Technology

Heading into a black hole, you pass a point of no return known as the ‘event horizon’ after which your impending oblivion is sealed. US recessions also have an event horizon, which we are fast approaching. We reveal a leading indicator of this event horizon, and what it means for investment strategy.

Global investors should sell Chinese assets on strength this year and diversify into other emerging markets. American investors should limit China exposure. Short CNY-USD.

China’s semiconductor demand and imports will continue to contract in 2023H1. Despite economic reopening, Chinese consumers will hold back spending on smartphones, personal computers (PC) and other consumer electronics over the next six months. Meanwhile, overseas customers will continue to reduce their orders for electronic goods made in China following the excessive consumption experienced during the pandemic. There is more downside for both Chinese and global semiconductor share prices. We recommend a relative trade: long Chinese semiconductor stocks / short global semi stocks.

Web 3.0 plays will boom in the coming decade. Play this through a diversified exposure to today’s main blockchain tokens. But the Web 2.0 oligopolies, like Amazon and Meta, are in big trouble.

Stay defensive at least until the US midterm election is over. Gridlock is disinflationary in 2023 and hence marginally positive for US equities. But any relief rally will be short-lived as recession risks are very high.

Please note I will be hosting a live webcast on September 29, 2022 at 9:00 AM HKT for the APAC region. I will discuss the global/China/EM macro outlooks and financial market implications. For clients in the Americas and EMEA, we had a webcast on September 28, 2022. You can access the replay via this link. Arthur Budaghyan Executive Summary Global Semi Stock Prices: Further Downside Ahead Global Semi Stock Prices: Further Downside Ahead Global Semi Stock Prices: Further Downside Ahead Global semiconductor stock prices are still vulnerable to meaningful downside over the next three months. Global semi consumption will contract due to the corresponding waning demand of smartphones, personal computers, and other consumer electronics. Global semi demand in sectors of automobiles and datacenters will continue growing. However, such an increase in demand cannot offset the demand reduction in other sectors. Semiconductor consumption in China has entered a contraction phase.  Semiconductor inventories have swelled. Alongside a sharp upsurge in chip production capacity, this increase in inventories will lead to chip price deflation in the next nine months. Nevertheless, the structural outlook for global semiconductor demand remains constructive. We are waiting for a better entry point for semi stocks.  Bottom Line: There is more downside in global semiconductor share prices as well as Taiwanese and Korean tech stocks. We will seek to recommend buying semiconductor stocks when a more material decline in semi companies’ profits is priced in their share prices. At the moment, we are downgrading Taiwanese stocks from neutral to underweight relative to the EM equity benchmark but are maintaining an overweight stance on the Korean bourse within an EM equity portfolio.   The global semiconductor equity index is breaking below its technical support (Chart 1). The implication is that these share prices are in an air pocket and investors should not chase a declining market. Based on previous cycles, we expect global semiconductor stocks to bottom late this year or early next year and semi sales to trough in 2023Q2. In the previous five cycles, global semi stocks always bottomed before global semi sales and lead times varied from three-to-six months. Chart 2 shows that Taiwan’s semiconductor new export orders lead global semi sales by about three months, and they continue to point to considerable downside in the global semi-industry. Chart 1Global Semi Stocks: Breaking Down Global Semi Stocks: Breaking Down Global Semi Stocks: Breaking Down Chart 2Global Semi Sales: More Downside Ahead Global Semi Sales: More Downside Ahead Global Semi Sales: More Downside Ahead The semiconductor industry has a history of cyclicality. Shortages have been followed by oversupply, which has led to declining prices, revenues, and profits for semi producers. This time is no exception Global Semi Sales: A Cyclical Slump Underway Global semiconductor demand began its downward trajectory in May of this year and will continue to slide in the next three-to-six months. Both the volume and value of China’s semiconductor imports are in a deep contraction and China’s imports from Taiwan have also plummeted (Chart 3). China is the world’s largest consumer of semiconductors, accounting for 35% of global demand. We expect semi sales to remain in contraction in China and to shrink in regions outside China in the next six-to-nine months (Chart 4).  Chart 3China's Semi Imports Plummeted China's Semi Imports Plummeted China's Semi Imports Plummeted Chart 4Semi Sales Will Contract Across Regions Semi Sales Will Contract Across Regions Semi Sales Will Contract Across Regions There are several important reasons for the retrenchment worldwide. First, the lockdowns around the world in 2020 and 2021 generated an unprecedented increase in online activities and a corresponding surge in demand for smartphones/PCs/tablets/game consoles/electronic gadgets. This was the main driving force for the boom in global semiconductor sales from 2020Q3 to 2022Q1. The excessive demand for consumer goods and electronics has run its course and global demand will sag in the next six months. As we have been contending since early this year, global exports are set to contract. Households that bought these goods in the past two years probably will not make new purchases in the near term. In addition, declining real disposable income and rising interest rates will constrain consumer spending. Smartphones, PCs, tablets, home appliances, and other household electronic goods consume about half of global semi output. In addition, rising job uncertainties resulting from China’s dynamic zero-COVID policy and slowing household income growth will curb consumption within China. Here are our takeaways for each segment: Chart 5China's Output Of Mobile Phones And PCs Has Been Shrinking China's Output Of Mobile Phones And PCs Has Been Shrinking China's Output Of Mobile Phones And PCs Has Been Shrinking Mobile phones: Mobile phones are the largest contributor to global semi sales, with a share of 31% as of 2021, based on the data from World Semiconductor Trade Statistics (WSTS). According to the International Data Corporation (IDC), global smartphone shipments are set to decline by 6.5% year-over-year in volume terms in 2022. Smartphone OEMs cut their orders drastically in 2022 because of high inventories and low demand, with no signs of an immediate recovery. China accounts for 67% of global mobile phone production and its mobile phone production has been contracting (Chart 5, top panel).   Traditional PCs and tablets: Based on data from the IDC, global traditional PC1  and tablet shipments are set to decline by 12.8% year-over-year in 2022 and by an additional 2.6% next year in volume terms. Computer production in China, which is the world’s largest computer producer and exporter, also shows massive downsizing (Chart 5, bottom panel).   Home appliances: China is also the largest producer and exporter of air conditioners (ACs), washing machines, refrigerators, and freezers. Except for a slight growth in AC output in response to heatwaves in China and Europe, China’s output of other home appliances will shrink. Globally, these industries accounted for about half of all semiconductor sales in 2021. Given the overconsumption of these goods worldwide over the past two years, we expect a material decline in these sectors in the next six-to-nine months. Second, automobiles, servers, and industrial electronics, which together account for about 30% of global semi sales, will have positive single-digit growth going forward. Yet, such an increase will not be enough to offset the lost demand from the consumer electronic goods sector in the next six-to-nine months.  Chart 6Global Auto Production Will Rise Global Auto Production Will Rise Global Auto Production Will Rise Automotive (accounts for 11% of world chip demand): The chip shortage in this sector has eased only moderately. Auto output levels in major producing countries remain well below their pre-pandemic levels (Chart 6). In light of improved foundry capacity, semiconductor producers will be able to produce automotive chips and reduce lingering shortages. However, for most chips to automakers, there are no supply shortages. Only a small number of categories of automotive chips, such as microcontrollers (MCU) and insulated-gate bipolar transistors (IGBT), are still in tight supply. Given that the total automotive sector only accounted for about 5% of total global semi sales last year, the recovery in global automobile output will contribute only limited growth to global semi sales.   Servers (account for 10% of world chip demand): The surge in online activities resulted in greater demand for cloud services and remote work applications, both of which require computer servers. Total server demand is comprised of data servers for cloud providers and private enterprises, with the former as the main driving force in recent years.  Data center expansion among cloud service providers will be driven by 5G, automotive, cloud gaming, and high-performance computing. After expanding by 10% last year, the pace of annual growth in global server shipments will likely be more moderate, to about 5%-6% in the next couple of quarters.   Chart 7Global Industrial Demand For Chips Is Set to Decelerate Global Industrial Demand For Chips Is Set to Decelerate Global Industrial Demand For Chips Is Set to Decelerate Industrial electronics (account for 9% of world chip demand): The growth rate in semi demand for this sector is falling. The global manufacturing new order-to-inventory ratio has plunged, and global manufacturing production is set to decline for the rest of this year and through to 2023H1 (Chart 7). Nevertheless, given structural tailwinds for industrial electronics, we expect semi demand in this sector to dip to single-digit growth in the near term rather than to contract.  Third, with semiconductor inventories having surged, new orders for chips, and hence their production, will plummet.   The length and intensity of the chip shortage, which started in 2020H2, triggered stockpiling among a broad range of customers, including manufacturers of smartphones and other consumer electronics. Moreover, the recent slowdown in smartphone/PC demand increased the inventory of silicon chips. Chart 8Semiconductor Inventory Overhang Semiconductor Inventory Overhang Semiconductor Inventory Overhang China had also stockpiled semiconductors from 2020Q2 to 2021Q4. With faltering demand, the country will continue its destocking process in the next couple of quarters. Semiconductor inventories in Taiwan and Korea have surged, corroborating the fact that the current cyclical downturn in the global semi sector will be a severe one (Chart 8). Hence, businesses in the semi supply chain will continue to draw upon their inventories rather than increase their semiconductors orders. This will reduce semiconductor demand meaningfully in the coming months. Bottom Line: The cyclical slump in worldwide semiconductor sales has further to go, with the sector’s sale volumes and prices projected to contract in the next six months. Semi producers will experience a substantial decline in their profits. Comparing Cycles Previous cycles may provide insight in the downside of the cyclical slump in global semi sales. In the previous five cycles, global semi sales experienced a contraction, ranging from 7% to 45% (Table 1). In the current cycle, global semi sales still had 7% year-over-year growth in 2022Q2 (Chart 9). Table 1Six Cyclical Downturns In Global Semiconductor Market Have Global Semi Stocks Hit Bottom? Have Global Semi Stocks Hit Bottom? Chart 9Global Semi Stocks And Global Semi Sales Global Semiconductor Market: Sales & Share Prices Global Semi Stocks And Global Semi Sales Global Semiconductor Market: Sales & Share Prices Global Semi Stocks And Global Semi Sales Global Semiconductor Market: Sales & Share Prices In fact, the current downturn could be deeper than the one between 2018 and 2019 (when sales contracted by 16%) for the following reasons: Sales of both cell phones and PCs will likely dwindle further this time than they did in 2018 to 2019. The pandemic boosted demand for consumer electronics, but this also brought forward future demand. In comparison with 2018, the current cycle might have a longer replacement cycle for mobile phones and PCs. Unlike 2019, global demand for consumer goods will likely contract rather than decelerate. This has ramifications for the duration and magnitude of the semi downturn.   Economic growth, and job and income uncertainties in China are much worse now than they were between 2018 and 2019. These factors will likely lead to a bigger cut in IT spending by both consumers and businesses, resulting in a larger downturn in global semi demand in this cycle. The tech battle between the US and China is more intense than in it was from 2018 to 2019. In mid-2018, the U.S. imposed a 25% tariff on Chinese imports of semiconductor goods, including machines and flat panel displays. China retaliated by imposing its own 25% tariff on U.S. exports of semiconductor goods, such as test equipment. This month, the US imposed new restrictions on NVIDIA and AMD in relation to selling artificial intelligence chips to Chinese customers. The US also plans to curb further its shipments of chipmaking tools to China. These plans will cut China’s imports of high-end semi products, for which producers enjoy high profit margins. In addition, the shortage of these chips will stall the development and sales of many consumer products within China, which will thereby reduce demand for other types of chips needed for consumer products. Chart 10Rapid Semi Capacity Expansion Worldwide Rapid Semi Capacity Expansion Worldwide Rapid Semi Capacity Expansion Worldwide Global semi capacity expansion has recently been much stronger in current cycle than it was in the 2016-2018 cycle. This may lead to a bigger supply surplus in this cycle than in the last one. It takes about 18-24 months, on average, to build a new semiconductor fabrication plant. Thus, large capital expenditures by semi producers in 2021-22 entail considerable new supply in 2023-24. According to IC Insights, the annual wafer capacity growth rates were 6.5% in 2020, 8.5% in 2021 and 8.7% in 2022. This compares with 4%-6.5% between 2016 and 2018 (Chart 10). Rapid capacity expansion typically leads to price deflation for chips and is therefore negative for the semi producers’ profitability and their share prices. Are global semi stock prices already pricing bad news? We do not think so. Nearly all major players saw a drop in revenues in the past cycle. In sharp contrast, only Intel’s revenues have dropped so far in the current cycle (Chart 11). Global semi stock prices will continue falling as companies report shrinking sales and earnings in the next couple of quarters. In former cycles when global semi stocks bottomed, investor sentiment – as measured by the net EPS revisions – was more downbeat than it is currently (Chart 12). Chart 11More Semi Companies' Sales Are Likely To Contract More Semi Companies' Sales Are Likely To Contract More Semi Companies' Sales Are Likely To Contract Chart 12Global Semi Stock Prices: Net EPS To Drop More Global Semi Stock Prices: Net EPS To Drop More Global Semi Stock Prices: Net EPS To Drop More Bottom Line: The global semiconductor sector’s cyclical slump could be deeper than it was in the 2018-2019 cycle. Hence, shares prices will fall considerably more than they did in late 2018. Ramifications For Taiwanese And Korean Markets Taiwanese and Korean semiconductor stock prices will probably continue to fall in absolute terms. The former recently broke its three-year moving average and the latter its six-year moving average (Chart 13). Chart 13Taiwanese And Korean Semi Stock Prices Will Fall Further Taiwanese And Korean Semi Stock Prices Will Fall Further Taiwanese And Korean Semi Stock Prices Will Fall Further Chart 14TSMC: Smartphone And HPC Make 81% Of Revenue Have Global Semi Stocks Hit Bottom? Have Global Semi Stocks Hit Bottom? For TSMC, the smartphone sector still accounts for 38% of revenues (Chart 14). Hence, a contraction in global smartphone sales in the next six-to-nine months could hurt the company’s top and bottom lines considerably. Meanwhile, the high-performance computing (HPC) sector became the largest contributor of TSMC revenues with a 43% share. A slowdown in data center investment and a decrease in GPU demand due to falling bitcoin prices will also materially affect the company’s profitability. In addition, the US government’s AI chips export restriction policy will decrease NVIDIA and AMD AI sales to China. According to NVIDIA’s news release, approximately US$400 million in potential chip sales to China (including Hong Kong) will likely be subject to this new restriction. AI chips are manufactured by TSMC with its advanced node technology and have a high-profit margin. Hence, the new policy will negatively impact TSMC’s revenues and profits. For Samsung, the memory market is in a free-fall due to plummeting demand (Chart 15). TrendForce expects the average overall DRAM price to drop by 13-18% in 2022Q4 because of high inventories in the supply chain and stagnant demand. The semi shipment-to-inventories ratios for both Taiwan and South Korea nosedived, pointing to lower semi stock prices in these two markets (Chart 16). Chart 15Samsung: Vulnerable To Sinking Prices Of Memory Chips Samsung: Vulnerable To Sinking Prices Of Memory Chips Samsung: Vulnerable To Sinking Prices Of Memory Chips Chart 16Semi Shipments-to-Inventory Ratios Plunged In Taiwan And Korea Semi Shipments-to-Inventory Ratios Plunged In Taiwan And Korea Semi Shipments-to-Inventory Ratios Plunged In Taiwan And Korea Bottom Line: Both TSMC and Samsung stock prices have more downside over the next three months.  Equity Valuations And Investment Conclusions The global semiconductor stock index in USD terms has tumbled by 45% from its recent peak. Multiples of semiconductor stocks are near their long-term average levels (Chart 17 and 18). These multiples could undershoot as they did in 2018-2019, which means even more downside is ahead. Chart 17Multiples Of Semi Stocks Could Undershoot Multiples Of Semi Stocks Could Undershoot Multiples Of Semi Stocks Could Undershoot Chart 18Multiples Of Semi Stocks Could Undershoot Multiples Of Semi Stocks Could Undershoot Multiples Of Semi Stocks Could Undershoot Aside from the profit outlook, higher US bond yields are also causing multiple compression for global semiconductor stocks (Chart 19). As to the allocation to semi stocks within an EM equity portfolio, we recommend downgrading Taiwan from a neutral allocation to underweight and reiterate an overweight stance on the KOSPI. The US-China geopolitical confrontation will escalate in the coming years and Taiwan is at the epicenter of this. These are relative calls, that is against the EM benchmark (Chart 20). We remain negative on their absolute performance. Chart 19Higher US Bond Yields = Multiple Compression In Global Semi Stocks Higher US Bond Yields = Multiple Compression In Global Semi Stocks Higher US Bond Yields = Multiple Compression In Global Semi Stocks Chart 20Downgrade Taiwan To Underweight Relative To The EM Benchmark Downgrade Taiwan To Underweight Relative To The EM Benchmark Downgrade Taiwan To Underweight Relative To The EM Benchmark   Finally, the structural outlook for global semiconductor demand remains constructive. We are waiting for a better entry point. We would recommend buying semiconductor stocks after pricing in a more material contraction in semi companies’ revenues and profits. Ellen JingYuan He Associate Vice President ellenj@bcaresearch.com Footnotes 1     Traditional PCs are comprised of desktops, notebooks and workstations.

Executive Summary Robotization Is Gaining Pace The Robot Revolution The Robot Revolution ​​​​In today’s publication, we will zero in on one of the most exciting areas of technological innovation that also presents substantial long-term investment potential – robotics. The robotics industry is expected to grow steadily both in the US and abroad thanks to a confluence of favorable long-term trends such as deteriorating global demographics, and a shift of manufacturing toward onshoring and customization. Thanks to technological breakthroughs in the areas of AI, machine learning, lidars, and machine vision, robots are becoming more intelligent and dexterous, thus suitable for an increasing list of tasks and applications. Robots are also becoming more affordable, which is a catalyst for ubiquitous adoption. Increased connectivity and broad-based automation and robotization, are ushering in Industrial Revolution 4.0, improving productivity manyfold. Over time, robotics will change our world beyond recognition, improving not only manufacturing and service industries but also our daily lives. Bottom Line: Robotics is an exciting story of technological innovation, which also presents substantial long-term investment potential. And while the US equity market is likely to remain volatile for months to come, the recent correction in robotics stocks presents an attractive entry point for patient investors with longer investment horizons.     Chart 1US Manufacturers Cannot Fill In Vacant Positions, Wages Are Surging US Manufacturers Cannot Fill In Vacant Positions, Wages Are Surging US Manufacturers Cannot Fill In Vacant Positions, Wages Are Surging Last month we published a report: “Industrials: A Trifecta Of Positives” in which we noted that the US is entering a period of industrial boom prompted by favorable government policy and generous spending, and strong new trends in onshoring and automation (Chart 1). This trifecta of positives helps the sector defy the gravity of the slowing economy.   In this week’s publication, we will zero in on automation and robotization. This is one of the most exciting areas of technological innovation, which presents substantial long-term investment potential. And while the US equity market is likely to remain volatile for months to come, robotics ETFs such as BOTZ, ROBO, IRBO, and ROBT are off some 40%-50% from their recent post-pandemic peaks (Table 1) and present an attractive entry point for patient investors with longer investment horizons. Table 1An Attractive Entry Point for Long-term Investors The Robot Revolution The Robot Revolution What Is A Robot? Recent breakthroughs in AI and robotics technology are awe-inspiring and unsettling. The "robot revolution" could be as transformative as previous General Purpose Technologies (GPT), including the steam engine, electricity, and the microchip. GPTs are technologies that radically alter the economy's production process and make a major contribution to living standards over time The most basic definition is "a device that automatically performs complicated and often repetitive tasks". Interestingly, according to the definition of the International Standards Organization (ISO), software (bots, AI, process automation), remotely controlled drones, voice assistants, autonomous cars, ATMs, smart washing machines, etc. are not robots. Broadly speaking, there are three types of robots: Industrial, service, and collaborative (cobots). Industrial robots work on assembly lines in manufacturing, service robots perform necessary as well as potentially harmful tasks for humans, while collaborative robots (or “cobots”) work next to human workers. We will discuss different types of robots in more depth in later sections. Robotics Industry Is Growing Steadily Global Adoption Chart 2Robotization Is Gaining Pace The Robot Revolution The Robot Revolution According to the International Federation of Robotics, as of 2020, industrial robot stock has constituted 3 million units and between 2015 and 2020 has been growing at 13% per year. A total of 383,000 units of industrial robots were installed in 2020. Industrial robots reported record preliminary sales in 2021, with 486,800 units shipped globally, a 27% increase from 2020. The pace of installations is forecasted to stay robust well into 2024 (Chart 2). Service robot adoption has also clearly been crossing the chasm: In 2020, nearly 132,000 service robots were installed, a 41% increase over 2019, and 19 million consumer service robots were installed, a 6% increase over 2019. Together, the service robot turnover was approximately $12 billion in 2020. The US Is Lagging But The Pace Is Accelerating Chart 3Industrial Robots Across The Globe The Robot Revolution The Robot Revolution The US has been lagging other developed countries in terms of automation and robotization (Chart 3). However, labor shortages brought about by the pandemic appear to have “moved the needle.” According to the Association for Advancing Automation (A3), the number of robots sold in the US in 2021 rose by 27% over 2020 with 49,900 units installed. 2022 is on pace to exceed previous records, with North American companies ordering a record 11,595 robots in Q1, a 28% increase over Q1-2021. Multiple Tailwinds Promote Ubiquitous Robotization The robotics industry is expected to grow steadily both in the US and abroad thanks to a confluence of forces, such as deteriorating global demographics, manufacturing shifts toward onshoring and customization, and technological breakthroughs that make robots more capable and affordable.  Aging Population Leads To Labor Shortages Populations in both developed and emerging markets is aging: More people both in high and upper-middle-income countries will retire in the next decade than will enter the workforce, making labor shortages inevitable. In the US, the problem is particularly acute. Since 2020, labor force participation has declined from 63.4% to 62.4%, most likely due to early retirements, while the unemployment rate stands at a historically low 3.7%. There are two job openings per job seeker, and many businesses report difficulty finding qualified staff. As companies are struggling to fill existing openings, they are increasingly turning towards robots: Replacing labor with automation/robots allows them to produce more and avoid a profit margin squeeze. IFR reports that an increasing number of small- and medium-sized businesses are deploying robots.  Related Report  US Equity StrategyIndustrials: A Trifecta Of Positives Onshoring And Reshoring As we pointed out in the recent report on Industrials, the onset of the pandemic and geopolitical tensions have accelerated the pace of reshoring. Supply chain disruptions have highlighted corporate vulnerabilities and made companies realize that “just-in-case” trumps “just-in-time.” However, companies that bring their businesses back home do realize that finding workers is a challenge, while labor costs are many times higher. Hence, one of the solutions they pursue is automation and robotization.   Mass Customization The “new normal” in many industries is mass customization, i.e., variations for a growing number of products, dubbed a “batch of one.” The shift towards high mix, low volume production raises the importance of manufacturing flexibility and agility – and that is when the industrial robot, capable of working in high to low-volume productions on simple to complex processes, comes to the rescue. The Lower Total Cost Of Ownership Technological advances have made robots both more sophisticated and more affordable. In addition, to a growing supply of low-cost robots, there are also novel pricing models, such as “Robots-as-a-Service” and pay-as-you-use, which support the ubiquitous adoption of robots even by smaller enterprises. Technological Breakthroughs Recent advances in artificial intelligence (AI), computer vision, radars, and networks have expanded the range of tasks that robots can do. Effectively, new technology gives the robot the ability to see, hear, and pick up objects, acting differently according to the data the robot receives, offering it a certain level of autonomous decision-making. Now that robots can “see” and “hear,”, they are being taught how to “feel,” and some of the recent technological advances are truly mind-boggling. Glasgow University researchers have developed ultra-sensitive electronic skin that learns from sensations it experiences. A robotic hand covered with the new e-skin recoiled from what it recognized as “painful” stimuli. This new technology will allow robots to interact with the world in a whole new way, an invention that can be leveraged in a wide range of applications, from prosthetic limbs to the “internet-of-things”.1 And this is just one of many recent inventions. Virtuous Cycle Of Innovation The Robotics industry is going through a perpetual and ever-accelerating cycle of innovation (Chart 4). Improvements to one domain of robotic applications can be transferred to others, benefitting from “adjacent” technologies. In other words, innovations in vacuum cleaners or transport trucks can be easily applied to other areas of robotics, as despite differences in prices and value-add, all the robotic applications are trying to solve the same problems. Advances in different fields in robotics create opportunities for ever more applications, creating a virtuous cycle. Chart 4Robotics Will Enter Into A Virtuous Cycle The Robot Revolution The Robot Revolution Furthermore, robotics is a poster child for Moore’s Law, which refers to the phenomenon whereby transistors on a microchip double every two years, eventually leading to exponential improvements in computing power. Automation and robotics take advantage of these improvements as they are challenged with more complex tasks. We predict the virtuous cycle for robots will span several decades. As the cost of automation drops, better solutions will be developed, resulting in the ‘early retirement’ of dated but otherwise fully functional robotic systems. The following is a brief synopsis of advances in technology and their applications to robotics. Technologies That Help Robots Act Like Humans AI And Machine Learning (ML) AI and ML not only teach robots to perform certain tasks but also makes machines more intelligent by training them to act in different scenarios. To do this, vast amounts of data are consumed. For example, to “teach” a robot to recognize an object and act accordingly, a massive number of images are used to train the computer vision model. Dexterity And Deep Imitation Learning One of the major challenges of roboticists is improving the dexterity of robots and empowering them to manipulate objects gripped by the hand, akin to humans. Some researchers are using machine learning to empower robots to independently identify and work out how to grab objects. Deep Imitation Learning, neural-network-based algorithms, allow the robot to “learn” from humans. For example, in a robotics study led by researchers from the University of Tokyo, the machine learning embedded in the robot practiced a method observed by a human demonstrator. After watching one of the researchers peel a banana periodically for thirteen hours, a robot successfully learned how to peel a banana without crushing the fruit.2 There are also major improvements in hardware, with grippers ranging from pincer-like appendages to human-like hands. Lidar Lidar (Light Detection and Ranging) technology uses sophisticated laser radars that allow robots to navigate their surroundings through object perception, identification, and collision avoidance. Lidar sensors provide information in real-time about the robot’s surroundings such as walls, doors, people, and various objects. While originally expensive, Lidar costs are starting to fall thanks to a more effective chip design and more economical mechanical implementation. Lidars are crucial for advances in industrial automation and warehouse robots. Machine Vision Deep Learning has brought about a groundbreaking advancement in machine vision. One of the early hurdles in machine vision may be described with a simple question: “Am I looking at a large object that’s far away or a tiny object that’s up close?”  The modern approach to answering this question is to use both 3-D cameras and the context. 3-D is simulated by using two or more overlapping cameras, correlating the information on camera movements with changing images from the cameras. Deep Learning algorithms help formulate the context of these changing images.3 Machine vision provides higher quality mapping at a more affordable cost than Lidar, especially when it comes to indoor robotics and automation. Industrial Internet Of Things In Robotics The implementation of the “Industrial Internet of Things” (IIoT) is vital for manufacturing automation and robotics. Its main goal is to create a constant tracking of inputs and outputs, enabling communication along the entire supply chain, passing data between enterprise level and plant floor systems, and improving productivity through the use of big data.  Robots working at different stages of the manufacturing process are interconnected, ensuring flawless production. IIoT technology aims to improve productivity by reducing human-to-human and human-to-computer interactions, reducing costs, and minimizing the probability of mistakes. Similar to smart homes, IIoT factories are smart factories.4 Industrial Revolution 4.0 Early industrial robots performed very specific operations under carefully controlled conditions – an assembly robot that encountered a misaligned component would simply install it that way, resulting in a defective product. However, thanks to improvements in vision systems, computing, AI, and mechanics, the ability of robots to perform increasingly complex tasks that involve some limited decision-making has improved. Increased connectivity, brought about by IIoT, and ubiquitous automation and robotization, are ushering in a new Industrial Revolution, dubbed 4.0. As in previous industrial revolutions, innovation improves productivity manifold. Chart 5Robots Are Proficient In Many Tasks The Robot Revolution The Robot Revolution Industrial robots are deployed to carry out a wide variety of tasks (Chart 5). Arc welding, spot welding, assembly, palletizing, material removal, inspection, material handling, and packaging are some of the most popular applications for robots, but the list does not stop with just those. Industrial robots limit the need for human interaction while being able to complete tasks accurately with a high level of repeatability. Proficiency with these many tasks allows robots to add value to a multitude of industries, such as automotive, electronics, aerospace, food, and medical. While in the past the automotive sector was the key end-demand market for global robotics sales, non-automotive sales now represent 58% of the total, demonstrating a broadening reach of automation. Metals, Auto, and Food and Consumer Goods have the highest growth in terms of the purchase of robots (Charts 6 & 7). Chart 6Robots Are Gaining Traction In Multiple Industries The Robot Revolution The Robot Revolution Chart 7In The US, Robotization Is Broad-Based The Robot Revolution The Robot Revolution We expect the rising digitalization of the manufacturing sector to lead to a new wave of automation investment in developed countries. Key Players In Industrial Robots Space The global industrial robotics market is largely dominated by established Japanese and European companies: ABB, Yaskawa, KUKA, and Fanuc. However, the sizzling demand for robots demonstrates that technological breakthroughs are no longer just about the established players, as many industrial companies, such as Rockwell Automation, Eaton, and Caterpillar, are becoming leaders in this new space. These companies also reach across the aisle to software companies to leverage their expertise in data storage, computing, and artificial intelligence. Rockwell has recently partnered with Microsoft, while others are acquiring software companies. Deere has acquired GUSS Automation, a pioneer in semi-autonomous spring for high-value crops. These companies will benefit from strong demand for their products and should exhibit strong sales and profit growth. Service Robots Are Here To Help Service robots can significantly benefit humans in a variety of fields, including healthcare, automation, construction, household, and entertainment. These robots are managed by internal control systems, with the option of modifying the operation manually. These service robots remove the possibility of human error, manage time, and increase production by lowering the workload of staff and labor. Chart 8Service Robots Across Industries The Robot Revolution The Robot Revolution Service robots are quickly becoming an essential part of business for service-focused companies in healthcare, logistics, and retail (Chart 8). Developments in edge artificial intelligence processors and the arrival of 5G telecom services are likely to propel the market for service robots to new heights. The usage of service robots is extremely broad and range from cleaning to preparing meals to delivering goods. The following are some of the key areas that benefit from service robots. Healthcare Common duties assigned to service robots include setting up patient rooms, tracking inventory and placing orders, and transporting supplies, medication, and linens. Cleaning and disinfection robots can also help create a safe and sanitized facility for everyone. Further, robots assist in performing difficult surgeries and medical procedures.  Robots also help the elderly and disabled. For example, ReWalk has developed a wearable robotic exoskeleton that provides powered hip and knee motion to enable individuals with spinal cord injury (SCI) to stand upright, walk, turn, and climb and descend stairs. The system allows independent, controlled walking while mimicking the natural gait pattern of the legs. Military Defense Autonomous Mobile Robots (AMR) are helpful for combating fires, disarming bombs, and traversing through dangerous areas. Fully automated drone robots are indispensable for military intelligence and combat operations. Logistics As e-commerce sales continue to surge, logistics businesses are using service robots to help overcome current labor shortages, assist current workers to avoid workforce burnout, and enable warehouse automation. Robotic arms are often assigned tasks like picking, placing, and sorting objects, and because these cobots can navigate warehouses independently, they are used to deliver materials to human workers for accurate and efficient order fulfillment. Some logistics companies, such as FedEx, are experimenting with using AMR for last-mile delivery of goods, which is often the most expensive and least productive part of the entire delivery chain. AMR can navigate sidewalks, unpaved surfaces, and steps while carrying cargo. Key Players In Service Robots Space Many US companies are active in this space. Amazon (AMZN) developed robots to support its fulfillment center operation: Robots help automate storage and retrieval mechanisms throughout vast warehouses. IRobot (IRBT) has developed a series of AI-enabled robot vacuums, mops, and pool cleaners – friendly pet-like bots you may see in many American homes. There are also highly sophisticated surgical robots, developed by Stryker (SYK) and Intelligent Surgical (ISRG).  Collaboration Between Humans And Robots Collaboration between humans and robots is still in its infancy but it is one of the fastest-growing fields within robotics. Cobots work alongside humans, allowing humans to be more productive and avoid tedious or strenuous tasks. Cobots can be installed directly in the current production system, with less space than conventional robots. Equipped with intelligent features such as vision and force sensors, the flexibility of cobots means they can perform tasks like parts handling, assembly, and bin picking. Manufacturers adopting cobots, particularly those featuring vision and inspection systems, are seeing an increase in quality and efficiency. Investment Characteristics I hope we have convinced our readers that Robotics is a promising long-term investment theme. We also noted that the robotics ETFs are currently down substantially from their peaks. However, this report would not have been complete without a closer look at the investment characteristics of the robotics ETFs. A few salient points: Table 2Price Sensitivity The Robot Revolution The Robot Revolution Robotics ETFs have betas to the S&P 500 ranging from 1.2 to 1.4 (Table 2), which signals that the robotics sector is a high octane play on the US equity market. The recent pullback in the S&P 500 was particularly punishing for the stocks exposed to robotics. In terms of market capitalization, companies in this space tend to be smaller than the median company in the S&P 500, as they constitute the robotics ecosystem and supply chain (AI, Lidar), and tend to be younger and smaller. Robotics ETFs have always traded at a premium to the market given their superb growth potential. However, currently, ROBO ETF, which is a proxy for the rest of the cohort on a relative basis, is trading just under a half standard deviation above the historical mean (Chart 9). In terms of macroeconomic exposure, all of the robotics ETFs have a pronounced negative exposure to the US dollar – after all, robotics and automation are a global phenomenon. A stronger dollar makes American multinational sales from abroad lower both because of the translation effect and higher prices. The robotics theme doesn’t have much exposure to interest rates, inflation, or commodities, but is somewhat positively exposed to bitcoin (Table 3). Chart 9Valuations And Technicals Are Attractive Valuations And Technicals Are Attractive Valuations And Technicals Are Attractive Table 3Robotics Is A High Octane Equities Theme With A Significant Sensitivity To USD The Robot Revolution The Robot Revolution Investment Implications Robotics is a compelling long-term investment theme as Industrial Revolution 4.0 is taking place in front of our eyes. And while over the short term, monetary tightening and slowing economic growth, both at home and abroad, will be a headwind; over time a new Google or Facebook may emerge in this space. We have already watched the success of Nvidia, a supplier of sophisticated chips for the industry. Table 4Comparing ETFs The Robot Revolution The Robot Revolution There are four ETFs that focus on Robotics and Automation (Table 4). BOTZ Is the largest ETF with $2.1 billion AUM, followed by ROBO at $1.7 billion, which is also the most expensive (Table A1 in the Appendix) Which one is the best? To answer this question, we have turned to the quant wizards at the BCA Equity Analyzer team. To compare the ETFs, they have assigned a BCA stock selection and Owl Analytics ESG scores to stocks in each of the robotics ETFs, to calculate composites.  We note the BCA composite score is low across the board, as robotics as a nascent investment theme scores low on valuations. We note that while ESG scores are comparable across the portfolios, there is some variation in BCA scores. Overall, ROBO is marginally better than the other options: It has the highest BCA score and is the most liquid. It also has a lower beta to the S&P 500 than BOTZ and IRBO, making it slightly less risky. Unfortunately, it is also the most expensive.  Bottom Line Robotics is an exciting long-term theme that benefits from multiple tailwinds, such as demographic trends, continuous technological innovation, reshoring, and customization. Robots are also becoming more intelligent and dexterous, and have better “senses,” making them suitable for an increasing list of tasks and applications. Robots are also becoming more affordable, which is a catalyst for ubiquitous adoption. Over time, robotics will change our world beyond recognition, improving not only manufacturing and service industries but also our daily lives. And that is a future from which investors should certainly profit.    Irene Tunkel Chief Strategist, US Equity Strategy irene.tunkel@bcaresearch.com   Appendix Table A1ETF Universe The Robot Revolution The Robot Revolution Footnotes 1     Clive Cookson in London, "Ouch! Robotic hand with smart skin recoils when jabbed in the palm,”  Financial Times, June 1, 2022, ft.com 2     Ron Jefferson, "Deep Learning Robot with Fine Motor Skills Peel Bananas Without Crushing the Fruit,”  Science Times, March 29, 2022, sciencetimes.com 3     "Is Lidar Going to be Replaced by Machine Vision?”  LiDAR News, January 12, 2022, blog.lidarnews.com 4     Jennifer Stowe, "Automation‌ ‌and‌ ‌IoT‌‌: ‌Transforming‌ ‌How‌ ‌Industries‌ ‌Function‌‌,”  IoT For All, October 12, 2020, iotforall.com Recommended Allocation Recommended Allocation: Addendum The Robot Revolution The Robot Revolution

Executive Summary Biden Taps China-Bashing Consensus Biden's Midterm Tactics Bear Fruit… But There's A Snake Biden's Midterm Tactics Bear Fruit… But There's A Snake House Speaker Nancy Pelosi’s visit to Taiwan reflects one of our emerging views in 2022: the Biden administration’s willingness to take foreign policy risks ahead of the midterm elections. Biden’s foreign policy will continue to be reactive and focused on domestic politics through the midterms. Hence global policy uncertainty and geopolitical risk will remain elevated at least until November 8.  Biden is seeing progress on his legislative agenda. Congress is passing a bill to compete with China while the Democrats are increasingly likely to pass a second reconciliation bill, both as predicted. These developments support our view that President Biden’s approval rating will stabilize and election races will tighten, keeping domestic US policy uncertainty elevated through November. These trends pose a risk to our view that Republicans will take the Senate, but the prevailing macroeconomic and geopolitical environment is still negative for the ruling Democratic Party. We expect legislative gridlock and frozen US fiscal policy in 2023-24. Close Recommendation (Tactical) Initiation Date  Return Long Refinitiv Renewables Vs. S&P 500 Mar 30, 2022 25.4% Long Biotech Vs. Pharmaceuticals Jul 8,  2022 -3.3% Bottom Line: While US and global uncertainty remain high, we will stay long US dollar, long large caps over small caps, and long US Treasuries versus TIPS. But these are tactical trades and are watching closely to see if macroeconomic and geopolitical factors improve later this year. Feature President Biden’s average monthly job approval rating hit its lowest point, 38.5%, in July 2022. However, Biden’s anti-inflation campaign and midterm election tactics are starting to bear fruit: gasoline prices have fallen from a peak of $5 per gallon to $4.2 today, the Democratic Congress is securing some last-minute legislative wins, and women voters are mobilizing to preserve abortion access.  These developments mean that the Democratic Party’s electoral prospects will improve marginally between now and the midterm election, causing Senate and congressional races to tighten – as we have expected. US policy uncertainty will increase. Investors will see a rising risk that Democrats will keep control of the Senate – and conceivably even the House – and hence retain unified control of the executive and legislative branches. This “Blue Sweep” risk will challenge the market consensus, which overwhelmingly (and still correctly) expects congressional gridlock in 2023-24. A continued blue sweep would mean larger tax hikes and social spending, while gridlock would neutralize fiscal policy for the next two years. Investors should fade this inflationary blue sweep risk and continue to plan for disinflationary gridlock. First, our quantitative election models still predict that Democrats will lose control of both House and Senate (Appendix). Second, Biden’s midterm tactics face very significant limitations, particularly emanating from geopolitics – the snake in this report’s title. Pelosi’s Trip To Taiwan Raises Near-Term Market Risks One of Biden’s election tactics is our third key view for 2022: reactive foreign policy. Initially we viewed this reactiveness as “risk-averse” but in May we began to argue that Biden could take risky bets given his collapsing approval ratings. Either way, Biden is using foreign policy as a means of improving his party’s domestic political fortunes. In particular, he is willing to take big risks with China, Russia, Iran, and terrorist groups like Al Qaeda. The template is the 1962 congressional election, when President John F. Kennedy largely defied the midterm election curse by taking a tough stance against Russia in the Cuban Missile Crisis (Chart 1). If Biden achieves a foreign policy victory, then Democrats will benefit. If he instigates a crisis, voters will rally around his administration out of patriotism. Nancy Pelosi’s visit to Taipei is the prominent example of this key view. The trip required full support from the US executive branch and military and was not only the swan song of a single politician. It was one element of the Biden administration’s decision to maintain the Trump administration’s hawkish China policy. Thus while Congress passes the $52 billion Chips and Science Act to enhance US competitiveness in technology and semiconductor manufacturing, Biden is also contemplating tightening export controls on computer chip equipment that China needs to upgrade its industry.1 Biden is reacting to a bipartisan and popular consensus holding that the US needs to take concrete measures to challenge China and protect American industry (Chart 2). This is different from the old norm of rhetorical China-bashing during midterms. Chart 1Biden Provokes Foreign Rivals Biden's Midterm Tactics Bear Fruit… But There's A Snake Biden's Midterm Tactics Bear Fruit… But There's A Snake Chart 2Biden Taps China-Bashing Consensus Biden's Midterm Tactics Bear Fruit… But There's A Snake Biden's Midterm Tactics Bear Fruit… But There's A Snake Reactive US foreign policy will continue through November and possibly beyond – including but not limited to China. The US chose to sell long-range weapons to Ukraine and provide intelligence targeting Russian forces, prompting Russia to declare that the US is now “directly” involved in the Ukraine conflict. The US decision to eradicate Al Qaeda leader Ayman Al-Zawahiri also reflects this foreign policy trend. Reactive foreign policy will increase the near-term risk of new negative geopolitical surprises for markets. Note that the 1962 Cuban Missile Crisis analogy is inverted when it comes to the Taiwan Strait. China is willing to take much greater risks than the US in its sphere of influence. The same goes for Russia in Ukraine. If US policy backfires then it may assist the Democrats in the election – but not if Biden suffers a humiliation or if the US economy suffers as a result. Chart 3US Import Prices Will Stay High From Greater China US Import Prices Will Stay High From Greater China US Import Prices Will Stay High From Greater China US import prices will continue to rise from Greater China (Chart 3), undermining Biden’s anti-inflation agenda. Supply kinks in the semiconductor industry will become relevant again whenever demand rebounds  (Chart 4). Global energy prices will also remain high as a result of the EU’s oil embargo and Russia’s continued tightening of European natural gas supplies. Chart 4New Semiconductor Kinks Will Appear When Demand Recovers New Semiconductor Kinks Will Appear When Demand Recovers New Semiconductor Kinks Will Appear When Demand Recovers OPEC has decided only to increase oil production by 100,000 barrels per day, despite Biden’s visit to Saudi Arabia cap in hand. We argued that the Saudis would give a token but would largely focus on weakening global demand rather than pumping substantially more oil to help Biden and the Democrats in the election. The Saudis know that Biden is still attempting to negotiate a nuclear deal with Iran that would free up Iranian exports. So the Saudis are not giving much relief, and if Biden fails on Iran, oil supply disruptions will increase. Bottom Line: Price pressures will intensify as a result of the US-China and US-Russia standoffs – and probably also the US-Iran standoff. Hawkish foreign policy is not conducive to reducing inflationary ills. Global policy uncertainty and geopolitical risk will remain high throughout the midterm election season, causing continued volatility for US equities. Abortion Boosts Democratic Election Odds Earlier this year we highlighted that the Supreme Court’s overturning of the 1972 Roe v. Wade decision would lead to a significant mobilization of women voters in favor of the Democratic Party ahead of the midterm election. The first major electoral test since the court’s ruling, a popular referendum in the state of Kansas, produced a surprising result on August 2 that confirms and strengthens this thesis. Kansas is a deeply religious and conservative state where President Trump defeated President Biden by a 15% margin in 2020. The referendum was held during the primary election season, when electoral turnout skews heavily toward conservatives and the elderly. Yet Kansans voted by an 18% margin (59% versus 41%) not to amend the constitution, i.e. not to empower the legislature to tighten regulations on abortion. Voter turnout is not yet reported but likely far higher than in recent non-presidential primary elections. Kansans voted in the direction of  nationwide opinion polling on whether abortion should be accessible in cases where the mother’s health is endangered. They did not vote in accordance with more expansive defenses of abortion, which are less popular (Chart 5). If the red state of Kansas votes this way then other states will see an even more substantial effect, at least when abortion is on the ballot. Chart 5Abortion Will Mitigate Democrats’ Losses Biden's Midterm Tactics Bear Fruit… But There's A Snake Biden's Midterm Tactics Bear Fruit… But There's A Snake The question is how much of this Roe v. Wade effect will carry over to the general congressional elections. The referendum focused exclusively on abortion. Voters did not vote on party lines. Voters never like it when governments try to take away rights or privileges that have previously been granted. But in November the election will center on other topics, including inflation and the economy. And midterm elections almost always penalize the incumbent party. Our quantitative election models imply that Democrats will lose 22 seats in the House and two seats in the Senate, yielding Congress to the Republicans next year (Appendix). Still, women’s turnout presents a risk to our models. Women’s support for the Democratic Party has not improved markedly since the Supreme Court ruling, as we have shown in recent reports (Chart 6). But the polling could pick up again. Women’s turnout could be a significant tailwind in a year of headwinds for the Democrats. Bottom Line: Democrats’ electoral prospects have improved, as we anticipated earlier this year (Chart 7). This trend will continue as a result of the mobilization of women. Republicans are still highly likely to take Congress but our conviction on the Senate is much lower than it is on the House. Chart 6Biden’s And Democrats’ Approval Among Women Biden's Midterm Tactics Bear Fruit… But There's A Snake Biden's Midterm Tactics Bear Fruit… But There's A Snake Chart 7Democrats’ Odds Will Improve On Margin Biden's Midterm Tactics Bear Fruit… But There's A Snake Biden's Midterm Tactics Bear Fruit… But There's A Snake Reconciliation Bill: Still 65% Chance Of Passing Ultimately Democrats’ electoral performance will depend on inflation, the economy, and cyclical dynamics. If inflation falls over the course of the next three months, then Democrats will have a much better chance of stemming midterm losses. That is why President Biden rebranded his slimmed down “Build Back Better” reconciliation bill as the “Inflation Reduction Act.” We maintain our 65% odds that the bill will pass, as we have done all year. There is still at least a 35% chance that Senator Kyrsten Sinema of Arizona could defect from the Democrats, given that she opposed any new tax hikes and the reconciliation bill will impose a 15% minimum tax on corporations. A single absence or defection would topple the budget reconciliation process, which enables Democrats to pass the bill on a simple majority vote. We have always argued that Sinema would ultimately fall in line rather than betraying her party at the last minute before the election. This is even more likely given that moderate-in-chief, Senator Joe Manchin of West Virginia, negotiated and now champions the bill. But some other surprise could still erase the Democrats’ single-seat majority, so we stick with 65% odds. Most notably the bill will succeed because it actually reduces the budget deficit – by an estimated $300 billion over a decade (Table 1). Deficit reduction was the original purpose of lowering the number of votes required to pass a bill under the budget reconciliation process. Now Democrats are using savings generated from new government caps on pharmaceuticals (a popular measure) to fund health and climate subsidies. Given deficit reduction, it is conceivable that a moderate Republican could even vote for the bill. Table 1Democrats’ Inflation Reduction Act (Budget Reconciliation) Biden's Midterm Tactics Bear Fruit… But There's A Snake Biden's Midterm Tactics Bear Fruit… But There's A Snake Bottom Line: Democrats are more likely than ever to pass their fiscal 2022 reconciliation bill by the September 30 deadline. The bill will cap some drug prices and reduce the deficit marginally, so it can be packaged as an anti-inflation bill, giving Democrats a legislative win ahead of the midterm. However, its anti-inflationary impact will ultimately be negligible as $300 billion in savings hardly effects the long-term rising trajectory of US budget deficits relative to output. The bill will add to voters’ discretionary income and spur the renewable energy industry. And if it helps the Democrats retain power, then it enables further spending and tax hikes down the road, which would prove inflationary. The reconciliation bill, annual appropriations, and the China competition bill were the remaining bills that we argued would narrowly pass before the US Congress became gridlocked again. So far this view is on track.   Investment Takeaways Companies that paid a high effective corporate tax rate before President Trump’s tax cuts have benefited relative to those that paid a low effective rate. They stood to suffer most if Trump’s tax cuts were repealed. But Democrats were forced to discard their attempt to raise the overall corporate tax rate last year. Instead the minimum corporate rate will rise to 15%, hitting those that paid the lowest effective rate, such as Big Tech companies, relative to high-tax rate sectors such as energy (Chart 8, top panel). Tactically energy may still underperform tech but cyclically energy could outperform and the reconciliation bill would feed into that trend. Similarly, companies that faced high foreign tax risk, because they made good income abroad but paid low foreign tax rates, stand to suffer most from the imposition of a minimum corporate tax rate (Chart 8, bottom panel). Again, Big Tech stands to suffer, although it has already priced a lot of bad news and may not perform poorly in the near term. Chart 8Market Responds To Minimum Corporate Tax Market Responds To Minimum Corporate Tax Market Responds To Minimum Corporate Tax Chart 9Market Responds To New Climate Subsidies Market Responds To New Climate Subsidies Market Responds To New Climate Subsidies Renewable energy stocks have rallied sharply on the news of the Democrats’ reconciliation bill getting back on track (Chart 9). We are booking a 25.4% gain on this tactical trade and will move to the sidelines for now, although renewable energy remains a secular investment theme. Health stocks, particularly pharmaceuticals, have taken a hit from the new legislation as we expected. However, biotech has not outperformed pharmaceuticals as we expected, so we will close this tactical trade for a loss of 3.3%. The reconciliation bill will cap drug prices for only the most popular generic drugs and does not pose as much of a threat to biotech companies (Chart 10). Biotech should perform well tactically as long bond yields decline – they are also historically undervalued, as noted by Dhaval Joshi of our Counterpoint strategy service. So we will stick to long Biotech versus the broad market. US semiconductors remain in a long bull market and will be in heavy demand once global and US economic activity stabilize. They are also likely to outperform competitors in Greater China that face a high and persistent geopolitical risk premium (Chart 11).  Chart 10Market Responds To Drug Price Caps Market Responds To Drug Price Caps Market Responds To Drug Price Caps Chart 11Market Responds To China Competition Bill Market Responds To China Competition Bill Market Responds To China Competition Bill Tactically we prefer bonds to stocks, US equities to global equities, defensive sectors to cyclicals, large caps to small caps, and growth stocks to value stocks (Chart 12). The US is entering a technical recession, Europe is entering recession, China’s economy is weak, and geopolitical tensions are at extreme highs over Ukraine, Taiwan, and Iran. The US is facing an increasingly uncertain midterm election. These trends prevent us from adding risk in our portfolio in the short term. However, much bad news is priced and we are on the lookout for positive economic surprises and successful diplomatic initiatives to change the investment outlook for 2023. If the US and China recommit to the status quo in the Taiwan Strait, if Russia moves toward ceasefire talks in Ukraine, if the US and Iran rejoin the 2015 nuclear deal, then we will take a much more optimistic attitude. Some political and geopolitical risks could begin to recede in the fourth quarter – although that remains to be seen. And even then, geopolitical risk is rising on a secular basis. Chart 12Tactically Recession And Geopolitics Will Weigh On Risk Assets Tactically Recession And Geopolitics Will Weigh On Risk Assets Tactically Recession And Geopolitics Will Weigh On Risk Assets Matt Gertken Senior Vice President Chief US Political Strategist mattg@bcaresearch.com       Footnotes 1     Alexandra Alper and Karen Freifeld, “U.S. considers crackdown on memory chip makers in China,” Reuters, August 1, 2022, reuters.com.   Strategic View Open Tactical Positions (0-6 Months) Open Cyclical Recommendations (6-18 Months) Table A2Political Risk Matrix Biden's Midterm Tactics Bear Fruit… But There's A Snake Biden's Midterm Tactics Bear Fruit… But There's A Snake Table A3US Political Capital Index Biden's Midterm Tactics Bear Fruit… But There's A Snake Biden's Midterm Tactics Bear Fruit… But There's A Snake Chart A1Presidential Election Model Third Quarter US Political Outlook: Last Ditch Effort Third Quarter US Political Outlook: Last Ditch Effort Chart A2Senate Election Model Third Quarter US Political Outlook: Last Ditch Effort Third Quarter US Political Outlook: Last Ditch Effort  Table A4House Election Model Biden's Midterm Tactics Bear Fruit… But There's A Snake Biden's Midterm Tactics Bear Fruit… But There's A Snake Table A5APolitical Capital: White House And Congress Biden's Midterm Tactics Bear Fruit… But There's A Snake Biden's Midterm Tactics Bear Fruit… But There's A Snake Table A5BPolitical Capital: Household And Business Sentiment Biden's Midterm Tactics Bear Fruit… But There's A Snake Biden's Midterm Tactics Bear Fruit… But There's A Snake Table A5CPolitical Capital: The Economy And Markets Biden's Midterm Tactics Bear Fruit… But There's A Snake Biden's Midterm Tactics Bear Fruit… But There's A Snake

Dear Client, On Monday August 8, I will be sending you an abbreviated version of our monthly Chart Pack. Our regular publication will resume on August 15. Kind regards, Irene Tunkel Executive Summary The US Is Vulnerable: Only 10% Of Chips Are Manufactured At Home What To Do With Semiconductors And The Energy Sector What To Do With Semiconductors And The Energy Sector In the following report we continue answering questions from our “Bear Market 2.0” webcast, by reviewing recent US legislative actions, and their effects on semiconductor and energy stocks. Semiconductors Bill: Over the long term, the recently passed CHIPS+ bill will have a moderately positive effect on the supply of chips and will benefit a select group of companies with chip manufacturing capabilities. Semiconductors Overview: Semis are "growthy" and have surged on the back of falling yields. They are also highly cyclical, and slowing growth will become a headwind to performance. Demand for chips is fading, especially in the consumer electronics space, with sales slowing and inventories building up. We prefer more stable growth areas of the Technology sector and are overweight Software and Services as opposed to semis stocks. The bill is not enough to "move the needle". What To Do With Energy? The stars are aligning for the price of energy to turn down decisively – not only is demand for energy flagging on the back of slowing economic growth, but also the Inflation Act will likely further boost energy production. As a result, we downgrade the Exploration & Production segment, maintain our overweight in the Equipment & Services, and boost Storage & Transportation from underweight to neutral on the back of the upcoming new pipeline construction. Bottom Line: We remain underweight semis as the one-off boost from the CHIPS+ bill does not counterbalance demand headwinds. When it comes to Energy, the capex upswing will lower the price of oil which warrants an underweight stance in Exploration & Production names. Feature This week investors experienced a deluge of news and data, spanning the Fed rate decision, the Q2-2022 GDP estimate, and earnings reports from some of the largest US corporations, such as Apple, Amazon, and Facebook. To top it off, we had major developments on the legislation front after a multi-month hiatus. Two major bills, the Chips and Science Act of 2022 (aka CHIPS+) and the Inflation Reduction Act of 2022 (an incarnation of Build Back Better), are close to passage, after months and months of dithering. In this report, we will discuss the potential effects of these pieces of legislation on the two equity sectors most affected, Semiconductors and Energy. Since these sectors are also at the epicenter of recent market action, we hope that this report is timely and will help you make the right investment decisions. Sneak Preview: We maintain our underweight on Semiconductors, and downgrade Energy Exploration and Production to an underweight on the back of falling energy prices. Semiconductors: Is It Time To Close The Underweight? When it comes to semis stocks, the current bear market caused a deeper peak-to-trough correction (40%) than at the bottom of the pandemic, implying that, perhaps, much of the bad news was priced in. We have been underweight semis since early January and are up 14% relative to the S&P 500. With the industry bouncing 20% off its June lows, we question whether we have overstayed our welcome and it is time to close this underweight, especially in light of the imminent passage of the CHIPS+ bill. Let’s start by discussing the bill: Designed In The US, Made In Asia In a November 2021 “Semiconductors: Aren’t They Fab?!” Special Report, we highlighted that semiconductor production is divided among chip designers and manufacturers, a so-called “fabless model,” which has grown in prominence as the pace of innovation made it increasingly difficult for firms to manage both the capital intensity of manufacturing and the high levels of R&D spending for design. The entire semiconductor industry depends on cooperation between two regions: North America, which houses global leaders in designing the most sophisticated chips, and Asia, which is home to companies that have the technology to manufacture them (Charts 1 & 2). As a result, the US share of chip manufacturing has been falling steadily for the past 30 years, from 37% to 10% (Chart 3). Recent, supply chain disruptions and heightening geopolitical tensions have underscored this country’s vulnerability due to outsourcing of chip manufacturing, which led to renewed calls for chip independence and onshoring. Chart 1Chips Are Designed In The US... What To Do With Semiconductors And The Energy Sector What To Do With Semiconductors And The Energy Sector Chart 2...And Manufactured In Asia What To Do With Semiconductors And The Energy Sector What To Do With Semiconductors And The Energy Sector Objective Of The CHIPS+ Bill Congress has passed the CHIPS+ bill to alleviate the chip shortage and shore up US competitiveness with China. Money is earmarked for domestic semiconductor production and research, and factory construction. The bill will provide financial incentives for both US and non-US chip makers to open manufacturing plants in the US while restricting semiconductor companies’ activities “in specific countries that present a national security threat to the United States.” The provision ensures that China, which has also been recently striving for chip independence, will not be a beneficiary of US government funds. The bill also comes with strings attached: It states that it will not allow companies to use any of the funds to buy back stocks or issue dividends. Chart 3The US Is Vulnerable: Only 10% Of Chips Are Manufactured At Home What To Do With Semiconductors And The Energy Sector What To Do With Semiconductors And The Energy Sector Cost Of The Bill Preliminary analysis from the Congressional Budget Office assesses that the bill will trigger roughly $79 billion in new spending over the coming decade. The key provision in the bill is the $52.7 billion for chip makers. Of those funds, $39 billion is earmarked to “build, expand, or modernize domestic facilities” for chip-making, while $11 billion is set aside for research and development. Funds will be spread over five years. The bill also adds $24 billion in tax incentives and other provisions for semiconductor manufacturing. In addition, $2 billion is allocated to translate laboratory advances into military and other applications. While $79 billion sounds like a lot of money, we need to keep things in perspective. As Barron’s pointed out: “According to IC Insights, total semiconductor industry capital spending is estimated to grow 24% this year, to $190 billion. Assuming some growth over the next several years, the bill would be a modest single digit percentage of the aggregate spending over the five-year time period.” Therefore, the financial benefits the bill provides are modest. Key Beneficiaries US chip makers with fab facilities, such as Intel (INTC), Micron Technology (MU), and Texas Instruments (TXN) will be the key beneficiaries of the bill as they are offered financial incentives for opening new plants. Foreign companies, such as TSMC, Samsung, and Global Foundries, might also qualify for financial incentives to open chip production facilities in the US. In fact, Intel, TSMC, and Global Foundries have already announced plans to build plants in the US contingent on the bill’s passing. Fabless chip designers, such as Nvidia (NVDA), AMD, and Qualcomm are unlikely to benefit from the package in a major way. Over the long term, the bill will have a moderately positive effect on the supply of chips and will benefit a select group of companies with chip manufacturing capabilities. Demand For Chips Is Fading While the bill will have some positive effect on chip manufacturing, there is a lurking danger that production is being ramped up globally just at a time when, after prolonged shortages, demand for chips is starting to fade. Historically, this highly cyclical industry has gone through boom and boost cycles every three to four years. During the Q2 earnings call, TSMC Chief Executive Mr. Wei said that the broader industry is dealing with an “inventory correction” that has led customers to cut orders from some of its peers. After two years of pandemic-driven demand, “our expectation is for the excess inventory in the semiconductor supply chain to take a few quarters to rebalance to a healthier level.” This is not surprising. Semiconductors are highly economically sensitive with sales declining in lockstep with slowing global growth (Chart 4), while inventory levels are picking up (Chart 5). Chart 4Sales Are Declining In Lockstep With Slowing Global Growth Sales Are Declining In Lockstep With Slowing Global Growth Sales Are Declining In Lockstep With Slowing Global Growth Chart 5Chip Inventory Levels Are Picking Up Chip Inventory Levels Are Picking Up Chip Inventory Levels Are Picking Up Demand for two of the industry’s key markets, computers and mobile phones, which account for 50% of the overall chip demand, seems to be deteriorating rapidly amid the slowing global economy. Demand for consumer electronics is fading after a pandemic surge of buying, when consumers pulled forward their spending on phones and computers. Most of these items don’t need to be upgraded or replaced for years. COVID-related lockdowns in China, meanwhile, have also weighed on consumer demand. According to IDC, worldwide shipments of personal computers fell 15% in the June quarter from a year earlier, due to “macroeconomic headwinds.” IDC has also lowered its forecast for 2022 expecting computer shipments to retreat by 8.2%. Canalys said global shipments for mobile phones fell 9% year over year, following economic headwinds, sluggish demand, and inventory pile-up. Memory chips represent 28% of the industry, and DRAM accounts represent three-fifths of memory sales. DRAM prices are falling (Chart 6). According to TrendForce, the average contract price for a DRAM, used widely in consumer items ranging from cars to phones to fridges, fell by 10.6% during the second quarter, compared to a year ago, the first such decline in two years. DRAM prices are expected to slide by 21% in Q3-2022. Companies are telling us similar stories: Micron, the No. 3 player in memory, recently issued revenue guidance well below analysts’ estimates. Chief Executive Sanjay Mehrotra warned that “the industry demand environment has weakened,” with PC and smartphone sales declining. Lisa Su, Chief Executive of AMD, expects computer demand to be roughly flat. Nvidia is bracing for a slowdown in the crypto space and game consoles. Intel has reported disappointing results: PC customers are reducing inventory levels at a rate not seen in a decade, Chief Executive Pat Gelsinger said in a call with analysts. PC makers typically reduce inventory levels of chips when they are expecting lower sales. Chart 6DRAM Prices Are Falling DRAM Prices Are Falling DRAM Prices Are Falling Of course, there is significant variability in demand for chips across sectors: While demand for phones and computers is fading, there is still pent-up demand for auto chips, and servers (Chart 7). According to Ms. Su, demand remains hot for chips used in high-performance computers and servers. TSMC, which has Apple and Nvidia among its clients, seconds this notion: Quarterly revenue for high-performance computers, increased 13% from the previous quarter and was greater than the revenue from smartphones, which rose 3%. There are also significant shortages of less-advanced auto chips (Chart 8). In a recent Q2 earnings call, GM reported that it carries 95,000 unfinished cars in its inventory due to the auto chip shortage. According to Mr. Wei of TSMC, the company will continue investing in auto chips, a product that historically it didn’t emphasize as much as its cutting-edge chips, in response to strong demand. Texas Instruments, which reported stellar results, also said that while it saw strength in the auto and industrial segments, demand from the consumer electronics market remained weak in both the second quarter and the current quarter. Chart 7Demand For Servers Is Still Strong Demand For Servers Is Still Strong Demand For Servers Is Still Strong Chart 8More Chips Will Boost Auto Sales More Chips Will Boost Auto Sales More Chips Will Boost Auto Sales Demand for chips is fading, especially in the consumer electronics space, with sales slowing and inventories building up. Pricing power is also fading. However, there are still areas immune to the downturn, such as chips for servers, high-performance computers, and less advanced auto chips. Valuations and Fundamentals Earnings growth expectations have also come down significantly off their peak, and are currently at 5% for the next 12 months, which indicates negative real growth (Chart 9). Chart 9Earnings Growth Is Slowing Earnings Growth Is Slowing Earnings Growth Is Slowing Chart 10Valuations Are Above Pre-Pandemic Trough Valuations Are Above Pre-Pandemic Trough Valuations Are Above Pre-Pandemic Trough Semi valuations have pulled back from a 33x trailing multiple to 17x over the course of six months, only to bounce back another 3x since June 16, currently trading at 20x multiple. While valuations certainly moderated, they are still above the pre-pandemic trough in 2019 when the global economy was also slowing. The BCA Valuation Indicator, an amalgamation of various valuation metrics, indicates that semiconductors trade at fair value (Chart 10 & Chart 11). The rebound rally was fast and furious; at nearly 20% off market lows, it feels like much of the recovery from severely oversold conditions has run its course. Chart 11Chips Are Moderately Priced, While Investor Position Is Light Chips Are Moderately Priced, While Investor Position Is Light Chips Are Moderately Priced, While Investor Position Is Light Semis Investment Implications Semiconductors are somewhat unique in that they are both cyclical and “growthy” (Chart 12). Since semis are “growthy,” the past six-week rebound may be attributed to falling rates, which have led to multiple expansion of most growth sectors. However, we need to keep in mind that rates have stabilized because of signs of global slowdown, and that the cyclical nature of semis will get in the way of further outperformance. While we also believe that the CHIPS+ bill is a modest tailwind, it is hard to commit to an industry in the early innings of contraction. For investors who would like to top up their allocations to semis, we recommend companies most exposed to demand from industrial sectors (autos, servers, high performance computers), and staying away from companies most exposed to consumer electronics. Much of the performance of companies that have reported so far hinged on their product mix. Chart 12Semis Are Both "Growthy" And Cyclical Semis Are Both "Growthy" And Cyclical Semis Are Both "Growthy" And Cyclical Bottom Line We are reluctant to add to semis after the sector gained nearly 20% in just six weeks. Economic challenges remain – demand for chips is slowing, and the process of clearing inventory build-up may take several quarters. CHIPS+ is a positive but, in our opinion, is not enough to move the needle. We prefer more stable growth areas of the Technology sector and are overweight Software and Services. We also prefer semis most exposed to demand from non-consumer sectors. What To Do With Energy? We are currently equal-weight Energy. More specifically, we are overweight Energy Equipment and Services, equal weight Explorations and Production (we closed an overweight in March, booking a profit of 50%), and underweight Energy Transportation industry groups. With Brent down 18% and GSCI down 15%, and economic growth slowing, it is essential to review what is in store for the sector. Further, the Inflation Reduction Act, which is now on President Biden desk expecting his signature, has quite a few provisions relevant to the sector. Inflation Reduction Act And Its Effects On The Fossil Fuels Industry This bill is a true marvel of political negotiation and gives all parties something to be happy about and something to complain about. While the bill earmarks $370 billion for clean energy spending at the insistence of Senator Manchin (D, WV), the legislative package provides support for traditional sources of energy like oil, gas, and coal. Broadly speaking, the bill is a positive for expanding domestic energy production and supporting its nascent Capex cycle, which we called for in the “Energy: After Seven Lean Years” Special Report. Development of new wells has already picked up over the past few months (Chart 13). Chart 13New Energy CAPEX Cycle New Energy CAPEX Cycle New Energy CAPEX Cycle Here are a few important rules stipulated by the bill, highlighted by the Wall Street Journal: Expanding offshore wind and solar power development on federal land will now require the federal government to offer more access for drilling on federal territory. Under the bill, the Interior Department would be required to offer up at least two million acres of federal land and 60 million acres of offshore acreage to oil and gas producers every year for the next decade. It would be the first-ever required minimum acreage for offshore oil and gas leasing and would significantly increase the acreage requirements for onshore leasing. The bill would also effectively reinstate an 80-million-acre sale of the Gulf of Mexico to the oil drillers last year that a federal judge had invalidated. The bill is also a major positive for the natural gas industry, providing an accelerated timeline for building the pipelines and terminals needed to increase production and export of fossil fuels. In exchange for access to more federal territory, oil and gas companies would also have to pay higher royalty rates for drilling there. It would also require them to pay royalties on methane they burn off or let intentionally escape from their operations on federal lands. The bill aims to increase the supply of oil, gas, and coal, and return the US towards energy independence. Over the medium term, it should lead to a normalization of the price of energy. Demand Vs. Supply Naturally, the price of oil is all about supply and demand. And the performance of the energy sector is inextricably linked to the price of oil (Chart 14). Supply: According to our EM Strategist, Arthur Budaghyan, “fears that sanctions on Russia will considerably reduce global oil supply have not yet materialized.” According to International Energy Agency (IEA) estimates, Russia’s shipments of crude and oil products have declined by only about 5% since January (Chart 15). Clearly, despite the sanctions and logistical challenges that Western governments have enforced on Russia, the country’s oil exports have not collapsed. Chart 14Price Of Oil Is Important For The Energy Sector's Profitability Price Of Oil Is Important For The Energy Sector's Profitability Price Of Oil Is Important For The Energy Sector's Profitability Chart 15Russia's Supply Of Oil Has Decreased By Only 5% Russia's Supply Of Oil Has Decreased By Only 5% Russia's Supply Of Oil Has Decreased By Only 5% Demand: Meanwhile, global commodities and energy demand is downshifting in response to both high fuel prices and weakening global growth. US consumption of gasoline and other motor fuel has marginally contracted (Chart 16, top panel). In China, rolling lockdowns and weak income growth will continue to suppress the nation’s crude oil imports, which have already been depressed over the past 12 months (Chart 16, bottom panel). In the rest of EM (excluding China), a strong dollar and high oil prices are leading to demand destruction. Chart 16US And Chinese Oil Consumption Is Weak US And Chinese Oil Consumption Is Weak US And Chinese Oil Consumption Is Weak Prices Are To Trend Down: Hence, the supply of energy and commodities is stable, but demand is flagging, which does not bode well for the prices of energy and materials. Odds are that oil prices will decline further and recouple with industrial and precious metal prices. In addition, as the market anticipates a turn in inflation, there is a pronounced rotation away from Energy and Materials towards Technology and other growth pockets of the market (Charts 17 & 18). With a supply of energy staying steady or even expanding, while demand is slowing on the back of the global slowdown, we expect the price of energy to trend down. Chart 17Energy And Materials Were Biggest Winners In the "Inflation High And Rising" Regime... What To Do With Semiconductors And The Energy Sector What To Do With Semiconductors And The Energy Sector Chart 18...But They Gave Back Their Gains In "Inflation High But Falling" Regime What To Do With Semiconductors And The Energy Sector What To Do With Semiconductors And The Energy Sector Energy Investment Implications It appears that the stars are aligning for the price of energy to turn down decisively – not only is demand for energy flagging on the back of slowing economic growth, but also the Inflation Act will likely further boost energy production. As production is expanded and prices fall, the profitability of the Oil Exploration and Production industry (upstream) will decline. In addition, inflation is about to turn, and a change in market leadership has already ensued. We downgrade Exploration and Production to an underweight. In the meantime, the Equipment and Services industry will benefit from contracts to develop new wells and will thrive. We maintain an overweight. We are currently underweight the Energy Storage and Transportation industry (mid-stream) as historically, this industry was marred in multiple regulations and most expansion projects faced obstacles, especially if running through public land. However, under the provisions of the Inflation Act, midstream will benefit from rising production volumes and expedited construction the pipelines and terminals needed to increase production and exports of fossil fuels. We upgrade Storage and Transportation to an equal weight. Bottom Line The Inflation Reduction Act will create conditions favorable for expanding the production of fossil fuels and will support US energy independence. As supply grows while demand is slowing, the price of energy is likely to turn – while a boon for US consumers, this is a headwind to the performance of the Energy sector.   Irene Tunkel Chief Strategist, US Equity Strategy irene.tunkel@bcaresearch.com   Recommended Allocation

Executive Summary Dollar Still The Largest Global Reserve Currency Dollar Still Dominating Global Reserves Dollar Still Dominating Global Reserves The rise of cryptocurrencies like stablecoins theoretically pose risks to fiat currencies and their general use. In the US, the Federal Reserve will look to adopt a Central Bank Digital Currency (CBDC) – a digital dollar – this decade, to stave off these risks and usher in a new era of central bank money. A digital dollar would likely be integrated as seamlessly as possible into the current monetary regime, thereby maintaining an intermediated role played by existing financial sector actors as well as operating alongside existing circulating currency. The US dollar will eventually face rising competition from digital currencies, both at home and abroad. While other central banks make headway into developing their own CBDCs, China is by far the most advanced. China’s digital yuan will not resolve all of China’s problems with internationalizing its currency but it will create new opportunities. Public and political pushback will occur and will slow adoption of a digital dollar. Gridlock in 2023 may prove to be another headwind. To adopt a digital dollar, politicians will need to work along bipartisan lines to ensure the US remains at the forefront of digital and monetary innovation, especially as foreign competition on CBDCs rises. Recommendation (Tactical) Initiation Date  Return Long DXY (Dollar Index) 23-FEB-22 10.7% Bottom Line: Policymakers will adopt a CBDC – a digital dollar – this decade. Political pushback may slow adoption, but foreign competition will overcome domestic constraints. Feature Technological innovation over the past decade has given rise to a new asset class – digital assets. Investors are most familiar with cryptocurrencies, and to a lesser extent, non-fungible tokens and decentralized finance-based lending, among others. These assets have witnessed a boom and bust over the past few years (Chart 1). Chart 1Manias: Then And Now Manias: Then And Now Manias: Then And Now Cryptocurrencies have been touted to have money-like characteristics, the most popular being Bitcoin, and others like stablecoins. Stablecoins are mostly used as a medium of exchange between fiat money and cryptocurrencies and vice versa. They are pegged to fiat money and often backed by highly liquid traditional assets1 to maintain their pegs. But cryptocurrencies do not exhibit the traits of durable money today. However, the technological innovation of digital currency represents a natural evolution of money that is irreversible and could someday possess the main characteristics of money: a medium of exchange, a unit of account, and store of value. Cryptocurrencies with money-like qualities theoretically pose a challenge to fiat currencies, i.e. those issued by governments that are not backed by any underlying real asset but rather by trust in government institutions, including the treasury and central bank. Not that trust is a poor basis for a currency. But that trust could fail and new trust could be placed in cryptocurrencies. Governments could eventually lose control of the money supply and payments system, suffer from financial instability, fail to provide regulatory oversight, or fail to prevent the illicit use of digital assets for criminal gain. The same technology driving growth in digital assets has led central banks the world around to research and in some cases develop CBDCs. For an introductory guide to CBDCs, see BCA’s “The Investor’s Guide To Central Bank Digital Currencies.” CBDC research and development are at varying stages across the world’s central banks.2 In the US, the Federal Reserve (Fed) continues to research a CBDC (digital dollar) and its use-case, or justification for being. The Fed has made no commitment to designing a digital dollar anytime soon. But we bet that the Fed’s position will change in coming years. Introducing a digital dollar will reduce the various risks associated with cryptocurrencies whilst also creating efficiencies in the US economy. These efficiencies will also transverse into cross-border efficiencies. Globally, central banks are showing increasing activity in developing CBDCs and introducing a digital dollar would help the Fed maintain monetary dominance across the world while staving off cryptocurrencies, especially stablecoins. The Fed won’t sit idle as a global monetary revolution unfolds. But the policy front is fraught with challenges. Policy makers in the US have expressed mixed views on adopting a digital dollar. Some suggest the Fed would exercise even more control over monetary policy than it does today. Others note risks to consumer data privacy, which could be exploited by government. Public opinion is also mixed with no clear understanding of or need for a digital dollar. Commercial bank business interests may come under attack too, with a digital dollar scalping profit margins from banks, depending on the type and extent of the CBDC operating model employed. Ultimately, the US will want to maintain its position as the global monetary leader. Continued dollar dominance in the global economy is strategically advantageous for the US, especially in a hypo-globalizing world (Chart 2). Ensuring ongoing monetary dominance while rooting out domestic competition from stablecoins will be aided by adopting a digital dollar. Chart 2Dollar Still Dominating Global Reserves Dollar Still Dominating Global Reserves Dollar Still Dominating Global Reserves Bottom Line: The Fed will most likely adopt a digital dollar within the decade. The Fed And A Digital Dollar The Fed has been actively researching a digital dollar for several years with growing research on design, implementation, and necessity. As it stands, the Fed has not committed to introducing a digital dollar in the foreseeable future. But what would a digital dollar look like and what role would it play in the economy if the Fed decided to introduce one? CBDC Model Briefly, the Fed could choose from three different CBDC operating models: unilateral, synthetic, or intermediated (Diagram 1). A unilateral model would mean the Fed performs all CBDC related functions including direct interaction with end-users. A synthetic model would mean non-Fed actors issuing money backed by Fed assets. Diagram 1Three CBDC Operating Models Digital Dollar, Will US Policymakers Launch One Soon? Digital Dollar, Will US Policymakers Launch One Soon? Realistically, a unilateral and synthetic digital dollar are unlikely. The former would crowd out traditional banking services, while the latter would let actors other than the Fed issue money, violating the Federal Reserve Act. Hence the Fed will most likely pursue an intermediated CBDC model. This model entails digital dollar issuance by the Fed but includes a role for private sector firms to interact with end-users. The intermediary role would be filled by financial firms but also other types of companies such as payment service providers and mobile phone operators. This means the Fed would not totally crowd out existing players across the payment and financial services space. An intermediated model would require the central bank to regulate and oversee other actors, which adds an extra layer of legal and operational complexity to implementation. But it is the model most consistent with the US’s combination of federal government and liberal capitalism, and the model cited by the Fed to most likely be adopted.3 The intermediated model will align with the current two-tier system currently in place (Diagram 2). Digital dollars will feature in both wholesale and retail transactions. Wholesale involves commercial banks and regulated financial intermediaries, while retail involves individuals and non-financial businesses. The model would also operate alongside existing paper money. A digital dollar would be a liability on the Fed, denominated in dollars, and would form an integral part of base money supply (M0). It would be distributed like, and act as a complement to, dollar bills and could be used in transactions conducted in currency and reserves. It would be legal tender just like the paper dollar. Diagram 2Two-Tier Monetary Regime System Digital Dollar, Will US Policymakers Launch One Soon? Digital Dollar, Will US Policymakers Launch One Soon? Digital Dollar Needs The Fed has stated that a digital dollar should, among other things, meet certain criteria before adoption (Table 1). Some of these criteria are already met. Others will be met with adoption. A digital dollar will benefit households, businesses, and the economy at large. For example, a digital dollar would enhance payment transparency, thereby supporting the Fed’s objective to promote safe and efficient payments. And depending on design choices, digital transactions could offer degrees of traceability and aggregate payment data could be analyzed in real time to provide insights into economic health and activity. Table 1Fed Criteria For CBDC Adoption Digital Dollar, Will US Policymakers Launch One Soon? Digital Dollar, Will US Policymakers Launch One Soon? Further, a digital dollar would promote diversification of the payments system, thereby increasing the safety and efficiency of US payment infrastructure. It may also attract new actors offering services related to the digital dollar, spurring financial innovation and fostering financial integration. The payments system is already broadly efficient but adding another layer of digitization with a digital dollar would mean that the US economy would be better positioned for the evolution of the digital economy over the next decade and beyond. The need for broad stakeholder support will be a difficult criterion to meet, however. There would need to be more engagement with the public, inter-government agencies, and Congress. For now, these “needs” outlined by the Fed are more than half met, signaling that a digital dollar could come to fruition within the decade from a policy perspective. International advances on this front will spur US policy makers into action even if they are disinclined. Bottom Line: The needs outlined by the Fed to adopt a digital dollar have been mostly met which ticks off one of the policy implementation checkboxes. There are gains to be had across the economy by introducing a digital dollar, ranging from a more efficient payments system to financial inclusion and decreasing transactions costs. Domestic Competition The proliferation of stablecoins has been noted by government agencies around the world. The Fed too has been keeping note. By the end of 2021, stablecoins had a relatively small market capitalization compared to the broader cryptocurrency market, approximately 6%. Now, stablecoins account for almost 16% of cryptocurrency market capitalization. But trading volumes point to stablecoins having a much larger role in transactions (Chart 3). Stablecoins resolve some of the problems of faith and trust that bedevil cryptocurrencies not backed by traditional assets. Chart 3Stablecoins Rise In Popularity Stablecoins Rise In Popularity Stablecoins Rise In Popularity Stablecoins pose two key threats that a digital dollar will essentially nullify: Systemic risk: A growing stablecoin market that is increasingly backed by traditional, high liquid assets could create systemic risk in traditional asset markets. An excessive rise or fall in demand for stablecoins would cause volatility in the liquid assets that back them. Moreover, for example, a fire sale in the stablecoin market would cause demand to fall excessively relative to the backing asset. Prices between stablecoins and the backing asset would diverge, potentially breaking the peg and resulting in further price divergence. And more broadly, high volatility from crypto markets can penetrate traditional or risk-free markets. A digital dollar would render stablecoins unnecessary, allowing cryptocurrency users to transact and convert digital dollars to cryptocurrency while enjoying the backing of the Fed on the value of digital dollars. Cross-border transactions: Stablecoins are also increasingly used for cross-border transactions. According to Fed data, the US pays 5.4% in fees on average per cross-border transaction, which also takes several days to settle. Stablecoins settle almost instantaneously and have much lower transaction fees. So too can a digital dollar. It would settle just as quickly as a stablecoin, if not quicker, and reduce transaction costs for cross-border payments. And because stablecoins are designed to maintain their pegs, they have more potential than cryptocurrencies to act as mediums of exchange outside of the crypto market and economy, potentially threatening the ongoing use of fiat money. Bottom Line: The Fed will design a CBDC around its existing monetary and payments system to allow for seamless integration. There are not many reasons holding back digital dollar adoption from a point of need and benefit. By adopting a digital dollar, the Fed will also fight off the growing risk of stablecoins, which could pose a threat to the use-case of fiat money in everyday life. Other Central Banks On The March The authority to issue money is an important element of economic power. History is replete with examples of currency competition both within countries and between them. CBDC research and development are picking up speed across central banks (Charts 4A and 4B). China is the world leader with its digital yuan, as we discuss below. Design and implementation of CBDCs will follow in coming years just like in the case of the digital yuan. If the theoretical payoffs to adopting a CBDC are met by real-world green shoots, then foreign CBDCs could pose a threat to continued dollar dominance in the global monetary and economic system, namely if countries can draw down their dependence on dollar reserves. Chart 4ACentral Banks Paying More Attention To CBDCs Digital Dollar, Will US Policymakers Launch One Soon? Digital Dollar, Will US Policymakers Launch One Soon? Chart 4BCentral Banks Paying More Attention To CBDCs Digital Dollar, Will US Policymakers Launch One Soon? Digital Dollar, Will US Policymakers Launch One Soon? Central Bank Competition Treasury Secretary Janet Yellen has noted this challenge in recent remarks explaining that any implementation of a “US central bank digital currency must support the prominent role the dollar plays in the global financial system.”4 The Fed is on the same page as the Treasury noting that any CBDC should be used to preserve the dominant international role of the dollar. The dollar is the world’s most widely used currency for payments and investments and serves as the world’s premier reserve currency. The dollar’s international role allows the US to influence the practices and standards of the global monetary and economic system. Basically, when the US constricts the supply of dollars in response to domestic conditions, the rest of the world suffers tighter monetary conditions, and when the US expands the supply, the rest of the world enjoys looser conditions, almost regardless of what other nations want or need. Central banks have made their policy goals clear in respect to developing a CBDC. Some central banks look to expand financial inclusion, market access, and their payments system while others are looking to compete with one another (Table 2). Canada, China, and Sweden want to gain a local and international market advantage for their currencies by introducing CBDCs. Table 2CBDC Policy Goals Of Central Banks Digital Dollar, Will US Policymakers Launch One Soon? Digital Dollar, Will US Policymakers Launch One Soon? China Leading CBDC Race, But… At this early stage, China’s digital yuan poses the largest threat to a digital dollar on the international stage. It is the most prominent CBDC project at this current juncture. The digital yuan entered beta testing at the end of 2020 in parts of the country. Wider testing across provinces is being phased in. China’s monetary endeavors began with the Cross-Border Inter-Bank Payment Service in 2015. The digital yuan will be positioned as an extension of this system to promote the national currency and fight global dollar dominance. But how big of a challenge could a digital yuan mount? The answer is not much, not now. China is the world’s largest trading partner but the renminbi accounts for less than 3% of the world’s reserve currency (Chart 5). The disparity between trade and currency status in the global economy reflects a lack of global trust in the renminbi and is a cause for concern for China. China is structurally invested in the dollar-dominated financial system and hence vulnerable to American influence by means of that system. Chart 5Global Renminbi Reserves Are Low Global Renminbi Reserves Are Low Global Renminbi Reserves Are Low The digital yuan would support more debt issuance based on cost and payment incentives to debt holders when financing BRI projects. This will help drive the use of the digital yuan going forward. For example, China can assert its influence over countries with Chinese debt by having them accumulate digital yuan reserves to pay back loans. China can even provide countries with concessions on loans to promote its digital yuan. Concessions on Chinese debt may lead to easier uptake, therefore promoting issuance. If the cost of switching to the digital yuan is low, countries will see no benefit in continuing their trade transactions with China in US dollars. Using the digital yuan as the currency of invoice to disburse loans can make these transactions more transparent and manageable. This could also allow for more state control over funds, an attractive scenario for China. However, China’s monetary ambitions face serious constraints. Lack of trust in the currency is the most critical challenge for internationalization of the yuan, digital or otherwise. Even if the digital yuan project is five to ten years ahead of the curve, countries still opt to hold the dollar over the yuan in any type of crisis, as has been amply demonstrated in history, and over a range of global shocks since 2019. Hence digital yuan adoption will require guarantees from Chinese institutions. But these same institutions have struggled to internationalize the paper renminbi. Lack of openness, transparency, and convertibility are persistent problems. Bottom Line: Central banks around the world are gearing up to introduce CBDCs in coming years. Some are looking to promote financial inclusivity. Others like China’s digital yuan want to chip away at the dollar’s global dominance. Digital versions of fiat currencies will have to demonstrate substantial economic and trade efficiencies in order to encourage diversification away from the US dollar, since there is no inherent reason a digital version of a nation’s currency would increase trust beyond what is already established. But those efficiencies could take shape, which would put pressure on the US to respond. The US faces significant monetary challenges over the long run, including from CBDCs. But the US is a technological power and will eventually respond by developing its own CBDC. Pushback Against A Digital Dollar The Fed has stated that it would only pursue a digital dollar in the context of broad public and cross-governmental support. However, neither the public nor congress broadly support one at present. Public opinion is uneducated on the issue and therefore highly malleable depending on leadership and events. Public Opinion Is Non-Supportive Across age groups, people do not know enough about digital currencies and think it is a bad idea to introduce a digital dollar (Chart 6). A 2020 poll found that only 13% of respondents approved of a digital dollar.5 Low approval is becoming a trend. However, the same poll showed that 38% of respondents think the US dollar is backed by gold, bonds, or oil. Addressing poor monetary literacy among the public would help to improve public support of a digital dollar. US households say they are more likely to trust traditional financial institutions than government agencies to safeguard their personal data (Chart 7). A digital dollar will grant the Fed and federal government far-reaching information regarding the everyday financial transactions of households. Trust in government has been declining and a digital dollar underpinned by a central ledger system would provoke consumer privacy lobby groups and government activists to fight and protest adoption (Chart 8). Chart 6Popular Support For A Digital Dollar Is Lacking Digital Dollar, Will US Policymakers Launch One Soon? Digital Dollar, Will US Policymakers Launch One Soon? Chart 7Households Trust Government Less Than Financial Institutions Digital Dollar, Will US Policymakers Launch One Soon? Digital Dollar, Will US Policymakers Launch One Soon? Chart 8Trust In Government Has Been Waning Digital Dollar, Will US Policymakers Launch One Soon? Digital Dollar, Will US Policymakers Launch One Soon? Chart 9Inflation Outbreak Will Limit Big Government Digital Dollar, Will US Policymakers Launch One Soon? Digital Dollar, Will US Policymakers Launch One Soon? About half of the US public already view the government as “doing too much” (Chart 9). The explosive inflation of 2020-22 will slow the underlying ideological shift to the political left, potentially limiting support for a digital dollar. Public opinion has been shifting for decades in favor of more government involvement in people’s day-to-day lives (Chart 10), but that trend may well stall now that excess of government creates tangible negatives for household pocketbooks (inflation). The bigger of a problem the Fed has in taming inflation in 2022-23, the bigger the political backlash will be. Federal solutions will suffer as a result. This is our theme of “Limited Big Government,” since the role of the state will increase relative to the past 40 years but still within an American context of checks and balances. Chart 10People Have Favored Government Involvement Digital Dollar, Will US Policymakers Launch One Soon? Digital Dollar, Will US Policymakers Launch One Soon? Bottom Line: There is no clear public demand for the digitization of the dollar at present. A major financial or economic disruption stemming from the monetary system or digital assets may be necessary to call public attention to the question. Meanwhile the private sector will drive innovation and the federal government will react to try to maintain domestic stability and international competitiveness. These data support the Fed taking an intermediated approach to cbdc when forced to take action. Policymakers Will Resist Policymakers are divided over the idea of a digital dollar. Senator Ted Cruz introduced a bill in March 2022 to “prohibit the Federal Reserve from offering products or services directly to individuals, maintaining accounts on behalf of individuals, or issuing a central bank digital currency directly to an individual.”6 Cruz has yet to receive widespread party support on the bill but he could get the backing from more GOP members if Republicans take over Congress, as expected, this November. Some Republicans and Democrats have favored cryptocurrencies while others have not, advocating for crypto-mining and crypto start-ups in progressive-left and libertarian right states. But the center-left and center-right might lean more toward cryptocurrency regulation and digital dollar adoption. Coalitions may need to be formed on the topic of a digital dollar, in parties and between parties. A digital dollar will cause a level of disruption, which will affect both the Democrats and Republicans. Government gridlock will create challenges to digital dollar adoption too. The upcoming mid-term elections favor the GOP. Both the House and the Senate are expected to flip in favor of the GOP in 2023. The “Blue Sweep” policy setting will end and only the White House will remain in Democrat control. Republicans have a shot at flipping the White House in 2024, which could see a “Red Sweep.” This scenario may slow adoption of a digital dollar but it will only preclude the unilateral cbdc model, not the intermediated model. The period of 2023-24 is too soon for adoption of a digital dollar anyway but the fact is that gridlock will delay the process until external factors force US action. Bottom Line: Public and political pushback will slow the adoption of a digital dollar. Politicians will need to work along bipartisan lines to ensure the US remains at the forefront of digital and monetary innovation but this will be difficult in a highly polarized country and will likely depend on foreign competition. Investment Takeaways We avoided cryptocurrencies during the irrational exuberance over the past two years. We expect governments to regulate the sector in order to preserve a monopoly over money supply and hence geopolitical interests. With monetary conditions tightening, we expect continued volatility in the crypto space. The US dollar remains strong tactically but is nearing its peak cyclically. We remain long but have put the currency on downgrade watch as the market more fully prices a range of bad news this year. On the global stage, the US dollar will remain the premier reserve currency despite cyclical ups and downs. The current macroeconomic backdrop is negative for the US financial sector (Chart 11). Mergers and acquisitions are drying up while regulatory risks loom. Initial public offerings are also slowing, while trading volume is low. Consumers had already accumulated debt earlier in the cycle and with rising interest rates amid a more challenging job environment, growth in loans and ultimately bank profits will slow. The commercial banking sector faces challenges during the upcoming transitional period of disruptive innovation and regulatory uncertainty. We believe the Fed and policymakers in general will want to cause as little disruption as possible, by integrating any digital dollar with the traditional finance sector as seamlessly as possible. However, transitions, especially those digital in nature, bring with them high uncertainty in the financial sector and elsewhere. Chart 11Financial Sector Facing Macro Headwinds Financial Sector Facing Macro Headwinds Financial Sector Facing Macro Headwinds     Guy Russell Senior Analyst guyr@bcaresearch.com     Footnotes 1     Stablecoins are backed by various assets and means. Fiat money, commodities, other cryptocurrencies and by algorithmic means are some examples. 2     See The Bank For International Settlements, Central Bank Digital Currencies: Executive Summary, September 2021, bis.org. 3    See The Board of Governors of the Federal Reserve System, Money and Payments: The U.S.Dollar in the Age of Digital Transformation, January 2022, federalreserve.gov. 4    See U.S. Department Of The Treasury, Remarks from Secretary of the Treasury Janet L. Yellen on Digital Assets, April 2022, treasury.gov. 5    See Cointelegraph, Most Americans are against a digital dollar CBDC, survey reveals,september 25, 2020, cointelegraph.com 6    See Ted Cruz’s Proposed Bill to amend the Federal Reserve Act to prohibit the Federal reserve banks from offering certain products or services directly to an individual, and for other purposes, March 2022, cruz.senate.gov.   Strategic View Open Tactical Positions (0-6 Months) Open Cyclical Recommendations (6-18 Months)   Table A2Political Risk Matrix Digital Dollar, Will US Policymakers Launch One Soon? Digital Dollar, Will US Policymakers Launch One Soon? Table A3US Political Capital Index Digital Dollar, Will US Policymakers Launch One Soon? Digital Dollar, Will US Policymakers Launch One Soon? Chart A1Presidential Election Model Third Quarter US Political Outlook: Last Ditch Effort Third Quarter US Political Outlook: Last Ditch Effort Chart A2Senate Election Model Third Quarter US Political Outlook: Last Ditch Effort Third Quarter US Political Outlook: Last Ditch Effort  Table A4House Election Model Will Trump Run Again? What About Biden? Will Trump Run Again? What About Biden? Table A5APolitical Capital: White House And Congress Digital Dollar, Will US Policymakers Launch One Soon? Digital Dollar, Will US Policymakers Launch One Soon? Table A5BPolitical Capital: Household And Business Sentiment Digital Dollar, Will US Policymakers Launch One Soon? Digital Dollar, Will US Policymakers Launch One Soon? Table A5CPolitical Capital: The Economy And Markets Digital Dollar, Will US Policymakers Launch One Soon? Digital Dollar, Will US Policymakers Launch One Soon?