Technology

Overweight (maintain cyclical trailing stop at 27% relative return since inception) The latest ISM services report followed its sibling ISM manufacturing survey lower as we have been expecting, given the leading properties and extreme economic sensitivity of the U.S. manufacturing sector. The bond market’s knee jerk reaction was a near certainty of a Fed cut in the October 30 meeting and a 54% probability of an additional cut in the December 11 meeting, on hopes that the Fed will save the day and stave off recession. As a result, equities recovered and growth stocks (software included) that are hyper-responsive to interest rate movements led the advance. We remain overweight the S&P software index since the late-2017 cyclical inception, however, from a risk management perspective we will obey our trailing stop near the 27% relative return mark. As a reminder, we recently booked relative tactical gains of 10% in this index and removed it from the high-conviction overweight list. Software Yellow Flags Software Yellow Flags While the secular drivers for the S&P software index remain intact, the latest ISM services survey drop was a warning shot that even mighty software demand may suffer a small setback (second panel). Moreover, recent losses in the IPO exchange traded fund also warn that gravity can pull skyrocketing growth stocks back to earth (bottom panel), especially given this year’s sizable rise in IPO supply (third panel). Bottom Line: Stick with a cyclical overweight stance on the S&P software for now, but remain prepared to pull the trigger and monetize gains by obeying the trailing stop at the 27% mark.   

In late-summer 2010, we published a Special Report overviewing long-term U.S. equity sector relative performance during deflationary periods. Since then, inflation – core PCE deflator to be more specific – only briefly flirted with the Federal Reserve’s 2% target in mid-2018, while long-term inflation expectations never managed to re-anchor higher. Worrisomely, there are now budding signs that inflation will weaken in the coming quarters rather than rear its ugly head. Pundits – us included – are still waiting for inflationary pressures to finally pass-through. Worrisomely, there are now budding signs that inflation will weaken in the coming quarters rather than rear its ugly head (Chart 1). The late-2018 tightening in financial conditions will exert downward pressure on year-over-year CPI growth, albeit with a slight lag (top panel, Chart 1). More broadly, the ongoing deceleration in the U.S. economy, as evidenced by the sharp decline in the ISM manufacturing PMI (and most of its subcomponents), represents a serious headwind for inflation (second panel, Chart 1). Given weak global growth, the appreciating U.S. dollar – a countercyclical currency – will also weigh on inflation going forward (not shown). Further, we don’t view the recent perky inflation prints as sustainable. In fact, core goods CPI – which accounts for 25% of core CPI and has been the main driver lately – is expected to roll over and contract over the next 18 months (third panel, Chart 1). Chart 1Still Looking For Inflation? Still Looking For Inflation? Still Looking For Inflation? U.S. Equity Strategy’s corporate pricing power proxy has also sharply sunk corroborating that the path of least resistance is lower for core inflation (bottom panel, Chart 1). In other words, if Marty McFly could ride the DeLorean to travel back in time once more, he would certainly approve of deflation/disinflation being a major equity theme at BCA, and would even ask us to delve deeper into our prior analysis. That is precisely what we do in this Special Report. We acknowledge the current disinflationary trend and provide more details on the historical relative performance of the different equity sectors in such periods. We introduce a simple trading rule based on these deflationary episodes, which we define as two or more consecutive quarters of negative corporate sector price deflator growth (Chart 2). We treat single quarters of positive growth within broader deflationary trends as outliers, which translate into the occasional quarterly rebounds within the shaded areas. Chart 2Deflationary Periods Deflationary Periods Deflationary Periods The next pages provide some more color on the sectors historical relative performance. Notably, we add a brief overview of the annualized returns realized by heeding the signals from two consecutive quarters of negative corporate sector price deflator growth. Since 1960, there have been 27 such signals, with a median duration of 15 months and the shortest one being six months. As such, we feel comfortable using 6-, 12- and 24-month horizons to go long (short) the sectors we identified did well during deflationary (inflationary) periods, whenever signaled. Table 1 summarizes the results of this empirical exercise. Table 1 Sector Relative Performance And Deflation (From 1960 To Present) Sector Performance In A Deflationary World: Back To The Future? Sector Performance In A Deflationary World: Back To The Future? Our hypothesis during disinflationary periods is that defensives outshine cyclicals. The results for the GICS11 relative sector performance are consistent with our hypothesis. Specifically, following our deflationary signal, defensives are up 1.4% on a 6-month horizon, while cyclicals are down 2.5%. We also note an inflection point around the 12-month mark as cyclicals start to recover their losses moving from -2.5% to just -0.21%, while defensives are giving up their gains moving from 1.38% to 0.76%. This finding is consistent with the median deflation period duration of 15 months, as highlighted earlier. Similarly, if we look 24 months out, we observe that cyclicals are outperforming the market by 0.5% (largely driven by tech), and defensives are lagging the market by -1.2% (dragged by telecom and utilities) signaling that the market has recovered. Diagram 1Performance Time Line Sector Performance In A Deflationary World: Back To The Future? Sector Performance In A Deflationary World: Back To The Future? Importantly, we are currently in a deflationary environment as defined by our two-quarter signal that commenced mid-2018, and U.S. Equity Strategy has been actively reducing cyclical exposure over the past six months and highlighting that investors should be cautious on the prospects of the broad equity market. Turning back to Table 1, we also see some divergences in the GICS1 sector performance vs. some of our expectations. Utilities should outperform during disinflation periods, owing to two factors: (1) steady cash flow growth, (2) falling interest rates boost the allure of high yielding competing assets. Another notable outlier is the S&P consumer discretionary index. Specifically, the roughly 2% underperformance in the six months following our deflationary signal took us by surprise, as discretionary spending should at the margin get a boost from declining interest rates. To conclude, we also present a time line that summarizes results from Table 1 as well as the sector specific comments. Importantly, the time line is a road map that should be only used “as a rule of thumb” guide to navigate a deflationary environment. Keep in mind, that even though the median duration for a deflationary period is 15 months, it can still last anywhere from just under a year to over four years. As always, context is key. Finally, stay tuned for an update on our traditional U.S. equity sector profit margin outlook report that is due in the upcoming months. What follows are additional details of our analysis on a per sector basis, along with charts on sector specific pricing power and revenue turnover.     Jeremie Peloso, Research Analyst JeremieP@bcaresearch.com   Arseniy Urazov, Research Associate ArseniyU@bcaresearch.com   Consumer Staples (Overweight) Consumer Staples Consumer Staples The S&P consumer staples index performs well during deflationary periods. Likely explanatory variables are the safe haven status of this index along with an ongoing industry consolidation. Our sector pricing power proxy reveals that staples have not experienced a contraction in pricing power since 2003. While relative share prices are staging a recovery, they are still one standard deviation below the historical time trend. Further gains are likely given impressive returns on a 6-, 12-, and 24-month time horizon following our deflationary signal. We remain overweight the S&P consumer staples index. Consumer Staples Consumer Staples Energy (Overweight) Energy Energy Among the cyclical sectors, S&P energy is the second largest underperformer, declining 3.4% on average in relative terms in the six months following our deflationary signal. The underperformance is also evident in our PP proxy. Energy companies’ PP declines right as the economy enters deflation, which is consistent with our expectations, as oil plays a key role in virtually any inflation/deflation measure. One caveat at the current juncture is the recent oil price spike that may serve as a catalyst to unlock excellent value in bombed out energy equities. As a result of the drone attacks on Saudi Arabia’s production and refining facilities we expect geopolitical premia to get built into crude oil prices on a sustained basis. We are currently overweight the S&P energy index. Energy Energy Health Care (Overweight) Health Care Health Care During deflationary periods the S&P health care sector has outperformed the broad market, similar to its defensive sibling, the S&P consumer staples sector. On top of the safe haven nature of the health care industry, pricing power has never crossed below the zero line during the entire history of the data series. This remarkable feat also applies to the sector’s sales growth. We are currently overweight the S&P health care index. Health Care Health Care Industrials (Overweight) Industrials Industrials On the eve of deflation, industrials equities start wrestling with two opposing forces: cheapened raw materials versus slowing economic activity. In the end, economic softness wins the tug-of-war as this deep cyclical index underperforms the market on 6-, 12- and 24-month time horizon by -1.4%, -1.0% and -0.5%, respectively. The sector’s pricing power usually displays a sharp decline as we enter a deflationary zone weighing on industrials revenue prospects and thus relative performance. We are currently overweight the S&P industrials sector. Industrials Industrials Financials (Overweight) Financials Financials Being an early cyclical sector, it is not surprising that the S&P financials sector tends to underperform the broad market on 6-, 12- and 24-month horizon following our two-quarter deflation signal. The largest underperformance for financials comes late into the deflationary period. In fact, had we excluded utilities from our analysis, the S&P financials sector would have been the worst performing sector across the board on a 12- and 24-month time horizon. The heavyweight banks subgroup accounting for roughly 42% of the S&P financials market capitalization weight explains the underperformance. As a reminder banks underperform when the price of credit is falling owing to deflation/disinflation. Given that our fixed income strategists expect a selloff in the bond market, we remain overweight the S&P financials index. Financials Financials Technology (Neutral – Downgrade Alert) Technology Technology Back in 2010, we reiterated that tech equities were deflationary winners, a fact that has not changed since then. The frenetic pace of innovation in and of itself, has prepared the sector to cope with episodes of deflation. Within cyclicals, technology is by far the best performing sector in our Table 1, but the present-day geopolitical and trade tensions compel us to be neutral on the sector with a potential downgrade coming down the line via a software subgroup downgrade. Tech pricing power is resilient during deflationary episodes. However, tech sales growth, which appears to have peaked for the cycle, swings violently, warning of potential turbulence ahead if a down oscillation is looming. We are neutral the S&P technology sector, which is also on our downgrade watch list. Technology Technology Telecommunication Services (Neutral) Telecommunication Services Telecommunication Services Traditionally defensive telecom services stocks have been struggling recently, saddled with rising debt, fighting to remain relevant and avoid becoming a “dumb pipe”. The industry’s pricing power proxy also highlights the point as telecom companies never managed to regain their footing since the GFC. Another important point is that the index materially underperforms the market across all the time horizons we examined returning: -1.5%, -2.0% and -4.4%. Our hypothesis was that telecom carriers should outperform during deflationary periods owing to stable cash flow growth generation and a high dividend yield profile. But, empirical evidence shows the opposite. Likely, the four decades-long sustained underperformance of this now niche safe haven industry suggests that sector specific dynamics are at fault. We are currently neutral the S&P telecommunication services index. Telecommunication Services Telecommunication Services Materials (Underweight) Materials Materials Despite the massive demand from China and, more generally, from the EM complex for commodities over the past several years, the S&P materials sector never actually managed to break free from its structural downtrend. The sector is one of the major disinflationary losers as evident from the chart. Importantly, since the mid-70s, most of the periods when materials managed to outperform the broad market occurred outside the shaded areas and recessions. On average, materials sector pricing power also tends to decline sharply when global growth weakens, as is currently the case. And, with a slight delay, materials sector revenue growth will likely suffer a setback, warning that revenue growth has crested for the cycle. We reiterate our recent downgrade of the S&P materials sector to underweight. Materials Materials Consumer Discretionary (Underweight – Upgrade Alert) Consumer Discretionary Consumer Discretionary Contrary to our hypothesis, S&P consumer discretionary stocks underperform during disinflationary periods that weigh on interest rates. Likely decelerating economic activity trumps that fall in interest rates and consumers gravitate toward staple goods and services and away from discretionarfy purchases. Table 1 reveals that consumer discretionary stocks actually suffer the most early in a deflationary period (-2.0%), and then sharply recover 12 months out and turn marginally positive (0.1%). We are currently underweight the S&P consumer discretionary index, but have it on upgrade alert as a potential buying opportunity. Consumer Discretionary Consumer Discretionary Utilities (Underweight) Utilities Utilities As for the final sector of this Special Report, we had highlighted that the S&P utilities is a notable outlier in our analysis as it does not behave according to our expectations. Likely, some industry specific dynamics are at play as high-yielding safe haven utilities stocks severely underperform during deflationary periods. The sector returns -3.5%, -4.3%, and -4.5% versus the broad marekt on a 6-, 12, and 24-month time horizon, respectively. In theory, two factors should have pushed the relative share price higher: (1) steady cash flow growth and (2) falling interest rates, both of which boost the allure of high yielding competing assets. Neither one was sufficient to break away from the structural downtrend that has been haunting the sector over the years. We are currently underweight the S&P utilites index. Utilities Utilities   Footnotes 1    We are using GICS 2 Telecommunication Services index instead of the parent GICS 1 Communication Services index due to the lack of data as the index was only recently introduced.

 Remain Cyclically Overweight, But Remove from High-Conviction Overweight List Our 10% stop on the S&P software high-conviction call got triggered and we are obeying it, booking gains and removing this index from the high-conviction overweight list. As a reminder, we are still overweight the S&P software index on a cyclical basis since November 2017, with a trailing stop at a the 27% relative return mark that has yet to get hit (bottom panel). Software stocks have offered bulletproof returns for investors as they are mostly insulated from direct impacts of the U.S./China trade war. In addition, these secular growth stocks are also perceived as immune to a growth slowdown and the drubbing in interest rates since the November 2018 peak in the 10-year Treasury yield has been more than reflected in high-flying multiples. Now that interest rates are trying to bottom, investors have been quick to rein in some of their enthusiasm on the largest tech subsector. We still believe that artificial intelligence, augmented reality, SaaS and the push to the cloud have staying power and are not fads, however from a risk management perspective we are compelled to act and protect profits for our portfolio. Software Is No Longer A High-Conviction Buy Software Is No Longer A High-Conviction Buy Bottom Line: Crystalize 10% gains in S&P software index and remove it from the high-conviction overweight list. We are still cyclically overweight the S&P software index and remain prepared to book profits at the 27% relative return mark and downgrade this key tech subgroup to neutral. Such a downgrade will push the S&P tech sector to an underweight stance and also give our portfolio a defensive over cyclical tilt. Stay tuned.

Continue Playing Defense Continue Playing Defense Neutral Downgrade Alert This Monday we published a summary of our portfolio allocation changes that we made over the past couple of months. They key underlying theme running through most of our recent moves was to reduce our cyclical exposure and pocket in some profits. Today we highlight one of the major moves we are preparing to make: downgrade the S&P technology sector. The downgrade will be executed via the S&P software index. As a reminder, we have a stop at the 27% relative return mark and once it’s triggered, we will go neutral on software pushing the overall tech sector to a below benchmark allocation. Our EPS model for the overall tech sector is on the verge of contraction on the back of sinking capex and a seemingly invincible U.S. dollar (middle panel). The San Francisco Fed’s Tech Pulse Index is also closing in on the expansion/contraction line warning that tech stocks are in for a rough ride (bottom panel). Bottom Line: We reiterate our defensive stance on the U.S. equity market as the risk/reward remains to the downside. For the full summary of our recent moves, please see this Monday’s Weekly Report.  

Highlights Portfolio Strategy Despite the Fed’s supra natural powers, the deep rooted global growth slowdown will likely win the tug of war versus flush liquidity, especially if the trade war spat stays unresolved and the U.S. dollar remains well bid, both of which undermine U.S. corporate sector profitability. Recent Changes There are no changes to the portfolio this week. Table 1 The Fed Apotheosis The Fed Apotheosis Feature Equities hit all-time highs last week, eagerly anticipating this Wednesday’s Fed decision to commence an easing interest rate cycle and save the day. The looming global liquidity injection is the sole reason that stocks are holding near their all-time highs. While markets are treating the Fed as a deity, empirical evidence suggests that risks are actually lurking beneath the surface. Over the past two decades the correlation between stocks and the fed funds rate has been tight and positive. Given the bond market’s view of four fed cuts in the coming year, equity gains are likely running on fumes (Chart 1). Chart 1Mind The Positive Correlation Mind The Positive Correlation Mind The Positive Correlation As we highlighted recently, we remain perplexed that stocks are diverging from earnings.1 Anticipating a flush global liquidity backdrop (i.e. global central banks increasing their reflationary efforts) likely explains this dynamic as the former should ultimately rekindle economic growth, which in turn should boost profit growth. However, the disinflationary fallout from the ongoing manufacturing recession and the petering out in the global credit impulse signal that the liquidity pipes remain clogged. We recently read and re-read the Bank For International Settlements (BIS) Hyun Song Shin’s “What is behind the recent slowdown” speech where he eloquently argues that the global trade deceleration predates last spring’s U.S./China trade dispute.2 Shin has a compelling argument blaming the growth deceleration on the drop in manufactured goods global value chains (GVC) and he depicts this as global trade trailing global GDP (top panel, Chart 2). Interestingly, despite the V-shaped recovery following the Great Recession, global trade never really regained its footing, failing to surpass the 2007 peak. Shin then links this slowdown in global supply chains to financial conditions and the role that banking plays in global trade financing. The middle panel of Chart 2 shows that the GVC move with the ebbs and flows of global banks. In other words, healthy banks tend to boost global trade and vice versa. Finally, given that most trade financing is conducted in U.S. dollars, the greenback’s recent appreciation also explains trade blues. Simply put, decreased availability of U.S. dollar denominated bank credit as a result of a rising greenback is another culprit (U.S. dollar shown inverted, bottom panel, Chart 2). Ergo, there is no miracle cure for the sputtering world economy, especially given the recent re-escalation in global trade tensions and the stubbornly high U.S. dollar, and the gap between buoyant share prices and poor profit performance is likely to narrow via a fall in the former. Two weeks ago we highlighted that foreign sourced profits for U.S. multinationals are under attack as BCA’s global ex-U.S. ZEW survey ticked down anew (top panel, Chart 3). Tack on the global race to ZIRP (and in some cases further into NIRP) and it is crystal clear that the profit recession has yet to run its course. Chart 2Grim Trade Backdrop... Grim Trade Backdrop... Grim Trade Backdrop... Chart 3...Will Continue To Weigh On Foreign Sourced Profits ...Will Continue To Weigh On Foreign Sourced Profits ...Will Continue To Weigh On Foreign Sourced Profits   Meanwhile, China is likely exporting its deflation to the rest of the world and until its business sector regains pricing power, U.S. profits will continue to suffer (bottom panel, Chart 3). Turning over to U.S. shores and domestic corporate pricing power, the news is equally grim. Our pricing power proxy is outright contracting and warns that revenue growth is also under duress for U.S. corporates. Similarly, the ISM manufacturing prices paid subcomponent fell below the 50 boom/bust line and steeply contracting raw industrials commodities are signaling that 6%/annum top line growth for the SPX is unsustainable (Chart 4). On a cyclical 3-12 month time horizon we remain cautious on the broad equity market. Chart 4Sales Pressures... Sales Pressures... Sales Pressures... Chart 5...Are Building Rapidly ...Are Building Rapidly ...Are Building Rapidly Melting inflation expectations and the NY Fed’s softening Underlying Inflation Gauge (UIG) best encapsulate this softening revenue backdrop and warn that any further letdown in inflation risks sinking S&P 500 sales growth below the zero line (Chart 5).   Netting it all out, despite the Fed’s supra natural powers, the deep rooted global growth slowdown will likely win the tug of war versus flush liquidity, especially if the trade war spat stays unresolved and the U.S. dollar remains well bid, both of which undermine U.S. corporate sector profitability. On a cyclical 3-12 month time horizon we remain cautious on the broad equity market. This is U.S. Equity Strategy’s view, which stands in contrast to the more sanguine equity BCA House View. What follows is a recap of recent (mostly) defensive moves in the health care, consumer staples, materials, tech, consumer discretionary and communication services sectors.   Anastasios Avgeriou, U.S. Equity Strategist anastasios@bcaresearch.com   S&P Health Care (Overweight) Upgraded from Neutral S&P Health Care Equipment (Overweight) Upgraded from Neutral Fear-based sell-off created a buying opportunity in the U.S. health care equipment index as fundamentals remain upbeat. Rising U.S. medical equipment exports are a tailwind for this health care subgroup as 60% of its revenues are generated outside the United States (second panel). The EM demographic shift (not shown) represents yet another boost to the sector as U.S. companies are the technology leaders and often the only source for equipping hospitals/clinics around the globe. Our move to upgrade the S&P health care equipment index also pushed the entire health care sector from neutral to overweight (bottom panel). S&P Health Care S&P Health Care S&P Health Care S&P Managed Health Care (Overweight) Upgraded from Neutral The Bernie Sanders “Medicare For All” bill reintroduction created a buying opportunity in the S&P managed health care index and we were swift to act on it in mid-April. Contained industry cost factors including wages staying at the 2% mark help preserve industry margins (bottom panel). Melting medical cost inflation signals that HMO profit margins will likely expand (third panel). Overall healthy labor market conditions with unemployment insurance claims probing 60-year lows should underpin managed health care enrollment (top & second panels). S&P Managed Health Care S&P Managed Health Care S&P Managed Health Care   S&P Hypermarkets (Overweight) Upgraded from Neutral S&P Soft Drinks (Neutral) Upgraded from Underweight A deteriorating macro landscape reflected in the steep fall in U.S. economic data surprises, the drubbing of the 10-year U.S. Treasury yield and melting inflation make a compelling case for an overweight stance in the S&P Hypermarkets index (top & second panels). Similarly, safe haven soft drinks stocks shine when economic conditions are deteriorating (third panel). This defensive pure-play consumer goods sub-sector is also enjoying a rebound in operating metrics, and thus it no longer pays to stay bearish. We lifted exposure to neutral last week, locking in gains of 5.5% since inception. S&P Hypermarkets S&P Hypermarkets S&P Hypermarkets   S&P Materials (Neutral) Downgraded from Overweight S&P Chemicals (Underweight) Downgraded from Neutral Global macro headwinds continue to weigh on this deep cyclical sub-index as the risks of a full-blown trade war will likely take a bite out of final demand (third panel). Chemical producers garner 60% of their revenues from abroad and falling U.S. chemical exports are troublesome for this index (top & second panels). Given that chemicals have a 74% market cap weight in the S&P materials index, our move to underweight on the sub-index level also pushed the entire S&P materials index to neutral from overweight. S&P Materials S&P Materials S&P Materials   S&P Technology (Neutral) Downgrade Alert S&P Software (Overweight) Lifted trailing stops As a part of our portfolio de-risking measures, we put a 27% profit-taking stop loss on our overweight S&P software index call on June 10. Once triggered, a downgrade to neutral in the S&P software index would also push our S&P tech sector weight to a below benchmark allocation. Meanwhile, our EPS model for the overall tech sector is on the verge of contraction on the back of sinking capex and a firming U.S. dollar (middle panel). The San Francisco Fed’s Tech Pulse Index is also closing in on the expansion/contraction line warning that tech stocks are in for a rough ride (bottom panel). S&P Technology S&P Technology S&P Technology   S&P Technology Hardware, Storage & Peripherals (Neutral) Downgraded from Overweight As nearly 60% of the revenues for the S&P technology hardware, storage & peripherals (THS&P) index are sourced from abroad, deflating EM currencies sap foreign consumer purchasing power and weigh on the industry’s exports (third panel). Global export volumes have sunk into contractionary territory, to a level last seen during the Great Recession (not shown) and underscore that industry exports will remain under pressure. The IFO World Economic Survey confirms this challenging export backdrop as it is still pointing toward sustained global export ails (second panel). As a result, all of this has shaken our confidence in an overweight stance in the S&P THS&P and we were compelled to move to the sidelines in early June for a modest relative loss since inception. S&P Technology Hardware, Storage & Peripherals S&P Technology Hardware, Storage & Peripherals S&P Technology Hardware, Storage & Peripherals S&P Consumer Discretionary (Underweight) Upgrade Alert S&P Home Improvement Retail (Neutral) Upgraded from underweight In the July 8 Weekly Report, we put the S&P consumer discretionary sector on an upgrade alert as this early-cyclical sector benefits the most from lower interest rates (bottom panel). The way we will execute this upgrade will be by triggering the upgrade alert on the S&P internet retail index. Melting interest rates and rebounding lumber prices are a boon for home improvement retailers (HIR, second & third panels). Tack on profit-augmenting industry productivity gains and it no longer pays to be bearish HIR. S&P Consumer Discretionary S&P Consumer Discretionary S&P Consumer Discretionary S&P Homebuilders (Neutral) Downgraded from overweight Long S&P Homebuilders / Short S&P Home Improvement Retail Booked Profits Lumber represents an input cost to homebuilders (we booked profits of 10% in our overweight recommendation on May 22 and downgraded to neutral) whereas it is an important selling item in Big Box building & supply retailers that make a set margin on it (third panel). On June 18, as part of our de-risking strategy, we locked in 10% gains in the long S&P homebuilders/short S&P home improvement retail trade that hit our stop loss and we moved to the sidelines. S&P Homebuilders S&P Homebuilders S&P Homebuilders S&P Telecommunication Services (Neutral) Upgraded from Underweight The recent escalation of the trade spat has pushed July’s Markit’s flash U.S. manufacturing PMI reading to 50 - the lowest level since the history of the data. Historically, relative S&P telecom services share price momentum has moved inversely with the manufacturing PMI and the current message is to expect a sustained rebound in the former (bottom panel). Rock bottom profit expectations and firming industry operating metrics signal that most of the grim news is priced in bombed out telecom services valuations (middle panel), and it no longer pays to be underweight. In late-May, we lifted exposure to neutral for 6% relative gains since inception. S&P Telecommunication Services S&P Telecommunication Services S&P Telecommunication Services S&P Movies & Entertainment (Overweight) Upgraded from Neutral Structural shifts in the streaming services industry marked a start of a pricing war with incumbents and new entrants fighting for market share, as evidenced by DIS’s pricing of their upcoming Disney+ service. Consumer confidence remains glued to multi-decade highs and there are high odds that the big gulf that has opened up between confidence and relative S&P movies & entertainment share prices will narrow via a rise in the latter (top panel). Moreover, more dollars spent on recreation is synonymous with a margin expansion in the S&P movies & entertainment index (bottom panel). This consumer spending backdrop is also conducive to a rise in relative profitability, the opposite of what the sell-side currently expects. S&P Movies & Entertainment S&P Movies & Entertainment S&P Movies & Entertainment   Arseniy Urazov, Research Associate ArseniyU@bcaresearch.com Footnotes 1      Please see BCA U.S. Equity Strategy Weekly Report, “Beware Profit Recession” dated July 8, 2019, available at uses.bcaresearch.com. 2      https://www.bis.org/speeches/sp190514.pdf   Current Recommendations Current Trades Size And Style Views Favor value over growth Favor large over small caps

Housekeeping Housekeeping Last Thursday we were stopped out from our tactical S&P semi equipment underweight position as it hit our -7% stop loss (bottom panel). We are obeying the stop loss and are returning this index to a neutral weighting as better than expected profits from both ASML and TSMC lifted all chip-related equities. In marked contrast, our long global gold miners/short S&P oil & gas exploration & production trade initiated just last week has gone parabolic, spiking to 17% (top panel). While our thesis has not changed in this high beta tactical pair trade, from a risk management perspective, we are moving our stop loss from -10% to +12% in order to protect profits. Bottom Line: Stick with the counter-cyclical long global gold miners/short S&P oil & gas exploration & production trade via the long GDX:US/short XOP:US exchange traded funds. For additional details on the rationale behind this trade, please refer to last Monday’s Weekly Report.  

Fade Semi Equipment Strength Fade Semi Equipment Strength Underweight A tactical trading opportunity has re-emerged in semi equipment stocks. This week we recommended trimming the S&P semi equipment index to underweight on a three-to-six month time horizon, but with a tight stop at the -7% relative return mark. Semi equipment stocks are capital intensive and require precision manufacturing, which makes their sales cycle a carbon copy of the broad manufacturing cycle. The middle panel of the chart shows this tight positive correlation with the ISM manufacturing index and sends a grim message for semi equipment manufacturers. With regard to industry operating metrics, the news is equally glum. Global semi cycles typically last four-to-five quarters and we only just passed the half way mark. Thus, there is more downside to industry sales momentum and we would lean against recent analyst relative revenue euphoria (bottom panel). Bottom Line: Downgrade the S&P semiconductor equipment index to underweight on a tactical – three-to-six month horizon – basis, but set a tight stop at the -7% relative return mark. For additional details please refer to this Monday’s Weekly Report. The ticker symbols for the stocks in this index are: BLBG – S5SEEQ – AMAT, LRCX, KLAC.

Highlights Portfolio Strategy Rising lumber prices, melting interest rates and profit-augmenting industry productivity gains all signal that it no longer pays to be bearish the S&P home improvement retail (HIR) index. Poor revenue growth prospects, the ongoing global manufacturing contraction and downbeat financial variables all indicate that high-beta semi equipment stocks have ample downside. Recent Changes Downgrade the S&P semi equipment index to underweight on a tactical three-to-six month time horizon, today. Upgrade the S&P home improvement retail index to neutral and remove from the high-conviction underweight list, today. Put the S&P consumer discretionary sector on upgrade alert and remove from the high-conviction underweight list, today. Table 1 Beware Profit Recession Beware Profit Recession Feature July 10 marks the two year anniversary of our seminal “SPX 3,000?” report.1 We were very early both compared with the sell and buy side (to our knowledge the great Byron Wien is the only other strategist that had such a target) and as a reminder, at the time, the S&P 500 was trading near 2,400. A number of BCA peers and BCA clients alike confronted our über bullishness with disbelief, but our 3,000 target – based on our dividend discount model, an EPS and multiple sensitivity analysis and an equilibrium equity risk premium analysis – proved a prescient call. Throughout this period (we had actually been bullish since Brexit, when our profit growth models hooked up) we maintained our cyclical bullishness and never wavered (top panel, Chart 1). Now that SPX futures hit our 2019 target, we want to remain ahead of the curve, as Stan Druckenmiller once mused: “…you have to visualize the situation 18 months from now, and whatever that is, that's where the price will be, not where it is today”. Chart 1Rally Running On Fumes Rally Running On Fumes Rally Running On Fumes In early June we shaved our 2021 EPS to $140 and our end-2020 SPX target fell to a range of 1,890-2,310. We posited that the easy gains in equities were behind us and we are not willing to play 100-200 points to the upside for a potential 1,000 point drawdown, owing to a souring macro backdrop (five key reasons underpin our cautious broad equity market stance that we outline in our recent webcast). On the eve of earnings season, investors have been obsessing with the “Fed put”, but neglecting the looming profit recession (bottom panel, Chart 1). Moreover, while markets cheered the trade truce following the recent G20 meeting, odds are high that manufacturing will remain in the doldrums as the tariff rate on $200bn of Chinese imports went up from 10% to 25% on May 10, and no tariff rollback was agreed. As a result, highly-cyclical global trade and manufacturing will likely continue to weigh on the economy for the remainder of the year. A simple liquidity indicator points to profit growth trouble into early-2020, which stands in marked contract with sell-side analysts who anticipate 10% EPS growth. Chart 2 shows the gulf gap between industrial production and broad money growth. Since 1960, this liquidity indicator has been an excellent leading indicator of SPX profit momentum and the current message is to expect a sustained deceleration in the latter. Chart 2Earnings… Earnings… Earnings… BCA U.S. Equity Strategy’s four-factor macro S&P 500 profit growth model corroborates this signal and warns that a profit contraction is nearing (Chart 3). Chart 3…Trouble… …Trouble… …Trouble… Following up from last week, Goldman Sachs’ U.S. Current Activity Indicator is also flashing red for SPX profit growth. Similarly, our corporate pricing power gauge is sinking steadily and underscores that a profit recession is a high probability outcome (Chart 4). Meanwhile, a longtime friend that I call “the smartest man in California” brought a slight variation of Chart 5 to my attention recently and highlighted that: “Historically, periods of falling manufacturing PMI result in larger negative earnings growth surprises as market forecasters rarely anticipate the breadth and depth of slowdowns. Profit growth trends are set to weaken further in the coming six months. Without profit growth, equity markets lack the necessary ‘oxygen’ for a durable high-quality rally, and until there is an upturn in growth momentum, rallies should be faded.” Chart 4…Proliferating …Proliferating …Proliferating   Chart 5Expect Downward… Expect Downward… Expect Downward… Even net EPS revisions have taken a turn for the worse and are probing recent lows (Chart 6). Drilling beneath the surface is revealing. Trade-exposed sectors bear the brunt of the EPS downgrades. Tech (60% foreign sales exposure), materials, industrials, and energy are deeply in negative territory (Chart 7). On the flip side, defensive sectors are offsetting some of the cyclical sectors' weakness with health care, real estate, utilities and consumer staples hovering close to zero (Chart 8). Chart 6…Profit Surprises …Profit Surprises …Profit Surprises Chart 7Net Earnings Revisions… Net Earnings Revisions… Net Earnings Revisions… Chart 8…Sectorial Breakdown …Sectorial Breakdown …Sectorial Breakdown With regard to the contribution to profit growth for calendar 2019, the divergences have widened significantly since our last update in early-April, with the financials sector solely holding the broad market’s profit fate in its hands. In more detail, Chart 9 shows that financials are responsible for 79% of the overall anticipated profit growth, up from 45% in early-April, whereas technology, energy and materials each have a negative profit growth contribution north of 30%. Chart 9 Table 2 puts all these figures in perspective, and also updates the sector market capitalization and profit weights. Table 2S&P 500 Earnings Analysis Beware Profit Recession Beware Profit Recession In sum, the SPX profit growth backdrop remains anemic and absent a pickup in growth momentum the risk/reward tradeoff is skewed to the down side. On a cyclical 3-12 month time horizon we remain cautious on the broad equity market. This is U.S. Equity Strategy’s view, which stands in contrast to the more sanguine equity BCA House View. This week we are making a subsurface change in an early-cyclical subgroup, and trimming a highly cyclical tech subindex. Put Consumer Discretionary Stocks On Upgrade Alert, And… Consumer discretionary stocks have marked time over the past year. But, now that the Fed is ready to ease monetary policy it will no longer pay to be bearish (Chart 10). This early-cyclical sector benefits the most from lower interest rates, and vice versa. Thus, we are putting this sector on our upgrade watch list and removing it from our high-conviction underweight list. We anticipate to execute this upgrade in coming weeks via boosting the S&P internet retail index to overweight. This subgroup is already on upgrade alert. Before triggering these upgrades, however, today we recommend a subsurface consumer discretionary move. Chart 10Lower Interest Rate Beneficiary Lower Interest Rate Beneficiary Lower Interest Rate Beneficiary …Lift The Home Improvement Retailers To Neutral We are compelled to upgrade the S&P HIR index to a benchmark allocation and remove it from our high-conviction underweight list for a small relative loss. Similar to the parent GICS1 sector, HIR stocks are inversely correlated with interest rates (fed funds rate discounter shown inverted, middle panel, Chart 11), given the close residential real estate market links they enjoy (top panel, Chart 12). Now that the bond market forecasts that the Fed will cut rates four times by next July, home improvement retailers should be cheering this news. Chart 11Two Profit Boosters Two Profit Boosters Two Profit Boosters Chart 12Resilient Pricing Power Resilient Pricing Power Resilient Pricing Power Jumping lumber prices should be a boon to HIR same-store sales. Recent steep production curtailments in lumber yards have been a tonic to prices that have rebounded $100/tbf in a little over a month. Keep in mind, that building materials & construction supplies stores make a set margin on lumber sales and thus higher selling prices translate straight into higher profits; the opposite is also true (bottom panel, Chart 11). Home improvement retailers have been flexing their pricing power muscles recently and this represents another boost to their top line growth prospects (middle panel, Chart 12). While the recent tariff rate increase related input cost inflation has yet to hit the industry’s bottom line, it remains to be seen if HIR margins will take a hit or retailers will pass it on through further price hikes. Importantly, industry labor restraint is a welcome offset and has been a profit booster as measured by our expanding productivity gauge (bottom panel, Chart 12). Our HIR model captures all these positive forces and has likely put in a durable trough recently, signaling that a brightening backdrop looms for the S&P HIR index (Chart 13). Chart 13Model Says It No Longer Pays To Be Bearish Model Says It No Longer Pays To Be Bearish Model Says It No Longer Pays To Be Bearish But prior to getting carried away up the bullish lane, these Big Box retailers have to contend with some key headwinds, and prevent us from boosting exposure to an above benchmark allocation. Residential fixed investment has been contracting for five consecutive quarters and remains a far cry from the 2006 peak as a share of output (Chart 14). Similarly, existing home sales, a key HIR demand driver, have softened recently at a time when home inventories have jumped (inventories shown inverted, top panel, Chart 15).  Chart 14But, Some Headwinds… But, Some Headwinds… But, Some Headwinds… Chart 15…Persist …Persist …Persist As a result, remodeling activity has taken a backseat, at the margin, weighing on industry same-store sales growth (bottom panel, Chart 15). Home owners have avoided dipping into their currently rebuilt home equity to undertake renovation projects. Until the reflationary wave of lower mortgage rates rekindles single family home sales and thus remodeling activity, only a neutral weighting is warranted in the S&P HIR index. All of this has led to a sustained deterioration in HIR operating metrics with the sales-to-inventories ratio contracting at an accelerating pace. The implication is that before long, home improvement retailers may have to resort to margin-denting price concessions to clear the inventory overhang (middle panel, Chart 15). Netting it all out, rising lumber prices, melting interest rates and profit-augmenting industry productivity gains all signal that it no longer pays to be bearish the S&P HIR index.   Bottom Line: Lift the S&P HIR index to neutral and remove from the high-conviction underweight list for a relative loss of 5.9% since inception. The ticker symbols for the stocks in this index are: BLBG – S5HOMI – HD, LOW. Downgrade Semi Equipment To Underweight     While the post G-20 trade related entente should have boosted semi equipment stocks that garner a large slice of their revenues in China, relative share prices are below Friday’s June 28 close. A tactical trading opportunity has re-emerged, and today we recommend trimming the S&P semi equipment index to underweight on a three-to-six month time horizon, but with a tight stop at the -7% relative return mark.  But before proceeding with our analysis, a brief recap of the recent history of our moves in this hyper-cyclical tech sub-index is in order. In late-November 2017 we recommended a high-conviction underweight position in the S&P semi equipment index at the height of the bitcoin fever.2 In mid-December 2018 we swung for the fences and upgraded this niche semi index to overweight as the street had finally capitulated and became extremely bearish on semi equipment stocks.3 Finally in early-March 2019 we booked handsome profits in this trade and moved to the sidelines (vertical lines denote recommendation changes, Chart 16).4 Semi equipment stocks are capital intensive, require precision manufacturing and their sales cycle is a carbon copy of the broad manufacturing cycle. The middle panel of Chart 17 shows this tight positive correlation with the ISM manufacturing index and sends a grim message for semi equipment manufacturers. Chart 16Time To Fade Semi Equipment Stocks Time To Fade Semi Equipment Stocks Time To Fade Semi Equipment Stocks Chart 17Chip Equipment Equities Follow The Manufacturing Cycle Chip Equipment Equities Follow The Manufacturing Cycle Chip Equipment Equities Follow The Manufacturing Cycle Global trade and manufacturing continue to contract and, specifically, the EM manufacturing PMI is below the 50 boom/bust line (second panel, Chart 18). Tack on elevated policy uncertainty, and the implication is that investors should sell semi equipment stock strength (top panel, Chart 18). Growth-sensitive financial variables also signal a challenging backdrop for relative share prices. Not only are emerging market stocks trailing their global peers year-to-date, but EM Asian currencies are also exerting downward pull on the relative share price ratio (third & bottom panels, Chart 18). Finally, with regard to industry operating metrics, the news is equally glum. Global semi cycles typically last four-to-five quarters and we only just passed the half way mark. Thus, there is more downside to industry sales momentum and we would lean against recent analyst relative revenue euphoria (middle panel, Chart 19). Asian DRAM prices are deflating, and this semi equipment industry pricing power proxy emits a similarly weak signal for top line growth (bottom panel, Chart 19). Chart 18Financial Variables Say Sell Financial Variables Say Sell Financial Variables Say Sell Chart 19Lean Against Recovering Top Line Growth Estimates Lean Against Recovering Top Line Growth Estimates Lean Against Recovering Top Line Growth Estimates Summing it all up, poor revenue growth prospects, the ongoing global manufacturing contraction and downbeat financial variables all indicate that semi equipment stocks have ample downside. Bottom Line: Downgrade the S&P semiconductor equipment index to underweight on a tactical basis (three-to-six month horizon), but set a tight stop at the -7% relative return mark. The ticker symbols for the stocks in this index are: BLBG – S5SEEQ– AMAT, LRCX, KLAC.   Anastasios Avgeriou, U.S. Equity Strategist anastasios@bcaresearch.com   Footnotes: 1      Please see BCA U.S. Equity Strategy Report, “SPX 3,000?” dated July 10, 2017, available at uses.bcaresearch.com. 2      Please see BCA U.S. Equity Strategy Weekly Report, “2018 High-Conviction Calls” dated November 27, 2017, available at uses.bcaresearch.com. 3      Please see BCA U.S. Equity Strategy Weekly Report, “Signal Vs. Noise” dated December 17, 2018, available at uses.bcaresearch.com. 4      Please see BCA U.S. Equity Strategy Weekly Report, “The Good, The Bad And The Ugly” dated March 4, 2019, available at uses.bcaresearch.com. Current Recommendations Current Trades Size And Style Views Favor value over growth Favor large over small caps

Productivity growth is experiencing a cyclical rebound, but remains structurally weak. The end of the deepening of globalization, statistical hurdles, and the possibility that today’s technological advances may not be as revolutionary as past ones all hamper productivity. On the back of rising market power and concentration, companies are increasing markups instead of production. This is depressing productivity and lowering the neutral rate of interest. For now, investors can generate alpha by focusing on consolidating industries. Growing market power cannot last forever and will meet a political wall. Structurally, this will hurt asset prices.   “We don’t have a free market; don’t kid yourself. (…) Businesspeople are enemies of free markets, not friends (…) businesspeople are all in favor of freedom for everybody else (…) but when it comes to their own business, they want to go to Washington to protect their businesses.” Milton Friedman, January 1991. Despite the explosion of applications of growing computing power, U.S. productivity growth has been lacking this cycle. This incapacity to do more with less has weighed on trend growth and on the neutral rate of interest, and has been a powerful force behind the low level of yields at home and abroad. In this report, we look at the different factors and theories advanced to explain the structural decline in productivity. Among them, a steady increase in corporate market power not only goes a long way in explaining the lack of productivity in the U.S., but also the high level of profit margins along with the depressed level of investment and real neutral rates. A Simple Cyclical Explanation The decline in productivity growth is both a structural and cyclical story. Historically, productivity growth has followed economic activity. When demand is strong, businesses can generate more revenue and therefore produce more. The historical correlation between U.S. nonfarm business productivity and the ISM manufacturing index illustrates this relationship (Chart II-1). Chart II-1The Cyclical Behavior Of Productivity The Cyclical Behavior Of Productivity The Cyclical Behavior Of Productivity Chart II-2Deleveraging Hurts Productivity Deleveraging Hurts Productivity Deleveraging Hurts Productivity Since 2008, as households worked off their previous over-indebtedness, the U.S. private sector has experienced its longest deleveraging period since the Great Depression. This frugality has depressed demand and contributed to lower growth this cycle. Since productivity is measured as output generated by unit of input, weak demand growth has depressed productivity statistics. On this dimension, the brief deleveraging experience of the early 1990s is instructive: productivity picked up only after 1993, once the private sector began to accumulate debt faster than the pace of GDP growth (Chart II-2). The recent pick-up in productivity reflects these debt dynamics. Since 2009, the U.S. non-financial private sector has stopped deleveraging, removing one anchor on demand, allowing productivity to blossom. Moreover, the pick-up in capex from 2017 to present is also helping productivity by raising the capital-to-workers ratio. While this is a positive development for the U.S. economy, the decline in productivity nonetheless seems structural, as the five-year moving average of labor productivity growth remains near its early 1980s nadir (Chart II-3). Something else is at play. Chart II-3 The Usual Suspects Three major forces are often used to explain why observed productivity growth is currently in decline: A slowdown in global trade penetration, the fact that statisticians do not have a good grasp on productivity growth in a service-based economy, and innovation that simply isn’t what it used to be. Slowdown In Global Trade Penetration Two hundred years ago, David Ricardo argued that due to competitive advantages, countries should always engage in trade to increase their economic welfare. This insight has laid the foundation of the argument that exchanges between nations maximizes the utilization of resources domestically and around the world. The collapse in new business formation in the U.S. is another fascinating development. Rarely was this argument more relevant than over the past 40 years. On the heels of the supply-side revolution of the early 1980s and the fall of the Berlin Wall, globalization took off. The share of the world's population participating in the global capitalist system rose from 30% in 1985 to nearly 100% today. Generating elevated productivity gains is simpler when a country’s capital stock is underdeveloped: each unit of investment grows the capital-to-labor ratio by a greater proportion. As a result, productivity – which reflects the capital-to-worker ratio – can grow quickly. As more poor countries have joined the global economy and benefitted from FDI and other capital inflows, their productivity has flourished. Consequently, even if productivity growth has been poor in advanced economies over the past 10 years, global productivity has remained high and has tracked the share of exports in global GDP (Chart II-4). Chart II-4The Apex Of Globalization Represented The Summit Of Global Productivity Growth The Apex Of Globalization Represented The Summit Of Global Productivity Growth The Apex Of Globalization Represented The Summit Of Global Productivity Growth This globalization tailwind to global productivity growth is dissipating. First, following an investment boom where poor decisions were made, EM productivity growth has been declining. Second, with nearly 100% of the world’s labor supply already participating in the global economy, it is increasingly difficult to expand the share of global trade in global GDP and increase the benefit of cross-border specialization. Finally, the popular backlash in advanced economies against globalization could force global trade into reverse. As economic nationalism takes hold, cross-border investments could decline, moving the world economy further away from an optimal allocation of capital. These forces may explain why global productivity peaked earlier this decade. Productivity Is Mismeasured Recently deceased luminary Martin Feldstein argued that the structural decline in productivity is an illusion. As the argument goes, productivity is not weak; it is only underestimated. A parallel with the introduction of electricity in the late 19th century often comes to mind. Back then, U.S. statistical agencies found it difficult to disentangle price changes from quantity changes in the quickly growing revenues of electrical utilities. As a result, the Bureau Of Labor Statistics overestimated price changes in the early 20th century, which depressed the estimated output growth of utilities by a similar factor. Since productivity is measured as output per unit of labor, this also understated actual productivity growth – not just for utilities but for the economy as a whole. Ultimately, overall productivity growth was revised upward. Chart II-5Plenty Of Room To Mismeasure Real Output Growth Plenty Of Room To Mismeasure Real Output Growth Plenty Of Room To Mismeasure Real Output Growth In today’s economy, this could be a larger problem, as 70% of output is generated in the service sector. Estimating productivity growth is much harder in the service sector than in the manufacturing sector, as there is no actual countable output to measure. Thus, distinguishing price increases from quantity or quality improvements is challenging. Adding to this difficulty, the service sector is one of the main beneficiaries of the increase in computational power currently disrupting industries around the world. The growing share of components of the consumer price index subject to hedonic adjustments highlight this challenge (Chart II-5). Estimating quality changes is hard and may bias the increase in prices in the economy. If prices are unreliably measured, so will output and productivity. Pushing The Production Frontier Is Increasingly Hard Chart II-6A Multifaceted Decline In Productivity A Multifaceted Decline In Productivity A Multifaceted Decline In Productivity Another school of thought simply accepts that productivity growth has declined in a structural fashion. It is far from clear that the current technological revolution is much more productivity-enhancing than the introduction of electricity 140 years ago, the development of the internal combustion engine in the late 19th century, the adoption of indoor plumbing, or the discovery of penicillin in 1928. It is easy to overestimate the economic impact of new technologies. At first, like their predecessors, the microprocessor and the internet created entirely new industries. But this is not the case anymore. For all its virtues, e-commerce is only a new method of selling goods and services. Cloud computing is mainly a way to outsource hardware spending. Social media’s main economic value has been to gather more information on consumers, allowing sellers to reach potential buyers in a more targeted way. Without creating entirely new industries, spending on new technologies often ends up cannibalizing spending on older technologies. For example, while Google captures 32.4% of global ad revenues, similar revenues for the print industry have fallen by 70% since their apex in 2000. If new technologies are not as accretive to production as the introduction of previous ones were, productivity growth remains constrained by the same old economic forces of capex, human capital growth and resource utilization. And as Chart II-6 shows, labor input, the utilization of capital and multifactor productivity have all weakened. Some key drivers help understand why productivity growth has downshifted structurally. Let’s look at human capital. It is much easier to grow human capital when very few people have a high-school diploma: just make a larger share of your population finish high school, or even better, complete a university degree. But once the share of university-educated citizens has risen, building human capital further becomes increasingly difficult. Chart II-7 illustrates this problem. Growth in educational achievement has been slowing since 1995 in both advanced and developing economies. This means that the growth of human capital is slowing. This is without even wading into whether or not the quality of education has remained constant. This is pure market power, and it helps explain the gap between wages and productivity. Human capital is also negatively impacted by demographic trends. Workers in their forties tend to be at the peak of their careers, with the highest accumulated job know-how. Problematically, these workers represent a shrinking share of the labor force, which is hurting productivity trends (Chart II-8). Chart II-7 Chart II-8Demographics Are Hurting Productivity Demographics Are Hurting Productivity Demographics Are Hurting Productivity   The capital stock too is experiencing its own headwinds. While Moore’s Law seems more or less intact, the decline in the cost of storing information is clearly decelerating (Chart II-9). Today, quality adjusted IT prices are contracting at a pace of 2.3% per annum, compared to annual declines of 14% at the turn of the millennium. Thus, even if nominal spending in IT investment had remained constant, real investment growth would have sharply decelerated (Chart II-10). But since nominal spending has decelerated greatly from its late 1990s pace, real investment in IT has fallen substantially. The growth of the capital stock is therefore lagging its previous pace, which is hurting productivity growth. Chart II-9 Chart II-10The Impact Of Slowing IT Deflation The Impact Of Slowing IT Deflation The Impact Of Slowing IT Deflation Chart II-11A Dearth Of New Businesses A Dearth Of New Businesses A Dearth Of New Businesses   The collapse in new business formation in the U.S. is another fascinating development (Chart II-11). New businesses are a large source of productivity gains. Ultimately, 20% of productivity gains have come from small businesses becoming large ones. Think Apple in 1977 versus Apple today. A large decline in the pace of new business formation suggests that fewer seeds have been planted over the past 20 years to generate those enormous productivity explosions than was the case in the previous 50 years.   The X Factor: Growing Market Concentration The three aforementioned explanations for the decline in productivity are all appealing, but they generally leave investors looking for more. Why are companies investing less, especially when profit margins are near record highs? Why is inflation low? Why has the pace of new business formation collapsed? These are all somewhat paradoxical. Chart II-12Wide Profit Margins: A Testament To The Weakness Of Labor Wide Profit Margins: A Testament To The Weakness Of Labor Wide Profit Margins: A Testament To The Weakness Of Labor This is where a growing body of works comes in. Our economy is moving away from the Adam Smith idea of perfect competition. Industry concentration has progressively risen, and few companies dominate their line of business and control both their selling prices and input costs. They behave as monopolies and monopsonies, all at once.1 This helps explain why selling prices have been able to rise relative to unit labor costs, raising margins in the process (Chart II-12). Let’s start by looking at the concept of market concentration. According to Grullon, Larkin and Michaely, sales of the median publicly traded firms, expressed in constant dollars, have nearly tripled since the mid-1990s, while real GDP has only increased 70% (Chart II-13).2 The escalation in market concentration is also vividly demonstrated in Chart II-14. The top panel shows that since 1997, most U.S. industries have experienced sharp increases in their Herfindahl-Hirshman Index (HHI),3 a measure of concentration. In fact, more than half of U.S. industries have experienced concentration increases of more than 40%, and as a corollary, more than 75% of industries have seen the number of firms decline by more than 40%. The last panel of the chart also highlights that this increase in concentration has been top-heavy, with a third of industries seeing the market share of their four biggest players rise by more than 40%. Rising market concentration is therefore a broad phenomenon – not one unique to the tech sector. Chart II-13 Chart II-14     This rising market concentration has also happened on the employment front. In 1995, less than 24% of U.S. private sector employees worked for firms with 10,000 or more employees, versus nearly 28% today. This does not seem particularly dramatic. However, at the local level, the number of regions where employment is concentrated with one or two large employers has risen. Azar, Marinescu and Steinbaum developed Map II-1, which shows that 75% of non-metropolitan areas now have high or extreme levels of employment concentration.4 Chart II- Chart II-15The Owners Of Capital Are Keeping The Proceeds Of The Meagre Productivity Gains The Owners Of Capital Are Keeping The Proceeds Of The Meagre Productivity Gains The Owners Of Capital Are Keeping The Proceeds Of The Meagre Productivity Gains This growing market power of companies on employment can have a large impact on wages. Chart II-15 shows that real wages have lagged productivity since the turn of the millennium. Meanwhile, Chart II-16 plots real wages on the y-axis versus the HHI of applications (top panel) and vacancies (bottom panel). This chart shows that for any given industry, if applicants in a geographical area do not have many options where to apply – i.e. a few dominant employers provide most of the jobs in the region – real wages lag the national average. The more concentrated vacancies as well as applications are with one employer, the greater the discount to national wages in that industry.5 This is pure market power, and it helps explain the gap between wages and productivity as well as the widening gap between metropolitan and non-metropolitan household incomes. Chart II-16 Growing market power and concentration do not only compress labor costs, they also result in higher prices for consumers. This seems paradoxical in a world of low inflation. But inflation could have been even lower if market concentration had remained at pre-2000s levels. In 2009, Matthew Weinberg showed that over the previous 22 years, horizontal mergers within an industry resulted in higher prices.6 In a 2014 meta-study conducted by Weinberg along with Orley Ashenfelter and Daniel Hosken, the authors showed that across 49 studies ranging across 21 industries, 36 showed that horizontal mergers resulted in higher prices for consumers.7 While today’s technology may be enhancing the productive potential of our economies, this is not benefiting output and measured productivity. Instead, it is boosting profit margins. In a low-inflation environment, the only way for companies to garner pricing power is to decrease competition, and M&As are the quickest way to achieve this goal. After examining nearly 50 merger and antitrust studies spanning more than 3,000 merger cases, John Kwoka found that, following mergers that augmented an industry’s concentration, prices increased in 95% of cases, and on average by 4.5%.8 In no industry is this effect more vividly demonstrated than in the healthcare field, an industry that has undergone a massive wave of consolidation – from hospitals, to pharmacies to drug manufacturers. As Chart II-17 illustrates, between 1980 and 2016, healthcare costs have increased at a much faster pace in the U.S. than in the rest of the world. However, life expectancy increased much less than in other advanced economies. Chart II-17 In this context of growing market concentration, it is easy to see why, as De Loecker and Eeckhout have argued, markups have been rising steadily since the 1980s (Chart II-18, top panel) and have tracked M&A activity (Chart II-18, bottom panel).9 In essence, mergers and acquisitions have been the main tool used by firms to increase their concentration. Another tool at their disposal has been the increase in patents. The top panel of Chart II-19 shows that the total number of patent applications in the U.S. has increased by 3.6-fold since the 1980s, but most interestingly, the share of patents coming from large, dominant players within each industry has risen by 10% over the same timeframe (Chart II-19, bottom panel). To use Warren Buffet’s terminology, M&A and patents have been how firms build large “moats” to limit competition and protect their businesses. Chart II-18Markups Rise Along With Growing M&A Activity Markups Rise Along With Growing M&A Activity Markups Rise Along With Growing M&A Activity Chart II-19How To Build A Moat? How To Build A Moat? How To Build A Moat?   Why is this rise in market concentration affecting productivity? First, from an empirical perspective, rising markups and concentration tend to lead to lower levels of capex. A recent IMF study shows that the more concentrated industries become, the higher the corporate savings rate goes (Chart II-20, top panel).10 These elevated savings reflect wider markups, but also firms with markups in the top decile of the distribution display significantly lower investment rates (Chart II-20, bottom panel). If more of the U.S. output is generated by larger, more concentrated firms, this leads to a lower pace of increase in the capital stock, which hurts productivity. Second, downward pressure on real wages is also linked to a drag on productivity. Monopolies and oligopolies are not incentivized to maximize output. In fact, for any market, a monopoly should lead to lower production than perfect competition would. Diagram II-I from De Loecker and Eeckhout shows that moving from perfect competition to a monopoly results in a steeper labor demand curve as the monopolist produces less. As a result, real wages move downward and the labor participation force declines. Does this sound familiar? Chart II-20 Chart II-   The rise of market power might mean that in some way Martin Feldstein was right about productivity being mismeasured – just not the way he anticipated. In a June 2017 Bank Credit Analyst Special Report, Peter Berezin showed that labor-saving technologies like AI and robotics, which are increasingly being deployed today, could lead to lower wages (Chart II-21).11 For a given level of technology in the economy, productivity is positively linked to real wages but inversely linked to markups – especially if the technology is of the labor-saving kind. So, if markups rise on the back of firms’ growing market power, the ensuing labor savings will not be used to increase actual input. Rather, corporate savings will rise. Thus, while today’s technology may be enhancing the productive potential of our economies, this is not benefiting output and measured productivity. Instead, it is boosting profit margins.12 Unsurprisingly, return on assets and market concentration are positively correlated (Chart II-22). Chart II-21 Chart II-22     Finally, market power and concentration weighing on capex, wages and productivity are fully consistent with higher returns of cash to shareholders and lower interest rates. The higher profits and lower capex liberate cash flows available to be redistributed to shareholders. Moreover, lower capex also depresses demand for savings in the economy, while weak wages depress middle-class incomes, which hurts aggregate demand. Additionally, higher corporate savings increases the wealth of the richest households, who have a high marginal propensity to save. This results in higher savings for the economy. With a greater supply of savings and lower demand for those savings, the neutral rate of interest has been depressed. Investment Implications First, in an environment of low inflation, investors should continue to favor businesses that can generate higher markups via pricing power. Equity investors should therefore continue to prefer industries where horizontal mergers are still increasing market concentration. Second, so long as the status quo continues, wages will have a natural cap, and so will the neutral rate of interest. This does not mean that wage growth cannot increase further on a cyclical basis, but it means that wages are unlikely to blossom as they did in the late 1960s, even within a very tight labor market. Without too-severe an inflation push from wages, the business cycle could remain intact even longer, keeping a window open for risk assets to rise further on a cyclical basis. Third, long-term investors need to keep a keen eye on the political sphere. A much more laissez-faire approach to regulation, a push toward self-regulation, and a much laxer enforcement of antitrust laws and merger rules were behind the rise in market power and concentration.13 The particularly sharp ascent of populism in Anglo-Saxon economies, where market power increased by the greatest extent, is not surprising. So far, populists have not blamed the corporate sector, but if the recent antitrust noise toward the Silicon Valley behemoths is any indication, the clock is ticking. On a structural basis, this could be very negative for asset prices. An end to this rise in market power would force profit margins to mean-revert toward their long-term trend, which is 4.7 percentage-points below current levels. This will require discounting much lower cash flows in the future. Additionally, by raising wages and capex, more competition would increase aggregate demand and lift real interest rates. Higher wages and aggregate demand could also structurally lift inflation. Thus, not only will investors need to discount lower cash flows, they will have to do so at higher discount rates. As a result, this cycle will likely witness both a generational peak in equity valuations as well as structural lows in bond yields. As we mentioned, these changes are political in nature. We will look forward to studying the political angle of this thesis to get a better handle on when these turning points will likely emerge. Mathieu Savary Vice President The Bank Credit Analyst   Footnotes 1       A monopsony is a firm that controls the price of its input because it is the dominant, if not unique, buyer of said input. 2       G. Grullon, Y. Larkin and R. Michaely, “Are Us Industries Becoming More Concentrated?,” April 2017. 3       The Herfindahl-Hirschman Index (HHI) is calculated by taking the market share of each firm in the industry, squaring them, and summing the result. Consider a hypothetical industry with four total firm where firm1, firm2, firm3 and firm4 has 40%, 30%, 15% and 15% of market share, respectively. Then HHI is 402+302+152+152 = 2,950. 4       J. Azar, I. Marinescu, M. Steinbaum, “Labor Market Concentration,” December 2017. 5     J. Azar, I. Marinescu, M. Steinbaum, “Labor Market Concentration,” December 2017. 6     M. Weinberg, “The Price Effects Of Horizontal Mergers”, Journal of Competition Law & Economics, Volume 4, Issue 2, June 2008, Pages 433–447. 7     O. Ashenfelter, D. Hosken, M. Weinberg, "Did Robert Bork Understate the Competitive Impact of Mergers? Evidence from Consummated Mergers," Journal of Law and Economics, University of Chicago Press, vol. 57(S3), pages S67 - S100. 8    J. Kwoka, “Mergers, Merger Control, and Remedies: A Retrospective Analysis of U.S. Policy,” MIT Press, 2015. 9     J. De Loecker, J. Eeckhout, G. Unger, "The Rise Of Market Power And The Macroeconomic Implications," Mimeo 2018. 10     “Chapter 2: The Rise of Corporate Market Power and Its Macroeconomic Effects,” World Economic Outlook, April 2019. 11     Please see The Bank Credit Analyst Special Report "Is Slow Productivity Growth Good Or Bad For Bonds?"dated May 31, 2017, available at bca.bcaresearch.com. 12     Productivity can be written as: Image 13     J. Tepper, D. Hearn, “The Myth of Capitalism: Monopolies and the Death of Competition,” Wiley, November 2018.