Software and Services

Highlights Portfolio Strategy The S&P hotels, resorts and cruise lines index will suffer from a profit margin squeeze, which should weigh on valuations. Cut exposure to underweight. A cyclical capex recovery is a boon for software outlays and coupled with reviving animal spirits, signal that it no longer pays to underweight the S&P software index. Augment positions to a benchmark allocation. Recent Changes Downgrade the defensive/cyclical portfolio bias to neutral. Downgrade the S&P hotels, resorts and cruise lines index to underweight today. Lift the S&P software index to neutral. Table 1 Feature Chart 1Weak Dollar Positive Contributor##br## To EPS Growth Equities broke out in a bullish fashion last week, as geopolitical fears subsided and the backlash from hurricane Irma was less severe than initially feared. Beneath the surface, non-inflationary synchronized global growth remains the dominant macro theme. While the latest U.S. CPI print was better than anticipated the Fed would have to see a couple more perky inflation reports before an uptrend is established, cementing the December hike. Until then, the path of least resistance is higher for equities. In our last Weekly Report, we noted that our four-factor S&P 500 operating EPS model has recently accelerated.1 This week, Chart 1 isolates the U.S. dollar as the sole regression variable on SPX earnings and the fitted value suggests that profits will likely surprise to the upside in the back half of the year despite difficult comparisons. Importantly, as we posited earlier this summer, irrespective of where the trade-weighted U.S. dollar ends the year, delayed FX translation effects will act as a tonic for S&P 500 profits. Since late-December's peak, the broad trade-weighted dollar has deflated by 9%. Regression analysis shows that a 1% fall in the U.S. dollar boosts operating EPS by 0.98%, with our dataset going back to the early 1970s. If, however, we narrow the interval of estimation starting in 1994 when NAFTA come into effect then the greenback's sensitivity on SPX EPS increases to 1.6%. While every cycle is different, a fresh all-time high in quarterly EPS - driven by a weak dollar - would not surprise us in Q3 and Q4. At some point, the deflating currency should show up in selling price inflation, again as a lagged effect (middle panel, Chart 2). This is encouraging for our firming operating leverage thesis, as a modest inflationary backdrop would reinforce top line growth (bottom panel, Chart 2). The implication of a sustainable revenue growth outlook is a profit margin-led flow through to EPS, especially for high fixed cost businesses. Already, sell side analysts' overall S&P 500 net earnings revisions are benefitting from the U.S. dollar's decline, and so is sector EPS breadth (trade-weighted dollar shown inverted, Chart 3). Chart 2Will The Dollar's Fall Show Up In Inflation? Chart 3EPS Breadth Improvement Moreover, U.S. dollar-based liquidity (defined as the sum of the Fed's balance sheet and foreign central bank U.S. Treasury holdings) has finally arrested its fall and has recently ticked higher above the zero line. This even mild increase in U.S. dollar-based liquidity represents a de facto easing in global monetary conditions, and historically has been synonymous with S&P 500 EPS acceleration (Chart 4). The upshot is that profits are on a solid upward trajectory. Chart 4Dollar Based Liquidity Also On The Rise The equity market's sensitivity to the greenback has been increasing as the percentage of foreign sourced earnings has been rising over the decades. Globally-exposed goods-producers are in the driver's seat. This raises the question: what to do with our long held preference for defensives versus cyclicals? We are taking our cue from the U.S. dollar-induced shifting macro backdrop, and locking in gains of 11% since the mid-2014 inception in our defensive over cyclical sector tilt, and moving to the sidelines. As a reminder, since the beginning of the spring we have been tweaking our portfolio adding cyclical exposure and, at the margin, removing defensive protection.2 Thus, a defensive over cyclical sector preference is no longer in place. Synchronized global growth, reviving emerging markets, a stable China, and a deflating U.S. dollar are all giving us confidence that it no longer pays to play defense (Chart 5). Finally, following a sling shot recovery, relative valuations are on a more even keel, as is our relative Technical Indicator which is hovering in the neutral zone (Chart 6). Chart 5Book Gains And Move##br## To Neutral Chart 6Valuations And Technicals##br## In The Neutral Zone This week we are making an early cyclical downshift and deep cyclical upshift to our portfolio. Hotels Update: Check Out Time This year has been a good one to be overweight the S&P hotels, resorts and cruise lines index which has outperformed the S&P 500 by a wide margin. However, earnings expectations have moved broadly in line with the market in 2017, meaning that the index's outperformance has been entirely valuation multiple driven. Normalizing earnings to smooth out profit volatility reveals a more severe picture with valuation multiples at decade highs, above the historical mean and at a 40% premium to the broad market (Chart 7). The index's strength has been most pronounced since the beginning of the summer and, unsurprisingly given the cyclical rotation into highly discretionary stocks, has been exclusive to the cruise line operator segment of the index. The two relevant stocks (RCL and CCL) now represent nearly half of the S&P hotels, resorts and cruise lines index's market capitalization. Cruise line operators' margins have climbed to 10-year highs (top panel, Chart 8), justifying soaring stock prices. Profit gains have come on the back of healthy unit revenue as unit costs have remained mostly unchanged (third panel, Chart 8). Chart 7Very Expensive Beneath The Surface Chart 8Cruise Lines Leading The Pack Cruise line occupancy rates corroborate this firm demand backdrop. They have risen in line with margin gains (second panel, Chart 8), a result of improving passenger growth and constrained capacity (bottom panel, Chart 8). This has been the industry's largest margin lever, i.e.: incremental passengers per room come with much higher incremental margin. As cruise lines cannot increase their occupancy ad infinitum (occupancy rates above 100% already imply more than two occupants of a double-occupancy berth), further margin gains of this magnitude seem doubtful. In fact, if cruise operators are to continue growing profits, a capacity growth cycle will eventually have to begin anew, meaning margin contraction rather than expansion. Thus, extrapolating profit growth far into the future is fraught with danger, warning that sky-high valuation multiples are vulnerable to even a modest de-rating. The outlook is even less bright for hotels, an industry that has been losing its share of the consumer's wallet for some time (Chart 9, second panel). Specifically, the low/non-corporate end of the market seems increasingly exposed to competition from Airbnb and other room share competitors; cutthroat competition is pricing power negative with industry selling prices sinking into outright deflation (Chart 9, third panel). Hoteliers are trying to compensate for low prices with huge capacity additions, adding a sense of permanence to recent pricing power declines. However, just as pricing has fallen, the accommodation related employment cost index has gone vertical (bottom panel, Chart 9). The implication of soft pricing power and a rising wage bill is a profit letdown. Our newly introduced S&P hotels, resorts and cruise lines EPS model (comprising the U.S. dollar, employment, PCE and confidence measures) does an excellent job encompassing all these moving parts and confirms our bearish industry profit stance. In fact, it is pointing to significant relative declines vis-à-vis the S&P 500 (Chart 10). Chart 9Mind The Deflationary Impulse Chart 10EPS Model Says Rush For The Exits Putting it together, shrinking margins and increased capital deployment mean lower return on capital and hence lower valuation multiples. This implies that the index's relative gains are in the past. Bottom Line: Take some chips off the table and reduce exposure to underweight in the S&P hotels, resorts and cruise lines index. The ticker symbols for the stocks in this index are: BLBG: S5HOTL - MAR, CCL, RCL, HLT, WYN. Software: A Capex Upcycle Winner? Software stock relative performance has returned to its long-term uptrend, but remains far from the two standard deviations above-the-mean peak reached during the tech bubble (top panel, Chart 11). The structural pull from the proliferation of cloud computing and software-as-a-service has served as a catalyst to raise the profile of this more defensive and mature tech sub-sector. Traditional hardware tech sectors, like communications equipment, are also suffering from the "virtualization" threat as software is making inroads into hardware and blurring the lines between the two. Beyond this constructive backdrop, cyclical forces are also painting a brighter picture for software equities. Importantly, there is tentative evidence that a fresh capex upcycle has commenced (see Chart 3 from last Monday's Weekly Report 3), and if software commands a larger slice of the overall spending pie, industry profits should enjoy a healthy rebound (second panel, Chart 11). Small business sector plans to expand have returned to a level last seen prior to the Great Recession, underscoring that software related outlays will likely follow them higher. Recovering bank loan growth is also corroborating this upbeat spending message: capital outlays on software are poised to accelerate based on rebounding bank loans. The latter signals that businesses are beginning to loosen their purse strings anew (third & fourth panels, Chart 11). Reviving animal spirits also suggest that demand for software upgrades will stay elevated. CEO confidence is pushing decade highs. Such ebullience is positive for a pickup in software investments (second panel, Chart 12). It has also rekindled software M&A activity, with the number of industry deals jumping in recent months (bottom panel, Chart 13). Chart 11Back To Trend Chart 12Capex Upcycle... Chart 13... And Reviving Animal Spirits Are Key Drivers Supply reduction presents a bullish backdrop for software selling prices that have exited deflation at a time when overall corporate sector inflation is decelerating. The upshot is that revenue growth will likely reaccelerate (middle panel, Chart 14). But before getting too carried away, there is some cause for concern. The S&P software index is priced to perfection fully reflecting most, if not all, of the positive drivers (bottom panel, Chart 14), warning that any sales/profit mishaps will likely knock relative performance over. Moreover, productivity dynamics are waving a yellow flag. Business sector productivity growth troughed in early 2017. Historically, this output per hour worked metric has been inversely correlated with software outlays (productivity shown inverted, third panel Chart 15). Importantly, even shown as a deviation from the long-term trend, productivity gains have troughed, suggesting that relative profit growth will likely remain muted (productivity shown inverted, bottom panel Chart 15). Keep in mind that, historically, software spending has been countercyclical (second panel, Chart 15) and given that we are not at the end of the line yet, relative outlays on software may not rebound to the same extent as our other aforementioned indicators suggest. Chart 14Impressive Pricing Power, ##br##But Fully Priced Chart 15Productivity Dynamics##br## Are A Sizable Offset Adding it up, enticing structural software forces aside, a cyclical capex recovery is a boon for software outlays and, coupled with reviving animal spirits, signal that it no longer pays to underweight this tech sub-sector. Bottom Line: The S&P software index does not deserve an underweight. Lift exposure to a benchmark allocation. The ticker symbols for the stocks in this index are: BLBG: S5SOFT - MSFT, ORCL, ADBE, CRM, ATVI, EA, INTU, ADSK, SYMC, RHT, SNPS, CTXS, ANSS, CA. Anastasios Avgeriou, Vice President U.S. Equity Strategy & Global Alpha Sector Strategy anastasios@bcaresearch.com 1 Please see Chart 5 of the U.S. Equity Strategy Report titled "Still Goldilocks", on September 11, 2017, available at uses.bcaresearch.com. 2 Please see the August 14, 2017 U.S. Equity Strategy Report titled "Three Risks" for a quick recap of most of our portfolio moves, available at uses.bcaresearch.com. 3 Please see the September 11, 2017 U.S. Equity Strategy Report titled "Still Goldilocks", available at uses.bcaresearch.com. Current Recommendations Current Trades Size And Style Views Favor small over large caps and stay neutral growth over value.

Special Report

Dear Client, Over the next three weeks, much of BCA’s Geopolitical Strategy team will be traveling in Australia, New Zealand, and Asia. As such, we are taking this week off from publication and will return to our regular schedule next week. In lieu of our regular missive, we are sending you the following Special Report, penned by our colleagues in the BCA Technology Sector Strategy. The report, originally published on May 16, tackles “The Coming Robotics Revolution” in an innovative way that aligns with our own views. Clients often ask us what will be the political consequences of the revolution in artificial intelligence and robotics. Our answers are controversial because we strongly disagree with the conventional, Terminator-inspired, doom and gloom. Brian Piccioni and Paul Kantorovich agree with us, which is reassuring given that they understand the technology behind robotics far better than we do. I hope you enjoy the enclosed report and encourage you to seek out the insights of our Technology Sector Strategy. Kindest Regards, Marko Papic, Senior Vice President Chief Geopolitical Strategist Feature "The amount of technology coming at us in the next five years is probably more than we've seen in the last 50" Mark Franks, Director Of Global Automation at General Motors, Bloomberg News, April 2017 There is good reason to believe we are at the cusp of a Robot Revolution which will have a dramatic impact on our economy. Robots have been around for decades or centuries, depending on the definition. Past robots were either fixed in place, as in the case of factory robots, or supervised by operators that are near the robot, or connected through telemetry. In contrast, the robots that are coming will not be fixed in place, and will be able to perform their functions without a human operator. This opens up massive markets for robots in industry (cutting lawns, cleaning windows, delivering parcels, etc.) and, most significantly, consumer applications. Part 1: Robots - Industrial Revolution To Early 21st Century The term "robot" can have different meanings. The most basic definition is "a device that automatically performs complicated and often repetitive tasks,"1 a definition which encompasses a broad range of machines: from the Jacquard Loom,2 which was invented over 200 years ago, on to Numerically Controlled (NC) mills and lathes, pick and place machines used in the manufacture of electronics, Autonomous Vehicles (AVs), and even homicidal robots from the future such as the Terminator. For much of history, most of the labor force was involved with the production of food: over 50% of the U.S. labor force was involved in agriculture until the late 1800s (Chart 1). Agriculture has benefitted immensely from automation as inventions such as the McCormick Reaper (a wheat cutting machine pulled by horses), the cotton gin, and other mechanical systems displaced human effort. Steam and then internal combustion-powered tractors, which can be viewed as "robotic horses," accelerated the process, as engines delivered much more power more cost effectively than mechanical devices (Chart 2). This massively improved productivity: within 20 years from 1830 to 1850, the labor to produce 100 bushels of wheat dropped from 250-300 to 75-90 hours, and by 1955 it only took 6 ½ hours of labor for a net reduction of 97.5% in 125 years.3 Chart 1Farm Workers Were Disrupted In The Late 19th Century Chart 2...And So Were Horses In other words there is nothing new about automation displacing workers while improving productivity, nor is a rapid displacement unprecedented. The industrial revolution was about replacing human craft labor with capital (i.e. machines), which did high-volume work with better quality and productivity. This freed humans for work which had not yet been automated, along with designing, producing, and maintaining the machinery. Automation Frightens People Although automation is nothing new, it has always engendered anxiety among workers. The anxiety boils down to concern for continued employment as well as fear of the technology itself. We discuss below why Artificial Intelligence (AI) does not present the sort of threat to humanity or even employment that seems to be the consensus view at the moment. Will Robots Become Self-Aware? We have covered the topic of Artificial Intelligence/Deep Learning as it relates to sentient/self-aware machines in some detail in our October 18, 2016 Special Report on Artificial Intelligence. In summary, most of the discussion surrounding AI is misinformation. Although AI uses algorithms called "artificial neural networks," which are extremely useful for solving certain classes of problems, these are nothing like biological neural networks. There is no reason whatsoever to believe AI technology in its current form can become sentient, or even meaningfully intelligent, and that will not change with increased computing power. Furthermore, whether or not AI can arise to the level of a threat, there is no current or imagined power source which could keep a rampaging robot active for more than a few hours. The Terminator would have been much less threatening if he required frequent recharging. Will Robots Make Human Workers Irrelevant? Automation in agriculture occurred rapidly enough to be felt by workers at the time - and yet there were no marauding hordes of unemployed hay cutters or cowboys. Improved productivity meant markets were opened which did not previously exist, and unemployed agricultural workers moved to factory work. Media coverage of automation tends to focus on the potential job losses without mentioning the fact that the economy and its workers adapt, and overall living standards generally improve (Chart 3). Technology has displaced entire classes of jobs very rapidly in the recent past, and many products such as smartphones would be extremely difficult to assemble if the work was done by hand. Box 1 provides several other examples. Yet as is usual for many things that have happened multiple times in the past, we are told "this time is different." Chart 3The Industrial Revolution Led To A Vast Improvement In Living Standards Box 1 Automation Displaced Entire Classes Of Jobs In The Recent Past, But Brought Enormous Benefits Before calculators and word processors were available, writing and mathematical calculations were done manually. Machines such as calculators and type writers enhanced productivity, eliminating many such jobs. Software applications such as Microsoft Word and Excel further accelerated this process. Not that long ago, welding was entirely a manual job but now most welding in factories is done by robots: you can usually tell a human weld on a mass produced product by its poor quality. Robots in the modern factory have freed up workers for other roles in the economy just as the massive loss of agricultural jobs in the 20th century did. Many modern electronic products such as smartphones would be extremely difficult to assemble if the work was done by hand, as the components are so small they require microscopes to manipulate. Even if it were possible to hand assemble a smartphone, it would take hours of manual labor to produce, and the quality would be very poor. The use of automation means that smartphones cost a few hundred dollars instead of a few thousand dollars and are affordable enough to be a mass market item. Some of the anxiety around automation-related job losses centers on the possibility that this time, robots will displace workers from the service and white-collar sectors. BCA's European Investment Strategy service has written about the potential for AI to replace jobs involving tasks that require specialized education and training, such as calculating credit scores or insurance premiums, or managing stock portfolios.4 Recent developments in AI (specifically deep learning algorithms) have allowed computers to solve pattern recognition problems that they could not previously solve. However, we do not believe AI in its current form poses a widespread risk to white collar employment for the following reasons: Both service-sector and white collar employees have been subject to replacement through automation already, and the economy has adapted: ATMs are robot bank tellers, self-checkout lanes are robot checkout kiosks, and "smart" gas and electric meters that can be read remotely replace human meter readers. The legal profession has been transformed by Google searches and the accounting business by accounting software. These tools allow certain clients to avoid the use of a lawyer or accountant altogether (for example in setting up a corporation or doing bookkeeping), or allow a firm to employ less skilled workers for the task. We can offer numerous other examples of white collar jobs which have been fully or partially automated over the past couple decades. In addition, recall that AI produces high probability answers which turn out to be wrong, and it requires a lot of subject specific training. Both of these are intrinsic to the implementation of the algorithm. In contrast, humans generally are much better at assigning confidence to decisions and train very rapidly because they have cross-expertise AI lacks. An implementation of AI has to meet BOTH of the following conditions to be successful: There has to be a lot of subject-specific data available A high probability assigned to a wrong answer is either inconsequential or can be easily overruled by a human It is also important to note that although AI may reduce the demand for accountants, insurance agents, credit analysts and other skilled professionals, these are exactly the sort of people that can handle retraining. Part 2: What Makes Upcoming Robots Revolutionary Upcoming robots will be different because they will not be confined to the factory floor. We believe this is a key transition point, and that the next 20 years or so will see as dramatic a change from robotics as was caused by the Internet. Factory robots have improved immensely due to cheaper and more capable control and vision systems. Early robots performed very specific operations under carefully controlled conditions -an assembly robot which encountered a misaligned component would simply install it that way, resulting in a defective product. Eventually vision systems were developed which allowed robots to adjust to varying conditions. As camera and computing costs continue to decline, vision systems are becoming more elaborate and useful, as they gather and process more information to make increasingly complex decisions. As these systems evolve, the abilities of robots to move around their environment while avoiding obstacles will improve, as will their ability to perform increasingly complex tasks. Mobile robots will likely rely on AI to make many decisions. In order to be cost effective, for many years AI will likely be hosted in cloud data centers. This is especially the case for consumer robots, which will have to be highly capable and yet cost effective. We discuss the implications for cloud services providers in more detail in Part 3: Investment Implications. We May Be Entering A 'Virtuous Cycle' In Robotics Improvements to one domain of robotic applications can be generally applied to others. Robotics technology is concurrently moving forward on many fronts ranging from the aforementioned vacuum cleaners, lawnmowers, and logistics robots, to medical orderlies,5 farm tractors,6 mining equipment,7 transport trucks,8 and cargo ships.9 Despite enormous differences in cost and value added, all of these applications are solving essentially the same problem. As with any other technological revolution, advances between different fields in robotics will be adapted, borrowed, extended and enhanced. This, in turn, creates opportunities for ever more applications, creating a virtuous cycle (Diagram 1). Diagram 1Robotics Will Enter Into A Virtuous Cycle There are few tasks which cannot be automated, but there is a definite cost-benefit tradeoff for each one. For example, a golf course may consider spending $25,000 for a robotic lawnmower, however costs were closer to $70 - $90,000 in 2015,10 and installed cost is even higher.11 Because the incremental cost of the machines is comprised of electronics, which will drop in price rapidly, it is probably a matter of another 2 or 3 years before the price moves to the point where mass adoption by groundskeepers begins. The same improvements to industrial lawnmowers will lead to more useable, albeit still pricy, consumer models which will probably enter mass market adoption 5 to 10 years from now. The same argument can be made for almost any manual chore ranging from cleaning the carpet to delivering parcels. We predict the virtuous cycle for robots will span several decades. As the cost of automation drops, better solutions will be developed, resulting in 'early retirement' of dated but otherwise fully functional robotic systems. This is the opposite of the Feature Saturation phenomenon currently present in the smartphone and PC industries - though feature saturation will eventually hit robots as well. A Self-Driving Car Is A Robot The most important robotics technology, from a macroeconomic perspective, is the rapidly advancing field of Autonomous Vehicles (AVs). The automobile industry is a significant part of the global economy, so changes in this industry will have profound implications. We covered AVs in detail in our April 8, 2016 Special Report. Due to technical and legal obstacles that must be overcome, a vehicle which can safely travel from point to point on major roads and city streets without driver intervention is probably 20 years away, +/- 5 years. The macro impact, however, will occur much sooner than that, due to the technologies developed on the way to full AVs. Vehicles are already offering features such as forward collision warning, autobrake, lane departure warning, lane departure prevention, adaptive headlights, and blind spot detection.12 Although we have only touched the surface, robotics are being applied across many industries, making even seemingly modest advances significant when measured in aggregate, as small changes in one industry are quickly adapted by other industries. It is noteworthy that this transition will likely occur during a period where demographic shifts, in particular in the most developed economies, signal the potential for labor shortages, or at least increasing cost of labor (Chart 4).13, 14 Robots may be showing up in the nick of time to improve both the economy and quality of life in the developed world. Chart 4Advances In Robotics Will Counter Adverse##br## Demographic Trends Part 3: Investment Implications The semiconductor industry has stagnated as the PC and smartphone markets entered a largely replacement-driven era (Chart 5). Although it may not be evident until the virtuous cycle is fully engaged, robotics represents another up-leg in demand for semiconductors and therefore should result in a significant improvement to industry growth rates. There is little opportunity for startup semiconductor companies nowadays due to the high costs of developing a new chip. Well positioned, established, semiconductor companies will be the primary beneficiaries of the robotics revolution. Large firms that attempt to fit their existing product offering into the industry (e.g. by remaining PC or mobile-phone centric) will fall behind. Winners System on a Chip (SoC) Vendors: Robotics hardware will more likely be implemented as "System on a Chip" (SoC) as this provides the greatest functionality with lowest cost and power consumption. SoCs generally consist of a variety of Intellectual Property (IP) "cores" which may be licensed from third parties. Typically, IP cores consist of a microprocessor and various specialized subsystems, depending on the application. Robotics SoCs are likely to include Digital Signal Processing (DSP) or Image Processing cores to process sensor data. SoC vendors who target or encourage robot development, such as Overweight-rated Texas Instruments, are likely to be favored by early movers in the space.15 We believe it is a matter of time before Graphics Processors (GPUs) currently used in AI/Deep Learning are replaced by processors specifically designed for AI, which will be cheaper and more power efficient.16 This is one of the reasons for our Underweight rating on Nvidia. Semiconductor Foundries, Mixed Signal and Automotive Semiconductor Vendors: This environment will favor the merchant semiconductor foundries which manufacture most SoCs. In addition, firms with "mixed signal" expertise will experience increased demand for motor controls, sensor interfaces, etc. As robotics features are added to automobiles, demand for automotive semiconductors should outpace that in other sectors. A significant degree of commonality in the parts and systems used in advanced automobiles will be used in other mobile robots, so "automotive" semiconductor demand should significantly outpace automobile sales. Sensor Vendors: Robots need a variety of sensors, depending on the application. Unlike factory floor robots which can make do with cameras, mobile robots will require advanced radar, ultrasound, laser scanning and other sensor types in order to provide redundancy and cope with weather and other related issues. Important sensors on prototype AVs are currently made in low volumes and are extremely expensive. Due to the number of sensors involved, we believe there is significant opportunity for companies offering aggressive cost reduction in sensor technology. Wireless Equipment and Service Providers: Most robotic systems will include some degree of wireless connectivity and participate in the "Internet of Things" (IoT). This will present challenges and opportunities for wireless equipment and service providers,17, 18 as networks will have to adapt to increased upload bandwidth (from robot to carrier) as well as novel billing schemes. Coverage will also have to be expanded to accommodate AVs as it is non-existent or spotty in large stretches of North American roadways. Not being able to check Facebook between two cities is one thing, losing your robot driver is much more serious. Our recent downgrade of Cisco to Underweight19 may appear inconsistent with the analysis above. However, the company's valuation is extremely elevated and revenues are declining (Chart 6). Any benefit Cisco will derive from investment into wireless infrastructure is several years out, and open-source hardware initiatives are gaining momentum.20 For that reason, we see the risks as outweighing the opportunities at the moment for the company. Chart 5Long Replacement Cycles Mean Slower ##br##Semiconductor Sales Chart 6Cisco's Stock Price Is Close To Tech Bubble##br## Levels Despite Declining Revenue Cloud Service Providers: Most robots will be on line and some will likely use cloud services to offload computational effort and minimize cost. A relatively "dumb" robotic lawnmower which offloads control to a shared computational resource in the cloud would probably be cheaper than a much more capable fully autonomous system. This will increase demand for cloud services, however the challenge of declining margins (due to increased competition in the space) will offset cloud services revenue growth somewhat in the long term. On balance, Overweight-rated Microsoft and Alphabet/Google, as well as Amazon, stand to benefit. Chart 7Eastman Kodak Tried To Ignore The Shift ##br##To Digital Cameras Losers We believe companies who ignore the robotics revolution will find themselves at a significant competitive disadvantage. This is not unprecedented in the technology sector: Digital Equipment Corporation (DEC) and Kodak vanished because their business models could not accommodate an obvious shift in their core markets (Chart 7). Similarly Intel and Microsoft completely missed the smartphone revolution. As we noted in our April 8, 2016 Special Report on AVs, the frequency and severity of crashes will decrease dramatically which will lead to reduced insurance rates, fewer repairs, and less money spent on accident related healthcare and rehabilitation. The economic losses of automobile crashes were estimated $871 billion in the US in 201021 and even a modest reduction in the frequency and severity of collisions due to partial automation would have a significant economic impact. "Dumb" Auto Parts Manufacturers: Fewer collisions will result in fewer repairs to people or vehicles. Auto parts manufacturers will fall into two camps: those with significant expertise in robotics will prosper, while those without such expertise will fall behind as the demand for replacement components (fenders, bumpers, doors, windshields, etc.) will decline. AVs are also likely to include advanced diagnostic and service reminder systems which will result in more timely service, reducing wear and tear on internal components as well. The Auto Insurance Industry: While it is doubtful robotics will ever eliminate auto accidents, the rate might be reduced to such a level that the auto-insurance industry, worth $157 billion in the US alone,22 will be much smaller in 20 years than it is today. This will be offset to a degree by greater demands for product liability insurance for AVs and robots in general. Brian Piccioni, Vice President Technology Sector Strategy brianp@bcaresearch.com Paul Kantorovich, Research Analyst paulk@bcaresearch.com 1 http://www.merriam-webster.com/dictionary/robot 2 http://www.computersciencelab.com/ComputerHistory/HistoryPt2.htm 3 https://www.agclassroom.org/gan/timeline/farm_tech.htm 4 Please see European Investment Strategy Special Report, "Female Participation: Another Mega-Trend," dated April 6, 2017, available at eis.bcaresearch.com. 5 http://www.tomsguide.com/us/Forth-Valley-Royal-Robots-Serco-Medicine,news-7124.html 6 http://modernfarmer.com/2013/04/this-tractor-drives-itself/ 7 http://www.asirobots.com/mining/ 8 http://www.theaustralian.com.au/business/powering-australia/rio-rolls-out-the-robot-trucks/story-fnnnpqpy-1227090421535 9 http://www.bloomberg.com/news/articles/2014-02-25/rolls-royce-drone-ships-challenge-375-billion-industry-freight 10 http://techon.nikkeibp.co.jp/english/NEWS_EN/20141210/393619/ 11 http://www.golfcourseindustry.com/article/do-robotic-mowers-dream-of-electric-turf/ 12 http://www.iihs.org/iihs/topics/t/crash-avoidance-technologies/topicoverview 13 http://gbr.pepperdine.edu/2010/08/preparing-for-a-future-labor-shortage/ 14 http://www.imf.org/external/pubs/ft/fandd/2013/06/das.htm 15 http://www.ti.com/corp/docs/engineeringChange/robotics.html 16 Please see Technology Sector Strategy Weekly Report, "Google - AI And Cloud Strategy," dated April 25, 2017, available at tech.bcaresearch.com. 17 http://www.fiercemobileit.com/press-releases/gartner-says-internet-things-will-transform-data-center 18 http://www.computerworld.com/article/2886316/mobile-networks-prep-for-the-internet-of-things.html 19 Please see Technology Sector Strategy Weekly Report, "Networking Equipment Update ," dated March 28, 2017, available at tech.bcaresearch.com. 20 http://www.businessinsider.com/att-white-box-test-should-scare-cisco-juniper-2017-4 21 http://www.nhtsa.gov/About+NHTSA/Press+Releases/2014/NHTSA-study-shows-vehicle-crashes-have-$871-billion-impact-on-U.S.-economy,-society 22 http://www.bloomberg.c/bw/articles/2014-09-10/why-self-driving-cars-could-doom-the-auto-insurance-industry

Highlights Portfolio Strategy If the Fed is about to begin interest rate re-normalization in earnest, then investors should heed the message from historic sector performance during tightening cycles. The tech sector remains vulnerable to tighter monetary conditions. Downshift communications equipment to neutral and stay clear of software. The OPEC supply agreement reinforces our current energy sector bias, overweight oil services and underweight refiners. Recent Changes S&P Communications Equipment - Reduce to neutral. Table 1 Feature Chart 1Why Is Equity Vol So Low? The equity market has been in a remarkably low volatility uptrend in recent weeks, powered by hopes that political regime shifts will invigorate growth. Signs of economic life have also played a role. The risk is that investors have pulled forward profit growth expectations on the basis of anticipated fiscal stimulus that may disappoint. In the meantime, the tighter domestic monetary conditions get, the less likely equity resilience can persist, especially in the face of rising instability in other financial markets. Volatility has jumped across asset classes, with the bond market leading the charge. The MOVE index of Treasury bond volatility has spiked. Typically, the MOVE leads the VIX index of implied equity market volatility (Chart 1, second panel). Currency and commodity price volatility has also picked up. It would be dangerous to assume that the equity market can remain so sedate. If the economy is about to grow in line with analysts double-digit profit growth expectations and/or what the surge in some cyclical sectors would suggest, then a re-pricing of Fed interest rate hike expectations is likely to persist. Against this backdrop, it is instructive to revisit historic sector performance during past Fed tightening cycles. If one views the next interest rate hike as the start of a sustained trend based on the steep trajectory of expected profit growth embedded in valuations and forecasts, then it is useful to use that as a starting point rather than last year's token 'one and done' interest rate hike. Charts 2 and 3 show the one-year and two-year average sector relative returns after Fed tightening cycles have commenced. A clear pattern is evident: defensive sectors have been the best performers by a wide margin, followed by financials, while cyclical sectors have underperformed over both time horizons. To be sure, every cycle is different, but this is a useful frame of reference for investors that have ramped up growth and cyclical sector earnings expectations in recent months. There has already been considerable tightening based on the Shadow Fed Funds Rate, a bond market-derived fed funds rate not bound by zero percent (Chart 4, shown inverted, top panel). The latter foreshadows a much tougher slog for the broad market. The point is that tighter monetary conditions can overwhelm valuation multiples and growth expectations. Chart 212-Month Performance After Fed Hikes Chart 324-Month Performance After Fed Hikes Chart 4A Blow-Off Top? The violent sub-surface equity rotation has presented a number of rebalancing opportunities. The defensive health care and consumer staples sectors have been shunned in recent weeks, with capital rotating into financials and industrials. As discussed previously, the industrials and materials sectors cannot rise in tandem for long with the U.S. dollar. These sectors should be used as a source of funds to take advantage of value creation in consumer discretionary, staples and health care where value has reappeared. Chart 5It's Not A ''Growth'' Trade Indeed, the abrupt jump in the cyclical vs. defensive share price ratio appears to have been driven solely by external forces, i.e. the sell-off in the bond market, rather than a shift in underlying operating profit drivers. For instance, emerging market (EM) equities and the cyclical vs. defensive share price ratio have tended to move hand-in-hand (Chart 5). The former are pro-cyclical, and outperform when economic growth prospects are perceived to be improving. Recent sharp EM underperformance has created a large negative divergence with the U.S. cyclical vs. defensive share price ratio. The surging U.S. dollar is a growth impediment for many developing countries with large foreign debt liabilities, and the lack of EM equity participation reinforces that the recent rise in industrials is not a one way bet. As a result, our preferred cyclical sector exposure lies in the consumer discretionary sector, and not in capital spending-geared deep cyclical sectors. A market weight in financials, utilities and energy is warranted, as discussed below, while the tech sector is vulnerable. A Roundtrip For The Tech Sector? After a semiconductor M&A-driven spurt of strength, the S&P technology sector has stumbled. As a long duration sector, technology has borne a disproportionate share of the backlash from a higher discount rate, similar to the taper-tantrum period in 2013. Then, bond yields soared as the Fed floated trial balloons about tapering QE. Tech stocks did not trough until yields peaked (Chart 6). In addition, a recovery in tech new orders confirmed that the sales outlook had brightened. Now, the capital spending outlook remains shaky, and tech new order growth is nil (Chart 6). Meanwhile, tech pricing power has nosedived (Chart 6). Domestic deflationary pressures are likely to intensify as the U.S. dollar appreciates, particularly against the manufacturing and tech-sensitive emerging Asian currencies. Tech sales growth is already sliding rapidly toward negative territory (Chart 7), with no reprieve in sight based on the contraction in emerging market exports, as well as U.S. consumer and capital goods import prices. Chart 6Tech Doesn't Like Rising Bond Yields Chart 7No Sales Growth True, tech stocks have a solid relative performance track record when the U.S. dollar initially embarks on a long-term bull market (Chart 8). Why? Because tech business models incorporate deflationary conditions, investors have been comfortable bidding up valuations in excess of the negative sales impact from a stronger U.S. dollar. Nevertheless, history shows that this relationship becomes untenable the longer currency appreciation persists. Chart 8 shows that in the final phase of the past two U.S. dollar bull markets, tech stocks have abruptly reversed course, rapidly ceding the previously accrued gains. Apart from a loss of competitiveness from currency strength, the new anti-globalization trend is bad for tech as it has the highest foreign sales exposure. The bottom line is that there is no rush to lift underweight tech sector allocations. In fact, we are further tweaking weightings to reduce exposure. For instance, software companies are worth another look through a bearish lens. Software sales growth is at risk from pricing power slippage amidst cooling final demand (Chart 9). Chart 8Beware Phase II Of Dollar Bull Markets Chart 9Sell Software... The financial sector is an influential technology sector end market. On the margin, financial companies are likely to reduce capital spending on the back of deteriorating credit quality. Chart 9 demonstrates that when financial sector corporate bond ratings start to trend negatively, it is a sign that software investment will stumble. A similar message is emanating from the decline in overall CEO confidence (Chart 10), which mirrors the relentless narrowing in the gap between the return on and cost of capital (Chart 8, bottom panel). Even C&I bank loans, previously an economic bright spot, are signaling that corporate sector demand for external funds and working capital are softening, consistent with slower capital spending. Against a backdrop of fading software M&A activity, we are skeptical that the S&P software index can maintain its premium valuation (Chart 11). Chart 10... Before Sales Erode Chart 11Not Worth A Premium Elsewhere, the communications equipment industry will have trouble sustaining this summer's outperformance. Communications equipment stocks broke out of a long-term downward sloping trend-line on the back of productivity improvement. Chart 12 shows that after a period of intense cost cutting, wage inflation was negative. Our productivity proxy, defined as sales/employment, is growing rapidly. These trends are supportive of profit margins, and at least a modest valuation re-rating from washed out levels. Nevertheless, our confidence that a major bullish trend change has occurred after years of underperformance has been shaken. The budding reacceleration in top-line growth has hit a snag. New orders for communications equipment have rolled over relative to inventories. Investment in communications equipment has dipped (Chart 13). The telecom services sector has scaled back capital spending (Chart 13, third panel), suggesting that final demand will continue to soften. It will be difficult for companies to maintain high productivity if revenue growth stagnates. Chart 12Productivity Strength... Chart 13... May Be Pressured Consequently, the most likely scenario is that relative performance is entering a base-building phase rather than a new bull market, warranting benchmark weightings. Bottom Line: Reduce the S&P communications equipment index (BLBG: S5COMM - CSCO, MSI, HRS, JNPR, FFIV) to neutral, in a move to further reduce underweight tech sector exposure. Stay underweight software (BLBG: S5SOFT - MSFT, ORCL, ADBE, CRM, INTU, ATVI, EA, ADSK, SYMC, RHT, CTXS, CA). Energy Strategy Post-OPEC Production Cut Chart 14Energy Stocks Need Rising Oil Prices The energy sector continues to mark time relative to the broad market, but that has masked furious sub-surface movement. We have maintained a benchmark exposure to the broad sector since the spring, but shifted our sub-industry exposure in October to favor oil field services over producers, while underemphasizing refiners. OPEC's recent agreement to trim flatters this positioning. Whether OPEC's announcement actually feeds through into meaningfully lower production next year and higher oil prices remains to be seen, but at a minimum, supply discipline should put a floor under prices. Rather than expecting the overall energy sector to break out of its lateral move relative to the broad market, we continue to recommend a targeted approach. The energy sector requires sustained higher commodity prices to outperform, and our concern is that a trading range is more likely (Chart 14). OPEC producers suffered considerable pain over the last two years as they overproduced in order to starve marginal producers of the capital needed for reinvestment. U.S. shale producers slashed capital expenditures by 65% from 2014 to 2016, and the International Oil Companies (IOCs) cut capital expenditures by 40% over the same period. Chart 15 shows that only OPEC has been expanding production. That has set the stage for limited global production growth, allowing for demand growth to eat into overstocked crude inventories in the coming years. OPEC's decision to trim output should mitigate downside commodity price risks, providing debt and equity markets with confidence to increase capital availability to the sector. With a lower cost and easier access to capital, producers, especially shale, will be able to accelerate drilling programs. The rig count has already troughed. The growth in OECD oil inventories has crested, which is consistent with a gradual rise in the number of active drilling rigs. As oversupply is absorbed, investment in oil field services will accelerate, unlocking relative value in the energy services space (Chart 16). Chart 15OPEC Cuts Would Help... Chart 16... Erode Excess Oil Supply This overweight position is still high risk, because it will take time to absorb the excesses from the previous drilling cycle. There is still considerable overcapacity in the oil field services industry, as measured by our idle rig proxy. Pricing power does not typically return until the latter rises above 1 (Chart 17). Companies will be eager to put crews to work and better cover overhead, and may accept suboptimal pricing, at least initially. Meanwhile, if EM currencies continue to weaken, confidence in EM oil demand growth may be shaken, eroding valuations. Still, we are willing to accept these risks, but will keep this overweight position on a tight leash and will take profits if OPEC does not follow through with plans to limit production. On the flipside, refiners will not receive any relief in feedstock prices, which should ensure that the gap between Brent and WTI prices remains non-existent (Chart 18). That is a strain on refining margins. Our model warns that there is little profit upside ahead. That is confirmed by both domestic and global trends. Chart 17Risks To A Sustained Rally Chart 18Sell Refiners Chart 19Global Capacity Growth Refiners have continued to produce flat out, even as domestic crude production has dropped (Chart 18). As a result, inventories of gasoline and distillates have surged, despite solid consumption growth. In fact, refined product output is about to eclipse the rate of consumption growth, which implies persistently swelling inventories. There is no export outlet to relieve excess supply. U.S. exports are becoming much less competitive on the back of U.S. dollar strength and the elimination of the gap between WTI and Brent input costs (Chart 19). Moreover, rising capacity abroad has trigged an acceleration of refined product exports in a number of low cost producer countries, including India, China and Saudi Arabia (Chart 19). Increased global refining capacity is a structural trend, and will keep valuation multiples lower than otherwise would be the case. The relative price/sales ratio is testing cyclical peaks, warning that downside risks remain acute. Bottom Line: Maintain a neutral overall sector weighting, with outsized exposure to the oil & gas field services industry (BLBG: S5ENRE - SLB, HAL, BHI, NOV, HP, FTI, RIG), and undersized allocations to the refining group (BLBG: S5OILR - PSX, VLO, MPC, TSO). Current Recommendations Current Trades Size And Style Views Favor small over large caps and growth over value.

We took profits in the S&P software index and downgraded to neutral in January, because the boost to corporate software investment to offset flagging productivity growth looked to have been fully discounted. After a six month consolidation, relative performance has jumped back to this year's highs, but the conditions to sustain a breakout are absent. Software demand is more levered to business investment than consumer spending. In the macro environment we envision, consumption will continue to outpace investment. The rise in the personal savings rate means that there is pent-up consumer spending to be realized as wage inflation recovers. On the flipside, stretched corporate balance sheets and a dearth of sales growth pose significant restrictions to capital spending budgets. Ominously, software sales are already contracting relative to total S&P 500 sales. The software industry's contribution to GDP growth invariably becomes negative, i.e. a drag, when overall capital spending retrenches, as is currently the case. Sales contraction, and profit margin erosion, is not conducive to premium valuations. Cut to underweight and please see yesterday's Weekly Report for more details. The ticker symbols for the stocks in this index are: BLBG-S5SOFT: ADBE, ADSK, CA, CTXS, EA, INTU, MSFT, ORCL, RHT, CRM, SYMC, ATVI.

The equity rally has been in a holding pattern, with some tactical fraying around the edges.

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