Technology

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

Highlights Key Portfolio Updates Synchronized global economic growth is driving real yields higher and boosting equities (Chart 1). Meantime, core inflation remains muted which will ensure that Fed policy stays sufficiently accommodative (Chart 2). Outside of the U.S., monetary tightening cycles are kicking into high gear, and this will sustain downward pressure on the greenback for now (Chart 3). Easy financial conditions are a boon for S&P 500 profit margins, and a slow moving Fed suggests that investors will extrapolate this goldilocks equity scenario for a while longer (Chart 4). Almost all of the S&P 500's advance year-to-date has been earnings driven (Chart 5). Buoyant EPS breadth bodes well for additional gains, a message in line with our SPX profit model. In terms of how far the broad market can advance from current levels before the next recession hits, we posit three ways to SPX 3,000 (Table 1). The ongoing sector rotation is a healthy development, and is not a precursor to a more viscous and widespread correction (Chart 6). Historically, receding sector correlations represent fertile ground for the overall equity market (Chart 7). Our macro models are signaling that investors should position for a sustained rebound in economic growth. Our interest rate-sensitive models are coming out on top, deep cyclicals are attempting to trough, while defensives took a turn for the worse (Chart 8). Deep cyclical sectors are the most overvalued followed by early cyclicals, while defensives remain in undervalued territory. Interest rate sensitives have recently become overbought, while both deep cyclicals and defensives are in the oversold zone (Charts 9 & 10). The most attractive combination of macro, valuation and technical readings are in the financials and consumer discretionary sectors. The least attractive combinations are in materials, technology and utilities sectors. Prospects for a durable synchronized global economic growth, a coordinated tightening G10 central bank backdrop and cheapened U.S. currency warrant an early cyclical portfolio tilt, with the defensive/deep cyclical stance shifting to a more neutral setting. Chart 1Synchronized Global Growth Synchronized Global Growth Synchronized Global Growth Chart 2Muted Core Inflation Muted Core Inflation Muted Core Inflation Chart 3G10 Central Banks Map Cyclical Indicator Update Cyclical Indicator Update Chart 4Easy Financial Conditions Boost Margins Easy Financial Conditions Boost Margins Easy Financial Conditions Boost Margins Chart 5Buoyant Breadth Bodes Well Buoyant Breadth Bodes Well Buoyant Breadth Bodes Well Table 1SPX Dividend Discount Model Cyclical Indicator Update Cyclical Indicator Update SPX EPS & Multiple Sensitivity Cyclical Indicator Update Cyclical Indicator Update ERP Analysis Cyclical Indicator Update Cyclical Indicator Update Chart 6Healthy Rotation Healthy Rotation Healthy Rotation Chart 7Falling Correlations Boost The S&P 500 Falling Correlations Boost The S&P500 Falling Correlations Boost The S&P 500 Falling Correlations Boost The S&P500 Falling Correlations Boost The S&P 500 Chart 8Interest Rate Sensitives Come Out On Top Interest Rate Sensitives Come Out On Top Interest Rate Sensitives Come Out On Top Chart 9Underowned... Underowned... Underowned... Chart 10...And Undervalued Defensives ...And Undervalued Defensives ...And Undervalued Defensives Chart 11Earnings Growth Set To Accelerate Earnings Growth Set To Accelerate Earnings Growth Set To Accelerate Chart 12Consumers Are Feeling Flush Consumers Are Feeling Flush Consumers Are Feeling Flush Chart 13Improving Fundamentals Signal A Trough Improving Fundamentals Signal A Trough Improving Fundamentals Signal A Trough Chart 14Staples Remain The Household's Choice Staples Remain The Household's Choice Staples Remain The Household's Choice Chart 15Weaker Rents And Higher Vacancies Bode Ill Weaker Rents And Higher Vacancies Bode Ill Weaker Rents And Higher Vacancies Bode Ill Chart 16Profits Look Set To Downshift Strong Fundamental Support Profits Look Set To Downshift Strong Fundamental Support Profits Look Set To Downshift Chart 17Cyclical Recovery Driving Backlogs Lower Cyclical Recovery Driving Backlogs Lower Cyclical Recovery Driving Backlogs Lower Chart 18Margin Recovery Appears Priced In Margin Recovery Appears Priced In Margin Recovery Appears Priced In Chart 19Pricing Collapse Driving Earnings Decline Pricing Collapse Driving Earnings Decline Pricing Collapse Driving Earnings Decline Chart 20Productivity Declines Will##br## Keep A Cap On Valuations Productivity Declines Will Keep A Cap On Valuations Productivity Declines Will Keep A Cap On Valuations Chart 21Valuations At Risk##br## When Inflation Returns Valuations At Risk When Inflation Returns Valuations At Risk When Inflation Returns Feature S&P Financials (Overweight) Our financials cyclical macro indicator (CMI) has climbed to new cyclical highs, supported by broad-based improvement among its components. Firming employment data, historically a precursor to credit growth and capital formation, has been a primary contributor to the lift in the CMI. Importantly, a tight labor market has not yet driven sector costs higher, which bodes well for near term profits (Chart 11 on page 8). A budding revival in loan demand is corroborated by our bank loan growth model, which points to the largest upswing in credit growth of the past 30 years. Soaring consumer and business confidence, rising corporate profits and a potential capital spending revival underpin our loans and leases model (Chart 11 on page 8). Expanding housing prices, increased housing turnover and rebounding mortgage purchase applications support household capital formation (Chart 11 on page 8). A recent lift in share prices partially reflects this much-improved cyclical outlook. Still, the message from our valuation indicator (VI) is that there is significant running room. Our technical indicator (TI) has retreated from overbought levels, but remains solidly in the buy zone, setting the stage for the next leg up in the budding relative bull market. We expect sentiment to steadily improve, buoyed by deregulation moving closer to reality as a partial Dodd-Frank replacement passed the House. Chart 22 S&P Financials S&P Financials S&P Consumer Discretionary (Overweight) Our CMI has snapped back after a tough year, driven by improving real wage growth. Higher home prices, a tighter labor market and increasing disposable income have consumers feeling flush, which should boost discretionary outlays. Importantly, consumer deleveraging is far advanced with the debt service ratio hovering near decade lows (Chart 12 on page 9). Further, our Consumer Drag Indicator remains near its modern high, suggesting EPS gains will prove resilient (Chart 12 on page 9). Although somewhat expensive from a historical perspective, our VI remains close to the neutral zone, underscoring that profits will be the primary sector price driver. Our TI has fully recovered from oversold levels, and is flirting with the buy zone, underscoring additional recovery potential. We continue to recommend an overweight position, favoring the media-oriented sub-indices. Chart 23 S&P Consumer Discretionary S&P Consumer Discretionary S&P Energy (Overweight) Our CMI has recently ticked up from its all-time lows, and is now diverging positively from the share price ratio. Ongoing gains in domestic production, partially offset by a still-high sector wage bill, underlie the recent CMI uptick. The steepest drilling upcycle in recent memory is showing some signs of fatigue. Baker Hughes reported the first weekly decline in 24 weeks in the oil rig count for the week ending June 30th. At least a modest deceleration in shale oil production is likely. Encouragingly, U.S. crude oil inventories are contracting, which could presage a renormalization of domestic inventories, market share gains for domestic production and at least a modest rally in energy shares (Chart 13 on page 9). Our S&P energy sector relative EPS model echoes this cautiously optimistic industry backdrop, indicating a burgeoning recovery in sector earnings (Chart 13 on page 9). The TI has returned to deeply oversold levels, suggesting that an oversold bounce could soon occur at a time when valuations are gravitating back to earth. Chart 24 S&P Energy S&P Energy S&P Consumer Staples (Overweight) The consumer staples CMI has turned lower recently, held back by healthy economic data, particularly among confidence indicators. That should drive a preference for spending over saving after a long period of thrift, although a relative switch from staples into discretionary consumption has not yet taken firm hold. The savings rate has also stayed resilient, despite consumer euphoria (Chart 14 on page 10). The good news is that tamed commodity prices and a soft U.S. dollar should provide bullish offsets for this global-exposed (Chart 14 on page 10) and commodity-input dependent sector. A modestly weaker outlook for staples is more than reflected in our VI, which is still parked in undervalued territory. Technical conditions are completely washed out, signaling widespread bearishness, which is positive from a contrary perspective. Chart 25 S&P Consumer Staples S&P Consumer Staples S&P Real Estate (Neutral) Ongoing improvements in commercial & residential real estate prices continues to push our real estate CMI higher. However, the outlook for REITs has darkened; rents have crested while the vacancy rate found its nadir in 2016, suggesting further rent weakness on the horizon (Chart 15 on page 10). Further, bankers appear less willing to extend commercial real estate credit; declines in credit availability will directly impact REIT valuations. Our VI is consistent with our Treasury bond indicator, indicating that both are at fair value. Our TI is starting to firm from extremely oversold levels, a positive indication for both 12- and 24-month relative performance. Chart 26 S&P Real Estate S&P Real Estate S&P Health Care (Neutral) Our CMI has rolled over, driven by a steep decline in pharma pricing power (Chart 16 on page 11). In fact, the breadth of sector pricing power softness has spread, just as the majority of the industries we cover is enjoying a selling price revival. The divergence between the CMI and recent sector relative performance suggests that the latter has been mostly politically motivated, and may lack staying power. Worrisomely, the sector wage bill has spiked; in combination with a weaker top line, the earnings resilience of the sector could be at risk. Relative valuations remain appealing, but technical conditions are shaky, as our TI has bounced from oversold levels but is still in negative territory. Taken altogether, we would lean against the recent advance in relative performance. Chart 27 S&P Health Care S&P Health Care S&P Industrials (Neutral) The CMI has recovered smartly in the past couple of quarters, lifted mostly by a weaker U.S. dollar. The sector has moved laterally since the U.S. election. The improved export outlook is a positive, but a lack of response in hard economic data to the surge in confidence is a sizable offset. An inventory imbalance has largely unwound over the past six months, as durable goods orders are easily outpacing inventories, coinciding with a return of some pricing power to the sector (Chart 17 on page 11). Still, years of capacity growth in excess of production and the resulting low utilization rates mean that pricing gains may stay muted unless demand picks up substantially. Our valuation gauge is near the neutral zone, but there is a wide discrepancy beneath the surface, with construction & engineering trading cheaply and railroads and machinery commanding premium valuation multiples. Our TI has returned close to overbought levels, potentially setting the stage for another move higher. Chart 28 S&P Industrials S&P Industrials S&P Utilities (Neutral) Our CMI for the utilities sector remains in a long-term downtrend, albeit one with periodic countertrend moves. Most of the weakness in the CMI relates to external factors, such as robust leading indicators of global economic growth (Chart 18 on page 12). Encouragingly, the sector's wage bill has slowed from punitively high levels, and combined with improving pricing power should allow for some margin recovery (Chart 18 on page 12). Utilities have outperformed other defensive sectors, likely due to the expectation that the new U.S. administration's long-awaited tax reform will have outsized benefits to this domestic-focused industry. As a result, valuations have been creeping up, though not sufficiently enough to warrant an underweight position. Our TI has reversed its steep fall over the past year, but is unlikely to bounce through neutral levels in the absence of a negative economic shock. Ergo, our preferred strategy is to remain at benchmark, but look for tradable rally opportunities. Chart 29 S&P Utilities S&P Utilities S&P Telecom Services (Underweight) Our CMI for telecom services has moved laterally, as much-reduced wage inflation is fully offset by the sector's plummeting share of the consumer's wallet and extremely deflationary conditions (Chart 19 on page 12). Our sales model paints a much darker picture, pointing to double-digit topline declines for at least the next few quarters, owing to the plunge in pricing power deep into negative territory (Chart 19 on page 12). The sector remains chronically cheap, and has all the hallmarks of a value trap, as relative forward earnings remain in a relentless secular downtrend. It would take a recession to trigger a valuation re-rating. Our Technical Indicator has nosedived but, like the VI, cycles deep in the sell zone have not proven reliable indicators that a relative bounce is in the offing. Chart 30 S&P Telecommunication Services S&P Telecommunication Services S&P Materials (Underweight) Recent Fed rate hikes have driven down the CMI close to all-time lows. The sector has historically performed very poorly in tightening cycles owing to U.S. dollar appreciation and the ensuing strains on the emerging world. Weak signals from China have also helped take the steam out of what looked like a recovery in the CMI last year. Commodity-currencies have rallied, but not by enough to offset a relapse in pricing power and weak sector productivity (Chart 20 on page 13). The heavyweight chemicals group (comprising more than 73% of the index) continues to suffer; earnings growth relies heavily on global reflation, an elusive ingredient in the era of a globally synchronized tightening cycle. Sagging productivity warns that profitability will remain under pressure. Valuations have now spent some time in overvalued territory; without a recovery in earnings growth, a derating is a high probability outcome. Our TI has dipped into the sell zone, indicating a loss of momentum and downside relative performance risks. It would be highly unusual for the sector to stay resilient in the face of a negative TI reading. Chart 31 S&P Materials S&P Materials S&P Technology (Underweight) The technology CMI is in full retreat, driven by ongoing relative pricing power declines and new order weakness. However, the sector had been resilient, until recently, as a mini-mania in a handful of stocks and the previously red-hot semiconductor group have provided resilient support. That reflected persistently low inflation and a belief that interest rates would still low forever. After all, tech stocks thrive in a disinflationary/deflationary environment and suffer during inflationary periods (Chart 21 on page 13). Nevertheless, a recovering economy from the first quarter's lull and tight labor market suggest that an aggressive de-rating in sky-high valuations in previous juggernauts is a serious threat, especially if recent disinflation proves transitory. Our relative EPS model signals a profit slide this year. In the context of analyst estimates of double-digit earnings growth, sector downside risk is elevated. Our VI is not overdone, but that partly reflects the massive overshoot during the bubble years. Our TI is extremely overbought, suggesting that profit-taking is likely to persist. Chart 32 S&P Technology S&P Technology Size Indicator (Overweight Small Vs. Large Caps) Our size CMI has retraced some of its 2016 climb, but remains firmly above the boom/bust line. Keep in mind that this CMI is not designed as a directional trend predictor, but rather as a buy/sell oscillator. Small company business optimism is near modern highs, as pricing and consumption vigor push domestic revenues higher. A smaller government footprint, i.e. fewer regulatory hurdles, and tax relief will disproportionately benefit SMEs. The prospect of trade barriers clearly favors the domestically focused small cap universe and underlie part of the post-election euphoria. Top line growth will need to persist if small businesses are to offset a higher wage bill, as labor looks more difficult to import and the economy pushes against full employment. Valuations have improved and the share price ratio has fully unwound previously overbought conditions. We expect the recent rally to gain steam.\ Chart 33 Style View Style View Anastasios Avgeriou, Vice President U.S. Equity Strategy & Global Alpha Sector Strategy anastasios@bcaresearch.com Chris Bowes, Associate Editor chrisb@bcaresearch.com

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

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

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

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

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

Highlights Although it is tempting to argue that emerging markets are in a new era where past correlations no longer matter, our belief is that it is only a matter of time until fundamentals reassert themselves. Several measures of equity markets have reached or are close to their previous structural peaks. In the second half of 1990s, booming U.S. and European growth as well as the tech mania, did not preclude a bear market in commodities and EM financial markets. Overall, EM risk assets will not be immune to selling off considerably from the current overbought levels if Chinese growth and commodities prices surprise to the downside, as we expect. Falling commodities prices will weigh on Indonesia's terms of trade. Equity investors should maintain an underweight position in this market and currency traders should continue shorting the rupiah. Feature A New Era? Money has been flowing into EM financial markets, irrespective of the evolution of many economic and financial variables that have in the past shaped markets dynamics. Indeed, EM share prices and currencies have refused rolling over despite a relapse in a number of variables they have historically been correlated with. EM share prices have continued to surge, even though the aggregate EM manufacturing PMI has rolled over (Chart I-1). Chart I-1Unsustainable Decoupling Unsustainable Decoupling Unsustainable Decoupling The recent relapse in the EM manufacturing PMI has not hurt EM currencies either (Chart I-2, top panel). In addition, EM currencies have diverged from commodities prices, an unprecedented historical occurrence (Chart I-2, bottom panel). The same applies to EM versus DM relative equity performance. Chart I-3 demonstrates that EM share prices have outperformed their DM counterparts year to date, even though the EM manufacturing PMI considerably underperformed DM's. Chart I-2Untenable Divergence Untenable Divergence Untenable Divergence Chart I-3Relative Share Prices And Relative PMIs Relative Share Prices And Relative PMIs Relative Share Prices And Relative PMIs Notably, EM stock prices have even defied the recent setback in EM net earnings revisions (Chart I-4). Typically, the latter correlate with swings in share prices, but this time both variables have diverged. Finally, it is important to note that this phenomena of decoupling cannot be explained by the performance of technology stocks. EM share prices excluding technology companies have still rallied, albeit much less, despite the decline in EM net earnings revisions and the EM manufacturing PMI. Remarkably, China's H shares - the index that does not include U.S.-listed Chinese internet/social media companies and is instead "heavy" in banks and "old economy" stocks - have still ignored both the drop in China's manufacturing PMI and rising local interest rates (Chart I-5). Chart I-4Even Analysts' Net EPS ##br##Revisions Have Rolled Over Even Analysts' Net EPS Revisions Have Rolled Over Even Analysts' Net EPS Revisions Have Rolled Over Chart I-5Puzzling... Puzzling... Puzzling... One could argue that the dominant macro drivers of EM in recent months have been the U.S. dollar and U.S. bond yields, both of which have downshifted since mid-December 2016. If the greenback and expectations of Federal Reserve policy continue to shape EM performance, the outlook is not much better. The basis is that the Fed will likely continue to hike interest rates if global stocks continue to rally. Notably, U.S. corporate bond yields/spreads are very low, the dollar is already down quite a bit, U.S. asset prices are reflating and U.S. economic growth is decent. If the Fed does not normalize interest rates now, when and under what conditions will it? Similarly, investor sentiment on the U.S. dollar is no longer bullish, and the market expects only 44 basis points in Fed rate hikes over the next 12 months. The latter is a low bar. We maintain that the dollar's selloff - even though it has lasted longer than we previously expected - is late, especially versus EM currencies. Bottom Line: Although it is tempting to argue that emerging markets are in a new era where past correlations no longer matter, our belief is that it is only a matter of time until fundamentals reassert themselves. As and when this happens - our hunch is that it is a matter of weeks not months - EM risk assets will sell off materially and underperform their DM counterparts. Signs Of A Top? Or Is This Time Different? The EM equity rally has been facilitated by the tech mania occurring worldwide as well as by falling financial market volatility and risk premia - leading investors to bet on EM carry trades. A relevant question is whether these trends are close to the end or have much further to go. We have the following observations: EM share prices in local currency terms, as well as the KOSPI and Taiwanese TSE indexes in U.S. dollar terms, all are testing their previous highs which they have never broken out from (Chart I-6). The question we would ask is: Why should this time be different, or why would these indexes break out this time around? In our opinion, EM fundamentals, including the outlook for EPS growth, remain poor. We have elaborated on this issue at length in previous reports1 and stand by our assessment. On many metrics, the U.S. equity market is expensive, and the rally is overstretched (Chart I-7). Chart I-6Facing A Major ##br##Technical Resistance Facing A Major Technical Resistance Facing A Major Technical Resistance Chart I-7U.S. Stocks Are Expensive ##br##And Overstretched U.S. Stocks Are Expensive And Overstretched U.S. Stocks Are Expensive And Overstretched These charts do not provide clues for the timing of a reversal, but when all these ratios reach their previous secular tops, investors should be critically examining the investment outlook. Our take is as follows: Without a broad-based U.S. corporate profit recession, a major bear market in the S&P 500 is not likely, but share prices could soon hit a major resistance and correct meaningfully from the current expensive and overbought levels. While EM stocks are not expensive, the outlook for their share prices is negative because we expect EM earnings to shrink again by early next year1. Finally, not only is U.S. equity market volatility extremely muted but EM equity as well as U.S. bond market volatility are testing their previous lows (Chart I-8). When implied volatility reached these low levels in the past, it marked a major market reversal. Bottom Line: Several measures of equity market performance have reached or are close to their previous structural peaks and financial markets volatility is at record lows. While one can make the case that this time is different and this EM equity rally will persist, we continue to err on the side of caution. Tech Mania And EM In The 1990s A recent narrative in the marketplace has been as follows: given the share of tech stocks' market cap has risen to 26%, and commodities sectors presently account for only 14% of the EM MSCI benchmark, it makes sense that EM equities have decoupled from commodities prices and have become correlated with tech stocks and DM growth. In this respect, it is instrumental to revisit what happened in the second half of the 1990s, when global tech/internet and telecom stocks were in the midst of a mania like social media/tech stocks nowadays. We have the following observations on this matter: EM share prices, currencies, and bonds plunged in the second half of the 1990s, even though U.S. and European real GDP growth was extremely strong - 4.5% and 3% on average, respectively (Chart I-9, top panel) - and the S&P 500 was in a full-fledged bull market. Chart I-8Volatility: As Low As It Gets Volatility: As Low As It Gets Volatility: As Low As It Gets Chart I-9EM Stocks And DM Growth In The 1990s EM Stocks And DM Growth In The 1990s EM Stocks And DM Growth In The 1990s EM share prices collapsed in 1997-'98, even though U.S. and European import volumes were expanding at a double-digit rates (Chart I-9, middle panel). Furthermore, the crises originated in emerging Asian countries such as Thailand, Korea and Malaysia that were large exporters to advanced economies. Besides, the share and importance of the U.S. and European economies was much larger 20 years ago than it is now. Back then, China was negligible in terms of its impact on EM in general and commodities in particular. The question is, if an economic boom in the U.S., and Europe in the second half of the 1990s did not preclude crises in export-oriented economies in East Asia, why would moderate DM growth today - as well as their much smaller share of global trade - boost EM share prices from already elevated levels. Twenty years ago, EM share prices fell along with declining U.S. bond yields (Chart I-10). The Fed hiked rates only once by 25 basis points in March 1997. In the past 18 months, the Fed has already hiked 3 times. In fact, the U.S. dollar was in a bull market in the second half of the 1990s, despite falling U.S. bond yields during that period. EM stocks collapsed along with falling commodities prices in 1997-'98 (Chart I-11, top panel) even though the S&P 500 was in the midst of a major bull market (Chart I-11, bottom panel). Chart I-10The 1990s: EM Bear Market ##br##Was Not Due To Rising U.S. Bond Yields The 1990s: EM Bear Market Was Not Due To Rising U.S. Bond Yields The 1990s: EM Bear Market Was Not Due To Rising U.S. Bond Yields Chart I-11EM Stocks, Commodities And The S&P 500 EM Stocks, Commodities And The S&P 500 EM Stocks, Commodities And The S&P 500 Importantly, the mania sectors of the late 1990s - technology and telecom - accounted for approximately 33% of EM market cap in January 2000. Presently, following an exponential rally and outperformance, technology and social media/internet stocks make up 27% of the EM MSCI benchmark. In addition, the market cap of energy and materials companies stood at 19% of the MSCI EM equity benchmark in January 2000, compared with 14% presently (Chart I-12). Hence, the market cap of commodities sectors was not substantially larger in the late 1990s than today. Chart I-12 Finally, Korean and Taiwanese bourses have historically had a high positive correlation with both oil and industrial metals prices (Chart I-13). The reason for this relationship is that both economies are leveraged to the global business cycle, and commodities prices are often driven by global trade cycles. Chart I-13Asian Bourses And Commodities Prices Asian Bourses And Commodities Prices Asian Bourses And Commodities Prices Bottom Line: In the late 1990s, EM crises/bear markets occurred despite booming U.S. and European growth, and at a time when these economies were much more important to EM than they are today. The EM bear market also occurred amid the S&P 500 bull market and falling U.S. bond yields. To be sure, we are not suggesting that everything is identical between today and the 1990s, but all the above suggests to us that EM risk assets will not be immune to selling off considerably from the current overbought levels if Chinese growth and commodities prices surprise to the downside, as we expect. Arthur Budaghyan, Senior Vice President Chief Emerging Markets Strategist arthurb@bcaresearch.com 1 Please refer to the Emerging Markets Strategy Weekly Report titled, "EM Profits, China And Commodities Redux", dated May 31, 2017, link available on page 16. Indonesia: Facing Commodities Headwinds (Again) Decelerating Chinese growth and falling commodities prices will weigh on Indonesia's exchange rate (Chart II-1). In turn, not only will the currency depreciation undermine foreign currency returns to investors in stocks and local bonds, but it will also exert upward pressure on local rates. The latter will extend the credit downturn and weigh on domestic demand. Chinese imports of Indonesian coal have begun falling in volume terms (Chart II-2). Consistently, Chinese thermal coal prices - the type of coal that China buys from Indonesia - have also rolled over decisively after rallying sharply in 2016. Chart II-1Indonesia Currency ##br##And Commodities Prices Indonesia Currency And Commodities Prices Indonesia Currency And Commodities Prices Chart II-2Indonesia's Coal Exports ##br##To China And Coal Prices Indonesia's Coal Exports To China And Coal Prices Indonesia's Coal Exports To China And Coal Prices Indonesia's exports of base metals and oil/gas to China are also declining in U.S. dollar terms. Commodities exports account for around 30% of Indonesia's total exports. As such, falling commodities prices will lead to negative terms of trade for this nation. On the domestic front, consumer demand remains sluggish. Although auto sales have revived, motorcycles sales are still declining for a fourth consecutive year (Chart II-3). Meanwhile, capital expenditures are tame. Capital goods imports are no longer contracting, but there has been no recovery so far (Chart II-4). Chart II-3Consumer Spending: ##br##Auto And Motorcycle Sales Consumer Spending: Auto And Motorcycle Sales Consumer Spending: Auto And Motorcycle Sales Chart II-4Indonesia: Capex Is Sluggish Indonesia: Capex Is Sluggish Indonesia: Capex Is Sluggish Bank loan growth has not recovered much (Chart II-5) despite low interest rates and a benign external backdrop since early 2016, specifically the revival in commodities prices and large foreign portfolio inflows. NPLs on banks' balance sheet will rise further due to weak growth and lower commodities prices. That, in turn, will dent banks' willingness to grow their loan book. In regard to the credit cycle, Indonesia might be following India's example with a several year lag. In India's banking system, high NPLs have curtailed public banks' desire to lend and, consequently, capital spending has been in disarray. Similarly, Indonesia's credit-sensitive consumer spending and investment expenditure growth will disappoint in the next 12 months as credit growth slows anew. Finally, at a trailing price-earnings ratio of 19.6, equity valuations are not attractive. The poor growth outlook that we foresee does not justify such high multiples. Besides, relative performance of this bourse versus the overall EM equity benchmark is stuck between technical support and resistance (Chart II-6). We are biased to believe that it will relapse from the current juncture. Chart II-5Indonesia's Credit Cycle Is Not Out Of The Woods Indonesia's Credit Cycle Is Not Out Of The Woods Indonesia's Credit Cycle Is Not Out Of The Woods Chart II-6Indonesian Equity Relative Performance Indonesian Equity Relative Performance Indonesian Equity Relative Performance Bottom Line: Weaker commodities prices emanating from slower Chinese growth will hurt Indonesia's currency. We recommend equity investors to keep an underweight position in this bourse. Also, we remain short IDR versus the U.S. dollar and underweight local currency bonds within the EM universe. Ayman Kawtharani, Associate Editor ayman@bcaresearch.com Equity Recommendations Fixed-Income, Credit And Currency Recommendations

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

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