Sectors

Highlights Portfolio Strategy Yield curve dynamics, higher oil prices, recovering balance sheets, and compelling valuations and technicals all suggest that energy stocks will burst higher in the coming months.  Melting medical cost inflation, BCA’s rising interest rate expectations along with an economy running at full steam, all suggest that managed health care margins and profits will overwhelm in the coming quarters. Recent Changes Upgrade the S&P managed health care index to overweight today. Add the S&P energy index to the high-conviction overweight list today. Table 1 Feature On the eve of earnings season, the SPX ended last week higher as bank profits delivered and allayed fears of recession. All-time absolute highs in the S&P tech sector and in the Philly SOX index suggest that global growth will likely reaccelerate in the back half of the year, vaulting the broad market to new highs. In addition, the suppressed Treasury term premium1 signals that the path of least resistance for equities is higher on a cyclical time horizon (term premium shown inverted, Chart 1). Chart 1All Clear... Nevertheless, some caution is still warranted from a tactical perspective. Since March 4 when we first turned short-term cautious on the broad equity market,2 the SPX has moved roughly 100 points both ways. Internal market moves, financial conditions, fund flows, complacency and the current economic backdrop all signal that stocks are not out of the woods yet. Namely, the S&P high beta versus the S&P low volatility tilt has failed to confirm the slingshot in the SPX (Chart 2). Similar to the small cap underperformance, mega cap tech is trouncing small cap tech stocks (Chart 3). Not only do large cap technology stocks have pristine balance sheets, but they also have earnings. In contrast, from the 89 S&P 600 tech constituents 54 have no forward profits. The weak over strong balance sheet underperformance is emitting the same signal (top panel, Chart 3). Chart 2...But Some... Chart 3...Caution... The bond market is also sending a warning shot. High yield corporate bonds are underperforming long-dated Treasurys (middle panel, Chart 2). And, the junk bond option adjusted spread has not fallen to the 2018 lows, let alone all-time lows (not shown). While a lot has been said on easier financial conditions, they have yet to return to the early-2018 lows. In fact, similar to the non-confirmation of the all-time SPX highs in late-September, the GS financial conditions index (FCI) is tracing a higher low, warning that equities have room to fall (FCI shown inverted, bottom panel, Chart 2). Mutual fund flows on all equity related products are contracting on a net sales basis. Historically, fund flows and equity returns are joined at the hip and the current divergence suggests that equity prices will likely succumb to deficient demand (top panel, Chart 4). Chart 4...Is Warranted On the economic front, last Wednesday we highlighted in an Insight Report, that lumber – a hyper sensitive economic indicator – failed to corroborate the recent equity market euphoria. The weak Citi Economic Surprise Index, also warns that the economic data has yet to turn the corner and should weigh on equities (bottom panel, Chart 4). What ties everything together is SPX profits. The news on this front is mixed, at least for the next little while: EPS will most likely contract in the first half of the year, but equity investors are looking through this earnings recession. Last year’s U.S. dollar appreciation will dent both revenues and EPS, and Q1/2019 is the first quarter where such greenback strength will subtract from corporate P&Ls (Chart 5). Chart 5Dollar Trouble? What worries us most is the sectorial concentration of 2019 profit growth in one sector, financials. Another source of concern is the heavyweight tech sector’s negative profit path for calendar 2019. Such sudden internal profit moves both in magnitude and in a short time frame are far from reassuring, especially given that overall profit estimates are still trimmed. Chart 6A depicts the current sector profit contribution to 2019 growth, and compares it with the January 22nd iteration (Chart 6B). What a difference three months make. In sum, internal equity and bond market dynamics, financial conditions, the economic soft-patch and the looming profit recession all signal that short-term equity market caution is still warranted. This week we upgrade a health care subsector and reiterate our bullish stance on a deep cyclical sector. Catch Up Phase Looms For Energy Stocks Last week we broadened out our research on the yield curve (YC) inversion beyond the S&P 500 to the GICS1 sectors.3 As a reminder, the SPX peaks following the yield curve inversion and on average the S&P energy sector performs the best from the time the YC inverts until the S&P 500 peters out (please refer to Table 3 from the April 8, Special Report). While every cycle is different, if history at least rhymes, deep cyclical energy stocks will likely outperform as the SPX eventually breaks out to fresh all-time highs. Already, year-to-date the S&P energy sector is the third best performing sector, besting the SPX by over 200bps. More gains are in store, especially given the big dichotomy between the oil price recovery and the relative share price ratio (Chart 7). What is perplexing is the ingrained sell-side analyst pessimism (Chart 6A) and lack of belief that oil prices will remain near current levels or even continue their ascent as our sister Commodity & Energy Strategy (CES) service publication predicts. Not only are EPS forecast to contract in every quarter this year, or 10% year-over-year according to IBES, but also revenues are slated to fall in every quarter in 2019. We would lean against this extreme analyst bearishness. While the $3.5/bbl backwardation in WTI oil futures prices one year out, and more than twice that 24-months out, underpins Wall Street’s gloomy energy sector outlook, U.S. oil extraction productivity reinforces sector profits. As U.S. crude oil production hits new all-time highs this is extracted by fewer oil rigs (bottom panel, Chart 7). If BCA’s CES constructive oil price expectation pans out, then energy stocks will easily surpass the profit and revenue bar that analysts have set extremely low for the sector. Delivering on the profit front will likely serve as a catalyst to rerate these deep cyclical stocks higher (Chart 8) and thus a catch up phase looms for energy stocks, at least up to the current level of WTI crude oil prices (top panel, Chart 7). Chart 7Catch Up Chart 8Bombed Out Valuation Granted, the U.S. dollar is a key determinant of oil prices and if BCA’s view proves accurate that global growth will return in the back half of the year (second panel, Chart 9), that is synonymous with a depreciating greenback, which in turn is bullish the broad commodity complex in general and oil prices (and thus energy stocks) in particular (middle panel, Chart 7). As a reminder, oil prices are an excellent global growth barometer, similar to their sibling Dr. Copper. Recovering global growth will boost energy stocks in an additional way: via a favorable supply/demand crude oil balance. Not only is OPEC rebalancing the global oil market through a reduction on the supply front, but a trio of potential supply shocks from Iranian sanctions, Venezuelan infrastructure and Libyan conflict are providing price support. Further, global growth has historically been tightly correlated with rising non-OECD oil demand (Chart 10). Chart 9Global Growth Beneficiary Chart 10Favorable Supply/Demand Dynamics Meanwhile, the broad energy sector is still licking its wounds from the late-2015/early-2016 manufacturing recession and is stabilizing debt and increasing EBITDA (fifth panel, Chart 11), thus the net debt/EBITDA ratio for the index has collapsed from over 11 to around 2, a level similar to the broad market (second panel, Chart 11). Interest coverage (EBIT/interest expense) is also renormalizing higher and is no longer sending a default warning for the energy space as a whole (third panel, Chart 11). The junk energy bond market corroborates/reflects this balance sheet improvement and is no longer flashing red (bottom panel, Chart 9). Finally, bombed out technical conditions are contrarily positive, and such extreme negative readings have marked the start of playable and sizable relative outperformance periods (Chart 12). Chart 11No Red Flags Chart 12Contrary Alert: Depressed Technicals Netting it all out, YC dynamics, higher oil prices on the back of rising global growth and a favorable supply/demand crude oil backdrop, recovering balance sheets, and compelling valuations and technicals suggest that energy stocks will burst higher in the coming months. Bottom Line: We reiterate our above benchmark recommendation in the S&P energy sector and today we are adding it to our high-conviction overweight list. Buy Into Managed Health Care Weakness A little over a year ago we moved to the sidelines in the S&P managed health care index, crystalizing significant relative profits of 28% for our U.S. equity portfolio.4 Now the time has come anew to explore this niche health care index from the long side. While we left some money on the table since our late-May 2018 move, relative share prices have come full circle, valuations have fallen roughly 18% from the late-2018 peak and analysts’ euphoria has been reined in (Chart 13). Chart 13Reset The inter- and intra-industry M&A fever has died down from mid-2018 and the rising momentum of a “Medicare For All” bill has weighed negatively on HMO sentiment. With regard to the latter, our geopolitical strategists believe that passage is possible. If the Democrats can unseat an incumbent president in 2020, they will also likely take the Senate and keep the House. This means they will be in the position to pass a major piece of legislation. While Trump is favored to win, barring a recession, the risk of both a Democratic sweep and a push for “Medicare for All” could be as high as 27%, and this would have a dramatic impact on the health care sector.5 Tack on the near 90bps drop in the 10-year U.S. Treasury yield since the November 2018 peak, and factors have fallen into place for a bearish raid in this pure play health insurance index. Thin managed health care margins and profits move in close lockstep with interest rates as roughly 10% of the industry’s operating income is tied to “investment income”. In other words, as insurers receive the premia they typically invest it in Treasurys and that explains the high EPS and margin sensitivity on interest rate moves (Chart 14). While at first sight, the outlook for profits appears grim, BCA’s bond strategists expect a selloff in the bond market to materialize in the back half of the year simultaneously with a pick-up in global growth which will prove a tonic to both margins and EPS. In addition, leading indicators of heath care insurance profit margins are flashing green. Not only are medical costs melting including drug price inflation (second & bottom panels, Chart 15), but also industry cost structures are kept at bay with wages climbing below a 2%/annum rate growth and trailing overall wage inflation (third panel, Chart 15). Chart 14Overdone Chart 15Melting Cost Inflation On the demand front, as the economy is running at full employment, with unemployment insurance claims probing 60-year lows and with wages representing a headache for small and medium business owners, enrollment should stay healthy (Chart 16). Most importantly, the combination of decreasing medical cost inflation and a healthy overall labor market herald a steep decline in the industry’s medical loss ratio. All of this is unambiguously bullish for margins and profits. Finally, relative valuations and technicals have both corrected from previously stretched levels and offer a compelling entry point for fresh capital (Chart 17). Chart 16Full Employment Is Bullish Chart 17Unloved And Under-Owned Netting it all out, despite the risks that “Medicare For All” pose, melting medical cost inflation, BCA’s rising interest rate expectations along with an economy running at full steam, all suggest that managed health care margins and profits will overwhelm in the coming quarters. Bottom Line: Boost the S&P managed health care index to overweight today. The ticker symbols for the stocks in this index are: BLBG: S5MANH - UNH, ANTH, HUM, CNC, WCG.   Anastasios Avgeriou, U.S. Equity Strategist anastasios@bcaresearch.com Footnotes 1      According to the NY Fed: “Treasury yields can be decomposed into two components: expectations of the future path of short-term Treasury yields and the Treasury term premium. The term premium is the compensation that investors require for bearing the risk that short-term Treasury yields do not evolve as they expected.” https://libertystreeteconomics.newyorkfed.org/2014/05/treasury-term-premia-1961-present.html 2      Please see BCA U.S. Equity Strategy Weekly Report, “The Good, The Bad And The Ugly” dated March 4, 2019, available at uses.bcaresearch.com. 3      Please see BCA U.S. Equity Strategy Special Report, “10 Most FAQs From The Road” dated April 8, 2019, available at uses.bcaresearch.com. 4      Please see BCA U.S. Equity Strategy Report, “Seeing The Light” dated May 29, 2018, available at uses.bcaresearch.com. 5      If there is a 60% chance the Democrats nominate a left-wing candidate, and a 45% chance they win the election, then there is a 27% chance that they are in a position to push for “Medicare for All” with fair odds of passage. Everything will depend on the specific outcomes of the Democratic primary, presidential campaign, general election, post-election government policy priorities, and congressional passage. Stay tuned as in the coming months we will be publishing a Special Report on “Medicare For All” and health care sector implications co-authored with our sister Geopolitical Strategy service. Current Recommendations Current Trades Size And Style Views Favor value over growth Favor large over small caps

  Underweight The relative resilience of consumer discretionary stocks has been puzzling over the past two years. Typically, rising interest rates prelude a period of underperformance in these highly rate sensitive stocks (fed funds rate shown inverted, bottom panel) but the divergence has grown exceptionally wide. Regardless, we believe our negative thesis is sound. Consumer confidence is near record highs (though it has started to decline), which appears to be driving the relative share price gains but consumer credit has not followed suit (second panel), implying consumers are not backing up their positivity with their wallets. The sell-side too appears to discount soaring consumer confidence as earnings estimates have not kept pace with share prices, driving sector valuations to a 25% premium to the broad market and well above sustainable average levels (third panel). However, this is partially explained by Amazon, which carries roughly 30% weight in the S&P consumer discretionary index but only 12.5% of operating profit, and its exceptional outperformance since the beginning of 2018. Nonetheless, we expect retail sales to follow the opposite path of interest rates, as it always has in past cycles, and a derating to occur. Bottom Line: We reiterate our below-benchmark allocation rating on the S&P consumer discretionary index as valuations have grown excessive and BCA’s view remains that interest rates are near their trough.

Overweight With a pickup in oil prices in general and jet fuel prices in particular, a logical inference would be a decline in airlines’ earnings power (second panel). However, the revenue side of the equation has proven much more resilient than anticipated, a result of industry discipline reflected in constrained capacity growth combined with elevated consumer confidence. The upshot is that consumers have been willing to part with greater shares of their wallets in order to fly (third panel). Much of this is reflected in Delta’s results yesterday. The company lifted their full-year guidance on the back of outstanding customer demand driving unit revenues higher, combined with single-digit capacity growth. While it is worth cautioning that DAL does not face the same 737 MAX grounding issues as peers LUV, UAL and AAL, we believe the exceptional fare environment is a tide that lifts all boats. Accordingly, we expect earnings in the S&P airlines index to continue to significantly outpace the broad market (bottom panel), particularly once the transitory 737 MAX grounding issue is resolved. Stay overweight. The ticker symbols for the stocks in this index are: BLBG: S5AIRL - DAL, LUV, UAL, AAL and ALK.   ​​​​​​​

Underweight We downgraded the S&P railroads index to underweight last month based on falling rail traffic leading railroad pricing power down from its recent highs. Last week’s release of traffic data showed further deterioration in volumes, the fundamental driver of pricing power, confirming our bearish thesis. Only four of the 20 commodity categories tracked by the Association of American Railroads (AAR) saw volumes increase last month and virtually all of this was petroleum products which itself is likely only a temporary gain, owing to easing in pipeline bottlenecks later this year. Overall traffic fell a stunning 5.2% from the same period last year (third panel). The Cass Freight Shipments Index too has recently rolled over, a likely precursor to a fall in the Expenditures component of the index, and predicting that railroad pricing challenges are in the early stages (second panel). Meanwhile, sector leverage ratios are at their highest level in a decade as railroads have retooled their capital structure to increase buybacks at the expense of the balance sheet, adding a new level of risk to the industry (bottom panel). Bottom Line: Valuations in the S&P railroads index have overstated earnings power and understated equity risk premia; stay underweight. The ticker symbols for the stocks in this index are: BLBG: S5RAIL - UNP, CSX, NSC, KSU. ​​​​​​​

Lumber is a hyper-sensitive variable that has historically moved in lockstep with the SPX, its momentum (bottom panel) and of course EPS. Lumber’s leading properties are tied to the housing market link and the recent plunge in lumber futures is disconcerting. The top panel of the chart shows that lumber peaked in mid-May and then the SPX followed suit in late-September. Similarly, lumber troughed in late-October again leading the SPX trough. Currently this economically sensitive indicator is not confirming the bullish SPX run as it peaked in early February. We reiterate our view held since early-March that at least some short-term equity market caution is warranted, especially given the negative EPS backdrop on the eve of earnings season.      

Special Report

Feature This week, instead of our regular Weekly Report, we will answer clients’ most frequently asked questions (FAQs) from our recent marketing trip to the old continent. Table 1 lists these questions and below we will attempt to weave a cohesive piece and answer all of these interesting questions. Clients inquiring about “how is everyone else positioned” or the related “what is the general investor sentiment like” is by far the most FAQ we always get from the road and we purposefully omit it from Table 1. Table 1Most FAQs From The Road During our last three developed markets (DM) trips, while we cannot comment on the positioning question, with regard to general investor sentiment, Australia and New Zealand are off the charts bullish. On the opposite end of the spectrum, Europe is extremely bearish, especially continental Europe. The U.S. is somewhere in the middle. Chart 1Fed’s Pivot On Display With that out of the way, the recent broadening out of the U.S. yield curve inversion to the 10/fed funds rate took center stage in our client interactions, especially the implications of the inversion for sector positioning and the duration of the business cycle. To set the record straight, a yield curve inversion does not forecast recession. Instead, it explicitly signals that the market expects the Fed’s next move to be an interest rate cut (top panel, Chart 1). In that context, the yield curve has never had a false-positive reading. Even in May 1998, it accurately forecast that the Fed would decrease the fed funds rate as it actually did in the fallout of the LTCM meltdown later that year (bottom panel, Chart 1). As equity investors, what consumes us is the SPX’s performance following the yield curve inversion. On that front, mid-December last year we showed the results of our research and made a simple observation that the yield curve inversion almost always takes place prior to the S&P peak (Table 2, Charts 2 & 3). Table 2Yield Curve Inversions And S&P 500 Peaks Chart 3…And Then The SPX Peaks In addition, today we show the S&P 500’s return and the sector returns from the time the 10/2 yield curve slope inverts until the S&P peaks, and we summarize the results in Table 3. Table 3Sector Returns From Y/C Inversion To SPX Peak While every cycle is different, clearly it pays to have energy exposure more often than not. In contrast, high-yielding defensive sectors like utilities and telecom services fare poorly in these late-cycle iterations. Meanwhile, Table 4 highlights sector performance from the SPX peak until the U.S. recession hits. We first showed these results on May 22, 2018, and we are on track to publish a Special Report on May 5 on how to position portfolios at the onset of a Fed easing cycle, so stay tuned. Table 4Defensive Stocks Beat Late Investors remain infatuated with the recession signal that the yield curve inversion emits. Moreover, recent news of an onslaught of Unicorn IPOs that would bring stock supply to the equity market, near the $100bn mark on an annualized basis according to some estimates, have also brought forward recession fears, as smart money is cashing in on their investments. Chart 4 shows that $100bn per annum in IPOs has coincided with the SPX peak in the previous two cycles. Our long-held view remains that either a mega M&A deal in the tech or biotech space or Uber’s IPO at a stratospheric valuation could serve as the anecdote that confirms the current cycle’s peak. On the yield curve front specifically, the top panel of Chart 5 shows that the most important yield curve, the 10/2, has not yet inverted. Moreover, the 30/10 and the 30/5 slopes are steepening. True, we are late cycle, but we need all the slopes to invert to get a confirmation that the recession is a foregone conclusion. Chart 4Mind The Excess Supply Chart 510/2 Y/C Has Yet To Invert The Fed’s tightening cycle has not only inverted most parts of the yield curve starting early last December, but has inflicted some damage on profit margins. Following up from our recent profit margin work highlighting nil corporate pricing power at a time when wage costs are perking up, BCA’s Monetary Indicator signals more SPX margin pain in the coming months (Chart 6). In fact, sell-side estimates call for another three consecutive quarters of a year-over-year contraction in profit margins. Chart 6Margin Trouble In more detail, the earnings deceleration that commenced in Q4 2018 and is gaining steam is disconcerting. As a reminder, Q4 included the lower corporate tax rate and the Q/Q deceleration is not solely due to the tech sector profit warnings. Eight out of the 11 GICS1 sectors sharply decelerated, two modestly accelerated and only industrials steeply accelerated to a cyclical EPS peak growth rate (Table 5). This EPS breadth deterioration is eerily reminiscent of early-2015 (Chart 7) and is disquieting. Short-term caution is also warranted given the increase in investor complacency. The one sided positioning in the VIX futures market is worrisome. As a reminder, net speculative positions are now at a lower low than the February 2018 level when the VIX snapped to over 50 and caused a massive tremor in the equity market (net speculative positions shown inverted, Chart 8). Table 5Historical/Current/Future Earnings Growth Rates Chart 7Bad Breadth Chart 8Too Complacent But, before getting overly bearish there are some growth green shoots that suggest that Q2-to-Q3 will likely mark the trough in EPS/EBITDA growth and margins (Chart 9). Beyond these positive leading profit indicators, a resolution to the U.S./China trade tussle and China’s trifecta of policy easing measures will also aid in turning profit growth around and really power up U.S. cyclicals’ EPS growth rates. Following up from the January Fed meeting, on February 4 we penned a report titled “Don’t Fight The PBoC” and it is now clear with the recent manufacturing PMI release that China’s easing on all three fronts – credit (Chart 10), monetary (Chart 11) and fiscal (Chart 12) – is starting to pay some dividends. In that light, the U.S. cyclicals vs. U.S. defensives recent outperformance has more room to run. Chart 9Growth Green Shoots Chart 10Chineasing… Chart 11...On All… Chart 12…Fronts   Deep cyclicals have another major advantage this cycle compared with defensives. While at this stage of the business cycle one would expect capital intensive businesses to become debt saddled, cyclicals are still de-levering from the depths of the late-2015/early-2016 manufacturing recession, i.e. paying down debt and increasing cash flow. Defensives, however, are doing the exact opposite with relative cash flow growth problems and piling on debt. Thus, on a relative basis Chart 13 shows that the indebtedness profile clearly favors deep cyclicals vs. defensives. From a bigger picture perspective, while the U.S. has not really purged any debt and it has just shifted it around from the financial and household sectors to the non-financial business and government sectors (Chart 14), the near all-time high in non-financial business sector credit as a share of GDP is disconcerting (top panel, Chart 14). Clearly the excesses are in this segment of U.S. debt and it is unsurprising that debt saddled stocks have been underperforming equities with pristine balance sheets since the 2016 presidential elections (top panel, Chart 15). Such outperformance has staying power, especially given that we are late in the cycle and the Fed has raised interest rates to the point where parts of the yield curve are inverted and a default cycle looms large (bottom panel, Chart 15). Chart 13Cyclicals Have The Upper Hand Chart 14U.S. Debt Profile Breakdown One sub-sector that epitomizes the current cycle’s excesses is commercial real estate (CRE). CRE prices have overshot the historical time trend by almost two standard deviations and it has already been three and a half years since they surpassed the previous all-time high (Chart 16). The recent pullback in the 10-year Treasury yield has pushed cap rates even lower and the bubble in CRE is further inflated. Looking back at the late-1980s pricking of that CRE bubble is instructive and when this cycle ends a big deflationary impulse will likely deal a blow to the CRE market.       Chart 15Hide In Pristine Balance Sheets Chart 16CRE Excesses Are A Yellow Flag Speaking of bubbles, the biggest bubble we currently see is not in equities, but in bonds. Table 6 shows that red is taking over and is reminiscent of mid-year 2016 when the 10-year U.S. Treasury yield troughed a hair above 1.3%. Globally, negative yielding debt is near all-time highs (Chart 17) and the excesses are even larger in the EM sovereign space and in select DM corporates. Mexico raising century debt in U.S. dollars, in cable and in euros is perplexing, as Mexico was at the epicenter of the 1982 LatAm crisis and again in 1994 with the Tequila crisis. Argentina also raising century debt recently in hard currency speaks to the magnitude of the current bond bubble. On the corporate side, Sanofi and LVMH placing negative yielding debt is beyond our understanding, or Total issuing a perpetual bond with a 1.75% coupon. Table 6Red Takes Over   Chart 17Bonds Are In A Bubble All of this is likely linked to the unintended consequences of global QE where fixed income investors are pushed out the risk spectrum and are forced into buying riskier credit. When this bond bubble gets pricked it will end in tears as it always does and the catalyst will likely be the next U.S. recession that will cause a global recession. While our cyclical 9-to-12 month equity market view is constructive and we believe the U.S. will avoid recession, our structural 1-to-3 year view is negative. Nevertheless, we constantly challenge our thesis and the biggest pushback to the negative structural view is the following: What if the Fed can engineer a soft landing in the U.S. as it did twice in the mid-1990s, and the business cycle runs hot for another 5 years (Chart 18)? What if the starting point of low interest rates with the real fed funds rates still close to zero is very stimulative for the U.S. economy as no recession has ever started with a fed funds rate perched near zero (Chart 19)? Finally, what if the late-2015/early-2016 manufacturing recession was actually an economic recession despite the fact that the NBER did not designate it as such and the business cycle got reignited, especially with President Trump’s election that lifted animal spirits? As a reminder, while S&P profits have contracted outside of an economic recession twice before, SPX sales had never achieved that feat, until late-2015/early-2016 (Chart 20). In other words, the revenue recession we had was unprecedented and felt like an economic recession. Chart 18The Fed Has Engineered A Soft Landing Chart 19Stimulative Real Rates Chart 20There Is Always A First Time If that were the case and the cycle were to extend into the 2020s, then the risk is that SPX EPS vault to $200 and valuations overshoot, i.e. the forward P/E multiple spikes to a 20 handle and the SPX catapults to 4,000. In that case, we would leave 1,000 points on the table and our SPX 3,000 view would be way offside. While this is a risk to our negative structural view, there are two sectors we really like for the long-term as we deem them secular growth plays and should do exceptionally well on a 10-year horizon: software and defense stocks. Three key drivers underpin our bullish view on software: galloping higher private and public sector software outlays, a structurally enticing software demand backdrop and ongoing industry M&A (Chart 21). Most importantly, the move to cloud computing and SaaS, the proliferation of AI, machine learning and augmented reality are not fads but enjoy a secular growth profile, and signal that capital outlays on software are in a structural uptrend. With regard to defense stocks, the three key pillars we highlighted in our “Brothers In Arms” Special Report on October 31, 2016 remain intact: the global rearmament is still gaining steam, a space race with manned missions to the moon now includes the U.S., China and India, and cybersecurity is a real threat for governments around the world (Chart 22). On all three fronts, defense stocks stand to benefit as they have beefed up their offerings to provide governments with a one-stop shop solution covering most of these needs. Chart 21Buy The Software Breakout Chart 22Defense Stocks Remain A Long-term Buy     Anastasios Avgeriou, U.S. Equity Strategist anastasios@bcaresearch.com

Overweight Caterpillar and, by virtue of its relative dominance, the S&P construction machinery & heavy truck (CMHT) index were at the front of the news cycle this week as an analyst downgraded CAT based on a belief that global growth had collapsed. The market largely ignored the report and both CAT and the S&P CMHT index have continued their outperformance since the late-October trough, when we reiterated our overweight recommendation in our Daily Sector Insight report titled “A Buying Opportunity In Construction Machinery”. The signals from the indicators we track imply that the “global growth collapse” is both late and overstated. The CRB raw industrials index, which moves in lockstep with the S&P CMHT index’s relative performance, unsurprisingly showed weakness at the end of 2018 but has since recovered (second panel). Further, the global credit impulse, an excellent leading indicator of relative profitability, has ticked up into positive territory after sending a weakening signal in 2018 and implies a resumption of profit outperformance (third panel). The combination of positive relative sales growth and still-tepid share price action has taken the relative valuation to levels not seen since the 2015-16 manufacturing recession (bottom panel), which marks an exceptionally affordable entry point, particularly for investors seeking to gain exposure to a China/U.S. trade tussle resolution. We continue to think such buying opportunities are rare and reiterate our overweight recommendation. The ticker symbols for the stocks in this index are: BLBG: S5CSTF - CAT, CMI, PCAR.

Highlights As long as Chinese policymakers remain committed to their anti-pollution campaign, we believe high-grade iron ore prices will remain supported by demand from newer steelmaking technologies. A continuation of the much-needed consolidation in steelmaking capacity in China – wherein larger, more efficient operators force their less competitive rivals from the market – will reinforce this trend (Chart of the Week). Chart of the WeekChina's Steel Sector Will Continue Consolidating Over time, the iron ore market will resemble other developed markets – e.g., crude oil – where higher- and lower-grades of the commodity are regularly traded against each other (Chart 2). As this develops, hedgers and investors will be able to fine tune exposures with greater precision, and prices from these markets will better reflect supply-demand fundamentals. The central and local governments also will have a valuable window on how policy is affecting fundamentals as they pursue their “blue skies” policies. We are initiating tactical spread, getting long spot high-grade 65% Fe vs. short spot 62% Fe at today’s Custeel Seaborne Iron Ore Price Index levels, consistent with our view.1 Chart 2Iron Ore Spread Markets Will Continue To Develop Highlights Energy: Overweight. The Trump administration is reviving the Monroe Doctrine with its demand Russia remove its troops and advisors from Venezuela immediately, based on comments by the U.S. National Security Advisor John Bolton. In addition, a “senior administration official” said waivers for eight of Iran’s largest crude oil importers could be allowed to expire May 4, and that the administration is considering additional sanctions against Iran.2 Brian Hook, the special U.S. envoy for Iran, this week said three of eight countries granted waivers to U.S. sanctions agreed to take oil imports to zero.3 In a related development, OPEC crude oil output fell to a four-year low of 30.4mm b/d in March, according to a Reuters’s survey, as Venezuelan output falls and Saudi Arabia continues to over-deliver on its production cuts. Base Metals: Neutral. Codelco’s mined copper ore output fell to 1.8mm MT last year, down 1.6% vs. 2017 levels. This took refined output down almost 3% to 1.7mm MT, according to Metal Bulletin. The Chilean state-owned company cited reduced ore content in its mined production as a reason for the decline. MB’s copper treatment and refining charges index for the Asia Pacific region is at its lowest level since March 26, 2018, reflecting the lower concentrate supplies. We remain long spot copper on the back of low inventories, and an expected recovery in demand. Precious Metals: Neutral. Strength in equities has taken some of the luster off gold’s rally in the near term as investors move to increase stock exposures, but we continue to favor gold as a portfolio hedge and remain long. Agriculture: Underweight. USDA’s corn planting intentions report released last week came in much stronger than earlier estimates. Corn and soybeans traded lower following the release of the report, but recovered some this week on the back of positive news from Sino - U.S. trade talks. The USDA estimated farmers intended to plant 92mm acres of corn, and 85mm acres of soybeans this year. Ahead of the report, a Farm Bureau survey estimated corn and soybean acreage would average 91.3mm acres of corn and 86.2mm acres of beans. Trade Recommendations: Our 1Q19 trade recommendations were up an average of 41% at end-March (Quarterly Performance Table below). Including recommendations that were open at the beginning of 1Q19, the average was 31%. Feature China’s push to reduce pollution in its steelmaking sector will continue to support demand for Brazil’s high-grade ores – i.e., ores with iron (Fe) content higher than 65%. Transitory Brazilian iron ore supply losses notwithstanding, China’s push to reduce pollution in its steelmaking sector will continue to support demand for Brazil’s high-grade ores – i.e., ores with iron (Fe) content higher than 65%. This will allow the continued development of an active spread market, not unlike spread markets in commodities like oil, which will expand hedging and trading opportunities for producers, consumers and investors (Chart 2). Older, more polluting steelmaking technology in China will continue to be replaced by plants that favor Brazil’s high-grade ores, then Australia’s benchmark-type grades (62% Fe), then, as a last resort, the lower quality domestic ores. In a steelmaking market still suffering significant overcapacity, we expect policymakers will, at some point, discover the benefit of letting markets forces do the work of forcing older technology offline, as happened with the country’s domestically produced lower-quality iron ore, which has lower iron content and higher impurities than Brazilian and Aussie imports.4 We believe growth in China’s steel and steel products demand – hence iron ore demand – likely has peaked and is in the process of flattening or declining slightly, which will alter the composition of iron ore imports and tilt them in favor of high-grade Fe imports from Brazil over the next 3 - 5 years (Chart 3). This leveling off in steel demand growth will put a premium on more efficient technology to meet future demand, particularly with the pollution constraints that will, we believe, be an enduring feature of this market.5 Chart 3China's Steel Demand Growth Likely Has Peaked Impurities found in lower-grade iron ore raise steelmaking costs by increasing unwanted mineral build-ups in blast furnaces, increase pollution and lower mills’ efficiency.  With inventories re-building following the winter steelmaking hiatus in China, imports will continue to grow market share at the expense of indigenous lower-quality ores (Chart 4). Imports from Australia, which mostly price to the 62% Fe benchmark, will continue to grow, but we strongly believe that in China’s post-anti-pollution-campaign market, Brazilian imports will see growth increasing (i.e., the 2nd derivative) at a higher rate (Chart 5). Chart 4Chinese Iron Ore Inventories Fall Relative To Steel Production Chart 5China's Brazil, Australia Import Growth Will Recover These imports are lower in cost, and higher in quality than the domestic iron ore. This is particularly important when it comes to keeping costs under control – impurities found in lower-grade iron ore raise steelmaking costs by increasing unwanted mineral build-ups in blast furnaces, increase pollution and lower mills’ efficiency. Extended Output Cuts Favor High-Grade Ores The biggest reason supporting our view high-grade iron ores will continue to grow market share at the expense of lower-quality domestic supply and benchmark 62% Fe material is the recent behavior of the central government and local governments vis-a-vis pollution. Both have shown they are not averse to extending operating restrictions on high-polluting industrial plants, even in provinces where steelmaking is a large employer. Last year, major steel producing regions– Hebei, Jiangsu, Shandong, Liaoning – increased production during the winter months, likely driven by higher margins at the steelmakers (Chart 6). This indicates compliance with anti-pollution regulations fell significantly (Chart 7). In turn, this led to higher pollution, according to the latest available data from China’s National Environmental Monitoring Centre, which shows concentrations of particulate matter 2.5 micrometers or less in diameter (i.e., PM2.5) rose again this year (Chart 8). Chart 6Higher Margins, Higher Output Consequently, Chinese authorities decided to tighten anti-pollution measures by extending production cuts beyond the heating season into 3Q and 4Q19.6 Furthermore, the top producing city, Tangshan, in the province of Hebei extended its most elevated level of smog alert on March 1 and deepened production cuts to 70% from 40%, with reported cases of complete operations being halted. Chart 8China's Pollution Is Increasing; Steelmaking Curbs Will Persist Last month, Chinese Communist Party (CCP) officials in Hebei announced plans to cut steel production by 14mm MT this year and next. Going forward, China’s environment ministry said winter restrictions will be extended for a third year during the 2019-2020 winter period. As we argued last year, winter curbs likely will become a permanent feature of China’s steelmaking landscape. Combined with China’s steel de-capacity reforms, iron ore and steel markets will continue to evolve to a less-polluting presence in the country.7 As a consequence, IO grade and form differentials are now crucial input in our analysis.8 We believe a wider than usual premium will remain until new high-grades and pellets supplies come on line in the next few years. Credit Stimulus Vs. Battle For Blue Skies The reversal in China’s credit cycle and in the Fed’s monetary policy stance will be supportive of steel and iron ore prices going forward. In fact, our credit cycle proxy suggests global industrial activity will increase in the next few months (Chart 9).9 Additionally, our geopolitical strategists’ base case suggests a resolution of the Sino-U.S. trade war likely will occur this year. This will support EM income growth, which will stimulate commodity demand generally at the margin. Chart 9Upturn in China's Credit Cycle Will Support Iron Ore Prices We believe China’s credit cycle bottomed in 1Q19 and that Chinese authorities will modestly increase stimulus in 2H19.10 As discussed previously, we do not expect this new round of stimulus to be as large as previous rounds; China’s economy is in better shape now than it was at the start of previous expansionary credit cycles, hence the magnitude of the stimulus needed to revive the economy is lower. Nonetheless, this stimulus will be sufficient to strengthen China’s and EM’s steel-intensive activities in the coming months. As long as China maintains its anti-pollution drive, high-grade iron ore will continue to grow market share. Historically, these sectors correlated positively with the 62% Fe content benchmark (Chart 10). However, the expected stimulus works against Beijing’s critically important battle for blue skies. A revival of China’s industrial activity would increase PM2.5 concentrations above targets. Chart 10China's Stimulus Will Stoke Iron Ore Demand These constraints, we believe, mean China’s policymakers will have to incentivize steelmakers to favor lower-polluting high-grade iron ore (Fe > 65%), in order to maximize steel output subject to their emissions target. This will widen the form and grade premiums ahead of next year’s winter period. Bottom Line: As long as China maintains its anti-pollution drive, high-grade iron ore will continue to grow market share, as steelmakers upgrade their technology and inefficient mills are shuttered. This will favor Brazilian exports going forward, and we expect the rate of growth in these imports to increase. In line with our view, we are opening a long 65% Fe spot vs. a short 62% Fe spot position at tonight’s close. This is a tactical position, but could easily become a strategic recommendation.   Robert P. Ryan, Senior Vice President Commodity & Energy Strategy rryan@bcaresearch.com Hugo Bélanger, Senior Analyst Commodity & Energy Strategy HugoB@bcaresearch.com   Footnotes 1      This index is published by Beijing Custeel E-Commerce Co., Ltd. 2      We flagged this risk in our February 21, 2019, report entitled “The New Political Economy of Oil.” We noted the odds of a U.S. – Russia military confrontation are low, and that “the U.S. would revive the Roosevelt Corollary to the Monroe Doctrine, and that Russia and China most likely would concede Venezuela is within the U.S.’s sphere of influence, as neither intends to project the force and maintain the supply lines … a confrontation would require.” That said, there is always the risk such a confrontation could go kinetic, or that either or both sides could lunch a cyberattack to disable its adversary. The Roosevelt Corollary refers to U.S. President Theodore Roosevelt’s extension of the Monroe Doctrine at the beginning of the 20th century, which has been used by the U.S. to justify the use of military power in the Western Hemisphere. Our February 21 report is available at ces.bcaresearch.com, as is a Special Report on Venezuela published November 22, 2018, entitled “Venezuela: What Cannot Go On Forever Will Stop,” which discusses Venezuela’s debts to China and Russia, et al. See also “Exclusive: Trump eyeing stepped-up Venezuela sanctions for foreign companies – Bolton” and “Oil hits 2019 high on OPEC cuts, concerns over demand ease,” published by reuters.com March 29 and April 2, 2019, respectively. 3      Please see “Three importers cut Iran oil shipments to zero - U.S. envoy” published April 2, 2019, by reuters.com. 4      According to Platts, “at least half of China’s previous 300 million mt plus iron ore mining capacity has left the market for good.” Please see “China’s quest for cleaner skies drives change in iron ore market,” published January 30, 2019, by S&P Global Platts. CRU estimates average iron content in China’s ores is 30%, which means they must undergo costly upgrading to be useful to steelmakers. 5      Australian miners are expected to bring on significant volumes of high-grade iron ore beginning in 2022 - 23, with Fe content as high as 70%, according to the Department of Industry, Innovation and Science’s March 2019 Resources and Energy Quarterly. 6      Please see “Tangshan mulls output curbs for 2nd, 3rd quarters of 2019” published January 22, 2019, by metal.com. 7      Please see China to extend winter anti-smog measures for another year published March 6, 2019, by reuters.com. 8      Grade premium: The chemistry of iron ore supply varies widely in terms of Fe content. Higher Fe content reduces production cost and pollution per unit of steel output. The higher the quality, the higher the volume of steel produced relative to energy consumed. The current global benchmark iron ore is 62% Fe, but China’s evolution to a less-polluting steelmaking sector will raise the importance of higher-grade markets. Form premium: A steelmaker’s blast furnace typically consumes iron ore in pellets, fines or lumps combined with coking coal. Fines are the most common form of iron ore, and account for ~ 75% of total seaborn IO market. This form cannot be directly fed in the blast furnace and requires an extra sintering step. Sintering is highly polluting and coal-intensive process that compresses fines into a more useable form. This process is usually conducted on-site at steel mills. On the other hand, lumps and pellets are direct feedstock and therefore completely avoid the highly polluting sintering step. Both types of premium are primarily affected by environmental policies in consuming countries, coke prices and steelmills’ profitability. 9      Modeling historical iron ore prices remains difficult because of the short sample available for spot iron prices – i.e., the benchmark 62% Fe. Before 2009, iron ore prices were determined using a producer pricing system. Once a year, prices were negotiated by miners and steelmakers and would be fixed for the remaining of the year. Given that iron ore supply was plentiful relative to demand, prices were fairly stable and this mechanism was used for over four decades. The rapid rise of emerging economies – mainly China – during the 2000s forced the pricing system to adjust toward a spot-market pricing system. The short spot-price time series available for analysis increases the distortion of policy-driven exogenous shocks like China’s de-capacity and winter restriction policies. This makes it difficult to identify the underlying relationships between its price and potential explanatory variables, and forces us to rely on theory and analogous experience in other markets like crude oil. 10     Please see BCA Commodity and Energy Strategy Weekly Report titled “Bottoming Of China’s Credit Cycle Bullish For Copper Over Near Term,” published March 14, 2019. It is available at ces.bcaresearch.com Investment Views and Themes Recommendations Strategic Recommendations Tactical Trades Trade Recommendation Performance In 2019 Q1 Commodity Prices and Plays Reference Table Trades Closed in 2019 Summary of Closed Trades