Consumer Discretionary

U.S. light vehicle sales continued their slump last month, falling to the lowest annual rate since 2014; full-year forecasts have been revised downward across the board. This year has seen banks significantly tighten vehicle-related credit standards and consumer confidence appears to have crested, further adding to the bleak outlook facing the industry. A bright spot for domestic auto components makers was the mix shift toward light trucks as, in the absence of a high fuel price constraint, consumers continued to sate their appetite for large vehicles. Still, overall sales have been declining at a much faster rate than production, implying a growing excess inventory position. With weak consumer demand unlikely to pick up the inventory slack, significant production cuts in the second half of the year look certain, impacting directly the top line of components makers. We reiterate our underweight position. The ticker symbols for the stocks in this index are: BLBG: S5AUTC -DLPH, BWA, GT.

2017 has been a tough year for movies & entertainment. The index has been in a steady downdraft and is now probing 5 year lows. Yesterday's U.S. consumer confidence number could presage an inflection point. Consumers are feeling ebullient (second panel), which typically heralds increased discretionary spending, particularly on media services. While cord cutting and concerns about TV ad spending have undermined the index of late, if cable spending continues to accelerate, then these concerns should fade. The sector enjoys high operating leverage, implying strong EPS gains from a sales lift (third panel). This rosy outlook is not yet reflected in valuations which are well below their long-term average (bottom panel). This offers investors a double feature of valuation rerating and significant earnings growth. Stay overweight. The ticker symbols for the stocks in this index are: BLBG: S5MOVI - DIS, TWX, FOXA, FOX, VIAB.

This week's housing data has told a story of increased activity in existing homes and wider financing availability; both are at their highest levels since emerging from the financial crisis (second panel). Importantly, mortgage refinancing applications reached their highest level since late last year, spurred by the decline in mortgage rates and rising house prices. This is a recipe for booming business at the country's home improvement retailers, which stands in sharp contrast to the rest of the retail industry's blues. A better retail environment has already shown up in producer price indexes for household furniture and durable goods appliances (third panel), indicating better profitability to come. Relative valuations have yet to catch up to the improved outlook (fourth panel), and the index has recently caught a small downdraft, creating a solid buying opportunity. Stay overweight. The ticker symbols for the stocks in this index are: BLBG: S5HOMI - HD, LOW.

Neutral One quarter ago, we posited that the consolidation phase in the broad consumer discretionary sector restored value and created an attractive entry point and an upgrade in the S&P restaurants sub-index provided an attractive way to execute that thesis. This view has largely played out, as restaurant shares have bested the market by double digits since March 20th. We doubt there is any more upside left. The National Restaurant Association's Restaurant Performance Index fell to the boom/bust 100 line and downside momentum has accelerated (second panel). Leading indicators of profit margins have also eroded. An uptick in commodity input costs and multi-decade highs in the industry's wage bill, which are running at close to 10% annual growth, stand in marked contrast with soft industry pricing power. Our restaurants profit margin gauge captures all of these forces and warns that a squeeze looms (third panel). In sum, the playable rally in the S&P restaurants index has run its course and a profit recovery is fully discounted in frothy valuations. We recommend booking profits of 11% in the S&P restaurants index and moving to a benchmark allocation. The ticker symbols for the stocks in this index are: BLBG: S5REST - MCD, SBUX, YUM, DRI, CMG.

Highlights Portfolio Strategy The rally in the S&P restaurants index has run its course and a profit recovery is fully discounted. Lock in profits and downgrade to neutral. Intensified inter-industry competition, the onslaught of online retailers and a rebounding U.S. economy are stiff headwinds for hypermarket stocks. Sell positions down to neutral. Recent Changes S&P Restaurants - Downgrade to neutral, booking profits of 11%. S&P Hypermarkets - Downgrade to neutral. Table 1 Feature The S&P 500 remained resilient in the face of the fourth Fed interest rate hike and the drubbing in the tech sector. The latter is notable given that a select few stocks have contributed roughly one quarter of the overall market's gains this year, and signals that money is not leaving equities en masse, but is merely rotating into other sectors. This suggests that consolidation rather than correction is the main watchword. Our view remains that stocks are in a sweet spot: a lack of inflation pressures has kept long-term interest rates at bay, despite decent economic momentum and rising corporate profits. The latter have been driven by impressive corporate pricing power gains (see Chart 1 from last week's Weekly Report), creating an ideal equity market scenario whereby the business sector can grow profits without any corresponding consumer price inflation pressures. Investors are likely to extrapolate this goldilocks equity scenario for a while longer, given that our Reflation Gauge (RG), a combination of oil prices, Treasury yields and the U.S. dollar, has exploded to the highest level since 2010 and just shy of all-time highs. The RG leads both the U.S. economic surprise index and equity sentiment (Chart 1). If economic activity begins to reaccelerate, as we expect and irrespective of tax reform success, the window is open for additional equity market gains. Meanwhile, the mini sector rotation that commenced two weeks ago is a healthy development and may not be a precursor to a more vicious and widespread correction. In recent Weekly Reports, we have shown that our Equity Market Internal Dynamics Indicator was signaling that upward momentum in the broad market was well supported by the character of market participation (see Chart 2 from the May 15th Weekly Report). Chart 1Coiled Spring Chart 2Healthy Rotation Chart 2 shows that lately the small/large ratio has sprung back to life. Growth/value stalled near the previous all-time peak, and capital has flowed out of frothy tech stocks and into the cheaper and more economic-sensitive financials sector. Against a backdrop of a budding rebound in domestic economic data, this recent market rotation is likely to stay intact. That view is corroborated by the collapse in correlations among stocks and overall assets. The CBOE's implied correlation index has fallen to fresh cyclical lows, which suggests that investors have become increasingly discerning and that earnings fundamentals/valuations should become the primary drivers of stock market returns. Keep in mind that empirical evidence shows that receding stock correlations also underpin the broad equity market (top & bottom panels, Chart 2). All of these fluctuations signal that the broad equity market is more likely to build a base before it resumes its advance to new cyclical highs, rather than suffer an imminent and major correction. As such, we continue to slowly and deliberately recalibrate our portfolio away from its previously heavy bias toward defensives. This week we make two consumer-related shifts. Restaurants: Beware Of Heartburn One quarter ago we posited that the consolidation phase in the broad consumer discretionary sector restored value and created an attractive entry point. Washed out technicals and an upswing in industry earnings fundamentals supported our thesis (Chart 3). An upgrade in the S&P restaurants sub-index to overweight provided an attractive way to execute that thesis. This view has largely played out, as restaurant shares have bested the market by double digits since March 20th. Is there any more upside left to this impressive quarterly relative return? We doubt it. While we remain constructive on the overall consumer discretionary sector (Chart 4), we recommend crystalizing gains of 11% in the S&P restaurants index and downshifting to neutral. Chart 3Stay ##br##The Course... Chart 4...As Our Consumer Drag ##br## Indicator Is Flashing Green Q1 industry conference calls revealed that improved store traffic and better offerings boosted same-store sales, and relative share prices followed suit from a technically depressed level. That caused sell side analysts to modestly lift relative EPS forecasts, but a valuation re-rating still explains the bulk of the stock price surge (Chart 5). We are reluctant to pay a 40% premium to the broad market on a 12-month forward P/E basis. The National Restaurant Association's Restaurant Performance Index fell to the boom/bust 100 line and downside momentum has accelerated (second panel, Chart 5). Worrisomely, the Current Situation Index (not shown) of the same survey was in the contraction zone for "the sixth time in the last seven months". Similarly, the Expectations Index also decelerated, heralding an uncertain dining outlook. Indeed, demand for away from home dining is on the decline in absolute terms and compared with overall retail sales and consumption (middle panel, Chart 6). This suggests that the first quarter increase in store traffic may not be sustainable (top panel, Chart 6). The recent spike in restaurant construction expenditures will further dilute same-store sales growth opportunities (bottom panel, Chart 6). Chart 5Too Expensive Chart 6Do Not Overstay Your Welcome Leading indicators of profit margins have also eroded. An uptick in commodity input costs and 8% growth in the industry's wage bill, stand in marked contrast with anemic industry pricing power. Our restaurants profit margin gauge captures all of these forces and warns that a squeeze looms (Chart 7). Nevertheless, it is not all bad news. The improvement in consumer finances should counterbalance some of the casual dining industry's deficient demand hiccups. Rising household net worth makes consumers feel wealthier, and therefore increases their marginal propensity to spend. Importantly, the $15-$35K income cohort also expects a sizable boost to their take home pay, according to the latest Conference Board survey data (not shown). Importantly, the earnings headwind from foreign sales exposure has likely morphed into a profit tailwind. U.S. dollar softness is not only evident against G10 currencies, but also emerging market (EM) FX rates (Chart 8). In addition, healthy EM domestic demand is the mirror image of fickle U.S. final demand. EM central banks are easing monetary policy - whereas the Fed hiked for a fourth time this cycle last week - in order to rekindle EM consumer spending/growth. As a result, EM restaurant sales should improve (Chart 8). Chart 7Rising Input Costs ##br##Are Eating Into Margins Chart 8Export ##br## Relief Valve In sum, the playable rally in the S&P restaurants index has run its course and a profit recovery is fully priced in frothy valuations. The V-shaped rebound in share prices has outpaced fundamental improvements, and a consolidation/corrective phase is inevitable. Bottom Line: While we remain overweight the S&P consumer discretionary sector, we recommend booking profits of 11% in the S&P restaurants index (MCD, SBUX, YUM, DRI, CMG), and moving to a benchmark allocation. Time To Downgrade Hypermarkets While investors have shed anything retail related year-to-date (YTD), big box retailers have been a positive exception. In fact, the S&P hypermarkets index has been a stalwart performer YTD, outshining both the broad consumer staples universe and the overall market. Is this impressive run-up sustainable? The short answer is no. Three main headwinds suggest that some caution is warranted now that index outperformance has eliminated the previous valuation appeal: soft pricing power likely further aggravated by new German competitors expanding in/entering the U.S. market, the ongoing assault from online retailers and the improving U.S. economy, especially consumer spending. These factors imply that profit margins will remain under chronic pressure, but concerns could become more acute on a cyclical basis. Consumer goods import prices have surged in recent months (Chart 9), and the depreciating U.S. dollar is likely to sustain this uptrend. Cutthroat competition means that retailers will likely absorb these rising costs, to the detriment of profit margins. While food prices are making an effort to exit the deflation zone, ALDI and Lidl, two deep-pocketed German competitors are entering the U.S. retail scene, reportedly with massive expansion plans. Tesco, Sainsbury's and ASDA in the U.K., Carrefour in Europe and Woolworth's and Coles in Australia continue to feel the wrath of German retailers. Consequently, it would be dangerous to extrapolate the nascent improvement in retail food CPI. All of this is likely to sustain the profit margin squeeze (Chart 9). Further, the online retail onslaught will continue to escalate. The Amazon juggernaut appears unstoppable. The latest news that it will take over Whole Foods Market confirms that even grocery sales are now seriously on its radar screen. Chart 10 shows that non-store retail sales continue to grow at a much faster pace than traditional retailers. The greater the market share gains for online retailers, the larger the downward pressure on hypermarkets relative profitability (relative retail sales shown inverted, second panel, Chart 10). Chart 9Margin Pressures Chart 10Beware Online Retailers' Onslaught Under such a tough operating backdrop we are reluctant to pay a premium valuation for this safe haven sector. Worrisomely, soft revenue growth argues against a further a valuation re-rating (Chart 11). Finally, macro forces required to spur better revenue no longer exist. The U.S. economy has entered a self-reinforcing recovery. While personal consumption expenditures have underwhelmed of late, buoyant job certainty and a vibrant housing market are boosting consumer confidence. Before long, consumers should loosen their purse strings and indulge anew. Historically, a lively consumer spending backdrop has been inversely correlated with relative share prices (PCE is shown inverted, Chart 12). Similarly, Federal tax coffers have started to refill following a one year hiatus (bottom panel, Chart 12). The implication is that incomes and profits are expanding, boosting the incentive for consumers to "trade up" and shop at higher ticket stores. Nevertheless, some partial offsets exist. The lower income consumer is the industry's main clientele and low interest rates, low gasoline prices and soaring income confidence for this consumer cohort should cushion store traffic woes (third panel, Chart 13). Chart 11Derating ##br## Warning Chart 12Improving Economy = ##br## Bad Omen For Hypermarkets Chart 13Positive ##br##Offsets Meanwhile, the overall retail sales price deflator has tentatively troughed, albeit it continues to deflate. Given the high volume nature of the hypermarket industry, any small positive change in pricing power tends to have a meaningful impact on sales growth (second panel, Chart 13). Multi-year highs in overall income growth signals that on average consumers will have more disposable income. The bottom panel of Chart 13 shows that income growth has been a reliable indicator for hypermarket EPS. Adding it up, this is an opportune time to book modest profits and downgrade exposure in the S&P hypermarkets index to neutral. Intensified inter-industry competition, the onslaught of online retailers and a rebounding U.S. economy argue against extrapolating recent optimism far into the future. Bottom Line: Downgrade the S&P hypermarkets index to a benchmark allocation (WMT, COST). Current Recommendations Current Trades Size And Style Views Favor small over large caps and stay neutral growth over value.

Highlights The U.K. and EU may get a technical divorce, but the underlying economic and financial relationship may not end up changing dramatically - which is good news for the pound in the long term. Our 6-12 month preference for currencies is euro first, pound second, dollar third. The euro area economy will perform at least in line with the U.S. economy through 2017, so the T-bond/German bund yield spread will continue to compress. Long euro area retailers, short U.S. retailers has catch-up potential. The focussed stock pair-trade would be long Hornbach (Germany), short Home Depot (U.S.) Feature Brexit Will Become A Fake Divorce Theresa May's stinging reversal at the ballot box last Thursday has left some people wondering: will Brexit actually happen? The answer is very likely yes, but this is no longer the right question to ask. Jeremy Corbyn's resurgent Labour Party, the Scottish National Party, the Liberal Democrats and pro-European Conservatives now form a parliamentary majority which proposes that a non-EU U.K. negotiates tariff-free access to the single market and customs union.1 In such an arrangement, the U.K. and EU would be technically divorced. But economically and financially, the relationship would not be so different to being married. In effect, Brexit would become a fake divorce. Unfortunately, there is a flipside. The U.K. would be unable to reclaim swathes of sovereignty over its borders and its law. This is because the tariff-free movement of goods, services and capital is, in theory, indivisible from the free movement of people. Furthermore, EU law would transcend national law in the regulation and policing of the single market's so-called 'four freedoms'. Admittedly, the four freedoms are an unachieved - and arguably unachievable - ideal. But they are an aspiration which EU policymakers do not want Brexit to threaten. Angela Merkel recently put it in very strong terms: "Cherry-picking (from the four freedoms) would have disastrous consequences for the other 27 member countries... Tariff-free access to the single market can only be possible on the conditions of respecting the four basic freedoms. Otherwise one has to talk about limits to access" Hence, Brexit reduces to a trade-off between the extent of tariff-free access to the European single market that the U.K. wants to keep, and the extent of national sovereignty it is willing to concede (Chart of the Week). Economically and financially, it is largely irrelevant whether the U.K. gets tariff-free access to the single market via a bespoke free-trade arrangement or via membership of an off-the-shelf structure like EFTA or the EEA.2 The much bigger question is: in order to keep most of its tariff-free access to the single market, will the U.K. now downgrade its plans to "take back full control" of its borders and law? Following last Thursday's stunning election result - and its impact on parliamentary composition (Chart I-2 and Chart I-3) - the answer seems to be yes. The U.K. and EU may get a technical divorce, but the underlying economic and financial relationship might not end up changing dramatically. Euro First, Pound Second, Dollar Third Avoiding a dramatic change in the U.K./EU economic and financial relationship reduces the risk of a major disruption to the U.K. economy and the need for further emergency easing from the Bank of England. Thereby, it is good news for the pound in the long term. That said, our 6-12 month preference for currencies is euro first, pound second, dollar third. The crucial point is that currencies and bond market relative performance depends front and centre on the evolution of relative interest rate expectations. In turn, the evolution of relative interest rate expectations must ultimately follow relative economic performance, as evidenced in hard data such as GDP growth, inflation and job creation. Over a period of a few months, central banks can look through hard data on the basis that the data is noisy or "transient". But over periods of 6 months and longer, the noisy and transient excuse wears thin. Central banks' strong commitment to data-dependency means that their actions and/or words must follow the hard data. No ifs, buts or maybes. Hence, relative interest rate expectations ultimately follow relative economic performance (Chart I-4 and Chart I-5). We are unashamedly republishing these two charts from last week because they prove the point so powerfully. Based on the latest PMIs which capture current economic sentiment, and on 6-month credit impulses which lead activity, euro area hard data will continue to perform at least in line with those in the U.S. (Chart I-6). In which case, relative interest rate expectations will continue to converge, the T-bond/German bund yield spread will continue to compress, and euro/dollar will ultimately drift higher. Chart I-4Relative Interest Rate Expectations Must Follow ##br##Relative Economic Performance Chart I-5Relative Bond Yields Must Follow Relative##br## Economic Performance Chart I-6Only A Modest Decline In The Euro Area ##br##6-Month Credit Impulse The Eurostoxx50 Is Not A Play On The Euro Area Economy. So What Is? Does it follow that the Eurostoxx50 equity index will outperform? Not necessarily. Unlike for currencies, interest rates and bond yields, the connection between relative economic performance and relative equity market performance is weak, or even non-existent. Note that the Eurostoxx50 has underperformed the S&P500 this year even though the euro area economy has outperformed. Chart I-7The Global Growth Pause ##br##Has Hurt Cyclicals The reason is that the over-arching driver of an equity market's relative performance is its skew to dominant international sectors and international stocks. The Eurostoxx50 has a higher exposure to the global growth cycle via its dominant weighting in Financials and Resources; conversely the S&P500 has a higher exposure to the less globally-sensitive Technology and Healthcare sectors. The defining sector skew has penalised the Eurostoxx50 versus the S&P500 because globally-sensitive cyclicals have strongly underperformed in a very clear global growth pause. Furthermore, the ever-reliable global 6-month credit impulse strongly suggests that the global growth pause will persist through the summer (Chart I-7). This begs the question: is there a way for equity investors to play the resilient performance of the euro area economy? The answer is yes. But before explaining how, a quick note of caution. An aggregate small cap equity index is not a good way to play a domestic economy. This is because the dominant characteristic of small cap stocks - in aggregate - is their very high beta. Hence, rather than a strong play on the domestic economy, investors are effectively buying highly leveraged exposure to market direction. Great when markets are rising, but painful when they are falling, irrespective of how the domestic economy is faring. Instead, a good equity play on relative economic performance is the relative performance of retailers (Chart I-8). Drilling down further, the relative performance of home improvement retailers is an even purer play (Chart I-9) - given that household spending on home improvement is closely tied to the domestic economic cycle. Chart I-8Retailers Are A Good Play On Relative ##br##Economic Performance Chart I-9Euro Area Home Improvement Retailers ##br##Can Now Ourperform Those In The U.S. On the expectation that the euro area economy will perform at least in line with the U.S. economy,3 the equity market play would be long euro area retailers, short U.S. retailers. In particular, long euro area home improvement retailers, short U.S. home improvement retailers has a lot of catch-up potential. And the focussed stock pair-trade would be long Hornbach (Germany), short Home Depot (U.S.) Dhaval Joshi, Senior Vice President European Investment Strategy dhaval@bcaresearch.com 1 In simple terms, the single market defines the zone of tariff-free trade for European countries with each other. Whereas the customs union defines the zone of a single set of rules and tariffs for European countries to trade with the rest of the world. Membership of the customs union allows goods and services that enter from the rest of the world to then move around Europe unhindered. 2 The European Free Trade Association (EFTA) is a free trade area consisting of Iceland, Liechtenstein, Norway and Switzerland. Iceland, Liechtenstein, and Norway participate in the EU single market through their membership of the European Economic Area (EEA). Whereas Switzerland participates through a set of bilateral agreements with the EU. 3 Based on growth in real GDP per head. Fractal Trading Model* Long nickel / short tin hit its 6.5% profit target and is now closed. This week's trade is to switch to long nickel / short palladium with a 10% profit target. For any investment, excessive trend following and groupthink can reach a natural point of instability, at which point the established trend is highly likely to break down with or without an external catalyst. An early warning sign is the investment's fractal dimension approaching its natural lower bound. Encouragingly, this trigger has consistently identified countertrend moves of various magnitudes across all asset classes. Chart I-10 The post-June 9, 2016 fractal trading model rules are: When the fractal dimension approaches the lower limit after an investment has been in an established trend it is a potential trigger for a liquidity-triggered trend reversal. Therefore, open a countertrend position. The profit target is a one-third reversal of the preceding 13-week move. Apply a symmetrical stop-loss. Close the position at the profit target or stop-loss. Otherwise close the position after 13 weeks. Use the position size multiple to control risk. The position size will be smaller for more risky positions. * For more details please see the European Investment Strategy Special Report "Fractals, Liquidity & A Trading Model," dated December 11, 2014, available at eis.bcaresearch.com Fractal Trading Model Recommendations Equities Bond & Interest Rates Currency & Other Positions Closed Fractal Trades Trades Closed Trades Asset Performance Currency & Bond Equity Sector Country Equity Indicators Bond Yields Chart I-1Indicators To Watch - Bond Yields Chart I-2Indicators To Watch - Bond Yields Chart I-3Indicators To Watch - Bond Yields Chart I-4Indicators To Watch - Bond Yields Interest Rate Chart II-5Indicators To Watch##br## - Interest Rate Expectations Chart II-6Indicators To Watch##br## - Interest Rate Expectations Chart II-7Indicators To Watch##br## - Interest Rate Expectations Chart II-8Indicators To Watch##br## - Interest Rate Expectations

The S&P hotels index has gone vertical since our upgrade to neutral in November of last year. Worryingly, sector valuations appear misleadingly attractive (second panel) as forward earnings revisions have spiked much faster than the index, leading to some concern about analyst overenthusiasm; periods of analyst exuberance have typically presaged corrections. The fall in hours worked underpins this concern. Net earnings revisions have historically moved in step with hours worked, but the relationship has broken down in the last 2 years as earnings estimates have whipsawed (third panel). Still, the profit outlook remains favorable for hoteliers. Pricing power has moved positively and the wage bill looks under control (fourth panel), all in line with our prior expectations. Thus, while the index is showing definite signs of flying too high, positive earnings momentum means a soft landing is the most likely result. Stay neutral and remove the upgrade alert. The ticker symbols for the stocks in this index are: BLBG: S5HOTL - MAR, CCL, RCL, WYN.

GAA DM Equity Country Allocation Model Update The model has increased its allocation to Netherland, Italy, France and Germany, the underweight in Australia is also reduced by half. All these are financed by a large reduction in the U.S. overweight, mostly due to the change in liquidity and technical indicators, compared to previous month as shown in Table 1 As shown in Table 2 and Charts 1, 2 and 3, Level 2 model ( the allocation among the 11 non-U.S. DM countries) outperformed its benchmark by 119 basis points (bps) in May, largely a result from the overweight of the euro area versus the underweight in Canada and Australia. Level 1 model, the allocation between U.S. and non-U.S., underperformed by 22 bps in May due to the large overweight in the U.S. Overall, the aggregate GAA model outperformed its MSCI World benchmark by 13 bps in May and by 157 bps since going live. Please see also on the website http://gaa.bcaresearch.com/trades/allocation_performance. For more details on the models, please see the January 29th, 2016 Special Report "Global Equity Allocation: Introducing the Developed Markets Country Allocation Model". http://gaa.bcaresearch.com/articles/view_report/18850. Table 1Model Allocation Vs. Benchmark Weights Table 2Performance (Total Returns In USD) Chart 1 Chart 2 Chart 3 GAA Equity Sector Selection Model The GAA Equity Sector Selection Model (Chart 4) is updated as of May 31, 2017. The model continues to overweight cyclical versus defensive sectors. However, the model has turned overweight utilities on the back of improved technicals. For more details on the model, please see the Special Report "Introducing The GAA Equity Sector Selection Model," July 27, 2016 available at https://gaa.bcaresearch.com. Chart 4Overall Model Performance Table 3Allocations Table 4Performance Since Going Live Xiaoli Tang, Associate Vice President xiaoli@bcaresearch.com Aditya Kurian, Research Analyst adityak@bcaresearch.com

Media shares have been under pressure of late, as a flare up in cord cutting worries and related concerns about TV ad spending. While these structural headwinds will likely remain intact for the foreseeable future, cheap valuations amidst positive cyclical signs suggest that a contrarily positive stance will be rewarded. In aggregate, demand for media services is brisk. Consumer outlays on media have soared to a two decade high, hitting a double digit annual growth rate. S&P media sales are tightly correlated with media spending (second panel). Importantly, buoyant demand is boosting industry productivity gains (third panel). Importantly, our Ad Spending Indicator, which incorporates key indicators of media demand, consumption and overall corporate profits, has hooked up, signaling that signaling that the path of least resistance for earnings estimates is up (bottom panel). Consequently, we recommend sticking with an overweight bias, please see yesterday’s Weekly Report for more details and analysis of the two major media sub-groups, movies & entertainment and cable & satellite. The ticker symbols for the stocks in these two indexes are BLBG: DIS, TWX, FOXA, FOX, VIAB and BLBG: S5CBST - CMCSA, CHTR, DISH, respectively.

Highlights Portfolio Strategy Upgrade capital markets stocks to overweight and put them on the high-conviction list. Capital formation is poised to accelerate in the second half of the year. Our Indicators suggest that demand for media services will continue to improve. Stay overweight both the movies and entertainment and cable and satellite indexes. Recent Changes S&P Investment Banking & Brokerage - Upgrade to overweight and add to the high-conviction overweight list. S&P Consumer Finance - Remove from the high-conviction overweight list. Table 1Sector Performance Returns (%) Feature The S&P 500 continues to churn near its highs. Following a robust earnings season, the onus is now on the economy to provide confidence that the corporate profit recovery will prove durable, thereby justifying thinning equity risk premia. While slumping commodity prices suggest that global end-demand has downshifted a notch, the former boost real purchasing power and provide a reflationary support for stocks, particularly since resource-dependent sectors do not have a market leadership role. In fact, financial conditions remain sufficiently accommodative to expect a growth reacceleration in the back half of the year. It is notable that the recent selloff in the Treasury market has been driven by the real component, while inflation expectations have moved sideways. As a result, there is little pressure on the Fed to normalize at a faster pace than currently discounted in the forward curve. Thus, we expect the window for additional equity price appreciation to remain open this summer, unless growth reaccelerates sufficiently to stir inflation fears. Nevertheless, selectivity will become even more critical. Cross asset correlations have collapsed. Diminishing global macro tail risks have reduced the dominance of the beta-oriented "risk on/risk off" trade as a source of return. Empirical evidence suggests that asset correlations and the broad equity market are inversely correlated. This message is corroborated by falling correlations between regional stock market returns. Receding equity index correlations have been associated with positive S&P 500 returns (middle panel, Chart 1). This inverse correlation is also mirrored in the CBOE's implied correlation index, which tracks the correlation of the S&P 500 stocks with one another: tumbling correlations imply solid overall equity returns (top panel, Chart 1). These relationships are intuitive. Diminished macro tail risks bring earnings fundamentals to the forefront as the key driver of returns, and reward differentiation and discrimination in sector/region/asset class selection. While an eerie calm has dominated markets of late, as our Asset Class Volatility Indicator has collapsed to a multi-decade low (bottom panel, Chart 1), a more bullish explanation is that all-time highs in equities are synonymous with all-time lows in the VIX. This can be viewed as a contrary warning sign, but history shows that the VIX can stay depressed for a prolonged period. Our Equity Market Internal Dynamics Indicator (EMIDI), first introduced in late-March, has tentatively troughed, suggesting that sub-surface dynamics are becoming more supportive of the broad market (Chart 2). The EMIDI, which comprises relative bank, relative transport, small/large and industrials/utilities share prices, has been coincident to the leading market indicator, especially since the GFC. Chart 1Tumbling Correlations = Rising Stock Returns Chart 2Sub-Surface Dynamics Have Turned The Corner In that light, this week we are further augmenting our cyclical portfolio exposure by lifting another interest rate-sensitive group to overweight and are also updating the early cyclical media index and its major components. Capital Markets Stocks Have Rally Potential Two weeks ago, we recommended using this year's financial sector underperformance to boost allocations to overweight. This week we are further augmenting our exposure by upgrading the S&P investment banks & brokerage index to above benchmark. While the equity bull market is in the later innings, our view is that the overshoot will be extended for a while longer as a consequence of the overall sales and profit recovery and low probability that monetary conditions will tighten meaningfully in the near run. If this plays out, there is an opportunity for capital markets stocks to recover from their recent consolidation. This sub-index thrives when investor risk appetites are healthy and the business sector is moving from retrenchment to expansion mode, and vice versa. The outlook for increased capital formation has improved considerably. The corporate sector financing gap is beginning to widen anew (Chart 3), reflecting the surge in business and consumer confidence since the pro-business U.S. Administration took power. The widening financing gap is particularly notable because it is occurring alongside improving profit growth. In other words, the wider financing gap reflects accelerating capex demand, not weak corporate cash flows. This is confirmed by BCA's Capital Spending Indicator, which signals an increase in business investment ahead. Consequently, corporate sector demand for external capital should accelerate. The latter is the lifeblood of capital markets profitability. The nascent recovery in total bank credit growth after a period of malaise reinforces that working capital requirements are on the upswing (Chart 3).1 As businesses shift from maintenance capital spending to a more expansionist mindset, and companies reach further for growth to justify high stock valuations, capital markets activity could accelerate in the second half of the year. After all, investor confidence is high. Corporate bond spreads have tightened and corporate bond issuance is soaring. The Equity Risk Premium is steadily narrowing (shown inverted, second panel, Chart 4), reducing the cost of equity capital. New stock issuance is following on the heels of corporate bond issuance. Stocks are outperforming bonds by a comfortable margin and total mutual fund assets have grown sharply (Chart 3). The upshot is that access to corporate sector capital should stay healthy. As flows into equities advance, it will fuel a reacceleration in M&A activity (Chart 5). Chart 3Capital Markets Activity Is... Chart 4...Firing On All Cylinders Chart 5ROE On The Upswing Capital markets return on equity (ROE) is highly levered to business and investor risk appetite. Fees earned on M&A activity heavily influence overall profitability. As such, it is normal for ROE to expand when M&A activity picks up, and shrink when financial conditions tighten and takeovers dry up. Currently, M&A transactions represent an historically elevated share of GDP, but that is not a barrier to an increased rate of takeover activity. Companies are no longer using their balance sheets to repurchase their own shares en masse. Instead, there is an incentive to pursue business combinations as the global economy reaccelerates, underscoring that capital allocation should shift in favor of capital markets firms. Indeed, Chart 5 shows that ROE also follows the trend in our global leading economic indicator, and the current message is bullish. Even capital markets companies themselves confirm that their pipelines are full. Hiring activity remains robust. Pro-cyclical firm headcount rises quickly alongside revenue opportunities, and is just as quick to shrink when the outlook darkens. Ergo, we interpret headcount growth as a net positive. While trading activity is always a wildcard, and could be a source of weakness if bond market, and generalized asset class, volatility stays muted, the upbeat outlook for fee generation from increased capital formation provides us with confidence to use share price weakness as an opportunity to build a bigger position. Bottom Line: Lift the S&P investment banking & brokerage index to overweight, adding to our recent decision to upgrade the overall financials sector to above-benchmark. The ticker symbols for the stocks in this index are BLBG: S5INBK - GS, MS, SCHW, RJF, ETFC. Media Stocks: Temporary Pressure Media stocks have come under pressure recently, giving back all of this year's relative gains. Investor worries have centered around two thorny issues: cord-cutting and ad spending. Cord-cutting is not new, but weak overall Q1 TV subscriber numbers have refocused investors' attention on the secular challenges ahead. In addition, a number of companies noted softening ad spending on Q1 conference calls. According to media executives, this slowdown is not isolated to the automotive segment. Is it time to pull the plug or is a worst case scenario already priced into the group? We side with the latter. In aggregate, demand for media services is brisk. Consumer outlays on media have soared to a two decade high, hitting a double digit annual growth rate. S&P media sales are tightly correlated with media spending (second panel, Chart 6). Despite coming off the boil recently after hitting unusually high growth rates, media pricing power also remains in expansionary territory. Importantly, buoyant demand is boosting industry productivity gains. The third panel of Chart 6 shows that our media productivity proxy has reaccelerated. Meanwhile, an improving economic backdrop also bodes well for media earnings prospects. The ISM services new orders sub component has been an excellent leading indicator of relative profit growth expectations and the current message is positive (middle panel, Chart 7). If the overall economy bounces smartly from the weak Q1 print, as we expect, then an earnings-led recovery should sustain the valuation re-rating phase (bottom panel, Chart 7). Chart 6Buoyant Media Demand Chart 7Valuation Re-Rating Looms Our Ad Spending Indictor (ASI) incorporates all of these key media profit drivers, including consumption and overall corporate profits. The ASI has recently hooked up, signaling that earnings estimates should continue to rise (bottom panel, Chart 8). Nevertheless, sub-media group returns have been bifurcated, with the S&P movies and entertainment index exerting downward pressure on the overall sector of late. Relative performance has mostly treaded water since our upgrade last summer, but hit a soft patch after recent quarterly results. Before rushing to make a bearish judgment, it is notable that the relative forward P/E remains close to an undervalued extreme, signaling that it will be increasingly difficult to disappoint. Historically cheap valuations exist despite depressed expectations, which should serve to artificially inflate valuations: both top and bottom line are expected to lag the broad market, representing a very low hurdle (Chart 9). Chart 8Rosier EPS Prospects Lie Ahead Chart 9Unloved And Undervalued Beyond the positive consumer spending backdrop (Chart 10), we are inclined to stick with overweight positions in this sub-component for four major reasons. First, merger and acquisition activity should reduce capacity, and by extension, support pricing power, especially if the AT&T/Time Warner deal clears the regulatory hurdle. There is scope for additional M&A that could further reduce shares outstanding (Chart 11). Chart 10Improving Demand... Chart 11...And M&A Activity Are An EPS Tonic Second, content providers are adapting to the competitive threat. New online-only offerings and slimmer/nimbler packages should stem the drag from the likes of Netflix and other streaming services. Consumer spending on electronics continues to surge, suggesting that content providers have ample opportunity to fill increasing demand. Third, there is no substitute for live TV. News and live sports are two sticky offerings that will continue to be cash cows for the industry and drive select subscriber growth. Fourth, media giants have stepped up focus on other segments with higher growth potential, such as studios and franchises highlighting increasingly diversified revenue streams. Moreover, CEOs have been aligning cost structures to the new realities of cord-cutting, exercising strict cost control. Companies have also been careful with capex allocation decisions. All of this suggests that any shakeout in this media subgroup is a good entry point for building new positions with a compelling valuation starting point. Unlike the S&P movies and entertainment index, the S&P cable and satellite group has been relentlessly grinding higher, underpinning the broad media index. The multiyear share price advance has been cash flow driven. As a consequence, cable stocks still trade at a 25% discount to the broad market on a price/cash flow basis and the relative multiple is hovering near the historical mean (third panel, Chart 12). Cable and satellite sales growth has surged to healthy low double-digit growth rates after a one year lull. Encouragingly, soaring pricing power signals that recent revenue momentum is sustainable (second panel, Chart 12). As mentioned above, consumer outlays on cable services have had a V-shaped recovery, underscoring that the latest upleg in selling prices is demand driven (bottom panel, Chart 12). It is remarkable that the industry has consistently raised selling prices at a faster pace than overall inflation for decades (Chart 13). This impressive track record reflects cable operators' ability to continually evolve offerings and provide attractive content, even in the face of cord-cutting. Chart 12Cash Flow Driven Outperformance Chart 13The Cable Signal Is As Strong As Ever Meanwhile, content inflation rates have remained within the range of the past few years, underscoring that threats to robust profit margins are limited (bottom panel, Chart 13). More recently, news that Comcast and Charter will come together and cooperate on a wireless offering adds another layer of defense in effectively combating cord-cutting. How? By increasing the bundle offering beyond cable and internet services, cable providers are positioned to attract new clients by offering a one stop shop triple-play solution. A move into wireless service offerings would also assist in retaining existing customers. In sum, most of our indicators suggest that the demand outlook for media services continues to improve. Our Ad Spending Indicator is climbing, underscoring that fears of a deep and widespread slump are overblown. Bottom Line: The media index remains an overweight and we continue to recommend an above benchmark exposure both in the S&P movies and entertainment and S&P cable and satellite sub-groups. The ticker symbols for the stocks in these two indexes are BLBG: S5MOVI - DIS, TWX, FOXA, FOX, VIAB and BLBG: S5CBST - CMCSA, CHTR, DISH, respectively. 1 Please see BCA U.S. Bond Strategy Weekly Report, "The Payback Period In Corporate Bonds," dated April 11, 2017, available at usbs.bcaresearch.com. Current Recommendations Current Trades Size And Style Views Favor small over large caps and stay neutral growth over value.