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

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

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

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

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

Overweight This year has proven a tough one for the consumer finance index, a result of the hangover following the Trump election ebullience. However, the path has been generally upward since the post-Q1 trough; we expect more of the same. The data is unambiguously positive for consumer finance growth and profitability. Vibrant equity markets and a bounce back in house prices have driven household net worth to a ten year-high (top panel), while debt service payments are very near their decade-low (second panel). The upshot is a long runway for consumer outlays. With chargeoffs at historically low levels (third panel), expanding credit should deliver outsized profits to consumer finance providers. Despite the bright outlook, the market is pricing in a steep profit recession with multiples 35% below their ten-year average (bottom panel). We think this has created an excellent buying opportunity; stay overweight. The ticker symbols for the stocks in the S&P consumer finance index are: BLBG: S5CFINX-AXP, COF, DFS, SYF, NAVI. Put It On The Card Put It On The Card

Feature Visions abound of a dystopia in which Artificial Intelligence (AI) obsoletes all human jobs. In these visions, mankind becomes a subservient sideshow in a world run by robots. But while such dystopian visions make excellent narratives for Hollywood blockbusters, the chance they become a reality is nil. Technological progress is nothing new. Each generation feels it is experiencing unprecedented disruptive changes, but the constant march of technological progress has defined humanity for centuries, or even millennia. In the process, innovation has already obsoleted countless occupations. Where are today's lamplighters, ostlers,1 livery-stable keepers, newspaper criers and boiler firemen? In 1910, one third of the labour force worked on farms,2 with many of these workers tending animals; today, those proportions are near zero. In 1950, one fifth of the workforce was a machine or vehicle operative; today, that proportion is less than a tenth. More recently, in 1970, over 5% of workers were 'stenographers, typists or secretaries'; again today, most of those jobs have vanished. Yet this mass of job obsolescence has not created mass unemployment. The reason is that an advancing economy creates as many new jobs to replace the obsoleted jobs (Feature Chart and Chart I-2). In 1910, less than 5% of workers were in 'professional or technical' jobs; today the category employs over a quarter of workers. In 1950, healthcare employed 2% of workers; today it employs 8%. Moreover, the nature of many of today's jobs might have been unimaginable just a few decades ago. The rapidly growing employment sector 'medical and dental technicians' did not even exist before 1950. In the same way, the precise type of jobs that will see very strong growth in the coming years and decades might be unimaginable today. Feature ChartTechnological Progress In The 20th ##br##Century Destroyed Many Jobs... Why Robots Will Kill Middle Incomes Why Robots Will Kill Middle Incomes Feature Chart...But Created As ##br##Many New Jobs Why Robots Will Kill Middle Incomes Why Robots Will Kill Middle Incomes Chart I-2Nothing New: Technological Progress Always ##br##Involves Job Destruction And Creation Why Robots Will Kill Middle Incomes Why Robots Will Kill Middle Incomes Say's Law Tells Us That Robots Will Not Kill Job Growth Technological progress has not killed job growth. Nor will it. This is because firms choose to replace human workers with machines only if it increases their productivity and profitability (Charts I-3, Chart I-4, Chart I-5). The higher productivity increases the ability to purchase other goods and services - thereby creating jobs elsewhere in the economy (Chart I-6), often in new and surprising industries. Chart I-3Machine And Vehicle Operative ##br##Work Peaked In The 50s Why Robots Will Kill Middle Incomes Why Robots Will Kill Middle Incomes Chart I-4Secretarial Work Peaked ##br## In The 70s Why Robots Will Kill Middle Incomes Why Robots Will Kill Middle Incomes Chart I-5Clerical Work Peaked##br## In The 80s Why Robots Will Kill Middle Incomes Why Robots Will Kill Middle Incomes Chart I-6Healthcare Work Is In##br## A Strong Uptrend Why Robots Will Kill Middle Incomes Why Robots Will Kill Middle Incomes This is the idea introduced in 1803 by French economist Jean-Baptiste Say, called Say's Law: The producer of X is able to buy Y, if his products are demanded. Thereby, supply of X creates demand for Y, as long as people wish to buy X. A producer replaces human workers with machines to generate his output at higher profit, enabling him to demand new goods and services that he desires. Crucially, human desires are varied, ever changing and ultimately unlimited. Satisfying those unlimited desires creates new economies and jobs. In this way, technological progress often paves the way for completely new and unrelated goods and services. It creates whole new industries. To give just one example, railways spawned the frozen food industry. The frozen food industry satisfied the human desire to eat fresh food - which railways could now transport (frozen) to cities from distant farms and fisheries. In real time though, it was difficult to connect the advent of railways with the birth of the frozen food industry. Likewise, today it is hard to know precisely which new economies, markets and associated jobs the current new technologies will spawn. Nevertheless, a new technology's disruptive effect on an economy does depend on the broad type of job it destroys versus the broad type of job it creates. Consider a stylized economy with three types of job: a high-income innovator, a middle-income manufacturer, and a low-income animal tender. And imagine two scenarios. Scenario 1: the innovator invents a machine that obsoletes the low-income animal tender. Having replaced the animal tender with a more productive machine, the innovator will use his higher income to satisfy additional desires for manufactured goods. This enables the obsoleted animal tender to retrain and make a better living as a middle-income manufacturer. Scenario 2: the innovator instead invents a machine that obsoletes the middle-income manufacturer. In this case, the innovator will use his higher income to satisfy additional desires for animal tending services. The obsoleted manufacturer must now make a living as a low-income animal tender. So while the innovator sees a rise in his standard of living, the outcome for the unfortunate middle-income manufacturer is a massive deflation in pay. It is our strong contention that whereas previous waves of technological progress looked like scenario 1, the current and forthcoming impact of AI looks more like scenario 2. In other words, robots will kill middle-income jobs rather than low-income jobs. And the reason comes from a discovery called Moravec's Paradox.3 Moravec's Paradox Tells Us That Robots Will Kill Middle Income Jobs Moravec's Paradox is a counterintuitive discovery by robotics researchers that, for AI, the hard problems are easy and the easy problems are hard: High-level reasoning - such as logic and algebra - requires very little computation, but supposedly low-level sensorimotor skills - such as mobility and perception - require vast computational resources. Logic and algebra are considered difficult for humans, a supposed sign of intelligence. Jobs that require them are relatively well paid. Conversely, basic mobility and perception are considered innate. Jobs that rely on them are relatively poorly paid. But from an evolutionary perspective, high-level reasoning is very recent, maybe less than 100 thousand years old. This explains why it seems un-mastered and requires conscious effort. Conversely, evolution has honed and perfected our mobility and perception skills over tens of millions of years. So those low-level skills are subconscious and effortless. As AI is, in effect, just reverse-engineering the brain, the difficulty of any task for AI is roughly proportional to the amount of time it has taken for nature to evolve and encode it in the human brain. Therefore, the 100 thousand year old 'high-level' skills like logic and algebra are relatively easy for AI to replicate and even surpass, whereas the 10 million year old 'low-level' skills like mobility and perception are extremely difficult to replicate. It follows that the jobs that AI can easily replicate and replace are those that require recently evolved skills like logic and algebra. They tend to be middle-income jobs. Conversely, the jobs that AI cannot easily replicate are those that rely on the deeply evolved skills like mobility and perception. They tend to be lower-income jobs. Hence, the current wave of technological progress is following scenario 2. AI is hollowing out middle-income jobs and creating lots of lower-income jobs. Put another way: Say's Law + Moravec's Paradox = Strong Job Creation + Middle Income Wage Depression Is there any evidence of this? Yes, in the United States where the job creation data is a lot more granular than in Europe, the strongest growing employment sub-sector for many years has been 'Food Services And Drinking Places' (Table I-1 and Chart I-7). In other words, bartenders and waiters - classic low-income jobs requiring mobility and perception. Meanwhile, job losses have been concentrated in middle-income occupations. Table I-1Which Sectors Are Seeing ##br##The Job Growth? Why Robots Will Kill Middle Incomes Why Robots Will Kill Middle Incomes Chart I-7Bartenders And Waiters Is The Fastest ##br##Growing Employment Sector! Bartenders And Waiters Is The Fastest Growing Employment Sector! Bartenders And Waiters Is The Fastest Growing Employment Sector! Stronger evidence comes from the weakening Phillips curve relationship between unemployment and wage inflation. In many economies, unemployment rates are hitting multi-decade lows, yet wage inflation remains dormant. This has baffled many economists, but it shouldn't. Moravec's Paradox tells us that strong job creation is at the lower-income end of the employment distribution. So a weakening Phillips curve relationship is exactly what we should see. Moreover, as the economic impacts of AI are still in their infancy, the trends we are seeing now have much further to run. The major investment takeaway is that the structural backdrop for bonds is benign. But with the ECB about to end its ultra-accommodation, bond investors should tilt their long-term exposure towards non-euro area government bonds. A New Investment Theme: Animal Care Chart I-8Animal Care: Strong And Steady Growth Animal Care: Strong And Steady Growth Animal Care: Strong And Steady Growth Despite the on-going disruption to many middle-income jobs, developed economies have grown and will continue to grow. But as we said, economic growth can come through new and surprising industries. The early identification of such industries can create excellent investment opportunities. So we will end this report by introducing an idea. In our stylized scenario 2 we said that the innovator would use his higher income to satisfy additional desires for animal tending services. As it happens, we are witnessing this precise phenomenon today. The demand for animal tending services, such as dog walking, is booming. We fully expect the animal and pet care industry to remain one of the strongest growth sectors in developed economies (Chart I-8). The strong uptrend will be supported by three sub-themes. First, increased pet ownership among wealthy retiring baby boomers. Second, a lower birth rate means that pets are becoming a substitute for a child. Third, the 'humanization of animals': as pets become regarded as equal members of the family, spending on their welfare rises accordingly. We expect to develop this long-term theme in future reports. But today, we are starting our Animal Care basket with 3 initial stocks (Table I-2). Table I-2The Animal Care Basket Why Robots Will Kill Middle Incomes Why Robots Will Kill Middle Incomes Dhaval Joshi, Senior Vice President Chief European Investment Strategist dhaval@bcaresearch.com 1 An ostler was a man employed to look after the horses of people staying at an inn. 2 Based on U.S. data. 3 Named after the robot engineer Hans Moravec. Fractal Trading Model There are no new trades this week. The short CAC40 / long Eurostoxx600 position reached the end of its 65 day term achieving half of its profit target, while the long DM / short EM position hit its stop-loss. This leaves three open positions. For any investment, excessive trend following and groupthink can reach a natural point of instability, at which point the established trend is highly likely to break down with or without an external catalyst. An early warning sign is the investment's fractal dimension approaching its natural lower bound. Encouragingly, this trigger has consistently identified countertrend moves of various magnitudes across all asset classes. Chart I-9 Short CAC40 / Long EUROSTOXX600 Short CAC40 / Long EUROSTOXX600 The post-June 9, 2016 fractal trading model rules are: When the fractal dimension approaches the lower limit after an investment has been in an established trend it is a potential trigger for a liquidity-triggered trend reversal. Therefore, open a countertrend position. The profit target is a one-third reversal of the preceding 13-week move. Apply a symmetrical stop-loss. Close the position at the profit target or stop-loss. Otherwise close the position after 13 weeks. Use the position size multiple to control risk. The position size will be smaller for more risky positions. * For more details please see the European Investment Strategy Special Report "Fractals, Liquidity & A Trading Model," dated December 11, 2014, available at eis.bcaresearch.com Fractal Trading Model Recommendations Equities Bond & Interest Rates Currency & Other Positions Closed Fractal Trades Trades Closed Trades Asset Performance Currency & Bond Equity Sector Country Equity Indicators Bond Yields Chart II-1Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Chart II-2Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Chart II-3Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Chart II-4Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Interest Rate Chart II-5Indicators To Watch##br## - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Chart II-6Indicators To Watch##br## - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Chart II-7Indicators To Watch##br## - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Chart II-8Indicators To Watch##br## - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations

Feature Turkey's banking system has in recent years relied on enormous liquidity provisions by the central bank (Chart I-1) to sustain its ongoing credit boom, and hence economic growth. Since early this year, the authorities have doubled down: they have also begun using fiscal policy to prop up growth. Chart I-1Turkey: Central Bank Large Liquidity Injections Turkey: Central Bank Large Liquidity Injections Turkey: Central Bank Large Liquidity Injections On the whole, this combination of colossal credit and fiscal stimulus is indisputably bearish for the currency. Despite strong performance by Turkish stocks this year, we are maintaining our bearish call on the lira. The lira is set to depreciate by 20-25% in the next 12 months or so versus both an equally-weighted basket of the U.S. dollar and the euro. Bringing Fiscal Stimulus Into Play The Turkish authorities have recently begun using fiscal means to stimulate growth: Last summer, a sovereign wealth fund was set up by presidential decree to pool shares in companies owned by the government and use them as collateral to raise debt and initiate spending on various infrastructure projects. The target size of the fund is US$ 200 billion, compared with the government non-interest expenditure of US$ 165 billion in the last 12 months. This would effectively allow the government to issue debt and increase expenditures off-balance sheet. In addition, this past March, the government decided to recapitalize the Credit Guarantee Fund. This initiative allowed it to underwrite US$ 50 billion, or 7% of GDP, worth of credit to Turkish companies. This is considerable as it compares with US$ 93 billion worth of loan origination by commercial banks last year. By assuming credit risk on these loans, the government is effectively encouraging banks to lend, in turn boosting economic growth. In effect, this has lowered lending standards and given a green light to banks to flood the economy with credit. Even though interest rates have risen since last November, credit growth has accelerated as banks have provided loans covered by government guarantees (Chart I-2). On top of this quasi-fiscal stimulus, government expenditures excluding interest payments have accelerated (Chart I-3). Chart I-2Bank Loan Growth Has Accelerated ##br##Despite Higher Interest Rates Bank Loan Growth Has Accelerated Despite Higher Interest Rates Bank Loan Growth Has Accelerated Despite Higher Interest Rates Chart I-3Turkey: Fiscal Spending Has Surged Turkey: Fiscal Spending Has Surged Turkey: Fiscal Spending Has Surged Such a rise in government spending has been financed by commercial banks whose holdings of government bonds have risen sharply. Essentially, government spending has also been funded by commercial banks' money creation. In short, fiscal and credit stimulus have boosted domestic demand, thereby widening the country's current account deficit once again (Chart I-4A and Chart I-4B). Chart I-4AWidening Twin Deficit Widening Twin Deficit Widening Twin Deficit Chart I-4BWidening Twin Deficit Widening Twin Deficit Widening Twin Deficit Given that the starting point of the government's fiscal position is good - public debt stands at only 28% of GDP - the authorities have ample room to rely on fiscal levers to promote growth. However, a widening fiscal deficit will be bearish for the currency. Bottom Line: Widening twin (current account and fiscal) deficits (Chart I-4A and Chart I-4B) are a bad omen for the lira. Monetary Tightening? What Monetary Tightening? Chart I-5Turkey: Money/Credit Growth Is Too Strong Turkey: Money/Credit Growth Is Too Strong Turkey: Money/Credit Growth Is Too Strong Although interbank and lending rates have risen in recent months, money and credit growth have been booming (Chart I-5). This does not support the idea that monetary policy is tight. On the contrary, thriving money and credit growth suggest that the policy stance is very easy. The Central Bank of Turkey (CBT) raised various policy rates and capped the overnight liquidity facility at the beginning of this year. However, commercial banks' usage of the late liquidity window facility - the one facility that has been left uncapped - has literally gone exponential - it has risen from zero to TRY 70 billion in the past 8 months. On the whole, the central bank’s net liquidity injections into the banking system continue to make new highs, even though the price of liquidity has been rising. Adding all the liquidity facilities – the intraday, overnight and late window facilities – the CBT's outstanding funding to banks is 90 billion TRY, or 3% of GDP, more than ever recorded (Chart 1, bottom panel). This entails that monetary policy is loose rather than tight. On the whole, commercial banks are requiring more and more liquidity, and the CBT is continuously supplying it. These injections maintain liquidity in the banking system to a sufficiently high level to allow aggressive money/credit creation among commercial banks. Bottom Line: The CBT is facilitating/accommodating an economy-wide credit binge by providing copious amounts of liquidity to commercial banks. The Victim Is The Lira The lira will inevitably depreciate in the months ahead: Chart I-6Turkey: Central Bank's Foreign ##br##Reserves Have Been Depleted Turkey: Central Bank's Foreign Reserves Have Been Depleted Turkey: Central Bank's Foreign Reserves Have Been Depleted The lira's exchange rate versus an equally-weighted basket of the U.S. dollar and the euro has been mostly flat year-to-date, despite the CBT intervening in the market to support the lira by selling U.S. dollars. Aggressive selling of CBT foreign exchange reserves has so far prevented much steeper lira depreciation in Turkey. However at this stage, the central bank is literally running out of reserves and will soon lose its ability to support the currency (Chart I-6). A developing country with foreign exchange reserves worth less than three months' imports is considered vulnerable. Therefore, at 0.5 months of imports coverage, or US$ 9.7 billion, the CBT has little capacity to continue supporting the currency via interventions. Economic growth has recovered: export volumes are very strong, driven by shipments to Europe, while loan growth is supporting private domestic demand and government expenditures have mushroomed. The ongoing economic recovery will boost inflation, and strong domestic demand will assure the current account deficit widens. This will weigh on the exchange rate. Core inflation measures have subsided from 10% to 7%, but remain well above the central bank's target of 5%. Provided inflation is a lagging variable, the acceleration in money growth and domestic demand this year will lead to higher inflation in the months ahead. Wage growth remains high and our profit margin proxy for both manufacturing and service industries - calculated as core CPI divided by unit labor costs - has relapsed signifying deteriorating corporate profitability (Chart I-7). This in turn will force businesses to raise prices. Provided demand is strong, companies will likely succeed in passing through higher prices to customers. In brief, odds are that inflation will rise significantly soon. Escalating unit labor costs also offsets the benefit of nominal currency depreciation. Chart I-8 illustrates that the real effective exchange rate is not cheap based on consumer prices, or unit labor costs. Chart I-7Companies Profit Margins Are Shrinking Companies Profit Margins Are Shrinking Companies Profit Margins Are Shrinking Chart I-8The Lira Is Not Cheap At All The Lira Is Not Cheap At All The Lira Is Not Cheap At All As inflation rises, residents' desire to convert their deposits from local to foreign currency will increase. In fact, this is already happening - households' foreign currency deposit growth is accelerating. In short, lingering high inflation will continue to weigh on the currency's value. Bottom Line: The authorities have doubled down on fiscal and credit stimulus, warranting a doubling down on bearish bets on the lira. Investment Implications On the whole, the authorities will continue resorting to fiscal and monetary stimulus to sustain economic growth. According to the Impossible Trinity theory, in countries with an open capital account structure, the authorities can control either interest rates or the exchange rate, but not both simultaneously. Chart I-9Bank Stocks Have Rallied Despite ##br##Shrinking Net Interest Margins Bank Stocks Have Rallied Despite Shrinking Net Interest Margins Bank Stocks Have Rallied Despite Shrinking Net Interest Margins In Turkey, policymakers will eventually opt to control interest rates, meaning they will not have much control over the exchange rate. We suggest currency traders who are not shorting the lira do so at this time. We remain short the lira versus the U.S. dollar. A weaker lira will undermine U.S. dollar returns on Turkish stocks and domestic bonds. Dedicated EM equity investors as well as those overseeing EM fixed income and credit portfolios should continue to underweight Turkish assets within their respective EM universes. Bank stocks have rallied strongly, and have decoupled from interest rates (Chart I-9). This reflects the recent credit binge, where banks are making profits on loan originations while the government is holding responsibility for bad loans. These dynamics could persist for a while. However, both loan growth and banks' profitability will be hurt if the credit guarantee scheme is not renewed. So far, it is estimated that TRY 200 billion of an announced TRY 250 billion of this credit guarantee scheme has been utilized. Continuous credit guarantee schemes and accumulation of off-balance-sheet liabilities by the government will widen sovereign credit spreads. In many EM countries, including Turkey, bank share prices have historically correlated with sovereign spreads. Hence, rising sovereign risk will weigh on banks stocks too. Finally, as the lira begins to depreciate and inflation rises, local interest rates will have to climb. This will also weigh on bank share prices. In brief, we are reiterating our negative/underweight stance on Turkish banks. Arthur Budaghyan, Senior Vice President Emerging Markets Strategy arthurb@bcaresearch.com Stephan Gabillard, Senior Analyst stephang@bcaresearch.com Equity Recommendations Fixed-Income, Credit And Currency Recommendations

Underweight Late-2013 saw all the right economic conditions moving in favor of insurers: the economy was entering a soft patch, the yield curve was flattening and the U.S. dollar was gaining momentum. The insurance market began hardening and the industry went on a hiring spree to capitalize on a much improved outlook (second panel). With the exception of the yield curve, those macro conditions reversed in 2017; the economy is booming, the dollar bull market has paused and BCA expects at least a modest yield curve steepening in the coming months (third panel). However, the insurers index has performed in line with the broad market so far this year (top panel). The hard pricing market of the past three years has recently turned flaccid (bottom panel) and organic revenue growth should soften. Meanwhile, sector employment remains elevated, implying weakening margins. In the context of the S&P 500 growing earnings by low-double digits, the insurers index should underperform. Stay underweight. The ticker symbols for the stocks in this index are: BLBG: S5INSU - AIG, CB, MET, MMC, PRU, TRV, AFL, AON, ALL, PGR, WLTW, HIG, PFG, L, CINF, LNC, XL, AJG, UNM, TMK, AIZ. Insurance Earnings Should Disappoint In H2 Insurance Earnings Should Disappoint In H2

Highlights Chart 1Too Close For Comfort Too Close For Comfort Too Close For Comfort The Fed is in the midst of tightening policy, but with inflation still below target it wants to ensure that overall policy settings remain accommodative. In the language of central bankers, the Fed wants to keep the real fed funds rate below its equilibrium level, the level that applies neither upward nor downward pressure to price growth. The equilibrium fed funds rate cannot be calculated with precision, but one popular estimate shows that policy settings are dangerously close to turning restrictive (Chart 1). While an announcement of balance sheet reduction is almost certain to occur next month, with the real fed funds rate so close to neutral, rate hikes are probably on hold until the gap widens. Higher inflation will widen the gap by causing the real fed funds rate to fall, and we are confident that core inflation will rise in the coming months (see page 11 for further details). This will permit the Fed to deliver more than the currently discounted 28 bps of rate increases during the next 12 months. Feature Investment Grade: Overweight Chart 2Investment Grade Market Overview Investment Grade Market Overview Investment Grade Market Overview Investment grade corporate bonds outperformed the duration-equivalent Treasury index by 60 basis points in July, bringing year-to-date excess returns up to 209 bps. The financial press is littered with stories highlighting extremely unattractive corporate bond valuations, but we think this storyline is exaggerated. In fact, the average spread on the Bloomberg Barclays corporate bond index is somewhat wider than is typically observed in the early stages of a Fed tightening cycle (Chart 2). We calculate that in the early stages of the prior two Fed tightening cycles (February 1994 to July 1994 & June 2004 to December 2005), the index option-adjusted spread averaged 86 bps and traded in a range between 66 bps and 104 bps.1 Viewed in this context, the current spread of 102 bps looks somewhat cheap. That being said, corporate balance sheet health is worse than is typically seen during the early stages of a tightening cycle and this will limit spread compression from current levels. But all in all, excess returns to corporate bonds should be consistent with carry during the next 6-12 months, with higher inflation and tighter Fed policy being pre-conditions for material spread widening. In a recent report2 we showed that bank bonds (both senior and subordinate) still offer a spread advantage compared to other similarly risky sectors (Table 3). Banks also continue to make progress shoring up their balance sheets and the outlook for bank profits is starting to brighten. Table 3ACorporate Sector Relative Valuation And Recommended Allocation* On Hold, But Not For Long On Hold, But Not For Long Table 3BCorporate Sector Risk Vs. Reward* On Hold, But Not For Long On Hold, But Not For Long High-Yield: Overweight Chart 3High-Yield Market Overview High-Yield Market Overview High-Yield Market Overview High-Yield outperformed the duration-equivalent Treasury index by 83 basis points in July, bringing year-to-date excess returns up to 448 bps. The index option-adjusted spread tightened 12 bps to end the month at 352 bps, 8 bps above the 2017 low. We calculate that in the early stages of the prior two Fed tightening cycles (February 1994 to July 1994 & June 2004 to December 2005), the index option-adjusted spread averaged 342 bps and traded in a range between 259 bps and 394 bps. This puts the current junk spread almost in line with the average witnessed during other similar monetary environments. In contrast, the VIX index, which co-moves with junk spreads (Chart 3), is well below levels seen during the early stages of the prior two tightening cycles. The VIX currently sits at 10, and its historical range in similar monetary environments is between 11 and 17, with an average of 13.3 In this way, there would appear to be more room for investment grade corporate bond spreads to tighten than junk spreads, especially on a volatility-adjusted basis. Despite somewhat more stretched valuations than in investment grade, high-yield still offers reasonable compensation relative to expected defaults. At present, our estimated default-adjusted spread is 206 bps, only slightly below its historical average (panel 3). This is based on an expected default rate of 2.8% during the next 12 months and an expected recovery rate of 48% (bottom panel). MBS: Underweight Chart 4MBS Market Overview MBS Market Overview MBS Market Overview Mortgage-Backed Securities outperformed the duration-equivalent Treasury index by 24 basis points in July, bringing year-to-date excess returns up to 4 bps. The conventional 30-year MBS yield declined 3 bps in July, as a small 1 bp increase in the rate component was offset by a 4 bps tightening of the option-adjusted spread (OAS). The compensation for prepayment risk (option cost) held flat. Index OAS has been in a widening trend since bottoming at 15 bps last September (Chart 4). Since then, MBS have returned 43 bps less than duration-equivalent Treasury securities. The Bloomberg Barclays Aaa-rated Credit index has outperformed Treasuries by 71 bps during that same timeframe. The back-up in OAS reflects, in large part, the market pricing in the upcoming wind-down of the Fed's balance sheet, set to be announced next month. However, we think OAS still have further to widen to catch up with the rising trend in net issuance. According to Flow of Funds data, net MBS issuance totaled $83 billion in the first quarter. If that pace continues for the rest of the year, then 2017 will be the strongest year for MBS issuance since 2009. While higher mortgage rates since the end of 2016 present a drag, at least so far, home sales have not shown much weakness (bottom panel). This is unlike the 2013 taper tantrum when home sales fell sharply following the surge in rates. We are underweight MBS on the expectation that the housing market will remain resilient in the face of higher rates, allowing issuance to continue its uptrend. However, we are closely tracking the spread advantage in MBS compared to Aaa-rated credit which is finally starting to look attractive (panel 3). Government-Related: Underweight Chart 5Government-Related Market Overview Government-Related Market Overview Government-Related Market Overview The Government-Related index outperformed the duration-equivalent Treasury index by 42 basis points in July, bringing year-to-date excess returns up to 149 bps. Sovereigns and Local Authorities outperformed the Treasury benchmark by 81 bps and 112 bps, respectively. The low-beta Supranational and Domestic Agency sectors each outperformed by 5 bps. The Foreign Agency sector outperformed the duration-matched Treasury index by 56 bps. USD-denominated sovereign bonds have underperformed the Baa-rated U.S. Corporate index (their closest comparable in terms of risk) during the past three months even though the U.S. dollar has continued its trend lower (Chart 5). But despite this recent underperformance, the Sovereign index still does not offer a spread advantage over the Baa-rated U.S. Corporate index (panel 3). Further, while our Emerging Markets Strategy service still looks favorably upon the Mexican peso relative to other emerging market currencies, it does not expect the peso to continue its recent appreciation versus the U.S. dollar.4 We share this opinion, and expect the broad trade-weighted dollar to appreciate as U.S. growth rebounds in the back-half of the year.5 In our cross-sectional model, which adjusts spreads for credit rating and duration. Local Authorities and Foreign Agencies continue to look attractive compared to most U.S. corporate sectors. In contrast, the Sovereign and Supranational sectors appear expensive. Municipal Bonds: Underweight Chart 6Municipal Market Overview Municipal Market Overview Municipal Market Overview Municipal bonds outperformed the duration-equivalent Treasury index by 38 basis points in July (before adjusting for the tax advantage). Munis have outperformed the Treasury benchmark by 186 bps year-to-date. The average Municipal / Treasury (M/T) yield ratio fell 2% in July, breaking below 85%. The average yield ratio remains extremely tight relative to its post-crisis trading range (Chart 6). There is more compensation available at the long-end of the muni curve than at the short-end (panel 2), and investors should continue to favor long maturities over short maturities on the Aaa Muni curve. Our early estimate, based on the recently released second quarter National Accounts data, shows that state & local government net borrowing probably moved higher in Q2 (panel 3), making the recent decline in yield ratios appear even more tenuous. The increase in net borrowing stems largely from a $21 billion drop in income tax revenues and a $20 billion decline in transfer receipts from the federal government. Income tax revenue should recover in the next two quarters,6 and we expect net borrowing will also start to decline. However, it is unlikely that net borrowing will fall by enough to justify current muni valuations. On July 6, the state House of Illinois overrode Governor Bruce Rauner's veto to finally pass a $36 billion budget. The move was sufficient for Moody's and S&P to both subsequently affirm the state's investment grade rating. The 10-year Illinois General Obligation bond yield declined 102 bps on the month, despite only a 1 bp drop in the 10-year Treasury yield. Treasury Curve: Favor 5-Year Bullet Over 2/10 Barbell Chart 7Treasury Yield Curve Overview Treasury Yield Curve Overview Treasury Yield Curve Overview The Treasury curve bull steepened in July. The 2/10 slope steepened 3 bps and the 5/30 slope steepened 10 bps. We currently recommend two tactical trades designed to profit from movements in the Treasury curve. First, we have been recommending a short position in the July 2018 fed funds futures contract since July 11.7 From current levels, we calculate this trade will deliver an un-levered return of 28 bps if there are two hikes between now and then, and 53 bps if there are three hikes. Our second recommendation is a long position in the 5-year bullet versus a short position in a duration-matched 2/10 barbell, a trade designed to profit from a steepening of the 2/10 yield curve. It remains our view that inflation and inflation expectations, and not Fed tightening, are the main determinants of the slope of the yield curve. We expect the 2/10 slope to steepen as inflation rebounds during the next few months. Two weeks ago we published a Special Report 8 that explained our rationale for taking views on the slope of the curve using butterfly trades. It also explained our butterfly spread valuation model, and how we use that model to determine how much steepening/flattening is currently discounted in the yield curve. According to our model, the curve is priced for 9 bps of 2/10 steepening during the next six months (Chart 7). Our recommended butterfly trade will earn positive returns if the curve steepens by more than that. TIPS: Overweight Chart 8TIPS Market Overview TIPS Market Overview TIPS Market Overview TIPS outperformed the duration-equivalent nominal Treasury index by 39 basis points in July. The 10-year TIPS breakeven inflation rate rose 9 bps on the month and, at 1.8%, it remains well below its pre-crisis trading range of 2.4% to 2.5%. Core inflation has moved sharply lower since February, but the fact that our Phillips Curve model of core inflation has not rolled over makes us inclined to view the downtrend as transitory. Also, during the past few weeks we have seen some preliminary signs that inflation is on the cusp of rebounding. Year-over-year core PCE inflation ticked higher in June for the first time since January. The PCE diffusion index, which has a good track record capturing near-term swings in core PCE, moved sharply higher (Chart 8). The prices paid components of the ISM manufacturing and non-manufacturing surveys increased from 55 to 62 and from 52.1 to 52.7, respectively, in July. We expect stronger realized inflation will lead TIPS breakevens higher during the next few months. However, even in a scenario where core inflation fails to rebound, the downside in breakevens from current levels is limited. The reason is that if inflation remains very low, the Fed will most likely refrain from hiking rates in December. Such a dovish capitulation from the Fed would put upward pressure on breakevens at the long-end of the curve. We discussed this possible scenario in more detail in a recent report.9 ABS: Overweight Chart 9ABS Market Overview ABS Market Overview ABS Market Overview Asset-Backed Securities outperformed the duration-equivalent Treasury index by 5 basis points in July, bringing year-to-date excess returns up to 59 bps. The index option-adjusted spread for Aaa-rated ABS held flat on the month, and remains well below its average pre-crisis level. The Federal Reserve released its Q2 Senior Loan Officer Survey last week. It showed that credit card lending standards moved back into "net tightening" territory after having eased the previous quarter (Chart 9). Auto loan lending standards tightened on net for the fifth consecutive quarter. Tightening lending standards are usually a response to deteriorating credit quality, and thus tend to correlate with higher losses and wider spreads. In that regard, net loss rates for auto loans continue to trend higher, and Moody's data show that the cumulative loss rate for prime auto loans originated in 2017 is worse than for any vintage since 2009, for loans with the same age. Conversely, the mild tightening in credit card lending standards has so far not translated into rising charge-offs (Chart 9), but the situation bears close monitoring. For now, we are content to remain overweight ABS given the attractive spread pick-up compared to other similarly risky sectors. However, we also recommend investors favor Aaa-rated credit cards over Aaa-rated auto loans, even though auto loans now once again offer an attractive spread differential, after adjusting for differences in duration and spread volatility (panel 3). Non-Agency CMBS: Underweight Chart 10CMBS Market Overview CMBS Market Overview CMBS Market Overview Non-agency Commercial Mortgage-Backed Securities outperformed the duration-equivalent Treasury index by 39 basis points in July, bringing year-to-date excess returns up to 96 bps. The index option-adjusted spread for non-agency Aaa-rated CMBS tightened 4 bps on the month, and remains below its average pre-crisis level. The Fed's Q2 Senior Loan Officer Survey showed that lending standards for all classes of commercial real estate (CRE) loans tightened, on net, for the eighth consecutive quarter. The survey also reported that demand for CRE loans is on the decline (Chart 10). The combination of tighter lending standards and weak loan demand suggests that credit concerns continue to mount in the private CMBS space. Agency CMBS: Overweight Agency CMBS outperformed the duration-equivalent Treasury index by 11 basis points in July, bringing year-to-date excess returns up to 65 bps. The average option-adjusted spread for the Agency CMBS index held flat on the month but, at 49 bps, the sector continues to look attractive compared to other similarly risky alternatives.10 Not only does the sector offer attractive spreads, but the agency guarantee and the lower delinquency rate in multi-family loans compared to other CRE loans (panel 5) makes its risk/reward profile particularly appealing. Treasury Valuation Chart 11Treasury Fair Value Models Treasury Fair Value Models Treasury Fair Value Models The current reading from our 2-factor Treasury model (which is based on Global PMI and dollar sentiment) places fair value for the 10-year Treasury yield at 2.62% (Chart 11). Our 3-factor version of the model, which also includes the Global Economic Policy Uncertainty Index, places fair value at 2.63%. The U.S. PMI bounced back in July, after having trended lower for most of this year. The Chinese PMI also increased last month, while the Eurozone reading moderated somewhat from a very high level (panel 4). Overall, the Global PMI came in at 52.7 in July, up from 52.6 in June. Bullish sentiment toward the U.S. dollar has also fallen sharply in recent weeks (bottom panel). Bearish dollar sentiment in an environment of expanding global growth sends a very bond-bearish signal. It means that the entire world is participating in the global expansion and any increase in Treasury yields is less likely to be met with an influx of foreign buying. For further details on our Treasury models please refer to the U.S. Bond Strategy Weekly Report, "The Message From Our Treasury Models", dated October 11, 2016, available at usbs.bcaresearch.com At the time of publication the 10-year Treasury yield was 2.26%. Ryan Swift, Vice President U.S. Bond Strategy rswift@bcaresearch.com Alex Wang, Research Analyst alexw@bcaresearch.com 1 Range calculated using monthly data, specifically the final day of each month. 2 Please see U.S. Bond Strategy Weekly Report, "Summer Snapback", dated July 11, 2017, available at usbs.bcaresearch.com 3 Ranges for junk spread and VIX calculated using monthly data, specifically the final day of each month. 4 Please see Emerging Markets Strategy Weekly Report, "The Case For A Major Top In EM", dated July 12, 2017, available at ems.bcaresearch.com 5 Mexico carries the largest weight in the Sovereign index, accounting for 23% of market cap. 6 Please see U.S. Bond Strategy Weekly Report, "Will The Fed Stick To Its Guns?", dated May 16, 2017, available at usbs.bcaresearch.com 7 Please see U.S. Bond Strategy Weekly Report, "Summer Snapback", dated July 11, 2017, available at usbs.bcaresearch.com 8 Please see U.S. Bond Strategy Special Report, "Bullets, Barbells And Butterflies", dated July 25, 2017, available at usbs.bcaresearch.com 9 Please see U.S. Bond Strategy Weekly Report, "Three Scenarios For Treasury Yields In 2017", dated June 20, 2017, available at usbs.bcaresearch.com 10 Please see U.S. Bond Strategy Weekly Report, "Risk Rally Extended", dated June 27, 2017, available at usbs.bcaresearch.com Fixed Income Sector Performance Recommended Portfolio Specification Corporate Sector Relative Valuation And Recommended Allocation Total Return Comparison: 7-Year Bullet Versus 2-20 Barbell (6-Month Investment Horizon)