Technology

Special Report

Highlights The renaming of telecommunication services and reallocation of some tech and consumer discretionary stocks ends a long run of a purely domestic, defensive GICS1 sector. Our initial recommendation is underweight for the newly minted S&P communication services sector. Interactive media & services, formerly (mostly) internet software & services, is moving from tech to communication services where it promises to be the core revenue and profit driver of the sector. However, regulatory risk, a rapid pace of change with extremely low switching costs and currency exposure in a very international sector keep us on the fence. We are initiating coverage on the S&P interactive media & services index with a neutral recommendation. Feature Several Indexes Have Found New Homes At the market's close last Friday, investors welcomed a new (rather, a renamed) GICS1 sector to the industry taxonomy: the S&P communication services sector (Table 1). The change had long been overdue as the progenitor sector, telecommunication services, had been hollowed down to three companies and represented approximately 2% of the S&P 500. Further, finding homes for various new media and technology companies had left a hodgepodge of consumer discretionary and information technology subsectors that bore little resemblance to their respective peers. In short, we welcome the new taxonomy. Table 1Classification Changes However, this change brings a good deal of uncertainty with it. The most recent GICS1 change was the reallocation of real estate (mostly REITs) from a financials sub-index to their own GICS1 classification; this change involved a relatively simple carve-out. The creation of communication services includes carve-outs as well as stock-by-stock changes for a brand new index with a core sub-index, interactive media & services, that we initiate coverage on later in this report. Importantly, the reshuffling dilutes an up-to-recently pure-play safe haven index. Previously, telecommunications services was an ultra-low beta, high-dividend yielding, zero currency-exposed prototypical defensive index. Communication services will be dominated by relatively high beta, low dividend yielding and heavily international stocks. In more detail, it morphs into a roughly 45% deep cyclical, 37.5% early cyclical and 17.5% defensive index. MSCI has proposed classifying communication services as cyclical, with no new defensive offset, meaning the market has lost a GICS1 defensive sector. Further, we estimate roughly 20% of the communication services index is value-oriented, a fairly drastic change from the 100% value-oriented former telecommunication services index. Now approximately 60% will be growth-oriented and the balance a blend of the two. One would presume that adding many new stocks to the sector would alleviate telecommunication services' lack of breadth (two companies split 95% of the market cap weight roughly evenly). However, the sheer dominance of Alphabet and Facebook, which will combine to represent approximately 40% of the S&P communication services sector, means that the absence of breadth is being replaced with less absence of breadth (Chart 1). Chart 1Before... And After Further impacting the cyclicality of the new index is the source of revenues. Telecommunication services revenues are relatively inelastic as the service they provide is very much a consumer staple. Communication services in general and interactive media & services in particular have much more volatile revenue profiles, relying heavily on ad sales (Facebook & Google) or consumer discretionary spending (Netflix & Disney). We have not covered the index that includes Facebook and Alphabet, so we have been de facto at a benchmark allocation. As detailed in the following section, we are not changing that recommendation with our initiation of coverage. Our telecom services recommendation remains underweight (though obviously now a subsector within communication services). Our recommendations on the other material industries moving into communication services (movies & entertainment and cable & satellite, collectively the media indexes) are similarly remaining unchanged at a benchmark allocation. Bottom Line: The net result is that we are negatively biased on the new S&P communication services sector and our initial recommendation is underweight. For investors seeking tech exposure we continue to recommend the S&P software and S&P tech hardware, storage & peripherals tech sub-indexes that are high-conviction overweights. Please see the housekeeping section at the end of this report for more details. Interactive Media & Services - Breaking Out? The new interactive media & services index broadly matches the former internet software & services index (that used to be a subsector of the information technology GICS1 sector), but with a twist. Facebook & Alphabet comprised more than 90% of the old index and will command a similar share of the new. However, eBay has found a new home alongside Amazon in the consumer discretionary index, swapping places with TripAdvisor. Meanwhile, Akamai and Verisign are moving to a new index, internet services & infrastructure. Still, the vast majority of the index was, and remains, weighted to two companies. Accordingly, and in the absence of new forward looking data, we will be basing much of our analysis on the old internet software & services index and extrapolating it to the new interactive media & services. It comes as no shock to market observers that the internet services & software index has been gaining share of the S&P 500 as its component stocks have been roaring ahead. In fact, the streak of outperformance has been uninterrupted from the beginning of 2017 until very recently (Chart 2). The usual conclusion is that this is the result of a dramatic surge in valuation. While it is true that the internet services & software index trades at a hefty valuation multiple from an absolute perspective, the valuation has in fact declined relative to the broad market since the beginning of 2017 (Chart 3). Underlying the meteoric rise in market share of the internet software & services stocks without a corresponding relative valuation increase has been a step higher in relative earnings. As shown in Chart 4, earnings growth in this index has vaulted higher in the past five years, dramatically outpacing the growth in the share price for most of the past three years. Chart 2Rising Prices Amidst... Chart 3... Falling Valuations Chart 4EPS Growth Has Outpaced Price A key differentiator between this index and virtually every other index we cover is the source of revenues and earnings, namely advertising. Despite years of acquisitions and organic R&D building non-advertising businesses, last year saw 86% of Alphabet's revenues derived from advertising. The number is even larger at Facebook, where nearly all of its revenues are generated through selling advertising placements. This revenue quite obviously comes with a high margin and extremely high operating leverage. As such, the past decade of economic expansion has been excellent for the index. In fact, Facebook's entire history as a public company has been in the midst of a bull market. The elevated degree of cyclicality of internet software & services profits largely explains the earnings outperformance in the expansion to date, though clearly presents a risk to relative profitability when the cycle turns. Profit Growth Has A Long Runway... Consumer confidence, which is still pushing up against multi-decade highs, combined with online's growing share of advertising dollars, will continue to drive revenue growth of interactive media & services well ahead of the broad market. Such historically high consumer confidence is supported by generationally low unemployment (Charts 5 and 6). In other words, as long as everyone who wants a job has a job, interactive media & services revenues are relatively secure. Chart 5Ad Revenues Are Solid... Chart 6... When Jobs Are Plenty A rebuttal to that bullish thesis that has grown more common since Facebook issued downbeat guidance in July that subsequently knocked more than $130 billion of market cap off the stock (it has since fallen even further) is that growth is decelerating and margins are tightening considerably. Google too has been downplaying cresting EPS growth rates. We counter with the argument we postulated in our mid-summer analysis of the impact of regulatory reform on the technology sector that negativity coming from management at these firms may be sandbagging to defray some of the elevated regulatory scrutiny into their outrageous profitability.1 Further, the sell side does not appear to believe the guidance; current estimates for revenue growth at Facebook & Google for the next three years are a 20% and 17% compounded annual growth rate (CAGR), respectively, or three times as high as the broad market. Nevertheless, even the always-optimistic sell side is calling for EPS growth rates that trail revenue growth, implying the message of declining profitability is hitting home; Facebook and Google have three-year EPS CAGRs of 16% and 12%, respectively. Under the watchful eye of regulators across the world, both firms are investing heavily in safety & security that each has flagged as a significant headwind to margins. While these growth rates are a far cry from earlier profitability, they broadly match the current S&P 500 long-term EPS growth rate of 16%. ...But Three Key Risks Keep Us On The Fence The declining profitability of the sector brings us to the first of three key risks that prevent us from turning positive on interactive media & services: regulation. In the previously noted analysis of regulatory reform on the tech sector,2 our colleagues in BCA's Geopolitical Strategy service noted that both concentration and privacy concerns should present significant sources of apprehension for investors. We would certainly agree. The stock market reaction to regulation (or regulatory action in the form of fines) has thus far been muted, but that does not put us completely at ease. We are conscious that an antitrust breakup of Google or a privacy/data sharing/first amendment issue action against Facebook or Twitter could be potentially business model-breaking. Accordingly, we weigh this against the index's spectacular profitability. With respect to our second key risk, we are reminded of a quote from Donald Rumsfeld in 2002: "there are things we know we know. We also know there are known unknowns; that is to say we know there are some things we do not know. But there are also unknown unknowns -- the ones we don't know we don't know". At BCA, we are neither technologists nor trend experts. Accordingly, there is a great deal of potential changes in consumer tastes or technology that we are unaware of that could deliver the same fate to Facebook and/or Google as the fallen tech giants of the past. In an environment where switching costs appear to be close to nil, this is particularly risky. This could come about either from within Silicon Valley where Schumpeter's creative destruction process is alive and well (keep in mind Google did not exist prior to 1998 and Facebook was born in 2004), or even from China that apparently has jumped ahead of the U.S. in terms of AI capabilities. Some early signs are worrying. A survey from the Pew Research Center last month said that 26% of respondents had deleted the Facebook app from their phone in the past year.3 While the core Facebook application is just one of several of the company's properties, recent news that the founders of Instagram, Facebook's second largest social media network, were exiting amidst internal turmoil reinforces our fears. We are unable to put our finger on how social media tastes or the technology used to consume content will change, but we are confident that any change will be both rapid and unpredictable. Chart 7U.S. Dollar Risk Our third risk is also the biggest: the U.S. dollar. One of BCA's key views for the next year is the appreciation of the U.S. dollar; we have been flagging this as the key source of risk to our otherwise sanguine view on the broad U.S. equity market in general and the heavily international tech sector (the early-cyclical semi and semi equipment sectors are the most exposed and we are underweight both4) in particular. Overseas sales for Facebook and Google represented 51% and 53% of overall sales, respectively, in 2017 and both companies have indicated growth outside North America will outpace domestic sales. Google's recent rumored foray into China is not only encouraging more government scrutiny of the search giant, but it would also exacerbate the EPS sensitivity to forex fluctuations. As long as the U.S. dollar is appreciating, the translation of foreign sales and profits to the home currency will further dampen EPS growth (Chart 7). In the context of the elevated valuations these companies share, combined with the empirical reactions when earnings or guidance have disappointed in the past, any headwinds to growth may drive a valuation derating. Bottom Line: Innovation and supportive macro trends are likely to keep driving profit growth in interactive media & services that, though slower than in the past, still outpaces the broad market. However, three key risks keep us on the sidelines: a renewed regulatory focus, rapid unpredictable changes in tastes & technology and an appreciating U.S. dollar that threatens to sap growth in the key foreign segments. We are initiating coverage with a neutral rating. The tickers in this index are BLBG: S5INMS - GOOG, GOOGL, FB, TWTR, TRIP. Housekeeping Items With the exception of the new neutral recommendation on interactive media & services, we are not changing any recommendations on any other sector with this report. However, in accordance with the GICS changes, we are shifting a number of sectors today. First, we are renaming telecommunication services to communication services; telecom services remains an underweight subsector under the new banner. We are moving four indexes from consumer discretionary to communication services: advertising (overweight), cable & satellite (neutral), movies & entertainment (neutral) and publishing (neutral). Though the new sector has one overweight subsector (advertising) and one underweight subsector (telecom services), the much greater weight of the latter subsector biases our recommendation on the communication services sector to underweight. Within consumer discretionary, our recommendation prior to this change was underweight. As we are moving only neutral- and overweight-recommended subsectors out of the larger index, our underweight recommendation for consumer discretionary is unchanged (modestly more negative, especially if we consider our recent intra-housing market sub sector swap5). Chris Bowes, Associate Editor chrisb@bcaresearch.com 1 Please see BCA U.S. Equity Strategy Special Report, "Is The Stock Rally Long In The FAANG?" dated August 1, 2018, available at uses.bcaresearch.com. 2 Ibid. 3 Pew Research Center http://www.pewresearch.org/fact-tank/2018/09/05/americans-are-changing-their-relationship-with-facebook/ 4 Please see BCA U.S. Equity Strategy Weekly Report, "Party Like It's 2004!" dated September 17, 2018, available at uses.bcaresearch.com. 5 Please see BCA U.S. Equity Strategy Weekly Report, "Indurated," dated September 24, 2018, available at uses.bcaresearch.com. Current Recommendations

Underweight In yesterday's Daily Insight, we highlighted our neutral barbell portfolio in tech, staying overweight secular growth defensive tech sub-sectors (namely S&P software and S&P tech hardware, storage & peripherals, both of which are high-conviction overweights) and underweight the hyper-cyclical chip and chip equipment stocks. With respect to the latter, we think the macro environment has deteriorated. Three factors underpin our negative view on semi equipment's growth prospects and there is no light at the end of the tunnel yet. Bitcoin's (and other cryptocurrencies) collapse is dealing a blow, at the margin, to demand for semi equipment (second panel). Taiwan's financials statement-reported data on IT capex and national data on overall Taiwanese capital outlays corroborates this downbeat demand backdrop (third panel). Finally, the drubbing in EM currencies is sapping purchasing power from the consumer and also warns that things will get worse for U.S. semi equipment stocks before they get better (bottom panel). Bottom Line: Continue to avoid the S&P semis and S&P semi equipment indexes; see Monday's Weekly Report for more details. The ticker symbols for the stocks in these indexes are: BLBG: S5SECO - INTC, NVDA, QCOM, TXN, AVGO, MU, ADI, AMD, MCHP, XLNX, SWKS, QRVO, and BLBG: S5SEEQ - AMAT, LRCX, KLAC, respectively.

  Neutral The stratospheric rise of tech profits, particularly in the past two years, have done most of the heavy lifting in pulling the S&P 500's profit margin ever higher, pushing the index itself to new all-time highs last month. The implication is that in order for the broad market to suffer a severe blow, tech has to take a hit, and vice versa. On the EPS front, our profit growth model has recently ticked higher from an already extended level, signaling that the profit outlook remains bright (second panel). The news on the operating front is equally encouraging. The San Francisco Fed's tech pulse index - an index of coincident indicators of technology sector activity - is reaccelerating (third panel). Such positivity is offset by the acknowledgment of three material risks. First, the tech sector garners 60% of its revenues from abroad and thus the appreciating U.S. dollar is a significant profit headwind (bottom panel). Second, a rising U.S. inflation backdrop along with the related looming selloff in the bond market should knock the wind out of the tech sector's sails. Third, leading indicators of emerging Asian demand are souring rapidly and were the trade war to re-escalate, EM economic data would retrench further. Bottom Line: We prefer to remain on the sidelines in the S&P information technology sector and sustain a barbell portfolio within the sector. Please see this week's Weekly Report for more details.    

Highlights Portfolio Strategy Stick with a neutral weighting in the tech sector as rising interest rates, higher inflation and a firming greenback offset improving industry operating metrics on the back of the virtuous capex upcycle. Chip and chip equipment stocks will remain under pressure as global semi sales are under attack and leading indicators of semi demand suggest that more pain lies ahead at a time when chip selling prices are steeply decelerating. Recent Changes There are no changes to our portfolio this week. Table 1 Feature Equities regained their footing last week and remain perched near all-time highs. Investors are largely ignoring the trade-related uncertainty and are instead focusing on the upbeat economic backdrop. Both soft and hard data continue to send an unambiguously healthy signal for the U.S. economy, a potent tonic for corporate profitability. Chart 1EPS Will Do All The Heavy Lifting While a lot of parallels have been drawn between today and the late-1990s, our sense is that the current financial market and economic outlooks resemble more the mid-2000s. Chart 1 shows that, between 2004 and the stock market peak in late-October 2007, forward profit growth estimates peaked at over 20%/annum and the forward multiple drifted steadily lower. Nevertheless, stocks remained well bid and rose alongside forward EPS (top and third panels, Chart 1). In other words, despite decelerating forward profit growth estimates and a contracting forward multiple, expanding forward EPS did the heavy lifting, explaining all of the advance in the SPX. The similarities to today are eerie: while profit growth peaked in Q1/2018, 10% EPS growth is elevated for the tenth year of an expansion, and the forward multiple is coming in (Chart 1). On the policy front, the Bush tax cuts hit in the mid-2000s with the elimination of the double taxation of dividends and a drop in personal income tax rates, along with a one-time cash repatriation of corporate profits stashed abroad. With regard to the economic backdrop, capex was roaring and nominal GDP was firing on all cylinders as a housing bubble was getting inflated. The GDP deflator also hit a high mark. The ISM manufacturing survey eclipsed 61 in 2004 and non-farm payrolls were expanding smartly (Chart 2). But despite all that apparent overheating especially in the housing market, the real fed funds rate was near zero in 2004 (top panel, Chart 3). Finally, a number of financial market metrics were also similar to today. Oil prices were on their way to triple digits, high yield spreads were below 400bps and the VIX probed, at the time, all-time lows (Chart 3). However, one key difference between the mid-2000s and today is the strengthening U.S. dollar. The firming greenback remains a key risk to our positive equity market view (bottom panel, Chart 3), as it will eventually infiltrate EPS. Netting it all out, if history at least rhymes, an earnings-led advance in the SPX is the most likely outcome. Our sanguine cyclical (9-12 month) equity market view remains predicated on a 10%/annum increase in EPS and a sideways-to-lower move in the forward multiple. Meanwhile, wage inflation is slowly starting to rear its ugly head. In fact, we are surprised by the fits and starts in average hourly earnings growth. At this stage of the cycle, wage growth should start galloping higher as executives aggressively bid up the price of labor in order to fill job openings and bring expansion plans to fruition. A simple wage growth indicator comprising resource utilization and the unemployment gap suggests that wage inflation will really kick into higher gear in the coming 12 months (shown as a Z-score, Chart 4). Chart 2Eerie... Chart 3...Parallels With 2004 Chart 4Mind The Return Of Inflation Two weeks ago we highlighted that the S&P 500's profit margins are benefiting from lower corporate taxes and muted wage growth, a goldilocks backdrop. Despite evidence of a pending inflationary impulse, as long as businesses are successful in passing rising input costs down the supply chain and onto the consumer, then margins and EPS will continue to expand. Nevertheless, deconstructing the SPX's all-time high profit margins is in order. Chart 5 & Chart 6 show the 11 GICS1 sector profit margin time series using Standard & Poor's data, and Chart 7 is a snapshot of Q2/2018 profit margins for the 11 sectors and the broad market. Chart 5Sectorial Profit ... Chart 6...Margin Breakdown Chart 7Tech Is A Clear Outlier Five sectors (tech, industrials, materials, consumer discretionary and utilities) are enjoying record-high profit margins, and four (financials, consumer staples, telecom services and real estate) are on the verge of joining that club. This leaves two sectors with declining margin profiles: health care and energy. While most sectors are +/- five percentage points away from the S&P 500, the tech sector sports profit margins at twice the level of the SPX or eleven percentage points higher and is the clear outlier (Chart 7). The implication is that the broad market's EPS fortunes are closely tied to the high-flying tech sector that commands a 26% market cap weight. Thus, this week we are compelled to highlight the deep cyclical tech sector, and two of its hyper-sensitive and foreign exposed subcomponents. Tech On Steroids In late-August we published a chart on tech margins (which we are reprinting today) showing the upward force they have exerted on the broad equity market for the better part of the past decade (top panel, Chart 8). Naturally, stratospheric profits must underpin these parabolic margins. The middle panel of Chart 8 highlights that since 2006 tech EPS have almost quadrupled, pulling SPX profits higher. As a reminder, the S&P tech sector commands a 24% profit weight in the S&P 500, the highest since the history of this data series and almost double the weight during the previous cycle's peak (bottom panel, Chart 8). The implication is that in order for the broad market to suffer a severe blow, tech has to take a hit, and vice versa. Chart 8Secular Tech EPS Growth Has Boosted Margins Chart 9EPS Growth Model Flashing Green On the EPS front, our profit growth model has recently ticked higher from an already extended level, signaling that the profit outlook remains bright (Chart 9). The virtuous capex upcycle - BCA's key theme for the year - remains the key driver behind our EPS model. Chart 10 shows that the tech sector continues to make inroads in the overall capex pie, according to financial statement-reported data, and has now doubled its share since the GFC trough to roughly 12%. National accounts corroborate this data and underscore that pent up demand is getting unleashed, following a near 15-year hibernation period (bottom panel, Chart 10). The news on the operating front is equally encouraging. The San Francisco Fed's tech pulse index - an index of coincident indicators of technology sector activity1 - is reaccelerating. Tech new orders-to-inventories are also picking up steam and suggest that sell side analysts have set the relative EPS bar too low (Chart 11). Finally, the latest PCE report revealed that consumer outlays on tech goods are also gaining momentum, even relative to overall consumer spending. While this upbeat backdrop would point to an above benchmark tech allocation, three risks keep us at bay. First, the tech sector garners 60% of its revenues from abroad and thus the appreciating U.S. dollar is a significant profit headwind, especially for 2019 when the delayed negative FX translation effects will most likely emerge (third panel, Chart 12). Chart 10Capex On The Upswing... Chart 11...Underpinning Tech Operating Metrics... Chart 12...But Three Risks Keep Us At Bay Second, a rising U.S. inflation backdrop along with the related looming selloff in the bond market should knock the wind out of the tech sector's sails. Tech business models are built to withstand deflation and thrive in a disinflationary environment. Thus, when inflation re-emerges, tech stocks suffer (CPI and 10-year UST yield shown inverted, top two panels, Chart 12). Third, leading indicators of emerging Asian demand are souring rapidly and were the trade war to re-escalate, EM in general and tech-laden Korean and Taiwanese economic data in particular would retrench further (bottom panel, Chart 12). Bottom Line: We prefer to remain on the sidelines in the S&P information technology sector and sustain a barbell portfolio within the sector. As a reminder we continue to express our bullishness via two high-conviction overweight defensive tech sub-sectors, S&P software and S&P tech hardware, storage & peripherals (THSP), and our bearishness via avoiding their early cyclical peers, S&P semis and S&P semi equipment. Avoid Chip Stocks At All Costs While we are neutral the broad tech sector and prefer secular growth defensive tech sub-sectors, we continue to recommend shying away from chip and chip equipment stocks. Chart 13 shows the extreme sensitivity to changes in final demand of chip related stocks versus their defensive tech peers. In more detail, software and THSP indexes are in a secular advance with regard to EPS outperformance, whereas semis and semi equipment profits are hyper-cyclical with mean-reverting relative profit profiles. Granted, the commoditization of semiconductors explains this close correlation with the business cycle. But, as we highlighted last November when we put the semi equipment index on the high-conviction underweight list, extrapolating EPS growth euphoria far into the future was fraught with danger.2 In fact, late-November 2017 marked the peak in semi equipment performance versus the overall IT sector, confirming the early cyclical nature of chip stocks (Chart 14). Chart 13Bifurcated EPS Chart 14Good Times... Three factors have weighed heavily on this industry's growth prospects and there is no light at the end of the tunnel yet. Bitcoin's (and other cryptocurrencies) collapse is dealing a blow, at the margin, to demand for semi equipment (top panel, Chart 15). Taiwan's financials statement-reported data on IT capex and national data on overall Taiwanese capital outlays corroborates this downbeat demand backdrop (Chart 16). Finally, the drubbing in EM currencies is sapping purchasing power from the consumer and also warns that things will get worse for U.S. semi equipment stocks before they get better (bottom panel, Chart 15). Chart 15...Do Not Last Forever Chart 16Semi-Heavy Taiwan Emits A Grim Signal The outlook for their brethren, semi producers, is equally downtrodden. Global semi sales have crested and leading indicators of future semi revenue growth are sending a warning signal. Chinese imports of electronics have come to an abrupt halt, and the U.S. dollar's appreciation is also waving a red flag (second & bottom panels, Chart 17). BCA's calculated global leading economic indicator excluding the U.S. and BCA's calculated global ZEW Indicator of Economic Sentiment excluding the U.S. both herald a steep deceleration in global semi sales (Chart 17). On the pricing power front, using Asian DRAM prices as an industry pricing power gauge, DRAM momentum is on a trajectory to contract some time in Q1/2019. The implication is that semi earnings will surprise to the downside. Still expanding global chip inventories are not providing an offset and also confirm that semi EPS optimism is unwarranted (middle & bottom panels, Chart 18). Finally, another source of demand for chip stocks has reversed, as industry M&A activity has plummeted toward decade lows. Not only is this negative for pricing power, but inflated premia are also now working in reverse especially given this year's QCOM/NXPI and AVGO/QCOM flops (top panel, Chart 18). Our Chip Stock Timing Model (CSTM) does an excellent job encapsulating all these moving parts and is currently in the sell zone (bottom panel, Chart 19). Chart 17Global Semi Sales Trouble... Chart 18...Abound Chart 19Chip Stock Timing Model Says Sell Bottom Line: Continue to avoid the S&P semis and S&P semi equipment indexes. The ticker symbols for the stocks in these indexes are: BLBG: S5SECO - INTC, NVDA, QCOM, TXN, AVGO, MU, ADI, AMD, MCHP, XLNX, SWKS, QRVO, and BLBG: S5SEEQ - AMAT, LRCX, KLAC, respectively. Anastasios Avgeriou, Vice President U.S. Equity Strategy anastasios@bcaresearch.com 1 https://www.frbsf.org/economic-research/indicators-data/tech-pulse/ 2 Please see BCA U.S. Equity Strategy Weekly Report, "2018 High-Conviction Calls," dated November 27, 2017, available at uses.bcaresearch.com. Current Recommendations Current Trades Size And Style Views Favor value over growth Favor large over small caps

Special Report

Following up from our inaugural U.S. Equity Market Indicators Report in early-August 2017, this week we introduce the second part in our Indicators series. In this Special Report we have drilled down to the ten GICS1 S&P 500 sectors (excluding the real estate sector) and have compiled the most important Indicators in four broad categories: earnings, financial statement reported, valuations and technicals. Once again this is by no means exhaustive, but contains a plethora of Indicators - roughly thirty Indicators per sector condensed in seven charts per sector - we deem significant in aiding us in our decision making process of setting/changing a view on a certain sector. The way we have structured this Special Report is by sector and we start with the early cyclicals continue with the deep cyclicals and finish with the defensives. Within each sector we then show the four broad categories. In more detail, the first three charts depict earnings Indicators including our EPS growth model, EPS breadth, profit margins, relative forward EPS and EBITDA growth forecasts and ROE and its deconstruction into its components. The following two charts relate to financial statement Indicators including indebtedness, cash flow growth and capital expenditures. And conclude with one valuation and one technical chart. As a reminder, the charts in this Special Report are also made available through BCA's Analytics platform for seamless continual updates. Due to length constraints, Part III of our Indicators series, expected in mid-October, will introduce a style and size flavor along with cyclicals versus defensives and end with the S&P 500, again highlighting Indicators in these four broad categories. Finally, likely before the end of 2018, we aim to conclude our Indicators series with Part IV that would feature our most sought after Macro Indicators per the ten GICS1 S&P 500 sectors, along with value/growth, small/large and cyclicals/defensives. We trust you will find this comprehensive Indicator chartbook useful and insightful. Anastasios Avgeriou, Vice President U.S. Equity Strategy anastasios@bcaresearch.com Dulce Cruz, Senior Analyst dulce@bcaresearch.com Consumer Discretionary Chart 1Consumer Discretionary: Earnings Indicators Chart 2Consumer Discretionary: Earnings Indicators Chart 3Consumer Discretionary: ROE And Its Components Chart 4Consumer Discretionary: Financial Statement Indicators Chart 5Consumer Discretionary: Financial Statement Indicators Chart 6Consumer Discretionary: Valuation Indicators Chart 7Consumer Discretionary: Technical Indicators Financials Chart 8Financials: Earnings Indicators Chart 9Financials: Earnings Indicators Chart 10Financials: ROE And Its Components Chart 11Financials: Financial Statement Indicators Chart 12Financials: Financial Statement Indicators Chart 13Financials: Valuation Indicators Chart 14Financials: Technical Indicators Energy Chart 15Energy: Earnings Indicators Chart 16Energy: Earnings Indicators Chart 17Energy: ROE And Its Components Chart 18Energy: Financial Statement Indicators Chart 19Energy: Financial Statement Indicators Chart 20Energy: Valuation Indicators Chart 21Energy: Technical Indicators Industrials Chart 22Industrials: Earnings Indicators Chart 23Industrials: Earnings Indicators Chart 24Industrials: ROE And Its Components Chart 25Industrials: Financial Statement Indicators Chart 26Industrials: Financial Statement Indicators Chart 27S&P Industrials: Valuation Indicators Chart 28S&P Industrials: Technical Indicators Materials Chart 29Materials: Earnings Indicators Chart 30Materials: Earnings Indicators Chart 31Materials: ROE And Its Components Chart 32Materials: Financial Statement Indicators Chart 33Materials: Financial Statement Indicators Chart 34Materials: Valuation Indicators Chart 35Materials: Technical Indicators Tech Chart 36Technology: Earnings Indicators Chart 37Technology: Earnings Indicators Chart 38ROE And Its Components Chart 39Technology: Financial Statement Indicators Chart 40Technology: Financial Statement Indicators Chart 41Technology: Valuation Indicators Chart 42Technology: Technical Indicators Health Care Chart 43Health Care: Earnings Indicators Chart 44Health Care: Earnings Indicators Chart 45Health Care: ROE And Its Components Chart 46Health Care: Financial Statement Indicators Chart 47Health Care: Financial Statement Indicators Chart 48Health Care: Valuation Indicators Chart 49Health Care: Technical Indicators Consumer Staples Chart 50Consumer Staples: Earnings Indicators Chart 51Consumer Staples: Earnings Indicators Chart 52Consumer Staples: ROE And Its Components Chart 53Consumer Staples: Financial Statement Indicators Chart 54Consumer Staples: Financial Statement Indicators Chart 55Consumer Staples: Valuation Indicators Chart 56Consumer Staples: Technical Indicators Telecom Services Chart 57Telecom Services: Earnings Indicators Chart 58Telecom Services: Earnings Indicators Chart 59Telecom Services: ROE And Its Components Chart 60Telecom Services: Financial Statement Indicators Chart 61Telecom Services: Financial Statement Indicators Chart 62Telecom Services: Valuation Indicators Chart 63Telecom Services: Technical Indicators Utilities Chart 64Utilities: Earnings Indicators Chart 65Utilities: Earnings Indicators Chart 66Utilities: ROE And Its Components Chart 67Utilities: Financial Statement Indicators Chart 68Utilities: Financial Statement Indicators Chart 69Utilities: Valuation Indicator Chart 70Utilities: Technical Indicator

The S&P communications equipment index received a substantial leg up in the past month as the quarterly results issued by index giant Cisco proved more resilient than anticipated and growth surpassed analyst expectations. However, on the earnings call management noted that pricing power continued to erode in the quarter and margins were under pressure from rising input costs. This is corroborated by the macro data we track which shows that communications equipment pricing power remains stubbornly in decline; the recent collapse in Asian currencies points to more of the same. Further, the industry wage bill is rapidly moving in the opposite direction of pricing power, pointing to a margin squeeze. Tack on valuations that have fully recovered and the message comes through clearly: stay underweight. The ticker symbols for the stocks in this index are: BLBG: S5COMM - CSCO, MSI, JNPR, FFIV.

  Overweight (High-Conviction) The S&P tech hardware, storage & peripherals (THSP) index has been an outstanding performer on our high-conviction list, returning more than 15% relative to the S&P 500 in the less than five months since it was added. Importantly, none of the key themes that drove our addition have finished playing out; the U.S. capex indicator remains persistently elevated, S&P THSP profit margins and the resulting cash flow remain robust and leverage ratios continue to lead the market (second & third panels). However, the breadth of the advance has narrowed as much of the outperformance has been due to Apple and the last two quarters of spectacular earnings beats. This adds a degree of specific risk to the exceptional S&P THSP outperformance. On top of this, risk of an escalating trade war with China continues to climb, to which the S&P THSP index is highly exposed. Accordingly, this morning we suggest that clients institute a stop in this high-conviction call at the 10% relative return mark, in line with our late-January introduced risk management policy. Bottom Line: We reiterate our high-conviction overweight status in the S&P THSP index, but recommend a 10% stop. The ticker symbols for the stocks in this index are: BLBG: S5CMPE - HPQ, WDC, STX, XRX, AAPL, HPE, NTAP.    

As the SPX and a slew of other indices have vaulted to fresh all-time highs, a deeper dive into profit margins is in order. While the S&P 500's profit margins are benefiting from the one-time fillip of lower corporate taxes in calendar 2018, it is important to remember that this is not affected by any massaging from CEOs/CFOs of the share count. In other words, given that "per share" cancel out of EPS/SPS, this margin number represents organic profit and revenue growth. The chart shows that SPX margins have recently slingshot to all-time highs. However, excluding tech they remain below the previous cycle's peak hit in mid-2007. While we are not fans of excluding sectors from our analysis, the magnitude and persistence of the tech sector's profit margin expansion is surprising. Tech sector profit margins are twice the SPX's margins, and tech stocks have been pulling SPX margins higher consistently for the past 8 years. The implication is that SPX EPS growth of 10% is likely in 2019, but the tech sector has to continue doing all the heavy lifting given the high profit and market cap weight in the SPX. Bottom Line: We remain neutral the broad tech sector and prefer the S&P software and S&P tech hardware, storage & peripherals indexes (both are high-conviction overweights) to the early cyclical tech indexes, S&P semis and S&P semi equipment subgroups (both are underweight). For additional details, please look forward to reading in this coming Tuesday's Weekly Report.

Special Report

Highlights Globalization, technological progress, weak trade unions, high debt levels, and population aging are often cited as reasons for why inflation will remain dormant. None of these reasons are inherently deflationary, and in some contexts, they may actually turn out to be quite inflationary. The combination of a stronger dollar and rising EM stress means that U.S. Treasury yields are more likely to fall than rise during the coming months. Over the long haul, however, bond yields are going higher - potentially much higher - as inflation surprises on the upside. Long-term bond investors should maintain below-benchmark exposure to duration risk in their portfolios. Gold offers some protection against rising inflation. That said, the yellow metal is still quite expensive in real terms, which limits its appeal. Investors would be better off simply buying inflation-protected securities such as TIPS. Historically, stocks have not performed well in inflationary environments. A neutral allocation to global equities is appropriate at this juncture. Feature Will Structural Forces Limit Inflation? In Part 1 of this report, we argued that inflation could surprise materially on the upside over the coming years due to the growing conviction among policymakers that: The neutral real rate of interest is extremely low; The natural rate of unemployment has fallen significantly over time; There is an exploitable trade-off between higher inflation and lower unemployment; The presence of the zero lower-bound on nominal short-term interest rates implies that it is better to be too late than too early in tightening monetary policy. A common refrain in response to these arguments is that the structural features of today's economy are so deflationary that policymakers simply would be not able to lift inflation even if they wanted to. Four features are often cited: 1) globalization; 2) modern technologies such as automation and e-commerce; 3) the declining influence of trade unions; and 4) population aging, high debt levels, and other contributors to "secular stagnation." In this week's report, we discuss all four features in turn. In every case, we conclude that the purported deflationary forces are not nearly as strong as most observers believe. Inflation And Globalization Imagine two closed economies, identical in every way other than the fact the one economy is larger than the other. Would one expect inflation to be structurally higher in the smaller economy? Most people would probably say no. After all, if one economy has more workers and capital than another economy, it will be able to generate more output. But all those additional workers will also want to spend more, so it is not immediately obvious why inflation should differ in the two regions. Now let us change the terminology a bit. Suppose the larger economy refers to the world as a whole. What would happen to the balance between aggregate demand and supply if we were to shift from a setting where countries do not trade with one another to a globalized world where they do? As the initial example suggests, to a first approximation, the answer is nothing. Since one country's exports are another's imports, globally, net exports will always be zero. Thus, it stands to reason that simply moving from autarky to free trade will not, in itself, boost global aggregate demand. Could a move towards free trade increase aggregate supply? Yes. Global production will rise if countries can specialize in the production of goods in which they have a comparative advantage. Productivity will also benefit from the fact that a large global market will allow companies to better exploit economies of scale by spreading their fixed costs over a greater quantity of output. But here's the catch: More production also means more income, and more income means more spending. Thus, if globalization increases aggregate supply, it will also increase aggregate demand. And if both aggregate demand and aggregate supply increase by the same amount, there is no reason to think that inflation will change. Granted, it is possible that desired demand will rise more slowly than supply in response to increasing globalization, putting downward pressure on inflation and interest rates in the process. This could be the case, for example, if globalization increases the share of income going towards rich people. As Chart 1 shows, rich people tend to save more than poor people. Chart 1Savings Heavily Skewed Towards Top Earners If globalization has increased income inequality, it is possible that this has had a deflationary effect. However, for this effect to persist, the world has to become even more globalized. This does not seem to be happening. Global trade has been flat as a share of GDP for over a decade (Chart 2). The share of U.S. national income flowing to workers has also been rising in recent years as the labor market has tightened (Chart 3). Chart 2Global Trade Has Peaked Chart 3Rising Labor Share Of Income Occurring ##br##Alongside Labor Market Tightening Globalization As An Inflationary Safety Valve The discussion above suggests that the often-heard argument that globalization is deflationary because it leads to an overabundance of production is not as straightforward as it seems. What about the argument that globalization is deflationary because it limits the ability of companies to raise prices? While this is a seemingly compelling argument, it runs square into the problem that profit margins are near record-high levels in many economies. Far from making companies more price-conscious, globalization has often created oligopolistic market structures. Granted, free trade can still provide a safety valve for countries suffering from excess demand. To see this, return to our earlier example of the large country versus the small country. Suppose that because of its well-diversified economy, the large country often encounters situations where one region is booming, while another is down in the dumps. When this happens, workers and capital will tend to flow to the thriving region, alleviating any capacity pressures there. The same adjustments often occur among countries. If desired spending exceeds a country's productive capacity, it can run a trade deficit with the rest of the world. Rather than the prices of goods and services needing to rise, excess demand can be satiated with more imports. However, for that realignment in demand to occur, exchange rates must adjust. In today's context, this means that the dollar may need to strengthen further. Notice that this dynamic only works if there is slack abroad. This is presently the case, but there is no assurance that this will always be so. The implication is that inflation could rise meaningfully as global spare capacity is absorbed. Technology And Inflation If the price of electronic goods is any guide, it would seem undeniable that technological innovation is a deflationary force. However, this belief involves a fallacy of composition. Above-average productivity gains in one sector of the economy will cause prices in that sector to decline relative to other prices. But falling prices will also boost real incomes, leading to more spending. It is possible that prices elsewhere in the economy will rise by enough to offset the decline in prices in the sector experiencing above-average productivity gains, so that the overall price level remains unchanged. Ultimately, whether inflation rises or falls in response to faster productivity growth depends on what policymakers do. Over the long haul, productivity growth will lead to higher real wages. However, real wages can go up either because the price level declines or because nominal wages rise. The extent to which one or the other happens depends on the stance of monetary policy. In any case, just as in our discussion of globalization, the whole narrative about how faster productivity growth is deflationary seems rather antiquated considering that productivity growth has been quite weak in most of the world for over a decade (Chart 4). Consistent with this, the price deflator for electronic goods has been falling a lot less rapidly in recent years than it has in the past (Chart 5). Chart 4Globally, Productivity Growth Has Been ##br##Falling For Over A Decade Chart 5Steadier Prices For Computer Hardware ##br##And Software In Recent Years Admittedly, it is possible to imagine a scenario where the pace of productivity growth slows but the nature of that growth changes in a more deflationary direction. However, evidence that this has happened is fairly thin. Take the so-called Amazon effect, which purports to show sizable deflationary consequences from the spread of e-commerce. As my colleague Mark McClellan has shown, outside of department stores, profit margins in the retail sector are well above their historic average (Chart 6).1 This calls into doubt claims that online shopping has undermined corporate pricing power. Recent productivity growth in the U.S. distribution sector has actually been slower than in the 1990s, a decade which produced large productivity gains stemming from the displacement of "mom and pop" stores with "big box" retailers such as Walmart and Costco. The Waning Power Of Unions The declining influence of trade unions is also often cited as a reason for why inflation will remain subdued. There are a number of empirical and conceptual problems with this argument. Empirically, unionization rates in the U.S. peaked in the mid-1950s, more than a decade before inflation began to accelerate. While the unionization rate continued to decline in the U.S. during the 1980s and 1990s, it remained elevated in Canada. Yet, this did not prevent Canadian inflation from falling as rapidly as it did in the United States (Chart 7). The widespread use of inflation-linked wage contracts in the 1970s appears mainly to have been a consequence of rising inflation rather than the cause of it (Chart 8). Chart 6Retail Sector Profit Margins Are Strong Chart 7Inflation Fell In Canada, Despite A ##br##High Unionization Rate Chart 8Higher Inflation Led To More Inflation-Indexed ##br##Wage Contracts, Not The Other Way Around Conceptually, the argument that strong unions tend to instigate price-wage spirals is highly suspect. Yes, firms may be forced to raise wages in response to union pressures, which could prompt them to increase prices, leading to demands for even higher wages, etc. However, the price level cannot increase on a sustained basis independent of other things such as the level of the money supply. Central banks must still play a decisive role. One can imagine a scenario where the presence of powerful trade unions creates a dual labor market, one with well-paid unionized workers and another with poorly-paid non-unionized workers. Governments may be tempted to run the economy hot to prop up the wages of non-unionized workers. On the flipside, one could also imagine a scenario where the absence of strong unions exacerbates income inequality, causing governments to pursue more demand-boosting macroeconomic policies. In either case, however, the ultimate cause of rising inflation would still be macroeconomic policy. Inflation And The Neutral Rate As the discussion so far illustrates, inflation is unlikely to rise unless policymakers let it happen. But what if the neutral rate of interest is so low that policymakers lose traction over monetary policy? In that case, central banks may not be able to bring inflation up even if they wanted to. This is not just an academic question. Japan has had near-zero interest rates for over two decades and this has not been enough to spur inflation. Chart 9Long-Term Inflation Expectations In The Euro Area ##br##Are Still Much Higher Than In Japan We do not disagree with the notion that the neutral rate of interest is lower today than it was in the past. However, magnitudes are important here. In thinking about the secular stagnation thesis, which underpins the rationale for why the neutral rate has fallen, one should distinguish between the "weak" form and the "strong" form versions of the thesis. The weak form says that the neutral nominal rate of interest is low but positive, whereas the strong form says that the neutral nominal rate is negative.2 While this may seem like a minor distinction, it has important policy and market implications. Under the strong form version of the thesis, central banks really do lose control of their most effective policy tool: the ability to change interest rates to keep the economy on an even keel. By definition, if the neutral nominal rate is deeply negative, then even a policy rate of zero would mean that monetary policy is too tight. Under such circumstances, an economy could easily succumb to a vicious circle where insufficient demand causes inflation to fall, leading to higher real rates and even less spending. Such a vicious circle is less probable when the weak form version of the secular stagnation thesis dominates. As long as the neutral nominal rate is positive, central banks can always choose a policy rate that is low enough to allow the economy to grow at an above-trend pace. If they keep the policy rate below neutral for an extended period of time, the economy will eventually overheat, generating higher inflation. The fact that the U.S. unemployment rate has managed to fall during the past few years, even as the Fed has been raising rates, strongly suggests that the weak form of the secular stagnation thesis is applicable to the United States. The euro area is a much tougher call, given the region's poor demographics and high debt levels. Nevertheless, at least so far, the euro area has one thing on its side: Long-term inflation expectations are still much higher than they are in Japan (Chart 9). Whereas a neutral real rate of zero implies a nominal rate of 1.8% in the euro area, it implies a much lower nominal rate of 0.5% in Japan. The Neutral Rate Will Likely Move Higher As we argued a few weeks ago, cyclically, the neutral real rate of interest has risen in the U.S., and to a lesser extent, the rest of the world.3 This has happened because deleveraging headwinds have abated, fiscal policy has turned more stimulative, asset values have risen, and faster wage growth has put more money into workers' pockets. Structurally, the neutral rate may also begin to creep higher as some of the very same long-term forces that have depressed the neutral rate in the past begin to push it up in the future. Demographics is a good example. For several decades, slower population growth has reduced the incentive for firms to expand capacity. Diminished investment spending has suppressed aggregate demand, leading to lower inflation. Population aging also pushed more people into their prime saving years - ages 30 to 50. By definition, more savings mean less spending. However, now that baby boomers are starting to retire en masse, they are moving from being savers to dissavers. Chart 10 shows that the "world support ratio" - effectively, the ratio of workers-to-consumers - has begun to fall for the first time in 40 years. As more people stop working, aggregate global savings will decline. The shortage of savings will put upward pressure on the neutral rate. Japan has been on the leading edge of this demographic transformation. The unemployment rate has fallen to a mere 2.4%, while the ratio of job openings-to-applicants has reached a 45-year high (Chart 11). The shackles that have kept Japan immersed in deflation for over two decades may be starting to break. Chart 10The Ratio Of Workers-To-Consumers Is Now Falling Chart 11Japan: Labor Market Tightening May Spur Inflation Debt Deflation Or Debt Inflation? The distinction between the weak form of secular stagnation and the strong form is critical for thinking about debt issues. Rising debt tends to boost spending, but when debt reaches very high levels, spending normally suffers as borrowers concentrate on paying back loans. As such, high indebtedness generally implies a lower neutral real rate of interest. There is an important caveat, however. The presence of a lot of debt in the financial system also creates an incentive for policymakers to boost inflation in order to erode the real value of that debt. This is particularly the case when governments are the main borrowers. When the strong form version of secular stagnation prevails, generating inflation is difficult, if not impossible. In such a setting, debt deflation becomes the main concern. In contrast, when the weak form version of secular stagnation prevails, higher inflation is achievable. Debt inflation becomes an increasingly likely outcome. If we are in a period where countries such as Japan are transitioning from a strong form of secular stagnation to a weak form, inflation could begin to move rapidly higher. We are positioned for this by being short 20-year versus 5-years JGBs. Inflation As A Political Choice There is a school of thought that argues that high inflation in the 1970s and early 80s was an aberration; that the natural state of capitalism is deflation rather than inflation. We reject this view. The natural state of capitalism is ever-increasing output. Whether prices happen to rise or fall along the way depends on the choice of monetary regime. This is a political decision, not an economic one. Regimes based on the gold standard tend to have a deflationary bias, whereas regimes based on fiat money tend to have an inflationary one. The introduction of universal suffrage in the first few decades of the twentieth century made inflation politically more palatable than deflation (Chart 12). There is little mystery as to why that was the case. In every society, wealth is unevenly distributed. Creditors tend to be rich while debtors tend to be poor. Unexpected inflation hurts the former, but benefits the latter. Chart 12Universal Suffrage Made Inflation Politically ##br##More Palatable Than Deflation Once universal suffrage was introduced, a poor farmer did not need to worry quite as much about losing his land to the bank, since he could now vote for someone who would ensure that crop prices increased rather than decreased. In William Jennings Bryan's colorful words, the rich and powerful "shall no longer crucify mankind on a cross of gold." Today, populism is on the rise. Trumpist Republicans have clobbered mainstream Republicans in one primary election after another. The democrats are also shifting to the left, as the ousting of ten-term incumbent Joe Crowley by the firebrand socialist candidate Alexandria Ocasio-Cortez in June illustrates. And the U.S. is not alone. Italy now has an avowedly populist government. Other European nations may not be far behind. Meanwhile, a growing chorus of prominent economists have argued in favor of raising inflation targets on the grounds that a higher level of inflation would allow central banks to push real interest rates deeper into negative territory in the event of a severe economic downturn. We doubt that any central bank would proactively raise its inflation target in the current environment. However, one could imagine a situation where inflation begins to gallop higher because central banks find themselves behind the curve in normalizing monetary policy. Confronted with the choice between engineering a painful recession and letting inflation stay elevated, it would not be too surprising in the current political context if some central banks chose the latter option. Investment Conclusions As we discussed last week, the combination of a stronger dollar and rising EM stress means that U.S. Treasury yields are more likely to fall than rise during the coming months.4 Over the long haul, however, bond yields are going higher - potentially much higher - as inflation surprises on the upside. Long-term bond investors should maintain below-benchmark exposure to duration risk in their portfolios. Gold offers some protection against inflation risk. However, the yellow metal is still quite expensive in real terms, which limits its appeal (Chart 13). Investors would be better off simply buying inflation-protected securities such as TIPS. Chart 13Gold Is Not Cheap Historically, equities have not performed well in inflationary environments. U.S. stocks are quite expensive these days (Chart 14). Analyst expectations are also far too rosy (Chart 15). Non-U.S. stocks are more attractively priced, but face a slew of near-term headwinds. A neutral allocation to global equities is appropriate at this juncture. Chart 14U.S. Stocks Are Expensive Chart 15Analysts Are Far Too Optimistic Peter Berezin, Chief Global Strategist Global Investment Strategy peterb@bcaresearch.com 1 Please see Global Investment Strategy Special Report, "Did Amazon Kill The Phillips Curve?" dated September 1, 2017. 2 To keep things simple, we are assuming that nominal interest rates cannot be negative. In practice, as we have seen over the past few years, the zero lower-bound constraint is rather fuzzy. Nevertheless, it is doubtful that interest rates can fall too far into negative territory before people begin to shift negative-yielding bank deposits into physical currency. 3 Please see Global Investment Strategy Weekly Report, "U.S. Housing Will Drive The Global Business Cycle... Again," dated July 6, 2018. 4 Please see Global Investment Strategy Weekly Report, "Hot Dollar, Cold Turkey," dated August 17, 2018. 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