Technology

As the SPX and a slew of other indices have vaulted to fresh all-time highs, a deeper dive into profit margins is in order. While the S&P 500's profit margins are benefiting from the one-time fillip of lower corporate taxes in calendar 2018, it is important to remember that this is not affected by any massaging from CEOs/CFOs of the share count. In other words, given that "per share" cancel out of EPS/SPS, this margin number represents organic profit and revenue growth. The chart shows that SPX margins have recently slingshot to all-time highs. However, excluding tech they remain below the previous cycle's peak hit in mid-2007. While we are not fans of excluding sectors from our analysis, the magnitude and persistence of the tech sector's profit margin expansion is surprising. Tech sector profit margins are twice the SPX's margins, and tech stocks have been pulling SPX margins higher consistently for the past 8 years. The implication is that SPX EPS growth of 10% is likely in 2019, but the tech sector has to continue doing all the heavy lifting given the high profit and market cap weight in the SPX. Bottom Line: We remain neutral the broad tech sector and prefer the S&P software and S&P tech hardware, storage & peripherals indexes (both are high-conviction overweights) to the early cyclical tech indexes, S&P semis and S&P semi equipment subgroups (both are underweight). For additional details, please look forward to reading in this coming Tuesday's Weekly Report. Off To The Races Off To The Races

Highlights Globalization, technological progress, weak trade unions, high debt levels, and population aging are often cited as reasons for why inflation will remain dormant. None of these reasons are inherently deflationary, and in some contexts, they may actually turn out to be quite inflationary. The combination of a stronger dollar and rising EM stress means that U.S. Treasury yields are more likely to fall than rise during the coming months. Over the long haul, however, bond yields are going higher - potentially much higher - as inflation surprises on the upside. Long-term bond investors should maintain below-benchmark exposure to duration risk in their portfolios. Gold offers some protection against rising inflation. That said, the yellow metal is still quite expensive in real terms, which limits its appeal. Investors would be better off simply buying inflation-protected securities such as TIPS. Historically, stocks have not performed well in inflationary environments. A neutral allocation to global equities is appropriate at this juncture. Feature Will Structural Forces Limit Inflation? In Part 1 of this report, we argued that inflation could surprise materially on the upside over the coming years due to the growing conviction among policymakers that: The neutral real rate of interest is extremely low; The natural rate of unemployment has fallen significantly over time; There is an exploitable trade-off between higher inflation and lower unemployment; The presence of the zero lower-bound on nominal short-term interest rates implies that it is better to be too late than too early in tightening monetary policy. A common refrain in response to these arguments is that the structural features of today's economy are so deflationary that policymakers simply would be not able to lift inflation even if they wanted to. Four features are often cited: 1) globalization; 2) modern technologies such as automation and e-commerce; 3) the declining influence of trade unions; and 4) population aging, high debt levels, and other contributors to "secular stagnation." In this week's report, we discuss all four features in turn. In every case, we conclude that the purported deflationary forces are not nearly as strong as most observers believe. Inflation And Globalization Imagine two closed economies, identical in every way other than the fact the one economy is larger than the other. Would one expect inflation to be structurally higher in the smaller economy? Most people would probably say no. After all, if one economy has more workers and capital than another economy, it will be able to generate more output. But all those additional workers will also want to spend more, so it is not immediately obvious why inflation should differ in the two regions. Now let us change the terminology a bit. Suppose the larger economy refers to the world as a whole. What would happen to the balance between aggregate demand and supply if we were to shift from a setting where countries do not trade with one another to a globalized world where they do? As the initial example suggests, to a first approximation, the answer is nothing. Since one country's exports are another's imports, globally, net exports will always be zero. Thus, it stands to reason that simply moving from autarky to free trade will not, in itself, boost global aggregate demand. Could a move towards free trade increase aggregate supply? Yes. Global production will rise if countries can specialize in the production of goods in which they have a comparative advantage. Productivity will also benefit from the fact that a large global market will allow companies to better exploit economies of scale by spreading their fixed costs over a greater quantity of output. But here's the catch: More production also means more income, and more income means more spending. Thus, if globalization increases aggregate supply, it will also increase aggregate demand. And if both aggregate demand and aggregate supply increase by the same amount, there is no reason to think that inflation will change. Granted, it is possible that desired demand will rise more slowly than supply in response to increasing globalization, putting downward pressure on inflation and interest rates in the process. This could be the case, for example, if globalization increases the share of income going towards rich people. As Chart 1 shows, rich people tend to save more than poor people. Chart 1Savings Heavily Skewed Towards Top Earners Savings Heavily Skewed Towards Top Earners Savings Heavily Skewed Towards Top Earners If globalization has increased income inequality, it is possible that this has had a deflationary effect. However, for this effect to persist, the world has to become even more globalized. This does not seem to be happening. Global trade has been flat as a share of GDP for over a decade (Chart 2). The share of U.S. national income flowing to workers has also been rising in recent years as the labor market has tightened (Chart 3). Chart 2Global Trade Has Peaked Global Trade Has Peaked Global Trade Has Peaked Chart 3Rising Labor Share Of Income Occurring ##br##Alongside Labor Market Tightening Rising Labor Share Of Income Occurring Alongside Labor Market Tightening Rising Labor Share Of Income Occurring Alongside Labor Market Tightening Globalization As An Inflationary Safety Valve The discussion above suggests that the often-heard argument that globalization is deflationary because it leads to an overabundance of production is not as straightforward as it seems. What about the argument that globalization is deflationary because it limits the ability of companies to raise prices? While this is a seemingly compelling argument, it runs square into the problem that profit margins are near record-high levels in many economies. Far from making companies more price-conscious, globalization has often created oligopolistic market structures. Granted, free trade can still provide a safety valve for countries suffering from excess demand. To see this, return to our earlier example of the large country versus the small country. Suppose that because of its well-diversified economy, the large country often encounters situations where one region is booming, while another is down in the dumps. When this happens, workers and capital will tend to flow to the thriving region, alleviating any capacity pressures there. The same adjustments often occur among countries. If desired spending exceeds a country's productive capacity, it can run a trade deficit with the rest of the world. Rather than the prices of goods and services needing to rise, excess demand can be satiated with more imports. However, for that realignment in demand to occur, exchange rates must adjust. In today's context, this means that the dollar may need to strengthen further. Notice that this dynamic only works if there is slack abroad. This is presently the case, but there is no assurance that this will always be so. The implication is that inflation could rise meaningfully as global spare capacity is absorbed. Technology And Inflation If the price of electronic goods is any guide, it would seem undeniable that technological innovation is a deflationary force. However, this belief involves a fallacy of composition. Above-average productivity gains in one sector of the economy will cause prices in that sector to decline relative to other prices. But falling prices will also boost real incomes, leading to more spending. It is possible that prices elsewhere in the economy will rise by enough to offset the decline in prices in the sector experiencing above-average productivity gains, so that the overall price level remains unchanged. Ultimately, whether inflation rises or falls in response to faster productivity growth depends on what policymakers do. Over the long haul, productivity growth will lead to higher real wages. However, real wages can go up either because the price level declines or because nominal wages rise. The extent to which one or the other happens depends on the stance of monetary policy. In any case, just as in our discussion of globalization, the whole narrative about how faster productivity growth is deflationary seems rather antiquated considering that productivity growth has been quite weak in most of the world for over a decade (Chart 4). Consistent with this, the price deflator for electronic goods has been falling a lot less rapidly in recent years than it has in the past (Chart 5). Chart 4Globally, Productivity Growth Has Been ##br##Falling For Over A Decade Globally, Productivity Growth Has Been Falling For Over A Decade Globally, Productivity Growth Has Been Falling For Over A Decade Chart 5Steadier Prices For Computer Hardware ##br##And Software In Recent Years Steadier Prices For Computer Hardware And Software In Recent Years Steadier Prices For Computer Hardware And Software In Recent Years Admittedly, it is possible to imagine a scenario where the pace of productivity growth slows but the nature of that growth changes in a more deflationary direction. However, evidence that this has happened is fairly thin. Take the so-called Amazon effect, which purports to show sizable deflationary consequences from the spread of e-commerce. As my colleague Mark McClellan has shown, outside of department stores, profit margins in the retail sector are well above their historic average (Chart 6).1 This calls into doubt claims that online shopping has undermined corporate pricing power. Recent productivity growth in the U.S. distribution sector has actually been slower than in the 1990s, a decade which produced large productivity gains stemming from the displacement of "mom and pop" stores with "big box" retailers such as Walmart and Costco. The Waning Power Of Unions The declining influence of trade unions is also often cited as a reason for why inflation will remain subdued. There are a number of empirical and conceptual problems with this argument. Empirically, unionization rates in the U.S. peaked in the mid-1950s, more than a decade before inflation began to accelerate. While the unionization rate continued to decline in the U.S. during the 1980s and 1990s, it remained elevated in Canada. Yet, this did not prevent Canadian inflation from falling as rapidly as it did in the United States (Chart 7). The widespread use of inflation-linked wage contracts in the 1970s appears mainly to have been a consequence of rising inflation rather than the cause of it (Chart 8). Chart 6Retail Sector Profit Margins Are Strong Retail Sector Profit Margins Are Strong Retail Sector Profit Margins Are Strong Chart 7Inflation Fell In Canada, Despite A ##br##High Unionization Rate Inflation Fell In Canada, Despite A High Unionization Rate Inflation Fell In Canada, Despite A High Unionization Rate Chart 8Higher Inflation Led To More Inflation-Indexed ##br##Wage Contracts, Not The Other Way Around Higher Inflation Led To More Inflation-Indexed Wage Contracts, Not The Other Way Around Higher Inflation Led To More Inflation-Indexed Wage Contracts, Not The Other Way Around Conceptually, the argument that strong unions tend to instigate price-wage spirals is highly suspect. Yes, firms may be forced to raise wages in response to union pressures, which could prompt them to increase prices, leading to demands for even higher wages, etc. However, the price level cannot increase on a sustained basis independent of other things such as the level of the money supply. Central banks must still play a decisive role. One can imagine a scenario where the presence of powerful trade unions creates a dual labor market, one with well-paid unionized workers and another with poorly-paid non-unionized workers. Governments may be tempted to run the economy hot to prop up the wages of non-unionized workers. On the flipside, one could also imagine a scenario where the absence of strong unions exacerbates income inequality, causing governments to pursue more demand-boosting macroeconomic policies. In either case, however, the ultimate cause of rising inflation would still be macroeconomic policy. Inflation And The Neutral Rate As the discussion so far illustrates, inflation is unlikely to rise unless policymakers let it happen. But what if the neutral rate of interest is so low that policymakers lose traction over monetary policy? In that case, central banks may not be able to bring inflation up even if they wanted to. This is not just an academic question. Japan has had near-zero interest rates for over two decades and this has not been enough to spur inflation. Chart 9Long-Term Inflation Expectations In The Euro Area ##br##Are Still Much Higher Than In Japan Long-Term Inflation Expectations In The Euro Area Are Still Much Higher Than In Japan Long-Term Inflation Expectations In The Euro Area Are Still Much Higher Than In Japan We do not disagree with the notion that the neutral rate of interest is lower today than it was in the past. However, magnitudes are important here. In thinking about the secular stagnation thesis, which underpins the rationale for why the neutral rate has fallen, one should distinguish between the "weak" form and the "strong" form versions of the thesis. The weak form says that the neutral nominal rate of interest is low but positive, whereas the strong form says that the neutral nominal rate is negative.2 While this may seem like a minor distinction, it has important policy and market implications. Under the strong form version of the thesis, central banks really do lose control of their most effective policy tool: the ability to change interest rates to keep the economy on an even keel. By definition, if the neutral nominal rate is deeply negative, then even a policy rate of zero would mean that monetary policy is too tight. Under such circumstances, an economy could easily succumb to a vicious circle where insufficient demand causes inflation to fall, leading to higher real rates and even less spending. Such a vicious circle is less probable when the weak form version of the secular stagnation thesis dominates. As long as the neutral nominal rate is positive, central banks can always choose a policy rate that is low enough to allow the economy to grow at an above-trend pace. If they keep the policy rate below neutral for an extended period of time, the economy will eventually overheat, generating higher inflation. The fact that the U.S. unemployment rate has managed to fall during the past few years, even as the Fed has been raising rates, strongly suggests that the weak form of the secular stagnation thesis is applicable to the United States. The euro area is a much tougher call, given the region's poor demographics and high debt levels. Nevertheless, at least so far, the euro area has one thing on its side: Long-term inflation expectations are still much higher than they are in Japan (Chart 9). Whereas a neutral real rate of zero implies a nominal rate of 1.8% in the euro area, it implies a much lower nominal rate of 0.5% in Japan. The Neutral Rate Will Likely Move Higher As we argued a few weeks ago, cyclically, the neutral real rate of interest has risen in the U.S., and to a lesser extent, the rest of the world.3 This has happened because deleveraging headwinds have abated, fiscal policy has turned more stimulative, asset values have risen, and faster wage growth has put more money into workers' pockets. Structurally, the neutral rate may also begin to creep higher as some of the very same long-term forces that have depressed the neutral rate in the past begin to push it up in the future. Demographics is a good example. For several decades, slower population growth has reduced the incentive for firms to expand capacity. Diminished investment spending has suppressed aggregate demand, leading to lower inflation. Population aging also pushed more people into their prime saving years - ages 30 to 50. By definition, more savings mean less spending. However, now that baby boomers are starting to retire en masse, they are moving from being savers to dissavers. Chart 10 shows that the "world support ratio" - effectively, the ratio of workers-to-consumers - has begun to fall for the first time in 40 years. As more people stop working, aggregate global savings will decline. The shortage of savings will put upward pressure on the neutral rate. Japan has been on the leading edge of this demographic transformation. The unemployment rate has fallen to a mere 2.4%, while the ratio of job openings-to-applicants has reached a 45-year high (Chart 11). The shackles that have kept Japan immersed in deflation for over two decades may be starting to break. Chart 10The Ratio Of Workers-To-Consumers Is Now Falling The Ratio Of Workers-To-Consumers Is Now Falling The Ratio Of Workers-To-Consumers Is Now Falling Chart 11Japan: Labor Market Tightening May Spur Inflation Japan: Labor Market Tightening May Spur Inflation Japan: Labor Market Tightening May Spur Inflation Debt Deflation Or Debt Inflation? The distinction between the weak form of secular stagnation and the strong form is critical for thinking about debt issues. Rising debt tends to boost spending, but when debt reaches very high levels, spending normally suffers as borrowers concentrate on paying back loans. As such, high indebtedness generally implies a lower neutral real rate of interest. There is an important caveat, however. The presence of a lot of debt in the financial system also creates an incentive for policymakers to boost inflation in order to erode the real value of that debt. This is particularly the case when governments are the main borrowers. When the strong form version of secular stagnation prevails, generating inflation is difficult, if not impossible. In such a setting, debt deflation becomes the main concern. In contrast, when the weak form version of secular stagnation prevails, higher inflation is achievable. Debt inflation becomes an increasingly likely outcome. If we are in a period where countries such as Japan are transitioning from a strong form of secular stagnation to a weak form, inflation could begin to move rapidly higher. We are positioned for this by being short 20-year versus 5-years JGBs. Inflation As A Political Choice There is a school of thought that argues that high inflation in the 1970s and early 80s was an aberration; that the natural state of capitalism is deflation rather than inflation. We reject this view. The natural state of capitalism is ever-increasing output. Whether prices happen to rise or fall along the way depends on the choice of monetary regime. This is a political decision, not an economic one. Regimes based on the gold standard tend to have a deflationary bias, whereas regimes based on fiat money tend to have an inflationary one. The introduction of universal suffrage in the first few decades of the twentieth century made inflation politically more palatable than deflation (Chart 12). There is little mystery as to why that was the case. In every society, wealth is unevenly distributed. Creditors tend to be rich while debtors tend to be poor. Unexpected inflation hurts the former, but benefits the latter. Chart 12Universal Suffrage Made Inflation Politically ##br##More Palatable Than Deflation Universal Suffrage Made Inflation Politically More Palatable Than Deflation Universal Suffrage Made Inflation Politically More Palatable Than Deflation Once universal suffrage was introduced, a poor farmer did not need to worry quite as much about losing his land to the bank, since he could now vote for someone who would ensure that crop prices increased rather than decreased. In William Jennings Bryan's colorful words, the rich and powerful "shall no longer crucify mankind on a cross of gold." Today, populism is on the rise. Trumpist Republicans have clobbered mainstream Republicans in one primary election after another. The democrats are also shifting to the left, as the ousting of ten-term incumbent Joe Crowley by the firebrand socialist candidate Alexandria Ocasio-Cortez in June illustrates. And the U.S. is not alone. Italy now has an avowedly populist government. Other European nations may not be far behind. Meanwhile, a growing chorus of prominent economists have argued in favor of raising inflation targets on the grounds that a higher level of inflation would allow central banks to push real interest rates deeper into negative territory in the event of a severe economic downturn. We doubt that any central bank would proactively raise its inflation target in the current environment. However, one could imagine a situation where inflation begins to gallop higher because central banks find themselves behind the curve in normalizing monetary policy. Confronted with the choice between engineering a painful recession and letting inflation stay elevated, it would not be too surprising in the current political context if some central banks chose the latter option. Investment Conclusions As we discussed last week, the combination of a stronger dollar and rising EM stress means that U.S. Treasury yields are more likely to fall than rise during the coming months.4 Over the long haul, however, bond yields are going higher - potentially much higher - as inflation surprises on the upside. Long-term bond investors should maintain below-benchmark exposure to duration risk in their portfolios. Gold offers some protection against inflation risk. However, the yellow metal is still quite expensive in real terms, which limits its appeal (Chart 13). Investors would be better off simply buying inflation-protected securities such as TIPS. Chart 13Gold Is Not Cheap Gold Is Not Cheap Gold Is Not Cheap Historically, equities have not performed well in inflationary environments. U.S. stocks are quite expensive these days (Chart 14). Analyst expectations are also far too rosy (Chart 15). Non-U.S. stocks are more attractively priced, but face a slew of near-term headwinds. A neutral allocation to global equities is appropriate at this juncture. Chart 14U.S. Stocks Are Expensive U.S. Stocks Are Expensive U.S. Stocks Are Expensive Chart 15Analysts Are Far Too Optimistic Analysts Are Far Too Optimistic Analysts Are Far Too Optimistic Peter Berezin, Chief Global Strategist Global Investment Strategy peterb@bcaresearch.com 1 Please see Global Investment Strategy Special Report, "Did Amazon Kill The Phillips Curve?" dated September 1, 2017. 2 To keep things simple, we are assuming that nominal interest rates cannot be negative. In practice, as we have seen over the past few years, the zero lower-bound constraint is rather fuzzy. Nevertheless, it is doubtful that interest rates can fall too far into negative territory before people begin to shift negative-yielding bank deposits into physical currency. 3 Please see Global Investment Strategy Weekly Report, "U.S. Housing Will Drive The Global Business Cycle... Again," dated July 6, 2018. 4 Please see Global Investment Strategy Weekly Report, "Hot Dollar, Cold Turkey," dated August 17, 2018. Strategy & Market Trends Tactical Trades Strategic Recommendations Closed Trades

Underweight This week we have been highlighting winners & losers in a global trade war. With the vast majority of revenues coming from overseas and a high estimated import tariff exposure (please refer to Chart II-5 of the Special Report we published on Monday) semiconductor companies are a stand-out sector to avoid. The drubbing that EM currencies have taken this weak on fear of contagion from Turkey highlights this risk. Global semi sales have historically tracked EM currencies and a leg down for semiconductor sales seems to be the path of least resistance (second panel). The timing is unfortunate; global semiconductor inventories have been growing strongly for the past year and a decline in sales may force a costly inventory clear out. Tack on headline risk from security flaws in index heavyweight Intel's chips and the decision to avoid this early cyclical tech sub-index looks easy; stay underweight. The ticker symbols for the stocks in this index are: BLBG: S5SECO - INTC, QCOM, TXN, AVGO, NVDA, ADI, MU, SWKS, MCHP, XLNX, QRVO. Semis Are Not A Place To Hide In A Trade War Semis Are Not A Place To Hide In A Trade War

Dear Client, This week we are sending you a Special Report written by Mark McClellan, Chief Strategist, The Bank Credit Analyst, Marko Papic, Chief Strategist, Geopolitical Strategy and our very own Chris Bowes, Associate Editor, U.S. Equity Strategy. This report deals with the implications of the U.S./Sino trade war for U.S. equity sectors. It identifies the next products to be targeted with higher tariffs on both sides of the dispute. A higher U.S. tariff wall will shield some industries from competition, but rising input costs will be widely felt because of extensive supply chains between and within industries. There is only a small handful of industries that will be winners in absolute terms. I trust you will find his report insightful. Kind regards, Anastasios Avgeriou, Vice President U.S. Equity Strategy In this Special Report, we shed light on the implications of the U.S./Sino trade war for U.S. equity sectors. The threat that trade action poses to the U.S. equity market is greater than in past confrontations. Perhaps most importantly, supply chains are much more extensive, globally and between China and the U.S. Automobile Components, Electrical Equipment, Materials, Capital Goods and Consumer Durables have the most extensive supply chain networks. The USTR claims that it is being strategic in the Chinese goods it is targeting, focusing on companies that will benefit from the "Made In China 2025" initiative. The list of Chinese goods targeted in both the first and second rounds covers virtually all of the broad import categories. The only major items left for the U.S. to hit are apparel, footwear, toys and cellphones. Beijing is clearly targeting U.S. products based on politics in order to exert as much pressure on the President's party as possible. Based on a list of products that comprise the top-10 most exported goods of Red and Swing States, China will likely lift tariffs in the next rounds on civilian aircraft, computer electronics, healthcare equipment, car engines, chemicals, wood pulp, telecommunication and integrated circuits. Supply chains within and between industries and firms mean that the impact of tariffs is much broader than the direct impact on exporters and importers. We measure the relative exposure of 24 GICs equity sectors to the trade war based on their proportion of foreign-sourced revenues and the proportion of each industry's total inputs that are affected by U.S. tariffs. The Semiconductors & Semiconductor Equipment sector stands out, but the Technology & Hardware Equipment, Capital Goods, Materials, Consumer Durables & Apparel and Motor Vehicle sectors are also highly exposed to anti-trade policy action. Energy, Software, Banks and all other service sectors are much less exposed. China may also attempt to disrupt supply chains via non-tariff barriers, placing even more pressure on U.S. firms that have invested heavily in China. Wholesale Trade, Chemicals, Transportation Equipment, Computers & Electronic Parts and Finance & Insurance are most exposed. U.S. technology companies are particularly vulnerable to an escalating trade war. Virtually all U.S. manufacturing industries will be negatively affected by an ongoing trade war, even defensive sectors such as Consumer Staples. The one exception is defense manufacturers, where we recommend overweight positions. Our analysis highlights that the best shelter from a trade war can be found in services, particularly services that are insulated from trade. Financial Services appears a logical choice, and the S&P Financial Exchanges & Data subsector is one of our favorites. The trade skirmish is transitioning to a full-on trade war. The U.S. has imposed a 25% tariff on $50 billion worth of Chinese goods, and has proposed a 10% levy on an additional $200 billion of imports by August 31. China retaliated with tariffs on $50 billion of imports from the U.S., but Trump has threatened tariffs on another $300 billion if China refuses to back down. That would add up to over $500 billion in Chinese goods and services that could be subject to tariffs, only slightly less than the total amount that China exported to the U.S. last year. BCA's Geopolitical Strategy has emphasized that President Trump is unconstrained on trade policy, giving him leeway to be tougher than the market expects.1 This is especially the case with respect to China. There will be strong pushback from Congress and the U.S. business lobby if the Administration tries to cancel NAFTA. In contrast, Congress is also demanding that the Administration be tough on China because it plays well with voters. Trump is a prisoner of his own tough pre-election campaign rhetoric against China. The U.S. primary economic goal is not to equalize tariffs but to open market access.2 The strategic goal is much larger. The U.S. wants to see China's rate of technological development slow down. Washington will expect robust guarantees to protect intellectual property and proprietary technology before it dials down the pressure on Beijing. The threat that the trade war poses to the U.S. equity market is greater than in past confrontations, such as that between Japan and the U.S. in the late 1980s. First, stocks are more expensive today. Second, interest rates are much lower, limiting how much central banks can react to adverse shocks. Third, and perhaps most importantly, supply chains are much more extensive, globally and between China and the U.S. Nearly every major S&P 500 multinational corporation is in some way exposed to these supply chains. Chart II-1 shows that Automobile Components, Electrical Equipment, Materials, Capital Goods and Consumer Durables have the most extensive supply chain networks. The Global Value Chain Participation rate, constructed by the OECD, is a measure of cross-border value-added linkages.3 In this Special Report, we shed light on the implications of the trade war for U.S. equity sectors. Complex industrial interactions make it difficult to be precise in identifying the winners and losers of a trade war. Nonetheless, we can identify the industries most and least exposed to a further rise in tariff walls or non-tariff barriers to trade. We focus on the U.S./Sino trade dispute in this Special Report, leaving the implications of a potential trade war with Europe and the possible failure of NAFTA negotiations for future research. Chart II-1Measuring Global Supply Chains August 2018 August 2018 Trade Channels There are at least five channels through which rising tariffs can affect U.S. industry: The Direct Effect: This can be positive or negative. The impact is positive for those industries that do not export much but are provided relief from stiff import competition via higher import tariffs. The impact is negative for those firms facing higher tariffs on their exports, as well as for those firms facing higher costs for imported inputs to their production process. These firms would be forced to absorb some of the tariff via lower profit margins. Some industries will fall into both positive and negative camps. U.S. washing machines are a good example. Whirlpool's stock price jumped after President Trump announced an import tariff on washing machines, but it subsequently fell back when the Administration imposed an import tariff on steel and aluminum (that are used in the production of washing machines); Indirect Effect: The higher costs for imported goods are passed along the supply chain within an industry and to other industries that are not directly affected by rising tariffs. This will undermine profit margins in these indirectly-affected industries to the extent that they cannot fully pass along the higher input costs; Foreign Direct Investment: Some Chinese exports emanate from U.S. multinationals' subsidiaries in China, or by Chinese or foreign OEM suppliers for U.S. firms. Even though it would undermine China's economy to some extent, the Chinese authorities could make life more difficult for these firms in retaliation for U.S. tariffs on Chinese goods. Macro Effect: A trade war would take a toll on global trade and reduce GDP growth globally. Besides the negative effect of uncertainty on business confidence and, thus, capital spending, rising prices for both consumer and capital goods will reduce the volume of spending in both cases. Moreover, corporate profits have a high beta with respect to economic activity. We would not rule out a U.S. recession in a worst-case scenario. Obviously, a recession or economic slowdown would inflict the most pain on the cyclical parts of the S&P 500 relative to the non-cyclicals, in typical fashion. Currency Effect: To the extent that a trade war pushes up the dollar relative to the other currencies, it would undermine export-oriented industries and benefit those that import. However, while we are bullish the dollar due to diverging monetary policy, the dollar may not benefit much from trade friction given retaliatory tariff increases by other countries. Some of the direct and indirect impact can be mitigated to the extent that importers facing higher prices for Chinese goods shift to similarly-priced foreign producers outside of China. Nonetheless, this adjustment will not be costless as there may be insufficient supply capacity outside of China, leading to upward pressure on prices globally. Targeted Sectors: (I) U.S. Tariffs On Chinese Goods As noted above, the U.S. has already imposed tariffs on $50 billion of Chinese imports and has published a list of another $200 billion of goods that are being considered for a 10% tariff in the second round of the trade war. The first round focused on intermediate and capital goods, while the second round includes consumer final demand categories such as furniture, air conditioners and refrigerators. The latter will show up as higher prices at retailers such as Wal Mart, having a direct and visible impact on U.S. households. Appendix Table II-A1 lists the goods that are on the first and second round lists, grouped according to the U.S. equity sectors in the S&P 500. The U.S. Trade Representative (USTR) claims that the Chinese items are being targeted strategically. It is focusing on companies that will benefit from China's structural policies, such as the "Made In China 2025" initiative that is designed to make the country a world leader in high-tech areas (see below). Table II-1 reveals the relative size of the broad categories of U.S. imports from China, based on trade categories. The top of the table is dominated by Motor Vehicles, Machinery, Telecommunication Equipment, Computers, Apparel & Footwear and other manufactured goods. The list of Chinese goods targeted in both the first and second rounds covers virtually all of the broad categories in Table II-1. The only major items left for the U.S. to hit are Apparel and Footwear, as well as two subcategories; Toys and Cellphones. These are all consumer demand categories. Table II-1U.S. Imports From China (January-May 2018) August 2018 August 2018 (II) Chinese Tariffs On U.S. Goods Total U.S. exports to China were less than $53 billion in the first five months of 2018, limiting the amount of direct retaliation that China can undertake (Table II-2). The list of individual U.S. products that China has targeted so far is long, but we have condensed it into the broad categories shown in Table II-3. The U.S. equity sectors that the new tariffs affect so far include Food, Beverage & Tobacco, Automobiles & Components, Materials and Energy. China has concentrated mainly on final goods in a politically strategic manner, such as Trump-supported rural areas and Harley Davidson bikes whose operations are based in Paul Ryan's home district in Wisconsin. Table II-2U.S. Exports To China (January-May 2018) August 2018 August 2018 Table II-3China Tariffs On U.S. Goods August 2018 August 2018 What will China target next? Chart II-2 shows exports to China as percent of total state exports, and Chart II-3 presents the value of products already tariffed by China as a percent of state exports. Other than Washington, the four states most targeted by Beijing are conservative: Alaska, Alabama, Louisiana and South Carolina. Chart II-2U.S. Exports To China By State August 2018 August 2018 Chart II-3Value Of U.S. Products Tariffed By China (By State) August 2018 August 2018 Beijing is clearly targeting products based on politics in order to exert as much pressure on the President's party as possible. To identify the next items to be targeted, we constructed a list of products that comprise the top-10 most exported goods of Red States (solidly conservative) and Swing States (competitive states that can go either to Republican or Democratic politicians). Appendix Tables II-A2 and II-A3 show this list of products, with those that have already been flagged by China for tariffs crossed out. Table II-4 shows the top-10 list of products that are not yet tariffed by China, but are distributed in a large proportion of Red and Swing states. What strikes us immediately is how important aircraft exports are to a large number of Swing and Red States. In total, 27 U.S. states export civilian aircraft, engines and parts to China. This is an obvious target of Beijing's retaliation. In addition, we believe that computer electronics, healthcare equipment, car engines, chemicals, wood pulp, telecommunication and integrated circuits are next. Table II-4Number Of U.S. States Exporting To China By Category August 2018 August 2018 Market Reaction Chart II-4 highlights how U.S. equity sectors performed during seven separate days when the S&P 500 suffered notable losses due to heightened fears of protectionism. Cyclical sectors such as Industrials and Materials fared worse during days of rising protectionist angst. Financials also generally underperformed, largely because such days saw a flattening of the yield curve. Tech, Health Care, Energy and Telecom performed broadly in line with the S&P 500. Consumer Staples outperformed the market, but still declined in absolute terms. Utilities and Real Estate were the only two sectors that saw absolute price gains. The market reaction seems sensible based on the industries caught in the cross-hairs of the trade action so far. At least some of the potential damage is already discounted in equity prices. Nonetheless, it is useful to take a closer look at the underlying factors that should determine the ultimate winners and losers from additional salvos in the trade war. Chart II-4S&P 500: Impact Of Trade-Related Events August 2018 August 2018 Determining The Winners And Losers The U.S. sectors that garner the largest proportion of total revenues from outside the U.S. are obviously the most exposed to a trade war. For the 24 level 2 GICS sectors in the S&P 500, Table II-5 presents the proportion of total revenues that is generated from operations outside the U.S. for the top five companies in the sector by market cap. Company reporting makes it difficult in some cases to identify the exact revenue amount coming from outside the U.S., as some companies regard "domestic" earnings as anything generated in North America. Nonetheless, we believe the data in Table II-5 provide a reasonably accurate picture. Table II-5Foreign Revenue Exposure (2017) August 2018 August 2018 Semiconductors, Tech Equipment, Materials, Food & Beverage, Software and Capital Goods are at the top of the list in terms of foreign-sourced revenues. Not surprisingly, service industries like Real Estate, Banking, Utilities and Telecommunications Services are at the bottom of the exposure list. U.S. companies are also exposed to U.S. tariffs that lift the price of imported inputs to the production process. This can occur directly when firm A imports a good from abroad, and indirectly, when firm A sells its intermediate good to firm B at a higher price, and then on to firm C. In order to capture the entire process, we used the information contained in the Bureau of Economic Analysis' Input/Output tables. We estimated the proportion of each industry's total inputs that are affected by already-implemented U.S. tariffs and those that are on the list for the next round of tariffs. These estimates, shown in Appendix Table II-A4 at a detailed industrial level, include both the direct and indirect effects of higher import costs. At the top of the list is Motor Vehicles and Parts, where Trump tariffs could affect more than 70% of the cost of all material inputs to the production process. Electrical Equipment, Machinery and other materials industries are also high on the list, together with Furniture, Computers & Electronic Parts and Construction. Unsurprisingly, service industries and Utilities are in the bottom half of the table.4 We then allocated all the industries in Appendix Table II-A4 to the 24 GICs level 2 sectors in the S&P 500, in order to obtain an import exposure ranking in S&P sector space (Table II-6). Table II-6U.S. Import Tariff Exposure August 2018 August 2018 Chart II-5 presents a scatter diagram that compares import tariff exposure (horizontal axis) with foreign revenue exposure (vertical axis). The industries clustered in the top-right of the diagram are the most exposed to a trade war. Chart II-5U.S. Industrial Exposure To A Trade War With China August 2018 August 2018 The Semiconductors & Semiconductor Equipment sector stands out by this metric, but the Technology & Hardware Equipment, Capital Goods, Materials, Consumer Durables & Apparel and Motor Vehicle sectors are also highly exposed to anti-trade policy action. Energy, Software, Banks and all other service sectors are much less exposed. Food, Beverage & Tobacco lies between the two extremes. Joint Ventures And FDI Table II-7Stock Of U.S. Direct ##br##Investment In China (2017) August 2018 August 2018 As mentioned above, most U.S. production taking place in China involves a joint venture. The Chinese authorities could attempt to disrupt the supply chain of a U.S. company by hindering production at companies that have ties to U.S. firms. Data on U.S. foreign direct investment (FDI) in China will be indicative of the industries that are most exposed to this form of retaliation. The stock of U.S. FDI in China totaled more than $107 billion last year (Table II-7). At the top of the table are Wholesale Trade, Chemicals, Transportation Equipment, Computers & Electronic Parts and Finance & Insurance. Apple is a good example of a U.S. company that is exposed to non-tariff retaliation, as the iPhone is assembled in China by Foxconn for shipment globally with mostly foreign sourced parts. Our Technology sector strategists argue that U.S. technology companies are particularly vulnerable to an escalating trade war (See Box II-1).5 BOX II-1 The Tech Sector The U.S. has applied tariffs on the raw materials of technology products rather than finished goods so far. At a minimum, this will penalize smaller U.S. tech firms which manufacture in the U.S. and provide an incentive to move production elsewhere. Worst case, the U.S. tariffs might lead to component shortages which could have a disproportionately negative impact, especially on smaller firms. Although it has not been proposed, U.S. tariffs on finished goods would be devastating to large tech companies such as Apple, which outsources its manufacturing to China. China appears determined to have a vibrant high technology sector. The "Made In China 2025" program, for example, combines ambitious goals in supercomputers, robotics, medical devices and smart cars, while setting domestic localization targets that would favor Chinese companies over foreigners. The ZTE sanctions and the potential for enhanced export controls have had a traumatic impact on China's understanding of its relatively weak position with respect to technology. As a result, because most high-tech products are available from non-U.S. sources, Chinese engineers will likely be encouraged to design with non-U.S. components; for example, selecting a Samsung instead of a Qualcomm processor for a smartphone. Similarly, China is a major buyer of semiconductor capital equipment as it follows through with plans to scale up its semiconductor industry. Most such equipment is also available from non-U.S. vendors, and it would be understandable if these suppliers are selected given the risk which would now be associated with selecting a U.S. supplier. The U.S. is targeting Chinese made resistors, capacitors, crystals, batteries, Light Emitting Diodes (LEDs) and semiconductors with a 25% tariff. For the most part these are simple, low cost devices, which are used by the billions in high-tech devices. Nonetheless, China could limit the export of these products to deliver maximum pain, leading to a potential shortage of qualified parts. A component shortage can have a devastating impact on production since the manufacturer may not have the ability to substitute a new part or qualify a new vendor. Since the product typically won't work unless all the right parts are installed, want of a dollar's worth of capacitors may delay shipping a $1,000 product. Thus, the economic and profit impact of a parts shortage in the U.S. could be quite severe. Conclusions: When it comes to absolute winners in case of a trade war, we believe there are three conditions that need to be met: Relatively high domestic input costs. Relatively high domestic consumption/sales; the true beneficiaries of a tariff are those industries who are allowed to either raise prices or displace foreign competitors, with the consumer typically bearing the cost. Relatively low direct exposure to global trade - international trade flows will certainly slow in a trade war. There are very few manufacturing industries that meet all of these criteria. Within manufacturing, one would typically expect the Consumer Staples and Discretionary sectors to be the best performers. However, roughly a third of the weight of Staples is in three stocks (PG, KO and PEP) that are massively dependent on foreign sales. Moreover, a similar weight of Discretionary is in two retailers (AMZN and HD) that are dependent on imports. As such, consumer indexes do not appear a safe harbor in a trade war. Nevertheless, if the trade war morphs into a recession then consumer staples (and other defensive safe-havens) will outperform, although they will still decrease in absolute terms. Transports are an industry that has relatively high domestic labor costs and an output that is consumed virtually entirely within domestic borders. However, their reliance on global trade flows - intermodal shipping is now more than half of all rail traffic - means they almost certainly lose from a prolonged trade dispute. There is one manufacturing industry that could be at least a relative winner and perhaps an absolute winner: defense. Defense manufacturers certainly satisfy the first two criteria above, though they do have reasonably heavy foreign exposure. However, we believe high switching costs and the lack of true global competitors mean that U.S. defense company foreign sales will be resilient. After all, a NATO nation does not simply switch out of F-35 jets for the Russian or Chinese equivalent. Further, if trade friction leads to rising military tension, defense stocks should outperform. Finally, the ongoing global arms race, space race and growing cybersecurity requirements all signal that these stocks are a secular growth story, as BCA has argued in the recent past.6 Still, as highlighted by the data presented above, the best shelter from a trade war can be found in services, particularly services that are insulated from trade. Financial Services appears a logical choice, especially the S&P Financial Exchanges & Data subsector (BLBG: S5FEXD - CME, SPGI, ICE, MCO, MSCI, CBOE, NDAQ). Another appealing - and defensive - sector is Health Care Services. With effectively no foreign exposure and a low beta, these stocks would outperform in the worst-case trade war-induced recession. Mark McClellan Senior Vice President The Bank Credit Analyst Marko Papic Senior Vice President Geopolitical Strategy Chris Bowes Associate Editor U.S. Equity Strategy 1 Please see BCA Geopolitical Strategy Special Report, "Constraints & Preferences Of The Trump Presidency," dated November 30, 2016, available at gps.bcaresearch.com. 2 Please see BCA Geopolitical Strategy Weekly Report, "Trump's Demands On China," dated April 4, 2018, available at gps.bcaresearch.com. 3 For more information, please see: "Global Value Chains (GVSs): United States." May 2013. OECD website. 4 Please see BCA U.S. Equity Strategy Special Report, "Brothers In Arms," dated October 31, 2016, available at uses.bcaresearch.com. 5 Please see BCA Technology Sector Strategy Special Report "Trade Wars And Technology," dated July 10, 2018, available at tech.bcaresearch.com 6 Please see BCA U.S. Equity Strategy Special Report, "Brothers In Arms," dated October 31, 2016, available at uses.bcaresearch.com. Appendix Table II-1 Allocating U.S. Import Tariffs To U.S. GICS Sectors August 2018 August 2018 Appendix Table II-2 Exports By U.S. Red States August 2018 August 2018 Appendix Table II-3 Exports By U.S. Swing States August 2018 August 2018 Appendix Table II-4 Exposure Of U.S. Industries To U.S. Import Tariffs August 2018 August 2018

Overweight (High-Conviction) The S&P tech hardware, storage & peripherals (THSP) index touched a new all-time relative high this week on the back of another stunning earnings outperformance by Apple. In our opinion, there are three numbers worth highlighting. First, iPhone pricing is surprisingly resilient, despite seasonality and what was supposed to be a weakening smart phone market. Second, high-margin services are growing at a rate above 30%, a significant step in transitioning the company from its hardware focus. Lastly, we estimate revenues from the key Chinese market grew by 25%, excluding currency, even though a trade war is heating up. Overall, it's hard to see what stands in Apple's way. From a higher level, we continue to point to the index's pristine balance sheets, which should support ongoing share repurchases (recall Apple has $140 billion of net debt with a commitment to bring it to zero and a $100 billion share repurchase program this year). Further, with valuations that trail the overall market, we think all the good news has yet to be priced in. We reiterate our high-conviction overweight recommendation on the S&P THSP index. The ticker symbols for the stocks in the S&P THSP index are: BLBG: S5CMPE - HPQ, WDC, STX, XRX, AAPL, HPE, NTAP. Apple Is Leading The Pack, Again Apple Is Leading The Pack, Again

Highlights The regulatory or "stroke of pen" risk is rising on FAANG stocks - Facebook, Apple, Amazon, Netflix, and Google; The U.S. anti-trust regulatory framework was designed to curb anti-competitive actions but has evolved to focus mostly on consumer welfare and prices; A shift toward the original regulatory regime would threaten the FAANGs, particularly Google and Amazon; A trade war hit to tech earnings could be the catalyst for a more general selloff today - but this is not our base case; For now, the market will view regulatory risk as noise and tech stocks will likely enter a blow-off phase; We remain neutral, preferring S&P software and hardware while underweighting semiconductors. Feature "I don't know what Twitter is up to." Rep. Devin Nunes (R-California), Chairman of the House Intelligence Committee, July 29, 2018 "I have stated my concerns with Amazon long before the Election. Unlike others, they pay little or no taxes to state & local governments, use our Postal System as their Delivery Boy (causing tremendous loss to the U.S.), and are putting many thousands of retailers out of business." President Donald J. Trump, March 29, 2018 "If we will not endure a king as a political power, we should not endure a king over the production, transportation, and sale of any of the necessities of life. If we would not submit to an emperor, we should not submit to an autocrat of trade, with power to prevent competition and to fix the price of any commodity." Senator John Sherman, 1890 Social media companies have had a terrible week, with Twitter falling 21% on July 27th and Facebook 19% on July 26th. Facebook posted weaker than expected earnings, but investors appeared to be particularly concerned with a miss in monthly active users. The shortfall in active users may have been affected by the new EU privacy rules, which came into force in May. Twitter's fall from grace came even though its revenues were up 24% on the year, with a record profit of $100 million. However, its effort to delete "bots" and suspicious user accounts brought its user total down to 335 million, from 336 million, prompting fears that the platform was slowing down. Twitter's and Facebook's enormous price volatility, despite decent earnings figures, reveals that investors are jittery about the performance of technology stocks, epitomized by the so-called FAANGs - Facebook, Apple, Amazon, Netflix, and Google. They are right to be, given that there are three broad risks to these companies: The next big thing: Before Facebook, there was MySpace. It is not inconceivable that new platforms - for instance, ones that emphasize privacy or that redistribute a portion of advertising revenue with users - could replace current market leaders. Revenue model: Although they are perceived to be cutting-edge technology companies, social media firms generate vast amount of their revenue through advertising. Facebook and Google have captured 25% of global media advertising revenues.1 At some point, Internet companies will reach a ceiling on this revenue as the attrition rate of local newspapers slows, as foreign markets introduce local alternatives (RenRen or Weibo in China, VKontakte in Russia), and as non-tariff barriers to trade begin impacting their international expansion (China's Internet Security Law). Regulation: Finally, regulatory pressure could grow for a number of reasons. First, European concerns regarding user privacy could migrate to the U.S. where a majority of voters already believe that tech companies need greater oversight (Chart 1). In fact, Americans now see tech companies as having as pernicious an influence as energy companies (Chart 2). Second, the U.S. approach to anti-trust problems could evolve away from the current paradigm that focuses on delivering lower prices to consumers. Third, President Trump and his conservative allies could target social media companies with perceived liberal bias for purely political reasons. Chart 1Majority Of Americans Want Tech Regulated Is The Stock Rally Long In The FAANG? Is The Stock Rally Long In The FAANG? Chart 2Tech And Energy Companies Now In Same Boat Is The Stock Rally Long In The FAANG? Is The Stock Rally Long In The FAANG? We have no particular insight into the competitive landscape of social media, web browsing, and Internet retail industries, so we will leave the first two threats to the experts in the field. Instead, we will focus in this report on the third threat, the "stroke of pen" regulatory risk. From Standard Oil To The Chicago School - America's Anti-Trust Framework Today's anti-trust regulatory framework has significantly deviated from the original intent behind the 1890 Sherman Act. As Lina M. Khan argues in "Amazon's Antitrust Paradox," "Congress enacted antitrust laws to rein in the power of industrial trusts, the large business organizations that had emerged in the late nineteenth century. Responding to a fear of concentrated power, antitrust sought to distribute it."2 Railroad construction in the late nineteenth century, largely financed by the municipal debt of farm-belt states, evolved from a shrewd capex investment in a new technology to a mania. To boost sagging profits, railroad barons fixed their prices to reduce competition. State anti-trust laws that emerged out of this era, the so-called "Granger laws," sought to curb monopolistic behavior by giving states control over railroad operations. These state laws ultimately coalesced into federal legislation, the 1890 Sherman Act. No trust had a larger impact on the U.S. legal and regulatory infrastructure than the case of Standard Oil in the early twentieth century.3 Although the company faced criticism in the immediate aftermath of the 1880s recession - particularly from the famous muckraking journalist Henry Demarest Lloyd - the dam broke for Standard Oil when the oil-price bubble popped in Kansas in 1904. A Standard Oil subsidiary - the Prairie Oil and Gas Company - decided to purchase oil by a specific gravity test, forcing some of the Kansas oil from the market. At the time, the oil boom in Kansas had turned many into stockholders in some prospecting company. When oil prices fell, so did the fortunes of these locals. The shock of the price collapse radicalized Kansas politics at the turn of the twentieth century. An idea for a state-owned oil refinery picked up steam in the state despite being labeled socialist. Ultimately, Kansas' delegation in the U.S. House of Representatives requested that the Secretary of Commerce investigate the causes of the low price of crude oil in the state. After several disastrous performances of Standard Oil executives on witness stands and in testimony, the federal government filed a petition against the company in November 1906. A large fine followed in August 1907. The 1890 Sherman Act and subsequent anti-trust policies were grounded in the theory of economic structuralism. "This view holds that a market dominated by a very small number of large companies is likely to be less competitive than a market populated with many small- and medium-sized companies." Through the 1960s, courts blocked mergers - both horizontal and vertical - and policed markets not only for size, or effect on consumer welfare, but also for conflicts of interest.4 In the 1970s and 1980s, however, the Chicago School approach gained prominence. The Chicago School rested on "faith in the efficiency of markets, propelled by profit-maximizing actors."5 While economic structuralists believed that the structure of an industry leads to market outcomes, Chicago School saw structure as the outcome of market dynamics, which themselves are sacrosanct. Chicago School adherents focused primarily on price dynamics and consumer welfare, ignoring how economic structures could create barriers to entry and thus uncompetitive markets. The most influential economist behind the Chicago School was Robert Bork, who asserted in his highly influential The Antitrust Paradox that the "only legitimate goal of antitrust is the maximization of consumer welfare."6 That said, his definition of consumer welfare was incredibly broad and revealed a clear corporate, if not a pro-monopoly, bias.7 The influential Chicago School ultimately impacted the Supreme Court, which declared in 1979 that "Congress designed the Sherman Act as a 'consumer welfare prescription.'"8 The Reagan Administration subsequently rewrote the 1968 merger guidelines to shift the focus purely to consumer welfare in the form of preventing monopolistic price increases and output restrictions. The government also stopped bringing anti-trust cases under the 1936 Robinson-Patman Act, which prohibits price discrimination by retailers among producers and vice versa. Bottom Line: The U.S. anti-trust regulatory framework was designed to curb broad anti-competitive actions of trusts. As Lina Khan discusses in her seminal article, these actions "include not only cost but also product quality, variety, and innovation."9 However, through subsequent regulatory evolution, the Chicago School has taken hold of the U.S. anti-trust process, solely focusing on consumer welfare and prices. We can draw two immediate conclusions from this historical overview of U.S. anti-trust policy. First, the laws on the books have not changed since World War Two. Despite the laws remaining the same, the theory of how to apply them in courts of law has dramatically changed, as economic structuralism gave way to the Chicago School's focus on prices and consumer welfare. If President Reagan and the courts could change how these laws are administered in the 1980s, then so can subsequent administrations and courts in the future. Second, a long period of slow growth, income inequality, and economic volatility - such as the 1870s-80s - can produce a political impetus for anti-trust policy. This was certainly the case for Standard Oil in 1911, which became a nation-wide boogeyman despite most of its transgressions occurring in the farm belt states. While the U.S. has not experienced a recession in almost a decade, it will eventually - and besides, income inequality is a prominent theme once again and a potential source of consumer discontent.10 A narrative could emerge - particularly if politically expedient - that growth has been unequally distributed between the old economy and the twenty-first century technology leaders. Will FAANGs Be De-FAANGed? At BCA Research, we are neither regulatory nor policy experts. As such, we do not have insight into current regulatory activity involving social media companies, Google, or Amazon. The preceding section merely illustrates that the federal government's approach to the anti-trust process could change. Indeed, the Obama administration signaled that its approach could become more active. One quantitative approach that investors can use to assess the risk of anti-trust legislation is the Herfindahl-Hirschman Index (HHI). It is the most commonly accepted measure of market concentration, used by the Department of Justice in assessing whether a particular market is controlled by a single firm.11 Chart 3 shows our reconstruction of the HHI for the present-day era, with three examples from the past. Chart 3Market Concentration By Industry And Eras Is The Stock Rally Long In The FAANG? Is The Stock Rally Long In The FAANG? The 1911 refined petroleum sector harkens back to the aforementioned Standard Oil case; The 2001 Internet browser market refers to the United States v. Microsoft Corp that led to the June 2000 decision (later reversed on appeal) to break-up the software giant; The 1983 telecommunication sector illustrates the HHI for the telecom market at the time of the AT&T divestiture. The data is clear: of the five FAANG companies, only Google reaches a concerning level on the HHI measure. This has already made it a target of European authorities. On the other hand, competition within both streaming (Netflix, Amazon) and social networks (Facebook) appears relatively healthy. However, social networks could be at risk of European-style privacy protections. The EU General Data Protection Regulation (GDPR), which came into force on May 2018, imposes considerable compliance burdens on any company handling user data. California has already signed its own version of the law - the Consumer Privacy Act - which will go into effect in January 2020. These laws give consumers the right to know what information companies are collecting about them and what companies that data is being shared with. They also allow consumers to ask technology companies to delete their data or not to sell it. While tech companies are likely to fight the new California law, we believe the writing is on the wall. The EU is by some measures the largest consumer market on the planet. California is certainly the largest U.S. market. It is unlikely that the momentum behind consumer protection will change, especially with the EU and California taking the lead. Given that advertising revenue is crucial to the business model of social media companies and Google, a significant uptick in privacy regulation could hurt their bottom line. On the other hand, as we discuss below, the new regulatory rules create massive barriers to entry for small firms looking to replace the tech giants. Furthermore, many of the targeted social media companies have run afoul of President Trump in particular and the broader conservative movement in general. As such, privacy advocates - who tend to lean left - and conservatives, who feel that their commentators are being silenced by Silicon Valley, could form a classic "bootleggers and abolitionists" coalition against the FAANGs (Chart 4). Finally, there is the question of Amazon. We do not construct an HHI for Amazon's place in the retail market because E-commerce only accounts for about 9.5% of total U.S. retail sales (Chart 5). Amazon has been leading the charge, but it still accounts for just under half of that 9.5% total figure (Chart 6). Chart 4Conservatives Distrust Tech Companies Is The Stock Rally Long In The FAANG? Is The Stock Rally Long In The FAANG? Chart 5E-Commerce: Steady Increase In Market Share E-Commerce: Steady Increase In Market Share E-Commerce: Steady Increase In Market Share Chart 6Amazon Dominates Is The Stock Rally Long In The FAANG? Is The Stock Rally Long In The FAANG? Amazon's strength is that, in the current anti-trust framework, it conforms fully to the "consumer welfare" priorities elucidated by the Chicago School. Amazon, by and large, lowers prices for consumers. However, several of its practices could be seen as predatory in the more expansive, economic structuralist, approach.12 In addition, President Trump has reserved most of his Twitter scorn on the firm, particularly because CEO Jeff Bezos owns the liberal-leaning Washington Post. Bottom Line: Investors are correct to fret that the "stroke of pen" risk is rising when it comes to FAANG companies. Google scores considerably higher than either Standard Oil or Microsoft on the Department of Justice HHI. Social media companies are already under the microscope by conservative legislators and voters, who perceive them to be biased. Liberals, on the other hand, support toughened-up privacy rules that could undermine the business model of social media companies. Amazon's market dominance is overstated. However, several of its business practices could come under greater scrutiny if any administration should revert back to the original reading of the 1890 Sherman Law. Technology Stocks Have Brought The S&P 500 Up; Could They Bring It Down? It is now a well-worn understanding that the reason why the S&P 500 has performed well is largely due to the performance of a few (enormous) technology stocks (see Chart 7 and Table 1) who have seen both earnings and valuation multiples expand amid one of the longest economic growth phases in history. The preceding section certainly suggests that frothy valuations and the rising regulatory impetus imply that future upside potential is swamped by downside risk. Chart 7FAANG Stocks + Microsoft Have##br## Dramatically Outperformed... FAANG Stocks + Microsoft Have Dramatically Outperformed... FAANG Stocks + Microsoft Have Dramatically Outperformed... Table 1...Generating 50% Of The##br## 2018 S&P 500 Return! Is The Stock Rally Long In The FAANG? Is The Stock Rally Long In The FAANG? If this negative scenario is what actually plays out in the market, the implications could be more severe than in the past. Indexed fund inflows have replaced actively managed fund outflows, as our colleagues in BCA's Global ETF Strategy recently pointed out (Chart 8).13 Considering the rise of these few technology stocks and their increasing weight in the S&P 500 and, necessarily, in the majority of ETFs, more people than ever before are invested in technology stocks, whether they know it or not. Accordingly, the performance of these stocks has become material to the household balance sheet, which is a driver of consumption and, hence, the economy. Thus, it may not be hyperbole to say the economy depends to some extent on Amazon maintaining a high valuation multiple. Chart 8ETF Inflows Offset Actively Managed Outflows ETF Inflows Offset Actively Managed Outflows ETF Inflows Offset Actively Managed Outflows Adding some weight to this thesis is the mounting concern over a global trade war. The technology sector in general is by far the most international (as defined by foreign-sourced revenues) of GICS 1 sectors. More specifically, the top three semiconductor & semiconductor equipment companies (INTC, NVDA & TXN), which collectively represent more than 50% of the weight of that index, generate on average only 17% of their revenues in the U.S. Moreover, the more dangerous and lasting trade risk emanates from the U.S.-China showdown, which centers on the technology sector. Should the worst trade outcomes occur, it is not unreasonable to see impaired technology earnings being the catalyst for a more general sell-off. We recommend underweight positions in both the S&P semiconductors and S&P semiconductor equipment indexes. We Think Not Despite the foregoing, we think a more likely scenario is actually a blow-off phase where technology stocks accelerate rather than decline in an increasingly restrictive regulatory environment. In a recent report analyzing sector performance in the last stages of the bull market, we noted that across seven iterations dating back to the 1960's, the information technology sector delivered a median 14% outperformance relative to the S&P 500 (Table 2).14 And, while returns in these stocks have been excellent this year, their gains seem modest compared to the performance in the 1999-2000 iteration. Table 2Tech Stocks Are Strong Late Cycle Performers Is The Stock Rally Long In The FAANG? Is The Stock Rally Long In The FAANG? Underpinning our expectations is the recent stock reactions to regulatory actions. Beginning with Facebook, in the week of March 26, 2018, the firm was hit with severely negative headlines. First, the Cambridge Analytica scandal pointed out that the firm may be caught on the wrong side of EU GDPR rules, followed by the firm being investigated for an EU antitrust suit for the online ad market; the stock fell 15% from the week prior. However, within two months, the stock had fully recovered and a further two months later the stock was up 18% from its starting point. Recently the stock has fallen significantly on the back of very weak guidance; the company noted that revenue growth would decelerate and operating margins would fall to the mid-30% range from the current mid-40% range. It is not unreasonable to think management may be sandbagging earnings growth to defray some of the elevated regulatory scrutiny into its outrageous profitability. Google too has seen negative regulatory headlines, having been hit with a $5 billion fine in the EU for abusing the dominance of the Android mobile operating system in July this year. The stock responded by closing higher and then rose a further 10% in the following two weeks. Overall, we think the market views regulatory risk as noise. For now. But What About The Earnings? Do They Matter? While the earnings implications of yet-to-be-proposed regulatory changes are unknowable, we believe even the pursuit of an answer is a red herring. As shown by Chart 9, the market does not appear to care about next year's earnings as valuation multiples have little consistency with either themselves or the broad market. The implication is that near-term earnings are of relatively little importance, at least compared to the long-term growth outlook. Chart 9Tech Valuations Are Meaningless Tech Valuations Are Meaningless Tech Valuations Are Meaningless Further, these companies are a collection of businesses that are not necessarily cohesive. For example, Facebook includes Instagram, WhatsApp and Oculus while Amazon Web Service is a non-retail business that delivers half of Amazon's profit. A reasonable case could be made that breaking up these companies into their components could actually unlock considerable value. Lastly, new regulation, particularly with respect to privacy and data protection, is likely to create significant barriers for new entrants as compliance costs will be relatively more onerous for those companies with fewer resources. Thus, incoming privacy legislation may neuter the impact of any anti-trust legislation. Be Wary With Technology But For The Right Reasons We fully expect more regulation to remain a significant part of the conversation with respect to FAANG stocks and further expect that conversation to promote higher than normal volatility in the sector. However, we also expect the market to mostly look through this risk; buying the dip has thus far been the right approach to headline risk in technology. We think there are better reasons to remain cautious with technology. As noted above, they are heavily international and a strengthening U.S. dollar will be a headwind to 2019 earnings to a greater extent than to the broad market (please see our June 4th Weekly Report for more details). Supporting the dollar, BCA expects higher interest rates in 2018 on the back of rising inflation. Overall, we prefer old tech (S&P software and S&P technology hardware, storage & peripherals, both which are high-conviction overweights) that is levered to our synchronized global capex upcycle theme. It also boasts high cash flow and low valuations. We are less sanguine about technology early cyclicals (S&P semiconductors and S&P semiconductor equipment) which we rate as underweight. Net, we think risks are balanced in the tech sector and maintain a neutral recommendation for the S&P information technology sector. BCA Geopolitical Strategy Housekeeping In light of several announcements regarding China's efforts to ease up on economic policy, we are closing several of our trades: Short China-exposed S&P 500 Companies versus U.S. financials and telecoms - opened on May 30 for a 7.13% gain; Long DXY - opened on January 31 for a 5.85% gain; Short GBP/USD - opened on February 14 for a 6.21% gain; Long Indian equities / short Brazilian equities - opened on March 6 for a 27.54% gain. Long French industrial equities / short German industrial equities - opened on May 16 for a 2.21% gain. We still believe that Chinese structural reforms will continue, weighing on domestic and global growth. In the face of ongoing U.S. fiscal stimulus, the interplay between the two major economies will therefore continue to produce a dollar-bullish environment. However, the dollar's stretched positioning and the Chinese reflation narrative could hurt the greenback while reflating global risk assets in the near term. We will therefore look for an opportunity to reassert our negative EM view. Over the next two weeks, our reports will focus on Chinese stimulus and ongoing structural reforms. Marko Papic, Senior Vice President Chief Geopolitical Strategist marko@bcaresearch.com Chris Bowes, Associate Editor U.S. Equity Strategy chrisb@bcaresearch.com 1 Please see WARC, "Mobile is the world's second-largest ad medium," dated November 30, 2017, available at warc.com. 2 Please see Lina M. Khan, "Amazon's Antitrust Paradox," The Yale Law Journal 126:710 (2017). 3 Please see Steven L. Piott, The Anti-Monopoly Persuasion (Westport, Connecticut: Greenwood Press, 1985). 4 Khan 718. 5 Khan 719. 6 Please see Robert H. Bork, The Antitrust Paradox: A Policy at War with Itself (New York: Free Press, 1978). 7 By Bork's broad definition of "consumer welfare," even Jeff Bezos is a consumer whose rights have to be protected by anti-trust policy. "Those who continue to buy after a monopoly is formed pay more for the same output, and that shifts income from them to the monopoly and its owners, who are also consumers. This is not dead-weight loss due to restriction of output but merely a shift in income between two classes of consumers. The consumer welfare model, which views consumers as a collectivity, does not take this income effect into account," Bork, 32, our emphasis. 8 Please see Reiter v. Sonotone Corp., 442 U.S. 330, 342 (1979). 9 Khan 737. 10 Please see BCA Geopolitical Strategy Special Report, "Populism Blues: How And Why Social Instability Is Coming To America," dated June 9, 2017, available at gps.bcaresearch.com. 11 Please see The U.S. Department of Justice, "Herfindahl-Hirschman Index," available at justice.gov. 12 Please see Olivia LaVecchia and Stacy Mitchell, "Amazon's Stranglehold: How the Company's Tightening Grip Is Stifling Competition, Eroding Jobs, and Threatening Communities," Institute for Local Self-Reliance, dated November 2016, available at ilsr.org. 13 Please see BCA Global ETF Strategy Special Report, "Do ETF Flows Lead Currencies?" dated April 18, 2018, available at etf.bcaresearch.com. 14 Please see BCA U.S. Equity Strategy Special Report, "Portfolio Positioning For A Late Cycle Surge," dated May 22, 2018, available at uses.bcaresearch.com.

Dear Client, This week I am sending you a Special Report written by Mark McClellan, Chief Strategist of the monthly Bank Credit Analyst. Mark deals with the implications of the U.S./Sino trade war for U.S. equity sectors. He identifies the next products to be targeted with higher tariffs on both sides of the dispute. A higher U.S. tariff wall will shield some industries from competition, but rising input costs will be widely felt because of extensive supply chains between and within industries. There is only a small handful of industries that will be winners in absolute terms. I trust you will find his report very informative. Best regards, Peter Berezin, Chief Global Strategist Global Investment Strategy Highlights In this Special Report, we shed light on the implications of the U.S./Sino trade war for U.S. equity sectors. The threat that trade action poses to the U.S. equity market is greater than in past confrontations. Perhaps most importantly, supply chains are much more extensive, globally and between the U.S. and China. Automobile Components, Electrical Equipment, Materials, Capital Goods and Consumer Durables have the most extensive supply chain networks. The USTR claims that it is being strategic in the Chinese goods it is targeting, focusing on companies that will benefit from the "Made In China 2025" initiative. The list of Chinese goods targeted in both the first and second rounds covers virtually all of the broad import categories. The only major items left for the U.S. to hit are apparel, footwear, toys and cellphones. Beijing is clearly targeting U.S. products based on politics in order to exert as much pressure on the President's party as possible. Based on a list of products that comprise the top-10 most exported goods of Red and Swing States, China will likely lift tariffs in the next rounds on civilian aircraft, computer electronics, healthcare equipment, car engines, chemicals, wood pulp, telecommunication and integrated circuits. Supply chains within and between industries and firms mean that the impact of tariffs is much broader than the direct impact on exporters and importers. We measure the relative exposure of 24 GICs equity sectors to the trade war based on their proportion of foreign-sourced revenues and the proportion of each industry's total inputs that are affected by U.S. tariffs. The Semiconductors & Semiconductor Equipment sector stands out, but the Technology & Hardware Equipment, Capital Goods, Materials, Consumer Durables & Apparel and Motor Vehicle sectors are also highly exposed to anti-trade policy action. Energy, Software, Banks and all other service sectors are much less exposed. China may also attempt to disrupt supply chains via non-tariff barriers, placing even more pressure on U.S. firms that have invested heavily in China. Wholesale Trade, Chemicals, Transportation Equipment, Computers & Electronic Parts and Finance & Insurance are most exposed. U.S. technology companies are particularly vulnerable to an escalating trade war. Virtually all U.S. manufacturing industries will be negatively affected by an ongoing trade war, even defensive sectors such as Consumer Staples. The one exception is defense manufacturers, where we recommend overweight positions. Our analysis highlights that the best shelter from a trade war can be found in services, particularly services that are insulated from trade. Financial Services appears a logical choice, and the S&P Financial Exchanges & Data subsector is one of our favorites. Feature The trade skirmish is transitioning to a full-on trade war. The U.S. has imposed a 25% tariff on $50 billion worth of Chinese goods, and has proposed a 10% levy on an additional $200 billion of imports by August 31. China retaliated with tariffs on $50 billion of imports from the U.S., but Trump has threatened tariffs on another $300 billion if China refuses to back down. That would add up to over $500 billion in Chinese goods and services that could be subject to tariffs, only slightly less than the total amount that China exported to the U.S. last year. BCA's Geopolitical Strategy has emphasized that President Trump is unconstrained on trade policy, giving him leeway to be tougher than the market expects.1 This is especially the case with respect to China. There will be strong pushback from Congress and the U.S. business lobby if the Administration tries to cancel NAFTA. In contrast, Congress is also demanding that the Administration be tough on China because it plays well with voters. Trump is a prisoner of his own tough pre-election campaign rhetoric against China. The U.S. primary economic goal is not to equalize tariffs but to open market access.2 The strategic goal is much larger. The U.S. wants to see China's rate of technological development slow down. Washington will expect robust guarantees to protect intellectual property and proprietary technology before it dials down the pressure on Beijing. The threat that the trade war poses to the U.S. equity market is greater than in past confrontations, such as that between Japan and the U.S. in the late 1980s. First, stocks are more expensive today. Second, interest rates are much lower, limiting how much central banks can react to adverse shocks. Third, and perhaps most importantly, supply chains are much more extensive, globally and between China and the U.S. Nearly every major S&P 500 multinational corporation is in some way exposed to these supply chains. Chart 1 shows that Automobile Components, Electrical Equipment, Materials, Capital Goods and Consumer Durables have the most extensive supply chain networks. The Global Value Chain Participation rate, constructed by the OECD, is a measure of cross-border value-added linkages.3 Chart 1Measuring Global Supply Chains U.S. Equity Sectors: Trade War Winners And Losers U.S. Equity Sectors: Trade War Winners And Losers In this Special Report, we shed light on the implications of the trade war for U.S. equity sectors. Complex industrial interactions make it difficult to be precise in identifying the winners and losers of a trade war. Nonetheless, we can identify the industries most and least exposed to a further rise in tariff walls or non-tariff barriers to trade. We focus on the U.S./Sino trade dispute in this Special Report, leaving the implications of a potential trade war with Europe and the possible failure of NAFTA negotiations for future research. Trade Channels There are at least five channels through which rising tariffs can affect U.S. industry: 1. The Direct Effect: This can be positive or negative. The impact is positive for those industries that do not export much but are provided relief from stiff import competition via higher import tariffs. The impact is negative for those firms facing higher tariffs on their exports, as well as for those firms facing higher costs for imported inputs to their production process. These firms would be forced to absorb some of the tariff via lower profit margins. Some industries will fall into both positive and negative camps. U.S. washing machines are a good example. Whirlpool's stock price jumped after President Trump announced an import tariff on washing machines, but it subsequently fell back when the Administration imposed an import tariff on steel and aluminum (that are used in the production of washing machines); 2. Indirect Effect: The higher costs for imported goods are passed along the supply chain within an industry and to other industries that are not directly affected by rising tariffs. This will undermine profit margins in these indirectly-affected industries to the extent that they cannot fully pass along the higher input costs; 3. Foreign Direct Investment: Some Chinese exports emanate from U.S. multinationals' subsidiaries in China, or by Chinese or foreign OEM suppliers for U.S. firms. Even though it would undermine China's economy to some extent, the Chinese authorities could make life more difficult for these firms in retaliation for U.S. tariffs on Chinese goods. 4. Macro Effect: A trade war would take a toll on global trade and reduce GDP growth globally. Besides the negative effect of uncertainty on business confidence and, thus, capital spending, rising prices for both consumer and capital goods will reduce the volume of spending in both cases. Moreover, corporate profits have a high beta with respect to economic activity. We would not rule out a U.S. recession in a worst-case scenario. Obviously, a recession or economic slowdown would inflict the most pain on the cyclical parts of the S&P 500 relative to the non-cyclicals, in typical fashion. 5. Currency Effect: To the extent that a trade war pushes up the dollar relative to the other currencies, it would undermine export-oriented industries and benefit those that import. However, while we are bullish the dollar due to diverging monetary policy, the dollar may not benefit much from trade friction given retaliatory tariff increases by other countries. Some of the direct and indirect impact can be mitigated to the extent that importers facing higher prices for Chinese goods shift to similarly-priced foreign producers outside of China. Nonetheless, this adjustment will not be costless as there may be insufficient supply capacity outside of China, leading to upward pressure on prices globally. Targeted Sectors: (I) U.S. Tariffs On Chinese Goods As noted above, the U.S. has already imposed tariffs on $50 billion of Chinese imports and has published a list of another $200 billion of goods that are being considered for a 10% tariff in the second round of the trade war. The first round focused on intermediate and capital goods, while the second round includes consumer final demand categories such as furniture, air conditioners and refrigerators. The latter will show up as higher prices at retailers such as Wal Mart, having a direct and visible impact on U.S. households. Appendix Table 1 lists the goods that are on the first and second round lists, grouped according to the U.S. equity sectors in the S&P 500. The U.S. Trade Representative (USTR) claims that the Chinese items are being targeted strategically. It is focusing on companies that will benefit from China's structural policies, such as the "Made In China 2025" initiative that is designed to make the country a world leader in high-tech areas (see below). Table 1 reveals the relative size of the broad categories of U.S. imports from China, based on trade categories. The top of the table is dominated by Motor Vehicles, Machinery, Telecommunication Equipment, Computers, Apparel & Footwear and other manufactured goods. The list of Chinese goods targeted in both the first and second rounds covers virtually all of the broad categories in Table 1. The only major items left for the U.S. to hit are Apparel and Footwear, as well as two subcategories; Toys and Cellphones. These are all consumer demand categories. Table 1U.S. Imports From China (January-May 2018) U.S. Equity Sectors: Trade War Winners And Losers U.S. Equity Sectors: Trade War Winners And Losers (II) Chinese Tariffs On U.S. Goods Total U.S. exports to China were less than $53 billion in the first five months of 2018, limiting the amount of direct retaliation that China can undertake (Table 2). The list of individual U.S. products that China has targeted so far is long, but we have condensed it into the broad categories shown in Table 3. The U.S. equity sectors that the new tariffs affect so far include Food, Beverage & Tobacco, Automobiles & Components, Materials and Energy. China has concentrated mainly on final goods in a politically strategic manner, such as Trump-supported rural areas and Harley Davidson bikes whose operations are based in Paul Ryan's home district in Wisconsin. Table 2U.S. Exports To China (January-May 2018) U.S. Equity Sectors: Trade War Winners And Losers U.S. Equity Sectors: Trade War Winners And Losers Table 3China Tariffs On U.S. Goods U.S. Equity Sectors: Trade War Winners And Losers U.S. Equity Sectors: Trade War Winners And Losers What will China target next? Chart 2 shows exports to China as percent of total state exports, and Chart 3 presents the value of products already tariffed by China as a percent of state exports. Other than Washington, the four states most targeted by Beijing are conservative: Alaska, Alabama, Louisiana and South Carolina. Chart 2U.S. Exports To China By State U.S. Equity Sectors: Trade War Winners And Losers U.S. Equity Sectors: Trade War Winners And Losers Chart 3Value Of U.S. Products Tariffed By China (By State) U.S. Equity Sectors: Trade War Winners And Losers U.S. Equity Sectors: Trade War Winners And Losers Beijing is clearly targeting products based on politics in order to exert as much pressure on the President's party as possible. To identify the next items to be targeted, we constructed a list of products that comprise the top-10 most exported goods of Red States (solidly conservative) and Swing States (competitive states that can go either to Republican or Democratic politicians). Appendix Tables 2 and 3 show this list of products, with those that have already been flagged by China for tariffs crossed out. Table 4 shows the top-10 list of products that are not yet tariffed by China, but are distributed in a large proportion of Red and Swing states. What strikes us immediately is how important aircraft exports are to a large number of Swing and Red States. In total, 27 U.S. states export civilian aircraft, engines and parts to China. This is an obvious target of Beijing's retaliation. In addition, we believe that computer electronics, healthcare equipment, car engines, chemicals, wood pulp, telecommunication and integrated circuits are next. Table 4Number Of U.S. States Exporting To China By Category U.S. Equity Sectors: Trade War Winners And Losers U.S. Equity Sectors: Trade War Winners And Losers Market Reaction Chart 4 highlights how U.S. equity sectors performed during seven separate days when the S&P 500 suffered notable losses due to heightened fears of protectionism. Cyclical sectors such as Industrials and Materials fared worse during days of rising protectionist angst. Financials also generally underperformed, largely because such days saw a flattening of the yield curve. Tech, Health Care, Energy and Telecom performed broadly in line with the S&P 500. Consumer Staples outperformed the market, but still declined in absolute terms. Utilities and Real Estate were the only two sectors that saw absolute price gains. Chart 4S&P 500: Impact Of Trade-Related Events U.S. Equity Sectors: Trade War Winners And Losers U.S. Equity Sectors: Trade War Winners And Losers The market reaction seems sensible based on the industries caught in the cross-hairs of the trade action so far. At least some of the potential damage is already discounted in equity prices. Nonetheless, it is useful to take a closer look at the underlying factors that should determine the ultimate winners and losers from additional salvos in the trade war. Determining The Winners And Losers The U.S. sectors that garner the largest proportion of total revenues from outside the U.S. are obviously the most exposed to a trade war. For the 24 level 2 GICS sectors in the S&P 500, Table 5 presents the proportion of total revenues that is generated from operations outside the U.S. for the top five companies in the sector by market cap. Company reporting makes it difficult in some cases to identify the exact revenue amount coming from outside the U.S., as some companies regard "domestic" earnings as anything generated in North America. Nonetheless, we believe the data in Table 5 provide a reasonably accurate picture. Table 5Foreign Revenue Exposure (2017) U.S. Equity Sectors: Trade War Winners And Losers U.S. Equity Sectors: Trade War Winners And Losers Semiconductors, Tech Equipment, Materials, Food & Beverage, Software and Capital Goods are at the top of the list in terms of foreign-sourced revenues. Not surprisingly, service industries like Real Estate, Banking, Utilities and Telecommunications Services are at the bottom of the exposure list. U.S. companies are also exposed to U.S. tariffs that lift the price of imported inputs to the production process. This can occur directly when firm A imports a good from abroad, and indirectly, when firm A sells its intermediate good to firm B at a higher price, and then on to firm C. In order to capture the entire process, we used the information contained in the Bureau of Economic Analysis' Input/Output tables. We estimated the proportion of each industry's total inputs that are affected by already-implemented U.S. tariffs and those that are on the list for the next round of tariffs. These estimates, shown in Appendix Table 4 at a detailed industrial level, include both the direct and indirect effects of higher import costs. At the top of the list is Motor Vehicles and Parts, where Trump tariffs could affect more than 70% of the cost of all material inputs to the production process. Electrical Equipment, Machinery and other materials industries are also high on the list, together with Furniture, Computers & Electronic Parts and Construction. Unsurprisingly, service industries and Utilities are in the bottom half of the table.4 We then allocated all the industries in Appendix Table 4 to the 24 GICs level 2 sectors in the S&P 500, in order to obtain an import exposure ranking in S&P sector space (Table 6). Chart 5 presents a scatter diagram that compares import tariff exposure (horizontal axis) with foreign revenue exposure (vertical axis). The industries clustered in the top-right of the diagram are the most exposed to a trade war. Table 6U.S. Import Tariff Exposure U.S. Equity Sectors: Trade War Winners And Losers U.S. Equity Sectors: Trade War Winners And Losers Chart 5U.S. Industrial Exposure To A Trade War With China U.S. Equity Sectors: Trade War Winners And Losers U.S. Equity Sectors: Trade War Winners And Losers The Semiconductors & Semiconductor Equipment sector stands out by this metric, but the Technology & Hardware Equipment, Capital Goods, Materials, Consumer Durables & Apparel and Motor Vehicle sectors are also highly exposed to anti-trade policy action. Energy, Software, Banks and all other service sectors are much less exposed. Food, Beverage & Tobacco lies between the two extremes. Joint Ventures And FDI Table 7Stock Of U.S. Direct Investment In China (2017) U.S. Equity Sectors: Trade War Winners And Losers U.S. Equity Sectors: Trade War Winners And Losers As mentioned above, most U.S. production taking place in China involves a joint venture. The Chinese authorities could attempt to disrupt the supply chain of a U.S. company by hindering production at companies that have ties to U.S. firms. Data on U.S. foreign direct investment (FDI) in China will be indicative of the industries that are most exposed to this form of retaliation. The stock of U.S. FDI in China totaled more than $107 billion last year (Table 7). At the top of the table are Wholesale Trade, Chemicals, Transportation Equipment, Computers & Electronic Parts and Finance & Insurance. Apple is a good example of a U.S. company that is exposed to non-tariff retaliation, as the iPhone is assembled in China by Foxconn for shipment globally with mostly foreign sourced parts. Our Technology sector strategists argue that U.S. technology companies are particularly vulnerable to an escalating trade war (See Box 1).5 BOX 1 The Tech Sector The U.S. has applied tariffs on the raw materials of technology products rather than finished goods so far. At a minimum, this will penalize smaller U.S. tech firms which manufacture in the U.S. and provide an incentive to move production elsewhere. Worst case, the U.S. tariffs might lead to component shortages which could have a disproportionately negative impact, especially on smaller firms. Although it has not been proposed, U.S. tariffs on finished goods would be devastating to large tech companies such as Apple, which outsources its manufacturing to China. China appears determined to have a vibrant high technology sector. The "Made In China 2025" program, for example, combines ambitious goals in supercomputers, robotics, medical devices and smart cars, while setting domestic localization targets that would favor Chinese companies over foreigners. The ZTE sanctions and the potential for enhanced export controls have had a traumatic impact on China's understanding of its relatively weak position with respect to technology. As a result, because most high-tech products are available from non-U.S. sources, Chinese engineers will likely be encouraged to design with non-U.S. components; for example, selecting a Samsung instead of a Qualcomm processor for a smartphone. Similarly, China is a major buyer of semiconductor capital equipment as it follows through with plans to scale up its semiconductor industry. Most such equipment is also available from non-U.S. vendors, and it would be understandable if these suppliers are selected given the risk which would now be associated with selecting a U.S. supplier. The U.S. is targeting Chinese made resistors, capacitors, crystals, batteries, Light Emitting Diodes (LEDs) and semiconductors with a 25% tariff. For the most part these are simple, low cost devices, which are used by the billions in high-tech devices. Nonetheless, China could limit the export of these products to deliver maximum pain, leading to a potential shortage of qualified parts. A component shortage can have a devastating impact on production since the manufacturer may not have the ability to substitute a new part or qualify a new vendor. Since the product typically won’t work unless all the right parts are installed, want of a dollar’s worth of capacitors may delay shipping a $1,000 product. Thus, the economic and profit impact of a parts shortage in the U.S. could be quite severe. Conclusions: When it comes to absolute winners in case of a trade war, we believe there are three conditions that need to be met: Relatively high domestic input costs. Relatively high domestic consumption/sales; the true beneficiaries of a tariff are those industries who are allowed to either raise prices or displace foreign competitors, with the consumer typically bearing the cost. Relatively low direct exposure to global trade - international trade flows will certainly slow in a trade war. There are very few manufacturing industries that meet all of these criteria. Within manufacturing, one would typically expect the Consumer Staples and Discretionary sectors to be the best performers. However, roughly a third of the weight of Staples is in three stocks (PG, KO and PEP) that are massively dependent on foreign sales. Moreover, a similar weight of Discretionary is in two retailers (AMZN and HD) that are dependent on imports. As such, consumer indexes do not appear a safe harbor in a trade war. Nevertheless, if the trade war morphs into a recession then consumer staples (and other defensive safe-havens) will outperform, although they will still decrease in absolute terms. Transports are an industry that has relatively high domestic labor costs and an output that is consumed virtually entirely within domestic borders. However, their reliance on global trade flows - intermodal shipping is now more than half of all rail traffic - means they almost certainly lose from a prolonged trade dispute. There is one manufacturing industry that could be at least a relative winner and perhaps an absolute winner: defense. Defense manufacturers certainly satisfy the first two criteria above, though they do have reasonably heavy foreign exposure. However, we believe high switching costs and the lack of true global competitors mean that U.S. defense company foreign sales will be resilient. After all, a NATO nation does not simply switch out of F-35 jets for the Russian or Chinese equivalent. Further, if trade friction leads to rising military tension, defense stocks should outperform. Finally, the ongoing global arms race, space race and growing cybersecurity requirements all signal that these stocks are a secular growth story, as BCA has argued in the recent past.6 Still, as highlighted by the data presented above, the best shelter from a trade war can be found in services, particularly services that are insulated from trade. Financial Services appears a logical choice, especially the S&P Financial Exchanges & Data subsector (BLBG: S5FEXD - CME, SPGI, ICE, MCO, MSCI, CBOE, NDAQ). Another appealing - and defensive - sector is Health Care Services. With effectively no foreign exposure and a low beta, these stocks would outperform in the worst-case trade war-induced recession. Mark McClellan, Senior Vice President The Bank Credit Analyst markm@bcaresearch.com Marko Papic, Senior Vice President Geopolitical Strategy marko@bcaresearch.com Chris Bowes, Associate Editor U.S. Equity Strategy chrisb@bcaresearch.com 1 Please see BCA Geopolitical Strategy Special Report, "Constraints & Preferences Of The Trump Presidency," dated November 30, 2016, available at gps.bcaresearch.com. 2 Please see BCA Geopolitical Strategy Weekly Report, "Trump's Demands On China," dated April 4, 2018, available at gps.bcaresearch.com. 3 For more information, please see: "Global Value Chains (GVSs): United States." May 2013. OECD website. 4 Please see BCA U.S. Equity Strategy Special Report, "Brothers In Arms," dated October 31, 2016, available at uses.bcaresearch.com. 5 Please see BCA Technology Sector Strategy Special Report "Trade Wars And Technology," dated July 10, 2018, available at tech.bcaresearch.com 6 Please see BCA U.S. Equity Strategy Special Report, "Brothers In Arms," dated October 31, 2016, available at uses.bcaresearch.com. Appendix Table 1Allocating U.S. Import Tariffs To U.S. GICS Sectors U.S. Equity Sectors: Trade War Winners And Losers U.S. Equity Sectors: Trade War Winners And Losers Appendix Table 2Exports By U.S. Red States U.S. Equity Sectors: Trade War Winners And Losers U.S. Equity Sectors: Trade War Winners And Losers Appendix Table 3Exports By U.S. Swing States U.S. Equity Sectors: Trade War Winners And Losers U.S. Equity Sectors: Trade War Winners And Losers Appendix Table 4Exposure Of U.S. Industries To U.S. Import Tariffs U.S. Equity Sectors: Trade War Winners And Losers U.S. Equity Sectors: Trade War Winners And Losers Strategy & Market Trends Tactical Trades Strategic Recommendations Closed Trades

In this Special Report, we shed light on the implications of the U.S./Sino trade war for U.S. equity sectors. The threat that trade action poses to the U.S. equity market is greater than in past confrontations. Perhaps most importantly, supply chains are much more extensive, globally and between China and the U.S. Automobile Components, Electrical Equipment, Materials, Capital Goods and Consumer Durables have the most extensive supply chain networks. The USTR claims that it is being strategic in the Chinese goods it is targeting, focusing on companies that will benefit from the "Made In China 2025" initiative. The list of Chinese goods targeted in both the first and second rounds covers virtually all of the broad import categories. The only major items left for the U.S. to hit are apparel, footwear, toys and cellphones. Beijing is clearly targeting U.S. products based on politics in order to exert as much pressure on the President's party as possible. Based on a list of products that comprise the top-10 most exported goods of Red and Swing States, China will likely lift tariffs in the next rounds on civilian aircraft, computer electronics, healthcare equipment, car engines, chemicals, wood pulp, telecommunication and integrated circuits. Supply chains within and between industries and firms mean that the impact of tariffs is much broader than the direct impact on exporters and importers. We measure the relative exposure of 24 GICs equity sectors to the trade war based on their proportion of foreign-sourced revenues and the proportion of each industry's total inputs that are affected by U.S. tariffs. The Semiconductors & Semiconductor Equipment sector stands out, but the Technology & Hardware Equipment, Capital Goods, Materials, Consumer Durables & Apparel and Motor Vehicle sectors are also highly exposed to anti-trade policy action. Energy, Software, Banks and all other service sectors are much less exposed. China may also attempt to disrupt supply chains via non-tariff barriers, placing even more pressure on U.S. firms that have invested heavily in China. Wholesale Trade, Chemicals, Transportation Equipment, Computers & Electronic Parts and Finance & Insurance are most exposed. U.S. technology companies are particularly vulnerable to an escalating trade war. Virtually all U.S. manufacturing industries will be negatively affected by an ongoing trade war, even defensive sectors such as Consumer Staples. The one exception is defense manufacturers, where we recommend overweight positions. Our analysis highlights that the best shelter from a trade war can be found in services, particularly services that are insulated from trade. Financial Services appears a logical choice, and the S&P Financial Exchanges & Data subsector is one of our favorites. The trade skirmish is transitioning to a full-on trade war. The U.S. has imposed a 25% tariff on $50 billion worth of Chinese goods, and has proposed a 10% levy on an additional $200 billion of imports by August 31. China retaliated with tariffs on $50 billion of imports from the U.S., but Trump has threatened tariffs on another $300 billion if China refuses to back down. That would add up to over $500 billion in Chinese goods and services that could be subject to tariffs, only slightly less than the total amount that China exported to the U.S. last year. BCA's Geopolitical Strategy has emphasized that President Trump is unconstrained on trade policy, giving him leeway to be tougher than the market expects.1 This is especially the case with respect to China. There will be strong pushback from Congress and the U.S. business lobby if the Administration tries to cancel NAFTA. In contrast, Congress is also demanding that the Administration be tough on China because it plays well with voters. Trump is a prisoner of his own tough pre-election campaign rhetoric against China. The U.S. primary economic goal is not to equalize tariffs but to open market access.2 The strategic goal is much larger. The U.S. wants to see China's rate of technological development slow down. Washington will expect robust guarantees to protect intellectual property and proprietary technology before it dials down the pressure on Beijing. The threat that the trade war poses to the U.S. equity market is greater than in past confrontations, such as that between Japan and the U.S. in the late 1980s. First, stocks are more expensive today. Second, interest rates are much lower, limiting how much central banks can react to adverse shocks. Third, and perhaps most importantly, supply chains are much more extensive, globally and between China and the U.S. Nearly every major S&P 500 multinational corporation is in some way exposed to these supply chains. Chart II-1 shows that Automobile Components, Electrical Equipment, Materials, Capital Goods and Consumer Durables have the most extensive supply chain networks. The Global Value Chain Participation rate, constructed by the OECD, is a measure of cross-border value-added linkages.3 In this Special Report, we shed light on the implications of the trade war for U.S. equity sectors. Complex industrial interactions make it difficult to be precise in identifying the winners and losers of a trade war. Nonetheless, we can identify the industries most and least exposed to a further rise in tariff walls or non-tariff barriers to trade. We focus on the U.S./Sino trade dispute in this Special Report, leaving the implications of a potential trade war with Europe and the possible failure of NAFTA negotiations for future research. Chart II-1Measuring Global Supply Chains August 2018 August 2018 Trade Channels There are at least five channels through which rising tariffs can affect U.S. industry: The Direct Effect: This can be positive or negative. The impact is positive for those industries that do not export much but are provided relief from stiff import competition via higher import tariffs. The impact is negative for those firms facing higher tariffs on their exports, as well as for those firms facing higher costs for imported inputs to their production process. These firms would be forced to absorb some of the tariff via lower profit margins. Some industries will fall into both positive and negative camps. U.S. washing machines are a good example. Whirlpool's stock price jumped after President Trump announced an import tariff on washing machines, but it subsequently fell back when the Administration imposed an import tariff on steel and aluminum (that are used in the production of washing machines); Indirect Effect: The higher costs for imported goods are passed along the supply chain within an industry and to other industries that are not directly affected by rising tariffs. This will undermine profit margins in these indirectly-affected industries to the extent that they cannot fully pass along the higher input costs; Foreign Direct Investment: Some Chinese exports emanate from U.S. multinationals' subsidiaries in China, or by Chinese or foreign OEM suppliers for U.S. firms. Even though it would undermine China's economy to some extent, the Chinese authorities could make life more difficult for these firms in retaliation for U.S. tariffs on Chinese goods. Macro Effect: A trade war would take a toll on global trade and reduce GDP growth globally. Besides the negative effect of uncertainty on business confidence and, thus, capital spending, rising prices for both consumer and capital goods will reduce the volume of spending in both cases. Moreover, corporate profits have a high beta with respect to economic activity. We would not rule out a U.S. recession in a worst-case scenario. Obviously, a recession or economic slowdown would inflict the most pain on the cyclical parts of the S&P 500 relative to the non-cyclicals, in typical fashion. Currency Effect: To the extent that a trade war pushes up the dollar relative to the other currencies, it would undermine export-oriented industries and benefit those that import. However, while we are bullish the dollar due to diverging monetary policy, the dollar may not benefit much from trade friction given retaliatory tariff increases by other countries. Some of the direct and indirect impact can be mitigated to the extent that importers facing higher prices for Chinese goods shift to similarly-priced foreign producers outside of China. Nonetheless, this adjustment will not be costless as there may be insufficient supply capacity outside of China, leading to upward pressure on prices globally. Targeted Sectors: (I) U.S. Tariffs On Chinese Goods As noted above, the U.S. has already imposed tariffs on $50 billion of Chinese imports and has published a list of another $200 billion of goods that are being considered for a 10% tariff in the second round of the trade war. The first round focused on intermediate and capital goods, while the second round includes consumer final demand categories such as furniture, air conditioners and refrigerators. The latter will show up as higher prices at retailers such as Wal Mart, having a direct and visible impact on U.S. households. Appendix Table II-A1 lists the goods that are on the first and second round lists, grouped according to the U.S. equity sectors in the S&P 500. The U.S. Trade Representative (USTR) claims that the Chinese items are being targeted strategically. It is focusing on companies that will benefit from China's structural policies, such as the "Made In China 2025" initiative that is designed to make the country a world leader in high-tech areas (see below). Table II-1 reveals the relative size of the broad categories of U.S. imports from China, based on trade categories. The top of the table is dominated by Motor Vehicles, Machinery, Telecommunication Equipment, Computers, Apparel & Footwear and other manufactured goods. The list of Chinese goods targeted in both the first and second rounds covers virtually all of the broad categories in Table II-1. The only major items left for the U.S. to hit are Apparel and Footwear, as well as two subcategories; Toys and Cellphones. These are all consumer demand categories. Table II-1U.S. Imports From China (January-May 2018) August 2018 August 2018 (II) Chinese Tariffs On U.S. Goods Total U.S. exports to China were less than $53 billion in the first five months of 2018, limiting the amount of direct retaliation that China can undertake (Table II-2). The list of individual U.S. products that China has targeted so far is long, but we have condensed it into the broad categories shown in Table II-3. The U.S. equity sectors that the new tariffs affect so far include Food, Beverage & Tobacco, Automobiles & Components, Materials and Energy. China has concentrated mainly on final goods in a politically strategic manner, such as Trump-supported rural areas and Harley Davidson bikes whose operations are based in Paul Ryan's home district in Wisconsin. Table II-2U.S. Exports To China (January-May 2018) August 2018 August 2018 Table II-3China Tariffs On U.S. Goods August 2018 August 2018 What will China target next? Chart II-2 shows exports to China as percent of total state exports, and Chart II-3 presents the value of products already tariffed by China as a percent of state exports. Other than Washington, the four states most targeted by Beijing are conservative: Alaska, Alabama, Louisiana and South Carolina. Chart II-2U.S. Exports To China By State August 2018 August 2018 Chart II-3Value Of U.S. Products Tariffed By China (By State) August 2018 August 2018 Beijing is clearly targeting products based on politics in order to exert as much pressure on the President's party as possible. To identify the next items to be targeted, we constructed a list of products that comprise the top-10 most exported goods of Red States (solidly conservative) and Swing States (competitive states that can go either to Republican or Democratic politicians). Appendix Tables II-A2 and II-A3 show this list of products, with those that have already been flagged by China for tariffs crossed out. Table II-4 shows the top-10 list of products that are not yet tariffed by China, but are distributed in a large proportion of Red and Swing states. What strikes us immediately is how important aircraft exports are to a large number of Swing and Red States. In total, 27 U.S. states export civilian aircraft, engines and parts to China. This is an obvious target of Beijing's retaliation. In addition, we believe that computer electronics, healthcare equipment, car engines, chemicals, wood pulp, telecommunication and integrated circuits are next. Table II-4Number Of U.S. States Exporting To China By Category August 2018 August 2018 Market Reaction Chart II-4 highlights how U.S. equity sectors performed during seven separate days when the S&P 500 suffered notable losses due to heightened fears of protectionism. Cyclical sectors such as Industrials and Materials fared worse during days of rising protectionist angst. Financials also generally underperformed, largely because such days saw a flattening of the yield curve. Tech, Health Care, Energy and Telecom performed broadly in line with the S&P 500. Consumer Staples outperformed the market, but still declined in absolute terms. Utilities and Real Estate were the only two sectors that saw absolute price gains. The market reaction seems sensible based on the industries caught in the cross-hairs of the trade action so far. At least some of the potential damage is already discounted in equity prices. Nonetheless, it is useful to take a closer look at the underlying factors that should determine the ultimate winners and losers from additional salvos in the trade war. Chart II-4S&P 500: Impact Of Trade-Related Events August 2018 August 2018 Determining The Winners And Losers The U.S. sectors that garner the largest proportion of total revenues from outside the U.S. are obviously the most exposed to a trade war. For the 24 level 2 GICS sectors in the S&P 500, Table II-5 presents the proportion of total revenues that is generated from operations outside the U.S. for the top five companies in the sector by market cap. Company reporting makes it difficult in some cases to identify the exact revenue amount coming from outside the U.S., as some companies regard "domestic" earnings as anything generated in North America. Nonetheless, we believe the data in Table II-5 provide a reasonably accurate picture. Table II-5Foreign Revenue Exposure (2017) August 2018 August 2018 Semiconductors, Tech Equipment, Materials, Food & Beverage, Software and Capital Goods are at the top of the list in terms of foreign-sourced revenues. Not surprisingly, service industries like Real Estate, Banking, Utilities and Telecommunications Services are at the bottom of the exposure list. U.S. companies are also exposed to U.S. tariffs that lift the price of imported inputs to the production process. This can occur directly when firm A imports a good from abroad, and indirectly, when firm A sells its intermediate good to firm B at a higher price, and then on to firm C. In order to capture the entire process, we used the information contained in the Bureau of Economic Analysis' Input/Output tables. We estimated the proportion of each industry's total inputs that are affected by already-implemented U.S. tariffs and those that are on the list for the next round of tariffs. These estimates, shown in Appendix Table II-A4 at a detailed industrial level, include both the direct and indirect effects of higher import costs. At the top of the list is Motor Vehicles and Parts, where Trump tariffs could affect more than 70% of the cost of all material inputs to the production process. Electrical Equipment, Machinery and other materials industries are also high on the list, together with Furniture, Computers & Electronic Parts and Construction. Unsurprisingly, service industries and Utilities are in the bottom half of the table.4 We then allocated all the industries in Appendix Table II-A4 to the 24 GICs level 2 sectors in the S&P 500, in order to obtain an import exposure ranking in S&P sector space (Table II-6). Table II-6U.S. Import Tariff Exposure August 2018 August 2018 Chart II-5 presents a scatter diagram that compares import tariff exposure (horizontal axis) with foreign revenue exposure (vertical axis). The industries clustered in the top-right of the diagram are the most exposed to a trade war. Chart II-5U.S. Industrial Exposure To A Trade War With China August 2018 August 2018 The Semiconductors & Semiconductor Equipment sector stands out by this metric, but the Technology & Hardware Equipment, Capital Goods, Materials, Consumer Durables & Apparel and Motor Vehicle sectors are also highly exposed to anti-trade policy action. Energy, Software, Banks and all other service sectors are much less exposed. Food, Beverage & Tobacco lies between the two extremes. Joint Ventures And FDI Table II-7Stock Of U.S. Direct ##br##Investment In China (2017) August 2018 August 2018 As mentioned above, most U.S. production taking place in China involves a joint venture. The Chinese authorities could attempt to disrupt the supply chain of a U.S. company by hindering production at companies that have ties to U.S. firms. Data on U.S. foreign direct investment (FDI) in China will be indicative of the industries that are most exposed to this form of retaliation. The stock of U.S. FDI in China totaled more than $107 billion last year (Table II-7). At the top of the table are Wholesale Trade, Chemicals, Transportation Equipment, Computers & Electronic Parts and Finance & Insurance. Apple is a good example of a U.S. company that is exposed to non-tariff retaliation, as the iPhone is assembled in China by Foxconn for shipment globally with mostly foreign sourced parts. Our Technology sector strategists argue that U.S. technology companies are particularly vulnerable to an escalating trade war (See Box II-1).5 BOX II-1 The Tech Sector The U.S. has applied tariffs on the raw materials of technology products rather than finished goods so far. At a minimum, this will penalize smaller U.S. tech firms which manufacture in the U.S. and provide an incentive to move production elsewhere. Worst case, the U.S. tariffs might lead to component shortages which could have a disproportionately negative impact, especially on smaller firms. Although it has not been proposed, U.S. tariffs on finished goods would be devastating to large tech companies such as Apple, which outsources its manufacturing to China. China appears determined to have a vibrant high technology sector. The "Made In China 2025" program, for example, combines ambitious goals in supercomputers, robotics, medical devices and smart cars, while setting domestic localization targets that would favor Chinese companies over foreigners. The ZTE sanctions and the potential for enhanced export controls have had a traumatic impact on China's understanding of its relatively weak position with respect to technology. As a result, because most high-tech products are available from non-U.S. sources, Chinese engineers will likely be encouraged to design with non-U.S. components; for example, selecting a Samsung instead of a Qualcomm processor for a smartphone. Similarly, China is a major buyer of semiconductor capital equipment as it follows through with plans to scale up its semiconductor industry. Most such equipment is also available from non-U.S. vendors, and it would be understandable if these suppliers are selected given the risk which would now be associated with selecting a U.S. supplier. The U.S. is targeting Chinese made resistors, capacitors, crystals, batteries, Light Emitting Diodes (LEDs) and semiconductors with a 25% tariff. For the most part these are simple, low cost devices, which are used by the billions in high-tech devices. Nonetheless, China could limit the export of these products to deliver maximum pain, leading to a potential shortage of qualified parts. A component shortage can have a devastating impact on production since the manufacturer may not have the ability to substitute a new part or qualify a new vendor. Since the product typically won't work unless all the right parts are installed, want of a dollar's worth of capacitors may delay shipping a $1,000 product. Thus, the economic and profit impact of a parts shortage in the U.S. could be quite severe. Conclusions: When it comes to absolute winners in case of a trade war, we believe there are three conditions that need to be met: Relatively high domestic input costs. Relatively high domestic consumption/sales; the true beneficiaries of a tariff are those industries who are allowed to either raise prices or displace foreign competitors, with the consumer typically bearing the cost. Relatively low direct exposure to global trade - international trade flows will certainly slow in a trade war. There are very few manufacturing industries that meet all of these criteria. Within manufacturing, one would typically expect the Consumer Staples and Discretionary sectors to be the best performers. However, roughly a third of the weight of Staples is in three stocks (PG, KO and PEP) that are massively dependent on foreign sales. Moreover, a similar weight of Discretionary is in two retailers (AMZN and HD) that are dependent on imports. As such, consumer indexes do not appear a safe harbor in a trade war. Nevertheless, if the trade war morphs into a recession then consumer staples (and other defensive safe-havens) will outperform, although they will still decrease in absolute terms. Transports are an industry that has relatively high domestic labor costs and an output that is consumed virtually entirely within domestic borders. However, their reliance on global trade flows - intermodal shipping is now more than half of all rail traffic - means they almost certainly lose from a prolonged trade dispute. There is one manufacturing industry that could be at least a relative winner and perhaps an absolute winner: defense. Defense manufacturers certainly satisfy the first two criteria above, though they do have reasonably heavy foreign exposure. However, we believe high switching costs and the lack of true global competitors mean that U.S. defense company foreign sales will be resilient. After all, a NATO nation does not simply switch out of F-35 jets for the Russian or Chinese equivalent. Further, if trade friction leads to rising military tension, defense stocks should outperform. Finally, the ongoing global arms race, space race and growing cybersecurity requirements all signal that these stocks are a secular growth story, as BCA has argued in the recent past.6 Still, as highlighted by the data presented above, the best shelter from a trade war can be found in services, particularly services that are insulated from trade. Financial Services appears a logical choice, especially the S&P Financial Exchanges & Data subsector (BLBG: S5FEXD - CME, SPGI, ICE, MCO, MSCI, CBOE, NDAQ). Another appealing - and defensive - sector is Health Care Services. With effectively no foreign exposure and a low beta, these stocks would outperform in the worst-case trade war-induced recession. Mark McClellan Senior Vice President The Bank Credit Analyst Marko Papic Senior Vice President Geopolitical Strategy Chris Bowes Associate Editor U.S. Equity Strategy 1 Please see BCA Geopolitical Strategy Special Report, "Constraints & Preferences Of The Trump Presidency," dated November 30, 2016, available at gps.bcaresearch.com. 2 Please see BCA Geopolitical Strategy Weekly Report, "Trump's Demands On China," dated April 4, 2018, available at gps.bcaresearch.com. 3 For more information, please see: "Global Value Chains (GVSs): United States." May 2013. OECD website. 4 Please see BCA U.S. Equity Strategy Special Report, "Brothers In Arms," dated October 31, 2016, available at uses.bcaresearch.com. 5 Please see BCA Technology Sector Strategy Special Report "Trade Wars And Technology," dated July 10, 2018, available at tech.bcaresearch.com 6 Please see BCA U.S. Equity Strategy Special Report, "Brothers In Arms," dated October 31, 2016, available at uses.bcaresearch.com. Appendix Table II-1 Allocating U.S. Import Tariffs To U.S. GICS Sectors August 2018 August 2018 Appendix Table II-2 Exports By U.S. Red States August 2018 August 2018 Appendix Table II-3 Exports By U.S. Swing States August 2018 August 2018 Appendix Table II-4 Exposure Of U.S. Industries To U.S. Import Tariffs August 2018 August 2018

Please note that our next publication will be a joint special report with BCA’s Geopolitical Service that will be published on Wednesday, August 1st instead of our usual Monday publishing schedule. Further, there will be no publication on Monday, August 6th. We will be returning to our normal publishing schedule thereafter. Highlights We continue to explore a cyclical over defensive portfolio bent, and the capex upcycle along with higher interest rates are our key investment themes for the remainder of the year. A number of sentiment indicators have broken out (Chart 1), and our sense is that the SPX will also hit fresh all-time highs in the coming quarters. While buybacks vaulted to uncharted territory in Q1/2018 (Chart 2), our profit growth model suggests that EPS will continue to expand at a healthy clip for the rest of the year (Chart 3) and 10% EPS growth is achievable in calendar 2019. Positive macro forces remain in place with the ISM - manufacturing and non-manufacturing - surveys reaccelerating. Beneath the surface, the new-orders-to-inventories ratio is gaining traction and even the trade-related subcomponents (new export orders and imports) are ticking higher. High backlogs also suggest that SPX revenue growth will remain upbeat (Chart 4). Non-farm payrolls are expanding on a month-over-month basis for 93 consecutive months, a record (Chart 5), at a time when the real fed funds rate remains near the zero line (Chart 6). As a result, the economy is overheating. Corporate selling price inflation is skyrocketing, according to our gauge, with our diffusion index catapulting to multi-decade highs. This represents a positive margin backdrop as wage inflation remains muted (Chart 7). While at first sight, valuations appear dear, a simple thought experiment suggests that soon they will deflate1 (Chart 8). And, on a forward price-to-earnings-to-growth (PEG) basis, valuations have sunk to one standard deviation below the historical mean (Chart 9). Two key risks that we are closely monitoring that can put our cyclically positive equity market view offside are: a sustained rise in the U.S. dollar infiltrating profit growth (Chart 10), and corporate balance sheet degradation short-circuiting the broad equity market (Chart 11). Chart 1Sentiment Is Breaking Out Sentiment Is Breaking Out Sentiment Is Breaking Out Chart 2Buybacks Are Soaring Buybacks Are Soaring Buybacks Are Soaring Chart 3Earnings Growth Hasnt Slowed... Earnings Growth Hasnt Slowed... Earnings Growth Hasnt Slowed... Chart 4...And Backlogs Suggest They Wont ...And Backlogs Suggest They Wont ...And Backlogs Suggest They Wont Chart 5Record Jobs Growth... Record Jobs Growth... Record Jobs Growth... Chart 6...And Still-Loose Monetary Policy ...And Still-Loose Monetary Policy ...And Still-Loose Monetary Policy Chart 7Wage Growth Is Trailing Pricing Power Flexing Its Muscles Wage Growth Is Trailing Pricing Power Flexing Its Muscles Wage Growth Is Trailing Chart 8The Market Is Not That Expensive... The Market Is Not That Expensive... The Market Is Not That Expensive... Chart 9...By Several Measures ...By Several Measures ...By Several Measures Chart 10A Strong Dollar Is A Risk A Strong Dollar Is A Risk A Strong Dollar Is A Risk Chart 11Corporate Sector Leverage Is Too High Corporate Sector Leverage Is Too High Corporate Sector Leverage Is Too High Feature S&P Industrials (Overweight) While our industrials CMI remains very near 20-year highs, it has lost its upward momentum this year due almost entirely to the strength of the U.S. dollar, though sliding global PMI surveys have also started to weigh (second panel, Chart 13). Combined with heightened fears of a trade war, the internationally geared S&P industrials have come under pressure. Chart 12S&P Industrials (Overweight) S&P Industrials S&P Industrials Chart 13Positive Industrial Growth Backdrop Positive Industrial Growth Backdrop Positive Industrial Growth Backdrop Still, demand growth has been resilient and continues to soar as the capex upcycle has not yet run its course and the implications for top line and profit growth are unambiguously positive (third and bottom panels, Chart 13). Should some let up emerge from the current break down of international trade, we would expect earnings to resume their role as the fundamental driver for industrials. Our valuation gauge has rapidly declined this year as extreme bearishness is not reflected by the strong profit backdrop. From a technical perspective, S&P industrials have been the most oversold since the Great Recession. S&P Energy (Overweight, High-Conviction) Our energy CMI has continued to push higher from the extremely depressed levels of 2016 and 2017. Still, the much better cyclical environment has started to get reflected in relative share prices with the S&P energy index besting all other GICS1 sectors in Q2. We recently refined our energy sector sub-surface positioning that sustains the broad energy complex in the overweight column, and we reiterated its high-conviction status. We believe the steep recovery in underlying commodity prices, which the market has thus far failed to show much confidence in, has started to restore some semblance of normality in the exploration & production (E&P) stocks space (top panel, Chart 15). Chart 14S&P Energy (Overweight, High Conviction) S&P Energy S&P Energy Chart 15A Capex Boom As Oil Reignites A Capex Boom As Oil Reignites A Capex Boom As Oil Reignites Similar to the broad energy complex that integrateds dominate, oil & gas E&P producers are a capital expenditure upcycle play, which remains a key BCA theme for the year (second panel, Chart 15). Accordingly, we raised the S&P oil & gas E&P index to an overweight stance. Simultaneously, weakening crack spreads (third panel, Chart 15) and rising gasoline inventories (bottom panel, Chart 15) have given us cause for concern for refiners. As a result, we trimmed the S&P oil & gas refining & marketing index to underweight, though this did not shake our high-conviction overweight position on the broad S&P energy index. Our Valuation Indicator (VI) remains near deeply undervalued territory, and indicates an attractive entry point for fresh capital. Our Technical Indicator (TI) has fully recovered from oversold levels and now sends a neutral message. S&P Financials (Overweight) The pace of improvement in our financials cyclical macro indicator (CMI) has not abated. However, the usual tight correlation between the CMI and the relative performance of the S&P financials index has broken down. An important culprit has been the heavyweight S&P banks sub-index and its transition from a correlation with the 10-year UST yield and toward the 10/2 yield curve slope earlier this year (top and second panels, Chart 17). While the former is still up year-over-year, the latter has continued to flatten and the result is likely a squeeze on banks' net interest margins, a key profit driver; we recently booked gains of 6% and removed it from the high-conviction overweight list, and the S&P banks index is currently on downgrade watch. Chart 16S&P Financials (Overweight) S&P Financials S&P Financials Chart 17Growth And Credit Quality Offset A Flat Yield Curve Growth And Credit Quality Offset A Flat Yield Curve Growth And Credit Quality Offset A Flat Yield Curve Still, our key three reasons for being overweight the S&P financials index remain unchanged. Rising yields and the accompanying higher price of credit are a boon to financials and a core BCA theme for 2018 remains higher interest rates. The global capex upcycle, another of BCA's key themes for 2018, has paused for breath, though it has been replaced by soaring U.S. demand. This exceptional willingness of U.S. CEOs to expand their balance sheets should mean capital formation will proceed at well above-trend pace, and further underpin C&I loan growth (third panel, Chart 17). Lastly, a low unemployment rate drives both expanding consumer credit and much better credit quality. At present, the unemployment rate is testing all-time lows, sending an unambiguously positive message for financials profitability (bottom panel, Chart 17). Market bearishness has more than offset the positive fundamentals and the S&P financials index has underperformed in 2018; the result has been a steep fall in our VI to nearly one standard deviation below normal. The bearishness is also reflected in our TI which has recently collapsed into oversold territory. S&P Consumer Staples (Overweight) Our consumer staples CMI has moved sideways since our last update, near a depressed level. This is reflected in the share price performance; defensives in general and staples in particular have been woefully unloved this year. However, we believe positive macro undercurrents have made bargain basement prices in consumer staples an exceptional deal, particularly for investors willing to withstand short term volatility for a long-term investment gain. We recently pointed out that, while non-discretionary demand is losing share versus overall outlays, spending on essentials as a percentage of disposable income is gaining steam. The bearish read on this would be that this could be a pre-cursor to recession, but our interpretation is that latent staples-related buying power may make a comeback from a still very depressed level and kick-start industry sales growth (top panel, Chart 19). Chart 18S&P Consumer Staples (Overweight) S&P Consumer Staples S&P Consumer Staples Chart 19Staples Are Poised For A Recovery Staples Are Poised For A Recovery Staples Are Poised For A Recovery Meanwhile consumer staples exports are flying in the face of a rising U.S. dollar, which has typically presaged relative earnings gains (second panel, Chart 19). Considering the already-strong industry return on equity, any relative earnings gains should result in a valuation rerating (third panel, Chart 19). Both our VI and TI concur; as they are both more than a standard deviation below fair value. S&P Health Care (Neutral) Earlier this month, we lifted the S&P pharma and biotech indexes to neutral and, given that these sectors command roughly a 50% weighting in the S&P health care sector, these upgrades also lifted the health care sector to a neutral portfolio weighting. Sentiment has moved squarely against the sector and the bar for upward surprises has been lowered enough to create fertile ground for upside surprises. As shown in the second panel of Chart 21, health care long-term EPS growth expectations have never been lower in the history of the I/B/E/S/ data. This is contrarily positive, particularly given how our VI has remained under pressure and our TI has sunk. Chart 20S&P Health Care (Neutral) S&P Health Care S&P Health Care Chart 21Peak Pessimism In Health Care Peak Pessimism In Health Care Peak Pessimism In Health Care Still, our health care CMI has been treading water at relatively low levels, but our S&P health care earnings model suggests that at least a bottom in profit growth has formed (bottom panel, Chart 21). S&P Technology (Neutral) We lifted the S&P technology index to neutral earlier this year to capitalize on one of BCA's key themes for 2018: synchronized global capex upcycle, of which the broad tech sector is a core beneficiary (second panel, Chart 23).2 Software and tech hardware & peripherals are the two key sub-indexes we prefer and have also put on our high-conviction overweight list. Chart 22S&P Technology (Neutral) S&P Technology S&P Technology Chart 23A Capex Upcycle Should Sustain High Valuations A Capex Upcycle Should Sustain High Valuations A Capex Upcycle Should Sustain High Valuations There is still pent up demand for tech spending that is being unleashed following over a decade of severe underinvestment. In addition, consumer spending on tech goods is also at the highest level since the history of the data, underscoring that end demand is upbeat (third panel, Chart 23). On the global demand front, EM Asian exports are climbing at the fastest clip in ten years; tech sales and EM Asian exports are historically joined at the hip and the current message is positive (bottom panel, Chart 23). The technology CMI has also turned positive this year after falling for the previous three, though an appreciating dollar and higher interest rates continue to suppress an otherwise exceptionally robust macro environment. Valuations, while still in the neutral zone, have reached their highest level in a decade. This may prove risky should inflation mount faster than expected; a de-rating phase in technology would likely follow. Our TI is in overbought territory, though it has been at this high level for several years. S&P Utilities (Neutral) Our utilities CMI appears to have found a bottom, arresting the linear downtrend of the previous decade. Declining earnings have steadied out as the industry has found some discipline; new investment has declined and turbine & generator inventories have ticked up (second panel, Chart 25). The result of declining investment has been a slight improvement in capacity utilization, albeit still at a relatively low level (third panel, Chart 25). Chart 24S&P Utilities (Neutral) S&P Utilities S&P Utilities Chart 25Earnings Are Looking For A Bottom Earnings Are Looking For A Bottom Earnings Are Looking For A Bottom The uptick in capacity utilization has driven a surge in industry pricing power, despite flat natural gas prices which have historically been the industry price setter; this could be the precursor to a recovery in sector earnings (bottom panel, Chart 25). Still, as with other defensive sectors, utilities have underperformed cyclical sectors in the last year; this has been exacerbated by utilities trading as fixed income proxies. Our VI does not provide much direction as it has been in the neutral zone for the past year, underscoring our benchmark allocation recommendation. Our TI fell steeply earlier this year, though it has recovered and offers a neutral reading. S&P Materials (Neutral) The materials CMI has come under pressure as the Fed has continued to tighten monetary policy. A further selloff in bonds remains the BCA view for 2018, implying rising real rates will weigh on the sector for at least the remainder of the year. The heavyweight chemicals component of the materials index typically sees earnings (and hence stock prices) underperform as real interest rates are moving higher (real rates shown inverted, top panel, Chart 27). Chart 26S&P Materials (Neutral) S&P Materials S&P Materials Chart 27This Time Is Different For Chemicals This Time Is Different For Chemicals This Time Is Different For Chemicals On the operating front, chemicals sector productivity has made solid gains over the past year and the sell-side bearishness for much of the past decade has finally reversed (second panel, Chart 27). Further, overcapacity, the usual death knell of the chemicals cycle, seems to be a thing of the past as the industry has massively scaled back on capital deployment on the heels of a mega global M&A cycle (third panel, Chart 27). Net, operating improvements might offset macro headwinds. Our VI echoes this neutral message and sits on the fair value line. Our TI is somewhat more bullish and is edging toward an oversold position. S&P Real Estate (Underweight) Our real estate CMI looks to have found a bottom earlier this year, though the only time it has been worse was during the Great Financial Crisis. Real estate stocks are continuing to behave like fixed income proxies, as they have since the overhang from the GFC gave way to a yield focus (top panel, Chart 29). In the context of a tightening monetary backdrop, we would need compelling operating or valuation reasons to maintain even a benchmark allocation in the sector; these are both absent. Chart 28S&P Real Estate (Underweight) S&P Real Estate S&P Real Estate Chart 29Dark Clouds Forming Dark Clouds Forming Dark Clouds Forming On the operating front, the commercial real estate (CRE) sector is waving a red flag. The occupancy rate has clearly crested and rents are headed down with it, warning of declining sector cash flows (second panel, Chart 29). While CRE credit quality shows no signs of deterioration, at this stage of the cycle and given weak industry profit fundamentals we would caution against extrapolating such good times far into the future (third panel, Chart 29). We recently initiated a trade to capitalize on relative CRE weakness by going long the S&P homebuilding index/short the S&P REITs index.3 Such overwhelming bearishness would suggest the sector would be relatively cheap, but our VI suggests that REITs are fairly valued. Our TI is has been unwinding an oversold position and is now in neutral territory. S&P Consumer Discretionary (Underweight) In early March, we identified three key factors that we expected to weigh on the consumer discretionary sector: a rising fed funds rate, quantitative tightening and higher prices at the pump. As highlighted in Chart 31, all of these factors remain intact and underlie the two-year decline in the consumer discretionary CMI. Chart 30S&P Consumer Discretionary (Underweight) S&P Consumer Discretionary S&P Consumer Discretionary Chart 31The Amazon Effect The Amazon Effect The Amazon Effect Further, were we to exclude AMZN from the day the S&P included it in the SPX and the S&P 500 consumer discretionary index (November 21st, 2005), then the vast majority of consumer discretionary stocks are actually following the typical historical relationship with the Fed's tightening cycle (fed funds rates shown inverted, top panel, Chart 31). Put differently, the equal weighted S&P consumer discretionary relative share price ratio is indeed following the Fed's historical tightening path (bottom panel, Chart 31). Meanwhile, our VI has broken out to nearly its highest level ever which we believe is largely a function of the decreasing diversification of the S&P consumer discretionary index as AMZN now represents nearly a quarter of its market value, and about to get even larger in the upcoming introduction of the Communications Services GICS1 sector, but only comprises 3% of this sector's net income. Our TI agrees with our VI and is well into overbought territory. S&P Telecommunication Services (Underweight) Our telecom services CMI, bounced off its 30-year low earlier this year, but not nearly enough for a bullish position to be established. Rather, our bearish thesis remains unchanged: A combination of still-tepid pricing power weighing on earnings (second panel, Chart 33), weak consumer spending (bottom panel, Chart 33) and higher Treasury yields (which are negatively correlated with high-dividend yielding telecom services stocks, top panel, Chart 33), should all keep relative performance suppressed. Chart 32S&P Telecommunication Services (Underweight) S&P Telecommunication Services S&P Telecommunication Services Chart 33Pricing Power Is Still On Hold Pricing Power Is Still On Hold Pricing Power Is Still On Hold Valuations have fallen significantly - our VI continues to touch new lows - and our TI has been indicating a persistently oversold position, but we think the industry is in a de-rating phase, implying the new valuation paradigm has a degree of permanence. Size Indicator (Favor Large Vs. Small Caps) Our size CMI has fallen back to the boom/bust line. Keep in mind that this CMI is not designed as a directional trend predictor, but rather as a buy/sell oscillator; the current message is neutral. Despite the neutral CMI reading, we downgraded small caps earlier this year,4 and moved to a large cap preference, based on the diverging (and unsustainable) debt levels of small caps vs. their large cap peers (top and second panels, Chart 35). We expect the divergence in leverage and stock price to be rationalized as it usually has: via a fall in the latter. Chart 34Size Indicator (Favor Large Vs. Small Caps) Style View Style View Chart 35Small Cap Leverage Is Critical Small Cap Leverage Is Critical Small Cap Leverage Is Critical Our call has thus far been slightly offside as small caps have been outperforming: investors have sought the trade-friction free shelter that small caps offer compared with internationally exposed large caps. Extreme optimism also reigns throughout the small cap world (third panel, Chart 35). However, we continue to think a turn is merely a matter of time; the NFIB's "good time to expand" reading is at its highest level in the history of the survey (bottom panel, Chart 35) which means small cap CEOs are more likely to push their already-stretched balance sheets closer to the breaking point. Our TI is telling us that small caps are overbought, but the VI continues to offer a neutral message. Chris Bowes, Associate Editor chrisb@bcaresearch.com 1 Please see BCA U.S. Equity Strategy Insight Report, "How Expensive Is The SPX?" dated July 6, 2018, available at uses.bcaresearch.com. 2 Please see BCA U.S. Equity Strategy Weekly Report, "Buying Opportunity," dated April 9, 2018, available at uses.bcaresearch.com. 3 Please see BCA U.S. Equity Strategy Special Report, "UnReal Estate Opportunity," dated July 9, 2018, available at uses.bcaresearch.com. 4 Please see BCA U.S. Equity Strategy Special Report, "UnReal Estate Opportunity," dated July 9, 2018, available at uses.bcaresearch.com.

Overweight (High Conviction) The S&P software index has continued to soar this year, helping the NASDAQ set an all-time high this week. Capex surveys are bouncing around the highest levels this millennium; such optimism has typically led software investment and, hence, earnings growth (second and third panels). The market has fully adopted an ebullient stance on U.S. software with the result that our high-conviction overweight trade has gained 15% versus the SPX since the late-November inception.1 At least part of the ascent of the S&P software index has been due to M&A premia being built into stock prices, with CA already being the subject of a takeover bid from AVGO. With the amount of industry consolidation, a speculative lift is hardly a surprise (bottom panel). Still, we view this as the flightiest sort of valuation upside and, from a portfolio management perspective, this morning we suggest that clients institute a stop in this high-conviction call at the 10% relative return mark, in line with our late-January introduced risk management policy. Bottom Line: We reiterate our high-conviction overweight status in the S&P software index, but recommend a 10% stop. The ticker symbols for the stocks in this index are: BLBG: S5SOFT - MSFT, ORCL, ADBE, CRM, ATVI, INTU, EA, RHT, ADSK, CTXS, ANSS, SNPS, SYMC, TTWO, CDNS, CA. 1 Please see BCA U.S. Equity Strategy Weekly Report, "High-Conviction Calls," dated November 27, 2017, available at uses.bcaresearch.com. Software Is Roaring Software Is Roaring