity was shuttered in 1H17. Going forward, China's steel and aluminum markets will be driven by: An estimated 3-4 mm MT of updated aluminum capacity is expected to come on line this year, offsetting constraints from last year's supply cuts. 30 mm MT of steel capacity shutdowns are planned this year, putting Beijing on track to meet its five-year target two years ahead of schedule. The Chinese National Development and Reform Commission (NDRC) has communicated its resolve to keep shuttered capacity offline. Major steelmaking cities in Hebei province - accounting for 22% of 2017 Chinese crude steel output - have announced plans to extend the capacity cuts to November 2018. The mid-November to mid-March capacity cuts implemented this past season are expected to be a recurring event. Winter Shutdowns Minimally Impact China's Steel Output ... According to steel production data released by the World Steel Association (WSA), winter capacity closures in China did not significantly affect overall output levels. Crude steel output from China was up 3.9% year-on-year (y/y) in the November to February period (Chart 2). At the same time, production from the rest of the world increased by 3.6% y/y in the November to February. Thus global crude steel supply remained in excess over the winter season, as global steel output increased 3.8% y/y. A caveat to these data: China does not account for the historical output of induction furnaces, which produced an estimated ~30-50 mm MT of steel in 2016. As mentioned in our previous research, the output of these furnaces was illegal and thus not carried in statistics we use to track supply.4 These data problems mean it is possible that actual output in the November 2016 to February 2017 period was higher than suggested by the data, and as a result, actual output during this year's winter season may actually be lower than last year. As induction-furnace data lie in the statistical shadows, we cannot ascertain this with certainty. Nevertheless, a buildup in China inventories - which we discuss below - indicates an oversupplied market. It is also likely producers - incentivized by high steel prices earlier this year - kept capacity utilization at maximum levels throughout the winter. ... And Aluminum Output According to International Aluminum Institute data, primary aluminum output in China fell 2.3% y/y in the November to February period, suggesting the winter cuts likely had an impact on aluminum supply (Chart 3). Data from the World Bureau of Metal Statistics (WBMS) show an even sharper decline in winter aluminum output: primary production in China fell 8.7% y/y in the November to January period. Chart 2Steel Output Grew##BR##Amid Winter Cuts Chart 3China Aluminum Market In Surplus##BR##Despite Production Decline Both sources reveal an especially pronounced contraction in November, at the onset of the winter cuts. Despite reduced supply, WBMS data indicate a positive Chinese aluminum market balance throughout the winter. A large contraction in demand offset the supply shortfall, and kept primary aluminum in a physical surplus throughout the winter, ultimately leading to a buildup in domestic inventories. A Look At The Trade Data Despite our disappointment regarding the impact of the winter cuts on steel and aluminum markets, trade data increasingly suggests China's steel exports have peaked. Aluminum exports from China, on the other hand, are likely to continue rising. Chinese Steel Exports Continue To Fall ... Chinese steel product net exports have been falling since mid-2016, and have continued falling in y/y terms throughout the winter. According to Chinese customs data, steel product net exports fell 35.1% y/y in the November to February period, driven by both falling exports as well as rising imports (Chart 4). Steel product exports plunged 30% y/y in the November to February period, more or less in line with the 2017 average. The decline mirrors the 2017 contraction in domestic supply, bringing exports to their lowest level since 2012. This indicates fears of a China slowdown leading to a flood of metal onto global markets have not materialized, at least not yet. In fact, Customs data show a 1.7% y/y increase in Chinese steel imports during the November to February period - a reversal from falling imports prior to the winter season. The conclusion we draw from this is that, while in the past, China was a source of supply for the world, ongoing capacity cuts and production controls could mean China will lack the ability to ramp up output in case of a global physical supply deficit. If this becomes the new normal, price volatility will likely increase. This trend is important, especially given our expectation of strong world ex-China demand this year. As such, global steel prices may find support amid this new normal. ... But Aluminum Exports Move Higher In the case of aluminum, Chinese net exports were up 28.7% y/y during the winter, continuing their upward trend. Customs data show a 14.8% y/y increase in aluminum exports in November to February, bringing exports in this period to their highest level since 2014/15 (Chart 5). At the same time, imports of aluminum have come down during this period - by 37.2% y/y. According to China customs data, 2017 imports over these winter months registered their lowest level since 1994. Chart 4Steel Exports Continue Falling ... Chart 5...While Aluminum Exports Are On the Uptrend The combination of growing exports amid falling imports puts China's net exports in expansionary territory. This will be especially true given the planned increase in capacity this year amid weak Chinese demand. All in all, ceteris paribus global supply of aluminum looks set to increase. However, we do not live in a ceteris paribus world and, as we explore below, sanctions against the top aluminum producer outside of China will have massive implications on the global aluminum supply chain. Are Inventories Due For A Turnaround? Chart 6Larger Than Expected##BR##Seasonal Inventory Buildup China Iron and Steel Association data indicate that since the beginning of the year, steel product inventories have been re-stocked to levels last seen in 1Q14. Inventories of the five main steel products we track have more than doubled since the beginning of the year (Chart 6). Although the Q1 build is seasonal, the re-stocking since the beginning of the year has been especially pronounced. This buildup occurred in an environment of stable supply - with minimal impact from the winter capacity cuts - amid weak exports, indicating domestic demand for the metal was subdued. However, steel inventories have turned around, and we expect further destocking as demand accelerates post the Chinese New Year. The question remains whether this destocking will bring inventories back down to their 5-year average. Aluminum inventories on the SHFE show similar dynamics. However in this case, it is part of the larger trend of rising stocks since the beginning of last year. Aluminum inventories at SHFE warehouses are up more than nine-fold - or 0.87 mm MT - since the end of 2016. In fact, the pace of buildup seems to have accelerated: the average weekly build of 16.6k MT of aluminum coming into warehouse inventories since the beginning of the year stands above the 2017 average weekly build of 12.6k MT. This brought SHFE aluminum inventories to almost 1 mm MT, more than double their previous record in 2010. Although the Chinese physical aluminum surplus weighed down on prices in 1Q18, we expect global aluminum prices to remain supported from here due to the impact of U.S. sanctions on world ex-China aluminum supply. U.S. Russian Sanctions Could Be A Game-Changer Chart 7Sanctions Will Restrict##BR##Marketable Aluminum Supply Last Friday, the U.S. announced sanctions on Russian oligarchs close to President Vladimir Putin. Among those sanctioned is Oleg Deripaska who controls EN+ Group, which owns a controlling interest in top aluminum producer United Company Rusal. Given that UC Rusal accounts for ~6% of global aluminum production, we view this move as significant to global aluminum markets. As the top producer of the metal outside China, Rusal aluminum likely makes up the majority of Russian supply, which account for 14% of U.S. imports (Chart 7). In fact, almost 15% of Rusal's revenues comes from its business with the U.S. While it is clear that these sanctions will, in effect, terminate aluminum trade between Russia and the U.S., more significant are the implications on the global supply chain. A clause in the U.S. Treasury Department's order extending the restrictions to non-U.S. citizens dealing with U.S. entities means the impact could be far-reaching, requiring a major re-shuffle in global aluminum trade. Earlier this week, the LME announced that it will no longer accept Rusal aluminum produced after April 6, effectively preventing the company's products from being delivered on the LME. These sanctions will likely turn global aluminum buyers off from Rusal products, as they can no longer deliver it to the LME. The net effect will be a contraction in global usable aluminum supply. Furthermore, these sanctions will likely disrupt supply chains as aluminum users scramble to avoid purchasing metal from the Russian producer. While the details of these restrictions are still unclear, the sanctions are a game changer in the global aluminum market - effectively restricting access to a major source of the metal. As such, primary aluminum on the LME is up more than 10% since the announcement last Friday. Bottom Line: While China's crude steel output increased y/y during government-mandated output cuts over the winter, seasonally weak demand meant that the metal piled up in inventories. Falling exports indicates that at least for now, the domestic surplus is not flooding global markets. The main risk to our neutral view here is that demand in China remains weak, and that this will lead to the offloading of Chinese metal to global markets, i.e. a pickup in exports. This has not yet materialized, so we are holding on to our neutral view for now. China's primary aluminum production declined y/y during the winter cuts. However the decline in domestic demand was greater - likely due to the decline in auto production and sales following the loss of tax credit incentives. Consequently, China's aluminum market remained in surplus throughout the winter. Some of the excess supply was exported, but SHFE inventories continued building. Our outlook on the aluminum market had been bearish, due to additional capacity coming online this year amid an uncertain China demand environment. However, the sanctions on Rusal could be a game changer, putting a floor beneath aluminum prices. This improves our near term outlook for the aluminum market. This makes our outlook on aluminum prices much more favorable. Roukaya Ibrahim, Associate Editor Commodity & Energy Strategy RoukayaI@bcaresearch.com 1 Please see "As U.S. and China trade tariff barbs, others scoop up U.S. soybeans," published by reuters.com on April 8, 2018. 2 The six non-ferrous metals represented in the LMEX and their respective weights are as follows: aluminum: 42.8%, copper: 31.2%, zinc: 14.8%, lead: 8.2%, nickel: 2.0%, and tin: 1.0%. 3 China's winter smog "battle plan" targeted polluting industries in the northern China region by mandating cuts on steel, cement and aluminum production during the smog-prone mid-November to mid-March months. Steel and aluminum production cuts targeted a range between 30-50% during this period. This event is expected to be an annually recurring event until 2020. 4 Please see BCA Research's Commodity & Energy Strategy Weekly Report titled "China's Environmental Reforms Drive Steel & Iron Ore," dated January 11, 2018, available at ces.bcaresearch.com. Investment Views and Themes Recommendations Strategic Recommendations Tactical Trades Commodity Prices and Plays Reference Table Trades Closed in 2018 Summary of Trades Closed in 2017

Overweight (High Conviction) As highlighted in this week's Weekly Report, we are moving to a benchmark allocation in the S&P information technology sector. The way we are executing the upgrade is by lifting the S&P tech hardware, storage & peripherals (THSP) index to an overweight stance. We are also adding this index to our high conviction overweight list. Building on the capex upcycle theme, U.S. tech hardware manufacturers also benefit from improving animal spirits and rising capital expenditures. U.S. capex intentions are as good as they can get, hanging near multi-decade highs (second panel). Importantly, global trade remains buoyant and signals that the global export pie is increasing in size. The tech-laden Korean and Taiwanese stock markets have positive momentum and are an excellent leading indicator of tech-heavy EM Asian exports. The current message is to expect a durable export growth phase in the coming months (third panel). Meanwhile, this industry that generates excessive amounts of free cash flow and sports a net debt/EBITDA ratio below par (bottom panel) will continue to be extremely generous to shareholders by continuing to aggressively retire equity and boost dividend payouts. Bottom Line: Boost the S&P THSP index to an overweight stance and add it to the high-conviction overweight list. The ticker symbols for the stocks in the S&P THSP index are: BLBG: S5CMPE - HPQ, WDC, STX, XRX, AAPL, HPE, NTAP.

Neutral We have been offside on tech sector positioning, but are not dogmatic and given recent market action and positive changes in a number of key drivers, we recommend acting on our mid-January upgrade alert, booking losses and lifting exposure to neutral. The core driver of our upgrade is to capitalize on one of BCA's key themes for 2018: synchronized global capex upcycle, of which the broad tech sector is a core beneficiary (second panel). There is still pent up demand for tech spending that is being unleashed following over a decade of severe underinvestment. In addition, consumer spending on tech goods is also at the highest level since the history of the data, underscoring that end demand is upbeat (third panel). On the global demand front, EM Asian exports are climbing at the fastest clip in ten years; tech sales and EM Asian exports are historically joined at the hip and the current message is positive (bottom panel). Despite the good news, crucial sector risks, including a bounce in the U.S. dollar, higher interest rates (another key BCA theme for 2018) and regulatory/political risks (the source of the recent tech sector wobble) prevent us from turning outright positive. Netting it all out, we are compelled to lift exposure in the S&P information technology sector to neutral; see yesterday's Weekly Report for more details.

Highlights Portfolio Strategy The capex upcycle, a soft U.S. dollar and improving end demand signal that it no longer pays to underweight the S&P tech sector. Lift exposure to neutral. Firming domestic and global final demand, the synchronized global capex upcycle, an overly pessimistic sell-side analyst community and cheap valuations compel us to upgrade the S&P tech hardware, storage & peripherals index to overweight. Recent Changes S&P Technology - Upgrade to neutral today. S&P Tech Hardware, Storage & Peripherals - Boost to overweight and add to the high-conviction overweight list today. Table 1 Feature The S&P 500 seesawed last week, and continues to absorb the early February drawdown. While global growth cannot continue its breakneck pace indefinitely and a soft patch is inevitable, global output growth remains significant and above trend. Our constructive cyclical equity market view remains intact, premised upon the longevity of the business cycle, at least for the next 9-12 months. In the U.S. specifically, the ISM manufacturing survey is perched closer to 60 than to 50, unemployment insurance claims hover near 50-year lows and the muted 10-year Treasury yield moves all signal that generalized fear has yet to grip markets (Chart 1). In fact, if one looks back at the 2015, 2011 and 2010 global growth scares, investors took shelter in U.S. Treasuries as the SPX sold off, sending the 10-year UST yield lower by 50, 70 and 70 bps respectively in a very short time span. The fact that the 10-year yield is only 15 bps below its peak should cause us to question whether the recent equity drawdown is really about slowing global growth. On the monetary policy front, while the Fed is increasing the fed funds rate and decreasing the size of its balance sheet and volatility is making a comeback (please see Chart 1 from the March 5th Special Report), the real fed funds rate remains below the zero line and the real 10-year UST yield is also close to nil (Chart 2). Economic slack measures confirm that the Fed remains behind the curve. The output and unemployment gaps have been closed for a while now, and BCA's unemployment diffusion index and the Taylor rule both signal that monetary policy is extremely accommodative (Chart 3). Chart 1Macro Conditions... Chart 2...Remain Conducive... Chart 3...To A Rising SPX The implication is that macro conditions remain conducive to a rising equity market from a cyclical time horizon perspective. Meanwhile, sifting through the noise reveals that the market is likely coming to grips with a calendar 2019 EPS growth of a more reasonable 10% annual rate compared with this year's near 20% peak growth rate. This transition, as we highlighted in recent research, will be turbulent,1 and likely an earnings validation phase will pave the way higher for the broad equity market. In fact, dissecting the tax relief impact on different sectors is in order. Charts 4 & 5 show the calendar 2018 forward estimates on December 31st, 2017 and what analysts pencil in today, respectively. Charts 6 & 7 highlight the delta in absolute terms and percentage change terms. Chart 42018 EPS Growth On March 30, 2018 Chart 52018 EPS Growth On December 31, 2017 Chart 6Delta Chart 7Delta % Change Telecom services will likely benefit tenfold from the lower corporate tax rate (shown truncated, Chart 7), and consumer discretionary stocks are also prime beneficiaries. But this also means that 2018 after-tax profit data are masking the negative underlying trend growth rate for both of these sectors which also sport grim operating metrics. The S&P telecom services sector is a high-conviction underweight,2 and we reiterate our recent downgrade to a below benchmark allocation in the S&P consumer discretionary sector.3 Industrials, energy and financials, also benefit greatly from tax relief (Chart 7), but higher commodity prices along with improving industry operating metrics contribute to the EPS euphoria for these sectors. Nevertheless, we have identified three key risks to our sanguine equity market view: Escalating geopolitical/regulatory uncertainty Severe global growth slowdown U.S. dollar surge All three risks are intertwined and could infiltrate profit growth in the coming months. As we have posited in recent research, U.S. dollar softness begets higher global growth and the two feed off of each other in a virtuous cycle. A depreciating currency is a profit fillip for SPX constituents with heavy export exposure, the opposite is also true (Chart 8). Chart 8S&P 500: Aggregate Sector International Revenue Exposure (%) If the Trump Administration continues to slap on tariffs with China retaliating, as we experienced last week, eventually triggering a global trade war, then all bets are off on the sustainability of global growth (Chart 9). Such an outcome would weigh heavily on both market sentiment and profits, as our Geopolitical Strategists argued last week.4 Chart 9Don't Throw In The Towel On Global Growth Yet Finally, regulatory clampdown on the tech sector specifically is also on our radar screen, especially given the monopolistic powers that a handful of U.S. tech titans command. This is not only a U.S. risk, but also a global one. However, the 2000s Microsoft and recent Google precedents suggest that a corporate breakup is a low probability event à la "Ma Bell" in 1983, and heavy fines are the most likely outcome (we will be covering this regulatory risk in an upcoming Special Report in conjunction with our sister Geopolitical Strategy publication, stay tuned). Adding it up, we assign low probabilities to all three risks. This week we are taking advantage of recent market weakness and adding some cyclical exposure to our portfolio. Lift Tech To Neutral... We have been offside on tech sector positioning, but are not dogmatic and given recent market action and positive changes in a number of key drivers, we recommend acting on our mid-January upgrade alert, booking losses and lifting exposure to neutral.5 Before exploring our thesis on why we are becoming more constructive on the largest S&P sector in terms of market capitalization weight, it is instructive to look back and identify what we missed. Two reasons for the tech sector's outperformance stand out. First, BCA's constructive view on the U.S. dollar has weighed heavily on our underweight positioning in the tech sector, especially since the greenback's peak in level terms in December 2016. U.S. tech firms garner 60% of their total revenues from abroad - the highest among the GICS1 sectors (Chart 8) - and the positive P&L translation gain effects have been a tonic to EPS. Irrespective of where the dollar will end 2018, due to lagged effects, the U.S. dollar's significant depreciation will continue to boost tech sector EPS. Second, the lack of inflation at this stage of the cycle has perplexed economists and presented a goldilocks macro backdrop for the tech sector that thrives in deflation/disinflation. This benign inflation backdrop has also coincided with the V-shaped global growth recovery following the late-2015/early-2016 global manufacturing recession and propelled technology stocks. Nevertheless, in mid-September we lifted the S&P software index to a benchmark allocation and subsequently to a high-conviction overweight in late-November in order to capitalize on one of BCA's key themes for 2018: synchronized global capex upcycle. Building on this thesis, the broad tech sector also benefits from rising capex (Chart 10). In fact, there is still pent up demand for tech spending that is being unleashed following over a decade of severe underinvestment. Not only is the tech sector gaining capex market share, largely at the expense of basic resources (Chart 11), but also in absolute terms tech spending is on fire and vaulting to fresh all-time highs (Chart 10). Chart 10Prime Capex Beneficiary Chart 11Sector Capex % Of Total National accounts confirm the stock market-reported capital outlays data and tech investment is firing on all cylinders (middle panel, Chart 12). In addition, consumer spending on tech goods is also at the highest level since the history of the data, underscoring that end-demand is upbeat (fourth panel, Chart 12). The San Francisco Fed's Tech Pulse Index encapsulates all this tech optimism underpinning tech stocks (second panel Chart 12).6 On the global demand front, EM Asian exports are climbing at the fastest clip in ten years, despite the smart rebound in the ADXY. Historically, tech sales and EM Asian exports are joined at the hip and the current message is positive (bottom panel, Chart 12). Importantly, a rising revenue backdrop is necessary, especially in the context of rising capital outlays, as they sustain the virtuous upcycle. A simple final demand indicator combining tech exports and new orders is also flashing green (Chart 13). Tack on the sizable losses in the U.S. dollar over the past year and resurgent tech exports will be a boon to tech EPS (bottom panel, Chart 13). Chart 12Firm End-Demand Chart 13Soft U.S. Dollar Helps Our tech profit model does an excellent job capturing all of these positive forces and is pointing to healthy growth for the rest of 2018 (second panel, Chart 14). However, there are also a few headwinds that the tech sector has to contend with and that prevent us from lifting exposure all the way to overweight. First, any knee-jerk bounce in the U.S. dollar is a clear negative for technology stocks. Second, BCA's second key theme we are exploring calls for higher interest rates in 2018 on the back of rising inflation (Chart 15). Were the selloff in the bond market to gain steam in the coming months as inflation rears its ugly head, then tech stocks would come under intense pressure. Third, as we highlighted above, regulatory/political risks have been at the epicenter of the recent tech sector wobble, and heightened regulatory uncertainty will continue to muddy the tech waters. Finally, while tech stocks are nowhere near as overvalued as in late-1999/early 2000, they are more expensive than the broad market on a number of valuation measures (third panel, Chart 14). Chart 14Our Tech Profit Model Flashes Green... Chart 15...But Interest Rates Are A Big Headwind Netting it all out, we are compelled to lift exposure in the S&P information technology sector to neutral, by augmenting the S&P tech hardware, storage & peripherals (THSP) index to an overweight stance. ...Via Boosting Tech Hardware To Overweight The way we are executing the upgrade to neutral on the broad S&P tech sector is by lifting the S&P THSP index to an overweight stance. We are also adding this index to our high-conviction overweight list. Building on the capex upcycle theme, U.S. tech hardware manufacturers also benefit from improving animal spirits and rising capital expenditures. U.S. capex intentions are as good as they can get, hanging near multi-decade highs (second panel, Chart 16). Already, U.S. factories are humming trying to fulfill perky end-demand. Industry production is far outpacing capacity growth and this represents a boon to pricing power that has exited deflation for the first time ever (bottom panel, Chart 16). The implication is that S&P THSP profits will overwhelm. Beyond U.S. shores, global fixed capital formation is also climbing sharply. This synchronized global capex upcycle represents a tailwind for this industry and will continue to underpin U.S. computer exports (Chart 17). Add on the depreciating greenback and U.S. manufacturers are well positioned for export market share gains (third panel, Chart 17). Chart 16Capex To The Rescue Chart 17Enticing Global ... Importantly, global trade remains buoyant and signals that the global export pie is increasing in size. In particular, EM Asian exports are expanding at a healthy clip, in spite of rising EM currencies, underpinning S&P THSP net earnings revisions (middle panel, Chart 18). The tech-laden Korean and Taiwanese stock markets have positive momentum and are an excellent leading indicator of tech-heavy EM Asian exports. The current message is to expect a durable export growth phase in the coming months (Chart 18). All of this suggests that S&P THSP sales and profits will shine in 2018, easily surpassing the extremely low relative hurdles that sell-side analysts are penciling in for the coming 12 months (second & third panels, Chart 19). Meanwhile, this industry that generates excessive amounts of free cash flow and sports a net debt/EBITDA ratio below par (Chart 20) will continue to be extremely generous to shareholders by continuing to aggressively retire equity and boost dividend payouts. Return on equity is also probing all-time highs. Chart 18...Demand Backdrop Chart 19Unwarranted Pessimism... Chart 20...Given Pristine B/S And Sky-High ROE Finally on the relative valuation front, this tech sub-index trades at a 20% discount to the broad market (and below the S&P tech sector) both on a forward P/E and EV/EBITDA basis, offering an appealing entry point. Bottom Line: Boost the S&P THSP index to an overweight stance for a loss of 16% since inception, and add it to the high-conviction overweight list. This shift also lifts the overall S&P tech sector to a benchmark allocation for a loss of 18% since inception. The ticker symbols for the stocks in the S&P THSP index are: BLBG: S5CMPE - HPQ, WDC, STX, XRX, AAPL, HPE, NTAP. Anastasios Avgeriou, Vice President U.S. Equity Strategy anastasios@bcaresearch.com 1 Please see BCA U.S. Equity Strategy Weekly Report, "Bumpier Ride," dated March 26, 2018, available at uses.bcaresearch.com. 2 Please see BCA U.S. Equity Strategy Weekly Report, "Manic-Depressive?" dated February 12, 2018, available at uses.bcaresearch.com. 3 Please see BCA U.S. Equity Strategy Weekly Report, "Reflective Or Restrictive?" dated March 12, 2018, available at uses.bcaresearch.com. 4 Please see BCA Geopolitical Strategy Weekly Report, "Trump's Demands On China," dated April 4, 2018, available at gps.bcaresearch.com. 5 Please see BCA U.S. Equity Strategy Special Report, "White Paper: Introducing Our U.S. Equity Sector Earnings Models," dated January 16, 2018, available at uses.bcaresearch.com. 6 "The Tech Pulse Index is an index of coincident indicators of activity in the U.S. information technology sector. It can be interpreted as a summary statistic that tracks the health of the tech sector in a timely manner. The indicators used to compute the index are investment in IT goods, consumption of personal computers and software, employment in the IT sector, as well as industrial production of and shipments by the technology sector. The index extracts the common trend that drives these series." https://www.frbsf.org/economic-research/indicators-data/tech-pulse/ Current Recommendations Current Trades Size And Style Views Favor value over growth. Stay neutral small over large caps (downgrade alert).

Special Report

Highlights In China, the central bank and commercial banks conducted outright monetization of real estate inventories, which caused the property markets' recovery post 2015. Despite destocking, aggregate property inventories remain excessive. Elevated inventories, poor affordability, and policy tightening will depress property demand and lead to a contraction in construction activity. Slumping construction, along with a slowdown in infrastructure investment, pose downside risks to China's demand for commodities, materials and industrial goods. This is the main risk to EM stocks and currencies and the primary reason we maintain our negative stance on EM risk assets. Continue shorting Chinese property developers stocks versus U.S. homebuilders. Feature With a flurry of policy tightening directed at the real estate market in the past year, property demand in China has weakened. The latter typically leads property starts and real estate investment, and is coincident with real estate prices (Chart I-1). Is China entering another property downturn, and if so will it be shallow, or severe? Answers to these questions are important not only for Chinese stocks, but also for China-plays throughout the rest of the world. To shed light on this issue, this week we re-examine how large the imbalances in the Chinese real estate market actually are - with respect to both affordability and supply (the stock of housing and inventories). We also discuss policy objectives and investment implications. Proper Measures Of Inventories And Housing Stock Both purchases and prices of Chinese residential properties surged between 2015 and 2017, when the authorities implemented a property de-stocking policy. As a result, housing inventories declined significantly. Does this mean that one of the major imbalances, namely swelling inventories, has been eliminated? If imbalances, namely inventories and prices, in a property market are very minor, one can expect an ensuing adjustment to be benign. Conversely, if imbalances are large, it is reasonable to bet on a meaningful property market downturn. With respect to China's real estate inventory levels, data from the National Bureau of Statistics (NBS) which many analysts follow, indicates inventories of residential buildings have indeed declined, with a significant 33% drop in residential vacant floor space for sale (Chart I-2). The term "vacant" is used by the data provider to denote the floor space completed but not sold. Clearly, China's de-stocking strategy since 2015 has worked well. Chart I-1China: Real Estate Is Slowing Down Chart I-2Property Developers' Inventories: ##br##Completed But Not Sold However, data from the NBS on vacant space for sale is not all-encompassing. First, it includes only commodity buildings - i.e., those developed by real estate developers - and does not include buildings built by non-real estate developers. For example, companies, universities, organizations and even a group of individuals can construct both residential and non-residential buildings for their own use. Commodity buildings are just a small subset of total constructed buildings in China. According to NBS data, residential buildings by property developers account for only 26% of total constructed residential buildings in terms of floor space area completed. In brief, the inventory data that the majority of analysts use covers only a part of property construction (Figure I-1). Figure I-1The Breakdown Of Residential ##br##Real Estate Inventory Second, the vacant floor space data - shown in Chart I-2 and used by many analysts - only measures commodity buildings that have been completed but not sold. It does not account for those units that are under construction and have not been sold. The latter should also be counted as inventory because in China both residential and non-residential properties can be sold even when they are in the construction phase. Unlike advanced economies, in China the housing market is by far dominated by new construction. In particular, about 80% of residential commodity floor space sold are properties that are still under construction. This is drastically different from real estate markets in the U.S. and other developed countries, where the secondary housing market is a major source of supply. Given the above,1 we propose several alternative measures that aim to more accurately reflect the real picture of Chinese property inventory. Real Estate Inventory To capture the flow of the entire residential property supply in China, we calculate the difference between cumulative floor space started and cumulative floor space sold over the period of 1995-2017. This produces a new measure of total space not yet sold (i.e., available for sale), which includes areas both under construction and completed. This is a much more comprehensive measure of the total inventory than other commonly used measures. It is important to note that this measure takes into account both types of floor space available for sale: under construction and completed. The top panel of Chart I-3 illustrates that our derived measure of residential inventory - cumulative floor space started minus cumulative floor space sold - currently stands at 2.5 billion square meters or 27 billion square feet. This is about eight times greater than the NBS measure of vacant floor space - completed by property developers but not sold, which presently amounts to only 0.3 billion square meters or 3.23 billion square feet. On the bottom panel of Chart I-3, we estimate how many months of sales it will take to clear this housing inventory. Our findings reveal that even though our new inventory measure for the residential sector has fallen sharply due to the de-stocking policy, it still takes 22 months of last year sales to clear it. This is much higher than the completed by property developers but unsold vacant space, which presently stands at 2.5 months of last year sales. Provided that (1) most housing for sale in China is new construction, and (2) it can be sold at any stage of the construction cycle, we believe our new estimate of residential inventory that is equal to 22 months of last year sales is a more accurate reflection of reality. We computed a similar measure of inventory for non-residential properties that includes malls, offices, and warehouses. The top panel of Chart I-4 shows that the proper inventory levels for the non-residential sector have kept rising to new record highs in absolute terms. Relative to floor space sold last year, inventories still stand at 170 months of sales (Chart I-4, bottom panel). Chart I-3Our Measure Of Residential Inventories: ##br##Floor Space Available For Sale Chart I-4Our Measure Of Non-Residential Inventories: ##br##Floor Space Available For Sale Clearly, China's non-residential markets still carry excessive inventories. It would be misleading to use completed but unsold data for the non-residential sector, which accounts for roughly 14 months of sales. Similar to the residential commodity buildings market, about 65% of non-residential commodity buildings sold are those that are still under construction. In short, despite the decline from 2015's exceptionally high levels, inventories for both residential and commercial properties are still extremely elevated. Furthermore, the inventory-to-sales ratio is not a good indicator for the property market outlook because it is heavily influenced by sales. When sales - the denominator of this ratio - are weak, this inventory ratio is high, and vice versa. In particular, this ratio has been a poor indicator for the property market in China, where sales of properties have been deeply influenced by government policies. Whenever sales dropped and this ratio surged, the authorities would begin easing policies, spurring sales to rise and allowing the market - prices, floor space starts and construction - to recover. As a final note, these inventory data show floor space built by property developers only. Stock Of Housing The measure of per-capita living space gauges the existing stock of housing. Hence, it is a structural measure. Still being a low-income country, China is often perceived to offer enormous construction potential. However, some statistics on per-capita living space are revealing. The NBS data show that the 2016 per-capita living space for both urban and rural area has risen to 36.6 square meters and 45.8 square meters, respectively (Chart I-5). By comparison, in Korea and Japan, living space per capita (the entire population average) is only 33 and 22 square meters, respectively. Chart I-5China: Per Capita Living ##br##Has Grown Dramatically Our calculation of per-capita urban living space based on the NBS building construction data also show similar results - 38 square meters for 2017. Consequently, these statistics on per-capita living space are supported by historical construction data, and hence are reliable. Both NBS per-capita living space data and our calculated per-capita living space data confirm that there is already massive stock of residential property in China - the nation's current existing residential floor space area already amounts to 30.8 billion square meters (332 billion square feet). Furthermore, the stock of housing is relatively new with 88% of this living space built in the past 20 years. Assuming the floor space area of each house is on average 90 square meters (970 square feet), we infer that on average every urban household already owns 1.3 houses. This is actually in line with the results of several domestic household surveys, which conclude that 20-25% of houses owned by urban residents are neither being used for living nor for renting out. Provided not every household in China owns a house, and that a meaningful share of the population still lives in smaller and older housing, these data suggest there have been considerable speculative/investor purchases of housing over the past 10 years. Many high-income individuals own multiple properties (that are often kept vacant) while a still-considerable number of families live in poor conditions. Bottom Line: China has constructed enormous amounts of real estate since 2002. Furthermore, inventories are vast for residential and non-residential sectors alike. Such an oversupply of properties poses a considerable risk to construction activity going forward. Property Demand Weakness: Cyclical Or Structural? Very poor affordability, slowing rural-to-urban migration, demographic changes, tightening mortgage lending, a successful government-led clampdown on speculative activity and the promotion of the rental housing all point to both a cyclical and structural slippage in housing purchases in China. House Price-Income Ratios and Affordability House prices in China remain extremely high relative to disposable income. By using NBS 70-city residential average price, our calculation shows for an average household (assuming double income earners) it will take 10.5 years of its disposable income to buy a 90-square-meter (equivalent to 970 square feet) house at current prices (Chart I-6). The same ratio for the U.S. is presently 3.4 and at the peak of U.S. housing bubble in 2006 it was 4. In regard to the ability to service mortgage payments, annual interest costs account for 45% of average household disposable income (assuming a double income household) when buying a 90 square meter house and assuming 20% down payment (Table I-1). Chart I-6House Price-Income Ratio: ##br##China & The U.S. Table I-1House Price-To-Income Ratios ##br##And Affordability If we use another data provider - Choice, covering 100 cities, house price per a square meter is 60% higher than the NBS 70-city residential average price. Using Choice house price data, the house price-to-income ratio is 17, and affordability - the share of interest payments as a percentage of disposable household income - is 72%. Clearly, there is a huge gap between these two aggregate measures of residential property prices. In this report, we use conservative (low) prices from the NBS, which still reveals that house prices and interest payments are exceptionally high relative to disposable income for a double-income family. Table I-1 contains house price-to-income ratios and affordability ratios for 31 provinces using the house prices from NBS. Given the average urban household already owns more than one property, it is reasonable to expect that a considerable proportion of potential future demand for housing will come from rural residents as urbanization continues, or as rural residents seek to buy homes in the city for access to better quality education in the urban areas for their children. However, rural residents' current and potential (when they move to cities) disposable income is much lower than the urban's. Therefore, housing affordability is a bigger challenge for them. Rural-to-Urban Migration Even though urbanization is an ongoing process in China and will continue for many years, the pace is slowing (Chart I-7). The number of individuals moving from rural areas to cities as a percentage of the urban population is decreasing. This will translate into decelerating growth rate in demand for urban residential properties. Chart I-7China: The Pace Of Urbanization Is Slowing The second panel of Chart I-7 illustrates that rural-to-urban net migration accelerated in the early 1990s and has been between 15-18 million people per year over the past 20 years. However, as a share of the urban population, net migration has fallen from 4.5% in the late 1990s to 2% today (Chart I-7, third panel). Overall, urban population growth has slowed below 3% (Chart I-7, bottom panel). In brief, the slowdown in net migration and, consequently, decelerating urban population growth will cap structural housing demand that has been booming over the past 20 years. Poor Demographics The Chinese population is aging rapidly. The proportion of citizens who are over the age of 65 has risen from 8% of the population in 2007 to 11.4% as of last year and will continue rising rapidly. Given Chinese life expectancy is currently at about 76 years, senior citizens cohort will leave a large number of houses to their children or grandchildren over the next 10-15 years. The reason behind this is because the former demographic cohort (11.4% of the total population) is larger than the 10-19-year-age group which accounts for only 10.5% of the total population. The latter would have been a major source of property demand over the next 10 years, as Chinese tradition requires them to own a house before marriage. However, this is no longer the case. For this generation - born in the late 1990s and 2000s and by the time they get married (in general at the age of around 25 or a bit later), each newly-formed family could potentially inherit four houses from their parents and grandparents. Tightening mortgage lending As part of the current property related restrictive policies, mortgage interest rates have been on the rise for both first- and second-home buyers. Mortgage rates have risen by 74 basis points in the past 12 months - from 4.52% to 5.26%. Additionally, banks have been tightening credit standards. Given house prices are very high relative to income, a small increase in mortgage rates meaningfully increases the share of disposable income that must be allocated to interest payments on mortgages. For example, with the house price-to-income ratio at 10.5 and down payment of 20% of house price for the average home buyer in China, a 75-basis-point increase in mortgage rates would lift the share of interest payments on a mortgage from 45% to 51% of disposable income. Hence, higher borrowing costs over the past year as well as the ongoing tightening in credit standards will continue to discourage property buyers. Mortgage loan growth has rolled over after booming between 2015 and 2017, yet at a 22% annual growth rate, it remains very high (Chart I-8). Policy-led clamp-down of speculation President Xi Jinping's mantra that "housing is for living in, not for speculation" - proclaimed in December 2016 - is the focal point of the government's current policies. Many regulations implemented by both the central government and local governments over the past 15 months have been aimed at reducing speculative purchases. The promotion of the housing rental market In large cities residential rental yields fluctuate between 1-2.5% (Chart I-9). This compares with mortgage rate of 5.3%. Currently, renting is significantly cheaper than buying. This may encourage renting in the long term. Rising demand for rental housing might be met by the available stock of empty apartments that investors have been accumulating over the years. If this occurs, it will reduce demand for new home purchases. Chart I-8China: Mortgage Lending Has Been Booming Chart I-9China: Residential Rental Yields Are Very Low Meanwhile, the central government is determined to develop a rental market by constructing rental housing. If building of rental housing offsets the potential decline in property construction, it will make our negative view on construction volumes widely off the mark. The crucial factor to watch is financing. If credit supply slows meaningfully, there will be less available financing for overall construction, including rental. Any gains by rental construction will be overwhelmed by a decline in the building of residential and commercial real estate. In turn, financing is contingent on the government deleveraging campaign. If the authorities adhere to their pledge of deleveraging, a slowdown in credit growth will dampen overall construction activity. There can be no construction without credit. Furthermore, it takes only a deceleration in credit growth, i.e., a negative credit impulse, to depress construction volumes. That is why we cover China's credit cycle dynamics in such details in our regular reports. Bottom Line: Chinese property demand is facing numerous cyclical and structural headwinds. Policy Driven Market China's central and local government policies have over time and in different combinations substantially influenced the country's housing market on both the supply and demand sides. Over the past two decades, each time the government implemented restrictive policies (for example, raising down-payment ratios, increasing policy or mortgage rates, setting restrictions on mortgage lending, and so on), the real estate market slowed and housing prices softened. The opposite has also held true - each time the government introduced stimulus, housing prices surged as buyers quickly dove into the market. Chart I-10 illustrates the interaction between government property related regulations and the domestic housing market. Chart I-10China: Policy-Driven Property Market The biggest problem with such policies in the long run is that the authorities want to control both prices and volume - they want flat prices and moderately rising volumes. However, no government can control both prices and volumes simultaneously in any industry. China's real estate market is not an exception. Even in a completely closed socialist system, controlling prices and volume simultaneously is almost impossible. As the authorities adhere to their policy objectives of controlling financial risks and unwinding financial excesses, thereby focusing on property price control over the next 12 months, we believe property starts and construction activity will shrink. Monetization of Housing Inventories In 2015-'17 Understanding what was behind the housing market's strong recovery since late 2015 is critical to assessing the outlook. Since the summer of 2015, authorities were not only easing purchasing restrictions and lowering mortgage rates, but they were also implementing outright monetization of housing inventories. After inventories of both residential and non-residential properties swelled, the central government commenced a de-stocking strategy in 2015, mainly through a monetized slum reconstruction program and by encouraging migrant workers to buy housing in smaller cities near their hometowns. The de-stocking strategy focused on smaller cities where inventories had mushroomed. Given tier-1 cities account for only 6% of floor space started by property developers, and most construction in recent years has been taking place in tier-2 and smaller cities, these policies had a substantial positive impact on national sales, as well as drawing down inventories - ultimately spurring a construction recovery. 1. The government's slum area reconstruction policy has been the major driver behind de-stocking within the residential property market. The People's Bank of China (PBoC) has provided a significant amount of financing in the form of pledged supplementary lending (PSL) directly to homebuyers that was intermediated by three policy banks (China Development Bank, Agricultural Development Bank of China and Export-Import Bank of China). To shed more detail on the PSL mechanism, the central bank lends credit to the three policy banks at very low interest rates. These policy banks in turn lend directly to local government and regional property developers (mainly in tier-2 and smaller cities). These entities then turn and buy slums from their owners which puts cash in the hands of these sellers. Consequently, a large number of households suddenly receive large cash infusions - essentially disbursed by the central bank - that can be used to purchase new and better properties. The outstanding amount - total financing - via the PSL has risen from RMB 383 billion in 2014 to RMB 971 billion in 2016. The total amount of the PSL disbursed for the slum reconstruction program over 2014-2017 amounted to 3 trillion, or 3.6% of 2017 GDP, as of March 31, 2018. The interest rate on the PSL currently stands at a mere 2.75%. It appears that huge amounts of cheap money have been directly injected into the real estate market by the central bank alone. This slum reconstruction program has had a material impact on construction activity. Chart I-11 portends that slum area reconstruction accounted for about 20% of floor space sold in 2017. Chart I-11China: Slum Reconstruction ##br##Has Had Meaningful Impact 2. In addition to the PSL financing, Chinese housing mortgages have increased by 85%, or by 11 trillion RMB in the past two and a half years - since the beginning of China's de-stocking policy. The sum of PSL financing and mortgage lending has been RMB 14 trillion (or $2.2 trillion) during the same period. Hence, not only has the PBoC financed the real estate market directly, but it has also allowed banks to flood the system with money to liquidate housing inventories. As we have argued in our series of reports, bank credit does not come from anyone's savings. Commercial banks originate loans out of thin air.2 In short, altogether these actions constitute outright monetization of real estate inventories and that caused the property markets' recovery post 2015. A Downturn Ahead? Since early 2017 and especially in the wake of last October's Party Congress, the authorities have shifted their policy focus from "de-stocking" to "eliminating speculative demand". Recent weakness in both demand and prices are a reflection of the current policy focus. This time, the government seems to have more determination to break popular perception that property prices will rise forever, and that investing in property markets cannot go wrong. Therefore, we sense the government's objective is to achieve flat or mildly declining property prices to prevent the return of speculators. In order to avoid a further ballooning of the real estate bubble, the government will raise the bar for another round of property stimulus. Therefore, if the authorities are successful in persuading speculators that prices will not rise much further in the years to come, speculative demand will wane. At the same time, not many first-time homebuyers can afford to buy at current prices. This will create an air pocket in sales and prices will deflate, at least modestly. Facing shrinking revenues and being overleveraged, real estate developers will reduce new starts, and property construction volumes will likely contract by 10% or so. Notably, floor space started by property developers in aggregate declined by 27% between 2012 and 2016 (Chart I-12). The construction slump in China, in tandem with rising supplies of commodities, led to a collapse in commodities prices in 2012-'15 (Chart 12). Hence, a decline in property construction is not unprecedented, even amid robust national income growth. We believe the acute structural imbalances will likely result in a property market downturn commensurable if not worse than those that occurred in 2011-'12 and 2014-'15. While the government will try to avoid a sudden bust, a 10% decline in both property prices and construction volumes in the next 12-18 months is our baseline scenario. The budding contraction in cement and plate glass production suggests that overall construction activity is already decelerating (Chart I-13). Chart I-12China: Property Cycles ##br##And Commodities Prices Chart I-13China: Nascent Contraction In Cement ##br##And Plate Glass Production Bottom Line: The Chinese authorities will for now maintain their current restrictions on the property market to contain financial excesses and risks in the system. This, amid lingering elevated inventories and price excesses, poses considerable downside risks to the mainland real estate market. Investment Implications Our view remains that construction activity in China is set to slump from a cyclical perspective, at least. At 13.2 billion square-meter (142 billion square-feet) the total 2017 residential and non-residential floor area under construction was immense (Chart I-14). This, along with a slowdown in infrastructure investment due to tighter control on local government finances, pose downside risks to China's demand for commodities, materials and industrial goods. This is the reason why we have been and remain bearish on commodities, Asian trade and EM risk assets. It appears that several commodities prices are finally beginning to roll over which is consistent with a slowdown in the mainland's construction activity (Chart I-15). Chart I-14China's Total Building Construction: ##br##Level And Annual Growth Chart I-15A Budding Downtrend In ##br##Commodities Prices China's construction activity is much larger than exports to the U.S. and EU combined. Hence, overall industrial activity in China is set to decelerate dragging down Asian trade flows and commodities prices despite robust domestic demand in the U.S. and EU. This heralds underweighting/shorting EM stocks, currencies and credit versus their DM counterparts. We also reiterate our long-standing recommendation of shorting Chinese property developers versus U.S. homebuilders. Chart I-16 depicts that the Chinese property developers listed in A-share market have a debt-to-equity ratio of 6 and the cash flow from operations for the median of 76 property developers has begun contracting again. Further relapse in property sales will cause their financial position to deteriorate and limit their ability to launch new or complete existing construction. In regard to U.S. homebuilders, the fundamentals in the U.S. housing market are much better than those in China. While rising U.S. interest rates could be a headwind for U.S. homebuilder share prices, they stand to resume their outperformance versus Chinese property developers (Chart I-17). Chart I-16China: Median Property Developer's ##br##Financial Ratios Are Worsening Chart I-17Short Chinese Property Developers / ##br##Long U.S. Homebuilders Ellen JingYuan He Senior Editor/Associate Vice President EllenJ@bcaresearch.com Arthur Budaghyan, Senior Vice President Emerging Markets Strategy arthurb@bcaresearch.com 1 Other oft-used measures of inventories are not correct either. Some analysts use floor space under construction data as a proxy for inventory - this is technically not correct as the data includes both the area that has already been sold in advance and the area that has been completed and sold. Others use cumulative floor space started minus cumulative floor space completed - this is also not correct as cumulative floor space completed includes areas that have not yet been sold. 2 Please see Emerging Markets Strategy Weekly Report "Is Investment Constrained By Savings? Tales Of China And Brazil," dated March 22, 2018, the link is available on page 20. Equity Recommendations Fixed-Income, Credit And Currency Recommendations

Neutral The S&P health care equipment (HCE) index has caught a bid recently, reflecting the sector's strong profit momentum, following nearly a decade of decline (second panel). We fear, however, that investors have become somewhat overzealous as the run up in stock prices has dramatically outpaced earnings expectations, pushing the forward price/earnings multiple to its highest level since the GFC (third panel). Such excitement, particularly when industry pricing power is lagging far behind the rest of the broad corporate sector (bottom panel) seems misplaced. Net, we continue to think the catalyst for a sustainable move higher in the index will be a recovery in pricing power and, in the absence of evidence of this, we reiterate our benchmark allocation. The ticker symbols for the stocks in this index are: BLBG: S5HCEP: MDT, ABT, DHR, BDX, SYK, ISRG, BSX, BAX, EW, ZBH, IDXX, RMB, VAR, HOLX.