Sectors

Neutral Wal-Mart's (WMT) second quarter earnings provided some insight into a retail landscape that is in the midst of upheaval at the hands of Amazon. While a still-strong consumer (second panel) helped drive a 1.8% same-store sales increase, the real story was the 60% surge in online sales. The retail giant's acquisition of jet.com (and a host of smaller sites) and the recent partnering with Google Home to deliver an Alexa-like offering are clear signals that WMT is committed to the online path; the third panel suggests they have little choice. An increasing share of online sales will dilute margins for two reasons: first, with the visibility and comparability of online shopping, the spike in sales will be biased towards the most heavily discounted items, driving an erosion of gross margins. Second, the online platforms are still being built up, with significant overhead expenses that will impact operating margins. Both of these impacts were evident in the second quarter. Net, while WMT looks reasonably strong gearing up for a fight with Amazon from a sales perspective, profitability is the clear loser in the near term. We prefer to sit on the sidelines until margins can stage a recovery (which may take considerable time); stay neutral. The ticker symbols for the stocks in this index are: BLBG: S5HYPC - WMT, COST.

Highlights Your portfolio cash weighting should be at least in the middle of its range, until the observed volatility of risk assets rises meaningfully from its record low. Cyclically add long SEK/USD to long EUR/USD. Within a European equity portfolio, this implies going cyclically underweight Sweden's OMX, given its high exposure to exporters. Go underweight Swedish real estate equities; overweight Spanish real estate equities. Within a global equity portfolio, overweight euro area banks versus U.S. banks. Feature Great expectations for Mario Draghi's appearance at the Jackson Hole Symposium have been dampened, and understandably so. After the last monetary policy meeting, Draghi emphasised that ECB discussions about policy direction would take place in the autumn. It would undermine this decision making process if Draghi's Jackson Hole speech front ran the ECB discussions. Nonetheless, twitchy markets will inevitably read the tone of Draghi's observations on the global and euro area economies. Chart of the WeekSwedish House Prices Are Up 50% In Just Four Years...Thanks To Negative Interest Rates But the more market-relevant presentation might come five hours earlier on Friday at 3pm London time, when Janet Yellen gives a keynote speech on the market's latest meme - financial stability. Three months ago in Madrid, Draghi delivered a keynote speech1 on the very same topic - The interaction between monetary policy and financial stability - available here https://www.ecb.europa.eu/press/key/date/2017/html/ecb.sp170524_1.en.html and well worth reading as a prelude to Yellen's presentation. Draghi explained that ultra-accommodative monetary policy endangers financial stability through three potential channels: Distorting investor behaviour. Generating credit-fuelled bubbles, especially in real estate. Squeezing bank profitability. Do any of these three channels give ground for concern today? Yes. Distorting Investor Behaviour In our view, central banks' distortive impact on investor behaviour is the single biggest source of financial instability today. Yet Draghi devoted only a cursory mention of this danger, noting that investors "could be prone to engage in search-for-yield behaviour and take on excessive risks." The difficulty is that the psychological and behavioural finance biases creating the current distortions lie outside central bankers' natural area of expertise. Nevertheless, we hope that Yellen develops this topic much further at Jackson Hole. Specifically, the behavioural finance distortion known as Mental Accounting Bias describes the irrational distinction between the part of an investment's return that comes from its income, and the part that comes from its capital growth. Rationally, people should not care about this distinction because the money that comes from income and the money that comes from capital growth is perfectly fungible.2 But in practice, many people want a minimum investment income - because they wish to match their known spending outlays with their known income. While they could meet their spending needs by crystalizing capital growth, many people create psychologically separate 'mental accounts': spending from investment income and saving from capital growth. This is especially true for retirees whose main or only income might come from accumulated assets. Traditionally, this psychological mental accounting bias would be unnoticeable because investors could easily match their spending needs with the safe income generated by cash and government bonds. But in recent years, central banks' extended experiments with zero and negative interest rates and QE have forced the 'income mental account' to chase the higher but much more risky income streams from high-yield bonds and equities (Chart I-2 and Chart I-3). To the point where these risk assets no longer offer a sufficient risk premium. Chart I-2A Positive Yield On Equities Can Produce##br## A Negative 5-Year Return... Chart I-3...And Even A Negative##br## 10-Year Return The search-for-yield pushed up the prices of these risk assets. Now add to the mix the phenomenon known as negative skew.3 Risk asset advances tend to be gradual and gentle, and the longer and more established the advance becomes, the lower the observed volatility goes. Some investors then mistakenly interpret lower observed volatility as justification for a lower risk premium, which warrants a further price advance. And so on, in a self-reinforcing feedback. Today, this has left us with a bizarre and unprecedented situation in which the observed volatility of the Eurostoxx50 equity index is a fraction of the observed volatility of the long-dated German bund! (Chart I-4) Chart I-4Unprecedented: The Observed Volatility Of The Eurostoxx50 ##br## Is Now Lower Than That On The German Bund! But given the strong inverse relationship between observed volatility and price, record low observed volatility categorically does not mean that prospective risk of a drawdown is low. Quite the reverse, the lower the observed volatility, the higher the prospective risk. And vice-versa. Investment bottom line: Your portfolio cash weighting should always be inversely proportional to the observed volatility of risk assets. Today, with observed volatility still near a record low, your cash weighting should be at least in the middle of its range. Generating Credit-Fuelled Bubbles... In Sweden Turning to the second channel of financial instability, the ECB sees no evidence of credit-fuelled bubbles. Banks are extending credit, but at a fraction of the rate seen prior to 2007 (Chart I-5). And although house prices are rising, the ECB claims that its ultra-accommodative monetary policy has not created imbalances in real estate markets in the euro area. Taken at face value, this claim might be true. Chart I-5Euro Area Banks Are Extending Credit... But At A Modest Rate But look across the Baltic Sea. Chart I-6Swedish House Prices Accelerated##br## After ZIRP And NIRP Sweden's Riksbank has had to shadow the ECB's ultra-loose policy, to prevent a sharp appreciation of the Swedish krona versus the euro. The trouble is that negative interest rates have been wholly inappropriate for an economy that has recently been growing at 4.5%. One worrying consequence is that Swedish house prices have gone up by 50% in just four years (Chart of the Week), with the bulk of the boom happening after ZIRP and NIRP (Chart I-6). Also, bear in mind that the Swedish real estate market did not suffer a meaningful setback in either 2008 or 2011, meaning the recent boom is not a corrective rebound - like say, in Spain and Ireland. So the ECB's ultra-loose policy may indeed have generated a credit-fuelled bubble... albeit in Sweden! Fortunately, as the ECB ends its ultra-accommodation, it will also liberate the Riksbank to end its incongruous and dangerous NIRP policy. Investment bottom line: Cyclically add long SEK/USD to long EUR/USD. For European equity investors, this implies going cyclically underweight Sweden's OMX, given its high exposure to exporters. Also, go underweight Swedish real estate equities which are now approaching peak price-to-book multiples (Chart I-7). Prefer to overweight Spanish real estate equities which offer much more attractive valuations (Chart I-8). Chart I-7Swedish Real Estate Equities ##br##Are Close To Peak Valuation Chart I-8Spanish Real Estate Equities ##br##Offer Better Value Squeezing Bank Profitability For the third channel of financial instability, the ECB concedes that ultra-loose monetary policy compresses banks' net interest margins and thus exerts pressure on their profitability. "Since banks carry out maturity transformation by borrowing short and lending long-term, both the slope of the yield curve and its level matter for profitability." In turn, lower retained profits means lower accumulation of capital, making banks more fragile. The evidence strongly supports this logic. Since the start of the ECB's asset-purchase program, euro area bank valuations - a good proxy for profitability - have formed a perfect mirror-image of the expected intensity of QE (Chart I-9). Chart I-9Bank Valuations Have Been A Mirror-Image Of QE It follows that as the ECB dials back accommodation, the valuations of euro area banks will continue to recover - at the very least, in relative terms versus banks elsewhere in the world. Investment bottom line: Global equity investors should stay overweight euro area banks versus U.S. banks. Dhaval Joshi, Senior Vice President Chief European Investment Strategist dhaval@bcaresearch.com 1 At the First Conference on Financial Stability, May 24 207. 2 Assuming the tax treatment of income and capital growth is equal. 3 Please see the European Investment Strategy Weekly Report titled 'Negative Skew: A Ticking Time-Bomb' dated July 27, 2017 available at eis.bcaresearch.com Fractal Trading Model* We are monitoring the Italian stock Tenaris which is approaching a point of being technically oversold. We are also monitoring a commodity pair-trade, short nickel / long silver which is also approaching a potential entry point in the coming days. But we have not yet opened either trade. For any investment, excessive trend following and groupthink can reach a natural point of instability, at which point the established trend is highly likely to break down with or without an external catalyst. An early warning sign is the investment's fractal dimension approaching its natural lower bound. Encouragingly, this trigger has consistently identified countertrend moves of various magnitudes across all asset classes. Chart I-10 The post-June 9, 2016 fractal trading model rules are: When the fractal dimension approaches the lower limit after an investment has been in an established trend it is a potential trigger for a liquidity-triggered trend reversal. Therefore, open a countertrend position. The profit target is a one-third reversal of the preceding 13-week move. Apply a symmetrical stop-loss. Close the position at the profit target or stop-loss. Otherwise close the position after 13 weeks. Use the position size multiple to control risk. The position size will be smaller for more risky positions. * For more details please see the European Investment Strategy Special Report "Fractals, Liquidity & A Trading Model," dated December 11, 2014, available at eis.bcaresearch.com Fractal Trading Model Recommendations Equities Bond & Interest Rates Currency & Other Positions Closed Fractal Trades Trades Closed Trades Asset Performance Currency & Bond Equity Sector Country Equity Indicators Bond Yields Chart II-1Indicators To Watch - Bond Yields Chart II-2Indicators To Watch - Bond Yields Chart II-3Indicators To Watch - Bond Yields Chart II-4Indicators To Watch - Bond Yields Interest Rate Chart II-5Indicators To Watch ##br##- Interest Rate Expectations Chart II-6Indicators To Watch##br## - Interest Rate Expectations Chart II-7Indicators To Watch##br## - Interest Rate Expectations Chart II-8Indicators To Watch ##br##- Interest Rate Expectations

Macro conditions are ripe to initiate a market neutral trade: long materials/short utilities. This trade provides exposure to the budding shift in underlying portfolio strength away from defensives toward cyclicals1 and also from domestic to global-exposed market areas. The balance of macro evidence is skewing increasingly toward robust manufacturing growth at home and abroad. The ISM manufacturing and global PMI indexes have maintained their recent gains, signaling that the path of least resistance for the relative share price ratio is higher (top panel). Synchronized global growth suggests that a relative earnings-led recovery will buttress this pair trade higher. The second and third panels highlight different ways of depicting coordinated EM and DM economic growth, giving us confidence that materials profits will outshine utilities EPS. The depreciating U.S. dollar is also a boon for commodity prices in general and base metals prices in particular. While natural gas prices are the marginal price setter for utilities pricing power, they represent an input feedstock cost to chemicals producers that dominate the materials sector. Taken together, a relative pricing power proxy suggests that materials stocks have the upper hand (bottom panel). Bottom Line: Initiate a long S&P materials/short S&P utilities pair trade. 1 For a recap of our major portfolio moves since May 1, please see U.S. Equity Strategy Weekly Report "Three Risks" dated August 14, 2017, available at uses.bcaresearch.com

Highlights Portfolio Strategy Execute a long S&P energy/short global gold miners pair trade to take advantage of the liquidity-to-growth handoff. Initiate another new trade, long S&P materials/short S&P utilities, to benefit from a shifting macro landscape. Synchronized global growth and commodity inflation are a boon for materials, but a bane for utilities. Recent Changes Initiate a long S&P energy/short global gold miners pair trade today. Initiate a long S&P materials/short utilities pair trade today. Table 1 Feature The S&P 500 failed to hold on to gains and drifted lower last week succumbing to Washington-related uncertainty. The transition from liquidity-to-growth remains the dominant macro theme which is prone to bouts of volatility. Nevertheless, a less hawkish Fed should, at the margin, underpin equities with easy monetary and financial conditions complementing the goldilocks equity backdrop (Chart 1). In fact, the St. Louis Fed Financial Stress Index (comprising "18 weekly data series: seven interest rate series, six yield spreads and five other indicators"1) is probing multi-decade lows. This primarily bond market-dependent indicator, has historically done an excellent job in leading the S&P 500 at major turning points at both peaks and troughs (Chart 2A). Recently, it has been more of a coincident indicator with equities, and currently waves the all-clear sign (St. Louis Fed Financial Stress Index shown inverted, Chart 2B). Chart 1Timid Fed Is Supportive Chart 2AExcellent Leading Properties Chart 2BAll Clear Nevertheless, we do not want to sound too complacent and following up from last week's brief discussion of rising geopolitical uncertainty and equity market performance, we are examining key post-WWII geopolitical events in more detail. The first three columns of Table 2, courtesy of BCA's Geopolitical Strategy Service2, update these episodes to mid-2017. While the S&P 500's drawdown from the three-month peak prior to the event to the three-month trough following the event averages out to roughly 10%, drilling beneath the surface is instructive. Table 2Geopolitical Crises And SPX Returns On average, broad equity market returns are muted one and three months post the event. Interestingly, on a six- and twelve-month horizon following the geopolitical incident, the S&P clearly shoots higher rising on average 5% and 8%, respectively (Table 2). Chart 3 shows the average profile of the S&P 500's returns during all of these post-WWII events, three months prior to the incident up to one year forward. Chart 3Geopolitical Opportunity? Two key takeaways stand out from this analysis. First, the coming quarter will likely prove volatile as the dust has yet to settle from the recent North Korea escalation. As a result, tactically buying some portfolio protection when the market is near all-time highs, as we cautioned last week3, is prudent and in order, especially given the seasonally challenging months of September and October. Second, on a cyclical horizon, the S&P 500 will likely resume its advance, ceteris paribus. Thus, if history at least rhymes and barring another major flare up of geopolitical risk, the path of least resistance will be higher for the overall equity market into mid-2018. This week we are executing two market neutral pair trades, one levered to the liquidity-to-growth handoff and the other to the synchronized global growth theme. Liquidity-To-Growth Handoff: Buy Energy/Sell Gold Producers A market-neutral way to benefit from the ongoing equity overshoot phase is to go long U.S. energy stocks/short global gold miners (Chart 4). This high-octane trade would benefit most from the handoff of global liquidity to economic growth. Relative share prices have plummeted since the mid-December 2016 peak, collapsing 34%. The selloff in oil prices along with a more accommodative Fed have propelled global gold miners and punished U.S. energy stocks. More recently, increasing geopolitical risks have also boosted flows into bullion and gold-related equities. However, if our thesis that growth will trump liquidity - posited three weeks ago4 - pans out in the coming months, then relative share prices should reverse. Gold prices serve as a global fear proxy, while energy prices move with the ebb and flow of global growth. Importantly, the oil/gold ratio (OGR) hit all-time lows in early 2016 and subsequently enjoyed a V-shaped recovery. But, year-to-date the OGR has relapsed on the back of rising policy uncertainty (policy uncertainty shown inverted, Chart 5). If this geopolitical uncertainty recedes, the upshot is that the OGR will rise in response. Chart 4Ready For A Bounce Chart 5Prefer Black Gold To Bullion Importantly, global trade is reaccelerating, also suggesting that the OGR should resume its advance (Chart 5). Chart 6 shows a simple growth/liquidity gauge using BCA's Global Synchronicity Indicator. Historically, this metric has been closely correlated with relative share price momentum, and the current message is to expect a sharp turn in oversold relative share prices. Moreover, were the liquidity thrust to convert into significantly higher output, then real interest rates should begin to reflect better growth prospects, and further boost the allure of the pair trade. As with bullion, the relative share price ratio is also overly sensitive to changes in real rates. In fact the 10-year TIPS yield does an excellent job in explaining relative share price fluctuation. Even a modest upturn in real interest rates will go a long way for relative share prices (Chart 7). Chart 6Ample Catch Up Space Chart 7Liquidity-To-Growth Beneficiary Meanwhile, on the relative operating front, the tide is also turning, favoring energy stocks versus gold miners. The oil and gas rig count has recovered smartly from the depths of the global manufacturing recession of late 2015/early-2016. On the flip side, demand for safe haven assets should ebb and further weigh on global gold ETF flows. Additional capital inflows into gold ETF funds from current levels would require either a sizable flare up in global geopolitical risk or another downdraft in global growth. Taken together, this relative demand indicator has surged, signaling that a catch up phase looms for the relative share price ratio (bottom panel, Chart 8). Similarly, relative pricing power is on the verge of climbing into expansionary territory. Extremely depressed pricing power for oil & gas field machinery is unlikely to deflate further, as recent anecdotes of new capital expenditure projects provide some glimmers of light for utilization rates. Conversely, bullion prices are pushing $1,300/oz. near the upper bound of the four year trading range, warning that at least a digestion phase lies ahead. The middle panel of Chart 8 shows that relative pricing power has been an excellent leading indicator of relative earnings. Our relative EPS models do an excellent job in capturing all of these different macro forces, and at the current juncture emit an unambiguously bullish signal: energy EPS will outshine gold producers' profits as the year draws to a close (Chart 9). Finally, relative valuations and technicals are both flashing a green light. Relative value is as compelling as it was during the depths of the Great Recession (middle panel, Chart 10), while our Technical Indicator is one standard deviation below the historical mean. Every time such extreme oversold levels are hit, relative performance has catapulted higher in the subsequent 3-6 months. Chart 8Relative Demand And Price Outlooks##br##Favor Energy Stocks Over Gold Miners Chart 9Earnings-Led##br## Outperformance Looms Chart 10Unloved ##br##And Oversold Bottom Line: Initiate a long S&P energy/short global gold miners pair trade to benefit from the passing of the baton from liquidity to growth. For investors seeking an alternative way to express this trade opportunity levered to the liquidity-to-growth theme, going long the S&P 1500 metals and mining index instead of the S&P energy sector would also produce similar results (bottom panel, Chart 9). New Pair Trade: Materials Vs. Utilities Macro conditions are ripe to initiate a market neutral trade: long materials/short utilities. This trade provides exposure to the budding shift in underlying portfolio strength away from defensives toward cyclicals5 and also from domestic to global-exposed market areas. In fact, our relative Cyclical Macro Indicators capture the shifting macro backdrop favoring a more cyclical portfolio tilt (Chart 11). The balance of macro evidence is skewing increasingly toward robust manufacturing growth at home and abroad. The ISM manufacturing and global PMI indexes have maintained their recent gains, signaling that the path of least resistance for the relative share price ratio is higher (Chart 12). Chart 11Reflation Trade Chart 12U.S. And... Reviving global growth is typically synonymous with rising inflation expectations and bond yields. BCA's view remains that a selloff in the bond markets is the most likely scenario in the coming months. The third panel of Chart 11 shows that relative share price momentum and the bond market are joined at the hip. This makes sense as materials stocks are reflationary beneficiaries, whereas the utilities sector acts as a fixed-income proxy. Not only does the pair trade benefit from rising bond yields in isolation, but also when the stock-to-bond (S/B) ratio is on fire. Currently, a wide gap has opened between the S/B and the materials/utilities ratios that will likely narrow via a catch up phase in the latter. Synchronized global growth suggests that a relative earnings-led recovery will buttress this pair trade higher. Chart 13 highlights four different ways of depicting coordinated EM and DM economic growth, giving us confidence that materials profits will outshine utilities EPS. Materials manufacturers have a sizable export component driving both the top and bottom line. In contrast, utilities are a domestic-only play. As a result, revving global trade and the significant fall in the trade-weighted U.S. dollar will buttress relative EPS prospects (Chart 14). In fact, irrespective of where the greenback ends the year, materials profits will get a lagged bump from a positive FX translation in the back half of the year. Chart 13...Global Growth Favor ##br##Materials Over Utilities Chart 14Cheapened Greenback = ##br##Buy Materials At The Expense Of Utilities The depreciating U.S. dollar is also a boon for commodity prices in general and base metals prices in particular. While natural gas prices are the marginal price setter for utilities pricing power, they represent an input feedstock cost to chemicals producers that dominate the materials sector. Taken together, a relative pricing power proxy suggests that materials stocks have the upper hand (bottom panel, Chart 14). Relative valuations and technical conditions also wave the green flag. Our valuation indicator has corrected back to the neutral zone and the technical indicator has unwound overbought conditions, offering a compelling entry point to the pair trade (Chart 15). Finally, our newly introduced relative EPS models encapsulate all of these diverging forces. Currently, the relative profit models signal that materials earnings are on track to outpace utilities profit generation for the remainder of the year (Chart 16). Chart 15Compelling Entry Point Chart 16Heed The Relative Profit Model Message Consequently, there is an opportunity to execute a long materials/short utilities pair trade in order to benefit from synchronized global growth and looming bond market selloff, and softening U.S. dollar and related commodity inflation. Bottom Line: Initiate a long S&P materials/short S&P utilities pair trade today. Anastasios Avgeriou, Vice President U.S. Equity Strategy & Global Alpha Sector Strategy anastasios@bcaresearch.com 1 https://www.stlouisfed.org/news-releases/st-louis-fed-financial-stress-index/stlfsi-key 2 Please see the August 16, 2017 Geopolitical Strategy Weekly Report titled "Can Pyongyang Derail The Bull Market?", available at gps.bcaresearch.com. 3 Please see the August 14, 2017 U.S. Equity Strategy Weekly Report titled "Three Risks", available at uses.bcaresearch.com. 4 Please see July 31, 2017 U.S. Equity Strategy Weekly Report titled "Growth Trumps Liquidity", available at uses.bcaresearch.com. 5 Please see the August 14, 2017 U.S. Equity Strategy Weekly Report titled "Three Risks" for a recap of our major portfolio moves since May 1, available at uses.bcaresearch.com. Current Recommendations Current Trades Size And Style Views Favor small over large caps and stay neutral growth over value.

When we upgraded the S&P industrial machinery group to overweight, we held back the S&P construction machinery & heavy trucks sibling to a neutral weighting. Our reasoning was threefold: heavy truck sales were very weak, the outlook for agriculture and food prices was shaky and the resource industry was not in a mood to deploy capital into expansion. That rationale has shifted somewhat. First, heavy truck sales have turned a corner and have pushed positively for the first time in two years (second panel). Still, in advance of a surge in orders, manufacturers boosted production earlier this year, likely offsetting a portion of the calendar 2017 earnings expansion. Second, food prices (to which the industry is highly correlated) have rebounded to some extent this year, arresting the general downtrend of the past five years (third panel). This is a sign for optimism, though whether the uptick becomes a trend remains unknown. Lastly, Caterpillar's machine sales to dealers to all regions have finally pulled out of their multiyear contraction (fourth panel), signaling a commodity production rebound. However, the resilience of this rebound is questionable with the recent Chinese fiscal and monetary tightening and a leadership change coming in the fall. Importantly, valuation multiples have fallen well off their peaks (bottom panel) as earnings estimates have surged, while the market has remained skeptical. We side with the market and remain on the sidelines, until some earnings growth validation materializes. Nevertheless, we acknowledge the mild positive macro backdrop shift and the S&P construction machinery & heavy trucks index is now on upgrade alert. Stay tuned. The ticker symbols for the stocks in this index are: BLBG: S5CSTF - CAT, PCAR, CMI.

The S&P advertising index broke down after a tough Q2 earnings season that saw caution, particularly from consumer goods clients holding back advertising budgets. However, management teams maintained their full-year guidance with expectations of a second half recovery; the analyst community concurred and earnings estimates barely budged (bottom panel). The market appears to have much less faith, driving valuation multiples to their lowest level since the GFC (second panel). We think this capitulation has created a significant buying opportunity. This mostly variable cost industry has a proven ability to downshift its cost base in line with a pullback in revenues; a steep decline in wages has been underway since the start of the year (third panel). This is driving a steep divergence between our vibrant industry margin proxy and muted EPS growth expectations (bottom panel). If management forecasts pan out, an EPS recovery should follow; more patient investors will be rewarded. Stay overweight. The ticker symbols for the stocks in this index are: BLBG: S5ADVT - IPG, OMC.

Special Report

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 Chart 2Tesla's Market Cap Surpasses GM's Chart 3Tesla: Financial Performance Chart 4GM: 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 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 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 Table 2TSLA Will Lose Market Share As Mass-Market Competition Expands 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 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 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 Chart 8Fast Chargers Are Much More Scarce ##br##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 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 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 Commodity Prices and Plays Reference Table Trades Closed in 2017 Summary of Trades Closed in 2016

Overweight Amidst a slew of weak retail earnings reports in Q2, HD surprised with a positive result as it benefited from a surge in remodeling activity. Existing home prices are pushing against highs, which benefits home improvement retailers (HIR) in two ways. First, high prices drive a shift toward renovation versus buying a new home as the latter becomes relatively more expensive. Second, existing owners can use their higher home equity as a source of funds for a renovation. Net, existing home prices and HIR sales move in lockstep (second panel). At the same time as sales are pressing upward, the HIRs are delivering productivity gains (third panel). This should amplify the operating leverage of a surge in same-store sales, driving margins higher. Relative valuations are lagging the solid operating performance (bottom panel). In fact, HIR stocks have not been this cheap since the GFC. This looks like an excellent buying opportunity; stay overweight. The ticker symbols for the stocks in this index are: BLBG: S5HOMI - HD, LOW.

Highlights Portfolio Strategy We reiterate our recent overweight calls in banks/financials and energy. Chemicals/materials and telecom services no longer deserve a below benchmark allocation. Pharma/health care and utilities are now in the underweight column. Recent Changes There are no changes to our portfolio this week. Table 1Sector Performance Returns (%) Feature Equities poked higher early last week on the eve of a robust earnings season as quarterly EPS vaulted to all-time highs (Chart 1), only to give up those gains and then some as North Korea jitters spoiled the party and ignited a mini selloff later in the week. While geopolitical uncertainty is dominating the news flow and an escalation is possible, we doubt North Korea tensions in isolation can significantly derail the stock market. With regard to the SPX's future return composition, our view remains intact that the onus falls on earnings to do the heavy lifting. In other words, the multiple expansion phase has mostly run its course, and explains the bulk of the board market's return since the 2011 trough (Chart 2). Now it is time for profits to shine. Chart 1Earnings-Led Advance Chart 2EPS Has To Do The Heavy Lifting Low double-digit EPS growth is likely in calendar 2018. Three key factors drive our sanguine profit view. First, as we posited three weeks ago, financials and energy will command a larger slice of the earnings pie, a backdrop not yet discounted in sell-side analysts' estimates (please see Table 2 from the July 24th Weekly Report). Second, irrespective of where the U.S. dollar heads in the coming months, SPX earnings will benefit from positive FX translation gains in Q3 and Q4. Finally, as the corporate sector flexes its operating leverage muscle, even modest sales growth will go a long way in terms of profit growth generation. Operating profit margins are poised to expand especially given muted wage inflation (Chart 3). Nevertheless, lack of profit validation is a key risk to our bullish S&P 500 thesis. Considering the post-GFC period, global growth scares (and resulting anemic earnings follow through) were the primary catalysts for the 2010, 2011 and late-2015/early-2016 equity corrections. The SPX fell 16%, 19% and 14% in each of those episodes, respectively. As a reminder, early in 2010 the Fed's QE ended and the ECB was scrambling to contain the government debt crisis as the Eurozone and the IMF bailed out Greece, Portugal and Ireland. In 2011, recession fears gripped the world economy, when then ECB President Jean-Claude Trichet tightened monetary policy twice in the euro area, while in the U.S. QE2 ended (Chart 4) and the debt ceiling fiasco spiraled out of control in the late-summer. More recently, a global manufacturing recession took hold in late-2015/early-2016 and the commodity drubbing re-concentrated investor's minds. Chart 3Margin Expansion Phase Chart 4Liquidity Removal = Market Turmoil A persistent flare up in geopolitical risk (i.e. in addition to the possible escalation of North Korea tensions) may lead consumers and CEOs alike to pull in their horns and short circuit the synchronized global economic recovery. Putting this risk in perspective is instructive. Table 2 documents the historical precedent of geopolitical crises since the mid-1950s, the maximum SPX drawdowns, and bid up of safe haven assets courtesy of our Geopolitical Strategy Service.1 Under such a backdrop, low-double digit EPS growth would be at risk, also causing some equity market consternation. Table 2Safe-Haven Demand Rises During Crises Table 2Safe-Haven Demand Rises During Crises, Continued Importantly, the Chinese Congress is quickly approaching in October and the dual tightening in Chinese monetary conditions (rising currency and interest rates) is unnerving. A related Chinese/EM relapse represents a risk to our bullish overall equity market thesis. Commodity producers/sectors would suffer a setback, jeopardizing the broad-based earnings recovery. Chart 5Mini Capex Upcycle Second, lack of tax reform is another risk we are closely monitoring that could put our upbeat SPX view offside. Lack of traction on this front as the year draws to a close will likely sabotage business confidence and put capex plans on the backburner anew. Moreover, this would shatter the confidence of small and medium businesses, especially given their greatest bugbears: high taxes and big government. Finally, repatriation tax holiday blues would cast a double dark shadow primarily over the tech and health care sectors: not only would shareholder-friendly activities like dividends and buybacks get postponed, but so would capex plans (Chart 5). One final risk worth monitoring is the handoff of liquidity to growth. Historically, there has been significant turmoil every time the Fed has removed balance sheet accommodation in the post-GFC era. We are in uncharted territory and the unwinding of the Fed's balance sheet, likely to be announced next month, may have unintended consequences. Unlike QE and QE2 ending, this time around the ECB is also on the cusp of removing balance sheet liquidity, at the margin. Chart 6A shows that the equity market may come under pressure if history at least rhymes. While we doubt that a larger than 10% correction is in the cards -- in line with the historical S&P 500 average drawdown during geopolitical crises (middle panel, Chart 6B)2 -- and our strategy will be to "buy the dip", the time to purchase portfolio insurance is now when the S&P 500 is near all-time highs, especially given the seasonally-weak and accident-prone months of September and October. Chart 6ADay Of Reckoning? Chart 6BAsset Class Returns During Crises We are comfortable with our overall early-cyclical portfolio exposure, while simultaneously maintaining a bit of defense in the form of our overweight consumer staples and underweight tech positions. This week we are recapping and reiterating all the major portfolio moves we have made since early May. Banking On Faster Growth Bank profit growth is supported by three main pillars: the quantity, price and quality of credit. All three are set to improve. Solid house price inflation and a tight labor market should ensure that consumer credit growth also firms (Chart 7A), pointing to the potential for a broad-based bank balance sheet expansion. Our U.S. bank loan growth model suggests that banks could enjoy the largest upswing in credit growth of the past 30 years (Chart 7B). Soaring consumer and business confidence, rising corporate profits and a potential capital spending revival are the key model drivers. BCA's view is that a better economy and rising inflation will materialize in the back half of the year, and serve as a catalyst to higher interest rates and a steeper yield curve. Banks profit from overall rising interest rates in two ways: reinvesting at higher yields and assets repricing at a faster pace than deposits. Thus, a steepening yield curve would signal that bank profit estimates should experience a re-rating, provided the yield lift at the long end of the curve was gradual and did not choke off growth via a sudden spike (Chart 7A). Chart 7ABanks Flexing Their Muscle Chart 7BBCA Bank Loans & Leases Growth Model In terms of credit quality, non-performing loans and charge-offs are sinking from already low levels. It would take a significant deterioration in the labor market to warn that credit quality was about to become a profit drag. Importantly, the reserve coverage ratio has climbed to near 100%, as non-current loans have fallen faster than banks have released reserves. Historically, credit quality improvement has been positively correlated with rising valuations (Chart 7A). Finally, even a modest easing in the regulatory backdrop along with a more shareholder friendly outlook now that the banks aced the Fed's stress test should help unlock excellent value in bank equities. Bottom Line: We reiterate our overweight stance in the S&P banks index that also lifted the S&P financials sector to overweight. Buy Energy Stocks Chart 8Energy EPS Model Says Buy Energy equities are down roughly 20% year-to-date versus the broad market, driven by rising U.S. shale oil production, inventory accumulation, and investor doubts about whether all nations will comply with OPEC's mandated production cuts. There are tentative signs that this relative performance bear phase is drawing to a close. Three main drivers support our modestly sanguine view of energy stocks. First, the long term inverse correlation between the U.S. dollar and the commodity complex has been reestablished; global growth suggests that a tightening interest rate cycle is brewing which should be supportive to energy stocks (top panel, Chart 8). Second, the steepest drilling upcycle in recent memory is showing signs of fatigue with Baker Hughes reporting flattening growth in domestic oil rig count; At least a modest deceleration in shale oil production is likely (Chart 8). Finally, our S&P energy sector Valuation Indicator has gravitated back to the neutral zone. Technicals are also washed out with our Technical Indicator breaching one standard deviation below its historical mean, a level that typically heralds a reversal. Recent anecdotes that the sell-side is throwing in the towel on their bullish oil forecasts for the remainder of the year are also contrarily positive. Bottom Line: Our newly introduced S&P energy sector relative EPS model encapsulates this cautiously optimistic industry backdrop (Chart 8), and gave us comfort to lift the S&P energy sector to a modest overweight position. DeREITing Chart 9Lighten Up On REITs REITs have marked time year-to-date, but recently operating conditions have downshifted a notch. Three key drivers argue for lightening up exposure on this newly formed S&P GICS1 sector. First, REITs had been unable to materially benefit from the 50bps fall in the 10-year Treasury yield from the mid-December peak to the mid-June trough. As the economy recovers from the first half lull, Treasury yields will resume their advance. This is a net negative for the fixed income proxy real estate sector (Chart 9). Second, real estate occupancy rates have crested and generationally high supply additions in the apartment space are all but certain to push vacancies higher still. The implication is that rental inflation will remain under intense downward pressure (Chart 9). Finally, according to the Fed's latest Senior Loan Officer Survey, bankers are less willing to extend CRE credit. If banks continue to close the credit taps, CRE prices will suffer a setback. Bottom Line: We reiterate our downgrade of the niche S&P real estate sector to a benchmark allocation. Positive Chemical Reaction? Chart 10Chemicals Are No Longer Toxic In the summer of 2014 we went underweight the S&P chemicals index, anticipating an earnings underperformance phase, driven by weak revenues as chemicals manufacturers were furiously adding capacity to benefit from lower domestic feedstocks. This view has largely panned out, and now three factors underpin our more neutral bias: synchronized global growth, receding global capacity and improving domestic operating conditions. The global manufacturing PMI has recently reaccelerated and jumped to a six year high. Similarly, the U.S. ISM manufacturing survey also vaulted higher. Synchronized global growth suggests that final demand is on the upswing and should bode well for chemical top- and bottom-line growth (Chart 10). This has driven a relative weakening of the U.S. dollar, much to the benefit of U.S. chemical producers, whose exports appear to be displacing German exports. Global chemicals M&A supports our expectation of demand-driven pricing power gains. We think the benefits of consolidation are twofold: First, reduced revenues of the past decade have left the industry with outsized cost structures; consolidation should sweep that away under the guise of synergy, driving margins higher. Second, industry overcapacity has historically impaired profitability due to soaring overhead and more competitive pricing; greater scale should impose greater capital discipline. Finally, domestic operating conditions have taken a turn for the better. This improving domestic final demand backdrop is reflected in higher resource utilization rates and solid pricing power gains have staying power (Chart 10). Bottom Line: Tentative evidence suggests that the bear market in chemicals producers is over. We reiterate our recent upgrade to neutral. Given that chemicals stocks comprise over 73% of the broad materials index, this bump also moved the S&P materials sector to a benchmark allocation. Utilities: Blackout Warning Chart 11Utilities Get Short Circuited While chemicals and materials are beneficiaries of an upgrading in global economic expectations, utilities sit at the opposite end of the table (global manufacturing PMI shown inverted, top panel, Chart 11), and therefore warrant a downgrade to a below benchmark allocation. Now that the Fed is ready to start unwinding its balance sheet, the ECB is preparing the waters for QE tapering and a slew of CBs are on the cusp of a new tightening interest rate cycle, there are high odds that still overvalued fixed income proxies will continue to suffer. Synchronized global growth and coordinated tightening in monetary policy spells trouble for bonds. Our sister publication U.S. Bond Strategy expects a bond selloff for the remainder of the year. Given that utilities essentially trade as a proxy for bonds, this macro backdrop leaves them vulnerable to a significant underperformance phase (Treasury yield shown inverted, bottom panel, Chart 11). Importantly, the stock-to-bond (S/B) ratio and utilities sector relative performance also has a tight inverse correlation (S/B shown inverted, second panel, Chart 11). The implication is that downside risks remain acute. Without the support of continued declines in bond yields, or of indiscriminate capital flight from all riskier assets, utilities advances depend on improving fundamentals. The news on the domestic operating front is grim. Contracting natural gas prices, the marginal price setter for the industry, suggest that recent utilities pricing power gains are running on empty. Tack on waning productivity, with labor additions handily outpacing electricity production, and the ingredients for a margin squeeze are in place. Bottom Line: We reiterate our recent downgrade to underweight. Pharma: Tough Pill To Swallow Chart 12Pharma Relapse Pharma stock profits have moved in lockstep with consumer spending on pharmaceuticals and both have roughly doubled over the past decade. However, relative pharma consumer outlays have crested recently, causing a significant pharma profit underperformance (Chart 12). If our cautious drug pricing power thesis pans out as we portrayed in the July 31st Weekly Report, then pharma earnings will suffer and exert downward pressure on relative share prices (Chart 12). Industry balance sheet deterioration represents another warning signal. Net debt/EBITDA is skyrocketing at a time when the broad non-financial corporate (NFC) sector has been in balance sheet rebuilding mode (bottom panel). While this metric does not suggest that pharma stocks are in deep financial trouble, the deterioration in finances is undeniable, and, at the margin, a rising interest rate backdrop will likely slow down debt issuance for equity retirement and dividend payout purposes. Bottom Line: We recently trimmed the S&P pharmaceuticals index to underweight, which also took the S&P health care index to underweight. Telecom Services: Signs Of Life Chart 13Telecom: Climbing Out Of Deflation2 Investors have shunned telecom services stocks vehemently year-to-date (YTD) on the back of an abysmal profit showing. We had been fortunate enough to underweight this niche sector since late January, adding alpha to our portfolio. Nevertheless, we did not want to overstay our welcome and recently booked profits of 12% and lifted the S&P telecom services sector to the neutral column. Our Cyclical Macro Indicator has arrested its fall giving us comfort that at least a lateral move in relative share prices is likely in coming months (Chart 13). The steep recalibration of cost structures to the new pricing reality is buttressing our CMI, offsetting the sector's plummeting share of the consumer's wallet (Chart 13). Encouragingly, selling prices cannot contract at 10% per annum indefinitely, and on a three month-rate of change basis, pricing power has staged a V-shaped recovery (Chart 13). Anecdotally, Verizon's first full quarter post the new pricing plans was solid and suggests that the peak deflationary impulse is likely behind the industry. Impressive labor cost discipline along with even a modest pricing power rebound signal that a grinding higher margin backdrop is likely in the coming months, in line with our margin proxy reading. This will also stabilize relative profitability. In sum, the bearish S&P telecom services narrative is more than discounted in ultra-depressed relative valuations on cyclically quashed profit estimates. Green shoots on the industry's pricing power front and impressive management focus on cost structures argue against being bearish this niche sector. Bottom Line: We reiterate the recent bump to neutral in the S&P telecom services sector. Anastasios Avgeriou, Vice President U.S. Equity Strategy & Global Alpha Sector Strategy anastasios@bcaresearch.com 1 Please see BCA Geopolitical Strategy Special Report, "Geopolitics And Safe Havens," dated November 11, 2015, available at gps.bcaresearch.com. 2 Ibid. Current Recommendations Current Trades Size And Style Views Favor small over large caps and stay neutral growth over value.

Leisure product stocks have taken a beating this summer to nearly their lowest level since the GFC (top panel). The slide followed a tough Q2 earnings season that saw the industry miss top line and margin estimates. Unsurprisingly, forward earnings estimates have fallen off a cliff (second panel). We think there is cause to remain optimistic. Consumer spending on toys and games has been firmly in expansion mode since the '09 trough and industry sales have been growing steadily for the past four years (third panel). The result has been leisure gaining a growing slice of the retail pie (fourth panel). The collapse in forward earnings has caused a valuation spike (bottom panel). If higher outlays translate into increasing EPS as we expect, then a playable recovery rally is likely, similar to early 2015. Stay overweight. The ticker symbols for the stocks in this index are: BLBG: S5LEPR - MAT, HAS.