Sectors

Special Report

We boosted the financials sector heavyweight S&P banks index to overweight on May 1, 2017,1 and in late-November we also included it in our 2018 high-conviction overweight list. Since last May, relative performance has added considerable alpha to our portfolio, to the tune of 10 percentage points. Currently the S&P banks index is also leading the pack on our 2018 high-conviction call list.2 Nevertheless, the recent steep selloff in the bond markets that actually commenced in September when the 10-year U.S. Treasury yield troughed near 2.05%, compels us to revisit our overweight exposure in the S&P banks index and gauge if there is any "gas left in the tank". In short, our analysis suggests that while banks have been stellar performers, there is still more upside left before we pull the trigger and book handsome profits for our portfolio. Below are our top 10 reasons why we still like banks, despite the recent run-up in relative share prices. Volatility comeback assisting bank profits and valuations. When the Fed injects liquidity and drops interest rates, and during the last cycle also embarked on quantitative easing, volatility takes the back seat (Chart 1). Now that the Fed has started to unwind its balance sheet and also mop up liquidity by lifting interest rates, volatility is springing higher. In other words, the Fed had successfully suppressed volatility for the better part of the past decade, but VIX prints below 10 were clearly not sustainable. Keep in mind, that not only equity market vol, but also FX, commodity and bond volatilities are all on the rise. Fixed income, currencies and commodities (FICC) trading revenues are directly linked to rising volatility and the implication is that this return of vol will boost bank FICC trading profits. Further, volatility has historically been an excellent leading indicator of relative bank valuations and the current message is positive (Chart 2). Chart 1VIX 'The Comeback Kid'... Chart 2...Is Bullish For Banks Accelerating price of credit. Higher interest rates is one of BCA's key themes for 2018 and the selloff in the bond market still has a ways to go. Hitting the 3.25% mark on the 10-year Treasury yield sometime this year would still not constrict the U.S. economy. Roughly 125bps of tightening in a short time span is how much the U.S. economy can withstand, according to recent empirical evidence (November 2010 to February 2011, taper tantrum May 2013 to July 2013 and July 2016 to Dec 2016, Chart 3A), before fanning recession fears as both housing and consumer spending get affected. Any selloff in the 10-year Treasury bond market beyond 3.25% would likely prove restrictive versus being reflective of ebullient growth, but we still remain 40bps shy of that level. Thus, this rising price of credit backdrop bodes well for bank profits and is a harbinger of further stock outperformance (top panel, Chart 3B). Chart 3AThe Rule Of 125bps... Chart 3B...Says Stick With Bank Exposure Pristine credit quality. The unemployment rate keeps on plumbing new cycle lows at a time when unemployment insurance claims are also probing all-time lows, and wages are on the cusp of breaking out of their multi-year lull. Full employment is synonymous with excellent credit quality. The implication is that non-performing loans will remain downbeat as a percentage of total loan books (Chart 4). The latest FDIC QBP released last week also confirmed that credit quality remains pristine. Upbeat credit growth prospects. While bank credit growth ground to a halt in 2017, following a doubling in the 10-year Treasury yield in the back half of 2016, the economy has since digested this massive tightening in credit conditions. We expect the budding recovery in loan growth to gain steam as the prospects for most loan categories are upbeat (commercial real estate is the sole sore spot). First, the capex upcycle should boost the appetite for C&I loan uptake and our overall U.S. commercial banks loans and leases model is firing on all cylinders (second panel, Chart 5). Second, animal spirits revival is lifting both business and consumer confidence on the back of the recent tax bill passage and overall easing in fiscal policy. The upshot is that loan demand is on a solid footing (third panel, Chart 5). Third, residential real estate (second largest loan category behind C&I loans) price inflation has reaccelerated of late. The home equity rebuild is ongoing and job certainty coupled with the recent uptick in wage inflation suggest that more housing related gains are in store (top panel, Chart 6). Finally, the high yield bond market is flashing green. Historically, narrowing junk spreads underpin loan growth albeit with a slight lag, and vice versa. Why? Tight spreads reflect a euphoric, "risk on" phase typical of later cycle stages when loan growth usually shifts into higher gear as businesses seek to expan Currently, near-cycle lows in the high yield OAS is signaling that loan origination will surge in 2018 (second panel, Chart 6). Chart 4Excellent Credit Quality Chart 5Loan Model Is Flashing Green Chart 6House Price Inflation Is Another Positive EPS growth model flashing green. The bottom panel of Chart 7 introduces our U.S. banks profit growth model and it is humming, reflecting this steadily improving credit growth backdrop. Our model suggests that bank EPS growth euphoria will easily surpass the 20% SPX earnings growth hurdle that we are penciling in for calendar 2018 (please refer to Charts 2 & 3 from the February 5th "Acrophobia" Weekly Report). Stock outperformance follows earnings outperformance and this cycle will prove no different. Dividend payout increases. This past summer marked the first time since the GFC that all examined banks passed the Fed's extremely stringent stress tests with flying colors. As a result, the Fed allowed banks to bump dividend payouts. Chart 8 shows that the dividend payout ratio has more room to run and we expect dividend growth to reaccelerate in 2018. Chart 7Bank Profits Are ##br##On A Solid Footing Chart 8Pent-Up Demand For ##br##Shareholder Friendly Activities Pent up buyback demand getting unleashed. In late-June of 2017 the Fed also allowed banks to reinstate buybacks as a result of the passing grade on the stress tests. If there is any sector with pent up equity buyback demand, banks fit the bill. Over the past decade, banks have been net issuers of equity as a result of the massive equity raisings during the GFC. The pendulum has now swung the opposite way and net equity retirement will be a boon to bank EPS. In sum, shareholder friendly activities should raise the appeal of owning banks. Best capitalized banking system in the world. From a global perspective, U.S. banks are the best capitalized banks in the G10. Unlike Japan in the 1990s and the Eurozone in the 2010s the U.S. was quick and forceful in recapitalizing the banking sector during the GFC. As Jamie Dimon once quipped about a "fortress balance sheet", Chart 9 corroborates that the U.S. banking system is on a solid footing especially compared with the rest of the G10 that has yet to fully wring out the GFC-related excesses. Thus, foreign flows will likely continue to chase U.S. banks in global equity portfolios. Dodd-Frank regulatory relief. The Dodd-Frank Wall Street Reform and Consumer Protection Act has been acting as a noose around banks' necks above and beyond the Basel III international regulatory framework for banks. The Trump administration is fighting to cut red tape and roll back regulations. Even a modest rethink and relaxation of the Dodd-Frank Act would go a long way in allowing banks to do what they do best: lend. Banks remain a big buyer of risk free and quasi risk free government paper, to the tune of $2.5tn (Chart 10). There is scope for some reshuffling of this asset mix, at the margin, away from the risk free asset and toward corporate and other credit origination. While this may seem somewhat contradictory to the eighth point, we doubt the "Volcker rule" will be fully reversed and entice banks to take similar risks leading up to the GFC and jeopardize the integrity of the U.S. banking system. Compelling valuations. Both on a relative price-to-book and relative forward P/E basis, banks look appealing. While during the GFC banks were correctly trading at a discount to the market's multiple reflecting ailing earnings prospects, now 10 years onward, a discount is no longer warranted. In fact, bank ROE has made a slingshot recovery, although it remains below the previous two cyclical peaks, underscoring that a relative valuation rerating is still in the cards. The S&L crisis of the late-1980s/early-1990s is the closest recent parallel to the GFC, and back then relative valuations played catch up to ROE only in the late 1990s. If history at least rhymes, there are high odds of excellent value getting unlocked before the next recession hits (second panel, Chart 11). Chart 9The U.S. ##br##Leads The Pack Chart 10Room To Reshuffle ##br##Asset Mix Chart 11Catch Up Phase In##br## Relative Valuations Looms Bottom Line: We reiterate the high-conviction overweight in the S&P banks index. The ticker symbols for the stocks in this index are: BLBG: S5BANKX - WFC, JPM, BAC, C, USB, PNC, BBT, STI, MTB, FITB, CFG, RF, KEY, HBAN, CMA, ZION, PBCT. Anastasios Avgeriou, Vice President U.S. Equity Strategy anastasios@bcaresearch.com 1 Please see BCA U.S. Equity Strategy Weekly Report, "Girding For A Breakout?" dated May 1, 2017, available at uses.bcaresearch.com. 2 Please see BCA U.S. Equity Strategy Weekly Report, "2018 High-Conviction Calls," dated November 27, 2017, available at uses.bcaresearch.com. Current Recommendations Current Trades Size And Style Views Favor value over growth. Stay neutral small over large caps (downgrade alert).

Overweight Since the beginning of February, the S&P air freight & logistics group has been waylaid by reports that Amazon was exploring its own logistics network. This is not new news; in fact, we wrote about this the last time a media outlet flagged Amazon's growing logistics efforts in October of last year.1 In that report, we noted three reasons (all of which are still valid) why the reaction in the index was an overreaction: First, Amazon represents approximately 3% of FDX' North American volume and 7% of UPS, according to Moody's, implying relatively small top line impacts from an Amazon shift. Second, those volumes come at extremely low margins and the companies may be able to replace them more profitably. Last, it is highly unlikely that Amazon could replace FDX and UPS completely, with their unmatched 'last mile' infrastructure, nor does this move signal that this is the intention. We think investors should stay focused on the fundamentals; air freight volumes move hand-in-hand with U.S. sales (second panel) and resilient global growth; the current message is unambiguously positive. Further, any Amazon effects have been ignored in sell side estimates which are currently pointing to a solid earnings recovery (third panel). Despite the positive backdrop, sentiment has taken the index's valuation to its lowest point in the last 15 years (bottom panel). This looks like as good an entry point as one could expect; stay overweight. The ticker symbols for the stocks in this index are: BLBG: S5AIRF - UPS, FDX, CHRW, EXPD. 1 Please see BCA U.S. Equity Strategy Insight Report, “Is Amazon Moving Vertical?” dated October 6, 2017, available at uses.bcaresearch.com.

Neutral (Downgrade Alert) Comcast shareholders were surprised earlier this week with the announcement that they were making an offer to purchase British satellite broadcaster Sky, besting an offer from 21st Century Fox for the 61% it doesn't already own. The announcement raises the specter of both an expensive bidding war for these assets as well as a potential bidding war for 21st Century Fox which is itself subject to a pending takeover from Disney. Overall, it appears that media distribution assets are being consolidated at high (and rising) valuations. Such consolidation is logical for U.S. media interests; pricing power has been negative for the past year (second panel) and relative EPS growth has flat lined (third panel). These conditions have been partially reflected in valuation multiples which are already well below normal (bottom panel). Should a bidding war emerge, balance sheets will get stretched resulting in higher risk premiums and deteriorating EPS, both of which mean valuations sink further. Altogether, we are adding a downgrade alert to our neutral rating on media stocks. The ticker symbols for the stocks in the movies & entertainment and cable & satellite indexes (collectively the media indexes) are BLBG: DIS, TWX, FOXA, FOX, VIAB and BLBG: S5CBST - CMCSA, CHTR, DISH, respectively.

Dear Client, I am travelling this week meeting clients in Asia, so this report has been written by my colleagues, Billy Zicheng Huang and Sophie McGrath. Greece, the epicentre of the euro debt crisis, is finally recovering. Declining net NPLs, an upturn in investor confidence and improving employment are encouraging. But there is a risk that growth will lose some momentum amid the country's exit from the third economic adjustment program. Hence, we are recommending a neutral weighting in the Greek equity market as a whole comprising four overweight ideas counterbalanced by four underweight ideas. We expect companies with essential product focus, low debt levels and strong asset health to outperform non-essential product providers, highly leveraged players and weak asset-quality counterparts. Dhaval Joshi Best Overweight And Underweight Ideas Table I-1Single-Stock Statistics On Select Greek Companies* Greece: The Long Road To Recovery Macro indicators in Greece have improved and investors have become more confident. This is highlighted by the recent upgrade of Greece's long-term sovereign credit rating to B and an oversubscribed seven-year bond sale, confirming high investor demand. Nevertheless, there is a risk that growth will lose some momentum amid the country's exit from the third economic adjustment program. Listing the improvements, economic sentiment is approaching previous peaks (Chart I-1), the unemployment rate has dropped to its lowest level since 2011 (Chart I-2) and the youth unemployment rate has fallen around 20 percentage points from its high (Chart I-3). Chart I-1Economic Sentiment Has Improved Chart I-2Unemployment Is Down... Chart I-3...Youth Unemployment Even More So Furthermore, the most intense headwinds from fiscal drag are over. In the depths of the debt crisis, fiscal drag reached 7% of annual GDP. While Greece is not set to receive a sustained fiscal 'thrust' in the medium term, it appears the worst is over on the austerity front (Chart I-4). The most promising indicator is competitiveness. Greece appears to have made the necessary adjustments to unit labor costs and is no longer a euro area outlier (Chart I-5). Chart I-4Peak Fiscal Drag##br## Is Over Chart I-5Unit Labour Costs Are Now In Line ##br##With Euro Area Counterparts Recent developments in the banking system are also encouraging. Bank liquidity has improved, and the use of ECB Emergency Liquidity Assistance (ELA) has significantly diminished (Chart I-6). Net NPLs have declined sharply and are now covered by bank equity capital (Chart I-7). An unprecedented legal foundation is now in place to address the NPL stockpile. These measures include the introduction of electronic auctions to recover claims, the simplification of the out-of-court settlement process and reducing the liability of individuals involved. If net NPLs continue to fall, we can expect a healthier banking sector to support the economy, as witnessed in Spain, Ireland, and more recently in Italy. Chart I-6Banks Are No Longer Reliant ##br##On Emergency Funding Chart I-7Bank Equity Capital Finally ##br##Exceeds Net NPLs Despite these encouraging signs, the consumption recovery is fragile as households continue to delever (Chart I-8). Additionally, retail sales have dipped again recently (Chart I-9). Chart I-8Households Continue To Delever Chart I-9Retail Sales Have Dipped Regarding the bailout exit and debt sustainability, markets have seemingly priced in the wrapping up of the third review later this year, with the Eurogroup meeting on January 22 having recorded progress. However, what is more uncertain is whether this will take the form of a 'clean' or 'dirty' exit. The level of post-bailout monitoring that is agreed upon will ultimately dictate the pace of Greece's return to capital market normalcy. Considering the uncertainties in the overall picture, we recommend a market neutral portfolio in Greece with an overall beta of 0.15, consisting of four overweight companies versus four underweight counterparts from the consumer discretionary, telecoms, real estate, banking, consumer staples and energy sectors (Table I-2). Through our selection process we focused on companies with better growth profiles in essential sectors of the Greek economy. Table I-2Select Companies And 12-Month Beta Vs. MSCI EM Sector Specifics/Dynamics Our overweight (OW) basket performance over the past three years has been exceptionally strong relative to the underweight (UW) names. The OW basket has outperformed by 59% (Chart I-10A). However, this was primarily due to a selloff in Piraeus Bank (UW) in the second half of 2015. On a short-term horizon we see a different picture. Looking at one-year performance, the OW basket has actually just closed the underperformance gap over the past two months (Chart I-10B). Chart I-10AThree-Year Performance: ##br##Overweight Vs. Underweight Basket Chart I-10BOne-Year Performance: ##br##Overweight Vs. Underweight Basket Valuations favor the OW basket, especially from the second half of 2017 on, when OW and UW share prices began to diverge. Compared to historical valuations, OW names are currently trading close to their three-year average P/E, while their UW counterparts are trading at one standard deviation above historical P/E (Chart I-11A, Chart I-11B, and Chart I-11C). Chart I-11AOW Basket Displays Appealing Valuations##br## Relative To UW Basket... Chart I-11B...And Its Own ##br##Historical Average... Chart I-11C...While UW Basket Is Trading One Standard##br## Deviation Above Mean Non-bank OW companies display stronger operating margin dynamics, despite a recent dip, while the OW bank demonstrates superior net interest margins. Both margin trends are translating into solid profitability (Chart I-12A and Chart I-12B). Chart I-12ARobust Operational Level Performance... Chart I-12B...Feeds Into Solid Profitability Additionally, the OW basket displays more favorable debt dynamics, with debt remaining at low levels and trending down, whereas the debt ratio in the UW basket is already at an elevated level and continues to climb (Chart I-13). Meanwhile, free cash flow yield has favored UW players since mid-2016 when banks are excluded (Chart I-14). Chart I-13Debt Levels Remain ##br##Low In OW Companies Chart I-14Free Cash Flow Yield Favors ##br##UW Non-bank Names Specifically for banks, Alpha Bank (OW) enjoys a much healthier asset quality profile compared to Piraeus Bank (UW), with a combination of a lower NPL ratio and a higher tier-1 ratio (Chart I-15). Please also note that EPS growth is not shown as we normally do in our reports due to abrupt volatility in both baskets, which prevents us from drawing comparative conclusions. Dividend yield is also omitted due to the fact that most companies we have selected do not pay dividends. Chart I-15Alpha Bank Illustrates Healthier Asset Quality The Overweight Basket Jumbo (BELA GA) Jumbo (BELA GA) (Chart I-16) Chart I-16Performance Since February 2017: ##br##Jumbo Vs. MSCI EM Jumbo reported financial results for the fiscal 2017 year on October 12. Revenue increased by 7% year over year. Despite a difficult year in Greece, sales were compensated largely by organic growth in Romania and Bulgaria, with one new store open in each country respectively. EBITDA grew by 6% year over year, on the back of an effective cost management effort, while EBITDA margin remained virtually flat at 25.2%. As a result, the bottom line expanded by 8% year over year, with profit margin up 20 basis points to 19.2% Jumbo is currently trading at a forward P/E of 15.5x, while the market is forecasting an EPS CAGR of 6.3% over the next three years. The company is expected to continue its strong expansion drive in Eastern Europe, with one more store open in Romania in November 2017 (the 9th store) and one more store to be open next year in Bulgaria. At the same time, a drop in unemployment and a pick-up in household consumption will help Jumbo's recovery in the Greek market, signaling upside potential for the share price. Hellenic Telecom (HTO GA) Hellenic Telecom (HTO GA) (Chart I-17) Chart I-17Performance Since February 2017: ##br##Hellenic Telecom Vs. MSCI EM Hellenic Telecom (OTE) reported full-year 2017 results on February 22. Revenues declined slightly year over year by 1.3% to €3857 million, dragged down mainly by mobile operations in Albania, where revenues declined by 11.8%. Mobile operations in Romania remained positive, aided by a strong fourth-quarter performance which saw revenues increase by 14.4% year over year. Revenue growth in Greece remained solid in both mobile and fixed line, increasing by 0.7% and 1% year over year respectively. EBITDA shrank by 1.3% year over year, while EBITDA margin remained flat at 33.8%. As a result of muted top line growth on an annual basis as well as elevated operating costs, the bottom line contracted by 20% year over year, in line with market expectations. Hellenic Telecom is currently trading at a forward P/E of 86x, while the market is forecasting an EPS CAGR of 6.9% over the next three years. Management guidance indicates that free cash flow (FCF) and adjusted capex will start to return to normal levels in 2018 after heavy investments in both its fixed and mobile network capabilities in 2017. Additionally, growing confidence in the company's outlook is signalled by its announcement of a new shareholder return policy, where 100% of the FCF will be distributed through a combination of a dividend payout and share buybacks. We expect that its recent investment in mobile and fixed capabilities and an improving Greek economy should drive a positive performance in 2018. Grivalia Properties (GRIV GA) Grivalia Properties (GRIV GA) (Chart I-18) Chart I-18Performance Since February 2017: ##br##Grivalia Properties Vs. MSCI EM Grivalia Properties reported stellar full-year 2017 financial results on January 31. The top line displayed solid results, with rental income advancing 7% year over year. Furthermore, the company realized a strong net gain of EUR18.8 million from fair value adjustments on investment property, compared to a EUR13.6 million loss in 2016. This was mainly driven by new property investments. As a result, operating profit surged by 102% year over year. All this translated into 139% year-over-year net income growth. Due to loan growth, the loan-to-value ratio grew by 8 percentage points to 14%, while NAV per share expanded by 5% year over year. Grivalia Properties is trading at a forward P/E of 15x, while the market is forecasting an EPS contraction of 1% over the next three years. The company announced in February the acquisition of office space in Maroussi, which has already been leased out to multinational companies. Two more properties were acquired in Greece in the same month. We believe a stabilizing property market leaves ample room for recovery, which is expected to support Grivalia's overweight Greek real estate portfolio and its risk diversification. Alpha Bank (APLHA GA) Alpha Bank (APLHA GA) (Chart I-19) Chart I-19Performance Since February 2017: ##br##Alpha Bank Vs. MSCI EM Alpha Bank reported solid third-quarter 2017 financial results on November 30. Net interest income improved by 2% year over year, with net interest margin growing 20 basis points to 2.9%. However, on a quarter-over-quarter basis, growth was negative. Fee income depicted a similar picture, up 2% year over year but down 7% quarter over quarter. On the positive side, operating expenses were under control, declining by 3% year over year, effectively pushing down the cost/income ratio. With the help of a decline in impairment losses, net income surged by 386% year over year. Asset quality showed a pattern of recovery: The NPL ratio went down by 7.4 percentage points to 33.2% year over year, while the tier-1 ratio improved by 1 percentage point to 17.8%. Moreover, ELA has trended down year to date. The market is forecasting an EPS CAGR of 53.6% over the next three years. Despite uncertainty regarding stress testing and the overall trajectory of Greek economic growth, Alpha Bank has demonstrated a solid pace of recovery in terms of a better asset-liability mix, improved liquidity and steady disengagement with the ELA. As guided by management, ELA funding is expected to be further replaced by strong deposit inflows, deleveraging initiatives and an increase in interbank lending. The Underweight Basket Intralot (INLOT GA) Intralot (INLOT GA) (Chart I-20) Chart I-20Performance Since February 2017:##br## Intralot Vs. MSCI EM Intralot reported mixed third-quarter financial results on November 27. Top-line growth was solid, up 10% year over year, mainly boosted by licensed operations in Jamaica, Azerbaijan and Poland. This also drove up gross margin by 2.8 percentage points to 18.1% year over year. However, a cost hike took a bite out of profits, with operating expenses expanding by 8%. Along with a 49% surge in R&D costs, the bottom line was still in negative territory. On a year-to-date basis, cash flow grew by 23%. However, this was mainly boosted by financing activities, with operating cash flow almost unchanged. Meanwhile, long-term debt has grown by over 50% year over year, which has prompted questions on solvency and the ability to further carry the interest payment burden. The market is forecasting negative EPS over the next three years. We believe the 80% share sale of the company's Peruvian operations reflects its need for cash inflow and raises concerns on balance sheet health. Coca-Cola HBC (EEE GA) Coca-Cola HBC (EEE GA) (Chart I-21) Chart I-21Performance Since February 2017:##br## Coca-Cola HBC Vs. MSCI EM Coca-Cola HBC reported solid full-year 2017 financial results on February 14. Revenues came in strong, growing by 5% year over year. Sales volume in developed markets, developing markets and emerging markets went up 1%, 7%, and 7% respectively. Looking at product lines, Sparkling was the best seller, driven by new flavor launches (such as lime, lemon, and cucumber). Stripping out foreign exchange effects, FX-neutral revenue grew by 6% year over year. Cost of sales ticked up by 4% year over year. EBITDA expanded by 10% year over year, while EBITDA margin added 60 basis points to 14.3%. As a result, the bottom line expanded by 24% year over year, beating market expectations. Coca-Cola HBC is currently trading at a forward P/E of 20x, while the market is forecasting an EPS CAGR of 11% over the next three years. The stock price rallied in the second half of 2017 following the company's announcement that it was acquiring 54.5% of Coca-Cola Beverages Africa (CCBA), indicating market complacency toward a strong synergy effect the deal could bring. However, given its weak profitability, CCBA is not expected to be as accretive as many investors believe. With the acquisition news priced in, CCHBC's year-to-date stock price has begun reverting to its true fundamentals. Hellenic Petroleum (ELPE GA) Hellenic Petroleum (ELPE GA) (Chart I-22) Chart I-22Performance Since February 2017:##br## Hellenic Petroleum Vs. MSCI EM Hellenic Petroleum reported full-year 2017 financial results on February 22. Revenue increased by 21% year over year, driven by higher volumes (exports +12% and +14% in domestic net sales, mainly helped by aviation and bunkering) in the refining division and improved average selling prices. However, this result was offset by higher cost of sales, up 23% year over year, driven by increased input prices, sending gross margin 160 basis points lower to 13.6%. Operating income was 4.7% higher year over year, helped by lower operating expenses. EBITDA was up 14% year over year, while EBITDA margin was 200 basis points lower, finishing at 10.6%. The company secured bottom line growth of 15.7%, but came in below the market expectation by 4.5%. Hellenic Petroleum is currently trading at a forward P/E of 6.5x, while the market is forecasting an EPS CAGR of 4.6% over the next three years. The reopening of the Elefsina refinery will enable Hellenic Petroleum to return to normal capacity in 2018. However, continued maintenance work expected to end in March 2018 and higher crude prices will continue to place pressure on margins. We expect weak domestic demand to continue to impact carbon revenue, despite strong sales growth from increased tourism. Piraeus Bank (TPEIR GA) Piraeus Bank (TPEIR GA) (Chart I-23) Chart I-23Performance Since February 2017: ##br##Piraeus Bank Vs. MSCI EM Piraeus Bank delivered disappointing third-quarter 2017 financial results on November 9. Net interest income came in weak, sliding 3% year over year, with net interest margin remaining virtually flat at 2.7%. On the positive side, net fee income displayed strong growth, up 24% year over year. Operating expenses contracted by 5% year over year, pushing down the cost/income ratio by 5 percentage points to 51%. Despite robust pre-provisional income, the impairment on loans dragged down net income into negative territory, compared to a positive bottom line during the same period last year. Asset quality was a mixed bag: The NPL ratio went down by 2.6 percentage points to 48.3%, but is still the highest among its peers. The loan-to-deposit ratio declined, with ELA loan exposure trending slightly down year-to-date. The market is forecasting an EPS contraction of 8.8% over the next three years. Piraeus Bank has shown little signs of operational recovery, with most cost-savings efforts achieved through branch reductions (-8% year to date) and employee layoffs (-7% year to date). We believe the bank is still a long way away from a real turning point and prefer to monitor on the sidelines. How To Trade? The EMES team recommends gaining exposure to the sector through a basket of the listed stocks below, which would consist of overweight positions in four select Greek companies and underweight positions in the other four. The main goal is active alpha generation by excluding laggards and including out-of-benchmark plays, to avoid passive index-hugging via an ETF. Direct: Equity access through the tickers (Bloomberg): Jumbo (BELA GA) vs. Intralot (INLOT GA) Hellenic Telecom (HTO GA) vs. Coca-Cola HBC (EEE GA) Grivalia Properties (GRIV GA) vs. Hellenic Petroleum (ELPE GA) Alpha Bank (ALPHA GA) vs. Piraeus Bank (TPEIR GA) ETFs: There are no ETFs that would allow for an overweight/underweight position in the same sector. Funds: There are no funds that would allow for an overweight/underweight position in the same sector. Please note this trade recommendation is strategic and based on an overweight/underweight pair trade. We do not see a need for specific market timing for this call (for technical indicators please refer to our website link). For convenience, the performance of both market cap-weighted and equal-weighted equity baskets will be tracked (please see upcoming updates as well as the website link to follow performance). Risks To Our Investment Case Because of the overall market neutral exposure, the portfolio performance will be largely immune to the direction of Greek economic growth and political developments. Some macro risk factors stem from a slower-than-expected property market recovery, which would affect the rental income of Grivalia Properties. Other major macro risks include an oil price drop, which would benefit Hellenic Petroleum's profit margins within its refining operations. Also, a slow recovery of consumer sentiment and retail sales would put downward pressure on Jumbo's domestic top-line performance. Company specific risks worth mentioning include remarkable management efforts in CCBA's financial performance in the coming quarters. This would send the market a bullish signal on Coca-Cola HBC's stock price due to potentially strong synergies, posing upside risk to the underweight basket. Furthermore, Jumbo would be negatively affected by excessive focus on overseas markets, and thus it could miss further business development and market share expansion opportunities in the domestic market. Last but not least, asset quality remains problematic among banks, reflected by elevated NPLs, which would weigh on performance indefinitely if not properly tackled. Billy Zicheng Huang, Research Analyst billyh@bcaresearch.com Sophie McGrath, Research Assistant sophiemc@bcaresearch.co.uk

The GAA DM Equity Country Allocation model is updated as of February 28, 2018. After the large upgrade in January, the model has furthered upgraded the U.S. to a small overweight of 3.3 percentage points from neutral in January. This change is mainly financed by a reduction in the large overweight in the Netherlands. Directionally, the model is becoming more defensive in the sense that the sizes of large bets have shrunk two months in a row, as shown in Table 1. As shown in Table 2 and Chart 1, Chart 2 and Chart 3, the overall model underperformed its benchmark by 55 bps in February, largely driven by the Level 2 model which underperformed by 131 bps. The large underweight in Japan hurt the performance the most because in USD terms Japan was the best performer thanks to the strength of JPY versus USD. Since going live in January 2016, the overall model has outperformed the benchmark by 102 bps, largely from the allocation among the 11 non-U.S. countries, which has outperformed its benchmark by 345 bps. The Level 1 model has performed on par with the MSCI benchmark. Table 1Model Allocation Vs. Benchmark Weights Table 2Performance (Total Returns In USD) Chart 1GAA DM Model Vs. MSCI World Chart 2GAA U.S. Vs. Non U.S. Model (Level 1) Chart 3GAA Non U.S. Model (Level 2) Please see also the website http://gaa.bcaresearch.com/trades/allocation_performance. For more details on the models, please see the January 29, 2016 Special Report, "Global Equity Allocation: Introducing the Developed Markets Country Allocation Model." http://gaa.bcaresearch.com/articles/view_report/18850. Please note that the overall country and sector recommendations published in our Monthly Portfolio Update and Quarterly Portfolio Outlook use the results of these quantitative models as one input, but do not stick slavishly to them. We believe that models are a useful check, but structural changes and unquantifiable factors need to be considered too in making overall recommendations. GAA Equity Sector Selection Model The GAA Equity Sector Selection Model (Chart 4) is updated as of February 28, 2018. Table 3Allocations Table 4Performance Since Going Live Chart 4Overall Model Performance The model has turned negative on cyclical sectors by sending negative signals from the growth component. Additionally, the recent correction in equity markets has also created unfavorable momentum signals. From being overweight on cyclical sectors by 10%, the model has now turned underweight by 1.3%. However, energy stocks have seen their overweight increase by 3% on the back of favorable valuations. The biggest change was an upgrade to overweight for the utilities sector on the back of the weaker growth outlook and not so negative momentum. 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. Xiaoli Tang, Associate Vice President xiaoli@bcaresearch.com Aditya Kurian, Research Analyst adityak@bcaresearch.com

For much of the past twelve years, pharmaceutical pricing power has been a reliable predictor of the S&P pharma relative share price ratio, both to the up and down sides (top panel). In 2018, this relationship appears to be breaking down somewhat as pricing power growth has stabilized at a relatively low level but the index has continued to fall. We think a more pressing concern than falling pricing power has taken over investor's attention, namely the soaring industry leverage ratios (shown inverted on second panel). With a declining share of both domestic (third panel) and foreign (bottom panel) wallets, the sustainability of even this low level of pricing power is questionable. As such, it seems likely that leverage will get worse before it gets better; in the context of a rising interest rate environment, weak operating metrics and high financing costs all bode poorly for industry EPS growth. Stay underweight. The ticker symbols for the stocks in the S&P pharmaceuticals index are: BLBG: S5PHAR - JNJ, PFE, MRK, BMY, AGN, LLY, ZTS, MYL, PRGO.

Neutral While internet retail moved to the mainstream more than a decade ago, it continues to capture the lion's share of retail growth and investors' imaginations along with it. Further, the philosophy of "profits don't matter" in pursuit of explosive growth has been replaced with more sustainable models. The consumer is gradually becoming more aware that the intangible benefits of convenience and comparison information and tangible benefits including transportation and time expenses should mean that internet retail should be able to command greater pricing power than physical peers. As such, an eventual convergence between bricks and mortar and online retail margins looks to be in the offing. Still, despite a market full of eye-watering valuations, the S&P internet retail index stands out as expensive; expectations appear to have overreached. Further, one of BCA's themes for 2018 is higher interest rates; with the Fed poised to increase rates at least three times this year, our style preference favoring value stocks over growth seems well supported. Bottom Line: We initiate coverage of the S&P internet retail index with a neutral weight. Please see yesterday's Special Report for more details. The ticker symbols for the stocks this index are: BLBG: S5INRE - AMZN, NFLX, PCLN (changing to BKNG, effective February 27, 2018), EXPE, TRIP.

Special Report

Highlights While internet retail moved to the mainstream more than a decade ago, it continues to capture the lion's share of retail growth and investors' imaginations along with it. Further, the philosophy of "profits don't matter" in pursuit of explosive growth has been replaced with more sustainable models and a convergence between bricks and mortar and online retail margins looks to be in the offing. Still, despite a market full of eye-watering valuations, the S&P internet retail index stands out as expensive; expectations appear to have overreached. Netting it out, superior growth and profit outlook have been priced in and a cautious approach is warranted. We are initiating coverage with a neutral rating. Feature Going Mainstream... A new type of story emerged last year and subsequently repeated itself a number of times: Amazon would express interest in a new segment and the existing traditional competitors would see fairly frightening share price pull backs. In Chart 1, we show the reactions of Walmart, Kroger and Costco to the acquisition of Whole Foods (top panel), Home Depot and Lowes to the announcement of a Kenmore licensing agreement (middle panel) and UPS and FedEx to the announcement that Amazon was examining creating its own last-mile logistics system (bottom panel). More examples have come this year, following Amazon's entrance into healthcare insurance and medical supply. Such is the heft of internet retailing. In fact, the meteoric rise of internet retail, particularly Amazon and Walmart, combined with the gig and sharing economies facilitated by companies like Airbnb and Uber, have been frequently blamed for the persistently low inflation of the past two years, despite a tight labor market and a roaring global economy. BCA's flagship publication, The Bank Credit Analyst, examined this last year but found scant evidence to support this assertion. Rather, BCA noted that e-commerce affects only a small part of the Consumer Price Index. Goods represent 40% of the CPI basket and, with approximately 8% of U.S. retail sales going online, the deflationary impact of online shopping is limited to just over 3% of CPI. Further, the authors note that the cost advantages for online sellers have been perennially overstated as the information technology, distribution centers, shipping, and returns processing required offset most of the advantage of not operating a brick-and-mortar retail space. Were online retailers truly deflationary, it should present itself in traditional retail's margins; as shown in Chart 2, no evidence exists of any sustainable negative impact from the rise of e-commerce. Chart 1The Amazon##br## Curse Chart 2E-Commerce Has Failed To##br## Dent Traditional Retail's Margins Still, the increasing penetration of the internet into the home should have the effect of broadening the online product portfolio, with consumer staples taking a greater share. This transition should largely be demographic in nature as millennials, who grew up shopping online are increasingly domesticated. Technology too should facilitate the change, aided by the rapid adoption into the home of smart speakers (Amazon Echo, Google Home, Apple HomePod, etc.) that, at least in the case of Amazon's offering, make ordering household items as simple as calling out into the ether. Similarly, the proliferation of smartphones is another assist to internet retail sales grabbing a larger slice of the overall retail sales pie. ...Doesn't Mean Selling Out Rather than remaining the domain of discounters, the intangible benefits of convenience and comparison information and tangible benefits including transportation and time expenses should mean that internet retail should be able to command greater pricing power than physical peers. Further, internet retailers enjoy significant advantages in scalability, both from a capital deployment and operating cost perspective. Adding it up, we expect an eventual margin convergence between traditional and online retailing as greater adoption, increasing online sales of consumer staples and demographics drive internet retail growth in excess of traditional retail for the foreseeable future. Early signs in the mature North America market support this assertion, as the representative giants of traditional and online retail, Walmart and Amazon, respectively, have seen their margin gaps closing (Chart 3). Chart 3North America Retail Operating Margins 'Not Cheap' Is An Understatement While internet retail remains a good news story, skyrocketing valuations mean that much of this good news is already reflected in the index. After a solid Q4 with positive revenue guidance, punctuated by a modest stumble in Walmart's competing online offering, BCA's S&P internet retail Valuation Indicator has risen more than two standard deviations above its mean (Chart 4). Chart 4Expensive By Any Measure In this context, it is difficult to make a case that the current levels make a compelling entry point. Rather, extremely high relative valuations could point to extended investor complacency in a niche sector; when complacency turns to anxiety, relative declines are likely to be amplified. Amazon Dominates We think a more granular approach to an analysis of the S&P internet retail index is appropriate. Further, some additional context is required; S&P Dow Jones Indices and MSCI have announced a shift of Netflix out of the internet retail index in September of this year and into a newly-renamed Communications Services sector. With that in mind, for all practical purposes the index is made up of Amazon and three travel-related stocks, Priceline (soon to be renamed Booking Holdings), Expedia and TripAdvisor. Accordingly, this is how we intend to analyze the group. It is also worth noting that Amazon's heft dominates both the S&P internet retail index and the GICS1 S&P consumer discretionary index, where it holds a 70% and 20% weighting, respectively. When the above-noted change is made the index (which also includes other consumer discretionary heavyweights like Comcast and Disney), these weights will be significantly magnified, further reducing the respective diversification of these indexes. A Role Reversal For David And Goliath As far as internet retailers go, Amazon is a relative dinosaur, dating back to 1995. It has since grown from a small online book retailer then to a global behemoth offering hundreds of millions of products. These products now include Amazon-developed and manufactured products, including the Kindle, Fire TV and previously mentioned Echo. The company's international and domestic segments comprise the retail consumer products operations of Amazon, which is the dominant revenue generator, the most visible part of the business and hence, the prevailing valuation driver (Chart 5). These segments include the commissions and related fulfillment and shipping fees charged to third-party sellers that now comprise roughly 20% of retail sales. Chart 5Sales Drive Amazon's Valuation But Not Profits Amazon Web Services (AWS) is the lesser known third segment of the Amazon empire, offering online compute and storage services to other businesses. While still relatively small (10% of 2017 sales), AWS is the fastest growing segment, averaging 50% increases in sales over the past two years. Further, the segment is by far the most profitable, yielding more operating profit than the other two segments individually and combined. Despite its incredible brand strength, Amazon remains a relatively misunderstood firm. As an example, Amazon bulls frequently quote a number of press reports stating that Amazon outspends any other company in the S&P 500 on research & development. In fact, Amazon does not disclose their R&D expense; they disclose a line item that includes R&D but also includes AWS' operating expenses, which add up to about half of that number. Further, and perhaps because of the goodwill that Amazon carries with its customers, little is made of regulatory risks to Amazon's business. However, considering the clear antipathy between Jeff Bezos, Amazon's CEO and owner of the Washington Post, and Donald Trump, nothing seems off the table. As an example, Trump tweeted that low rates charged by the U.S. Postal Service (USPS) were "making Amazon richer and the Post Office dumber and poorer". With the power to appoint the rate-setting governors of the USPS, it is not unreasonable to think that a spiteful president could impact the retailer's cost structure. Perhaps more relevant is Amazon's size. A recent report claimed that Amazon had 43.5% of U.S. e-commerce sales, larger than every other public online retailer's share combined. Considering that share grew from 38% in 2016, the trajectory suggests that Department of Justice (notably headed by a Trump surrogate, Attorney General Jeff Sessions) may be casting a wary eye, particularly in the context of domestic e-commerce sales growth that continues to vastly outpace overall retail sales growth (Chart 6). Despite these potential headwinds, the market has pushed Amazon's valuation beyond a 50% premium to the S&P 500's overall valuation (Chart 7) while at the same time making the firm one of the most valuable in the world. Chart 6E-Commerce Takes More Of The Retail Pie... Chart 7Let By Its Behemoth The recent market euphoria has only accelerated the already-high expectations for Amazon's share price, pushing it to heady levels not seen since the early 2000's. With our memories of how that story finished still relatively fresh in our minds, we think this has amplified Amazon's risk profile, causing us to take a fairly cautious stance, underpinning our overall neutral recommendation on the S&P internet retail index. Travel Has Been Fully Democratized Much like their significantly larger cap S&P internet retail peer, the travel companies (Priceline, TripAdvisor and Expedia) have been accused of being price deflators, though on a significantly narrower scale. The democratization of the travel industry, for which they are largely responsible, and the clarity of pricing and quality it has brought have mostly rendered obsolete the traditional sales force, the travel agent. Further, airlines and hotel operators have had to compete on price to a degree previously unseen, forcing a tightening of margins across both industries (Chart 8, top panel). However, declining airfares and room prices have brought a commensurate increase in travelers, which has spurred capacity increases in both industries (Chart 8, bottom panel). Chart 8Airline & Hotelier Price Declines##br## Are Offset By New Capacity United Airlines, for example, recently provided capacity growth guidance of 4-6% per year until 2020. Odds are other airlines will match this capacity rather than cede market share, implying more supply to travelers and cheaper prices; the airlines' loss is internet travel retail's gain (as a reminder, we remain underweight the S&P airlines index). However, as with Amazon, the internet travel stocks (particularly Priceline, by far the largest component stock) have seen significant inflation in their valuations. This makes us doubly cautious; elevated multiples should amplify a downfall in a shock scenario and these stocks are heavily exposed to a sector that is prone to shocks. Adding it up, we believe an approach at least as cautious as that for Amazon is warranted, considering the significantly greater exogenous shock risk. This further supports our neutral stance on the S&P internet retail index. Stay On The Sidelines One of BCA's themes for 2018 is higher interest rates, with our bond strategists still expecting an inflation-driven rise in the 10-year Treasury yield to 3.25% this year. With the Fed poised to increase rates at least three times this year, combined with its balance sheet unwinding, monetary conditions look set to tighten considerably. This underlies our style preference favoring value stocks over growth.1 With consumer discretionary stocks in general and internet retail in particular meeting the definition of growth stocks, we are naturally biased to a negative view for the S&P internet retail index. Tack on the aforementioned unsustainably high valuations and our negative view is confirmed. However, we believe the earnings growth trajectory for internet retail stocks, in the absence of an economic downturn, should outpace the broad market. With no recession on the horizon, we are hard pressed to find a catalyst to take the wind out of the index's sails. Bottom Line: We initiate coverage of the S&P internet retail index with a neutral weight. The ticker symbols for the stocks this index are: AMZN, NFLX, PCLN (changing to BKNG, effective February 27, 2018), EXPE, TRIP. Chris Bowes, Associate Editor chrisb@bcaresearch.com 1 Please see BCA U.S. Equity Strategy Weekly Report, "Too Good To Be True?" dated January 22, 2018, available at uses.bcaresearch.com.

Overweight It has paid handsomely to be overweight the S&P home improvement retail index over the past year. However, the last few months have seen a significant step upward in valuation (top panel), we think with good reason. First, lumber prices have pushed through modern highs, driven by fire-related supply constraints and duties on Canadian imports. Home improvement retailers typically earn a fixed spread such that a high dollar value sold will boost profitability; sales have not yet caught up with lumber prices, though this should only be a matter of time (second panel). Second, household appliances, the other large sales category of home improvement retailers, has also seen a shift upwards in price (third panel), thanks to newly imposed duties; this should provide an incremental lift to sales in the coming year. At the same time, the valuation looks reasonable relative to history (bottom panel) which we think underprices the above-normal earnings growth trajectory. Accordingly, we reiterate our overweight recommendation for the S&P home improvement retail index. The ticker symbols for the stocks in this index are: BLBG: S5HOMI - HD, LOW.

Special Report

We estimate the corporate sector's vulnerability to rising interest rates and a weaker economic environment, highlighting the industries that will be hit the hardest. Both our top-down and bottom-up Corporate Health Monitors show that overall corporate finances improved last year on the back of a mini profit boom. Nonetheless, leverage remained on the up-escalator. The re-leveraging of the corporate sector has been widespread across industries and ratings. The credit cycle has entered a late stage and we are biased to take profits early on our overweight corporate bond positioning. Rising interest rates will not, on their own, trigger a downgrade and default wave in the next few years. Nonetheless, the starting point for interest coverage ratios is low. The interest coverage ratio for the U.S. non-financial corporate sector will likely drop to all-time lows even in a mild recession. Downgrades will proliferate when the rating agencies realize that the economy is turning south. Our profit indicators are more likely to give an early warning sign than the economic data. We remain overweight corporates within fixed income portfolios for now, but a downgrade would be warranted given some combination of rising core consumer price inflation, a further increase in the 10-year TIPS breakeven to 2.3%, and/or a deterioration in our margin proxy. February's "volatility" tremors focused investor attention on leveraged pressure points in the financial system, at a time when valuation is stretched and central banks are turning down the monetary thermostat. The market swoon may have simply reflected the unwinding of crowded volatility-related trades, but the risk is that there are other landmines lurking just ahead. The corporate sector is one candidate. Equity buybacks have not been especially large compared to previous cycles after adjusting for the length of the expansion (i.e. adjusting for cumulative GDP over the period, Chart II-1).1 But the expansion has gone on for so long that cumulative buybacks exceed the previous three expansions in absolute terms (Chart II-1, bottom panel). One would expect a lot of financial engineering to take place in an environment where borrowing costs are held at very low levels for an extended period. But, of course, one should also expect there to be consequences. Chart II-1Cycle Comparison: Corporate Finance Trends As Chart II-2 shows, corporate spreads tend to follow the broad trends in leverage, albeit with lengthy periods of divergence. The chart suggests that current spreads are far too narrow given the level of corporate leverage. Balance sheet health is obviously not the key driver of corporate bond relative returns at the moment. Nonetheless, this will change as interest rates rise and investors begin to worry about the growth outlook rather than squeezing the last drop of yield out of spread product. Chart II-2Corporate Bond Spreads And Leverage In this Special Report, we estimate the corporate sector's vulnerability to rising interest rates and a weaker economic environment, highlighting the industries that will be hit the hardest. But first, we review recent trends in leverage and overall balance sheet health. BCA's Corporate Health Monitors BCA's top-down Corporate Health Monitor (CHM) has been a workhorse for our corporate bond strategy for almost 20 years (Chart II-3). It is based on six financial ratios constructed from the U.S. Flow of Funds data for the entire non-financial corporate sector (Table II-1). The top-down CHM shifted into "deteriorating health" territory in 2014 on the back of rising leverage and an eroding return on capital.2 The downward trend in the return on capital since 2007 is disturbing, as it suggests that there is a surplus of capital on U.S. balance sheets that is largely unproductive and not lifting profits. This can also be seen in the run-up in corporate borrowing in recent years that has been used to undertake share buybacks. If a company's best investment idea is to take on debt to repurchase its own stock, rather than borrow to invest in its own business, then the expected internal rate of return on investment must be quite low. This is a longer-term problem for corporate health. Alternatively, financial engineering may reflect misaligned incentives, such as stock options, rather than poor investment opportunities. Chart II-3Top Down U.S. Corporate Health Monitor Table II-1Definitions Of Ratios That Go Into The CHMs The good news is that profit margins bounced back in 2017, which was reflected in a small decline in our top-down CHM toward the zero line over the past year (although it remained in 'deteriorating' territory). While the top-down CHM has been a useful indicator to time bear markets in corporate bond relative performance, it tells us nothing about the distribution of credit quality. In 2016 we looked at the financials of 1,600 U.S. companies to obtain a more detailed picture of corporate health. After removing ones with limited history or missing data, our sample shrank to a still-respectable 770 companies from across the industrial and quality spectrum. We then constructed an overall Corporate Health Monitor for all companies in the sample, as well as for the nine non-financial industries. We refer to these indicators as bottom-up CHMs, which we regard as complements to our top-down Health Monitor. The companies selected for our universe provided a sector and credit-quality composition that roughly matched the Barclays corporate bond indexes. In our first report, published in the February 2016 monthly Bank Credit Analyst, we highlighted that the financial ratios and overall corporate health looked only a little better excluding the troubled energy and materials sectors. The level of debt/equity was even a bit higher outside of the commodity industries. The implication was that, at the time, corporate credit quality had deteriorated across industrial sectors and levels of credit quality. Profitability Drove Improving Health In 2017... An update of the bottom-up CHMs shows that corporate financial health improved in 2017 for both the investment-grade (IG) and high-yield (HY) sectors (Chart II-4 and Chart II-5). The IG bottom-up Monitor remains in "deteriorating health" territory, but HY Monitor moved almost all the way back to the neutral line by year end. Leverage continued to trend higher last year for both IG and HY, but this was more than offset by a strong earnings performance that was reflected in rising operating margins, interest coverage and debt coverage. Chart II-4Bottom-Up IG CHM Chart II-5Bottom-Up HY CHM These improvements were particularly evident in the sub-investment grade universe. Our industry high-yield CHMs fell significantly in 2017 from elevated (i.e. poor) levels all the way back to the neutral line for Consumer Discretionary, Energy, Industrials, Materials and Utilities (not shown). The high-yield Technology and Health Care sector CHMs are also close to neutral. ...But The Earnings Runway Is Limited Unfortunately, the profit tailwind won't last forever. At some point, earnings growth will stall and this cycle's debt accumulation will start to bite in the context of rising interest rates. While interest coverage (EBIT divided by interest payments) improved last year for most industries, it remains depressed by historical standards. This is despite ultra-low borrowing rates and a robust earnings backdrop. U.S. companies are not facing an imminent cash crunch that would raise downgrade/default risk, but depressed interest coverage suggests that there is less room for error than in previous years. Table II-2Widespread Re-Leveraging Now that government bond yields have bottomed for the cycle and the "green shoots" of inflation are beginning to emerge, it begs the question of corporate sector exposure to rising interest costs. The sensitivity is important because Moody's assigns a weight of between 20% and 40% for the leverage and coverage ratios when rating a company, depending on the industry. Downgrade risk will escalate if corporate borrowing rates continue rising and, especially, if the U.S. economy enters a downturn. Comparing the level of debt or leverage across industries is complicated by the fact that some industries perpetually carry more debt than others due to the nature of the business. Moody's uses different thresholds for leverage when rating companies, depending on the industry. Thus, the change in the leverage ratio is perhaps more important than its level when comparing industries. Table II-2 shows the change in the ratio of debt to the book value of equity from our bottom-up universe of companies from 2010 to 2017. Leverage rose sharply in all sectors except Utilities. The worse two sectors were Communications and Consumer Discretionary, where leverage rose by 81 and 104 percentage points, respectively. Highest Risk Sectors We expect a traditional end to the business cycle; the Fed overdoes the rate hike cycle, sending the economy into recession. The industrial sectors with the poorest financial health and the greatest earnings "beta" to the overall market are most at risk in this macro scenario. We first estimate earnings betas by comparing the peak-to-trough decline in EPS for each sector to the overall decline in the non-financial S&P 500 EPS, taking an average of the last two recessions (we could not include the early 1990s recession due to data limitations). Not surprisingly, Materials, Technology, Consumer Discretionary and Energy sport the highest earnings beta based on this methodology (Chart II-6). Chart II-6Earnings Beta Chart II-7 presents a scatter plot of 2017 leverage versus the industry's earnings beta. Consumer Discretionary stands out on the high side on both counts. Materials and Energy are also high-beta industries, but have lower leverage. Communications is a high-debt industry with a medium earnings beta. These same industries stand out when comparing the earnings beta to the interest coverage ratio (the lower the interest coverage ratio the more risky in Chart II-8). Chart II-7Leverage Vs. Earnings Beta Chart II-8Interest Coverage Ratio Vs. Earnings Beta Of course, a sector's sensitivity to rising interest rates will depend on both the level of debt and its maturity distribution. Higher rates will not have much impact in the near term for firms that have little debt to roll over in the next couple of years. Chart II-9 presents the percentage of total debt that will come due over the next three years by industry. Consumer Discretionary, Tech, Staples and Industrials are the most exposed to debt rollover. To further refine the analysis, we estimate the change in the interest coverage ratio over the next three years for a 100 basis point rise in interest rates across the corporate curve, taking into consideration the maturity distribution of the debt. We make the simplifying assumptions that companies do not issue any more debt over the three years, and that EBIT is unchanged, in order to isolate the impact of higher interest rates. For the universe of our companies, the interest coverage ratio would drop from about 4 to 2½, well below the lows of the Great Recession (denoted as "x" in Chart II-10). The Consumer Staples, Tech and Health Care are affected most deeply (Chart II-11 and Chart II-12). Char II-9Debt Maturing In Next ##br##Three Years (% Of Total) Chart II-10Interest Coverage Ratio ##br##Headed To New Lows Chart II-11Interest Coverage By ##br##Sector (IG Plus HY) Chart II-12Interest Coverage By ##br##Sector (IG Plus HY) Recession Shock Of course, the decline in interest coverage will be much worse if the Fed steps too far and monetary tightening sparks a recession. Looking again at Charts II-10 to II-12, "o" denotes the combination of a 100 basis point interest rate shock and a mild recession in which the S&P 500 suffers a 25% peak-to-trough decline in EPS. We estimate the decline in EPS based on the industry's earnings beta to the overall market. The overall interest coverage ratio falls even further into uncharted territory below two. The additional shock of the earnings recession makes little difference to earnings coverage for the low beta sectors such as Consumer Staples and Health Care. The coverage ratio falls sharply for the Communications and Industries, although not to new lows. It is a different story for Consumer Discretionary and Materials. The combination of elevated debt and a high earnings beta means that the interest coverage ratio would likely plunge to levels well below previous lows for these two industries. Corporate bond investors and rating agencies will certainly notice. Signposts Our top-down Corporate Health Monitor is one of the key indicators we use to identify cyclical bear phases for corporate bond excess returns. A shift from "improving" to "deteriorating" health has been a reliable confirming indicator for periods of sustained spread widening. The other two key indicators are (Chart II-13): Chart II-13Key Cyclical Drivers Of Corporate Excess Returns Bank lending standards for Commercial & Industrial loans: Banks begin to tighten up on lending standards when they realize that the economy is slowing and credit quality is deteriorating as a result. By making it more difficult for firms to roll over bank loans or replace bond financing, more restrictive standards reinforce the negative trend in corporate credit quality. We traditionally view lending standards as a confirming indicator for a turn in the credit cycle, since tightening standards are typically preceded by deteriorating corporate health and restrictive monetary policy. Restrictive monetary policy: This is the most difficult of the three indicators for which to determine critical values. We had a good idea of the level of the neutral real fed funds rate prior to 2007. Since then, our monetary compass is far less certain because the neutral rate has likely declined for cyclical and structural reasons. The real fed funds rate has moved just slightly into restrictive territory if we take the Laubach-Williams estimate at face value (Chart II-13, third panel). That said, we would expect the 2/10 Treasury yield curve to be closer to inverting if real short-term interest rates are indeed in restrictive territory. Taking the two indicators together, we conclude that monetary policy is not yet outright restrictive. Historically, all three indicators had to be flashing red in order to justify a shift to below-benchmark on corporate bonds within fixed-income portfolios. Only the CHM is negative at the moment, but this time we are unlikely to wait for all three signals to take profits. Poor valuation, lopsided positioning, financial engineering and uncertainty regarding the neutral fed funds rate all argue in favor of erring on the side of caution and not trying to closely time the peak in excess returns. The violent unwinding of short-volatility trades in January highlighted the potential for a quick and nasty repricing of corporate bonds spreads on any disappointments regarding the default rate outlook. Conclusion Both our top-down and bottom-up Corporate Health Monitors show that overall corporate finances improved last year on the back of a mini profit boom. Nonetheless, leverage remained on the up-escalator as businesses continued to pile up debt and return cash to shareholders. Our sample of individual companies reveals that the re-leveraging of the corporate sector has been widespread across industries and ratings. We have clearly entered the late stage of the credit cycle. Rising interest rates will not, on their own, trigger a downgrade and default wave in the next few years. However, debt levels are elevated and the starting point for interest coverage ratios is low. This means that, for any given size of recession, the next economic downturn will have a larger negative impact on corporate health than in the past. The interest coverage ratio for the non-financial corporate sector will likely drop to all-time lows even in a mild recession. Downgrades will proliferate when the rating agencies realize that the economy is turning and the profit boom is over. Last month's Overview listed the top economic indicators we are watching in order to time our exit from risky assets. Inflation expectations will be key; A rise in the 10-year inflation breakeven rate above 2.3% would be a warning that the FOMC will need to ramp up the speed of rate hikes to avoid a large inflation overshoot. While we are also watching a list of economic indicators, they have not provided any lead time for corporate spreads in the past (since the latter are themselves leading indicators). Our profit indicators are probably more likely to give an early warning sign than the economic data. Indeed, the profit outlook will be particularly important in this cycle because of the heightened sensitivity of corporate financial health changes in the macro backdrop. None of our earnings indicators are flashing a warning sign at the moment. A recent Special Report on corporate pricing power found that almost 80% of the sectors covered are lifting selling prices, at a time when labor costs are still subdued.3 These trends are captured by our U.S. Equity Strategy service's margin proxy, which remains in positive territory (Chart II-14). The margin proxy fell into negative territory ahead of the start of the last three sustained widening phases in U.S. corporate bonds. Chart II-14For Corporate Spreads, Watch Our Margin Proxy The bottom line is that we remain overweight corporates within fixed income portfolios for now, but a downgrade would be warranted given some combination of rising core consumer price inflation, a further increase in the 10-year TIPS breakeven to 2.3%, and/or a deterioration in our margin proxy. We expect to pull the trigger later this year but the timing is uncertain. Mark McClellan Senior Vice President The Bank Credit Analyst 1 The accumulation of equity buybacks, net equity withdrawal, dividends and capital spending are all adjusted by the accumulation of GDP during the expansion to facilitate comparison across business cycles. 2 The Monitor is an average of six financial ratios that are used by rating agencies to rate individual companies. We have applied the approach to the entire non-financial corporate sector, using the Fed's Flow of Funds data. To facilitate comparison with corporate spreads, the ratios are inverted so that a rising CHM indicates deteriorating health. The CHM has a very good track record of heralding trend changes in investment-grade and high-yield spreads over many cycles. 3 Please see BCA U.S. Equity Strategy Service Weekly Report, "Corporate Pricing Power Update," dated January 29, 2018, available at uses.bcaresearch.com.