Energy

Highlights Several economic and financial market indicators point to a budding downtrend in Chinese capital spending and its industrial sector. The recent underperformance of global mining, chemicals and machinery/industrials corroborate that capital spending in China is starting to slump. Shipments-to-inventory ratios for Korea and Taiwan also point to a relapse in Asian manufacturing. This is occurring as our global growth sentiment proxy sits on par with previous peaks, and investor positioning in EM and commodities is overextended. Stay put on EM. Markets with currency pegs to the U.S. dollar, such as the Gulf states and Hong Kong, will face tightening local liquidity. Share prices in these markets have probably topped out. Feature On the surface, EM equities, currencies and local bond and credit markets are still trading well. However, there are several economic indicators and financial variables that herald negative surprises for global and Chinese growth. In particular: China's NBS manufacturing PMI new orders and backlogs of orders have relapsed in the past several months. Chart I-1 illustrates the annual change in new orders and backlogs of orders to adjust for seasonality. The measure leads industrial profits, and presently foreshadows a slowdown going forward. Furthermore, the average of NBS manufacturing PMI, new orders, and backlog orders also points to a potential relapse in industrial metals prices in general as well as mainland steel and iron ore prices (Chart I-2). The message from Charts I-1 and I-2 is that the recent weakness in iron ore and steel prices could mark the beginning of a downtrend in Chinese capital spending. While supply cuts could limit downside in steel prices, it would be surprising if demand weakness does not affect steel prices at all.1 Chart I-1China: Slowdown Has Further To Run China: Slowdown Has Further To Run China: Slowdown Has Further To Run Chart I-2Industrial Metals Prices Have Topped Out Industrial Metals Prices Have Topped Out Industrial Metals Prices Have Topped Out Although China's money and credit have been flagging potential economic weakness for a while, the recent manufacturing PMI data from the National Bureau of Statistics finally confirmed an impending deceleration in industrial activity and ensuing corporate profit disappointment. Our credit and fiscal spending impulses continue to point to negative growth surprises in capital spending. The latter is corroborated by the weakening Komatsu's Komtrax index, which measures the average hours of machine work per unit in China (Chart I-3). In both Korea and Taiwan, the overall manufacturing shipments-to-inventory ratios have dropped, heralding material weakness in both countries' export volumes (Chart I-4). Chart I-3Signs Of Weakness In Chinese Construction Signs Of Weakness In Chinese Construction Signs Of Weakness In Chinese Construction Chart I-4Asia Exports Are Slowing Asia Exports Are Slowing Asia Exports Are Slowing Notably, global cyclical equity sectors that are leveraged to China's capital spending such as materials, industrials and energy have all recently underperformed the global benchmark (Chart I-5). Some of their sub-sectors such as machinery, mining and chemicals have also begun to underperform (Chart I-6). Chart I-5Global Cyclicals Have ##br##Begun Underperforming... Global Cyclicals Have Begun Underperforming... Global Cyclicals Have Begun Underperforming... Chart I-6...Including Machinery ##br##And Chemical Stocks ...Including Machinery And Chemical Stocks ...Including Machinery And Chemical Stocks Among both global and U.S. traditional cyclicals, only the technology sector is outperforming the benchmark. However, we do not think tech should be treated as a cyclical sector, at least for now. In brief, the underperformance of global cyclical equity sectors and sub-sectors following last month's equity market correction corroborate that China's capital spending is beginning to slump. Notably, this is occurring as our global growth sentiment proxy rests on par with its previous apexes (Chart I-7). Previous tops in this proxy for global growth sentiment have historically coincided with tops in EM EPS net revisions, as shown in this chart. Chart I-7Global Growth Sentiment: As Good As It Gets Global Growth Sentiment: As Good As It Gets Global Growth Sentiment: As Good As It Gets All told, we may be finally entering a meaningful slowdown in China that will dampen commodities prices and EM corporate earnings. The latter are still very strong but EPS net revisions have rolled over and turned negative again (Chart I-8). Chart I-8EM EPS Net Revisions Have Plummeted EM EPS Net Revisions Have Plummeted EM EPS Net Revisions Have Plummeted EM share prices typically lead EPS by about nine months. In 2016, EM stocks bottomed in January-February, yet EPS did not begin to post gains until December 2016. Even if EM corporate profits are to contract in the fourth quarter of this year, EM share prices, being forward looking, will likely begin to wobble soon. Poor EM Equity Breadth There is also evidence of poor breadth in the EM equity universe, especially compared to the U.S. equity market. First, the rally in the EM equally-weighted index - where all individual stocks have equal weights - has substantially lagged the market cap-weighted index since mid 2017. This suggests that only a few large-cap companies have contributed a non-trivial share of capital gains. Second, the EM equal-weighted stock index's and EM small-caps' relative share prices versus their respective U.S. counterparts have fallen rather decisively in the past six weeks (Chart I-9, top and middle panels). While the relative performance of market cap-weighted indexes has not declined that much, it has still rolled over (Chart I-9, bottom panel). We compare EM equity performance with that of the U.S. because DM ex-U.S. share prices themselves have been rather sluggish. In fact, DM ex-U.S. share prices have barely rebounded since the February correction. Third, EM technology stocks have begun underperforming their global peers (Chart I-10). This is a departure from the dynamics that prevailed last year, when a substantial share of EM outperformance versus DM equities was attributed to EM tech outperformance versus their DM counterparts and tech's large weight in the EM benchmark. Chart I-9EM Versus U.S. Equities: Relative ##br##Performance Is Reversing EM Versus U.S. Equities: Relative Performance Is Reversing EM Versus U.S. Equities: Relative Performance Is Reversing Chart I-10EM Tech Has Started ##br##Underperforming DM Tech EM Tech Has Started Underperforming DM Tech EM Tech Has Started Underperforming DM Tech Finally, the relative advance-decline line between EM versus U.S. bourses has been deteriorating (Chart I-11). This reveals that EM equity breadth - the advance-decline line - is substantially worse relative to the U.S. Chart I-11EM Versus U.S.: Relative Equity Breadth Is Very Poor EM Versus U.S.: Relative Equity Breadth Is Very Poor EM Versus U.S.: Relative Equity Breadth Is Very Poor Bottom Line: Breadth of EM equity performance versus DM/U.S. has worsened considerably. This bodes ill for the sustainability of EM outperformance versus DM/U.S. We continue to recommend an underweight EM versus DM position within global equity portfolios. Three Pillars Of EM Stocks EM equity performance is by and large driven by three sectors: technology, banks (financials) and commodities. Table I-1 illustrates that technology, financials and commodities (energy and materials) account for 66% of the EM MSCI market cap and 75% of MSCI EM total (non-diluted) corporate earnings. Therefore, getting the outlook of these sectors right is crucial to the EM equity call. Table I-1EM Equity Sectors: Earnings & Market Cap Weights EM: Disguised Risks EM: Disguised Risks Technology Four companies - Alibaba, Tencent, Samsung and TSMC - account for 17% of EM and 58% of EM technology market cap, respectively. This sector can be segregated into hardware tech (Samsung and TSMC) and "new concept" stocks (Alibaba and Tencent). We do not doubt that new technologies will transform many industries, and there will be successful companies that profit enormously from this process. Nevertheless, from a top-down perspective, we can offer little insight on whether EM's "new concept" stocks such as Alibaba and Tencent are cheap or expensive, nor whether their business models are proficient. Further, these and other global internet/social media companies' revenues are not driven by business cycle dynamics, making top-down analysis less imperative in forecasting their performance. We can offer some insight for technology hardware companies such as Samsung and TSMC. Chart I-12 demonstrates that semiconductor shipment-to-inventory ratios have rolled over decisively in both Korea and Taiwan. In addition, semiconductor prices have softened of late (Chart I-13) Together, this raises a red flag for technology hardware stocks in Asia. Chart I-12Asia's Semiconductor Industry Asia's Semiconductor Industry Asia's Semiconductor Industry Chart I-13Semiconductor Prices: A Soft Spot? Semiconductor Prices: A Soft Spot? Semiconductor Prices: A Soft Spot? Finally, Chart I-14 compares the current run-up in U.S. FANG stocks (Facebook, Amazon, Netflix and Google) with the Nasdaq mania in the 1990s. An equal-weighted average stock price index of FANG has risen by 10-fold in the past four and a half years. Chart I-14U.S. FANG Stocks Now ##br##And 1990s Nasdaq Mania U.S. FANG Stocks Now And 1990s Nasdaq Mania U.S. FANG Stocks Now And 1990s Nasdaq Mania A similar 10-fold increase was also registered by the Nasdaq top 100 stocks in the 1990s over eight years (Chart I-14). While this is certainly not a scientific approach, the comparison helps put the rally in "hot" technology stocks into proper historical perspective. The main take away here is that even by bubble standards, the recent acceleration in "new concept" stocks has been too fast. That said, it is impossible to forecast how long any mania will persist. This has been and remains a major risk to our investment strategy of being negative on EM stocks. In sum, there is little visibility in EM "new concept" tech stocks. Yet Asia's manufacturing cycle is rolling over, entailing downside risks to tech hardware businesses. Putting all this together, we conclude that it is unlikely that EM tech stocks will be able to drive the EM rally and outperformance in 2018 as they did in 2017. Banks We discussed the outlook for EM bank stocks in our February 14 report,2 and will not delve into additional details here. In brief, several countries' banks have boosted their 2017 profits by reducing their NPL provisions. This has artificially boosted profits and spurred investors to bid up bank equity prices. We believe banks in a number of EM countries are meaningfully under-provisioned and will have to augment their NPL provisions. The latter will hurt their profits and constitutes a major risk for EM bank share prices. Energy And Materials The outlook for absolute performance of these sectors is contingent on commodities prices. Industrial metals prices are at risk of slower capex in China. The mainland accounts for 50% of global demand for all industrial metals. Oil prices are at risk from traders' record-high net long positions in oil futures, according to CFTC data (Chart I-15, top panel). Traders' net long positions in copper are also elevated, according to the data from the same source (Chart I-15, bottom panel). Hence, it may require only some U.S. dollar strength and negative news out of China for these commodities prices to relapse. Chart I-15Traders' Net Long Positions In ##br##Oil And Copper Are Very Elevated Traders' Net Long Positions In Oil And Copper Are Very Elevated Traders' Net Long Positions In Oil And Copper Are Very Elevated How do we incorporate the improved balance sheets of materials and energy companies into our analysis? If and as commodities prices slide, share prices of commodities producers will deflate in absolute terms. However, this does not necessarily mean they will underperform the overall equity benchmark. Relative performance dynamics also depend on the performance of other sectors. Commodities companies could outperform the overall equity benchmark amid deflating commodities prices if other equity sectors drop more. In brief, the improved balance sheets of commodities producers may be reflected in terms of their relative resilience amid falling commodities prices but will still not preclude their share prices from declining in absolute terms. Bottom Line: If EM bank stocks and commodities prices relapse as we expect, the overall EM equity index will likely experience a meaningful selloff and underperform the DM/U.S. benchmarks. Exchange Rate Pegs Versus U.S. Dollar With the U.S. dollar depreciating in the past 12 months, pressure on exchange rate regimes that peg their currencies to the dollar has subsided. These include but are not limited to Hong Kong, Saudi Arabia and the United Arab Emirates (UAE). As a result, these countries' interest rate differentials versus the U.S. have plunged (Chart I-16). In short, domestic interest rates in these markets have risen much less than U.S. short rates. This has kept domestic liquidity conditions easier than they otherwise would have been. However, maneuvering room for these central banks is narrowing. In Hong Kong, the exchange rate is approaching the lower bound of its narrow band (Chart I-17). As it touches 7.85, the Hong Kong Monetary Authority (HKMA) will have no choice but to tighten liquidity and push up interest rates. Chart I-16Markets With U.S. Dollar Peg: ##br##Policymakers' Maneuvering Window Is Closing Markets With U.S. Dollar Peg: Policymakers' Maneuvering Window Is Closing Markets With U.S. Dollar Peg: Policymakers' Maneuvering Window Is Closing Chart I-17Hong Kong: Interest ##br##Rates Are Heading Higher Hong Kong: Interest Rates Are Heading Higher Hong Kong: Interest Rates Are Heading Higher In Saudi Arabia and the UAE, the monetary authorities have used the calm in their foreign exchange markets over the past year to not match the rise in U.S. short rates (Chart I-18A and Chart I-18B). However, with their interest rate differentials over U.S. now at zero, these central banks will have no choice but to follow U.S. rates to preserve their currency pegs.3 Chart I-18ASaudi Arabian Interest Rates Will Rise The UAE Interest Rates Will Rise The UAE Interest Rates Will Rise Chart I-18BThe UAE Interest Rates Will Rise Saudi Arabian Interest Rates Will Rise Saudi Arabian Interest Rates Will Rise If U.S. interest rates were to move above local rates in Saudi Arabia and the UAE, those countries' currencies will come under considerable depreciation pressure because capital will move from local currencies into U.S. dollars. Hence, if U.S. short rates move higher, which is very likely, local rates in these and other Gulf countries will have to rise if their exchange rate pegs are to be preserved. Neither the Hong Kong dollar nor Gulf currencies are at risk of devaluation. The monetary authorities there have enough foreign currency reserves to defend their respective pegs. Nevertheless, the outcome will be domestic liquidity tightening in the Gulf's and Hong Kong's banking system. In addition, potentially lower oil prices will weigh on Gulf bourses and China's slowdown will hurt growth and equity sentiment in Hong Kong. All in all, equity markets in Gulf countries and Hong Kong have probably seen their best in terms of absolute performance. Potential negative external shocks and higher interest rates due to Fed tightening have darkened the outlook for these bourses. Bottom Line: Local liquidity in Gulf markets and Hong Kong is set to tighten. Share prices in these markets have probably topped out. However, given these equity markets have massively underperformed the EM equity benchmark, they are unlikely to underperform when the overall EM index falls. Hence, we do not recommend underweighting these bourses within an EM equity portfolio. For asset allocators, a neutral or overweight allocation to these bourses is warranted. Arthur Budaghyan, Senior Vice President Emerging Markets Strategy arthurb@bcaresearch.com 1 Please see Emerging Markets Strategy Special Report "China's "De-Capacity" Reforms: Where Steel & Coal Prices Are Headed," dated November 22, 2017; the link is available on page 16. 2 Please see Emerging Markets Strategy Special Report "EM Bank Stocks Hold The Key," dated February 14, 2018; the link is available on page 16. 3 Please see BCA's Frontier Markets Strategy Special Report "United Arab Emirates: Domestic Tailwinds, External Headwinds," dated March 12, 2018. The link is available on fms.bcaresearch.com. Equity Recommendations Fixed-Income, Credit And Currency Recommendations

Highlights The global economic mini-cycle is set to weaken while the euro is set to grind higher. Upgrade Telecoms to overweight. Also overweight Healthcare and Airlines. Underweight Banks, Basic Materials and Energy. Overweight France, Ireland, U.K., Switzerland and Denmark. Underweight Italy, Spain, Sweden and Norway. The Eurostoxx50 will struggle to outperform the S&P500. Feature We are strong believers in Investment Reductionism, a philosophy synthesized from the Pareto Principle and Occam's Razor.1 Investment reductionism offers a liberating thesis - the incessant barrage of investment research, newsfeeds and ten thousand word commentaries is largely superfluous to the investment process. What seems like a complexity of investment choice usually reduces to getting a few over-arching decisions right. Chart of the WeekIn Quadrant 4, Overweight Domestic Defensives And Underweight International Cyclicals The Four Quadrants Of Cyclical Investing The Four Quadrants Of Cyclical Investing For equity sector and country allocation, two over-arching decisions dominate: Whether the global economic mini-cycle is set to strengthen or weaken (Chart I-2). Whether the domestic currency is set to strengthen or weaken. Chart I-2The Empirical Evidence For Credit And Economic Mini-Cycles Is Irrefutable The Empirical Evidence For Credit And Economic Mini-Cycles Is Irrefutable The Empirical Evidence For Credit And Economic Mini-Cycles Is Irrefutable The four permutations of these two decisions create the four quadrants of cyclical investing (Chart of the Week). Right now, European investors find themselves in quadrant four: the global economic mini-cycle is set to weaken while the euro is set to grind higher. This favours an overweight stance to defensives, especially domestic-focused defensives. Therefore today, we are upgrading Telecoms to overweight. We also recommend an underweight stance to the most cyclical sectors, especially international-focused cyclicals such as Basic Materials and Energy. Country allocation then just drops out of this sector allocation. The Global Economic Mini-Cycle Is Set To Weaken We can predict the changes of the seasons and the tides of the sea with utmost precision. How? Not because we have an ingenious leading indicator for the seasons and tides, but because we recognise that these phenomena follow perfectly regular cycles. Regular cycles create predictability. Significantly, global bank credit flows also exhibit remarkably regular cycles with half-cycle lengths averaging around eight months. Recognizing these mini-cycles is immensely powerful because, just as for the seasons and the tides, it creates predictability. Furthermore, if most investors are unaware of these cycles, the next turn will not be discounted in today's price - providing a compelling investment opportunity for those who do recognise the predictability. The empirical evidence for credit mini-cycles is irrefutable. The theoretical foundation is also rock solid, based on an economic model called the Cobweb Theory.2 This states that in any market where supply lags demand, both the quantity supplied and the price must oscillate. Given that credit supply clearly lags credit demand, the quantity of credit supplied and its price (the bond yield) must experience mini-cycles (Chart I-3). And as the quantity of credit supplied is a marginal driver of economic activity, economic activity will also experience the same regular oscillations. Today, the global 6-month credit impulse is turning from mini-upswing to mini-downswing, with all three subcomponents - the euro area, the U.S. and China - now in decline (Chart I-4). This is exactly in line with prediction. Mini half-cycles average eight months, and the latest mini-upswing started eight months ago. Chart I-3The Global Economic Mini-Cycle##br## Is Set To Weaken The Global Economic Mini-Cycle Is Set To Weaken The Global Economic Mini-Cycle Is Set To Weaken Chart I-4All Three Subcomponents Of The Global 6-Month ##br##Credit Impulse Are Now Declining All Three Subcomponents Of The Global 6-Month Credit Impulse Are Now Declining All Three Subcomponents Of The Global 6-Month Credit Impulse Are Now Declining More importantly, as we enter a mini-downswing, we can also predict that global growth is likely to experience at least a modest deceleration through the coming two to three quarters. The Euro Is Set To Grind Higher, Except Versus The Yen Chart I-5Lost In Translation Lost In Translation Lost In Translation Nowadays, mainstream stock markets tend to be eclectic collections of multinational companies which happen to be quoted on bourses in Frankfurt, Paris, New York, and so on. For example, BASF is not really a German chemical company, it is a global chemical company headquartered in Germany. For operational hedging, multinational companies like BASF will intentionally diversify their sales and profits across multiple major currencies, say euros and dollars. But of course, the primary stock market quotation will be in the currency of its home bourse, euros. Therefore, when the euro strengthens, the company's multi-currency profits, translated back into a stronger euro, will necessarily weaken (Chart I-5). Clearly, more domestic-focused companies like telecoms will not experience such a strong currency-translation headwind. We expect the main euro crosses to continue strengthening over the next 8 months, with the exception being the cross versus the Japanese yen. Our central thesis is that the payoff profile for a foreign exchange rate just tracks the bond yield spread. This means that when a central bank has already taken bond yields close to their lower bound, its currency possesses a highly attractive asymmetry called positive skew. In essence, as the ECB is at the realistic limit of ultra-loose policy, long-term expectations for the ECB policy rate possess an asymmetry: they cannot go significantly lower, but they could go significantly higher. Exactly the same applies to long-term expectations for the BoJ policy rate. In contrast, long-term expectations for the Fed policy rate possess full symmetry: they could go either way, lower or higher. This stark asymmetry of central bank 'degrees of freedom' favours the euro and the yen over the dollar. Which Sectors And Countries To Own And Which To Avoid? Pulling together the preceding two sections, the global economic mini-cycle is set to weaken while the euro is set to grind higher. This puts Europe in quadrant four of our four quadrant framework for cyclical investing. Unsurprisingly, the relative performance of the most cyclical sectors - Banks, Basic Materials and Energy - very closely tracks the regular mini-cycles in the global 6-month credit impulse. In a mini-downswing these cyclical sectors always underperform (Chart I-6, Chart I-7 and Chart I-8). Accordingly, underweight these three sectors on a two to three quarter horizon. Chart I-6In A Mini-Downswing, ##br##Banks Always Underperform In A Mini-Downswing, Banks Always Underperform In A Mini-Downswing, Banks Always Underperform Chart I-7In A Mini-Downswing,##br## Basic Materials Always Underperform In A Mini-Downswing, Basic Materials Always Underperform In A Mini-Downswing, Basic Materials Always Underperform Chart I-8In A Mini-Downswing,##br## Energy Always Underperforms In A Mini-Downswing, Energy Always Underperform In A Mini-Downswing, Energy Always Underperform Conversely, overweight the relatively defensive Healthcare sector. Also overweight the Airlines sector. Airlines' performance is a mirror-image of the oil price cycle, given that aviation fuel comprises the sector's main variable cost. Furthermore, as aviation fuel is priced in dollars, it also insulates European Airlines against a strengthening euro. Today, we are also upgrading the Telecoms sector to overweight given its relative non-cyclicality (Chart I-9), its domestic-focus, and the excessively negative groupthink towards it (Chart I-10). Chart I-9In A Mini-Downswing, ##br##Telecoms Always Outperform In A Mini-Downswing, Telecoms Always Outperform In A Mini-Downswing, Telecoms Always Outperform Chart I-10Telecoms Are Due ##br##A Trend Reversal Telecoms Are Due A Trend Reversal Telecoms Are Due A Trend Reversal In summary: Overweight: Healthcare, Telecoms, and Airlines Underweight: Banks, Basic Materials and Energy Then to arrive at a country allocation, just combine the cyclical view on the major sectors with the country sector skews in Box 1. The result is the following unchanged European equity market allocation. Overweight: France, Ireland, U.K., Switzerland and Denmark Neutral: Germany and Netherlands Underweight: Italy, Spain, Sweden and Norway Lastly, what is the prognosis for the Eurostoxx50 relative to the S&P500? Essentially, this reduces to a battle between the multinational cyclicals - especially banks - that dominate euro area bourses and the multinational technology giants that dominate the U.S. stock market. With the global economic mini-cycle set to weaken and the euro set to grind higher, the Eurostoxx50 will struggle to outperform the S&P500. Box 1: The Vital Few Sector Skews That Drive Country Relative Performance For major equity indexes in the euro area, the dominant sector skews that drive relative performance are as follows: Germany (DAX) is overweight Chemicals, underweight Banks. France (CAC) is underweight Banks and Basic Materials. Italy (MIB) is overweight Banks. Spain (IBEX) is overweight Banks. Netherlands (AEX) is overweight Technology, underweight Banks. Ireland (ISEQ) is overweight Airlines (Ryanair) which is, in effect, underweight Energy. And for major equity indexes outside the euro area: The U.K. (FTSE100) is effectively underweight the pound. Switzerland (SMI) is overweight Healthcare, underweight Energy. Sweden (OMX) is overweight Industrials. Denmark (OMX20) is overweight Healthcare and Industrials. Norway (OBX) is overweight Energy. The U.S. (S&P500) is overweight Technology, underweight Banks. Dhaval Joshi, Senior Vice President Chief European Investment Strategist dhaval@bcaresearch.com 1 The Pareto Principle, often known as the 80-20 rule, says that 80% of effects come from just 20% of causes. Occam's Razor says that when there are many competing explanations for the same effect, the simplest explanation is usually the best. 2 Please see the European Investment Strategy Special Report 'The Cobweb Theory And Market Cycles' published on January 11, 2018 and available at eis.bcaresearch.com. Fractal Trading Model* This week's recommended trade is to short the Helsinki OMX versus the Eurostoxx600. Apply a profit target of 3% with a symmetrical stop-loss. In other trades, we are pleased to report that short Japanese Energy versus the market achieved its 8% profit target at which it was closed. This leaves four open positions. For any investment, excessive trend following and groupthink can reach a natural point of instability, at which point the established trend is highly likely to break down with or without an external catalyst. An early warning sign is the investment's fractal dimension approaching its natural lower bound. Encouragingly, this trigger has consistently identified countertrend moves of various magnitudes across all asset classes. Chart 11 Helsinki OMX Vs. Eurostoxx 600 Helsinki OMX Vs. Eurostoxx 600 The post-June 9, 2016 fractal trading model rules are: When the fractal dimension approaches the lower limit after an investment has been in an established trend it is a potential trigger for a liquidity-triggered trend reversal. Therefore, open a countertrend position. The profit target is a one-third reversal of the preceding 13-week move. Apply a symmetrical stop-loss. Close the position at the profit target or stop-loss. Otherwise close the position after 13 weeks. Use the position size multiple to control risk. The position size will be smaller for more risky positions. * For more details please see the European Investment Strategy Special Report "Fractals, Liquidity & A Trading Model," dated December 11, 2014, available at eis.bcaresearch.com Fractal Trading Model Recommendations Equities Bond & Interest Rates Currency & Other Positions Closed Fractal Trades Trades Closed Trades Asset Performance Currency & Bond Equity Sector Country Equity Indicators Bond Yields Chart II-1Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Chart II-2Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Chart II-3Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Chart II-4Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Interest Rate Chart II-5Indicators To Watch##br## - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Chart II-6Indicators To Watch##br## - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Chart II-7Indicators To Watch##br## - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Chart II-8Indicators To Watch##br## - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations

Highlights Global trade data we track as indicators of current and expected commodity demand - particularly EM import volumes - will provide a lift to oil prices over the course of 1H18. We continue to expect global oil demand growth, led by EM growth, to rise by 1.7mm and 1.6mm b/d this year and next, respectively. Against this still-positive backdrop, heightened geopolitical tensions are ratcheting up volatility in our outlook. A global trade war - now a factor following the Trump administration's bellicose rhetoric - would reduce our oil demand forecasts. That said, our Geopolitical Strategy team notes past U.S. administrations have used the threat of trade wars to cheapen the USD, which would be bullish commodities.1 Energy: Overweight. Even though it is not a surprise, the anti-trade rhetoric coming out of Washington is a wake-up call for oil markets. Trade is deeply entwined with EM income growth, which drives commodity demand globally. A shock to global trade would be a shock to aggregate demand and oil demand, hence oil prices. Base Metals: Neutral. President Trump announced 25% and 10% tariffs on steel and aluminum last week. Markets are fretting over the possibility of a full-blown trade war if the U.S. zeroes in on China, as it apparently is doing, and Washington's allies impose retaliatory tariffs, should the Trump administration level tariffs on their exports.2 Precious Metals: Neutral. A global trade war would boost gold's appeal, and we continue to recommend it as a strategic portfolio hedge. Ags/Softs: Underweight. In a series of tweets earlier this week, President Trump suggested concessions on steel and aluminum tariffs to Canada and Mexico in exchange for concessions on NAFTA. Neither Mexico nor Canada supported this link. Feature Our short-term models of global trade volumes continue to indicate EM imports - a key variable in our analysis of industrial commodity demand - will continue to grow (Chart of The Week).3 This will be supportive of commodity prices generally, particularly oil, in 1H18. In 2H18 and beyond, the outlook is getting cloudier. And more volatile. A fundamental underpinning of our oil-demand expectation for this year and next is that a slowdown in China in 2H18 will be offset by a pickup in EM and DM aggregate demand - and trade volumes - ex-China, in line with the IMF's expectation for EM and DM growth this year and next (Chart 2).4 DM markets and India likely will take up the slack created by China's slight slowdown. In fact, India already is moving out ahead: Based on official data, India's economy grew at a 7.2% rate in December, topping China's 6.8% rate, according to a Reuters survey at the end of February.5 Chart 1EM Import Volumes Will Continue To Grow EM Import Volumes Will Continue To Grow EM Import Volumes Will Continue To Grow Chart 2EM Growth Ex-China Keeps Oil Demand Strong EM Growth Ex-China Keeps Oil Demand Strong EM Growth Ex-China Keeps Oil Demand Strong EM Import Volumes Are Important To Oil Prices EM demand drives global oil demand. Over the long haul, the relationship between oil prices and EM import volumes has been strong: A 1% increase in EM import volumes has translated into roughly a 1% increase in Brent and WTI prices since 2000 (Chart 3).6 These variables all are linked: EM economic growth correlates with higher incomes, higher commodity demand and higher import volumes. All else equal (i.e., assuming supply is unchanged), this increases oil prices (via higher demand). The biggest weight in the EM import volume variable is China's imports, so the sustainability of the current Chinese growth is important, as is how smoothly policymakers there slow the economy in 2H18 as we expect. Chinese imports are sensitive to industrial output, which is captured by the Li Keqiang index, global PMIs, and FX markets (Chart 4). Provided policymakers can maintain income growth as the country pivots - once again - away from heavy industrial-export-led growth to consumer- and services-led growth, oil demand will not be materially affected, and should continue growing. At present, China's import volume growth has leveled off as Chart 4 shows, indicating income growth is holding up. China recently guided toward a GDP growth target of 6.5% for this year. Given they have a solid track record of achieving such targets, this indicates that they do not expect a severe slowdown. However, a hard economic landing - always a risk in transforming such a huge economy - would force us to reconsider our growth estimates. Chart 3EM Imports Supportive Of Prices EM Imports Supportive Of Prices EM Imports Supportive Of Prices Chart 4Growth In China's Import Volumes Levels Off Growth In China's Import Volumes Levels Off Growth In China's Import Volumes Levels Off In our analysis, we do not yet have enough information to determine whether the Trump administration will launch a trade war with China. The impact of President Trump's proposed steel and aluminum tariffs on China is de minimis: Chinese exports of these commodities to the U.S. amount to less than 0.2% of China's total exports, as our colleagues at BCA Research's China Investment Strategy note in this week's analysis.7 The big risk from these tariffs lies in what happens next. If they are the first step in additional tariffs directed at industries far more important to China, they could invite retaliation.8 If the recently announced tariffs expand to a global trade war - already the EU, Canada and Mexico have indicated they will not sit idly by while tariffs are imposed on exporters in their countries - the threat to world trade, and EM imports in particular, rises considerably. This would threaten crude oil prices. Trade Wars And Oil Flows Other than exports from the U.S., which could be targeted by states retaliating against tariffs, it is difficult to imagine the flow of oil being affected by a trade war in the short term: Oil is an internationally traded commodity, and traders adapt quickly to disruptions - e.g., re-routing crude flows in response to events affecting production, consumption, inventories or shipping.9 However, it does not require much of an intellectual leap to see EM trade volumes being significantly impacted by a trade war via the slowing in income growth globally. Such a turn of events would reduce aggregate demand in that part of the market - EM - that is responsible for the bulk of commodity demand growth. Falling EM trade volumes would be the natural result of falling incomes. This would be disinflationary, as well, which is not unexpected (Chart 5). We have found a long-term relationship with strong co-movement properties between EM import volumes and U.S. CPI and PCE inflation indexes. Our modelling indicates a 1% decrease (increase) in EM import volumes translates into a decrease (increase) in these U.S. inflation indexes of 15 to 20bp with a 6- to 12-month lag. These are non-trivial quantities: For instance, a decline in EM import volumes of 10% or more could shave as much as 2 points from U.S. inflation (Chart 6). Such a disinflation impulse once again coming from the real economy would, in all likelihood, force the Fed to throttle back on its interest-rate normalization policy or reverse course. Chart 5Lower EM Import Volumes##BR##Would Take U.S. Inflation Lower Lower EM Import Volumes Would Take U.S. Inflation Lower Lower EM Import Volumes Would Take U.S. Inflation Lower Chart 6EM Trade Volumes##BR##Over Time EM Trade Volumes Over Time EM Trade Volumes Over Time Volatility Likely To Pick Up As we noted above, our Geopolitical Strategy (GPS) colleagues point out the threat of tariffs and quotas has been used by U.S. administrations in the past to get systemically important central banks to support a weaker USD.10 The end game always is to spur exports to boost economic growth. The downside risk from trade wars discussed above is fairly obvious. Not so obvious is the upside commodity-price risk arising from a depreciation in the USD, which falls out of a strategy of using the threat of tariffs to ultimately weaken the USD. Our GPS colleagues quote Paul Volcker's summary of a similar gambit by Richard Nixon, who also ran a mercantilist presidential campaign in the late 1960s, to ultimately weaken the USD: The conclusion reached by some that the United States shrugged off responsibilities for the dollar and for leadership in preserving an open world order does seem to me a misinterpretation of the facts ... The devaluation itself was the strongest argument we had to repel protectionism. The operating premise throughout was that a necessary realignment of exchange rates and other measures consistent with more open trade and open capital markets could accomplish the necessary balance-of-payments adjustment. It is impossible to say whether such a depreciation is the Trump administration's end-game. However, if it is, this would be bullish commodities generally, gold and base metals in particular. For oil, a weaker USD would be bullish, but, as we have shown recently, fundamentals now drive oil price formation.11 Bottom Line: Current and expected EM import volumes indicate oil prices will continue to be supported by rising demand over the course of 1H18. We continue to expect global oil demand growth, led by EM growth, to rise by 1.7mm and 1.6mm b/d this year and next, respectively. Still, heightened geopolitical tensions brought on by bellicose trade signaling from the U.S. are ratcheting up volatility in our outlook. A global trade war would force us to lower our forecast for Brent and WTI crude oil from our current $74 and $70/bbl expectations for this year. However, as our Geopolitical Strategy team notes, past U.S. administrations have used the threat of trade wars to cheapen the USD. Should this turn out to be the Trump administration's strategy, the weaker USD would be bullish for commodity prices. Robert P. Ryan, Senior Vice President Commodity & Energy Strategy rryan@bcaresearch.com Hugo Bélanger, Research Analyst Commodity & Energy Strategy HugoB@bcaresearch.com 1 Please see BCA Research's Geopolitical Strategy Weekly Report "Market Reprices Odds Of A Global Trade War," published March 6, 2018. It is available at gps.bceresearch.com. Our colleagues note, "Import tariffs ought to be bullish for the greenback, given that they lead to higher domestic policy rates as inflationary pressures rise (and not just passing ones). However, as the previous two examples of U.S. protectionism teach us, the U.S. uses threats of tariffs so that it can get a cheaper USD. From Washington's perspective, both accomplish the same thing. Intriguingly, the U.S. dollar has sold off on the most recent news of protectionism." (Emphasis added.) 2 Please see BCA Research's Commodity & Energy Strategy Weekly Report "Global Aluminum Deficit Set To Ease," published March 1, 2018, particularly the discussion beginning on p. 7. It is available at ces.bcaresearch.com. 3 Our 3-month ahead projections are based on two components: (1) the first principal component of a basket of currencies exposed to global growth; and (2) lagged U.S. monetary variables. Our modeling shows that exchange rates are forward-looking variables containing information of future fundamentals. Therefore, by selecting currencies exposed to global and EM growth, this allows us to run short-term forecasts of EM import volumes. The analysis is also confirmed using Granger-causality tests. 4 Please see "Brighter Prospects, Optimistic Markets, Challenges Ahead," in the IMF's January 22, 2018, World Economic Outlook Update, which notes its revised forecast calling for stronger global growth reflects improved DM growth expectations. 5 Please see "India regains status as fastest growing major economy," published by reuters.com on February 28, 2018. 6 These results fall out of co-integration regressions. 7 Please see BCA Research's China Investment Strategy Weekly Report "China And The Risk Of Escalation," published March 7, 2018. It is available at cis.bcaresearch.com. See also footnote 2 above. 8 President Trump reportedly is considering broadening the tariffs on a range of Chinese imports and limiting Chinese investment in the U.S., to punish the country for "its alleged theft of intellectual property," according to Bloomberg. Please see "U.S. Considers Broad Curbs on Chinese Imports, Takeovers," published by Bloomberg.com, March 6, 2018. 9 The U.S. is exporting a little over 1.5mm b/d of crude oil and 4.6mm b/d of refined products at present, according to EIA data. A drawn-out trade war resulting in U.S. oil exports being hit with retaliatory tariffs or quotas could derail the expansion of crude exports brought on by the growth in shale-oil output in America. The IEA expects the U.S. to account for the largest increase in crude exports in the world between now and 2040, "propelling the region above Russia, Africa and South America in the global rankings." This has the effect of reducing net U.S. crude imports to 3mm b/d by 2040 from 7mm b/d at present. An increase in product exports - from 2mm b/d to 4mm b/d - makes the U.S. a net exporter of crude and product, based on the IEA's analysis. The largest demand for crude imports comes from Asia over this period, which grows 9mm b/d to 30mm b/d in total. Please see "WEO Analysis: A sea change in the global oil trade," published by the IEA February 23, 2018, on its website at iea.org. 10 We urge our readers to pick up BCA Research's Geopolitical Strategy Weekly Report cited in footnote 1 above, which lays out our GPS team's analytical framework regarding trade wars. They note, "If constraints to trade protectionism were considerable, Trump would not have the ability to surprise the markets with bellicose rhetoric on a whim. BCA Research's Geopolitical Strategy cannot predict individual triggers for events. But our framework allows us to elucidate the constraint context in which policymakers operate. On protectionism, Trump operates in a poorly constrained context. This is why we have been alarmist on trade since day one." 11 We found that the more backwardated oil forward curves are the less impact the USD has on the evolution of prices. Please see BCA Research's Commodity & Energy Strategy Weekly Report "OPEC 2.0 Getting Comfortable With Higher Prices," published on February 22, 2018. It is available at ces.bcaresearch.com. Investment Views and Themes Recommendations Strategic Recommendations Tactical Trades Commodity Prices and Plays Reference Table Trade Tensions Cloud Oil Outlook Trade Tensions Cloud Oil Outlook Trades Closed in 2018 Summary of Trades Closed in 2017 Trade Tensions Cloud Oil Outlook Trade Tensions Cloud Oil Outlook

Highlights This past week, oil ministers from the Kingdom of Saudi Arabia (KSA) and Russia - OPEC 2.0's putative leaders - separately indicated increased comfort with higher prices over the next year or so.1 This suggests they are converging on a common production-management strategy, which accommodates KSA's need for higher prices over the short term to support the IPO of Saudi Aramco, and Russia's longer term desire to avoid reaching price levels where U.S. shale-oil production is massively incentivized to expand. We believe OPEC 2.0's production cuts will be extended to year-end, given signaling by Khalid Al-Falih, KSA's energy minister. As a result, we expect Brent and WTI crude oil prices to average $74 and $70/bbl this year, respectively (Chart Of The Week). These expectations are up from our previous estimates of $67 and $63/bbl, which were premised on curtailed production slowly being returned to market beginning in July. For next year, the extended cuts could lift Brent and WTI to $67 and $64/bbl, up from our previous expectations of $55 and $53/bbl, respectively. Extending OPEC 2.0's production cuts will accelerate OECD inventory draws, which have been faster than expected. Higher prices caused by maintaining the cuts will lift U.S. shale production more than our earlier estimates. Backwardations in both Brent and WTI forward curves will remain steep in this regime, muting the impact of Fed policy on oil prices. Energy: Overweight. We are getting long Dec/18 $65/bbl Brent calls vs. short Dec/18 $70/bbl calls on the back of our updated price forecast. We also are taking profits on our long 4Q19 $55/bbl Brent puts vs. short 4Q19 $50/bbl Brent puts, which were up 27.4% as of Tuesday's close. Base Metals: Neutral. The U.S. Commerce Department proposed "Section 232" tariffs and quotas on U.S. aluminum and steel imports, following national security reviews. President Trump has until mid-April to respond, and we expect him to go through with one of the three proposed options. Precious Metals: Gold remains range-bound around $1,350/oz, as markets wrestle with the likely evolution of the Fed's rate-hiking regimen. Ags/Softs: Underweight. USDA economists project grain and soybean prices to slowly rise over the next 10 years, according to agriculture.com. Feature Chart Of The WeekBCA Lifts Oil Price Forecasts BCA Lifts Oil Price Forecasts BCA Lifts Oil Price Forecasts Over the past week, comments from Saudi and Russian oil ministers indicate they are more comfortable with maintaining OPEC 2.0's production cuts to end-2018, which, along with strong global demand growth, raises the odds Brent crude oil prices will exceed $70/bbl this year, and possibly next. Whether this is the result of the Saudi's need for higher prices to support the Aramco IPO, or it reflects an assessment by OPEC 2.0's leaders that the world economy can absorb higher prices without damaging demand over the short term is not clear. Markets have yet to receive what we could consider definitive forward guidance from OPEC 2.0 leadership, indicating that recent signaling could be foreshadowing the coalition's new policy. We are raising the odds that it is, and are moving our Brent and WTI forecasts higher for this year and next. Lifting 2018 Brent, WTI Forecasts To $74 And $70/bbl Maintaining OPEC 2.0's production cuts to end-2018 will lift average Brent and WTI crude oil prices to $74 and $70/bbl, respectively, this year, based on our updated supply-demand balances modeling (Chart Of The Week). This is not definitive OPEC 2.0 policy guidance: KSA's and Russia's oil ministers indicated they expect such an outcome in separate statements, and not, as has been the case with previous announcements, at a joint press conference.2 We are assuming the odds strongly favor such an outcome, and give an 80% weight to it. The remaining 20% reflects our previous expectation that OPEC 2.0's production cuts would cease at end-June, and curtailed volumes would slowly be restored over 2H18. Resolving this in favor of the former expectation would lift our price expectations to $76 and $73/bbl for Brent and WTI this year, and $70 and $68/bbl next year. These expectations are up from our previous estimates of $67 and $63/bbl for Brent and WTI prices this year, which were premised on curtailed OPEC 2.0 production slowly returning to market beginning in July, and a subsequent OECD inventory rebuilding. By maintaining production cuts to year-end, supply-demand balances remain tighter, which keeps inventories drawing for a longer period of time (Chart 2). Higher inventories would have increased the sensitivity of oil prices to the USD, which we showed in research on February 8th 2018. With OPEC 2.0's production cuts maintained throughout the year, OECD inventories will be more depleted by year-end (Chart 3). Extending OPEC 2.0's production cuts to end-2018 would result in an additional 130mm bbls reduction to OECD inventories versus our prior modeling. This means Brent and WTI forward curves will be more backwardated than they would have been had the barrels taken off the market at the beginning of 2017 been slowly restored starting in July of this year, as we earlier expected. Chart 2Fundamental Balances Remain In Deficit Longer Fundamental Balances Remain In Deficit Longer Fundamental Balances Remain In Deficit Longer Chart 3Maintaining Production Cuts Depletes Inventories Even More Maintaining Production Cuts Depletes Inventories Even More Maintaining Production Cuts Depletes Inventories Even More A steeper backwardation in oil forward curves - i.e., the front of the curve trades premium to the deferred contracts - reduces the USD effects on oil, all else equal. In other words, supply-demand fundamentals dominate the evolution of oil prices when forward curves are more backwardated, and the influence of financial variables -the USD in particular - is muted.3 For next year, we assume the volumes cut by OPEC 2.0 are slowly restored to the market over 1H19, lifting Brent and WTI to $67 and $64/bbl on average, up from our previous expectations of $55 and $53/bbl, respectively.4 Higher Shale Output, Strong Global Demand We expect U.S. shale production increases by 1.15mm b/d from December 2017 to December 2018, and another 1.3-1.4mm b/d during calendar 2019. This dominates non-OPEC production growth this year and next (Chart 4, top panel). Due to the supply response of the shales to higher prices in 2018, global production levels would see a net increase from March 2019 and beyond. Our assumption OPEC 2.0 production cuts will be maintained through 2018 puts our OPEC production assessment 0.14mm b/d below U.S. EIA's estimates (Chart 4, bottom panel). On the demand side, we continue to expect non-OECD (EM) growth to push global oil consumption up by 1.7mm b/d this year and 1.6mm b/d next year, respectively (Chart 5). Non-OECD demand is expected to account for 1.24mm b/d and 1.21mm b/d of this growth in 2018 and 2019, respectively (Table 1). Chart 4U.S. Shales Dominate Non-OPEC Supply Growth U.S. Shales Dominate Non-OPEC Supply Growth U.S. Shales Dominate Non-OPEC Supply Growth Chart 5Non-OECD Demand Growth Continues Non-OECD Demand Growth Continues Non-OECD Demand Growth Continues Table 1BCA Global Oil Supply - Demand Balances (mm b/d) OPEC 2.0 Getting Comfortable With Higher Prices OPEC 2.0 Getting Comfortable With Higher Prices Aramco IPO Driving OPEC 2.0's Short-Term Agenda In previous research, we noted what appeared to be a relatively minor divergence between the goals of KSA and Russia when it comes to the level prices each would prefer over the short term. Recent press reports - unattributed, of course - suggest Saudi Aramco officials prefer a Brent price closer to $70/bbl further along the forward curve (two years out) to support their upcoming IPO.5 This obviously would bolster Aramco's oil-export revenues - some 7mm b/d of its 10mm b/d of production are exported - and income, which shareholders would welcome. However, until this past week, Russia's energy minister, Alexander Novak, was signaling a range of $50 to $60/bbl works better for his constituents, i.e., shareholder-owned Russian oil companies. Novak recently amended his range to $50 to $70/bbl for Brent.6 These positions are not irreconcilable. One is shorter term (2 years forward) and the other is longer term, attempting to balance competitive threats over a longer horizon - e.g., from U.S. shale-oil producers, electric vehicles, etc. This most recent indication the leadership of OPEC 2.0 is comfortable with higher prices over the short term is an indication - at least to us - that these issues are being dealt with in a way that allows markets to incorporate forward guidance into pricing of crude oil over the next two years. Beyond that, however, markets will need to hear an articulated strategy containing a post-Aramco IPO view of the world, so that capital can be efficiently allocated. KSA and Russia are in a global competition for foreign direct investment (FDI), and having a fully articulated strategy re how they will manage their production in fast-changing markets - where, for example, shale-oil approaches becoming a "just-in-time" supply option - will be critical. Signing a formal alliance by year-end would support this, but that, too, will require a level of cooperation that runs deeper than what OPEC 2.0 has so far demonstrated, impressive though it may be. Bottom Line: OPEC 2.0 leadership is signalling production cuts will be maintained for the entire year, not, as we expected, left to expire at end-June with curtailed barrels slowly returned to the market over 2H18. While this does not appear to be official policy of the producer coalition yet, we are revising our price expectations in line with tighter markets this year, lower OECD inventories and continued backwardation in Brent and WTI forward curves. OPEC 2.0's shorter-term agenda, driven by KSA's IPO of Saudi Aramco, and its longer-term agenda - maintaining oil's competitive edge and accommodating U.S. shale-oil production (but not too much) - appear to be getting reconciled. Robert P. Ryan, Senior Vice President Commodity & Energy Strategy rryan@bcaresearch.com Matt Conlan, Senior Vice President Energy Sector Strategy mattconlan@bcaresearchny.com Hugo Bélanger, Research Analyst HugoB@bcaresearch.com  1 OPEC 2.0 is the name we coined for OPEC/non-OPEC coalition led by KSA and Russia, has removed some 1.4 to 1.5mm b/d of oil production from the market beginning in 2017. 2 Please see, "Brent crude settles flat, U.S. oil up on short covering," published by reuters.com on February 15th 2018, in which KSA's oil minister Khalid Al-Falih indicated OPEC would maintain production cuts throughout 2018. See also, "On the air of the TV channel 'Russia 24' Alexander Novak summed up the participation in the work of the Russian investment forum 'Sochi-2018,'" published by Ministry of Energy of the Russian Federation on February 15th 2018. Lastly, please see "Saudi Arabia Is Taking a Harder Line on Oil Prices," published by bloomberg.com on February 19th 2018. 3 We discuss this in "OPEC 2.0 vs. The Fed," which was published on February 8th 2018 by BCA Research's Commodity & Energy Strategy. It is available at ces.bcaresearch.com. 4 These expectations are highly conditional. Toward the end of this year, KSA and Russia are indicating the OPEC 2.0 coalition will become a more formal organization, with members signing a long-term alliance. Among other things, OPEC 2.0 members would be expected to build buffer stocks to address any sudden supply outages, in order to maintain orderly markets. Please see "Oil producers to draft long-term alliance deal by end-2018: UAE minister," published by reuters.com on February 15th 2018. 5 Please see "For timing of Aramco IPO, watch forward oil price curve," published by reuters.com on February 19th 2018. 6 Please see reference in footnote 3 and "Russia's Novak says current oil price is acceptable," published by reuters.com on February 15th 2018. Investment Views and Themes Recommendations Strategic Recommendations Tactical Trades Commodity Prices and Plays Reference Table OPEC 2.0 Getting Comfortable With Higher Prices OPEC 2.0 Getting Comfortable With Higher Prices Trades Closed In 2018 Summary Of Trades Closed In 2017 OPEC 2.0 Getting Comfortable With Higher Prices OPEC 2.0 Getting Comfortable With Higher Prices

Highlights The financial landscape has shifted over the past month with the arrival of some inflation 'green shoots' and a major shift in U.S. fiscal policy. Fiscal policy is shaping up to be a major source of demand and a possible headache for the FOMC. Tax cuts and the spending deal will result in fiscal stimulus of about 0.8% of GDP in 2018 and 1.3% in 2019. The latest U.S. CPI and average hourly earnings reports caught investors' attention. However, most other wage measures are consistent with our base-case view that inflation will trend higher in an orderly fashion. If correct, this will allow the FOMC to avoid leaning heavily against the fiscal stimulus. Stronger nominal growth and a patient Fed are a positive combination for risk assets such as corporate bonds and equities. The projected peak in S&P profit growth now occurs later in the year and at a higher level compared with our previous forecast. The bad news is that the fiscal stimulus and budding inflation signs imply that investors cannot count as much on the "Fed Put" to offset negative shocks. Our fixed income strategists have raised their year-end target for the 10-year Treasury yield from around 3% to the 3.3-3.5% range, partly reflecting the U.S. fiscal shock. That said, extreme short positioning and oversold conditions suggest that a consolidation phase is likely in the near term. Loose fiscal and tight money should be bullish for the currency. However, angst regarding the U.S. "twin deficits" problem appears to be weighing on the dollar. We do not believe that fiscal largesse will cause the current account deficit to blow out by enough to seriously undermine the dollar. We still expect a bounce in the dollar, but we cannot rule out further weakness in the near term. Fiscal stimulus could extend the expansion, but the more important point is that faster growth in the coming quarters will deepen the next recession. For now, stay overweight risk assets (equities and corporate bonds), and below benchmark in duration. Feature The financial landscape has shifted over the past month with the arrival of some inflation 'green shoots' and a major shift in U.S. fiscal policy. This has not come as a surprise to BCA's Geopolitical Strategy, which has been flagging the shift away from fiscal conservatism and towards populism for some time, particularly in the U.S. context.1 The move is wider than just in the U.S. In Germany, the Grand Coalition deal was only concluded after Chancellor Merkel conceded to demands for more spending on everything from education to public investment in technology and defense. The German fiscal surplus will likely be fully spent. There is no fiscal room outside of Germany, but the austerity era is over. Japan is also on track to ease fiscal policy this year. The big news, however, is in the U.S. President Trump is moving to the middle ground in order to avoid losing the House in this year's midterm elections. Deficit hawks have mutated into doves with the passage of profligate tax cuts, and Congress is now on the brink of a monumental two-year appropriations bill that will add significantly to the Federal budget deficit (Chart I-1). The deficit will likely rise to about 5½% of GDP in FY2019, up from 3.3% in last year's CBO baseline forecast for that year. This includes the impact of the tax cuts, as well as outlays for disaster relief ($45 billion), the military ($165 billion) and non-defense discretionary items ($131 billion), spread over the next two years. A deal on infrastructure spending would add to this already-lofty total. Chart I-1U.S. Budget Deficit To Reach 5 1/2 % In 2019 U.S. Budget Deficit to Reach 5 1/2 % in 2019 U.S. Budget Deficit to Reach 5 1/2 % in 2019 There is also talk in Congress of re-authorizing "earmarks" - legislative tags that direct funding to special interests in representatives' home districts. Earmarks could add another $50 billion in spending over 2018 and 2019. While not a major stimulative measure, earmarks could further reduce Congressional gridlock and underscore that all pretense of fiscal restraint is gone. Chart I-2Substantial Stimulus In The Pipeline March 2018 March 2018 Chart I-2 presents an estimate of U.S. fiscal thrust, which is a measure of the initial economic impulse of changes in government tax and spending policies.2 The IMF's baseline, done before the tax cuts were passed, suggested that policy would be contractionary this year (about ½% of GDP), and slightly expansionary in 2019. Incorporating the impact of the tax cuts and the Senate deal on spending, the fiscal impulse will now be positive in 2018, to the tune of 0.8% of GDP. Next year's impulse will be even larger, at 1.3%. These figures are tentative, because it is not clear exactly how much of the spending will take place this year versus 2019 and 2020. A lot can change in the coming months as Congress hammers out the final deal. Moreover, the impact on GDP growth will be less than these figures suggest, because the economic multipliers related to tax cuts are less than those for spending. Nonetheless, the key point is that fiscal policy is shaping up to be a major source of demand and a possible headache for the FOMC. The Fed's Dilemma Chart I-3U.S. Inflation Green Shoots U.S. Inflation Green Shoots U.S. Inflation Green Shoots Textbook economic models tell us that the combination of expansionary fiscal policy and tightening monetary policy is a recipe for rising interest rates and a stronger currency. However, it is not clear how much of the coming pickup in nominal GDP growth will be due to inflation versus real growth, given that the U.S. already appears to be near full employment. How will the Fed respond to the new fiscal outlook? We do not believe policymakers will respond aggressively, but much depends on the evolution of inflation. January's 0.3% rise in the core CPI index grabbed investors' attention, coming on the heels of a surprisingly strong average hourly earnings report (AHE). The 3-month annualized core inflation rate surged to 2.9% (Chart I-3). Among the components, the large rent and owners' equivalent rent indexes each rose 0.3% in the month, while medical care services jumped by 0.6%. Also notable was the 1.7% surge in apparel prices, which may reflect 'catch up' with the perky PPI apparel index. More generally, it appears that the upward trend in import price inflation is finally leaking into consumer prices. That said, investors should not get carried away. Most other wage measures, such as unit labor costs, are not flashing red. This is consistent with our base-case view that inflation will trend higher in an orderly fashion over the coming months. Moreover, the Fed's preferred measure, core PCE inflation, is still well below 2%. If our 'gradual rise' inflation view proves correct, it will allow the FOMC to avoid leaning heavily against the fiscal stimulus. We argued in last month's Overview that the new FOMC will strive to avoid major shifts in policy, and that Chair Powell has shown during his time on the FOMC that he is not one to rock the boat. It is doubtful that the FOMC will try to head off the impact of the fiscal stimulus on growth via sharply higher rates, opting instead to maintain the current 'dot plot' for now and wait to see how the stimulus translates into growth versus inflation. Stronger nominal growth and a patient Fed is a positive combination for risk assets such as corporate bonds and equities. Chart I-4 provides an update of our top-down S&P operating profit forecast, incorporating the economic impact of the new fiscal stimulus. We still expect profit growth to peak this year as industrial production tops out and margins begin to moderate on the back of rising wages. However, the projected peak now occurs later in the year and at a higher level compared with our previous forecast, and the whole profile is shifted up. Most of this improvement in the profit outlook is already discounted in prices, but the key point is that the earnings backdrop will remain a tailwind for stocks at least into early 2019. Chart I-4The Profile For S&P EPS Growth Shifts Up The Profile For S&P EPS Growth Shifts Up The Profile For S&P EPS Growth Shifts Up The End Of The Low-Vol Period That said, the U.S. is in the late innings of the expansion and risk assets have entered a new, more volatile phase. We have been warning of upheaval when investor complacency regarding inflation is challenged, because the rally in risk assets has been balanced precariously on a three-legged stool of low inflation, depressed interest rates and modest economic volatility. All it took was a couple of small positive inflation surprises to spark a reset in the market for volatility. The key question is whether February's turmoil represented a healthy market correction or a signal that a bear market is approaching. The good news is that the widening in high-yield corporate bond spreads was muted (Chart I-5). This market has often provided an early warning sign of an approaching major top in the stock market. The adjustment in other risk gauges, such as EM stocks and gold, was also fairly modest. This suggests that equity and volatility market action was largely technical in nature, in the context of extended investor positioning, crowded trades and elevated valuations. There has been no change in the items on our checklist for trimming equity exposure. We presented the checklist in last month's Overview. Our short-term economic growth models for the major countries remain upbeat and our global capital spending indicators are also bullish (Chart I-6). Industrial production in the advanced economies is in hyper-drive as global capital spending growth accelerates (Chart I-7). Chart I-5February's Volatility Reset February's Volatility Reset February's Volatility Reset Chart I-6Near-Term Growth Outlook Still Solid... Near-Term Growth Outlook Still Solid... Near-Term Growth Outlook Still Solid... Chart I-7... Partly Due To Capex Acceleration ... Partly Due to Capex Acceleration ... Partly Due to Capex Acceleration Nonetheless, it will be difficult to put the 'vol genie' back into the bottle. The surge in bond yields has focused market attention on the leverage pressure points in the system. One potential source of volatility is the corporate bond space. This month's Special Report, beginning on page 17, analyses the vulnerability of the U.S. corporate sector to rising interest rates. We conclude that higher rates on their own won't cause significant pain, but the combination of higher rates and a downturn in earnings would lead to a major deterioration in credit quality. Moreover, expansionary fiscal policy and recent inflation surprises have limited the Fed's room to maneuver. Under Fed Chairs Bernanke and Yellen, markets relied on a so-called "Fed Put". When inflation was low and stable, economic slack was abundant and long-term inflation expectations were depressed then disappointing economic data or equity market setbacks were followed by an easing in the expectations for Fed rate hikes. This helped to calm investors' nerves. We do not think that the Powell FOMC represents a regime shift in terms of the Fed's reaction function, but the rise in long-term inflation expectations and the January inflation report have altered the Fed's calculus. The new Committee will be more tolerant of equity corrections and tighter financial conditions than in the past. Indeed, some FOMC members would welcome reduced frothiness in financial markets, as long as the correction is not large enough to undermine the economy (i.e. a 20% or greater equity market decline). The implication is that we are unlikely to see a return of market volatility to the lows observed early this year. Bonds: Due For Consolidation Chart I-8Market Is Converging With Fed 'Dots' Market is Converging With Fed 'Dots' Market is Converging With Fed 'Dots' A lot of adjustment has already taken place in the bond market. Market expectations for the Fed funds rate have moved up sharply since last month (Chart I-8). The market now discounts three rate hikes in 2018, in line with the Fed 'dot plot'. Expectations still fall short of the Fed's plan in 2019, but the market's estimate of the terminal fed funds rate has largely converged with the Fed's dots. Meanwhile, the latest Bank of America Merrill Lynch Global Fund Manager Survey revealed that investors cut bond allocations to the lowest level in the 20-year history of the report. All of this raises the odds that the rise in U.S. and global bond yields will correct before the bear phase resumes. Our fixed income strategists have raised their year-end target for the 10-year Treasury yield from around 3% to the 3.3-3.5% range. The 10-year TIPS breakeven rate has jumped to 2.1% even as oil prices have softened, signaling that the market is seeing more evidence of underlying inflationary pressure. This breakeven rate will likely rise by another 30 basis points and settle back into its pre-Lehman trading range of 2.3-2.5%. Importantly, the latter range was consistent with stable inflation expectations in the pre-Lehman years. The upward revision to our 10-year nominal yield target is due to a higher real rate assumption. In part, this reflects the fact that we have been impressed by last year's productivity performance. We are not expecting a major structural upshift in underlying productivity growth, for reasons cited by our colleague Peter Berezin in a recent report.3 Nonetheless, capital spending has picked up and Chart I-9 suggests that productivity growth should move a little higher in the coming years based on the acceleration in growth of the capital stock. Equilibrium interest rates should rise in line with slightly faster potential economic growth. Should we worry about a higher fiscal risk premium in bond yields? In the pre-Lehman era, academic studies suggested that every percentage point rise in the government's debt-to-GDP ratio added three basis points to the equilibrium level of bond yields. We shouldn't think of this as a 'default risk premium', because there is little default risk for a country that can print its own currency. Rather, higher yields reflect a crowding-out effect; since growth is limited in the long run by the supply side of the economy, a larger government sector means that some private sector demand needs to be crowded out via higher real interest rates. Plentiful economic slack negated the need for any crowding out as government debt exploded in aftermath of the Great Recession. Moreover, quantitative easing programs soaked up more than all of net government issuance for the major economies. Chart I-10 shows that the flow of the major economies' government bonds available for the private sector to purchase was negative in each of 2015, 2016 and 2017. The flow will swing to a positive figure of US$957 billion this year and US$1,127 billion in 2019. Real interest rates may therefore be higher to the extent that government bonds will have to compete with private sector issuance for available savings. Chart I-9U.S. Productivity Should Improve Modestly U.S. Productivity Should Improve Modestly U.S. Productivity Should Improve Modestly Chart I-10Government Bond Supply Is Accelerating Government Bond Supply is Accelerating Government Bond Supply is Accelerating The bottom line is that duration should be kept short of benchmarks within fixed-income portfolios, although we would not be surprised to see a consolidation phase or even a counter-trend rally in the near term. Dollar Cross Currents As mentioned earlier, standard theory suggests that loose fiscal policy and tight money should be bullish for the currency. However, the U.S. situation is complicated by the fact that fiscal stimulus will likely worsen the "twin deficits" problem. The current account deficit widened last year to 2.6% of GDP (Chart I-11). The fiscal measures will result in a jump in the Federal budget deficit to roughly 5½% in 2019, up from 3½% in last summer's CBO baseline projection. As a ballpark estimate, the two percentage point increase will cause the current account deficit to widen by only 0.3 percentage points. Of course, this will be partly offset by the continued improvement in the energy balance due to surging shale oil production. The poor international investment position is another potential negative for the greenback. Persistent U.S. current account deficits have resulted in a huge shortfall in the country's international investment account, which has reached 40% of GDP (Chart I-12). This means that foreign investors own a larger stock of U.S. financial assets than U.S. investors own abroad. Nonetheless, what matters for the dollar are the returns that flow from these assets. U.S. investors have always earned more on their overseas investments than foreigners make on their U.S. assets (which are dominated by low-yielding fixed-income securities). Thus, the U.S. still enjoys a 0.5% of GDP net positive inflow of international income (Chart I-12, bottom panel). Chart I-11A U.S. Twin Deficits Problem? A U.S. Twin Deficits Problem? A U.S. Twin Deficits Problem? Chart I-12U.S. Net International Investment U.S. Net International Investment U.S. Net International Investment Interest income flowing abroad will rise along with U.S. bond yields. This will undermine the U.S. surplus on international income to the extent that it is not offset by rising returns on U.S. investments held abroad. We estimate that a further 60 basis point rise in the U.S. Treasury curve (taking the 10-year yield from 2.9% to our target of 3½%) would cause the primary income surplus to fall by about 0.7 percentage points (Chart I-13). Adding this to the 0.3 percentage points from the direct effect of the increased fiscal deficit, the current account shortfall would deteriorate to roughly 3½% of GDP. While the deterioration is significant, the external deficit would simply return to 2009 levels. We doubt this would justify an ongoing dollar bear market on its own. Historically, a widening current account deficit has not always been the dominant driver of dollar trends. What should matter more is the Fed's response to the fiscal stimulus. If the FOMC does not immediately respond to head off the growth impulse, then rising inflation expectations could depress real rates at the short-end of the curve and undermine the dollar temporarily, especially in the context of a deteriorating external balance. The dollar would likely receive a bid later, when inflation clearly shifts higher and long-term inflation expectations move into the target zone discussed above. At that point, policymakers will step up the pace of rate hikes in order to get ahead of the inflation curve. The bottom line is that we still believe that the dollar will move somewhat higher on a 12-month horizon, but we can't rule out a continued downtrend in the near term until inflation clearly bottoms. It will also be difficult for the dollar to rally in the near term in trade-weighted terms if our currency strategists are correct on the yen outlook. The Japanese labor market is extremely tight, industrial production is growing at an impressive 4.4% pace, and the OECD estimates that output is now more than one percentage point above its non-inflationary level (Chart I-14). Investors are betting that a booming economy will give the monetary authorities the chance to move away from extraordinarily accommodative conditions. Investors are thus lifting their estimates of where Japanese policy will stand in three or five years. Chart I-13U.S. Fiscal Stimulus ##br##Impact On External Deficit U.S. Fiscal Stimulus Impact On External Deficit U.S. Fiscal Stimulus Impact On External Deficit Chart I-14Yen Benefitting From ##br##Domestic And Foreign Growth Yen Benefitting From Domestic And Foreign Growth Yen Benefitting From Domestic And Foreign Growth Increased volatility in global markets is also yen-bullish, especially since speculative shorts in the yen had reached near record levels. The pullback in global risk assets triggered some short-covering in yen-funded carry trades. Finally, the yen trades at a large discount to purchasing power parity. A strong Yen could prevent dollar rally in trade-weighted terms in the near term. Finally, A Word On Oil Oil prices corrected along with the broader pullback in risk assets in February. Nonetheless, the fundamentals point to a continued tightening in crude oil markets in the first half of 2018 (Chart I-15). Chart I-15Oil Inventory Correction Continuing Oil Inventory Correction Continuing Oil Inventory Correction Continuing OPEC's goal of reducing OECD inventories to five-year average levels will likely be met late this year. OPEC and Russia's production cuts are pretty much locked in to the end of June, when the producer coalition will next meet. Even with U.S. shale-oil output increasing, solid global demand will ensure that OECD inventories will continue to draw through the spring period. Over the past week, comments from Saudi and Russian oil ministers indicate they are more comfortable with extending OPEC 2.0's production cuts to end-2018, which, along with strong global demand growth, raises the odds Brent crude oil prices will exceed $70/bbl this year and possibly next year. Whether this is the result of the Saudi's need for higher prices to support the Aramco IPO, or it reflects an assessment by OPEC 2.0 that the world economy can absorb such prices without damaging demand too much, is not clear. Markets have yet to receive forward guidance from OPEC 2.0 leadership indicating this is the coalition's new policy, but our oil analysts are raising the odds that it is, and will be adjusting their forecast accordingly this week. Investment Conclusions The combination of an initially plodding Fed and faster earnings growth this year provides a bullish backdrop for the equity market. Treasury yields will continue to trend higher but, as long as the Fed sticks with the current 'dot plot', the pain in the fixed-income pits will not prevent the equity bull phase to continue for a while longer. Nonetheless, the fiscal stimulus is arriving very late in the U.S. economic cycle. The fact that there is little economic slack means that, rather than extending the expansion and the runway for earnings, stimulus might simply generate a more exaggerated boom/bust scenario; the FOMC sticks with the current game plan in the near term, but ends up falling behind the inflation curve and then is forced to catch up. The implication is 'faster growth now, deeper recession later'. Timing the end of the business cycle keeps coming back to the inflation outlook. If the result of the fiscal stimulus is more inflation but not much more growth, then the Fed will be forced to step harder and earlier on the brakes. Our base case is that inflation rises in a gradual way, but it has been very difficult to forecast inflation in this cycle. The bottom line is that our recommended asset allocation is unchanged for now. We are overweight risk assets (equities and corporate bonds), and below benchmark on duration. We will continue to watch the items in our Exit Checklist for warning signs (see last month's Overview). We are likely to trim corporate bond exposure within fixed-income portfolios to neutral or underweight in advance of taking profits on equities. The dollar should head up at some point, although not in the near term. The yen should be the strongest currency of the majors in the next 3-6 months. In currency-hedged terms, our fixed-income team still believes that JGBs are the best place to hide from the bond bear market. Gilts and Aussie governments also provide some protection. The worst performers will likely be government bonds in the U.S., Canada and Europe. Mark McClellan Senior Vice President The Bank Credit Analyst February 22, 2018 Next Report: March 29, 2018 1 Please see BCA Geopolitical Strategy Special Report, "Constraints & Preferences Of The Trump Presidency," dated November 30, 2016, available at gps.bcaresearch.com. 2 The fiscal thrust is defined as the change in the cyclically-adjusted budget balance, expressed as a percent of GDP. 3 Please see BCA Global Investment Strategy Weekly Report, "A Structural Bear Market In Bonds," dated February 16, 2018, available at gis.bcaresearch.com. II. Leverage And Sensitivity To Rising Rates: The U.S. Corporate Sector 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 March 2018 March 2018 Chart II-2Corporate Bond Spreads And Leverage Corporate Bond Spreads And Leverage Corporate Bond Spreads And Leverage 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. 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 Chart II-3Top Down U.S. Corporate Health Monitor Top Down U.S. Corporate Health Monitor Top Down U.S. Corporate Health Monitor Table II-1Definitions Of Ratios That Go Into The CHMs March 2018 March 2018 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. 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 BOTTOM-UP IG CHM BOTTOM-UP IG CHM Chart II-5Bottom-Up HY CHM BOTTOM-UP HY CHM BOTTOM-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 March 2018 March 2018 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 March 2018 March 2018 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 March 2018 March 2018 Chart II-8Interest Coverage Ratio Vs. Earnings Beta March 2018 March 2018 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). Chart II-9Debt Maturing In Next ##br##Three Years (% Of Total) March 2018 March 2018 Chart II-10Interest Coverage Ratio ##br##Headed To New Lows Interest Coverage Ratio Headed To New Lows Interest Coverage Ratio Headed To New Lows Chart II-11Interest Coverage By ##br##Sector (IG Plus HY) Interest Coverage By Sector (IG plus HY) Interest Coverage By Sector (IG plus HY) Chart II-12Interest Coverage By ##br##Sector (IG Plus HY) Interest Coverage By Sector (IG plus HY) Interest Coverage By 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 Key Cyclical Drivers Of Corporate Excess Returns Key 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 For Corporate Spreads, Watch Our Margin Proxy For 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. III. Indicators And Reference Charts Volatility returned to financial markets in February. The good news is that it appears to have been a healthy technical correction that has tempered frothy market conditions, rather than the start of an equity bear phase. The VIX has shot from very low levels to above the long-term mean, indicating that there is less complacency among investors. This is confirmed by the pullback in our Composite Sentiment Indicator, although it remains at the high end of its historical range. Our Composite Speculation Indicator is also still hovering at a high level, suggesting that frothiness has not been fully washed out. Similarly, our Equity Valuation Indicator has pulled back, but remains close to our threshold for overvaluation at +1 standard deviations. Our Equity Technical Indicator came close, but did not give a 'sell' signal in February (i.e. it remained above its 9-month moving average). Our Monetary Indicator moved slightly further into 'restrictive' territory in February. We highlight in the Overview section that monetary policy will become a significant headwind once long-term inflation expectations have fully normalized. It is constructive that the indicators for near-term earnings growth remain upbeat; both the net revisions ratio and the earnings surprise index continue to point to further increases in 12-month forward earnings estimates. Our Revealed Preference Indicator (RPI) returned to its bullish equity signal in February, following a temporary shift to neutral in January. The RPI combines the idea of market momentum with valuation and policy measures. It provides a powerful bullish signal if positive market momentum lines up with constructive signals from the policy and valuation measures. Conversely, if constructive market momentum is not supported by valuation and policy, investors should lean against the market trend. Our Willingness-to-Pay (WTP) indicators are bullish on stocks in the U.S., Europe and Japan. However, the WTP for the U.S. market appears to have rolled over, suggesting that flows are becoming less constructive for U.S. stocks. The WTP indicators track flows, and thus provide information on what investors are actually doing, as opposed to sentiment indexes that track how investors are feeling. At the margin, the WTP indicator suggest that flows favor the European and Japanese markets to the U.S. Treasurys moved closer to 'inexpensive' territory in February, but are not there yet. Extended technicals suggest a period of consolidation, but value is not a headwind to a continuation in the cyclical bear phase. EQUITIES: Chart III-1U.S. Equity Indicators U.S. Equity Indicators U.S. Equity Indicators Chart III-2Willingness To Pay For Risk Willingness To Pay For Risk Willingness To Pay For Risk Chart III-3U.S. Equity Sentiment Indicators U.S. Equity Sentiment Indicators U.S. Equity Sentiment Indicators Chart III-4Revealed Preference Indicator Revealed Preference Indicator Revealed Preference Indicator Chart III-5U.S. Stock Market Valuation U.S. Stock Market Valuation U.S. Stock Market Valuation Chart III-6U.S. Earnings U.S. Earnings U.S. Earnings Chart III-7Global Stock Market And ##br##Earnings: Relative Performance Global Stock Market And Earnings: Relative Performance Global Stock Market And Earnings: Relative Performance Chart III-8Global Stock Market And ##br##Earnings: Relative Performance Global Stock Market And Earnings: Relative Performance Global Stock Market And Earnings: Relative Performance FIXED INCOME: Chart III-9U.S. Treasurys And Valuations U.S. Treasurys and Valuations U.S. Treasurys and Valuations Chart III-10U.S. Treasury Indicators U.S. Treasury Indicators U.S. Treasury Indicators Chart III-11Selected U.S. Bond Yields Selected U.S. Bond Yields Selected U.S. Bond Yields Chart III-1210-Year Treasury Yield Components 10-Year Treasury Yield Components 10-Year Treasury Yield Components Chart III-13U.S. Corporate Bonds And Health Monitor U.S. Corporate Bonds And Health Monitor U.S. Corporate Bonds And Health Monitor Chart III-14Global Bonds: Developed Markets Global Bonds: Developed Markets Global Bonds: Developed Markets Chart III-15Global Bonds: Emerging Markets Global Bonds: Emerging Markets Global Bonds: Emerging Markets CURRENCIES: Chart III-16U.S. Dollar And PPP U.S. Dollar And PPP U.S. Dollar And PPP Chart III-17U.S. Dollar And Indicator U.S. Dollar And Indicator U.S. Dollar And Indicator Chart III-18U.S. Dollar Fundamentals U.S. Dollar Fundamentals U.S. Dollar Fundamentals Chart III-19Japanese Yen Technicals Japanese Yen Technicals Japanese Yen Technicals Chart III-20Euro Technicals Euro Technicals Euro Technicals Chart III-21Euro/Yen Technicals Euro/Yen Technicals Euro/Yen Technicals Chart III-22Euro/Pound Technicals Euro/Pound Technicals Euro/Pound Technicals COMMODITIES: Chart III-23Broad Commodity Indicators Broad Commodity Indicators Broad Commodity Indicators Chart III-24Commodity Prices Commodity Prices Commodity Prices Chart III-25Commodity Prices Commodity Prices Commodity Prices Chart III-26Commodity Sentiment Commodity Sentiment Commodity Sentiment Chart III-27Speculative Positioning Speculative Positioning Speculative Positioning ECONOMY: Chart III-28U.S. And Global Macro Backdrop U.S. And Global Macro Backdrop U.S. And Global Macro Backdrop Chart III-29U.S. Macro Snapshot U.S. Macro Snapshot U.S. Macro Snapshot Chart III-30U.S. Growth Outlook U.S. Growth Outlook U.S. Growth Outlook Chart III-31U.S. Cyclical Spending U.S. Cyclical Spending U.S. Cyclical Spending Chart III-32U.S. Labor Market U.S. Labor Market U.S. Labor Market Chart III-33U.S. Consumption U.S. Consumption U.S. Consumption Chart III-34U.S. Housing U.S. Housing U.S. Housing Chart III-35U.S. Debt And Deleveraging U.S. Debt And Deleveraging U.S. Debt And Deleveraging Chart III-36U.S. Financial Conditions U.S. Financial Conditions U.S. Financial Conditions Chart III-37Global Economic Snapshot: Europe Global Economic Snapshot: Europe Global Economic Snapshot: Europe Chart III-38Global Economic Snapshot: China Global Economic Snapshot: China Global Economic Snapshot: China Mark McClellan Senior Vice President The Bank Credit Analyst

Highlights Portfolio Strategy Synchronized global capex growth and higher interest rates are two key themes that will continue to dominate this year. Three high-conviction calls are levered to the former theme and two to the latter. A special situation completes our sextet. Reinstate the S&P construction machinery & heavy truck index to the high-conviction overweight list. We also reiterate our high-conviction underweight call in the newcomer S&P telecom services sector. Recent Changes S&P Construction Machinery & Heavy Truck - Add back to high-conviction overweight list. Table 1 Semblance Of Calm Semblance Of Calm Feature Chart 1Market Bounced Smartly Market Bounced Smartly Market Bounced Smartly Equities regained their footing last week, as volatility took a breather. There are high odds that the technical, mostly-sentiment driven, pullback that we have been flagging since January 22nd is nearly over, as the market smartly bounced off the 200-day moving average (top panel, Chart 1).1 A consolidation/absorption phase is looming and, according to our "buy the dip" cycle-on-cycle analysis, a retest of the recent lows is likely before the market gets out of the woods (please refer to Chart 1 from last week's publication). While inflation expectations, crude oil prices and financial conditions are all tightly linked with and weighing on the S&P 500 (second and third panels, Chart 1), a number of tactical high-frequency financial market indicators suggest that the cyclical SPX bull market remains intact. First, SPX e-mini futures positioning is an excellent leading indicator of market momentum, and the current message is positive (net speculative positions are advanced by 40 weeks, Chart 2). Second, bond market internal dynamics suggest that this mini "risk off" episode is an isolated one and not a precursor to a real tremor. The high yield bond ETF outperformed the long dated Treasury bond ETF (bottom panel, Chart 3). It would be unprecedented for an equity market downdraft to morph into a fully blown bear market without junk bonds sinking compared with the ultimate risk free asset. Even when adjusted for its lower duration, the high yield bond ETF remained resilient versus the 3-7 year Treasury bond ETF (top panel, Chart 3). Chart 2Futures Positioning... Futures Positioning... Futures Positioning... Chart 3...Junk Bonds... ...Junk Bonds... ...Junk Bonds... Third, the calmness in the TED spread corroborates the message from the bond market. Were a systemic risk to materialize, the TED spread should have widened and not come in as it did in the past two weeks (Chart 4). Put differently, quiet interbank markets are a healthy sign. Chart 4...And TED Spread All Flashing Green Semblance Of Calm Semblance Of Calm Finally, relative valuations have corrected not only on an absolute basis (please refer to the bottom panel of Chart 2A from last week's Report), but also controlled for equity market volatility. In fact, Chart 5 shows that both the VIX-adjusted Shiller P/E and the 12-month forward P/E have returned to the neutral zone. Meanwhile, two key macro indicators we track are also flashing green. Chart 6 shows momentum in money velocity or how fast "one unit of currency is used to purchase domestically-produced goods and services".2 Historically, velocity of M2 money stock has been positively correlated with stock market momentum. The recent spike in this indicator suggests that the longevity of the business cycle remains intact, and investors with a cyclical (9-12 month) investment horizon should start "buying the dip", as we suggested on February 8th.3 Another yield curve-type macro indicator confirms this buoyant business cycle message: real GDP growth is easily outpacing real interest rates, as per the 10-year TIPS market (Chart 7). In other words, real rates are not yet restrictive enough to choke off GDP growth, despite the recent 35bps increase. Were this spread to plunge below the zero line, it would predict recession. Thus, the recent widening underscores that recession is not imminent. Chart 5Valuations Return To Earth Valuations Return To Earth Valuations Return To Earth Chart 6Money Velocity... Money Velocity... Money Velocity... Chart 7...And Yield Curve Emit Bullish Signal ...And Yield Curve Emit Bullish Signal ...And Yield Curve Emit Bullish Signal Under such a backdrop, the upshot is that earnings will remain upbeat in 2018 and continue to underpin equity prices. This week we revisit our 2018 high-conviction call list and reinstate one sector to the overweight column. Chart 8Both Themes Remains Intact Both Themes Remains Intact Both Themes Remains Intact The Themes Two key BCA themes formed the cornerstone of our 2018 high conviction call list: Synchronized global capex upcycle Higher interest rates Last autumn, we started to articulate the synchronized global capital spending macro theme4 that, despite still flying under the radar, will likely dominate this year. Both advanced and emerging economies are simultaneously expanding gross fixed capital formation (middle panel, Chart 8). As a result, we reiterate our cyclical over defensive portfolio bent,5 and continue to tie three high-conviction overweight calls to this theme. Similarly, late last year we started to highlight BCA's U.S. Bond Strategy view of a higher 10-year yield on the back of rising inflation expectations for 2018 (bottom panel, Chart 8). Back in late-November we posited that if BCA's constructive crude oil view pans out then inflation and rates may get an added boost. Two high-conviction calls remain levered to this theme. Finally, a special situation rounds up our call this year. But before we update the call list and make a small tweak, a quick housekeeping note is in order. Taking The Tally Early this year, we added trailing stops to our high-conviction call list as a risk management tool. The goal was to help protect profits as a number of our calls were showing outsized gains for such a short time span. Our tactically souring view of the overall market also compelled us to introduce this risk management metric. As a result of the recent careening in the SPX, half of our calls got stopped out with lofty double digit gains since inception a mere two and a half months ago. Namely, our speculative underweights in the S&P semi equipment and S&P homebuilders registered gains of 20% and 10%, respectively. The high-conviction underweight in the S&P utilities sector got called at an 18% gain, and our high-conviction overweight call in the S&P construction machinery & heavy truck (CMHT) index got stopped out at the 10% mark. (Please refer to page 15 for the closed trades table). Last week we added the S&P telecom services sector as a high-conviction underweight replacing the S&P utilities sector, and now that the worst is likely behind us, we are reinstating the S&P CMHT index to the high-conviction overweight list. Anastasios Avgeriou, Vice President U.S. Equity Strategy anastasios@bcaresearch.com Construction Machinery & Heavy Truck (Overweight, Capex Theme) The capex upcycle is underpinning machinery stocks. Not only are expectations for overall capital outlays as good as they get (Chart 9), but there are also tentative signs that even the previously moribund mining and oil & gas complexes will be capex upcycle participants. While we are not calling for a return to the previous cycle's peak, even a modest renormalization of capital spending plans in these two key machinery client segments would rekindle industry sales growth. Recent news of oil majors accelerating their capex plans is a step in the right direction. This machinery end-demand improvement is not only a U.S. phenomenon, but also a global one. The middle panel of Chart 9 shows Caterpillar's global machinery sales to dealers hitting a decade high. Tack on the drubbing in the U.S. dollar and related commodity price inflation and the ingredients are in place for a global machinery export boom. While most of the countries we track enjoy a sizable rebound in machinery orders, Japan's machine tools orders have surged to an all-time high confirming that machinery global end demand is brisk (bottom panel, Chart 9). Finally, our machinery EPS model is firing on all cylinders, underscoring that the earnings-led recovery has more running room (fourth panel, Chart 9). Reinstate the S&P CMHT index to the high-conviction overweight list. The ticker symbols for the stocks in this index are: BLBG: S5CSTF - CAT, CMI, PCAR. Energy (Overweight, Capex Theme) The S&P energy sector is a key beneficiary of our synchronized global capex theme. The Dallas Fed manufacturing outlook survey is firing on all cylinders and, given the importance of oil to the state of Texas, it serves as an excellent gauge for oil activity. Importantly, the capital expenditures part of the survey hit its highest level in a decade, and capex intentions in the coming six months are also probing multi-year highs. The overall message is that the budding recovery in energy capital budgets will likely gain steam (second panel, Chart 10). Following the late-2015/early-2016 drubbing in oil prices, energy projects ground to a halt and only now are green shoots appearing (middle panel, Chart 10). Recent news that Exxon Mobil would bump domestic capital spending up to $50bn over the next five years is encouraging. New projects/investments comprise 70% of this figure. OECD oil stocks are receding steadily and so are U.S. crude oil inventories. OPEC 2.0 remains in place and will likely balance the oil market by continuing to constrain supply. Our Commodity & Energy Strategy service is still penciling in higher oil prices for 2018. On the demand side, emerging markets/Chinese demand is the key determinant of overall oil demand, and the news on this front is encouraging and consistent with BCA's synchronized global growth theme: following the recent lull, non-OECD demand is growing anew by roughly 1.5mn bbl/day. The upshot is that S&P energy relative revenues will climb out of the recent trough (bottom panel, Chart 10). The ticker symbols for the stocks in this index are: BLBG: S5ENRS - XLE: US. Chart 9Construction Machinery & Heavy Truck ##br##(Overweight, Capex Theme) Construction Machinery & Heavy Truck (Overweight, Capex Theme) Construction Machinery & Heavy Truck (Overweight, Capex Theme) Chart 10Energy (Overweight, Capex Theme) Energy (Overweight, Capex Theme) Energy (Overweight, Capex Theme) Software (Overweight, Capex Theme) The S&P software index is another clear capex upcycle beneficiary. If software commands a larger slice of the overall capital spending pie as we expect, then industry profits should enjoy a healthy rebound (second panel, Chart 11). Small business sector plans to expand keep on hitting fresh recovery highs, underscoring that software related outlays will likely follow them higher. Rebounding bank loan growth also corroborates the upbeat spending message and signals that businesses are beginning to loosen their purse strings (Chart 11). Reviving animal spirits suggest that demand for software upgrades will stay elevated. CEO confidence is pushing decade highs (middle panel, Chart 11). Such ebullience is positive for a pickup in software outlays. It has also rekindled software M&A activity, and pushed take out premia higher. Meanwhile, the structural pull from the proliferation of cloud computing and software-as-a-service has served as a catalyst to raise the profile of this more defensive and mature tech sub-sector. Tax reform is another bonus for this group that benefits from cash repatriation, which will likely result in increased shareholder friendly activities. The ticker symbols for the stocks in this index are: BLBG: S5SOFT-MSFT, ORCL, ADBE, CRM, ATVI, INTU, EA, ADSK, RHT, SYMC, SNPS, ANSS, CDNS, CTXS, CA. Banks (Overweight, Higher Interest Rates Theme) The S&P banks index remains a core overweight portfolio holding and there are high odds of additional relative gains in the coming quarters beyond the current 10% relative return mark since the November 27th, 2017 inception. All three key drivers of bank profits, namely price of credit, loan growth and credit quality, are simultaneously moving in the right direction. On the price front, BCA expects the 10-year yield will continue to rise more quickly than is discounted in the forward curve. Our U.S. bond strategists think that inflation expectations have more room to run, likely pushing the 10-year Treasury yield close to 3.25% (top panel, Chart 12). C&I and consumer loans, two large credit categories, are both forecast to reaccelerate in the coming months. The ISM remains squarely above the 50 boom/bust line and consumer confidence is still buoyant. Our credit growth model captures these positive forces and is sending an unambiguously positive message for loan reacceleration in the coming months (third panel, Chart 12). Finally, credit quality remains pristine despite some pockets of weakness in auto loans (especially subprime) and credit card debt. At this stage of the cycle, with a closed unemployment gap, NPLs will remain muted. 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.  Chart 11Software (Overweight, Capex Theme) Software (Overweight, Capex Theme) Software (Overweight, Capex Theme) Chart 12Banks (Overweight, Higher Interest Rates Theme) Banks (Overweight, Higher Interest Rates Theme) Banks (Overweight, Higher Interest Rates Theme) Telecom Services (Underweight, Higher Interest Rates Theme) We downgraded the S&P telecom services index to underweight and added it to the high-conviction underweight list last week, filling the void left by the S&P utilities sector.6 Three main reasons are behind our dislike for this fixed income proxy sector: BCA's 2018 rising interest rate theme, both our Cyclical Macro Indicator (CMI) and our sales model send a distress signal, and a profit margin squeeze is looming. The top panel of Chart 13 shows that high dividend yielding telecom services stocks and the 10-year yield are nearly perfectly inversely correlated. In fact, telecom services stocks are prime beneficiaries of disinflation/deflation and vice versa. BCA's bond market view remains that the 10-year yield will continue to rise likely piercing through 3% and weigh heavily on this fixed income proxied sector. Our CMI has melted and relative consumer outlays on telecom services have also taken a nosedive (second & third panels, Chart 13), warning that revenue growth will be hard to come by for telecom carriers. In fact, while nearly all of the GICS1 sectors have come out of the top line growth lull of late-2015/early-2016, telecom services sales growth has relapsed. Worrisomely, our S&P telecom services revenue growth model remains deep in contractionary territory, waving a red flag (bottom panel, Chart 13). Finally, still steeply deflating selling prices are a major headwind for the sector's top and bottom line growth prospects and coupled with a still expanding wage bill, suggest that a profit margin squeeze is looming. The ticker symbols for the stocks in this index are: VZ, T, CTL. Pharmaceuticals (Underweight, Special Situation) Weak pricing power fundamentals, a soft spending backdrop, a depreciating U.S. dollar and deteriorating industry operating metrics will sustain downward pressure on pharma stocks. Industry selling prices remain soft (Chart 14). In the context of a bloated industry workforce, the profit margin outlook darkens significantly. If the Trump administration also manages to clamp down on the secular growth of pharma selling price inflation, as we expect, then industry margins will remain under chronic downward pressure. Our dual synchronized global economic and capex growth themes bode ill for this safe haven index. Nondiscretionary health care outlays jump in times of duress and underwhelm during expansions. Currently, the elevated ISM manufacturing index is signaling that pharma profits will underwhelm in the coming months as the most cyclical parts of the economy flex their muscles (the ISM survey is shown inverted, second panel, Chart 14). A depreciating currency is also synonymous with pharma profit sickness (bottom panel, Chart 14). While pharma exports should at least provide some top line growth relief during depreciating U.S. dollar phases, they are still contracting (middle panel, Chart 14), warning that global pharma demand is ill. Finally, even on the operating metric front, the outlook is dark. Pharma industrial production is nil and our productivity proxy remains muted, warning that the valuation derating phase is far from over. The ticker symbols for the stocks in this index are: BLBG: S5PHAR - JNJ, PFE, MRK, BMY, AGN, LLY, ZTS, MYL, PRGO. Chart 13Telecom Services ##br##(Underweight, Higher Interest Rates Theme) Telecom Services (Underweight, Higher Interest Rates Theme) Telecom Services (Underweight, Higher Interest Rates Theme) Chart 14Pharmaceuticals ##br##(Underweight, Special Situation) Pharmaceuticals (Underweight, Special Situation) Pharmaceuticals (Underweight, Special Situation) 1 Please see BCA U.S. Equity Strategy Weekly Report, "Too Good To Be True?" dated January 22, 2018, available at uses.bcaresearch.com. 2 https://fred.stlouisfed.org/series/M2V 3 Please see BCA U.S. Equity Strategy Insight, "Buy The Dip," dated February 8, 2018, available at uses.bcaresearch.com. 4 Please see BCA U.S. Equity Strategy Weekly Report, "Invincible," dated November 6, 2017, available at uses.bcaresearch.com. 5 Please see BCA U.S. Equity Strategy Special Report, "Top 5 Reasons To Favor Cyclicals Over Defensives," dated October 16, 2017, available at uses.bcaresearch.com. 6 Please see BCA U.S. Equity Strategy Weekly Report, "Manic Depressive?" dated February 12, 2018, 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).

In early September, we opportunistically upgraded the niche S&P oil & gas refining & marketing index to capture the earnings upside from hurricane-related capacity constraints. Such constraints have since normalized and, with some clouds on the horizon, last week we reversed our recommendation to a benchmark allocation, locking in profits of 9%. Refining margins have tightened considerably, as has the Brent-WTI crude oil spread (second panel); both signal that refiner profits will be challenged in the year to come. Analyst estimates have not yet incorporated the darker outlook, projecting lights-out earnings growth (third panel) with momentum to the upside (bottom panel). These elevated expectations introduce considerable forecast risk, offsetting the still-firm demand for refined products, underscoring our neutral recommendation. Please see our Feb 5, 2018 Weekly Report for more details. The ticker symbols for the stocks in this index are: BLBG: S5OILR- PSX, VLO, MPC and ANDV. The Good News Is Priced In For Refiners The Good News Is Priced In For Refiners

Highlights This week's global equities sell-off spilled into oil markets, taking Brent and WTI down 2.7% and 3.7% as of Tuesday's close, in line with the S&P 500 decline, which began Friday. In line with our House view, we do not believe this will, in and of itself, deter the Fed from raising overnight rates four times this year. Nor do we believe oil-price weakness earlier this week reflects a breakdown in fundamentals. Any demand-dampening effects coming from a stronger USD in the wake of Fed rate hikes will have a muted effect on oil prices, provided OPEC 2.0 can maintain production discipline, and, critically, keep the Brent and WTI forward curves backwardated.1 Likewise, any demand stimulation coming from a weaker USD in the wake of a more measured Fed policy - e.g., two or three hikes - also will be muted by backwardation. Energy: Overweight. Fundamentally, we cannot see anything that warrants a change in our average-price forecast of $67 and $63/bbl for Brent and WTI this year. Our long Jul/18 WTI vs. short Dec/18 WTI calendar spread, put on in expectation of continued backwardation in oil forward curves, is up 81.5% since Nov 2/17, when we recommended it. Base Metals: Neutral. Base metals also were caught up in the equities sell-off, with spot copper trading ~ $3.15 - $3.20/lb on the COMEX. As with oil, we do not see the equities sell-off as a harbinger of a bearish shift in base metals fundamentals. Precious Metals: Neutral. Gold returns were relatively flat amid the equities sell-off with only a 0.6% loss. Our long gold portfolio hedge is up 7.9% since it was recommended on May 4/17. Ags/Softs: Underweight. China opened an anti-dumping and anti-subsidy investigation into U.S. sorghum imports, which the country's foreign ministry insisted was not related to recent U.S. tariffs on solar panels and washing machines. China accounts for ~ 80% of U.S. sorghum exports. Feature The global equity sell-off spilled into oil markets, with Brent and WTI prompt futures down 2.7% and 3.7% over the past week when the equity slide began (Chart of The Week). The proximate cause of the equities down leg appears to be the stronger-than-expected U.S. wage growth reported last week, suggesting inflationary pressures continue to build in the U.S. This prompted speculation the Fed would be inclined to increase the number of rate hikes it executes this year - going from a consensus view of three hikes to four - and that financial conditions would tighten. The equities sell-off this prompted then led to speculation the Fed would dial back the number of rate hikes it executes this year. We believe the Fed will look through the recent equity-market volatility, and will lift rates four times this year, in line with BCA's once-out-of-consensus House view. Chart of the WeekOil Prices Caught Up In Equities Sell-Off Oil Prices Caught Up In Equities Sell-Off Oil Prices Caught Up In Equities Sell-Off Chart 2Fundamentals Support Backwardation Fundamentals Support Backwardation Fundamentals Support Backwardation As far as oil markets are concerned, as long as the Brent and WTI forward curves remain backwardated (Chart 2), any impact from U.S. monetary policy on oil prices - chiefly through currency effects - will be muted. Demand-dampening effects coming from a stronger USD in the wake of Fed rate hikes will be dissipated in backwardated markets. Likewise, any demand stimulation coming from a weaker USD in the wake of fewer rate hikes policy at the Fed - e.g., two or three hikes - will be muted by backwardation. Fundamentals Dominate Oil-Price Evolution Chart 3Strong Fundamentals##BR##Force Inventories Lower Strong Fundamentals Force Inventories Lower Strong Fundamentals Force Inventories Lower Fundamentals point to continued tightening of crude oil markets in 1H18, the period we have the greatest visibility on: OPEC 2.0's production cuts are pretty much locked in to end-June, when the producer coalition again will meet to assess market conditions, and global demand growth will remain robust. Even with U.S. shale-oil output increasing, OECD inventories will continue to draw during this period (Chart 3). OPEC 2.0's goal of reducing OECD inventories to five-year average levels likely will be met late in 1H18 or early in 2H18, based on our global balances model. While it is possible OPEC 2.0 will extend its production cuts to year-end 2018, we don't believe it is likely. Voluntary production cuts by Russia and Gulf OPEC nations, combined with decline-curve losses in non-Gulf OPEC producers have removed ~ 1.4mm b/d from the market since January 2017. The bulk of these cuts have been made by KSA and Russia, which account for close to 1.0mm b/d of OPEC 2.0 production cuts. Based on our fundamentally driven econometric model, extending OPEC 2.0's cuts to year-end would lift average prices in 2018 from our current expectation of $67/bbl for Brent and $63/bbl for WTI to $71 and $67/bbl, respectively. Counterintuitively, we believe maintaining prices at this level for the entire year is not the desired outcome of OPEC 2.0's production-cutting strategy. Higher price levels will incentivize larger-than-expected shale-oil production gains than we currently are forecasting - ~ 1.0mm b/d in 2018 and 1.2mm b/d in 2019. In addition, they would breathe life into marginal production around the world, particularly in provinces where break-evens and services costs have fallen - e.g., the North Sea, Barents Sea and offshore Brazil. OPEC 2.0's Long Game KSA's and Russia's oil ministers, the leaders of OPEC 2.0, have stated they would prefer to see their coalition endure beyond end-2018, when their production-cutting deal expires. Be that as it may, they have yet to publicly articulate an agreed strategy for OPEC 2.0, either in terms of a preferred price level or price band, or a strategy that builds on the gains they've made in backwardating oil forward curves. Chart 4Stakes Are High For OPEC 2.0##BR##If No Post-2018 Strategy Emerges Stakes Are High For OPEC 2.0 If No Post-2018 Strategy Emerges Stakes Are High For OPEC 2.0 If No Post-2018 Strategy Emerges Russian Energy Minister Alexander Novak recently suggested a preferred range for prices of $50 to $60/bbl for Brent, the international crude-oil benchmark. In the short term, KSA likely prefers a higher price - between $60 and $70/bbl for Brent - to support the IPO of Saudi Aramco, which probably will occur later this year. As we near the end of 1H18, OPEC 2.0's leaders will have to provide some indication they are converging on a common production-management strategy. They will, we believe, have to begin behaving more like a central bank - i.e., providing the market forward guidance - and less like a loose alliance of like-minded producers lurching between stop-gap measures to support prices. Importantly, when they do provide such guidance, they will have to follow through on publicly stated goals, or risk losing credibility with markets. The stakes are fairly high. If, as we've modeled in our unconstrained case, OPEC 2.0 returns ~ 1.1 - 1.2 mm b/d of actual production cuts (ex-decline-curve losses) to the market beginning in 2H18, and U.S. shale and other producers respond to 2018's higher prices with aggressive production growth that carries through 2019, Brent and WTI prices could be pushing toward $40/bbl by the end of 2019 (Chart 4). Also note that if prices start to moderate in H2 2018, 2019 shale production growth may ultimately be less than the 1.2 MMb/d we have forecast, softening the decline in prices during 2019. Longer term, we believe KSA and Russia are aligned with Russia's preference, if for no reason other than to keep U.S. shale-oil production from realizing the run-away growth sustained higher prices almost surely would provoke. Such growth would accelerate the development of U.S. crude oil export capacity - already hovering around ~ 2mm b/d - and the competition for market share in markets OPEC 2.0 members are keen to defend. Higher prices also would improve the competitive position of non-hydrocarbon-based transportation - e.g., electric vehicles and hybrids - which works against OPEC 2.0's long-term goals. Backwardation Matters For OPEC 2.0 Price levels always will be an important policy variable for OPEC 2.0. Equally important, we believe, will be having a strategy that maintains a backwardated forward curve in the Brent and WTI markets. This is because OPEC 2.0 member states sell oil at spot-price levels - the highest point of a backwardated forward curve - while shale-oil producers hedge their revenues over a 1- to 2-year interval. Other than allowing prices to collapse once again, this is the most viable way of constraining U.S. shale production growth longer term. The steeper the backwardation in the WTI forward curve, in particular, the lower the average price level of the hedges producers are able to lock in when they hedge forward revenues. This translates directly into lower output, since producers cannot afford to field as many rigs at lower prices over the life of the hedge as they would be able to field at higher prices. The extent to which OPEC 2.0 can keep forward curves backwardated will determine the extent to which the USD influences oil prices, as well. Our recently concluded research reveals backwardation can mitigate FX effects on oil prices induced by U.S. monetary policy. There is a long-term equilibrium between the level of the USD's broad trade-weighted index (TWIB) and crude oil prices (Chart 5). Indeed, the USD TWIB is one of the key variables we use in our demand, supply and price models. A weak dollar spurs consumption - USD/bbl prices ex-U.S. are cheaper in local-currency terms, especially for fast-growing emerging markets - while production costs ex-U.S. are higher, which limits output growth at the margin. A stronger dollar restrains consumption and encourages production ex-U.S., at the margin. However, this long-term equilibrium is asymmetric. The strength of the correlation between the level of the USD and crude oil prices is such that as oil inventories fall - and backwardation becomes more pronounced - the USD becomes less important to the evolution of oil prices.2 This can be seen in the month-on-month (m-o-m) rolling correlation between prompt WTI futures and the USD TWIB plotted against the spread between 1st nearby WTI futures and 12th nearby WTI futures (Chart 6). Chart 5Long-Term Inverse Correlation##BR##Between USD TWIB And Crude Prices Long-Term Inverse Correlation Between USD TWIB And Crude Prices Long-Term Inverse Correlation Between USD TWIB And Crude Prices Chart 6Backwardated Forward Curves##BR##Limit USD's Effect On Oil Prices Backwardated Forward Curves Limit USD's Effect On Oil Prices Backwardated Forward Curves Limit USD's Effect On Oil Prices With the exception of the Global Financial Crisis (GFC), the higher the backwardation in crude oil forward curves, the smaller the USD-WTI correlation becomes.3 This suggests that, if OPEC 2.0 can maintain the backwardation in WTI and Brent in 2018, the correlation between crude oil prices and the USD TWIB likely will not go back to the large negative correlation typical of previous cycles. In other words, sustained backwardation will weaken the inverse relationship between WTI prices and the USD TWIB vs. the long-term average in place since 2000, which is roughly when oil prices became random-walking variables. We also looked at year-on-year change in U.S. commercial inventories vs. the USD-WTI prices correlation (Chart 7). Our analysis indicates that when inventories are building, the correlation between USD and WTI prices becomes negative, and when they are falling the correlation goes to zero or positive. This supports our earlier observation that when crude inventories fall, the USD becomes less important to the evolution of WTI prices, particularly spot prices. One more point that we should note: the inverse relationship between the USD and oil prices is a two-way street. In addition to a weaker USD helping to support higher oil prices, higher oil prices have also tended to weaken the USD by inflating the U.S. trade deficit through more expensive petroleum imports. However, over the past decade, the U.S. has reduced its volumes of petroleum imports by roughly 75%, from 12-13 MMB/d in 2007 to only 3-4 MM b/d today (Chart 8). Therefore, this feedback loop of higher oil prices weakening the USD, and lower oil prices strengthening the USD, is greatly reduced. Chart 7Tighter Inventories Limit##BR##USD's Effect On Oil Prices Tighter Inventories Limit USD's Effect On Oil Prices Tighter Inventories Limit USD's Effect On Oil Prices Chart 8Lower Imports Of Petroleum Help##BR##Insulate USD From Oil Price Moves Lower Imports Of Petroleum Help Insulate USD From Oil Price Moves Lower Imports Of Petroleum Help Insulate USD From Oil Price Moves The USD's influence on the evolution of oil prices essentially is an exogenous variable out of OPEC 2.0's control. To the extent it can minimize these effects by backwardating oil forward curves, the coalition reduces the impact of an essentially exogenous USD risk from its production-management strategy. Bottom Line: The Fed likely will view the equity sell-off as a transitory event, and proceed with four overnight-rate hikes this year, in line with our House view. Any read-through from Fed policy decisions to the USD TWIB will be muted by continued backwardation in crude oil forward curves. To the extent OPEC 2.0 can maintain backwardated forward oil curves, it reduces the impact of an essentially exogenous USD risk from its production-management strategy. Robert P. Ryan, Senior Vice President Commodity & Energy Strategy rryan@bcaresearch.com Hugo Bélanger, Research Analyst HugoB@bcaresearch.com 1 Jargon recap: OPEC 2.0 is the moniker we coined for the producer coalition led by the Kingdom of Saudi Arabia (KSA) and Russia. Its historic production-cutting Agreement to remove 1.8mm b/d of production from the market - via a combination of outright cuts and decline-curve run-off - has largely held, despite wide-spread skepticism. "Backwardation" is a term of art in commodities describing a forward curve in which prompt-delivered crude oil trades at a higher price than crude delivered in the future - e.g., a year hence. This is a reflection of a tight market - i.e., refiners are willing to pay more for oil delivered tomorrow or next month than they are willing to pay for oil delivered next year. The opposite of a backwardated market is a "contango" market, another term of art. 2 Generally, falling commodity inventories put a premium on prompt-delivered supply. As inventories fall, there is less readily available supply in place to meet unexpected supply outages. Under such conditions, refiners will attempt to conserve inventory and bid for flowing supply more aggressively, either to replace consumption out of inventory or to keep inventories at safe levels so as to minimize stockout risks. Either way, prompt-delivered supply becomes more valuable than deferred supply. Backwardation reflects this dynamic by keeping prompt-delivered prices above prices for deferred delivery. Backwardation is the market's way of incentivizing storage holders to release inventory to the market. It also is the source of returns for long-only commodity index products. 3 The GFC of 2008 - 09 was a global liquidity event, in which correlations between most tradeable assets went to 1.0 as prices collapsed. Investment Views and Themes Recommendations Strategic Recommendations Tactical Trades Commodity Prices and Plays Reference Table OPEC 2.0 Vs. The Fed OPEC 2.0 Vs. The Fed Trades Closed in 2018 Summary of Trades Closed in 2017 OPEC 2.0 Vs. The Fed OPEC 2.0 Vs. The Fed

Highlights Portfolio Strategy Recovering energy related capex and upbeat oil prices are a powerful tonic for the S&P integrated oil & gas index. Augment positions to overweight. A diverging crude/refined product inventory backdrop, narrowing Brent-WTI crude oil spread, and extreme analyst optimism warn that the easy money has been made in refiners. Lock in profits and downgrade to a benchmark allocation. Recent Changes S&P Integrated Oil & Gas - Upgrade to overweight. S&P Oil & Gas Refining & Marketing - Book profits of 9% and downgrade to neutral today. Table 1 Acrophobia Acrophobia Feature Chart 1Vertigo Alert Vertigo Alert Vertigo Alert Equities have been rising at a dizzying speed year-to-date, as investors have extrapolated the tax reform EPS tailwind far into the future in a very short time span. The risk of a tactical, and likely short lived, 5-10% pullback is very high. Putting this potential correction in perspective is in order. A drop in the SPX to near its 50-day moving average would set the market back 6%, to near the 2,700 mark. As a reminder, the S&P 500 crossed 2,700 on January 3, 2018. A 10% drawdown would push the market below 2,600, a level first surpassed on Black Friday (Chart 1). While steep stock price increases are not unprecedented, at the current juncture all of our tactical indicators suggest that caution is warranted (please refer to the January 22 and January 29 Weekly Reports for more details). The way we recommend defending against such exuberance is to book gains in high-beta pair trades, institute trailing stops to the high-conviction list high flyers (see page 19) and make some subsurface changes to intra-sector positioning. From a cyclical perspective we remain constructive on the broad market and given our view of no recession in the coming 9-12 months our investment strategy is to "buy the dip". Chart 2 shows our S&P 500 EPS model using trailing EPS data directly from Standard & Poor's. Calendar 2017 profit growth is on track to hit 17% year-over-year. Chart 3 shows our S&P 500 EPS model using IBES trailing EPS data. We decided to regress the same variables on the IBES trailing EPS dataset since the market trades on the forward EPS from IBES. According to IBES, calendar 2017 EPS growth will hit 12%, so there is a 5% delta between the two datasets. Our understanding of the difference between the two numbers is what each provider considers one time I/S items. Currently, IBES bottom-up forecasts pencil in 18% growth in calendar 2018 and our model suggests that 21% is possible (Chart 3). S&P forecasts call for a 23% calendar 2018 increase and our model is pointing toward 24% (Chart 2). Chart 2No Matter The Data Set... No Matter The Data Set... No Matter The Data Set... Chart 3...EPS Will Shine In 2018 ...EPS Will Shine In 2018 ...EPS Will Shine In 2018 Irrespective of what data one uses the signal is clear: EPS will have a blowout year in 2018. Studying such EPS reacceleration phases is very interesting. Since the mid-1980s there have been four other periods where EPS exhibited breakneck growth (excluding the GFC, Chart 3). Importantly, we analyzed what the prevalent macro conditions were in all four iterations and Charts A1-A4 in the Appendix on page 16 detail the results. In all iterations, the 10-year Treasury yield was rising, the ISM manufacturing survey was well above the 50 boom/bust line, the U.S. dollar was falling, and crude oil prices were increasing. Currently, we believe reaching and even surpassing the 20% EPS growth rate number in 2018 is likely, given the similarities between the current macro backdrop and these four prior periods (Chart 4). However, this does not necessarily mean that there will be no stock market volatility and equites will increase uninterruptedly in a straight line. Chart 5 shows how the S&P 500 performed in these four periods and in all of them short-term tactical pullbacks occurred. We think 2018 will prove no different. This week we update our view on a deep cyclical sector and tweak our intra-sector positioning. Chart 4Favorable Macro Conditions... Favorable Macro Conditions... Favorable Macro Conditions... Chart 5...But Don't Get Carried Away ...But Don't Get Carried Away ...But Don't Get Carried Away Stay Long Energy... We put the S&P energy sector on our high-conviction overweight list in late-November as a key beneficiary of our synchronized global capex theme.1 Since then, the broad energy complex has bested the S&P 500 by over 3%, and our macro indicators suggest that more gains are in store for this deep cyclical sector. The Dallas Fed manufacturing outlook survey is firing on all cylinders and, given the importance of oil to the state of Texas, it serves as an excellent gauge for oil activity. Importantly, the capital expenditures part of the survey hit the highest level in a decade. Similarly, capex intentions in the coming six months are also probing multi-year highs and signaling that the budding recovery in energy capital budgets will likely gain steam (middle panel, Chart 6). Following the late-2015/early-2016 drubbing in oil prices, energy projects ground to a halt and only now are green shoots appearing (bottom panel, Chart 6). Indeed, rising oil prices are providing a much needed assist. Higher crude prices make more global projects economical and coupled with the steadily lower breakeven costs of shale oil suggest that EPS and sales growth normalcy is likely to return to this commodity complex. Moreover, the indiscriminate selling of the U.S. dollar explains part of the oil price rise, but other macro forces are also at play (Chart 7). Chart 6Capex Theme Beneficiary Capex Theme Beneficiary Capex Theme Beneficiary Chart 7Catch Up Phase Looming Catch Up Phase Looming Catch Up Phase Looming Chart 8Levered To Global Growth##BR## And Rising Inflation Levered To Global Growth And Rising Inflation Levered To Global Growth And Rising Inflation Similar to "Dr. Copper", crude oil prices are an excellent global growth barometer. In fact, oil price swings move in lockstep with the ebb and flow of global output growth and the current message is positive (Chart 8). Not only is our proprietary measure of global Industrial Production rising, but the multi-year high in the forward looking global manufacturing PMI survey also suggests that more good news on the global economic front lies ahead. As unemployment gaps close around the world, with more and more countries following in the U.S.'s footsteps toward full employment, inflation is bound to reaccelerate. Recently, the 10-year U.S. Treasury yield has been on a tear driven mostly by rising inflation expectations. Higher interest rates is another key BCA theme for 2018 and energy stocks also stand to benefit from this rising interest rate backdrop. Historically, relative share prices have been positively correlated both with bond yields and inflation expectations and the current message is to expect a catch up phase in the former (bottom panel, Chart 8). Beyond an enticing macro backdrop, favorable industry supply/demand dynamics are a harbinger of sunnier energy days. OECD oil stocks are receding steadily and so are U.S. crude oil inventories. The implication is that relative share prices will remain well bid (oil inventories shown inverted, middle panel, Chart 9). OPEC 2.0 remains in place and will likely balance the oil market by continuing to constrain supply. Our Commodity & Energy Strategy service is still penciling in higher oil prices for 2018. On the demand side, emerging markets/Chinese demand is the key determinant of overall oil demand, and the news on this front is encouraging and consistent with BCA's synchronized global growth theme: following the recent lull, non-OECD demand is growing anew roughly by 1.5mn bbl/day. The upshot is that S&P energy relative revenues will climb out of the recent trough (bottom panel, Chart 9). Our energy profit model does an excellent job capturing all of these different forces and is signaling that energy EPS will easily outpace the SPX and continue to capture a larger share of the broad market's earnings pie (Chart 10). Chart 9Favorable Supply/Demand Backdrop Favorable Supply/Demand Backdrop Favorable Supply/Demand Backdrop Chart 10EPS Model Flashing Green EPS Model Flashing Green EPS Model Flashing Green Bottom Line: We reiterate our high-conviction overweight call in the S&P energy index. ...Boost The Integrated Oil & Gas Index To Overweight, But... Factors are falling into place for the heavyweight S&P integrated oil & gas index to generate outsized returns in the coming year, and we are compelled to lift this beaten-down energy sub-index to an above benchmark allocation. Investment spending and relative performance are one and the same for this capital-outlay-reliant group. The time to buy these capital intensive high-operating leverage stocks is during a capex upcycle when a virtuous EPS cycle takes root. The opposite is also true. Earlier this decade, the energy sector's share of the U.S. stock market reported capex pie got halved to 16% (top panel, Chart 11). While we are not calling for a return to the heyday of triple digit oil, even a modest renormalization of capital spending would go a long way. Recent news that Exxon Mobil would bump domestic capital spending to $50bn over the next five years is a step in the right direction. New projects/investments comprise 70% of this figure. The company cited the new U.S. tax law as a reason behind the announcement, and tax reform has the potential to drive industry capex plans/budgets. Our sense is that more announcements like the Exxon Mobil one may be brewing and could serve as a catalyst to unlock excellent value in the S&P integrated oil & gas index. Meanwhile, higher oil prices will result in a pickup in global energy project outlays. The top panel of Chart 12 shows that the global oil & gas rig count is rebounding from an extremely depressed level. Encouragingly, these investments will likely pay dividends and translate into cash flow growth extending the virtuous upcycle (bottom panel, Chart 12). Chart 11Buy Oil Majors Buy Oil Majors Buy Oil Majors Chart 12Prime Beneficiary Of Rising Capex Prime Beneficiary Of Rising Capex Prime Beneficiary Of Rising Capex As we mentioned earlier in the energy section, BCA still has a sanguine 2018 oil view, and if it pans out, it will continue to underpin not only the broad energy space, but also oil majors. Action in the commodity pits corroborates that the path of least resistance is higher both for the underlying commodity and relative share prices. Crude oil net speculative positions just hit a record high as a percent of open interest (bottom panel, Chart 13). Similarly, consensus on oil just breached the 50 line and is now in bullish territory, signaling that momentum in the relative share price ratio will gain steam in the coming months (middle panel, Chart 13). Adding it up, recovering energy related capex coupled with upbeat oil prices are a powerful tonic for the S&P integrated oil & gas index. Under such a backdrop a valuation rerating phase is looming (Chart 14). Chart 13Encouraging Oil Market Dynamics Encouraging Oil Market Dynamics Encouraging Oil Market Dynamics Chart 14Cheap With A 150bps Dividend Carry Cheap With A 150bps Dividend Carry Cheap With A 150bps Dividend Carry Bottom Line: Boost the S&P integrated oil & gas index to overweight. This index also sports a 150bps positive dividend carry. The ticker symbols for the stocks in this index are: XOM, CVX & OXY. ...Take Profits In Refiners While we recommend upgrading the S&P integrated oil & gas index to overweight, we are booking gains of 9% in the niche S&P oil & gas refining & marketing index and downgrading to a benchmark allocation. We upgraded refiners to overweight in early September, as a way to capitalize on the havoc that hurricane season dealt to refining capacity. Since then, our portfolio has benefited handsomely from the run up in refining stocks, but we do not want to overstay our welcome in this niche space as refinery runs have now returned to normal (Chart 15). Moreover, a number of headwinds signal that the easy gains are already behind this group. First, refining margins are under pressure as the Brent-WTI crude oil spread is steadily narrowing. Historically, refining margins and this oil price spread have been joined at the hip and the current message is negative for margins. A diverging inventory backdrop also points toward margin trouble ahead. Refined product inventories are outpacing crude oil supplies, warning that a further softening in crack spreads is in the cards (bottom panel, Chart 16). In fact, crude oil inventories are whittled down, whereas gasoline and distillate fuel stocks are built up (middle panel, Chart 15). This inventory accumulation represents, at the margin, a challenging pricing outlook for refiners. Chart 15Return To Normalcy... Return To Normalcy... Return To Normalcy... Chart 16...But Cracks Are Forming ...But Cracks Are Forming ...But Cracks Are Forming Worrisomely, sell side analysts have been extrapolating a euphoric EPS backdrop far into the future with five year profit forecasts pushing all-time highs. While tax reform represents a one-time boost to EPS in 2018, we cannot comprehend how this highly cyclical industry with razor thin margins can attain 34% EPS growth for the next 3-5 years, outpacing the overall market by a staggering 20 percentage points (Chart 17). Putting this sky-high long-term EPS growth number in perspective is instructive. Typically, relative share prices hit a wall when such analyst optimism reigns. The tech sector in the late 1990s, biotech stocks twice in 2001 and 2014, and semi equipment stocks late last year all suffered a major setback when long-term profit forecasts catapulted near the 25% mark (Chart 17). (As a reminder chip equipment stocks are a high-conviction underweight and have benefitted our portfolio by 17.2% since the November 27th inception, please see page 19.) Finally, from a technical perspective, a bearish pennant formation with lower highs has formed and is warning that a breakdown is possible in the relative share price ratio in the coming quarters (top panel, Chart 16). Nevertheless, we refrain from turning outright bearish on refiners as there is a sizeable offset. Refined product consumption is as firm as ever. Gasoline demand remains upbeat and this indicator has historically been positively correlated with relative share prices, relative 12-month forward EPS and relative valuations (Chart 18). Chart 17Watch Out Down Below Watch Out Down Below Watch Out Down Below Chart 18Consumption Is A Positive Offset Consumption Is A Positive Offset Consumption Is A Positive Offset Any let-up in demand or a further jump in refined product inventories could prove deflationary for refiners and were that to take place we would not hesitate to further prune exposure to a below benchmark allocation. Bottom Line: Lock in profits of 9% in the S&P oil & gas refining & marketing index and downgrade to neutral. The ticker symbols for the stocks in this index are: PSX, VLO, MPC and ANDV. Anastasios Avgeriou, Vice President U.S. Equity Strategy anastasios@bcaresearch.com 1 Please see BCA U.S. Equity Strategy Weekly Report, "High-Conviction Calls," dated November 27, 2017, available at uses.bcaresearch.com. Appendix Chart A1 Chart A1 Chart A1 Chart A2 Chart A2 Chart A2 Chart A3 Chart A3 Chart A3 Chart A4 Chart A4 Chart A4 Current Recommendations Current Trades Size And Style Views Favor value over growth. Stay neutral small over large caps (downgrade alert).

Overweight In a welcome reversal of fortunes, the S&P energy services index caught a bid last month, lifted by rising oil prices, healthy earnings and bullish 2018 forecasts. We think this is just the beginning for the beleaguered sector. OPEC crude oil production remains firmly in contraction territory with the mantle being taken up by non-OPEC producers (second panel), the key customer group for the energy services index. However, the increases have not been enough to offset the declines and OECD oil stocks have fallen for the past year, a trend that has sparked the biggest revival in oil patch capex in the last five years (third panel). In the context of the valuation pounding the sector has taken during the oil downturn, the rebound has a very long runway. We reiterate our overweight recommendation. The ticker symbols for the stocks in this index are: BLBG: S5ENRE- SLB, HAL, FTI, NOV, BHGE, HP. Energy Services Are Just Getting Warmed Up Energy Services Are Just Getting Warmed Up