Developed Countries

President-elect Trump and the specter of his spendthrift policy proposals have generated significant client interest/inquiries on equities and inflation - not asset price, but of the more traditional kind: consumer price inflation. Accelerating inflation is a modest risk, but not our base case forecast. Nevertheless, for investors that are more worried about the prospect of higher inflation, the purpose of yesterday's Special Report is to serve as an equity sector positioning roadmap if inflationary pressures become more acute sooner than we anticipate. Historically, inflation has been synonymous with an aggressive Fed and hard asset outperformance, suggesting that deep cyclical sectors would be primary beneficiaries. The table shows that over the last six major inflationary cycles, energy, materials, real estate and health care have been consistent outperformers. Utilities, tech and telecom have been clear underperformers. The remaining sectors have been a mixed bag (please see the next Insight).

Highlights The rise in both bond yields and the U.S. dollar represents significant tightening in monetary conditions, which will be difficult for stock prices to digest. Technical indicators suggest that the rally could persist in the near term, but investors should nonetheless prepare a shopping list once prices correct. Both consumer discretionary and health care stocks are appealing longer-term plays that are less expensive than the broad market. Feature The current rally in equity prices is high risk. Since the summer, our main worry for the stock market has been the likelihood of profit disappointments, given that corporations lack pricing power and that the outlook for top-line growth is lackluster. That worry has not gone away, but now the more pressing issue has become the impact on equity prices of the swift and aggressive tightening in monetary conditions via both the bond market sell-off and rise in the dollar (Chart 1). The 10-year Treasury yield is now trading above fair value. True, in the past, equity prices have sustained gains until yields rose much further into undervalued territory, but the big difference this time is that the dollar is rising in tandem. Simultaneous powerful rises in the currency and yields are rare, and typically result in steep market pullbacks. Investors should be on high-alert for this outcome. The possibility that equity market euphoria persists for another month or two should not be ruled out, i.e. until the Fed's next meeting and until there is more clarity on the course of fiscal and trade policy. Indeed, a simple read of technical indicators and market sentiment suggest that the rally could continue, but the risk/reward balance is poor (Chart 2). Chart 1Monetary Conditions Have Changed Chart 2Technicals: Not Flashing A Warning Yet With that in mind, one of the most frequently asked (and difficult) questions we receive is, Where is the value in U.S. equities? Presently, this is akin to looking for deals on New York's Upper 5th Avenue.1 As Chart 3 shows, U.S. equity multiples remain near or at historic (ex. TMT mania) highs. This is true for both small and large caps. And relative to global equity valuations, U.S. stocks appear even more expensive. There are few sectors that we believe offer compelling absolute value today. However, on a relative basis, the Trump rally has caused a flight out of traditional safe havens that has gone too far. For instance, consumer products stocks (household products, beverages and packaged food) are now trading below the broad market P/E multiple, in aggregate, on a trailing 12-month basis (Chart 4). According to our U.S. Equity Strategy service, forward relative returns are typically very robust when the group trades at a discount to the market. Importantly, consumer products stocks have a positive correlation with the U.S. dollar, which means that recent share price weakness represents a buying opportunity. Chart 3No Deals Here Chart 4Good Entry Point To Consumer Products? As highlighted above, we are on high-alert for an equity shakeout, triggered by the rapid rise in bond yields, and reinforced by profit disappointment. Still, we have assembled a short shopping list of sectors that we believe offer long-term upside. Health care and consumer discretionary stocks already offer better value than other areas of the market. Consumer Discretionary Will Last Longer This Cycle We have recommended favoring domestic over global exposure within U.S. equities and, in-line with our U.S. Equity Strategy service, we have favored non-cyclical holdings. But the cyclical interest rate-sensitive consumer discretionary sector deserves more attention, especially given good relative valuations. The recent back-up in bond yields has sent the relative performance of consumer discretionary stocks to a four-year low, once heavyweight Amazon is excluded (Chart 5). Admittedly, this comes on the back of an almost uninterrupted run higher since 2010. Still, since we believe it unlikely that the current back-up in yields can continue much longer, any cooling in bond yields could start a rotation back into consumer discretionary stocks. In last week's Special Report,2 we outlined the case as to why structural headwinds make it highly unlikely that the Fed will need to aggressively tighten in the coming year. In our view, the interest rate backdrop is unlikely to be an insurmountable headwind for this sector. Most importantly, fundamentals for consumer spending have been slowly improving. The labor market is now tight enough that consumers have job security (Chart 6). Incidentally, consumer confidence is now back to historically buoyant levels. The greatest ramification of this is that higher job security historically goes hand in hand with greater demand for credit. Until this point of the cycle, consumption growth has been capped by income growth trends because there has been no appetite to borrow in the aftermath of the Great Recession. We highly doubt that a new debt-fuelled spending spree will get underway, but rising job security should help fuel some credit growth. Chart 5Consumer Discretionary Stocks##br## Should Resume Outperformance Chart 6Consumers: The Future##br## Is Brighter Alongside improved job security, consumers are enjoying a tailwind from a historically light drag on their finances (Chart 6). Consumer spending on essential items, which includes energy costs, interest expense, insurance, taxes, etc. is at multi-decade lows. If BCA's benign forecast for energy prices (around $50 per barrel) and rate backdrop pans out, then there should continue to be ample spending room on discretionary items. The bottom line is that consumer discretionary stocks are one of the few sectors that are trading at historically reasonable valuations. We believe that a combination of a benign rate backdrop, better consumer confidence and a strong dollar will help this sector outperform late into the business cycle. Particular emphasis should be placed on industry groups and companies that can maintain positive pricing power. This includes movie & entertainment and restaurant stocks. Retailers should be de-emphasized until deflationary pressures ease, as we discuss on page 9. Follow The Baby Boomers To...Health Care Stocks In our Special Report last week, we explained how the aging population will continue to have implications for the labor market and wages. We also believe that demographics will eventually have important implications for equity sector outperformance. BCA Research periodically puts forward investment mania candidates. Charles Kindleberger described three conditions that must be met in order to create a financial mania and bubble: a powerful theme that captures the imagination of investors which is often the result of a major economic displacement; low interest rates; and finally, investment vehicles that allow rampant speculation (Chart 7). We believe that the aging of the population and the need for increased resources to service that population could be a powerful theme that captures investors' attention in the coming years. Chart 7A History Of Manias Since the baby boomers came of age (in the 1960s), their massive numbers relative to other age cohorts has given this generation an outsized influence on political, social and economic trends. Put simply, the baby boom generation has had the most clout because of their sheer numbers. And what do baby boomers want now? This age cohort is now focused on prolonging good health for as long as possible! It makes sense, then, any coming pent-up demand for goods and services will focus on health-related spending. As Chart 8 shows, spending on health care increases significantly for the 65-year and over cohort. This massive increase in health care spending has already begun but is likely to increase much more in the coming years. Chart 8Spending On Health Care Accelerates With Age To further highlight this point, in a Special Report last year,3 we made the case that health care will be one of the greatest sources of innovation this cycle. As we highlighted then, government R&D spending on basic research tends to lead practical applications, such as in the 1950s innovation boom after WWII (Chart 9). Currently, government R&D spending is growing much faster in healthcare than in tech. The private sector is also in agreement with tech VC investment still well below its 2000 peak, whereas healthcare is hitting new highs. Chart 9Health Care R&D Spending Is An Outlier Health care relative valuations are significantly below their post-2008 mean (Chart 10). We will explore the potential for health care as a mania candidate in an upcoming Special Report, but our preliminary work suggests that health care stocks should be on the top of investors' shopping lists. Chart 10Long-Term Value In Health Care Stocks Economic Momentum Heating Up? The surprising election results have stolen the financial media's focus away from economic and profit fundamentals in the past few weeks. Admittedly, investors who were focused on the elections did not miss much: the overall picture of economic growth has not changed in recent weeks. Indeed, the Fed's Beige Book of anecdotes on the state of the U.S. economy, released last week, indicates that growth remains mediocre, although sufficient enough for the Fed to raise rates later this month. Nevertheless, we have been monitoring consumer and business confidence closely, as we believe that this will be a key gauge to the likelihood that a more virtuous economic cycle is underway. There is some improvement: Consumer Confidence: A missing ingredient thus far in the recovery has been optimism among households. But that may be finally changing. Surveys of consumer sentiment ticked up markedly in November. As discussed above, this appears mainly to be attributed to better job security as the labor market tightens. If sustained, we view this as a very positive development, since a rising confidence in the outlook allows consumers to take on debt - or at least reduce their savings rate (Chart 6). Business Confidence: Business confidence has mirrored - and even lagged - soggy consumer confidence throughout this cycle. This makes sense, since optimism about a company's future hinges on prospects for demand for its products. In an economy where 70% of GDP is consumption, it is rational that businesses take their cue from consumer sentiment. The most recent ISM manufacturing survey was positive; new orders are rising. Respondent comments were particularly sunny. The bulk of survey responses were collected after the November 8 election and so should be reflective of business attitudes toward the new political administration. Consumer Spending: Black Friday/Cyber Monday sales were reported as lackluster relative to last year, according to the National Retail Federation (NRF). Apparently, about 3 million more shoppers than in 2015 were enticed into stores and onto their computers, but they spent about 3.5% less, while overall sales were down about 1.5% over last year. But the survey also picked up on one of our critical themes: deflation in the retailing sector is still rampant. Price discounting remains a dominant tactic to entice shoppers and over half of the NRF survey respondents reported that deals were "too good to pass up." In real terms, annual consumer spending growth has trended sideways at 2.5%. We see little risk of a slowdown, and in fact as highlighted above, now that consumer confidence has improved, any modest wage gains could lead to an improved spending outlook. All in all, the modest growth backdrop that has characterized the economic recovery since to date is still intact. We are closely watching consumer and business confidence for signs that the economy can or cannot handle the rise in bond yields and dollar: if recent optimism can be maintained, the odds of a more virtuous economic cycle will improve. Lenka Martinek, Vice President U.S. Investment Strategy lenka@bcaresearch.com 1 According to Cushman & Wakefield, New York's Upper 5th Avenue had the highest average rents of any shopping street in the world in 2015. A square foot of retail space cost $3,500. 2 Please see U.S. Investment Strategy Special Report "U.S. Wage Growth: Paid In Full?," dated November 28, 2016, available at usis.bcaresearch.com 3 Please see U.S. Investment Strategy Special Report "The Next Big Thing: How To Profit From Disruptive Innovation," dated March 9, 2015, available at usis.bcaresearch.com

Special Report

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

Special Report

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

Special Report

Highlights Trump is adding stimulus and potential rigidities to the U.S. economy as the labor market slack vanishes. This evocates the 1970s and stagflation. This risk could resonate among investors as there are enough similarities with the late 1960s / early 1970s. But as well, crucial differences greatly reduce the likelihood of such a scenario. Ultimately, the Fed holds the key. If the Fed stays behind the curve for too long, inflation will emerge. Our bet is that the Fed will not fall behind the curve significantly. On a cyclical basis, the dollar will remain strong and the yen will underperform massively. Feature On November 11 we argued that the first round effect of a Trump victory would be to boost an already improving U.S. economy, giving the Fed more reason to increase interest rates faster than was priced in by markets.1 However, we did conclude our economic assessment of Trump by highlighting the potential for a dangerous outcome: "In the long-run, the Trump growth dividend is likely to require a payback, but this discussion is for another day." What will be the nature of this payback? Goosing up the economy as the U.S. approaches full employment evokes the inflationary policies of the late 1960s and early 1970s. Back then, the Vietnam War caused the Federal government deficit to increase while economic slack was limited. Stagflation ensued. While this parallel is appealing, it is also too simplistic. Trump's policies will be inflationary, but, key structural factors will prevent the fiery inflationary inferno that engulfed the 1970s. Policymakers will need to be careful, however, because while stagflation and the 1970s are only distant risks today, a Pandora's box is being opened. The Similarities The first similarity between the late 1960s / early 1970s is that Trump promises to inject stimulus exactly as the economy hits full employment. When President Johnson increased the U.S.'s involvement in Vietnam, the U.S. output gap was already closed. The result of this fiscal stimulus was to create excess demand. This excess demand not only put upward pressure on wages and prices, but also caused the U.S. current account deficit to balloon. Trump wants to cut taxes by US$6.2 trillion, as expected by the Tax Policy Institute. Before November 8, the labor market had already tightened and wage growth was already accelerating (Chart 1). Stimulating in this context could unleash potent inflationary forces. The second similarity to Vietnam-era stagflation is that Trump's fiscal stimulus will materialize as monetary policy remains easy. By 1969, U.S. real short rates were already hovering near 0%, and were negative for three years between 1974 and 1977 (Chart 2). Today, we are also experiencing deeply negative real rates. However, back then these easy monetary conditions were being felt at the tail end of a multi-decade boom. Today, they reflect the aftermath of a financial crisis that has greatly increased the demand for precautionary savings and depressed the private sector's appetite for credit. Chart 1Tightening Labor Market Chart 2Similarity: Low Real Rates The third parallel comes from the liquidity on bank balance sheets. Today, as was the case in the late 1960s and early 1970s, banks are flush with liquid assets (Chart 3). Thus, banks have the fuel to aggressively lend and create money. Outside of banking crises, the willingness of banks to lend is often closely correlated with the demand for loans.2 Both respond to the same economic shocks, whether positive or negative. After the 1970 recession, the Fed eased aggressively, and business investment rebounded quickly. Today, Trump's fiscal reflation could revive animal spirits in a similar fashion. In both instances, banks have the wherewithal to support growing capex and loan demand. Another troubling resemblance is the illiquid state of household balance sheets. Today, household liquidity represents as small a share of disposable income as it did in 1970 (Chart 4). In fact, compared to total liabilities, household liquidity remains in the lower end of the historical distribution. Why does this matter? Chart 3Similarity: Bank Liquidity Chart 4Similarity: Household Illiquidity Under this set of circumstances, households will have a higher political tolerance for inflation. Except for the rich, the average household has little to lose from inflation, especially if the rise in prices emanates from an over-stimulated labor market. Inflation does decrease the real value of household liquid assets, but it does the same thing to their much larger debt burdens. The large increase over the past 30 years in U.S. income inequality only reinforces these dynamics (Chart 5). Chart 5Growing Inequalities The last parallel is the potential for a return to pre-Reagan economic rigidities. Trump has talked about imposing tariffs on global exporters in order "to make America great again." He also mentioned limiting immigration in the U.S. Neither of these promises are clear, and like the fiscal stimulus, they could be greatly dialed back compared to the campaign-trail promises. What would be the impact of such a move away from globalization? Our Global Investment Strategy service argues that the growth impact would be limited. Academic models show that since 1990, only 5% of the increase in global GDP growth can be attributed to deeper trade linkages.3 However, the integration of China in the global supply chain and the expansion of the American labor force through immigration has depressed wages for less skilled U.S. workers. Yet, the emergence of new markets outside of the G10 has boosted profits for U.S. multinationals. This has accentuated income inequality. Meanwhile, the marginal propensity to save of rich households is around 60%, while that of the middle class and the poor sits much closer to zero. Thus, the change in the U.S. income distribution has depressed U.S. consumption by 3% since 1980 (Chart 6). This has created a strong deflationary impact on in the economy. Chart 6Unequal Income Depresses Consumption Therefore, if Trump does implement a protectionist and anti-immigration agenda, it would likely put upward pressure on prices by causing both a small inward shift in U.S. aggregate supply as well as from the increase in demand resulting from higher middle class wages (and therefore consumption). Bottom Line: Today, like in the late 1960s / early 1970s, five conditions are present to lift inflation: Trump is set to stimulate the economy as it is hitting full employment; Monetary policy is extremely accommodative; Banks have plenty of liquidity to fuel any resurgence in excess demand; household balance sheet make them politically friendly to inflationary dynamics; And by moving away from globalization and immigration, Trump may add further fuel to any inflationary developments The Differences While there are troubling parallels between Trump and the 1970s, key differences could prove to be just as important if not even more so than the similarities. The first difference between now and then is the structure of the labor market. Unionization rates have collapsed from 30% of employees in 1960 to 11% today. The accompanying fall in the weight of wages and salaries in national income demonstrates the decline in the power of labor (Chart 7). Without this power, it is much more difficult for household income to grow as fast as it did in the 1960s and 1970s. In conjunction, cost-of-living-adjustment clauses have vanished from U.S. labor contracts (Chart 8). Hence, the key mechanism that fed the vicious inflationary circle between wages and prices is now extinct. Chart 7Difference: Labor Has Lost Its Power Chart 8With No Bargaining Power, Concessions To Labor Ceased... Second, the broad capacity utilization picture could not be more different than in the 1970s. In 1970, the U.S was at the tail end of a decade of strong cyclical spending, which was powered by consumer durable-goods purchases, not by capex and capacity growth (Chart 9). In fact, the stock of fixed assets as a percent of GDP is much higher today than it was back then, pointing to excess capacity in the system, at least relative to the 1970s (Chart 10). Chart 9Difference: Cyclical Spending Chart 10Difference: Capital Stock Corroborating this image, capacity utilization remains quite low by historical standards. Interestingly, this series continues to hold good explanatory power for inflation (Chart 11). While a Trump stimulus would cause this measure to perk up, and for deflationary risk to vanish, we are nowhere near levels associated with a major inflation outbreak. Chart 11Difference: Capacity Utilization Even when we look at capacity in the labor market, the picture is once again markedly different. Today, unemployment is only beginning to flirt with its equilibrium after nearly nine years of deep labor market slack. In contrast, by the late 1960s, the unemployment gap had been negative for seven years. It barely moved into positive territory during the 1970 recession and only surged higher after 1974 (Chart 12). This was a very inflationary labor market. Mirroring the U.S., global capacity utilization is depressed and the rest of the world remains a deflationary anchor (Chart 13). In the late 1960s and early 1970s, non-U.S. inflation was just as high as U.S. inflation, as global capacity was tight and global money growth was strong. Today, heavy capex in EM means that despite a sharp slowdown in DM investment after 2000, global capex has remained at 25% or so of global GDP - a very high level compared to history - for 7 out of the last 10 years. Chart 12Difference: Labor Market Chart 13Global Capacity Utilization Is Low Third, in the 1960s and 1970s, animal spirits were running wild. Despite growing government deficits and rising borrowing costs, the crowding out of the private sector never materialized (Chart 14). This was a testament to the optimistic belief of the era, a belief fed by the resilience of the economy since 1950, as well as by the implicit support created by decades of Keynesian policies. Today, fiscal stimulus and rising consumer spending could resurrect animal spirits. However, this would be a nascent phenomenon, not a multi-decade one, implying a very different set of expectations for investors, consumers, and business than in the late 1960s / early 70s. Fourth, the monetary picture is very different. Today, both the money multiplier and money velocity are extremely depressed, a sign that monetary constipation still defines our age. In the 1960s and 1970s, money velocity and the money multiplier were both elevated or experiencing sharp upturns (Chart 15). This is why low real rates of that era did translate into accelerated economic activity and inflation, unlike the uninspiring effects of low rates or QE programs today. Chart 14Raging Animal Spirits Chart 15Difference: Monetary Backdrop Finally and most crucially, the rising inflation of the late 1960s only mutated into genuine stagflation after the economy was hit by a massive supply shock: the 1973 oil embargo. In the wake of the Yom Kippur War, OPEC tripled the price of oil - the commodity powering the modern economic machine. Global capacity utilization was already tight, but this shock created a massive inward shift in global aggregate supply, ratcheting aggregate price levels higher while hurting aggregate output (Chart 16). But the true coup de grace only emerged when fiscal and monetary authorities massively eased policy in response to this shock: The U.S. federal deficit skyrocketed from 2.3% of GDP in 1974 to 8% in 1975 and short rates fell from 8.9% in 1974 to 4.9% in 1976. This boosted aggregate demand back to its original level, but with sharply more elevated price levels (Chart 16). Chart 16Mechanics Of A Supply Shock Today, we have seen oil prices collapse by 56% since 2014 in response to a positive supply shock, and global capacity utilization is low. Thus, while fiscal stimulus could push aggregate price levels upward as it lifts aggregate demand, the effect on inflation should prove much more muted than when such policies are implemented in the face of a supply shock. Bottom Line: Important similarities exist between the potential effect of Trump's suggested policies and the economic environment of the late 1960s / early 1970s. However, five structural and cyclical differences suggest that Trump is not bound to recreate stagflation: The de-unionization of the labor force has removed its pricing power, capacity utilization is now infinitely more benign than back then, animal spirits are only recovering today while they were running wild in the late 1960s / early 1970s, the monetary environment backdrop is also much less inflationary, and finally, we are not experiencing the kind of supply shock and mistaken policy response that hit the world in the wake of the 1973 oil embargo. Question Marks Key to the outlook is the Fed itself. Trump's policies will put upward pressure on prices. However, the Fed continues to avoid committing to a tighter policy path beyond this December. The Fed has good reasons to do so: Trump has offered the world no clarity regarding his actual plans while in office. With little labor market slack, any stimulus is inflationary; how inflationary will be a function of the details. So should be the Fed's response. For inflation to truly emerge in the system, the Fed will need to keep policy easy even as Trump's plans become clearer. In the 1970s, a too-easy Fed spurred excess demand that lifted inflation and inflation expectations. Moreover, if the Fed had not cut rates as aggressively as it did in 1974 - a policy that boosted demand but that did nothing to compensate for the shortfall in aggregate supply - the inflationary shock from the oil embargo should have proven much more transitory. The Fed's recent talk of a "high-pressure" economy evokes a repeat of the 1970s mistake. However, there is no guarantee that this error will be repeated. For one, the references to a "high-pressure" economy predated the Trump victory. Second, fiscal stimulus is what the Fed has wanted for a long time. Trump is giving the FOMC the cover they have needed to do what they have tried to do since 2014: increase rates. Finally, inflation expectations are beginning to move upward. This is what the Fed needs to push interest rates higher. Moreover, this is happening as long-term inflation expectations begin decoupling from oil prices (Chart 17). This is important as it suggests that the economy is gaining traction and that markets are starting to anticipate a lift off from the zero lower bound. Thus, while we think a lagging Fed is a risk, it is not currently our base-case scenario. The second question mark is the dollar. One of the key factors that prompted the dis-anchoring of inflation and inflation expectations in the early 1970s was the suspension of the dollar's convertibility to gold in August 1971. This unleashed a period of weakness for the greenback that culminated in a 30% devaluation by 1980 (Chart 18). Moreover, a weak dollar fueled the commodity bull market. Chart 17The Fed Must Enjoy This Chart 18The Dollar Added To Inflation Today, the dollar is strong and expensive, creating a deflationary anchor in the U.S. economy. Our expectations that the Fed will not fall behind the curve once the nature of the Trump stimulus becomes clearer would re-inforce this trend. However, a failure by the Fed to tighten monetary policy appropriately, leaving the U.S. central bank behind the curve, would have a negative impact on the dollar. Not only would it put downward pressure on real rate differentials between the U.S. and the rest of the world, but it would also depress the PPP fair value of the dollar by increasing domestic inflation. Bottom Line: The two key swing factors are the Fed's policy response and the dollar. In the late 1960s / early 1970s, the Fed kept policy too easy. Not only did this greatly fan the underlying inflationary dynamics that were already present in the economy, but it also created a very negative environment for the dollar, prompting the end of the dollar peg in August 1971. This further lifted inflation in the economy. The Endgame And Investment Conclusion Given all these conflicting forces, how will this experiment end? Pure stagflation with late 1970s-style inflation is out of the picture. However, inflation of 4% to 5% is very possible, but it could take time to show up in the data. In the 1960s, it took U.S. inflation until mid-1968 to hit 4%. By that time, the output gap had been positive for around 5 years, hitting 6% of GDP in 1966 (Chart 19). Unemployment had been below its equilibrium rate since 1963, and by 1968 was 2.5% below NAIRU. Chart 19No Slack In The 1960s This suggests that unless the Fed falls significantly behind the curve, even 4% inflation may take a long time to emerge this cycle. However, inflationary risks will grow considerably after the next recession. We do not know when this recession will happen, but we know what the result will be: more policy easing. It took until the 1970 recession and the associated policy boost to genuinely dis-anchor inflation expectations in the U.S. Today, an easing in policy and an associated fall in the dollar are likely to be the key criteria to generate real inflation risk in the U.S. As for currency implications, the lack of an inflationary outburst along with a responsible Fed will continue to support the dollar and hurt precious metals. In terms of exchange rates, USD/JPY should perform particularly well. The Japanese economy is near full employment and the Abe administration also is talking about additional stimulus. Yet, while the Fed will not stay behind the curve for long, the BoJ is explicitly aiming at staying behind the curve. This is a recipe for a higher dollar/yen on a 12-18 months basis. The euro is likely to continue to weaken as there remains more slack in the euro area than the U.S. However, this slack is diminishing and the ECB would respond to its disappearance, which implies that EUR/USD has less downside than the yen on a 12-18 months basis. Commodities are unlikely to repeat their amazing performance seen in the 1970s. Thus, commodity currencies should continue to suffer from dollar strength. The pound will be dominated by its own set of dynamics. While the probability of a soft Brexit has been growing ever since the High Court's ruling was issued, the appeal decision still needs to be made. Moreover, headline risk remains very elevated. Thus while valuation argues in favor of GBP, buying GBP today is a high-risk gamble. Mathieu Savary, Vice President Foreign Exchange Strategy mathieu@bcaresearch.com 1 Please see Foreign Exchange Strategy Weekly Report, "Reaganomics 2.0?", dated November 11, 2016, available at fes.bcaresearch.com 2 William F. Bassett, Mary Beth Chosak, John C. Driscoll, and Egon Zakrajsek, "Changes In Bank Lending Standards And The Macroeconomy," Journal of Monetary Economics 62 (2014): pp. 23-40. 3 Please see Global Investment Strategy Weekly Report, "The Elusive Gains From Globalization", dated November 25, 2016, available at gis.bcaresearch.com Trades & Forecasts Forecast Summary Core Portfolio Tactical Trades Closed Trades

Special Report

Highlights Trump's foreign policy proposals will exacerbate geopolitical risks. Sino-American relations are the chief risk - they will determine global stability. A Russian reset will benefit Europe, especially outside the Russian periphery. Trump will retain the gist of the Iran nuclear deal. Turkey and North Korea are wildcards. Feature Chart 1Market Rally Redoubled After Trump's Win Financial markets rallied sharply after the election of Donald Trump and the resulting prospect of lower taxes, fewer regulations, and greater fiscal thrust (Chart 1). But is the euphoria justified in light of Trump's unorthodox views on U.S. foreign policy and trade? Is Trump's "normalization" amid the transition to the White House a reliable indicator that the geopolitical status quo will largely be preserved? We believe Trump's election marks a substantial increase in geopolitical risk that is being understated by markets.1 This is not because of his personality, though that is not particularly reassuring, but rather because of his policy proposals. If acted on, Trump's geopolitical agenda would exacerbate global trends that are already underway: Waning U.S. Dominance: American power, relative to other nations, has been declining in recent years as a result of the emergence of new economic and military powers like China and India (Chart 2). If Trump allows himself to be sucked into another conflict despite his campaign promises - say, by overturning the nuclear deal with Iran - he could embroil the U.S. at a time when it is relatively weak. Multipolarity: America's relative decline has emboldened various other nations to pursue their interests independently, increasing global friction and creating a world with multiple "poles" of influence.2 If Trump keeps his word on reducing foreign commitments he will speed along this historically dangerous process. Lesser powers like Russia and Turkey will try to fill vacuums created by the U.S. with their own ambitions, with competition for spheres of influence potentially sparking conflict. Multipolarity has already increased the incidence of global conflicts (Chart 3). De-Globalization: The greatest risk of the incoming administration is protectionism. Trump ran on an overtly protectionist platform. Democratic-leaning economic patriots in the American "Rust Belt" handed him the victory (Chart 4), and he will enact policies to maintain these pivotal supporters in 2018 and 2020 elections. This will hasten the decline of trade globalization, which we signaled was peaking back in 2014.3 It does not help that multipolarity and collapse of globalization have tended to go hand in hand in the past. And historically speaking, big reversals in global trade do not end well (Chart 5). Chart 2U.S. Power Eroding In A Relative Sense Chart 3Multipolarity Increases Conflict Frequency Chart 5Declines In Global Trade Preceded World Wars In what follows we assess what we think are likely to be the most important geopolitical effects of Trump's "America First" policies. We see Russia and Europe as the chief beneficiaries, and China and Iran as the chief risks. A tougher stance on China, in particular, will feed broader strategic distrust; the combination of internal and external pressures on China will ensure that the latter will not be as flexible as in the past. For the past five years, BCA's Geopolitical Strategy has stressed that the deterioration in Sino-American cooperation is the greatest geopolitical risk for investors - and the world. Trump's election will accelerate this process. Trump And Eurasia Trump's election is clearly a boon for Russia. Over the past 16 years, Russia has methodically attempted to collect the pieces from the Soviet collapse. The purpose of Putin's assertiveness has been to defend the Russian sphere of influence (namely Ukraine and Belarus in Europe, the Caucasus, and Central Asia) from outside powers: the U.S. and NATO seemed eager to "move in for the kill" after Russia emerged from the ashes. Putin also needed to rally popular support at various times by distracting the public with "rally around the flag" operations. We view Ukraine and Syria through this analytical prism. Lastly, Russia acted aggressively because it needed to reassure its allies that it would stand up for them.4 And yet the U.S. can live with a "strong" Russia. It can make a deal with Russia if the Trump administration recognizes some core interests (e.g. Crimea) and calls off the "democracy promotion" activities that Putin considers to be directly aimed at the Kremlin. As we argued during the Ukraine invasion, it is the U.S., not Russia, which poses the greatest risk of destabilization.5 That is because the U.S. lacks constraints. It can be aggressive towards Russia and face zero consequences: it has no economic relationship with Russia (Chart 6) and does not stand directly in the way of any retaliation, as Europe does. That is why we think Trump and Putin will manage to reset relations. The U.S. can step back and allow Russia to control its sphere of influence. Trump's team may be comfortable with the concept, unlike the Obama administration, whose Vice-President Joe Biden famously pronounced that America "will not recognize any nation having a sphere of influence." We could even see the U.S. pledging not to expand NATO from this point onwards, given that it has already expanded as far as it can feasibly and credibly go. Note, however, that a Russo-American truce may not last long. George W. Bush famously "looked into Putin's eyes and ... saw his soul," but relations soured nonetheless. Obama went further with his "Russian reset," removing European missile defense plans from avowed NATO allies Poland and Czech Republic merely one year after Russian troops invaded Georgia. And yet Moscow and Washington ended up rattling sabers and meddling in each other's internal affairs. Ultimately, U.S. resets fail because Russia is in a structural decline as a great power and is attempting to hold on to a very large sphere of influence whose denizens are not entirely willing participants.6 Because Moscow often must use blunt force to prevent the revolt of its vassal states (e.g. Georgia in 2008, Ukraine in 2014), it renews tensions with the West. Unless Russia strengthens significantly in the next few years, we would expect the cycle to continue. On the horizon may be Ukraine-like incidents in neighboring Belarus and Kazakhstan, both key components of the Russian sphere of influence. Bottom Line: Russia will get a reprieve from U.S. pressure under Trump. While we expect Europe to extend sanctions through the end of 2017, a rapprochement with Washington could ultimately thaw relations by the end of next year. Europe stands to benefit, being able to resume business as usual with Russia and face less of a risk of Russian provocations via the Middle East, like in Syria. The recent decline in refugee flows will be made permanent with Russia's cooperation. The losers will be states in the Russian periphery that will feel less secure about American, EU and NATO backing, particularly Ukraine, but also Turkey. Countries like Belarus, which enjoyed playing Moscow against the West in the past, will lose the ability to do so. Once the U.S. abandons plans to prop up pro-West regimes in the Russian sphere of influence, Europeans will drop their designs to do the same as well. Trump And The Middle East Trump's "America First" foreign policy promises to be Obama's "geopolitical deleveraging" on steroids. He is opposed to American adventurism and laser-focused on counter-terrorism and U.S. domestic security. He also wants to deregulate the U.S. energy sector aggressively to encourage even greater energy independence (Chart 7). The chief difference from Obama - and a major risk to global stability - is Iran, where Trump could overturn the Obama administration's 2015 nuclear deal, potentially setting the two countries back onto the path of confrontation. Nevertheless, this deal never depended on Obama's preferences but was rooted in a strategic logic that still holds:7 Iraqi stability: The U.S. needed to withdraw troops from Iraq without creating a power vacuum that would open up a regional war or vast terrorist safe haven. With the advent of the Islamic State, this plan clearly failed. However, Iran did provide a Shia-led central government that has maintained security for investments and oil outflows (Chart 8). Iranian defenses: Bombing Iran is extremely difficult logistically, and the U.S. did not want to force the country into a corner where asymmetric warfare, like cutting off shipping in the Straits of Hormuz, seemed necessary. Despite growing American oil production, the U.S. will always care about the transit of oil through the Straits of Hormuz, as this impacts global oil prices.8 China's emergence: Strategic threats grew rapidly in Asia while the U.S. was preoccupied in Iraq and Afghanistan. China has emerged as a more technologically advanced and assertive global power that threatens to establish hegemony in the region. The deal with Iran was therefore a crucial piece of President Obama's "Pivot to Asia" strategy. Chart 7U.S. Becoming More Energy Independent Chart 8U.S. Policy Boosts Iraqi And Iranian Oil None of the above will change with Obama's moving on. Nor will the other powers that participated in sanctioning Iran (Germany, France, the U.K., Russia, and China) be convinced to re-impose sanctions now, just as they gain access to Iranian resources and markets. It is also not clear why Trump would seek confrontation with Iran in light of his desire to improve relations with Russia and concentrate U.S. firepower on ISIS - both objectives make Iran the ideal and obvious partner. Trump will therefore begrudgingly agree to the détente with Iran, perhaps after tweaking some aspects of the deal to save face. Meanwhile, it will serve the hawks in both countries if they can go back to calling each other "Satan." Iran itself is comfortable with the current situation, so it does not have an incentive to reverse the deal. It controls almost half of Iraq (and specifically the portion of Iraq that produces oil), its ally Hezbollah is safe in Lebanon, its ally Bashar Assad will win in Syria (more so with Trump in charge!), and its allies in Yemen (Houthi rebels) are a status quo power secure in a mountain fortress in the north of the country. It is hard to see where Trump would dislodge Iranian influence if he sought to do so. The U.S. is a powerful country that could put a lot of resources into rolling back Iranian influence, but the logic for such a move simply does not exist. Trump will also maintain Obama's aloof policy toward Saudi Arabia, which keeps it constrained (Chart 9).9 The country is in some ways the stereotype of the "ungrateful ally" that Trump wants to downgrade. For instance, Trump supported the law allowing victims of the September 11 attacks to sue the kingdom (a law that Obama tried unsuccessfully to veto). He has blamed the Saudis for the rise of ISIS and the failure to take care of Syrian refugees. His primary focus is on preventing terrorists from striking the U.S., and to that end he wants to cooperate with Russia and stabilize the region's regimes. This entails the relative neglect of Sunni groups under Shia rule in Syria and Iraq. Indeed, the few issues where the Saudis will welcome Trump - opposition to the Iran nuclear deal, support for Egypt's military ruler Abdel Fattah el-Sisi, and opposition to aggressive democracy promotion - are so far rhetorical, not concrete, commitments. Chart 9Saudi Arabia Sees The U.S. Stepping Back Will Trump get sucked into the region to intervene against ISIS? We do not think so. A bigger risk is Turkey.10 President Recep Erdogan may think that Trump will either be too complacent about Turkish interests in Syria, or that Trump is in fact a "kindred nationalist spirit" who will not prevent Turkey from pursuing its own sphere of influence in Syria and northern Iraq. Trump's foreign policy of "offshore balancing" would call for the U.S. to prevent Turkey from resurrecting any kind of regional empire, especially if it risks a war with Russia and Iran or comes at the cost of regional influence for American allies like the Kurds.11 Turkey will also be starkly at odds on Syria and ISIS. This means Turkey and the U.S. could see already tense relations get substantially worse in 2017. We would not be surprised to see President Trump threaten Erdogan with expulsion from NATO within his first term. Bottom Line: The biggest risk to our view is that Trump rejects the consensus of the intelligence and defense establishment and pushes Iran too far, leading to conflict. We do not think this will happen, but his rhetoric on the nuclear deal has been consistently negative and he seems likely to favor "Middle East hands" for top cabinet positions. He could involve the country in new Middle East entanglements if he does not show discipline in adhering to his non-interventionist preferences - particularly if he overreacts to an attack. Nonetheless, we believe that America's policy of geopolitical deleveraging from the Middle East will continue. Trump may have a mandate to be tough on terrorism from his voters, but he definitely does not have a free hand to commit military resources to the region. Trump And Asia Trump criticized China furiously during the campaign, declaring that he would name China a currency manipulator on his first day in office and threatening to impose a 45% tariff on Chinese imports. However, there is a familiar pattern of China bashing in U.S. presidential elections that leads to no sharp changes in policy.12 Will Trump be different? Some would argue that relations may actually improve, given how bad they already are. First, Trump's chief concern is to fire up the U.S. economy's animal spirits, and that would support China's ailing economy as long as he does not couple his tax cuts and fiscal stimulus with aggressive protectionist measures (Chart 10). Proponents of this view would point out that Trump's tougher measures may be called off when he realizes that the Chinese current account surplus has fallen sharply in recent years (Chart 11), and that the PBoC is propping up the RMB, not suppressing it. Similarly, Trump's China-bashing trade advisor, the former steel executive Dan DiMicco, may not get much traction given that the U.S. has largely shifted to Brazilian steel imports (Chart 12). In short, the U.S. could take a somewhat tougher stance on specific trade spats without provoking a vicious spiral of discriminatory actions. The fact that the U.S. is more exposed than ever to trade with emerging markets only reinforces the idea that it does not want to spark a real trade war (Chart 13). Chart 10A Trump Boom, Sans Protectionism, Would Lift Chinese Growth Chart 11China's Economy Rebalancing Chart 12China Already Lost The Chart 13A Reason To Eschew Protectionism Second, the Obama administration's "Pivot to Asia" and attempts to undermine China's economic influence in the region through the Trans-Pacific Partnership (TPP) have aggravated China with little substantive gain. By contrast, Trump may emphasize American business access to China over Chinese citizens' freedoms - which could reduce the risk of conflict. He may not go beyond symbolic protectionist moves, like the currency manipulation charge, and meanwhile canceling the never-ratified TPP would be a net gain for China.13 In essence, Trump, despite his populist rhetoric, could prove both pragmatic and willing to inherit the traditional Republican stance of business-oriented positive engagement with China. This is a compelling argument and we take it seriously. But it is not our baseline case. Rather, we think Trump will eventually take concrete populist steps that will mark a departure from U.S. policy in recent memory. As mentioned, it was protectionist blue-collar voters in the Midwest who gave Trump the White House, and he will need to retain their loyalty in coming elections. Moreover, the secular flatlining of American wages and the growth of income inequality have moved the median U.S. voter to the left of the economic spectrum, as we have argued.14 Neo-liberal economic policy has fewer powerful proponents than in the recent past. Thus, in the long run, we expect the grand renegotiation with China to fall short of market hopes, and Sino-American tensions to resume their upward trajectory.15 Why are we so pessimistic? Three main reasons: The "Thucydides Trap": Sino-U.S. tensions are fundamentally driven not by trade disputes but by the U.S.'s fear of China's growing capability and ambition.16 Great conflicts in history have often occurred when a new economic and military power emerged and tried to alter the regional political arrangements set up by the dominant power. This was as true in late nineteenth-century Europe, with the rise of Germany vis-à-vis the U.K. and France (Chart 14), as it was in ancient Greece. The rise of Japan in the first half of the twentieth century had a similar effect in Asia (Chart 15). Trump could, of course, endorse Xi's idea of a "new type of great power relations," which is supposed to avoid this problem. But nobody knows what that would look like, and greater trade openness is the only conceivable foundation for it. Chart 15AThe Disruptive Rise Of Germany Chart 15BThe Disruptive Rise Of Japan China's economic imbalances: A caustic dose of trade remedies from the Trump administration will compound internal economic pressures in China resulting from rampant credit expansion, misallocation of capital, excessive money printing, and capital outflows (Chart 16).17 The combination of internal and external pressures is potentially fatal and China's leaders will fight it. Otherwise, they risk either the fate of the Soviets or of the Asian strongman regimes that succumbed to democracy after embracing capitalism fully. Instead, China will avoid rushing its structural reforms (it is, after all, currently closing its capital account), and protect its consumer market, which it hopes to be the growth engine going forward. This is not a strong basis for the "better deal" that Trump will demand. President Trump will want China to open up further to U.S. manufacturing, tech, and service exports. Economics and the security dilemma: China and the U.S. will not be able to prevent economic tensions from spilling over into broader strategic tensions. Compare the spike in trade tensions with Japan in the 1980s, when Japanese exports to the U.S. peaked and the U.S. strong-armed Japan into appreciating its currency (Chart 17). The U.S. had nurtured Japan and South Korea out of their post-war devastation by running large trade deficits and enabling them to focus on manufacturing exports while minimizing spending on defense. China joined this system in the 1980s and has largely resembled the formal U.S. allies (Chart 18). Given that China has largely followed Japan's path, it was inevitable that the U.S. would eventually lose patience and become more competitive with China. China has seized a greater share of the U.S. market than Japan had done at that time, and its exports are even more important to the U.S. as a share of GDP (Chart 19). Comparing the exchange rates then and now, the Trump administration will be able to argue that China's currency is overdue for appreciation (Chart 20). However, in the 1980s, the U.S. and Japan faced no risk of military conflict - their strategic hierarchy was entirely settled in 1945. The U.S. and China have no such understanding. There is no way of assuring China that U.S. economic pressure is not about strategic dominance. In fact, it is about that. So while China may be cajoled into promising faster reforms - given that its trade surplus with the U.S. is the only thing that stands between it and current account deficits (Chart 21) - nevertheless it will tend to dilute and postpone these reforms for the sake of its own security, putting Trump's resolve to the test. Chart 16Flashing Red Light On China's Economy Chart 17The U.S. Forced Structural Changes On Japan Chart 18Asia Sells, America Rules Chart 19The U.S. Will Get Tougher On China Trade Chart 20China Drags Its Feet On RMB Appreciation Chart 21A Reason For China To Kowtow Trump's victory may also heighten Beijing's fears that it is being surrounded by the U.S. and its partners. That is because Trump will make the following developments more likely: Better Russian relations: From a bird's eye view, Trump's thaw with Putin could mark an inversion of Nixon's thaw with Mao. China is the only power today that can stand a comparison with the Soviet Union during the Cold War. The U.S. at least needs to make sure the Sino-Russian relationship does not become too warm (Chart 22).18 Russo-Japanese peace treaty: The two sides are already working on a treaty, never signed after World War II. Aside from their historic territorial dispute, the U.S. has been the main impediment by demanding Japan help penalize Russia after the invasion of Ukraine. Yet negotiations have advanced regardless, and Japanese air force scrambles against Russia have fallen while those against China have continued to spike (Chart 23). The best chance for a deal since the 1950s is now, with Abe and Putin both solidly in power until 2018. This would reduce Russian dependency on China for energy markets and capital investment, and free up Japan's security establishment to focus on China and North Korea. American allies are not defecting: The United States armed forces are deeply embedded in the Asia Pacific region and setbacks to the "pivot" policy should not be mistaken for setbacks to U.S. power in the absolute.19 U.S. allies like Thailand, the Philippines, and (soon) South Korea are in the headlines for seeking to warm up ties with China, but there is no hard evidence that they will turn away from the U.S. security umbrella. Rather, the pivot reassured them of U.S. commitment, giving them the flexibility to focus on boosting their economies, which means sending emissaries to Beijing. The problem is that Beijing knows this and will therefore still suspect that a "containment" strategy is underfoot over time. Better Indian relations: The Bush administration made considerable progress in improving ties with India. Trump also seems India-friendly, which would be supported by better ties with Russia and Iran. India could therefore become a greater obstacle to China's influence in South and Southeast Asia. Chart 22Energy A Solid Foundation For Sino-Russian Ties Chart 23Japan's Strategic Predicament From the above, we can draw three main conclusions: The U.S. role in the Pacific will determine global geopolitical stability under the Trump administration. The primary question is whether China is willing and able to accede to enough of Trump's demands to ensure that the U.S. and China have at least "one more fling," a further extension to the post-1979 trade relationship. It is possible that China is simply unable to do so and in the face of any concrete sanctions by Trump, will batten down the hatches, rally people around the flag, and shore up the state-led economy. There may be a tactical U.S.-China "improvement" over the next year - relative to the worst fears of trade war under Trump - but it will not be durable. The year 2017 will be the year of Trump's "honeymoon," while Xi Jinping will be focused on internal politics ahead of the Communist Party's crucial National Party Congress in the fall.20 Thus, after Trump gives China a "shot across the bow," like charging it with currency manipulation, the two sides will likely settle down at the negotiating table and send positive signals to the world about their time-tried ability to manage tensions. Financial markets will see through Trump's initially symbolic actions and begin to behave as if nothing has changed in U.S.-China relations. However, this calm will be deceiving, since economic and security tensions will eventually rise to the surface again, likely in a more disruptive way than ever before. China's periphery will be decisive, especially the Korean peninsula. The Koreas could become the locus of East Asia tensions for two reasons. First, North Korea's nuclear weaponization has reached a level that is truly alarming to the U.S. and Japan.21 New sanctions, if enforced, have real teeth because they target commodity exports (Chart 24). The problem is that China is unlikely to enforce them and South Korean politics are likely to turn more China-friendly and more pacific toward the North with the impending change of ruling parties. This will leave the U.S. and Japan with legitimate security grievances but less of an ability to change the outcome through non-military means. That is an arrangement ripe for confrontation. Separately, China's worsening relations with Taiwan, Vietnam's resistance to China's power-grab in the South China Sea, and conflicts between India and Pakistan will be key barometers of regional stability vis-à-vis China. Chart 24Will China Cut Imports From Here? The risk to this view, again, is that a Middle East crisis could distract the Trump administration. This would mark an excellent opportunity for China to build on its growing regional sway, and it would delay our baseline view that the Asia Pacific is now the chief source of geopolitical risk in the world. Investment Conclusions There is no geopolitical risk premium associated with Sino-American tensions. Our clients, colleagues, and friends in the industry are at a loss when we ask how one should hedge tensions in the region. This is a major risk for investors as the market will have to price emerging tensions quickly. Broadly speaking, Sino-American tensions will reinforce the ongoing de-globalization. If the top two global economies are at geopolitical loggerheads, they are more likely to see their geopolitical tensions spill over to the economic sphere. Unwinding globalization implies that inflation will make a comeback, as the reduction in flows of goods, services, capital, and people gradually increases supply constraints. This is primarily bad for bonds, which have enjoyed a bull market for the past three decades that we see reversing.22 At the same time, these trends suggest that investors should favor consumer-oriented sectors and countries relative to their export-reliant counterparts, and small-to-medium sized businesses over externally-exposed multinationals. BCA Geopolitical Strategy's long S&P 600 / short S&P 100 trade is up 7.4% since inceptionon November 9. Finally, these trends, combined with the associated geopolitical risks of various powers struggling for elbow room, warrant a continuation of the Geopolitical Strategy theme of favoring Developed Markets over Emerging Markets, which has made a 45.5% return since inception in November 2012. The centrality of China risk only reinforces this view. Matt Gertken, Associate Editor mattg@bcaresearch.com Marko Papic, Senior Vice President Geopolitical Strategy marko@bcaresearch.com 1 Please see our initial discussion of Trump's foreign policy, "U.S. Election Update: Trump, Presidential Powers, And Investment Implications," in BCA Geopolitical Strategy Monthly Report, "The Socialism Put," dated May 11, 2016, available at gps.bcaresearch.com. 2 Please see BCA Geopolitical Strategy Monthly Report, "Multipolarity And Investing," dated April 9, 2014, available at gps.bcaresearch.com. 3 Please see BCA Geopolitical Strategy Special Report, "The Apex Of Globalization: All Downhill From Here," dated November 12, 2014, and, more recently, "Constraints & Preferences Of The Trump Presidency," dated November 30, 2016, available at gps.bcaresearch.com. 4 Please see "In Focus - Cold War Redux?" in BCA Geopolitical Strategy Monthly Report, "It's A Long Way Down From The 'Wall Of Worry,'" dated March 2014, and Geopolitical Strategy Special Report, "Russia: To Buy Or Not To Buy?" dated March 20, 2015, available at gps.bcaresearch.com. 5 Please see BCA Geopolitical Strategy Special Report, "Russia-West Showdown: The West, Not Putin, Is The 'Wild Card,'" dated July 31, 2014, available at gps.bcaresearch.com. 6 Please see BCA's Emerging Markets Strategy Special Report, "Russia's Trilemma And The Coming Power Paralysis," dated February 21, 2012, available at ems.bcaresearch.com. 7 Please see BCA Geopolitical Strategy Special Report, "Out Of The Vault: Explaining The U.S.-Iran Détente," dated July 15, 2015, available at gps.bcaresearch.com. 8 Please see BCA Geopolitical Strategy Special Report, "End Of An Era For Oil And The Middle East," dated April 8, 2015, available at gps.bcaresearch.com. 9 Please see BCA Geopolitical Strategy Special Report, "Saudi Arabia's Choice: Modernity Or Bust," dated May 11, 2016, available at gps.bcaresearch.com. 10 Please see BCA Geopolitical Strategy Special Report, "Turkey: Strategy After The Attempted Coup," dated July 18, 2016, available at gps.bcaresearch.com. 11 Please see John J. Meirsheimer and Stephen M. Walt, "The Case For Offshore Balancing: A Superior U.S. Grand Strategy," Foreign Affairs, July/August 2016, available at www.foreignaffairs.com. 12 Please see BCA China Investment Strategy, "China As A Currency Manipulator?" dated November 24, 2016, available at cis.bcaresearch.com. 13 One of his foreign policy advisors, former CIA head James Woolsey, has floated the idea that the U.S. could turn positive about Chinese initiatives like the Asian Infrastructure Investment Bank and the One Belt One Road program to link Eurasian economies. Please see Woolsey, "Under Donald Trump, the US will accept China's rise - as long as it doesn't challenge the status quo," South China Morning Post, dated November 10, 2016, available at www.scmp.com. 14 Please see BCA Geopolitical Strategy Special Report, "The End Of The Anglo-Saxon Economy?" dated April 13, 2016, available at gps.bcaresearch.com. 15 Please see BCA Geopolitical Strategy and Global Investment Strategy Joint Special Report, "Sino-American Conflict: More Likely Than You Think, Part II," dated November 6, 2015, available at gps.bcaresearch.com. 16 Please see Graham Allison, "The Thucydides Trap: Are The U.S. And China Headed For War?" The Atlantic, September 24, 2015, available at www.theatlantic.com. 17 Please see BCA Emerging Markets Strategy Special Report, "China's Money Creation Redux And The RMB," dated November 23, 2016, available at ems.bcaresearch.com. 18 Please see BCA Geopolitical Strategy and Emerging Markets Strategy Special Report, "Can Russia Import Productivity From China?" dated June 29, 2016, available at gps.bcaresearch.com. 19 Please see BCA Geopolitical Strategy and Emerging Markets Strategy Special Report, "Philippine Elections: Taking The Shine Off Reform," dated May 11, 2016, available at gps.bcaresearch.com. 20 Please see BCA Geopolitical Strategy Monthly Report, "De-Globalization," dated November 9, 2016, available at gps.bcaresearch.com. 21 Please see "North Korea: A Red Herring No More?" in BCA Geopolitical Strategy Monthly Report, "Partem Mirabilis," dated April 13, 2016, available at gps.bcaresearch.com. 22 Please see BCA Global Investment Strategy Special Report, "End Of The 35-Year Bond Bull Market," dated July 5, 2016, available at gis.bcaresearch.com.

GAA DM Equity Country Allocation Model Update The GAA DM Equity Country Allocation model is updated as of November 30, 2016. The model further augmented the overweight to the U.S. despite the fact that the U.S. had already been the largest overweight, at the expenses of the Euro Area. Japan's underweight is reduced again, albeit slightly. The model continues to dislike Canada and Australia even though the two countries have outperformed year to date. U.K. remains the largest underweight (Table 1). Table 1Model Allocation Vs. Benchmark Weights As shown in Table 2 and Chart 1, Chart 2 and Chart 3, the large overweight of the U.S. versus the non-U.S. (Level 1 model) worked well in November with 49 bps of outperformance versus the MSCI World benchmark, the level 2 (allocation within the 11 non-U.S. countries), however, underperformed significantly, resulting the overall model to underperform by 16 bps. Please see also on the website http://gaa.bcaresearch.com/trades/allocation_performance. Table 2Performance (Total Returns In USD) Chart 1GAA DM Model Vs. MSCI World Chart 2GAA U.S. Vs. Non U.S. Model (Level1) Chart 3GAA Non U.S. Model (Level 2) For more details on the models, please see the January 29th, 2016 Special Report "Global Equity Allocation: Introducing the Developed Markets Country Allocation Model." http://gaa.bcaresearch.com/articles/view_report/18850. GAA Equity Sector Selection Model The GAA Equity Sector Selection Model (Chart 4) is updated as of November 30, 2016. Table 3AllocationsTable 4Performance Since Going Live Chart 4Overall Model Performance The momentum component has shifted Consumer Discretionary from underweight to overweight. For mode details on the model, please see the Special Report "Introducing The GAA Equity Sector Selection Model," July 27, 2016 available at https://gaa.bcaresearch.com. Xiaoli Tang, Associate Vice President xiaoli@bcaresearch.com Patrick Trinh, Senior Analyst patrick@bcaresearch.com Aditya Kurian, Research Analyst adityak@bcaresearch.com

Whether OPEC's announcement of its intention to curtail production actually feeds through into meaningfully lower output next year remains to be seen, but at a minimum, supply discipline should put a floor under prices. Rather than expect the overall energy sector to break out of its lateral move relative to the broad market, we continue to recommend a targeted approach. On the downside, refiners will not receive any relief in feedstock prices, which should ensure that the gap between Brent and WTI prices remains non-existent. That is a strain on refining margins. Our model warns that there is little profit upside ahead. Instead, our preference is to maintain outsized exposure to the oil field services group. Increased E&P confidence that underlying commodity prices could drift toward the top end of their trading should boost drilling activity. The rig count has already troughed. The growth in OECD oil inventories has crested, which is consistent with a gradual rise in the former. We are underweight refiners, overweight oil field services, and neutral on the broad sector.

The abrupt jump in 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 profit drivers. For instance, emerging markets (EM) and the cyclical vs. defensive share price ratio have tended to move hand in hand. The former is pro-cyclical, and outperforms when economic growth prospects are perceived to be improving. Recent sharp EM underperformance has created a large negative divergence with the cyclical vs. defensive share price ratio. The surging U.S. dollar is a growth impediment for many developing countries with large foreign debt liabilities. By extension, the growth impetus required to support deep cyclical sector profit outperformance may be elusive. As a result, we expect re-convergence to occur via a rebound in defensive vs. cyclical sectors.

Highlights An Italian referendum 'no' is not really revolting. Some people are voting no for no change to the current constitution's vital checks and balances. Lean against any knee-jerk widening of the Italian sovereign yield spread versus France that followed a no vote. Lean against any knee-jerk rally in Italian banks that followed a yes vote. A 50bps spike in the JPM Global Government Bond Yield in just 3 months is normally a bad omen for risk-asset performance. Retain a cautious stance to risk-assets on a 3-month horizon. Feature After shock victories for Brexit and Donald Trump at the polls, a 'no' vote in Italy's December 4 referendum on constitutional reform would be the next worrying sign of a growing grassroots revolt against the establishment. Or would it? An Italian 'No' Is Not Really Revolting The votes for Brexit or Donald Trump were clearly votes for change. At first glance, an Italian no would also look like a revolt, with the potential to trigger political uncertainty and instability in the euro area's third largest economy. Chart of the WeekItalian Banks Are Tracking Japanese 'Zombie' Banks The truth is more nuanced. Clearly, some Italians are voting no to reject Prime Minister Renzi. But others - including former Prime Minister Mario Monti - are voting no for no change. These voters want to leave in place the current constitution's vital checks and balances. If Italians vote yes to constitutional reform, the upper house of parliament - the Senate - would be relegated to an advisory chamber. Meanwhile, an already approved new electoral law for the lower house of parliament - the Chamber of Deputies - hands an automatic 55 percent majority of seats to the largest party. Some people fear that this combination would amount to excessive executive power. So they are voting no to mitigate the danger. Granted, a no vote might also force Renzi to resign, but this would not necessarily trigger new elections. President Sergio Mattarella would likely explore options for a new government - perhaps a technocratic government - which the parties in the current governing coalition have a strong incentive to support until the next elections are due in 2018. Even if there were early elections, it is improbable that they would result in a government led by the populist 5 Star Movement. If 5 Star was the largest party, it would hold a 55 percent majority of seats in the lower house, but only 30 percent in the upper house, in proportion to its popular vote share (Chart I-2). Therefore, it could not form a government. Under the current constitution, the government needs the support of both houses. The irony is that a yes vote - by giving the executive excessive powers - would make it more likely for a populist party like 5 Star to form a government in 2018 or beyond. Still, even this might prove a tall order. Italy's constitutional court is reviewing the electoral law change that gives 55 percent of lower house seats to the largest party. The court will likely demand more proportionality, making it hard for any one party to win an outright majority. This means more coalition governments, which 5 Star rejects. Hence, an Italian no will not be the equivalent of the Brexit vote or U.S. election of Donald Trump. Fears that it will unleash a dangerous phase of populism and political instability in Italy are overblown. Yet in the last three months, the Italian sovereign yield spread has widened sharply versus France (Chart I-3). Note also that the 65-day fractal dimension of the Italy versus France sovereign bond performance is close to its technical limit, indicating excessive pessimistic groupthink. Chart I-2The 5 Star Movement Could Not Form A ##br##Government Under The Current Constitution Chart I-3Italy's Political Risk Premium Has ##br##Increased, But Is It Justified? If December 4 brings a no vote in the Italian referendum combined with the election of a far-right President of Austria - whose role is largely ceremonial - the knee-jerk market response might still be fright. In which case, a further widening in the Italy/France yield spread would be a tactical entry opportunity, given that political risk is overstated. Fixing Italian Banks Needs A 'Deep-V' Or A 'Long-L' The real question in Italy is not about an imminent populist backlash. The real question is what does the cure for Italy's banking malaise look like? The answer is either a 'deep-V', meaning a banking crisis forces a quick workout; or a 'long-L', meaning no banking crisis but a very long struggle back to normal health. As an investor, neither seems particularly appealing. Italy's banking malaise has built up stealthily, generating frequent financial tremors but without an outright crisis. In contrast, the housing-related credit booms in Ireland, Spain, the U.K. and the U.S. did eventually cause housing busts and full-blown financial crises - requiring urgent government-led and central bank-led bailouts. Today, Italian banks' non-performing loans (NPLs) account for 18% of gross lending, and NPLs net of provisions equal 85% of equity capital. A few years ago, Irish banks looked even worse. Irish NPLs peaked at 25% of gross lending in 2013 and net NPLs peaked at 100% of equity capital. Following government bailouts Irish banks have recovered well (Chart I-4 and Chart I-5). Likewise, the Spanish government created a 'bad bank' in 2012 to offload bank NPLs. Subsequently, Spanish banks' NPLs as a share of gross lending has almost halved. Chart I-4Ireland Looked Worse Than Italy##br## For NPLs As A Share Of Loans Chart I-5Ireland Looked Worse Than Italy ##br##For NPLs As A Share Of Capital Compared to Ireland and Spain, Italy's avoidance of outright crisis (thus far) appears a blessing. Unfortunately, it is now a curse. In waiting so long, Italy cannot follow Ireland, Spain, the U.K. and the U.S. in their escapes from their banking woes. The EU Bank Recovery and Resolution Directive (BRRD), which came into full force on January 1 2016, has blocked the bailout escape route. The BRRD does allow state intervention in a banking crisis. But the overarching aim is to protect banks' critical functions and stakeholders, specifically: payment systems, taxpayers and depositors. Therefore, in a banking crisis "other parts may be allowed to fail in the normal way... after shares in full... then evenly on holders of subordinated bonds and then evenly on senior bondholders." For bank investors, this would constitute the 'deep-V' cure: likely intense pain up-front albeit with much better long-term prospects thereafter. Alternatively, without a crisis, the process to recognise and expunge NPLs would be largely up to the private sector and markets. But a long chain of events from the repossession of assets under bankruptcy law, to valuation, to full divestment from the banks' balance sheets could take years. Indeed, the Chart of the Week shows a striking parallel between Italian bank profits and Japan's 'zombie' bank profits, if we lag the Japanese experience by 17 years. Japan perfectly illustrates this alternative 'long-L' cure: no outright crisis, just a long and seemingly never-ending struggle back to normal health. Either way, absent any further information, we would lean against any knee-jerk rally in Italian banks that followed a yes vote on December 4. What Happens When Bond Yields Spike? Turning to the broader financial markets, a bigger concern is the impact that sharply higher bond yields will have on growth and/or on risk-asset valuations. Higher long-term borrowing costs depress credit growth as captured in the credit impulse (Chart I-6 and Chart I-7). A depressed credit impulse then almost always drags down subsequent GDP growth. The recent spike in U.S. 15-year and 30-year mortgage rates has already caused mortgage refinancing applications to plunge by 40% since July (Chart I-8). Chart I-6Higher Bond Yields Depress##br## Credit Growth In Europe... Chart I-7...And In ##br##The U.S. Chart I-8Mortgage Applications##br## Have Plunged Prior to the current incidence, a 50bps rise in the JPM Global Government Bond Yield in just 3 months has occurred only eight times this century (Chart I-9). Table I-1 lists those eight occasions and the subsequent 3-month performance of the equity market. On three out of the eight occasions, the equity market rose modestly, but on the other five it fell. Chart I-9The Bond Yield Has Spiked Table I-1What Happens When Bond Yields Spike? But perhaps the most interesting finding is that on all eight occasions, the equity market's subsequent 3-month performance consistently deteriorated, on average by -7%, compared to the preceding 3-month performance. For reference, today's preceding 3-month performance is just 0.7%. Given this evidence, it is prudent to retain a cautious stance to risk-assets on a 3-month horizon. Dhaval Joshi, Senior Vice President European Investment Strategy dhaval@bcaresearch.com Fractal Trading Model* The Italy versus France sovereign bond underperformance indicates excessive pessimistic groupthink. However, in this instance we would wait until after Italy's December 4 referendum on constitutional reform before initiating the countertrend trade. For any investment, excessive trend following and groupthink can reach a natural point of instability, at which point the established trend is highly likely to break down with or without an external catalyst. An early warning sign is the investment's fractal dimension approaching its natural lower bound. Encouragingly, this trigger has consistently identified countertrend moves of various magnitudes across all asset classes. Chart I-10 * For more details please see the European Investment Strategy Special Report "Fractals, Liquidity & A Trading Model," dated December 11, 2014, available at eis.bcaresearch.com The post-June 9, 2016 fractal trading model rules are: When the fractal dimension approaches the lower limit after an investment has been in an established trend it is a potential trigger for a liquidity-triggered trend reversal. Therefore, open a countertrend position. The profit target is a one-third reversal of the preceding 13-week move. Apply a symmetrical stop-loss. Close the position at the profit target or stop-loss. Otherwise close the position after 13 weeks. Use the position size multiple to control risk. The position size will be smaller for more risky positions. Fractal Trading Model Recommendations Equities Bond & Interest Rates Currency & Other Positions Closed Fractal Trades Trades Closed Trades Asset Performance Currency & Bond Equity Sector Country Equity Indicators Bond Yields Chart II-1Indicators To Watch - Bond Yields Chart II-2Indicators To Watch - Bond Yields Chart II-3Indicators To Watch - Bond Yields Chart II-4Indicators To Watch - Bond Yields Interest Rate Chart II-5Indicators To Watch##br## - Interest Rate Expectations Chart II-6Indicators To Watch ##br##- Interest Rate Expectations Chart II-7Indicators To Watch##br## - Interest Rate Expectations Chart II-8Indicators To Watch ##br##- Interest Rate Expectations