Technology

Special Report

A "culture of profound cost reduction" has gripped the business sector since the GFC according to one school of thought, permanently changing the relationship between labor market slack and wages or inflation. If true, it could mean that central banks are almost powerless to reach their inflation targets. Amazon, Airbnb, Uber, robotics, contract workers, artificial intelligence, horizontal drilling and driverless cars are just a few examples of companies and technologies that are cutting costs and depressing prices and wages. In the first of our series on inflation, we will focus on the rise of e-commerce and the related "Amazonification" of the economy. In theory, positive supply shocks should not have more than a temporary impact on inflation if the price level is indeed a monetary phenomenon in the long term. But a series of positive supply shocks could make it appear for quite a while that low inflation is structural in nature. We are keeping an open mind and reserving judgement on the disinflationary impact of robotics, artificial intelligence and the gig economy until we do more research. But in terms of the impact of e-commerce, it is difficult to find supportive evidence at the macro level. The admittedly inadequate measures of online prices available today do not suggest that e-commerce sales are depressing the overall inflation rate by more than 0.1 or 0.2 percentage points. Moreover, it does not appear that the disinflationary impact of competition in the retail sector has intensified over the years. Today's creative destruction in retail may be no more deflationary than the shift to 'big box' stores in the 1990s. Perhaps lower online prices are forcing traditional retailers to match the e-commerce vendors, allowing for a larger disinflationary effect than we estimate. However, the fact that retail margins are near secular highs outside of department stores argues against this thesis. The sectors potentially affected by e-commerce make up a small part of the CPI index. The deceleration of inflation since the GFC has been in areas unaffected by online sales. High profit margins for the overall corporate sector and depressed productivity growth also argue against the idea that e-commerce represents a large positive macro supply shock. Perhaps the main way that e-commerce is affecting the macro economy and financial markets is not through inflation, but via the reduction in the economy's capital spending requirement. This would reduce the equilibrium level of interest rates, since the Fed has to stimulate other parts of the economy to offset the loss of demand in capital spending in the retail sector. Anecdotal evidence is all around us. The global economy is evolving and it seems that all of the major changes are deflationary. Amazon, Airbnb, Uber, robotics, contract workers, artificial intelligence, horizontal drilling and driverless cars are just a few examples of companies and technologies that are cutting costs and depressing prices and wages. Central banks in the major advanced economies are having difficulty meeting their inflation targets, even in the U.S. where the labor market is tight by historical standards. Based on the depressed level of bond yields, it appears that the majority of investors believe that inflation headwinds will remain formidable for a long time. One school of thought is that low inflation reflects a lack of demand growth in the post-Great Financial Crisis (GFC) period. Another school points to the supply side of the economy. A recent report by Prudential Financial highlights "...obvious examples of ... new business models and new organizational structures, whereby higher-cost traditional methods of production, transportation, and distribution are displaced by more nontraditional cost-effective ways of conducting business."1 A "culture of profound cost reduction" has gripped the business sector since the GFC according to this school, permanently changing the relationship between labor market slack and wages or inflation (i.e., the Phillips Curve). Employees are less aggressive in their wage demands in a world where robots are threatening humans in a broadening array of industrial categories. Many feel lucky just to have a job. In a highly sensationalized article called "How The Internet Economy Killed Inflation," Forbes argued that "the internet has reduced many of the traditional barriers to entry that protect companies from competition and created a race to the bottom for prices in a number of categories." Forbes believes that new technologies are placing downward pressure on inflation by depressing wages, increasing productivity and encouraging competition. There are many factors that have the potential to weigh on prices, but analysts are mainly focusing on e-commerce, robotics, artificial intelligence, and the gig economy. In the first of our series on inflation, we will focus on the rise of e-commerce and the related "Amazonification" of the economy. The latter refers to the advent of new business models that cut out layers of middlemen between producers and consumers. Amazonification E-commerce has grown at a compound annual rate of more than 9% over the past 15 years, and now accounts for about 8½% of total U.S. retail sales (Chart II-1). Amazon has been leading the charge, accounting for 43% of all online sales in 2016 (Chart II-2). Amazon's business model not only cuts costs by eliminating middlemen and (until recently) avoiding expensive showrooms, but it also provides a platform for improved price discovery on an extremely broad array of goods. In 2013, Amazon carried 230 million items for sale in the United States, nearly 30 times the number sold by Walmart, one of the largest retailers in the world. Chart II-1E-Commerce: Steady Increase In Market Share Chart II-2Amazon Dominates With the use of a smartphone, consumers can check the price of an item on Amazon while shopping in a physical store. Studies show that it does not require a large price gap for shoppers to buy online rather than in-store. Amazon appears to be impacting other retailers' ability to pass though cost increases, leading to a rash of retail outlet closings. Sears alone announced the closure of 300 retail outlets this year. The devastation that Amazon inflicted on the book industry is well known. It is no wonder then, that Amazon's purchase of Whole Foods Market, a grocery chain, sent shivers down the spines of CEOs not only in the food industry, but in the broader retail industry as well. What would prevent Amazon from applying its model to furniture and appliances, electronics or drugstores? It seems that no retail space is safe. A Little Theory Before we turn to the evidence, let's review the macro theory related to positive supply shocks. The internet could be lowering prices by moving product markets toward the "perfect competition" model. The internet trims search costs, improves price transparency and reduces barriers to entry. The internet also allows for shorter supply chains, as layers of wholesalers and other intermediaries are removed and e-commerce companies allow more direct contact between consumers and producers. Fewer inventories and a smaller "brick and mortar" infrastructure take additional costs out of the system. Economic theory suggests that the result of this positive supply shock will be greater product market competition, increased productivity and reduced profitability. In the long run, workers should benefit from the productivity boost via real wage gains (even if nominal wage growth is lackluster). Workers may lower their reservation wage if they feel that increased competitive pressures or technology threaten their jobs. The internet is also likely to improve job matching between the unemployed and available vacancies, which should lead to a fall in the full-employment level of unemployment (NAIRU). Nonetheless, the internet should not have a permanent impact on inflation. The lower level of NAIRU and the direct effects of the internet on consumer prices discussed above allow inflation to fall below the central bank's target. The bank responds by lowering interest rates, stimulating demand and thereby driving unemployment down to the new lower level of NAIRU. Over time, inflation will drift back up toward target. In other words, a greater degree of the competition should boost the supply side of the economy and lower NAIRU, but it should not result in a permanently lower rate of inflation if inflation is indeed a monetary phenomenon and central banks strive to meet their targets. Still, one could imagine a series of supply shocks that are spread out over time, with each having a temporary negative impact on prices such that it appears for a while that inflation has been permanently depressed. This could be an accurate description of the current situation in the U.S. and some of the other major countries. We have sympathy for the view that the internet and new business models are increasing competition, cutting costs and thereby limiting price increases in some areas. But is there any hard evidence? Is the competitive effect that large, and is it any more intense than in the past? There are a number of reasons to be skeptical because most of the evidence does not support Forbes' claim that the internet has killed inflation. (1) E-commerce affects only a small part of the Consumer Price Index As mentioned above, online shopping for goods represents 8.5% of total retail sales in the U.S. E-commerce is concentrated in four kinds of businesses (Table II-1): Furniture & Home Furnishings (7% of total retail sales), Electronics & Appliances (20%), Health & Personal Care (15%), and Clothing (10%). Since goods make up 40% of the CPI, then 3.2% (8% times 40%) is a ballpark estimate for the size of goods e-commerce in the CPI. Table II-1E-Commerce Market Share Of Goods Sector (2015) Table II-2 shows the relative size of e-commerce in the service sector. The analysis is complicated by the fact that the data on services includes B-to-B sales in addition to B-to-C.2 However, e-commerce represents almost 4% of total sales for the service categories tracked by the BLS. Services make up 60% of the CPI, but the size drops to 26% if we exclude shelter (which is probably not affected by online shopping). Thus, e-commerce in the service sector likely affects 1% (3.9% times 26%) of the CPI. Table II-2E-Commerce Market Share Of Service Sector (2015) Adding goods and services, online shopping affects about 4.2% of the CPI index at most. The bottom line is that the relatively small size of e-commerce at the consumer level limits any estimate of the impact of online sales on the broad inflation rate. (2) Most of the deceleration in inflation since 2007 has been in areas unaffected by e-commerce Table II-3 compares the average contribution to annual average CPI inflation during 2000-2007 with that of 2007-2016. Average annual inflation fell from 2.9% in the seven years before the Great Recession to 1.8% after, for a total decline of just over 1 percentage point. The deceleration is almost fully explained by Energy, Food and Owners' Equivalent Rent. The bottom part of Table II-3 highlights that the sectors with the greatest exposure to e-commerce had a negligible impact on the inflation slowdown. Table II-3Comparison Of Pre- and Post-Lehman Inflation Rates (3) The cost advantages for online sellers are overstated Bain & Company, a U.S. consultancy, argues that e-commerce will not grow in importance indefinitely and come to dominate consumer spending.3 E-commerce sales are already slowing. Market share is following a classic S-shaped curve that, Bain estimates, will top out at under 30% by 2030. First, not everyone wants to buy everything online. Products that are well known to consumers and purchased on a regular basis are well suited to online shopping. But for many other products, consumers need to see and feel the product in person before making a purchase. Second, the cost savings of online selling versus traditional brick and mortar stores is not as great as many believe. Bain claims that many e-commerce businesses struggle to make a profit. The information technology, distribution centers, shipping, and returns processing required by e-commerce companies can cost as much as running physical stores in some cases. E-tailers often cannot ship directly from manufacturers to consumers; they need large and expensive fulfillment centers and a very generous returns policy. Moreover, online and offline sales models are becoming blurred. Retailers with physical stores are growing their e-commerce operations, while previously pure e-commerce plays are adding stores or negotiating space in other retailers' stores. Even Amazon now has storefronts. The shift toward an "multichannel" selling model underscores that there are benefits to traditional brick-and-mortar stores that will ensure that they will not completely disappear. (4) E-commerce is not the first revolution in the retail sector The retail sector has changed significantly over the decades and it is not clear that the disinflationary effect of the latest revolution, e-commerce, is any more intense than in the past. Economists at Goldman Sachs point out that the growth of Amazon's market share in recent years still lags that of Walmart and other "big box" stores in the 1990s (Chart II-3).4 This fact suggests that "Amazonification" may not be as disinflationary as the previous big-box revolution. (5) Weak productivity growth and high profit margins are inconsistent with a large supply-side benefit from e-commerce As discussed above, economic theory suggests that a positive supply shock that cuts costs and boosts competition should trim profit margins and lift productivity. The problem is that the margins and productivity have moved in the opposite direction that economic theory would suggest (Chart II-4). Chart II-3Amazon Vs. Walmart: ##br##Who's More Deflationary? Chart II-4Incompatible With A Supply Shock By definition, productivity rises when firms can produce the same output with fewer or cheaper inputs. However, it is well documented that productivity growth has been in a downtrend since the 1990s, and has been dismally low since the Great Recession. A Special Report from BCA's Global Investment Strategy5 service makes a convincing case that mismeasurement is not behind the low productivity figures. In fact, in many industries it appears that productivity is over-estimated. If e-commerce is big enough to "move the dial" on overall inflation, it should be big enough to see in the aggregate productivity figures. Chart II-5Retail Margin Squeeze ##br##Only In Department Stores One would also expect to see a margin squeeze across industries if e-commerce is indeed generating a lot of deflationary competitive pressure. Despite dismally depressed productivity, however, corporate profit margins are at the high end of the historical range across most of the sectors of the S&P 500. This is the case even in the retailing sector outside of department stores (Chart II-5). These facts argue against the idea that the internet has moved the economy further toward a disinflationary "perfect competition" model. (6) Online price setting is characterized by frictions comparable to traditional retail We would expect to observe a low price dispersion across online vendors since the internet has apparently lowered the cost of monitoring competitors' prices and the cost of searching for the lowest price. We would also expect to see fairly synchronized price adjustments; if one vendor adjusts its price due to changing market conditions, then the rest should quickly follow to avoid suffering a massive loss of market share. However, a recent study of price-setting practices in the U.S. and U.K. found that this is not the case.6 The dataset covered a broad spectrum of consumer goods and sellers over a two-year period, comparing online with offline prices. The researchers found that market pricing "frictions" are surprisingly elevated in the online world. Price dispersion is high in absolute terms and on par with offline pricing. Academics for years have puzzled over high price rigidities and dispersion in retail stores in the context of an apparently stiff competitive environment, and it appears that online pricing is not much better. The study did not cover a long enough period to see if frictions were even worse in the past. Nonetheless, the evidence available suggests that the lower cost of monitoring prices afforded by the internet has not led to significant price convergence across sellers online or offline. Another study compared online and offline prices for multichannel retailers, using the massive database provided by the Billion Prices Project at MIT.7 The database covers prices across 10 countries. The study found that retailers charged the same price online as in-store in 72% of cases. The average discount was 4% for those cases in which there was a markdown online. If the observations with identical prices are included, the average online/offline price difference was just 1%. (7) Some measures of online prices have grown at about the same pace as the CPI index The U.S. Bureau of Labor Statistics does include online sales when constructing the Consumer Price Index. It even includes peer-to-peer sales by companies such as Airbnb and Uber. However, the BLS admits that its sample lags the popularity of such services by a few years. Moreover, while the BLS is trying to capture the rising proportion of sales done via e-commerce, "outlet bias" means that the CPI does not capture the price effect in cases where consumers are finding cheaper prices online. This is because the BLS weights the growth rate of online and offline prices, not the price levels. While there may be level differences, there is no reason to believe that the inflation rates for similar goods sold online and offline differ significantly. If the inflation rates are close, then the growing share of online sales will not affect overall inflation based on the BLS methodology. The BLS argues that any bias in the CPI due to outlet bias is mitigated to the extent that physical stores offer a higher level of service. Thus, price differences may not be that great after quality-adjustment. All this suggests that the actual consumer price inflation rate could be somewhat lower than the official rate. Nonetheless, it does not necessarily mean that inflation, properly measured, is being depressed by e-commerce to a meaningful extent. Indeed, Chart II-6 highlights that the U.S. component of the Billion Prices Index rose at a faster pace than the overall CPI between 2009 and 2014. The Online Price Index fell in absolute and relative terms from 2014 to mid-2016, but rose sharply toward the end of 2016. Applying our guesstimate of the weight of e-commerce in the CPI (3.2% for goods), online price inflation added to overall annual CPI inflation by about 0.3 percentage points in 2016 (bottom panel of Chart II-6). There is more deflation evident in the BLS' index of prices for Electronic Shopping and Mail Order Houses (Chart II-7). Online prices fell relative to the overall CPI for most of the time since the early 1990s, with the relative price decline accelerating since the GFC. However, our estimate of the contribution to overall annual CPI inflation is only about -0.15 percentage points in June 2017, and has never been more than -0.3 percentage points. This could be an underestimate because it does not include the impact of services, although the service e-commerce share of the CPI is very small. Chart II-6Online Price Index Chart II-7Electronic Shopping Price Index Another way to approach this question is to focus on the parts of the CPI that are most exposed to e-commerce. It is impossible to separate the effect of e-commerce on inflation from other drivers of productivity. Nonetheless, if online shopping is having a significant deflationary impact on overall inflation, we should see large and persistent negative contributions from these parts of the CPI. We combined the components of the CPI that most closely matched the sectors that have high e-commerce exposure according to the BLS' annual Retail Survey (Chart II-8). The sectors in our aggregate e-commerce price proxy include hotels/motels, taxicabs, books & magazines, clothing, computer hardware, drugs, health & beauty aids, electronics & appliances, alcoholic beverages, furniture & home furnishings, sporting goods, air transportation, travel arrangement and reservation services, educational services and other merchandise. The sectors are weighted based on their respective weights in the CPI. Our e-commerce price proxy has generally fallen relative to the overall CPI index since 2000. However, while the average contribution of these sectors to the overall annual CPI inflation rate has fallen in the post GFC period relative to the 2000-2007 period, the average difference is only 0.2 percentage points. The contribution has hovered around the zero mark for the past 2½ years. Surprisingly, price indexes have increased by more than the overall CPI since 2000 in some sectors where one would have expected to see significant relative price deflation, such as taxis, hotels, travel arrangement and even books. One could argue that significant measurement error must be a factor. How could the price of books have gone up faster than the CPI? Sectors displaying the most relative price declines are clothing, computers, electronics, furniture, sporting goods, air travel and other goods. We recalculated our e-commerce proxy using only these deflating sectors, but we boosted their weights such that the overall weight of the proxy in the CPI is kept the same as our full e-commerce proxy discussed above. In other words, this approach implicitly assumes that the excluded sectors (taxis, books, hotels and travel arrangement) actually deflated at the average pace of the sectors that remain in the index. Our adjusted e-commerce proxy suggests that online pricing reduced overall CPI inflation by about 0.1-to-0.2 percentage points in recent years (Chart II-9). This contribution is below the long-term average of the series, but the drag was even greater several times in the past. Chart II-8BCA E-Commerce Proxy Price Index Chart II-9BCA E-Commerce Adjusted Proxy Price Index Admittedly, data limitations mean that all of the above estimates of the impact of e-commerce are ballpark figures. Conclusions We are keeping an open mind and reserving judgement on the disinflationary impact of robotics, artificial intelligence and the gig economy until we do more research. But in terms of the impact of e-commerce, it is difficult to find supportive evidence. The available data are admittedly far from ideal for confirming or disproving the "Amazonification" thesis. Perhaps better measures of e-commerce pricing will emerge in the future. Nonetheless, the measures available today do not suggest that online sales are depressing the overall inflation rate by more than 0.1 or 0.2 percentage points, and it does not appear that the disinflationary impact has intensified by much. One could argue that lower online prices are forcing traditional retailers to match the e-commerce vendors, allowing for a larger disinflationary effect than we estimate. Nonetheless, if this were the case, then we would expect to see significant margin compression in the retail sector. The sectors potentially affected by e-commerce make up a small part of the CPI index. The deceleration of inflation since the GFC has been in areas unaffected by online sales. High corporate profit margins and depressed productivity growth also argue against the idea that e-commerce represents a large positive macro supply shock. Finally, today's creative destruction in retail may be no more deflationary than the shift to 'big box' stores in the 1990s. Perhaps the main way that e-commerce is affecting the macro economy and financial markets is not through inflation, but via the reduction in the economy's capital spending requirement. Rising online activity means that we need fewer shopping malls and big box outlets to support a given level of consumer spending. This would reduce the equilibrium level of interest rates, since the Fed has to stimulate other parts of the economy to offset the loss of demand in capital spending in the retail sector. To the extent that central banks were slow to recognize that equilibrium rates had fallen to extremely low levels, then policy was behind the curve and this might have contributed to the current low inflation environment. Mark McClellan Senior Vice President The Bank Credit Analyst 1 Robert F. DeLucia, "Economic Perspective: A Nontraditional Analysis Of Inflation," Prudential Capital Group (August 21, 2017). 2 Business to business, and business to consumer. 3 Aaron Cheris, Darrell Rigby and Suzanne Tager, "The Power Of Omnichannel Stores," Bain & Company Insights: Retail Holiday Newsletter 2016-2017 (December 19, 2016). 4 "US Daily: The Internet And Inflation: How Big Is The Amazon Effect?" Goldman Sachs Economic Research (August 2, 2017). 5 Please see Global Investment Strategy Weekly Report, "Weak Productivity Growth: Don't Blame The Statisticians," dated March 25, 2016, available at gis.bcaresearch.com 6 Yuriy Gorodnichenko, Viacheslav Sheremirov, and Oleksandr Talavera, "Price Setting In Online Markets: Does IT Click?" Journal of the European Economic Association (July 2016). 7 Alberto Cavallo, "Are Online And Offline Prices Similar? Evidence From Large Multi-Channel Retailers," NBER Working Paper No. 22142 (March 2016).

Cisco Systems, the communications equipment index heavyweight, reported tough quarterly results that highlighted the issues continuing to strain the industry. Revenues have continued to fall as telecom carriers, the key customer group, remain engaged in a deflationary price war (second panel) which has been exacerbated by U.S. federal government spending uncertainty; management guided to more of the same next quarter. Encouragingly, margins have improved despite sliding sales, evidence of solid cost control. This should (eventually) result in outsized profits when revenues turn the corner. On that front, telecom services providers have made significant progress in slowing the rate of decline in sales (third panel). Still, inventories & production have been diverging in an unhealthy direction (bottom panel) which could herald a liquidation phase, rendering the progress on margins unsustainable. We think the risks to profitability, combined with ongoing top line shrinkage, will keep investors away. Stay underweight. The ticker symbols for the stocks in this index are: BLBG: S5COMM - CSCO, HRS, MSI, JNPR, FFIV.

Special Report

Feature Visions abound of a dystopia in which Artificial Intelligence (AI) obsoletes all human jobs. In these visions, mankind becomes a subservient sideshow in a world run by robots. But while such dystopian visions make excellent narratives for Hollywood blockbusters, the chance they become a reality is nil. Technological progress is nothing new. Each generation feels it is experiencing unprecedented disruptive changes, but the constant march of technological progress has defined humanity for centuries, or even millennia. In the process, innovation has already obsoleted countless occupations. Where are today's lamplighters, ostlers,1 livery-stable keepers, newspaper criers and boiler firemen? In 1910, one third of the labour force worked on farms,2 with many of these workers tending animals; today, those proportions are near zero. In 1950, one fifth of the workforce was a machine or vehicle operative; today, that proportion is less than a tenth. More recently, in 1970, over 5% of workers were 'stenographers, typists or secretaries'; again today, most of those jobs have vanished. Yet this mass of job obsolescence has not created mass unemployment. The reason is that an advancing economy creates as many new jobs to replace the obsoleted jobs (Feature Chart and Chart I-2). In 1910, less than 5% of workers were in 'professional or technical' jobs; today the category employs over a quarter of workers. In 1950, healthcare employed 2% of workers; today it employs 8%. Moreover, the nature of many of today's jobs might have been unimaginable just a few decades ago. The rapidly growing employment sector 'medical and dental technicians' did not even exist before 1950. In the same way, the precise type of jobs that will see very strong growth in the coming years and decades might be unimaginable today. Feature ChartTechnological Progress In The 20th ##br##Century Destroyed Many Jobs... Feature Chart...But Created As ##br##Many New Jobs Chart I-2Nothing New: Technological Progress Always ##br##Involves Job Destruction And Creation Say's Law Tells Us That Robots Will Not Kill Job Growth Technological progress has not killed job growth. Nor will it. This is because firms choose to replace human workers with machines only if it increases their productivity and profitability (Charts I-3, Chart I-4, Chart I-5). The higher productivity increases the ability to purchase other goods and services - thereby creating jobs elsewhere in the economy (Chart I-6), often in new and surprising industries. Chart I-3Machine And Vehicle Operative ##br##Work Peaked In The 50s Chart I-4Secretarial Work Peaked ##br## In The 70s Chart I-5Clerical Work Peaked##br## In The 80s Chart I-6Healthcare Work Is In##br## A Strong Uptrend This is the idea introduced in 1803 by French economist Jean-Baptiste Say, called Say's Law: The producer of X is able to buy Y, if his products are demanded. Thereby, supply of X creates demand for Y, as long as people wish to buy X. A producer replaces human workers with machines to generate his output at higher profit, enabling him to demand new goods and services that he desires. Crucially, human desires are varied, ever changing and ultimately unlimited. Satisfying those unlimited desires creates new economies and jobs. In this way, technological progress often paves the way for completely new and unrelated goods and services. It creates whole new industries. To give just one example, railways spawned the frozen food industry. The frozen food industry satisfied the human desire to eat fresh food - which railways could now transport (frozen) to cities from distant farms and fisheries. In real time though, it was difficult to connect the advent of railways with the birth of the frozen food industry. Likewise, today it is hard to know precisely which new economies, markets and associated jobs the current new technologies will spawn. Nevertheless, a new technology's disruptive effect on an economy does depend on the broad type of job it destroys versus the broad type of job it creates. Consider a stylized economy with three types of job: a high-income innovator, a middle-income manufacturer, and a low-income animal tender. And imagine two scenarios. Scenario 1: the innovator invents a machine that obsoletes the low-income animal tender. Having replaced the animal tender with a more productive machine, the innovator will use his higher income to satisfy additional desires for manufactured goods. This enables the obsoleted animal tender to retrain and make a better living as a middle-income manufacturer. Scenario 2: the innovator instead invents a machine that obsoletes the middle-income manufacturer. In this case, the innovator will use his higher income to satisfy additional desires for animal tending services. The obsoleted manufacturer must now make a living as a low-income animal tender. So while the innovator sees a rise in his standard of living, the outcome for the unfortunate middle-income manufacturer is a massive deflation in pay. It is our strong contention that whereas previous waves of technological progress looked like scenario 1, the current and forthcoming impact of AI looks more like scenario 2. In other words, robots will kill middle-income jobs rather than low-income jobs. And the reason comes from a discovery called Moravec's Paradox.3 Moravec's Paradox Tells Us That Robots Will Kill Middle Income Jobs Moravec's Paradox is a counterintuitive discovery by robotics researchers that, for AI, the hard problems are easy and the easy problems are hard: High-level reasoning - such as logic and algebra - requires very little computation, but supposedly low-level sensorimotor skills - such as mobility and perception - require vast computational resources. Logic and algebra are considered difficult for humans, a supposed sign of intelligence. Jobs that require them are relatively well paid. Conversely, basic mobility and perception are considered innate. Jobs that rely on them are relatively poorly paid. But from an evolutionary perspective, high-level reasoning is very recent, maybe less than 100 thousand years old. This explains why it seems un-mastered and requires conscious effort. Conversely, evolution has honed and perfected our mobility and perception skills over tens of millions of years. So those low-level skills are subconscious and effortless. As AI is, in effect, just reverse-engineering the brain, the difficulty of any task for AI is roughly proportional to the amount of time it has taken for nature to evolve and encode it in the human brain. Therefore, the 100 thousand year old 'high-level' skills like logic and algebra are relatively easy for AI to replicate and even surpass, whereas the 10 million year old 'low-level' skills like mobility and perception are extremely difficult to replicate. It follows that the jobs that AI can easily replicate and replace are those that require recently evolved skills like logic and algebra. They tend to be middle-income jobs. Conversely, the jobs that AI cannot easily replicate are those that rely on the deeply evolved skills like mobility and perception. They tend to be lower-income jobs. Hence, the current wave of technological progress is following scenario 2. AI is hollowing out middle-income jobs and creating lots of lower-income jobs. Put another way: Say's Law + Moravec's Paradox = Strong Job Creation + Middle Income Wage Depression Is there any evidence of this? Yes, in the United States where the job creation data is a lot more granular than in Europe, the strongest growing employment sub-sector for many years has been 'Food Services And Drinking Places' (Table I-1 and Chart I-7). In other words, bartenders and waiters - classic low-income jobs requiring mobility and perception. Meanwhile, job losses have been concentrated in middle-income occupations. Table I-1Which Sectors Are Seeing ##br##The Job Growth? Chart I-7Bartenders And Waiters Is The Fastest ##br##Growing Employment Sector! Stronger evidence comes from the weakening Phillips curve relationship between unemployment and wage inflation. In many economies, unemployment rates are hitting multi-decade lows, yet wage inflation remains dormant. This has baffled many economists, but it shouldn't. Moravec's Paradox tells us that strong job creation is at the lower-income end of the employment distribution. So a weakening Phillips curve relationship is exactly what we should see. Moreover, as the economic impacts of AI are still in their infancy, the trends we are seeing now have much further to run. The major investment takeaway is that the structural backdrop for bonds is benign. But with the ECB about to end its ultra-accommodation, bond investors should tilt their long-term exposure towards non-euro area government bonds. A New Investment Theme: Animal Care Chart I-8Animal Care: Strong And Steady Growth Despite the on-going disruption to many middle-income jobs, developed economies have grown and will continue to grow. But as we said, economic growth can come through new and surprising industries. The early identification of such industries can create excellent investment opportunities. So we will end this report by introducing an idea. In our stylized scenario 2 we said that the innovator would use his higher income to satisfy additional desires for animal tending services. As it happens, we are witnessing this precise phenomenon today. The demand for animal tending services, such as dog walking, is booming. We fully expect the animal and pet care industry to remain one of the strongest growth sectors in developed economies (Chart I-8). The strong uptrend will be supported by three sub-themes. First, increased pet ownership among wealthy retiring baby boomers. Second, a lower birth rate means that pets are becoming a substitute for a child. Third, the 'humanization of animals': as pets become regarded as equal members of the family, spending on their welfare rises accordingly. We expect to develop this long-term theme in future reports. But today, we are starting our Animal Care basket with 3 initial stocks (Table I-2). Table I-2The Animal Care Basket Dhaval Joshi, Senior Vice President Chief European Investment Strategist dhaval@bcaresearch.com 1 An ostler was a man employed to look after the horses of people staying at an inn. 2 Based on U.S. data. 3 Named after the robot engineer Hans Moravec. Fractal Trading Model There are no new trades this week. The short CAC40 / long Eurostoxx600 position reached the end of its 65 day term achieving half of its profit target, while the long DM / short EM position hit its stop-loss. This leaves three open positions. For any investment, excessive trend following and groupthink can reach a natural point of instability, at which point the established trend is highly likely to break down with or without an external catalyst. An early warning sign is the investment's fractal dimension approaching its natural lower bound. Encouragingly, this trigger has consistently identified countertrend moves of various magnitudes across all asset classes. Chart I-9 The post-June 9, 2016 fractal trading model rules are: When the fractal dimension approaches the lower limit after an investment has been in an established trend it is a potential trigger for a liquidity-triggered trend reversal. Therefore, open a countertrend position. The profit target is a one-third reversal of the preceding 13-week move. Apply a symmetrical stop-loss. Close the position at the profit target or stop-loss. Otherwise close the position after 13 weeks. Use the position size multiple to control risk. The position size will be smaller for more risky positions. * For more details please see the European Investment Strategy Special Report "Fractals, Liquidity & A Trading Model," dated December 11, 2014, available at eis.bcaresearch.com Fractal Trading Model Recommendations Equities Bond & Interest Rates Currency & Other Positions Closed Fractal Trades Trades Closed Trades Asset Performance Currency & Bond Equity Sector Country Equity Indicators Bond Yields Chart II-1Indicators To Watch - Bond Yields Chart II-2Indicators To Watch - Bond Yields Chart II-3Indicators To Watch - Bond Yields Chart II-4Indicators To Watch - Bond Yields Interest Rate Chart II-5Indicators To Watch##br## - Interest Rate Expectations Chart II-6Indicators To Watch##br## - Interest Rate Expectations Chart II-7Indicators To Watch##br## - Interest Rate Expectations Chart II-8Indicators To Watch##br## - Interest Rate Expectations

Special Report

Dear Client, Over the next three weeks, much of BCA’s Geopolitical Strategy team will be traveling in Australia, New Zealand, and Asia. As such, we are taking this week off from publication and will return to our regular schedule next week. In lieu of our regular missive, we are sending you the following Special Report, penned by our colleagues in the BCA Technology Sector Strategy. The report, originally published on May 16, tackles “The Coming Robotics Revolution” in an innovative way that aligns with our own views. Clients often ask us what will be the political consequences of the revolution in artificial intelligence and robotics. Our answers are controversial because we strongly disagree with the conventional, Terminator-inspired, doom and gloom. Brian Piccioni and Paul Kantorovich agree with us, which is reassuring given that they understand the technology behind robotics far better than we do. I hope you enjoy the enclosed report and encourage you to seek out the insights of our Technology Sector Strategy. Kindest Regards, Marko Papic, Senior Vice President Chief Geopolitical Strategist Feature "The amount of technology coming at us in the next five years is probably more than we've seen in the last 50" Mark Franks, Director Of Global Automation at General Motors, Bloomberg News, April 2017 There is good reason to believe we are at the cusp of a Robot Revolution which will have a dramatic impact on our economy. Robots have been around for decades or centuries, depending on the definition. Past robots were either fixed in place, as in the case of factory robots, or supervised by operators that are near the robot, or connected through telemetry. In contrast, the robots that are coming will not be fixed in place, and will be able to perform their functions without a human operator. This opens up massive markets for robots in industry (cutting lawns, cleaning windows, delivering parcels, etc.) and, most significantly, consumer applications. Part 1: Robots - Industrial Revolution To Early 21st Century The term "robot" can have different meanings. The most basic definition is "a device that automatically performs complicated and often repetitive tasks,"1 a definition which encompasses a broad range of machines: from the Jacquard Loom,2 which was invented over 200 years ago, on to Numerically Controlled (NC) mills and lathes, pick and place machines used in the manufacture of electronics, Autonomous Vehicles (AVs), and even homicidal robots from the future such as the Terminator. For much of history, most of the labor force was involved with the production of food: over 50% of the U.S. labor force was involved in agriculture until the late 1800s (Chart 1). Agriculture has benefitted immensely from automation as inventions such as the McCormick Reaper (a wheat cutting machine pulled by horses), the cotton gin, and other mechanical systems displaced human effort. Steam and then internal combustion-powered tractors, which can be viewed as "robotic horses," accelerated the process, as engines delivered much more power more cost effectively than mechanical devices (Chart 2). This massively improved productivity: within 20 years from 1830 to 1850, the labor to produce 100 bushels of wheat dropped from 250-300 to 75-90 hours, and by 1955 it only took 6 ½ hours of labor for a net reduction of 97.5% in 125 years.3 Chart 1Farm Workers Were Disrupted In The Late 19th Century Chart 2...And So Were Horses In other words there is nothing new about automation displacing workers while improving productivity, nor is a rapid displacement unprecedented. The industrial revolution was about replacing human craft labor with capital (i.e. machines), which did high-volume work with better quality and productivity. This freed humans for work which had not yet been automated, along with designing, producing, and maintaining the machinery. Automation Frightens People Although automation is nothing new, it has always engendered anxiety among workers. The anxiety boils down to concern for continued employment as well as fear of the technology itself. We discuss below why Artificial Intelligence (AI) does not present the sort of threat to humanity or even employment that seems to be the consensus view at the moment. Will Robots Become Self-Aware? We have covered the topic of Artificial Intelligence/Deep Learning as it relates to sentient/self-aware machines in some detail in our October 18, 2016 Special Report on Artificial Intelligence. In summary, most of the discussion surrounding AI is misinformation. Although AI uses algorithms called "artificial neural networks," which are extremely useful for solving certain classes of problems, these are nothing like biological neural networks. There is no reason whatsoever to believe AI technology in its current form can become sentient, or even meaningfully intelligent, and that will not change with increased computing power. Furthermore, whether or not AI can arise to the level of a threat, there is no current or imagined power source which could keep a rampaging robot active for more than a few hours. The Terminator would have been much less threatening if he required frequent recharging. Will Robots Make Human Workers Irrelevant? Automation in agriculture occurred rapidly enough to be felt by workers at the time - and yet there were no marauding hordes of unemployed hay cutters or cowboys. Improved productivity meant markets were opened which did not previously exist, and unemployed agricultural workers moved to factory work. Media coverage of automation tends to focus on the potential job losses without mentioning the fact that the economy and its workers adapt, and overall living standards generally improve (Chart 3). Technology has displaced entire classes of jobs very rapidly in the recent past, and many products such as smartphones would be extremely difficult to assemble if the work was done by hand. Box 1 provides several other examples. Yet as is usual for many things that have happened multiple times in the past, we are told "this time is different." Chart 3The Industrial Revolution Led To A Vast Improvement In Living Standards Box 1 Automation Displaced Entire Classes Of Jobs In The Recent Past, But Brought Enormous Benefits Before calculators and word processors were available, writing and mathematical calculations were done manually. Machines such as calculators and type writers enhanced productivity, eliminating many such jobs. Software applications such as Microsoft Word and Excel further accelerated this process. Not that long ago, welding was entirely a manual job but now most welding in factories is done by robots: you can usually tell a human weld on a mass produced product by its poor quality. Robots in the modern factory have freed up workers for other roles in the economy just as the massive loss of agricultural jobs in the 20th century did. Many modern electronic products such as smartphones would be extremely difficult to assemble if the work was done by hand, as the components are so small they require microscopes to manipulate. Even if it were possible to hand assemble a smartphone, it would take hours of manual labor to produce, and the quality would be very poor. The use of automation means that smartphones cost a few hundred dollars instead of a few thousand dollars and are affordable enough to be a mass market item. Some of the anxiety around automation-related job losses centers on the possibility that this time, robots will displace workers from the service and white-collar sectors. BCA's European Investment Strategy service has written about the potential for AI to replace jobs involving tasks that require specialized education and training, such as calculating credit scores or insurance premiums, or managing stock portfolios.4 Recent developments in AI (specifically deep learning algorithms) have allowed computers to solve pattern recognition problems that they could not previously solve. However, we do not believe AI in its current form poses a widespread risk to white collar employment for the following reasons: Both service-sector and white collar employees have been subject to replacement through automation already, and the economy has adapted: ATMs are robot bank tellers, self-checkout lanes are robot checkout kiosks, and "smart" gas and electric meters that can be read remotely replace human meter readers. The legal profession has been transformed by Google searches and the accounting business by accounting software. These tools allow certain clients to avoid the use of a lawyer or accountant altogether (for example in setting up a corporation or doing bookkeeping), or allow a firm to employ less skilled workers for the task. We can offer numerous other examples of white collar jobs which have been fully or partially automated over the past couple decades. In addition, recall that AI produces high probability answers which turn out to be wrong, and it requires a lot of subject specific training. Both of these are intrinsic to the implementation of the algorithm. In contrast, humans generally are much better at assigning confidence to decisions and train very rapidly because they have cross-expertise AI lacks. An implementation of AI has to meet BOTH of the following conditions to be successful: There has to be a lot of subject-specific data available A high probability assigned to a wrong answer is either inconsequential or can be easily overruled by a human It is also important to note that although AI may reduce the demand for accountants, insurance agents, credit analysts and other skilled professionals, these are exactly the sort of people that can handle retraining. Part 2: What Makes Upcoming Robots Revolutionary Upcoming robots will be different because they will not be confined to the factory floor. We believe this is a key transition point, and that the next 20 years or so will see as dramatic a change from robotics as was caused by the Internet. Factory robots have improved immensely due to cheaper and more capable control and vision systems. Early robots performed very specific operations under carefully controlled conditions -an assembly robot which encountered a misaligned component would simply install it that way, resulting in a defective product. Eventually vision systems were developed which allowed robots to adjust to varying conditions. As camera and computing costs continue to decline, vision systems are becoming more elaborate and useful, as they gather and process more information to make increasingly complex decisions. As these systems evolve, the abilities of robots to move around their environment while avoiding obstacles will improve, as will their ability to perform increasingly complex tasks. Mobile robots will likely rely on AI to make many decisions. In order to be cost effective, for many years AI will likely be hosted in cloud data centers. This is especially the case for consumer robots, which will have to be highly capable and yet cost effective. We discuss the implications for cloud services providers in more detail in Part 3: Investment Implications. We May Be Entering A 'Virtuous Cycle' In Robotics Improvements to one domain of robotic applications can be generally applied to others. Robotics technology is concurrently moving forward on many fronts ranging from the aforementioned vacuum cleaners, lawnmowers, and logistics robots, to medical orderlies,5 farm tractors,6 mining equipment,7 transport trucks,8 and cargo ships.9 Despite enormous differences in cost and value added, all of these applications are solving essentially the same problem. As with any other technological revolution, advances between different fields in robotics will be adapted, borrowed, extended and enhanced. This, in turn, creates opportunities for ever more applications, creating a virtuous cycle (Diagram 1). Diagram 1Robotics Will Enter Into A Virtuous Cycle There are few tasks which cannot be automated, but there is a definite cost-benefit tradeoff for each one. For example, a golf course may consider spending $25,000 for a robotic lawnmower, however costs were closer to $70 - $90,000 in 2015,10 and installed cost is even higher.11 Because the incremental cost of the machines is comprised of electronics, which will drop in price rapidly, it is probably a matter of another 2 or 3 years before the price moves to the point where mass adoption by groundskeepers begins. The same improvements to industrial lawnmowers will lead to more useable, albeit still pricy, consumer models which will probably enter mass market adoption 5 to 10 years from now. The same argument can be made for almost any manual chore ranging from cleaning the carpet to delivering parcels. We predict the virtuous cycle for robots will span several decades. As the cost of automation drops, better solutions will be developed, resulting in 'early retirement' of dated but otherwise fully functional robotic systems. This is the opposite of the Feature Saturation phenomenon currently present in the smartphone and PC industries - though feature saturation will eventually hit robots as well. A Self-Driving Car Is A Robot The most important robotics technology, from a macroeconomic perspective, is the rapidly advancing field of Autonomous Vehicles (AVs). The automobile industry is a significant part of the global economy, so changes in this industry will have profound implications. We covered AVs in detail in our April 8, 2016 Special Report. Due to technical and legal obstacles that must be overcome, a vehicle which can safely travel from point to point on major roads and city streets without driver intervention is probably 20 years away, +/- 5 years. The macro impact, however, will occur much sooner than that, due to the technologies developed on the way to full AVs. Vehicles are already offering features such as forward collision warning, autobrake, lane departure warning, lane departure prevention, adaptive headlights, and blind spot detection.12 Although we have only touched the surface, robotics are being applied across many industries, making even seemingly modest advances significant when measured in aggregate, as small changes in one industry are quickly adapted by other industries. It is noteworthy that this transition will likely occur during a period where demographic shifts, in particular in the most developed economies, signal the potential for labor shortages, or at least increasing cost of labor (Chart 4).13, 14 Robots may be showing up in the nick of time to improve both the economy and quality of life in the developed world. Chart 4Advances In Robotics Will Counter Adverse##br## Demographic Trends Part 3: Investment Implications The semiconductor industry has stagnated as the PC and smartphone markets entered a largely replacement-driven era (Chart 5). Although it may not be evident until the virtuous cycle is fully engaged, robotics represents another up-leg in demand for semiconductors and therefore should result in a significant improvement to industry growth rates. There is little opportunity for startup semiconductor companies nowadays due to the high costs of developing a new chip. Well positioned, established, semiconductor companies will be the primary beneficiaries of the robotics revolution. Large firms that attempt to fit their existing product offering into the industry (e.g. by remaining PC or mobile-phone centric) will fall behind. Winners System on a Chip (SoC) Vendors: Robotics hardware will more likely be implemented as "System on a Chip" (SoC) as this provides the greatest functionality with lowest cost and power consumption. SoCs generally consist of a variety of Intellectual Property (IP) "cores" which may be licensed from third parties. Typically, IP cores consist of a microprocessor and various specialized subsystems, depending on the application. Robotics SoCs are likely to include Digital Signal Processing (DSP) or Image Processing cores to process sensor data. SoC vendors who target or encourage robot development, such as Overweight-rated Texas Instruments, are likely to be favored by early movers in the space.15 We believe it is a matter of time before Graphics Processors (GPUs) currently used in AI/Deep Learning are replaced by processors specifically designed for AI, which will be cheaper and more power efficient.16 This is one of the reasons for our Underweight rating on Nvidia. Semiconductor Foundries, Mixed Signal and Automotive Semiconductor Vendors: This environment will favor the merchant semiconductor foundries which manufacture most SoCs. In addition, firms with "mixed signal" expertise will experience increased demand for motor controls, sensor interfaces, etc. As robotics features are added to automobiles, demand for automotive semiconductors should outpace that in other sectors. A significant degree of commonality in the parts and systems used in advanced automobiles will be used in other mobile robots, so "automotive" semiconductor demand should significantly outpace automobile sales. Sensor Vendors: Robots need a variety of sensors, depending on the application. Unlike factory floor robots which can make do with cameras, mobile robots will require advanced radar, ultrasound, laser scanning and other sensor types in order to provide redundancy and cope with weather and other related issues. Important sensors on prototype AVs are currently made in low volumes and are extremely expensive. Due to the number of sensors involved, we believe there is significant opportunity for companies offering aggressive cost reduction in sensor technology. Wireless Equipment and Service Providers: Most robotic systems will include some degree of wireless connectivity and participate in the "Internet of Things" (IoT). This will present challenges and opportunities for wireless equipment and service providers,17, 18 as networks will have to adapt to increased upload bandwidth (from robot to carrier) as well as novel billing schemes. Coverage will also have to be expanded to accommodate AVs as it is non-existent or spotty in large stretches of North American roadways. Not being able to check Facebook between two cities is one thing, losing your robot driver is much more serious. Our recent downgrade of Cisco to Underweight19 may appear inconsistent with the analysis above. However, the company's valuation is extremely elevated and revenues are declining (Chart 6). Any benefit Cisco will derive from investment into wireless infrastructure is several years out, and open-source hardware initiatives are gaining momentum.20 For that reason, we see the risks as outweighing the opportunities at the moment for the company. Chart 5Long Replacement Cycles Mean Slower ##br##Semiconductor Sales Chart 6Cisco's Stock Price Is Close To Tech Bubble##br## Levels Despite Declining Revenue Cloud Service Providers: Most robots will be on line and some will likely use cloud services to offload computational effort and minimize cost. A relatively "dumb" robotic lawnmower which offloads control to a shared computational resource in the cloud would probably be cheaper than a much more capable fully autonomous system. This will increase demand for cloud services, however the challenge of declining margins (due to increased competition in the space) will offset cloud services revenue growth somewhat in the long term. On balance, Overweight-rated Microsoft and Alphabet/Google, as well as Amazon, stand to benefit. Chart 7Eastman Kodak Tried To Ignore The Shift ##br##To Digital Cameras Losers We believe companies who ignore the robotics revolution will find themselves at a significant competitive disadvantage. This is not unprecedented in the technology sector: Digital Equipment Corporation (DEC) and Kodak vanished because their business models could not accommodate an obvious shift in their core markets (Chart 7). Similarly Intel and Microsoft completely missed the smartphone revolution. As we noted in our April 8, 2016 Special Report on AVs, the frequency and severity of crashes will decrease dramatically which will lead to reduced insurance rates, fewer repairs, and less money spent on accident related healthcare and rehabilitation. The economic losses of automobile crashes were estimated $871 billion in the US in 201021 and even a modest reduction in the frequency and severity of collisions due to partial automation would have a significant economic impact. "Dumb" Auto Parts Manufacturers: Fewer collisions will result in fewer repairs to people or vehicles. Auto parts manufacturers will fall into two camps: those with significant expertise in robotics will prosper, while those without such expertise will fall behind as the demand for replacement components (fenders, bumpers, doors, windshields, etc.) will decline. AVs are also likely to include advanced diagnostic and service reminder systems which will result in more timely service, reducing wear and tear on internal components as well. The Auto Insurance Industry: While it is doubtful robotics will ever eliminate auto accidents, the rate might be reduced to such a level that the auto-insurance industry, worth $157 billion in the US alone,22 will be much smaller in 20 years than it is today. This will be offset to a degree by greater demands for product liability insurance for AVs and robots in general. Brian Piccioni, Vice President Technology Sector Strategy brianp@bcaresearch.com Paul Kantorovich, Research Analyst paulk@bcaresearch.com 1 http://www.merriam-webster.com/dictionary/robot 2 http://www.computersciencelab.com/ComputerHistory/HistoryPt2.htm 3 https://www.agclassroom.org/gan/timeline/farm_tech.htm 4 Please see European Investment Strategy Special Report, "Female Participation: Another Mega-Trend," dated April 6, 2017, available at eis.bcaresearch.com. 5 http://www.tomsguide.com/us/Forth-Valley-Royal-Robots-Serco-Medicine,news-7124.html 6 http://modernfarmer.com/2013/04/this-tractor-drives-itself/ 7 http://www.asirobots.com/mining/ 8 http://www.theaustralian.com.au/business/powering-australia/rio-rolls-out-the-robot-trucks/story-fnnnpqpy-1227090421535 9 http://www.bloomberg.com/news/articles/2014-02-25/rolls-royce-drone-ships-challenge-375-billion-industry-freight 10 http://techon.nikkeibp.co.jp/english/NEWS_EN/20141210/393619/ 11 http://www.golfcourseindustry.com/article/do-robotic-mowers-dream-of-electric-turf/ 12 http://www.iihs.org/iihs/topics/t/crash-avoidance-technologies/topicoverview 13 http://gbr.pepperdine.edu/2010/08/preparing-for-a-future-labor-shortage/ 14 http://www.imf.org/external/pubs/ft/fandd/2013/06/das.htm 15 http://www.ti.com/corp/docs/engineeringChange/robotics.html 16 Please see Technology Sector Strategy Weekly Report, "Google - AI And Cloud Strategy," dated April 25, 2017, available at tech.bcaresearch.com. 17 http://www.fiercemobileit.com/press-releases/gartner-says-internet-things-will-transform-data-center 18 http://www.computerworld.com/article/2886316/mobile-networks-prep-for-the-internet-of-things.html 19 Please see Technology Sector Strategy Weekly Report, "Networking Equipment Update ," dated March 28, 2017, available at tech.bcaresearch.com. 20 http://www.businessinsider.com/att-white-box-test-should-scare-cisco-juniper-2017-4 21 http://www.nhtsa.gov/About+NHTSA/Press+Releases/2014/NHTSA-study-shows-vehicle-crashes-have-$871-billion-impact-on-U.S.-economy,-society 22 http://www.bloomberg.c/bw/articles/2014-09-10/why-self-driving-cars-could-doom-the-auto-insurance-industry

Highlights Key Portfolio Updates Synchronized global economic growth is driving real yields higher and boosting equities (Chart 1). Meantime, core inflation remains muted which will ensure that Fed policy stays sufficiently accommodative (Chart 2). Outside of the U.S., monetary tightening cycles are kicking into high gear, and this will sustain downward pressure on the greenback for now (Chart 3). Easy financial conditions are a boon for S&P 500 profit margins, and a slow moving Fed suggests that investors will extrapolate this goldilocks equity scenario for a while longer (Chart 4). Almost all of the S&P 500's advance year-to-date has been earnings driven (Chart 5). Buoyant EPS breadth bodes well for additional gains, a message in line with our SPX profit model. In terms of how far the broad market can advance from current levels before the next recession hits, we posit three ways to SPX 3,000 (Table 1). The ongoing sector rotation is a healthy development, and is not a precursor to a more viscous and widespread correction (Chart 6). Historically, receding sector correlations represent fertile ground for the overall equity market (Chart 7). Our macro models are signaling that investors should position for a sustained rebound in economic growth. Our interest rate-sensitive models are coming out on top, deep cyclicals are attempting to trough, while defensives took a turn for the worse (Chart 8). Deep cyclical sectors are the most overvalued followed by early cyclicals, while defensives remain in undervalued territory. Interest rate sensitives have recently become overbought, while both deep cyclicals and defensives are in the oversold zone (Charts 9 & 10). The most attractive combination of macro, valuation and technical readings are in the financials and consumer discretionary sectors. The least attractive combinations are in materials, technology and utilities sectors. Prospects for a durable synchronized global economic growth, a coordinated tightening G10 central bank backdrop and cheapened U.S. currency warrant an early cyclical portfolio tilt, with the defensive/deep cyclical stance shifting to a more neutral setting. Chart 1Synchronized Global Growth Chart 2Muted Core Inflation Chart 3G10 Central Banks Map Chart 4Easy Financial Conditions Boost Margins Chart 5Buoyant Breadth Bodes Well Table 1SPX Dividend Discount Model SPX EPS & Multiple Sensitivity ERP Analysis Chart 6Healthy Rotation Chart 7Falling Correlations Boost The S&P 500 Chart 8Interest Rate Sensitives Come Out On Top Chart 9Underowned... Chart 10...And Undervalued Defensives Chart 11Earnings Growth Set To Accelerate Chart 12Consumers Are Feeling Flush Chart 13Improving Fundamentals Signal A Trough Chart 14Staples Remain The Household's Choice Chart 15Weaker Rents And Higher Vacancies Bode Ill Chart 16Profits Look Set To Downshift Chart 17Cyclical Recovery Driving Backlogs Lower Chart 18Margin Recovery Appears Priced In Chart 19Pricing Collapse Driving Earnings Decline Chart 20Productivity Declines Will##br## Keep A Cap On Valuations Chart 21Valuations At Risk##br## When Inflation Returns Feature S&P Financials (Overweight) Our financials cyclical macro indicator (CMI) has climbed to new cyclical highs, supported by broad-based improvement among its components. Firming employment data, historically a precursor to credit growth and capital formation, has been a primary contributor to the lift in the CMI. Importantly, a tight labor market has not yet driven sector costs higher, which bodes well for near term profits (Chart 11 on page 8). A budding revival in loan demand is corroborated by our bank loan growth model, which points to the largest upswing in credit growth of the past 30 years. Soaring consumer and business confidence, rising corporate profits and a potential capital spending revival underpin our loans and leases model (Chart 11 on page 8). Expanding housing prices, increased housing turnover and rebounding mortgage purchase applications support household capital formation (Chart 11 on page 8). A recent lift in share prices partially reflects this much-improved cyclical outlook. Still, the message from our valuation indicator (VI) is that there is significant running room. Our technical indicator (TI) has retreated from overbought levels, but remains solidly in the buy zone, setting the stage for the next leg up in the budding relative bull market. We expect sentiment to steadily improve, buoyed by deregulation moving closer to reality as a partial Dodd-Frank replacement passed the House. Chart 22 S&P Consumer Discretionary (Overweight) Our CMI has snapped back after a tough year, driven by improving real wage growth. Higher home prices, a tighter labor market and increasing disposable income have consumers feeling flush, which should boost discretionary outlays. Importantly, consumer deleveraging is far advanced with the debt service ratio hovering near decade lows (Chart 12 on page 9). Further, our Consumer Drag Indicator remains near its modern high, suggesting EPS gains will prove resilient (Chart 12 on page 9). Although somewhat expensive from a historical perspective, our VI remains close to the neutral zone, underscoring that profits will be the primary sector price driver. Our TI has fully recovered from oversold levels, and is flirting with the buy zone, underscoring additional recovery potential. We continue to recommend an overweight position, favoring the media-oriented sub-indices. Chart 23 S&P Energy (Overweight) Our CMI has recently ticked up from its all-time lows, and is now diverging positively from the share price ratio. Ongoing gains in domestic production, partially offset by a still-high sector wage bill, underlie the recent CMI uptick. The steepest drilling upcycle in recent memory is showing some signs of fatigue. Baker Hughes reported the first weekly decline in 24 weeks in the oil rig count for the week ending June 30th. At least a modest deceleration in shale oil production is likely. Encouragingly, U.S. crude oil inventories are contracting, which could presage a renormalization of domestic inventories, market share gains for domestic production and at least a modest rally in energy shares (Chart 13 on page 9). Our S&P energy sector relative EPS model echoes this cautiously optimistic industry backdrop, indicating a burgeoning recovery in sector earnings (Chart 13 on page 9). The TI has returned to deeply oversold levels, suggesting that an oversold bounce could soon occur at a time when valuations are gravitating back to earth. Chart 24 S&P Consumer Staples (Overweight) The consumer staples CMI has turned lower recently, held back by healthy economic data, particularly among confidence indicators. That should drive a preference for spending over saving after a long period of thrift, although a relative switch from staples into discretionary consumption has not yet taken firm hold. The savings rate has also stayed resilient, despite consumer euphoria (Chart 14 on page 10). The good news is that tamed commodity prices and a soft U.S. dollar should provide bullish offsets for this global-exposed (Chart 14 on page 10) and commodity-input dependent sector. A modestly weaker outlook for staples is more than reflected in our VI, which is still parked in undervalued territory. Technical conditions are completely washed out, signaling widespread bearishness, which is positive from a contrary perspective. Chart 25 S&P Real Estate (Neutral) Ongoing improvements in commercial & residential real estate prices continues to push our real estate CMI higher. However, the outlook for REITs has darkened; rents have crested while the vacancy rate found its nadir in 2016, suggesting further rent weakness on the horizon (Chart 15 on page 10). Further, bankers appear less willing to extend commercial real estate credit; declines in credit availability will directly impact REIT valuations. Our VI is consistent with our Treasury bond indicator, indicating that both are at fair value. Our TI is starting to firm from extremely oversold levels, a positive indication for both 12- and 24-month relative performance. Chart 26 S&P Health Care (Neutral) Our CMI has rolled over, driven by a steep decline in pharma pricing power (Chart 16 on page 11). In fact, the breadth of sector pricing power softness has spread, just as the majority of the industries we cover is enjoying a selling price revival. The divergence between the CMI and recent sector relative performance suggests that the latter has been mostly politically motivated, and may lack staying power. Worrisomely, the sector wage bill has spiked; in combination with a weaker top line, the earnings resilience of the sector could be at risk. Relative valuations remain appealing, but technical conditions are shaky, as our TI has bounced from oversold levels but is still in negative territory. Taken altogether, we would lean against the recent advance in relative performance. Chart 27 S&P Industrials (Neutral) The CMI has recovered smartly in the past couple of quarters, lifted mostly by a weaker U.S. dollar. The sector has moved laterally since the U.S. election. The improved export outlook is a positive, but a lack of response in hard economic data to the surge in confidence is a sizable offset. An inventory imbalance has largely unwound over the past six months, as durable goods orders are easily outpacing inventories, coinciding with a return of some pricing power to the sector (Chart 17 on page 11). Still, years of capacity growth in excess of production and the resulting low utilization rates mean that pricing gains may stay muted unless demand picks up substantially. Our valuation gauge is near the neutral zone, but there is a wide discrepancy beneath the surface, with construction & engineering trading cheaply and railroads and machinery commanding premium valuation multiples. Our TI has returned close to overbought levels, potentially setting the stage for another move higher. Chart 28 S&P Utilities (Neutral) Our CMI for the utilities sector remains in a long-term downtrend, albeit one with periodic countertrend moves. Most of the weakness in the CMI relates to external factors, such as robust leading indicators of global economic growth (Chart 18 on page 12). Encouragingly, the sector's wage bill has slowed from punitively high levels, and combined with improving pricing power should allow for some margin recovery (Chart 18 on page 12). Utilities have outperformed other defensive sectors, likely due to the expectation that the new U.S. administration's long-awaited tax reform will have outsized benefits to this domestic-focused industry. As a result, valuations have been creeping up, though not sufficiently enough to warrant an underweight position. Our TI has reversed its steep fall over the past year, but is unlikely to bounce through neutral levels in the absence of a negative economic shock. Ergo, our preferred strategy is to remain at benchmark, but look for tradable rally opportunities. Chart 29 S&P Telecom Services (Underweight) Our CMI for telecom services has moved laterally, as much-reduced wage inflation is fully offset by the sector's plummeting share of the consumer's wallet and extremely deflationary conditions (Chart 19 on page 12). Our sales model paints a much darker picture, pointing to double-digit topline declines for at least the next few quarters, owing to the plunge in pricing power deep into negative territory (Chart 19 on page 12). The sector remains chronically cheap, and has all the hallmarks of a value trap, as relative forward earnings remain in a relentless secular downtrend. It would take a recession to trigger a valuation re-rating. Our Technical Indicator has nosedived but, like the VI, cycles deep in the sell zone have not proven reliable indicators that a relative bounce is in the offing. Chart 30 S&P Materials (Underweight) Recent Fed rate hikes have driven down the CMI close to all-time lows. The sector has historically performed very poorly in tightening cycles owing to U.S. dollar appreciation and the ensuing strains on the emerging world. Weak signals from China have also helped take the steam out of what looked like a recovery in the CMI last year. Commodity-currencies have rallied, but not by enough to offset a relapse in pricing power and weak sector productivity (Chart 20 on page 13). The heavyweight chemicals group (comprising more than 73% of the index) continues to suffer; earnings growth relies heavily on global reflation, an elusive ingredient in the era of a globally synchronized tightening cycle. Sagging productivity warns that profitability will remain under pressure. Valuations have now spent some time in overvalued territory; without a recovery in earnings growth, a derating is a high probability outcome. Our TI has dipped into the sell zone, indicating a loss of momentum and downside relative performance risks. It would be highly unusual for the sector to stay resilient in the face of a negative TI reading. Chart 31 S&P Technology (Underweight) The technology CMI is in full retreat, driven by ongoing relative pricing power declines and new order weakness. However, the sector had been resilient, until recently, as a mini-mania in a handful of stocks and the previously red-hot semiconductor group have provided resilient support. That reflected persistently low inflation and a belief that interest rates would still low forever. After all, tech stocks thrive in a disinflationary/deflationary environment and suffer during inflationary periods (Chart 21 on page 13). Nevertheless, a recovering economy from the first quarter's lull and tight labor market suggest that an aggressive de-rating in sky-high valuations in previous juggernauts is a serious threat, especially if recent disinflation proves transitory. Our relative EPS model signals a profit slide this year. In the context of analyst estimates of double-digit earnings growth, sector downside risk is elevated. Our VI is not overdone, but that partly reflects the massive overshoot during the bubble years. Our TI is extremely overbought, suggesting that profit-taking is likely to persist. Chart 32 Size Indicator (Overweight Small Vs. Large Caps) Our size CMI has retraced some of its 2016 climb, but remains firmly above the boom/bust line. Keep in mind that this CMI is not designed as a directional trend predictor, but rather as a buy/sell oscillator. Small company business optimism is near modern highs, as pricing and consumption vigor push domestic revenues higher. A smaller government footprint, i.e. fewer regulatory hurdles, and tax relief will disproportionately benefit SMEs. The prospect of trade barriers clearly favors the domestically focused small cap universe and underlie part of the post-election euphoria. Top line growth will need to persist if small businesses are to offset a higher wage bill, as labor looks more difficult to import and the economy pushes against full employment. Valuations have improved and the share price ratio has fully unwound previously overbought conditions. We expect the recent rally to gain steam.\ Chart 33 Anastasios Avgeriou, Vice President U.S. Equity Strategy & Global Alpha Sector Strategy anastasios@bcaresearch.com Chris Bowes, Associate Editor chrisb@bcaresearch.com

Highlights EM growth is set to falter due to budding weakness in Asia's trade, a decline in commodities prices, and the frailty of EM banking systems. U.S./DM bond yields are heading higher for now and China's money/credit growth is set to decelerate. Together, these will trigger a selloff in EM risk assets. The EM equity outperformance versus DM has been extremely narrow and, hence, it is unsustainable. The EM tech sector is unlikely to support the equity rally much further because these stocks are overbought, and the Asian semiconductor cycle is entering a soft patch. Take profits on the yield curve flattening trade in Mexico. Stay long MXN on crosses versus BRL and ZAR and continue overweighting Mexican bonds. Feature Higher bond yields within the advanced economies and policy tightening in China remain the key threats to EM risk assets in the near term (the next three months). In the medium-term (the next three to 12 months or so), the principle risk is weaker growth in EM/China, and hence contracting corporate profits in EM. While this rally has lasted longer and has gone further than we had anticipated, we find the risk-reward for EM risk assets extremely unattractive. In fact, the huge amount of money that has flown into EM equity and debt markets in the past year amid poor fundamentals suggests to us that the next move will not be a simple correction but rather a major bear market. EM Recovery To Falter Although on the surface global growth appears to be on solid footing, there are early signs of a slowdown in Asian exports. Both Taiwanese exports of electronic parts and the country's overall exports to China have rolled over - the latter two lead global export volumes by a few months, as shown in Chart I-1. The reason why Taiwanese exports of electronic parts lead global trade cycles is because these parts are used in the assembly of final products, and producers order and receive these parts before final products are made and shipped. Similarly, a lot of Taiwanese exports to China serve as inputs into final products assembled in China and shipped worldwide. This is why Taiwan's overall shipments to China lead global trade cycles. On top of this, Korea's overall manufacturing and semiconductor shipments-to-inventory ratios have relapsed. Historically, these ratios have correlated with the KOSPI (Chart I-2). Chart I-1Signs Of Slowdown ##br##In Asian Trade Chart I-2Korea's Manufacturing ##br##Growth Has Peaked Outside the manufacturing-based Asian economies, most other EMs are basically commodities plays, except for India and Turkey. The latter two countries are not only relatively small, but Indian stocks are also expensive and overbought while Turkey is sufferings from its own malaise. In short, if the Asian tech cycle rolls over, China slows down and commodities prices relapse, EM growth will falter. That is why the focus of our analysis has been and remains on China's growth, commodities prices and the Asian trade cycle. Meanwhile, many banking systems in the developing world remain frail following the credit excesses of the preceding years. BCA's Emerging Markets Strategy service remains bearish on commodities, and believes the breakdown in the correlation between commodities prices and EM risk assets since the beginning of this year is temporary and unsustainable. As for the increased importance of the technology sector in the EM equity benchmark, we offer further analysis on page 10. Our negative view on EM growth is not contingent on a relapse in U.S. and euro area growth. In fact, our current baseline scenario is that DM growth will remain solid, and government bond yields in these markets will rise further. Although growth in both the U.S. and euro area is robust, their importance for EM has become small. For example, exports to the U.S. and EU altogether account for 35% of total exports in China, 22% in Korea and 20% in Taiwan. All in all, if commodities prices continue to downshift and Asian trade slows, as we expect, EM growth will decelerate. Bottom Line: EM growth is set to falter notably, despite solid demand growth in DM. Liquidity Backdrop To Deteriorate Investors and market commentators often use the term "liquidity" loosely, and denote numerous things by it. We use the term 'liquidity' to signify the level and/or direction of interest rates as well as the level and/or direction of money/credit growth. Below we review some different perspectives of liquidity: EM narrow money (M1) growth points to both lower share prices and a relapse in EPS growth in the months ahead (Chart I-3). Chart I-3EM: Narrow Money (M1) Points To EPS Downturn And Lower Stock Prices This is an equity market cap-weighted aggregate of narrow money growth. M1 growth in China - the largest market cap in the EM equity benchmark - has been essential in driving aggregate EM M1 cycles in recent years. More importantly, China has been tightening liquidity, yet the majority of investors remain complacent about its impact on growth. In this regard, investors should remind themselves that monetary policy works with time lags, and the considerable rise in China's interbank rates and corporate bond yields will produce a growth slowdown in the real economy later this year. Chart I-4 demonstrates that China's broad money growth (M2) - which has in effect dropped to an all-time low - leads bank and non-bank credit origination. This suggests the odds of a slowdown in bank and non-bank credit flows are considerable. There has been no stable correlation between the size of DM central banks' balance sheets and EM stock prices, bond yields and currencies since 2011. Therefore, the Fed's move to reduce its balance sheet by itself should not matter for EM risk assets from a fundamental perspective. Nevertheless, EM risk assets have been negatively correlated with U.S. TIPS yields (Chart I-5), and the potential further rise in U.S./DM real and nominal yields will hurt EM sentiment, with flows to EM drying up. Chart I-4China: M2 Heralds ##br##Slowdown In Credit Growth Chart I-5EM Currencies To Depreciate ##br##As U.S. Real Yields Drift Higher Importantly, traders' bets on U.S. yield curve flattening have risen, as evidenced by large short positions in 2-year U.S. notes and considerable long positions in 10- and 30-year bonds. The unwinding of these positions will drive bond yields higher. Chart I-6Precious Metals Signal ##br##Higher Real Yields Ahead Notably, precious metal prices have failed to break out amid a weak U.S. dollar and have lately relapsed (Chart I-6). Precious metals prices could be sensing a further rise in U.S. real yields and/or an upleg in the U.S. dollar. Both the rise in U.S. yields and a stronger dollar will be negative for EM. Bottom Line: We maintain that U.S./DM bond yields are heading higher in the months ahead and China's money/credit growth is set to decelerate. Altogether these will trigger a selloff in EM risk assets. Underwhelming EM Technicals It is a well-known fact that flows into EM debt funds have been enormous, making EM fixed-income markets vulnerable to a reversal of these flows at the hands of tightening liquidity and EM growth disappointments, as argued above. This section focuses on a number of bearish technical signals for EM share prices. In particular: The EM equity implied volatility curve - 12-month VOL minus 1-month VOL - is at a record steep level, based on available history (Chart I-7). Periods of VOL curve flattening have historically coincided with a selloff in EM share prices, as evidenced by Chart I-7. Given that the VOL curve is record steep, the odds of flattening are substantial. Consistently, the probability of an EM selloff is considerable. Chart I-7A Sign Of Top In EM Share Prices? In absolute terms, EM equity implied 1-month VOL is at an all-time low and reflects enormous complacency about EM. EM equity breadth has also been poor. The MSCI EM equally weighted stock index (where each stock commands an equal weight) has considerably underperformed the EM market cap-weighted index since May 2016 (Chart I-8). This suggests the EM rally has been very narrowly driven. The same measure for DM stocks has done relatively better (Chart I-8). Remarkably, EM has underperformed DM based on equal-weighted equity indexes since July 2016 (Chart I-9). This confirms that EM outperformance against DM since early this year has been largely driven by a few stocks, namely the five companies accounting for the bulk of the EM tech index. Furthermore, EM ex-tech stocks have also failed to establish a bull market, in that the index remains below its prior low (Chart I-10). Chart I-8EM Equity Breadth ##br##Has Been Poor Chart I-9EM Versus DM: Relative ##br##Equity Performance Chart I-10EM Ex-Technology Stocks: ##br##Rebound But No Bull Market Finally, the magnitude of the EM rally this year is somewhat misleading. Only three out of 11 sectors - technology, real estate and consumer discretionary (mainly, autos) - have outperformed the EM benchmark this year. Table I-1 illustrates that these three sectors have been responsible for about 50% of the EM rally year-to-date while their market cap is only 36% of total. Table I-1EM Rally In 2017: Return Decomposition Bottom Line: The EM equity outperformance versus DM has been extremely narrow: it has been due to five tech companies that are currently very overbought (see Chart I-8 on page 7). Valuations EM equity valuations are not cheap, as most of the rally since the early 2016 bottom has been driven by a multiple expansion rather than a rise in corporate earnings (Chart I-11). We are not suggesting EM stocks are expensive, but they do not offer good value either. In fact, good companies/countries/sectors are expensive, while those, that appear "cheap", command low multiples for a reason. As for currencies, they are not cheap either. The real effective exchange rate of EM ex-China is rather elevated after the rally of the past year or so (Chart I-12). Finally, not only are EM sovereign and corporate spreads close to record lows, but also local government bond yield spreads over U.S. Treasurys are at multi-year lows (Chart I-13). Chart I-11Decomposing EM Equity ##br##Return Into P/E And EPS Chart I-12EM Ex-China Currencies ##br##Are Not Cheap And Vulnerable Chart I-13EM Local Bond Yields Spreads ##br##Over U.S. Treasurys Is Low Bottom Line: Adjusted for fundamentals, EM equity, currency and credit market valuations are rather expensive. The odds are that the reality will underwhelm expectations, and that EM risk assets will sell off. A Word On EM Tech: Is This Time Different? During our recent trip to Europe, many clients argued that the increased weight of technology in the EM equity benchmark will cause EM share prices to decouple from the traditional variables they have historically been correlated with, like commodities prices, commodities stocks and others. In brief, the argument is that EM has entered a new paradigm, and past correlations will not work. The last time we at BCA heard similar arguments was back in early 2000 at the peak of the global tech bubble. At the time, the argument was that this time was truly different - that tech stocks could drive the market higher regardless of the old indicators and the performance of other sectors. Chart I-14 portrays that in 2000 the EM equity index, for several months, decoupled from global mining and energy stocks when tech and telecom stocks went ballistic. Chart I-14EM And Commodities Stocks: Can The Recent Decoupling Persist? Back in 2000, the bubble was in tech and telecom stocks. These two sectors together comprised 33% of the EM benchmark as of January 2000 (Chart I-15). This compares with a 27% weighting of technology stocks alone in the EM benchmark now. The combined weight of energy and materials is currently 14% versus 19% in January 2000, as can been seen in Chart I-15. Chart I-15EM Equities Sector Composition Now And In Late 1990s To be sure, we are not suggesting that tech stocks are in a bubble as they were in 2000, and that a bust in share prices is imminent. However, several observations are noteworthy: Chart I-16EM Equities Sector ##br##Composition Now And In Late 1990s Just because EM tech stocks have skyrocketed in the past six months does not mean they will continue to do so. In fact, EM tech is already extremely overbought and likely over-owned (Chart I-16). As global bond yields rise, high-multiples stocks, especially social media/internet companies, could selloff. We, like all macro strategists, can add little value on how to value internet/social media companies and assess their business models. However, we can shed some light on the business cycle in the semiconductor sector that influences performance of heavyweight companies like TSMC and Samsung. As Chart I-1 and I-2 on pages 1 and 3 demonstrate, there are signs that the semi/electronics cycle in Asia has peaked. We do not mean that this sector is headed toward recession. But this is a very cyclical sector, and some slowdown is to be expected following the growth outburst of the past 18 months. This will be enough to cause a correction in semi stocks from extremely overbought levels. The tight correlation between EM share prices and energy and mining stocks has persisted for the past 20 years (Chart I-14 on page 10), and we believe it will re-establish as technology stocks' shine diminishes. Finally, we have been recommending an overweight position in Taiwanese, Korean, and Chinese stocks primarily because of their large tech exposure. For now we maintain this strategy. Bottom Line: While the technology sector could make a difference for EM economies and equity markets in the long run, it is unlikely to support the current rally and outperformance much further. Indeed, tech stocks are heavily overbought, and the Asian semiconductor cycle is entering a soft patch. In brief, the overall EM equity benchmark is at a major risk of relapse and underperformance versus the DM bourses. Stay underweight. Arthur Budaghyan, Senior Vice President Emerging Markets Strategy arthurb@bcaresearch.com Mexico: Take Profits On Yield Curve Flattener And Stay Long MXN On Crosses Mexico's 10/1-year swap curve has inverted for the first time in history and we are taking a 160 basis points profit on our yield curve flattening trade recommended on June 8, 2016 (Chart II-1). Will the central bank begin cutting interest rates soon? Is it time to get bullish on stocks? We do not think so: Inflation is well above the central bank's target and is broad based (Chart II-2). Notably, wage growth is elevated (Chart II-3). Chart II-1Mexico's Yield Cruve Has Inverted: Take Profits Chart II-2Mexico: Inflation Is Above The Target Chart II-3Mexico: Wage Inflation Is High Provided productivity growth is meager in Mexico, unit labor costs - which are calculated as wage per hour divided by productivity (output per hour) - are rising. This will depress companies' profit margins and make them eager to hike selling prices. This will in turn prevent inflation from falling and, consequently, hamper Banxico's ability to cut rates for now. Meanwhile, the impact of higher interest rates will continue filtering through the economy. High interest rates entail further slowdown in money and credit growth and, hence, in domestic demand. Both consumer spending and capital expenditure by companies are set to weaken a lot (Chart II-4). This will weigh on corporate profits and share prices. Fiscal policy is not going to support growth either because policymakers will opt to consolidate the recent improvement in the fiscal deficit. This is especially true given the latest selloff in oil prices. Notably, oil accounts for about 20% of government revenues. Even though non-oil exports and manufacturing output are accelerating (Chart II-5), non-oil exports - that make about 30% of GDP - are not large enough to offset the deceleration in domestic demand from monetary tightening. Chart II-4Mexico: Domestic Demand To Buckle Chart II-5Mexico: Exports Are Robust Investment Conclusions The outlook for Mexican stocks in absolute terms is poor as domestic demand will slump, further hampering corporate profits. Meanwhile, inflation is still elevated to justify rate cuts by the central bank. Within an EM equity portfolio, we recommend neutral allocation to this bourse mainly due to our expectations of the peso outperforming other EM currencies. The Mexican peso is still cheap (Chart II-6). Therefore, we continue to recommend long positions in MXN versus ZAR and BRL. If EM currencies depreciate and oil prices drop further as we expect, it will be hard for the peso to appreciate versus the U.S. dollar. However, the peso will outperform many other EM currencies. Mexican local currency bonds and sovereign credit offer good value relative to their EM counterparts. (Chart II-7). Fixed income investors should continue to overweight Mexican local currency and sovereign credit within their respective EM benchmarks. Chart II-6Mexico: Peso Is Cheap Chart II-7Continue Overweighting Mexican Bonds Stephan Gabillard, Senior Analyst stephang@bcaresearch.com Arthur Budaghyan, Senior Vice President Emerging Markets Strategy arthurb@bcaresearch.com Equity Recommendations Fixed-Income, Credit And Currency Recommendations

Out of the gate, our financials versus tech sector pair trade has caught fire, returning 6.2% in the last 2 weeks. This reflects the tightening of the historically wide relative market capitalization differential (second and third panels), as we expected. Despite the solid return since we put the trade on, we think we are in the early stages of an earnings-driven rotational correction, with greater gains ahead. Pricing power in financials has continued to strengthen at the expense of deflating tech selling prices (bottom panel) which should start closing the profit gap. We expect early validation of this thesis to begin this week with the opening of earnings season for financials on Friday. Net, investors should gain exposure to S&P financials using S&P tech as a source of funds.

Over the past month, we have reduced the extent of our consumer staples overweight, downgrading soft drinks to underweight and hypermarkets to neutral. In contrast, in May we boosted the S&P financials index to overweight on the back of improving earnings fundamentals. As a result, swapping out consumer staples for financials in our existing pair trade versus the tech sector makes sense. This relative share price ratio is at a critical juncture and has dropped to its long term support level (top panel). The valuation case is equally compelling: financials are deeply undervalued and unloved compared with the tech sector (bottom panel), such that even a modest shift in sentiment would drive a large relative price swing. Adding it up, we recommend swapping consumer staples with financials in our pair trade versus the tech sector. Bottom Line: Switch consumer staples out and sub financials in the pair trade versus tech stocks. For additional details, please see Monday's Weekly Report.

Highlights Portfolio Strategy Swap consumer staples into financials in our pair trade versus the tech sector. Relative profit fundamentals signal that this relative share price ratio will soon come alive. Global growth tailwinds argue for lifting the air freight & logistics index to high-conviction overweight status. Recent Changes S&P Financials/S&P Tech - Switch the long side of the S&P Consumer Staples/S&P Tech pair trade from S&P Consumer Staples to S&P Financials. S&P Consumer Staples - Remove from the high-conviction overweight list. S&P Air Freight & Logistics - Add to the high-conviction overweight list. Table 1Sector Performance Returns (%) Feature Equities broke out to new highs early last week, and there are good odds that a playable rally will unfold. Investors' jitters have recently focused on the bear market in oil prices and weak core CPI, which have joined forces to push down inflation expectations (Chart 1). However, we have a more bullish interpretation. Unlike in late-2015/early-2016, oil and stock prices have decoupled. True, energy stocks are plumbing multi-decade lows relative to the broad market, but the energy sector comprises less than 6% of the S&P 500's market cap. In fact, the two largest S&P 500 constituents have a greater weight than the 34 stocks in the S&P energy index combined. In other words, the energy sector's broad market influence has been severely diluted. We think it is unlikely that the positive correlation between oil and stock prices reasserts itself. Rather, our sense is that this is likely an energy/commodity-centered deflation that will not have a serious contagion on the rest of the corporate sector. High yield energy spreads continue to widen, but the overall junk spread is flirting with cyclical lows. This stands in marked contrast with the summer of 2014 and late-2015, the last time oil prices melted (second panel, Chart 1). Chart 2 shows that the nonfarm business sector and the GDP implicit price deflators, both of which are reliable corporate sector pricing power proxies, are positively deviating from core CPI. These deflators have historically been excellent leading indicators of inflation and signal that the recent poor inflation prints will likely prove transitory. Importantly, the U.S. is a large closed economy that benefits greatly from lower oil prices, via a boost to discretionary income. Lower energy costs are adding to an already stimulative backdrop owing to the decline in the U.S. dollar and Treasury yields. At the margin, the broad corporate sector also benefits from oil price deflation: energy is a non-trivial input cost. Our more optimistic overall economic and market outlook is also borne out by survey data: economists revised higher their U.S and global GDP growth expectations both for 2017 and 2018, according to Bloomberg estimates (bottom panel, Chart 1). Finally, real yields, the bond market's gauge for economic growth expectations, have climbed close to a 2-year high, and suggest that GDP growth will soon pick up steam (Chart 1). Our view remains that this is a goldilocks scenario for equities, as it may keep the Fed at bay for a while longer and sustain easy financial conditions. This thesis also assumes that the corporate sector will maintain its pricing power gains, and likely pull consumer prices out of their lull. On that front, we have updated our corporate pricing power proxy and while it has lost some steam of late, it continues to expand at a healthy clip (Chart 3). Chart 1Decoupled Chart 2Implicit Price Deflators Lead Core CPI Chart 3Corporate Pricing Power Is Fine Table 2 shows our updated industry group pricing power gauges, which are calculated from the relevant CPI, PPI, PCE and commodity growth rates for each of the 60 industry groups we track. The table also highlights shorter term pricing power trends and each industry's spread to overall inflation in order to identify potential profit winners and losers. Table 2Industry Group Pricing Power Our analysis concludes that still ¾ of the industries we cover are enjoying rising selling prices and 43% are also beating overall inflation rates. Admittedly, the inflation rates have come down since our April update, and there was a tick up in the number of deflating industries from 14 to 16, but that figure is still down from the 19 registered in January. Importantly, 27 out of 60 industries have clocked a rising pricing power trend down from 31 in April, but still up from 20 in January, 14 have a flat trend and 19 are falling. Encouragingly, corporate sector selling prices are still comfortably outpacing wage inflation, which suggests that the positive momentum in profit margins has staying power (Chart 3). One theme that stands out from our analysis is that commodity related industries have either falling or flat inflation trends, with the exception of aluminum and chemicals. We take this as confirmation that resources are at the epicenter of deflation/disinflation pressures. Similarly, the majority of tech sub-sectors are still fighting deflation and suffer from a flat or down trend in selling prices. Adding it all up, the recent mild slowdown in corporate sector selling prices is transitory, mostly commodity related and unlikely to infect the broad business sector. There are high odds that an earnings-led playable break out phase in the equity market will develop from here. This week we promote an industrials sub-sector to our high-conviction overweight list and swap a safe haven sector out, and also tweak our long/short pair trade. Pair Trade Tweak: Long Financials/Short Tech Over the past month, we have reduced the extent of our consumer staples overweight, downgrading soft drinks to underweight and hypermarkets to neutral. In contrast, in May we boosted the S&P financials index to overweight on the back of improving earnings fundamentals. As a result, swapping out consumer staples for financials in our existing pair trade versus the tech sector makes sense. This relative share price ratio is at a critical juncture and has dropped to its long term support level (top panel, Chart 4). Importantly, the relative market capitalization differential is at its widest gap since the tech bubble (Chart 5) and a renormalization is in order. Chart 4Long Term Support Should Hold Chart 5Unsustainable Gap The valuation case is equally compelling: financials are deeply undervalued and unloved compared with the tech sector (Chart 4), such that even a modest shift in sentiment would drive a large relative price swing. The macro outlook is rife with catalysts to trigger a renormalization. Our respective Cyclical Macro Indicators (CMI) signal that financials profits will best tech sector earnings in the coming quarters (top panel, Chart 6). Historically, relative performance has moved in lockstep with relative profitability. The message from our CMIs is that relative earnings will move decisively in favor of the financials sector, thereby producing positive price momentum (bottom panel, Chart 6). A simple relative demand indicator concurs with our CMIs message: bank loan growth should outpace tech capital expenditures in the back half of the year. The middle panel of Chart 6 shows our recently published bank loans and leases regression model compared with our U.S. Capex Indicator (a good proxy for tech spending) and the message is to expect a catchup phase in relative share prices. If our thesis proves accurate, then relative demand will soon show up in relative top line figures. On that front, our forward looking relative sales per share models argue that the budding recovery in relative revenue is sustainable (Chart 7). Relative pricing power dynamics provide another source of support, both in terms of sales and operating profit margins. Firming financials pricing power is the mirror image of chronically deflating tech selling prices (Chart 7). Keep in mind that overall mild price inflation is a boon for financials because it will keep monetary conditions from becoming overly tight, which would undermine credit quality and availability. Using the nonfarm business sector's implicit price deflator as a proxy for overall inflation, the (third panel, Chart 7) shows that relative share prices move in lockstep with overall corporate sector prices. In terms of economic undercurrents, if geopolitical risks remain muted and financial conditions reasonably accommodative, then a further boost in economic and investor sentiment is likely. History shows that the financials/tech share price ratio has benefited when risk premia recede. The same relationship is also evident in the positive correlation with our U.S. sentiment indicator and real 10-year bond yield (Chart 8), and inverse correlation with corporate bond spreads (not shown). Chart 6Heed The Relative##br## CMI Signal Chart 7Financials Have##br## The Upper Hand Chart 8Improving Economy = ##br##Go Long Financials/Short Tech Finally, recent positive bank sector news suggests that financials have the upper hand in this share price ratio. Banks passed the Fed's stringent stress test with flying colors and should become more shareholder friendly, i.e. boost dividend payouts and reinstate/augment share retirement. In addition, even a modest watering down of Dodd-Frank will also lift the appeal of banks and financials at the expense of tech stocks in the coming quarters. Adding it up, we recommend swapping consumer staples with financials in our pair trade versus the tech sector. Relative profit fundamentals suggest that this relative share price ratio will soon spring into action. Bottom Line: Switch consumer staples out and sub financials in the pair trade versus tech stocks. We are also removing the S&P consumer staples index from our high-conviction overweight list for a modest gain of 0.1% since the early-January inclusion. The latter move makes room for an upgrade to high-conviction of a transportation sub-group that has caught fire since our recent upgrade to overweight. Air Freight Stocks Achieve Liftoff! We raised the S&P air freight & logistics group to overweight two months ago, reflecting a lack of recognition in either valuations or earnings estimates that a global trade revival was unfolding and washed out technical conditions. Since then, this transportation sub-group has regained its footing, and firming profit fundamentals now embolden us to add air freight stocks to our high-conviction overweight list. The relative share price ratio has smartly bounced off its GFC lows. Similarly, our Technical Indicator found support at one standard deviation below the historical mean, a typical launch point for playable rallies. Importantly, deeply discounted valuations remain in place, both in terms of P/S and P/E ratios (Chart 9). We expect the rebound in global growth to help unlock excellent value in air freight equities. Global trade is reviving. The synchronized DM and EM economic recovery has buoyed the global manufacturing PMI, which continues to trend well above the boom/bust line. Both global export volumes and prices are expanding. Yet buoyant global trade expectations are still not reflected in tumbling relative sales expectations (Chart 10). Chart 9Unwarranted ##br##Grounding Chart 10Buoyant Trade Growth Is Neither Reflected##br## In Collapsing Sales Expectations... Chart 11 highlights two additional Indicators to gauge the stage of the global trade recovery. Korea and Taiwan are two small open economies: exports in both countries are accelerating. Meanwhile, our Global Trade Activity Indicator, comprising the economically-sensitive Baltic Dry Index and lumber prices, is also waving a green flag. The upshot is that a number of Indicators confirm that a durable pickup in trade is underway, which should ultimately translate into a recovery in relative earnings expectations (Chart 11). Domestically, business shipments-to-inventories ratios are expanding comfortably in all three major segments: manufacturing, wholesale and retail (bottom panel, Chart 10). Anecdotally, recent news that FedEx beat both top and bottom line estimates also reinforces a firm global activity backdrop. All of this serves as reliable evidence that the budding recovery in global (and domestic) growth has morphed into a sustainable advance. The implication is that air freight pricing power has ample room to grow. Wholesale price momentum has reached a 5-year high. If our thesis plays out, more pricing power gains are in store, which will boost profit margins given the industry's impressive labor cost restraint and high operating leverage (Chart 12). Chart 11...Nor In Depressed##br## Forward EPS Chart 12Margin Expansion##br##Phase Looms Finally while investors are digesting the Walmart in-store pick up option and Amazon's push for its own delivery service plans, the persistent ascent in online shopping suggests that the structural increase in rapid delivery services will remain intact. Investors should expect pricing power to gravitate toward the long-term trend (bottom panel, Chart 12). Tack on the recent corrective action in the commodity pits and this group also benefits from the fall in fuel costs. Taken together, profit margins should resume expanding. In sum, appealing relative valuations along with a durable synchronized global growth rebound argue for increasing conviction in our overweight position in this transportation sub-group. Bottom Line: Stay overweight the S&P air freight & logistics group (UPS, FDX, CHRW, EXPD), and bump it to the high-conviction overweight list. Current Recommendations Current Trades Size And Style Views Favor small over large caps and stay neutral growth over value.

The signal from communications equipment stocks continues to worsen. Communications equipment pricing power is experiencing decade-high decline rates and the ratio of new orders to inventories has rolled over, both of which indicate the early stages of an inventory clear-out with production declines not far behind. Cisco Systems’ recent layoff announcement confirms an inventory oversupply. A liquidation phase will be exacerbated by woes at two important buying groups; telecom carriers, the primary customer group, remain engaged in a severely deflationary price war which makes increased capex unlikely, while the U.S. federal government remains shrouded in uncertainty with respect to budget outlays. All of this points to a shrinking top line, ongoing weakening in profitability and continued underperformance. We reiterate our recent downgrade to underweight. The ticker symbols for the stocks in this index are: BLBG: S5COMM - CSCO, HRS, MSI, JNPR, FFIV.