Communications Equipment

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

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

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

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.

Communications equipment stocks have diverged negatively from the broad tech sector and now trade broadly in line with telecom carrier stocks - a key end-market, with a slight lag. The latest signal from telecom services stocks is bearish, and we recommend a downgrade to a below-benchmark allocation in the S&P communications equipment group. While valuations look compelling, the risk of further near-term losses and a longer-term value trap remains high; all three key communications equipment end-markets point to additional demand weakness ahead. First, a full blown price war has engulfed the telecom services industry, driving outright deflation. In the absence of revenue growth, telecom capex is unlikely to reaccelerate. Secondly, delays/uncertainty with regard to U.S. fiscal policy and the Trump administration's strict budget control warns that the government's purse strings will remain tight for some time, representing another source of drag. Finally, export markets are unlikely to offset domestic cooling, as soaring Chinese & European telecom equipment exports suggest that U.S. manufacturers are losing competitiveness, and market share. Meanwhile, deflationary industry specific forces such as virtual networking will also contribute to margin pressure. We recommend shifting to underweight. Please see yesterday's Weekly Report for more details. The ticker symbols for this index are: BLBG: S5COMM - CSCO, HRS, MSI, JNPR, FFIV.

Highlights Portfolio Strategy Downgrade communications equipment stocks to underweight. All three end-markets are weak and signal that profits will continue to surprise to the downside. Continue to avoid the electrical components & equipment index. Deficient demand warns that the profit down cycle is far from over. Recent Changes S&P Communications Equipment - Downgrade to underweight. Table 1Sector Performance Returns (%) Feature Equities broke out to new highs last week. The minutes from the latest FOMC meeting implied that it would take considerable economic strength for the Fed to tighten more than markets currently forecast. A reactive rather than proactive Fed raises the odds that the equity overshoot will persist, because it means monetary conditions will still support profits. A good part of this year's market advance has been concentrated in a small number of stocks, but that belies the breadth of the profit recovery. Net analyst earnings revisions have hit their highest level since the initial post-GFC surge. The number of S&P industry groups with rising earnings estimates has climbed above 80%, reflecting broad-based earnings upgrades. Such widespread participation is consistent with ongoing upward revisions to 12-month forward earnings estimates (Chart 1). Evidence of a healthy earnings recovery is supported by our own Indicators. Of our ten sector pricing power gauges, seven are in positive territory. On a more granular basis, the majority of our 64 industry group pricing power proxies is also rising. This reflects increased global business activity and U.S. dollar depreciation. In terms of costs, six out of ten wage inflation proxies are decelerating, and more than 50% of our industry labor expense gauges are falling. As a result, seven out of ten of our broad sector profit margin proxies are in positive territory, i.e. pricing power is rising at a faster pace than wage inflation. Of the three in negative territory, two are easing in intensity, i.e. margin pressures are diminishing. These profit trends will support stocks, at least until they generate economic overheating and by extension, a more restrictive Fed. Thus, the good news for bulls is that financial conditions will remain sufficiently easy to sustain a durable profit recovery (see Chart 1 from last week's Report), so much so that investors are lengthening their time horizons. Evidence of the first synchronized global expansion in years and the ability of regional economies to bounce back from a headline risk, such as Brexit, have boosted conviction in the sustainability and strength of long-term earnings growth: analyst 5-year earnings growth forecasts are being steadily upgraded. History shows that as long as economic tail risk remains on the back burner, then valuations can camp out in overshoot territory, as occurred in the second half of the 1990s (Chart 2). To be sure, nosebleed valuation levels underscore that the rally is in a high risk phase and virtually guarantee paltry long-term returns. Still, timing pullbacks is notoriously difficult. We follow a checklist of five reliable indicators that should provide a helpful timing tool. Emerging market currencies have weakened prior to or coincident with U.S. stock market corrections (Chart 3). Exchange rate depreciation in these high beta economies is emblematic of growth disappointment, fears of capital flight and/or risk aversion. At the moment, our proxy of EM currencies is accelerating. Chart 1Buoyant Breadth Bodes Well Chart 2Long-Term Profit Conviction Is Driving Multiples Chart 34/5 Lights Flash Green Corporate bond spreads, both in the U.S. and emerging markets, have also widened coincident with, or in advance of, meaningful equity setbacks (Chart 3). So far, spreads remain tight in both regions, suggesting minimal concerns about debt servicing capabilities. In addition, bullish individual investor sentiment has also eclipsed the 60% zone in advance of the two largest post-GFC drawdowns. Individual investors are currently upbeat, but are not yet frothing bulls, according to the latest survey data (Chart 3). Of the five checklist items, the behavior of the yield curve is the most disconcerting. The curve has narrowed considerably in recent weeks, and is closing in on the pre-U.S. election lows as inflation expectations recede (Chart 3). If real long-term yields do not soon advance and confirm the profit/economic recovery narrative, then the odds of an imminent corrective phase will ratchet higher. In sum, the overshoot should remain intact for a while longer. But we continue to recommend a barbell portfolio rather than one with excessive beta, favoring select defensives and early cyclical sectors such as consumer discretionary and financials given the lack of economic confirmation from the bond market. This week we highlight two exceptions to the generally bullish profit backdrop, which reinforces that selectivity remains critical to portfolio construction. A Weak Signal From Communications Equipment: Downgrade To Underweight Communications equipment stocks have diverged negatively from the broad tech sector and have also trailed the broad market. Instead, this small corner of the tech industry moves with the ebb and flow of telecom carrier stocks - a key end-market, with a slight lag (top panel, Chart 4). The latest signal from telecom services stocks is bearish, and we recommend a downgrade to a below-benchmark allocation in the S&P communications equipment group. While the share price ratio has lost ground and valuations look compelling (Chart 4), the risks of further near-term losses and a longer-term value trap remain high. Technical conditions are still far from previously extreme washed out levels. In fact, the overbought conditions' unwind is recent and there is ample downside left before a full capitulation materializes (middle panel, Chart 4). Worryingly, all three key communications equipment end-markets point to additional weakness in the coming months. Telecom carrier outlays have hit a wall. Telecom providers are at each other's throats and a full blown price war has engulfed the industry. This is outright deflationary, and telecom services pricing power has contracted at a double-digit rate during the past three months (bottom panel, Chart 5). In the absence of revenue growth, telecom capex is unlikely to reaccelerate. U.S. telecom facilities construction and communications equipment new order growth move in lockstep (second panel, Chart 5). Both have collapsed on a short-term rate of change basis, warning that communications equipment demand is soggy. Tack on the quickest industry inventory accumulation since 2011 (third panel, Chart 5), a soft order backlog (not shown), and the industry sales growth outlook has darkened even further. Overall corporate outlays are also soft. While a capex upcycle looms and some capital will inevitably flow to the communication equipment industry (middle panel, Chart 6), anemic C&I loan growth (an excellent proxy for broad corporate health, not shown) is a yellow flag. Chart 4Value Trap Chart 5Weak Telecom Segment Capex... Chart 6...Aggravates The Sales Risk Moreover, enterprise spending has not been concentrated on communications equipment gear for years, as the industry has been unable to gain any share of total corporate investment. The implication is that any business sector uptick is unlikely to match the pressure stemming from the telecom services sector. The government segment represents another source of drag. True, a global move away from austerity is a plus, but delays/uncertainty with regard to U.S. fiscal policy is a sizeable offset. In fact, U.S. government spending as a percentage of output is in decline (not shown) and the Trump administration's strict budget control warns that the government's purse strings will remain tight for some time. Finally, export markets are unlikely to offset domestic cooling. While the cheapened U.S. dollar should boost U.S. communication equipment manufacturers' competitiveness, China's global networking ascendancy and Europe's recent V-shaped export recovery suggest that U.S. gear providers are losing market share (Chart 7). All of this paints a grim picture for communications equipment sales. As such, cyclically stretched operating margins are at risk (Chart 8). Industry productivity growth has crested, and is likely to recede because slowing new orders and rising inventories imply reduced output. The implication will be profit margin pressure and a return on equity squeeze (middle panel, Chart 8). While the industry constantly realigns headcount to the challenging operating environment, a sustainable profit turnaround requires a demand driven rebound. Chart 7U.S. Manufacturers Are Losing Market Share Chart 8Beware A Margin Squeeze Meanwhile, industry specific forces will also contribute to margin pressure. Five years ago, Cisco's CEO dismissed the nascent virtual networking threat. However, today, virtual networking is a deflationary reality. Such intense deflationary pressure is a clear profit negative and warns that relative EPS are headed south (Chart 8). Bottom Line: The S&P communications equipment index is breaking down. Trim exposure to below benchmark. The ticker symbols for this index are: BLBG: S5COMM - CSCO, HRS, MSI, JNPR, FFIV. Electrical Components & Equipment Are Out Of Power The niche S&P electrical components & equipment (ECE) industrials sub-index has marked time since our late-November downgrade to underweight. Our bearish thesis remains intact. Cyclical momentum has sputtered after the relative share price ratio failed to sustain its post-U.S. election euphoria. Valuations remain dear, with the forward P/E ratio trading at a 15% premium to the broad market (bottom panel, Chart 9). If profits continue to disappoint, as we expect, then a de-rating phase is inevitable. ECE companies garner roughly half of their sales from abroad. Thus, the U.S. dollar's fluctuations are inversely correlated with relative share prices. Delayed translation effects from the U.S. dollar's large run-up last year should continue to weigh on profits, and offset the European and emerging market economic recoveries. Worrisomely, there is a wide gap between relative performance and the greenback. If history rhymes, then a convergence phase is likely with the relative share price ratio deflating closer to the level predicted by the U.S. dollar (currency shown inverted, top panel, Chart 9). Domestically, news is equally grim. Investment spending on electrical equipment remains moribund: outlays are contracting in absolute terms and continue to trail overall investment. Historically, the industry's new orders-to-inventories ratio has been closely correlated with relative outlays and the current message is bleak (bottom panel, Chart 10). Chart 9No Reasons To Pay For Premium Valuations Chart 10No Reasons To Pay For Premium Valuations Importantly, the surge in ECE inventory growth and deceleration in backlog growth point to pricing power pressure in the coming months. Chart 11 shows that a rising wage bill and anemic pricing power have squeezed our industry margin proxy. In terms of industry productivity, gains have given way to losses, according to our gauge. This suggests that profits will continue to languish (middle panel, Chart 10). Tack on the slump in weekly hours worked, and there is cause to doubt recent sell side analyst optimism (bottom panel, Chart 11). A demand-driven increase in revenues/backlogs is needed to reverse the industry's profit fortunes. However, our relative EPS model is forecasting the opposite: profits will continue to underwhelm and trail the broad market into the back half of the year (Chart 12). Chart 11Lean Against Analysts' Exuberance Chart 12EPS Model Says Sell Against this backdrop, we remain reluctant to pay a premium valuation to own an industry with an uncertain, at best, earnings profile. Bottom Line: While we are neutral on the broad industrials sector, we continue to recommend underweight exposure in the S&P electrical components & equipment index. The ticker symbols for the stocks in this index are: BLBG: S5ELCO - EMR, ETN, ROK, AME, AYI. Current Recommendations Current Trades Size And Style Views Favor small over large caps and stay neutral growth over value.

The previous Insight showed that the broad tech sector will have trouble if overall inflationary pressures continue to build, sustaining upward pressure on bond yields. The communications equipment sub-group should be somewhat immune to these forces, however, given already cheap valuations. Nevertheless, the strong U.S. dollar already appears to be causing a competitive response. Industry pricing power has plunged deeper into the deflation zone, with more downside ahead as Asian currencies devalue (second panel). The good news is that U.S. telecom equipment exports have actually perked up, and the telecom services sector appears to have stabilized capital spending based on the message from new facilities construction. That will help offset deflationary pressure, but if exports roll over and/or domestic capital spending indicators cool, communications equipment stocks could go from consolidation to underperformance. Stay neutral, for now. The ticker symbols for the stocks in this index are: BLBG: S5COMM-CSCO, MSI, HRS, JNPR, FFIV.

Communications equipment stocks broke out of a long-term downward sloping trend-line on the back of productivity improvement this summer, powered by a marked productivity improvement. Indeed, our productivity proxy, defined as sales/employment, is growing rapidly. These trends were supportive of profit margins, and at least a modest valuation re-rating from washed out levels. Nevertheless, our confidence that a major bullish trend change has occurred after years of underperformance has been shaken. The budding reacceleration in top-line growth has hit a snag. New orders for communications equipment have rolled over relative to inventories. Investment in communications equipment has dipped. The telecom services sector has scaled back capital spending (third panel), suggesting that final demand will continue to soften. It will be difficult for companies to maintain high productivity if revenue growth stagnates. Consequently, the most likely scenario is that relative performance is entering a base-building phase rather than a new bull market, warranting a reduction to benchmark weightings. The ticker symbols for the stocks in this index are: BLBG: S5COMM - CSCO, MSI, HRS, JNPR, FFIV.

Highlights Portfolio Strategy If the Fed is about to begin interest rate re-normalization in earnest, then investors should heed the message from historic sector performance during tightening cycles. The tech sector remains vulnerable to tighter monetary conditions. Downshift communications equipment to neutral and stay clear of software. The OPEC supply agreement reinforces our current energy sector bias, overweight oil services and underweight refiners. Recent Changes S&P Communications Equipment - Reduce to neutral. Table 1 Feature Chart 1Why Is Equity Vol So Low? The equity market has been in a remarkably low volatility uptrend in recent weeks, powered by hopes that political regime shifts will invigorate growth. Signs of economic life have also played a role. The risk is that investors have pulled forward profit growth expectations on the basis of anticipated fiscal stimulus that may disappoint. In the meantime, the tighter domestic monetary conditions get, the less likely equity resilience can persist, especially in the face of rising instability in other financial markets. Volatility has jumped across asset classes, with the bond market leading the charge. The MOVE index of Treasury bond volatility has spiked. Typically, the MOVE leads the VIX index of implied equity market volatility (Chart 1, second panel). Currency and commodity price volatility has also picked up. It would be dangerous to assume that the equity market can remain so sedate. If the economy is about to grow in line with analysts double-digit profit growth expectations and/or what the surge in some cyclical sectors would suggest, then a re-pricing of Fed interest rate hike expectations is likely to persist. Against this backdrop, it is instructive to revisit historic sector performance during past Fed tightening cycles. If one views the next interest rate hike as the start of a sustained trend based on the steep trajectory of expected profit growth embedded in valuations and forecasts, then it is useful to use that as a starting point rather than last year's token 'one and done' interest rate hike. Charts 2 and 3 show the one-year and two-year average sector relative returns after Fed tightening cycles have commenced. A clear pattern is evident: defensive sectors have been the best performers by a wide margin, followed by financials, while cyclical sectors have underperformed over both time horizons. To be sure, every cycle is different, but this is a useful frame of reference for investors that have ramped up growth and cyclical sector earnings expectations in recent months. There has already been considerable tightening based on the Shadow Fed Funds Rate, a bond market-derived fed funds rate not bound by zero percent (Chart 4, shown inverted, top panel). The latter foreshadows a much tougher slog for the broad market. The point is that tighter monetary conditions can overwhelm valuation multiples and growth expectations. Chart 212-Month Performance After Fed Hikes Chart 324-Month Performance After Fed Hikes Chart 4A Blow-Off Top? The violent sub-surface equity rotation has presented a number of rebalancing opportunities. The defensive health care and consumer staples sectors have been shunned in recent weeks, with capital rotating into financials and industrials. As discussed previously, the industrials and materials sectors cannot rise in tandem for long with the U.S. dollar. These sectors should be used as a source of funds to take advantage of value creation in consumer discretionary, staples and health care where value has reappeared. Chart 5It's Not A ''Growth'' Trade Indeed, the abrupt jump in the cyclical vs. defensive share price ratio appears to have been driven solely by external forces, i.e. the sell-off in the bond market, rather than a shift in underlying operating profit drivers. For instance, emerging market (EM) equities and the cyclical vs. defensive share price ratio have tended to move hand-in-hand (Chart 5). The former are pro-cyclical, and outperform when economic growth prospects are perceived to be improving. Recent sharp EM underperformance has created a large negative divergence with the U.S. cyclical vs. defensive share price ratio. The surging U.S. dollar is a growth impediment for many developing countries with large foreign debt liabilities, and the lack of EM equity participation reinforces that the recent rise in industrials is not a one way bet. As a result, our preferred cyclical sector exposure lies in the consumer discretionary sector, and not in capital spending-geared deep cyclical sectors. A market weight in financials, utilities and energy is warranted, as discussed below, while the tech sector is vulnerable. A Roundtrip For The Tech Sector? After a semiconductor M&A-driven spurt of strength, the S&P technology sector has stumbled. As a long duration sector, technology has borne a disproportionate share of the backlash from a higher discount rate, similar to the taper-tantrum period in 2013. Then, bond yields soared as the Fed floated trial balloons about tapering QE. Tech stocks did not trough until yields peaked (Chart 6). In addition, a recovery in tech new orders confirmed that the sales outlook had brightened. Now, the capital spending outlook remains shaky, and tech new order growth is nil (Chart 6). Meanwhile, tech pricing power has nosedived (Chart 6). Domestic deflationary pressures are likely to intensify as the U.S. dollar appreciates, particularly against the manufacturing and tech-sensitive emerging Asian currencies. Tech sales growth is already sliding rapidly toward negative territory (Chart 7), with no reprieve in sight based on the contraction in emerging market exports, as well as U.S. consumer and capital goods import prices. Chart 6Tech Doesn't Like Rising Bond Yields Chart 7No Sales Growth True, tech stocks have a solid relative performance track record when the U.S. dollar initially embarks on a long-term bull market (Chart 8). Why? Because tech business models incorporate deflationary conditions, investors have been comfortable bidding up valuations in excess of the negative sales impact from a stronger U.S. dollar. Nevertheless, history shows that this relationship becomes untenable the longer currency appreciation persists. Chart 8 shows that in the final phase of the past two U.S. dollar bull markets, tech stocks have abruptly reversed course, rapidly ceding the previously accrued gains. Apart from a loss of competitiveness from currency strength, the new anti-globalization trend is bad for tech as it has the highest foreign sales exposure. The bottom line is that there is no rush to lift underweight tech sector allocations. In fact, we are further tweaking weightings to reduce exposure. For instance, software companies are worth another look through a bearish lens. Software sales growth is at risk from pricing power slippage amidst cooling final demand (Chart 9). Chart 8Beware Phase II Of Dollar Bull Markets Chart 9Sell Software... The financial sector is an influential technology sector end market. On the margin, financial companies are likely to reduce capital spending on the back of deteriorating credit quality. Chart 9 demonstrates that when financial sector corporate bond ratings start to trend negatively, it is a sign that software investment will stumble. A similar message is emanating from the decline in overall CEO confidence (Chart 10), which mirrors the relentless narrowing in the gap between the return on and cost of capital (Chart 8, bottom panel). Even C&I bank loans, previously an economic bright spot, are signaling that corporate sector demand for external funds and working capital are softening, consistent with slower capital spending. Against a backdrop of fading software M&A activity, we are skeptical that the S&P software index can maintain its premium valuation (Chart 11). Chart 10... Before Sales Erode Chart 11Not Worth A Premium Elsewhere, the communications equipment industry will have trouble sustaining this summer's outperformance. Communications equipment stocks broke out of a long-term downward sloping trend-line on the back of productivity improvement. Chart 12 shows that after a period of intense cost cutting, wage inflation was negative. Our productivity proxy, defined as sales/employment, is growing rapidly. These trends are supportive of profit margins, and at least a modest valuation re-rating from washed out levels. Nevertheless, our confidence that a major bullish trend change has occurred after years of underperformance has been shaken. The budding reacceleration in top-line growth has hit a snag. New orders for communications equipment have rolled over relative to inventories. Investment in communications equipment has dipped (Chart 13). The telecom services sector has scaled back capital spending (Chart 13, third panel), suggesting that final demand will continue to soften. It will be difficult for companies to maintain high productivity if revenue growth stagnates. Chart 12Productivity Strength... Chart 13... May Be Pressured Consequently, the most likely scenario is that relative performance is entering a base-building phase rather than a new bull market, warranting benchmark weightings. Bottom Line: Reduce the S&P communications equipment index (BLBG: S5COMM - CSCO, MSI, HRS, JNPR, FFIV) to neutral, in a move to further reduce underweight tech sector exposure. Stay underweight software (BLBG: S5SOFT - MSFT, ORCL, ADBE, CRM, INTU, ATVI, EA, ADSK, SYMC, RHT, CTXS, CA). Energy Strategy Post-OPEC Production Cut Chart 14Energy Stocks Need Rising Oil Prices The energy sector continues to mark time relative to the broad market, but that has masked furious sub-surface movement. We have maintained a benchmark exposure to the broad sector since the spring, but shifted our sub-industry exposure in October to favor oil field services over producers, while underemphasizing refiners. OPEC's recent agreement to trim flatters this positioning. Whether OPEC's announcement actually feeds through into meaningfully lower production next year and higher oil prices remains to be seen, but at a minimum, supply discipline should put a floor under prices. Rather than expecting the overall energy sector to break out of its lateral move relative to the broad market, we continue to recommend a targeted approach. The energy sector requires sustained higher commodity prices to outperform, and our concern is that a trading range is more likely (Chart 14). OPEC producers suffered considerable pain over the last two years as they overproduced in order to starve marginal producers of the capital needed for reinvestment. U.S. shale producers slashed capital expenditures by 65% from 2014 to 2016, and the International Oil Companies (IOCs) cut capital expenditures by 40% over the same period. Chart 15 shows that only OPEC has been expanding production. That has set the stage for limited global production growth, allowing for demand growth to eat into overstocked crude inventories in the coming years. OPEC's decision to trim output should mitigate downside commodity price risks, providing debt and equity markets with confidence to increase capital availability to the sector. With a lower cost and easier access to capital, producers, especially shale, will be able to accelerate drilling programs. The rig count has already troughed. The growth in OECD oil inventories has crested, which is consistent with a gradual rise in the number of active drilling rigs. As oversupply is absorbed, investment in oil field services will accelerate, unlocking relative value in the energy services space (Chart 16). Chart 15OPEC Cuts Would Help... Chart 16... Erode Excess Oil Supply This overweight position is still high risk, because it will take time to absorb the excesses from the previous drilling cycle. There is still considerable overcapacity in the oil field services industry, as measured by our idle rig proxy. Pricing power does not typically return until the latter rises above 1 (Chart 17). Companies will be eager to put crews to work and better cover overhead, and may accept suboptimal pricing, at least initially. Meanwhile, if EM currencies continue to weaken, confidence in EM oil demand growth may be shaken, eroding valuations. Still, we are willing to accept these risks, but will keep this overweight position on a tight leash and will take profits if OPEC does not follow through with plans to limit production. On the flipside, refiners will not receive any relief in feedstock prices, which should ensure that the gap between Brent and WTI prices remains non-existent (Chart 18). That is a strain on refining margins. Our model warns that there is little profit upside ahead. That is confirmed by both domestic and global trends. Chart 17Risks To A Sustained Rally Chart 18Sell Refiners Chart 19Global Capacity Growth Refiners have continued to produce flat out, even as domestic crude production has dropped (Chart 18). As a result, inventories of gasoline and distillates have surged, despite solid consumption growth. In fact, refined product output is about to eclipse the rate of consumption growth, which implies persistently swelling inventories. There is no export outlet to relieve excess supply. U.S. exports are becoming much less competitive on the back of U.S. dollar strength and the elimination of the gap between WTI and Brent input costs (Chart 19). Moreover, rising capacity abroad has trigged an acceleration of refined product exports in a number of low cost producer countries, including India, China and Saudi Arabia (Chart 19). Increased global refining capacity is a structural trend, and will keep valuation multiples lower than otherwise would be the case. The relative price/sales ratio is testing cyclical peaks, warning that downside risks remain acute. Bottom Line: Maintain a neutral overall sector weighting, with outsized exposure to the oil & gas field services industry (BLBG: S5ENRE - SLB, HAL, BHI, NOV, HP, FTI, RIG), and undersized allocations to the refining group (BLBG: S5OILR - PSX, VLO, MPC, TSO). Current Recommendations Current Trades Size And Style Views Favor small over large caps and growth over value.

Stocks are flirting with new highs, courtesy of a gradualist Fed and the reduced threat
of incremental near-term U.S. dollar strength.