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STRATEGY NOTE

USA | Equity Strategy

March 9, 2017

Equity StrategyJEF's Collaborative Research: InflationGetting Hot But What Does It All Mean

EQU

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Ward McCarthy *US Economist

(212) 323-7576 [email protected] G. DeSanctis, CFA *

Equity Strategist(212) 284-2056 [email protected]

Randal J. Konik *Equity Analyst

(212) 708-2719 [email protected] Barish *

Equity Analyst(415) 229-1524 [email protected]

Stephen Volkmann, CFA *Equity Analyst

(212) 284-2031 [email protected] LaFemina, CFA *


Seth Rosenfeld, CFA §Equity Analyst

+44 (0) 20 7029 8772 [email protected] Alexander, CFA *


Philip Ng, CFA *Equity Analyst

(212) 336-7369 [email protected] Binder, CFA *


* Jefferies LLC § Jefferies International Limited

^Prior trading day's closing price unlessotherwise noted.

Key TakeawayIn a relatively short period of time, the US inflation picture has escalated fromdormant to a state of semi-perkiness. The Jefferies forecast is for a continuedrise with CPI peaking at 3.2% in Q3 and hovering near 3% thereafter.Higher inflation has not been a good thing in the past for equity markets,as performance generally weakens as inflation rises. A faster pace of risinginflation could bring about more rate hikes, which also weakens returns.

Ward McCarthy: Inflation is back but is it sustainable? Inflation has been uber lowin the last few years due to a number of reasons with the biggest being the sharp drop incommodity prices. However, more recently we have seen the CPI tick up to 2.5% and theFed-followed PCE at 1.9%. We project that service inflation continues to rise modestly with amore meaningful uptick in commodity inflation. Thus, Jefferies forecast is for the CPIto peak at 3.2% by the third quarter and hover around the 3% mark thereafter.

Steven DeSanctis: Higher inflation is not great for market. Small, mid, and large-cap performance has been below average when inflation rears its ugly head. At sector level,we found few decent relationships, thus need to get more granular.

Randy Konik: Spec Retail—Curb enthusiasm, higher inflation = higher rates. If itcan't get any worse for the specialty retail industry, higher inflation leading to higher interestrates could curb consumer spending and be another dagger in this group's performancehopes.Andy Barish: Restaurants—More headwinds for the group: lower margins.Another industry that has had a tough time of late and now with wages rising outside ofminimum wage increases, the group faces more headwinds going forward. Also as ratesrise, this could knock down lofty smaller-cap restaurants.Steve Volkmann: Machinery—Up and to the right. Higher commodity inflationboosts those names that are levered to the extraction business. However, higher costs of rawmaterials provide some margin pressure.Chris LaFemina: Metals & Mining—Chinese PPI data tells you everything. As Wardhas argued, the rebound in commodity prices has been on the incremental increase ininflation and this has generally been good for the Materials sector. China is the main driverand there is a fear that inflation in this country is running too hot and may need to be cooleddown. If EM is seeing strong growth, rate hikes should not impact this group.Seth Rosenfeld: Steel—Emerging inflation strongly positive for steel. Thereflationary tailwinds blow hard and heavy for steel and will boost the group. We are nowseeing the strongest cost-push steel price support in quite some time and this will allowsteel companies to push through price hikes boosting margins.Laurence Alexander: Chemicals—Pick-up positive for intermediate & spec. Thiscould be the first cycle where broad-based inflation is picking up faster than the cost-pushfrom oil and crops. If so, this helps those areas and stocks in which pricing is based on valueadd and efficiency savings.Phil Ng: Paper, Packing, Building Products: Higher input costs 2017 theme.Companies have been calling out cost inflation as a factor in 2017 guidance, and this hasadded to investor concerns regarding margin pressures. We view cost inflation as an overallpositive for the group however, as companies have shown better pricing discipline.Dan Binder: Hardline Retail—A little inflation is good, but too much hurts.Inflation can lead to higher average selling prices and often times provide a tailwind tosales growth. Better sales growth allows a retailer to better leverage fixed costs. However,rising Fed funds hurt retail stocks, as they tend to experience multiple compression andunderperform as a group.

Inflation ideas: ROST, TJX, NKE, TIF, FL, PLAY, FOGO, GLEN LN*, FM CN*, BBL,RIO, NUE, STLD, MT, X, AKS, UNVR, EMN, WRK, IP, PKG, OC

Please see analyst certifications, important disclosure information, and information regarding the status of non-US analysts on pages 28 to 32 of this report.

Inflation Is Back, Is It Sustainable? In a relatively short period of time, the US inflation picture has migrated from a state of

dormancy to a state of semi-perkiness. Specifically, the yoy change in the headline CPI has

accelerated from 0% as recently as September 2015 to 2.5% as of January of this year.

Over the same time period, the yoy change in the headline PCE deflator, which has been

the Fed’s official inflation target since January 2012, has accelerated from 0.2% to 1.9%.

Chart 1: CPI & PCE Deflator, YoY% Change

Source: Bloomberg; Jefferies

This commentary addresses the following:

1. Where did inflation come from?

2. Why import prices are so important

3. Where do we go from here?

Where Did Inflation Come From? In order to understand why inflation has been accelerating, it is necessary to understand

why inflation was low in the first place.

Chart 2: CPI: Commodity-Based Goods vs Service Components

Source: BLS; Jefferies

Ward McCarthy Fixed Income Economist

(212) 323-7576

[email protected]

Equity Strategy

March 9, 2017

page 2 of 32 , US Economist, (212) 323-7576, [email protected] McCarthy

Please see important disclosure information on pages 28 - 32 of this report.

mailto:[email protected]

The prior graph decomposes the CPI into the yoy changes in service prices and

commodity-based goods prices. The former comprises roughly 64% of the CPI, while the

latter comprises the balance.

Service prices have accelerated gradually since early 2010 from a yoy change of 0.5% to

3.1% as of January of this year.

The behavior of commodity-based goods prices has been far more volatile and,

consequently, has been the primary source of volatility in headline CPI readings.

Since early 2010, commodity-based prices in the CPI have been down as much as 4.3%

yoy and up as much as 6.6%. These prices surged to a yoy increase of 6.6% in August

2011 before decelerating in a sharp disinflation and eventually plummeting into outright

deflation that bottomed with a 4.3% decline in January 2015.

Beginning in February 2015, deflationary pressures on the goods side of the equation

have been gradually easing and very recently again contributed to headline inflation with

yoy increase of 0.4% in December of 2016 and 1.6% in January 2017.

As of January, the yoy change in the headline CPI was running at 2.5%, while the PCE

deflator was running at a more moderate 1.9%. Why is the CPI running at a faster pace

than the headline reading on the headline PCE deflator?

Chart 3: CPI & PCE Deflator, YoY% Change


The primary reason is that service prices in the CPI are running at a faster pace than

service prices in the PCE deflator.

Equity Strategy

March 9, 2017



Chart 4: Service Inflation: CPI vs PCE Deflator


The primary cause of the diversion in the pace of service inflation in the CPI and PCE

deflator is the composition, with shelter in the CPI receiving a weighting that is roughly

double the weighting of the PCE deflator. In contrast, the behavior of the commodity-

based goods component of the PCE deflator has been closely correlated with the goods

side of the equation in the CPI.

Chart 5: Goods Prices: CPI vs Deflator


Historically, the yoy change in the CPI has tended to run at a faster pace than the PCE

deflator, the spread averaging 49 bps since 1980. Since the beginning of the current

business cycle in Q3 2009, the spread has averaged a narrower 16 bps.

Equity Strategy

March 9, 2017



Chart 6: CPI-PCE Deflator, YoY% Change


Connecting Dots: Importance of Import Prices

One of the hallmarks of Trump’s campaign and the early days of his administration has

been the loss of manufacturing jobs in the US and the implications of the downward

spiral of the manufacturing sector on the middle class.

As we have demonstrated in many prior notes, the change in the structure of the US

economy away from good-producing activities toward service-providing activities has

been ongoing for decades.

Chart 7: Composition of US Private Sector Labor Force

Source: Bureau of Labor Statistics; Jefferies

One of the implications of the change in the structure of the US economy and decline in

manufacturing activity has been an increase in goods imports from overseas and a

consequential increase in the size of the trade deficit.

Equity Strategy

March 9, 2017



Chart 8: Goods Deficit vs Service Surplus

Source: Census Bureau; Jefferies

In 2016, for example, the US ran a $750 bln goods trade deficit and imported $2.2 bln

goods from overseas.

Because the US imports so much, the behavior of import prices is a very important

determinant of headline inflation in the US. Global commodity-goods prices are

determined in global markets. These goods are then imported into the US.

That is why there is a strong correlation between the CRB index, for example, and US

import prices. When commodity prices were falling and the dollar was strong, the US

imported deflation. Once commodity prices bottomed, deflationary pressures on import

prices began to abate, with yoy changes in both commodity prices and import prices

turning positive.

A continuation of a rise in commodity prices will translate into a continued rise in US

import prices.

Chart 9: YoY% Change: Import Prices (LHS) vs CRB (RHS)


Equity Strategy

March 9, 2017



Given the nature of the US trade flows on the commodity-based goods side of the

equation, the rise in import prices has translated a turnaround in the commodity-goods

based component of CPI that has been the primary source of volatility in the headline CPI.

Chart 10: YoY% Chg.: Import Prices (LHS) vs CPI Commodity-Based Goods

(RHS)


Where Do We Go From Here? The gradual upward trend in service prices is likely to continue going forward, driven by

rents and the OER. However, commodity-based goods prices are more likely to be the

primary driving force behind movement in both the headline CPI and the headline PCE

deflator

The following tables run through scenarios for the CPI going forward. The columns under

“goods” and “services” reflect the contribution of these components to the headline CPI.

Scenario #1 is based on pure base effects for both service and commodity-based goods

prices.

Scenario #2 is based on steady-state service price inflation of 3.1% and pure base effects

on commodity inflation.

Scenario #3 is the JEF Economics CPI forecast and based on gradually accelerating

service price inflation and a continuation of the ongoing gradual upward trend in

commodity inflation.

In scenario #1, which is pure base effects, the yoy reading on the CPI would peak at

2.7% and gradually decelerate to 0%.

In scenario #2, which is based on steady-state service inflation of 3.1% and pure base

effects on commodity inflation, the yoy reading on the CPI would accelerate to 2.8% and

fluctuate between 2.6% and 2.8% before decelerating back to 2%.

Equity Strategy

March 9, 2017



Chart 11: CPI: Year/Year % Change Contributions by Component

Source: Jefferies

In scenario #3, which is the JEF Economics projection, is based on gradually

accelerating service price inflation and a continuation of the ongoing gradual upward

trend in commodity inflation. The yoy change in the CPI would peak-out at 3.2% in Q3,

but hover near 3%.

Equity Strategy

March 9, 2017



Chart 12: CPI: Year/Year % Change Contributions by Component

Source: Jefferies

What could derail ongoing inflation reemergence? Short-term: Given the importance of import prices to the US inflation environment, and

the importance of the behavior of global commodity markets to import prices, China

always poses a risk in the short term.

Chart 13: CRB vs YoY Chinese Industrial Production (YoY% Change)


Equity Strategy

March 9, 2017



China is the single largest consumer of commodities in the world, so any type of

downturn in China significantly affects global commodity market.

The prior graph demonstrates the relationship between the yoy change in Chinese

industrial production and the CRB index. In recent years, there have been episodic issues

in China that have roiled the global currency, financial and commodity markets. Events

like the ones that occurred in August 2015 and January 2016 are not predictable.

Longer-term: There has been significant slippage in the historical correlation between

wage growth and headline inflation, although both have tended to move in the same

direction in the broadest terms.

Chart 14: CPI vs AHE, YoY% Change


There has also been significant slippage in the historical correlation between wage growth

and core inflation, but the correlation between wage growth and core inflation has been

more stable.

Chart 15: Core CPI vs AHE, YoY% Change


The bottom line, however, is that inflation tends to be sustainable when wage growth has

been faster than it is now. However, we are headed in the right direction, and wage

growth will likely continue to accelerate as the labor market continues to tighten.

Equity Strategy

March 9, 2017



Higher inflation = lower equity returns With Ward thinking that inflation is moving higher, we decided to take a look at what it

means for the overall market’s performance and then specifically for sectors. We reviewed

a number of inflation measures, looking at the index level versus absolute and relative

performance along with the year-over-year change. We lagged inflation by one month, as

monthly statistics tend to come out in the subsequent month and more than likely, were

somewhat delayed when we went back in time. The measures we used were:

CPI Total —1-Year change in consumer price index, all items.

CPI excluding food and energy —1-Year change in CPI all Items less food and

energy.

PCE Total (which is what Fed focuses on)—1-Year change in personal

consumption expenditures.

PCE excluding food and energy – 1-Year change in PCE excluding the volatile

food and energy groups.

Total PPI — 1-year change in finished goods.

PPI excluding food and energy— 1-year change in finished goods excluding

food and energy.

Most measures gave us the same conclusions We reviewed performance for small, mid, and large going back to 1948 versus the six

inflation measures and it turns out the PCE total and PCE ex Food and Energy are the best

measures. These are the inflation measures that the Fed looks at but the bad news for

stocks is that performance is inversely correlated. As inflation ticks higher, small, mid, and

large tend to weaken and vice versa. Inflation heading higher means that interest rates

should also rise, and thus valuations for equities falls. The correlation between PCE total

and performance for small stands at -0.41, for mid -0.43, and for large -0.44 (Table 1).

When we use PCE excluding Food and Energy, correlations rise a bit. We also found that

PPI excluding food & energy is inversely correlated to small-cap performance in particular

and less so for mid and large but still pretty decent.

All of the measures we looked at when we compared small to large points to higher

inflation leading to weaker small-cap performance. Again, the PCE excluding food and

energy has the best relationship with a correlation of -0.52 but PPI ex food and energy is

also a good measure. As for relative performance of mid versus large, we did not see the

same relationships as we did in small with the best of the bunch being PPI (excluding

food and energy) at -0.35.

Table 1: Turns out, the Fed measure of inflation has a decent correlation

Correlations

Absolute Relative

Inflation Measure Small Mid Large Small Mid

CPI Total -0.16 -0.29 -0.29 -0.30 -0.04

CPI (ex Food & Energy) -0.36 -0.41 -0.42 -0.44 -0.12

PCE Total -0.41 -0.43 -0.44 -0.47 -0.20

PCE (ex Food & Energy) -0.47 -0.47 -0.48 -0.52 -0.19

PPI Total -0.09 -0.18 -0.18 -0.19 -0.05

PPI (ex Food & Energy) -0.62 -0.41 -0.42 -0.49 -0.35

Note: Relative is versus the large caps. Source: Center for Research in Security Prices (CRSP®), The University of Chicago Booth School of Business; Jefferies

Steven DeSanctis, CFA SMID Cap Strategist

(212) 284-2056

[email protected]

Equity Strategy

March 9, 2017




Chart 16: PCE ex food & energy works for small vs. large

Source: Center for Research in Security Prices (CRSP®), The University of Chicago Booth School of Business; Jefferies

Chart 17: In mid PPI ex food & energy works mid vs. large

Source: Center for Research in Security Prices (CRSP®), The University of Chicago Booth School of Business; Jefferies

Another slice says same thing; weaker performance Correlations get masked by periods of strong relationships coupled with periods of weak,

and we think this is certainly the case with inflation given just how low all measures have

been post the Great Financial Crisis. Thus, we decided to take an easy approach and

looked at the annual performance of the size segments versus PCE ex food and energy.

We looked at when it was rising or falling, in various buckets of inflation, above and

below the historical average as well as above or below median. We also measured relative

performance.

When PCE is heading up and above median, performance for the three size segments are

lower than average (Table 2). We see a very big difference in large when PCE is heading

up versus heading down, as the average gain when moving north is 7.6% and 16.1%

when moving south. Performance for all three size segments have been better when PCE

tops 4% or between 0% and 2% then when it is between 2% and 4%. This is where PCE

stands today.

This analysis does not take into account where we are in the Fed cycle, where valuations

stand, etc. We do see that when PCE ex food and energy is rising and above median, this

bodes well for small and mid versus large. This could be a function of strong small and

mid-cap performance back in the 1970’s and early 1980’s.

Table 2: Higher PCE ex food & energy means lower avg absolute performance

Absolute Relative Versus Large

PCE ex Food & Energy Small Mid Large Small Mid

Up 13.4 11.3 7.6 5.0 3.2

Down 16.7 16.8 16.1 0.3 0.5


>4 18.3 16.3 12.1 5.4 3.7

2-4 8.3 8.9 8.1 -0.6 0.3

0-2 18.2 16.7 15.2 2.7 1.5


Above Avg. 15.1 14.3 11.8 2.4 2.0

Below Avg. 15.3 14.2 12.3 2.5 1.7

0.5

1.0

1.5

2.0

2.5

3.0

3.5

0.5

2.5

4.5

6.5

8.5

10.5

12.5

PCE (X Food & Energy—LHS) Small versus Large (RHS)

Correlation: -0.52

1.0

1.5

2.0

2.5

3.0

3.5

-2.0

0.0

2.0

4.0

6.0

8.0

10.0

12.0

14.0

16.0

18.0

Dec-

74

Dec-

79

Dec-

84

Dec-

89

Dec-

94

Dec-

99

Dec-

04

Dec-

09

Dec-

14

PPI ex Food & Energy (LHS) Mid versus Large (RHS)

Correlation: -0.35

Equity Strategy

March 9, 2017



Table 2: Higher PCE ex food & energy means lower avg absolute performance

Absolute Relative Versus Large


Above Median 14.3 13.2 10.4 3.0 2.3

Below Median 16.1 15.2 13.8 2.0 1.3

Overall 15.2 14.2 12.1 2.5 1.8

Note: Average annual performance calculated during different periods of 1-year percent change in PCE ex Food & Energy. Source: Center for Research in Security Prices (CRSP®), The University of Chicago Booth School of Business; Jefferies

Across sectors, only a few impacted by inflation We then took our six measures and added a seventh (average hourly earnings) and ran

correlations back to 1986 for each of the GICS sectors for large and small. Performance

was relative to their respective benchmarks (Tables 3 and 4). Broadly speaking,

correlations were pretty weak and some sectors have their own inflation measurements

that help drive performance.

Large Caps:

As one would expect, Discretionary was inversely correlated to all of the

measures we reviewed, but a rise in total CPI, PCE, or of course hourly wages

really does not help this sector.

Staples hold up decently well when CPI and PPI ex Food and Energy rises, while

the group seemed immune to the other inflation measures.

As one would expect, rises in total CPI, PCE, and PPI benefits Energy and of

course much of the time these measures are rising due to jumps in oil prices.

Financials were pretty immune to inflation measures and for the most part that

was the case for Health Care, but we think changes in drug prices drive this

sector.

The interesting item for Industrials is that the sign flips when we use total PPI

and PPI excluding food and energy.

Most measures did not have a real effect on Tech’s performance and surprising

to us was this was the same for Materials. As for Materials, it is guided more by

commodity prices than overall inflation measures.

Although one thinks of Real Estate as an inflation hedge, all of the signs were

negative. Here we think this was driven by the fact that higher inflation is

generally met with rising rates, and this hurts this sector. A rising PPI excluding

food and energy seems to have the biggest impact on the group.

Utilities are in the reverse camp as Real Estate as they tend to perform well when

PPI excluding food and energy heads higher. Again, we think there are better

inflation measures used for this sector.

Equity Strategy

March 9, 2017



Table 3: A number of large-cap groups are impacted by higher inflation…

Correlations

Inflation Measure

Discretionary

Staples

Energy

Financials

Health

Care

Industrials

Info

Tech

Materials

Real

Estate

Utilities

CPI Total -0.46 0.03 0.53 -0.08 -0.08 0.14 -0.11 0.15 -0.15 -0.02

CPI (X Food & Energy) -0.27 0.31 0.06 0.02 0.17 -0.15 -0.25 0.04 -0.30 0.11

PCE Total -0.40 0.04 0.49 -0.10 -0.15 0.14 -0.17 0.20 -0.11 0.02

PCE ( Food & Energy) -0.23 0.24 0.14 -0.02 0.00 -0.05 -0.29 0.14 -0.19 0.14

PPI Total -0.33 -0.16 0.60 -0.20 -0.21 0.27 0.01 0.17 -0.03 -0.02

PPI (X Food & Energy) -0.13 0.33 0.10 -0.40 0.26 -0.25 -0.16 -0.08 -0.36 0.35

Average Hourly

Earnings

-0.39 0.12 0.27 0.03 0.12 -0.02 -0.04 -0.11 -0.29 0.07

Note: Relative performance versus the Russell 1000 Source: FactSet; Russell Investment Group; Jefferies

Small Caps:

In small-cap Discretionary, the relationships are weaker, and it is surprising that

average hourly earnings failed to drive performance (Table 4). Small-cap

Discretionary has a higher weighting in Retail and Restaurants and one would

think that these groups are really impacted by this inflation measure.

Staples had the same reaction as Discretionary in which we don’t see a great

relation by any of the measures.

Energy is more tied to inflation measures in small than in large with PPI quite

strong at 0.72.

Financials in small caps share the same indicator as large with a slightly higher

correlation and same holds true for Health Care. As for Health Care, drug pricing

may not have the same impact as it does in large caps.

Industrials, Info Tech, and Materials fail to respond to inflation measures, and

again, we think these seven may not be the end all be all for these groups.

PPI ex food and energy has a decent fit with relative performance for Real Estate

and Utilities with the signs going in the opposite directions.

Equity Strategy

March 9, 2017



Table 4: …Whereas fewer are impacted in small

Correlations

Inflation Measure

Discretionary

Staples

Energy

Financials

Health

Care

Industrials

Info

Tech

Materials

Real

Estate

Utilities

CPI Total -0.25 -0.23 0.60 -0.29 0.14 0.13 -0.01 0.21 -0.17 -0.06

CPI (X Food & Energy) -0.06 -0.01 0.01 0.01 0.19 -0.05 -0.08 -0.02 -0.25 0.20

PCE Total -0.21 -0.23 0.54 -0.32 0.09 0.14 -0.05 0.26 -0.16 -0.02

PCE (X Food & Energy) -0.04 -0.06 0.10 -0.12 0.09 0.05 -0.13 0.13 -0.21 0.17

PPI Total -0.27 -0.28 0.72 -0.45 0.10 0.17 0.06 0.29 -0.11 -0.16

PPI (X Food & Energy) -0.19 0.08 -0.02 -0.29 0.39 -0.04 -0.03 -0.03 -0.37 0.35

Average Hourly Earnings -0.20 0.14 0.35 -0.02 0.07 0.12 -0.06 0.03 -0.04 0.05


Not that we are gluttons for punishment, but we also looked at relative performance at

the industry level versus the seven inflation measures for large and small. Here we used

the GICS Industry Groups, in which there are 24 classifications.

Table 5: Going one step further, we ran correlations between GICs industry level II and inflation measures in large…

Large Caps

GICS Industry Group

CPI

CPI (X Food &

Energy)

PCE

PCE (X Food &

Energy)

PPI

PPI (X Food &

Energy)

Avg. Hourly

Earnings

Automobiles & Components -0.18 -0.16 -0.18 -0.18 -0.18 -0.36 -0.13

Banks -0.16 -0.07 -0.16 -0.12 -0.23 -0.34 -0.08

Capital Goods -0.13 -0.11 -0.13 -0.14 -0.16 -0.33 -0.09

Commercial & Professional Services -0.15 -0.08 -0.16 -0.13 -0.21 -0.28 -0.08

Consumer Durables & Apparel -0.16 -0.09 -0.16 -0.13 -0.21 -0.30 -0.12

Consumer Services -0.16 -0.10 -0.16 -0.14 -0.20 -0.30 -0.12

Diversified Financials -0.14 -0.09 -0.15 -0.13 -0.21 -0.36 -0.07

Energy -0.07 -0.08 -0.08 -0.11 -0.10 -0.29 -0.05

Food & Staples Retailing -0.15 -0.07 -0.16 -0.13 -0.21 -0.27 -0.05

Food Beverage & Tobacco -0.13 -0.05 -0.13 -0.10 -0.19 -0.26 -0.06

Health Care Equipment & Services -0.13 -0.06 -0.13 -0.11 -0.19 -0.27 -0.09

Household & Personal Products -0.12 -0.04 -0.13 -0.09 -0.20 -0.28 -0.06

Insurance -0.14 -0.08 -0.15 -0.13 -0.20 -0.33 -0.07

Materials -0.13 -0.09 -0.13 -0.12 -0.17 -0.30 -0.08

Media -0.19 -0.16 -0.19 -0.19 -0.18 -0.33 -0.15

Pharma Biotech & Life Sciences -0.15 -0.06 -0.17 -0.13 -0.22 -0.27 -0.06

Real Estate -0.16 -0.13 -0.16 -0.16 -0.19 -0.34 -0.10

Retailing -0.18 -0.09 -0.18 -0.14 -0.23 -0.29 -0.10

Semi & Semi Equipment -0.15 -0.09 -0.15 -0.13 -0.20 -0.32 -0.10

Software & Services -0.17 -0.17 -0.18 -0.21 -0.18 -0.35 -0.12

Technology Hardware & Equipment -0.16 -0.13 -0.16 -0.16 -0.17 -0.29 -0.12

Telecommunication Services -0.15 -0.10 -0.15 -0.14 -0.18 -0.29 -0.10

Transportation -0.14 -0.10 -0.14 -0.14 -0.17 -0.30 -0.08

Utilities -0.13 -0.12 -0.12 -0.13 -0.15 -0.29 -0.12


Equity Strategy

March 9, 2017



Table 6: …And in small caps

Small Caps

GICs Level II

CPI

CPI (X Food &

Energy)

PCE

PCE (X Food &

Energy)

PPI

PPI (X Food &

Energy)

Avg. Hourly

Earnings

Automobiles & Components 0.00 -0.02 0.02 0.04 0.02 -0.26 -0.20

Banks -0.28 0.01 -0.32 -0.13 -0.47 -0.31 -0.03

Capital Goods 0.25 -0.15 0.23 -0.05 0.37 -0.08 0.19

Commercial & Professional Services -0.06 -0.03 -0.07 -0.06 -0.06 0.02 0.11

Consumer Durables & Apparel -0.15 -0.11 -0.10 -0.04 -0.10 -0.17 -0.24

Consumer Services -0.05 0.14 -0.01 0.16 -0.15 0.05 -0.01

Diversified Financials 0.05 0.14 -0.01 0.04 -0.10 -0.21 0.27

Energy 0.60 0.06 0.58 0.19 0.70 -0.01 0.32

Food & Staples Retailing -0.21 -0.02 -0.24 -0.10 -0.24 0.18 0.11

Food Beverage & Tobacco -0.19 0.00 -0.21 -0.09 -0.25 0.05 0.25

Health Care Equipment & Services 0.24 0.37 0.22 0.31 0.09 0.40 0.08

Household & Personal Products -0.18 0.00 -0.14 0.00 -0.21 0.03 -0.21

Insurance -0.10 0.19 -0.12 0.11 -0.30 0.05 0.05

Materials 0.18 -0.12 0.22 0.04 0.34 -0.08 0.05

Media -0.19 -0.17 -0.23 -0.24 -0.14 -0.35 -0.04

Pharma Biotech & Life Sciences 0.09 0.09 0.07 0.03 0.11 0.28 0.10

Real Estate -0.20 -0.20 -0.20 -0.20 -0.20 -0.42 -0.12

Retailing -0.30 -0.12 -0.27 -0.12 -0.28 -0.12 -0.16

Semi & Semi Equipment -0.40 -0.41 -0.37 -0.36 -0.22 -0.21 -0.26

Software & Services 0.02 0.07 0.02 0.04 0.05 0.22 -0.11

Technology Hardware & Equipment 0.02 -0.03 0.00 -0.07 0.06 -0.05 -0.01

Telecommunication Services 0.02 -0.02 0.04 0.04 0.05 0.01 -0.03

Transportation -0.13 0.05 -0.09 0.08 -0.18 -0.06 -0.05

Utilities -0.10 0.07 -0.14 -0.04 -0.15 0.23 0.20


Equity Strategy

March 9, 2017



Randy Konik: Specialty Retail

Curbing Enthusiasm—higher inflation=higher rates An accelerated pace of sustained Fed rate hikes due to higher inflation has the potential to

curb consumer spending and subsequently hurt retail stocks which tend to be “early

cycle”. While interest rates are low from a historical perspective, the potential for a higher

interest rate environment creates less incentive for consumers to borrow for larger

purchases, such as houses or cars, just as a low interest rate environment encourages

consumers to spend more on discretionary items. Importantly, we do not believe a single

rate hike will change the mindset of most consumers, but a consistent pace of increases

has the potential to impact adjustable-rate mortgage loans, variable-rate credit cards, auto

loans, small business loans, and private (not Federal) student loans. While we foresee

higher interest payments stemming from higher rates eventually pinching wallets, we that

could be offset if job growth materializes from President Trump’s economic policy

initiatives. While quantifying the net impact on retailers is difficult, it’s clear rising wages

are moderating operating margin expansion but also benefiting comparable store sales

from lower-income consumers (to a degree).

Stock Call-Outs – Rising Wages:

ROST / TJX: We continue to acknowledge the strength of off-price retailer fundamentals,

aided by increasingly value-conscience consumers who have driven consistent increases

in foot traffic. Looking beyond relatively fair valuations in our opinion, the potential for

further increases in wages has been a key reason for our caution on the off-price retail

space. Competitors like TJX and Ross Stores have been particularly vocal on the topic

given their large store associate bases of 216,000 and 78,000 employees, respectively.

When providing guidance for 2017, TJX management cited that wages increases are

anticipated to have a 2% negative impact on EPS growth for the year and will linger (to a

lesser extent) in the foreseeable future. While we are encouraged with the success of

initiatives to offset prior wage hikes, we believe there is a limit to the degree to which

future increases can be offset. While rising wages will impact all retailers, particularly

those with large store fleets (and sales associates), off-price retailers have been more

proactive in mandated hourly salary increases than other sectors of retail and are likely

more disadvantaged.

Stock Call-Outs – Pricing Power:

NKE: We reiterate NKE as our top pick for 2017 given its solid LT growth story, driven by

resurgence in basketball recently and initiatives to scale women’s and international. We

also see significant margin opportunity as it relates to growing DTC penetration, rising

ASPs, and manufacturing efficiencies. When we consider the potential impact of rising

wages on our coverage universe, we prefer names that have significant pricing power,

and for that reason, NKE comes to mind. With unmatched brand resonance (that is

strengthening), we believe NKE is better-positioned than others in a rising wage

environment.

TIF: We see opportunity for TIF owing to accelerated product newness (particularly its

high-margin fashion jewelry assortment), more innovative marketing, and improved

operational discipline. With a higher-income consumer that is particularly strong given

the recent rise in equity markets and well-positioned with the potential for lower personal

income taxes, we believe TIF is one of few retailers under our coverage with clear pricing

power to offset the impact of potentially higher wages. TIF has exercised its pricing power

over the past few years through gradual increases in ASPs across product categories.

FL: We continue to like the FL story given the ongoing athletic and retro footwear cycle

and limited competition stemming from the oligopolistic nature of the footwear retail

Randy Konik

Specialty Retail Analyst

(212) 708-2719

[email protected]

Equity Strategy

March 9, 2017




sector. FL is another name that comes to mind when we think about pricing power,

which we believe is supported by consistent increases in foot traffic (one of the few mall

retailers to achieve this in the current environment).

Andy Barish: Restaurants

Restaurants Face Margin Headwinds Margin headwinds from labor: While a federal minimum wage increase is unlikely

near-term, with full employment and states and localities moving minimum wage higher,

there does not appear to be any '17 relief in sight for mid-single-digit wage inflation,

especially with less possible menu pricing offsets given weak industry traffic since Spring.

Market forces and lack of availability are driving wages higher and making it challenging

for restaurants as we have been discussing. We expect most companies to see wage

inflation in a range of 4%-5%, reflective of mandatory minimum wage increases, the new

overtime rules, Affordable Care Act (we think most chains unlikely to take back any of

these benefits/changes) as well as increased benefits related to employee recruitment and

retention efforts in an increasingly competitive labor market. Partially offsetting these

pressures will be commodity deflation (although likely to a lesser-degree than 2016), as

we expect further easing in certain protein commodity prices to continue into 2017. That

said, with most companies taking a measured approach with pricing and likely to use

commodity tailwinds to offset labor headwinds, we do not expect a significant benefit to

margins for all companies.

Higher rates should negatively impact valuations. We would suspect that rate

increases will increasingly have a negative impact on already high restaurant valuations,

particularly for small-cap names. Additionally, many franchisors are highly valued as well

right now as “bond proxies” given they return significant cash to shareholders in the form

of dividends and share repurchase, which might not be as attractive to investors going

forward as rates increase and these companies also carry significant debt.

We believe companies’ best positioned for margin expansion and EPS growth in 2017 are

those with inherent structural labor advantages within their business model and those

with exposure to markets where restaurants will collectively be seeking price increases to

offset labor pressures. We also believe some franchisor models are overvalued.

Structural labor advantaged Buys include:

PLAY (Buy-Rated, $65 Price Target): Our favorite new unit growth story with an

underappreciated, differentiated brand and business model with no real direct

competitors. We expect this to work to PLAY’s advantage as we move later in the cycle,

which along with continued focus on new, proprietary games/amusements backed by

marketing, should drive growth and broad based brand awareness to support

incremental SSS and margin leverage on 50%-60% flow-through. New unit growth of

10%+ has been very productive as well.

FOGO (Buy-Rated, $17 Price Target): Although the stock has bounced back post-

election, it still trades at just 12.5-13.0x ’17 EPS, which we believe is too much of a

discount despite Brazil concerns & a cautious implied SSS outlook for the US business in

4Q due to Hurricane Matthew. We think FOGO represents an appealing opportunity, with

a differentiated concept and industry-leading unit economics, including structural labor

advantages. Although NT results have been somewhat choppy, and this likely continues

into 4Q with the hurricane, we expect solid growth and margin expansion to continue

heading into ‘17.

Andy Barish

Restaurant Analyst

(415) 229-1524

[email protected]

Equity Strategy

March 9, 2017




Highly valued franchisor stock, we don’t favor:

DNKN (Underperform, $45 Price Target): Our PT stays at 13x ’17 EV/EBITDA, which

implies about 14% downside. We don’t believe SSS have broken out above +2% and

traffic still likely negative with more than 3% price taken in ’16. We feel as if the brand is

trying to avoid getting “stuck in middle” of QSR/c-store and SBUX, but not sure can fully

rise above competition currently with premium beverages and products. Additionally,

new store productivity has been softer in emerging/Western markets, making unit growth

gravitate towards lower end of +4-6% range. The company’s international growth (or lack

thereof) has been disappointing. The ‘17 roll out of RTD coffee beverages with Coca-Cola

should give EPS flexibility but we believe near-term stock performance more likely driven

by SSS visibility and acceleration, which we are not projecting.

Stephen Volkmann: Machinery

Double edge sword, up and to right For industrial stocks, inflation has historically been a double-edged sword, albeit one that

points up and to the right. Many industrial end markets are levered to the extraction,

transportation and processing of commodities (e.g., agriculture, energy, mining, basic

materials), so clearly commodity related inflation is positive overall. At the same time,

higher costs for raw materials and labor – both of which have been depressed for some

time – will provide some margin headwinds for the group.

Interest rates are often viewed as demand proxies by industrial investors – if rates are

going up, then business must be good. Unfortunately, markets do tend to overshoot, so

the markets have historically run out of patience with interest rate cycles. For now, any

increases will be off a very low base. As rates continue to increase, the potential for

demand destruction tends to play a bigger role in stock performance.

Chris LaFemina: Metals & Mining

Inflation and commodity prices Commodity prices have historically often been correlated with inflation. During some

periods, such as in the 1970s and during the China supercycle, higher commodity prices

were arguably a cause of inflation rather than a symptom. For instance, during the

supercycle, most commodity markets were affected by strong demand growth and

significant supply constraints. The combination of strong demand and a lack of supply led

to higher commodity prices. Since commodities are input costs in construction and

manufacturing, higher commodity prices during the supercycle led to higher construction

costs and higher manufacturing costs, which builders and factory owners were ultimately

able to pass on to their customers (because demand was strong) in the form of higher

prices. The China supercycle was characterized by demand pull commodity price inflation

which was one of the causes of global inflation, in our view.

Our analysis indicates that commodities are more likely to be a cause of general inflation

during periods of strong growth in emerging economies, such as during the China

supercycle. When the engine of global growth is consumer spending and/or services in

developed economies rather than fixed asset investment and industrial production in

emerging economies, commodity prices are likely to be weak and therefore are unlikely to

contribute to global inflation. This was the case in the 1990s, when the US consumer and

tech/services companies drove the global economy.

Stephen Volkmann

Machinery Analyst

(212) 284-2031

[email protected]

Chris LaFemina

Global Metals & Mining Analyst

(212) 336-7304

[email protected]

Equity Strategy

March 9, 2017





We believe that commodity prices have very recently been one of the causes of inflation.

China had been in a deflationary period with PPI falling year-over-year for every month

over nearly a four year period. The fear was that China was exporting deflation and the

world was therefore in a deflationary death spiral. In 2016, the Chinese government put

in place workday restrictions on domestic coal miners, and Chinese coal production fell

by 10% following these supply restrictions. Less coal supply led to much higher coal

prices. China is a coal-based economy (much like the US is an oil-based economy), and

higher coal prices in China led to higher inflation in Chinese factories and ultimately in the

broader Chinese economy. This increased inflation can be clearly seen in Chinese PPI data.

Now, the concern is that Chinese inflation is running too high, and the government is

attempting to cool the economy to stabilize inflation and prevent bubbles from

forming/growing.

Interest rates and commodity prices During periods of slow growth and high inflation, we would consider higher interest rates

to be an unequivocal negative for commodity prices since high commodity prices during

those periods could be attributed almost entirely to monetary policy. This was the case in

the 1970s. However, during periods of strong growth - especially in emerging economies

- a rate hike cycle is less of a concern as long as tightening monetary policy does not lead

to significantly slower global growth. That is the question now, in our view. If the Fed is

increasing rates due to high inflation and that inflation has been caused by strong growth,

it is not clear whether a tightening cycle should be a negative for commodity prices. This

is especially the case if higher rates lead to higher capex, as some economists

expect. More private investment rather than government investment could be a positive

for demand for commodities and could offset the negative impact of slightly slower

growth due to higher interest rates.

The stocks—GLEN-LN, FM-CN, BBL, RIO While the market reaction to rate hikes would likely be negative and mining share prices

are therefore high risk in the very short term, higher interest rates in response to

accelerating global growth would not necessarily be a negative for commodity prices or

mining share prices. Higher rates would almost certainly be a positive for commodity

traders such as Glencore as trading arbitrage opportunities increase when rates rise. In

some metals markets, such as copper, major supply constraints are intensifying and prices

should go higher even if rate increases lead to slightly slower growth. Again, Glencore

should benefit. We would also buy shares of First Quantum, BHP Billiton and Rio

Tinto, especially after any short-term weakness resulting from a rate hike.

Equity Strategy

March 9, 2017



Seth Rosenfeld: Steel

Emerging Inflation Strongly Positive for Steel The US steel industry is uniquely positioned as both a driver of emerging inflation and

also a key beneficiary of said reflationary tailwinds. With rising virgin raw materials,

steelmakers are now seeing the strongest cost-push steel price support in years, and with

increasing supply constraints as a result of industry consolidation and rising trade

protectionism, steelmakers are in a position to push through outsized price hikes that

allow for attractive margin expansion. With a high fixed cost base and relatively high

sector-wide debt burden, these reflationary tailwinds should be strongly supportive of

steel sector equity momentum in the year to come. Our top sector picks are NUE,

STLD, MT, X and AKS.

Chart 18: US CPI YoY vs S&P 1500 Steel

Source: Jefferies estimates, US BLS, Factset

Steel as a driver of inflation The steel industry is emerging as a direct driver of broader US inflation as a result of both

rising raw materials inputs and improved industry pricing power. Historically, steelmakers

have shown a consistent ability to pass on rising raw materials prices to customers, but in

a falling raw materials environment steelmakers have been forced to similarly pass on

these benefits. As discussed previously by Chris LaFemina, bulk raw materials prices finally

began to rally in 2016 after nearly five years of weakness partly as a result of improving

supply discipline (both industry consolidation and low capacity growth). Surging iron ore

and coking coal prices have been the driver of rising steel prices.

Further, directly within the steel industry, Chinese supply-side reform and rising

protectionist trade barriers in the West have improved steelmakers' pricing power. Within

China, efforts launched last year to finally address massive steelmaking overcapacity have

driven a return to healthy steelmaker margins. And in the US, rising trade barriers pushed

down finished steel imports by -16% YoY in 2016. The Obama administration already

drove significant steps in trade policy to fast-track trade cases, and the new administration

is likely to further progress these policies and dissuade new entrants from entering the US

market for fear of retaliatory measures. As a result, US steel metal spreads are now

comfortably above their historical averages for many key products.

In absolute terms, US steel prices are now 78% above their lows of late 2015 but remain

27% below the post-global financial crisis high of early 2011. Rising steel prices will push

up prices for a wide variety of industrial and consumer goods, driving inflation, and there

is of course risk that this ultimately weighs on demand. But, with steel prices still relatively

low in absolute terms, consumers should be capable of absorbing higher input costs.

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Seth Rosenfeld

Global Steel Analyst

+44 (0)20 7029 8772

[email protected]

Equity Strategy

March 9, 2017




Chart 19: US CPI YoY vs US HRC Steel $/t

Source: Jefferies estimates, US BLS, MB

Steel as a beneficiary of inflation The steel industry has historically been able to achieve attractive margin expansion in a

reflationary environment for two key reasons. First, as mentioned above in a cost-push

steel pricing environment, inflation leads to higher absolute steel prices. As rising steel

sales prices often hit P&L faster than changes in raw materials input costs, steelmakers can

often achieve margin expansion. US blast furnace-based steelmakers are uniquely well

positioned versus global peers as they are often vertically integrated to iron ore and have

long term annual supply contracts for coking coal, meaning they benefit from higher

global steel prices while their own input costs are relatively stable.

Chart 20: US CPI YoY vs Metal Spread $/t

Metal Spread = US Steel HRC $/s – Steel Scrap Input Cost

Source: Jefferies estimates, US BLS, MB

Second, steel buyer behavior may change dramatically in a rising price environment. The

global steel industry has seen nearly five years of raw materials-led deflation and

destocking as in a deflationary environment steel buyers delay purchases and eat into

inventories in the hope of purchasing steel for a lower price in the future. At present, US

steel inventories are 24% below the historical average in absolute terms and seasonally

adjusted months-on-hand (taking into account shipment volumes) stand at 2.2 vs

historical average 2.7. Finally in recent months we have begun to see steel buyers step

back into the market, including both steel service centers and also end market consumers,

and there is hope that a restocking cycle could emerge should pricing/demand hold up.

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Equity Strategy

March 9, 2017



US steel industry utilization rates currently stand at just 74.7%, and both integrated and

mini mill producers have significant idled/latent capacity that could be ramped-up should

demand conditions permit. As steelmakers have significant fixed cost leverage, rising

shipments brought about by customer restocking and improving apparent demand

would be a significant positive driver of realized margins and help support a further wave

of upside to earnings expectations.

Chart 21: US Steel Mill Utilization vs Steel Distributor Shipments SA

Source: Jefferies estimates, MSCI, AISI

Laurence Alexander: Chemicals

Broad pick-up positive for intermediate and specialty chemicals This looks like it could be the first cycle since the 1990s where broad-based inflation is

picking up faster than the cost-push from oil prices and crop prices. If so, that would

be broadly positive for intermediate and specialty chemicals, which price based on “value

add” and “efficiency saving” arguments, whereas in the last two cycles the best strategy

was to stick “close to the cracker” to leverage the rise in oil prices. The historical data

shows CPI is a pretty poor trading indicator for the sector (broad dispersion in outcomes),

partly because the sector tends to see incremental margins deteriorate later in each

economic cycle.

In the near-term, bottlenecks are most apparent in titanium dioxide and naphtha

derivatives, partly as a combination of underinvestment in the US and Europe followed by

a Chinese curtailments of less efficient, and environmentally problematic, assets. In the

medium-term, the chemical companies with the most direct leverage to a persistent

inflationary trend would be the industrial gases (we favor buy-rated Linde and Praxair)

and the chemical distributors (we favor Buy-rated Univar, Brenntag).

In prior cycles, the third or fourth rate hike starts a rotation towards more defensive or

“self-help” stories. Near-term, if a rate increase is viewed as validating, rather than

undermining, improving industrial growth prospects, chemicals as a sector should do

fine. If the interpretation is the rate increases are intended to cool consumer

demand/wage inflation, this sector will start to lag more noticeably.

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Laurence Alexander

Chemicals Analyst

(212) 284-2553

[email protected]

Equity Strategy

March 9, 2017




Phil Ng: Paper & Packaging and

Building Products

Input cost inflation a 2017 theme Paper & Packaging

Input cost inflation has been a central theme in 2017 for Paper & Packaging, with the

majority of companies calling out input cost inflation as a factor in 2017 guidance. We’ve

seen resin prices move higher in 1Q and OCC prices reached a multi-decade high in

March, which has added to investors’ concerns about near term price/cost mismatches in

the industry driving margin pressure. That said, we view input cost inflation as an overall

positive for the group, since the level of consolidation in the industry has driven better

pricing discipline and paper & packaging companies have shown an ability to drive

margin expansion by raising prices in an inflationary environment, particularly in the

paper and flexible packaging industries. For instance, we’ve seen back to back $50 / ton

containerboard price increases recently after 3 years of flat to declining prices, $50 / ton

price increases announced in boxboard (CRB, CUK, SBS), $60 / ton in URB, and a price

increase in Sealed Air’s Product Care divisions which have all used input cost backstops as

rationale to boost pricing and drive margin expansion. For the rigid packaging producers,

input costs in the U.S. are typically passed to customers on a real time basis, so inflation

can be a margin headwind but is neutral to earnings dollars.

Stock Picks:

We believe the best ways to play inflation in Paper & Packaging are the containerboard

producers, who are benefitting from tight market conditions, no meaningful supply

coming online the next few years, cost justification to raise prices (OCC), and strong

demand from e-commerce, ag, and potentially manufacturing. From a risk:reward

standpoint, WRK, IP, and PKG all offer different dynamics, but we think

shares remain compelling at current levels.

WRK is the cheapest on FCF and EV/EBITDA and has optionality from successfully

integrating MPSX, but has the least net leverage to pricing with its exposure to

OCC.

PKG is the cleanest play with 85% of its EBIT coming from containerboard, and

80% of its fiber mix is in virgin, but the stock trades at 1x premium on

EV/EBITDA vs IP and WRK.

As for IP, it offers good value and optionality from the WY acquisition and pulp

prices are starting to rise, but earnings should be inherently more volatile due to

its exposure to pulp.

Building Products:

We believe that inflation and corresponding rate hikes by the Federal Reserve should be a

positive indicator for economic health given the low base of interest rates currently. This

should lead to increased demand for construction activity and support price increases for

the manufacturers at or above inflation, more than offsetting any input cost increases for

the manufacturers. Manufacturers have already begun to implement price increases for

products such as asphalt roofing shingles, gypsum wallboard, and insulation. For

example, manufacturers have implemented a price increase for fiberglass insulation,

which has seen prices slide in 2016; however, with increasing demand / tighter capacity,

rising prices, and an inflationary backdrop we anticipate this trend to reverse.

Additionally, while the Federal Reserve does not have direct control over mortgage rates,

its decisions around the federal funds rate can indirectly impact mortgage rates.

Phil Ng

Paper & Packaging and Building

Products Analyst

(212) 336-7369

[email protected]

Equity Strategy

March 9, 2017




Therefore, conversations around the impact of rising rates and higher home prices on the

housing market have become more abundant. However, we do not believe it will deter

households from purchasing a home given the small incremental cost and healthy

personal balance sheets, which should aid both new residential construction and repair

and remodel activity. Further, disposable incomes should continue to see an uptick,

especially if Trump can successfully lower individual taxes and drive wage growth. When

interest rates have risen off of a low level, correlation to home sales are low. For example,

in 2013 home sales accelerated when interest rates ticked higher, given other factors such

as consumer confidence, household formation, and wage growth proved to be more

important drivers. That said, the group could pull back on higher rates, and tactically we

would view this as a buying opportunity.

Owens Corning – Top Pick:

We continue to like Owens Corning (Top Pick, $65), who should benefit from continued

strength in U.S. based construction, particularly on the residential side. Given the

historically low level of interest rates, any moves by the Federal Reserve should indicate

that the economy is healthy supporting continued growth in construction markets.

Additionally, while inflation will impact input costs, it should also aid the implementation

of price increases ahead of inflation, particularly for insulation and roofing products,

which have seen weakness throughout the past year.

Daniel Binder: Hardline Retail

Too much of a good thing hurts multiples A little inflation in retail is a good thing, but too much can be bad. Inflation can lead to

higher average selling prices and often times provide a tailwind to sales growth. In turn,

better sales growth allows a retailer to better leverage fixed costs. However, if broader

inflation escalates and leads to a rising Fed rate environment, retail stocks tend to

experience multiple compression and underperform as a group.

History has shown us that portfolio managers take their cue from the Fed when it comes

to early cycle trades, so we will find retail stocks start outperforming the market as rates

go down, despite what may be soft operating results at that point in time (typically at a

time when the economy has slowed). Similarly, retail stocks tend to underperform when

the Fed is raising rates, despite what may be good operating results at that point in time.

This reflects the market’s willingness to look forward and factor in the next step-up or

step-down in consumer spending. Ultimately, if inflation and rising rates have an impact

on banks’ willingness to lend in a negative way, the credit cycle softens and retail sales

growth rates decelerate. For this reason, following the Fed’s lead has generally been a

good way to determine when to underweight and overweight the retail group.

Daniel Binder

Hardline Retail Analyst

(212) 284-4614

[email protected]

Equity Strategy

March 9, 2017




Chart 22: Retail P/E in Interest Rate Environments

Source: Federal Reserve; Jefferies

Chart 23: Jefferies Retail Index Relative to S&P 500

Source: BEA; Federal Reserve; Jefferies

Equity Strategy

March 9, 2017



Our inflation stocks Our analysts identified 22 stocks inside their coverage universes that should be boosted

by higher inflation and potentially higher interest rates.

Table 7: Our Analysts these stocks will be impacted the most by an uptick in inflation

Symbol

Name

Price

Market Cap

(Mil)

Sector

Analyst

Rating

ROST Ross Stores 66.71 26,291.7 Apparel Retail Randy Konik Hold

TJX TJX Companies 78.45 51,141.6 Apparel Retail Randy Konik Hold

NKE NIKE 56.51 74,888.5 Footwear Randy Konik Buy

TIF Tiffany & Co. 89.12 11,091.4 Specialty Stores Randy Konik Buy

FL Foot Locker 77.26 10,226.5 Apparel Retail Randy Konik Buy

PLAY Dave & Buster's 56.60 2,381.0 Restaurants Andy Barish Buy

FOGO Fogo de Chao 13.30 374.1 Restaurants Andy Barish Buy

GLEN LN* Glencore 3.19 45,868.8 Diversified Metals & Mining Chris LaFemina Buy

FM CN* First Quantum 14.07 9,699.5 Copper Chris LaFemina Buy

BBL BHP Billiton 31.23 83,321.6 Diversified Metals & Mining Chris LaFemina Buy

RIO Rio Tinto 39.90 71,700.3 Diversified Metals & Mining Chris LaFemina Buy

NUE Nucor 60.97 19,440.2 Steel Seth Rosenfeld Buy

STLD Steel Dynamics 34.50 8,361.1 Steel Seth Rosenfeld Buy

MT ArcelorMittal 8.49 26,331.1 Steel Seth Rosenfeld Buy

X United States Steel 35.96 6,267.5 Steel Seth Rosenfeld Buy

AKS AK Steel 7.78 2,449.1 Steel Seth Rosenfeld Buy

UNVR Univar 31.52 4,408.4 Trading Companies & Distributors Laurence Alexander Buy

EMN Eastman Chemical 78.32 11,473.0 Diversified Chemicals Laurence Alexander Buy

WRK WestRock 51.30 12,845.7 Paper Packaging Phil Ng Buy

IP Int'l Paper Company 51.54 21,196.1 Paper Packaging Phil Ng Buy

PKG Packaging Corp. 92.97 8,758.3 Paper Packaging Phil Ng Buy

OC Owens Corning 59.99 6,742.2 Building Products Phil Ng Buy

Note: Glencore (GLEN LN) is quoted in GBP; First Quantum (FM CN) is quoted in CAD. Source: FactSet; Jefferies

Equity Strategy

March 9, 2017



Analyst Certification:I, Ward McCarthy, certify that all of the views expressed in this research report accurately reflect my personal views about the subject security(ies) andsubject company(ies). I also certify that no part of my compensation was, is, or will be, directly or indirectly, related to the specific recommendationsor views expressed in this research report.I, Steven G. DeSanctis, CFA, certify that all of the views expressed in this research report accurately reflect my personal views about the subjectsecurity(ies) and subject company(ies). I also certify that no part of my compensation was, is, or will be, directly or indirectly, related to the specificrecommendations or views expressed in this research report.I, Randal J. Konik, certify that all of the views expressed in this research report accurately reflect my personal views about the subject security(ies) andsubject company(ies). I also certify that no part of my compensation was, is, or will be, directly or indirectly, related to the specific recommendationsor views expressed in this research report.I, Andy Barish, certify that all of the views expressed in this research report accurately reflect my personal views about the subject security(ies) andsubject company(ies). I also certify that no part of my compensation was, is, or will be, directly or indirectly, related to the specific recommendationsor views expressed in this research report.I, Stephen Volkmann, CFA, certify that all of the views expressed in this research report accurately reflect my personal views about the subjectsecurity(ies) and subject company(ies). I also certify that no part of my compensation was, is, or will be, directly or indirectly, related to the specificrecommendations or views expressed in this research report.I, Christopher LaFemina, CFA, certify that all of the views expressed in this research report accurately reflect my personal views about the subjectsecurity(ies) and subject company(ies). I also certify that no part of my compensation was, is, or will be, directly or indirectly, related to the specificrecommendations or views expressed in this research report.I, Seth Rosenfeld, CFA, certify that all of the views expressed in this research report accurately reflect my personal views about the subjectsecurity(ies) and subject company(ies). I also certify that no part of my compensation was, is, or will be, directly or indirectly, related to the specificrecommendations or views expressed in this research report.I, Laurence Alexander, CFA, certify that all of the views expressed in this research report accurately reflect my personal views about the subjectsecurity(ies) and subject company(ies). I also certify that no part of my compensation was, is, or will be, directly or indirectly, related to the specificrecommendations or views expressed in this research report.I, Philip Ng, CFA, certify that all of the views expressed in this research report accurately reflect my personal views about the subject security(ies) andsubject company(ies). I also certify that no part of my compensation was, is, or will be, directly or indirectly, related to the specific recommendationsor views expressed in this research report.I, Daniel Binder, CFA, certify that all of the views expressed in this research report accurately reflect my personal views about the subject security(ies) andsubject company(ies). I also certify that no part of my compensation was, is, or will be, directly or indirectly, related to the specific recommendationsor views expressed in this research report.As is the case with all Jefferies employees, the analyst(s) responsible for the coverage of the financial instruments discussed in this report receivescompensation based in part on the overall performance of the firm, including investment banking income. We seek to update our research asappropriate, but various regulations may prevent us from doing so. Aside from certain industry reports published on a periodic basis, the large majorityof reports are published at irregular intervals as appropriate in the analyst's judgement.

Investment Recommendation Record(Article 3(1)e and Article 7 of MAR)

Recommendation Published , 20:02 ET. March 8, 2017Recommendation Distributed , 00:00 ET. March 9, 2017

Company Specific DisclosuresFor Important Disclosure information on companies recommended in this report, please visit our website at https://javatar.bluematrix.com/sellside/Disclosures.action or call 212.284.2300.

Explanation of Jefferies RatingsBuy - Describes securities that we expect to provide a total return (price appreciation plus yield) of 15% or more within a 12-month period.Hold - Describes securities that we expect to provide a total return (price appreciation plus yield) of plus 15% or minus 10% within a 12-month period.Underperform - Describes securities that we expect to provide a total return (price appreciation plus yield) of minus 10% or less within a 12-monthperiod.The expected total return (price appreciation plus yield) for Buy rated securities with an average security price consistently below $10 is 20% or morewithin a 12-month period as these companies are typically more volatile than the overall stock market. For Hold rated securities with an averagesecurity price consistently below $10, the expected total return (price appreciation plus yield) is plus or minus 20% within a 12-month period. ForUnderperform rated securities with an average security price consistently below $10, the expected total return (price appreciation plus yield) is minus20% or less within a 12-month period.NR - The investment rating and price target have been temporarily suspended. Such suspensions are in compliance with applicable regulations and/or Jefferies policies.CS - Coverage Suspended. Jefferies has suspended coverage of this company.NC - Not covered. Jefferies does not cover this company.Restricted - Describes issuers where, in conjunction with Jefferies engagement in certain transactions, company policy or applicable securitiesregulations prohibit certain types of communications, including investment recommendations.

Equity Strategy

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https://javatar.bluematrix.com/sellside/Disclosures.action


Monitor - Describes securities whose company fundamentals and financials are being monitored, and for which no financial projections or opinionson the investment merits of the company are provided.

Valuation MethodologyJefferies' methodology for assigning ratings may include the following: market capitalization, maturity, growth/value, volatility and expected totalreturn over the next 12 months. The price targets are based on several methodologies, which may include, but are not restricted to, analyses of marketrisk, growth rate, revenue stream, discounted cash flow (DCF), EBITDA, EPS, cash flow (CF), free cash flow (FCF), EV/EBITDA, P/E, PE/growth, P/CF,P/FCF, premium (discount)/average group EV/EBITDA, premium (discount)/average group P/E, sum of the parts, net asset value, dividend returns,and return on equity (ROE) over the next 12 months.

Jefferies Franchise PicksJefferies Franchise Picks include stock selections from among the best stock ideas from our equity analysts over a 12 month period. Stock selectionis based on fundamental analysis and may take into account other factors such as analyst conviction, differentiated analysis, a favorable risk/rewardratio and investment themes that Jefferies analysts are recommending. Jefferies Franchise Picks will include only Buy rated stocks and the numbercan vary depending on analyst recommendations for inclusion. Stocks will be added as new opportunities arise and removed when the reason forinclusion changes, the stock has met its desired return, if it is no longer rated Buy and/or if it triggers a stop loss. Stocks having 120 day volatility inthe bottom quartile of S&P stocks will continue to have a 15% stop loss, and the remainder will have a 20% stop. Franchise Picks are not intendedto represent a recommended portfolio of stocks and is not sector based, but we may note where we believe a Pick falls within an investment stylesuch as growth or value.

Risks which may impede the achievement of our Price TargetThis report was prepared for general circulation and does not provide investment recommendations specific to individual investors. As such, thefinancial instruments discussed in this report may not be suitable for all investors and investors must make their own investment decisions basedupon their specific investment objectives and financial situation utilizing their own financial advisors as they deem necessary. Past performance ofthe financial instruments recommended in this report should not be taken as an indication or guarantee of future results. The price, value of, andincome from, any of the financial instruments mentioned in this report can rise as well as fall and may be affected by changes in economic, financialand political factors. If a financial instrument is denominated in a currency other than the investor's home currency, a change in exchange rates mayadversely affect the price of, value of, or income derived from the financial instrument described in this report. In addition, investors in securities suchas ADRs, whose values are affected by the currency of the underlying security, effectively assume currency risk.

Other Companies Mentioned in This Report• AK Steel Holding Corp. (AKS: $7.78, BUY)• ArcelorMittal (MT: $8.49, BUY)• BHP Billiton (BBL: $31.23, BUY)• Dave & Buster's Entertainment, Inc. (PLAY: $56.60, BUY)• Eastman Chemical Company (EMN: $78.32, BUY)• First Quantum (FM CN: C$14.07, BUY)• Fogo de Chão, Inc. (FOGO: $13.30, BUY)• Foot Locker, Inc. (FL: $77.26, BUY)• Glencore (GLEN LN: p318.65, BUY)• International Paper (IP: $51.54, BUY)• Nike (NKE: $56.51, BUY)• Nucor Corp. (NUE: $60.97, BUY)• Owens Corning (OC: $59.99, BUY)• Packaging Corp of America (PKG: $92.97, BUY)• Rio Tinto (RIO: $39.90, BUY)• Ross Stores, Inc. (ROST: $66.71, HOLD)• Steel Dynamics, Inc. (STLD: $34.50, BUY)• The TJX Companies, Inc. (TJX: $78.45, HOLD)• Tiffany & Co. (TIF: $89.12, BUY)• United States Steel (X: $35.96, BUY)• Univar Inc. (UNVR: $31.52, BUY)• WestRock Company (WRK: $51.30, BUY)

For Important Disclosure information on companies recommended in this report, please visit our website at https://javatar.bluematrix.com/sellside/Disclosures.action or call 212.284.2300.

Equity Strategy

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Distribution of RatingsIB Serv./Past 12 Mos.

Rating Count Percent Count Percent

BUY 1098 50.23% 336 30.60%HOLD 913 41.77% 180 19.72%UNDERPERFORM 175 8.01% 15 8.57%

Equity Strategy

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Other Important DisclosuresJefferies does and seeks to do business with companies covered in its research reports. As a result, investors should be aware that Jefferies may have aconflict of interest that could affect the objectivity of this report. Investors should consider this report as only a single factor in making their investmentdecision.Jefferies Equity Research refers to research reports produced by analysts employed by one of the following Jefferies Group LLC (“Jefferies”) groupcompanies:United States: Jefferies LLC which is an SEC registered firm and a member of FINRA.United Kingdom: Jefferies International Limited, which is authorized and regulated by the Financial Conduct Authority; registered in England andWales No. 1978621; registered office: Vintners Place, 68 Upper Thames Street, London EC4V 3BJ; telephone +44 (0)20 7029 8000; facsimile +44 (0)207029 8010.Hong Kong: Jefferies Hong Kong Limited, which is licensed by the Securities and Futures Commission of Hong Kong with CE number ATS546; locatedat Suite 2201, 22nd Floor, Cheung Kong Center, 2 Queen’s Road Central, Hong Kong.Singapore: Jefferies Singapore Limited, which is licensed by the Monetary Authority of Singapore; located at 80 Raffles Place #15-20, UOB Plaza 2,Singapore 048624, telephone: +65 6551 3950.Japan: Jefferies (Japan) Limited, Tokyo Branch, which is a securities company registered by the Financial Services Agency of Japan and is a memberof the Japan Securities Dealers Association; located at Hibiya Marine Bldg, 3F, 1-5-1 Yuraku-cho, Chiyoda-ku, Tokyo 100-0006; telephone +813 52516100; facsimile +813 5251 6101.India: Jefferies India Private Limited (CIN - U74140MH2007PTC200509), which is licensed by the Securities and Exchange Board of India as a MerchantBanker (INM000011443), Research Analyst (INH000000701) and a Stock Broker with Bombay Stock Exchange Limited (INB011491033) and NationalStock Exchange of India Limited (INB231491037) in the Capital Market Segment; located at 42/43, 2 North Avenue, Maker Maxity, Bandra-KurlaComplex, Bandra (East) Mumbai 400 051, India; Tel +91 22 4356 6000.This material has been prepared by Jefferies employing appropriate expertise, and in the belief that it is fair and not misleading. The information setforth herein was obtained from sources believed to be reliable, but has not been independently verified by Jefferies. Therefore, except for any obligationunder applicable rules we do not guarantee its accuracy. Additional and supporting information is available upon request. Unless prohibited by theprovisions of Regulation S of the U.S. Securities Act of 1933, this material is distributed in the United States ("US"), by Jefferies LLC, a US-registeredbroker-dealer, which accepts responsibility for its contents in accordance with the provisions of Rule 15a-6, under the US Securities Exchange Act of1934. Transactions by or on behalf of any US person may only be effected through Jefferies LLC. In the United Kingdom and European EconomicArea this report is issued and/or approved for distribution by Jefferies International Limited and is intended for use only by persons who have, or havebeen assessed as having, suitable professional experience and expertise, or by persons to whom it can be otherwise lawfully distributed. JefferiesInternational Limited Equity Research personnel are separated from other business groups and are not under their supervision or control. JefferiesInternational Limited has implemented policies to (i) address conflicts of interest related to the preparation, content and distribution of research reports,public appearances, and interactions between research analysts and those outside of the research department; (ii) ensure that research analysts areinsulated from the review, pressure, or oversight by persons engaged in investment banking services activities or other persons who might be biased intheir judgment or supervision; and (iii) promote objective and reliable research that reflects the truly held opinions of research analysts and prevents theuse of research reports or research analysts to manipulate or condition the market or improperly favor the interests of the Jefferies International Limitedor a current or prospective customer or class of customers. Jefferies International Limited may allow its analysts to undertake private consultancywork. Jefferies International Limited’s conflicts management policy sets out the arrangements Jefferies International Limited employs to manage anypotential conflicts of interest that may arise as a result of such consultancy work. Jefferies International Ltd, its affiliates or subsidiaries, may make amarket or provide liquidity in the financial instruments referred to in this investment recommendation. For Canadian investors, this material is intendedfor use only by professional or institutional investors. None of the investments or investment services mentioned or described herein is available toother persons or to anyone in Canada who is not a "Designated Institution" as defined by the Securities Act (Ontario). In Singapore, Jefferies SingaporeLimited is regulated by the Monetary Authority of Singapore. For investors in the Republic of Singapore, this material is provided by Jefferies SingaporeLimited pursuant to Regulation 32C of the Financial Advisers Regulations. The material contained in this document is intended solely for accredited,expert or institutional investors, as defined under the Securities and Futures Act (Cap. 289 of Singapore). If there are any matters arising from, orin connection with this material, please contact Jefferies Singapore Limited, located at 80 Raffles Place #15-20, UOB Plaza 2, Singapore 048624,telephone: +65 6551 3950. In Japan this material is issued and distributed by Jefferies (Japan) Limited to institutional investors only. In Hong Kong,this report is issued and approved by Jefferies Hong Kong Limited and is intended for use only by professional investors as defined in the Hong KongSecurities and Futures Ordinance and its subsidiary legislation. In the Republic of China (Taiwan), this report should not be distributed. The researchin relation to this report is conducted outside the PRC. This report does not constitute an offer to sell or the solicitation of an offer to buy any securitiesin the PRC. PRC investors shall have the relevant qualifications to invest in such securities and shall be responsible for obtaining all relevant approvals,licenses, verifications and/or registrations from the relevant governmental authorities themselves. In India this report is made available by JefferiesIndia Private Limited. In Australia this information is issued solely by Jefferies International Limited and is directed solely at wholesale clients withinthe meaning of the Corporations Act 2001 of Australia (the "Act") in connection with their consideration of any investment or investment servicethat is the subject of this document. Any offer or issue that is the subject of this document does not require, and this document is not, a disclosuredocument or product disclosure statement within the meaning of the Act. Jefferies International Limited is authorised and regulated by the FinancialConduct Authority under the laws of the United Kingdom, which differ from Australian laws. Jefferies International Limited has obtained relief underAustralian Securities and Investments Commission Class Order 03/1099, which conditionally exempts it from holding an Australian financial serviceslicence under the Act in respect of the provision of certain financial services to wholesale clients. Recipients of this document in any other jurisdictionsshould inform themselves about and observe any applicable legal requirements in relation to the receipt of this document.

This report is not an offer or solicitation of an offer to buy or sell any security or derivative instrument, or to make any investment. Any opinion orestimate constitutes the preparer's best judgment as of the date of preparation, and is subject to change without notice. Jefferies assumes no obligationto maintain or update this report based on subsequent information and events. Jefferies, its associates or affiliates, and its respective officers, directors,and employees may have long or short positions in, or may buy or sell any of the securities, derivative instruments or other investments mentioned ordescribed herein, either as agent or as principal for their own account. Upon request Jefferies may provide specialized research products or servicesto certain customers focusing on the prospects for individual covered stocks as compared to other covered stocks over varying time horizons orunder differing market conditions. While the views expressed in these situations may not always be directionally consistent with the long-term views

Equity Strategy

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expressed in the analyst's published research, the analyst has a reasonable basis and any inconsistencies can be reasonably explained. This materialdoes not constitute a personal recommendation or take into account the particular investment objectives, financial situations, or needs of individualclients. Clients should consider whether any advice or recommendation in this report is suitable for their particular circumstances and, if appropriate,seek professional advice, including tax advice. The price and value of the investments referred to herein and the income from them may fluctuate. Pastperformance is not a guide to future performance, future returns are not guaranteed, and a loss of original capital may occur. Fluctuations in exchangerates could have adverse effects on the value or price of, or income derived from, certain investments. This report has been prepared independently ofany issuer of securities mentioned herein and not in connection with any proposed offering of securities or as agent of any issuer of securities. Noneof Jefferies, any of its affiliates or its research analysts has any authority whatsoever to make any representations or warranty on behalf of the issuer(s).Jefferies policy prohibits research personnel from disclosing a recommendation, investment rating, or investment thesis for review by an issuer priorto the publication of a research report containing such rating, recommendation or investment thesis. Any comments or statements made herein arethose of the author(s) and may differ from the views of Jefferies.

This report may contain information obtained from third parties, including ratings from credit ratings agencies such as Standard & Poor’s. Reproductionand distribution of third party content in any form is prohibited except with the prior written permission of the related third party. Third party contentproviders do not guarantee the accuracy, completeness, timeliness or availability of any information, including ratings, and are not responsible forany errors or omissions (negligent or otherwise), regardless of the cause, or for the results obtained from the use of such content. Third party contentproviders give no express or implied warranties, including, but not limited to, any warranties of merchantability or fitness for a particular purpose oruse. Third party content providers shall not be liable for any direct, indirect, incidental, exemplary, compensatory, punitive, special or consequentialdamages, costs, expenses, legal fees, or losses (including lost income or profits and opportunity costs) in connection with any use of their content,including ratings. Credit ratings are statements of opinions and are not statements of fact or recommendations to purchase, hold or sell securities. Theydo not address the suitability of securities or the suitability of securities for investment purposes, and should not be relied on as investment advice.

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For Important Disclosure information, please visit our website at https://javatar.bluematrix.com/sellside/Disclosures.action or call 1.888.JEFFERIES

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Equity Strategy

March 9, 2017



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