Technology

Highlights We update the long-term structural themes that we expect will be key drivers of financial market performance over the next one to five years, drawing investment conclusions from each. Debt Supercycle. The final stage of a debt supercycle is often marked by an increase in public debt, which we may now see in the U.S. Meanwhile, the eurozone and emerging markets are still at an early stage of post-debt deleveraging. Technological Disruption. The IT revolution has reached the mature phase, and behind it is a new wave of technologies including artificial intelligence and biotech. The first and last stages of tech waves are the only times where investors typically make profits. Emerging Market Deleveraging. EM assets will continue to underperform until these countries complete structural reforms and deal with the consequences of a decade of credit excesses. Multipolar Geopolitics. The end of American hegemony raises the risk of military conflicts and will make the world less globalized. End Of The Bond Bull Market. Interest rates have been in structural decline since the early 1980s. With a rotation to fiscal policy and (eventually) higher inflation, the path of least resistance for yields is upwards. Subpar Long-Run Returns. With bond yields low and equities expensive, investors will find it hard to achieve the returns they have become accustomed to over the past 30 years. Substantially more risk will be required to achieve the same level of return. Bear Market In Commodities. Weak demand growth (as China reengineers its economy), excess resource capacity, and an appreciating dollar make this a very different environment to the 2000s. Mal-Distribution Of Income. The backlash from stagnant incomes in Anglo-Saxon economies will continue. Populism is likely to cause the labor share of GDP to rise, hurting profits and lowering investment returns. Feature I. Introduction Chart 1Major Market Cycles Major Market Cycles Major Market Cycles The key views in Global Asset Allocation (GAA), as in other BCA services, center on the cyclical time-horizon, six to 12 months. This means analyzing principally where we are in the business cycle, the impact of liquidity and monetary conditions, and the current outlook for economic and earnings growth. But it is also important to understand the long-term picture: the structural trends in asset prices, debt, demographics, technology, and other "long wave" factors that have profound and protracted impacts on investment performance. Specifically, investors need to get right long-term shifts in things such as economic growth, the U.S. dollar, commodity prices, interest rates, and the relative performance of stocks and bonds (Chart 1). Such long-term themes, therefore, represent the road-map around which GAA develops its cyclical views. Ever since the service began in 2011 (and indeed in its predecessor, the BCA Premium Service), we have published a list of Major Themes, that "should be key drivers of financial market performance over the next 1-5 years." This Special Report updates and fleshes out these major themes. We have retained five of our current themes: The End of The Debt Supercycle The End of The 35-Year Global Bond Bull Market Subpar Long-Run Returns Bear Market in Commodities The Mal-Distribution of Income &Social Unrest And have added three new themes: Technological Disruption EM in A Multi-Year Deleveraging Multipolar Geopolitics In the report we describe each of these themes and draw investment conclusions from them. The descriptions are relatively brief (since most of these themes will be familiar to BCA clients), but we spend more time on analyzing the new themes and on the Debt Supercycle, which is central to our world view. We have dropped two of our earlier themes: Financial Sector Re-Regulation: Bank regulation has indeed been drastically tightened in the years since the Global Financial Crisis. As a result, banks have deleveraged significantly in most regions (Chart 2), their profitability has declined (Chart 3), and share price performance has been poor. But this phase may be over. Bank loan growth has recovered in the U.S. and the new Trump administration may both boost demand for borrowing and ease regulation. In Europe and Japan, bank stock performance will henceforth be driven more by shifts in loan demand and the shape of the yield curve than by regulation. Chart 2Banks Have Deleveraged... bca.gaa_sr_2016_12_05_c2 bca.gaa_sr_2016_12_05_c2 Chart 3... And Become Much Less Profitable bca.gaa_sr_2016_12_05_c3 bca.gaa_sr_2016_12_05_c3 Chart 4The Lowest Interest Rates Ever bca.gaa_sr_2016_12_05_c4 bca.gaa_sr_2016_12_05_c4 A Generational Shift: Our concept was that Millennials (usually defined as those who came of age after 2000 - so born between 1977 and 1994) would behave differently: they would own less (preferring to Uber and couch-surf), depend on social media, and be less focused on their careers. Arguably, this has not been the case. Like previous generations, Millennials have started to acquire possessions. In the U.S. last year, one-half of homebuyers were under 36; Millennials bought 4 million cars (making them the second largest group of purchasers behind baby-boomers). Moreover, this is a hard theme to draw investment conclusions from. Every generation is slightly different - but how concretely does this affect asset prices? One final thought. A common thread running through our themes is that there is little new under the sun. Most phenomena in economics and markets are cyclical. Many of the charts in this report show that the same environment comes round time and again, after five, 10 or 50 years. Much analysis in investment theory is based on this (think of Kontratiev waves, "the fourth turning," Dow Theory etc.) But what is fascinating about today's world is that there are trends we are experiencing for the first time in history: Zero or negative interest rates: never in history have governments, companies, and individuals been able to borrow so cheaply (Chart 4), sometimes even being paid for the privilege. Demographics: The world population has grown continuously since the Black Death in 1350. Indeed the fastest population growth on record was as recent as the 1960s (Chart 5). But growth has slowed sharply since, and is expected to be only 0.1% a year by the end of the century. As a result, we are seeing an unprecedented slowdown - and even decline - in the size of the workforce in many countries (Chart 6). Chart 5Population Growth Has Slowed Drastically bca.gaa_sr_2016_12_05_c5 bca.gaa_sr_2016_12_05_c5 Chart 6The Workforce In Some Countries Is Shrinking bca.gaa_sr_2016_12_05_c6 bca.gaa_sr_2016_12_05_c6 The impacts of these two trends will be profound - but they won't be found by looking at historical precedents. II. Debt Supercycles One of the key ways in which BCA has long looked at the world is through the concept of debt supercycles. Our founder, Hamilton Bolton, wrote in 1967 of "the possibilities inherent in an intensive study of changes in bank credit as a major cyclical and supercyclical investment tool....History shows period after period of excessive bank credit inflation. It also shows a number of periods in which bank credit deflation has been allowed to erode the whole economic and investment structure."1 Simply put, when credit in the economy expands (and these days one needs to look more broadly than at just bank credit) it tends to boost growth, raise asset prices, and underpin the effectiveness of monetary policy. At some point, the level of credit becomes unsustainable and the subsequent deleveraging causes financial conservatism as borrowers focus on repairing their balance-sheets. This makes monetary policy relatively ineffective, and has negative effects on growth and asset prices. The two biggest debt supercycles over the past 50 years were in Japan from 1970 to 1990, and in the U.S. and parts of Europe starting in the early 1980s and culminating with the Global Financial Crisis in 2007 (Chart 7). The fallout from the end of Japan's debt supercycle has been stark: since 1990, Japanese nominal GDP has grown by only 0.4% a year (compared to 6% a year over the previous 10 years) and even today the Nikkei index is 55% below its peak. In the U.S., the early 1980s' financial deregulation and the fiscal policies of the Reagan government caused both private and government debt to begin to rise as a percentage of GDP (Chart 8). From the late 1990s, monetary policy was kept too easy, which culminated in the housing bubble of 2004-7. After that bubble burst, households reduced debt (partly through defaults) and government spending rose sharply for a few years to cushion the recession. Chart 7Debt Supercycles Everywhere Debt Supercycles Everywhere Debt Supercycles Everywhere Chart 8U.S. Debt Started To Rise From 1980 bca.gaa_sr_2016_12_05_c8 bca.gaa_sr_2016_12_05_c8 Since 2009, BCA has been talking about a "post debt supercycle" in the U.S.2 The household savings rate rose (Chart 9), as consumers became cautious, preferring to save rather than spend (Chart 10). This has meant that consumption growth has been lower than wage growth, whereas the opposite was the case up to 2007. Monetary policy also became ineffective since, in such a weak growth environment, companies were not inclined to spend on capital investment despite ultra-low interest rates (Chart 11). Chart 9Household Savings Rate Has Risen Since The Crisis bca.gaa_sr_2016_12_05_c9 bca.gaa_sr_2016_12_05_c9 Chart 10Consumers Prefer To Save Than Spend Consumers Prefer To Save Than Spend Consumers Prefer To Save Than Spend Chart 11Companies Not Spending Despite Low Rates Companies Not Spending Despite Low Rates Companies Not Spending Despite Low Rates There are two competing theories to explain the sub-trend growth of the current expansion. Larry Summers' theory of secular stagnation3 describes a world in which, even with ultra-low interest rates, desired levels of saving exceed desired levels of investment, leading to chronic shortfall in demand. BCA's debt supercycle explanation is closer to that of economists such as Kenneth Rogoff, who argues that once deleveraging and borrowing headwinds subside, growth trends might rise again.4But the two theories may not be so incompatible: secular factors, such as demographics, play a role in both. The final stage of a debt supercycle is often an increase in public debt. That has certainly been the case in Japan: while the private sector has deleveraged aggressively since 1990, government debt to GDP has risen from 67% to 250% - without having much discernible effect on boosting growth. In the U.S., government debt has stabilized as a percentage of GDP over the past two years, and the baseline projection made by the Congressional Budget Office in March this year forecasts it to increase by only 10 percentage points over the next decade. But the election of President Trump might change that. His campaign promised tax cuts and infrastructure spending amounting to about USD6 Trn which, all else being equal, would increase government debt/GDP by another 30 percentage points over a decade. There are two other regions where we see the debt supercycle being an important factor over the coming years: the Eurozone and emerging markets. In Europe, some of the most indebted countries, notably the U.K. and Spain, have made progress in deleveraging since the Global Financial Crisis - although the balance-sheet repair is likely to remain a drag on the economy for a while longer. But France and Italy have hardly delevered at all, and some smaller countries such as Belgium have seen a substantial increase in private debt/GDP (Chart 12). The Eurozone remains generally a very heavily bank-dependent economy, with total bank credit almost back to a historical peak (Chart 13). Germany, by contrast, has long had an aversion to debt: private sector debt/GDP has never been above 130% and is currently only around 100%. This unwillingness to borrow and spend by the world's fourth largest economy has been a drag on European growth. Chart 12Deleveraging In Europe Has Been Patchy Deleveraging In Europe Has Been Patchy Deleveraging In Europe Has Been Patchy Chart 13Eurozone Bank Loans Have Not Declined Eurozone Bank Loans Have Not Declined Eurozone Bank Loans Have Not Declined Emerging markets delevered after the Asian crisis in 1997-8 but the wave of global liquidity created in 2009-12 flowed into EMs, triggering excessively high credit growth. Private-sector EM debt has reached an average of 140% of GDP (Chart 14), and a higher percentage of global GDP than was U.S. debt at the peak of the housing bubble in 2006. Although the debt buildup is most extreme in China, where private-sector debt/GDP has risen by 70 percentage points over the past seven years, the same phenomenon is apparent in many other emerging markets, notably Brazil, Turkey, Russia and Malaysia (Chart 15). Chart 14The EM Debt Supercycle May Be Ending The EM Debt Supercycle May Be Ending The EM Debt Supercycle May Be Ending Chart 15And It's Not Just About China And It's Not Just About China And It's Not Just About China BCA's Emerging Markets Strategy has argued for a while that this is unsustainable and that a period of deleveraging will cause growth to slow in many emerging markets and that the strains from the excessive lending, such as rising NPL ratios, will become apparent.5 The deleveraging has already started to happen, with loan growth in Brazil, Malaysia and Turkey - but not yet China - slowing sharply (Charts 16 & 17). Chart 16EM Bank Lending Now Slowing... EM Bank Lending Now Slowing... EM Bank Lending Now Slowing... Chart 17...Almost Everywhere ... Almost Everywhere ... Almost Everywhere We draw a number of conclusions for long-term asset allocation from this analysis. The post debt supercycle is likely to remain a drag on global growth, and therefore on returns from risk assets, for some years to come. But the U.S. is likely to be less affected than the eurozone since the household sector there has already substantially deleveraged and the Trump administration is more likely to use government spending to fill the gap. Emerging markets will underperform for some years to come as they too go through a period of deleveraging. III. Disruptive Technology Technological change is a key driving force of economies and markets. As Joseph Schumpeter said, capitalism is a "process of industrial mutation...that incessantly revolutionizes the economic structure from within, incessantly destroying the old one, incessantly creating a new one." Nikolai Kondratiev described 45-60 year waves that were triggered by "the irruption of a technological revolution and the absorption of its effects." Understanding where we are in the technological cycle, then, is very important for investors wanting to catch deep trends. But it is particularly hard at the moment because, at the same time as the world is still seeing ramifications coming through from personal computing (which began as long ago as 1971, with Intel's announcement of the first microprocessor) and from the internet (which started as Arpanet in 1969), there is a new wave of revolutionary technologies still mainly on the drawing-board, including robotics, artificial intelligence, and genetic engineering. The best framework for thinking about technological cycles is provided by economist Carlota Perez.6 She describes five "surges of development" starting with the Industrial Revolution, which she dates from the opening of Arkwright's cotton spinning mill in Cromford in 1771 (Table 1). Her key argument is that these revolutionary technologies have powerful and long drawn-out effects on the financial, social, institutional, and organizational framework and therefore tend to move through a similar pattern of four phases (Chart 18) lasting around 50 years in all. The fifth wave, Information Technology, for example, started in its installation phase with development of the microprocessor, PCs, and mobile phones in the 1970s and 1980s, reached frenzy in the 1990s, hit a turning-point (which often triggers a stock market crash) in 2000-2, before reaching the deployment phase in the 2000s, and may now be at maturity (growth in computers and smart phones is slowing). Table 1The Five Historic Technology ##br##'Surges Of Development' Refreshing Our Long-Term Themes Refreshing Our Long-Term Themes Chart 18The Four Stages Of Technology Waves Refreshing Our Long-Term Themes Refreshing Our Long-Term Themes But Perez wrote her book in 2002, and we could now be close to the beginning of the sixth wave. Think about the situation 30 years ago, in 1986. It would not have been hard to extrapolate how technology might develop over the coming years since some people already used PCs, mobile phones, and the internet but, as William Gibson said at the time, "the future is already, here - it's just not very evenly distributed." Today there are still a few further developments to come in these fifth-wave technologies (we've listed some in Table 2). But there is a whole further set of technologies (self-driving cars, graphene, distributed energy generation) which almost nobody uses now, but which could become important. Many of these build on the developments of the fifth wave (ubiquitous connectivity, cheap and powerful computing) in the same way that previous revolutions grew from their predecessors (cars wouldn't have been possible without steel, for example). Table 2Fifth And Sixth Wave Technologies Still To Come Refreshing Our Long-Term Themes Refreshing Our Long-Term Themes The implications of these new technologies are hard to predict, and many have undoubtedly been over-hyped. As Bill Gates said: "We always overestimate the change that will occur in the next two years and underestimate the change that will occur in the next ten." So how should investors deal with this? The macro implications are enormous. Every new wave of technologies has a large impact on employment, as jobs in dying industries disappear. U.S. farm workers, for example, fell from over half of the labor force in 1880 to only 12% by 1950 (Chart 19). But perhaps more relevant - given that self-driving vehicles may replace taxi, truck, and delivery drivers - is that the number of horses in the U.S. fell from 26 million to 4 million over the 50 years starting in 1915 (Chart 20). These jobs, of course, were replaced by new opportunities in manufacturing or services. And the number of drivers in the U.S. is only 3.8 million currently, or less than 3% of the workforce. Nonetheless, in the maturity phase of the technology wave (where we are now for the IT revolution), Perez points out, there is often popular unrest as "workers organize and demand...the benefits that have been promised and not delivered." Chart 19Farm Workers Were Disrupted ##br##In The Late 19th Century Refreshing Our Long-Term Themes Refreshing Our Long-Term Themes Chart 20...And So ##br##Were Horses Refreshing Our Long-Term Themes Refreshing Our Long-Term Themes Investing in new technologies is naturally appealing to investors, but often tricky to get right. Alastair Nairn7 identifies five similar phases for investing in technology but concludes that investors can usually make money only in the first stage, when initial skepticism reigns, and in the final stage, when the technology has matured and the surviving handful of leading players can now make good profit. Analysis by economists at the Atlanta Fed showed (Table 3) that, of the 24 U.S. PC manufacturers listed on the U.S. stock market between 1983 and 2006, only 10 made a positive return for shareholders.8 Of these, only five beat the overall index. The picture is similar for other technology waves, except perhaps for the nascent auto industry when 12 of 23 listed manufacturers outperformed the index in 1912-1928. Table 3Investments In New Technology Companies Rarely Beat The Market Refreshing Our Long-Term Themes Refreshing Our Long-Term Themes Nairn also argues that it is easier to spot losers than winners: "The winners take many years to emerge and...it is well-nigh impossible to identify them early. ...Conversely, the losers tend to be more obvious, and more obvious at an early stage." Think back to the early days of the internet. Investors would have struggled to pick the eventual winners (Apple, Amazon, Google - but many might have guessed Yahoo or even Pets.com) but should have understood that the media, travel, retailing, and film-camera industries would all be disrupted. Chart 21IT And Healthcare Sectors ##br##Are Likely To Continue To Outperform IT And Healthcare Sectors Are Likely To Continue To Outperform IT And Healthcare Sectors Are Likely To Continue To Outperform So how should investors apply these conclusions? If we are in the mature phase of the Fifth Wave and the skepticism phase of the Sixth, this is a time when investors can benefit from tilts towards sectors where technological changes are taking place, most notably IT and Healthcare, which are likely to continue to outperform over the long run (Chart 21). Exposure to what our colleague Peter Berezin calls BRAIN stocks - biotech, robotics, artificial intelligence, nanotech - makes sense.9 This can be captured through venture capital funds. Potential losers might include energy companies and utilities, as improvements in solar energy lead to more distributed power. Even oil company BP reckons that renewables will provide 16% of power generation in 2035 - and 35% in the EU - up from 4% today, with the cost of solar power expected to fall by 40% over the time. Other sectors that could be disrupted include automakers, which could be challenged by developments in electric vehicles, and financial institutions, whose business model could be under threat from peer-to-peer lending, robo-advisers and other developments in fintech. IV. Emerging Markets In A Multi-Year Deleveraging BCA has recommended a structural underweight on emerging market (EM) equities relative to developed markets (DM) since 2010.10 This call worked well until the end of last year. So far this year, however, EM equities have outperformed DM by 5%, despite their sharp selloff (Chart 22) after the U.S. election. Our view is that emerging markets remain structurally challenged and that their long-run underperformance is likely to continue. We view the outperformance this year as simply a counter-trend move driven largely by two factors: a) the extreme relative undervaluation of EM vs. DM at the beginning of the year; and b) unconventional quantitative easing from the ECB and BoJ, and massive back-door liquidity injections (Chart 23) by EM central banks, such as in China and Turkey. Chart 22Counter-Trend Rally Largley Driven By... bca.gaa_sr_2016_12_05_c22 bca.gaa_sr_2016_12_05_c22 Chart 23QE / Massive Liquidity Injection By PBoC bca.gaa_sr_2016_12_05_c23 bca.gaa_sr_2016_12_05_c23 After the bounce, however, EM equities are no longer especially cheap relative to their DM counterparts, with the relative forward PE ratio now at its five-year average. Going forward, the poor profit outlook - due to persistent structural problems in the EM economies - will continue to weigh on the relative performance of EM assets. We maintain our structural underweight call on EM equities in a global portfolio. First, the factors that drove the massive outperformance of emerging markets in 2002-2010 have disappeared: the once-in-a-generation debt-fueled consumption binge in DM, and the investment-fueled double-digit growth in China which triggered a bull market in commodities (Chart 24). But EM countries did not take full advantage of these exogenous forces to reform their economies: to foster domestic demand, and optimize resource allocation and industrial structure. When China slowed and U.S. consumers went through a much-needed deleveraging after the Great Recession, exports to DM slowed and even contracted, and commodities prices declined sharply. As a result, the export-driven economic model of EM countries has broken down. The structural drivers of economic growth in the EM, both productivity and capital efficiency (Chart 25), have been in a downtrend, while debt (Chart 26) has continued to soar. Chart 24Regime Has Shifted bca.gaa_sr_2016_12_05_c24 bca.gaa_sr_2016_12_05_c24 Chart 25Structural Drivers Have Weakened bca.gaa_sr_2016_12_05_c25 bca.gaa_sr_2016_12_05_c25 Chart 26Debt Has Soared Debt Has Soared Debt Has Soared Structural problems require structural solutions. These solutions vary by country, but in general require less state intervention in the economy, flexible labor markets, and better incentive structures to encourage innovation and entrepreneurship. But structural reforms are a painful process and take strong political will to implement. A case in point is China, which delayed its announced supply-side reforms and reverted to monetary and fiscal stimulus when growth slowed. Second, history shows that no credit boom can last forever. Chart 27 shows private non-financial credit-to-GDP ratios in major developed economies. They have experienced periods of deleveraging of various magnitudes and durations, even though these nations have deep and sophisticated banking, credit, and financial markets, and some have plenty of domestic savings. Similar patterns have been observed in EM economies, although their deleveraging episodes have tended to be more frequent and of larger magnitude (Chart 28). Chart 27No Credit Boom Lasts ##br##Forever In DM Economies No Credit Boom Lasts Forever In DM Economies No Credit Boom Lasts Forever In DM Economies Chart 28Asian Economies: Many Interruptions During Structural Leveraging Process bca.gaa_sr_2016_12_05_c28 bca.gaa_sr_2016_12_05_c28 The main reason for these boom-bust credit cycles is the burden of debt servicing. As the private credit-to-GDP ratio rises, if interest rates are held constant, a larger share of income needs to be allocated to paying interest. At some point, debt service eats too much into debtors' incomes, causing debtors to default and creditors to reduce credit provision. This causes the economy to slow, followed by a painful but necessary restructuring to work off the excess leverage before a new cycle can start. We see no reason see why EM countries, China in particular, can sustain their current high and rising leverage levels. Deleveraging is inevitable. Third, this deleveraging in EM is at a very early stage, since credit in most EM countries continues to grow faster than nominal GDP (Chart 29). After years of booming corporate and household debt, a period of consolidation is inevitable. Hence, credit growth is set to slow to at least the level of nominal GDP growth. The credit impulse - the change in the rate of credit growth - is a key factor influencing GDP and profit growth. Chart 30 shows that if credit growth converges to nominal GDP growth within the next 12-24 months, the credit impulse will turn negative, ensuring a slowdown in the EM economies and a further contraction in corporate earnings, thus putting downside pressure on asset prices. Chart 29A Break In LEveraging Cycle Is Overdue bca.gaa_sr_2016_12_05_c29 bca.gaa_sr_2016_12_05_c29 Chart 30Negative Credit Impulse Bodes Ill For Profit And Equities Prices Negative Credit Impulse Bodes Ill For Profit And Equities Prices Negative Credit Impulse Bodes Ill For Profit And Equities Prices Chart 31Dismal Return on Equity Dismal Return on Equity Dismal Return on Equity Bottom Line: EM economies are at a very early stage of a multi-year deleveraging to work off credit excesses. Despite their year-to-date outperformance, we expect EM equities will continue to underperform their DM counterparts over the long run until their return on equity (Chart 31) improves significantly. V. Geopolitical Multipolarity Since the end of the Cold War, geopolitics has mostly remained in the background for investors. This is because the collapse of the Soviet Union ushered in an era of American hegemony that lasted for roughly two decades. During this period, the global concentration of economic, trade, and military power increased as the U.S. became the only true superpower (Chart 32). The world entered a period of "hegemonic stability," an era during which regional powers dared not pursue an independent foreign policy for fear of U.S. retaliation and during which the "Washington consensus" of laissez-faire capitalism and free trade was adopted by policymakers in both developed and emerging markets. Chart 32The End Of American Hegemony bca.gaa_sr_2016_12_05_c32 bca.gaa_sr_2016_12_05_c32 A central thesis of BCA's Geopolitical Strategy is that the world has entered a multipolar phase.11 Multipolarity implies that the number of states powerful enough to pursue an independent and globally-relevant foreign policy is greater than one (unipolarity) or two (bipolarity). Today, multipolarity is the product of America's decaying unipolar moment. The U.S. remains, by far, the most powerful country in the absolute sense, but it is experiencing a relative decline as regional powers become more capable on both the economic and geopolitical fronts (Chart 33). Multipolarity is not a popular theme with investors. It augurs uncertainty, rising risk premia, and unanticipated "Black Swan" events. In addition, some of our clients take issue with the thesis that the U.S. is in "decline." Although we can measure hard power and illustrate the relative decline of the U.S. empirically, perhaps the greatest evidence of global multipolarity are recent events that were unimaginable just five or ten years ago: Russia's annexation of Crimea; China's military expansion in South China Sea; Turkey's disregard for U.S. interests in Syria; U.S.-Iran détente (with little evidence that Tehran has actually curbed its nuclear capabilities); Dramatic withdrawal of U.S. troops in the Middle East. The point of a multipolar world is not that Russia, China, Turkey, Iran, and other powers seek to challenge America's global reach, but rather that each is more than capable of pursuing an independent foreign policy within their own spheres of influence. As the number of "veto players" in the global "Great Game" increases, however, equilibrium becomes more difficult to achieve. Uncertainty rises and conflicts emerge where none were expected. So what does multipolarity mean for investors? First, we know from formal modeling in political science, and from history, that a multipolar world is unstable and more likely to produce military conflict (Chart 34).12 There are three reasons: Chart 33U.S. Experiencing Relative Decline U.S. Experiencing Relative Decline U.S. Experiencing Relative Decline Chart 34Geopolitical Risk Is The Outcome Of Global Multipolarity bca.gaa_sr_2016_12_05_c34 bca.gaa_sr_2016_12_05_c34 During periods of multipolarity, more states can effectively pursue foreign policies that lead to war, thus creating more potential "conflict dyads" in the parlance of International Relations theory. In fact, evidence shows that this has already happened (and continues to happen), with the number of international or internationalized conflicts rising since 2010 dramatically (Chart 35). Power imbalances between states are more likely if there are more states that matter geopolitically. And power imbalances invite conflict as they are more likely to produce a situation in which one country's rising capabilities threaten another. During the Cold War, it didn't matter that Iran was more powerful than Saudi Arabia because the U.S. was present in the Middle East and willing to balance against Tehran. In a multipolar world, the weaker states are on their own. The probability of miscalculation rises due to the number of relevant states making geopolitical decisions simultaneously. For example, last year's shooting down of a Russian jet by the Turkish air force over Syria is an example of an incident that is mathematically more likely in a multipolar world. During the Cold War, the chances that Turkey would independently make the decision to shoot down a Soviet jet was far smaller as its foreign policy was closely aligned with that of its NATO ally the U.S. Chart 35Multipolarity Increases ##br##The Frequency Of Conflict Multipolarity Increases The Frequency Of Conflict Multipolarity Increases The Frequency Of Conflict There are a number of derivatives from the multipolarity thesis that will be relevant for investors. For example, despite Brexit, a multipolar world will support European integration.13 With geopolitical uncertainty rising in Europe's neighborhood - particularly in the Middle East and with Russia reasserting itself - Europe's core countries will not follow down the "exit" path that the U.K. pursued. On the other hand, the geopolitical disequilibrium in East Asia is deepening, with China's pursuit of a sphere of influence in the South and East China Seas likely to continue to raise tensions in the region. But the overarching concern for investors should be how multipolarity impacts the global economy. Global macroeconomic imbalances - such as the current combination of insufficient demand and excessive capacity - can be overcome either by unilateral policy from the hegemon or through coordination among the major economic and political powers. A multipolar world, however, lacks such coordination. Globalization is therefore at risk from multipolarity.14 Not only are regional powers pursuing spheres of influence, which is by definition incompatible with a globalized world, but the world lacks the hegemon that normally provides the expensive, and hard to come by, global public goods: namely economic coordination and geopolitical stability. History teaches us that the ebb and flow of trade globalization has been closely associated in the past with the shifting global balance of power (Chart 36). Trade globalization collapsed right around 1880, when the rise of a unified Germany and the ascendant U.S. undermined the century-old Pax Britannica. This trend ushered in a rise of competitive tariffs as the laggards of industrialization attempted to catch up with the established powers. Trade globalization recovered and began to grown again in the early twentieth century and immediately after the First World War, but both attempts were aborted by the lack of a clear hegemon willing to undertake the coordinating role necessary for globalization to take root and persevere. Chart 36Back To The 1930's? bca.gaa_sr_2016_12_05_c36 bca.gaa_sr_2016_12_05_c36 The lack of a clear hegemon and the diffusion of geopolitical power amongst multiple states can act as a headwind to global coordination. In the late nineteenth and early twentieth century, the U.K. was too weak to enforce global rules and norms, and the surging U.S. was unwilling to do so. Today, the U.S. is (relatively) too weak and unwilling to do the job of a hegemon, while China is understandably unwilling to coordinate its economic policy with a strategic rival. The investment implications of multipolarity center on three broad themes: Apex globalization: Going forward, the world is going to be less, not more, globalized. This will favor domestic over global sectors and consumer-oriented economies over the export-oriented ones. Globalization is also a major deflationary force, which would suggest that, on the margin, a world that is less globalized should be more inflationary. DM over EM: Multipolarity is more likely to produce a number of conflicts, some of which lay dormant throughout the Cold War and subsequent era of American hegemony. These conflicts tend to be in emerging or frontier markets. Safe Havens: With the frequency of geopolitical conflict on the rise, safe haven assets like the U.S. Treasurys, U.S. dollar, gold, and Swiss and Japanese government bonds, should continue to hold an important place in investors' asset allocation. VI. End Of The 35-Year Global Bond Bull Market Since the early 1980s, interest rates have been in a structural decline on the back of falling inflation expectations. Thirty-five years later, the global bond bull market has reached its end (Chart 37). Importantly, this is not to suggest that a secular bear market in bonds is beginning. The global economy is still suffering from significant spare capacity and markets usually go through a volatile bottoming process before a new secular trend is established. Nevertheless, the path of least resistance for yields is upwards. Chart 37Long-Term Yields Have Bottomed Long-Term Yields Have Bottomed Long-Term Yields Have Bottomed The most significant shift regarding sovereign yields is the global transition from monetary to fiscal stimulus. Over the next few years, central bank asset purchases will be negligible at best, with normalization in central bank balance sheets being far more likely, albeit at a muted pace. From the fiscal perspective, the rotation has already occurred in several regions, with the liberal government in Canada promising to increase infrastructure spending, Japanese Prime Minister Shinzo Abe postponing next year's planned VAT tax hike, and incoming U.S. President Donald Trump expected to ramp up fiscal spending. Sovereign bond yields have been weighed down by the rise in inequality. IMF studies found that this increase in inequality has had substantial negative effects on real GDP growth and therefore the real component. Populism is growing, as evidenced by the surprising outcome of the Brexit vote, the rise of anti-establishment parties in Europe, and the highly polarizing candidates in the U.S. elections. However, as populism continues to mount, policymakers will be further pressured to take on additional reflationary measures, inevitably leading to higher inflation. Anemic productivity growth has dampened aggregate demand and applied downward pressure to bond yields. Initially, weak productivity gains are deflationary as they reduce the incentive for firms to invest and consumers to reduce their spending. The longer term effect however, is that the supply side catches up, causing the economy to overheat and inflation to rise (Chart 38). This was the case in low productivity economies in Africa and Latin America. Chart 38A Decline In Productivity Growth Is Deflationary In The Short Run, But Inflationary In The Long Run Refreshing Our Long-Term Themes Refreshing Our Long-Term Themes Nevertheless, not all factors are pointing to higher yields. Demographic trends have been unfavorable, as working age population growth in the major countries has decelerated sharply since 2007. Conditions will likely worsen, with the UN forecasting growth to reach zero in the latter half of the next decade. The effect is further compression in the real component of bond yields as slower labor force growth reduces the incentive for firms to build new factories, shopping malls and office towers. Overall, while the global economy has been plagued by deflation, these signs suggest that the tide is finally turning. Higher consumer prices will not only lead to an increase in the inflation expectations component, but also the inflation risk premium, which compensates investors over the inflation outlook. As the majority of the rise in bond yields will come via the inflation component and not the real component, we advocate a long-term allocation to TIPS. VII. Subpar Long-Run Returns Asset prices have surged following the global financial crisis and have reached fairly expensive valuations. While this not to say that a bear market is imminent, it certainly makes financial assets more vulnerable to correction and it does suggest that long-term return prospects are bleak. Lower future returns will shift the efficient frontier inward, requiring substantially more risk to achieve the same level of returns. Investors will find it far more difficult to achieve returns they have become accustomed to over the past 30 years. Sovereign Bonds: After 35 years, the structural decline in interest rates is at an end. While we do not expect an outright bond bear market, the path of least resistance for yields is up (Chart 39). Across all major countries and regions, starting long-term real yields have been an excellent predictor for future five-year returns. Given that yields are at multi-century lows, and even negative in some regions, future returns will be meager. Investors should reduce their long-term allocation to sovereign debt. Chart 39Yields: The Path Of Least Resistance Is Up Yields: The Path Of Least Resistance Is Up Yields: The Path Of Least Resistance Is Up Corporate Bonds: Corporate debt is also priced expensively relative to its long-term history. The credit cycle is in its late stages, and while accommodative monetary policy will extend this phase, defaults will eventually grind higher and low starting yields will limit long-term returns. Investment grade real returns can be mostly explained by their starting real yields. In fact, real yields have been an even better predictor for investment grade returns than they have for sovereigns. Investment grade spreads are less important as they have historically been stable, and defaults are fairly rare in this space. For high yield, while starting real yields are important, spreads and defaults are also crucial determinants for performance. All valuation metrics suggest that both future investment grade and high-yield returns will fall far short of investors' ingrained expectations (Chart 40). Equities: The relationship between cyclically-adjusted price-to-earnings ratios (CAPEs) and real returns is well established, as a simple regression generates a high r-squared (Chart 41). Current valuations are expensive, suggesting low to mid single digit returns. However, there is reason to believe that this scenario is overly optimistic. First, global equities have benefitted from the structural decline in interest rates. Going forward however, the end of the bond bull market removes a substantial tailwind. Secondly, the Debt Supercycle, in which each cycle begins with more indebtedness than the one that preceded it, is played out in the developed world. The implication is that household credit demand will be weak and businesses are less likely to spend on capex, thereby dampening economic growth. Chart 40Low Starting Yields = Low Future Returns bca.gaa_sr_2016_12_05_c40 bca.gaa_sr_2016_12_05_c40 Chart 41Shiller P/E Suggests Below-Average Long-Run Equity Returns Shiller P/E Suggests Below-Average Long-Run Equity Returns Shiller P/E Suggests Below-Average Long-Run Equity Returns In order for investors to reach their return targets, we recommend several options. The end of the structural decline in interest rates does not bode well for sovereign bond returns. Instead, allocators should increase their structural exposure to equities. Investors should also focus more on bottom-up analysis and differentiating at lower levels, i.e. industry groups (GICS level 2). Finally, we advocate a long-term allocation to alternative assets. Alternatives provide downside protection through volatility reduction and substantial return enhancement potential given their active management and an illiquidity premium. VIII. Structural Bull Market In Resources Is Over Commodities experienced an unusually strong bull market in the 2000s, driven by very supportive global economic and financial conditions (Chart 42): 1) the U.S. dollar spent the decade in decline; 2) investment in mining capacity was depressed following the bear market of the 1990s; 3) rapid industrialization and double-digit growth in China. The bull market of 2000s lasted longer than its predecessors and was driven more by demand growth than by supply shortages. Commodities have never been a long-term buy. While there have been cyclical bull markets, the commodity complex in real terms has been in a structural downtrend for the past two centuries (Chart 43). This is despite a 20-fold increase in real GDP, a sign that rapid economic growth and weaker commodity prices can go hand in hand. The simple reason is that humans constantly find ways to extract commodities from the ground more cheaply and use them more efficiently. The current cyclical downturn is likely to continue for some years. Demand: A number cyclical and structural factors (Chart 44) will weigh on marginal demand for commodities in the long run: Chart 42Very SUpportive Backdrop In The 1990s bca.gaa_sr_2016_12_05_c42 bca.gaa_sr_2016_12_05_c42 Chart 43Not A Good Long-Term Investment Not A Good Long-Term Investment Not A Good Long-Term Investment Chart 44Shaky Demand Outlook bca.gaa_sr_2016_12_05_c44 bca.gaa_sr_2016_12_05_c44 Anemic Global Growth: Despite rising incomes, per capita consumption of base metals has been flat in most developed nations. With growth in the working age population slowing to 0.7% in 2010 - 2050, down from 1.7% in 1970 - 2010, the long-term outlook for consumer demand is poor. China: China consumes more zinc, aluminium and copper than the U.S., Japan, and Europe combined. It comprises more than 40% of global base metal demand, while it has only a 15% share of global GDP. With China's plans to transition into a consumer-driven services economy, this magnitude of incremental demand is highly unlikely in the future. Alternatives & Technological Advancements: Improved energy efficiency, the transition to renewable sources, and growth in electric-hybrid vehicles will weigh on demand for traditional sources of energy. A large-scale push towards nuclear energy, led by China's plans for 80GW of installed capacity by 2020, will pose a serious threat to marginal demand. Supply: Coordinated production cuts are a thing of the past. Underutilization (Chart 45) and market share-wars by countries that need to finance rising fiscal deficits have changed supply dynamics: Excess Capacity: Following the Global Financial Crisis, completion of projects which had been previously committed to, led to enormous capacity expansion when global growth was struggling. Both mining and oil & gas extraction capacity have reached new highs led by the U.S. This will continue to put downward pressure on both metals and energy prices until excess capacity has been removed. Proven Reserves: Known reserves of most metals have risen over the past decade and reached new highs: for example, in the case of copper, nearly three tons have been added to reserves for every ton consumed. In the crude oil market, technological progress has led to discovery of unconventional deposits, the best-known being Canadian oil sands, which by some estimates contain more than twice Saudi Arabia's crude oil reserves. Price Elasticity: The shale revolution brought with it leaner drilling operations which have a much shorter supply response time. The key to the price of crude is how quickly U.S. shale oil producers respond once the oil price rises above their current average cash cost of $50. This will limit the upside potential to crude oil for the next few years. U.S. Dollar & Real Rates: The dollar (Chart 46) has much more explanatory power for commodity prices than Chinese demand does. Given monetary policy and growth divergence between the U.S. and the rest of the world, the U.S. dollar will continue to appreciate. When real rates are low, the opportunity cost of keeping resources in the ground is also low. As growth starts to stabilize, rising real rates will add downward pressure on prices. Chart 45Relentless Supply Response bca.gaa_sr_2016_12_05_c45 bca.gaa_sr_2016_12_05_c45 Chart 46U.S. Dollar Vs Chinese Growth bca.gaa_sr_2016_12_05_c46 bca.gaa_sr_2016_12_05_c46 We remain structurally bearish on the overall commodity complex, but expect short-lived divergences within the group. As more nations agree on production cuts in oil, we expect energy markets to outperform metals. Precious metals will continue to stage mini-rallies on the back of heightened equity market volatility. Agricultural commodities will continue to bear the brunt of poor global demographics. IX. Mal-Distribution Of Income And Social Unrest The decision by the U.K. in June's referendum to leave the EU and Donald Trump's victory in the U.S. presidential election suggest a high degree of dissatisfaction with the status quo in Anglo-Saxon economies. This is hardly surprising given the stagnation of median wages in developed economies since the early 1980s, especially among the less educated (Chart 47), and growing inequality. The middle class (defined as those with disposable income between 25% below and 25% above the median) in the U.S. has fallen to 27% of the population from 33% in the early 1980s, and in the U.K. to 33% from 40% (Chart 48). Note that the decline in the middle class is much less prominent in continental Europe and Canada. Chart 47Wages For Less Educated Have Stagnated bca.gaa_sr_2016_12_05_c47 bca.gaa_sr_2016_12_05_c47 Chart 48Middle Class Has Shrunk In U.S. And U.K. But Not In Continental Europe Refreshing Our Long-Term Themes Refreshing Our Long-Term Themes The Gini coefficient in the U.S. has risen to as high a level as during the 1920s (Chart 49). Branko Milanovic, the leading academic working on global inequality, explains the reasons are follows: "The forces that pushed U.S. inequality up in the roaring twenties were, in many ways, similar to the forces that pushed it up in the 1990s: downward pressure on wages (from immigration and/or increased trade), capital-based technological change (Taylorism and the Internet), monopolization of the economy (Standard Oil and large banks), suppression or decreasing attractiveness of trade unions, and a shift toward plutocracy in government."15 Chart 49U.S. Inequality Back To 1920's Level Refreshing Our Long-Term Themes Refreshing Our Long-Term Themes The backlash has begun. BCA's Geopolitical Strategy service has described how the median voter in the Anglo-Saxon world is shifting to the left.16 Around the world governments are abandoning austerity and moving to fiscal stimulus and spending to improve infrastructure. Many, for example, are raising the minimum wage. In the U.K., it is due to go up from GBP7.20 to 60% of the median wage (about GBP9.35) by 2020, and in California from $10 to $15 by 2022. The 40 years of a falling labor share of GDP and rising capital share have started to reverse in the U.S. over the past two or three years (Chart 50). These shifts also threaten growth of global trade. Trump opposes the Trans-Pacific Partnership (TPP) trade agreement and says he will renegotiate or scrap the North America Free Trade Agreement (NAFTA). Global trade, after continuous growth as a percentage of GDP since World War Two, has slowed since the Great Recession (Chart 51). The WTO reports an increase in trade-restrictive measures and a fall in trade-facilitating measures over the past 12 months (Chart 52). Chart 50Fall In Labor Share ##br##Of GDP Starting To Reverse Fall In Labor Share Of GDP Starting To Reverse Fall In Labor Share Of GDP Starting To Reverse Chart 51Trade Globalization* bca.gaa_sr_2016_12_05_c51 bca.gaa_sr_2016_12_05_c51 Chart 52Trade Measures Are Getting ##br##Increasingly Restrictive Refreshing Our Long-Term Themes Refreshing Our Long-Term Themes Chart 53Populism Could Cause ##br##Profit Margins To Mean Revert Populism Could Cause Profit Margins To Mean Revert Populism Could Cause Profit Margins To Mean Revert These trends have significant implications for investors. The shift to populist politics is likely to be inflationary, as governments increasingly fall back on stimulative fiscal policy. A faster rise in wages will hurt corporate profit margins which, in the U.S., are likely to mean-revert from their current near-record highs (Chart 53). The popular discontent (and the growing unreliability of opinion polls) will make election results more unpredictable, as witnessed in the Brexit vote and the U.S. presidential election. A further pullback in global trade will hurt exporting sectors and export-dependent countries. All these factors lead to the conclusion that returns from investment assets over coming years are likely to be lower, and volatility higher, than has been the case over the past 40 years. Garry Evans, Senior Vice President Global Asset Allocation garry@bcaresearch.com Marko Papic, Senior Vice President Geopolitical Strategy marko@bcaresearch.com Xiaoli Tang, Associate Vice President xiaoli@bcaresearch.com Patrick Trinh, Senior Analyst patrick@bcaresearch.com Aditya Kurian, Research Analyst adityak@bcaresearch.com 1 Money And Investment Profits, A. Hamilton Bolton, Dow-Jones-Irwin Inc, 1967, pp74, 304. 2 For our most recent detailed analysis of this, please see BCA Special Report, "The End Of The Debt Supercycle, An Update," dated May 11, 2016, available at reports.bcaresearch.com 3 Please see, for example, Summers' article in Foreign Affairs, "The Age of Secular Stagnation," dated February 15, 2016. 4 Please see, for example, Rogoff's article, "Debt Supercycle, not secular stagnation," Centre for Economic Policy Research, dated April 22, 2015. 5 Please see, for example, Emerging Markets Strategy Special Report, "Gauging EM/China Credit Impulses," dated August 31, 2016, available at ems.bcaresearch.com 6 Please see, for example, her book Technological Revolutions and Financial Capital, published in 2002. 7 Please see Alasdair Nairn, "Engines That Move Markets," Wiley, dated January 4, 2002. 8 Measured either over the whole period, or between the dates that they were listed during the period. 9 Please see The Bank Credit Analyst, "Human Intelligence And Economic Growth," March 2013, available at bca.bcaresearch.com. 10 Please see Emerging Markets Strategy Weekly Report, "EM Equities: Downgrade To Underweight," dated April 20, 2010, available at ems.bcaresearch.com. 11 Please see BCA Geopolitical Strategy Monthly Report, "Multipolarity And Investing," dated April 9, 2014, and Geopolitical Strategy Strategic Outlook, "Stay The Course: EM Risk - DM Reward," dated January 23, 2014, available at gps.bcaresearch.com. 12 Please see Mearsheimer, John "The Tragedy Of Great Power Politics," New York: W.W. Norton & Company (2001). 13 Please see BCA Geopolitical Strategy Special Report, "After BREXIT, N-Exit?," dated July 13, 2016, available at gps.bcaresearch.com, and BCA The Bank Credit Analyst, "Europe's Geopolitical Gambit: Relevance Through Integration," dated November 2011, available at bca.bcaresearch.com. 14 Please see BCA Geopolitical Strategy Special Report, "The Apex Of Globalization: All Downhill From Here," dated November 12, 2014. 15 Please see Branco Milanovic, "Global Inequality: A New Approach for the Age of Globalization," Harvard University Press, 2016. 16 Please see Geopolitical Strategy Monthly Report, "Introducing: The Median Voter Theory," dated June 8, 2016, available at gps.bcaresearch.com.

President-elect Trump and the specter of his spendthrift policy proposals have generated significant client interest/inquiries on equities and inflation - not asset prices, but of the more traditional kind: consumer price inflation. Chart 1 shows that a little bit of inflation would be positive for the broad equity market, further fueling the high-risk, liquidity-driven blow off phase. However, when inflation has reached 3.7%-4% in the past, the broad equity market has stumbled (Chart 2). Sizeable tax cuts, increased infrastructure and defense spending (i.e. loose fiscal policy), protectionism and a tougher stance on immigration are inherently inflationary policies (and bond price negative) ceteris paribus. Chart 1A Whiff Of Inflation##br## Is Good For Stocks... bca.uses_sr_2016_12_05_c1 bca.uses_sr_2016_12_05_c1 Chart 2...But Too Much ##br##Is Restrictive ...But Too Much Is Restrictive ...But Too Much Is Restrictive However, our working assumption is that in the next 9-12 months, CPI headline inflation will only renormalize, rather than surge. Importantly, the magnitude and timing of the implementation of Trump's policy pledges is unknown. Moreover, the Fed's reaction function is also uncertain, and the resulting economic growth and U.S. dollar impact will be critical in determining whether any lasting inflation acceleration occurs. Table 1 Equity Sector Winners And Losers When Inflation Climbs Equity Sector Winners And Losers When Inflation Climbs For global inflation to take root beyond the short term, Europe and Japan would also have to follow Canada's and America's fiscal largesse to swing the global deflation/inflation pendulum toward sustained inflation. The Fed's Reaction Function Our sense is that a Yellen-led Fed will allow for some inflation overshoot to materialize. This view was originally posited in her 2012 "optimal control"1 speech and more recently reiterated with her mid-October speech emphasizing "temporarily running a "high-pressure economy," with robust aggregate demand and a tight labor market."2 The Fed has credible tools to deal with inflation. If economic growth does not soar, but rather sustains its post-GFC steady 2-2.5% real GDP growth profile as we expect, then taking some inflation risk is a high-probability. The implication is that the Fed will likely not rush to abruptly tighten monetary policy, a view confirmed by the bond market , which is penciling in only 40bps for 2017 (Chart 3). A sustainable breakout in bond yields would require inflation (and to a lesser extent real GDP growth) to significantly surprise to the upside and thus compel the Fed to aggressively raise the fed funds rate. Is that on the horizon? While wage inflation has perked up, unit labor cost inflation has a spotty track record in terms of leading core consumer goods prices. Why? About 20% of the CPI and PCE inflation baskets are produced abroad, underscoring that domestic costs are not a factor in setting prices. There is a tighter correlation between unit labor costs and service sector inflation, but even here there is not a consistent relationship (Chart 4). Consequently, there is minimal pressure on the Fed to get aggressive, suggesting that most of the cyclical back up in long-term yields may have already occurred. Chart 3Fed Will Be Late, As Always bca.uses_sr_2016_12_05_c3 bca.uses_sr_2016_12_05_c3 Chart 4Wage And CPI Inflation Often Diverge Wage And CPI Inflation Often Diverge Wage And CPI Inflation Often Diverge The 1960s Analogy The 1960s period provides an instructive guide for today. Then, an extremely tight labor market and a positive output gap was initially ignored by the Fed, i.e. the economy was allowed to overheat (Chart 5). This ultimately led to the surge of inflation in the 1970s, especially given the then highly unionized labor market (see appendix Chart A1). While there are similarities between the current backdrop and the 1960s, namely an extended business cycle, full employment, narrowing output gap, easy monetary and a path to easing fiscal policies, and rising money multiplier, there are also striking differences. At the current juncture, wage inflation is half of what it was in the mid-1960s. Even unit labor costs heated up to over 8% back then, nearly four times the current level. Chart 5The 1960's... bca.uses_sr_2016_12_05_c5 bca.uses_sr_2016_12_05_c5 Chart 6... And Today bca.uses_sr_2016_12_05_c6 bca.uses_sr_2016_12_05_c6 Full employment has only been recently attained (Chart 6) and in order to pose a long-term inflation worry, it would have to stay near 5% for another three years. True, the output gap is almost closed, and is forecast to turn marginally positive in 2017/2018, but much will depend on the timing of fiscal stimulus. Industrial production has diverged negatively from the output gap of late, suggesting that excess capacity still lingers in some parts of the economy (Chart 7). The upshot is that inflationary pressures may stay contained for some time, especially if the U.S. dollar continues to firm. The global environment remains marked by deficient demand, not scarce resources. Chart 8 shows that the NFIB survey of the small business sector has a good track record in leading core inflation. The survey shows that businesses are still finding it difficult to lift selling prices. That is confirmed by deflation in the retail price deflator. Chart 7Divergent Economic Slack Messages bca.uses_sr_2016_12_05_c7 bca.uses_sr_2016_12_05_c7 Chart 8Pricing Power Trouble bca.uses_sr_2016_12_05_c8 bca.uses_sr_2016_12_05_c8 Finally, while the money multiplier has troughed, it would have to jump to a level of 4.9 to parallel the 1960s (Chart 9). This is a tall order and it would really require the Fed to very aggressively wind down its balance sheet. Chart 9Monitoring The Money Multiplier bca.uses_sr_2016_12_05_c9 bca.uses_sr_2016_12_05_c9 Therefore, a 1960s repeat would be a tail risk, and not our base case forecast. What About The Greenback? Chart 10 shows that inflation decelerates during U.S. dollar bull markets. Our Foreign Exchange Strategy service believes that the currency has more cyclical upside3, given that it has not yet overshot on a valuation basis and interest rate differentials will favor the U.S. for the foreseeable future. Accordingly, it may be difficult for inflation to rise on a sustained basis. Chart 10Appreciating Dollar Is##br## Always Disinflationary Appreciating Dollar Is Always Disinflationary Appreciating Dollar Is Always Disinflationary So What? Accelerating inflation is a modest risk, but not our base case forecast. Nevertheless, for investors that are more worried about the prospect of higher inflation, the purpose of this Special Report is to serve as an equity sector positioning roadmap if inflationary pressures become more acute sooner than we anticipate. Historically, inflation has been synonymous with an aggressive Fed and hard asset outperformance, suggesting that deep cyclical sectors would be primary beneficiaries. Table 1 on Page 2 shows that over the last six major inflationary cycles, energy, materials, real estate and health care have been consistent outperformers. Utilities, tech and telecom have been clear underperformers. The remaining sectors have been a mixed bag. However, this cycle, potential growth is much lower than in the past, underscoring that the hit to overall profits from tighter monetary policy could be pronounced, potentially undermining equity market risk premiums. If inflation rises too quickly and the Fed hits the economic brakes, then it is hard to envision cyclical sectors putting in a strong market performance, especially given their high debt loads and shaky balance sheets, i.e. they are at the epicenter of corporate sector vulnerability if interest rates rise too quickly. Owning shaky balance sheets in a sluggish global economy is a strategy fraught with risk. On the flipside, the recent knee jerk sell off in more defensive sectors represents a reversal of external capital flows, and is not representative of an underlying vulnerability in their earnings prospects. As a result of this shift, valuations now favor more defensive sectors by a wide margin. Ultimately, we expect relative profit trends to dictate relative performance on a cyclical investment horizon, and are not rushing to position our portfolio for accelerating inflation. Anastasios Avgeriou, Vice President Global Alpha Sector Strategy anastasios@bcaresearch.com 1 https://www.federalreserve.gov/newsevents/speech/yellen20120411a.htm 2 https://www.federalreserve.gov/newsevents/speech/yellen20161014a.htm 3 https://fes.bcaresearch.com/articles/view_report/20812 Health Care (Overweight) Health care stocks have consistently outperformed during the six inflationary periods we studied. Over the long haul it has paid to overweight this sector given the structural uptrend in relative share prices. Spending on health care services is non-cyclical and demand for such services is also on a secular rise around the globe: in the developed markets driven largely by the aging population and in the emerging markets by the adoption of health care safety nets (Chart 11). Health care pricing power is expanding at a healthy clip, outshining overall CPI. Importantly, recent geopolitical uncertainty had cast a shadow on the sector's pricing power prospects that suffered from a constant derating. Now that political and pricing power uncertainty is lifting, a rerating looms. Finally, the health care sector's dividend yield allure is the lowest among defensive sectors and remains 44bps below the broad market, somewhat insulating the sector from the inflation driven selloff in the bond market (Chart 12). Chart 11Health Care bca.uses_sr_2016_12_05_c11 bca.uses_sr_2016_12_05_c11 Chart 12Health Care bca.uses_sr_2016_12_05_c12 bca.uses_sr_2016_12_05_c12 Consumer Staples (Overweight) Similar to the health care sector, consumer staples stocks have been stellar outperformers over the past 55 years. The sector's track record during the six inflationary periods we studied is split down the middle. Most consumer staples companies are global conglomerates and their efforts have been focused on building global consumer brands, allowing them to implement a stickier pricing strategy. As a result, overall inflation/deflation pressures are more benign (Chart 13). Relative consumer staples pricing power is expanding and has been in an uptrend for the past five years. As the U.S. dollar has been in a bull market since 2011, short-circuiting the commodity super cycle, consumer staples manufacturers have been beneficiaries of falling commodity input costs. The implication is that profit margins have been expanding due to both rising pricing power and lower input costs (Chart 14). Chart 13Consumer Staples bca.uses_sr_2016_12_05_c13 bca.uses_sr_2016_12_05_c13 Chart 14Consumer Staples bca.uses_sr_2016_12_05_c14 bca.uses_sr_2016_12_05_c14 Telecom Services (Overweight - High Conviction) Relative telecom services performance and inflation appear broadly inversely correlated since the early 1970s, underperforming 60% of the time when core PCE prices accelerate. Importantly, in two of the periods we studied (during the late-70s and the TMT bubble) the drawdowns were massive, skewing the mean results portrayed in Table 1 on page 2. This fixed income proxy sector tends to suffer in times of inflation as competing assets dilute its yield appeal and vice versa (Chart 15). Telecom services pricing power has been declining over time as the government deregulated this once monopolistic industry. As more entrants forayed into the sector boosting competition, pricing power erosion accelerated. While relative sector pricing power has been mostly mired in deflation with a few rare expansionary spurts, there is an offset as the industry has entered a less volatile selling price backdrop: communications equipment costs are also constantly sinking (they represent a major input cost), counterbalancing the industry's profit margin outlook (Chart 16). Chart 15Telecom Services bca.uses_sr_2016_12_05_c15 bca.uses_sr_2016_12_05_c15 Chart 16Telecom Services bca.uses_sr_2016_12_05_c16 bca.uses_sr_2016_12_05_c16 Consumer Discretionary (Overweight) While the overall trend in consumer discretionary stocks has been higher since the mid-1970s, relative performance mostly declines during inflationary times. Consumer spending takes the backseat as a performance driver when interest rates rise on the back of higher inflation. In addition, previous inflationary periods have also coincided with surging energy prices, representing another source of diminishing consumer discretionary purchasing power (Chart 17). Consumer discretionary selling prices are expanding relative to overall wholesale price inflation, but they have been losing some steam of late. Were energy prices to sustain their recent cyclical advance, as BCA's Commodity & Energy Strategy service expects, that would represent a minor headwind to discretionary outlays. True, the tightening in monetary conditions could also be a risk, but we doubt the Yellen-led Fed would slam on the brakes at a time when the greenback is close to 15 year highs. The latter continues to suppress import prices and act as a tailwind to consumer spending and more than offsetting the energy and interest rate headwinds (Chart 18). Chart 17Consumer Discretionary bca.uses_sr_2016_12_05_c17 bca.uses_sr_2016_12_05_c17 Chart 18Consumer Discretionary bca.uses_sr_2016_12_05_c18 bca.uses_sr_2016_12_05_c18 Real Estate (Overweight) REITs have been outperforming the overall market during the five inflationary periods we analyzed, exemplifying their hard asset profile. While the 1976-81 iteration skewed the mean results, REITs still come out with the third best showing among the top eleven sectors even on median return basis (see Table 1 on page 2). Real estate prices tend to appreciate when inflation is accelerating, because landlords have consistently raised rents at least on a par with inflation (Chart 19). REITs pricing power has outpaced overall CPI. Apartment REITs rental inflation has been on a tear since the GFC, and the multi-family construction boom will eventually act as a restraint. The selloff in the bond market represents another risk to REITs relative returns as this index falls under the fixed income proxied equity basket, but the sector is now attractively valued (Chart 20). Chart 19Real Estate bca.uses_sr_2016_12_05_c19 bca.uses_sr_2016_12_05_c19 Chart 20Real Estate Real Estate Real Estate Energy (Neutral) The energy sector comes out on top of the median relative return results in times of inflation, and second best in average terms (Table 1 on page 2). Oil price surges are typically synonymous with other forms of inflation. During the six inflationary periods we analyzed, all but one period were associated with relative share price outperformance. Oil producers in particular benefit from the increase in the underlying commodity almost immediately (assuming little to no hedging), which also serves as an excellent inflation hedge (Chart 21). While relative energy pricing power had stabilized following the tumultuous GFC, Saudi Arabia's decision in late 2014 to refrain from balancing the oil market triggered a plunge in oil prices, similar to the mid-1980s collapse. The OPEC deal reached last week to curtail oil production should rebalance the market more quickly, assuming OPEC cheating will be limited, removing downside price risks. Nevertheless, any oil price acceleration to the $60/bbl level will likely prove self-limiting, as supply will come to the market and producers would rush to lock in prices by hedging forward (Chart 22). Chart 21Energy Energy Energy Chart 22Energy Energy Energy Financials (Neutral) Financials relative returns are neither hot nor cold when inflation rears its ugly head. In fact they sit in the middle of the pack in terms of relative median and mean returns. This lack of consistency reflects different factors that exerted significant influence in some of these inflationary periods. Moreover, Chart 23 shows that relative share prices have been mean reverting since the 1960s, likely blurring the inflation influence. Ultimately, the yield curve, credit growth and credit quality determine the path of least resistance for the relative share price ratio of this early cyclical sector. Financials sector pricing power has jumped by about 400bps over the past 18 months. Given the recent steepening of the yield curve, the odds are high that sector pricing power will remain firm via rising net interest margins. Any easing in the regulatory backdrop could also provide a fillip to margins (Chart 24). Chart 23Financials Financials Financials Chart 24Financials Financials Financials Utilities (Neutral) Utilities relative returns during inflationary bouts are the second worst among the top eleven sectors on an average basis and dead last on a median return basis. In five out of the six inflationary phases we examined, utilities stocks suffered a setback. The industry's lack of economic leverage and fixed income attributes anchor the relative share price ratio during inflationary times (Chart 25). Our utilities sector pricing power proxy has sprung to life recently moderately outpacing overall inflation. Natural gas prices, the industry's marginal price setter, have experienced a V-shaped recovery since the March trough, as excess inventories have been whittled down, signaling that recent pricing power gains have more upside. Nevertheless, the recent inflation driven jack up in interest rates has dealt a blow to this high dividend yielding defensive sector. Barring a sustained selloff in the bond market at least a technical rebound in relative share prices is looming (Chart 26). Chart 25Utilities Utilities Utilities Chart 26Utilities Utilities Utilities Tech (Underweight) Technology stocks have underperformed every time inflation has accelerated with two exceptions, in the mid-to-late 1960s and mid-to-late 1970s. Creative destruction forces in the tech industry are inherently deflationary. As a result, tech business models have evolved to thrive during disinflationary periods. Moreover, tech stocks have become more mature than typically perceived, having more stable cash flows and paying dividends. The implication is that the negative correlation with inflation will likely remain in place (Chart 27). Tech companies are constantly mired in deflation. While relative pricing power has been in an uptrend since 2011, it has recently relapsed into the deflationary zone. Worrisomely, deflation pressures are likely to intensify as the U.S. dollar appreciates, eating into the sector's earnings growth prospects. Finally, as a reminder, among the top eleven sectors tech stocks have the highest international sales exposure (Chart 28). Chart 27Tech Tech Tech Chart 28Tech Tech Tech Industrials (Underweight - High Conviction) The industrials sector tends to outperform during inflationary periods. In fact, relative share prices have risen 50% of the time since the mid-1960s when inflation was accelerating. The two oil shocks in the 1970s raised the profile of all commodity-related sectors as investors were scrambling to find reliable inflation hedges (Chart 29). Industrials pricing power is sinking steadily, weighed down by the multi-year commodity plunge on the back of China's economic growth deceleration, rising U.S. dollar and increasing supplies. While infrastructure spending is slated to increase at some point in late-2017 or early-2018, we doubt a lot of shovel ready projects will get off the ground quickly enough to satisfy the recent spike in expectations. We are in a wait and see period and remain skeptical that all this fiscal spending enthusiasm will translate into a sustainable earnings driven outperformance phase (Chart 30). Chart 29Industrials Industrials Industrials Chart 30Industrials bca.uses_sr_2016_12_05_c30 bca.uses_sr_2016_12_05_c30 Materials (Underweight) Materials equities have a tight positive correlation with accelerating inflation. Resource-related stocks are the closest representation of hard assets, given their ability to store value among the eleven GICS1 sectors. As inflation takes root and commodity prices rise, materials sales and EPS growth get a boost with relative share prices following right behind (Chart 31). From peak-to-trough relative materials prices collapsed by over 35 percentage points and only recently have managed to stage a modest comeback. Our relative pricing power gauge is flirting with the zero line, but may not move much higher. Deleveraging has not even commenced in the emerging markets, and the soaring U.S. dollar is highly deflationary. It will be extremely difficult for materials prices to advance sustainably if EM financial stress intensifies, given the inevitable backlash onto regional economic growth (Chart 32). Chart 31Materials bca.uses_sr_2016_12_05_c31 bca.uses_sr_2016_12_05_c31 Chart 32Materials bca.uses_sr_2016_12_05_c32 bca.uses_sr_2016_12_05_c32 Appendix Chart A1 bca.uses_sr_2016_12_05_c33 bca.uses_sr_2016_12_05_c33 Chart A2 bca.uses_sr_2016_12_05_c34 bca.uses_sr_2016_12_05_c34 Chart A3 bca.uses_sr_2016_12_05_c35 bca.uses_sr_2016_12_05_c35 Chart A4 bca.uses_sr_2016_12_05_c36 bca.uses_sr_2016_12_05_c36 Chart A5 bca.uses_sr_2016_12_05_c37 bca.uses_sr_2016_12_05_c37 Chart A6 bca.uses_sr_2016_12_05_c38 bca.uses_sr_2016_12_05_c38

After a semiconductor-driven, M&A related relative performance surge, the S&P technology sector has stumbled in recent weeks. The sell-off bears some similarities with the taper-tantrum period in 2013. Then, bond yields soared as the Fed floated trial balloons about tapering QE. As a long duration sector, technology bore the brunt of the backlash from a higher discount rate. Tech stocks did not trough until yields peaked. Moreover, in that period, BCA's Capital Spending Indicator had firmed while tech stocks were being sold off, signaling that corporate sector tech demand would soon improve. A recovery in tech new order confirmed that the sales outlook had brightened. Now, the capital spending outlook remains shaky, and tech new order growth is nil. Meanwhile, tech pricing power has nosedived. Deflation pressures are likely to intensify as the U.S. dollar appreciates. The bottom line is that there is no rush to lift underweight tech sector allocations. Technology Sector Sell-Off Is Not Over Technology Sector Sell-Off Is Not Over

Feature Today’s Insight is a Special Report written by BCA’s Senior Technology Strategist, Brian Piccioni. Brian discusses the reasons for ongoing M&A in the semiconductor industry, and the investment implications. We trust you will find this report insightful and informative. Semiconductor Consolidation Makes Sense But Changes Little We have written extensively about our stance against financial engineering through M&A in the high tech sector.1 However, we view the semiconductor space as somewhat of an anomaly. Unlike most tech goods, a large portion of semiconductor products generate revenues for many years, even decades, after they are first released. Although most of the development costs of these devices are depreciated in the first few years after introduction, price deflation continues. This means that for most such devices, margins do not rise to a very high level. In addition, incremental costs may be associated with "die shrinks" (making smaller devices with the same function), and changes in IC packaging, as the cost of the package can be more than the semiconductor itself. In addition to the inherent benefits of buying a company that makes a product line with long duration revenues, most semiconductors are sold through the same channels and have similar, if not identical, customers. This can allow for the rationalization of sales and marketing efforts. On the surface it might appear there is an opportunity for economies of scale in manufacturing, but these can prove elusive. It is often not worth the effort to consolidate manufacturing for an acquired company due to large differences in manufacturing processes. This is especially true since it would require an investment in R&D for a catalog of mostly dated products. These products would have to be "re-qualified" by customers, as there is no guarantee parts produced in a different factory will function the same as the old one. While most high tech M&A destroys shareholder value, that is less likely to be the case when two mature semiconductor companies combine (Chart 1). However, industry consolidation is not likely to lead to pricing power or unusual profitability post consolidation because: Semiconductor buyers are reluctant to adopt a product made by only one vendor; There is a powerful push for the adoption of technologies based upon Open Standards in order to avoid semiconductor vendors having too much power over customers; and For the most part, with the exception of leading edge process technology used in CPU and commodity memory devices, semiconductor expertise is well understood and widely available, as are the tools for the development of new devices. Total Intangible Asset Writedowns And Restructuring Charges As A Percent ##br##Of Assets By S&P 500 Tech Sub-Sector, 2000 - 2016 Feeding Frenzy: Semiconductor M&A Feeding Frenzy: Semiconductor M&A Semiconductor Buyers Are Reluctant To Adopt A Product Made By Only One Vendor Large device manufacturers always had an aversion to single sourced semiconductors but exceptions were made when there was a critical need or simply no other choice. For example, if you are going to design a PC you are either going to use a single-sourced device from Intel or AMD. Things changed after the "Dot Com" bubble when equipment manufacturers found themselves unable to ship finished products because a single-source vendor had declared bankruptcy and the parts were no longer being made. Even when a single source part is specified, an effort is made to ensure there are substitutes available. This hedges against the possibility the part may no longer be available and also reduces vendor pricing power. Powerful Push For The Adoption Of Technologies Based Upon Open Standards Open standards are standards where form, fit, and function, are both defined and easily referenced. The standard itself is typically inexpensive to license and any related Intellectual Property is available for license on "fair and equitable" terms, meaning that the price is reasonable and the same for all licensees. Open standards have a long history in the semiconductor industry. The market for certain devices such as memory chips would likely have never developed if every vendor had a different way of doing things. Nevertheless, companies such as Intel were able to establish a proprietary standard CPU architecture and profited handsomely as a result. Similarly, purported abuses by companies such as Rambus and Qualcomm have resulted in all players being leery of patent suits. It is now very difficult to get manufacturers to accept a new standard unless it is open. Difficult To Benefit From Competitive Advantage, Even For Largest Players The components sold by most small semiconductor companies do not require cutting edge process technology or expertise. The largest companies such as Intel, Samsung, and TSMC may have an advantage due to their process R&D, but competition among themselves limits returns. In addition, there are very few "must have" products nowadays, and consumers and businesses can typically decide to simply not purchase a new PC, video game, etc., if prices get out of hand. Industry Consolidation Will Not Fuel Growth As we have frequently noted, semiconductor industry growth has slowed to GDP plus or minus a few points (Chart 2). The industry operates within the context of chronic high price deflation, meaning many more units have to be sold each year just to keep revenues flat. Some end markets allowed for the sale of higher value-add components with increased functionality, offsetting some of the deflation. However, the era of hyper growth in PCs, networking gear and smartphones is in the past. This places downward pressure on pricing through the value chain. Chart 2Semiconductor Industry Growth Has Slowed, ##br##Now Near GDP Growth Rate Semiconductor Industry Growth Has Slowed, Now Near GDP Growth Rate Semiconductor Industry Growth Has Slowed, Now Near GDP Growth Rate Loosely speaking the industry can be separated into commodity semiconductors and proprietary ones. Commodity devices are exact functional equivalents to devices sold by multiple vendors. Examples might be discrete devices such as transistors and diodes, memory chips, logic devices, and so on. The competition in commodity semiconductors is so extreme that for some products package costs can be similar to the cost of the semiconductor itself and saving a small amount of plastic or using slightly thinner leads influences profit margins. The product life of many commodity products extends to decades. The market for proprietary semiconductors is somewhat more complicated than for commodity devices. Intel is the prototypical example of a company that makes mostly proprietary devices, though Qualcomm, Xilinx, and others exist. Some companies such as Texas Instruments are a sort of hybrid, offering both commodity and proprietary products. It would be a mistake to assume that proprietary vendors have no competition, because substitutes are typically available. A smartphone vendor can select a high end ARM-based microprocessor from Qualcomm, make its own, or buy from any number of licensees selling similar devices, depending on the market segment and price range it is targeting. This has the effect of limiting the price of a proprietary device and the associated margins. As with any M&A transaction the opportunity arises to take associated restructuring charges, write-downs, and all manner of "one-time" items which can make "non-GAAP" earnings look better than before. Similarly, management may decide to cut costs by reducing R&D and other expenses to improve near-term performance at the expense of long term results. Company managers typically highlight "synergies" and "complimentary businesses" when selling their latest M&A transactions. Nevertheless, it is rare that the combination of two semiconductor companies actually amounts to something greater than what the two were apart. Instead, what tends to result is a mix of products and activities with varying degrees of margins and growth potential. Like any overly diversified portfolio, the combined companies are more likely to grow at the same rate as the industry than to become high-tech powerhouses. In summary there is no reason to believe that organic revenue growth will arise as a consequence of any particular semiconductor M&A transaction and it is far more likely that revenue growth and margins will trend towards the mean for the industry, setting aside the impact of "non-GAAP" adjustments. Why Is There A Buyer's Panic? As we have shown, in most cases industry consolidation will not provide much in the way of operational leverage to the consolidator's results. Similarly there is little reason to believe that companies which remain independent will be affected positively or negatively from the trend.2 This raises the question of why these transactions are occurring at such a frenetic pace. Most likely the answer has more to do with capital market trends than objective business decisions. Investors have elected to reward high tech companies for financial engineering on an equal footing with organic growth (i.e. innovation), and the capital is very cheap nowadays (Chart 3). As we have addressed previously, increasingly imaginative "non-GAAP" financial presentation means that overpaying for an acquired product line is better for the bottom line than developing it in house, so managers are focusing more on financial engineering than actual engineering. Cheap capital and less-than-rational capital markets mean that companies become acquirers or targets. As companies get larger, the targets need to be large enough to "move the needle" with respect to financial impact. This goes all the way down the food chain as mid-cap companies buy small-cap companies and large cap-companies buy mid-cap companies. There are a finite number of target firms for any given company and this creates a sort of "buyer's panic" which stimulates the buyers to move quickly before the target is acquired by a rival (Chart 4). As acquirers get bigger they become the targets of larger acquirers, as they are now large enough to provide the illusion of growth. Chart 3Capital For Financial Engineering Is Cheap bca.tech_wr_2016_11_15_c3 bca.tech_wr_2016_11_15_c3 Chart 4'Buyer's Panic' In Semiconductor Industry "Buyer's Panic" In Semiconductor Industry "Buyer's Panic" In Semiconductor Industry Non-S&P 500 Semiconductor Companies Are Also Targets Unless the cost of capital rises significantly or investors suddenly get concerned about actual operating results rather than "non-GAAP" performance, consolidation will continue until there is a relatively modest number of large semiconductor companies. As we explained above, this does not mean these companies will have superior margins or revenue growth. Indeed we believe the end of the consolidation period will have negative impact for semiconductor industry valuations because: Opportunities for financial engineering of revenue growth and managing "non-GAAP" earnings will be limited; Balance sheets will typically be highly leveraged; and Valuation premiums associated with M&A activity will disappear. Until the consolidation phase runs its course investors should be able to profit by assembling a portfolio of smaller names since these are more likely to be acquired. This is a major reason we have most of the smaller members of the S&P 500 Semiconductor sub-index rated Overweight. Table 1Summary Of Potential Semiconductor Targets Feeding Frenzy: Semiconductor M&A Feeding Frenzy: Semiconductor M&A We have identified 14 additional small semiconductor firms that are not included in the S&P 500 as likely targets (Table 1). This list is not exhaustive but represents companies which are both likely to be acquired and large and liquid enough to be investible. We selected the most attractive companies based on the Price-Earnings-to-Growth (PEG) ratio, which attempts to adjust valuation for growth prospects. These companies, which have a PEG ratio close to or below 1, are bolded in Table 1 above. We are adding these 10 companies to our Overweight list, and will track these recommendations as an equally-weighted index (Chart 5). Chart 5Small Semiconductor Companies Should ##br##Outperform Due To M&A Small Semiconductor Companies Should Outperform Due To M&A Small Semiconductor Companies Should Outperform Due To M&A However, due to the "buyer's panic" described above, companies that appear expensive or exhibit deteriorating financial performance are also potential acquisition targets. As such, it is important to note that our recommendations in this sub-sector are not driven by company fundamentals. Alternatively, investors might consider playing consolidation through the iShares PHLX Semiconductor ETF (SOXX). The structure of this ETF limits the weight of each constituent to approximately 8%, effectively overweighing smaller firms. Brian Piccioni, Vice President Technology Sector Strategy brianp@bcaresearch.com Paul Kantorovich, Research Analyst paulk@bcaresearch.com 1 Please see Technology Sector Strategy Weekly Report, "Tech Company Red Flags Part 2: Intangible Assets And Restructuring Charges," dated July 12, 2016, available at tech.bcaresearch.com 2 That would not be the case if, for example, Hynix and Samsung, two major DRAM manufacturers, were to merge which would be problematic for the #3 player Micron. However, we doubt regulators would permit such a merger.

The technology sector has spiked higher of late, supported by the merger premium in semiconductor stocks. However, the fundamental justification for the recent valuation expansion remains shaky. Tech sales growth remains non-existent. A dearth of new order growth and the ongoing contraction in Asian exports warn that it is premature to position for a recovery in top-line performance. That is confirmed by the impending corporate sector retrenchment, as the steady narrowing in the gap between the return on and cost of capital warns that business investment on tech goods will stay sluggish. Consumer spending on tech has been the lone bright spot, but even that has mostly been moving in line with overall consumption in recent years, not enough to deliver sales outperformance. As a result, fading recent tech strength makes sense, given vulnerability to a valuation squeeze. bca.uses_in_2016_10_27_002_c1 bca.uses_in_2016_10_27_002_c1

While the corporate sector has run up debt levels and is struggling to generate profit growth, consumers have rebuilt their savings and are enjoying the benefits of a positive wealth effect. The increase in real wage and salaries growth is supporting consumer income expectations, according to the latest consumer confidence survey (top panel). The implication is that consumption-oriented plays should be well positioned to deliver profit outperformance. Consumer finance stocks provide an attractively valued play on this theme, as does the S&P data processing index. The latter is levered to total transaction volumes, and a healthy consumer should translate into positive sales momentum. We are overweight both indexes. bca.uses_in_2016_10_27_001_c1 bca.uses_in_2016_10_27_001_c1

The frenzy in semiconductor stocks has reached an overshoot phase. Relative performance had been buoyed by a flurry of M&A activity, but that has since waned without a similar response in share prices. If fundamentals return as the main driver, then a setback is probable. Our concern is that the inventory overhang continues to linger. Our proxy for global semiconductor inventories continues to grow, albeit at a slowing rate. Still, the semi sales-to-inventory ratio is deep in negative territory, which is typically deflationary and a harbinger of semiconductor profit contraction (bottom panel). That is confirmed by ongoing sluggishness in Taiwanese and Korean export and export price growth (second panel). The implication is that the surge in semi stocks is vulnerable to an abrupt reversal and an underweight position is warranted. The ticker symbols for the stocks in this index are: BLBG: S5SECO - INTC, QCOM, TXN, AVGO, NVDA, ADI, MU, SWKS, LLTC, MCHP, XLNX, QRVO, FSLR. bca.uses_in_2016_10_20_002_c1 bca.uses_in_2016_10_20_002_c1

Highlights EM tech stocks are overbought while banks are fundamentally vulnerable due to bad-loan overhang. EM stocks have never decoupled from the U.S. dollar and commodities prices. There has been no recovery in EM corporate profitability and EPS. We reiterate two equity trades: short EM banks / long U.S. banks, and short Chinese property developers / long U.S. homebuilders. Upgrade Thai stocks to overweight within the EM equity benchmark and go long THB versus KRW. Feature Our Reflation Confirming Indicator - an equal-weighted aggregate of platinum prices (a proxy for global reflation), industrial metals prices (a proxy for China growth) and U.S. lumber prices (a proxy for U.S. reflation) - has decisively rolled over, and is spelling trouble for emerging market (EM) equities (Chart I-1). In particular, platinum prices have relapsed after hitting a major resistance at their 800-day moving average (Chart I-2). Such a technical pattern often leads to new lows. If so, it could presage a major selloff in EM markets in the months ahead. Chart I-1A Red Flag From ##br##Reflation Confirming Indicator A Red Flag From Reflation Confirming Indicator A Red Flag From Reflation Confirming Indicator Chart I-2Platinum: A Canary##br## In A Coal Mine? bca.ems_wr_2016_10_19_s1_c2 bca.ems_wr_2016_10_19_s1_c2 The rationale behind using platinum rather than gold or silver prices is because platinum is a precious metal that also has industrial uses. Besides, we have found that platinum prices correlate with EM stocks better than gold or silver. The latter two sometimes rally due to global demand for safety, even as EM markets tank. Finally, platinum seems to be the most high-beta precious metal in the sense that it "catches a cold" sooner and, thus, might be leading other reflationary plays. In short, EM share prices have been flat since August 15, and odds are that they are topping out and the next large move will be to the downside. Can EM De-Couple From The U.S. Dollar? Many investors are asking whether EM risk assets can rally if the greenback continues to rebound. Chart I-3 illustrates that since the early 1980s, there have been no periods when EM share prices rallied amid strength in the real broad trade-weighted U.S. dollar (the dollar is shown inverted on this and the proceeding charts). The same holds true if one uses the nominal narrow trade-weighted U.S. dollar1 (Chart I-4). Chart I-3Real Trade-Weighted ##br##U.S. Dollar And EM Stocks Real Trade-Weighted U.S. Dollar And EM Stocks Real Trade-Weighted U.S. Dollar And EM Stocks Chart I-4Nominal Trade-Weighted ##br##U.S. Dollar And EM Stocks Nominal Trade-Weighted U.S. Dollar And EM Stocks Nominal Trade-Weighted U.S. Dollar And EM Stocks One could disregard these charts and argue that this time around is different. We don't quite see it that way. Chart I-5Nominal Trade-Weighted ##br##U.S. Dollar And Commodities Nominal Trade-Weighted U.S. Dollar And Commodities Nominal Trade-Weighted U.S. Dollar And Commodities Notably, the narrative behind the EM rally since February's lows has been based on the Federal Reserve backing off from rate hikes and the U.S. dollar weakening - with the latter propelling a rally in commodities prices. These arguments appear to be reversing: the U.S. dollar is already firming up and commodities prices are at best mixed. The broad index for commodities prices always drops when the U.S. dollar rallies (Chart I-5). In recent months, the advance in commodities prices has been uneven and narrow based. While oil prices have spiked substantially, industrial metals prices have advanced very little. The current oil price rally is proving a bit more durable and lasting than we thought a few months ago. Nevertheless, China's apparent consumption of petroleum products is beginning to contract (Chart I-6). Consequently, resurfacing worries about EM/China's demand for commodities will lead to a meaningful pullback in crude prices in the months ahead, especially since the likelihood that oil producers act to restrain supply at the current prices is very low. As for commodities trading in China such as steel, iron ore, rubber, plate glass and others, they have been on a roller-coaster ride in recent months (Chart I-7). Chart I-6China's Demand For Oil Products Is Very Weak China's Demand For Oil Products Is Very Weak China's Demand For Oil Products Is Very Weak Chart I-7Commodities Prices In China Commodities Prices In China Commodities Prices In China Bottom Line: There are reasonably high odds that as the U.S. dollar strengthens and commodities prices roll over, EM risk assets (stocks, currencies and credit markets) will start to relapse. EM Beyond Commodities: Still Shrinking Profits Table I-1EM Sectors Weights: In 2011 And Now The EM Rally: Running Out Of Steam? The EM Rally: Running Out Of Steam? Another question that many investors have been asking is as follows: Is there not a positive story in EM beyond commodities? Given that the weight of the EM equity market benchmark in commodities stocks - energy and materials - has drastically declined in recent years, from 29.2% in 2011 to 13.7% now (Table I-1), and the weight in technology stocks has risen substantially (from 12.9% in 2011 to 23.9% now), couldn't non-commodities stocks drive the index higher? In this regard, we have the following observations: Information technology stocks are overbought. The EM information technology equity index has surged to its previous highs (Chart I-8, top panel). This sector is dominated by five companies that have a very large weight also in the overall EM benchmark: Samsung (3.6% weight in the EM equity benchmark), TMSC (3.5%), Alibaba (2.9%), Hon Hai Precision (1%) and Tencent (3.8%). Their share price performance has been spectacular, and some of them have gone ballistic (Chart I-9). TMSC and to a lesser extent Samsung have benefited from the rising prices of semiconductors (Chart I-9, second panel from top). However, it is not assured that semiconductor prices will continue soaring from these levels as global aggregate demand remains very weak. In short, the outlook for semi stocks is by and large a semiconductor industry call, not a macro one. As for Alibaba and Tencent, they are bottom-up stories - not macro bets at all. At the macro level, we reassert that EM/China demand for technology goods and services as well as for health care will stay robust. Hence, from a revenue perspective, technology and health care companies will outperform other EM sectors. This still warrants an overweight allocation to technology and health care stocks, a recommendation that we have had in place since June 2010 (Chart I-8, bottom panel). Odds are that tech outperformance will persist, but we are not sure about absolute performance, given overbought conditions and not-so-cheap valuations. Excluding information technology, the EM benchmark is somewhat weaker (Chart I-10). Chart I-8EM Technology Stocks: Sky Is Limit? bca.ems_wr_2016_10_19_s1_c8 bca.ems_wr_2016_10_19_s1_c8 Chart I-9Individual Tech Names Are Overbought Individual Tech Names Are Overbought Individual Tech Names Are Overbought Chart I-10EM Equities: Overall And Excluding Tech EM Equities: Overall And Excluding Tech EM Equities: Overall And Excluding Tech There is no improvement in EM corporate profitability The return on equity (RoE) for EM non-financial listed companies has stabilized at very low levels, but it has not improved at all (Chart I-11, top panel). The reason we use non-financials' RoE rather than overall RoE is because in EM the latter is artificially inflated at the moment, as banks are originating a lot of new loans but are not sufficiently provisioning for bad loans. Among the three components of non-financials RoE, net profit margins have stabilized but asset turnover is falling and leverage continues to mushroom (Chart I-11, bottom two panels). Remarkably, the relative performance between EM and U.S. stocks has historically been driven by relative RoE. When non-financial RoE in EM is above that of the U.S., EM stocks outperform U.S. ones, and vice-versa (Chart I-12). This relationships argues for EM stocks underperformance versus the S&P 500. Chart I-11EM Non-Financials: ##br##RoE And Its Components EM Non-Financials: RoE And Its Components EM Non-Financials: RoE And Its Components Chart I-12EM Versus U.S.: ##br##Relative RoE And Share Prices EM Versus U.S.: Relative RoE And Share Prices EM Versus U.S.: Relative RoE And Share Prices Overall EM EPS is still contracting in both local currency and U.S. dollar terms (Chart I-13). Even though the rate of contraction is easing for EPS in U.S. dollar terms, it is due to EM exchange rate appreciation versus the greenback this year. Furthermore, EPS in U.S. dollars is contracting in a majority of non-commodities sectors (Chart I-13A, Chart I-13B). The exceptions are utilities and industrials, which both exhibit strong EPS growth despite poor share price performance. The latter could be a sign that strong industrials and utilities EPS have been due to temporary factors and are not sustainable. Chart I-13AEM EPS Growth: Overall And By Sector EM EPS Growth: Overall And By Sector EM EPS Growth: Overall And By Sector Chart I-13BEM EPS Growth: Overall And By Sector EM EPS Growth: Overall And By Sector EM EPS Growth: Overall And By Sector Banks hold the key. Apart from commodities/the U.S. dollar and tech stocks, EM banks' share prices are probably the most important precursor to the direction of the overall EM benchmark. Financials are the second-largest sector in the EM equity benchmark (26.4% weight), so if bank share prices break down, the broader EM index will likely relapse. Our analysis of bank health in various EM countries leads us to believe that banks are under-provisioned for non-performing loans (NPL) (Chart I-14A, Chart I-14B). As EM growth disappointments resurface, investors will question the quality of banks' balance sheets and push down bank equity valuation. Hence, odds are bank share prices will drop sooner than later. Chart I-14AEM NPLs Are Unrecognized ##br##And Under-Provisioned EM NPLs Are Unrecognized And Under-Provisioned EM NPLs Are Unrecognized And Under-Provisioned Chart I-14BEM NPLs Are Unrecognized ##br##And Under-Provisioned EM NPLs Are Unrecognized And Under-Provisioned EM NPLs Are Unrecognized And Under-Provisioned In turn, concerns about EM banks will heighten doubts about overall EM growth and the EM equity benchmark will sell off. Bottom Line: EM tech stocks are overbought, while banks are fundamentally vulnerable due to the bad-loan overhang. As commodities prices relapse anew and worries about the EM credit cycle resurface, the EM benchmark will drop considerably. An Update On Two Relative Equity Trades We reiterate two relative equity trades: short EM banks / long U.S. banks, and short Chinese property developers / long U.S. homebuilders. For investors who do not have these positions, now is a good time to initiate them. Short EM banks / long U.S. banks (Chart I-15). The credit cycle in EM/China will undergo a further downturn: credit growth is set to decelerate as banks recognize NPLs and seek to raise capital. Even if a crisis is avoided, the need to raise substantial amounts of equity will considerably erode the value of EM bank shares. Meanwhile, risks to U.S. banks such as a flat yield curve and a possible spillover effect from European banking tremors are considerably less severe than the problems faced by EM banks. Importantly, unlike EM banks, U.S. banks' balance sheets are very healthy. Short Chinese property developers / long U.S. homebuilders (Chart I-16). Chart I-15Stay Short EM Banks##br## Versus U.S. Banks Stay Short EM Banks Versus U.S. Banks Stay Short EM Banks Versus U.S. Banks Chart I-16Stay Short Chinese Property ##br##Developers Versus U.S. Homebuilders Stay Short Chinese Property Developers Versus U.S. Homebuilders Stay Short Chinese Property Developers Versus U.S. Homebuilders Chinese property developers are on the verge of another downturn, as the authorities have tightened policy surrounding housing. Residential and non-residential property sales have boomed in the past 12 months, but starts have been less robust (Chart I-17). The upshot could still be high shadow inventories. Going forward, as speculative demand for housing cools off, property developers' chronic malaise - high leverage and lack of cash flow - will come back to play. Remarkably, property stocks trading in Hong Kong have failed to break out amid the buoyant residential market frenzy in the past 12 months, and are likely to break down as demand growth falters in the coming months (Chart I-18). Chart I-17China's Real Estate: ##br##Sales And Starts Will Contract China's Real Estate: Sales And Starts Will Contract China's Real Estate: Sales And Starts Will Contract Chart I-18Chinese Property Developers: ##br##On A Verge Of Breakdown? Chinese Property Developers: On A Verge Of Breakdown? Chinese Property Developers: On A Verge Of Breakdown? Arthur Budaghyan, Senior Vice President Emerging Markets Strategy & Frontier Markets Strategy arthurb@bcaresearch.com Thailand: Upgrade Stocks To Overweight And Go Long THB Versus KRW The death of King Bhumibol Adulyadej marks the end of an era not only because he symbolized national unity but also because his entire generation is passing. This generational shift has far-reaching consequences for Thailand's political establishment: in the long run it could hurt the Thai military's - and its allies' - attempt to cement their dominance over parliament. However, as Box II-1 (on page 17) explains, there is a low probability of serious domestic instability over the next 12 months2 - although beyond that risks will be heating up. For now, the military junta faces no major political or economic constraints: The junta has already consolidated control over all major organs of government and has purged or intimidated political enemies. The military will have to turn power back to parliament, or make a major policy mistake, for the opposition movement to rise again. The government's fiscal deficit has been stable (around 3% of GDP) over the past few years, public debt is at 33% of GDP, government bond yields are low and debt servicing costs are at 5% of total expenditures (Chart II-1). Hence, the military government can ramp up expenditures further to appease the disaffected. Indeed, the military junta has already accelerated public capital expenditures (Chart II-2) and investments have poured into the Northeast, a populous base of opposition to the junta. Chart II-1Thailand: More Room ##br##For Fiscal Stimulus Thailand: More Room For Fiscal Stimulus Thailand: More Room For Fiscal Stimulus Chart II-2Thailand: Government ##br##Capex Has Been Booming bca.ems_wr_2016_10_19_s2_c2 bca.ems_wr_2016_10_19_s2_c2 Likewise, fiscal expenditure has also accelerated in areas such as general public services, defense, and social protection (Chart II-3). Additionally, the Bank of Thailand (BoT) has scope to cut interest rates as the policy rate is still above a very low inflation rate (Chart II-4). This will limit the downside for credit growth and contribute to economic and political stability. Chart II-3Rising Public Spending bca.ems_wr_2016_10_19_s2_c3 bca.ems_wr_2016_10_19_s2_c3 Chart II-4Thailand: No Inflation; Room To Cut Rates bca.ems_wr_2016_10_19_s2_c4 bca.ems_wr_2016_10_19_s2_c4 The large current account surplus - standing at 11% of GDP - provides the authorities with plenty of fiscal and monetary maneuverability without having to worry about a major depreciation in the Thai baht (Chart II-5). Amid this sensitive political transition, the central bank will likely defend the currency if downward pressure on the baht emerges due to U.S. dollar strength. Therefore, we recommend traders to go long the Thai baht versus the Korean won (Chart II-6). Despite Korea's enormous current account, the won is at risk from depreciation in the RMB and the Japanese yen. Chart II-5Enormous Current Account ##br##Surplus Will Support The Baht Enormous Current Account Surplus Will Support The Baht Enormous Current Account Surplus Will Support The Baht Chart II-6Go Long THB Against KRW bca.ems_wr_2016_10_19_s2_c6 bca.ems_wr_2016_10_19_s2_c6 On the whole, although the Thai economy has been stagnant (Chart II-7), fiscal spending and low interest rates will limit the downside in growth. Bottom Line: We expect relative calm on the political surface in Thailand over the next 12 months and a stable macro backdrop. Therefore, we are using the latest weakness to upgrade this bourse from neutral to overweight within an EM equity portfolio (Chart II-8). Chart II-7Thai Growth Has Been Stagnant bca.ems_wr_2016_10_19_s2_c7 bca.ems_wr_2016_10_19_s2_c7 Chart II-8Upgrade Thai Stocks ##br##From Neutral To Overweight Upgrade Thai Stocks From Neutral To Overweight Upgrade Thai Stocks From Neutral To Overweight In addition, currency traders should go long THB versus KRW. Ayman Kawtharani, Research Analyst aymank@bcaresearch.com Matt Gertken, Associate Editor mattg@bcaresearch.com BOX 1 The Military Coup In 2014 Pre-empted The King's Death... The May 2014 military coup was timed to pre-empt this event. The king's health had been declining for years and it was only a matter of time until he died. This raised the prospect of an intense political struggle that could have escalated into a full-blown succession crisis. Thus the military moved preemptively so that it would be in control of the country ahead of the king's death and could reshape the constitutional system in the military's favor before his death, as it has done. ... And This Means Stability For Now If the populist, anti-royalist faction had been in control of government at the time of the king's death, it could have attempted to manipulate the less popular new king and take advantage of the vacuum of royal authority in order to reduce the role of the military and their allies. That in turn could have sparked a wave of mass protests from royalists, pressuring the government to collapse, or a military coup that would not have carried the king's implicit approval like the 2014 coup. That would have fed the narrative that a final showdown between the factions was finally emerging, and would have been highly alarming to foreign investors. But Risks Still Linger Make no mistake: a new long-term cycle of political instability is now emerging. Potential military mistakes and the return to parliamentary rule are potential dangers. The country's deep divisions - between (1) the Bangkok-centered royalist bureaucratic and military establishment and (2) the provincial opposition -have not been healed but aggravated since the 2014 coup and the new pro-military constitution: The junta's constitutional and electoral reforms will weaken the representation of the largest opposition party, the Pheu Thai Party, and will marginalize a large share of the 65% of the country's population that lives in the opposition-sympathetic provinces. It is also conceivable that the new king could trigger conflict by lending support to the populist opposition. For instance, he could pardon the exiled leader of the rural opposition movement, or he could transform the powerful Privy Council. However, we do not expect discontent to flare up significantly until late 2017 or 2018 when the military steps back and a new election cycle begins.3 We will reassess and alert investors if we foresee a rapid deterioration in the palace-military network, or in the military's ability to prevent seething resistance in the provinces. 1 The narrow U.S. dollar is a trade-weighted exchange rate versus the euro, Canadian dollar, Japanese yen, British pound, Swiss franc, Australian dollar, and Swedish krona. Source: The Federal Reserve. 2 The exception is that isolated acts of terrorism remain likely and could well strike key areas in Bangkok, signaling the reality that the underground opposition to military dictatorship remains alive and well. 3 The junta will use the one-year national period of mourning to its advantage and opposition forces will not want to be targeted for causing any trouble during a time of mourning. The junta could very easily delay the transition to nominal civilian rule, including the elections slated for November 2017. Equity Recommendations Fixed-Income, Credit And Currency Recommendations

Data processing stocks have marked time since we took profits and downgraded to neutral in mid-February. Increasingly, this lateral move looks to be a consolidation rather than a trend change. This group fits into our consumption vs. capital spending theme, and outperforms when economic growth slippage is the dominant driver of a disinflationary macro backdrop. Data processing sales went through a rough patch, but the seeds of a recovery have been sown. Top-line performance is highly correlated with consumer sector transaction volumes. Resilient consumer confidence, a high savings rate, decent job growth, and rising incomes all imply that spending should remain an economic bright spot. The relative performance consolidation has allowed the industry to grow into premium valuations, at a time when the high margin and recurring revenue nature of the industry's operating profile stands out in a disinflationary world struggling to grow at trend, let alone above it. Please see yesterday's Weekly Report for more details on the upgrade. The ticker symbols for the stocks in this index are: BLBG: S5DPOS - V, MA, PYPL, ADP, FIS, FISV, PAYX, ADS, GPN, WU, XRX, TSS. bca.uses_in_2016_09_27_001_c1 bca.uses_in_2016_09_27_001_c1

Stocks are flirting with new highs, courtesy of a gradualist Fed and the reduced threat
of incremental near-term U.S. dollar strength.