MacroResearch Board

I n d e p e n d e n t I n v e s t m e n t S t r a t e g y

partnersmrbSeptember 17, 2013

THEME REPORT

M R B PA R T N E R S I N C . m w w w . m r b p a r t n e r s . c o m m C o p y r i g h t 2 0 1 3 © ( s e e f i n a l p a g e f o r f u l l c o p y r i g h t ) 1

Next Report Weekly Macro Strategy Friday, September 20th

U.S. Equity Sector Positioning: Beyond Fed TaperingWe continue to recommend a moderately

pro-cyclical bias for U.S. equity portfolios (table).

The economic recovery in the U.S. is gradually

solidifying and broadening. In addition, prospects

outside the U.S. are slowly beginning to brighten,

including in China, Europe, and Japan. With domestic

and global economic growth on the mend, U.S.

earnings growth should rebound as revenue and

margins gradually firm, thereby supporting further

upside in equity prices in the year ahead. Equity

valuations remain reasonable, and are especially

attractive relative to bonds (chart 1).

The looming onset of Fed tapering and the unsettled

Treasury market could continue to cause some

near-term choppiness in equities. However, we

expect the underlying uptrend in stock prices to

remain intact. Tapering does not imply an actual

tightening of monetary policy. The Fed’s balance

sheet will continue to expand at least through

mid-2014, thus keeping liquidity conditions and

monetary policy highly reflationary. Furthermore,

our forecast for modest growth and subdued

inflation implies that interest rates will stay below

equilibrium levels for the foreseeable future. Against

this backdrop, bond yields should only slowly grind

higher from current levels (perhaps after a brief

m We recommend a moderately pro-cyclical equity

sector stance in the U.S., favoring mid-cycle sectors

and financials over late-cycle plays and defensives.

m As the Fed tapers, sectors with earnings leverage and

undemanding valuations will have the largest cushion

against rising bond yields. Tech, industrials and

financials are best-positioned to outperform on a 6-12

month horizon.

m Overweight U.S. communications equipment stocks to

benefit from a gradual revival in telecom capex and a

pick-up in enterprise spending.

m Stay underweight U.S. energy stocks. Significantly

higher oil prices are needed to unlock value.

m A benchmark allocation is recommended for U.S.

chemical stocks. While cyclical tailwinds will benefit

the industry, elevated earnings expectations and

valuations limit relative upside potential.

MRB U.S. Global Equity Sectors Allocation*

Consumer Discretionary

Consumer Staples

Energy

Financials

Health Care

Industrials

Information Technology

Materials

Telecom Services

Utilities

+- N

* 6-12 month horizonNote: + = maximum overweight, N = neutral, – = maximum underweight

MRB Partners Inc © 09/2013

2M R B PA R T N E R S I N C . m w w w . m r b p a r t n e r s . c o m m C o p y r i g h t 2 0 1 3 © ( s e e f i n a l p a g e f o r f u l l c o p y r i g h t )

mrb THEME REPORT m September 17, 2013

Chart 1 Equities Supported By Rising Earnings And Good Relative Value

800

1,200

1,600S&P 500*:

100

150

200

250

300 12-Month Forward Earnings**

-8

-4

1995 1996 1998 2000 2002 2004 2006 2008 2010 2012

Earnings Yield Gap*** (%)

* Source: Standard & Poor's** Rebased to January 1995 = 100; source: Thomson Financial / IBES*** U.S. real 10-year government bond yield minus U.S. 12-month forward earnings yield

MRB Partners Inc © 09/2013

Gap should narrow further

period of consolidation), thus remaining supportive of

the economic recovery and equity valuations.

The prospect of Fed tapering will continue to have a

pronounced impact at the sector level (see below). The

rise in bond yields from their lows in early-May reflects

an improving growth outlook and the need for less Fed

stimulus. Consequently, as bond yields have risen, stock

market leadership has shifted in favor of cyclical sectors.

Our pro-cyclical tilt is consistent with our expectation

that investors will continue to migrate from bonds to

stocks, and from defensive yield plays such as telecoms,

utilities, and staples into economically-sensitive sectors

as economic growth gains traction.

In addition, we have the following sector views:

Overweight Capex Plays And Financials

Within cyclicals, we prefer sectors that are geared to

the mid-cycle stage of the recovery. Technology and

industrials (i.e. mainly capital goods) fit well with this

theme as their earnings are leveraged to business

investment (capex). Capex has lagged in the past year,

but should improve as the economic recovery becomes

more assured1. These sectors also have significant

foreign exposure, and will benefit as the global economy

becomes healthier and global trade gradually revives.

We also favor financials given their attractive valuations

and upside leverage to growth. In addition, banks and insurers (the sector’s two main

constituents) benefit from a moderately steepening yield curve2.

Underweight Late-Cycle Sectors

We recommend an underweight allocation to commodity-based sectors such as

energy and materials. Although commodities enjoyed a recent bounce, adverse supply

conditions coupled with modest economic growth will temper prospective upside

in prices, thus keeping the relative earnings performance of commodity producers

soggy. As we highlight below, energy companies are experiencing declining ROEs due

to cost inflation and are in need of significantly higher oil prices to generate earnings

1 MRB Theme Report, "U.S. Business Investment: Back On Track", February 12, 20132 MRB Theme Report, "Banking On U.S. Financial Stocks", June 18, 2013

Fed tapering will continue to have a pronounced impact on sector performance

3M R B PA R T N E R S I N C . m w w w . m r b p a r t n e r s . c o m m C o p y r i g h t 2 0 1 3 © ( s e e f i n a l p a g e f o r f u l l c o p y r i g h t )

mrb THEME REPORT m September 17, 2013

Chart 2 U.S. Pharma Stocks: Relative Earnings Have Lagged

120

160

S&P 500 Pharmaceuticals:Relative Stock Prices*

120

160

200

1995 1996 1998 2000 2002 2004 2006 2008 2010 2012

Relative 12-Month Forward Earnings**

* Relative to benchmark; rebased to January 1995 = 100; source: Standard & Poor's** Relative to benchmark; rebased to January 1995 = 100; source: Thomson Financial / IBESNote: - - - 40 week moving average

MRB Partners Inc © 09/2013

Weak

outperformance. Meanwhile, chemical producers, the

main constituent in the U.S. materials sector, are fully

valued after a multi-year bull market.

Stay Cautious On Health Care

Our maximum underweight in health care reflects our

view that earnings for the sector will significantly lag

as the U.S. recovery deepens. Health care stocks are

well-loved and have re-rated despite weak relative

forward earnings. We expect relative earnings in the

pharmaceuticals industry to remain pressured by

better growth in cyclical sectors, ongoing generic drug

competition and reimbursement cuts from curtailments

in U.S. government health care expenditures (chart 2).

Caution is especially warranted on high-flying biotech

stocks, which are long duration assets, and hence

vulnerable to rising bond yields (chart 3).

Remain Neutral On Discretionary Stocks

We have a neutral stance on consumer discretionary

stocks. While U.S. consumption will continue to be

supported by rising employment, benign inflation, and

low borrowing costs, the sector’s early-cycle leadership is

in the late innings3. Extended valuations are making U.S.

discretionary plays increasingly risky as the economic

recovery spreads to other less expensive cyclical sectors

(i.e. tech and capital goods).

Overall, there is very little differentiation between our

sector positioning in the U.S. and that which was provided

for the global market in our latest MRB Quarterly Global

Equity Sectors. The only variation is in the consumer

staples sector where we are underweight in the U.S.,

but neutral at the global level. The staples sector is

more prone to underperform in the U.S. given stronger

tailwinds for the U.S. economy.

Below we take a closer look at the impact of Fed tapering on our sector positioning

strategy. In addition, we analyze prospects for the U.S. communications equipment

3 MRB Theme Report, "Global Consumer Discretionary Stocks: Running Out Of Time", February 5, 2013

Chart 3 U.S. Biotech Stocks: Vulnerable To Rising Bond Yields

1995 2000 2005 2010

Relative Biotechnology Stock Prices* (LS)10-Year Government Bond Yield (%, Inverted, RS)

200 –

400 –

600 –2–

4–

6–

U.S:

* Relative to S&P 500 benchmark; rebased to January 1995 = 100; source: Standard & Poor's

MRB Partners Inc © 09/2013

4M R B PA R T N E R S I N C . m w w w . m r b p a r t n e r s . c o m m C o p y r i g h t 2 0 1 3 © ( s e e f i n a l p a g e f o r f u l l c o p y r i g h t )

mrb THEME REPORT m September 17, 2013

industry and discuss why energy stocks are risky despite their cheap valuations. Finally,

we examine whether U.S. chemical stocks have outrun their prospects.

Final Word: Investors should continue to overweight financials and mid-cycle plays within

a U.S. equity portfolio. Attractive valuations plus leverage to improving growth make these

sectors best-positioned to outperform on a 6-12 month horizon. Conversely, avoid old leaders

that benefited from economic uncertainty, and investors’ preference for income.

Fed Tapering: Impact On Sector Strategy

While the weaker-than-expected August employment report has raised some doubts

about the timing and magnitude of a Fed tapering announcement, a shift in the

monetary landscape is inevitable as the U.S. economic recovery solidifies. The start of

Fed tapering does not imply monetary tightening, but can be thought of as a first step

on the path towards gradual policy normalization, and is a signal that the U.S. economy

is transitioning to a healthier phase of growth.

There is no precedent for judging the impact of Fed tapering on sector performance. As

the market becomes less liquidity driven and bond yields grind higher, earnings growth is

likely to become an increasingly important driver of sector performance. Once tapering

ends in mid-2014, investors will begin to worry about a true rate-hiking cycle. This section

provides our views on how sectors are likely to behave as the Fed gradually exits its

monetary experiment.

Although it is too early to put rate hikes on the radar, Fed tapering (and rising bond yields)

will raise some periodic doubts about the durability of economic growth. As long as the

change in monetary policy does not front-run the improvement in the economy, sectors

with the highest earnings leverage will be best-positioned to outperform, while those

with less earnings leverage will be prone to lag.

Consistent with this view, defensive sectors such as staples and health care do not look

like attractive bets as the Fed tapers. The relative earnings performance of these sectors

tends to weaken during periods when economic growth strengthens and policy becomes

less accommodative. Furthermore, with both sectors trading at a premium to the broad

market on a forward P/E basis, risks to valuation multiples are clearly on the downside.

Utilities and telecoms should also fare poorly given their bond proxy status. As

bond yields grind higher, the income appeal of the telecom and utility sectors will

continue to diminish, thereby resulting in a further de-rating of these stocks. While

earnings for both sectors are very depressed relative to the broad market, we expect

weak growth prospects to persist and to keep relative profitability constrained.

Fed tapering is a signal that the economy is transitioning to healthier growth

Earnings growth will become a more important driver of sector performance

Sectors with the highest earnings leverage will outperform

5M R B PA R T N E R S I N C . m w w w . m r b p a r t n e r s . c o m m C o p y r i g h t 2 0 1 3 © ( s e e f i n a l p a g e f o r f u l l c o p y r i g h t )

mrb THEME REPORT m September 17, 2013

Chart 4 U.S. Consumer Discretionary Stocks: Earnings Have Already Recovered

80

100

120

S&P 500 Consumer Discretionary:Relative Stock Prices*

60

80

100

1995 1996 1998 2000 2002 2004 2006 2008 2010 2012

Relative 12-Month Forward Earnings**

* Relative to benchmark; rebased to January 1995 = 100; source: Standard & Poor's** Relative to benchmark; rebased to January 1995 = 100; source: Thomson Financial / IBESNote: - - - 40 week moving average

MRB Partners Inc © 09/2013

Elevated

Consumer discretionary stocks are interest rate sensitive.

Therefore, risks in the sector will intensify as monetary

policy gradually begins to normalize. The sector has

already enjoyed a significant earnings recovery, which

leaves less room for improvement going forward

(chart 4). Moreover, valuations are stretched after an

extended period of outperformance. While it is too early

to underweight the sector as consumption will stay

well supported, the bear case for discretionary stocks

will grow more compelling once earnings leadership

decisively shifts to other cyclical groups.

Although financial stocks are also an early-cycle play,

we do not believe the sector will become a casualty of

Fed tapering. Yield curve steepening will be positive for

financial stocks, especially if it coincides with an expansion

of credit. The latter remains subdued, implying that the

U.S. credit cycle is still young, and thus has further to

run. With ROE significantly below historical norms and

asset quality continuing to improve, upside in relative

earnings is likely as credit demand picks up (chart 5).

Moreover, attractive valuations give financial stocks solid

re-rating potential, which when combined with

recovering earnings, should support outperformance.

The energy and material sectors are late-cycle plays

geared to commodity prices. Our view is that modest

economic growth will keep upside in commodity prices

capped, with risks remaining skewed to the downside

due to rising supplies4. As a result, these sectors will

have atypically weak relative earnings momentum, thus

making underperformance likely as the Fed tapers.

We expect mid-cycle sectors such as technology and

industrials (mainly capital goods) to outperform as

monetary policy shifts in the months ahead. Fed tapering

is a sign that the economy is transitioning from early- to

mid-cycle growth. The tech and industrial sectors have

earnings that are leveraged to business investment,

Chart 5 U.S. Financials: Solid Upside As Earnings Gradually Recover

80

120

160

S&P 500 Financials:Relative Stock Prices*

80

120

1995 1996 1998 2000 2002 2004 2006 2008 2010 2012

Relative 12-Month Forward Earnings**

* Relative to benchmark; rebased to January 1995 = 100; source: Standard & Poor's** Relative to benchmark; rebased to January 1995 = 100; source: Thomson Financial / IBESNote: - - - 40 week moving average

MRB Partners Inc © 09/2013

4 MRB Theme Reports, "End Of The Commodity Boom (Part I)", September 25, 2012 and "End Of The Commodity Boom (Part II)", October 2, 2012

Improving from depressed levels

6M R B PA R T N E R S I N C . m w w w . m r b p a r t n e r s . c o m m C o p y r i g h t 2 0 1 3 © ( s e e f i n a l p a g e f o r f u l l c o p y r i g h t )

mrb THEME REPORT m September 17, 2013

Chart 6 U.S. Mid-Cycle Plays: Undemanding Valuations

-20

-10

0

10

U.S. Relative 12-Month Forward P/E Ratio*:Capital Goods Industry

Mean

0

50

100

1995 1996 1998 2000 2002 2004 2006 2008 2010 2012

Information Technology

Mean

* % Premium(+), Discount(-) to S&P 500 benchmark; source: Thomson Financial / IBES

MRB Partners Inc © 09/2013

which normally improves as economic growth becomes

more entrenched5. In addition, reasonable valuations

give these sectors scope to re-rate as they deliver

stronger earnings growth (chart 6).

Final Word: As the U.S. monetary landscape begins

to shift, earnings growth will become an increasingly

important driver of sector performance. In this

environment, sectors with the most gearing to the

expansion and attractive valuations are likely to have the

largest cushion against rising bond yields, provided that

monetary policy continues to lag the improvement in the

economy, as we expect.

U.S. Communications Equipment Stocks: Resurgence Ahead

We are bullish on the outlook for U.S. communications

equipment stocks and view the industry as one of the

most cyclically attractive areas within the tech sector

on a 6-12 month horizon. Despite positively-trending

relative earnings, communications equipment stocks

have continued to de-rate in recent years, thereby

creating a buying opportunity for investors as the

spending backdrop for communications gear becomes

more favorable (chart 7).

The top panel in chart 8 highlights that the

momentum of new orders for communications

equipment (as measured by the year-over-year percent

change) is bottoming and output is starting to hook

up. These trends are corroborated by the latest data

points from U.S. equipment makers, which suggest

that telecom spending is beginning to firm after several

years of underinvestment.

Several factors point to a gradual revival of telecom

capex. Capital expenditures as a share of total sales

Chart 7 U.S. Communications Equipment Stocks: Relative Earnings Rising

100

200

300

S&P 500 Communications Equipment:Relative Stock Prices*

50

100

150

1995 2000 2005 2010

Relative 12-Month Forward Earnings**

* Relative to benchmark; rebased to January 1995 = 100; source: Standard & Poor's** Relative to benchmark; rebased to January 1995 = 100; source: Thomson Financial / IBESNote: - - - 40 week moving average

MRB Partners Inc © 09/2013

5 MRB Theme Reports, "Assessing Prospects For The Global Capital Goods Industry", April 2, 2013 and "Global Technology: Superior Growth At Bargain Prices", April 23, 2013

7M R B PA R T N E R S I N C . m w w w . m r b p a r t n e r s . c o m m C o p y r i g h t 2 0 1 3 © ( s e e f i n a l p a g e f o r f u l l c o p y r i g h t )

mrb THEME REPORT m September 17, 2013

Chart 8 U.S. Communications Equipment Stocks: Mounting Cyclical Tailwinds

-20

0

20

40

-40

0

40

Industrial Production* (%YoY, LS)New Orders** (%YoY, RS)

U.S. Communications Equipment:

-20

0

20

40

Inventories*** (%YoY)

40

80

120Capacity Utilization* (%, LS)Industrial Production* (RS)

60 –

80 –

-30

-20

-10

0

Relative Return On Equity**** (%)

1

2

3

1995 1996 1998 2000 2002 2004 2006 2008 2010 2012

Relative Price / Book Ratio****

* Source: Federal Reserve** Smoothed; source: U.S. Census Bureau*** Source: U.S. Census Bureau**** Relative to U.S. broad equity benchmark; source: MSCI

MRB Partners Inc © 09/2013

Inventories contracting

Attractive valuation

for telecom companies are historically depressed

(chart 9, panel 1). The decade following the bursting

of the TMT bubble was a period of capital preservation

as carriers consolidated acquired networks and

focused on increasing payouts to shareholders. Looking

ahead, telecom operators are likely to invest for growth

as they commercialize new technologies in an attempt

to gain market share, generate higher average revenue

per user (ARPU), and satisfy growing demand for

broadband services stemming from the rapid expansion

of wireless traffic.

The U.S. telecom industry is at the forefront of this trend,

with the commercial rollout of next generation wireless

technology, also known as Long-Term Evolution (LTE) or

4G. Moreover, newly funded competitors with rich foreign

backers in the U.S. wireless industry are likely to step-up

investments as they go on the offensive to challenge large

incumbents for market share in the coming months. The

outlook for telecom spending is also improving globally,

with Asian and European carriers expected to follow the

U.S. lead and prioritize 4G deployments.

In addition to resurgent spending from telecom

operators, the communications equipment industry

is poised to benefit from stronger demand in the

enterprise sector. Recent surveys of U.S. capex

intentions are pointing to an increase in the coming

months. Spending on communications equipment as

a percent of total non-residential fixed investment is

at the low-end of its historical range, suggesting that

there is pent-up demand for networking gear (chart 9,

panel 2). Aging IT infrastructure will need to be replaced

to support new technology platforms built around cloud

computing and mobility.

As orders firm and output increases, the relative

ROE of communications equipment makers should

continue to rise. With inventories still contracting and

near their all-time lows in level terms, the ramp-up in

production could be significant, thus driving positive

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mrb THEME REPORT m September 17, 2013

Chart 9 Pent-Up Demand For Communications Equipment

16

20

24

28

Global Telecom Services:Capital Expenditure / Sales* (%)

U.S. Fixed Investment**:

5

6

7

8

1980 1985 1990 1995 2000 2005 2010

Communications Equipment (% of Total Non-Residential)

* Source: Datastream** Source: U.S. Bureau of Economic Analysis

MRB Partners Inc © 09/2013

earnings surprises as utilization rates improve (chart 8,

panels 2 & 3). Lean inventories will also help mitigate

downside risks, an important consideration given the

cyclical nature of the industry.

Furthermore, valuations do not reflect improving

business fundamentals. Communications equipment

stocks trade at the low-end of their ten-year range

relative to the broad market on both a forward P/E and

P/B basis (chart 8, panel 5). The industry has steadily

de-rated due to the long period of retrenchment in

telecom capex and recent weakness in enterprise

spending. As investment in networking gear rebounds,

communication equipment stocks are likely to

generate superior profit growth, thus supporting their

outperformance in the next 6-12 months.

Final Word: We recommend an overweight allocation

to U.S. communications equipment stocks. A revival of

telecom and enterprise spending should catalyze earnings

outperformance and a re-rating of the industry.

U.S. Energy Stocks: Why They Remain Risky

We are staying cautious on the outlook for U.S. energy stocks. The recent spike in oil prices

has been primarily driven by near-term supply fears stemming from geopolitical tensions

in the Middle East, rather than a fundamental shift in the supply/demand balance for oil.

In fact, the oil futures curve is in backwardation (i.e. the 12-month contract is significantly

lagging the spot price), signalling that the rise in oil prices will be short-lived (see the

August 30th and September 13th MRB Weekly Macro Strategy).

Short-term geopolitical tensions aside, we expect oil prices to continue trading within

their two-year range. Until global growth picks up more markedly, oil demand in the

OECD (the key swing factor in oil demand cycles) will remain weak, thereby limiting the

upside in prices. Meanwhile, there are downside risks given surging U.S. production.

As long as upside in oil prices is capped, the relative earnings power of oil producers will

remain constrained, thus making it difficult for the energy sector to re-rate. Despite the

spike in oil prices, energy stocks have barely outperformed the market (chart 10). This is

consistent with the notion that the recent rise in oil prices is being driven by temporary

factors. It also reflects the significant operational challenges facing energy companies,

Energy exploration and production costs have continued to rise

9M R B PA R T N E R S I N C . m w w w . m r b p a r t n e r s . c o m m C o p y r i g h t 2 0 1 3 © ( s e e f i n a l p a g e f o r f u l l c o p y r i g h t )

mrb THEME REPORT m September 17, 2013

Chart 10 U.S. Energy Stocks Lagging Oil Price Increase

100

120

140

Crude Oil Prices*

100

110

2010 2012

Stock Prices**:S&P Energy / S&P Benchmark

* Average of OPEC, Brent and WTI oil prices; rebased to January 2010 = 100** Rebased to January 2010 = 100; source: Standard & Poor's

Barely outperforming

MRB Partners Inc © 09/2013

Chart 11 U.S. Energy Stocks: Rising Costs Squeezing Margins

100

150

200

U.S. Energy:Relative Stock Prices*

0

10

20

40

60Relative Return On Equity** (%, LS)Real Crude Oil Prices*** (RS)

120

160

200

50

100

Oil Exploration And Production Cost Proxy**** (LS)Crude Oil Prices***** (RS)

5

10

1995 2000 2005 2010

Henry Hub Natural Gas Prices******

* Relative to U.S. broad equity benchmark; rebased to January 1995 = 100; source: MSCI** Relative to U.S. broad equity benchmark; source: MSCI*** Equally-weighted aggregate of Brent, OPEC and WTI crude oil; deflated by U.S. headline CPI; advanced**** Equally-weighted aggregate of U.S. PPI price indices for drilling oil & gas wells, oil & gas operation support activities, and oil field machinery & equipment***** Equally-weighted aggregate of Brent, OPEC and WTI crude oil****** Source: Thomson ReutersNote: - - - 40 week moving average in panel 1

MRB Partners Inc © 09/2013

Technically vulnerable

Costs rising...

...while oil prices have stagnated...

...and nat gas prices have plummeted

which reinforces that meaningfully higher oil prices are

needed to unlock value in the sector.

The two middle panels of chart 11 highlight the main

problem with the sector: since oil prices peaked in 2008,

exploration and production costs have continued to rise.

Without an offsetting increase in volumes, margins have

been squeezed. As a result, the sector’s ROE has plunged

from its peak in 2009. Profitability did improve as oil prices

rebounded in the early stages of the recovery, but the rise

in ROE was moderate, and returns have subsequently

weakened as oil prices have range traded in the past two

years, and the cost curve has continued to extend upwards.

For a sector with relative pricing power (measured by real

oil prices) at the upper-end of its historic range, relative

ROE performance has been unimpressive.

Costs have been on a long-term rising trend as maturing conventional oil fields have left

the industry reliant on hard-to-exploit basins as the main source of production growth.

The complexity of these plays has made them highly susceptible to cost overruns.

10M R B PA R T N E R S I N C . m w w w . m r b p a r t n e r s . c o m m C o p y r i g h t 2 0 1 3 © ( s e e f i n a l p a g e f o r f u l l c o p y r i g h t )

mrb THEME REPORT m September 17, 2013

Chart 12U.S.EnergyStocks:WeakProfitabilityDespite Elevated Oil Prices

0

20

40

40

80

120

Free Cash Flow Less Dividends* ($bn, LS)Crude Oil Prices** (RS)

U.S. Integrated Oil Companies:

0

10

U.S. Energy:Relative Return On Equity*** (%)

Relative Price / Book Ratio***

0.6

0.8

1.0

1.2

1995 1996 1998 2000 2002 2004 2006 2008 2010 2012* Source: Bloomberg** Equally-weighted aggregate of Brent, OPEC and WTI crude oil*** Relative to U.S. broad equity benchmark; source: MSCI

MRB Partners Inc © 09/2013

Latest 12 months

Plunge in relative ROE...

...driving de-rating

The drag from rising costs has been compounded

by poor volume growth stemming from a lack of

exploration success, especially by the oil majors, the

largest constituent in the U.S. energy sector (i.e. just

over 50% of total sector market cap). Although U.S.

oil production has soared, the benefits have mostly

accrued to smaller oil companies, which were early

to exploit shale plays. In contrast, the integrated oil

companies moved into shale gas with expensive and

ill-timed acquisitions in the mid- to late-part of the

last decade, thus leaving them with exposure to falling

natural gas prices (chart 11, panel 4). As a result, they

have had to cut back on unprofitable gas drilling,

contributing to overall volume declines. Recent forays

into shale oil have yet to yield positive results. Even

then, success will be critically dependent on oil prices

remaining elevated given the higher break-even rates

of these unconventional plays.

Absent an increase in volumes and/or a significant rise in

oil prices to offset an upward-sloping cost curve, there is

little scope for relative ROE to improve. As far as costs,

they are unlikely to decline, unless the price of oil falls

to a level that makes new fields unprofitable, thereby

forcing the industry to scale back spending. Otherwise,

rising capex will continue to be a structural drag on

earnings as it will keep increasing future depreciation

and amortization expense.

Historically, the massive free cash flow generation of oil majors has supported an

above-average dividend yield for the sector. However, the deteriorating financial

performance of integrated oil companies calls into question their ability to sustain future

dividend growth. The top panel in chart 12 shows the capacity of U.S. oil majors to cover

dividends with free cash flow (i.e. cash flow from operations less capex) over the past

two decades. In the latest 12-month period, operating cash flow has been insufficient

to cover both dividends and capex. This has happened twice before: in 1998-1999 and

in 2009. Those periods were marked by significant declines in oil prices. This time, the

squeeze has occurred without a plunge in oil prices, underscoring that dividend growth

may be at risk even if oil prices remain near their current elevated levels.

Operating cash flow has been insufficient to cover dividends and capex

11M R B PA R T N E R S I N C . m w w w . m r b p a r t n e r s . c o m m C o p y r i g h t 2 0 1 3 © ( s e e f i n a l p a g e f o r f u l l c o p y r i g h t )

mrb THEME REPORT m September 17, 2013

Chart 13 U.S. Chemical Stocks: Cyclical Conditions Improving

-20

0

20

98

100

102

Relative 12-Month Forward Earnings* (%YoY, LS)Global Leading Economic Indicator** (RS)

S&P 500 Chemicals:

-20

-10

0

10

Shipments For Basic Chemicals*** (%YoY)

10

20

Return On Equity**** (%)

70

80

1995 2000 2005 2010

Capacity Utilization***** (%)

* Relative to benchmark; source: Thomson Financial / IBES** Advanced 12 months; deviation from trend; includes OECD members plus six major non-OECD countries; source: OECD*** Source: U.S. Census Bureau**** Source: MSCI***** Source: Federal Reserve

MRB Partners Inc © 09/2013

At mid-cycle levels

Elevated

Although the oil majors can borrow and/or divest assets

to fund the shortfall, eroding profitability has undermined

investor confidence in the sector. As a result, the sector

has de-rated for the better part of the past three years.

With relative valuations closely correlated to relative

ROE performance, the broader energy sector is unlikely

to re-rate until the profit dynamics for major integrated

oil companies improve (chart 12, panels 2 and 3). In the

meantime, the relative stock price ratio looks technically

vulnerable (chart 11, panel 1).

Final Word: Underweight energy stocks within a U.S. equity

portfolio. The sector is heavily influenced by large integrated

oil companies, whose relative profitability will remain

encumbered by poor production growth and continued high

spending. Energy stocks are unlikely to re-rate until prospects

for sustained upside in oil prices improve.

U.S. Chemical Stocks: Fully-Priced

While U.S. chemical stocks should benefit from firmer

global growth, rich valuations and elevated earnings

expectations have kept us at a neutral weighting.

The upturn in the global leading economic indicator

is pointing to an improvement in the relative earnings

momentum of U.S. chemical stocks (chart 13, panel 1).

Shipment growth has resumed and should continue to

modestly accelerate as global industrial activity picks up

in the year ahead (chart 13, panel 2).

In the U.S., gradual recoveries in major end markets such

as autos and construction are driving increased sales

of paints, coatings, insulation, and plastics. Demand

conditions are poised to further improve based on trends

in consumer confidence, homebuilder sentiment, and

billings for architectural work. Outside the U.S., end demand growth is likely to be more

subdued given the slower pace of economic improvement in Europe and China.

Despite improving cyclical dynamics, there are good reasons to be cautious on U.S.

chemical stocks. Relative forward earnings are already very elevated, thus leaving

12M R B PA R T N E R S I N C . m w w w . m r b p a r t n e r s . c o m m C o p y r i g h t 2 0 1 3 © ( s e e f i n a l p a g e f o r f u l l c o p y r i g h t )

mrb THEME REPORT m September 17, 2013

Chart 14 U.S. Chemical Stocks: Procurement Cost Advantage Fueling Expansion

-4

-2

0

Chemicals Industry: Employment* (%YoY)

20

40

60

1995 1996 1998 2000 2002 2004 2006 2008 2010 2012

Brent Oil Price** / Henry Hub Natural Gas Price***

Mean

* Source: U.S. Bureau of Labor Statistics** Source: ICIS Pricing*** Source: Thomson Reuters

MRB Partners Inc © 09/2013

less room for upside compared with prior cycles.

Return-on-equity, while having moderately eroded in

recent months, is closer to the upper end of its historical

range (chart 13, panel 3). With industry utilization rates set

to bottom at a higher level compared with previous cycle

lows, margin leverage is likely to be modest, especially as

volumes will only gradually improve (chart 13, panel 4).

Operating rates (and margins) did not drop significantly

during last year’s global slowdown due to the market

share growth of U.S. producers. The fracking boom and

resulting decline in U.S. natural gas prices have lowered

supply costs for the U.S. industry, thus enabling it to

sell petrochemicals at lower prices. Consequently, U.S.

and Middle Eastern producers have captured a growing

share of global chemical trade volumes at the expense of

their European counterparts (the Middle East also has a

big energy cost advantage given its rich endowment of

oil and natural gas).

As a result of these structural tailwinds, the U.S. chemical

industry is expanding aggressively, hiring at its fastest pace in several years (chart 14,

panel 1). Moreover, capacity additions are planned in the next few years in hopes of

further boosting chemical exports and winning even greater market share versus global

rivals that must rely on more expensive oil-based feedstock to manufacture chemicals.

The ratio of Brent oil prices to Henry Hub natural gas is a good proxy for the cost

advantage enjoyed by the U.S. petrochemicals industry. It peaked in 2012, but remains

stretched relative to its history, thus warning that a further correction is possible

(chart 14, panel 2). Further declines in the ratio could dent investor optimism towards

the sustainability of the U.S. chemical industry’s high gross margins. U.S. chemical

stocks are trading near an all-time high relative to the broad market, and are vulnerable

to negative earnings surprises.

The industry’s relative P/B ratio, while having recently corrected, remains elevated

and suggests that chemical stocks are priced for a continuation of strong ROE

performance (chart 15, panel 3). On a forward P/E basis, the industry trades in line with

the broad market. However, the forward P/E multiple is unlikely to expand from its

current level given its historical tendency to peak as industry operating rates bottom

(chart 15, panel 4). Moreover, less cyclical subgroups within the industry, such as

specialty chemicals and industrial gases, already trade at rich premiums to the market

U.S. chemical industry margins have been boosted by low feedstock costs

13M R B PA R T N E R S I N C . m w w w . m r b p a r t n e r s . c o m m C o p y r i g h t 2 0 1 3 © ( s e e f i n a l p a g e f o r f u l l c o p y r i g h t )

mrb THEME REPORT m September 17, 2013

Chart 15 U.S. Chemical Stocks: No Margin Of Safety In Valuations

60

80

100

S&P 500 Chemicals:Relative Stock Prices*

80

100

Relative 12-Month Forward Earnings**

0.5

1.0

1.5

Relative Price / Book Ratio**

0.6

0.8

1.0

1.268

72

76

80

Relative 12-Month Forward P/E Ratio** (LS)Capacity Utilization*** (%, Inverted, RS)

-50

0

50

1995 2000 2005 2010

Industrial GasesSpecialty Chemicals

Relative 12-Month Forward P/E Ratio**** (%)

* Relative to benchmark; rebased to January 1995 = 100; source: Standard & Poor's** Relative to benchmark; rebased to January 1995 = 100; source: Thomson Financial / IBES*** Source: Federal Reserve**** % Premium(+), Discount(-) to benchmark; source: Thomson Financial / IBESNote: - - - 40 week moving average

MRB Partners Inc © 09/2013

Near all-time highs

Already elevated

Expensive

Stretched

(chart 15, panel 5), limiting their re-rating potential.

While earnings tailwinds should support the stock

market performance of the chemical industry, there

is better risk/return in other cyclical groups (such as

tech and capital goods) where valuations and earnings

expectations are not as elevated.

Final Word: We recommend a benchmark allocation to

chemical stocks within a U.S. equity portfolio. Earnings

are already elevated implying only modest relative upside

from current levels. Furthermore, the industry’s structural

positives are well known and embedded in current

valuations, thus leaving little cushion for disappointment.

Salvatore Ruscitti

Next MRB Webcast

U.S. Equity Sector Positioning: Beyond Fed Tapering

Wednesday, September 18th For more information: click here

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September 17, 2013

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This document is the property of MRB Partners Inc. and should not be circulated without the express authorization of MRB Partners Inc. Any use of graphs, text or other material from this report by the recipient must acknowledge MRB Partners Inc. as the source and requires advance authorization.

MRB Partners Inc. relies on a variety of data providers for economic and financial market information. The data used in this report are judged to be reliable, but MRB Partners Inc. cannot be held accountable for the accuracy of data used herein.

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