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Alexa! Show me the future

Our Bank of America Global Wealth & Investment Management Chief Investment Office presents what we believe to be possible high-conviction investment opportunities for the next 12-18 months, and some longer term (10 years plus) megatrends which could change our economy, societies and businesses.

U.S. equity markets have been on a historic run in the last few years. While fundamentals still look good for stocks in our opinion, increasingly, investors are looking for opportunistic areas of cyclical and secular strength. Here we present what we believe to be possible high-conviction investment opportunities for the next 12-18 months, and some longer term (10 years plus) megatrends which could change our economy, societies and businesses.

In the near term, an improving U.S. and global economy is unleashing renewed vigor in corporate spending, while semiconductor companies continue to benefit being the engine that drives the new digital economy. While rising consumer confidence and early signs of millennial buying are seemingly providing a foundation for the U.S. housing sector, defense companies are seeing a rise in queries from governments concerned about a volatile geopolitical environment.

Over the long term, we believe the two powerful forces of demographics and technology will help dictate future trends in global consumer spending—more purchases made online and via mobile phones, a preference for experiences over goods, and, increasingly, consumerism in emerging markets. Technological advances in areas such as big data, artificial intelligence and robotics could change business models in virtually all industries, largely by bringing down costs, raising productivity and enabling the creation of novel products and services—think autonomous vehicles and manufacturing coming back to the U.S. Medical advances could help extend lifespans with novel, often customized, treatments, delivered more quickly and more cheaply than today.

Next 12-18 months

Stars aligning for a Capex comeback
After years of underinvestment, business capital spending has started to recover, as economic growth has improved, corporate profits have risen and business confidence has remained healthy. The components of tax reform, most notably the full and immediate expensing of capital expenditures, or capex, should act as added incentive for companies to boost capex. In addition, market behavior, in our opinion has shown that investors are increasingly placing a premium on companies that deploy cash flow for the purposes of capex rather than stock buybacks or dividends.

The U.S. annually spends over $2 trillion on domestic private nonresidential fixed investment,1 most of which is accounted for by information technology equipment, software & infrastructure or industrial & manufacturing equipment and factories. Specifically, we anticipate that communication equipment and networking companies will be beneficiaries of next generation capex plans which includes Web 2.0 (characterized especially by the change from static web pages to dynamic or user-generated content and the growth of social media) spending and video traffic growth, as the 5 largest U.S. internet content providers have all communicated their intent to spend more in 2018. In addition, corporate spending plans on cloud-based infrastructure, data centers and security remain robust.

De-regulation in financial markets
In our view, bank stocks should maintain their momentum in 2018 as the Federal Reserve is poised to continue raising interest rates, de-regulation policies remain on track, and capital return is expected to improve (especially now, with additional capital anticipated from lower taxes)—all while credit quality remains strong. Our BofA Merrill Lynch Global Research bank analyst believes that regulatory reform is even more impactful to bank tangible return on equity (ROE) than tax reform, and that 200250 basis points (bp) of the 500bp “lost” to regulation between 2010 and 2016 is recoverable.2

In particular, mid-size and smaller banks and capital market operators may benefit from a reduction in costly federal supervision and interjection. The regulatory roll-backs could come in the form of proposed legislative reform, personnel changes at various agencies, and enforcement policies on existing law. While Republican control of the Oval Office has allowed for the direct installation of leadership considered more amenable to deregulation, there has also been Congressional support for less onerous legislation. In December, the Senate Banking Committee advanced legislation, with bipartisan support, that would ease certain mortgage requirements, create a safe harbor from the Volker Rule, and substantially raise the threshold for banks having to comply with enhanced federal supervision.

Rising Geopolitical complexities
While mounting geopolitical tensions contributed to the outperformance of the defense sector in 2017, we see more upside this year owing to rising military budgets around the world. North Korea’s expanding ballistic missile capabilities, combined with China’s rising military muscle, have buoyed defense spending in Japan and South Korea, as well as in Vietnam, Singapore and India. In the Middle East, the continuing rivalry between Saudi Arabia (predominantly Sunni) and Iran (predominantly Shiite) and their proxies has had a similar effect, i.e., more orders for planes, missiles, drones, and other armaments. Spending is also currently trending higher in Europe thanks to Russia’s expanding influence in Eastern Europe, and rising cyber-attacks. The main upshot from this: the global demand for weapons has rarely been stronger, in our view.

Global military spending is on a secular upswing and expected to hit $1.67 trillion in 2018, a 3.3% rise from the prior year and a level of spending not seen since the Cold War era.3 We expect a big winner in this chilly backdrop will be U.S. defense contractors, which not only are on the receiving end of rising defense spending at home but also account for a third of global defense spending.

Home building plough on
Currently, U.S. housing fundamentals are strong. Homebuilders are scrambling to meet strong demand that is supported by low unemployment, rising incomes, low mortgage rates and high confidence levels. Recent commentary from homebuilders also suggests that first time/entry level buyers are indeed coming back to the market and could be a significant driver of growth in coming years. On the one hand, tax reform is supportive of the housing market, as it increases disposable income for households. On the other, a lower cap on mortgage interest and local tax deductions may be a headwind for higher-end home sales in higher-tax states. Therefore, we envision strong new home sales growth, particularly for lower priced properties, but slower growth in existing home sales.

Our housing analyst estimates that residential new construction growth will remain solid and potentially accelerate in 2018. The analyst is also forecasting 10% year-over-year (YoY) growth in new home sales and single family housing starts in 2018, followed by high single digit gains in 2019 and 2020.4 Repair & remodel spending is also expected to grow in the low- to mid-single digits in 2018-2020. This may benefit publically traded homebuilders, which were one of the best-performing industry groups in 2017, and building product companies.

Digital transformation
Semiconductor stocks have doubled in the last two years due to favorable cyclical and secular fundamentals, and we continue to think there is more upside. Our BofA Merrill Lynch Global Research semiconductor analyst believes that we are in quarter 7 of a typical 3-quarter cycle.5 However, we believe investors should expect higher volatility and be more selective in this space. Semiconductors (semis) are a cyclical sector; and accelerating global growth in 2018 is a favorable backdrop for the industry. Semis are the building blocks of the global digital economy; and longer term, faster growth areas in semis could include data processing, cloud servers, deep learning, and artificial intelligence. Automotive could be the next growth frontier, as more advanced safety features trickle down from high-end to mass-market cars, and as autonomous driving becomes more prevalent. In addition, electric vehicle adoption will potentially boost average semiconductor content. Finally, the industrial sector is driving secular growth in semis from various areas such as factory automation, security, energy management etc, where traditional mechanical modules are being replaced by more digital gear.

Next 10 years

Demographics and Technology shifts spending patterns
We anticipate that future consumption patterns will be vastly different—from the “how” (more online and mobile), to the “what” (experiences and sharing), to the “where” (developing economies). Large cities are expected to account for most of the global consumption going forward, and, in our view, three particular groups may have the scale and spending power to reshape that demand: 1) the 60-plus age group in developed economies, 2) the working age population of North America, and 3) the working age population of China and India. Together, these groups are expected to generate more than half of urban consumption growth through 2030;6 and investors should remain acutely aware of their spending habits and the industries or companies poised to accommodate them.

Retirees spend significantly more on healthcare than younger people but they are also showing a penchant for personal goods, entertainment, travel, wellness and housing related spending, like renovation. Meanwhile, Millennials are moving into their prime working and spending years. They are emerging as a huge group of consumers—more than 2.3 billion strong globally, they have overtaken Boomers to become the largest generation in U.S. history.7 Having grown up in challenging economic times (the economic downturn in 2008), we view this generation is cost-conscious, trusts peers more than institutions, and is upending traditional ways of shopping by making more of their transactions online or on their mobile phones, and experimenting with new models for efficient exchanges of pre-owned goods. In China, India and other emerging markets, consumption on a per-capita basis is still quite low, but as their economies grow and wages rise, the aspirations of their citizens would be expected to continue to align with those of their wealthier Western counterparts. Urban Chinese and Indian consumers are increasing their spending on discretionary items such as autos, household appliances as well as on services such as communications, restaurants, health care, entertainment, travel and education.

The Rise of Machines
We expect the expanding use of Big Data to augment efficiencies in machine learning and artificial intelligence (AI), enhancing robotic functionality. In our view, this confluence of advancements should broaden their use in industries, from enhancing the consumer experience to optimizing operational costs for business. Global sales of industrial and service robots are expected to reach record highs again this year, with key growth areas including the automotive and electrical/electronics industries. In 2016, China, Korea, Japan, the U.S. and Germany represented nearly three-fourths of total sales in volume, ), although the global proliferation of robots is set to expand sharply over the next few years.

Over the past five years, AI capabilities have improved to such an extent that a range of commercial applications are now possible in areas such as consumer electronics, industrial automation and online retail, to name a few. Owing to new programming techniques, more data and faster chips, AI has neared or equaled human-level performance in the key areas of image classification and speech recognition. Over the coming years, we expect AI software and related products to gain widespread industrial and consumer adoption across a range of sectors, including transportation, health care, security, consumer electronics, and finance. Near term, we expect the biggest beneficiaries to be providers of AI-enabling technology, and industries that gain the most in product enhancement from improvements in AI performance. Chipmakers, particularly makers of graphical processing units for AI program training, stand to benefit from increased demand for processing power. Semiconductor manufacturing equipment makers could also gain.

U.S. leads Manufacturing’s new dawn
We believe manufacturing’s so-called new era will be defined in large part by rapid automation and “near shoring.” China emerged over the past few decades as a manufacturing powerhouse thanks to lower labor costs; and yet, due to rising labor costs and a shrinking labor force, China’s competitiveness is now under pressure.

Meanwhile, manufacturing activities are increasingly dependent and driven by more advanced technologies encompassing 3D-printing, big data analytics, the Internet of Things (IoT) (explained in our CIO Weekly Letter: The Wild, Wild Web), and advanced robotics. Future factories may be built where demand growth, technology and skills exist, more or less ensuring that the future of U.S. manufacturing will remain relatively bright, in our opinion. Indeed, America’s global manufacturing competitiveness continues to improve: according to Deloitte’s 2016 Global Manufacturing Competitiveness Index, America’s ranking has improved from fourth in 2010 to third in 2013, and to second in 2016. By 2020, global CEOs expect, the U.S. will retake the top spot from China.8

The age of cyber warfare
The proliferation of the internet and devices connected to it has spurred a rise in cybercrimes. With almost half of the world connected to the internet, corporations are increasingly finding the need to invest in cybersecurity to help protect sensitive customer data, safeguard intellectual property and other critical assets, and avoid the potentially outsized costs of a data breach. Additionally, even as the Internet of Things multiplies to an estimated 21 billion connected devices in 2020, cybersecurity is becoming integrated into every aspect of the economy—from banking and healthcare to automobiles and household appliances.9 Defense against cyber threats calls for collaboration among governments, academic institutions, corporations and non-profit organizations. With the threat growing, more and more funds have been allocated to cyber protection. For example, in 2017, the federal government set aside $19 billion for cybersecurity, a 35% increase from the prior year.10 We believe specialized cybersecurity companies, as well as traditional software, services and networking companies, could benefit.

Impact Investing
Over the past decade, environmental, social and governance (ESG) factors have become an ever-more important part of the investment process, with assets under management focused on sustainability growing from negligible figures to about one in five dollars of total managed assets.11 This has coincided with strong consumer and investor demand for companies to act sustainably on topics including workplace conditions, environmental impact and gender equality, and so forth. The 2017 U.S. Trust Wealth and Worth® Survey of high-net-worth (HNW) investors found that: 45% own or are interested in owning impact investments, with Millennials (80%) and women (52%) being particularly interested.12 We think the area is poised for further growth as investor awareness increases with respect to incorporating ESG factors into investment processes and strategies. ESG factor analysis provides new information that can complement the existing financial analytical framework. ESG data integration and analysis is rapidly evolving. Rather than a specialized strategy practiced by “social” investors, ESG may eventually be considered a normal component of investment decision-making.

Newer and targeted healthcare treatments
We expect ongoing advances in drug treatment to remain a key growth driver for the healthcare sector. Most important here has been the rapid decline in the cost of genetic sequencing for humans—from just under $50,000 at the start of 2010 to roughly $1,000 today—which is enabling more research into the links between genetic expression and clinical conditions.13 This in turn is opening the door for new techniques in drug discovery, particularly in areas such as cancer treatment, where genetic variation plays a major role. In 2017, the FDA delivered its first approval for an immunotherapy drug—a class of treatments that alter immune system cells on the genetic level to fight leukemia and other cancers. The efficacy of these new immunotherapy approaches could potentially mean that more candidates within this class of treatments are approved over the coming years. This could benefit pharmaceuticals and larger biotechnology firms that develop their own treatments, or that purchase or fund smaller drug developers to expand their pipelines.

Designers of next-generation sequencing equipment that can make early identifications of developing tumors would seemingly also be positioned to benefit from the continuing decline in sequencing costs. Other treatments in early stages are designed to target inherited diseases by editing gene sequences, with a growing number of clinical trials in the planning phase. To be sure, it is early days for many of these emerging therapies. And bottlenecks, such as the interpretation of genetic data and the still-high cost of sequencing machines, are still headwinds for many research laboratories. But we would expect new advances and further cost declines to bring more widespread adoption into next year and beyond.

Clean energy becomes mainstream
The U.S. federal government’s withdrawal from the landmark United Nations climate accord made headlines in 2017. Despite this, we expect the global trend toward de-carbonization to continue in 2018 as renewable energy adoption increases. The falling cost of renewables remains a key driver.

The average price of silicon photovoltaic solar modules, for example, has fallen by over 80% since the start of 2010, and by half in just the past three years.14 And the falling cost of installation, service and equipment is leading to lower prices on a fully installed basis.

Simultaneously, economies of scale are driving down the cost of wind power. Larger-scale wind farms are reducing the cost of transporting, installing and servicing turbines, while longer turbine blades mounted on higher towers are better able to produce electricity. The U.S. Environmental Protection Agency now has 995 organizations, including corporations, universities and state government departments, on its 100% Green Power Users list (which counts those using clean energy to meet all of their electricity needs), up from 784 a year ago. And we see a similar trend in place globally, with growth in world consumption of renewable energy dwarfing that of energy sourced from fossil fuels. From 2013 to 2016, global wind power consumption increased at an annualized rate of 14.2%, with solar growing even more quickly, at 34.3%. By contrast, natural gas consumption grew at just 1.5%, and coal consumption dropped over the same period.14

Future of Mobility is in shared and cleaner vehicles
In our view, the internal combustion engine is facing its most credible threat in over 150 years. The medallions, or permits, for New York City taxis powered by gasoline, priced at $1.05 million in 2013, are now listed at $350,000; and total U.S. gasoline-vehicle sales may have peaked at 17.5 million in 2016.15 The future of mobility as we know it is primed for incredible disruption. We expect the method of transportation to increasingly shift towards hybrid and electric vehicles (EV), spurred by the total cost of ownership of EVs falling below that of internal combustion vehicles by 2024. The mode and utilization of vehicles could also change as car-sharing and ride-hailing services reduce private vehicle ownership, in addition to freeing up large swaths of land committed to parking. Lastly, self-driving technology could enhance safety and the efficiency of supply-chains while also prompting ethical questions and labor concerns.

We believe, the potential benefactors of auto-making in the future may include familiar names but also hundreds of start-ups. With coding-laden self-driving vehicles more prevalent, software firms stand to be just as important as traditional automakers. Similarly, many car companies are already beginning to look a little like technology outfits. Beyond auto making, sectors including insurance, real estate, banks/financing, and energy may all see varying effects from shared mobility services, while autonomous vehicles could provide efficiencies to transport and logistic firms.

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