Sectors

An Insight on December 13 showed that the tech sector and the U.S. dollar have historically been positively correlated during the initial phase of a currency bull market, but that correlation reverses in the latter stages. The loss of competitiveness and anti-globalization are serious headwinds for the tech sector, particularly given that inflation pressures in the broader economy have started to build. The tech sector shines in deflationary periods rather than inflationary environments. Rising bond yields and rising headline inflation imply higher discount rates and by extension, lower valuations, all other things equal, for the long duration tech sector. While the broad market has maintained strong momentum, the tech sector is unlikely to keep pace. Reducing exposure on price strength is a prudent strategy.

After the election, machinery stocks jumped sharply on the hope that only Trump's growth-oriented policies will be successful while growth-restrictive proposals will be watered down, supporting commodity prices and ultimately reinvigorating machinery demand. However, the risk is that the waiting period will prove longer than expected, testing investor patience. While global manufacturing surveys have perked up on the back of inventory restocking, global machinery orders are still sinking, and U.S. machinery new orders are contracting. The strong U.S. dollar makes it dangerous to extrapolate firming global surveys into strong U.S. corporate performance. The chart shows that relative machinery EPS estimates have moved in the opposite direction of relative share prices. As a result, the bottom panel of the chart shows that relative valuations have skyrocketed. The S&P machinery sector's forward P/E is now trading at a 20% premium to the broad market (over a two decade high, excluding the Great Recession) spiking 6% since November. If earnings fail to live up to extremely optimistic expectations, as we expect, then relative share prices are at risk of a retracement. Bottom Line: Continue to underweight the S&P machinery index.

Special Report

Highlights U.S. Investment Grade (IG): We recommend overweights in Energy, Financials, Airlines, Building Materials within an overall neutral allocation to U.S. Investment Grade. Euro Area IG: Maintain overweights in Euro Area IG vs U.S. equivalents, favoring Energy, Financials and Wireless sectors. U.K. IG: Maintain an above-benchmark stance on U.K. IG, favoring Banks, Technology and Telecommunications sectors. Feature Last September, we introduced a new element to the BCA Global Fixed Income Strategy investment framework - translating our views on individual bond markets into a model portfolio. This was intended to be a tool providing something closer to a "real world" percentage allocation among the various countries and sectors that we cover, more in line with the day-to-day decisions faced by a typical bond manager. We came up with a custom benchmark for that portfolio, combining government debt, corporate bonds and other spread products from the major developed economies. We used the market capitalization weightings of the Bloomberg Barclays bond indices to determine the relative size of each sector. Our chosen benchmark index goes into considerable detail for our government bond allocations, with several maturity buckets, to allow for more precision in our overall country and duration calls. As the next step in the evolution of our model portfolio framework, we are adding a detailed sectoral breakdown of the Investment Grade (IG) corporate bond universes for the U.S., Euro Area and U.K. This will provide more granularity in our IG recommendations, and give our clients additional investment ideas beyond our major portfolio allocation calls. Going forward, we will provide a regular update of our sector allocations in our first Weekly Report published each month. For this week, we are recommending sectors that have cheaper valuations but with riskiness close to the overall IG indices where spreads remain tight. For example, in the U.S., overweight Energy within an overall neutral IG allocation; in the Euro Area, overweight Wireless within an overall above-benchmark IG allocation; and in the U.K., overweight Basic Industries within an overall above-benchmark IG allocation (Chart of the Week). Chart of the WeekSome Of Our Preferred IG Sectors A Brief Description Of Our Sectoral Relative Value Framework Our existing sector relative value methodology assesses the attractiveness of each IG sector within a cross-sectional analysis. The option-adjusted spread (OAS) for each sector is regressed against common risk factors (interest rate duration and credit quality) with the residual spread determining the valuation of each sector. As an additional measure of the overall riskiness of each sector, we use the concept of "duration times spread" (DTS). We have shown in previous research that allocating to sectors in an IG corporate bond portfolio using a DTS weighting scheme produces better risk-adjusted returns with lower drawdown risk.1 It is our plan to eventually incorporate DTS-weightings into our asset allocation framework more directly, as we build out our model portfolio infrastructure to include quantitative risk management metrics. For now, we will look at the relationship between the OAS residuals from our sector relative value models to the DTS of each sector to give a reading on the risk/reward tradeoff for each sector. In some cases, we may not wish to overweight sectors with cheap spreads (positive residuals in our model) that have an above-average DTS, if we are relatively more cautious on taking overall spread risk. The opposite could also occur, where we could overweight sectors that do not have positive spread residuals but have a DTS close to our desired level of credit risk. At the moment, we see overall IG spreads as fully valued in the U.S., Europe and the U.K., so we are aiming for sectors with credit risk closer to the levels of the benchmark indices. Therefore, in the absence of any strong sector-specific views, we are looking for sectors with positive residuals from our relative value model, but with a DTS close to the level of the overall IG index for each region. U.S. Investment Grade - Stay Cautious In Sector Allocations, Except For Energy In Table 1, we present the output of our U.S. IG sector valuation model. The index OAS, model residual ("risk-adjusted valuation"), and DTS is provided for each sector. In addition, a four-letter abbreviation is shown which is used in Chart 2, a scatter diagram showing the residuals versus the DTS for all the sectors. TABLE 1U.S. Investment Grade Corporate Sector Valuation* Within the U.S. IG universe, our valuation model shows spreads are attractive in sectors within Basic Industry (most notably, Metals & Mining and Paper), Building Materials, Energy (most notably, Independent, Refining and Midstream), Communications (most notably, Cable & Satellite and Wireless), Airlines and Financials (most notably, Brokerages/Asset Mangers/Exchanges, Finance Companies, Life Insurers and Property/Casualty Insurers). Among those sectors, the names that have a DTS relatively close to, or lower than, the overall U.S. IG index DTS are: Finance Companies, Building Materials, Airlines, and Brokerages/Asset Managers/Exchanges. These are also sectors with an absolute (non-risk-adjusted) OAS above that of the overall U.S. IG index, adding to their attractiveness. Despite our overall cautiousness on spread risk, the Energy-related sectors represent a special case where we would consider overweighting these higher DTS names. As global oil markets have rebalanced in the latter half of 2016, the subsequent rise in oil prices helped reduce the large risk premiums that had built up in Energy corporate debt (both IG and high-yield). BCA's Commodity strategists see oil prices holding up well over the next year, trading in a range between $50/bbl and $65/bbl for the Brent benchmark. In that scenario, we see a full convergence of the spread between Energy related names and the U.S. IG index, which makes the case for overweighting the cheaper Energy sub-sectors a compelling one, even with the higher risk as measured by DTS. This is particularly true given the large weighting of those names in the overall IG benchmark (just over 6%). Therefore, in our recommended U.S. IG sector allocation, we are adding overweights in Independent Energy, Refining and Midstream to the other names mentioned above. The actual percentage sector allocations for our model portfolio are shown in Table 2. The table is presented in a similar format to the model portfolio tables that we present in the back of our Weekly Reports. The weightings reflect all the investment goals outlined above, including the preferred overweights, while delivering a portfolio DTS that is equal to the overall IG index DTS of 9. Bottom Line: We recommend overweights in Energy, Financials, Airlines, Building Materials within an overall neutral allocation to U.S. Investment Grade. Chart 2U.S. Investment Grade Corporate Sector Risk Vs Reward* TABLE 2Our Recommended U.S. IG Corporate Sector Portfolio Allocation Euro Area Investment Grade - Overweight Vs U.S., Favoring Wireless, Energy & Financials In Table 3, we show the output for our Euro Area IG sector model and, in an identical fashion to the U.S. IG analysis above, we show a scatter diagram showing the model residuals versus the sector DTS scores in Chart 3. TABLE 3Euro Area Investment Grade Corporate Sector Valuation* Chart 3Euro Area Investment Grade Corporate Sector Risk Vs Reward* In this case, we are sticking with our current model portfolio recommendation to overweight Euro Area IG, but while maintaining the same relatively cautious stance towards the DTS exposure given tight overall spread levels. Our call to overweight European IG is a relative one versus U.S. IG, given the stronger signals given by our relative Corporate Health Monitors and the ongoing presence of European Central Bank corporate bond asset purchases (Chart 4). Within Euro Area IG, the cheapest valuations within our model framework are among the Financials - specifically, within the Insurance sectors. The Insurers, however, have very high DTS scores relative to the overall index, and thus we are choosing not to overweight the names despite the wider risk-adjusted spreads on offer. From a fundamental perspective, higher Euro Area interest rates will be required to make us turn more bullish on the Insurers, which is an outcome that we do not anticipate until at least the latter half of 2017. We are recommending overweights in sectors with non-zero model residuals that have relatively neutral DTS scores: Wireless, Packaging, Integrated Energy, Banks, Brokerages/Asset Managers/Exchanges, and Other Finance. Our recommended Euro Area IG sector allocations are presented in Table 4, with the weighted DTS of our portfolio in line with the index DTS of 6. Bottom Line: Maintain overweights in Euro Area IG vs U.S. equivalents, favoring Energy, Packaging, Financials and Wireless sectors. Chart 4Continue To Favor Europe IG Over U.S. IG TABLE 4Our Recommended Euro Area IG Corporate Sector Portfolio Allocation U.K. Investment Grade - Stay Overweight, Focusing on Financials, Technology & Telecommunications Table 5 contains the output from our U.K. IG sector model, while the scatter diagram of model residuals versus DTS scores is in Chart 5. Again, the Insurers look attractive in the U.K. as in the Euro Area, but the high DTS score deters us from overweightings these names. Banks and Other Financials look attractive, with lower DTS scores, as does the debt of Metals & Mining, Cable & Satellite, Wireless, & Technology. TABLE 5U.K. Investment Grade Corporate Sector Valuation* Chart 5U.K. Investment Grade Corporate Sector Risk Vs Reward* We continue to recommend an above-benchmark allocation to U.K. IG within out model portfolio, given the highly stimulative monetary settings in the U.K. (low interest rates, a deeply undervalued currency), as well as the continued presence of Bank of England corporate bond asset purchases. Our recommended allocation within the above-benchmark allocation to U.K. IG can be found in Table 6. Again, we sought an overall DTS score in line with the U.K. IG DTS of 12. Bottom Line: Maintain an above-benchmark stance on U.K. IG, favoring Banks, Technology and Telecommunications sectors. TABLE 6Our Recommended U.K. IG Corporate Sector Portfolio Allocation Robert Robis, Senior Vice President Global Fixed Income Strategy rrobis@bcaresearch.com 1 Please see BCA U.S. Bond Strategy/Global Fixed Income Strategy Special Report, "Managing Bond Portfolios In A Rising Spread Environment, Part 1: Choosing The Right Benchmark", dated September 1, 2015, available at usbs.bcaresearch.com and gfis.bcaresearch.com. The GFIS Recommended Portfolio Vs. The Custom Benchmark Index

Chemicals stocks have significantly underperformed the broad market since our underweight call in 2014, pulled lower by the soaring U.S. dollar and sagging industry productivity. Net earnings revisions have been consistently revised lower over the past few years, and are unlikely to recover without a reflationary push that revives chemical final demand (global real yields are shown inverted, second panel). However, global manufacturing improvement seems likely to accrue mostly to firms outside the U.S. German chemical new orders have surged, and the IFO survey of chemical industry executives signals optimism about the future. U.S. executives appear to be equally confident, but that optimism is misplaced. The American Chemical Council expects U.S. chemical exports to increase 7% a year through 2021. Over $170B is expected to be invested in U.S. chemical manufacturing capacity, representing nearly 25% of the total industry size, which is anticipated to boost the chemical trade surplus to new records. So far, roughly $76B of projects has either been completed or is under construction. If these planned projects all come to fruition, our concern is that new capacity will be idle rather than productive. Capacity is already growing much faster than output, unleashing significant deflationary and productivity-draining forces. We expect chemicals stocks to continue to lag the broad market. Stay clear and please see yesterday's Weekly Report for more details. The ticker symbols for the stocks in this index are: BLBG: S5CHEM - APD, ARG, CF, DOW, EMN, ECL, DD, FMC, IFF, LYB, MON, MOS, PPG, PX, SHW.

Media stocks are on track to set new relative performance highs. Media sales growth is in recovery mode. Consumers have significantly boosted spending on media services, as measured by personal consumption expenditures data. Pricing power has surged in response to demand strength (bottom panel). In turn, strong demand is boosting measures of productivity: our proxy for sales/employment is accelerating toward the double-digit growth zone. Productivity is diverging positively from relative forward earnings expectations, implying there is room for a re-rating. As long as the U.S. economy is growing, media companies should be able to garner an increasing share of consumer wallets. Real spending on media services has been in a steady uptrend for well over a decade, reflecting its ability to continually innovate, only pausing during recessions when consumers are forced to retrench. Rising spending underscores that pricing power gains are sustainable (bottom panel). Stay overweight, and please refer to yesterday's Weekly Report for more details.

Highlights Portfolio Strategy Media stocks are poised to challenge previous relative performance highs as sales growth reaccelerates. Stay overweight. The materials sector has lagged behind the commodity price rally, a sign of underlying weakness rather than latent strength. Chemicals overcapacity will remain a headwind until U.S. competitiveness improves. Stay clear. Recent Changes There are no changes to our portfolio this week. Table 1Sector Performance Returns (%) Feature The broad market has been very strong since the November election. While advance/decline lines have firmed, participation in the rally has been uneven and may be fraying around the edges. For example, the number of groups trading above their 40-week moving average has been diverging negatively from the broad market in the last few months, suggesting diminishing breadth (Chart 1). In fact, the industrials (I) and financials (F) sectors have carried the market since November. Other deep cyclical sectors, such as energy, materials and tech, have mostly matched market performance. The 'IF' rally is based on an expected upgrade to the economic growth plane that matches the surge in various sentiment gauges. If validation does not occur, then the IF rally will become iffy indeed, unless sector breadth improves. Last week we showed that market cap-to-GDP was so far above its long-term average that even if nominal growth boomed at 8% per annum for the next five years this valuation ratio would still not have normalized. That valuation backdrop may not upend additional short-term market momentum, but it is a true measure of just how bullish sentiment has become and should be a critical input to the portfolio construction process, because of its warning about divergences from fundamental supports. Another unconventional sentiment gauge is observed from sub-surface market patterns. Chart 1 shows that the number of defensive groups with a positive 52-week rate of change, in relative terms, is in freefall, plunged to virtually nil. In the last two decades, investors eschewing capital preservation and non-cyclical sectors so aggressively has typically preceded major market peaks (Chart 1). The steep drop in the put/call ratio confirms that euphoria and greed are trumping mistrust and fear. The put/call ratio has recently bounced, but is well below levels that signal investors are accumulating significant portfolio protection. The Fed's tightening bias, contracting U.S. dollar-based financial liquidity amid the strong U.S. dollar all threaten to keep a lid on corporate sector sales prospects. As such, we remain biased toward non-cyclical and consumer sectors, even excluding fiscal policy uncertainty. Chart 2 shows that these areas are in a base-building phase, in relative terms, following their post-election drubbing. We expect momentum to steadily build toward sustained outperformance by midyear. Conversely, a reversal in the 'IF' sectors already appears to be developing, while other capital spending-dependent sectors are unable to gain momentum (Chart 3). This week we highlight both a winning group and an area we expect to disappoint. Chart 1The Rally Is Fraying Around The Edges Chart 2Defensive Base-Building? Chart 3Cyclical Sector Distribution New Highs Ahead For Media While the consumer discretionary sector has a poor track record during Fed tightening cycles, the S&P media sub-component can buck this trend. Media stocks outperformed in the second half of the 1990s and also trended higher in the 1980s while the Fed was tightening. The key was the U.S. dollar (Chart 4). As long as the dollar was strong, media companies sustained a profit advantage over the rest of the corporate sector owing to limited external exposure. A replay is currently playing out, and has the potential to persist for at least the next few quarters based on upbeat cyclical indicators. Media sales growth is in recovery mode. Consumers have significantly boosted spending on media services, as measured by personal consumption expenditures data (Chart 5). Pricing power has surged in response to demand strength (Chart 5, bottom panel). In turn, strong demand is boosting measures of productivity: our proxy for sales/employment is accelerating toward the double-digit growth zone (Chart 5). Productivity is diverging positively from relative forward earnings expectations, implying there is room for a re-rating. As long as the U.S. economy is growing, media companies should be able to garner an increasing share of consumer wallets. Chart 6 shows that real spending on media services has been in a steady uptrend for well over a decade, reflecting its ability to continually innovate, only pausing during recessions when consumers are forced to retrench. Typically, a rise in spending pulls up pricing power (Chart 6). Chart 4Media Stocks Like Dollar Strength Chart 5Sales Are Set To Accelerate Chart 6Secular Strength All of this has spurred a recovery in media cash flow growth (Chart 7, top panel). Relative performance and cash flow move hand-in-hand. Rising cash flows also imply that the media sector can further reduce shares outstanding through buybacks and/or M&A activity (Chart 7), bolstering ROE. The S&P movies & entertainment index has been one of the driving forces behind the broader media index recovery. We upgraded the former to overweight after the vicious selloff related to Disney's ESPN woes and the takeover saga at Viacom had pushed the index to an undervalued extreme. While slightly early, this upgrade is now paying off (Chart 8). The expectations hurdle remains surmountable. Both forward earnings and sales growth estimates are deeply negative (Chart 8), reflecting the well-known cooling in cable subscriber growth. But even here, there is room for potential upside surprises. Consumer spending on recreation has been growing at a low single-digit clip, but the surge in consumer confidence, courtesy of rising wage growth and a positive wealth effect from rising real estate and financial asset prices, should support increased discretionary consumer spending. The message from the jump in the ISM services index is bullish for recreation spending (Chart 9, second panel). Chart 7Shareholder-Friendly Chart 8Cheap With Low Expectations Chart 9Still Early In The Recovery In turn, faster spending would support ongoing pricing power gains (Chart 9). The industry is already sporting one of the most robust selling price increases of all that we track, as advertising rate inflation is growing anew. Importantly, real outlays on cable services have recovered after a steep decline (Chart 9), suggesting that the drag from disappointing cable subscriber growth and cord cutting may be easing. Less churn implies more pricing power. Content cost inflation also remains under wraps. The implication is that the fundamental forces to propel a retest of previous relative performance highs are in place. Technical conditions are also sending a bullish signal. Cyclical momentum, as measured by the 52-week rate of change, is on the cusp of breaking into positive territory (Chart 9), while the share price ratio has already crossed decisively above key resistance at its 40-week moving average. A dual breakout would confirm a new bull trend. Bottom Line: Media stocks have good odds of retesting previous relative performance highs as discretionary consumer spending perks up. Stay overweight the overall media group, and the S&P movies and entertainment index in particular. Chemical Stocks: A Toxic Portfolio Blend The commodity price recovery has not carried over into the S&P materials sector, as relative performance has been moving laterally for much of the last twelve months. Rather than view this as an opportunity to play catch up, the more likely outcome is that the sector has missed its chance to outperform. In fact, downside risks have intensified. The strong U.S. dollar will exact a toll on U.S. exporters, particularly if emerging markets and China do not experience accelerating final demand. While there has been a massive amount of stimulus in China over the past 18 months, the thrust of that impulse is fading. Fiscal spending growth has dropped sharply and the authorities trying to cool rampant real estate speculation. The yield curve remains flat (Chart 10), as local funding costs rise on the back of the authorities attempt to mitigate capital outflows, and loan demand remains weak. Persistent weakness in the Chinese currency may reflect a lack of confidence in local returns, i.e. sub-par growth. All of that argues against expecting a major impetus to raw materials demand, at a time when the materials sector total wage bill is inflating more aggressively. Our Cyclical Macro Indicator for the materials sector is hitting new lows (Chart 10), heralding earnings underperformance, underscoring that below-benchmark allocations remain appropriate. The S&P chemicals group represents for than 70% of the overall materials market cap. It has underperformed since its peak and our underweight call in 2014, pulled lower by the soaring U.S. dollar and sagging industry productivity (Chart 11). Net earnings revisions have been consistently revised lower over the past few years, and are unlikely to recover without a reflationary push (global real yields are shown inverted, second panel, Chart 11) that revives chemical final demand. Analysts have latched on to the firming in global purchasing manager survey sentiment, aggressively pushing up sales growth expectations in recent months (Chart 12). Clearly, manufacturing sector expansion is expected to reverse the contraction in chemical output growth (Chart 12). Chart 10Higher PMIs Are Not Enough Chart 11Higher Yields Are A Bad Omen Chart 12Expectations Are Inflated However, this may be yet another case of analysts chronically overestimating the industry's earnings power. Global manufacturing improvement seems likely to accrue mostly to firms outside the U.S. Chart 13 shows that chemicals relative performance is heavily influenced by the U.S. dollar. Valuations and sentiment are tightly linked with chemical export growth (Chart 13), as the latter represent 14% of total U.S. exports. The U.S. dollar surge is diverting orders away from U.S. manufacturers: German chemical new orders have surged, and the IFO survey of chemical industry executives signals optimism about the future (Chart 14). Chart 13The Dollar Is Hurting The U.S. ... Chart 14... But Helping Foreign Competitors U.S. executives appear to be equally confident, but that optimism is misplaced. The American Chemical Council expects U.S. chemical exports to increase 7% a year through 2021. Over $170B is expected to be invested in U.S. chemical manufacturing capacity, representing nearly 25% of the total industry size, which is anticipated to boost the chemical trade surplus to new records. So far, roughly $76B of projects has either been completed or is under construction. If these planned projects all come to fruition, our concern is that new capacity will be idle rather than productive. The industry is in the crosshairs of anti-globalization and protectionism, and a strong U.S. dollar and rising domestic cost structures threaten to reduce competitiveness. Chemical imports are a fairly large portion of sales, rendering profitability vulnerable should an import-tax ever be introduced. From a cyclical standpoint, deflationary pressures are already very acute. Chemical capacity is growing much faster than production, warning that pricing power will be under significant pressure (Chart 15). Many chemical products are destined for interest rate-sensitive end markets such as autos, underscoring that a Fed tightening cycle is a headwind. While capacity expansion was planned when interest rates and feedstock costs were expected to remain at rock bottom levels for the foreseeable future, this is no longer the case. Chemical companies can either use natural gas (ethane) or oil (naphtha) as a primary feedstock. U.S. production is largely ethane-based, while global capacity is geared to naphtha. Rising U.S. natural gas prices are undermining the U.S. input cost advantage (Chart 16). Chart 15Persistent Deflation Pressures Chart 16U.S. Cost Structures Are Unattractive Increased capacity has also put significant upward pressure on wage costs, as our proxy for the total wage bill is rising at a high single-digit rate (Chart 16). With capital spending slated to stay robust in the coming years, it will likely continue to take a larger share of sales, impairing profit margins. While the planned merger between heavyweights Dow Chemical and Dupont may eventually help to rationalize costs, this is a necessary but not sufficient step in the face of a loss of global market share. Without accelerating sales, U.S. chemical makers will be hard pressed to improve productivity sufficiently to reverse the slide in relative forward earnings estimates. Bottom Line: The S&P materials sector hasn't been able to outperform during a period of improving global manufacturing activity, raising doubts about its performance potential when global output growth inevitably slows. Part of this reflects the challenging outlook for the sector heavyweight chemicals index, and we recommend staying underweight both. The symbols for the stocks in this index are: BLBG: S5CHEM - APD, ARG, CF, DOW, EMN, ECL, DD, FMC, IFF, LYB, MON, MOS, PPG, PX, SHW. Current Recommendations Current Trades Size And Style Views Favor small over large caps. Favor growth over value (downgrade alert).

In early 2016, our sister publication Global Alpha Sector Strategy did a cycle-on-cycle analysis on the ISM manufacturing index and relative industrials performance in the following twelve months every time the ISM sank below the boom/bust line for 5 or more consecutive months. The conclusion was that it did not pay to underweight industrials stocks, as too much bearishness was already baked in the cake. The opposite is also true. We analyzed relative industrials performance since the early 1990s every time the ISM manufacturing new orders sub-index hit 60. The bottom panel of the chart shows median relative performance in the ensuing twelve months. The implication is that industrials stocks will suffer in the coming quarters as too much optimism is already discounted since the post-election reflex advance. Bottom Line: We reiterate our recent high-conviction underweight stance on the S&P industrials sector.

Special Report

Feature Which of the following activities requires more brainpower: beating a grandmaster at chess, or cleaning the table underneath the chessboard? The answer is cleaning the table. This explains why Artificial Intelligence (AI) can now trounce the best human chess player, but no AI can (yet) reliably pick up the chessboard and dust underneath it. The cognitive scientist Steven Pinker points out that the human mind can understand quantum physics, send a rocket to the moon and decode the genome, but reverse-engineering simple human movements involves a mind-boggling complexity. "The hard problems are easy and the easy problems are hard." AI researchers call this Moravec's Paradox:1 the counterintuitive result that much less computing power is required for advanced problem solving than for simple sensorimotor skills.2 Feature ChartCooks, Waitresses And Bartenders Is The Fastest Growing Employment Sector Pay Deflation For The Many... The hard problems that are easy for AI are those that require the application of complex algorithms and pattern recognition to large quantities of data - such as beating a grandmaster at chess. Or a job such as calculating a credit score or insurance premium, translating a report from English to Mandarin Chinese, or managing a stock portfolio. The easy problems that are hard for AI are those that require the replication of human movement in everyday tasks. Jobs such as cleaning, gardening, or cooking. Therefore: "As the new generation of intelligent devices appears, it will be the stock analysts who are in danger of being replaced by machines... (Cleaners), gardeners, and cooks are secure in their jobs for decades to come." For societies and economies, Moravec's Paradox generates a chilling deflationary headwind. Many of the jobs that AI will destroy - like credit scoring, language translation, or managing a stock portfolio - are regarded as skilled, and require years of advanced education and training. They have limited human competition, and are well-paid. Conversely, many of the jobs that AI cannot (yet) destroy - like cleaning, gardening or cooking - are relatively unskilled. They have unlimited human competition, and are low-paid. ...Pay Inflation For The Tiny Few As well as sensorimotor skills, humans still beat AI in three other fields: creativity, innovation, and complex communication. As Erik Brynjolfsson and Andrew McAfee3 observe in The Second Machine Age: "Computers are still machines for generating answers, not posing interesting new questions... We've never seen a truly creative machine, or an entrepreneurial one, or an innovative one." Hence, these are the skills you should encourage your children to acquire as their defence against AI. Moreover, the leaders in these fields - the very best entrepreneurs, innovators and communicators as well as top sportsmen and musicians - now find themselves in a particularly strong position. This is because a second powerful dynamic is at play. As we showed in the first Special Report in this series The Superstar Economy,4 the internet allows the very best entrepreneurs, innovators and communicators to sell their services to an effectively unlimited audience. And social media, as a large-scale validation system, reinforces the winner-takes-all dynamic. Therefore, as the proliferation and power of the internet and social media have increased dramatically, so too have both the earnings growth rate and the longevity of the superstars - exaggerating the skew in the Pareto distribution of incomes. Simply put, the superstars in sensorimotor skills, creativity, innovation, and complex communication will continue to see very strong pay inflation (Chart I-2). Chart I-2The Cost Of Living Extremely Well Continues To Rise Unabated The Hollowing Out Of The Middle Class Sadly, only a tiny fraction of the population can become superstars. As AI takes over mid-skill knowledge work, the vast majority of displaced workers start going after jobs lower on the skills and wage ladder. As these jobs also have lower security, this keeps a lid on credit growth, because without income security, households are less willing to borrow and banks are less willing to lend. The result is that the on-going Second Machine Age - the ushering in of Artificial Intelligence - is hollowing out the middle class. Contrast this with the First Machine Age - the ushering in of 'Artificial Strength'. The steam engine replaced muscle power, both human and animal. Thereby, it destroyed mostly low-skill work and effectively created the middle class. But does the evidence support the narrative for the Second Machine Age? The answer is yes. The changing sectoral profile of the jobs market through 1997-2017 is almost identical to the changing profile of output, as captured by GVA.5 Which means that job destruction and creation has kept relative productivity between sectors broadly unchanged through the past 20 years (Tables I-1-I-5). In other words, human jobs have disappeared where AI can do them better. And they have gone to where AI cannot do them better, because the jobs involve some degree of sensorimotor or communication skill. Table I-1U.K. Jobs Have Gone To Where Machines Cannot (Yet) Beat Humans Table I-2The U.K. Value Added Profile Is Similar To The Jobs Profile Table I-3U.S. Jobs Have Gone... Table I-4...To Where Machines Cannot (Yet) Beat Humans Table I-5The U.S. Value Added Profile Is Similar To The Jobs Profile U.S. data provides fascinating sub-sector detail. The employment sub-sectors that have grown the most are relatively low-income but which require sensorimotor skills: Food Services and Drinking Places - cooks, waitresses and bartenders - and Social Services, followed by communication-dependent Education Services (Feature Chart). And now comes the bombshell. A separate study by Ball State University carried out an attribution analysis of the 6 million U.S. manufacturing destroyed through 2000-20106 (Table I-6). The study's salutary conclusion was that only 13% of the job losses resulted from trade, and almost 90% resulted from productivity improvements - in other words, because AI can do the jobs better than humans. Table I-6Only 13% Of Manufacturing Job Losses Are Due To Trade It follows that short of reversing the advance of technology, no amount of "Take Back Control", "Build A Wall" or "Make America Great Again" can change the powerful wind of change in the employment market. The Implications Of The Superstar Economy In terms of implications for policymakers and investors, all of the conclusions in the original Special Report The Superstar Economy remain valid, so we will reiterate them. Bear in mind that we originally wrote these on March 24, 2016. Several of the predictions have already proved eerily prescient. Headline and aggregate-economy statistics such as GDP and income are no longer representative statistics for the living standards of the vast majority of the population. Therefore, politicians will need to pay close attention to the underlying distribution of these statistics. But as many politicians seem blissfully unaware of the extreme skews in the Pareto distribution, we can expect a higher frequency of shocks at the ballot box. If economic growth is mostly happening at the top-end of the Pareto distribution, the vast majority of incomes will be stagnating or declining.7 So we can expect structurally weak private sector credit growth. Lacking rampant house price inflation or confidence in income growth, households and firms will be unwilling to borrow, and banks will be unwilling to lend. Hence, the opportunities to own bank equities will be limited to short-term tactical timeframes. If economic growth is mostly happening at the top-end of the Pareto distribution, and credit growth is weak, we can expect a continued absence of generalised price inflation. Monetary policymakers need to immediately discard discredited concepts such as the Phillips curve relationship between headline growth, unemployment and the inflation rate. But as many of these conventionally-trained economists will find it difficult to change their thinking, we can expect a higher frequency of policy errors. Interest rates and bond yields will remain structurally depressed. Bond yields will move cyclically, but there will be no persistent uptrend. A long sequence of rate hikes anywhere will be unsustainable. Dhaval Joshi, Senior Vice President European Investment Strategy dhaval@bcaresearch.com 1 Named after the roboticist Hans Moravec 2 Evolutionary biology provides a good explanation for Moravec's Paradox. The part of the brain - the cerebellum - that is responsible for sensorimotor skills has experienced much more evolution and development compared with the part of the brain - the neocortex - that is responsible for problem-solving. It follows that AI requires exponentially greater computational resources to replicate even low-level sensorimotor skills than it does to replicate problem-solving. 3 Andrew McAfee spoke at our 2015 New York Conference. 4 Published on March 24, 2016 and available at eis.bcaresearch.com 5 Gross Value Added 6 The Myth and the Reality of Manufacturing in America by Michael J. Hicks and Srikant Devaraj, June 2015 Ball State University Center for Business and Economic Research. 7 Please also see Chart 10 in the Global Investment Strategy Weekly Report, titled "Low Rates Forever", dated March 4, 2016 available at gis.bcaresearch.com

Highlights China's supply-side structural reforms will focus mainly on its coal and steel markets this year. In addition, environmental policies will become stricter in 2017, as Beijing puts more weight on environmental protection than economic development. As as result, supply growth will slow, particularly in steel markets, which will be good news for global steel producers and bad news for iron ore exporters in Australia and Brazil. While we are more bearish on iron ore than steel due to supply-side reforms and stricter environmental policies, we remain cautious getting short iron ore, given the Dalian Commodity Exchange's iron-ore futures are backwardated (prompt prices exceed deferred prices). This indicates buyers are willing to pay more for prompt delivery (e.g., next week) than they are for deferred delivery (e.g., next year). Energy: Overweight. The Saudi-Russia production deal will slow the rate of growth in supply relative to demand, which will tighten physical markets. This will cause inventories to draw, and the backwardation in crude to deepen. Our long Dec/17 vs. short Dec/18 WTI recommendation is up 700%. We are long at +$0.04/bbl, and will risk the spread going to -$0.05/bbl. We will take profits at $0.50/bbl. Base Metals: Neutral. Supply-side reforms, coupled with environmental restrictions will slow the growth of steel production in China this year, benefiting producers ex-China. Precious Metals: Neutral. Gold markets will become increasing volatile, with the Fed likely to keep any rate-hike decision on hold until it has greater clarity re the incoming Trump administration's fiscal policy intentions. Ags/Softs: Underweight. The USDA's most recent supply-demand balances continue to paint a bearish picture for grains, with global ending stocks expected to grow. Feature China will continue its supply-side structural reforms this year, focusing mainly on its coal and steel markets. China environmental policies will become stricter in 2017. This year will mark the first time the central government puts more weight on environmental protection over economic development in evaluating officials' performance since 1949, when the People's Republic of China was established. Supply growth will be slower than last year due to continuing reforms, and stricter environmental policies in the country. Among base metals and bulks, the steel and iron ore markets will be most affected. This will be good news for global steel producers and bad news for global iron ore producers. We are more bearish on iron ore than steel strategically, due to these supply-side reforms, stricter environmental policies, scrap steel substitution, and rising global iron ore supply. That said, we remain cautious getting short iron ore, given the Dalian Commodity Exchange's iron-ore futures are backwardated (prompt prices exceed deferred prices). This indicates buyers are willing to pay more for prompt delivery (e.g., next week) than they are for deferred delivery (e.g., next year). We are downgrading nickel from bullish to neutral, both tactically and strategically. We also are downgrading our tactically bullish stance on aluminum to neutral, as the Indonesian government on January 12 unexpectedly allowed exports of nickel ore and bauxite under certain conditions. China's Supply-Side Reforms In 2017 In 2016, steel prices rallied more than 90% from year-end 2015 levels, but Chinese crude steel and steel products production rose a mere 0.4% and 1.3% yoy, respectively. Back in 2009, when steel prices rose about 30% from November 2008 to August 2009, production grew 12.9% and 17.8% yoy for Chinese crude steel and the output of steel products, respectively (Chart 1). Chart 1China: A Slower Steel Production##br## Recovery Than In 2009 One reason for these disparate performances can be found in the massive production cuts made in China last year to crude steel capacity. In February 2016, China's central government announced that it planned to cut 100 to 150 million metric tons (mmt) of crude steel capacity over the five-year period of 2016-2020. While the country aimed to cut 45 mmt in 2016, the actual reduction accelerated in 2016H2 making the full year decrease much larger. According to the China Iron and Steel Association (CISA), 70 mmt of crude steel capacity was taken off line last year, equivalent to 6.2% of total crude steel production capacity in China. This explains, in part, the much slower crude steel production recovery last year when compared to the post-Global Financial Crisis (GFC) recovery in 2009. How much crude steel production capacity will China cut in 2017? Even though last year's 70 mmt capacity cut means about half of the five-year 100-150 mmt capacity-cut target was already achieved, the Chinese government does not show any sign of moderating its desire to see additional cuts. The Chinese Central Economic Work Conference (December 14-16, 2016) emphasized that 2017 will be a year to deepen supply-side structural reforms. Although the central government still has not finalized its 2017 target, we believe a further 40-50 mmt cut in 2017 is possible. For example, China's largest steel producing province - Hebei - has already announced its 2017 crude steel capacity reduction target, which will be 14.39 mmt, similar to its 2016 target of 14.22 mmt. We would note here that the actual cut for the Hebei province in 2016 was 16.24 mmt, much higher than the target, indicating officials will seek to err on the high side when it comes to taking production off line. In December 2016, the country launched a nationwide crackdown on production of so-called shoddy steel, also known as ditiaogang in Chinese - low-quality crude steel made from scrap metal, which is commonly used to produce substandard construction steel products. This material accounts for about 4% of Chinese crude steel output. Last week, the Chinese government ordered a full ban on "shoddy steel" production to be completed before June 30, 2017. This month, 12 inspection groups were sent to major shoddy steel producing provinces to oversee the implementation of the directive. In 2017, the Chinese government also plans to: rein in new steel production capacity; scrutinize new projects; push for more mergers; and generally tighten supervision in the steel sector. In early January, China's top economic planner - the National Development and Reform Commission (NDRC) - toughened its tiered electricity pricing to limit availabilities to outdated steel producers, and to advance its goal of capacity cuts. According to the NRDC website, the new measures raised the price paid by "outdated" steelmakers by 66.7% to 0.5 yuan per kWh, effective on Jan. 1, 2017. Outdated steelmakers, in the government's reckoning, are those scheduled to be phased out - for example, those shoddy steel producers - most of which are privately owned small- or medium- scale mills. Bottom Line: A further capacity cut will limit Chinese steel production growth in 2017. China's Environmental Policies In 2017 In 2016, the Chinese government increased the frequency at which it sent environmental inspection teams to major metal-producing provinces and cities, to ensure the smelters and refiners comply with state environmental rules. Factories that failed to meet environmental standards were ordered to permanently or temporarily shut down, depending on the severity of their violations. This year, with persistent and intensifying smog becoming a greater threat to the health of China's population, environmental policies will only get stricter, resulting in more frequent supply disruptions, especially in its steel industry. In addition to plant-specific environmental measures, in late 2016, China rolled out rules to evaluate the "green" efforts of local governments. For the first time since 1949, when the People's Republic of China was established, the central government indicated it would put more weight on environmental protection than on economic development, as measured by GDP, in evaluating local government officials' performance. This likely will reduce the local governments' incentive to support unqualified or unprofitable steel/aluminum production. Bottom Line: China's stricter environmental policies will cause more supply disruptions and increase production costs for the Chinese metal sector, especially the steel industry. Our Views On Iron Ore And Steel In 2017 We are strategically neutral on steel prices and bearish on iron ore prices. Supply-side reforms and stricter environmental policies in China likely will result in zero growth or even a small contraction in Chinese steel production, which may well support steel prices while reducing iron ore demand. This will be good news for global steel producers ex-China, and bad news for global iron ore producers. China is determined to cull all "shoddy steel" production by the end of June, which will make considerable volumes of scrap steel available to be used in good-quality steel production. Chinese steel producers are currently willing to replace iron ore with scrap steel in their steel production, given scrap steel prices are cheap versus iron ore and steel product prices (Chart 2). In addition, using scrap as an input to produce crude steel will save steel producers money on coking coal, the price of which has surged over the past year. Chinese steel demand growth may remain robust in 2017H1. Last year's stimulus still has not run out of steam, and this year's fiscal and monetary policy will stay accommodative.1 Raw-material costs in the form of iron ore, coking coal and oil soared versus levels seen last year, which means the production costs of steel now are much higher than last year. This will support steel prices (Chart 3). Chart 2More Scrap Steel Will Replace##br## Iron Ore In Steel Production Chart 3Cost Push Will Support ##br##Steel Prices Steel product inventories at the major cities in China are still low; producers' inventory holdings have declined to levels last seen in 2014, which also will be supportive of steel prices (Chart 4). China's iron ore inventories are high, while domestic iron ore production is recovering (Chart 5, panels 1 and 2). With slowing domestic steel production, Chinese iron ore import growth likely will be subdued this year (Chart 5, panel 3). Global iron ore supplies are increasing. The "Big Three" producers - Vale, Rio Tinto, and BHP - all plan to boost production in response to profitable iron ore prices this year. Indeed, this month, Vale started its first iron-ore shipments from the giant new S11D mine. Chart 4Low Inventory Supports Steel Prices As Well Chart 5Limited Chinese Iron Ore Import Growth In 2017 Bottom Line: The outlook for steel prices this year is brighter relative to iron ore in 2017, although, the backwardation in the Dalian Commodity Exchange's iron-ore futures suggests markets may be pricing in tighter iron-ore supply in the near term. We will explore this in future research. Downgrading Our Nickel And Aluminum Views We are downgrading nickel from bullish to neutral, both tactically and strategically. Chart 6Downgrading Nickel And Aluminum View In November, we expected the global nickel supply deficit to widen on rising stainless steel demand and falling nickel ore supply. One major reason we were bullish nickel was that there was no sign Indonesia's export ban - imposed in January 2014 - would be removed. With elevated global nickel output, surging Chinese nickel pig iron (NPI) imports, and rebounding Indonesian nickel ore exports, Chinese NPI production will recover in 2017, which will reduce the country's need for refined nickel imports (Chart 6). Our long Dec/17 LME nickel contract versus Dec/17 LME zinc contract was stopped out for a 5.1% loss this week. We are no longer bullish nickel versus zinc. We also are downgrading our tactically bullish stance on aluminum to neutral, after the Indonesian government unexpectedly allowed exports of nickel ore and bauxite under certain conditions earlier this month. We are removing our buy limit order to go long Mar/17 aluminum contracts if it falls to $1,640/MT from our shopping list. Ellen JingYuan He, Editor/Strategist ellenj@bcaresearch.com 1 Please see Commodity & Energy Strategy Weekly Report "China Commodity Focus: How China's Monetary And Fiscal Policy Will Affect Metal Markets," dated January 12, 2017, available at ces.bcaresearch.com Grains/Softs Global Grain Stocks Set To Rise Overall: Despite some positive developments in the U.S. - where corn supplies are falling faster than demand - we remain underweight grains. This is largely because of the continued growth of production relative to consumption globally, which looks like it will lift global stocks by the end of the 2016-17 crop year in September. While we do expect a slight decrease in output this year, it is difficult to upgrade our view at this point (Table 1). Table 1World Grains Estimates - January 2017 Wheat: Worldwide, output growth in Argentina, Russia and the EU added 1.3mm tons of production to global supplies. In the U.S., ending stocks are projected to reach levels not seen since the late 1980s, according to the USDA. Global consumption, meanwhile, is projected to increase a mere 100k tons, according to the USDA, which will lift ending stocks 1.2mm tons by the end of the crop year to a record 253.3mm tons. Corn: U.S. production is expected to fall, which, along with higher usage in the ethanol market, will contribute to lower stocks. However, on a global basis, production is set to outstrip consumption resulting in higher ending stocks at the end of the crop year. Soybeans: Same story here: Production growth outstripping consumption, leaving ending stocks higher by close to 7% yoy, based on the USDA's estimates. Rice: In relative terms, the rice market has the most bullish fundamentals - global production and consumption are roughly balanced, leaving expected ending stocks slightly above last year's level. We continue to favor rice over the other grains (save wheat) for this reason. Investment Views and Themes Recommendations Strategic Recommendations Tactical Trades Commodity Prices and Plays Reference Table Trades Closed In 2017

The sharp packaged food share price decline means that difficult conditions are now being discounted. Sales growth expectations have cratered, reflecting the negative impact of food price deflation and the strong U.S. dollar on this export-dependent industry. However, the strong currency no longer appears to be crimping demand: real exports of food and beverage products have surged in recent months. On the flipside, imports have declined, suggesting less fierce foreign competition. In addition, a strong U.S. dollar should continue to keep a lid on raw food prices. Low input commodity costs have helped propel our profit margin proxy to new cyclical highs, heralding ongoing margin expansion. The latter demonstrates impressive operating discipline amidst a tough sales backdrop. We recommend using the sell-off to lift underweight positions up to neutral. The ticker symbols for the stocks in this index are: BLBG: S5PACK-MDLZ, KHC, GIS, K, TSN, CAG, SJM, HSY, MJN, CPB, MKC, HRL.