Mega Themes

Highlights We estimate total Belt & Road Initiative (BRI) investment will rise from US$120 billion this year to about US$170 billion in 2020. The size of BRI investments is about 47 times smaller than China's annual gross fixed capital formation (GFCF). Therefore, a slump in domestic capital spending in China will fully offset the increase in demand for industrial goods and commodities as a result of BRI projects. Pakistan, Kazakhstan and Ghana will benefit the most among major frontier markets from BRI. Investors should consider buying these bourses in sell-off. On a positive note, BRI leads to improved global capital allocation, allows China to export its excess construction and heavy industry capacity, and boosts recipient countries' demand for Chinese exports. Feature China's 'Belt and Road' Initiative (BRI) is on an accelerating path (Chart I-1), with total investment expected to rise from US$120 billion to about US$170 billion over the next three years. Chart I-1Accelerating BRI Investment From China bca.ems_sr_2017_09_13_s1_c1 bca.ems_sr_2017_09_13_s1_c1 The BRI has been one of the central government's main priorities since late 2013. The primary objectives of the BRI are: To export China's excess capacity in heavy industries and construction to other countries - i.e., build infrastructure in other countries; To expand the country's international influence via a grand plan of funding investments into the 69 countries along the Belt and the Road (B&R) (Chart I-2); To build transportation and communication networks as well as energy supply to facilitate trade and provide China access to other regions, especially Europe and Africa; To facilitate the internationalization of the RMB; To speed up the development of China's poor (and sometimes restive) central and western regions, namely by turning them into economic hubs between coastal China and the BRI countries in the rest of Asia; To boost China's strategic position in central, south, and southeast Asia through security linkages arising from BRI cooperation, as well as from assets (like ports) that could provide military as well as commercial uses in the long run. From a cyclical investment perspective, the pertinent questions for investors are: How big is the current scale of BRI investment, and where is the funding coming from? Will rising BRI investment be able to offset the negative impact from a potential slowdown in Chinese capex spending? Which frontier markets will benefit most from Chinese BRI investment? Chart I-2The Belt And Road Program China's Belt And Road Initiative: Can It Offset A Mainland Slowdown? China's Belt And Road Initiative: Can It Offset A Mainland Slowdown? China's BRI: Scale And Funding Scale China has been implementing its strategic BRI since 2013. To date it has invested in 69 B&R countries through two major approaches: infrastructure project contracts and outward direct investment (ODI). The first approach - investment through projects - is the main mechanism of BRI implementation. BRI projects center on infrastructure development in recipient countries, encompassing construction of transportation (railways, highways, subways, and bridges), energy (power plants and pipelines) and telecommunication infrastructure. The cumulative size of the signed contracts with B&R countries over the past three years is US$383 billion, of which US$182 billion of projects are already completed. However, the value of newly signed contracts in a year does not equal the actual project investment occurred in that year, as generally these contracts will take several years to be implemented and completed. Table I-1 shows our projection of Chinese BRI project investment over the years of 2017-2020, which will reach US$168 billion in 2020. This projection is based on two assumptions: an average three-year investing and implementation period for BRI projects from the date of signing the contract to the commercial operation date (COD) of the project, and an average annual growth rate of 10% for the total value of the annual newly signed contracts over the next three years. Table I-1Projection Of Chinese BRI Project Investment Over The Years 2017-2020 China's Belt And Road Initiative: Can It Offset A Mainland Slowdown? China's Belt And Road Initiative: Can It Offset A Mainland Slowdown? The basis for the first assumption is that the majority of the completed BRI projects were by and large finished within three years, and most of the existing and future BRI projects are also expected to be completed within a three-year period.1 The second assumption of the 10% future growth rate is reasonable, given the 13.5% average annual growth rate for the past two years, but from a low base. These large-scale infrastructure projects were led mainly by Chinese state-owned enterprises (SOEs), and often in the form of BOTs (Build-Operate Transfers), Design-Build-Operate (DBOs), BOOT (Build-Own-Operate-Transfers), BOO (Build-Own-Operate) and other types of Public-Private Partnerships (PPPs). After a Chinese SOE successfully wins a bid on an infrastructure project in a hosting country, the company will typically seek financing from a Chinese source to fund the project, and then execute construction of the project. After the completion of the project, depending on the terms pre-specified in the contract, the company will operate the project for a number of years, which will generate revenues as returns for the company. The second approach - investing into the recipient countries through ODI - is insignificant, with an amount of US$14.5 billion last year. This was only 12% of BRI project investment, and only 8.5% of China's total ODI. Chinese ODI has so far been mainly focused on tertiary industries, particularly in developed countries that can educate China in technology, management, innovation and branding. Besides, most of the Chinese ODI has been in the form of cross-border M&A purchases by Chinese firms, with only a small portion of the ODI targeted at green-field projects, which do not lead to an increase in demand for commodities and capital goods. Therefore, in this report we will only focus on the analysis of project investment as a proxy of Chinese BRI investment, as opposed to ODI. The focal point of this analysis is to gauge the demand outlook for commodities and capital goods originating from BRI. The Sources Of Chinese Funding The projected US$120 billion to US$170 billion BRI investment every year seems affordable for China. This is small in comparison to about US$3-3.5 trillion of new money origination, or about US$3 trillion of bank and shadow-bank credit (excluding borrowing by central and local governments) annually in the past two years. The financing sources for China's BRI investment include China's two policy banks (China Development Bank and the Export-Import Bank of China), two newly established funding sources (Silk Road Fund and Asia Infrastructure Investment Bank), Chinese commercial banks, and other financial institutions/funds. Table I-2 shows our estimate of the breakdown of BRI funding in 2016. Table I-2BRI Funding Sources In 2016 China's Belt And Road Initiative: Can It Offset A Mainland Slowdown? China's Belt And Road Initiative: Can It Offset A Mainland Slowdown? China Development Bank (CDB): As the country's largest development bank, the CDB has total assets of US$2.1 trillion, translating into more than US$350 billion of potential BRI projects over the next 10 years, which could well result in US$35 billion in funding annually from the CDB. The Export-Import Bank of China (EXIM): The EXIM holds an outstanding balance of over 1,000 BRI projects, and has also set up a special lending scheme worth US$19.5 billion over the next three years. This will increase EXIM's BRI lending from last year's US$5 billion to at least US$6.5 billion per year. Silk Road Fund (SRF): The Chinese government launched the SRF in late 2014 with initial funding of US$40 billion to directly support the BRI mission. This year, Chinese President Xi Jinping pledged a funding boost to the SRF with an extra 100 billion yuan (US$15 billion). Therefore, SRF funding to BRI projects over the next three years will be higher than the US$6 billion recorded last year. The Asian Infrastructure Investment Bank (AIIB): The AIIB was established in October 2014 and started lending in January 2016. It only invested US$1.7 billion in loans for nine BRI projects last year. The BRI funding from the AIIB is set to accelerate as the number of member countries has significantly expanded from an original 57 to 80 currently. Chinese commercial banks: Chinese domestic commercial banks, the largest source of BRI funding, have been driving BRI investment momentum. Chinese commercial banks currently fund about 62% of BRI investment and the main financiers are Bank of China (BoC) and Industrial & Commercial Bank of China (ICBC). After lending about US$60 billion over the past two years, the BOC plans to provide US$40 billion this year. The ICBC has 412 BRI projects in its pipeline, involving a total investment of US$337 billion over the next 10 years, which will likely result in an annual US$34 billion in BRI investment. The China Construction Bank (CCB) also has over 180 BRI projects in its pipeline, worth a total investment of US$90 billion over the next five to 10 years. Only three commercial banks will likely fund US$80 billion of BRI projects over the next three years. A few more words about the currency used in BRI funding. The U.S. dollar and Chinese RMB will be the two main currencies employed in BRI funding. Chinese companies can get loans denominated either in RMBs or in USDs from domestic commercial banks/policy banks/special funds/multilateral international banks to buy machinery and equipment (ME) from China. For some PPP projects that involve non-Chinese companies or governments (i.e. those of recipient countries), the local presence can use either USD loans or their central bank's Chinese RMB reserves from the currency swap deal made with China's central bank. China has long looked to recycle its large current account surpluses by pursuing investments in hard assets (land, commodities, infrastructure, etc.) across the world, to mitigate its structural habit of building up large foreign exchange reserves that are mostly invested in low-interest-bearing American government securities. Risky but profitable BRI infrastructure projects are a continuation of this trend. China had so far signed bilateral currency swap agreements worth an aggregate of more than 1 trillion yuan (US$150 billion) with 22 countries or regions along the B&R. The establishment of cross-border RMB payment, clearing and settlement has been gaining momentum, and the use of RMB has been expanding gradually in global trade and investment, notwithstanding inevitable setbacks. Bottom Line: We estimate total BRI investment with Chinese financing will rise from US$120 billion this year to about US$170 billion in 2020, and Chinese financial institutions will be capable of funding it. Can BRI Offset A Slowdown In China's Capex? From a global investors' perspective, a pertinent question around the BRI program is whether the BRI-funded capital spending can offset the potential slowdown in China's domestic investment expenditure. This is essential to gauge the demand outlook for industrial commodities and capital goods worldwide. Our short answer is not likely. Table I-3 reveals that in 2016, gross fixed capital formation (GFCF) in China was estimated by the National Bureau of Statistics to be at RMB 32 trillion, or $4.8 trillion. Table I-3China's GFCF* Vs. China's BRI Investment Expenditures China's Belt And Road Initiative: Can It Offset A Mainland Slowdown? China's Belt And Road Initiative: Can It Offset A Mainland Slowdown? Meantime, China-funded BRI investment expenditure amounted to US$102 billion in 2016. In a nutshell, last year GFCF in China was about 47 times larger than BRI investment expenditures. The question is how much of a drop in mainland GFCF would need to take place to offset the projected BRI investment. The latter will likely amount to US$139 billion in 2018, US$153 billion in 2019 and US$168 billion in 2020. Provided estimated sizes of Chinese GFCF in 2017 are RMB 33.5 trillion (US$4.9 trillion), it would take only 0.4% contraction in GFCF in 2018, 0.3% in 2019 and 2020 to completely offset the rise in BRI-related investment expenditure (Table 3). Chart I-3Record Low Credit Growth... bca.ems_sr_2017_09_13_s1_c3 bca.ems_sr_2017_09_13_s1_c3 We derive these results by comparing the expected absolute change in BRI capital spending expenditures with the size of China's GFCF. The expected increases in BRI in 2018, 2019 and 2020 are US$20 billion, US$14 billion and US$15 billion. Given the starting point of GFCF in 2017 was US$4.9 trillion, it will take only about 0.4% of decline in $4.9 trillion to offset the $20 billion rise in BRI. In the same way, we estimated that it would take only an annual 0.3% contraction in nominal GFCF in China to completely offset the rise in BRI capital spending in both 2019 and 2020. To be sure, we are not certain that the GFCF will contract in each of the next three years. Yet, odds of such shrinkage in one of these years are substantial. As always, investors face uncertainty, and they need to make assessments. Is an annual 0.4% decline in China's GFCF likely in 2018? In our opinion, it is quite likely, based on our money and credit growth, as illustrated in Chart I-3. Importantly, interest rates in China continue to drift higher. A higher cost of borrowing and regulatory tightening on banks and shadow banking will lead to a meaningful deterioration in China's credit origination. The latter will weigh on investment expenditures. The basis is that the overwhelming portion of GFCF is funded by credit to public and private debtors, and aggregate credit growth has already relapsed. Chart I-4 and Chart I-5 demonstrate that money and credit impulses lead several high-frequency economic variables that tend to correlate with capital expenditure cycles. Chart I-4Negative Money Credit Impulses Point To... ...Negative Money Credit Impulses Point To... ...Negative Money Credit Impulses Point To... Chart I-5...Slowing Capital Expenditure ...Slowing Capital Expenditure ...Slowing Capital Expenditure Therefore, we conclude that meaningful weakness in the GFCF is quite likely in 2018, and that it will spill out to 2019 if the government does not counteract it with major stimulus. By and large, odds are that a slump in domestic capital spending in China offset the rise in BRI-related capital expenditures. BCA's Emerging Markets Strategy service has written substantively on motives surrounding China's capital spending and how it is set to slow, and we will not cover these topics. Some reasons why investment spending is bound to slow include: considerable credit excesses/high indebtedness of companies; misallocation of capital and resultant weak cash flow position of companies; non-performing assets on banks' and other creditors' balance sheets and their weak liquidity position. To be sure, investors often ask whether or not material weakness in mainland growth will lead the authorities to stimulate. Odds are they will. Yet, before the slowdown becomes visible in economic numbers, financial markets will likely sell-off. In brief, policymakers are currently tightening and will be late to reverse their policies. Finally, should one compare the entire GFCF, or only part of it? There is a dearth of data to analyze various types of capital spending. In a nutshell, Chart I-6 reveals that installation accounts for roughly 70% of investment, while purchases of equipment account for the remaining 18%. Therefore, we guess the composition of BRI projects will be similar to structure of investment spending in China, and hence it makes sense to use overall GFCF as a comparative benchmark. In addition, the GFCF data is a better measure for Chinese capital spending over Chinese fixed asset investment (FAI) data, as the FAI number includes land values, which have risen significantly over the years and already account for about half of the FAI (Chart I-7). Chart I-6Chinese Fixed Investment Structure Chinese Fixed Investment Structure Chinese Fixed Investment Structure Chart I-7GFCF Is A Better Measure Than FAI GFCF Is A Better Measure Than FAI GFCF Is A Better Measure Than FAI Bottom Line: While it is hard to forecast and time exact dynamics over the next several years, odds are that the next 12-24 months will turn out to be a period of a slump in China's capital spending. This will more than offset the increase in demand for industrial goods and commodities as a result of BRI projects. Implication For Frontier Markets The BRI, which currently covers 69 countries, will keep expanding its coverage for the foreseeable future. Insofar as it is a way for China to create new markets for its exports, Beijing has no reason to exclude any country. In practice, however, certain countries will receive greater dedication, for the simple reason that their development fits into China's political, military and strategic interests as well as economic interests. As most of the investments are infrastructure-focused, aiming to improve transportation, energy and telecommunication connectivity as well as special economic zones, the recipient countries, especially underdeveloped frontier markets, will benefit considerably from China's BRI. Table I-4 shows that Pakistan, Kazakhstan and Ghana will benefit the most among major frontier markets, as the planned BRI investment in those countries amounts to a significant amount of their GDP. Chart I-8 also shows that, in terms of current account deficit coverage by the Chinese BRI funding, the three countries that stand to benefit most are also Pakistan, Kazakhstan and Ghana. Table I-1The B&R Countries That Benefit From ##br##China's BRI Investment (Ranged From High-To-Low) China's Belt And Road Initiative: Can It Offset A Mainland Slowdown? China's Belt And Road Initiative: Can It Offset A Mainland Slowdown? Chart I-8Chinese BRI Funding's Impact On ##br##External Account Of B&R Countries China's Belt And Road Initiative: Can It Offset A Mainland Slowdown? China's Belt And Road Initiative: Can It Offset A Mainland Slowdown? Of these, clearly Pakistan and Kazakhstan have the advantage of attracting China's strategic as well as economic interest: Kazakhstan offers China greater access into Central Asia and broader Eurasia; Pakistan is a large-population market that offers a means of accessing the Indian Ocean without the geopolitical complications of Southeast and East Asia. These states also neighbor China's restive Xinjiang, where Beijing hopes economic development can discourage separatist and terrorist activities. Pakistan Pakistan is a key prospect for China's exports in of itself, and in the long run offers a maritime waystation and an energy transit hub separate from China's other supply lines. For China, it is a critical alternative to Myanmar and the Malacca Strait. In April 2015, China announced a remarkable US$46.4 billion CPEC (China-Pakistan Economic Corridor) investment plan in Pakistan, equal to 16.4% of Pakistani GDP. It is expected to be implemented over five years. In particular, the planned US$33.2 billion energy investment will increase Pakistan's existing power capacity by 70% from 2017 to 2023. On the whole, China's CPEC plan will be significantly positive to economic development in Pakistan in the long run, but in the near term it is still not enough to boost the nation's competitiveness (Chart I-9A, top panel). Chart I-9AOur Calls Have Been Correct Top 3 Frontier Markets Benefiting Most From Chinese BRI Investment Top 3 Frontier Markets Benefiting Most From Chinese BRI Investment Chart I-9BTop 3 Frontier Markets Benefiting Most ##br##From Chinese BRI Investment Our Calls Have Been Correct Our Calls Have Been Correct Also, as about 40% of the investment has already been invested over the previous two years, odds are that China's CPEC investment will go slower and smaller this year and over the next few years. BCA's Frontier Markets Strategy service's recent tactical bearish call on Pakistani stocks has been correct, with a 25% decline in the MSCI Pakistan Index in U.S. dollar terms since our recommendation in March (Chart I-9B, top panel).2 We remain tactically cautious for now. Kazakhstan Kazakhstan is a key transit corridor for Chinese goods to enter Europe and the Middle East. In June 2017, Chinese and Kazakh enterprises and financial institutions signed at least 24 deals worth more than US$8 billion. China's BRI investment in Kazakhstan facilitated the country's accelerated economic growth (Chart I-9A, middle panel). BCA's Frontier Markets Strategy service reiterates its positive view on Kazakhstan equities because of a recuperating economy, considerable fiscal stimulus and rising Chinese BRI investment (Chart I-9B, middle panel).3 Ghana Ghana is not strategic for China (it is a minor supplier of oil). Instead, it illustrates the fact that BRI is not always relevant to China's strategic or geopolitical interests. Sometimes it is simply about China's need to invest its surplus U.S. liquidity into hard assets around the world. Of course, Ghana itself will benefit considerably from the committed US$19 billion BRI investment, which was announced only a few months ago. This is a huge amount for the country, equaling 45% of Ghana's 2016 GDP. This massive fresh investment will boost Ghana's economic growth in both the near and long term (Chart I-9A, bottom panel). BCA's Frontier Markets Strategy service upgraded its stance on the Ghanaian equity market from negative to neutral in absolute terms at the end of July, and we also recommended overweighting the bourse relative to the broader MSCI EM universe (Chart I-9B, bottom panel).4 Our positive view on Ghana remains unchanged for now and we are looking to establish a long position in the absolute terms in this bourse amid a potential EM-wide sell-off. Other Macro Ramifications Industrial goods and commodities/materials are vulnerable. BRI will not change the fact that a potential relapse in capital spending in China will lead to diminishing growth in commodities demand. If there is a massive slowdown in property market like China experienced in 2015, which is very likely due to lingering excesses, Chinese commodity and industrial goods demand could even contract (Chart I-10). Notably, mainland's imports of base metals have been flat since 2010, and imports of capital goods shank in 2015 even though GDP and GFCF growth were positive (Chart I-11). The point is that there could be another cyclical contraction in Chinese imports of commodities and industrial goods, even if headline GDP and GFCF do not contract. Chart I-10Chinese Capital Goods Imports Could Contract Again bca.ems_sr_2017_09_13_s1_c10 bca.ems_sr_2017_09_13_s1_c10 Chart I-11Imports Of Metals Could Slow Further Imports Of Metals Could Slow Further Imports Of Metals Could Slow Further As China accounts for 50% of global demand of industrial metals and it imports about US$ 589 billion of industrial goods and materials annually, either decelerating growth or outright demand contraction will be negative news for global commodities markets and industrial goods producers. China's Exports Have A Brighter Outlook China's machinery and equipment (ME) exports account for 47% of total exports, and 9% of its GDP (Table I-5). The BRI investment will boost Chinese ME exports directly through large infrastructure projects. Table I-5Structure Of Chinese Exports (2016) China's Belt And Road Initiative: Can It Offset A Mainland Slowdown? China's Belt And Road Initiative: Can It Offset A Mainland Slowdown? Meantime, robust income growth in the recipient countries will boost their demand for household goods (Chart I-12). China has a very strong competitive advantage in white and consumer goods production, especially in low-price segments that are popular in developing economies. Therefore, not only is China exporting its excess construction and heavy industry capacity, but the BRI is also boosting recipient countries' demand for Chinese household and other goods exports. Adding up dozens of countries like Ghana can result in a meaningful augmentation in China's customer base. Notably, Chinese total exports have exhibited signs of improvement as Chinese ME exports and exports to the major B&R countries have contributed to a rising share of total Chinese exports since 2015 (Chart I-13). Chart I-12BRI Will Lift Chinese Exports Of ##br##Capital And Consumer Goods BRI Will Lift Chinese Exports Of Capital And Consumer Goods BRI Will Lift Chinese Exports Of Capital And Consumer Goods Chart I-13Signs Of Improvement In Chinese Exports ##br##Due To Rising BRI Investment Signs Of Improvement In Chinese Exports Due To Rising BRI Investment Signs Of Improvement In Chinese Exports Due To Rising BRI Investment BRI Leads To Improved Global Capital Allocation BRI is one of a very few global initiatives that improves the quality of global capital allocation. Therefore, it is bullish for global growth from a structural perspective. By shifting capital spending from a country that has already invested a lot in the past 20 years (China) to the ones that have been massively underinvested, BRI boosts the marginal productivity of capital. One billion dollars invested in the underinvested recipient countries will generate more benefits than the same amount invested in China. Risks To BRI Projects Notable deterioration in the health of Chinese banks may meaningfully curtail BRI funding, as Chinese non-policy banks will likely need to provide 60% of BRI projects' funding. Political stability/changes in destination countries: As most infrastructure projects have been authorized by the top government and need their cooperation, any changes in the recipient countries' governments or regimes may slow down or deter BRI projects. China already has a checkered past with developing countries where it has invested heavily. This is because of its employment of Chinese instead of local labor, its pursuit of flagship projects seen as benefiting elites rather than commoners, its allegedly corrupt ties with ruling parties, and perceived exploitation of natural resources to the neglect of the home nation. As China's involvement grows, local politics will be more difficult to manage, requiring China to suffer occasional losses due to political reversals or to defend its assets through aggressive economic sanctions, or even expeditionary force. For now, as there are no clear signs that any these risks are imminent, we remain positive on the further implementation of China's BRI program. Ellen JingYuan He, Editor/Strategist ellenj@bcaresearch.com Arthur Budaghyan, Senior Vice President Emerging Markets Strategy arthurb@bcaresearch.com 1 China has long been known to use three-year periods - as distinct from its better known "five year plans" - for major domestic initiatives. In 2016, the National Development and Reform Commission re-emphasized three-year planning periods for "continuous, rolling" implementation. 2 Please see BCA's Frontier Markets Strategy Special Report "Pakistani Stocks: A Top Is At Hand", published March 13, 2017. Available at fms.bcaresearch.com. 3 Please see BCA's Frontier Markets Strategy Special Report "Kazakhstan: A Touch Less Dependent On Oil Prices", published March 28, 2017. Available at fms.bcaresearch.com. 4 Please see BCA's Frontier Markets Strategy Special Report "Ghana: Sailing On Chinese Winds", published July 31, 2017. Available at fms.bcaresearch.com.

Dear Client, In addition to this Special Report written by my colleague Mark McClellan, we are sending you an abbreviated weekly report, which includes the Tactical Global Asset Allocation Monthly Update. Best regards, Peter Berezin, Chief Global Strategist Global Investment Strategy Highlights 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 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. Feature 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 1). Amazon has been leading the charge, accounting for 43% of all online sales in 2016 (Chart 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 1E-Commerce: Steady Increase In Market Share E-Commerce: Steady Increase In Market Share E-Commerce: Steady Increase In Market Share Chart 2Amazon Dominates Did Amazon Kill The Phillips Curve? Did Amazon Kill The Phillips Curve? 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 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 1E-Commerce Market Share Of Goods Sector Did Amazon Kill The Phillips Curve? Did Amazon Kill The Phillips Curve? Table 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 2E-Commerce Market Share Of Service Sector Did Amazon Kill The Phillips Curve? Did Amazon Kill The Phillips Curve? 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 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 3 highlights that the sectors with the greatest exposure to e-commerce had a negligible impact on the inflation slowdown. Table 3Comparison Of Pre- And Post-Lehman Inflation Rates Did Amazon Kill The Phillips Curve? Did Amazon Kill The Phillips Curve? 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 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 4). Chart 3Comparison Of Pre- And Post-Lehman Inflation Rates Did Amazon Kill The Phillips Curve? Did Amazon Kill The Phillips Curve? Chart 4Incompatible With A Supply Shock Incompatible With A Supply Shock Incompatible 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 Strategy 5 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 5Retail Margin Squeeze Only In Department Stores Retail Margin Squeeze Only In Department Stores Retail Margin Squeeze 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 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 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 6). There is more deflation evident in the BLS' index of prices for Electronic Shopping and Mail Order Houses (Chart 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 6Online Price Index Online Price Index Online Price Index Chart 7Electronic Shopping Price Index Electronic Shopping Price Index Electronic 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 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 9). This contribution is below the long-term average of the series, but the drag was even greater several times in the past. Chart 8BCA E-Commerce Proxy Price Index BCA E-Commerce Proxy Price Index BCA E-Commerce Proxy Price Index Chart 9BCA E-Commerce Adjusted Proxy Price Index BCA E-Commerce Adjusted Proxy Price Index BCA 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 markm@bcaresearch.com 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).

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 E-Commerce: Steady Increase In Market Share E-Commerce: Steady Increase In Market Share Chart II-2Amazon Dominates September 2017 September 2017 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) September 2017 September 2017 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) September 2017 September 2017 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 September 2017 September 2017 (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? September 2017 September 2017 Chart II-4Incompatible With A Supply Shock Incompatible With A Supply Shock Incompatible 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 Retail Margin Squeeze Only In Department Stores Retail Margin Squeeze 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 Online Price Index Online Price Index Chart II-7Electronic Shopping Price Index Electronic Shopping Price Index Electronic 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 BCA E-Commerce Proxy Price Index BCA E-Commerce Proxy Price Index Chart II-9BCA E-Commerce Adjusted Proxy Price Index BCA E-Commerce Adjusted Proxy Price Index BCA 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).

Feature This is the second of three Special Reports on Electric Vehicles. In the first report published two weeks ago,1 we looked at the current costs of ownership of a typical mass-market EV, including and excluding subsidies, versus a similar Internal Combustion Engine Vehicle (ICEV). Based on current manufacturing costs and battery capabilities, EVs carry a significantly higher total cost per mile, even including current subsidies. In this second report, we determine that EV-specific manufacturers (specifically, TSLA) do not hold any material manufacturing advantage over conventional auto manufacturers, and lack their financial resources and intellectual experiences managing mass production operations. In addition to the risks from increased mass-market competition, the EV market faces risks of today's EV subsidies morphing into tomorrow's EV taxes, retarding the exponential growth of adoption many EV enthusiasts are betting on today. In our forthcoming third report, we will look at the potential regional and global impacts EV adoption will have on energy, power, and commodity markets. Despite the current cost and utility disadvantages of EVs, we expect governments (especially Europe and China) will continue to provide subsidies (carrots) and mandates (sticks) to further the adoption of EVs for the purposes of reducing CO2 emissions and tailpipe particulate pollution. The longer-term hope is that by forcing the EV market to expand, meaningful technological breakthroughs on batteries will eventually enable EVs to exceed ICEVs on a cost and utility basis. In this report, we conclude that: EV-specific manufacturers (TSLA) will face increasingly stiff competition from conventional auto manufacturers, who may enjoy lower manufacturing, distribution, and service costs and have ICEV profits to subsidize near-term EV losses. Access to chargers will be a growing problem for widespread EV adoption, especially for EVs to penetrate apartment-dwellers. Government EV subsidies will become fiscally difficult to continue as adoption increases and gasoline taxes are lost (especially in Europe). The small amount of carbon saved by EVs does not justify the subsidies, further increasing the risk subsidies are reduced or allowed to phase out (especially in the U.S.). EVs: Winners And Losers Investor interest in EVs tends to focus on the only publicly traded play in the space, Tesla Motors (TSLA, Q). Tesla has an enthusiastic fan base, which seems to extend well beyond the rather modest number of people who actually own the vehicles (Chart 1). That enthusiasm is probably somewhat responsible for favorable media coverage and the company's speculatively-high market cap (Chart 2), which is currently on a par with General Motors (GM, N), despite the fact that Tesla has never made a profit. (Chart 3 and Chart 4).When we read media and analyst coverage of Tesla, we often wonder if those writing the articles know anything about automobiles besides how to drive them. An example is this Forbes article regarding Tesla as uniquely visionary, building up a big lead on its sleepy competition. Chart 1Tesla's EV Sales Are Modest Tesla's EV Sales Are Modest Tesla's EV Sales Are Modest Chart 2Tesla's Market Cap Surpasses GM's Tesla's Market Cap Surpasses GM's Tesla's Market Cap Surpasses GM's Chart 3Tesla: Financial Performance TSLA: Financial Performance TSLA: Financial Performance Chart 4GM: Financial Performance GM: Financial Performance GM: Financial Performance "[Manufacturer] complacency about electric vehicle (EV) technology is worse than perceived. Despite more talk of developing EVs for mass-market adoption, a lack of real action and strategic commitments betray their underlying conviction, with no clear pathway to high-volume EV production before the mid-2020s"2 Setting aside for a moment the question as to whether Tesla, as a serial destroyer of capital (to date), will have access to the financial resources needed to become itself a "high-volume" producer of EVs, most commentators ignore the fact that building an EV is far less complicated than building an ICEV, and the conventional car companies are likely to have cost advantages (not to mention the benefits of decades of experience with mass production) once they do commit to the EV. What's The Difference Between An EV And An ICEV? In a general sense, an automobile consists of two main components: the drivetrain and the rest of the vehicle. What differentiates an EV from an ICEV is almost entirely the drivetrain and battery pack. Although the shape and weight of the battery pack requires some alteration to the body frame of the vehicle, and many EVs include regenerative brakes, substantially everything else in the rest of the EV is very similar. Drivetrain The drivetrain of an ICEV is where the vast majority of precision parts are located. A typical ICEV has hundreds of precision parts and must be manufactured and assembled to exact tolerances in order to last beyond the typically expected 100,000+ mile trouble-free life. Engines are also subject to extremes in temperatures ranging from -40°C (-40°F) at start up in a cold winter to close to 90°C (190°F) under operation. Transmissions are similarly complicated. In contrast, the drivetrain of an EV is extremely simple, consisting essentially of an electric motor and a transmission, which is also greatly simplified due to the nature of the torque curve of electric motors (Illustration 1). Illustration 1Key Components Of A Bolt EV Drive Unit Electric Vehicles Part 2: EV Investment Impact Electric Vehicles Part 2: EV Investment Impact Unlike an ICEV which has numerous reciprocating parts (which are hard to engineer), all parts of an EV drivetrain rotate (which are much easier to engineer). Similarly, while there are numerous parts on an ICEV which require precision machining, friction bearings, and pressurized lubrication and cooling, analogous parts on an EV drivetrain are much fewer in number, can use ball bearings, and are lubricated for life. The fact that an EV drivetrain does not require pressurized lubrication and has a much simpler cooling system further simplifies the design and reduces the number of parts. It would not be an exaggeration to suggest that the drivetrain of an EV has an order of magnitude fewer parts than an ICEV of similar size. Any automotive company capable of designing and manufacturing an ICEV drivetrain should be capable of producing an EV drivetrain or outsourcing one if necessary. Battery Pack And Electronics Similarly, the battery pack of an EV is a mechanically simple thing to make. Battery cells are assembled into modules and the modules are assembled into the final battery pack (Illustration 2). The major challenge and potential differentiator is in the battery cells, which are effectively commodities (see below), and not in the manufacture or design of the battery pack. EV battery packs can produce a lot of heat when running or charging, and the battery packs tend to have simple cooling systems which vary from manufacturer to manufacturer.3 Illustration 2Battery Packs Are Battery Cells Assembled In Groups Electric Vehicles Part 2: EV Investment Impact Electric Vehicles Part 2: EV Investment Impact An EV requires a significant amount of power electronics for the control of the motor, charging, and so on. Such power systems have been designed and made for decades, and, besides some unusual requirements due to the need to operate at extreme temperatures, there is no great technical challenge inherent in such systems. Indeed, while the operating life of an ICEV is typically on the order of 5,000 to 10,000 hours (100,000-200,000 miles), power electronics are often designed to operate for 100,000 hours or more. The drivetrain will not be the limiting factor on the longevity of an EV. Most likely, the cost of an EV's drivetrain (excluding the battery pack) and typical features such as regenerative brakes, a more robust suspension (due to the greater weight of the EV on account of the heavy battery), and accommodation for the battery pack, is somewhat less than that of an equivalent ICEV. Although the EV drivetrain is simpler to build, high-output electric motors and related control electronics are not cheap to manufacture due to the requirement for materials such as copper and exotic alloys. The reason for the substantially higher cost of EVs is the battery pack. And The Winners Are ... Despite investor enthusiasm for the "technological revolution" EVs represent, it is actually far more complicated and technologically difficult to design and manufacture an ICEV than an EV. The EV has far fewer precision-made parts, and few such components are truly proprietary. Electric motors have been made for over a century, and their design and manufacture are not complicated - at least when compared to the vastly more complicated and precision-made ICEV. Similarly, an EV transmission is significantly simpler than the transmissions found in all ICEVs. We conclude that the design and manufacture of an EV drivetrain should be simple for a company accustomed to making ICEVs. Even the power and charging electronics are similar to the sorts of things electrical engineers have been making for a long time. Similarly, the assembly of a battery pack from commodity cells should be a relatively straightforward process for any company used to volume manufacturing. As we predicted, battery production appears to be scaling up, and sourcing commodity batteries should not be difficult if demand for EVs emerges as some predict. Although we have largely skipped over a discussion of the non-drivetrain components of an automobile, traditional manufacturers have been manufacturing these for a very long time and are capable of producing them at a reasonable cost and in vast numbers. The major difference between the non-drivetrain components of an EV and ICEV is accommodation for the shape and weight of the battery pack, which, again, should not be a substantial engineering challenge for any large auto manufacturer. For many years, auto manufacturers have developed "platforms" that allow them to mass produce standardized components that are used on what are apparently very different vehicles. Most likely, traditional vendors will produce a platform which can be used for both ICEVs and EVs, meaning that they can reuse parts produced for their ICEVs in EVs, saving money in terms of design, tooling, and volume manufacturing. Obviously, an EV-only vendor does not have that option. Finally, large automobile manufacturers have a global distribution channel as well as nearly omnipresent parts and service networks, including parts and service available from an assortment of third party providers. Developing this support system is particularly important for EVs to enter the mainstream: it is false to assume the simpler drivetrain of an EV will mean the vehicles never need repairs, as there are many failure modes. Beyond wealthy early-adopting EV enthusiasts who purchase EVs as a second or third auto, the typical consumer owns only a single vehicle, making prompt and affordable repairs critical to the utility of a mass-market vehicle, regardless of whether that vehicle is an EV or an ICEV. In summary, we conclude that there is no particular engineering challenge for existing large automakers to enter and dominate the EV business (Tables 1 and 2). Most likely, profit margins on EVs will be low or negative for some time (see Part 1), and large vendors will be in a position to use their profitable ICEV sales to subsidize their market share in the EV business. The main competitive uncertainty for EV manufacturing is how much battery performance and price can be improved from current levels. The battery cells themselves are rather commoditized, making it difficult for any single auto company to develop a substantial lead on the field in battery pack performance. Table 1Conventional Auto Manufacturers Are Ramping Up EV Penetration Electric Vehicles Part 2: EV Investment Impact Electric Vehicles Part 2: EV Investment Impact Table 2TSLA Will Lose Market Share As Mass-Market Competition Expands Electric Vehicles Part 2: EV Investment Impact Electric Vehicles Part 2: EV Investment Impact Rate Of Adoption As we showed in Part 1, costs of ownership of EVs are quite high compared to ICEVs over the EV's assumed 100,000 mile life. Although we believe accelerated depreciation of the EV will significantly increase the differential, most consumers are unaware of that likelihood. Governments and EV manufacturers heavily subsidize EVs; without such subsidies, consumers' costs of ownership would be materially higher. If EVs become a significant share of the vehicle market, such subsidies will have to be reduced, and high taxes would have to be applied to either the vehicle or the fuel (electricity) to make up for the loss of massive government revenues from today's gasoline taxes. The most expensive item in an EV is the battery pack (Chart 5). It appears to be an article of faith among EV advocates that existing batteries will somehow see cost reductions to below their current materials costs, and/or that revolutionary battery technology will emerge in (rapid) due course. It is interesting to speculate as to what might occur in the future. However, we prefer to be data driven. After all, why confine speculation on technological advancements only to things battery-related? Rapid technological advancements in oil production have cut gasoline prices dramatically in the past few years, while continued improvements of conventional engines can raise fuel efficiency and dramatically lower pollution/CO2 emissions of ICEVs, stiffening the competition against the rise of EVs. Chart 5As The Battery Pack Increases In Size,##BR##It Commands A Larger Share Of The Total Cost Of The EV Electric Vehicles Part 2: EV Investment Impact Electric Vehicles Part 2: EV Investment Impact Besides cost, there are numerous compromises associated with an EV which may temper adoption. These include the limited range and slow refueling times, which are important if the owner regularly--or even occasionally--makes long trips; degraded performance in temperature extremes, and so on. An important consideration for many buyers is the size of the car: a soccer mom is not likely to find a Bolt a suitable replacement for a minivan. Larger EVs require disproportionally larger batteries: the Tesla Model S 85 has a 40% larger battery but only a 10% greater range compared to the Bolt. EVs More Likely To Be Popular In The EU Than In North America Europeans tend to drive fewer kilometers and take fewer long trips than North Americans. The average distance traveled by car is 14,000 km4 (8,700 miles) in Europe compared to 20,000 km (12,000 miles) in the U.S., so a European would likely get a few more years out an EV - though not many more kilometers. Similarly, most of the population of Europe lives in areas where temperature extremes are less severe than they are in certain areas of the U.S. and Canada, meaning some of the compromises associated with operating an EV would be less significant. Europe has a much higher population density than the U.S., making particulate pollution a larger issue, and Europeans have more concerns regarding climate change. Much higher gasoline taxes and narrow roads in Europe also incentivize drivers to own smaller vehicles, similar to the Bolt. Due to these factors and the "carrot and stick" approach of subsidies and mandates favored by some EU countries, we conclude EVs are likely to be much more popular in the EU than in the U.S. (Chart 6) Chart 6European EV Sales Are Outpacing U.S. Sales European EV Sales Are Outpacing U.S. Sales European EV Sales Are Outpacing U.S. Sales Regardless, even EV adoption in the EU is bound to be constrained by: Higher costs of EVs compared to ICEVs; Driving habits which may preclude ownership by some people; Access to both private and public chargers; Long lives of ICEVs; and Availability of EVs for purchase. In Part 1 of our EV analysis, we break down the substantially higher cost of ownership for an EV compared to an ICEV. Driving habits boil down to the question of standard deviation: although the average EU driver may travel about 70 km (43 miles) per work day, a sizeable minority may travel much more than that or regularly make round trips beyond the range of their EVs. Alternatively, some may want to pull a trailer (caravan), etc... These drivers would be less likely to purchase an EV except perhaps as a second vehicle. Access to private chargers depends on the nature of the buyer's housing: somebody living in a house with a driveway can pay to have a slow charger installed, whereby somebody who relies on street parking or a nearby parking lot does not have that option. Due to the far greater population density of Europe, access to public chargers may be more of a constraint in the EU than in the U.S. In Part 1, we explained why we believe that ICEVs will outlast EVs for the foreseeable future due to degradation inherent with all battery technologies. There may be a dramatic breakthrough in battery technology, but batteries have numerous parameters which must be acceptable before they can be used in an EV. Most likely, an EV will be scrapped rather than have its battery replaced after about 160,000 km, whereas many ICEVs are routinely kept on the road for double that range. Consumers will eventually realize this and incorporate accelerated depreciation into their costs of ownership calculation. Not only that, but many will choose to keep their ICEVs on the road as long as possible simply to save the expense of purchasing a new vehicle, especially if the inherent limitations of EVs mean they are not suitable for that particular driver. Despite still-generous government subsidies, GM is believed to lose $9,000 for every Bolt it sells. Similarly, the CEO of Fiat lamented some time ago the company was losing $14,000 for every Fiat 500 EV it sold,5 and Tesla loses money despite selling into a premium segment. There is no reason to believe any EV vendor will actually make money on EVs for many years. After all, they all have the same problems with respect to the cost of batteries. We believe auto vendors are likely to limit sales of EVs through rationing or high prices in order to limit their own losses. EVs Are Unlikely To Replace All ICEVs The compromises/deficiencies associated with EVs mean that they will not be suitable for many consumers unless a massive battery breakthrough is achieved. The limited range is an obvious issue: a consumer might, for example, travel an average of 12,000 miles (20,000 km) per year but may regularly take a drive of a few hundred miles, which would require one or more recharging stops. It is all well and good to speak of rapid charging, but even this would quickly lose its allure after long trips, especially given the issues noted in "EVs Will Require a Sizeable Charging Infrastructure" below. Almost 3 million pickup trucks are sold in the U.S. every year, out of 17.5 million vehicle sales. Light trucks, including SUVs and Crossovers, make up another 10.5 million sales. Whether or not the trucks are actually used for hauling, the battery size, and therefore cost of ownership, would have to be particularly large for a pickup truck. A 120 kWh battery would add about 1,600 pounds (720 kg) to the vehicle, which is about half the cargo capacity of a Ford F-150 full size pickup truck. Many pickup trucks have significantly oversized engines in order to tow heavy loads. It is questionable an EV pickup truck would have the range or towing capacity required by many buyers. EVs Will Require A Sizeable Charging Infrastructure First-time EV owners will either have to invest in a charging station for their homes or somehow get access to one. Charging stations come in different types. In the case of the Bolt, a typical home charger delivers 4 miles (6.5 km) of range/hour of charge or about 32 miles (52 km) of range for 8 hours. What GM calls "Fast Charging" delivers almost a full charge over 8 hours. What GM refers to as "Super Fast Charging", or true fast charging, delivers 90 miles (145 km) of range in 30 minutes or 160 miles (258 km) in 1 hour, but is only available in public locations6 and requires a special option on the vehicle. "Super Fast Charging" means that a customer planning a trip of over 238 miles will have to plan for at least one 30 minute stop for every 90 miles of additional travel. Of course, this is when the vehicle is new and under ideal conditions without any temperature extremes, etc. An older EV may require a 30 minute stop after the first 150 miles and a subsequent 30 minute stop for every hour of travel (60-70 miles) after that. Private Chargers Unless they are satisfied with multi-day charging, new EV buyers have to pay an electrician to install a high current charger outlet which is accessible to the vehicle. Not all homes have ample parking, nor is it easy to install a high current port accessible to a vehicle in all homes. A typical high current charging port required for a "slow charger" requires a 40, 50, or 60 amp outlet. Many homes have only a 100 amp service, which may pose issues if the vehicle is charging and, for example, an air conditioner starts up. Similarly, apartment/condo dwellers with access to parking may have access to EV chargers provided by the building, though the electric service to the building/parking lot may require upgrading in the event a significant number of owners buy EVs. Publicly Available Chargers The largest challenge might be for would-be EV buyers who park on the street, as is fairly common in many urban areas. The cost of installing EV chargers is not trivial, and it is hard to believe cities will accept the costs of installing a large number of chargers to ensure EV owners can charge their vehicles. This doesn't even account for the fact that somebody has to pay for the electricity, and street-side chargers are both expensive and dangerous, require maintenance and snow removal, and may be subject to vandalism. Additionally, some parking lots feature a couple of EV chargers, and most EV vendors provide access to a rather sparse assortment of chargers. On the surface, a 6:1 ratio of global EVs to publicly available chargers may not appear to be as much of a concern, however, the ratio is about 16:1 for slow chargers and 105:1 for fast chargers in the U.S., and 6:1 and 68:1 in the EU, respectively (Charts 7 and 8). Recall that the Bolt's "Fast charger" only supplies about 25 miles of range for every hour of charging, so public units would only be useful as a "top-up". Public chargers will have to become far more common as the number of EVs increases or owners risk planning a trip which assumes access to a charger only to discover the unit is in use and the EV owner who is using it is off shopping. Chart 7Globally, There Is One Public Charger ##br##Per Six EVs Globally, There Is One Public Charger Per Six EVs Globally, There Is One Public Charger Per Six EVs Chart 8Fast Chargers Are Much More Scarce ##br##Than Slow Chargers Fast Chargers Are Much More Scarce Than Slow Chargers Fast Chargers Are Much More Scarce Than Slow Chargers Fast chargers are of particular significance in the event an EV owner wishes to make a trip in excess of the vehicle's fully-charged range. "Fast charge" times - whether with a Bolt or any other EV - assume a charging station is available when the EV arrives. This may be the case on typical days, but less likely during holiday or vacation season: "A video shot yesterday at the Supercharger in Barstow, CA shows a line at the station of Teslas waiting to juice up. The driver who shot the video was number 21 in the queue, and with wait times upwards of two hours just to get to the charger, Tesla's going to have some unhappy customers on its hands."7 One can only imagine how frustrated the owner of an aged Bolt would be if they had to wait 2 hours every 60 miles. Impact Of EV Adoption On Pollution And Greenhouse Gas Emissions The production and operation of any product leaves an environmental impact in terms of pollution and Greenhouse Gas (GHG) emissions. The environmental impact associated with vehicles arises from the production of the commodities used to make the components, the manufacture of the vehicle components, the assembly of the vehicle itself, and the operation of the vehicle. EVs are not "zero emission vehicles" in any meaningful sense. It is true that they do not discharge particulate or CO2 emissions from the tailpipe, but emissions arise from the production of the vehicle platform, the battery pack, and the production of electricity used to charge the battery. The fuel mix of power generation in a particular region has a significant impact on the GHG emissions associated with electric power: countries with significant hydroelectric or nuclear power sources will have lower GHG emissions per kW than those which burn coal, oil, or natural gas. Similarly, the GHG emissions associated with the manufacture of a vehicle and its components depend on the power mix in the country in which those components are manufactured. As previously noted, an EV is very similar to an ICEV except for the drivetrain and battery. The EV's drivetrain is simpler than an ICEV's, but total GHG emissions associated with manufacturing an EV and equivalent ICEV are estimated to be quite similar, excluding the battery pack. GHG emissions associated with the manufacture and recycling of a battery pack are quite hard to pin down. The best and most recent example we found comes from IVL Swedish Environmental Research Institute, and notes: "Based on our review, greenhouse gas emissions of 150-200 kg CO2-eq/kWh battery looks to correspond to the greenhouse gas burden of current battery production."8 To put things in perspective, the GHG burden associated with the lifecycle of a 60 kWh Bolt battery pack is between 9,000 and 12,000 kg, or 9 to 12 metric tons. Because the battery pack is likely larger than advertised to limit degradation, the actual figure is probably at least 20% more, or 10.8 to 14.4 metric tons. At just 9 metric tons, assuming a 160,000 km life, the GHG burden associated manufacture and recycling of a Bolt battery pack is about 56 g CO2/km, and at 14.4 metric tons the burden is about 88 g CO2/km. To be as favorable as possible to the Bolt's potential to reduce GHG emissions, we have used the lower bound of the estimated CO2 burden of the Bolt's 60 kWh battery, 9 metric tons, in our GHG analysis in Table 3. The actual CO2 burden could be as much as 5.4 metric tons more. Note that the above calculations do not include the GHG emissions associated with recharging the battery. Recall that in Part 1, we estimated the power consumption associated with a Bolt operating for 160,000 km would be about 31,250 kWh, or ~0.20 kWh/km (0.3125 kWh/mile). The GHG burden of recharging the battery varies considerably depending on the regional mix of power generation. As shown in Table 3: Table 3EVs Will Reduce Carbon Emissions Only If Power Grid Is Green Electric Vehicles Part 2: EV Investment Impact Electric Vehicles Part 2: EV Investment Impact In France, where power is primarily generated via carbon-free nuclear energy, recharging the Bolt will release just 2 metric tons of CO2 during its 160,000KM life (11g/km). In coal-heavy Germany (40+% coal), recharging the Bolt will generate ~18 metric tons of CO2 (109g/km), slightly more carbon than the fuel-efficient gasoline-powered ICEV Opel Astra (104g/km). In the U.S., with the current diversified mix of power generated by natural gas (34%), coal (30%), nuclear (20%), hydro (7%), wind (6%) and solar (1%), CO2 emissions from recharging the Bolt would be only 13 metric tons (83g/km), 60% lower than the 32 tons of CO2 emitted by the ICEV Chevy Sonic. As shown, despite the higher CO2 footprint associated with manufacturing the EV's battery pack, an EV may indeed lead to an overall reduction in GHG emissions in a region where electricity generation is already low-carbon; however, the EV actually emits more CO2 in Germany, a coal-heavy country (40% coal) with fuel-efficient ICEVs. This implies EVs would create even greater CO2 increases in countries like China or India, which both generate over 70% of power from coal. The carbon intensity of U.S. power generation has been reduced by roughly 23% over the past decade due to the increased displacement of coal with natural gas (~70% of the carbon reduction) and renewables. As the U.S. and other countries continue to de-carbonize their power grids, the emissions to recharge EVs will further decline. However, even where reductions are achieved, the lifecycle emissions of the EV is nothing close to what is implied by the term "Zero Emission Vehicle." Using our generous assumptions for the carbon footprint of the EV's battery, we calculate the approximate lifecycle CO2 reductions for an EV are ~9 metric tons in the U.S., and ~6 metric tons in France. In Germany, the EV actually emits ~10 metric tons more CO2 than a comparable ICEV. EVs in coal-heavy China and India would also be expected to emit more lifecycle CO2 than a fuel-efficient ICEV. Even if power generation were 100% carbon-free in the EU and in the U.S., the CO2 savings would be only 23 tons per vehicle in the U.S and 8 tons per vehicle in the EU (lower savings in the EU due to the higher fuel efficiency of the European ICEV). One area where the EV is bound to come out ahead is in reducing particulates, NOx, and other non-GHG related pollutants, at least in the areas where the vehicles are operated, which provides cleaner air in highly populated areas. EV Subsidies Are Not Justified By Carbon Emissions In order to simplify the cost/benefit debate over legislation and regulation aimed at reducing carbon emissions, the U.S. EPA and other various U.S. agencies have calculated/estimated a "Social Cost of Carbon," i.e., the estimated economic damage created by emitting a ton of CO2 in a given year.9 In the base case, the social cost of carbon was pegged at $36/metric ton in 2015, with expectations that it would rise to $50/metric ton in 2030 and $69/metric ton in 2050 as climate issues became more severe. By comparison, the "market value" for a ton of CO2 on traded exchanges in California and in the E.U. is between $5-$15/ton. Assuming an average value of $50/metric ton, the current CO2 savings of the EV will yield about an economic benefit per vehicle of ~$450 in the U.S, and ~$300 benefit in France. In Germany, where CO2 emissions for the EV are higher than the ICEV, it adds another ~$500 to the economic cost of the EV. At a value of $50/ton, the value of CO2 savings in each region are only ~4-5% of the value of the public subsidies of $7,200-$9,500/vehicle in the U.S. and France, and only 1-2% of the total ~$22,000-$27,000 total extra societal costs of the vehicles (Table 4). In other words, the subsidies alone cost 20x more than the economic benefit of the CO2 reductions, while the total extra costs of the EV are 55-75x higher than the economic value of the CO2 reductions. Germany is offering subsidies for vehicles that increase CO2 emissions. Table 4EV Carbon Reductions Are Way Too Expensive Electric Vehicles Part 2: EV Investment Impact Electric Vehicles Part 2: EV Investment Impact Of course, industry may be able to lower emissions associated with battery manufacturing and recycling, and power generation may continue to be de-carbonized as well, leading to lower GHG emissions associated with EVs in the future. However, the same might be said regarding continuing improvements in ICEVs as well. For example: If U.S. drivers changed preferences to drive European-style cars with smaller engines and greater fuel efficiency (that is, wider adoption of technology that already exists today), that alone could save ~17 tons of carbon per vehicle in the U.S., dwarfing the ~10 tons of carbon savings achieved by owning an EV, at a much lower economic cost. Again, one area where the EV is bound to come out ahead is in reducing particulates, NOx, and other non-GHG related pollutants, at least in the areas where the vehicles are operated, which provides cleaner air in highly populated areas. This reduction/transfer of pollution from the city center to the power generation stations has a real health/quality of life value that we have not included in the above analysis, as the overwhelming amount of EV interest we read and receive is specifically based on EVs' (overestimated) ability to reduce global carbon emissions.10 Bottom Line: TSLA does not have an insurmountable technological lead on conventional car producers in the mass-production EV market, and is likely to lose market share to larger competitors that have better costs, infrastructure, and experience supporting a global fleet of mass-produced vehicles. Near-term adoption of EVs will be forced higher by governmental carrot and stick incentives, but these will become too expensive to continue as EVs' market share increases. Today's EV subsidies will turn into tomorrow's EV taxes as gasoline taxes are diminished, weighing on the longer-term arc of commonly-forecasted EV adoption. Finally, EVs do not necessarily reduce CO2 emissions, and when they do, the value of those CO2 reductions is exceedingly small compared to the added cost of the vehicles to producers, consumers, and government coffers. A modest ICEV only emits ~$2,000 worth of CO2 over 100,000 miles in the first place, elucidating how difficult it will be for an EV to reduce GHG emissions on a cost-competitive basis. For mass-market EVs to successfully displace ICEVs in the eyes of cost-conscious consumers and taxpayers, EV battery technology needs to improve massively, not incrementally. The batteries need to provide multiples of today's energy storage capacity with lower weight, lower cost, faster recharge abilities, and a lower carbon footprint. Furthermore, since an EV's battery recharging is only as green as the power source behind it, continued (expensive) greening and expansion of global power generation would also be necessary for EVs to demonstrate a positive impact on GHG emissions, as will be discussed more in Part 3 of this report series. Brian Piccioni, Vice President Technology Sector Strategy brianp@bcaresearch.com Matt Conlan, Senior Vice President Energy Sector Strategy mattconlan@bcaresearchny.com Robert P. Ryan, Senior Vice President Commodity & Energy Strategy rryan@bcaresearch.com Michael Commisso, Research Analyst michaelc@bcaresearch.com Johanna El-Hayek, Research Assistant johannah@bcaresearch.com Hugo Bélanger, Research Assistant HugoB@bcaresearch.com 1 Please see Technology Sector Strategy Special Report, "Electric Vehicles Part 1: Costs of Ownership", dated August 1, 2017, available at tech.bcaresearch.com. 2 https://www.forbes.com/sites/neilwinton/2017/06/29/tesla-focus-means-victory-versus-complacent-mainstream-in-electric-car-market-report/#4d0d4684577e 3 http://www.hybridcars.com/2017-chevy-bolt-battery-cooling-and-gearbox-details/ 4 http://www.acea.be/publications/article/cars-trucks-and-the-environment 5 http://jalopnik.com/sergio-marchionne-doesnt-want-you-to-buy-a-fiat-500e-1579578914 6 https://www.chevyevlife.com/bolt-ev-charging-guide 7 http://bgr.com/2016/12/27/tesla-supercharger-wait-times-lines-california/ 8 http://www.ivl.se/download/18.5922281715bdaebede9559/1496046218976/C243+The+life+cycle+energy+consumption+and+CO2+emissions+from+lithium+ion+batteries+.pdf (page 42) 9 https://www.epa.gov/sites/production/files/2016-12/documents/social_cost_of_carbon_fact_sheet.pdf 10 It is worth pointing out that if the incentive structure is such that entrepreneurs are rewarded for finding ways to economically reduce carbon emissions in ICEVs in a way that is cost-competitive with EVs, the principal advantage of EVs would be challenged. There is no ironclad rule of physics we are aware of that precludes such a development. Investment Views and Themes Recommendations Strategic Recommendations Tactical Trades Electric Vehicles Part 2: EV Investment Impact Electric Vehicles Part 2: EV Investment Impact Commodity Prices and Plays Reference Table Electric Vehicles Part 2: EV Investment Impact Electric Vehicles Part 2: EV Investment Impact Trades Closed in 2017 Summary of Trades Closed in 2016

Feature This is the first of two Special Reports on Electric Vehicles. In this report, we will look at the current costs of ownership of a typical mass-market EV, including and excluding subsidies, versus a similar Internal Combustion Engine Vehicle (ICEV). Based on current manufacturing costs and battery capabilities, EVs carry a significantly higher total cost per mile, even including current subsidies. Electric Vehicles have galvanized the interest of consumers, investors, and governments for several years now. We touched on the subject in our Special Report "Electric Vehicle Batteries", published September 20, 2016, where we noted that there were many misconceptions regarding batteries in general and EV batteries in particular. Despite the current cost and utility disadvantages of EVs, we expect governments (especially Europe and China) will continue to provide subsidies (carrots) and mandates (sticks) to further the adoption of EVs for the purposes of reducing CO2 emissions and tailpipe particulate pollution. The longer-term hope is that by forcing the EV market to expand, meaningful technological breakthroughs on batteries will eventually enable EVs to exceed ICEVs on a cost and utility basis. In our second report, we will look at the potential issues associated with adoption of EVs and the investment implications for the auto industry and energy markets. Cost Comparison: EV Vs. ICEV We estimated the difference in cost of ownership of a Chevy Bolt EV (known as the Opel Ampera-e in Europe) and two equivalent Internal Combustion Engine Vehicles (ICEVs), the Chevy Sonic and the Opel Astra, over 160,000 km or 100,000 miles (Table 1). Depreciation is an important consideration in cost of ownership, and we expect EVs to depreciate much more rapidly than ICEVs, a cost that many consumers either ignore or simply fail to incorporate into their purchase decisions. Table 1Comparison Of Costs Of Ownership Between EV And ICEV Automobiles Electric Vehicles Part 1: Costs Of Ownership Electric Vehicles Part 1: Costs Of Ownership There are many unknowns, such as actual selling price, actual manufacturing cost, etc., in this exercise which may add or subtract a thousand dollars or more to the net results. Under realistic assumptions, those probably cancel out. In summary, EVs are more expensive than ICEVs: Excluding subsidies, the net difference is about $16,100 in the U.S., $18,500 in Germany, and $13,200 in France. After subsidies, the difference is about $6,600 in New York State, $13,900 in Germany, and $6,000 in France. Even if electricity were free, after subsidies, the difference in cost of ownership in the U.S. (NY) would be $3,400, $3,200 in Germany, and $600 in France. The U.S. Federal subsidy of $7,500 is designed to be phased out once a manufacturer sells 200,000 vehicles, which would happen quickly if EVs are to become main stream. Therefore, the total premium cost of ownership of an EV over a comparable ICEV in the U.S. should be assumed to be $16,100 less state subsidy, if any. European subsidies are probably more politically acceptable, even though they will become quite costly if EV sales accelerate as many predict. GM is believed to be losing $9,000 with every Bolt it sells. If so, and if GM changed its pricing to deliver the company's average Gross Margin of around 13%, assuming it currently allows a 10% markup by dealers and discounts the vehicle by 10%, the price of the car would need to be raised to around $48,300 from its current MSRP of $37,500. This would increase the cost of ownership by nearly $11,000 (Table 2), or $0.11 per mile. To make the Bolt's ownership costs - after subsidies - competitive with GM's Opel Astra in France, the Bolt's manufacturing costs would need to be cut by about $14,750 or 34%. Table 2Comparison Of Costs Of Ownership Between EV And ICEV Automobiles, ##br##If GM Sold Bolt At Average Corporate Profitability Electric Vehicles Part 1: Costs Of Ownership Electric Vehicles Part 1: Costs Of Ownership Note that although we have focused on the Bolt, the common denominator for all EVs is the cost of batteries, which are a commodity. As such, our estimates probably hold for similarly sized vehicles and the differential costs of ownership are likely larger for larger EVs. As we will show in Part 2, integrated auto manufacturers probably have a significant cost advantage over "pure play" EV vendors such as Tesla, because outside of the drive train, they are able to use many of the same components they manufacture for ICEVs. Batteries: A Review All assumptions regarding EV technology are predicated on continued improvements in the cost, durability, and performance of batteries. The leading battery technology for EVs is a Lithium Ion technology (Illustration 1), and there really are no proven near-term alternatives worth discussing. Illustration 1Lithium Ion Technology Electric Vehicles Part 1: Costs Of Ownership Electric Vehicles Part 1: Costs Of Ownership In our Special Report "Electric Vehicle Batteries", we concluded that: Although the consensus view is that EV battery prices have experienced rapid (8 - 14% per annum) price declines over the past few years, we found no evidence to support that position; Battery durability is at least as important as price, and batteries will not likely last much more than 100,000 miles (160,000 km); Planned expansion of EV battery manufacturing capacity may significantly exceed demand by 2020, resulting in the collapse of EV battery prices and heavy losses for battery manufacturers. We continue to stand by those conclusions, and would like to stress that recent stories such as "China Is About to Bury Elon Musk in Batteries"1 and "10 Battery Gigafactories Are Now in the Works and Elon Musk May Add 4 More"2 are more or less consistent with our comment that "even though there is no reason to expect significant price improvements due to technological shifts, battery prices might drop due to oversupply - at least as long as manufacturers are willing to sell batteries at a loss."3 It seems likely now that China may follow the path it took to the solar industry and mass produce batteries, likely at a loss. The exact motivation for them to do so is uncertain, but this would be moot from the perspective of a western auto manufacturer or consumer. Finally A Reliable Battery Price Data Point! As we will demonstrate in Part 2 of our EV report, excluding the cost of the battery, it should be slightly cheaper to manufacture an EV than a similar ICEV. The EV drive train is much simpler and should be less expensive than that of an ICEV (Illustration 2), offset slightly by the need for a somewhat more robust chassis and suspension due to the weight of the battery, the requirement for electric powered air conditioning, and regenerative braking. Illustration 2Key Components Of A Bolt EV Drive Unit Electric Vehicles Part 1: Costs Of Ownership Electric Vehicles Part 1: Costs Of Ownership The battery is the most expensive part of an EV and responsible for the higher vehicle prices, and that is likely to remain the case even as manufacturing efficiencies allow EV prices to decline. Unfortunately, the cost of EV batteries is subject to much more speculation than should be the case: many articles cite speculative forecasts, projections, anecdotes, and so on, but without hard data backing them up. Fortunately, we finally have a data point: GM lists the cost of the Bolt EV battery pack as $15,734 for a 60 kWh unit, or $262/kWh.4 Some reports claim the battery cells cost $145/kWh,5 however, battery cells are not the same thing as a battery pack, which is a fully assembled unit complete with wiring, electronics, and a cooling system. Peer reviewed research suggests the cost of the battery pack is about 50% greater than the cost of the battery cells,6 however, we note the same article suggests that ratio will remain the same as battery prices drop. This is unlikely as there is no reason to believe the largely mechanical battery pack will decline proportionately any more than the cost of an engine or transmission will decline. Most likely, the battery pack assembly, excluding the cells, will decline only slightly. EV vendors likely oversize their battery pack in order to limit stress on the batteries (Illustration 3). In other words, the actual capacity of the battery is likely somewhat larger than the rated or useable capacity. If GM is indeed paying $145/kWh for its cells and its pack costs are 50% more than its cell costs and it is oversizing its pack by 20%, the cost of the pack works out to $261/kWh. Illustration 3Oversizing Battery To Account For Capacity Fade Electric Vehicles Part 1: Costs Of Ownership Electric Vehicles Part 1: Costs Of Ownership The reports which cite a $145/kWh cell price further suggest GM believes cells will cost $100/kWh in 2022, which implies a potential battery cost reduction of $2,700 (assuming the packs are not oversized) over the next 5 years (Table 3). The aforementioned research paper states: "The pure material costs for the VDA-type batteries are estimated to be currently about 50 EUR/kWh ($67.50), which seems to be the lower possible limit at long term." Even if the difference between materials cost and selling price is only 20%, that implies a lower limit of $81/kWh for the cells, meaning savings of $64/kWh are possible. This has not prevented some commentators from suggesting batteries will decline in price by 77% (or $112, implying $33/kWh pricing) by 2030.7 Regardless, savings of $64/kWh work out to $3,840 assuming a 60 kWh pack, or $4,680 assuming the pack is 20% oversized. Even if the pack cost were to decline a similar amount, the cost savings (assuming 50% for the pack, 20% oversized) would only be $7,000. Table 3GM Aims To Cut The Battery Cost By $2,700 By 2022 Electric Vehicles Part 1: Costs Of Ownership Electric Vehicles Part 1: Costs Of Ownership According to press reports, at the onset GM will lose $9,000 for every Bolt it sells.8 Since the major difference in costs between an EV and an ICEV is the battery pack, the $262 price cited above is probably not representative of the true cost. It may be that part of GM's commercial strategy is to show EV buyers that a replacement battery pack is not overwhelmingly expensive, and it is therefore willing to offer them at a loss. After all, the vehicle comes with a 100,000-mile, 8-year warranty on the battery, and we doubt many consumers would spend $15,734 (plus labor) to replace the battery on an 8-year-old EV. Therefore, GM is probably not going to sell that many replacements, so they won't suffer many losses by offering a replacement battery below its cost. The price differential between a Bolt and a Chevy Sonic, which is a similar vehicle manufactured in the same factory, is about $22,300. If we include the reported $9,000 expected loss, the "true" difference in price is $31,300. We believe that most likely the actual cost of the battery pack of the Bolt is much higher than $15,734. GM Confirms That Batteries Get Used Up Although the Bolt battery pack is covered by an 8-year 100,000-mile warranty, that warranty considers the potential for degradation of up to 40%: "Like all batteries, the amount of energy that the high voltage 'propulsion' battery can store will decrease with time and miles driven. Depending on use, the battery may degrade as little as 10% to as much as 40% of capacity over the warranty period."9 We highlight "all batteries" because this is the fate of all existing battery technologies. We further note that the amount of degradation will depend on the driving habits of the user: if the car is "lightly used" (i.e. traveled much less than 12,000 miles/year), chances are the battery degradation will be at the low end of the scale, whereas if the car is used a lot, chances are it will be at the high end of the scale. The average U.S. driver travels ~13,500 miles (22,000 km) per year,10 meaning the average driver with a single car would exceed the warranty on the Bolt in less than 8 years and, most likely, battery degradation would be closer to 40% than to 10%. Assuming a normal distribution, half of drivers would likely exceed the average annual miles driven, and as a result, their battery degradation would be even greater and happen even sooner, since they would be stressing the battery system through deeper and more frequent charging. Of course, if you were to travel 100,000 miles in 5 years, your battery warranty would expire. A major motivation for buying an EV is the expectation that it will save money on gasoline, which is true as shown in Table 1. However, the more you drive, the faster you use up the battery, and the sooner you would be faced with buying an expensive replacement battery. As such, drivers who drive a lot would be best to be cautious about purchasing an EV, as their costs of ownership due to battery degradation/replacement would be even higher. The Bolt has a purported range of 238 miles, but that range is achieved only when the battery is new and likely measured under ideal circumstances. Use of air conditioning, extreme temperatures (i.e. winter), etc., would probably trim the range significantly, likely to well below 200 miles. Assuming a reasonable usage for the vehicle, an 8-year-old Bolt would probably have a range closer to 100 miles than to 200 miles. This would significantly affect resale value as a vehicle with a range of 100 miles has much less utility than one with 200 miles. Difference In Cost Of Ownership: Chevy Bolt Vs. ICEV Calculating costs of ownership is subject to numerous assumptions, and this is especially the case with respect to an emerging technology such as EVs. Because we have a significant amount of information from GM on the cost and operating characteristics of the Bolt, and because GM makes "mass market" ICEVs which are roughly comparable to the Bolt, we thought it would be a uniquely useful benchmark for a cost of ownership analysis. We are neither making a claim that the Bolt or any EV will be commercially successful, nor are we endorsing it in any way; we are simply identifying the Bolt as representative of a typical mass-market EV. In our analysis we assume: The Chevy Bolt is a typical mass market EV; The sales price of the Bolt is roughly the same in the U.S.11 and Europe12 at $37,495; The Bolt is comparable to the Sonic in North America and the Opel Astra in Europe (Table 4); There are no direct financial subsidies associated with EVs; and After 100,000 miles, both the EV and the comparable ICEV have a similar residual value. Table 4The Bolt Is Much More Expensive Than Similarly-Sized GM ICEVs Electric Vehicles Part 1: Costs Of Ownership Electric Vehicles Part 1: Costs Of Ownership As we noted above, GM is believed to be taking a $9,000 loss associated with each Bolt sold. This is not sustainable if the firm expects to sell a lot of them. Most likely, either the company sees a path to significant cost reduction over the life of the product, or the company will artificially limit supply and use profits from its other products to subsidize the sales of Bolts. For the purpose of this analysis, we will assume the company and its rivals believe they can sell such vehicles at a reasonable profit in the future. The difference in the cost of ownership for similar vehicles is mainly associated with purchase cost, fuel costs, repair costs, and resale value. Insurance, parking, and so on would be a wash and annual repair and maintenance bills on most new cars are quite modest, so it would not significantly tilt the balance. Although EV enthusiasts tend to highlight the fact EVs do not require oil changes, the significantly increased weight of the battery means EVs require more frequent tire replacement than an equivalent ICEV.13 For example, modern ICEVs require an oil change every 10,000 miles. At $70/oil change this works out to $700, similar in price to a set of tires. Furthermore, the repair experience with EVs is extremely limited, and if we are to take Tesla as an example, they do not fare as well as many had hoped.14 We address the likely higher depreciation rates of EVs below. Estimating Electric Power Costs For An EV Charging a battery is not 100% efficient as losses occur in the charger and at the battery. Batteries get warm as they are charged, and that is a sign of inefficiencies in the charging process. As smartphone and notebook owners are aware, aged batteries produce a lot more heat when they are charged because the charging becomes less efficient as the batteries age. A new EV with a "slow" charger (see below) is about 85% efficient,15,16 while the figure is almost certainly lower for an aged battery. Assuming the system were 100% efficient, the Bolt vehicle goes 238 miles on 60 kWh, averaging about 0.25 kWh/mile, or approximately 25,000 kWh for 100,000 miles. Assuming lifetime average efficiency of 80% (85% when new, 75% when old), lifetime power consumption would be about 31,250 kWh. EV advocates note there are numerous "free" public charging stations. This is true, but there are far fewer public charging stations than there are EVs, which means the average EV owner pays for her electricity (Chart 1). Regardless, somebody has to pay for the electricity, and it is unreasonable to assume that "free charging" will persist if EVs gain significant market share, which apparently they have been doing in the past few years, especially in the U.S. and the EU (Chart 2). Chart 1Globally, EVs Outnumber Charging Stations By 6 To 1 Globally, EVs Outnumber Charging Stations By 6 To 1 Globally, EVs Outnumber Charging Stations By 6 To 1 Chart 2EV Market Share Is Increasing, Especially In Europe EV Market Share Is Increasing, Especially In Europe EV Market Share Is Increasing, Especially In Europe Furthermore, although many utilities have "time of use" utility rates which are lower in the evening when an EV is being charged, there is reason to question whether those can coexist with significant EV market penetration, a subject we will address in Part 2. Regardless, average power rates incorporate discounted time of use power to some extent, so that is the figure we use. Net Operating Costs: U.S. The Bolt17 is roughly comparable to a Chevy Sonic18 in terms of size, and the vehicles are made in the same factory. The difference in price is about $22,300. At 25/33 mpg, fuel use of the Sonic over 100,000 miles would be about 3,600 gallons (13,627 liters), costing about $9,000, assuming a gasoline price of $2.50 per gallon ($0.66/liter), which is slightly higher than the current nationwide average of ~$2.30/gallon. Assuming lifetime power consumption of 31,250 kWh and an average electricity price in the U.S. of $0.104/kWh,19 electric power costs for the Bolt would be around $3,250, for a net "fuel costs savings" of $5,700 in favor of the Bolt. However, the substantially higher initial purchase price and faster depreciation still results in the Sonic costing about $16,100 less over the duration of the vehicles' 100,000 miles (160,000 km). Put another way, the Bolt's total operating costs would average about $0.38 per mile, 73% higher than the $0.22/mile cost of the Sonic. Net Operating Costs: Europe In Europe, both fuel and electricity costs are typically much higher than in the U.S., but ICEVs also tend to be more fuel efficient. The Bolt is roughly equivalent to an Opel Astra, which costs €16,700 ($19,160) in France and consumes 4.4 litres/100 km20 (53 MPG). The difference in price between the Bolt and the Astra is about $18,300, a smaller premium than in the U.S. comparison. However, even though gasoline prices are more than twice as expensive in Europe than in the U.S., fuel costs for the Astra are moderated by the car's higher fuel efficiency, approximating $10,500 for the first 100,000 miles. Energy costs and EV subsidies vary widely across the EU. Because the economic impact of EVs would be roughly proportional to GDP, we decided to look at the largest EU economies excluding the UK. It happens that EV sales in Italy are negligible, with total market share less than 0.1%,21 and EV subsidies in the country are somewhat opaque. Therefore, we confined our analysis to Germany and France. Assuming lifetime power consumption of 31,250 kWh, the electric power costs of the Bolt would be around $5,350 in France, which has low power prices, for net energy savings of $5,100. In Germany, where power prices of $0.34/kWh are considerably higher, the Bolt and the Astra would have energy costs that are roughly equal. In France, EVs' ownership costs would be $13,200 (49%) higher than the ICEV; in Germany, EV ownership costs would be $18,500 (68%) higher. Bolt Vs Sonic Cost Of Ownership: Impact Of Subsidies In the U.S., there is a federal subsidy of $7,500 and some states also have an EV incentive. In New York State, the subsidy is $2,000, meaning the net increased cost of owning the Bolt instead of a Sonic drops to around $6,600. Note that the federal subsidy is designed to "phase out" once a manufacturer sells 200,000 vehicles. GM hopes to sell 30,000 EVs in 2017 despite only launching U.S.-wide in summer 2017. Combined with prior Volt sales of over 150,000 units, GM should exhaust its federal subsidies in early 2018. Subsidies vary considerably across the EU.22 In France, there is a subsidy of €6,300 ($7,200)23 associated with the purchase of an EV, while Germany24 has a €4,000 ($4,600) incentive. Besides subsidies, there are other benefits of owning an EV including reserved or even free parking spaces, often including free charging. These are offset to some extent by the limited range of EVs which may disqualify them from purchase by some. It remains to be seen how long EV subsidies will persist. They may be affordable to governments as long as the number of vehicles sold remains small, but they would become very costly if EV sales accelerate. For example, about 2 million new passenger cars are registered in France every year. If only half of those were EVs, subsides would total $7.2B. Money for roads, infrastructure maintenance, policing, and so on have to come from somewhere, and if ICEV sales decline substantially, European governments' huge gasoline tax revenues would also deteriorate; in such an environment, it is reasonable to assume that EV subsidies would eventually disappear and be replaced by taxes. It seems highly unlikely to us that a massive subsidy program would be a politically acceptable solution in the U.S. auto market; however, it may very well be that over the near term subsidies persist in the EU where concerns over climate change have greater political weight. Cost Of Ownership: Depreciation Depreciation of the EV is almost certainly going to be much higher than the ICEV, which accounts for some of the higher cost of ownership. We believe that most EV batteries will be substantially degraded after 160,000 km (100,000 miles), and we doubt there will be many EVs on the road past about 200,000 km or 15 years of operation. In contrast, the average age of a vehicle in the EU is over 10.5 years,25 while the average age of a vehicle in the U.S. is 11.6 years.26 The overwhelming majority of EVs on the road today are still under warranty and, in either event, relatively new, which means consumers lack the information to understand the inherent issues of battery degradation. As more consumers have experience with EVs, the problems of degradation and replacement cost (i.e. the high cost of depreciation) will likely temper demand. This would be the case even if battery costs drop significantly: few consumers would invest even $5,000 into repairing a 10-year-old vehicle, and an EV with a 100 mile (160 km) range is significantly less useful than one with a 200 mile (320 km) range. Rapid depreciation has been the experience of Nissan Leaf owners who are discovering their vehicles have lost 80% of their value after only 3 years.27 EV advocates suggest that degradation is not an issue and that, in any event, batteries are getting better and better. This flies in the face of what essentially every consumer has experienced with mobile phones, notebook computers, or any other cordless device. We believe GM has better insights into the issue than EV advocates do and, in any event, we see no evidence for significant improvements in battery life. If, indeed, significant improvements are made to batteries, prior-generation EVs (including today's Bolt) will plummet in value. That said, consumer understanding of battery degradation is not likely to be a factor for EV adoption over the near term. Conclusion: Costs Of Ownership Assuming similar depreciation and excluding subsidies, the net difference in cost of ownership over 160,000 km (100,000 miles) between a Bolt and an equivalent ICEV is about $16,100 in the U.S., $13,200 in France, and $18,500 in Germany, in favor of the ICEV. After subsidies, an optimistic analysis suggests the difference in cost of ownership to travel 100,000 miles (160,000 km) between a Bolt EV and a roughly similar ICEV is about $6,600 in the U.S. (New York), $6,000 in France, and $13,900 in Germany, in favor of the ICEV. Electric power costs for the Bolt are around $3,250 in the U.S., $10,600 in Germany, and around $5,350 in France. Even if electricity were free, after subsidies, the difference in cost of ownership would be $3,400 in the U.S. (NY), $3,200 in Germany, and $600 in France. GM is believed to be losing $9,000 with every Bolt it sells. If so, and it wanted to sell the vehicle at its average Gross Margin of around 13%, it would sell for closer to $48,300, which would increase cost of ownership by about $11,000. In other words it would take a cost reduction of around $14,750 (about 34%) of likely manufacturing cost before the cost of ownership would favor the Bolt in France after subsidies. As noted above in our discussion of battery costs, GM expects a $2,700 cost saving associated with battery cells by 2022. Given that it is losing money on the vehicle, it is hard to believe they will immediately pass these savings on to the consumer. Even if they did, cost of ownership would still favor the ICEVs. Brian Piccioni, Vice President Technology Sector Strategy brianp@bcaresearch.com Matt Conlan, Senior Vice President Energy Sector Strategy mattconlan@bcaresearchny.com Robert P. Ryan, Senior Vice President Commodity & Energy Strategy rryan@bcaresearch.com Johanna El-Hayek, Research Assistant johannah@bcaresearch.com 1 https://www.bloomberg.com/news/articles/2017-06-28/china-is-about-to-bury-elon-musk-in-batteries 2 https://www.greentechmedia.com/articles/read/10-battery-gigafactories-are-now-in-progress-and-musk-may-add-4-more 3 Please see Technology Sector Strategy Special Report "Electric Vehicle Batteries", dated September 20, 2016. 4 http://insideevs.com/heres-how-much-a-chevrolet-bolt-replacement-battery-costs/ 5 http://insideevs.com/gm-chevrolet-bolt-for-2016-145kwh-cell-cost-volt-margin-improves-3500/ 6 https://www.researchgate.net/publication/260339436_An_Overview_of_Costs_for_Vehicle_Components_Fuels_and_Greenhouse_Gas_Emissions 7 https://www.bloomberg.com/news/articles/2017-05-26/electric-cars-seen-cheaper-than-gasoline-models-within-a-decade 8 https://www.bloomberg.com/news/articles/2016-11-30/gm-s-ready-to-lose-9-000-a-pop-and-chase-the-electric-car-boom 9 https://electrek.co/2016/12/07/gm-chevy-bolt-ev-battery-degradation-up-to-40-warranty/ 10 http://www.carinsurance.com/Articles/average-miles-driven-per-year-by-state.aspx 11 http://www.chevrolet.com/byo-vc/client/en/US/chevrolet/bolt-ev/2017/bolt-ev/features/trims/?section=Highlights§ion=Fuel%20Efficiency§ion=Dimensions&styleOne=388584 12 https://electrek.co/2016/12/15/chevy-bolt-ev-europe-june-2017-opel-ampera-e-gm/ 13 The Bolt weighs almost 800 pounds (360 kg) more than a similar sized Chevrolet Sonic. 14 http://www.consumerreports.org/cars-tesla-reliability-doesnt-match-its-high-performance/ 15 https://www.veic.org/docs/Transportation/20130320-EVT-NRA-Final-Report.pdf 16 http://teslaliving.net/2014/07/07/measuring-ev-charging-efficiency/ 17 http://www.chevrolet.com/bolt-ev-electric-vehicle 18 http://www.chevrolet.com/sonic-small-car 19 https://www.eia.gov/electricity/state/ 20 http://www.opel.fr/vehicules/gamme-astra/astra-5-portes/points-forts.html#trim-edition 21 http://www.eafo.eu/content/italy 22 https://www.iea.org/publications/freepublications/publication/GlobalEVOutlook2017.pdf pages 53-55 23 http://insideevs.com/overview-incentives-buying-electric-vehicles-eu/ 24 https://electrek.co/2016/04/27/germany-electric-vehicle-incentive-4000/ 25 http://www.acea.be/statistics/tag/category/average-vehicle-age 26 http://www.autonews.com/article/20161122/RETAIL05/161129973/average-age-of-vehicles-on-road-hits-11.6-years 27 http://blog.caranddriver.com/tesla-aside-resale-values-for-electric-cars-are-still-tanking/ Investment Views and Themes Recommendations Strategic Recommendations Tactical Trades Electric Vehicles Part 1: Costs Of Ownership Electric Vehicles Part 1: Costs Of Ownership Commodity Prices and Plays Reference Table Electric Vehicles Part 1: Costs Of Ownership Electric Vehicles Part 1: Costs Of Ownership Trades Closed in 2017 Summary of Trades Closed in 2016

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 The Coming Robotics Revolution The Coming Robotics Revolution Chart 2...And So Were Horses The Coming Robotics Revolution The Coming Robotics Revolution 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 The Industrial Revolution Led To A Vast Improvement In Living Standards The 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 The Coming Robotics Revolution The Coming Robotics Revolution 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 Advances In Robotics Will Counter Adverse Demographic Trends Advances In Robotics Will Counter Adverse 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 Long Replacement Cycles Mean Slower Semiconductor Sales Long Replacement Cycles Mean Slower Semiconductor Sales Chart 6Cisco's Stock Price Is Close To Tech Bubble##br## Levels Despite Declining Revenue Cisco's Stock Price Is Close To Tech Bubble Levels Despite Declining Revenue Cisco's Stock Price Is Close To Tech Bubble 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 Eastman Kodak Tried To Ignore The Shift To Digital Cameras Eastman Kodak Tried To Ignore The Shift 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 Unilateral economic sanctions show that geopolitical risks are rising in Asia Pacific; China is using sanctions to get its way with its neighbors; South Korea was the latest victim, and will be rewarded for its pro-China shift; Trump's Mar-a-Lago honeymoon with Xi Jinping is over; Tactically, go long South Korean consumers / short Taiwanese exporters. Feature Geopolitical risk is shifting to the Asia Pacific region - and the increasing use of economic sanctions is evidence of the trend. Korean stocks have rallied sharply since the leadership change from December 2016 through May of this year (Chart 1). The impeachment rally was entirely expected after a year of domestic political turmoil.1 The election is also eventually expected to decrease Korean geopolitical risks - the country's new President Moon Jae-in, of the left-leaning Democratic Party, aims to patch up relations with China and revive diplomacy with North Korea.2 Chart 1South Korean Impeachment Rally Over South Korean Impeachment Rally Over South Korean Impeachment Rally Over A key barometer of Moon's success will be whether he convinces China to remove economic sanctions imposed since last summer as punishment for his predecessor's agreement to host the U.S. THAAD missile defense system. Moon has suspended the system's deployment in a nod to China.3 South Korea is thus the latest example of an important trend in the region: China's successful use of "economic statecraft" to pressure wayward neighbors into closer alignment with its interests. Since 2014, Thailand, Malaysia, Vietnam and the Philippines have each sought in different ways to reorient their foreign policies toward China, either to court Chinese assistance or get relief from Chinese pressure. Judging by our research below, the rewards are palpable, and a sign of Beijing's rising global influence. Because U.S.-China tensions are rising structurally, we see these country-by-country shifts toward China not as a decisive loss for the U.S. alliance but rather as the latest phase in a long game of tug-of-war that will intensify in the coming years.4 Hence the trend of unilateral economic sanctions will continue. Who is next on China's hit list? How will the U.S. respond? What countries are most and least likely to be affected? And what are the market implications? China's Economic Statecraft The United States launched a "pivot to Asia" strategy under the Obama administration to reassert American primacy in Asia Pacific and address the emerging challenge from China. The U.S.'s Asian partners largely welcomed this shift. Over the preceding decade, they had struggled with China's emergence as a military and strategic superior. The most prominent flashpoints came in the East and South China Seas. Beijing's newfound naval and air power caused regional anxiety. As the allies invited a larger U.S. role, Beijing began to assert its sovereignty claims over disputed waters and rocks, most ambitiously by creating artificial islands in the South China Sea and fortifying them with military capabilities. In three notable periods since the Great Recession, China's tensions with its neighbors have splashed over into the economic realm, prompting Beijing to impose punitive measures: Chart 2Japan's 2012 Clash With China Japan's 2012 Clash With China Japan's 2012 Clash With China Chart 3Chinese Boycotted Japanese Cars... Chinese Boycotted Japanese Cars... Chinese Boycotted Japanese Cars... Japan 2010-2012: In 2010, China and Japan clashed as the former challenged Japan's control of the Senkaku (Diaoyu) islands in the East China Sea. In the September-November 2010 clash, China notoriously cut off exports of rare earths to Japan.5 A greater clash occurred from July-November 2012. Chinese people rose up in large-scale protests, damaging Japanese and other foreign property and assets. Impact: The growth of Japanese exports to China slowed noticeably between the 2010 and 2012 clashes, underperforming both that of China's neighbors and Europe (Chart 2). In particular, Chinese consumers stopped buying as many Japanese cars and switched to other brands (Chart 3). Chinese investment in Japan, which is generally very small, fell sharply in the year after the major 2012 clash, by contrast with the global trend (Chart 4). Chinese tourism to Japan also fell sharply after both incidents, though only for a short period of time (Chart 5). Chart 4...And Cut Investments In Japan... ...And Cut Investments In Japan... ...And Cut Investments In Japan... Chart 5...While Tourists Went Elsewhere ...While Tourists Went Elsewhere ...While Tourists Went Elsewhere Philippines 2012-2016: Tensions between China and the Philippines over the contested Spratly Islands and other rocks in the South China Sea have a long history. The latest round began in the mid-2000s, and the two countries have skirmished many times since then, including in a major showdown at Scarborough Shoal in 2012 that required the intercession of the United States to be resolved. The pressure intensified after January 2013, when the Philippines brought a high-profile case against China's maritime-territorial claims to the Permanent Court of Arbitration at the Hague. The U.S. and the Philippines upped the ante in April 2014 by signing an Enhanced Defense Cooperation Agreement. Ultimately, the court dealt a humiliating blow to China's maritime-territorial claims in July 2016, but a bigger confrontation was avoided because of what had happened in the remarkable May 2016 Philippine elections, which put China-friendly populist President Rodrigo Duterte in Manila on July 1. Impact: China tightened phytosanitary restrictions on Philippine bananas during the 2012 crisis and Philippine exports to China underperformed those of its neighbors after the onset of diplomatic crisis in 2013 (Chart 6). Nevertheless, the overall impact on headline exports is debatable. Tourism suffered straightforwardly both after the 2012 showdown at sea and after the new U.S.-Philippines military deal in 2014 (Chart 7). As with Japan, the impact was temporary. Chart 6Philippine Clash With China Over Sovereignty Philippine Clash With China Over Sovereignty Philippine Clash With China Over Sovereignty Chart 7Chinese Tourists Snub The Philippines Chinese Tourists Snub The Philippines Chinese Tourists Snub The Philippines Vietnam 2011-14: China's quarrels with Vietnam go back millennia, but in recent years have centered on the South China Sea. As with the Philippines, frictions began rising in the mid-2000s and flared up after the global financial crisis. In the summer of 2012, Vietnam and China engaged in a dispute over new laws encompassing their territorial claims. In May 2014, the two countries fought a highly unorthodox sea-battle near the Paracel Islands. Anti-Chinese protests erupted throughout Vietnam, prompting China to restrict travel.6 Impact: It is not clear that China imposed trade measures against Vietnam - export growth was plummeting in 2012 because of China's nominal GDP slowdown as well - but certainly exports skyrocketed after the two sides began tothaw diplomatic relations in August 2014 (Chart 8).7 Direct investment from China into Vietnam fell in 2014, even as that from the rest of the world rose. Chinese tourism to Vietnam shrank in the aftermath. Chart 8Vietnam Reboots China Trade Vietnam Reboots China Trade Vietnam Reboots China Trade The above incidents complement a growing body of academic research demonstrating China's use of unilateral economic sanctions and their trade and market impacts.8 Bottom Line: China has employed unilateral, informal, and discrete economic sanctions and has encouraged or condoned citizen boycotts and popular activism against Japan, the Philippines, Vietnam, Taiwan, and other states since at least the early 2000s. Moreover, three international confrontations since 2010 suggest that China's foreign policy is growing bolder - it is not afraid to throw its economic weight around to get what it wants politically or to deter countries from challenging its interests. How Significant Is China's Wrath? Both our evidence and the scholarly literature reveal that China-inflicted economic damage tends to be temporary and sometimes ambiguous from a macro-perspective.9 For instance, if there were negative trade effects of Vietnam's 2014 clash with China, they were overwhelmed by Vietnam's rising share of China's market in the following years (Chart 9). And, as hinted above, Chinese sanctions on Philippine banana exports in 2012 can be overstated according to close inspection of the data.10 Nevertheless, since 2016, three new episodes have reinforced the fact that China's punitive measures are a significant trend with potentially serious consequences for Asian economies: Taiwan 2016: Taiwanese politics have shifted away from mainland China in recent years. The "Sunflower Protests" of 2014 marked a shift in popular opinion away from the government's program of ever-deeper economic integration with the mainland. Local elections later that year set the stage for a sweeping victory by the Democratic Progressive Party (DPP), taking both the presidency and, for the first time, the legislature, in January 2016.11 Tsai is a proponent of eventual Taiwanese independence and dissents from key diplomatic agreements with the mainland, the "One China Policy" and "1992 Consensus." Within six months of the election Beijing had cut off diplomatic communication. Impact: The number of mainland visitors has nosedived, by contrast with global trends (Chart 10). Taiwan's exports and access to China's market are arguably weaker than they would otherwise be. Given the historic cross-strait Economic Cooperation Framework Agreement in 2010, and the strong export growth in the immediate aftermath of that deal, it is curious that exports have been so weak since 2014 (Chart 11). Chart 9China Flings Open Doors To Vietnam China Flings Open Doors To Vietnam China Flings Open Doors To Vietnam Chart 10Mainland Tourists Punish Rebel Taiwan Mainland Tourists Punish Rebel Taiwan Mainland Tourists Punish Rebel Taiwan Chart 11So Much For Cross-Strait Trade Deals? So Much For Cross-Strait Trade Deals? So Much For Cross-Strait Trade Deals? South Korea 2016-17: China and South Korea are on the cusp of improving relations after a year of Beijing-imposed sanctions. The former government of President Park Geun-hye, who was impeached in December 2016 and removed from office in March this year, moved rapidly with the U.S. to deploy the THAAD missile defense system on South Korean soil while her government was collapsing, so as to make it a fait accompli for her likely left-leaning (and more China-friendly) successor. Her government agreed to the deployment in July 2016 and since then China has exacted substantial economic costs via Korean exports and Chinese tourism.12 The new President Moon Jae-in is now calling on China to remove these sanctions, while initiating an "environmental review" that will delay deployment of THAAD, possibly permanently. Impact: South Korean exports to China have underperformed the regional trend throughout the downfall of the Park regime and its last-minute alliance-building measures with both the U.S. and Japan (Chart 12). South Korea has also lost market share in China since agreeing to host THAAD in July 2016 (Chart 13). Furthermore, Korean car sales on the mainland have deviated markedly both from their long-term historical trend and from Japan's contemporary sales (Chart 14), the inverse of what occurred in 2012 (see Chart 3 above). Chinese tourism to South Korea has sharply declined. Chart 12China Cools On Korean Imports China Cools On Korean Imports China Cools On Korean Imports Chart 13China Hits South Korea Over THAAD China Hits South Korea Over THAAD China Hits South Korea Over THAAD Chart 14Korean Car Sales And Tourist Sales Slump Korean Car Sales And Tourist Sales Slump Korean Car Sales And Tourist Sales Slump North Korea 2016-17: Ironically, China brought sanctions against both Koreas last year - the South for THAAD, the North for its unprecedented slate of missile and nuclear tests. These provoked the United States into pressuring China via "secondary sanctions." Impact: China's sanctions on the North - which include a potentially severe ban on coal imports - are limited so far, according to the headline trade data, as China is wary of destabilizing the hermit kingdom (Chart 15). But if China does grant President Trump's request and increase the economic pressure on North Korea, it will be no less of a sign of a greater willingness to utilize economic statecraft, especially given that the North is China's only formal ally. Other countries will not fail to see the implications should they, like either Korea, cross Beijing's interests. Bottom Line: Doubts about China's new foreign policy "assertiveness" are overstated. China is increasing its unilateral use of economic levers to pressure political regimes in its neighborhood, including major EMs like Taiwan and South Korea over the past year. Korean President Moon Jae-in's rise to power is likely to produce better Sino-Korean relations, but neither it nor Taiwan is out of the woods yet, according to the data. Moreover, the rest of the region may be cautious before accepting new U.S. military deployments or contravening China's demands in other ways. The Asian "Pivot To China" Over the past two years, several Asian states have begun to vacillate toward China, not because they fear American abandonment but because the U.S. "pivot" gave them so much security reassurance that it threatened to provoke conflict with China - essentially risking a new Cold War. They live on the frontlines and wanted to discourage this escalation. At the same time, the growth slump in China/EM in 2014 - followed by China's renewed stimulus in 2015 - encouraged these states to improve business with China. Thailand began to shift in 2014, when a military junta took power in a coup and sought external support. China's partnership did not come with strings attached, as opposed to that of the U.S., with its demands about democracy and civil rights.13 The rewards of this foreign policy shift are palpable (Chart 16). China signed some big investment deals and improved strategic cooperation through arms sales. It did the same with Malaysia for similar reasons.14 China's "One Belt One Road" (OBOR) economic development initiative provided ample opportunities for expanding ties. Chart 15No Chinese Embargo On North Korea... Yet No Chinese Embargo On North Korea... Yet No Chinese Embargo On North Korea... Yet Chart 16China Opens Doors To Thai Junta China Opens Doors To Thai Junta China Opens Doors To Thai Junta The year 2016 was a major turning point. Three of China's neighbors - two of which U.S. allies - underwent domestic political transitions ushering in more favorable policies toward China: Vietnam: The Vietnamese Communist Party held its twelfth National Congress in January 2016. Prime Minister Nguyen Tan Dung, a pro-market reformer from the capitalist south, failed to secure the position of general secretary of the party and retired. The incumbent General Secretary Nguyen Phu Trong retained his seat, and oversaw the promotion of key followers, strengthening Vietnam's pro-China faction. Since then Trong has visited President Xi in Beijing and signed a joint communique on improving strategic relations. As mentioned above, Vietnamese exports to China have exploded since tensions subsided in 2014. South Korea: In April 2016, South Korean legislative elections saw the left-leaning Democratic Party win a plurality of seats, setting the stage for the 2017 election discussed above, when Korea officially moved in a more China-friendly direction under President Moon. The Philippines: In May 2016, the Philippines elected Duterte, a firebrand southern populist who declared that the Philippines would "separate" itself from the U.S. and ally with Russia and China. Though Duterte has already modified his anti-American stance - as we expected - he is courting Chinese trade and investment at the expense of the Philippines' sovereignty concerns.15 Trump's election contributed to this regional trend. By suggesting a desire for the U.S. to stop playing defender of last resort in the region, Trump reinforced the need for allies like Thailand, the Philippines, and South Korea to go their own way. And by canceling the Trans-Pacific Partnership, Trump forced Malaysia and Vietnam to make amends with China, while vindicating those (like Thailand and Indonesia) that had remained aloof. Bottom Line: Having brandished its sticks, China is now offering carrots to states that recognize its growing regional influence. These do not have to be express measures, given that China is stimulating its economy and increasing outbound investment for its own reasons. All China need do is refrain from denying access to its market and investment funds. Whom Will China Sanction Next? Geopolitical risk on the Korean peninsula remains elevated given that North Korea remains in "provocation mode" and Trump has prioritized the issue. However, we expect that Moon will cooperate with China enough to give a boost to South Korean exports and China-exposed companies and sectors. With South Korea's shifting policy, Beijing has a major opportunity to demonstrate the positive economic rewards of pro-China foreign policy. If a new round of international negotiations gets under way and North Korean risk subsides for a time (our baseline view),16 then East Asian governments will turn to other interests. We see two key places of potential confrontation over the next 12-24 months: Taiwan is the top candidate for Chinese sanctions going forward. The cross-strait relationship is fraught and susceptible to tempests. The ruling DPP lacks domestic political constraints, which could be conducive to policy mistakes. Moreover, Trump has signaled his intention to strengthen the alliance with Taiwan, which could cause problems. China is likely to oppose the new $1.4 billion package of U.S. arms more actively than in the past, given its greater global heft. Trump's initial threat of altering the One China Policy has not been forgotten. In terms of timing, China may not want to give a tailwind to the DPP by acting overly aggressive ahead of the 2018 local elections, which are crucial for the opposition Kuomintang's attempt to revive in time for the 2020 presidential vote. But this is not a hard constraint on Beijing's imposing sanctions before then. Japan is the second-likeliest target of Chinese economic pressure. Japanese Prime Minister Shinzo Abe is up for re-election no later than December 2018 and is becoming more vulnerable as he shifts emphasis from pocketbook issues to Japan's national security.17 Needless to say, the revival of the military is the part of Abe's agenda that Beijing most opposes. China would like to see Abe weakened, or voted out, and would especially like to see Abe's proposed constitutional revisions fail in the popular referendum slated for 2020. China would not want to strengthen Abe by provoking Japanese nationalism. But if Abe is losing support, and Beijing calculates that the Japanese public is starting to view Abe and his constitutional revisions as too provocative and destabilizing, then a well-timed diplomatic crisis with economic sanctions may be in order.18 Next in line are Hong Kong and Singapore, though Beijing has already largely gotten its way in recent disputes with the two city-states.19 Other possibilities on the horizon: The eventual return to a fractious civilian government in Thailand, or improved U.S.-Thai relations, could spoil China's infrastructure plans and sour its willingness to support an otherwise lackluster Thai economy. Also, a surprise victory by the opposition in Malaysian general elections (either this year or next) could see the recent rapprochement with China falter. The latter would be cyclical tensions, whereas suppressed structural tensions with Vietnam and the Philippines could boil back up to the surface fairly quickly at any time and provoke Chinese retaliation. Bottom Line: The most likely targets of Chinese economic sanctions in the near future are Taiwan and Japan. South Korea could remain a target if events should force Moon to abandon his policy agenda, though we see this as unlikely. Hong Kong and Singapore also remain in the danger zone, as do Vietnam and the Philippines in the long run. Investment Implications Cyclical and structural macro trends drive exports and investment trends in Asia Pacific. The biggest immediate risk to EM Asian economies stems not from Chinese sanctions - given that most of these economies have adjusted their policies to appease China to some extent - but from China's economic policy uncertainty, which remains at very elevated levels (Chart 17). It was after this uncertainty surged in 2015 that China's neighbors took on a more accommodating stance with a focus on economic cooperation rather than strategic balancing. Chart 17Chinese Economic Policy Uncertainty Still Asia's Biggest Risk Does It Pay To Pivot To China? Does It Pay To Pivot To China? Currently Chinese economic policy uncertainty is hooking back up as a result of the decision by state authorities to intensify their financial crackdown - the so-called "deleveraging campaign." BCA's Emerging Markets Strategy has recently pointed out that China's slowing fiscal and credit impulse will drag down both Chinese import volumes and emerging market corporate earnings in the coming months (Chart 18). Already commodity prices and commodity currencies have dropped off, heralding a broader slowdown in global trade as a result of China's policy tightening. This trend will overwhelm the effect of almost any new geopolitical spats or sanctions. The same can be said for Chinese investment as for Chinese trade. Over the past couple of decades, China has emerged as one of the world's leading sources of direct investment (Chart 19). This is a secular trend. Thus while foreign relations have affected China's investment patterns - most recently in giving the Philippines a boost under Duterte - the general trend of rising Chinese investment abroad will continue regardless of temporary quarrels. This is particularly true in light of China's efforts to energize OBOR. Chart 18China: Stimulus Fading China: Stimulus Fading China: Stimulus Fading Chart 19China's Emergence As Major Global Investor Does It Pay To Pivot To China? Does It Pay To Pivot To China? The key question is how will China's political favor or disfavor impact neighboring economies on the margin, in relative terms, on a sectoral basis, or in the short term? The evidence above feeds into several trends in relative equity performance: China fights either Japan or Korea: Going long Korea / short Japan would have paid off throughout the major Sino-Japanese tensions 2010-12, and would have paid off again during the South Korean impeachment rally (Chart 20). Of course, geopolitics is only one factor. But even Japan's economic shift in 2012 (Abenomics) is part of the geopolitical dynamic. Chart 20China Fights Either Japan Or Korea China Fights Either Japan Or Korea China Fights Either Japan Or Korea Chart 21Taiwan's Loss = Japan's Gain Taiwan's Loss = Japan's Gain Taiwan's Loss = Japan's Gain Taiwan's loss is Japan's gain: China's measures against Japanese exporters from 2010-12 coincided with a period of intense cross-strait economic integration that benefited Taiwanese exporters. Then Japan adopted Abenomics and dialed down tensions with China, and Taiwan underwent a pro-independence turn, provoking Beijing's displeasure (Chart 21). If one of these countries ends up quarreling with China in the near future, as we expect, the other country's exporters may reap the benefit. If relations worsen with both, South Korea stands to gain. Favor EM reformers: Vietnamese and Philippine equities outperformed EM from 2011-16 despite heightened tensions in the South China Sea (Chart 22). During this time, we recommended an overweight position on both countries relative to EM, even though we took the maritime tensions very seriously, because we favored EM reformers and both countries were undertaking structural reforms.20 Later, in May 2016, we downgraded the Philippines to neutral, expecting a loss of reform momentum after Duterte's election. The Philippines has notably underperformed the EM equity benchmark since that time.21 The "One China Policy": We closed out our "long One China Policy" trade on June 14 as a result of China's persistence in its crackdown on the banks, which we see as very risky.22 However, we may reinitiate the trade in the future, as Hong Kong and Taiwan remain vulnerable both to the slowdown in globalization and to Beijing's sanctions over deepening political differences (Chart 23). Chart 22Reforms Pay... Even During Island Tensions Reforms Pay... Even During Island Tensions Reforms Pay... Even During Island Tensions Chart 23The 'One China Policy' As A Trade The 'One China Policy' As A Trade The 'One China Policy' As A Trade From Sunshine to Moonshine: South Korea's Moon Jae-in has substantial political capital and we expect that he will succeed in boosting growth, wages, and the social security net, all of which will be bullish for South Korean consumer stocks. Yet we remain wary of the fact that North Korea is not yet falling into line with new negotiations. A way to hedge is to go long the South Korean consumer relative to Taiwanese exporters (Chart 24), which will live under the shadow of Beijing's disfavor at least until the 2020 elections, if not beyond. Taiwan has also allowed its currency to appreciate notably against the USD since Trump's post-election phone call with President Tsai, which is negative for Taiwanese exporters. Chart 24Go Long Korean Consumer /##br## Short Taiwanese Exporter Go Long Korean Consumer / Short Taiwanese Exporter Go Long Korean Consumer / Short Taiwanese Exporter China's sanctions are essentially a "slap on the wrist" in economic terms. But sometimes they reflect deeper structural tensions, and thus they may foreshadow far more damaging clashes down the road that could have longer term consequences, just as the Sino-Japanese incident of 2012 demonstrated. That is all the more reason to hedge one's bets on Taiwan today. These sanctions are bound to recur and will provide investors with trading opportunities, if not long-term investment themes. It will pay to capitalize quickly at the outset of any serious increase in tensions going forward. As a final word, the Trump administration's recent moves to impose economic penalties on China - namely through "secondary sanctions" due to North Korea, but also through potential trade tariffs and/or penalties related to human trafficking and human rights - highlight the fact that the use of unilateral sanctions is not limited to China. Geopolitical risk is rising in Asia as a result of actions on both sides of the Pacific. Sino-American antagonism in particular poses the greatest geopolitical danger to global markets, as we have frequently emphasized.23 And as Trump's domestic agenda struggles he will seek to get tougher on China, as he promised to his populist base on the campaign trail. In the event of a major geopolitical crisis in the region, we recommend the same mix of safe-haven assets that we have recommended in the past: U.S. treasuries, Swiss bonds, JGBs, and gold.24 Matt Gertken, Associate Vice President Geopolitical Strategy mattg@bcaresearch.com 1 Please see BCA Geopolitical Strategy Weekly Report, "Northeast Asia: Moonshine, Militarism, And Markets," dated May 24, 2017, available at gps.bcaresearch.com. For our longstanding investment theme of rising geopolitical risk in East Asia, please see BCA Geopolitical Strategy Special Report, "Power And Politics In East Asia: Cold War 2.0?" dated September 25, 2012, and Monthly Report, "The Great Risk Rotation," dated December 11, 2013, available at gps.bcaresearch.com. 2 Please see BCA Emerging Market Equity Sector and Geopolitical Strategy Special Report, "South Korea: A Comeback For Consumer Stocks?" dated June 27, 2017, available at gps.bcaresearch.com. 3 However, Moon is walking a tight rope in relation to the United States. During his visit to Washington on June 29, he assured Congressman Paul Ryan among others that he did not necessarily intend to reverse the THAAD agreement as a whole. That would depend on the outcome of the environmental review and due legal process in South Korea as well as on whether North Korea's behavior makes the missile defense system necessary. Please see Kim Ji-eun, "In US Congress, Pres. Moon Highlights Democratic Values Of Alliance With US," The Hankyoreh, July 1, 2017, available at English.hani.co.kr. 4 Please see BCA Geopolitical Strategy Weekly Report, "How To Play The Proxy Battles In Asia," dated March 1, 2017, available at gps.bcaresearch.com. 5 Please see Jeffrey R. Dundon, "Triggers of Chinese Economic Coercion," Naval Postgraduate School, September, 2014, available at calhoun.nps.edu. 6 For a very conservative estimate of China's actions during the Haiyang Shiyou 981 incident, please see Angela Poh, "The Myth Of Chinese Sanctions Over South China Sea Disputes," Washington Quarterly 40:1 (2017), pp. 143-165. 7 Please see "Vietnam Party official heads to China to defuse tensions," Thanh Nien Daily, August 25, 2014, available at www.thanhniennews.com. 8 Please see Faqin Lin, Cui Hu, and Andreas Fuchs, "How Do Firms Respond To Political Tensions? The Heterogeneity Of The Dalai Lama Effect On Trade," University of Heidelberg Department of Economics Discussion Paper Series 628, August 2016, available at papers.ssrn.com. This study improves upon earlier ones, notably Andreas Fuchs and Nils-Hendrik Klann, "Paying A Visit: The Dalai Lama Effect On International Trade," Journal Of International Economics 91 (2013), pp 164-77. See also Christina L. Davis, Andreas Fuchs, and Kristina Johnson, "State Control And The Effects Of Foreign Relations On Bilateral Trade," October 16, 2016, MPRA Paper No. 74597, available at https://mpra.ub.uni-muenchen.de/74597/ ; Yinghua He, Ulf Nielsson, and Yonglei Wang, "Hurting Without Hitting: The Economic Cost of Political Tension," Toulouse School of Economics Working Papers 14-484 (July 2015), available at econpapers.repec.org; Raymond Fisman, Yasushi Hamao, and Yongxiang Wang, "Nationalism and Economic Exchange: Evidence from Shocks to Sino-Japanese Relations," NBER Working Paper 20089 (May 2014) available at www.nber.org; Scott L. Kastner, "Buying Influence? Assessing the Political Effects of China's International Trade," Journal of Conflict Resolution 60:6 (2016), pp. 980-1007. 9 The "Dalai Lama effect," in which countries that host a visit from the Dalai Lama suffer Chinese trade retaliation, has been revised downward over the years - the trade costs are only statistically significant in the second quarter after the visit. Please see "How Do Firms Respond," cited in footnote 8. 10 See "Myth Of Chinese Sanctions," cited in footnote 6. Chinese sanctions on Norwegian salmon exports after Liu Xiaobo's Nobel Peace Prize in 2010 also fall under this category. 11 Please see BCA Geopolitical Strategy and China Investment Strategy Special Report, "Taiwan's Election: How Dire Will The Straits Get?" dated January 13, 2016, available at gps.bcaresearch.com. 12 Please see Lee Ho-Jeong, "Thaad may lead to $7.5B in economic losses in 2017," Joongang Daily, May 4, 2017, available at www.joongangdaily.com. 13 Please see Ian Storey, "Thailand's Post-Coup Relations With China And America: More Beijing, Less Washington," Yusof Ishak Institute, Trends in Southeast Asia 20 (2015). 14 Malaysia began to move closer to China after its 2013 election, which initiated a period of political turbulence and scandal. This trend, along with economic slowdown, prompted the ruling coalition to turn to Beijing for support. 15 He is also, as current chair of the Association of Southeast Asian Nations (ASEAN), assisting China's negotiations toward settling a "Code of Conduct" in the South China Sea. This is not likely to be a binding agreement - China will not voluntarily reverse its strategic maritime-territorial gains - but it could dampen tensions for a time in the region and encourage better relations between China and Southeast Asia. For the 2016 Asian pivot to China discussed above, please see BCA Geopolitical Strategy and China Investment Strategy Special Report, "Five Myths About Chinese Politics," dated August 10, 2016, and Geopolitical Strategy and Global Investment Strategy Special Report, "The Geopolitics Of Trump," dated December 2, 2016, available at gps.bcaresearch.com. 16 Please see BCA Geopolitical Strategy Special Report, "North Korea: Beyond Satire," dated April 19, 2017, available at gps.bcaresearch.com. 17 The LDP's dramatic defeat in Tokyo's local elections on July 2 is the first tangible sign that the constitutional agenda, Abe's corruption scandals, and the emergence of a competing political leader, Yuriko Koike, are taking a toll on the LDP. 18 Also, Beijing may at any point rotate its maritime assertiveness back to the East China Sea, where tensions with Japan have quieted since 2013-14. Further, Beijing will want to exploit worsening relations between Japan and South Korea, and drive a wedge between Japan and Russia as they attempt a historic diplomatic thaw. 19 Beijing is attempting to steal a march on these states, especially in finance, while putting pressure on them to avoid activities that undermine Beijing's regional influence. So far there is only small evidence that tensions have affected trade. First, Hong Kong saw a drop in tourists and a block on cultural exports amid the Umbrella Protests of 2014. China's central government has acted aggressively over the past year to suppress Hong Kong agitation, by excluding rebel lawmakers from office and by drawing a "red line" against undermining Chinese sovereignty. Yet agitation will persist because of the frustration of local political forces and the youth, both of which resent the mainland's increasing heavy-handedness. Meanwhile, China and Singapore are in the process this month of improving relations after the November-January spat relating to Singapore-Taiwanese military ties. But China's encroachment on Singapore's traditional advantages - finance, oil refining, freedom of navigation, strong military relations with the U.S. and Taiwan, political stability - is likely to continue. 20 Please see BCA Geopolitical Strategy Monthly Report, "The Coming Bloodbath In Emerging Markets," dated August 12, 2015, "Geopolitical Risk: A Golden Opportunity?" dated July 9, 2014, and "In Need Of Global Political Recapitalization," dated June 2012, available at gps.bcaresearch.com. See also Frontier Markets Strategy Special Report, "Buy Vietnamese Stocks," dated July 17, 2015, available at fms.bcaresearch.com. 21 Please see BCA Geopolitical Strategy and Emerging Markets Strategy Special Report, "Philippine Elections: Taking The Shine Off Reform," dated May 11, 2016, available at gps.bcaresearch.com. 22 Please see BCA Geopolitical Strategy Weekly Report, "Has Europe Switched From Reward To Risk," dated June 7, 2017, available at gps.bcaresearch.com. 23 Please see BCA Geopolitical Strategy Strategic Outlook, "Strategic Outlook 2017: We Are All Geopolitical Strategists Now," dated December 14, 2016, available at gps.bcaresearch.com. 24 Please see The Bank Credit Analyst Special Report, "Stairway To (Safe) Haven: Investing In Times Of Crisis," dated August 25, 2016, available at bca.bcaresearch.com. Equity Recommendations Fixed-Income, Credit And Currency Recommendations

Dear Client, I am visiting clients in Asia. Along with a brief Weekly Report, we are sending you this Special Report written by my colleague Marko Papic, Chief Strategist of BCA's Geopolitical Strategy service. Marko argues that the U.S. is vulnerable to serious socio-political instability by the 2020 election, as a result of the widening gulf between elites and the rest. Trump, thus far, seems unlikely to bridge this gap. I hope you will find this report both interesting and informative. Best regards, Peter Berezin, Chief Strategist Global Investment Strategy Highlights The United States has produced too many elites, while popular well-being has fallen; Elite-controlled institutions have failed to protect households from the negatives of globalization and technological change; Tribalism, polarization, and money politics are preventing political compromise; Trump won by assaulting the "elites" but neither his policies, Congress, nor the economy look to improve well-being; With recession likely by 2019, the U.S. will see a revolt of some kind by the 2020 election. Feature Crime is increasing Trigger happy policing Panic is spreading God knows where We're heading Oh, make me wanna holler They don't understand Make me wanna holler They don't understand - Marvin Gaye, "Inner City Blues," 1971 If we had to explain the election of Donald Trump and the decision by U.K. voters to exit the EU with one chart it would be Chart 1. It depicts the relationship between high income inequality and low generational mobility and suggests that highly unequal societies develop structures that perpetuate unequal income through generations.1 The U.S. and the U.K. stand at the extreme of the relationship, with Italy close behind. Chart 1 Not surprisingly, the common people, "the plebs," in all three countries are dissatisfied with the arrangement. Low social mobility perpetuates unequal economic outcomes, throwing middle- and low-income voters into a sense of desperation. They fear that both their children's lot in life and their own is already decided, i.e. cannot and will not improve. A pre-election Gallup study of 125,000 American adults confirms that President Trump's support was strongest among voters in communities with poor health and low generational mobility.2 Of no relevance was whether respondents came from areas supposed to suffer most heavily from the ills that Trump opposed, i.e. communities exposed to global competition via trade, or those with high levels of immigration, or areas with relatively high unemployment and low incomes. America is supposed to be immune to income inequality because of social mobility. Equality of opportunity matters more than equality of outcome. This is the trade-off that has existed at the heart of America since its founding. For decades this trade-off has atrophied. Donald Trump was then elected to bring the U.S. back to its default setting. In this report, we explain why it may be too late and what will happen if he fails. If BCA's House View is correct, that a recession will occur by the end of 2019 (if not earlier), then the economic and political conditions are ripe for serious socio-political instability by the 2020 election.3 The Dynamic Of Elite Overproduction In Why Nations Fail, economist Daron Acemoglu and political scientist James Robinson tell a story of "How Venice Became A Museum."4 From the eleventh to fourteenth century, Venice was one of the richest places in the world. Behind its rapid economic expansion was the commenda, an early form of a joint-stock company formed for the duration of a single trading mission. It spurred Venice's ambitious entrepreneurs to find new trading routes by allowing them to share in the profits with the owners of capital who funded the risky journeys. As new families enriched themselves, political institutions grew more inclusive to accommodate them: in 1032, for instance, Venice held elections for its doge, or leader. An independent judiciary, private contracts, and bankruptcy laws followed. By 1330, Venice was a wealthy and strikingly modern republic with a population as large as that of Paris. The commenda system, however, had a dark side: creative destruction. Each new wave of young, enterprising explorers reduced the political privileges and profits of the established elites. In the late thirteenth century, these elites began to restrict membership in the Great Council, or legislature. Such efforts culminated in La Serrata ("The Closure") in 1297, which severely restricted access to the Great Council for new members but expanded it for families of established elites. An economic serrata quickly followed the political one, and the commenda system that underpinned Venice's wealth was replaced by a state monopoly on trade in 1314. The rest is, as they say, history. Venice rapidly declined as the newly closed economic and political institutions failed to deal with the rise of Portugal and Spain, the revolution in navigation and discovery of new trade routes to the East, and various regional attempts to encroach on its wealth and power. After the seventeenth century this decline accelerated. Today, its only source of income is tourism, which parlays the pre-Serrata wonders - such as the Doge's Palace and St. Mark's Cathedral - for cash that the city desperately needs to keep itself afloat.5 Acemoglu and Robinson make the case in their research that societies with both politically and economically inclusive institutions are rare. They cite a number of reasons for this, but the one that is most relevant to this report is "elite overproduction." Elites have a perfectly human and rational desire to perpetuate their political and economic privileges and pass them on to their children. A society that truly promotes equality of opportunity is one that leaves its elites to the fates. The elite desire to pass on privileges to future generations is a constant, but human conflict and state collapse are cyclical. Peter Turchin, a biologist who studies human conflict, has noted that periods of intense conflict in societies tend to recur within 40-to-60-year cycles. He posits that elite overproduction - and its counterpart, low societal well-being - is to blame.6 In post-industrial societies, low and falling labor costs are one of the principal conditions for elite multiplication. International trade, immigration, technological advancements, and investment in human and physical capital all suppress labor costs, benefiting the consumers of labor, i.e. the elites. Globalization has played a particularly important role in suppressing wages in the modern developed world. It expanded the global supply of labor by opening up new populations to capitalism (Chart 2), leading to suppressed wage growth for the middle classes in advanced economies (Chart 3). This process has been reinforced by technological change, particularly innovation that is biased in favor of capital (i.e. saving on labor costs) (Chart 4). Chart 2Globalization Expanded ##br##The Global Supply Of Labor... Globalization Expanded The Global Supply Of Labor... Globalization Expanded The Global Supply Of Labor... Chart 3 Chart 4 As elites capture an ever-greater share of the economic pie (even a growing economic pie), they become accustomed to ever greater levels of consumption, which drives inter-elite competition for social status. Everyone tries to "keep up with the Joneses," which for many is only achievable by supplementing wages with debt (Chart 5).7 The demand for elite goods - say homes in the "right" zip codes - exhibits runaway growth as the cost of elite membership rises and as sub-elites with rising income levels compete for access (Chart 6). Chart 5Credit Supplanted Income Credit Supplanted Income Credit Supplanted Income Chart 6Middle Class Incomes Don't ##br##Buy Middle Class Goods Middle Class Incomes Don't Buy Middle Class Goods Middle Class Incomes Don't Buy Middle Class Goods Focusing on the U.S., Turchin shows that Americans are today living in the second "Gilded Age." His research shows that "elite overproduction" has not been this high, and "population well-being" this low, since the early twentieth century (Chart 7). He calculates population well-being as a combination of general health, family formation, and wage and employment prospects. All indicators are currently in decline relative to history, save for health. But even life expectancy is taking a hit, albeit for select demographic groups most negatively impacted by poor job and wage prospects (Chart 8). Chart 7 Chart 8 For elite overproduction, Turchin relies on standard measures: wealth inequality, university education cost, and political polarization. This makes intuitive sense, since major policies aimed at reversing entrenched inequality can only be enacted after polarization has fallen due to events that subdued elites, such as major economic calamities or geopolitical challenges - e.g. the New Deal following the Great Depression, or the Great Society following World War II and amidst the Cold War. The danger of extreme polarization between elite prosperity and general well-being is that it is theoretically and empirically associated with political polarization, social unrest, and war. Acemoglu and Robinson detail case after case - from ancient Mayans and Romans to modern French and Japanese - in which the competition for resources between elites and the general population led to civil strife or all-out warfare. Meanwhile Turchin's research shows that politically motivated violence in the U.S. (Chart 9), which last peaked 50 years ago in the late 1960s, is associated with large gaps in well-being between elites and the masses (Chart 10).8 Chart 9 Chart 10 Bottom Line: Elite overproduction has been identified by academic research as a constant source of social instability throughout human history. Elites subvert inclusive political and economic institutions in order to stifle creative destruction, which would enrich new entrepreneurs but dilute elite privileges. As such, societies that prevent elite overproduction and promote equality of opportunity (and creative destruction) are successful in perpetuating themselves over the long term. Repatrimonialization In The U.S. Chart 11Tax Rates Were High In The Roaring '50s Tax Rates Were High In The Roaring '50s Tax Rates Were High In The Roaring '50s A sure sign that a society is in decline? When elites strive to hold onto their status and create barriers to entry for others. In the case of Venice, these barriers were overtly political. Le Serrata was followed by the introduction of Libro d'Oro (the "Golden Book"), which created an official registry of Venetian families that would be allowed to share in the deliberations of the Great Council. As the population revolted against such measures, Venice introduced a police force in 1310, with other coercive methods to follow. Today, the U.S. exhibits similar signs of institutional capture by the elites, albeit updated for the twenty-first century. Political theorist Francis Fukuyama calls this process "repatrimonialization." It occurs amidst long periods of economic prosperity and peace, as elites lose sight of their symbiotic relationship with fellow citizens and begin to serve their own "tribal" interests.9 Note in the above Chart 7 that elite overproduction, as defined by Turchin, reaches its peak after long periods of peace: the first high point came in 1902, 37 years after the Civil War, and the second came in 2007, 62 years after World War II. The latter case in particular suggests that as threats dissipate, elites lose sight of personal sacrifices - military service, income redistribution, public service, public works - that are required for geopolitical competition with peer challengers. At the height of the Cold War (1949 to 1962), for example, the top marginal tax rate in the U.S. was 92% (Chart 11).10 The point is not the tax rate, but that elites were far more acquiescent to fiscal sacrifices on behalf of the public. Fukuyama points to the U.K. and the U.S. as the two countries that have been the least politically responsive to the challenges of globalization and technological change in the developed world. In the case of the U.S., this is because interest groups are capable of steering policy towards further globalization and technological change. Both processes have also empowered elites, which have steered policy towards less redistribution and more austerity for the middle classes. The data is clear on this point. Despite Europe's being as exposed to globalization and technological advances as the U.S., European median wage growth has kept pace with GDP growth since 2000, whereas in the U.S. it not only failed to keep up but declined over the same time period (Chart 12). Chart 12Europe Shielded ##br##Households From Global Winds Europe Shielded Households From Global Winds Europe Shielded Households From Global Winds What are some of the mechanisms of repatrimonialization in the U.S. and can they be reversed? The good news is that elite capture of state institutions is now out in the open and easy to identify. Both Donald Trump and Democratic candidate Senator Bernie Sanders campaigned explicitly against it. The bad news is that it is unlikely to be reversed endogenously, at least not without a catalyst. What follows is a short description of the most salient problems facing the country as a result of elite entrenchment. Campaign Financing The 2010 Supreme Court decision Citizens United v. Federal Election Commission gave rise to political action committees, also known as Super PACs. These groups are allowed to receive unlimited contributions from individuals and corporations as long as they do not cooperate, coordinate, or directly contribute funding to actual candidates. This supposed firewall, however, is a fig leaf. The elimination of caps on this type of campaign financing allows single-issue groups and even single individuals with deep pockets to fund fringe candidates or support single-issue ballot measures that would otherwise lack sources of funding. This is especially important in primary elections where turnout is very low. In response, incumbent legislators have to tread carefully and avoid angering individual donors or Super PACs that could single-handedly fund a campaign against them in the primary elections, especially since the average cost of a congressional election campaign is relatively low at $1.4 million (a small amount compared to the funds that can be brought to bear by activist donors). In 2012, more than 40% of the campaign donations used in all federal elections was contributed by 0.01% of the voting-age population. That means that about 24,000 people were responsible for a near-majority of all contributions.11 Two other findings reported in the academic literature provide insight on how (and if) that money might steer policy. First, a study confirmed the general belief that the wealthiest Americans are much more conservative than the general public when it comes to tax policy and economic regulation.12 Second, another study found that when the policy preferences of the top 10% of income earners diverge from the preferences of the bottom 50%, the policy outcome is more likely to reflect the intentions of the former group.13 Polarization Political polarization benefits elites by impeding the democratic process and locking in rules that are beneficial to the status quo. Chart 13 shows that income inequality and political polarization in the sphere of economic policy are correlated.14 The simple reason the two are so highly correlated is because the right-of-center Republican Party increasingly opposes redistribution, while the left-of-center Democratic Party favors it. As the two parties diverge on matters of economic principle, compromises become virtually impossible, locking redistributive efforts at the current levels favored by the elites. Polarization is subsequently reinforced by electoral-district "gerrymandering" and an extremely bifurcated and increasingly distrusted news media. Over the last two decades, both the Democrats and Republicans (but mainly the latter due to their superior position at the state level) have redrawn administrative boundaries to create "ideologically pure" electoral districts. Of the 435 seats in the House of Representatives, only about 56 are truly competitive (Chart 14). Chart 13Inequality Fuels Political Polarization Inequality Fuels Political Polarization Inequality Fuels Political Polarization Chart 14Few Congressional Seats Truly Competitive Few Congressional Seats Truly Competitive Few Congressional Seats Truly Competitive Tribalization Elite overproduction often leads to the tribalization of society. Elites, to ensure that they are not torn asunder by the plebs, mobilize the population behind various causes that divert attention away from themselves, i.e. away from the real cause of social malaise. These causes are "wedge issues," in today's parlance. They can include identity politics, religious issues, as well as foreign policy. The Democratic Party has often relied on identity issues to mobilize support, but the effort kicked into high gear as it evolved from a redistributive "Old Left" party to the more centrist, "Third Way," neo-liberal orientation of Bill Clinton's presidency. Senator Bernie Sanders attempted to reverse this trend and overtly downplayed identity politics during his presidential campaign. He saw his party's neo-liberal turn as an elite-driven effort to distract from the real problems affecting low-income households. Hillary Clinton, the neo-liberal Democrat, by contrast, suffered as a result of the perception that she was an elite. Chart 15 The problem is that these wedge issues have begun to ossify into actual identities. For example, Pew Research showed in 2012 that the difference between Americans on a list of 48 values is the greatest between Republicans and Democrats, as opposed to other elements of identity. This has not always been the case, as Chart 15 shows. We suspect that this data will grow even starker after the divisive, borderline hysterical 2016 campaign. This means that "Republican" and "Democrat" labels have become almost tribal in nature. In fact, one's values are now determined more by one's party identification than race, education, income, religiosity, or gender! This is incredible, given America's history of racial and religious divisions. Bottom Line: America's repatrimonialization is advanced. The democratic process, which is supposed to adjudicate between interest groups and regulate elite economic and political privileges, has been drawn to a halt by polarization, the political influence of big money, and emerging tribalism between non-elites. It is extremely difficult to see how these hurdles can be overcome via America's regular political process. As such, they will be resolved only after some kind of crisis, whether endogenous or exogenous. Will Trump Fix It? President Donald Trump famously said in his nomination speech at the Republican Convention, "I alone can fix it." In a way, he may be correct. Although he is very much part of the American economic elite, he has no links to the D.C. establishment and owes no favors to special interest groups.15 His entire campaign personified the conclusions of this report: that the U.S. economy has been captured by economic and political elites and that the well-being of regular citizens is in the doldrums. It is unfair to judge President Trump's record and legacy based on a little over four months in office. However, we lean heavily towards the conclusion that his efforts to undermine American patricians will ultimately fail. Here is why: Policy President Trump does not have much of a legislative record. Nonetheless, his first major piece of legislation - the Obamacare repeal and replace bill - would, in its current form, leave 14 million people without health care - and an estimated 24 million by 2026. If not substantially revised, the bill is likely to impose a roughly $445 billion burden on U.S. households in order to pay for the "hyuge" tax cuts that Trump has promised (Chart 16). Further throwing Trump's plebeian credentials into doubt is his second signature legislative act: tax reform. His campaign proposal fell largely in line with previous Republican efforts, which, it should be noted, have contributed greatly to elite overproduction in the U.S. (Chart 17). Trump's original proposal would cut the top marginal rate from 39.6% to 33%, but would also leave a significant number of middle-class Americans with an increase, or no change, to their marginal tax rate.16 We expect that his White House team will adjust this original plan to offer middle-class tax cuts, but the main thrust of the effort is still to eliminate estate taxes and lower the top marginal rates significantly. Chart 16 Chart 17Tax Reform Always Benefits Elites Tax Reform Always Benefits Elites Tax Reform Always Benefits Elites On trade and immigration, Trump has little record to show. His meeting with President Xi Jinping of China revealed that he is like previous presidents in talking tough about Chinese trade on the campaign trail yet lacking the desire to take aggressive action once in office. We expect that Trump will eventually pivot towards greater protectionism, but it is not clear that it will be executed in a way that actually improves household well-being.17 Congress So far Trump has shown that he is more interested in getting legislation passed than shaping it in a populist way. For example, he has urged Congress to pass the Obamacare replacement even though many conservative Senators are wary of its negative impact on households. If he adopts the same strategy with tax reform, we would suspect that he will err on the side of "getting things done," rather than fulfilling his campaign pledges to blue-collar workers. The problem for Trump is the same problem President Obama had: polarization. Trump would be far more successful in passing populist legislation if he developed a working relationship with Democrats, who ostensibly have discarded the elitism of the Clinton years. Yet to do so he would have to "betray" his only friends, leaving himself vulnerable should the Democrats refuse to play ball. He is thus stuck with partisan Republican policies, which means voters are stuck with a lack of compromise. Macroeconomics Populists everywhere have one overarching goal when they come to power: boosting nominal GDP growth (Chart 18). We suspect that Trump will ultimately get tax reform through Congress and that it will be moderately stimulative.18 Chart 18 The problem is that the U.S. economic recovery is already far advanced. As such, even moderate stimulus could hasten the timing of an economic recession. Given the lack of major economic imbalances, it is unlikely that such a recession would freeze the financial system and be as painful as that of 2008-9. Nonetheless, the trade-off between moderate stimulus and a quicker recession is unlikely to benefit Trump's voters. Bottom Line: Donald Trump has tapped into the deep social malaise in the U.S. and responded to the populace's demands that elite overproduction be curbed. Unfortunately, his track record during the campaign and as president gives little evidence that he will be successful in restraining America's elites. Especially because he is forced to cooperate with them through Congress, and in a way that does not encourage broad compromise. Investment Implications We suspect that polarization will grow throughout Trump's term and that he will largely be unsuccessful in pursuing an agenda that genuinely increases opportunity or well-being. In fact, we would bet that most of his policies will contribute to, not reduce, elite overproduction in the U.S. What happens when Donald Trump fails to reform America and resolve its elite overproduction problem? If a recession occurs by 2019 - our House View at BCA - then the economic and political conditions suggest that a serious revolt is in the cards by the time of the 2020 election. By this we mean not just an electoral revolt, like Trump's election, but also a concrete increase in social tension and unrest. A repeat of the 2011 Occupy Wall Street protests, yet more violent, could be in cards. By the 2020 election, we would also suspect that our clients may look back fondly, with nostalgia, for Senator Bernie Sander's campaign platform, which by that point may look downright centrist. Investors should prepare for an increase in economic populist policy proposals, from both the left and the right. If economic policy begins to steer towards populism, investors should bet on higher inflation and thus higher nominal - but potentially lower real - Treasury yields. The independence of the Fed could also suffer, putting considerable downward pressure on the USD. In this environment, equities will outperform bonds, but global assets should outperform those of the U.S. Gold, which has failed as a safe-haven asset in the contemporary deflationary era, should become attractive once again.19 Marko Papic, Senior Vice President Chief Geopolitical Strategist marko@bcaresearch.com 1 Please see Miles Corak, "Income Inequality, Equality of Opportunity, and Intergenerational Mobility," Forschungsinstitut zur Zukunft der Arbeit, Discussion paper no. 7520, July 2013, available at iza.org. 2 Please see Jonathan Rothwell and Pablo Diego-Rosell, "Explaining Nationalist Political Views: The Case Of Donald Trump," Gallup, dated November 2, 2016, available at papers.ssrn.com. 3 Please see BCA's The Bank Credit Analyst Special Report, "Beware The 2019 Trump Recession," dated March 7, 2017, available at bca.bcaresearch.com, and Global Investment Strategy Outlook, "Second Quarter 2017: A Three-Act Play," dated March 31, 2017, available at gis.bcaresearch.com. 4 Please see Daren Acemoglu and James A. Robinson, Why Nations Fail (New York: Crown Publishers, 2012). 5 Literally. 6 Please see Peter Turchin and Sergey Nefedov, Secular Cycles (Princeton, NJ: Princeton University Press, 2009). 7 Please see Neal Fligstein et al, "Keeping up with the Joneses: Inequality and Indebtedness, in the Era of the Housing Price Bubble, 1999-2007," presented at the Annual Meetings of the American Sociological Association, August 2015. 8 Please see Peter Turchin, "Dynamics of political instability in the United States, 1780-2010," Journal of Peace Research 49:4 (2012), pp. 577-91. 9 Please see Francis Fukuyama, Political Order And Political Decay (New York: Farrar, Straus, and Giroux, 2014). 10 Today's dispersed terrorist threat does not even come close to approximating the threat that the Soviet Union during the Cold War presented to the U.S., and as such we do not consider it seriously as an existential threat to either the U.S. or the West. Please see BCA Global Investment Strategy and Geopolitical Strategy, "A Bull Market For Terror," dated August 5, 2016, available at gis.bcaresearch.com. 11 Please see Adam Bonica et al., "Why Hasn't Democracy Slowed Rising Inequality?" Journal of Economic Perspectives 27:3 (Summer 2013), pp. 103-24. 12 Please see Benjamin Page et al., "Democracy And The Policy Preferences Of Wealthy Americans," Perspectives On Politics 11:1 (March 2013), pp. 51-73. 13 Please see Martin Gilens, "Inequality And Democratic Responsiveness," Public Opinion Quarterly 69:5 (2005), pp. 778-796. 14 The latter measure of polarization is one of Turchin's factors in elite overproduction. 15 Save for the Kremlin! We jest, we jest. At least, we think we jest ... 16 Several groups would have seen no substantial tax cuts under his original campaign plan. Those making $15,000-$19,000 would have seen their tax rate increase from 10% to 12%. Those making $52,500-101,500 would have seen their rate stay the same at 25%, while those making $127,500-$200,500 would have seen their rate rise from 28% to 33%. Please see Jim Nunns et al, "An Analysis Of Donald Trump's Revised Tax Plan," Tax Policy Center, October 18, 2016, available at www.taxpolicycenter.org. For our original discussion, see BCA Geopolitical Strategy Special Report, "Constraints And Preferences Of The Trump Presidency," dated November 30, 2016, available at gps.bcaresearch.com. 17 Please see BCA Geopolitical Strategy Weekly Report, "Political Risks Are Understated In 2018," dated April 12, 2017, available at gps.bcaresearch.com. 18 Please see BCA Geopolitical Strategy Weekly Report, "Buy In May And Enjoy Your Day," dated April 26, 2017, available at gps.bcaresearch.com. 19 Please see The Bank Credit Analyst Special Report, "Stairway To (Safe) Haven: Investing In Times Of Crisis," dated August 25, 2016, available at bca.bcaresearch.com.

Dear Client, I will be visiting clients in Asia over the next ten days, so we are sending you this week's report a bit ahead of schedule. In addition, at the end of this report, we are including the recommendations from our tactical asset allocation model. Going forward, we will be updating these recommendations on our website at the end of every month. Please feel free to contact us if you have any questions. Best regards, Peter Berezin, Chief Global Strategist Global Investment Strategy Highlights Productivity growth has declined in most countries. This appears to be a structural problem that will remain with us for years to come. In theory, slower productivity growth should reduce the neutral rate of interest, benefiting bonds in the process. In reality, countries with chronically low productivity growth typically have higher interest rates than faster growing economies. The passage of time helps account for this seeming paradox: Slower productivity growth tends to depress interest rates at the outset, but leads to higher rates later on. The U.S. has reached an inflection point where weak productivity growth is starting to push up both the neutral real rate and inflation. Other countries will follow. The implication for investors is that government bond yields have begun a long-term secular uptrend. The market is not at all prepared for this. Feature Slow Productivity Growth: A Structural Problem Productivity growth has fallen sharply in most developed and emerging economies (Chart 1). As we argued in "Weak Productivity Growth: Don't Blame The Statisticians," there is little compelling evidence that measurement error explains the productivity slowdown.1 Yes, the unmeasured utility accruing from free internet services is large, but so was the unmeasured utility from antibiotics, indoor plumbing, and air conditioning. No one has offered a convincing explanation for why the well-known problems with productivity calculations suddenly worsened about 12 years ago. Chart 1 If mismeasurement is not responsible for the productivity slowdown, what is? Cyclical factors have undoubtedly played a role. In particular, lackluster investment spending has curtailed the growth in the capital stock (Chart 2). This means that today's workers have not benefited from the improvement in the quality and quantity of capital to the same extent as previous generations. However, the timing of the productivity slowdown - it began in 2004-05 in most countries, well before the financial crisis struck - suggests that structural factors have been key. These include: Waning gains from the IT revolution. Recent innovations have focused more on consumers than businesses. As nice as Facebook and Instagram are, they do little to boost business productivity - in fact, they probably detract from it, given how much time people waste on social media these days. The rising share of value added coming from software relative to hardware has also contributed to the decline in productivity growth. Chart 3 shows that productivity gains in the latter category have been much smaller than in the former. Chart 2The Great Recession Hit##BR##Capital Stock Accumulation The Great Recession Hit Capital Stock Accumulation The Great Recession Hit Capital Stock Accumulation Chart 3The Shift Towards Software Has##BR##Dampened IT Productivity Gains The Shift Towards Software Has Dampened IT Productivity Gains The Shift Towards Software Has Dampened IT Productivity Gains Slower human capital accumulation. Globally, the fraction of adults with a secondary degree or higher is increasing at half the pace it did in the 1990s (Chart 4). Educational achievement, as measured by standardized test scores in mathematics and science, is edging lower in the OECD, and is showing very limited gains in most emerging markets (Chart 5). Test scores tend to be much lower in countries with rapidly growing populations (Chart 6). Consequently, the average level of global mathematical proficiency is now declining for the first time in modern history. Chart 4 Chart 5 Decreased creative destruction. The birth rate of new firms in the U.S. has fallen by half since the late 1970s and is now barely above the death rate (Chart 7). In addition, many firms in advanced economies are failing to replicate the best practices of industry leaders. The OECD reckons that this has been a key reason for the productivity slowdown.2 Chart 6 Chart 7Secular Decline In U.S. Firm Births Secular Decline In U.S. Firm Births Secular Decline In U.S. Firm Births Productivity Growth And Interest Rates Investors typically assume that long-term interest rates will converge to nominal GDP growth. All things equal, this implies that faster productivity growth should lead to higher interest rates. Most economic models share this assumption - they predict that an acceleration in productivity growth will raise the rate of return on capital and incentivize households to save less in anticipation of faster income gains.3 Both factors should cause interest rates to rise. The problem is that these theories do not accord with the data. Chart 8 shows that interest rates are far higher in regions such as Africa and Latin America, which have historically suffered from chronically weak productivity growth. In contrast, rates are lower in regions such as East Asia, which have experienced rapid productivity growth. One sees the same negative correlation between interest rates and productivity growth over time in developed economies. In the U.S., for example, interest rates rose rapidly during the 1970s, a decade when productivity growth fell sharply (Chart 9). Chart 8 Chart 9U.S. Interest Rates Soared In The 1970s##BR##While Productivity Swooned U.S. Interest Rates Soared In The 1970s While Productivity Swooned U.S. Interest Rates Soared In The 1970s While Productivity Swooned Two Reasons Why Slower Productivity Growth May Lead To Higher Interest Rates There are two main reasons why slower productivity growth may lead to higher nominal interest rates over time: Slower productivity growth may eventually lead to higher inflation; Slower productivity growth may deplete national savings, thereby raising the neutral real rate of interest. We discuss each reason in turn. Reason #1: Slower Productivity Growth May Fuel Inflation Chart 10The Fed Continuously Overstated The Magnitude##BR##Of Economic Slack In The 1970s The Fed Continuously Overstated The Magnitude Of Economic Slack In The 1970s The Fed Continuously Overstated The Magnitude Of Economic Slack In The 1970s Most economists agree that chronically weak productivity growth tends to be associated with higher inflation. Even Janet Yellen acknowledged as much, noting in a 2005 speech that "the evidence suggests that the predominant medium-term effect of a slowdown in trend productivity growth would likely be higher inflation."4 In theory, the causation between productivity and inflation can run in either direction: Weak productivity gains can fuel inflation while high inflation can, in turn, undermine growth. With respect to the latter, economists have focused on three channels: First, higher inflation may make it difficult for firms to distinguish between relative and absolute price shocks, leading to suboptimal resource allocation. Second, higher inflation may stymie capital accumulation because investors typically pay capital gains taxes even when the increase in asset values is entirely due to inflation. Third, high inflation may cause households and firms to waste time and effort on economizing their cash holdings. There are also several ways in which slower productivity growth can lead to higher inflation. For example, sluggish productivity growth may increase the likelihood that a country will be forced to inflate its way out of any debt problems. In addition, central banks may fail to recognize structural declines in productivity growth in real time, leading them to keep interest rates too low in the errant belief that weak GDP growth is due to inadequate demand when, in fact, it is due to insufficient supply. There is strong evidence that this happened in the U.S. in the 1970s. Chart 10 shows that the Fed consistently overestimated the size of the output gap during that period. Reason #2: Slower Productivity Growth May Deplete National Savings, Leading To A Higher Neutral Real Rate Imagine that you have a career where your real income is projected to grow by 2% per year, but then something auspicious happens that leads you to revise your expected annual income growth to 20%. How do you react? If you are like most people, your initial inclination might be to celebrate by purchasing a new car or treating yourself to a lavish vacation. As such, your saving rate is likely to fall at the outset. However, as the income gains pile up, you might find yourself running out of stuff to buy, resulting in a higher saving rate. This is particularly likely to be true if you grew up poor and have not yet acquired a taste for conspicuous consumption. Now consider the opposite case: One where you realize that your income will slowly contract over time as your skills become increasingly obsolete. The logic above suggests that your immediate reaction will be to hunker down and spend less - in other words, your saving rate will rise. However, as time goes by and the roof needs to be changed and the kids sent off to college, you may find it hard to pay the bills - your saving rate will then fall. The same reasoning applies to economy-wide productivity growth. When productivity growth increases, household savings are likely to decline as consumers spend more in anticipation of higher incomes. Meanwhile, investment is likely to rise as firms move swiftly to expand capacity to meet rising demand for their products. The combination of falling savings and rising investment will cause real rates to increase. As time goes by, however, it may become increasingly difficult for the economy to generate enough incremental demand to keep up with rising productive capacity. At that point, real rates will begin falling. The historic evidence is consistent with the notion that higher productivity growth causes savings to fall at the outset, but rise later on. Chart 11 shows that East Asian economies all had rapid growth rates before they had high saving rates. China is a particularly telling example. Chinese productivity growth took off in the early 1990s. Inflation accelerated over the subsequent years, while the country flirted with current account deficits - both telltale signs of excess demand. It was not until a decade later that the saving rate took off, pushing the current account into a large surplus, even though investment was also rising at the time (Chart 12). Chart 11Asian Tigers: Growth Took Off First,##BR##Followed By Higher Savings Asian Tigers: Growth Took Off First, Followed By Higher Savings Asian Tigers: Growth Took Off First, Followed By Higher Savings Chart 12China: Productivity Growth Accelerated,##BR##Then Savings Rate Took Off China: Productivity Growth Accelerated, Then Savings Rate Took Off China: Productivity Growth Accelerated, Then Savings Rate Took Off Today, Chinese deposit rates are near rock-bottom levels, and yet the household sector continues to save like crazy. This will change over time. The working-age population has peaked (Chart 13). As millions of Chinese workers retire and begin to dissave, aggregate household savings will fall. Meanwhile, Chinese youth today have no direct memory of the hardships that their parents endured. As happened in Korea and Japan, the flowering of a consumer culture will help bring down the saving rate. Meanwhile, sluggish income growth in the developed world will make it difficult for households to save much. Population aging will only exacerbate this effect. As my colleague Mark McClellan pointed out in last month's edition of the Bank Credit Analyst, elderly people in advanced economies consume more than any other age cohort once government spending for medical care on their behalf is taken into account (Chart 14).5 Our estimates suggest that population aging will reduce the household saving rate by five percentage points in the U.S. over the next 15 years (Chart 15). The saving rate could fall as much as ten points in Germany, leading to the evaporation of the country's mighty current account surplus. As saving rates around the world begin to fall, real interest rates will rise. Chart 13China's Very High Rate Of National Savings Will Face Pressure From Demographics China's Very High Rate Of National Savings Will Face Pressure From Demographics China's Very High Rate Of National Savings Will Face Pressure From Demographics Chart 14 Chart 15Aging Will Reduce##BR##Aggregate Savings Aging Will Reduce Aggregate Savings Aging Will Reduce Aggregate Savings The Two Reasons Reinforce Each Other The discussion above has focused on two reasons why chronically low productivity growth could lead to higher interest rates: 1) weak productivity growth could fuel inflation; and 2) weak productivity growth could deplete national savings, leading to higher real rates. There is an important synergy between these two reasons. Suppose, for example, that weak productivity growth does eventually raise the neutral real rate. Since central banks cannot measure the neutral rate directly and monetary policy affects the economy with a lag, it is possible that actual rates will end up below the neutral rate. This would cause the economy to overheat, resulting in higher inflation. Thus, if the first reason proves to be true, it is more likely that the second reason will prove to be true as well. The Technological Wildcard So far, we have discussed productivity growth in very generic terms - as basically anything that raises output-per-hour. In reality, the source of productivity gains can have a strong bearing on interest rates. Economists describe innovations that raise the demand for labor relative to capital goods as being "capital saving." Paul David and Gavin Wright have argued that the widespread adoption of electrically-powered processes in the early 20th century serves as "a textbook illustration of capital-saving technological growth."6 They note that "Electrification saved fixed capital by eliminating heavy shafts and belting, a change that also allowed factory buildings themselves to be more lightly constructed." In contrast, recent technological innovations have tended to be more of the "labor saving" than "capital saving" variety. Robotics and AI come to mind, but so do more mundane advances such as containerization. Marc Levinson has contended that the widespread adoption of "The Box" in the 1970s completely revolutionized international trade. Nowadays, huge cranes move containers off ships and place them onto waiting trucks or trains. Thus, the days when thousands of longshoremen toiled in the great ports of Baltimore and Long Beach are gone.7 If technological progress is driven by labor-saving innovations, real wages will tend to grow more slowly than overall productivity (Chart 16). In fact, if technological change is sufficiently biased in favour of capital (i.e., if it is extremely "labor saving"), real wages may actually decline in absolute terms (Chart 17). Owners of capital tend to be wealthier than workers. Since richer people save more of their income than poorer people, the shift in income towards the former will depress aggregate demand (Chart 18). This will result in a lower neutral rate. Chart 16U.S.: Real Wages Have Been##BR##Lagging Productivity Gains U.S.: Real Wages Have Been Lagging Productivity Gains U.S.: Real Wages Have Been Lagging Productivity Gains Chart 17 Chart 18Savings Heavily Skewed##BR##Towards Top Earners Savings Heavily Skewed Towards Top Earners Savings Heavily Skewed Towards Top Earners It is difficult to know if the forces described above will dissipate over time. Productivity growth is largely a function of technological change. We like to think that we are living in an era of unprecedented technological upheavals, but if productivity growth has slowed, it is likely that the pace of technological innovation has also diminished. If so, the impact that technological change is having on such things as the distribution of income and global savings - and by extension on interest rates - could become more muted. To use an analogy, the music might remain the same, but the volume from the speakers could still drop. Capital In A Knowledge-Based Economy Labor-saving technological change has not been the only force pushing down interest rates. Modern economies are transitioning away from producing goods towards producing knowledge. Companies such as Google, Apple, and Amazon have thrived without having to undertake massive amounts of capital spending. This has left them with billions of dollars in cash on their balance sheets. The price of capital goods has also tumbled over the past three decades, allowing companies to cut their capex budgets (Chart 19). In addition, technological advances have facilitated the emergence of "winner-take-all" industries where scale and network effects allow just a few companies to rule the roost (Chart 20). Such market structures exacerbate inequality by shifting income into the hands of a few successful entrepreneurs and business executives. As noted above, this leads to higher aggregate savings. Market structures of this sort could also lead to less aggregate investment because low profitability tends to constrain capital spending by second- or third-tier firms, while the worry that expanding capacity will erode profit margins tends to constrain spending by winning companies. The combination of higher savings and decreased investment results in a lower neutral rate. As with labor-saving technological change, it is difficult to know how these forces will evolve over time. The growth of winner-take-all industries has benefited greatly from globalization. Globalization, however, may be running out of steam. Tariffs are already extremely low in most countries, while the gains from further breaking down the global supply chain are reaching diminishing returns (Chart 21). Perhaps more importantly, political pressures for greater income distribution, trade protectionism, and stronger anti-trust measures are likely to intensify. If that happens, it may be enough to reverse some of the downward pressure on the neutral rate. Chart 19Falling Capital Goods Prices Have Allowed Companies To Slash Capex Budgets Falling Capital Goods Prices Have Allowed Companies To Slash Capex Budgets Falling Capital Goods Prices Have Allowed Companies To Slash Capex Budgets Chart 20 Chart 21The Low-Hanging Fruits Of##BR##Globalization Have Been Picked The Low-Hanging Fruits Of Globalization Have Been Picked The Low-Hanging Fruits Of Globalization Have Been Picked Investment Conclusions Is slow productivity growth good or bad for bonds? The answer is both: Slow productivity growth is likely to depress interest rates at the outset, but is liable to lead to higher rates later on. Chart 22Output Gap Has Narrowed##BR##Thanks To Lower Potential Growth Output Gap Has Narrowed Thanks To Lower Potential Growth Output Gap Has Narrowed Thanks To Lower Potential Growth The U.S. has likely reached the inflection point where slow productivity is going from being a boon to a bane for bonds. Chart 22 shows that the U.S. output gap would be over 8% of GDP had potential GDP grown at the pace the IMF projected back in 2008. Instead, it is close to zero and will likely turn negative if growth remains over 2% over the next few quarters. Other countries are likely to follow in the footsteps of the U.S. To be clear, productivity is just one of several factors affecting interest rates - demographics, globalization, and political decisions being others. However, as we argued in our latest Strategy Outlook, these forces are also shifting in a more inflationary direction.8 As such, fixed-income investors with long-term horizons should pare back duration risk and increase allocations to inflation-linked securities. Peter Berezin, Chief Global Strategist Global Investment Strategy peterb@bcaresearch.com 1 Please see Global Investment Strategy Special Report, "Weak Productivity Growth: Don't Blame The Statisticians," dated March 25, 2016, available at gis.bcaresearch.com. 2 Dan Andrews, Chiara Criscuolo, and Peter N. Gal,"The Best versus the Rest: The Global Productivity Slowdown, Divergence across Firms and the Role of Public Policy," OECD Productivity Working Papers, No. 5 (November 2016). 3 Consider the widely-used Solow growth model. The model says that the neutral real rate, r, is equal to (a/s) (n + g + d), where a is the capital share of income, s is the saving rate, n is labor force growth, g is total factor productivity growth, and d is the depreciation rate of capital. All things equal, an increase in g will result in a higher equilibrium real interest rate. The same is true in the Ramsey model, which goes a step further and endogenizes the saving rate within a fully specified utility-maximization framework. In this model, consumption growth is pinned down by the so-called Euler equation. Assuming that utility can be described by a constant relative risk aversion utility function, the Euler equation states that consumption will grow at (r-d)/h where d is the rate at which households discount future consumption and h is a measure of the degree to which households want to smooth consumption over time. In a steady state, consumption increases at the same rate as GDP, n+g. Rearranging the terms yields: r=(n+g)h+d. Notice that both models provide a mechanism by which a higher g can decrease r. In the Solow model, this comes from thinking about the saving rate not as an exogenous variable, but as something that can be influenced by the growth rate of the economy. In particular, if s rises in response to a higher g, r could fall. Likewise, in the Ramsey model, a higher g could make households more willing to forgo consumption today in return for higher consumption tomorrow (equivalent to a decrease in the rate of time preference, d). This, too, would translate into a lower neutral rate. 4 Janet L. Yellen, "The U.S. Economic Outlook," Presentation to the Stanford Institute of Economic Policy Research, February 11, 2005. 5 Please see The Bank Credit Analyst, "Beware Inflection Points In The Secular Drivers Of Global Bonds," April 28, 2017, available at bca.bcaresearch.com. 6 Paul A. David, and Gavin Wright,"General Purpose Technologies And Surges In Productivity: Historical Reflections On the Future Of The ICT Revolution," January 2012. 7 Marc Levinson, "The Box: How the Shipping Container Made the World Smaller and the World Economy Bigger," Princeton University Press, 2006. 8 Please see Global Investment Strategy, "Strategy Outlook Second Quarter 2017: A Three-Act Play," dated March 31, 2017, available at gis.bcaresearch.com. APPENDIX: Tactical Global Asset Allocation Monthly Update To complement our analysis and intuition, we use a variety of time-tested models to assess the global investment outlook. Compared to last month, our tactical (3-month) model is recommending an upgrade to global equities at the expense of government bonds. Global equities have consolidated their gains, removing some of the overbought conditions that prevailed earlier in May. Bullish equity sentiment has also waned somewhat, while net speculative positioning in U.S. stocks has moved from being net long to net short. In contrast, speculative positioning in Treasurys has jumped into net long territory (Chart A1). Our models say that government bonds in most economies remain overbought. Image Regionally, we continue to favor higher-beta developed equity markets such as Europe and Japan. Canada, Australia, and most emerging markets have also received an upgrade, owing to a more favorable near-term outlook for commodity prices. Within the bond universe, U.S. Treasurys are most vulnerable to a selloff, given that the market is pricing in only two rate hikes over the next 12 months. Image Strategy & Market Trends Tactical Trades Strategic Recommendations Closed Trades

This month's Special Report was written by Peter Berezin, Chief Global Strategist for BCA's Global Investment Strategy Service. The report is a companion piece to last month's Special Report, which argued that some of the structural factors that have depressed global interest rates are at an inflection point. These factors include demographic trends and the integration of China's massive labor supply into the global economy. Peter's report focuses on technology's impact on bond yields. He presents the non-consensus view that slow productivity growth likely depresses interest rates at the outset, but will lead to higher rates later on. Not only could sluggish productivity growth lead to higher inflation, it could also deplete national savings. Both factors would be bond bearish, reinforcing the other factors discussed in last month's Special Report. I trust that you will find the report as insightful and educational as I did. Mark McClellan Productivity growth has declined in most countries. This appears to be a structural problem that will remain with us for years to come. In theory, slower productivity growth should reduce the neutral rate of interest, benefiting bonds in the process. In reality, countries with chronically low productivity growth typically have higher interest rates than faster growing economies. The passage of time helps account for this seeming paradox: Slower productivity growth tends to depress interest rates at the outset, but leads to higher rates later on. The U.S. has reached an inflection point where weak productivity growth is starting to push up both the neutral real rate and inflation. Other countries will follow. The implication for investors is that government bond yields have begun a long-term secular uptrend. The market is not at all prepared for this. Slow Productivity Growth: A Structural Problem Productivity growth has fallen sharply in most developed and emerging economies (Chart II-1). As we argued in "Weak Productivity Growth: Don't Blame The Statisticians," there is little compelling evidence that measurement error explains the productivity slowdown.1 Yes, the unmeasured utility accruing from free internet services is large, but so was the unmeasured utility from antibiotics, indoor plumbing, and air conditioning. No one has offered a convincing explanation for why the well-known problems with productivity calculations suddenly worsened about 12 years ago. Chart II-1 If mismeasurement is not responsible for the productivity slowdown, what is? Cyclical factors have undoubtedly played a role. In particular, lackluster investment spending has curtailed the growth in the capital stock (Chart II-2). This means that today's workers have not benefited from the improvement in the quality and quantity of capital to the same extent as previous generations. However, the timing of the productivity slowdown - it began in 2004-05 in most countries, well before the financial crisis struck - suggests that structural factors have been key. These include: Waning gains from the IT revolution. Recent innovations have focused more on consumers than businesses. As nice as Facebook and Instagram are, they do little to boost business productivity - in fact, they probably detract from it, given how much time people waste on social media these days. The rising share of value added coming from software relative to hardware has also contributed to the decline in productivity growth. Chart II-3 shows that productivity gains in the latter category have been much smaller than in the former. Chart II-2The Great Recession Hit ##br##Capital Stock Accumulation The Great Recession Hit Capital Stock Accumulation The Great Recession Hit Capital Stock Accumulation Chart II-3The Shift Towards Software Has ##br##Dampened IT Productivity Gains The Shift Towards Software Has Dampened IT Productivity Gains The Shift Towards Software Has Dampened IT Productivity Gains Slower human capital accumulation. Globally, the fraction of adults with a secondary degree or higher is increasing at half the pace it did in the 1990s (Chart II-4). Educational achievement, as measured by standardized test scores in mathematics and science, is edging lower in the OECD, and is showing very limited gains in most emerging markets (Chart II-5). Test scores tend to be much lower in countries with rapidly growing populations (Chart II-6). Consequently, the average level of global mathematical proficiency is now declining for the first time in modern history. Chart II-4 Chart II-5 Chart II-6 Decreased creative destruction. The birth rate of new firms in the U.S. has fallen by half since the late 1970s and is now barely above the death rate (Chart II-7). In addition, many firms in advanced economies are failing to replicate the best practices of industry leaders. The OECD reckons that this has been a key reason for the productivity slowdown.2 Chart II-7Secular Decline In U.S. Firm Births Secular Decline In U.S. Firm Births Secular Decline In U.S. Firm Births Productivity Growth And Interest Rates Investors typically assume that long-term interest rates will converge to nominal GDP growth. All things equal, this implies that faster productivity growth should lead to higher interest rates. Most economic models share this assumption - they predict that an acceleration in productivity growth will raise the rate of return on capital and incentivize households to save less in anticipation of faster income gains.3 Both factors should cause interest rates to rise. The problem is that these theories do not accord with the data. Chart II-8 shows that interest rates are far higher in regions such as Africa and Latin America, which have historically suffered from chronically weak productivity growth. In contrast, rates are lower in regions such as East Asia, which have experienced rapid productivity growth. One sees the same negative correlation between interest rates and productivity growth over time in developed economies. In the U.S., for example, interest rates rose rapidly during the 1970s, a decade when productivity growth fell sharply (Chart II-9). Chart II-8 Chart II-9U.S. Interest Rates Soared In The ##br##1970s While Productivity Swooned U.S. Interest Rates Soared In The 1970s While Productivity Swooned U.S. Interest Rates Soared In The 1970s While Productivity Swooned Two Reasons Why Slower Productivity Growth May Lead To Higher Interest Rates There are two main reasons why slower productivity growth may lead to higher nominal interest rates over time: Slower productivity growth may eventually lead to higher inflation; Slower productivity growth may deplete national savings, thereby raising the neutral real rate of interest. We discuss each reason in turn. Reason #1: Slower Productivity Growth May Fuel Inflation Most economists agree that chronically weak productivity growth tends to be associated with higher inflation. Even Janet Yellen acknowledged as much, noting in a 2005 speech that "the evidence suggests that the predominant medium-term effect of a slowdown in trend productivity growth would likely be higher inflation."4 Chart II-10The Fed Continuously Overstated The ##br##Magnitude Of Economic Slack In The 1970s The Fed Continuously Overstated The Magnitude Of Economic Slack In The 1970s The Fed Continuously Overstated The Magnitude Of Economic Slack In The 1970s In theory, the causation between productivity and inflation can run in either direction: Weak productivity gains can fuel inflation while high inflation can, in turn, undermine growth. With respect to the latter, economists have focused on three channels: First, higher inflation may make it difficult for firms to distinguish between relative and absolute price shocks, leading to suboptimal resource allocation. Second, higher inflation may stymie capital accumulation because investors typically pay capital gains taxes even when the increase in asset values is entirely due to inflation. Third, high inflation may cause households and firms to waste time and effort on economizing their cash holdings. There are also several ways in which slower productivity growth can lead to higher inflation. For example, sluggish productivity growth may increase the likelihood that a country will be forced to inflate its way out of any debt problems. In addition, central banks may fail to recognize structural declines in productivity growth in real time, leading them to keep interest rates too low in the errant belief that weak GDP growth is due to inadequate demand when, in fact, it is due to insufficient supply. There is strong evidence that this happened in the U.S. in the 1970s. Chart II-10 shows that the Fed consistently overestimated the size of the output gap during that period. Reason #2: Slower Productivity Growth May Deplete National Savings, Leading To A Higher Neutral Real Rate Imagine that you have a career where your real income is projected to grow by 2% per year, but then something auspicious happens that leads you to revise your expected annual income growth to 20%. How do you react? If you are like most people, your initial inclination might be to celebrate by purchasing a new car or treating yourself to a lavish vacation. As such, your saving rate is likely to fall at the outset. However, as the income gains pile up, you might find yourself running out of stuff to buy, resulting in a higher saving rate. This is particularly likely to be true if you grew up poor and have not yet acquired a taste for conspicuous consumption. Now consider the opposite case: One where you realize that your income will slowly contract over time as your skills become increasingly obsolete. The logic above suggests that your immediate reaction will be to hunker down and spend less - in other words, your saving rate will rise. However, as time goes by and the roof needs to be changed and the kids sent off to college, you may find it hard to pay the bills - your saving rate will then fall. The same reasoning applies to economy-wide productivity growth. When productivity growth increases, household savings are likely to decline as consumers spend more in anticipation of higher incomes. Meanwhile, investment is likely to rise as firms move swiftly to expand capacity to meet rising demand for their products. The combination of falling savings and rising investment will cause real rates to increase. As time goes by, however, it may become increasingly difficult for the economy to generate enough incremental demand to keep up with rising productive capacity. At that point, real rates will begin falling. The historic evidence is consistent with the notion that higher productivity growth causes savings to fall at the outset, but rise later on. Chart II-11 shows that East Asian economies all had rapid growth rates before they had high saving rates. China is a particularly telling example. Chinese productivity growth took off in the early 1990s. Inflation accelerated over the subsequent years, while the country flirted with current account deficits - both telltale signs of excess demand. It was not until a decade later that the saving rate took off, pushing the current account into a large surplus, even though investment was also rising at the time (Chart II-12). Chart II-11Asian Tigers: Growth Took Off First, ##br##Followed By Higher Savings Asian Tigers: Growth Took Off First, Followed By Higher Savings Asian Tigers: Growth Took Off First, Followed By Higher Savings Chart II-12China: Productivity Growth Accelerated, ##br##Then Savings Rate Took Off China: Productivity Growth Accelerated, Then Savings Rate Took Off China: Productivity Growth Accelerated, Then Savings Rate Took Off Today, Chinese deposit rates are near rock-bottom levels, and yet the household sector continues to save like crazy. This will change over time. The working-age population has peaked (Chart II-13). As millions of Chinese workers retire and begin to dissave, aggregate household savings will fall. Meanwhile, Chinese youth today have no direct memory of the hardships that their parents endured. As happened in Korea and Japan, the flowering of a consumer culture will help bring down the saving rate. Meanwhile, sluggish income growth in the developed world will make it difficult for households to save much. Population aging will only exacerbate this effect. As my colleague Mark McClellan pointed out in last month's edition of the Bank Credit Analyst, elderly people in advanced economies consume more than any other age cohort once government spending for medical care on their behalf is taken into account (Chart II-14).5 Our estimates suggest that population aging will reduce the household saving rate by five percentage points in the U.S. over the next 15 years (Chart II-15). The saving rate could fall as much as ten points in Germany, leading to the evaporation of the country's mighty current account surplus. As saving rates around the world begin to fall, real interest rates will rise. Chart II-13China's Very High Rate Of National Savings ##br##Will Face Pressure From Demographics China's Very High Rate Of National Savings Will Face Pressure From Demographics China's Very High Rate Of National Savings Will Face Pressure From Demographics Chart II-14 Chart II-15Aging Will Reduce ##br##Aggregate Savings Aging Will Reduce Aggregate Savings Aging Will Reduce Aggregate Savings The Two Reasons Reinforce Each Other The discussion above has focused on two reasons why chronically low productivity growth could lead to higher interest rates: 1) weak productivity growth could fuel inflation; and 2) weak productivity growth could deplete national savings, leading to higher real rates. There is an important synergy between these two reasons. Suppose, for example, that weak productivity growth does eventually raise the neutral real rate. Since central banks cannot measure the neutral rate directly and monetary policy affects the economy with a lag, it is possible that actual rates will end up below the neutral rate. This would cause the economy to overheat, resulting in higher inflation. Thus, if the first reason proves to be true, it is more likely that the second reason will prove to be true as well. The Technological Wildcard So far, we have discussed productivity growth in very generic terms - as basically anything that raises output-per-hour. In reality, the source of productivity gains can have a strong bearing on interest rates. Economists describe innovations that raise the demand for labor relative to capital goods as being "capital saving." Paul David and Gavin Wright have argued that the widespread adoption of electrically-powered processes in the early 20th century serves as "a textbook illustration of capital-saving technological growth."6 They note that "Electrification saved fixed capital by eliminating heavy shafts and belting, a change that also allowed factory buildings themselves to be more lightly constructed." In contrast, recent technological innovations have tended to be more of the "labor saving" than "capital saving" variety. Robotics and AI come to mind, but so do more mundane advances such as containerization. Marc Levinson has contended that the widespread adoption of "The Box" in the 1970s completely revolutionized international trade. Nowadays, huge cranes move containers off ships and place them onto waiting trucks or trains. Thus, the days when thousands of longshoremen toiled in the great ports of Baltimore and Long Beach are gone.7 If technological progress is driven by labor-saving innovations, real wages will tend to grow more slowly than overall productivity (Chart II-16). In fact, if technological change is sufficiently biased in favour of capital (i.e., if it is extremely "labor saving"), real wages may actually decline in absolute terms (Chart II-17). Owners of capital tend to be wealthier than workers. Since richer people save more of their income than poorer people, the shift in income towards the former will depress aggregate demand (Chart II-18). This will result in a lower neutral rate. Chart II-16U.S.: Real Wages Have Been ##br##Lagging Productivity Gains U.S.: Real Wages Have Been Lagging Productivity Gains U.S.: Real Wages Have Been Lagging Productivity Gains Chart II-17 Chart II-18Savings Heavily Skewed ##br##Towards Top Earners Savings Heavily Skewed Towards Top Earners Savings Heavily Skewed Towards Top Earners It is difficult to know if the forces described above will dissipate over time. Productivity growth is largely a function of technological change. We like to think that we are living in an era of unprecedented technological upheavals, but if productivity growth has slowed, it is likely that the pace of technological innovation has also diminished. If so, the impact that technological change is having on such things as the distribution of income and global savings - and by extension on interest rates - could become more muted. To use an analogy, the music might remain the same, but the volume from the speakers could still drop. Capital In A Knowledge-Based Economy Labor-saving technological change has not been the only force pushing down interest rates. Modern economies are transitioning away from producing goods towards producing knowledge. Companies such as Google, Apple, and Amazon have thrived without having to undertake massive amounts of capital spending. This has left them with billions of dollars in cash on their balance sheets. The price of capital goods has also tumbled over the past three decades, allowing companies to cut their capex budgets (Chart II-19). In addition, technological advances have facilitated the emergence of "winner-take-all" industries where scale and network effects allow just a few companies to rule the roost (Chart II-20). Such market structures exacerbate inequality by shifting income into the hands of a few successful entrepreneurs and business executives. As noted above, this leads to higher aggregate savings. Market structures of this sort could also lead to less aggregate investment because low profitability tends to constrain capital spending by second- or third-tier firms, while the worry that expanding capacity will erode profit margins tends to constrain spending by winning companies. The combination of higher savings and decreased investment results in a lower neutral rate. Chart II-19Falling Capital Goods Prices Have ##br##Allowed Companies To Slash Capex Budgets Falling Capital Goods Prices Have Allowed Companies To Slash Capex Budgets Falling Capital Goods Prices Have Allowed Companies To Slash Capex Budgets Chart II-20 As with labor-saving technological change, it is difficult to know how these forces will evolve over time. The growth of winner-take-all industries has benefited greatly from globalization. Globalization, however, may be running out of steam. Tariffs are already extremely low in most countries, while the gains from further breaking down the global supply chain are reaching diminishing returns (Chart II-21). Perhaps more importantly, political pressures for greater income distribution, trade protectionism, and stronger anti-trust measures are likely to intensify. If that happens, it may be enough to reverse some of the downward pressure on the neutral rate. Chart II-21The Low-Hanging Fruits Of ##br##Globalization Have Been Picked The Low-Hanging Fruits Of Globalization Have Been Picked The Low-Hanging Fruits Of Globalization Have Been Picked Investment Conclusions Is slow productivity growth good or bad for bonds? The answer is both: Slow productivity growth is likely to depress interest rates at the outset, but is liable to lead to higher rates later on. The U.S. has likely reached the inflection point where slow productivity is going from being a boon to a bane for bonds. Chart II-22 shows that the U.S. output gap would be over 8% of GDP had potential GDP grown at the pace the IMF projected back in 2008. Instead, it is close to zero and will likely turn negative if growth remains over 2% over the next few quarters. Other countries are likely to follow in the footsteps of the U.S. Chart II-22Output Gap Has Narrowed Thanks ##br##To Lower Potential Growth Output Gap Has Narrowed Thanks To Lower Potential Growth Output Gap Has Narrowed Thanks To Lower Potential Growth To be clear, productivity is just one of several factors affecting interest rates - demographics, globalization, and political decisions being others. However, as we argued in our latest Strategy Outlook, these forces are also shifting in a more inflationary direction.8 As such, fixed-income investors with long-term horizons should pare back duration risk and increase allocations to inflation-linked securities. Peter Berezin, Chief Global Strategist Global Investment Strategy 1 Please see Global Investment Strategy Special Report, "Weak Productivity Growth: Don't Blame The Statisticians," dated March 25, 2016, available at gis.bcaresearch.com. 2 Dan Andrews, Chiara Criscuolo, and Peter N. Gal,"The Best versus the Rest: The Global Productivity Slowdown, Divergence across Firms and the Role of Public Policy," OECD Productivity Working Papers, No. 5 (November 2016). 3 Consider the widely-used Solow growth model. The model says that the neutral real rate, r, is equal to (a/s) (n + g + d), where a is the capital share of income, s is the saving rate, n is labor force growth, g is total factor productivity growth, and d is the depreciation rate of capital. All things equal, an increase in g will result in a higher equilibrium real interest rate. The same is true in the Ramsey model, which goes a step further and endogenizes the saving rate within a fully specified utility-maximization framework. In this model, consumption growth is pinned down by the so-called Euler equation. Assuming that utility can be described by a constant relative risk aversion utility function, the Euler equation states that consumption will grow at (r-d)/h where d is the rate at which households discount future consumption and h is a measure of the degree to which households want to smooth consumption over time. In a steady state, consumption increases at the same rate as GDP, n+g. Rearranging the terms yields: r=(n+g)h+d. Notice that both models provide a mechanism by which a higher g can decrease r. In the Solow model, this comes from thinking about the saving rate not as an exogenous variable, but as something that can be influenced by the growth rate of the economy. In particular, if s rises in response to a higher g, r could fall. Likewise, in the Ramsey model, a higher g could make households more willing to forgo consumption today in return for higher consumption tomorrow (equivalent to a decrease in the rate of time preference, d). This, too, would translate into a lower neutral rate. 4 Janet L. Yellen, "The U.S. Economic Outlook," Presentation to the Stanford Institute of Economic Policy Research, February 11, 2005. 5 Please see The Bank Credit Analyst, "Beware Inflection Points In The Secular Drivers Of Global Bonds," April 28, 2017, available at bca.bcaresearch.com. 6 Paul A. David, and Gavin Wright,"General Purpose Technologies And Surges In Productivity: Historical Reflections On the Future Of The ICT Revolution," January 2012. 7 Marc Levinson, "The Box: How the Shipping Container Made the World Smaller and the World Economy Bigger," Princeton University Press, 2006. 8 Please see Global Investment Strategy, "Strategy Outlook Second Quarter 2017: A Three-Act Play," dated March 31, 2017, available at gis.bcaresearch.com.