Semiconductors

Highlights Portfolio Strategy Synchronized global capex growth, a derivative of BCA's synchronized global growth thesis, will be a dominant theme next year, benefiting cyclicals over defensives. Three high-conviction calls are levered to this theme. Higher interest rates on the back of a pickup in inflation expectations is another BCA theme that should materialize in 2018. Three calls focus on a selloff in the bond markets for the coming year. Two special situations round up our high-conviction calls for 2018. Recent Changes S&P Software index - Boost to overweight. S&P Homebuilding index - Downgrade to underweight. Table 1 Feature Equities continued to grind higher last week, largely ignoring tax bill passage jitters. The S&P 500 is on track to register an eighth consecutive month of positive monthly returns, an impressive feat. Firm global economic data suggests that the synchronized global growth theme is gaining traction and remains investors' focal point. While the 10/2 yield curve flattening is a bit unnerving, another curve to watch is the spread between 2-year yields and the Fed funds rate, or what BCA often refers to as the "Fed Spread". This spread has widened 50bps since early September closely tracking the Citi economic surprise index (Chart 1A), and signals that the U.S. economy remains on a solid footing. We would be most worried that a recession was imminent were both slopes concurrently flattening and approaching inversion (third panel, Chart 1A). Chart 1AThe 'Fed Spread'Is Right Chart 1BHigher Interest Rates Theme Moreover, credit growth has turned the corner, and the three, six and twelve month credit impulses are all simultaneously rising at a time when total loans outstanding have hit an all-time high. Importantly, credit breadth is also broad-based. Our six month impulse diffusion index shows that six out of the eight credit categories that the Fed tracks have a positive second derivative (Chart 1A). All of this suggests that, cyclically, the path of least resistance is higher for equities, especially given BCA's view of a recession hitting only in 2019. In this context, we are revealing our high-conviction calls for the next year. Most of our calls leverage two BCA themes: synchronized global capex growth (a derivative of our flagship publication's "The Bank Credit Analyst" synchronized global growth theme articulated in last week's outlook)1 and a higher interest rate theme ("The Bank Credit Analyst" expects yields to be under upward pressure in most major markets during 2018)2. Over the past few months we have been articulating the ongoing synchronized global capital spending macro theme3 that, despite still flying under the radar, will likely dominate in 2018. Table 2 on page 4 shows that both DM and EM countries are simultaneously expanding gross fixed capital formation. As a result, we reiterate our recent cyclical over defensive portfolio bent,4 and tie three high-conviction overweight calls to this theme. Table 2Synchronized Global Capex Growth Similarly in recent reports we have been highlighting BCA's U.S. Bond Strategy view of a higher 10-year yield on the back of rising inflation expectations for 2018. If BCA's constructive crude oil view pans out then inflation and rates may get an added boost (Chart 1B). Three high-conviction calls are levered to this theme. Finally, we have a couple of special situations, and this year we characterize two out of these eight calls as speculative. Anastasios Avgeriou, Vice President U.S. Equity Strategy anastasios@bcaresearch.com 1 Please see BCA The Bank Credit Analyst Monthly Report, "OUTLOOK 2018 Policy And The Markets: On A Collision Course," dated November 20, 2017, available at bca.bcaresearch.com. 2 Ibid. 3 Please see BCA U.S. Equity Strategy Weekly Report, "Invincible" dated November 6, 2017, available at uses.bcaresearch.com. 4 Please see BCA U.S. Equity Strategy Special Report, "Top 5 Reasons To Favor Cyclicals Over Defensives" dated October 16, 2017, available at uses.bcaresearch.com. 5 Please see BCA U.S. Bond Strategy Weekly Report, "Living With The Carry Trade" dated October 17, 2017, available at usbs.bcaresearch.com. Construction Machinery & Heavy Trucks (Overweight, Capex Theme) The capex upcycle will likely fuel the next machinery stock outperformance upleg. Not only are expectations for overall capital outlays as good as they get (Chart 2), but there are also tentative signs that even the previously moribund mining and oil & gas complexes will be capex upcycle participants. While we are not calling for a return to the previous cycle's peak, even a modest renormalization of capital spending plans (i.e. maintenance capex alone would suffice) in these two key machinery client segments would rekindle industry sales growth. A quick channel check also waves the green flag. Both machinery shipments and new orders are outpacing inventory accumulation (Chart 2). Moreover, backlogs are rebuilding at the quickest pace of the past five years (not shown). This suggests that client demand visibility is returning. This machinery end-demand improvement is a global phenomenon. In fact, the fourth panel of Chart 2 shows that global machinery new orders are climbing faster than domestic new order growth. Tack on the reaccelerating global credit impulse courtesy of the latest Bank for International Settlements Quarterly Review and the ingredients are in place for a global machinery export boom. Finally, our machinery EPS model is firing on all cylinders, underscoring that the earnings-led recovery has more running room (Chart 2). The ticker symbols for the stocks in this index are: BLBG: S5CSTF - CAT, CMI, PCAR. Chart 2S&P Construction Machinery & Heavy Trucks Energy (Overweight, Capex Theme) The slingshot recovery in basic resources investment - albeit from a very low base - suggests that there is more room for relative gains in the S&P energy index in the coming months (second panel, Chart 3). The U.S. dollar remains down significantly for the year and, irrespective of future moves, it should continue to goose energy sector profits owing to the positive impact on the underlying commodity. Importantly, energy producers are a levered play on oil prices and the latter have jumped roughly $14/bbl to $58/bbl or ~32% since July 10th, but energy stocks are up only 8% in absolute terms. Given BCA's still sanguine crude oil market view, we expect a significant catch up phase in energy equity prices into 2018. On the supply front, Cushing and OECD oil stocks are now contracting. As oil inventories get whittled down, OPEC stays disciplined and oil demand grinds higher, oil prices will remain well bid. The implication is that the relative share price advance is still in the early innings. Relative valuations have ticked up in the neutral zone according to our composite relative Valuation Indicator, but on a number of metrics value remains extremely compelling in the energy space. Finally, our EPS model heralds additional growth in the coming quarters on the back of solid industry pricing power and sustained global oil producer discipline. The ticker symbols for the stocks in this index are: BLBG: S5ENRS - XLE:US. Chart 3S&P Energy Software (Overweight, Capex Theme) The S&P software index is a clear capex upcycle beneficiary (Chart 4) and we recommend an upgrade to a high-conviction overweight stance today. If software commands a larger slice of the overall capital spending pie as we expect, then industry profits should enjoy a healthy rebound (second panel, Chart 4). 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 (Chart 4). Reviving animal spirits 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. It has also rekindled software M&A activity, with the number of industry deals jumping in recent months. Meanwhile, 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. Finally, our newly introduced S&P software EPS model encapsulates this sanguine industry backdrop and heralds a bright profit outlook. The ticker symbols for the stocks in this index are: BLBG: S5SOFT-MSFT, ORCL, ADBE, CRM, ATVI, INTU, EA, ADSK, RHT, SYMC, SNPS, ANSS, CDNS, CTXS, CA. Chart 4S&P Software Banks (Overweight, Higher Interest Rates Theme) The S&P banks index is a core overweight portfolio holding and there are high odds of significant relative gains in the coming quarters. All three key drivers of bank profits, namely price of credit, loan growth and credit quality, are simultaneously moving in the right direction. On the price front, the market expects the 10-year yield to hit 2.47% in November 2018 from roughly 2.32% currently. BCA expects the 10-year yield will rise more quickly than is discounted in the forward curve. Our U.S. bond strategists think core inflation will soon resume its modest cyclical uptrend (Chart 5). A parallel recovery in the cost of inflation protection will impart 50-60 basis points of upside to the 10-year Treasury yield by the time core inflation reaches the Fed's 2% target.5 C&I and consumer loans, two large credit categories, are both forecast to reaccelerate in the coming months. The ISM has been on fire lately and consumer confidence has been following closely behind. Our credit growth model captures these positive forces and is sending an unambiguously positive message for loan reacceleration in the coming months (Chart 5). Finally, credit quality remains pristine despite some pockets of weakness in, subprime especially, auto loans. At this stage of the cycle, near or at full employment, NPLs will remain muted. The ticker symbols for the stocks in this index are: BLBG: S5BANKX - WFC, JPM, BAC, C, USB, PNC, BBT, STI, MTB, FITB, CFG, RF, KEY, HBAN, CMA, ZION, PBCT.  Chart 5S&P Banks Utilities (Underweight, Higher Interest Rates Theme) Increasing global economic growth expectations bode ill for defensive utilities stocks (global manufacturing PMI diffusion index shown inverted, top panel, Chart 6). Synchronized global economic and capex growth (second panel, Chart 6) and coordinated tightening in monetary policy spells trouble for bonds. Our U.S. Bond strategists expect a bond selloff to gain steam in 2018. Given that utilities essentially trade as a proxy for bonds, this macro backdrop leaves them vulnerable to a significant underperformance phase. Importantly, the stock-to-bond (S/B) ratio and utilities sector relative performance also has a tight inverse correlation. The implication is that downside risks remain acute. Without the support of continued declines in bond yields, or of indiscriminate capital flight from all riskier assets, utilities advances depend on improving fundamentals. The news on the domestic operating front is grim. Contracting natural gas prices, the marginal price setter for the industry, suggest that recent utilities pricing power gains are running on empty. Add on waning productivity, with labor additions handily outpacing electricity production, and the ingredients for a margin squeeze are in place. Finally, industry utilization rates are probing multi-decade lows and overcapacity is negative for pricing power. Turbine and generator inventories have been hitting all-time highs. This is a deflationary backdrop. The ticker symbols for the stocks in this index are: BLBG: S5UTIL - XLU:US. Chart 6S&P Utilities Pharmaceuticals (Underweight, Special Situation) Weak pricing power fundamentals, a soft spending backdrop, a depreciating U.S. dollar and deteriorating industry operating metrics will sustain downward pressure on pharma stocks in the coming year. Both in absolute terms and relative to overall PPI, pharma selling prices are steadily losing steam (Chart 7). In the context of a bloated industry workforce, the profit margin outlook darkens significantly. If the Trump administration also manages to clamp down on the secular growth of pharma selling price inflation, then industry margins will remain under chronic pressure. Moreover, our dual synchronized global economic and capex growth themes bode ill for defensive pharma stocks. Nondiscretionary health care outlays jump in times of duress and underwhelm during expansions. Currently, the soaring ISM manufacturing index is signaling that pharma profits will remain under pressure in the coming months as the most cyclical parts of the economy flex their muscles (the ISM survey is shown inverted, second panel, Chart 7). A depreciating currency is also synonymous with pharma profit sickness (bottom panel, Chart 7). While pharma exports should at least provide some top line growth relief during depreciating U.S. dollar phases, they are contracting at an accelerating pace (middle panel, Chart 7), warning that global pharma demand is ill. Finally, even on the operating metric front, the outlook is dark. Pharma industrial production is nil and our productivity proxy remains muted, warning that profits will likely underwhelm. The ticker symbols for the stocks in this index are: BLBG: S5PHAR - JNJ, PFE, MRK, BMY, AGN, LLY, ZTS, MYL, PRGO. Chart 7S&P Pharma Homebuilding (Speculative Underweight, Higher Interest Rates Theme) Year-to-date, the niche homebuilding index is the best performing sub-index within consumer discretionary stocks surpassing even the internet retail subgroup that AMZN is part of, and has bested the broad market by 50 percentage points. Such exuberance is unwarranted and we deem that stocks prices have run way ahead of earnings fundamentals. Worrisomely the trifecta of higher interest rates, high lumber prices and likely tax reform blues are substantial headwinds to the index's profit potential. The second panel of Chart 8 shows that if BCA's interest rate view materializes in 2018, then 30-year fixed mortgage rates will rise in tandem with the 10-year yield (assuming the spread stays intact) and cause, at the margin, some consternation to homeownership. Near all-time highs in lumber prices are also a cause for concern (bottom panel, Chart 8). Lumber is an input cost to new homes built and eats into homebuilder margins if they decide not to pass it on to the consumer. If they do add it as a surcharge to new home selling prices, then existing homes become a "cheaper" alternative, hurting new home demand. Finally, the GOP tax plan may change mortgage interest and property tax deductions, affecting largely new home owners and becoming a net negative to the homebuilding index. The ticker symbols for the stocks in this index are: BLBG: S5HOME-DHI, LEN, PHM, LEN / B. Chart 8S&P Homebuilding Semiconductor Equipment (Speculative Underweight, Special Situation) Semiconductor stocks in general and semi equipment in particular have gone parabolic. The latter have bested the market by 60 percentage points year-to-date, and over a two-year period the outperformance jumps to roughly 180 percentage points (top panel, Chart 9). Something has got to give, and we are putting the S&P semi equipment index on our speculative high-conviction underweight list. A global M&A frenzy and the bitcoin/ICO mania (bottom panel, Chart 9) have pushed chip equipment stocks to the stratosphere. In absolute terms this index is near the tech bubble peak, and relative share prices are following close behind (top panel, Chart 9). Worrisomely five year EPS growth forecasts recently surpassed the 25% mark, an all-time high. Both the tech sector's (in 2000) and the biotech index's (2001 and 2014) long term growth estimates hit a wall near such breakneck pace (second panel, Chart 9). This indefinite profit euphoria is unwarranted and we would lean against it. On the operating front, DRAM prices (a pricing power proxy) have tentatively peaked and so have semi sales (an industry end-demand proxy), warning that extrapolating the recent semi equipment V-shaped profit recovery far into the future is fraught with danger (third & fourth panels, Chart 9). The ticker symbols for the stocks in this index are: BLBG: S5SEEQ-AMAT, LRCX, KLC. Chart 9S&P Semis 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 The structural theme of overweighting technology stocks within the overall equity benchmark, and relative to other cyclical sectors such as commodities and machinery stocks, remains intact. However, in absolute terms, EM tech/semi share prices have become overbought and have already priced in a lot of good news. They will likely sell off soon due to the potential slowdown in the pace of semiconductor demand. Continue overweighting EM tech stocks, Taiwanese and Korean bourses within EM equity portfolios. We also reiterate our long-standing long tech / short materials strategy. Feature EM technology stocks have surged to all-time highs (Chart I-1, top panel), contributing significantly to the ongoing EM rally. In fact, excluding tech stocks, EM share prices have not yet surpassed a major technical hurdle, as shown in the bottom panel of Chart I-1. BCA's Emerging Markets Strategy (EMS) team has been recommending that investors overweight tech stocks since June 8, 2010. In our report titled, How To Play EM Growth In The Coming Decade,1 we contended that the structural bull market in commodities was over, and that in the coming decade (2010-2019) the winners would be health care and technology (Chart I-2). We also identified a potential mania candidate - i.e., a segment that was poised for exponential price gains. We reasoned that the fusion between technology and health care - health care equipment stocks - could experience exponential price moves. This strategy has paid off exceptionally well. Consistently, within the EM equity benchmark, we have been overweighting Taiwanese and Korean tech stocks since 2007 and 2010, respectively (Chart I-3). Chart I-1EM Tech Stocks Have ##br##Surged To All Time Highs Chart I-2EMS Strategy Since 2010: ##br##Long Tech / Short Materials Chart I-3Taiwanese & Korean Tech ##br##Stocks Relative To Overall EM After such enormous gains, a relevant question is whether technology share prices will continue to rally in absolute terms, boosting the EM equity benchmark, or whether their absolute performance and/or relative performance will roll over. Chart I-4EM Tech Stocks Are Overbought Before we proceed in laying out our analysis, a caveat is in order: we can offer thematic long-term views on various sectors, but investors should realize the investment calls on many technology, internet and social media companies are driven by bottom-up - not macro - views. From a top-down perspective, we can offer little insight on whether EM internet and social media stocks such as Alibaba, Tencent and Baidu are cheap or expensive, whether their business models are or are not proficient, or what their profit outlooks might be. The reason is that these and other global internet/social media companies' revenues are not driven by business cycle dynamics and top-down analysis is less imperative in forecasting their performance. In this report we will shed some light on the business cycle in the global/Asian semiconductor industry. The latter is subject to both business cycle swings as well as sector-specific factors. Again, sector-unique factors for the semi industry are also beyond our top-down approach. The five largest constituents of the EM MSCI tech sector are Samsung (4.3% of EM MSCI market cap), Tencent (4.0%), Taiwan Semiconductor Manufacturing Company (3.5%), Alibaba (3.0%), and Baidu (1.0%). Chart I-4 shows their share prices. In short, they have become a large part of the EM benchmark and are also extremely overbought, increasing the risk of correction. Technology's Structural Bull Market Is Intact... Even though EM tech prices have skyrocketed in both absolute and relative terms, odds are that the structural bull market has further to run. There are no structural excesses in the technology sector that would warrant a bust for now. Even in China, credit/leverage excesses are concentrated in the old industries, not among the tech and new economy segments. Demand for tech products in general and semiconductors in particular is not very dependent on the credit cycle in EM. In both developed market (DM) and EM economies, spending on many tech gadgets is contingent on income gains rather than credit growth. Our bearish view on EM/China growth is primarily due to our expectations of a credit downturn that will affect spending that is financed by credit. Investment expenditures driven by credit are much more important for commodities and industrial goods than technology products. While the share prices of technology and new economy companies are overbought and may be expensive, global/EM economic demand growth will be skewed toward new industries and technologies rather than commodities. In brief, the outlook for global tech spending remains positive, both cyclically and structurally. Having outperformed all other sectors by a large margin, the EM technology sector presently accounts for 26% of the EM MSCI benchmark, while at its previous structural peak in 2000 its market share stood at 22% (Chart I-5, top panel). During the 1999-2000 tech bubble, the U.S. and DM tech sector’s share of market cap reached 34% and 24% of the U.S. MSCI and DM MSCI benchmark market caps, respectively (Chart I-5, middle and bottom panels). Despite being stretched, it is possible that the technology sector's market cap will rise further before another structural top transpires. Hence, we are not yet ready to call the top in the tech's share of the overall market cap either in EM or DM. From a very long-term perspective (since 1960), the relative performance of the U.S. technology sector against the S&P 500 has not yet reached two standard deviations above its time trend, as it did in the year 2000 during the tech bubble. Conversely, the same measure for energy, materials and machinery stocks is not yet depressed enough to warrant a mean reversion bet (Chart I-6). Chart I-5Tech Stocks Market Cap Share ##br##Of Overall Equity Benchmarks Chart I-6Relative Performance Of ##br##U.S. Sectors Vs. S&P 500 Finally, secular leadership rotations within global equities typically occur during market downturns. Chart I-7 shows that commodities stocks and tech leadership changed in 2001 and 2008. It is possible that new sectoral leadership will emerge in global equities during the next bear market/severe selloff. However, it is too early to bet on it now. The current character of equity markets - which favors technology over commodities - will persist. Bottom Line: The structural theme of overweighting technology stocks within the overall equity benchmark and relative to other cyclical sectors such as resources/commodities and machinery stocks remains intact. ...But The Semi Cycle Upswing Is Advanced The semiconductors industry is cyclical, and as such business cycle analysis is pertinent here. The rest of the technology sector, however, is not correlated with overall business cycles. Therefore, there is little value that macro analysis can deliver on the outlook for non-semi tech areas. This is why this section is focused on semiconductors rather than the overall tech sector. There is no basis as to why semiconductor/tech cycles should correlate with commodities cycles. However, when they do, the amplitude of global business cycle fluctuations rises. Indeed, Asian exports and global trade tumbled in 2015 and have subsequently improved over the past 12 months for the following reason: the 2015 downturn and the ensuing recovery in the semiconductor cycle overlapped with similar swings in commodities and Chinese capital goods demand (Chart I-8). This has increased the amplitude of the global business cycle's swings in the past two years. Chart I-7Secular Leadership ##br##Rotation: Tech Vs. Energy Chart I-8Chinese Capital Goods Imports & ##br##Global Semiconductor Cycle We remain bearish on Chinese capital spending in general and construction in particular. This entails weaker demand for commodities and industrial goods. Yet we are not bearish on Chinese demand for semiconductors and tech devices. The semiconductor cycle has experienced a mini boom in the past 12-18 months. Demand for electronic products in the U.S. has been exceptionally strong (Chart I-9, top panel). Moreover, European production and sale of overall high-tech products as well as computer and electronic products have been robust (Chart I-9, bottom panel). In China, retail sales of communication appliances have also been extremely healthy (Chart I-10, top panel). By extension, the mainland's production of electronics has also boomed (Chart I-10, bottom panel). Chart I-9DM Demand For Tech Is Strong... Chart I-10...And So Is China's One soft spot for semi demand, however, could emanate from the global auto sector. U.S. auto sales have begun to contract, and auto production will likely shrink as well (Chart I-11, top panel). In addition, the growth rate of auto sales in both China and Europe may have reached a peak (Chart I-11, middle and bottom panels). Annual vehicle sales have reached 25 million units in China, and 17 million vehicles in both the U.S. and euro area. Overall global auto production is set to decelerate and this will weigh on semiconductor demand given that autos consume a lot of electronics. In addition, there are several other indications that suggest a mini-slowdown will likely transpire in the global semiconductor sector later this year: Taiwan's narrow money (M1) growth impulse has historically been correlated with the tech-heavy TSE index and has led export cycles (Chart I-12). This money impulse currently heralds a major top and relapse in both share prices and exports. Chart I-11Global Auto Production Chart I-12Taiwanese M1 Money Impulse Is Signaling A ##br##Growth Slowdown And Risk To Stocks The semiconductor shipments-to-inventory ratio has peaked in Korea and Taiwan (Chart I-13). This indicates that the best of the semi upswing may be behind us. Consistently, both global semiconductor producers' and semiconductor equipment stocks' forward EPS net revisions have already surged, and are elevated. This implies that a lot of earnings optimism has been priced in. Historically, when forward earning net revisions have reached these levels, global semi share prices have rolled over or entered a consolidation period (Chart I-14). Chart I-13Korea's & Taiwan's Semi ##br##Cycle Is Topping Out Chart I-14Semiconductors' Forward EPS ##br##Revisions Are Elevated Bottom Line: We expect a moderation in semi demand, but not recession. Semi share prices may react negatively to slower demand growth as the former have become extremely overbought and have already priced in a lot of good news. Investment Conclusions Semiconductor stocks have become overbought and a marginal slowdown in demand might be enough to cause a shake-out. The same is true for the overall tech sector. That said, we continue to recommend that investors overweight EM tech stocks, Taiwanese and Korean bourses within the EM equity portfolios. We also reiterate our long-standing long tech / short materials strategy. Remarkably, the KOSPI and Taiwanese TSE indexes - highly leveraged to semiconductors - have rallied to their previous highs (Chart I-15). In the past, they failed to break above these levels and we expect them to struggle again. If these equity indexes pull back and tech stocks correct, the overall EM stock index will roll over too. The rest of EM equity universe has much poorer fundamentals than tech companies. Financials and commodities sectors make 25% and 7% of the EM MSCI benchmark's market cap, respectively. The former is at risk from credit slowdown in EM and the latter is at a risk from lower commodities prices (Chart I-16). Chart I-15KOSPI & TSE Have Reached ##br##Major Resistances Chart I-16Industrial Metals ##br##Prices To Head Lower On the whole, we believe the recent divergence of EM risk assets from commodities prices and the EM/China credit cycles does not represent a structural regime shift in EM fundamentals, it rather reflects complacency in the marketplace. Arthur Budaghyan, Senior Vice President Emerging Markets Strategy arthurb@bcaresearch.com Ayman Kawtharani, Associate Editor aymank@bcaresearch.com 1 Please refer to the Emerging Markets Strategy Special Report titled, "How The Play Emerging Market Growth In The Coming Decade", dated June 8, 2010, available at ems.bcaresearch.com. Equity Recommendations Fixed-Income, Credit And Currency Recommendations

After an M&A driven outperformance phase, semiconductor stocks appear to be putting in a major top. M&A activity has plunged, warning that deal premiums are likely to be removed from valuations. The recovery in global chip sales growth also looks to be at risk. Our global chip sales model has rolled over, reflecting softening new order growth in a number of chip-intensive industries. If top-line growth begins to recede, then the tentative trough in chip inventories is likely to turn into a full blown rebound. History shows that the highly anticipatory chip index fares poorly when chip supply accelerates. The latter signals that future chip output will decelerate, revealing the downside of a cyclical business with high operating leverage. Our Chip Stock Timing Model, a combination of technical and fundamental forces, has dropped sharply in recent weeks, reinforcing that relative performance is at serious risk. Stay underweight. 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.

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 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 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 Chart 4'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 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 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 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.

Housing activity should accelerate in the back half of the year given the drop in Treasury yields. Buy home improvement retailers and add to long homebuilding positions.

Asian exports (volumes and prices) have been contracting, as global trade has hit a wall. While this broad deflationary backdrop has taken a toll on Asian DRAM prices (bottom panel), global semiconductor supply/demand imbalances best explain the industry's dwindling pricing power. Not only are global semi sales shrinking, but also BCA's global semi inventory proxy is surging. Taken together, our global semi sales-to-inventories (S/I) ratio is contracting at an accelerating pace, signaling that an inventory liquidation phase is looming. Historically, the S/I ratio has been an excellent leading indicator of semi earnings and the current message is to expect a significant drop in profits (middle panel). Bottom line: Steer clear from the broad tech sector, continue to underweight the tech hardware, storage & peripherals sub-index and we reiterate our high-conviction underweight status for the S&P semis index. The ticker symbols for the stocks in the S&P semis index are: BLBG: S5SECO - INTC, QCOM, TXN, AVGO, NVDA, ADI, SWKS, XLNX, MU, LLTC, MCHP, QRVO, FSLR. The ticker symbols for the stocks in the S&P technology hardware, storage & peripherals index are: BLBG: S5THSP - AAPL, EMC, HPE, HPQ, SNDK, WDC, STX, NTAP.

Bearish sentiment is a red herring, as most other measures of investor positioning point to a strong undercurrent of bullishness. That is contrarily worrying.

An Insight yesterday showed that the overall technology sector was likely to record its worst quarterly earnings performance in four years. The highest beta components of the sector are most at risk. For instance, the semiconductor industry is losing its main source of support, namely an M&A premium. Last year's mini-M&A frenzy is petering out, which will put the onus on profits to support relative performance. However, global chip sales continue to deteriorate, and leading indicators such as Chinese electronics imports and Emerging Market currencies continue to warn of tepid chip demand. With chip producer inventories still growing at a historically rapid clip, there will be downward pressure on average chip selling prices. TSMC's profit warning earlier this week likely provides a good read for the overall industry, and we reiterate our high-conviction underweight rating. The ticker symbols for the stocks in this index are: BLBG: S5SECO - INTC, QCOM, TXN, AVGO, NVDA, ADI, SWKS, XLNX, MU, LLTC, MCHP, QRVO, FSLR.