Auto Components

Neutral We have successfully ridden down the S&P 1500 components index on a structural basis over the past four years. But now, factors are falling into place for an end to this multi-year bloodbath. On Monday, we lifted exposure to neutral from underweight, locking in relative gains of 36% since inception. In the U.S., light vehicle sales have been stable over the past five years and the latest Conference Board consumer confidence release showed that consumers’ plans to purchase a car remain upbeat, and could serve as a catalyst to unlock excellent relative value (middle panel). With regard to President Trump’s hawkish tariff rhetoric and the ongoing U.S./China trade tussle, automobile components makers have taken a big hit. But, there are high odds of an end to the U.S./China trade dispute. Tack on a softening greenback courtesy of a more dovish Fed. U.S. auto components producers will likely grab a larger slice of the global auto parts revenue pie (top panel). Still a number of risks keep us from turning outright bullish on this consumer discretionary subsector, including auto loan delinquencies which are increasing rapidly, approaching last cycle’s peak (bottom panel). Bottom Line: The easy money has already been made by shying away from auto component manufacturers and we lifted the S&P 1500 auto components index to neutral; please see Monday’s Weekly Report for more details. The ticker symbols for the stocks in this index are: BLBG: S15AUTC – APTV, BWA, GNTX, GT, DAN, VC, FOXF, DORM, LCII, DJPH, AXL, ADNT, CTB, THRM, GTX, SMP, CPS, MPAA, SUP.

Highlights Portfolio Strategy While equities will likely be higher in the coming 9-12 months, we would refrain from committing fresh capital to the market at this juncture. A better entry point lies ahead. Tactically, this market needs a breather to digest the V-shaped formation since last December’s G20 meeting before it resumes its bull run. Firming leading indicators of global auto sales, upbeat auto components industry operating metrics, a softening U.S. dollar, the looming truce in the U.S./China trade spat and depressed relative technicals and valuations all suggest that it no longer pays to be bearish the S&P 1500 auto components index. Augment positions to neutral. The global economic soft patch that is exerting downward pressure on real interest rates, a soft U.S. dollar and rising global policy uncertainty, all signal that it still makes sense to hold a global gold mining equity portfolio hedge. Recent Changes Lift the S&P 1500 auto components index to neutral and cement gains of 36% today. From a portfolio management perspective, downgrade the S&P semi equipment index to neutral for a gain of 16% since the December 17, 2018 inception. Table 1 Feature The S&P 500 hit a trouble spot last week, despite positive news on the U.S./China trade tussle. Clearly, there is an element of “buy the rumor sell the news” in the market as equities have come a long way this year, reversing all of last December’s steep losses. But, the SPX now faces stiff resistance at the most important 2,800 level as we highlighted in recent research.1 Chart 1 shows “The Good”. From a sentiment/technical perspective, fresh all-time highs in the S&P 500 advance/decline line portend ongoing gains in this broad-based equity market advance. The junk bond market sends an equally encouraging signal: The Barclays total return high yield corporate bond index has vaulted to new highs, which bodes well for the SPX (middle panel, Chart 1). Finally, all three of the S&P risk parity total return indexes2 have slingshot into uncharted territory and suggest that the S&P 500 is headed there next. Chart 1The Good… Nevertheless, there are some cracks appearing in the U.S. economy. News of an abysmal retail sales report was quickly discredited by pundits, with some blaming poor data collection due to the government shutdown. Chart 2 shows “The Bad”. Worrisomely, contracting intermodal rail carloads and a nosedive in the “First Data merchant services dollar spend” at retailers likely corroborate the Commerce Department’s weak retail sales data. Moreover, the recent plunge in the Goldman Sachs MAP (Macro-data Assessment Platform) Surprise Index, which is now probing a three year low, suggests that the U.S. economy is in a soft-patch. Chart 2…The Bad… Charts 3 & 4 show “The Ugly”. Our Economic Impulse Indicator (EII) first introduced last October,3 has taken a turn for the worse. Six economic indicators encapsulating the U.S. economy comprise the EII, and there is clear deterioration in economic activity on a second derivative basis. The recent contraction in the overall business (manufacturing, wholesale and retail) sales-to-inventories (SI) ratio also warns of profit trouble in the coming quarters (Chart 4). Keep in mind that this data series only goes to November 2018 and once it gets updated to include December later this week, the SI ratio will likely fall deeper into the contraction zone. Chart 3…And The… Chart 4…Ugly So should investors take some chips off the table given this macro backdrop? Prior to answering the question, as a reminder, BCA’s view remains that the business cycle is alive and well and there is no recession on a cyclical time horizon. Therefore, equities should be higher in the coming 9-12 months. Our end-2019 SPX target remains at 3,000 based on $181 EPS for calendar year 2020 assuming a 16.5 multiple.4 Nevertheless from a shorter-term perspective, we would refrain from committing fresh capital to this market, as we believe a better entry point lies ahead. Tactically, this market now needs a breather to digest the V-shaped formation since last December’s G20 meeting, before it resumes its bull run. In addition, we would book gains on any alpha generating tactical trades; today we crystalize 16% gains in the S&P semi equipment tactical overweight position since the December 17, 2018 inception and downgrade to neutral. This week, we book handsome profits on a long-held underweight in a consumer discretionary subindex that Trump’s hawkish tariff rhetoric and actions have badly wounded. We also update a materials subsector that benefits from the ongoing global reflationary impulse. Auto Components: Aiming For Pole Position? We have successfully ridden down the S&P 1500 components index on a structural basis over the past four years. But now, factors are falling into place for an end to this multi-year bloodbath. We are lifting exposure to neutral from underweight, locking in relative gains of 36% since inception. Global auto sales are the main driver of auto components profits, thus identifying where we stand in the global auto sales cycle is key. Bellwether German automakers have been caught in an emissions-related downdraft with “Dieselgate” weighing heavily on this sector when new emissions-test procedures were implemented last quarter. The top panel of Chart 5 shows that the worst is likely behind this drubbing in German automobile production as new orders have recently gone vertical. Backlogs are also sky-high and suggest that a definitive turn looms in German motor vehicle output. The upshot is that global auto sales may come out of their recent funk. Chart 5Global Auto Sales Are About To Turn The Japanese car industry, the other global heavyweight, also suffered a minor setback last year, but leading indicators of Japanese auto production are also ticking higher. Japanese industrial robot shipments are at fresh cyclical highs and signal that global auto sales will hook up (bottom panel, Chart 5). In the U.S., light vehicle sales have been stable over the past five years, but auto industrial production growth has been roaring, rising 40 percentage points from the manufacturing recession trough (second panel, Chart 6). Chart 6Improving… All of this paints a brightening backdrop for U.S. auto components manufacturers. Indeed, auto components new orders are at all-time highs (middle panel, Chart 7), at a time when inventories remain tame. In fact the new orders-to-inventories ratio sits squarely above one and continues to firm, with unfilled orders also at all-time highs (Chart 8). As a result, selling prices are accelerating at a healthy clip (third panel, Chart 6). The upshot is that industry profits will likely overwhelm. Chart 7…Operating… Chart 8...Auto Component Metrics On the domestic demand front, the latest Conference Board consumer confidence release showed that consumers’ plans to purchase a car remain upbeat, and could serve as a catalyst to unlock excellent relative value (bottom panel, Chart 7). With regard to President Trump’s hawkish tariff rhetoric and the ongoing U.S./China trade tussle, automobile components makers have taken a big hit. But, there are high odds of an end to the U.S./China trade dispute. Tack on a softening greenback courtesy of a more dovish Fed. U.S. auto components producers will likely grab a larger slice of the global auto parts revenue pie (top panel, Chart 7). Despite these tailwinds, investors have relentlessly avoided auto component stocks. Technicals remain washed out and industry valuations are a small fraction of the broad market and below the historical mean as per the relative price-to-sales ratio (Chart 9). Chart 9Cheap And Oversold… Nevertheless, we refrain from turning outright bullish on this consumer discretionary subsector given the following risks: First, auto loan delinquencies are increasing rapidly, approaching last cycle’s peak. Second, car financing interest rates are still rising, which, at the margin, dents demand for new car sales. Third, auto credit growth is decelerating and demand for auto loans is also anemic according to the Fed’s latest Senior Loan Officer survey (Chart 10). This stands in marked contrast to the aforementioned Conference Board’s survey of consumers’ plans to buy a car. Finally, were President Trump to proceed with auto tariffs on European car manufacturers once he strikes a deal with China, U.S. auto parts producers will suffer a setback. Chart 10…But There Are Some Risks Netting it all out, the easy money has already been made by shying away from auto component manufacturers. Firming leading indicators of global auto sales, upbeat auto components industry operating metrics, a softening U.S. dollar, the looming truce in the U.S./China trade spat and depressed relative technicals and valuations all suggest that it no longer pays to be bearish the S&P 1500 auto components index. Bottom Line: Lift the S&P 1500 auto components index to neutral and crystalize gains of 36% today. The ticker symbols for the stocks in this index are: BLBG: S15AUTC – APTV, BWA, GNTX, GT, DAN, VC, FOXF, DORM, LCII, DJPH, AXL, ADNT, CTB, THRM, GTX, SMP, CPS, MPAA, SUP. A Modest Gold Portfolio Hedge Still Makes Sense Within our broad-based U.S. equity sector and subsector coverage, we continue to recommend a modest gold-related hedge via being overweight the global gold mining index (given that the S&P gold index only comprises a single stock) versus the MSCI All-Country World Index, expressed through the long GDX:US/short ACWI:US exchange traded funds. There is compelling evidence that gold bullion is a reliable reflationary gauge. The shiny metal troughed in mid-August, leading even the JP Morgan EM FX index. Since then, it has been in an uninterrupted run rising over $180/oz. or 15% and sniffing out a reflationary impulse. Not only is there a tight inverse correlation with the trade-weighted U.S. dollar, but over the past three years the Chinese renminbi also moves in close lockstep with gold (Chart 11). Now that Chinese policymakers have opened the credit spigots (January credit data revealed the largest ever month-over-month loan increase in the history of the data, please refer to the second panel of Chart 2 in last week’s publication)5 reflating their economy, there are high odds that gold can break out of its past five year trading range in a bullish fashion. Chart 11Gold Is Sniffing Out A Reflationary Impulse Commodity sentiment and positioning data suggest that gold’s run up will prove durable and continue to underpin the relative share price ratio (second & third panels, Chart 12). Chart 12Bullish Bullion Positioning Underpins Global Gold Miners Importantly, the precious metals industry has not stood still. It has embarked on a massive consolidation phase and the recent spike in M&A activity in global gold miners signals that there is more upside for relative share prices (top panel, Chart 12). But the good news does not stop there. Globally there is a slowdown that has infected a number of economies and BCA’s calculated Global ZEW economic sentiment index has lit a fire under gold mining stocks (Global ZEW shown inverted, second panel, Chart 13). The longer the global soft-patch lasts the longer Central Banks will remain on the sidelines or even ease monetary policy in order to rekindle growth. This macro backdrop represents fertile ground for gold and gold related equities (bottom panel, Chart 14). Chart 13Rising Uncertainty, Global Growth Softpatch And… Chart 14…Falling Real Rates Are Excellent Gold Mining Supports Keep in mind that gold bullion yields zero and the gold mining equities’ dividend yield trails the broad market by 100bps; thus, there is an opportunity cost to holding gold and gold related equities, especially now that even U.S. cash yields 2.5%. This explains the inverse correlation with real interest rates and the recent 30bps fall in the U.S. 10-year TIPS yield reinforces gold bullion and the relative share price ratio (TIPS yield shown inverted, middle panel, Chart 14). Moreover, the global policy uncertainty index is perking up given the ongoing U.S./China trade tussle (top panel, Chart 13), recent news of a no deal between the U.S. and North Korea and looming Brexit deadline. All of this underpins global gold stocks (top panel, Chart 13). Tack on the recent fear that gripped markets, and skyrocketing equity risk premia, and the ingredients are in place for additional gains in the relative share price ratio (third panel, Chart 13). While some semblance of normality has returned to global bourses year-to-date, fixed income investors do not share the euphoria their equity peers are emitting. Such a dichotomy favors global gold mining stocks. Finally, with regard to relative valuations and technicals, global gold equities remain in undervalued territory, but have recently recovered smartly from deeply oversold conditions (Chart 15). Chart 15Valuations Ready To Shine In sum, gold bullion is sniffing out a reflationary impulse that is bullish for global gold mining equities. The global economic soft patch that is exerting downward pressure on real interest rates, a soft U.S. dollar and rising global policy uncertainty, all signal that it still makes sense to hold a global gold mining equity portfolio hedge. Bottom Line: Stay overweight the global gold miners index (long GDX:US/short ACWI:US), and remove the downgrade alert.   Anastasios Avgeriou, U.S. Equity Strategist anastasios@bcaresearch.com   Footnotes 1      Please see BCA U.S. Equity Strategy Weekly Report, “Trader’s Paradise” dated January 28, 2019,available at uses.bcaresearch.com. 2      https://us.spindices.com/documents/methodologies/methodology-sp-risk-parity-indices.pdf?force_download=true 3      Please see BCA U.S. Equity Strategy Report, “Icarus Moment” dated October 22, 2018, available at uses.bcaresearch.com. 4      Please see BCA U.S. Equity Strategy Report, “Catharsis” dated January 14, 2019, available at uses.bcaresearch.com. 5      Please see BCA U.S. Equity Strategy Report, “Reflationary Or Recessionary” dated February 25, 2019, available at uses.bcaresearch.com. Current Recommendations Current Trades Size And Style Views Favor value over growth Favor large over small caps

Both autos and automotive components stocks have been underperforming, the former since 2013 and the latter quite dramatically since the beginning of 2018 (top panel). This in spite of light vehicle sales stuck at persistently elevated levels that have driven auto components new orders to all-time highs (second panel). However, with light vehicle sales seemingly unable to breach the levels of the past three years, the chorus that the peak of the automotive cycle has passed is impossible to ignore. We think the reason for the stalling of the automotive growth engine is the lack of available credit. For the better part of the past two years, lenders have been tightening standards for auto loans (third panel). With both financing rates and loan delinquencies on the rise (bottom panel), both the demand for and supply of credit for auto lending seems likely to worsen. Accordingly, we are squarely in the bearish camp for light vehicle sales, hence light vehicle production, hence auto component manufacturers. Stay underweight. The ticker symbols for the stocks in the S&P auto components index are: BLBG: S5AUTC - APTV, BWA, GT.    

  Underweight (Upgrade Alert) Auto components stocks found a rare bit of relief this week on the back of news of a trade deal with Mexico and hopes that a similar deal can be made with Canada. Importantly, the scant details gleaned about Mexico are better than had been feared. Of particular note are the increase in regional value content from 62.5% previously to 75% and a 40-45% auto content made by workers earning at least $16 per hour requirement. Both of these should see a diversion of supply chain from overseas to domestic auto parts companies. This makes us reasonably optimistic on the industry's medium-term growth outlook. However, we caution that the situation is highly fluid and the details of final trade deal may be vastly different from the ones thus far released. Further, industry-operating metrics have been deteriorating; light vehicle sales have flat lined, consumer confidence (at least with respect to making a purchase of a new vehicle) has declined and vehicle pricing has fallen back into deflation. Bottom Line: we remain bearish on the S&P auto components index but are cognizant that NAFTA renegotiations could offer a solid tailwind to a beaten-up sector. Accordingly, we are putting this niche index on upgrade alert. The ticker symbols for the stocks in the S&P auto components index are: BLBG: S5AUTC - APTV, BWA, GT.

Underweight As with other metals-consuming industries, stocks in both the S&P auto components and S&P autos indexes have traded sharply lower following the announcement of the proposed steel and aluminum tariffs (top panel). With roughly a quarter share of domestic steel consumption, autos are second only to the construction industry in terms of exposure to higher steel prices. Fears of higher prices are amplified as new vehicle sales growth appears to be petering out. We think fears are well-founded but not because of higher steel prices but rather from a contraction in credit growth (second panel). Tighter lending standards (third panel) have followed a glut of subprime lending with rising defaults (bottom panel) that are only now working their way through lenders' balance sheets. A backdrop of potentially higher prices only fuels the flames on this negative story; stay underweight. The ticker symbols for the stocks in the S&P auto components index are: BLBG: S5AUTC - APTV, BWA, GT.

Underweight Presenters at this week's Detroit Auto Show have reason to celebrate; December light vehicle sales numbers showed the industry had sold more than 17 million vehicles for a third consecutive year, marking the best winning streak ever for auto makers. Even better, falling pricing appears to be staging a much needed comeback (third panel). The picture is somewhat murkier beneath the surface. J.D. Power reported that average manufacturer incentive spending per unit set a new record in December, exceeding 10% of MSRP for the 17th time in 18 months. At the same time, lenders have continued to clamp down sharply on auto lending (bottom panel), implying that ongoing incentives are required to maintain even the status quo. This is negative to component makers from both a pricing and potentially volume basis. Better growth can be found elsewhere; stay underweight. The ticker symbols for the stocks in the S&P auto components index are: BLBG: S5AUTC - DLPH, BWA, GT.

Special Report

As we near the end of an impressive year for equities, the relationship between price growth and earnings growth and how to best position a portfolio for 2018 bears some reflection. The purpose of this report, rather than take a position on inflation or growth, is to create a roadmap such that investors can allocate according to their expectations for both and also avoid potential pitfalls and embrace likely winners. Diagram 1Four Quadrants Of Earnings And Inflation In framing our analysis, we will focus on the top half of a well-known growth/inflation matrix presented in Diagram 1 below (stay tuned for a follow-up Special Report when we examine the sector impacts of deflation). We have used S&P 500 earnings as our measure of growth for two reasons: first, they lead GDP and IP growth and second, they are most relevant in a discussion of S&P 500 sector allocations. While inflation and earnings growth tend to move together, this has not always been the case. We have identified six time periods in which inflation has been visibly rising (shaded in Chart 1) and compared it with S&P 500 EPS growth. The mean reverting nature of S&P 500 earnings growth makes discerning a pattern difficult but, more often than not, there is a positive correlation with rising inflation. Over the last 60 years S&P 500 earnings growth has averaged 7.6%, while core PCE prices increased on average by 3.3%. As shown in Table 1 below, S&P 500 earnings outpaced core inflation in four periods (indeed, they grew much faster) and fell behind in two periods. We thus place 1965-1971 and 1998-2002 in the top-left quadrant of our matrix (Stagflation) and 1973-1975, 1976-1981, 1987-1989 and 2003-2006 in the top-right (Boom Times). It is important to qualify that, for the purposes of this report, we are considering all periods in which inflation is increasing, not necessarily periods when it is elevated on an absolute basis. Chart 1Earnings And Inflation Usually Move Together... Table 1...But Not Always In our examination of inflation and sector winners last year1, we presented Table 2 below, now modified to tie sector earnings growth to relative share price performance. Breaking down sector performance in boom and bust periods is revealing. The first and most obvious observation is that stock performance tracks earnings growth in all periods, implying that fundamentals lead valuation, as they should. The second observation is that empirical evidence supports sector allocation theory in inflationary boom/bust periods. Table 2Sector Performance When Inflation Rises In theory, the best performing stocks in a stagflation environment would have low economic sensitivity but high pricing power. This is borne out with S&P health care being the top performing sector both from an earnings growth and, predictably, relative stock performance perspective. By contrast, the top performing boom time stocks should be the most economically sensitive yet still stores of value. In these periods, the top overall performer was energy which checks all the boxes. This year, we are expanding our analysis to the GICS2 sectors which have shared the same cyclical return profile as their GICS1 peers (Table 3). In the inflationary busts, defensive stocks including healthcare equipment and food & beverage outperformed. As expected, the inflationary booms saw traditional cyclical indices including energy and transportation outperform. Table 3GICS2 Sector Performance When Inflation Rises In the next section, we will take a deeper look at three of the GICS2 top and two bottom quartile performers when inflation is rising. Energy - (Currently Overweight) The S&P energy index has been a stellar performer in all six high inflation periods we have examined and has the highest average return of all GICS2 sectors. This is logical, considering the sector's revenue, profit and share price leverage to the underlying commodity. During periods of high inflation, all stores of value tend to increase and oil is no exception. An additional tailwind for energy prices with inflation is the associated elevated industrial production; the current synchronized global growth backdrop should sustain a healthy level of demand for energy. Keep in mind oil prices are an excellent gauge of global growth. In the context of a falling rig count and contracting oil stocks (Chart 2), energy prices and stocks seem likely to remain well bid, underpinning our overweight recommendation on the S&P energy index. Transportation - (Currently Overweight) Transportation can largely be summarized as S&P railroads (currently overweight) and S&P air freight & logistics (currently overweight) which together comprise 75% of the index. The index has been a very strong performer in periods of rising inflation, driven by coincident accelerating global trade volumes (Chart 3). Historically, global industrial production and both rail and air freight EPS have moved in tandem as relatively fixed supply drives pricing power firmly on the side of logistics providers (Chart 3). This pricing power allows the transportation to mitigate the usually coincidentally highly volatile energy price via oil surcharges, offsetting what is typically the largest input cost. Together, firming volumes and pricing gains support an outsized earnings outlook and our overweight recommendation in transportation. Chart 2Inflation, IP And Oil Prices Move Together Chart 3Rising Inflation Is A Boon To Global Trade Volume Health Care Equipment - (Currently Neutral) The S&P health care equipment index has consistently been an outperformer in each of the six high inflation impulse periods we analyzed. This is all the more interesting, considering it is the least cyclical of the top quartile relative performers. Health care equipment sales are largely driven by new facility construction which is, in turn, driven at least in part by consumer spending on health care. Consumer health care expenditure has a demonstrated propensity to follow (with significantly greater amplitude) overall inflation (Chart 4). Further, health care equipment is highly levered to global demand; the latter clearly rises hand in hand with inflation and should be EPS accretive to the former. Elevated relative valuations offsetting the positive operating environment keep us on the sidelines. Chart 4Health Care Spending Tracks Inflation Automotive - (Currently Underweight) Returns in the S&P automotive index are by far the most consistently negative when inflation is rising. Rising interest rates driving the costs of ownership higher, combined with the rational avoidance of a depreciating asset when stores of value are preferable, have historically impaired light vehicle sales as inflation climbs. In fact, the two have a tight negative correlation (Chart 5). In an industry where margins are razor thin at the best of times and fixed costs are relatively high, a shrinking top line implies significant profit contraction. Add on a highly geared balance sheet in a rising rate environment and the ingredients are all in place for underperformance. The current environment echoes this analysis; inventories are still elevated despite manufacturer incentives hitting their highest level in history and seven-year auto loans becoming the norm, something unheard of in previous cycles. Chart 5Inflation And Auto Sales Are Inversely Correlated Utilities - (Currently Underweight) Utilities, as the prototypical defensive sector, have unsurprisingly performed poorly as inflation is rising. Rising inflation expectations go hand in hand with rising bond yields (Chart 6); as a fixed-income proxy, utilities are likely to be subject to the same drubbing as the bond market when yields rise. Further, surging global trade is a notable boon to the three outperformers previously highlighted with their exceptional international exposure; utilities are a domestic-only investment and are bound to underperform. Overall, we recommend an underweight position in utilities. Chart 6Inflation Is A Headwind To Fixed Income Proxies Chris Bowes, Associate Editor U.S. Equity Strategy chrisb@bcaresearch.com 1 Please see BCA U.S. Equity Strategy Weekly Report, "Equity Sector Winners And Losers When Inflation Climbs," dated December 5, 2016, available at uses.bcaresearch.com.

Automotive components companies (as well as auto manufacturers) just finished their best month of the year in September (top panel), lifted by expectations of a spike in sales to replace the estimated 700,000 light vehicles destroyed by hurricanes Harvey and Irma. Yesterday's best monthly auto sales report since the end of the recession (second panel) validated this expectation. It is too soon to break out the party hats for three reasons. First, vehicle replacement does not translate one-for-one into new vehicle sales as the used vehicle market will likely take up the bulk of the demand. Second, August lost a week of normal sales in the southern states which were pushed into September, skewing the month. Lastly, and most importantly, manufacturer incentives reached their highest level ever (according to J.D. Power) in an effort to clear out the end-of-model-year inventory; neither this nor weak pricing (third panel) support the idea of a strong auto consumer and constrained supply. Bottom Line: Exceptionally strong September (and probably October as well) vehicle sales are masking still-weak core auto demand. Stay underweight. The ticker symbols for the stocks in this index are: BLBG: S5AUTC - DLPH, BWA, GT.

Special Report

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