Aerospace & Defense

Special Report

Highlights So What? The bull market in defense stocks is global and only beginning. We construct a BCA Global Defense Index to give investors exposure to this theme. Why? Multipolarity will drive uncertainty and conflict, spurring arms demand to Cold War heights. Contemporary geopolitical hotspots require expensive and modern technology. Cold War-era weapon systems are long in the tooth and in need of replacement. Also... We close our long Energy / short S&P 500 portfolio hedge for a gain. Feature It is somewhat of a cliché to tell clients that one of our highest conviction calls is to be overweight defense stocks. We are, after all, geopolitical investment strategists! Our decision to go long S&P 500 aerospace and defense stocks / short MSCI ACW is up 14% since initiation in December 2016. In this report, we build on previous work focusing on U.S. defense stocks and expand our analysis to global plays. GPS' Mega-Theme: Multipolarity Is Good For War International affairs are characterized by an anarchic governance structure. In the absence of a global government, the vacuum of power is filled by powerful states. These states behave like bullies in the schoolyard. When a single, powerful bully dominates the lunch break, all other kids fall in line or suffer the bully's wrath. When two bullies split the yard into warring camps, proxy fights may emerge on the sidelines, but generally an equilibrium is preserved. Formal political science theory and history teach us that the further we are from a hegemonic global structure where one country (the hegemon) dominates and bullies all others, the closer we are to anarchy. The "offensive realism" school of International Relations theory further splits multipolarity into two types: Balanced multipolarity is characterized by a number of roughly equally powerful states, similar to the distribution of power of continental Europe during the "Concert of Europe" era in the nineteenth century. Unbalanced multipolarity is closest to contemporary geopolitics. In The Tragedy Of Great Power Politics, John Mearsheimer reviewed 200 years of European history and concluded that unbalanced multipolarity is by far the most volatile geopolitical system (Table 1).1 Table 1Global System Structure And War A multipolar ordering of global power, therefore, produces the highest level of disorder (Chart 1). This finding is theoretically elegant, but normatively disturbing. Every country gets a voice and an opportunity to defend its sovereignty. But the international order is normatively ignorant and desires a bully or hegemon. Chart 1Multipolarity Produces Disorder Over the past fifty years, there have been three identifiable periods in the global arms market (Chart 2): Chart 2Further Upside In The 'War Bull Market' Cold War Arms Race - 1961-1982: The arms trade grew by a whopping 177% during this period, with an average annual growth rate of 5.5%; Disarmament - 1982-2002: Arms trade shrunk by 61% and average annual growth rate was -3.9%; Multipolarity - 2002-present: What started with the U.S. defense buildup following 9/11 has evolved into a truly global response to emerging multipolarity. The arms trade grew by 73% from 2002 to 2017, with an average annual growth rate of 3.4%. Bottom Line: In 2017, the total arms trade was 68% of its peak in 1982, signifying that we have more room to go in this recent "War Bull Market." Given that unbalanced multipolarity produces a higher volume of conflict than a bipolar system, we would expect the current phase to be more fruitful for the global arms race than even the Cold War era. The Pillars Of An Arms Bull Market Chart 3Global Defense Spending... In this report, we focus on the global arms trade, which is different from global defense spending (Chart 3). This is because global defense spending includes non-investible transactions, such as spending on salaries, buildings, health care, and pensions. The global arms trade was once 20% of global defense spending, but is now only 1.9% (Chart 4). Chart 4...Is Different From The Global Arms Trade The reason is that salaries and pensions now dominate defense budgets. In the U.S., they make up 42% of all expenditure. They are higher in much of the developed world (66% in Italy, for example). Moreover, many countries that in 1960 did not have an armaments industry have become quite adept at satisfying demand via domestic production. We nonetheless would expect the global arms trade to bounce off of its lows today. There are three main reasons. Evolving Conflict Zones: Asia And Europe The primary reason to expect a brisk pickup in the global arms race is that the global conflict zones are evolving. Multipolarity is causing shifting geopolitical equilibriums. We expect both East Asia and Europe - largely dormant as hotspots since the end of the Cold War - to catch up with the Middle East as zones of tensions. Periods of rising conflict tend to coincide with the rise in the global arms trade (Chart 5). Chart 5Rising Conflict Coincides With Escalating Arms Trade East Asia is our primary concern. Sino-American tensions have been brewing for decades, well before the trade war initiated by the Trump administration. Recently, the trade war has begun to spill into strategic areas (Table 2), creating a vicious feedback loop that could spark an accident or outright military conflict. Table 2Trade War Spills Into Strategic Areas The South China Sea is the premier geographic location of U.S.-China strategic friction. It is a hub for international trade, a vital supply route for all major Asian economies, and the premier focus of China's attempt to rewrite global rules (Diagram 1). We update our list of clashes in this area in Appendix A. Diagram 1South China Sea As Traffic Roundabout China has used its growing economic heft in the region to bully its neighbors into acquiescing to its geopolitical posture (Chart 6). It has used economic sanctions, trade boycotts, and tourism bans to get its way with the neighborhood. China's East Asia neighbors - including Japan - will look to balance their growing dependence on the Chinese economy with a desire to maintain sovereignty. One way to do so will be to rearm and present a formidable challenge to Beijing's regional hegemony. This means that not only the South China Sea but also China's entire periphery is at risk of friction, and this is true regardless of any U.S. interest in Asia. Chart 6China Uses Its Economic Might To Bully Europe is also growing as a potential source of global arms demand. Since the end of the Cold War, Europe has seen a decline in defense spending. One reason is the NATO alliance, which has allowed Europeans to pass the buck to the U.S. This has not only been the case with the safely cocooned Western European states. Poland, intimately familiar with the built-in geopolitical risks of its neighborhood, reduced its defense spending once it joined NATO. President Trump has made awakening Europe from its stupor a key pillar of his trans-Atlantic policy. A combination of Trump's pestering and concerns that the U.S. is trending towards isolationism with an evolving threat matrix that now includes terrorism, migration, and Russia should be enough to spur Europeans to meet their commitment to spend 2% of GDP on defense (Chart 7). Chart 7Europeans Will Be Swayed To Meet Defense Commitments... If NATO member states and Japan were to respond to their evolving threats and commit to spending 2% of GDP on defense, the impact on global arms demand would be significant. The extra spending would be roughly $145 billion, a 14% increase from current levels (Chart 8). Chart 8...Raising Global Arms Demand What about the Middle East? In the short term, we are concerned that President Trump's "maximum pressure" policy could lead to kinetic action against Iran. In the medium and long term, we expect some form of an equilibrium to emerge in the Middle East that would keep regional demand for weapons stable at current elevated levels. Saudi Arabia has been the primary importer of weapons, with 13% of total demand since 2002. Saudi purchases have accelerated as the U.S. has geopolitically deleveraged out of the region (Chart 9 and Chart 10). Chart 9As The U.S. Military Deleverages... Chart 10...The Saudi Arabian Military Leverages Evolving Technological Demands The U.S. invasion of Afghanistan and Iraq at the beginning of this century was probably the last large-scale mechanized conflict involving large formations of main battle tanks (MBT). The evolving threat matrixes in East Asia and Europe are likely to create a growing demand for naval, air superiority, and drone/autonomous technology. In East Asia, the two main risk theaters are the South and East China Seas. In Europe, the Mediterranean, the Baltic, and the Black Seas are increasingly becoming a risk vector due to the instability of North African and Middle East countries, as well as Russian assertiveness. This is good news for the arms industry as aircraft and ships are some of the most lucrative exports given the high level of technological sophistication that goes into developing them (Chart 11). A war fought in the trenches and jungles by soldiers and insurgents is unlikely to be very profitable, other than for small arms manufacturers. But tensions between sovereign nations across large distances and bodies of water will be highly lucrative for major defense manufacturers that specialize in anti-access/area-denial systems.2 Chart 11Aircraft And Ships Are Most Lucrative Furthermore, capital depreciation is advanced for the most sophisticated (and thus expensive) military technology that was introduced at the tail-end of the Cold War expansionary phase. The U.S. aircraft carrier fleet, for example, is mostly made up of Nimitz-class carriers, which have served for the past 43 years on average (Chart 12). Chart 12Capital Depreciation Is Advanced Our back-of-the-envelope calculations show that the cyclicality in U.S. aircraft carriers is apparent across the major defense systems. Looking at 40 countries and their respective aircraft and MBTs, the bulk of these weapons is beyond the average age of the previous generation when it was retired (Chart 13). Part of the reason for the extended life cycle is better technology, but we suspect the main reason is that these major weapon systems were developed at the height of the Cold War and have not been updated since then. Chart 13Weapons Are Beyond Retirement Age, Need Updating Population Aging The demographic trends of population aging and low birth rates have wide-ranging macroeconomic implications. But they will also impact the defense industry by encouraging automation. There are benefits to automation in the military sphere beyond simply replacing a shrinking pool of able-bodied youth. First, the likely geopolitical hotspots of this century - East Asian seas, the Persian Gulf, the Black Sea, the Mediterranean, and the Indian Ocean - are conducive to high-tech warfare. These bodies of water will be patrolled by drones and plied by autonomous surface vessels while hypersonic missiles deny access to the enemy. Second, by shifting the burden of fighting wars from humans to robots, policymakers will face lower constraints to conflict. This development will not only encourage policymakers to develop autonomous weapon systems, but might also increase the frequency with which they are used, destroyed, and thus re-ordered, shortening the hardware life-cycle and thus increasing the sales volume. Bottom Line: Global multipolarity has seen the U.S. geopolitically deleverage from the Middle East, threaten Europe with abandonment, and put pressure on China in East Asia. These are trends that we believe are here to stay irrespective of President Trump's success or failure in the 2020 election. They are all bullish for defense spending and arms trade. In addition, evolving technological demands and global demographic trends will buoy the arms trade. We expect this era of unbalanced multipolarity to be even more lucrative for global defense contractors. The U.S.: Remain Overweight Anastasios Avgeriou, BCA's chief U.S. equity strategist, recommends that investors remain overweight the pure-play BCA defense index and add exposure to it on any meaningful pullbacks while keeping it as a structural overweight within the GICS1 S&P industrials index. In the U.S., defense spending and investment have bottomed and will continue to accelerate. The Congressional Budget Office (CBO) continues to project that defense outlays will jump further next year (middle panel, Chart 14). We expect that this breakneck pace is actually sustainable, mainly because any fiscal compromise with Democrats on discretionary, non-defense spending would require acquiescence on GOP spending priorities, such as defense. Defense outlays will therefore continue to expand into the 2020s. Chart 14Upbeat Defense Outlays... Such a buoyant demand backdrop is music to the ears of defense contractor CEOs and represents a boost to defense equity revenue growth prospects. Defense contractors enjoy high operating leverage. No wonder M&A activity is robust: at least four large deals have been announced in the past year that are underpinning both takeout premia and relative share prices (bottom panel, Chart 15). Chart 15...And A Flurry Of M&A Is A Boon For Defense A closer look at operating metrics corroborates the view that defense goods manufacturers are firing on all cylinders. New orders recently jumped to fresh all-time highs and the industry's shipments-to-inventories ratio is rising, on track to surpass the 2008 peak. Unfilled orders are also running at a high rate, signaling that factories will keep on humming at least for the next few quarters (Chart 16). Chart 16Firming Operating Metrics Importantly, the industry is not standing still and is making significant investments. U.S. defense capex as reported in the financial statements of constituent firms is growing at roughly 20% annually, or twice as fast as overall capex (Chart 17). Defense ROE is running near 30%, again roughly double the rate of the broad market (Chart 18). Chart 17Industry Is Not Standing Still Chart 18Healthy Balance Sheet With High ROE... Valuations are on the expensive side and in overshoot territory (Chart 19). This is clearly a risk to the overall view. However, if our structural thesis pans out, then defense stocks in the U.S. will grow into their pricey valuations as happened in the back half of the 1960s. Chart 19...But Valuations Are Expensive Bottom Line: The secular advance in pure-play defense stocks remains in place. BCA's U.S. Equity Strategy recommends an above-benchmark allocation. The ticker symbols for the stocks in the BCA defense index are: LMT, LLC, NOC, GD, and RTN. Global Stocks: Be Discerning Beyond the U.S., which global defense stocks are appealing? We believe that there are several market and structural factors to consider. We have ranked national defense sectors by market and structural factors in Tables 3 and 4. Further, Appendix B lists all the non-U.S. weapon manufacturers that we examined, as well as market performance by country. Table 3Russian Defense Sector Attractive On Market Factors Table 4European Companies Rank Highly On Structural Factors Momentum - We like stocks from equity markets that have momentum behind them, i.e. whose stock are above their 200-day moving average. Relative valuation - We like defense sectors that are at a discount relative to the U.S. plays. Performance since Trump - For any country that has outperformed the U.S. aerospace and defense sector since the inauguration of President Trump on January 20, the market believes in its competitiveness vis-à-vis the largest exporter. Geographical diversity - We have ranked country defense sectors by how diverse their sources of revenue are. The higher the figure, the more geographically diverse the revenue pool. Russian and Indian defense plays score very low on this variable as they depend solely on one source: themselves. Exposure to arms trade - We have ranked country defense sectors by how exposed their contractors are to defense as opposed to civilian production. Most companies have major civilian outlays. To fully capture our multipolarity theme, we have ranked companies based on how fully focused they are on producing and selling weapons. Share of global arms market - We recommend that clients buy defense companies in countries that already have a high share of the global arms market. Decisions on purchasing weapons often involve path dependency due to the need to acquire compatible systems. Defense spending - We penalize countries that are already spending 2% of GDP on defense. Their companies will see little boost to domestic demand. It is the other, under-spending countries that will significantly increase their outlays over the next decade. Russian companies score high on market factors. They have good momentum, are attractively valued relative to the U.S. aerospace and defense sector, and are structurally supported. Israel, Canada, Australia, and Brazil are also attractive. All of these are made up of only one stock. On structural factors alone, we like German, British, Italian, and Swedish defense companies. They are geographically diversified, have a respectable share of the global arms trade, and have both reason and room to increase domestic spending. French companies are also structurally attractive, although France may have less need to increase defense outlays. Putting it all together, we are creating a BCA Global Defense Basket. We would include the following global tickers in that basket: A:ASBX, F:AIRS, F:CSF, F:SGM, F:AM@F, C:CAE, D:RHM, D:TKA, I:LDO, I:FCTI, ULE, COB and W:SAAB. Clients may want to include in the basket the five U.S. tickers recommended by BCA's U.S. Equity Strategy: LMT, LLL, NOC, GD, and RTN. We recommend that investors buy this basket, in absolute terms, as a structural investment. Housekeeping We are closing two of our hedges today. First, we are closing long Brent / Short S&P 500 for a gain of 6% and our long U.S. energy / short U.S. information technology for a loss of 1.63%. We initiated the two tactical trades on October 3, which means we timed the market correction perfectly. However, concerns over a supply glut in the oil market meant that the "long" part of our trade did not work out. Furthermore, there have been leaks from the White House to the media that the U.S. may award exceptions to the oil embargo to several critical importers. This would suggest that the Trump administration is beginning to see the risks of its aggressive maximum pressure strategy toward Iran and therefore may be trying to backtrack from it. We still think that the odds of an oil spike due to geopolitics in 2019 are high, but they do appear to be declining, at least for the time being. As such, we are closing the two trades for a net gain. We will continue to monitor the Iran embargo carefully as we expect that geopolitical risks will again be understated in the future, offering investors another opportunity to be long energy. Jesse Anak Kuri, Consulting Editor jesse.anakkuri@mail.mcgill.ca 1 Please see John Mearsheimer, The Tragedy Of Great Power Politics (New York: W.W. Norton & Company, 2001). 2 Anti-access/area-denial (A2/AD) is a strategy of preventing an adversary from occupying or transiting a geographic area. Defense systems that perform A2/AD functions in the modern era tend to be expensive and technologically sophisticated. They include anti-ship missiles, sophisticated radars, attack submarines, and air-superiority fighter jets. Appendix A Notable Clashes In The South China Sea (2010-18) Notable Clashes In The South China Sea (2010-18) (Continued) Notable Clashes In The South China Sea (2010-18) (Continued) Appendix B Appendix B Chart 20British Defense Stocks Appendix B Chart 21French Defense Stocks Appendix B Chart 22German Defense Stocks Appendix B Chart 23Italian Defense Stocks Appendix B Chart 24Swedish Defense Stocks Appendix B Chart 25Norwegian Defense Stocks Appendix B Chart 26Canadian Defense Stocks Appendix B Chart 27Australian Defense Stocks Appendix B Chart 28Korean Defense Stocks Appendix B Chart 29Japanese Defense Stocks Appendix B Chart 30Singaporean Defense Stocks Appendix B Chart 31Israeli Defense Stocks Appendix B Chart 32Russian Defense Stocks Appendix B Chart 33Brazilian Defense Stocks Appendix B Chart 34Indian Defense Stocks Appendix B Chart 35Turkish Defense Stocks Appendix B Table 1Key Aerospace And Defense Companies Appendix B Table 1Key Aerospace And Defense Companies, Continued

Overweight We have been overweight the pure-play BCA defense index since late-2015 and our strategy is to add exposure on any meaningful pullbacks and keep this index as a structural overweight within the GICS1 S&P industrials index. In the U.S., where military spending in absolute terms is greater than the rest of the world put together, defense spending and investment have bottomed and will continue to accelerate. In fact, the CBO continues to project that defense outlays will jump further next year (second panel). While such a breakneck pace is clearly unsustainable, this administration appears serious about upgrading and updating the U.S. military. The upshot is that defense outlays will continue to expand into the 2020s. Still, undoubtedly valuations are on the expensive side. Not only is recent M&A fever the culprit, but global investors' insatiable appetite for pure-play defense stocks has also driven valuations into overshoot territory (bottom panel), though if our thesis pans out, then these stocks will grow into their pricey valuations as happened in the back half of the 1960s.1 Bottom Line: The secular advance in pure-play defense stocks remains in place. We continue to recommend an above benchmark allocation; please see Monday's Weekly Report for more details. The ticker symbols for the stocks in the BCA defense index are: LMT, LLL, NOC, GD and RTN. 1 Please see BCA U.S. Equity Strategy Special Report, "Brothers In Arms," dated October 31, 2016, available at uses.bcaresearch.com.

Highlights Portfolio Strategy Debt saddled small caps have to wrestle with rising interest rates at a time when they lack a valuation cushion. Tack on their high beta status and investors should continue to avoid small caps and instead prefer large caps. Upbeat global demand for U.S. defense goods, firming defense industry operating metrics and a flurry of M&A will more than offset the defense contractors' valuation overshoot. Stay structurally overweight. Recent Changes There are no changes to the portfolio this week. Table 1 Feature In Greek mythology, Daedalus warned his son Icarus not to fly too close to the sun when the pair of them were escaping from Crete, as his wax-made wings would melt. Icarus ignored his father's warning and soared toward the sun that eventually led to his drowning in the Aegean Sea when his wings melted. Is the equity market experiencing an Icarus moment? The S&P 500 is undergoing a healthy reset during crash-prone October, but post-midterms it should make an attempt to vault to fresh all-time highs into year-end. The selloff in the bond market (largely driven by the real component) most likely caused the consternation in stocks, but our sense is that the backup in yields is reflective and not yet restrictive both for stocks and, most importantly, the economy. In the coming weeks we expect a retest, and hold, of the recent lows before waving the all clear sign. Nevertheless, the latest bout of volatility is a cause for concern especially given that the SPX pullback is not sentiment/technical driven as it was earlier in the year when on January 221 and again on January 292 we cautioned clients that the equity market advance was too good to be true and complacency reigned supreme. As a reminder in late-January, equities looked extremely stretched on a number of sentiment and technical indicators. This was not the case, however, heading into October (Charts 1 & 2), and it raises the question: what are stocks discounting with regard to the economic backdrop? Chart 1Leading Into The Recent Pullback Sentiment And Technicals... Chart 2...Were Not As Extended As In Late-January Our biggest worry is that the 2018 goosing of the economy will soon fall flat as President Trump runs out of firepower to further buoy the economy. In other words, we have likely brought demand/consumption forward which should get reflected in softer 2019 output data, especially if there is gridlock in Congress post the midterms. Keep in mind, that most of the fiscal easing that pertains to stocks is front loaded to this year. The drop in corporate taxes is a one-off EPS boost for 2018, as is the surge in buybacks that was driven by cash repatriation. Buybacks are on pace to reach $1tn in 2018, but are likely to fall back to the more typical $400bn/annum rate next year. The U.S. economy and stock market will have to grapple with both of these fading tailwinds in 2019. One simple way to depict this is our newly conceived BCA Economic Impulse Indicator (EII). Chart 3 shows six economic indicators gauging the state of the U.S. economy. The EII comprises housing, capex, manufacturing, confidence, employment and credit; it is equally weighted shown as a Z-score. At present it is wobbling and diverging negatively from euphoric SPX EPS growth rates. Chart 3 Mind The Gap Not only is the economy humming at an unsustainable pace, but the Fed is also tightening monetary policy and letting maturing securities run off its balance sheet at approximately $50bn/month. If the Fed hikes rates three more times by June 2019, as both the bond market and our fixed income strategists expect, the fed funds rate will reach a range of 2.75%-3%. It then becomes plausible that any letdown in economic data could cause the yield curve to invert. The elimination of the unemployment gap increases the probability of curve inversion (see Chart 1 from the October 23, 2017 Weekly Report), as does another indicator of labor market tightness that recently dropped below zero (Chart 4). Chart 4Full Employment And Yield Curve Joined At The Hip But, we are not there yet and want to be systematic in calling the end of the business cycle, and thus equity bull market, using the three signposts we deemed most important earlier in the year: a yield curve inversion (leading indicator), doubling in year-over-year oil prices based on monthly dataset (coincident indicator) and a mega-merger announcement either in tech or biotech space (confirming anecdotal indicator). With regard to the latter, the rumored Uber IPO fetching a valuation of $120bn may also qualify as an end of cycle anecdotal indicator. Still, none of these three boxes have yet been ticked. Moreover, two other catalysts may assist in prolonging the cycle and breathe a sigh of relief not only in U.S. equities, but also in global bourses: a trade deal with China, and/or a reversal in U.S. dollar strength that would boost global ex-U.S. growth. Netting it all out, while the recent equity market swoon is worrisome it is still too early to call the end of the cycle and we do not think we are in an "Icarus moment". Our broad equity market strategy is to "buy the dip" as we expect EPS to do all the heavy lifting next year with the multiple drifting lower, and we continue to recommend a cyclical over defensive portfolio bent. This week we highlight a deep cyclical capital goods subsector and revisit our size bias. The Bigger The Better The days in the sun are over for small cap stocks. Similar to the double top formation in the early 1980s, small cap stocks have hit a wall and are giving in to their larger brethren. There are high odds that the small over large multi-year ascendancy is over and a reversion, at least, to the historical time trend mean is in order (Chart 5). Chart 5Double Top Since changing our size bias to a large cap bias on May 10, 2018, the S&P 500 has bested the S&P 600 index by over 300bps. Small caps however remain fully valued using different metrics and are extremely overvalued versus the SPX according to the Shiller P/E (or cyclically adjusted P/E, CAPE) methodology of smoothing the earnings cycle over a decade (Chart 6). In fact, this 40% CAPE premium leaves no space for any small cap profit mishaps. Chart 6Small Caps Valuations Are Stretched... Unfortunately, on a number of fronts small cap EPS will underwhelm and significantly trail SPX EPS, the opposite of what optimistic sell-side analysts expect. First, small caps are severely debt saddled as we have highlighted in our recent research. Sustained small cap balance sheet degradation is worrying, with S&P 600 net debt-to-EBITDA close to 4 (compared with 1.5 for the SPX, middle panel, Chart 7). Such gearing is fraught with danger as the default rate has nowhere to go but higher. Chart 7...Amidst Balance Sheet Degradation... Second, small and medium businesses have a higher dependency on bank credit as opposed to the bond market access that mega caps enjoy. Most bank credit is floating rate debt and so are lines of credit, and as the Fed remains firm on tightening monetary policy, interest expense costs are skyrocketing for SMEs. In a relative sense this will weigh on net profits. More generally, given the high indebtedness, small caps are a lot more sensitive to interest rates, and the selloff in the 10-year Treasury note heralds more pain in 2019 (10-year Treasury yield shown inverted, Chart 8). Chart 8 ...And With Rates Rising... Third, relative wage costs are flashing red for small caps. Small cap margins are thin - roughly mid-single digits or 800bps below large caps, and rising labor costs (according to the latest NFIB survey) are warning that this delta will widen, further suppressing relative margins and profitability as large cap wage costs are still well contained (Chart 9). Chart 9...And Labor Costs Perking Up, A Margin Squeeze Looms Fourth, small caps are high(er) beta stocks and when volatility spikes they underperform large caps. When the Fed ballooned its balance sheet and dropped the fed funds rate to zero it suppressed volatility. Now that the Fed has been decreasing the size of its balance sheet and raising interest rates, this is working in reverse and volatility is making a comeback as we have been highlighting in our research, and will continue to weigh on small caps (VIX shown inverted, top panel, Chart 10). Chart 10Large Caps Have The Upper Hand Another way to showcase small caps' riskier status is the close correlation they have with the relative EM equity share price ratio. When EMs outperform the SPX, small caps follow suit and vice versa. Importantly a wide gap has opened recently and we suspect that it will narrow via small caps following the EM higher beta stocks lower (SPX vs. EM ratio shown inverted, bottom panel, Chart 10). Adding it up, a high small cap debt burden, rising interest rates, lack of a valuation cushion, and their high beta status all signal that investors should continue to avoid small caps and instead prefer large caps. Bottom Line: Stick with a large cap bias. Stay With Defense Stocks For The Long-Term We have been overweight the pure-play BCA defense index since late-2015 and there are high odds that this juggernaut that really commenced with the George Walker Bush presidency remains in a secular growth trajectory (top panel, Chart 11). Our strategy is to add exposure on any meaningful pullbacks and keep this index as a structural overweight within the GICS1 S&P industrials index. Chart 11Defense Stocks Are A Secular Growth Play The rise of global "multipolarity" - or competition between the world's great nations - and the decline of globalization, along with a global arms race and increased risk of cyber-attacks, have been documented in our "Brothers In Arms" Special Report. These trends all signal that global defense related spending will remain upbeat in the coming decade.3 In the U.S. in particular, where military spending in absolute terms is greater that the rest of the world put together, defense spending and investment have bottomed and will continue to accelerate. In fact, the CBO continues to project that defense outlays will jump further next year (middle panel, Chart 12). While such a breakneck pace is clearly unsustainable, President Trump is serious about upgrading and updating the U.S. military in order to keep China's geopolitical and military ascendancy in check (as well as to deal with Russia and Iran).4 The upshot is that defense outlays will continue to expand into the 2020s. Chart 12Upbeat Defense Outlays... Such a buoyant demand backdrop is music to the ears of defense contractor CEOs, and represents a boost to defense equity revenue growth prospects. This capital goods sub-industry has extremely high fixed costs and thus any increase in top line growth flows straight to the bottom line. Put differently, defense contractors enjoy high operating leverage. No wonder M&A activity is robust: at least four large deals have been announced in the past year that are underpinning both takeout premia and relative share prices (bottom panel, Chart 13). Chart 13 ...And A Flurry Of M&A Is A Boon For Defense Stocks A closer look at operating metrics corroborates that defense goods manufacturers are firing on all cylinders. New orders recently jumped to fresh all-time highs and the industry's shipments-to-inventories ratio is rising, on track to surpass the 2008 peak. Unfilled orders are also running at a high rate, signaling that factories will keep on humming at least for the next few quarters (Chart 14). Chart 14Firming Operating Metrics Importantly, the industry is not standing still and is making significant investments. U.S. defense capex as reported in the financial statements of constituent firms is growing at roughly 20%/annum or twice as fast as overall capex (Chart 15). Chart 15Industry Is Not Standing Still True, industry indebtedness is also on the rise as some of the expansion has been debt financed, but net debt-to-EBITDA trails the overall market (ex-financials). Similarly, interest coverage has been modestly deteriorating, but is twice as high as the overall market. Impressively, defense ROE is running near 30%, again roughly double the rate of the broad market (Chart 16). Chart 16Healthy B/S With High ROE... Nevertheless, undoubtedly valuations are on the expensive side. Not only is recent M&A fever the culprit, but global investors' insatiable appetite for pure-play defense stocks has also driven valuations into overshoot territory (Chart 17). This is a clear risk to our secular overweight view, however, if our thesis pans out, then these stocks will grow into their pricey valuations as happened in the back half of the 1960s.5 Chart 17 ...But Valuations Are Expensive In sum, upbeat global demand for U.S. defense goods, firming industry operating metrics and a flurry of M&A will more than offset the defense contractors' valuation overshoot. Bottom Line: The secular advance in pure-play defense stocks remains in place. We continue to recommend an above benchmark allocation. The ticker symbols for the stocks in the BCA defense index are: LMT, LLL, NOC, GD and RTN. Anastasios Avgeriou, Vice President U.S. Equity Strategy anastasios@bcaresearch.com 1 Please see BCA U.S. Equity Strategy Weekly Report, "Too Good To Be True?" dated January 22, 2018, available at uses.bcaresearch.com. 2 Please see BCA U.S. Equity Strategy Weekly Report, "Corporate Pricing Power Update," dated January 29, 2018, available at uses.bcaresearch.com. 3 Please see BCA U.S. Equity Strategy Special Report, "Brothers In Arms," dated October 31, 2016, available at uses.bcaresearch.com. 4 Please see BCA Geopolitical Strategy Special Report, "A Global Show Of Force?" dated October 10, 2018, available at gps.bcaresearch.com. 5 Please see BCA U.S. Equity Strategy Special Report, "Brothers In Arms," dated October 31, 2016, available at uses.bcaresearch.com. Current Recommendations Current Trades Size And Style Views Favor value over growth Favor large over small caps

Overweight On Monday of this week, President Trump signed the John S. McCain National Defense Authorization Act into law. Most significantly, the bill authorizes $717 billion in defense funding for FY2019, a small increase from the $696 billion in FY2018, which was a significant increase from the FY2016 $580 billion budget. The administration's commitment to returning military funding to wartime levels (regardless of budget constraints or geopolitical threat) are confirmed by defense spending surging at the fastest rate in nearly a decade (second panel). This is further reflected in the recovery in defense investment (bottom panel). We highlighted earlier this week that defense stocks should be winners in a trade war, particularly if such a war increases the threat of a more conventional one. Tack on above-normal earnings growth from exceptional government funding and defense stocks look even more appealing; stay overweight. The ticker symbols for the stocks in the BCA Defense index are: LMT, GD, RTN, NOC, LLL.

Overweight Defense stocks have been range-bound in the last week as geopolitical maneuvering has seen probabilities of conflict on the Korean peninsula swinging wildly back and forth. Using this conflict to value defense equities seems fraught with forecast risk and we would argue that focusing on domestic rearmament is a better use of investors' time. In last month's data release, Department of Defense outlays showed the longest streak of increases this decade, pointing to a continued acceleration in defense spending (second panel). This is mirrored by surging government investment in defense, now at its highest level in 5 years (third panel). The Trump administration's commitment to rearmament has now made it into the federal budget; the Congressional Budget Office (CBO) estimates defense outlays will approximate wartime levels in 2019 (bottom panel). Net, we expect earnings visibility will peak through the fog of war and be the ultimate driver of stock market returns; stay overweight. The ticker symbols for the stocks in the BCA Defense index are: LMT, GD, RTN, NOC, LLL.

Overweight Defense stocks were battered this week as, despite earnings exceeding expectations and both guidance and forecasts moving higher, the market sold off. It appears a softer tone from President Trump with respect to North Korean leader Kim Jong Un, combined with the latter's announcement that North Korea would no longer test nuclear weapons and intercontinental ballistic missiles, has eased geopolitical fears enough to lower defense expectations. We think this matters relatively little with respect to the top line growth of defense firms. Domestic defense spending is set to take off to unprecedented levels as the Trump administration appears committed to rearmament. Moreover, this is a global trend; the Stockholm International Peace Research Institute (SIPRI) noted late last year that global arms sales (as measured by the revenues of the largest 100 defense companies) had arrested their 6-year long decline last year, rising by 1.9% in 2017. As fears of a global trade war are receding, we think the relatively soft U.S. dollar should be supportive of international orders while domestic demand remains resilient; stay overweight. The ticker symbols for the stocks in the BCA Defense index are: LMT, GD, RTN, NOC, LLL

Overweight S&P defense shares have been enjoying a terrific streak over the past three years, solidly outperforming the S&P 500 in each of them. This is in no small part because of new orders, which have been steadily recovering (second panel) and surging demand eroding inventories (third panel), implying outsized cash generation. Adding to this excitement is President Trump's 2019 defense budget request of $686 billion, which would arrest seven years of real defense budget declines. It is thus unsurprising that threats of a global trade war have taken some of the energy out of the index, though we think recent declines are an overreaction for three reasons. First, the administration has shown a willingness to exclude allies (the principal international customer group for defense firms) from trade restrictions. Second, given high switching costs, a weaker U.S. dollar should be supportive of international orders regardless of the administration's stance. Third, as shown in the bottom panel, the fundamental performance driver of defense equities is domestic defense spending; as noted above, this is clearly biased higher from a secular perspective. Net, recent declines represent a buying opportunity; we reiterate our overweight recommendation. The ticker symbols for the stocks in the BCA Defense index are: LMT, GD, RTN, NOC, LLL

Overweight The U.S. defense complex has seen a solid recovery in orders over the last three years (second panel), a notable feat because of the absence of a major conflict driving domestic orders. In fact in the past decade, domestic real defense spending has contracted more than it has expanded and even when it is growing, it has not been at a pace faster than mid-single digits (third panel). That may soon change. If early reports are correct, the Trump administration will raise its defense spending target to $716 billion for the 2019 budget, an increase of 13% from this past year's level. Such largesse should sustain the valuation rerating defense stocks have been enjoying. Stay overweight. The ticker symbols for the stocks in the BCA Defense index are: LMT, GD, RTN, NOC, LLL .

Overweight The Stockholm International Peace Research Institute (SIPRI) released data earlier this week showing that global arms sales (as measured by the revenues of the largest 100 defense companies) had arrested their 6-year long decline last year, rising by 1.9%. The key driver appears to be Lockheed Martin (LMT), which saw rising sales for the international F-35 program and also purchased helicopter producer Sikorsky, thus cementing its position as the number one defense firm. Importantly, 2016 saw arms sales for South Korean companies surge by 20.6% in response to the rising tensions on the Korean peninsula, both to meet domestic demand and for international exports. There are two implications from this statistic: first, rising South Korean arms production means overall demand is increasing and second, defense demand is becoming heterogeneous. In conjunction with growth in domestic armed forces (second panel), the demand environment for U.S. defense firms remains bright and while valuations are lofty on a P/E and P/CF basis, they are not out of line with the broad market measured by EV/EBITDA (third panel); stay overweight. The ticker symbols for the stocks in the BCA Defense index are: LMT, GD, RTN, NOC, LLL.

Special Report

A capex revival is underway, powered by exceptionally strong business and consumer sentiment, the breadth of which covers virtually all developed economies. This global capex upcycle should underpin top-line growth and margin expansion for the industrial conglomerates index, whose product and geographic diversification ensures exposure to the global upswing. However, the index has underperformed the broad market, dragged down by heavyweight GE and its specific headwinds. Further, the index's highest exposure sectors (namely aerospace, health care equipment, energy equipment & services and utilities) are mostly weighted negatively in our overall sector view. Adding it up, the negatives offset the positives and, in the context of fair valuations, we expect the S&P industrial conglomerates index to perform in line with the overall market. We are initiating coverage with a neutral rating. The key theme that has been driving our investment thesis in U.S. Equity Strategy in the past quarter has been accelerating global industrial production and trade, with a corresponding rotation out of defensive and into cyclical stocks. We have been adjusting our portfolio accordingly and it now has a deep cyclical bent with leverage to a burgeoning capex cycle. Enticing Macro Outlook Industrial conglomerates capitalize on most of these themes: they are globally-oriented and capex-driven, and leading indicators of final demand suggest that earnings should accelerate in the near-term. Capex Upcycle On the domestic front, regional Fed surveys of domestic capex intentions and the ISM manufacturing survey are hitting modern highs; both have been excellent indicators of a capex upcycle and the signal is unambiguously positive (Chart 1). Our Capex Indicator also corroborates this message. Durable goods orders have already surged and inventories have reverted to a more normal level, coming out of the late-2015/early-2016 manufacturing recession (Chart 2). This implies increasingly resilient pricing power from a demand-driven capital goods upcycle. Further, the capital goods cycle has significant room to run as new orders remain well below the 2013-2014 levels. Chart 1Exceptionally Strong Sentiment... Chart 2...Is Already Reflected In A Capex Upcycle Chart 3Capital Goods Demand Is Globally Synchronous The global picture echoes the domestic, with the global manufacturing PMI surging to a six-year high. The global strength is remarkably broad: all 46 of the economies tracked by the OECD are expected to see gains in 2017, a first since the GFC, and the BCA global leading economic indicator is signaling all-clear (Chart 3). U.S. Dollar Reflation The greenback's slide in 2017 should further boost global demand for domestic exports. In fact, given the diversity of industries served by the industrial conglomerates and the relatively high proportion of foreign sales (Table 1), the U.S. dollar is the single largest driver of both sales and earnings (Chart 4). Due to the lagged impact on results from the currency, industrial conglomerates margins should benefit from translation gains in the next two quarters, regardless of where the U.S. dollar moves. Table 1Conglomerates More Global Than Industrial Peers Chart 4U.S. Dollar Drives Conglomerate Profits But GE Weighs On The Index With the enormously supportive demand environment in mind, one could safely assume that the globally integrated niche industrial conglomerates index has been a strong performer in 2017. That would be true were it not for index heavyweight (and laggard) General Electric. Excluding GE from this index, industrial conglomerates have outperformed the S&P 500 by 20% since the start of the year (Chart 5). However, GE represents 40% of the index (Chart 5) and its current transformation continues to weigh heavily on its share price and, hence, the index at large. The new CEO, who took over earlier this month, has stated that "everything is on the table" as part of a $20 billion target for divestitures over the coming two years. The current fear among investors is that GE will need to reduce its dividend to preserve enough liquidity to continue growing despite the fairly synchronous storm in its end-markets. In March, 2009, GE's share price reached its modern nadir, a level not seen since the recession of the early 1990's, a week following its dividend cut announcement. While hardly analogous to GE today (recall that a cash crisis at GE Capital threatened to bankrupt the entire firm), the risk of a dividend cut will keep GE's share price suppressed, and likely hold the overall index hostage. Payout ratios in the industrial conglomerates index reflect GE's cash flow woes and have now surpassed the pre-dividend cut level during the GFC (Chart 6). This largely reflects cash contraction, combined with an unwillingness to even halt dividend growth. Regardless, GE investors clearly anticipate the new CEO will reduce the dividend, having pushed the yield to its highest level since the last dividend cut (Chart 6). Chart 5GE Still Dominates The Index Chart 6A Dividend Cut Looks To Be In The Cards Soft End-Markets Backdrop From the mid-1990's until 2007, the narrative of the S&P industrial conglomerates index was the rise and fall of GE Capital, as evidenced by the index' price. In 2015, the now largely complete sale of the majority of GE Capital was announced, realigning the company as an industrial manufacturer. Accordingly, analyzing the key end-market industries that the S&P industrial conglomerates cater to is in order: aerospace, healthcare, oil & gas and utilities. Chart 7Aerospace Profits Look Set To Fall Chart 8Health Care Equipment Pricing Collapsing Aerospace (Underweight recommendation) - We downgraded the BCA aerospace index to underweight at the end of 2015, corresponding fairly closely to the peak of the aerospace orders cycle (Chart 7). Since then, orders have fallen by half reflecting a downturn in the commercial aerospace cycle. While shipments have been falling, the decline has been much less precipitous as manufacturers have been running down backlogs. Historically, maintenance has buffered aerospace profits, repair and consumables activity, though weak current pricing power suggests that this may prove less sustainable than in previous cycles. Both GE & HON share extensive exposure to aerospace demand as it represented 23% and 38% of 2016 revenues, respectively. Health Care Equipment (Neutral recommendation) - We reduced our recommendation to neutral earlier this year as weaker demand no longer supported the thesis of an earnings-led outperformance. Since then the industry's outlook has not improved as demand has downshifted and pricing has cooled substantially; orders and production both crested last year and pricing power has contracted relative to overall since December 2016 (Chart 8). This bodes ill for medical equipment margins. Health care equipment represented 16% and 18% of GE & MMM 2016 revenues, respectively. Energy Equipment & Services (Overweight recommendation) - Energy Equipment & Services is our only overweight recommended sector relevant to the industrial conglomerates analysis. We upgraded in late 2016 (and doubled down on June 2) based on three key factors: troughing rig counts, cresting global oil inventories and falling production growth. Two of these factors have come to fruition: the global rig count bottomed in 2015, and has staged its best recovery since 2009 (Chart 9) and the growth in total OECD oil stocks is moderating rapidly with recent large storage draws. The key missing ingredient has been pricing power, which should eventually turn up if rig counts prove resilient. Energy equipment & services represented 11% of GE's 2016 revenues. Utilities (Underweight recommendation) - As previously noted, a key macro theme in U.S. Equity Strategy is accelerating global industrial production and trade. Utilities tend to move in the opposite direction of that theme given their safe haven status (top panel, Chart 10). Combined with falling domestic electricity production and capacity utilization, and rising turbine & generator inventories, the industry's outlook is bleak (middle & bottom panels, Chart 10). GE's Power segment is one of the world's largest gas and steam turbine manufacturers and delivered 24% of 2016 revenues. Investment Recommendation A roaring, globally synchronous capital goods upcycle should mostly keep sales and profits buoyant in this industrials subsector. However, high concentration in one stock, which is experiencing a greater than normal amount of flux, adds significant specific risk. Further, we are less optimistic about the key industries served by the industrial conglomerates than we are for the economy at large, implying more opportunity for outperformance from other, more focused, S&P industrials peers. If valuations were particularly compelling they could provide a cushion to any profit mishap, but this is not the case. Our Valuation Indicator is in the neutral zone and, while our Technical Indicator is in oversold territory, it has shown an ability to remain at these levels for prolonged periods (Chart 11). Chart 9Energy Services Is A Bright Spot Chart 10Utilities Are In A Deep Cyclical Decline Chart 11Valuations Are Not Compelling Bottom Line: Netting it out, we think the S&P industrial conglomerates index should perform broadly in line with the overall market. Accordingly, we are initiating coverage with a neutral rating. The ticker symbols for the stocks in this index are: BLBG: S5INDCX - GE, MMM, HON, ROP. Chris Bowes, Associate Editor U.S. Equity Strategy chrisb@bcaresearch.com